diff --git a/API_request.py b/API_request.py new file mode 100644 index 0000000..3489d74 --- /dev/null +++ b/API_request.py @@ -0,0 +1,58 @@ +import os +import requests +import json +from pathlib import Path +import time + +# Constants +API_URL = "https://openrouter.ai/api/v1/chat/completions" +OPENROUTER_API_KEY = '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' # Secure this in your environment or a config file +CLEANED_TEXT_DIR = 'src/data/cleaned-sec-edgar-filings' +OUTPUT_DIR = 'src/data/output-responses' +REQUEST_INTERVAL = 60 # seconds to wait between requests to manage API rate limit + +def make_request(text): + prompt = """ + "Please provide a comprehensive financial analysis including year-over-year growth, key financial ratios, and a detailed discussion on expenses and revenue sources. Compare these figures to industry averages and discuss any significant deviations." + """ + headers = { + "Authorization": f"Bearer {OPENROUTER_API_KEY}", + "Content-Type": "application/json" + } + data = json.dumps({ + "model": "mistralai/mistral-7b-instruct:free", + "messages": [{"role": "user", "content": text + prompt}] + }) + response = requests.post(API_URL, headers=headers, data=data) + if response.status_code == 200: + return response.json() + else: + print(f"Failed to fetch data: {response.status_code}, {response.text}") + return None + +def save_response(response, filename): + """Save the response data to a JSON file.""" + os.makedirs(OUTPUT_DIR, exist_ok=True) # Ensure the output directory exists + file_path = os.path.join(OUTPUT_DIR, filename) + with open(file_path, 'w', encoding='utf-8') as f: + json.dump(response, f, indent=4) + print(f"Response saved to {file_path}") + +def process_text_files(): + pathlist = Path(CLEANED_TEXT_DIR).rglob('*.txt') # Find all .txt files recursively + for path in pathlist: + file_path = str(path) + print(f"Processing file: {file_path}") + with open(file_path, 'r', encoding='utf-8') as file: + text_content = file.read() + + response = make_request(text_content) + if response: + print("Received response:", response) + # Create a filename from the path to save the response + response_filename = f"{path.stem}_response.json" + save_response(response, response_filename) + time.sleep(REQUEST_INTERVAL) # Respect the API rate limit + +if __name__ == '__main__': + process_text_files() diff --git a/pre_processing.py b/pre_processing.py new file mode 100644 index 0000000..b1851a0 --- /dev/null +++ b/pre_processing.py @@ -0,0 +1,141 @@ +import os +from bs4 import BeautifulSoup +from pathlib import Path + +# Define the root directory where the original filings are stored and the directory to save cleaned text +ROOT_DIRECTORY = 'src/data/sec-edgar-filings' +CLEANED_TEXT_DIR = 'src/data/cleaned-sec-edgar-filings' + +# Ensure the directory for cleaned text exists +os.makedirs(CLEANED_TEXT_DIR, exist_ok=True) + +# Function to clean and extract text using Beautiful Soup +def clean_html(content): + soup = BeautifulSoup(content, 'html.parser') + + # Remove script, style, and meta tags as they do not contain relevant text + for script_or_style in soup(["script", "style", "meta"]): + script_or_style.decompose() + + # Attempt to find the main content div by inspecting common tags used for main content + # Modify this according to actual document structure observed + main_content = soup.find('div', attrs={'class': 'document'}) + if not main_content: + main_content = soup.body # Fallback to using the entire body if specific div is not found + + # Extracting text and reducing whitespace + text = ' '.join(main_content.stripped_strings if main_content else []) + return text + +# Function to read file, clean content, and save the cleaned text +def process_file(file_path, output_dir): + try: + with open(file_path, 'r', encoding='utf-8') as file: + content = file.read() + cleaned_text = clean_html(content) + + # Construct a new path in the cleaned directory with the same file structure + relative_path = os.path.relpath(file_path, ROOT_DIRECTORY) + new_path = os.path.join(output_dir, relative_path) + os.makedirs(os.path.dirname(new_path), exist_ok=True) + + with open(new_path, 'w', encoding='utf-8') as file: + file.write(cleaned_text) + print(f"Saved cleaned text to {new_path}") + except Exception as e: + print(f"Failed to process file {file_path}: {e}") + +# Main function to walk through the directory structure and process each filing +def process_filings(root_dir, output_dir): + pathlist = Path(root_dir).rglob('*.txt') # Find all .txt files recursively + for path in pathlist: + file_path = str(path) + print(f"Processing file: {file_path}") + process_file(file_path, output_dir) + +if __name__ == '__main__': + process_filings(ROOT_DIRECTORY, CLEANED_TEXT_DIR) + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + + +# import os +# from bs4 import BeautifulSoup +# from pathlib import Path + +# # Define the root directory where original filings are stored and the directory to save cleaned text +# ROOT_DIRECTORY = 'src/data/sec-edgar-filings' +# CLEANED_TEXT_DIR = 'src/data/cleaned-sec-edgar-filings' + +# # Ensure the directory for cleaned text exists +# os.makedirs(CLEANED_TEXT_DIR, exist_ok=True) + +# # Function to extract text using Beautiful Soup +# def extract_text(file_path): +# try: +# with open(file_path, 'r', encoding='utf-8') as file: +# content = file.read() +# soup = BeautifulSoup(content, 'html.parser') +# text = soup.get_text() +# return text +# except Exception as e: +# print(f"Failed to process file {file_path}: {e}") +# return None + +# # Function to save the cleaned text to a new file +# def save_cleaned_text(text, original_path): +# try: +# # Construct a new path in the cleaned directory with the same file structure +# relative_path = os.path.relpath(original_path, ROOT_DIRECTORY) +# new_path = os.path.join(CLEANED_TEXT_DIR, relative_path) +# os.makedirs(os.path.dirname(new_path), exist_ok=True) +# with open(new_path, 'w', encoding='utf-8') as file: +# file.write(text) +# print(f"Saved cleaned text to {new_path}") +# except Exception as e: +# print(f"Failed to save cleaned text for {original_path}: {e}") + +# # Main function to process all filings +# def process_filings(): +# pathlist = Path(ROOT_DIRECTORY).rglob('*.txt') # Find all .txt files recursively +# for path in pathlist: +# file_path = str(path) +# print(f"Processing file: {file_path}") +# extracted_text = extract_text(file_path) +# if extracted_text: +# save_cleaned_text(extracted_text, file_path) + +# if __name__ == '__main__': +# process_filings() \ No newline at end of file diff --git a/requirements.txt b/requirements.txt index 1fba7e0..01e9ae3 100644 --- a/requirements.txt +++ b/requirements.txt @@ -1,3 +1,7 @@ pandas flask -sec_edgar_downloader \ No newline at end of file +sec_edgar_downloader +matplotlib +plotly +json +bs4 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-17-000070/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-17-000070/full-submission.txt new file mode 100644 index 0000000..d02127f --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-17-000070/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 30, 2017 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) (408) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.00001 par value per share 1.000% Notes due 2022 1.375% Notes due 2024 0.875% Notes due 2025 1.625% Notes due 2026 2.000% Notes due 2027 1.375% Notes due 2029 3.050% Notes due 2029 3.600% Notes due 2042 The Nasdaq Stock Market LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC (Title of each class) (Name of each exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ (Do not check if a smaller reporting company) Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 31, 2017 , the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $747,509,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 5,134,312,000 shares of common stock were issued and outstanding as of October 20, 2017 . DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2018 annual meeting of shareholders (the “ 2018 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2018 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 30, 2017 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 8 Item 1B. Unresolved Staff Comments 16 Item 2. Properties 17 Item 3. Legal Proceedings 17 Item 4. Mine Safety Disclosures 17 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 18 Item 6. Selected Financial Data 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 36 Item 8. Financial Statements and Supplementary Data 38 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 72 Item 9A. Controls and Procedures 72 Item 9B. Other Information 72 Part III Item 10. Directors, Executive Officers and Corporate Governance 73 Item 11. Executive Compensation 73 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 73 Item 13 . Certain Relationships and Related Transactions, and Director Independence 73 Item 14. Principal Accounting Fees and Services 73 Part IV Item 15. Exhibits, Financial Statement Schedules 74 Item 16. Form 10-K Summary 76 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , Apple Watch ® , Apple TV ® , a portfolio of consumer and professional software applications, iOS, macOS ® , watchOS ® and tvOS™ operating systems, iCloud ® , Apple Pay ® and a variety of accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store ® , App Store ® , Mac App Store, TV App Store, iBooks Store ® and Apple Music ® (collectively “Digital Content and Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software and services to provide its customers products and solutions with innovative design, superior ease-of-use and seamless integration. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of digital content and applications through its Digital Content and Services, which allows customers to discover and download digital content, iOS, Mac, Apple Watch and Apple TV applications, and books through either a Mac or Windows personal computer or through iPhone, iPad and iPod touch ® devices (“iOS devices”), Apple TV and Apple Watch. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. Therefore, the Company’s strategy also includes building and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience. The Company believes ongoing investment in research and development (“R&D”), marketing and advertising is critical to the development and sale of innovative products, services and technologies. Business Organization The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments may be found in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Apple Inc. | 2017 Form 10-K | 1 Products iPhone iPhone is the Company’s line of smartphones based on its iOS operating system. iPhone includes Siri ® , a voice-activated intelligent assistant, and Apple Pay and Touch ID ® on qualifying devices. In September 2017, the Company introduced iPhone 8 and 8 Plus, featuring a new glass and aluminum design, enhanced cameras and speakers, wireless charging and augmented reality optimization. Additionally, in September 2017, the Company announced iPhone X, featuring an all-glass design with a Super Retina™ OLED display and facial recognition. iPhone 8 and 8 Plus were available starting in September 2017, and iPhone X is expected to be available in November 2017. The Company’s line of smartphones also includes iPhone 7, 7 Plus, 6s, 6s Plus and SE models. iPhone works with the iTunes Store, App Store, iBooks Store and Apple Music for purchasing, organizing and playing digital content and apps. iPad iPad is the Company’s line of multi-purpose tablets based on its iOS operating system, which includes iPad Pro ® , iPad and iPad mini™. iPad includes Siri, Apple Pay and Touch ID. In June 2017, the Company released a new 10.5-inch iPad Pro and an updated 12.9-inch iPad Pro with more advanced displays and enhanced performance. iPad works with the iTunes Store, App Store, iBooks Store and Apple Music for purchasing, organizing and playing digital content and apps. Mac Mac is the Company’s line of desktop and portable personal computers based on its macOS operating system. Mac includes Siri and Apple Pay and also includes Touch ID on qualifying devices. The Company’s desktop computers include iMac ® , 21.5” iMac with Retina ® 4K display, 27” iMac with Retina 5K display, Mac Pro ® and Mac mini ® . In June 2017, the Company announced the new iMac Pro™, which is expected to be available in December 2017. The Company’s portable computers include MacBook ® , MacBook Air ® , MacBook Pro ® and MacBook Pro with Touch Bar™. Operating Systems iOS iOS is the Company’s mobile operating system that serves as the foundation for iOS devices. Devices running iOS are compatible with both Mac and Windows personal computers and Apple’s iCloud services. In September 2017, the Company released iOS 11, which includes new iPad features, new capabilities to improve images in Photos and Camera, enhanced Siri functionality and a redesigned App Store. iOS 11 also introduces ARKit, an augmented reality framework for developers. macOS macOS is the Company’s desktop operating system and is built on an open-source UNIX-based foundation and provides an intuitive and integrated computer experience. Support for iCloud is built into macOS so users can access content and information from Mac, iOS devices and other supported devices and access downloaded content and apps from the iTunes Store. macOS High Sierra, released in September 2017, is the 14th major release of macOS and incorporates new storage, video and graphics technologies, and includes improvements to Photos, Safari ® and Mail. watchOS watchOS is the Company’s operating system for Apple Watch. In September 2017, the Company released watchOS 4, which adds a proactive Siri watch face that displays the information users need most throughout the day, personalized activity coaching and a new music experience. watchOS 4 also includes an enhanced Workout app and introduces GymKit™, a technology platform that offers users connected workouts with cardio equipment. tvOS tvOS is the Company’s operating system for Apple TV. The tvOS operating system is based on the Company’s iOS platform and enables developers to create new apps and games specifically for Apple TV and deliver them to customers through the Apple TV App Store. tvOS incorporates Siri capabilities that allow searching across apps and services. Apple Inc. | 2017 Form 10-K | 2 Application Software The Company’s application software includes iWork ® and various other software, including Final Cut Pro ® , Logic Pro ® X and FileMaker ® Pro. iWork is the Company’s integrated productivity suite included with all Mac computers and is designed to help users create, present and publish documents through Pages ® , presentations through Keynote ® and spreadsheets through Numbers ® . The Company also has Multi-Touch™ versions of iWork applications designed specifically for use on iOS devices, which are available as free downloads for all new iOS devices. Services Digital Content and Services The iTunes Store, available for iOS devices, Mac and Windows personal computers and Apple TV, allows customers to purchase and download music and TV shows, rent or purchase movies and download free podcasts. The App Store, available for iOS devices, allows customers to discover and download apps and purchase in-app content. The Mac App Store, available for Mac computers, allows customers to discover, download and install Mac applications. The TV App Store allows customers access to apps and games specifically for Apple TV. The iBooks Store, available for iOS devices and Mac computers, features e-books from major and independent publishers. Apple Music offers users a curated listening experience with on-demand radio stations that evolve based on a user’s play or download activity and a subscription-based internet streaming service that also provides unlimited access to the Apple Music library. iCloud iCloud is the Company’s cloud service which stores music, photos, contacts, calendars, mail, documents and more, keeping them up-to-date and available across multiple iOS devices, Mac and Windows personal computers and Apple TV. iCloud services include iCloud Drive ® , iCloud Photo Library, Family Sharing, Find My iPhone, iPad or Mac, Find My Friends, Notes, iCloud Keychain ® and iCloud Backup for iOS devices. AppleCare The Company offers a range of support options for its customers. These include assistance that is built into software products, electronic product manuals, online support including comprehensive product information as well as technical assistance, the AppleCare ® Protection Plan (“APP”) and AppleCare+ (“AC+”). APP and AC+ are fee-based services that extend the coverage of phone support eligibility and hardware warranty repairs. APP and AC+ offer additional coverage under some circumstances for instances of accidental damage and are available in certain countries for certain products. Apple Pay Apple Pay is the Company’s cashless payment service available in certain countries that offers an easy, secure and private way to pay. Apple Pay allows users to pay for purchases in participating stores accepting contactless payments and to pay for purchases within participating apps on qualifying devices. Apple Pay accepts credit and debit cards across major card networks and also supports reward programs and store-issued credit and debit cards. The Company expects to release an update to iOS 11 and watchOS 4 in fall 2017 that will allow peer-to-peer payments using Apple Pay. Other Products Accessories The Company sells a variety of Apple-branded and third-party accessories, including Beats ® products, headphones, displays, storage devices, and various other connectivity and computing products and supplies. In December 2016, the Company released AirPods ® , new wireless headphones that interact with Siri. Additionally, in June 2017, the Company announced the HomePod™ wireless speaker and in September 2017, announced AirPower™, a new wireless charging accessory, which are expected to be available in December 2017 and calendar year 2018, respectively. Apple TV Apple TV connects to consumers’ TVs and enables them to access digital content directly for streaming video, playing music and games, and viewing photos. Content from Apple Music and other media services is also available on Apple TV. Apple TV allows streaming digital content from Mac and Windows personal computers through Home Share and from compatible Mac and iOS devices through AirPlay ® . Apple TV runs on the Company’s tvOS operating system and is based on apps built for the television. Additionally, the Apple TV remote features Siri, allowing users to search and access content with their voice. In September 2017, the Company introduced Apple TV 4K, which supports 4K and High Dynamic Range content, providing customers with enhanced picture quality. Apple Inc. | 2017 Form 10-K | 3 Apple Watch Apple Watch is a personal electronic device that combines the watchOS user interface and technologies created specifically for a smaller device, including the Digital Crown™, a unique navigation tool that allows users to seamlessly scroll, zoom and navigate, and Force Touch, a technology that senses the difference between a tap and a press and allows users to access controls within apps. Apple Watch enables users to communicate in new ways from their wrist, track their health and fitness through activity and workout apps, and includes Siri and Apple Pay. In September 2017, the Company introduced Apple Watch Series 3, featuring health and fitness enhancements and built-in cellular capability on qualifying devices. iPod touch iPod touch, based on the Company’s iOS operating system, is a flash memory-based digital music and media player that works with the iTunes Store, App Store, iBooks Store and Apple Music for purchasing and playing digital content and apps. Developer Programs The Company’s developer programs support app developers with building, testing and distributing apps for iOS, macOS, watchOS and tvOS. Developer program membership provides access to beta software and advanced app capabilities (e.g., CloudKit ® , HealthKit™ and Apple Pay), the ability to test apps using TestFlight ® , distribution on the App Store, access to App Analytics and code-level technical support. Developer programs also exist for businesses creating apps for internal use (the Apple Developer Enterprise Program) and developers creating accessories for Apple devices (the MFi Program). All developers, even those who are not developer program members, can sign in with their Apple ID to post on the Apple Developer Forums and use Xcode ® , the Company’s integrated development environment for creating apps for Apple platforms. Xcode includes project management tools; analysis tools to collect, display and compare app performance data; simulation tools to locally run, test and debug apps; and tools to simplify the design and development of user interfaces. All developers also have access to extensive technical documentation and sample code. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers and small and mid-sized businesses through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and value-added resellers. During 2017 , the Company’s net sales through its direct and indirect distribution channels accounted for 28% and 72%, respectively, of total net sales. The Company believes that sales of its innovative and differentiated products and services are enhanced by knowledgeable salespersons who can convey the value of the hardware and software integration and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company continues to build and improve its distribution capabilities by expanding the number of its own retail stores worldwide. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable high-traffic locations the Company is better positioned to ensure a high-quality customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and related solutions. The retail stores employ experienced and knowledgeable personnel who provide product advice, service and training, and offer a wide selection of third-party hardware, software and other accessories that complement the Company’s products. The Company has also invested in programs to enhance reseller sales by placing high-quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a high level of product expertise, integration and support services. The Company is committed to delivering solutions to help educators teach and students learn. The Company believes effective integration of technology into classroom instruction can result in higher levels of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also supports mobile learning and real-time distribution of, and access to, education-related materials through iTunes U ® , a platform that allows students and teachers to share and distribute educational media online. The Company sells its products to the education market through its direct sales force, select third-party resellers and its retail and online stores. Apple Inc. | 2017 Form 10-K | 4 The Company also sells its hardware and software products to enterprise and government customers in each of its reportable segments. The Company’s products are deployed in these markets because of their performance, productivity, ease-of-use and seamless integration into information technology environments. The Company’s products are compatible with thousands of third-party business applications and services, and its tools enable the development and secure deployment of custom applications as well as remote device administration. No single customer accounted for more than 10% of net sales in 2017 , 2016 and 2015 . Competition The markets for the Company’s products and services are highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the capabilities and use of mobile communication and media devices, personal computers and other digital electronic devices. Many of the Company’s competitors that sell mobile devices and personal computers based on other operating systems seek to compete primarily through aggressive pricing and very low cost structures. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. Principal competitive factors important to the Company include price, product features (including security features), relative price and performance, product quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support and corporate reputation. The Company is focused on expanding its market opportunities related to personal computers and mobile communication and media devices. These markets are highly competitive and include many large, well-funded and experienced participants. The Company expects competition in these markets to intensify significantly as competitors attempt to imitate some of the features of the Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. These markets are characterized by aggressive price competition, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors and price sensitivity on the part of consumers and businesses. The Company’s digital content services have faced significant competition from other companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company’s future financial condition and operating results depend on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets in which it competes. The Company believes it offers superior innovation and integration of the entire solution including the hardware (iOS devices, Mac, Apple Watch and Apple TV), software (iOS, macOS, watchOS and tvOS), online services and distribution of digital content and applications (Digital Content and Services). Some of the Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, a few components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. Apple Inc. | 2017 Form 10-K | 5 Substantially all of the Company’s hardware products are currently manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s manufacturing purchase obligations typically cover its requirements for periods up to 150 days . Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through R&D, licensing of intellectual property and acquisition of third-party businesses and technology. Total R&D expense was $ 11.6 billion , $ 10.0 billion and $ 8.1 billion in 2017 , 2016 and 2015 , respectively. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, copyrights, trademarks, service marks, trade dress and other forms of intellectual property rights in the U.S. and a number of foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents, including utility patents, design patents and others. The Company also holds copyrights relating to certain aspects of its products and services. No single intellectual property right is solely responsible for protecting the Company’s products. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products. Many of the Company’s products are designed to include intellectual property obtained from third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of its products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage and the rapid rate of issuance of new patents, it is possible that certain components of the Company’s products, processes and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data During 2017 , the Company’s domestic and international net sales accounted for 37% and 63% , respectively, of total net sales. Information regarding financial data by geographic segment is set forth in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Substantially all of the Company’s hardware products are currently manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. The supply and manufacture of a number of components is performed by sole-sourced outsourcing partners in the U.S., Asia and Europe. Margins on sales of the Company’s products in foreign countries and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. Information regarding concentration in the available sources of supply of materials and products is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies.” Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new product inventory following a product introduction, and often, channel inventory of a particular product declines as the next related major product launch approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. However, neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, future net sales or financial performance. Apple Inc. | 2017 Form 10-K | 6 Warranty The Company offers a limited parts and labor warranty on its hardware products. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day limited warranty on the service parts used to repair the Company’s hardware products. In certain jurisdictions, local law requires that manufacturers guarantee their products for a period prescribed by statute, typically at least two years. In addition, where available, consumers may purchase APP or AC+, which extends service coverage on many of the Company’s hardware products. Backlog In the Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases immediately following new product introductions as customers anticipate shortages. Backlog is often reduced once customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial performance. Employees As of September 30, 2017 , the Company had approximately 123,000 full-time equivalent employees. Available Infor mation The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities and Exchange Commission (the “SEC”). The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at investor.apple.com/sec.cfm when such reports are available on the SEC’s website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2017 Form 10-K | 7 Item 1A. Risk Factors The following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding other statements in this Form 10-K. The following information should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price. Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Global and regional economic conditions could materially adversely affect the Company. The Company’s operations and performance depend significantly on global and regional economic conditions. Uncertainty about global and regional economic conditions poses a risk as consumers and businesses may postpone spending in response to tighter credit, higher unemployment, financial market volatility, government austerity programs, negative financial news, declines in income or asset values and/or other factors. These worldwide and regional economic conditions could have a material adverse effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations as a result of currency fluctuations because the Company generally raises prices on goods and services sold outside the U.S. to correspond with the effect of a strengthening of the U.S. dollar. Other factors that could influence worldwide or regional demand include changes in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare costs, access to credit, consumer confidence and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services. In the event of financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be tightening in the credit markets, low liquidity and extreme volatility in fixed income, credit, currency and equity markets. This could have a number of effects on the Company’s business, including the insolvency or financial instability of outsourcing partners or suppliers or their inability to obtain credit to finance development and/or manufacture products, resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the Company’s products; failure of derivative counterparties and other financial institutions; and restrictions on the Company’s ability to issue new debt. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting from revaluations of debt and equity securities and other investments; changes in interest rates; increases or decreases in cash balances; volatility in foreign exchange rates; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk of the actual amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services compete in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors and price sensitivity on the part of consumers. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. The Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. Apple Inc. | 2017 Form 10-K | 8 The Company markets certain mobile communication and media devices based on the iOS mobile operating system and also markets related services, including third-party digital content and applications. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships; and the Company has a minority market share in the global smartphone market. Additionally, the Company faces significant competition as competitors reduce their selling prices and attempt to imitate the Company’s product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. Some of the Company’s competitors have greater experience, product breadth and distribution channels than the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide products and services at little or no profit or even at a loss. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to maintain their functional and design advantages. The Company is the only authorized maker of hardware using macOS, which has a minority market share in the personal computer market. This market has been contracting and is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and accessories, the Company faces a significant number of competitors, many of which have broader product lines, lower-priced products and a larger installed customer base. Historically, consolidation in this market has resulted in larger competitors. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. An increasing number of internet-enabled devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s existing products. The Company’s financial condition and operating results also depend on its ability to continually improve the Mac platform to maintain its functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and successfully manage the transition to these new and upgraded products. The success of new product introductions depends on a number of factors including, but not limited to, timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand and the risk that new products may have quality or other defects or deficiencies in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions. The Company depends on the performance of distributors, carriers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers and value-added resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers and consumers and small and mid-sized businesses through its retail and online stores. Some carriers providing cellular network service for iPhone subsidize users’ purchases of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. Apple Inc. | 2017 Form 10-K | 9 The Company faces substantial inventory and other asset risk in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its provisions related to inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently adequate, no assurance can be given that the Company will not incur additional related charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company must order components for its products and build inventory in advance of product announcements and shipments. Manufacturing purchase obligations typically cover forecasted component and manufacturing requirements for periods up to 150 days . Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. While the Company has entered into agreements for the supply of many components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. A number of suppliers of components may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms. The effects of global or regional economic conditions on the Company’s suppliers, described in “ Global and regional economic conditions could materially adversely affect the Company” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected for any number of reasons, including if those suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The supply of components for a new or existing product could be delayed or constrained, or a key manufacturing vendor could delay shipments of completed products to the Company. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by a few outsourcing partners located primarily in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect or warranty liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on sole-sourced outsourcing partners in the U.S., Asia and Europe to supply and manufacture many critical components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform may have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, military actions or economic, business, labor, environmental, public health, or political issues. The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply could be reduced or terminated and the net realizable value of these assets could be negatively impacted. Apple Inc. | 2017 Form 10-K | 10 The Company’s products and services may experience quality problems from time to time that can result in decreased sales and operating margin and harm to the Company’s reputation. The Company sells complex hardware and software products and services that can contain design and manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. The Company’s online services may from time to time experience outages, service slowdowns or errors. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, significant warranty and other expenses and harm to the Company’s reputation. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell currently available music, movies, TV shows and books. The licensing or other distribution arrangements with these third parties are for relatively short terms and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license or otherwise distribute their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make third-party digital content available, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s financial condition and operating results. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. With respect to its Mac products, the Company believes the availability of third-party software applications and services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software for the Company’s products compared to Windows-based products. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of Mac sales and the costs of developing such applications and services. If the Company’s minority share of the global personal computer market causes developers to question the Mac’s prospects, developers could be less inclined to develop or upgrade software for the Company’s Mac products and more inclined to devote their resources to developing and upgrading software for the larger Windows market. With respect to iOS devices, the Company relies on the continued availability and development of compelling and innovative software applications, including applications distributed through the App Store. iOS devices are subject to rapid technological change, and, if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied customers. As with applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the relative benefits of developing, maintaining or upgrading software for the Company’s iOS devices rather than its competitors’ platforms, such as Android. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s iOS devices may suffer. Apple Inc. | 2017 Form 10-K | 11 The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products include third-party intellectual property, which requires licenses from those third parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on acceptable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products or otherwise have a material adverse impact on the Company’s financial condition and operating results. The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights. The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and have not yet been fully resolved, and new claims may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which may subject the Company to costs and damages in the event of a claim against an indemnified third party. Claims against the Company based on allegations of patent infringement or other violations of intellectual property rights have generally increased over time and may continue to increase. In particular, the Company has historically faced a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and before the U.S. International Trade Commission, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, litigation may be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into licensing agreements or other arrangements to settle litigation and resolve such disputes. No assurance can be given that such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements may also significantly increase the Company’s operating expenses. In management’s opinion, there is not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain. Although management considers the likelihood of such an outcome to be remote, if one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. The Company is subject to laws and regulations worldwide, changes to which could increase the Company’s costs and individually or in the aggregate adversely affect the Company’s business. The Company is subject to laws and regulations affecting its domestic and international operations in a number of areas. These U.S. and foreign laws and regulations affect the Company’s activities including, but not limited to, in areas of labor, advertising, digital content, consumer protection, real estate, billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import and export requirements, anti-corruption, foreign exchange controls and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health and safety. By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes could include, among others, restrictions on the production, manufacture, distribution and use of devices, locking devices to a carrier’s network, or mandating the use of devices on more than one carrier’s network. These devices are also subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications, or delays in product shipment dates, or could preclude the Company from selling certain products. Apple Inc. | 2017 Form 10-K | 12 Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent from jurisdiction to jurisdiction, further increasing the cost of compliance and doing business. Any such costs, which may rise in the future as a result of changes in these laws and regulations or in their interpretation, could individually or in the aggregate make the Company’s products and services less attractive to the Company’s customers, delay the introduction of new products in one or more regions, or cause the Company to change or limit its business practices. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies and procedures. The Company’s business is subject to the risks of international operations. The Company derives a significant portion of its revenue and earnings from its international operations. Compliance with applicable U.S. and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy requirements, environmental laws, labor laws and anti-competition regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with these laws and regulations, a violation by the Company’s employees, contractors or agents could nevertheless occur. In some cases, compliance with the laws and regulations of one country could violate the laws and regulations of another country. Violations of these laws and regulations could materially adversely affect the Company’s brand, international growth efforts and business. The Company also could be significantly affected by other risks associated with international activities including, but not limited to, economic and labor conditions, increased duties, taxes and other costs and political instability. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by international trade regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its trade receivables with customers in certain international markets. There can be no assurance the Company can effectively limit its credit risk and avoid losses. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and uncertainties. These risks and uncertainties include, but are not limited to, macro-economic factors that could have an adverse effect on general retail activity, as well as the Company’s inability to manage costs associated with store construction and operation, the Company’s failure to manage relationships with its existing retail partners, more challenging environments in managing retail operations outside the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and the Company’s inability to obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital and unidentified issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. The Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company may be subject to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. System redundancy and other continuity measures may be ineffective or inadequate, and the Company’s business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s reputation, financial condition and operating results. Apple Inc. | 2017 Form 10-K | 13 There may be losses or unauthorized access to or releases of confidential information, including personally identifiable information, that could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information, including, among other things, personally identifiable information (“PII”) with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information may still occur, which could materially adversely affect the Company’s reputation, financial condition and operating results. The Company’s business also requires it to share confidential information with suppliers and other third parties. Although the Company takes steps to secure confidential information that is provided to third parties, such measures may not be effective and losses or unauthorized access to or releases of confidential information may still occur, which could materially adversely affect the Company’s reputation, financial condition and operating results. For example, the Company may experience a security breach impacting the Company’s information technology systems that compromises the confidentiality, integrity or availability of confidential information. Such an incident could, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the Company’s stock price, materially damage supplier relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Although malicious attacks perpetrated to gain access to confidential information, including PII, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties may attempt to fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, may result in the delay or loss of customer orders or impede customer access to the Company’s products and services. In addition to the risks relating to general confidential information described above, the Company may also be subject to specific obligations relating to health data and payment card data. Health data may be subject to additional privacy, security and breach notification requirements, and the Company may be subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data is handled in a manner not permitted by law or under the Company’s agreements with healthcare institutions, the Company could be subject to litigation or government investigations, may be liable for associated investigatory expenses, and could also incur significant fees or fines. Under payment card rules and obligations, if cardholder information is potentially compromised, the Company could be liable for associated investigatory expenses and could also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which would materially adversely affect the Company’s reputation, financial condition and operating results. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also may restrict transfers of PII among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of PII through its privacy policy, information provided on its website and press statements. Any failure by the Company to comply with these public statements or with other federal, state or international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. Apple Inc. | 2017 Form 10-K | 14 The Company’s success depends largely on the continued service and availability of key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. The Company’s business may be impacted by political events, war, terrorism, public health issues, natural disasters and other business interruptions. War, terrorism, geopolitical uncertainties, public health issues and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a material adverse effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to interruption by, among others, natural disasters, whether as a result of climate change or otherwise, fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, labor disputes, public health issues and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and deliver products to its customers, including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in disruption to the Company’s business and harm to the Company’s reputation. Should major public health issues, including pandemics, arise, the Company could be adversely affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products and disruptions in the operations of the Company’s manufacturing vendors and component suppliers. The majority of the Company’s R&D activities, its corporate headquarters, information technology systems and other critical business operations, including certain component suppliers and manufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, the Company could incur significant losses, require substantial recovery time and experience significant expenditures in order to resume operations. The Company expects its quarterly revenue and operating results to fluctuate. The Company’s profit margins vary across its products and distribution channels. The Company’s software, accessories, and service and support contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition, the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, component cost increases, the strengthening U.S. dollar, price competition, or the introduction of new products, including those that have higher cost structures with flat or reduced pricing. The Company has typically experienced higher net sales in its first quarter compared to other quarters due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Further, the Company generates a majority of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments late in a quarter, such as lower-than-anticipated demand for the Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock price has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its own stock to exceed the stock’s price at a given point in time. The Company believes its stock price should reflect expectations of future growth and profitability. The Company also believes its stock price should reflect expectations that its cash dividend will continue at current levels or grow and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employee retention. Apple Inc. | 2017 Form 10-K | 15 The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar versus local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non-U.S. dollar-denominated sales and operating expenses worldwide. Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. Margins on sales of the Company’s products in foreign countries and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign currency exchange rate fluctuations. In some circumstances, for competitive or other reasons, the Company may decide not to raise local prices to fully offset the dollar’s strengthening, or at all, which would adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the market values of its investment portfolio. Given the global nature of its business, the Company has both domestic and international investments. Credit ratings and pricing of the Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents and marketable securities, future fluctuations in their value could result in significant realized losses. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. The Company also sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party financing arrangements or credit insurance. The Company’s exposure to credit and collectability risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 30, 2017 , a significant portion of the Company’s trade receivables was concentrated within cellular network carriers, and its vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service (the “IRS”) and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition, operating results and cash flows could be adversely affected. Item 1B. Unresolved Staff Comments None. Apple Inc. | 2017 Form 10-K | 16 Item 2. Properties The Company’s headquarters are located in Cupertino, California. As of September 30, 2017 , the Company owned 13.4 million square feet and leased 23.0 million square feet of building space, primarily in the U.S. Additionally, the Company owned a total of 4,928 acres of land, primarily in the U.S. As of September 30, 2017 , the Company owned facilities and land for corporate functions, R&D and data centers at various locations throughout the U.S. Outside the U.S., the Company owned additional facilities and land for various purposes. The Company believes its existing facilities and equipment, which are used by all operating segments, are in good operating condition and are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to make investments in capital equipment as needed to meet anticipated demand for its products. Item 3. Legal Proceedings The Company is subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. See the risk factor “ The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights ” in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2017 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Item 4. Mine Safety Disclosures Not applicable. Apple Inc. | 2017 Form 10-K | 17 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the Nasdaq Stock Market LLC (“Nasdaq”) under the symbol AAPL. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest intraday sales prices for the Company’s common stock on the Nasdaq during each quarter of the two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter 2017 price range per share $164.94 – $142.41 $156.65 – $140.06 $144.50 – $114.76 $118.69 – $104.08 2016 price range per share $116.18 – $91.50 $112.39 – $89.47 $109.43 – $92.39 $123.82 – $105.57 Holders As of October 20, 2017 , there were 25,333 shareholders of record. Dividends The Company paid a total of $12.6 billion and $12.0 billion in dividends during 2017 and 2016 , respectively, and expects to pay quarterly dividends of $0.63 per common share each quarter, subject to declaration by the Board of Directors. The Company also plans to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Apple Inc. | 2017 Form 10-K | 18 Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 30, 2017 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) July 2, 2017 to August 5, 2017: Open market and privately negotiated purchases 10,076 $ 148.87 10,076 August 6, 2017 to September 2, 2017: May 2017 ASR 4,510 (2) 4,510 August 2017 ASR 15,069 (3) (3) 15,069 (3) Open market and privately negotiated purchases 9,684 $ 160.06 9,684 September 3, 2017 to September 30, 2017: Open market and privately negotiated purchases 9,313 $ 155.69 9,313 Total 48,652 $ 44,023 (1) In May 2017 , the Company’s Board of Directors increased the Company’s share repurchase authorization from $175 billion to $210 billion of the Company’s common stock, of which $166 billion had been utilized as of September 30, 2017 . The remaining $44 billion in the table represents the amount available to repurchase shares under the authorized repurchase program as of September 30, 2017 . The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In May 2017, the Company entered into an accelerated share repurchase arrangement (“ASR”) to purchase up to $3.0 billion of the Company’s common stock. In August 2017, the purchase period for this ASR ended and an additional 4.5 million shares were delivered and retired. In total, 20.1 million shares were delivered under this ASR at an average repurchase price of $149.20 . (3) In August 2017, the Company entered into a new ASR to purchase up to $3.0 billion of the Company’s common stock. In exchange for an up-front payment of $3.0 billion , the financial institution party to the arrangement committed to deliver shares to the Company during the ASR’s purchase period, which will end in November 2017 . The total number of shares ultimately delivered, and therefore the average price paid per share, will be determined at the end of the applicable purchase period based on the volume-weighted average price of the Company’s common stock during that period. Apple Inc. | 2017 Form 10-K | 19 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 30, 2017 . The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 28, 2012. Note that historic stock price performance is not necessarily indicative of future stock price performance. * $100 invested on 9/28/12 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2017 S&P, a division of McGraw Hill Financial. All rights reserved. Copyright © 2017 Dow Jones & Co. All rights reserved. September 2012 September 2013 September 2014 September 2015 September 2016 September 2017 Apple Inc. $ 100 $ 74 $ 111 $ 128 $ 129 $ 179 S&P 500 Index $ 100 $ 119 $ 143 $ 142 $ 164 $ 194 S&P Information Technology Index $ 100 $ 107 $ 138 $ 141 $ 173 $ 223 Dow Jones U.S. Technology Supersector Index $ 100 $ 105 $ 137 $ 137 $ 167 $ 214 Apple Inc. | 2017 Form 10-K | 20 Item 6. Selected Financial Data The information set forth below for the five years ended September 30, 2017 , is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in thousands, and per share amounts). 2017 2016 2015 2014 2013 Net sales $ 229,234 $ 215,639 $ 233,715 $ 182,795 $ 170,910 Net income $ 48,351 $ 45,687 $ 53,394 $ 39,510 $ 37,037 Earnings per share: Basic $ 9.27 $ 8.35 $ 9.28 $ 6.49 $ 5.72 Diluted $ 9.21 $ 8.31 $ 9.22 $ 6.45 $ 5.68 Cash dividends declared per share $ 2.40 $ 2.18 $ 1.98 $ 1.82 $ 1.64 Shares used in computing earnings per share: Basic 5,217,242 5,470,820 5,753,421 6,085,572 6,477,320 Diluted 5,251,692 5,500,281 5,793,069 6,122,663 6,521,634 Total cash, cash equivalents and marketable securities $ 268,895 $ 237,585 $ 205,666 $ 155,239 $ 146,761 Total assets $ 375,319 $ 321,686 $ 290,345 $ 231,839 $ 207,000 Commercial paper $ 11,977 $ 8,105 $ 8,499 $ 6,308 $ — Total term debt (1) $ 103,703 $ 78,927 $ 55,829 $ 28,987 $ 16,960 Other long-term obligations (2) $ 40,415 $ 36,074 $ 33,427 $ 24,826 $ 20,208 Total liabilities $ 241,272 $ 193,437 $ 170,990 $ 120,292 $ 83,451 Total shareholders’ equity $ 134,047 $ 128,249 $ 119,355 $ 111,547 $ 123,549 (1) Includes current and long-term portion of term debt. (2) Excludes non-current deferred revenue. Apple Inc. | 2017 Form 10-K | 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview and Highlights The Company designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, Apple Watch, Apple TV, a portfolio of consumer and professional software applications, iOS, macOS, watchOS and tvOS operating systems, iCloud, Apple Pay and a variety of accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store, App Store, Mac App Store, TV App Store, iBooks Store and Apple Music (collectively “Digital Content and Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Fiscal Period The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s fiscal year 2017 included 53 weeks and ended on September 30, 2017 . A 14th week was included in the first quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. The Company’s fiscal years 2016 and 2015 ended on September 24, 2016 and September 26, 2015 , respectively, and spanned 52 weeks each. Fiscal 2017 Highlights Net sales increased 6% or $13.6 billion during 2017 compared to 2016, primarily driven by growth in Services, iPhone and Mac. The year-over-year increase in net sales reflected growth in each of the geographic operating segments, with the exception of Greater China. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on net sales during 2017 compared to 2016. In May 2017, the Company announced an increase to its capital return program by raising the expected total size of the program from $250 billion to $300 billion through March 2019. This included increasing its share repurchase authorization from $175 billion to $210 billion and raising its quarterly dividend from $0.57 to $0.63 per share beginning in May 2017. During 2017, the Company spent $33.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $12.8 billion . Additionally, the Company issued $24.0 billion of U.S. dollar-denominated term debt, €2.5 billion of euro-denominated term debt and C$2.5 billion of Canadian dollar-denominated term debt during 2017. Fiscal 2016 Highlights Net sales declined 8% or $18.1 billion during 2016 compared to 2015, primarily driven by a year-over-year decrease in iPhone net sales and the effect of weakness in most foreign currencies relative to the U.S. dollar, partially offset by an increase in Services. In April 2016, the Company announced an increase to its capital return program by raising the expected total size of the program from $200 billion to $250 billion through March 2018. This included increasing its share repurchase authorization from $140 billion to $175 billion and raising its quarterly dividend from $0.52 to $0.57 per share beginning in May 2016. During 2016, the Company spent $29.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $12.2 billion. Additionally, the Company issued $23.9 billion of U.S. dollar-denominated term debt and A$1.4 billion of Australian dollar-denominated term debt during 2016. Apple Inc. | 2017 Form 10-K | 22 Sales Data The following table shows net sales by operating segment and net sales and unit sales by product for 2017 , 2016 and 2015 (dollars in millions and units in thousands): 2017 Change 2016 Change 2015 Net Sales by Operating Segment: Americas $ 96,600 12 % $ 86,613 (8 )% $ 93,864 Europe 54,938 10 % 49,952 (1 )% 50,337 Greater China 44,764 (8 )% 48,492 (17 )% 58,715 Japan 17,733 5 % 16,928 8 % 15,706 Rest of Asia Pacific 15,199 11 % 13,654 (10 )% 15,093 Total net sales $ 229,234 6 % $ 215,639 (8 )% $ 233,715 Net Sales by Product: iPhone (1) $ 141,319 3 % $ 136,700 (12 )% $ 155,041 iPad (1) 19,222 (7 )% 20,628 (11 )% 23,227 Mac (1) 25,850 13 % 22,831 (10 )% 25,471 Services (2) 29,980 23 % 24,348 22 % 19,909 Other Products (1)(3) 12,863 16 % 11,132 11 % 10,067 Total net sales $ 229,234 6 % $ 215,639 (8 )% $ 233,715 Unit Sales by Product: iPhone 216,756 2 % 211,884 (8 )% 231,218 iPad 43,753 (4 )% 45,590 (17 )% 54,856 Mac 19,251 4 % 18,484 (10 )% 20,587 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from Digital Content and Services, AppleCare, Apple Pay, licensing and other services. Services net sales in the fourth quarter of 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. (3) Includes sales of Apple TV, Apple Watch, Beats products, iPod touch and Apple-branded and third-party accessories. Apple Inc. | 2017 Form 10-K | 23 Product Performance iPhone The following table presents iPhone net sales and unit sales information for 2017 , 2016 and 2015 (dollars in millions and units in thousands): 2017 Change 2016 Change 2015 Net sales $ 141,319 3 % $ 136,700 (12 )% $ 155,041 Percentage of total net sales 62 % 63 % 66 % Unit sales 216,756 2 % 211,884 (8 )% 231,218 iPhone net sales increased during 2017 compared to 2016 due to higher iPhone unit sales and a different mix of iPhones with higher average selling prices. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on iPhone net sales during 2017 compared to 2016. iPhone net sales decreased during 2016 compared to 2015. The Company believes the sales decline was due primarily to a lower rate of iPhone upgrades during 2016 compared to 2015 and challenging macroeconomic conditions in a number of major markets in 2016. Average selling prices for iPhone were lower year-over-year during 2016 due primarily to a different mix of iPhones, including the iPhone SE introduced in 2016, and the effect of weakness in most foreign currencies relative to the U.S. dollar. iPad The following table presents iPad net sales and unit sales information for 2017 , 2016 and 2015 (dollars in millions and units in thousands): 2017 Change 2016 Change 2015 Net sales $ 19,222 (7 )% $ 20,628 (11 )% $ 23,227 Percentage of total net sales 8 % 10 % 10 % Unit sales 43,753 (4 )% 45,590 (17 )% 54,856 iPad net sales decreased during 2017 compared to 2016 due to lower iPad unit sales and a different mix of iPads with lower average selling prices. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on iPad net sales during 2017 compared to 2016. iPad net sales decreased during 2016 compared to 2015 primarily due to lower unit sales and the effect of weakness in most foreign currencies relative to the U.S. dollar, partially offset by higher average selling price due to a shift in mix to higher-priced iPads. Mac The following table presents Mac net sales and unit sales information for 2017 , 2016 and 2015 (dollars in millions and units in thousands): 2017 Change 2016 Change 2015 Net sales $ 25,850 13 % $ 22,831 (10 )% $ 25,471 Percentage of total net sales 11 % 11 % 11 % Unit sales 19,251 4 % 18,484 (10 )% 20,587 Mac net sales increased during 2017 compared to 2016 due primarily to a different mix of Macs with higher average selling prices and higher Mac unit sales. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Mac net sales during 2017 compared to 2016. Mac net sales decreased during 2016 compared to 2015 primarily due to lower year-over-year Mac unit sales, which declined at rates similar to the overall market. The effect of weakness in most foreign currencies relative to the U.S. dollar also negatively impacted Mac net sales. Apple Inc. | 2017 Form 10-K | 24 Services The following table presents Services net sales information for 2017 , 2016 and 2015 (dollars in millions): 2017 Change 2016 Change 2015 Net sales $ 29,980 23 % $ 24,348 22 % $ 19,909 Percentage of total net sales 13 % 11 % 9 % The year-over-year growth in Services net sales in 2017 was due primarily to increases in App Store and licensing sales. Services net sales in the fourth quarter of 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. The year-over-year increase in Services net sales in 2016 was due primarily to growth from the App Store, licensing and AppleCare sales, partially offset by the effect of weakness in most foreign currencies relative to the U.S. dollar. During the first quarter of 2016, the Company received $548 million from Samsung Electronics Co., Ltd. related to its patent infringement lawsuit, which was recorded as licensing net sales within Services. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Americas The following table presents Americas net sales information for 2017 , 2016 and 2015 (dollars in millions): 2017 Change 2016 Change 2015 Net sales $ 96,600 12 % $ 86,613 (8 )% $ 93,864 Percentage of total net sales 42 % 40 % 40 % Americas net sales increased during 2017 compared to 2016 due primarily to higher net sales of iPhone, Services and Mac. Americas net sales decreased during 2016 compared to 2015 due primarily to lower net sales of iPhone. Europe The following table presents Europe net sales information for 2017 , 2016 and 2015 (dollars in millions): 2017 Change 2016 Change 2015 Net sales $ 54,938 10 % $ 49,952 (1 )% $ 50,337 Percentage of total net sales 24 % 23 % 22 % Europe net sales increased during 2017 compared to 2016 due primarily to higher net sales of iPhone and Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Europe net sales during 2017 compared to 2016. Europe net sales decreased during 2016 compared to 2015 driven primarily by the effect of weakness in foreign currencies relative to the U.S. dollar and a decrease in net sales of Mac, largely offset by an increase in iPhone unit sales and Services. Apple Inc. | 2017 Form 10-K | 25 Greater China The following table presents Greater China net sales information for 2017 , 2016 and 2015 (dollars in millions): 2017 Change 2016 Change 2015 Net sales $ 44,764 (8 )% $ 48,492 (17 )% $ 58,715 Percentage of total net sales 20 % 22 % 25 % Greater China net sales decreased during 2017 compared to 2016 due primarily to lower net sales of iPhone, partially offset by higher net sales of Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Greater China net sales during 2017 compared to 2016. Greater China net sales decreased during 2016 compared to 2015 due primarily to lower net sales of iPhone and the effect of weakness in foreign currencies relative to the U.S. dollar. Japan The following table presents Japan net sales information for 2017 , 2016 and 2015 (dollars in millions): 2017 Change 2016 Change 2015 Net sales $ 17,733 5 % $ 16,928 8 % $ 15,706 Percentage of total net sales 8 % 8 % 7 % The year-over-year increase in Japan net sales in 2017 and 2016 was due primarily to higher net sales of Services and the strength in the Japanese yen relative to the U.S. dollar. Rest of Asia Pacific The following table presents Rest of Asia Pacific net sales information for 2017 , 2016 and 2015 (dollars in millions): 2017 Change 2016 Change 2015 Net sales $ 15,199 11 % $ 13,654 (10 )% $ 15,093 Percentage of total net sales 7 % 6 % 6 % Rest of Asia Pacific net sales increased during 2017 compared to 2016 due primarily to higher net sales of iPhone, Services and Mac. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on Rest of Asia Pacific net sales during 2017 compared to 2016. Rest of Asia Pacific net sales decreased during 2016 compared to 2015 due primarily to lower net sales of iPhone and the effect of weakness in foreign currencies relative to the U.S. dollar. Gross Margin Gross margin for 2017 , 2016 and 2015 was as follows (dollars in millions): 2017 2016 2015 Net sales $ 229,234 $ 215,639 $ 233,715 Cost of sales 141,048 131,376 140,089 Gross margin $ 88,186 $ 84,263 $ 93,626 Gross margin percentage 38.5 % 39.1 % 40.1 % Gross margin percentage decreased in 2017 compared to 2016 due primarily to higher product costs, partially offset by a favorable shift in mix to services. Year-over-year gross margin increased due primarily to a shift in mix to services and an overall increase in product volumes. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on gross margin percentage and gross margin during 2017 compared to 2016. Gross margin percentage decreased in 2016 compared to 2015 due primarily to the effect of weakness in most foreign currencies relative to the U.S. dollar and, to a lesser extent, unfavorable leverage on fixed costs from lower net sales, partially offset by a favorable shift in mix to services. Apple Inc. | 2017 Form 10-K | 26 The Company anticipates gross margin percentage during the first quarter of 2018 to be between 38.0% and 38.5%. The foregoing statement regarding the Company’s expected gross margin percentage in the first quarter of 2018 is forward-looking and could differ from actual results. The Company’s future gross margins can be impacted by multiple factors including, but not limited to, those set forth in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and those described in this paragraph. In general, the Company believes gross margins will remain under downward pressure due to a variety of factors, including continued industry-wide global product pricing pressures, increased competition, compressed product life cycles, product transitions, potential increases in the cost of components, and potential strengthening of the U.S. dollar, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to competitive pressures, the Company expects it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due to the Company’s significant international operations, its financial condition and operating results, including gross margins, could be significantly affected by fluctuations in exchange rates. Operating Expenses Operating expenses for 2017 , 2016 and 2015 were as follows (dollars in millions): 2017 Change 2016 Change 2015 Research and development $ 11,581 15 % $ 10,045 25 % $ 8,067 Percentage of total net sales 5 % 5 % 3 % Selling, general and administrative $ 15,261 8 % $ 14,194 (1 )% $ 14,329 Percentage of total net sales 7 % 7 % 6 % Total operating expenses $ 26,842 11 % $ 24,239 8 % $ 22,396 Percentage of total net sales 12 % 11 % 10 % Research and Development The year-over-year growth in R&D expense in 2017 and 2016 was driven primarily by increases in headcount-related expenses and material costs to support expanded R&D activities. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products and services that are central to the Company’s core business strategy. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2017 compared to 2016 was driven primarily by an increase in headcount-related expenses, variable selling expenses and infrastructure-related costs. The decrease in selling, general and administrative expense in 2016 compared to 2015 was due primarily to lower discretionary expenditures and advertising costs, partially offset by an increase in headcount-related expenses. Other Income/(Expense), Net Other income/(expense), net for 2017 , 2016 and 2015 was as follows (dollars in millions): 2017 Change 2016 Change 2015 Interest and dividend income $ 5,201 $ 3,999 $ 2,921 Interest expense (2,323 ) (1,456 ) (733 ) Other expense, net (133 ) (1,195 ) (903 ) Total other income/(expense), net $ 2,745 104 % $ 1,348 5 % $ 1,285 The year-over-year increase in other income/(expense), net during 2017 was due primarily to higher interest income and the favorable impact of foreign exchange-related items, partially offset by higher interest expense on debt. The year-over-year increase in other income/(expense), net during 2016 was due primarily to higher interest income, partially offset by higher interest expense on debt and the unfavorable impact of foreign exchange-related items. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.99%, 1.73% and 1.49% in 2017 , 2016 and 2015 , respectively. Apple Inc. | 2017 Form 10-K | 27 Provision for Income Taxes Provision for income taxes and effective tax rates for 2017 , 2016 and 2015 were as follows (dollars in millions): 2017 2016 2015 Provision for income taxes $ 15,738 $ 15,685 $ 19,121 Effective tax rate 24.6 % 25.6 % 26.4 % The Company’s effective tax rates for 2017 , 2016 and 2015 differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided when such earnings are intended to be indefinitely reinvested outside the U.S. The lower effective tax rate in 2017 compared to 2016 was due to a different geographic mix of earnings and higher U.S. R&D tax credits. The lower effective tax rate in 2016 compared to 2015 was due primarily to greater R&D tax credits. As of September 30, 2017 , the Company had deferred tax assets arising from deductible temporary differences, tax losses and tax credits of $3.9 billion and deferred tax liabilities of $31.5 billion . Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and the amount of a valuation allowance. The IRS concluded its review of the years 2010 through 2012 during the third quarter of 2017. All years prior to 2013 are closed, and the IRS is currently examining the years 2013 through 2015. The Company is also subject to audits by state, local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 2003 generally remain open and could be subject to examination by the taxing authorities. Management believes that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision orders Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and appealed to the General Court of the Court of Justice of the European Union. Ireland has also appealed the State Aid Decision. Although Ireland is still computing the recovery amount, the Company expects the amount to be in line with the European Commission’s announced recovery amount of €13 billion , plus interest of €1 billion . Once the recovery amount is finalized by Ireland, the Company anticipates funding it, including interest, out of foreign cash. These amounts are expected to be placed into escrow in 2018, where they will remain pending conclusion of all appeals. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes. Recent Accounting Pronouncements Hedging In August 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 expands component and fair value hedging, specifies the presentation of the effects of hedging instruments, and eliminates the separate measurement and presentation of hedge ineffectiveness. The Company will adopt ASU 2017-12 in its first quarter of 2020 utilizing the modified retrospective transition method and is currently evaluating the impact of adoption on its consolidated financial statements. Restricted Cash In November 2016, the FASB issued ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (“ASU 2016-18”), which enhances and clarifies the guidance on the classification and presentation of restricted cash in the statement of cash flows. The Company will adopt ASU 2016-18 in its first quarter of 2019 utilizing the retrospective transition method. Currently, the Company’s restricted cash balance is not significant. Apple Inc. | 2017 Form 10-K | 28 Income Taxes In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. The Company will adopt ASU 2016-16 in its first quarter of 2019 utilizing the modified retrospective transition method. Currently, the Company anticipates recording up to $9 billion of net deferred tax assets on its Consolidated Balance Sheets upon adoption. However, the ultimate impact of adopting ASU 2016-16 will depend on the balance of intellectual property transferred between its subsidiaries as of the adoption date. The Company will recognize incremental deferred income tax expense thereafter as these deferred tax assets are utilized. Stock Compensation In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which modifies certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards, and classification in the statement of cash flows. The Company will adopt ASU 2016-09 in its first quarter of 2018. Currently, excess tax benefits or deficiencies from the Company’s equity awards are recorded as additional paid-in capital in its Consolidated Balance Sheets. Upon adoption, the Company will record any excess tax benefits or deficiencies from its equity awards in its Consolidated Statements of Operations in the reporting periods in which vesting occurs. As a result, subsequent to adoption the Company’s income tax expense and associated effective tax rate will be impacted by fluctuations in stock price between the grant dates and vesting dates of equity awards. Leases In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modifies lease accounting for lessees to increase transparency and comparability by recording lease assets and liabilities for operating leases and disclosing key information about leasing arrangements. The Company will adopt ASU 2016-02 in its first quarter of 2020 utilizing the modified retrospective transition method. While the Company is currently evaluating the timing and impact of adopting ASU 2016-02, currently the Company anticipates recording lease assets and liabilities in excess of $9.5 billion on its Consolidated Balance Sheets, with no material impact to its Consolidated Statements of Operations. However, the ultimate impact of adopting ASU 2016-02 will depend on the Company’s lease portfolio as of the adoption date. Financial Instruments In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The Company will adopt ASU 2016-01 in its first quarter of 2019 utilizing the modified retrospective transition method. Based on the composition of the Company’s investment portfolio, the adoption of ASU 2016-01 is not expected to have a material impact on its consolidated financial statements. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. The Company will adopt ASU 2016-13 in its first quarter of 2021 utilizing the modified retrospective transition method. Based on the composition of the Company’s investment portfolio, current market conditions, and historical credit loss activity, the adoption of ASU 2016-13 is not expected to have a material impact on its consolidated financial statements. Revenue Recognition In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. Subsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”); and ASU No. 2016-20, Technical Corrections and Improvements to Topic 606, Revenue from Contracts with Customers (“ASU 2016-20”). The Company must adopt ASU 2016-08, ASU 2016-10, ASU 2016-12 and ASU 2016-20 with ASU 2014-09 (collectively, the “new revenue standards”). The new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company will adopt the new revenue standards in its first quarter of 2019 utilizing the full retrospective transition method. The new revenue standards are not expected to have a material impact on the amount and timing of revenue recognized in the Company’s consolidated financial statements. Apple Inc. | 2017 Form 10-K | 29 Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended September 30, 2017 , September 24, 2016 and September 26, 2015 (in millions): 2017 2016 2015 Cash, cash equivalents and marketable securities $ 268,895 $ 237,585 $ 205,666 Property, plant and equipment, net $ 33,783 $ 27,010 $ 22,471 Commercial paper $ 11,977 $ 8,105 $ 8,499 Total term debt $ 103,703 $ 78,927 $ 55,829 Working capital $ 27,831 $ 27,863 $ 8,768 Cash generated by operating activities $ 63,598 $ 65,824 $ 81,266 Cash used in investing activities $ (46,446 ) $ (45,977 ) $ (56,274 ) Cash used in financing activities $ (17,347 ) $ (20,483 ) $ (17,716 ) The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with its existing operations over the next 12 months. The Company currently anticipates the cash used for future dividends, the share repurchase program and debt repayments will come from its current domestic cash, cash generated from ongoing U.S. operating activities and from borrowings. As of September 30, 2017 and September 24, 2016 , the Company’s cash, cash equivalents and marketable securities held by foreign subsidiaries were $252.3 billion and $216.0 billion , respectively, and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. In connection with the State Aid Decision, Ireland is still computing the recovery amount. The Company expects the amount to be in line with the European Commission’s announced recovery amount of €13 billion , plus interest of €1 billion . Once the recovery amount is finalized by Ireland, the Company anticipates funding it, including interest, out of foreign cash. These amounts are expected to be placed into escrow in 2018, where they will remain pending conclusion of all appeals. The Company’s marketable securities investment portfolio is primarily invested in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. During 2017 , cash generated by operating activities of $63.6 billion was a result of $48.4 billion of net income, non-cash adjustments to net income of $20.8 billion and a decrease in the net change in operating assets and liabilities of $5.6 billion , which included a one-time payment of $1.9 billion related to a multi-year license agreement. Cash used in investing activities of $46.4 billion during 2017 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $33.1 billion and cash used to acquire property, plant and equipment of $12.5 billion . Cash used in financing activities of $17.3 billion during 2017 consisted primarily of cash used to repurchase common stock of $32.9 billion , cash used to pay dividends and dividend equivalents of $12.8 billion and cash used to repay term debt of $3.5 billion , partially offset by proceeds from the issuance of term debt, net of $28.7 billion and proceeds from commercial paper, net of $3.9 billion . During 2016 , cash generated by operating activities of $65.8 billion was a result of $45.7 billion of net income and non-cash adjustments to net income of $20.1 billion . Cash used in investing activities of $46.0 billion during 2016 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $30.6 billion and cash used to acquire property, plant and equipment of $12.7 billion . Cash used in financing activities of $20.5 billion during 2016 consisted primarily of cash used to repurchase common stock of $29.7 billion , cash used to pay dividends and dividend equivalents of $12.2 billion and cash used to repay term debt of $2.5 billion , partially offset by proceeds from the issuance of term debt, net of $25.0 billion . Capital Assets The Company’s capital expenditures were $14.9 billion during 2017 . The Company anticipates utilizing approximately $16.0 billion for capital expenditures during 2018 , which includes product tooling and manufacturing process equipment; data centers; corporate facilities and infrastructure, including information systems hardware, software and enhancements; and retail store facilities. Debt The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses the net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 30, 2017 , the Company had $12.0 billion of Commercial Paper outstanding, with a weighted-average interest rate of 1.20% and maturities generally less than nine months . Apple Inc. | 2017 Form 10-K | 30 As of September 30, 2017 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $104.0 billion (collectively the “Notes”). During 2017 , the Company repaid $3.5 billion of its Notes upon maturity. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on the Notes. In addition, the Company has entered, and in the future may enter, into foreign currency swaps to manage foreign currency risk on the Notes. The future principal payments for the Company’s Notes as of September 30, 2017 are as follows (in millions): 2018 $ 6,500 2019 8,863 2020 9,220 2021 7,750 2022 10,297 Thereafter 61,391 Total term debt $ 104,021 Further information regarding the Company’s debt issuances and related hedging activity can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 2, “Financial Instruments” and Note 6, “Debt.” Capital Return Program In May 2017 , the Company’s Board of Directors increased the total capital return program from $250 billion to $300 billion , which included an increase in the share repurchase authorization from $175 billion to $210 billion of the Company’s common stock. Additionally, the Company announced that the Board of Directors raised the Company’s quarterly cash dividend from $0.57 to $0.63 per share, beginning with the dividend paid during the third quarter of 2017. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. As of September 30, 2017 , $166 billion of the share repurchase program had been utilized. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. The following table presents the Company’s dividends, dividend equivalents, share repurchases and net share settlement activity from the start of the capital return program in August 2012 through September 30, 2017 (in millions): Dividends and Dividend Equivalents Paid Accelerated Share Repurchases Open Market Share Repurchases Taxes Related to Settlement of Equity Awards Total 2017 $ 12,769 $ 15,000 $ 18,001 $ 1,874 $ 47,644 2016 12,150 12,000 17,000 1,570 42,720 2015 11,561 6,000 30,026 1,499 49,086 2014 11,126 21,000 24,000 1,158 57,284 2013 10,564 13,950 9,000 1,082 34,596 2012 2,488 — — 56 2,544 Total $ 60,658 $ 67,950 $ 98,027 $ 7,239 $ 233,874 The Company expects to execute its capital return program by the end of March 2019 by paying dividends and dividend equivalents, repurchasing shares and remitting withheld taxes related to net share settlement of restricted stock units. The Company plans to continue to access the domestic and international debt markets to assist in funding its capital return program. Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company, or engages in leasing, hedging, or R&D services with the Company. Apple Inc. | 2017 Form 10-K | 31 The following table presents certain payments due by the Company as of September 30, 2017 , and excludes amounts already recorded on the Consolidated Balance Sheet, except for term debt (in millions): Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Total Term debt $ 6,500 $ 18,083 $ 18,047 $ 61,391 $ 104,021 Operating leases 1,223 2,295 1,904 4,123 9,545 Manufacturing purchase obligations (1) 32,787 2,632 2,147 — 37,566 Other purchase obligations 4,019 1,669 417 14 6,119 Total $ 44,529 $ 24,679 $ 22,515 $ 65,528 $ 157,251 (1) Represents amount expected to be paid under manufacturing-related supplier arrangements, substantially all of which is noncancelable. Operating Leases As of September 30, 2017 , the Company’s total future minimum lease payments under noncancelable operating leases were $9.5 billion . The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days . The Company also obtains individual components for its products from a wide variety of individual suppliers. As of September 30, 2017 , the Company expects to pay $37.6 billion under manufacturing-related supplier arrangements, substantially all of which is noncancelable. Other Purchase Obligations The Company’s other purchase obligations consisted of noncancelable obligations to acquire capital assets, including product tooling and manufacturing process equipment, and noncancelable obligations related to advertising, licensing, R&D, internet and telecommunications services and other obligations. As of September 30, 2017 , the Company had other purchase obligations of $6.1 billion . The Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of September 30, 2017 , the Company had deferred tax liabilities of $31.5 billion , gross unrecognized tax benefits of $8.4 billion and an additional $1.2 billion for gross interest and penalties. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table. Indemnification Agreements entered into by the Company sometimes include indemnification provisions which may subject the Company to costs and damages in the event of a claim against an indemnified third party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to indemnification of third parties. The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers of the Company and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. While the Company maintains directors and officers liability insurance coverage, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2017 Form 10-K | 32 Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation and impairment of marketable securities, inventory valuation, valuation of manufacturing-related assets and estimation of purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software and/or undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For sales of qualifying versions of iOS devices, Mac, Apple Watch and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. The Company’s process for determining ESPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s ESPs and the future rate of related amortization for unspecified software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the unspecified software upgrade rights and non-software services offered, the estimated value of unspecified software upgrade rights and non-software services and the estimated period unspecified software upgrades and non-software services are expected to be provided. Apple Inc. | 2017 Form 10-K | 33 The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, the estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s operating results. Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the Company’s Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the period any such determination is made. In making this determination, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company’s assessment of whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security, which would have an adverse impact on the Company’s financial condition and operating results. Inventory Valuation, Valuation of Manufacturing-Related Assets and Estimation of Purchase Commitment Cancellation Fees The Company must purchase components and build inventory in advance of product shipments and has invested in manufacturing-related assets, including capital assets held at its suppliers’ facilities. In addition, the Company has made prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory components. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a regular review of inventory that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels and component cost trends. The Company also reviews its manufacturing-related capital assets and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value of such an asset exceeds its fair value. The industries in which the Company competes are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. In certain circumstances the Company may be required to record additional write-downs of inventory and/or impairments of manufacturing-related assets or inventory prepayments. These circumstances include future demand or market conditions for the Company’s products being less favorable than forecasted, unforeseen technological changes or changes to the Company’s product development plans that negatively impact the utility of any of these assets, or significant deterioration in the financial condition of one or more of the Company’s suppliers that hold any of the Company’s manufacturing-related assets or to whom the Company has made an inventory prepayment. Such write-downs would adversely affect the Company’s financial condition and operating results in the period when the additional write-downs were recorded. The Company accrues for estimated purchase commitment cancellation fees related to inventory orders that have been canceled or are expected to be canceled. Manufacturing purchase obligations typically cover the Company’s forecasted component and manufacturing requirements for periods up to 150 days . If there is an abrupt and substantial decline in demand for one or more of the Company’s products, a change in the Company’s product development plans, or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional accruals for cancellation fees that would adversely affect its results of operations in the period when the cancellation fees were identified and recorded. Apple Inc. | 2017 Form 10-K | 34 Warranty Costs The Company accrues for the estimated cost of warranties in the period the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost per claim and knowledge of specific product failures that are outside of the Company’s typical experience. The Company regularly reviews these estimates and the current installed base of products subject to warranty protection to assess the appropriateness of its recorded warranty liabilities and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities could be required and could materially affect the Company’s financial condition and operating results. Income Taxes The Company records a tax provision for the anticipated tax consequences of its reported operating results. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the Company’s deferred tax assets. In the event that the Company determines all or part of its net deferred tax assets are not realizable in the future, the Company will record an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. | 2017 Form 10-K | 35 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. The Company’s investment policy and strategy are focused on preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 30, 2017 and September 24, 2016 , a hypothetical 100 basis point increase in interest rates across all maturities would result in a $6.0 billion and $4.9 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. As of September 30, 2017 and September 24, 2016 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $103.7 billion and $78.9 billion , respectively. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on term debt are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 30, 2017 and September 24, 2016 to increase by $376 million and $271 million on an annualized basis, respectively. Further details regarding the Company’s debt is provided in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 6, “Debt.” Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and in the future may enter, into foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign-denominated debt issuances. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to accounting considerations and the prohibitive economic cost of hedging particular exposures. Apple Inc. | 2017 Form 10-K | 36 To provide a meaningful assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $485 million as of September 30, 2017 compared to a maximum one-day loss in fair value of $434 million as of September 24, 2016 . Because the Company uses foreign currency instruments for hedging purposes, the loss in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 30, 2017 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchange rates and the Company’s actual exposures and positions. Apple Inc. | 2017 Form 10-K | 37 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 39 Consolidated Statements of Comprehensive Income for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 40 Consolidated Balance Sheets as of September 30, 2017 and September 24, 2016 41 Consolidated Statements of Shareholders’ Equity for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 42 Consolidated Statements of Cash Flows for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 43 Notes to Consolidated Financial Statements 44 Selected Quarterly Financial Information (Unaudited) 68 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 70 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. Apple Inc. | 2017 Form 10-K | 38 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 30, 2017 September 24, 2016 September 26, 2015 Net sales $ 229,234 $ 215,639 $ 233,715 Cost of sales 141,048 131,376 140,089 Gross margin 88,186 84,263 93,626 Operating expenses: Research and development 11,581 10,045 8,067 Selling, general and administrative 15,261 14,194 14,329 Total operating expenses 26,842 24,239 22,396 Operating income 61,344 60,024 71,230 Other income/(expense), net 2,745 1,348 1,285 Income before provision for income taxes 64,089 61,372 72,515 Provision for income taxes 15,738 15,685 19,121 Net income $ 48,351 $ 45,687 $ 53,394 Earnings per share: Basic $ 9.27 $ 8.35 $ 9.28 Diluted $ 9.21 $ 8.31 $ 9.22 Shares used in computing earnings per share: Basic 5,217,242 5,470,820 5,753,421 Diluted 5,251,692 5,500,281 5,793,069 Cash dividends declared per share $ 2.40 $ 2.18 $ 1.98 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2017 Form 10-K | 39 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 30, 2017 September 24, 2016 September 26, 2015 Net income $ 48,351 $ 45,687 $ 53,394 Other comprehensive income/(loss): Change in foreign currency translation, net of tax effects of $(77), $8 and $201, respectively 224 75 (411 ) Change in unrealized gains/losses on derivative instruments: Change in fair value of derivatives, net of tax benefit/(expense) of $(478), $(7) and $(441), respectively 1,315 7 2,905 Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $475, $131 and $630, respectively (1,477 ) (741 ) (3,497 ) Total change in unrealized gains/losses on derivative instruments, net of tax (162 ) (734 ) (592 ) Change in unrealized gains/losses on marketable securities: Change in fair value of marketable securities, net of tax benefit/(expense) of $425, $(863) and $264, respectively (782 ) 1,582 (483 ) Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $35, $(31) and $(32), respectively (64 ) 56 59 Total change in unrealized gains/losses on marketable securities, net of tax (846 ) 1,638 (424 ) Total other comprehensive income/(loss) (784 ) 979 (1,427 ) Total comprehensive income $ 47,567 $ 46,666 $ 51,967 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2017 Form 10-K | 40 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 30, 2017 September 24, 2016 ASSETS: Current assets: Cash and cash equivalents $ 20,289 $ 20,484 Short-term marketable securities 53,892 46,671 Accounts receivable, less allowances of $58 and $53, respectively 17,874 15,754 Inventories 4,855 2,132 Vendor non-trade receivables 17,799 13,545 Other current assets 13,936 8,283 Total current assets 128,645 106,869 Long-term marketable securities 194,714 170,430 Property, plant and equipment, net 33,783 27,010 Goodwill 5,717 5,414 Acquired intangible assets, net 2,298 3,206 Other non-current assets 10,162 8,757 Total assets $ 375,319 $ 321,686 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 49,049 $ 37,294 Accrued expenses 25,744 22,027 Deferred revenue 7,548 8,080 Commercial paper 11,977 8,105 Current portion of long-term debt 6,496 3,500 Total current liabilities 100,814 79,006 Deferred revenue, non-current 2,836 2,930 Long-term debt 97,207 75,427 Other non-current liabilities 40,415 36,074 Total liabilities 241,272 193,437 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 5,126,201 and 5,336,166 shares issued and outstanding, respectively 35,867 31,251 Retained earnings 98,330 96,364 Accumulated other comprehensive income/(loss) (150 ) 634 Total shareholders’ equity 134,047 128,249 Total liabilities and shareholders’ equity $ 375,319 $ 321,686 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2017 Form 10-K | 41 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands) Common Stock and Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders’ Equity Shares Amount Balances as of September 27, 2014 5,866,161 $ 23,313 $ 87,152 $ 1,082 $ 111,547 Net income — — 53,394 — 53,394 Other comprehensive income/(loss) — — — (1,427 ) (1,427 ) Dividends and dividend equivalents declared — — (11,627 ) — (11,627 ) Repurchase of common stock (325,032 ) — (36,026 ) — (36,026 ) Share-based compensation — 3,586 — — 3,586 Common stock issued, net of shares withheld for employee taxes 37,624 (231 ) (609 ) — (840 ) Tax benefit from equity awards, including transfer pricing adjustments — 748 — — 748 Balances as of September 26, 2015 5,578,753 27,416 92,284 (345 ) 119,355 Net income — — 45,687 — 45,687 Other comprehensive income/(loss) — — — 979 979 Dividends and dividend equivalents declared — — (12,188 ) — (12,188 ) Repurchase of common stock (279,609 ) — (29,000 ) — (29,000 ) Share-based compensation — 4,262 — — 4,262 Common stock issued, net of shares withheld for employee taxes 37,022 (806 ) (419 ) — (1,225 ) Tax benefit from equity awards, including transfer pricing adjustments — 379 — — 379 Balances as of September 24, 2016 5,336,166 31,251 96,364 634 128,249 Net income — — 48,351 — 48,351 Other comprehensive income/(loss) — — — (784 ) (784 ) Dividends and dividend equivalents declared — — (12,803 ) — (12,803 ) Repurchase of common stock (246,496 ) — (33,001 ) — (33,001 ) Share-based compensation — 4,909 — — 4,909 Common stock issued, net of shares withheld for employee taxes 36,531 (913 ) (581 ) — (1,494 ) Tax benefit from equity awards, including transfer pricing adjustments — 620 — — 620 Balances as of September 30, 2017 5,126,201 $ 35,867 $ 98,330 $ (150 ) $ 134,047 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2017 Form 10-K | 42 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 30, 2017 September 24, 2016 September 26, 2015 Cash and cash equivalents, beginning of the year $ 20,484 $ 21,120 $ 13,844 Operating activities: Net income 48,351 45,687 53,394 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 10,157 10,505 11,257 Share-based compensation expense 4,840 4,210 3,586 Deferred income tax expense 5,966 4,938 1,382 Other (166 ) 486 385 Changes in operating assets and liabilities: Accounts receivable, net (2,093 ) 527 417 Inventories (2,723 ) 217 (238 ) Vendor non-trade receivables (4,254 ) (51 ) (3,735 ) Other current and non-current assets (5,318 ) 1,055 (283 ) Accounts payable 9,618 1,837 5,001 Deferred revenue (626 ) (1,554 ) 1,042 Other current and non-current liabilities (154 ) (2,033 ) 9,058 Cash generated by operating activities 63,598 65,824 81,266 Investing activities: Purchases of marketable securities (159,486 ) (142,428 ) (166,402 ) Proceeds from maturities of marketable securities 31,775 21,258 14,538 Proceeds from sales of marketable securities 94,564 90,536 107,447 Payments made in connection with business acquisitions, net (329 ) (297 ) (343 ) Payments for acquisition of property, plant and equipment (12,451 ) (12,734 ) (11,247 ) Payments for acquisition of intangible assets (344 ) (814 ) (241 ) Payments for strategic investments, net (395 ) (1,388 ) — Other 220 (110 ) (26 ) Cash used in investing activities (46,446 ) (45,977 ) (56,274 ) Financing activities: Proceeds from issuance of common stock 555 495 543 Excess tax benefits from equity awards 627 407 749 Payments for taxes related to net share settlement of equity awards (1,874 ) (1,570 ) (1,499 ) Payments for dividends and dividend equivalents (12,769 ) (12,150 ) (11,561 ) Repurchases of common stock (32,900 ) (29,722 ) (35,253 ) Proceeds from issuance of term debt, net 28,662 24,954 27,114 Repayments of term debt (3,500 ) (2,500 ) — Change in commercial paper, net 3,852 (397 ) 2,191 Cash used in financing activities (17,347 ) (20,483 ) (17,716 ) Increase/(Decrease) in cash and cash equivalents (195 ) (636 ) 7,276 Cash and cash equivalents, end of the year $ 20,289 $ 20,484 $ 21,120 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 11,591 $ 10,444 $ 13,252 Cash paid for interest $ 2,092 $ 1,316 $ 514 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2017 Form 10-K | 43 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, Apple Watch, Apple TV, a portfolio of consumer and professional software applications, iOS, macOS, watchOS and tvOS operating systems, iCloud, Apple Pay and a variety of accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store, App Store, Mac App Store, TV App Store, iBooks Store and Apple Music (collectively “Digital Content and Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in these consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s fiscal year 2017 included 53 weeks and ended on September 30, 2017 . A 14th week was included in the first fiscal quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. The Company’s fiscal years 2016 and 2015 ended on September 24, 2016 and September 26, 2015 , respectively, and spanned 52 weeks each. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For the sale of most third-party products, the Company recognizes revenue based on the gross amount billed to customers because the Company establishes its own pricing for such products, retains related inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its customers. For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. Apple Inc. | 2017 Form 10-K | 44 The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on iTunes Store, App Store, Mac App Store, TV App Store and iBooks Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited warranty. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For the Company’s other customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For multi-element arrangements accounted for in accordance with industry-specific software accounting guidance, the Company allocates revenue to all deliverables based on the VSOE of each element, and if VSOE does not exist revenue is recognized when elements lacking VSOE are delivered. For sales of qualifying versions of iPhone, iPad, iPod touch, Mac, Apple Watch and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. The Company has identified up to three deliverables regularly included in arrangements involving the sale of these devices. The first deliverable, which represents the substantial portion of the allocated sales price, is the hardware and software essential to the functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with qualifying devices to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the product’s essential software. The third deliverable is the non-software services to be provided to qualifying devices. The Company allocates revenue between these deliverables using the relative selling price method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based on the Company’s ESPs. Revenue allocated to the delivered hardware and the related essential software is recognized at the time of sale, provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses as incurred. The Company’s process for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable including, where applicable, prices charged by the Company and market trends in the pricing for similar offerings, product-specific business objectives, estimated cost to provide the non-software services and the relative ESP of the upgrade rights and non-software services as compared to the total selling price of the product. Shipping Costs Amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s shipping and handling costs are classified as cost of sales. Warranty Costs The Company generally provides for the estimated cost of hardware and software warranties in the period the related revenue is recognized. The Company assesses the adequacy of its accrued warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. Apple Inc. | 2017 Form 10-K | 45 Software Development Costs Research and development (“R&D”) costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established and as a result software development costs were expensed as incurred. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Share-based Compensation The Company recognizes expense related to share-based payment transactions in which it receives employee services in exchange for (a) equity instruments of the Company or (b) liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. Share-based compensation expense for restricted stock units (“RSUs”) and restricted stock is measured based on the closing fair market value of the Company’s common stock on the date of grant. The Company estimates forfeitures expected to occur and recognizes share-based compensation expense for those equity awards expected to vest. The Company recognizes share-based compensation expense over the award’s requisite service period on a straight-line basis for time-based RSUs and on a graded basis for RSUs that are contingent on the achievement of performance conditions. The Company recognizes a benefit from share-based compensation in the Consolidated Statements of Shareholders’ Equity if an excess tax benefit is realized. In addition, the Company recognizes the indirect effects of share-based compensation on R&D tax credits, foreign tax credits and domestic manufacturing deductions in the Consolidated Statements of Operations. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Income Taxes The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. See Note 5, “Income Taxes” for additional information. Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include unvested RSUs, unvested restricted stock, outstanding stock options and shares to be purchased by employees under the Company’s employee stock purchase plan. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. Apple Inc. | 2017 Form 10-K | 46 The following table shows the computation of basic and diluted earnings per share for 2017 , 2016 and 2015 (net income in millions and shares in thousands): 2017 2016 2015 Numerator: Net income $ 48,351 $ 45,687 $ 53,394 Denominator: Weighted-average shares outstanding 5,217,242 5,470,820 5,753,421 Effect of dilutive securities 34,450 29,461 39,648 Weighted-average diluted shares 5,251,692 5,500,281 5,793,069 Basic earnings per share $ 9.27 $ 8.35 $ 9.28 Diluted earnings per share $ 9.21 $ 8.31 $ 9.22 Potentially dilutive securities whose effect would have been antidilutive are excluded from the computation of diluted earnings per share. Financial Instruments Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the classifications at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. Marketable equity securities, including mutual funds, are classified as either short-term or long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity securities are carried at fair value, with unrealized gains and losses, net of taxes, reported as a component of accumulated other comprehensive income/(loss) (“AOCI”) in shareholders’ equity, with the exception of unrealized losses believed to be other-than-temporary which are reported in earnings in the current period. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of AOCI in shareholders’ equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized in earnings in the current period. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments that hedge the exposure to changes in the fair value of an asset or a liability and that are designated as fair value hedges, both the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item are recognized in earnings in the current period. For derivative instruments and foreign currency debt that hedge the exposure to changes in foreign currency exchange rates used for translation of the net investment in a foreign operation and that are designated as a net investment hedge, the net gain or loss on the effective portion of the derivative instrument is reported in the same manner as a foreign currency translation adjustment. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this forward carry component are recognized in earnings in the current period. Derivatives that do not qualify as hedges are adjusted to fair value through earnings in the current period. Apple Inc. | 2017 Form 10-K | 47 Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors, including historical experience, age of the accounts receivable balances, credit quality of the Company’s customers, current economic conditions and other factors that may affect the customers’ abilities to pay. Inventories Inventories are stated at the lower of cost, computed using the first-in, first-out method, and net realizable value. Any adjustments to reduce the cost of inventories to their net realizable value are recognized in earnings in the current period. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between one and five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease term or useful life for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which range from three to five years . Depreciation and amortization expense on property and equipment was $8.2 billion , $8.3 billion and $9.2 billion during 2017 , 2016 and 2015 , respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment, inventory component prepayments and identifiable intangibles, excluding goodwill and intangible assets with indefinite useful lives, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment, inventory component prepayments and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the asset exceeds its fair value. The Company does not amortize goodwill and intangible assets with indefinite useful lives; rather, such assets are required to be tested for impairment at least annually or sooner if events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible asset impairment tests in the fourth quarter of each year. The Company did not recognize any impairment charges related to goodwill or indefinite lived intangible assets during 2017 , 2016 and 2015 . For purposes of testing goodwill for impairment, the Company established reporting units based on its current reporting structure. Goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. In 2017 and 2016 , the Company’s goodwill was primarily allocated to the Americas and Europe reporting units. The Company amortizes its intangible assets with definite useful lives over their estimated useful lives and reviews these assets for impairment. The Company typically amortizes its acquired intangible assets with definite useful lives over periods from three to seven years . Fair Value Measurements The Company applies fair value accounting for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities that are required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use to price the asset or liability, such as risks inherent in valuation techniques, transfer restrictions and credit risk. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability. Apple Inc. | 2017 Form 10-K | 48 The Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. In accordance with the fair value accounting requirements, companies may choose to measure eligible financial instruments and certain other items at fair value. The Company has not elected the fair value option for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in AOCI in shareholders’ equity. The Company’s subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property and nonmonetary assets and liabilities at historical rates. Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and available-for-sale securities by significant investment category as of September 30, 2017 and September 24, 2016 (in millions): 2017 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 7,982 $ — $ — $ 7,982 $ 7,982 $ — $ — Level 1: Money market funds 6,534 — — 6,534 6,534 — — Mutual funds 799 — (88 ) 711 — 711 — Subtotal 7,333 — (88 ) 7,245 6,534 711 — Level 2: U.S. Treasury securities 55,254 58 (230 ) 55,082 865 17,228 36,989 U.S. agency securities 5,162 2 (9 ) 5,155 1,439 2,057 1,659 Non-U.S. government securities 7,827 210 (37 ) 8,000 9 123 7,868 Certificates of deposit and time deposits 5,832 — — 5,832 1,142 3,918 772 Commercial paper 3,640 — — 3,640 2,146 1,494 — Corporate securities 152,724 969 (242 ) 153,451 172 27,591 125,688 Municipal securities 961 4 (1 ) 964 — 114 850 Mortgage- and asset-backed securities 21,684 35 (175 ) 21,544 — 656 20,888 Subtotal 253,084 1,278 (694 ) 253,668 5,773 53,181 194,714 Total $ 268,399 $ 1,278 $ (782 ) $ 268,895 $ 20,289 $ 53,892 $ 194,714 Apple Inc. | 2017 Form 10-K | 49 2016 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 8,601 $ — $ — $ 8,601 $ 8,601 $ — $ — Level 1: Money market funds 3,666 — — 3,666 3,666 — — Mutual funds 1,407 — (146 ) 1,261 — 1,261 — Subtotal 5,073 — (146 ) 4,927 3,666 1,261 — Level 2: U.S. Treasury securities 41,697 319 (4 ) 42,012 1,527 13,492 26,993 U.S. agency securities 7,543 16 — 7,559 2,762 2,441 2,356 Non-U.S. government securities 7,609 259 (27 ) 7,841 110 818 6,913 Certificates of deposit and time deposits 6,598 — — 6,598 1,108 3,897 1,593 Commercial paper 7,433 — — 7,433 2,468 4,965 — Corporate securities 131,166 1,409 (206 ) 132,369 242 19,599 112,528 Municipal securities 956 5 — 961 — 167 794 Mortgage- and asset-backed securities 19,134 178 (28 ) 19,284 — 31 19,253 Subtotal 222,136 2,186 (265 ) 224,057 8,217 45,410 170,430 Total $ 235,810 $ 2,186 $ (411 ) $ 237,585 $ 20,484 $ 46,671 $ 170,430 The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management. The maturities of the Company’s long-term marketable securities generally range from one to five years . The Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates and the Company’s intent to sell, or whether it is more likely than not it will be required to sell the investment before recovery of the investment’s cost basis. As of September 30, 2017 , the Company does not consider any of its investments to be other-than-temporarily impaired. Derivative Financial Instruments The Company may use derivatives to partially offset its business exposure to foreign currency and interest rate risk on expected future cash flows, on net investments in certain foreign subsidiaries and on certain existing assets and liabilities. However, the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange or interest rates. To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar may hedge a portion of forecasted foreign currency revenue, and subsidiaries whose functional currency is not the U.S. dollar and who sell in local currencies may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company may enter into forward contracts, option contracts or other instruments to manage this risk and may designate these instruments as cash flow hedges. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months . To help protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. In addition, the Company may use non-derivative financial instruments, such as its foreign currency-denominated debt, as economic hedges of its net investments in certain foreign subsidiaries. In both of these cases, the Company designates these instruments as net investment hedges. Apple Inc. | 2017 Form 10-K | 50 The Company may also enter into non-designated foreign currency contracts to partially offset the foreign currency exchange gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. The Company may enter into interest rate swaps, options, or other instruments to manage interest rate risk. These instruments may offset a portion of changes in income or expense, or changes in fair value of the Company’s term debt or investments. The Company designates these instruments as either cash flow or fair value hedges. The Company’s hedged interest rate transactions as of September 30, 2017 are expected to be recognized within 10 years . The Company may enter into foreign currency swaps to manage currency risk on its foreign currency-denominated term debt. These instruments may offset a portion of the foreign currency remeasurement gains or losses on the Company’s term debt and related interest payments. The Company designates these instruments as cash flow hedges. The Company’s hedged term debt-related foreign currency transactions as of September 30, 2017 are expected to be recognized within 25 years . Cash Flow Hedges The effective portions of cash flow hedges are recorded in AOCI until the hedged item is recognized in earnings. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow hedges of interest income or expense are recognized in other income/(expense), net in the same period as the related income or expense is recognized. The ineffective portions and amounts excluded from the effectiveness testing of cash flow hedges are recognized in other income/(expense), net. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified into other income/(expense), net in the period of de-designation. Any subsequent changes in fair value of such derivative instruments are reflected in other income/(expense), net unless they are re-designated as hedges of other transactions. Net Investment Hedges The effective portions of net investment hedges are recorded in other comprehensive income/(loss) (“OCI”) as a part of the cumulative translation adjustment. The ineffective portions and amounts excluded from the effectiveness testing of net investment hedges are recognized in other income/(expense), net. Fair Value Hedges Gains and losses related to changes in fair value hedges are recognized in earnings along with a corresponding loss or gain related to the change in value of the underlying hedged item. Non-Designated Derivatives Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. As a result, the Company recognized a gain of $20 million in net sales, a loss of $40 million in cost of sales and a gain of $606 million in other income/(expense), net for 2017 . The Company records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these derivative instruments is based on its hedge designation. The following tables show the Company’s derivative instruments at gross fair value as of September 30, 2017 and September 24, 2016 (in millions): 2017 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,049 $ 363 $ 1,412 Interest rate contracts $ 218 $ — $ 218 Derivative liabilities (2) : Foreign exchange contracts $ 759 $ 501 $ 1,260 Interest rate contracts $ 303 $ — $ 303 Apple Inc. | 2017 Form 10-K | 51 2016 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 518 $ 153 $ 671 Interest rate contracts $ 728 $ — $ 728 Derivative liabilities (2) : Foreign exchange contracts $ 935 $ 134 $ 1,069 Interest rate contracts $ 7 $ — $ 7 (1) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets and other non-current assets in the Consolidated Balance Sheets. (2) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses and other non-current liabilities in the Consolidated Balance Sheets. The following table shows the pre-tax gains and losses of the Company’s derivative and non-derivative instruments designated as cash flow, net investment and fair value hedges in OCI and the Consolidated Statements of Operations for 2017 , 2016 and 2015 (in millions): 2017 2016 2015 Gains/(Losses) recognized in OCI – effective portion: Cash flow hedges: Foreign exchange contracts $ 1,797 $ 109 $ 3,592 Interest rate contracts 7 (57 ) (111 ) Total $ 1,804 $ 52 $ 3,481 Net investment hedges: Foreign exchange contracts $ — $ — $ 167 Foreign currency debt 67 (258 ) (71 ) Total $ 67 $ (258 ) $ 96 Gains/(Losses) reclassified from AOCI into net income – effective portion: Cash flow hedges: Foreign exchange contracts $ 1,958 $ 885 $ 4,092 Interest rate contracts (2 ) (11 ) (17 ) Total $ 1,956 $ 874 $ 4,075 Gains/(Losses) on derivative instruments: Fair value hedges: Interest rate contracts $ (810 ) $ 341 $ 337 Gains/(Losses) related to hedged items: Fair value hedges: Fixed-rate debt $ 810 $ (341 ) $ (337 ) Apple Inc. | 2017 Form 10-K | 52 The following table shows the notional amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of September 30, 2017 and September 24, 2016 (in millions): 2017 2016 Notional Amount Credit Risk Amount Notional Amount Credit Risk Amount Instruments designated as accounting hedges: Foreign exchange contracts $ 56,156 $ 1,049 $ 44,678 $ 518 Interest rate contracts $ 33,000 $ 218 $ 24,500 $ 728 Instruments not designated as accounting hedges: Foreign exchange contracts $ 69,774 $ 363 $ 54,305 $ 153 The notional amounts for outstanding derivative instruments provide one measure of the transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s exposure to credit loss and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. The Company generally enters into master netting arrangements, which are designed to reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values in its Consolidated Balance Sheets. The net cash collateral received by the Company related to derivative instruments under its collateral security arrangements was $35 million and $163 million as of September 30, 2017 and September 24, 2016 , respectively, which were recorded as accrued expenses in the Consolidated Balance Sheets. Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net settle transactions with a single net amount payable by one party to the other. As of September 30, 2017 and September 24, 2016 , the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $1.4 billion and $1.5 billion , respectively, resulting in net derivative assets of $32 million and $160 million , respectively. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, value-added resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 30, 2017 , the Company had two customers that individually represented 10% or more of total trade receivables, each of which accounted for 10% . As of September 24, 2016 , the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10% . The Company’s cellular network carriers accounted for 59% and 63% of trade receivables as of September 30, 2017 and September 24, 2016 , respectively. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. As of September 30, 2017 , the Company had three vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 42% , 19% and 10% . As of September 24, 2016 , the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 47% and 21% . Apple Inc. | 2017 Form 10-K | 53 Note 3 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 30, 2017 and September 24, 2016 (in millions): Property, Plant and Equipment, Net 2017 2016 Land and buildings $ 13,587 $ 10,185 Machinery, equipment and internal-use software 54,210 44,543 Leasehold improvements 7,279 6,517 Gross property, plant and equipment 75,076 61,245 Accumulated depreciation and amortization (41,293 ) (34,235 ) Total property, plant and equipment, net $ 33,783 $ 27,010 Other Non-Current Liabilities 2017 2016 Deferred tax liabilities $ 31,504 $ 26,019 Other non-current liabilities 8,911 10,055 Total other non-current liabilities $ 40,415 $ 36,074 Other Income/(Expense), Net The following table shows the detail of other income/(expense), net for 2017 , 2016 and 2015 (in millions): 2017 2016 2015 Interest and dividend income $ 5,201 $ 3,999 $ 2,921 Interest expense (2,323 ) (1,456 ) (733 ) Other expense, net (133 ) (1,195 ) (903 ) Total other income/(expense), net $ 2,745 $ 1,348 $ 1,285 Note 4 – Acquired Intangible Assets The Company’s acquired intangible assets with definite useful lives primarily consist of patents and licenses. The following table summarizes the components of acquired intangible asset balances as of September 30, 2017 and September 24, 2016 (in millions): 2017 2016 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite-lived and amortizable acquired intangible assets $ 7,507 $ (5,309 ) $ 2,198 $ 8,912 $ (5,806 ) $ 3,106 Indefinite-lived and non-amortizable acquired intangible assets 100 — 100 100 — 100 Total acquired intangible assets $ 7,607 $ (5,309 ) $ 2,298 $ 9,012 $ (5,806 ) $ 3,206 Apple Inc. | 2017 Form 10-K | 54 Amortization expense related to acquired intangible assets was $1.2 billion , $1.5 billion and $1.3 billion in 2017 , 2016 and 2015 , respectively. As of September 30, 2017 , the remaining weighted-average amortization period for acquired intangible assets is 3.4 years . The expected annual amortization expense related to acquired intangible assets as of September 30, 2017 , is as follows (in millions): 2018 $ 948 2019 505 2020 323 2021 222 2022 131 Thereafter 69 Total $ 2,198 Note 5 – Income Taxes The provision for income taxes for 2017 , 2016 and 2015 , consisted of the following (in millions): 2017 2016 2015 Federal: Current $ 7,842 $ 7,652 $ 11,730 Deferred 5,980 5,043 3,408 Total (1) 13,822 12,695 15,138 State: Current 259 990 1,265 Deferred 2 (138 ) (220 ) Total 261 852 1,045 Foreign: Current 1,671 2,105 4,744 Deferred (16 ) 33 (1,806 ) Total 1,655 2,138 2,938 Provision for income taxes $ 15,738 $ 15,685 $ 19,121 (1) Includes taxes of $7.9 billion , $6.7 billion and $7.3 billion provided on foreign pre-tax earnings in 2017 , 2016 and 2015 , respectively. The foreign provision for income taxes is based on foreign pre-tax earnings of $44.7 billion , $41.1 billion and $47.6 billion in 2017 , 2016 and 2015 , respectively. The Company’s consolidated financial statements provide for any related tax liability on undistributed earnings that the Company does not intend to be indefinitely reinvested outside the U.S. Substantially all of the Company’s undistributed international earnings intended to be indefinitely reinvested in operations outside the U.S. were generated by subsidiaries organized in Ireland, which has a statutory tax rate of 12.5% . As of September 30, 2017 , U.S. income taxes have not been provided on a cumulative total of $128.7 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be $42.2 billion . As of September 30, 2017 and September 24, 2016 , $252.3 billion and $216.0 billion , respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. Apple Inc. | 2017 Form 10-K | 55 A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate ( 35% in 2017 , 2016 and 2015 ) to income before provision for income taxes for 2017 , 2016 and 2015 , is as follows (dollars in millions): 2017 2016 2015 Computed expected tax $ 22,431 $ 21,480 $ 25,380 State taxes, net of federal effect 185 553 680 Indefinitely invested earnings of foreign subsidiaries (6,135 ) (5,582 ) (6,470 ) Domestic production activities deduction (209 ) (382 ) (426 ) Research and development credit, net (678 ) (371 ) (171 ) Other 144 (13 ) 128 Provision for income taxes $ 15,738 $ 15,685 $ 19,121 Effective tax rate 24.6 % 25.6 % 26.4 % The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan awards. For RSUs, the Company receives an income tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. The Company had net excess tax benefits from equity awards of $620 million , $379 million and $748 million in 2017 , 2016 and 2015 , respectively, which were reflected as increases to common stock. As of September 30, 2017 and September 24, 2016 , the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2017 2016 Deferred tax assets: Accrued liabilities and other reserves $ 4,019 $ 4,135 Basis of capital assets 1,230 2,107 Deferred revenue 1,521 1,717 Deferred cost sharing 667 667 Share-based compensation 703 601 Other 834 788 Total deferred tax assets, net of valuation allowance of $0 8,974 10,015 Deferred tax liabilities: Unremitted earnings of foreign subsidiaries 36,355 31,436 Other 207 485 Total deferred tax liabilities 36,562 31,921 Net deferred tax liabilities $ (27,588 ) $ (21,906 ) Deferred tax assets and liabilities reflect the effects of tax losses, credits and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Uncertain Tax Positions Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one year as non-current liabilities in the Consolidated Balance Sheets. As of September 30, 2017 , the total amount of gross unrecognized tax benefits was $8.4 billion , of which $2.5 billion , if recognized, would affect the Company’s effective tax rate. As of September 24, 2016 , the total amount of gross unrecognized tax benefits was $7.7 billion , of which $2.8 billion , if recognized, would have affected the Company’s effective tax rate. Apple Inc. | 2017 Form 10-K | 56 The aggregate changes in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2017 , 2016 and 2015 , is as follows (in millions): 2017 2016 2015 Beginning balances $ 7,724 $ 6,900 $ 4,033 Increases related to tax positions taken during a prior year 333 1,121 2,056 Decreases related to tax positions taken during a prior year (952 ) (257 ) (345 ) Increases related to tax positions taken during the current year 1,880 1,578 1,278 Decreases related to settlements with taxing authorities (539 ) (1,618 ) (109 ) Decreases related to expiration of statute of limitations (39 ) — (13 ) Ending balances $ 8,407 $ 7,724 $ 6,900 The Company includes interest and penalties related to unrecognized tax benefits within the provision for income taxes. As of September 30, 2017 and September 24, 2016 , the total amount of gross interest and penalties accrued was $1.2 billion and $1.0 billion , respectively, which is classified as non-current liabilities in the Consolidated Balance Sheets. In connection with tax matters, the Company recognized interest and penalty expense in 2017 , 2016 and 2015 of $165 million , $295 million and $709 million , respectively. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. The U.S. Internal Revenue Service (the “IRS”) concluded its review of the years 2010 through 2012 during the third quarter of 2017. All years prior to 2013 are closed, and the IRS is currently examining the years 2013 through 2015. The Company is also subject to audits by state, local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 2003 generally remain open and could be subject to examination by the taxing authorities. The Company believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with its expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company does not believe it is reasonably possible that its gross unrecognized tax benefits would materially change in the next 12 months. On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision orders Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and appealed to the General Court of the Court of Justice of the European Union. Ireland has also appealed the State Aid Decision. Although Ireland is still computing the recovery amount, the Company expects the amount to be in line with the European Commission’s announced recovery amount of €13 billion , plus interest of €1 billion . Once the recovery amount is finalized by Ireland, the Company anticipates funding it, including interest, out of foreign cash. These amounts are expected to be placed into escrow in 2018, where they will remain pending conclusion of all appeals. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes. Apple Inc. | 2017 Form 10-K | 57 Note 6 – Debt Commercial Paper The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 30, 2017 and September 24, 2016 , the Company had $12.0 billion and $8.1 billion of Commercial Paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 1.20% as of September 30, 2017 and 0.45% as of September 24, 2016 . The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2017 and 2016 (in millions): 2017 2016 Maturities less than 90 days: Proceeds from/(Repayments of) commercial paper, net $ (1,782 ) $ (869 ) Maturities greater than 90 days: Proceeds from commercial paper 17,932 3,632 Repayments of commercial paper (12,298 ) (3,160 ) Proceeds from/(Repayments of) commercial paper, net 5,634 472 Total change in commercial paper, net $ 3,852 $ (397 ) Term Debt As of September 30, 2017 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $104.0 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and interest is payable in arrears, quarterly for the U.S. dollar-denominated and Australian dollar-denominated floating-rate notes, semi-annually for the U.S. dollar-denominated, Australian dollar-denominated, British pound-denominated, Japanese yen-denominated and Canadian dollar-denominated fixed-rate notes and annually for the euro-denominated and Swiss franc-denominated fixed-rate notes. The following table provides a summary of the Company’s term debt as of September 30, 2017 and September 24, 2016 : Maturities 2017 2016 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 debt issuance of $17.0 billion: Floating-rate notes 2018 2018 $ 2,000 1.10% 1.10 % $ 2,000 1.10% 1.10 % Fixed-rate 1.000% – 3.850% notes 2018 – 2043 12,500 1.08% – 3.91 % 12,500 1.08% – 3.91 % 2014 debt issuance of $12.0 billion: Floating-rate notes 2019 2019 1,000 1.61% 1.61 % 2,000 0.86% – 1.09 % Fixed-rate 2.100% – 4.450% notes 2019 – 2044 8,500 1.61% – 4.48 % 10,000 0.85% – 4.48 % 2015 debt issuances of $27.3 billion: Floating-rate notes 2019 – 2020 1,549 1.56% – 1.87 % 1,781 0.87% – 1.87 % Fixed-rate 0.350% – 4.375% notes 2019 – 2045 24,522 0.28% – 4.51 % 25,144 0.28% – 4.51 % 2016 debt issuances of $24.9 billion: Floating-rate notes 2019 – 2021 1,350 1.45% – 2.44 % 1,350 0.91% – 1.95 % Fixed-rate 1.100% – 4.650% notes 2018 – 2046 23,645 1.13% – 4.78 % 23,609 1.13% – 4.58 % Apple Inc. | 2017 Form 10-K | 58 Maturities 2017 2016 (Continued) Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate Second quarter 2017 debt issuance of $10.0 billion: Floating-rate notes 2019 500 1.39 % — — % Floating-rate notes 2020 500 1.51 % — — % Floating-rate notes 2022 1,000 1.81 % — — % Fixed-rate 1.550% notes 2019 500 1.59 % — — % Fixed-rate 1.900% notes 2020 1,000 1.51 % — — % Fixed-rate 2.500% notes 2022 1,500 1.80 % — — % Fixed-rate 3.000% notes 2024 1,750 2.11 % — — % Fixed-rate 3.350% notes 2027 2,250 2.25 % — — % Fixed-rate 4.250% notes 2047 1,000 4.26 % — — % Second quarter 2017 debt issuance of $1.0 billion: Fixed-rate 4.300% notes 2047 1,000 4.30 % — — % Third quarter 2017 debt issuance of $7.0 billion: Floating-rate notes 2020 500 1.38 % — — % Floating-rate notes 2022 750 1.66 % — — % Fixed-rate 1.800% notes 2020 1,000 1.84 % — — % Fixed-rate 2.300% notes 2022 1,000 2.34 % — — % Fixed-rate 2.850% notes 2024 1,750 2.25 % — — % Fixed-rate 3.200% notes 2027 2,000 2.43 % — — % Third quarter 2017 euro-denominated debt issuance of €2.5 billion: Fixed-rate 0.875% notes 2025 1,469 3.03 % — — % Fixed-rate 1.375% notes 2029 1,469 3.37 % — — % Third quarter 2017 debt issuance of $1.0 billion: Fixed-rate 3.000% notes 2027 1,000 3.03 % — — % Fourth quarter 2017 Canadian dollar-denominated debt issuance of C$2.5 billion: Fixed-rate 2.513% notes 2024 2,017 2.66 % — — % Fourth quarter 2017 debt issuance of $5.0 billion: Fixed-rate 1.500% notes 2019 1,000 1.54 % — — % Fixed-rate 2.100% notes 2022 1,000 1.92 % — — % Fixed-rate 2.900% notes 2027 2,000 2.55 % — — % Fixed-rate 3.750% notes 2047 1,000 3.78 % — — % Total term debt 104,021 78,384 Unamortized premium/(discount) and issuance costs, net (225 ) (174 ) Hedge accounting fair value adjustments (93 ) 717 Less: Current portion of long-term debt (6,496 ) (3,500 ) Total long-term debt $ 97,207 $ 75,427 To manage interest rate risk on certain of its U.S. dollar-denominated fixed- or floating-rate notes, the Company has entered into interest rate swaps to effectively convert the fixed interest rates to floating interest rates or the floating interest rates to fixed interest rates on a portion of these notes. Additionally, to manage foreign currency risk on certain of its foreign currency-denominated notes, the Company has entered into foreign currency swaps to effectively convert these notes to U.S. dollar-denominated notes. A portion of the Company’s Japanese yen-denominated notes is designated as a hedge of the foreign currency exposure of the Company’s net investment in a foreign operation. As of September 30, 2017 and September 24, 2016 , the carrying value of the debt designated as a net investment hedge was $1.6 billion and $1.9 billion , respectively. For further discussion regarding the Company’s use of derivative instruments see the Derivative Financial Instruments section of Note 2, “Financial Instruments.” Apple Inc. | 2017 Form 10-K | 59 The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $2.2 billion , $1.4 billion and $722 million of interest expense on its term debt for 2017 , 2016 and 2015 , respectively. The future principal payments for the Company’s Notes as of September 30, 2017 are as follows (in millions): 2018 $ 6,500 2019 8,863 2020 9,220 2021 7,750 2022 10,297 Thereafter 61,391 Total term debt $ 104,021 As of September 30, 2017 and September 24, 2016 , the fair value of the Company’s Notes, based on Level 2 inputs, was $106.1 billion and $81.7 billion , respectively. Note 7 – Shareholders’ Equity Dividends The Company declared and paid cash dividends per share during the periods presented as follows: Dividends Per Share Amount (in millions) 2017: Fourth quarter $ 0.63 $ 3,252 Third quarter 0.63 3,281 Second quarter 0.57 2,988 First quarter 0.57 3,042 Total cash dividends declared and paid $ 2.40 $ 12,563 2016: Fourth quarter $ 0.57 $ 3,071 Third quarter 0.57 3,117 Second quarter 0.52 2,879 First quarter 0.52 2,898 Total cash dividends declared and paid $ 2.18 $ 11,965 Future dividends are subject to declaration by the Board of Directors. Share Repurchase Program In May 2017 , the Company’s Board of Directors increased the share repurchase authorization from $175 billion to $210 billion of the Company’s common stock, of which $166 billion had been utilized as of September 30, 2017 . The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company has entered, and in the future may enter, into accelerated share repurchase arrangements (“ASRs”) with financial institutions. In exchange for up-front payments, the financial institutions deliver shares of the Company’s common stock during the purchase periods of each ASR. The total number of shares ultimately delivered, and therefore the average repurchase price paid per share, is determined at the end of the applicable purchase period of each ASR based on the volume-weighted average price of the Company’s common stock during that period. The shares received are retired in the periods they are delivered, and the up-front payments are accounted for as a reduction to shareholders’ equity in the Company’s Consolidated Balance Sheets in the periods the payments are made. The Company reflects the ASRs as a repurchase of common stock in the period delivered for purposes of calculating earnings per share and as forward contracts indexed to its own common stock. The ASRs met all of the applicable criteria for equity classification, and therefore were not accounted for as derivative instruments. Apple Inc. | 2017 Form 10-K | 60 The following table shows the Company’s ASR activity and related information during the years ended September 30, 2017 and September 24, 2016 : Purchase Period End Date Number of Shares (in thousands) Average Repurchase Price Per Share ASR Amount (in millions) August 2017 ASR November 2017 15,069 (1) (1) $ 3,000 May 2017 ASR August 2017 20,108 (2) $ 149.20 $ 3,000 February 2017 ASR May 2017 20,949 $ 143.20 $ 3,000 November 2016 ASR February 2017 51,157 $ 117.29 $ 6,000 August 2016 ASR November 2016 26,850 $ 111.73 $ 3,000 May 2016 ASR August 2016 60,452 $ 99.25 $ 6,000 November 2015 ASR April 2016 29,122 $ 103.02 $ 3,000 (1) “Number of Shares” represents those shares delivered at the beginning of the purchase period and does not represent the final number of shares to be delivered under the ASR. The total number of shares ultimately delivered, and therefore the average repurchase price paid per share, will be determined at the end of the purchase period based on the volume-weighted average price of the Company’s common stock during that period. The August 2017 ASR purchase period will end in November 2017 . (2) Includes 15.6 million shares delivered and retired at the beginning of the purchase period, which began in the third quarter of 2017, and 4.5 million shares delivered and retired at the end of the purchase period, which concluded in the fourth quarter of 2017. Additionally, the Company repurchased shares of its common stock in the open market, which were retired upon repurchase, during the periods presented as follows: Number of Shares (in thousands) Average Repurchase Price Per Share Amount (in millions) 2017: Fourth quarter 29,073 $ 154.78 $ 4,500 Third quarter 30,356 $ 148.24 4,500 Second quarter 31,070 $ 128.74 4,001 First quarter 44,333 $ 112.78 5,000 Total open market common stock repurchases 134,832 $ 18,001 2016: Fourth quarter 28,579 $ 104.97 $ 3,000 Third quarter 41,238 $ 97.00 4,000 Second quarter 71,766 $ 97.54 7,000 First quarter 25,984 $ 115.45 3,000 Total open market common stock repurchases 167,567 $ 17,000 Note 8 – Comprehensive Income Comprehensive income consists of two components, net income and OCI. OCI refers to revenue, expenses, and gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and unrealized gains and losses on marketable securities classified as available-for-sale. Apple Inc. | 2017 Form 10-K | 61 The following table shows the pre-tax amounts reclassified from AOCI into the Consolidated Statements of Operations, and the associated financial statement line item, for 2017 and 2016 (in millions): Comprehensive Income Components Financial Statement Line Item 2017 2016 Unrealized (gains)/losses on derivative instruments: Foreign exchange contracts Revenue $ (662 ) $ (865 ) Cost of sales (654 ) (130 ) Other income/(expense), net (638 ) 111 Interest rate contracts Other income/(expense), net 2 12 (1,952 ) (872 ) Unrealized (gains)/losses on marketable securities Other income/(expense), net (99 ) 87 Total amounts reclassified from AOCI $ (2,051 ) $ (785 ) The following table shows the changes in AOCI by component for 2017 and 2016 (in millions): Cumulative Foreign Currency Translation Unrealized Gains/Losses on Derivative Instruments Unrealized Gains/Losses on Marketable Securities Total Balances as of September 26, 2015 $ (653 ) $ 772 $ (464 ) $ (345 ) Other comprehensive income/(loss) before reclassifications 67 14 2,445 2,526 Amounts reclassified from AOCI — (872 ) 87 (785 ) Tax effect 8 124 (894 ) (762 ) Other comprehensive income/(loss) 75 (734 ) 1,638 979 Balances as of September 24, 2016 (578 ) 38 1,174 634 Other comprehensive income/(loss) before reclassifications 301 1,793 (1,207 ) 887 Amounts reclassified from AOCI — (1,952 ) (99 ) (2,051 ) Tax effect (77 ) (3 ) 460 380 Other comprehensive income/(loss) 224 (162 ) (846 ) (784 ) Balances as of September 30, 2017 $ (354 ) $ (124 ) $ 328 $ (150 ) Note 9 – Benefit Plans 2014 Employee Stock Plan In the second quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the 2014 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. Each share issued with respect to RSUs granted under the 2014 Plan reduces the number of shares available for grant under the plan by two shares. RSUs canceled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the number of RSUs canceled or shares withheld. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 385 million shares plus the number of shares remaining that were reserved but not issued under the 2003 Plan. Shares subject to outstanding awards under the 2003 Plan that expire, are canceled or otherwise terminate, or are withheld to satisfy tax withholding obligations with respect to RSUs, will also be available for awards under the 2014 Plan. As of September 30, 2017 , approximately 327.9 million shares were reserved for future issuance under the 2014 Plan. Apple Inc. | 2017 Form 10-K | 62 2003 Employee Stock Plan The 2003 Plan is a shareholder approved plan that provided for broad-based equity grants to employees, including executive officers. The 2003 Plan permitted the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights and performance-based awards. Options granted under the 2003 Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years , based on continued employment, with either annual, semi-annual or quarterly vesting. RSUs granted under the 2003 Plan generally vest over two to four years , based on continued employment and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. All RSUs, other than RSUs held by the Chief Executive Officer, granted under the 2003 Plan have DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. In the second quarter of 2014, the Company terminated the authority to grant new awards under the 2003 Plan. 1997 Director Stock Plan The 1997 Director Stock Plan (the “Director Plan”) is a shareholder approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants without shareholder approval. Each share issued with respect to RSUs granted under the Director Plan reduces the number of shares available for grant under the plan by two shares. The Director Plan expires November 9, 2019 . All RSUs granted under the Director Plan are entitled to DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. As of September 30, 2017 , approximately 1.1 million shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the three months ended September 30, 2017 , Section 16 officers Angela Ahrendts, Timothy D. Cook, Luca Maestri, Daniel Riccio and Philip Schiller had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired pursuant to the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder approved plan under which substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning or the end of six -month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10% of the employee’s compensation and employees may not purchase more than $25,000 of stock during any calendar year. As of September 30, 2017 , approximately 41.5 million shares were reserved for future issuance under the Purchase Plan. 401(k) Plan The Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ( $18,000 for calendar year 2017). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. Apple Inc. | 2017 Form 10-K | 63 Restricted Stock Units A summary of the Company’s RSU activity and related information for 2017 , 2016 and 2015 , is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per Share Aggregate Fair Value (in millions) Balance as of September 27, 2014 103,822 $ 70.98 RSUs granted 45,587 $ 105.51 RSUs vested (41,684 ) $ 71.32 RSUs canceled (6,258 ) $ 80.34 Balance as of September 26, 2015 101,467 $ 85.77 RSUs granted 49,468 $ 109.28 RSUs vested (46,313 ) $ 84.44 RSUs canceled (5,533 ) $ 96.48 Balance as of September 24, 2016 99,089 $ 97.54 RSUs granted 50,112 $ 121.65 RSUs vested (45,735 ) $ 95.48 RSUs canceled (5,895 ) $ 106.87 Balance as of September 30, 2017 97,571 $ 110.33 $ 15,038 The fair value as of the respective vesting dates of RSUs was $6.1 billion , $5.1 billion and $4.8 billion for 2017 , 2016 and 2015 , respectively. The majority of RSUs that vested in 2017 , 2016 and 2015 were net share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 15.4 million , 15.9 million and 14.1 million for 2017 , 2016 and 2015 , respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $2.0 billion , $1.7 billion and $1.6 billion in 2017 , 2016 and 2015 , respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net share settlements had the effect of share repurchases by the Company as they reduced the number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. Share-based Compensation The following table shows a summary of the share-based compensation expense included in the Consolidated Statements of Operations for 2017 , 2016 and 2015 (in millions): 2017 2016 2015 Cost of sales $ 877 $ 769 $ 575 Research and development 2,299 1,889 1,536 Selling, general and administrative 1,664 1,552 1,475 Total share-based compensation expense $ 4,840 $ 4,210 $ 3,586 The income tax benefit related to share-based compensation expense was $1.6 billion , $1.4 billion and $1.2 billion for 2017 , 2016 and 2015 , respectively. As of September 30, 2017 , the total unrecognized compensation cost related to outstanding RSUs, restricted stock and stock options was $8.1 billion , which the Company expects to recognize over a weighted-average period of 2.5 years . Note 10 – Commitments and Contingencies Accrued Warranty and Indemnification The following table shows changes in the Company’s accrued warranties and related costs for 2017 , 2016 and 2015 (in millions): 2017 2016 2015 Beginning accrued warranty and related costs $ 3,702 $ 4,780 $ 4,159 Cost of warranty claims (4,322 ) (4,663 ) (4,401 ) Accruals for product warranty 4,454 3,585 5,022 Ending accrued warranty and related costs $ 3,834 $ 3,702 $ 4,780 Apple Inc. | 2017 Form 10-K | 64 Agreements entered into by the Company sometimes include indemnification provisions which may subject the Company to costs and damages in the event of a claim against an indemnified third party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to indemnification of third parties. The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers of the Company and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. While the Company maintains directors and officers liability insurance coverage, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, a few components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s manufacturing purchase obligations typically cover its requirements for periods up to 150 days . Other Off-Balance Sheet Commitments Operating Leases The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. As of September 30, 2017 , the Company’s total future minimum lease payments under noncancelable operating leases were $9.5 billion . The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. Apple Inc. | 2017 Form 10-K | 65 Rent expense under all operating leases, including both cancelable and noncancelable leases, was $1.1 billion , $939 million and $794 million in 2017 , 2016 and 2015 , respectively. Future minimum lease payments under noncancelable operating leases having initial or remaining terms in excess of one year as of September 30, 2017 , are as follows (in millions): 2018 $ 1,223 2019 1,187 2020 1,108 2021 1,033 2022 871 Thereafter 4,123 Total $ 9,545 Unconditional Purchase Obligations The Company has entered into certain off-balance sheet arrangements which require the future purchase of goods or services (“Unconditional Purchase Obligations”). The Company’s Unconditional Purchase Obligations primarily consist of payments for supplier arrangements, internet and telecommunication services and intellectual property licenses. Future payments under noncancelable Unconditional Purchase Obligations having a remaining term in excess of one year as of September 30, 2017 , are as follows (in millions): 2018 $ 1,798 2019 2,675 2020 1,626 2021 1,296 2022 1,268 Thereafter 14 Total $ 8,677 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully adjudicated, as further discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings.” In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. v. Samsung Electronics Co., Ltd., et al. On August 24, 2012, a jury returned a verdict awarding the Company $1.05 billion in its lawsuit against Samsung Electronics Co., Ltd. and affiliated parties in the United States District Court, Northern District of California, San Jose Division. On March 6, 2014, the District Court entered final judgment in favor of the Company in the amount of approximately $930 million . On May 18, 2015, the U.S. Court of Appeals for the Federal Circuit affirmed in part, and reversed in part, the decision of the District Court. As a result, the Court of Appeals ordered entry of final judgment on damages in the amount of approximately $548 million , with the District Court to determine supplemental damages and interest, as well as damages owed for products subject to the reversal in part. Samsung paid $548 million to the Company in December 2015, which was included in net sales in the Consolidated Statement of Operations. On December 6, 2016, the U.S. Supreme Court remanded the case to the U.S. Court of Appeals for the Federal Circuit for further proceedings related to the $548 million in damages. On February 7, 2017, the U.S. Court of Appeals for the Federal Circuit remanded the case to the District Court to determine what additional proceedings, if any, are needed. On October 22, 2017, on remand from the U.S. Supreme Court, the District Court ordered a new trial on damages. Apple Inc. | 2017 Form 10-K | 66 Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable segments. Costs excluded from segment operating income include various corporate expenses such as R&D, corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. The following table shows information by reportable segment for 2017 , 2016 and 2015 (in millions): 2017 2016 2015 Americas: Net sales $ 96,600 $ 86,613 $ 93,864 Operating income $ 30,684 $ 28,172 $ 31,186 Europe: Net sales $ 54,938 $ 49,952 $ 50,337 Operating income $ 16,514 $ 15,348 $ 16,527 Greater China: Net sales $ 44,764 $ 48,492 $ 58,715 Operating income $ 17,032 $ 18,835 $ 23,002 Japan: Net sales $ 17,733 $ 16,928 $ 15,706 Operating income $ 8,097 $ 7,165 $ 7,617 Rest of Asia Pacific: Net sales $ 15,199 $ 13,654 $ 15,093 Operating income $ 5,304 $ 4,781 $ 5,518 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2017 , 2016 and 2015 is as follows (in millions): 2017 2016 2015 Segment operating income $ 77,631 $ 74,301 $ 83,850 Research and development expense (11,581 ) (10,045 ) (8,067 ) Other corporate expenses, net (4,706 ) (4,232 ) (4,553 ) Total operating income $ 61,344 $ 60,024 $ 71,230 Apple Inc. | 2017 Form 10-K | 67 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2017, 2016 and 2015. There was no single customer that accounted for more than 10% of net sales in 2017, 2016 and 2015. Net sales for 2017 , 2016 and 2015 and long-lived assets as of September 30, 2017 and September 24, 2016 were as follows (in millions): 2017 2016 2015 Net sales: U.S. $ 84,339 $ 75,667 $ 81,732 China (1) 44,764 48,492 58,715 Other countries 100,131 91,480 93,268 Total net sales $ 229,234 $ 215,639 $ 233,715 2017 2016 Long-lived assets: U.S. $ 20,637 $ 16,364 China (1) 10,211 7,875 Other countries 2,935 2,771 Total long-lived assets $ 33,783 $ 27,010 (1) China includes Hong Kong and Taiwan. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets related to retail stores and related infrastructure. Net sales by product for 2017 , 2016 and 2015 were as follows (in millions): 2017 2016 2015 iPhone (1) $ 141,319 $ 136,700 $ 155,041 iPad (1) 19,222 20,628 23,227 Mac (1) 25,850 22,831 25,471 Services (2) 29,980 24,348 19,909 Other Products (1)(3) 12,863 11,132 10,067 Total net sales $ 229,234 $ 215,639 $ 233,715 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from Digital Content and Services, AppleCare, Apple Pay, licensing and other services. Services net sales in the fourth quarter of 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. (3) Includes sales of Apple TV, Apple Watch, Beats products, iPod touch and Apple-branded and third-party accessories. Note 12 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters of 2017 and 2016 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2017: Net sales $ 52,579 $ 45,408 $ 52,896 $ 78,351 Gross margin $ 19,931 $ 17,488 $ 20,591 $ 30,176 Net income $ 10,714 $ 8,717 $ 11,029 $ 17,891 Earnings per share (1) : Basic $ 2.08 $ 1.68 $ 2.11 $ 3.38 Diluted $ 2.07 $ 1.67 $ 2.10 $ 3.36 Apple Inc. | 2017 Form 10-K | 68 Fourth Quarter Third Quarter Second Quarter First Quarter 2016: Net sales $ 46,852 $ 42,358 $ 50,557 $ 75,872 Gross margin $ 17,813 $ 16,106 $ 19,921 $ 30,423 Net income $ 9,014 $ 7,796 $ 10,516 $ 18,361 Earnings per share (1) : Basic $ 1.68 $ 1.43 $ 1.91 $ 3.30 Diluted $ 1.67 $ 1.42 $ 1.90 $ 3.28 (1) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. Apple Inc. | 2017 Form 10-K | 69 Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 30, 2017 and September 24, 2016 , and the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 30, 2017 . These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Inc. at September 30, 2017 and September 24, 2016 , and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2017 , in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple Inc.’s internal control over financial reporting as of September 30, 2017 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated November 3, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California November 3, 2017 Apple Inc. | 2017 Form 10-K | 70 Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 30, 2017 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 30, 2017 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2017 consolidated financial statements of Apple Inc. and our report dated November 3, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California November 3, 2017 Apple Inc. | 2017 Form 10-K | 71 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 30, 2017 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 30, 2017 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2017 , which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information Not applicable. Apple Inc. | 2017 Form 10-K | 72 PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Corporate Governance,” “Directors,” “Executive Officers” and “Other Information—Security Ownership of Certain Beneficial Owners and Management” in the Company’s 2018 Proxy Statement to be filed with the SEC within 120 days after September 30, 2017 in connection with the solicitation of proxies for the Company’s 2018 annual meeting of shareholders and is incorporated herein by reference. The Company has a code of ethics, “Business Conduct: The way we do business worldwide,” that applies to all employees, including the Company’s principal executive officer, principal financial officer, and principal accounting officer, as well as to the members of the Board of Directors of the Company. The code is available at investor.apple.com/corporate-governance.cfm. The Company intends to disclose any changes in, or waivers from, this code by posting such information on the same website or by filing a Form 8-K, in each case to the extent such disclosure is required by rules of the SEC or Nasdaq. Item 11. Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation,” under the subheadings “Board Oversight of Risk Management” and “Compensation Committee Interlocks and Insider Participation” under the heading “Corporate Governance” and under the subheadings “Compensation of Directors” and “Director Compensation— 2017 ” under the heading “Directors” in the Company’s 2018 Proxy Statement to be filed with the SEC within 120 days after September 30, 2017 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Other Information—Security Ownership of Certain Beneficial Owners and Management” and “Other Information—Equity Compensation Plan Information” in the Company’s 2018 Proxy Statement to be filed with the SEC within 120 days after September 30, 2017 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the subheadings “Board Committees”, “Review, Approval, or Ratification of Transactions with Related Persons” and “Transactions with Related Persons” under the heading “Corporate Governance” in the Company’s 2018 Proxy Statement to be filed with the SEC within 120 days after September 30, 2017 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm” under the proposal “Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2018 Proxy Statement to be filed with the SEC within 120 days after September 30, 2017 and is incorporated herein by reference. Apple Inc. | 2017 Form 10-K | 73 PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 39 Consolidated Statements of Comprehensive Income for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 40 Consolidated Balance Sheets as of September 30, 2017 and September 24, 2016 41 Consolidated Statements of Shareholders’ Equity for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 42 Consolidated Statements of Cash Flows for the years ended September 30, 2017, September 24, 2016 and September 26, 2015 43 Notes to Consolidated Financial Statements 44 Selected Quarterly Financial Information (Unaudited) 68 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 70 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant effective as of June 6, 2014. 8-K 3.1 6/6/14 3.2 Amended and Restated Bylaws of the Registrant effective as of December 13, 2016. 8-K 3.2 12/15/16 4.1 Form of Common Stock Certificate of the Registrant. 10-Q 4.1 12/30/06 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of June 10, 2015, including forms of global notes representing the 0.350% Notes due 2020. 8-K 4.1 6/10/15 Apple Inc. | 2017 Form 10-K | 74 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.9 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.10 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 4.11 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.12 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.13 Officer’s Certificate of the Registrant, dated as of June 22, 2016, including form of global note representing 4.15% Notes due 2046. 8-K 4.1 6/22/16 4.14 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.15 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.16 Officer’s Certificate of the Registrant, dated as of March 3, 2017, including form of global note representing 4.300% Notes due 2047. 8-K 4.1 3/3/17 4.17 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.18 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.19 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.20 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.21 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* 1997 Director Stock Plan, as amended through August 23, 2012. 10-Q 10.3 12/28/13 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.6* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of April 6, 2012. 10-Q 10.8 3/31/12 10.7* Summary Description of Amendment, effective as of May 24, 2012, to certain Restricted Stock Unit Award Agreements outstanding as of April 5, 2012. 10-Q 10.8 6/30/12 10.8*, ** 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan as of February 28, 2014. 8-K 10.2 3/5/14 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of February 28, 2014. 8-K 10.3 3/5/14 10.11* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.11 9/27/14 Apple Inc. | 2017 Form 10-K | 75 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 10.12* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.12 9/27/14 10.13* Form of Amendment, effective as of August 26, 2014, to Restricted Stock Unit Award Agreements and Performance Award Agreements outstanding as of August 26, 2014. 10-K 10.13 9/27/14 10.14* Offer Letter, dated August 1, 2013, from the Registrant to Angela Ahrendts. 10-Q 10.14 12/27/14 10.15* Form of Restricted Stock Unit Award Agreement under the 1997 Director Stock Plan as of November 17, 2015. 10-Q 10.15 12/26/15 10.16* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.16 3/26/16 10.17* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.17 3/26/16 10.18* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.18 9/24/16 10.19* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.19 9/24/16 10.20*, ** Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10.21*, ** Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 12.1** Computation of Ratio of Earnings to Fixed Charges. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS** XBRL Instance Document. 101.SCH** XBRL Taxonomy Extension Schema Document. 101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document. 101.DEF** XBRL Taxonomy Extension Definition Linkbase Document. 101.LAB** XBRL Taxonomy Extension Label Linkbase Document. 101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16. Form 10-K Summary None. Apple Inc. | 2017 Form 10-K | 76 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: November 3, 2017 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) November 3, 2017 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) November 3, 2017 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) November 3, 2017 CHRIS KONDO /s/ James A. Bell Director November 3, 2017 JAMES A. BELL /s/ Al Gore Director November 3, 2017 AL GORE /s/ Robert A. Iger Director November 3, 2017 ROBERT A. IGER /s/ Andrea Jung Director November 3, 2017 ANDREA JUNG /s/ Arthur D. Levinson Director November 3, 2017 ARTHUR D. LEVINSON /s/ Ronald D. Sugar Director November 3, 2017 RONALD D. SUGAR /s/ Susan L. Wagner Director November 3, 2017 SUSAN L. WAGNER Apple Inc. | 2017 Form 10-K | 77 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-18-000145/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-18-000145/full-submission.txt new file mode 100644 index 0000000..e3d52e1 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-18-000145/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 29, 2018 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) One Apple Park Way Cupertino, California 95014 (Address of principal executive offices) (Zip Code) (408) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.00001 par value per share 1.000% Notes due 2022 1.375% Notes due 2024 0.875% Notes due 2025 1.625% Notes due 2026 2.000% Notes due 2027 1.375% Notes due 2029 3.050% Notes due 2029 3.600% Notes due 2042 The Nasdaq Stock Market LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC (Title of each class) (Name of each exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 30, 2018 , the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $828,880,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 4,745,398,000 shares of common stock were issued and outstanding as of October 26, 2018 . DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2019 annual meeting of shareholders (the “ 2019 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2019 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 29, 2018 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 8 Item 1B. Unresolved Staff Comments 17 Item 2. Properties 18 Item 3. Legal Proceedings 18 Item 4. Mine Safety Disclosures 18 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 19 Item 6. Selected Financial Data 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 35 Item 8. Financial Statements and Supplementary Data 37 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 67 Item 9A. Controls and Procedures 67 Item 9B. Other Information 67 Part III Item 10. Directors, Executive Officers and Corporate Governance 68 Item 11. Executive Compensation 68 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 68 Item 13 . Certain Relationships and Related Transactions, and Director Independence 68 Item 14. Principal Accounting Fees and Services 68 Part IV Item 15. Exhibits, Financial Statement Schedules 69 Item 16. Form 10-K Summary 71 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , Apple Watch ® , AirPods ® , Apple TV ® , HomePod™, a portfolio of consumer and professional software applications, iOS, macOS ® , watchOS ® and tvOS™ operating systems, iCloud ® , Apple Pay ® and a variety of other accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store ® , App Store ® , Mac App Store, TV App Store, Book Store and Apple Music ® (collectively “Digital Content and Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories, through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software and services to provide its customers products and solutions with innovative design, superior ease-of-use and seamless integration. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of digital content and applications through its Digital Content and Services, which allows customers to discover and download or stream digital content, iOS, Mac, Apple Watch and Apple TV applications, and books through either a Mac or Windows personal computer or through iPhone, iPad and iPod touch ® devices (“iOS devices”), Apple TV, Apple Watch and HomePod. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. Therefore, the Company’s strategy also includes building and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience. The Company believes ongoing investment in research and development (“R&D”), marketing and advertising is critical to the development and sale of innovative products, services and technologies. Products iPhone iPhone is the Company’s line of smartphones based on its iOS operating system. iPhone includes Siri ® , an intelligent assistant, and Apple Pay, Touch ID ® and Face ID ® on qualifying devices. In September 2018, the Company introduced three new iPhones . iPhone Xs and Xs Max feature a Super Retina™ OLED display, an all-screen stainless steel and glass design, faster processors and enhanced cameras, and were available beginning in September 2018. iPhone X R features a Liquid Retina™ LCD display in an all-screen aluminum and glass design, and was available beginning in October 2018. The Company’s line of smartphones also includes iPhone 8, 8 Plus, 7 and 7 Plus models. iPhone works with the iTunes Store, App Store, Book Store and Apple Music for purchasing, organizing and playing digital content and apps. Apple Inc. | 2018 Form 10-K | 1 iPad iPad is the Company’s line of multi-purpose tablets based on its iOS operating system, which includes iPad Pro ® , iPad and iPad mini ® . iPad includes Siri, Apple Pay and Touch ID. In March 2018, the Company released a new 9.7-inch iPad with Apple Pencil ® compatibility. In October 2018, the Company introduced a new version of iPad Pro as well as a new Apple Pencil and Smart Keyboard Folio™. The new 11-inch and 12.9-inch iPad Pro models feature a Liquid Retina LCD display in an all-screen aluminum and glass design and integrate Face ID. iPad works with the iTunes Store, App Store, Book Store and Apple Music for purchasing, organizing and playing digital content and apps. Mac Mac is the Company’s line of desktop and portable personal computers based on its macOS operating system. Mac includes Siri and supports Apple Pay, and also includes Touch ID on qualifying devices. The Company’s desktop computers include iMac ® 21.5-inch, iMac 21.5-inch with Retina ® 4K display, iMac 27-inch with Retina 5K display, iMac Pro ® , Mac Pro ® and Mac mini ® . The Company’s portable computers include MacBook ® , MacBook Air ® , MacBook Pro ® and MacBook Pro with Touch Bar™. In October 2018, the Company introduced a new MacBook Air featuring a Retina display and Touch ID, and a new Mac mini with upgraded performance. Operating Systems iOS iOS is the Company’s mobile operating system that serves as the foundation for iOS devices. Devices running iOS are compatible with both Mac and Windows personal computers and Apple’s iCloud services. In September 2018, the Company released iOS 12, which includes improved performance and responsiveness, new augmented reality capabilities and expressive communication features, and introduces Siri Shortcuts, enabling Siri to intelligently pair with third-party apps. macOS macOS is the Company’s desktop operating system and is built on an open-source UNIX-based foundation and provides an intuitive and integrated computer experience. Support for iCloud is built into macOS so users can access content and information from Mac, iOS devices and other supported devices and access downloaded content and apps from the iTunes Store. macOS Mojave, released in September 2018, is the 15th major release of macOS and makes apps such as News, Stocks, Voice Memos and Home available on the Mac for the first time. macOS Mojave also adds desktop and Finder ® enhancements, such as Dark Mode, and introduces a full redesign of the Mac App Store. watchOS watchOS is the Company’s operating system for Apple Watch. In September 2018, the Company released watchOS 5, which helps users stay healthy and connected with new features including Activity Sharing competitions, auto-workout detection, advanced running features, Walkie-Talkie, Apple Podcasts and third-party apps on the Siri watch face. tvOS tvOS is the Company’s operating system for Apple TV. The tvOS operating system is based on the Company’s iOS platform and enables developers to create new apps and games specifically for Apple TV and deliver them to customers through the Apple TV App Store. tvOS incorporates Siri capabilities that allow searching across apps and services. In September 2018, the Company released tvOS 12, which supports enhanced sound quality and provides additional 4K high dynamic range (“HDR”) content. Services Digital Content and Services The iTunes Store, available for iOS devices, Mac and Windows personal computers and Apple TV, allows customers to purchase and download or stream music and TV shows, rent or purchase movies and download free podcasts. The App Store, available for iOS devices, allows customers to discover and download apps and purchase in-app content. The Mac App Store, available for Mac computers, allows customers to discover, download and install Mac applications. The TV App Store allows customers access to apps and games specifically for Apple TV. The Book Store, available for iOS devices and Mac computers, features e-books from major and independent publishers. Apple Music offers users a curated listening experience with on-demand radio stations that evolve based on a user’s play or download activity and a subscription-based internet streaming service that also provides unlimited access to the Apple Music library. Apple Inc. | 2018 Form 10-K | 2 iCloud iCloud is the Company’s cloud service which stores music, photos, contacts, calendars, mail, documents and more, keeping them up-to-date and available across multiple iOS devices, Mac and Windows personal computers and Apple TV. iCloud services include iCloud Drive ® , iCloud Photos, Family Sharing, Find My iPhone, iPad or Mac, Find My Friends, Notes, iCloud Keychain ® and iCloud Backup for iOS devices. AppleCare The Company offers a range of support options for its customers. These include assistance that is built into software products, electronic product manuals, online support including comprehensive product information as well as technical assistance, AppleCare + (“AC+”) and the AppleCare ® Protection Plan (“APP”). AC+ and APP are fee-based services that extend the coverage of phone support eligibility and hardware repairs. AC+ offers additional coverage for instances of accidental damage and is available in certain countries for certain products. Additionally, AC+ with theft and loss protection is available for iPhone in the U.S. Apple Pay Apple Pay is the Company’s cashless payment service available in certain countries that offers an easy, secure and private way to pay. Apple Pay allows users to pay for purchases in participating stores accepting contactless payments and to pay for purchases within participating apps on qualifying devices. Apple Pay accepts credit and debit cards across major card networks and also supports reward programs and store-issued credit and debit cards. In December 2017, the Company released an update to iOS 11 and watchOS 4 introducing Apple Pay Cash in the U.S., allowing peer-to-peer payments using Apple Pay. Other Products Apple TV Apple TV connects to consumers’ TVs and enables them to access digital content directly for streaming video, playing music and games, and viewing photos. Content from Apple Music and other media services is also available on Apple TV. Apple TV allows streaming digital content from Mac and Windows personal computers through Home Sharing and from compatible Mac and iOS devices through AirPlay ® . Apple TV runs on the Company’s tvOS operating system and is based on apps built for the television. Additionally, the Apple TV remote features Siri, allowing users to search and access content with their voice. The Company offers Apple TV and Apple TV 4K ® , which supports 4K and HDR content. Apple Watch Apple Watch is a personal electronic device that combines the watchOS user interface and technologies created specifically for a smaller device, including the Digital Crown ® , a unique navigation tool that allows users to seamlessly scroll, zoom and navigate, and Force Touch, a technology that senses the difference between a tap and a press and allows users to access controls within apps. Apple Watch enables users to communicate from their wrist, track their health and fitness through activity and workout apps, and includes Siri and Apple Pay. In September 2018, the Company introduced Apple Watch Series 4, with a new design including a larger display and thinner case, and featuring new health monitoring capabilities. Other The Company also sells AirPods, Beats ® products, HomePod, iPod touch and other Apple-branded and third-party accessories. AirPods are the Company’s wireless headphones that interact with Siri. In February 2018, the Company released HomePod, a high-fidelity wireless smart speaker that interacts with Siri and Apple Music. Developer Programs The Company’s developer programs support app developers with building, testing and distributing apps for iOS, macOS, watchOS and tvOS. Developer program membership provides access to beta software and advanced app capabilities (e.g., CloudKit ® , HealthKit™ and Apple Pay), the ability to test apps using TestFlight ® , distribution on the App Store, access to App Analytics and code-level technical support. Developer programs also exist for businesses creating apps for internal use (the Apple Developer Enterprise Program) and developers creating accessories for Apple devices (the MFi Program). All developers, even those who are not developer program members, can sign in with their Apple ID to post on the Apple Developer Forums and use Xcode ® , the Company’s integrated development environment for creating apps for Apple platforms. Xcode includes project management tools; analysis tools to collect, display and compare app performance data; simulation tools to locally run, test and debug apps; and tools to simplify the design and development of user interfaces. All developers also have access to extensive technical documentation and sample code. Apple Inc. | 2018 Form 10-K | 3 Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers and small and mid-sized businesses through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and resellers. During 2018 , the Company’s net sales through its direct and indirect distribution channels accounted for 29% and 71%, respectively, of total net sales. The Company believes that sales of its innovative and differentiated products and services are enhanced by knowledgeable salespersons who can convey the value of the hardware and software integration and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company continues to build and improve its distribution capabilities by expanding the number of its own retail stores worldwide. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable high-traffic locations the Company is better positioned to ensure a high-quality customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and related solutions. The retail stores employ experienced and knowledgeable personnel who provide product advice, service and training, and offer a wide selection of third-party hardware, software and other accessories that complement the Company’s products. The Company has also invested in programs to enhance reseller sales by placing high-quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a high level of product expertise, integration and support services. The Company is committed to delivering solutions to help educators teach and students learn. The Company believes effective integration of technology into classroom instruction can result in higher levels of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also supports mobile learning and real-time distribution of, and access to, education-related materials through iTunes U ® , a platform that allows students and teachers to share and distribute educational media online. The Company sells its products to the education market through its direct sales force, select third-party resellers and its retail and online stores. The Company also sells its hardware and software products to enterprise and government customers in each of its reportable segments. The Company’s products are deployed in these markets because of their performance, productivity, ease-of-use and seamless integration into information technology environments. The Company’s products are compatible with thousands of third-party business applications and services, and its tools enable the development and secure deployment of custom applications as well as remote device administration. No single customer accounted for more than 10% of net sales in 2018 , 2017 and 2016 . Competition The markets for the Company’s products and services are highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the capabilities and use of mobile communication and media devices, personal computers and other digital electronic devices. Many of the Company’s competitors that sell mobile devices and personal computers based on other operating systems seek to compete primarily through aggressive pricing and very low cost structures. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. Principal competitive factors important to the Company include price, product and service features (including security features), relative price and performance, product and service quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support and corporate reputation. The Company is focused on expanding its market opportunities related to personal computers and mobile communication and media devices. These markets are highly competitive and include many large, well-funded and experienced participants. The Company expects competition in these markets to intensify significantly as competitors attempt to imitate some of the features of the Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. These markets are characterized by aggressive price competition, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological advancements by competitors and price sensitivity on the part of consumers and businesses. Apple Inc. | 2018 Form 10-K | 4 The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s future financial condition and operating results depend on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets in which it competes. The Company believes it offers superior innovation and integration of the entire solution including the hardware (iOS devices, Mac, Apple Watch and Apple TV), software (iOS, macOS, watchOS and tvOS), online services and distribution of digital content and applications (Digital Content and Services). Some of the Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are single-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s financial condition and operating results could be materially adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s manufacturing purchase obligations typically cover its requirements for periods up to 150 days . Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through R&D, licensing of intellectual property and acquisition of third-party businesses and technology. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, copyrights, trademarks, service marks, trade dress and other forms of intellectual property rights in the U.S. and a number of foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. Apple Inc. | 2018 Form 10-K | 5 The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents, including utility patents, design patents and others. The Company also holds copyrights relating to certain aspects of its products and services. No single intellectual property right is solely responsible for protecting the Company’s products. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products. Many of the Company’s products are designed to include intellectual property obtained from third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of the Company’s products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage and the rapid rate of issuance of new patents, it is possible that certain components of the Company’s products, processes and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data During 2018, the Company’s domestic and international net sales accounted for 37% and 63% , respectively, of total net sales. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including duties, tariffs and antidumping penalties. Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new product inventory following a product introduction, and channel inventory of a particular product often declines as the next related major product launch approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. However, neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, future net sales or financial performance. Warranty The Company offers a limited parts and labor warranty on its hardware products. The basic warranty period is typically one year from the date of purchase by the original end user. The Company also offers a 90-day limited warranty on the service parts used to repair the Company’s hardware products. In certain jurisdictions, local law requires that manufacturers guarantee their products for a period prescribed by statute, typically at least two years. In addition, where available, consumers may purchase APP or AC+, which extends service coverage on many of the Company’s hardware products. Backlog In the Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases immediately following new product introductions as customers anticipate shortages. Backlog is often reduced once customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial performance. Employees As of September 29, 2018 , the Company had approximately 132,000 full-time equivalent employees. Apple Inc. | 2018 Form 10-K | 6 Available Information The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities and Exchange Commission (the “SEC”). The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge at investor.apple.com/investor-relations/sec-filings/default.aspx when such reports are available on the SEC’s website. The SEC maintains an internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. The Company periodically provides other information for investors on its corporate website, www.apple.com, and its investor relations website, investor.apple.com. This includes press releases and other information about financial performance, information on corporate governance and details related to the Company’s annual meeting of shareholders. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2018 Form 10-K | 7 Item 1A. Risk Factors The following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding other statements in this Form 10-K. The following information should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price. Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Global and regional economic conditions could materially adversely affect the Company’s business, results of operations, financial condition and growth . The Company has international operations with sales outside the U.S. representing a majority of the Company’s total net sales. In addition, a majority of the Company’s supply chain, and its manufacturing and assembly activities, are located outside the U.S. As a result, the Company’s operations and performance depend significantly on global and regional economic conditions. Adverse macroeconomic conditions, including inflation, slower growth or recession, new or increased tariffs, changes to fiscal and monetary policy, tighter credit, higher interest rates, high unemployment and currency fluctuations could materially adversely affect demand for the Company’s products and services. In addition, consumer confidence and spending could be adversely affected in response to financial market volatility, negative financial news, conditions in the real estate and mortgage markets, declines in income or asset values, changes to fuel and other energy costs, labor and healthcare costs and other economic factors. In addition to an adverse impact on demand for the Company’s products, uncertainty about, or a decline in, global or regional economic conditions could have a significant impact on the Company’s suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. Potential effects include financial instability; inability to obtain credit to finance operations and purchases of the Company’s products; and insolvency. A downturn in the economic environment could also lead to increased credit and collectibility risk on the Company’s trade receivables; the failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair value of the Company’s financial instruments. These and other economic factors could materially adversely affect the Company’s business, results of operations, financial condition and growth. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services are offered in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological advancements by competitors and price sensitivity on the part of consumers and businesses. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. There can be no assurance that these investments will achieve expected returns, and the Company may not be able to develop and market new products and services successfully. The Company currently holds a significant number of patents and copyrights and has registered, and applied to register, numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. Apple Inc. | 2018 Form 10-K | 8 The Company has a minority market share in the global smartphone, tablet and personal computer markets. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors may have the resources, experience or cost structures to provide products at little or no profit or even at a loss. Additionally, the Company faces significant competition as competitors attempt to imitate the Company’s product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. Some of the markets in which the Company competes, including the market for personal computers, have from time to time experienced little to no growth or contracted. In addition, an increasing number of internet-enabled devices that include software applications and are smaller, simpler and cheaper than traditional personal computers compete with some of the Company’s existing products. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve its products and services in order to maintain their functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent introductions and transitions of products and services. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and services and successfully manage the transition to these new and upgraded products and services. The success of new product and service introductions depends on a number of factors including, but not limited to, timely and successful development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand and the risk that new products and services may have quality or other defects or deficiencies. Accordingly, the Company cannot determine in advance the ultimate effect of new product and service introductions and transitions. The Company depends on the performance of carriers, wholesalers, retailers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, retailers and resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers and consumers and small and mid-sized businesses through its retail and online stores. Some carriers providing cellular network service for iPhone offer financing, installment payment plans or subsidies for users’ purchases of the device. There is no assurance that such offers will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. Apple Inc. | 2018 Form 10-K | 9 The Company faces substantial inventory and other asset risk in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand, or for which cost exceeds net realizable value. The Company also accrues necessary cancellation fee reserves for orders of excess products and components. The Company reviews long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the assets may not be recoverable. If the Company determines that an impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently recoverable, no assurance can be given that the Company will not incur write-downs, fees, impairments and other charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company orders components for its products and builds inventory in advance of product announcements and shipments. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days . Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains certain components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. While the Company has entered into agreements for the supply of many components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. Component suppliers may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms. The effects of global or regional economic conditions on the Company’s suppliers, described in “ Global and regional economic conditions could materially adversely affect the Company’s business, results of operations, financial condition and growth ” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected for any number of reasons, including if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over production and distribution. Such diminished control may have an adverse effect on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect or warranty liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on single-sourced outsourcing partners in the U.S., Asia and Europe to supply and manufacture many components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform may have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, military actions, economic, business, labor, environmental, public health or political issues, or international trade disputes. Apple Inc. | 2018 Form 10-K | 10 The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply could be reduced or terminated and the recoverability of manufacturing process equipment or prepayments could be negatively impacted. The Company’s products and services may be affected from time to time by design and manufacturing defects that could materially adversely affect the Company’s business and result in harm to the Company’s reputation. The Company offers complex hardware and software products and services that can be affected by design and manufacturing defects. Sophisticated operating system software and applications, such as those offered by the Company, often have issues that can unexpectedly interfere with the intended operation of hardware or software products. Defects may also exist in components and products the Company purchases from third parties. Component defects could make the Company’s products unsafe and create a risk of environmental or property damage and personal injury. These risks may increase as the Company’s products are introduced into specialized applications, including healthcare. In addition, the Company’s service offerings may have quality issues and from time to time experience outages, service slowdowns or errors. As a result, the Company’s services may not perform as anticipated and may not meet customer expectations. There can be no assurance the Company will be able to detect and fix all issues and defects in the hardware, software and services it offers. Failure to do so could result in widespread technical and performance issues affecting the Company’s products and services. In addition, the Company may be exposed to product liability claims, recalls, product replacements or modifications, write-offs of inventory, property, plant and equipment, and/or intangible assets, and significant warranty and other expenses, including litigation costs and regulatory fines. Quality problems could also adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, delay in new product and services introductions and lost revenue. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell currently available music, movies, TV shows and books. The licensing or other distribution arrangements with these third parties are for relatively short terms and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license or otherwise distribute their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make third-party digital content available, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s financial condition and operating results. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes the availability of third-party software applications and services for its products depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software and services for the Company’s products compared to competitors’ platforms, such as Android for smartphones and tablets and Windows for personal computers. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of product sales and the costs of developing such applications and services. Apple Inc. | 2018 Form 10-K | 11 The Company’s minority market share in the global smartphone, tablet and personal computer markets could make developers less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for competitors’ products with larger market share. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices may suffer. The Company relies on the continued availability and development of compelling and innovative software applications for its products. The Company’s products and operating systems are subject to rapid technological change, and if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not take advantage of these changes to deliver improved customer experiences or might not operate correctly and may result in dissatisfied customers. The Company sells and delivers third-party applications for its products through the App Store, Mac App Store and TV App Store. The Company retains a commission from sales through these platforms. If developers reduce their use of these platforms to distribute their applications and offer in-app purchases to customers, then the volume of sales, and the commission that the Company earns on those sales, would decrease. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products include third-party intellectual property, which requires licenses from those third parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on acceptable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products or services, or otherwise have a material adverse impact on the Company’s financial condition and operating results. The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights . The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and have not yet been fully resolved, and new claims may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which may subject the Company to costs and damages in the event of a claim against an indemnified third party. Claims against the Company based on allegations of patent infringement or other violations of intellectual property rights have generally increased over time and may continue to increase. In particular, the Company has historically faced a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and before the U.S. International Trade Commission, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, litigation may be expensive, time consuming, disruptive to the Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into licensing agreements or other arrangements to settle litigation and resolve such disputes. No assurance can be given that such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements may also significantly increase the Company’s operating expenses. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 9, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims, including matters related to infringement of intellectual property rights. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts in excess of management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2018 Form 10-K | 12 The Company is subject to laws and regulations worldwide, changes to which could increase the Company’s costs and individually or in the aggregate adversely affect the Company’s business. The Company is subject to laws and regulations affecting its domestic and international operations in a number of areas. These U.S. and foreign laws and regulations affect the Company’s activities in areas including, but not limited to, labor, advertising, digital content, consumer protection, real estate, billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import and export requirements, anti-corruption, foreign exchange controls and cash repatriation restrictions, data privacy and data localization requirements, anti-competition, environmental, health and safety. By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes could include, among others, restrictions on the production, manufacture, distribution and use of devices, locking devices to a carrier’s network, or mandating the use of devices on more than one carrier’s network. These devices are also subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications, or delays in product shipment dates, or could preclude the Company from selling certain products. Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent from jurisdiction to jurisdiction, further increasing the cost of compliance and doing business. Any such costs, which may rise in the future as a result of changes in these laws and regulations or in their interpretation, could individually or in the aggregate make the Company’s products and services less attractive to the Company’s customers, delay the introduction of new products in one or more regions, or cause the Company to change or limit its business practices. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies and procedures. The Company’s business is subject to the risks of international operations. The Company derives a majority of its revenue and earnings from its international operations. Compliance with applicable U.S. and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy and data localization requirements, environmental laws, labor laws and anti-competition regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with these laws and regulations, a violation by the Company’s employees, contractors or agents could nevertheless occur. In some cases, compliance with the laws and regulations of one country could violate the laws and regulations of another country. Violations of these laws and regulations could materially adversely affect the Company’s brand, international growth efforts and business. The Company also could be significantly affected by other risks associated with international activities including, but not limited to, economic and labor conditions, increased duties, taxes and other costs, political instability and international trade disputes. Gross margins on the Company’s products in foreign countries, and on products that include components obtained from foreign suppliers, could be materially adversely affected by international trade regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectibility risk on its trade receivables with customers in certain international markets. There can be no assurance the Company can effectively limit its credit risk and avoid losses. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. The Company’s retail operations are subject to many factors that pose risks and uncertainties and could adversely impact the Company’s financial condition and operating results, including macro-economic factors that could have an adverse effect on general retail activity. Other factors include, but are not limited to, the Company’s ability to manage costs associated with retail store construction and operation; manage relationships with existing retail partners; manage costs associated with fluctuations in the value of retail inventory; and obtain and renew leases in quality retail locations at a reasonable cost. Apple Inc. | 2018 Form 10-K | 13 Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital and unidentified issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. The Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company may be subject to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. System redundancy and other continuity measures may be ineffective or inadequate, and the Company’s business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s reputation, financial condition and operating results. There may be losses or unauthorized access to or releases of confidential information, including personally identifiable information, that could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information including, among other things, personally identifiable information (“PII”) with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s reputation, financial condition and operating results. The Company’s business also requires it to share confidential information with suppliers and other third parties. Although the Company takes steps to secure confidential information that is provided to third parties, such measures are not always effective and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s reputation, financial condition and operating results. For example, the Company may experience a security breach impacting the Company’s information technology systems that compromises the confidentiality, integrity or availability of confidential information. Such an incident could, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the Company’s stock price, materially damage supplier relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Although malicious attacks perpetrated to gain access to confidential information, including PII, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties attempt to fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, may result in the delay or loss of customer orders or impede customer access to the Company’s products and services. In addition to the risks relating to general confidential information described above, the Company may also be subject to specific obligations relating to health data and payment card data. Health data may be subject to additional privacy, security and breach notification requirements, and the Company may be subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data is handled in a manner not permitted by law or under the Company’s agreements with healthcare institutions, the Company could be subject to litigation or government investigations, may be liable for associated investigatory expenses, and could also incur significant fees or fines. Apple Inc. | 2018 Form 10-K | 14 Under payment card rules and obligations, if cardholder information is potentially compromised, the Company could be liable for associated investigatory expenses and could also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which would materially adversely affect the Company’s reputation, financial condition and operating results. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also may restrict transfers of PII among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of PII through its privacy policy, information provided on its website and press statements. Any failure by the Company to comply with these public statements or with other federal, state or international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. The Company’s success depends largely on the continued service and availability of key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. The Company’s business may be impacted by political events, international trade disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions. Political events, international trade disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions could harm or disrupt international commerce and the global economy, and could have a material adverse effect on the Company and its customers, suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. International trade disputes could result in tariffs and other protectionist measures that could adversely affect the Company’s business. Tariffs could increase the cost of the Company’s products and the components and raw materials that go into making them. These increased costs could adversely impact the gross margin that the Company earns on its products. Tariffs could also make the Company’s products more expensive for customers, which could make the Company’s products less competitive and reduce consumer demand. Countries may also adopt other protectionist measures that could limit the Company’s ability to offer its products and services. Political uncertainty surrounding international trade disputes and protectionist measures could also have a negative effect on consumer confidence and spending, which could adversely affect the Company’s business. Many of the Company’s operations and facilities as well as critical business operations of the Company’s suppliers and contract manufacturers are in locations that are prone to earthquakes and other natural disasters. In addition, such operations and facilities are subject to the risk of interruption by fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, labor disputes, public health issues and other events beyond the Company’s control. Global climate change could result in certain types of natural disasters occurring more frequently or with more intense effects. Such events could make it difficult or impossible for the Company to manufacture and deliver products to its customers, create delays and inefficiencies in the Company’s supply and manufacturing chain, and result in slowdowns and outages to the Company’s service offerings. Following an interruption to its business, the Company could require substantial recovery time, experience significant expenditures in order to resume operations, and lose significant revenue. Because the Company relies on single or limited sources for the supply and manufacture of many critical components, a business interruption affecting such sources would exacerbate any negative consequences to the Company. Apple Inc. | 2018 Form 10-K | 15 The Company’s operations are also subject to the risks of industrial accidents at its suppliers and contract manufacturers. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in disruption to the Company’s business and harm to the Company’s reputation. Should major public health issues, including pandemics, arise, the Company could be adversely affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products and disruptions in the operations of the Company’s suppliers and contract manufacturers. The Company expects its quarterly revenue and operating results to fluctuate. The Company’s profit margins vary across its products, services, geographic segments and distribution channels. For example, gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product transitions, pricing and configuration changes, and component, warranty and other cost fluctuations. The Company’s financial results may be materially adversely impacted as a result of shifts in the mix of products and services that the Company sells; shifts in the geographic, currency or channel mix of the Company’s sales; component cost increases; price competition; or the introduction of new products, including new products with higher cost structures. The Company has typically experienced higher net sales in its first quarter compared to other quarters due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Further, the Company generates a majority of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments, such as lower-than-anticipated demand for the Company’s products, issues with new product introductions, information technology system failures or network disruptions, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock price has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its own stock to exceed the stock’s price at a given point in time. The Company believes its stock price should reflect expectations of future growth and profitability. The Company also believes its stock price should reflect expectations that its cash dividend will continue at current levels or grow and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employee retention. The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar relative to local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non–U.S. dollar–denominated sales and operating expenses worldwide. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers could be materially adversely affected by foreign currency exchange rate fluctuations. Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency–denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise international pricing to offset the U.S. dollar’s strengthening, which would adversely affect the U.S. dollar value of the gross margins the Company earns on foreign currency–denominated sales. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency–denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not be effective to offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. Apple Inc. | 2018 Form 10-K | 16 The Company is exposed to credit risk and fluctuations in the market values of its investment portfolio. The Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, market and economic conditions, political risk, sovereign risk, interest rate fluctuations or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents and marketable securities, future fluctuations in their value could result in significant realized losses and could have a material adverse impact on the Company’s financial condition and operating results. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and resellers. The Company also sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party bank support or financing arrangements, or credit insurance. The Company’s exposure to credit and collectibility risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 29, 2018 , a significant portion of the Company’s trade receivables was concentrated within cellular network carriers, and its vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service (the “IRS”) and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition, operating results and cash flows could be materially adversely affected. Item 1B. Unresolved Staff Comments None. Apple Inc. | 2018 Form 10-K | 17 Item 2. Properties The Company’s headquarters are located in Cupertino, California. As of September 29, 2018 , the Company owned 16.5 million square feet and leased 24.3 million square feet of building space, primarily in the U.S. Additionally, the Company owned a total of 7,376 acres of land, primarily in the U.S. As of September 29, 2018 , the Company owned facilities and land for corporate functions, R&D and data centers at various locations throughout the U.S. Outside the U.S., the Company owned additional facilities and land for various purposes. The Company believes its existing facilities and equipment, which are used by all reportable segments, are in good operating condition and are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to make investments in capital equipment as needed to meet anticipated demand for its products and services. Item 3. Legal Proceedings The Company is subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 9, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Refer to the risk factor “ The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights ” in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2018 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Item 4. Mine Safety Disclosures Not applicable. Apple Inc. | 2018 Form 10-K | 18 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on The Nasdaq Stock Market LLC (“Nasdaq”) under the symbol AAPL. Holders As of October 26, 2018 , there were 23,712 shareholders of record. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 29, 2018 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) July 1, 2018 to August 4, 2018: Open market and privately negotiated purchases 26,859 $ 192.50 26,859 August 5, 2018 to September 1, 2018: Open market and privately negotiated purchases 36,575 $ 214.07 36,575 September 2, 2018 to September 29, 2018: Open market and privately negotiated purchases 29,029 $ 222.07 29,029 Total 92,463 $ 70,970 (1) On May 1, 2018, the Company announced the Board of Directors had authorized a program to repurchase up to $100 billion of the Company’s common stock, of which $29.0 billion had been utilized as of September 29, 2018 . The remaining $71.0 billion in the table represents the amount available to repurchase shares under the authorized repurchase program as of September 29, 2018 . The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. Apple Inc. | 2018 Form 10-K | 19 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend-reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 29, 2018 . The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 27, 2013 . Note that historic stock price performance is not necessarily indicative of future stock price performance. * $100 invested on September 27, 2013 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2018 Standard & Poor’s, a division of S&P Global. All rights reserved. Copyright © 2018 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. September 2013 September 2014 September 2015 September 2016 September 2017 September 2018 Apple Inc. $ 100 $ 149 $ 173 $ 174 $ 242 $ 359 S&P 500 Index $ 100 $ 120 $ 119 $ 137 $ 163 $ 192 S&P Information Technology Index $ 100 $ 129 $ 132 $ 162 $ 209 $ 275 Dow Jones U.S. Technology Supersector Index $ 100 $ 130 $ 130 $ 159 $ 203 $ 266 Apple Inc. | 2018 Form 10-K | 20 Item 6. Selected Financial Data The information set forth below for the five years ended September 29, 2018 , is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in thousands, and per share amounts). 2018 2017 2016 2015 2014 Net sales $ 265,595 $ 229,234 $ 215,639 $ 233,715 $ 182,795 Net income $ 59,531 $ 48,351 $ 45,687 $ 53,394 $ 39,510 Earnings per share: Basic $ 12.01 $ 9.27 $ 8.35 $ 9.28 $ 6.49 Diluted $ 11.91 $ 9.21 $ 8.31 $ 9.22 $ 6.45 Cash dividends declared per share $ 2.72 $ 2.40 $ 2.18 $ 1.98 $ 1.82 Shares used in computing earnings per share: Basic 4,955,377 5,217,242 5,470,820 5,753,421 6,085,572 Diluted 5,000,109 5,251,692 5,500,281 5,793,069 6,122,663 Total cash, cash equivalents and marketable securities $ 237,100 $ 268,895 $ 237,585 $ 205,666 $ 155,239 Total assets $ 365,725 $ 375,319 $ 321,686 $ 290,345 $ 231,839 Non-current portion of term debt $ 93,735 $ 97,207 $ 75,427 $ 53,329 $ 28,987 Other non-current liabilities $ 45,180 $ 40,415 $ 36,074 $ 33,427 $ 24,826 Apple Inc. | 2018 Form 10-K | 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview and Highlights The Company designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories and third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, Apple Watch, AirPods, Apple TV, HomePod, a portfolio of consumer and professional software applications, iOS, macOS, watchOS and tvOS operating systems, iCloud, Apple Pay and a variety of other accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store, App Store, Mac App Store, TV App Store, Book Store and Apple Music (collectively “Digital Content and Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories, through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Fiscal Period The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2018 and 2016 spanned 52 weeks each, whereas fiscal year 2017 included 53 weeks. A 14th week was included in the first quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. Fiscal 2018 Highlights Net sales increased 16% or $36.4 billion during 2018 compared to 2017, driven by higher net sales of iPhone, Services and Other Products. Net sales increased year-over-year in each of the geographic reportable segments. In May 2018, the Company announced a new capital return program of $100 billion and raised its quarterly dividend from $0.63 to $0.73 per share beginning in May 2018. During 2018, the Company spent $73.1 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $13.7 billion . Fiscal 2017 Highlights Net sales increased 6% or $13.6 billion during 2017 compared to 2016, primarily driven by growth in Services, iPhone and Mac. The year-over-year increase in net sales reflected growth in each of the geographic reportable segments, with the exception of Greater China. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on net sales during 2017. In May 2017, the Company announced an increase to its capital return program by raising the total size of the program from $250 billion to $300 billion. This included increasing its share repurchase authorization from $175 billion to $210 billion and raising its quarterly dividend from $0.57 to $0.63 per share beginning in May 2017. During 2017, the Company spent $33.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $12.8 billion . The $210 billion share repurchase program was completed in the third quarter of 2018. The Company issued $24.0 billion of U.S. dollar–denominated term debt, €2.5 billion of euro-denominated term debt and C$2.5 billion of Canadian dollar–denominated term debt during 2017. Apple Inc. | 2018 Form 10-K | 22 Sales Data The following table shows net sales by reportable segment and net sales and unit sales by product for 2018 , 2017 and 2016 (dollars in millions and units in thousands): 2018 Change 2017 Change 2016 Net Sales by Reportable Segment: Americas $ 112,093 16 % $ 96,600 12 % $ 86,613 Europe 62,420 14 % 54,938 10 % 49,952 Greater China 51,942 16 % 44,764 (8 )% 48,492 Japan 21,733 23 % 17,733 5 % 16,928 Rest of Asia Pacific 17,407 15 % 15,199 11 % 13,654 Total net sales $ 265,595 16 % $ 229,234 6 % $ 215,639 Net Sales by Product: iPhone (1) $ 166,699 18 % $ 141,319 3 % $ 136,700 iPad (1) 18,805 (2 )% 19,222 (7 )% 20,628 Mac (1) 25,484 (1 )% 25,850 13 % 22,831 Services (2) 37,190 24 % 29,980 23 % 24,348 Other Products (1)(3) 17,417 35 % 12,863 16 % 11,132 Total net sales $ 265,595 16 % $ 229,234 6 % $ 215,639 Unit Sales by Product: iPhone 217,722 — % 216,756 2 % 211,884 iPad 43,535 — % 43,753 (4 )% 45,590 Mac 18,209 (5 )% 19,251 4 % 18,484 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from Digital Content and Services, AppleCare, Apple Pay, licensing and other services. Services net sales in 2018 included a favorable one-time item of $236 million in connection with the final resolution of various lawsuits. Services net sales in 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. (3) Includes sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and other Apple-branded and third-party accessories. Apple Inc. | 2018 Form 10-K | 23 Product Performance iPhone The following table presents iPhone net sales and unit sales information for 2018 , 2017 and 2016 (dollars in millions and units in thousands): 2018 Change 2017 Change 2016 Net sales $ 166,699 18 % $ 141,319 3 % $ 136,700 Percentage of total net sales 63 % 62 % 63 % Unit sales 217,722 — % 216,756 2 % 211,884 iPhone net sales increased during 2018 compared to 2017 due primarily to a different mix of iPhones resulting in higher average selling prices. iPhone net sales increased during 2017 compared to 2016 due to higher iPhone unit sales and a different mix of iPhones with higher average selling prices. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on iPhone net sales during 2017. iPad The following table presents iPad net sales and unit sales information for 2018 , 2017 and 2016 (dollars in millions and units in thousands): 2018 Change 2017 Change 2016 Net sales $ 18,805 (2 )% $ 19,222 (7 )% $ 20,628 Percentage of total net sales 7 % 8 % 10 % Unit sales 43,535 — % 43,753 (4 )% 45,590 iPad net sales decreased during 2018 compared to 2017 due primarily to a different mix of iPads resulting in lower average selling prices. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on iPad net sales during 2018. iPad net sales decreased during 2017 compared to 2016 due to lower iPad unit sales and a different mix of iPads with lower average selling prices. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on iPad net sales during 2017. Mac The following table presents Mac net sales and unit sales information for 2018 , 2017 and 2016 (dollars in millions and units in thousands): 2018 Change 2017 Change 2016 Net sales $ 25,484 (1 )% $ 25,850 13 % $ 22,831 Percentage of total net sales 10 % 11 % 11 % Unit sales 18,209 (5 )% 19,251 4 % 18,484 Mac net sales decreased during 2018 compared to 2017 due primarily to lower Mac unit sales, partially offset by a different mix of Macs with higher average selling prices. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on Mac net sales during 2018. Mac net sales increased during 2017 compared to 2016 due primarily to a different mix of Macs with higher average selling prices and higher Mac unit sales. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Mac net sales during 2017. Apple Inc. | 2018 Form 10-K | 24 Services The following table presents Services net sales information for 2018 , 2017 and 2016 (dollars in millions): 2018 Change 2017 Change 2016 Net sales $ 37,190 24 % $ 29,980 23 % $ 24,348 Percentage of total net sales 14 % 13 % 11 % The year-over-year growth in Services net sales in 2018 was due primarily to licensing, App Store and AppleCare. During 2018, the Company recognized a favorable one-time item of $236 million in connection with the final resolution of various lawsuits. The year-over-year growth in Services net sales in 2017 was due primarily to increases in App Store and licensing sales. Services net sales in 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Segment Information and Geographic Data.” Americas The following table presents Americas net sales information for 2018 , 2017 and 2016 (dollars in millions): 2018 Change 2017 Change 2016 Net sales $ 112,093 16 % $ 96,600 12 % $ 86,613 Percentage of total net sales 42 % 42 % 40 % Americas net sales increased during 2018 compared to 2017 due to higher net sales of iPhone, Services and Other Products. Americas net sales increased during 2017 compared to 2016 due primarily to higher net sales of iPhone, Services and Mac. Europe The following table presents Europe net sales information for 2018 , 2017 and 2016 (dollars in millions): 2018 Change 2017 Change 2016 Net sales $ 62,420 14 % $ 54,938 10 % $ 49,952 Percentage of total net sales 24 % 24 % 23 % Europe net sales increased during 2018 compared to 2017 due primarily to higher net sales of iPhone and Services. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on Europe net sales during 2018. Europe net sales increased during 2017 compared to 2016 due primarily to higher net sales of iPhone and Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Europe net sales during 2017. Apple Inc. | 2018 Form 10-K | 25 Greater China The following table presents Greater China net sales information for 2018 , 2017 and 2016 (dollars in millions): 2018 Change 2017 Change 2016 Net sales $ 51,942 16 % $ 44,764 (8 )% $ 48,492 Percentage of total net sales 20 % 20 % 22 % Greater China net sales increased during 2018 compared to 2017 due primarily to higher net sales of iPhone and Services. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on Greater China net sales during 2018. Greater China net sales decreased during 2017 compared to 2016 due primarily to lower net sales of iPhone, partially offset by higher net sales of Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Greater China net sales during 2017. Japan The following table presents Japan net sales information for 2018 , 2017 and 2016 (dollars in millions): 2018 Change 2017 Change 2016 Net sales $ 21,733 23 % $ 17,733 5 % $ 16,928 Percentage of total net sales 8 % 8 % 8 % Japan net sales increased during 2018 compared to 2017 due primarily to higher net sales of iPhone and Services. The year-over-year increase in Japan net sales in 2017 was due to higher net sales of Services and the strength in the Japanese yen relative to the U.S. dollar. Rest of Asia Pacific The following table presents Rest of Asia Pacific net sales information for 2018 , 2017 and 2016 (dollars in millions): 2018 Change 2017 Change 2016 Net sales $ 17,407 15 % $ 15,199 11 % $ 13,654 Percentage of total net sales 7 % 7 % 6 % Rest of Asia Pacific net sales increased during 2018 compared to 2017 due primarily to higher net sales of iPhone and Services. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on Rest of Asia Pacific net sales during 2018. Rest of Asia Pacific net sales increased during 2017 compared to 2016 due primarily to higher net sales of iPhone, Services and Mac. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on Rest of Asia Pacific net sales during 2017. Gross Margin Gross margin for 2018 , 2017 and 2016 was as follows (dollars in millions): 2018 2017 2016 Net sales $ 265,595 $ 229,234 $ 215,639 Cost of sales 163,756 141,048 131,376 Gross margin $ 101,839 $ 88,186 $ 84,263 Gross margin percentage 38.3 % 38.5 % 39.1 % Gross margin increased in 2018 compared to 2017 due primarily to a favorable shift in mix of iPhones with higher average selling prices and higher Services net sales, partially offset by higher product cost structures. Gross margin percentage decreased year-over-year due primarily to higher product cost structures, partially offset by higher Services net sales. The strength in foreign currencies relative to the U.S. dollar had a favorable impact on gross margin and gross margin percentage during 2018. Apple Inc. | 2018 Form 10-K | 26 Gross margin increased in 2017 compared to 2016 due primarily to a shift in mix to Services and an overall increase in product volumes. Gross margin percentage decreased year-over-year due primarily to higher product costs, partially offset by a favorable shift in mix to Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on gross margin and gross margin percentage during 2017. The Company anticipates gross margin percentage during the first quarter of 2019 to be between 38.0% and 38.5%. The foregoing statement regarding the Company’s expected gross margin percentage in the first quarter of 2019 is forward-looking and could differ from actual results. The Company’s future gross margins can be impacted by multiple factors including, but not limited to, those set forth in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and those described in this paragraph. In general, the Company believes gross margins will be subject to volatility and remain under downward pressure due to a variety of factors, including: continued industry-wide global product pricing pressures and product pricing actions that the Company may take in response to such pressures; increased competition; the Company’s ability to effectively stimulate demand for certain of its products; compressed product life cycles; potential increases in the cost of components and outside manufacturing services; the Company’s ability to manage product quality and warranty costs effectively; shifts in the mix of products and services, or in the geographic, currency or channel mix; fluctuations in exchange rates; and costs associated with the Company’s frequent introductions and transitions of products and services. Operating Expenses Operating expenses for 2018 , 2017 and 2016 were as follows (dollars in millions): 2018 Change 2017 Change 2016 Research and development $ 14,236 23 % $ 11,581 15 % $ 10,045 Percentage of total net sales 5 % 5 % 5 % Selling, general and administrative $ 16,705 9 % $ 15,261 8 % $ 14,194 Percentage of total net sales 6 % 7 % 7 % Total operating expenses $ 30,941 15 % $ 26,842 11 % $ 24,239 Percentage of total net sales 12 % 12 % 11 % Research and Development The year-over-year growth in R&D expense in 2018 was driven primarily by increases in headcount-related expenses, infrastructure-related costs and material costs to support expanded R&D activities. R&D expense increased during 2017 compared to 2016 due primarily to increases in headcount-related expenses and material costs to support expanded R&D activities. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products and services that are central to the Company’s core business strategy. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2018 was driven primarily by increases in in headcount-related expenses, professional services and infrastructure-related costs. The increase in selling, general and administrative expense in 2017 compared to 2016 was driven primarily by an increase in headcount-related expenses, variable selling expenses and infrastructure-related costs. Other Income/(Expense), Net Other income/(expense), net for 2018 , 2017 and 2016 was as follows (dollars in millions): 2018 Change 2017 Change 2016 Interest and dividend income $ 5,686 $ 5,201 $ 3,999 Interest expense (3,240 ) (2,323 ) (1,456 ) Other expense, net (441 ) (133 ) (1,195 ) Total other income/(expense), net $ 2,005 (27 )% $ 2,745 104 % $ 1,348 The year-over-year decrease in other income/(expense), net during 2018 was due primarily to higher interest expense on debt and the impact of foreign exchange–related items, partially offset by higher interest income. The year-over-year increase in other income/(expense), net during 2017 was due primarily to higher interest income and the favorable impact of foreign exchange–related items, partially offset by higher interest expense on debt. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 2.16%, 1.99% and 1.73% in 2018 , 2017 and 2016 , respectively. Apple Inc. | 2018 Form 10-K | 27 Provision for Income Taxes Provision for income taxes and effective tax rates for 2018 , 2017 and 2016 were as follows (dollars in millions): 2018 2017 2016 Provision for income taxes $ 13,372 $ 15,738 $ 15,685 Effective tax rate 18.3 % 24.6 % 25.6 % On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which significantly changed U.S. tax law. The Act lowered the Company’s U.S. statutory federal income tax rate from 35% to 21% effective January 1, 2018, while also imposing a deemed repatriation tax on previously deferred foreign income. By operation of law, the Company applied a blended U.S. statutory federal income tax rate of 24.5% for 2018 (the “2018 blended U.S. tax rate”). The Act also created a new minimum tax on certain future foreign earnings. The Company’s effective tax rate for 2018 was lower than the 2018 blended U.S. tax rate due primarily to the lower tax rate on foreign earnings, partially offset by the remeasurement of deferred tax assets and liabilities as a result of the Act. The Company’s effective tax rates for 2017 and 2016 were lower than the historical statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes were provided when such earnings were intended to be indefinitely reinvested outside the U.S. The lower effective tax rate in 2018 compared to 2017 was due primarily to the lower 2018 blended U.S. tax rate, partially offset by the remeasurement of deferred tax assets and liabilities as a result of the Act. The lower effective tax rate in 2017 compared to 2016 was due to a different geographic mix of earnings and higher U.S. R&D tax credits. As a result of adopting Accounting Standards Update (“ASU”) No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), in 2018, the Company records any excess tax benefits or deficiencies from its equity awards as part of the provision for income taxes. The Company anticipates that these excess tax benefits or deficiencies will have the greatest impact on its effective tax rates in the first and third quarters, as the majority of the Company’s equity awards vest in those quarters. As of September 29, 2018 , the Company had deferred tax assets arising from deductible temporary differences, tax losses and tax credits of $6.3 billion and deferred tax liabilities of $426 million . Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and the amount of a valuation allowance. On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. The recovery amount was calculated to be €13.1 billion , plus interest of €1.2 billion . Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and appealed to the General Court of the Court of Justice of the European Union. Ireland has also appealed the State Aid Decision. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes, subject to any foreign tax credit limitations in the Act. As of September 29, 2018 , the entire recovery amount plus interest was funded into escrow, where it will remain restricted from general use pending conclusion of all appeals. On July 24, 2018, the U.S. Ninth Circuit Court of Appeals reversed the U.S. Tax Court's decision in Altera Corp v. Commissioner , regarding the inclusion of share-based compensation in cost-sharing arrangements with foreign subsidiaries. The reversal was subsequently withdrawn, and the Company believes adequate provision has been made for any adjustments that may result from the final resolution of the case. Recent Accounting Pronouncements Hedging In August 2017, the Financial Accounting Standards Board (the “FASB”) issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 expands component and fair value hedging, specifies the presentation of the effects of hedging instruments, and eliminates the separate measurement and presentation of hedge ineffectiveness. The Company will adopt ASU 2017-12 in its first quarter of 2020 utilizing the modified retrospective transition method and is currently evaluating the impact of adoption on its consolidated financial statements. Apple Inc. | 2018 Form 10-K | 28 Income Taxes In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. The Company will adopt ASU 2016-16 in its first quarter of 2019 utilizing the modified retrospective transition method. Currently, the Company estimates recording $3 billion of net deferred tax assets on its Condensed Consolidated Balance Sheets upon adoption. However, the ultimate impact of adopting ASU 2016-16 will depend on the balance of intellectual property transferred between its subsidiaries as of the adoption date, as well as the deferred tax impact of the new minimum tax on certain future foreign earnings. The Company will recognize incremental deferred income tax expense thereafter as these net deferred tax assets are utilized. Leases In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modifies lease accounting for lessees to increase transparency and comparability by recording lease assets and liabilities for operating leases and disclosing key information about leasing arrangements. The Company will adopt ASU 2016-02 utilizing the modified retrospective transition method through a cumulative-effect adjustment at the beginning of its first quarter of 2020. While the Company is currently evaluating the impact of adopting ASU 2016-02, based on the lease portfolio as of September 29, 2018 , the Company anticipates recording lease assets and liabilities of approximately $8.9 billion on its Condensed Consolidated Balance Sheets, with no material impact to its Condensed Consolidated Statements of Operations. However, the ultimate impact of adopting ASU 2016-02 will depend on the Company’s lease portfolio as of the adoption date. Financial Instruments In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The Company will adopt ASU 2016-01 in its first quarter of 2019 utilizing the modified retrospective transition method. Based on the composition of the Company’s investment portfolio, the adoption of ASU 2016-01 is not expected to have a material impact on its consolidated financial statements. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. The Company will adopt ASU 2016-13 in its first quarter of 2021 utilizing the modified retrospective transition method. Based on the composition of the Company’s investment portfolio, current market conditions, and historical credit loss activity, the adoption of ASU 2016-13 is not expected to have a material impact on its consolidated financial statements. Revenue Recognition In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. Subsequently, the FASB issued additional ASUs to clarify the guidance in ASU 2014-09. ASU 2014-09 and its related ASUs are collectively referred to herein as the “new revenue standard.” The new revenue standard may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company will adopt the new revenue standard in its first quarter of 2019 utilizing the full retrospective transition method. The new revenue standard will not have a material impact on the amount and timing of revenue recognized in the Company’s consolidated financial statements. Apple Inc. | 2018 Form 10-K | 29 Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended September 29, 2018 , September 30, 2017 and September 24, 2016 (in millions): 2018 2017 2016 Cash, cash equivalents and marketable securities (1) $ 237,100 $ 268,895 $ 237,585 Property, plant and equipment, net $ 41,304 $ 33,783 $ 27,010 Commercial paper $ 11,964 $ 11,977 $ 8,105 Total term debt $ 102,519 $ 103,703 $ 78,927 Working capital $ 14,473 $ 27,831 $ 27,863 Cash generated by operating activities (2) $ 77,434 $ 64,225 $ 66,231 Cash generated by/(used in) investing activities $ 16,066 $ (46,446 ) $ (45,977 ) Cash used in financing activities (2) $ (87,876 ) $ (17,974 ) $ (20,890 ) (1) As of September 29, 2018 , total cash, cash equivalents and marketable securities included $20.3 billion that was restricted from general use, related to the State Aid Decision and other agreements. (2) Refer to Note 1, “Summary of Significant Accounting Polices” in the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K for more information on the prior period reclassification related to the Company’s adoption of ASU 2016-09. The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with its existing operations over the next 12 months. The Company currently anticipates the cash used for future dividends, the share repurchase program and debt repayments will come from its current cash and cash generated from ongoing operating activities. In connection with the State Aid Decision, as of September 29, 2018 , the entire recovery amount of €13.1 billion plus interest of €1.2 billion was funded into escrow, where it will remain restricted from general use pending conclusion of all appeals. The Company’s marketable securities investment portfolio is primarily invested in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. During 2018 , cash generated by operating activities of $77.4 billion was a result of $59.5 billion of net income and an increase in the net change in operating assets and liabilities of $34.7 billion , partially offset by non-cash adjustments to net income of $16.8 billion . Cash generated by investing activities of $16.1 billion during 2018 consisted primarily of proceeds from maturities and sales of marketable securities, net of purchases, of $32.4 billion , partially offset by cash used to acquire property, plant and equipment of $13.3 billion . Cash used in financing activities of $87.9 billion during 2018 consisted primarily of cash used to repurchase common stock of $72.7 billion , cash used to pay dividends and dividend equivalents of $13.7 billion and cash used to repay term debt of $6.5 billion , partially offset by proceeds from the issuance of term debt, net of $7.0 billion . During 2017 , cash generated by operating activities of $64.2 billion was a result of $48.4 billion of net income, non-cash adjustments to net income of $20.8 billion and a decrease in the net change in operating assets and liabilities of $4.9 billion , which included a one-time payment of $1.9 billion related to a multi-year license agreement. Cash used in investing activities of $46.4 billion during 2017 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $33.1 billion and cash used to acquire property, plant and equipment of $12.5 billion . Cash used in financing activities of $18.0 billion during 2017 consisted primarily of cash used to repurchase common stock of $32.9 billion , cash used to pay dividends and dividend equivalents of $12.8 billion and cash used to repay term debt of $3.5 billion , partially offset by proceeds from the issuance of term debt, net of $28.7 billion and proceeds from commercial paper, net of $3.9 billion . Capital Assets The Company’s capital expenditures were $16.7 billion during 2018 . The Company anticipates utilizing approximately $14.0 billion for capital expenditures during 2019 , which includes product tooling and manufacturing process equipment; data centers; corporate facilities and infrastructure, including information systems hardware, software and enhancements; and retail store facilities. Debt The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses the net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 29, 2018 , the Company had $12.0 billion of Commercial Paper outstanding, with a weighted-average interest rate of 2.18% and maturities generally less than nine months . Apple Inc. | 2018 Form 10-K | 30 As of September 29, 2018 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $104.2 billion (collectively the “Notes”). During 2018 , the Company issued $7.0 billion and repaid $6.5 billion of Notes. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on the Notes. In addition, the Company has entered, and in the future may enter, into foreign currency swaps to manage foreign currency risk on the Notes. Further information regarding the Company’s debt issuances and related hedging activity can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 2, “Financial Instruments” and Note 5, “Debt.” Capital Return Program During 2018 , the Company repurchased 405.5 million shares of its common stock for $73.1 billion in connection with two separate share repurchase programs. Of the $73.1 billion , $44.0 billion was repurchased under the Company’s previous share repurchase program of up to $210 billion , thereby completing that program. On May 1, 2018, the Company announced the Board of Directors had authorized a new program to repurchase up to $100 billion of the Company’s common stock. The remaining $29.0 billion repurchased during 2018 was in connection with the new share repurchase program. The Company’s new share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. On May 1, 2018, the Company also announced the Board of Directors raised the Company’s quarterly cash dividend from $0.63 to $0.73 per share, beginning with the dividend paid during the third quarter of 2018. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. The Company plans to use current cash and cash generated from ongoing operating activities to fund its share repurchase program and quarterly cash dividend. Contractual Obligations The following table presents certain payments due by the Company as of September 29, 2018 , and excludes amounts already recorded on the Consolidated Balance Sheet, except for term debt and the deemed repatriation tax payable (in millions): Payments Due in 2019 Payments Due in 2020–2021 Payments Due in 2022–2023 Payments Due After 2023 Total Term debt $ 8,797 $ 18,933 $ 17,978 $ 58,485 $ 104,193 Operating leases 1,298 2,507 1,838 3,984 9,627 Manufacturing purchase obligations (1) 41,548 2,469 1,183 — 45,200 Other purchase obligations 3,784 2,482 681 66 7,013 Deemed repatriation tax payable — 5,366 5,942 22,281 33,589 Total $ 55,427 $ 31,757 $ 27,622 $ 84,816 $ 199,622 (1) Represents amount expected to be paid under manufacturing-related supplier arrangements, substantially all of which is noncancelable. Operating Leases The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days . The Company also obtains individual components for its products from a wide variety of individual suppliers. Other Purchase Obligations The Company’s other purchase obligations consist of noncancelable obligations to acquire capital assets, including product tooling and manufacturing process equipment, and noncancelable obligations related to advertising, licensing, R&D, internet and telecommunications services, content creation and other activities. Apple Inc. | 2018 Form 10-K | 31 Deemed Repatriation Tax Payable As of September 29, 2018 , a significant portion of the other non-current liabilities in the Company’s Consolidated Balance Sheet consisted of the deemed repatriation tax payable imposed by the Act. The Company plans to pay the deemed repatriation tax payable in installments in accordance with the Act. Other Non-Current Liabilities The Company’s remaining other non-current liabilities primarily consist of items for which the Company is unable to make a reasonably reliable estimate of the timing of payments; therefore, such amounts are not included in the above contractual obligation table. Indemnification Agreements entered into by the Company may include indemnification provisions which may subject the Company to costs and damages in the event of a claim against an indemnified third party. Except as disclosed in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 9, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to indemnification of third parties. The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers of the Company, and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. While the Company maintains directors and officers liability insurance coverage, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation and impairment of marketable securities, inventory valuation, valuation of manufacturing-related assets and estimation of purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Apple Inc. | 2018 Form 10-K | 32 Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software and/or undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For sales of iPhone, iPad, Mac and certain other products, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. The Company’s process for determining ESPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s ESPs and the future rate of related amortization for unspecified software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the unspecified software upgrade rights and non-software services offered, the estimated value of unspecified software upgrade rights and non-software services and the estimated period unspecified software upgrades and non-software services are expected to be provided. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, the estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s operating results. Apple Inc. | 2018 Form 10-K | 33 Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are generally recognized in accumulated other comprehensive income, net of tax, in the Company’s Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the period any such determination is made. In making this determination, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company’s assessment of whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security, which would have an adverse impact on the Company’s financial condition and operating results. Inventory Valuation, Valuation of Manufacturing-Related Assets and Estimation of Purchase Commitment Cancellation Fees The Company purchases components and builds inventory in advance of product shipments and invests in manufacturing-related assets, including capital assets held at its suppliers’ facilities. In addition, the Company makes prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory. The Company performs a regular review of inventory that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels and component cost trends. If the Company determines inventories of components and products, including third-party products held for resale, have become obsolete or are in excess of anticipated demand or net realizable value, it records a write-down of the inventories. The Company also reviews its manufacturing-related capital assets and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value of such an asset exceeds its fair value. Any write-downs and/or impairments the Company may be required to record would adversely affect the Company’s financial condition and operating results. The Company accrues for estimated purchase commitment cancellation fees related to inventory orders that have been canceled or are expected to be canceled. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days . If there is an abrupt and substantial decline in demand for one or more of the Company’s products, a change in the Company’s product development plans, or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record accruals for cancellation fees that would adversely affect its operating results. Warranty Costs The Company accrues the estimated cost of warranties in the period the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost per claim and knowledge of specific product failures outside of the Company’s typical experience. The Company regularly reviews these estimates and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect the Company’s financial condition and operating results. Income Taxes The Company records a tax provision for the anticipated tax consequences of its reported operating results. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that will be in effect for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Apple Inc. | 2018 Form 10-K | 34 Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to recover the Company’s deferred tax assets. In the event that the Company determines all or part of its net deferred tax assets are not realizable in the future, the Company will record an adjustment to the valuation allowance and a corresponding charge to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. On December 22, 2017, the U.S. enacted the Act, which significantly changed U.S. tax law. The Act lowered the Company’s U.S. statutory federal income tax rate from 35% to 21% effective January 1, 2018, while also imposing a deemed repatriation tax on previously deferred foreign income. The Act also created a new minimum tax on certain future foreign earnings. The impact of the Act increased the Company’s provision for income taxes by $1.5 billion during 2018. This increase was composed of $2.0 billion related to the remeasurement of net deferred tax assets and liabilities and $1.2 billion associated with the deemed repatriation tax, partially offset by a $1.7 billion impact the deemed repatriation tax had on the Company’s unrecognized tax benefits. Certain amounts reported by the Company related to the Act are provisional estimates in accordance with the SEC Staff Accounting Bulletin No. 118. Resolution of the Act’s effects different from the assumptions made by the Company could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 9, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 9, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. The Company’s investment policy and strategy are focused on preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 29, 2018 and September 30, 2017 , a hypothetical 100 basis point increase in interest rates across all maturities would result in a $4.9 billion and $6.0 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. Apple Inc. | 2018 Form 10-K | 35 As of September 29, 2018 and September 30, 2017 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $102.5 billion and $103.7 billion , respectively. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on term debt are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 29, 2018 and September 30, 2017 to increase by $399 million and $376 million on an annualized basis, respectively. Further details regarding the Company’s debt is provided in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 5, “Debt.” Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and in the future may enter, into foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign currency–denominated debt issuances. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. To provide a meaningful assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $592 million as of September 29, 2018 compared to a maximum one-day loss in fair value of $485 million as of September 30, 2017 . Because the Company uses foreign currency instruments for hedging purposes, the losses in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio, debt and derivative positions may differ materially from the sensitivity analyses performed as of September 29, 2018 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchange rates and the Company’s actual exposures and positions. Apple Inc. | 2018 Form 10-K | 36 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 38 Consolidated Statements of Comprehensive Income for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 39 Consolidated Balance Sheets as of September 29, 2018 and September 30, 2017 40 Consolidated Statements of Shareholders’ Equity for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 41 Consolidated Statements of Cash Flows for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 42 Notes to Consolidated Financial Statements 43 Selected Quarterly Financial Information (Unaudited) 64 Reports of Independent Registered Public Accounting Firm 65 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. Apple Inc. | 2018 Form 10-K | 37 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 29, 2018 September 30, 2017 September 24, 2016 Net sales $ 265,595 $ 229,234 $ 215,639 Cost of sales 163,756 141,048 131,376 Gross margin 101,839 88,186 84,263 Operating expenses: Research and development 14,236 11,581 10,045 Selling, general and administrative 16,705 15,261 14,194 Total operating expenses 30,941 26,842 24,239 Operating income 70,898 61,344 60,024 Other income/(expense), net 2,005 2,745 1,348 Income before provision for income taxes 72,903 64,089 61,372 Provision for income taxes 13,372 15,738 15,685 Net income $ 59,531 $ 48,351 $ 45,687 Earnings per share: Basic $ 12.01 $ 9.27 $ 8.35 Diluted $ 11.91 $ 9.21 $ 8.31 Shares used in computing earnings per share: Basic 4,955,377 5,217,242 5,470,820 Diluted 5,000,109 5,251,692 5,500,281 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2018 Form 10-K | 38 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 29, 2018 September 30, 2017 September 24, 2016 Net income $ 59,531 $ 48,351 $ 45,687 Other comprehensive income/(loss): Change in foreign currency translation, net of tax effects of $(1), $(77) and $8, respectively (525 ) 224 75 Change in unrealized gains/losses on derivative instruments: Change in fair value of derivatives, net of tax benefit/(expense) of $(149), $(478) and $(7), respectively 523 1,315 7 Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $(104), $475 and $131, respectively 382 (1,477 ) (741 ) Total change in unrealized gains/losses on derivative instruments, net of tax 905 (162 ) (734 ) Change in unrealized gains/losses on marketable securities: Change in fair value of marketable securities, net of tax benefit/(expense) of $1,156, $425 and $(863), respectively (3,407 ) (782 ) 1,582 Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $21, $35 and $(31), respectively 1 (64 ) 56 Total change in unrealized gains/losses on marketable securities, net of tax (3,406 ) (846 ) 1,638 Total other comprehensive income/(loss) (3,026 ) (784 ) 979 Total comprehensive income $ 56,505 $ 47,567 $ 46,666 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2018 Form 10-K | 39 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 29, 2018 September 30, 2017 ASSETS: Current assets: Cash and cash equivalents $ 25,913 $ 20,289 Marketable securities 40,388 53,892 Accounts receivable, net 23,186 17,874 Inventories 3,956 4,855 Vendor non-trade receivables 25,809 17,799 Other current assets 12,087 13,936 Total current assets 131,339 128,645 Non-current assets: Marketable securities 170,799 194,714 Property, plant and equipment, net 41,304 33,783 Other non-current assets 22,283 18,177 Total non-current assets 234,386 246,674 Total assets $ 365,725 $ 375,319 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 55,888 $ 44,242 Other current liabilities 32,687 30,551 Deferred revenue 7,543 7,548 Commercial paper 11,964 11,977 Term debt 8,784 6,496 Total current liabilities 116,866 100,814 Non-current liabilities: Deferred revenue 2,797 2,836 Term debt 93,735 97,207 Other non-current liabilities 45,180 40,415 Total non-current liabilities 141,712 140,458 Total liabilities 258,578 241,272 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 4,754,986 and 5,126,201 shares issued and outstanding, respectively 40,201 35,867 Retained earnings 70,400 98,330 Accumulated other comprehensive income/(loss) (3,454 ) (150 ) Total shareholders’ equity 107,147 134,047 Total liabilities and shareholders’ equity $ 365,725 $ 375,319 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2018 Form 10-K | 40 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands and per share amounts) Common Stock and Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders’ Equity Shares Amount Balances as of September 26, 2015 5,578,753 $ 27,416 $ 92,284 $ (345 ) $ 119,355 Net income — — 45,687 — 45,687 Other comprehensive income/(loss) — — — 979 979 Dividends and dividend equivalents declared at $2.18 per share or RSU — — (12,188 ) — (12,188 ) Repurchase of common stock (279,609 ) — (29,000 ) — (29,000 ) Share-based compensation — 4,262 — — 4,262 Common stock issued, net of shares withheld for employee taxes 37,022 (806 ) (419 ) — (1,225 ) Tax benefit from equity awards, including transfer pricing adjustments — 379 — — 379 Balances as of September 24, 2016 5,336,166 31,251 96,364 634 128,249 Net income — — 48,351 — 48,351 Other comprehensive income/(loss) — — — (784 ) (784 ) Dividends and dividend equivalents declared at $2.40 per share or RSU — — (12,803 ) — (12,803 ) Repurchase of common stock (246,496 ) — (33,001 ) — (33,001 ) Share-based compensation — 4,909 — — 4,909 Common stock issued, net of shares withheld for employee taxes 36,531 (913 ) (581 ) — (1,494 ) Tax benefit from equity awards, including transfer pricing adjustments — 620 — — 620 Balances as of September 30, 2017 5,126,201 35,867 98,330 (150 ) 134,047 Cumulative effect of change in accounting principle — — 278 (278 ) — Net income — — 59,531 — 59,531 Other comprehensive income/(loss) — — — (3,026 ) (3,026 ) Dividends and dividend equivalents declared at $2.72 per share or RSU — — (13,735 ) — (13,735 ) Repurchase of common stock (405,549 ) — (73,056 ) — (73,056 ) Share-based compensation — 5,443 — — 5,443 Common stock issued, net of shares withheld for employee taxes 34,334 (1,109 ) (948 ) — (2,057 ) Balances as of September 29, 2018 4,754,986 $ 40,201 $ 70,400 $ (3,454 ) $ 107,147 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2018 Form 10-K | 41 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 29, 2018 September 30, 2017 September 24, 2016 Cash and cash equivalents, beginning of the year $ 20,289 $ 20,484 $ 21,120 Operating activities: Net income 59,531 48,351 45,687 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 10,903 10,157 10,505 Share-based compensation expense 5,340 4,840 4,210 Deferred income tax expense/(benefit) (32,590 ) 5,966 4,938 Other (444 ) (166 ) 486 Changes in operating assets and liabilities: Accounts receivable, net (5,322 ) (2,093 ) 527 Inventories 828 (2,723 ) 217 Vendor non-trade receivables (8,010 ) (4,254 ) (51 ) Other current and non-current assets (423 ) (5,318 ) 1,055 Accounts payable 9,175 8,966 2,117 Deferred revenue (44 ) (626 ) (1,554 ) Other current and non-current liabilities 38,490 1,125 (1,906 ) Cash generated by operating activities 77,434 64,225 66,231 Investing activities: Purchases of marketable securities (71,356 ) (159,486 ) (142,428 ) Proceeds from maturities of marketable securities 55,881 31,775 21,258 Proceeds from sales of marketable securities 47,838 94,564 90,536 Payments for acquisition of property, plant and equipment (13,313 ) (12,451 ) (12,734 ) Payments made in connection with business acquisitions, net (721 ) (329 ) (297 ) Purchases of non-marketable securities (1,871 ) (521 ) (1,388 ) Proceeds from non-marketable securities 353 126 — Other (745 ) (124 ) (924 ) Cash generated by/(used in) investing activities 16,066 (46,446 ) (45,977 ) Financing activities: Proceeds from issuance of common stock 669 555 495 Payments for taxes related to net share settlement of equity awards (2,527 ) (1,874 ) (1,570 ) Payments for dividends and dividend equivalents (13,712 ) (12,769 ) (12,150 ) Repurchases of common stock (72,738 ) (32,900 ) (29,722 ) Proceeds from issuance of term debt, net 6,969 28,662 24,954 Repayments of term debt (6,500 ) (3,500 ) (2,500 ) Change in commercial paper, net (37 ) 3,852 (397 ) Cash used in financing activities (87,876 ) (17,974 ) (20,890 ) Increase/(Decrease) in cash and cash equivalents 5,624 (195 ) (636 ) Cash and cash equivalents, end of the year $ 25,913 $ 20,289 $ 20,484 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 10,417 $ 11,591 $ 10,444 Cash paid for interest $ 3,022 $ 2,092 $ 1,316 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2018 Form 10-K | 42 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures and markets mobile communication and media devices and personal computers, and sells a variety of related software, services, accessories and third-party digital content and applications. The Company’s products and services include iPhone, iPad, Mac, Apple Watch, AirPods, Apple TV, HomePod, a portfolio of consumer and professional software applications, iOS, macOS, watchOS and tvOS operating systems, iCloud, Apple Pay and a variety of other accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store, App Store, Mac App Store, TV App Store, Book Store and Apple Music (collectively “Digital Content and Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories, through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these consolidated financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2018 and 2016 spanned 52 weeks each, whereas fiscal year 2017 included 53 weeks. A 14th week was included in the first fiscal quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For the sale of most third-party products, the Company recognizes revenue based on the gross amount billed to customers because the Company establishes its own pricing for such products, retains related inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its customers. For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. Apple Inc. | 2018 Form 10-K | 43 The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on iTunes Store, App Store, Mac App Store, TV App Store and Book Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited warranty. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For the Company’s other customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For multi-element arrangements accounted for in accordance with industry-specific software accounting guidance, the Company allocates revenue to all deliverables based on the VSOE of each element, and if VSOE does not exist revenue is recognized when elements lacking VSOE are delivered. For sales of iPhone, iPad, Mac and certain other products, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. The Company has identified up to three deliverables regularly included in arrangements involving the sale of these devices. The first deliverable, which represents the substantial portion of the allocated sales price, is the hardware and software essential to the functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with qualifying devices to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the product’s essential software. The third deliverable is the non-software services to be provided to qualifying devices. The Company allocates revenue between these deliverables using the relative selling price method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based on the Company’s ESPs. Revenue allocated to the delivered hardware and the related essential software is recognized at the time of sale, provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses as incurred. The Company’s process for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable including, where applicable, prices charged by the Company and market trends in the pricing for similar offerings, product-specific business objectives, estimated cost to provide the non-software services and the relative ESP of the upgrade rights and non-software services as compared to the total selling price of the product. Shipping Costs Amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s shipping and handling costs are classified as cost of sales. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Apple Inc. | 2018 Form 10-K | 44 Share-Based Compensation The Company generally measures share-based compensation based on the closing price of the Company’s common stock on the date of grant, and recognizes expense on a straight-line basis for its estimate of equity awards that will ultimately vest. Further information regarding share-based compensation can be found in Note 8, “Benefit Plans.” During the first quarter of 2018, the Company adopted the Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Update (“ASU”) No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which modified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification in the statement of cash flows. Historically, excess tax benefits or deficiencies from the Company’s equity awards were recorded as additional paid-in capital in its Consolidated Balance Sheets and were classified as a financing activity in its Consolidated Statements of Cash Flows. Beginning in 2018, the Company records any excess tax benefits or deficiencies from its equity awards as part of the provision for income taxes in its Consolidated Statements of Operations in the reporting periods in which equity vesting occurs. The Company elected to apply the cash flow classification requirements related to excess tax benefits retrospectively to all periods presented, which resulted in an increase to cash generated by operating activities in the Consolidated Statements of Cash Flows of $627 million and $407 million for 2017 and 2016 , respectively. Earnings Per Share The following table shows the computation of basic and diluted earnings per share for 2018 , 2017 and 2016 (net income in millions and shares in thousands): 2018 2017 2016 Numerator: Net income $ 59,531 $ 48,351 $ 45,687 Denominator: Weighted-average basic shares outstanding 4,955,377 5,217,242 5,470,820 Effect of dilutive securities 44,732 34,450 29,461 Weighted-average diluted shares 5,000,109 5,251,692 5,500,281 Basic earnings per share $ 12.01 $ 9.27 $ 8.35 Diluted earnings per share $ 11.91 $ 9.21 $ 8.31 Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable equity securities, including mutual funds, are classified as short-term based on the nature of the securities and their availability for use in current operations. The cost of securities sold is determined using the specific identification method. Inventories Inventories are computed using the first-in, first-out method. Property, Plant and Equipment Depreciation on property, plant and equipment is recognized on a straight-line basis over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between one and five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease term or useful life for leasehold improvements. Capitalized costs related to internal-use software are amortized on a straight-line basis over the estimated useful lives of the assets, which range from three to five years . Depreciation and amortization expense on property and equipment was $9.3 billion , $8.2 billion and $8.3 billion during 2018 , 2017 and 2016 , respectively. During 2018 , non-cash investing activities involving property, plant and equipment resulted in a net increase to accounts payable and other current liabilities of $3.4 billion . Apple Inc. | 2018 Form 10-K | 45 Fair Value Measurements The Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities are derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, which generally have counterparties with high credit ratings, are based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and available-for-sale securities by significant investment category as of September 29, 2018 and September 30, 2017 (in millions): 2018 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 11,575 $ — $ — $ 11,575 $ 11,575 $ — $ — Level 1 (1) : Money market funds 8,083 — — 8,083 8,083 — — Mutual funds 799 — (116 ) 683 — 683 — Subtotal 8,882 — (116 ) 8,766 8,083 683 — Level 2 (2) : U.S. Treasury securities 47,296 — (1,202 ) 46,094 1,613 7,606 36,875 U.S. agency securities 4,127 — (48 ) 4,079 1,732 360 1,987 Non-U.S. government securities 21,601 49 (250 ) 21,400 — 3,355 18,045 Certificates of deposit and time deposits 3,074 — — 3,074 1,247 1,330 497 Commercial paper 2,573 — — 2,573 1,663 910 — Corporate securities 123,001 152 (2,038 ) 121,115 — 25,162 95,953 Municipal securities 946 — (12 ) 934 — 178 756 Mortgage- and asset-backed securities 18,105 8 (623 ) 17,490 — 804 16,686 Subtotal 220,723 209 (4,173 ) 216,759 6,255 39,705 170,799 Total (3) $ 241,180 $ 209 $ (4,289 ) $ 237,100 $ 25,913 $ 40,388 $ 170,799 Apple Inc. | 2018 Form 10-K | 46 2017 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 7,982 $ — $ — $ 7,982 $ 7,982 $ — $ — Level 1 (1) : Money market funds 6,534 — — 6,534 6,534 — — Mutual funds 799 — (88 ) 711 — 711 — Subtotal 7,333 — (88 ) 7,245 6,534 711 — Level 2 (2) : U.S. Treasury securities 55,254 58 (230 ) 55,082 865 17,228 36,989 U.S. agency securities 5,162 2 (9 ) 5,155 1,439 2,057 1,659 Non-U.S. government securities 7,827 210 (37 ) 8,000 9 123 7,868 Certificates of deposit and time deposits 5,832 — — 5,832 1,142 3,918 772 Commercial paper 3,640 — — 3,640 2,146 1,494 — Corporate securities 152,724 969 (242 ) 153,451 172 27,591 125,688 Municipal securities 961 4 (1 ) 964 — 114 850 Mortgage- and asset-backed securities 21,684 35 (175 ) 21,544 — 656 20,888 Subtotal 253,084 1,278 (694 ) 253,668 5,773 53,181 194,714 Total $ 268,399 $ 1,278 $ (782 ) $ 268,895 $ 20,289 $ 53,892 $ 194,714 (1) Level 1 fair value estimates are based on quoted prices in active markets for identical assets or liabilities. (2) Level 2 fair value estimates are based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. (3) As of September 29, 2018 , total cash, cash equivalents and marketable securities included $20.3 billion that was restricted from general use, related to the State Aid Decision (refer to Note 4, “Income Taxes”) and other agreements. The Company may sell certain of its marketable securities prior to their stated maturities for reasons including, but not limited to, managing liquidity, credit risk, duration and asset allocation. The maturities of the Company’s long-term marketable securities generally range from one to five years . The following tables show information about the Company’s marketable securities that had been in a continuous unrealized loss position for less than 12 months and for 12 months or greater as of September 29, 2018 and September 30, 2017 (in millions): 2018 Continuous Unrealized Losses Less than 12 Months 12 Months or Greater Total Fair value of marketable securities $ 126,238 $ 60,599 $ 186,837 Unrealized losses $ (2,400 ) $ (1,889 ) $ (4,289 ) 2017 Continuous Unrealized Losses Less than 12 Months 12 Months or Greater Total Fair value of marketable securities $ 101,986 $ 8,290 $ 110,276 Unrealized losses $ (596 ) $ (186 ) $ (782 ) Apple Inc. | 2018 Form 10-K | 47 The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates and the Company’s intent to sell, or whether it is more likely than not it will be required to sell the investment before recovery of the investment’s cost basis. As of September 29, 2018 , the Company does not consider any of its investments to be other-than-temporarily impaired. Derivative Financial Instruments The Company may use derivatives to partially offset its business exposure to foreign currency and interest rate risk on expected future cash flows, net investments in certain foreign subsidiaries, and certain existing assets and liabilities. However, the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange or interest rates. To protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar may hedge a portion of forecasted foreign currency revenue, and subsidiaries whose functional currency is not the U.S. dollar may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company may enter into forward contracts, option contracts or other instruments to manage this risk and may designate these instruments as cash flow hedges. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months . To protect the net investment in a foreign operation from fluctuations in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset a portion of the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. In addition, the Company may use non-derivative financial instruments, such as its foreign currency–denominated debt, as hedges of its net investments in certain foreign subsidiaries. In both of these cases, the Company designates these instruments as net investment hedges. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, cross-currency swaps or other instruments. These instruments may offset a portion of the foreign currency remeasurement gains or losses, or changes in fair value. The Company may designate these instruments as either cash flow or fair value hedges. As of September 29, 2018 , the Company’s hedged term debt– and marketable securities–related foreign currency transactions are expected to be recognized within 24 years . The Company may also enter into non-designated foreign currency contracts to offset a portion of the foreign currency exchange gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in interest rates, the Company may enter into interest rate swaps, options or other instruments. These instruments may offset a portion of the changes in interest income or expense, or changes in fair value. The Company designates these instruments as either cash flow or fair value hedges. As of September 29, 2018 , the Company’s hedged interest rate transactions are expected to be recognized within 9 years . Cash Flow Hedges The effective portions of cash flow hedges are recorded in accumulated other comprehensive income/(loss) (“AOCI”) until the hedged item is recognized in earnings. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow hedges of interest income or expense are recognized in other income/(expense), net in the same period as the related income or expense is recognized. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness. The ineffective portions and amounts excluded from the effectiveness testing of cash flow hedges are recognized in other income/(expense), net. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified into other income/(expense), net in the period of de-designation. Any subsequent changes in fair value of such derivative instruments are reflected in other income/(expense), net unless they are re-designated as hedges of other transactions. Apple Inc. | 2018 Form 10-K | 48 Net Investment Hedges The effective portions of net investment hedges are recorded in other comprehensive income/(loss) (“OCI”) as a part of the cumulative translation adjustment. The ineffective portions and amounts excluded from the effectiveness testing of net investment hedges are recognized in other income/(expense), net. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this forward carry component are recognized in earnings in the current period. Fair Value Hedges Gains and losses related to changes in fair value hedges are recognized in earnings along with a corresponding loss or gain related to the change in value of the underlying hedged item in the same line in the Consolidated Statements of Operations. Non-Designated Derivatives Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. As a result, during 2018 , the Company recognized a gain of $20 million in net sales, a gain of $85 million in cost of sales and a loss of $198 million in other income/(expense), net. During 2017 , the Company recognized a gain of $20 million in net sales, a loss of $40 million in cost of sales and a gain of $606 million in other income/(expense), net. The Company records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these derivative instruments is based on its hedge designation. The following tables show the Company’s derivative instruments at gross fair value as of September 29, 2018 and September 30, 2017 (in millions): 2018 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,015 $ 259 $ 1,274 Derivative liabilities (2) : Foreign exchange contracts $ 543 $ 137 $ 680 Interest rate contracts $ 1,456 $ — $ 1,456 2017 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,049 $ 363 $ 1,412 Interest rate contracts $ 218 $ — $ 218 Derivative liabilities (2) : Foreign exchange contracts $ 759 $ 501 $ 1,260 Interest rate contracts $ 303 $ — $ 303 (1) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets and other non-current assets in the Consolidated Balance Sheets. (2) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as other current liabilities and other non-current liabilities in the Consolidated Balance Sheets. The Company classifies cash flows related to derivative financial instruments as operating activities in its Consolidated Statements of Cash Flows. Apple Inc. | 2018 Form 10-K | 49 The following table shows the pre-tax gains and losses of the Company’s derivative and non-derivative instruments designated as cash flow, net investment and fair value hedges in OCI and the Consolidated Statements of Operations for 2018 , 2017 and 2016 (in millions): 2018 2017 2016 Gains/(Losses) recognized in OCI – effective portion: Cash flow hedges: Foreign exchange contracts $ 682 $ 1,797 $ 109 Interest rate contracts 1 7 (57 ) Total $ 683 $ 1,804 $ 52 Net investment hedges: Foreign currency debt $ 4 $ 67 $ (258 ) Gains/(Losses) reclassified from AOCI into net income – effective portion: Cash flow hedges: Foreign exchange contracts $ (482 ) $ 1,958 $ 885 Interest rate contracts 1 (2 ) (11 ) Total $ (481 ) $ 1,956 $ 874 Gains/(Losses) on derivative instruments: Fair value hedges: Foreign exchange contracts $ (168 ) $ — $ — Interest rate contracts (1,363 ) (810 ) 341 Total $ (1,531 ) $ (810 ) $ 341 Gains/(Losses) related to hedged items: Fair value hedges: Marketable securities $ 167 $ — $ — Fixed-rate debt 1,363 810 (341 ) Total $ 1,530 $ 810 $ (341 ) The following table shows the notional amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of September 29, 2018 and September 30, 2017 (in millions): 2018 2017 Notional Amount Credit Risk Amount Notional Amount Credit Risk Amount Instruments designated as accounting hedges: Foreign exchange contracts $ 65,368 $ 1,015 $ 56,156 $ 1,049 Interest rate contracts $ 33,250 $ — $ 33,000 $ 218 Instruments not designated as accounting hedges: Foreign exchange contracts $ 63,062 $ 259 $ 69,774 $ 363 The notional amounts for outstanding derivative instruments provide one measure of the transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s exposure to credit loss and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. Apple Inc. | 2018 Form 10-K | 50 The Company generally enters into master netting arrangements, which are designed to reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values in its Consolidated Balance Sheets. As of September 29, 2018 , the net cash collateral posted by the Company related to derivative instruments under its collateral security arrangements was $1.0 billion , which was recorded as other current assets in the Condensed Consolidated Balance Sheet. As of September 30, 2017 , the net cash collateral received by the Company related to derivative instruments under its collateral security arrangements was $35 million , which was recorded as other current liabilities in the Consolidated Balance Sheet. Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net settle transactions with a single net amount payable by one party to the other. As of September 29, 2018 and September 30, 2017 , the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $2.1 billion and $1.4 billion , respectively, resulting in net derivative assets of $138 million and $32 million , respectively. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral or third-party credit support in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 29, 2018 , the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10% . As of September 30, 2017 , the Company had two customers that individually represented 10% or more of total trade receivables, each of which accounted for 10% . The Company’s cellular network carriers accounted for 59% of total trade receivables as of both September 29, 2018 and September 30, 2017 . Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. As of September 29, 2018 , the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 62% and 12% . As of September 30, 2017 , the Company had three vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 42% , 19% and 10% . Note 3 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 29, 2018 and September 30, 2017 (in millions): Property, Plant and Equipment, Net 2018 2017 Land and buildings $ 16,216 $ 13,587 Machinery, equipment and internal-use software 65,982 54,210 Leasehold improvements 8,205 7,279 Gross property, plant and equipment 90,403 75,076 Accumulated depreciation and amortization (49,099 ) (41,293 ) Total property, plant and equipment, net $ 41,304 $ 33,783 Apple Inc. | 2018 Form 10-K | 51 Other Non-Current Liabilities 2018 2017 Long-term taxes payable $ 33,589 $ 257 Deferred tax liabilities 426 31,504 Other non-current liabilities 11,165 8,654 Total other non-current liabilities $ 45,180 $ 40,415 Other Income/(Expense), Net The following table shows the detail of other income/(expense), net for 2018 , 2017 and 2016 (in millions): 2018 2017 2016 Interest and dividend income $ 5,686 $ 5,201 $ 3,999 Interest expense (3,240 ) (2,323 ) (1,456 ) Other expense, net (441 ) (133 ) (1,195 ) Total other income/(expense), net $ 2,005 $ 2,745 $ 1,348 Note 4 – Income Taxes U.S. Tax Cuts and Jobs Act On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which significantly changed U.S. tax law. The Act lowered the Company’s U.S. statutory federal income tax rate from 35% to 21% effective January 1, 2018, while also imposing a deemed repatriation tax on previously deferred foreign income. The Act also created a new minimum tax on certain future foreign earnings. The impact of the Act increased the Company’s provision for income taxes by $1.5 billion during 2018. This increase was composed of $2.0 billion related to the remeasurement of net deferred tax assets and liabilities and $1.2 billion associated with the deemed repatriation tax, partially offset by a $1.7 billion impact the deemed repatriation tax had on the Company’s unrecognized tax benefits. Deferred Tax Balances As a result of the Act, the Company remeasured certain deferred tax assets and liabilities based on the revised rates at which they are expected to reverse, including items for which the related income tax effects were originally recognized in OCI. In addition, the Company elected to record certain deferred tax assets and liabilities related to the new minimum tax on certain future foreign earnings. Of the $2.0 billion recognized related to the remeasurement of net deferred tax assets and liabilities, $1.2 billion is a provisional estimate that incorporates assumptions based upon the most recent interpretations of the Act and may change as the Company continues to analyze the impact of additional implementation guidance. The Company’s provisional estimates are in accordance with the U.S. Securities and Exchange Commission Staff Accounting Bulletin No. 118. Deemed Repatriation Tax As of September 30, 2017, the Company had a U.S. deferred tax liability of $36.4 billion for deferred foreign income. During 2018, the Company replaced $36.1 billion of its U.S. deferred tax liability with a deemed repatriation tax payable of $37.3 billion , which was based on the Company’s cumulative post-1986 deferred foreign income. The deemed repatriation tax payable is a provisional estimate that may change as the Company continues to analyze the impact of additional implementation guidance. The Company plans to pay the tax in installments in accordance with the Act. Adoption of ASU No. 2018-02 During the second quarter of 2018, the FASB issued ASU No. 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (“ASU 2018-02”). ASU 2018-02 allows an entity to elect to reclassify the income tax effects of the Act on items within AOCI to retained earnings. The Company elected to apply the provision of ASU 2018-02 in 2018 with a reclassification of net tax benefits related to cumulative foreign currency translation and unrealized gains/losses on derivative instruments and marketable securities, resulting in a $278 million decrease in AOCI and a corresponding increase in retained earnings in the Consolidated Balance Sheet and Consolidated Statement of Shareholders’ Equity. Apple Inc. | 2018 Form 10-K | 52 Provision for Income Taxes and Effective Tax Rate The provision for income taxes for 2018 , 2017 and 2016 , consisted of the following (in millions): 2018 2017 2016 Federal: Current $ 41,425 $ 7,842 $ 7,652 Deferred (33,819 ) 5,980 5,043 Total 7,606 13,822 12,695 State: Current 551 259 990 Deferred 48 2 (138 ) Total 599 261 852 Foreign: Current 3,986 1,671 2,105 Deferred 1,181 (16 ) 33 Total 5,167 1,655 2,138 Provision for income taxes $ 13,372 $ 15,738 $ 15,685 The foreign provision for income taxes is based on foreign pre-tax earnings of $48.0 billion , $44.7 billion and $41.1 billion in 2018 , 2017 and 2016 , respectively. A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate ( 24.5% in 2018 ; 35% in 2017 and 2016 ) to income before provision for income taxes for 2018 , 2017 and 2016 , is as follows (dollars in millions): 2018 2017 2016 Computed expected tax $ 17,890 $ 22,431 $ 21,480 State taxes, net of federal effect 271 185 553 Impacts of the Act 1,515 — — Earnings of foreign subsidiaries (5,606 ) (6,135 ) (5,582 ) Domestic production activities deduction (195 ) (209 ) (382 ) Research and development credit, net (560 ) (678 ) (371 ) Other 57 144 (13 ) Provision for income taxes $ 13,372 $ 15,738 $ 15,685 Effective tax rate 18.3 % 24.6 % 25.6 % The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan awards. For restricted stock units (“RSUs”), the Company receives an income tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. Prior to adopting ASU 2016-09 in the first quarter of 2018, the Company reflected net excess tax benefits from equity awards as increases to additional paid-in capital, which amounted to $620 million and $379 million in 2017 and 2016 , respectively. Refer to Note 1, “Summary of Significant Accounting Policies” for more information. Apple Inc. | 2018 Form 10-K | 53 Deferred Tax Assets and Liabilities As of September 29, 2018 and September 30, 2017 , the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2018 2017 Deferred tax assets: Accrued liabilities and other reserves $ 3,151 $ 4,019 Basis of capital assets 137 1,230 Deferred revenue 1,141 1,521 Deferred cost sharing — 667 Share-based compensation 513 703 Unrealized losses 871 — Other 797 834 Total deferred tax assets 6,610 8,974 Deferred tax liabilities: Earnings of foreign subsidiaries 275 36,355 Other 501 207 Total deferred tax liabilities 776 36,562 Net deferred tax assets/(liabilities) $ 5,834 $ (27,588 ) Deferred tax assets and liabilities reflect the effects of tax losses, credits and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Uncertain Tax Positions As of September 29, 2018 , the total amount of gross unrecognized tax benefits was $9.7 billion , of which $7.4 billion , if recognized, would impact the Company’s effective tax rate. As of September 30, 2017 , the total amount of gross unrecognized tax benefits was $8.4 billion , of which $2.5 billion , if recognized, would have impacted the Company’s effective tax rate. The aggregate changes in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2018 , 2017 and 2016 , is as follows (in millions): 2018 2017 2016 Beginning balances $ 8,407 $ 7,724 $ 6,900 Increases related to tax positions taken during a prior year 2,431 333 1,121 Decreases related to tax positions taken during a prior year (2,212 ) (952 ) (257 ) Increases related to tax positions taken during the current year 1,824 1,880 1,578 Decreases related to settlements with taxing authorities (756 ) (539 ) (1,618 ) Decreases related to expiration of statute of limitations — (39 ) — Ending balances $ 9,694 $ 8,407 $ 7,724 The Company includes interest and penalties related to unrecognized tax benefits within the provision for income taxes. As of September 29, 2018 and September 30, 2017 , the total amount of gross interest and penalties accrued was $1.4 billion and $1.2 billion , respectively. Both the unrecognized tax benefits and the associated interest and penalties that are not expected to result in payment or receipt of cash within one year are classified as other non-current liabilities in the Consolidated Balance Sheets. In connection with tax matters, the Company recognized interest and penalty expense in 2018 , 2017 and 2016 of $236 million , $165 million and $295 million , respectively. Apple Inc. | 2018 Form 10-K | 54 The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. The U.S. Internal Revenue Service (the “IRS”) concluded its review of the years 2013 through 2015 in 2018, and all years prior to 2016 are closed. Tax years subsequent to 2006 in certain major U.S. states and subsequent to 2007 in certain major foreign jurisdictions remain open, and could be subject to examination by the taxing authorities. The Company believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner inconsistent with its expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although timing of resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease (either by payment, release or a combination of both) in the next 12 months by as much as $800 million . European Commission State Aid Decision On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. The recovery amount was calculated to be €13.1 billion , plus interest of €1.2 billion . Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and appealed to the General Court of the Court of Justice of the European Union. Ireland has also appealed the State Aid Decision. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes, subject to any foreign tax credit limitations in the Act. As of September 29, 2018 , the entire recovery amount plus interest was funded into escrow, where it will remain restricted from general use pending conclusion of all appeals. Refer to Note 2, “Financial Instruments” for more information. Note 5 – Debt Commercial Paper The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of both September 29, 2018 and September 30, 2017 , the Company had $12.0 billion of Commercial Paper outstanding with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 2.18% as of September 29, 2018 and 1.20% as of September 30, 2017 . The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2018 , 2017 and 2016 (in millions): 2018 2017 2016 Maturities 90 days or less: Proceeds from/(Repayments of) commercial paper, net $ 1,044 $ (1,782 ) $ (869 ) Maturities greater than 90 days: Proceeds from commercial paper 14,555 17,932 3,632 Repayments of commercial paper (15,636 ) (12,298 ) (3,160 ) Proceeds from/(Repayments of) commercial paper, net (1,081 ) 5,634 472 Total change in commercial paper, net $ (37 ) $ 3,852 $ (397 ) Apple Inc. | 2018 Form 10-K | 55 Term Debt As of September 29, 2018 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $104.2 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and interest is payable in arrears, quarterly for the U.S. dollar–denominated and Australian dollar–denominated floating-rate notes, semi-annually for the U.S. dollar–denominated, Australian dollar–denominated, British pound–denominated, Japanese yen–denominated and Canadian dollar–denominated fixed-rate notes and annually for the euro-denominated and Swiss franc–denominated fixed-rate notes. The following table provides a summary of the Company’s term debt as of September 29, 2018 and September 30, 2017 : Maturities (calendar year) 2018 2017 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 debt issuance of $17.0 billion: Floating-rate notes — $ — — % $ 2,000 1.10 % Fixed-rate 2.400% – 3.850% notes 2023 – 2043 8,500 2.44% – 3.91 % 12,500 1.08% – 3.91 % 2014 debt issuance of $12.0 billion: Floating-rate notes 2019 1,000 2.64 % 1,000 1.61 % Fixed-rate 2.100% – 4.450% notes 2019 – 2044 8,500 2.64% – 4.48 % 8,500 1.61% – 4.48 % 2015 debt issuances of $27.3 billion: Floating-rate notes 2019 – 2020 1,507 1.87% – 2.64 % 1,549 1.56% – 1.87 % Fixed-rate 0.350% – 4.375% notes 2019 – 2045 24,410 0.28% – 4.51 % 24,522 0.28% – 4.51 % 2016 debt issuances of $24.9 billion: Floating-rate notes 2019 – 2021 1,350 2.48% – 3.44 % 1,350 1.45% – 2.44 % Fixed-rate 1.100% – 4.650% notes 2019 – 2046 23,059 1.13% – 4.78 % 23,645 1.13% – 4.78 % 2017 debt issuances of $28.7 billion: Floating-rate notes 2019 – 2022 3,250 2.41% – 2.84 % 3,250 1.38% – 1.81 % Fixed-rate 0.875% – 4.300% notes 2019 – 2047 25,617 1.54% – 4.30 % 25,705 1.51% – 4.30 % First quarter 2018 debt issuance of $7.0 billion: Fixed-rate 1.800% notes 2019 1,000 1.83 % — — % Fixed-rate 2.000% notes 2020 1,000 2.03 % — — % Fixed-rate 2.400% notes 2023 750 2.66 % — — % Fixed-rate 2.750% notes 2025 1,500 2.77 % — — % Fixed-rate 3.000% notes 2027 1,500 3.05 % — — % Fixed-rate 3.750% notes 2047 1,250 3.80 % — — % Total term debt 104,193 104,021 Unamortized premium/(discount) and issuance costs, net (218 ) (225 ) Hedge accounting fair value adjustments (1,456 ) (93 ) Less: Current portion of term debt (8,784 ) (6,496 ) Total non-current portion of term debt $ 93,735 $ 97,207 To manage interest rate risk on certain of its U.S. dollar–denominated fixed- or floating-rate notes, the Company has entered into interest rate swaps to effectively convert the fixed interest rates to floating interest rates or the floating interest rates to fixed interest rates on a portion of these notes. Additionally, to manage foreign currency risk on certain of its foreign currency–denominated notes, the Company has entered into foreign currency swaps to effectively convert these notes to U.S. dollar–denominated notes. A portion of the Company’s Japanese yen–denominated notes is designated as a hedge of the foreign currency exposure of the Company’s net investment in a foreign operation. As of September 29, 2018 and September 30, 2017 , the carrying value of the debt designated as a net investment hedge was $811 million and $1.6 billion , respectively. For further discussion regarding the Company’s use of derivative instruments, refer to the Derivative Financial Instruments section of Note 2, “Financial Instruments.” The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $3.0 billion , $2.2 billion and $1.4 billion of interest expense on its term debt for 2018 , 2017 and 2016 , respectively. Apple Inc. | 2018 Form 10-K | 56 The future principal payments for the Company’s Notes as of September 29, 2018 are as follows (in millions): 2019 $ 8,797 2020 10,183 2021 8,750 2022 8,583 2023 9,395 Thereafter 58,485 Total term debt $ 104,193 As of September 29, 2018 and September 30, 2017 , the fair value of the Company’s Notes, based on Level 2 inputs, was $103.2 billion and $106.1 billion , respectively. Note 6 – Shareholders’ Equity Share Repurchase Program During 2018 , the Company repurchased 405.5 million shares of its common stock for $73.1 billion in connection with two separate share repurchase programs. Of the $73.1 billion , $44.0 billion was repurchased under the Company’s previous share repurchase program of up to $210 billion , thereby completing that program. On May 1, 2018, the Company announced the Board of Directors had authorized a new program to repurchase up to $100 billion of the Company’s common stock. The remaining $29.0 billion repurchased during 2018 was in connection with the new share repurchase program. The Company’s new share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Note 7 – Comprehensive Income The Company’s OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and unrealized gains and losses on marketable securities classified as available-for-sale. The following table shows the pre-tax amounts reclassified from AOCI into the Consolidated Statements of Operations, and the associated financial statement line item, for 2018 and 2017 (in millions): Comprehensive Income Components Financial Statement Line Item 2018 2017 Unrealized (gains)/losses on derivative instruments: Foreign exchange contracts Net sales $ 214 $ (662 ) Cost of sales (70 ) (654 ) Other income/(expense), net 344 (638 ) Interest rate contracts Other income/(expense), net (2 ) 2 486 (1,952 ) Unrealized (gains)/losses on marketable securities Other income/(expense), net (20 ) (99 ) Total amounts reclassified from AOCI $ 466 $ (2,051 ) Apple Inc. | 2018 Form 10-K | 57 The following table shows the changes in AOCI by component for 2018 and 2017 (in millions): Cumulative Foreign Currency Translation Unrealized Gains/Losses on Derivative Instruments Unrealized Gains/Losses on Marketable Securities Total Balances as of September 24, 2016 $ (578 ) $ 38 $ 1,174 $ 634 Other comprehensive income/(loss) before reclassifications 301 1,793 (1,207 ) 887 Amounts reclassified from AOCI — (1,952 ) (99 ) (2,051 ) Tax effect (77 ) (3 ) 460 380 Other comprehensive income/(loss) 224 (162 ) (846 ) (784 ) Balances as of September 30, 2017 (354 ) (124 ) 328 (150 ) Other comprehensive income/(loss) before reclassifications (524 ) 672 (4,563 ) (4,415 ) Amounts reclassified from AOCI — 486 (20 ) 466 Tax effect (1 ) (253 ) 1,177 923 Other comprehensive income/(loss) (525 ) 905 (3,406 ) (3,026 ) Cumulative effect of change in accounting principle (1) (176 ) 29 (131 ) (278 ) Balances as of September 29, 2018 $ (1,055 ) $ 810 $ (3,209 ) $ (3,454 ) (1) Refer to Note 4, “Income Taxes” for more information on the Company’s adoption of ASU 2018-02 in 2018. Note 8 – Benefit Plans 2014 Employee Stock Plan In the second quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the 2014 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. Each share issued with respect to RSUs granted under the 2014 Plan reduces the number of shares available for grant under the plan by two shares. RSUs canceled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the number of RSUs canceled or shares withheld. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 385 million shares plus the number of shares remaining that were reserved but not issued under the 2003 Plan. Shares subject to outstanding awards under the 2003 Plan that expire, are canceled or otherwise terminate, or are withheld to satisfy tax withholding obligations with respect to RSUs, will also be available for awards under the 2014 Plan. As of September 29, 2018 , approximately 280.2 million shares were reserved for future issuance under the 2014 Plan. Apple Inc. Non-Employee Director Stock Plan The Apple Inc. Non-Employee Director Stock Plan (the “Director Plan”) is a shareholder-approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the value and relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants, in each case within the limits set forth in the Director Plan and without further shareholder approval. Each share issued with respect to RSUs granted under the Director Plan reduces the number of shares available for grant under the plan by two shares. The Director Plan expires November 12, 2027 . All RSUs granted under the Director Plan are entitled to DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. As of September 29, 2018 , approximately 1.1 million shares were reserved for future issuance under the Director Plan. Apple Inc. | 2018 Form 10-K | 58 Rule 10b5-1 Trading Plans During the three months ended September 29, 2018 , Section 16 officers Angela Ahrendts, Timothy D. Cook, Chris Kondo, Luca Maestri, Daniel Riccio, Philip Schiller and Jeffrey Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired pursuant to the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder-approved plan under which substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning or the end of six -month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10% of the employee’s compensation and employees may not purchase more than $25,000 of stock during any calendar year. As of September 29, 2018 , approximately 36.5 million shares were reserved for future issuance under the Purchase Plan. 401(k) Plan The Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ( $18,500 for calendar year 2018). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2018 , 2017 and 2016 , is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per RSU Aggregate Fair Value (in millions) Balance as of September 26, 2015 101,467 $ 85.77 RSUs granted 49,468 $ 109.28 RSUs vested (46,313 ) $ 84.44 RSUs canceled (5,533 ) $ 96.48 Balance as of September 24, 2016 99,089 $ 97.54 RSUs granted 50,112 $ 121.65 RSUs vested (45,735 ) $ 95.48 RSUs canceled (5,895 ) $ 106.87 Balance as of September 30, 2017 97,571 $ 110.33 RSUs granted 45,351 $ 162.86 RSUs vested (44,718 ) $ 111.24 RSUs canceled (6,049 ) $ 127.82 Balance as of September 29, 2018 92,155 $ 134.60 $ 20,803 The fair value as of the respective vesting dates of RSUs was $7.6 billion , $6.1 billion and $5.1 billion for 2018 , 2017 and 2016 , respectively. The majority of RSUs that vested in 2018 , 2017 and 2016 were net share settled such that the Company withheld shares with value equivalent to the employees’ obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 16.0 million , 15.4 million and 15.9 million for 2018 , 2017 and 2016 , respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $2.7 billion , $2.0 billion and $1.7 billion in 2018 , 2017 and 2016 , respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net share settlements had the effect of share repurchases by the Company as they reduced the number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. Apple Inc. | 2018 Form 10-K | 59 Share-Based Compensation The following table shows a summary of the share-based compensation expense included in the Consolidated Statements of Operations for 2018 , 2017 and 2016 (in millions): 2018 2017 2016 Cost of sales $ 1,010 $ 877 $ 769 Research and development 2,668 2,299 1,889 Selling, general and administrative 1,662 1,664 1,552 Total share-based compensation expense $ 5,340 $ 4,840 $ 4,210 The income tax benefit related to share-based compensation expense was $1.9 billion , $1.6 billion and $1.4 billion for 2018 , 2017 and 2016 , respectively. As of September 29, 2018 , the total unrecognized compensation cost related to outstanding RSUs and stock options was $9.4 billion , which the Company expects to recognize over a weighted-average period of 2.5 years . Note 9 – Commitments and Contingencies Accrued Warranty and Indemnification The following table shows changes in the Company’s accrued warranties and related costs for 2018 , 2017 and 2016 (in millions): 2018 2017 2016 Beginning accrued warranty and related costs $ 3,834 $ 3,702 $ 4,780 Cost of warranty claims (4,115 ) (4,322 ) (4,663 ) Accruals for product warranty 3,973 4,454 3,585 Ending accrued warranty and related costs $ 3,692 $ 3,834 $ 3,702 Agreements entered into by the Company may include indemnification provisions which may subject the Company to costs and damages in the event of a claim against an indemnified third party. Except as disclosed under the heading “Contingencies” below, in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to indemnification of third parties. The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers of the Company, and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. While the Company maintains directors and officers liability insurance coverage, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. Apple Inc. | 2018 Form 10-K | 60 The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are single-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s financial condition and operating results could be materially adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s manufacturing purchase obligations typically cover its requirements for periods up to 150 days . Other Off–Balance Sheet Commitments Operating Leases The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off–balance sheet financing arrangements. As of September 29, 2018 , the Company’s total future minimum lease payments under noncancelable operating leases were $9.6 billion . The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. Rent expense under all operating leases, including both cancelable and noncancelable leases, was $1.2 billion , $1.1 billion and $939 million in 2018 , 2017 and 2016 , respectively. Future minimum lease payments under noncancelable operating leases having initial or remaining terms in excess of one year as of September 29, 2018 , are as follows (in millions): 2019 $ 1,298 2020 1,289 2021 1,218 2022 1,038 2023 800 Thereafter 3,984 Total $ 9,627 Unconditional Purchase Obligations The Company has entered into certain off–balance sheet arrangements which require the future purchase of goods or services (“unconditional purchase obligations”). The Company’s unconditional purchase obligations primarily consist of payments for supplier arrangements, internet and telecommunication services and intellectual property licenses. Future payments under noncancelable unconditional purchase obligations having a remaining term in excess of one year as of September 29, 2018 , are as follows (in millions): 2019 $ 2,447 2020 3,202 2021 1,749 2022 1,596 2023 268 Thereafter 66 Total $ 9,328 Apple Inc. | 2018 Form 10-K | 61 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully adjudicated, as further discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings.” The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims, except for the following matters: VirnetX VirnetX, Inc. filed two lawsuits in the U.S. District Court for the Eastern District of Texas (the “Eastern Texas District Court”) against the Company alleging that certain Company products infringe four patents (the “VirnetX Patents”) relating to network communications technology (“VirnetX I” and “VirnetX II”). On September 30, 2016, a jury returned a verdict in VirnetX I against the Company and awarded damages of $302 million , which later increased to $440 million in post-trial proceedings. VirnetX I is currently on appeal at the U.S. Court of Appeals for the Federal Circuit (the “Federal Circuit”). On April 11, 2018, a jury returned a verdict in VirnetX II against the Company and awarded damages of $503 million . VirnetX II is currently on appeal. The Company has challenged the validity of the VirnetX Patents at the U.S. Patent and Trademark Office (the “PTO”). In response, the PTO has declared the VirnetX Patents invalid. VirnetX has appealed, and those appeals are currently pending at the Federal Circuit. The Federal Circuit has consolidated the Company’s appeal of the Eastern Texas District Court VirnetX I verdict and VirnetX’s appeals from the PTO invalidity proceedings. The Company believes it will prevail on the merits. Qualcomm On January 20, 2017, the Company filed a lawsuit against Qualcomm Incorporated and affiliated parties (“Qualcomm”) in the U.S. District Court for the Southern District of California seeking, among other things, to enjoin Qualcomm from requiring the Company to pay royalties at the rate demanded by Qualcomm. As the Company does not believe the demanded royalty it has historically paid contract manufacturers for each applicable device is fair, reasonable and non-discriminatory, and believes it to be invalid and/or overstated in other respects as well, no Qualcomm-related royalty payments have been remitted by the Company to its contract manufacturers since the beginning of the second quarter of 2017. The Company believes it will prevail on the merits of the case and has accrued its best estimate for the ultimate resolution of this matter. Note 10 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable segments. Costs excluded from segment operating income include various corporate expenses such as research and development, corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Apple Inc. | 2018 Form 10-K | 62 The following table shows information by reportable segment for 2018 , 2017 and 2016 (in millions): 2018 2017 2016 Americas: Net sales $ 112,093 $ 96,600 $ 86,613 Operating income $ 34,864 $ 30,684 $ 28,172 Europe: Net sales $ 62,420 $ 54,938 $ 49,952 Operating income $ 19,955 $ 16,514 $ 15,348 Greater China: Net sales $ 51,942 $ 44,764 $ 48,492 Operating income $ 19,742 $ 17,032 $ 18,835 Japan: Net sales $ 21,733 $ 17,733 $ 16,928 Operating income $ 9,500 $ 8,097 $ 7,165 Rest of Asia Pacific: Net sales $ 17,407 $ 15,199 $ 13,654 Operating income $ 6,181 $ 5,304 $ 4,781 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2018 , 2017 and 2016 is as follows (in millions): 2018 2017 2016 Segment operating income $ 90,242 $ 77,631 $ 74,301 Research and development expense (14,236 ) (11,581 ) (10,045 ) Other corporate expenses, net (5,108 ) (4,706 ) (4,232 ) Total operating income $ 70,898 $ 61,344 $ 60,024 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2018 , 2017 and 2016 . There was no single customer that accounted for more than 10% of net sales in 2018 , 2017 and 2016 . Net sales for 2018 , 2017 and 2016 and long-lived assets as of September 29, 2018 and September 30, 2017 were as follows (in millions): 2018 2017 2016 Net sales: U.S. $ 98,061 $ 84,339 $ 75,667 China (1) 51,942 44,764 48,492 Other countries 115,592 100,131 91,480 Total net sales $ 265,595 $ 229,234 $ 215,639 2018 2017 Long-lived assets: U.S. $ 23,963 $ 20,637 China (1) 13,268 10,211 Other countries 4,073 2,935 Total long-lived assets $ 41,304 $ 33,783 (1) China includes Hong Kong and Taiwan. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets related to retail stores and related infrastructure. Apple Inc. | 2018 Form 10-K | 63 Net sales by product for 2018 , 2017 and 2016 were as follows (in millions): 2018 2017 2016 iPhone (1) $ 166,699 $ 141,319 $ 136,700 iPad (1) 18,805 19,222 20,628 Mac (1) 25,484 25,850 22,831 Services (2) 37,190 29,980 24,348 Other Products (1)(3) 17,417 12,863 11,132 Total net sales $ 265,595 $ 229,234 $ 215,639 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from Digital Content and Services, AppleCare, Apple Pay, licensing and other services. Services net sales in 2018 included a favorable one-time item of $236 million in connection with the final resolution of various lawsuits. Services net sales in 2017 included a favorable one-time adjustment of $640 million due to a change in estimate based on the availability of additional supporting information. (3) Includes sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and other Apple-branded and third-party accessories. Note 11 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters of 2018 and 2017 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2018: Net sales $ 62,900 $ 53,265 $ 61,137 $ 88,293 Gross margin $ 24,084 $ 20,421 $ 23,422 $ 33,912 Net income $ 14,125 $ 11,519 $ 13,822 $ 20,065 Earnings per share (1) : Basic $ 2.94 $ 2.36 $ 2.75 $ 3.92 Diluted $ 2.91 $ 2.34 $ 2.73 $ 3.89 Fourth Quarter Third Quarter Second Quarter First Quarter 2017: Net sales $ 52,579 $ 45,408 $ 52,896 $ 78,351 Gross margin $ 19,931 $ 17,488 $ 20,591 $ 30,176 Net income $ 10,714 $ 8,717 $ 11,029 $ 17,891 Earnings per share (1) : Basic $ 2.08 $ 1.68 $ 2.11 $ 3.38 Diluted $ 2.07 $ 1.67 $ 2.10 $ 3.36 (1) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. Apple Inc. | 2018 Form 10-K | 64 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 29, 2018 and September 30, 2017 , and the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 29, 2018 , and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of Apple Inc. at September 29, 2018 and September 30, 2017 , and the results of its operations and its cash flows for each of the three years in the period ended September 29, 2018 , in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), Apple Inc.’s internal control over financial reporting as of September 29, 2018 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated November 5, 2018 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of Apple Inc.’s management. Our responsibility is to express an opinion on Apple Inc.’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ Ernst & Young LLP We have served as Apple Inc.’s auditor since 2009. San Jose, California November 5, 2018 Apple Inc. | 2018 Form 10-K | 65 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on Internal Control over Financial Reporting We have audited Apple Inc.’s internal control over financial reporting as of September 29, 2018 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 29, 2018 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), the consolidated balance sheets of Apple Inc. as of September 29, 2018 and September 30, 2017 , and the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 29, 2018 , and the related notes and our report dated November 5, 2018 expressed an unqualified opinion thereon. Basis for Opinion Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on Apple Inc.’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California November 5, 2018 Apple Inc. | 2018 Form 10-K | 66 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 29, 2018 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 29, 2018 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2018 , which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information None. Apple Inc. | 2018 Form 10-K | 67 PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Corporate Governance,” “Directors,” “Executive Officers” and “Other Information—Security Ownership of Certain Beneficial Owners and Management” in the Company’s 2019 Proxy Statement to be filed with the SEC within 120 days after September 29, 2018 in connection with the solicitation of proxies for the Company’s 2019 annual meeting of shareholders and is incorporated herein by reference. The Company has a code of ethics, “Business Conduct: The way we do business worldwide,” that applies to all employees, including the Company’s principal executive officer, principal financial officer, and principal accounting officer, as well as to the members of the Board of Directors of the Company. The code is available at investor.apple.com/investor-relations/leadership-and-governance/. The Company intends to disclose any changes in, or waivers from, this code by posting such information on the same website or by filing a Form 8-K, in each case to the extent such disclosure is required by rules of the SEC or Nasdaq. Item 11. Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation,” under the subheadings “Board Oversight of Risk Management” and “Compensation Committee Interlocks and Insider Participation” under the heading “Corporate Governance” and under the subheadings “Compensation of Directors” and “Director Compensation— 2018 ” under the heading “Directors” in the Company’s 2019 Proxy Statement to be filed with the SEC within 120 days after September 29, 2018 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Other Information—Security Ownership of Certain Beneficial Owners and Management” and “Other Information—Equity Compensation Plan Information” in the Company’s 2019 Proxy Statement to be filed with the SEC within 120 days after September 29, 2018 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the subheadings “Board Committees”, “Review, Approval, or Ratification of Transactions with Related Persons” and “Transactions with Related Persons” under the heading “Corporate Governance” in the Company’s 2019 Proxy Statement to be filed with the SEC within 120 days after September 29, 2018 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm” under the proposal “Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2019 Proxy Statement to be filed with the SEC within 120 days after September 29, 2018 and is incorporated herein by reference. Apple Inc. | 2018 Form 10-K | 68 PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 38 Consolidated Statements of Comprehensive Income for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 39 Consolidated Balance Sheets as of September 29, 2018 and September 30, 2017 40 Consolidated Statements of Shareholders’ Equity for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 41 Consolidated Statements of Cash Flows for the years ended September 29, 2018, September 30, 2017 and September 24, 2016 42 Notes to Consolidated Financial Statements 43 Selected Quarterly Financial Information (Unaudited) 64 Reports of Independent Registered Public Accounting Firm 65 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant effective as of June 6, 2014. 8-K 3.1 6/6/14 3.2 Amended and Restated Bylaws of the Registrant effective as of December 13, 2016. 8-K 3.2 12/15/16 4.1 Form of Common Stock Certificate of the Registrant. 10-Q 4.1 12/30/06 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of June 10, 2015, including forms of global notes representing the 0.350% Notes due 2020. 8-K 4.1 6/10/15 Apple Inc. | 2018 Form 10-K | 69 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.9 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.10 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 4.11 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.12 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.13 Officer’s Certificate of the Registrant, dated as of June 22, 2016, including form of global note representing 4.15% Notes due 2046. 8-K 4.1 6/22/16 4.14 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.15 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.16 Officer’s Certificate of the Registrant, dated as of March 3, 2017, including form of global note representing 4.300% Notes due 2047. 8-K 4.1 3/3/17 4.17 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.18 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.19 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.20 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.21 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 4.22 Officer’s Certificate of the Registrant, dated as of November 13, 2017, including forms of global notes representing the 1.800% Notes due 2019, 2.000% Notes due 2020, 2.400% Notes due 2023, 2.750% Notes due 2025, 3.000% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 11/13/17 4.23* Apple Inc. Deferred Compensation Plan. S-8 4.1 8/23/18 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* Apple Inc. Non-Employee Director Stock Plan, as amended and restated as of February 13, 2018. 8-K 10.1 2/14/18 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.6* 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10-K 10.8 9/30/17 10.7* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.11 9/27/14 10.8* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.12 9/27/14 Apple Inc. | 2018 Form 10-K | 70 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 10.9* Form of Amendment, effective as of August 26, 2014, to Restricted Stock Unit Award Agreements and Performance Award Agreements outstanding as of August 26, 2014. 10-K 10.13 9/27/14 10.10* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.16 3/26/16 10.11* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.17 3/26/16 10.12* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.18 9/24/16 10.13* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.19 9/24/16 10.14* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.20 9/30/17 10.15* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.21 9/30/17 10.16* Form of Restricted Stock Unit Award Agreement under Non-Employee Director Stock Plan effective as of February 13, 2018. 10-Q 10.2 3/31/18 10.17*, ** Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10.18*, ** Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS** XBRL Instance Document. 101.SCH** XBRL Taxonomy Extension Schema Document. 101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document. 101.DEF** XBRL Taxonomy Extension Definition Linkbase Document. 101.LAB** XBRL Taxonomy Extension Label Linkbase Document. 101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16. Form 10-K Summary None. Apple Inc. | 2018 Form 10-K | 71 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: November 5, 2018 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) November 5, 2018 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) November 5, 2018 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) November 5, 2018 CHRIS KONDO /s/ James A. Bell Director November 5, 2018 JAMES A. BELL /s/ Al Gore Director November 5, 2018 AL GORE /s/ Robert A. Iger Director November 5, 2018 ROBERT A. IGER /s/ Andrea Jung Director November 5, 2018 ANDREA JUNG /s/ Arthur D. Levinson Director November 5, 2018 ARTHUR D. LEVINSON /s/ Ronald D. Sugar Director November 5, 2018 RONALD D. SUGAR /s/ Susan L. Wagner Director November 5, 2018 SUSAN L. 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aapl:OtherCountriesMember 2019-09-28 0000320193 2018-09-30 2018-12-29 0000320193 2019-03-31 2019-06-29 0000320193 2018-12-30 2019-03-30 0000320193 2019-06-30 2019-09-28 0000320193 2018-07-01 2018-09-29 0000320193 2018-04-01 2018-06-30 0000320193 2017-12-31 2018-03-31 0000320193 2017-10-01 2017-12-30 iso4217:USD iso4217:USD xbrli:shares xbrli:shares aapl:Vendor xbrli:pure aapl:Customer aapl:obligation aapl:Subsidiary iso4217:EUR UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 28, 2019 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) One Apple Park Way Cupertino California 95014 (Address of principal executive offices) (Zip Code) ( 408 ) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading symbol(s) Name of each exchange on which registered Common Stock, $0.00001 par value per share AAPL The Nasdaq Stock Market LLC 1.000% Notes due 2022 — The Nasdaq Stock Market LLC 1.375% Notes due 2024 — The Nasdaq Stock Market LLC 0.875% Notes due 2025 — The Nasdaq Stock Market LLC 1.625% Notes due 2026 — The Nasdaq Stock Market LLC 2.000% Notes due 2027 — The Nasdaq Stock Market LLC 1.375% Notes due 2029 — The Nasdaq Stock Market LLC 3.050% Notes due 2029 — The Nasdaq Stock Market LLC 3.600% Notes due 2042 — The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 29, 2019 , the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $ 874,698,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 4,443,265,000 shares of common stock were issued and outstanding as of October 18, 2019 . DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2020 annual meeting of shareholders (the “ 2020 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2020 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 28, 2019 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 5 Item 1B. Unresolved Staff Comments 14 Item 2. Properties 14 Item 3. Legal Proceedings 14 Item 4. Mine Safety Disclosures 14 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 15 Item 6. Selected Financial Data 17 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 18 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 26 Item 8. Financial Statements and Supplementary Data 28 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 59 Item 9A. Controls and Procedures 59 Item 9B. Other Information 59 Part III Item 10. Directors, Executive Officers and Corporate Governance 60 Item 11. Executive Compensation 60 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 60 Item 13 . Certain Relationships and Related Transactions, and Director Independence 60 Item 14. Principal Accounting Fees and Services 60 Part IV Item 15. Exhibits, Financial Statement Schedules 61 Item 16. Form 10-K Summary 63 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. Unless otherwise stated, all information presented herein is based on the Company’s fiscal calendar, and references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures and markets smartphones, personal computers, tablets, wearables and accessories, and sells a variety of related services. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company is a California corporation established in 1977. Products iPhone iPhone ® is the Company’s line of smartphones based on its iOS operating system. In September 2019, the Company introduced three new iPhones: iPhone 11, iPhone 11 Pro and iPhone 11 Pro Max. Mac Mac ® is the Company’s line of personal computers based on its macOS ® operating system. During 2019, the Company released a new version of MacBook Air ® and a new Mac mini ® , and introduced an updated Mac Pro ® , which is expected to be available in the fall of 2019. iPad iPad ® is the Company’s line of multi-purpose tablets. iPad is based on the Company’s iPadOS™ operating system, which was introduced during 2019. Also during 2019, the Company released two new versions of iPad Pro ® , an iPad Air ® , an updated iPad mini ® and a new 10.2-inch iPad. Wearables, Home and Accessories Wearables, Home and Accessories includes AirPods ® , Apple TV ® , Apple Watch ® , Beats ® products, HomePod™, iPod touch ® and other Apple-branded and third-party accessories. AirPods are the Company’s wireless headphones that interact with Siri. In October 2019, the Company introduced AirPods Pro™. Apple Watch is a personal electronic device that combines the watchOS ® user interface and other technologies created specifically for a smaller device. In September 2019, the Company introduced Apple Watch Series 5. Services Digital Content Stores and Streaming Services The Company operates various platforms that allow customers to discover and download applications and digital content, such as books, music, video, games and podcasts. These platforms include the App Store ® , available for iPhone and iPad, the Mac App Store, the TV App Store and the Watch App Store. The Company also offers subscription-based digital content streaming services, including Apple Music ® , which offers users a curated listening experience with on-demand radio stations, and Apple TV+, which offers exclusive original content, and is expected to be available in November 2019. Apple Inc. | 2019 Form 10-K | 1 AppleCare AppleCare ® includes AppleCare + (“AC+”) and the AppleCare Protection Plan, which are fee-based services that extend the coverage of phone support eligibility and hardware repairs. AC+ offers additional coverage for instances of accidental damage and is available in certain countries for certain products. Additionally, AC+ with theft and loss protection is available for iPhone in the U.S. iCloud iCloud ® is the Company’s cloud service, which stores music, photos, contacts, calendars, mail, documents and more, keeping them up-to-date and available across multiple Apple devices and Windows personal computers. Licensing The Company licenses the use of certain of its intellectual property, and provides other related services. Other Services The Company delivers a variety of other services available in certain countries, including Apple Arcade™, a game subscription service; Apple Card™, a co-branded credit card; Apple News+, a subscription news and magazine service; and Apple Pay, a cashless payment service. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and resellers. During 2019 , the Company’s net sales through its direct and indirect distribution channels accounted for 31% and 69%, respectively, of total net sales. No single customer accounted for more than 10% of net sales in 2019 , 2018 and 2017 . Competition The markets for the Company’s products and services are highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the capabilities and use of smartphones, personal computers, tablets and other electronic devices. Many of the Company’s competitors that sell mobile devices and personal computers based on other operating systems seek to compete primarily through aggressive pricing and very low cost structures. Principal competitive factors important to the Company include price, product and service features (including security features), relative price and performance, product and service quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support, and corporate reputation. The Company is focused on expanding its market opportunities related to smartphones, personal computers, tablets and other electronic devices. These markets are highly competitive and include many large, well-funded and experienced participants. The Company expects competition in these markets to intensify significantly as competitors imitate features of the Company’s products and applications within their products, or collaborate to offer solutions that are more competitive than those they currently offer. These markets are characterized by aggressive price competition, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company believes it offers superior innovation and integration of the entire solution, including hardware, software and services. Some of the Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit, or even at a loss, to compete with the Company’s offerings. Apple Inc. | 2019 Form 10-K | 2 Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets and other electronic devices. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through research and development (“R&D”), licensing of intellectual property and acquisition of third-party businesses and technology. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, copyrights, trademarks, service marks, trade dress and other forms of intellectual property rights in the U.S. and various foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents, including utility patents, design patents and others. The Company also holds copyrights relating to certain aspects of its products and services. No single intellectual property right is solely responsible for protecting the Company’s products. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products. In addition to Company-owned intellectual property, many of the Company’s products and services are designed to include intellectual property owned by third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of the Company’s products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. The timing of product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new inventory following a product launch, and channel inventory of an older product often declines as the launch of a newer product approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. Employees As of September 28, 2019 , the Company had approximately 137,000 full-time equivalent employees. Apple Inc. | 2019 Form 10-K | 3 Available Information The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities and Exchange Commission (the “SEC”). The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge at investor.apple.com/investor-relations/sec-filings/default.aspx when such reports are available on the SEC’s website. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC at www.sec.gov. The Company periodically provides other information for investors on its corporate website, www.apple.com, and its investor relations website, investor.apple.com. This includes press releases and other information about financial performance, information on corporate governance and details related to the Company’s annual meeting of shareholders. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2019 Form 10-K | 4 Item 1A. Risk Factors The following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding other statements in this Form 10-K. The following information should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price. Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Global and regional economic conditions could materially adversely affect the Company’s business, results of operations, financial condition and growth . The Company has international operations with sales outside the U.S. representing a majority of the Company’s total net sales. In addition, a majority of the Company’s supply chain, and its manufacturing and assembly activities, are located outside the U.S. As a result, the Company’s operations and performance depend significantly on global and regional economic conditions. Adverse macroeconomic conditions, including inflation, slower growth or recession, new or increased tariffs, changes to fiscal and monetary policy, tighter credit, higher interest rates, high unemployment and currency fluctuations could materially adversely affect demand for the Company’s products and services. In addition, consumer confidence and spending could be adversely affected in response to financial market volatility, negative financial news, conditions in the real estate and mortgage markets, declines in income or asset values, changes to fuel and other energy costs, labor and healthcare costs and other economic factors. In addition to an adverse impact on demand for the Company’s products, uncertainty about, or a decline in, global or regional economic conditions could have a significant impact on the Company’s suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. Potential effects include financial instability; inability to obtain credit to finance operations and purchases of the Company’s products; and insolvency. A downturn in the economic environment could also lead to increased credit and collectibility risk on the Company’s trade receivables; the failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair value of the Company’s financial instruments. These and other economic factors could materially adversely affect the Company’s business, results of operations, financial condition and growth. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services are offered in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. There can be no assurance that these investments will achieve expected returns, and the Company may not be able to develop and market new products and services successfully. The Company currently holds a significant number of patents, trademarks and copyrights and has registered, and applied to register, numerous patents, trademarks and copyrights. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. Apple Inc. | 2019 Form 10-K | 5 The Company has a minority market share in the global smartphone, personal computer and tablet markets. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors may have the resources, experience or cost structures to provide products at little or no profit or even at a loss. Additionally, the Company faces significant competition as competitors imitate the Company’s product features and applications within their products or collaborate to offer solutions that are more competitive than those they currently offer. The Company also expects competition to intensify as competitors imitate the Company’s approach to providing components seamlessly within their offerings or work collaboratively to offer integrated solutions. Some of the markets in which the Company competes have from time to time experienced little to no growth or contracted. In addition, an increasing number of Internet-enabled devices that include software applications and are smaller, simpler and cheaper than traditional personal computers compete with some of the Company’s existing products. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve its products and services to maintain their functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent introductions and transitions of products and services. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and services, and successfully manage the transition to these new and upgraded products and services. The success of new product and service introductions depends on a number of factors including, but not limited to, timely and successful development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand, and the risk that new products and services may have quality or other defects or deficiencies. Accordingly, the Company cannot determine in advance the ultimate effect of new product and service introductions and transitions. The Company depends on the performance of carriers, wholesalers, retailers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, retailers and resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. Some carriers providing cellular network service for iPhone offer financing, installment payment plans or subsidies for users’ purchases of the device. There is no assurance that such offers will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs can require a substantial investment while not assuring return or incremental sales. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. Apple Inc. | 2019 Form 10-K | 6 The Company is exposed to the risk of write-downs on the value of its inventory and other assets, in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand, or for which cost exceeds net realizable value. The Company also accrues necessary cancellation fee reserves for orders of excess products and components. The Company reviews long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the assets may not be recoverable. If the Company determines that an impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently recoverable, no assurance can be given that the Company will not incur write-downs, fees, impairments and other charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company orders components for its products and builds inventory in advance of product announcements and shipments. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days . Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains certain components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. While the Company has entered into agreements for the supply of many components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. Component suppliers may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms. The effects of global or regional economic conditions on the Company’s suppliers, described in “ Global and regional economic conditions could materially adversely affect the Company’s business, results of operations, financial condition and growth ,” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, can be affected for any number of reasons, including if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the source, or to identify and obtain sufficient quantities from an alternative source. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. The Company has also outsourced much of its transportation and logistics management. While these arrangements can lower operating costs, they also reduce the Company’s direct control over production and distribution. Such diminished control may have an adverse effect on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for product defect expense reimbursement, the Company generally remains responsible to the consumer for warranty and out-of-warranty service in the event of product defects and could experience an unanticipated product defect liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on single-source outsourcing partners in the U.S., Asia and Europe to supply and manufacture many components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform can have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations can be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, military actions, economic, business, labor, environmental, public health or political issues, or international trade disputes. Apple Inc. | 2019 Form 10-K | 7 The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply can be reduced or terminated and the recoverability of manufacturing process equipment or prepayments can be negatively impacted. The Company’s products and services may be affected from time to time by design and manufacturing defects that could materially adversely affect the Company’s business and result in harm to the Company’s reputation. The Company offers complex hardware and software products and services that can be affected by design and manufacturing defects. Sophisticated operating system software and applications, such as those offered by the Company, often have issues that can unexpectedly interfere with the intended operation of hardware or software products. Defects can also exist in components and products the Company purchases from third parties. Component defects could make the Company’s products unsafe and create a risk of environmental or property damage and personal injury. These risks may increase as the Company’s products are introduced into specialized applications, including healthcare. In addition, the Company’s service offerings may have quality issues and from time to time experience outages, service slowdowns or errors. As a result, the Company’s services may not perform as anticipated and may not meet customer expectations. There can be no assurance the Company will be able to detect and fix all issues and defects in the hardware, software and services it offers. Failure to do so could result in widespread technical and performance issues affecting the Company’s products and services. In addition, the Company can be exposed to product liability claims, recalls, product replacements or modifications, write-offs of inventory, property, plant and equipment, and/or intangible assets, and significant warranty and other expenses, including litigation costs and regulatory fines. Quality problems can also adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, delay in new product and service introductions and lost sales. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell currently available content. The licensing or other distribution arrangements with these third parties are for relatively short terms and do not guarantee the continuation or renewal of these arrangements on commercially reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and can take actions to make it more difficult or impossible for the Company to license or otherwise distribute their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at commercially reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make third-party digital content available, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s financial condition and operating results. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes the availability of third-party software applications and services for its products depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software and services for the Company’s products compared to competitors’ platforms, such as Android for smartphones and tablets and Windows for personal computers. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of product sales, and the costs of developing such applications and services. Apple Inc. | 2019 Form 10-K | 8 The Company’s minority market share in the global smartphone, personal computer and tablet markets could make developers less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for competitors’ products with larger market share. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices may suffer. The Company relies on the continued availability and development of compelling and innovative software applications for its products. The Company’s products and operating systems are subject to rapid technological change, and if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not take advantage of these changes to deliver improved customer experiences or might not operate correctly and may result in dissatisfied customers. The Company sells and delivers third-party applications for its products through the App Store, Mac App Store, TV App Store and Watch App Store. The Company retains a commission from sales through these platforms. If developers reduce their use of these platforms to distribute their applications and offer in-app purchases to customers, then the volume of sales, and the commission that the Company earns on those sales, would decrease. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products and services are designed to include intellectual property owned by third parties, which requires licenses from those third parties. In addition, because of technological changes in the industries in which the Company currently competes or in the future may compete, current extensive patent coverage and the rapid rate of issuance of new patents, the Company’s products and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Based on experience and industry practice, the Company believes licenses to such third-party intellectual property can generally be obtained on commercially reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on commercially reasonable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products or services, or otherwise have a material adverse impact on the Company’s financial condition and operating results. The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights . The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and have not yet been fully resolved, and new claims may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which can subject the Company to costs and damages in the event of a claim against an indemnified third party. Claims against the Company based on allegations of patent infringement or other violations of intellectual property rights have generally increased over time and may continue to increase. In particular, the Company has historically faced a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in several U.S. jurisdictions, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, litigation can be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into licensing agreements or other arrangements to settle litigation and resolve such disputes. No assurance can be given that such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements may also significantly increase the Company’s cost of sales and operating expenses. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims, including matters related to infringement of intellectual property rights. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2019 Form 10-K | 9 The Company is subject to complex and changing laws and regulations worldwide, which exposes the Company to potential liabilities, increased costs and other adverse effects on the Company’s business. The Company’s global operations are subject to complex and changing laws and regulations on subjects including, but not limited to: antitrust; privacy, data security and data localization; consumer protection; advertising, sales, billing and e-commerce; product liability; intellectual property ownership and infringement; digital platforms; Internet, telecommunications, and mobile communications; media, television, film and digital content; availability of third-party software applications and services; labor and employment; anti-corruption; import, export and trade; foreign exchange controls and cash repatriation restrictions; anti–money laundering; foreign ownership and investment; tax; and environmental, health and safety. Compliance with these laws and regulations may be onerous and expensive, increasing the cost of conducting the Company’s global operations. Changes to laws and regulations can adversely affect the Company’s business by increasing the Company’s costs, limiting the Company’s ability to offer a product or service to customers, requiring changes to the Company’s business practices or otherwise making the Company’s products and services less attractive to customers. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors or agents will not violate such laws and regulations or the Company’s policies and procedures. If the Company is found to have violated laws and regulations, it could materially adversely affect the Company’s reputation, financial condition and operating results. The technology industry, including, in some instances, the Company, is subject to intense media, political and regulatory scrutiny, which exposes the Company to government investigations, legal actions and penalties. For example, the Company is subject to antitrust investigations in various jurisdictions around the world, which can result in legal proceedings and claims against the Company that could, individually or in the aggregate, have a material impact on the Company’s financial condition and operating results. There can be no assurance that the Company’s business will not be materially adversely affected, individually or in the aggregate, by the outcomes of such investigations or changes to laws and regulations in the future. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of an individual store or multiple stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. The Company’s retail operations are subject to many factors that pose risks and uncertainties and could adversely impact the Company’s financial condition and operating results, including macro-economic factors that could have an adverse effect on general retail activity. Other factors include, but are not limited to, the Company’s ability to: manage costs associated with retail store construction and operation; manage relationships with existing retail partners; manage costs associated with fluctuations in the value of retail inventory; and obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater-than-expected liabilities and expenses, inadequate return on capital, and unidentified issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. The Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company is exposed to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. System redundancy and other continuity measures may be ineffective or inadequate, and the Company’s business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions can adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s reputation, financial condition and operating results. Apple Inc. | 2019 Form 10-K | 10 There may be losses or unauthorized access to or releases of confidential information, including personally identifiable information, that could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information including, among other things, personally identifiable information (“PII”) with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s reputation, financial condition and operating results. The Company’s business also requires it to share confidential information with suppliers and other third parties. Although the Company takes steps to secure confidential information that is provided to third parties, such measures are not always effective and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s reputation, financial condition and operating results. For example, the Company may experience a security breach impacting the Company’s information technology systems that compromises the confidentiality, integrity or availability of confidential information. Such an incident could, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the Company’s stock price, materially damage supplier relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Although malicious attacks perpetrated to gain access to confidential information, including PII, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may, in turn, be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, may result in the delay or loss of customer orders or impede customer access to the Company’s products and services. In addition to the risks relating to general confidential information described above, the Company is also subject to specific obligations relating to health data and payment card data. Health data is subject to additional privacy, security and breach notification requirements, and the Company can be subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data is handled in a manner not permitted by law or under the Company’s agreements with healthcare institutions, the Company could be subject to litigation or government investigations, may be liable for associated investigatory expenses, and could also incur significant fees or fines. Under payment card rules and obligations, if cardholder information is potentially compromised, the Company could be liable for associated investigatory expenses and could also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which would materially adversely affect the Company’s reputation, financial condition and operating results. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also may restrict transfers of PII among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of PII through its privacy policy, information provided on its website and press statements. Any failure by the Company to comply with these public statements or with other federal, state or international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. Apple Inc. | 2019 Form 10-K | 11 The Company’s success depends largely on the continued service and availability of key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. The Company’s business can be impacted by political events, international trade disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions. Political events, international trade disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions could harm or disrupt international commerce and the global economy, and could have a material adverse effect on the Company and its customers, suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. International trade disputes can result in tariffs and other measures that can adversely affect the Company’s business. For example, trade tensions have led to a series of tariffs imposed by the U.S. on imports from China. Tariffs increase the cost of the Company’s products and the components and raw materials that go into making them. These increased costs adversely impact the gross margin that the Company earns on its products. Tariffs can also make the Company’s products more expensive for customers, which could make the Company’s products less competitive and reduce consumer demand. Countries may also adopt other measures that could limit the Company’s ability to offer its products and services. Political uncertainty surrounding international trade disputes and measures could also have a negative effect on consumer confidence and spending, which could adversely affect the Company’s business. Many of the Company’s operations and facilities, as well as critical business operations of the Company’s suppliers and contract manufacturers, are in locations that are prone to earthquakes and other natural disasters. In addition, such operations and facilities are subject to the risk of interruption by fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, labor disputes, public health issues and other events beyond the Company’s control. Global climate change could result in certain types of natural disasters occurring more frequently or with more intense effects. Such events could make it difficult or impossible for the Company to manufacture and deliver products to its customers, create delays and inefficiencies in the Company’s supply and manufacturing chain, and result in slowdowns and outages to the Company’s service offerings. Following an interruption to its business, the Company could require substantial recovery time, experience significant expenditures to resume operations, and lose significant sales. Because the Company relies on single or limited sources for the supply and manufacture of many critical components, a business interruption affecting such sources would exacerbate any negative consequences to the Company. The Company’s operations are also subject to the risks of industrial accidents at its suppliers and contract manufacturers. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in disruption to the Company’s business and harm to the Company’s reputation. Should major public health issues, including pandemics, arise, the Company could be adversely affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products, and disruptions in the operations of the Company’s suppliers and contract manufacturers. While the Company maintains insurance coverage for certain types of losses, such insurance coverage may be insufficient to cover all losses that may arise. The Company expects its quarterly net sales and operating results to fluctuate. The Company’s profit margins vary across its products, services, geographic segments and distribution channels. For example, gross margins on the Company’s hardware products vary across product lines and can change over time. The Company’s gross margins are subject to volatility and downward pressure due to a variety of factors, including: continued industry-wide global product pricing pressures and product pricing actions that the Company may take in response to such pressures; increased competition; the Company’s ability to effectively stimulate demand for certain of its products and services; compressed product life cycles; potential increases in the cost of components, outside manufacturing services, and acquiring and delivering content for the Company’s services; the Company’s ability to manage product quality and warranty costs effectively; shifts in the mix of products and services, or in the geographic, currency or channel mix; fluctuations in foreign exchange rates; and the introduction of new products or services, including new products or services with higher cost structures. These and other factors could have a materially adverse impact on the Company’s financial condition and operating results. Apple Inc. | 2019 Form 10-K | 12 The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. Further, the Company generates a significant portion of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments, such as lower-than-anticipated demand for the Company’s products or services, issues with new product or service introductions, information technology system failures or network disruptions, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock price has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its stock to exceed the stock’s price at a given point in time. The Company believes its stock price should reflect expectations of future growth and profitability. The Company also believes its stock price should reflect expectations that its cash dividend will continue at current levels or grow, and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employee retention. The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar relative to local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non–U.S. dollar–denominated sales, cost of sales and operating expenses worldwide. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers could be materially adversely affected by foreign currency exchange rate fluctuations. The weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency–denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise international pricing to offset the U.S. dollar’s strengthening, which would adversely affect the U.S. dollar value of the gross margins the Company earns on foreign currency–denominated sales. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency–denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not be effective to offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the values of its investment portfolio. The Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, market and economic conditions, political risk, sovereign risk, interest rate fluctuations or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents, and marketable and non-marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents, and marketable and non-marketable securities, future fluctuations in their value could result in significant losses and could have a material adverse impact on the Company’s financial condition and operating results. Apple Inc. | 2019 Form 10-K | 13 The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and resellers. The Company also sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party bank support or financing arrangements, or credit insurance. The Company’s exposure to credit and collectibility risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 28, 2019 , a significant portion of the Company’s trade receivables was concentrated within cellular network carriers, and its vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition and operating results could be materially adversely affected. Item 1B. Unresolved Staff Comments None. Item 2. Properties The Company’s headquarters are located in Cupertino, California. As of September 28, 2019 , the Company owned or leased facilities and land for corporate functions, R&D, data centers, retail and other purposes at locations throughout the U.S. and in various places outside the U.S. The Company believes its existing facilities and equipment, which are used by all reportable segments, are in good operating condition and are suitable for the conduct of its business. Item 3. Legal Proceedings The Company is subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Refer to the risk factor “ The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights ” in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2019 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Item 4. Mine Safety Disclosures Not applicable. Apple Inc. | 2019 Form 10-K | 14 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on The Nasdaq Stock Market LLC under the symbol AAPL. Holders As of October 18, 2019 , there were 23,233 shareholders of record. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 28, 2019 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) June 30, 2019 to August 3, 2019: Open market and privately negotiated purchases 23,860 $ 205.36 23,860 August 4, 2019 to August 31, 2019: February 2019 ASR 6,886 (2) 6,886 Open market and privately negotiated purchases 34,705 $ 204.59 34,705 September 1, 2019 to September 28, 2019: Open market and privately negotiated purchases 27,178 $ 217.17 27,178 Total 92,629 $ 78,869 (1) On April 30, 2019, the Company announced the Board of Directors increased the current share repurchase program authorization from $100 billion to $175 billion of the Company’s common stock, of which $96.1 billion had been utilized as of September 28, 2019 . The remaining $78.9 billion in the table represents the amount available to repurchase shares under the authorized repurchase program as of September 28, 2019 . The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In February 2019, the Company entered into an accelerated share repurchase arrangement (“ASR”) to purchase up to $12.0 billion of the Company’s common stock. In August 2019, the purchase period for this ASR ended and an additional 6.9 million shares were delivered and retired. In total, 62.0 million shares were delivered under this ASR at an average repurchase price of $193.69 . Apple Inc. | 2019 Form 10-K | 15 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend-reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 28, 2019 . The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 26, 2014 . Note that historic stock price performance is not necessarily indicative of future stock price performance. * $100 invested on September 26, 2014 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2019 Standard & Poor’s, a division of S&P Global. All rights reserved. Copyright © 2019 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. September 2014 September 2015 September 2016 September 2017 September 2018 September 2019 Apple Inc. $ 100 $ 116 $ 116 $ 162 $ 240 $ 237 S&P 500 Index $ 100 $ 99 $ 115 $ 136 $ 160 $ 167 S&P Information Technology Index $ 100 $ 102 $ 125 $ 162 $ 213 $ 231 Dow Jones U.S. Technology Supersector Index $ 100 $ 100 $ 122 $ 156 $ 205 $ 218 Apple Inc. | 2019 Form 10-K | 16 Item 6. Selected Financial Data The information set forth below for the five years ended September 28, 2019 , is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes thereto included in Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in thousands, and per share amounts). 2019 2018 2017 2016 2015 Total net sales $ 260,174 $ 265,595 $ 229,234 $ 215,639 $ 233,715 Net income $ 55,256 $ 59,531 $ 48,351 $ 45,687 $ 53,394 Earnings per share: Basic $ 11.97 $ 12.01 $ 9.27 $ 8.35 $ 9.28 Diluted $ 11.89 $ 11.91 $ 9.21 $ 8.31 $ 9.22 Cash dividends declared per share $ 3.00 $ 2.72 $ 2.40 $ 2.18 $ 1.98 Shares used in computing earnings per share: Basic 4,617,834 4,955,377 5,217,242 5,470,820 5,753,421 Diluted 4,648,913 5,000,109 5,251,692 5,500,281 5,793,069 Total cash, cash equivalents and marketable securities $ 205,898 $ 237,100 $ 268,895 $ 237,585 $ 205,666 Total assets $ 338,516 $ 365,725 $ 375,319 $ 321,686 $ 290,345 Non-current portion of term debt $ 91,807 $ 93,735 $ 97,207 $ 75,427 $ 53,329 Other non-current liabilities $ 50,503 $ 48,914 $ 44,212 $ 39,986 $ 38,104 Apple Inc. | 2019 Form 10-K | 17 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in Part II, Item 8 of this Form 10-K. Unless otherwise stated, all information presented herein is based on the Company’s fiscal calendar, and references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. This section of this Form 10-K generally discusses 2019 and 2018 items and year-to-year comparisons between 2019 and 2018 . Discussions of 2017 items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended September 29, 2018 . Fiscal Period The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2019 and 2018 spanned 52 weeks each, whereas fiscal year 2017 included 53 weeks. A 14th week was included in the first quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. Fiscal 2019 Highlights Total net sales decreased 2% or $5.4 billion during 2019 compared to 2018, driven by lower net sales of iPhone, partially offset by higher net sales of Wearables, Home and Accessories and Services in all geographic operating segments. The weakness in foreign currencies had a significant unfavorable impact on net sales during 2019. In April 2019, the Company announced an increase to its current share repurchase program authorization from $100 billion to $175 billion and raised its quarterly dividend from $0.73 to $0.77 per share beginning in May 2019. During 2019, the Company repurchased $67.1 billion of its common stock and paid dividends and dividend equivalents of $14.1 billion . Apple Inc. | 2019 Form 10-K | 18 Products and Services Performance Beginning in the first quarter of 2019, the Company classified the amortization of the deferred value of Maps, Siri and free iCloud services, which are bundled in the sales price of iPhone, Mac, iPad and certain other products, in Services net sales. Historically, the Company classified the amortization of these amounts in Products net sales consistent with its management reporting framework. As a result, Products and Services net sales for 2018 and 2017 were reclassified to conform to the 2019 presentation. The following table shows net sales by category for 2019 , 2018 and 2017 (dollars in millions): 2019 Change 2018 Change 2017 Net sales by category: iPhone (1) $ 142,381 (14 )% $ 164,888 18 % $ 139,337 Mac (1) 25,740 2 % 25,198 (1 )% 25,569 iPad (1) 21,280 16 % 18,380 (2 )% 18,802 Wearables, Home and Accessories (1)(2) 24,482 41 % 17,381 36 % 12,826 Services (3) 46,291 16 % 39,748 22 % 32,700 Total net sales $ 260,174 (2 )% $ 265,595 16 % $ 229,234 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and Apple-branded and third-party accessories. (3) Services net sales include sales from the Company’s digital content stores and streaming services, AppleCare, licensing and other services. Services net sales also include amortization of the deferred value of Maps, Siri and free iCloud services, which are bundled in the sales price of certain products. iPhone iPhone net sales decreased during 2019 compared to 2018 due primarily to lower iPhone unit sales. Mac Mac net sales increased during 2019 compared to 2018 due primarily to higher net sales of MacBook Air, partially offset by lower net sales of MacBook ® and MacBook Pro ® . iPad iPad net sales increased during 2019 compared to 2018 due primarily to higher net sales of iPad Pro. Wearables, Home and Accessories Wearables, Home and Accessories net sales increased during 2019 compared to 2018 due primarily to higher net sales of AirPods and Apple Watch. Services Services net sales increased during 2019 compared to 2018 due primarily to higher net sales from the App Store, licensing and AppleCare. Apple Inc. | 2019 Form 10-K | 19 Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” The following table shows net sales by reportable segment for 2019 , 2018 and 2017 (dollars in millions): 2019 Change 2018 Change 2017 Net sales by reportable segment: Americas $ 116,914 4 % $ 112,093 16 % $ 96,600 Europe 60,288 (3 )% 62,420 14 % 54,938 Greater China 43,678 (16 )% 51,942 16 % 44,764 Japan 21,506 (1 )% 21,733 23 % 17,733 Rest of Asia Pacific 17,788 2 % 17,407 15 % 15,199 Total net sales $ 260,174 (2 )% $ 265,595 16 % $ 229,234 Americas Americas net sales increased during 2019 compared to 2018 due primarily to higher Services and Wearables, Home and Accessories net sales, partially offset by lower iPhone net sales. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Americas net sales during 2019. Europe Europe net sales decreased during 2019 compared to 2018 due to lower iPhone net sales, partially offset by higher Wearables, Home and Accessories and Services net sales. The weakness in foreign currencies relative to the U.S. dollar had a significant unfavorable impact on Europe net sales during 2019. Greater China Greater China net sales decreased during 2019 compared to 2018 due primarily to lower iPhone net sales, partially offset by higher Wearables, Home and Accessories and Services net sales. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Greater China net sales during 2019. Japan Japan net sales decreased during 2019 compared to 2018 due to lower iPhone net sales, partially offset by higher Services and Wearables, Home and Accessories net sales. The value of the Japanese Yen relative to the U.S. dollar had a favorable impact on Japan net sales during 2019. Rest of Asia Pacific Rest of Asia Pacific net sales increased during 2019 compared to 2018 due primarily to higher Wearables, Home and Accessories and Services net sales, partially offset by lower iPhone net sales. The weakness in foreign currencies relative to the U.S. dollar had a significant unfavorable impact on Rest of Asia Pacific net sales during 2019. Apple Inc. | 2019 Form 10-K | 20 Gross Margin Products and Services gross margin and gross margin percentage for 2019 , 2018 and 2017 were as follows (dollars in millions): 2019 2018 2017 Gross margin: Products $ 68,887 $ 77,683 $ 70,197 Services 29,505 24,156 17,989 Total gross margin $ 98,392 $ 101,839 $ 88,186 Gross margin percentage: Products 32.2 % 34.4 % 35.7 % Services 63.7 % 60.8 % 55.0 % Total gross margin percentage 37.8 % 38.3 % 38.5 % Products Gross Margin Products gross margin and Products gross margin percentage decreased during 2019 compared to 2018 due primarily to lower iPhone unit sales and the weakness in foreign currencies relative to the U.S. dollar. Products gross margin increased during 2018 compared to 2017 due primarily to a favorable shift in mix of iPhones and the strength in foreign currencies relative to the U.S. dollar, partially offset by higher product cost structures. Year-over-year Products gross margin percentage decreased during 2018 due primarily to higher product cost structures, partially offset by the strength in foreign currencies relative to the U.S. dollar. Services Gross Margin Year-over-year Services gross margin increased during 2019 and 2018 due primarily to higher Services net sales and a different services mix. Year-over-year Services gross margin percentage increased during 2019 and 2018 due primarily to a different services mix and leverage of the Company’s services fixed cost structure from higher Services net sales. The Company’s future gross margins can be impacted by a variety of factors, as set forth in Part I, Item 1A of this Form 10-K under the heading “Risk Factors”. As a result, the Company believes, in general, gross margins will be subject to volatility and remain under downward pressure. Operating Expenses Operating expenses for 2019 , 2018 and 2017 were as follows (dollars in millions): 2019 Change 2018 Change 2017 Research and development $ 16,217 14 % $ 14,236 23 % $ 11,581 Percentage of total net sales 6 % 5 % 5 % Selling, general and administrative $ 18,245 9 % $ 16,705 9 % $ 15,261 Percentage of total net sales 7 % 6 % 7 % Total operating expenses $ 34,462 11 % $ 30,941 15 % $ 26,842 Percentage of total net sales 13 % 12 % 12 % Research and Development The year-over-year growth in R&D expense in 2019 was driven primarily by increases in headcount-related expenses. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products and services that are central to the Company’s core business strategy. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2019 was driven primarily by increases in headcount-related expenses and higher spending on marketing and advertising and infrastructure-related costs. Apple Inc. | 2019 Form 10-K | 21 Other Income/(Expense), Net Other income/(expense), net (“OI&E”) for 2019 , 2018 and 2017 was as follows (dollars in millions): 2019 Change 2018 Change 2017 Interest and dividend income $ 4,961 $ 5,686 $ 5,201 Interest expense (3,576 ) (3,240 ) (2,323 ) Other income/(expense), net 422 (441 ) (133 ) Total other income/(expense), net $ 1,807 (10 )% $ 2,005 (27 )% $ 2,745 The year-over-year decrease in OI&E during 2019 was due primarily to lower interest income and higher interest expense, partially offset by the impact of foreign exchange–related items. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 2.19% and 2.16% in 2019 and 2018 , respectively. Provision for Income Taxes Provision for income taxes, effective tax rate and statutory federal income tax rate for 2019 , 2018 and 2017 were as follows (dollars in millions): 2019 2018 2017 Provision for income taxes $ 10,481 $ 13,372 $ 15,738 Effective tax rate 15.9 % 18.3 % 24.6 % Statutory federal income tax rate 21.0 % 24.5 % 35.0 % On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which significantly changed U.S. tax law. The Act lowered the Company’s U.S. statutory federal income tax rate from 35% to 21% effective January 1, 2018, while also imposing a deemed repatriation tax on previously deferred foreign income. By operation of law, the Company applied a blended U.S. statutory federal income tax rate of 24.5% for 2018 (the “2018 blended U.S. tax rate”). The Act also created a new minimum tax on certain foreign earnings. The Company’s effective tax rate for 2019 was lower than the statutory federal income tax rate due primarily to the lower tax rate on foreign earnings and tax benefits from share-based compensation. The Company’s effective tax rate for 2018 was lower than the 2018 blended U.S. tax rate due primarily to the lower tax rate on foreign earnings, partially offset by the remeasurement of deferred tax assets and liabilities as a result of the Act. The Company’s effective tax rate for 2019 was lower compared to 2018 due primarily to a lower statutory federal income tax rate in 2019 and the impact of the Act in 2018, partially offset by higher taxes on foreign earnings in 2019. As of September 28, 2019 , the Company had net deferred tax assets arising from deductible temporary differences and tax credits of $14.3 billion and deferred tax liabilities of $6.2 billion . Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to recover the net deferred tax assets. The Company will continue to evaluate the amount of the valuation allowance, if any, by assessing the realizability of deferred tax assets. Recent Accounting Pronouncements Hedging In August 2017, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 expands component and fair value hedging, specifies the presentation of the effects of hedging instruments, and eliminates the separate measurement and presentation of hedge ineffectiveness. The Company will adopt ASU 2017-12 in its first quarter of 2020 utilizing the modified retrospective transition method. Based on the Company’s derivative portfolio and hedging strategies, the adoption of ASU 2017-12 is not expected to have a material impact on its consolidated financial statements. Financial Instruments In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses on certain financial instruments. The Company will adopt ASU 2016-13 in its first quarter of 2021 utilizing the modified retrospective transition method. Based on the composition of the Company’s investment portfolio, current market conditions, and historical credit loss activity, the adoption of ASU 2016-13 is not expected to have a material impact on its consolidated financial statements. Apple Inc. | 2019 Form 10-K | 22 Leases In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modifies lease accounting for lessees to increase transparency and comparability by recording lease assets and liabilities for operating leases and disclosing key information about leasing arrangements. The Company will adopt ASU 2016-02 utilizing the modified retrospective transition method through a cumulative-effect adjustment at the beginning of its first quarter of 2020. Upon adoption, the Company anticipates recording lease-related assets and liabilities of approximately $8 billion on its Condensed Consolidated Balance Sheet, with no material impact to its Condensed Consolidated Statements of Operations. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended September 28, 2019 , September 29, 2018 and September 30, 2017 (in millions): 2019 2018 2017 Cash, cash equivalents and marketable securities (1) $ 205,898 $ 237,100 $ 268,895 Property, plant and equipment, net $ 37,378 $ 41,304 $ 33,783 Commercial paper $ 5,980 $ 11,964 $ 11,977 Total term debt $ 102,067 $ 102,519 $ 103,703 Working capital $ 57,101 $ 15,410 $ 28,792 Cash generated by operating activities $ 69,391 $ 77,434 $ 64,225 Cash generated by/(used in) investing activities $ 45,896 $ 16,066 $ (46,446 ) Cash used in financing activities $ (90,976 ) $ (87,876 ) $ (17,974 ) (1) As of September 28, 2019 and September 29, 2018 , total cash, cash equivalents and marketable securities included $18.9 billion and $20.3 billion , respectively, that was restricted from general use, related to the State Aid Decision (refer to Note 5, “Income Taxes” in the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) and other agreements. The Company believes its existing balances of cash, cash equivalents and marketable securities, along with commercial paper and other short-term liquidity arrangements, will be sufficient to satisfy its working capital needs, capital asset purchases, dividends, share repurchases, debt repayments and other liquidity requirements associated with its existing operations over the next 12 months. In connection with the State Aid Decision, as of September 28, 2019 , the entire adjusted recovery amount of €12.9 billion plus interest of €1.2 billion was funded into escrow, where it will remain restricted from general use pending the conclusion of all appeals. Further information regarding the State Aid Decision can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 5, “Income Taxes.” The Company’s marketable securities investment portfolio is primarily invested in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. During 2019 , cash generated by operating activities of $69.4 billion was a result of $55.3 billion of net income and non-cash adjustments to net income of $17.6 billion , partially offset by a decrease in the net change in operating assets and liabilities of $3.5 billion . Cash generated by investing activities of $45.9 billion during 2019 consisted primarily of proceeds from sales and maturities of marketable securities, net of purchases, of $57.5 billion , partially offset by cash used to acquire property, plant and equipment of $10.5 billion . Cash used in financing activities of $91.0 billion during 2019 consisted primarily of cash used to repurchase common stock of $66.9 billion , cash used to pay dividends and dividend equivalents of $14.1 billion , cash used to repay term debt of $8.8 billion and net repayments of commercial paper of $6.0 billion , partially offset by net proceeds from the issuance of term debt of $7.0 billion . During 2018 , cash generated by operating activities of $77.4 billion was a result of $59.5 billion of net income and an increase in the net change in operating assets and liabilities of $34.7 billion , partially offset by non-cash adjustments to net income of $16.8 billion . Cash generated by investing activities of $16.1 billion during 2018 consisted primarily of proceeds from maturities and sales of marketable securities, net of purchases, of $32.4 billion , partially offset by cash used to acquire property, plant and equipment of $13.3 billion . Cash used in financing activities of $87.9 billion during 2018 consisted primarily of cash used to repurchase common stock of $72.7 billion , cash used to pay dividends and dividend equivalents of $13.7 billion and cash used to repay term debt of $6.5 billion , partially offset by net proceeds from the issuance of term debt of $7.0 billion . Apple Inc. | 2019 Form 10-K | 23 Capital Assets The Company’s capital expenditures were $7.6 billion during 2019 , which included product tooling and manufacturing process equipment; data centers; corporate facilities and infrastructure, including information systems hardware, software and enhancements; and retail store facilities. Debt The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses the net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 28, 2019 , the Company had $6.0 billion of Commercial Paper outstanding, with a weighted-average interest rate of 2.24% and maturities generally less than nine months . As of September 28, 2019 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $101.7 billion (collectively the “Notes”). During 2019 , the Company issued $7.0 billion and repaid $8.8 billion of Notes. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on the Notes. In addition, the Company has entered, and in the future may enter, into foreign currency swaps to manage foreign currency risk on the Notes. Further information regarding the Company’s debt issuances and related hedging activity can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 3, “Financial Instruments” and Note 6, “Debt.” Capital Return Program On April 30, 2019, the Company announced the Board of Directors increased the current share repurchase program authorization from $100 billion to $175 billion of the Company’s common stock, of which $96.1 billion had been utilized as of September 28, 2019 . During 2019 , the Company repurchased 345.2 million shares of its common stock for $67.1 billion , including 62.0 million shares delivered under a $12.0 billion ASR dated February 2019, which settled in August 2019. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. On April 30, 2019, the Company also announced the Board of Directors raised the Company’s quarterly cash dividend from $0.73 to $0.77 per share, beginning with the dividend paid during the third quarter of 2019. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Contractual Obligations The following table presents certain payments due by the Company as of September 28, 2019 , and excludes amounts already recorded on the Consolidated Balance Sheet, except for term debt and the deemed repatriation tax payable (in millions): Payments due in 2020 Payments due in 2021–2022 Payments due in 2023–2024 Payments due after 2024 Total Term debt $ 10,270 $ 18,278 $ 19,329 $ 53,802 $ 101,679 Operating leases 1,306 2,413 1,746 5,373 10,838 Manufacturing purchase obligations (1) 40,076 1,974 808 69 42,927 Other purchase obligations 3,744 2,271 572 41 6,628 Deemed repatriation tax payable — 4,350 8,501 16,655 29,506 Total $ 55,396 $ 29,286 $ 30,956 $ 75,940 $ 191,578 (1) Represents amount expected to be paid under manufacturing-related supplier arrangements, which are primarily noncancelable. Operating Leases The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days . The Company also obtains individual components for its products from a wide variety of individual suppliers. Apple Inc. | 2019 Form 10-K | 24 Other Purchase Obligations The Company’s other purchase obligations consist of noncancelable obligations to acquire capital assets, including product tooling and manufacturing process equipment, and noncancelable obligations related to advertising, licensing, R&D, Internet and telecommunications services, content creation and other activities. Deemed Repatriation Tax Payable As of September 28, 2019 , a significant portion of the other non-current liabilities in the Company’s Consolidated Balance Sheet consisted of the deemed repatriation tax payable imposed by the Act. The Company plans to pay the deemed repatriation tax payable in installments in accordance with the Act. Other Non-Current Liabilities The Company’s remaining other non-current liabilities primarily consist of items for which the Company is unable to make a reasonably reliable estimate of the timing or amount of payments; therefore, such amounts are not included in the above contractual obligation table. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported. Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation of manufacturing-related assets and estimation of inventory purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud, Siri and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative stand-alone selling prices (“SSPs”). Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. The Company’s process for determining estimated SSPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s SSPs and the future rate of related amortization for product-related bundled services and unspecified software upgrade rights related to future sales of these devices could change. Factors subject to change include the nature of the product-related bundled services and unspecified software upgrade rights offered, their estimated value and the estimated period they are expected to be provided. Apple Inc. | 2019 Form 10-K | 25 Valuation of Manufacturing-Related Assets and Estimation of Inventory Purchase Commitment Cancellation Fees The Company invests in manufacturing-related assets, including capital assets held at its suppliers’ facilities and prepayments provided to certain of its suppliers associated with long-term agreements to secure the supply of inventory. The Company also accrues estimated purchase commitment cancellation fees related to inventory orders that have been canceled or are expected to be canceled. The Company’s estimates of future product development plans and demand for its products are the key inputs in the determination of the recoverability of manufacturing-related assets and the assessment of the adequacy of any purchase commitment cancellation fee accruals. If there is an abrupt and substantial decline in estimated demand for one or more of the Company’s products, a change in the Company’s product development plans, or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record write-downs or impairments of manufacturing-related assets or accrue purchase commitment cancellation fees. Warranty Costs The Company offers limited warranties on its new hardware products and on parts used to repair its hardware products, and customers may purchase extended service coverage, where available, on many of the Company’s hardware products. The Company accrues the estimated cost of warranties in the period the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost per claim and knowledge of specific product failures outside the Company’s typical experience. The Company regularly reviews these estimates and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required. Income Taxes The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater-than-50% likelihood of being realized upon ultimate settlement. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. Apple Inc. | 2019 Form 10-K | 26 The Company’s investment policy and strategy are focused on the preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 28, 2019 and September 29, 2018 , a hypothetical 100 basis point increase in interest rates across all maturities would result in a $2.8 billion and $4.9 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. As of September 28, 2019 and September 29, 2018 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $102.1 billion and $102.5 billion , respectively. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on term debt are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 28, 2019 and September 29, 2018 to increase by $325 million and $399 million on an annualized basis, respectively. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and in the future may enter, into foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign currency–denominated debt issuances. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. To provide an assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $452 million as of September 28, 2019 , compared to a maximum one-day loss in fair value of $592 million as of September 29, 2018 . Because the Company uses foreign currency instruments for hedging purposes, the losses in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio, debt and derivative positions may differ materially from the sensitivity analyses performed as of September 28, 2019 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchange rates and the Company’s actual exposures and positions. Apple Inc. | 2019 Form 10-K | 27 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 29 Consolidated Statements of Comprehensive Income for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 30 Consolidated Balance Sheets as of September 28, 2019 and September 29, 2018 31 Consolidated Statements of Shareholders’ Equity for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 32 Consolidated Statements of Cash Flows for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 33 Notes to Consolidated Financial Statements 34 Selected Quarterly Financial Information (Unaudited) 55 Reports of Independent Registered Public Accounting Firm 56 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes. Apple Inc. | 2019 Form 10-K | 28 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 28, 2019 September 29, 2018 September 30, 2017 Net sales: Products $ 213,883 $ 225,847 $ 196,534 Services 46,291 39,748 32,700 Total net sales 260,174 265,595 229,234 Cost of sales: Products 144,996 148,164 126,337 Services 16,786 15,592 14,711 Total cost of sales 161,782 163,756 141,048 Gross margin 98,392 101,839 88,186 Operating expenses: Research and development 16,217 14,236 11,581 Selling, general and administrative 18,245 16,705 15,261 Total operating expenses 34,462 30,941 26,842 Operating income 63,930 70,898 61,344 Other income/(expense), net 1,807 2,005 2,745 Income before provision for income taxes 65,737 72,903 64,089 Provision for income taxes 10,481 13,372 15,738 Net income $ 55,256 $ 59,531 $ 48,351 Earnings per share: Basic $ 11.97 $ 12.01 $ 9.27 Diluted $ 11.89 $ 11.91 $ 9.21 Shares used in computing earnings per share: Basic 4,617,834 4,955,377 5,217,242 Diluted 4,648,913 5,000,109 5,251,692 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2019 Form 10-K | 29 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 28, 2019 September 29, 2018 September 30, 2017 Net income $ 55,256 $ 59,531 $ 48,351 Other comprehensive income/(loss): Change in foreign currency translation, net of tax ( 408 ) ( 525 ) 224 Change in unrealized gains/losses on derivative instruments, net of tax: Change in fair value of derivatives ( 661 ) 523 1,315 Adjustment for net (gains)/losses realized and included in net income 23 382 ( 1,477 ) Total change in unrealized gains/losses on derivative instruments ( 638 ) 905 ( 162 ) Change in unrealized gains/losses on marketable securities, net of tax: Change in fair value of marketable securities 3,802 ( 3,407 ) ( 782 ) Adjustment for net (gains)/losses realized and included in net income 25 1 ( 64 ) Total change in unrealized gains/losses on marketable securities 3,827 ( 3,406 ) ( 846 ) Total other comprehensive income/(loss) 2,781 ( 3,026 ) ( 784 ) Total comprehensive income $ 58,037 $ 56,505 $ 47,567 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2019 Form 10-K | 30 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 28, 2019 September 29, 2018 ASSETS: Current assets: Cash and cash equivalents $ 48,844 $ 25,913 Marketable securities 51,713 40,388 Accounts receivable, net 22,926 23,186 Inventories 4,106 3,956 Vendor non-trade receivables 22,878 25,809 Other current assets 12,352 12,087 Total current assets 162,819 131,339 Non-current assets: Marketable securities 105,341 170,799 Property, plant and equipment, net 37,378 41,304 Other non-current assets 32,978 22,283 Total non-current assets 175,697 234,386 Total assets $ 338,516 $ 365,725 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 46,236 $ 55,888 Other current liabilities 37,720 33,327 Deferred revenue 5,522 5,966 Commercial paper 5,980 11,964 Term debt 10,260 8,784 Total current liabilities 105,718 115,929 Non-current liabilities: Term debt 91,807 93,735 Other non-current liabilities 50,503 48,914 Total non-current liabilities 142,310 142,649 Total liabilities 248,028 258,578 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 4,443,236 and 4,754,986 shares issued and outstanding, respectively 45,174 40,201 Retained earnings 45,898 70,400 Accumulated other comprehensive income/(loss) ( 584 ) ( 3,454 ) Total shareholders’ equity 90,488 107,147 Total liabilities and shareholders’ equity $ 338,516 $ 365,725 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2019 Form 10-K | 31 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except per share amounts) Years ended September 28, 2019 September 29, 2018 September 30, 2017 Total shareholders’ equity, beginning balances $ 107,147 $ 134,047 $ 128,249 Common stock and additional paid-in capital: Beginning balances 40,201 35,867 31,251 Common stock issued 781 669 555 Common stock withheld related to net share settlement of equity awards ( 2,002 ) ( 1,778 ) ( 1,468 ) Share-based compensation 6,194 5,443 4,909 Tax benefit from equity awards, including transfer pricing adjustments — — 620 Ending balances 45,174 40,201 35,867 Retained earnings: Beginning balances 70,400 98,330 96,364 Net income 55,256 59,531 48,351 Dividends and dividend equivalents declared ( 14,129 ) ( 13,735 ) ( 12,803 ) Common stock withheld related to net share settlement of equity awards ( 1,029 ) ( 948 ) ( 581 ) Common stock repurchased ( 67,101 ) ( 73,056 ) ( 33,001 ) Cumulative effects of changes in accounting principles 2,501 278 — Ending balances 45,898 70,400 98,330 Accumulated other comprehensive income/(loss): Beginning balances ( 3,454 ) ( 150 ) 634 Other comprehensive income/(loss) 2,781 ( 3,026 ) ( 784 ) Cumulative effects of changes in accounting principles 89 ( 278 ) — Ending balances ( 584 ) ( 3,454 ) ( 150 ) Total shareholders’ equity, ending balances $ 90,488 $ 107,147 $ 134,047 Dividends and dividend equivalents declared per share or RSU $ 3.00 $ 2.72 $ 2.40 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2019 Form 10-K | 32 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 28, 2019 September 29, 2018 September 30, 2017 Cash, cash equivalents and restricted cash, beginning balances $ 25,913 $ 20,289 $ 20,484 Operating activities: Net income 55,256 59,531 48,351 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 12,547 10,903 10,157 Share-based compensation expense 6,068 5,340 4,840 Deferred income tax expense/(benefit) ( 340 ) ( 32,590 ) 5,966 Other ( 652 ) ( 444 ) ( 166 ) Changes in operating assets and liabilities: Accounts receivable, net 245 ( 5,322 ) ( 2,093 ) Inventories ( 289 ) 828 ( 2,723 ) Vendor non-trade receivables 2,931 ( 8,010 ) ( 4,254 ) Other current and non-current assets 873 ( 423 ) ( 5,318 ) Accounts payable ( 1,923 ) 9,175 8,966 Deferred revenue ( 625 ) ( 3 ) ( 593 ) Other current and non-current liabilities ( 4,700 ) 38,449 1,092 Cash generated by operating activities 69,391 77,434 64,225 Investing activities: Purchases of marketable securities ( 39,630 ) ( 71,356 ) ( 159,486 ) Proceeds from maturities of marketable securities 40,102 55,881 31,775 Proceeds from sales of marketable securities 56,988 47,838 94,564 Payments for acquisition of property, plant and equipment ( 10,495 ) ( 13,313 ) ( 12,451 ) Payments made in connection with business acquisitions, net ( 624 ) ( 721 ) ( 329 ) Purchases of non-marketable securities ( 1,001 ) ( 1,871 ) ( 521 ) Proceeds from non-marketable securities 1,634 353 126 Other ( 1,078 ) ( 745 ) ( 124 ) Cash generated by/(used in) investing activities 45,896 16,066 ( 46,446 ) Financing activities: Proceeds from issuance of common stock 781 669 555 Payments for taxes related to net share settlement of equity awards ( 2,817 ) ( 2,527 ) ( 1,874 ) Payments for dividends and dividend equivalents ( 14,119 ) ( 13,712 ) ( 12,769 ) Repurchases of common stock ( 66,897 ) ( 72,738 ) ( 32,900 ) Proceeds from issuance of term debt, net 6,963 6,969 28,662 Repayments of term debt ( 8,805 ) ( 6,500 ) ( 3,500 ) Proceeds from/(Repayments of) commercial paper, net ( 5,977 ) ( 37 ) 3,852 Other ( 105 ) — — Cash used in financing activities ( 90,976 ) ( 87,876 ) ( 17,974 ) Increase/(Decrease) in cash, cash equivalents and restricted cash 24,311 5,624 ( 195 ) Cash, cash equivalents and restricted cash, ending balances $ 50,224 $ 25,913 $ 20,289 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 15,263 $ 10,417 $ 11,591 Cash paid for interest $ 3,423 $ 3,022 $ 2,092 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2019 Form 10-K | 33 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of Apple Inc. and its wholly owned subsidiaries (collectively “Apple” or the “Company”). Intercompany accounts and transactions have been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these consolidated financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2019 and 2018 spanned 52 weeks each, whereas fiscal year 2017 included 53 weeks. A 14th week was included in the first fiscal quarter of 2017, as is done every five or six years, to realign the Company’s fiscal quarters with calendar quarters. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Recently Adopted Accounting Pronouncements Revenue Recognition In the first quarter of 2019, the Company adopted the Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), and additional ASUs issued to clarify the guidance in ASU 2014-09 (collectively the “new revenue standard”), which amends the existing accounting standards for revenue recognition. The Company adopted the new revenue standard utilizing the full retrospective transition method. The Company did not restate total net sales in the prior periods presented, as the adoption of the new revenue standard did not have a material impact on previously reported amounts. Additionally, beginning in the first quarter of 2019, the Company classified the amortization of the deferred value of Maps, Siri and free iCloud services, which are bundled in the sales price of iPhone, Mac, iPad and certain other products, in Services net sales. Historically, the Company classified the amortization of these amounts in Products net sales consistent with its management reporting framework. As a result, Products and Services net sales for 2018 and 2017 were reclassified to conform to the 2019 presentation. Financial Instruments In the first quarter of 2019, the Company adopted FASB ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of the recognition, measurement, presentation and disclosure of financial instruments. The adoption of ASU 2016-01 did not have a material impact on the Company’s consolidated financial statements. Income Taxes In the first quarter of 2019, the Company adopted FASB ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory (“ASU 2016-16”), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. The Company adopted ASU 2016-16 utilizing the modified retrospective transition method. Upon adoption, the Company recorded $ 2.7 billion of net deferred tax assets, reduced other non-current assets by $ 128 million , and increased retained earnings by $ 2.6 billion on its Consolidated Balance Sheet. The Company will recognize incremental deferred income tax expense as these net deferred tax assets are utilized. Restricted Cash In the first quarter of 2019, the Company adopted FASB ASU No. 2016-18, Statement of Cash Flows (Topic 230): Restricted Cash (“ASU 2016-18”), which enhances and clarifies the guidance on the classification and presentation of restricted cash in the statement of cash flows and requires additional disclosures about restricted cash balances. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Apple Inc. | 2019 Form 10-K | 34 Share-Based Compensation The Company generally measures share-based compensation based on the closing price of the Company’s common stock on the date of grant, and recognizes expense on a straight-line basis for its estimate of equity awards that will ultimately vest. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Earnings Per Share The following table shows the computation of basic and diluted earnings per share for 2019 , 2018 and 2017 (net income in millions and shares in thousands): 2019 2018 2017 Numerator: Net income $ 55,256 $ 59,531 $ 48,351 Denominator: Weighted-average basic shares outstanding 4,617,834 4,955,377 5,217,242 Effect of dilutive securities 31,079 44,732 34,450 Weighted-average diluted shares 4,648,913 5,000,109 5,251,692 Basic earnings per share $ 11.97 $ 12.01 $ 9.27 Diluted earnings per share $ 11.89 $ 11.91 $ 9.21 The Company applies the treasury stock method to determine the dilutive effect of potentially dilutive securities. Potentially dilutive securities representing 15.5 million shares of common stock were excluded from the computation of diluted earnings per share for 2019 because their effect would have been antidilutive. Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s investments in marketable debt securities have been classified and accounted for as available-for-sale. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Unrealized gains and losses on marketable debt securities classified as available-for-sale are recognized in other comprehensive income/(loss) (“OCI”). The Company’s investments in marketable equity securities are classified based on the nature of the securities and their availability for use in current operations. The Company’s marketable equity securities are measured at fair value with gains and losses recognized in other income/(expense), net (“OI&E”). The cost of securities sold is determined using the specific identification method. Inventories Inventories are measured using the first-in, first-out method. Property, Plant and Equipment Depreciation on property, plant and equipment is recognized on a straight-line basis over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between one and five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease term or useful life for leasehold improvements. Capitalized costs related to internal-use software are amortized on a straight-line basis over the estimated useful lives of the assets, which range from three to five years . Depreciation and amortization expense on property and equipment was $ 11.3 billion , $ 9.3 billion and $ 8.2 billion during 2019 , 2018 and 2017 , respectively. Non-cash investing activities involving property, plant and equipment resulted in a net increase/(decrease) to accounts payable and other current liabilities of $( 2.9 ) billion and $ 3.4 billion during 2019 and 2018 , respectively. Apple Inc. | 2019 Form 10-K | 35 Non-Marketable Securities The Company has elected to apply the measurement alternative to equity securities without readily determinable fair values. As such, the Company’s non-marketable equity securities are measured at cost, less any impairment, and are adjusted for changes in fair value resulting from observable transactions for identical or similar investments of the same issuer. Gains and losses on non-marketable equity securities are recognized in OI&E. Restricted Cash and Restricted Marketable Securities The Company considers cash and marketable securities to be restricted when withdrawal or general use is legally restricted. The Company records restricted cash as other assets in the Consolidated Balance Sheets, and determines current or non-current classification based on the expected duration of the restriction. The Company records restricted marketable securities as current or non-current marketable securities in the Consolidated Balance Sheets based on the classification of the underlying securities . Fair Value Measurements The fair values of the Company’s money market funds and certain marketable equity securities are based on quoted prices in active markets for identical assets. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, which generally have counterparties with high credit ratings, are based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. Note 2 – Revenue Recognition Net sales consist of revenue from the sale of iPhone, Mac, iPad, Services and other products. The Company recognizes revenue at the amount to which it expects to be entitled when control of the products or services is transferred to its customers. Control is generally transferred when the Company has a present right to payment and title and the significant risks and rewards of ownership of products or services are transferred to its customers. For most of the Company’s Products net sales, control transfers when products are shipped. For the Company’s Services net sales, control transfers over time as services are delivered. Payment for Products and Services net sales is collected within a short period following transfer of control or commencement of delivery of services, as applicable. The Company records reductions to Products net sales related to future product returns, price protection and other customer incentive programs based on the Company’s expectations and historical experience. For arrangements with multiple performance obligations, which represent promises within an arrangement that are capable of being distinct, the Company allocates revenue to all distinct performance obligations based on their relative stand-alone selling prices (“SSPs”). When available, the Company uses observable prices to determine SSPs. When observable prices are not available, SSPs are established that reflect the Company’s best estimates of what the selling prices of the performance obligations would be if they were sold regularly on a stand-alone basis. The Company’s process for estimating SSPs without observable prices considers multiple factors that may vary depending upon the unique facts and circumstances related to each performance obligation including, where applicable, prices charged by the Company for similar offerings, market trends in the pricing for similar offerings, product-specific business objectives and the estimated cost to provide the performance obligation. The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud, Siri and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative SSPs. Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the delivered hardware and bundled software is recognized when control has transferred to the customer, which generally occurs when the product is shipped. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. Cost of sales related to delivered hardware and bundled software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide product-related bundled services and unspecified software upgrade rights are recognized as cost of sales as incurred. For certain long-term service arrangements, the Company has performance obligations for services it has not yet delivered. For these arrangements, the Company does not have a right to bill for the undelivered services. The Company has determined that any unbilled consideration relates entirely to the value of the undelivered services. Accordingly, the Company has not recognized revenue, and has elected not to disclose amounts, related to these undelivered services. Apple Inc. | 2019 Form 10-K | 36 For the sale of third-party products where the Company obtains control of the product before transferring it to the customer, the Company recognizes revenue based on the gross amount billed to customers. The Company considers multiple factors when determining whether it obtains control of third-party products including, but not limited to, evaluating if it can establish the price of the product, retains inventory risk for tangible products or has the responsibility for ensuring acceptability of the product. For third-party applications sold through the App Store, Mac App Store, TV App Store and Watch App Store and certain digital content sold through the Company’s other digital content stores, the Company does not obtain control of the product before transferring it to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in Services net sales only the commission it retains. The Company has elected to record revenue net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded within other current liabilities until remitted to the relevant government authority. Deferred Revenue As of September 28, 2019 and September 29, 2018 , the Company had total deferred revenue of $ 8.1 billion and $ 8.8 billion , respectively. As of September 28, 2019 , the Company expects 68 % of total deferred revenue to be realized in less than a year, 25 % within one-to-two years, 6 % within two-to-three years and 1 % in greater than three years. Disaggregated Revenue Net sales disaggregated by significant products and services for 2019 , 2018 and 2017 were as follows (in millions): 2019 2018 2017 iPhone (1) $ 142,381 $ 164,888 $ 139,337 Mac (1) 25,740 25,198 25,569 iPad (1) 21,280 18,380 18,802 Wearables, Home and Accessories (1)(2) 24,482 17,381 12,826 Services (3) 46,291 39,748 32,700 Total net sales (4) $ 260,174 $ 265,595 $ 229,234 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and Apple-branded and third-party accessories. (3) Services net sales include sales from the Company’s digital content stores and streaming services, AppleCare, licensing and other services. Services net sales also include amortization of the deferred value of Maps, Siri and free iCloud services, which are bundled in the sales price of certain products. (4) Includes $ 5.9 billion of revenue recognized in 2019 that was included in deferred revenue as of September 29, 2018 , $ 5.8 billion of revenue recognized in 2018 that was included in deferred revenue as of September 30, 2017 , and $ 6.3 billion of revenue recognized in 2017 that was included in deferred revenue as of September 24, 2016 . The Company’s proportion of net sales by disaggregated revenue source was generally consistent for each reportable segment in Note 11, “Segment Information and Geographic Data” for 2019 , 2018 and 2017 . Apple Inc. | 2019 Form 10-K | 37 Note 3 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and marketable securities by significant investment category as of September 28, 2019 and September 29, 2018 (in millions): 2019 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 12,204 $ — $ — $ 12,204 $ 12,204 $ — $ — Level 1 (1) : Money market funds 15,897 — — 15,897 15,897 — — Subtotal 15,897 — — 15,897 15,897 — — Level 2 (2) : U.S. Treasury securities 30,293 33 ( 62 ) 30,264 6,165 9,817 14,282 U.S. agency securities 9,767 1 ( 3 ) 9,765 6,489 2,249 1,027 Non-U.S. government securities 19,821 337 ( 50 ) 20,108 749 3,168 16,191 Certificates of deposit and time deposits 4,041 — — 4,041 2,024 1,922 95 Commercial paper 12,433 — — 12,433 5,193 7,240 — Corporate debt securities 85,383 756 ( 92 ) 86,047 123 26,127 59,797 Municipal securities 958 8 ( 1 ) 965 — 68 897 Mortgage- and asset-backed securities 14,180 67 ( 73 ) 14,174 — 1,122 13,052 Subtotal 176,876 1,202 ( 281 ) 177,797 20,743 51,713 105,341 Total (3) $ 204,977 $ 1,202 $ ( 281 ) $ 205,898 $ 48,844 $ 51,713 $ 105,341 2018 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 11,575 $ — $ — $ 11,575 $ 11,575 $ — $ — Level 1 (1) : Money market funds 8,083 — — 8,083 8,083 — — Mutual funds 799 — ( 116 ) 683 — 683 — Subtotal 8,882 — ( 116 ) 8,766 8,083 683 — Level 2 (2) : U.S. Treasury securities 47,296 — ( 1,202 ) 46,094 1,613 7,606 36,875 U.S. agency securities 4,127 — ( 48 ) 4,079 1,732 360 1,987 Non-U.S. government securities 21,601 49 ( 250 ) 21,400 — 3,355 18,045 Certificates of deposit and time deposits 3,074 — — 3,074 1,247 1,330 497 Commercial paper 2,573 — — 2,573 1,663 910 — Corporate debt securities 123,001 152 ( 2,038 ) 121,115 — 25,162 95,953 Municipal securities 946 — ( 12 ) 934 — 178 756 Mortgage- and asset-backed securities 18,105 8 ( 623 ) 17,490 — 804 16,686 Subtotal 220,723 209 ( 4,173 ) 216,759 6,255 39,705 170,799 Total (3) $ 241,180 $ 209 $ ( 4,289 ) $ 237,100 $ 25,913 $ 40,388 $ 170,799 (1) Level 1 fair value estimates are based on quoted prices in active markets for identical assets or liabilities. (2) Level 2 fair value estimates are based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. (3) As of September 28, 2019 and September 29, 2018 , total cash, cash equivalents and marketable securities included $ 18.9 billion and $ 20.3 billion , respectively, that was restricted from general use, related to the State Aid Decision (refer to Note 5, “Income Taxes”) and other agreements. Apple Inc. | 2019 Form 10-K | 38 The Company may sell certain of its marketable debt securities prior to their stated maturities for reasons including, but not limited to, managing liquidity, credit risk, duration and asset allocation. The maturities of the Company’s long-term marketable debt securities generally range from one to five years . The following tables show information about the Company’s marketable securities that had been in a continuous unrealized loss position for less than 12 months and for 12 months or greater as of September 28, 2019 and September 29, 2018 (in millions): 2019 Continuous Unrealized Losses Less than 12 Months 12 Months or Greater Total Fair value of marketable debt securities $ 28,151 $ 28,167 $ 56,318 Unrealized losses $ ( 138 ) $ ( 143 ) $ ( 281 ) 2018 Continuous Unrealized Losses Less than 12 Months 12 Months or Greater Total Fair value of marketable securities $ 126,238 $ 60,599 $ 186,837 Unrealized losses $ ( 2,400 ) $ ( 1,889 ) $ ( 4,289 ) The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. Fair values were determined for each individual security in the investment portfolio. When evaluating a marketable debt security for other-than-temporary impairment, the Company reviews factors such as the duration and extent to which the fair value of the security is less than its cost, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. As of September 28, 2019 , the Company does not consider any of its marketable debt securities to be other-than-temporarily impaired. Non-Marketable Securities The Company holds non-marketable equity securities of certain privately held companies without readily determinable fair values. As of September 28, 2019 , the Company’s non-marketable equity securities had a carrying value of $ 2.9 billion . Restricted Cash A reconciliation of the Company’s cash and cash equivalents in the Consolidated Balance Sheet to cash, cash equivalents and restricted cash in the Consolidated Statement of Cash Flows as of September 28, 2019 is as follows (in millions): 2019 Cash and cash equivalents $ 48,844 Restricted cash included in other current assets 23 Restricted cash included in other non-current assets 1,357 Cash, cash equivalents and restricted cash $ 50,224 The Company’s restricted cash primarily consisted of cash required to be on deposit under a contractual agreement with a bank to support the Company’s iPhone Upgrade Program. Derivative Financial Instruments The Company may use derivatives to partially offset its business exposure to foreign currency and interest rate risk on expected future cash flows, net investments in certain foreign subsidiaries, and certain existing assets and liabilities. However, the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange or interest rates. To protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar may hedge a portion of forecasted foreign currency revenue, and subsidiaries whose functional currency is not the U.S. dollar may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company may enter into forward contracts, option contracts or other instruments to manage this risk and may designate these instruments as cash flow hedges. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months . Apple Inc. | 2019 Form 10-K | 39 To protect the net investment in a foreign operation from fluctuations in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset a portion of the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. In addition, the Company may use non-derivative financial instruments, such as its foreign currency–denominated debt, as hedges of its net investments in certain foreign subsidiaries. In both of these cases, the Company designates these instruments as net investment hedges. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, cross-currency swaps or other instruments. These instruments may offset a portion of the foreign currency remeasurement gains or losses, or changes in fair value. The Company may designate these instruments as either cash flow or fair value hedges. As of September 28, 2019 , the Company’s hedged term debt– and marketable securities–related foreign currency transactions are expected to be recognized within 23 years . The Company may also enter into non-designated foreign currency contracts to offset a portion of the foreign currency exchange gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in interest rates, the Company may enter into interest rate swaps, options or other instruments. These instruments may offset a portion of the changes in interest income or expense, or changes in fair value. The Company designates these instruments as either cash flow or fair value hedges. As of September 28, 2019 , the Company’s hedged interest rate transactions are expected to be recognized within 8 years . Cash Flow Hedges The effective portions of cash flow hedges are recorded in accumulated other comprehensive income/(loss) (“AOCI”) until the hedged item is recognized in earnings. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow hedges of interest income or expense are recognized in OI&E in the same period as the related income or expense is recognized. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness. The ineffective portions and amounts excluded from the effectiveness testing of cash flow hedges are recognized in OI&E. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified into OI&E in the period of de-designation. Any subsequent changes in fair value of such derivative instruments are reflected in OI&E unless they are re-designated as hedges of other transactions. Net Investment Hedges The effective portions of net investment hedges are recorded in OCI as a part of the cumulative translation adjustment. The ineffective portions and amounts excluded from the effectiveness testing of net investment hedges are recognized in OI&E. For foreign exchange forward contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its assessment of hedge effectiveness. Accordingly, any gains or losses related to this forward carry component are recognized in earnings in the current period. Fair Value Hedges Gains and losses related to changes in fair value hedges are recognized in earnings along with a corresponding loss or gain related to the change in value of the underlying hedged item in the same line in the Consolidated Statements of Operations. For foreign exchange forward contracts designated as fair value hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its assessment of hedge effectiveness. The amount excluded from the effectiveness testing of fair value hedges was a gain of $ 777 million for 2019 , and was recognized in OI&E. Non-Designated Derivatives Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. Apple Inc. | 2019 Form 10-K | 40 The Company records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these derivative instruments is based on its hedge designation. The following tables show the Company’s derivative instruments at gross fair value as of September 28, 2019 and September 29, 2018 (in millions): 2019 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,798 $ 323 $ 2,121 Interest rate contracts $ 685 $ — $ 685 Derivative liabilities (2) : Foreign exchange contracts $ 1,341 $ 160 $ 1,501 Interest rate contracts $ 105 $ — $ 105 2018 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,015 $ 259 $ 1,274 Derivative liabilities (2) : Foreign exchange contracts $ 543 $ 137 $ 680 Interest rate contracts $ 1,456 $ — $ 1,456 (1) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets and other non-current assets in the Consolidated Balance Sheets. (2) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as other current liabilities and other non-current liabilities in the Consolidated Balance Sheets. The Company classifies cash flows related to derivative financial instruments as operating activities in its Consolidated Statements of Cash Flows. Apple Inc. | 2019 Form 10-K | 41 The following table shows the pre-tax gains and losses of the Company’s derivative and non-derivative instruments designated as cash flow, net investment and fair value hedges in OCI and the Consolidated Statements of Operations for 2019 , 2018 and 2017 (in millions): 2019 2018 2017 Gains/(Losses) recognized in OCI – effective portion: Cash flow hedges: Foreign exchange contracts $ ( 959 ) $ 682 $ 1,797 Interest rate contracts — 1 7 Total $ ( 959 ) $ 683 $ 1,804 Net investment hedges: Foreign currency debt $ ( 58 ) $ 4 $ 67 Gains/(Losses) reclassified from AOCI into net income – effective portion: Cash flow hedges: Foreign exchange contracts $ ( 116 ) $ ( 482 ) $ 1,958 Interest rate contracts ( 7 ) 1 ( 2 ) Total $ ( 123 ) $ ( 481 ) $ 1,956 Gains/(Losses) on derivative instruments: Fair value hedges: Foreign exchange contracts $ 1,020 $ ( 168 ) $ — Interest rate contracts 2,068 ( 1,363 ) ( 810 ) Total $ 3,088 $ ( 1,531 ) $ ( 810 ) Gains/(Losses) related to hedged items: Fair value hedges: Marketable securities $ ( 1,018 ) $ 167 $ — Fixed-rate debt ( 2,068 ) 1,363 810 Total $ ( 3,086 ) $ 1,530 $ 810 The following table shows the notional amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of September 28, 2019 and September 29, 2018 (in millions): 2019 2018 Notional Amount Credit Risk Amount Notional Amount Credit Risk Amount Instruments designated as accounting hedges: Foreign exchange contracts $ 61,795 $ 1,798 $ 65,368 $ 1,015 Interest rate contracts $ 31,250 $ 685 $ 33,250 $ — Instruments not designated as accounting hedges: Foreign exchange contracts $ 76,868 $ 323 $ 63,062 $ 259 The notional amounts for outstanding derivative instruments provide one measure of the transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s exposure to credit loss and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. Apple Inc. | 2019 Form 10-K | 42 The Company generally enters into master netting arrangements, which are designed to reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values in its Consolidated Balance Sheets. As of September 28, 2019 , the net cash collateral received by the Company related to derivative instruments under its collateral security arrangements was $ 1.6 billion , which was recorded as other current liabilities in the Consolidated Balance Sheet. As of September 29, 2018 , the net cash collateral posted by the Company related to derivative instruments under its collateral security arrangements was $ 1.0 billion , which was recorded as other current assets in the Consolidated Balance Sheet. Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net settle transactions with a single net amount payable by one party to the other. As of September 28, 2019 and September 29, 2018 , the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $ 2.7 billion and $ 2.1 billion , respectively, resulting in a net derivative liability of $ 407 million and a net derivative asset of $ 138 million , respectively. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral or third-party credit support in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 28, 2019 , the Company had no customers that individually represented 10% or more of total trade receivables. As of September 29, 2018 , the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10 % . The Company’s cellular network carriers accounted for 51 % and 59 % of total trade receivables as of September 28, 2019 and September 29, 2018 , respectively. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. As of September 28, 2019 , the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 59 % and 14 % . As of September 29, 2018 , the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 62 % and 12 % . Note 4 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 28, 2019 and September 29, 2018 (in millions): Property, Plant and Equipment, Net 2019 2018 Land and buildings $ 17,085 $ 16,216 Machinery, equipment and internal-use software 69,797 65,982 Leasehold improvements 9,075 8,205 Gross property, plant and equipment 95,957 90,403 Accumulated depreciation and amortization ( 58,579 ) ( 49,099 ) Total property, plant and equipment, net $ 37,378 $ 41,304 Apple Inc. | 2019 Form 10-K | 43 Other Non-Current Liabilities 2019 2018 Long-term taxes payable $ 29,545 $ 33,589 Other non-current liabilities 20,958 15,325 Total other non-current liabilities $ 50,503 $ 48,914 Other Income/(Expense), Net The following table shows the detail of OI&E for 2019 , 2018 and 2017 (in millions): 2019 2018 2017 Interest and dividend income $ 4,961 $ 5,686 $ 5,201 Interest expense ( 3,576 ) ( 3,240 ) ( 2,323 ) Other income/(expense), net 422 ( 441 ) ( 133 ) Total other income/(expense), net $ 1,807 $ 2,005 $ 2,745 Note 5 – Income Taxes U.S. Tax Cuts and Jobs Act On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which significantly changed U.S. tax law. The Act lowered the Company’s U.S. statutory federal income tax rate from 35 % to 21 % effective January 1, 2018, while also imposing a deemed repatriation tax on previously deferred foreign income. The Act also created a new minimum tax on certain foreign earnings, for which the Company has elected to record certain deferred tax assets and liabilities. The Company completed its accounting for the income tax effects of the Act during 2019, in accordance with the U.S. Securities and Exchange Commission Staff Accounting Bulletin No. 118. Provision for Income Taxes and Effective Tax Rate The provision for income taxes for 2019 , 2018 and 2017 , consisted of the following (in millions): 2019 2018 2017 Federal: Current $ 6,384 $ 41,425 $ 7,842 Deferred ( 2,939 ) ( 33,819 ) 5,980 Total 3,445 7,606 13,822 State: Current 475 551 259 Deferred ( 67 ) 48 2 Total 408 599 261 Foreign: Current 3,962 3,986 1,671 Deferred 2,666 1,181 ( 16 ) Total 6,628 5,167 1,655 Provision for income taxes $ 10,481 $ 13,372 $ 15,738 The foreign provision for income taxes is based on foreign pre-tax earnings of $ 44.3 billion , $ 48.0 billion and $ 44.7 billion in 2019 , 2018 and 2017 , respectively. Apple Inc. | 2019 Form 10-K | 44 A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate ( 21 % in 2019 ; 24.5 % in 2018 ; 35 % in 2017 ) to income before provision for income taxes for 2019 , 2018 and 2017 , is as follows (dollars in millions): 2019 2018 2017 Computed expected tax $ 13,805 $ 17,890 $ 22,431 State taxes, net of federal effect 423 271 185 Impacts of the Act — 1,515 — Earnings of foreign subsidiaries ( 2,625 ) ( 5,606 ) ( 6,135 ) Research and development credit, net ( 548 ) ( 560 ) ( 678 ) Excess tax benefits from equity awards ( 639 ) ( 675 ) — Other 65 537 ( 65 ) Provision for income taxes $ 10,481 $ 13,372 $ 15,738 Effective tax rate 15.9 % 18.3 % 24.6 % The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan awards. For restricted stock units (“RSUs”), the Company receives an income tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. Prior to 2018, the Company reflected net excess tax benefits from equity awards as increases to additional paid-in capital, which amounted to $ 620 million in 2017 . Deferred Tax Assets and Liabilities As of September 28, 2019 and September 29, 2018 , the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2019 2018 Deferred tax assets: Amortization and depreciation $ 11,433 $ 137 Accrued liabilities and other reserves 5,389 3,151 Deferred revenue 1,372 1,141 Share-based compensation 749 513 Unrealized losses — 871 Other 697 797 Total deferred tax assets, net 19,640 6,610 Deferred tax liabilities: Minimum tax on foreign earnings 10,809 — Earnings of foreign subsidiaries 330 275 Other 456 501 Total deferred tax liabilities 11,595 776 Net deferred tax assets/(liabilities) $ 8,045 $ 5,834 Deferred tax assets and liabilities reflect the effects of tax credits and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Apple Inc. | 2019 Form 10-K | 45 Uncertain Tax Positions As of September 28, 2019 , the total amount of gross unrecognized tax benefits was $ 15.6 billion , of which $ 8.6 billion , if recognized, would impact the Company’s effective tax rate. As of September 29, 2018 , the total amount of gross unrecognized tax benefits was $ 9.7 billion , of which $ 7.4 billion , if recognized, would have impacted the Company’s effective tax rate. The aggregate change in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2019 , 2018 and 2017 , is as follows (in millions): 2019 2018 2017 Beginning balances $ 9,694 $ 8,407 $ 7,724 Increases related to tax positions taken during a prior year 5,845 2,431 333 Decreases related to tax positions taken during a prior year ( 686 ) ( 2,212 ) ( 952 ) Increases related to tax positions taken during the current year 1,697 1,824 1,880 Decreases related to settlements with taxing authorities ( 852 ) ( 756 ) ( 539 ) Decreases related to expiration of the statute of limitations ( 79 ) — ( 39 ) Ending balances $ 15,619 $ 9,694 $ 8,407 The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisdictions. The U.S. Internal Revenue Service (the “IRS”) concluded its review of the years 2013 through 2015 in 2018, and all years before 2016 are closed. Tax years after 2014 remain open in certain major foreign jurisdictions and are subject to examination by the taxing authorities. The Company believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner inconsistent with its expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although the timing of resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease in the next 12 months by as much as $ 2.0 billion . Interest and Penalties The Company includes interest and penalties related to income tax matters within the provision for income taxes. As of September 28, 2019 and September 29, 2018 , the total amount of gross interest and penalties accrued was $ 1.3 billion and $ 1.4 billion , respectively. The Company recognized interest and penalty expense in 2019 , 2018 and 2017 of $ 73 million , $ 489 million and $ 238 million , respectively. European Commission State Aid Decision On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. The recovery amount was calculated to be € 13.1 billion , plus interest of € 1.2 billion . During the fourth quarter of 2019, the Irish Minister for Finance approved the Company’s request to reduce the recovery amount by € 190 million due to taxes paid to other countries, resulting in an adjusted recovery amount of € 12.9 billion as of September 28, 2019. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and appealed to the General Court of the Court of Justice of the European Union. Ireland has also appealed the State Aid Decision. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes, subject to any foreign tax credit limitations in the Act. As of September 28, 2019 , the entire adjusted recovery amount plus interest was funded into escrow, where it will remain restricted from general use pending the conclusion of all appeals. Refer to the Cash, Cash Equivalents and Marketable Securities section of Note 3, “Financial Instruments” for more information. Apple Inc. | 2019 Form 10-K | 46 Note 6 – Debt Commercial Paper The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 28, 2019 and September 29, 2018 , the Company had $ 6.0 billion and $ 12.0 billion of Commercial Paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 2.24 % and 2.18 % as of September 28, 2019 and September 29, 2018 , respectively. The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2019 , 2018 and 2017 (in millions): 2019 2018 2017 Maturities 90 days or less: Proceeds from/(Repayments of) commercial paper, net $ ( 3,248 ) $ 1,044 $ ( 1,782 ) Maturities greater than 90 days: Proceeds from commercial paper 13,874 14,555 17,932 Repayments of commercial paper ( 16,603 ) ( 15,636 ) ( 12,298 ) Proceeds from/(Repayments of) commercial paper, net ( 2,729 ) ( 1,081 ) 5,634 Total proceeds from/(repayments of) commercial paper, net $ ( 5,977 ) $ ( 37 ) $ 3,852 Term Debt As of September 28, 2019 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $ 101.7 billion (collectively the “Notes”). The Notes are senior unsecured obligations and interest is payable in arrears. The following table provides a summary of the Company’s term debt as of September 28, 2019 and September 29, 2018 : Maturities (calendar year) 2019 2018 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013–2018 debt issuances: Floating-rate notes 2020 – 2022 $ 4,250 2.25 % – 3.28 % $ 7,107 1.87 % – 3.44 % Fixed-rate 0.350% – 4.650% notes 2019 – 2047 90,429 0.28 % – 4.78 % 97,086 0.28 % – 4.78 % 2019 debt issuance: Fixed-rate 1.700% – 2.950% notes 2022 – 2049 7,000 1.71 % – 2.99 % — — % Total term debt 101,679 104,193 Unamortized premium/(discount) and issuance costs, net ( 224 ) ( 218 ) Hedge accounting fair value adjustments 612 ( 1,456 ) Less: Current portion of term debt ( 10,260 ) ( 8,784 ) Total non-current portion of term debt $ 91,807 $ 93,735 To manage interest rate risk on certain of its U.S. dollar–denominated fixed- or floating-rate notes, the Company has entered into interest rate swaps to effectively convert the fixed interest rates to floating interest rates or the floating interest rates to fixed interest rates on a portion of these notes. Additionally, to manage foreign currency risk on certain of its foreign currency–denominated notes, the Company has entered into foreign currency swaps to effectively convert these notes to U.S. dollar–denominated notes. A portion of the Company’s Japanese yen–denominated notes is designated as a hedge of the foreign currency exposure of the Company’s net investment in a foreign operation. As of September 28, 2019 and September 29, 2018 , the carrying value of the debt designated as a net investment hedge was $ 1.0 billion and $ 811 million , respectively. For further discussion regarding the Company’s use of derivative instruments, refer to the Derivative Financial Instruments section of Note 3, “Financial Instruments.” The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $ 3.2 billion , $ 3.0 billion and $ 2.2 billion of interest cost on its term debt for 2019 , 2018 and 2017 , respectively. Apple Inc. | 2019 Form 10-K | 47 The future principal payments for the Company’s Notes as of September 28, 2019 are as follows (in millions): 2020 $ 10,270 2021 8,750 2022 9,528 2023 9,290 2024 10,039 Thereafter 53,802 Total term debt $ 101,679 As of September 28, 2019 and September 29, 2018 , the fair value of the Company’s Notes, based on Level 2 inputs, was $ 107.5 billion and $ 103.2 billion , respectively. Note 7 – Shareholders’ Equity Share Repurchase Program On April 30, 2019, the Company announced the Board of Directors increased the current share repurchase program authorization from $ 100 billion to $ 175 billion of the Company’s common stock, of which $ 96.1 billion had been utilized as of September 28, 2019 . During 2019 , the Company repurchased 345.2 million shares of its common stock for $ 67.1 billion , including 62.0 million shares delivered under a $ 12.0 billion accelerated share repurchase arrangement dated February 2019, which settled in August 2019. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Shares of Common Stock The following table shows the changes in shares of common stock for 2019 , 2018 and 2017 (in thousands): 2019 2018 2017 Common stock outstanding, beginning balances 4,754,986 5,126,201 5,336,166 Common stock repurchased ( 345,205 ) ( 405,549 ) ( 246,496 ) Common stock issued, net of shares withheld for employee taxes 33,455 34,334 36,531 Common stock outstanding, ending balances 4,443,236 4,754,986 5,126,201 Note 8 – Comprehensive Income The Company’s OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and unrealized gains and losses on marketable debt securities classified as available-for-sale. The following table shows the pre-tax amounts reclassified from AOCI into the Consolidated Statements of Operations, and the associated financial statement line item, for 2019 and 2018 (in millions): Comprehensive Income Components Financial Statement Line Item 2019 2018 Unrealized (gains)/losses on derivative instruments: Foreign exchange contracts Total net sales $ ( 206 ) $ 214 Total cost of sales ( 482 ) ( 70 ) Other income/(expense), net 784 344 Interest rate contracts Other income/(expense), net 7 ( 2 ) 103 486 Unrealized (gains)/losses on marketable securities Other income/(expense), net 31 ( 20 ) Total amounts reclassified from AOCI $ 134 $ 466 Apple Inc. | 2019 Form 10-K | 48 The following table shows the changes in AOCI by component for 2019 and 2018 (in millions): Cumulative Foreign Currency Translation Unrealized Gains/Losses on Derivative Instruments Unrealized Gains/Losses on Marketable Securities Total Balances as of September 30, 2017 $ ( 354 ) $ ( 124 ) $ 328 $ ( 150 ) Other comprehensive income/(loss) before reclassifications ( 524 ) 672 ( 4,563 ) ( 4,415 ) Amounts reclassified from AOCI — 486 ( 20 ) 466 Tax effect ( 1 ) ( 253 ) 1,177 923 Other comprehensive income/(loss) ( 525 ) 905 ( 3,406 ) ( 3,026 ) Cumulative effect of change in accounting principle ( 176 ) 29 ( 131 ) ( 278 ) Balances as of September 29, 2018 ( 1,055 ) 810 ( 3,209 ) ( 3,454 ) Other comprehensive income/(loss) before reclassifications ( 421 ) ( 949 ) 4,854 3,484 Amounts reclassified from AOCI — 103 31 134 Tax effect 13 208 ( 1,058 ) ( 837 ) Other comprehensive income/(loss) ( 408 ) ( 638 ) 3,827 2,781 Cumulative effect of change in accounting principle (1) — — 89 89 Balances as of September 28, 2019 $ ( 1,463 ) $ 172 $ 707 $ ( 584 ) (1) Refer to Note 1, “Summary of Significant Accounting Policies” for more information on the Company’s adoption of ASU 2016-01 in 2019. Note 9 – Benefit Plans 2014 Employee Stock Plan In the second quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the 2014 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. RSUs granted under the 2014 Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. RSUs canceled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the number of RSUs canceled or shares withheld. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 385 million shares plus the number of shares remaining that were reserved but not issued under the 2003 Plan. Shares subject to outstanding awards under the 2003 Plan that expire, are canceled or otherwise terminate, or are withheld to satisfy tax withholding obligations for RSUs, will also be available for awards under the 2014 Plan. As of September 28, 2019 , approximately 246.4 million shares were reserved for future issuance under the 2014 Plan. Apple Inc. Non-Employee Director Stock Plan The Apple Inc. Non-Employee Director Stock Plan (the “Director Plan”) is a shareholder-approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the value and relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants, in each case within the limits set forth in the Director Plan and without further shareholder approval. RSUs granted under the Director Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. The Director Plan expires on November 12, 2027 . All RSUs granted under the Director Plan are entitled to DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. As of September 28, 2019 , approximately 1.1 million shares were reserved for future issuance under the Director Plan. Apple Inc. | 2019 Form 10-K | 49 Rule 10b5-1 Trading Plans During the three months ended September 28, 2019 , Section 16 officers Timothy D. Cook, Chris Kondo, Luca Maestri, Deirdre O’Brien and Jeffrey Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired under the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder-approved plan under which substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85 % of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10 % of the employee’s compensation and employees may not purchase more than $ 25,000 of stock during any calendar year. As of September 28, 2019 , approximately 31.1 million shares were reserved for future issuance under the Purchase Plan. 401(k) Plan The Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ( $ 19,000 for calendar year 2019 ). The Company matches 50 % to 100 % of each employee’s contributions, depending on length of service, up to a maximum of 6 % of the employee’s eligible earnings. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2019 , 2018 and 2017 , is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per RSU Aggregate Fair Value (in millions) Balance as of September 24, 2016 99,089 $ 97.54 RSUs granted 50,112 $ 121.65 RSUs vested ( 45,735 ) $ 95.48 RSUs canceled ( 5,895 ) $ 106.87 Balance as of September 30, 2017 97,571 $ 110.33 RSUs granted 45,351 $ 162.86 RSUs vested ( 44,718 ) $ 111.24 RSUs canceled ( 6,049 ) $ 127.82 Balance as of September 29, 2018 92,155 $ 134.60 RSUs granted 36,852 $ 215.95 RSUs vested ( 42,088 ) $ 135.21 RSUs canceled ( 5,402 ) $ 162.85 Balance as of September 28, 2019 81,517 $ 169.18 $ 17,838 The fair value as of the respective vesting dates of RSUs was $ 8.6 billion , $ 7.6 billion and $ 6.1 billion for 2019 , 2018 and 2017 , respectively. The majority of RSUs that vested in 2019 , 2018 and 2017 were net share settled such that the Company withheld shares with a value equivalent to the employees’ obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 14.8 million , 16.0 million and 15.4 million for 2019 , 2018 and 2017 , respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $ 3.0 billion , $ 2.7 billion and $ 2.0 billion in 2019 , 2018 and 2017 , respectively. These net share settlements had the effect of share repurchases by the Company as they reduced the number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. Apple Inc. | 2019 Form 10-K | 50 Share-Based Compensation The following table shows share-based compensation expense and the related income tax benefit included in the Consolidated Statements of Operations for 2019 , 2018 and 2017 (in millions): 2019 2018 2017 Share-based compensation expense $ 6,068 $ 5,340 $ 4,840 Income tax benefit related to share-based compensation expense $ ( 1,967 ) $ ( 1,893 ) $ ( 1,632 ) As of September 28, 2019 , the total unrecognized compensation cost related to outstanding RSUs and stock options was $ 10.5 billion , which the Company expects to recognize over a weighted-average period of 2.5 years . Note 10 – Commitments and Contingencies Accrued Warranty and Guarantees The following table shows changes in the Company’s accrued warranties and related costs for 2019 , 2018 and 2017 (in millions): 2019 2018 2017 Beginning accrued warranty and related costs $ 3,692 $ 3,834 $ 3,702 Cost of warranty claims ( 3,857 ) ( 4,115 ) ( 4,322 ) Accruals for product warranty 3,735 3,973 4,454 Ending accrued warranty and related costs $ 3,570 $ 3,692 $ 3,834 The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within net sales. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets and other electronic devices. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Other Off–Balance Sheet Commitments Operating Leases The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off–balance sheet financing arrangements. As of September 28, 2019 , the Company’s total future minimum lease payments under noncancelable operating leases were $ 10.8 billion . The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. Apple Inc. | 2019 Form 10-K | 51 Rent expense under all operating leases, including both cancelable and noncancelable leases, was $ 1.3 billion , $ 1.2 billion and $ 1.1 billion in 2019 , 2018 and 2017 , respectively. Future minimum lease payments under noncancelable operating leases having initial or remaining terms in excess of one year as of September 28, 2019 , are as follows (in millions): 2020 $ 1,306 2021 1,276 2022 1,137 2023 912 2024 834 Thereafter 5,373 Total $ 10,838 Unconditional Purchase Obligations The Company has entered into certain off–balance sheet commitments that require the future purchase of goods or services (“unconditional purchase obligations”). The Company’s unconditional purchase obligations primarily consist of payments for supplier arrangements, Internet and telecommunication services, intellectual property licenses and content creation. Future payments under noncancelable unconditional purchase obligations having a remaining term in excess of one year as of September 28, 2019 , are as follows (in millions): 2020 $ 2,476 2021 2,386 2022 1,859 2023 1,162 2024 218 Thereafter 110 Total $ 8,211 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully resolved. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims, except for the following matters: VirnetX VirnetX, Inc. (“VirnetX”) filed two lawsuits in the U.S. District Court for the Eastern District of Texas (the “Eastern Texas District Court”) against the Company alleging that certain Company products infringe four patents (the “VirnetX Patents”) relating to network communications technology (“VirnetX I” and “VirnetX II”). On September 30, 2016, a jury returned a verdict in VirnetX I against the Company and awarded damages of $ 302 million , which later increased to $ 440 million in post-trial proceedings. The Company appealed the VirnetX I verdict to the U.S. Court of Appeals for the Federal Circuit (the “Federal Circuit”). On April 11, 2018, a jury returned a verdict in VirnetX II against the Company and awarded damages of $ 503 million . VirnetX II is currently on appeal. The Company has challenged the validity of the VirnetX Patents at the U.S. Patent and Trademark Office (the “PTO”). In response, the PTO has declared the VirnetX Patents invalid. VirnetX appealed the invalidity decision of the PTO to the Federal Circuit. The Federal Circuit consolidated the Company’s appeal of the Eastern Texas District Court VirnetX I verdict and VirnetX’s appeals from the PTO invalidity proceedings. On January 15, 2019, the Federal Circuit affirmed the VirnetX I verdict, which the Company intends to further appeal. On July 8, 2019, the Federal Circuit remanded one of VirnetX’s two appeals of the PTO’s invalidity decisions back to the PTO for further proceedings. On August 1, 2019, the Federal Circuit affirmed-in-part, vacated-in-part, and remanded back to the PTO portions of VirnetX’s second appeal. The Company has accrued its best estimate for the ultimate resolution of these matters. Apple Inc. | 2019 Form 10-K | 52 Qualcomm On January 20, 2017, the Company filed a lawsuit against Qualcomm Incorporated and affiliated parties (“Qualcomm”) in the U.S. District Court for the Southern District of California seeking, among other things, to enjoin Qualcomm from requiring the Company to pay royalties at the rate demanded by Qualcomm. No Qualcomm-related royalty payments had been remitted by the Company to its contract manufacturers since the beginning of the second quarter of 2017. Following the Company’s lawsuit, Qualcomm filed patent infringement suits against the Company and its affiliates in the U.S. and various international jurisdictions, some of which sought to enjoin the sale of certain of the Company’s products in particular countries. On April 16, 2019, the Company and Qualcomm reached a settlement agreement to dismiss all litigation between the two companies worldwide. The companies also reached a multi-year license agreement and a multi-year supply agreement. Under the terms of the settlement agreement, Apple made a payment to Qualcomm to, among other things, resolve disputes over the withheld royalty payments. iOS Performance Management Cases Various civil litigation matters have been filed in state and federal courts in the U.S. and in various international jurisdictions alleging violation of consumer protection laws, fraud, computer intrusion and other causes of action related to the Company’s performance management feature used in its iPhone operating systems, introduced to certain iPhones in iOS updates 10.2.1 and 11.2. The claims seek monetary damages and other non-monetary relief. On April 5, 2018, several U.S. federal actions were consolidated through a Multidistrict Litigation process into a single action in the U.S. District Court for the Northern District of California. In addition to civil litigation, the Company is also responding to governmental investigations and requests for information relating to the performance management feature. The Company believes that its iPhones were not defective, that the performance management feature introduced with iOS updates 10.2.1 and 11.2 was intended to, and did, improve customers’ user experience, and that the Company did not make any misleading statements or fail to disclose any material information. The Company has accrued its best estimate for the ultimate resolution of these matters. French Competition Authority In June 2019, the French Competition Authority (“FCA”) issued a report alleging that aspects of the Company’s sales and distribution practices in France violate French competition law. The Company vigorously disagrees with the allegations, and a hearing of arguments was held before the FCA on October 15, 2019. The Company is awaiting the decision of the FCA, which may include a fine. Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable segments. Costs excluded from segment operating income include various corporate expenses such as research and development, corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Apple Inc. | 2019 Form 10-K | 53 The following table shows information by reportable segment for 2019 , 2018 and 2017 (in millions): 2019 2018 2017 Americas: Net sales $ 116,914 $ 112,093 $ 96,600 Operating income $ 35,099 $ 34,864 $ 30,684 Europe: Net sales $ 60,288 $ 62,420 $ 54,938 Operating income $ 19,195 $ 19,955 $ 16,514 Greater China: Net sales $ 43,678 $ 51,942 $ 44,764 Operating income $ 16,232 $ 19,742 $ 17,032 Japan: Net sales $ 21,506 $ 21,733 $ 17,733 Operating income $ 9,369 $ 9,500 $ 8,097 Rest of Asia Pacific: Net sales $ 17,788 $ 17,407 $ 15,199 Operating income $ 6,055 $ 6,181 $ 5,304 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2019 , 2018 and 2017 is as follows (in millions): 2019 2018 2017 Segment operating income $ 85,950 $ 90,242 $ 77,631 Research and development expense ( 16,217 ) ( 14,236 ) ( 11,581 ) Other corporate expenses, net ( 5,803 ) ( 5,108 ) ( 4,706 ) Total operating income $ 63,930 $ 70,898 $ 61,344 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2019 , 2018 and 2017 . There was no single customer that accounted for more than 10% of net sales in 2019 , 2018 and 2017 . Net sales for 2019 , 2018 and 2017 and long-lived assets as of September 28, 2019 and September 29, 2018 were as follows (in millions): 2019 2018 2017 Net sales: U.S. $ 102,266 $ 98,061 $ 84,339 China (1) 43,678 51,942 44,764 Other countries 114,230 115,592 100,131 Total net sales $ 260,174 $ 265,595 $ 229,234 2019 2018 Long-lived assets: U.S. $ 24,711 $ 23,963 China (1) 9,064 13,268 Other countries 3,603 4,073 Total long-lived assets $ 37,378 $ 41,304 (1) China includes Hong Kong and Taiwan. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets related to retail stores and related infrastructure. Apple Inc. | 2019 Form 10-K | 54 Note 12 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters of 2019 and 2018 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2019: Total net sales $ 64,040 $ 53,809 $ 58,015 $ 84,310 Gross margin $ 24,313 $ 20,227 $ 21,821 $ 32,031 Net income $ 13,686 $ 10,044 $ 11,561 $ 19,965 Earnings per share (1) : Basic $ 3.05 $ 2.20 $ 2.47 $ 4.22 Diluted $ 3.03 $ 2.18 $ 2.46 $ 4.18 Fourth Quarter Third Quarter Second Quarter First Quarter 2018: Total net sales $ 62,900 $ 53,265 $ 61,137 $ 88,293 Gross margin $ 24,084 $ 20,421 $ 23,422 $ 33,912 Net income $ 14,125 $ 11,519 $ 13,822 $ 20,065 Earnings per share (1) : Basic $ 2.94 $ 2.36 $ 2.75 $ 3.92 Diluted $ 2.91 $ 2.34 $ 2.73 $ 3.89 (1) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. Apple Inc. | 2019 Form 10-K | 55 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 28, 2019 and September 29, 2018 , the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 28, 2019 , and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of Apple Inc. at September 28, 2019 and September 29, 2018 , and the results of its operations and its cash flows for each of the three years in the period ended September 28, 2019 , in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), Apple Inc.’s internal control over financial reporting as of September 28, 2019 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated October 30, 2019 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of Apple Inc.’s management. Our responsibility is to express an opinion on Apple Inc.’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. European Commission State Aid Matter Uncertain Tax Position Description of the Matter As discussed in Note 5 of the financial statements, the European Commission (“EC”) has announced its decision that Ireland granted state aid to Apple Inc. by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of Apple Inc. The decision ordered Ireland to calculate and recover additional taxes from Apple Inc. for the period from June 2003 through December 2014. The adjusted amount indicated by the EC to be recovered is up to €12.9 billion, plus interest. Auditing management’s evaluation of the uncertain tax position stemming from the effects of the EC decision is complex and highly judgmental due to the inherent uncertainty in predicting the ultimate resolution of the matter. Apple Inc. | 2019 Form 10-K | 56 How We Addressed the Matter in Our Audit We tested controls over the risk of material misstatement relating to the evaluation of the EC state aid matter, including management’s evaluation of the advice of legal counsel, the assessment as to whether Apple Inc.’s position is more likely than not to be sustained and the development of the related disclosure. To evaluate Apple Inc.’s assessment of whether sustainment of its position is a more likely than not outcome, including underlying assumptions, our audit procedures included, among others, reading the EC August 2016 ruling and available correspondence between Apple Inc. and the EC, and the EC and Ireland. We also requested and received internal and external legal counsel confirmation letters, discussed the allegations with internal and external legal counsel and Apple Inc. tax personnel and obtained a representation letter from Apple Inc. We involved our EC and tax subject matter resources in considering the applicable tax laws, the pending appeal, the current status of legal precedent relevant to that appeal and the proceedings at the court hearing in September 2019. In addition, we evaluated Apple Inc.’s disclosure included in Note 5 in relation to this matter. /s/ Ernst & Young LLP We have served as Apple Inc.’s auditor since 2009. San Jose, California October 30, 2019 Apple Inc. | 2019 Form 10-K | 57 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on Internal Control Over Financial Reporting We have audited Apple Inc.’s internal control over financial reporting as of September 28, 2019 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 28, 2019 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), the consolidated balance sheets of Apple Inc. as of September 28, 2019 and September 29, 2018 , the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 28, 2019 , and the related notes and our report dated October 30, 2019 expressed an unqualified opinion thereon. Basis for Opinion Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Apple Inc.’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California October 30, 2019 Apple Inc. | 2019 Form 10-K | 58 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 28, 2019 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 28, 2019 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2019 , which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information None. Apple Inc. | 2019 Form 10-K | 59 PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Corporate Governance,” “Directors,” “Executive Officers” and “Other Information—Security Ownership of Certain Beneficial Owners and Management” in the Company’s 2020 Proxy Statement to be filed with the SEC within 120 days after September 28, 2019 in connection with the solicitation of proxies for the Company’s 2020 annual meeting of shareholders, and is incorporated herein by reference. Item 11. Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation,” under the subheadings “Board Oversight of Risk Management” and “Compensation Committee Interlocks and Insider Participation” under the heading “Corporate Governance” and under the subheadings “Compensation of Directors” and “Director Compensation— 2019 ” under the heading “Directors” in the Company’s 2020 Proxy Statement to be filed with the SEC within 120 days after September 28, 2019 , and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Other Information—Security Ownership of Certain Beneficial Owners and Management” and “Other Information—Equity Compensation Plan Information” in the Company’s 2020 Proxy Statement to be filed with the SEC within 120 days after September 28, 2019 , and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the subheadings “Board Committees”, “Review, Approval, or Ratification of Transactions with Related Persons” and “Transactions with Related Persons” under the heading “Corporate Governance” in the Company’s 2020 Proxy Statement to be filed with the SEC within 120 days after September 28, 2019 , and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm” under the proposal “Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2020 Proxy Statement to be filed with the SEC within 120 days after September 28, 2019 , and is incorporated herein by reference. Apple Inc. | 2019 Form 10-K | 60 PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 29 Consolidated Statements of Comprehensive Income for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 30 Consolidated Balance Sheets as of September 28, 2019 and September 29, 2018 31 Consolidated Statements of Shareholders’ Equity for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 32 Consolidated Statements of Cash Flows for the years ended September 28, 2019, September 29, 2018 and September 30, 2017 33 Notes to Consolidated Financial Statements 34 Selected Quarterly Financial Information (Unaudited) 55 Reports of Independent Registered Public Accounting Firm 56 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant effective as of June 6, 2014. 8-K 3.1 6/6/14 3.2 Amended and Restated Bylaws of the Registrant effective as of December 13, 2016. 8-K 3.2 12/15/16 4.1** Description of Securities of the Registrant. 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of June 10, 2015, including forms of global notes representing the 0.350% Notes due 2020. 8-K 4.1 6/10/15 Apple Inc. | 2019 Form 10-K | 61 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.9 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.10 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 4.11 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.12 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.13 Officer’s Certificate of the Registrant, dated as of June 22, 2016, including form of global note representing 4.15% Notes due 2046. 8-K 4.1 6/22/16 4.14 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.15 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.16 Officer’s Certificate of the Registrant, dated as of March 3, 2017, including form of global note representing 4.300% Notes due 2047. 8-K 4.1 3/3/17 4.17 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.18 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.19 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.20 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.21 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 4.22 Officer’s Certificate of the Registrant, dated as of November 13, 2017, including forms of global notes representing the 1.800% Notes due 2019, 2.000% Notes due 2020, 2.400% Notes due 2023, 2.750% Notes due 2025, 3.000% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 11/13/17 4.23 Indenture, dated as of November 5, 2018, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 11/5/18 4.24 Officer’s Certificate of the Registrant, dated as of September 11, 2019, including forms of global notes representing the 1.700% Notes due 2022, 1.800% Notes due 2024, 2.050% Notes due 2026, 2.200% Notes due 2029 and 2.950% Notes due 2049. 8-K 4.1 9/11/19 4.25* Apple Inc. Deferred Compensation Plan. S-8 4.1 8/23/18 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* Apple Inc. Non-Employee Director Stock Plan, as amended and restated as of February 13, 2018. 8-K 10.1 2/14/18 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.6* 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10-K 10.8 9/30/17 Apple Inc. | 2019 Form 10-K | 62 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 10.7* Form of Amendment, effective as of August 26, 2014, to Restricted Stock Unit Award Agreements and Performance Award Agreements outstanding as of August 26, 2014. 10-K 10.13 9/27/14 10.8* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.16 3/26/16 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.18 9/24/16 10.10* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.20 9/30/17 10.11* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.21 9/30/17 10.12* Form of Restricted Stock Unit Award Agreement under Non-Employee Director Stock Plan effective as of February 13, 2018. 10-Q 10.2 3/31/18 10.13* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.17 9/29/18 10.14* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.18 9/29/18 10.15*, ** Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10.16*, ** Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101** Inline XBRL Document Set for the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. 104** Inline XBRL for the cover page of this Annual Report on Form 10-K, included in the Exhibit 101 Inline XBRL Document Set. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16. Form 10-K Summary None. Apple Inc. | 2019 Form 10-K | 63 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: October 30, 2019 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) October 30, 2019 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) October 30, 2019 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) October 30, 2019 CHRIS KONDO /s/ James A. Bell Director October 30, 2019 JAMES A. BELL /s/ Al Gore Director October 30, 2019 AL GORE /s/ Andrea Jung Director October 30, 2019 ANDREA JUNG /s/ Arthur D. Levinson Director October 30, 2019 ARTHUR D. LEVINSON /s/ Ronald D. Sugar Director October 30, 2019 RONALD D. SUGAR /s/ Susan L. Wagner Director October 30, 2019 SUSAN L. 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0000320193 country:CN 2020-09-26 0000320193 country:CN 2019-09-28 0000320193 aapl:OtherCountriesMember 2020-09-26 0000320193 aapl:OtherCountriesMember 2019-09-28 0000320193 srt:MinimumMember 2020-09-26 0000320193 srt:MaximumMember 2020-09-26 0000320193 2020-06-28 2020-09-26 0000320193 2020-03-29 2020-06-27 0000320193 2019-12-29 2020-03-28 0000320193 2019-09-29 2019-12-28 0000320193 2019-06-30 2019-09-28 0000320193 2019-03-31 2019-06-29 0000320193 2018-12-30 2019-03-30 0000320193 2018-09-30 2018-12-29 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 26, 2020 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) One Apple Park Way Cupertino , California 95014 (Address of principal executive offices) (Zip Code) ( 408 ) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading symbol(s) Name of each exchange on which registered Common Stock, $0.00001 par value per share AAPL The Nasdaq Stock Market LLC 1.000% Notes due 2022 — The Nasdaq Stock Market LLC 1.375% Notes due 2024 — The Nasdaq Stock Market LLC 0.000% Notes due 2025 — The Nasdaq Stock Market LLC 0.875% Notes due 2025 — The Nasdaq Stock Market LLC 1.625% Notes due 2026 — The Nasdaq Stock Market LLC 2.000% Notes due 2027 — The Nasdaq Stock Market LLC 1.375% Notes due 2029 — The Nasdaq Stock Market LLC 3.050% Notes due 2029 — The Nasdaq Stock Market LLC 0.500% Notes due 2031 — The Nasdaq Stock Market LLC 3.600% Notes due 2042 — The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 27, 2020, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $ 1,070,633,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 17,001,802,000 shares of common stock were issued and outstanding as of October 16, 2020. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2021 annual meeting of shareholders (the “2021 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2021 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 26, 2020 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 5 Item 1B. Unresolved Staff Comments 15 Item 2. Properties 15 Item 3. Legal Proceedings 16 Item 4. Mine Safety Disclosures 16 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 17 Item 6. Selected Financial Data 19 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 20 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 28 Item 8. Financial Statements and Supplementary Data 30 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 62 Item 9A. Controls and Procedures 62 Item 9B. Other Information 62 Part III Item 10. Directors, Executive Officers and Corporate Governance 63 Item 11. Executive Compensation 63 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 63 Item 13 . Certain Relationships and Related Transactions, and Director Independence 63 Item 14. Principal Accountant Fees and Services 63 Part IV Item 15. Exhibit and Financial Statement Schedules 64 Item 16. Form 10-K Summary 66 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. For example, statements in this Form 10-K regarding the potential future impact of the COVID-19 pandemic on the Company’s business and results of operations are forward-looking statements. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Unless otherwise stated, all information presented herein is based on the Company’s fiscal calendar, and references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly owned subsidiaries, unless otherwise stated. PART I Item 1.    Business Company Background The Company designs, manufactures and markets smartphones, personal computers, tablets, wearables and accessories, and sells a variety of related services. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company is a California corporation established in 1977. Products iPhone iPhone ® is the Company’s line of smartphones based on its iOS operating system. During 2020, the Company released a new iPhone SE. In October 2020, the Company announced four new iPhone models with 5G technology: iPhone 12 and iPhone 12 Pro were available starting in October 2020, and iPhone 12 Pro Max and iPhone 12 mini are both expected to be available in November 2020. Mac Mac ® is the Company’s line of personal computers based on its macOS ® operating system. During 2020, the Company released a new 16-inch MacBook Pro ® , a fully redesigned Mac Pro ® , and updated versions of its MacBook Air ® , 13-inch MacBook Pro and 27-inch iMac ® . iPad iPad ® is the Company’s line of multi-purpose tablets based on its iPadOS ® operating system. During 2020, the Company released an updated iPad Pro ® . In September 2020, the Company released an eighth-generation iPad and introduced an all-new iPad Air ® , which was available starting in October 2020. Wearables, Home and Accessories Wearables, Home and Accessories includes AirPods ® , Apple TV ® , Apple Watch ® , Beats ® products, HomePod ® , iPod touch ® and other Apple-branded and third-party accessories. AirPods are the Company’s wireless headphones that interact with Siri ® . During 2020, the Company released AirPods Pro ® . Apple Watch is the Company’s line of smart watches based on its watchOS ® operating system. In September 2020, the Company released Apple Watch Series 6 and a new Apple Watch SE. In October 2020, the Company announced HomePod mini™, which is expected to be available in November 2020. Services Advertising The Company’s advertising services include various third-party licensing arrangements and the Company’s own advertising platforms. Apple Inc. | 2020 Form 10-K | 1 AppleCare The Company offers a portfolio of fee-based service and support products under the AppleCare ® brand. The offerings provide priority access to Apple technical support, access to the global Apple authorized service network for repair and replacement services, and in many cases additional coverage for instances of accidental damage and/or theft and loss, depending on the country and type of product. Cloud Services The Company’s cloud services store and keep customers’ content up-to-date and available across multiple Apple devices and Windows personal computers. Digital Content The Company operates various platforms, including the App Store ® , that allow customers to discover and download applications and digital content, such as books, music, video, games and podcasts. The Company also offers digital content through subscription-based services, including Apple Arcade SM , a game subscription service; Apple Music ® , which offers users a curated listening experience with on-demand radio stations; Apple News+ SM , a subscription news and magazine service; and Apple TV+ SM , which offers exclusive original content. In September 2020, the Company announced Apple Fitness+ SM , a personalized fitness service built for Apple Watch, which is expected to be available before the end of calendar 2020. Payment Services The Company offers payment services, including Apple Card™, a co-branded credit card, and Apple Pay ® , a cashless payment service. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and resellers. During 2020, the Company’s net sales through its direct and indirect distribution channels accounted for 34% and 66%, respectively, of total net sales. No single customer accounted for more than 10% of net sales in 2020, 2019 and 2018. Competition The markets for the Company’s products and services are highly competitive, and are characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. Many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by emulating the Company’s products and infringing on its intellectual property. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. Principal competitive factors important to the Company include price, product and service features (including security features), relative price and performance, product and service quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support, and corporate reputation. Apple Inc. | 2020 Form 10-K | 2 The Company is focused on expanding its market opportunities related to smartphones, personal computers, tablets and other electronic devices and services. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software, and service offerings with large customer bases. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors may have the resources, experience or cost structures to provide products at little or no profit or even at a loss. The Company’s services compete with business models that provide content to users for free and use illegitimate means to obtain third-party digital content and applications. The Company expects competition in these markets to intensify significantly as competitors imitate the Company’s product features and applications within their products, or collaborate to offer integrated solutions that are more competitive than those they currently offer. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets and other electronic devices. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through research and development (“R&D”), licensing of intellectual property and acquisition of third-party businesses and technology. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, copyrights, trademarks, service marks, trade dress and other forms of intellectual property rights in the U.S. and various foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents, including utility patents, design patents and others. The Company also holds copyrights relating to certain aspects of its products and services. No single intellectual property right is solely responsible for protecting the Company’s products. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products. In addition to Company-owned intellectual property, many of the Company’s products and services are designed to include intellectual property owned by third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of the Company’s products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Apple Inc. | 2020 Form 10-K | 3 Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. The timing of product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new inventory following a product launch, and channel inventory of an older product often declines as the launch of a newer product approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. Employees As of September 26, 2020, the Company had approximately 147,000 full-time equivalent employees. Available Information The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities and Exchange Commission (the “SEC”). Such reports and other information filed by the Company with the SEC are available free of charge at investor.apple.com/investor-relations/sec-filings/default.aspx when such reports are available on the SEC’s website. The Company periodically provides other information for investors on its corporate website, www.apple.com, and its investor relations website, investor.apple.com. This includes press releases and other information about financial performance, information on corporate governance and details related to the Company’s annual meeting of shareholders. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2020 Form 10-K | 4 Item 1A.    Risk Factors The following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding other statements in this Form 10-K. The following information should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price. Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. The Company’s business, results of operations, financial condition and stock price have been adversely affected and could in the future be materially adversely affected by the COVID-19 pandemic. COVID-19 has spread rapidly throughout the world, prompting governments and businesses to take unprecedented measures in response. Such measures have included restrictions on travel and business operations, temporary closures of businesses, and quarantines and shelter-in-place orders. The COVID-19 pandemic has significantly curtailed global economic activity and caused significant volatility and disruption in global financial markets. The COVID-19 pandemic and the measures taken by many countries in response have adversely affected and could in the future materially adversely impact the Company’s business, results of operations, financial condition and stock price. Following the initial outbreak of the virus, the Company experienced disruptions to its manufacturing, supply chain and logistical services provided by outsourcing partners, resulting in temporary iPhone supply shortages that affected sales worldwide. During the course of the pandemic, the Company’s retail stores, as well as channel partner points of sale, have been temporarily closed at various times. In many cases, where stores and points of sale have reopened they are subject to operating restrictions to protect public health and the health and safety of employees and customers. The Company has at times required substantially all of its employees to work remotely. The Company is continuing to monitor the situation and take appropriate actions in accordance with the recommendations and requirements of relevant authorities. The full extent of the impact of the COVID-19 pandemic on the Company’s operational and financial performance is currently uncertain and will depend on many factors outside the Company’s control, including, without limitation, the timing, extent, trajectory and duration of the pandemic, the development and availability of effective treatments and vaccines, the imposition of and compliance with protective public safety measures, and the impact of the pandemic on the global economy and demand for consumer products. Additional future impacts on the Company may include, but are not limited to, material adverse effects on: demand for the Company’s products and services; the Company’s supply chain and sales and distribution channels; the Company’s ability to execute its strategic plans; and the Company’s profitability and cost structure. To the extent the COVID-19 pandemic adversely affects the Company’s business, results of operations, financial condition and stock price, it may also have the effect of heightening many of the other risks described in this Part I, Item 1A of this Form 10-K. Global and regional economic conditions could materially adversely affect the Company’s business, results of operations, financial condition and growth. The Company has international operations with sales outside the U.S. representing a majority of the Company’s total net sales. In addition, a majority of the Company’s supply chain, and its manufacturing and assembly activities, are located outside the U.S. As a result, the Company’s operations and performance depend significantly on global and regional economic conditions. Adverse macroeconomic conditions, including inflation, slower growth or recession, new or increased tariffs and other barriers to trade, changes to fiscal and monetary policy, tighter credit, higher interest rates, high unemployment and currency fluctuations could materially adversely affect demand for the Company’s products and services. In addition, consumer confidence and spending could be adversely affected in response to financial market volatility, negative financial news, conditions in the real estate and mortgage markets, declines in income or asset values, changes to fuel and other energy costs, labor and healthcare costs and other economic factors. Apple Inc. | 2020 Form 10-K | 5 In addition to an adverse impact on demand for the Company’s products, uncertainty about, or a decline in, global or regional economic conditions could have a significant impact on the Company’s suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. Potential effects include financial instability; inability to obtain credit to finance operations and purchases of the Company’s products; and insolvency. A downturn in the economic environment could also lead to increased credit and collectibility risk on the Company’s trade receivables; the failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair value of the Company’s financial instruments. These and other economic factors could materially adversely affect the Company’s business, results of operations, financial condition and growth. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services are offered in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. There can be no assurance that these investments will achieve expected returns, and the Company may not be able to develop and market new products and services successfully. The Company currently holds a significant number of patents, trademarks and copyrights and has registered, and applied to register, numerous patents, trademarks and copyrights. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by emulating the Company’s products and infringing on its intellectual property. Effective intellectual property protection may not be consistently available in every country in which the Company operates. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. The Company has a minority market share in the global smartphone, personal computer and tablet markets. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors may have the resources, experience or cost structures to provide products at little or no profit or even at a loss. Some of the markets in which the Company competes have from time to time experienced little to no growth or contracted overall. Additionally, the Company faces significant competition as competitors imitate the Company’s product features and applications within their products or collaborate to offer solutions that are more competitive than those they currently offer. The Company also expects competition to intensify as competitors imitate the Company’s approach to providing components seamlessly within their offerings or work collaboratively to offer integrated solutions. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve its products and services to maintain their functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. Apple Inc. | 2020 Form 10-K | 6 To remain competitive and stimulate customer demand, the Company must successfully manage frequent introductions and transitions of products and services. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and services, and successfully manage the transition to these new and upgraded products and services. The success of new product and service introductions depends on a number of factors including, but not limited to, timely and successful development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand, and the risk that new products and services may have quality or other defects or deficiencies. Accordingly, the Company cannot determine in advance the ultimate effect of new product and service introductions and transitions. The Company depends on the performance of carriers, wholesalers, retailers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, retailers and resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. Some carriers providing cellular network service for iPhone offer financing, installment payment plans or subsidies for users’ purchases of the device. There is no assurance that such offers will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs can require a substantial investment while not assuring return or incremental sales. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. The Company is exposed to the risk of write-downs on the value of its inventory and other assets, in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand, or for which cost exceeds net realizable value. The Company also accrues necessary cancellation fee reserves for orders of excess products and components. The Company reviews long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the assets may not be recoverable. If the Company determines that an impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently recoverable, no assurance can be given that the Company will not incur write-downs, fees, impairments and other charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company orders components for its products and builds inventory in advance of product announcements and shipments. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Apple Inc. | 2020 Form 10-K | 7 Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains certain components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. While the Company has entered into agreements for the supply of many components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. Component suppliers may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms. The effects of global or regional economic conditions on the Company’s suppliers, described in “ Global and regional economic conditions could materially adversely affect the Company’s business, results of operations, financial condition and growth, ” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, can be affected for any number of reasons, including if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the source, or to identify and obtain sufficient quantities from an alternative source. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. The Company has also outsourced much of its transportation and logistics management. While these arrangements can lower operating costs, they also reduce the Company’s direct control over production and distribution. Such diminished control may have an adverse effect on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for product defect expense reimbursement, the Company generally remains responsible to the consumer for warranty and out-of-warranty service in the event of product defects and could experience an unanticipated product defect liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on single-source outsourcing partners in the U.S., Asia and Europe to supply and manufacture many components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform can have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations can be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, military actions, economic, business, labor, environmental, public health or political issues, or international trade disputes. The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply can be reduced or terminated, and the recoverability of manufacturing process equipment or prepayments can be negatively impacted. Apple Inc. | 2020 Form 10-K | 8 The Company’s products and services may be affected from time to time by design and manufacturing defects that could materially adversely affect the Company’s business and result in harm to the Company’s reputation. The Company offers complex hardware and software products and services that can be affected by design and manufacturing defects. Sophisticated operating system software and applications, such as those offered by the Company, often have issues that can unexpectedly interfere with the intended operation of hardware or software products. Defects can also exist in components and products the Company purchases from third parties. Component defects could make the Company’s products unsafe and create a risk of environmental or property damage and personal injury. These risks may increase as the Company’s products are introduced into specialized applications, including healthcare. In addition, the Company’s service offerings may have quality issues and from time to time experience outages, service slowdowns or errors. As a result, the Company’s services may not perform as anticipated and may not meet customer expectations. There can be no assurance the Company will be able to detect and fix all issues and defects in the hardware, software and services it offers. Failure to do so could result in widespread technical and performance issues affecting the Company’s products and services. In addition, the Company can be exposed to product liability claims, recalls, product replacements or modifications, write-offs of inventory, property, plant and equipment, and/or intangible assets, and significant warranty and other expenses, including litigation costs and regulatory fines. Quality problems can also adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, delay in new product and service introductions and lost sales. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell currently available content. The licensing or other distribution arrangements with these third parties are for relatively short terms and do not guarantee the continuation or renewal of these arrangements on commercially reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and can take actions to make it more difficult or impossible for the Company to license or otherwise distribute their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at commercially reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make third-party digital content available, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s financial condition and operating results. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes the availability of third-party software applications and services for its products depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software and services for the Company’s products compared to competitors’ platforms, such as Android for smartphones and tablets and Windows for personal computers. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of product sales, and the costs of developing such applications and services. The Company’s minority market share in the global smartphone, personal computer and tablet markets could make developers less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for competitors’ products with larger market share. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices may suffer. Apple Inc. | 2020 Form 10-K | 9 The Company relies on the continued availability and development of compelling and innovative software applications for its products. The Company’s products and operating systems are subject to rapid technological change, and if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not take advantage of these changes to deliver improved customer experiences or might not operate correctly and may result in dissatisfied customers. The Company sells and delivers third-party applications for its products through the App Store. For the vast majority of applications, developers keep all of the revenue they generate on the App Store. The Company only retains a commission from sales of applications through its platforms and in situations where a developer offers purchases for digital features, services, or goods within an application. If developers reduce their use of the Company’s platforms, including in-app purchases, then the volume of sales, and the commission that the Company earns on those sales, would decrease. If the rate of the commission that the Company retains on such sales is reduced, or if it is otherwise narrowed in scope or eliminated, the Company’s financial condition and operating results could be materially adversely affected. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products and services are designed to include intellectual property owned by third parties, which requires licenses from those third parties. In addition, because of technological changes in the industries in which the Company currently competes or in the future may compete, current extensive patent coverage and the rapid rate of issuance of new patents, the Company’s products and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Based on experience and industry practice, the Company believes licenses to such third-party intellectual property can generally be obtained on commercially reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on commercially reasonable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products or services, or otherwise have a material adverse impact on the Company’s financial condition and operating results. The Company’s financial condition and operating results could be adversely impacted by unfavorable results of legal proceedings or government investigations. The Company is subject to various claims, legal proceedings and government investigations that have arisen in the ordinary course of business and have not yet been fully resolved, and new matters may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which can subject the Company to costs and damages in the event of a claim against an indemnified third party. The number of claims, legal proceedings and government investigations involving the Company, and the alleged magnitude of such claims, proceedings and government investigations, has generally increased over time and may continue to increase. The Company has faced and continues to face a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in several U.S. jurisdictions, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, defending against litigation or responding to government investigations can be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into agreements or other arrangements to settle litigation and resolve such challenges. No assurance can be given that such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements may also significantly increase the Company’s cost of sales and operating expenses. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims, including matters related to infringement of intellectual property rights. The outcome of litigation or government investigations is inherently uncertain. If one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company, and could require the Company to change its business practices or limit the Company’s ability to offer certain products and services, all of which could materially adversely affect its financial condition and operating results. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2020 Form 10-K | 10 The Company is subject to complex and changing laws and regulations worldwide, which exposes the Company to potential liabilities, increased costs and other adverse effects on the Company’s business. The Company’s global operations are subject to complex and changing laws and regulations on subjects including, but not limited to: antitrust; privacy, data security and data localization; consumer protection; advertising, sales, billing and e-commerce; product liability; intellectual property ownership and infringement; digital platforms; Internet, telecommunications, and mobile communications; media, television, film and digital content; availability of third-party software applications and services; labor and employment; anti-corruption; import, export and trade; foreign exchange controls and cash repatriation restrictions; anti–money laundering; foreign ownership and investment; tax; and environmental, health and safety. Compliance with these laws and regulations may be onerous and expensive, increasing the cost of conducting the Company’s global operations. Changes to laws and regulations can adversely affect the Company’s business by increasing the Company’s costs, limiting the Company’s ability to offer a product or service to customers, requiring changes to the Company’s supply chain and business practices or otherwise making the Company’s products and services less attractive to customers. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors or agents will not violate such laws and regulations or the Company’s policies and procedures. If the Company is found to have violated laws and regulations, it could materially adversely affect the Company’s reputation, financial condition and operating results. The technology industry, including, in some instances, the Company, is subject to intense media, political and regulatory scrutiny, which exposes the Company to government investigations, legal actions and penalties. For example, the Company is subject to antitrust investigations in various jurisdictions around the world, which can result in legal proceedings and claims against the Company that could, individually or in the aggregate, have a materially adverse impact on the Company’s financial condition and operating results. In addition, if enacted, legislative and other proposals to further regulate technology companies could result in changes to the Company’s business, including requiring the Company to modify its product and service offerings, limiting the Company’s ability to invest in strategic acquisitions, or affecting the Company’s business relationships with other technology companies, and could have a materially adverse impact on the Company’s financial condition and operating results. Further, the Company’s business partners are or may become subject to litigation that, if resolved against them, could affect the Company’s relationships with these business partners and have a materially adverse impact on the Company’s financial condition and operating results. There can be no assurance that the Company’s business will not be materially adversely affected, individually or in the aggregate, by the outcomes of such investigations, litigation or changes to laws and regulations in the future. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of an individual store or multiple stores, including as a result of protective public safety measures in response to the COVID-19 pandemic, could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. The Company’s retail operations are subject to many factors that pose risks and uncertainties and could adversely impact the Company’s financial condition and operating results, including macro-economic factors that could have an adverse effect on general retail activity. Other factors include, but are not limited to, the Company’s ability to: manage costs associated with retail store construction and operation; manage relationships with existing retail partners; manage costs associated with fluctuations in the value of retail inventory; and obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business, present risks not originally contemplated and adversely affect the Company’s reputation, financial condition and operating results. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater-than-expected liabilities and expenses, economic, political, legal and regulatory challenges associated with operating in new businesses, regions or countries, inadequate return on capital, potential impairment of tangible and intangible assets, and significant write-offs. These new ventures are inherently risky and may not be successful. The failure of any significant investment could adversely affect the Company’s reputation, financial condition and operating results. Apple Inc. | 2020 Form 10-K | 11 The Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company is exposed to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. System redundancy and other continuity measures may be ineffective or inadequate, and the Company’s business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions can adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s reputation, financial condition and operating results. There may be losses or unauthorized access to or releases of confidential information, including personally identifiable information, that could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information including, among other things, personally identifiable information (“PII”) with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s reputation, financial condition and operating results. The Company’s business also requires it to share confidential information with suppliers and other third parties. Although the Company takes steps to secure confidential information that is provided to third parties, such measures are not always effective and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s reputation, financial condition and operating results. For example, the Company may experience a security breach impacting the Company’s information technology systems that compromises the confidentiality, integrity or availability of confidential information. Such an incident could, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the Company’s stock price, materially damage supplier relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Although malicious attacks perpetrated to gain access to confidential information, including PII, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may, in turn, be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, may result in the delay or loss of customer orders or impede customer access to the Company’s products and services. In addition to the risks relating to general confidential information described above, the Company is also subject to specific obligations relating to health data and payment card data. Health data is subject to additional privacy, security and breach notification requirements, and the Company can be subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data is handled in a manner not permitted by law or under the Company’s agreements with healthcare institutions, the Company could be subject to litigation or government investigations, may be liable for associated investigatory expenses, and could also incur significant fees or fines. Under payment card rules and obligations, if cardholder information is potentially compromised, the Company could be liable for associated investigatory expenses and could also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which would materially adversely affect the Company’s reputation, financial condition and operating results. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2020 Form 10-K | 12 The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also may restrict transfers of PII among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of PII through its privacy policy, information provided on its website and press statements. Any failure by the Company to comply with these public statements or with other federal, state or international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. The Company’s success depends largely on the continued service and availability of key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. The Company’s business can be impacted by political events, international trade disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions. Political events, international trade disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions could harm or disrupt international commerce and the global economy, and could have a material adverse effect on the Company and its customers, suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. The Company has a large, global business, and the Company believes that it generally benefits from growth in international trade. International trade disputes can result in tariffs, sanctions, and other measures that restrict international trade and can adversely affect the Company’s business. For example, tensions between the U.S. and China have led to a series of tariffs being imposed by the U.S. on imports from China mainland, as well as other business restrictions. Tariffs may increase the cost of the Company’s products and the components and raw materials that go into making them. These increased costs adversely impact the gross margin that the Company earns on its products. Tariffs can also make the Company’s products more expensive for customers, which could make the Company’s products less competitive and reduce consumer demand. Countries may also adopt other measures, such as controls on imports or exports of goods, technology or data, that could adversely impact the Company’s operations and supply chain and limit the Company’s ability to offer its products and services as designed. These measures can require the Company to take various actions, including change suppliers, restructure business relationships, and stop offering third-party applications on its platforms. Changing the Company’s operations in accordance with new or changed trade restrictions may be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. Trade restrictions may be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. Political uncertainty surrounding international trade disputes could also have a negative effect on consumer confidence and spending, which could adversely affect the Company’s business. Many of the Company’s operations and facilities, as well as critical business operations of the Company’s suppliers and contract manufacturers, are in locations that are prone to earthquakes and other natural disasters. In addition, such operations and facilities are subject to the risk of interruption by fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, labor disputes, public health issues, including pandemics such as the COVID-19 pandemic, and other events beyond the Company’s control. Global climate change could result in certain types of natural disasters occurring more frequently or with more intense effects. Such events could make it difficult or impossible for the Company to manufacture and deliver products to its customers, create delays and inefficiencies in the Company’s supply and manufacturing chain, and result in slowdowns and outages to the Company’s service offerings. Following an interruption to its business, the Company could require substantial recovery time, experience significant expenditures to resume operations, and lose significant sales. Because the Company relies on single or limited sources for the supply and manufacture of many critical components, a business interruption affecting such sources would exacerbate any negative consequences to the Company. Apple Inc. | 2020 Form 10-K | 13 The Company’s operations are also subject to the risks of industrial accidents at its suppliers and contract manufacturers. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in disruption to the Company’s business and harm to the Company’s reputation. Major public health issues, including pandemics such as the COVID-19 pandemic, have adversely affected, and could in the future adversely affect, the Company due to their impact on the global economy and demand for consumer products; the imposition of protective public safety measures, such as stringent employee travel restrictions and limitations on freight services and the movement of products between regions; and disruptions in the Company’s supply chain and sales and distribution channels, resulting in interruptions of the supply of current products and delays in production ramps of new products. While the Company maintains insurance coverage for certain types of losses, such insurance coverage may be insufficient to cover all losses that may arise. The Company expects its quarterly net sales and operating results to fluctuate. The Company’s profit margins vary across its products, services, geographic segments and distribution channels. For example, the gross margins on the Company’s products and services vary significantly and can change over time. The Company’s gross margins are subject to volatility and downward pressure due to a variety of factors, including: continued industry-wide global product pricing pressures and product pricing actions that the Company may take in response to such pressures; increased competition; the Company’s ability to effectively stimulate demand for certain of its products and services; compressed product life cycles; potential increases in the cost of components, outside manufacturing services, and developing, acquiring and delivering content for the Company’s services; the Company’s ability to manage product quality and warranty costs effectively; shifts in the mix of products and services, or in the geographic, currency or channel mix; fluctuations in foreign exchange rates; and the introduction of new products or services, including new products or services with higher cost structures. These and other factors could have a materially adverse impact on the Company’s financial condition and operating results. The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. Further, the Company generates a significant portion of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments, such as lower-than-anticipated demand for the Company’s products or services, issues with new product or service introductions, information technology system failures or network disruptions, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock price has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its stock to exceed the stock’s price at a given point in time. The Company believes its stock price should reflect expectations of future growth and profitability. The Company also believes its stock price should reflect expectations that its cash dividend will continue at current levels or grow, and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employee retention. The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar relative to local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non–U.S. dollar–denominated sales, cost of sales and operating expenses worldwide. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers could be materially adversely affected by foreign currency exchange rate fluctuations. The weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency–denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise international pricing to offset the U.S. dollar’s strengthening, which would adversely affect the U.S. dollar value of the gross margins the Company earns on foreign currency–denominated sales. Apple Inc. | 2020 Form 10-K | 14 Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency–denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not be effective to offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the values of its investment portfolio. The Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, market and economic conditions, political risk, sovereign risk, interest rate fluctuations or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents, and marketable and non-marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents, and marketable and non-marketable securities, future fluctuations in their value could result in significant losses and could have a material adverse impact on the Company’s financial condition and operating results. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and resellers. The Company also sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party bank support or financing arrangements, or credit insurance, and a significant portion of the Company’s trade receivables can be concentrated within cellular network carriers or other resellers. The Company’s exposure to credit and collectibility risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 26, 2020, the Company’s vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, the introduction of new taxes, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition and operating results could be materially adversely affected. Item 1B.    Unresolved Staff Comments None. Item 2.    Properties The Company’s headquarters are located in Cupertino, California. As of September 26, 2020, the Company owned or leased facilities and land for corporate functions, R&D, data centers, retail and other purposes at locations throughout the U.S. and in various places outside the U.S. The Company believes its existing facilities and equipment, which are used by all reportable segments, are in good operating condition and are suitable for the conduct of its business. Apple Inc. | 2020 Form 10-K | 15 Item 3.    Legal Proceedings The Company is subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. The Company’s material legal proceedings are described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies.” The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. The Company settled certain matters during the fourth quarter of 2020 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Item 4.    Mine Safety Disclosures Not applicable. Apple Inc. | 2020 Form 10-K | 16 PART II Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on The Nasdaq Stock Market LLC under the symbol AAPL. Common Stock Split On August 28, 2020, the Company effected a four-for-one stock split to shareholders of record as of August 24, 2020. All share, restricted stock unit (“RSU”) and per share or per RSU information has been retroactively adjusted to reflect the stock split. Holders As of October 16, 2020, there were 22,797 shareholders of record. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 26, 2020 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) June 28, 2020 to August 1, 2020: Open market and privately negotiated purchases 67,990 $ 94.68 67,990 August 2, 2020 to August 29, 2020: May 2020 ASR 3,115 (2) 3,115 Open market and privately negotiated purchases 40,004 $ 115.99 40,004 August 30, 2020 to September 26, 2020: Open market and privately negotiated purchases 60,725 $ 114.00 60,725 Total 171,834 $ 56,353 (1) As of September 26, 2020, the Company was authorized to purchase up to $225 billion of the Company’s common stock under a share repurchase program announced on April 30, 2020, of which $168.6 billion had been utilized. The remaining $56.4 billion in the table represents the amount available to repurchase shares under the authorized repurchase program as of September 26, 2020. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In May 2020, the Company entered into an accelerated share repurchase arrangement (“ASR”) to purchase up to $6.0 billion of the Company’s common stock. In August 2020, the purchase period for this ASR ended and an additional 3 million shares were delivered and retired. In total, 64 million shares were delivered under this ASR at an average repurchase price of $94.14. Apple Inc. | 2020 Form 10-K | 17 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend-reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 26, 2020. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 25, 2015. Note that past stock price performance is not necessarily indicative of future stock price performance. * $100 invested on September 25, 2015 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2020 Standard & Poor’s, a division of S&P Global. All rights reserved. Copyright © 2020 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. September 2015 September 2016 September 2017 September 2018 September 2019 September 2020 Apple Inc. $ 100 $ 100 $ 140 $ 208 $ 204 $ 424 S&P 500 Index $ 100 $ 115 $ 137 $ 161 $ 168 $ 194 S&P Information Technology Index $ 100 $ 123 $ 158 $ 208 $ 226 $ 333 Dow Jones U.S. Technology Supersector Index $ 100 $ 122 $ 156 $ 205 $ 218 $ 325 Apple Inc. | 2020 Form 10-K | 18 Item 6.    Selected Financial Data The information set forth below for the five years ended September 26, 2020, is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes included in Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in thousands, and per share amounts). 2020 2019 2018 2017 2016 Total net sales $ 274,515 $ 260,174 $ 265,595 $ 229,234 $ 215,639 Net income $ 57,411 $ 55,256 $ 59,531 $ 48,351 $ 45,687 Earnings per share: Basic $ 3.31 $ 2.99 $ 3.00 $ 2.32 $ 2.09 Diluted $ 3.28 $ 2.97 $ 2.98 $ 2.30 $ 2.08 Cash dividends declared per share $ 0.795 $ 0.75 $ 0.68 $ 0.60 $ 0.545 Shares used in computing earnings per share: Basic 17,352,119 18,471,336 19,821,510 20,868,968 21,883,281 Diluted 17,528,214 18,595,651 20,000,435 21,006,767 22,001,126 Total cash, cash equivalents and marketable securities $ 191,830 $ 205,898 $ 237,100 $ 268,895 $ 237,585 Total assets $ 323,888 $ 338,516 $ 365,725 $ 375,319 $ 321,686 Non-current portion of term debt $ 98,667 $ 91,807 $ 93,735 $ 97,207 $ 75,427 Other non-current liabilities $ 54,490 $ 50,503 $ 48,914 $ 44,212 $ 39,986 Apple Inc. | 2020 Form 10-K | 19 Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in Part II, Item 8 of this Form 10-K. This section of this Form 10-K generally discusses 2020 and 2019 items and year-to-year comparisons between 2020 and 2019. Discussions of 2018 items and year-to-year comparisons between 2019 and 2018 that are not included in this Form 10-K can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended September 28, 2019. Fiscal Year Highlights COVID-19 Update COVID-19 has spread rapidly throughout the world, prompting governments and businesses to take unprecedented measures in response. Such measures have included restrictions on travel and business operations, temporary closures of businesses, and quarantines and shelter-in-place orders. The COVID-19 pandemic has significantly curtailed global economic activity and caused significant volatility and disruption in global financial markets. The COVID-19 pandemic and the measures taken by many countries in response have adversely affected and could in the future materially adversely impact the Company’s business, results of operations, financial condition and stock price. During 2020, aspects of the Company’s business were adversely affected by the COVID-19 pandemic, with many of the Company’s retail stores, as well as channel partner points of sale, temporarily closed at various times, and the vast majority of the Company’s employees working remotely. The Company has reopened some of its offices and the majority of its retail stores, subject to operating restrictions to protect public health and the health and safety of employees and customers, and it continues to work on safely re-opening the remainder of its offices and retail stores, subject to local rules and regulations. The full extent of the future impact of the COVID-19 pandemic on the Company’s operational and financial performance is currently uncertain and will depend on many factors outside the Company’s control, including, without limitation, the timing, extent, trajectory and duration of the pandemic, the development and availability of effective treatments and vaccines, the imposition of protective public safety measures, and the impact of the pandemic on the global economy and demand for consumer products. Refer to Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” for more information. The Company believes its existing balances of cash, cash equivalents and marketable securities, along with commercial paper and other short-term liquidity arrangements, will be sufficient to satisfy its working capital needs, capital asset purchases, dividends, share repurchases, debt repayments and other liquidity requirements associated with its existing operations. Fiscal 2020 Highlights Total net sales increased 6% or $14.3 billion during 2020 compared to 2019, primarily driven by higher net sales of Services and Wearables, Home and Accessories. The weakness in foreign currencies had an unfavorable impact on net sales during 2020. In April 2020, the Company announced an increase to its current share repurchase program authorization from $175 billion to $225 billion and raised its quarterly dividend from $0.1925 to $0.205 per share beginning in May 2020. During 2020, the Company repurchased $72.5 billion of its common stock and paid dividends and dividend equivalents of $14.1 billion. On August 28, 2020, the Company effected a four-for-one stock split to shareholders of record as of August 24, 2020. All share, RSU and per share or per RSU information has been retroactively adjusted to reflect the stock split. Apple Inc. | 2020 Form 10-K | 20 Products and Services Performance The following table shows net sales by category for 2020, 2019 and 2018 (dollars in millions): 2020 Change 2019 Change 2018 Net sales by category: iPhone (1) $ 137,781 (3) % $ 142,381 (14) % $ 164,888 Mac (1) 28,622 11 % 25,740 2 % 25,198 iPad (1) 23,724 11 % 21,280 16 % 18,380 Wearables, Home and Accessories (1)(2) 30,620 25 % 24,482 41 % 17,381 Services (3) 53,768 16 % 46,291 16 % 39,748 Total net sales $ 274,515 6 % $ 260,174 (2) % $ 265,595 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and Apple-branded and third-party accessories. (3) Services net sales include sales from the Company’s advertising, AppleCare, digital content and other services. Services net sales also include amortization of the deferred value of Maps, Siri, and free iCloud ® storage and Apple TV+ services, which are bundled in the sales price of certain products. iPhone iPhone net sales decreased during 2020 compared to 2019 due primarily to the absence of new iPhone models in the fourth quarter of 2020 and the weakness in foreign currencies relative to the U.S. dollar, partially offset by the introduction of iPhone SE in the third quarter of 2020. Mac Mac net sales increased during 2020 compared to 2019 due primarily to higher net sales of MacBook Pro. iPad iPad net sales increased during 2020 compared to 2019 due primarily to higher net sales of 10-inch versions of iPad, iPad Air and iPad Pro. Wearables, Home and Accessories Wearables, Home and Accessories net sales increased during 2020 compared to 2019 due primarily to higher net sales of AirPods and Apple Watch. Services Services net sales increased during 2020 compared to 2019 due primarily to higher net sales from the App Store, advertising and cloud services. Apple Inc. | 2020 Form 10-K | 21 Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” The following table shows net sales by reportable segment for 2020, 2019 and 2018 (dollars in millions): 2020 Change 2019 Change 2018 Net sales by reportable segment: Americas $ 124,556 7 % $ 116,914 4 % $ 112,093 Europe 68,640 14 % 60,288 (3) % 62,420 Greater China 40,308 (8) % 43,678 (16) % 51,942 Japan 21,418 — % 21,506 (1) % 21,733 Rest of Asia Pacific 19,593 10 % 17,788 2 % 17,407 Total net sales $ 274,515 6 % $ 260,174 (2) % $ 265,595 Americas Americas net sales increased during 2020 compared to 2019 due primarily to higher net sales of Services and Wearables, Home and Accessories. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Americas net sales during 2020. Europe Europe net sales increased during 2020 compared to 2019 due primarily to higher net sales of iPhone, Wearables, Home and Accessories and Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Europe net sales during 2020. Greater China Greater China net sales decreased during 2020 compared to 2019 due primarily to lower net sales of iPhone, partially offset by higher net sales of Services and iPad. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Greater China net sales during 2020. Japan Japan net sales were flat during 2020 compared to 2019 due primarily to lower net sales of iPhone, offset by higher net sales of Services and Wearables, Home and Accessories. The strength of the Japanese yen relative to the U.S. dollar had a favorable impact on Japan net sales during 2020. Rest of Asia Pacific Rest of Asia Pacific net sales increased during 2020 compared to 2019 due primarily to higher net sales of Wearables, Home and Accessories, Services and iPhone. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable impact on Rest of Asia Pacific net sales during 2020. Apple Inc. | 2020 Form 10-K | 22 Gross Margin Products and Services gross margin and gross margin percentage for 2020, 2019 and 2018 were as follows (dollars in millions): 2020 2019 2018 Gross margin: Products $ 69,461 $ 68,887 $ 77,683 Services 35,495 29,505 24,156 Total gross margin $ 104,956 $ 98,392 $ 101,839 Gross margin percentage: Products 31.5 % 32.2 % 34.4 % Services 66.0 % 63.7 % 60.8 % Total gross margin percentage 38.2 % 37.8 % 38.3 % Products Gross Margin Products gross margin increased during 2020 compared to 2019 due primarily to higher Products volume and material cost savings, partially offset by the weakness in foreign currencies relative to the U.S. dollar and a different Products mix. Products gross margin percentage decreased during 2020 compared to 2019 due primarily to the weakness in foreign currencies relative to the U.S. dollar and a different Products mix, partially offset by material cost savings and higher leverage. Services Gross Margin Services gross margin increased during 2020 compared to 2019 due primarily to higher Services net sales and a different Services mix. Services gross margin percentage increased during 2020 compared to 2019 due primarily to a different Services mix and higher leverage, partially offset by higher Services costs. The Company’s future gross margins can be impacted by a variety of factors, as set forth in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” As a result, the Company believes, in general, gross margins will be subject to volatility and remain under downward pressure. Operating Expenses Operating expenses for 2020, 2019 and 2018 were as follows (dollars in millions): 2020 Change 2019 Change 2018 Research and development $ 18,752 16 % $ 16,217 14 % $ 14,236 Percentage of total net sales 7 % 6 % 5 % Selling, general and administrative $ 19,916 9 % $ 18,245 9 % $ 16,705 Percentage of total net sales 7 % 7 % 6 % Total operating expenses $ 38,668 12 % $ 34,462 11 % $ 30,941 Percentage of total net sales 14 % 13 % 12 % Research and Development The year-over-year growth in R&D expense in 2020 was driven primarily by increases in headcount-related expenses. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products and services that are central to the Company’s core business strategy. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2020 was driven primarily by increases in headcount-related expenses, higher spending on marketing and advertising, and higher variable selling expenses. Apple Inc. | 2020 Form 10-K | 23 Other Income/(Expense), Net Other income/(expense), net (“OI&E”) for 2020, 2019 and 2018 was as follows (dollars in millions): 2020 Change 2019 Change 2018 Interest and dividend income $ 3,763 $ 4,961 $ 5,686 Interest expense (2,873) (3,576) (3,240) Other income/(expense), net (87) 422 (441) Total other income/(expense), net $ 803 (56) % $ 1,807 (10) % $ 2,005 The year-over-year decrease in OI&E during 2020 was due primarily to lower interest income and net impairment/gain activity on non-marketable securities, partially offset by lower interest expense. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.85% and 2.19% in 2020 and 2019, respectively. Provision for Income Taxes Provision for income taxes, effective tax rate and statutory federal income tax rate for 2020, 2019 and 2018 were as follows (dollars in millions): 2020 2019 2018 Provision for income taxes $ 9,680 $ 10,481 $ 13,372 Effective tax rate 14.4 % 15.9 % 18.3 % Statutory federal income tax rate 21 % 21 % 24.5 % The Company’s effective tax rate for both 2020 and 2019 was lower than the statutory federal income tax rate due primarily to the lower tax rate on foreign earnings, including the impact of tax settlements, and tax benefits from share-based compensation. The Company’s effective tax rate for 2020 was lower compared to 2019 due primarily to a one-time adjustment of U.S. foreign tax credits in response to regulations issued by the U.S. Department of the Treasury in December 2019 in connection with the U.S. Tax Cuts and Jobs Act of 2017 (the “Act”) and higher tax benefits from share-based compensation. As of September 26, 2020, the Company had net deferred tax assets arising from deductible temporary differences and tax credits of $11.0 billion and deferred tax liabilities of $2.8 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to recover the net deferred tax assets. The Company will continue to evaluate the amount of the valuation allowance, if any, by assessing the realizability of deferred tax assets. Recent Accounting Pronouncements Financial Instruments In June 2016, the Financial Accounting Standards Board issued Accounting Standards Update No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses on certain financial instruments. The Company will adopt ASU 2016-13 in its first quarter of 2021 utilizing the modified retrospective transition method. Based on the composition of the Company’s investment portfolio, current market conditions, and historical credit loss activity, the adoption of ASU 2016-13 will not have a material impact on its consolidated financial statements. Apple Inc. | 2020 Form 10-K | 24 Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended September 26, 2020, September 28, 2019 and September 29, 2018 (in millions): 2020 2019 2018 Cash, cash equivalents and marketable securities (1) $ 191,830 $ 205,898 $ 237,100 Property, plant and equipment, net $ 36,766 $ 37,378 $ 41,304 Commercial paper $ 4,996 $ 5,980 $ 11,964 Total term debt $ 107,440 $ 102,067 $ 102,519 Working capital $ 38,321 $ 57,101 $ 15,410 Cash generated by operating activities $ 80,674 $ 69,391 $ 77,434 Cash generated by/(used in) investing activities $ (4,289) $ 45,896 $ 16,066 Cash used in financing activities $ (86,820) $ (90,976) $ (87,876) (1) As of September 26, 2020 and September 28, 2019, total marketable securities included $18.6 billion and $18.9 billion, respectively, that was restricted from general use, related to the State Aid Decision (refer to Note 5, “Income Taxes” in the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K) and other agreements. The Company believes its existing balances of cash, cash equivalents and marketable securities, along with commercial paper and other short-term liquidity arrangements, will be sufficient to satisfy its working capital needs, capital asset purchases, dividends, share repurchases, debt repayments and other liquidity requirements associated with its existing operations over the next 12 months. In connection with the State Aid Decision, as of September 26, 2020, the adjusted recovery amount of €12.9 billion plus interest of €1.2 billion was funded into escrow, where it will remain restricted from general use pending the conclusion of all legal proceedings. Further information regarding the State Aid Decision can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 5, “Income Taxes.” The Company’s marketable securities investment portfolio is primarily invested in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. During 2020, cash generated by operating activities of $80.7 billion was a result of $57.4 billion of net income, non-cash adjustments to net income of $17.6 billion and an increase in the net change in operating assets and liabilities of $5.7 billion. Cash used in investing activities of $4.3 billion during 2020 consisted primarily of cash used to acquire property, plant and equipment of $7.3 billion and cash paid for business acquisitions, net of cash acquired, of $1.5 billion, partially offset by proceeds from maturities and sales of marketable securities, net of purchases, of $5.5 billion. Cash used in financing activities of $86.8 billion during 2020 consisted primarily of cash used to repurchase common stock of $72.4 billion, cash used to pay dividends and dividend equivalents of $14.1 billion, cash used to repay or redeem term debt of $12.6 billion and net repayments of commercial paper of $1.0 billion, partially offset by net proceeds from the issuance of term debt of $16.1 billion. During 2019, cash generated by operating activities of $69.4 billion was a result of $55.3 billion of net income and non-cash adjustments to net income of $17.6 billion, partially offset by a decrease in the net change in operating assets and liabilities of $3.5 billion. Cash generated by investing activities of $45.9 billion during 2019 consisted primarily of proceeds from sales and maturities of marketable securities, net of purchases, of $57.5 billion, partially offset by cash used to acquire property, plant and equipment of $10.5 billion. Cash used in financing activities of $91.0 billion during 2019 consisted primarily of cash used to repurchase common stock of $66.9 billion, cash used to pay dividends and dividend equivalents of $14.1 billion, cash used to repay term debt of $8.8 billion and net repayments of commercial paper of $6.0 billion, partially offset by net proceeds from the issuance of term debt of $7.0 billion. Debt The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses the net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 26, 2020, the Company had $5.0 billion of Commercial Paper outstanding, with a weighted-average interest rate of 0.62% and maturities generally less than nine months. The Company may enter into agreements to sell certain of its marketable securities with a promise to repurchase the securities at a specified time and amount as an additional short-term liquidity arrangement. Apple Inc. | 2020 Form 10-K | 25 As of September 26, 2020, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $106.1 billion (collectively the “Notes”). During 2020, the Company issued $16.1 billion and repaid or redeemed $12.6 billion of Notes. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on the Notes. In addition, the Company has entered, and in the future may enter, into foreign currency swaps to manage foreign currency risk on the Notes. Further information regarding the Company’s debt issuances and related hedging activity can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 3, “Financial Instruments” and Note 6, “Debt.” Capital Return Program As of September 26, 2020, the Company was authorized to purchase up to $225 billion of the Company’s common stock under a share repurchase program, of which $168.6 billion had been utilized. During 2020, the Company repurchased 917 million shares of its common stock for $72.5 billion, including 141 million shares delivered under a $10.0 billion November 2019 ASR and 64 million shares delivered under a $6.0 billion May 2020 ASR. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. As of September 26, 2020, the Company’s quarterly cash dividend was $0.205 per share. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Contractual Obligations The following table presents certain payments due by the Company as of September 26, 2020, and includes amounts already recorded on the Consolidated Balance Sheet, except for manufacturing purchase obligations, other purchase obligations and certain lease obligations (in millions): Payments due in 2021 Payments due in 2022–2023 Payments due in 2024–2025 Payments due after 2025 Total Term debt $ 8,750 $ 20,958 $ 21,029 $ 55,341 $ 106,078 Leases 1,622 3,097 2,352 5,888 12,959 Manufacturing purchase obligations (1) 47,961 1,849 61 40 49,911 Other purchase obligations 6,178 2,736 400 90 9,404 Deemed repatriation tax payable 1,533 5,923 12,955 9,254 29,665 Total $ 66,044 $ 34,563 $ 36,797 $ 70,613 $ 208,017 (1) Represents amount expected to be paid under manufacturing-related supplier arrangements, which are primarily noncancelable. Leases The Company has lease arrangements for certain equipment and facilities, including retail, corporate, manufacturing and data center space. The Company’s retail store and other facility leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options. The above contractual obligations table includes future payments under leases that had commenced as of September 26, 2020, and were therefore recorded on the Company’s Consolidated Balance Sheet, as well as leases that had been signed but not yet commenced as of September 26, 2020. Further information regarding the Company’s leases can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 12, “Leases.” Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Other Purchase Obligations The Company’s other purchase obligations consist of noncancelable obligations to acquire capital assets, including product tooling and manufacturing process equipment, and noncancelable obligations related to advertising, licensing, R&D, Internet and telecommunications services, content creation and other activities. Apple Inc. | 2020 Form 10-K | 26 Deemed Repatriation Tax Payable As of September 26, 2020, a significant portion of the other non-current liabilities in the Company’s Consolidated Balance Sheet consisted of the deemed repatriation tax payable imposed by the Act. The Company plans to pay the deemed repatriation tax payable in installments in accordance with the Act. Other Non-Current Liabilities The Company’s remaining other non-current liabilities primarily consist of items for which the Company is unable to make a reasonably reliable estimate of the timing or amount of payments; therefore, such amounts are not included in the above contractual obligations table. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported. Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation of manufacturing-related assets and estimation of inventory purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud, Siri and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative stand-alone selling prices (“SSPs”). Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. The Company’s process for determining estimated SSPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s SSPs and the future rate of related amortization for product-related bundled services and unspecified software upgrade rights related to future sales of these devices could change. Factors subject to change include the nature of the product-related bundled services and unspecified software upgrade rights offered, their estimated value and the estimated period they are expected to be provided. Valuation of Manufacturing-Related Assets and Estimation of Inventory Purchase Commitment Cancellation Fees The Company invests in manufacturing-related assets, including capital assets held at its suppliers’ facilities and prepayments provided to certain of its suppliers associated with long-term agreements to secure the supply of inventory. The Company also accrues estimated purchase commitment cancellation fees related to inventory orders that have been canceled or are expected to be canceled. The Company’s estimates of future product development plans and demand for its products are key inputs in determining the recoverability of manufacturing-related assets and assessing the adequacy of any purchase commitment cancellation fee accruals. If there is an abrupt and substantial decline in estimated demand for one or more of the Company’s products, a change in the Company’s product development plans, or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record write-downs or impairments of manufacturing-related assets or accrue purchase commitment cancellation fees. Apple Inc. | 2020 Form 10-K | 27 Warranty Costs The Company offers limited warranties on its new and certified refurbished hardware products and on parts used to repair its hardware products, and customers may purchase extended service coverage, where available, on many of the Company’s hardware products. The Company accrues the estimated cost of warranties in the period the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost per claim and knowledge of specific product failures outside the Company’s typical experience. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required. Income Taxes The Company recognizes tax benefits from uncertain tax positions if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are measured based on the largest benefit that has a greater-than-50% likelihood of being realized upon ultimate settlement. The calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Except as described in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Item 7A.    Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. The Company’s investment policy and strategy are focused on the preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 26, 2020 and September 28, 2019, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $3.1 billion and $2.8 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. Apple Inc. | 2020 Form 10-K | 28 As of September 26, 2020 and September 28, 2019, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $107.4 billion and $102.1 billion, respectively. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on term debt are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 26, 2020 and September 28, 2019 to increase by $218 million and $325 million on an annualized basis, respectively. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and in the future may enter, into foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign currency–denominated debt issuances. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. To provide an assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $551 million as of September 26, 2020, compared to a maximum one-day loss in fair value of $452 million as of September 28, 2019. Because the Company uses foreign currency instruments for hedging purposes, the losses in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio, debt and derivative positions may differ materially from the sensitivity analyses performed as of September 26, 2020 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchange rates and the Company’s actual exposures and positions. Apple Inc. | 2020 Form 10-K | 29 Item 8.    Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 26 , 20 20 , September 28 , 201 9 and September 29 , 201 8 31 Consolidated Statements of Comprehensive Income for the years ended September 26, 2020, September 28, 2019 and September 29, 2018 32 Consolidated Balance Sheets as of Septe mber 26, 2020 and September 28, 2019 33 Consolidated Statements of Shareholders’ Equity for the years ended S eptember 26, 2020, September 28, 2019 and September 29, 2018 34 Consolidated Statements of Cash Flows for the years ended S eptember 26, 2020, September 28, 2019 and September 29, 2018 35 Notes to Consolidated Financial Statements 36 Selected Quarterly Financial Information (Unaudited) 57 Reports of Independent Registered Public Accounting Firm 59 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes. Apple Inc. | 2020 Form 10-K | 30 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 26, 2020 September 28, 2019 September 29, 2018 Net sales: Products $ 220,747 $ 213,883 $ 225,847 Services 53,768 46,291 39,748 Total net sales 274,515 260,174 265,595 Cost of sales: Products 151,286 144,996 148,164 Services 18,273 16,786 15,592 Total cost of sales 169,559 161,782 163,756 Gross margin 104,956 98,392 101,839 Operating expenses: Research and development 18,752 16,217 14,236 Selling, general and administrative 19,916 18,245 16,705 Total operating expenses 38,668 34,462 30,941 Operating income 66,288 63,930 70,898 Other income/(expense), net 803 1,807 2,005 Income before provision for income taxes 67,091 65,737 72,903 Provision for income taxes 9,680 10,481 13,372 Net income $ 57,411 $ 55,256 $ 59,531 Earnings per share: Basic $ 3.31 $ 2.99 $ 3.00 Diluted $ 3.28 $ 2.97 $ 2.98 Shares used in computing earnings per share: Basic 17,352,119 18,471,336 19,821,510 Diluted 17,528,214 18,595,651 20,000,435 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2020 Form 10-K | 31 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 26, 2020 September 28, 2019 September 29, 2018 Net income $ 57,411 $ 55,256 $ 59,531 Other comprehensive income/(loss): Change in foreign currency translation, net of tax 88 ( 408 ) ( 525 ) Change in unrealized gains/losses on derivative instruments, net of tax: Change in fair value of derivatives 79 ( 661 ) 523 Adjustment for net (gains)/losses realized and included in net income ( 1,264 ) 23 382 Total change in unrealized gains/losses on derivative instruments ( 1,185 ) ( 638 ) 905 Change in unrealized gains/losses on marketable debt securities, net of tax: Change in fair value of marketable debt securities 1,202 3,802 ( 3,407 ) Adjustment for net (gains)/losses realized and included in net income ( 63 ) 25 1 Total change in unrealized gains/losses on marketable debt securities 1,139 3,827 ( 3,406 ) Total other comprehensive income/(loss) 42 2,781 ( 3,026 ) Total comprehensive income $ 57,453 $ 58,037 $ 56,505 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2020 Form 10-K | 32 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 26, 2020 September 28, 2019 ASSETS: Current assets: Cash and cash equivalents $ 38,016 $ 48,844 Marketable securities 52,927 51,713 Accounts receivable, net 16,120 22,926 Inventories 4,061 4,106 Vendor non-trade receivables 21,325 22,878 Other current assets 11,264 12,352 Total current assets 143,713 162,819 Non-current assets: Marketable securities 100,887 105,341 Property, plant and equipment, net 36,766 37,378 Other non-current assets 42,522 32,978 Total non-current assets 180,175 175,697 Total assets $ 323,888 $ 338,516 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 42,296 $ 46,236 Other current liabilities 42,684 37,720 Deferred revenue 6,643 5,522 Commercial paper 4,996 5,980 Term debt 8,773 10,260 Total current liabilities 105,392 105,718 Non-current liabilities: Term debt 98,667 91,807 Other non-current liabilities 54,490 50,503 Total non-current liabilities 153,157 142,310 Total liabilities 258,549 248,028 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $ 0.00001 par value: 50,400,000 shares authorized; 16,976,763 and 17,772,945 shares issued and outstanding, respectively 50,779 45,174 Retained earnings 14,966 45,898 Accumulated other comprehensive income/(loss) ( 406 ) ( 584 ) Total shareholders’ equity 65,339 90,488 Total liabilities and shareholders’ equity $ 323,888 $ 338,516 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2020 Form 10-K | 33 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except per share amounts) Years ended September 26, 2020 September 28, 2019 September 29, 2018 Total shareholders’ equity, beginning balances $ 90,488 $ 107,147 $ 134,047 Common stock and additional paid-in capital: Beginning balances 45,174 40,201 35,867 Common stock issued 880 781 669 Common stock withheld related to net share settlement of equity awards ( 2,250 ) ( 2,002 ) ( 1,778 ) Share-based compensation 6,975 6,194 5,443 Ending balances 50,779 45,174 40,201 Retained earnings: Beginning balances 45,898 70,400 98,330 Net income 57,411 55,256 59,531 Dividends and dividend equivalents declared ( 14,087 ) ( 14,129 ) ( 13,735 ) Common stock withheld related to net share settlement of equity awards ( 1,604 ) ( 1,029 ) ( 948 ) Common stock repurchased ( 72,516 ) ( 67,101 ) ( 73,056 ) Cumulative effects of changes in accounting principles ( 136 ) 2,501 278 Ending balances 14,966 45,898 70,400 Accumulated other comprehensive income/(loss): Beginning balances ( 584 ) ( 3,454 ) ( 150 ) Other comprehensive income/(loss) 42 2,781 ( 3,026 ) Cumulative effects of changes in accounting principles 136 89 ( 278 ) Ending balances ( 406 ) ( 584 ) ( 3,454 ) Total shareholders’ equity, ending balances $ 65,339 $ 90,488 $ 107,147 Dividends and dividend equivalents declared per share or RSU $ 0.795 $ 0.75 $ 0.68 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2020 Form 10-K | 34 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 26, 2020 September 28, 2019 September 29, 2018 Cash, cash equivalents and restricted cash, beginning balances $ 50,224 $ 25,913 $ 20,289 Operating activities: Net income 57,411 55,256 59,531 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 11,056 12,547 10,903 Share-based compensation expense 6,829 6,068 5,340 Deferred income tax benefit ( 215 ) ( 340 ) ( 32,590 ) Other ( 97 ) ( 652 ) ( 444 ) Changes in operating assets and liabilities: Accounts receivable, net 6,917 245 ( 5,322 ) Inventories ( 127 ) ( 289 ) 828 Vendor non-trade receivables 1,553 2,931 ( 8,010 ) Other current and non-current assets ( 9,588 ) 873 ( 423 ) Accounts payable ( 4,062 ) ( 1,923 ) 9,175 Deferred revenue 2,081 ( 625 ) ( 3 ) Other current and non-current liabilities 8,916 ( 4,700 ) 38,449 Cash generated by operating activities 80,674 69,391 77,434 Investing activities: Purchases of marketable securities ( 114,938 ) ( 39,630 ) ( 71,356 ) Proceeds from maturities of marketable securities 69,918 40,102 55,881 Proceeds from sales of marketable securities 50,473 56,988 47,838 Payments for acquisition of property, plant and equipment ( 7,309 ) ( 10,495 ) ( 13,313 ) Payments made in connection with business acquisitions, net ( 1,524 ) ( 624 ) ( 721 ) Purchases of non-marketable securities ( 210 ) ( 1,001 ) ( 1,871 ) Proceeds from non-marketable securities 92 1,634 353 Other ( 791 ) ( 1,078 ) ( 745 ) Cash generated by/(used in) investing activities ( 4,289 ) 45,896 16,066 Financing activities: Proceeds from issuance of common stock 880 781 669 Payments for taxes related to net share settlement of equity awards ( 3,634 ) ( 2,817 ) ( 2,527 ) Payments for dividends and dividend equivalents ( 14,081 ) ( 14,119 ) ( 13,712 ) Repurchases of common stock ( 72,358 ) ( 66,897 ) ( 72,738 ) Proceeds from issuance of term debt, net 16,091 6,963 6,969 Repayments of term debt ( 12,629 ) ( 8,805 ) ( 6,500 ) Repayments of commercial paper, net ( 963 ) ( 5,977 ) ( 37 ) Other ( 126 ) ( 105 ) — Cash used in financing activities ( 86,820 ) ( 90,976 ) ( 87,876 ) Increase/(Decrease) in cash, cash equivalents and restricted cash ( 10,435 ) 24,311 5,624 Cash, cash equivalents and restricted cash, ending balances $ 39,789 $ 50,224 $ 25,913 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 9,501 $ 15,263 $ 10,417 Cash paid for interest $ 3,002 $ 3,423 $ 3,022 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2020 Form 10-K | 35 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Basis of Presentation and Preparation The consolidated financial statements include the accounts of Apple Inc. and its wholly owned subsidiaries (collectively “Apple” or the “Company”). Intercompany accounts and transactions have been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these consolidated financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2020, 2019 and 2018 spanned 52 weeks each. An additional week is included in the first fiscal quarter every five or six years to realign the Company’s fiscal quarters with calendar quarters. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Common Stock Split On August 28, 2020, the Company effected a four -for-one stock split to shareholders of record as of August 24, 2020. All share, restricted stock unit (“RSU”) and per share or per RSU information has been retroactively adjusted to reflect the stock split. Recently Adopted Accounting Pronouncements Leases At the beginning of the first quarter of 2020, the Company adopted the Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), and additional ASUs issued to clarify and update the guidance in ASU 2016-02 (collectively, the “new leases standard”), which modifies lease accounting for lessees to increase transparency and comparability by recording lease assets and liabilities for operating leases and disclosing key information about leasing arrangements. The Company adopted the new leases standard utilizing the modified retrospective transition method, under which amounts in prior periods presented were not restated. For contracts existing at the time of adoption, the Company elected to not reassess (i) whether any are or contain leases, (ii) lease classification, and (iii) initial direct costs. Upon adoption, the Company recorded $ 7.5 billion of right-of-use (“ROU”) assets and $ 8.1 billion of lease liabilities on its Condensed Consolidated Balance Sheet. Hedging At the beginning of the first quarter of 2020, the Company adopted FASB ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities (“ASU 2017-12”). ASU 2017-12 expands component and fair value hedging, specifies the presentation of the effects of hedging instruments, eliminates the separate measurement and presentation of hedge ineffectiveness, and updates disclosure requirements related to hedging. The Company adopted ASU 2017-12 utilizing the modified retrospective transition method. Upon adoption, the Company recorded a $ 136 million increase in accumulated other comprehensive income/(loss) (“AOCI”) and a corresponding decrease in retained earnings in the Condensed Consolidated Statement of Shareholders’ Equity. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Share-Based Compensation The Company generally measures share-based compensation based on the closing price of the Company’s common stock on the date of grant, and recognizes expense on a straight-line basis for its estimate of equity awards that will ultimately vest. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Apple Inc. | 2020 Form 10-K | 36 Earnings Per Share The following table shows the computation of basic and diluted earnings per share for 2020, 2019 and 2018 (net income in millions and shares in thousands): 2020 2019 2018 Numerator: Net income $ 57,411 $ 55,256 $ 59,531 Denominator: Weighted-average basic shares outstanding 17,352,119 18,471,336 19,821,510 Effect of dilutive securities 176,095 124,315 178,925 Weighted-average diluted shares 17,528,214 18,595,651 20,000,435 Basic earnings per share $ 3.31 $ 2.99 $ 3.00 Diluted earnings per share $ 3.28 $ 2.97 $ 2.98 The Company applies the treasury stock method to determine the dilutive effect of potentially dilutive securities. Potentially dilutive securities representing 62 million shares of common stock were excluded from the computation of diluted earnings per share for 2019 because their effect would have been antidilutive. Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s investments in marketable debt securities have been classified and accounted for as available-for-sale. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Unrealized gains and losses on marketable debt securities classified as available-for-sale are recognized in other comprehensive income/(loss) (“OCI”). The Company’s investments in marketable equity securities are classified based on the nature of the securities and their availability for use in current operations. The Company’s marketable equity securities are measured at fair value with gains and losses recognized in other income/(expense), net (“OI&E”). The cost of securities sold is determined using the specific identification method. Inventories Inventories are measured using the first-in, first-out method. Property, Plant and Equipment Depreciation on property, plant and equipment is recognized on a straight-line basis over the estimated useful lives of the assets, which for buildings is the lesser of 40 years or the remaining life of the building; between one and five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease term or useful life for leasehold improvements. Capitalized costs related to internal-use software are amortized on a straight-line basis over the estimated useful lives of the assets, which range from three to seven years . Depreciation and amortization expense on property and equipment was $ 9.7 billion, $ 11.3 billion and $ 9.3 billion during 2020, 2019 and 2018, respectively. Non-cash investing activities involving property, plant and equipment resulted in a net increase/(decrease) to accounts payable and other current liabilities of $( 2.9 ) billion and $ 3.4 billion during 2019 and 2018, respectively. Apple Inc. | 2020 Form 10-K | 37 Non-Marketable Securities The Company has elected to apply the measurement alternative to equity securities without readily determinable fair values. As such, the Company’s non-marketable equity securities are measured at cost, less any impairment, and are adjusted for changes in fair value resulting from observable transactions for identical or similar investments of the same issuer. Gains and losses on non-marketable equity securities are recognized in OI&E. Restricted Cash and Restricted Marketable Securities The Company considers cash and marketable securities to be restricted when withdrawal or general use is legally restricted. The Company reports restricted cash as other assets in the Consolidated Balance Sheets, and determines current or non-current classification based on the expected duration of the restriction. The Company reports restricted marketable securities as current or non-current marketable securities in the Consolidated Balance Sheets based on the classification of the underlying securities. Fair Value Measurements The fair values of the Company’s money market funds and certain marketable equity securities are based on quoted prices in active markets for identical assets. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, which generally have counterparties with high credit ratings, are based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. Note 2 – Revenue Recognition Net sales consist of revenue from the sale of iPhone, Mac, iPad, Services and other products. The Company recognizes revenue at the amount to which it expects to be entitled when control of the products or services is transferred to its customers. Control is generally transferred when the Company has a present right to payment and title and the significant risks and rewards of ownership of products or services are transferred to its customers. For most of the Company’s Products net sales, control transfers when products are shipped. For the Company’s Services net sales, control transfers over time as services are delivered. Payment for Products and Services net sales is collected within a short period following transfer of control or commencement of delivery of services, as applicable. The Company records reductions to Products net sales related to future product returns, price protection and other customer incentive programs based on the Company’s expectations and historical experience. For arrangements with multiple performance obligations, which represent promises within an arrangement that are distinct, the Company allocates revenue to all distinct performance obligations based on their relative stand-alone selling prices (“SSPs”). When available, the Company uses observable prices to determine SSPs. When observable prices are not available, SSPs are established that reflect the Company’s best estimates of what the selling prices of the performance obligations would be if they were sold regularly on a stand-alone basis. The Company’s process for estimating SSPs without observable prices considers multiple factors that may vary depending upon the unique facts and circumstances related to each performance obligation including, where applicable, prices charged by the Company for similar offerings, market trends in the pricing for similar offerings, product-specific business objectives and the estimated cost to provide the performance obligation. The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud, Siri and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative SSPs. Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the delivered hardware and bundled software is recognized when control has transferred to the customer, which generally occurs when the product is shipped. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. Cost of sales related to delivered hardware and bundled software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide product-related bundled services and unspecified software upgrade rights are recognized as cost of sales as incurred. For certain long-term service arrangements, the Company has performance obligations for services it has not yet delivered. For these arrangements, the Company does not have a right to bill for the undelivered services. The Company has determined that any unbilled consideration relates entirely to the value of the undelivered services. Accordingly, the Company has not recognized revenue, and has elected not to disclose amounts, related to these undelivered services. Apple Inc. | 2020 Form 10-K | 38 For the sale of third-party products where the Company obtains control of the product before transferring it to the customer, the Company recognizes revenue based on the gross amount billed to customers. The Company considers multiple factors when determining whether it obtains control of third-party products including, but not limited to, evaluating if it can establish the price of the product, retains inventory risk for tangible products or has the responsibility for ensuring acceptability of the product. For third-party applications sold through the App Store and certain digital content sold through the Company’s other digital content stores, the Company does not obtain control of the product before transferring it to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in Services net sales only the commission it retains. The Company has elected to record revenue net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded within other current liabilities until remitted to the relevant government authority. Deferred Revenue As of September 26, 2020 and September 28, 2019, the Company had total deferred revenue of $ 10.2 billion and $ 8.1 billion, respectively. As of September 26, 2020, the Company expects 65 % of total deferred revenue to be realized in less than a year, 25 % within one-to-two years, 8 % within two-to-three years and 2 % in greater than three years. Disaggregated Revenue Net sales disaggregated by significant products and services for 2020, 2019 and 2018 were as follows (in millions): 2020 2019 2018 iPhone (1) $ 137,781 $ 142,381 $ 164,888 Mac (1) 28,622 25,740 25,198 iPad (1) 23,724 21,280 18,380 Wearables, Home and Accessories (1)(2) 30,620 24,482 17,381 Services (3) 53,768 46,291 39,748 Total net sales (4) $ 274,515 $ 260,174 $ 265,595 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and Apple-branded and third-party accessories. (3) Services net sales include sales from the Company’s advertising, AppleCare, digital content and other services. Services net sales also include amortization of the deferred value of Maps, Siri, and free iCloud storage and Apple TV+ services, which are bundled in the sales price of certain products. (4) Includes $ 5.0 billion of revenue recognized in 2020 that was included in deferred revenue as of September 28, 2019, $ 5.9 billion of revenue recognized in 2019 that was included in deferred revenue as of September 29, 2018, and $ 5.8 billion of revenue recognized in 2018 that was included in deferred revenue as of September 30, 2017. The Company’s proportion of net sales by disaggregated revenue source was generally consistent for each reportable segment in Note 11, “Segment Information and Geographic Data” for 2020, 2019 and 2018. Apple Inc. | 2020 Form 10-K | 39 Note 3 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and marketable securities by significant investment category as of September 26, 2020 and September 28, 2019 (in millions): 2020 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 17,773 $ — $ — $ 17,773 $ 17,773 $ — $ — Level 1 (1) : Money market funds 2,171 — — 2,171 2,171 — — Subtotal 2,171 — — 2,171 2,171 — — Level 2 (2) : U.S. Treasury securities 28,439 331 — 28,770 8,580 11,972 8,218 U.S. agency securities 8,604 8 — 8,612 2,009 3,078 3,525 Non-U.S. government securities 19,361 275 ( 186 ) 19,450 255 3,329 15,866 Certificates of deposit and time deposits 10,399 — — 10,399 4,043 6,246 110 Commercial paper 11,226 — — 11,226 3,185 8,041 — Corporate debt securities 76,937 1,834 ( 175 ) 78,596 — 19,687 58,909 Municipal securities 1,001 22 — 1,023 — 139 884 Mortgage- and asset-backed securities 13,520 314 ( 24 ) 13,810 — 435 13,375 Subtotal 169,487 2,784 ( 385 ) 171,886 18,072 52,927 100,887 Total (3) $ 189,431 $ 2,784 $ ( 385 ) $ 191,830 $ 38,016 $ 52,927 $ 100,887 2019 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 12,204 $ — $ — $ 12,204 $ 12,204 $ — $ — Level 1 (1) : Money market funds 15,897 — — 15,897 15,897 — — Subtotal 15,897 — — 15,897 15,897 — — Level 2 (2) : U.S. Treasury securities 30,293 33 ( 62 ) 30,264 6,165 9,817 14,282 U.S. agency securities 9,767 1 ( 3 ) 9,765 6,489 2,249 1,027 Non-U.S. government securities 19,821 337 ( 50 ) 20,108 749 3,168 16,191 Certificates of deposit and time deposits 4,041 — — 4,041 2,024 1,922 95 Commercial paper 12,433 — — 12,433 5,193 7,240 — Corporate debt securities 85,383 756 ( 92 ) 86,047 123 26,127 59,797 Municipal securities 958 8 ( 1 ) 965 — 68 897 Mortgage- and asset-backed securities 14,180 67 ( 73 ) 14,174 — 1,122 13,052 Subtotal 176,876 1,202 ( 281 ) 177,797 20,743 51,713 105,341 Total (3) $ 204,977 $ 1,202 $ ( 281 ) $ 205,898 $ 48,844 $ 51,713 $ 105,341 (1) Level 1 fair value estimates are based on quoted prices in active markets for identical assets or liabilities. (2) Level 2 fair value estimates are based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. (3) As of September 26, 2020 and September 28, 2019, total marketable securities included $ 18.6 billion and $ 18.9 billion, respectively, that was restricted from general use, related to the State Aid Decision (refer to Note 5, “Income Taxes”) and other agreements. Apple Inc. | 2020 Form 10-K | 40 The Company may sell certain of its marketable debt securities prior to their stated maturities for reasons including, but not limited to, managing liquidity, credit risk, duration and asset allocation. The maturities of the Company’s non-current marketable debt securities generally range from one to five years . The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. Fair values were determined for each individual security in the investment portfolio. When evaluating a marketable debt security for other-than-temporary impairment, the Company reviews factors such as the duration and extent to which the fair value of the security is less than its cost, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. As of September 26, 2020, the Company does not consider any of its marketable debt securities to be other-than-temporarily impaired. Non-Marketable Securities The Company holds non-marketable equity securities of certain privately held companies without readily determinable fair values. As of September 26, 2020 and September 28, 2019, the Company’s non-marketable equity securities had a carrying value of $ 2.8 billion and $ 2.9 billion, respectively. Restricted Cash A reconciliation of the Company’s cash and cash equivalents in the Consolidated Balance Sheets to cash, cash equivalents and restricted cash in the Consolidated Statements of Cash Flows as of September 26, 2020 and September 28, 2019 is as follows (in millions): 2020 2019 Cash and cash equivalents $ 38,016 $ 48,844 Restricted cash included in other current assets 36 23 Restricted cash included in other non-current assets 1,737 1,357 Cash, cash equivalents and restricted cash $ 39,789 $ 50,224 The Company’s restricted cash primarily consisted of cash to support the Company’s iPhone Upgrade Program. Derivative Financial Instruments The Company may use derivatives to partially offset its business exposure to foreign currency and interest rate risk on expected future cash flows, net investments in certain foreign subsidiaries, and certain existing assets and liabilities. However, the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange or interest rates. To protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar may hedge a portion of forecasted foreign currency revenue, and subsidiaries whose functional currency is not the U.S. dollar may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company may enter into forward contracts, option contracts or other instruments to manage this risk and may designate these instruments as cash flow hedges. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. To protect the net investment in a foreign operation from fluctuations in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset a portion of the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. In addition, the Company may use non-derivative financial instruments, such as its foreign currency–denominated debt, as hedges of its net investments in certain foreign subsidiaries. In both of these cases, the Company designates these instruments as net investment hedges. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, cross-currency swaps or other instruments. These instruments may offset a portion of the foreign currency remeasurement gains or losses, or changes in fair value. The Company may designate these instruments as either cash flow or fair value hedges. As of September 26, 2020, the Company’s hedged term debt– and marketable securities–related foreign currency transactions are expected to be recognized within 22 years. The Company may also enter into non-designated foreign currency contracts to offset a portion of the foreign currency exchange gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. Apple Inc. | 2020 Form 10-K | 41 To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in interest rates, the Company may enter into interest rate swaps, options or other instruments. These instruments may offset a portion of the changes in interest income or expense, or changes in fair value. The Company designates these instruments as either cash flow or fair value hedges. As of September 26, 2020, the Company’s hedged interest rate transactions are expected to be recognized within seven years . Cash Flow Hedges Cash flow hedge amounts that are included in the assessment of hedge effectiveness are deferred in AOCI until the hedged item is recognized in earnings. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow hedges of interest income or expense are recognized in OI&E in the same period as the related income or expense is recognized. For options designated as cash flow hedges, the time value is excluded from the assessment of hedge effectiveness and recognized in the financial statement line item to which the hedge relates on a straight-line basis over the life of the hedge. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in OCI. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified into OI&E in the period of de-designation. Any subsequent changes in fair value of such derivative instruments are reflected in OI&E unless they are re-designated as hedges of other transactions. Net Investment Hedges Net investment hedge amounts that are included in the assessment of hedge effectiveness are recorded in OCI as a part of the cumulative translation adjustment. For foreign exchange forward contracts designated as net investment hedges, the forward carry component is excluded from the assessment of hedge effectiveness and recognized in OCI on a straight-line basis over the life of the hedge. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in OCI. Fair Value Hedges Fair value hedge gains and losses related to amounts that are included in the assessment of hedge effectiveness are recognized in earnings along with a corresponding loss or gain related to the change in value of the hedged item in the same line in the Consolidated Statements of Operations. For foreign exchange forward contracts designated as fair value hedges, the forward carry component is excluded from the assessment of hedge effectiveness and recognized in OI&E on a straight-line basis over the life of the hedge. Amounts excluded from the effectiveness assessment of fair value hedges and recognized in OI&E were gains of $ 465 million and $ 777 million for 2020 and 2019, respectively. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in OCI. Non-Designated Derivatives Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. The Company records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these derivative instruments is based on its hedge designation. The following tables show the Company’s derivative instruments at gross fair value as of September 26, 2020 and September 28, 2019 (in millions): 2020 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 749 $ 303 $ 1,052 Interest rate contracts $ 1,557 $ — $ 1,557 Derivative liabilities (2) : Foreign exchange contracts $ 1,561 $ 485 $ 2,046 Apple Inc. | 2020 Form 10-K | 42 2019 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,798 $ 323 $ 2,121 Interest rate contracts $ 685 $ — $ 685 Derivative liabilities (2) : Foreign exchange contracts $ 1,341 $ 160 $ 1,501 Interest rate contracts $ 105 $ — $ 105 (1) The fair value of derivative assets is measured using Level 2 fair value inputs and is included in other current assets and other non-current assets in the Consolidated Balance Sheets. (2) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is included in other current liabilities and other non-current liabilities in the Consolidated Balance Sheets. The Company classifies cash flows related to derivative financial instruments as operating activities in its Consolidated Statements of Cash Flows. The following table shows the pre-tax gains and losses of the Company’s derivative and non-derivative instruments designated as cash flow and fair value hedges in OCI and the Consolidated Statements of Operations for 2020, 2019 and 2018 (in millions): 2020 2019 2018 Gains/(Losses) recognized in OCI – included in effectiveness assessment: Cash flow hedges: Foreign exchange contracts $ 365 $ ( 959 ) $ 682 Interest rate contracts ( 57 ) — 1 Total $ 308 $ ( 959 ) $ 683 Net investment hedges: Foreign currency debt $ 15 $ ( 58 ) $ 4 Gains/(Losses) reclassified from AOCI into net income – included in effectiveness assessment: Cash flow hedges: Foreign exchange contracts $ 1,553 $ ( 116 ) $ ( 482 ) Interest rate contracts ( 8 ) ( 7 ) 1 Total $ 1,545 $ ( 123 ) $ ( 481 ) The amount excluded from the effectiveness assessment of the Company’s hedges and recognized in OCI was a loss of $ 168 million for 2020. Apple Inc. | 2020 Form 10-K | 43 The following tables show information about the Company’s derivative instruments designated as fair value hedges and the related hedged items for 2020, 2019 and 2018 and as of September 26, 2020 (in millions): 2020 2019 2018 Gains/(Losses) on derivative instruments (1) : Foreign exchange contracts $ ( 992 ) $ 1,020 $ ( 168 ) Interest rate contracts 1,114 2,068 ( 1,363 ) Total $ 122 $ 3,088 $ ( 1,531 ) Gains/(Losses) related to hedged items (1) : Marketable securities $ 991 $ ( 1,018 ) $ 167 Fixed-rate debt ( 1,114 ) ( 2,068 ) 1,363 Total $ ( 123 ) $ ( 3,086 ) $ 1,530 2020 Carrying amounts of hedged assets/(liabilities): Marketable securities (2) $ 16,270 Fixed-rate debt (3) $ ( 21,033 ) Cumulative hedging adjustments included in the carrying amounts of hedged items: Marketable securities carrying amount increases/(decreases) $ 493 Fixed-rate debt carrying amount (increases)/decreases $ ( 1,541 ) (1) Gains and losses related to fair value hedges are included in OI&E in the Consolidated Statements of Operations. (2) The carrying amounts of marketable securities that are designated as hedged items in fair value hedges are included in current marketable securities and non-current marketable securities in the Consolidated Balance Sheet. (3) The carrying amounts of fixed-rate debt instruments that are designated as hedged items in fair value hedges are included in current term debt and non-current term debt in the Consolidated Balance Sheet. The following table shows the notional amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of September 26, 2020 and September 28, 2019 (in millions): 2020 2019 Notional Amount Credit Risk Amount Notional Amount Credit Risk Amount Instruments designated as accounting hedges: Foreign exchange contracts $ 57,410 $ 749 $ 61,795 $ 1,798 Interest rate contracts $ 20,700 $ 1,557 $ 31,250 $ 685 Instruments not designated as accounting hedges: Foreign exchange contracts $ 88,636 $ 303 $ 76,868 $ 323 The notional amounts for outstanding derivative instruments provide one measure of the transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s exposure to credit loss and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. Apple Inc. | 2020 Form 10-K | 44 The Company generally enters into master netting arrangements, which are designed to reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values in its Consolidated Balance Sheets. As of September 26, 2020 and September 28, 2019, the net cash collateral received by the Company related to derivative instruments under its collateral security arrangements was $ 875 million and $ 1.6 billion, respectively. The Company includes gross collateral posted and received in other current assets and other current liabilities in the Consolidated Balance Sheets, respectively. Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net settle transactions with a single net amount payable by one party to the other. As of September 26, 2020 and September 28, 2019, the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $ 2.8 billion and $ 2.7 billion, respectively, resulting in net derivative liabilities of $ 312 million and $ 407 million, respectively. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral or third-party credit support in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of both September 26, 2020 and September 28, 2019, the Company had no customers that individually represented 10% or more of total trade receivables. The Company’s cellular network carriers accounted for 51 % of total trade receivables as of September 28, 2019. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. As of September 26, 2020, the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 57 % and 11 %. As of September 28, 2019, the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 59 % and 14 %. Note 4 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 26, 2020 and September 28, 2019 (in millions): Property, Plant and Equipment, Net 2020 2019 Land and buildings $ 17,952 $ 17,085 Machinery, equipment and internal-use software 75,291 69,797 Leasehold improvements 10,283 9,075 Gross property, plant and equipment 103,526 95,957 Accumulated depreciation and amortization ( 66,760 ) ( 58,579 ) Total property, plant and equipment, net $ 36,766 $ 37,378 Other Non-Current Liabilities 2020 2019 Long-term taxes payable $ 28,170 $ 29,545 Other non-current liabilities 26,320 20,958 Total other non-current liabilities $ 54,490 $ 50,503 Apple Inc. | 2020 Form 10-K | 45 Other Income/(Expense), Net The following table shows the detail of OI&E for 2020, 2019 and 2018 (in millions): 2020 2019 2018 Interest and dividend income $ 3,763 $ 4,961 $ 5,686 Interest expense ( 2,873 ) ( 3,576 ) ( 3,240 ) Other income/(expense), net ( 87 ) 422 ( 441 ) Total other income/(expense), net $ 803 $ 1,807 $ 2,005 Note 5 – Income Taxes U.S. Tax Cuts and Jobs Act On December 22, 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which significantly changed U.S. tax law. The Act lowered the Company’s U.S. statutory federal income tax rate from 35 % to 21 % effective January 1, 2018, while also imposing a deemed repatriation tax on previously deferred foreign income. The Act also created a new minimum tax on certain foreign earnings, for which the Company has elected to record certain deferred tax assets and liabilities. Provision for Income Taxes and Effective Tax Rate The provision for income taxes for 2020, 2019 and 2018, consisted of the following (in millions): 2020 2019 2018 Federal: Current $ 6,306 $ 6,384 $ 41,425 Deferred ( 3,619 ) ( 2,939 ) ( 33,819 ) Total 2,687 3,445 7,606 State: Current 455 475 551 Deferred 21 ( 67 ) 48 Total 476 408 599 Foreign: Current 3,134 3,962 3,986 Deferred 3,383 2,666 1,181 Total 6,517 6,628 5,167 Provision for income taxes $ 9,680 $ 10,481 $ 13,372 The foreign provision for income taxes is based on foreign pre-tax earnings of $ 38.1 billion, $ 44.3 billion and $ 48.0 billion in 2020, 2019 and 2018, respectively. A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate ( 21 % in 2020 and 2019; 24.5 % in 2018) to income before provision for income taxes for 2020, 2019 and 2018, is as follows (dollars in millions): 2020 2019 2018 Computed expected tax $ 14,089 $ 13,805 $ 17,890 State taxes, net of federal effect 423 423 271 Impacts of the Act ( 582 ) — 1,515 Earnings of foreign subsidiaries ( 2,534 ) ( 2,625 ) ( 5,606 ) Research and development credit, net ( 728 ) ( 548 ) ( 560 ) Excess tax benefits from equity awards ( 930 ) ( 639 ) ( 675 ) Other ( 58 ) 65 537 Provision for income taxes $ 9,680 $ 10,481 $ 13,372 Effective tax rate 14.4 % 15.9 % 18.3 % Apple Inc. | 2020 Form 10-K | 46 Deferred Tax Assets and Liabilities As of September 26, 2020 and September 28, 2019, the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2020 2019 Deferred tax assets: Amortization and depreciation $ 8,317 $ 11,645 Accrued liabilities and other reserves 4,934 5,196 Lease liabilities 2,038 — Deferred revenue 1,638 1,372 Other 2,409 2,174 Total deferred tax assets 19,336 20,387 Less: Valuation allowance ( 1,041 ) ( 747 ) Total deferred tax assets, net 18,295 19,640 Deferred tax liabilities: Minimum tax on foreign earnings 7,045 10,809 Right-of-use assets 1,862 — Unrealized gains 526 186 Other 705 600 Total deferred tax liabilities 10,138 11,595 Net deferred tax assets $ 8,157 $ 8,045 Deferred tax assets and liabilities reflect the effects of tax credits and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Uncertain Tax Positions As of September 26, 2020, the total amount of gross unrecognized tax benefits was $ 16.5 billion, of which $ 8.8 billion, if recognized, would impact the Company’s effective tax rate. As of September 28, 2019, the total amount of gross unrecognized tax benefits was $ 15.6 billion, of which $ 8.6 billion, if recognized, would have impacted the Company’s effective tax rate. The aggregate change in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2020, 2019 and 2018, is as follows (in millions): 2020 2019 2018 Beginning balances $ 15,619 $ 9,694 $ 8,407 Increases related to tax positions taken during a prior year 454 5,845 2,431 Decreases related to tax positions taken during a prior year ( 791 ) ( 686 ) ( 2,212 ) Increases related to tax positions taken during the current year 1,347 1,697 1,824 Decreases related to settlements with taxing authorities ( 85 ) ( 852 ) ( 756 ) Decreases related to expiration of the statute of limitations ( 69 ) ( 79 ) — Ending balances $ 16,475 $ 15,619 $ 9,694 The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisdictions. The U.S. Internal Revenue Service (the “IRS”) concluded its review of the years 2013 through 2015 in 2018, and all years before 2016 are closed. Tax years after 2014 remain open in certain major foreign jurisdictions and are subject to examination by the taxing authorities. The Company believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner inconsistent with its expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although the timing of resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease in the next 12 months by as much as $ 3.9 billion. Apple Inc. | 2020 Form 10-K | 47 Interest and Penalties The Company includes interest and penalties related to income tax matters within the provision for income taxes. As of September 26, 2020 and September 28, 2019, the total amount of gross interest and penalties accrued was $ 1.4 billion and $ 1.3 billion, respectively. The Company recognized interest and penalty expense in 2020, 2019 and 2018 of $ 85 million, $ 73 million and $ 489 million, respectively. European Commission State Aid Decision On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The recovery amount was calculated to be € 13.1 billion, plus interest of € 1.2 billion. The Company and Ireland appealed the State Aid Decision to the General Court of the Court of Justice of the European Union (the “General Court”). On July 15, 2020, the General Court annulled the State Aid Decision. On September 25, 2020, the European Commission appealed the General Court’s decision to the European Court of Justice. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes, subject to any foreign tax credit limitations in the Act. On an annual basis, the Company may request approval from the Irish Minister for Finance to reduce the recovery amount for certain taxes paid to other countries. As of September 26, 2020, the adjusted recovery amount was € 12.9 billion, excluding interest. The adjusted recovery amount plus interest is funded into escrow, where it will remain restricted from general use pending the conclusion of all legal proceedings. Refer to the Cash, Cash Equivalents and Marketable Securities section of Note 3, “Financial Instruments” for more information. Note 6 – Debt Commercial Paper and Repurchase Agreements The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 26, 2020 and September 28, 2019, the Company had $ 5.0 billion and $ 6.0 billion of Commercial Paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 0.62 % and 2.24 % as of September 26, 2020 and September 28, 2019, respectively. The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2020, 2019 and 2018 (in millions): 2020 2019 2018 Maturities 90 days or less: Proceeds from/(Repayments of) commercial paper, net $ 100 $ ( 3,248 ) $ 1,044 Maturities greater than 90 days: Proceeds from commercial paper 6,185 13,874 14,555 Repayments of commercial paper ( 7,248 ) ( 16,603 ) ( 15,636 ) Repayments of commercial paper, net ( 1,063 ) ( 2,729 ) ( 1,081 ) Total repayments of commercial paper, net $ ( 963 ) $ ( 5,977 ) $ ( 37 ) In 2020, the Company entered into agreements to sell certain of its marketable securities with a promise to repurchase the securities at a specified time and amount (“Repos”). Due to the Company’s continuing involvement with the marketable securities, the Company accounted for its Repos as collateralized borrowings. The Company entered into $ 5.2 billion of Repos during 2020, all of which had been settled as of September 26, 2020. Apple Inc. | 2020 Form 10-K | 48 Term Debt As of September 26, 2020, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $ 106.1 billion (collectively the “Notes”). The Notes are senior unsecured obligations and interest is payable in arrears. The following table provides a summary of the Company’s term debt as of September 26, 2020 and September 28, 2019: Maturities (calendar year) 2020 2019 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 – 2019 debt issuances: Floating-rate notes 2021 – 2022 $ 2,250 0.60 % – 1.39 % $ 4,250 2.25 % – 3.28 % Fixed-rate 0.375 % – 4.650 % notes 2020 – 2049 87,487 0.28 % – 4.78 % 97,429 0.28 % – 4.78 % First quarter 2020 debt issuance of € 2.0 billion: Fixed-rate 0.000 % – 0.500 % notes 2025 – 2031 2,341 0.03 % – 0.56 % — — % Third quarter 2020 debt issuance of $ 8.5 billion: Fixed-rate 0.750 % – 2.650 % notes 2023 – 2050 8,500 0.84 % – 2.72 % — — % Fourth quarter 2020 debt issuance of $ 5.5 billion: Fixed-rate 0.550 % – 2.550 % notes 2025 – 2060 5,500 0.60 % – 2.59 % — — % Total term debt 106,078 101,679 Unamortized premium/(discount) and issuance costs, net ( 314 ) ( 224 ) Hedge accounting fair value adjustments 1,676 612 Less: Current portion of term debt ( 8,773 ) ( 10,260 ) Total non-current portion of term debt $ 98,667 $ 91,807 To manage interest rate risk on certain of its U.S. dollar–denominated fixed- or floating-rate notes, the Company has entered into interest rate swaps to effectively convert the fixed interest rates to floating interest rates or the floating interest rates to fixed interest rates on a portion of these notes. Additionally, to manage foreign currency risk on certain of its foreign currency–denominated notes, the Company has entered into foreign currency swaps to effectively convert these notes to U.S. dollar–denominated notes. As of September 28, 2019, a portion of the Company’s Japanese yen–denominated notes with a carrying value of $ 1.0 billion was designated as a hedge of the foreign currency exposure of the Company’s net investment in a foreign operation. The Company’s Japanese yen–denominated notes matured during 2020 and the associated net investment hedges were terminated. For further discussion regarding the Company’s use of derivative instruments, refer to the Derivative Financial Instruments section of Note 3, “Financial Instruments.” The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $ 2.8 billion, $ 3.2 billion and $ 3.0 billion of interest cost on its term debt for 2020, 2019 and 2018, respectively. The future principal payments for the Company’s Notes as of September 26, 2020, are as follows (in millions): 2021 $ 8,750 2022 9,569 2023 11,389 2024 10,115 2025 10,914 Thereafter 55,341 Total term debt $ 106,078 As of September 26, 2020 and September 28, 2019, the fair value of the Company’s Notes, based on Level 2 inputs, was $ 117.1 billion and $ 107.5 billion, respectively. Apple Inc. | 2020 Form 10-K | 49 Note 7 – Shareholders’ Equity Share Repurchase Program As of September 26, 2020, the Company was authorized to purchase up to $ 225 billion of the Company’s common stock under a share repurchase program, of which $ 168.6 billion had been utilized. During 2020, the Company repurchased 917 million shares of its common stock for $ 72.5 billion, including 141 million shares delivered under a $ 10.0 billion November 2019 accelerated share repurchase arrangement (“ASR”) and 64 million shares delivered under a $ 6.0 billion May 2020 ASR. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under this program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Shares of Common Stock The following table shows the changes in shares of common stock for 2020, 2019 and 2018 (in thousands): 2020 2019 2018 Common stock outstanding, beginning balances 17,772,945 19,019,943 20,504,805 Common stock repurchased ( 917,270 ) ( 1,380,819 ) ( 1,622,198 ) Common stock issued, net of shares withheld for employee taxes 121,088 133,821 137,336 Common stock outstanding, ending balances 16,976,763 17,772,945 19,019,943 Note 8 – Comprehensive Income The Company’s OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and unrealized gains and losses on marketable debt securities classified as available-for-sale. The following table shows the pre-tax amounts reclassified from AOCI into the Consolidated Statements of Operations, and the associated financial statement line items, for 2020 and 2019 (in millions): Comprehensive Income Components Financial Statement Line Items 2020 2019 Unrealized (gains)/losses on derivative instruments: Foreign exchange contracts Total net sales $ ( 365 ) $ ( 206 ) Total cost of sales ( 584 ) ( 482 ) Other income/(expense), net ( 604 ) 784 Interest rate contracts Other income/(expense), net 8 7 ( 1,545 ) 103 Unrealized (gains)/losses on marketable debt securities Other income/(expense), net ( 82 ) 31 Total amounts reclassified from AOCI $ ( 1,627 ) $ 134 Apple Inc. | 2020 Form 10-K | 50 The following table shows the changes in AOCI by component for 2020 and 2019 (in millions): Cumulative Foreign Currency Translation Unrealized Gains/Losses on Derivative Instruments Unrealized Gains/Losses on Marketable Debt Securities Total Balances as of September 29, 2018 $ ( 1,055 ) $ 810 $ ( 3,209 ) $ ( 3,454 ) Other comprehensive income/(loss) before reclassifications ( 421 ) ( 949 ) 4,854 3,484 Amounts reclassified from AOCI — 103 31 134 Tax effect 13 208 ( 1,058 ) ( 837 ) Other comprehensive income/(loss) ( 408 ) ( 638 ) 3,827 2,781 Cumulative effect of change in accounting principle — — 89 89 Balances as of September 28, 2019 ( 1,463 ) 172 707 ( 584 ) Other comprehensive income/(loss) before reclassifications 91 115 1,560 1,766 Amounts reclassified from AOCI — ( 1,545 ) ( 82 ) ( 1,627 ) Tax effect ( 3 ) 245 ( 339 ) ( 97 ) Other comprehensive income/(loss) 88 ( 1,185 ) 1,139 42 Cumulative effect of change in accounting principle (1) — 136 — 136 Balances as of September 26, 2020 $ ( 1,375 ) $ ( 877 ) $ 1,846 $ ( 406 ) (1) Refer to Note 1, “Summary of Significant Accounting Policies” for more information on the Company’s adoption of ASU 2017-12 in 2020. Note 9 – Benefit Plans 2014 Employee Stock Plan In the second quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the 2014 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. RSUs granted under the 2014 Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. RSUs canceled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the number of RSUs canceled or shares withheld. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 1.54 billion shares plus the number of shares remaining that were reserved but not issued under the 2003 Plan. Shares subject to outstanding awards under the 2003 Plan that expire, are canceled or otherwise terminate, or are withheld to satisfy tax withholding obligations for RSUs, will also be available for awards under the 2014 Plan. As of September 26, 2020, approximately 808 million shares were reserved for future issuance under the 2014 Plan. Apple Inc. Non-Employee Director Stock Plan The Apple Inc. Non-Employee Director Stock Plan (the “Director Plan”) is a shareholder-approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the value and relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants, in each case within the limits set forth in the Director Plan and without further shareholder approval. RSUs granted under the Director Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. The Director Plan expires on November 12, 2027. All RSUs granted under the Director Plan are entitled to DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. As of September 26, 2020, approximately 4 million shares were reserved for future issuance under the Director Plan. Apple Inc. | 2020 Form 10-K | 51 Rule 10b5-1 Trading Plans During the three months ended September 26, 2020, Section 16 officers Katherine L. Adams, Timothy D. Cook, Chris Kondo, Luca Maestri, Deirdre O’Brien and Jeffrey Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired under the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder-approved plan under which substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85 % of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10 % of the employee’s compensation and employees may not purchase more than $ 25,000 of stock during any calendar year. As of September 26, 2020, approximately 107 million shares were reserved for future issuance under the Purchase Plan. 401(k) Plan The Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($ 19,500 for calendar year 2020). The Company matches 50 % to 100 % of each employee’s contributions, depending on length of service, up to a maximum of 6 % of the employee’s eligible earnings. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2020, 2019 and 2018, is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per RSU Aggregate Fair Value (in millions) Balance as of September 30, 2017 390,284 $ 27.58 RSUs granted 181,402 $ 40.72 RSUs vested ( 178,873 ) $ 27.81 RSUs canceled ( 24,195 ) $ 31.95 Balance as of September 29, 2018 368,618 $ 33.65 RSUs granted 147,409 $ 53.99 RSUs vested ( 168,350 ) $ 33.80 RSUs canceled ( 21,609 ) $ 40.71 Balance as of September 28, 2019 326,068 $ 42.30 RSUs granted 156,800 $ 59.20 RSUs vested ( 157,743 ) $ 40.29 RSUs canceled ( 14,347 ) $ 48.07 Balance as of September 26, 2020 310,778 $ 51.58 $ 34,894 The fair value as of the respective vesting dates of RSUs was $ 10.8 billion, $ 8.6 billion and $ 7.6 billion for 2020, 2019 and 2018, respectively. The majority of RSUs that vested in 2020, 2019 and 2018 were net share settled such that the Company withheld shares with a value equivalent to the employees’ obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 56 million, 59 million and 64 million for 2020, 2019 and 2018, respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $ 3.9 billion, $ 3.0 billion and $ 2.7 billion in 2020, 2019 and 2018, respectively. Apple Inc. | 2020 Form 10-K | 52 Share-Based Compensation The following table shows share-based compensation expense and the related income tax benefit included in the Consolidated Statements of Operations for 2020, 2019 and 2018 (in millions): 2020 2019 2018 Share-based compensation expense $ 6,829 $ 6,068 $ 5,340 Income tax benefit related to share-based compensation expense $ ( 2,476 ) $ ( 1,967 ) $ ( 1,893 ) As of September 26, 2020, the total unrecognized compensation cost related to outstanding RSUs and stock options was $ 12.2 billion, which the Company expects to recognize over a weighted-average period of 2.6 years. Note 10 – Commitments and Contingencies Accrued Warranty and Guarantees The following table shows changes in the Company’s accrued warranties and related costs for 2020, 2019 and 2018 (in millions): 2020 2019 2018 Beginning accrued warranty and related costs $ 3,570 $ 3,692 $ 3,834 Cost of warranty claims ( 2,956 ) ( 3,857 ) ( 4,115 ) Accruals for product warranty 2,740 3,735 3,973 Ending accrued warranty and related costs $ 3,354 $ 3,570 $ 3,692 The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and China mainland. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within net sales. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets and other electronic devices. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Apple Inc. | 2020 Form 10-K | 53 Unconditional Purchase Obligations The Company has entered into certain off–balance sheet commitments that require the future purchase of goods or services (“unconditional purchase obligations”). The Company’s unconditional purchase obligations primarily consist of payments for supplier arrangements, Internet and telecommunication services, intellectual property licenses and content creation. Future payments under noncancelable unconditional purchase obligations having a remaining term in excess of one year as of September 26, 2020, are as follows (in millions): 2021 $ 3,476 2022 2,885 2023 1,700 2024 357 2025 104 Thereafter 130 Total $ 8,652 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully resolved. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims, except for the following matters: VirnetX VirnetX, Inc. (“VirnetX”) filed a lawsuit against the Company alleging that certain of the Company’s products infringe on patents owned by VirnetX. On April 11, 2018, a jury returned a verdict against the Company and awarded damages of $ 503 million. The Company appealed the verdict to the U.S. Court of Appeals for the Federal Circuit, which remanded the case back to the U.S. District Court for the Eastern District of Texas, where it is scheduled for a re-trial in October 2020. The Company has challenged the validity of the patents at issue in the re-trial at the U.S. Patent and Trademark Office (the “PTO”), and the PTO has declared the patents invalid, subject to further appeal by VirnetX. iOS Performance Management Cases Various civil litigation matters have been filed in state and federal courts in the U.S. and in various international jurisdictions alleging violation of consumer protection laws, fraud, computer intrusion and other causes of action related to the Company’s performance management feature used in its iPhone operating systems, introduced to certain iPhones in iOS updates 10.2.1 and 11.2. The claims seek monetary damages and other non-monetary relief. On April 5, 2018, several U.S. federal actions were consolidated through a Multidistrict Litigation process into a single action in the U.S. District Court for the Northern District of California (the “Northern California District Court”). On February 28, 2020, the parties in the Multidistrict Litigation reached a settlement to resolve the U.S. federal and California state class actions. Under the terms of the settlement, which the Northern California District Court preliminarily approved in May 2020, the Company has agreed to pay up to $ 500 million in the aggregate to certain U.S. owners of iPhones if certain conditions are met. The final amount of the settlement will be determined based on the number of consumers who file valid claims and the attorneys’ fee award. However, the Company has agreed to pay at least $ 310 million to settle the claims. In addition to civil litigation, the Company is also responding to governmental investigations and requests for information relating to the performance management feature. The Company continues to believe that its iPhones were not defective, that the performance management feature introduced with iOS updates 10.2.1 and 11.2 was intended to, and did, improve customers’ user experience, and that the Company did not make any misleading statements or fail to disclose any material information. The Company has accrued its best estimate for the ultimate resolution of these matters. French Competition Authority On March 16, 2020, the French Competition Authority (“FCA”) announced its decision that aspects of the Company’s sales and distribution practices in France violate French competition law, and issued a fine of € 1.1 billion. The Company strongly disagrees with the FCA’s decision, and has appealed. Apple Inc. | 2020 Form 10-K | 54 Optis Optis Wireless Technology, LLC and related entities (“Optis”) filed a lawsuit in the U.S. District Court for the Eastern District of Texas against the Company alleging that certain of the Company’s products infringe on patents owned by Optis. On August 11, 2020, a jury returned a verdict against the Company and awarded damages of $ 506 million. The Company has asked the court to set aside the verdict, where the case remains pending. Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable segments. Costs excluded from segment operating income include various corporate expenses such as research and development, corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. The following table shows information by reportable segment for 2020, 2019 and 2018 (in millions): 2020 2019 2018 Americas: Net sales $ 124,556 $ 116,914 $ 112,093 Operating income $ 37,722 $ 35,099 $ 34,864 Europe: Net sales $ 68,640 $ 60,288 $ 62,420 Operating income $ 22,170 $ 19,195 $ 19,955 Greater China: Net sales $ 40,308 $ 43,678 $ 51,942 Operating income $ 15,261 $ 16,232 $ 19,742 Japan: Net sales $ 21,418 $ 21,506 $ 21,733 Operating income $ 9,279 $ 9,369 $ 9,500 Rest of Asia Pacific: Net sales $ 19,593 $ 17,788 $ 17,407 Operating income $ 6,808 $ 6,055 $ 6,181 Apple Inc. | 2020 Form 10-K | 55 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2020, 2019 and 2018 is as follows (in millions): 2020 2019 2018 Segment operating income $ 91,240 $ 85,950 $ 90,242 Research and development expense ( 18,752 ) ( 16,217 ) ( 14,236 ) Other corporate expenses, net ( 6,200 ) ( 5,803 ) ( 5,108 ) Total operating income $ 66,288 $ 63,930 $ 70,898 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2020, 2019 and 2018. There was no single customer that accounted for more than 10% of net sales in 2020, 2019 and 2018. Net sales for 2020, 2019 and 2018 and long-lived assets as of September 26, 2020 and September 28, 2019 were as follows (in millions): 2020 2019 2018 Net sales: U.S. $ 109,197 $ 102,266 $ 98,061 China (1) 40,308 43,678 51,942 Other countries 125,010 114,230 115,592 Total net sales $ 274,515 $ 260,174 $ 265,595 2020 2019 Long-lived assets: U.S. $ 25,890 $ 24,711 China (1) 7,256 9,064 Other countries 3,620 3,603 Total long-lived assets $ 36,766 $ 37,378 (1) China includes Hong Kong and Taiwan. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets related to retail stores and related infrastructure. Note 12 – Leases The Company has lease arrangements for certain equipment and facilities, including retail, corporate, manufacturing and data center space. These leases typically have original terms not exceeding 10 years and generally contain multi-year renewal options, some of which are reasonably certain of exercise. The Company’s lease arrangements may contain both lease and non-lease components. The Company has elected to combine and account for lease and non-lease components as a single lease component for leases of retail, corporate, and data center facilities. Payments under the Company’s lease arrangements may be fixed or variable, and variable lease payments are primarily based on purchases of output of the underlying leased assets. Lease costs associated with fixed payments on the Company’s operating leases were $ 1.5 billion for 2020. Lease costs associated with variable payments on the Company’s leases were $ 9.3 billion for 2020. Rent expense for operating leases, as previously reported under former lease accounting standards, was $ 1.3 billion and $ 1.2 billion in 2019 and 2018, respectively. For 2020, the Company made $ 1.5 billion of fixed cash payments related to operating leases. Non-cash activities involving ROU assets obtained in exchange for lease liabilities were $ 10.5 billion for 2020, including the impact of adopting the new leases standard in the first quarter of 2020. Apple Inc. | 2020 Form 10-K | 56 The following table shows ROU assets and lease liabilities, and the associated financial statement line items, as of September 26, 2020 (in millions): Lease-Related Assets and Liabilities Financial Statement Line Items 2020 Right-of-use assets: Operating leases Other non-current assets $ 8,570 Finance leases Property, plant and equipment, net 629 Total right-of-use assets $ 9,199 Lease liabilities: Operating leases Other current liabilities $ 1,436 Other non-current liabilities 7,745 Finance leases Other current liabilities 24 Other non-current liabilities 637 Total lease liabilities $ 9,842 Lease liability maturities as of September 26, 2020, are as follows (in millions): Operating Leases Finance Leases Total 2021 $ 1,493 $ 43 $ 1,536 2022 1,461 43 1,504 2023 1,317 54 1,371 2024 1,068 30 1,098 2025 960 25 985 Thereafter 3,845 895 4,740 Total undiscounted liabilities 10,144 1,090 11,234 Less: Imputed interest ( 963 ) ( 429 ) ( 1,392 ) Total lease liabilities $ 9,181 $ 661 $ 9,842 The weighted-average remaining lease term and discount rate related to the Company’s lease liabilities as of September 26, 2020 were 10.3 years and 2.0 %, respectively. The discount rates are generally based on estimates of the Company’s incremental borrowing rate, as the discount rates implicit in the Company’s leases cannot be readily determined. As of September 26, 2020, the Company had $ 1.7 billion of future payments under additional leases, primarily for corporate facilities and retail space, that had not yet commenced. These leases will commence between 2021 and 2022, with lease terms ranging from 1 year to 20 years. Note 13 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters of 2020 and 2019 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2020: Total net sales $ 64,698 $ 59,685 $ 58,313 $ 91,819 Gross margin $ 24,689 $ 22,680 $ 22,370 $ 35,217 Net income $ 12,673 $ 11,253 $ 11,249 $ 22,236 Earnings per share (1) : Basic $ 0.74 $ 0.65 $ 0.64 $ 1.26 Diluted $ 0.73 $ 0.65 $ 0.64 $ 1.25 Apple Inc. | 2020 Form 10-K | 57 Fourth Quarter Third Quarter Second Quarter First Quarter 2019: Total net sales $ 64,040 $ 53,809 $ 58,015 $ 84,310 Gross margin $ 24,313 $ 20,227 $ 21,821 $ 32,031 Net income $ 13,686 $ 10,044 $ 11,561 $ 19,965 Earnings per share (1) : Basic $ 0.76 $ 0.55 $ 0.62 $ 1.05 Diluted $ 0.76 $ 0.55 $ 0.61 $ 1.05 (1) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. Apple Inc. | 2020 Form 10-K | 58 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 26, 2020 and September 28, 2019, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 26, 2020, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of Apple Inc. at September 26, 2020 and September 28, 2019, and the results of its operations and its cash flows for each of the three years in the period ended September 26, 2020, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), Apple Inc.’s internal control over financial reporting as of September 26, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated October 29, 2020 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of Apple Inc.’s management. Our responsibility is to express an opinion on Apple Inc.’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. Uncertain Tax Positions Description of the Matter As discussed in Note 5 to the financial statements, Apple Inc. is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisdictions. As of September 26, 2020, the total amount of gross unrecognized tax benefits was $16.5 billion, of which $8.8 billion, if recognized, would impact Apple Inc.’s effective tax rate. Apple Inc. uses significant judgment in the calculation of tax liabilities in estimating the impact of uncertainties in the application of technical merits and complex tax laws. Auditing management’s evaluation of whether an uncertain tax position is more likely than not to be sustained and the measurement of the benefit of various tax positions can be complex, involves significant judgment, and is based on interpretations of tax laws and legal rulings. Apple Inc. | 2020 Form 10-K | 59 How We Addressed the Matter in Our Audit We tested controls relating to the evaluation of uncertain tax positions, including controls over management’s assessment as to whether tax positions are more likely than not to be sustained, management’s process to measure the benefit of its tax positions, and the development of the related disclosures. To evaluate Apple Inc.’s assessment of which tax positions are more likely than not to be sustained, our audit procedures included, among others, reading and evaluating management’s assumptions and analysis, and, as applicable, Apple Inc.’s communications with taxing authorities, that detailed the basis and technical merits of the uncertain tax positions. We involved our tax subject matter resources in assessing the technical merits of certain of Apple Inc.’s tax positions based on our knowledge of relevant tax laws and experience with related taxing authorities. For certain tax positions, we also received external legal counsel confirmation letters and discussed the matters with external advisors and Apple Inc. tax personnel. In addition, we evaluated Apple Inc.’s disclosure in relation to these matters included in Note 5 to the financial statements. /s/ Ernst & Young LLP We have served as Apple Inc.’s auditor since 2009. San Jose, California October 29, 2020 Apple Inc. | 2020 Form 10-K | 60 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on Internal Control Over Financial Reporting We have audited Apple Inc.’s internal control over financial reporting as of September 26, 2020, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 26, 2020, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), the consolidated balance sheets of Apple Inc. as of September 26, 2020 and September 28, 2019, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 26, 2020, and the related notes and our report dated October 29, 2020 expressed an unqualified opinion thereon. Basis for Opinion Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Apple Inc.’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California October 29, 2020 Apple Inc. | 2020 Form 10-K | 61 Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A.    Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 26, 2020 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 26, 2020 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2020, which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B.    Other Information None. Apple Inc. | 2020 Form 10-K | 62 PART III Item 10.    Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Corporate Governance,” “Directors,” “Executive Officers” and, if applicable, “Other Information—Security Ownership of Certain Beneficial Owners and Management” in the Company’s 2021 Proxy Statement to be filed with the SEC within 120 days after September 26, 2020 in connection with the solicitation of proxies for the Company’s 2021 annual meeting of shareholders, and is incorporated herein by reference. Item 11.    Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation,” under the subheadings “Board Oversight of Risk Management” and, if applicable, “Compensation Committee Interlocks and Insider Participation” under the heading “Corporate Governance” and under the subheadings “Compensation of Directors” and “Director Compensation—2020” under the heading “Directors” in the Company’s 2021 Proxy Statement to be filed with the SEC within 120 days after September 26, 2020, and is incorporated herein by reference. Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Other Information—Security Ownership of Certain Beneficial Owners and Management” and “Other Information—Equity Compensation Plan Information” in the Company’s 2021 Proxy Statement to be filed with the SEC within 120 days after September 26, 2020, and is incorporated herein by reference. Item 13.    Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the subheadings “Role of the Board of Directors,” “Board Committees”, “Review, Approval, or Ratification of Transactions with Related Persons” and “Transactions with Related Persons” under the heading “Corporate Governance” in the Company’s 2021 Proxy Statement to be filed with the SEC within 120 days after September 26, 2020, and is incorporated herein by reference. Item 14.    Principal Accountant Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm” under the proposal “Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2021 Proxy Statement to be filed with the SEC within 120 days after September 26, 2020, and is incorporated herein by reference. Apple Inc. | 2020 Form 10-K | 63 PART IV Item 15.    Exhibit and Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 26, 2020, September 28, 2019 and September 29, 2018 31 Consolidated Statements of Comprehensive Income for the years ended September 26, 2020, September 28, 2019 and September 29, 2018 32 Consolidated Balance Sheets as of September 26, 2020 and September 28, 2019 33 Consolidated Statements of Shareholders’ Equity for the years ended September 26, 2020 , September 28, 2019 and September 29, 2018 34 Consolidated Statements of Cash Flows for the years ended September 26, 2020, September 28, 2019 and September 29, 2018 35 Notes to Consolidated Financial Statements 36 Selected Quarterly Financial Information (Unaudited) 57 Reports of Independent Registered Public Accounting Firm 59 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant filed on August 3 , 2020 . 8-K 3.1 8/7/20 3.2 Amended and Restated Bylaws of the Registrant effective as of December 13, 2016. 8-K 3.2 12/15/16 4.1** Description of Securities of the Registrant. 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 Apple Inc. | 2020 Form 10-K | 64 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.9 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 4.10 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.11 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.12 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.13 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.14 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.15 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.16 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.17 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.18 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 4.19 Officer’s Certificate of the Registrant, dated as of November 13, 2017, including forms of global notes representing the 1.800% Notes due 2019, 2.000% Notes due 2020, 2.400% Notes due 2023, 2.750% Notes due 2025, 3.000% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 11/13/17 4.20 Indenture, dated as of November 5, 2018, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 11/5/18 4.21 Officer’s Certificate of the Registrant, dated as of September 11, 2019, including forms of global notes representing the 1.700% Notes due 2022, 1.800% Notes due 2024, 2.050% Notes due 2026, 2.200% Notes due 2029 and 2.950% Notes due 2049. 8-K 4.1 9/11/19 4.22 Officer’s Certificate of the Registrant, dated as of No vember 15, 2019 , including forms of global notes representing the 0.000 % Notes due 202 5 and 0.500 % Notes due 20 31 . 8-K 4.1 11/15/19 4.23 Officer’s Certificate of the Registrant, dated as of May 11, 2020, including forms of global notes representing the 0.750% Notes due 2023, 1.125% Notes due 2025, 1.650% Notes due 2030 and 2.650% Notes due 2050. 8-K 4.1 5/11/20 4.24 Officer’s Certificate of the Registrant, dated as of August 20 , 2020, including forms of global notes representing the 0.550 % Notes due 202 5 , 1. 25% Notes due 20 30 , 2.40 0% Notes due 20 5 0 and 2. 5 50% Notes due 20 6 0. 8-K 4.1 8/20/20 4.25* Apple Inc. Deferred Compensation Plan. S-8 4.1 8/23/18 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* Apple Inc. Non-Employee Director Stock Plan, as amended and restated as of February 13, 2018. 8-K 10.1 2/14/18 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 Apple Inc. | 2020 Form 10-K | 65 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 10.5* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.6* 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10-K 10.8 9/30/17 10.7* Form of Amendment, effective as of August 26, 2014, to Restricted Stock Unit Award Agreements and Performance Award Agreements outstanding as of August 26, 2014. 10-K 10.13 9/27/14 10.8* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.18 9/24/16 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.20 9/30/17 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.21 9/30/17 10.11* Form of Restricted Stock Unit Award Agreement under Non-Employee Director Stock Plan effective as of February 13, 2018. 10-Q 10.2 3/31/18 10.12* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.17 9/29/18 10.13* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.18 9/29/18 10.14* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.15 9/28/19 10.15* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.16 9/28/19 10.16*, ** Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 18 , 20 20 . 10.17*, ** Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 18 , 20 20 . 21.1** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101** Inline XBRL Document Set for the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. 104** Inline XBRL for the cover page of this Annual Report on Form 10-K, included in the Exhibit 101 Inline XBRL Document Set. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16.    Form 10-K Summary None. Apple Inc. | 2020 Form 10-K | 66 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: October 29, 2020 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) October 29, 2020 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) October 29, 2020 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) October 29, 2020 CHRIS KONDO /s/ James A. Bell Director October 29, 2020 JAMES A. BELL /s/ Al Gore Director October 29, 2020 AL GORE /s/ Andrea Jung Director October 29, 2020 ANDREA JUNG /s/ Arthur D. Levinson Director October 29, 2020 ARTHUR D. LEVINSON /s/ Ronald D. Sugar Director October 29, 2020 RONALD D. SUGAR /s/ Susan L. Wagner Director October 29, 2020 SUSAN L. 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aapl:OtherCountriesMember 2021-09-25 0000320193 aapl:OtherCountriesMember 2020-09-26 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 25 , 2021 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) One Apple Park Way Cupertino , California 95014 (Address of principal executive offices) (Zip Code) ( 408 ) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading symbol(s) Name of each exchange on which registered Common Stock, $0.00001 par value per share AAPL The Nasdaq Stock Market LLC 1.000% Notes due 2022 — The Nasdaq Stock Market LLC 1.375% Notes due 2024 — The Nasdaq Stock Market LLC 0.000% Notes due 2025 — The Nasdaq Stock Market LLC 0.875% Notes due 2025 — The Nasdaq Stock Market LLC 1.625% Notes due 2026 — The Nasdaq Stock Market LLC 2.000% Notes due 2027 — The Nasdaq Stock Market LLC 1.375% Notes due 2029 — The Nasdaq Stock Market LLC 3.050% Notes due 2029 — The Nasdaq Stock Market LLC 0.500% Notes due 2031 — The Nasdaq Stock Market LLC 3.600% Notes due 2042 — The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 26, 2021, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $ 2,021,360,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 16,406,397,000 shares of common stock were issued and outstanding as of October 15, 2021. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2022 annual meeting of shareholders (the “2022 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2022 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 25, 2021 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 6 Item 1B. Unresolved Staff Comments 17 Item 2. Properties 17 Item 3. Legal Proceedings 17 Item 4. Mine Safety Disclosures 17 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 18 Item 6. [Reserved] 19 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 20 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 26 Item 8. Financial Statements and Supplementary Data 28 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 55 Item 9A. Controls and Procedures 55 Item 9B. Other Information 56 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 56 Part III Item 10. Directors, Executive Officers and Corporate Governance 56 Item 11. Executive Compensation 56 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 56 Item 13 . Certain Relationships and Related Transactions, and Director Independence 56 Item 14. Principal Accountant Fees and Services 56 Part IV Item 15. Exhibit and Financial Statement Schedules 57 Item 16. Form 10-K Summary 59 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. For example, statements in this Form 10-K regarding the potential future impact of the COVID-19 pandemic on the Company’s business and results of operations are forward-looking statements. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Unless otherwise stated, all information presented herein is based on the Company’s fiscal calendar, and references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly owned subsidiaries, unless otherwise stated. PART I Item 1.    Business Company Background The Company designs, manufactures and markets smartphones, personal computers, tablets, wearables and accessories, and sells a variety of related services. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. Products iPhone iPhone ® is the Company’s line of smartphones based on its iOS operating system. In October and November 2020, the Company released iPhone 12, iPhone 12 mini, iPhone 12 Pro and iPhone 12 Pro Max, all with 5G technology. In September 2021, the Company released iPhone 13, iPhone 13 mini, iPhone 13 Pro and iPhone 13 Pro Max. Mac Mac ® is the Company’s line of personal computers based on its macOS ® operating system. In November 2020, the Company released new versions of MacBook Air ® , 13-inch MacBook Pro ® and Mac mini ® , and in May 2021, the Company released a redesigned iMac ® , all powered by the Apple M1 chip. In October 2021, the Company released a redesigned MacBook Pro, available in 14- and 16-inch models and powered by the Apple M1 Pro or M1 Max chip. iPad iPad ® is the Company’s line of multipurpose tablets based on its iPadOS ® operating system. In October 2020, the Company released a new iPad Air ® , and in April 2021, the Company released a new iPad Pro ® powered by the Apple M1 chip. In September 2021, the Company released an updated iPad and a new iPad mini ® . Wearables, Home and Accessories Wearables, Home and Accessories includes AirPods ® , Apple TV ® , Apple Watch ® , Beats ® products, HomePod ® , iPod touch ® and accessories. AirPods are the Company’s wireless headphones that interact with Siri ® . In December 2020, the Company released AirPods Max™, new over-ear wireless headphones, and in October 2021, the Company released the third generation of AirPods. Apple Watch is the Company’s line of smart watches based on its watchOS ® operating system. In September 2021, the Company announced Apple Watch Series 7, which was available starting in October 2021. Apple Inc. | 2021 Form 10-K | 1 Services Advertising The Company’s advertising services include various third-party licensing arrangements and the Company’s own advertising platforms. AppleCare The Company offers a portfolio of fee-based service and support products under the AppleCare ® brand. The offerings provide priority access to Apple technical support, access to the global Apple authorized service network for repair and replacement services, and in many cases additional coverage for instances of accidental damage and/or theft and loss, depending on the country and type of product. Cloud Services The Company’s cloud services store and keep customers’ content up-to-date and available across multiple Apple devices and Windows personal computers. Digital Content The Company operates various platforms, including the App Store ® , that allow customers to discover and download applications and digital content, such as books, music, video, games and podcasts. The Company also offers digital content through subscription-based services, including Apple Arcade ® , a game subscription service; Apple Music ® , which offers users a curated listening experience with on-demand radio stations; Apple News+ ® , a subscription news and magazine service; and Apple TV+ SM , which offers exclusive original content. During 2021, the Company released Apple Fitness+ SM , a personalized fitness service. Payment Services The Company offers payment services, including Apple Card ® , a co-branded credit card, and Apple Pay ® , a cashless payment service. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and resellers. During 2021, the Company’s net sales through its direct and indirect distribution channels accounted for 36% and 64%, respectively, of total net sales. Competition The markets for the Company’s products and services are highly competitive, and are characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. Many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by imitating the Company’s products and infringing on its intellectual property. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. Principal competitive factors important to the Company include price, product and service features (including security features), relative price and performance, product and service quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support, and corporate reputation. Apple Inc. | 2021 Form 10-K | 2 The Company is focused on expanding its market opportunities related to smartphones, personal computers, tablets, wearables and accessories, and services. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software, and service offerings with large customer bases. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors have the resources, experience or cost structures to provide products at little or no profit or even at a loss. The Company’s services compete with business models that provide content to users for free and use illegitimate means to obtain third-party digital content and applications. The Company faces significant competition as competitors imitate the Company’s product features and applications within their products, or collaborate to offer integrated solutions that are more competitive than those they currently offer. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets, wearables and accessories. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through research and development (“R&D”), licensing of intellectual property and acquisition of third-party businesses and technology. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, copyrights, trademarks, service marks, trade dress and other forms of intellectual property rights in the U.S. and various foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents, including utility patents, design patents and others. The Company also holds copyrights relating to certain aspects of its products and services. No single intellectual property right is solely responsible for protecting the Company’s products. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products. In addition to Company-owned intellectual property, many of the Company’s products and services are designed to include intellectual property owned by third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of the Company’s products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Apple Inc. | 2021 Form 10-K | 3 Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. The timing of product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new inventory following a product launch, and channel inventory of an older product often declines as the launch of a newer product approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. Human Capital The Company believes it has a talented, motivated, and dedicated team, and is committed to supporting the development of all of its team members and to continuously building on its strong culture. As of September 25, 2021, the Company had approximately 154,000 full-time equivalent employees. Workplace Practices and Policies The Company is committed to providing a workplace free of harassment or discrimination based on race, color, religion, sex, sexual orientation, gender identity, national origin, disability, veteran status, caste or other legally protected characteristic. The Company is an equal opportunity employer committed to inclusion and diversity. Compensation and Benefits The Company believes that compensation should not only be competitive; it should be equitable and should enable employees to share in the Company’s success as shareholders of the Company. The Company recognizes its people are most likely to thrive when they have the resources to meet their needs and the time and support to succeed in their professional and personal lives. In support of this, the Company offers a wide variety of benefits to employees around the world. Growth and Development The Company invests in tools and resources that support employees’ individual growth and development. The Company also provides classes and seminars to foster understanding and critical thinking about the Company’s culture, organization and values. Inclusion and Diversity The Company is committed to hiring inclusively, providing training and development opportunities, fostering an inclusive culture, and ensuring equitable pay for employees, and is continuing to focus on increasing diverse representation at every level of the Company. The Company has initiatives in place to implement its commitment to increase diverse representation, including creating diverse interview panels and candidate slates, focusing on robust diversity recruiting efforts, and expanding diversity outreach efforts through organizations that serve and engage talent from underrepresented communities. The Company also offers team members access to ongoing inclusion and diversity education, and support throughout their career journey and helps them find community and connection through employee groups that create spaces for belonging, learning, and growing inclusivity, diversity and equity efforts. Engagement The Company believes that open and honest communication among team members, managers and leadership fosters an open, collaborative work environment where everyone can participate, develop and thrive. Team members are encouraged to come to their managers with questions, feedback or concerns, and the Company regularly conducts surveys that gauge employee sentiment in areas like career development, manager performance and inclusivity. Health and Safety The Company is committed to protecting its employees everywhere it operates. The Company identifies potential risks associated with workplace activities in order to develop measures to mitigate possible hazards. The Company supports employees with general safety training and puts specific programs in place for those working in potentially high-hazard environments, including chemical management, laser safety, equipment and machinery safety, hazardous materials management and electrical safety. The Company has taken additional measures during the COVID-19 pandemic, including providing information resources, testing, face masks and personal protective equipment, and case support. The Company also offers special sick leave for employees with possible COVID-19 symptoms, as well as comprehensive health coverage. Apple Inc. | 2021 Form 10-K | 4 Available Information The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and other information filed by the Company with the SEC are available free of charge at investor.apple.com/investor-relations/sec-filings/default.aspx when such reports are available on the SEC’s website. The Company periodically provides other information for investors on its corporate website, www.apple.com, and its investor relations website, investor.apple.com. This includes press releases and other information about financial performance, information on environmental, social and corporate governance and details related to the Company’s annual meeting of shareholders. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2021 Form 10-K | 5 Item 1A.    Risk Factors The Company’s business, reputation, results of operations and financial condition, as well as the price of the Company’s stock, can be affected by a number of factors, whether currently known or unknown, including those described below. When any one or more of these risks materialize from time to time, the Company’s business, reputation, results of operations and financial condition, as well as the price of the Company’s stock, can be materially and adversely affected. Because of the following factors, as well as other factors affecting the Company’s results of operations and financial condition, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. This discussion of risk factors contains forward-looking statements. This section should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. Risks Related to COVID-19 The Company’s business, results of operations and financial condition, as well as the price of the Company’s stock, have been adversely affected and could in the future be materially adversely affected by the COVID-19 pandemic. COVID-19 has had, and continues to have, a significant impact around the world, prompting governments and businesses to take unprecedented measures in response. Such measures have included restrictions on travel and business operations, temporary closures of businesses, and quarantine and shelter-in-place orders. The COVID-19 pandemic has at times significantly curtailed global economic activity and caused significant volatility and disruption in global financial markets. The COVID-19 pandemic and the measures taken by many countries in response have adversely affected and could in the future materially adversely impact the Company’s business, results of operations and financial condition, as well as the price of the Company’s stock. During the course of the pandemic, certain of the Company’s component suppliers and manufacturing and logistical service providers have experienced disruptions, resulting in supply shortages that affected sales worldwide, and similar disruptions could occur in the future. The Company’s retail stores, as well as channel partner points of sale, have been temporarily closed at various times. In many cases, as stores and points of sale have reopened, they are subject to operating restrictions to protect public health and the health and safety of employees and customers. The Company has at times required substantially all of its employees to work remotely. The Company continues to monitor the situation and take appropriate actions in accordance with the recommendations and requirements of relevant authorities. The extent to which the COVID-19 pandemic may impact the Company’s operational and financial performance remains uncertain and will depend on many factors outside the Company’s control, including the timing, extent, trajectory and duration of the pandemic, the emergence of new variants, the development, availability, distribution and effectiveness of vaccines and treatments, the imposition of protective public safety measures, and the impact of the pandemic on the global economy and demand for consumer products. Additional future impacts on the Company may include, but are not limited to, material adverse effects on demand for the Company’s products and services, the Company’s supply chain and sales and distribution channels, the Company’s ability to execute its strategic plans, and the Company’s profitability and cost structure. To the extent the COVID-19 pandemic adversely affects the Company’s business, results of operations, financial condition and stock price, it may also have the effect of heightening many of the other risks described in this Part I, Item 1A of this Form 10-K. Macroeconomic and Industry Risks The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition. The Company has international operations with sales outside the U.S. representing a majority of the Company’s total net sales. In addition, the Company’s global supply chain is large and complex and a majority of the Company’s supplier facilities, including manufacturing and assembly sites, are located outside the U.S. As a result, the Company’s operations and performance depend significantly on global and regional economic conditions. Adverse macroeconomic conditions, including inflation, slower growth or recession, new or increased tariffs and other barriers to trade, changes to fiscal and monetary policy, tighter credit, higher interest rates, high unemployment and currency fluctuations can materially adversely affect demand for the Company’s products and services. In addition, consumer confidence and spending can be adversely affected in response to financial market volatility, negative financial news, conditions in the real estate and mortgage markets, declines in income or asset values, changes to fuel and other energy costs, labor and healthcare costs and other economic factors. Apple Inc. | 2021 Form 10-K | 6 In addition to an adverse impact on demand for the Company’s products, uncertainty about, or a decline in, global or regional economic conditions can have a significant impact on the Company’s suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. Potential effects include financial instability; inability to obtain credit to finance operations and purchases of the Company’s products; and insolvency. A downturn in the economic environment can also lead to increased credit and collectibility risk on the Company’s trade receivables; the failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair value of the Company’s financial instruments. These and other economic factors can materially adversely affect the Company’s business, results of operations and financial condition. The Company’s business can be impacted by political events, trade and other international disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions. Political events, trade and other international disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions can harm or disrupt international commerce and the global economy, and could have a material adverse effect on the Company and its customers, suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. The Company has a large, global business, and the Company believes that it generally benefits from growth in international trade. Trade and other international disputes can result in tariffs, sanctions, and other measures that restrict international trade and can adversely affect the Company’s business. For example, tensions between the U.S. and China have led to a series of tariffs being imposed by the U.S. on imports from China mainland, as well as other business restrictions. Tariffs increase the cost of the Company’s products and the components and raw materials that go into making them. These increased costs adversely impact the gross margin that the Company earns on its products. Tariffs can also make the Company’s products more expensive for customers, which could make the Company’s products less competitive and reduce consumer demand. Countries may also adopt other measures, such as controls on imports or exports of goods, technology or data, that could adversely impact the Company’s operations and supply chain and limit the Company’s ability to offer its products and services as designed. These measures can require the Company to take various actions, including changing suppliers, restructuring business relationships, and ceasing to offer third-party applications on its platforms. Changing the Company’s operations in accordance with new or changed trade restrictions can be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. Such restrictions can be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. Political uncertainty surrounding trade and other international disputes could also have a negative effect on consumer confidence and spending, which could adversely affect the Company’s business. Many of the Company’s operations and facilities, as well as critical business operations of the Company’s suppliers and contract manufacturers, are in locations that are prone to earthquakes and other natural disasters. In addition, such operations and facilities are subject to the risk of interruption by fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, ransomware and other cybersecurity attacks, labor disputes, public health issues, including pandemics such as the COVID-19 pandemic, and other events beyond the Company’s control. Global climate change is resulting in certain types of natural disasters occurring more frequently or with more intense effects. Such events can make it difficult or impossible for the Company to manufacture and deliver products to its customers, create delays and inefficiencies in the Company’s supply and manufacturing chain, and result in slowdowns and outages to the Company’s service offerings. Following an interruption to its business, the Company can require substantial recovery time, experience significant expenditures to resume operations, and lose significant sales. Because the Company relies on single or limited sources for the supply and manufacture of many critical components, a business interruption affecting such sources would exacerbate any negative consequences to the Company. The Company’s operations are also subject to the risks of industrial accidents at its suppliers and contract manufacturers. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in disruption to the Company’s business and harm to the Company’s reputation. Major public health issues, including pandemics such as the COVID-19 pandemic, have adversely affected, and could in the future adversely affect, the Company due to their impact on the global economy and demand for consumer products; the imposition of protective public safety measures, such as stringent employee travel restrictions and limitations on freight services and the movement of products between regions; and disruptions in the Company’s supply chain and sales and distribution channels, resulting in interruptions of the supply of current products and delays in production ramps of new products. While the Company maintains insurance coverage for certain types of losses, such insurance coverage may be insufficient to cover all losses that may arise. Apple Inc. | 2021 Form 10-K | 7 Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services are offered in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. There can be no assurance these investments will achieve expected returns, and the Company may not be able to develop and market new products and services successfully. The Company currently holds a significant number of patents, trademarks and copyrights and has registered, and applied to register, additional patents, trademarks and copyrights. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by imitating the Company’s products and infringing on its intellectual property. Effective intellectual property protection is not consistently available in every country in which the Company operates. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. The Company has a minority market share in the global smartphone, personal computer and tablet markets. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors have the resources, experience or cost structures to provide products at little or no profit or even at a loss. Some of the markets in which the Company competes have from time to time experienced little to no growth or contracted overall. Additionally, the Company faces significant competition as competitors imitate the Company’s product features and applications within their products or collaborate to offer solutions that are more competitive than those they currently offer. The Company also expects competition to intensify as competitors imitate the Company’s approach to providing components seamlessly within their offerings or work collaboratively to offer integrated solutions. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s business, results of operations and financial condition depend substantially on the Company’s ability to continually improve its products and services to maintain their functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. Business Risks To remain competitive and stimulate customer demand, the Company must successfully manage frequent introductions and transitions of products and services. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and services, and successfully manage the transition to these new and upgraded products and services. The success of new product and service introductions depends on a number of factors, including timely and successful development, market acceptance, the Company’s ability to manage the risks associated with production ramp-up issues, the availability of application software for the Company’s products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand, and the risk that new products and services may have quality or other defects or deficiencies. There can be no assurance the Company will successfully manage future introductions and transitions of products and services. Apple Inc. | 2021 Form 10-K | 8 The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. The Company has also outsourced much of its transportation and logistics management. While these arrangements can lower operating costs, they also reduce the Company’s direct control over production and distribution. Such diminished control has from time to time and may in the future have an adverse effect on the quality or quantity of products manufactured or services provided, or adversely affect the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for product defect expense reimbursement, the Company generally remains responsible to the consumer for warranty and out-of-warranty service in the event of product defects and experiences an unanticipated product defect liability from time to time. While the Company relies on its partners to adhere to its supplier code of conduct, violations of the supplier code of conduct occur from time to time and can materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company relies on single-source outsourcing partners in the U.S., Asia and Europe to supply and manufacture many components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform can have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations can be disrupted for a variety of reasons, including natural and man-made disasters, information technology system failures, commercial disputes, military actions, economic, business, labor, environmental, public health or political issues, or international trade disputes. The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply can be reduced or terminated, and the recoverability of manufacturing process equipment or prepayments can be negatively impacted. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains certain components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations that can materially adversely affect the Company’s business, results of operations and financial condition. For example, the global semiconductor industry is experiencing high demand and shortages of supply, which has adversely affected, and could materially adversely affect, the Company’s ability to obtain sufficient quantities of components and products on commercially reasonable terms or at all. While the Company has entered into agreements for the supply of many components, there can be no assurance the Company will be able to extend or renew these agreements on similar terms, or at all. Component suppliers may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms or at all. The effects of global or regional economic conditions on the Company’s suppliers, described in “ The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition, ” above, can also affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its business, results of operations and financial condition. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, can be affected for any number of reasons, including if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. When the Company’s supply of components for a new or existing product has been delayed or constrained, or when an outsourcing partner has delayed shipments of completed products to the Company, the Company’s business, results of operations and financial condition have been adversely affected and future delays or constraints could materially adversely affect the Company’s business, results of operations and financial condition. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the source, or to identify and obtain sufficient quantities from an alternative source. Apple Inc. | 2021 Form 10-K | 9 The Company’s products and services may be affected from time to time by design and manufacturing defects that could materially adversely affect the Company’s business and result in harm to the Company’s reputation. The Company offers complex hardware and software products and services that can be affected by design and manufacturing defects. Sophisticated operating system software and applications, such as those offered by the Company, often have issues that can unexpectedly interfere with the intended operation of hardware or software products. Defects can also exist in components and products the Company purchases from third parties. Component defects could make the Company’s products unsafe and create a risk of environmental or property damage and personal injury. These risks may increase as the Company’s products are introduced into specialized applications, including healthcare. In addition, the Company’s service offerings can have quality issues and from time to time experience outages, service slowdowns or errors. As a result, the Company’s services from time to time have not performed as anticipated and may not meet customer expectations. There can be no assurance the Company will be able to detect and fix all issues and defects in the hardware, software and services it offers. Failure to do so can result in widespread technical and performance issues affecting the Company’s products and services. In addition, the Company can be exposed to product liability claims, recalls, product replacements or modifications, write-offs of inventory, property, plant and equipment, and/or intangible assets, and significant warranty and other expenses, including litigation costs and regulatory fines. Quality problems can also adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, delay in new product and service introductions and lost sales. The Company is exposed to the risk of write-downs on the value of its inventory and other assets, in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand, or for which cost exceeds net realizable value. The Company also accrues necessary cancellation fee reserves for orders of excess products and components. The Company reviews long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the assets may not be recoverable. If the Company determines that an impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently recoverable, there can be no assurance the Company will not incur write-downs, fees, impairments and other charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company orders components for its products and builds inventory in advance of product announcements and shipments. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. The Company’s products and services are designed to include intellectual property owned by third parties, which requires licenses from those third parties. In addition, because of technological changes in the industries in which the Company currently competes or in the future may compete, current extensive patent coverage and the rapid rate of issuance of new patents, the Company’s products and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Based on experience and industry practice, the Company believes licenses to such third-party intellectual property can generally be obtained on commercially reasonable terms. However, there can be no assurance the necessary licenses can be obtained on commercially reasonable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, can preclude the Company from selling certain products or services, or otherwise have a material adverse impact on the Company’s business, results of operations and financial condition. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There can be no assurance third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes the availability of third-party software applications and services for its products depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software and services for the Company’s products compared to competitors’ platforms, such as Android for smartphones and tablets, Windows for personal computers and tablets, and PlayStation, Nintendo and Xbox for gaming platforms. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of product sales, and the costs of developing such applications and services. Apple Inc. | 2021 Form 10-K | 10 The Company’s minority market share in the global smartphone, personal computer and tablet markets can make developers less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for competitors’ products with larger market share. When developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices can suffer. The Company relies on the continued availability and development of compelling and innovative software applications for its products. The Company’s products and operating systems are subject to rapid technological change, and when third-party developers are unable to or choose not to keep up with this pace of change, their applications can fail to take advantage of these changes to deliver improved customer experiences and can operate incorrectly and can result in dissatisfied customers. The Company distributes third-party applications for its products through the App Store. For the vast majority of applications, developers keep all of the revenue they generate on the App Store. The Company only retains a commission from sales of applications and sales of digital services or goods within an application. From time to time, the Company has made changes to its App Store, including actions taken in response to competition, market and legal conditions. The Company may make further business changes in the future. New legislative initiatives, such as the proposed European Union (“EU”) Digital Markets Act, could, if enacted, require further changes. The Company is also subject to litigation and investigations relating to the App Store, which have resulted in changes to the Company’s business practices, and may in the future result in further changes. These changes could include how and to what extent the Company charges developers for access to its platforms and manages distribution of apps outside of the App Store. This could reduce the volume of sales, and the commission that the Company earns on those sales, would decrease. If the rate of the commission that the Company retains on such sales is reduced, or if it is otherwise narrowed in scope or eliminated, the Company’s business, results of operations and financial condition could be materially adversely affected. Failure to obtain or create digital content that appeals to the Company’s customers, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s business, results of operations and financial condition. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell, or offer subscriptions to, third-party content, as well as the right to incorporate specific content into the Company’s own services. The licensing or other distribution arrangements for this content can be for relatively short time periods and do not guarantee the continuation or renewal of these arrangements on commercially reasonable terms, or at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and can take actions to make it difficult or impossible for the Company to license or otherwise distribute their content. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at commercially reasonable prices with acceptable usage rules. The Company also produces its own digital content, which can be costly to produce due to intense and increasing competition for talent, content and subscribers, and may fail to appeal to the Company’s customers. The COVID-19 pandemic has also caused additional restrictions on production and increased costs for digital content. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There can be no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. The Company’s success depends largely on the continued service and availability of highly skilled employees, including key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. The Company believes that its distinctive and inclusive culture is a significant driver of its success. If the Company is unable to nurture and maintain its culture, it could adversely affect the Company’s ability to recruit and retain highly skilled employees and materially adversely affect the Company’s business, results of operations and financial condition. The Company depends on the performance of carriers, wholesalers, retailers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, retailers and resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. Some carriers providing cellular network service for the Company’s products offer financing, installment payment plans or subsidies for users’ purchases of the device. There can be no assurance such offers will be continued at all or in the same amounts. Apple Inc. | 2021 Form 10-K | 11 The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs can require a substantial investment while not assuring return or incremental sales. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. The Company’s business and reputation are impacted by information technology system failures and network disruptions. The Company and its global supply chain are exposed to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, ransomware or other cybersecurity incidents, or other events or disruptions. System redundancy and other continuity measures may be ineffective or inadequate, and the Company’s or its vendors’ business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions can adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Losses or unauthorized access to or releases of confidential information, including personal information, could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information, including personal information, with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company’s business also requires it to share confidential information with suppliers and other third parties. The Company relies on global suppliers that are also exposed to ransomware and other malicious attacks that can disrupt business operations. Although the Company takes steps to secure confidential information that is provided to or accessible by third parties working on the Company’s behalf, such measures are not always effective and losses or unauthorized access to or releases of confidential information occur. Such incidents and other malicious attacks could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company experiences malicious attacks and other attempts to gain unauthorized access to its systems on a regular basis. These attacks seek to compromise the confidentiality, integrity or availability of confidential information or disrupt normal business operations, and could, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the price of the Company’s stock, materially damage commercial relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Globally, attacks are expected to continue accelerating in both frequency and sophistication with increasing use by actors of tools and techniques that are designed to circumvent controls, avoid detection, and remove or obfuscate forensic evidence, all of which hinders the Company’s ability to identify, investigate and recover from incidents. Although malicious attacks perpetrated to gain access to confidential information, including personal information, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, and mitigate the impact of unauthorized access, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, ransomware attacks, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties can fraudulently induce the Company’s or its vendors’ employees or customers into disclosing user names, passwords or other sensitive information, which can, in turn, be used for unauthorized access to the Company’s or its vendors’ systems and services. To help protect customers and the Company, the Company deploys and makes available technologies like multifactor authentication, monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, can result in the delay or loss of customer orders or impede customer access to the Company’s products and services. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2021 Form 10-K | 12 Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business, present risks not originally contemplated and adversely affect the Company’s business, reputation, results of operations and financial condition. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater-than-expected liabilities and expenses, economic, political, legal and regulatory challenges associated with operating in new businesses, regions or countries, inadequate return on capital, potential impairment of tangible and intangible assets, and significant write-offs. Investment and acquisition transactions are exposed to additional risks, including failing to obtain required regulatory approvals on a timely basis or at all, or the imposition of onerous conditions that could delay or prevent the Company from completing a transaction or otherwise limit the Company’s ability to fully realize the anticipated benefits of a transaction. These new ventures are inherently risky and may not be successful. The failure of any significant investment could adversely affect the Company’s business, reputation, results of operations and financial condition. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of an individual store or multiple stores, including as a result of protective public safety measures in response to the COVID-19 pandemic, could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. The Company’s retail operations are subject to many factors that pose risks and uncertainties and could adversely impact the Company’s business, results of operations and financial condition, including macro-economic factors that could have an adverse effect on general retail activity. Other factors include the Company’s ability to: manage costs associated with retail store construction and operation; manage relationships with existing retail partners; manage costs associated with fluctuations in the value of retail inventory; and obtain and renew leases in quality retail locations at a reasonable cost. Legal and Regulatory Compliance Risks The Company’s business, results of operations and financial condition could be adversely impacted by unfavorable results of legal proceedings or government investigations. The Company is subject to various claims, legal proceedings and government investigations that have arisen in the ordinary course of business and have not yet been fully resolved, and new matters may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which can subject the Company to costs and damages in the event of a claim against an indemnified third party. The number of claims, legal proceedings and government investigations involving the Company, and the alleged magnitude of such claims, proceedings and government investigations, has generally increased over time and may continue to increase. The Company has faced and continues to face a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in several U.S. jurisdictions, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, defending against litigation or responding to government investigations can be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into agreements or other arrangements to settle litigation and resolve such challenges. There can be no assurance such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements can also significantly increase the Company’s cost of sales and operating expenses and require the Company to change its business practices and limit the Company’s ability to offer certain products and services. Except as described in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. Apple Inc. | 2021 Form 10-K | 13 The outcome of litigation or government investigations is inherently uncertain. If one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts above management’s expectations, the Company’s results of operations and financial condition for that reporting period could be materially adversely affected. Further, such an outcome can result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company, and can require the Company to change its business practices and limit the Company’s ability to offer certain products and services, all of which could materially adversely affect the Company’s business, results of operations and financial condition. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. The Company is subject to complex and changing laws and regulations worldwide, which exposes the Company to potential liabilities, increased costs and other adverse effects on the Company’s business. The Company’s global operations are subject to complex and changing laws and regulations on subjects, including antitrust; privacy, data security and data localization; consumer protection; advertising, sales, billing and e-commerce; product liability; intellectual property ownership and infringement; digital platforms; Internet, telecommunications, and mobile communications; media, television, film and digital content; availability of third-party software applications and services; labor and employment; anticorruption; import, export and trade; foreign exchange controls and cash repatriation restrictions; anti–money laundering; foreign ownership and investment; tax; and environmental, health and safety, including electronic waste, recycling, and climate change. Compliance with these laws and regulations is onerous and expensive, increasing the cost of conducting the Company’s global operations. Changes to laws and regulations can adversely affect the Company’s business by increasing the Company’s costs, limiting the Company’s ability to offer a product or service to customers, requiring changes to the Company’s supply chain and business practices or otherwise making the Company’s products and services less attractive to customers. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance the Company’s employees, contractors or agents will not violate such laws and regulations or the Company’s policies and procedures. If the Company is found to have violated laws and regulations, it could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Regulatory changes and other actions that materially adversely affect the Company’s business may be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. The technology industry, including, in some instances, the Company, is subject to intense media, political and regulatory scrutiny, which exposes the Company to increasing regulation, government investigations, legal actions and penalties. From time to time, the Company has made changes to its App Store, including actions taken in response to competition, market and legal conditions. The Company may make further business changes in the future. New legislative initiatives, such as the proposed EU Digital Markets Act, could, if enacted, require further changes. These changes could include how and to what extent the Company charges developers for access to its platforms and manages distribution of apps outside of the App Store. The Company is also currently subject to antitrust investigations in various jurisdictions around the world, which can result in legal proceedings and claims against the Company that could, individually or in the aggregate, have a materially adverse impact on the Company’s business, results of operations and financial condition. For example, the Company is the subject of investigations in Europe and other jurisdictions relating to App Store terms and conditions. If such investigations result in adverse findings against the Company, the Company could be exposed to significant fines and may be required to make changes to its App Store business, all of which could materially adversely affect the Company’s business, results of operations and financial condition. The Company is also subject to litigation relating to the App Store, which has resulted in changes to the Company’s business practices, and may in the future result in further changes. Further, the Company has commercial relationships with other companies in the technology industry that are or may become subject to investigations and litigation that, if resolved against those other companies, could adversely affect the Company’s commercial relationships with those business partners and materially adversely affect the Company’s business, results of operations and financial condition. For example, the Company earns revenue from licensing arrangements with other companies to offer their search services on the Company’s platforms and apps, and certain of these arrangements are currently subject to government investigations and legal proceedings. There can be no assurance the Company’s business will not be materially adversely affected, individually or in the aggregate, by the outcomes of such investigations, litigation or changes to laws and regulations in the future. Changes to the Company’s business practices to comply with new laws and regulations or in connection with other legal proceedings could negatively impact the reputation of the Company’s products for privacy and security and otherwise adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, and lost sales. Apple Inc. | 2021 Form 10-K | 14 The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of various types of personal information. In many cases, these laws apply not only to third-party transactions, but also restrict transfers of personal information among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and additional jurisdictions are considering imposing additional restrictions or have laws that are pending. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing requirements causes the Company to incur substantial costs and has required and may in the future require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of personal information through its privacy policy, information provided on its website, press statements and other privacy notices provided to customers. Any failure by the Company to comply with these public statements or with other federal, state or international privacy or data protection laws and regulations could result in inquiries or proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. In addition to the risks generally relating to the collection, use, retention, security and transfer of personal information, the Company is also subject to specific obligations relating to information considered sensitive under applicable laws, such as health data, financial data and biometric data. Health data is subject to additional privacy, security and breach notification requirements, and the Company is subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data is handled in a manner not permitted by law or under the Company’s agreements with healthcare institutions, the Company can be subject to litigation or government investigations, and can be liable for associated investigatory expenses, and can also incur significant fees or fines. Financial data, such as payment card data, is also subject to additional requirements. Under payment card rules and obligations, if cardholder information is potentially compromised, the Company can be liable for associated investigatory expenses and can also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which would materially adversely affect the Company’s business, reputation, results of operations and financial condition. Financial Risks The Company expects its quarterly net sales and results of operations to fluctuate. The Company’s profit margins vary across its products, services, geographic segments and distribution channels. For example, the gross margins on the Company’s products and services vary significantly and can change over time. The Company’s gross margins are subject to volatility and downward pressure due to a variety of factors, including: continued industry-wide global product pricing pressures and product pricing actions that the Company may take in response to such pressures; increased competition; the Company’s ability to effectively stimulate demand for certain of its products and services; compressed product life cycles; potential increases in the cost of components, outside manufacturing services, and developing, acquiring and delivering content for the Company’s services; the Company’s ability to manage product quality and warranty costs effectively; shifts in the mix of products and services, or in the geographic, currency or channel mix, including to the extent that regulatory changes require the Company to modify its product and service offerings; fluctuations in foreign exchange rates; and the introduction of new products or services, including new products or services with higher cost structures. These and other factors could have a materially adverse impact on the Company’s results of operations and financial condition. The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. Further, the Company generates a significant portion of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments, such as lower-than-anticipated demand for the Company’s products or services, issues with new product or service introductions, information technology system failures or network disruptions, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar relative to local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non–U.S. dollar–denominated sales, cost of sales and operating expenses worldwide. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers could be materially adversely affected by foreign currency exchange rate fluctuations. Apple Inc. | 2021 Form 10-K | 15 The weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency–denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise international pricing to offset the U.S. dollar’s strengthening, which would adversely affect the U.S. dollar value of the gross margins the Company earns on foreign currency–denominated sales. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency–denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not be effective to offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the values of its investment portfolio. The Company’s investments can be negatively affected by changes in liquidity, credit deterioration, financial results, market and economic conditions, political risk, sovereign risk, interest rate fluctuations or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents, and marketable and non-marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents, and marketable and non-marketable securities, future fluctuations in their value could result in significant losses and could have a material adverse impact on the Company’s results of operations and financial condition. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and resellers. The Company also sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party bank support or financing arrangements, or credit insurance, and a significant portion of the Company’s trade receivables can be concentrated within cellular network carriers or other resellers. The Company’s exposure to credit and collectibility risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture subassemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 25, 2021, the Company’s vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company is subject to changes in tax rates, the adoption of new U.S. or international tax legislation and exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax laws and tax rates for income taxes and other non-income taxes in various jurisdictions may be subject to significant change. The Company’s effective tax rates are affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, the introduction of new taxes, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s business, results of operations and financial condition could be materially adversely affected. Apple Inc. | 2021 Form 10-K | 16 General Risks The price of the Company’s stock is subject to volatility. The Company’s stock has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have, from time to time, experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility may cause the average price at which the Company repurchases its stock in a given period to exceed the stock’s price at a given point in time. The Company believes the price of its stock should reflect expectations of future growth and profitability. The Company also believes the price of its stock should reflect expectations that its cash dividend will continue at current levels or grow, and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, the price of the Company’s stock may decline significantly, which could have a material adverse impact on investor confidence and employee retention. Item 1B.    Unresolved Staff Comments None. Item 2.    Properties The Company’s headquarters are located in Cupertino, California. As of September 25, 2021, the Company owned or leased facilities and land for corporate functions, R&D, data centers, retail and other purposes at locations throughout the U.S. and in various places outside the U.S. The Company believes its existing facilities and equipment, which are used by all reportable segments, are in good operating condition and are suitable for the conduct of its business. Item 3.    Legal Proceedings The Company is subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. The Company’s material legal proceedings are described below and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies.” The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. The Company settled certain matters during the fourth quarter of 2021 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Epic Games Epic Games, Inc. (“Epic”) filed a lawsuit in the U.S. District Court for the Northern District of California (the “Northern California District Court”) against the Company alleging violations of federal and state antitrust laws and California’s unfair competition law based upon the Company’s operation of its App Store. The Company filed a counterclaim for breach of contract. On September 10, 2021, the Northern California District Court ruled in favor of the Company with respect to nine out of the ten counts included in Epic’s claim, and in favor of the Company with respect to the Company’s claims for breach of contract. The Northern California District Court found that certain provisions of the Company’s App Store Review Guidelines violate California’s unfair competition law and issued an injunction. Epic appealed the decision. The Company filed a cross-appeal and is seeking a stay of the injunction pending appeal. Item 4.    Mine Safety Disclosures Not applicable. Apple Inc. | 2021 Form 10-K | 17 PART II Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on The Nasdaq Stock Market LLC under the symbol AAPL. Holders As of October 15, 2021, there were 23,502 shareholders of record. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 25, 2021 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) June 27, 2021 to July 31, 2021: Open market and privately negotiated purchases 59,216 $ 143.54 59,216 August 1, 2021 to August 28, 2021: May 2021 ASR 4,921 (2) 4,921 Open market and privately negotiated purchases 42,343 $ 147.61 42,343 August 29, 2021 to September 25, 2021: Open market and privately negotiated purchases 35,041 $ 149.81 35,041 Total 141,521 $ 60,851 (1) As of September 25, 2021, the Company was authorized to purchase up to $315 billion of the Company’s common stock under a share repurchase program announced on April 28, 2021 (the “Program”), of which $254.1 billion had been utilized. The remaining $60.9 billion in the table represents the amount available to repurchase shares under the Program as of September 25, 2021. The Program does not obligate the Company to acquire any specific number of shares. Under the Program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In May 2021, the Company entered into an accelerated share repurchase agreement (“ASR”) to purchase up to $5.0 billion of the Company’s common stock. In August 2021, the purchase period for this ASR ended and an additional 5 million shares were delivered and retired. In total, 36 million shares were delivered under this ASR at an average repurchase price of $137.20. Apple Inc. | 2021 Form 10-K | 18 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend-reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 25, 2021. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 23, 2016. Note that past stock price performance is not necessarily indicative of future stock price performance. * $100 invested on September 23, 2016 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2021 Standard & Poor’s, a division of S&P Global. All rights reserved. Copyright © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. September 2016 September 2017 September 2018 September 2019 September 2020 September 2021 Apple Inc. $ 100 $ 139 $ 207 $ 204 $ 422 $ 556 S&P 500 Index $ 100 $ 119 $ 140 $ 146 $ 168 $ 218 S&P Information Technology Index $ 100 $ 129 $ 169 $ 184 $ 271 $ 349 Dow Jones U.S. Technology Supersector Index $ 100 $ 128 $ 168 $ 178 $ 265 $ 362 Item 6.    [Reserved] Apple Inc. | 2021 Form 10-K | 19 Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in Part II, Item 8 of this Form 10-K. This section of this Form 10-K generally discusses 2021 and 2020 items and year-to-year comparisons between 2021 and 2020. Discussions of 2019 items and year-to-year comparisons between 2020 and 2019 are not included in this Form 10-K, and can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended September 26, 2020. Fiscal Year Highlights COVID-19 Update The COVID-19 pandemic has had, and continues to have, a significant impact around the world, prompting governments and businesses to take unprecedented measures, such as restrictions on travel and business operations, temporary closures of businesses, and quarantine and shelter-in-place orders. The COVID-19 pandemic has at times significantly curtailed global economic activity and caused significant volatility and disruption in global financial markets. The COVID-19 pandemic and the measures taken by many countries in response have affected and could in the future materially impact the Company’s business, results of operations and financial condition, as well as the price of the Company’s stock. During 2021, aspects of the Company’s business continued to be affected by the COVID-19 pandemic, with many of the Company’s retail stores, as well as channel partner points of sale, temporarily closed at various times, and a significant number of the Company’s employees working remotely. The Company has reopened all of its retail stores and substantially all of its other facilities, subject to operating restrictions to protect public health and the health and safety of employees and customers, and it continues to work on safely reopening the remainder of its facilities, subject to local rules and regulations. During the fourth quarter of 2021, certain of the Company’s component suppliers and logistical service providers experienced disruptions, resulting in supply shortages that affected sales worldwide. Similar disruptions could occur in the future. The extent of the continuing impact of the COVID-19 pandemic on the Company’s operational and financial performance is uncertain and will depend on many factors outside the Company’s control, including the timing, extent, trajectory and duration of the pandemic, the emergence of new variants, the development, availability, distribution and effectiveness of vaccines and treatments, the imposition of protective public safety measures, and the impact of the pandemic on the global economy and demand for consumer products. Refer to Part I, Item 1A of this Form 10-K under the heading “Risk Factors” for more information. Fiscal 2021 Highlights Total net sales increased 33% or $91.3 billion during 2021 compared to 2020, driven by growth in all Products and Services categories. Year-over-year net sales during 2021 also grew in each of the Company’s reportable segments. In April 2021, the Company announced an increase to its current share repurchase program authorization from $225 billion to $315 billion and raised its quarterly dividend from $0.205 to $0.22 per share beginning in May 2021. During 2021, the Company repurchased $85.5 billion of its common stock and paid dividends and dividend equivalents of $14.5 billion. Apple Inc. | 2021 Form 10-K | 20 Products and Services Performance The following table shows net sales by category for 2021, 2020 and 2019 (dollars in millions): 2021 Change 2020 Change 2019 Net sales by category: iPhone (1) $ 191,973 39 % $ 137,781 (3) % $ 142,381 Mac (1) 35,190 23 % 28,622 11 % 25,740 iPad (1) 31,862 34 % 23,724 11 % 21,280 Wearables, Home and Accessories (1)(2) 38,367 25 % 30,620 25 % 24,482 Services (3) 68,425 27 % 53,768 16 % 46,291 Total net sales $ 365,817 33 % $ 274,515 6 % $ 260,174 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and accessories. (3) Services net sales include sales from the Company’s advertising, AppleCare, cloud, digital content, payment and other services. Services net sales also include amortization of the deferred value of services bundled in the sales price of certain products. iPhone iPhone net sales increased during 2021 compared to 2020 due primarily to higher net sales from the Company’s new iPhone models launched in the first quarter and fourth quarter of 2021 and a favorable mix of iPhone sales. Mac Mac net sales increased during 2021 compared to 2020 due primarily to higher net sales of MacBook Air, MacBook Pro and iMac. iPad iPad net sales increased during 2021 compared to 2020 due primarily to higher net sales of iPad Air and iPad Pro. Wearables, Home and Accessories Wearables, Home and Accessories net sales increased during 2021 compared to 2020 due primarily to higher net sales of accessories and Apple Watch. Services Services net sales increased during 2021 compared to 2020 due primarily to higher net sales from advertising, the App Store and cloud services. Apple Inc. | 2021 Form 10-K | 21 Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” The following table shows net sales by reportable segment for 2021, 2020 and 2019 (dollars in millions): 2021 Change 2020 Change 2019 Net sales by reportable segment: Americas $ 153,306 23 % $ 124,556 7 % $ 116,914 Europe 89,307 30 % 68,640 14 % 60,288 Greater China 68,366 70 % 40,308 (8) % 43,678 Japan 28,482 33 % 21,418 — % 21,506 Rest of Asia Pacific 26,356 35 % 19,593 10 % 17,788 Total net sales $ 365,817 33 % $ 274,515 6 % $ 260,174 Americas Americas net sales increased during 2021 compared to 2020 due primarily to higher net sales of iPhone, Services and Mac. Europe Europe net sales increased during 2021 compared to 2020 due primarily to higher net sales of iPhone, Services and iPad. The movement of foreign currencies in Europe relative to the U.S. dollar had a net favorable impact on Europe net sales during 2021. Greater China Greater China net sales increased during 2021 compared to 2020 due primarily to higher net sales of iPhone, iPad and Services. The strength of the Chinese renminbi relative to the U.S. dollar had a favorable impact on Greater China net sales during 2021. Japan Japan net sales increased during 2021 compared to 2020 due primarily to higher net sales of iPhone and Services. Rest of Asia Pacific Rest of Asia Pacific net sales increased during 2021 compared to 2020 due primarily to higher net sales of iPhone, iPad and Services. The movement of foreign currencies in the Rest of Asia Pacific relative to the U.S. dollar had a favorable impact on Rest of Asia Pacific net sales during 2021. Apple Inc. | 2021 Form 10-K | 22 Gross Margin Products and Services gross margin and gross margin percentage for 2021, 2020 and 2019 were as follows (dollars in millions): 2021 2020 2019 Gross margin: Products $ 105,126 $ 69,461 $ 68,887 Services 47,710 35,495 29,505 Total gross margin $ 152,836 $ 104,956 $ 98,392 Gross margin percentage: Products 35.3 % 31.5 % 32.2 % Services 69.7 % 66.0 % 63.7 % Total gross margin percentage 41.8 % 38.2 % 37.8 % Products Gross Margin Products gross margin increased during 2021 compared to 2020 due primarily to higher Products volume, a different Products mix and the strength in foreign currencies relative to the U.S. dollar. Products gross margin percentage increased during 2021 compared to 2020 due primarily to a different Products mix, improved leverage and the strength in foreign currencies relative to the U.S. dollar. Services Gross Margin Services gross margin increased during 2021 compared to 2020 due primarily to higher Services net sales and a different Services mix. Services gross margin percentage increased during 2021 compared to 2020 due primarily to a different Services mix and improved leverage, partially offset by higher Services costs. The Company’s future gross margins can be impacted by a variety of factors, as discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” As a result, the Company believes, in general, gross margins will be subject to volatility and downward pressure. Operating Expenses Operating expenses for 2021, 2020 and 2019 were as follows (dollars in millions): 2021 Change 2020 Change 2019 Research and development $ 21,914 17 % $ 18,752 16 % $ 16,217 Percentage of total net sales 6 % 7 % 6 % Selling, general and administrative $ 21,973 10 % $ 19,916 9 % $ 18,245 Percentage of total net sales 6 % 7 % 7 % Total operating expenses $ 43,887 13 % $ 38,668 12 % $ 34,462 Percentage of total net sales 12 % 14 % 13 % Research and Development The year-over-year growth in R&D expense in 2021 was driven primarily by increases in headcount-related expenses, R&D-related professional services and infrastructure-related costs. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products and services that are central to the Company’s core business strategy. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2021 was driven primarily by increases in headcount-related expenses, variable selling expenses and professional services. Apple Inc. | 2021 Form 10-K | 23 Other Income/(Expense), Net Other income/(expense), net (“OI&E”) for 2021, 2020 and 2019 was as follows (dollars in millions): 2021 Change 2020 Change 2019 Interest and dividend income $ 2,843 $ 3,763 $ 4,961 Interest expense (2,645) (2,873) (3,576) Other income/(expense), net 60 (87) 422 Total other income/(expense), net $ 258 (68) % $ 803 (56) % $ 1,807 The year-over-year decrease in OI&E during 2021 was due primarily to lower interest income and net losses on marketable securities, partially offset by positive fair value adjustments on non-marketable securities and lower interest expense on term debt. Provision for Income Taxes Provision for income taxes, effective tax rate and statutory federal income tax rate for 2021, 2020 and 2019 were as follows (dollars in millions): 2021 2020 2019 Provision for income taxes $ 14,527 $ 9,680 $ 10,481 Effective tax rate 13.3 % 14.4 % 15.9 % Statutory federal income tax rate 21 % 21 % 21 % The Company’s effective tax rate for 2021 was lower than the statutory federal income tax rate due primarily to a lower effective tax rate on foreign earnings, tax benefits from share-based compensation and foreign-derived intangible income deductions. The Company’s effective tax rate for 2020 was lower than the statutory federal income tax rate due primarily to the lower tax rate on foreign earnings, including the impact of tax settlements, and tax benefits from share-based compensation. The Company’s effective tax rate for 2021 was lower compared to 2020 due primarily to higher tax benefits from foreign-derived intangible income deductions and share-based compensation and the favorable impact of changes in unrecognized tax benefits, partially offset by a one-time adjustment in 2020 of U.S. foreign tax credits in response to regulations issued by the U.S. Department of the Treasury in December 2019. During 2021, the Company established deferred tax assets (“DTAs”) for foreign tax credit carryforwards in Ireland and increased DTAs for R&D tax credit carryforwards in California, which resulted in a combined $3.5 billion increase in the valuation allowance on the Company’s DTAs, with no effect on net income. Management believes it is more likely than not that forecasted income, together with future reversals of existing taxable temporary differences, will be sufficient to realize substantially all of the Company’s remaining DTAs. Liquidity and Capital Resources The Company believes its balances of cash, cash equivalents and unrestricted marketable securities, which totaled $172.6 billion as of September 25, 2021, along with cash generated by ongoing operations and continued access to debt markets, will be sufficient to satisfy its cash requirements and capital return program over the next 12 months and beyond. The Company’s material cash requirements include the following contractual and other obligations. Debt As of September 25, 2021, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $118.1 billion (collectively the “Notes”), with $9.6 billion payable within 12 months. Future interest payments associated with the Notes total $39.5 billion, with $2.9 billion payable within 12 months. The Company also issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. As of September 25, 2021, the Company had $6.0 billion of Commercial Paper outstanding, all of which was payable within 12 months. Apple Inc. | 2021 Form 10-K | 24 Leases The Company has lease arrangements for certain equipment and facilities, including retail, corporate, manufacturing and data center space. As of September 25, 2021, the Company had fixed lease payment obligations of $14.6 billion, with $1.8 billion payable within 12 months. Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture subassemblies for the Company’s products and to perform final assembly and testing of finished products. The Company also obtains individual components for its products from a wide variety of individual suppliers. Outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. As of September 25, 2021, the Company had manufacturing purchase obligations of $54.8 billion, with $54.7 billion payable within 12 months. The Company’s manufacturing purchase obligations are primarily noncancelable. Other Purchase Obligations The Company’s other purchase obligations primarily consist of noncancelable obligations to acquire capital assets, including product tooling and manufacturing process equipment, and noncancelable obligations related to advertising, content creation and Internet and telecommunications services. As of September 25, 2021, the Company had other purchase obligations of $8.3 billion, with $4.8 billion payable within 12 months. Deemed Repatriation Tax Payable As of September 25, 2021, the balance of the deemed repatriation tax payable imposed by the U.S. Tax Cuts and Jobs Act of 2017 (the “Act”) was $24.6 billion, none of which is payable within 12 months. In addition to its cash requirements, the Company has a capital return program authorized by the Board of Directors. The Program does not obligate the Company to acquire any specific number of shares. As of September 25, 2021, the Company’s quarterly cash dividend was $0.22 per share. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Critical Accounting Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported. Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Uncertain Tax Positions The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions. The evaluation of the Company’s uncertain tax positions involves significant judgment in the interpretation and application of GAAP and complex domestic and international tax laws, including the Act and matters related to the allocation of international taxation rights between countries. Although management believes the Company’s reserves are reasonable, no assurance can be given that the final tax outcome of these matters will not be different from that which is reflected in the Company’s reserves. Reserves are adjusted considering changing facts and circumstances, such as the closing of a tax examination or the refinement of an estimate. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies The Company is subject to various legal proceedings and claims that arise in the ordinary course of business, the outcomes of which are inherently uncertain. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Resolution of legal matters in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Apple Inc. | 2021 Form 10-K | 25 Item 7A.    Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. The Company’s investment policy and strategy are focused on the preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 25, 2021 and September 26, 2020, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $4.1 billion and $3.1 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. As of September 25, 2021 and September 26, 2020, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $118.7 billion and $107.4 billion, respectively. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on term debt are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 25, 2021 and September 26, 2020 to increase by $186 million and $218 million on an annualized basis, respectively. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and in the future may enter, into foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign currency–denominated debt issuances. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. Apple Inc. | 2021 Form 10-K | 26 To provide an assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $550 million as of September 25, 2021, compared to a maximum one-day loss in fair value of $551 million as of September 26, 2020. Because the Company uses foreign currency instruments for hedging purposes, the losses in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio, debt and derivative positions may differ materially from the sensitivity analyses performed as of September 25, 2021 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchange rates and the Company’s actual exposures and positions. Apple Inc. | 2021 Form 10-K | 27 Item 8.    Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 29 Consolidated Statements of Comprehensive Income for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 30 Consolidated Balance Sheets as of September 25, 2021 and September 26, 2020 31 Consolidated Statements of Shareholders’ Equity for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 32 Consolidated Statements of Cash Flows for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 33 Notes to Consolidated Financial Statements 34 Reports of Independent Registered Public Accounting Firm 52 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes. Apple Inc. | 2021 Form 10-K | 28 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 25, 2021 September 26, 2020 September 28, 2019 Net sales: Products $ 297,392 $ 220,747 $ 213,883 Services 68,425 53,768 46,291 Total net sales 365,817 274,515 260,174 Cost of sales: Products 192,266 151,286 144,996 Services 20,715 18,273 16,786 Total cost of sales 212,981 169,559 161,782 Gross margin 152,836 104,956 98,392 Operating expenses: Research and development 21,914 18,752 16,217 Selling, general and administrative 21,973 19,916 18,245 Total operating expenses 43,887 38,668 34,462 Operating income 108,949 66,288 63,930 Other income/(expense), net 258 803 1,807 Income before provision for income taxes 109,207 67,091 65,737 Provision for income taxes 14,527 9,680 10,481 Net income $ 94,680 $ 57,411 $ 55,256 Earnings per share: Basic $ 5.67 $ 3.31 $ 2.99 Diluted $ 5.61 $ 3.28 $ 2.97 Shares used in computing earnings per share: Basic 16,701,272 17,352,119 18,471,336 Diluted 16,864,919 17,528,214 18,595,651 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2021 Form 10-K | 29 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 25, 2021 September 26, 2020 September 28, 2019 Net income $ 94,680 $ 57,411 $ 55,256 Other comprehensive income/(loss): Change in foreign currency translation, net of tax 501 88 ( 408 ) Change in unrealized gains/losses on derivative instruments, net of tax: Change in fair value of derivative instruments 32 79 ( 661 ) Adjustment for net (gains)/losses realized and included in net income 1,003 ( 1,264 ) 23 Total change in unrealized gains/losses on derivative instruments 1,035 ( 1,185 ) ( 638 ) Change in unrealized gains/losses on marketable debt securities, net of tax: Change in fair value of marketable debt securities ( 694 ) 1,202 3,802 Adjustment for net (gains)/losses realized and included in net income ( 273 ) ( 63 ) 25 Total change in unrealized gains/losses on marketable debt securities ( 967 ) 1,139 3,827 Total other comprehensive income/(loss) 569 42 2,781 Total comprehensive income $ 95,249 $ 57,453 $ 58,037 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2021 Form 10-K | 30 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 25, 2021 September 26, 2020 ASSETS: Current assets: Cash and cash equivalents $ 34,940 $ 38,016 Marketable securities 27,699 52,927 Accounts receivable, net 26,278 16,120 Inventories 6,580 4,061 Vendor non-trade receivables 25,228 21,325 Other current assets 14,111 11,264 Total current assets 134,836 143,713 Non-current assets: Marketable securities 127,877 100,887 Property, plant and equipment, net 39,440 36,766 Other non-current assets 48,849 42,522 Total non-current assets 216,166 180,175 Total assets $ 351,002 $ 323,888 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 54,763 $ 42,296 Other current liabilities 47,493 42,684 Deferred revenue 7,612 6,643 Commercial paper 6,000 4,996 Term debt 9,613 8,773 Total current liabilities 125,481 105,392 Non-current liabilities: Term debt 109,106 98,667 Other non-current liabilities 53,325 54,490 Total non-current liabilities 162,431 153,157 Total liabilities 287,912 258,549 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $ 0.00001 par value: 50,400,000 shares authorized; 16,426,786 and 16,976,763 shares issued and outstanding, respectively 57,365 50,779 Retained earnings 5,562 14,966 Accumulated other comprehensive income/(loss) 163 ( 406 ) Total shareholders’ equity 63,090 65,339 Total liabilities and shareholders’ equity $ 351,002 $ 323,888 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2021 Form 10-K | 31 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except per share amounts) Years ended September 25, 2021 September 26, 2020 September 28, 2019 Total shareholders’ equity, beginning balances $ 65,339 $ 90,488 $ 107,147 Common stock and additional paid-in capital: Beginning balances 50,779 45,174 40,201 Common stock issued 1,105 880 781 Common stock withheld related to net share settlement of equity awards ( 2,627 ) ( 2,250 ) ( 2,002 ) Share-based compensation 8,108 6,975 6,194 Ending balances 57,365 50,779 45,174 Retained earnings: Beginning balances 14,966 45,898 70,400 Net income 94,680 57,411 55,256 Dividends and dividend equivalents declared ( 14,431 ) ( 14,087 ) ( 14,129 ) Common stock withheld related to net share settlement of equity awards ( 4,151 ) ( 1,604 ) ( 1,029 ) Common stock repurchased ( 85,502 ) ( 72,516 ) ( 67,101 ) Cumulative effects of changes in accounting principles — ( 136 ) 2,501 Ending balances 5,562 14,966 45,898 Accumulated other comprehensive income/(loss): Beginning balances ( 406 ) ( 584 ) ( 3,454 ) Other comprehensive income/(loss) 569 42 2,781 Cumulative effects of changes in accounting principles — 136 89 Ending balances 163 ( 406 ) ( 584 ) Total shareholders’ equity, ending balances $ 63,090 $ 65,339 $ 90,488 Dividends and dividend equivalents declared per share or RSU $ 0.85 $ 0.795 $ 0.75 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2021 Form 10-K | 32 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 25, 2021 September 26, 2020 September 28, 2019 Cash, cash equivalents and restricted cash, beginning balances $ 39,789 $ 50,224 $ 25,913 Operating activities: Net income 94,680 57,411 55,256 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 11,284 11,056 12,547 Share-based compensation expense 7,906 6,829 6,068 Deferred income tax benefit ( 4,774 ) ( 215 ) ( 340 ) Other ( 147 ) ( 97 ) ( 652 ) Changes in operating assets and liabilities: Accounts receivable, net ( 10,125 ) 6,917 245 Inventories ( 2,642 ) ( 127 ) ( 289 ) Vendor non-trade receivables ( 3,903 ) 1,553 2,931 Other current and non-current assets ( 8,042 ) ( 9,588 ) 873 Accounts payable 12,326 ( 4,062 ) ( 1,923 ) Deferred revenue 1,676 2,081 ( 625 ) Other current and non-current liabilities 5,799 8,916 ( 4,700 ) Cash generated by operating activities 104,038 80,674 69,391 Investing activities: Purchases of marketable securities ( 109,558 ) ( 114,938 ) ( 39,630 ) Proceeds from maturities of marketable securities 59,023 69,918 40,102 Proceeds from sales of marketable securities 47,460 50,473 56,988 Payments for acquisition of property, plant and equipment ( 11,085 ) ( 7,309 ) ( 10,495 ) Payments made in connection with business acquisitions, net ( 33 ) ( 1,524 ) ( 624 ) Purchases of non-marketable securities ( 131 ) ( 210 ) ( 1,001 ) Proceeds from non-marketable securities 387 92 1,634 Other ( 608 ) ( 791 ) ( 1,078 ) Cash generated by/(used in) investing activities ( 14,545 ) ( 4,289 ) 45,896 Financing activities: Proceeds from issuance of common stock 1,105 880 781 Payments for taxes related to net share settlement of equity awards ( 6,556 ) ( 3,634 ) ( 2,817 ) Payments for dividends and dividend equivalents ( 14,467 ) ( 14,081 ) ( 14,119 ) Repurchases of common stock ( 85,971 ) ( 72,358 ) ( 66,897 ) Proceeds from issuance of term debt, net 20,393 16,091 6,963 Repayments of term debt ( 8,750 ) ( 12,629 ) ( 8,805 ) Proceeds from/(Repayments of) commercial paper, net 1,022 ( 963 ) ( 5,977 ) Other ( 129 ) ( 126 ) ( 105 ) Cash used in financing activities ( 93,353 ) ( 86,820 ) ( 90,976 ) Increase/(Decrease) in cash, cash equivalents and restricted cash ( 3,860 ) ( 10,435 ) 24,311 Cash, cash equivalents and restricted cash, ending balances $ 35,929 $ 39,789 $ 50,224 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 25,385 $ 9,501 $ 15,263 Cash paid for interest $ 2,687 $ 3,002 $ 3,423 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2021 Form 10-K | 33 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Basis of Presentation and Preparation The consolidated financial statements include the accounts of Apple Inc. and its wholly owned subsidiaries (collectively “Apple” or the “Company”). Intercompany accounts and transactions have been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these consolidated financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. An additional week is included in the first fiscal quarter every five or six years to realign the Company’s fiscal quarters with calendar quarters. The Company’s fiscal years 2021, 2020 and 2019 spanned 52 weeks each. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Recently Adopted Accounting Pronouncements Financial Instruments – Credit Losses At the beginning of the first quarter of 2021, the Company adopted the Financial Accounting Standards Board’s (the “FASB”) Accounting Standards Update (“ASU”) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses on certain financial instruments. The Company adopted ASU 2016-13 utilizing the modified retrospective transition method. The adoption of ASU 2016-13 did not have a material impact on the Company’s condensed consolidated financial statements. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Share-Based Compensation The Company generally measures share-based compensation based on the closing price of the Company’s common stock on the date of grant, and recognizes expense on a straight-line basis for its estimate of equity awards that will ultimately vest. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Earnings Per Share The following table shows the computation of basic and diluted earnings per share for 2021, 2020 and 2019 (net income in millions and shares in thousands): 2021 2020 2019 Numerator: Net income $ 94,680 $ 57,411 $ 55,256 Denominator: Weighted-average basic shares outstanding 16,701,272 17,352,119 18,471,336 Effect of dilutive securities 163,647 176,095 124,315 Weighted-average diluted shares 16,864,919 17,528,214 18,595,651 Basic earnings per share $ 5.67 $ 3.31 $ 2.99 Diluted earnings per share $ 5.61 $ 3.28 $ 2.97 Apple Inc. | 2021 Form 10-K | 34 The Company applies the treasury stock method to determine the dilutive effect of potentially dilutive securities. Potentially dilutive securities representing 62 million shares of common stock were excluded from the computation of diluted earnings per share for 2019 because their effect would have been antidilutive. Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s investments in marketable debt securities have been classified and accounted for as available-for-sale. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Unrealized gains and losses on marketable debt securities classified as available-for-sale are recognized in other comprehensive income/(loss) (“OCI”). The Company’s investments in marketable equity securities are classified based on the nature of the securities and their availability for use in current operations. The Company’s marketable equity securities are measured at fair value with gains and losses recognized in other income/(expense), net (“OI&E”). The cost of securities sold is determined using the specific identification method. Inventories Inventories are measured using the first-in, first-out method. Property, Plant and Equipment Depreciation on property, plant and equipment is recognized on a straight-line basis over the estimated useful lives of the assets, which for buildings is the lesser of 40 years or the remaining life of the building; between one and five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease term or useful life for leasehold improvements. Capitalized costs related to internal-use software are amortized on a straight-line basis over the estimated useful lives of the assets, which range from five to seven years . Depreciation and amortization expense on property and equipment was $ 9.5 billion, $ 9.7 billion and $ 11.3 billion during 2021, 2020 and 2019, respectively. Noncash investing activities involving property, plant and equipment resulted in a net decrease to accounts payable and other current liabilities of $ 2.9 billion during 2019. Restricted Cash and Restricted Marketable Securities The Company considers cash and marketable securities to be restricted when withdrawal or general use is legally restricted. The Company reports restricted cash as other assets in the Consolidated Balance Sheets, and determines current or non-current classification based on the expected duration of the restriction. The Company reports restricted marketable securities as current or non-current marketable securities in the Consolidated Balance Sheets based on the classification of the underlying securities. Derivative Instruments and Hedging All derivative instruments are recorded in the Consolidated Balance Sheets at fair value. The accounting treatment for derivative gains and losses is based on intended use and hedge designation. Gains and losses arising from amounts that are included in the assessment of cash flow hedge effectiveness are initially deferred in accumulated other comprehensive income/(loss) (“AOCI”) and subsequently reclassified into earnings when the hedged transaction affects earnings, and in the same line item in the Consolidated Statements of Operations. For options designated as cash flow hedges, the Company excludes time value from the assessment of hedge effectiveness and recognizes it on a straight-line basis over the life of the hedge in the Consolidated Statements of Operations line item to which the hedge relates. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in OCI. Gains and losses arising from amounts that are included in the assessment of fair value hedge effectiveness are recognized in the Consolidated Statements of Operations line item to which the hedge relates along with offsetting losses and gains related to the change in value of the hedged item. For foreign exchange forward contracts designated as fair value hedges, the Company excludes the forward carry component from the assessment of hedge effectiveness and recognizes it in OI&E on a straight-line basis over the life of the hedge. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in OCI. Gains and losses arising from changes in the fair values of derivative instruments that are not designated as accounting hedges are recognized in the Consolidated Statements of Operations line items to which the derivative instruments relate. Apple Inc. | 2021 Form 10-K | 35 The Company presents derivative assets and liabilities at their gross fair values in the Consolidated Balance Sheets. The Company classifies cash flows related to derivative instruments as operating activities in the Consolidated Statements of Cash Flows. Fair Value Measurements The fair values of the Company’s money market funds and certain marketable equity securities are based on quoted prices in active markets for identical assets. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, which generally have counterparties with high credit ratings, are based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. Note 2 – Revenue Recognition Net sales consist of revenue from the sale of iPhone, Mac, iPad, Services and other products. The Company recognizes revenue at the amount to which it expects to be entitled when control of the products or services is transferred to its customers. Control is generally transferred when the Company has a present right to payment and title and the significant risks and rewards of ownership of products or services are transferred to its customers. For most of the Company’s Products net sales, control transfers when products are shipped. For the Company’s Services net sales, control transfers over time as services are delivered. Payment for Products and Services net sales is collected within a short period following transfer of control or commencement of delivery of services, as applicable. The Company records reductions to Products net sales related to future product returns, price protection and other customer incentive programs based on the Company’s expectations and historical experience. For arrangements with multiple performance obligations, which represent promises within an arrangement that are distinct, the Company allocates revenue to all distinct performance obligations based on their relative stand-alone selling prices (“SSPs”). When available, the Company uses observable prices to determine SSPs. When observable prices are not available, SSPs are established that reflect the Company’s best estimates of what the selling prices of the performance obligations would be if they were sold regularly on a stand-alone basis. The Company’s process for estimating SSPs without observable prices considers multiple factors that may vary depending upon the unique facts and circumstances related to each performance obligation including, where applicable, prices charged by the Company for similar offerings, market trends in the pricing for similar offerings, product-specific business objectives and the estimated cost to provide the performance obligation. The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud ® , Siri and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative SSPs. Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the delivered hardware and bundled software is recognized when control has transferred to the customer, which generally occurs when the product is shipped. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. Cost of sales related to delivered hardware and bundled software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide product-related bundled services and unspecified software upgrade rights are recognized as cost of sales as incurred. For certain long-term service arrangements, the Company has performance obligations for services it has not yet delivered. For these arrangements, the Company does not have a right to bill for the undelivered services. The Company has determined that any unbilled consideration relates entirely to the value of the undelivered services. Accordingly, the Company has not recognized revenue, and has elected not to disclose amounts, related to these undelivered services. For the sale of third-party products where the Company obtains control of the product before transferring it to the customer, the Company recognizes revenue based on the gross amount billed to customers. The Company considers multiple factors when determining whether it obtains control of third-party products including, but not limited to, evaluating if it can establish the price of the product, retains inventory risk for tangible products or has the responsibility for ensuring acceptability of the product. For third-party applications sold through the App Store and certain digital content sold through the Company’s other digital content stores, the Company does not obtain control of the product before transferring it to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in Services net sales only the commission it retains. The Company has elected to record revenue net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded within other current liabilities until remitted to the relevant government authority. Apple Inc. | 2021 Form 10-K | 36 Deferred Revenue As of September 25, 2021 and September 26, 2020, the Company had total deferred revenue of $ 11.9 billion and $ 10.2 billion, respectively. As of September 25, 2021, the Company expects 64 % of total deferred revenue to be realized in less than a year, 26 % within one-to-two years, 8 % within two-to-three years and 2 % in greater than three years. Disaggregated Revenue Net sales disaggregated by significant products and services for 2021, 2020 and 2019 were as follows (in millions): 2021 2020 2019 iPhone (1) $ 191,973 $ 137,781 $ 142,381 Mac (1) 35,190 28,622 25,740 iPad (1) 31,862 23,724 21,280 Wearables, Home and Accessories (1)(2) 38,367 30,620 24,482 Services (3) 68,425 53,768 46,291 Total net sales (4) $ 365,817 $ 274,515 $ 260,174 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod, iPod touch and accessories. (3) Services net sales include sales from the Company’s advertising, AppleCare, cloud, digital content, payment and other services. Services net sales also include amortization of the deferred value of services bundled in the sales price of certain products. (4) Includes $ 6.7 billion of revenue recognized in 2021 that was included in deferred revenue as of September 26, 2020, $ 5.0 billion of revenue recognized in 2020 that was included in deferred revenue as of September 28, 2019, and $ 5.9 billion of revenue recognized in 2019 that was included in deferred revenue as of September 29, 2018. The Company’s proportion of net sales by disaggregated revenue source was generally consistent for each reportable segment in Note 11, “Segment Information and Geographic Data” for 2021, 2020 and 2019. Apple Inc. | 2021 Form 10-K | 37 Note 3 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash, cash equivalents and marketable securities by significant investment category as of September 25, 2021 and September 26, 2020 (in millions): 2021 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 17,305 $ — $ — $ 17,305 $ 17,305 $ — $ — Level 1 (1) : Money market funds 9,608 — — 9,608 9,608 — — Mutual funds 175 11 ( 1 ) 185 — 185 — Subtotal 9,783 11 ( 1 ) 9,793 9,608 185 — Level 2 (2) : Equity securities 1,527 — ( 564 ) 963 — 963 — U.S. Treasury securities 22,878 102 ( 77 ) 22,903 3,596 6,625 12,682 U.S. agency securities 8,949 2 ( 64 ) 8,887 1,775 1,930 5,182 Non-U.S. government securities 20,201 211 ( 101 ) 20,311 390 3,091 16,830 Certificates of deposit and time deposits 1,300 — — 1,300 490 810 — Commercial paper 2,639 — — 2,639 1,776 863 — Corporate debt securities 83,883 1,242 ( 267 ) 84,858 — 12,327 72,531 Municipal securities 967 14 — 981 — 130 851 Mortgage- and asset-backed securities 20,529 171 ( 124 ) 20,576 — 775 19,801 Subtotal 162,873 1,742 ( 1,197 ) 163,418 8,027 27,514 127,877 Total (3) $ 189,961 $ 1,753 $ ( 1,198 ) $ 190,516 $ 34,940 $ 27,699 $ 127,877 2020 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 17,773 $ — $ — $ 17,773 $ 17,773 $ — $ — Level 1 (1) : Money market funds 2,171 — — 2,171 2,171 — — Level 2 (2) : U.S. Treasury securities 28,439 331 — 28,770 8,580 11,972 8,218 U.S. agency securities 8,604 8 — 8,612 2,009 3,078 3,525 Non-U.S. government securities 19,361 275 ( 186 ) 19,450 255 3,329 15,866 Certificates of deposit and time deposits 10,399 — — 10,399 4,043 6,246 110 Commercial paper 11,226 — — 11,226 3,185 8,041 — Corporate debt securities 76,937 1,834 ( 175 ) 78,596 — 19,687 58,909 Municipal securities 1,001 22 — 1,023 — 139 884 Mortgage- and asset-backed securities 13,520 314 ( 24 ) 13,810 — 435 13,375 Subtotal 169,487 2,784 ( 385 ) 171,886 18,072 52,927 100,887 Total (3) $ 189,431 $ 2,784 $ ( 385 ) $ 191,830 $ 38,016 $ 52,927 $ 100,887 (1) Level 1 fair value estimates are based on quoted prices in active markets for identical assets or liabilities. (2) Level 2 fair value estimates are based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. (3) As of September 25, 2021 and September 26, 2020, total marketable securities included $ 17.9 billion and $ 18.6 billion, respectively, that was restricted from general use, related to the State Aid Decision (refer to Note 5, “Income Taxes”) and other agreements. Apple Inc. | 2021 Form 10-K | 38 The Company may sell certain of its marketable debt securities prior to their stated maturities for reasons including, but not limited to, managing liquidity, credit risk, duration and asset allocation. The following table shows the fair value of the Company’s non-current marketable debt securities, by contractual maturity, as of September 25, 2021 (in millions): Due after 1 year through 5 years $ 83,755 Due after 5 years through 10 years 23,915 Due after 10 years 20,207 Total fair value $ 127,877 The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. Fair values were determined for each individual security in the investment portfolio. Derivative Instruments and Hedging The Company may use derivative instruments to partially offset its business exposure to foreign exchange and interest rate risk. However, the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange or interest rates. Foreign Exchange Risk To protect gross margins from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, option contracts or other instruments, and may designate these instruments as cash flow hedges. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, cross-currency swaps or other instruments. The Company designates these instruments as either cash flow or fair value hedges. As of September 25, 2021, the Company’s hedged term debt– and marketable securities–related foreign currency transactions are expected to be recognized within 21 years. The Company may also enter into derivative instruments that are not designated as accounting hedges to protect gross margins from certain fluctuations in foreign currency exchange rates, as well as to offset a portion of the foreign currency exchange gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. Interest Rate Risk To protect the Company’s term debt or marketable securities from fluctuations in interest rates, the Company may enter into interest rate swaps, options or other instruments. The Company designates these instruments as either cash flow or fair value hedges. The notional amounts of the Company’s outstanding derivative instruments as of September 25, 2021 and September 26, 2020 were as follows (in millions): 2021 2020 Derivative instruments designated as accounting hedges: Foreign exchange contracts $ 76,475 $ 57,410 Interest rate contracts $ 16,875 $ 20,700 Derivative instruments not designated as accounting hedges: Foreign exchange contracts $ 126,918 $ 88,636 The gross fair values of the Company’s derivative assets and liabilities were not material as of September 25, 2021 and September 26, 2020. The gains and losses recognized in OCI and amounts reclassified from AOCI to net income for the Company’s derivative instruments designated as cash flow hedges were not material in 2021, 2020 and 2019. Apple Inc. | 2021 Form 10-K | 39 The carrying amounts of the Company’s hedged items in fair value hedges as of September 25, 2021 and September 26, 2020 were as follows (in millions): 2021 2020 Hedged assets/(liabilities): Current and non-current marketable securities $ 15,954 $ 16,270 Current and non-current term debt $ ( 17,857 ) $ ( 21,033 ) The gains and losses on the Company’s derivative instruments designated as fair value hedges and the related hedged item adjustments were not material in 2021, 2020 and 2019. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral or third-party credit support in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of both September 25, 2021 and September 26, 2020, the Company had no customers that individually represented 10% or more of total trade receivables. The Company’s cellular network carriers accounted for 42 % of total trade receivables as of September 25, 2021. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture subassemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. As of September 25, 2021, the Company had three vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 52 %, 11 % and 11 %. As of September 26, 2020, the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 57 % and 11 %. Note 4 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 25, 2021 and September 26, 2020 (in millions): Property, Plant and Equipment, Net 2021 2020 Land and buildings $ 20,041 $ 17,952 Machinery, equipment and internal-use software 78,659 75,291 Leasehold improvements 11,023 10,283 Gross property, plant and equipment 109,723 103,526 Accumulated depreciation and amortization ( 70,283 ) ( 66,760 ) Total property, plant and equipment, net $ 39,440 $ 36,766 Other Non-Current Liabilities 2021 2020 Long-term taxes payable $ 24,689 $ 28,170 Other non-current liabilities 28,636 26,320 Total other non-current liabilities $ 53,325 $ 54,490 Apple Inc. | 2021 Form 10-K | 40 Other Income/(Expense), Net The following table shows the detail of OI&E for 2021, 2020 and 2019 (in millions): 2021 2020 2019 Interest and dividend income $ 2,843 $ 3,763 $ 4,961 Interest expense ( 2,645 ) ( 2,873 ) ( 3,576 ) Other income/(expense), net 60 ( 87 ) 422 Total other income/(expense), net $ 258 $ 803 $ 1,807 Note 5 – Income Taxes Provision for Income Taxes and Effective Tax Rate The provision for income taxes for 2021, 2020 and 2019, consisted of the following (in millions): 2021 2020 2019 Federal: Current $ 8,257 $ 6,306 $ 6,384 Deferred ( 7,176 ) ( 3,619 ) ( 2,939 ) Total 1,081 2,687 3,445 State: Current 1,620 455 475 Deferred ( 338 ) 21 ( 67 ) Total 1,282 476 408 Foreign: Current 9,424 3,134 3,962 Deferred 2,740 3,383 2,666 Total 12,164 6,517 6,628 Provision for income taxes $ 14,527 $ 9,680 $ 10,481 The foreign provision for income taxes is based on foreign pretax earnings of $ 68.7 billion, $ 38.1 billion and $ 44.3 billion in 2021, 2020 and 2019, respectively. A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate ( 21 % in 2021, 2020 and 2019) to income before provision for income taxes for 2021, 2020 and 2019, is as follows (dollars in millions): 2021 2020 2019 Computed expected tax $ 22,933 $ 14,089 $ 13,805 State taxes, net of federal effect 1,151 423 423 Impacts of the U.S. Tax Cuts and Jobs Act of 2017 — ( 582 ) — Earnings of foreign subsidiaries ( 4,715 ) ( 2,534 ) ( 2,625 ) Foreign-derived intangible income deduction ( 1,372 ) ( 169 ) ( 149 ) Research and development credit, net ( 1,033 ) ( 728 ) ( 548 ) Excess tax benefits from equity awards ( 2,137 ) ( 930 ) ( 639 ) Other ( 300 ) 111 214 Provision for income taxes $ 14,527 $ 9,680 $ 10,481 Effective tax rate 13.3 % 14.4 % 15.9 % Apple Inc. | 2021 Form 10-K | 41 Deferred Tax Assets and Liabilities As of September 25, 2021 and September 26, 2020, the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2021 2020 Deferred tax assets: Amortization and depreciation $ 5,575 $ 8,317 Accrued liabilities and other reserves 5,895 4,934 Lease liabilities 2,406 2,038 Deferred revenue 5,399 1,638 Tax credit carryforwards 4,262 797 Other 1,639 1,612 Total deferred tax assets 25,176 19,336 Less: Valuation allowance ( 4,903 ) ( 1,041 ) Total deferred tax assets, net 20,273 18,295 Deferred tax liabilities: Minimum tax on foreign earnings 4,318 7,045 Right-of-use assets 2,167 1,862 Unrealized gains 203 526 Other 512 705 Total deferred tax liabilities 7,200 10,138 Net deferred tax assets $ 13,073 $ 8,157 Deferred tax assets and liabilities reflect the effects of tax credits and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The Company has elected to record certain deferred tax assets and liabilities in connection with the minimum tax on certain foreign earnings created by the U.S. Tax Cuts and Jobs Act of 2017 (the “Act”). As of September 25, 2021, the Company had $ 2.6 billion in foreign tax credit carryforwards in Ireland and $ 1.6 billion in California research and development credit carryforwards, both of which can be carried forward indefinitely. A valuation allowance has been recorded for the tax credit carryforwards and a portion of other temporary differences. Uncertain Tax Positions As of September 25, 2021, the total amount of gross unrecognized tax benefits was $ 15.5 billion, of which $ 6.6 billion, if recognized, would impact the Company’s effective tax rate. As of September 26, 2020, the total amount of gross unrecognized tax benefits was $ 16.5 billion, of which $ 8.8 billion, if recognized, would have impacted the Company’s effective tax rate. The aggregate change in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2021, 2020 and 2019, is as follows (in millions): 2021 2020 2019 Beginning balances $ 16,475 $ 15,619 $ 9,694 Increases related to tax positions taken during a prior year 816 454 5,845 Decreases related to tax positions taken during a prior year ( 1,402 ) ( 791 ) ( 686 ) Increases related to tax positions taken during the current year 1,607 1,347 1,697 Decreases related to settlements with taxing authorities ( 1,838 ) ( 85 ) ( 852 ) Decreases related to expiration of the statute of limitations ( 181 ) ( 69 ) ( 79 ) Ending balances $ 15,477 $ 16,475 $ 15,619 The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisd ictions. Tax years after 2015 for the U.S. federal jurisdiction, and after 2014 in certain major foreign jurisdictions, remain subject to examination. Although the timing of resolution and/or closure of examinations is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease in the next 12 months by as much as $ 1.2 billion. Apple Inc. | 2021 Form 10-K | 42 Interest and Penalties The Company includes interest and penalties related to income tax matters within the provision for income taxes. As of September 25, 2021 and September 26, 2020, the total amount of gross interest and penalties accrued was $ 1.5 billion and $ 1.4 billion, respectively. The Company recognized interest and penalty expense of $ 219 million, $ 85 million and $ 73 million in 2021, 2020 and 2019, respectively. European Commission State Aid Decision On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The recovery amount was calculated to be € 13.1 billion, plus interest of € 1.2 billion. The Company and Ireland appealed the State Aid Decision to the General Court of the Court of Justice of the European Union (the “General Court”). On July 15, 2020, the General Court annulled the State Aid Decision. On September 25, 2020, the European Commission appealed the General Court’s decision to the European Court of Justice. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes, subject to any foreign tax credit limitations in the Act. On an annual basis, the Company may request approval from the Irish Minister for Finance to reduce the recovery amount for certain taxes paid to other countries. As of September 25, 2021, the adjusted recovery amount was € 12.7 billion, excluding interest. The adjusted recovery amount plus interest is funded into escrow, where it will remain restricted from general use pending the conclusion of all legal proceedings. Refer to the Cash, Cash Equivalents and Marketable Securities section of Note 3, “Financial Instruments” for more information. Note 6 – Leases The Company has lease arrangements for certain equipment and facilities, including retail, corporate, manufacturing and data center space. These leases typically have original terms not exceeding 10 years and generally contain multiyear renewal options, some of which are reasonably certain of exercise. The Company’s lease arrangements may contain both lease and nonlease components. The Company has elected to combine and account for lease and nonlease components as a single lease component for leases of retail, corporate, and data center facilities. Payments under the Company’s lease arrangements may be fixed or variable, and variable lease payments are primarily based on purchases of output of the underlying leased assets. Lease costs associated with fixed payments on the Company’s operating leases were $ 1.7 billion and $ 1.5 billion for 2021 and 2020, respectively. Lease costs associated with variable payments on the Company’s leases were $ 12.9 billion and $ 9.3 billion for 2021 and 2020, respectively. Rent expense for operating leases, as previously reported under former lease accounting standards, was $ 1.3 billion in 2019. The Company made $ 1.4 billion and $ 1.5 billion of fixed cash payments related to operating leases in 2021 and 2020, respectively. Noncash activities involving right-of-use (“ROU”) assets obtained in exchange for lease liabilities were $ 3.3 billion for 2021 and $ 10.5 billion for 2020, including the impact of adopting FASB ASU No. 2016-02, Leases (Topic 842) in the first quarter of 2020. The following table shows ROU assets and lease liabilities, and the associated financial statement line items, as of September 25, 2021 and September 26, 2020 (in millions): Lease-Related Assets and Liabilities Financial Statement Line Items 2021 2020 Right-of-use assets: Operating leases Other non-current assets $ 10,087 $ 8,570 Finance leases Property, plant and equipment, net 861 629 Total right-of-use assets $ 10,948 $ 9,199 Lease liabilities: Operating leases Other current liabilities $ 1,449 $ 1,436 Other non-current liabilities 9,506 7,745 Finance leases Other current liabilities 79 24 Other non-current liabilities 769 637 Total lease liabilities $ 11,803 $ 9,842 Apple Inc. | 2021 Form 10-K | 43 Lease liability maturities as of September 25, 2021, are as follows (in millions): Operating Leases Finance Leases Total 2022 $ 1,629 $ 104 $ 1,733 2023 1,560 123 1,683 2024 1,499 99 1,598 2025 1,251 46 1,297 2026 1,061 26 1,087 Thereafter 5,187 868 6,055 Total undiscounted liabilities 12,187 1,266 13,453 Less: Imputed interest ( 1,232 ) ( 418 ) ( 1,650 ) Total lease liabilities $ 10,955 $ 848 $ 11,803 The weighted-average remaining lease term related to the Company’s lease liabilities as of September 25, 2021 and September 26, 2020 was 10.8 years and 10.3 years, respectively. The discount rate related to the Company’s lease liabilities as of both September 25, 2021 and September 26, 2020 was 2.0 %. The discount rates are generally based on estimates of the Company’s incremental borrowing rate, as the discount rates implicit in the Company’s leases cannot be readily determined. As of September 25, 2021, the Company had $ 1.1 billion of future payments under additional leases, primarily for corporate facilities and retail space, that had not yet commenced. These leases will commence between 2022 and 2023, with lease terms ranging from 3 years to 20 years. Note 7 – Debt Commercial Paper and Repurchase Agreements The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 25, 2021 and September 26, 2020, the Company had $ 6.0 billion and $ 5.0 billion of Commercial Paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 0.06 % and 0.62 % as of September 25, 2021 and September 26, 2020, respectively. The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2021, 2020 and 2019 (in millions): 2021 2020 2019 Maturities 90 days or less: Proceeds from/(Repayments of) commercial paper, net $ ( 357 ) $ 100 $ ( 3,248 ) Maturities greater than 90 days: Proceeds from commercial paper 7,946 6,185 13,874 Repayments of commercial paper ( 6,567 ) ( 7,248 ) ( 16,603 ) Proceeds from/(Repayments of) commercial paper, net 1,379 ( 1,063 ) ( 2,729 ) Total proceeds from/(repayments of) commercial paper, net $ 1,022 $ ( 963 ) $ ( 5,977 ) In 2020, the Company entered into agreements to sell certain of its marketable securities with a promise to repurchase the securities at a specified time and amount (“Repos”). Due to the Company’s continuing involvement with the marketable securities, the Company accounted for its Repos as collateralized borrowings. The Company entered into $ 5.2 billion of Repos during 2020, all of which had been settled as of September 26, 2020. Apple Inc. | 2021 Form 10-K | 44 Term Debt As of September 25, 2021, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $ 118.1 billion (collectively the “Notes”). The Notes are senior unsecured obligations and interest is payable in arrears. The following table provides a summary of the Company’s term debt as of September 25, 2021 and September 26, 2020: Maturities (calendar year) 2021 2020 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 – 2020 debt issuances: Floating-rate notes 2022 $ 1,750 0.48 % – 0.63 % $ 2,250 0.60 % – 1.39 % Fixed-rate 0.000 % – 4.650 % notes 2022 – 2060 95,813 0.03 % – 4.78 % 103,828 0.03 % – 4.78 % Second quarter 2021 debt issuance: Fixed-rate 0.700 % – 2.800 % notes 2026 – 2061 14,000 0.75 % – 2.81 % — — % Fourth quarter 2021 debt issuance: Fixed-rate 1.400 % – 2.850 % notes 2028 – 2061 6,500 1.43 % – 2.86 % — — % Total term debt 118,063 106,078 Unamortized premium/(discount) and issuance costs, net ( 380 ) ( 314 ) Hedge accounting fair value adjustments 1,036 1,676 Less: Current portion of term debt ( 9,613 ) ( 8,773 ) Total non-current portion of term debt $ 109,106 $ 98,667 To manage interest rate risk on certain of its U.S. dollar–denominated fixed- or floating-rate notes, the Company has entered into interest rate swaps to effectively convert the fixed interest rates to floating interest rates or the floating interest rates to fixed interest rates on a portion of these notes. Additionally, to manage foreign currency risk on certain of its foreign currency–denominated notes, the Company has entered into foreign currency swaps to effectively convert these notes to U.S. dollar–denominated notes. The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $ 2.6 billion, $ 2.8 billion and $ 3.2 billion of interest expense on its term debt for 2021, 2020 and 2019, respectively. The future principal payments for the Company’s Notes as of September 25, 2021, are as follows (in millions): 2022 $ 9,583 2023 11,391 2024 10,202 2025 10,914 2026 11,408 Thereafter 64,565 Total term debt $ 118,063 As of September 25, 2021 and September 26, 2020, the fair value of the Company’s Notes, based on Level 2 inputs, was $ 125.3 billion and $ 117.1 billion, respectively. Apple Inc. | 2021 Form 10-K | 45 Note 8 – Shareholders’ Equity Share Repurchase Program As of September 25, 2021, the Company was authorized to purchase up to $ 315 billion of the Company’s common stock under a share repurchase program (the “Program”). During 2021, the Company repurchased 656 million shares of its common stock for $ 85.5 billion, including 36 million shares delivered under a $ 5.0 billion accelerated share repurchase agreement entered into in May 2021, bringing the total utilization under the Program to $ 254.1 billion as of September 25, 2021. The Program does not obligate the Company to acquire any specific number of shares. Under the Program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Shares of Common Stock The following table shows the changes in shares of common stock for 2021, 2020 and 2019 (in thousands): 2021 2020 2019 Common stock outstanding, beginning balances 16,976,763 17,772,945 19,019,943 Common stock repurchased ( 656,340 ) ( 917,270 ) ( 1,380,819 ) Common stock issued, net of shares withheld for employee taxes 106,363 121,088 133,821 Common stock outstanding, ending balances 16,426,786 16,976,763 17,772,945 Note 9 – Benefit Plans 2014 Employee Stock Plan The 2014 Employee Stock Plan (the “2014 Plan”) is a shareholder-approved plan that provides for broad-based equity grants to employees, including executive officers, and permits the granting of restricted stock units (“RSUs”), stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the 2014 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. RSUs granted under the 2014 Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. RSUs canceled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the number of RSUs canceled or shares withheld. All RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the underlying RSUs. As of September 25, 2021, approximately 760 million shares were reserved for future issuance under the 2014 Plan. Shares subject to outstanding awards under the 2003 Employee Stock Plan that expire, are canceled or otherwise terminate, or are withheld to satisfy tax withholding obligations for RSUs, will also be available for awards under the 2014 Plan. Apple Inc. Non-Employee Director Stock Plan The Apple Inc. Non-Employee Director Stock Plan (the “Director Plan”) is a shareholder-approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the value and relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants, in each case within the limits set forth in the Director Plan and without further shareholder approval. RSUs granted under the Director Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. The Director Plan expires on November 12, 2027. All RSUs granted under the Director Plan are entitled to DERs, which are subject to the same vesting and other terms and conditions as the underlying RSUs. As of September 25, 2021, approximately 4 million shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the three months ended September 25, 2021, Section 16 officers Katherine L. Adams, Timothy D. Cook, Luca Maestri, Deirdre O’Brien and Jeffrey Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that preestablishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired under the Company’s employee and director equity plans. Apple Inc. | 2021 Form 10-K | 46 Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder-approved plan under which substantially all employees may voluntarily enroll to purchase the Company’s common stock through payroll deductions at a price equal to 85 % of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10 % of the employee’s compensation and employees may not purchase more than $ 25,000 of stock during any calendar year. As of September 25, 2021, approximately 96 million shares were reserved for future issuance under the Purchase Plan. 401(k) Plan The Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pretax earnings, up to the U.S. Internal Revenue Service annual contribution limit ($ 19,500 for calendar year 2021). The Company matches 50 % to 100 % of each employee’s contributions, depending on length of service, up to a maximum of 6 % of the employee’s eligible earnings. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2021, 2020 and 2019, is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per RSU Aggregate Fair Value (in millions) Balance as of September 29, 2018 368,618 $ 33.65 RSUs granted 147,409 $ 53.99 RSUs vested ( 168,350 ) $ 33.80 RSUs canceled ( 21,609 ) $ 40.71 Balance as of September 28, 2019 326,068 $ 42.30 RSUs granted 156,800 $ 59.20 RSUs vested ( 157,743 ) $ 40.29 RSUs canceled ( 14,347 ) $ 48.07 Balance as of September 26, 2020 310,778 $ 51.58 RSUs granted 89,363 $ 116.33 RSUs vested ( 145,766 ) $ 50.71 RSUs canceled ( 13,948 ) $ 68.95 Balance as of September 25, 2021 240,427 $ 75.16 $ 35,324 The fair value as of the respective vesting dates of RSUs was $ 19.0 billion, $ 10.8 billion and $ 8.6 billion for 2021, 2020 and 2019, respectively. The majority of RSUs that vested in 2021, 2020 and 2019 were net share settled such that the Company withheld shares with a value equivalent to the employees’ obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 53 million, 56 million and 59 million for 2021, 2020 and 2019, respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $ 6.8 billion, $ 3.9 billion and $ 3.0 billion in 2021, 2020 and 2019, respectively. Share-Based Compensation The following table shows share-based compensation expense and the related income tax benefit included in the Consolidated Statements of Operations for 2021, 2020 and 2019 (in millions): 2021 2020 2019 Share-based compensation expense $ 7,906 $ 6,829 $ 6,068 Income tax benefit related to share-based compensation expense $ ( 4,056 ) $ ( 2,476 ) $ ( 1,967 ) As of September 25, 2021, the total unrecognized compensation cost related to outstanding RSUs and stock options was $ 13.6 billion, which the Company expects to recognize over a weighted-average period of 2.5 years. Apple Inc. | 2021 Form 10-K | 47 Note 10 – Commitments and Contingencies Accrued Warranty and Guarantees The following table shows changes in the Company’s accrued warranties and related costs for 2021, 2020 and 2019 (in millions): 2021 2020 2019 Beginning accrued warranty and related costs $ 3,354 $ 3,570 $ 3,692 Cost of warranty claims ( 2,674 ) ( 2,956 ) ( 3,857 ) Accruals for product warranty 2,684 2,740 3,735 Ending accrued warranty and related costs $ 3,364 $ 3,354 $ 3,570 The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and China mainland. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right, with subsequent changes to the guarantee liability recognized within net sales. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets, wearables and accessories. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Unconditional Purchase Obligations The Company has entered into certain off–balance sheet commitments that require the future purchase of goods or services (“unconditional purchase obligations”). The Company’s unconditional purchase obligations primarily consist of payments for content creation, Internet and telecommunications services and supplier arrangements. Future payments under noncancelable unconditional purchase obligations having a remaining term in excess of one year as of September 25, 2021, are as follows (in millions): 2022 $ 4,551 2023 2,165 2024 984 2025 405 2026 51 Thereafter 28 Total $ 8,184 Apple Inc. | 2021 Form 10-K | 48 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully resolved. The outcome of litigation is inherently uncertain. When a loss related to a legal proceeding or claim is probable and reasonably estimable, the Company accrues its best estimate for the ultimate resolution of the matter. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims, except for the following matters: VirnetX VirnetX, Inc. (“VirnetX”) filed a lawsuit against the Company alleging that certain of the Company’s products infringe on patents owned by VirnetX. On April 11, 2018, a jury returned a verdict against the Company in the U.S. District Court for the Eastern District of Texas (the “Eastern Texas District Court”). The Company appealed the verdict to the U.S. Court of Appeals for the Federal Circuit, which remanded the case back to the Eastern Texas District Court, where a retrial was held in October 2020. The jury returned a verdict against the Company and awarded damages of $ 503 million, which the Company has appealed. The Company has challenged the validity of the patents at issue in the retrial at the U.S. Patent and Trademark Office (the “PTO”), and the PTO has declared the patents invalid, subject to further appeal by VirnetX. iOS Performance Management Cases On April 5, 2018, several U.S. federal actions alleging violation of consumer protection laws, fraud, computer intrusion and other causes of action related to the Company’s performance management feature used in its iPhone operating systems, introduced to certain iPhones in iOS updates 10.2.1 and 11.2, were consolidated through a Multidistrict Litigation process into a single action in the U.S. District Court for the Northern District of California (the “Northern California District Court”). On February 28, 2020, the parties in the Multidistrict Litigation reached a settlement to resolve the U.S. federal and California state class actions. On March 18, 2021, the Northern California District Court granted final approval of the Multidistrict Litigation settlement, which will result in an aggregate payment of $ 310 million to settle all claims. The Company continues to believe that its iPhones were not defective, that the performance management feature introduced with iOS updates 10.2.1 and 11.2 was intended to, and did, improve customers’ user experience, and that the Company did not make any misleading statements or fail to disclose any material information. French Competition Authority On March 16, 2020, the French Competition Authority (“FCA”) announced its decision that aspects of the Company’s sales and distribution practices in France violate French competition law, and issued a fine of € 1.1 billion. The Company strongly disagrees with the FCA’s decision, and has appealed. Optis Optis Wireless Technology, LLC and related entities (“Optis”) filed a lawsuit in the U.S. District Court for the Eastern District of Texas against the Company alleging that certain of the Company’s products infringe on patents owned by Optis. On August 11, 2020, a jury returned a verdict against the Company and awarded damages. In post-trial proceedings, the damages portion of the verdict was set aside. A retrial on damages was held in August 2021 and the jury in that proceeding awarded damages of $ 300 million against the Company, which the Company plans to appeal. Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” Apple Inc. | 2021 Form 10-K | 49 The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable segments. Costs excluded from segment operating income include various corporate expenses such as research and development, corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. The following table shows information by reportable segment for 2021, 2020 and 2019 (in millions): 2021 2020 2019 Americas: Net sales $ 153,306 $ 124,556 $ 116,914 Operating income $ 53,382 $ 37,722 $ 35,099 Europe: Net sales $ 89,307 $ 68,640 $ 60,288 Operating income $ 32,505 $ 22,170 $ 19,195 Greater China: Net sales $ 68,366 $ 40,308 $ 43,678 Operating income $ 28,504 $ 15,261 $ 16,232 Japan: Net sales $ 28,482 $ 21,418 $ 21,506 Operating income $ 12,798 $ 9,279 $ 9,369 Rest of Asia Pacific: Net sales $ 26,356 $ 19,593 $ 17,788 Operating income $ 9,817 $ 6,808 $ 6,055 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2021, 2020 and 2019 is as follows (in millions): 2021 2020 2019 Segment operating income $ 137,006 $ 91,240 $ 85,950 Research and development expense ( 21,914 ) ( 18,752 ) ( 16,217 ) Other corporate expenses, net ( 6,143 ) ( 6,200 ) ( 5,803 ) Total operating income $ 108,949 $ 66,288 $ 63,930 Apple Inc. | 2021 Form 10-K | 50 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2021, 2020 and 2019. There was no single customer that accounted for more than 10% of net sales in 2021, 2020 and 2019. Net sales for 2021, 2020 and 2019 and long-lived assets as of September 25, 2021 and September 26, 2020 were as follows (in millions): 2021 2020 2019 Net sales: U.S. $ 133,803 $ 109,197 $ 102,266 China (1) 68,366 40,308 43,678 Other countries 163,648 125,010 114,230 Total net sales $ 365,817 $ 274,515 $ 260,174 2021 2020 Long-lived assets: U.S. $ 28,203 $ 25,890 China (1) 7,521 7,256 Other countries 3,716 3,620 Total long-lived assets $ 39,440 $ 36,766 (1) China includes Hong Kong and Taiwan. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets related to retail stores and related infrastructure. Apple Inc. | 2021 Form 10-K | 51 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 25, 2021 and September 26, 2020, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 25, 2021, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of Apple Inc. at September 25, 2021 and September 26, 2020, and the results of its operations and its cash flows for each of the three years in the period ended September 25, 2021, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), Apple Inc.’s internal control over financial reporting as of September 25, 2021, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated October 28, 2021 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of Apple Inc.’s management. Our responsibility is to express an opinion on Apple Inc.’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. Uncertain Tax Positions Description of the Matter As discussed in Note 5 to the financial statements, Apple Inc. is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisdictions. As of September 25, 2021, the total amount of gross unrecognized tax benefits was $15.5 billion, of which $6.6 billion, if recognized, would impact Apple Inc.’s effective tax rate. Apple Inc. uses significant judgment in the calculation of tax liabilities in estimating the impact of uncertainties in the application of technical merits and complex tax laws. Auditing management’s evaluation of whether an uncertain tax position is more likely than not to be sustained and the measurement of the benefit of various tax positions can be complex, involves significant judgment, and is based on interpretations of tax laws and legal rulings. Apple Inc. | 2021 Form 10-K | 52 How We Addressed the Matter in Our Audit We tested controls relating to the evaluation of uncertain tax positions, including controls over management’s assessment as to whether tax positions are more likely than not to be sustained, management’s process to measure the benefit of its tax positions, and the development of the related disclosures. To evaluate Apple Inc.’s assessment of which tax positions are more likely than not to be sustained, our audit procedures included, among others, reading and evaluating management’s assumptions and analysis, and, as applicable, Apple Inc.’s communications with taxing authorities, that detailed the basis and technical merits of the uncertain tax positions. We involved our tax subject matter resources in assessing the technical merits of certain of Apple Inc.’s tax positions based on our knowledge of relevant tax laws and experience with related taxing authorities. For certain tax positions, we also received external legal counsel confirmation letters and discussed the matters with external advisors and Apple Inc. tax personnel. In addition, we evaluated Apple Inc.’s disclosure in relation to these matters included in Note 5 to the financial statements. /s/ Ernst & Young LLP We have served as Apple Inc.’s auditor since 2009. San Jose, California October 28, 2021 Apple Inc. | 2021 Form 10-K | 53 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on Internal Control Over Financial Reporting We have audited Apple Inc.’s internal control over financial reporting as of September 25, 2021, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 25, 2021, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), the consolidated balance sheets of Apple Inc. as of September 25, 2021 and September 26, 2020, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 25, 2021, and the related notes and our report dated October 28, 2021 expressed an unqualified opinion thereon. Basis for Opinion Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Apple Inc.’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California October 28, 2021 Apple Inc. | 2021 Form 10-K | 54 Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A.    Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 25, 2021 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 25, 2021 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2021, which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Apple Inc. | 2021 Form 10-K | 55 Item 9B.    Other Information Disclosure Pursuant to Section 13(r) of the Exchange Act Under Section 13(r) of the Exchange Act, the Company is required to disclose in its periodic reports if it or any of its affiliates knowingly conducted a transaction or dealing with entities or individuals designated pursuant to certain Executive Orders. On March 2, 2021, the U.S. Secretary of State designated the Russian Federal Security Service (the “FSB”) as a blocked party under Executive Order 13382. On the same day, the U.S. Department of the Treasury’s Office of Foreign Assets Control updated General License No. 1B to authorize transactions and activities with the FSB that are necessary and ordinarily incident to requesting, receiving, utilizing, paying for, or dealing in certain licenses, permits, certifications or notifications issued or registered by the FSB for the importation, distribution or use of certain information technology products in the Russian Federation. As previously disclosed in the Company’s Quarterly Report on Form 10-Q for the three-month period ended June 26, 2021, during such period, the Company filed legally required administrative notifications with the FSB in connection with the importation of the Company’s products into the Russian Federation, as permitted by General License No. 1B. The Company did not make any payments, nor did it receive gross revenues or net profits, in connection with such engagement. The Company may in the future engage with the FSB for activities necessary to conduct business in the Russian Federation, in accordance with applicable U.S. laws and regulations. Item 9C.    Disclosure Regarding Foreign Jurisdictions that Prevent Inspections Not applicable. PART III Item 10.    Directors, Executive Officers and Corporate Governance The information required by this Item is included in the Company’s 2022 Proxy Statement to be filed with the SEC within 120 days after September 25, 2021 in connection with the solicitation of proxies for the Company’s 2022 annual meeting of shareholders, and is incorporated herein by reference. Item 11.    Executive Compensation The information required by this Item is included in the Company’s 2022 Proxy Statement to be filed with the SEC within 120 days after September 25, 2021, and is incorporated herein by reference. Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is included in the Company’s 2022 Proxy Statement to be filed with the SEC within 120 days after September 25, 2021, and is incorporated herein by reference. Item 13.    Certain Relationships and Related Transactions, and Director Independence The information required by this Item is included in the Company’s 2022 Proxy Statement to be filed with the SEC within 120 days after September 25, 2021, and is incorporated herein by reference. Item 14.    Principal Accountant Fees and Services The information required by this Item is included in the Company’s 2022 Proxy Statement to be filed with the SEC within 120 days after September 25, 2021, and is incorporated herein by reference. Apple Inc. | 2021 Form 10-K | 56 PART IV Item 15.    Exhibit and Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 29 Consolidated Statements of Comprehensive Income for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 30 Consolidated Balance Sheets as of September 25, 2021 and September 26, 2020 31 Consolidated Statements of Shareholders’ Equity for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 32 Consolidated Statements of Cash Flows for the years ended September 25, 2021, September 26, 2020 and September 28, 2019 33 Notes to Consolidated Financial Statements 34 Reports of Independent Registered Public Accounting Firm 52 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant filed on August 3, 2020. 8-K 3.1 8/7/20 3.2 Amended and Restated Bylaws of the Registrant effective as of December 13, 2016. 8-K 3.2 12/15/16 4.1** Description of Securities of the Registrant. 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 Apple Inc. | 2021 Form 10-K | 57 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.9 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 4.10 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.11 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.12 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.13 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.14 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.15 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.16 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.17 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.18 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 4.19 Officer’s Certificate of the Registrant, dated as of November 13, 2017, including forms of global notes representing the 1.800% Notes due 2019, 2.000% Notes due 2020, 2.400% Notes due 2023, 2.750% Notes due 2025, 3.000% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 11/13/17 4.20 Indenture, dated as of November 5, 2018, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 11/5/18 4.21 Officer’s Certificate of the Registrant, dated as of September 11, 2019, including forms of global notes representing the 1.700% Notes due 2022, 1.800% Notes due 2024, 2.050% Notes due 2026, 2.200% Notes due 2029 and 2.950% Notes due 2049. 8-K 4.1 9/11/19 4.22 Officer’s Certificate of the Registrant, dated as of November 15, 2019, including forms of global notes representing the 0.000% Notes due 2025 and 0.500% Notes due 2031. 8-K 4.1 11/15/19 4.23 Officer’s Certificate of the Registrant, dated as of May 11, 2020, including forms of global notes representing the 0.750% Notes due 2023, 1.125% Notes due 2025, 1.650% Notes due 2030 and 2.650% Notes due 2050. 8-K 4.1 5/11/20 4.24 Officer’s Certificate of the Registrant, dated as of August 20, 2020, including forms of global notes representing the 0.550% Notes due 2025, 1.25% Notes due 2030, 2.400% Notes due 2050 and 2.550% Notes due 2060. 8-K 4.1 8/20/20 4.25 Officer’s Certificate of the Registrant, dated as of February 8, 2021, including forms of global notes representing the 0.700% Notes due 2026, 1.200% Notes due 2028, 1.650% Notes due 2031, 2.375% Notes due 2041, 2.650% Notes due 2051 and 2.800% Notes due 2061. 8-K 4.1 2/8/21 4.26 Officer’s Certificate of the Registrant, dated as of August 5, 2021, including forms of global notes representing the 1.400% Notes due 2028, 1.700% Notes due 2031, 2.700% Notes due 2051 and 2.850% Notes due 2061. 8-K 4.1 8/5/21 4.27* Apple Inc. Deferred Compensation Plan. S-8 4.1 8/23/18 Apple Inc. | 2021 Form 10-K | 58 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* Apple Inc. Non-Employee Director Stock Plan, as amended and restated as of February 13, 2018. 8-K 10.1 2/14/18 10.4* 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10-K 10.8 9/30/17 10.5* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10-K 10.18 9/24/16 10.6* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.20 9/30/17 10.7* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.21 9/30/17 10.8* Form of Restricted Stock Unit Award Agreement under Non-Employee Director Stock Plan effective as of February 13, 2018. 10-Q 10.2 3/31/18 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.17 9/29/18 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.18 9/29/18 10.11* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.15 9/28/19 10.12* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.16 9/28/19 10.13* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 18, 2020. 10-K 10.16 9/26/20 10.14* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 18, 2020. 10-K 10.17 9/26/20 10.15* Form of CEO Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 27, 2020. 10-Q 10.1 1/28/21 10.16* Form of CEO Performance Award Agreement under 2014 Employee Stock Plan effective as of September 27, 2020. 10-Q 10.2 1/28/21 21.1** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101** Inline XBRL Document Set for the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. 104** Inline XBRL for the cover page of this Annual Report on Form 10-K, included in the Exhibit 101 Inline XBRL Document Set. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16.    Form 10-K Summary None. Apple Inc. | 2021 Form 10-K | 59 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: October 28, 2021 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) October 28, 2021 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) October 28, 2021 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) October 28, 2021 CHRIS KONDO /s/ James A. Bell Director October 28, 2021 JAMES A. BELL /s/ Al Gore Director October 28, 2021 AL GORE /s/ Andrea Jung Director October 28, 2021 ANDREA JUNG /s/ Arthur D. Levinson Director and Chair of the Board October 28, 2021 ARTHUR D. LEVINSON /s/ Monica Lozano Director October 28, 2021 MONICA LOZANO /s/ Ronald D. Sugar Director October 28, 2021 RONALD D. SUGAR /s/ Susan L. Wagner Director October 28, 2021 SUSAN L. 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2022-09-24 0000320193 country:US 2021-09-25 0000320193 country:CN 2022-09-24 0000320193 country:CN 2021-09-25 0000320193 aapl:OtherCountriesMember 2022-09-24 0000320193 aapl:OtherCountriesMember 2021-09-25 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 24 , 2022 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) One Apple Park Way Cupertino , California 95014 (Address of principal executive offices) (Zip Code) ( 408 ) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading symbol(s) Name of each exchange on which registered Common Stock, $0.00001 par value per share AAPL The Nasdaq Stock Market LLC 1.000% Notes due 2022 — The Nasdaq Stock Market LLC 1.375% Notes due 2024 — The Nasdaq Stock Market LLC 0.000% Notes due 2025 — The Nasdaq Stock Market LLC 0.875% Notes due 2025 — The Nasdaq Stock Market LLC 1.625% Notes due 2026 — The Nasdaq Stock Market LLC 2.000% Notes due 2027 — The Nasdaq Stock Market LLC 1.375% Notes due 2029 — The Nasdaq Stock Market LLC 3.050% Notes due 2029 — The Nasdaq Stock Market LLC 0.500% Notes due 2031 — The Nasdaq Stock Market LLC 3.600% Notes due 2042 — The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 25, 2022, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $ 2,830,067,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 15,908,118,000 shares of common stock were issued and outstanding as of October 14, 2022. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2023 annual meeting of shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The Registrant’s definitive proxy statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 24, 2022 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 5 Item 1B. Unresolved Staff Comments 17 Item 2. Properties 17 Item 3. Legal Proceedings 17 Item 4. Mine Safety Disclosures 17 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 18 Item 6. [Reserved] 19 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 20 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 26 Item 8. Financial Statements and Supplementary Data 28 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 53 Item 9A. Controls and Procedures 53 Item 9B. Other Information 54 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 54 Part III Item 10. Directors, Executive Officers and Corporate Governance 54 Item 11. Executive Compensation 54 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 54 Item 13 . Certain Relationships and Related Transactions, and Director Independence 54 Item 14. Principal Accountant Fees and Services 54 Part IV Item 15. Exhibit and Financial Statement Schedules 55 Item 16. Form 10-K Summary 57 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part I, Item 1 of this Form 10-K under the heading “Business” and Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. For example, statements in this Form 10-K regarding the potential future impact of the COVID-19 pandemic on the Company’s business and results of operations are forward-looking statements. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Unless otherwise stated, all information presented herein is based on the Company’s fiscal calendar, and references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly owned subsidiaries, unless otherwise stated. PART I Item 1.    Business Company Background The Company designs, manufactures and markets smartphones, personal computers, tablets, wearables and accessories, and sells a variety of related services. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. Products iPhone iPhone ® is the Company’s line of smartphones based on its iOS operating system. The iPhone line includes iPhone 14 Pro, iPhone 14, iPhone 13, iPhone SE ® , iPhone 12 and iPhone 11. Mac Mac ® is the Company’s line of personal computers based on its macOS ® operating system. The Mac line includes laptops MacBook Air ® and MacBook Pro ® , as well as desktops iMac ® , Mac mini ® , Mac Studio™ and Mac Pro ® . iPad iPad ® is the Company’s line of multipurpose tablets based on its iPadOS ® operating system. The iPad line includes iPad Pro ® , iPad Air ® , iPad and iPad mini ® . Wearables, Home and Accessories Wearables, Home and Accessories includes: • AirPods ® , the Company’s wireless headphones, including AirPods, AirPods Pro ® and AirPods Max™; • Apple TV ® , the Company’s media streaming and gaming device based on its tvOS ® operating system, including Apple TV 4K and Apple TV HD; • Apple Watch ® , the Company’s line of smartwatches based on its watchOS ® operating system, including Apple Watch Ultra™, Apple Watch Series 8 and Apple Watch SE ® ; and • Beats ® products, HomePod mini ® and accessories. Apple Inc. | 2022 Form 10-K | 1 Services Advertising The Company’s advertising services include various third-party licensing arrangements and the Company’s own advertising platforms. AppleCare The Company offers a portfolio of fee-based service and support products under the AppleCare ® brand. The offerings provide priority access to Apple technical support, access to the global Apple authorized service network for repair and replacement services, and in many cases additional coverage for instances of accidental damage and/or theft and loss, depending on the country and type of product. Cloud Services The Company’s cloud services store and keep customers’ content up-to-date and available across multiple Apple devices and Windows personal computers. Digital Content The Company operates various platforms, including the App Store ® , that allow customers to discover and download applications and digital content, such as books, music, video, games and podcasts. The Company also offers digital content through subscription-based services, including Apple Arcade ® , a game subscription service; Apple Fitness+ SM , a personalized fitness service; Apple Music ® , which offers users a curated listening experience with on-demand radio stations; Apple News+ ® , a subscription news and magazine service; and Apple TV+ ® , which offers exclusive original content and live sports. Payment Services The Company offers payment services, including Apple Card ® , a co-branded credit card, and Apple Pay ® , a cashless payment service. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and resellers. During 2022, the Company’s net sales through its direct and indirect distribution channels accounted for 38% and 62%, respectively, of total net sales. Competition The markets for the Company’s products and services are highly competitive, and are characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. Many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by imitating the Company’s products and infringing on its intellectual property. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. Principal competitive factors important to the Company include price, product and service features (including security features), relative price and performance, product and service quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support, and corporate reputation. Apple Inc. | 2022 Form 10-K | 2 The Company is focused on expanding its market opportunities related to smartphones, personal computers, tablets, wearables and accessories, and services. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software, and service offerings with large customer bases. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors have the resources, experience or cost structures to provide products at little or no profit or even at a loss. The Company’s services compete with business models that provide content to users for free and use illegitimate means to obtain third-party digital content and applications. The Company faces significant competition as competitors imitate the Company’s product features and applications within their products, or collaborate to offer integrated solutions that are more competitive than those they currently offer. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets, wearables and accessories. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through research and development (“R&D”), licensing of intellectual property and acquisition of third-party businesses and technology. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, designs, copyrights, trademarks and other forms of intellectual property rights in the U.S. and various foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in differentiating its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent, design, copyright and trademark applications to protect innovations arising from its research, development, design and marketing, and is currently pursuing thousands of applications around the world. Over time, the Company has accumulated a large portfolio of issued and registered intellectual property rights around the world. No single intellectual property right is solely responsible for protecting the Company’s products and services. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products and services. In addition to Company-owned intellectual property, many of the Company’s products and services are designed to include intellectual property owned by third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of the Company’s products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Apple Inc. | 2022 Form 10-K | 3 Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. The timing of product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new inventory following a product launch, and channel inventory of an older product often declines as the launch of a newer product approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. Human Capital The Company believes it has a talented, motivated and dedicated team, and works to create an inclusive, safe and supportive environment for all of its team members. As of September 24, 2022, the Company had approximately 164,000 full-time equivalent employees. Workplace Practices and Policies The Company is an equal opportunity employer committed to inclusion and diversity and to providing a workplace free of harassment or discrimination. Compensation and Benefits The Company believes that compensation should be competitive and equitable, and should enable employees to share in the Company’s success. The Company recognizes its people are most likely to thrive when they have the resources to meet their needs and the time and support to succeed in their professional and personal lives. In support of this, the Company offers a wide variety of benefits for employees around the world and invests in tools and resources that are designed to support employees’ individual growth and development. Inclusion and Diversity The Company remains committed to its vision to build and sustain a more inclusive workforce that is representative of the communities it serves. The Company continues to work to increase diverse representation at every level, foster an inclusive culture, and support equitable pay and access to opportunity for all employees. Engagement The Company believes that open and honest communication among team members, managers and leaders helps create an open, collaborative work environment where everyone can contribute, grow and succeed. Team members are encouraged to come to their managers with questions, feedback or concerns, and the Company conducts surveys that gauge employee sentiment in areas like career development, manager performance and inclusivity. Health and Safety The Company is committed to protecting its team members everywhere it operates. The Company identifies potential workplace risks in order to develop measures to mitigate possible hazards. The Company supports employees with general safety, security and crisis management training, and by putting specific programs in place for those working in potentially high-hazard environments. Additionally, the Company works to protect the safety and security of its team members, visitors and customers through its global security team. The Company has also taken additional health and safety measures during the COVID-19 pandemic. Available Information The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and other information filed by the Company with the SEC are available free of charge at investor.apple.com/investor-relations/sec-filings/default.aspx when such reports are available on the SEC’s website. The Company periodically provides certain information for investors on its corporate website, www.apple.com, and its investor relations website, investor.apple.com. This includes press releases and other information about financial performance, information on environmental, social and governance matters, and details related to the Company’s annual meeting of shareholders. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2022 Form 10-K | 4 Item 1A.    Risk Factors The Company’s business, reputation, results of operations, financial condition and stock price can be affected by a number of factors, whether currently known or unknown, including those described below. When any one or more of these risks materialize from time to time, the Company’s business, reputation, results of operations, financial condition and stock price can be materially and adversely affected. Because of the following factors, as well as other factors affecting the Company’s results of operations and financial condition, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. This discussion of risk factors contains forward-looking statements. This section should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. Macroeconomic and Industry Risks The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition. The Company has international operations with sales outside the U.S. representing a majority of the Company’s total net sales. In addition, the Company’s global supply chain is large and complex and a majority of the Company’s supplier facilities, including manufacturing and assembly sites, are located outside the U.S. As a result, the Company’s operations and performance depend significantly on global and regional economic conditions. Adverse macroeconomic conditions, including inflation, slower growth or recession, new or increased tariffs and other barriers to trade, changes to fiscal and monetary policy, tighter credit, higher interest rates, high unemployment and currency fluctuations can adversely impact consumer confidence and spending and materially adversely affect demand for the Company’s products and services. In addition, consumer confidence and spending can be materially adversely affected in response to financial market volatility, negative financial news, conditions in the real estate and mortgage markets, declines in income or asset values, energy shortages and cost increases, labor and healthcare costs and other economic factors. In addition to an adverse impact on demand for the Company’s products, uncertainty about, or a decline in, global or regional economic conditions can have a significant impact on the Company’s suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. Potential effects include financial instability; inability to obtain credit to finance operations and purchases of the Company’s products; and insolvency. A downturn in the economic environment can also lead to increased credit and collectibility risk on the Company’s trade receivables; the failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair value of the Company’s financial instruments. These and other economic factors can materially adversely affect the Company’s business, results of operations, financial condition and stock price. The Company’s business, results of operations, financial condition and stock price have been adversely affected and could in the future be materially adversely affected by the COVID-19 pandemic. COVID-19 has had, and continues to have, a significant impact around the world, prompting governments and businesses to take unprecedented measures in response. Such measures have included restrictions on travel and business operations, temporary closures of businesses, and quarantine and shelter-in-place orders. The COVID-19 pandemic has at times significantly curtailed global economic activity and caused significant volatility and disruption in global financial markets. The COVID-19 pandemic and the measures taken by many countries in response have adversely affected and could in the future materially adversely impact the Company’s business, results of operations, financial condition and stock price. During the course of the pandemic, certain of the Company’s component suppliers and manufacturing and logistical service providers have experienced disruptions, resulting in supply shortages that affected sales worldwide, and similar disruptions could occur in the future. Public safety measures can also adversely impact consumer demand for the Company’s products and services in affected areas. Apple Inc. | 2022 Form 10-K | 5 The Company continues to monitor the situation and take appropriate actions in accordance with the recommendations and requirements of relevant authorities. The extent to which the COVID-19 pandemic may impact the Company’s operational and financial performance remains uncertain and will depend on many factors outside the Company’s control, including the timing, extent, trajectory and duration of the pandemic, the emergence of new variants, the development, availability, distribution and effectiveness of vaccines and treatments, the imposition of protective public safety measures, and the impact of the pandemic on the global economy and demand for consumer products and services. Additional future impacts on the Company may include material adverse effects on demand for the Company’s products and services, the Company’s supply chain and sales and distribution channels, the Company’s ability to execute its strategic plans, and the Company’s profitability and cost structure. To the extent the COVID-19 pandemic adversely affects the Company’s business, results of operations, financial condition and stock price, it may also have the effect of heightening many of the other risks described in this Part I, Item 1A of this Form 10-K. The Company’s business can be impacted by political events, trade and other international disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions. Political events, trade and other international disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions can harm or disrupt international commerce and the global economy, and could have a material adverse effect on the Company and its customers, suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. The Company has a large, global business with sales outside the U.S. representing a majority of the Company’s total net sales, and the Company believes that it generally benefits from growth in international trade. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia, including China mainland, India, Japan, South Korea, Taiwan and Vietnam. Trade policies and disputes and other international conflicts can result in tariffs, sanctions and other measures that restrict international trade, and can materially adversely affect the Company’s business, particularly if these measures occur in regions where the Company derives a significant portion of its revenues and/or has significant supply chain operations. For example, tensions between the U.S. and China have led to a series of tariffs being imposed by the U.S. on imports from China mainland, as well as other business restrictions. Tariffs increase the cost of the Company’s products and the components and raw materials that go into making them. These increased costs can adversely impact the gross margin that the Company earns on its products. Tariffs can also make the Company’s products more expensive for customers, which could make the Company’s products less competitive and reduce consumer demand. Countries may also adopt other measures, such as controls on imports or exports of goods, technology or data, that could adversely impact the Company’s operations and supply chain and limit the Company’s ability to offer its products and services as designed. These measures can require the Company to take various actions, including changing suppliers, restructuring business relationships, and ceasing to offer third-party applications on its platforms. Changing the Company’s operations in accordance with new or changed trade restrictions can be expensive, time-consuming and disruptive to the Company’s operations. Such restrictions can be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. If disputes and conflicts further escalate in the future, actions by governments in response could be significantly more severe and restrictive and could materially adversely affect the Company’s business. Political uncertainty surrounding trade and other international disputes could also have a negative effect on consumer confidence and spending, which could adversely affect the Company’s business. Many of the Company’s operations and facilities, as well as critical business operations of the Company’s suppliers and contract manufacturers, are in locations that are prone to earthquakes and other natural disasters. In addition, such operations and facilities are subject to the risk of interruption by fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, ransomware and other cybersecurity attacks, labor disputes, public health issues, including pandemics such as the COVID-19 pandemic, and other events beyond the Company’s control. Global climate change is resulting in certain types of natural disasters occurring more frequently or with more intense effects. Such events can make it difficult or impossible for the Company to manufacture and deliver products to its customers, create delays and inefficiencies in the Company’s supply and manufacturing chain, and result in slowdowns and outages to the Company’s service offerings. Following an interruption to its business, the Company can require substantial recovery time, experience significant expenditures to resume operations, and lose significant sales. Because the Company relies on single or limited sources for the supply and manufacture of many critical components, a business interruption affecting such sources would exacerbate any negative consequences to the Company. Apple Inc. | 2022 Form 10-K | 6 The Company’s operations are also subject to the risks of industrial accidents at its suppliers and contract manufacturers. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in serious injuries or loss of life, disruption to the Company’s business, and harm to the Company’s reputation. Major public health issues, including pandemics such as the COVID-19 pandemic, have adversely affected, and could in the future materially adversely affect, the Company due to their impact on the global economy and demand for consumer products; the imposition of protective public safety measures, such as stringent employee travel restrictions and limitations on freight services and the movement of products between regions; and disruptions in the Company’s supply chain and sales and distribution channels, resulting in interruptions of the supply of current products and delays in production ramps of new products. While the Company maintains insurance coverage for certain types of losses, such insurance coverage may be insufficient to cover all losses that may arise. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services are offered in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. There can be no assurance these investments will achieve expected returns, and the Company may not be able to develop and market new products and services successfully. The Company currently holds a significant number of patents, trademarks and copyrights and has registered, and applied to register, additional patents, trademarks and copyrights. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by imitating the Company’s products and infringing on its intellectual property. Effective intellectual property protection is not consistently available in every country in which the Company operates. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be materially adversely affected. The Company has a minority market share in the global smartphone, personal computer and tablet markets. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors have the resources, experience or cost structures to provide products at little or no profit or even at a loss. Some of the markets in which the Company competes have from time to time experienced little to no growth or contracted overall. Additionally, the Company faces significant competition as competitors imitate the Company’s product features and applications within their products or collaborate to offer solutions that are more competitive than those they currently offer. The Company also expects competition to intensify as competitors imitate the Company’s approach to providing components seamlessly within their offerings or work collaboratively to offer integrated solutions. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s business, results of operations and financial condition depend substantially on the Company’s ability to continually improve its products and services to maintain their functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. Apple Inc. | 2022 Form 10-K | 7 Business Risks To remain competitive and stimulate customer demand, the Company must successfully manage frequent introductions and transitions of products and services. Due to the highly volatile and competitive nature of the markets and industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and services, and successfully manage the transition to these new and upgraded products and services. The success of new product and service introductions depends on a number of factors, including timely and successful development, market acceptance, the Company’s ability to manage the risks associated with production ramp-up issues, the availability of application software for the Company’s products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand, and the risk that new products and services may have quality or other defects or deficiencies. There can be no assurance the Company will successfully manage future introductions and transitions of products and services. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in Asia, including China mainland, India, Japan, South Korea, Taiwan and Vietnam, and a significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Changes or additions to the Company’s supply chain require considerable time and resources and involve significant risks and uncertainties. The Company has also outsourced much of its transportation and logistics management. While these arrangements can lower operating costs, they also reduce the Company’s direct control over production and distribution. Such diminished control has from time to time and may in the future have an adverse effect on the quality or quantity of products manufactured or services provided, or adversely affect the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for product defect expense reimbursement, the Company generally remains responsible to the consumer for warranty and out-of-warranty service in the event of product defects and experiences unanticipated product defect liabilities from time to time. While the Company relies on its partners to adhere to its supplier code of conduct, violations of the supplier code of conduct occur from time to time and can materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company relies on single-source outsourcing partners in the U.S., Asia and Europe to supply and manufacture many components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform can have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations can be disrupted for a variety of reasons, including natural and man-made disasters, information technology system failures, commercial disputes, armed conflict, economic, business, labor, environmental, public health or political issues, or international trade disputes. The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply can be reduced or terminated, and the recoverability of manufacturing process equipment or prepayments can be negatively impacted. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains certain components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations that can materially adversely affect the Company’s business, results of operations and financial condition. For example, the global semiconductor industry is experiencing high demand and shortages of supply, which has adversely affected, and could materially adversely affect, the Company’s ability to obtain sufficient quantities of components and products on commercially reasonable terms or at all. While the Company has entered into agreements for the supply of many components, there can be no assurance the Company will be able to extend or renew these agreements on similar terms, or at all. Component suppliers may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms or at all. The effects of global or regional economic conditions on the Company’s suppliers, described in “ The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition, ” above, can also affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its business, results of operations and financial condition. Apple Inc. | 2022 Form 10-K | 8 The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, can be affected for any number of reasons, including if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. When the Company’s supply of components for a new or existing product has been delayed or constrained, or when an outsourcing partner has delayed shipments of completed products to the Company, the Company’s business, results of operations and financial condition have been adversely affected and future delays or constraints could materially adversely affect the Company’s business, results of operations and financial condition. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the source, or to identify and obtain sufficient quantities from an alternative source. The Company’s products and services may be affected from time to time by design and manufacturing defects that could materially adversely affect the Company’s business and result in harm to the Company’s reputation. The Company offers complex hardware and software products and services that can be affected by design and manufacturing defects. Sophisticated operating system software and applications, such as those offered by the Company, often have issues that can unexpectedly interfere with the intended operation of hardware or software products. Defects can also exist in components and products the Company purchases from third parties. Component defects could make the Company’s products unsafe and create a risk of environmental or property damage and personal injury. These risks may increase as the Company’s products are introduced into specialized applications, including health. In addition, the Company’s service offerings can have quality issues and from time to time experience outages, service slowdowns or errors. As a result, the Company’s services from time to time have not performed as anticipated and may not meet customer expectations. There can be no assurance the Company will be able to detect and fix all issues and defects in the hardware, software and services it offers. Failure to do so can result in widespread technical and performance issues affecting the Company’s products and services. In addition, the Company can be exposed to product liability claims, recalls, product replacements or modifications, write-offs of inventory, property, plant and equipment, and/or intangible assets, and significant warranty and other expenses, including litigation costs and regulatory fines. Quality problems can also adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, delay in new product and service introductions and lost sales. The Company is exposed to the risk of write-downs on the value of its inventory and other assets, in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand, or for which cost exceeds net realizable value. The Company also accrues necessary cancellation fee reserves for orders of excess products and components. The Company reviews long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the assets may not be recoverable. If the Company determines that an impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently recoverable, there can be no assurance the Company will not incur write-downs, fees, impairments and other charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company orders components for its products and builds inventory in advance of product announcements and shipments. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. The Company’s products and services are designed to include intellectual property owned by third parties, which requires licenses from those third parties. In addition, because of technological changes in the industries in which the Company currently competes or in the future may compete, current extensive patent coverage and the rapid rate of issuance of new patents, the Company’s products and services can unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Based on experience and industry practice, the Company believes licenses to such third-party intellectual property can generally be obtained on commercially reasonable terms. However, there can be no assurance the necessary licenses can be obtained on commercially reasonable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, can preclude the Company from selling certain products or services, or otherwise have a material adverse impact on the Company’s business, results of operations and financial condition. Apple Inc. | 2022 Form 10-K | 9 The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There can be no assurance third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes the availability of third-party software applications and services for its products depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software and services for the Company’s products compared to competitors’ platforms, such as Android for smartphones and tablets, Windows for personal computers and tablets, and PlayStation, Nintendo and Xbox for gaming platforms. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of product sales, and the costs of developing such applications and services. The Company’s minority market share in the global smartphone, personal computer and tablet markets can make developers less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for competitors’ products with larger market share. When developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices can suffer. The Company relies on the continued availability and development of compelling and innovative software applications for its products. The Company’s products and operating systems are subject to rapid technological change, and when third-party developers are unable to or choose not to keep up with this pace of change, their applications can fail to take advantage of these changes to deliver improved customer experiences and can operate incorrectly and can result in dissatisfied customers. The Company distributes third-party applications for its products through the App Store. For the vast majority of applications, developers keep all of the revenue they generate on the App Store. The Company only retains a commission from sales of applications and sales of digital services or goods within an application. From time to time, the Company has made changes to its App Store, including actions taken in response to competition, market and legal conditions. The Company may make further business changes in the future. New legislative initiatives, such as the European Union (“EU”) Digital Markets Act, could require further changes. The Company is also subject to litigation and investigations relating to the App Store, which have resulted in changes to the Company’s business practices, and may in the future result in further changes. These changes could include how and to what extent the Company charges developers for access to its platforms and manages distribution of apps outside of the App Store. This could reduce the volume of sales, and the commission that the Company earns on those sales, would decrease. If the rate of the commission that the Company retains on such sales is reduced, or if it is otherwise narrowed in scope or eliminated, the Company’s business, results of operations and financial condition could be materially adversely affected. Failure to obtain or create digital content that appeals to the Company’s customers, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s business, results of operations and financial condition. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell, or offer subscriptions to, third-party content, as well as the right to incorporate specific content into the Company’s own services. The licensing or other distribution arrangements for this content can be for relatively short time periods and do not guarantee the continuation or renewal of these arrangements on commercially reasonable terms, or at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and can take actions to make it difficult or impossible for the Company to license or otherwise distribute their content. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at commercially reasonable prices with acceptable usage rules. The Company also produces its own digital content, which can be costly to produce due to intense and increasing competition for talent, content and subscribers, and may fail to appeal to the Company’s customers. The COVID-19 pandemic has also caused additional restrictions on production and increased costs for digital content. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There can be no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. Apple Inc. | 2022 Form 10-K | 10 The Company’s success depends largely on the talents and efforts of its team members, the continued service and availability of highly skilled employees, including key personnel, and the Company’s ability to nurture its distinctive and inclusive culture. Much of the Company’s future success depends on the talents and efforts of its team members, the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. In addition to intense competition for talent, workforce dynamics are constantly evolving. If the Company does not manage changing workforce dynamics effectively, it could materially adversely affect the Company’s culture, reputation and operational flexibility. The Company believes that its distinctive and inclusive culture is a significant driver of its success. If the Company is unable to nurture its culture, it could materially adversely affect the Company’s ability to recruit and retain the highly skilled employees who are critical to its success, and could otherwise materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company depends on the performance of carriers, wholesalers, retailers and other resellers. The Company distributes its products and certain of its services through cellular network carriers, wholesalers, retailers and resellers, many of which distribute products and services from competitors. The Company also sells its products and services and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. Some carriers providing cellular network service for the Company’s products offer financing, installment payment plans or subsidies for users’ purchases of the device. There can be no assurance such offers will be continued at all or in the same amounts. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs can require a substantial investment while not assuring return or incremental sales. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. The Company’s business and reputation are impacted by information technology system failures and network disruptions. The Company and its global supply chain are exposed to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, ransomware or other cybersecurity incidents, or other events or disruptions. System redundancy and other continuity measures may be ineffective or inadequate, and the Company’s or its vendors’ business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions can adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Losses or unauthorized access to or releases of confidential information, including personal information, could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information, including personal information, with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company’s business also requires it to share confidential information with suppliers and other third parties. The Company relies on global suppliers that are also exposed to ransomware and other malicious attacks that can disrupt business operations. Although the Company takes steps to secure confidential information that is provided to or accessible by third parties working on the Company’s behalf, such measures are not always effective and losses or unauthorized access to or releases of confidential information occur. Such incidents and other malicious attacks could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Apple Inc. | 2022 Form 10-K | 11 The Company experiences malicious attacks and other attempts to gain unauthorized access to its systems on a regular basis. These attacks seek to compromise the confidentiality, integrity or availability of confidential information or disrupt normal business operations, and could, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the Company’s stock price, materially damage commercial relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Globally, attacks are expected to continue accelerating in both frequency and sophistication with increasing use by actors of tools and techniques that are designed to circumvent controls, avoid detection, and remove or obfuscate forensic evidence, all of which hinders the Company’s ability to identify, investigate and recover from incidents. In addition, attacks against the Company and its customers can escalate during periods of severe diplomatic or armed conflict. Although malicious attacks perpetrated to gain access to confidential information, including personal information, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, and mitigate the impact of unauthorized access, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, ransomware attacks, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties can fraudulently induce the Company’s or its vendors’ employees or customers into disclosing user names, passwords or other sensitive information, which can, in turn, be used for unauthorized access to the Company’s or its vendors’ systems and services. To help protect customers and the Company, the Company deploys and makes available technologies like multifactor authentication, monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, can result in the delay or loss of customer orders or impede customer access to the Company’s products and services. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business, present risks not originally contemplated and materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater-than-expected liabilities and expenses, economic, political, legal and regulatory challenges associated with operating in new businesses, regions or countries, inadequate return on capital, potential impairment of tangible and intangible assets, and significant write-offs. Investment and acquisition transactions are exposed to additional risks, including failing to obtain required regulatory approvals on a timely basis or at all, or the imposition of onerous conditions that could delay or prevent the Company from completing a transaction or otherwise limit the Company’s ability to fully realize the anticipated benefits of a transaction. These new ventures are inherently risky and may not be successful. The failure of any significant investment could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of an individual store or multiple stores, including as a result of protective public safety measures in response to the COVID-19 pandemic, could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. The Company’s retail operations are subject to many factors that pose risks and uncertainties and could adversely impact the Company’s business, results of operations and financial condition, including macro-economic factors that could have an adverse effect on general retail activity. Other factors include the Company’s ability to: manage costs associated with retail store construction and operation; manage relationships with existing retail partners; manage costs associated with fluctuations in the value of retail inventory; and obtain and renew leases in quality retail locations at a reasonable cost. Apple Inc. | 2022 Form 10-K | 12 Legal and Regulatory Compliance Risks The Company’s business, results of operations and financial condition could be adversely impacted by unfavorable results of legal proceedings or government investigations. The Company is subject to various claims, legal proceedings and government investigations that have arisen in the ordinary course of business and have not yet been fully resolved, and new matters may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which can subject the Company to costs and damages in the event of a claim against an indemnified third party. The number of claims, legal proceedings and government investigations involving the Company, and the alleged magnitude of such claims, proceedings and government investigations, has generally increased over time and may continue to increase. The Company has faced and continues to face a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in several U.S. jurisdictions, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, defending against litigation or responding to government investigations can be expensive, time-consuming and disruptive to the Company’s operations. In recognition of these considerations, the Company may enter into agreements or other arrangements to settle litigation and resolve such challenges. There can be no assurance such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements can also significantly increase the Company’s cost of sales and operating expenses and require the Company to change its business practices and limit the Company’s ability to offer certain products and services. Except as described in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. The outcome of litigation or government investigations is inherently uncertain. If one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts above management’s expectations, the Company’s results of operations and financial condition for that reporting period could be materially adversely affected. Further, such an outcome can result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company, and can require the Company to change its business practices and limit the Company’s ability to offer certain products and services, all of which could materially adversely affect the Company’s business, reputation, results of operations and financial condition. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. The Company is subject to complex and changing laws and regulations worldwide, which exposes the Company to potential liabilities, increased costs and other adverse effects on the Company’s business. The Company’s global operations are subject to complex and changing laws and regulations on subjects, including antitrust; privacy, data security and data localization; consumer protection; advertising, sales, billing and e-commerce; financial services and technology; product liability; intellectual property ownership and infringement; digital platforms; internet, telecommunications, and mobile communications; media, television, film and digital content; availability of third-party software applications and services; labor and employment; anticorruption; import, export and trade; foreign exchange controls and cash repatriation restrictions; anti–money laundering; foreign ownership and investment; tax; and environmental, health and safety, including electronic waste, recycling, and climate change. Apple Inc. | 2022 Form 10-K | 13 Compliance with these laws and regulations is onerous and expensive. New and changing laws and regulations can adversely affect the Company’s business by increasing the Company’s costs, limiting the Company’s ability to offer a product, service or feature to customers, impacting customer demand for the Company’s products and services, and requiring changes to the Company’s supply chain and its business. New and changing laws and regulations can also create uncertainty about how such laws and regulations will be interpreted and applied. These risks and costs may increase as the Company’s products and services are introduced into specialized applications, including health and financial services. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance the Company’s employees, contractors or agents will not violate such laws and regulations or the Company’s policies and procedures. If the Company is found to have violated laws and regulations, it could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Regulatory changes and other actions that materially adversely affect the Company’s business may be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. For example, the Company is subject to changing regulations relating to the export and import of its products. Although the Company has programs, policies and procedures in place that are designed to satisfy regulatory requirements, there can be no assurance that such policies and procedures will be effective in preventing a violation or a claim of a violation. As a result, the Company’s products could be delayed or prohibited from importation, either of which could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Expectations relating to environmental, social and governance considerations expose the Company to potential liabilities, increased costs, reputational harm, and other adverse effects on the Company’s business. Many governments, regulators, investors, employees, customers and other stakeholders are increasingly focused on environmental, social and governance considerations relating to businesses, including climate change and greenhouse gas emissions, human and civil rights, and diversity, equity and inclusion. In addition, the Company makes statements about its environmental, social and governance goals and initiatives through its environmental, social and governance report, its other non-financial reports, information provided on its website, press statements and other communications. Responding to these environmental, social and governance considerations and implementation of these goals and initiatives involves risks and uncertainties, requires investments, and depends in part on third-party performance or data that is outside the Company’s control. The Company cannot guarantee that it will achieve its announced environmental, social and governance goals and initiatives. In addition, some stakeholders may disagree with the Company’s goals and initiatives. Any failure, or perceived failure, by the Company to achieve its goals, further its initiatives, adhere to its public statements, comply with federal, state or international environmental, social and governance laws and regulations, or meet evolving and varied stakeholder expectations and standards could result in legal and regulatory proceedings against the Company and materially adversely affect the Company’s business, reputation, results of operations, financial condition and stock price. The technology industry, including, in some instances, the Company, is subject to intense media, political and regulatory scrutiny, which exposes the Company to increasing regulation, government investigations, legal actions and penalties. From time to time, the Company has made changes to its App Store, including actions taken in response to competition, market and legal conditions. The Company may make further business changes in the future. New legislative initiatives, such as the EU Digital Markets Act, or similar laws in other jurisdictions, could require further changes. These changes could include how and to what extent the Company charges developers for access to its platforms and manages distribution of apps outside of the App Store. The Company is also currently subject to antitrust investigations in various jurisdictions around the world, which can result in legal proceedings and claims against the Company that could, individually or in the aggregate, have a materially adverse impact on the Company’s business, results of operations and financial condition. For example, the Company is the subject of investigations in Europe and other jurisdictions relating to App Store terms and conditions. If such investigations result in adverse findings against the Company, the Company could be exposed to significant fines and may be required to make changes to its App Store business, all of which could materially adversely affect the Company’s business, results of operations and financial condition. The Company is also subject to litigation relating to the App Store, which has resulted in changes to the Company’s business practices, and may in the future result in further changes. Further, the Company has commercial relationships with other companies in the technology industry that are or may become subject to investigations and litigation that, if resolved against those other companies, could materially adversely affect the Company’s commercial relationships with those business partners and materially adversely affect the Company’s business, results of operations and financial condition. For example, the Company earns revenue from licensing arrangements with other companies to offer their search services on the Company’s platforms and apps, and certain of these arrangements are currently subject to government investigations and legal proceedings. Apple Inc. | 2022 Form 10-K | 14 There can be no assurance the Company’s business will not be materially adversely affected, individually or in the aggregate, by the outcomes of such investigations, litigation or changes to laws and regulations in the future. Changes to the Company’s business practices to comply with new laws and regulations or in connection with other legal proceedings could negatively impact the reputation of the Company’s products for privacy and security and otherwise adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, and lost sales. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of various types of personal information. In many cases, these laws apply not only to third-party transactions, but also restrict transfers of personal information among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and additional jurisdictions are considering imposing additional restrictions or have laws that are pending. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing requirements causes the Company to incur substantial costs and has required and may in the future require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of personal information through its privacy policy, information provided on its website, press statements and other privacy notices provided to customers. Any failure by the Company to comply with these public statements or with other federal, state or international privacy or data protection laws and regulations could result in inquiries or proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. In addition to the risks generally relating to the collection, use, retention, security and transfer of personal information, the Company is also subject to specific obligations relating to information considered sensitive under applicable laws, such as health data, financial data and biometric data. Health data and financial data are subject to additional privacy, security and breach notification requirements, and the Company is subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data or financial data is handled in a manner not permitted by law or under the Company’s agreements with healthcare or financial institutions, the Company can be subject to litigation or government investigations, and can be liable for associated investigatory expenses, and can also incur significant fees or fines. Payment card data is also subject to additional requirements. Under payment card rules and obligations, if cardholder information is potentially compromised, the Company can be liable for associated investigatory expenses and can also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Financial Risks The Company expects its quarterly net sales and results of operations to fluctuate. The Company’s profit margins vary across its products, services, geographic segments and distribution channels. For example, the gross margins on the Company’s products and services vary significantly and can change over time. The Company’s gross margins are subject to volatility and downward pressure due to a variety of factors, including: continued industry-wide global product pricing pressures and product pricing actions that the Company may take in response to such pressures; increased competition; the Company’s ability to effectively stimulate demand for certain of its products and services; compressed product life cycles; supply shortages; potential increases in the cost of components, outside manufacturing services, and developing, acquiring and delivering content for the Company’s services; the Company’s ability to manage product quality and warranty costs effectively; shifts in the mix of products and services, or in the geographic, currency or channel mix, including to the extent that regulatory changes require the Company to modify its product and service offerings; fluctuations in foreign exchange rates; inflation and other macroeconomic pressures; and the introduction of new products or services, including new products or services with higher cost structures. These and other factors could have a materially adverse impact on the Company’s results of operations and financial condition. The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. Further, the Company generates a significant portion of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments, such as lower-than-anticipated demand for the Company’s products or services, issues with new product or service introductions, information technology system failures or network disruptions, or failure of one of the Company’s logistics, components supply, or manufacturing partners. Apple Inc. | 2022 Form 10-K | 15 The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar relative to local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non–U.S. dollar–denominated sales, cost of sales and operating expenses worldwide. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers could be materially adversely affected by foreign currency exchange rate fluctuations. The weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency–denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise international pricing to offset the U.S. dollar’s strengthening, which would adversely affect the U.S. dollar value of the gross margins the Company earns on foreign currency–denominated sales. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency–denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not be effective to offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the values of its investment portfolio. The Company’s investments can be negatively affected by changes in liquidity, credit deterioration, financial results, market and economic conditions, political risk, sovereign risk, interest rate fluctuations or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents, and marketable and non-marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents, and marketable and non-marketable securities, future fluctuations in their value could result in significant losses and could have a material adverse impact on the Company’s results of operations and financial condition. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products and certain of its services through third-party cellular network carriers, wholesalers, retailers and resellers. The Company also sells its products and services directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party bank support or financing arrangements, or credit insurance, and a significant portion of the Company’s trade receivables can be concentrated within cellular network carriers or other resellers. The Company’s exposure to credit and collectibility risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture subassemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 24, 2022, the Company’s vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company is subject to changes in tax rates, the adoption of new U.S. or international tax legislation and exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax laws and tax rates for income taxes and other non-income taxes in various jurisdictions may be subject to significant change. The Company’s effective tax rates are affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, the introduction of new taxes, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The application of tax laws may be uncertain, require significant judgment and be subject to differing interpretations. Apple Inc. | 2022 Form 10-K | 16 The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s business, results of operations and financial condition could be materially adversely affected. General Risks The price of the Company’s stock is subject to volatility. The Company’s stock has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have, from time to time, experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility may cause the average price at which the Company repurchases its stock in a given period to exceed the stock’s price at a given point in time. The Company believes the price of its stock should reflect expectations of future growth and profitability. The Company also believes the price of its stock should reflect expectations that its cash dividend will continue at current levels or grow, and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, the price of the Company’s stock may decline significantly, which could have a material adverse impact on investor confidence and employee retention. Item 1B.    Unresolved Staff Comments None. Item 2.    Properties The Company’s headquarters are located in Cupertino, California. As of September 24, 2022, the Company owned or leased facilities and land for corporate functions, R&D, data centers, retail and other purposes at locations throughout the U.S. and in various places outside the U.S. The Company believes its existing facilities and equipment, which are used by all reportable segments, are in good operating condition and are suitable for the conduct of its business. Item 3.    Legal Proceedings Epic Games Epic Games, Inc. (“Epic”) filed a lawsuit in the U.S. District Court for the Northern District of California (the “Northern California District Court”) against the Company alleging violations of federal and state antitrust laws and California’s unfair competition law based upon the Company’s operation of its App Store. The Company filed a counterclaim for breach of contract. On September 10, 2021, the Northern California District Court ruled in favor of the Company with respect to nine out of the ten counts included in Epic’s claim, and in favor of the Company with respect to the Company’s claims for breach of contract. The Northern California District Court found that certain provisions of the Company’s App Store Review Guidelines violate California’s unfair competition law and issued an injunction. Epic appealed the decision. The Company filed a cross-appeal and has been granted a stay pending the appeal. Other Legal Proceedings The Company is subject to other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. The Company settled certain matters during the fourth quarter of 2022 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Item 4.    Mine Safety Disclosures Not applicable. Apple Inc. | 2022 Form 10-K | 17 PART II Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on The Nasdaq Stock Market LLC under the symbol AAPL. Holders As of October 14, 2022, there were 23,838 shareholders of record. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 24, 2022 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) June 26, 2022 to July 30, 2022: Open market and privately negotiated purchases 41,690 $ 145.91 41,690 July 31, 2022 to August 27, 2022: Open market and privately negotiated purchases 54,669 $ 168.29 54,669 August 28, 2022 to September 24, 2022: Open market and privately negotiated purchases 63,813 $ 155.59 63,813 Total 160,172 $ 60,665 (1) As of September 24, 2022, the Company was authorized by the Board of Directors to purchase up to $405 billion of the Company’s common stock under a share repurchase program most recently announced on April 28, 2022 (the “Program”), of which $344.3 billion had been utilized. The Program does not obligate the Company to acquire a minimum amount of shares. Under the Program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. Apple Inc. | 2022 Form 10-K | 18 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend-reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 24, 2022. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 29, 2017. Past stock price performance is not necessarily indicative of future stock price performance. * $100 invested on September 29, 2017 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2022 Standard & Poor’s, a division of S&P Global. All rights reserved. Copyright © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. September 2017 September 2018 September 2019 September 2020 September 2021 September 2022 Apple Inc. $ 100 $ 149 $ 146 $ 303 $ 400 $ 411 S&P 500 Index $ 100 $ 118 $ 123 $ 142 $ 184 $ 156 S&P Information Technology Index $ 100 $ 131 $ 143 $ 210 $ 271 $ 217 Dow Jones U.S. Technology Supersector Index $ 100 $ 131 $ 139 $ 208 $ 283 $ 209 Item 6.    [Reserved] Apple Inc. | 2022 Form 10-K | 19 Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in Part II, Item 8 of this Form 10-K. This section of this Form 10-K generally discusses 2022 and 2021 items and year-to-year comparisons between 2022 and 2021. Discussions of 2020 items and year-to-year comparisons between 2021 and 2020 are not included in this Form 10-K, and can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended September 25, 2021. Fiscal Year Highlights Fiscal 2022 Highlights Total net sales increased 8% or $28.5 billion during 2022 compared to 2021, driven primarily by higher net sales of iPhone, Services and Mac. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable year-over-year impact on all Products and Services net sales during 2022. The Company announces new product, service and software offerings at various times during the year. Significant announcements during fiscal 2022 included the following: First Quarter 2022: • Updated MacBook Pro 14” and MacBook Pro 16”, powered by the Apple M1 Pro or M1 Max chip; and • Third generation of AirPods. Second Quarter 2022: • Updated iPhone SE with 5G technology; • All-new Mac Studio, powered by the Apple M1 Max or M1 Ultra chip; • All-new Studio Display™; and • Updated iPad Air with 5G technology, powered by the Apple M1 chip. Third Quarter 2022: • Updated MacBook Air and MacBook Pro 13”, both powered by the Apple M2 chip; • iOS 16, macOS Ventura, iPadOS 16 and watchOS 9, updates to the Company’s operating systems; and • Apple Pay Later, a buy now, pay later service. Fourth Quarter 2022: • iPhone 14, iPhone 14 Plus, iPhone 14 Pro and iPhone 14 Pro Max; • Second generation of AirPods Pro; and • Apple Watch Series 8, updated Apple Watch SE and all-new Apple Watch Ultra. In April 2022, the Company announced an increase to its Program authorization from $315 billion to $405 billion and raised its quarterly dividend from $0.22 to $0.23 per share beginning in May 2022. During 2022, the Company repurchased $90.2 billion of its common stock and paid dividends and dividend equivalents of $14.8 billion. COVID-19 The COVID-19 pandemic has had, and continues to have, a significant impact around the world, prompting governments and businesses to take unprecedented measures, such as restrictions on travel and business operations, temporary closures of businesses, and quarantine and shelter-in-place orders. The COVID-19 pandemic has at times significantly curtailed global economic activity and caused significant volatility and disruption in global financial markets. The COVID-19 pandemic and the measures taken by many countries in response have affected and could in the future materially impact the Company’s business, results of operations and financial condition. Certain of the Company’s outsourcing partners, component suppliers and logistical service providers have experienced disruptions during the COVID-19 pandemic, resulting in supply shortages. Similar disruptions could occur in the future. Apple Inc. | 2022 Form 10-K | 20 Products and Services Performance The following table shows net sales by category for 2022, 2021 and 2020 (dollars in millions): 2022 Change 2021 Change 2020 Net sales by category: iPhone (1) $ 205,489 7 % $ 191,973 39 % $ 137,781 Mac (1) 40,177 14 % 35,190 23 % 28,622 iPad (1) 29,292 (8) % 31,862 34 % 23,724 Wearables, Home and Accessories (1)(2) 41,241 7 % 38,367 25 % 30,620 Services (3) 78,129 14 % 68,425 27 % 53,768 Total net sales $ 394,328 8 % $ 365,817 33 % $ 274,515 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod mini and accessories. (3) Services net sales include sales from the Company’s advertising, AppleCare, cloud, digital content, payment and other services. Services net sales also include amortization of the deferred value of services bundled in the sales price of certain products. iPhone iPhone net sales increased during 2022 compared to 2021 due primarily to higher net sales from the Company’s new iPhone models released since the beginning of the fourth quarter of 2021. Mac Mac net sales increased during 2022 compared to 2021 due primarily to higher net sales of laptops. iPad iPad net sales decreased during 2022 compared to 2021 due primarily to lower net sales of iPad Pro. Wearables, Home and Accessories Wearables, Home and Accessories net sales increased during 2022 compared to 2021 due primarily to higher net sales of Apple Watch and AirPods. Services Services net sales increased during 2022 compared to 2021 due primarily to higher net sales from advertising, cloud services and the App Store. Apple Inc. | 2022 Form 10-K | 21 Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” The following table shows net sales by reportable segment for 2022, 2021 and 2020 (dollars in millions): 2022 Change 2021 Change 2020 Net sales by reportable segment: Americas $ 169,658 11 % $ 153,306 23 % $ 124,556 Europe 95,118 7 % 89,307 30 % 68,640 Greater China 74,200 9 % 68,366 70 % 40,308 Japan 25,977 (9) % 28,482 33 % 21,418 Rest of Asia Pacific 29,375 11 % 26,356 35 % 19,593 Total net sales $ 394,328 8 % $ 365,817 33 % $ 274,515 Americas Americas net sales increased during 2022 compared to 2021 due primarily to higher net sales of iPhone, Services and Mac. Europe Europe net sales increased during 2022 compared to 2021 due primarily to higher net sales of iPhone and Services. The weakness in foreign currencies relative to the U.S. dollar had a net unfavorable year-over-year impact on Europe net sales during 2022. Greater China Greater China net sales increased during 2022 compared to 2021 due primarily to higher net sales of iPhone and Services. The strength of the renminbi relative to the U.S. dollar had a favorable year-over-year impact on Greater China net sales during 2022. Japan Japan net sales decreased during 2022 compared to 2021 due to the weakness of the yen relative to the U.S. dollar. Rest of Asia Pacific Rest of Asia Pacific net sales increased during 2022 compared to 2021 due primarily to higher net sales of iPhone, Mac and Services. The weakness in foreign currencies relative to the U.S. dollar had an unfavorable year-over-year impact on Rest of Asia Pacific net sales during 2022. Apple Inc. | 2022 Form 10-K | 22 Gross Margin Products and Services gross margin and gross margin percentage for 2022, 2021 and 2020 were as follows (dollars in millions): 2022 2021 2020 Gross margin: Products $ 114,728 $ 105,126 $ 69,461 Services 56,054 47,710 35,495 Total gross margin $ 170,782 $ 152,836 $ 104,956 Gross margin percentage: Products 36.3 % 35.3 % 31.5 % Services 71.7 % 69.7 % 66.0 % Total gross margin percentage 43.3 % 41.8 % 38.2 % Products Gross Margin Products gross margin increased during 2022 compared to 2021 due primarily to a different Products mix and higher Products volume, partially offset by the weakness in foreign currencies relative to the U.S. dollar. Products gross margin percentage increased during 2022 compared to 2021 due primarily to a different Products mix, partially offset by the weakness in foreign currencies relative to the U.S. dollar. Services Gross Margin Services gross margin increased during 2022 compared to 2021 due primarily to higher Services net sales, partially offset by the weakness in foreign currencies relative to the U.S. dollar. Services gross margin percentage increased during 2022 compared to 2021 due primarily to improved leverage and a different Services mix, partially offset by the weakness in foreign currencies relative to the U.S. dollar. The Company’s future gross margins can be impacted by a variety of factors, as discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” As a result, the Company believes, in general, gross margins will be subject to volatility and downward pressure. Operating Expenses Operating expenses for 2022, 2021 and 2020 were as follows (dollars in millions): 2022 Change 2021 Change 2020 Research and development $ 26,251 20 % $ 21,914 17 % $ 18,752 Percentage of total net sales 7 % 6 % 7 % Selling, general and administrative $ 25,094 14 % $ 21,973 10 % $ 19,916 Percentage of total net sales 6 % 6 % 7 % Total operating expenses $ 51,345 17 % $ 43,887 13 % $ 38,668 Percentage of total net sales 13 % 12 % 14 % Research and Development The year-over-year growth in R&D expense in 2022 was driven primarily by increases in headcount-related expenses and engineering program costs. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2022 was driven primarily by increases in headcount-related expenses, advertising and professional services. Apple Inc. | 2022 Form 10-K | 23 Other Income/(Expense), Net Other income/(expense), net (“OI&E”) for 2022, 2021 and 2020 was as follows (dollars in millions): 2022 Change 2021 Change 2020 Interest and dividend income $ 2,825 $ 2,843 $ 3,763 Interest expense (2,931) (2,645) (2,873) Other income/(expense), net (228) 60 (87) Total other income/(expense), net $ (334) (229) % $ 258 (68) % $ 803 The decrease in OI&E during 2022 compared to 2021 was due primarily to higher realized losses on debt securities, unfavorable fair value adjustments on equity securities and higher interest expense, partially offset by higher foreign exchange gains. Provision for Income Taxes Provision for income taxes, effective tax rate and statutory federal income tax rate for 2022, 2021 and 2020 were as follows (dollars in millions): 2022 2021 2020 Provision for income taxes $ 19,300 $ 14,527 $ 9,680 Effective tax rate 16.2 % 13.3 % 14.4 % Statutory federal income tax rate 21 % 21 % 21 % The Company’s effective tax rate for 2022 was lower than the statutory federal income tax rate due primarily to a lower effective tax rate on foreign earnings, tax benefits from share-based compensation and the impact of the U.S. federal R&D credit, partially offset by state income taxes. The Company’s effective tax rate for 2021 was lower than the statutory federal income tax rate due primarily to a lower effective tax rate on foreign earnings, tax benefits from share-based compensation and foreign-derived intangible income deductions. The Company’s effective tax rate for 2022 was higher compared to 2021 due primarily to a higher effective tax rate on foreign earnings, including the impact to U.S. foreign tax credits as a result of regulatory guidance issued by the U.S. Department of the Treasury in 2022, and lower tax benefits from foreign-derived intangible income deductions and share-based compensation. Liquidity and Capital Resources The Company believes its balances of cash, cash equivalents and unrestricted marketable securities, which totaled $156.4 billion as of September 24, 2022, along with cash generated by ongoing operations and continued access to debt markets, will be sufficient to satisfy its cash requirements and capital return program over the next 12 months and beyond. The Company’s material cash requirements include the following contractual obligations. Debt As of September 24, 2022, the Company had outstanding fixed-rate notes with varying maturities for an aggregate principal amount of $111.8 billion (collectively the “Notes”), with $11.1 billion payable within 12 months. Future interest payments associated with the Notes total $41.3 billion, with $2.9 billion payable within 12 months. The Company also issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. As of September 24, 2022, the Company had $10.0 billion of Commercial Paper outstanding, all of which was payable within 12 months. Leases The Company has lease arrangements for certain equipment and facilities, including corporate, data center, manufacturing and retail space. As of September 24, 2022, the Company had fixed lease payment obligations of $15.3 billion, with $2.0 billion payable within 12 months. Apple Inc. | 2022 Form 10-K | 24 Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture subassemblies for the Company’s products and to perform final assembly and testing of finished products. The Company also obtains individual components for its products from a wide variety of individual suppliers. Outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. As of September 24, 2022, the Company had manufacturing purchase obligations of $71.1 billion, with $68.4 billion payable within 12 months. The Company’s manufacturing purchase obligations are primarily noncancelable. Other Purchase Obligations The Company’s other purchase obligations primarily consist of noncancelable obligations to acquire capital assets, including assets related to product manufacturing, and noncancelable obligations related to internet services and content creation. As of September 24, 2022, the Company had other purchase obligations of $17.8 billion, with $6.8 billion payable within 12 months. Deemed Repatriation Tax Payable As of September 24, 2022, the balance of the deemed repatriation tax payable imposed by the U.S. Tax Cuts and Jobs Act of 2017 (the “Act”) was $22.0 billion, with $5.3 billion expected to be paid within 12 months. In addition to its contractual cash requirements, the Company has a capital return program authorized by the Board of Directors. The Program does not obligate the Company to acquire a minimum amount of shares. As of September 24, 2022, the Company’s quarterly cash dividend was $0.23 per share. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Critical Accounting Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported. Note 1, “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Uncertain Tax Positions The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions. The evaluation of the Company’s uncertain tax positions involves significant judgment in the interpretation and application of GAAP and complex domestic and international tax laws, including the Act and matters related to the allocation of international taxation rights between countries. Although management believes the Company’s reserves are reasonable, no assurance can be given that the final outcome of these uncertainties will not be different from that which is reflected in the Company’s reserves. Reserves are adjusted considering changing facts and circumstances, such as the closing of a tax examination. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies The Company is subject to various legal proceedings and claims that arise in the ordinary course of business, the outcomes of which are inherently uncertain. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Resolution of legal matters in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Apple Inc. | 2022 Form 10-K | 25 Item 7A.    Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, it is most affected by fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. The Company’s investment policy and strategy are focused on the preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly rated securities, with the primary objective of minimizing the potential risk of principal loss. The Company’s investment policy generally requires securities to be investment grade and limits the amount of credit exposure to any one issuer. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 24, 2022 and September 25, 2021, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $4.0 billion and $4.1 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. As of September 24, 2022, the Company had outstanding fixed-rate notes and as of September 25, 2021, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $110.1 billion and $118.7 billion, respectively. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on term debt are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 24, 2022 and September 25, 2021 to increase by $201 million and $186 million on an annualized basis, respectively. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and in the future may enter, into foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign currency–denominated debt issuances. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including accounting considerations or the prohibitive economic cost of hedging particular exposures. Apple Inc. | 2022 Form 10-K | 26 To provide an assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $1.0 billion as of September 24, 2022, compared to a maximum one-day loss in fair value of $550 million as of September 25, 2021. Because the Company uses foreign currency instruments for hedging purposes, the losses in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio, debt and derivative positions may differ materially from the sensitivity analyses performed as of September 24, 2022 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchange rates and the Company’s actual exposures and positions. Apple Inc. | 2022 Form 10-K | 27 Item 8.    Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 29 Consolidated Statements of Comprehensive Income for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 30 Consolidated Balance Sheets as of September 24, 2022 and September 25, 2021 31 Consolidated Statements of Shareholders’ Equity for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 32 Consolidated Statements of Cash Flows for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 33 Notes to Consolidated Financial Statements 34 Reports of Independent Registered Public Accounting Firm 50 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes. Apple Inc. | 2022 Form 10-K | 28 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 24, 2022 September 25, 2021 September 26, 2020 Net sales: Products $ 316,199 $ 297,392 $ 220,747 Services 78,129 68,425 53,768 Total net sales 394,328 365,817 274,515 Cost of sales: Products 201,471 192,266 151,286 Services 22,075 20,715 18,273 Total cost of sales 223,546 212,981 169,559 Gross margin 170,782 152,836 104,956 Operating expenses: Research and development 26,251 21,914 18,752 Selling, general and administrative 25,094 21,973 19,916 Total operating expenses 51,345 43,887 38,668 Operating income 119,437 108,949 66,288 Other income/(expense), net ( 334 ) 258 803 Income before provision for income taxes 119,103 109,207 67,091 Provision for income taxes 19,300 14,527 9,680 Net income $ 99,803 $ 94,680 $ 57,411 Earnings per share: Basic $ 6.15 $ 5.67 $ 3.31 Diluted $ 6.11 $ 5.61 $ 3.28 Shares used in computing earnings per share: Basic 16,215,963 16,701,272 17,352,119 Diluted 16,325,819 16,864,919 17,528,214 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2022 Form 10-K | 29 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 24, 2022 September 25, 2021 September 26, 2020 Net income $ 99,803 $ 94,680 $ 57,411 Other comprehensive income/(loss): Change in foreign currency translation, net of tax ( 1,511 ) 501 88 Change in unrealized gains/losses on derivative instruments, net of tax: Change in fair value of derivative instruments 3,212 32 79 Adjustment for net (gains)/losses realized and included in net income ( 1,074 ) 1,003 ( 1,264 ) Total change in unrealized gains/losses on derivative instruments 2,138 1,035 ( 1,185 ) Change in unrealized gains/losses on marketable debt securities, net of tax: Change in fair value of marketable debt securities ( 12,104 ) ( 694 ) 1,202 Adjustment for net (gains)/losses realized and included in net income 205 ( 273 ) ( 63 ) Total change in unrealized gains/losses on marketable debt securities ( 11,899 ) ( 967 ) 1,139 Total other comprehensive income/(loss) ( 11,272 ) 569 42 Total comprehensive income $ 88,531 $ 95,249 $ 57,453 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2022 Form 10-K | 30 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 24, 2022 September 25, 2021 ASSETS: Current assets: Cash and cash equivalents $ 23,646 $ 34,940 Marketable securities 24,658 27,699 Accounts receivable, net 28,184 26,278 Inventories 4,946 6,580 Vendor non-trade receivables 32,748 25,228 Other current assets 21,223 14,111 Total current assets 135,405 134,836 Non-current assets: Marketable securities 120,805 127,877 Property, plant and equipment, net 42,117 39,440 Other non-current assets 54,428 48,849 Total non-current assets 217,350 216,166 Total assets $ 352,755 $ 351,002 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 64,115 $ 54,763 Other current liabilities 60,845 47,493 Deferred revenue 7,912 7,612 Commercial paper 9,982 6,000 Term debt 11,128 9,613 Total current liabilities 153,982 125,481 Non-current liabilities: Term debt 98,959 109,106 Other non-current liabilities 49,142 53,325 Total non-current liabilities 148,101 162,431 Total liabilities 302,083 287,912 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $ 0.00001 par value: 50,400,000 shares authorized; 15,943,425 and 16,426,786 shares issued and outstanding, respectively 64,849 57,365 Retained earnings/(Accumulated deficit) ( 3,068 ) 5,562 Accumulated other comprehensive income/(loss) ( 11,109 ) 163 Total shareholders’ equity 50,672 63,090 Total liabilities and shareholders’ equity $ 352,755 $ 351,002 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2022 Form 10-K | 31 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except per share amounts) Years ended September 24, 2022 September 25, 2021 September 26, 2020 Total shareholders’ equity, beginning balances $ 63,090 $ 65,339 $ 90,488 Common stock and additional paid-in capital: Beginning balances 57,365 50,779 45,174 Common stock issued 1,175 1,105 880 Common stock withheld related to net share settlement of equity awards ( 2,971 ) ( 2,627 ) ( 2,250 ) Share-based compensation 9,280 8,108 6,975 Ending balances 64,849 57,365 50,779 Retained earnings/(Accumulated deficit): Beginning balances 5,562 14,966 45,898 Net income 99,803 94,680 57,411 Dividends and dividend equivalents declared ( 14,793 ) ( 14,431 ) ( 14,087 ) Common stock withheld related to net share settlement of equity awards ( 3,454 ) ( 4,151 ) ( 1,604 ) Common stock repurchased ( 90,186 ) ( 85,502 ) ( 72,516 ) Cumulative effect of change in accounting principle — — ( 136 ) Ending balances ( 3,068 ) 5,562 14,966 Accumulated other comprehensive income/(loss): Beginning balances 163 ( 406 ) ( 584 ) Other comprehensive income/(loss) ( 11,272 ) 569 42 Cumulative effect of change in accounting principle — — 136 Ending balances ( 11,109 ) 163 ( 406 ) Total shareholders’ equity, ending balances $ 50,672 $ 63,090 $ 65,339 Dividends and dividend equivalents declared per share or RSU $ 0.90 $ 0.85 $ 0.795 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2022 Form 10-K | 32 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 24, 2022 September 25, 2021 September 26, 2020 Cash, cash equivalents and restricted cash, beginning balances $ 35,929 $ 39,789 $ 50,224 Operating activities: Net income 99,803 94,680 57,411 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 11,104 11,284 11,056 Share-based compensation expense 9,038 7,906 6,829 Deferred income tax expense/(benefit) 895 ( 4,774 ) ( 215 ) Other 111 ( 147 ) ( 97 ) Changes in operating assets and liabilities: Accounts receivable, net ( 1,823 ) ( 10,125 ) 6,917 Inventories 1,484 ( 2,642 ) ( 127 ) Vendor non-trade receivables ( 7,520 ) ( 3,903 ) 1,553 Other current and non-current assets ( 6,499 ) ( 8,042 ) ( 9,588 ) Accounts payable 9,448 12,326 ( 4,062 ) Deferred revenue 478 1,676 2,081 Other current and non-current liabilities 5,632 5,799 8,916 Cash generated by operating activities 122,151 104,038 80,674 Investing activities: Purchases of marketable securities ( 76,923 ) ( 109,558 ) ( 114,938 ) Proceeds from maturities of marketable securities 29,917 59,023 69,918 Proceeds from sales of marketable securities 37,446 47,460 50,473 Payments for acquisition of property, plant and equipment ( 10,708 ) ( 11,085 ) ( 7,309 ) Payments made in connection with business acquisitions, net ( 306 ) ( 33 ) ( 1,524 ) Other ( 1,780 ) ( 352 ) ( 909 ) Cash used in investing activities ( 22,354 ) ( 14,545 ) ( 4,289 ) Financing activities: Payments for taxes related to net share settlement of equity awards ( 6,223 ) ( 6,556 ) ( 3,634 ) Payments for dividends and dividend equivalents ( 14,841 ) ( 14,467 ) ( 14,081 ) Repurchases of common stock ( 89,402 ) ( 85,971 ) ( 72,358 ) Proceeds from issuance of term debt, net 5,465 20,393 16,091 Repayments of term debt ( 9,543 ) ( 8,750 ) ( 12,629 ) Proceeds from/(Repayments of) commercial paper, net 3,955 1,022 ( 963 ) Other ( 160 ) 976 754 Cash used in financing activities ( 110,749 ) ( 93,353 ) ( 86,820 ) Decrease in cash, cash equivalents and restricted cash ( 10,952 ) ( 3,860 ) ( 10,435 ) Cash, cash equivalents and restricted cash, ending balances $ 24,977 $ 35,929 $ 39,789 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 19,573 $ 25,385 $ 9,501 Cash paid for interest $ 2,865 $ 2,687 $ 3,002 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2022 Form 10-K | 33 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Basis of Presentation and Preparation The consolidated financial statements include the accounts of Apple Inc. and its wholly owned subsidiaries (collectively “Apple” or the “Company”). Intercompany accounts and transactions have been eliminated. The preparation of these consolidated financial statements and accompanying notes in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. An additional week is included in the first fiscal quarter every five or six years to realign the Company’s fiscal quarters with calendar quarters, which will occur in the first quarter of the Company’s fiscal year ending September 30, 2023. The Company’s fiscal years 2022, 2021 and 2020 spanned 52 weeks each. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Revenue Recognition Net sales consist of revenue from the sale of iPhone, Mac, iPad, Services and other products. The Company recognizes revenue at the amount to which it expects to be entitled when control of the products or services is transferred to its customers. Control is generally transferred when the Company has a present right to payment and title and the significant risks and rewards of ownership of products or services are transferred to its customers. For most of the Company’s Products net sales, control transfers when products are shipped. For the Company’s Services net sales, control transfers over time as services are delivered. Payment for Products and Services net sales is collected within a short period following transfer of control or commencement of delivery of services, as applicable. The Company records reductions to Products net sales related to future product returns, price protection and other customer incentive programs based on the Company’s expectations and historical experience. For arrangements with multiple performance obligations, which represent promises within an arrangement that are distinct, the Company allocates revenue to all distinct performance obligations based on their relative stand-alone selling prices (“SSPs”). When available, the Company uses observable prices to determine SSPs. When observable prices are not available, SSPs are established that reflect the Company’s best estimates of what the selling prices of the performance obligations would be if they were sold regularly on a stand-alone basis. The Company’s process for estimating SSPs without observable prices considers multiple factors that may vary depending upon the unique facts and circumstances related to each performance obligation including, where applicable, prices charged by the Company for similar offerings, market trends in the pricing for similar offerings, product-specific business objectives and the estimated cost to provide the performance obligation. The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud ® , Siri ® and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative SSPs. Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the delivered hardware and bundled software is recognized when control has transferred to the customer, which generally occurs when the product is shipped. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. Cost of sales related to delivered hardware and bundled software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide product-related bundled services and unspecified software upgrade rights are recognized as cost of sales as incurred. For certain long-term service arrangements, the Company has performance obligations for services it has not yet delivered. For these arrangements, the Company does not have a right to bill for the undelivered services. The Company has determined that any unbilled consideration relates entirely to the value of the undelivered services. Accordingly, the Company has not recognized revenue, and does not disclose amounts, related to these undelivered services. Apple Inc. | 2022 Form 10-K | 34 For the sale of third-party products where the Company obtains control of the product before transferring it to the customer, the Company recognizes revenue based on the gross amount billed to customers. The Company considers multiple factors when determining whether it obtains control of third-party products, including evaluating if it can establish the price of the product, retains inventory risk for tangible products or has the responsibility for ensuring acceptability of the product. For third-party applications sold through the App Store and certain digital content sold through the Company’s other digital content stores, the Company does not obtain control of the product before transferring it to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in Services net sales only the commission it retains. The Company records revenue net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded within other current liabilities until remitted to the relevant government authority. Share-Based Compensation The Company generally measures share-based compensation based on the closing price of the Company’s common stock on the date of grant, and recognizes expense on a straight-line basis for its estimate of equity awards that will ultimately vest. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Earnings Per Share The following table shows the computation of basic and diluted earnings per share for 2022, 2021 and 2020 (net income in millions and shares in thousands): 2022 2021 2020 Numerator: Net income $ 99,803 $ 94,680 $ 57,411 Denominator: Weighted-average basic shares outstanding 16,215,963 16,701,272 17,352,119 Effect of dilutive securities 109,856 163,647 176,095 Weighted-average diluted shares 16,325,819 16,864,919 17,528,214 Basic earnings per share $ 6.15 $ 5.67 $ 3.31 Diluted earnings per share $ 6.11 $ 5.61 $ 3.28 The Company applies the treasury stock method to determine the dilutive effect of potentially dilutive securities. Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s investments in marketable debt securities have been classified and accounted for as available-for-sale. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. The Company’s investments in marketable equity securities are classified based on the nature of the securities and their availability for use in current operations. The cost of securities sold is determined using the specific identification method. Inventories Inventories are measured using the first-in, first-out method. Apple Inc. | 2022 Form 10-K | 35 Restricted Marketable Securities The Company considers marketable securities to be restricted when withdrawal or general use is legally restricted. The Company reports restricted marketable securities as current or non-current marketable securities in the Consolidated Balance Sheets based on the classification of the underlying securities. Property, Plant and Equipment Depreciation on property, plant and equipment is recognized on a straight-line basis over the estimated useful lives of the assets, which for buildings is the shorter of 40 years or the remaining life of the building; between one and five years for machinery and equipment, including manufacturing equipment; and the shorter of the lease term or useful life for leasehold improvements. Capitalized costs related to internal-use software are amortized on a straight-line basis over the estimated useful lives of the assets, which range from five to seven years . Depreciation and amortization expense on property, plant and equipment was $ 8.7 billion, $ 9.5 billion and $ 9.7 billion during 2022, 2021 and 2020, respectively. Derivative Instruments and Hedging All derivative instruments are recorded in the Consolidated Balance Sheets at fair value. The accounting treatment for derivative gains and losses is based on intended use and hedge designation. Gains and losses arising from amounts that are included in the assessment of cash flow hedge effectiveness are initially deferred in accumulated other comprehensive income/(loss) (“AOCI”) and subsequently reclassified into earnings when the hedged transaction affects earnings, and in the same line item in the Consolidated Statements of Operations. For options designated as cash flow hedges, the Company excludes time value from the assessment of hedge effectiveness and recognizes it on a straight-line basis over the life of the hedge in the Consolidated Statements of Operations line item to which the hedge relates. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in other comprehensive income/(loss) (“OCI”). Gains and losses arising from amounts that are included in the assessment of fair value hedge effectiveness are recognized in the Consolidated Statements of Operations line item to which the hedge relates along with offsetting losses and gains related to the change in value of the hedged item. For foreign exchange forward contracts designated as fair value hedges, the Company excludes the forward carry component from the assessment of hedge effectiveness and recognizes it in other income/(expense), net (“OI&E”) on a straight-line basis over the life of the hedge. Changes in the fair value of amounts excluded from the assessment of hedge effectiveness are recognized in OCI. Gains and losses arising from changes in the fair values of derivative instruments that are not designated as accounting hedges are recognized in the Consolidated Statements of Operations line items to which the derivative instruments relate. The Company presents derivative assets and liabilities at their gross fair values in the Consolidated Balance Sheets. The Company classifies cash flows related to derivative instruments as operating activities in the Consolidated Statements of Cash Flows. Fair Value Measurements The fair values of the Company’s money market funds and certain marketable equity securities are based on quoted prices in active markets for identical assets. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, which generally have counterparties with high credit ratings, are based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. Income Taxes The Company records certain deferred tax assets and liabilities in connection with the minimum tax on certain foreign earnings created by the U.S. Tax Cuts and Jobs Act of 2017 (the “Act”). Leases The Company combines and accounts for lease and nonlease components as a single lease component for leases of corporate, data center and retail facilities. The discount rates related to the Company’s lease liabilities are generally based on estimates of the Company’s incremental borrowing rate, as the discount rates implicit in the Company’s leases cannot be readily determined. Apple Inc. | 2022 Form 10-K | 36 Segment Reporting The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described elsewhere in this Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable segments. Costs excluded from segment operating income include various corporate expenses such as research and development (“R&D”), corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Note 2 – Revenue Net sales disaggregated by significant products and services for 2022, 2021 and 2020 were as follows (in millions): 2022 2021 2020 iPhone (1) $ 205,489 $ 191,973 $ 137,781 Mac (1) 40,177 35,190 28,622 iPad (1) 29,292 31,862 23,724 Wearables, Home and Accessories (1)(2) 41,241 38,367 30,620 Services (3) 78,129 68,425 53,768 Total net sales (4) $ 394,328 $ 365,817 $ 274,515 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Wearables, Home and Accessories net sales include sales of AirPods, Apple TV, Apple Watch, Beats products, HomePod mini and accessories. (3) Services net sales include sales from the Company’s advertising, AppleCare, cloud, digital content, payment and other services. Services net sales also include amortization of the deferred value of services bundled in the sales price of certain products. (4) Includes $ 7.5 billion of revenue recognized in 2022 that was included in deferred revenue as of September 25, 2021, $ 6.7 billion of revenue recognized in 2021 that was included in deferred revenue as of September 26, 2020, and $ 5.0 billion of revenue recognized in 2020 that was included in deferred revenue as of September 28, 2019. The Company’s proportion of net sales by disaggregated revenue source was generally consistent for each reportable segment in Note 11, “Segment Information and Geographic Data” for 2022, 2021 and 2020, except in Greater China, where iPhone revenue represented a moderately higher proportion of net sales in 2022 and 2021. As of September 24, 2022 and September 25, 2021, the Company had total deferred revenue of $ 12.4 billion and $ 11.9 billion, respectively. As of September 24, 2022, the Company expects 64 % of total deferred revenue to be realized in less than a year, 27 % within one-to-two years, 7 % within two-to-three years and 2 % in greater than three years. Apple Inc. | 2022 Form 10-K | 37 Note 3 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash, cash equivalents and marketable securities by significant investment category as of September 24, 2022 and September 25, 2021 (in millions): 2022 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 18,546 $ — $ — $ 18,546 $ 18,546 $ — $ — Level 1 (1) : Money market funds 2,929 — — 2,929 2,929 — — Mutual funds 274 — ( 47 ) 227 — 227 — Subtotal 3,203 — ( 47 ) 3,156 2,929 227 — Level 2 (2) : U.S. Treasury securities 25,134 — ( 1,725 ) 23,409 338 5,091 17,980 U.S. agency securities 5,823 — ( 655 ) 5,168 — 240 4,928 Non-U.S. government securities 16,948 2 ( 1,201 ) 15,749 — 8,806 6,943 Certificates of deposit and time deposits 2,067 — — 2,067 1,805 262 — Commercial paper 718 — — 718 28 690 — Corporate debt securities 87,148 9 ( 7,707 ) 79,450 — 9,023 70,427 Municipal securities 921 — ( 35 ) 886 — 266 620 Mortgage- and asset-backed securities 22,553 — ( 2,593 ) 19,960 — 53 19,907 Subtotal 161,312 11 ( 13,916 ) 147,407 2,171 24,431 120,805 Total (3) $ 183,061 $ 11 $ ( 13,963 ) $ 169,109 $ 23,646 $ 24,658 $ 120,805 2021 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 17,305 $ — $ — $ 17,305 $ 17,305 $ — $ — Level 1 (1) : Money market funds 9,608 — — 9,608 9,608 — — Mutual funds 175 11 ( 1 ) 185 — 185 — Subtotal 9,783 11 ( 1 ) 9,793 9,608 185 — Level 2 (2) : Equity securities 1,527 — ( 564 ) 963 — 963 — U.S. Treasury securities 22,878 102 ( 77 ) 22,903 3,596 6,625 12,682 U.S. agency securities 8,949 2 ( 64 ) 8,887 1,775 1,930 5,182 Non-U.S. government securities 20,201 211 ( 101 ) 20,311 390 3,091 16,830 Certificates of deposit and time deposits 1,300 — — 1,300 490 810 — Commercial paper 2,639 — — 2,639 1,776 863 — Corporate debt securities 83,883 1,242 ( 267 ) 84,858 — 12,327 72,531 Municipal securities 967 14 — 981 — 130 851 Mortgage- and asset-backed securities 20,529 171 ( 124 ) 20,576 — 775 19,801 Subtotal 162,873 1,742 ( 1,197 ) 163,418 8,027 27,514 127,877 Total (3) $ 189,961 $ 1,753 $ ( 1,198 ) $ 190,516 $ 34,940 $ 27,699 $ 127,877 (1) Level 1 fair value estimates are based on quoted prices in active markets for identical assets or liabilities. (2) Level 2 fair value estimates are based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. (3) As of September 24, 2022 and September 25, 2021, total marketable securities included $ 12.7 billion and $ 17.9 billion, respectively, that were restricted from general use, related to the State Aid Decision (refer to Note 5, “Income Taxes”) and other agreements. Apple Inc. | 2022 Form 10-K | 38 The following table shows the fair value of the Company’s non-current marketable debt securities, by contractual maturity, as of September 24, 2022 (in millions): Due after 1 year through 5 years $ 87,031 Due after 5 years through 10 years 16,429 Due after 10 years 17,345 Total fair value $ 120,805 Derivative Instruments and Hedging The Company may use derivative instruments to partially offset its business exposure to foreign exchange and interest rate risk. However, the Company may choose not to hedge certain exposures for a variety of reasons including accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange or interest rates. Foreign Exchange Risk To protect gross margins from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, option contracts or other instruments, and may designate these instruments as cash flow hedges. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in foreign currency exchange rates, the Company may enter into forward contracts, cross-currency swaps or other instruments. The Company designates these instruments as either cash flow or fair value hedges. As of September 24, 2022, the maximum length of time over which the Company is hedging its exposure to the variability in future cash flows for term debt–related foreign currency transactions is 20 years. The Company may also enter into derivative instruments that are not designated as accounting hedges to protect gross margins from certain fluctuations in foreign currency exchange rates, as well as to offset a portion of the foreign currency exchange gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. Interest Rate Risk To protect the Company’s term debt or marketable securities from fluctuations in interest rates, the Company may enter into interest rate swaps, options or other instruments. The Company designates these instruments as either cash flow or fair value hedges. The notional amounts of the Company’s outstanding derivative instruments as of September 24, 2022 and September 25, 2021 were as follows (in millions): 2022 2021 Derivative instruments designated as accounting hedges: Foreign exchange contracts $ 102,670 $ 76,475 Interest rate contracts $ 20,125 $ 16,875 Derivative instruments not designated as accounting hedges: Foreign exchange contracts $ 185,381 $ 126,918 Apple Inc. | 2022 Form 10-K | 39 The gross fair values of the Company’s derivative assets and liabilities as of September 24, 2022 were as follows (in millions): 2022 Fair Value of Derivatives Designated as Accounting Hedges Fair Value of Derivatives Not Designated as Accounting Hedges Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 4,317 $ 2,819 $ 7,136 Derivative liabilities (2) : Foreign exchange contracts $ 2,205 $ 2,547 $ 4,752 Interest rate contracts $ 1,367 $ — $ 1,367 (1) Derivative assets are measured using Level 2 fair value inputs and are included in other current assets and other non-current assets in the Consolidated Balance Sheets. (2) Derivative liabilities are measured using Level 2 fair value inputs and are included in other current liabilities and other non-current liabilities in the Consolidated Balance Sheets. The derivative assets above represent the Company’s gross credit exposure if all counterparties failed to perform. To mitigate credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair values of certain derivatives fluctuate from contractually established thresholds. To further limit credit risk, the Company generally enters into master netting arrangements with the respective counterparties to the Company’s derivative contracts, under which the Company is allowed to settle transactions with a single net amount payable by one party to the other. As of September 24, 2022, the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $ 7.8 billion, resulting in a net derivative asset of $ 412 million. The carrying amounts of the Company’s hedged items in fair value hedges as of September 24, 2022 and September 25, 2021 were as follows (in millions): 2022 2021 Hedged assets/(liabilities): Current and non-current marketable securities $ 13,378 $ 15,954 Current and non-current term debt $ ( 18,739 ) $ ( 17,857 ) Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral or third-party credit support in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 24, 2022, the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10 %. The Company’s cellular network carriers accounted for 44 % and 42 % of total trade receivables as of September 24, 2022 and September 25, 2021, respectively. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture subassemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. As of September 24, 2022, the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 54 % and 13 %. As of September 25, 2021, the Company had three vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 52 %, 11 % and 11 %. Apple Inc. | 2022 Form 10-K | 40 Note 4 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 24, 2022 and September 25, 2021 (in millions): Property, Plant and Equipment, Net 2022 2021 Land and buildings $ 22,126 $ 20,041 Machinery, equipment and internal-use software 81,060 78,659 Leasehold improvements 11,271 11,023 Gross property, plant and equipment 114,457 109,723 Accumulated depreciation and amortization ( 72,340 ) ( 70,283 ) Total property, plant and equipment, net $ 42,117 $ 39,440 Other Non-Current Liabilities 2022 2021 Long-term taxes payable $ 16,657 $ 24,689 Other non-current liabilities 32,485 28,636 Total other non-current liabilities $ 49,142 $ 53,325 Other Income/(Expense), Net The following table shows the detail of OI&E for 2022, 2021 and 2020 (in millions): 2022 2021 2020 Interest and dividend income $ 2,825 $ 2,843 $ 3,763 Interest expense ( 2,931 ) ( 2,645 ) ( 2,873 ) Other income/(expense), net ( 228 ) 60 ( 87 ) Total other income/(expense), net $ ( 334 ) $ 258 $ 803 Note 5 – Income Taxes Provision for Income Taxes and Effective Tax Rate The provision for income taxes for 2022, 2021 and 2020, consisted of the following (in millions): 2022 2021 2020 Federal: Current $ 7,890 $ 8,257 $ 6,306 Deferred ( 2,265 ) ( 7,176 ) ( 3,619 ) Total 5,625 1,081 2,687 State: Current 1,519 1,620 455 Deferred 84 ( 338 ) 21 Total 1,603 1,282 476 Foreign: Current 8,996 9,424 3,134 Deferred 3,076 2,740 3,383 Total 12,072 12,164 6,517 Provision for income taxes $ 19,300 $ 14,527 $ 9,680 The foreign provision for income taxes is based on foreign pretax earnings of $ 71.3 billion, $ 68.7 billion and $ 38.1 billion in 2022, 2021 and 2020, respectively. Apple Inc. | 2022 Form 10-K | 41 A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate ( 21 % in 2022, 2021 and 2020) to income before provision for income taxes for 2022, 2021 and 2020, is as follows (dollars in millions): 2022 2021 2020 Computed expected tax $ 25,012 $ 22,933 $ 14,089 State taxes, net of federal effect 1,518 1,151 423 Impacts of the Act 542 — ( 582 ) Earnings of foreign subsidiaries ( 4,366 ) ( 4,715 ) ( 2,534 ) Foreign-derived intangible income deduction ( 296 ) ( 1,372 ) ( 169 ) Research and development credit, net ( 1,153 ) ( 1,033 ) ( 728 ) Excess tax benefits from equity awards ( 1,871 ) ( 2,137 ) ( 930 ) Other ( 86 ) ( 300 ) 111 Provision for income taxes $ 19,300 $ 14,527 $ 9,680 Effective tax rate 16.2 % 13.3 % 14.4 % Deferred Tax Assets and Liabilities As of September 24, 2022 and September 25, 2021, the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2022 2021 Deferred tax assets: Amortization and depreciation $ 1,496 $ 5,575 Accrued liabilities and other reserves 6,515 5,895 Lease liabilities 2,400 2,406 Deferred revenue 5,742 5,399 Unrealized losses 2,913 53 Tax credit carryforwards 6,962 4,262 Other 1,596 1,639 Total deferred tax assets 27,624 25,229 Less: Valuation allowance ( 7,530 ) ( 4,903 ) Total deferred tax assets, net 20,094 20,326 Deferred tax liabilities: Minimum tax on foreign earnings 1,983 4,318 Right-of-use assets 2,163 2,167 Unrealized gains 942 203 Other 469 565 Total deferred tax liabilities 5,557 7,253 Net deferred tax assets $ 14,537 $ 13,073 As of September 24, 2022, the Company had $ 4.4 billion in foreign tax credit carryforwards in Ireland and $ 2.5 billion in California R&D credit carryforwards, both of which can be carried forward indefinitely. A valuation allowance has been recorded for the credit carryforwards and a portion of other temporary differences. Apple Inc. | 2022 Form 10-K | 42 Uncertain Tax Positions As of September 24, 2022, the total amount of gross unrecognized tax benefits was $ 16.8 billion, of which $ 8.0 billion, if recognized, would impact the Company’s effective tax rate. As of September 25, 2021, the total amount of gross unrecognized tax benefits was $ 15.5 billion, of which $ 6.6 billion, if recognized, would have impacted the Company’s effective tax rate. The aggregate change in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2022, 2021 and 2020, is as follows (in millions): 2022 2021 2020 Beginning balances $ 15,477 $ 16,475 $ 15,619 Increases related to tax positions taken during a prior year 2,284 816 454 Decreases related to tax positions taken during a prior year ( 1,982 ) ( 1,402 ) ( 791 ) Increases related to tax positions taken during the current year 1,936 1,607 1,347 Decreases related to settlements with taxing authorities ( 28 ) ( 1,838 ) ( 85 ) Decreases related to expiration of the statute of limitations ( 929 ) ( 181 ) ( 69 ) Ending balances $ 16,758 $ 15,477 $ 16,475 The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisd ictions. Tax years after 2017 for the U.S. federal jurisdiction, and after 2014 in certain major foreign jurisdictions, remain subject to examination. Although the timing of resolution and/or closure of examinations is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease in the next 12 months by as much as $ 4.8 billion. European Commission State Aid Decision On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The recovery amount was calculated to be € 13.1 billion, plus interest of € 1.2 billion. The Company and Ireland appealed the State Aid Decision to the General Court of the Court of Justice of the European Union (the “General Court”). On July 15, 2020, the General Court annulled the State Aid Decision. On September 25, 2020, the European Commission appealed the General Court’s decision to the European Court of Justice. The Company believes that any incremental Irish corporate income taxes potentially due related to the State Aid Decision would be creditable against U.S. taxes, subject to any foreign tax credit limitations in the Act. On an annual basis, the Company may request approval from the Irish Minister for Finance to reduce the recovery amount for certain taxes paid to other countries. As of September 24, 2022, the adjusted recovery amount was € 12.7 billion, excluding interest. The adjusted recovery amount plus interest is funded into escrow, where it will remain restricted from general use pending the conclusion of all legal proceedings. Refer to the Cash, Cash Equivalents and Marketable Securities section of Note 3, “Financial Instruments” for more information. Note 6 – Leases The Company has lease arrangements for certain equipment and facilities, including corporate, data center, manufacturing and retail space. These leases typically have original terms not exceeding 10 years and generally contain multiyear renewal options, some of which are reasonably certain of exercise. Payments under the Company’s lease arrangements may be fixed or variable, and variable lease payments are primarily based on purchases of output of the underlying leased assets. Lease costs associated with fixed payments on the Company’s operating leases were $ 1.9 billion, $ 1.7 billion and $ 1.5 billion for 2022, 2021 and 2020, respectively. Lease costs associated with variable payments on the Company’s leases were $ 14.9 billion, $ 12.9 billion and $ 9.3 billion for 2022, 2021 and 2020, respectively. The Company made $ 1.8 billion, $ 1.4 billion and $ 1.5 billion of fixed cash payments related to operating leases in 2022, 2021 and 2020, respectively. Noncash activities involving right-of-use (“ROU”) assets obtained in exchange for lease liabilities were $ 2.8 billion for 2022, $ 3.3 billion for 2021 and $ 10.5 billion for 2020, including the impact of adopting the Financial Accounting Standards Board’s Accounting Standards Update No. 2016-02, Leases (Topic 842) in the first quarter of 2020. Apple Inc. | 2022 Form 10-K | 43 The following table shows ROU assets and lease liabilities, and the associated financial statement line items, as of September 24, 2022 and September 25, 2021 (in millions): Lease-Related Assets and Liabilities Financial Statement Line Items 2022 2021 Right-of-use assets: Operating leases Other non-current assets $ 10,417 $ 10,087 Finance leases Property, plant and equipment, net 952 861 Total right-of-use assets $ 11,369 $ 10,948 Lease liabilities: Operating leases Other current liabilities $ 1,534 $ 1,449 Other non-current liabilities 9,936 9,506 Finance leases Other current liabilities 129 79 Other non-current liabilities 812 769 Total lease liabilities $ 12,411 $ 11,803 Lease liability maturities as of September 24, 2022, are as follows (in millions): Operating Leases Finance Leases Total 2023 $ 1,758 $ 155 $ 1,913 2024 1,742 130 1,872 2025 1,677 81 1,758 2026 1,382 48 1,430 2027 1,143 34 1,177 Thereafter 5,080 906 5,986 Total undiscounted liabilities 12,782 1,354 14,136 Less: Imputed interest ( 1,312 ) ( 413 ) ( 1,725 ) Total lease liabilities $ 11,470 $ 941 $ 12,411 The weighted-average remaining lease term related to the Company’s lease liabilities as of September 24, 2022 and September 25, 2021 was 10.1 years and 10.8 years, respectively. The discount rate related to the Company’s lease liabilities as of September 24, 2022 and September 25, 2021 was 2.3 % and 2.0 %, respectively. As of September 24, 2022, the Company had $ 1.2 billion of future payments under additional leases, primarily for corporate facilities and retail space, that had not yet commenced. These leases will commence between 2023 and 2026, with lease terms ranging from less than 1 year to 21 years. Apple Inc. | 2022 Form 10-K | 44 Note 7 – Debt Commercial Paper and Repurchase Agreements The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 24, 2022 and September 25, 2021, the Company had $ 10.0 billion and $ 6.0 billion of Commercial Paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 2.31 % and 0.06 % as of September 24, 2022 and September 25, 2021, respectively. The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2022, 2021 and 2020 (in millions): 2022 2021 2020 Maturities 90 days or less: Proceeds from/(Repayments of) commercial paper, net $ 5,264 $ ( 357 ) $ 100 Maturities greater than 90 days: Proceeds from commercial paper 5,948 7,946 6,185 Repayments of commercial paper ( 7,257 ) ( 6,567 ) ( 7,248 ) Proceeds from/(Repayments of) commercial paper, net ( 1,309 ) 1,379 ( 1,063 ) Total proceeds from/(repayments of) commercial paper, net $ 3,955 $ 1,022 $ ( 963 ) In 2020, the Company entered into agreements to sell certain of its marketable securities with a promise to repurchase the securities at a specified time and amount (“Repos”). Due to the Company’s continuing involvement with the marketable securities, the Company accounted for its Repos as collateralized borrowings. The Company entered into $ 5.2 billion of Repos during 2020, all of which had been settled as of September 26, 2020. Term Debt The Company has outstanding fixed-rate notes with varying maturities (collectively the “Notes”). The Notes are senior unsecured obligations and interest is payable in arrears. The following table provides a summary of the Company’s term debt as of September 24, 2022 and September 25, 2021: Maturities (calendar year) 2022 2021 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 – 2021 debt issuances: Floating-rate notes $ — $ 1,750 0.48 % – 0.63 % Fixed-rate 0.000 % – 4.650 % notes 2022 – 2061 106,324 0.03 % – 4.78 % 116,313 0.03 % – 4.78 % Fourth quarter 2022 debt issuance: Fixed-rate 3.250 % – 4.100 % notes 2029 – 2062 5,500 3.27 % – 4.12 % — Total term debt 111,824 118,063 Unamortized premium/(discount) and issuance costs, net ( 374 ) ( 380 ) Hedge accounting fair value adjustments ( 1,363 ) 1,036 Less: Current portion of term debt ( 11,128 ) ( 9,613 ) Total non-current portion of term debt $ 98,959 $ 109,106 To manage interest rate risk on certain of its U.S. dollar–denominated fixed-rate notes, the Company has entered into interest rate swaps to effectively convert the fixed interest rates to floating interest rates on a portion of these notes. Additionally, to manage foreign currency risk on certain of its foreign currency–denominated notes, the Company has entered into foreign currency swaps to effectively convert these notes to U.S. dollar–denominated notes. The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $ 2.8 billion, $ 2.6 billion and $ 2.8 billion of interest expense on its term debt for 2022, 2021 and 2020, respectively. Apple Inc. | 2022 Form 10-K | 45 The future principal payments for the Company’s Notes as of September 24, 2022, are as follows (in millions): 2023 $ 11,139 2024 9,910 2025 10,645 2026 11,209 2027 9,631 Thereafter 59,290 Total term debt $ 111,824 As of September 24, 2022 and September 25, 2021, the fair value of the Company’s Notes, based on Level 2 inputs, was $ 98.8 billion and $ 125.3 billion, respectively. Note 8 – Shareholders’ Equity Share Repurchase Program During 2022, the Company repurchased 569 million shares of its common stock for $ 90.2 billion under a share repurchase program authorized by the Board of Directors (the “Program”). The Program does not obligate the Company to acquire a minimum amount of shares. Under the Program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. Shares of Common Stock The following table shows the changes in shares of common stock for 2022, 2021 and 2020 (in thousands): 2022 2021 2020 Common stock outstanding, beginning balances 16,426,786 16,976,763 17,772,945 Common stock repurchased ( 568,589 ) ( 656,340 ) ( 917,270 ) Common stock issued, net of shares withheld for employee taxes 85,228 106,363 121,088 Common stock outstanding, ending balances 15,943,425 16,426,786 16,976,763 Note 9 – Benefit Plans 2022 Employee Stock Plan In the second quarter of 2022, shareholders approved the Apple Inc. 2022 Employee Stock Plan (the “2022 Plan”), which provides for broad-based equity grants to employees, including executive officers, and permits the granting of restricted stock units (“RSUs”), stock grants, performance-based awards, stock options and stock appreciation rights. RSUs granted under the 2022 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. RSUs granted under the 2022 Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. RSUs canceled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2022 Plan utilizing a factor of two times the number of RSUs canceled or shares withheld. All RSUs granted under the 2022 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the underlying RSUs. A maximum of approximately 1.3 billion shares were authorized for issuance pursuant to 2022 Plan awards at the time the plan was approved on March 4, 2022. 2014 Employee Stock Plan The Apple Inc. 2014 Employee Stock Plan (the “2014 Plan”) is a shareholder-approved plan that provided for broad-based equity grants to employees, including executive officers. The 2014 Plan permitted the granting of substantially the same types of equity awards with substantially the same terms as the 2022 Plan. The 2014 Plan also permitted the granting of cash bonus awards. In the third quarter of 2022, the Company terminated the authority to grant new awards under the 2014 Plan. Apple Inc. | 2022 Form 10-K | 46 Apple Inc. Non-Employee Director Stock Plan The Apple Inc. Non-Employee Director Stock Plan (the “Director Plan”) is a shareholder-approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the value and relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants, in each case within the limits set forth in the Director Plan and without further shareholder approval. RSUs granted under the Director Plan reduce the number of shares available for grant under the plan by a factor of two times the number of RSUs granted. The Director Plan expires on November 12, 2027. All RSUs granted under the Director Plan are entitled to DERs, which are subject to the same vesting and other terms and conditions as the underlying RSUs. A maximum of approximately 45 million shares (split-adjusted) were authorized for issuance pursuant to Director Plan awards at the time the plan was last amended on November 9, 2021. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder-approved plan under which substantially all employees may voluntarily enroll to purchase the Company’s common stock through payroll deductions at a price equal to 85 % of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10 % of the employee’s eligible compensation and employees may not purchase more than $ 25,000 of stock during any calendar year. A maximum of approximately 230 million shares (split-adjusted) were authorized for issuance under the Purchase Plan at the time the plan was last amended and restated on March 10, 2015. 401(k) Plan The Company’s 401(k) Plan is a tax-qualified deferred compensation arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may contribute a portion of their eligible earnings, subject to applicable U.S. Internal Revenue Service and plan limits. The Company matches 50 % to 100 % of each employee’s contributions, depending on length of service, up to a maximum of 6 % of the employee’s eligible earnings. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2022, 2021 and 2020, is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per RSU Aggregate Fair Value (in millions) Balance as of September 28, 2019 326,068 $ 42.30 RSUs granted 156,800 $ 59.20 RSUs vested ( 157,743 ) $ 40.29 RSUs canceled ( 14,347 ) $ 48.07 Balance as of September 26, 2020 310,778 $ 51.58 RSUs granted 89,363 $ 116.33 RSUs vested ( 145,766 ) $ 50.71 RSUs canceled ( 13,948 ) $ 68.95 Balance as of September 25, 2021 240,427 $ 75.16 RSUs granted 91,674 $ 150.70 RSUs vested ( 115,861 ) $ 72.12 RSUs canceled ( 14,739 ) $ 99.77 Balance as of September 24, 2022 201,501 $ 109.48 $ 30,312 The fair value as of the respective vesting dates of RSUs was $ 18.2 billion, $ 19.0 billion and $ 10.8 billion for 2022, 2021 and 2020, respectively. The majority of RSUs that vested in 2022, 2021 and 2020 were net share settled such that the Company withheld shares with a value equivalent to the employees’ obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 41 million, 53 million and 56 million for 2022, 2021 and 2020, respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments to taxing authorities for employees’ tax obligations were $ 6.4 billion, $ 6.8 billion and $ 3.9 billion in 2022, 2021 and 2020, respectively. Apple Inc. | 2022 Form 10-K | 47 Share-Based Compensation The following table shows share-based compensation expense and the related income tax benefit included in the Consolidated Statements of Operations for 2022, 2021 and 2020 (in millions): 2022 2021 2020 Share-based compensation expense $ 9,038 $ 7,906 $ 6,829 Income tax benefit related to share-based compensation expense $ ( 4,002 ) $ ( 4,056 ) $ ( 2,476 ) As of September 24, 2022, the total unrecognized compensation cost related to outstanding RSUs and stock options was $ 16.7 billion, which the Company expects to recognize over a weighted-average period of 2.6 years. Note 10 – Commitments and Contingencies Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets, wearables and accessories. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia, with some Mac computers manufactured in the U.S. and Ireland. Unconditional Purchase Obligations The Company has entered into certain off–balance sheet commitments that require the future purchase of goods or services (“unconditional purchase obligations”). The Company’s unconditional purchase obligations primarily consist of payments for supplier arrangements, internet services and content creation. Future payments under noncancelable unconditional purchase obligations with a remaining term in excess of one year as of September 24, 2022, are as follows (in millions): 2023 $ 13,488 2024 4,876 2025 1,418 2026 6,780 2027 312 Thereafter 412 Total $ 27,286 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully resolved. The outcome of litigation is inherently uncertain. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. Apple Inc. | 2022 Form 10-K | 48 Note 11 – Segment Information and Geographic Data The following table shows information by reportable segment for 2022, 2021 and 2020 (in millions): 2022 2021 2020 Americas: Net sales $ 169,658 $ 153,306 $ 124,556 Operating income $ 62,683 $ 53,382 $ 37,722 Europe: Net sales $ 95,118 $ 89,307 $ 68,640 Operating income $ 35,233 $ 32,505 $ 22,170 Greater China: Net sales $ 74,200 $ 68,366 $ 40,308 Operating income $ 31,153 $ 28,504 $ 15,261 Japan: Net sales $ 25,977 $ 28,482 $ 21,418 Operating income $ 12,257 $ 12,798 $ 9,279 Rest of Asia Pacific: Net sales $ 29,375 $ 26,356 $ 19,593 Operating income $ 11,569 $ 9,817 $ 6,808 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2022, 2021 and 2020 is as follows (in millions): 2022 2021 2020 Segment operating income $ 152,895 $ 137,006 $ 91,240 Research and development expense ( 26,251 ) ( 21,914 ) ( 18,752 ) Other corporate expenses, net ( 7,207 ) ( 6,143 ) ( 6,200 ) Total operating income $ 119,437 $ 108,949 $ 66,288 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2022, 2021 and 2020. Net sales for 2022, 2021 and 2020 and long-lived assets as of September 24, 2022 and September 25, 2021 were as follows (in millions): 2022 2021 2020 Net sales: U.S. $ 147,859 $ 133,803 $ 109,197 China (1) 74,200 68,366 40,308 Other countries 172,269 163,648 125,010 Total net sales $ 394,328 $ 365,817 $ 274,515 2022 2021 Long-lived assets: U.S. $ 31,119 $ 28,203 China (1) 7,260 7,521 Other countries 3,738 3,716 Total long-lived assets $ 42,117 $ 39,440 (1) China includes Hong Kong and Taiwan. Long-lived assets located in China consist primarily of assets related to product manufacturing, retail stores and related infrastructure. Apple Inc. | 2022 Form 10-K | 49 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 24, 2022 and September 25, 2021, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 24, 2022, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of Apple Inc. at September 24, 2022 and September 25, 2021, and the results of its operations and its cash flows for each of the three years in the period ended September 24, 2022, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), Apple Inc.’s internal control over financial reporting as of September 24, 2022, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated October 27, 2022 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of Apple Inc.’s management. Our responsibility is to express an opinion on Apple Inc.’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. Uncertain Tax Positions Description of the Matter As discussed in Note 5 to the financial statements, Apple Inc. is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisdictions. As of September 24, 2022, the total amount of gross unrecognized tax benefits was $ 16.8 billion, of which $ 8.0 billion, if recognized, would impact Apple Inc.’s effective tax rate. In accounting for uncertain tax positions, Apple Inc. uses significant judgment in the interpretation and application of complex domestic and international tax laws. Auditing management’s evaluation of whether an uncertain tax position is more likely than not to be sustained and the measurement of the benefit of various tax positions can be complex, involves significant judgment, and is based on interpretations of tax laws and legal rulings. Apple Inc. | 2022 Form 10-K | 50 How We Addressed the Matter in Our Audit We tested controls relating to the evaluation of uncertain tax positions, including controls over management’s assessment as to whether tax positions are more likely than not to be sustained, management’s process to measure the benefit of its tax positions, and the development of the related disclosures. To evaluate Apple Inc.’s assessment of which tax positions are more likely than not to be sustained, our audit procedures included, among others, reading and evaluating management’s assumptions and analysis, and, as applicable, Apple Inc.’s communications with taxing authorities, that detailed the basis and technical merits of the uncertain tax positions. We involved our tax subject matter resources in assessing the technical merits of certain of Apple Inc.’s tax positions based on our knowledge of relevant tax laws and experience with related taxing authorities. For certain tax positions, we also received external legal counsel confirmation letters and discussed the matters with external advisors and Apple Inc. tax personnel. In addition, we evaluated Apple Inc.’s disclosure in relation to these matters included in Note 5 to the financial statements. /s/ Ernst & Young LLP We have served as Apple Inc.’s auditor since 2009. San Jose, California October 27, 2022 Apple Inc. | 2022 Form 10-K | 51 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on Internal Control Over Financial Reporting We have audited Apple Inc.’s internal control over financial reporting as of September 24, 2022, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 24, 2022, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), the consolidated balance sheets of Apple Inc. as of September 24, 2022 and September 25, 2021, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 24, 2022, and the related notes and our report dated October 27, 2022 expressed an unqualified opinion thereon. Basis for Opinion Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Apple Inc.’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California October 27, 2022 Apple Inc. | 2022 Form 10-K | 52 Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A.    Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 24, 2022 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 24, 2022 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2022, which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Apple Inc. | 2022 Form 10-K | 53 Item 9B.    Other Information Rule 10b5-1 Trading Plans During the three months ended September 24, 2022, Katherine L. Adams, Timothy D. Cook, Luca Maestri, Deirdre O’Brien and Jeffrey Williams, each an officer for purposes of Section 16 of the Exchange Act, had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that preestablishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including sales of shares acquired under the Company’s employee and director equity plans. Item 9C.    Disclosure Regarding Foreign Jurisdictions that Prevent Inspections Not applicable. PART III Item 10.    Directors, Executive Officers and Corporate Governance The information required by this Item will be included in the Company’s definitive proxy statement to be filed with the SEC within 120 days after September 24, 2022, in connection with the solicitation of proxies for the Company’s 2023 annual meeting of shareholders (the “2023 Proxy Statement”), and is incorporated herein by reference. Item 11.    Executive Compensation The information required by this Item will be included in the 2023 Proxy Statement, and is incorporated herein by reference. Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item will be included in the 2023 Proxy Statement, and is incorporated herein by reference. Item 13.    Certain Relationships and Related Transactions, and Director Independence The information required by this Item will be included in the 2023 Proxy Statement, and is incorporated herein by reference. Item 14.    Principal Accountant Fees and Services The information required by this Item will be included in the 2023 Proxy Statement, and is incorporated herein by reference. Apple Inc. | 2022 Form 10-K | 54 PART IV Item 15.    Exhibit and Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 29 Consolidated Statements of Comprehensive Income for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 30 Consolidated Balance Sheets as of September 24, 2022 and September 25, 2021 31 Consolidated Statements of Shareholders’ Equity for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 32 Consolidated Statements of Cash Flows for the years ended September 24, 2022, September 25, 2021 and September 26, 2020 33 Notes to Consolidated Financial Statements 34 Reports of Independent Registered Public Accounting Firm* 50 * Ernst & Young LLP, PCAOB Firm ID No. 000 42 . (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant filed on August 3, 2020. 8-K 3.1 8/7/20 3.2 Amended and Restated Bylaws of the Registrant effective as of August 17, 2022. 8-K 3.2 8/19/22 4.1** Description of Securities of the Registrant. 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.9 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 Apple Inc. | 2022 Form 10-K | 55 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.10 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.11 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.12 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.13 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.14 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.15 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.16 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.17 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.18 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 4.19 Officer’s Certificate of the Registrant, dated as of November 13, 2017, including forms of global notes representing the 1.800% Notes due 2019, 2.000% Notes due 2020, 2.400% Notes due 2023, 2.750% Notes due 2025, 3.000% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 11/13/17 4.20 Indenture, dated as of November 5, 2018, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 11/5/18 4.21 Officer’s Certificate of the Registrant, dated as of September 11, 2019, including forms of global notes representing the 1.700% Notes due 2022, 1.800% Notes due 2024, 2.050% Notes due 2026, 2.200% Notes due 2029 and 2.950% Notes due 2049. 8-K 4.1 9/11/19 4.22 Officer’s Certificate of the Registrant, dated as of November 15, 2019, including forms of global notes representing the 0.000% Notes due 2025 and 0.500% Notes due 2031. 8-K 4.1 11/15/19 4.23 Officer’s Certificate of the Registrant, dated as of May 11, 2020, including forms of global notes representing the 0.750% Notes due 2023, 1.125% Notes due 2025, 1.650% Notes due 2030 and 2.650% Notes due 2050. 8-K 4.1 5/11/20 4.24 Officer’s Certificate of the Registrant, dated as of August 20, 2020, including forms of global notes representing the 0.550% Notes due 2025, 1.25% Notes due 2030, 2.400% Notes due 2050 and 2.550% Notes due 2060. 8-K 4.1 8/20/20 4.25 Officer’s Certificate of the Registrant, dated as of February 8, 2021, including forms of global notes representing the 0.700% Notes due 2026, 1.200% Notes due 2028, 1.650% Notes due 2031, 2.375% Notes due 2041, 2.650% Notes due 2051 and 2.800% Notes due 2061. 8-K 4.1 2/8/21 4.26 Officer’s Certificate of the Registrant, dated as of August 5, 2021, including forms of global notes representing the 1.400% Notes due 2028, 1.700% Notes due 2031, 2.700% Notes due 2051 and 2.850% Notes due 2061. 8-K 4.1 8/5/21 4.27 Indenture, dated as of October 28, 2021, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 10/29/21 4.28 Officer’s Certificate of the Registrant, dated as of August 8, 2022, including forms of global notes representing the 3.250% Notes due 2029, 3.350% Notes due 2032, 3.950% Notes due 2052 and 4.100% Notes due 2062. 8-K 4.1 8/8/22 Apple Inc. | 2022 Form 10-K | 56 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.29* Apple Inc. Deferred Compensation Plan. S-8 4.1 8/23/18 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* Apple Inc. Non-Employee Director Stock Plan, as amended November 9, 2021. 10-Q 10.1 12/25/21 10.4* 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10-K 10.8 9/30/17 10.5* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.20 9/30/17 10.6* Form of Restricted Stock Unit Award Agreement under Non-Employee Director Stock Plan effective as of February 13, 2018. 10-Q 10.2 3/31/18 10.7* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.17 9/29/18 10.8* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.18 9/29/18 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.15 9/28/19 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.16 9/28/19 10.11* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 18, 2020. 10-K 10.16 9/26/20 10.12* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 18, 2020. 10-K 10.17 9/26/20 10.13* Form of CEO Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 27, 2020. 10-Q 10.1 12/26/20 10.14* Form of CEO Performance Award Agreement under 2014 Employee Stock Plan effective as of September 27, 2020. 10-Q 10.2 12/26/20 10.15* 2022 Employee Stock Plan. 8-K 10.1 3/4/22 10.16* Form of Restricted Stock Unit Award Agreement under 2022 Employee Stock Plan effective as of March 4, 2022. 8-K 10.2 3/4/22 10.17* Form of Performance Award Agreement under 2022 Employee Stock Plan effective as of March 4, 2022. 8-K 10.3 3/4/22 10.18* Apple Inc. Executive Cash Incentive Plan. 8-K 10.1 8/19/22 21.1** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101** Inline XBRL Document Set for the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. 104** Inline XBRL for the cover page of this Annual Report on Form 10-K, included in the Exhibit 101 Inline XBRL Document Set. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16.    Form 10-K Summary None. Apple Inc. | 2022 Form 10-K | 57 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: October 27, 2022 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) October 27, 2022 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) October 27, 2022 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) October 27, 2022 CHRIS KONDO /s/ James A. Bell Director October 27, 2022 JAMES A. BELL /s/ Al Gore Director October 27, 2022 AL GORE /s/ Alex Gorsky Director October 27, 2022 ALEX GORSKY /s/ Andrea Jung Director October 27, 2022 ANDREA JUNG /s/ Arthur D. Levinson Director and Chair of the Board October 27, 2022 ARTHUR D. LEVINSON /s/ Monica Lozano Director October 27, 2022 MONICA LOZANO /s/ Ronald D. Sugar Director October 27, 2022 RONALD D. SUGAR /s/ Susan L. Wagner Director October 27, 2022 SUSAN L. 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For the transition period from to . Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) One Apple Park Way Cupertino , California 95014 (Address of principal executive offices) (Zip Code) ( 408 ) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading symbol(s) Name of each exchange on which registered Common Stock, $0.00001 par value per share AAPL The Nasdaq Stock Market LLC 1.375% Notes due 2024 — The Nasdaq Stock Market LLC 0.000% Notes due 2025 — The Nasdaq Stock Market LLC 0.875% Notes due 2025 — The Nasdaq Stock Market LLC 1.625% Notes due 2026 — The Nasdaq Stock Market LLC 2.000% Notes due 2027 — The Nasdaq Stock Market LLC 1.375% Notes due 2029 — The Nasdaq Stock Market LLC 3.050% Notes due 2029 — The Nasdaq Stock Market LLC 0.500% Notes due 2031 — The Nasdaq Stock Market LLC 3.600% Notes due 2042 — The Nasdaq Stock Market LLC Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the Registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ If securities are registered pursuant to Section 12(b) of the Act, indicate by check mark whether the financial statements of the registrant included in the filing reflect the correction of an error to previously issued financial statements. ☐ Indicate by check mark whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant’s executive officers during the relevant recovery period pursuant to §240.10D-1(b). ☐ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 31, 2023, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $ 2,591,165,000,000 . Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 15,552,752,000 shares of common stock were issued and outstanding as of October 20, 2023. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2024 annual meeting of shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The Registrant’s definitive proxy statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 30, 2023 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 5 Item 1B. Unresolved Staff Comments 16 Item 1C. C ybersecurity 16 Item 2. Properties 17 Item 3. Legal Proceedings 17 Item 4. Mine Safety Disclosures 17 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 18 Item 6. [Reserved] 19 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 20 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 26 Item 8. Financial Statements and Supplementary Data 27 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 52 Item 9A. Controls and Procedures 52 Item 9B. Other Information 53 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 53 Part III Item 10. Directors, Executive Officers and Corporate Governance 53 Item 11. Executive Compensation 53 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 53 Item 13 . Certain Relationships and Related Transactions, and Director Independence 53 Item 14. Principal Accountant Fees and Services 53 Part IV Item 15. Exhibit and Financial Statement Schedules 54 Item 16. Form 10-K Summary 57 This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part I, Item 1 of this Form 10-K under the heading “Business” and Part II, Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. For example, statements in this Form 10-K regarding the potential future impact of macroeconomic conditions on the Company’s business and results of operations are forward-looking statements. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Unless otherwise stated, all information presented herein is based on the Company’s fiscal calendar, and references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly owned subsidiaries, unless otherwise stated. PART I Item 1.    Business Company Background The Company designs, manufactures and markets smartphones, personal computers, tablets, wearables and accessories, and sells a variety of related services. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. Products iPhone iPhone ® is the Company’s line of smartphones based on its iOS operating system. The iPhone line includes iPhone 15 Pro, iPhone 15, iPhone 14, iPhone 13 and iPhone SE ® . Mac Mac ® is the Company’s line of personal computers based on its macOS ® operating system. The Mac line includes laptops MacBook Air ® and MacBook Pro ® , as well as desktops iMac ® , Mac mini ® , Mac Studio ® and Mac Pro ® . iPad iPad ® is the Company’s line of multipurpose tablets based on its iPadOS ® operating system. The iPad line includes iPad Pro ® , iPad Air ® , iPad and iPad mini ® . Wearables, Home and Accessories Wearables includes smartwatches and wireless headphones. The Company’s line of smartwatches, based on its watchOS ® operating system, includes Apple Watch Ultra™ 2, Apple Watch ® Series 9 and Apple Watch SE ® . The Company’s line of wireless headphones includes AirPods ® , AirPods Pro ® , AirPods Max™ and Beats ® products. Home includes Apple TV ® , the Company’s media streaming and gaming device based on its tvOS ® operating system, and HomePod ® and HomePod mini ® , high-fidelity wireless smart speakers. Accessories includes Apple-branded and third-party accessories. Apple Inc. | 2023 Form 10-K | 1 Services Advertising The Company’s advertising services include third-party licensing arrangements and the Company’s own advertising platforms. AppleCare The Company offers a portfolio of fee-based service and support products under the AppleCare ® brand. The offerings provide priority access to Apple technical support, access to the global Apple authorized service network for repair and replacement services, and in many cases additional coverage for instances of accidental damage or theft and loss, depending on the country and type of product. Cloud Services The Company’s cloud services store and keep customers’ content up-to-date and available across multiple Apple devices and Windows personal computers. Digital Content The Company operates various platforms, including the App Store ® , that allow customers to discover and download applications and digital content, such as books, music, video, games and podcasts. The Company also offers digital content through subscription-based services, including Apple Arcade ® , a game subscription service; Apple Fitness+ SM , a personalized fitness service; Apple Music ® , which offers users a curated listening experience with on-demand radio stations; Apple News+ ® , a subscription news and magazine service; and Apple TV+ ® , which offers exclusive original content and live sports. Payment Services The Company offers payment services, including Apple Card ® , a co-branded credit card, and Apple Pay ® , a cashless payment service. Segments The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to customers through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and resellers. During 2023, the Company’s net sales through its direct and indirect distribution channels accounted for 37% and 63%, respectively, of total net sales. Competition The markets for the Company’s products and services are highly competitive, and are characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. Many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by imitating the Company’s products and infringing on its intellectual property. Apple Inc. | 2023 Form 10-K | 2 The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. Principal competitive factors important to the Company include price, product and service features (including security features), relative price and performance, product and service quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support, and corporate reputation. The Company is focused on expanding its market opportunities related to smartphones, personal computers, tablets, wearables and accessories, and services. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software, and service offerings with large customer bases. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors have the resources, experience or cost structures to provide products at little or no profit or even at a loss. The Company’s services compete with business models that provide content to users for free and use illegitimate means to obtain third-party digital content and applications. The Company faces significant competition as competitors imitate the Company’s product features and applications within their products, or collaborate to offer integrated solutions that are more competitive than those they currently offer. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets, wearables and accessories. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and services, and to expand the range of its offerings through research and development (“R&D”), licensing of intellectual property and acquisition of third-party businesses and technology. Intellectual Property The Company currently holds a broad collection of intellectual property rights relating to certain aspects of its hardware devices, accessories, software and services. This includes patents, designs, copyrights, trademarks and other forms of intellectual property rights in the U.S. and various foreign countries. Although the Company believes the ownership of such intellectual property rights is an important factor in differentiating its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent, design, copyright and trademark applications to protect innovations arising from its research, development, design and marketing, and is currently pursuing thousands of applications around the world. Over time, the Company has accumulated a large portfolio of issued and registered intellectual property rights around the world. No single intellectual property right is solely responsible for protecting the Company’s products and services. The Company believes the duration of its intellectual property rights is adequate relative to the expected lives of its products and services. In addition to Company-owned intellectual property, many of the Company’s products and services are designed to include intellectual property owned by third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of the Company’s products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Apple Inc. | 2023 Form 10-K | 3 Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. The timing of product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new inventory following a product launch, and channel inventory of an older product often declines as the launch of a newer product approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. Human Capital The Company believes it has a talented, motivated and dedicated team, and works to create an inclusive, safe and supportive environment for all of its team members. As of September 30, 2023, the Company had approximately 161,000 full-time equivalent employees. Workplace Practices and Policies The Company is an equal opportunity employer committed to inclusion and diversity and to providing a workplace free of harassment or discrimination. Compensation and Benefits The Company believes that compensation should be competitive and equitable, and should enable employees to share in the Company’s success. The Company recognizes its people are most likely to thrive when they have the resources to meet their needs and the time and support to succeed in their professional and personal lives. In support of this, the Company offers a wide variety of benefits for employees around the world and invests in tools and resources that are designed to support employees’ individual growth and development. Inclusion and Diversity The Company is committed to its vision to build and sustain a more inclusive workforce that is representative of the communities it serves. The Company continues to work to increase diverse representation at every level, foster an inclusive culture, and support equitable pay and access to opportunity for all employees. Engagement The Company believes that open and honest communication among team members, managers and leaders helps create an open, collaborative work environment where everyone can contribute, grow and succeed. Team members are encouraged to come to their managers with questions, feedback or concerns, and the Company conducts surveys that gauge employee sentiment in areas like career development, manager performance and inclusivity. Health and Safety The Company is committed to protecting its team members everywhere it operates. The Company identifies potential workplace risks in order to develop measures to mitigate possible hazards. The Company supports employees with general safety, security and crisis management training, and by putting specific programs in place for those working in potentially high-hazard environments. Additionally, the Company works to protect the safety and security of its team members, visitors and customers through its global security team. Available Information The Company’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and other information filed by the Company with the SEC are available free of charge at investor.apple.com/investor-relations/sec-filings/default.aspx when such reports are available on the SEC’s website. The Company periodically provides certain information for investors on its corporate website, www.apple.com, and its investor relations website, investor.apple.com. This includes press releases and other information about financial performance, information on environmental, social and governance matters, and details related to the Company’s annual meeting of shareholders. The information contained on the websites referenced in this Form 10-K is not incorporated by reference into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2023 Form 10-K | 4 Item 1A.    Risk Factors The Company’s business, reputation, results of operations, financial condition and stock price can be affected by a number of factors, whether currently known or unknown, including those described below. When any one or more of these risks materialize from time to time, the Company’s business, reputation, results of operations, financial condition and stock price can be materially and adversely affected. Because of the following factors, as well as other factors affecting the Company’s results of operations and financial condition, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. This discussion of risk factors contains forward-looking statements. This section should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. Macroeconomic and Industry Risks The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition. The Company has international operations with sales outside the U.S. representing a majority of the Company’s total net sales. In addition, the Company’s global supply chain is large and complex and a majority of the Company’s supplier facilities, including manufacturing and assembly sites, are located outside the U.S. As a result, the Company’s operations and performance depend significantly on global and regional economic conditions. Adverse macroeconomic conditions, including slow growth or recession, high unemployment, inflation, tighter credit, higher interest rates, and currency fluctuations, can adversely impact consumer confidence and spending and materially adversely affect demand for the Company’s products and services. In addition, consumer confidence and spending can be materially adversely affected in response to changes in fiscal and monetary policy, financial market volatility, declines in income or asset values, and other economic factors. In addition to an adverse impact on demand for the Company’s products and services, uncertainty about, or a decline in, global or regional economic conditions can have a significant impact on the Company’s suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners, and developers. Potential outcomes include financial instability; inability to obtain credit to finance business operations; and insolvency. Adverse economic conditions can also lead to increased credit and collectibility risk on the Company’s trade receivables; the failure of derivative counterparties and other financial institutions; limitations on the Company’s ability to issue new debt; reduced liquidity; and declines in the fair values of the Company’s financial instruments. These and other impacts can materially adversely affect the Company’s business, results of operations, financial condition and stock price. The Company’s business can be impacted by political events, trade and other international disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions. Political events, trade and other international disputes, war, terrorism, natural disasters, public health issues, industrial accidents and other business interruptions can harm or disrupt international commerce and the global economy, and could have a material adverse effect on the Company and its customers, suppliers, contract manufacturers, logistics providers, distributors, cellular network carriers and other channel partners. Apple Inc. | 2023 Form 10-K | 5 The Company has a large, global business with sales outside the U.S. representing a majority of the Company’s total net sales, and the Company believes that it generally benefits from growth in international trade. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in China mainland, India, Japan, South Korea, Taiwan and Vietnam. Restrictions on international trade, such as tariffs and other controls on imports or exports of goods, technology or data, can materially adversely affect the Company’s operations and supply chain and limit the Company’s ability to offer and distribute its products and services to customers. The impact can be particularly significant if these restrictive measures apply to countries and regions where the Company derives a significant portion of its revenues and/or has significant supply chain operations. Restrictive measures can require the Company to take various actions, including changing suppliers, restructuring business relationships, and ceasing to offer third-party applications on its platforms. Changing the Company’s operations in accordance with new or changed restrictions on international trade can be expensive, time-consuming and disruptive to the Company’s operations. Such restrictions can be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. For example, tensions between governments, including the U.S. and China, have in the past led to tariffs and other restrictions being imposed on the Company’s business. If disputes and conflicts further escalate in the future, actions by governments in response could be significantly more severe and restrictive and could materially adversely affect the Company’s business. Political uncertainty surrounding trade and other international disputes could also have a negative effect on consumer confidence and spending, which could adversely affect the Company’s business. Many of the Company’s operations and facilities, as well as critical business operations of the Company’s suppliers and contract manufacturers, are in locations that are prone to earthquakes and other natural disasters. In addition, such operations and facilities are subject to the risk of interruption by fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, ransomware and other cybersecurity attacks, labor disputes, public health issues, including pandemics such as the COVID-19 pandemic, and other events beyond the Company’s control. Global climate change is resulting in certain types of natural disasters, such as droughts, floods, hurricanes and wildfires, occurring more frequently or with more intense effects. Such events can make it difficult or impossible for the Company to manufacture and deliver products to its customers, create delays and inefficiencies in the Company’s supply and manufacturing chain, and result in slowdowns and outages to the Company’s service offerings, and negatively impact consumer spending and demand in affected areas. Following an interruption to its business, the Company can require substantial recovery time, experience significant expenditures to resume operations, and lose significant sales. Because the Company relies on single or limited sources for the supply and manufacture of many critical components, a business interruption affecting such sources would exacerbate any negative consequences to the Company. The Company’s operations are also subject to the risks of industrial accidents at its suppliers and contract manufacturers. While the Company’s suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in serious injuries or loss of life, disruption to the Company’s business, and harm to the Company’s reputation. Major public health issues, including pandemics such as the COVID-19 pandemic, have adversely affected, and could in the future materially adversely affect, the Company due to their impact on the global economy and demand for consumer products; the imposition of protective public safety measures, such as stringent employee travel restrictions and limitations on freight services and the movement of products between regions; and disruptions in the Company’s operations, supply chain and sales and distribution channels, resulting in interruptions to the supply of current products and offering of existing services, and delays in production ramps of new products and development of new services. While the Company maintains insurance coverage for certain types of losses, such insurance coverage may be insufficient to cover all losses that may arise. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services are offered in highly competitive global markets characterized by aggressive price competition and resulting downward pressure on gross margins, frequent introduction of new products and services, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, rapid adoption of technological advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s ability to compete successfully depends heavily on ensuring the continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. There can be no assurance these investments will achieve expected returns, and the Company may not be able to develop and market new products and services successfully. Apple Inc. | 2023 Form 10-K | 6 The Company currently holds a significant number of patents, trademarks and copyrights and has registered, and applied to register, additional patents, trademarks and copyrights. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and by imitating the Company’s products and infringing on its intellectual property. Effective intellectual property protection is not consistently available in every country in which the Company operates. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be materially adversely affected. The Company has a minority market share in the global smartphone, personal computer and tablet markets. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. In addition, some of the Company’s competitors have broader product lines, lower-priced products and a larger installed base of active devices. Competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. Certain competitors have the resources, experience or cost structures to provide products at little or no profit or even at a loss. Some of the markets in which the Company competes have from time to time experienced little to no growth or contracted overall. Additionally, the Company faces significant competition as competitors imitate the Company’s product features and applications within their products or collaborate to offer solutions that are more competitive than those they currently offer. The Company also expects competition to intensify as competitors imitate the Company’s approach to providing components seamlessly within their offerings or work collaboratively to offer integrated solutions. The Company’s services also face substantial competition, including from companies that have significant resources and experience and have established service offerings with large customer bases. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. The Company’s business, results of operations and financial condition depend substantially on the Company’s ability to continually improve its products and services to maintain their functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. Business Risks To remain competitive and stimulate customer demand, the Company must successfully manage frequent introductions and transitions of products and services. Due to the highly volatile and competitive nature of the markets and industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and services, and successfully manage the transition to these new and upgraded products and services. The success of new product and service introductions depends on a number of factors, including timely and successful development, market acceptance, the Company’s ability to manage the risks associated with new technologies and production ramp-up issues, the availability of application software for the Company’s products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand, and the risk that new products and services may have quality or other defects or deficiencies. There can be no assurance the Company will successfully manage future introductions and transitions of products and services. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by outsourcing partners located primarily in China mainland, India, Japan, South Korea, Taiwan and Vietnam, and a significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Changes or additions to the Company’s supply chain require considerable time and resources and involve significant risks and uncertainties. The Company has also outsourced much of its transportation and logistics management. While these arrangements can lower operating costs, they also reduce the Company’s direct control over production and distribution. Such diminished control has from time to time and may in the future have an adverse effect on the quality or quantity of products manufactured or services provided, or adversely affect the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for product defect expense reimbursement, the Company generally remains responsible to the consumer for warranty and out-of-warranty service in the event of product defects and experiences unanticipated product defect liabilities from time to time. While the Company relies on its partners to adhere to its supplier code of conduct, violations of the supplier code of conduct occur from time to time and can materially adversely affect the Company’s business, reputation, results of operations and financial condition. Apple Inc. | 2023 Form 10-K | 7 The Company relies on single-source outsourcing partners in the U.S., Asia and Europe to supply and manufacture many components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform can have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations can be disrupted for a variety of reasons, including natural and man-made disasters, information technology system failures, commercial disputes, armed conflict, economic, business, labor, environmental, public health or political issues, or international trade disputes. The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply can be reduced or terminated, and the recoverability of manufacturing process equipment or prepayments can be negatively impacted. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains certain components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations that can materially adversely affect the Company’s business, results of operations and financial condition. For example, the global semiconductor industry has in the past experienced high demand and shortages of supply, which adversely affected the Company’s ability to obtain sufficient quantities of components and products on commercially reasonable terms or at all. Such disruptions could occur in the future. While the Company has entered into agreements for the supply of many components, there can be no assurance the Company will be able to extend or renew these agreements on similar terms, or at all. Component suppliers may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms or at all. The effects of global or regional economic conditions on the Company’s suppliers, described in “ The Company’s operations and performance depend significantly on global and regional economic conditions and adverse economic conditions can materially adversely affect the Company’s business, results of operations and financial condition, ” above, can also affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its business, results of operations and financial condition. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, can be affected for any number of reasons, including if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. When the Company’s supply of components for a new or existing product has been delayed or constrained, or when an outsourcing partner has delayed shipments of completed products to the Company, the Company’s business, results of operations and financial condition have been adversely affected and future delays or constraints could materially adversely affect the Company’s business, results of operations and financial condition. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the source, or to identify and obtain sufficient quantities from an alternative source. The Company’s products and services may be affected from time to time by design and manufacturing defects that could materially adversely affect the Company’s business and result in harm to the Company’s reputation. The Company offers complex hardware and software products and services that can be affected by design and manufacturing defects. Sophisticated operating system software and applications, such as those offered by the Company, often have issues that can unexpectedly interfere with the intended operation of hardware or software products and services. Defects can also exist in components and products the Company purchases from third parties. Component defects could make the Company’s products unsafe and create a risk of environmental or property damage and personal injury. These risks may increase as the Company’s products are introduced into specialized applications, including health. In addition, the Company’s service offerings can have quality issues and from time to time experience outages, service slowdowns or errors. As a result, from time to time the Company’s services have not performed as anticipated and may not meet customer expectations. There can be no assurance the Company will be able to detect and fix all issues and defects in the hardware, software and services it offers. Failure to do so can result in widespread technical and performance issues affecting the Company’s products and services. In addition, the Company can be exposed to product liability claims, recalls, product replacements or modifications, write-offs of inventory, property, plant and equipment or intangible assets, and significant warranty and other expenses, including litigation costs and regulatory fines. Quality problems can also adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, delay in new product and service introductions and lost sales. Apple Inc. | 2023 Form 10-K | 8 The Company is exposed to the risk of write-downs on the value of its inventory and other assets, in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand, or for which cost exceeds net realizable value. The Company also accrues necessary cancellation fee reserves for orders of excess products and components. The Company reviews long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the assets may not be recoverable. If the Company determines that an impairment has occurred, it records a write-down equal to the amount by which the carrying value of the asset exceeds its fair value. Although the Company believes its inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently recoverable, there can be no assurance the Company will not incur write-downs, fees, impairments and other charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company orders components for its products and builds inventory in advance of product announcements and shipments. Manufacturing purchase obligations cover the Company’s forecasted component and manufacturing requirements, typically for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. The Company’s products and services are designed to include intellectual property owned by third parties, which requires licenses from those third parties. In addition, because of technological changes in the industries in which the Company currently competes or in the future may compete, current extensive patent coverage and the rapid rate of issuance of new patents, the Company’s products and services can unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Based on experience and industry practice, the Company believes licenses to such third-party intellectual property can generally be obtained on commercially reasonable terms. However, there can be no assurance the necessary licenses can be obtained on commercially reasonable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, can preclude the Company from selling certain products or services, or otherwise have a material adverse impact on the Company’s business, results of operations and financial condition. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There can be no assurance third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes the availability of third-party software applications and services for its products depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software and services for the Company’s products compared to competitors’ platforms, such as Android for smartphones and tablets, Windows for personal computers and tablets, and PlayStation, Nintendo and Xbox for gaming platforms. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of product sales, and the costs of developing such applications and services. The Company’s minority market share in the global smartphone, personal computer and tablet markets can make developers less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for competitors’ products with larger market share. When developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices can suffer. The Company relies on the continued availability and development of compelling and innovative software applications for its products. The Company’s products and operating systems are subject to rapid technological change, and when third-party developers are unable to or choose not to keep up with this pace of change, their applications can fail to take advantage of these changes to deliver improved customer experiences, can operate incorrectly, and can result in dissatisfied customers and lower customer demand for the Company’s products. Apple Inc. | 2023 Form 10-K | 9 The Company distributes third-party applications for its products through the App Store. For the vast majority of applications, developers keep all of the revenue they generate on the App Store. The Company retains a commission from sales of applications and sales of digital services or goods initiated within an application. From time to time, the Company has made changes to its App Store, including actions taken in response to competition, market conditions and legal and regulatory requirements. The Company expects to make further business changes in the future, including as a result of legislative initiatives impacting the App Store, such as the European Union (“EU”) Digital Markets Act, which the Company is required to comply with by March 2024. The Company is also subject to litigation and investigations relating to the App Store, which have resulted in changes to the Company’s business practices, and may in the future result in further changes. Changes have included how developers communicate with consumers outside the App Store regarding alternative purchasing mechanisms. Future changes could also affect what the Company charges developers for access to its platforms, how it manages distribution of apps outside of the App Store, and how and to what extent it allows developers to communicate with consumers inside the App Store regarding alternative purchasing mechanisms. This could reduce the volume of sales, and the commission that the Company earns on those sales, would decrease. If the rate of the commission that the Company retains on such sales is reduced, or if it is otherwise narrowed in scope or eliminated, the Company’s business, results of operations and financial condition could be materially adversely affected. Failure to obtain or create digital content that appeals to the Company’s customers, or to make such content available on commercially reasonable terms, could have a material adverse impact on the Company’s business, results of operations and financial condition. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell, or offer subscriptions to, third-party content, as well as the right to incorporate specific content into the Company’s own services. The licensing or other distribution arrangements for this content can be for relatively short time periods and do not guarantee the continuation or renewal of these arrangements on commercially reasonable terms, or at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and can take actions to make it difficult or impossible for the Company to license or otherwise distribute their content. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at commercially reasonable prices with acceptable usage rules. The Company also produces its own digital content, which can be costly to produce due to intense and increasing competition for talent, content and subscribers, and may fail to appeal to the Company’s customers. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There can be no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. The Company’s success depends largely on the talents and efforts of its team members, the continued service and availability of highly skilled employees, including key personnel, and the Company’s ability to nurture its distinctive and inclusive culture. Much of the Company’s future success depends on the talents and efforts of its team members and the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. In addition to intense competition for talent, workforce dynamics are constantly evolving. If the Company does not manage changing workforce dynamics effectively, it could materially adversely affect the Company’s culture, reputation and operational flexibility. The Company believes that its distinctive and inclusive culture is a significant driver of its success. If the Company is unable to nurture its culture, it could materially adversely affect the Company’s ability to recruit and retain the highly skilled employees who are critical to its success, and could otherwise materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company depends on the performance of carriers, wholesalers, retailers and other resellers. The Company distributes its products and certain of its services through cellular network carriers, wholesalers, retailers and resellers, many of which distribute products and services from competitors. The Company also sells its products and services and resells third-party products in most of its major markets directly to consumers, small and mid-sized businesses, and education, enterprise and government customers through its retail and online stores and its direct sales force. Some carriers providing cellular network service for the Company’s products offer financing, installment payment plans or subsidies for users’ purchases of the device. There can be no assurance such offers will be continued at all or in the same amounts. Apple Inc. | 2023 Form 10-K | 10 The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs can require a substantial investment while not assuring return or incremental sales. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. The Company’s business and reputation are impacted by information technology system failures and network disruptions. The Company and its global supply chain are dependent on complex information technology systems and are exposed to information technology system failures or network disruptions caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, ransomware or other cybersecurity incidents, or other events or disruptions. System upgrades, redundancy and other continuity measures may be ineffective or inadequate, and the Company’s or its vendors’ business continuity and disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions can adversely impact the Company’s business by, among other things, preventing access to the Company’s online services, interfering with customer transactions or impeding the manufacturing and shipping of the Company’s products. These events could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Losses or unauthorized access to or releases of confidential information, including personal information, could subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store confidential information, including personal information, with respect to the Company’s customers and employees. The Company devotes significant resources to network and data security, including through the use of encryption and other security measures intended to protect its systems and data. But these measures cannot provide absolute security, and losses or unauthorized access to or releases of confidential information occur and could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company’s business also requires it to share confidential information with suppliers and other third parties. The Company relies on global suppliers that are also exposed to ransomware and other malicious attacks that can disrupt business operations. Although the Company takes steps to secure confidential information that is provided to or accessible by third parties working on the Company’s behalf, such measures are not always effective and losses or unauthorized access to, or releases of, confidential information occur. Such incidents and other malicious attacks could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company experiences malicious attacks and other attempts to gain unauthorized access to its systems on a regular basis. These attacks seek to compromise the confidentiality, integrity or availability of confidential information or disrupt normal business operations, and can, among other things, impair the Company’s ability to attract and retain customers for its products and services, impact the Company’s stock price, materially damage commercial relationships, and expose the Company to litigation or government investigations, which could result in penalties, fines or judgments against the Company. Globally, attacks are expected to continue accelerating in both frequency and sophistication with increasing use by actors of tools and techniques that are designed to circumvent controls, avoid detection, and remove or obfuscate forensic evidence, all of which hinders the Company’s ability to identify, investigate and recover from incidents. In addition, attacks against the Company and its customers can escalate during periods of severe diplomatic or armed conflict. Although malicious attacks perpetrated to gain access to confidential information, including personal information, affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the value of the confidential information it creates, owns, manages, stores and processes. The Company has implemented systems and processes intended to secure its information technology systems and prevent unauthorized access to or loss of sensitive data, and mitigate the impact of unauthorized access, including through the use of encryption and authentication technologies. As with all companies, these security measures may not be sufficient for all eventualities and may be vulnerable to hacking, ransomware attacks, employee error, malfeasance, system error, faulty password management or other irregularities. For example, third parties can fraudulently induce the Company’s or its vendors’ employees or customers into disclosing usernames, passwords or other sensitive information, which can, in turn, be used for unauthorized access to the Company’s or its vendors’ systems and services. To help protect customers and the Company, the Company deploys and makes available technologies like multifactor authentication, monitors its services and systems for unusual activity and may freeze accounts under suspicious circumstances, which, among other things, can result in the delay or loss of customer orders or impede customer access to the Company’s products and services. While the Company maintains insurance coverage that is intended to address certain aspects of data security risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2023 Form 10-K | 11 Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business, present risks not originally contemplated and materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater-than-expected liabilities and expenses, economic, political, legal and regulatory challenges associated with operating in new businesses, regions or countries, inadequate return on capital, potential impairment of tangible and intangible assets, and significant write-offs. Investment and acquisition transactions are exposed to additional risks, including failing to obtain required regulatory approvals on a timely basis or at all, or the imposition of onerous conditions that could delay or prevent the Company from completing a transaction or otherwise limit the Company’s ability to fully realize the anticipated benefits of a transaction. These new ventures are inherently risky and may not be successful. The failure of any significant investment could materially adversely affect the Company’s business, reputation, results of operations and financial condition. The Company’s retail stores are subject to numerous risks and uncertainties. The Company’s retail operations are subject to many factors that pose risks and uncertainties and could adversely impact the Company’s business, results of operations and financial condition, including macroeconomic factors that could have an adverse effect on general retail activity. Other factors include the Company’s ability to: manage costs associated with retail store construction and operation; manage relationships with existing retail partners; manage costs associated with fluctuations in the value of retail inventory; and obtain and renew leases in quality retail locations at a reasonable cost. Legal and Regulatory Compliance Risks The Company’s business, results of operations and financial condition could be adversely impacted by unfavorable results of legal proceedings or government investigations. The Company is subject to various claims, legal proceedings and government investigations that have arisen in the ordinary course of business and have not yet been fully resolved, and new matters may arise in the future. In addition, agreements entered into by the Company sometimes include indemnification provisions which can subject the Company to costs and damages in the event of a claim against an indemnified third party. The number of claims, legal proceedings and government investigations involving the Company, and the alleged magnitude of such claims, proceedings and government investigations, has generally increased over time and may continue to increase. The Company has faced and continues to face a significant number of patent claims relating to its cellular-enabled products, and new claims may arise in the future, including as a result of new legal or regulatory frameworks. For example, technology and other patent-holding companies frequently assert their patents and seek royalties and often enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. The Company is vigorously defending infringement actions in courts in several U.S. jurisdictions, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the merit of particular claims, defending against litigation or responding to government investigations can be expensive, time-consuming and disruptive to the Company’s operations. In recognition of these considerations, the Company may enter into agreements or other arrangements to settle litigation and resolve such challenges. There can be no assurance such agreements can be obtained on acceptable terms or that litigation will not occur. These agreements can also significantly increase the Company’s cost of sales and operating expenses and require the Company to change its business practices and limit the Company’s ability to offer certain products and services. Except as described in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 12, “Commitments, Contingencies and Supply Concentrations” under the heading “Contingencies,” in the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. The outcome of litigation or government investigations is inherently uncertain. If one or more legal matters were resolved against the Company or an indemnified third party in a reporting period for amounts above management’s expectations, the Company’s results of operations and financial condition for that reporting period could be materially adversely affected. Further, such an outcome can result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company, and has from time to time required, and can in the future require, the Company to change its business practices and limit the Company’s ability to offer certain products and services, all of which could materially adversely affect the Company’s business, reputation, results of operations and financial condition. While the Company maintains insurance coverage for certain types of claims, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise. Apple Inc. | 2023 Form 10-K | 12 The Company is subject to complex and changing laws and regulations worldwide, which exposes the Company to potential liabilities, increased costs and other adverse effects on the Company’s business. The Company’s global operations are subject to complex and changing laws and regulations on subjects, including antitrust; privacy, data security and data localization; consumer protection; advertising, sales, billing and e-commerce; financial services and technology; product liability; intellectual property ownership and infringement; digital platforms; machine learning and artificial intelligence; internet, telecommunications and mobile communications; media, television, film and digital content; availability of third-party software applications and services; labor and employment; anticorruption; import, export and trade; foreign exchange controls and cash repatriation restrictions; anti–money laundering; foreign ownership and investment; tax; and environmental, health and safety, including electronic waste, recycling, product design and climate change. Compliance with these laws and regulations is onerous and expensive. New and changing laws and regulations can adversely affect the Company’s business by increasing the Company’s costs, limiting the Company’s ability to offer a product, service or feature to customers, imposing changes to the design of the Company’s products and services, impacting customer demand for the Company’s products and services, and requiring changes to the Company’s supply chain and its business. New and changing laws and regulations can also create uncertainty about how such laws and regulations will be interpreted and applied. These risks and costs may increase as the Company’s products and services are introduced into specialized applications, including health and financial services. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance the Company’s employees, contractors or agents will not violate such laws and regulations or the Company’s policies and procedures. If the Company is found to have violated laws and regulations, it could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Regulatory changes and other actions that materially adversely affect the Company’s business may be announced with little or no advance notice and the Company may not be able to effectively mitigate all adverse impacts from such measures. For example, the Company is subject to changing regulations relating to the export and import of its products. Although the Company has programs, policies and procedures in place that are designed to satisfy regulatory requirements, there can be no assurance that such policies and procedures will be effective in preventing a violation or a claim of a violation. As a result, the Company’s products could be banned, delayed or prohibited from importation, which could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Expectations relating to environmental, social and governance considerations and related reporting obligations expose the Company to potential liabilities, increased costs, reputational harm, and other adverse effects on the Company’s business. Many governments, regulators, investors, employees, customers and other stakeholders are increasingly focused on environmental, social and governance considerations relating to businesses, including climate change and greenhouse gas emissions, human and civil rights, and diversity, equity and inclusion. In addition, the Company makes statements about its goals and initiatives through its various non-financial reports, information provided on its website, press statements and other communications. Responding to these environmental, social and governance considerations and implementation of these goals and initiatives involves risks and uncertainties, requires investments, and depends in part on third-party performance or data that is outside the Company’s control. The Company cannot guarantee that it will achieve its announced environmental, social and governance goals and initiatives. In addition, some stakeholders may disagree with the Company’s goals and initiatives. Any failure, or perceived failure, by the Company to achieve its goals, further its initiatives, adhere to its public statements, comply with federal, state or international environmental, social and governance laws and regulations, or meet evolving and varied stakeholder expectations and standards could result in legal and regulatory proceedings against the Company and materially adversely affect the Company’s business, reputation, results of operations, financial condition and stock price. The technology industry, including, in some instances, the Company, is subject to intense media, political and regulatory scrutiny, which exposes the Company to increasing regulation, government investigations, legal actions and penalties. From time to time, the Company has made changes to its App Store, including actions taken in response to litigation, competition, market conditions and legal and regulatory requirements. The Company expects to make further business changes in the future, including as a result of legislative initiatives impacting the App Store, such as the EU Digital Markets Act, which the Company is required to comply with by March 2024, or similar laws in other jurisdictions. Changes have included how developers communicate with consumers outside the App Store regarding alternative purchasing mechanisms. Future changes could also affect what the Company charges developers for access to its platforms, how it manages distribution of apps outside of the App Store, and how and to what extent it allows developers to communicate with consumers inside the App Store regarding alternative purchasing mechanisms. Apple Inc. | 2023 Form 10-K | 13 The Company is also currently subject to antitrust investigations in various jurisdictions around the world, which can result in legal proceedings and claims against the Company that could, individually or in the aggregate, have a materially adverse impact on the Company’s business, results of operations and financial condition. For example, the Company is the subject of investigations in Europe and other jurisdictions relating to App Store terms and conditions. If such investigations result in adverse findings against the Company, the Company could be exposed to significant fines and may be required to make changes to its App Store business, all of which could materially adversely affect the Company’s business, results of operations and financial condition. The Company is also subject to litigation relating to the App Store, which has resulted in changes to the Company’s business practices, and may in the future result in further changes. Further, the Company has commercial relationships with other companies in the technology industry that are or may become subject to investigations and litigation that, if resolved against those other companies, could materially adversely affect the Company’s commercial relationships with those business partners and materially adversely affect the Company’s business, results of operations and financial condition. For example, the Company earns revenue from licensing arrangements with other companies to offer their search services on the Company’s platforms and applications, and certain of these arrangements are currently subject to government investigations and legal proceedings. There can be no assurance the Company’s business will not be materially adversely affected, individually or in the aggregate, by the outcomes of such investigations, litigation or changes to laws and regulations in the future. Changes to the Company’s business practices to comply with new laws and regulations or in connection with other legal proceedings could negatively impact the reputation of the Company’s products for privacy and security and otherwise adversely affect the experience for users of the Company’s products and services, and result in harm to the Company’s reputation, loss of competitive advantage, poor market acceptance, reduced demand for products and services, and lost sales. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to an increasing number of federal, state and international laws relating to the collection, use, retention, security and transfer of various types of personal information. In many cases, these laws apply not only to third-party transactions, but also restrict transfers of personal information among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and additional jurisdictions are considering imposing additional restrictions or have laws that are pending. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing requirements causes the Company to incur substantial costs and has required and may in the future require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of personal information through its privacy policy, information provided on its website, press statements and other privacy notices provided to customers. Any failure by the Company to comply with these public statements or with other federal, state or international privacy or data protection laws and regulations could result in inquiries or proceedings against the Company by governmental entities or others. In addition to reputational impacts, penalties could include ongoing audit requirements and significant legal liability. In addition to the risks generally relating to the collection, use, retention, security and transfer of personal information, the Company is also subject to specific obligations relating to information considered sensitive under applicable laws, such as health data, financial data and biometric data. Health data and financial data are subject to additional privacy, security and breach notification requirements, and the Company is subject to audit by governmental authorities regarding the Company’s compliance with these obligations. If the Company fails to adequately comply with these rules and requirements, or if health data or financial data is handled in a manner not permitted by law or under the Company’s agreements with healthcare or financial institutions, the Company can be subject to litigation or government investigations, and can be liable for associated investigatory expenses, and can also incur significant fees or fines. Payment card data is also subject to additional requirements. Under payment card rules and obligations, if cardholder information is potentially compromised, the Company can be liable for associated investigatory expenses and can also incur significant fees or fines if the Company fails to follow payment card industry data security standards. The Company could also experience a significant increase in payment card transaction costs or lose the ability to process payment cards if it fails to follow payment card industry data security standards, which could materially adversely affect the Company’s business, reputation, results of operations and financial condition. Apple Inc. | 2023 Form 10-K | 14 Financial Risks The Company expects its quarterly net sales and results of operations to fluctuate. The Company’s profit margins vary across its products, services, geographic segments and distribution channels. For example, the gross margins on the Company’s products and services vary significantly and can change over time. The Company’s gross margins are subject to volatility and downward pressure due to a variety of factors, including: continued industry-wide global product pricing pressures and product pricing actions that the Company may take in response to such pressures; increased competition; the Company’s ability to effectively stimulate demand for certain of its products and services; compressed product life cycles; supply shortages; potential increases in the cost of components, outside manufacturing services, and developing, acquiring and delivering content for the Company’s services; the Company’s ability to manage product quality and warranty costs effectively; shifts in the mix of products and services, or in the geographic, currency or channel mix, including to the extent that regulatory changes require the Company to modify its product and service offerings; fluctuations in foreign exchange rates; inflation and other macroeconomic pressures; and the introduction of new products or services, including new products or services with higher cost structures. These and other factors could have a materially adverse impact on the Company’s results of operations and financial condition. The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product and service introductions can significantly impact net sales, cost of sales and operating expenses. Further, the Company generates a significant portion of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments, such as lower-than-anticipated demand for the Company’s products or services, issues with new product or service introductions, information technology system failures or network disruptions, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar relative to local currencies. The Company’s primary exposure to movements in foreign exchange rates relates to non–U.S. dollar–denominated sales, cost of sales and operating expenses worldwide. Gross margins on the Company’s products in foreign countries and on products that include components obtained from foreign suppliers have in the past been adversely affected and could in the future be materially adversely affected by foreign exchange rate fluctuations. The weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency–denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise international pricing to offset the U.S. dollar’s strengthening, which would adversely affect the U.S. dollar value of the gross margins the Company earns on foreign currency–denominated sales. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency–denominated sales and earnings, could cause the Company to reduce international pricing or incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign exchange rates. The use of such hedging activities may not be effective to offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the values of its investment portfolio. The Company’s investments can be negatively affected by changes in liquidity, credit deterioration, financial results, market and economic conditions, political risk, sovereign risk, interest rate fluctuations or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents and marketable securities, future fluctuations in their value could result in significant losses and could have a material adverse impact on the Company’s results of operations and financial condition. Apple Inc. | 2023 Form 10-K | 15 The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products and certain of its services through third-party cellular network carriers, wholesalers, retailers and resellers. The Company also sells its products and services directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party bank support or financing arrangements, or credit insurance, and a significant portion of the Company’s trade receivables can be concentrated within cellular network carriers or other resellers. The Company’s exposure to credit and collectibility risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture subassemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 30, 2023, the Company’s vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company is subject to changes in tax rates, the adoption of new U.S. or international tax legislation and exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland and Singapore, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax laws and tax rates for income taxes and other non-income taxes in various jurisdictions may be subject to significant change. For example, the Organisation for Economic Co-operation and Development continues to advance proposals for modernizing international tax rules, including the introduction of global minimum tax standards. The Company’s effective tax rates are affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, the introduction of new taxes, and changes in tax laws or their interpretation. The application of tax laws may be uncertain, require significant judgment and be subject to differing interpretations. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s business, results of operations and financial condition could be materially adversely affected. General Risks The price of the Company’s stock is subject to volatility. The Company’s stock has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have, from time to time, experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility may cause the average price at which the Company repurchases its stock in a given period to exceed the stock’s price at a given point in time. The Company believes the price of its stock should reflect expectations of future growth and profitability. The Company also believes the price of its stock should reflect expectations that its cash dividend will continue at current levels or grow, and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, the price of the Company’s stock may decline significantly, which could have a material adverse impact on investor confidence and employee retention. Item 1B.    Unresolved Staff Comments None. Item 1C.    Cybersecurity Not applicable. Apple Inc. | 2023 Form 10-K | 16 Item 2.    Properties The Company’s headquarters is located in Cupertino, California. As of September 30, 2023, the Company owned or leased facilities and land for corporate functions, R&D, data centers, retail and other purposes at locations throughout the U.S. and in various places outside the U.S. The Company believes its existing facilities and equipment, which are used by all reportable segments, are in good operating condition and are suitable for the conduct of its business. Item 3.    Legal Proceedings Epic Games Epic Games, Inc. (“Epic”) filed a lawsuit in the U.S. District Court for the Northern District of California (the “District Court”) against the Company alleging violations of federal and state antitrust laws and California’s unfair competition law based upon the Company’s operation of its App Store. On September 10, 2021, the District Court ruled in favor of the Company with respect to nine out of the ten counts included in Epic’s claim. The District Court found that certain provisions of the Company’s App Store Review Guidelines violate California’s unfair competition law and issued an injunction enjoining the Company from prohibiting developers from including in their apps external links that direct customers to purchasing mechanisms other than Apple in-app purchasing. The injunction applies to apps on the U.S. storefront of the iOS and iPadOS App Store. On April 24, 2023, the U.S. Court of Appeals for the Ninth Circuit (the “Circuit Court”) affirmed the District Court’s ruling. On June 7, 2023, the Company and Epic filed petitions with the Circuit Court requesting further review of the decision. On June 30, 2023, the Circuit Court denied both petitions. On July 17, 2023, the Circuit Court granted Apple’s motion to stay enforcement of the injunction pending appeal to the U.S. Supreme Court. If the U.S. Supreme Court denies Apple’s petition, the stay of the injunction will expire. Masimo Masimo Corporation and Cercacor Laboratories, Inc. (together, “Masimo”) filed a complaint before the U.S. International Trade Commission (the “ITC”) alleging infringement by the Company of five patents relating to the functionality of the blood oxygen feature in Apple Watch Series 6 and 7. In its complaint, Masimo sought a permanent exclusion order prohibiting importation to the United States of certain Apple Watch models that include blood oxygen sensing functionality. On October 26, 2023, the ITC entered a limited exclusion order (the “Order”) prohibiting importation and sales in the United States of Apple Watch models with blood oxygen sensing functionality, which includes Apple Watch Series 9 and Ultra 2. The Order will not go into effect until the end of the administrative review period, which is currently expected to end on December 25, 2023. The Company intends to appeal the Order and seek a stay pending the appeal. Other Legal Proceedings The Company is subject to other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. The Company settled certain matters during the fourth quarter of 2023 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. The outcome of litigation is inherently uncertain. If one or more legal matters were resolved against the Company in a reporting period for amounts above management’s expectations, the Company’s financial condition and operating results for that reporting period could be materially adversely affected. Item 4.    Mine Safety Disclosures Not applicable. Apple Inc. | 2023 Form 10-K | 17 PART II Item 5.    Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on The Nasdaq Stock Market LLC under the symbol AAPL. Holders As of October 20, 2023, there were 23,763 shareholders of record. Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 30, 2023 was as follows (in millions, except number of shares, which are reflected in thousands, and per-share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) July 2, 2023 to August 5, 2023: Open market and privately negotiated purchases 33,864 $ 191.62 33,864 August 6, 2023 to September 2, 2023: August 2023 ASRs 22,085 (2) (2) 22,085 (2) Open market and privately negotiated purchases 30,299 $ 178.99 30,299 September 3, 2023 to September 30, 2023: Open market and privately negotiated purchases 20,347 $ 176.31 20,347 Total 106,595 $ 74,069 (1) As of September 30, 2023, the Company was authorized by the Board of Directors to purchase up to $90 billion of the Company’s common stock under a share repurchase program announced on May 4, 2023, of which $15.9 billion had been utilized. During the fourth quarter of 2023, the Company also utilized the final $4.6 billion under its previous repurchase program, which was most recently authorized in April 2022. The programs do not obligate the Company to acquire a minimum amount of shares. Under the programs, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In August 2023, the Company entered into new accelerated share repurchase agreements (“ASRs”). Under the terms of the ASRs, two financial institutions committed to deliver shares of the Company’s common stock during the purchase periods in exchange for up-front payments totaling $5.0 billion. The total number of shares ultimately delivered under the ASRs, and therefore the average repurchase price paid per share, is determined based on the volume-weighted average price of the Company’s common stock during the ASRs’ purchase periods, which end in the first quarter of 2024. Apple Inc. | 2023 Form 10-K | 18 Company Stock Performance The following graph shows a comparison of five-year cumulative total shareholder return, calculated on a dividend-reinvested basis, for the Company, the S&P 500 Index and the Dow Jones U.S. Technology Supersector Index. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 28, 2018. Past stock price performance is not necessarily indicative of future stock price performance. September 2018 September 2019 September 2020 September 2021 September 2022 September 2023 Apple Inc. $ 100 $ 98 $ 204 $ 269 $ 277 $ 317 S&P 500 Index $ 100 $ 104 $ 118 $ 161 $ 136 $ 160 Dow Jones U.S. Technology Supersector Index $ 100 $ 105 $ 154 $ 227 $ 164 $ 226 Item 6.    [Reserved] Apple Inc. | 2023 Form 10-K | 19 Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the consolidated financial statements and accompanying notes included in Part II, Item 8 of this Form 10-K. This Item generally discusses 2023 and 2022 items and year-to-year comparisons between 2023 and 2022. Discussions of 2021 items and year-to-year comparisons between 2022 and 2021 are not included, and can be found in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part II, Item 7 of the Company’s Annual Report on Form 10-K for the fiscal year ended September 24, 2022. Fiscal Period The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. An additional week is included in the first fiscal quarter every five or six years to realign the Company’s fiscal quarters with calendar quarters, which occurred in the first quarter of 2023. The Company’s fiscal year 2023 spanned 53 weeks, whereas fiscal years 2022 and 2021 spanned 52 weeks each. Fiscal Year Highlights The Company’s total net sales were $383.3 billion and net income was $97.0 billion during 2023. The Company’s total net sales decreased 3% or $11.0 billion during 2023 compared to 2022. The weakness in foreign currencies relative to the U.S. dollar accounted for more than the entire year-over-year decrease in total net sales, which consisted primarily of lower net sales of Mac and iPhone, partially offset by higher net sales of Services. The Company announces new product, service and software offerings at various times during the year. Significant announcements during fiscal year 2023 included the following: First Quarter 2023: • iPad and iPad Pro; • Next-generation Apple TV 4K; and • MLS Season Pass, a Major League Soccer subscription streaming service. Second Quarter 2023: • MacBook Pro 14”, MacBook Pro 16” and Mac mini; and • Second-generation HomePod. Third Quarter 2023: • MacBook Air 15”, Mac Studio and Mac Pro; • Apple Vision Pro™, the Company’s first spatial computer featuring its new visionOS™, expected to be available in early calendar year 2024; and • iOS 17, macOS Sonoma, iPadOS 17, tvOS 17 and watchOS 10, updates to the Company’s operating systems. Fourth Quarter 2023: • iPhone 15, iPhone 15 Plus, iPhone 15 Pro and iPhone 15 Pro Max; and • Apple Watch Series 9 and Apple Watch Ultra 2. In May 2023, the Company announced a new share repurchase program of up to $90 billion and raised its quarterly dividend from $0.23 to $0.24 per share beginning in May 2023. During 2023, the Company repurchased $76.6 billion of its common stock and paid dividends and dividend equivalents of $15.0 billion. Macroeconomic Conditions Macroeconomic conditions, including inflation, changes in interest rates, and currency fluctuations, have directly and indirectly impacted, and could in the future materially impact, the Company’s results of operations and financial condition. Apple Inc. | 2023 Form 10-K | 20 Segment Operating Performance The following table shows net sales by reportable segment for 2023, 2022 and 2021 (dollars in millions): 2023 Change 2022 Change 2021 Net sales by reportable segment: Americas $ 162,560 (4) % $ 169,658 11 % $ 153,306 Europe 94,294 (1) % 95,118 7 % 89,307 Greater China 72,559 (2) % 74,200 9 % 68,366 Japan 24,257 (7) % 25,977 (9) % 28,482 Rest of Asia Pacific 29,615 1 % 29,375 11 % 26,356 Total net sales $ 383,285 (3) % $ 394,328 8 % $ 365,817 Americas Americas net sales decreased 4% or $7.1 billion during 2023 compared to 2022 due to lower net sales of iPhone and Mac, partially offset by higher net sales of Services. Europe Europe net sales decreased 1% or $824 million during 2023 compared to 2022. The weakness in foreign currencies relative to the U.S. dollar accounted for more than the entire year-over-year decrease in Europe net sales, which consisted primarily of lower net sales of Mac and Wearables, Home and Accessories, partially offset by higher net sales of iPhone and Services. Greater China Greater China net sales decreased 2% or $1.6 billion during 2023 compared to 2022. The weakness in the renminbi relative to the U.S. dollar accounted for more than the entire year-over-year decrease in Greater China net sales, which consisted primarily of lower net sales of Mac and iPhone. Japan Japan net sales decreased 7% or $1.7 billion during 2023 compared to 2022. The weakness in the yen relative to the U.S. dollar accounted for more than the entire year-over-year decrease in Japan net sales, which consisted primarily of lower net sales of iPhone, Wearables, Home and Accessories and Mac. Rest of Asia Pacific Rest of Asia Pacific net sales increased 1% or $240 million during 2023 compared to 2022. The weakness in foreign currencies relative to the U.S. dollar had a significantly unfavorable year-over-year impact on Rest of Asia Pacific net sales. The net sales increase consisted of higher net sales of iPhone and Services, partially offset by lower net sales of Mac and iPad. Apple Inc. | 2023 Form 10-K | 21 Products and Services Performance The following table shows net sales by category for 2023, 2022 and 2021 (dollars in millions): 2023 Change 2022 Change 2021 Net sales by category: iPhone (1) $ 200,583 (2) % $ 205,489 7 % $ 191,973 Mac (1) 29,357 (27) % 40,177 14 % 35,190 iPad (1) 28,300 (3) % 29,292 (8) % 31,862 Wearables, Home and Accessories (1) 39,845 (3) % 41,241 7 % 38,367 Services (2) 85,200 9 % 78,129 14 % 68,425 Total net sales $ 383,285 (3) % $ 394,328 8 % $ 365,817 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Services net sales include amortization of the deferred value of services bundled in the sales price of certain products. iPhone iPhone net sales decreased 2% or $4.9 billion during 2023 compared to 2022 due to lower net sales of non-Pro iPhone models, partially offset by higher net sales of Pro iPhone models. Mac Mac net sales decreased 27% or $10.8 billion during 2023 compared to 2022 due primarily to lower net sales of laptops. iPad iPad net sales decreased 3% or $1.0 billion during 2023 compared to 2022 due primarily to lower net sales of iPad mini and iPad Air, partially offset by the combined net sales of iPad 9th and 10th generation. Wearables, Home and Accessories Wearables, Home and Accessories net sales decreased 3% or $1.4 billion during 2023 compared to 2022 due primarily to lower net sales of Wearables and Accessories. Services Services net sales increased 9% or $7.1 billion during 2023 compared to 2022 due to higher net sales across all lines of business. Apple Inc. | 2023 Form 10-K | 22 Gross Margin Products and Services gross margin and gross margin percentage for 2023, 2022 and 2021 were as follows (dollars in millions): 2023 2022 2021 Gross margin: Products $ 108,803 $ 114,728 $ 105,126 Services 60,345 56,054 47,710 Total gross margin $ 169,148 $ 170,782 $ 152,836 Gross margin percentage: Products 36.5 % 36.3 % 35.3 % Services 70.8 % 71.7 % 69.7 % Total gross margin percentage 44.1 % 43.3 % 41.8 % Products Gross Margin Products gross margin decreased during 2023 compared to 2022 due to the weakness in foreign currencies relative to the U.S. dollar and lower Products volume, partially offset by cost savings and a different Products mix. Products gross margin percentage increased during 2023 compared to 2022 due to cost savings and a different Products mix, partially offset by the weakness in foreign currencies relative to the U.S. dollar and decreased leverage. Services Gross Margin Services gross margin increased during 2023 compared to 2022 due primarily to higher Services net sales, partially offset by the weakness in foreign currencies relative to the U.S. dollar and higher Services costs. Services gross margin percentage decreased during 2023 compared to 2022 due to higher Services costs and the weakness in foreign currencies relative to the U.S. dollar, partially offset by a different Services mix. The Company’s future gross margins can be impacted by a variety of factors, as discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” As a result, the Company believes, in general, gross margins will be subject to volatility and downward pressure. Operating Expenses Operating expenses for 2023, 2022 and 2021 were as follows (dollars in millions): 2023 Change 2022 Change 2021 Research and development $ 29,915 14 % $ 26,251 20 % $ 21,914 Percentage of total net sales 8 % 7 % 6 % Selling, general and administrative $ 24,932 (1) % $ 25,094 14 % $ 21,973 Percentage of total net sales 7 % 6 % 6 % Total operating expenses $ 54,847 7 % $ 51,345 17 % $ 43,887 Percentage of total net sales 14 % 13 % 12 % Research and Development The year-over-year growth in R&D expense in 2023 was driven primarily by increases in headcount-related expenses. Selling, General and Administrative Selling, general and administrative expense was relatively flat in 2023 compared to 2022. Apple Inc. | 2023 Form 10-K | 23 Provision for Income Taxes Provision for income taxes, effective tax rate and statutory federal income tax rate for 2023, 2022 and 2021 were as follows (dollars in millions): 2023 2022 2021 Provision for income taxes $ 16,741 $ 19,300 $ 14,527 Effective tax rate 14.7 % 16.2 % 13.3 % Statutory federal income tax rate 21 % 21 % 21 % The Company’s effective tax rate for 2023 and 2022 was lower than the statutory federal income tax rate due primarily to a lower effective tax rate on foreign earnings, the impact of the U.S. federal R&D credit, and tax benefits from share-based compensation, partially offset by state income taxes. The Company’s effective tax rate for 2023 was lower compared to 2022 due primarily to a lower effective tax rate on foreign earnings and the impact of U.S. foreign tax credit regulations issued by the U.S. Department of the Treasury in 2022, partially offset by lower tax benefits from share-based compensation. Liquidity and Capital Resources The Company believes its balances of cash, cash equivalents and unrestricted marketable securities, which totaled $148.3 billion as of September 30, 2023, along with cash generated by ongoing operations and continued access to debt markets, will be sufficient to satisfy its cash requirements and capital return program over the next 12 months and beyond. The Company’s material cash requirements include the following contractual obligations: Debt As of September 30, 2023, the Company had outstanding fixed-rate notes with varying maturities for an aggregate principal amount of $106.6 billion (collectively the “Notes”), with $9.9 billion payable within 12 months. Future interest payments associated with the Notes total $41.1 billion, with $2.9 billion payable within 12 months. The Company also issues unsecured short-term promissory notes pursuant to a commercial paper program. As of September 30, 2023, the Company had $6.0 billion of commercial paper outstanding, all of which was payable within 12 months. Leases The Company has lease arrangements for certain equipment and facilities, including corporate, data center, manufacturing and retail space. As of September 30, 2023, the Company had fixed lease payment obligations of $15.8 billion, with $2.0 billion payable within 12 months. Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture subassemblies for the Company’s products and to perform final assembly and testing of finished products. The Company also obtains individual components for its products from a wide variety of individual suppliers. As of September 30, 2023, the Company had manufacturing purchase obligations of $53.1 billion, with $52.9 billion payable within 12 months. The Company’s manufacturing purchase obligations are primarily noncancelable. Other Purchase Obligations The Company’s other purchase obligations primarily consist of noncancelable obligations to acquire capital assets, including assets related to product manufacturing, and noncancelable obligations related to supplier arrangements, licensed intellectual property and content, and distribution rights. As of September 30, 2023, the Company had other purchase obligations of $21.9 billion, with $5.6 billion payable within 12 months. Deemed Repatriation Tax Payable As of September 30, 2023, the balance of the deemed repatriation tax payable imposed by the U.S. Tax Cuts and Jobs Act of 2017 (the “Act”) was $22.0 billion, with $6.5 billion expected to be paid within 12 months. Apple Inc. | 2023 Form 10-K | 24 Capital Return Program In addition to its contractual cash requirements, the Company has an authorized share repurchase program. The program does not obligate the Company to acquire a minimum amount of shares. As of September 30, 2023, the Company’s quarterly cash dividend was $0.24 per share. The Company intends to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Critical Accounting Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported. Note 1, “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Uncertain Tax Positions The Company is subject to income taxes in the U.S. and numerous foreign jurisdictions. The evaluation of the Company’s uncertain tax positions involves significant judgment in the interpretation and application of GAAP and complex domestic and international tax laws, including the Act and matters related to the allocation of international taxation rights between countries. Although management believes the Company’s reserves are reasonable, no assurance can be given that the final outcome of these uncertainties will not be different from that which is reflected in the Company’s reserves. Reserves are adjusted considering changing facts and circumstances, such as the closing of a tax examination. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies The Company is subject to various legal proceedings and claims that arise in the ordinary course of business, the outcomes of which are inherently uncertain. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. Resolution of legal matters in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Apple Inc. | 2023 Form 10-K | 25 Item 7A.    Quantitative and Qualitative Disclosures About Market Risk The Company is exposed to economic risk from interest rates and foreign exchange rates. The Company uses various strategies to manage these risks; however, they may still impact the Company’s consolidated financial statements. Interest Rate Risk The Company is primarily exposed to fluctuations in U.S. interest rates and their impact on the Company’s investment portfolio and term debt. Increases in interest rates will negatively affect the fair value of the Company’s investment portfolio and increase the interest expense on the Company’s term debt. To protect against interest rate risk, the Company may use derivative instruments, offset interest rate–sensitive assets and liabilities, or control duration of the investment and term debt portfolios. The following table sets forth potential impacts on the Company’s investment portfolio and term debt, including the effects of any associated derivatives, that would result from a hypothetical increase in relevant interest rates as of September 30, 2023 and September 24, 2022 (dollars in millions): Interest Rate Sensitive Instrument Hypothetical Interest Rate Increase Potential Impact 2023 2022 Investment portfolio 100 basis points, all tenors Decline in fair value $ 3,089 $ 4,022 Term debt 100 basis points, all tenors Increase in annual interest expense $ 194 $ 201 Foreign Exchange Rate Risk The Company’s exposure to foreign exchange rate risk relates primarily to the Company being a net receiver of currencies other than the U.S. dollar. Changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. Fluctuations in exchange rates may also affect the fair values of certain of the Company’s assets and liabilities. To protect against foreign exchange rate risk, the Company may use derivative instruments, offset exposures, or adjust local currency pricing of its products and services. However, the Company may choose to not hedge certain foreign currency exposures for a variety of reasons, including accounting considerations or prohibitive cost. The Company applied a value-at-risk (“VAR”) model to its foreign currency derivative positions to assess the potential impact of fluctuations in exchange rates. The VAR model used a Monte Carlo simulation. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. Based on the results of the model, the Company estimates, with 95% confidence, a maximum one-day loss in fair value of $669 million and $1.0 billion as of September 30, 2023 and September 24, 2022, respectively. Changes in the Company’s underlying foreign currency exposures, which were excluded from the assessment, generally offset changes in the fair values of the Company’s foreign currency derivatives. Apple Inc. | 2023 Form 10-K | 26 Item 8.    Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 28 Consolidated Statements of Comprehensive Income for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 29 Consolidated Balance Sheets as of September 30, 2023 and September 24, 2022 30 Consolidated Statements of Shareholders’ Equity for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 31 Consolidated Statements of Cash Flows for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 32 Notes to Consolidated Financial Statements 33 Reports of Independent Registered Public Accounting Firm 49 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes. Apple Inc. | 2023 Form 10-K | 27 Apple Inc. CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares, which are reflected in thousands, and per-share amounts) Years ended September 30, 2023 September 24, 2022 September 25, 2021 Net sales: Products $ 298,085 $ 316,199 $ 297,392 Services 85,200 78,129 68,425 Total net sales 383,285 394,328 365,817 Cost of sales: Products 189,282 201,471 192,266 Services 24,855 22,075 20,715 Total cost of sales 214,137 223,546 212,981 Gross margin 169,148 170,782 152,836 Operating expenses: Research and development 29,915 26,251 21,914 Selling, general and administrative 24,932 25,094 21,973 Total operating expenses 54,847 51,345 43,887 Operating income 114,301 119,437 108,949 Other income/(expense), net ( 565 ) ( 334 ) 258 Income before provision for income taxes 113,736 119,103 109,207 Provision for income taxes 16,741 19,300 14,527 Net income $ 96,995 $ 99,803 $ 94,680 Earnings per share: Basic $ 6.16 $ 6.15 $ 5.67 Diluted $ 6.13 $ 6.11 $ 5.61 Shares used in computing earnings per share: Basic 15,744,231 16,215,963 16,701,272 Diluted 15,812,547 16,325,819 16,864,919 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2023 Form 10-K | 28 Apple Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 30, 2023 September 24, 2022 September 25, 2021 Net income $ 96,995 $ 99,803 $ 94,680 Other comprehensive income/(loss): Change in foreign currency translation, net of tax ( 765 ) ( 1,511 ) 501 Change in unrealized gains/losses on derivative instruments, net of tax: Change in fair value of derivative instruments 323 3,212 32 Adjustment for net (gains)/losses realized and included in net income ( 1,717 ) ( 1,074 ) 1,003 Total change in unrealized gains/losses on derivative instruments ( 1,394 ) 2,138 1,035 Change in unrealized gains/losses on marketable debt securities, net of tax: Change in fair value of marketable debt securities 1,563 ( 12,104 ) ( 694 ) Adjustment for net (gains)/losses realized and included in net income 253 205 ( 273 ) Total change in unrealized gains/losses on marketable debt securities 1,816 ( 11,899 ) ( 967 ) Total other comprehensive income/(loss) ( 343 ) ( 11,272 ) 569 Total comprehensive income $ 96,652 $ 88,531 $ 95,249 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2023 Form 10-K | 29 Apple Inc. CONSOLIDATED BALANCE SHEETS (In millions, except number of shares, which are reflected in thousands, and par value) September 30, 2023 September 24, 2022 ASSETS: Current assets: Cash and cash equivalents $ 29,965 $ 23,646 Marketable securities 31,590 24,658 Accounts receivable, net 29,508 28,184 Vendor non-trade receivables 31,477 32,748 Inventories 6,331 4,946 Other current assets 14,695 21,223 Total current assets 143,566 135,405 Non-current assets: Marketable securities 100,544 120,805 Property, plant and equipment, net 43,715 42,117 Other non-current assets 64,758 54,428 Total non-current assets 209,017 217,350 Total assets $ 352,583 $ 352,755 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 62,611 $ 64,115 Other current liabilities 58,829 60,845 Deferred revenue 8,061 7,912 Commercial paper 5,985 9,982 Term debt 9,822 11,128 Total current liabilities 145,308 153,982 Non-current liabilities: Term debt 95,281 98,959 Other non-current liabilities 49,848 49,142 Total non-current liabilities 145,129 148,101 Total liabilities 290,437 302,083 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $ 0.00001 par value: 50,400,000 shares authorized; 15,550,061 and 15,943,425 shares issued and outstanding, respectively 73,812 64,849 Accumulated deficit ( 214 ) ( 3,068 ) Accumulated other comprehensive loss ( 11,452 ) ( 11,109 ) Total shareholders’ equity 62,146 50,672 Total liabilities and shareholders’ equity $ 352,583 $ 352,755 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2023 Form 10-K | 30 Apple Inc. CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except per-share amounts) Years ended September 30, 2023 September 24, 2022 September 25, 2021 Total shareholders’ equity, beginning balances $ 50,672 $ 63,090 $ 65,339 Common stock and additional paid-in capital: Beginning balances 64,849 57,365 50,779 Common stock issued 1,346 1,175 1,105 Common stock withheld related to net share settlement of equity awards ( 3,521 ) ( 2,971 ) ( 2,627 ) Share-based compensation 11,138 9,280 8,108 Ending balances 73,812 64,849 57,365 Retained earnings/(Accumulated deficit): Beginning balances ( 3,068 ) 5,562 14,966 Net income 96,995 99,803 94,680 Dividends and dividend equivalents declared ( 14,996 ) ( 14,793 ) ( 14,431 ) Common stock withheld related to net share settlement of equity awards ( 2,099 ) ( 3,454 ) ( 4,151 ) Common stock repurchased ( 77,046 ) ( 90,186 ) ( 85,502 ) Ending balances ( 214 ) ( 3,068 ) 5,562 Accumulated other comprehensive income/(loss): Beginning balances ( 11,109 ) 163 ( 406 ) Other comprehensive income/(loss) ( 343 ) ( 11,272 ) 569 Ending balances ( 11,452 ) ( 11,109 ) 163 Total shareholders’ equity, ending balances $ 62,146 $ 50,672 $ 63,090 Dividends and dividend equivalents declared per share or RSU $ 0.94 $ 0.90 $ 0.85 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2023 Form 10-K | 31 Apple Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 30, 2023 September 24, 2022 September 25, 2021 Cash, cash equivalents and restricted cash, beginning balances $ 24,977 $ 35,929 $ 39,789 Operating activities: Net income 96,995 99,803 94,680 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 11,519 11,104 11,284 Share-based compensation expense 10,833 9,038 7,906 Other ( 2,227 ) 1,006 ( 4,921 ) Changes in operating assets and liabilities: Accounts receivable, net ( 1,688 ) ( 1,823 ) ( 10,125 ) Vendor non-trade receivables 1,271 ( 7,520 ) ( 3,903 ) Inventories ( 1,618 ) 1,484 ( 2,642 ) Other current and non-current assets ( 5,684 ) ( 6,499 ) ( 8,042 ) Accounts payable ( 1,889 ) 9,448 12,326 Other current and non-current liabilities 3,031 6,110 7,475 Cash generated by operating activities 110,543 122,151 104,038 Investing activities: Purchases of marketable securities ( 29,513 ) ( 76,923 ) ( 109,558 ) Proceeds from maturities of marketable securities 39,686 29,917 59,023 Proceeds from sales of marketable securities 5,828 37,446 47,460 Payments for acquisition of property, plant and equipment ( 10,959 ) ( 10,708 ) ( 11,085 ) Other ( 1,337 ) ( 2,086 ) ( 385 ) Cash generated by/(used in) investing activities 3,705 ( 22,354 ) ( 14,545 ) Financing activities: Payments for taxes related to net share settlement of equity awards ( 5,431 ) ( 6,223 ) ( 6,556 ) Payments for dividends and dividend equivalents ( 15,025 ) ( 14,841 ) ( 14,467 ) Repurchases of common stock ( 77,550 ) ( 89,402 ) ( 85,971 ) Proceeds from issuance of term debt, net 5,228 5,465 20,393 Repayments of term debt ( 11,151 ) ( 9,543 ) ( 8,750 ) Proceeds from/(Repayments of) commercial paper, net ( 3,978 ) 3,955 1,022 Other ( 581 ) ( 160 ) 976 Cash used in financing activities ( 108,488 ) ( 110,749 ) ( 93,353 ) Increase/(Decrease) in cash, cash equivalents and restricted cash 5,760 ( 10,952 ) ( 3,860 ) Cash, cash equivalents and restricted cash, ending balances $ 30,737 $ 24,977 $ 35,929 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 18,679 $ 19,573 $ 25,385 Cash paid for interest $ 3,803 $ 2,865 $ 2,687 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2023 Form 10-K | 32 Apple Inc. Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Basis of Presentation and Preparation The consolidated financial statements include the accounts of Apple Inc. and its wholly owned subsidiaries. The preparation of these consolidated financial statements and accompanying notes in conformity with GAAP requires the use of management estimates. Certain prior period amounts in the consolidated financial statements and accompanying notes have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52- or 53-week period that ends on the last Saturday of September. An additional week is included in the first fiscal quarter every five or six years to realign the Company’s fiscal quarters with calendar quarters, which occurred in the first fiscal quarter of 2023. The Company’s fiscal year 2023 spanned 53 weeks, whereas fiscal years 2022 and 2021 spanned 52 weeks each. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Revenue The Company records revenue net of taxes collected from customers that are remitted to governmental authorities. Share-Based Compensation The Company recognizes share-based compensation expense on a straight-line basis for its estimate of equity awards that will ultimately vest. Cash Equivalents All highly liquid investments with maturities of three months or less at the date of purchase are treated as cash equivalents. Marketable Securities The cost of securities sold is determined using the specific identification method. Inventories Inventories are measured using the first-in, first-out method. Property, Plant and Equipment Depreciation on property, plant and equipment is recognized on a straight-line basis. Derivative Instruments The Company presents derivative assets and liabilities at their gross fair values in the Consolidated Balance Sheets. Income Taxes The Company records certain deferred tax assets and liabilities in connection with the minimum tax on certain foreign earnings created by the Act. Leases The Company combines and accounts for lease and nonlease components as a single lease component for leases of corporate, data center and retail facilities. Apple Inc. | 2023 Form 10-K | 33 Note 2 – Revenue The Company recognizes revenue at the amount to which it expects to be entitled when control of the products or services is transferred to its customers. Control is generally transferred when the Company has a present right to payment and title and the significant risks and rewards of ownership of products or services are transferred to its customers. For most of the Company’s Products net sales, control transfers when products are shipped. For the Company’s Services net sales, control transfers over time as services are delivered. Payment for Products and Services net sales is collected within a short period following transfer of control or commencement of delivery of services, as applicable. The Company records reductions to Products net sales related to future product returns, price protection and other customer incentive programs based on the Company’s expectations and historical experience. For arrangements with multiple performance obligations, which represent promises within an arrangement that are distinct, the Company allocates revenue to all distinct performance obligations based on their relative stand-alone selling prices (“SSPs”). When available, the Company uses observable prices to determine SSPs. When observable prices are not available, SSPs are established that reflect the Company’s best estimates of what the selling prices of the performance obligations would be if they were sold regularly on a stand-alone basis. The Company’s process for estimating SSPs without observable prices considers multiple factors that may vary depending upon the unique facts and circumstances related to each performance obligation including, where applicable, prices charged by the Company for similar offerings, market trends in the pricing for similar offerings, product-specific business objectives and the estimated cost to provide the performance obligation. The Company has identified up to three performance obligations regularly included in arrangements involving the sale of iPhone, Mac, iPad and certain other products. The first performance obligation, which represents the substantial portion of the allocated sales price, is the hardware and bundled software delivered at the time of sale. The second performance obligation is the right to receive certain product-related bundled services, which include iCloud ® , Siri ® and Maps. The third performance obligation is the right to receive, on a when-and-if-available basis, future unspecified software upgrades relating to the software bundled with each device. The Company allocates revenue and any related discounts to these performance obligations based on their relative SSPs. Because the Company lacks observable prices for the undelivered performance obligations, the allocation of revenue is based on the Company’s estimated SSPs. Revenue allocated to the delivered hardware and bundled software is recognized when control has transferred to the customer, which generally occurs when the product is shipped. Revenue allocated to the product-related bundled services and unspecified software upgrade rights is deferred and recognized on a straight-line basis over the estimated period they are expected to be provided. For certain long-term service arrangements, the Company has performance obligations for services it has not yet delivered. For these arrangements, the Company does not have a right to bill for the undelivered services. The Company has determined that any unbilled consideration relates entirely to the value of the undelivered services. Accordingly, the Company has not recognized revenue, and does not disclose amounts, related to these undelivered services. For the sale of third-party products where the Company obtains control of the product before transferring it to the customer, the Company recognizes revenue based on the gross amount billed to customers. The Company considers multiple factors when determining whether it obtains control of third-party products, including evaluating if it can establish the price of the product, retains inventory risk for tangible products or has the responsibility for ensuring acceptability of the product. For third-party applications sold through the App Store, the Company does not obtain control of the product before transferring it to the customer. Therefore, the Company accounts for all third-party application–related sales on a net basis by recognizing in Services net sales only the commission it retains. Apple Inc. | 2023 Form 10-K | 34 Net sales disaggregated by significant products and services for 2023, 2022 and 2021 were as follows (in millions): 2023 2022 2021 iPhone (1) $ 200,583 $ 205,489 $ 191,973 Mac (1) 29,357 40,177 35,190 iPad (1) 28,300 29,292 31,862 Wearables, Home and Accessories (1) 39,845 41,241 38,367 Services (2) 85,200 78,129 68,425 Total net sales $ 383,285 $ 394,328 $ 365,817 (1) Products net sales include amortization of the deferred value of unspecified software upgrade rights, which are bundled in the sales price of the respective product. (2) Services net sales include amortization of the deferred value of services bundled in the sales price of certain products. Total net sales include $ 8.2 billion of revenue recognized in 2023 that was included in deferred revenue as of September 24, 2022, $ 7.5 billion of revenue recognized in 2022 that was included in deferred revenue as of September 25, 2021, and $ 6.7 billion of revenue recognized in 2021 that was included in deferred revenue as of September 26, 2020. The Company’s proportion of net sales by disaggregated revenue source was generally consistent for each reportable segment in Note 13, “Segment Information and Geographic Data” for 2023, 2022 and 2021, except in Greater China, where iPhone revenue represented a moderately higher proportion of net sales. As of September 30, 2023 and September 24, 2022, the Company had total deferred revenue of $ 12.1 billion and $ 12.4 billion, respectively. As of September 30, 2023, the Company expects 67 % of total deferred revenue to be realized in less than a year, 25 % within one-to-two years, 7 % within two-to-three years and 1 % in greater than three years. Note 3 – Earnings Per Share The following table shows the computation of basic and diluted earnings per share for 2023, 2022 and 2021 (net income in millions and shares in thousands): 2023 2022 2021 Numerator: Net income $ 96,995 $ 99,803 $ 94,680 Denominator: Weighted-average basic shares outstanding 15,744,231 16,215,963 16,701,272 Effect of dilutive share-based awards 68,316 109,856 163,647 Weighted-average diluted shares 15,812,547 16,325,819 16,864,919 Basic earnings per share $ 6.16 $ 6.15 $ 5.67 Diluted earnings per share $ 6.13 $ 6.11 $ 5.61 Approximately 24 million restricted stock units (“RSUs”) were excluded from the computation of diluted earnings per share for 2023 because their effect would have been antidilutive. Apple Inc. | 2023 Form 10-K | 35 Note 4 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash, cash equivalents and marketable securities by significant investment category as of September 30, 2023 and September 24, 2022 (in millions): 2023 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 28,359 $ — $ — $ 28,359 $ 28,359 $ — $ — Level 1: Money market funds 481 — — 481 481 — — Mutual funds and equity securities 442 12 ( 26 ) 428 — 428 — Subtotal 923 12 ( 26 ) 909 481 428 — Level 2 (1) : U.S. Treasury securities 19,406 — ( 1,292 ) 18,114 35 5,468 12,611 U.S. agency securities 5,736 — ( 600 ) 5,136 36 271 4,829 Non-U.S. government securities 17,533 6 ( 1,048 ) 16,491 — 11,332 5,159 Certificates of deposit and time deposits 1,354 — — 1,354 1,034 320 — Commercial paper 608 — — 608 — 608 — Corporate debt securities 76,840 6 ( 5,956 ) 70,890 20 12,627 58,243 Municipal securities 628 — ( 26 ) 602 — 192 410 Mortgage- and asset-backed securities 22,365 6 ( 2,735 ) 19,636 — 344 19,292 Subtotal 144,470 18 ( 11,657 ) 132,831 1,125 31,162 100,544 Total (2) $ 173,752 $ 30 $ ( 11,683 ) $ 162,099 $ 29,965 $ 31,590 $ 100,544 2022 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Current Marketable Securities Non-Current Marketable Securities Cash $ 18,546 $ — $ — $ 18,546 $ 18,546 $ — $ — Level 1: Money market funds 2,929 — — 2,929 2,929 — — Mutual funds 274 — ( 47 ) 227 — 227 — Subtotal 3,203 — ( 47 ) 3,156 2,929 227 — Level 2 (1) : U.S. Treasury securities 25,134 — ( 1,725 ) 23,409 338 5,091 17,980 U.S. agency securities 5,823 — ( 655 ) 5,168 — 240 4,928 Non-U.S. government securities 16,948 2 ( 1,201 ) 15,749 — 8,806 6,943 Certificates of deposit and time deposits 2,067 — — 2,067 1,805 262 — Commercial paper 718 — — 718 28 690 — Corporate debt securities 87,148 9 ( 7,707 ) 79,450 — 9,023 70,427 Municipal securities 921 — ( 35 ) 886 — 266 620 Mortgage- and asset-backed securities 22,553 — ( 2,593 ) 19,960 — 53 19,907 Subtotal 161,312 11 ( 13,916 ) 147,407 2,171 24,431 120,805 Total (2) $ 183,061 $ 11 $ ( 13,963 ) $ 169,109 $ 23,646 $ 24,658 $ 120,805 (1) The valuation techniques used to measure the fair values of the Company’s Level 2 financial instruments, which generally have counterparties with high credit ratings, are based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. (2) As of September 30, 2023 and September 24, 2022, total marketable securities included $ 13.8 billion and $ 12.7 billion, respectively, that were restricted from general use, related to the State Aid Decision (refer to Note 7, “Income Taxes”) and other agreements. Apple Inc. | 2023 Form 10-K | 36 The following table shows the fair value of the Company’s non-current marketable debt securities, by contractual maturity, as of September 30, 2023 (in millions): Due after 1 year through 5 years $ 74,427 Due after 5 years through 10 years 9,964 Due after 10 years 16,153 Total fair value $ 100,544 The Company’s investments in marketable debt securities have been classified and accounted for as available-for-sale. The Company classifies marketable debt securities as either current or non-current based solely on each instrument’s underlying contractual maturity date. Derivative Instruments and Hedging The Company may use derivative instruments to partially offset its business exposure to foreign exchange and interest rate risk. However, the Company may choose not to hedge certain exposures for a variety of reasons including accounting considerations or the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign exchange or interest rates. The Company classifies cash flows related to derivative instruments in the same section of the Consolidated Statements of Cash Flows as the items being hedged, which are generally classified as operating activities. Foreign Exchange Rate Risk To protect gross margins from fluctuations in foreign exchange rates, the Company may use forwards, options or other instruments, and may designate these instruments as cash flow hedges. The Company generally hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months. To protect the Company’s foreign currency–denominated term debt or marketable securities from fluctuations in foreign exchange rates, the Company may use forwards, cross-currency swaps or other instruments. The Company designates these instruments as either cash flow or fair value hedges. As of September 30, 2023, the maximum length of time over which the Company is hedging its exposure to the variability in future cash flows for term debt–related foreign currency transactions is 19 years. The Company may also use derivative instruments that are not designated as accounting hedges to protect gross margins from certain fluctuations in foreign exchange rates, as well as to offset a portion of the foreign currency gains and losses generated by the remeasurement of certain assets and liabilities denominated in non-functional currencies. Interest Rate Risk To protect the Company’s term debt or marketable securities from fluctuations in interest rates, the Company may use interest rate swaps, options or other instruments. The Company designates these instruments as either cash flow or fair value hedges. The notional amounts of the Company’s outstanding derivative instruments as of September 30, 2023 and September 24, 2022 were as follows (in millions): 2023 2022 Derivative instruments designated as accounting hedges: Foreign exchange contracts $ 74,730 $ 102,670 Interest rate contracts $ 19,375 $ 20,125 Derivative instruments not designated as accounting hedges: Foreign exchange contracts $ 104,777 $ 185,381 Apple Inc. | 2023 Form 10-K | 37 The gross fair values of the Company’s derivative assets and liabilities as of September 24, 2022 were as follows (in millions): 2022 Fair Value of Derivatives Designated as Accounting Hedges Fair Value of Derivatives Not Designated as Accounting Hedges Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 4,317 $ 2,819 $ 7,136 Derivative liabilities (2) : Foreign exchange contracts $ 2,205 $ 2,547 $ 4,752 Interest rate contracts $ 1,367 $ — $ 1,367 (1) Derivative assets are measured using Level 2 fair value inputs and are included in other current assets and other non-current assets in the Consolidated Balance Sheet. (2) Derivative liabilities are measured using Level 2 fair value inputs and are included in other current liabilities and other non-current liabilities in the Consolidated Balance Sheet. The derivative assets above represent the Company’s gross credit exposure if all counterparties failed to perform. To mitigate credit risk, the Company generally uses collateral security arrangements that provide for collateral to be received or posted when the net fair values of certain derivatives fluctuate from contractually established thresholds. To further limit credit risk, the Company generally uses master netting arrangements with the respective counterparties to the Company’s derivative contracts, under which the Company is allowed to settle transactions with a single net amount payable by one party to the other. As of September 24, 2022, the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $ 7.8 billion, resulting in a net derivative asset of $ 412 million. The carrying amounts of the Company’s hedged items in fair value hedges as of September 30, 2023 and September 24, 2022 were as follows (in millions): 2023 2022 Hedged assets/(liabilities): Current and non-current marketable securities $ 14,433 $ 13,378 Current and non-current term debt $ ( 18,247 ) $ ( 18,739 ) Accounts Receivable Trade Receivables As of September 24, 2022, the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10 %. The Company’s third-party cellular network carriers accounted for 41 % and 44 % of total trade receivables as of September 30, 2023 and September 24, 2022, respectively. The Company requires third-party credit support or collateral from certain customers to limit credit risk. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture subassemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. The Company does not reflect the sale of these components in products net sales. Rather, the Company recognizes any gain on these sales as a reduction of products cost of sales when the related final products are sold by the Company. As of September 30, 2023, the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 48 % and 23 %. As of September 24, 2022, the Company had two vendors that individually represented 10% or more of total vendor non-trade receivables, which accounted for 54 % and 13 %. Apple Inc. | 2023 Form 10-K | 38 Note 5 – Property, Plant and Equipment The following table shows the Company’s gross property, plant and equipment by major asset class and accumulated depreciation as of September 30, 2023 and September 24, 2022 (in millions): 2023 2022 Land and buildings $ 23,446 $ 22,126 Machinery, equipment and internal-use software 78,314 81,060 Leasehold improvements 12,839 11,271 Gross property, plant and equipment 114,599 114,457 Accumulated depreciation ( 70,884 ) ( 72,340 ) Total property, plant and equipment, net $ 43,715 $ 42,117 Depreciation expense on property, plant and equipment was $ 8.5 billion, $ 8.7 billion and $ 9.5 billion during 2023, 2022 and 2021, respectively. Note 6 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 30, 2023 and September 24, 2022 (in millions): Other Non-Current Assets 2023 2022 Deferred tax assets $ 17,852 $ 15,375 Other non-current assets 46,906 39,053 Total other non-current assets $ 64,758 $ 54,428 Other Current Liabilities 2023 2022 Income taxes payable $ 8,819 $ 6,552 Other current liabilities 50,010 54,293 Total other current liabilities $ 58,829 $ 60,845 Other Non-Current Liabilities 2023 2022 Long-term taxes payable $ 15,457 $ 16,657 Other non-current liabilities 34,391 32,485 Total other non-current liabilities $ 49,848 $ 49,142 Other Income/(Expense), Net The following table shows the detail of other income/(expense), net for 2023, 2022 and 2021 (in millions): 2023 2022 2021 Interest and dividend income $ 3,750 $ 2,825 $ 2,843 Interest expense ( 3,933 ) ( 2,931 ) ( 2,645 ) Other income/(expense), net ( 382 ) ( 228 ) 60 Total other income/(expense), net $ ( 565 ) $ ( 334 ) $ 258 Apple Inc. | 2023 Form 10-K | 39 Note 7 – Income Taxes Provision for Income Taxes and Effective Tax Rate The provision for income taxes for 2023, 2022 and 2021, consisted of the following (in millions): 2023 2022 2021 Federal: Current $ 9,445 $ 7,890 $ 8,257 Deferred ( 3,644 ) ( 2,265 ) ( 7,176 ) Total 5,801 5,625 1,081 State: Current 1,570 1,519 1,620 Deferred ( 49 ) 84 ( 338 ) Total 1,521 1,603 1,282 Foreign: Current 8,750 8,996 9,424 Deferred 669 3,076 2,740 Total 9,419 12,072 12,164 Provision for income taxes $ 16,741 $ 19,300 $ 14,527 The foreign provision for income taxes is based on foreign pretax earnings of $ 72.9 billion, $ 71.3 billion and $ 68.7 billion in 2023, 2022 and 2021, respectively. A reconciliation of the provision for income taxes to the amount computed by applying the statutory federal income tax rate ( 21 % in 2023, 2022 and 2021) to income before provision for income taxes for 2023, 2022 and 2021, is as follows (dollars in millions): 2023 2022 2021 Computed expected tax $ 23,885 $ 25,012 $ 22,933 State taxes, net of federal effect 1,124 1,518 1,151 Earnings of foreign subsidiaries ( 5,744 ) ( 4,366 ) ( 4,715 ) Research and development credit, net ( 1,212 ) ( 1,153 ) ( 1,033 ) Excess tax benefits from equity awards ( 1,120 ) ( 1,871 ) ( 2,137 ) Foreign-derived intangible income deduction — ( 296 ) ( 1,372 ) Other ( 192 ) 456 ( 300 ) Provision for income taxes $ 16,741 $ 19,300 $ 14,527 Effective tax rate 14.7 % 16.2 % 13.3 % Apple Inc. | 2023 Form 10-K | 40 Deferred Tax Assets and Liabilities As of September 30, 2023 and September 24, 2022, the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2023 2022 Deferred tax assets: Tax credit carryforwards $ 8,302 $ 6,962 Accrued liabilities and other reserves 6,365 6,515 Capitalized research and development 6,294 1,267 Deferred revenue 4,571 5,742 Unrealized losses 2,447 2,913 Lease liabilities 2,421 2,400 Other 2,343 3,407 Total deferred tax assets 32,743 29,206 Less: Valuation allowance ( 8,374 ) ( 7,530 ) Total deferred tax assets, net 24,369 21,676 Deferred tax liabilities: Right-of-use assets 2,179 2,163 Depreciation 1,998 1,582 Minimum tax on foreign earnings 1,940 1,983 Unrealized gains 511 942 Other 490 469 Total deferred tax liabilities 7,118 7,139 Net deferred tax assets $ 17,251 $ 14,537 As of September 30, 2023, the Company had $ 5.2 billion in foreign tax credit carryforwards in Ireland and $ 3.0 billion in California R&D credit carryforwards, both of which can be carried forward indefinitely. A valuation allowance has been recorded for the credit carryforwards and a portion of other temporary differences. Uncertain Tax Positions As of September 30, 2023, the total amount of gross unrecognized tax benefits was $ 19.5 billion, of which $ 9.5 billion, if recognized, would impact the Company’s effective tax rate. As of September 24, 2022, the total amount of gross unrecognized tax benefits was $ 16.8 billion, of which $ 8.0 billion, if recognized, would have impacted the Company’s effective tax rate. The aggregate change in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2023, 2022 and 2021, is as follows (in millions): 2023 2022 2021 Beginning balances $ 16,758 $ 15,477 $ 16,475 Increases related to tax positions taken during a prior year 2,044 2,284 816 Decreases related to tax positions taken during a prior year ( 1,463 ) ( 1,982 ) ( 1,402 ) Increases related to tax positions taken during the current year 2,628 1,936 1,607 Decreases related to settlements with taxing authorities ( 19 ) ( 28 ) ( 1,838 ) Decreases related to expiration of the statute of limitations ( 494 ) ( 929 ) ( 181 ) Ending balances $ 19,454 $ 16,758 $ 15,477 The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisd ictions. Tax years after 2017 for the U.S. federal jurisdiction, and after 2014 in certain major foreign jurisdictions, remain subject to examination. Altho ugh the timing of resolution or closure of examinations is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease in the next 12 months by as much as $ 4.5 billion. Apple Inc. | 2023 Form 10-K | 41 European Commission State Aid Decision On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the “State Aid Decision”). The State Aid Decision ordered Ireland to calculate and recover additional taxes from the Company for the period June 2003 through December 2014. Irish legislative changes, effective as of January 2015, eliminated the application of the tax opinions from that date forward. The recovery amount was calculated to be € 13.1 billion, plus interest of € 1.2 billion. The Company and Ireland appealed the State Aid Decision to the General Court of the Court of Justice of the European Union (the “General Court”). On July 15, 2020, the General Court annulled the State Aid Decision. On September 25, 2020, the European Commission appealed the General Court’s decision to the European Court of Justice (the “ECJ”) and a hearing was held on May 23, 2023. A decision from the ECJ is expected in calendar year 2024. The Company believes it would be eligible to claim a U.S. foreign tax credit for a portion of any incremental Irish corporate income taxes potentially due related to the State Aid Decision. On an annual basis, the Company may request approval from the Irish Minister for Finance to reduce the recovery amount for certain taxes paid to other countries. As of September 30, 2023, the adjusted recovery amount was € 12.7 billion, excluding interest. The adjusted recovery amount plus interest is funded into escrow, where it will remain restricted from general use pending the conclusion of all legal proceedings. Refer to the Cash, Cash Equivalents and Marketable Securities section of Note 4, “Financial Instruments” for more information. Note 8 – Leases The Company has lease arrangements for certain equipment and facilities, including corporate, data center, manufacturing and retail space. These leases typically have original terms not exceeding 10 years and generally contain multiyear renewal options, some of which are reasonably certain of exercise. Payments under the Company’s lease arrangements may be fixed or variable, and variable lease payments are primarily based on purchases of output of the underlying leased assets. Lease costs associated with fixed payments on the Company’s operating leases were $ 2.0 billion, $ 1.9 billion and $ 1.7 billion for 2023, 2022 and 2021, respectively. Lease costs associated with variable payments on the Company’s leases were $ 13.9 billion, $ 14.9 billion and $ 12.9 billion for 2023, 2022 and 2021, respectively. The Company made $ 1.9 billion, $ 1.8 billion and $ 1.4 billion of fixed cash payments related to operating leases in 2023, 2022 and 2021, respectively. Noncash activities involving right-of-use (“ROU”) assets obtained in exchange for lease liabilities were $ 2.1 billion, $ 2.8 billion and $ 3.3 billion for 2023, 2022 and 2021, respectively. The following table shows ROU assets and lease liabilities, and the associated financial statement line items, as of September 30, 2023 and September 24, 2022 (in millions): Lease-Related Assets and Liabilities Financial Statement Line Items 2023 2022 Right-of-use assets: Operating leases Other non-current assets $ 10,661 $ 10,417 Finance leases Property, plant and equipment, net 1,015 952 Total right-of-use assets $ 11,676 $ 11,369 Lease liabilities: Operating leases Other current liabilities $ 1,410 $ 1,534 Other non-current liabilities 10,408 9,936 Finance leases Other current liabilities 165 129 Other non-current liabilities 859 812 Total lease liabilities $ 12,842 $ 12,411 Apple Inc. | 2023 Form 10-K | 42 Lease liability maturities as of September 30, 2023, are as follows (in millions): Operating Leases Finance Leases Total 2024 $ 1,719 $ 196 $ 1,915 2025 1,875 151 2,026 2026 1,732 120 1,852 2027 1,351 52 1,403 2028 1,181 34 1,215 Thereafter 5,983 872 6,855 Total undiscounted liabilities 13,841 1,425 15,266 Less: Imputed interest ( 2,023 ) ( 401 ) ( 2,424 ) Total lease liabilities $ 11,818 $ 1,024 $ 12,842 The weighted-average remaining lease term related to the Company’s lease liabilities as of September 30, 2023 and September 24, 2022 was 10.6 years and 10.1 years, respectively. The discount rate related to the Company’s lease liabilities as of September 30, 2023 and September 24, 2022 was 3.0 % and 2.3 %, respectively. The discount rates related to the Company’s lease liabilities are generally based on estimates of the Company’s incremental borrowing rate, as the discount rates implicit in the Company’s leases cannot be readily determined. As of September 30, 2023, the Company had $ 544 million of future payments under additional leases, primarily for corporate facilities and retail space, that had not yet commenced. These leases will commence between 2024 and 2026, with lease terms ranging from 1 year to 21 years. Note 9 – Debt Commercial Paper The Company issues unsecured short-term promissory notes pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 30, 2023 and September 24, 2022, the Company had $ 6.0 billion and $ 10.0 billion of commercial paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s commercial paper was 5.28 % and 2.31 % as of September 30, 2023 and September 24, 2022, respectively. The following table provides a summary of cash flows associated with the issuance and maturities of commercial paper for 2023, 2022 and 2021 (in millions): 2023 2022 2021 Maturities 90 days or less: Proceeds from/(Repayments of) commercial paper, net $ ( 1,333 ) $ 5,264 $ ( 357 ) Maturities greater than 90 days: Proceeds from commercial paper — 5,948 7,946 Repayments of commercial paper ( 2,645 ) ( 7,257 ) ( 6,567 ) Proceeds from/(Repayments of) commercial paper, net ( 2,645 ) ( 1,309 ) 1,379 Total proceeds from/(repayments of) commercial paper, net $ ( 3,978 ) $ 3,955 $ 1,022 Apple Inc. | 2023 Form 10-K | 43 Term Debt The Company has outstanding Notes, which are senior unsecured obligations with interest payable in arrears. The following table provides a summary of the Company’s term debt as of September 30, 2023 and September 24, 2022: Maturities (calendar year) 2023 2022 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 – 2022 debt issuances: Fixed-rate 0.000 % – 4.650 % notes 2024 – 2062 $ 101,322 0.03 % – 6.72 % $ 111,824 0.03 % – 4.78 % Third quarter 2023 debt issuance: Fixed-rate 4.000 % – 4.850 % notes 2026 – 2053 5,250 4.04 % – 4.88 % — Total term debt principal 106,572 111,824 Unamortized premium/(discount) and issuance costs, net ( 356 ) ( 374 ) Hedge accounting fair value adjustments ( 1,113 ) ( 1,363 ) Total term debt 105,103 110,087 Less: Current portion of term debt ( 9,822 ) ( 11,128 ) Total non-current portion of term debt $ 95,281 $ 98,959 To manage interest rate risk on certain of its U.S. dollar–denominated fixed-rate notes, the Company uses interest rate swaps to effectively convert the fixed interest rates to floating interest rates on a portion of these notes. Additionally, to manage foreign exchange rate risk on certain of its foreign currency–denominated notes, the Company uses cross-currency swaps to effectively convert these notes to U.S. dollar–denominated notes. The effective interest rates for the Notes include the interest on the Notes, amortization of the discount or premium and, if applicable, adjustments related to hedging. The Company recognized $ 3.7 billion, $ 2.8 billion and $ 2.6 billion of interest expense on its term debt for 2023, 2022 and 2021, respectively. The future principal payments for the Company’s Notes as of September 30, 2023, are as follows (in millions): 2024 $ 9,943 2025 10,775 2026 12,265 2027 9,786 2028 7,800 Thereafter 56,003 Total term debt principal $ 106,572 As of September 30, 2023 and September 24, 2022, the fair value of the Company’s Notes, based on Level 2 inputs, was $ 90.8 billion and $ 98.8 billion, respectively. Note 10 – Shareholders’ Equity Share Repurchase Program During 2023, the Company repurchased 471 million shares of its common stock for $ 76.6 billion, excluding excise tax due under the Inflation Reduction Act of 2022. The Company’s share repurchase programs do not obligate the Company to acquire a minimum amount of shares. Under the programs, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. Apple Inc. | 2023 Form 10-K | 44 Shares of Common Stock The following table shows the changes in shares of common stock for 2023, 2022 and 2021 (in thousands): 2023 2022 2021 Common stock outstanding, beginning balances 15,943,425 16,426,786 16,976,763 Common stock repurchased ( 471,419 ) ( 568,589 ) ( 656,340 ) Common stock issued, net of shares withheld for employee taxes 78,055 85,228 106,363 Common stock outstanding, ending balances 15,550,061 15,943,425 16,426,786 Note 11 – Share-Based Compensation 2022 Employee Stock Plan The Apple Inc. 2022 Employee Stock Plan (the “2022 Plan”) is a shareholder-approved plan that provides for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights. RSUs granted under the 2022 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. All RSUs granted under the 2022 Plan have dividend equivalent rights, which entitle holders of RSUs to the same dividend value per share as holders of common stock. A maximum of approximately 1.3 billion shares were authorized for issuance pursuant to 2022 Plan awards at the time the plan was approved on March 4, 2022. 2014 Employee Stock Plan The Apple Inc. 2014 Employee Stock Plan (the “2014 Plan”) is a shareholder-approved plan that provided for broad-based equity grants to employees, including executive officers. The 2014 Plan permitted the granting of substantially the same types of equity awards with substantially the same terms as the 2022 Plan. The 2014 Plan also permitted the granting of cash bonus awards. In the third quarter of 2022, the Company terminated the authority to grant new awards under the 2014 Plan. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2023, 2022 and 2021, is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per RSU Aggregate Fair Value (in millions) Balance as of September 26, 2020 310,778 $ 51.58 RSUs granted 89,363 $ 116.33 RSUs vested ( 145,766 ) $ 50.71 RSUs canceled ( 13,948 ) $ 68.95 Balance as of September 25, 2021 240,427 $ 75.16 RSUs granted 91,674 $ 150.70 RSUs vested ( 115,861 ) $ 72.12 RSUs canceled ( 14,739 ) $ 99.77 Balance as of September 24, 2022 201,501 $ 109.48 RSUs granted 88,768 $ 150.87 RSUs vested ( 101,878 ) $ 97.31 RSUs canceled ( 8,144 ) $ 127.98 Balance as of September 30, 2023 180,247 $ 135.91 $ 30,860 The fair value as of the respective vesting dates of RSUs was $ 15.9 billion, $ 18.2 billion and $ 19.0 billion for 2023, 2022 and 2021, respectively. The majority of RSUs that vested in 2023, 2022 and 2021 were net share settled such that the Company withheld shares with a value equivalent to the employees’ obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 37 million, 41 million and 53 million for 2023, 2022 and 2021, respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments to taxing authorities for employees’ tax obligations were $ 5.6 billion, $ 6.4 billion and $ 6.8 billion in 2023, 2022 and 2021, respectively. Apple Inc. | 2023 Form 10-K | 45 Share-Based Compensation The following table shows share-based compensation expense and the related income tax benefit included in the Consolidated Statements of Operations for 2023, 2022 and 2021 (in millions): 2023 2022 2021 Share-based compensation expense $ 10,833 $ 9,038 $ 7,906 Income tax benefit related to share-based compensation expense $ ( 3,421 ) $ ( 4,002 ) $ ( 4,056 ) As of September 30, 2023, the total unrecognized compensation cost related to outstanding RSUs was $ 18.6 billion, which the Company expects to recognize over a weighted-average period of 2.5 years. Note 12 – Commitments, Contingencies and Supply Concentrations Unconditional Purchase Obligations The Company has entered into certain off–balance sheet commitments that require the future purchase of goods or services (“unconditional purchase obligations”). The Company’s unconditional purchase obligations primarily consist of supplier arrangements, licensed intellectual property and content, and distribution rights. Future payments under noncancelable unconditional purchase obligations with a remaining term in excess of one year as of September 30, 2023, are as follows (in millions): 2024 $ 4,258 2025 2,674 2026 3,434 2027 1,277 2028 5,878 Thereafter 3,215 Total $ 20,736 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully resolved. The outcome of litigation is inherently uncertain. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss greater than a recorded accrual, concerning loss contingencies for asserted legal and other claims. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain components are currently obtained from single or limited sources. The Company also competes for various components with other participants in the markets for smartphones, personal computers, tablets, wearables and accessories. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant commodity pricing fluctuations. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or their manufacturing capacities have increased. The continued availability of these components at acceptable prices, or at all, may be affected if suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in China mainland, India, Japan, South Korea, Taiwan and Vietnam. Apple Inc. | 2023 Form 10-K | 46 Note 13 – Segment Information and Geographic Data The Company manages its business primarily on a geographic basis. The Company’s reportable segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. Americas includes both North and South America. Europe includes European countries, as well as India, the Middle East and Africa. Greater China includes China mainland, Hong Kong and Taiwan. Rest of Asia Pacific includes Australia and those Asian countries not included in the Company’s other reportable segments. Although the reportable segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The Company evaluates the performance of its reportable segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment consists of net sales to third parties, related cost of sales, and operating expenses directly attributable to the segment. The information provided to the Company’s chief operating decision maker for purposes of making decisions and assessing segment performance excludes asset information. The following table shows information by reportable segment for 2023, 2022 and 2021 (in millions): 2023 2022 2021 Americas: Net sales $ 162,560 $ 169,658 $ 153,306 Operating income $ 60,508 $ 62,683 $ 53,382 Europe: Net sales $ 94,294 $ 95,118 $ 89,307 Operating income $ 36,098 $ 35,233 $ 32,505 Greater China: Net sales $ 72,559 $ 74,200 $ 68,366 Operating income $ 30,328 $ 31,153 $ 28,504 Japan: Net sales $ 24,257 $ 25,977 $ 28,482 Operating income $ 11,888 $ 12,257 $ 12,798 Rest of Asia Pacific: Net sales $ 29,615 $ 29,375 $ 26,356 Operating income $ 12,066 $ 11,569 $ 9,817 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2023, 2022 and 2021 is as follows (in millions): 2023 2022 2021 Segment operating income $ 150,888 $ 152,895 $ 137,006 Research and development expense ( 29,915 ) ( 26,251 ) ( 21,914 ) Other corporate expenses, net (1) ( 6,672 ) ( 7,207 ) ( 6,143 ) Total operating income $ 114,301 $ 119,437 $ 108,949 (1) Includes corporate marketing expenses, certain share-based compensation expenses, various nonrecurring charges, and other separately managed general and administrative costs. Apple Inc. | 2023 Form 10-K | 47 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2023, 2022 and 2021. Net sales for 2023, 2022 and 2021 and long-lived assets as of September 30, 2023 and September 24, 2022 were as follows (in millions): 2023 2022 2021 Net sales: U.S. $ 138,573 $ 147,859 $ 133,803 China (1) 72,559 74,200 68,366 Other countries 172,153 172,269 163,648 Total net sales $ 383,285 $ 394,328 $ 365,817 2023 2022 Long-lived assets: U.S. $ 33,276 $ 31,119 China (1) 5,778 7,260 Other countries 4,661 3,738 Total long-lived assets $ 43,715 $ 42,117 (1) China includes Hong Kong and Taiwan. Apple Inc. | 2023 Form 10-K | 48 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 30, 2023 and September 24, 2022, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 30, 2023, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of Apple Inc. at September 30, 2023 and September 24, 2022, and the results of its operations and its cash flows for each of the three years in the period ended September 30, 2023, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), Apple Inc.’s internal control over financial reporting as of September 30, 2023, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated November 2, 2023 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of Apple Inc.’s management. Our responsibility is to express an opinion on Apple Inc.’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. Uncertain Tax Positions Description of the Matter As discussed in Note 7 to the financial statements, Apple Inc. is subject to taxation and files income tax returns in the U.S. federal jurisdiction and many state and foreign jurisdictions. As of September 30, 2023, the total amount of gross unrecognized tax benefits was $ 19.5 billion, of which $ 9.5 billion, if recognized, would impact Apple Inc.’s effective tax rate. In accounting for some of the uncertain tax positions, Apple Inc. uses significant judgment in the interpretation and application of complex domestic and international tax laws. Auditing management’s evaluation of whether an uncertain tax position is more likely than not to be sustained and the measurement of the benefit of various tax positions can be complex, involves significant judgment, and is based on interpretations of tax laws and legal rulings. Apple Inc. | 2023 Form 10-K | 49 How We Addressed the Matter in Our Audit We tested controls relating to the evaluation of uncertain tax positions, including controls over management’s assessment as to whether tax positions are more likely than not to be sustained, management’s process to measure the benefit of its tax positions, and the development of the related disclosures. To evaluate Apple Inc.’s assessment of which tax positions are more likely than not to be sustained, our audit procedures included, among others, reading and evaluating management’s assumptions and analysis, and, as applicable, Apple Inc.’s communications with taxing authorities, that detailed the basis and technical merits of the uncertain tax positions. We involved our tax subject matter resources in assessing the technical merits of certain of Apple Inc.’s tax positions based on our knowledge of relevant tax laws and experience with related taxing authorities. For certain tax positions, we also received external legal counsel confirmation letters and discussed the matters with external advisors and Apple Inc. tax personnel. In addition, we evaluated Apple Inc.’s disclosure in relation to these matters included in Note 7 to the financial statements. /s/ Ernst & Young LLP We have served as Apple Inc.’s auditor since 2009. San Jose, California November 2, 2023 Apple Inc. | 2023 Form 10-K | 50 Report of Independent Registered Public Accounting Firm To the Shareholders and the Board of Directors of Apple Inc. Opinion on Internal Control Over Financial Reporting We have audited Apple Inc.’s internal control over financial reporting as of September 30, 2023, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the “COSO criteria”). In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 30, 2023, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the “PCAOB”), the consolidated balance sheets of Apple Inc. as of September 30, 2023 and September 24, 2022, the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 30, 2023, and the related notes and our report dated November 2, 2023 expressed an unqualified opinion thereon. Basis for Opinion Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on Apple Inc.’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to Apple Inc. in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California November 2, 2023 Apple Inc. | 2023 Form 10-K | 51 Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A.    Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 30, 2023 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 30, 2023 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2023, which were identified in connection with management’s evaluation required by paragraph (d) of Rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Apple Inc. | 2023 Form 10-K | 52 Item 9B.    Other Information Insider Trading Arrangements On August 30, 2023 , Deirdre O’Brien , the Company’s Senior Vice President, Retail , and Jeff Williams , the Company’s Chief Operating Officer , each entered into a trading plan intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) under the Exchange Act. The plans provide for the sale of all shares vested during the duration of the plans pursuant to certain equity awards granted to Ms. O’Brien and Mr. Williams, respectively, excluding any shares withheld by the Company to satisfy income tax withholding and remittance obligations. Ms. O’Brien’s plan will expire on October 15, 2024, and Mr. Williams’ plan will expire on December 15, 2024, subject to early termination for certain specified events set forth in the plans. Item 9C.    Disclosure Regarding Foreign Jurisdictions that Prevent Inspections Not applicable. PART III Item 10.    Directors, Executive Officers and Corporate Governance The information required by this Item will be included in the Company’s definitive proxy statement to be filed with the SEC within 120 days after September 30, 2023, in connection with the solicitation of proxies for the Company’s 2024 annual meeting of shareholders (the “2024 Proxy Statement”), and is incorporated herein by reference. Item 11.    Executive Compensation The information required by this Item will be included in the 2024 Proxy Statement, and is incorporated herein by reference. Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item will be included in the 2024 Proxy Statement, and is incorporated herein by reference. Item 13.    Certain Relationships and Related Transactions, and Director Independence The information required by this Item will be included in the 2024 Proxy Statement, and is incorporated herein by reference. Item 14.    Principal Accountant Fees and Services The information required by this Item will be included in the 2024 Proxy Statement, and is incorporated herein by reference. Apple Inc. | 2023 Form 10-K | 53 PART IV Item 15.    Exhibit and Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 28 Consolidated Statements of Comprehensive Income for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 29 Consolidated Balance Sheets as of September 30, 2023 and September 24, 2022 30 Consolidated Statements of Shareholders’ Equity for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 31 Consolidated Statements of Cash Flows for the years ended September 30, 2023, September 24, 2022 and September 25, 2021 32 Notes to Consolidated Financial Statements 33 Reports of Independent Registered Public Accounting Firm* 49 * Ernst & Young LLP, PCAOB Firm ID No. 000 42 . (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and accompanying notes included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant filed on August 3, 2020. 8-K 3.1 8/7/20 3.2 Amended and Restated Bylaws of the Registrant effective as of August 17, 2022. 8-K 3.2 8/19/22 4.1** Description of Securities of the Registrant. 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.9 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 Apple Inc. | 2023 Form 10-K | 54 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.10 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.11 Supplement No. 1 to the Officer’s Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.12 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 4.13 Officer’s Certificate of the Registrant, dated as of February 9, 2017, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.550% Notes due 2019, 1.900% Notes due 2020, 2.500% Notes due 2022, 3.000% Notes due 2024, 3.350% Notes due 2027 and 4.250% Notes due 2047. 8-K 4.1 2/9/17 4.14 Officer’s Certificate of the Registrant, dated as of May 11, 2017, including forms of global notes representing the Floating Rate Notes due 2020, Floating Rate Notes due 2022, 1.800% Notes due 2020, 2.300% Notes due 2022, 2.850% Notes due 2024 and 3.200% Notes due 2027. 8-K 4.1 5/11/17 4.15 Officer’s Certificate of the Registrant, dated as of May 24, 2017, including forms of global notes representing the 0.875% Notes due 2025 and 1.375% Notes due 2029. 8-K 4.1 5/24/17 4.16 Officer’s Certificate of the Registrant, dated as of June 20, 2017, including form of global note representing the 3.000% Notes due 2027. 8-K 4.1 6/20/17 4.17 Officer’s Certificate of the Registrant, dated as of August 18, 2017, including form of global note representing the 2.513% Notes due 2024. 8-K 4.1 8/18/17 4.18 Officer’s Certificate of the Registrant, dated as of September 12, 2017, including forms of global notes representing the 1.500% Notes due 2019, 2.100% Notes due 2022, 2.900% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 9/12/17 4.19 Officer’s Certificate of the Registrant, dated as of November 13, 2017, including forms of global notes representing the 1.800% Notes due 2019, 2.000% Notes due 2020, 2.400% Notes due 2023, 2.750% Notes due 2025, 3.000% Notes due 2027 and 3.750% Notes due 2047. 8-K 4.1 11/13/17 4.20 Indenture, dated as of November 5, 2018, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 11/5/18 4.21 Officer’s Certificate of the Registrant, dated as of September 11, 2019, including forms of global notes representing the 1.700% Notes due 2022, 1.800% Notes due 2024, 2.050% Notes due 2026, 2.200% Notes due 2029 and 2.950% Notes due 2049. 8-K 4.1 9/11/19 4.22 Officer’s Certificate of the Registrant, dated as of November 15, 2019, including forms of global notes representing the 0.000% Notes due 2025 and 0.500% Notes due 2031. 8-K 4.1 11/15/19 4.23 Officer’s Certificate of the Registrant, dated as of May 11, 2020, including forms of global notes representing the 0.750% Notes due 2023, 1.125% Notes due 2025, 1.650% Notes due 2030 and 2.650% Notes due 2050. 8-K 4.1 5/11/20 4.24 Officer’s Certificate of the Registrant, dated as of August 20, 2020, including forms of global notes representing the 0.550% Notes due 2025, 1.25% Notes due 2030, 2.400% Notes due 2050 and 2.550% Notes due 2060. 8-K 4.1 8/20/20 4.25 Officer’s Certificate of the Registrant, dated as of February 8, 2021, including forms of global notes representing the 0.700% Notes due 2026, 1.200% Notes due 2028, 1.650% Notes due 2031, 2.375% Notes due 2041, 2.650% Notes due 2051 and 2.800% Notes due 2061. 8-K 4.1 2/8/21 4.26 Officer’s Certificate of the Registrant, dated as of August 5, 2021, including forms of global notes representing the 1.400% Notes due 2028, 1.700% Notes due 2031, 2.700% Notes due 2051 and 2.850% Notes due 2061. 8-K 4.1 8/5/21 4.27 Indenture, dated as of October 28, 2021, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 10/29/21 4.28 Officer’s Certificate of the Registrant, dated as of August 8, 2022, including forms of global notes representing the 3.250% Notes due 2029, 3.350% Notes due 2032, 3.950% Notes due 2052 and 4.100% Notes due 2062. 8-K 4.1 8/8/22 Apple Inc. | 2023 Form 10-K | 55 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 4.29 Officer’s Certificate of the Registrant, dated as of May 10, 2023, including forms of global notes representing the 4.421% Notes due 2026, 4.000% Notes due 2028, 4.150% Notes due 2030, 4.300% Notes due 2033 and 4.850% Notes due 2053. 8-K 4.1 5/10/23 4.30* Apple Inc. Deferred Compensation Plan. S-8 4.1 8/23/18 10.1* Apple Inc. Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* Apple Inc. Non-Employee Director Stock Plan, as amended November 9, 2021. 10-Q 10.1 12/25/21 10.4* Apple Inc. 2014 Employee Stock Plan, as amended and restated as of October 1, 2017. 10-K 10.8 9/30/17 10.5* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 26, 2017. 10-K 10.20 9/30/17 10.6* Form of Restricted Stock Unit Award Agreement under Non-Employee Director Stock Plan effective as of February 13, 2018. 10-Q 10.2 3/31/18 10.7* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.17 9/29/18 10.8* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 21, 2018. 10-K 10.18 9/29/18 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.15 9/28/19 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of September 29, 2019. 10-K 10.16 9/28/19 10.11* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 18, 2020. 10-K 10.16 9/26/20 10.12* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 18, 2020. 10-K 10.17 9/26/20 10.13* Form of CEO Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of September 27, 2020. 10-Q 10.1 12/26/20 10.14* Form of CEO Performance Award Agreement under 2014 Employee Stock Plan effective as of September 27, 2020. 10-Q 10.2 12/26/20 10.15* Apple Inc. 2022 Employee Stock Plan. 8-K 10.1 3/4/22 10.16* Form of Restricted Stock Unit Award Agreement under 2022 Employee Stock Plan effective as of March 4, 2022. 8-K 10.2 3/4/22 10.17* Form of Performance Award Agreement under 2022 Employee Stock Plan effective as of March 4, 2022. 8-K 10.3 3/4/22 10.18* Apple Inc. Executive Cash Incentive Plan. 8-K 10.1 8/19/22 10.19* Form of CEO Restricted Stock Unit Award Agreement under 2022 Employee Stock Plan effective as of September 25, 2022. 10-Q 10.1 12/31/22 10.20* Form of CEO Performance Award Agreement under 2022 Employee Stock Plan effective as of September 25, 2022. 10-Q 10.2 12/31/22 21.1** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101** Inline XBRL Document Set for the consolidated financial statements and accompanying notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. Apple Inc. | 2023 Form 10-K | 56 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 104** Inline XBRL for the cover page of this Annual Report on Form 10-K, included in the Exhibit 101 Inline XBRL Document Set. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Item 16.    Form 10-K Summary None. Apple Inc. | 2023 Form 10-K | 57 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: November 2, 2023 Apple Inc. By: /s/ Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/ Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) November 2, 2023 TIMOTHY D. COOK /s/ Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) November 2, 2023 LUCA MAESTRI /s/ Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) November 2, 2023 CHRIS KONDO /s/ James A. Bell Director November 2, 2023 JAMES A. BELL /s/ Al Gore Director November 2, 2023 AL GORE /s/ Alex Gorsky Director November 2, 2023 ALEX GORSKY /s/ Andrea Jung Director November 2, 2023 ANDREA JUNG /s/ Arthur D. Levinson Director and Chair of the Board November 2, 2023 ARTHUR D. LEVINSON /s/ Monica Lozano Director November 2, 2023 MONICA LOZANO /s/ Ronald D. Sugar Director November 2, 2023 RONALD D. SUGAR /s/ Susan L. Wagner Director November 2, 2023 SUSAN L. WAGNER Apple Inc. | 2023 Form 10-K | 58 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-95-000016/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-95-000016/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-96-000023/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000320193-96-000023/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000912057-00-053623/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000912057-00-053623/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000912057-99-010244/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0000912057-99-010244/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-02-007674/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-02-007674/full-submission.txt new file mode 100644 index 0000000..5586601 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-02-007674/full-submission.txt @@ -0,0 +1,1690 @@ +QuickLinks -- Click here to rapidly navigate through this document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 28, 2002 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 0-10030 APPLE COMPUTER, INC. (Exact name of Registrant as specified in its charter) CALIFORNIA (State or other jurisdiction of incorporation or organization) 942404110 (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California (Address of principal executive offices) 95014 (Zip Code) Registrant's +telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: None Securities +registered pursuant to Section 12(g) of the Act: Common Stock, no par value Common Share Purchase Rights (Titles of classes) Indicate +by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding +12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o Indicate +by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's +knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or any amendment to this +Form 10-K. ý Indicate +by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act +Rule 12b-2). Yes ý No o The +aggregate market value of voting stock held by nonaffiliates of the Registrant was approximately $4,925,788,282 as of December 6, 2002, based upon the closing price on the NASDAQ National Market +reported for such date. Shares of Common Stock held by each executive officer and director and by each person who beneficially owns more than 5% of the outstanding Common Stock have been excluded in +that such persons may under certain circumstances be deemed to be affiliates. This determination of executive officer or affiliate status is not necessarily a conclusive determination for other +purposes. 359,135,584 +shares of Common Stock Issued and Outstanding as of December 6, 2002 PART I The Business section and other parts of this Annual Report on Form 10-K ("Form 10-K") contain forward-looking +statements that involve risks and uncertainties. The Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such +differences include, but are not limited to, those discussed in the subsection entitled "Factors That May Affect Future Results and Financial Condition" under Part II, Item 7 of this +Form 10-K. Item 1. Business Company Background Apple Computer, Inc. ("Apple" or the "Company") was incorporated under the laws of the State of California on January 3, 1977. The Company designs, manufactures +and markets personal computers and related personal computing solutions for sale primarily to education, creative, consumer, and business customers. Substantially all of the Company's net sales over +the last five years have been derived from the sale of its Apple® Macintosh® line of personal computers and related software and peripherals. The Company's fiscal year ends on +the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company's fiscal calendar. Business Strategy Digital Hub Apple is committed to bringing the best possible personal computing experience to students, educators, creative professionals, businesses and consumers around the world through +its innovative hardware, +software, and Internet offerings. The Company believes that personal computing has entered a new era in which the personal computer functions for both professionals and consumers as the digital hub +for advanced new digital devices such as digital music players, personal digital assistants, cellular phones, digital still and movie cameras, CD and DVD players, and other electronic devices. The +attributes of the personal computer, including its ability to run complex applications, possess a high quality user interface, contain large and relatively inexpensive storage, and easily connect to +the Internet in multiple ways and at varying speeds, can individually add value to these devices and interconnect them as well. Apple is the only company in the personal computer industry that designs +and manufactures the entire personal computer—from the hardware and operating system to sophisticated applications. Apple ties it all together with its innovative industrial design, +intuitive ease-of-use, and built-in networking, graphics, and multimedia capabilities. Thus, the Company is uniquely positioned to offer digital hub products and +solutions. Apple +develops products and technologies that adhere to many industry standards in order to provide an optimized user experience through interoperability. Apple has played a role in the development, +enhancement, promotion, and/or use of numerous of these industry standards, many of which are discussed below. Retail Since inception of its retail initiative in 2001, the Company has opened 51 retail stores in the United States. The Company has located its stores at quality high traffic +locations in shopping malls and urban shopping districts. Before the end of the first quarter of 2003, the Company estimates that over 30% of the U.S. population will live within 15 miles of one of +its stores. In addition to its own hardware and software products, the Company's retail stores carry in inventory a variety of third-party hardware and software products. One +of the main goals of the retail initiative is to bring new customers to the Company and expand its installed base through sales to both first time computer buyers and those switching from other +computing platforms. By operating its own stores, the Company is able to better control the customer retail experience. The stores are designed to enhance the presentation and marketing of personal +computing 1 products. The stores employ experienced and knowledgeable personnel, provide post sale advice and support, offer a wide selection of third-party products selected to complement the Company's own +products, host training and marketing presentations, and provide certain hardware support services. Additionally, the stores provide a forum in which the Company is able to present entire computing +solutions to users in areas such as digital photography, digital video, music, children's software, and home computing. Recent survey results available to the Company indicate that approximately 40% +of customers buying systems in its stores do not currently own a Macintosh. Education For more than 25 years, the Company has focused on educational uses of technology. The Company believes that effective integration of technology into classroom +instruction can result in higher levels of student achievement, especially when used to support collaboration, information access, and the expression and representation of student thought and ideas. +The Company's commitment to education encompasses a range of products and services designed to help schools maximize their investments in technology. This commitment is manifest in many of the +Company's products and services, including hardware that meets the needs of education customers, video editing solutions, wireless networking capabilities, student information systems, and +high-quality curriculum and professional development solutions. Creative Professionals Creative professionals constitute one of the Company's most important markets for both hardware and software products. This market is also important to many third-party +developers who provide Macintosh-compatible hardware and software solutions. Creative customers utilize the Company's products for a variety of creative activities including digital video and film +production and editing; digital video and film special effects, compositing, and titling; digital still photography; graphic design, publishing, and print production; music performance and production; +audio production and sound design; and web design, development, and administration. The +Company designs its high-end hardware solutions, including servers and desktop and portable Macintosh systems, to incorporate the power, expandability, and features desired by creative +professionals. Additionally, the Company's client operating system, Mac OS® X, incorporates powerful graphics and audio technologies and features developer tools to optimize system and +application performance when running powerful creative solutions provided by the Company or by third-party developers. The Company also offers various software solutions to meet the needs of its +creative customers, many of which are described below. Business Organization The Company manages its business primarily on a geographic basis. The Company's geographic operating segments include the Americas, Europe, Japan, and Asia Pacific. The +Americas segment includes both North and South America, except for the Company's Retail segment which operates Apple-owned retail stores in the United States. The Europe segment includes European +countries as well as the Middle East and Africa. The Japan segment includes only Japan, while the Asia Pacific segment includes Australia and Asia except for Japan. Each geographic operating segment +provides similar hardware and software products and similar services. Non-geographic operating segments include the Company's subsidiary, FileMaker, Inc. and the Company's Retail segment. +Further information regarding the Company's operating segments may be found in Part II, Item 7 of this Form 10-K under the heading "Segment Operating Performance," and in +Part II, Item 8 on this Form 10-K in the Notes to Consolidated Financial Statements at Note 11, "Segment Information and Geographic Data." 2 Hardware Products The Company offers a range of personal computing products including desktop and notebook personal computers, related devices and peripherals, networking and connectivity +products, and various third-party hardware products. All of the Company's Macintosh products utilize PowerPC® RISC-based microprocessors. The Company's entire line of Macintosh +systems, excluding servers, features the Company's suite of software for digital photography, music, and movies. Further information regarding the Company's products may be found in Part II, +Item 7 of this Form 10-K under the heading "Factors That May Affect Future Results and Financial Condition." Power Mac ®G4 The +Power Mac line of desktop personal computers is targeted at business and professional users and is designed to meet the speed, expansion and networking needs of the most demanding Macintosh user. +The current Power Mac line features dual PowerPC G4 processors in all models, a new high-performance architecture, and on certain models Apple's SuperDrive™, a combination +CD-RW/DVD-R drive that can burn DVDs that can be played in most consumer DVD players. Xserve ™ During +the third quarter of 2002, the Company introduced and shipped Xserve™, a 1U rack-mount server designed for simple set up and remote management. Xserve was designed for +I/O intensive applications such as digital video, high-resolution digital imagery, and large databases. Xserve delivers high-speed networking, 15 gigaflops of computational +power, and almost a half terabyte of hot-plug storage. Server Admin, a new services monitoring and remote management tool, allows administrators to easily set up and manage all key Mac OS +X Server network services remotely. Server Monitor, a new hardware monitoring tool, allows system administrators to remotely monitor one or many servers. The Company offers a choice of services and +support programs including 4-hour onsite response, 24x7 technical support, AppleCare® Service Parts Kits and AppleCare Professional SupportLine and Tools program. PowerBook ® The +PowerBook family of portable computers is designed to meet the mobile computing needs of professionals and advanced consumer users. The Company's current PowerBook line, the Titanium PowerBook G4, +was introduced in January 2001. The Titanium PowerBook is a full-featured notebook computer that incorporates PowerPC G4 processors, thin film transistor ("TFT") +wide-screen active-matrix displays, integrated wireless capabilities, advanced networking and graphics capabilities, and on the latest version, a model with a built-in +slot-loading SuperDrive. The Titanium PowerBook G4 is 1-inch thick, weighs as little as 5.4 pounds and is encased in a pure-grade titanium body. iMac® The iMac line of desktop computers is targeted at education and consumer markets. The original iMac features innovative industrial design with a built-in +15-inch shadow-mask cathode ray tube ("CRT") display, easy Internet access, fan-less operation, and a PowerPC G3 processor, making it suitable for a wide range of +education and consumer applications. The Company offers its original CRT iMac design at a suggested retail price under $1,000. In +January 2002, the Company introduced the new iMac featuring an innovative industrial design that incorporates an adjustable 15-inch TFT active-matrix flat panel display and an +ultra-compact base. New iMac models with 15-inch displays are available in three base configurations and feature PowerPC G4 processors, advanced graphics capabilities, and a SuperDrive on +one model for playing and burning custom CDs and DVDs. In July 2002, the Company introduced an updated version of its new iMac that features a 17-inch TFT active-matrix flat panel +display, a high-end PowerPC G4 processor, and a SuperDrive. 3 eMac™ In April 2002, the Company introduced the eMac™, a new Macintosh desktop system designed for the Company's education customers. The eMac was made available +to consumers in June 2002. The eMac features a PowerPC G4 processor, a high resolution 17-inch flat CRT display, a SuperDrive option, and preserves the +all-in-one compact design of the original iMac favored by many of the Company's education and consumer customers. iBook ® Designed +for the portable computing needs of education and consumer users, the current iBook design was introduced in May of 2001. Current iBook models feature 12.1-inch or +14.1-inch TFT active-matrix displays, include integrated wireless capabilities, utilize PowerPC G3 processors, offer a choice of optical drive configurations, weigh as little as 4.9 +pounds, and have a long battery life. iBooks are currently available in a configuration with a suggested retail price under $1,000. iPod™ Introduced in October 2001, the original iPod portable digital music player utilized a 5GB hard disk drive allowing it to hold up to 1,000 CD-quality songs +in a 6.5 ounce design. The iPod features an intuitive user interface on a 2-inch liquid crystal display, automatic synchronization with a music collection on a Macintosh system via Apple's +iTunes ® digital music software, a high-speed FireWire® connection for power and data transfer and up to +10 hours of battery life. iPods also provide access to +contact and calendar information downloaded from other applications on a Macintosh system. By enhancing the overall functionality and integration of the digital music player and by expanding the +usefulness of digital music and other information stored on a computer, the iPod represents an important and natural extension of Apple's digital hub strategy. In March 2002, the Company added +a 10GB model to its iPod line, and in July 2002, the Company added a 20GB model and announced that all iPod models would be made available in Windows-compatible versions. The newer 10GB and +20GB iPod models come with carrying cases, wired remotes, and feature a solid-state touch wheel control. Peripheral Products The Company sells certain associated Apple-branded computer hardware peripherals, including a range of high quality flat panel TFT active-matrix digital color displays. The +Company also sells a variety of third-party Macintosh-compatible hardware products directly to end users through both its retail and online stores, including computer printers and printing supplies, +storage devices, computer memory, digital video and still cameras, personal digital assistants, digital music players and related accessories, and various other computing products and supplies. Software Products and Computer Technologies Operating System and Server Software During 2001, the Company introduced the first customer release of its new client operating system, Mac OS® X, and its first significant upgrade, Mac OS X version +10.1. At its introduction, Mac OS X offered advanced functionality built on an open-source UNIX-based foundation and incorporated the most fundamental changes in both core +technology and user interface design made by the Company to the Mac OS in a single upgrade since the original introduction of the Macintosh in 1984. Mac OS X features memory protection, +pre-emptive multi-tasking, and symmetric multiprocessing. Mac OS X includes Apple's Quartz™ 2D graphics engine (based on the Internet-standard Portable Document Format) for +enhanced graphics and broad font support, OpenGL for enhanced 3D graphics and gaming, and Apple's new user interface named "Aqua ® ," which +combines superior ease-of-use with new functionality. In January 2002, the Company made Mac OS X the default operating system on all new Macintosh systems. Mac OS X +allows users to run Mac OS 9 applications natively in the Classic compatibility environment in 4 Mac OS X. The Company also develops and distributes extensions to the Macintosh system software including utilities, languages, and developer tools. In +August 2002, the Company released Mac OS X version 10.2 (code named "Jaguar"), the current release of Mac OS X. Jaguar includes a new Mail application designed to manage junk mail; +iChat™, an AIM-compatible instant messenger; a system-wide Address Book; Inkwell™ handwriting recognition; +improved Universal Access; an enhanced Finder; an updated version of QuickTime®, the Company's multimedia software for playing, interacting with or viewing video, audio, and graphics +files; and an updated version of Sherlock®, the Company's advanced Internet search engine. Jaguar also features accelerated graphics performance, increased compatibility with Windows +networks, and a UNIX-based foundation with enhancements including FreeBSD 4.4 and GCC 3.1-based developer tools. Mac +OS X server software was initially introduced in May 2001. The current version of Mac OS X Server, Mac OS X Server version 10.2 (code named "Jaguar Server") was released in +August 2002. Jaguar Server is a UNIX-based operating system designed for superior performance and reliability. It delivers high-performance services for Internet and web +serving, filing, printing, and networking services needed to manage a network of Mac, UNIX, and Windows clients. Based on the Mach 3.0 microkernel and the BSD 4.4 operating system, Jaguar Server is a +modern UNIX-based server built on open standards. It provides performance and stability through full pre-emptive multi-tasking, symmetric multiprocessing, protected memory, +advanced virtual memory, software RAID support, and support for networking and security standards. Jaguar Server also includes Apple's Open Directory architecture for centralized management of network +resources using LDAPv3 directory services and a suite of built-in, standards-based Internet services like an optimized Apache web server for high-performance hosting of secure +dynamic web sites and QuickTime Streaming Server and QuickTime Broadcaster for streaming live events over the Internet. Jaguar Server also comes with a flexible mail server that supports POP and +secure IMAP, as well as WebMail for browser-based email access. Further +information regarding the introduction of and updates to Mac OS X and Mac OS X Server may be found in Part II, Item 7 of this Form 10-K under the heading "Factors +That May Affect Future Results and Financial Condition." Professional Application Software Final Cut Pro® 3 is a video authoring application designed to meet the demanding needs of the professional video editing environment by combining in a single +software package professional-quality video editing and compositing, real-time effects, professional color correction tools and an innovative interface that seamlessly integrates editing, +compositing and effects tools for an efficient and powerful media creation workflow. Final Cut Pro is especially popular among broadcast professionals because it allows them to increase their +programming output at a fraction of the cost of traditional editing systems. Post production facilities use Final Cut Pro for the production of a wide range of projects including feature-length films, +primetime television shows, news broadcasts, documentaries, trailers and commercials. Final Cut Pro was honored by the Academy of Television Arts and Sciences with a 2002 Primetime Emmy Engineering +Award for its impact on the television industry. Shake® +is the Company's industry-leading compositing and visual effects software designed for large format film and video productions. Shake features a fast rendering engine, an extensive +and mature compositing toolset, two industry-standard keyers, a complete suite of color correction tools, tracking/stabilization capabilities, integrated procedural paint, rotoscoping tools, and +support for leading plug-in vendors. Shake has been used in the production of over a hundred motion pictures including the past five winners of the Academy Award for Best Visual Effects. +Introduced during the fourth quarter of 2002, Shake 2.5 was the +first Mac OS X native version of the software and added an improved image input, a disk-based proxy system, and the ability to limit the rendering process to a portion of an image for +quicker processing. 5 Introduced +in 2002, Cinema Tools for Final Cut Pro™ is a new software package that enhances Final Cut Pro 3's 24 frames-per-second (fps) editing capabilities with +support for film cut lists and 24-frame edit decision lists (EDLs) for high-definition (HD) video. The 24-frame EDL support allows off-line HD projects +to be finished using significantly more affordable Final Cut Pro®-based HD finishing systems. Cinema Tools for Final Cut Pro is a robust solution for filmmakers who shoot and finish with +35mm or 16mm film, but want to take advantage of the cost and time benefits of digital editing on a Final Cut Pro system. Cinema Tools converts "telecined" content to its native 24-frame +rate for editing, then generates a 24-fps cut list for negative conform. With its support for 24-fps EDL import/export, Cinema Tools for Final Cut Pro provides video +professionals with not only an affordable path to online HD finishing, but also the EDL conversion capabilities required to create high-definition 24P universal masters used to efficiently +meet the needs of varying international distribution formats. DVD +Studio Pro® 1.5 lets professional users encode video, conduct complex authoring tasks and preview finished product in real-time and allows users to burn DVDs using +SuperDrive-equipped Macintosh systems. It handles the MPEG encoding, menu creation, asset organization, linking, and output formatting that are required to produce DVD-Video disks. DVD +Studio Pro 1.5 has been optimized for Mac OS X and features enhanced integration with Final Cut Pro. The +Company was honored in 2002 by the National Academy of Recording Arts and Sciences with a Technical GRAMMY Award for its outstanding technical contributions to the music industry and recording +field. This was the first Technical GRAMMY ever awarded to a personal computer company. From the original Macintosh, the first personal computer to include built-in audio capabilities, +Apple has helped change the way music is written, recorded, mixed and enjoyed. The Company acquired Emagic, a leading provider of professional software and hardware solutions for computer based music +production, during the fourth quarter of 2002. Emagic's most popular product, Logic®, is actively used by musicians around the world and by professionals in music production, film scoring, +and post production facilities. At the time of the acquisition, Macintosh-based products accounted for over 65% of Emagic's revenues. Emagic's Windows-based product offerings were discontinued by the +Company during its first fiscal quarter of 2003. Consumer, Education and Business Oriented Application Software iMovie™ 2, the Company's easy-to-use consumer digital video editing software for creation of home and classroom movies, features an enhanced +user interface, improved audio editing capabilities, enhanced controls for titling and transitions, and added special effects. iMovie 2 is currently preinstalled on all of the Company's Macintosh +systems. iDVD™ 2 is consumer oriented software that makes it easy to turn iMovie files, QuickTime files and digital pictures into DVDs that can be played on most consumer DVD players. iDVD +2 simplifies DVD authoring by including professionally designed themes and +drag-and-drop simplicity. iDVD 2 is currently preinstalled on all Macintosh systems equipped with a SuperDrive. The +Company introduced iPhoto™ in January 2002. Designed exclusively for Mac OS X, iPhoto makes it easy to import, edit, save, share, and print digital photos, as well as organize +and manage an entire digital photo collection containing thousands of photos. Users are able to view their photos in full-screen; using the slide show feature accompanied by their favorite +music; automatically create custom web pages of their photos; email photos to friends and family; order professionally-processed prints and enlargements online; or easily design and order +custom-printed, linen-covered hard bound photo books online. Prints, enlargements, and hard bound book production is currently only available to U.S. customers. iPhoto is currently preinstalled on all +of the Company's Macintosh systems. iTunes® +is a digital music application for the Macintosh that lets users create and manage their own digital music library. iTunes organizes music using searching, browsing and playlist +features. It supports both audio and MP3 CD burning, features a graphic equalizer and cross fading between songs, and supports automatic synchronization with the music stored on an iPod, Apple's +portable digital music player. iTunes is currently preinstalled on all Macintosh systems. In July 2002, the Company introduced iTunes 3, 6 featuring Smart Playlists, which automatically and dynamically updates playlists based on simple rules set by the user, and Sound Check for consistent volume playback. During +the fourth quarter of 2002, the Company released two new applications, iCal and iSync Public Beta. iCal is a new calendar program that allows users to manage multiple calendars and share them +over the Internet. iCal makes it easy for consumers, students, educators and small business users to create and manage individual or group activities on single or multiple calendars; publish these +calendars on the web for viewing by colleagues, friends and family members; subscribe to automatically updated calendars via the Internet to keep up with work schedules, family events and school +events; organize and track activities with To Do list management; quickly locate any event via a search tool; and take calendars to go using iSync with Bluetooth-enabled mobile phones, Palm OS devices +and iPod. iSync Public Beta is a preview version of Apple's new software application that automatically synchronizes address books and calendars between Macintosh systems and the new generation of +Bluetooth-enabled GPRS mobile phones, Apple's iPod and Palm OS-compatible handheld organizers. In addition, users with a .Mac™ account can use iSync to seamlessly synchronize +their calendars and address books across multiple Macintosh systems connected to the Internet. AppleWorks® +6.2 is an integrated productivity application that incorporates word processing, page layout, image manipulation, spreadsheets, databases and presentations in a single +application. Intended to be an easy-to-use product for the Company's consumer and education customers, AppleWorks makes it simple to create professional-looking documents in +the classroom and at home. FileMaker +Corporation, a wholly owned subsidiary of the Company, develops, publishes, and distributes desktop-based database management application software for Mac OS and Windows-based systems. +FileMaker's FileMaker ® Pro database software and related products offer strong relational databases and advanced +desktop-to-web publishing capabilities. Internet Software, Integration, and Services Apple's Internet strategy is focused on delivering seamless integration with and access to the Internet throughout the Company's product lines. The Company's Internet products +and technologies adhere to many industry standards in order to provide an optimized user experience through interoperability. An easy Internet Setup Assistant is included with the Mac OS. QuickTime®, +the Company's multimedia software for Macintosh and Windows platforms, features streaming of live and stored video and audio over the Internet and playback of +high-quality audio and video on computers. QuickTime Player is an easy-to-use application for playing, interacting with or viewing video, audio, QuickTime VR 3D +images, or graphics files. More than 125 million copies of QuickTime Player were downloaded via the Internet during the last year. Tens of thousands of software applications and content CDs +feature QuickTime, and more than 150 models of digital cameras from most major brands use QuickTime to capture and display their images. The +current version of QuickTime, QuickTime 6, was released in July of 2002 and features support for the open-standard MPEG 4 format. QuickTime 6 includes the new Instant-On +Streaming feature that eliminates buffer delays and provides users with the ability to quickly and easily scrub through streaming media content to locate and instantly view specific sections. In +addition, QuickTime 6 running on Mac OS X now supports JPEG 2000, the next generation JPEG standard that allows users to capture still images in a higher quality and smaller file size than ever +before. QuickTime 6 also includes Advanced Audio Coding (AAC), the standard MPEG-4 audio format. AAC is the next generation professional-quality audio format that delivers superior sound +quality with reduced file sizes. QuickTime +Pro is a suite of software that allows creation and editing of Internet-ready audio and video files and allows a user to add special effects and other features to QuickTime movies. 7 QuickTime Streaming Server software is the underlying server technology that powers QuickTime's ability to stream live and stored video and audio over the Internet. QuickTime Streaming Server is based +on an open sourced, standards-based Real-Time Transport Protocol/Real-Time Streaming Protocol (RTP/RTSP) engine. The current version, QuickTime Streaming Server 4, extends +support for standards by adding support for both MPEG 4 and MP3. While QuickTime Streaming Server is designed for Mac OS X Server, it is also available as an open source server. Because QuickTime +Streaming Server is an open source technology it can be ported to other platforms, and versions are available for Linux, Solaris and Windows NT/2000. QuickTime +Broadcaster is the Company's live encoding software that allows users to quickly and easily produce professional-quality live events for online delivery. The combination of QuickTime +Broadcaster, QuickTime Streaming Server 4 and QuickTime 6 provides the industry's first end-to-end MPEG-4-based Internet broadcasting system, which +allows users to reach not only the large and growing base of installed QuickTime Players, but also any ISO-compliant MPEG-4 player. WebObjects®, +the Company's Java-based application server for web publishing and enterprise application development, offers a complete solution for rapid development and +deployment of web applications. WebObjects features sophisticated graphical development tools, comprehensive prebuilt and reusable components, integration with numerous data sources, and robust +deployment tools. Introduced +with Mac OS X Jaguar, Sherlock® 3 is the Company's advanced Internet search engine. Sherlock 3 functions for users as an Internet service tool that retrieves and displays a +personalized view of some of the most practical and useful information available on the Internet, such as stock news, general headlines, movie previews, locations and show times, yellow pages +listings, eBay auction activity and more. Sherlock displays each of these 'channels' in its own arrangement of columns and panes. When used for Internet searches, Sherlock utilizes multiple search +engines to provide search results ranked by relevance, name, or web site. In +July 2002, the Company launched .Mac™, a new suite of Internet services that for an annual fee provides Macintosh users with powerful Internet tools. .Mac features email service +with IMAP, POP or web-based access, 100MB of Internet storage, and hosting for personalized homepages and shared digital photo albums. Also included with .Mac is McAfee's Virex +anti-virus software and Backup, a personal back-up solution that allows users to archive data to their Internet storage, CD, or DVD. Wireless Connectivity and Networking AirPort ® is the Company's wireless networking technology that allows users to create a computer network and connect +to the Internet without cables, additional phone lines, or complicated networking hardware. Based on the IEEE 802.11b wireless standard and Wi-Fi certified, AirPort allows +high-speed wireless communications within a radius of approximately 150 feet from an AirPort base station. AirPort includes security features like firewall protection and +128-bit encryption to protect user data. With the addition of an AirPort networking card, all of the Company's desktop and portable Macintosh systems have built-in support for +AirPort wireless networking, including built-in antennas and an AirPort card slot. During +2002, the Company released its Bluetooth technology for Mac OS X. Bluetooth is an emerging industry standard for wirelessly connecting computers and peripherals that supports transmission of +data at up to 1 Mbps within a range of approximately 30 feet. The Company's Bluetooth technology for Mac OS X lets customers wirelessly share files between Macintosh systems, synchronize and share +contact information with Palm-OS based PDAs, and access the Internet through Bluetooth-enabled cell phones. A Bluetooth USB adaptor can Bluetooth-enable any USB-based Macintosh +computer running in Mac OS X version 10.1.4 or higher. Bluetooth software is built into Max OS X Jaguar. Introduced +in the fourth quarter of 2002, the Company's new Rendezvous™ networking technology is based on open Internet Engineering Task Force (IETF) Standard Protocols such as IP, ARP and +DNS. Rendezvous uses industry standard networking protocols and zero configuration technology to 8 automatically discover and connect devices over any IP network, including Ethernet or 802.11-based wireless networks like the Company's AirPort product. Major developers such as Canon, +Epson, Hewlett-Packard, Lexmark, Philips, Sybase, World Book and Xerox have announced support for Rendezvous in a broad range of products including network printers, consumer electronics, enterprise +database management and educational applications. In September 2002, the Company announced that it was "open sourcing" the code for Rendezvous. By making the source code freely available, the +Company allows developers to use Rendezvous technology in their network-enabled devices or software applications. The Rendezvous source code includes software to support UNIX, Linux, and Windows- +based systems and devices. Rendezvous support is built into Mac OS X Jaguar. Apple +Remote Desktop™ for Mac OS X software enables users, teachers and administrators to remotely manage other Macintosh systems anywhere on a local network, AirPort wireless network or +across the Internet. With Apple Remote Desktop, teachers can view students' computer screens, perform group demonstrations and help individuals with real-time screen-sharing, text chat and +the "request attention" command. System administrators can provide remote assistance, get comprehensive system profiles, reconfigure system settings and quickly and easily distribute software +applications across hundreds of computers—all from one central location over both Ethernet and AirPort wireless networks. Apple Remote Desktop supports multiple levels of administrator +access, each with its own password, providing a secure way for teachers or department-level administrators to assist users while restricting privileges for deleting items or changing system settings. The +Company invented FireWire® technology, also referred to as IEEE 1394, which is a high-speed serial input/output technology for connecting digital devices such as digital +camcorders and cameras to desktop and portable computers. With its high data-transfer speed and "hot plug-and-play" capability, FireWire has become an established +cross-platform industry standard for both consumers and professionals and is the data interface of choice for today's digital video and audio devices, as well as external hard drives and other +high-speed peripherals. Industry data indicates that FireWire will be included on more than 64 million personal computers and nearly 100 million digital devices by the end of +calendar 2002. The Company received a 2001 Primetime Emmy Engineering Award for FireWire's impact on the television industry. FireWire is currently included on all Macintosh systems and is the data +transfer technology utilized by iPod. Third-Party Software Products Thousands of third-party software titles and solutions are available for the Macintosh platform. The Company sells a variety of these third-party software products directly to +end users through both its retail and online stores. Additional information regarding the Company's relationship with and dependence upon third-party software developers, including Microsoft +Corporation, may be found in Part II, Item 7 of this Form 10-K under the heading "Factors That May Affect Future Results and Financial Condition." Product Support and Services AppleCare ® offers a range of support options for Apple customers. These options include assistance that is built +into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare Protection Plan. The +AppleCare Protection Plan is a fee-based service that typically includes three years of phone support and hardware repairs, dedicated web-based support resources, and user +diagnostic tools. Apple +Training offers comprehensive system administration and development training on Apple technologies, together with certification programs that test customers' skills and verify their technical +proficiency. Apple Professional Services offers a range of custom, personalized technical services, including Internet consulting and setup, installation and integration services. The Company also +offers specialized loan programs including loans for consumers, students, and educators. Apple also provides leasing 9 solutions for its education institution customers and its business and professional customers. The Company uses several third-party lenders to originate and carry these loans and leases. Specialized Education Products and Services The Company offers a variety of unique services and products to its education customers, including a separate online store for education customers offering special education +price lists and promotions; special financing programs for K-12 and higher education students, faculty, and staff; a special edition of its productivity software suite, AppleWorks, that is +cross platform for both Macintosh and Windows computers; the iBook Wireless Mobile Lab that allows teachers and students to share iBook computers, a printer, and a wireless network/Internet connection +stored on a cart for mobility between classrooms; and three special Digital Media Studio solutions designed for education, including one that is integrated into a mobile cart. Additionally, Apple +Professional Services offers a range of technical services to education customers. In +2001, Apple acquired PowerSchool Inc., a privately held provider of web-based student information systems for K-12 schools and school districts. +PowerSchool ® software products give school administrators and teachers the ability to easily and cost-effectively manage student +records and give parents real-time access to track their children's performance via the Internet. PowerSchool offers the option of remote hosting with an application service provider +model. Markets and Distribution The Company's customers are primarily in the education, creative, consumer, and business markets. Certain customers are attracted to Macintosh computers for a variety of +reasons, including the reduced amount of training resulting from the Macintosh computer's intuitive ease of use, advanced graphics capabilities, industrial design features of the Company's hardware +products, and ability of Macintosh computers to network and communicate with other computer systems and environments. Apple personal computers were first introduced to education customers in the late +1970s. Over 21% of the Company's net sales in 2002 were to education customers in the United States, including sales to elementary and secondary schools and college and university customers. Further +information relating to the U.S. education market and the Company's position in that market may be found in Part II, Item 7 of this Form 10-K under the heading "Factors That +May Affect Future Results and Financial Condition." The +Company distributes its products through wholesalers, resellers, national and regional retailers and cataloguers. During 2000 a single distributor, Ingram Micro Inc., accounted for +approximately 11.5% of net sales. No other customer accounted for more than 10% of net sales during 2000, and no individual customer accounted for more than 10% of net sales in 2002 or 2001. The +Company also sells many of its products and resells certain third-party products in most of its major markets directly to consumers, education customers, businesses, and certain resellers through its +retail stores in the United States, or through one of its online stores around the world. Net sales attributable to the Company's online stores totaled approximately $2.4 billion and +$2.0 billion for fiscal years 2002 and 2001, respectively. Competition The Company is confronted by aggressive competition in all areas of its business. The market for the design, manufacture, and sale of personal computers and related software +and peripheral products is highly competitive. This market continues to be characterized by rapid technological advances in both hardware and software development, which have substantially increased +the capabilities and applications of these products, and have resulted in the frequent introduction of new products and significant price, feature, and performance competition. Over the past several +years price competition in the market for personal computers has been particularly intense. The Company's competitors who sell Windows-based personal computers have aggressively cut prices and lowered +their product margins to gain or maintain market share in response to weakness in demand for personal computing products. The Company's results 10 of operations and financial condition have been, and in the future may continue to be, adversely affected by these and other industry wide pricing pressures and downward pressures on gross margins. The +principal competitive factors in the market for personal computers include relative price/performance, product quality and reliability, design innovation, availability of software, product +features, marketing and distribution capability, service and support, availability of hardware peripherals, and corporate reputation. Further, as the personal computer industry and its customers place +more reliance on the Internet, an increasing number of Internet devices that are smaller, simpler, and less expensive than traditional personal computers may compete for market share with the +Company's existing products. The +Company is currently taking and will continue to take steps to respond to the competitive pressures being placed on its personal computer sales as a result of innovations in the Windows platform. +The Company's future operating results and financial condition are substantially dependent on its ability to continue to develop improvements to the Macintosh platform in order to maintain perceived +functional and design advantages over competing platforms. Further +information relating to the competitive conditions of the personal computing industry and the Company's competitive position in that market place may be found in Part II, Item 7 of this +Form 10-K under the heading "Factors That May Affect Future Results and Financial Condition." Raw Materials Although most components essential to the Company's business are generally available from multiple sources, certain key components (including microprocessors and +application-specific integrated circuits ("ASICs")) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from +multiple sources, are at times subject to industry wide availability constraints and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal +computer industry, and new products introduced by the Company often initially utilize custom components obtained from only one source +until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. If the supply of a key or single-sourced component to the Company were to be delayed or +curtailed or in the event a key manufacturing vendor delays shipments of completed products to the Company, the Company's ability to ship related products in desired quantities and in a timely manner +could be adversely affected. The Company's business and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, +or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of +common components instead of components customized to meet the Company's requirements. The Company attempts to mitigate these potential risks by working closely with these and other key suppliers on +product introduction plans, strategic inventories, coordinated product introductions, and internal and external manufacturing schedules and levels. Consistent with industry practice, the Company +acquires components through a combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. These formal and informal commitments typically cover +the Company's requirements for periods ranging from 30 to 130 days. The +Company believes there are several component suppliers and manufacturing vendors whose loss to the Company could have a material adverse effect upon the Company's business and financial position. +At this time, such vendors include Agere Systems, Inc., Ambit Microsystems Corporation, ATI Technologies, Inc., Elite Computer Systems Co., Inc., Hon Hai Precision Industry +Co., Ltd., IBM Corporation, Inventec Appliances Corporation, LG. Phillips Co., Ltd., Matsushita, Mitsubishi Electric Corporation, Motorola, Inc., Nvidia Corp., Quanta +Computer, Inc., Samsung Electronics, Solectron Corporation, and Toshiba Corporation. 11 Further +discussion relating to availability and supply of components and product may be found in Part II, Item 7 of this Form 10-K under the heading "Factors That May Affect +Future Results and Financial Condition," and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at Note 10 under the subheading +"Concentrations in the Available Sources of Supply of Materials and Product." Research and Development Because the personal computer industry is characterized by rapid technological advances, the Company's ability to compete successfully is heavily dependent upon its ability to +ensure a continuing and timely flow of competitive products and technology to the marketplace. The Company continues to develop new products and technologies and to enhance existing products in the +areas of hardware and peripherals, system software, applications software, networking and communications software and solutions, and the Internet. The Company's research and development expenditures, +before any charges for purchased in-process research and development, totaled $446 million, $430 million, and $380 million in 2002, 2001, and 2000, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its computer systems, peripheral systems, and software. In addition, the Company has +registered, and/or has applied to register, trademarks and service marks in the United States and a number of foreign countries for "Apple," the Apple silhouette logo, the Apple color logo, +"Macintosh," and numerous other product trademarks and service marks. In 1986, the Company acquired ownership of the trademark "Macintosh" for use in connection with computer products. Although the +Company believes the ownership of such patents, copyrights, trademarks and service marks is an important factor in its business and that its success does depend in part on the ownership thereof, the +Company relies primarily on the innovative skills, technical competence, and marketing abilities of its personnel. Many +of the Company's products are designed to include intellectual property obtained from third parties. While it may be necessary in the future to seek or renew licenses relating to various aspects +of its products and business methods, the Company believes that based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms. Because of +technological changes in the computer industry, current extensive patent coverage, and the rapid rate of issuance of new patents, it is possible certain components of the Company's products and +business methods may unknowingly infringe existing patents of others. The Company has from time to time been notified that it may be infringing certain patents or other intellectual property rights of +others. Information +regarding claims and litigation involving the Company related to alleged patent infringement and risks related to the Company's reliance on third-party intellectual property is set forth +in Part I, Item 3 of this Form 10-K, and in Part II, Item 7 of this Form 10-K under the heading "Factors That May Affect Future Results and +Financial Condition." Foreign and Domestic Operations and Geographic Data The United States represents the Company's largest geographic marketplace. Approximately 57% of the Company's net sales in fiscal 2002 came from sales to customers inside the +United States. Final assembly of products sold by the Company is conducted in the Company's manufacturing facilities in Sacramento, California, and Cork, Ireland, and by external vendors in Fullerton, +California, Taiwan, Korea, the People's Republic of China, and the Czech Republic. Margins on sales of Apple products in foreign countries, and on sales of products that include components obtained +from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. 12 Information +regarding financial data by geographic segment is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at +Note 11, "Segment Information and Geographic Data." Additional information regarding the risks associated with international operations +is set forth in Part II, Item 7 of this Form 10-K under the heading "Factors That May Affect Future Results and Financial Condition." Seasonal Business Although the Company does not consider its business to be highly seasonal, it has historically experienced increased net sales in its first and fourth fiscal quarters, compared +to other quarters in its fiscal year, due to seasonal demand related to the holiday season and the school year. However, over the past two years the Company has not experienced these seasonal +fluctuations in net sales due to the negative impact of current economic conditions on the overall demand for the Company's products. Past performance should not be considered a reliable indicator of +the Company's future net sales or financial performance. Warranty The Company offers a limited parts and labor warranty on its hardware products. The warranty period is typically one year from the date of purchase by the end user. The Company +also offers a 90-day warranty for Apple software and for Apple service parts used to repair Apple hardware products. In addition, consumers may purchase extended service coverage on most +Apple hardware products in all of the Company's major markets. Backlog In the Company's experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog +often increases in anticipation of or immediately following new product introductions because of over ordering by dealers anticipating shortages. Backlog often is reduced once dealers and customers +believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company's ability to achieve any particular level of revenue or +financial performance. Environmental Laws Compliance with federal, state, local, and foreign laws enacted for the protection of the environment has to date had no material effect upon the Company's capital +expenditures, earnings, or competitive position. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the subject of these +laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on the Company. The +parliament of the European Union is working to finalize the Waste Electrical and Electronic Equipment Directive (the Directive). The Directive makes manufacturers of electrical goods, including +personal computers, financially responsible for the collection, recycling, and safe disposal of past and future products. The Directive must now be approved and implemented by individual European +Union governments by 2005. The Company's potential liability resulting from the Directive related to past sales of its products and expenses associated with future sales of its product may be +substantial. However, because it is likely that specific laws, regulations, and enforcement policies will vary significantly between individual European member states, it is not currently possible to +estimate the Company's existing liability or future expenses resulting from the Directive. As the European Union and its individual member states clarify specific requirements and policies with +respect to the Directive, the Company will continue to assess its potential financial impact. Similar legislation may be enacted in other geographies, including federal and state legislation in the +United States, the cumulative impact of which could be significant. 13 Employees As of September 28, 2002, Apple and its subsidiaries worldwide had 10,211 employees and an additional 2,030 temporary employees and contractors. Item 2. Properties The +Company's headquarters are located in Cupertino, California. The Company has manufacturing facilities in Sacramento, California, Cork, Ireland, and Singapore. As of September 28, 2002, the +Company leased approximately 2.7 million square feet of space, primarily in the United States, and to a lesser extent, in Europe, Japan, and the Asia Pacific region. Leased space in the United +States includes 395,000 square feet of retail space. Leases are generally for terms of 5 to 10 years, and usually provide renewal options for terms of 3 to 5 additional years. The +Company owns its manufacturing facilities in Cork, Ireland, and Singapore, which total approximately 617,000 square feet. The Company also owns a 752,000 square-foot facility in +Sacramento, California, which is used as a manufacturing, warehousing and distribution center. The Sacramento and Cork facilities also house customer support call centers. In addition, the Company +owns 930,000 square feet of facilities located in Cupertino, California, used for research and development and corporate functions. Outside the United States, the Company owns additional facilities +totaling approximately 106,000 square feet. The +Company believes its existing facilities and equipment are well maintained and in good operating condition. The Company has invested in internal capacity and strategic relationships with outside +manufacturing vendors, and therefore believes it has adequate manufacturing capacity for the +foreseeable future. The Company continues to make investments in capital equipment as needed to meet anticipated demand for its products. Information +regarding critical business operations that are located near major earthquake faults is set forth in Part II, Item 7 of this Form 10-K under the heading "Factors +That May Affect Future Results and Financial Condition." Item 3. Legal Proceedings The +Company is subject to certain legal proceedings and claims, including those described below, which have arisen in the ordinary course of business and have not been fully adjudicated. Information +regarding the risks and potential financial impact of these legal matters is set forth in Part II, Item 7 of this Form 10-K under the heading "Factors That May Affect Future +Results and Financial Condition," and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at Note 10 under the subheading +"Commitments and Contingencies." Articulate Systems, Inc. v. Apple Computer, Inc. Plaintiff Articulate filed this action in March 1996 in the United States District Court in Massachusetts claiming patent infringement relating to voice recognition +technology. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting numerous affirmative defenses. The Company also asserted +counterclaims requesting declaratory judgment for non-infringement, unenforceability and invalidity. The case was stayed for several months pending resolution of four summary judgment +motions filed by the Company, all of which were denied by the Court. Through a series of corporate transactions the assets belonging to Plaintiff were acquired by a subsidiary, Lernout & +Hauspie Speech Products N.V. ("L&H"). L&H filed for bankruptcy in November 2000 and is being liquidated as part of the bankruptcy. The case is currently stayed pending the resolution of the +liquidation. 14 Bancroft v. Apple Computer, Inc. Plaintiff Bancroft filed this purported class action on January 30, 2002 in Los Angeles Superior Court on behalf of a potentially nationwide class of purchasers of +certain Power Macintosh G3 computers. Plaintiff alleges violation of the Consumer Legal Remedies Act ("CLRA") arising from allegedly poor performance while running the Company's Mac OS X operating +system, specifically relating to 2D +hardware acceleration, QuickTime movie hardware acceleration, 3D graphics performance and DVD movie playback. Plaintiff seeks actual damages, injunctive relief, restitution, punitive damages, +attorneys' fees and other relief. The Company has answered the complaint, denying all allegations and alleging numerous affirmative defenses. The parties participated in mediation in +October 2002 without resolution. The parties are in discovery. BIAX Corporation v. Apple Computer, Inc. Plaintiff BIAX filed this action on September 5, 2001 in the United States District Court in Delaware claiming patent infringement relating to dual processor technology. +IBM and Motorola were added as defendants in an amended complaint. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting +numerous affirmative defenses. The Company also asserted counterclaims requesting a declaratory judgment for non-infringement, unenforceability and invalidity. The parties are in +discovery. Dynacore Holdings Corp. v. Apple Computer, Inc. Plaintiff Dynacore filed this action on June 6, 2001 in United States District Court for the Southern District of New York against the Company and thirteen other +defendants claiming patent infringement relating to IEEE 1394 technology, also known as FireWire. Plaintiff claims that any computer system or other electronic product that uses or complies with the +IEEE 1394 standard violates the patent. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting numerous affirmative +defenses. The Company also asserted counterclaims requesting declaratory judgment for non-infringement and invalidity. Defendants are seeking to amend the pleading to assert a counterclaim +for inequitable conduct against Dynacore. The case was stayed pending the Federal Circuit's decision in Datapoint Corp. v. Standard Microsystems Corp ., +a related case in which plaintiff claimed that its patent was infringed by products complying with the fast Ethernet standard. In February 2002, the Federal Circuit affirmed the judgment of +non-infringement in Datapoint, and the District Court lifted the stay in this action. The defendants filed a joint motion for summary judgment based upon the decision in Datapoint. The +Court heard the motion on October 4, 2002 and has not yet issued its ruling. Elonex IP Holdings Ltd., EIP Licensing, B.V. v. Apple Computer, Inc. Plaintiffs filed this action on February 12, 2001 in the United States District Court in Delaware claiming patent infringement relating to a low power consumption +monitor standby system. Plaintiffs filed numerous identical lawsuits against other computer monitor manufacturers and computer systems manufacturers. Plaintiffs seek unspecified damages and other +relief. The Company answered the complaint, denying all allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims requesting declaratory judgment for +non-infringement, unenforceability and invalidity of the patents at issue. The parties reached a settlement in July 2002. Settlement of this matter did not have a material effect on +the Company's financial position or results of operations. FTC Inquiry–Prado v. Apple Computer, Inc. (and related actions) In October 1997, Apple began charging all U.S. non-education customers for live telephone technical support beyond 90 days after purchase of Apple +products. In late 1997, the Federal Trade Commission (FTC) commenced an investigation into customer complaints that Apple's change in technical support practices was either unfair or contrary to +earlier representations to certain customers. Four purported class action lawsuits were filed against Apple related to this change. During the fourth quarter of 1999, the 15 regional and national offices of the FTC approved a settlement with the Company, and a settlement was approved by the Court in three of the class action suits. In November 1999, two appeals +were filed objecting to the settlement. The California Court of Appeal upheld the settlement, and the California Supreme Court denied review of the Court of Appeal's decision. No further appeals were +taken and the Company is administering the settlement. Settlement of this matter did not have a material effect on the Company's financial position or results of operations. Hawaii Structural Iron Workers and Pension Trust Fund v. Apple Computer, Inc. and Steven P. Jobs; Young v. Apple Computer, Inc. et al; Hsu v. +Apple Computer Inc. et al Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against +the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company's publicly traded common stock between +July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company +believes these claims are without merit and intends to defend them vigorously. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. +On December 11, 2002, the Court granted the Company's motion to dismiss for failure to state a cause of action, with leave to plaintiffs to amend their complaint within thirty days. Pierce et al. v. Apple Computer, Inc. Plaintiff Pierce filed this action on June 15, 2000 in Santa Clara County Superior Court. This case was a purported nationwide consumer class action brought on behalf of +purchasers of the Company's AirPort Card and AirPort Base Station ("AirPort System"). Plaintiffs alleged that the Company engaged in false advertising and unfair business practices (among other causes +of action) by advertising that the AirPort System is Internet-ready and failing to disclose that the AirPort System is incompatible with certain Internet service providers, primarily America Online. +The Company answered the complaint, denying all allegations and alleging numerous affirmative defenses. The parties reached a settlement that received final approval by the Court on October 8, +2002. The Company is administering the settlement. Settlement of this matter did not have a material effect on the Company's financial position or results of operations. Pitney Bowes Inc. v. Apple Computer, Inc. Plaintiff Pitney Bowes filed this patent infringement action on June 18, 2001 in the United States District Court in Connecticut alleging patent infringement relating to +laser printer technology. Plaintiff has filed similar lawsuits against other companies. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all +allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims requesting a declaratory judgment for non-infringement, unenforceability and invalidity of +the patents at issue. The Connecticut Court transferred this case to the Eastern District of Kentucky on February 1, 2002 and consolidated the case with two other lawsuits, a declaratory +judgment action filed by Xerox and Pitney Bowes' patent infringement case against Epson. The case is set for trial on June 8, 2004. Sternberg v. Apple Computer, Inc. and Gordon et al. v. Apple Computer, Inc. Plaintiff Sternberg filed this action against the Company on March 17, 2000 in the Santa Clara County Superior Court. The case was a purported nationwide consumer class +action brought on behalf of purchasers of iMac DV and iMac DV SE computers. Plaintiff alleged that Apple engaged in false advertising, unfair competition and breach of warranty, among other causes of +action, by marketing and selling a DVD player with iMac DV and iMac DV SE computers where the playback was unacceptable. A companion case, Gordon et al. v. Apple Computer, +Inc . was filed by largely the same plaintiffs on June 14, 2000. This case was essentially the same as Sternberg but with respect to a different computer +model—the Power Macintosh G4. The Company answered both complaints, denying all allegations and alleging numerous affirmative defenses. The parties reached a settlement in +August 2001 that received final 16 approval by the Court on February 25, 2002. The Company is administering the settlement. Settlement of this matter did not have a material effect on the Company's financial position or results +of operations. UNOVA, Inc. v. Apple Computer, Inc., et al. Plaintiff UNOVA filed this patent infringement action against the Company and six other defendants on May 8, 2002 in the Central District of California for infringement +of eight UNOVA patents related to "Smart Battery Management". Plaintiff alleges that the Company's portable computers manufactured since 1996 infringe these eight patents. Plaintiff has filed similar +lawsuits against other companies in addition to the co-defendants in this case. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all +allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims requesting a declaratory judgment for non-infringement, invalidity and unenforceability. Item 4. Submission of Matters to a Vote of Security Holders No +matters were submitted to a vote of security holders during the fourth quarter of the Company's fiscal year ended September 28, 2002. 17 PART II Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters The +Company's common stock is traded on the over-the-counter market and is quoted on the Nasdaq National Market under the symbol AAPL, on the Tokyo Stock Exchange under the +symbol APPLE, and on the Frankfurt Stock Exchange under the symbol APCD. As of December 6, 2002, there were 28,310 shareholders of record. On +June 21, 2000, the Company effected a two-for-one stock split in the form of a Common Stock dividend to shareholders of record as of May 19, 2000. All share +price and per share data and numbers of Common shares have been retroactively adjusted to reflect the stock split. The Company did not pay cash dividends in either fiscal 2002 or 2001. The Company +anticipates that, for the foreseeable future, it will retain any earnings for use in the operation of its business. The price range per share of common stock presented below represents the highest and +lowest closing prices for the Company's common stock on the Nasdaq National Market during each quarter. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2002 price range per common share $ 18.74-$13.99 $ 26.11-$16.55 $ 25.45-$20.78 $ 23.76-$14.98 Fiscal 2001 price range per common share $ 25.22-$14.68 $ 27.12-$18.75 $ 23.75-$14.44 $ 26.75-$13.63 Item 6. Selected Financial Data The +following selected financial information has been derived from the audited consolidated financial statements. The information set forth below is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related +notes thereto included in Item 8 of this Form 10-K in order to fully understand factors that may affect the comparability of the information presented below. Five fiscal years ended September 28, 2002 (In millions, except share and per share amounts) 2002 2001 2000 1999 1998 Net sales $ 5,742 $ 5,363 $ 7,983 $ 6,134 $ 5,941 Net income (loss) $ 65 $ (25 ) $ 786 $ 601 $ 309 Earnings (loss) per common share: Basic $ 0.18 $ (0.07 ) $ 2.42 $ 2.10 $ 1.17 Diluted $ 0.18 $ (0.07 ) $ 2.18 $ 1.81 $ 1.05 Cash dividends declared per common share $ — $ — $ — $ — $ — Shares used in computing earnings (loss) per share (in thousands): Basic 355,022 345,613 324,568 286,314 263,948 Diluted 361,785 345,613 360,324 348,328 335,834 Cash, cash equivalents, and short-term investments $ 4,337 $ 4,336 $ 4,027 $ 3,226 $ 2,300 Total assets $ 6,298 $ 6,021 $ 6,803 $ 5,161 $ 4,289 Long-term debt $ 316 $ 317 $ 300 $ 300 $ 954 Total liabilities $ 2,203 $ 2,101 $ 2,696 $ 2,057 $ 2,647 Shareholders' equity $ 4,095 $ 3,920 $ 4,107 $ 3,104 $ 1,642 A +net loss before taxes related to the Company's non-current debt and equity investments of $42 million was recognized in 2002. Net gains before taxes related to the +Company's non-current debt and equity investments of $75 million, $367 million, $230 million, and $40 million were recognized in 2001, 2000, 1999, and 1998, +respectively. In 2002, the Company acquired Emagic resulting in a charge of approximately 18 $1 million for acquired in-process technologies with no alternative future use. The Company recognized a similar charge of $11 million in 2001 related to its acquisition of +PowerSchool. Net charges related to Company restructuring actions of $30 million, $8 million, and $27 million were recognized in 2002, 2000, and 1999, respectively. During 2000, +the Company recognized the cost of a special executive bonus for the Company's Chief Executive Officer for past services in the form of an aircraft with a total cost to the Company of approximately +$90 million. In 2002, of the original $90 million accrual, $2 million remained unspent and was reversed. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This +section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. The Company's actual results may differ significantly from +the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled "Factors That May Affect +Future Results and Financial Condition" below. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this +Form 10-K. All information presented herein is based on the Company's fiscal calendar. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with generally accepted accounting principles and the Company's discussion and analysis of its +financial condition and results of operations requires the Company's management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements +and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in Item 8 of this Form 10-K describe the significant accounting policies and methods used in +the preparation of the Company's consolidated financial +statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for +making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. Management +believes the following to be critical accounting policies. That is, they are both important to the portrayal of the Company's financial condition and results, and they require management to +make judgments and estimates about matters that are inherently uncertain. Revenue Recognition The Company recognizes revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software +Revenue Recognition , as amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in +Financial Statements . SAB 101, as amended, summarizes certain of the SEC's views in applying generally accepted accounting principles to revenue recognition in financial +statements and provides guidance on revenue recognition issues in the absence of authoritative literature addressing a specific arrangement or a specific industry. The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collectibility is probable. Product is considered +delivered to the customer once it has been shipped, and title and risk of loss have been transferred. Revenue on multiple element sales arrangements is allocated to various elements based on vendor +specific objective evidence of the fair value of each element of the transaction and is recognized as each element is delivered. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end user rebates and other sales programs +and volume-based incentives. Future market conditions and product transitions may require the Company to increase customer incentive programs and incur incremental price protection obligations that +could result in incremental reductions of revenue at the time such programs are offered. Additionally, certain customer 19 incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions of particular +incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue. Allowance for Doubtful Accounts The Company distributes its products through third-party computer resellers and directly to certain education, consumer, and commercial customers. The Company generally does +not require collateral from its customers. However, when possible, the Company does attempt to limit credit risk on trade receivables through the use of flooring arrangements for selected customers +with third-party financing companies and credit insurance for certain customers in Europe, Asia, and Latin America. However, considerable trade receivables that are not covered by collateral, flooring +arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. The +allowance for doubtful accounts is based on management's assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition +of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible. The Company also records an allowance for +all other trade receivables based on multiple factors including historical experience with bad debts, the general economic environment, the financial condition of the Company's distribution channels, +and the aging of such receivables. If there is a deterioration of a major customer's financial condition, if the Company becomes aware of additional information related to the credit worthiness of a +major customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful accounts, which +would affect earnings in the period the adjustments are made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of +components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed +review of inventory each period that considers multiple factors including demand forecasts, product lifecycle status, product development plans, and component cost trends. The personal computer +industry is subject to a rapid and unpredictable pace of product and component obsolescence. If future demand or market conditions for the Company's products are less favorable than forecasted or if +unforeseen technological changes negatively impact the utility of component inventory, the Company may be required to record additional write-downs which would negatively affect gross margins in the +period when the write-downs are made. The +Company accrues necessary reserves for cancellation fees related to component orders that have been canceled. Consistent with industry practice, the Company acquires components through a +combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. These formal and informal commitments typically cover the Company's requirements for +periods ranging from 30 to 130 days. If there is an abrupt and substantial decline in demand for one or more of the Company's products or an unanticipated change in technological requirements +for any of the Company's products, the Company may be required to record additional reserves for cancellation fees, negatively affecting gross margins in the period when the cancellation fees are +identified. Valuation of Long-Lived Assets Including Acquired Intangibles The Company reviews property, plant, and equipment and certain identifiable intangible assets for impairment whenever events or changes in circumstances indicate the carrying +amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate. +If such assets are considered to be 20 impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value. Although the Company has recognized no material +impairment adjustments related to its property, plant, and equipment or identifiable intangibles during the past three fiscal years, except those made in conjunction with restructuring actions, +deterioration in the Company's business in a geographic region or business segment in the future, including deterioration in the performance of individual retail stores, could lead to such impairment +adjustments in the future periods in which such business issues are identified. As +of September 28, 2002, the Company had $85 million in goodwill. The Company adopted SFAS No. 142, Goodwill and Other Intangible +Assets , in the first quarter of fiscal 2002. As a result, the Company no longer amortizes goodwill but instead performs a review of goodwill for impairment annually, or earlier +if indicators of potential impairment exist. The review of goodwill for potential impairment is highly subjective and requires that: (1) goodwill be allocated to various business units of the +Company's business to which it relates; (2) the Company estimate the fair value of those business units to which the goodwill relates; and (3) the Company determine the book value of +those business units. If the estimated fair value of business units with allocated goodwill is determined to be less than their book value, the Company is required to estimate the fair value of all +identifiable assets and liabilities of those business units in a manner similar to a purchase price allocation for an acquired business. This requires independent valuation of certain internally +developed and unrecognized assets including in-process research and development and developed technology. Once this process is complete, the amount of goodwill impairment, if any, can be +determined. Based +on the Company's estimates as of September 28, 2002, there was no impairment of goodwill. However, changes in various circumstances including changes in the Company's market +capitalization, changes in the Company's forecasts, and changes in the Company's internal business structure could cause one or more of the Company's business units to be valued differently thereby +causing an impairment of goodwill. Additionally, in response to changes in the personal computer industry and changes in global or regional economic conditions, the Company may strategically realign +its resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of property, plant, and equipment, identifiable intangibles, or goodwill. Valuation of Non-Current Debt and Equity Investments As of September 28, 2002, the Company held investments in certain debt and equity securities with a combined carrying value of $39 million. These investments, +which are reflected in the consolidated balance sheets as non-current debt and equity investments, have been categorized as available-for-sale requiring that they +be carried at fair value with unrealized gains and losses, net of taxes, reported in +equity as a component of accumulated other comprehensive income. The Company recognizes an impairment charge to earnings when it is judged an investment has experienced a decline in value that is +other-than-temporary. The Company has recognized material impairment charges related to its non-current debt and equity investments in two quarters during the last +two fiscal years. Various factors are considered in determining whether a decline in value is other-than-temporary, including the length of time and extent to which the +investment's market value has been less than its cost basis, the financial condition and near-term prospects of the issuer, and the Company's intent and ability to hold the investment for +a period of time sufficient to allow for any anticipated recovery in market value. The +Company's non-current debt and equity investments are in public companies whose security prices are subject to significant volatility. The Company recognized a pre-tax +impairment loss of $50 million related to two of these investments in the fourth quarter of 2002. As a result, as of September 28, 2002, the Company had no significant unrealized gains +or losses recorded against the carrying value of its non-current debt and equity investments. Should the fair value of these investments fall below the Company's current cost bases and/or +the financial condition or prospects of either company deteriorate, the Company may determine in a future period that such a decline in fair value is other-than-temporary, 21 requiring an impairment loss be recognized in the period such a determination is made. Additional information regarding these investments and potential charges related to their impairment may be +found below under the caption "Factors That May Affect Future Results and Financial Condition." Net Sales Net sales and Macintosh unit sales for geographic segments and by product follow (net sales in millions and Macintosh unit sales in thousands): 2002 Change 2001 Change 2000 Americas net sales $ 3,088 3 % $ 2,996 (30 )% $ 4,298 Europe net sales 1,251 0 % 1,249 (31 )% 1,817 Japan net sales 710 0 % 713 (47 )% 1,345 Retail net sales 283 — 19 — — Other segments net sales 410 6 % 386 (26 )% 523 Total net sales $ 5,742 7 % $ 5,363 (33 )% $ 7,983 Americas Macintosh unit sales 1,728 (2 )% 1,768 (29 )% 2,507 Europe Macintosh unit sales 722 (4 )% 754 (32 )% 1,110 Japan Macintosh unit sales 386 (2 )% 394 (46 )% 730 Retail Macintosh unit sales 92 — 7 — — Other segments Macintosh unit sales 173 5 % 164 (22 )% 211 Total Macintosh unit sales 3,101 0 % 3,087 (32 )% 4,558 Power Macintosh net sales (a) $ 1,380 (17 )% $ 1,664 (39 )% $ 2,747 PowerBook net sales 831 2 % 813 (14 )% 948 iMac net sales 1,448 30 % 1,117 (53 )% 2,381 iBook net sales 875 8 % 809 0 % 809 Software, Service, and Other net sales 1,208 26 % 960 (13 )% 1,098 Total net sales $ 5,742 7 % $ 5,363 (33 )% $ 7,983 Power Macintosh unit sales (a) 766 (18 )% 937 (35 )% 1,436 PowerBook unit sales 357 3 % 346 (10 )% 383 iMac unit sales 1,301 8 % 1,208 (45 )% 2,194 iBook unit sales 677 14 % 596 9 % 545 Total Macintosh unit sales 3,101 0 % 3,087 (32 )% 4,558 Net sales per Macintosh unit sold (b) $ 1,462 $ 1,426 $ 1,510 (a) Includes +server sales and amounts previously reported as Power Macintosh G4 Cube. (b) Based +on net sales associated with Macintosh units and total Macintosh units sold. Net +sales increased $379 million or 7% during 2002 compared to 2001, while Macintosh unit sales were relatively flat year-over-year at approximately 3.1 million +units. On a geographic basis, performance in the domestic market was relatively strong, especially when considering the performance of the Company's Retail segment which currently operates exclusively +in the United States. However, the European and Japanese markets remained sluggish throughout 2002. The Company's net sales in 2002 were positively influenced by a number of factors. First, +net sales from software, service, and other sources rose $248 million or 26% in 2002 versus 2001. This increase was driven by several factors including a 28% increase in combined +third-party and Apple- 22 branded software sales; $143 million in net sales of iPod, the Company's portable digital music player that was introduced in the first half of 2002; a 9% increase in the sale of computer +accessories; and a 14% increase in service revenue caused primarily by increased revenue associated with extended maintenance and support contracts. The growth in software revenue was primarily the +result of increased sales of third-party software in the Company's retail and online stores and expansion in recent years in the number of Apple-branded software titles. Second, +overall unit sales of Macintosh portable systems grew by 92,000 units or 10% in 2002 reflecting a general trend in the personal computer market away from desktop systems towards portable +systems. During 2002, portable Macintosh systems represented 33% of total systems sales versus 31% in 2001 and 20% in 2000. Growth in this area has been most pronounced for iBook, the Company's +education and consumer oriented portable Macintosh system. iBook unit sales increased 14% in 2002 and 9% in 2001. Third, +the Company's Retail segment grew from 8 stores at the end of 2001 to 40 stores at the end of 2002. The Retail segment's net sales grew from $19 million in 2001 to $283 million in +2002. While the Retail segment may cannibalize some net sales from the Company's preexisting sales channels in the U.S., the Company does believe that a substantial portion of the Retail segment's net +sales are incremental to the Company's total net sales. See additional comments below related to the Retail segment under the heading "Segment Operating Performance." Fourth, +the Company's average unit pricing remained relatively stable during 2002 as a result of various changes in overall unit mix offset by somewhat lower pricing +year-over-year on comparative Macintosh systems. Net sales per Macintosh unit sold during 2002 of $1,462 per unit reflects the shift in mix towards relatively higher-priced +portable Macintosh systems and reflects the impact on net sales of the relatively higher-priced new iMac design introduced during 2002. The impact of these changes in mix were offset by the decline in +unit sales of relatively higher-priced Power Macintosh systems and by lower pricing on comparative Macintosh systems during 2002 for most of the Company's Macintosh product lines in response to +industry pricing pressure. Fifth, +any comparison of net sales in 2002 versus 2001 must consider the effect of unusually low net sales during the first quarter of 2001. As discussed below, this was attributable to several +factors at the beginning of 2001, including continuing deterioration in worldwide demand for personal computers, rebate programs and price cuts instituted by the Company during that quarter that cost +the Company approximately $138 million, and a plan implemented by the Company during the first quarter of 2001 to reduce substantially the level of inventory in its distribution channels that +resulted in a decline in channel inventory of approximately 300,000 units during that quarter. Net sales during the first quarter of 2001 are discussed in more detail below. Offsetting +the favorable factors discussed above, the Company's net sales in 2002 were negatively impacted by several notable factors. First, unit sales of Power Macintosh systems fell 18% during 2002 +as compared to 2001. This followed a 35% decline in Power Macintosh unit sales in 2001 from 2000. The Company continues to believe that weak economic conditions over the past several years are having +a pronounced negative impact on its professional and creative customers and that many of these customers continue to delay upgrades of their Power Macintosh systems due to the Company's ongoing +transition to Mac OS X, its new operating system, and in anticipation of certain software vendors transitioning their Macintosh applications to run natively in Mac OS X. Further, the Company did not +experience the anticipated increase in Power Macintosh sales that it expected following the introduction of Adobe's PhotoShop 7 during 2002. Additionally, many professional users may have postponed +upgrading their systems until after the introduction of Mac OS X Jaguar released in the fourth quarter +of 2002. Others may have delayed upgrading until after the availability of other professionally oriented software applications for Mac OS X such as QuarkXpress. 23 Second, despite the overall increase in net sales during 2002 in the Americas, the Company continues to see weakness in its U.S. education channel. Total net sales in this channel fell 15% in 2002 and +4% in 2001. These declines are consistent with industry data that shows the Company losing market share in the U.S. education market in each of the last two fiscal years. The Company believes this +weakness has been caused by multiple factors, including increased price competition in this price sensitive market from the Company's competitors who sell Windows-based personal computers. +Additionally, some of the Company's education customers appear to be delaying technology purchases due to concerns about the overall impact of the weaker economy on their available funding. The +Company continues to take steps to address weakness in the U.S. education channel. However, it is difficult to anticipate how this trend will affect fiscal 2003 and to anticipate when and if this +trend will reverse. Third, +the personal computer industry in general and the Company specifically continue to see relatively soft demand for its products. Despite an overall increase in unit sales of consumer oriented +Macintosh systems during 2002, consumer sales remain far below levels experienced in 2000 and earlier. Worsening global economic conditions over the past three years exacerbated by the economic and +political uncertainties caused by terrorist activities and the associated international responses have clearly had a pronounced negative effect on the overall demand for the Company's products in +virtually all of its markets. Further, growth in the overall personal computer industry has been slowed due to the high market penetration of personal computers and a lengthening of consumer, +creative, and business personal computer upgrade cycles. In short, the Company believes that expansion in the overall market for personal computers has for the most part stalled and that growth awaits +a combination of economic recovery and technological advancements. Net +sales decreased $2.6 billion or 33% during 2001 compared to 2000, while Macintosh unit sales fell 32% from 2000. Demand for all of the Company's products in all of the Company's geographic +operating segments was negatively impacted throughout 2001 by unfavorable global economic conditions. On a year-over-year basis, net sales and Macintosh unit sales were down in +all of the Company's geographic operating segments, and net sales and unit sales by product were down for each Macintosh product category except iBook. In addition to general economic conditions, two +other primary factors contributed to the decline in net sales during 2001. First, as discussed below, the Company executed a plan during the first three quarters of 2001 to reduce substantially the +level of inventory in its distribution channels. As a result of these efforts, the Company's Macintosh channel inventory fell by approximately 450,000 units during the first nine months of 2001. +Second, the Company believes that many of its professional users were delaying upgrades of their Power Macintosh systems due to the Company's ongoing transition to Mac OS X, its new operating system, +and in anticipation of software vendors transitioning their Mac applications to run natively in Mac OS X. Several +positive factors combined to partially mitigate the overall decline in net sales during 2001. The net sales per Macintosh unit sold remained relatively strong during 2001 after adjusting for +the $138 million impact to net sales of the rebate programs and price cuts instituted by the Company during the first quarter of 2001, falling only about 2.5% from 2000. The relatively strong +per unit sales in 2001 reflects somewhat lower year-over-year pricing on comparative systems, offset by a shift in overall sales mix toward higher-priced portable systems. +Also, the Company experienced very little shift in the mix of overall combined unit sales of relatively lower-priced consumer and education Macintosh systems, iMac and iBook, and their higher-priced +professionally oriented equivalents. Combined unit sales of iMac and iBook systems accounted for 58% of total Macintosh unit sales in 2001 and 60% in 2000. Second, combined unit sales of portable +systems, iBook and PowerBook, actually rose 2% during 2001 despite the negative economic climate and the overall decline in unit sales. Not only does this increase in portable system sales reflect a +general industry shift toward portable systems, it is also specifically attributable to the strong demand for redesigned iBooks introduced during the third quarter of 2001 and for the Titanium +PowerBook G4 which was introduced during the second quarter of 2001. Third, a small decline in net sales 24 in the U.S. education market during 2001 compared to 2000 was partially mitigated by a 7% increase in U.S. education unit sales during 2001. First +quarter 2001 net sales decreased 57% to $1.007 billion compared to the same quarter in 2000 and decreased 46% from the fourth quarter of 2000. Both the +year-over-year and sequential declines in net sales during the first quarter of 2001 were attributable to several factors, including continued deterioration in worldwide demand +for personal computers and rebate programs and price cuts instituted by the Company during the quarter that cost the Company approximately $138 million. In addition, the Company implemented a +plan during the first quarter to reduce substantially the level of inventory in its distribution channels from the amounts at the end of fiscal 2000 to lower levels by the end of the first quarter of +2001. The Company ended fiscal 2000 with substantially more inventory in its distribution channels than planned due to the lower than expected sell-through of the Company's products during +the fourth quarter of that year. The Company reduced Macintosh channel inventory during the first quarter by approximately 300,000 units. These factors contributed to the 52% +year-over-year decline during the first quarter in total Macintosh unit sales that were experienced across the Company's entire product line. These factors also reduced the net +sales per Macintosh unit sold (a function of total net sales associated with Macintosh units and total Macintosh CPU unit sales) during the first quarter of 2001 to $1,476, a decline of approximately +12% from the same period in 2000. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company's reportable operating segments include the Americas, Europe, Japan, and Retail. The Americas +segment includes both North and South America, except for the Company's Retail segment. The European segment includes European countries as well as the Middle East and Africa. The Japan segment +includes only Japan. The Retail segment operates Apple-owned retail stores in the United States. Each reportable geographic operating segment provides similar hardware and software products and +similar services. Further information regarding the Company's operating segments may be found in Part II, Item 8 on this Form 10-K in the Notes to Consolidated Financial +Statements at Note 11, "Segment Information and Geographic Data." Americas Net sales for the Americas segment increased 3% or $92 million in 2002. As discussed above, the Americas segment was negatively affected by a decline in U.S. education +sales in 2002 of $215 million. The Americas segment also experienced a 17% decline in Power Macintosh unit sales. However, outside of the U.S. education channel, unit sales of consumer desktop +and portable systems rebounded from the substantial declines experienced in 2001, rising a combined 31% in 2002. Sales of software, peripherals, and accessories were also up in the Americas during +2002. Growth in unit sales of consumer oriented systems during 2002 in the Americas is somewhat attributable to the significantly depressed level of net sales experienced in the first quarter of 2001 +discussed above. However, growth in the Americas was somewhat negatively affected, particularly with respect to consumer-oriented systems, by the significant growth of the Company's Retail segment in +the U.S. More than 70% of the Retail segment's Macintosh unit sales during 2002 were for iMacs and iBooks. The +Americas segment's 2001 net sales and unit sales declined 30% and 29%, respectively, from 2000. The operating performance of the Americas segment for 2001 reflects the Company's overall +performance characterized by significant declines in year-over-year quarterly net sales and units sales, particularly during the first quarter and particularly in consumer +channels, with sequential increases in unit sales and net sales during each of the last three quarters of 2001. Net sales in the Americas segment during 2001 were also negatively affected by the +Company's overall reduction in channel inventories during the year. Consumer sales in the Americas were particularly hard hit by current economic conditions. Outside of the U.S. education channel, +unit sales of the Company's consumer oriented iMac fell 64% in 2001. The effect of falling consumer demand in the Americas segment was partially offset by strong U.S. education sales. The Company's +unit sales in U.S. education markets rose 7% in 2001 driven by the acceptance of the 25 Company's new portable products, particularly the iBook, and reflect a general shift in demand in the U.S. education market towards portable versus desktop systems. Portable systems accounted for 28% +of total unit sales in the Company's U.S. education market in 2001 compared to 18% during 2000. During +2002 and 2001, the Americas segment represented approximately 54% and 56%, respectively, of the Company's total net sales and represented approximately 56% and 57%, respectively, of total +Macintosh unit sales. Europe Economic conditions in Europe remained weak throughout 2002, and the overall demand for the Company's products in that region remained flat during 2002 versus 2001. Unit sales +in Europe for 2002 reflect relatively stronger demand for consumer-oriented products, particularly iBook whose unit sales increased 27% in 2002, offset by declines in Power Macintosh unit sales. Net +sales in Europe fell $568 million or 31% during 2001 compared to 2000, while Europe's unit sales fell 32%. Europe's results reflect the worsening economic climate in Europe in the latter +half of 2001 and reductions in channel inventories as experienced in the Company's other geographic operating segments. Combined unit sales of the Company's consumer oriented products in Europe were +particularly impacted during 2001, falling 40% from 2000. Japan Net sales in Japan remained flat during 2002 versus 2001, with a slight decline in unit sales of 2%. Consistent with the Company's other geographic operating segments, during +2002 Japan showed growth in unit sales of consumer systems and a decline in unit sales of Power Macintosh systems. Japan's iMac unit sales increased 85% in 2002. However, in the case of Japan the +increase in iMac unit shipments in 2002 versus 2001 was primarily the result of the unusually depressed level of net sales experienced by the Company in the first quarter of 2001 discussed above. +Additionally, net sales in Japan on a sequential and year-over-year comparative basis generally worsened as 2002 progressed reflecting particularly poor economic conditions +that currently exist in Japan. Net +sales and unit sales in Japan fell 47% and 46%, respectively, in 2001 versus 2000. Although unit sales and net sales in Japan have generally trended upwards as 2001 progressed, the Japan segment +has been particularly affected by current unfavorable economic conditions. Reflecting the continuing harsh consumer climate in Japan, the Japan segment's combined unit sales of iMacs and iBooks during +2001 were down 58% from 2000, and professionally oriented systems unit sales fell 30%. Retail By the end of September 2002, the Company had 40 retail stores operating in the United States, 32 of which were opened during fiscal 2002. The Company has opened 11 +additional stores during the first quarter of 2003. During 2002, approximately 39% of the Retail segment's net sales came from the sale of Apple-branded and third-party peripherals and software. This +compares to 21% for the Company as a whole. With an average of 35 stores open, the Retail segment achieved average annualized revenue per store during the fourth quarter of approximately +$12 million and had approximately 2.25 million visitors. The Retail segment reported a loss for all of 2002 of $22 million, and a loss for the fourth quarter of 2002 of +$3 million. Expansion +of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease commitments, personnel, and other +operating expenses. Capital expenditures associated with the Retail segment totaled $106 million in 2002 and $92 million in 2001. As of September 28, 2002, the Retail segment had +807 employees and had outstanding operating lease commitments associated with retail store space and related facilities of $209 million. The Company would incur substantial costs should it +choose to terminate its Retail segment or close individual stores. Such costs could adversely affect the Company's results of operations and financial condition. Investment 26 in a new business model such as the Retail segment is inherently risky, particularly in light of the significant investment involved, the current economic climate, and the fixed nature of a +substantial portion of the Retail segment's operating expenses. Results for this segment are dependent upon a number of risks and uncertainties, some of which are discussed below under the heading +"Factors That May Affect Future Results and Financial Condition." Backlog In the Company's experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog +often increases in anticipation of or immediately following new product introductions because of over-ordering by dealers anticipating shortages. Backlog often is reduced once dealers and +customers believe they can obtain sufficient supply. Because of the foregoing, backlog cannot be considered a reliable indicator of the Company's ability to achieve any particular level of revenue or +financial performance. Further information regarding the Company's backlog may be found below under the heading "Factors That May Affect Future Results and Financial Condition." Gross Margin Gross margin for the three fiscal years ended September 28, 2002 are as follows (in millions, except gross margin percentages): 2002 2001 2000 Net sales $ 5,742 $ 5,363 $ 7,983 Cost of sales 4,139 4,128 5,817 Gross margin $ 1,603 $ 1,235 $ 2,166 Gross margin percentage 28 % 23 % 27 % Gross +margin increased to 28% of net sales in 2002 from 23% in 2001. As discussed below, gross margin in 2001 was unusually low resulting from negative gross margin of 2% experienced in the first +quarter of 2001. As a percentage of net sales, the Company's quarterly gross margins declined during fiscal 2002 from 31% in the first quarter down to 26% in the fourth quarter. This decline resulted +from several factors including a rise in component costs as the year progressed and aggressive pricing by the Company across its products lines instituted as a result of continued pricing pressures in +the personal computer industry. The Company anticipates that its gross margin and the gross margin of the overall personal computer industry will remain under pressure throughout fiscal 2003 in light +of weak economic conditions, flat demand for personal computers in general, and the resulting pressure on prices. The +foregoing statements regarding anticipated gross margin in 2003 and the general demand for personal computers during 2003 are forward-looking. Gross margin could differ from anticipated levels +because of several factors, including certain of those set forth below in the subsection entitled "Factors That May Affect Future Results and Financial Condition." There can be no assurance that +current gross margins will be maintained, targeted gross margin levels will be achieved, or current margins on existing individual products will be maintained. In general, gross margins and margins on +individual products will remain under significant downward pressure due to a variety of factors, including continued industry wide global pricing pressures, increased competition, compressed product +life cycles, potential increases in the cost and availability of raw material and outside manufacturing services, and potential changes to the Company's product mix, including higher unit sales of +consumer products with lower average selling prices and lower gross margins. In response to these downward pressures, the Company expects it will continue to take pricing actions with respect to its +products. Gross margins could also be affected by the Company's ability to effectively manage quality problems and warranty costs and to stimulate demand for certain of its products. The Company's +operating strategy and pricing take into account anticipated changes in foreign 27 currency exchange rates over time; however, the Company's results of operations can be significantly affected in the short-term by fluctuations in exchange rates. The +Company orders components for its products and builds inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, there +is a risk the Company will forecast incorrectly and produce or order from third parties excess or insufficient inventories of particular products or components. The Company's operating results and +financial condition have been in the past and may in the future be materially adversely affected by the Company's ability to manage its inventory levels and outstanding purchase commitments and to +respond to short-term shifts in customer demand patterns. Gross +margin declined to 23% of net sales in 2001 from 27% in 2000. This decline resulted primarily from gross margin of negative 2% experienced during the first quarter of 2001 compared to 26% gross +margin for the same quarter in 2000. In addition to lower than normal net sales, first quarter 2001 margins were negatively impacted by the rebate programs and price cuts discussed above that +decreased revenue by approximately $138 million. Additionally, actual and forecasted declines in net sales caused the Company to recognize during the first quarter of 2001 approximately +$122 million of charges associated with purchase order cancellations and loss commitments for component purchases. Without these charges, gross margin for the first quarter of 2001 would have +been approximately 21%, and gross margin for all of 2001 would have been approximately 27%. As a percentage of net sales, the Company's gross margin increased each quarter as 2001 progressed reaching +30% during the fourth quarter. This pattern reflects the favorable impact during 2001 of declining component costs, especially for DRAM, hard drives, and flat panel screens. Operating Expenses Operating expenses for the three fiscal years ended September 28, 2002 are as follows (in millions, except for percentages): 2002 2001 2000 Research and development $ 446 $ 430 $ 380 Percentage of net sales 8 % 8 % 5 % Selling, general, and administrative expenses $ 1,111 $ 1,138 $ 1,166 Percentage of net sales 19 % 21 % 15 % Research and Development (R&D) The Company recognizes that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely +development of new and enhanced products that are central to the Company's core business strategy. R&D expense increased 4% or $16 million to $446 million in 2002 as compared to 2001. +This followed a $50 million or 13% increase in 2001 as compared to 2000. The overall increase in R&D expense over the last two years relates primarily to increased R&D headcount and support for +new product development activities. R&D spending in 2002 also included capitalized software development costs of approximately $13.3 million associated with the development of Mac OS X +Jaguar and approximately $6 million associated with the new PowerSchool enterprise student information system. R&D spending in 2001 also included capitalized software development costs of +approximately $5.4 million associated with the development of the original version of Mac OS X. Further information related to the Company's capitalization of software development costs +may be found in Part II, Item 8 of this Form 10-K at Note 1 of Notes to Consolidated Financial Statements. Selling, General, and Administrative Expense (SG&A) SG&A decreased $27 million or 2% during 2002 as compared to 2001. The decrease in SG&A in 2002 is primarily the result of lower discretionary spending on marketing and +advertising expenses, decreased spending related to information systems, and benefits directly related to the Company's restructuring 28 actions in 2002 and 2001. These decreases were partially offset by higher sales expense in 2002 resulting from increased operating expenses associated with expansion of the Company's Retail segment. +SG&A expenditures decreased $28 million or 2% during 2001 as compared to 2000. Declines in SG&A spending in both 2002 and 2001 reflect the Company's overall efforts to stabilize and selectively +reduce recurring SG&A costs in light of lower net sales and to reduce discretionary marketing and advertising expenses. Given current economic conditions and the Company's continued strategic +investments in new product development and its Retail segment, the Company is currently identifying additional opportunities to make appropriate reductions in SG&A costs. Special Charges Included in Operating Expenses Special charges included in operating expense for the three fiscal years ended September 28, 2002 are as follows (in millions): 2002 2001 2000 Restructuring costs $ 30 — $ 8 Purchased in-process research and development $ 1 $ 11 — Executive bonus $ (2 ) — $ 90 2002 Restructuring Actions During fiscal 2002, the Company recorded total restructuring charges of $30 million related to actions intended to eliminate certain activities and better align the +Company's operating expenses with existing general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company's Retail +operating segment. Once fully implemented, the Company estimates these restructuring actions will result in reduced quarterly operating expenses of approximately $10 million. Of +the $30 million restructuring charge for fiscal 2002, $6 million was incurred in the fourth quarter of 2002 related to actions designed to reduce headcount costs in Corporate +operations and sales and to adjust its PowerSchool product strategy. Headcount actions, primarily in Corporate operations, sales, and PowerSchool related research and development, resulted in the +elimination of approximately 180 positions worldwide at a cost of $1.8 million. The shift in product strategy at PowerSchool included discontinuing development and marketing of a PowerSchool +product that resulted in the impairment of previously capitalized development costs associated with the product in the amount of $4.5 million. The remaining charge in 2002 of $24 million +was incurred in the first quarter of 2002 and will ultimately result in the elimination of approximately 425 positions worldwide, 415 of which were eliminated by September 28, 2002, at a cost +of $8 million. Positions were eliminated primarily in the Company's operations, information systems, and administrative functions. In addition, these restructuring actions also included +significant changes in the Company's information systems strategy resulting in termination of equipment leases and cancellation of existing projects and activities. Related lease and contract +cancellation charges totaled $12 million, and charges for asset impairments totaled $4 million. Of the total charge in 2002 of $30 million, substantially all had been spent by +September 28, 2002, except for approximately $1 million related primarily to future payments on abandoned operating leases. 2000 Restructuring Actions During the first quarter of 2000, the Company initiated restructuring actions resulting in recognition of an $8 million restructuring charge. This charge was comprised +of $3 million for the write-off of various operating assets and $5 million for severance payments to approximately 95 employees associated with consolidation of various +domestic and international sales and marketing functions. Of the $5 million accrued for severance, $2.5 million had been spent before the end of 2000, and the remainder was spent in +2001. Of the $3 million accrued for the write-off of various assets, substantially all was utilized before the end of 2000. 29 Purchased In-Process Research and Development (IPR&D) During the fourth quarter of 2002, the Company acquired Emagic GmbH, a provider of professional software solutions for computer based music production, for approximately +$30 million in cash; $551,000 of which was allocated to IPR&D. The amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of +products under development had not been established and no alternative future uses existed. The IPR&D relates primarily to Emagic's Logic series technology and extensions. At the date of the +acquisition, the products under development were between 43%-83% complete, and it was expected that the remaining work would be completed during the Company's fiscal 2003 at a cost of +approximately $415,000. The remaining efforts include finalizing user interface design and development, and testing. The fair value of the IPR&D was determined by an independent third-party valuation +using the income approach, which reflects the projected free cash flows that will be generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected +net cash flows back to their present value using a discount rate of 25%. In +May 2001, the Company acquired PowerSchool, Inc. (PowerSchool), a provider of web-based student information systems for K-12 schools and districts that enables +schools to record, access, report, and manage their student data and performance in real-time, and gives parents real-time web access to track their children's progress. Of +total purchase consideration of $66.1 million, $10.8 million was allocated to IPR&D and was expensed upon acquisition because the technological feasibility of products under development +had not been established and no alternative future uses existed. The IPR&D relates to technologies representing processes and expertise employed to design, develop, and deploy a functioning, scalable +web-based student information system for use by K-12 schools. At the date of the acquisition, the PowerSchool product under development was approximately 50% complete, and it +was expected that the remaining 50% would be completed during the Company's fiscal 2002 at a cost of approximately $9.25 million. The remaining efforts, which were completed during 2002, +included completion of coding, finalizing user interface design and development, and testing. The fair value of the IPR&D was determined by an independent third-party valuation using the income +approach, which reflects the projected free cash flows that will be generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected net cash flows +back to their present value using a discount rate of 25%. Executive Bonus During the first quarter of 2000, the Company's Board of Directors approved a special executive bonus for the Company's Chief Executive Officer for past services in the form of +an aircraft with a total cost to the Company of approximately $90 million, the majority of which was not tax deductible. Approximately half of the total charge was for the cost of the aircraft. +The other half represents all other costs and taxes associated with the bonus. In the fourth quarter of 2002, all significant work and payments associated with the aircraft were complete. Of the +original $90 million accrual, $2.4 million remained unspent at the end of fiscal 2002 and was reversed. 30 Other Income and Expense Other income and expense for the three fiscal years ended September 28, 2002 are as follows (in millions): 2002 2001 2000 Gains (losses) on non-current investments, net $ (42 ) $ 88 $ 367 Unrealized loss on convertible securities $ — (13 ) $ — Interest income $ 118 $ 218 $ 210 Interest expense (11 ) (16 ) (21 ) Miscellaneous other income and expense 5 15 14 Interest and other income, net $ 112 $ 217 $ 203 Total other income and expense $ 70 $ 292 $ 570 Gains and Losses on Non-current Investments Investments categorized as non-current debt and equity investments on the consolidated balance sheet are in equity and debt instruments of public companies. The +Company's non-current debt and equity investments, and certain investments in private companies carried in other assets, have been categorized as available-for-sale +requiring that they be carried at fair value with unrealized gains and losses, net of taxes, reported in equity as a component of accumulated other comprehensive income. However, the Company +recognizes an impairment charge to earnings in the event a decline in fair value below the cost basis of one of these investments is determined to be other-than-temporary. The +Company includes recognized gains and losses resulting from the sale or from other-than-temporary declines in fair value associated with these investments in other income and +expense. Further information related to the Company's non-current debt and equity investments may be found in Part II, Item 8 of this Form 10-K at Note 2 +of Notes to Consolidated Financial Statements. During +2002, the Company determined that declines in the fair value of certain of these investments were other-than-temporary. As a result, the Company recognized a +$44 million charge to earnings to write-down the basis of its investment in EarthLink, Inc. (EarthLink), a $6 million charge to earnings to write-down the +basis of its investment in Akamai Technologies, Inc. (Akamai), and a $15 million charge to earnings to write-down the basis of its investment in a private company investment. +These losses in 2002 were partially offset by the sale of 117,000 shares of EarthLink stock for net proceeds of $2 million and a gain before taxes of $223,000, the sale of 250,000 shares of +Akamai stock for net proceeds of $2 million and a gain before taxes of $710,000, and the sale of approximately 4.7 million shares of ARM Holdings plc (ARM) stock for both net proceeds +and a gain before taxes of $21 million. During +2001, the Company sold a total of approximately 1 million shares of Akamai stock for net proceeds of $39 million and recorded a gain before taxes of $36 million, and sold a +total of approximately 29.8 million shares of ARM stock for net proceeds of $176 million and recorded a gain before taxes of $174 million. These gains during 2001 were partially +offset by a $114 million charge to earnings that reflected an other-than-temporary decline in the fair value of the Company's investment in EarthLink and an +$8 million charge that reflected an other-than-temporary decline in the fair value of certain private company investments. During 2000, the Company sold a total of +approximately 45.2 million shares of ARM stock for net proceeds of $372 million and a gain before taxes of $367 million. The +combined carrying value of the Company's investments in EarthLink, Akamai, and ARM as of September 28, 2002, was $39 million. The Company believes it is likely there will continue to +be significant fluctuations in the fair value of these investments in the future. 31 Accounting for Derivatives and Cumulative Effect of Accounting Change On October 1, 2000, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 133, Accounting for Derivative Instruments +and Hedging Activities . SFAS No. 133 established accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. Net of the +related income tax effect of approximately $5 million, adoption of SFAS No. 133 resulted in a favorable cumulative-effect-type adjustment to net income of approximately +$12 million for the first quarter of 2001. The $17 million gross transition adjustment was comprised of a $23 million favorable adjustment for the restatement to fair value of the +derivative component of the Company's investment in Samsung Electronics Co., Ltd. (Samsung), partially offset by the unfavorable adjustments to certain foreign currency and interest rate +derivatives. SFAS No. 133 also required the Company to adjust the carrying value of the derivative component of its investment in Samsung to earnings during the first quarter of 2001, the +before tax effect of which was an unrealized loss of approximately $13 million. Interest and Other Income, Net Net interest and other income was $112 million in fiscal 2002, compared to $217 million in fiscal 2001. This $105 million or 48% decrease is primarily the +result of declining investment yields on the Company's cash and short-term investments resulting from substantially lower market interest rates. The weighted average interest rate earned +by the Company on its cash, cash equivalents and short-term investments fell to 2.85% in 2002 compared to 5.38% in 2001. Net +interest and other income increased $14 million or 7% to $217 million during 2001. The increase was due in part to interest income from higher cash and invested balances in 2001, +partially offset by declining interest rates and investment yields, and a rebalancing of the aggregate investment portfolio to a higher proportion of lower risk and better credit investments. The +weighted average interest rate earned by the Company on its cash, cash equivalents and short-term investments fell to 5.38% in 2001 compared to 6.12% in 2000. The +Company expects interest and other income, net to decline substantially in 2003 as declines in interest rates continue to impact earnings on the Company's investment portfolio. The Company's +expects this decline to be most pronounced in the second half of the fiscal year. The foregoing statements are forward-looking. Interest and other income, net could differ from expected levels because +of several factors, including certain of those set forth below in the subsection entitled "Factors That May Affect Future Results and Financial Condition." Additionally, actual future interest and +other income, net may be significantly impacted by unforeseen changes in market interest rates, foreign currency exchange rates, and the fair value of the Company's short-term and +long-term investments. Provision for Income Taxes The Company's effective tax rate for 2002 was 25% compared to the higher statutory rate due primarily to the research and development credit and the reversal of valuation +allowances. As of September 28, 2002, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax credits of $369 million before being offset +against certain deferred tax liabilities for presentation on the Company's balance sheet. Management believes it is more likely than not that forecasted income, including income that may be generated +as a result of certain tax planning strategies, will be sufficient to fully recover the remaining net deferred tax assets. As of September 28, 2002, a valuation allowance of $30 million +was recorded against the deferred tax asset for the benefits of tax losses that may not be realized. The valuation allowance relates principally to the operating loss carryforwards acquired from NeXT +and other acquisitions, the utilization of which is subject to certain limitations imposed by the Internal Revenue Code. The Company will continue to evaluate the realizability of the deferred tax +assets quarterly by assessing the need for and amount of the valuation allowance. 32 The +Internal Revenue Service (IRS) has completed audits of the Company's federal income tax returns through 1997. Substantially all IRS audit issues for years through 1997 have been resolved. +Management believes that adequate provision has been made for any adjustments that may result from tax examinations. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board issued SFAS No. 143, Accounting for Asset Retirement +Obligations , which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated +asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or +normal use of the asset. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate +of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. The +Company is required to adopt the provisions of SFAS No. 143 for the first quarter of its fiscal 2003. Management does not expect the adoption of SFAS No. 143 to have a material impact on +the Company's financial statements. In +August 2001, the Financial Accounting Standards Board issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived +Assets (Statement 144), which supersedes both SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for +Long-Lived Assets to Be Disposed Of and the +accounting and reporting provisions of APB Opinion No. 30 (Opinion 30), Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of +a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions , for the disposal of a segment of a business (as previously defined in that Opinion). +SFAS No. 144 retains the fundamental provisions in SFAS No. 121 for recognizing and measuring impairment losses on long-lived assets held for use and long-lived +assets to be disposed of by sale, while also resolving significant implementation issues associated with SFAS No. 121. For example, SFAS No. 144 provides guidance on how a +long-lived asset that is used as part of a group should be evaluated for impairment, establishes criteria for when a long-lived asset is held for sale, and prescribes the +accounting for a long-lived asset that will be disposed of other than by sale. SFAS No. 144 retains the basic provisions of Opinion 30 on how to present discontinued operations in +the income statement but broadens that presentation to include a component of an entity (rather than a segment of a business). Unlike SFAS No. 121, an impairment assessment under SFAS +No. 144 will never result in a write-down of goodwill. Rather, goodwill is evaluated for impairment under SFAS No. No. 142, Goodwill and Other +Intangible Assets. The +Company is required to adopt the provisions of SFAS No. 144 for the first quarter of its fiscal 2003. Management does not expect the adoption of SFAS No. 144 for +long-lived assets held for use to have a material impact on the Company's financial statements because the impairment assessment under SFAS No. 144 is largely unchanged from SFAS +No. 121. The provisions of SFAS No. 144 for assets held for sale or other disposal generally are required to be applied prospectively after the adoption date to newly initiated disposal +activities. In +June 2002, the Financial Accounting Standards Board issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal +Activities . SFAS No. 146 supersedes Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee +Termination Benefits and Other Costs To Exit an Activity (Including Certain Costs Associated with a Restructuring) and requires that a liability for a cost associated with an +exit or disposal activity be recognized when the liability is incurred, as opposed to when management is committed to an exit plan. SFAS No. 146 also establishes that the liability should +initially be measured and recorded at fair value. This Statement is effective for exit or disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 are +required to be applied prospectively after the adoption date to newly initiated exit activities, and may affect the timing of recognizing future restructuring costs, as well as the amounts recognized. 33 Liquidity and Capital Resources The following table presents selected financial information and statistics for each of the last three fiscal years (dollars in millions): 2002 2001 2000 Cash, cash equivalents, and short-term investments $ 4,337 $ 4,336 $ 4,027 Accounts receivable, net $ 565 $ 466 $ 953 Inventory $ 45 $ 11 $ 33 Working capital $ 3,730 $ 3,625 $ 3,494 Days sales in accounts receivable (a) 36 29 46 Days of supply in inventory (b) 4 1 2 Annual operating cash flow $ 89 $ 185 $ 868 (a) Based +on ending net trade receivables and most recent quarterly net sales for each period. (b) Based +on ending inventory and most recent quarterly cost of sales for each period. As +of September 28, 2002, the Company had $4.337 billion in cash, cash equivalents, and short-term investments, virtually unchanged from the end of fiscal 2001. The primary +sources of total cash, cash equivalents, and short-term investments in fiscal 2002 were $89 million in cash generated by operating activities and $105 million in proceeds +from the exercise of employee stock options, offset by cash utilized for business and asset acquisitions of $52 million and capital expenditures of $174 million. The +Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its working capital needs, capital expenditures, stock +repurchase activity, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. Lease Commitments As of September 28, 2002, the Company had total outstanding commitments on noncancelable operating leases of $464 million, $209 million of which related to +the lease of retail space and related facilities. Remaining terms on the Company's existing operating leases range from 1 to 12 years. Subsequent to September 28, 2002, the Company +entered into additional operating lease commitments for retail space with future lease commitments totaling $65 million for periods ranging from 5 to 10 years. Long-Term Debt The Company currently has long-term debt outstanding in the form of $300 million of aggregate principal amount 6.5% unsecured notes. The notes were sold at +99.925% of par, for an effective yield to maturity of 6.51%. The notes pay interest semiannually and mature on February 15, 2004. Purchase Commitments with Contract Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Company's products and to perform final assembly and test of finished +products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 1 to 3 months. The Company +also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of formal +purchase orders, supplier contracts, and open orders based on projected demand information. Such formal and informal purchase commitments typically cover the Company's forecasted component and +manufacturing requirements for periods ranging from 30 to 130 days. As of September 28, 2002, the Company had outstanding third-party manufacturing commitments and component purchase +commitments of approximately $525 million. 34 Capital Expenditures Of total capital expenditures in 2002 of $174 million, $106 million was for retail store facilities and equipment related to the Company's Retail segment and +$68 million was for corporate infrastructure including information systems enhancements and operating facilities enhancements and expansions. The Company currently anticipates it will utilize +approximately $160 million for capital expenditures during 2003, approximately $77 million of which is expected to be utilized for further expansion of the Company's Retail segment and +the remainder utilized to support normal replacement of existing capital assets and enhancements to general information technology infrastructure. Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During 2002 and 2001, the Company repurchased no common shares. However, during +the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per share +for a total cost of $25.5 million. Since inception of the repurchase plan, the Company has repurchased or committed to repurchase a total of 6.55 million shares of its common stock at a +cost of $217 million. Non-Current Debt and Equity Investments The Company has held significant investments in ARM, Samsung Electronics Co., Ltd, Akamai, and EarthLink. These investments are reflected in the consolidated balance +sheets as non-current debt and equity investments and have been categorized as available-for-sale requiring that they be carried at fair value with unrealized gains +and losses, net of taxes, reported in equity as a component of accumulated +other comprehensive income. All realized gains on the sale of these investments have been included in other income. The combined fair value of these investments was $39 million, +$128 million, and $786 million as of the end of fiscal 2002, 2001, and 2000, respectively. The Company believes it is likely there will continue to be significant fluctuations in the +fair value of these investments in the future. Further +information related to the Company's non-current debt and equity investments may be found in Part II, Item 8 of this Form 10-K at Note 2 of Notes +to Consolidated Financial Statements. Factors That May Affect Future Results and Financial Condition Because of the following factors, as well as other factors affecting the Company's operating results and financial condition, past financial performance should not be +considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. General economic conditions and current economic and political uncertainty could adversely affect the Company. The Company's operating performance depends significantly on general economic conditions. For much of the past 3 years, demand for the Company's products has been +negatively impacted by worsening global economic conditions. Continued uncertainty about future economic conditions continues to make it difficult to forecast future operating results. Should global +and regional economic conditions fail to improve or continue to deteriorate, demand for the Company's products could continue to be adversely affected, as could the financial health of its suppliers, +distributors, and resellers. The +terrorist attacks that took place on September 11, 2001, disrupted commerce throughout the world and created many economic and political uncertainties that have had a strong negative impact +on the global economy. The long-term effects of the September 11, 2001 attacks on the Company's future operating results and financial condition remain unknown. The national and +international responses to terrorist attacks, the potential for future terrorist attacks and other acts of hostility, and the potential for 35 war in the Middle East have created economic and political uncertainties that could adversely affect the Company's future operating results and financial condition. The market for personal computers is highly competitive. The personal computer industry is highly competitive and is characterized by aggressive pricing practices, downward pressure on gross margins, frequent introduction of new +products, short product +life cycles, continual improvement in product price/performance characteristics, price sensitivity on the part of consumers, and a large number of competitors. Over the past several years, price +competition in the market for personal computers has been particularly intense. The Company's competitors who sell Windows-based personal computers have aggressively cut prices and lowered their +product margins in order to gain or maintain market share in response to weakness in demand for personal computing products that began in the second half of calendar 2000. The Company's results of +operations and financial condition have been, and in the future may continue to be, adversely affected by these and other industry-wide pricing pressures and downward pressures on gross margins. The +personal computer industry has also been characterized by rapid technological advances in software functionality, hardware performance, and features based on existing or emerging industry +standards. Further, as the personal computer industry and its customers place more reliance on the Internet, an increasing number of Internet devices that are smaller and simpler than traditional +personal computers may compete for market share with the Company's existing products. Several competitors of the Company have either targeted or announced their intention to target certain of the +Company's key market segments, including consumer, education, professional and consumer digital video editing, and design and publishing. Additionally, several of the Company's competitors have +introduced or announced plans to introduce products that mimic many of the unique design, technical features, and solutions of the Company's products. The Company has many substantial competitors, +many of whom have greater financial, marketing, manufacturing, and technological resources, as well as broader product lines and larger installed customer bases than those of the Company. +Additionally, there has been a trend towards consolidation in the personal computer industry that has resulted in larger and potentially stronger competitors in the Company's markets. The +Company is currently the only maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer market, which is dominated by makers of computers utilizing +Microsoft's Windows operating systems. The Company's future operating results and financial condition are substantially dependent on its ability to continue to develop improvements to the Macintosh +platform in order to maintain perceived design and functional advantages over competing platforms, including Windows. The Company has higher research and development and selling, general and administrative costs, as a percentage of revenues, than many of competitors. The Company's ability to compete successfully and maintain attractive gross margins is heavily dependent upon its ability to ensure a continuing and timely flow of innovative +and competitive products and technology to the marketplace. As a result, the Company incurs higher research and development costs as a percentage of revenue than its competitors who sell Windows-based +personal computers. Many of these competitors seek to compete aggressively on price and maintain very low cost structures. Further, as a result of the expansion of the Company's Retail segment and +costs associated with marketing the Company's brand including its unique operating system, the Company incurs higher selling costs as a percent of revenue than many of its competitors. If the Company +is unable to continue to develop and sell innovative new products with attractive gross margins, its results of operations may be materially adversely affected by its operating cost structure. 36 The Company must successfully manage frequent product introductions and transitions. Due to the highly volatile nature of the personal computer industry, which is characterized by dynamic customer demand patterns and rapid technological advances, the Company +must continually introduce new products and technologies and enhance existing products in order to remain competitive. The success of new product introductions is dependent on a number of factors, +including market acceptance, the Company's ability to manage the risks associated with product transitions, the availability of application software for new products, the effective management of +inventory levels in line with anticipated product demand, the availability of products in appropriate quantities to meet anticipated demand, and the risk that new products may have quality or other +defects in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect that new products will have on its sales or results of operations. During +2001, the Company introduced a new client operating system, Mac OS X, and delivered its first major upgrade, Mac OS X version 10.1. During 2002, the Company delivered another major upgrade, Mac +OS X Jaguar. Inability of the Company to improve the performance and functionality of Mac OS X, advance customer acceptance of the new operating system and its upgrades, or obtain the continued +commitment of software developers to transition existing applications to run on Mac OS X or create new applications to run on Mac OS X, may have an adverse impact on the Company's operating results +and financial condition. Because orders for components, and in some cases commitments to purchase components, must be placed in advance of customer orders, the Company faces substantial inventory risk. The Company records a write-down for inventories of components and products that have become obsolete or are in excess of anticipated demand or net realizable value +and accrues necessary reserves for cancellation fees of orders for inventories that have been canceled. Although the Company believes its inventory and related provisions are adequate, given the rapid +and unpredictable pace of product obsolescence in the computer industry, no assurance can be given the Company will not incur additional inventory and related charges. In addition, such charges have +had, and may again have, a material effect on the Company's financial position and results of operations. The +Company must order components for its products and build inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, +there is a risk the Company will forecast incorrectly and produce or order from third parties excess or insufficient inventories of particular products. Consistent with industry practice, components +are normally acquired through a combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. Such formal and informal purchase commitments +typically cover the Company's forecasted component and manufacturing requirements for periods ranging from 30 to 130 days. The Company's operating results and financial condition have been in +the past and may in the future be materially adversely affected by the Company's ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results are dependent upon the Company's ability to obtain a sufficient supply of components, some of which are in short supply or available only from limited +sources. Although most components essential to the Company's business are generally available from multiple sources, certain key components including microprocessors and application +specific integrated circuits ("ASICs") are currently obtained by the Company from single or limited sources. Some key components (including without limitation DRAM, TFT-LCD +flat-panel displays, and optical and magnetic disk drives), while currently available to the Company from multiple sources, are at times subject to industry-wide availability +and pricing pressures. In addition, new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a +need for, and subsequently qualifies, additional suppliers. In situations where a component or product utilizes new technologies, initial capacity constraints may exist until such time as the +suppliers' yields have 37 matured. The Company and other producers in the personal computer industry also compete for various components with other industries that have experienced increased demand for their products. The +Company uses some components that are not common to the rest of the personal computer industry including certain microprocessors and ASICs. Continued availability of these components may be affected +if producers were to decide to concentrate on the production of components other than those customized to meet the Company's requirements. If the supply of a key component were to be delayed or +constrained on a new or existing product, the Company's results of operations and financial condition could be adversely affected. The +Company's ability to produce and market competitive products is also dependent on the ability and desire of IBM and Motorola, the sole suppliers of the PowerPC RISC-based +microprocessor for the Company's Macintosh computers, to provide the Company with a sufficient supply of microprocessors with price/performance features that compare favorably to those supplied to the +Company's competitors by Intel Corporation and other developers and producers of microprocessors used by personal computers using the Windows operating systems. Further, despite its efforts to educate +the marketplace to the contrary, the Company believes that many of its current and potential customers believe that the relatively slower MHz rating or clock speed of the microprocessors it utilizes +in its Macintosh systems compares unfavorably to those utilized by Windows-based systems and translates to slower overall system performance. There have been instances in recent years where the +inability of the Company's suppliers to provide advanced G4 and G3 microprocessors with higher clock speeds in sufficient quantity has had significant adverse effects on the Company's results of +operations. The inability in the future of the Company to obtain microprocessors in sufficient quantities with competitive price/performance features could have an adverse impact on the Company's +results of operations and financial condition. The Company is dependent on manufacturing and logistics services provided by third parties, many of whom are located outside of the United States. Many of the Company's products are manufactured in whole or in part by third-party manufacturers. In addition, the Company has outsourced much of its transportation and +logistics management. While outsourcing arrangements may lower the fixed cost of operations, they also reduce the Company's +direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of the products manufactured, or the flexibility of the +Company to respond to changing market conditions. Moreover, although arrangements with such manufacturers may contain provisions for warranty expense reimbursement, the Company may remain at least +initially responsible to the ultimate consumer for warranty service or in the event of product defects. Any unanticipated product defect or warranty liability, whether pursuant to arrangements with +contract manufacturers or otherwise, could adversely affect the Company's future operating results and financial condition. Final +assembly of products sold by the Company is conducted in the Company's manufacturing facilities in Sacramento, California, and Cork, Ireland, and by external vendors in Fullerton, California, +Taiwan, Korea, the People's Republic of China, and the Czech Republic. Currently, manufacture of many of the components used in the Company's products and final assembly of all of the Company's +portable products including PowerBooks, iBooks, and the iPod is performed by third-party vendors in Taiwan. If for any reason manufacturing or logistics in any of these locations is disrupted by +regional economic, business, environmental, political, or military conditions or events, the Company's results of operations and financial condition could be adversely affected. The Company's products could experience quality problems that result in decreased net sales and operating profits. The Company sells highly complex hardware and software products that may contain defects in design and manufacture. Sophisticated operating system software and applications +such as the Company sells often contains "bugs" that can unexpectedly interfere with the operation of the software. Defects may also occur in components and products the Company purchases from third +parties that may be beyond its control. 38 There can be no assurance that the Company will be able to detect and fix all defects in the hardware and software it sells. Failure to do so could result in lost revenues, loss of reputation, and +significant expense to remedy. The Company's retail initiative requires a substantial investment and commitment of resources and is subject to numerous risks and uncertainties. Since May of 2001, the Company has opened 51 retail stores in the United States and anticipates opening more stores in calendar 2003. The Company's retail initiative has +required substantial investment in equipment and leasehold improvements, information systems, inventory, and personnel. The Company has also entered into substantial operating leases commitments for +retail space with lease terms ranging from 5 to 12 years. The Company would incur substantial costs should it choose to terminate this initiative or close individual stores. Such costs could +adversely affect the Company's results of operations and financial condition. Additionally, a relatively high proportion of the Retail segment's costs are fixed because of depreciation on store +constructions costs and lease expense. As a result, should the Retail segment experience a decline in sales for any reason, significant losses would result. Certain +of the Company's stores have been intentionally designed and built to serve as high profile venues that function as vehicles for general corporate marketing, corporate events, and brand +awareness. Because of their unique design elements, locations and size, these stores require substantially more investment in equipment and leasehold improvements than the Company's typical retail +stores. The Company has opened two such stores and has several others under development. Because of their location and size, these high profile stores also require the Company to enter into +substantially larger operating lease commitments compared to those required for its more typical stores. Current leases on such locations have terms ranging from 5 to 10 years with total +commitments per location over the lease terms ranging from $25 million to $50 million. Closure or poor performance of one of these high profile stores could have a particularly +significant negative impact on the Company's results of operations and financial condition. Many +of the general risks and uncertainties the Company faces could also have an adverse impact on its Retail segment. Also, many factors unique to retail operations present risks and uncertainties, +some of which are beyond the Company's control, that could adversely affect the Retail segment's future results, cause its actual results to differ from those currently expected, and/or have an +adverse effect on the Company's consolidated results of operations. Potential risks and uncertainties unique to retail operations that could have an adverse impact on the Retail segment include, among +other things, macro-economic factors that have a negative impact on general retail activity; inability to manage costs associated with store construction and operation; lack of consumer acceptance of +the Company's retail approach; failure to attract new users to the Macintosh platform; inability to sell third-party hardware and software products at adequate margins; failure to manage relationships +with existing retail channel partners; lack of experience in managing retail operations; costs associated with unanticipated fluctuations in the value of Apple-branded and third-party retail +inventory; and inability to obtain quality retail locations at reasonable cost. Unit sales of the Company's professionally oriented desktop systems have declined sharply over past two to three years negatively impacting net sales and gross margin. Unit sales of Power Macintosh systems fell 18% during 2002 as compared to 2001 and fell 35% in 2001 from 2000. Power Macintosh unit sales have fallen as a percentage of total +Macintosh unit sales from 38% in 1999 to 25% in 2002. The Company believes that weak economic conditions over the past several years are having a pronounced negative impact on its professional and +creative customers who are the primary users of such systems. The Company also believes that many of these customers continue to delay upgrades of their Power Macintosh systems due to the Company's +ongoing transition to Mac OS X and in anticipation of certain software vendors transitioning their professionally oriented Macintosh software applications to run natively in Mac OS X. In addition to +the negative impact on net sales, declining sales of Power Macintosh systems also have a negative effect on the Company's overall gross margin because Power Macintosh systems are generally higher +priced and have higher individual gross margins than the 39 Company's other Macintosh systems. Continued deterioration in Power Macintosh unit sales will adversely affect the Company's future net sales and gross margin. If future unit sales of Power Macintosh +systems fail to partially or fully recover, it will be difficult for the Company to improve its overall profitability. The Company faces increasing competition in the U.S. education market. Sales in the United States to both elementary and secondary schools, as well as for college and university customers, remains a core market for Apple. Net sales in these +markets fell to 21% of the Company's total net sales in 2002 from 26% in 2001. This drop reflects declines in both net sales and Macintosh unit sales in these markets of 15% and 14%, respectively, in +fiscal 2002 compared to 2001. These developments are consistent with industry data showing the Company losing market share in the U.S. education market in each of the last two fiscal years. Several +competitors of the Company have either targeted or announced their intention to target the education market for personal computers. Although the Company has taken certain steps to strengthen its +position in the education market, there can be no assurance that the Company will be able to increase its share of the education market or maintain its existing share of that market. Failure to +increase or maintain market share in the education market may have an adverse impact on the Company's operating results and financial condition. The Company's future operating performance is dependent on the performance of distributors and other resellers of the Company's products. The Company distributes its products through wholesalers, resellers, national and regional retailers and cataloguers, many of whom distribute products from competing +manufacturers. In addition, the Company also sells many of its products and resells certain third-party products in most of its major markets directly to end users, certain education customers, and +certain resellers through its online stores around the world. The Company also sells its own products and certain third-party products through its retail stores in the United States. Many of the +Company's significant resellers operate on narrow product margins and have been negatively affected by current economic conditions. Considerable trade receivables that are not covered by collateral or +credit insurance are outstanding with the Company's distribution and retail channel partners. The Company's business and financial results could be adversely affected if the financial condition of +these resellers weakened, if resellers within consumer channels were to cease distribution of the Company's products, or if uncertainty regarding demand for the Company's products caused resellers to +reduce their ordering and marketing of the Company's products. Further +information regarding risks associated with Marketing and Distribution may be found in Part I, Item 1 of this Form 10-K under the heading "Markets and Distribution," +which information is hereby incorporated by reference. The Company's business is subject to the risks of international operations. A large portion of the Company's revenue is derived from its international operations. As a result, the Company's operating results and financial condition could be +significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries), and +changes in the value of the U.S. dollar versus the local currency in which the products are sold and goods and services are purchased. Historically, the Company's primary exposure to movements in +foreign currency exchange rates relate to non-dollar denominated sales in +Europe, Japan, Australia, Canada, and certain parts of Asia and non-dollar denominated operating expenses incurred throughout the world. Weaknesses in foreign currencies, particularly the +Japanese Yen and the Euro, can adversely impact consumer demand for the Company's products and the U.S. dollar value of the Company's foreign currency denominated sales. Conversely, strengthening in +these and other foreign currencies can increase the cost to the Company of product components, negatively affecting the Company's results of operations. 40 Margins +on sales of Apple products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate +fluctuations and by international trade regulations, including tariffs and antidumping penalties. Further +information related to the Company's global market risks may be found in Part II, Item 7A of this Form 10-K under the subheading "Foreign Currency Risk" and may be +found in Part II, Item 8 of this Form 10-K at Notes 1 and 2 of Notes to Consolidated Financial Statements, which information is hereby incorporated by reference. The Company's future performance is dependent upon support from third-party software developers. The Company believes that decisions by customers to purchase the Company's personal computers, as opposed to Windows-based systems, are often based on the availability of +third-party software for particular applications such as Microsoft Office. The Company also believes the availability of third-party application software for the Company's hardware products depends in +part on third-party developers' perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company's products versus software for the larger +Windows market. This analysis is based on factors such as the perceived strength of the Company and its products, the anticipated potential revenue that may be generated, acceptance by customers of +Mac OS X, and the costs of developing such software products. To the extent the Company's financial losses in prior years and the minority market share held by the Company in the personal computer +market, as well as the Company's decision to end its Mac OS licensing program, have caused software developers to question the Company's prospects in the personal computer market, developers could be +less inclined to develop new application software or upgrade existing software for the Company's products and more inclined to devote their resources to developing and upgrading software for the +larger Windows market. In addition, past and future development by the Company of its own software applications and solutions may negatively impact the decision of software developers to develop, +maintain, and upgrade similar or competitive software for the Company's products. Moreover, there can be no assurance software developers will continue to develop software for Mac OS X, the Company's +new operating system, on a timely basis or at all. In +August 1997, the Company and Microsoft Corporation entered into patent cross license and technology agreements. In addition, for a period of five years through August 2002, and +subject to certain limitations related to the number of Macintosh computers sold by the Company, Microsoft was +required to make versions of its Microsoft Office and Internet Explorer products for the Mac OS. Although Microsoft has released Microsoft Office and Internet Explorer for Mac OS X, Microsoft is not +obligated to produce future versions of its products subsequent to August 2002. While the Company believes its relationship with Microsoft has been and will continue to be beneficial to the +Company and to its efforts to increase the installed base for the Mac OS, the Company does compete directly with Microsoft in a number of key areas. Accordingly, Microsoft's interest in producing +application software for the Mac OS following expiration of the agreements may be influenced by Microsoft's perception of its interests as the vendor of the Windows operating system. Discontinuance of +Microsoft Office and other Microsoft products for the Macintosh platform would have an adverse effect on the Company's net sales and results of operations. The Company's business relies on access to patents and intellectual property obtained from third parties, and the Company's future results could be adversely affected if it is +alleged or found to have infringed on the intellectual property rights of others. Many of the Company's products are designed to include intellectual property obtained from third parties. While it may be necessary in the future to seek or renew licenses +relating to various aspects of its products and business methods, the Company believes that based upon past experience and industry practice, such licenses generally could be obtained on commercially +reasonable terms. However, there can be no assurance that the necessary licenses would be available or available on acceptable terms. 41 Because +of technological changes in the computer industry, current extensive patent coverage, and the rapid rate of issuance of new patents, it is possible certain components of the Company's products +and business methods may unknowingly infringe existing patents of others. The Company has from time to time been notified that it may be infringing certain patents or other intellectual property +rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in significant expenses, and cause the diversion of management and technical personnel. Several +pending claims are in various stages of evaluation. The Company may consider the desirability of entering into licensing agreements in certain of these cases. However, no assurance can be given that +such licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting the Company from marketing or selling +certain of its products or a successful claim of infringement against the Company requiring it to pay royalties to a third-party, the Company's future operating results and financial condition could +be adversely effected. Information regarding claims and potential litigation involving the Company related to alleged patent infringement and other matters is set forth in Part I, Item 3 of +this Form 10-K. In the opinion of management, the Company does not have a potential liability for damages or royalties from any current legal proceedings or claims related to the +infringement of patent or other intellectual property rights of others that would have a material adverse effect on its results of operations, or financial condition. However, the results of such +legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of the matters related to infringement of patent or other intellectual property rights of others +described in Part I, Item 3 of this Form 10-K or should several of these matters be resolved against the Company in the same reporting period, the operating results of a +particular reporting period could be materially adversely affected. The Company expects its quarterly revenues and operating results to fluctuate for a variety of reasons. The Company's profit margins vary among its products, its geographic markets, and its distribution channels. As a result, the overall profitability of the Company in any given +period will depend, in part, on the product, geographic, and channel mix reflected in that period's net sales. The typical concentration of net sales in the third month of the Company's fiscal quarters can adversely affect the Company's business and operating results. The Company generally sells more products during the third month of each quarter than it does during either of the first two months, a pattern typical in the personal computer +industry. This sales pattern can produce pressure on the Company's internal infrastructure during the third month of a quarter and may adversely impact the Company's ability to predict its financial +results accurately. Developments late in a quarter, such as lower-than-anticipated demand for the Company's products, an internal systems failure, or failure of one of the +Company's key logistics or components suppliers, can have significant adverse impacts on the Company and its results of operations and financial condition. The Company's success depends largely on its ability to attract and retain key personnel. Much of the future success of the Company depends on the continued service and availability of skilled personnel, including those in technical, marketing and staff positions. +Experienced personnel in the information technology industry are in high demand and competition for their talents is intense, especially in the Silicon Valley, where the majority of the Company's +employees are located. There can be no assurance that the Company will be able to successfully attract and retain the key personnel it needs. Additionally, volatility or a lack of positive performance +in the Company's stock price may adversely affect its ability to retain key employees. As of September 28, 2002, a substantial majority of the Company's outstanding employee stock options were +out-of-the-money. The Company is subject to risks associated with the availability and cost of insurance. The Company has observed rapidly changing conditions in the insurance markets relating to nearly all areas of traditional corporate insurance. Such conditions have resulted in +higher premium costs, higher policy deductibles, and lower coverage limits. For some risks, because of cost and/or availability, the 42 Company does not have insurance coverage. For these reasons, the Company is retaining a greater portion of its insurable risks than it has in the past at relatively greater cost. The Company is exposed to credit risk on its accounts receivables. This risk is heightened as economic conditions worsen. The Company distributes its products through third-party computer resellers and retailers and directly to certain educational institutions and commercial customers. A +substantial majority of the Company's outstanding trade receivables are not covered by collateral or credit insurance. The Company also has non-trade receivables from certain of its +manufacturing vendors resulting from the sale by the Company of raw material components to these manufacturing vendors who manufacture sub-assemblies or assemble final products for the +Company. While the Company has procedures in place to monitor and limit exposure to credit risk on its trade and non-trade receivables, there can be assurance that such procedures will be +effective in limiting its credit risk and avoiding losses. Additionally, if the global economy and regional economies fail to improve or continue to deteriorate, it becomes more likely that the +Company will incur a material loss or losses as a result of the weakening financial condition of one or more of its customers or manufacturing vendors. The market value of the Company's non-current debt and equity investments is subject to significant volatility. The Company holds minority investments in several public companies with a combined fair market value of approximately $39 million as of September 28, 2002. These +investments are in publicly traded companies whose share prices are subject to significant volatility. The Company has categorized its investments in these companies as +available-for-sale requiring the investments be carried at fair value, with unrealized gains and losses, net of taxes, reported as a component of accumulated other +comprehensive income. The Company recognizes an impairment charge to earnings when it is judged an investment has experienced a decline in value that is other-than-temporary. +The Company has recognized material impairment charges related to its non-current debt and equity investments twice in the last two fiscal years. The Company is subject to risks associated with environmental regulations. Production and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the +requirement that the Company provide consumers with the ability to return to the Company product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling +with the Company. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such +existing laws or future laws will not have a material adverse effect on the Company. The +parliament of the European Union is working on finalizing the Waste Electrical and Electronic Equipment Directive (the Directive). The Directive makes producers of electrical goods, including +personal computers, financially responsible for the collection, recycling, and safe disposal of past and future products. The Directive must now be approved and implemented by individual European +Union governments by June 2004, while the producers' financial obligations are scheduled to start June 2005. The Company's potential liability resulting from the Directive related to +past sales of its products and expenses associated with future sales of its product may be substantial. However, because it is likely that specific +laws, regulations, and enforcement policies will vary significantly between individual European member states, it is not currently possible to estimate the Company's existing liability or future +expenses resulting from the Directive. As the European Union and its individual member states clarify specific requirements and policies with respect to the Directive, the Company will continue to +assess its potential financial impact. Similar legislation may be enacted in other geographies, including federal and state legislation in the United States, the cumulative impact of which could be +significant. 43 Business interruptions could adversely affect the Company's future operating results. The Company's major business operations are subject to interruption by earthquake, fire, power shortages, terrorist attacks and other hostile acts, labor disputes, and other +events beyond its control. The majority of the Company's research and development activities, its corporate headquarters, and other critical business operations, including certain major components +suppliers and manufacturing vendors, are located near major seismic faults. The Company does not carry earthquake insurance for direct quake-related losses. The Company's operating results and +financial condition could be materially adversely affected in the event of a major earthquake or other natural or manmade disaster. Unanticipated changes in the Company's tax rates could affect its future results. The Company's future effective tax rates could be favorably or unfavorably affected by unanticipated changes in the mix of earnings in countries with differing statutory tax +rates, changes in the valuation of the Company deferred tax assets and liabilities, or by changes in tax laws or their interpretation. The Company's stock price may be volatile. The Company's stock has at times experienced substantial price volatility as a result of variations between its actual and anticipated financial results and as a result of +announcements by the Company and its competitors. In addition, the stock market has experienced extreme price and volume fluctuations that have affected the market price of many technology companies +in ways that have been unrelated to the operating performance of these companies. These factors, as well as general economic and political conditions and investors' concerns regarding the credibility +of corporate financial reporting and integrity of financial markets, may materially adversely affect the market price of the Company's common stock in the future. 44 Item 7A. Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management To ensure the adequacy and effectiveness of the Company's foreign exchange and interest rate hedge positions, as well as to monitor the risks and opportunities of the +non-hedge portfolios, the Company continually monitors its foreign exchange forward and option positions, and its interest rate swap and option positions both on a stand-alone basis and in +conjunction with its underlying foreign currency and interest rate related exposures, respectively, from both an accounting and an economic perspective. However, given the effective horizons of the +Company's risk management activities and the anticipatory nature of the exposures intended to hedge, there can be no assurance the aforementioned programs will offset more than a portion of the +adverse financial impact resulting from unfavorable movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains and losses related to +mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely +affect the Company's operating results and financial position. The Company adopted Statement of Financial Accounting Standard No. 133, Accounting for Derivative +Instruments and Hedging Activities , as of October 1, 2000. SFAS No. 133 establishes accounting and reporting standards for derivative instruments, hedging +activities, and exposure definition. Management does not believe that ongoing application of SFAS No. 133 will significantly alter the Company's hedging strategies. However, its application may +increase the volatility of other income and expense and other comprehensive income. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world's leading industrialized countries, the Company's interest income and expense is most sensitive +to fluctuations in the general level of U.S. interest rates. In this regard, changes in U.S. interest rates affect the interest earned on the Company's cash, cash equivalents, and +short-term investments as well as costs associated with foreign currency hedges. The +Company's fixed income investment policy and strategy is to ensure the preservation of capital, meet liquidity requirements, and optimize return in light of the current credit and interest rate +environment. The Company benchmarks its performance by utilizing external money managers to manage a small portion of the aggregate investment portfolio. The external managers adhere to the Company's +investment policies and also provide occasional research and market information that supplements internal research used to make credit decisions in the investment process. During +1994, the Company issued $300 million aggregate principal amount of 6.5% unsecured notes in a public offering registered with the SEC. The notes were sold at 99.925% of par, for an +effective yield to maturity of 6.51%. The notes pay interest semiannually and mature on February 15, 2004. The +Company's exposure to market risk for changes in interest rates relates primarily to the Company's investment portfolio and long-term debt obligations and related derivative financial +instruments. The Company places its short-term investments in highly liquid securities issued by high credit quality issuers and, by policy, limits the amount of credit exposure to any one +issuer. The Company's general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with maturities of +three months or less are classified as cash equivalents; highly liquid investments with maturities greater than three months are classified as short-term investments. As of +September 28, 2002, $1.087 billion of the Company's investment portfolio classified as short-term investments was invested in U.S. Agency and corporate debt securities with +maturities ranging from 1 to 5 years. As of September 29, 2001, $313 million of the Company's investment portfolio classified as short-term investments was in U.S. +agency securities with underlying maturities ranging from 1 to 4 years. The remainder all had underlying maturities between 3 and 12 months. Due to liquidity needs, or in anticipation of +credit deterioration, or for the purpose of duration management of the Company's 45 investment portfolio, the Company may sell investments prior to their stated maturities. As a result of such activity, the Company recognized net gains of $7 million in 2002 and +$1 million in 2001. In +order to provide a meaningful assessment of the interest rate risk associated with the Company's investment portfolio, the Company performed a sensitivity analysis to determine the impact that a +change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 28, +2002, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $37.7 million decline in the fair market value of the portfolio. As of +September 29, 2001, a similar 100 basis point shift in the yield curve would have resulted in a $17.8 million decline in fair value. Such losses would only be realized if the Company +sold the investments prior to maturity. Except in instances noted above, the Company's policy is to hold investments to maturity. The +Company sometimes enters into interest rate derivative transactions, including interest rate swaps, collars, and floors, with financial institutions in order to better match the Company's +floating-rate interest income on its cash equivalents and short-term investments with its fixed-rate interest expense on its long-term debt, and/or to +diversify a portion of the Company's exposure away from fluctuations in short-term U.S. interest rates. The Company may also enter into interest rate contracts that are intended to reduce +the cost of the interest rate risk management program. During +the last two years, the Company has entered into interest rate swaps with financial institutions in order to better match the Company's floating-rate interest income on its cash +equivalents and short-term investments with its fixed-rate interest expense on its long-term debt, and/or to diversify a portion of the Company's exposure away from +fluctuations in short-term U.S. interest rates. The interest rate swaps, which qualified as accounting hedges, generally required the Company to pay a floating interest rate based on the +three- or six-month U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of the underlying notional amounts. These swaps effectively converted the Company's +fixed-rate 10-year debt to floating-rate debt and convert a portion of the floating rate investments to fixed rate. Due to prevailing market interest rates, during +2002 the Company entered into and then subsequently closed out debt swap positions realizing a gain of $6 million. During 2001 +the Company closed out all of its then existing debt swap positions realizing a gain of $17 million. Both the gains in 2001 and 2002 were deferred, recognized in long-term debt and +are being amortized to other income and expense over the remaining life of the debt. At certain times in the past, the Company has also entered into interest rate contracts that are intended to reduce +the cost of the interest rate risk management program. The Company does not hold or transact in such financial instruments for purposes other than risk management. The +Company's asset swaps did not qualify for hedge accounting treatment and were recorded at fair value on the balance sheet with associated gains and losses recorded in interest and other income. +Interest rate asset swaps outstanding as of September 30, 2000, had a weighted-average receive rate of 5.50% and a weighted-average pay rate of 6.66%. The unrealized loss on these assets swaps +as of September 30, 2000, of $5.7 million was deferred and then recognized in income in 2001 as part of the SFAS No. 133 transition adjustment effective on October 1, 2000. +The Company closed out all of its existing interest rate asset swaps during 2001 realizing a gain of $1.1 million. Foreign Currency Risk Overall, the Company is a net receiver of currencies other than the U.S. dollar and, as such, benefits from a weaker dollar and is adversely affected by a stronger dollar +relative to major currencies worldwide. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect the Company's net sales and gross margins as +expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing within the time frame of our hedged positions due to competitive pressures when +there has been significant volatility in foreign currency exchange rates. 46 The +Company enters into foreign currency forward and option contracts with financial institutions primarily to protect against foreign exchange risks associated with existing assets and liabilities, +certain firmly committed transactions, and probable but not firmly committed transactions. Generally, the Company's practice is to hedge a majority of its existing material foreign exchange +transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and limited +availability of appropriate of hedging instruments. The Company also enters into foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the +re-measurement of certain recorded assets and liabilities denominated in non-functional currencies of its foreign subsidiaries. In +order to provide a meaningful assessment of the foreign currency risk associated with certain of the Company's foreign currency derivative positions, the Company performed a sensitivity analysis +using a value-at-risk (VAR) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate 3000 +random market price paths. The value-at-risk is the maximum expected loss in fair value, for a given confidence interval, to the Company's foreign exchange portfolio due to +adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model +assumes normal market conditions. Forecasted transactions, firm commitments, and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the +model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $3.8 million as of September 28, 2002 compared to a maximum one-day loss +of $6.8 million as of September 29, 2001. Because the Company uses foreign currency instruments for hedging purposes, losses incurred on those instruments are generally offset by +increases in the fair value of the underlying exposures. Actual +gains and losses in the future associated with the Company's investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of +September 28, 2002 due to the inherent limitations associated with predicting the changes in the timing and amount of interest rates, foreign currency exchanges rates, and the Company's actual +exposures and positions. 47 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Financial Statements: Consolidated Balance Sheets as of September 28, 2002, and September 29, 2001 49 Consolidated Statements of Operations for the three fiscal years ended September 28, 2002 50 Consolidated Statements of Shareholders' Equity for the three fiscal years ended September 28, 2002 51 Consolidated Statements of Cash Flows for the three fiscal years ended September 28, 2002 52 Notes to Consolidated Financial Statements 53 Selected Quarterly Financial Information (Unaudited) 87 Report of Independent Auditors, KPMG LLP 89 All +financial statement schedules have been omitted, since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the Consolidated Financial Statements and Notes thereto. 48 CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 28, 2002 September 29, 2001 ASSETS: Current assets: Cash and cash equivalents $ 2,252 $ 2,310 Short-term investments 2,085 2,026 Accounts receivable, less allowances of $51 and $51, respectively 565 466 Inventories 45 11 Deferred tax assets 166 169 Other current assets 275 161 Total current assets 5,388 5,143 Property, plant, and equipment, net 621 564 Non-current debt and equity investments 39 128 Acquired intangible assets 119 76 Other assets 131 110 Total assets $ 6,298 $ 6,021 LIABILITIES AND SHAREHOLDERS' EQUITY: Current liabilities: Accounts payable $ 911 $ 801 Accrued expenses 747 717 Total current liabilities 1,658 1,518 Long-term debt 316 317 Deferred tax liabilities 229 266 Total liabilities 2,203 2,101 Commitments and contingencies Shareholders' equity: Common stock, no par value; 900,000,000 shares authorized; 358,958,989 and 350,921,661 shares issued and outstanding, respectively 1,826 1,693 Acquisition-related deferred stock compensation (7 ) (11 ) Retained earnings 2,325 2,260 Accumulated other comprehensive income (loss) (49 ) (22 ) Total shareholders' equity 4,095 3,920 Total liabilities and shareholders' equity $ 6,298 $ 6,021 See +accompanying notes to consolidated financial statements. 49 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) Three fiscal years ended September 28, 2002 2002 2001 2000 Net sales $ 5,742 $ 5,363 $ 7,983 Cost of sales 4,139 4,128 5,817 Gross margin 1,603 1,235 2,166 Operating expenses: Research and development 446 430 380 Selling, general, and administrative 1,111 1,138 1,166 Special charges: Restructuring costs 30 — 8 In-process research and development 1 11 — Executive bonus (2 ) — 90 Total operating expenses 1,586 1,579 1,644 Operating income (loss) 17 (344 ) 522 Other income and expense: Gains (losses) on non-current investments, net (42 ) 88 367 Unrealized loss on convertible securities — (13 ) — Interest and other income, net 112 217 203 Total other income and expense 70 292 570 Income (loss) before provision for income taxes 87 (52 ) 1,092 Provision for (benefit from) income taxes 22 (15 ) 306 Income (loss) before accounting change 65 (37 ) 786 Cumulative effect of accounting change, net of income taxes of $5 — 12 — Net income (loss) $ 65 $ (25 ) $ 786 Earnings (loss) per common share before accounting change: Basic $ 0.18 $ (0.11 ) $ 2.42 Diluted $ 0.18 $ (0.11 ) $ 2.18 Earnings (loss) per common share: Basic $ 0.18 $ (0.07 ) $ 2.42 Diluted $ 0.18 $ (0.07 ) $ 2.18 Shares used in computing earnings (loss) per share (in thousands): Basic 355,022 345,613 324,568 Diluted 361,785 345,613 360,324 See +accompanying notes to consolidated financial statements. 50 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) Preferred Stock Common Stock Acquisition- Related Deferred Stock Compensation Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Shareholders' Equity Shares Amount Shares Amount Balances as of September 25, 1999 150 $ 150 321,598 $ 1,349 $ 1,499 $ — $ 106 $ 3,104 Components of comprehensive income: Net income 786 786 Foreign currency translation — — — — — — (17 ) (17 ) Change in unrealized gain on available-for-sale securities, net of tax — — — — — — 155 155 Total comprehensive income 924 Common stock issued under stock option and purchase plans — — 7,632 85 — — — 85 Conversion of Series A preferred stock (74 ) (74 ) 9,000 74 — — — — Common stock repurchased — — (2,553 ) (116 ) — — — (116 ) Tax benefit related to stock options — — — 110 — — — 110 Balances as of September 30, 2000 76 $ 76 335,677 $ 1,502 $ 2,285 $ — $ 244 $ 4,107 Components of comprehensive income (loss): Net income (loss) (25 ) (25 ) Foreign currency translation — — — — — — (3 ) (3 ) Change in unrealized gain on available-for-sale securities, net of tax — — — — — — (267 ) (267 ) Change in unrealized gain on derivative investments, net of tax — — — — — — 4 4 Total comprehensive income (loss) (291 ) Issuance of common stock and assumption of stock options in connection with acquisition — — 2,403 66 — (13 ) — 53 Amortization of acquisition-related deferred stock compensation — — — — — 2 — 2 Common stock issued under stock option and purchase plans — — 3,660 42 — — 42 Conversion of Series A preferred stock (76 ) (76 ) 9,182 76 — — — — Tax benefit related to stock options — — — 7 — — — 7 Balances as of September 29, 2001 — $ — 350,922 $ 1,693 $ 2,260 $ (11 ) $ (22 ) $ 3,920 Components of comprehensive income (loss): Net income (loss) 65 65 Foreign currency translation — — — — — — 5 5 Change in unrealized gain on available-for-sale securities, net of tax — — — — — — (17 ) (17 ) Change in unrealized gain on derivative investments, net of tax — — — — — — (15 ) (15 ) Total comprehensive income (loss) 38 Amortization of acquisition-related deferred stock compensation — — — — — 4 — 4 Common stock issued under stock option and purchase plans — — 8,037 105 — — 105 Tax benefit related to stock options — — — 28 — — — 28 Balances as of September 28, 2002 — $ — 358,959 $ 1,826 $ 2,325 $ (7 ) $ (49 ) $ 4,095 See accompanying notes to consolidated financial statements. 51 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 28, 2002 2002 2001 2000 Cash and cash equivalents, beginning of the year $ 2,310 $ 1,191 $ 1,326 Operating: Net income (loss) 65 (25 ) 786 Cumulative effect of accounting change, net of taxes — (12 ) — Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 118 102 84 Provision for deferred income taxes (34 ) (36 ) 163 Loss on disposition of property, plant, and equipment 7 9 10 (Gains) losses on investments, net 35 (88 ) (367 ) Unrealized loss on convertible securities — 13 — Purchased in-process research and development 1 11 — Changes in operating assets and liabilities: Accounts receivable (99 ) 487 (272 ) Inventories (34 ) 22 (13 ) Other current assets (114 ) 106 (37 ) Other assets (11 ) 12 20 Accounts payable 110 (356 ) 318 Other current liabilities 45 (60 ) 176 Cash generated by operating activities 89 185 868 Investing: Purchase of short-term investments (4,144 ) (4,268 ) (4,267 ) Proceeds from maturities of short-term investments 2,846 4,811 3,075 Proceeds from sales of short-term investments 1,254 278 256 Purchases of long-term investments — (1 ) (232 ) Purchase of property, plant, and equipment (174 ) (232 ) (142 ) Proceeds from sales of equity investments 25 340 372 Cash used for business acquisitions (52 ) — — Other (7 ) (36 ) (34 ) Cash generated by (used for) investing activities (252 ) 892 (972 ) Financing: Proceeds from issuance of common stock 105 42 85 Cash used for repurchase of common stock — — (116 ) Cash generated by (used for) financing activities 105 42 (31 ) Increase (decrease) in cash and cash equivalents (58 ) 1,119 (135 ) Cash and cash equivalents, end of the year $ 2,252 $ 2,310 $ 1,191 Supplemental cash flow disclosures: Cash paid during the year for interest $ 20 $ 20 $ 20 Cash paid for income taxes, net $ 11 $ 42 $ 47 Noncash transactions: Issuance of common stock for conversion of Series A preferred stock $ — $ 76 $ 74 Issuance of common stock in connection with acquisition $ — $ 66 $ — See +accompanying notes to consolidated financial statements. 52 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1—Summary of Significant Accounting Policies Apple +Computer, Inc. and its subsidiaries (the Company) designs, manufactures, and markets personal computers and related personal computing and communicating solutions for sale primarily to +education, creative, consumer, and business customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these +consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these +consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Typically, +the Company's fiscal year ends on the last Saturday of September. Fiscal years 2002 and 2001 were each 52-week years. However, approximately every six years, the Company reports +a 53-week fiscal year to align its fiscal quarters with calendar quarters by adding a week to its first fiscal quarter. Consequently, an additional week was added to the first quarter of +fiscal 2000. All information presented herein is based on the Company's fiscal calendar. Financial Instruments Investments The Company places its short-term investments in highly liquid securities issued by high credit quality issuers. All highly liquid investments with maturities of +three months or less at the date of purchase are classified as cash equivalents; highly liquid investments with maturities greater than three months are classified as short-term +investments. Management determines the appropriate classification of its investments in debt and marketable equity securities at the time of purchase and reevaluates such designation as of each +balance sheet date. The Company's marketable debt and equity securities have been classified and accounted for as available-for-sale. These securities are carried at fair +value, with the unrealized gains and losses, net of taxes, reported as a component of shareholders' equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments On October 1, 2000, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments +and Hedging Activities . SFAS No. 133 establishes accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS +No. 133 requires that all derivatives be recognized as either assets or liabilities at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the +derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through +earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. Net of the related income tax effect of approximately $5 million, adoption of SFAS +No. 133 resulted in a favorable cumulative-effect-type adjustment to net income of approximately $12 million. Net of the related income tax effect of approximately +$5 million, adoption of SFAS No. 133 resulted in a favorable cumulative-effect-type adjustment to other comprehensive income of approximately $12 million, all of which +was reclassified to earnings during 2001. Management does not believe that ongoing application of SFAS No. 133 will significantly alter the Company's hedging strategies. However, its +application may increase the volatility of other income and expense and other comprehensive income. For +derivative instruments that hedge the exposure to variability in expected future cash flows that are attributable to a particular risk and that are designated as cash flow hedges, the net gain or +loss on the 53 derivative instrument is reported as a component of other comprehensive income in stockholders' equity and reclassified into earnings in the same period or periods during which the hedged transaction +affects earnings. To receive hedge accounting treatment, cash flow hedges must be highly effective in achieving offsetting changes to expected future cash flows on hedged transactions. For derivative +instruments that hedge the exposure to changes in the fair value of an asset or a liability or an identified portion thereof that are attributable to a particular risk and that are designated as fair +value hedges, the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in earnings in the current +period. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the net investment in a foreign +operation is reported in the same manner as a foreign currency translation adjustment. For forward contracts designated as net investment hedges, the Company excludes changes in fair value relating to +changes in the forward carry +component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current earnings. For derivative instruments not designated as hedging +instruments, changes in fair value are recognized in earnings in the current period. For +foreign currency forward contracts designated as cash flow hedges, hedge effectiveness is measured based on changes in the fair value of the contract attributable to changes in the forward +exchange rate. Changes in the expected future cash flows on the forecasted hedged transaction and changes in the fair value of the forward hedge are both measured from the contract rate to the forward +exchange rate associated with the forward contract's maturity date. For currency option contracts designated as cash flow hedges, hedge effectiveness is measured based on changes in total fair value +of the option contract. Hedge effectiveness is assessed by comparing the present value of the cumulative change in expected cash flows on the hedged transactions determined as the sum of the +probability-weighted outcomes with respect to the option strike rates with the total change in fair value of the option hedge. For interest rate swap agreements qualifying as fair value hedges, the +Company assumes no ineffectiveness because these swaps meet the criteria for accounting under the short-cut method defined in SFAS No. 133. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. If the cost of the inventories exceeds their market value, provisions are +made currently for the difference between the cost and the market value. Property, Plant, and Equipment Property, plant, and equipment are stated at cost. Depreciation is computed by use of the declining balance and straight-line methods over the estimated useful +lives of the assets, which are 30 years for buildings, from 2 to 5 years for equipment, and the shorter of lease terms or estimated useful lives for leasehold improvements. The Company +capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use +software are amortized using the straight-line method over the estimated useful lives of the assets, which range from 3 to 5 years. Prior +to the fourth quarter of 2001, the Company had classified capitalized costs related to internal-use software on the balance sheet in other assets. Effective as of +September 29, 2001, and for all other periods presented, the Company has reclassified internal-use software to property, plant, and equipment and reclassified related cash flows for +the purchase or development of internal-use software from cash flow from operations to cash flow from investing activities. 54 Non-Current Debt and Equity Investments Investments categorized as non-current debt and equity investments on the consolidated balance sheet are in equity and debt instruments of public companies. They +are not categorized as current assets either because, given their nature, they are not readily convertible into cash or because they represent potentially longer-term investments by the +Company. Further, the fair value of these investments has been subject to a high degree of volatility. The Company's non-current debt and equity investments have been categorized as +available-for-sale requiring that they be carried at fair value with unrealized gains and losses, net of taxes, reported in equity as a component of accumulated other +comprehensive income. However, the Company recognizes an impairment charge to earnings in the event a decline in fair value below the cost basis of one of these investments is determined to be +other-than-temporary. The Company includes recognized gains and losses resulting from the sale or from other-than-temporary declines in fair value +associated with these investments in other income and expense. Occasionally, the Company uses short-term equity derivatives to manage potential dispositions of non-current debt +and equity investments. Any gains or losses associated with such derivatives are recognized currently in other income and expense. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and certain identifiable intangibles, excluding goodwill, for impairment whenever events or changes in circumstances indicate +the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of its carrying amount to future undiscounted cash flows the assets are expected to +generate. If property, plant, and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the +assets exceeds its fair market value. For the three years ended September 28, 2002, the Company has made no material adjustments to its long-lived assets except those made in +connection with the restructuring actions described in Note 5. The +Company adopted SFAS No. 142, Goodwill and Other Intangible Assets , in the first quarter of fiscal 2002. SFAS No. 142 requires that +goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually or sooner whenever events or changes in circumstances +indicate that they may be impaired. Prior to fiscal 2002, goodwill was amortized using the straight-line method over its estimated useful life. The Company completed its transitional and +annual goodwill impairment tests as of October 1, 2001, and August 30, 2002, respectively, and found no impairment. The Company established reporting units based on its current reporting +structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. SFAS +No. 142 also requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived +Assets and for Long-Lived Assets to Be Disposed Of . The Company is currently +amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 7 years. Foreign Currency Translation The Company translates the assets and liabilities of its international non-U.S. functional currency subsidiaries into U.S. dollars using exchange rates in effect at +the end of each period. Revenues and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are +credited or charged to "accumulated translation adjustment" included in "accumulated other comprehensive income (loss)" in shareholders' equity. The Company's foreign manufacturing subsidiaries and +certain other international subsidiaries that use the U.S. dollar as their functional currency, remeasure monetary assets and liabilities at year-end exchange 55 rates, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these translations are included in the Company's results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale of products (hardware, software, and peripherals), consulting and implementation services, and extended warranty and +support contracts. The Company recognizes revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software +Revenue Recognition , as amended. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and +collectibility is probable. Product is considered delivered to the customer once it has been shipped, and title and risk of loss have been transferred. For online sales to individuals, for some sales +to education customers in the United States, and for certain other sales, the Company defers revenue until product is received by the customer because the Company legally retains a portion of the risk +of loss on these sales during transit. For other product sales, these criteria are met by the Company at the time product is shipped. The Company records reductions to revenue for estimated +commitments related to price protection and for customer incentive programs, including reseller and end user rebates and other sales programs and volume-based incentives. Revenue +for consulting and implementation services is recognized upon performance and acceptance by the customer. Revenue from extended warranty and support contracts is recognized ratably over the +contract period. Amounts billed to customers in excess of revenue recognized on extended warranty and support contracts are recognized as deferred revenue until revenue recognition criteria are met. Revenue +on arrangements that include multiple elements such as hardware, software, and services is allocated to each element based on vendor specific objective evidence of the fair value of each +element. Allocated revenue for each element is recognized when revenue recognition criteria have been met for each element. Vendor specific objective evidence of fair value is generally determined +based on the price charged when each element is sold separately. Shipping Costs The Company's shipping and handling costs are included in cost of sales for all periods presented. Warranty Expense The Company provides currently for the estimated cost that may be incurred under product warranties at the time related revenue is recognized. Research and Development Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased or otherwise marketed are subject to capitalization beginning +when a product's technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company's products are released soon +after technological feasibility has been established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally all software +development costs have been expensed. During +the third and fourth quarter of 2002, the Company incurred substantial development costs associated with the development of Mac OS X version 10.2 (code-named "Jaguar") subsequent to +achievement of technological feasibility as evidenced by public demonstration and release of a developer beta in May 2002 and prior to release of the final version of the product in the fourth +quarter. As such, the Company capitalized approximately $13.3 million of development costs associated with development of 56 Jaguar. Amortization of this asset began in the fourth quarter when Jaguar was shipped and is being recognized on a straight-line basis over 3 years. In addition, during 2002, the +Company also began capitalizing certain costs related to development of its new PowerSchool enterprise student information system. Capitalization, which began upon achievement of technological +feasibility in the first quarter, amounted to approximately $6 million during the first nine months of fiscal 2002. The final version of the enterprise student information system was released +in July. During +2001 the Company incurred substantial development costs associated with the development of the original version of Mac OS X, subsequent to release of a public beta version of the product and +prior to release of the final product version. As a result, the Company capitalized approximately $5.4 million of development costs during 2001 associated with development of Mac OS X. Related +amortization is computed by use of the straight-line method over the estimated useful life of the asset of 8 years. Total +amortization related to capitalized software development costs was $1.2 million and $350,000 in 2002 and 2001, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $209 million, $261 million, and $281 million for 2002, 2001, and 2000, respectively. Stock-Based Compensation The Company measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (APB) +Opinion 25, Accounting for Stock Issued to Employees and has provided pro forma disclosures of the effect on net income and earnings per share as if the +fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB No. 25 because, as discussed below, the alternative fair value accounting +provided for under SFAS No. 123, Accounting for Stock-Based Compensation , requires use of option valuation models that were not developed for use +in valuing employee stock options and employee stock purchase plan shares. Under APB Opinion No. 25, when the exercise price of the Company's employee stock options equals the market price of +the underlying stock on the date of the grant, no compensation expense is recognized. Pro +forma information regarding net income (loss) per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock options granted and +employee stock purchase plan purchases subsequent to September 29, 1995, under the fair value method of that statement. The fair values for these options and stock purchases were estimated at +the date of grant and beginning of the period, respectively, using a Black-Scholes option pricing model. For purposes of pro forma disclosures, the estimated fair value of the options and shares are +amortized to pro forma net income over the options' vesting period and the shares' plan period. The +Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option +valuation models require the input of highly subjective assumptions including the expected life of options and the Company's expected stock price volatility. Because the Company's employee stock +options and employee stock purchase plan shares have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect +the fair value estimate, in management's opinion, the existing models do not provide a reliable measure of the fair value of the Company's employee stock options and employee stock purchase plan +shares. 57 For +purposes of the pro forma disclosures pursuant to SFAS No. 123 provided in the Company's annual reports through 2002, the expected volatility assumptions used by the Company have been based +solely on historical volatility rates of the Company's common stock. The Company has made no adjustments to its expected volatility assumptions based on current market conditions, current market +trends, or expected volatility implicit in market traded options on the Company's stock. The Company will continue to monitor the propriety of this approach to developing its expected volatility +assumption and could determine for future periods that adjustments to historical volatility and/or use of a methodology that is based on the expected volatility implicit in market traded options on +the Company's common stock are more appropriate based on the facts and circumstances existing in future periods. Earnings Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the +period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period +increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of +outstanding options is reflected in diluted earnings per share by application of the treasury stock method. The dilutive effect of convertible securities is reflected using the +if-converted method. Dilutive potential shares of common stock related to stock options were excluded from the calculation of diluted loss per common share for fiscal 2001 because their +effect would have been antidilutive. Stock Split On June 21, 2000, the Company affected a two-for-one stock split in the form of a Common Stock dividend to shareholders of record as of +May 19, 2000. All per share data and numbers of Common shares have been retroactively adjusted to reflect the stock split. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under +generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income is comprised of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, from unrealized gains and losses on marketable securities categorized as +available-for-sale, and from net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Segment Information The Company reports segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions +and assessing performance as the source of the Company's reportable segments. Information about the Company's products, major customers, and geographic areas on a company-wide basis is +also disclosed. Note 2—Financial Instruments The +carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate their fair value due to the short maturities of those instruments. 58 Cash, Cash Equivalents and Short-Term Investments The following table summarizes the fair value of the Company's cash and available-for-sale securities held in its short-term investment +portfolio, recorded as cash and cash equivalents or short-term investments as of September 28, 2002, and September 29, 2001 (in millions): September 28, 2002 September 29, 2001 Cash $ 161 $ 138 U.S. Treasury and Agency securities 47 — U.S. corporate securities 1,952 1,998 Foreign securities 92 174 Total cash equivalents 2,091 2,172 U.S. Treasury and Agency securities 681 1,042 U.S. corporate securities 988 692 Foreign securities 416 292 Total short-term investments 2,085 2,026 Total cash, cash equivalents, and short-term investments $ 4,337 $ 4,336 The +Company's U.S. corporate securities include commercial paper, loan participations, certificates of deposit, time deposits and corporate debt securities. Foreign securities include foreign +commercial paper, loan participation, certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. Net unrealized gains on the Company's +investment portfolio, primarily related to investments with stated maturities greater than 1 year, were $20 million as of September 28, 2002 and $11 million as of +September 29, 2001. The Company occasionally sells short-term investments prior to their stated maturities. As a result of such sales, the Company recognized net gains of +$7 million in 2002 and $1 million in 2001. These net gains were included in interest and other income, net. As +of September 28, 2002, approximately $1.087 billion of the Company's short-term investments had underlying maturities of between 1 and 5 years. The remaining +short-term investments as of September 28, 2002 all had maturities of between 3 and 12 months. As of September 29, 2001, approximately $313 million of the +Company's short-term investments in U.S. agency securities had underlying maturities of between 1 and 4 years. The remaining short-term investments as of +September 29, 2001, all had maturities of between 3 and 12 months. Accounts Receivable Trade Receivables The Company distributes its products through third-party computer resellers and directly to certain education and consumer customers. The Company generally does not require +collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables through the use of flooring arrangements for selected customers with +third-party financing companies and credit insurance for certain customers in Latin America and Asia. However, considerable trade receivables that are not covered by collateral or credit insurance are +outstanding with the Company's distribution and retail channel partners. Trade receivables from a single customer, Ingram Micro, Inc., accounted for approximately 10.8% and 9.4% of net accounts +receivable as of September 28, 2002, and September 29, 2001, respectively. 59 The +following table summarizes the activity in the allowance for doubtful accounts (in millions). 2002 2001 2000 Beginning allowance balance $ 51 $ 64 $ 68 Charged to costs and expenses 10 7 5 Deductions (a) (10 ) (20 ) (9 ) Ending allowance balance $ 51 $ 51 $ 64 (a) Represent +amounts written off against the allowance, net of recoveries. Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale by the Company of raw material components to these +manufacturing vendors who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these raw material components directly from suppliers. These +non-trade receivables, which are included in the consolidated balances sheets in other current assets, totaled $142 million and $68 million as of September 28, 2002, +and September 29, 2001, respectively. The Company does not recognize any profits on these sales or reflect the sale of these components in its net sales. Inventory Prepayment In April 2002, the Company made a $100 million prepayment to an Asian supplier for the purchase of components over the following nine months. In return for this +deposit, the supplier agreed to supply the Company with a specified level of components in the three consecutive fiscal quarters ending December 28, 2002. If the supplier fails to supply the +agreed upon level of components in any of those three fiscal quarters, the Company may cancel the arrangement and receive the amount of the prepayment not utilized plus a penalty. Approximately +$53 million of this deposit remained unused as of September 28, 2002, and is reflected in the condensed consolidated balance sheets in other current assets. The amount of the prepayment +not utilized by the Company on or before December 31, 2002, is refundable to the Company by January 31, 2003. Although +the supplier's existing debt is unrated, its public debt pricing is consistent with other BBB rated companies. The deposit is unsecured and has no stated interest component. The Company is +imputing an amount to cost of sales and interest income during each period the deposit is outstanding at an appropriate market interest rate to reflect the economics of this transaction. In light of +the supplier's implied debt rating and because the Company's prepayment is unsecured, non-performance by and/or economic deterioration of the supplier could place all or some of the +Company's deposit at risk. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign exchange and interest rate risk. Foreign currency forward and option contracts are used to +offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenues and cost of sales. From +time to time, the Company enters into interest rate swap agreements to modify the interest rate profile of certain investments and debt. The Company's accounting policies for these instruments are +based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at fair value. 60 The following table shows the notional principal, net fair value, and credit risk amounts of the Company's interest rate derivative and foreign currency instruments as of +September 28, 2002 and September 29, 2001 (in millions). September 28, 2002 September 29, 2001 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Credit Risk Amounts Transactions qualifying as accounting hedges: Interest rate instruments: Swaps $ — $ — $ — $ — $ — $ — Foreign exchange instruments: Spot/Forward contracts, net $ 462 $ 1 $ 1 $ 562 $ 8 $ 8 Purchased options, net $ 196 $ — $ — $ 551 $ 11 $ 11 Sold options, net $ 392 $ (4 ) $ — $ 712 $ (8 ) $ — Transactions other than accounting hedges: Foreign exchange instruments: Spot/Forward contracts, net $ 302 $ — $ — $ 455 $ (4 ) $ — Purchased options, net $ — $ — $ — $ 334 $ 1 $ 1 Sold options, net $ — $ — $ — $ 354 $ (1 ) $ — The +notional principal amounts for derivative instruments provide one measure of the transaction volume outstanding as of year-end, and do not represent the amount of the Company's +exposure to credit or market loss. The credit risk amount shown in the table above represents the Company's gross exposure to potential accounting loss on these transactions if all counterparties +failed to perform according to the terms of the contract, based on then-current currency exchange and interest rates at each respective date. The Company's exposure to credit loss and +market risk will vary over time as a function of interest rates and currency exchange rates. The +estimates of fair value are based on applicable and commonly used pricing models using prevailing financial market information as of September 28, 2002 and September 29, 2001. In +certain instances where judgment is required in estimating fair value, price quotes were obtained from several of the Company's counterparty financial institutions. Although the table above reflects +the notional principal, +fair value, and credit risk amounts of the Company's interest rate and foreign exchange instruments, it does not reflect the gains or losses associated with the exposures and transactions that the +interest rate and foreign exchange instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the +underlying exposures, will depend on actual market conditions during the remaining life of the instruments. Foreign Exchange Risk Management The Company enters into foreign currency forward and option contracts with financial institutions primarily to protect against foreign exchange risk associated with existing +assets and liabilities, certain firmly committed transactions and certain probable but not firmly committed transactions. Generally, the Company's practice is to hedge a majority of its existing +material foreign exchange transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular +exposures, or availability of appropriate hedging instruments. 61 In +accordance with SFAS No. 133, hedges related to probable but not firmly committed transactions of an anticipatory nature are designated and documented at hedge inception as cash flow hedges +and evaluated for hedge effectiveness quarterly. For currency forward contracts, hedge effectiveness is measured based on changes in the total fair value of the contract attributable to changes in the +forward exchange rate. Changes in the expected future cash flows on the forecasted hedged transaction and changes in the fair value of the forward hedge are both measured from the contract rate to the +forward exchange rate associated with the forward contract's maturity date. For +currency option contracts, hedge effectiveness is measured based on changes in the total fair value of the option contract. Hedge effectiveness is assessed by comparing the present value of the +cumulative change in expected future cash flows on the hedged transaction determined as the sum of the probability-weighted outcomes with respect to the option strike rates with the total change in +fair value of the option hedge. The net gains or losses on derivative instruments qualifying as cash flow hedges are reported as components of other comprehensive income in stockholders' equity and +reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. Any residual changes in fair value of these instruments are recognized in current +earnings in other income and expense. To +protect gross margins from fluctuations in foreign currency exchange rates, the Company's U.S. dollar functional subsidiaries hedge a portion of forecasted foreign currency revenues, and the +Company's non-U.S. dollar functional subsidiaries selling in local currencies hedge a portion of forecasted inventory purchases not denominated in the subsidiaries' functional currency. +Other comprehensive income associated with hedges of foreign currency revenues is recognized as a component of net sales in the same period as the related sales are recognized, and other comprehensive +income related to inventory purchases is recognized as a component of cost of sales in +the same period as the related costs are recognized. Typically, the Company hedges portions of its forecasted foreign currency exposure associated with revenues and inventory purchases over a time +horizon of 3 to 9 months. The +Company also enters into foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the re-measurement of certain recorded assets and +liabilities in non-functional currencies. Changes in the fair value of these derivatives are recognized in current earnings in other income and expense as offsets to the changes in the +fair value of the related assets or liabilities. The +Company may enter into foreign currency forward contracts to offset the translation and economic exposure of a net investment position in a foreign subsidiary. Hedge effectiveness on forwards +designated as net investment hedges is measured based on changes in the fair value of the contract attributable to changes in the spot exchange rate. The effective portion of the net gain or loss on a +derivative instrument designated as a hedge of the net investment position in a foreign subsidiary is reported in the same manner as a foreign currency translation adjustment. Any residual changes in +fair value of the forward contract, including changes in fair value based on the differential between the spot and forward exchange rates are recognized in current earnings in other income and +expense. As +discussed above, the Company enters into foreign currency option contracts as items that provide an offset to the re-measurement of certain recorded assets and liabilities denominated +in non-functional currencies. All changes in the fair value of these derivative contracts based on changes in option time value are recorded in current earnings in other income and +expense. Due to market movements, changes in option time value can lead to increased volatility in other income and expense. Derivative +instruments designated as cash flow hedges must be de-designated as hedges when it is probable that the forecasted hedged transaction will not occur in the initially identified +time period or within a 62 subsequent 2 month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are immediately reclassified into earnings in other income +and expense. Any subsequent changes in fair value of such derivative instruments are also reflected in current earnings unless they are re-designated as hedges of other transactions. +During 2002, the Company recorded net gains of $2.5 million in other income and expense related to the loss of hedge designation on discontinued cash flow hedges due to changes in the Company's +forecast of future net sales and cost of sales and due to prevailing market conditions. During 2001, the Company recorded a net gain of $5.1 million in other income and expense related to the +loss of hedge designation on discontinued cash flow hedges due to changes in the Company's forecast of future net sales and cost of sales. Interest Rate Risk Management The Company sometimes enters into interest rate derivative transactions, including interest rate swaps, collars, and floors, with financial institutions in order to better +match the Company's floating-rate interest income on its cash equivalents and short-term investments with its fixed-rate interest expense on its +long-term debt, and/or to diversify a portion of the Company's exposure away from fluctuations in short-term U.S. interest rates. The Company may also enter into interest rate +contracts that are intended to reduce the cost of the interest rate risk management program. The Company does not hold or transact in such financial instruments for purposes other than risk +management. As +of September 30, 2000, the Company had entered into interest rate swaps with financial institutions in order to better match the Company's floating-rate interest income on its +cash equivalents and short-term investments with its fixed-rate interest expense on its long-term debt, and to diversify a portion of the Company's exposure away +from fluctuations in short-term U.S. interest rates. The interest rate swaps generally required the Company to pay a floating interest rate based on the three- or six-month +U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of the underlying notional amounts. These swaps effectively converted the Company's fixed-rate 10-year +debt to floating-rate debt and converted a portion of the floating rate investments to fixed rate. The Company assumed no ineffectiveness with regard to the debt interest swaps as each +debt interest rate swap met the criteria for accounting under the short-cut method defined in SFAS No. 133 for fair value hedges of debt instruments. Accordingly, no net gains or +losses were recorded in income relative to the Company's underlying debt interest rate swaps. During fiscal 2001, the Company closed out all of its existing debt interest rate swap positions due to +prevailing market interest rates realizing a gain of $17 million. This gain was deferred, recognized in long-term debt and is being amortized to other income and expense over the +remaining life of the debt. The +unrealized loss on the assets swaps as of September 30, 2000, of $5.7 million was deferred and then recognized in income in 2001 as part of the SFAS No. 133 transition +adjustment effective on October 1, 2000. The Company closed out all of its existing interest rate asset swaps during 2001 realizing a gain of $1.1 million. As +of September 28, 2002, the Company had no interest rate derivatives outstanding. Due to perceived market risk, the Company entered into interest rate swaps in early 2002. These interest rate +swaps were entered into with financial institutions in order to better match the Company's floating-rate interest income on its cash equivalents and short-term investments with +its fixed-rate interest expense on its long-term debt. The interest rate swaps required the Company to pay a floating interest rate based on six-month U.S. dollar +LIBOR and receive a fixed rate of interest without exchanges of the underlying notional amounts. These swaps effectively converted the Company's fixed-rate 10-year debt to +floating-rate debt. The Company assumed no ineffectiveness with regard to the debt interest swaps as each debt interest rate swap met the criteria for accounting under the +short-cut method defined in SFAS No. 133 for fair 63 value hedges of debt instruments. Accordingly, no net gains or losses were recorded in income relative to the Company's underlying debt interest rate swaps during fiscal 2002 until the Company closed +out the positions in late 2002 due to prevailing market interest rates. Closing the debt interest rate swaps resulted in a realized gain of $6 million. This gain was deferred, recognized in +long-term debt and is being amortized to other income and expense over the remaining life of the debt. Long-Term Debt During 1994, the Company issued $300 million aggregate principal amount of 6.5% unsecured notes in a public offering registered with the SEC. The notes were sold at +99.925% of par, for an effective yield to maturity of 6.51%. The notes pay interest semiannually and mature on February 15, 2004. As of September 28, 2002 and September 29, 2001, +the carrying amount of these notes, including unamortized deferred gains associated with closed debt interest rate swaps, was $316 million and $317 million, respectively, while the fair +value was $299 million and $295 million, respectively. The fair value of the notes is based on their listed market values as of September 28, 2002 and September 29, 2001. Non-Current Debt and Equity Investments and Related Gains and Losses The Company has held significant investments in EarthLink Network, Akamai Technologies, Inc. (Akamai), ARM Holdings plc (ARM), and Samsung Electronics Co., Ltd +(Samsung). These investments have been reflected in the consolidated balance sheets as non-current debt and equity investments, and their combined fair value was $39 million and +$128 million as of September 28, 2002, and September 29, 2001, respectively. EarthLink In January 2000, the Company invested $200 million in EarthLink, an Internet service provider (ISP). The investment is in EarthLink's Series C Convertible +Preferred Stock, which is convertible by the Company after January 4, 2001, into approximately 7.1 million shares of EarthLink common stock. Concurrent with this investment, EarthLink +and the Company entered into a multi-year agreement to deliver ISP service to Macintosh users in the United States. Under the terms of the agreement, the Company profits from each new Mac +customer that subscribes to EarthLink's ISP service for a specified period of time, and EarthLink is the default ISP in the Company's Internet Setup Software included with all Macintosh computers sold +in the United States. During +the second quarter of 2001, the Company determined that the then current decline in the fair value of its investment in EarthLink was other-than-temporary requiring that its cost basis be +written down to fair value as a new cost basis and the amount of the write-down be included in earnings. As a result, the Company recognized a $114 million charge to earnings to +write-down the basis of its investment in EarthLink to $86 million. This charge was included in gains (losses) on non-current investments, net. During the fourth quarter +of 2001, the Company sold a total of approximately 425,000 shares of EarthLink stock for net proceeds of approximately $6 million and recorded a gain before taxes of approximately $800,000. As +of September 29, 2001, the Company held 6.7 million shares of EarthLink stock with a fair value of approximately $102 million. During +the first quarter of 2002, the Company sold 117,000 shares of EarthLink stock for net proceeds of $2 million and a gain before taxes of $223,000. No sales of EarthLink were made in any +of the subsequent quarters of fiscal 2002. However, during the fourth quarter of 2002, the Company determined that the then +current decline in the fair value of its investment in EarthLink was other-than-temporary. As a result, the Company recognized a $44 million charge to earnings to write-down the +basis of its investment in 64 EarthLink to $35 million. This charge was included in gains (losses) on non-current investments, net. As of September 28, 2002, the Company holds 6.5 million shares +of EarthLink stock valued at $35 million. Akamai In June 1999, the Company invested $12.5 million in Akamai, a global Internet content delivery service. The investment was in the form of convertible preferred +stock that converted into 4.1 million shares of Akamai common stock (adjusted for subsequent stock splits) at the time of Akamai's initial public offering in October 1999. Beginning in +the first quarter of 2000, the Company categorized its shares in Akamai as available-for-sale. The fair value of the Company's investment in Akamai was approximately +$216 million as of September 30, 2000. During 2001, the Company sold a total of approximately 1 million shares of Akamai stock for net proceeds of approximately $39 million +and recorded a gain before taxes of approximately $36 million. As of September 29, 2001, the Company held 3.1 million shares of Akamai stock valued at $9 million. During +the first quarter of 2002, the Company sold 250,000 shares of Akamai stock for net proceeds of $2 million and a gain before taxes of $710,000. No sales of Akamai were made in any of the +subsequent quarters of fiscal 2002. However, during the fourth quarter of 2002, the Company determined that the decline in the fair value of its investment in Akamai was other-than-temporary. As a +result, the Company recognized a $6 million charge to earnings to write-down the basis of its investment in Akamai to $3 million. This charge was included in gains (losses) +on non-current investments, net. As of September 28, 2002, the Company holds 2.9 million shares of Akamai stock valued at $3 million. ARM Holdings ARM is a publicly held company in the United Kingdom involved in the design and licensing of high performance microprocessors and related technology. During the first quarter +of 2002, the Company sold 4.7 million shares of ARM stock for both net proceeds and a gain before taxes of $21 million. No sales of ARM were made in any of the subsequent quarters of +fiscal 2002. As of September 28, 2002, the Company holds 278,000 shares of ARM stock valued at $578,000. During +2001, the Company sold a total of approximately 29.8 million shares of ARM stock for net proceeds of approximately $176 million and recorded a gain before taxes of approximately +$174 million. As of September 29, 2001, the Company held 5 million shares of ARM stock valued at $17 million. During 2000, the Company sold a total of approximately +45.2 million shares of ARM stock for net proceeds of approximately $372 million and recorded a gain before taxes of approximately $367 million. Samsung During the fourth quarter of 1999, the Company invested $100 million in Samsung to assist in the further expansion of Samsung's TFT-LCD +flat-panel display production capacity. The investment was in the form of three year unsecured bonds, which were convertible into approximately 550,000 shares of Samsung common stock +beginning in July 2000. The bonds carried an annual coupon rate of 2% and pay a total yield to maturity of 5% if redeemed at their maturity. The fair value of the Company's investment in +Samsung was approximately $123 million as of September 30, 2000. Prior +to its sale, the Company had categorized its investment in Samsung as available-for-sale requiring that it be carried at fair value with unrealized gains and losses, net +of taxes, reported in equity as a component of accumulated other comprehensive income. The fair value of the Company's investment in Samsung was approximately $123 million as of +September 30, 2000. With the adoption of SFAS No. 133 on October 1, 2000, the Company was required to account for the conversion option embedded in the 65 Samsung bonds separately from the related debt. The conversion feature was carried at fair value with any changes in fair value recognized in earnings in the period in which they occur. Included in +the $17 million gross SFAS No. 133 transition adjustment recorded in earnings during the first quarter of fiscal 2001 was a $23 million favorable adjustment for the restatement to +fair value as of October 1, 2000, of the derivative component of the Company's investment in Samsung. To adjust the carrying value of the derivative component of its investment in Samsung to +fair value as of December 30, 2000, the Company recognized an unrealized loss of approximately $13 million during the first quarter of 2001. During the second quarter of 2001, the +Company sold this investment for book value, including accrued interest, and received net proceeds of approximately $117 million. Other Strategic Investments The Company has made additional minority debt and equity investments in several privately held technology companies which were reflected in the consolidated balance sheets in +other assets. These investments are inherently risky because the products and/or markets of these companies are typically not fully developed. During 2001 the Company determined that the decline in +fair value of certain of these investments was other-than-temporary and, accordingly, recognized a charge to earnings of approximately $8 million. This charge was included in gains (losses) on +non-current investments, net. During 2002, the Company determined that the decline in fair value of certain of these investments was other-than-temporary and, accordingly, recognized a +charge to earnings of $15 million. These charges were included in gains (losses) on non-current investments, net. As of September 28, 2002, the Company has no private debt or +equity investments reflected in its consolidated balance sheet. Note 3—Consolidated Financial Statement Details Inventories (in millions) 2002 2001 Purchased parts $ 9 $ 1 Work in process — — Finished goods 36 10 Total inventories $ 45 $ 11 Property, Plant, and Equipment (in millions) 2002 2001 Land and buildings $ 342 $ 337 Machinery and equipment 183 182 Office furniture and equipment 67 63 Internal-use software 184 192 Leasehold improvements 281 186 1,057 960 Accumulated depreciation and amortization (436 ) (396 ) Net property, plant, and equipment $ 621 $ 564 66 Accrued Expenses (in millions) 2002 2001 Accrued compensation and employee benefits $ 93 $ 88 Accrued marketing and sales programs 136 131 Deferred revenue 253 184 Accrued warranty and related costs 69 87 Other current liabilities 196 227 Total accrued expenses $ 747 $ 717 Interest and Other Income, Net (in millions) 2002 2001 2000 Interest income $ 118 $ 218 $ 210 Interest expense (11 ) (16 ) (21 ) Foreign currency gain (loss), net 4 15 1 Net premiums and discounts on foreign exchange instruments (11 ) (8 ) 7 Miscellaneous other income and expense 12 8 6 Total interest and other income, net $ 112 $ 217 $ 203 Note 4—Acquisitions Goodwill and Other Acquisition-Related Intangibles The following table summarizes the components of gross and net intangible asset balances (in millions): September 28, 2002 September 29, 2001 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Goodwill (a) $ 85 — $ 85 $ 66 — $ 66 Other acquired intangible assets 5 (5 ) — 5 (4 ) 1 Acquired technology 42 (8 ) 34 12 (3 ) 9 Total acquired intangible assets $ 132 $ (13 ) $ 119 $ 83 $ (7 ) $ 76 (a) Accumulated +amortization related to goodwill of $55 million arising prior to the adoption of SFAS No. 142 has been reflected in the gross carrying amount of goodwill as +of September 28, 2002 and September 29, 2001. 67 Expected annual amortization expense related to acquired technology is as follows (in millions): Fiscal Years: 2003 $ 9 2004 7 2005 6 2006 3 Thereafter 9 Total expected annual amortization expense $ 34 Amortization +expense related to acquired intangible assets is as follows (in millions): 2002 2001 2000 Goodwill amortization $ — $ 16 $ 21 Other acquired intangible assets amortization 1 3 3 Acquired technology amortization 5 2 — Total amortization $ 6 $ 21 $ 24 Net +income (loss) and net income (loss) per share adjusted to exclude amortization of goodwill in fiscal periods prior to 2002 follows (in millions, except per share amounts): 2002 2001 2000 Net income (loss), as reported $ 65 $ (25 ) $ 786 Add: goodwill amortization $ — $ 16 $ 21 Net income (loss), as adjusted $ 65 $ (9 ) $ 807 Basic earnings (loss) per share, as reported $ 0.18 $ (0.07 ) $ 2.42 Add: goodwill amortization $ — $ 0.04 $ 0.06 Basic earnings (loss) per share, as adjusted $ 0.18 $ (0.03 ) $ 2.48 Diluted earnings (loss) per share, as reported $ 0.18 $ (0.07 ) $ 2.18 Add: goodwill amortization $ — $ 0.04 $ 0.06 Diluted earnings (loss) per share, as adjusted $ 0.18 $ (0.03 ) $ 2.24 Acquisition of Emagic During the fourth quarter of 2002, the Company acquired Emagic GmbH, a provider of professional software solutions for computer based music production, for approximately +$30 million in cash; $26 million of which was paid immediately upon closing of the deal and $4 million of which was held-back for future payment contingent on +continued employment by certain employees that will be allocated to future compensation expense in the appropriate periods over the next 3 years. The acquisition has been accounted for as a +purchase. The portion of the purchase price allocated to purchased in-process research and development (IPR&D) was expensed immediately, and the portion of the purchase price allocated to 68 acquired technology and to tradename will be amortized over their estimated useful lives of 3 years. Total consideration was allocated as follows (in millions): Net tangible assets acquired $ 2.3 Acquired technology 3.8 Tradename 0.8 In-process research and development 0.5 Goodwill 18.6 Total consideration $ 26.0 The +amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of products under development had not been established and no alternative +future uses existed. The IPR&D relates primarily to Emagic's Logic series technology and extensions. At the date of the acquisition, the products under development were between 43%-83% +complete, and it was expected that the remaining work would be completed during the Company's fiscal 2003 at a cost of approximately $415,000. The remaining efforts include finalizing user interface +design and development, and testing. The fair value of the IPR&D was determined by an independent third-party valuation using the income approach, which reflects the projected free cash flows that +will be generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount rate of 25%. Acquisition of certain assets of Zayante, Inc., Prismo Graphics, and Silicon Grail During fiscal 2002 the Company acquired certain technology and patent rights of Zayante, Inc., Prismo Graphics, and Silicon Grail Corporation for a total of +$20 million in cash. These transactions have been accounted for as asset acquisitions. The purchase price for these asset acquisitions, except for $1 million identified as contingent +consideration which will be allocated to compensation expense over the next 3 years, has been allocated to acquired technology and will be amortized on a straight-line basis over +3 years, except for certain assets acquired from Zayante associated with patent royalty streams that will be amortized over 10 years. Acquisition of Nothing Real, LLC During the second quarter of 2002, the Company acquired certain assets of Nothing Real, LLC (Nothing Real), a privately-held company that develops and markets high +performance tools designed for the digital image creation market. Of the $15 million purchase price, the Company has allocated $7 million to acquired technology, which will be amortized +over its estimated life of 5 years. The remaining $8 million, which has been identified as contingent consideration, rather than recorded as an +additional component of the cost of the acquired assets, will be allocated to future compensation expense in the appropriate periods over the next 3 years. Acquisition of Spruce Technologies, Inc. In July 2001, the Company acquired Spruce Technologies, Inc. (Spruce), a privately-held company that develops and markets DVD authoring products, for +$14.9 million in cash. Goodwill associated with the acquisition of Spruce is not subject to amortization pursuant to the transition provisions of SFAS No. 142. 69 The consolidated financial statements include the operating results of Spruce from the date of acquisition. Total consideration was allocated as follows (in millions): Net tangible liabilities assumed $ (0.7 ) Identifiable intangible assets 5.9 Goodwill 9.7 Total consideration $ 14.9 Acquisition of PowerSchool, Inc. In May 2001, the Company acquired PowerSchool, Inc. (PowerSchool), a provider of web-based student information systems for K-12 schools +and districts that enables schools to record, access, report, and manage their student data and performance in real-time, and gives parents real-time web access to track their +children's progress. The consolidated financial statements include the operating results of PowerSchool from the date of acquisition. The +purchase price of approximately $66.1 million consisted of the issuance of approximately 2.4 million shares of the Company's common stock with a fair value of $61.2 million, +the issuance of stock options with a fair value of $4.5 million, and $300,000 of direct transaction costs. The fair value of the common stock options issued was determined using a Black-Scholes +option pricing model with the following +assumptions: volatility of 67%, expected life of 4 years, dividend rate of 0%, and risk-free rate of 4.73%. Total consideration was allocated as follows (in millions): Net tangible assets acquired $ 0.2 Deferred stock compensation 12.8 Identifiable intangible assets 2.6 In-process research and development 10.8 Goodwill 39.7 Total consideration $ 66.1 The +amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of products under development had not been established and no alternative +future uses existed. The IPR&D relates to technologies representing processes and expertise employed to design, develop, and deploy a functioning, scalable web-based student information +system for use by K-12 schools. At the date of the acquisition, the product under development was approximately 50% complete, and it was expected that the remaining 50% would be completed +during the Company's fiscal 2002 at a cost of approximately $9.25 million. The remaining efforts, which were completed in 2002, included completion of coding, finalizing user interface design +and development, and testing. The fair value of the IPR&D was determined by an independent third-party valuation using the income approach, which reflects the projected free cash flows that will be +generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount rate of 25%. The +acquired intangibles are being amortized over their estimated useful lives of three years, respectively. Deferred stock compensation associated with restricted stock and options is being amortized +over the required future vesting period of three years. 70 In +the fourth quarter of 2001, an adjustment was made to increase goodwill associated with the acquisition of PowerSchool by $5.9 million due to the identification of previously unidentified +loss contingencies that were in existence prior to consummation of the acquisition. Acquisition-Related Deferred Stock Compensation The Company allocated $12.8 million of its purchase consideration for PowerSchool to acquisition-related deferred stock compensation within shareholders' equity. This +amount represents the intrinsic value of stock options assumed that vest as future services are provided by employees and related to 445,000 common shares issued contingent on continued employment of +certain PowerSchool employee stockholders. Pro Forma Financial Information The unaudited pro forma financial information below presents the condensed consolidated financial results of the Company assuming that PowerSchool and Spruce, acquired in 2001, +had been acquired at the beginning of 2000 and includes the effect of amortization of goodwill and other acquired identifiable intangible assets from that date. The impact of the charge for IPR&D +associated with the acquisition of PowerSchool has been excluded. This pro forma financial information is presented for informational purposes only and is not necessarily indicative of the results of +future operations that would have been achieved had the acquisitions taken place at the beginning of 2000. Pro forma information follows (in millions, except per share amounts): 2001 2000 Net sales $ 5,370 $ 7,994 Net income (loss) $ (44 ) $ 767 Basic earnings (loss) per common share $ (0.13 ) $ 2.35 Diluted earnings (loss) per common share $ (0.13 ) $ 2.11 Note 5—Special Charges Restructuring Actions 2002 Restructuring Actions During fiscal 2002, the Company recorded total restructuring charges of approximately $30 million related to actions intended to eliminate certain activities and better +align the Company's operating expenses with existing general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company's +Retail operating segment. During +the fourth quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $6 million designed to reduce headcount costs in +Corporate operations and sales and to adjust its PowerSchool product strategy. These restructuring actions resulted in the elimination of approximately 180 positions worldwide at a cost of +$1.8 million, 161 of which were eliminated by September 28, 2002. Eliminated positions were primarily in Corporate operations, sales, and PowerSchool related research and development. +The shift in product strategy at PowerSchool included discontinuing development and marketing of PowerSchool's PSE product. This shift resulted in the impairment of previously capitalized development +costs associated with the PSE product in the amount of $4.5 million. As of September 28, 2002, substantially all of the $6 million accrual had been utilized, except for +insignificant severance and related costs associated with the 19 remaining positions. 71 During the first quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $24 million. These +restructuring actions will result in the elimination of approximately 425 positions worldwide, 415 of which were eliminated by September 28, 2002, at a cost of $8 million. Positions were +eliminated primarily in the Company's operations, information systems, and administrative functions. In addition, these restructuring actions also included significant changes in the Company's +information systems strategy resulting in termination of equipment leases and cancellation of existing projects and activities. Related lease and contract cancellation charges totaled +$12 million, and charges for asset impairments totaled $4 million. Of the original $24 million restructuring charge made during the first quarter of 2002, approximately +$23 million had been spent as of September 28, 2002 and approximately $250,000 was reversed during the second quarter of 2002 due to lower actual costs than originally estimated for +certain lease commitments and severance benefits. The remaining $1 million accrual relates primarily to future payments on abandoned operating leases. 2000 Restructuring Actions During the first quarter of 2000, the Company initiated restructuring actions resulting in recognition of an $8 million restructuring charge. This charge was comprised +of $3 million for the write-off of various operating assets and $5 million for severance payments to approximately 95 employees associated with consolidation of various +domestic and international sales and marketing functions. Of the $5 million accrued for severance, $2.5 million had been spent before the end of 2000, and the remainder was spent in +2001. Of the $3 million accrued for the write-off of various assets, substantially all was utilized before the end of 2000. Executive Bonus During the first quarter of 2000, the Company's Board of Directors approved a special executive bonus for the Company's Chief Executive Officer for past services in the form of +an aircraft with a total cost to the Company of approximately $90 million, the majority of which was not tax deductible. Approximately half of the total charge is for the cost of the aircraft. +The other half represents all other costs and taxes associated with the bonus. In the fourth quarter of 2002, all significant work and payments associated with the aircraft were complete. Of the +original $90 million accrual, $2.4 million remained unspent at the end of fiscal 2002 and was reversed. Technology Acquisition As discussed in Note 4, during both 2002 and 2001 in its acquisition of Emagic and PowerSchool, respectively, the Company acquired certain technology that was under +development and had no alternative future use. This resulted in the recognition of purchased in-process research and development in the amount of $551,000 for Emagic and +$10.8 million for PowerSchool, which was charged to operations upon acquisition. 72 Note 6—Income Taxes The +provision for income taxes consisted of the following (in millions): 2002 2001 2000 Federal: Current $ 8 $ (20 ) $ 9 Deferred (28 ) (8 ) 239 (20 ) (28 ) 248 State: Current 2 — — Deferred 7 (10 ) 23 9 (10 ) 23 Foreign: Current 29 21 37 Deferred 4 2 (2 ) 33 23 35 Provision for income taxes $ 22 $ (15 ) $ 306 The +foreign provision for income taxes is based on foreign pretax earnings of approximately $284 million, $363 million and $1.019 billion in 2002, 2001, and 2000, respectively. As +of September 28, 2002, approximately half of the Company's cash, cash equivalents, and short-term investments is held by foreign subsidiaries and is generally based in U.S. +dollar-denominated holdings. Amounts held by foreign subsidiaries would be subject to U.S. income taxation on repatriation to the United States. The Company's consolidated financial statements fully +provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company's foreign subsidiaries that are intended to be indefinitely +reinvested in operations outside the United States. U.S. income taxes have not been provided on a cumulative total of $755 million of such earnings. It is not practicable to determine the +income tax liability that might be incurred if these earnings were to be distributed. Deferred +tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts +of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected +to be recovered or settled. 73 As +of September 28, 2002 and September 29, 2001, the significant components of the Company's deferred tax assets and liabilities were (in millions): 2002 2001 Deferred tax assets: Accounts receivable and inventory reserves $ 23 $ 26 Accrued liabilities and other reserves 102 110 Basis of capital assets and investments 35 54 Tax losses and credits 209 319 Total deferred tax assets 369 509 Less valuation allowance 30 33 Net deferred tax assets 339 476 Deferred tax liabilities: Unremitted earnings of subsidiaries 308 489 Available-for-sale securities 1 14 Other 26 18 Total deferred tax liabilities 335 521 Net deferred tax asset (liability) $ 4 $ (45 ) As +of September 28, 2002, the Company had operating loss carryforwards for federal tax purposes of approximately $72 million, which expire from 2009 through 2021. These carryforwards are +comprised of remaining operating loss carryforwards acquired from NeXT and other acquisitions, the utilization of which is subject to certain limitations imposed by the Internal Revenue Code. The +Company also has Federal credit carryforwards and various state and foreign tax loss and credit carryforwards, the tax effect of which is approximately $94 million and which expire between 2003 +and 2022. The remaining benefits +from tax losses and credits do not expire. As of September 28, 2002, a valuation allowance of $30 million was recorded against the deferred tax asset for the benefits of tax losses that +may not be realized. The valuation allowance relates primarily to the operating loss carryforwards acquired from NeXT and other acquisitions. Management believes it is more likely than not that +forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully +recover the remaining deferred tax assets. 74 A +reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate (35% in 2001, 2000, and 1999) to income (loss) before provision for +income taxes, is as follows (in millions): 2002 2001 2000 Computed expected tax (benefit) $ 30 $ (18 ) $ 382 State taxes, net of federal effect 7 (7 ) 15 Indefinitely invested earnings of foreign subsidiaries — — (82 ) Nondeductible executive compensation (1 ) — 32 Purchase accounting and asset acquisitions 3 10 — Change in valuation allowance (16 ) — (27 ) Research & development credit, net (8 ) (5 ) (5 ) Nondeductible expenses 4 3 — Other items 3 2 (9 ) Provision for (benefit from) income taxes $ 22 $ (15 ) $ 306 Effective tax rate 25 % 30 % 28 % The +Internal Revenue Service (IRS) has completed audits of the Company's federal income tax returns through 1997. Substantially all IRS audit issues for years through 1997 have been resolved. The IRS +is currently auditing the Company's federal income tax returns for fiscal years 1998 through 2000. Management believes that adequate provision has been made for any adjustments that may result from +tax examinations. Note 7—Shareholders' Equity Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During 2000, the Company repurchased a total of 2.55 million shares of its +common stock at a cost of $116 million. During the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in +September of 2003 at an average price of $16.64 per share for a total cost of $25.5 million. The Company engaged in no transactions relating to the stock repurchase plan in fiscal 2002. Since +inception of the repurchase plan, the Company has repurchased or committed to repurchase a total of 6.55 million shares of its common stock at a cost of $217 million. Preferred Stock In August 1997, the Company and Microsoft Corporation (Microsoft) entered into a patent cross license and technology agreements. In addition, Microsoft purchased 150,000 +shares of Apple Series A nonvoting convertible preferred stock ("preferred stock") for $150 million. These shares were convertible by Microsoft after August 5, 2000, into shares +of the Company's common stock at a conversion price of $8.25 per share. During 2000, 74,250 shares of preferred stock were converted to 9 million shares of the +Company's common stock. During 2001, the remaining 75,750 preferred shares were converted into 9.2 million shares of the Company's common stock. 75 Comprehensive Income The following table summarizes the components of accumulated other comprehensive income, net of taxes, (in millions): 2002 2001 2000 Unrealized gains on available-for-sale securities $ 13 $ 30 $ 297 Unrealized gains (losses) on derivative investments (11 ) 4 — Cumulative translation adjustments (51 ) (56 ) (53 ) Accumulated other comprehensive income (loss) $ (49 ) $ (22 ) $ 244 The +following table summarizes activity in other comprehensive income related to available-for-sale securities, net of taxes (in millions): 2002 2001 2000 Change in fair value of available-for-sale securities $ (49 ) $ (183 ) $ 427 Less: adjustment for net (gains) losses realized and included in net income 32 (84 ) (272 ) Change in unrealized gain on available-for-sale securities $ (17 ) $ (267 ) $ 155 The +tax effect related to the change in unrealized gain on available-for-sale securities was $10 million, $157 million, $(91) million for fiscal 2002, 2001, and +2000, respectively. The tax effect on the reclassification adjustment for net gains included in net income was $10 million, $35 million and $94 million for fiscal 2002, 2001, and +2000, respectively. The +following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company (in millions): 2002 2001 Cumulative effect of adopting SFAS No. 133 $ — $ 12 Changes in fair value of derivatives 4 45 Less: adjustment for net gains realized and included in net income (19 ) (53 ) Change in unrealized gain on derivatives $ (15 ) $ 4 The +tax effect related to the cumulative effect of adopting SFAS No. 133 was $(5) as of September 29, 2001. The tax effect related to the changes in fair value of derivatives was $(2) +million and $(19) million for fiscal 2002 and 2001, respectively. The tax effect related to derivative gains reclassified from OCI was $8 million and $23 million for fiscal 2002 and +2001, respectively. Note 8—Employee Benefit Plans 1998 Executive Officer Stock Plan The 1998 Executive Officer Stock Plan (the 1998 Plan) is a shareholder approved plan which replaced the 1990 Stock Option Plan terminated in April 1998, the 1981 Stock +Option Plan terminated in October 1990, and the 1987 Executive Long Term Stock Option Plan terminated in July 1995. Options granted before these plans' termination dates remain +outstanding in accordance with their terms. Options may be granted under the 1998 Plan to the Chairman of the Board of Directors, executive officers of the Company at the 76 level of Senior Vice President and above, and other key employees. These options generally become exercisable over a period of 4 years, based on continued employment, and generally expire +10 years after the grant date. The 1998 Plan permits the granting of incentive stock options, nonstatutory stock options, stock appreciation rights, and stock purchase rights. 1997 Employee Stock Option Plan In August 1997, the Company's Board of Directors approved the 1997 Employee Stock Option Plan (the 1997 Plan), a non-shareholder approved plan for grants of +stock options to employees who are not officers of the Company. Options may be granted under the 1997 Plan to employees at not less than the fair market value on the date of grant. These options +generally become exercisable over a period of 4 years, based on continued employment, and generally expire 10 years after the grant date. 1997 Director Stock Option Plan In August 1997, the Company's Board of Directors adopted a shareholder approved Director Stock Option Plan (DSOP) for non-employee directors of the Company. +Initial grants of 30,000 options under the DSOP vest in three equal installments on each of the first through third anniversaries of the date of grant, and subsequent annual grants of 10,000 options +are fully vested at grant. Prior to adoption of the DSOP, 60,000 options were granted in total to two then-current members of the Company's Board of Directors. Employee Stock Purchase Plan The Company has a shareholder approved employee stock purchase plan (the Purchase Plan), under which substantially all employees may purchase common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six-month offering periods. Stock purchases under the Purchase Plan are limited to +10% of an employee's compensation, up to a maximum of $25,000 in any calendar year. During 2002, 2001, and 2000, 1.8 million, 1.8 million and 766,000 shares, respectively, were issued +under the Purchase Plan. As of September 28, 2002, approximately 2.1 million shares were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an employee savings plan (the Savings Plan) qualifying as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the +Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the Internal Revenue Service annual contribution limit ($11,000 for calendar year 2002). The +Company matches 50% to 100% of each employee's contributions, depending on length of service, up to a maximum 6% of the employee's earnings. The Company's matching contributions to the Savings Plan +were approximately $19 million, $17 million, and $16 million in 2002, 2001, and 2000, respectively. 77 Stock Option Activity A summary of the Company's stock option activity and related information for the years ended September 28, 2002, September 29, 2001 and September 30, 2000 +follows (option amounts are presented in thousands): Outstanding Options Shares Available for Grant Number of Shares Weighted Average Exercise Price Balance at 9/25/99 41,727 36,808 $ 13.20 Additional Options Authorized 13,500 — — Options Granted (45,662 ) 45,662 $ 46.52 Options Cancelled 4,846 (4,846 ) $ 28.42 Options Exercised — (6,866 ) $ 9.62 Plan Shares Expired (2,881 ) — — Balance at 9/30/00 11,530 70,758 $ 34.01 Additional Options Authorized 27,000 — — Options Granted (34,857 ) 34,857 $ 18.58 Options Cancelled 6,605 (6,605 ) $ 29.32 Options Exercised — (1,831 ) $ 10.05 Plan Shares Expired (203 ) — — Balance at 9/29/01 10,075 97,179 $ 29.24 Additional Options Authorized 15,000 — — Options Granted (23,239 ) 23,239 $ 19.89 Options Cancelled 4,737 (4,737 ) $ 30.98 Options Exercised — (6,251 ) $ 11.99 Plan Shares Expired (2 ) — — Balance at 9/28/02 6,571 109,430 $ 28.17 78 The options outstanding as of September 28, 2002, have been segregated into five ranges for additional disclosure as follows (option amounts are presented in thousands): Options Outstanding Options Exercisable Options Outstanding as of September 28, 2002 Weighted-Average Remaining Contractual Life in Years Weighted Average Exercise Price Options Exercisable as of September 28, 2002 Weighted Average Exercise Price $0.83-$17.31 22,000 6.63 $ 14.26 13,459 $ 12.74 $17.32-$18.50 26,785 8.32 $ 18.40 10,138 $ 18.38 $18.51-$25.93 20,851 8.86 $ 21.35 4,902 $ 21.14 $25.94-$43.59 21,492 7.27 $ 42.92 20,896 $ 43.16 $43.60-$69.78 18,302 7.37 $ 49.64 8,529 $ 49.71 $0.83-$69.78 109,430 7.72 $ 28.17 57,924 $ 30.85 The +Company had exercisable options to purchase 42.1 million shares outstanding as of September 29, 2001 with a weighted average exercise price of $32.15. As of September 30, +2000, the Company had exercisable options outstanding to purchase 23.7 million shares with a weighted average exercise price of $31.94. Note 9—Stock-Based Compensation Pro +forma information regarding net income (loss) per share is required by SFAS No. 123 and has been determined as if the Company had accounted for its employee stock options granted and +employee stock purchase plan purchases subsequent to September 29, 1995, under the fair value method of that statement. The fair values for these options and stock purchases were estimated at +the date of grant and beginning of the period, respectively, using a Black-Scholes option pricing model. The assumptions used for each of the last three fiscal years and the resulting estimate of +weighted-average fair value per share of options granted during those years are as follows: 2002 2001 2000 Expected life of stock options 4 years 4 years 4 years Expected life of stock purchases 6 months 6 months 6 months Interest rate—stock options 2.90 % 4.90 % 6.20 % Interest rate—stock purchases 2.71 % 5.97 % 6.21 % Volatility—stock options 64 % 66 % 67 % Volatility—stock purchases 51 % 90 % 60 % Dividend yields 0 0 0 Weighted-average fair value of options granted during the year $ 10.11 $ 10.15 $ 25.92 Weighted-average fair value of stock purchases during the year $ 6.73 $ 11.15 $ 10.66 79 For +purposes of pro forma disclosures, the estimated fair value of the options and shares are amortized to pro forma net income over the options' vesting period and the shares' plan period. The +Company's +pro forma information for each of the last three fiscal years follows (in millions, except per share amounts): 2002 2001 2000 Net income (loss)—as reported $ 65 $ (25 ) $ 786 Net income (loss)—pro forma $ (164 ) $ (396 ) $ 483 Net income (loss) per common share—as reported Basic $ 0.18 $ (0.07 ) $ 2.42 Diluted $ 0.18 $ (0.07 ) $ 2.18 Net income (loss) per common share—pro forma Basic $ (0.46 ) $ (1.15 ) $ 1.49 Diluted $ (0.46 ) $ (1.15 ) $ 1.38 Note 10—Commitments and Contingencies Lease Commitments The Company leases various facilities and equipment under noncancelable operating lease arrangements. The major facilities leases are for terms of 5 to 10 years and +generally provide renewal options for terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to 12 years and often contain multi-year renewal options. Rent +expense under all operating leases, including both cancelable and noncancelable leases, was $92 million, $80 million, and $72 million in 2002, 2001, and 2000, respectively. Future +minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 28, 2002, are as follows (in millions): Fiscal Years 2003 $ 83 2004 78 2005 66 2006 55 2007 42 Later years 140 Total minimum lease payments $ 464 Concentrations in the Available Sources of Supply of Materials and Product Although certain components essential to the Company's business are generally available from multiple sources, other key components (including microprocessors and +application-specific integrated circuits, or ("ASICs")) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from +multiple sources, are at times subject to industry-wide availability and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal computer +industry, and new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for and +subsequently qualifies additional suppliers. If the supply of a key single-sourced component to the Company were to be delayed or curtailed or in the event a key manufacturing 80 vendor delays shipments of completed products to the Company, the Company's ability to ship related products in desired quantities and in a timely manner could be adversely affected. The Company's +business and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient +quantities from an alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of common components instead of +components customized to meet the Company's requirements. Finally, significant portions of the Company's CPUs, logic boards, and assembled products are now manufactured by outsourcing partners, the +majority of which occurs in various parts of Asia. Although the Company works closely with its outsourcing partners on manufacturing schedules and levels, the Company's operating results could be +adversely affected if its outsourcing partners were unable to meet their production obligations. Contingencies Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against +the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company's publicly traded common stock between +July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company +believes these claims are without merit and intends to defend them vigorously. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. +On December 11, 2002, the Court granted the Company's motion to dismiss for failure to state a cause of action, with leave to plaintiffs to amend their complaint within thirty days. The +Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. In the opinion of management, the Company +does not have a potential liability related to any current legal proceedings and claims that would have a material adverse effect on its financial condition, liquidity or results of operations. +However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved +against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. The +parliament of the European Union is working on finalizing the Waste Electrical and Electronic Equipment Directive (the Directive). The Directive makes producers of electrical goods, including +personal computers, financially responsible for the collection, recycling, and safe disposal of past and future products. The Directive must now be approved and implemented by individual European +Union governments by June 2004, while the producers' financial obligations are scheduled to start June 2005. The Company's potential liability resulting from the Directive related to +past sales of its products and expenses associated with future sales of its product may be substantial. However, because it is likely that specific laws, regulations, and enforcement policies will +vary significantly between individual European member states, it is not currently possible to estimate the Company's existing liability or future expenses resulting from the Directive. As the European +Union and its individual member states clarify specific requirements and policies with respect to the Directive, the Company will continue to assess its potential financial impact. Similar legislation +may be enacted in other geographies, including federal and state legislation in the United States, the cumulative impact of which could be significant. 81 Note 11—Segment Information and Geographic Data The +Company manages its business primarily on a geographic basis. The Company's reportable segments are comprised of the Americas, Europe, Japan, and Retail. The Americas segment includes both North +and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment includes only +Japan. The Retail segment operates Apple-owned retail stores in the United States. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and +the Company's subsidiary, Filemaker, Inc. Each reportable geographic operating segment provides similar products and services, and the accounting policies of the various segments are the same +as those described in the Summary of Significant Accounting Policies in Note 1, except as described below for the Retail segment. The +Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for geographic segments are based on the location of the customers. Operating income +for each segment includes revenue from third-parties, cost of sales, and operating expenses directly attributable to the segment. Operating income for each segment excludes other income and expense +and certain expenses that are managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, manufacturing costs not included in standard +costs, income taxes, and various nonrecurring charges. Corporate expenses include research and development, corporate marketing expenses, and other separately managed general and administrative +expenses including certain corporate expenses associated with support of the Retail segment. The Company does not include intercompany transfers between segments for management reporting purposes. +Segment assets exclude corporate assets. Corporate assets include cash, short-term and long-term investments, manufacturing facilities, miscellaneous corporate infrastructure, +goodwill and other acquired intangible assets, and retail store construction-in-progress which is not subject to depreciation. Except for the Retail segment, capital +expenditures for long-lived assets are not reported to management by segment. Capital expenditures by the Retail segment were $106 million in 2002 and $92 million in 2001. Operating +income for all segments except Retail includes cost of sales at standard cost. Certain manufacturing expenses and related adjustments not included in segment cost of sales, including +variances between standard and actual manufacturing costs and the mark-up above standard cost for product supplied to the Retail segment, are included in corporate expenses. To +assess the operating performance of the Retail segment several significant items are included in its results for internal management reporting that are not included in results of the Company's +other segments. First, cost of sales for the Retail segment includes a mark-up above the Company's standard cost to approximate the price normally charged to the Company's major channel +partners in the United States. For the twelve-month period ended September 28, 2002 and September 29, 2001, this resulted in the recognition of additional cost of sales above standard +cost by the Retail segment and an offsetting benefit to corporate expenses of approximately $52 million and $4 million, respectively. Second, the Retail segment includes in its net sales +proceeds from sales of the Company's extended warranty and support contracts. This treatment is consistent with how the Company's major channel partners account for the sale of the Company's extended +warranty and support contracts. Because the revenue from these contracts has yet to be earned by the Company, an offset to this amount is reflected as a decrease in other segments' net sales. For the +twelve-month period ended September 28, 2002, this resulted in the recognition of additional net sales by the Retail segment, and an offsetting reduction to other segments' net sales of +$4.8 million. This amount was insignificant in 2001. Third, a portion of the operating expenses associated with certain high profile retail stores are allocated from the Retail segment to +corporate marketing expense. Allocation of these expenses reflects the unique nature of these stores which, given their larger size and extraordinary design elements, function as vehicles for general +corporate marketing, corporate events, and brand 82 awareness. Allocated operating costs are those in excess of operating costs incurred by one of the Company's more typical retail locations. Stores were open in two such high profile locations in New +York and Los Angeles as of September 28, 2002, both of which were opened in fiscal 2002. Expenses allocated to corporate marketing resulting from the operations of these two stores was +$1 million in 2002. Summary +information by operating segment follows (in millions): 2002 2001 2000 Americas: Net sales $ 3,088 $ 2,996 $ 4,298 Operating income $ 280 $ 133 $ 614 Depreciation and amortization $ 4 $ 4 $ 5 Segment assets(a) $ 395 $ 334 $ 618 Europe: Net sales $ 1,251 $ 1,249 $ 1,817 Operating income $ 122 $ 68 $ 243 Depreciation and amortization $ 4 $ 6 $ 4 Segment assets $ 165 $ 137 $ 248 Japan: Net sales $ 710 $ 713 $ 1,345 Operating income $ 140 $ 98 $ 352 Depreciation and amortization $ 2 $ 2 $ 2 Segment assets $ 50 $ 44 $ 137 Retail: Net sales $ 283 $ 19 — Operating income $ (22 ) $ (21 ) — Depreciation and amortization(b) $ 16 $ 2 — Segment assets(b) $ 141 $ 46 — Other Segment: Net sales $ 410 $ 386 $ 523 Operating income $ 88 $ 63 $ 137 Depreciation and amortization $ 2 $ 2 $ 3 Segment assets $ 67 $ 70 $ 95 (a) The +Americas asset figures do not include fixed assets held in the United States. Such fixed assets are not allocated specifically to the Americas segment and are included in the +corporate assets figures below. (b) Retail +segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. Retail store +construction-in-progress, which is not subject to depreciation, is reflected in corporate assets. 83 A reconciliation of the Company's segment operating income, and assets to the consolidated financial statements follows (in millions): 2002 2001 2000 Segment operating income $ 608 $ 341 $ 1,346 Corporate expenses, net (562 ) (674 ) (726 ) Purchased in-process research and development (1 ) (11 ) — Restructuring costs (30 ) — (8 ) Executive bonus 2 — (90 ) Consolidated operating income $ 17 $ (344 ) $ 522 Segment assets $ 818 $ 630 $ 1,098 Corporate assets $ 5,480 $ 5,391 $ 5,705 Consolidated assets $ 6,298 $ 6,021 $ 6,803 Segment depreciation and amortization $ 28 $ 16 $ 14 Corporate depreciation and amortization 90 86 70 Consolidated depreciation and amortization $ 118 $ 102 $ 84 A +large portion of the Company's net sales is derived from its international operations. Also, a majority of the raw materials used in the Company's products is obtained from sources outside of the +United States, and a majority of the products sold by the Company is assembled internationally in the Company's facilities in Cork, Ireland and Singapore or by third-party vendors in Taiwan, Korea, +Mexico, the People's Republic of China, and the Czech Republic. As a result, the Company is subject to risks associated with foreign operations, such as obtaining governmental permits and approvals, +currency exchange fluctuations, currency restrictions, political instability, labor problems, trade restrictions, and changes in tariff and freight charges. During 2000, a single distributor, Ingram +Micro Inc. accounted for approximately 11.5% of the Company's net sales. Net sales during 2000 to Ingram Micro Inc. in the Americas and Europe segments were $651 million and +$255 million, respectively. Net sales to Ingram Micro Inc. in all other segments were $14 million. No other single customer accounted for more than 10% of net sales in 2000. No +single customer accounted for more than 10% of net sales in 2002 or 2001. 84 Net +sales and long-lived assets related to operations in the United States, Japan, and other foreign countries are as follows (in millions): 2002 2001 2000 Net Sales: United States $ 3,272 $ 2,936 $ 4,145 Japan 710 713 1,345 Other Foreign Countries 1,760 1,714 2,493 Total Net Sales $ 5,742 $ 5,363 $ 7,983 Long-Lived Assets: United States $ 561 $ 498 $ 387 Japan 2 3 5 Other Foreign Countries 69 77 52 Total Long-Lived Assets $ 632 $ 578 $ 444 Information +regarding net sales by product is as follows (in millions): 2002 2001 2000 Net Sales: Power Macintosh(a) $ 1,380 $ 1,664 $ 2,747 PowerBook 831 813 948 iMac 1,448 1,117 2,381 iBook 875 809 809 Software, Service, and Other Net Sales 1,208 960 1,098 Total Net Sales $ 5,742 $ 5,363 $ 7,983 (a) Includes +server sales and amounts previously reported as G4 Cube. 85 Note 12—Earnings Per Common Share The following table sets forth the computation of basic and diluted earnings per share (in thousands, except net income (loss) and per share amounts): For the Years Ended September 28, 2002 September 29, 2001 September 30, 2000 Numerator (in millions): Income (loss) before accounting change $ 65 $ (37 ) $ 786 Denominator: Weighted-average shares outstanding 355,022 345,613 324,568 Effect of dilutive securities: Convertible preferred stock — — 17,914 Dilutive options 6,763 — 17,842 Dilutive potential common shares 6,763 — 35,756 Denominator for diluted earnings (loss) per share 361,785 345,613 360,324 Basic earnings (loss) per share before accounting change $ 0.18 $ (0.11 ) $ 2.42 Cumulative effect of accounting change, net of tax — $ 0.04 — Basic earnings (loss) per share after accounting change $ 0.18 $ (0.07 ) $ 2.42 Diluted earnings (loss) per share before accounting change $ 0.18 $ (0.11 ) $ 2.18 Cumulative effect of accounting change, net of tax — $ 0.04 — Diluted earnings (loss) per share after accounting change $ 0.18 $ (0.07 ) $ 2.18 Options +to purchase 101.8 million shares of common stock were outstanding at the end of 2002 that were not included in the computation of diluted earnings per share for that year because the +options' exercise price was greater than the average market price of the Company's common shares for that year and, therefore, the effect would be antidilutive. At September 29, 2001, the +Company had options to purchase 97.2 million shares of its common stock outstanding, all of which were excluded from the computation of diluted loss per share for 2001 because the effect would +have been antidilutive. Options to purchase 2.5 million shares of common stock were outstanding at the end of 2000 that were not included in the computation of diluted earnings per share for +that year because the options' exercise price was greater than the average market price of the Company's common shares for that year and, therefore, the effect would be antidilutive. Note 13—Related Party Transactions Mr. Jerome +York, a member of the Board of the Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. +(" MicroWarehouse ") in January 2000. He also serves as its Chairman, President and Chief Executive Officer. MicroWarehouse is a multi-billion +dollar specialty catalog and online retailer and direct marketer of computer products, including products made by the 86 Company, through its MacWarehouse catalog. MicroWarehouse accounted for 3.3% and 2.89% of the Company's net sales in 2002 and 2001, respectively. Trade receivables from MicroWarehouse were +$20.9 million and $7.6 million as of September 28, 2002, and September 29, 2001, respectively. These receivables are subject to the same credit risk as the Company's other +trade receivables. In addition, the Company purchases miscellaneous equipment and supplies from MicroWarehouse. Total purchases amounted to approximately $2.9 million in 2002 and +$3.4 million in 2001. In +March 2002, the Company entered into a Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in +the operation of his private plane when used for Apple business. The Reimbursement Agreement is effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of +the plane in May 2001. During 2002, the Company recognized a total of $1,168,000 in expenses pursuant to this reimbursement agreement related to expenses incurred by Mr. Jobs during 2001 +and 2002. In +connection with a relocation assistance package, the Company loaned Mr. Ronald B. Johnson, Senior Vice President, Retail, $1.5 million for the purchase of his principal residence. The +loan is secured by a deed of trust and is due and payable in May 2004. Under the terms of the loan, Mr. Johnson agreed that should he exercise any of his stock options prior to the due +date of the loan, that he would pay the Company an amount equal to the lesser of (1) an amount equal to 50% of the total net gain realized +from the exercise of the options; or (2) $375,000 multiplied by the number of years between the exercise date and the date of the loan. Note 14—Selected Quarterly Financial Information (Unaudited) Fourth Quarter Third Quarter Second Quarter First Quarter (Tabular amounts in millions, except per share amounts) 2002 Net sales $ 1,443 $ 1,429 $ 1,495 $ 1,375 Gross margin $ 381 $ 391 $ 409 $ 422 Net income (loss) $ (45 ) $ 32 $ 40 $ 38 Earnings (loss) per common share: Basic $ (0.13 ) $ 0.09 $ 0.11 $ 0.11 Diluted $ (0.13 ) $ 0.09 $ 0.11 $ 0.11 2001 Net sales $ 1,450 $ 1,475 $ 1,431 $ 1,007 Gross margin $ 437 $ 434 $ 385 $ (21 ) Net income (loss) $ 66 $ 61 $ 43 $ (195 ) Earnings (loss) per common share: Basic $ 0.19 $ 0.17 $ 0.12 $ (0.58 ) Diluted $ 0.19 $ 0.17 $ 0.12 $ (0.58 ) Basic +and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic +and diluted earnings per share. Net +income for the fourth quarter of 2002 included several non-recurring items, net of tax: the write-down of certain equity investments totaling $49 million; a +restructuring charge of $4 million; an in-process research and development charge of approximately $1 million; and the reversal of a portion of a previous 87 executive compensation expense resulting in a favorable impact of $2 million. Net income for the first quarter of 2002 included a restructuring charge, net of tax, $18 million. Net +income during the first quarter of 2002 also included gains, net of tax, of $17 million related to non-current investments. Net +income during the fourth, third, second, and first quarters of 2001 included after-tax net gains related to non-current investments of $1 million, $8 million, +$4 million, and $41 million, respectively. Net income for the third quarter of 2001 included an after-tax charge for purchased IPR&D of $8 million associated with the +Company's acquisition of PowerSchool. Net income for the first quarter of 2001 includes an after-tax favorable cumulative-effect-type adjustment for the adoption of SFAS +No. 133 of $12 million. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not +applicable. 88 REPORT OF INDEPENDENT AUDITORS The +Board of Directors and Shareholders Apple Computer, Inc.: We +have audited the accompanying consolidated balance sheets of Apple Computer, Inc. and subsidiaries as of September 28, 2002 and September 29, 2001, and the related consolidated +statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended September 28, 2002. These consolidated financial statements are +the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We +conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe +that our audits provide a reasonable basis for our opinion. In +our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Computer, Inc. and subsidiaries as of +September 28, 2002 and September 29, 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended September 28, +2002, in conformity with accounting principles generally accepted in the United States of America. As +discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for goodwill in 2002 and changed its method of accounting for derivative +instruments and hedging activities in 2001. KPMG LLP Mountain +View, California October 15, 2002 89 PART III Item 10. Directors and Executive Officers of the Registrant Directors Listed below are the Company's five directors whose terms expire at the next annual meeting of shareholders. Name Position With the Company Age Director Since William V. Campbell Director 62 1997 Millard S. Drexler Director 58 1999 Steven P. Jobs Director and Chief Executive Officer 47 1997 Arthur D. Levinson Director 52 2000 Jerome B. York Director 64 1997 William V. Campbell has been Chairman of the Board of Directors of Intuit, Inc. (Intuit) since +August 1998. From September 1999 to January 2000, Mr. Campbell acted as Chief Executive Officer of Intuit. From April 1994 to August 1998, Mr. Campbell +was President and Chief Executive Officer and a director of Intuit. From January 1991 to December 1993, Mr. Campbell was President and Chief Executive Officer of GO Corporation. +Mr. Campbell also serves on the board of directors of SanDisk Corporation and Loudcloud, Inc. Millard S. Drexler was Chief Executive Officer of Gap Inc. from 1995 and President from 1987 until September 2002. Mr. Drexler was +also a member of the Board of Directors of Gap Inc. from November 1983 until October 2002. He also served as the President of the Gap Division from 1983 to 1987. Steven P. Jobs is one of the Company's co-founders and currently serves as its Chief Executive Officer. Mr. Jobs is also the Chairman +and Chief Executive Officer of Pixar Animation Studios. In addition, Mr. Jobs co-founded NeXT Software, Inc. ( NeXT ) and served +as the Chairman and Chief Executive Officer of NeXT from 1985 until 1997 when NeXT was acquired by the Company. Arthur D. Levinson, Ph.D. has been President, Chief Executive Officer and a director of Genentech Inc. +( Genentech ) since July 1995. Dr. Levinson has been Chairman of the Board of Directors of Genentech since September 1999. He joined +Genentech in 1980 and served in a number of executive positions, including Senior Vice President of R&D from 1993 to 1995. Jerome B. York is Chairman and Chief Executive Officer of Micro Warehouse, Inc. Previously, he was Vice Chairman of Tracinda Corporation from +September 1995 to October 1999. In May 1993, he joined International Business Machines Corporation ( IBM ) as Senior Vice President +and Chief Financial Officer, and he served as a director of IBM from January 1995 to August 1995. Prior to joining IBM, Mr. York served in a number of executive positions at +Chrysler Corporation, including Executive Vice President-Finance and Chief Financial Officer from May 1990 to May 1993. He also served as a director of Chrysler Corporation from 1992 to +1993. Mr. York is also a director of Tyco International Ltd. and Metro-Goldwyn- Mayer, Inc. In +September 2002, Lawrence J. Ellison resigned as a director. Mr. Ellison had served as a director since 1997. Executive Officers The following sets forth certain information regarding executive officers of the Company. Information pertaining to Mr. Jobs, who is both a director and an executive +officer of the Company, may be found in the section entitled " Directors. " 90 Fred D. Anderson , Executive Vice President and Chief Financial Officer (age 58), joined the Company in April 1996. Prior to joining the Company, +Mr. Anderson was Corporate Vice President and Chief Financial Officer of Automatic Data Processing, Inc., a position he held from August 1992 to March 1996. +Mr. Anderson also serves as a director of 3Com Corporation. Timothy D. Cook , Executive Vice President, Worldwide Sales and Operations (age 42), joined the Company in February 1998. Prior to joining the +Company, Mr. Cook held the position of Vice President, Corporate Materials for Compaq Computer Corporation ( Compaq ). Previous to his work at +Compaq, Mr. Cook was the Chief Operating Officer of the Reseller Division at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, most recently as Director of North +American Fulfillment. Nancy R. Heinen , Senior Vice President, General Counsel and Secretary (age 46), joined the Company in September 1997. Prior to joining the +Company, Ms. Heinen held the position of Vice President, General Counsel and Secretary of the Board of Directors at NeXT from February 1994 until the acquisition of NeXT by the Company +in February 1997. Ronald B. Johnson , Senior Vice President, Retail (age 44), joined the Company in January 2000. Prior to joining the Company, Mr. Johnson +spent 10 years with Target Stores, most recently as Senior Merchandising Executive. Peter Oppenheimer , Senior Vice President of Finance and Corporate Controller (age 40), joined the Company in July 1996. Mr. Oppenheimer +also served with the Company in the position of Vice President and Corporate Controller and as Senior Director of Finance for the Americas. Prior to joining the Company, Mr. Oppenheimer was CFO +of one of the four business units for Automatic Data Processing ( ADP ). Prior to joining ADP, Mr. Oppenheimer spent six years in the Information +Technology Consulting Practice with Coopers and Lybrand. Jonathan Rubinstein , Senior Vice President, Hardware Engineering (age 46), joined the Company in February 1997. Before joining the Company, +Mr. Rubinstein was Executive Vice President and Chief Operating Officer of FirePower Systems Incorporated, from May 1993 to August 1996. Mr. Rubinstein also serves as a +member of the Board of Directors of Immersion Corporation. Philip W. Schiller , Senior Vice President, Worldwide Product Marketing (age 42), rejoined the Company in 1997. Prior to rejoining the Company, +Mr. Schiller was Vice President of Product Marketing at Macromedia, Inc. from December 1995 to March 1997 and was Director of Product Marketing at FirePower +Systems, Inc. from 1993 to December 1995. Prior to that Mr. Schiller spent six years at the Company in various marketing positions. Sina Tamaddon , Senior Vice President, Applications (age 45), joined the Company in September 1997. Mr. Tamaddon has also served with the +Company in the position of Senior Vice President Worldwide Service and Support, and Vice President and General Manager, Newton Group. Before joining the Company, Mr. Tamaddon held the position +of Vice President, Europe with NeXT from September 1996 through March 1997. From August 1994 to August 1996, Mr. Tamaddon held the position of Vice President, +Professional Services with NeXT. Avadis Tevanian, Jr., Ph.D. , Senior Vice President, Software Engineering (age 41), joined the Company in February 1997 upon the Company's +acquisition of NeXT. With NeXT, Dr. Tevanian held several positions, including Vice President, Engineering, from April 1995 to February 1997. Prior to April 1995, +Dr. Tevanian worked as an engineer with NeXT and held several management positions. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's officers and directors, and persons who own more than ten percent of a +registered class of the Company's equity securities, to file reports of securities ownership and changes in such ownership with the Securities and Exchange Commission (the +" SEC "). Officers, directors and greater than ten percent shareholders also are 91 required by rules promulgated by the SEC to furnish the Company with copies of all Section 16(a) forms they file. Based +solely upon a review of the copies of such forms furnished to the Company or written representations that no Forms 5 were required, the Company believes that, during fiscal year 2002, its +officers, directors and greater than ten percent beneficial owners complied with all applicable Section 16(a) filing requirements. Item 11. Executive Compensation Information Regarding Executive Compensation The following table summarizes compensation information for the last three fiscal years for (i) Mr. Jobs, Chief Executive Officer and (ii) the four most +highly compensated executive officers other than the Chief Executive Officer who were serving as executive officers of the Company at the end of the fiscal year (collectively, the Named Executive Officers ). SUMMARY COMPENSATION TABLE Annual Compensation Long-Term Compensation Name and Principal Position Fiscal Year Salary ($) Bonus ($) Securities Underlying Options* (#) All Other Compensation ($) Steven P. Jobs Chief Executive Officer 2002 2001 2000 1 1 1 2,268,698 43,511,534 (1) (1) 7,500,000 — 20,000,000 1,302,795 40,484,594 — (1) (1) Fred D. Anderson Executive Vice President and Chief Financial Officer 2002 2001 2000 656,631 657,039 660,414 — — — — 1,000,000 — 11,000 7,312 6,750 (2) (2) (2) Timothy D. Cook Executive Vice President, Worldwide Sales and Operations 2002 2001 2000 563,829 452,219 451,673 — 500,000 — (3) — 1,000,000 — 8,025 7,875 6,352 (2) (2) (2) Jonathan Rubinstein Senior Vice President, Hardware Engineering 2002 2001 2000 452,588 469,737 451,949 — — — — 1,000,000 — 9,996 7,875 6,577 (2) (2) (2) Avadis Tevanian, Jr. Ph.D Senior Vice President, Software Engineering 2002 2001 2000 492,212 460,873 451,673 — 500 — (4) — 1,000,000 — 10,700 10,200 10,200 (2) (2) (2) (1) In +December 1999, Mr. Jobs was given a special executive bonus for serving as the Company's interim Chief Executive Officer for past services, in the form of an aircraft +with a total cost to the Company of approximately $90,000,000. This amount was previously reported as a bonus for fiscal year 2000 in the Company's 2000 Form 10-K and 2000 Proxy +Statement. Because the aircraft was transferred to Mr. Jobs in 2001, the amount of approximately $43.5 million paid by the Company during fiscal year 2001 towards the purchase of the +plane and the related tax assistance of approximately $40.5 million was reported as income to Mr. Jobs. In fiscal 2002, approximately $2.27 million paid by the Company towards the +purchase of the plane and approximately $1.3 million in related tax +assistance was reported as income to Mr. Jobs. Accordingly, the $90 million previously reported as a bonus in 2000 has been removed from the table above, and the amounts reported as +taxable income by Mr. Jobs related to the aircraft during each of fiscal 2001 and 2002 is reported as compensation. (2) Consists +of matching contributions made by the Company in accordance with the terms of the 401(k) plan. (3) A +special executive bonus was given to Mr. Cook for accepting the position of Senior Vice President, Worldwide Sales Service & Support in addition to holding the +position of Senior Vice President Operations. In January 2002, Mr. Cook was named Executive Vice President, Worldwide Sales and Operations. (4) Patent +award. 92 Option Grants in Last Fiscal Year The following table provides information about option grants to the Named Executive Officers during fiscal year 2002. OPTION GRANTS IN LAST FISCAL YEAR Individual Grants Number of Securities Underlying Options Granted (#) Percent of Total Options Granted to Employees in Fiscal Year(1) Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term(3) Name Exercise or Base Price ($/Sh)(2) Expiration Date 5% ($) 10% ($) Steven P. Jobs 7,500,000 32.27 % $ 18.30 10/19/2011 $ 86,315,788 $ 218,741,153 Fred D. Anderson — — — — — — Timothy D. Cook — — — — — — Jonathan Rubinstein — — — — — — Avadis Tevanian, Jr. — — — — — — (1) Based +on an aggregate of 23,239,444 options granted to all employees during fiscal year 2002. Options granted in fiscal year 2002 typically vest over four years in sixteen equal +quarterly increments. Options granted to executive officers including those granted to the Named Executive Officers typically vest in four equal annual installments commencing on the first anniversary +of the date of grant. Of the options granted to Mr. Jobs, 25% were vested as of the date of grant and the remainder vest in three equal annual installments commencing on the first anniversary +of the date of grant. (2) All +options were granted at an exercise price equal to the fair market value based on the closing market value of Common Stock on the Nasdaq National Market on the date of grant. (3) Potential +gains are net of exercise price, but before taxes associated with exercise. These amounts represent certain assumed rates of appreciation only, based on SEC rules, and do +not represent the Company's estimate or projection of the price of the Company's stock in the future. Actual gains, if any, on stock option exercises depend upon the actual future price of Common +Stock and the continued employment of the option holders throughout the vesting period. Accordingly, the potential realizable values set forth in this table may not be achieved. 93 Options Exercised and Year-End Option Holdings The following table provides information about stock option exercises by the Named Executive Officers during fiscal year 2002 and stock options held by each of them at fiscal +year-end. AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Number of Securities Underlying Unexercised Options at Fiscal Year-End (#) Value of Unexercised In-the-Money Options at Fiscal Year-End ($)(2) Name Shares Acquired on Exercise (#) Value Realized ($)(1) Exercisable Unexercisable Exercisable Unexercisable Steven P. Jobs — — 21,935,000 (3) 5,625,000 $ 193,200 $ 0 Fred D. Anderson 583,332 $ 10,122,169 600,000 1,350,000 $ 0 $ 0 Timothy D. Cook 700,000 $ 10,710,393 250,000 1,350,000 $ 0 $ 0 Jonathan Rubinstein — — 1,050,000 1,350,000 $ 3,960,000 $ 0 Avadis Tevanian, Jr. 87,920 $ 1,514,782 1,050,000 1,350,000 $ 2,996,283 $ 0 (1) Market +value of underlying securities (based on the fair market value of Common Stock on the Nasdaq National Market) at the time of exercise, minus the exercise price. (2) Market +value of securities underlying in-the-money options at the end of fiscal year 2002 (based on $14.72 per share, the closing price of Common Stock on the +Nasdaq National Market on September 28, 2002), minus the exercise price. (3) Includes +60,000 options granted to Mr. Jobs in his capacity as a director pursuant to the 1997 Director Stock Option Plan. Director Compensation In 1997, the Company ended its practice of paying cash retainers and fees to directors, and approved the Apple Computer, Inc. 1997 Director Stock Option Plan (the Director Plan ). +The Director Plan was approved by the shareholders in April 1998 and 800,000 shares have been reserved for issuance under the +Director Plan. Pursuant to the Director Plan, the Company's non-employee directors are granted an option to acquire 30,000 shares of Common Stock upon their initial election to the Board +( Initial Options ). On the fourth anniversary of a non-employee director's initial election to the Board and on each subsequent anniversary, +the director will be entitled to receive an option to acquire 10,000 shares of Common Stock ( Annual Options ). Initial Options vest and become +exercisable in equal annual installments on each of the first through third anniversaries of the date of grant. Annual Options are fully vested and immediately exercisable on their date of grant. As +of the end of the fiscal year, there +were options for 360,000 shares outstanding under the Director Plan. Since accepting the position of CEO, Mr. Jobs is no longer eligible for grants under the Director Plan. Compensation Committee Interlocks and Insider Participation The current members of the Compensation Committee are Messrs. William V. Campbell, Millard S. Drexler and Arthur B. Levinson, none of whom are employees of the Company +and all of whom are considered "independent" directors under the applicable NASDAQ rules. During fiscal 2002, William V. Campbell, Arthur D. Levinson and Jerome B. York served as members of the +Compensation Committee, none of whom were employees of the Company. No person who was an employee of the Company in fiscal year 2002 served on the Compensation Committee. During fiscal year 2002, +Mr. Jobs served as a director of Gap Inc. ("Gap") (though not on the compensation committee of that board of directors) and Mr. Drexler served as a director of the Company. +Mr. Jobs resigned as a director of Gap in September 2002. Mr. Drexler resigned as president and CEO of Gap in September 2002 and resigned as a 94 director of Gap in October 2002. Subsequently, in November 2002, Mr. York resigned from the committee, and Mr. Drexler was appointed as a member of the Compensation +Committee. No executive officer of the Company (i) served as a member of the compensation committee (or other board committee performing similar functions or, in the absence of any such +committee, the board of directors) of another entity, one of whose executive officers served on the Company's Compensation Committee, (ii) served as a director of another entity, one of whose +executive officers served on the Company's Compensation Committee, or (iii) served as a member of the compensation committee (or other board committee performing similar functions or, in the +absence of any such committee, the board of directors) of another entity, one of whose executive officers served as a director of the Company. Item 12. Security Ownership of Certain Beneficial Owners and Management The +following table sets forth certain information as of October 31, 2002 (the " Table Date ") with respect to the beneficial ownership of the +Company's Common Stock by (i) each person the Company believes beneficially holds more than 5% of the outstanding shares of Common Stock; (ii) each director; (iii) each Named +Executive Officer listed in the Summary Compensation Table under the heading " Executive Compensation; " and (iv) all directors and executive +officers as a group. On the Table Date, 359,007,837 shares of Common Stock were issued and outstanding. Unless otherwise indicated, all persons named as beneficial owners of Common Stock have sole +voting power and sole investment power with respect to the shares indicated as beneficially owned. Security Ownership of Directors, Nominees and Executive Officers Name of Beneficial Owner Shares of Common Stock Beneficially Owned(1) Percent of Common Stock Outstanding Lord, Abbett & Co 29,381,015 (2) 7.56 % Steven P. Jobs 23,810,002 (3) 6.22 % Fred D. Anderson 602,672 (4) * William V. Campbell 80,502 (5) * Timothy D. Cook 253,091 (6) * Millard S. Drexler 80,000 (7) * Arthur D. Levinson 221,600 (8) * Jonathan Rubinstein 1,058,275 (9) * Avadis Tevanian, Jr. 1,051,252 (10) * Jerome B. York 100,000 (5) * All executive officers and directors as a group (14 persons) 29,376,803 7.56 % (1) Represents +shares of Common Stock held and/or options held by such individuals that were exercisable at the Table Date or within 60 days thereafter. (2) Based +on a Form 13F-HR/A filed October 10, 2002 by Lord, Abbett & Co., 767 Fith Avenue, New York, NY 10153. (3) Includes +23,810,000 shares of Common Stock which Mr. Jobs has the right to acquire by exercise of stock options. (4) Includes +600,000 shares of Common Stock which Mr. Anderson has the right to acquire by exercise of stock options. (5) Includes +80,000 shares of Common Stock which Messrs. Campbell and York each have the right to acquire by exercise of stock options. 95 (6) Includes +250,000 shares of Common Stock which Mr. Cook has the right to acquire by exercise of stock options. (7) Includes +60,000 shares of Common Stock which Mr. Drexler has the right to acquire by exercise of stock options. (8) Includes +1,400 shares of Common Stock which Mr. Levinson holds indirectly and 20,000 shares of Common Stock which Mr. Levinson has the right to acquire by exercise of +stock options. (9) Includes +1,050,000 shares of Common Stock which Mr. Rubinstein has the right to acquire by exercise of stock options. (10) Includes +1,050,000 shares of Common Stock which Dr. Tevanian has the right to acquire by exercise of stock options. * Represents +less than 1% of the issued and outstanding shares of Common Stock on the Table Date. Equity Compensation Plan Information The following table sets forth certain information, as of September 28, 2002, concerning shares of common stock authorized for issuance under all of the Company's equity +compensation plans (shares in thousands). (a) Number of Securities to be Issued Upon Exercise of Options (b) Weighted Average Exercise price of Outstanding Options (c) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) Equity compensation plans approved by shareholders 44,867 $ 29.75 7,497 (1) Equity compensation plans not approved by shareholders 64,563 $ 27.07 1,221 (2) Total equity compensation plans 109,430 $ 28.17 8,718 (1) This +number includes 2,146,906 shares of common stock reserved for issuance under the Employee Stock Purchase Plan, 360,000 shares available for issuance under the 1997 Director Stock +Option Plan and 4,989,890 shares available for issuance under the 1998 Executive Officer Stock Plan. It does not include shares under the 1990 Stock Option Plan which was terminated in 1997. No new +options can be granted under the 1990 Stock Option Plan. (2) Reflects +shares authorized for future issuance under the 1997 Employee Stock Option Plan. 1997 Employee Stock Option Plan In August 1997, the Company's Board of Directors approved the 1997 Employee Stock Option Plan (the 1997 Plan), a non-shareholder approved plan for grants of +stock options to employees who are not officers of the Company. Options may be granted under the 1997 Plan to employees at not less than the fair market value on the date of grant. These options +generally become exercisable over a period of 4 years, based on continued employment, and generally expire 10 years after the grant date. Change In Control Arrangements—Stock Options In the event of a "change in control" of the Company, all outstanding options under the Company's stock option plans, except the Director Plan, will, unless otherwise +determined by the plan administrator, become exercisable in full, and will be cashed out at an amount equal to the difference between the applicable "change in control price" and the exercise price. +The Director Plan provides that upon a 96 "change in control" of the Company, all unvested options held by non-employee directors will automatically become fully vested and exercisable and will be cashed out at an amount equal to +the difference between the applicable "change in control price" and the exercise price of the options. A "change in control" under these plans is generally defined as (i) the acquisition by any +person of 50% or more of the combined voting power of the Company's outstanding securities or (ii) the occurrence of a transaction requiring shareholder approval and involving the sale of all +or substantially all of the assets of the Company or the merger of the Company with or into another corporation. In +addition, options granted to the Named Executive Officers generally provide that in the event there is a "change in control", as defined in the Company's stock option plans, and if in connection +with or following such "change in control", their employment is terminated without "Cause" or if they should resign for "Good Reason", those options outstanding that are not yet vested and exercisable +as of the date of such "change in control" shall become fully vested and exercisable. Generally, "Cause" is defined to include a felony conviction, willful disclosure of confidential information or +willful and continued failure to perform his or her employment duties. "Good Reason" includes resignation of employment as a result of a substantial diminution in position or duties, or an adverse +change in title or reduction in annual base salary. Item 13. Certain Relationships and Related Transactions In +connection with a relocation assistance package, the Company loaned Mr. Johnson (Senior Vice President, Retail) $1,500,000 for the purchase of his principal residence. The loan is secured by +a deed of trust and is due and payable in May 2004. Under the terms of the loan, Mr. Johnson agreed that should he exercise any of his stock options prior to the due date of the loan, +that he would pay the +Company an amount equal to the lesser of (1) an amount equal to 50% of the total net gain realized from the exercise of the options; or (2) $375,000 multiplied by the number of years +between the exercise date and the date of the loan. The largest amount of the indebtedness outstanding on this loan during fiscal year 2002 was $1,500,000. Mr. Jerome +York, a member of the Board of the Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. +( MicroWarehouse ) in January 2000. He also serves as its Chairman, President and Chief Executive Officer. MicroWarehouse is a multi-billion dollar +specialty catalog and online retailer and direct marketer of computer products, including products made by the Company, through its MacWarehouse catalogue. During fiscal year 2002, MicroWarehouse +accounted for 3.3% of the Company's net sales. The Company also purchases products from MicroWarehouse for its own internal use. In +March 2002, the Company entered into a Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in +the operation of his private plane when used for Apple business. The Reimbursement Agreement is effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of +the plane in May 2001. During 2002, the Company recognized a total of $1,168,000 in expenses pursuant to this reimbursement agreement related to expenses incurred by Mr. Jobs during 2001 +and 2002. Item 14. Controls and Procedures Based +on an evaluation under the supervision and with the participation of the Company's management as of a date within 90 days of the filing date of this Annual Report on +Form 10-K, the Company's principal executive officer and principal financial officer have concluded that the Company's disclosure controls and procedures (as defined in +Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended ( Exchange Act ) are effective to +ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods +specified in Securities and Exchange Commission rules and forms. 97 There +were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. There were no +significant deficiencies or material weaknesses, and therefore there were no corrective actions taken. However, the design of any system of controls is based in part upon certain assumptions about the +likelihood of future events and there is no certainty that any design will succeed in achieving its stated goal under all potential future considerations, regardless of how remote. 98 PART IV Item 15. Exhibits (a) Items +Filed as Part of Report: 1. Financial +Statements The +financial statements of the Company filed as part of this report on Form 10-K are set forth in the Index to Consolidated Financial Statements under Part II, Item 8 of +this Form 10-K. 2. Financial +Statement Schedules All +financial statement schedules have been omitted, since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the Consolidated Financial Statements and Notes thereto under Part II, Item 8 of this Form 10-K. 3. Exhibits The +following exhibits are filed as part of this Form 10-K. Exhibit Number Description 10.A.49** 1997 Employee Stock Option Plan, as amended through October 19, 2001. 21 Subsidiaries of Apple Computer, Inc. 23.1 Consent of KPMG LLP 99.1 Certificate of Apple Computer, Inc. Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. ** Represents +a management contract or compensatory plan or arrangement (b) Reports +on Form 8-K The +Company filed a current report on Form 8-K on August 8, 2002, to report that the Company had submitted to the Securities and Exchange Commission the Statements under Oath +of Principal Executive Officer and Principal Financial Officer in accordance with the SEC's June 27, 2002 Order requiring the filing of sworn statements pursuant to Section 21(a)(1) of +the Securities and Exchange Act of 1934. The +Company filed a current report on Form 8-K on August 1, 2002, to report the filing of a SEC Form 4 Statement of Changes in Beneficial Ownership filed with the +Securities and Exchange Commission by Mr. Arthur Levinson on August 2, 2002. (c) Exhibits +Incorporated by Reference Exhibit Number Notes* Description 3.1 88-S3 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on January 27, 1988. 3.2 00/3Q Amendment to Restated Articles of Incorporation, filed with the Secretary of State of the State of California on May 4, 2000. 3.3 00/3Q By-Laws of the Company, as amended through April 20, 2000. 4.2 94/2Q Indenture dated as of February 1, 1994, between the Company and Morgan Guaranty Trust Company of New York (the Indenture"). 99 4.3 94/2Q Supplemental Indenture dated as of February 1, 1994, among the Company, Morgan Guaranty Trust Company of New York, as resigning trustee, and Citibank, N.A., as successor trustee. 4.5 94/2Q Form of the Company's 6 1/2% Notes due 2004. 4.8 96-S3/A Registration Rights Agreement, dated June 7, 1996 among the Company and Goldman, Sachs & Co. and Morgan Stanley & Co. Incorporated. 4.9 97K Certificate of Determination of Preferences of Series A Non-Voting Convertible Preferred Stock of Apple Computer Inc. 10.A.1 93/3Q** 1981 Stock Option Plan, as amended. 10.A.3 91K** Apple Computer, Inc. Savings and Investment Plan, as amended and restated effective as of October 1, 1990. 10.A.3-1 92K** Amendment of Apple Computer, Inc. Savings and Investment Plan dated March 1, 1992. 10.A.3-2 97/2Q** Amendment No. 2 to the Apple Computer, Inc. Savings and Investment Plan. 10.A.5 98/1Q** 1990 Stock Option Plan, as amended through November 5, 1997. 10.A.6 99K** Apple Computer, Inc. Employee Stock Purchase Plan, as amended through October 6, 1999. 10.A.8 97K** Form of Indemnification Agreement between the Registrant and each officer of the Registrant. 10.A.43 97/2Q** NeXT Computer, Inc. 1990 Stock Option Plan, as amended. 10.A.50 98/2Q** 1997 Director Stock Option Plan. 10.A.51 02/3Q** 1998 Executive Officer Stock Plan, as amended through April 24, 2002. 10.A.52 02/3Q** Reimbursement Agreement. 10.B.8 91-8K-8 Participation in the Customer Design Center by the Registrant dated as of September 30, 1991 between IBM and the Registrant. 10.B.9 91-8K-9 Agreement for Purchase of IBM Products (Original Equipment Manufacturer) dated as of September 30, 1991 between IBM and the Registrant. 10.B.12 92K Microprocessor Requirements Agreement dated January 31, 1992 between the Registrant and Motorola, Inc. 10.B.16 96/3Q Fountain Manufacturing Agreement dated May 31, 1996 between Registrant and SCI Systems, Inc. 24.1 02K Power of Attorney. * Notes +appear on page 101. ** Represents +a management contract or compensatory plan or arrangement 100 NOTES 88-S3 Incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-3 (file no. 33-23317) filed July 27, 1988. 91K Incorporated by reference to the exhibit of that number in the Company's Annual Report on Form 10-K for the fiscal year ended September 27, 1991 (the "1991 Form 10-K"). 91-8K-8 Incorporated by reference to Exhibit 8 to the October 1991 Form 8-K. 91-8K-9 Incorporated by reference to Exhibit 9 to the October 1991 Form 8-K. 92K Incorporated by reference to the exhibit of that number in the Company's Annual Report on Form 10-K for the fiscal year ended September 25, 1992 (the "1992 Form 10-K"). 93/3Q Incorporated by reference to Exhibit 10.A.1 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 25, 1993. 94/2Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended April 1, 1994. 96/2Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended March 29, 1996. 96-S3/A-4.1.1, - -4.2.1, -4.3.1, -4.8 Incorporated by reference to the exhibit 4.1, 4.2, 4.3, and 4.8, respectively, in the Company's Registration Statement on Form S-3/A (file no. 333-10961) filed October 30, 1996. 97/2Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended March 28, 1997. 97K Incorporated by reference to the exhibit of that number in the Company's Annual Report on Form 10-K for the fiscal year ended September 26, 1997 (the "1997 Form 10-K"). 98/1Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended December 26, 1997. 98/2Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended March 27, 1998. 99K Incorporated by reference to the exhibit of that number in the Company's Annual Report on Form 10-K for the fiscal year ended September 25, 1999 (the "1999 Form 10-K"). 00/3Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended July 1, 2000. 02/3Q Incorporated by reference to the exhibit of that number in the Company's Quarterly Report on Form 10-Q for the quarter ended June 29, 2002. 02K Incorporated by reference to Page 102 of this Annual Report on Form 10-K for the fiscal year ended September 28, 2002 (the "2002 Form 10-K"). 101 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the +undersigned, thereunto duly authorized, this 19th day of December 2002. APPLE COMPUTER, INC. By: /s/ FRED D. ANDERSON Fred D. Anderson Executive Vice President and Chief Financial Officer KNOW +ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven P. Jobs and Fred D. Anderson, jointly and severally, his +attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to +file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said +attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates +indicated: Name Title Date /s/ STEVEN P. JOBS STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) December 19, 2002 /s/ FRED D. ANDERSON FRED D. ANDERSON Executive Vice President and Chief Financial Officer (Principal Financial Officer) December 19, 2002 /s/ WILLIAM V. CAMPBELL WILLIAM V. CAMPBELL Director December 19, 2002 /s/ MILLARD S. DREXLER MILLARD S. DREXLER Director December 19, 2002 /s/ ARTHUR D. LEVINSON ARTHUR D. LEVINSON Director December 19, 2002 /s/ JEROME B. YORK JEROME B. YORK Director December 19, 2002 102 I, Steven P. Jobs, certify that: 1. I +have reviewed this annual report on Form 10-K of Apple Computer, Inc.; 2. Based +on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of +the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based +on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, +results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The +registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act +Rules 13a-14 and 15d-14) for the registrant and we have: a) designed +such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others +within those entities, particularly during the period in which this annual report is being prepared; b) evaluated +the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation +Date"); and c) presented +in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The +registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of +directors (or persons performing the equivalent functions): a) all +significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial +data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any +fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The +registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could +significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. December 19, +2002 By: /s/ STEVEN P. JOBS Steven P. Jobs Chief Executive Officer 103 I, +Fred D. Anderson, certify that: 1. I +have reviewed this annual report on Form 10-K of Apple Computer, Inc.; 2. Based +on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of +the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based +on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, +results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The +registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act +Rules 13a-14 and 15d-14) for the registrant and we have: a) designed +such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others +within those entities, particularly during the period in which this annual report is being prepared; b) evaluated +the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation +Date"); and c) presented +in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The +registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of +directors (or persons performing the equivalent functions): a) all +significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial +data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any +fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The +registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could +significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. December 19, +2002 By: /s/ FRED D. ANDERSON Fred D. Anderson Executive Vice President and Chief Financial Officer 104 QuickLinks PART I Item 1. Business Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure REPORT OF INDEPENDENT AUDITORS PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation SUMMARY COMPENSATION TABLE OPTION GRANTS IN LAST FISCAL YEAR AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Item 12. Security Ownership of Certain Beneficial Owners and Management Security Ownership of Directors, Nominees and Executive Officers Item 13. Certain Relationships and Related Transactions Item 14. Controls and Procedures PART IV Item 15. Exhibits SIGNATURES \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-03-041604/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-03-041604/full-submission.txt new file mode 100644 index 0000000..335588e --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-03-041604/full-submission.txt @@ -0,0 +1,2004 @@ +QuickLinks -- Click here to rapidly navigate through this document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 27, 2003 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 0-10030 APPLE COMPUTER, INC. (Exact name of registrant as specified in its charter) CALIFORNIA (State or other jurisdiction of incorporation or organization) 942404110 (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California (Address of principal executive offices) 95014 (Zip Code) Registrant's +telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: None Securities +registered pursuant to Section 12(g) of the Act: Common Stock, no par value (Titles of classes) Indicate +by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding +12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o Indicate +by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be +contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or any amendment +to this Form 10-K. o Indicate +by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the +Act). Yes ý No o The +aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant, as of March 29, 2003, was approximately $4,479,669,616 based upon +the closing price reported for such date on the NASDAQ National Market. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 5% of the outstanding shares of +Common Stock and shares held by executive officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. This determination of executive officer or +affiliate status is not necessarily a conclusive determination for other purposes. 367,734,960 +shares of Common Stock Issued and Outstanding as of December 5, 2003 PART I The Business section and other parts of this Annual Report on Form 10-K ("Form 10-K") contain forward-looking +statements that involve risks and uncertainties. Many of the forward-looking statements are located in "Management's Discussion and Analysis of Financial Condition and Results of Operations." +Forward-looking statements can also be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future +performance and the Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not +limited to, those discussed in the subsection entitled "Factors That May Affect Future Results and Financial Condition" under Part II, Item 7 of this Form 10-K. The Company +assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Item 1. Business Company Background Apple Computer, Inc. ("Apple" or the "Company") was incorporated under the laws of the State of California on January 3, 1977. The Company designs, manufactures +and markets personal computers and related software, peripherals and personal computing and communicating solutions. The Company's products include the Macintosh® line of desktop and +notebook computers, the Mac OS® X operating system, the iPod™ digital music player, and a portfolio of software and peripheral products for education, creative, consumer and +business customers. The Company sells its products through its online stores, direct sales force, third-party wholesalers and resellers, and its own retail stores. The Company's fiscal year ends on +the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company's fiscal calendar. Business Strategy Digital Hub Apple is committed to bringing the best possible personal computing experience to students, educators, creative professionals, businesses and consumers around the world through +its innovative hardware, software, peripherals and Internet offerings, including .Mac™ and the iTunes® Music Store™. The Company believes that personal computing +has entered a new era in which the personal computer functions for both professionals and consumers as the digital hub for advanced new digital devices such as the Company's iPod digital music +players, personal digital assistants, cellular phones, digital still and movie cameras, CD and DVD players, and other electronic devices. The attributes of the personal computer, including its ability +to run complex applications, possess a high quality user interface, contain large and relatively inexpensive storage, and easily connect to the Internet in multiple ways and at varying speeds, can +individually add value to these devices and interconnect them as well. Apple is the only company in the personal computer industry that designs and manufactures the entire personal +computer—from the hardware and operating system to sophisticated applications. Apple provides innovative industrial design, intuitive ease-of-use, and +built-in networking, graphics, and multimedia capabilities. Thus, the Company is uniquely positioned to offer digital hub products and solutions. Apple +develops products and technologies that adhere to many industry standards in order to provide an optimized user experience through interoperability with peripherals and devices from other +companies. Apple has played a role in the development, enhancement, promotion, and/or use of numerous of these industry standards, many of which are discussed below. Retail Since inception of its retail initiative in 2001, the Company has opened 65 retail stores in the United States through fiscal year 2003 and during the first quarter of 2004 +opened 9 additional stores, including its first international store in the Ginza in Tokyo, Japan. The Company has located its stores at high traffic 1 locations +in quality shopping malls and urban shopping districts. In addition to its own hardware, software and peripheral products, the Company's stores carry a variety of third-party hardware and +software products. One +of the main goals of the retail initiative is to bring new customers to the Company and expand its installed base through sales to both first time personal computer buyers and those switching to +the Macintosh platform from competing operating system platforms. By operating its own stores, the Company is able to better control the customer retail experience. The stores are designed to simplify +and enhance the presentation and marketing of personal computing products. To that end, retail store configurations have expanded to various sizes in order to accommodate market demands. The stores +employ experienced and knowledgeable personnel, provide post-sale advice and support, offer a wide selection of third-party products selected to complement the Company's own products, host +training and marketing presentations, and provide certain hardware support services. Additionally, the stores provide a forum in which the Company is able to present entire computing solutions to +users in areas such as digital photography, digital video, music, children's software, and home and small business computing. Education For more than 25 years, the Company has focused on the use of technology in education. The Company believes that effective integration of technology into classroom +instruction can result in higher levels of student achievement, especially when used to support collaboration, information access, and the expression and representation of student thought and ideas. +The Company provides a range of products and services designed to help schools maximize their investments in technology. This is manifested in many of the Company's products and services, including +hardware products like the eMac™ and the iBook® that are designed to meet the needs of education customers, video editing solutions, wireless networking capabilities, student +information systems, one-to-one learning solutions, and high-quality curriculum and professional development solutions. Creative Professionals Creative professionals constitute one of the Company's most important markets for both hardware and software products. This market is also important to many third-party +developers who provide Macintosh compatible hardware and software solutions. Creative customers utilize the Company's products for a variety of creative activities including digital video and film +production and editing; digital video and film special effects, compositing, and titling; digital still photography; graphic design, publishing, and print production; music performance and production; +audio production and sound design; and web design, development, and administration. The +Company designs its high-end hardware solutions, including servers and desktop and portable Macintosh systems, to incorporate the power, expandability, and features desired by creative +professionals. Additionally, the Company's operating system, Mac OS X, incorporates powerful graphics and audio technologies and features developer tools to optimize system and application performance +when running powerful creative solutions provided by the Company or by third-party developers. The Company also offers various software solutions to meet the needs of its creative customers, many of +which are described below. Business Organization The Company manages its business primarily on a geographic basis. The Company's reportable operating segments are the Americas, Europe, Japan, and Retail. The Americas segment +includes both North and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. The Japan +segment includes only Japan, except for the activities of the Company's Retail segment. The Retail segment currently operates Apple-owned retail stores in the United States and in the first quarter of +fiscal 2004, opened its first international store in Tokyo, Japan. Other operating segments include Asia-Pacific, which includes Australia and Asia except for 2 Japan, +and the Company's subsidiary, FileMaker, Inc. Each reportable operating segment provides similar hardware and software products and similar services. Further information regarding the +Company's operating segments may be found in Part II, Item 7 of this Form 10-K under the heading "Segment Operating Performance," and in Part II, Item 8 on this +Form 10-K in the Notes to Consolidated Financial Statements at Note 11, "Segment Information and Geographic Data." Hardware Products The Company offers a range of personal computing products including desktop and notebook personal computers, related devices and peripherals, networking and connectivity +products, and various third-party hardware products. All of the Company's Macintosh products utilize PowerPC® RISC-based microprocessors. The Company's entire line of Macintosh +systems, excluding servers, features the Company's suite of software for digital photography, music, and movies. Power Mac® The Power Mac line of desktop personal computers is targeted at business and professional users and is designed to meet the speed, expansion and networking needs of the most +demanding Macintosh user. Powered by the PowerPC G5 processor, designed by IBM and Apple, and featuring up to a 1 GHz front-side bus and the ability to address up to 8GB of memory, the +current Power Mac G5 utilizes 64-bit processing technology for advanced 64-bit computation, while running existing 32-bit applications natively. The PowerPC G5 +processor architecture is based on a completely new execution core that features massively parallel computation, full symmetric multi-processing, two double precision floating point units and an +optimized Velocity Engine™. Power Mac G5 systems, encased in a professional aluminum enclosure with computer controlled cooling for quiet operation, also include on all models SuperDrive +CD-RW/DVD-R drives, digital audio and PCI-X expansion, and advanced input and output technologies including Gigabit Ethernet, FireWire® and USB ports. +The system also supports 54 Mbps AirPort Extreme® wireless networking and is Bluetooth ready for wireless connections to a host of Bluetooth-enabled peripherals. Prior to the availability +of the Power Mac G5 in August 2003, the +Company's Power Mac line during most of fiscal 2003 featured PowerPC G4 processors in all models. The Company continues to offer a Power Macintosh G4 system with a single or dual 1.25 Ghz processor +configuration. Xserve® and Xserve RAID Storage System Xserve, the Company's first ever rack-mount server product, was designed for simple setup and remote management of intensive input/output (I/O) applications such as +digital video, high-resolution digital imagery, and large databases. In February 2003, the Company upgraded its Xserve 1U rack servers with more powerful processors, more storage +capacity, and a FireWire 800 interface. At the same time, the Company introduced the Xserve RAID Storage System, a rack storage system that holds up to 14 hot-swapable drive modules +capable of holding up to 3.5 terabytes of data. Xserve RAID architecture combines affordable, high-capacity ATA/100 drive technology with a Fibre Channel interface for reliable and fast +data access. Xserve RAID provides RAID level 5 throughput that supports affordable real-time high definition (HD) 1080i video editing. PowerBook ® The +PowerBook family of portable computers is designed to meet the mobile computing needs of professionals and advanced consumer users. The 17-inch PowerBook G4 features a +17-inch wide-format active-matrix display, is encased in a durable aluminum alloy enclosure, is 1-inch thick, and weighs as little as 6.9 pounds. The +17-inch PowerBook G4 also features built-in support for AirPort Extreme 54 Mbps 802.11g wireless networking, new high-speed FireWire 800, a backlit keyboard with +ambient light sensors, and built-in Bluetooth for wireless connection to cell phones and other Bluetooth equipped peripherals. The 12-inch PowerBook G4 features a +12-inch, active-matrix display housed in a lightweight, durable aluminum alloy enclosure weighing approximately 4.6 pounds. The 12-inch PowerBook G4 features a +high-speed PowerPC G4 processor, NVIDIA graphics, built-in Bluetooth wireless networking, and battery 3 life +of up to five hours on a single charge. In September 2003, the Company introduced a new 15-inch PowerBook G4, which features a 15.2-inch widescreen display, +and is encased in a sleek aluminum design weighing as little as 5.6 pounds. This product line addition complements the Company's other two PowerBook models, the 12-inch and +17-inch PowerBook G4s that were introduced in January 2003 and updated in September 2003. iMac® The iMac line of desktop computers is targeted to education and consumer markets. The Company's iMac product line features an innovative industrial design that incorporates an +adjustable 15-inch or 17-inch thin film transistor (TFT) active-matrix flat panel display and an ultra-compact base. In November 2003, a new 20-inch iMac +model was released. All models utilize PowerPC G4 processors, fast 333 MHz DDR memory, NVIDIA graphics, two FireWire 400 and three high-speed USB 2.0 ports. The iMac also offers the latest +in wireless communications with support for 54 Mbps AirPort Extreme and Bluetooth wireless connectivity. eMac™ The eMac, which is targeted primarily at the Company's education and consumer customers, features a PowerPC G4 processor, a high resolution 17-inch flat cathode ray +tube (CRT) display, a SuperDrive option, and preserves the all-in-one compact design of the original iMac favored by many of the Company's education and consumer customers. iBook ® The +iBook is designed to meet the portable computing needs of education and consumer users. The current iBooks, upgraded in October 2003, feature PowerPC G4 processors and either a +12-inch or 14-inch display. These systems offer advanced connectivity with AirPort Extreme and Bluetooth, and certain models include 256 MB of DDR memory and +slot-load Combo drives for burning CDs and watching DVDs. Each iBook is outfitted with a sleek polycarbonate plastic enclosure and weighs as little as 4.9 pounds. Peripheral Products The Company sells certain associated Apple-branded computer hardware peripherals, including iPod™ digital music players, iSight™ digital video cameras, +and a range of high quality flat panel TFT active-matrix digital color displays. The Company also sells a variety of third-party Macintosh compatible hardware products directly to end users through +both its retail and online stores, including computer printers and printing supplies, storage devices, computer memory, digital video and still cameras, personal digital assistants, and various other +computing products and supplies. iPod™ The Company's newest iPod portable music player, compatible with both the Macintosh and Windows platforms, is smaller and lighter than previous versions and is available in +three models with storage capacity of either 10GB, 20GB, or 40GB; the latter holding up to 10,000 songs. In addition to MP3, iPod now supports the Advanced Audio Coding (AAC) audio format. The new +iPod models also feature solid-state interfaces and the 20GB and 40GB models include the iPod Dock, which facilitates fast and easy connection to a computer or stereo. The iPod's functionality extends +well beyond playing music. Other key capabilities include data storage, calendar and contact information utility, and a selection of games. With the addition of third-party iPod peripherals, the +capabilities of certain iPods can be enhanced to include voice recording and photo downloading from certain digital cameras. Along with the iPod, the Company has developed a seamless +end-to-end music solution with the Company's iTunes® digital music management software and the iTunes Music Store, a service that consumers may use to purchase +music over the Internet. Further discussion on these related music offerings may be found below under the headings "Software Products and Computer Technologies" and "Internet Software, Integration, +and Services." 4 iSight™ The Company introduced the iSight digital video camera and the beta version of its iChat™ AV software application in June 2003. Together they enable +high-quality audio and videoconferences between two Macintosh systems over broadband connections. iSight is a small, portable aluminum alloy camera with all audio, video and power provided +by a single FireWire cable. iSight features a custom designed lens with auto-focus and a high-end CCD sensor to provide high-resolution images and +full-motion video at up to 30 frames per second. iSight includes an integrated microphone that suppresses ambient noise for clear digital audio. With its on-board processor, +iSight automatically adjusts color, white balance, sharpness and contrast to provide high-quality images with accurate color reproduction in most lighting conditions. iSight is designed to +be center-mounted on the top of a computer screen and uses its integrated tilt and rotate mechanism to easily position the camera for natural, face-to-face video conferencing. Displays The Company's all-digital, active-matrix LCD flat panel displays, including the 23-inch Cinema HD Display®, 20-inch Apple Cinema +Display® and the 17-inch Apple Studio Display®, produce flicker-free images with twice the brightness, sharpness, and contrast ratio of a typical CRT +display. Software Products and Computer Technologies The Company offers a range of software products for education, creative, consumer and business customers, including Mac OS X, the Company's proprietary operating system +software for the Macintosh; server software and related solutions; professional application software; and consumer, education and business oriented application software. Operating System Software During 2001, the Company introduced the first customer release of its new client operating system, Mac OS X, and its first significant upgrade, Mac OS X version 10.1. At its +introduction, Mac OS X offered advanced functionality built on an open-source UNIX-based foundation and incorporated the most fundamental changes in both core technology and +user interface design made by the Company to the Mac OS in a single upgrade since the original introduction of the Macintosh in 1984. Mac OS X features memory protection, pre-emptive +multi-tasking, and symmetric multiprocessing. Mac OS X includes Apple's Quartz™® 2D graphics engine (based on the Internet-standard Portable Document Format) for enhanced +graphics and broad font support, OpenGL for enhanced 3D graphics and gaming, and Apple's new user interface named "Aqua ® ," which combines +superior ease-of-use with new functionality. In January 2002, the Company made Mac OS X the default operating system on all new Macintosh systems. In +August 2002, the Company introduced Mac OS X version 10.2 (code named "Jaguar"), the second significant upgrade to the original Mac OS X version. Jaguar included a new Mail application +designed to manage junk mail; iChat, an AIM-compatible instant messenger; a system-wide Address Book; Inkwell™ handwriting recognition; improved Universal Access; +an enhanced Finder™; an updated version of QuickTime®, the Company's multimedia software for playing, interacting with or viewing video, audio, and graphics files; and an +updated version of Sherlock®, the Company's advanced Internet search engine. Jaguar also featured accelerated graphics performance, increased compatibility with Windows networks, and a +UNIX-based foundation with enhancements including FreeBSD 4.4 and GCC 3.1-based developer tools. In +October 2003, the Company released Mac OS X version 10.3 (code named "Panther"), the Company's current version of Mac OS X. Panther incorporates more than 150 new features including a +completely new Finder™; Exposé, a new way to organize windows and instantly see all open windows at once; FileVault™, a new feature that secures the contents of +a home directory with 128-bit AES encryption; iChat AV, a complete desktop video conferencing solution; and enhanced support for use on Windows-based networks. 5 Server Software and Server Solutions Mac OS X server software was initially introduced in May 2001, followed by Mac OS X Server version 10.2 (code named "Jaguar Server") that was released in +August 2002. Jaguar Server delivers high-performance services for Internet and web serving, filing, printing, and networking services needed to manage a network of Mac, UNIX, and +Windows clients. It provides performance and stability through full pre-emptive multi-tasking, symmetric multiprocessing, protected memory, advanced virtual memory, software RAID support, +and support for networking and security standards. Jaguar Server also includes Apple's Open Directory architecture for centralized management of network resources using LDAPv3 directory services and a +suite of built-in, standards-based Internet services like an optimized Apache web server for high-performance hosting of secure dynamic web sites and QuickTime Streaming Server +and QuickTime Broadcaster for streaming live events over the Internet. Jaguar Server also comes with a flexible mail server that supports POP and secure IMAP, as well as WebMail for browser-based +email access. In +October 2003, the Company began shipping the current version of its server operating system, which is called Mac OS X Server version 10.3 "Panther Server." This release integrates leading +open source and open standards server software with easy-to-use management tools that make it easy to serve Macintosh, Windows and Linux clients. Panther Server includes +powerful open source solutions and easy-to-use server management capabilities. New features in Panther Server include Server Admin tool for easily setting up multiple servers; +Open Directory 2 for hosting scalable LDAP directory and Kerberos authentication services; Samba 3 for providing login and home directory support for Windows clients; and the JBoss application server +for running powerful J2EE applications. Apple +Remote Desktop™ for Mac OS X software enables users, teachers and administrators to remotely manage other Macintosh systems anywhere on a local network, +AirPort ® wireless network or across the Internet. With Apple Remote Desktop, teachers can view students' computer screens, perform group +demonstrations and help individuals with real-time screen-sharing, text chat and the "request attention" command. System administrators can provide remote assistance, get comprehensive +system profiles, reconfigure system settings and quickly and easily distribute software applications across hundreds of computers—all from one central location over both Ethernet and +AirPort wireless networks. Apple Remote Desktop supports multiple levels of administrator access, each with its own password, providing a secure way for teachers or department-level administrators to +assist users while restricting privileges for deleting items or changing system settings. Professional Application Software Final Cut Pro® is a video editing application designed to meet the demanding needs of professional video editors by providing them with a +high-performance, scalable, and cost-effective solution for editing in virtually any format: DV, SD, HD and film. Final Cut Pro includes tools for editing, compositing and +effects, color-correction and audio. Final Cut Pro 4, released in June 2003, introduced RT Extreme, a multi-stream real-time effects engine, new interface customization tools, high +performance codecs for uncompressed SD and HD video, and +32-bit floating point (per channel) image processing. Final Cut Pro 4 also includes three completely new integrated tools—LiveType for creating animated, broadcast-quality +titles, Soundtrack for music composition, and Compressor for batch encoding and output of high-quality MPEG-2, MPEG-4, and QuickTime files directly from Final Cut +Pro 4's timeline. Version 4.1 of Final Cut Pro was released in November 2003 and included optimizations for the Power Mac G5 and Mac OS X Panther. Shake ® 3, an upgrade of the Company's compositing and visual effects software designed for large format film and video productions, was +announced in April 2003 and released in June 2003. Shake 3 includes new Mac OS X only features such as the Shake Qmaster network render management software and unlimited network +rendering licenses which allow visual effects artists to easily distribute rendering tasks across a cluster of Apple's Xserve rack servers or desktop Power Macintosh computers for enhanced performance 6 and +efficiency. Shake 3 also includes new visual effects features available to Mac OS X, Linux and IRIX customers including motion-tracking and real-time broadcast preview. The +Company acquired Emagic, a leading provider of professional software and hardware solutions for computer based music production, during the fourth quarter of 2002. Emagic's most popular product, +Logic®, is actively used by musicians around the world and by professionals in music production, film scoring, and post-production facilities. It combines composition, notation +and audio production facilities in one comprehensive product. Logic Platinum offers a comprehensive set of music creation tools featuring rock-solid MIDI timing and synchronization, mixing +and automation with total recall, and non-destructive real-time editing of both audio and MIDI. It also offers MIDI timing with 960 PPQN and sends and receives synchronized +MIDI clock, MTC, MMC and word clock signals, making it ideal for film, TV and video post-production facilities. DVD +Studio Pro ® 2 was announced in April 2003 and released in August 2003. It is a completely new DVD authoring product, +rebuilt from the ground up with a new user interface, professionally designed and fully customizable templates, an innovative new menu editor, timeline-based track editing and a new software-based +MPEG-2 encoder. Consumer, Education and Business Oriented Application Software Introduced in January 2003, iLife™ is the Company's integrated suite of digital lifestyle applications that features the Company's iTunes®, +iPhoto™, iMovie™ ® , and iDVD™ software applications. These applications are integrated to allow users +easy access to their digital music, photos and movies from within each application. All of these iLife applications come preinstalled on the Company's Macintosh systems, except for iDVD, which is only +available on Macintosh systems configured with a SuperDrive. iTunes® +is a digital music management application that lets users create and manage their own digital music library. iTunes organizes music using searching, browsing and playlist features. +It supports both audio and MP3 CD burning, features a graphic equalizer and cross fading between songs, and supports automatic synchronization with the music stored on an iPod. In July 2002, +the Company introduced iTunes 3, featuring Smart Playlists, which automatically and dynamically updates playlists based on simple rules set by the user, and Sound Check for consistent volume playback. +In April 2003, the Company launched iTunes 4, which integrated the Company's iTunes Music Store. Further discussion on the iTunes Music Store may be found below under the heading "Internet +Software, Integration, and Services." In October 2003, the Company launched iTunes for Windows, the first version of the Company's digital music management software for users of Windows-based +personal computers. iTunes for Windows includes all of the same features as the Macintosh version, including MP3 and AAC encoding from audio CDs, Smart Playlists, free Internet radio stations, and the +ability to burn custom playlists to CDs and MP3 CDs, burn content to DVDs to back-up an entire music collection and share music between networked computers via Rendezvous™, the +Company's zero configuration networking technology. iMovie®, +the Company's easy-to-use consumer digital video editing software for creation of home and classroom movies, features an enhanced user interface, improved +audio editing capabilities, enhanced controls for titling and transitions, and added special effects. iDVD™ +is consumer oriented software that makes it easy to turn iMovie files, QuickTime files and digital pictures into DVDs that can be played on most consumer DVD players. iDVD simplifies +DVD authoring by including professionally designed themes and drag-and-drop simplicity. iPhoto™ +is consumer oriented digital photo software that makes it easy to import, edit, save, share, and print digital photos, as well as organize and manage an entire digital photo +collection containing thousands of photos. Users are able to view their photos in full-screen; use the slide show feature accompanied by their favorite music; automatically create custom +web pages of their photos; email photos to friends and family; order professionally-processed prints and enlargements online; or easily design and order custom- 7 printed, +linen-covered hard bound photo books online. Prints, enlargements, and hardbound book production are currently only available to U.S. and Canadian customers. The +Company's iChat AV software application and the iSight digital video camera together enable high-quality audio and video conferences between two Macintosh systems over broadband +connections. iChat AV also enables audio conferences over dial-up connections to the Internet. iChat AV requires no setup or configuration beyond installing the software +and plugging in a FireWire video camera and microphone, such as iSight or certain third-party FireWire based cameras with microphones. Final +Cut® Express, introduced in January 2003, is based on Apple's award-winning Final Cut Pro software. Final Cut Express enables small business users, educators, students and +advanced hobbyists to perform professional-quality digital video editing. Final Cut Express includes key features used by video editors such as the same interface and workflow as Final Cut Pro, +powerful video editing tools, hundreds of special effects, and easy delivery of output to DVD, the Internet, or tape. Keynote™ +is the Company's presentation software introduced in January 2003 that gives users the ability to create high-quality presentations. Designed to be easy to use, +Keynote includes professionally designed themes, advanced typography, professional-quality image resizing, animated charts and tables that can be created quickly, and cinematic-quality transitions. +Keynote imports and exports PowerPoint, QuickTime, and PDF files to simplify the creation and sharing of presentations. AppleWorks® +6.2 is an integrated productivity application that incorporates word processing, page layout, image manipulation, spreadsheets, databases and presentations in a single +application. Intended to be an easy-to-use product for the Company's consumer and education customers, AppleWorks makes it simple to create professional-looking documents in +the classroom and at home. FileMaker +Corporation, a wholly owned subsidiary of the Company, develops, publishes, and distributes desktop-based database management application software for Mac OS and Windows-based systems. The +FileMaker ® Pro database software and related products offer strong relational databases and advanced desktop-to-web +publishing capabilities. Third-Party Software Products Thousands of third-party software titles and solutions are available for the Macintosh platform. The Company sells a variety of these third-party software products directly to +end users through both its retail and online stores. Internet Software, Integration, and Services Apple's Internet strategy is focused on delivering seamless integration with and access to the Internet throughout the Company's product lines. The Company's Internet products +and technologies adhere to many industry standards in order to provide an optimized user experience through interoperability. An easy Internet Setup Assistant is included with the Mac OS. iTunes Music Store™ In April 2003, the Company launched the iTunes Music Store in the United States, an online music store that allows Macintosh customers to find, purchase, and download +music for 99 cents per song or, in most cases, $9.99 per album. The iTunes Music Store is fully integrated with a one-click download directly into the latest version of the iTunes +software, allowing customers to purchase, download, organize, share, and transfer their digital music to an iPod using a single software application. Requiring no subscription fee, the iTunes Music +Store with iTunes software offers customers a broad range of personal rights to the songs purchased, including playing songs on up to three computers, burning songs onto an unlimited number of CDs for +personal use, playing songs on an unlimited number of iPods, and using songs in certain applications such as iPhoto, iMovie, and iDVD. Users can easily search the contents of the entire music 8 store +to locate songs by title, artist, or album, or browse the entire contents of the music store by genre and artist. Users can also listen to a free 30-second preview of any song in the +store. The +second generation of the iTunes Music Store for both Macintosh and Windows users became available in October 2003. New features of the music store include online gift certificates that can +be sent to family and friends via e-mail, an "allowance" feature that enables users to automatically deposit funds into an iTunes Music Store account every month, and the availability of +audio books for purchase directly from the iTunes Music Store. The Company is exploring ways to enhance awareness and promote use of the iTunes Music Store, including arrangements with America +Online, Inc. (AOL) to integrate links to the iTunes Music Store into AOL's Music site and Pepsi-Cola North America to give away songs from the iTunes Music Store. Safari™ In June 2003, the Company introduced Safari 1.0, the Company's new Mac OS X compatible web browser that is capable of loading web pages rapidly. Safari uses the advanced +interface technologies underlying Mac OS X and includes built-in Google search; SnapBack™ to instantly return to search results; a new way to name, organize and present +bookmarks; tabbed browsing; and automatic "pop-up" ad blocking. The Company also released a software development kit that allows developers to embed the Safari HTML rendering engine +directly into their applications. Quicktime ® QuickTime, +the Company's multimedia software for Macintosh and Windows platforms, features streaming of live and stored video and audio over the Internet and playback of high-quality audio +and video on computers. The current version of QuickTime, +QuickTime 6, features support for the open-standard MPEG 4 format. QuickTime 6 includes the new Instant-On Streaming feature that eliminates buffer delays and provides users +with the ability to quickly and easily scrub through streaming media content to locate and instantly view specific sections. In addition, QuickTime 6 running on Mac OS X now supports JPEG 2000, the +next generation JPEG standard that allows users to capture still images in a higher quality and smaller file size than ever before. QuickTime 6 also includes AAC, the standard MPEG-4 audio +format. AAC is the next generation professional-quality audio format that delivers superior sound quality with reduced file sizes. The +Company also offers several other QuickTime products, including QuickTime Pro, a suite of software tools that allows creation and editing of Internet-ready audio and video files and allows a user +to add special effects and other features to QuickTime movies; QuickTime Streaming Server which facilitates the broadcasting of streaming digital video; and QuickTime Broadcaster that allows users to +quickly and easily produce professional-quality live events for online delivery. .Mac ™ The +Company's .Mac offering is a suite of Internet services that for an annual fee provides Macintosh users with powerful Internet tools. .Mac features email service with IMAP, POP or +web-based access, 100MB of iDisk Internet storage, and hosting for personalized homepages and shared digital photo albums. Also included with .Mac is McAfee's Virex anti-virus +software and Backup, a personal back-up solution allowing users to archive data to their Internet storage, CD, or DVD. Wireless Connectivity and Networking AirPort Extreme ™® AirPort +Extreme, introduced in January 2003, is the Company's next generation of Wi-Fi wireless networking technology based on the new ultra-fast 802.11g standard. With +speeds up to 54 Mbps, AirPort Extreme delivers almost five times the data rate of today's 802.11b based products, yet is fully compatible with the millions of 802.11b Wi-Fi devices around +the world. AirPort Extreme Base Stations can serve up 9 to +50 Macintosh and Windows users simultaneously, provide wireless bridging to extend the range beyond just one base station, and support USB printer sharing to allow multiple users to wirelessly +share USB printers connected directly to the base station. Embedded +into Mac OS X is Bluetooth technology. Bluetooth is an emerging industry standard for wirelessly connecting computers and peripherals that supports transmission of data at up to 1 Mbps within +a range of approximately 30 feet. The Company's Bluetooth technology for Mac OS X lets customers wirelessly share files between Macintosh systems, synchronize and share contact information with +Palm-OS based PDAs, and access the Internet through Bluetooth-enabled cell phones. A Bluetooth USB adaptor can Bluetooth-enable any USB-based Macintosh computer running in Mac +OS X version 10.1.4 or higher. The +Company's Rendezvous™ networking technology is based on open Internet Engineering Task Force (IETF) Standard Protocols such as IP, ARP and DNS. Rendezvous uses industry standard +networking protocols and zero configuration technology to automatically discover and connect devices over any IP network, including Ethernet or 802.11-based wireless networks like the +Company's AirPort product. Major developers such as Canon, Epson, Hewlett-Packard, Lexmark, Philips, Sybase, World Book and Xerox have announced support for Rendezvous in a broad range of products +including network printers, consumer electronics, enterprise database management and educational applications. The Company has made the Rendezvous source code freely available allowing developers to +use Rendezvous technology in their network-enabled devices or software applications. The Rendezvous source code includes software to support UNIX, Linux, and Windows-based systems and devices. +Rendezvous support is built into Mac OS X. The +Company developed FireWire ® technology, also referred to as IEEE 1394, which is a high-speed serial I/O technology for +connecting digital devices such as digital camcorders and cameras to desktop and portable computers. With its high data-transfer speed and "hot plug-and-play" +capability, FireWire has become an established cross-platform industry standard for both consumers and professionals and is the data interface of choice for today's digital video and audio devices, as +well as external hard drives and other high-speed peripherals. FireWire is currently included on all Macintosh systems and is a data transfer technology utilized by iPod. Product Support and Services AppleCare ® offers a range of support options for Apple customers. These options include assistance that is built +into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare Protection Plan. The +AppleCare Protection Plan is a fee-based service that typically includes three years of phone support and hardware repairs, dedicated web-based support resources, and user +diagnostic tools. Apple +Training offers comprehensive system administration and development training on Apple technologies, together with certification programs that test customers' skills and verify their technical +proficiency. Apple Professional Services offers a range of custom, personalized technical services, including Internet consulting and setup, installation and integration services. The Company also +offers +specialized loan programs including loans for consumers, students, and educators. Apple also provides leasing solutions for its education institution customers and its business and professional +customers. The Company uses several third-party lenders to originate and carry these loans and leases, all of which are non-recourse to the Company. Specialized Education Products and Services The Company offers a variety of unique services and products to its education customers, including a separate online store for education customers offering special education +price lists and promotions; special financing programs for K-12 and higher education students, faculty, and staff; a special edition of its productivity software suite, AppleWorks, that is +cross platform for both Macintosh and Windows computers; the iBook Wireless Mobile Lab that allows teachers and students to share iBook computers, a printer, and a wireless network/Internet connection +stored on a cart for mobility between classrooms; and 10 three +special Digital Media Studio solutions designed for education, including one that is integrated into a mobile cart. Additionally, Apple Professional Services offers a range of technical services +to education customers. In +2001, Apple acquired PowerSchool Inc., a privately held provider of web-based student information systems for K-12 schools and school districts. +PowerSchool ® software products give school administrators and teachers the ability to easily and cost-effectively manage student +records and give parents real-time access to track their children's performance via the Internet. PowerSchool offers the option of remote hosting with an application service provider +model. Markets and Distribution The Company's customers are primarily in the education, creative, consumer, and business markets. Certain customers are attracted to Macintosh computers for a variety of +reasons, including the reduced amount of training resulting from the Macintosh computer's intuitive ease of use, advanced graphics capabilities, industrial design features of the Company's hardware +products, and ability of Macintosh computers to network and communicate with other computer systems and environments. Apple personal computers were first introduced to education customers in the late +1970s. Over 18% of the Company's net sales in 2003 were to education customers in the United States, including sales to elementary and secondary schools and college and university customers. The +Company distributes its products through wholesalers, resellers, national and regional retailers and cataloguers. No individual customer accounted for more than 10% of net sales in 2003, 2002 or +2001. The Company also sells many of its products and resells certain third-party products in most of its +major markets directly to education customers, consumers, businesses, and certain resellers through its retail stores in the United States, or through one of its online stores around the world. Total +direct and indirect sales attributable to the Company's online stores totaled approximately $2.9 billion, $2.4 billion, and $2.0 billion for fiscal years 2003, 2002 and 2001, +respectively. Competition The Company is confronted by aggressive competition in all areas of its business. The market for the design, manufacture, and sale of personal computers and related software +and peripheral products is highly competitive. This market continues to be characterized by rapid technological advances in both hardware and software development, which have substantially increased +the capabilities and applications of these products, and have resulted in the frequent introduction of new products and significant price, feature, and performance competition. Over the past several +years, price competition in the market for personal computers has been particularly intense. The Company's competitors who sell personal computers based on other operating systems have aggressively +cut prices and lowered their product margins to gain or maintain market share. The Company's results of operations and financial condition have been, and in the future may continue to be, adversely +affected by these and other industry-wide downward pressures on gross margins. The +principal competitive factors in the market for personal computers include relative price/performance, product quality and reliability, design innovation, availability of software, product +features, marketing and distribution capability, service and support, availability of hardware peripherals, and corporate reputation. Further, as the personal computer industry and its customers place +more reliance on the Internet, an increasing number of Internet devices that are smaller, simpler, and less expensive than traditional personal computers may compete for market share with the +Company's existing products. The +Company is currently taking and will continue to take steps to respond to the competitive pressures being placed on its personal computer sales as a result of innovations in competing platforms. +The Company's future operating results and financial condition are substantially dependent on its ability to continue to develop improvements to the Macintosh platform in order to maintain perceived +functional and design advantages over competing platforms. 11 The Company's initial success with the development of an end-to-end music offering, which includes the iTunes digital music management software, iTunes Music Store and iPod +digital music player, has already encouraged significant competition in this area from other companies, many of whom have greater financial, marketing, and manufacturing resources than those of the +Company. The Company believes it maintains a competitive advantage by more effectively integrating the entire end-to-end music solution, including the hardware (iPod), software +(iTunes) and music content (iTunes Music Store). Raw Materials Although most components essential to the Company's business are generally available from multiple sources, certain key components (including microprocessors and +application-specific integrated circuits ("ASICs")) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from +multiple sources, are at times subject to industry wide availability constraints and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal +computer industry, and new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for, and +subsequently qualifies, additional suppliers. If the supply of a key or single-sourced component to the Company were to be delayed or curtailed or in the event a key manufacturing vendor delays +shipments of completed products to the Company, the Company's ability to ship related products in desired quantities and in a timely manner could be adversely affected. The Company's business and +financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an +alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of common components instead of components customized to +meet the Company's requirements. The Company attempts to mitigate these potential risks by working closely with these and other key suppliers on product introduction plans, strategic inventories, +coordinated product introductions, and internal and external manufacturing schedules and levels. Consistent with industry practice, the Company acquires components through a combination of formal +purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the Company's requirements for periods ranging from 30 to +130 days. The +Company believes there are several component suppliers and manufacturing vendors whose loss to the Company could have a material adverse effect upon the Company's business and financial position. +At this time, such vendors include Agere Systems, Inc., Ambit Microsystems Corporation, ASUSTeK Corporation, ATI Technologies, Inc., Broadcom Corporation, Compal Corporation, Hon Hai +Precision Industry Co., Ltd., IBM Corporation, International Display Technology, Inventec Appliances Corporation, LG. Phillips Co., Ltd., Matsushita, Mitsubishi Electric Corporation, +Motorola, Inc., Nvidia Corp., Quanta Computer, Inc., Samsung Electronics, Synaptics, Inc., and Toshiba Corporation. Research and Development Because the personal computer industry is characterized by rapid technological advances, the Company's ability to compete successfully is heavily dependent upon its ability to +ensure a continuing and timely flow of competitive products and technology to the marketplace. The Company continues to develop new products and technologies and to enhance existing products in the +areas of hardware and peripherals, system software, applications software, networking and communications software and solutions, and the Internet. The Company's research and development expenditures, +before any charges for purchased in-process research and development, totaled $471 million, $446 million, and $430 million in 2003, 2002, and 2001, respectively. 12 Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its computer systems, peripheral systems, and software. In addition, the Company has +registered, and/or has applied to register, trademarks and service marks in the United States and a number of foreign countries for "Apple," the Apple logo, "Macintosh," and numerous other trademarks +and service marks. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an important factor in its business and that its success does depend in part +on the ownership thereof, the Company relies primarily on the innovative skills, technical competence, and marketing abilities of its personnel. Many +of the Company's products are designed to include intellectual property obtained from third-parties. While it may be necessary in the future to seek or renew licenses relating to various aspects +of its products and business methods, the Company believes that based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms; however, +there is no guarantee that such licenses could be obtained at all. Because of technological changes in the computer industry, current extensive patent coverage, and the rapid rate of issuance of new +patents, it is possible certain components of the Company's products and business methods may unknowingly infringe existing patents of others. The Company has from time to time been notified that it +may be infringing certain patents or other intellectual property rights of others. Foreign and Domestic Operations and Geographic Data The United States represents the Company's largest geographic marketplace. Approximately 58% of the Company's net sales in fiscal 2003 came from sales to customers inside the +United States. Final assembly of products sold by the Company is conducted in the Company's manufacturing facilities in Sacramento, California, and Cork, Ireland, and by external vendors in Fremont, +California, Fullerton, California, Taiwan, Korea, the Netherlands, the People's Republic of China, and the Czech Republic. +Currently, manufacture of many of the components used in the Company's products and final assembly of substantially all of the Company's portable products including PowerBooks, iBooks, and the iPod +are performed by third-party vendors in Japan, Taiwan and China. Margins on sales of Apple products in foreign countries, and on sales of products that include components obtained from foreign +suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. Information +regarding financial data by geographic segment is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at +Note 11, "Segment Information and Geographic Data." Seasonal Business Although the Company does not consider its business to be highly seasonal, it has historically experienced increased net sales in its first and fourth fiscal quarters, compared +to other quarters in its fiscal year, due to seasonal demand related to the holiday season and the school year, respectively. Past performance should not be considered a reliable indicator of the +Company's future net sales or financial performance. Warranty The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of +purchase by the end-user. The Company also offers a 90-day basic warranty for Apple software and for Apple service parts used to repair Apple hardware products. In addition, +consumers may purchase extended service coverage on most Apple hardware products in all of the Company's major markets. Backlog In the Company's experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog +often increases in anticipation 13 of +or immediately following new product introductions because of over ordering by dealers anticipating shortages. Backlog often is reduced once dealers and customers believe they can obtain sufficient +supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company's ability to achieve any particular level of revenue or financial performance. Environmental Laws Compliance with federal, state, local, and foreign laws enacted for the protection of the environment has to date had no material effect upon the Company's capital +expenditures, earnings, or competitive position. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the subject of these +laws, there is no assurance that such existing laws or future laws will not have a material adverse affect on the Company. Production +and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement that the Company +provide consumers with the ability to return to the Company product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws +and regulations have recently been passed in several jurisdictions in which the Company operates, including various European Union member states, Japan and California. Although the Company does not +anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not have a +material adverse affect on the Company. Employees As of September 27, 2003, Apple and its subsidiaries worldwide had 10,912 employees and an additional 2,654 temporary employees and contractors. Available Information Beginning in fiscal 2003, the Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on +Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available on its website at +www.apple.com/investor when such reports are available on the Securities and Exchange Commission (SEC) website. The public may read and copy any materials filed by the Company with the SEC at the +SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at +1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file +electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing. Further, the Company's references to the URLs for these websites are intended +to be inactive textual references only. Item 2. Properties The +Company's headquarters are located in Cupertino, California. The Company has manufacturing facilities in Sacramento, California and Cork, Ireland. As of September 27, 2003, the Company +leased approximately 3.2 million square feet of space, primarily in the United States, and to a lesser extent, in Europe, Japan, and the Asia Pacific region. Leased space in the United States +includes 538,000 square feet of retail space. The major facility leases are for terms of 5 to 10 years and generally provide renewal options for terms of 3 to 5 additional years. Leases for +retail space are for terms of 5 to 15 years and often contain multi-year renewal options. The +Company owns its manufacturing facility in Cork, Ireland, which has approximately 352,000 square feet. The Company also owns a 752,000 square-foot facility in Sacramento, California, +which is used as a manufacturing, warehousing and distribution center. The Sacramento and Cork facilities also house 14 customer +support call centers. In addition, the Company owns 930,000 square feet of facilities located in Cupertino, California, used for research and development and corporate functions. Outside the +United States, the Company owns additional facilities totaling approximately 169,000 square feet. The +Company believes its existing facilities and equipment are well maintained and in good operating condition. The Company has invested in internal capacity and strategic relationships with outside +manufacturing vendors, and therefore believes it has adequate manufacturing capacity for the foreseeable future. The Company continues to make investments in capital equipment as needed to meet +anticipated demand for its products. Item 3. Legal Proceedings The +Company is subject to various legal proceedings and claims that are discussed below. The Company is also subject to certain other legal proceedings and claims that have arisen in the ordinary +course of business and which have not been fully adjudicated. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that +would individually or in the aggregate have a material adverse effect on its financial condition, liquidity or results of operations. However, the results of legal proceedings cannot be predicted with +certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results +of a particular reporting period could be materially adversely affected. The Company settled certain legal matters in 2003, which did not individually or in the aggregate have a material impact on the +Company's results of operations. Antor Media Corporation v. Apple Computer, Inc. et al. Plaintiff, Antor Media filed this action on September 5, 2003 in the United States District Court in the Eastern District of Texas alleging infringement by the Company +and other defendants of patent 5,754,961 relating to a "Method and Apparatus for Transmitting Information Recorded on Information Storage Means from a Central Server to Subscribers via a High Data +Rate Digital Telecommunications Network." Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting numerous affirmative +defenses. The Company also asserted counterclaims requesting declaratory judgment for non-infringement and invalidity. Apple Corps Ltd. v. Apple Computer, Inc.; Apple Computer, Inc. v. Apple Corps Ltd. Plaintiff, Apple Corps filed this action on July 4, 2003 in the High Court of Justice, Chancery Division, in London alleging that the Company has breached a 1991 +agreement which resolved earlier trademark litigation regarding use of the Apple marks. Plaintiff seeks unspecified damages and other relief. The Company filed a motion on October 13, 2003, +challenging jurisdiction in the U.K. On October 8, 2003, the Company filed a case in the United States District Court for the Northern District of California requesting a declaratory judgment +that the Company has not breached the 1991 agreement. Articulate Systems, Inc. v. Apple Computer, Inc. Plaintiff Articulate filed this action in March 1996 in the United States District Court in Massachusetts claiming patent infringement relating to voice recognition +technology. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting numerous affirmative defenses. The Company also asserted +counterclaims requesting declaratory judgment for non-infringement, unenforceability and invalidity. The case was stayed for several months pending resolution of four summary judgment +motions filed by the Company, all of which were denied by the Court. Through a series of corporate transactions the assets belonging to Plaintiff were acquired by a subsidiary, Lernout & +Hauspie Speech Products N.V. ("L&H"). L&H filed for bankruptcy in November 2000 and is being liquidated as part of the bankruptcy. The case has been inactive since approximately +May 2002, pending the resolution of the L&H bankruptcy and liquidation. 15 Bancroft v. Apple Computer, Inc. Plaintiff Bancroft filed this purported class action on January 30, 2002 in Los Angeles Superior Court on behalf of a potentially nationwide class of purchasers of +certain Power Macintosh G3 computers. Plaintiff alleged violation of the Consumer Legal Remedies Act ("CLRA") arising from allegedly poor performance while running the Company's Mac OS X operating +system, specifically relating to 2D hardware acceleration, QuickTime movie hardware acceleration, 3D graphics performance and DVD movie playback. The parties reached a settlement and the Court granted +preliminary approval on September 2, 2003. The final approval hearing is set for January 26, 2004. Settlement of the matter will not have a material effect on the Company's financial +position or results of operations. BIAX Corporation v. Apple Computer, Inc. Plaintiff BIAX filed this action on September 5, 2001 in the United States District Court in Delaware claiming patent infringement relating to dual processor technology. +IBM and Motorola were added as defendants in an amended complaint. Plaintiff sought unspecified damages and other relief. The Company answered the complaint, denied all allegations and asserted +numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment for non-infringement, unenforceability and invalidity. The parties settled this case in +August 2003 and the matter is concluded. Settlement of this matter did not have a material effect on the Company's financial position or results of operations. Dan, et al. v. Apple Computer, Inc. et al. Plaintiffs filed this purported class action on September 22, 2003 in Los Angeles Superior Court against the Company and other members of the industry on behalf of a +nationwide class of purchasers of certain computer hard drives. The case alleges violations of Civil Code Section 17200 ("Unfair Competition"), the Consumer Legal Remedies Act ("CLRA") and +false advertising related to the size +of the drives. Plaintiffs allege that calculation of hard drive size using the decimal method misrepresents the actual size of the drive. The complaint seeks unspecified damages and other relief. The +case is stayed pending resolution of whether the case will be considered "complex" and potentially a new judge assigned. The Company is beginning its investigation of these allegations. Digital Development Corporation v. Apple Computer, Inc. Plaintiff, Digital Development Corporation filed this action on April 25, 2003 in the United States District Court in New Jersey, claiming patent infringement of two +patents, 4,975,950 and 5,121,345, related to a "System and Method of Protecting Integrity of Computer Data and Software." Plaintiff requests unspecified damages and other relief. The complaint has not +yet been served on the Company. Dowhal v. Apple Computer, Inc. Plaintiff filed this representative action in San Francisco County Superior Court on February 4, 2003 alleging that the Company and numerous other defendants have +participated in false advertising and unfair business practices related to alleged misrepresentation of printer speed. Plaintiff asserts causes of action for violation of California Business and +Professions Code §17200 and §17500. Plaintiff requests an injunction, restitution and other unspecified damages and relief. The Company was served on February 10, 2003. +Apple filed a response on March 12, 2003. The parties are in discovery. Dynacore Holdings Corp. v. Apple Computer, Inc. Plaintiff Dynacore filed this action on June 6, 2001 in United States District Court for the Southern District of New York against the Company and thirteen other +defendants claiming patent infringement relating to IEEE 1394 technology, also known as FireWire. Plaintiff claims that any computer system or other electronic product that uses or complies with the +IEEE 1394 standard violates the patent. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting numerous affirmative +defenses. The Company also asserted counterclaims requesting declaratory judgment for non-infringement and invalidity. Defendants are seeking to amend the 16 pleading +to assert a counterclaim for inequitable conduct against Dynacore. The case was initially stayed pending the Federal Circuit's decision in Datapoint Corp. v. Standard Microsystems Corp., a +related case in which plaintiff claimed that its patent was infringed by products complying with the fast Ethernet standard. In February 2002, the Federal Circuit affirmed the judgment of +non-infringement in Datapoint, and the District Court lifted the stay in this action. The defendants in this action filed a joint motion for summary judgment based upon the decision in +Datapoint. The Court heard the motion on October 4, 2002 and granted summary judgment in favor of the defendants on February 11, 2003. Dynacore has appealed the ruling. The parties have +filed their respective briefs, and the case is scheduled for oral argument before the Federal Circuit Court on January 5, 2004. Hawaii Structural Iron Workers and Pension Trust Fund v. Apple Computer, Inc. and Steven P. Jobs; Young v. Apple Computer, Inc. et al; +Hsu v. Apple Computer Inc. et al Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against +the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company's publicly traded common stock between +July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company +believes these claims are without merit and intends to defend them vigorously. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. +On December 11, 2002, the Court granted the Company's motion to dismiss for failure to state a cause of action, with leave to Plaintiffs to amend their complaint within thirty days. Plaintiffs +filed their amended complaint on January 31, 2003, and on March 17, 2003, the Company filed a motion to dismiss the amended complaint. The Court heard the Company's motion on +July 11, 2003 and dismissed Plaintiff's claims with prejudice on August 12, 2003. Plaintiffs have appealed the ruling. John W. Davis v Apple Computer, Inc. Plaintiff filed this purported class action in San Francisco County Superior Court on December 5, 2002, alleging that the Company has engaged in unfair and deceptive +business practices relating to its AppleCare Extended Service and Warranty Plan. Plaintiff asserts causes of action for violation of the California Business and Professions Code §17200 and +§17500, breach of the Song-Beverly Warranty Act, intentional misrepresentation and concealment. The +Company was served on December 11, 2002 and is continuing its investigation of the allegations. Plaintiff requests unspecified damages and other relief. Apple filed a motion on +October 29, 2003 to disqualify Plaintiff's counsel, which the Court approved. The case is set for trial on February 23, 2004. MacTech v. Apple Computer, Inc.; Macadam v. Apple Computer, Inc.; Computer International, Inc. v. Apple Computer, Inc.; Elite Computers and +Software, Inc. v. Apple Computer, Inc.; The Neighborhood Computer Store v. Apple Computer, Inc. (All in Santa Clara County Superior Court). Five +resellers have filed similar lawsuits against the Company for various causes of action including breach of contract, fraud, negligent and intentional interference with economic relationship, +negligent misrepresentation, trade libel, unfair competition and false advertising. Plaintiffs request unspecified damages and other relief. The parties are in discovery. On October 1, 2003, +one of the resellers, Macadam was deauthorized as an Apple reseller. Macadam filed a motion for a temporary order to re-instate it as a reseller, which the Court denied. A hearing on its +motion for a preliminary injunction is scheduled for December 18, 2003. Palmieri v. Apple Computer, Inc. Plaintiff filed this purported class action on September 5, 2003 in Los Angeles Superior Court on behalf of a nationwide class of purchasers of certain PowerBooks. The +case alleges violations of Civil Code Section 17200 (Unfair Competition) and the Consumer Legal Remedies Act ("CLRA") arising from an alleged design defect in the PowerBooks which purportedly +causes marks and dead pixels in the LCD 17 screens. +Plaintiffs amended their complaint to allege an additional defect in the new 15" PowerBook, introduced in September, 2003, which purportedly causes "white spots" on the screen. The complaint +seeks unspecified damages and other relief. The Company's response is not yet due. The Company is beginning its investigation of these allegations. TIBCO Software, Inc. v. Apple Computer, Inc. Plaintiff filed this case on August 27, 2003 in United States District Court for the Northern District of California alleging trademark infringement by the Company for +using the mark "Rendezvous." Plaintiff's mark is "TIBCO Rendezvous." The complaint seeks unspecified damages and other relief. The Company answered the complaint denying all allegations and asserting +numerous affirmative defenses. The Company also asserted counterclaims requesting a declaratory judgment for non-infringement, invalidity and no dilution. UNOVA, Inc. v. Apple Computer, Inc., et al. Plaintiff UNOVA filed this patent infringement action against the Company and six other defendants on May 8, 2002 in the Central District of California for infringement +of eight UNOVA patents related to "Smart Battery Management." Plaintiff alleges that the Company's portable computers manufactured since 1996 infringe these eight patents. Plaintiff has filed similar +lawsuits against other companies in addition to the co-defendants in this case. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying all +allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims requesting a declaratory judgment for non-infringement, invalidity and unenforceability. +The case is in discovery and is set for trial on March 16, 2004. Item 4. Submission of Matters to a Vote of Security Holders No +matters were submitted to a vote of security holders during the fourth quarter of the Company's fiscal year ended September 27, 2003. 18 PART II Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters The +Company's common stock is traded on the over-the-counter market and is quoted on the Nasdaq National Market under the symbol AAPL, on the Tokyo Stock Exchange under the +symbol APPLE, and on the Frankfurt Stock Exchange under the symbol APCD. As of December 5, 2003, there were 29,015 shareholders of record. On +June 21, 2000, the Company effected a two-for-one stock split in the form of a Common Stock dividend to shareholders of record as of May 19, 2000. All share +price and per share data and numbers of common shares have been retroactively adjusted to reflect the stock split. The Company did not pay cash dividends in either fiscal 2003 or 2002. The Company +anticipates that, for the foreseeable future, it will retain any earnings for use in the operation of its business. The price range per share of common stock presented below represents the highest and +lowest closing prices for the Company's common stock on the Nasdaq National Market during each quarter. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2003 price range per common share $ 23.10-$19.06 $ 19.29-$13.12 $ 15.27-$13.80 $ 17.22-$13.59 Fiscal 2002 price range per common share $ 18.74-$13.99 $ 26.11-$16.55 $ 25.45-$20.78 $ 23.76-$14.98 Item 6. Selected Financial Data The +following selected financial information has been derived from the audited consolidated financial statements. The information set forth below is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related +notes thereto included in Item 8 of this Form 10-K in order to fully understand factors that may affect the comparability of the information presented below. Five fiscal years ended September 27, 2003 (In millions, except share and per share amounts) 2003 2002 2001 2000 1999 Net sales $ 6,207 $ 5,742 $ 5,363 $ 7,983 $ 6,134 Net income (loss) $ 69 $ 65 $ (25 ) $ 786 $ 601 Earnings (loss) per common share: Basic $ 0.19 $ 0.18 $ (0.07 ) $ 2.42 $ 2.10 Diluted $ 0.19 $ 0.18 $ (0.07 ) $ 2.18 $ 1.81 Cash dividends declared per common share $ — $ — $ — $ — $ — Shares used in computing earnings (loss) per share (in thousands): Basic 360,631 355,022 345,613 324,568 286,314 Diluted 363,466 361,785 345,613 360,324 348,328 Cash, cash equivalents, and short-term investments $ 4,566 $ 4,337 $ 4,336 $ 4,027 $ 3,226 Total assets $ 6,815 $ 6,298 $ 6,021 $ 6,803 $ 5,161 Long-term debt (including current maturities) $ 304 $ 316 $ 317 $ 300 $ 300 Total liabilities $ 2,592 $ 2,203 $ 2,101 $ 2,696 $ 2,057 Shareholders' equity $ 4,223 $ 4,095 $ 3,920 $ 4,107 $ 3,104 Net +gains before taxes related to the Company's non-current debt and equity investments of $10 million, $75 million, $367 million, and $230 million were +recognized in 2003, 2001, 2000, and 1999, respectively. A net loss before taxes related to the Company's non-current debt and equity investments of $42 million was 19 recognized +in 2002. In 2002, the Company acquired Emagic resulting in a charge of approximately $1 million for acquired in-process technologies with no alternative future use. The +Company recognized a similar charge of $11 million in 2001 related to its acquisition of PowerSchool. Net charges related to Company restructuring actions of $26 million, +$30 million, $8 million, and $27 million were recognized in 2003, 2002, 2000, and 1999, respectively. During 2000, the Company recognized the cost of a special executive bonus for +the Company's Chief Executive Officer for past services in the form of an aircraft with a total cost to the Company of approximately $90 million. In 2002, of the original $90 million +accrual, $2 million remained unspent and was reversed. In 2003, settlement of the Company's forward stock purchase agreement resulted in a gain of $6 million. Favorable cumulative-effect +type adjustments of $1 million and $12 million were recognized in 2003 and 2001, respectively. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can also +be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future performance and the Company's +actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the +subsection entitled "Factors That May Affect Future Results and Financial Condition" below. The following discussion should be read in conjunction with the consolidated financial statements and notes +thereto included in Item 8 of this Form 10-K. All information +presented herein is based on the Company's fiscal calendar. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by +law. Critical Accounting Policies The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company's discussion and analysis of +its financial condition and results of operations requires the Company's management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial +statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements in Item 8 of this Form 10-K describe the significant accounting policies and +methods used in the preparation of the Company's consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions that it believes to be +reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates. Management +believes the following to be critical accounting policies. That is, they are both important to the portrayal of the Company's financial condition and results, and they require management to +make judgments and estimates about matters that are inherently uncertain. Revenue Recognition Net sales consist primarily of revenue from the sale of products (i.e., hardware, software, and peripherals), and extended warranty and support contracts. The Company +recognizes revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software Revenue +Recognition , as amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial +Statements . The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped, and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is +shipped. For online sales to individuals, for some sales to education customers in the United States, and for certain other sales, the Company defers revenue until the customer receives the product +because the Company legally retains 20 a +portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed to not be, fixed and determinable, +revenue is deferred and subsequently recognized as amounts become due and payable. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other +sales programs and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The +Company also records reductions to revenue for expected future product returns based on the Company's historical experience. Future market conditions and product transitions may require the Company to +increase customer incentive programs and incur incremental price protection obligations that could result in additional reductions of revenue at the time such programs are offered. Additionally, +certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions +of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which could have +a material adverse impact on the Company's results of operations. Allowance for Doubtful Accounts The Company distributes its products through third-party resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require +collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe and Asia +and by arranging with third-party financing companies to provide flooring arrangements and other loan and lease programs to the Company's direct customers. These credit-financing arrangements are +directly between the third-party financing company and the end customer. As such, the Company does not assume any recourse or credit risk sharing related to any of these arrangements. However, +considerable trade receivables that are not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. The +allowance for doubtful accounts is based on management's assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition +of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible. The Company also records an allowance for +all other trade receivables based on multiple factors including historical experience with bad debts, the general economic environment, the financial condition of the Company's distribution channels, +and the aging of such receivables. If there is a deterioration of a major customer's financial condition, if the Company becomes aware of additional information related to the credit worthiness of a +major customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful accounts, which +would affect earnings in the period the adjustments are made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of +components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed +review of inventory each period that considers multiple factors including demand forecasts, product lifecycle status, product development plans, current sales levels, and component cost trends. The +personal computer industry is subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company's products are +less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the Company may be required 21 to +record additional write-downs which would negatively affect gross margins in the period when the write-downs are recorded. The +Company accrues necessary reserves for cancellation fees related to component orders that have been cancelled. Consistent with industry practice, the Company acquires components through a +combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company's requirements for periods ranging from +30 to 130 days. If there is an abrupt and substantial decline in demand for one or more of the Company's products or an unanticipated change in technological requirements for any of the +Company's products, the Company may be required to record additional reserves for cancellation fees that would negatively affect gross margins in the period when the cancellation fees are identified. Valuation of Long-Lived Assets Including Acquired Intangibles The Company reviews property, plant, and equipment and certain identifiable intangible assets for impairment whenever events or changes in circumstances indicate the carrying +amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate. +If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value. Although the +Company has recognized no material impairment adjustments related to its property, plant, and equipment or identifiable intangibles during the past three fiscal years, except those made in conjunction +with restructuring actions, deterioration in the Company's business in a geographic region or business segment in the future, including deterioration in the performance of individual retail stores, +could lead to such impairment adjustments in the future periods in which such business issues are identified. The +Company adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets , in the first quarter of +fiscal 2002. As a result, the Company no longer amortizes goodwill but instead performs a review of goodwill for impairment annually, or earlier if indicators of potential impairment exist. The review +of goodwill for potential impairment is highly subjective and requires that: (1) goodwill be allocated to various reporting units of the Company's business to which it relates; (2) the +Company estimate the fair value of those reporting units to which the goodwill relates; +and (3) the Company determine the book value of those reporting units. If the estimated fair value of reporting units with allocated goodwill is determined to be less than their book value, the +Company is required to estimate the fair value of all identifiable assets and liabilities of those reporting units in a manner similar to a purchase price allocation for an acquired business. This +requires independent valuation of certain internally developed and unrecognized assets including in-process research and development and developed technology. Once this process is +complete, the amount of goodwill impairment, if any, can be determined. Based +on the Company's estimates as of September 27, 2003, there was no impairment of goodwill. However, changes in various circumstances including changes in the Company's market +capitalization, changes in the Company's forecasts, and changes in the Company's internal business structure could cause one or more of the Company's reporting units to be valued differently thereby +causing an impairment of goodwill. Additionally, in response to changes in the personal computer industry and changes in global or regional economic conditions, the Company may strategically realign +its resources and consider restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of property, plant, and equipment, identifiable intangibles, or goodwill. Warranty Costs The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized based on historical experience of failure rates. Each +quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities and adjusts the amounts 22 as +necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company's results +of operations. Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, Accounting for Income Taxes , the +provision for income taxes is computed using the asset and liability method, under which deferred tax assets and +liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax +credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected +to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Management +believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the +deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the +future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if the Company subsequently realizes deferred tax assets that were +previously determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings in the period such determination is made. In addition, +the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner +inconsistent with management's expectations could have a material impact on the Company's results of operations and financial position. 23 Net Sales Net sales and Macintosh unit sales by operating segment and net sales and unit sales by product follow (net sales in millions and Macintosh unit sales in thousands): 2003 Change 2002 Change 2001 Net Sales by Operating Segment: Americas net sales (a) $ 3,181 2 % $ 3,131 3 % $ 3,037 Europe net sales 1,309 5 % 1,251 0 % 1,249 Japan net sales 698 (2 )% 710 0 % 713 Retail net sales 621 119 % 283 — 19 Other segments net sales (a) 398 8 % 367 6 % 345 Total net sales $ 6,207 8 % $ 5,742 7 % $ 5,363 Unit Sales by Operating Segment: Americas Macintosh unit sales 1,620 (6 )% 1,728 (2 )% 1,768 Europe Macintosh unit sales 684 (5 )% 722 (4 )% 754 Japan Macintosh unit sales 339 (12 )% 386 (2 )% 394 Retail Macintosh unit sales 187 103 % 92 — 7 Other segments Macintosh unit sales (a) 182 5 % 173 5 % 164 Total Macintosh unit sales 3,012 (3 )% 3,101 0 % 3,087 Net Sales by Product: Power Macintosh net sales (b) $ 1,237 (10 )% $ 1,380 (17 )% $ 1,664 PowerBook net sales 1,299 56 % 831 2 % 813 iMac net sales 1,238 (15 )% 1,448 30 % 1,117 iBook net sales 717 (18 )% 875 8 % 809 Total Macintosh net sales 4,491 (1 )% 4,534 3 % 4,403 Peripherals and other hardware (c) 1,058 57 % 674 74 % 387 Software (d) 362 18 % 307 33 % 230 Service and other sales 296 30 % 227 (34 )% 343 Total net sales $ 6,207 8 % $ 5,742 7 % $ 5,363 Unit Sales by Product: Power Macintosh unit sales (b) 667 (13 )% 766 (18 )% 937 PowerBook unit sales 604 69 % 357 3 % 346 iMac unit sales 1,094 (16 )% 1,301 8 % 1,208 iBook unit sales 647 (4 )% 677 14 % 596 Total Macintosh unit sales 3,012 (3 )% 3,101 0 % 3,087 Net sales per Macintosh unit sold (e) $ 1,491 2 % $ 1,462 3 % $ 1,426 iPod unit sales 939 146 % 381 — — iPod net sales $ 345 141 % $ 143 — — Notes: (a) Other +segments consists of Asia Pacific and FileMaker. Certain net sales in 2002 and 2001 related to recent acquisitions and Internet services have been reclassified from Other +segments net sales to Americas segment net sales to conform to the 2003 presentation. 24 (b) Power +Macintosh figures include server sales. (c) Net +sales of peripherals and other hardware include sales of iPod, Apple-branded and third-party displays, and other hardware accessories. (d) Net +sales of software include sales of Apple-branded operating system and application software and sales of third-party software. (e) Net +sales per Macintosh unit sold is derived by dividing total Macintosh net sales by total Macintosh unit sales. Fiscal Year 2003 versus 2002 Net sales increased $465 million or 8% during 2003 compared to 2002 while Macintosh unit sales declined 3% year-over-year to approximately +3 million units in 2003. Several factors have contributed favorably to net sales during 2003 including: • The +Retail segment's net sales grew to $621 million during 2003 from $283 million in 2002, an increase of 119%. While the Company's customers may elect to +purchase product from their local Apple Retail store rather than through other preexisting sales channels in the United States, the Company believes that a substantial portion of the Retail segment's +net sales is incremental to total net sales. See additional comments below related to the Retail segment under the heading "Segment Operating Performance." • Net +sales of peripherals and other hardware rose $384 million or 57% during 2003 compared 2002, which follows a $287 million or 74% increase in 2002 as +compared to 2001. The current year increase was primarily driven by the $202 million, or 141%, year-over-year increase in iPod net sales to $345 million. All of +the Company's operating segments experienced substantial increases in iPod net sales and unit sales during 2003. iPod sales during 2003 were favorably affected by the introduction of substantially +redesigned new models, which are compatible with both Macintosh and Windows operating systems and by the Company's introduction of its iTunes Music Store for the Macintosh operating system in +April 2003. The Company's iPod digital music player is sold by a variety of resellers, many of which do not currently market the Company's Macintosh systems. The Company has expanded this +distribution network during 2003, which has contributed to the current year increase in iPod unit sales of 146%. In +addition to the iPod, the increase in net sales of peripherals and other hardware during 2003 also reflects an overall increase in net sales of other computer accessories including AirPort cards +and base stations, which facilitate wireless connectivity; third party digital cameras and printers; and a number of portable computer related accessories. • Although +total Macintosh unit sales were down 3% in 2003, unit sales of the Company's portable systems were relatively strong primarily due to the 69% or 247,000 unit +increase in PowerBook unit sales, slightly offset by a 4% or 30,000 unit decrease in iBook unit sales. The increase in PowerBook net sales of $468 million or 56% is due primarily to the success +of the Company's new 12-inch, 15-inch and 17-inch models that were introduced during 2003. The decline in iBook consumer portable sales during 2003 is primarily due +to a lower average price per unit. Portable systems represented 42% of all Macintosh systems sold in 2003 versus 33% in 2002 and 31% in 2001, which reflects an overall industry trend towards portable +systems. • The +Company's average net sales per Macintosh unit sold increased 2% to $1,491 in 2003 as a result of various changes in overall unit mix towards relatively higher-priced +PowerBook systems and an increase in direct sales primarily from the Company's retail and online stores, offset by somewhat lower year-over-year pricing on comparable Macintosh +systems for most of the Company's Macintosh product lines in response to industry pricing pressure, particularly with the Company's 25 iBook +consumer portable systems. PowerBook and Power Macintosh systems accounted for 42% of total unit sales in 2003 versus 36% in 2002. • Net +sales of software increased $55 million or 18% during 2003 compared to the prior year and reflects higher net sales of Apple-branded application and server +software and third-party +software. Net sales of Apple-branded application and server software increased due to the introduction of several new software titles during the year including Final Cut Express, iLife, and Keynote, +as well as from higher sales of software related to recent acquisitions including PowerSchool and Emagic. Growth in net sales of third-party software during 2003 was particularly strong in the +Americas Segment due to strong sales of software by the Company's online store and its Retail segment. • Service +and other sales rose $69 million or 30% during 2003 and results from significant year-over-year increases in net sales associated with +AppleCare Protection Plan (APP) extended maintenance and support services, as well as the Company's Internet related services. Increased net sales associated with APP are primarily the result of +increasing attach rates over the last several years. Increased net sales associated with Internet services are due to net sales from the iTunes Music Store introduced in April 2003 and +increased net sales of the Company's .Mac Internet service. Offsetting +the favorable factors discussed above, the Company's net sales during 2003 were negatively impacted by the following factors: • Total +unit sales of desktop systems fell 15% during 2003 compared to 2002. iMac systems unit sales declined 16% from 2003 to 2002 resulting from a shift in sales away from +desktop systems in favor of portables. Also, the current flat panel iMac form factor was in the eighth quarter of its life cycle by the end of 2003 and did not experience significant enhancements +until the release of the 20-inch flat-panel iMac in November 2003. • Unit +sales of Power Macintosh systems fell 13% during 2003 compared to 2002. For the first nine months of 2003 compared to the same period in 2002, unit sales of Power +Macintosh systems decreased 24%, which is representative of the decline of Power Macintosh systems sales experienced by the Company during recent years and is also believed to be attributable to +delays in purchasing pending the release of the Power Mac G5. As expected, this trend reversed in the fourth quarter of 2003 with unit sales increasing 26% during the quarter as compared to the same +period in the prior year due largely to the new Power Mac G5, which the Company introduced in June 2003 and began shipping at the end of fiscal 2003. The decline in Power Macintosh sales over +the last several years also reflects the shift in sales to portable systems, particularly PowerBooks. In addition, the Company continues to believe that weak economic conditions over the past several +years are having a pronounced negative impact on its professional and creative customers. Additionally, some of the Company's professional and creative customers may have delayed upgrades of their +systems in anticipation of certain software vendors transitioning their professionally oriented Macintosh software applications to run natively on Mac OS X. Currently there are many applications that +run natively on Mac OS X, including Adobe's PhotoShop 7 and QuarkXPress 6; however, there is no assurance that this will result in additional sales of Macintosh systems, particularly Power Macintosh +units. • The +Company has continued to experience ongoing weakness in its U.S. education channel during 2003. Net sales and unit sales in U.S. education during 2003 were down 4% and +6%, respectively, as compared to 2002. This decline was due to a decrease in K-12 sales, partially offset by an increase in higher education sales. Net sales declined primarily as a result +of a continued shift in mix away from higher priced Power Macintosh and iMac systems towards lower priced eMac and iBook systems, although the Company did experience a significant increase in sales of +its PowerBook systems primarily to higher education customers. Portable systems accounted for approximately 43% of total unit sales in the education channel during 2003, as compared to approximately +34% in 2002. 26 The +Company's one-to-one (1:1) learning solutions are a complete solution consisting of an iBook portable system for every student and teacher along with a wireless network +connected to a central server. The Company has experienced significant competition in 1:1 learning solutions and, accordingly, has experienced a lower sales price per unit, on average, in these +transactions. The +Company believes weakness in its U.S. education channel, particularly K-12, has been caused by multiple factors including funding pressures due to weak economic conditions, large +budget deficits in many states, and increased competition particularly for desktop computers. Although the Company has taken steps, and will continue to take steps, to address weakness in the U.S. +education channel, it remains difficult to anticipate when and if this negative trend will reverse. • The +personal computer industry in general, and the Company specifically, continue to see relatively soft demand for their products. Sales of professional and consumer +oriented Macintosh systems remain far below levels experienced in fiscal 2000 and earlier. Difficult global economic conditions during the past several years exacerbated by the economic and political +uncertainties caused by terrorist activities and the associated international responses have clearly had a pronounced negative effect on the overall demand for the Company's products in virtually all +of its markets. Further, growth in the overall personal computer industry has slowed due to the high market penetration of personal computers and a lengthening of consumer, creative, and business +personal computer upgrade cycles. Fiscal Year 2002 versus 2001 Net sales increased $379 million or 7% during 2002 compared to 2001, while Macintosh unit sales were relatively flat year-over-year at +approximately 3.1 million units. On a geographic basis, performance in the domestic market was relatively strong, especially when considering the performance of the Company's Retail segment, +which operated during 2002 exclusively in the United States. However, the European and Japanese markets remained sluggish throughout 2002. The Company's net sales in 2002 were positively influenced by +a number of factors. • First, +net sales from software, service, peripherals, and other sources rose $248 million or 26% in 2002 versus 2001. This increase was driven by several factors +including a 28% increase in combined third-party and Apple-branded software sales; $143 million in net sales of iPod, the Company's portable digital music player that was introduced in the +first half of 2002; a 9% increase in the sale of computer accessories; and a 14% increase in service revenue caused primarily by increased revenue associated with extended maintenance and support +contracts. The growth in software revenue was primarily the result of increased sales of third-party software in the Company's retail and online stores and expansion in recent years in the number of +Apple-branded software titles. • Second, +overall unit sales of Macintosh portable systems grew by 92,000 units or 10% in 2002 reflecting a general trend in the personal computer market away from desktop +systems towards portable systems. During 2002, portable Macintosh systems represented 33% of total systems sales versus 31% in 2001 and 20% in 2000. Growth in this area has been most pronounced for +iBook, the Company's education and consumer oriented portable Macintosh system. iBook unit sales increased 14% in 2002 and 9% in 2001. • Third, +the Company's Retail segment grew from 8 stores at the end of 2001 to 40 stores at the end of 2002. The Retail segment's net sales grew from $19 million in +2001 to $283 million in 2002. While the Retail segment may have cannibalized some net sales from the Company's preexisting sales channels in the U.S., the Company believed that a substantial +portion of the Retail segment's net sales was incremental to the Company's total net sales. See additional comments below related to the Retail segment under the heading "Segment Operating +Performance." 27 • Fourth, +the Company's average unit pricing increased 3% during 2002 as a result of various changes in overall unit mix offset by somewhat lower pricing +year-over-year on comparative Macintosh systems. Net sales per Macintosh unit sold during 2002 of $1,462 per unit reflected the shift in mix towards relatively higher-priced +portable Macintosh systems and reflected the impact on net sales of the relatively higher-priced new iMac design introduced during 2002. The impact of these changes in mix were offset by the decline +in unit sales of relatively higher-priced Power Macintosh systems and by lower pricing on comparative Macintosh systems during 2002 for most of the Company's Macintosh product lines in response to +industry pricing pressure. • Fifth, +any comparison of net sales in 2002 versus 2001 must consider the effect of unusually low net sales during the first quarter of 2001. This was attributable to several +factors at the beginning of 2001, including continued deterioration in worldwide demand for personal computers, rebate programs and price cuts instituted by the Company during that quarter that cost +the Company approximately $138 million, and a plan implemented by the Company during the first quarter of 2001 that reduced substantially the level of inventory in its distribution channels +that resulted in a decline in channel inventory of approximately 300,000 units during that quarter. Offsetting +the favorable factors discussed above, the Company's net sales in 2002 were negatively impacted by several notable factors. • First, +unit sales of Power Macintosh systems fell 18% during 2002 as compared to 2001. This followed a 35% decline in Power Macintosh unit sales in 2001 from 2000. The +Company believed that weak economic conditions over the past several years had a pronounced negative impact on its professional and creative customers and that many of these customers continued to +delay upgrades of their Power Macintosh systems due to the Company's ongoing transition to Mac OS X, its new operating system, and in anticipation of certain software vendors transitioning their +Macintosh applications to run natively in Mac OS X. Further, the Company did not experience the anticipated increase in Power Macintosh sales that it expected following the introduction +of Adobe's PhotoShop 7 during 2002. Additionally, many professional users may have postponed upgrading their systems until after the introduction of Mac OS X Jaguar released in +the fourth quarter of 2002. Others may have delayed upgrading until after the availability of other professionally oriented software applications for Mac OS X such as QuarkXPress. • Second, +despite the overall increase in net sales during 2002 in the Americas, the Company continued to see weakness in its U.S. education channel. Total net sales in this +channel fell 15% in 2002 and 4% in 2001. These declines were consistent with industry data that showed the Company losing market share in the U.S. education market in each of the last two fiscal +years. The Company believed this weakness was caused by multiple factors, including increased price competition in this price sensitive market from the Company's competitors who sell Windows-based +personal computers. Additionally, some of the Company's education customers appeared to be delaying technology purchases due to concerns about the overall impact of the weaker economy on their +available funding. • Third, +the personal computer industry in general and the Company specifically experienced soft demand for its products due to adverse global economic conditions, political +uncertainties, and a lengthening of consumer, creative, and business personal computer upgrade cycles. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company's reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas segment includes both North and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. +The Japan segment includes only Japan, except for the activities of the Company's Retail segment. The Retail segment currently operates 28 Apple-owned +retail stores in the United States and opened its first international store in Tokyo, Japan in the first quarter of 2004. Each reportable operating segment provides similar hardware and +software products and similar services. Further information regarding the Company's operating segments may be found in Item 8 of this Form 10-K in the Notes to Consolidated +Financial Statements at Note 11, "Segment Information and Geographic Data." Americas Net sales in the Americas segment during 2003 increased $50 million or 2% compared to 2002. During 2003 and 2002, the Americas segment represented approximately 51% and +55%, respectively, of the Company's total net sales and represented approximately 54% and 56%, respectively, of total Macintosh unit sales. The results of the Americas segment are similar to the +overall results of the Company as they reflect substantially lower unit sales and net sales of Power Macintosh systems and iMac systems, partially offset by increases in unit sales and net sales of +PowerBooks. The net sales of the Americas segment, and the Company in total, also reflect substantially higher sales of peripherals, software, and services during 2003 compared to 2002 due primarily +to higher sales of iPods and +Internet services. The Americas segment has been negatively affected by weakness in its U.S. education channel. As noted above, total net sales and unit sales in the U.S. education channel during 2003 +were down 4% and 6%, respectively, compared to the same period in 2002. The Company believes this decline is caused by increased competition in the education market and by a reduction in spending by +U.S. educational institutions due to federal and state funding concerns and tax revenue shortfalls resulting from the weak economy. Additionally, some of the decline during 2003 in net sales and unit +sales of Macintosh systems in the Americas segment may be the result of the operation of the Company's Retail segment whose net sales, all of which occurred within the U.S., increased significantly +during 2003. Net +sales for the Americas segment increased 3% or $94 million in 2002 compared to 2001. The Americas segment was negatively affected by a decline in U.S. education sales in 2002 of +$215 million. The Americas segment also experienced a 17% decline in Power Macintosh unit sales. However, outside of the U.S. education channel, unit sales of consumer desktop and portable +systems rebounded from the substantial declines experienced in 2001, rising a combined 31% in 2002. Sales of software, peripherals, and accessories were also up in the Americas during 2002. Growth in +unit sales of consumer oriented systems during 2002 in the Americas is somewhat attributable to the significantly depressed level of net sales experienced in the first quarter of 2001 as discussed +above. However, growth in the Americas was somewhat negatively affected, particularly with respect to consumer-oriented systems, by the significant growth of the Company's Retail segment in the U.S. +More than 70% of the Retail segment's Macintosh unit sales during 2002 were for iMacs and iBooks. Europe Net sales in Europe increased $58 million or 5% during 2003 as compared to 2002 while Macintosh unit sales declined by 5% during the same period. Europe's operating +results were consistent with the trend experienced in the Americas and by the Company as a whole. Europe experienced weakened demand for Power Macintosh, iMac and iBook systems in 2003, partially +offset by strong demand for PowerBooks whose net sales increased by 48% or $100 million from 2002. Europe also realized increased sales of peripherals, software, and service, primarily +attributable to higher sales of iPods, accessories and APP. Economic +conditions in Europe remained weak throughout 2002, and the overall demand for the Company's products in that region remained flat during 2002 versus 2001. Unit sales in Europe for 2002 +reflect relatively stronger demand for consumer-oriented products, particularly iBook whose unit sales increased 27% in 2002, offset by declines in Power Macintosh unit sales. Japan Net sales in Japan decreased $12 million or 2% during 2003 as compared to the same period in 2002, the weakest year-to-date performance of any of +the Company's operating segments. Japan's Macintosh unit 29 sales +were particularly weak in 2003, declining 12%, and were primarily attributable to lower sales of iMac and iBook systems, partially offset by an increase in PowerBook sales as well as higher +sales of peripherals and other hardware. Japan's Macintosh unit sales remain significantly below the segment's historic levels due to current economic conditions that remain particularly negative in +Japan. Net +sales in Japan remained flat during 2002 versus 2001, with a slight decline in unit sales of 2%. Consistent with the Company's other geographic operating segments, during 2002 Japan showed growth +in unit sales of consumer systems and a decline in unit sales of Power Macintosh systems. Japan's iMac unit sales increased 85% in 2002. However, in the case of Japan the increase in iMac unit +shipments in 2002 versus 2001 was primarily the result of the unusually depressed level of net sales experienced by the Company in the first quarter of 2001 as discussed above. Additionally, net sales +in Japan on a sequential and year-over-year comparative basis generally worsened as 2002 progressed reflecting particularly poor economic conditions in Japan. Retail The Company opened 25 new retail stores during 2003, bringing the total number of open stores to 65 as of September 27, 2003, which compares to 40 open stores as of +September 28, 2002 and 8 open stores as of September 29, 2001. During the first quarter of fiscal 2004, the Company opened 9 additional stores including its first international store in +the Ginza in Tokyo, Japan. The Retail segment's net sales grew to $621 million during 2003 from $283 million in 2002 and from $19 million in 2001. The $338 million or 119% +increase in net sales during 2003 reflects the impact from opening 25 new stores in 2003, the full year impact of 2002 store openings, as well as an increase in average revenue per store. Total +Macintosh sales increased by approximately $170 million of which $108 million related to year-over-year increases in PowerBook sales. The Retail segment has also +contributed strongly to the increases in net sales of peripherals, software and services experienced by the Company during 2003. During 2003, approximately 45% of the Retail segment's net sales came +from the sale of Apple-branded and third-party peripherals, software and services as compared to 28% for the Company as a whole. With an average of 54 stores open during 2003, the Retail segment +achieved annualized revenue per store of approximately $11.5 million, as compared to approximately $10.2 million based on an average of 28 stores open in 2002. As +measured by the Company's operating segment reporting, the Retail segment improved from a loss of $22 million during 2002 to a loss of $5 million during 2003. This improvement is +primarily attributable to the segment's year-over-year increase in net sales, which resulted in higher leverage on occupancy, depreciation and other fixed costs. Expansion +of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease commitments, personnel, and other +operating expenses. Capital expenditures associated with the Retail segment since its inception totaled approximately $290 million through the end of fiscal 2003, $92 million of which +was incurred during 2003. As of September 27, 2003, the Retail segment had approximately 1,300 employees and had outstanding operating lease commitments associated with retail store space and +related facilities of $354 million. The Company would incur substantial costs should it choose to terminate its Retail segment or close individual stores. Such costs could adversely affect the +Company's results of operations and financial condition. Investment in a new business model such as the Retail segment is inherently risky, particularly in light of the significant investment +involved, the current economic climate, and the fixed nature of a substantial portion of the Retail segment's operating expenses. 30 Gross Margin Gross margin for the three fiscal years ended September 27, 2003 are as follows (in millions, except gross margin percentages): 2003 2002 2001 Net sales $ 6,207 $ 5,742 $ 5,363 Cost of sales 4,499 4,139 4,128 Gross margin $ 1,708 $ 1,603 $ 1,235 Gross margin percentage 27.5 % 27.9 % 23.0 % Gross +margin decreased to 27.5% of net sales in 2003 from 27.9% of net sales in 2002. This decline in gross margin reflects relatively aggressive pricing actions on several Macintosh models instituted +by the Company beginning in late fiscal 2002 as a result of continued pricing pressure throughout the personal computer industry, lower sales of relatively higher margin Power Macintosh systems during +the first three fiscal quarters of 2003, and increased air freight and manufacturing costs associated with the production ramp-up of the new Power Mac G5 and 15-inch +PowerBook, both of which began shipping in volume during September 2003. This decline is also attributable to a rise in certain component costs as the year progressed. The aforementioned +negative factors affecting gross margins during 2003 were partially offset by the increase in higher margin software and direct sales. The +Company anticipates that its gross margin and the gross margin of the overall personal computer industry will remain under pressure throughout fiscal 2004 in light of weak economic conditions, +price competition in the personal computer industry, and potential increases in component pricing. The Company also expects to continue to incur air freight charges on the Power Mac G5 and +other products during 2004. The +foregoing statements regarding the Company's expected gross margin during 2004, general demand for personal computers, anticipated industry component pricing, anticipated air freight charges, and +future economic conditions are forward-looking. There can be no assurance that current gross margins will be maintained, targeted gross margin levels will be achieved, or current margins on existing +individual products will be maintained. In general, gross margins and margins on individual products will remain under significant downward pressure due to a variety of factors, including continued +industry wide global pricing pressures, increased competition, compressed product life cycles, potential increases in the cost and availability of raw material and outside manufacturing services, and +potential changes to the Company's product mix, including higher unit sales of consumer products with lower average selling prices and lower gross margins. In response to these downward pressures, the +Company expects it will continue to take pricing actions with respect to its products. Gross margins could also be affected by the Company's ability to effectively manage product quality and warranty +costs and to stimulate demand for certain of its products. The Company's operating strategy and pricing take into account anticipated changes in foreign currency exchange rates over time; however, the +Company's results of operations can be significantly affected in the short-term by fluctuations in exchange rates. The +Company orders components for its products and builds inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, there +is a risk the Company will forecast incorrectly and produce or order from third-parties excess or insufficient inventories of particular products or components. The Company's operating results and +financial condition in the past have been and may in the future be materially adversely affected by the Company's ability to manage its inventory levels and outstanding purchase commitments and to +respond to short-term shifts in customer demand patterns. Gross +margin increased to 27.9% of net sales in 2002 from 23.0% in 2001. Gross margin in 2001 was unusually low resulting from negative gross margin of 2% experienced in the first quarter of 2001. As +a 31 percentage +of net sales, the Company's quarterly gross margins declined during fiscal 2002 from 31% in the first quarter down to 26% in the fourth quarter. This decline resulted from several factors +including a rise in component costs as the year progressed and aggressive pricing by the Company across its products lines instituted as a result of continued pricing pressures in the personal +computer industry. Operating Expenses Operating expenses for the three fiscal years ended September 27, 2003 are as follows (in millions, except for percentages): 2003 2002 2001 Research and development $ 471 $ 446 $ 430 Percentage of net sales 8 % 8 % 8 % Selling, general, and administrative expenses $ 1,212 $ 1,109 $ 1,138 Percentage of net sales 20 % 19 % 21 % Restructuring costs $ 26 $ 30 — Purchased in-process research and development — $ 1 $ 11 Research and Development (R&D) The Company recognizes that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely +development of new and enhanced products that are central to the Company's core business strategy. The Company has historically relied upon innovation to remain competitive. R&D expense amounted to +approximately 8% of total net sales during 2003, 2002 and 2001, up substantially from approximately 5% of total net sales in fiscal year 2000 and recent earlier periods. The Company's management +believes that maintaining or increasing the pace of innovation and product development is the best way to respond to current economic and market conditions and will continue to position the Company +for future growth as conditions improve. R&D expense increased 6% or $25 million to $471 million in 2003 as compared to 2002, which follows a $16 million increase in 2002 as +compared to 2001. The overall increase in R&D expense relates primarily to increased headcount and support for new product development activities. R&D spending also included capitalized software +development costs of approximately $14.7 million related to the development of Mac OS X Panther in 2003; approximately $13.3 million associated with the development of +Mac OS X Jaguar and approximately $6 million associated with the PowerSchool enterprise student information system in 2002; and approximately $5.4 million associated with +the development of the original version of Mac OS X in 2001. Further information related to the Company's capitalization of software development costs may be found in Part II, +Item 8 of this Form 10-K at Note 1 of Notes to Consolidated Financial Statements. Selling, General, and Administrative Expense (SG&A) SG&A increased $103 million or 9% during 2003 as compared to 2002 due primarily to the Company's continued expansion of the Retail segment and increases in headcount. +The overall increase was partially offset by a decrease in current year discretionary spending on marketing and advertising and by savings resulting from the 2003 and 2002 restructuring activities +described below. SG&A +decreased $29 million or 3% during 2002 as compared to 2001. The decrease in SG&A in 2002 was primarily the result of lower discretionary spending on marketing and advertising expenses, +decreased spending related to information systems, and benefits directly related to the Company's restructuring actions in 2002 and 2001. The decreases were partially offset by higher sales expense in +2002 resulting from increased operating expenses associated with expansion of the Company's Retail segment. 32 Restructuring Actions During the second quarter of 2003, the Company's management approved and initiated restructuring actions that resulted in recognition of a total restructuring charge of +$2.8 million. The primary focus of actions taken in the second quarter were for the most part supplemental to actions initiated in the prior two quarters and focused on further headcount +reductions in various sales and marketing functions in the Company's Americas and Europe operating segments and further reductions associated with PowerSchool related activities in the Americas +operating segment. The second quarter actions resulted in recognition of severance costs of $2.4 million for termination of 93 employees, 92 of whom were terminated prior to the end of 2003 at +a cost of $2.2 million. During the second quarter of 2003, an additional $400,000 was accrued for asset write-offs and lease payments on an abandoned facility in the Americas +operating segment. The Company estimates these restructuring actions will reduce quarterly operating expenses by $1.5 million. During +the first quarter of 2003, the Company's management approved and initiated restructuring actions with a total cost of $24 million that resulted in the termination of manufacturing +operations at the Company-owned facility in Singapore, further reductions in headcount resulting from the shift in PowerSchool product strategy that took place at the end of fiscal 2002, and +termination of various sales and marketing activities in the United States and Europe. These restructuring actions will ultimately result in the elimination of 260 positions worldwide, all but one was +eliminated by the end of 2003. The Company estimates these restructuring actions will reduce quarterly operating expenses by $6 million. During +fiscal 2002, the Company recorded total restructuring charges of $30 million related to actions intended to eliminate certain activities and better align the Company's operating expenses +with existing general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company's Retail operating segment. The Company +estimates these restructuring actions will result in reduced quarterly operating expenses of approximately $10 million. Of +the $30 million restructuring charge for fiscal 2002, $6 million was incurred in the fourth quarter of 2002 related to actions designed to reduce headcount costs in corporate +operations and sales and to adjust its PowerSchool product strategy. Headcount actions, primarily in corporate operations, sales, and PowerSchool related research and development, resulted in the +elimination of approximately 180 positions worldwide at a cost of $1.8 million. The shift in product strategy at PowerSchool included discontinuing development and marketing of a PowerSchool +product that resulted in the impairment of previously capitalized development costs associated with the product in the amount of $4.5 million. The remaining charge in 2002 of $24 million +was incurred in the first quarter of 2002 and resulted in the elimination of approximately 425 positions worldwide, at a cost of $8 million. Positions were eliminated primarily in the Company's +operations, information systems, and administrative functions. In addition, these restructuring actions also included significant changes in the Company's information systems strategy resulting in +termination of equipment leases and cancellation of existing projects and activities. Related lease and contract cancellation charges totaled $12 million, and charges for asset impairments +totaled $4 million. During the first quarter of 2003, the Company reversed the remaining unused accrual of $600,000. Purchased In-Process Research and Development (IPR&D) During the fourth quarter of 2002, the Company acquired Emagic GmbH, a provider of professional software solutions for computer based music production, for approximately +$30 million in cash; $551,000 of which was allocated to IPR&D. The amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of +products under development had not been established and no alternative future uses existed. The IPR&D relates primarily to Emagic's Logic series technology and extensions. At the date of the +acquisition, the products under development were between 43%-83% complete, and it was expected that the remaining work would be completed during the Company's fiscal 2003 at a cost of +approximately $415,000. The remaining efforts, which were completed in 2003, included finalizing user interface design and development, and testing. The fair value of the IPR&D was determined 33 using +the income approach, which reflects the projected free cash flows that will be generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected +net cash flows back to their present value using a discount rate of 25%. In +May 2001, the Company acquired PowerSchool, Inc., a provider of web-based student information systems for K-12 schools and districts that enables schools to +record, access, report, and manage their student data and performance in real-time, and gives parents real-time web access to track their children's progress. Of total purchase +consideration of $66.1 million, $10.8 million was allocated to IPR&D and was expensed upon acquisition because the technological feasibility of products under development had not been +established and no alternative future uses existed. The IPR&D relates to technologies representing processes and expertise employed to design, develop, and deploy a functioning, scalable +web-based student information system for use by K-12 schools. At the date of the acquisition, the PowerSchool product under development was approximately 50% complete, and it +was expected that the remaining 50% would be completed during the Company's fiscal 2002 at a cost of approximately $9.25 million. The remaining efforts, which were completed during 2002, +included completion of coding, finalizing user interface design and development, and testing. The fair value of the IPR&D was determined using the income approach, which reflects the projected free +cash flows that will be generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount +rate of 25%. Other Income and Expense Other income and expense for the three fiscal years ended September 27, 2003 are as follows (in millions): 2003 2002 2001 Gains (losses) on non-current investments, net $ 10 $ (42 ) $ 88 Unrealized loss on convertible securities $ — $ — $ (13 ) Interest income $ 69 $ 118 $ 218 Interest expense (8 ) (11 ) (16 ) Gains on sales of short term investments, net 21 7 — Other income (expense), net (5 ) (2 ) 15 Gain on forward purchase agreement 6 — — Interest and other income, net $ 83 $ 112 $ 217 Total other income and expense $ 93 $ 70 $ 292 Gains and Losses on Non-current Investments The Company has held investments in EarthLink Inc. (EarthLink), Akamai Technologies, Inc. (Akamai), ARM Holdings plc (ARM) and certain investments in private +companies. These investments have been reflected in the consolidated balance sheets as long term assets within other assets and have been categorized as available-for-sale +requiring that they be carried at fair value with unrealized gains and losses, net of taxes, reported in equity as a component of accumulated other comprehensive income. The Company recognizes an +impairment charge to earnings in the event a decline in fair value below the cost basis of one of these investments is determined to be other-than-temporary. The Company +includes recognized gains and losses resulting from the sale or from other-than-temporary declines in fair value associated with these investments in other income and expense. +Further information related to the Company's non-current debt and equity investments may be found in Part II, Item 8 of this Form 10-K at Note 2 of +Notes to Consolidated Financial Statements. During +2003, the Company sold 1,875,000 shares of Akamai stock for net proceeds of approximately $9 million, and a gain before taxes of approximately $8 million. Additionally, the +Company sold its remaining investment in ARM stock, 278,000 shares, for net proceeds of approximately $295,000, and a 34 gain +before taxes of $270,000, and sold its remaining investment in EarthLink stock, 6,540,000 shares, for net proceeds of approximately $37 million, and a gain before taxes of +$2 million. The fair value of the Company's remaining investment in Akamai as of September 27, 2003, was approximately $5 million. During +2002, the Company determined that declines in the fair value of certain of these investments were other-than-temporary. As a result, the Company recognized a +$44 million charge to earnings to writedown the basis of its investment in EarthLink, a $6 million charge to earnings to writedown the basis of its investment in Akamai, and a +$15 million charge to earnings to writedown the basis of its investment in a private company investment. These losses in 2002 were partially offset by the sale of 117,000 shares of EarthLink +stock for net proceeds of $2 million and a gain before taxes of $223,000, the sale of 250,000 shares of Akamai stock for net proceeds of $2 million and a gain before taxes of $710,000, +and the sale of approximately 4.7 million shares of ARM stock for both net proceeds and a gain before taxes of $21 million. During +2001, the Company sold a total of approximately 1 million shares of Akamai stock for net proceeds of $39 million and recorded a gain before taxes of $36 million, and sold a +total of approximately 29.8 million shares of ARM stock for net proceeds of $176 million and recorded a gain before taxes of $174 million. These gains during 2001 were partially +offset by a $114 million charge to earnings that reflected an other-than-temporary decline in the fair value of the Company's investment in EarthLink and an +$8 million charge that reflected an other-than-temporary decline in the fair value of certain private company investments. Unrealized Loss on Convertible Securities On October 1, 2000, the Company adopted Statement of Financial Accounting Standard (SFAS) No. 133, Accounting for Derivative Instruments +and Hedging Activities . SFAS No. 133 established accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS +No. 133 required the Company to adjust the carrying value of the derivative component of its investment in Samsung to earnings during the first quarter of 2001, the before tax effect of which +was an unrealized loss of approximately $13 million. Interest and Other Income, Net Net interest and other income decreased $29 million or 26% to $83 million during 2003. The decrease is primarily the result of declining investment yields on the +Company's cash and short-term investments resulting from substantially lower market interest rates. The weighted average interest rate earned by the Company on its cash, cash equivalents +and short-term investments fell to 1.89% in 2003 compared to 2.85% in 2002. The decrease is offset by the increase of $14 million from the gain on the sales of short term +investments from the Company's fixed income portfolio, and the increase of $6 million from the gain on the forward purchase agreement during the fourth quarter of 2003. Net +interest and other income was $112 million in fiscal 2002, compared to $217 million in fiscal 2001. This $105 million or 48% decrease was primarily the result of declining +investment yields on the Company's cash and short-term investments resulting from substantially lower market interest rates. The weighted average interest rate earned by the Company on its +cash, cash equivalents and short-term investments fell to 2.85% in 2002 compared to 5.38% in 2001. Provision for Income Taxes The Company's effective tax rate for 2003 was 26% compared to the higher statutory rate due primarily to research and development credits, a non-taxable gain on +stock repurchase and certain undistributed foreign earnings for which no U.S. taxes were provided. As of September 27, 2003, the Company had deferred tax assets arising from deductible +temporary differences, tax losses, and tax credits of $452 million before being offset against certain deferred tax liabilities and a valuation allowance for presentation on the Company's +consolidated balance sheet. As of September 27, 2003, a valuation allowance of $30 million was 35 recorded +against the deferred tax asset for the benefits of tax losses that may not be realized. The valuation allowance relates principally to the operating loss carryforwards acquired from NeXT and +other acquisitions, the utilization of which is subject to certain limitations imposed by the Internal Revenue Code. Management believes it is more likely than not that forecasted income, including +income that may be generated as a result of certain tax planning strategies, will be sufficient to fully recover the remaining net deferred tax assets. The Company will continue to evaluate the +realizability of the deferred tax assets quarterly by assessing the need for and amount of the valuation allowance. On +April 10, 2003, the Internal Revenue Service (IRS) proposed adjustments to the Company's federal income tax returns for the years 1998 through 2000, and the Company has made certain +prepayments thereon. Certain of these adjustments are being contested through the IRS Appeals Office. Substantially all IRS audit issues for years prior to 1998 have been resolved. Management believes +that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. Should any issues addressed in +the Company's tax audits be resolved in a manner not consistent with management's expectations, the Company could be required to adjust its provision for income tax in the period such resolution +occurs. Cumulative Effects of Accounting Changes Financial Instruments with Characteristics of Both Liabilities and Equity On May 15, 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 150, Accounting for Certain Financial Instruments with +Characteristics of Both Liabilities and Equity . SFAS No. 150 requires issuers to classify as liabilities certain freestanding financial instruments that embody +obligations for the issuer and have characteristics of both liabilities and equity. The Company adopted the provisions of SFAS No. 150 on June 29, 2003, which resulted in a favorable +cumulative effect type adjustment of approximately $3 million. This adjustment represented the mark-to-market adjustment to fair value for a forward purchase agreement +that allowed the Company to acquire 1.5 million shares of its common stock at a price of +$16.64 per share. The Company settled this forward purchase agreement in August 2003. The settlement resulted in an additional gain of approximately $6 million, which is included in +interest and other income, net. Accounting for Asset Retirement Obligations On September 29, 2002, the Company adopted SFAS No. 143, Accounting for Asset Retirement Obligations , which +addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Net of the related +income tax effect of approximately $1 million, adoption of SFAS No. 143 resulted in an unfavorable cumulative-effect type adjustment to net income during 2003 of approximately +$2 million. This adjustment represents cumulative depreciation and accretion that would have been recognized through the date of adoption of SFAS No. 143 had the statement been applied +to the Company's existing asset retirement obligations at the time they were initially incurred. Accounting for Derivatives The adoption of SFAS 133 during 2001 resulted in a favorable cumulative-effect type adjustment of approximately $12 million, net of a related income tax effect of +approximately $5 million. Further +information related to the adoption of SFAS Nos. 133, 143 and 150 and the resulting cumulative accounting effects may be found in Part II, Item 8 of this +Form 10-K at Note 1 of Notes to Consolidated Financial Statements. Accounting for Stock-Based Compensation The Company currently measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board +(APB) Opinion No. 25, 36 Accounting for Stock Issued to Employees and provides pro forma disclosures of the effect on net income and earnings per share as if the fair value-based method had been +applied in measuring compensation expense. The Company has elected to follow APB Opinion No. 25 because, as further discussed in Part II, Item 8 of this +Form 10-K at Note 1 of the Notes to Consolidated Financial Statements, the alternative fair value accounting provided for under SFAS No. 123, Accounting for Stock-Based Compensation , +requires use of option valuation models that were not developed for use in valuing employee stock options and +employee stock purchase plan shares. Under APB Opinion No. 25, when the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the +grant, no compensation expense is recognized. The +FASB decided on April 22, 2003 to require all companies to expense the value of employee stock options. Companies will be required to measure the cost of employee stock options according to +their fair value. The FASB has indicated that it plans to issue in the first quarter of calendar year 2004 an exposure draft of a new accounting standard addressing this matter. Prior to issuance of +this exposure draft, the FASB has indicated it will be addressing several significant technical issues. Among other things, the FASB must determine the extent to which the new accounting standard will +permit adjustments to recognized expense for actual option forfeitures and actual performance outcomes. This determination will affect the timing and amount of compensation expense recognized. Also, a +method to determine the fair value of employee stock options must be established. Current accounting standards require use of an option-pricing model, such as the Black-Scholes formula, to determine +fair value and provide guidance on adjusting some of the input factors used in the model. This valuation approach has received significant criticism and may be subject to changes that could have a +significant impact on the calculated fair value of employee stock options under the new standard. At +the Company's annual shareholder's meeting on April 24, 2003, shareholders approved a proposal requesting that the Company's Board of Directors (the Board) establish a policy of expensing +the value of all future employee stock options issued by the Company. The Board and management appreciate and take seriously the views expressed by the Company's shareholders. As discussed in the +Company's Form 10-Q for the period ended March 29, 2003, the Company had decided not to expense the value of employee stock options until the FASB finalizes its new +accounting standard on the matter. The Company based this decision on the FASB's announced intention to soon require all companies to expense the value of employee stock options and the FASB's +near-term review of technical issues that will play a significant role in determining the fair value of and accounting for employee stock options. The Company monitors progress at the FASB +and other developments with respect to the general issue of employee stock compensation. In the future, should the Company expense the value of employee stock options, either out of choice or due to +new requirements issued by the FASB, the Company may have to recognize substantially more compensation expense in future periods that could have a material adverse impact on the Company's future +results of operations. Recent Accounting Pronouncements In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest +Entities . FIN 46 clarifies the application of Accounting Research Bulletin No. 51 and applied immediately to any variable interest entities created after +January 31, 2003 and to variable interest entities in which an interest is obtained after that date. For variable interest entities created or acquired prior to February 1, 2003, the +provisions of FIN 46 must be applied for the first interim or annual period beginning after December 15, 2003. The adoption of the provision of FIN 46 related to variable +interests created after January 31, 2003 did not have a material impact on the Company's results of operations or financial position. The Company continues to evaluate the provisions of +FIN 46, and does not believe that the adoption of the remaining provisions will have a material impact on its results of operations or financial position. 37 In May 2003, the FASB's Emerging Issues Task Force (EITF) reached consensus on EITF Issue No. 00-21, Revenue Arrangements with Multiple +Deliverables . EITF Issue No. 00-21 provides guidance on how to account for certain arrangements that involve the delivery or performance of multiple +products, services, and/or rights to use assets. The provisions of EITF Issue No. 00-21 apply to revenue transactions entered into in fiscal periods beginning after June 15, +2003. Additionally, in August 2003, the EITF reached consensus on EITF Issue No. 03-5, Applicability of AICPA Statement of +Position 97-2, "Software Revenue Recognition," to Non-Software Deliverables in an Arrangement Containing More-than-Incidental +Software. EITF Issue No. 03-5 provides guidance on determining whether non-software deliverables are included within the scope of +SOP 97-2, and accordingly, whether multiple element arrangements are to be accounted for in accordance with EITF Issue No. 00-21 or SOP 97-2. +The Company currently applies the requirements of SOP No. 97-2 when accounting for all multiple element transactions. The Company does not anticipate the application of either EITF +Issue Nos. 00-21 or 03-5 will have a significant impact on its results of operations or financial position. Liquidity and Capital Resources The following table presents selected financial information and statistics for each of the last three fiscal years (dollars in millions): 2003 2002 2001 Cash, cash equivalents, and short-term investments $ 4,566 $ 4,337 $ 4,336 Accounts receivable, net $ 766 $ 565 $ 466 Inventory $ 56 $ 45 $ 11 Working capital $ 3,530 $ 3,730 $ 3,625 Days sales in accounts receivable (DSO) (a) 41 36 29 Days of supply in inventory (b) 4 4 1 Days payables outstanding (DPO) (c) 82 77 73 Annual operating cash flow $ 289 $ 89 $ 185 (a) DSO +is based on ending net trade receivables and most recent quarterly net sales for each period. (b) Days +supply of inventory is based on ending inventory and most recent quarterly cost of sales for each period. (c) DPO +is based on ending accounts payable and most recent quarterly cost of sales adjusted for the change in inventory. As +of September 27, 2003, the Company's cash, cash equivalents, and short-term investments portfolio totaled $4.566 billion, an increase of $229 million from the end +of fiscal 2002. The Company's short-term investment portfolio consists primarily of investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities. +Foreign securities consist primarily of foreign commercial paper, certificates of deposit and time deposits with foreign +institutions, most of which are denominated in U.S. dollars. The Company's investments are generally liquid and investment grade. As +a result of declining investment yields on the Company's cash equivalents and short-term investments resulting from substantially lower market interest rates during 2003, the Company +has elected to reduce the average maturity of its portfolio to maintain liquidity for future investment opportunities when market interest rates increase. Accordingly, during 2003 the Company +increased its holdings in short-term investment grade instruments, both in U.S. corporate and foreign securities, that are classified as cash equivalents and has reduced its holdings in +longer-term U.S. corporate securities classified as short-term investments. Although +the Company's cash, cash equivalents, and short-term investments increased in 2003, the Company's working capital at September 27, 2003 decreased by $200 million as +compared to the end of 38 fiscal +2002 due primarily to the current year reclassification of the Company's long-term debt as a current obligation resulting from its scheduled maturity in February 2004. The +primary sources of total cash and cash equivalents in fiscal 2003 were $289 million in cash generated by operating activities and $53 million in proceeds from the issuance of common +stock, partially offset by $164 million utilized for capital expenditures and $26 million for the repurchase of common stock. The +Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its working capital needs, capital expenditures, debt +obligations, stock repurchase activity, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. Debt The Company currently has debt outstanding in the form of $300 million of aggregate principal amount 6.5% unsecured notes that were originally issued in 1994. The notes, +which pay interest semiannually, were sold at 99.925% of par, for an effective yield to maturity of 6.51%. The notes, along with approximately $4 million of unamortized deferred gains on closed +interest rate swaps, are due in February 2004 and therefore have been classified as current debt as of September 27, 2003. The Company currently anticipates utilizing its existing cash +balances to settle these notes when due. Capital Expenditures The Company's total capital expenditures were $164 million during fiscal 2003, $92 million of which were for retail store facilities and equipment related to the +Company's Retail segment and $72 million of which were primarily for corporate infrastructure, including information systems enhancements and operating facilities enhancements and expansions. +The Company currently anticipates it will utilize approximately $160 million for capital expenditures during 2004, approximately $85 million of which is expected to be utilized for +further expansion of the Company's Retail segment and the remainder utilized to support normal replacement of existing capital assets and enhancements to general information technology infrastructure. Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During +the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per +share for a total cost of $25.5 million. In August 2003, the Company settled this agreement prior to its maturity, at which time the Company's common stock had a fair value of $22.81. +Other than this forward purchase transaction, the Company has not engaged in any transactions to repurchase its common stock since fiscal 2000. Since inception of the stock repurchase plan, the +Company had repurchased a total of 6.55 million shares at a cost of $217 million. The Company was still authorized to repurchase up to an additional $283 million of its common +stock as of September 27, 2003. Off-Balance Sheet Arrangements The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative +instruments or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity +that provides financing, liquidity, market risk or credit risk support to the Company. 39 Lease Commitments As of September 27, 2003, the Company had total outstanding commitments on noncancelable operating leases of approximately $600 million, $354 million of +which related to the lease of retail space and related facilities. Remaining terms on the Company's existing operating leases range from 1 to 12 years. Subsequent to September 27, 2003, +the Company entered into additional operating lease commitments for retail space with future lease commitments totaling $64 million for periods ranging from 10 to 12 years. Purchase Commitments with Contract Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Company's products and to perform final assembly and test of finished +products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 1 to 3 months. The +Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of +purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the Company's forecasted component and manufacturing requirements +for periods ranging from 30 to 130 days. As of September 27, 2003, the Company had outstanding third-party manufacturing commitments and component purchase commitments of approximately +$848 million. Indemnifications The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party +intellectual property rights. Other licensing agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in +the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement +claim asserted against itself or an indemnified third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims that would have a material +adverse effect on its financial condition, liquidity or results of operations. Factors That May Affect Future Results and Financial Condition Because of the following factors, as well as other factors affecting the Company's operating results and financial condition, past financial performance should not be +considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. General economic conditions and current economic and political uncertainty could adversely affect the demand for the Company's products and the financial health of its +suppliers, distributors, and resellers. The Company's operating performance depends significantly on general economic conditions. For much of the past several years, demand for the Company's products has been +negatively impacted by difficult global economic conditions. Additionally, some of the Company's education customers appear to be delaying technology purchases due to concerns about the overall impact +of the weaker economy on their available funding. Continued uncertainty about future economic conditions continues to make it difficult to forecast future operating results. Should global and regional +economic conditions fail to improve or continue to deteriorate, demand for the Company's products could continue to be adversely affected, as could the financial health of its suppliers, distributors, +and resellers. War, terrorism or public health issues could disrupt supply, delivery or demand of products which could negatively affect the Company's operations and performance. War, terrorism or public health issues, whether in the U.S. or abroad, have caused and could continue to cause damage or disruption to international commerce by creating +economic and political uncertainties 40 that +may have a strong negative impact on the global economy, the Company, and the Company's suppliers or customers. Although it is impossible to predict the occurrences or consequences of any such +events, such events could result in a decrease in demand for the Company's products, make it difficult or impossible to deliver products to its customers, or to receive components from its suppliers, +and could create delays and inefficiencies in the Company's supply chain. The Company's operating results and financial condition have been, and in the future may continue to be, adversely affected by +these events. The +Company and some of its manufacturing vendors and component suppliers have significant operations in various locations throughout Asia, including locations in mainland China, the Hong Kong Special +Administrative Region, and Singapore, all of which were subject to the World Health Organization and Centers for Disease Control and Prevention severe acute respiratory syndrome (SARS) travel +advisories at times during the second and third quarters of fiscal 2003. Similar travel advisories were issued for Taiwan, where a significant amount of the Company's portable Macintosh systems and +the iPod are assembled. Should the severity of the SARs threat increase or other public health issues arise, the Company could be negatively impacted by the need for more stringent employee travel +restrictions, additional limitations in the availability of freight services, governmental actions limiting the movement of products between various regions, delays in production ramps of new +products, and disruptions in the operations of the Company's manufacturing vendors and component suppliers. The market for personal computers and related peripherals and services is highly competitive. If the Company is unable to effectively compete in these markets, its results of +operations could be adversely affected. The personal computer industry is highly competitive and is characterized by aggressive pricing practices, downward pressure on gross margins, frequent introduction of new +products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by +competitors, price sensitivity on the part of consumers, and a large number of competitors. Over the past several years, price competition in the market for personal computers and related peripherals +has been particularly intense. The Company's competitors who sell Windows-based personal computers have aggressively cut prices and lowered their product margins in order to gain or maintain market +share in response to the weakness in demand that began in the second half of calendar 2000 for personal computing products. The Company's results of operations and financial condition have been, and +in the future may continue to be, adversely affected by these and other industry-wide pricing pressures and downward pressures on gross margins. The +personal computer industry has also been characterized by rapid technological advances in software functionality, hardware performance, and features based on existing or emerging industry +standards. Further, as the personal computer industry and its customers place more reliance on the Internet, an increasing number of Internet devices that are smaller and simpler than traditional +personal computers may compete for market share with the Company's existing products. Several competitors of the Company have either targeted or announced their intention to target certain of the +Company's key market segments, including consumer, education, professional and consumer digital video editing, and design and publishing. Several of the Company's competitors have introduced or +announced plans to introduce digital music products that mimic many of the unique design, technical features, and solutions of the Company's products. The Company has a significant number of +competitors, many of whom have greater financial, marketing, manufacturing, and technological resources, as well as broader product lines and larger installed customer bases than those of the Company. +Additionally, there has been a trend towards consolidation in the personal computer industry that has resulted in larger and potentially stronger competitors in the Company's markets. The +Company is currently the only maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer market, which is dominated by makers of computers utilizing +Microsoft's Windows operating systems. The Company's future operating results and financial condition 41 are +substantially dependent on its ability to continue to develop improvements to the Macintosh platform in order to maintain perceived design and functional advantages over competing platforms, +including Windows. The +Company is currently focused on market opportunities related to digital music distribution and related consumer electronic devices including iPods. The Company faces increasing competition from +other companies promoting their own digital music distribution services, free peer-to-peer music services, emerging companies, and larger companies that may have greater +resources, including technical and marketing resources, and supplier relationships. There can be no assurance that the Company will be able to provide products and services that effectively compete in +these markets. Failure to effectively compete could negatively affect the Company's operating results and financial position. The Company has higher research and development and selling, general and administrative costs, as a percentage of revenue, than many of its competitors. The Company's ability to compete successfully and maintain attractive gross margins is heavily dependent upon its ability to ensure a continuing and timely flow of innovative +and competitive products and technologies to the marketplace. As a result, the Company incurs higher research and development costs as a percentage of revenue than its competitors who sell personal +computers based on other operating systems. Many of these competitors seek to compete aggressively on price and maintain very low cost structures. Further, as a result of the expansion of the +Company's Retail segment and costs associated with marketing the Company's brand including its unique operating system, the Company incurs higher selling costs as a percentage of revenue than many of +its competitors. If the Company is unable to continue to develop and sell innovative new products with attractive gross margins, its results of operations may be materially adversely affected by its +operating cost structure. The Company must successfully manage frequent product introductions and transitions in order to remain competitive and effectively stimulate customer demand. Due to the highly volatile nature of the personal computer industry, which is characterized by dynamic customer demand patterns and rapid technological advances, the Company +must continually introduce new products and technologies, enhance existing products in order to remain competitive, and effectively stimulate customer demand for new products and upgraded versions of +the Company's existing products. The success of new product introductions is dependent on a number of factors, including market acceptance; the Company's ability to manage the risks associated with +product transitions, including production ramp issues; the availability of application software for new products; the effective management of inventory levels in line with anticipated product demand; +the availability of products in appropriate quantities to meet anticipated demand; and the risk that new products may have quality or other defects in the early stages of introduction. Accordingly, +the Company cannot determine in advance the ultimate effect that new products will have on its sales or results of operations. During +2001, the Company introduced a new client operating system, Mac OS X, and delivered its first major upgrade, Mac OS X version 10.1. Other major upgrades include Mac OS X Jaguar in 2002 and most +recently Mac OS X Panther in October 2003. Inability of the Company to provide additional improvements in the performance and functionality of Mac OS X, advance customer acceptance of the new +operating system and its upgrades, obtain the continued commitment of software developers to transition existing applications to run on Mac OS X, or create new applications to run on Mac OS X, may +have an adverse impact on the Company's operating results and financial condition. Because orders for components, and in some cases commitments to purchase components, must be placed in advance of customer orders, the Company faces substantial inventory risk. The Company records a write-down for inventories of components and products that have become obsolete or are in excess of anticipated demand or net realizable value +and accrues necessary reserves for cancellation fees of orders for inventories that have been cancelled. Although the Company believes its 42 inventory +and related provisions are adequate, given the rapid and unpredictable pace of product obsolescence in the computer industry, no assurance can be given that the Company will not incur +additional inventory and related charges. In addition, such charges have had, and may have, a material effect on the Company's financial position and results of operations. The +Company must order components for its products and build inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, +there is a risk the Company will forecast incorrectly and produce or order from third parties excess or insufficient inventories of particular products. Consistent with industry practice, components +are normally acquired through a combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the +Company's forecasted component and manufacturing requirements for periods ranging from 30 to 130 days. The Company's operating results and financial condition have been in the past and may in +the future be materially adversely affected by the Company's ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results are dependent upon the Company's ability to obtain a sufficient supply of components, some of which are in short supply or available only from limited +sources. Although most components essential to the Company's business are generally available from multiple sources, certain key components including microprocessors and ASICs are +currently obtained by the Company from single or limited sources. Some key components (including without limitation DRAM, TFT-LCD flat-panel displays, and optical and magnetic +disk drives), while currently available to the Company from multiple sources, are at times subject to industry-wide availability and pricing pressures. In addition, new products introduced +by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. In +situations where a component or product utilizes new technologies, initial capacity constraints may exist until such time as the suppliers' yields have matured. The Company and other producers in the +personal computer industry also compete for various components with other industries that have experienced increased demand for their products. The Company uses some components that are not common to +the rest of the personal computer industry including certain microprocessors and ASICs. Continued availability of these components may be affected if producers were to decide to concentrate on the +production of components other than those customized to meet the Company's requirements. If +the supply of a key component were to be delayed or constrained on a new or existing product, the Company's results of operations and financial condition could be adversely affected. The +Company's ability to produce and market competitive products is also dependent on the ability and desire of IBM and Motorola, the sole suppliers of the PowerPC RISC-based +microprocessor for the Company's Macintosh computers, to provide the Company with a sufficient supply of microprocessors with price/performance features that compare favorably to those supplied to the +Company's competitors by Intel Corporation and other developers and producers of microprocessors used by personal computers using other operating systems. Further, despite its efforts to educate the +marketplace to the contrary, the Company believes that many of its current and potential customers believe that the relatively slower MHz rating or clock speed of the microprocessors it utilizes in +its Macintosh systems compares unfavorably to those utilized by other operating systems and translates to slower overall system performance. There have been instances in recent years where the +inability of the Company's suppliers to provide advanced PowerPC G4 and G3 microprocessors with higher clock speeds in sufficient quantity has had significant adverse effects on the Company's results +of operations. In addition, currently IBM is the Company's sole supplier of the G5 processor used in current Power Macintosh products and Motorola is the sole supplier of the G4 processors. The +inability in the future of the Company to obtain microprocessors in sufficient quantities with competitive price/performance features could have an adverse impact on the Company's results of +operations and financial condition. 43 The Company relies on third-party music content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with third parties to offer their music content to customers through the Company's iTunes Music Store. The Company pays substantial fees to obtain the +rights to offer to its customers this third-party music. Many of the Company's licensing arrangements with these third-party content providers are short-term in nature and do not guarantee +the future renewal of these arrangements at commercially reasonable terms, if at all. Certain parties in the music industry have announced their intent to consolidate their music distribution +operations, which could limit the availability and increase the fees required to offer music content to customers through the iTunes Music Store. If the Company is unable to continue to offer a wide +variety of music content at reasonable prices with acceptable usage rules, or expand its geographic reach outside the United States, then sales and gross margins of the Company's iTunes Music Store as +well as related hardware and peripherals, including iPods, may be adversely affected. Third-party +content providers and artists require that the Company provide certain digital rights management solutions and other security mechanisms. If the requirements from content providers or +artists change, then the Company may be required to further develop or license technology to address such new rights and requirements. There is no assurance that the Company will be able to develop or +license such solutions at a reasonable cost and in a timely manner, if at all, which could have a materially adverse affect on the Company's operating results and financial position. The Company is dependent on manufacturing and logistics services provided by third parties, many of whom are located outside of the United States. Many of the Company's products are manufactured in whole or in part by third-party manufacturers. In addition, the Company has outsourced much of its transportation and +logistics management. While outsourcing arrangements may lower the fixed cost of operations, they also reduce the Company's direct control over production and distribution. It is uncertain what effect +such diminished control will have on the quality or quantity of the products manufactured, or the flexibility of the Company to respond to changing market conditions. Moreover, although arrangements +with such manufacturers may contain provisions for warranty expense reimbursement, the Company may remain at least initially responsible to the ultimate consumer for warranty service in the event of +product defects. Any unanticipated product defect or warranty liability, whether pursuant to arrangements with contract manufacturers or otherwise, could adversely affect the Company's future +operating results and financial condition. Final +assembly of products sold by the Company is conducted in the Company's manufacturing facilities in Sacramento, California, and Cork, Ireland, and by external vendors in Fremont, California, +Fullerton, California, Taiwan, Korea, the Netherlands, the People's Republic of China, and the Czech Republic. Currently, manufacture of many of the components used in the Company's products and final +assembly of substantially all of the Company's portable products including PowerBooks, iBooks, and the iPod is performed by third-party vendors in Japan, Taiwan and China. If for any reason +manufacturing or logistics in any of these locations is disrupted by regional economic, business, environmental, medical, political, or military conditions or events, the Company's results of +operations and financial condition could be adversely affected. The Company's products, from time to time, experience quality problems that can result in decreased net sales and operating profits. The Company sells highly complex hardware and software products that can contain defects in design and manufacture. Sophisticated operating system software and applications, +such as those sold by the Company, often contain "bugs" that can unexpectedly interfere with the operation of the software. Defects may also occur in components and products the Company purchases from +third-parties that may be beyond its control. There can be no assurance that the Company will be able to detect and fix all defects in the hardware and software it sells. Failure to do so could result +in lost revenue, loss of reputation, and significant expense to remedy. 44 The Company's retail initiative has required and will continue to require a substantial investment and commitment of resources and is subject to numerous risks and +uncertainties. Through November 2003, the Company has opened 74 retail stores including its first international store in Tokyo, Japan. The Company's retail initiative has required +substantial investment in equipment and leasehold improvements, information systems, inventory, and personnel. The Company has also entered into substantial operating lease commitments for retail +space with lease terms ranging from 5 to 15 years. The Company could incur substantial costs should it choose to terminate this initiative or close individual stores. Such costs could adversely +affect the Company's results of operations and financial condition. Additionally, a relatively high proportion of the Retail segment's costs are fixed because of depreciation on store construction +costs and lease expense. As a result, significant losses would result should the Retail segment experience a decline in sales for any reason. Certain +of the Company's stores have been designed and built to serve as high profile venues that function as vehicles for general corporate marketing, corporate events, and brand awareness. Because +of their unique design elements, locations and size, these stores require substantially more investment in equipment and leasehold improvements than the Company's more typical retail stores. The +Company has opened four such stores and has one under construction. Because of their location and size, these high profile stores also require the Company to enter into substantially larger operating +lease commitments compared to those required for its more typical stores. Current leases on such locations have terms ranging from 10 to 15 years with total commitments per location over the +lease terms ranging from $25 million to $50 million. Closure or poor performance of one of these high profile stores could have a particularly significant negative impact on the +Company's results of operations and financial condition. Many +of the general risks and uncertainties the Company faces could also have an adverse impact on its Retail segment. Also, many factors unique to retail operations present risks and uncertainties, +some of which are beyond the Company's control, that could adversely affect the Retail segment's future results, cause its actual results to differ from those currently expected, and/or have an +adverse effect on the Company's consolidated results of operations. Potential risks and uncertainties unique to retail operations that could have an adverse impact on the Retail segment include, among +other things, macro-economic factors that have a negative impact on general retail activity; inability to manage costs associated with store construction and operation; lack of consumer acceptance of +the Company's retail approach; failure to attract new users to the Macintosh platform; inability to sell third-party hardware and software products at adequate margins; failure to manage relationships +with existing retail channel partners; lack of experience in managing retail operations outside the United States; costs associated with unanticipated fluctuations in the value of Apple-branded and +third-party retail inventory; and inability to obtain quality retail locations at reasonable cost. Unit sales of the Company's professionally oriented desktop systems have declined sharply over the past several years negatively impacting net sales and gross margin. Unit sales of Power Macintosh systems fell 13% during 2003 as compared to 2002 and fell 18% in 2002 from 2001. Power Macintosh unit sales have fallen as a percentage of total +Macintosh unit sales from 30% in 2001 to 22% in 2003. The Company believes that weak economic conditions over the past several years are having a pronounced negative impact on its professional and +creative customers who are the primary users of such systems. Also, it is likely that many of the Company's current and potential customers, particularly professional and creative customers who are +most likely to utilize the Company's Power Macintosh systems, believe that the relatively slower MHz rating or clock speed of the microprocessors it utilizes in its Macintosh systems compares +unfavorably to those utilized by other operating systems and translates to slower overall system performance. In addition to the negative impact on net sales, declining sales of Power Macintosh +systems also have a negative effect on the Company's overall gross margin because Power Macintosh systems generally have higher individual gross margins than the Company's other Macintosh systems. +Continued deterioration in Power Macintosh unit sales could adversely affect the Company's future net sales and gross margin. If future unit sales of Power Macintosh systems fail to 45 partially +or fully recover, it will be difficult for the Company to improve its overall profitability. While the Company has introduced faster Power Macintosh systems utilizing 64-bit +PowerPC G5 processors during 2003, there can be no assurance that introduction of such systems will favorably impact net sales either in the short or long term. The Company faces increasing competition in the U.S. education market. Sales in the United States to both elementary and secondary schools, as well as for college and university customers, remain a core market for Apple. Net sales in these markets +fell to 18% of the Company's total net sales in 2003 from 21% and 26% in 2002 and 2001, respectively. The drop in 2003 reflects declines in both net sales and Macintosh unit sales in these markets of +4% and 6%, respectively, in fiscal 2003 compared to 2002. Additionally, several competitors of the Company have either targeted or announced their intention to target the education market for personal +computers, which could also negatively affect the Company's market share. In an effort to regain market share and remain competitive, the Company has been and will continue to pursue 1:1 learning +solutions in education. These 1:1 solutions and other strategic sales are generally priced more aggressively and could result in significantly less profitability or even in financial losses, +particularly for larger deals. Although the Company believes it has taken certain steps to strengthen its position in the education market, there can be no assurance that the Company will be able to +increase or maintain its share of the education market or execute profitably on large strategic arrangements. Failure to do so may have an adverse impact on the Company's operating results and +financial condition. The Company's future operating performance is dependent on the performance of distributors and other resellers of the Company's products. The Company distributes its products through wholesalers, resellers, national and regional retailers and cataloguers, many of whom distribute products from competing +manufacturers. In addition, the Company also sells many of its products and resells certain third-party products in most of its major markets directly to end users, certain education customers, and +certain resellers through its online +stores around the world. The Company also sells its own products and certain third-party products through its retail stores. Many of the Company's significant resellers operate on narrow product +margins and have been negatively affected by current economic conditions. Considerable trade receivables that are not covered by collateral or credit insurance are outstanding with the Company's +distribution and retail channel partners. The Company's business and financial results could be adversely affected if the financial condition of these resellers weaken, if resellers within consumer +channels were to cease distribution of the Company's products, or if uncertainty regarding demand for the Company's products caused resellers to reduce their ordering and marketing of the Company's +products. The Company has invested and will continue to invest in various programs to enhance reseller sales, including staffing selected resellers' stores with Company employees. These programs could +require a substantial investment from the Company, while providing no assurance of return or incremental revenue to offset this investment. Over +the past several years, an increasing proportion of the Company's net sales have been made by the Company directly to end-users through its online stores around the world and through +its retail stores in the United States. Some of the Company's resellers have perceived this expansion of the Company's direct sales as conflicting with their own business and economic interests as +distributors and resellers of the Company's products. Perception of such a conflict could discourage the Company's resellers from investing additional resources in the distribution and sale of the +Company's products or lead them to limit or cease distribution of the Company's products. The Company's business and financial results could be adversely affected if expansion of its direct sales to +end-users causes some or all of its resellers to cease or limit distribution of the Company's products. Further +information regarding risks associated with Marketing and Distribution may be found in Part I, Item 1 of this Form 10-K under the heading "Markets and Distribution," +which information is hereby incorporated by reference. 46 The Company's business is subject to the risks of international operations. A large portion of the Company's revenue is derived from its international operations. As a result, the Company's operating results and financial condition could be +significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries), and +changes in the value of the U.S. dollar versus the local currency in which the products are sold and goods and services are purchased. The Company's primary exposure to movements in foreign currency +exchange rates relate to non-dollar denominated sales in Europe, Japan, Australia, Canada, and certain parts of Asia and non-dollar denominated operating expenses incurred +throughout the world. Weaknesses in foreign currencies, particularly the Japanese Yen and the Euro, can adversely impact consumer demand for the Company's products and the U.S. dollar value of the +Company's foreign currency denominated sales. Conversely, strengthening in these and other foreign currencies can increase the cost to the Company of product components, negatively affecting the +Company's results of operations. Margins +on sales of Apple products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate +fluctuations and by international trade regulations, including tariffs and antidumping penalties. Derivative +instruments, such as foreign exchange forward and option positions, and interest rate swap and option positions have been utilized by the Company to hedge exposures to fluctuations in +interest rates and foreign currency exchange rates. The use of such hedging activities may not offset more than a portion of the adverse financial impact resulting from unfavorable movements in either +foreign exchange or interest rates. Further +information related to the Company's global market risks may be found in Part II, Item 7A of this Form 10-K under the subheading "Foreign Currency Risk" and may be +found in Part II, Item 8 of this Form 10-K at Notes 1 and 2 of Notes to Consolidated Financial Statements, which information is hereby incorporated by reference. The Company's future performance is dependent upon support from third-party software developers. If third-party software applications cease to be developed or available for the +Company's hardware products, then customers may choose not to buy the Company's products. The Company believes that decisions by customers to purchase the Company's personal computers, as opposed to Windows-based systems, are often based on the availability of +third-party software for particular applications such as Microsoft Office. The Company also believes the availability of third-party application software for the Company's hardware products depends in +part on third-party developers' perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company's products versus software for the larger +Windows market. This analysis is based on factors such as the perceived strength of the Company and its products, the anticipated potential revenue that may be generated, acceptance by customers of +Mac OS X, and the costs of developing such software products. To the extent the Company's financial losses in prior years and the minority market share held by the Company in the personal computer +market, as well as the Company's decision to end its Mac OS licensing program, have caused software developers to question the Company's prospects in the personal computer market, developers could be +less inclined to develop new application software or upgrade existing software for the Company's products and more inclined to devote their resources to developing and upgrading software for the +larger Windows market. Moreover, there can be no assurance software developers will continue to develop software for Mac OS X, the Company's operating system, on a timely basis or at all. In +addition, past and future development by the Company of its own software applications and solutions may negatively impact the decision of software developers to develop, maintain, and upgrade +similar or competitive software for the Company's products. The Company currently markets and sells a variety of software applications for use by professionals, consumers, and education customers that +could influence 47 the +decision of third-party software developers to develop or upgrade Macintosh-compatible software products. Software applications currently marketed by the Company include software for professional +film and video editing, professional compositing and visual effects for large format film and video productions, professional music production and music post production, professional and consumer DVD +encoding and authoring, consumer digital video and digital photo editing and management, digital music management, desktop-based database management, and high-quality presentations. The +Company also markets an integrated productivity application that incorporates word processing, page layout, image manipulation, spreadsheets, databases, and presentations in a single application. In +August 1997, the Company and Microsoft Corporation entered into patent cross license and technology agreements. In addition, for a period of five years through August 2002, and +subject to certain limitations related to the number of Macintosh computers sold by the Company, Microsoft was required to make versions of its Microsoft Office and Internet Explorer products for the +Mac OS. Although Microsoft has released Microsoft Office and Internet Explorer for Mac OS X, Microsoft is not obligated to produce future versions of its products subsequent to August 2002. +While the Company believes its relationship with Microsoft has been and will continue to be beneficial to the Company and to its efforts to increase the installed base for the Mac OS, the Company does +compete directly with Microsoft in a number of key areas. Accordingly, Microsoft's interest in producing application software for the Mac OS following expiration of the agreements may be influenced by +Microsoft's perception of its interests as the vendor of the Windows operating system. Discontinuance of Microsoft Office and other Microsoft products for the Macintosh platform would have an adverse +effect on the Company's net sales and results of operations. In June of 2003, Microsoft stated that it would no longer develop new versions of Internet Explorer for the Mac OS. Microsoft's decision to +discontinue development of Internet Explorer for Mac OS X appears to have been influenced in part by the Company's introduction during 2003 of its own web browser, Safari. It is unclear what impact, +if any, Microsoft's decision to cease further development of Internet Explorer for Mac OS X will have on the Company. However, if customers chose not to purchase the Company's products because +Internet Explorer is not available on the Macintosh platform or should websites fail to provide support for web browsers other than Internet Explorer, the Company's net sales and results of operations +could be materially adversely affected. The Company's business relies on access to patents and intellectual property obtained from third parties, and the Company's future results could be adversely affected if it is +alleged or found to have infringed on the intellectual property rights of others. Many of the Company's products are designed to include intellectual property obtained from third parties. While it may be necessary in the future to seek or renew licenses +relating to various aspects of its products and business methods, the Company believes that based upon past experience and industry +practice, such licenses generally could be obtained on commercially reasonable terms. However, there can be no assurance that the necessary licenses would be available or available on acceptable +terms. Because +of technological changes in the computer industry, current extensive patent coverage, and the rapid rate of issuance of new patents, it is possible certain components of the Company's products +and business methods may unknowingly infringe existing patents of others. The Company has from time to time been notified that it may be infringing certain patents or other intellectual property +rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in significant expenses, and cause the diversion of management and technical personnel. Several +pending claims are in various stages of evaluation. The Company may consider the desirability of entering into licensing agreements in certain of these cases. However, no assurance can be given that +such licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting the Company from marketing or selling +certain of its products or a successful claim of infringement against the Company requiring it to pay royalties to a third-party, the Company's future operating results and financial condition could +be adversely affected. Information regarding claims and litigation involving the Company related to alleged patent infringement and other matters is set forth in 48 Part I, +Item 3 of this Form 10-K. In the opinion of management, the Company does not have a potential liability for damages or royalties from any current legal proceedings or +claims related to the infringement of patent or other intellectual property rights of others that would individually or in the aggregate have a material adverse effect on its results of operations, or +financial condition. However, the results of such legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of the matters related to infringement of patent or +other intellectual property rights of others described in Part I, Item 3 of this Form 10-K or should several of these matters be resolved against the Company in the same +reporting period, the operating results of a particular reporting period could be materially adversely affected. The Company expects its quarterly revenue and operating results to fluctuate for a variety of reasons. The Company's profit margins vary among its products and its distribution channels. As a result, the overall profitability of the Company in any given period will depend, in +part, on the product, geographic, and channel mix reflected in that period's net sales. The typical concentration of net sales in the third month of the Company's fiscal quarters can adversely affect the Company's business and operating results. The Company generally sells more products during the third month of each quarter than it does during either of the first two months, a pattern typical in the personal computer +industry. This sales pattern can produce pressure on the Company's internal infrastructure during the third month of a quarter and may adversely impact the Company's ability to predict its financial +results accurately. Developments late in a quarter, such as lower-than-anticipated demand for the Company's +products, an internal systems failure, or failure of one of the Company's key logistics, components suppliers, or manufacturing partners, can have significant adverse impacts on the Company and its +results of operations and financial condition. The Company's success depends largely on its ability to attract and retain key personnel. Much of the future success of the Company depends on the continued service and availability of skilled personnel, including its Chief Executive Officer, members of its +executive team, and those in technical, marketing and staff positions. Experienced personnel in the information technology industry are in high demand and competition for their talents is intense, +especially in the Silicon Valley, where the majority of the Company's employees are located. The Company has relied on its ability to grant stock options as one mechanism for recruiting and retaining +this highly skilled talent. Potential accounting regulations requiring the expensing of stock options may impair the Company's future ability to provide these incentives without incurring significant +compensation costs. There can be no assurance that the Company will continue to successfully attract and retain key personnel. The Company is subject to risks associated with the availability and cost of insurance. The Company has observed rapidly changing conditions in the insurance markets relating to nearly all areas of traditional corporate insurance. Such conditions have resulted in +higher premium costs, higher policy deductibles, and lower coverage limits. For some risks, because of cost and/or availability, the Company does not have insurance coverage. For these reasons, the +Company is retaining a greater portion of its insurable risks than it has in the past at relatively greater cost. Business interruptions could adversely affect the Company's future operating results. The Company's major business operations are subject to interruption by earthquake, fire, power shortages, terrorist attacks and other hostile acts, labor disputes, medical +conditions, and other events beyond its control. The majority of the Company's research and development activities, its corporate headquarters, information technology systems, and other critical +business operations, including certain component suppliers and manufacturing vendors, are located near major seismic faults. The Company does not carry earthquake insurance for direct quake-related +losses. The Company's operating results and financial 49 condition +could be materially adversely affected in the event of a major earthquake or other natural or manmade disaster. Failure of the Company's information technology systems and breaches in the security of data could adversely affect the Company's future operating results. Information technology system failures and breaches of data security could disrupt the Company's ability to function in the normal course of business by potentially causing +delays or cancellation of customer orders, impeding the manufacture or shipment of products, or resulting in the unintentional disclosure of customer or Company information. Management has taken steps +to address these concerns by its implementation of sophisticated network security and internal control measures. However, there can be no assurance that a system failure or data security breach will +not have a material adverse effect on the Company's results of operations. The Company is exposed to credit risk on its accounts receivables. This risk is heightened as economic conditions worsen. The Company distributes its products through third-party computer resellers and retailers and directly to certain educational institutions and commercial customers. A +substantial majority of the Company's outstanding trade receivables are not covered by collateral or credit insurance. The Company also has non-trade receivables from certain of its +manufacturing vendors resulting from the sale by the Company of raw material components to these manufacturing vendors who manufacture sub-assemblies or assemble final products for the +Company. While the Company has procedures in place to monitor and limit exposure to credit risk on its trade and non-trade receivables, there can be no assurance that such procedures will +be effective in limiting its credit risk and avoiding losses. Additionally, if the global economy and regional economies fail to improve or continue to deteriorate, it becomes more likely that the +Company will incur a material loss or losses as a result of the weakening financial condition of one or more of its customers or manufacturing vendors. The Company is subject to risks associated with environmental regulations. Production and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and +regulations have recently been passed in several jurisdictions in which the Company operates, including various European Union member countries, Japan and California. Although the Company does not +anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not have a +material adverse effect on the Company's results of operation and financial position. Changes in accounting rules could adversely affect the Company's future operating results. Financial statements are prepared in accordance with U.S. generally accepted accounting principles. These principles are subject to interpretation by various governing bodies, +including the FASB and the SEC, who interpret and create appropriate accounting regulations. A change from current accounting +regulations can have a significant effect on the Company's results of operations and could impact the manner in which the Company conducts business. Unanticipated changes in the Company's tax rates could affect its future results. The Company's future effective tax rates could be favorably or unfavorably affected by unanticipated changes in the mix of earnings in countries with differing statutory tax +rates, changes in the valuation of the Company's deferred tax assets and liabilities, or by changes in tax laws or their interpretation. In addition, the Company is subject to the continuous +examination of our income tax returns by the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of adverse outcomes 50 resulting +from these examinations to determine the adequacy of our provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse +effect on its operating results and financial condition. The Company's stock price may be volatile. The Company's stock has at times experienced substantial price volatility as a result of variations between its actual and anticipated financial results and as a result of +announcements by the Company and its competitors. In addition, the stock market has experienced extreme price and volume fluctuations that have affected the market price of many technology companies +in ways that have been unrelated to the operating performance of these companies. These factors, including lack of positive performance in the Company's stock price, as well as general economic and +political conditions and investors' concerns regarding the credibility of corporate financial reporting and integrity of financial markets, may materially adversely affect the market price of the +Company's stock in the future. The Company's acquisition activity could disrupt its ongoing business and may present risks not contemplated at the time of the transaction. The Company has acquired and may continue to acquire companies that have products, services, personnel and technologies that complement the Company's strategic direction and +product roadmap. These acquisitions may involve significant risks and uncertainties, including difficulties in incorporating the acquired companies' operations and technologies; distraction of +management's attention away from normal business operations; insufficient revenue generation to offset liabilities assumed and expenses associated with acquisition; and unidentified issues not +discovered in the Company's due diligence process, including product quality issues and legal contingencies. Acquisitions are inherently risky, and no assurance can be given that the Company's +previous or future acquisitions will be successful and will not materially adversely affect business, operating results or financial condition. The Company has generally paid cash for its +acquisitions. Should the Company issue its common stock or other equity +related purchase rights as consideration in an acquisition, current shareholders' percentage ownership and earnings per share may become diluted. 51 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management To ensure the adequacy and effectiveness of the Company's foreign exchange and interest rate hedge positions, as well as to monitor the risks and opportunities of the +non-hedge portfolios, the Company regularly reviews its foreign exchange forward and option positions, and its interest rate swap and option positions both on a stand-alone basis and in +conjunction with its underlying foreign currency and interest rate related exposures, respectively, from both an accounting and an economic perspective. However, given the effective horizons of the +Company's risk management activities and the anticipatory nature of the exposures intended to hedge, there can be no assurance the aforementioned programs will offset more than a portion of the +adverse financial impact resulting from unfavorable movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains and losses related to +mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely +affect the Company's operating results and financial position. The Company adopted SFAS No. 133 as of October 1, 2000. SFAS No. 133 established accounting and reporting standards +for derivative instruments, hedging activities, and exposure definition. Management does not believe that ongoing application of SFAS No. 133 will significantly alter the Company's hedging +strategies. However, its application may increase the volatility of other income and expense and other comprehensive income. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world's leading industrialized countries, the Company's interest income and expense is most sensitive +to fluctuations in the general level of U.S. interest rates. In this regard, changes in U.S. interest rates affect the interest earned on the Company's cash, cash equivalents, and +short-term investments as well as costs associated with foreign currency hedges. The +Company's fixed income investment policy and strategy is to ensure the preservation of capital, meet liquidity requirements, and optimize return in light of the current credit and interest rate +environment. The Company benchmarks its performance by utilizing external money managers to manage a small portion of the aggregate investment portfolio. The external managers adhere to the Company's +investment policies and also provide occasional research and market information that supplements internal research used to make credit decisions in the investment process. During +1994, the Company issued $300 million aggregate principal amount of 6.5% unsecured notes in a public offering registered with the SEC. The notes were sold at 99.925% of par, for an +effective yield to maturity of 6.51%. The notes pay interest semiannually and mature on February 15, 2004. The +Company's exposure to market risk for changes in interest rates relates primarily to the Company's investment portfolio and debt obligations and related derivative financial instruments. The +Company places its short-term investments in highly liquid securities issued by high credit quality issuers and, by policy, limits the amount of credit exposure to any one issuer. The +Company's general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with maturities of three +months or less are classified as cash equivalents; highly liquid investments with maturities greater than three months are classified as short-term investments. As of September 27, +2003, approximately $629 million of the Company's short-term investments had underlying maturities ranging from 1 and 5 years. As of September 28, 2002, +$1.087 billion of the Company's investment portfolio classified as short-term investments had maturities ranging from 1 to 5 years. The remainder all had underlying +maturities between 3 and 12 months. Due to liquidity needs, or in anticipation of credit deterioration, or for the purpose of duration management of the Company's investment portfolio, the +Company may sell investments prior to their stated maturities. As a result of such activity, the Company recognized net gains of $21 million in 2003 and $7 million in 2002. 52 In +order to provide a meaningful assessment of the interest rate risk associated with the Company's investment portfolio, the Company performed a sensitivity analysis to determine the impact that a +change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 27, +2003, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $12.9 million decline in the fair market value of the portfolio. As of +September 28, 2002, a similar 100 basis point shift in the yield curve would have resulted in a $37.7 million decline in fair value. Such losses would only be realized if the Company +sold the investments prior to maturity. Except in instances noted above, the Company's policy is to hold investments to maturity. The +Company sometimes enters into interest rate derivative transactions, including interest rate swaps, collars, and floors, with financial institutions in order to better match the Company's +floating-rate interest income on its cash equivalents and short-term investments with its fixed-rate interest expense on its debt, and/or to diversify a portion +of the Company's exposure away from fluctuations in short-term U.S. interest rates. The Company may also enter into interest rate contracts that are intended to reduce the cost of the +interest rate risk management program. The Company entered into no interest rate asset swaps during 2003 or 2002 and had no open interest rate asset swaps at September 27, 2003. In +prior years, the Company had entered into interest rate debt swaps with financial institutions. The interest rate debt swaps, which qualified as accounting hedges, generally required the Company to +pay a floating interest rate based on the three- or six-month U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of the underlying notional amounts. These swaps +effectively converted the Company's fixed-rate 10-year debt to floating-rate debt and convert a portion of the floating rate investments to fixed rate. Due to +prevailing market interest rates, during 2002 the Company entered into and then subsequently closed out debt swap positions realizing a gain of $6 million. During 2001 the Company closed out +all of its then existing debt swap positions realizing a gain of $17 million. Both the gains in 2002 and 2001 were deferred, recognized in long-term debt and are being amortized to +other income and expense over the remaining life of the debt. Foreign Currency Risk Overall, the Company is a net receiver of currencies other than the U.S. dollar and, as such, generally benefits from a weaker dollar and is adversely affected by a stronger +dollar relative to major currencies worldwide. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, may negatively affect the Company's net sales and gross +margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing within the time frame of our hedged positions due to competitive +pressures when there has been significant volatility in foreign currency exchange rates. The +Company enters into foreign currency forward and option contracts with financial institutions primarily to protect against foreign exchange risks associated with existing assets and liabilities, +certain firmly committed transactions, and probable but not firmly committed transactions. Generally, the Company's practice is to hedge a majority of its existing material foreign exchange +transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and limited +availability of appropriate hedging instruments. The Company also enters into foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the +re-measurement of certain recorded assets and liabilities denominated in non-functional currencies of its foreign subsidiaries. In +order to provide a meaningful assessment of the foreign currency risk associated with certain of the Company's foreign currency derivative positions, the Company performed a sensitivity analysis +using a value-at-risk (VAR) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate 3000 +random market price paths. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company's foreign 53 exchange +portfolio due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market +conditions. Forecasted transactions, firm commitments, and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company +estimates with 95% confidence a maximum one-day loss in fair value of $7.5 million as of September 27, 2003 compared to a maximum one-day loss of +$3.8 million as of September 28, 2002. Because the Company uses foreign currency instruments for hedging purposes, losses incurred on those instruments are generally offset by increases +in the fair value of the underlying exposures. Actual +gains and losses in the future associated with the Company's investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of +September 27, 2003 due to the inherent limitations associated with predicting the changes in the timing and amount of interest rates, foreign currency exchanges rates, and the Company's actual +exposures and positions. 54 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Financial Statements: Consolidated Balance Sheets as of September 27, 2003 and September 28, 2002 56 Consolidated Statements of Operations for the three fiscal years ended September 27, 2003 57 Consolidated Statements of Shareholders' Equity for the three fiscal years ended September 27, 2003 58 Consolidated Statements of Cash Flows for the three fiscal years ended September 27, 2003 59 Notes to Consolidated Financial Statements 60 Selected Quarterly Financial Information (Unaudited) 100 Report of Independent Auditors, KPMG LLP 102 All +financial statement schedules have been omitted, since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the Consolidated Financial Statements and Notes thereto. 55 CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 27, 2003 September 28, 2002 ASSETS: Current assets: Cash and cash equivalents $ 3,396 $ 2,252 Short-term investments 1,170 2,085 Accounts receivable, less allowances of $49 and $51, respectively 766 565 Inventories 56 45 Deferred tax assets 190 166 Other current assets 309 275 Total current assets 5,887 5,388 Property, plant, and equipment, net 669 621 Goodwill 85 85 Acquired intangible assets 24 34 Other assets 150 170 Total assets $ 6,815 $ 6,298 LIABILITIES AND SHAREHOLDERS' EQUITY: Current liabilities: Accounts payable $ 1,154 $ 911 Accrued expenses 899 747 Current debt 304 — Total current liabilities 2,357 1,658 Long-term debt — 316 Deferred tax liabilities and other non-current liabilities 235 229 Total liabilities 2,592 2,203 Commitments and contingencies Shareholders' equity: Common stock, no par value; 900,000,000 shares authorized; 366,726,584 and 358,958,989 shares issued and outstanding, respectively 1,926 1,826 Deferred stock compensation (62 ) (7 ) Retained earnings 2,394 2,325 Accumulated other comprehensive income (loss) (35 ) (49 ) Total shareholders' equity 4,223 4,095 Total liabilities and shareholders' equity $ 6,815 $ 6,298 See +accompanying notes to consolidated financial statements. 56 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) Three fiscal years ended September 27, 2003 2003 2002 2001 Net sales $ 6,207 $ 5,742 $ 5,363 Cost of sales 4,499 4,139 4,128 Gross margin 1,708 1,603 1,235 Operating expenses: Research and development 471 446 430 Selling, general, and administrative 1,212 1,109 1,138 Restructuring costs 26 30 — Purchased in-process research and development — 1 11 Total operating expenses 1,709 1,586 1,579 Operating income (loss) (1 ) 17 (344 ) Other income and expense: Gains (losses) on non-current investments, net 10 (42 ) 88 Unrealized loss on convertible securities — — (13 ) Interest and other income, net 83 112 217 Total other income and expense 93 70 292 Income (loss) before provision for (benefit from) income taxes 92 87 (52 ) Provision for (benefit from) income taxes 24 22 (15 ) Income (loss) before accounting changes 68 65 (37 ) Cumulative effects of accounting changes, net of income taxes 1 — 12 Net income (loss) $ 69 $ 65 $ (25 ) Earnings (loss) per common share before accounting changes: Basic $ 0.19 $ 0.18 $ (0.11 ) Diluted $ 0.19 $ 0.18 $ (0.11 ) Earnings (loss) per common share: Basic $ 0.19 $ 0.18 $ (0.07 ) Diluted $ 0.19 $ 0.18 $ (0.07 ) Shares used in computing earnings (loss) per share (in thousands): Basic 360,631 355,022 345,613 Diluted 363,466 361,785 345,613 See +accompanying notes to consolidated financial statements. 57 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) Preferred Stock Common Stock Accumulated Other Comprehensive Income (Loss) Retained Earnings Deferred Stock Compensation Total Shareholders' Equity Shares Amount Shares Amount Balances as of September 30, 2000 76 $ 76 335,677 $ 1,502 $ 2,285 $ — $ 244 $ 4,107 Components of comprehensive loss: Net loss — — — — (25 ) — — (25 ) Change in foreign currency translation — — — — — — (3 ) (3 ) Change in unrealized gain on available-for-sale securities, net of tax — — — — — — (267 ) (267 ) Change in unrealized gain on derivative investments, net of tax — — — — — — 4 4 Total comprehensive loss (291 ) Issuance of common stock and assumption of stock options in connection with acquisition — — 2,403 66 — (13 ) — 53 Amortization of deferred stock compensation — — — — — 2 — 2 Common stock issued under stock plans — — 3,660 42 — — — 42 Conversion of Series A preferred stock (76 ) (76 ) 9,182 76 — — — — Tax benefit related to stock options — — — 7 — — — 7 Balances as of September 29, 2001 — $ — 350,922 $ 1,693 $ 2,260 $ (11 ) $ (22 ) $ 3,920 Components of comprehensive income: Net income — — — — 65 — — 65 Change in foreign currency translation — — — — — — 5 5 Change in unrealized gain on available-for-sale securities, net of tax — — — — — — (17 ) (17 ) Change in unrealized gain on derivative investments, net of tax — — — — — — (15 ) (15 ) Total comprehensive income 38 Amortization of deferred stock compensation — — — — — 4 — 4 Common stock issued under stock plans — — 8,037 105 — — — 105 Tax benefit related to stock options — — — 28 — — — 28 Balances as of September 28, 2002 — $ — 358,959 $ 1,826 $ 2,325 $ (7 ) $ (49 ) $ 4,095 Components of comprehensive income: Net income — — — — 69 — — 69 Change in foreign currency translation — — — — — — 31 31 Change in unrealized gain on available-for-sale securities, net of tax — — — — — — (12 ) (12 ) Change in unrealized gain on derivative investments, net of tax — — — — — — (5 ) (5 ) Total comprehensive income 83 Amortization of deferred stock compensation — — — — — 15 — 15 Write-off of deferred stock compensation — — — — — 5 — 5 Common stock issued under stock plans — — 9,299 128 — (75 ) — 53 Settlement of forward purchase agreement — — (1,531 ) (35 ) — — — (35 ) Tax benefit related to stock options — — — 7 — — — 7 Balances as of September 27, 2003 — $ — 366,727 $ 1,926 $ 2,394 $ (62 ) $ (35 ) $ 4,223 See accompanying notes to consolidated financial statements. 58 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 27, 2003 2003 2002 2001 Cash and cash equivalents, beginning of the year $ 2,252 $ 2,310 $ 1,191 Operating Activities: Net income (loss) 69 65 (25 ) Cumulative effects of accounting changes, net of taxes (1 ) — (12 ) Adjustments to reconcile net income (loss) to cash generated by operating activities: Depreciation, amortization and accretion 113 114 100 Stock based compensation expense 16 5 2 Non-cash restructuring 12 8 — Benefit from deferred income taxes (11 ) (34 ) (36 ) Loss on disposition of property, plant, and equipment 2 7 9 Gains on sales of short-term investments, net (21 ) (7 ) — (Gains) losses on sales of non-current investments, net (10 ) 42 (88 ) Gain on forward purchase agreement (6 ) — — Unrealized loss on convertible securities — — 13 Purchased in-process research and development — 1 11 Changes in operating assets and liabilities: Accounts receivable (201 ) (99 ) 487 Inventories (11 ) (34 ) 22 Other current assets (34 ) (114 ) 106 Other assets (30 ) (11 ) 12 Accounts payable 243 110 (356 ) Other liabilities 159 36 (60 ) Cash generated by operating activities 289 89 185 Investing Activities: Purchases of short-term investments (2,648 ) (4,144 ) (4,268 ) Proceeds from maturities of short-term investments 2,446 2,846 4,811 Proceeds from sales of short-term investments 1,116 1,254 278 Proceeds from sales of non-current investments 45 25 340 Purchases of property, plant, and equipment (164 ) (174 ) (232 ) Cash used for business acquisitions — (52 ) (19 ) Other 33 (7 ) (18 ) Cash generated by (used for) investing activities 828 (252 ) 892 Financing Activities: Proceeds from issuance of common stock 53 105 42 Cash used for repurchase of common stock (26 ) — — Cash generated by financing activities 27 105 42 Increase (decrease) in cash and cash equivalents 1,144 (58 ) 1,119 Cash and cash equivalents, end of the year $ 3,396 $ 2,252 $ 2,310 Supplemental cash flow disclosures: Cash paid during the year for interest $ 20 $ 20 $ 20 Cash paid for income taxes, net $ 45 $ 11 $ 42 Noncash transactions: Issuance of common stock for conversion of Series A preferred stock $ — $ — $ 76 Issuance of common stock in connection with acquisition $ — $ — $ 66 See +accompanying notes to consolidated financial statements. 59 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1—Summary of Significant Accounting Policies Apple +Computer, Inc. and its subsidiaries (the Company) designs, manufactures and markets personal computers and related software, peripherals and personal computing and communicating +solutions. The Company's products include the Macintosh line of desktop and notebook computers, the Mac OS X operating system, the iPod digital music player, and a portfolio of software products and +peripherals for education, creative, consumer and business customers. The Company sells its products through its online stores, direct sales force, third-party wholesalers and resellers, and its own +retail stores. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these +consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these +consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes +thereto have been reclassified to conform to the current year presentation. Typically, +the Company's fiscal year ends on the last Saturday of September. Fiscal years 2003, 2002 and 2001 were each 52-week years. However, approximately every six years, the Company +reports a 53-week fiscal year to align its fiscal quarters with calendar quarters by adding a week to its first fiscal quarter. All information presented herein is based on the Company's +fiscal calendar. Financial Instruments Cash Equivalents and Short-term Investments The Company places its short-term investments in highly liquid securities issued by high credit quality issuers. All highly liquid investments with maturities of +three months or less at the date of purchase are classified as cash equivalents; highly liquid investments with maturities greater than three months are classified as short-term +investments. Management determines the appropriate classification of its investments in debt and marketable equity securities at the time of purchase and reevaluates such designation as of each +balance sheet date. The Company's debt and marketable equity securities have been classified and accounted for as available-for-sale. These securities are carried at fair +value, with the unrealized gains and losses, net of taxes, reported as a component of shareholders' equity. The cost of securities sold is based upon the specific identification method. Non-Current Debt and Equity Investments The Company has made investments in non-current debt and equity investments of public and privately held companies that have been reflected in the consolidated +balance sheets as long-term assets within other assets. They are not categorized as current assets either because, given their nature, they are not readily convertible into cash or because +they represent potentially longer-term investments by the Company. Further, the fair value of these investments has been subject to a high degree of volatility. The Company's +non-current debt and equity investments have been categorized as available-for-sale requiring that they be carried at fair value with unrealized gains and losses, +net of taxes, reported in equity as a component of accumulated other comprehensive income. However, the Company recognizes an impairment charge to earnings in the event a decline in fair value below +the cost basis of one of these investments is determined to be other-than-temporary. The Company includes recognized gains and losses resulting from the sale or from +other-than-temporary declines in fair value associated with these investments in other income and expense. Occasionally, the Company uses short-term equity +derivatives to 60 manage +potential dispositions of non-current debt and equity investments. Any gains or losses associated with such derivatives are recognized currently in other income and expense. Financial Instruments with Characteristics of Both Liabilities and Equity On May 15, 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of +Both Liabilities and Equity . SFAS No. 150 requires issuers to classify as +liabilities (or assets in some circumstances) certain freestanding financial instruments that embody obligations for the issuer and have characteristics of both liabilities and equity. The Company +adopted the provisions of SFAS No. 150 on June 29, 2003, which resulted in a favorable cumulative-effect type adjustment of approximately $3 million. This adjustment related to a +forward purchase agreement that allowed the Company to acquire 1.5 million shares of its common stock at an average price of $16.64 per share for a total cost of $25.5 million. The +Company settled this forward purchase agreement in August 2003, which resulted in an additional gain of approximately $6 million representing the increase in fair value of the agreement +from June 29, 2003 through the settlement date. Derivative Financial Instruments On October 1, 2000, the Company adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging +Activities . SFAS No. 133 establishes accounting and reporting standards for derivative instruments, hedging activities, and exposure definition. SFAS No. 133 +requires that all derivatives be recognized as either assets or liabilities at fair value. Derivatives that are not hedges must be adjusted to fair value through income. If the derivative is a hedge, +depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings, or +recognized in other comprehensive income until the hedged item is recognized in earnings. Net of the related income tax effect of approximately $5 million, adoption of SFAS No. 133 +resulted in a favorable cumulative-effect type adjustment to net income of approximately $12 million. Net of the related income tax effect of approximately $5 million, adoption of SFAS +No. 133 resulted in a favorable cumulative-effect-type adjustment to other comprehensive income of approximately $12 million, all of which was reclassified to earnings during +2001. Management does not believe that ongoing application of SFAS No. 133 will significantly alter the Company's hedging strategies. However, its application may increase the volatility of +other income and expense and other comprehensive income. For +derivative instruments that hedge the exposure to variability in expected future cash flows that are attributable to a particular risk and that are designated as cash flow hedges, the net gain or +loss on the derivative instrument is reported as a component of other comprehensive income in shareholders' equity and reclassified into earnings in the same period or periods during which the hedged +transaction affects earnings. To receive hedge accounting treatment, cash flow hedges must be highly effective in achieving offsetting changes to expected future cash flows on hedged transactions. For +derivative instruments that hedge the exposure to changes in the fair value of an asset or a liability or an identified portion thereof that are attributable to a particular risk and that are +designated as fair value hedges, the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in earnings +in the current period. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the net +investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward contracts designated as net investment hedges, the Company excludes changes +in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current 61 earnings. +For derivative instruments not designated as hedging instruments, changes in fair value are recognized in earnings in the current period. For +foreign currency forward contracts designated as cash flow hedges, hedge effectiveness is measured based on changes in the fair value of the contract attributable to changes in the forward +exchange rate. Changes in the expected future cash flows on the forecasted hedged transaction and changes in the fair value of the forward hedge are both measured from the contract rate to the forward +exchange rate associated with the forward contract's maturity date. For currency option contracts, hedge effectiveness is measured based on changes in the total fair value of the option contract. +Hedge effectiveness is assessed by comparing the present value of the cumulative change in expected future cash flows on the hedged transaction to changes in expected cash flow of the option hedge at +maturity. The net gains or losses on derivative instruments qualifying as cash flow hedges are reported as components of other comprehensive income in shareholders' equity and reclassified into +earnings in the same period or periods during which the hedged transaction affects earnings. Any hedge ineffectiveness is recognized in current earnings in other income and expense. For interest rate +swap agreements qualifying as fair value hedges, the Company assumes no ineffectiveness because these swaps meet the criteria for accounting under the short-cut method defined in SFAS +No. 133. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. If the cost of the inventories exceeds their market value, provisions are +made currently for the difference between the cost and the market value. Property, Plant, and Equipment Property, plant, and equipment are stated at cost. Depreciation is computed by use of the declining balance and straight-line methods over the estimated useful +lives of the assets, which are 30 years for buildings, from 2 to 5 years for equipment, and the shorter of lease terms or 10 years for leasehold improvements. The Company +capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use +software are amortized using the straight-line method over the estimated useful lives of the assets, which range from 3 to 5 years. Asset Retirement Obligations On September 29, 2002, the Company adopted SFAS No. 143, Accounting for Asset Retirement Obligations , which +addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to +legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. SFAS No. 143 +requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of +the liability is added to the carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. All of the Company's existing asset retirement +obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. The Company estimated that as of September 29, 2002, +gross expected future cash flows of $9.5 million would be required to fulfill these obligations. 62 As +of the date of adoption, the Company recorded a $6 million long-term asset retirement liability and a corresponding increase in leasehold improvements. This amount represents the +present value of expected future cash flows associated with returning certain of the Company's leased properties to original condition. The difference between the gross expected future cash flow of +$9.5 million and its present value of $6 million at September 29, 2002, is being accreted over the life of the related leases as an operating expense. Net of the related income +tax effect of approximately $1 million, adoption of SFAS No. 143 resulted in an unfavorable cumulative-effect type adjustment to net income during the first quarter of 2003 of +approximately $2 million. This adjustment represents cumulative depreciation and accretion that would have been recognized through the date of adoption of SFAS No. 143 had the statement +been applied to the Company's existing asset retirement obligations at the time they were initially incurred. The +following table reconciles changes in the Company's asset retirement liability for fiscal 2003 (in millions): Asset retirement liability recorded at September 29, 2002 $ 5.5 Additional asset retirement obligations recognized 0.5 Accretion recognized 1.2 Asset retirement liability as of September 27, 2003 $ 7.2 Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and certain identifiable intangibles, excluding goodwill, for impairment whenever events or changes in circumstances indicate +the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of its carrying amount to future undiscounted cash flows the assets are expected to +generate. If property, plant, and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the +assets exceeds its fair market value. For the three years ended September 27, 2003, the Company has made no material adjustments to its long-lived assets, except those made in +connection with the restructuring actions described in Note 5. The +Company adopted SFAS No. 142, Goodwill and Other Intangible Assets , in the first quarter of fiscal 2002. SFAS No. 142 requires that +goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually or sooner whenever events or changes in circumstances +indicate that they may be impaired. Prior to fiscal 2002, goodwill was amortized using the straight-line method over its estimated useful life. The Company completed its transitional +goodwill impairment test as of October 1, 2001, and its annual goodwill impairment tests at August 30, 2003 and August 30, 2002, respectively, and found no impairment. The Company +established reporting units based on its current reporting structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to +each reporting unit. SFAS +No. 142 also requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived +Assets and for Long-Lived Assets to Be Disposed Of . The Company is currently +amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 10 years. Foreign Currency Translation The Company translates the assets and liabilities of its international non-U.S. functional currency subsidiaries into U.S. dollars using exchange rates in effect at +the end of each period. Revenue and 63 expenses +for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are credited or charged to foreign currency +translation included in "accumulated other comprehensive income (loss)" in shareholders' equity. The Company's foreign manufacturing subsidiaries and certain other international subsidiaries that use +the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property, and nonmonetary assets and +liabilities at historical rates. Gains and losses from these translations were insignificant and have been included in the Company's results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale of products (hardware, software, and peripherals), and extended warranty and support contracts. The Company recognizes +revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software Revenue Recognition , as +amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial Statements . The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is shipped. +For online sales to individuals, for some sales to education customers in the United States, and for certain other sales, the Company defers revenue until the customer receives the product because the +Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed to not be, +fixed and determinable, revenue is deferred and subsequently recognized as amounts become due and payable. Revenue +from extended warranty and support contracts is deferred and recognized ratably over the warranty and support periods. These contracts typically include extended phone support, certain +repairs, web-based support resources, diagnostic tools, and extend the Company's one-year basic limited parts and labor warranty. The +Company sells software and peripheral products obtained from other companies. The Company establishes its own pricing and retains related inventory risk, is the primary obligor in sales +transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company recognizes revenue for the sale of products obtained from other companies at +the gross amount billed. Revenue +on arrangements that include multiple elements such as hardware, software, and services is allocated to each element based on vendor specific objective evidence (VSOE) of the fair value of +each element. Allocated revenue for each element is recognized when revenue recognition criteria have been met for each element. VSOE is determined based on the price charged when each element is sold +separately. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end user rebates, and other sales programs +and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The Company also records +reductions to revenue for expected future product returns based on the Company's historical experience. 64 Generally, +the Company does not offer specified or unspecified upgrade rights to its customers in connection with software sales or the sale of extended warranty and support contracts. However, a +limited number of the Company's software products are available with maintenance agreements that grant customers rights to unspecified future upgrades over the maintenance term on a when and if +available basis. Revenue associated with such maintenance is recognized ratably over the maintenance term. Shipping Costs The Company's shipping and handling costs are included in cost of sales for all periods presented. Warranty Expense The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized. Research and Development Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased or otherwise marketed are subject to capitalization beginning +when a product's technological feasibility has been established and ending when a product is available for general release to customers pursuant to SFAS No. 86, Computer +Software to be Sold, Leased, or Otherwise Marketed . In most instances, the Company's products are released soon after technological feasibility has been established. Therefore, +costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally all software development costs have been expensed. During +the third and fourth quarters of 2003, the Company incurred substantial development costs associated with the development of Mac OS X version 10.3 (code-named "Panther"), which +enhances the features and functionality of the previous version of Mac OS X, subsequent to achievement of technological feasibility as evidenced by public demonstration and release of a developer beta +in June 2003, and prior to release of the final version of the product in the first quarter of 2004. Therefore, during 2003 the Company capitalized approximately $14.7 million of +development costs associated with the development of Panther. Amortization of this asset began in the first quarter of 2004 when Panther was shipped and is being recognized on a +straight-line basis in accordance with SFAS No. 86 over a 3 year estimated useful life. During +the third and fourth quarters of 2002, the Company incurred substantial development costs associated with the development of Mac OS X version 10.2 (code-named "Jaguar") subsequent +to achievement of technological feasibility as evidenced by public demonstration and release of a developer beta in May 2002, and prior to release of the final version of the product in the +fourth quarter of 2002. As such, the Company capitalized approximately $13.3 million of development costs associated with development of Jaguar. Amortization of this asset began in the fourth +quarter of 2002 when Jaguar was shipped and is being recognized on a straight-line basis in accordance with SFAS No. 86 over a 3 year estimated useful life. In addition, +during 2002, the Company also began capitalizing certain costs related to development of its new PowerSchool enterprise student information system. Capitalization of approximately $6 million +began upon achievement of technological feasibility in the first quarter of 2002. The final version of the enterprise student information system was released in July 2002. During +2001 the Company incurred substantial development costs associated with the development of the original version of Mac OS X, subsequent to release of a public beta version of the product and +prior to release of the final product version. As a result, the Company capitalized approximately $5.4 million of development costs during 2001 associated with development of Mac OS X. Related +amortization is 65 computed +by use of the straight-line method in accordance with SFAS No. 86 over a 8 year estimated useful life. Total +amortization related to capitalized software development costs was $5.8 million, $1.2 million and $350,000 in 2003, 2002 and 2001, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $193 million, $209 million, and $261 million for 2003, 2002, and 2001, respectively. Restructuring Charges In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities . SFAS +No. 146 supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs +To Exit an Activity (Including Certain Costs Associated with a Restructuring) and requires that a liability for a cost associated with an exit or disposal activity be +recognized when the liability is incurred, as opposed to when management commits to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at +fair value. This Statement was effective for exit or disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 were required to be applied prospectively after +the adoption date to newly initiated exit activities. Stock-Based Compensation The Company measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (APB) +Opinion No. 25, Accounting for Stock Issued to Employees. The Company applies the disclosure provisions of SFAS No. 123, Accounting for Stock-based +Compensation , as amended by SFAS No. 148 , Accounting for Stock-based +Compensation—Transition and Disclosure as if the fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB +Opinion No. 25 because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123 requires use of option valuation models that were not developed for use +in valuing employee stock options and employee stock purchase plan shares. Under APB Opinion No. 25, when the exercise price of the Company's employee stock options equals the market price of +the underlying stock on the date of the grant, no compensation expense is recognized. As +required under SFAS No. 123, the pro forma effects of stock-based compensation on net income and earnings per common share for employee stock options granted and employee stock purchase plan +purchases have been estimated at the date of grant and beginning of the period, respectively, using a Black-Scholes option pricing model. For purposes of pro forma disclosures, the estimated fair +value of the options and shares is amortized to pro forma net income over the options' vesting period and the shares' plan period. The +Black-Scholes option valuation model was developed for use in estimating the fair value of freely traded options that have no vesting restrictions and are fully transferable. In addition, option +valuation models require the input of highly subjective assumptions including the expected life of options and the Company's expected stock price volatility. Because the Company's employee stock +options and employee stock purchase plan shares have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially +affect the fair value estimate, in 66 management's +opinion, the existing models do not provide a reliable measure of the fair value of the Company's employee stock options and employee stock purchase plan shares. For +purposes of pro forma disclosures, the estimated fair value of the options and shares is amortized to pro forma net income (loss) over the options' vesting period and the shares' plan period. The +Company's pro forma information for each of the last three fiscal years follows (in millions, except per share amounts): 2003 2002 2001 Net income (loss)—as reported $ 69 $ 65 $ (25 ) Add: Stock-based employee compensation expense included in reported net income (loss), net of tax 15 5 2 Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of tax (181 ) (234 ) (373 ) Net loss—pro forma $ (97 ) $ (164 ) $ (396 ) Net income (loss) per common share—as reported Basic $ 0.19 $ 0.18 $ (0.07 ) Diluted $ 0.19 $ 0.18 $ (0.07 ) Net loss per common share—pro forma Basic $ (0.27 ) $ (0.46 ) $ (1.15 ) Diluted $ (0.27 ) $ (0.46 ) $ (1.15 ) Earnings Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the +period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period +increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of +outstanding options and restricted stock is reflected in diluted earnings per share by application of the treasury stock method. Dilutive potential shares of common stock related to stock options were +excluded from the calculation of diluted loss per common share for fiscal 2001 because their effect would have been antidilutive. 67 The +following table sets forth the computation of basic and diluted earnings per share: For the Years Ended September 27, 2003 September 28, 2002 September 29, 2001 Numerator (in millions): Income (loss) before accounting changes $ 68 $ 65 $ (37 ) Cumulative effects of accounting changes, net of income taxes $ 1 $ — $ 12 Net income (loss) $ 69 $ 65 $ (25 ) Denominator (in thousands): Weighted-average shares outstanding 360,631 355,022 345,613 Effect of dilutive options and dilutive restricted stock 2,835 6,763 — Denominator for diluted earnings (loss) per share 363,466 361,785 345,613 Basic earnings (loss) per share before accounting changes $ 0.19 $ 0.18 $ (0.11 ) Cumulative effects of accounting changes, net of tax — — $ 0.04 Basic earnings (loss) per share after accounting changes $ 0.19 $ 0.18 $ (0.07 ) Diluted earnings (loss) per share before accounting changes $ 0.19 $ 0.18 $ (0.11 ) Cumulative effects of accounting changes, net of tax — — $ 0.04 Diluted earnings (loss) per share after accounting changes $ 0.19 $ 0.18 $ (0.07 ) Options +to purchase 50.8 million and 58.0 million shares of common stock were outstanding at the end of 2003 and 2002, respectively, that were not included in the computation of diluted +earnings per share for that year because the options' exercise price was greater than the average market price of the Company's common shares for that year and, therefore, the effect would be +antidilutive. At September 29, 2001, the Company had options to purchase 97.2 million shares of its common stock outstanding, all of which were excluded from the computation of diluted +loss per share for 2001 because the effect would have been antidilutive. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under +generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income is comprised of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Segment Information The Company reports segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions +and assessing performance as the source of the Company's reportable segments. Information about the Company's products, major customers, and geographic areas on a company-wide basis is +also disclosed. 68 Note 2—Financial Instruments The +carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate their fair value due to the short maturities of those instruments. Cash, Cash Equivalents and Short-Term Investments The following table summarizes the fair value of the Company's cash and available-for-sale securities held in its short-term investment +portfolio, recorded as cash and cash equivalents or short-term investments as of September 27, 2003, and September 28, 2002 (in millions): September 27, 2003 September 28, 2002 Cash $ 158 $ 161 U.S. Treasury and Agency securities 87 47 U.S. corporate securities 2,368 1,828 Foreign securities 783 216 Total cash equivalents 3,238 2,091 U.S. Treasury and Agency securities 454 674 U.S. corporate securities 623 1,330 Foreign securities 93 81 Total short-term investments 1,170 2,085 Total cash, cash equivalents, and short-term investments $ 4,566 $ 4,337 The +Company's short-term investment portfolio consists of investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities. The Company's U.S. +corporate securities consist primarily of commercial paper, certificates of deposit, time deposits and corporate debt securities. Foreign securities consist primarily of foreign commercial paper, +certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. The Company had net unrealized losses totaling $1 million on its investment +portfolio, primarily related to investments with stated maturities greater than 1 year as of September 27, 2003 and net unrealized gains of $20 million on its investment +portfolio, primarily related to investments with stated maturities greater than 1 year, as of September 28, 2002. The Company occasionally sells short-term investments prior +to their stated maturities. As a result of such sales, the Company recognized net gains of $21 million in 2003 and $7 million in 2002. These net gains were included in interest and other +income, net. As +of September 27, 2003, approximately $629 million of the Company's short-term investments had underlying maturities ranging from 1 to 5 years. The remaining +short-term investments as of September 27, 2003 had maturities of 3 to 12 months. As of September 28, 2002, approximately $1.087 billion of the Company's +short-term investments had underlying maturities ranging from 1 to 5 years. The remaining short-term investments as of September 28, 2002 had maturities of 3 to +12 months. Accounts Receivable Trade Receivables The Company distributes its products through third-party resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require +collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe and Asia +and by arranging with third- 69 party +financing companies to provide flooring arrangements and other loan and lease programs to the Company's direct customers. These credit financing arrangements are directly between the third-party +financing company and the end customer. As such, the Company does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade receivables that are +not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. Trade receivables from a single customer, +Ingram Micro, Inc., accounted for approximately 10.3% and 10.8% of net accounts receivable as of September 27, 2003, and September 28, 2002, respectively. The +following table summarizes the activity in the allowance for doubtful accounts (in millions): 2003 2002 2001 Beginning allowance balance $ 51 $ 51 $ 64 Charged to costs and expenses 4 10 7 Deductions (a) (6 ) (10 ) (20 ) Ending allowance balance $ 49 $ 51 $ 51 (a) Represents +amounts written off against the allowance, net of recoveries. Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of raw material components to these manufacturing vendors +who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these raw material components directly from suppliers. These non-trade +receivables, which are included in the consolidated balance sheets in other current assets, totaled $184 million and $142 million as of September 27, 2003, and +September 28, 2002, respectively. The Company does not recognize any profits on these sales or reflect the sale of these components in its net sales. Inventory Prepayment In April 2002, the Company made a $100 million prepayment to an Asian supplier for the purchase of components over the following nine months. In return for this +deposit, the supplier agreed to supply the Company with a specified level of components during the three consecutive fiscal quarters ended December 28, 2002. Approximately $53 million of +this deposit remained unused as of September 28, 2002 and was reflected in the consolidated balance sheets in other current assets. During the first six months of 2003, the remainder of the +deposit balance was fully utilized for the purchase of components. The deposit was unsecured and had no stated interest component. The Company imputed an amount to cost of sales and interest income +during each period the deposit was outstanding at a 3.25% interest rate to reflect the economics of this transaction. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign exchange and interest rate risk. Foreign currency forward and option contracts are used to +offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenues and cost of sales. From +time to time, the Company enters into interest rate swap agreements to modify the interest rate profile of certain investments and debt. The Company's 70 accounting +policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at +fair value. The +following table shows the notional principal, net fair value, and credit risk amounts of the Company's foreign currency instruments as of September 27, 2003 and September 28, 2002 +(in millions): September 27, 2003 September 28, 2002 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Credit Risk Amounts Foreign exchange instruments qualifying as accounting hedges: Spot/Forward contracts $ 464 $ (21 ) $ — $ 462 $ 1 $ 1 Purchased options $ 512 $ 3 $ 3 $ 196 $ — $ — Sold options $ 645 $ (8 ) $ — $ 392 $ (4 ) $ — Foreign exchange instruments other than accounting hedges: Spot/Forward contracts $ 445 $ 3 $ 3 $ 302 $ — $ — Purchased options $ 8 $ — $ — $ — $ — $ — Sold options $ 5 $ — $ — $ — $ — $ — The +notional principal amounts for derivative instruments provide one measure of the transaction volume outstanding as of year-end, and do not represent the amount of the Company's +exposure to credit or market loss. The credit risk amount shown in the table above represents the Company's gross exposure to potential accounting loss on these transactions if all counterparties +failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company's exposure to credit loss and market risk will +vary over time as a function of currency exchange rates. The +estimates of fair value are based on applicable and commonly used pricing models using prevailing financial market information as of September 27, 2003 and September 28, 2002. In +certain instances where judgment is required in estimating fair value, price quotes were obtained from several of the Company's counterparty financial institutions. Although the table above reflects +the notional principal, fair value, and credit risk amounts of the Company's foreign exchange instruments, it does not reflect the gains or losses associated with the exposures and transactions that +the foreign exchange instruments +are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market +conditions during the remaining life of the instruments. Foreign Exchange Risk Management The Company enters into foreign currency forward and option contracts with financial institutions primarily to protect against foreign exchange risk associated with existing +assets and liabilities, certain firmly committed transactions and certain probable but not firmly committed transactions. Generally, the Company's practice is to hedge a majority of its existing +material foreign exchange transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular +exposures, or limited availability of appropriate hedging instruments. 71 In +accordance with SFAS No. 133, hedges related to probable but not firmly committed transactions of an anticipatory nature are designated and documented at hedge inception as cash flow hedges +and evaluated for hedge effectiveness quarterly. For currency forward contracts, hedge effectiveness is measured based on changes in the total fair value of the contract attributable to changes in the +forward exchange rate. Changes in the expected future cash flows on the forecasted hedged transaction and changes in the fair value of the forward hedge are both measured from the contract rate to the +forward exchange rate associated with the forward contract's maturity date. For +currency option contracts, hedge effectiveness is measured based on changes in the total fair value of the option contract. Hedge effectiveness is assessed by comparing the present value of the +cumulative change in expected future cash flows on the hedged transaction to changes in expected cash flow of the option hedge at maturity. The net gains or losses on derivative instruments qualifying +as cash flow hedges are reported as components of other comprehensive income in shareholders' equity and reclassified into earnings in the same period or periods during which the hedged transaction +affects earnings. Any hedge ineffectiveness is recognized in current earnings in other income and expense. To +protect gross margins from fluctuations in foreign currency exchange rates, the Company's U.S. dollar functional subsidiaries hedge a portion of forecasted foreign currency revenues, and the +Company's non-U.S. dollar functional subsidiaries selling in local currencies hedge a portion of forecasted inventory purchases not denominated in the subsidiaries' functional currency. +Other comprehensive income associated with hedges of foreign currency revenues is recognized as a component of net sales in the same period as the related sales are recognized, and other comprehensive +income related to inventory purchases is recognized as a component of cost of sales in the same period as the related costs are recognized. Typically, the Company hedges portions of its forecasted +foreign currency exposure associated with revenues and inventory purchases over a time horizon of 3 to 9 months. The +Company also enters into foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the re-measurement of certain recorded assets and +liabilities in non-functional currencies. Changes in the fair value of these derivatives are recognized in current earnings in other income and expense as offsets to the changes in the +fair value of the related assets or liabilities. The +Company may enter into foreign currency forward contracts to offset the translation and economic exposure of a net investment position in a foreign subsidiary. Hedge effectiveness on forwards +designated as net investment hedges is measured based on changes in the fair value of the contract attributable to changes in the spot exchange rate. The effective portion of the net gain or loss on a +derivative instrument designated as a hedge of the net investment position in a foreign subsidiary is reported in the same manner as a foreign currency translation adjustment. Any residual changes in +fair value of the forward contract, including changes in fair value based on the differential between the spot and forward exchange rates, are recognized in current earnings in other income and +expense. As +discussed above, the Company enters into foreign currency option contracts as items that provide an offset to the re-measurement of certain recorded assets and liabilities denominated +in non-functional currencies. All changes in the fair value of these derivative contracts based on changes in option time value are recorded in current earnings in other income and +expense. Due to market movements, changes in option time value can lead to increased volatility in other income and expense. Derivative +instruments designated as cash flow hedges must be de-designated as hedges when it is probable that the forecasted hedged transaction will not occur in the initially identified +time period or within a subsequent 2 month time period. Deferred gains and losses in other comprehensive income associated with 72 such +derivative instruments are immediately reclassified into earnings in other income and expense. Any subsequent changes in fair value of such derivative instruments are also reflected in current +earnings unless they are re-designated as hedges of other transactions. During 2002, the Company recorded net gains of $2.5 million in other income and expense related to the loss +of hedge designation on discontinued cash flow hedges due to changes in the Company's forecast of future net sales and cost of sales and due to prevailing market conditions. During 2001, the Company +recorded a net gain of $5.1 million in other income and expense related to the loss of hedge designation on discontinued cash flow hedges due to changes in the Company's forecast of future net +sales and cost of sales. No net gains, or losses, of a similar nature were recorded in 2003. Interest Rate Risk Management The Company sometimes enters into interest rate derivative transactions, including interest rate swaps, collars, and floors, with financial institutions in order to better +match the Company's floating-rate interest income on its cash equivalents and short-term investments with its fixed-rate interest expense on its +long-term debt, and/or to diversify a portion of the Company's exposure away from fluctuations in short-term U.S. interest rates. As +of September 30, 2000, the Company had entered into interest rate swaps with financial institutions in order to better match the Company's floating-rate interest income on its +cash equivalents and short-term investments with its fixed-rate interest expense on its long-term debt, and to diversify a portion of the Company's exposure away +from fluctuations in short-term U.S. interest rates. The interest rate swaps generally required the Company to pay a floating interest rate based on the three- or six-month +U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of the underlying notional amounts. These swaps effectively converted the Company's fixed-rate 10-year +debt to floating-rate debt and converted a portion of the floating rate investments to fixed rate. The Company assumed no ineffectiveness with regard to the debt interest swaps as each +debt interest rate swap met the criteria for accounting under the short-cut method defined in SFAS No. 133 for fair value hedges of debt instruments. Accordingly, no net gains or +losses were recorded in income relative to the Company's underlying debt interest rate swaps. During fiscal 2001, the Company closed out all of its existing debt interest rate swap positions due to +prevailing market interest rates realizing a gain of $17 million. This gain was deferred, recognized in long-term debt and is being amortized to other income and expense over the +remaining life of the debt. The +unrealized loss on the asset swaps as of September 30, 2000, of $5.7 million was deferred and then recognized in income in 2001 as part of the SFAS No. 133 transition +adjustment effective on October 1, 2000. The Company closed out all of its existing interest rate asset swaps during 2001 realizing a gain of $1.1 million. As +of September 27, 2003 and September 28, 2002, the Company had no interest rate derivatives outstanding. Due to perceived market risk, the Company entered into interest rate swaps in +early 2002. The interest rate swaps required the Company to pay a floating interest rate based on six-month U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of the +underlying notional amounts. These swaps effectively converted the Company's fixed-rate 10-year debt to floating-rate debt. The Company assumed no ineffectiveness +with regard to the debt interest swaps as each debt interest rate swap met the criteria for accounting under the short-cut method defined in SFAS No. 133 for fair value hedges of +debt instruments. Accordingly, no net gains or losses were recorded in income relative to the Company's underlying debt interest rate swaps during fiscal 2002 until the Company closed out the +positions in late 2002 due to prevailing market interest rates. Closing the debt interest rate swaps resulted in a realized gain 73 of +$6 million. This gain was deferred, recognized in long-term debt and is being amortized to other income and expense over the remaining life of the debt. Debt The Company currently has debt outstanding in the form of $300 million of aggregate principal amount 6.5% unsecured notes that were originally issued in 1994. The notes, +which pay interest semiannually, were sold at 99.925% of par, for an effective yield to maturity of 6.51%. The notes, along with approximately $4 million of related unamortized deferred gains +on closed interest rate swaps, are due in February of 2004 and therefore have been classified as current debt as of September 27, 2003. As of September 27, 2003 and September 28, +2002, the carrying amount of these notes, including unamortized deferred gains associated with closed debt interest rate swaps, was $304 million and $316 million, respectively, while the +fair value was $302 million and $299 million, respectively. The fair value of the notes is based on their listed market values as of September 27, 2003 and September 28, +2002. Non-Current Debt and Equity Investments and Related Gains and Losses The Company has held investments in EarthLink, Inc. (EarthLink), Akamai Technologies, Inc. (Akamai), ARM Holdings plc (ARM), and Samsung Electronics +Co., Ltd (Samsung). These investments have been reflected in the consolidated balance sheets as long term assets within other assets and have been categorized as +available-for-sale requiring that they be carried at fair value with unrealized gains and losses, net of taxes, reported in equity as a component of accumulated other +comprehensive income. All realized gains on the sale of these investments have been included in total other income and expense. The combined fair value of these investments held by the Company was +$5 million and $39 million as of September 27, 2003 and September 28, 2002, respectively. EarthLink In January 2000, the Company invested $200 million in EarthLink, an Internet service provider (ISP). The investment was in EarthLink's Series C Convertible +Preferred Stock, which was convertible by the Company after January 4, 2001, into approximately 7.1 million shares of EarthLink common stock. Concurrent with this investment, EarthLink +and the Company entered into a multi-year agreement to deliver ISP service to Macintosh users in the United States. Under the terms of the agreement, the Company profits from each new Mac +customer that subscribes to EarthLink's ISP service for a specified period of time, and EarthLink is the default ISP in the Company's Internet Setup Software included with all Macintosh computers sold +in the United States. During +the first quarter of 2003, the Company sold 2,580,000 shares of EarthLink stock for net proceeds of approximately $13.7 million, an amount that approximated the Company's carrying value +of the shares. During the third quarter of 2003, the Company sold all of its remaining holdings in EarthLink, consisting of 3,960,000 shares of stock for net proceeds of approximately +$23 million, and a gain before taxes of $2 million. During +the first quarter of 2002, the Company sold 117,000 shares of EarthLink stock for net proceeds of $2 million and a gain before taxes of $223,000. No sales of EarthLink were made in any +of the subsequent quarters of fiscal 2002. However, during the fourth quarter of 2002, the Company determined that the then current decline in the fair value of its investment in EarthLink was +other-than-temporary. As a result, the Company recognized a $44 million charge to earnings to write-down the basis of its investment in EarthLink to +$35 million. This charge was included in gains (losses) on non-current investments, net. As of September 28, 2002, the Company held 6.5 million shares of EarthLink +stock valued at $35 million. 74 During +the second quarter of 2001, the Company determined that the decline in the fair value of its investment in EarthLink was other-than-temporary requiring that its cost +basis be written down to fair value as a new cost basis and the amount of the write-down be included in earnings. As a result, the Company recognized a $114 million charge to +earnings to write-down the basis of its investment in EarthLink to $86 million. This charge was included in gains (losses) on non-current investments, net. During the +fourth quarter of 2001, the Company sold a total of approximately 425,000 shares of EarthLink stock for net proceeds of approximately $6 million, recorded a gain before taxes of approximately +$800,000, and recognized related income tax of approximately $200,000. Akamai In June 1999, the Company invested $12.5 million in Akamai, a global Internet content delivery service. The investment was in the form of convertible preferred +stock that converted into 4.1 million shares of Akamai common stock (adjusted for subsequent stock splits) at the time of Akamai's initial public +offering in October 1999. Beginning in the first quarter of 2000, the Company categorized its shares in Akamai as available-for-sale. During +the fourth quarter of 2003, the Company sold 1,875,000 shares of Akamai stock for net proceeds of $9 million and a gain before taxes of $8 million. As of September 27, +2003, the Company's remaining investment in Akamai consists of 986,000 shares of Akamai stock valued at $5 million. During +the first quarter of 2002, the Company sold 250,000 shares of Akamai stock for net proceeds of $2 million and a gain before taxes of $710,000. No sales of Akamai were made in any of the +subsequent quarters of fiscal 2002. However, during the fourth quarter of 2002, the Company determined that the decline in the fair value of its investment in Akamai was +other-than-temporary. As a result, the Company recognized a $6 million charge to earnings to write-down the basis of its investment in Akamai to +$3 million. This charge was included in gains (losses) on non-current investments, net. As of September 28, 2002, the Company held 2.9 million shares of Akamai stock +valued at $3 million. During +2001, the Company sold a total of approximately 1 million shares of Akamai stock for net proceeds of approximately $39 million and recorded a gain before taxes of approximately +$36 million. ARM ARM is a publicly held company in the United Kingdom involved in the design and licensing of high performance microprocessors and related technology. During +the third quarter of 2003, the Company sold all of its remaining holdings in ARM stock, consisting of 278,000 shares for net proceeds of approximately $295,000, and a gain before taxes of +$270,000. During +the first quarter of 2002, the Company sold 4.7 million shares of ARM stock for both net proceeds and a gain before taxes of $21 million. No sales of ARM were made in any of the +subsequent quarters of fiscal 2002. As of September 28, 2002, the Company held 278,000 shares of ARM stock valued at $578,000. During +2001, the Company sold a total of approximately 29.8 million shares of ARM stock for net proceeds of approximately $176 million, recorded a gain before taxes of approximately +$174 million, and recognized related income tax expense of approximately $52 million. 75 Samsung During the fourth quarter of 1999, the Company invested $100 million in Samsung to assist in the further expansion of Samsung's TFT-LCD +flat-panel display production capacity. The investment was in the form of three year unsecured bonds, which were convertible into approximately 550,000 shares of Samsung common stock +beginning in July 2000. The bonds carried an annual coupon rate of 2% and paid a total yield to maturity of 5% if redeemed at maturity. Prior +to its sale, the Company had categorized its investment in Samsung as available-for-sale requiring that it be carried at fair value with unrealized gains and losses, net +of taxes, reported in equity as a component of accumulated other comprehensive income. The fair value of the Company's investment in Samsung was approximately $123 million as of +September 30, 2000. With the adoption of SFAS No. 133 on October 1, 2000, the Company was required to account for the conversion option embedded in the Samsung bonds separately +from the related debt. The conversion feature was carried at fair value with any changes in fair value recognized in earnings in the period in which they occur. Included in the $17 million +gross SFAS No. 133 transition adjustment recorded in earnings during the first quarter of fiscal 2001 was a $23 million favorable adjustment for the restatement to fair value as of +October 1, 2000, of the derivative component of the Company's investment in Samsung. To adjust the carrying value of the derivative component of its investment in Samsung to fair value as of +December 30, 2000, the Company recognized an unrealized loss of approximately $13 million during the first quarter of 2001. During the second quarter of 2001, the Company sold this +investment for book value, including accrued interest, and received net proceeds of approximately $117 million. Other Strategic Investments The Company has made additional minority debt and equity investments in several privately held technology companies, which were reflected in the consolidated balance sheets in +other assets. These investments were inherently risky because the products and/or markets of these companies were typically not fully developed. During 2002 and 2001, the Company determined that the +decline in fair value of certain of these investments was other-than-temporary and, accordingly, recognized a charge to earnings of $15 million and $8 million, +respectively. These charges +were included in gains (losses) on non-current investments, net. As of September 27, 2003 and September 28, 2002, the Company had no private debt or equity investments +reflected in its consolidated balance sheets. Note 3—Consolidated Financial Statement Details (in millions) Inventories 2003 2002 Purchased parts $ 2 $ 9 Work in process 4 — Finished goods 50 36 Total inventories $ 56 $ 45 76 Other Current Assets 2003 2002 Vendor non-trade receivables $ 184 $ 142 Other current assets 125 133 Total other current assets $ 309 $ 275 Property, Plant, and Equipment 2003 2002 Land and buildings $ 350 $ 342 Machinery, equipment, and internal-use software 393 367 Office furniture and equipment 74 67 Leasehold improvements 357 281 1,174 1,057 Accumulated depreciation and amortization (505 ) (436) Net property, plant, and equipment $ 669 $ 621 Other Assets 2003 2002 Non-current deferred tax assets $ 60 $ 70 Non-current debt and equity investments 5 39 Capitalized software development costs, net 28 19 Other assets 57 42 Total other assets $ 150 $ 170 Accrued Expenses 2003 2002 Deferred revenue $ 368 $ 240 Accrued marketing and distribution 124 136 Accrued compensation and employee benefits 101 93 Accrued warranty and related costs 67 69 Other current liabilities 239 209 Total accrued expenses $ 899 $ 747 77 Interest and Other Income, Net 2003 2002 2001 Interest income $ 69 $ 118 $ 218 Interest expense (8 ) (11 ) (16 ) Gains on sales of short term investments 21 7 — Other income (expense) net (5 ) (2 ) 15 Gain on forward purchase agreement 6 — — Total interest and other income, net $ 83 $ 112 $ 217 Note 4—Acquisitions Goodwill and Other Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 10 years. The Company ceased amortization of +goodwill at the beginning of fiscal 2002 when it adopted SFAS No. 142. The +following table summarizes the components of gross and net intangible asset balances (in millions): September 27, 2003 September 28, 2002 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Goodwill (a) $ 85 — $ 85 $ 85 — $ 85 Other acquired intangible assets 5 (5 ) — 5 (5 ) — Acquired technology 42 (18 ) 24 42 (8 ) 34 Total acquired intangible assets $ 132 $ (23 ) $ 109 $ 132 $ (13 ) $ 119 (a) Accumulated +amortization related to goodwill of $55 million arising prior to the adoption of SFAS No. 142 has been reflected in the gross carrying amount of goodwill as +of September 27, 2003 and September 28, 2002. Expected +annual amortization expense related to acquired technology is as follows (in millions): Fiscal Years: 2004 $ 7 2005 5 2006 3 2007 2 Thereafter 7 Total expected annual amortization expense $ 24 78 Amortization +expense related to acquired intangible assets is as follows (in millions): 2003 2002 2001 Goodwill amortization $ — $ — $ 16 Other acquired intangible assets amortization — 1 3 Acquired technology amortization 10 5 2 Total amortization $ 10 $ 6 $ 21 Net +loss and net loss per share adjusted to exclude amortization of goodwill in fiscal periods prior to the adoption of SFAS No. 142 in fiscal 2002 follows (in millions, except per share +amounts): 2001 Net loss, as reported $ (25 ) Add: goodwill amortization $ 16 Net loss, as adjusted $ (9 ) Basic loss per share, as reported $ (0.07 ) Add: goodwill amortization $ 0.04 Basic loss per share, as adjusted $ (0.03 ) Diluted loss per share, as reported $ (0.07 ) Add: goodwill amortization $ 0.04 Diluted loss per share, as adjusted $ (0.03 ) Acquisition of Emagic GmbH During the fourth quarter of 2002, the Company acquired Emagic GmbH (Emagic), a provider of professional software solutions for computer based music production, for +approximately $30 million in cash; $26 million of which was paid immediately upon closing of the deal and $4 million of which was held-back for future payment +contingent on continued employment by certain employees that will be allocated to future compensation expense in the appropriate periods over the next 3 years. During fiscal 2003, contingent +consideration totaling $1.3 million was paid. The acquisition has been accounted for as a purchase. The portion of the purchase price allocated to purchased in-process research and +development (IPR&D) was expensed immediately, and the portion of the purchase price allocated to acquired technology and to tradename will be amortized over their estimated useful lives of +3 years. Goodwill associated with the acquisition of Emagic is not subject to amortization pursuant to the provisions of SFAS No. 142. Total consideration was allocated as follows (in +millions): Net tangible assets acquired $ 2.3 Acquired technology 3.8 Tradename 0.8 In-process research and development 0.5 Goodwill 18.6 Total consideration $ 26.0 79 The +amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of products under development had not been established and no alternative +future uses existed. The IPR&D relates primarily to Emagic's Logic series technology and extensions. At the date of the acquisition, the products under development were between 43%-83% +complete, and it was expected that the remaining work would be completed during the Company's fiscal 2003 at a cost of approximately $415,000. The remaining efforts, which were completed in 2003, +included finalizing user interface design and development, and testing. The fair value of the IPR&D was determined using an income approach, which reflects the projected free cash flows that will be +generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount rate of 25%. Acquisition of certain assets of Zayante, Inc., Prismo Graphics, and Silicon Grail During fiscal 2002 the Company acquired certain technology and patent rights of Zayante, Inc., Prismo Graphics, and Silicon Grail Corporation for a total of +$20 million in cash. These transactions have been accounted for as asset acquisitions. The purchase price for these asset acquisitions, except for $1 million identified as contingent +consideration which will be allocated to compensation expense over the next 3 years, has been allocated to acquired technology and will be amortized on a straight-line basis over +3 years, except for certain assets acquired from Zayante associated with patent royalty streams that will be amortized over 10 years. Acquisition of Nothing Real, LLC During the second quarter of 2002, the Company acquired certain assets of Nothing Real, LLC (Nothing Real), a privately-held company that develops and markets high +performance tools designed for the digital image creation market. Of the $15 million purchase price, the Company has allocated $7 million to acquired technology, which will be amortized +over its estimated life of 5 years. The remaining $8 million, which has been identified as contingent consideration, rather than recorded as an additional component of the cost of the +acquired assets, will be allocated to future compensation expense in the appropriate periods over the next 3 years. Acquisition of Spruce Technologies, Inc. In July 2001, the Company acquired Spruce Technologies, Inc. (Spruce), a privately-held company that develops and markets DVD authoring products, for +$14.9 million in cash. Goodwill associated with the acquisition of Spruce is not subject to amortization pursuant to the transition provisions of SFAS No. 142. The consolidated financial +statements include the operating results of Spruce from the date of acquisition. Total consideration was allocated as follows (in millions): Net tangible liabilities assumed $ (0.7 ) Identifiable intangible assets 5.9 Goodwill 9.7 Total consideration $ 14.9 Acquisition of PowerSchool, Inc. In May 2001, the Company acquired PowerSchool, Inc. (PowerSchool), a provider of web-based student information systems for K-12 schools +and districts that enable schools to record, access, report, and manage their student data and performance in real-time, and gives parents real-time web access to track 80 their +children's progress. The consolidated financial statements include the operating results of PowerSchool from the date of acquisition. The +purchase price of approximately $66.1 million consisted of the issuance of approximately 2.4 million shares of the Company's common stock with a fair value of $61.2 million, +the issuance of stock options with a fair value of $4.5 million, and $300,000 of direct transaction costs. The fair value of the common stock options issued was determined using a Black-Scholes +option pricing model with the following assumptions: volatility of 67%, expected life of 4 years, dividend rate of 0%, and risk-free rate of 4.73%. Total +consideration was allocated as follows (in millions): Net tangible assets acquired $ 0.2 Deferred stock compensation 12.8 Identifiable intangible assets 2.6 In-process research and development 10.8 Goodwill 39.7 Total consideration $ 66.1 The +amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of products under development had not been established and no alternative +future uses existed. The IPR&D relates to technologies representing processes and expertise employed to design, develop, and deploy a functioning, scalable web-based student information +system for use by K-12 schools. At the date of the acquisition, the product under development was approximately 50% complete, and it was expected that the remaining 50% would be completed +during the Company's fiscal 2002 at a cost of approximately $9.25 million. The remaining efforts, which were completed in 2002, included completion of coding, finalizing user interface design +and development, and testing. The fair value of the IPR&D was determined using an income approach, which reflects the projected free cash flows that will be generated by the IPR&D projects and that +are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount rate of 25%. The acquired intangibles are being amortized over +their estimated useful lives of 3 years. Deferred stock compensation associated with restricted stock and options is being amortized over the required future vesting period of 3 years. In +the fourth quarter of 2001, an adjustment was made to increase goodwill associated with the acquisition of PowerSchool by $5.9 million due to the identification of previously unidentified +loss contingencies that were in existence prior to consummation of the acquisition. The +Company allocated $12.8 million of its purchase consideration for PowerSchool to deferred stock compensation within shareholders' equity. This amount represented the intrinsic value of +stock options assumed that vest as future services are provided by employees and related to 445,000 common shares issued contingent on continued employment of certain PowerSchool employee +stockholders. Certain PowerSchool employee stockholders were terminated in the first quarter of 2003 resulting in the $5 million recognition of previously deferred stock compensation as part of +the Company's first quarter restructuring action. Unamortized PowerSchool related deferred stock compensation of approximately $294,000 remains as of September 27, 2003. Pro Forma Financial Information The unaudited pro forma financial information below presents the condensed consolidated financial results of the Company assuming that PowerSchool and Spruce, acquired in 2001, +had been acquired at the 81 beginning +of 2001 and includes the effect of amortization of goodwill and other acquired identifiable intangible assets from that date. The impact of the charge for IPR&D associated with the +acquisition of PowerSchool has been excluded. This pro forma financial information is presented for informational purposes only and is not necessarily indicative of the results of future operations +that would have been achieved had the acquisitions taken place at the beginning of 2001. Pro forma information follows (in millions, except per share amounts): 2001 Net sales $ 5,370 Net loss $ (44 ) Basic loss per common share $ (0.13 ) Diluted loss per common share $ (0.13 ) Note 5—Restructuring Charges Fiscal 2003 Restructuring Actions The Company recorded total restructuring charges of approximately $26.8 million during the year ended September 27, 2003, including approximately +$7.4 million in severance costs, a $5.0 million charge to write-off deferred compensation, $7.1 million in asset impairments and a $7.3 million +charge for lease cancellations. Of the $26.8 million, nearly all had been spent by the end of 2003, except for approximately $400,000 of severance costs and approximately $4.5 million +related to operating lease costs on abandoned facilities. During the third quarter of 2003, approximately $500,000 of the amount originally accrued for lease cancellations was determined to be in +excess due to the sublease of a property sooner than originally estimated and an approximately $500,000 shortfall was identified in the severance accrual due to higher than expected severance costs +related to the closure of the Company's Singapore manufacturing operations. These adjustments had no net effect on reported operating expense. During +the second quarter of 2003, the Company's management approved and initiated restructuring actions that resulted in recognition of a total restructuring charge of $2.8 million, including +$2.4 million in severance costs and $400,000 for asset write-offs and lease payments on an abandoned facility. Actions taken in the second quarter were for the most part +supplemental to actions initiated in the prior two quarters and focused on further headcount reductions in various sales and marketing functions in the Company's Americas and Europe operating segments +and further reductions associated with PowerSchool-related activities in the Americas operating segment, including an accrual for asset write-offs and lease payments on an abandoned +facility. The second quarter actions resulted in the termination of 93 employees, 92 were terminated prior to the end of 2003. During +the first quarter of 2003, the Company's management approved and initiated restructuring actions with a total cost of $24 million that resulted in the termination of manufacturing +operations at the Company-owned facility in Singapore, further reductions in headcount resulting from the shift in PowerSchool product strategy that took place at the end of fiscal 2002, and +termination of various sales and marketing activities in the United States and Europe. These restructuring actions will ultimately result in the elimination of 260 positions worldwide, all but one of +which were eliminated by the end of 2003. Closure +of the Company's Singapore manufacturing operations resulted in severance costs of $1.8 million and costs of $6.7 million to write-off manufacturing related fixed +assets, whose use ceased during the first quarter. PowerSchool related costs included severance of approximately $550,000 and recognition of $5 million of previously deferred stock compensation +that arose when PowerSchool was acquired by the 82 Company +in 2001 related to certain PowerSchool employee stockholders who were terminated in the first quarter of 2003. Termination of sales and marketing activities and employees, principally in the +United States and Europe, resulted in severance costs of $2.8 million and accrual of costs associated with operating leases on closed facilities of $6.7 million. The total net +restructuring charge of $23 million recognized during the first quarter of 2003 also reflects the reversal of $600,000 of unused restructuring accrual originally made during the first quarter +of 2002. Except +for certain costs associated with operating leases on closed facilities, the Company currently anticipates that all of the remaining accrual for severance costs of approximately $400,000 will +be spent by the end of the first quarter of fiscal 2004. The +following table summarizes activity associated with restructuring actions initiated during fiscal 2003 (in millions): Employee Severance Benefits Deferred Compensation Write-off Asset Impairments Lease Cancellations Totals Total charge $ 7.4 $ 5.0 $ 7.1 $ 7.3 $ 26.8 Total spending through September 27, 2003 (7.5 ) — — (2.3 ) (9.8 ) Total non-cash items — (5.0 ) (7.1 ) — (12.1 ) Adjustments 0.5 — — (0.5 ) — Accrual at September 27, 2003 $ 0.4 $ — $ — $ 4.5 $ 4.9 Fiscal 2002 Restructuring Actions During fiscal 2002, the Company recorded total restructuring charges of approximately $30 million related to actions intended to eliminate certain activities and better +align the Company's operating expenses with existing general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company's +Retail operating segment. During +the fourth quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $6 million designed to reduce headcount costs in +corporate operations and sales and to adjust its PowerSchool product strategy. These restructuring actions resulted in the elimination of approximately 180 positions worldwide at a cost of +$1.8 million, all of which were eliminated by September 27, 2003. Eliminated positions were primarily in corporate operations, sales, and PowerSchool related research and development in +the Americas operating segment. The shift in product strategy at PowerSchool included discontinuing development and marketing of PowerSchool's PSE product. This shift resulted in the impairment of +previously capitalized development costs associated with the PSE product in the amount of $4.5 million. During +the first quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $24 million. These restructuring actions resulted in +the elimination of approximately 425 positions worldwide at a cost of $8 million. Positions were eliminated primarily in the Company's operations, information systems, and administrative +functions. In addition, these restructuring actions also included significant changes in the Company's information systems strategy resulting in termination of equipment leases and cancellation of +existing projects and activities. The Company ceased using the assets associated with first quarter 2002 restructuring actions during that same quarter. Related lease and contract cancellation charges +totaled $12 million, and charges for asset impairments totaled 83 $4 million. +The first quarter 2002 restructuring actions were primarily related to corporate activity not allocated to operating segments. During the first quarter of 2003, the Company reversed +the remaining unused accrual of $600,000. The +following table summarizes activity associated with restructuring actions initiated during fiscal 2002 (in millions): Employee Severance Benefits Asset Impairments Lease and Contract Cancellations Totals Total charge $ 10 $ 8 $ 12 $ 30 Total spending through September 27, 2003 (10 ) — (11 ) (21 ) Total non-cash items — (8 ) — (8 ) Adjustments — — (1 ) (1 ) Accrual at September 27, 2003 $ — $ — $ — $ — Note 6—Income Taxes The +provision for income taxes consisted of the following (in millions): 2003 2002 2001 Federal: Current $ 18 $ 12 $ (20 ) Deferred (7 ) (32 ) (8 ) 11 (20 ) (28 ) State: Current 4 3 — Deferred (11 ) 6 (10 ) (7 ) 9 (10 ) Foreign: Current 21 29 21 Deferred (1 ) 4 2 20 33 23 Provision for income taxes $ 24 $ 22 $ (15 ) 84 The +foreign provision for income taxes is based on foreign pretax earnings of approximately $250 million, $284 million and $363 million in 2003, 2002, and 2001, respectively. As +of September 27, 2003, approximately $2.5 billion of the Company's cash, cash equivalents, and short-term investments are held by foreign subsidiaries and are generally based +in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries would be subject to U.S. income taxation on repatriation to the United States. The Company's consolidated financial statements +fully provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company's foreign subsidiaries that are intended to be indefinitely +reinvested in operations outside the United States. U.S. income taxes have not been provided on a cumulative total of $822 million of such earnings. It is not practicable to determine the +income tax liability that might be incurred if these earnings were to be distributed. Deferred +tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts +of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected +to be recovered or settled. As +of September 27, 2003 and September 28, 2002, the significant components of the Company's deferred tax assets and liabilities were (in millions): 2003 2002 Deferred tax assets: Accounts receivable and inventory reserves $ 35 $ 32 Accrued liabilities and other reserves 155 126 Basis of capital assets and investments 47 34 Tax losses and credits 204 125 Other 11 11 Total deferred tax assets 452 328 Less valuation allowance 30 30 Net deferred tax assets 422 298 Deferred tax liabilities: Unremitted earnings of subsidiaries 398 293 Available-for-sale securities — 1 Total deferred tax liabilities 398 294 Net deferred tax asset $ 24 $ 4 As +of September 27, 2003, the Company had operating loss carryforwards for federal tax purposes of approximately $189 million, which expire from 2011 through 2023. A portion of these +carryforwards was acquired from NeXT and other acquisitions, the utilization of which is subject to certain limitations imposed by the Internal Revenue Code. The Company also has Federal credit +carryforwards and various state and foreign tax loss and credit carryforwards, the tax effect of which is approximately $117 million and which expire between 2004 and 2023. The remaining +benefits from tax losses and credits do not expire. As of September 27, 2003, a valuation allowance of $30 million was recorded against the deferred tax asset for the benefits of tax +losses that may not be realized. The valuation allowance relates primarily to the operating loss carryforwards acquired from NeXT and other acquisitions. Management believes it is more likely than not +that forecasted income, including income that may be generated as a result of certain tax 85 planning +strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. A +reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate (35% in 2003, 2002, and 2001) to income (loss) before provision for +(benefit from) income taxes, is as follows (in millions): 2003 2002 2001 Computed expected tax (benefit) $ 32 $ 30 $ (18 ) State taxes, net of federal effect (4 ) 7 (7 ) Indefinitely invested earnings of foreign subsidiaries (13 ) — — Nondeductible executive compensation 5 (1 ) — Stock repurchase (2 ) — — Purchase accounting and asset acquisitions 4 3 10 Change in valuation allowance — (16 ) — Research & development credit, net (7 ) (8 ) (5 ) Nondeductible expenses 6 4 3 Other items 3 3 2 Provision for (benefit from) income taxes $ 24 $ 22 $ (15 ) Effective tax rate 26 % 25 % 30 % On +April 10, 2003, the Internal Revenue Service (IRS) completed its audit of the Company's federal income tax returns for the years 1998 through 2000 and proposed certain adjustments. Certain +of these adjustments are being contested through the IRS Appeals Office. Substantially all IRS audit issues for years prior to 1998 have been resolved. Management believes that adequate provision has +been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. Should any issues addressed in the Company's tax audits be +resolved in a manner not consistent with management's expectations, the Company could be required to adjust its provision for income tax in the period such resolution occurs. Note 7—Shareholders' Equity CEO Restricted Stock Award On March 19, 2003, the Company entered into an Option Cancellation and Restricted Stock Award Agreement (the Agreement) with Steven P. Jobs, its Chief Executive Officer +(CEO). The Agreement cancelled stock option awards for the purchase of 27.5 million shares of the Company's common stock previously granted to Mr. Jobs in 2000 and 2001. Mr. Jobs +retained options to purchase 60,000 shares of the Company's common stock granted in August of 1997 in his capacity as a member of the Company's Board of Directors, prior to becoming the Company's CEO. +The Agreement replaced the cancelled options with a restricted stock award of 5 million shares of the Company's common stock. The restricted stock award generally vests three years from date of +grant. Vesting of some or all of the restricted shares will be accelerated in the event Mr. Jobs is terminated without cause, dies, or has his management role reduced following a change in +control of the Company. The +Company has recorded the value of the restricted stock award of $74.75 million as a component of shareholders' equity and is amortizing that amount on a straight-line basis over +the 3-year service/vesting period. The value of the restricted stock award was based on the closing market price of the Company's 86 common +stock on the date of the award. Total amortization of approximately $13 million has been included in selling, general, and administrative expense in 2003 and will continue to be included +at approximately $6.2 million per quarter through March 2006. The 5 million restricted shares have been included in the calculation of diluted earnings per share utilizing the +treasury stock method. Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During +the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per +share for a total cost of $25.5 million. In August 2003, the Company settled this agreement prior to its maturity, at which time the Company's common stock had a fair value of $22.81. +Other than this forward purchase transaction, the Company has not engaged in any transactions to repurchase its common stock since fiscal 2000. Since inception of the stock repurchase plan, the +Company had repurchased a total of 6.55 million shares at a cost of $217 million. The Company was authorized to repurchase up to an additional $283 million of its common stock as +of September 27, 2003. Preferred Stock In August 1997, the Company and Microsoft Corporation (Microsoft) entered into patent cross license and technology agreements. In addition, Microsoft purchased 150,000 +shares of Apple Series A nonvoting convertible preferred stock ("preferred stock") for $150 million. These shares were convertible by Microsoft after August 5, 2000, into shares +of the Company's common stock at a conversion price of $8.25 per share. During 2000, 74,250 shares of preferred stock were converted to 9 million shares of the Company's common stock. During +2001, the remaining 75,750 preferred shares were converted into 9.2 million shares of the Company's common stock. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under +generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income consists of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. The +following table summarizes the components of accumulated other comprehensive income (loss), net of taxes (in millions): 2003 2002 2001 Unrealized gains on available-for-sale securities $ 1 $ 13 $ 30 Unrealized gains (losses) on derivative investments (16 ) (11 ) 4 Cumulative foreign currency translation (20 ) (51 ) (56 ) Accumulated other comprehensive income (loss) $ (35 ) $ (49 ) $ (22 ) 87 The +following table summarizes activity in other comprehensive income related to available-for-sale securities, net of taxes (in millions): 2003 2002 2001 Change in fair value of available-for-sale securities $ 11 $ (49 ) $ (183 ) Adjustment for net (gains) losses realized and included in net income (loss) (23 ) 32 (84 ) Change in unrealized gain on available-for-sale securities $ (12 ) $ (17 ) $ (267 ) The +tax effect related to the change in unrealized gain on available-for-sale securities was $6 million, $10 million, $157 million for fiscal 2003, 2002, +and 2001, respectively. The tax effect on the reclassification adjustment for net gains (losses) included in net income (loss) was $(8) million, $10 million and $35 million for fiscal +2003, 2002, and 2001, respectively. The +following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company (in millions): 2003 2002 2001 Changes in fair value of derivatives $ (24 ) $ 4 $ 45 Adjustment for net gains realized and included in net income (loss) 19 (19 ) (53 ) Cumulative effect of adopting SFAS No. 133 — — 12 Change in unrealized gain on derivative instruments $ (5 ) $ (15 ) $ 4 The +tax effect related to the cumulative effect of adopting SFAS No. 133 was $(5) as of September 29, 2001. The tax effect related to the changes in fair value of derivatives was +$11 million, $(2) million and $(19) million for fiscal 2003, 2002, and 2001, respectively. The tax effect related to derivative gains (losses) reclassified from other comprehensive income was +$(7) million, $8 million and $23 million for fiscal 2003, 2002, and 2001, respectively. Note 8—Employee Benefit Plans 2003 Employee Stock Option Plan At the Annual Meeting of Shareholders held on April 24, 2003, the shareholders approved an amendment to the 1998 Executive Officer Stock Plan to change the name of the +plan to the 2003 Employee Stock Option Plan (the 2003 Plan), to provide for broad-based grants to all employees in addition to executive officers and other key employees and to prohibit future +"repricings" of employee stock options, including +6-months-plus-1-day option exchange programs, without shareholder approval. Based on the terms of individual option grants, options granted under the +2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly +vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, restricted stock, stock appreciation rights, and stock purchase rights. 1997 Employee Stock Option Plan In August 1997, the Company's Board of Directors approved the 1997 Employee Stock Option Plan (the 1997 Plan), a non-shareholder approved plan for grants of +stock options to employees who are not officers of the Company. Options may be granted under the 1997 Plan to employees at not less than the fair market value on the date of grant. Based on the terms +of individual option grants, options granted under the 1997 88 Plan +generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly +vesting. As a result of shareholder approval of amendments to the 1998 Executive Officer Stock Plan in April 2003, the Company terminated the 1997 Employee Stock Option Plan and cancelled all +remaining unissued shares, following the completion of an employee stock option exchange program in October 2003. Employee Stock Option Exchange Program On March 20, 2003, the Company announced a voluntary employee stock option exchange program (the Exchange Program) whereby eligible employees, other than executive +officers and members of the Board of Directors, had an opportunity to exchange outstanding options with exercise prices at or above $25.00 per share for a predetermined smaller number of new stock +options issued with exercise prices equal to the fair market value of one share of the Company's common stock on the day the new awards are issued, which would be at least six months plus one day +after the exchange options are cancelled. On April 17, 2003, in accordance with the Exchange Program, the Company accepted and cancelled options to purchase 16,569,193 shares of its common +stock. On October 22, 2003, new stock options totaling 6,697,368 shares were issued to employees at an exercise price of $22.76 per share, which is equivalent to the closing price of the +Company's stock on that date. No financial or accounting impact to the Company's financial position, results of operations or cash flow was associated with this transaction. 1997 Director Stock Option Plan In August 1997, the Company's Board of Directors adopted a shareholder approved Director Stock Option Plan (DSOP) for non-employee directors of the Company. +Initial grants of 30,000 options under the DSOP vest in three equal installments on each of the first through third +anniversaries of the date of grant, and subsequent annual grants of 10,000 options are fully vested at grant. Rule 10b5-1 Trading Plans Certain of the Company's executive officers, including Mr. Timothy D. Cook and Mr. Fred D. Anderson, have entered into trading plans pursuant to +Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended. A trading plan is a written document that pre-establishes the amounts, prices and dates (or formula +for determining the amounts, prices and dates) of future purchases or sales of Apple stock including the exercise and sale of employee stock options and shares acquired pursuant to the Company's +Employee Stock Purchase Plan. Employee Stock Purchase Plan The Company has a shareholder approved employee stock purchase plan (the Purchase Plan), under which substantially all employees may purchase common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six-month offering periods. Stock purchases under the Purchase Plan are limited to +10% of an employee's compensation, up to a maximum of $25,000 in any calendar year. In the third quarter of 2003, the Company's shareholders also approved an amendment to the Employee Stock Purchase +Plan to increase the number of shares authorized for issuance by 4 million shares. Beginning with the six-month offering period that started on June 30, 2003, the number of +shares authorized for issuance is limited to a total of 1 million shares per offering period. During 2003, 2002, and 2001, 2.1 million, 1.8 million and 1.8 million shares, +respectively, were issued under the Purchase Plan. As of September 27, 2003, approximately 4.0 million shares were reserved for future issuance under the Purchase Plan. 89 Employee Savings Plan The Company has an employee savings plan (the Savings Plan) qualifying as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the +Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the Internal Revenue Service annual contribution limit ($12,000 for calendar year 2003). The +Company matches 50% to 100% of each employee's contributions, depending on length of service, up to a maximum 6% of the employee's earnings. The Company's matching contributions to the Savings Plan +were approximately $21 million, $19 million, and $17 million in 2003, 2002, and 2001, respectively. Stock Option Activity A summary of the Company's stock option activity and related information for the years ended September 27, 2003, September 28, 2002 and September 29, 2001 +follows (option amounts are presented in thousands): Outstanding Options Shares Available for Grant Number of Shares Weighted Average Exercise Price Balance at 9/30/00 11,530 70,758 $ 34.01 Additional Options Authorized 27,000 — — Options Granted (34,857 ) 34,857 $ 18.58 Options Cancelled 6,605 (6,605 ) $ 29.32 Options Exercised — (1,831 ) $ 10.05 Plan Shares Expired (203 ) — — Balance at 9/29/01 10,075 97,179 $ 29.24 Additional Options Authorized 15,000 — — Options Granted (23,239 ) 23,239 $ 19.89 Options Cancelled 4,737 (4,737 ) $ 30.98 Options Exercised — (6,251 ) $ 11.99 Plan Shares Expired (2 ) — — Balance at 9/28/02 6,571 109,430 $ 28.17 Restricted Stock Granted (5,000 ) — $ 14.95 Options Granted (4,179 ) 4,179 $ 16.38 Options Cancelled 48,443 (48,443 ) $ 39.61 Options Exercised — (2,154 ) $ 14.04 Plan Shares Expired (5 ) — — Balance at 9/27/03 45,830 63,012 $ 19.08 Total +options outstanding at September 27, 2003 to purchase approximately 63 million shares do not include options to purchase approximately 6.7 million shares that were issued in +October 2003 pursuant to the Exchange Program described above. 90 The +options outstanding as of September 27, 2003 have been segregated into six ranges for additional disclosure as follows (option amounts are presented in thousands): Options Outstanding Options Exercisable Options Outstanding as of September 27, 2003 Weighted- Average Remaining Contractual Life in Years Weighted Average Exercise Price Options Exercisable as of September 27, 2003 Weighted Average Exercise Price $0.83-$15.59 11,216 5.49 $ 11.83 8,237 $ 10.83 $15.60-$17.31 11,936 6.41 $ 17.00 7,022 $ 17.07 $17.32-$18.50 17,843 7.04 $ 18.43 11,903 $ 18.43 $18.51-$22.21 14,416 7.88 $ 20.31 6,886 $ 20.27 $22.22-$38.81 5,006 7.49 $ 24.03 2,844 $ 24.29 $38.82-$69.78 2,595 6.28 $ 48.08 1,864 $ 48.11 $0.83-$69.78 63,012 6.84 $ 19.08 38,756 $ 18.75 As +of September 28, 2002, the Company had exercisable options to purchase 57.9 million shares outstanding with a weighted average exercise price of $30.85 per share. As of +September 29, 2001, the Company had exercisable options to purchase 42.1 million shares outstanding with a weighted average exercise price of $32.15. Note 9—Stock-Based Compensation The +Company has provided pro forma disclosures in Note 1 of these Notes to Consolidated Financial Statements of the effect on net income (loss) and earnings (loss) per share as if the fair +value method of accounting for stock compensation had been used for its employee stock option grants and employee stock purchase plan purchases. These pro forma effects have been estimated at the date +of grant and beginning of the period, respectively, using the Black-Scholes option pricing model. For +purposes of the pro forma disclosures provided pursuant to SFAS No. 123, the option awards issued in October 2003 and the awards cancelled as part of the Exchange Program have been +accounted for using modification accounting. In accordance with SFAS No. 123, the grant date of the awards issued is the date of acceptance of the exchange offer by participating employees. The +cancellation of certain of the Company's Chief Executive Officer's options and replacement with restricted shares in March 2003 is also being accounted for using modification accounting for +purposes of the pro forma disclosures provided pursuant to SFAS No. 123. 91 The +assumptions used for each of the last three fiscal years and the resulting estimate of weighted-average fair value per share of options granted during those years are as follows: 2003 2002 2001 Expected life of stock options 3.5-4 years 4 years 4 years Expected life of stock purchases 6 months 6 months 6 months Interest rate—stock options 2.14%-2.45 % 2.90 % 4.90 % Interest rate—stock purchases 1.10%-1.77 % 2.71 % 5.97 % Volatility—stock options 40%-63 % 64 % 66 % Volatility—stock purchases 35%-44 % 51 % 90 % Dividend yields 0 0 0 Weighted-average fair value of options granted during the year $ 6.63 $ 10.11 $ 10.15 Weighted-average fair value of stock purchases during the year $ 4.24 $ 6.73 $ 11.15 For +purposes of the pro forma disclosures provided pursuant to SFAS No. 123, the expected volatility assumptions used by the Company prior to the third quarter of 2003 have been based solely on +the historical volatility of the Company's common stock over the most recent period commensurate with the estimated expected life of the Company's stock options. Beginning in the third quarter of +2003, the Company has modified this approach to consider other relevant factors including implied volatility in market traded options on the Company's common stock and the impact of unusual +fluctuations not reasonably expected to recur on the historical volatility of the Company's common stock. The Company will continue to monitor these and other relevant factors in developing the +expected volatility assumption used to value future awards. Beginning +in the third quarter of 2003, the Company shortened its estimate of the expected life of new options granted to its employees from 4 years to 3.5 years. The Company bases its +expected life assumption on its historical experience and on the terms and conditions of the stock options it grants to employees. The change in the expected life assumption made during the third +quarter of 2003 was the result of the expected impact of shortening the contractual life of new options granted to employees from 10 years to 7 years and changing the vesting provisions +of new options granted to employees from 4 year straight-line annual vesting to 4 year straight-line quarterly vesting. Note 10—Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other +off-balance-sheet financing arrangements. The major facility leases are for terms of 5 to 10 years and generally provide renewal options for terms of 3 to 5 additional years. Leases +for retail space are for terms of 5 to 15 years and often contain multi-year renewal options. As of September 27, 2003, the Company's total future minimum lease payments +under noncancelable operating leases were $600 million, of which $354 million related to leases for retail space. Rent +expense under all operating leases, including both cancelable and noncancelable leases, was $97 million, $92 million, and $80 million in 2003, 2002, and 2001, respectively. +Future minimum lease 92 payments +under noncancelable operating leases having remaining terms in excess of one year as of September 27, 2003, are as follows (in millions): Fiscal Years 2004 $ 100 2005 100 2006 83 2007 64 2008 51 Later years 202 Total minimum lease payments $ 600 Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of +purchase by the end-user. The Company also offers a 90-day basic warranty for Apple software and for Apple service parts used to repair Apple hardware products. The Company +provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time related revenue is recognized. Factors considered in determining appropriate +accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical warranty claim rates, historical and projected +cost-per-claim, and knowledge of specific product failures that are outside of the Company's typical experience. The Company assesses the adequacy of its preexisting warranty +liabilities and adjusts the amounts as necessary based on actual experience and changes in future expectations. The +following table reconciles changes in the Company's accrued warranties and related costs (in millions): 2003 2002 2001 Beginning accrued warranty and related costs $ 69 $ 87 $ 108 Cost of warranty claims (71 ) (79 ) (92 ) Accruals for product warranties 69 61 71 Ending accrued warranty and related costs $ 67 $ 69 $ 87 The +Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property +rights. Other licensing agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an +infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted +against itself or an indemnified third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims that would have a material adverse effect +on its financial condition, liquidity or results of operations. Therefore, the Company did not record a liability for infringement costs as of either September 27, 2003 or September 28, +2002. 93 Concentrations in the Available Sources of Supply of Materials and Product Although certain components essential to the Company's business are generally available from multiple sources, other key components (including microprocessors and +application-specific integrated circuits, or ("ASICs")) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from +multiple sources, are at times subject to industry-wide availability and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal +computer industry, and new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for and +subsequently qualifies additional suppliers. If the supply of a key single-sourced component to the Company were to be delayed or curtailed or in the event a key manufacturing vendor delays shipments +of completed products to the Company, the Company's ability to ship related products in desired quantities and in a timely manner could be adversely affected. The Company's business and financial +performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an +alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of common components instead of components customized to +meet the Company's requirements. Finally, significant portions of the Company's CPUs, logic boards, and assembled products are now manufactured by outsourcing partners, the majority of which occurs in +various parts of Asia. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company's operating results could be adversely affected if its outsourcing +partners were unable to meet their production obligations. Contingencies Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against +the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company's publicly traded common stock between +July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company +believes these claims are without merit and intends to defend them vigorously. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. +On December 11, 2002, the Court granted the Company's +motion to dismiss for failure to state a cause of action, with leave to Plaintiffs to amend their complaint within thirty days. Plaintiffs filed their amended complaint on January 31, 2003, and +on March 17, 2003, the Company filed a motion to dismiss the amended complaint. The Court heard the Company's motion on July 11, 2003 and dismissed Plaintiff's claims with prejudice on +August 12, 2003. Plaintiffs have appealed the ruling. The +Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. In the opinion of management, the Company +does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial condition, liquidity +or results of operations. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these +legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. Production +and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers 94 the +ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have recently been +passed in several jurisdictions that the Company operates including various European Union member countries, Japan and California. Although the Company does not anticipate any material adverse affects +in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on the Company's +results of operations and financial position. Note 11—Segment Information and Geographic Data The +Company manages its business primarily on a geographic basis. The Company's reportable segments are comprised of the Americas, Europe, Japan, and Retail. The Americas segment includes both North +and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment includes only +Japan. As of September 27, 2003, the Retail segment currently operates Apple-owned retail stores in the United States. Other operating segments include Asia-Pacific, which includes +Australia and Asia except for Japan, and the Company's subsidiary, Filemaker, Inc. Each reportable operating segment provides similar hardware and software products and similar services, and +the accounting policies of the various segments are the same as those described in the Summary of Significant Accounting Policies in Note 1, except as described below for the Retail segment. The +Company evaluates the performance of its operating segments based on net sales. The Retail segment's performance is also evaluated based on operating income. Net sales for geographic segments are +based on the location of the customers. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses directly attributable to the segment. +Operating income for each segment excludes other income and expense and certain expenses that are managed outside the operating segments. Costs excluded from segment operating income include various +corporate expenses, manufacturing costs not included in standard costs, income taxes, and various nonrecurring charges. Corporate expenses include research and development, corporate marketing +expenses, and other separately managed general and administrative expenses including certain corporate expenses associated with support of the Retail segment. The Company does not include intercompany +transfers between segments for management reporting purposes. Segment assets exclude corporate assets. Corporate assets include cash, short-term and long-term investments, +manufacturing facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets, and retail store construction-in-progress that is not subject +to depreciation. Except for the Retail segment, capital expenditures for long-lived assets are not reported to management by segment. Capital expenditures by the Retail segment were +$92 million, $106 million, and $92 million in 2003, 2002, and 2001, respectively. Operating +income for all segments except Retail includes cost of sales at standard cost. Certain manufacturing expenses and related adjustments not included in segment cost of sales, including +variances between standard and actual manufacturing costs and the mark-up above standard cost for product supplied to the Retail segment, are included in corporate expenses. To +assess the operating performance of the Retail segment several significant items are included in its results for internal management reporting that are not included in results of the Company's +other segments. First, cost of sales for the Retail segment includes a mark-up above the Company's standard cost to approximate the price normally charged to the Company's major channel +partners in the United States. For the years ended September 27, 2003, September 28, 2002, and September 29, 2001 this resulted in the 95 recognition +of additional cost of sales above standard cost by the Retail segment and an offsetting benefit to corporate expenses of approximately $106 million, $52 million, and +$4 million, respectively. Second, +the Retail segment includes in its net sales proceeds from sales of the Company's extended warranty and support contracts and also recognizes related cost of sales based on the amount at which +such contracts are normally sold to the Company's resellers operating retail stores in the United States. This treatment is consistent with how the Company's major resellers account for the sales and +cost of the Company's extended warranty and support contracts. Because the Company has not yet earned the revenue or incurred the costs associated with the sale of these contracts, an offset to these +amounts is recognized in the Americas segment's net sales and cost of sales. For the year ended September 27, 2003, this resulted in the recognition of net sales and cost of sales by the Retail +segment, with +corresponding offsets in the Americas segment, of $30 million and $20 million, respectively. For the year ended September 28, 2002, this resulted in the recognition of net sales +and cost of sales by the Retail segment, with corresponding offsets in the Americas segment, of $8 million and $6 million, respectively. These amounts were insignificant in fiscal 2001. Third, +a portion of the operating expenses associated with certain high profile retail stores are allocated from the Retail segment to corporate marketing expense. Allocation of these expenses +reflects the unique nature of these stores which, given their larger size and extraordinary design elements, function as vehicles for general corporate marketing, corporate sales and marketing events, +and brand awareness. Allocated operating costs are those in excess of operating costs incurred by one of the Company's more typical retail locations. Stores were open in three such high profile +locations in New York, Los Angeles, and Chicago as of September 27, 2003. Expenses allocated to corporate marketing resulting from the operations of these three stores were $6 million +and $1 million in fiscal 2003 and 2002, respectively. 96 Summary +information by operating segment follows (in millions): 2003 2002 2001 Americas: Net sales $ 3,181 $ 3,131 $ 3,037 Operating income $ 323 $ 278 $ 128 Depreciation, amortization and accretion $ 5 $ 4 $ 4 Segment assets(a) $ 494 $ 395 $ 334 Europe: Net sales $ 1,309 $ 1,251 $ 1,249 Operating income $ 130 $ 122 $ 68 Depreciation and amortization $ 4 $ 4 $ 6 Segment assets $ 252 $ 165 $ 137 Japan: Net sales $ 698 $ 710 $ 713 Operating income $ 121 $ 140 $ 98 Depreciation, amortization and accretion $ 3 $ 2 $ 2 Segment assets $ 130 $ 50 $ 44 Retail: Net sales $ 621 $ 283 $ 19 Operating loss $ (5 ) $ (22 ) $ (21 ) Depreciation, amortization and accretion(b) $ 25 $ 16 $ 2 Segment assets(b) $ 243 $ 141 $ 46 Other Segments(c): Net sales $ 398 $ 367 $ 345 Operating income $ 51 $ 44 $ 24 Depreciation, amortization and accretion $ 2 $ 2 $ 2 Segment assets $ 78 $ 67 $ 70 (a) The +Americas asset figures do not include fixed assets held in the United States. Such fixed assets are not allocated specifically to the Americas segment and are included in the +corporate assets figures below. (b) Retail +segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. Retail store +construction-in-progress, which is not subject to depreciation, is reflected in corporate assets. (c) Other +Segments consists of Asia-Pacific and FileMaker. Certain amounts in prior fiscal periods related to recent acquisitions and Internet services have been reclassified +from Other Segments to the Americas segment to conform to the 2003 presentation. 97 A +reconciliation of the Company's segment operating income and assets to the consolidated financial statements follows (in millions): 2003 2002 2001 Segment operating income $ 620 $ 562 $ 297 Corporate expenses, net (595 ) (514 ) (630 ) Purchased in-process research and development — (1 ) (11 ) Restructuring costs (26 ) (30 ) — Consolidated operating income (loss) $ (1 ) $ 17 $ (344 ) Segment assets $ 1,197 $ 818 $ 631 Corporate assets $ 5,618 $ 5,480 $ 5,390 Consolidated assets $ 6,815 $ 6,298 $ 6,021 Segment depreciation, amortization and accretion $ 39 $ 28 $ 16 Corporate depreciation, amortization and accretion 74 86 84 Consolidated depreciation, amortization and accretion $ 113 $ 114 $ 100 A +large portion of the Company's net sales is derived from its international operations. Also, a majority of the raw materials used in the Company's products is obtained from sources outside of the +United States, and a majority of the products sold by the Company is assembled internationally in the Company's facility in Cork, Ireland or by third-party vendors in Taiwan, Korea, the Netherlands, +the People's Republic of China, and the Czech Republic. As a result, the Company is subject to risks associated with foreign operations, such as obtaining governmental permits and approvals, currency +exchange fluctuations, currency restrictions, political instability, labor problems, trade restrictions, and changes in tariff and freight charges. No single customer accounted for more than 10% of +net sales in 2003, 2002 or 2001. Net +sales and long-lived assets related to operations in the United States, Japan, and other foreign countries are as follows (in millions): 2003 2002 2001 Net Sales: United States $ 3,627 $ 3,272 $ 2,936 Japan 698 710 713 Other Foreign Countries 1,882 1,760 1,714 Total Net Sales $ 6,207 $ 5,742 $ 5,363 Long-Lived Assets: United States $ 635 $ 561 $ 498 Japan 19 2 3 Other Foreign Countries 60 69 77 Total Long-Lived Assets $ 714 $ 632 $ 578 98 Information +regarding net sales by product is as follows (in millions): 2003 2002 2001 Net Sales: Power Macintosh(a) $ 1,237 $ 1,380 $ 1,664 PowerBook 1,299 831 813 iMac 1,238 1,448 1,117 iBook 717 875 809 Total Macintosh Net Sales $ 4,491 $ 4,534 $ 4,403 Peripherals and other hardware(b) 1,058 674 387 Software(c) 362 307 230 Service and other Net Sales 296 227 343 Total Net Sales $ 6,207 $ 5,742 $ 5,363 (a) Power +Macintosh figures include server sales. (b) Net +sales of peripherals and other hardware include sales of iPod, Apple-branded and third-party displays, and other hardware accessories. (c) Net +sales of software include sales of Apple-branded operating system and application software and sales of third-party software. Note 12—Related Party Transactions and Certain Other Transactions During +the first quarter of 2000, the Company's Board of Directors approved a special executive bonus for the Company's Chief Executive Officer for past services in the form of an aircraft with a +total cost to the Company of approximately $90 million, the majority of which was not tax deductible. Approximately half of the total charge was for the cost of the aircraft. The other half +represented all other costs and taxes associated with the bonus. In the fourth quarter of 2002, all significant work and payments associated with the aircraft were completed. Of the original +$90 million accrual, $2.4 million remained unspent at the end of fiscal 2002 and was reversed. In +March 2002, the Company entered into a Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in +the operation of his private plane when used for Apple business. The Reimbursement Agreement is effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of +the plane in May 2001. The Company recognized a total of $404,000 in expenses pursuant to the Reimbursement Agreement during fiscal 2003. For fiscal 2002, the Company recognized a total of +$1,168,000 in expenses pursuant to the Reimbursement Agreement related to expenses incurred by Mr. Jobs during 2001 and 2002. All expenses recognized pursuant to the Reimbursement Agreement +have been included by the Company in selling, general, and administrative expenses. In +connection with a relocation assistance package, the Company loaned Mr. Ronald B. Johnson, Senior Vice President, Retail, $1.5 million for the purchase of his principal residence. The +loan is secured by a deed of trust and is due and payable in May 2004. Under the terms of the loan, Mr. Johnson agreed that should he exercise any of his stock options prior to the due +date of the loan, he would pay the Company an amount equal to the lesser of (1) an amount equal to 50% of the total net gain realized from the exercise 99 of +the options; or (2) $375,000 multiplied by the number of years between the exercise date and the date of the loan. Mr. Johnson repaid $750,000 of this loan in fiscal 2003. The +remaining $750,000 is due and payable in May 2004. Mr. Jerome +York, a member of the Board of Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. (MicroWarehouse) in January 2000. Until +September 7, 2003, he also served as its Chairman, President and Chief Executive Officer. MicroWarehouse is a reseller of computer hardware, software and peripheral products, including products +made by the Company. On September 8, 2003, CDW Corporation (CDW), acquired selected North American assets of MicroWarehouse. MicroWarehouse subsequently filed for Chapter 11 bankruptcy +protection in the +United States. MicroWarehouse accounted for 2.4%, 3.3%, and 2.9% of the Company's net sales in fiscal 2003, 2002 and 2001, respectively. Trade receivables from MicroWarehouse were $9.9 million +and $20.9 million as of September 27, 2003, and September 28, 2002, respectively. The Company has provided what it believes to be an adequate allowance on the outstanding +receivable based on the Company's secured interest position in selected MicroWarehouse assets and the expected payments to unsecured creditors. Sales to MicroWarehouse and related trade receivables +were generally subject to the same terms and conditions as those with the Company's other resellers. In addition, the Company purchases miscellaneous equipment and supplies from MicroWarehouse. Total +purchases amounted to approximately $2.3 million, $2.9 million, and $3.4 million in fiscal 2003, 2002, and 2001, respectively. Note 13—Selected Quarterly Financial Information (Unaudited) Fourth Quarter Third Quarter Second Quarter First Quarter (Tabular amounts in millions, except per share amounts) 2003 Net sales $ 1,715 $ 1,545 $ 1,475 $ 1,472 Gross margin $ 456 $ 428 $ 418 $ 406 Net income (loss) $ 44 $ 19 $ 14 $ (8 ) Earnings (loss) per common share: Basic $ 0.12 $ 0.05 $ 0.04 $ (0.02 ) Diluted $ 0.12 $ 0.05 $ 0.04 $ (0.02 ) 2002 Net sales $ 1,443 $ 1,429 $ 1,495 $ 1,375 Gross margin $ 381 $ 391 $ 409 $ 422 Net income (loss) $ (45 ) $ 32 $ 40 $ 38 Earnings (loss) per common share: Basic $ (0.13 ) $ 0.09 $ 0.11 $ 0.11 Diluted $ (0.13 ) $ 0.09 $ 0.11 $ 0.11 Basic +and diluted earnings (loss) per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual +basic and diluted earnings (loss) per share. Net +income during the fourth and third quarters of 2003 included after-tax net gains related to non-current investments of $5 million and $1 million, +respectively. Net income for the fourth quarter also included settlement of the Company's forward purchase agreement resulting in a gain of $6 million and a favorable cumulative-effect type +adjustment related to the adoption of SFAS 150 of $3 million. Net income (loss) 100 during +the second and first quarters of 2003 included restructuring charges, net of tax, of $2 million and $18 million, respectively. Net loss for the first quarter of 2003 included an +after-tax unfavorable cumulative-effect type adjustment for the adoption of SFAS No.143 of $2 million. Net +loss for the fourth quarter of 2002 included the following items, net of tax: the write-down of certain equity investments totaling $49 million; a restructuring charge of +$4 million; an in-process research and development charge of approximately $1 million; and the reversal of a portion of a previous executive compensation expense resulting in +a favorable impact of $2 million. Net income for the first quarter of 2002 included a restructuring charge, net of tax, of $18 million. Net income during the first quarter of 2002 also +included gains, net of tax, of $17 million related to non-current investments. 101 REPORT OF INDEPENDENT AUDITORS The +Board of Directors and Shareholders Apple Computer, Inc.: We +have audited the accompanying consolidated balance sheets of Apple Computer, Inc. and subsidiaries as of September 27, 2003 and September 28, 2002, and the related consolidated +statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended September 27, 2003. These consolidated financial statements are +the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We +conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial +statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe +that our audits provide a reasonable basis for our opinion. In +our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Computer, Inc. and subsidiaries as of +September 27, 2003 and September 28, 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended September 27, +2003, in conformity with accounting principles generally accepted in the United States of America. As +discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for asset retirement obligations and for financial instruments with characteristics +of both liabilities and equity in 2003, changed its method of accounting for goodwill in 2002, and changed its method of accounting for hedging activities in 2001. /s/ KPMG LLP Mountain +View, California October 14, 2003 102 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not +applicable. Item 9A. Controls and Procedures Based +on an evaluation under the supervision and with the participation of the Company's management, the Company's principal executive officer and principal financial officer have concluded that the +Company's disclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended +( Exchange Act )) were effective as of September 27, 2003 to ensure that information required to be disclosed by the Company in reports that it +files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There +were no significant changes in the Company's internal control over financial reporting identified in management's evaluation during the fourth quarter of fiscal 2003 that have materially +affected or are reasonably likely to materially affect the Company's internal control over financial reporting. 103 PART III Item 10. Directors and Executive Officers of the Registrant Directors Listed below are the Company's six directors whose terms expire at the next annual meeting of shareholders. Name Position With the Company Age Director Since William V. Campbell Director 63 1997 Millard S. Drexler Director 59 1999 Albert Gore, Jr. Director 56 2003 Steven P. Jobs Director and Chief Executive Officer 48 1997 Arthur D. Levinson Director 53 2000 Jerome B. York Director 65 1997 William V. Campbell has been Chairman of the Board of Directors of Intuit, Inc. ("Intuit") since +August 1998. From September 1999 to January 2000, Mr. Campbell acted as Chief Executive Officer of Intuit. From April 1994 to August 1998, Mr. Campbell +was President and Chief Executive Officer and a director of Intuit. From January 1991 to December 1993, Mr. Campbell was President and Chief Executive Officer of GO Corporation. +Mr. Campbell also serves on the board of directors of Opsware, Inc. Albert Gore, Jr. has served as a Senior Advisor to Google, Inc. and Vice Chairman of Metropolitan West Financial LLC since 2001. He is a visiting +professor at the University of California Los Angeles, Fisk University and Middle Tennessee State University. Mr. Gore was inaugurated as the 45th Vice President of the United States in 1993. +He was re-elected in 1996 and served for a total of eight years as President of the Senate, a member of the cabinet and the National Security Council, and as the leader of a wide range of +Administration initiatives including environmental policy, technology, science, communications and government cost reduction. Millard S. Drexler has been Chairman and Chief Executive Officer of J. Crew Group, Inc. since March 2003. Previously, Mr. Drexler +was Chief Executive Officer of Gap Inc. from 1995 and President from 1987 until September 2002. Mr. Drexler was also a member of the Board of Directors of Gap Inc. from +November 1983 until October 2002. Steven P. Jobs is one of the Company's co-founders and currently serves as its Chief Executive Officer. Mr. Jobs is also the Chairman +and Chief Executive Officer of Pixar Animation Studios. In addition, Mr. Jobs co-founded NeXT Software, Inc. (" NeXT" ) and +served as the Chairman and Chief Executive Officer of NeXT from 1985 until 1997 when NeXT was acquired by the Company. Arthur D. Levinson, Ph.D. has been President, Chief Executive Officer and a director of Genentech Inc. +(" Genentech" ) since July 1995. Dr. Levinson has been Chairman of the Board of Directors of Genentech since September 1999. He +joined Genentech in 1980 and served in a number of executive positions, including Senior Vice President of R&D from 1993 to 1995. Jerome B. York has been Chief Executive Officer of Harwinton Capital Corporation, a private investment company which he controls, since +September 2003. From January 2000 until September 2003, Mr. York was Chairman and Chief Executive Officer of MicroWarehouse, Inc., a reseller of computer hardware, +software and peripheral products. From September 1995 to October 1999, he was Vice Chairman of Tracinda Corporation. From May 1993 to September 1995 he was Senior Vice +President and Chief Financial Officer of IBM Corporation, and served as a member of IBM's Board of Directors from January 1995 to August 1995. Previously his career was in the automotive +industry, with his last position being Executive Vice President-Finance and Chief Financial Officer and a member of the Board of Directors of Chrysler Corporation. Mr. York is also a director +of Tyco International Ltd. and Metro-Goldwyn-Mayer, Inc. 104 Role of the Board; Corporate Governance Matters It is the paramount duty of the Board of Directors to oversee the Chief Executive Officer and other senior management in the competent and ethical operation of the Company on a +day-to-day basis and to assure that the long-term interests of the shareholders are being served. To satisfy this duty, the directors take a proactive, focused +approach to their position, and set standards to ensure that the Company is committed to business success through maintenance of the highest standards of responsibility and ethics. Members +of the Board bring to the Company a wide range of experience, knowledge and judgment. These varied skills mean that good governance depends on far more than a "check the box" approach to +standards or procedures. The governance structure in the Company is designed to be a working structure for principled actions, effective decision-making and appropriate monitoring of both compliance +and performance. The key practices and procedures of the Board are outlined in the Corporate Governance Guidelines available on the Company's website at www.apple.com/investor. Board Committees The Board has a standing Compensation Committee, a Nominating and Corporate Governance Committee (" Nominating Committee" ) and an +Audit and Finance Committee (" Audit Committee "). The +Compensation Committee is primarily responsible for reviewing the compensation arrangements for the Company's executive officers, including the Chief Executive Officer, and for administering the +Company's stock option plans. Members of the Compensation Committee are Messrs. Campbell, Drexler, Gore and Dr. Levinson. The +Nominating Committee assists the Board in identifying qualified individuals to become directors, determines the composition of the Board and its committees, monitors the process to assess Board +effectiveness and helps develop and implement the Company's corporate governance guidelines. Members of the Nominating Committee are Messrs. Campbell, Drexler, Gore and Dr. Levinson. The +Audit Committee is primarily responsible for overseeing the services performed by the Company's independent auditors and internal audit department, evaluating the Company's accounting policies and +its system of internal controls and reviewing significant financial transactions. Consistent with the Nasdaq audit committee structure and membership requirements, the Audit Committee is comprised of +three members: Messrs. Campbell, York and Dr. Levinson. Because of Mr. York's affiliation with MicroWarehouse, (see Item 13. Certain Relationships and Related Transactions), he is +deemed to be a "non-independent" director. As permitted under the Nasdaq requirements, the Board carefully considered Mr. York's affiliation with MicroWarehouse as well as his +accounting and financial expertise and determined that it is in the best interest of the Company and its shareholders that he continue to serve as a member of the Audit Committee. Both +Mr. Campbell and Dr. Levinson are independent directors. The +Audit, Compensation and Nominating Committees operate under written charters adopted by the Board. These charters are available on the Company's website at www.apple.com/investor. Audit Committee Financial Expert While more than one member of the Company's Audit Committee qualifies as an "audit committee financial expert" under Item 401(h) of Regulation S-K, +Mr. William V. Campbell, the Committee chairperson, is the designated audit committee financial expert. Mr. Campbell is considered "independent" as the term is used in Item +7(d)(3)(iv) of Schedule 14A under the Exchange Act. Code of Ethics The Company has a code of ethics that applies to all of the Company's employees, including its principal executive officer, principal financial officer and principal accounting +officer. A copy of this code, "Ethics: The Way We Do Business Worldwide" is available on the Company's website at www.apple.com/investor and is +filed as an exhibit to this annual report on Form 10-K. The Company intends to disclose any 105 changes +in or waivers from its code of ethics by posting such information on its website or by filing a Form 8-K. Executive Officers The following sets forth certain information regarding executive officers of the Company. Information pertaining to Mr. Jobs, who is both a director and an executive +officer of the Company, may be found in the section entitled " Directors. " Fred D. Anderson , Executive Vice President and Chief Financial Officer (age 59), joined the Company in April 1996. Prior to joining the Company, +Mr. Anderson was Corporate Vice President and Chief Financial Officer of Automatic Data Processing, Inc., a position he held from August 1992 to March 1996. +Mr. Anderson also serves as a director of eBay Inc. and E.piphany, Inc. Timothy D. Cook , Executive Vice President, Worldwide Sales and Operations (age 43), joined the Company in February 1998. Prior to joining the +Company, Mr. Cook held the position of Vice President, Corporate Materials for Compaq Computer Corporation (" Compaq" ). Previous to his work at +Compaq, Mr. Cook was the Chief Operating Officer of the Reseller Division at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, most recently as Director of North +American Fulfillment. Nancy R. Heinen , Senior Vice President, General Counsel and Secretary (age 47), joined the Company in September 1997. Prior to joining the +Company, Ms. Heinen held the position of Vice President, General Counsel and Secretary of the Board of Directors at NeXT from February 1994 until the acquisition of NeXT by the Company +in February 1997. Ronald B. Johnson , Senior Vice President, Retail (age 45), joined the Company in January 2000. Prior to joining the Company, Mr. Johnson +spent 16 years with Target Stores, most recently as Senior Merchandising Executive. Peter Oppenheimer , Senior Vice President of Finance and Corporate Controller (age 41), joined the Company in July 1996. Mr. Oppenheimer +also served with the Company in the position of Vice President and Corporate Controller and as Senior Director of Finance for the Americas. Prior to joining the Company, Mr. Oppenheimer was CFO +of one of the four business units for Automatic Data Processing, Inc. (" ADP" ). Prior to joining ADP, Mr. Oppenheimer spent six years in the +Information Technology Consulting Practice with Coopers and Lybrand. Jonathan Rubinstein , Senior Vice President, Hardware Engineering (age 47), joined the Company in February 1997. Before joining the Company, +Mr. Rubinstein was Executive Vice President and Chief Operating Officer of FirePower Systems Incorporated, from May 1993 to August 1996. Mr. Rubinstein also serves as a +member of the Board of Directors of Immersion Corporation. Philip W. Schiller , Senior Vice President, Worldwide Product Marketing (age 43), rejoined the Company in 1997. Prior to rejoining the Company, +Mr. Schiller was Vice President of Product Marketing at Macromedia, Inc. from December 1995 to March 1997 and was Director of Product Marketing at FirePower +Systems, Inc. from 1993 to December 1995. Prior to that, Mr. Schiller spent six years at the Company in various marketing positions. Bertrand Serlet, Ph.D., Senior Vice President, Software Engineering (age 42), joined the Company in February 1997 upon the Company's acquisition +of NeXT. At NeXT, Dr. Serlet held several engineering and managerial positions, including Director of Web Engineering. Prior to NeXT, from 1985 to 1989, Dr. Serlet worked as a research +engineer at Xerox PARC. Sina Tamaddon , Senior Vice President, Applications (age 46), joined the Company in September 1997. Mr. Tamaddon has also served with the +Company in the position of Senior Vice President Worldwide Service and Support, and Vice President and General Manager, Newton Group. Before joining the Company, Mr. Tamaddon held the position +of Vice President, Europe with NeXT from September 1996 106 through +March 1997. From August 1994 to August 1996, Mr. Tamaddon held the position of Vice President, Professional Services with NeXT. Avadis Tevanian, Jr., Ph.D. , Senior Vice President, Chief Software Technology Officer (age 42), joined the Company in February 1997 upon the +Company's acquisition of NeXT. Dr. Tevanian served with the Company in the position of Senior Vice President, Software Engineering from 1997 to July 2003. With NeXT, Dr. Tevanian +held several positions, including Vice President, Engineering, from April 1995 to February 1997. Prior to April 1995, Dr. Tevanian worked as an engineer with NeXT and held +several management positions. Item 11. Executive Compensation Information Regarding Executive Compensation The following table summarizes compensation information for the last three fiscal years for (i) Mr. Jobs, Chief Executive Officer and (ii) the four most +highly compensated executive officers other than the Chief Executive Officer who were serving as executive officers of the Company at the end of the fiscal year (collectively, the +" Named Executive Officers" ). SUMMARY COMPENSATION TABLE Annual Compensation Long-Term Compensation Name and Principal Position Fiscal Year Salary ($) Bonus ($) Restricted Stock Award ($) Securities Underlying Options* (#) All Other Compensation ($) Steven P. Jobs Chief Executive Officer 2003 2002 2001 1 1 1 — 2,268,698 43,511,534 (2) (2) 74,750,000 (1) — 7,500,000 — (1) — 1,302,795 40,484,594 (2) (2) Fred D. Anderson Executive Vice President and Chief Financial Officer 2003 2002 2001 656,631 656,631 657,039 — — — — — — — — 1,000,000 11,450 11,000 7,312 (3) (3) (3) Timothy D. Cook Executive Vice President, Worldwide Sales and Operations 2003 2002 2001 617,673 563,829 452,219 — — 500,000 — — — — — 1,000,000 9,929 8,025 7,875 (3) (3) (3) Ronald B. Johnson Senior Vice President, Retail 2003 2002 2001 452,404 452,404 452,429 1,500,000 — — — — — — 300,000 300,000 — — — Avadis Tevanian, Jr. Ph.D Senior Vice President, Chief Software Technology Officer 2003 2002 2001 456,731 492,212 460,873 — — 500 — — — — — 1,000,000 11,962 10,700 10,200 (3) (3) (3) (1) In +March 2003, Mr. Jobs voluntarily cancelled all of his outstanding options, excluding those granted to him in his capacity as a director. In March 2003, the +Board awarded Mr. Jobs five million restricted shares of the Company's Common Stock which generally vest in full on the third anniversary of the grant date. (2) In +December 1999, Mr. Jobs was given a special executive bonus for past services as the Company's interim Chief Executive Officer, in the form of an aircraft with a +total cost to the Company of approximately $90,000,000. Because the aircraft was transferred to Mr. Jobs in 2001, the amount of approximately $43.5 million paid by the Company during +fiscal year 2001 towards the purchase of the plane and the related tax assistance of approximately $40.5 million was reported as income to Mr. Jobs. In fiscal 2002, approximately +$2.27 million paid by the Company towards the purchase of the plane and approximately $1.3 million in related tax assistance was reported as income to Mr. Jobs. (3) Consists +of matching contributions made by the Company in accordance with the terms of the 401(k) plan. 107 Option Grants in Last Fiscal Year There were no options granted to the Named Executive Officers during fiscal year 2003. Options Exercised and Year-End Option Holdings The following table provides information about stock option exercises by the Named Executive Officers during fiscal year 2003 and stock options held by each of them at fiscal +year-end. AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Number of Securities Underlying Unexercised Options at Fiscal Year-End (#) Value of Unexercised In-the-Money Options at Fiscal Year-End ($)(1) Name Shares Acquired on Exercise (#) Value Realized ($) Exercisable Unexercisable Exercisable Unexercisable Steven P. Jobs — — 60,000 (2) — $ 551,400 — Fred D. Anderson — — 1,150,000 800,000 $ 4,134,125 $ 2,952,000 Timothy D. Cook — — 800,000 800,000 $ 2,952,000 $ 2,952,000 Ronald B. Johnson — — 1,181,250 618,750 $ 451,687 $ 205,312 Avadis Tevanian, Jr. — — 1,600,000 800,000 $ 9,636,522 $ 2,952,000 (1) Market +value of securities underlying in-the-money options at the end of fiscal year 2003 (based on $20.69 per share, the closing price of Common Stock on the +Nasdaq National Market on September 27, 2003), minus the exercise price. (2) Includes +60,000 options granted to Mr. Jobs in his capacity as a director pursuant to the 1997 Director Stock Option Plan. In March 2003, Mr. Jobs voluntarily +cancelled all of his outstanding options, excluding those granted to him in his capacity as a director. Director Compensation The form and amount of director compensation is determined by the Board after a review of recommendations made by the Nominating Committee. The current practice of the Board is +that a substantial portion of a director's annual retainer be equity-based. In 1998, shareholders approved the 1997 Director Stock Option Plan (the " Director +Plan" ) and 800,000 shares were reserved for issuance thereunder. Pursuant to the Director Plan, the Company's non-employee directors are granted an option to +acquire 30,000 shares of Common Stock upon their initial election to the Board (" Initial Options" ). The Initial Options vest and become exercisable in +three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee director's initial election to the Board and +on each subsequent anniversary thereafter, the director will be entitled to receive an option to acquire 10,000 shares of Common Stock (" Annual +Options" ). Annual Options are fully vested and immediately exercisable on their date of grant. As of the end of the fiscal year, there were options for 370,000 shares +outstanding under the Director Plan. Since accepting the position of CEO, Mr. Jobs is no longer eligible for grants under the Director Plan. Directors also receive a $50,000 annual retainer +paid in quarterly increments. Directors do not receive any additional consideration for serving on committees or as committee chairperson. Compensation Committee Interlocks and Insider Participation The current members of the Compensation Committee are Messrs. William V. Campbell, Millard S. Drexler, Albert Gore, Jr. and Dr. Arthur B. Levinson, none of whom +are employees of the Company and all of whom are considered "independent" directors under the applicable NASDAQ rules. At the beginning of the fiscal year, Mr. Jerome B. York served on the +Committee until his resignation in November 2002 at which time Mr. Drexler was appointed as a member of the Committee. No person who 108 was +an employee of the Company in fiscal year 2003 served on the Compensation Committee. No executive officer of the Company (i) served as a member of the compensation committee (or other board +committee performing similar functions or, in the absence of any such committee, the board of directors) of another entity, one of whose executive officers served on the Company's Compensation +Committee, (ii) served as a director of another entity, one of whose executive officers served on the Company's Compensation Committee, or (iii) served as a member of the compensation +committee (or other board committee performing similar functions or, in the absence of any such committee, the board of directors) of another entity, one of whose executive officers served as a +director of the Company. Item 12. Security Ownership of Certain Beneficial Owners and Management The +following table sets forth certain information as of October 31, 2003 (the " Table Date ") with respect to the beneficial ownership of the +Company's Common Stock by (i) each person the Company believes beneficially holds more than 5% of the outstanding shares of Common Stock; (ii) each director; (iii) each Named +Executive Officer listed in the Summary Compensation Table under the heading " Executive Compensation; " and (iv) all directors and executive +officers as a group. On the Table Date, 367,490,665 shares of Common Stock were issued and outstanding. Unless otherwise indicated, all persons named as beneficial owners of Common Stock have sole +voting power and sole investment power with respect to the shares indicated as beneficially owned. Security Ownership of Directors, Nominees and Executive Officers Name of Beneficial Owner Shares of Common Stock Beneficially Owned(1) Percent of Common Stock Outstanding Lord, Abbett & Co. 34,864,239 (2) 9.49 % Steven P. Jobs 5,060,002 (3) 1.38 % Fred D. Anderson 1,152,672 (4) * William V. Campbell 90,502 (5) * Timothy D. Cook 804,334 (6) * Millard S. Drexler 90,000 (7) * Albert Gore, Jr — * Ronald B. Johnson 1,204,334 (8) * Arthur D. Levinson 231,600 (9) * Avadis Tevanian, Jr. 1,601,252 (10) * Jerome B. York 110,000 (5) * All executive officers and directors as a group (16 persons) 14,715,373 4.00 % (1) Represents +shares of Common Stock held and/or options held by such individuals that were exercisable at the Table Date or within 60 days thereafter. (2) Based +on a Form 13F-HR filed October 22, 2003 by Lord, Abbett & Co., 767 Fifth Avenue, New York, NY 10153. (3) Includes +60,000 shares of Common Stock which Mr. Jobs has the right to acquire by exercise of stock options. (4) Includes +1,150,000 shares of Common Stock which Mr. Anderson has the right to acquire by exercise of stock options. (5) Includes +90,000 shares of Common Stock which Messrs. Campbell and York each have the right to acquire by exercise of stock options. 109 (6) Includes +800,000 shares of Common Stock which Mr. Cook has the right to acquire by exercise of stock options. (7) Includes +70,000 shares of Common Stock which Mr. Drexler has the right to acquire by exercise of stock options. (8) Includes +1,200,000 shares of Common Stock which Mr. Johnson has the right to acquire by exercise of stock options. (9) Includes +1,400 shares of Common Stock which Dr. Levinson holds indirectly and 30,000 shares of Common Stock which Dr. Levinson has the right to acquire by exercise of +stock options. (10) Includes +1,600,000 shares of Common Stock which Dr. Tevanian has the right to acquire by exercise of stock options. * Represents +less than 1% of the issued and outstanding shares of Common Stock on the Table Date. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's officers and directors, and persons who own more than ten percent of a +registered class of the Company's equity securities, to file reports of securities ownership and changes in such ownership with the Securities and Exchange Commission +(" SEC "). Officers, directors and greater than ten percent shareholders also are required by rules promulgated by the SEC to furnish the Company with +copies of all Section 16(a) forms they file. Based +solely upon a review of the copies of such forms furnished to the Company or written representations that no Forms 5 were required, the Company believes that all Section 16(a) filing +requirements were met during fiscal year 2003, except that Messrs. Campbell and York each filed one Form 4 late under the new two-day reporting requirements. Equity Compensation Plan Information The following table sets forth certain information, as of September 27, 2003, concerning shares of common stock authorized for issuance under all of the Company's equity +compensation plans. (a) Number of Securities to be Issued Upon Exercise of Options (b) Weighted Average Exercise Price of Outstanding Options (c) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) Equity compensation plans approved by shareholders 19,507,624 $ 18.75 29,142,907 (1) Equity compensation plans not approved by shareholders 43,343,560 $ 19.29 20,689,245 (2) Total equity compensation plans (3) 62,851,184 $ 19.12 49,832,152 (2) (1) This +number includes 4,002,123 shares of common stock reserved for issuance under the Employee Stock Purchase Plan, 310,000 shares available for issuance under the 1997 Director Stock +Option Plan and 24,830,784 shares available for issuance under the 2003 Employee Stock Plan. It does not include shares under the 1990 Stock Option Plan which was terminated in 1997. No new options +can be granted under the 1990 Stock Option Plan. (2) On +October 22, 2003, the Company granted 6,697,368 shares under the 1997 Employee Stock Option Plan (the "1997 Plan") pursuant to the stock option exchange program (see +Part II, Item 8 of this 110 Form 10-K +in the Notes to Consolidated Financial Statements at Note 8, under the heading "Employee Stock Option Exchange Program"). Following that grant, the Company +terminated the 1997 Plan, its only non-shareholder approved equity plan. All remaining unissued shares in that plan were cancelled and no new options can be granted under that plan. (3) This +table does not include 160,975 outstanding options assumed in connection with mergers with and acquisitions of the companies which originally established those plans. These +assumed options have a weighted average exercise price of $3.69 per share. No additional options may be granted under those assumed plans. Arrangements with Named Executive Officers Change In Control Arrangements—Stock Options In the event of a "change in control" of the Company, all outstanding options under the Company's stock option plans, except the Director Plan, will, unless otherwise +determined by the plan administrator, become exercisable in full, and will be cashed out at an amount equal to the difference between the applicable "change in control price" and the exercise price. +The Director Plan provides that upon a "change in control" of the Company, all unvested options held by non-employee directors will automatically become fully vested and exercisable and +will be cashed out at an amount equal to the difference between the applicable "change in control price" and the exercise price of the options. A "change in control" under these plans is generally +defined as (i) the acquisition by any person of 50% or more of the combined voting power of the Company's outstanding securities or (ii) the occurrence of a transaction requiring +shareholder approval and involving the sale of all or substantially all of the assets of the Company or the merger of the Company with or into another corporation. In +addition, options granted to the Named Executive Officers generally provide that in the event there is a "change in control," as defined in the Company's stock option plans, and if in connection +with or following such "change in control," their employment is terminated without "Cause" or if they should resign for "Good Reason," those options outstanding that are not yet vested and exercisable +as of the date of such "change in control" shall become fully vested and exercisable. Generally, "Cause" is defined to include a felony conviction, willful disclosure of confidential information or +willful and continued failure to perform his or her employment duties. "Good Reason" includes resignation of employment as a result of a substantial diminution in position or duties, or an adverse +change in title or reduction in annual base salary. Item 13. Certain Relationships and Related Transactions In +connection with a relocation assistance package, the Company loaned Mr. Johnson (Senior Vice President, Retail) $1,500,000 for the purchase of his principal residence. The loan is secured by +a deed of trust and is due and payable in May 2004. Under the terms of the loan, Mr. Johnson agreed that should he exercise any of his stock options prior to the due date of the loan, he +would pay the Company an amount equal to the lesser of (1) an amount equal to 50% of the total net gain realized from the exercise of the options; or (2) $375,000 multiplied by the +number of years between the exercise date and the date of the loan. The largest amount of the indebtedness outstanding on this loan during fiscal year 2003 was $1,500,000. Mr. Johnson repaid +the Company $750,000 during the fiscal year and the amount remaining on the loan is $750,000. Mr. Jerome +York, a member of the Board of Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. +(" MicroWarehouse" ) in January 2000. Until September 2003, he served as its Chairman, President and Chief Executive Officer. MicroWarehouse +is a reseller of computer hardware, software and peripheral products, including products made by the Company. During fiscal year 2003, MicroWarehouse accounted for 2.4% of the Company's net sales. The +Company also purchased products from MicroWarehouse for its own internal use. 111 In +March 2002, the Company entered into a Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in +the operation of his private plane when used for Apple business. The Reimbursement Agreement is effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of +the plane in May 2001. During 2003, the Company recognized a total of $403,766 in expenses pursuant to this reimbursement agreement related to expenses incurred by Mr. Jobs during 2003. Item 14. Principal Accountant Fees and Services The +following table sets forth the fees paid to the Company's independent auditor, KPMG LLP, during fiscal years 2003 and 2002. Audit and Non-Audit Fees 2003 2002 Audit Fees $ 3,028,000 (1) $ 2,635,000 Audit-Related Fees $ 144,600 (2) $ 140,000 Tax Fees $ 1,017,100 (3) $ 1,055,000 All Other Fees $ — $ 75,000 Total $ 4,189,700 $ 3,905,000 (1) Audit +fees relate to professional services rendered in connection with the audit of the Company's annual financial statements, quarterly review of financial statements included in the +Company's Forms 10-Q, and audit services provided in connection with other statutory and regulatory filings. (2) Audit-related +fees include professional services related to the audit of the Company's financial statements, consultation on accounting standards or transactions, and audits of +employee benefit plans. (3) Tax +fees include $901,500 for professional services rendered in connection with tax compliance and preparation relating to the Company's expatriate program, tax audits and +international tax compliance; and $115,600 for tax consulting and planning services relating to interest computations and international tax changes. The Company does not engage KPMG to perform +personal tax services for its executive officers. Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Auditors Prior to the enactment of the Sarbanes-Oxley Act of 2002 (the " Act "), the Company adopted an auditor independence policy that +banned its auditors from performing non-financial consulting services, such as information technology consulting and internal audit services. This auditor policy also mandates that an +annual budget for both audit and non-audit services be approved by the Audit Committee in advance, and that the Audit Committee be provided with quarterly reporting on actual spending. +This policy also mandates that no auditor engagements for non-audit services may be entered into without the express approval of the Audit Committee. 112 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. (a) Items +Filed as Part of Report: 1. Financial +Statements The +financial statements of the Company filed as part of this report on Form 10-K are set forth in the Index to Consolidated Financial Statements under Part II, Item 8 of +this Form 10-K. 2. Financial +Statement Schedules All +financial statement schedules have been omitted, since the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the Consolidated Financial Statements and Notes thereto under Part II, Item 8 of this Form 10-K. 3. Exhibits Incorporated by Reference Exhibit Number Filed herewith Exhibit Description Form Filing Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on January 27, 1988. S-3 7/27/88 3.2 Amendment to Restated Articles of Incorporation, filed with the Secretary of State of the State of California on May 4, 2000. 10-Q 5/11/00 3.3 By-Laws of the Company, as amended through March 19, 2003. 10-Q 5/13/03 4.2 Indenture dated as of February 1, 1994, between the Company and Morgan Guaranty Trust Company of New York. 10-Q 4/01/94 4.3 Supplemental Indenture dated as of February 1, 1994, among the Company, Morgan Guaranty Trust Company of New York, as resigning trustee, and Citibank, N.A., as successor trustee. 10-Q 4/01/94 4.5 Form of the Company's 6 1 / 2 % Notes due 2004. 10-Q 4/01/94 4.8 Registration Rights Agreement, dated June 7, 1996 among the Company and Goldman, Sachs & Co. and Morgan Stanley & Co. Incorporated. S-3 8/28/96 4.9 Certificate of Determination of Preferences of Series A Non-Voting Convertible Preferred Stock of Apple Computer, Inc. 10-K 9/26/97 10.A.3 Apple Computer, Inc. Savings and Investment Plan, as amended and restated effective as of October 1, 1990. 10-K 9/27/91 10.A.3-1 Amendment of Apple Computer, Inc. Savings and Investment Plan dated March 1, 1992. 10-K 9/25/92 10.A.3-2 Amendment No. 2 to the Apple Computer, Inc. Savings and Investment Plan. 10-Q 3/28/97 10.A.5 1990 Stock Option Plan, as amended through November 5, 1997. 10-Q 12/26/97 113 10.A.6 Apple Computer, Inc. Employee Stock Purchase Plan, as amended through April 24, 2003. S-8 6/24/03 10.A.8 Form of Indemnification Agreement between the Registrant and each officer of the Registrant. 10-K 9/26/97 10.A.43 NeXT Computer, Inc. 1990 Stock Option Plan, as amended. S-8 3/21/97 10.A.49 1997 Employee Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.A.50 1997 Director Stock Option Plan. 10-Q 3/27/98 10.A.51 2003 Employee Stock Option Plan, as amended through April 24, 2003. 10-Q 6/28/03 10.A.52 Reimbursement Agreement. 10-Q 6/29/02 10.A.53 Option Cancellation and Restricted Stock Award Agreement 10-Q 6/28/03 10.B.18 Custom Sales Agreement effective October 21, 2002 between the Registrant and International Business Machines Corporation. X 14.1 Code of Ethics of the Company X 21 Subsidiaries of Apple Computer, Inc. X 23.1 Independent Auditors' Consent X 31.1 Rule13a-14(a) / 15d-14(a) Certification of Chief Executive Officer X 31.2 Rule13a-14(a) / 15d-14(a) Certification of Chief Financial Officer X 32.1 Section 1350 Certification of Chief Executive and Chief Financial Officer X (b) Reports +on Form 8-K The +Company filed a current report on Form 8-K on October 15, 2003, to reference and furnish as exhibits a press release and data sheet issued to the public by the Company on +October 15, 2003. The +Company filed a current report on Form 8-K on July 16, 2003, to reference and furnish as exhibits a press release and data sheet issued to the public by the Company on +July 16, 2003. 114 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the +undersigned, thereunto duly authorized, this 18th day of December 2003. APPLE COMPUTER, INC. By: /s/ FRED D. ANDERSON Fred D. Anderson Executive Vice President and Chief Financial Officer KNOW +ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven P. Jobs and Fred D. Anderson, jointly and severally, his +attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to +file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said +attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated: Name Title Date /s/ STEVEN P. JOBS STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) December 18, 2003 /s/ FRED D. ANDERSON FRED D. ANDERSON Executive Vice President and Chief Financial Officer (Principal Financial Officer) December 18, 2003 /s/ PETER OPPENHEIMER PETER OPPENHEIMER Senior Vice President of Finance and Corporate Controller (Principal Accounting Officer) December 18, 2003 /s/ WILLIAM V. CAMPBELL WILLIAM V. CAMPBELL Director December 18, 2003 /s/ MILLARD S. DREXLER MILLARD S. DREXLER Director December 18, 2003 /s/ ALBERT GORE, JR. ALBERT GORE, JR. Director December 18, 2003 /s/ ARTHUR D. LEVINSON ARTHUR D. LEVINSON Director December 18, 2003 /s/ JEROME B. YORK JEROME B. YORK Director December 18, 2003 115 QuickLinks PART I Item 1. Business Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT AUDITORS Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation SUMMARY COMPENSATION TABLE AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Item 12. Security Ownership of Certain Beneficial Owners and Management Security Ownership of Directors, Nominees and Executive Officers Item 13. Certain Relationships and Related Transactions Item 14. Principal Accountant Fees and Services Audit and Non-Audit Fees PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K. SIGNATURES \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-04-035975/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-04-035975/full-submission.txt new file mode 100644 index 0000000..1fa3a3f --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-04-035975/full-submission.txt @@ -0,0 +1,2055 @@ +QuickLinks -- Click here to rapidly navigate through this document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 25, 2004 OR o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 0-10030 APPLE COMPUTER, INC. (Exact name of registrant as specified in its charter) CALIFORNIA (State or other jurisdiction of incorporation or organization) 942404110 (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California (Address of principal executive offices) 95014 (Zip Code) Registrant's +telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: None Securities +registered pursuant to Section 12(g) of the Act: Common Stock, no par value (Titles of classes) Indicate +by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding +12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained +herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference to Part III of this +Form 10-K or any amendment to this Form 10-K. ý Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the +Act). Yes ý No o The aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant, as of March 27, 2004, was approximately +$8,336,330,708 based upon the closing price reported for such date on the NASDAQ National Market. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 5% of the +outstanding shares of Common Stock and shares held by executive officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. This determination of +executive officer or affiliate status is not necessarily a conclusive determination for other purposes. 402,057,856 +shares of Common Stock Issued and Outstanding as of November 19, 2004 PART I The Business section and other parts of this Annual Report on Form 10-K ("Form 10-K") contain forward-looking +statements that involve risks and uncertainties. Many of the forward-looking statements are located in "Management's Discussion and Analysis of Financial Condition and Results of Operations." +Forward-looking statements can also be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future +performance and the Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not +limited to, those discussed in the subsection entitled "Factors That May Affect Future Results and Financial Condition" under Part II, Item 7 of this Form 10-K. The +Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Item 1. Business Company Background Apple Computer, Inc. ("Apple" or the "Company") was incorporated under the laws of the State of California on January 3, 1977. The Company designs, manufactures +and markets personal computers and related software, services, peripherals and networking solutions. The Company also designs, develops and markets a line of portable digital music players along with +related accessories and services including the online distribution of third-party music and audio books. The Company's products and services include the Macintosh line of desktop and notebook +computers, the iPod digital music player, the Xserve server and Xserve RAID storage products, a portfolio of consumer and professional software applications, the Mac OS X operating system, the online +iTunes Music Store, a portfolio of peripherals that support and enhance the Macintosh and iPod product lines, and a variety of other service and support offerings. The Company sells its products +worldwide through its online stores, its own retail stores, its direct sales force, and third-party wholesalers, resellers and value added resellers. In addition, the Company sells a variety of +third-party products that are compatible with the Company's Macintosh and iPod product lines, including computer printers and printing supplies, storage devices, computer memory, digital video and +still cameras, personal digital assistants, iPod accessories, and various other computing products and supplies through its online and retail stores. The Company's +fiscal year ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company's fiscal calendar. Business Strategy Apple is committed to bringing the best personal computing and music experience to students, educators, creative professionals, businesses and consumers around the world +through its innovative hardware, software, peripherals and Internet offerings. The Company's business strategy leverages its unique ability, through the design and development of its own operating +system, hardware and many software applications and technologies, to bring to its customers around the world meaningful new products and solutions with superior ease-of-use, +seamless integration and innovative industrial design. The Company believes continual investment in research and development is critical to facilitate innovation of new and improved products and +technologies. Besides updates to its existing line of personal computers and related software, services, and peripherals, the Company continues to capitalize on the convergence of digital consumer +electronics and the computer by creating product innovations like the iPod and iTunes Music Store. The Company has also invested in new product areas such as rack-mount servers, RAID +storage systems and wireless technologies. The Company's strategy also includes expanding its distribution network to effectively reach more of its targeted customers. Digital Hub The Company believes personal computing is in an era in which the personal computer functions for both professionals and consumers as the digital hub for advanced new digital +devices such as the Company's iPod digital music players, personal digital assistants, cellular phones, digital still and movie cameras, CD 1 and +DVD players, and other consumer electronic devices. The attributes of the personal computer, including its ability to run complex applications, possess a high quality user interface, contain large +and relatively inexpensive storage, and easily connect to the Internet in multiple ways and at varying speeds, can individually add value to these devices and interconnect them as well. Apple is the +only company in the personal computer industry that controls the design and development of the entire personal computer—from the hardware and operating system to sophisticated +applications. Apple provides innovative industrial design, intuitive ease-of-use, and built-in networking, graphics, and multimedia capabilities. Thus, the Company +is uniquely positioned to offer integrated digital hub products and solutions. Apple +develops products and technologies that adhere to many industry standards in order to provide an optimized user experience through interoperability with peripherals and devices from other +companies. Apple has played a role in the development, enhancement, promotion, and/or use of numerous of these industry standards, many of which are discussed below. Expanded Distribution The Company believes a high quality buying experience with knowledgeable salespersons, who can convey the value of the Company's products and services, is critical to +attracting and retaining customers. As such, in addition to expanding its indirect distribution channels, the Company has expanded its product distribution strategy to include its own retail +locations, Apple online stores worldwide, and the Apple Sales Consultant Program. The Company sells many of its products and resells certain third-party products in most of its major markets directly +to consumers, education customers, and businesses through its retail stores in the U.S. and internationally, or through one of its online stores around the world. The Company has also invested in +programs like the Apple Sales Consultant Program, which is designed to enhance reseller sales by the placement of Apple badged employees at selected third-party reseller locations. The Company +believes enabling a direct interface with its targeted end customer provides an efficient means to effectively demonstrate the advantages of the Company's Macintosh and other products over those of +its competitors. For certain of its consumer electronic products, including the iPod product family, the Company has also significantly expanded the points of distribution in order to make available +its products at locations where its customers shop. Since +inception of its retail initiative in 2001, the Company has opened 84 retail stores in the U.S. and 2 international stores in Tokyo and Osaka, Japan through the end of fiscal year 2004. During +the first quarter of 2005, the Company anticipates opening 14 additional stores, and expects to exit the calendar year at approximately 100 stores. The Company has typically located its stores at high +traffic locations in quality shopping malls and urban shopping districts. Approximately half of the stores expected to open during the first quarter of 2005 are in the new "mini" store design, which +is the Company's smallest store format to date, allowing them to be placed in a variety of new locations to introduce the Company's products to even more customers. The Company also opened its third +international store in London, England during the first quarter of 2005. One +of the goals of the retail initiative is to bring new customers to the Company and expand its installed base through sales to both first time personal computer buyers and those switching to the +Macintosh platform from competing operating system platforms. By operating its own stores and building them in desirable high traffic locations, the Company is able to better control the customer +retail experience and attract new Apple customers. The stores are designed to simplify and enhance the presentation and marketing of personal computing products. To that end, retail store +configurations have evolved into various sizes in order to accommodate market demands. The stores employ experienced and knowledgeable personnel who provide product advice and certain hardware support +services. The stores offer a wide selection of third-party hardware and software products selected to complement the Company's own products. Additionally, the stores provide a forum in which the +Company is able to present entire computing solutions to users in areas such as digital photography, digital video, music, children's software, and home and small business computing. Apple retail +stores host customer events and free 2 classes, +including the popular "Getting Started" class, and have brought back the concept of customer service with innovations like the Genius Bar. Education For more than 25 years, the Company has focused on the use of technology in education and has been committed to delivering tools to help educators teach and students +learn. The Company believes effective integration of technology into classroom instruction can result in higher levels of student achievement, especially when used to support collaboration, +information access, and the expression and representation of student thought and ideas. The Company creates solutions that enable new modes of curriculum delivery, better ways of conducting research, +and opportunities for professional development of faculty, students, and staff. A range of products and services is designed by the Company to help schools maximize their investments in technology. +This is manifested in many of the Company's products and services that are designed to meet the needs of education customers, including the eMac™ and the iBook®, video editing +solutions, wireless networking capabilities, student information systems, one-to-one learning solutions, and high-quality curriculum and professional development +solutions. Creative Professionals Creative professionals constitute one of the Company's most important markets for both hardware and software products. This market is also important to many third-party +developers who provide Macintosh compatible hardware and software solutions. Creative customers utilize the Company's products for a variety of creative activities including digital video and film +production and editing; digital video and film special effects, compositing, and titling; digital still photography; graphic design, publishing, and print production; music performance and production; +audio production and sound design; and web design, development and administration. The +Company designs its high-end hardware solutions, including servers, desktops, and portable Macintosh systems, to incorporate the power, expandability, and features desired by creative +professionals. Additionally, the Company's operating system, Mac OS X, incorporates powerful graphics and audio technologies and features developer tools to optimize system and application performance +when running powerful creative solutions provided by the Company or third-party developers. The Company also offers various software solutions to meet the needs of its creative customers, many of +which are described below. Business Organization The Company manages its business primarily on a geographic basis. The Company's reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas segment includes both North and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. +The Japan segment includes only Japan and excludes revenue from the Company's own retail stores in Japan, which is included in the Company's Retail segment. The Retail segment currently operates +Apple-owned retail stores in the U.S., Japan and England. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and the Company's subsidiary, +FileMaker, Inc. Each reportable geographic operating segment provides similar hardware and software products and similar services. Further information regarding the Company's operating segments +may be found in Part II, Item 7 of this Form 10-K under the heading "Segment Operating Performance," and in Part II, Item 8 of this Form 10-K in the +Notes to Consolidated Financial Statements at Note 11, "Segment Information and Geographic Data." Hardware Products The Company offers a range of personal computing products including desktop and notebook personal computers, related devices and peripherals, and various third-party hardware +products. All of the Company's Macintosh® products utilize PowerPC® RISC-based microprocessors. The Company's entire line of Macintosh systems, excluding servers +and storage systems, features the Company's Mac OS® X 3 Version +10.3 "Panther" and iLife® suite of software for digital photography, music, movies, and music creation. Power Mac® The Power Mac line of desktop personal computers is targeted at business and professional users and is designed to meet the speed, expansion and networking needs of the most +demanding Macintosh user. Powered by the PowerPC G5 processor, the Power Mac G5 utilizes 64-bit processing technology for memory expansion up to 8GB, and advanced 64-bit +computation while also running existing 32-bit applications natively. The Power Mac G5 product line comes in four processor configurations—single 1.8GHz, dual 1.8GHz, +dual 2.0GHz and dual 2.5GHz. All Power Mac G5 desktops feature a SuperDrive™ and either the NVIDIA GeForceFX 5200 Ultra or the ATI Radeon 9600 XT graphics card. In addition, all +Power Mac G5 desktops deliver connectivity and high-performance input/output (I/O), including Gigabit Ethernet, FireWire® 800 and FireWire 400 ports, +USB 2.0 ports, optical digital audio input and output, built-in support for 54 Mbps AirPort® Extreme wireless networking, and optional Bluetooth connectivity. Xserve ® and Xserve RAID Storage System Xserve, the Company's first rack-mount server product, was designed for simple setup and remote management of intensive I/O applications such as digital video, +high-resolution digital imagery, and large databases. In January 2004, the Company announced Xserve G5, which is available with either a single or dual 2.0 GHz PowerPC G5 +processor. Xserve G5 includes a system controller with up to 8GB of PC3200 error correcting code memory; three hot-plug Serial ATA drive modules that deliver up to 750GB of storage; +and dual on-board Gigabit Ethernet for high-performance networking. In January 2004, the Company also introduced its Xserve RAID storage system, a 3U +high-availability rack storage system, along with support for Windows and Linux-based computing environments. In October 2004, the Company updated its Xserve RAID storage system to +deliver 5.6 terabytes of storage capacity and also expanded support for heterogeneous environments. The dual independent RAID controllers with 512MB cache per controller offer sustained +throughput of over 380MBps—high enough to support two streams of uncompressed 10-bit HD video editing using protected RAID level 5. PowerBook ® The +PowerBook family of portable computers is designed to meet the mobile computing needs of professionals and advanced consumer users. In April 2004, the Company updated its PowerBook G4 +notebooks with faster PowerPC G4 processors. Both the 15-inch and 17-inch PowerBook G4 offer up to a 1.5 GHz PowerPC G4 processor, an available SuperDrive and the ATI Mobility +Radeon 9700 graphics processor. The 12-inch PowerBook G4 features a 1.33 GHz PowerPC processor, an available SuperDrive, and NVIDIA GeForce FX Go5200 graphics. Every PowerBook G4 notebook +comes with built-in AirPort Extreme wireless networking, an internal Bluetooth module for wireless connectivity, as well as a full complement of I/O ports including Firewire 400, USB 2.0., +a built-in 56K v.92 modem and Ethernet (10/100BASE-T), for connectivity to a wide range of peripherals. +The 15-inch and 17-inch PowerBook G4 models also include built-in Gigabit Ethernet and Firewire 800. iMac® The iMac line of desktop computers is targeted to consumer and education markets. In August 2004, the Company introduced the iMac® G5, featuring the +PowerPC G5 processor and a design that integrates the entire computer into the flat panel display. The line offers 17- or 20-inch active matrix widescreen LCDs and PowerPC G5 +processors running up to 1.8 GHz. The 17-inch models come with either a 1.8 GHz PowerPC G5 processor and a SuperDrive, or a 1.6 GHz PowerPC G5 processor and a Combo drive. The +20-inch model has a 1.8 GHz PowerPC G5 processor and a SuperDrive. The iMac G5 offers up to a 600 MHz front-side bus, 400 MHz DDR memory expandable to 2GB, AGP 8X +graphics and 7200 rpm Serial ATA drives holding up to 250GB. The iMac G5 comes standard with NVIDIA graphics with dedicated video memory. The iMac G5 desktops offer a total of five USB +ports (three USB 2.0) and two 4 FireWire® 400 +ports, an optional internal Bluetooth module, a built-in antenna and card slot to support an optional AirPort Extreme Card for 54 Mbps 802.11g wireless +networking, and also includes built-in Ethernet (10/100BASE-T) and a 56K V.92 modem. eMac™ The eMac, which is targeted primarily at the Company's education and consumer customers, features a PowerPC G4 processor, a high resolution 17-inch flat cathode ray +tube display, and preserves the all-in-one compact design of the original iMac favored by many of the Company's education and consumer customers. In April 2004, the +Company updated its eMac, which now has a suggested retail price starting at $799 and is available with a SuperDrive for a suggested retail price starting at $999. The eMac offers PowerPC G4 +processors running at up to 1.25 GHz, 333 MHz DDR memory, ATI Radeon graphics and USB 2.0 connectivity to peripherals. iBook® The iBook is designed to meet the portable computing needs of education and consumer users. In October 2004, the Company upgraded its iBook® G4 line to +include faster PowerPC G4 processors running up to 1.33 GHz, built-in AirPort Extreme 54 Mpbs 802.11g wireless networking and an available slot-load SuperDrive. The +12-inch model +features a 1.2 GHz PowerPC G4 processor and a slot-load Combo drive, while the 14-inch models include a 1.33GHz G4 processor and either a Combo or +SuperDrive optical drive. All iBook G4 models offer a full complement of I/O ports including FireWire 400, USB 2.0, a built-in 56K v.92 modem and Ethernet +(10/100BASE-T), as well as an optional internal wireless Bluetooth module, for connectivity to a wide range of peripherals. Music Products and Services The Company offers its iPod® line of digital music players and related accessories to Macintosh and Windows users. The Company also provides an online service to +distribute third-party music and audio books through its iTunes® Music Store. Net sales of iPods and other music products and services generated year-over-year +revenue growth of 316% and accounted for 19% of the Company's total net sales in fiscal 2004. iPod ® In +July 2004, the Company introduced the fourth generation of the iPod, the Company's portable digital music player, featuring Apple's patent pending click wheel, which combines a +touch-sensitive wheel with five push buttons for one handed navigation, and up to 12 hours of battery life. The iPod features Apple's patent pending Auto-Sync technology that +automatically downloads an entire digital music library onto the iPod and keeps it up-to-date whenever it is plugged into a Macintosh or Windows computer using FireWire or USB. +The iPod also features Shuffle Songs, which randomly plays songs in a selected playlist or across the entire library. All iPods work with Apple's iTunes digital music management software on either a +Macintosh or Windows computer. The iPod is available in 20GB and 40GB models. The +iPod's functionality extends beyond playing music and listening to audio books. Other key capabilities include data storage, calendar and contact information utility, and a selection of games. +With the addition of third-party iPod peripherals, the capabilities of certain iPods can be enhanced to include voice recording and photo downloading directly from certain digital cameras. Along with +the iPod, the Company has developed a seamless end-to-end music solution with the Company's iTunes software and the iTunes Music +Store ® , a service that consumers may use to purchase third-party music and audio books over the Internet. The +Company has entered into a strategic alliance with Hewlett-Packard Company (HP), which provides for a HP-branded digital music player based on the iPod, the preinstallation of iTunes +software on HP's consumer PCs and notebooks and access to the iTunes Music Store. The Company has also entered into an alliance with BMW Group for the BMW iPod Adapter, a device that offers seamless +integration of the iPod and certain BMW automobiles in North America. In addition, the Company formed an alliance with 5 Founder +Technology Group Corporation, a supplier of PCs to the Chinese market, that provides for the preinstallation of iTunes on all Founder Technology Windows-based PCs. A similar alliance was +formed with Synnex Technology International Corporation, a Taiwan-based wholesaler and distributor of personal computers, for the preinstallation of iTunes on its Windows-based laptop and desktop PCs. In +October 2004, the Company introduced the iPod U2 Special Edition as part of a strategic alliance with the musical band, U2, and Universal Music Group. The U2 iPod holds up to 5,000 songs, +features a black enclosure with a red click wheel and custom engraving of U2 band member signatures. iPod® photo In October 2004, the Company introduced iPod® photo. The iPod photo holds digital photos alongside the music library and displays them on its +high-resolution color screen, which allows users to scroll through the photo library almost instantly using iPod's patent pending click wheel. iPod photo can auto sync music and photos +with a Macintosh or Windows-based computer. The iPod photo also allows users to simultaneously play music and view photo slideshows on the iPod, as well as on televisions and projectors. The iPod +photo comes in 40GB or 60GB models and has an extended battery life that gives users up to 15 hours of music playback or up to 5 hours of slideshows. The iPod photo can hold up to 25,000 +digital photos or 15,000 digital songs. iPod ® mini In January 2004, the Company introduced the iPod mini. Smaller and lighter than the iPod, the iPod mini has storage capacity of 4GB and holds up to 1,000 songs, utilizes +the patent pending click wheel and is encased in an anodized aluminum case available in a selection of five colors: silver, gold, pink, blue or green. The iPod mini retains the same user interface as +the iPod and works seamlessly with the Company's iTunes Music Store® and the iTunes software for buying, managing and listening to digital music on either a Macintosh or Windows-based +computer. iTunes Music Store ® The +Company's iTunes Music Store, available for both Windows-based and Macintosh computers, is an online music download store that allows customers to find, purchase, and download third-party digital +music and audio books. Users can easily search the contents of the music store catalog to locate works by title, artist, or album, or browse the entire contents of the store by genre and artist. Users +can also listen to a free 30-second preview of any song in the store. Since April 2003, the iTunes Music Store has been available to U.S. customers. A similar store became available +in the U.K., France and Germany in June 2004 and was followed by the October 2004 launch of an English language music store covering nine additional European countries. The Company has +also announced its intention to open an iTunes Music Store in Canada during fiscal 2005. The +iTunes Music Store is fully integrated directly into the latest version of the iTunes software, allowing customers to preview, purchase, download, organize, share, and transfer their digital music +to an iPod using a single software application. Further discussion on the iTunes software may be found below under the heading "Software Products and Computer Technologies." Requiring no subscription +fee, the iTunes Music Store with iTunes software offers customers a broad range of personal rights to the third-party content they have purchased, including playing songs on up to five personal +computers, burning a single song onto CDs an unlimited number of times, burning the same playlist up to seven times, listening to their music on an unlimited number of iPods, and using songs in +certain media applications such as iPhoto, iMovie, and iDVD. The iTunes Music Store also features availability of audio books for purchase directly from the iTunes Music Store. Additional +features currently available within the U.S. iTunes Music Store include gift certificates that can be sent via e-mail, prepaid gift cards, an "allowance" feature that enables +users to automatically deposit 6 funds +into an iTunes Music Store account every month; and "Radio Charts," a feature that allows users to search and buy the top songs played on radio stations in major U.S. markets. Peripheral Products The Company sells certain associated Apple-branded computer hardware peripherals, including iSight™ digital video cameras, and a range of high quality flat panel +TFT active-matrix digital color displays. The Company also sells a variety of third-party Macintosh compatible hardware products directly to end users through both its retail and online stores, +including computer printers and printing supplies, storage devices, computer memory, digital video and still cameras, personal digital assistants, and various other computing products and supplies. iSight ™ The +Company's iSight digital video camera enables video conferencing over broadband. iSight is a small, portable aluminum alloy camera with all audio, video and power provided by a single FireWire +cable. iSight is designed to be center-mounted on the top of a computer screen and uses its integrated tilt and rotate mechanism to easily position the camera for natural, +face-to-face video conferencing. iSight +features an autofocusing autoexposure F/2.8 lens which captures high-quality pictures and full-motion video. With its on-board processor, iSight +automatically adjusts color, white balance, sharpness and contrast to provide high-quality images with accurate color reproduction in most lighting conditions. iSight also includes a +dual-element microphone that suppresses ambient noise for clear digital audio. Displays In June 2004, the Company announced a family of widescreen flat panel displays featuring the 30-inch Apple Cinema HD Display, a widescreen active-matrix LCD +with 2560-by-1600 pixel resolution, a 23-inch widescreen Apple Cinema Display with 1920-by-1200 pixel resolution and a 20-inch +widescreen Apple Cinema Display with 1680-by-1050 pixel resolution. The displays feature dual FireWire and dual USB 2.0 ports built into the display and use the industry +standard DVI interface for a pure digital connection with the Company's latest Power Mac and PowerBook systems. The Cinema Displays feature an aluminum design with a very thin bezel, suspended by an +aluminum stand that allows viewing angle adjustment. Software Products and Computer Technologies The Company offers a range of software products for education, creative, consumer and business customers, including Mac OS X, the Company's proprietary operating system +software for the Macintosh; server software and related solutions; professional application software; and consumer, education and business oriented application software. Operating System Software The Company released Mac OS X version 10.3 (code-named "Panther"), the Company's current version of Mac OS X, in October 2003. +Panther incorporates features including a new version of Finder™; Exposé™, a way to organize windows and instantly see all open windows at once; FileVault, a +feature that secures the contents of a home directory with 128-bit AES encryption; iChat AV; and enhanced support for use on Windows-based networks. In +June 2004, the Company previewed Mac OS X version 10.4 (code-named "Tiger"), the fifth major version of Mac OS X that is expected to ship in +the first half of calendar 2005. Tiger will contain new features including Spotlight, a new way to instantly find any file, document or information on a Macintosh created by any application on the +Macintosh; Safari™ RSS, a new version of Apple's web browser that incorporates instant access to Really Simple Syndication (RSS) data feeds on the web; Dashboard, a new way to instantly +access "Widgets," a new collection of desktop mini application accessories, including a datebook, stock ticker, calculator, address book and iTunes controller; and a new version of iChat instant +messaging client with multi-person audio and video conferencing in a 3D interface. 7 Server Software and Server Solutions In October 2003, the Company began shipping the current version of its server operating system, Mac OS X Server version 10.3 (code-named +"Panther Server"). This release integrates open source and open standards server software with easy-to-use management tools that make it easy to serve Macintosh, Windows and +Linux clients. Features in Panther Server include Server Admin tool for easily setting up multiple servers; Open Directory 2 for hosting scalable LDAP directory and Kerberos authentication services; +Samba 3 for providing login and home directory support for Windows clients; and the JBoss application server for running powerful J2EE applications. In +June 2004, the Company previewed Mac OS X Server version 10.4 (code-named "Tiger Server"), the next major release of the Company's UNIX-based +server operating system that deploys open source solutions for Macintosh, Windows and Linux clients. Tiger Server includes native support for 64-bit applications; iChat Server to deploy +private, encrypted communications within an organization; and migration tools to make it easy to upgrade from legacy Windows servers to Mac OS X Server. In +June 2004, the Company introduced Apple Remote Desktop™ 2, the second generation of the Company's asset management, software distribution and help desk support software. Along +with improvements in screen sharing performance, Apple Remote Desktop 2 includes more than 50 features for centrally managing Mac OS X systems. Apple Remote Desktop 2 can +perform a wide range of desktop management tasks such as installing operating system and application software, running hardware and software inventory reports and executing commands on one or more +remote Mac OS X systems on the network. Remote software installation tools allow IT professionals to install single or multiple software packages immediately or at specific dates and +times. Comprehensive hardware and software reports based on more than 200 system information attributes allow administrators to keep track of their Mac OS X systems. In addition, built-in +real-time screen sharing enables help desk professionals to provide online assistance by observing and controlling the desktops of any remote Macintosh or Virtual Network Computing-enabled +computer, including Windows and Linux systems. Xsan, +the Company's enterprise-class Storage Area Network (SAN) file system, was introduced as a beta version in April 2004 and is expected to be available for general release in the Fall of +2004. Xsan is a 64-bit cluster file system for Mac OS X that enables organizations to consolidate storage resources and provide multiple computers with concurrent file-level +read/write access to shared volumes over Fibre Channel. Advanced features such as metadata controller failover and Fibre Channel multipathing ensure high availability; file-level locking +allows multiple systems to read and write concurrently to the same volume which is ideal for complex workflows; bandwidth reservation provides for effective ingestion of bandwidth-intensive data +streams, such as high resolution video; and flexible volume management results in more efficient use of storage resources. Since Xsan is interoperable with ADIC's StorNext File System, it can be used +in heterogeneous environments that include Windows, UNIX and Linux server operating system platforms. Professional Application Software Final Cut Pro® HD, the latest version of the Company's video editing software, was introduced in April 2004 and features real-time performance of +high-quality native DVCPRO HD, a high-definition video format, in addition to real-time support for digital video (DV) and standard definition (SD) formats. Final +Cut Pro HD supports native DVCPRO HD editing with no recompression or image degradation and enables HD preview monitoring through the computer's DVI display output via the Digital Cinema Desktop +feature. Final Cut Pro HD's support of native DVCPRO HD makes media conversion unnecessary, preserving the full quality of the camera original. Final Cut Pro HD includes precision, +non-modal editing and trimming tools; powerful interface customization features; advanced real-time color correction and image control; and enhanced audio editing capabilities +with multi-track audio mixing and multi-channel audio output. 8 In +April 2004, the Company announced DVD Studio Pro® 3, the latest version of the Company's professional DVD authoring application. DVD Studio Pro 3 features Alpha +Transitions, which are QuickTime® based movie transitions that may be used as segues between DVD menus and as DVD slide show transitions, and a new Graphical View for easy visualization of +a project's entire flow in a storyboard environment. Graphical View makes it easy to see the relationships between menus, tracks, slideshows, stories and scripts. DVD Studio Pro 3 also includes +Compressor 1.2, the latest version of the Company's digital media encoding and compression software that provides high-quality constant and variable bit rate MPEG-2 encoding. +In addition to DV and SD, DVD Studio Pro 3 now provides the ability to scale HD and encode directly to MPEG-2 all in one step. In +August 2004, the Company began shipping Motion, a motion graphic design and production application. Motion features interactive animation of text, graphics and video, with +real-time previewing of multiple filters and particle effects. Motion introduces "Behaviors," a procedural animation technology that allows for the adding of natural looking movement to +type and graphics, such as gravity and wind, without the use of complex keyframes. Motion's "Interactive Dashboard" gives users access to a contextual, semi-transparent floating palette +that provides the tools and slider parameters for objects being manipulated on screen. Motion's "Project Pane" allows users to view and manage all filters, Behaviors, masks and other properties +applied to all objects and layers of objects within a project. In +August 2004, the Company introduced Production Suite, which combines the latest versions of Final Cut Pro HD, DVD Studio Pro 3 and Apple Motion into a software suite for film and +video production that delivers real-time production tools in one comprehensive and integrated package. Production Suite provides an integrated workflow environment where content that is +updated in one of the applications in the suite is automatically updated in the other applications. Shake® 3.5, +an upgrade of the Company's compositing and visual effects software designed for large format film and video productions was introduced in April 2004. +Shake 3.5 features shape-based morphing and warping tools for advanced compositing and "shape shifting" special effects. Morphing and warping further enhance Shake's visual effects tools, +including layering, tracking, rotoscoping, painting and color correction. Shake 3.5 also improves upon the Shake Qmaster network render manager that can now handle distributed rendering tasks +for both Shake and Alias Systems Corp.'s Maya product, allowing for distribution of rendering tasks across a cluster of servers or computers. Logic® +Pro 7, introduced by the Company in September 2004 is actively used by musicians around the world and by professionals in music production, film scoring, and audio +post-production facilities. It combines digital music composition, notation and audio production facilities in one comprehensive product and includes software instruments such as +Sculpture, a component-modeling based synthesizer; UltraBeat, a drum synthesizer with built-in step sequencer; and digital signal processing (DSP) plug-ins including Guitar Amp +Pro, a full-featured guitar amplifier simulator. Along with over 100 workflow enhancements, mastering plug-ins and support for Apple Loops, Logic Pro 7 debuts +distributed audio processing, a technology which allows audio pros to tap into a number of Macintosh systems to expand available DSP power via an Ethernet network. Consumer, Education and Business Oriented Application Software In January 2004, the Company introduced iLife® '04, the next generation suite of its digital lifestyle applications, which features iPhoto®, +iMovie®, iDVD®, iTunes® software, and introduced GarageBand™, a music creation software application. All of these iLife applications come preinstalled +on the Company's Macintosh systems, excluding servers and storage systems. Burning DVDs with iDVD requires a Macintosh system configured with a SuperDrive. iTunes® +software, available for both Macintosh and Windows-based computers, lets users create and manage their own digital music library. iTunes organizes music using searching, browsing +and playlist features and supports automatic synchronization with the music stored on an iPod. iTunes supports AAC 9 and +MP3 encoding from audio CDs, provides the ability to burn custom playlists to CDs and MP3 CDs, and allows for music sharing between networked computers. In October 2004, the Company's +newest version, iTunes 4.7, included support for copying photos to an iPod photo. Since April 2003, the Company's iTunes software has been integrated with the Company's iTunes Music +Store® to facilitate the sale of third-party music and audio books. Further discussion of the iTunes Music Store may be found above under the heading "Music Products and Services." iMovie® +is the Company's consumer digital video editing software for creation of home and classroom movies. iMovie 4 features an enhanced user interface, improved audio editing +capabilities, enhanced controls for titling and transitions, and added special effects. Users may edit and trim audio and video clips in the enhanced timeline with +click-and-drag editing and even select and edit multiple clips simultaneously. With graphical audio waveforms and live audio scrubbing, users can locate specific edit points in +audio tracks, and alignment guides make it easy to precisely sync video and audio. iDVD® +is consumer oriented software that makes it easy to turn iMovie files, QuickTime files and digital pictures into DVDs that can be played on most consumer DVD players. iDVD simplifies +DVD authoring by including professionally designed themes and drag-and-drop simplicity. iDVD® 4 includes themes and professional effects that allow users to +use photos and movies as buttons, backgrounds and menus. Movies from iMovie, photos from iPhoto and music from either iTunes or GarageBand can be added directly to a DVD via the media browser, and +enhanced photo slideshows can include cinematic transitions and iTunes playlists. The DVD Map provides an overview of an entire DVD project and instant accessibility to all project elements. GarageBand™, +the Company's consumer oriented music creation software, allows users to play, record and create music using a simple interface. With GarageBand, recorded performances, +digital audio and looping tracks can be arranged and edited to create songs. GarageBand comes with more than 50 software instruments, pre-recorded audio loops for making complete +songs or backing tracks, pro-quality effects presets for mixing, and vintage amplifier sounds for the guitar. The Company also offers three different Jam Packs, which provide additional +software instruments and loops that enhance the use of GarageBand to create and record music. iPhoto® +is consumer oriented digital photo software that makes it easy to import, edit, save, share, and print digital photos, as well as organize and manage an entire digital photo +collection containing thousands of photos. Users are able to view their photos in full-screen; use the slide show feature accompanied by their favorite music; automatically create custom +web pages of their photos; email photos to friends and family; order professionally-processed prints and enlargements online; or easily design and order custom-printed, linen-covered hard bound photo +books online. Customers in numerous countries can order prints, enlargements, and photo books directly from within iPhoto. iPhoto® 4 has features that allow users to scroll through +thousands of photos in seconds to easily find a particular photo, contains Smart Albums which automatically organizes photos based on date, keyword or the user's own rating, and has controls for +rotating, rating and deleting photos. Final +Cut® Express, based on Final Cut Pro, enables small business users, educators, students and advanced hobbyists to perform professional-quality digital video editing. In +January 2004, the Company introduced Final Cut Express 2, which features RT Extreme for real-time compositing and effects, an enhanced user interface, real-time +color correction tools and enhanced audio editing capabilities. Logic® +Express 7, introduced by the Company in September 2004, is a streamlined version of Logic Pro 7 that provides a basic set of professional tools to compose and +produce music for students, educators and advanced hobbyists. Logic Express 7 comes with support for projects from GarageBand offering users a smooth migration path to high-end +audio production. Keynote™ +is the Company's presentation software that gives users the ability to create high-quality presentations. Designed to be easy to use, Keynote includes professionally +designed themes, advanced 10 typography, +professional-quality image resizing, animated charts and tables that can be created quickly, and cinematic-quality transitions. Keynote imports and exports PowerPoint, QuickTime, and PDF +files to simplify the creation and sharing of presentations. AppleWorks® +6.2 is an integrated productivity application that incorporates word processing, page layout, image manipulation, spreadsheets, databases and presentations in a single +application. Intended to be an easy-to-use product for the Company's consumer and education customers, AppleWorks makes it simple to create professional-looking documents in +the classroom and at home. FileMaker, Inc., +a wholly owned subsidiary of the Company, develops, publishes, and distributes desktop-based database management application software for either a Macintosh or Windows-based +computer. The FileMaker ® Pro database software and related products offer relational databases and desktop-to-web +publishing capabilities. In March 2004, the Company introduced FileMaker Pro 7 with new architecture and enhancements in ease-of-use, customizability and +developer productivity. FileMaker Pro 7 has been redesigned using a modern, streamlined relational architecture, which enables users to simplify information management by storing multiple tables +within a single file and includes the relationships graph feature which presents a visual "map" of the database and lets users create and modify relationships with a simple click and drag tool. +FileMaker Pro 7 has also expanded its data capacity to 8 terabytes per file or 4,000 times the former limit. Internet Software, Integration, and Services Apple's Internet strategy is focused on delivering seamless integration with and access to the Internet throughout the Company's product lines. The Company's Internet products +and technologies adhere to many industry standards in order to provide an optimized user experience through interoperability. An easy to use Internet Setup Assistant is included with the Mac OS. Safari™ Safari, the Company's Mac OS X compatible web browser, is capable of loading web pages rapidly. Safari uses the advanced interface technologies underlying +Mac OS X and includes built-in Google search; SnapBack™ to instantly return to search results; a way to name, organize and present bookmarks; tabbed browsing; and +automatic "pop-up" ad blocking. The Company also released a software development kit that allows developers to embed the Safari HTML rendering engine directly into their applications. Quicktime ® QuickTime, +the Company's multimedia software for either a Macintosh or Windows-based computer, features streaming of live and stored video and audio over the Internet and playback of +high-quality audio and video on computers. QuickTime 6 includes the Instant-On Streaming feature that eliminates buffer delays and provides users with the +ability to quickly and easily scrub through streaming media content to locate and instantly view specific sections. In addition, QuickTime 6 running on Mac OS X now supports +JPEG 2000, the next generation JPEG standard that allows users to capture still images in a higher quality and smaller file size than ever before. QuickTime 6 also includes AAC, the +standard MPEG-4 audio format. AAC is the next generation professional-quality audio format that delivers superior sound quality with reduced file sizes. The +Company also offers several other QuickTime products, including QuickTime Pro, a suite of software tools that allows creation and editing of Internet-ready audio and video files and allows a user +to add special effects and other features to QuickTime movies; QuickTime Streaming Server which facilitates the broadcasting of streaming digital video; and QuickTime Broadcaster that allows users to +quickly and easily produce professional-quality live events for online delivery. 11 .Mac ™ The +Company's .Mac offering is a suite of Internet services that for an annual fee provides Macintosh users with powerful Internet tools. .Mac features email service with IMAP, POP or +web-based access and 125MB of storage, iDisk Internet storage capacity of an additional 125MB, and hosting for personalized homepages and shared digital photo albums. Also included with +..Mac is McAfee's Virex anti-virus software and Backup, a personal back-up solution allowing users to archive data to their Internet storage, CD, or DVD. Wireless Connectivity and Networking AirPort Extreme ® AirPort +Extreme, introduced in January 2003, is the Company's next generation of Wi-Fi wireless networking technology. AirPort Extreme is based on the 802.11g standard, which +supports speeds up to 54 Mbps, and is fully compatible with most Wi-Fi devices which use the 802.11b standard. AirPort Extreme Base Stations can serve up to 50 Macintosh and +Windows users simultaneously, provide wireless bridging to extend the range beyond just one base station, and support USB printer sharing to allow multiple users to wirelessly share USB printers +connected directly to the base station. AirPort® Express In June 2004, the Company introduced AirPort® Express, the first 802.11g mobile base station that can be plugged directly into the wall for wireless Internet +connections and USB printing. Airport Express also features analog and digital audio outputs that can be connected to a stereo and AirTunes™ music networking software which works with +iTunes, giving users a way to wirelessly stream iTunes music from their Macintosh or Windows-based computer to any room in the house. AirPort Express features a single piece design weighing +6.7 ounces. Other Connectivity and Networking Solutions Mac OS X includes capabilities for Bluetooth technology. Bluetooth is an industry standard for wirelessly connecting computers and peripherals that supports +transmission of data at up to 1 Mbps within a range of approximately 30 feet. The Company's Bluetooth technology for Mac OS X lets customers wirelessly share files between +Macintosh systems, synchronize and share contact information with Palm-OS based PDAs, and access the Internet through Bluetooth-enabled cell phones. A Bluetooth USB adaptor can +Bluetooth-enable any USB-based Macintosh computer running in Mac OS X version 10.1.4 or higher. The +Company's zero configuration networking technology is based on open Internet Engineering Task Force (IETF) Standard Protocols such as IP, ARP and DNS and is built into Mac OS X. This technology +uses industry standard networking protocols and zero configuration technology to automatically discover and connect devices over any IP network, including Ethernet or 802.11-based wireless +networks like the Company's AirPort products. The source code for this technology also includes software to support UNIX, Linux, and Windows-based systems and devices. Major developers such as Canon, +Epson, Hewlett-Packard, Lexmark, Philips, Sybase, World Book and Xerox have announced support for this zero configuration networking technology in a broad range of products including network printers, +consumer electronics, enterprise database management and educational applications. The Company has made the source code for this technology freely available to developers for use in their +network-enabled devices or software applications. The +Company developed FireWire ® technology, also referred to as IEEE 1394, which is a high-speed serial I/O technology for +connecting digital devices such as digital camcorders and cameras to desktop and portable computers. With its high data-transfer speed and "hot plug-and-play" +capability, FireWire has become an established cross-platform industry standard for both consumers and professionals and is the data interface of choice for today's digital video and audio devices, as +well as external hard drives and 12 other +high-speed peripherals. FireWire is currently included on all Macintosh systems and is a data transfer technology utilized by iPod. Product Support and Services AppleCare ® offers a range of support options for Apple customers. These options include assistance that is built +into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare Protection Plan. The +AppleCare Protection Plan is a fee-based service that typically includes three years of phone support and hardware repairs, dedicated web-based support resources, and user +diagnostic tools. Specialized Education Products and Services The Company offers a variety of unique services and products to its education customers, including a separate online store for education customers offering special education +price lists and promotions; special financing programs for K-12 and higher education students, faculty, and staff; a special edition of its productivity software suite, AppleWorks, that is +compatible for both Macintosh and Windows-based computers; Wireless Mobile Labs that allows teachers and students to share iBook computers, a printer, and a wireless network/Internet connection stored +on a cart for mobility between classrooms; and three special Digital Media Studio solutions designed for education, including one that is integrated into a mobile cart. Additionally, the Company +offers one-to-one (1:1) learning solutions, which are a complete solution typically consisting of an iBook portable system for every student and teacher along with a wireless +network connected to a central server. The +Company's PowerSchool ® software product is a web-based student information system for K-12 schools and school +districts. PowerSchool software products give school administrators and teachers the ability to easily and cost-effectively manage student records and give parents real-time +access to track their children's performance via the Internet. PowerSchool offers the option of remote hosting with an application service provider model. Markets and Distribution The Company's customers are primarily in the education, creative, consumer, and business markets. Apple customers are attracted to Macintosh computers for a variety of reasons, +including the reduced amount of training resulting from the Macintosh computer's intuitive ease of use, advanced graphics capabilities, industrial design features of the Company's hardware products, +and ability of Macintosh computers to network and communicate with other computer systems and environments. Apple personal computers were first introduced to education customers in the late 1970s. +Over 16% of the Company's net sales in 2004 were through its U.S. education channel, including sales to elementary and secondary schools, higher education institutions and individual customers. The +Company distributes its products through wholesalers, resellers, national and regional retailers and cataloguers. No individual customer accounted for more than 10% of net sales in 2004, 2003 or +2002. The Company also sells many of its products and resells certain third-party products in most of its major markets directly to consumers, education customers, and businesses through its retail +stores in the U.S. and internationally, or through one of its online stores around the world. Total direct and indirect sales transacted through the Company's online stores totaled approximately +$3.9 billion, $2.9 billion, and $2.4 billion for fiscal years 2004, 2003 and 2002, respectively. Competition The Company is confronted by aggressive competition in all areas of its business. The market for the design, manufacture, and sale of personal computers and related software +and peripheral products is highly competitive. This market continues to be characterized by rapid technological advances in both hardware and software development, which have substantially increased +the capabilities and applications of these products, and have resulted in the frequent introduction of new products and significant price, 13 feature, +and performance competition. Over the past several years, price competition in the market for personal computers has been particularly intense. The Company's competitors who sell personal +computers based on other operating systems have aggressively cut prices and lowered their product margins to gain or maintain market share. The Company's results of operations and financial condition +have been, and in the future may continue to be, adversely affected by these and other industry-wide downward pressures on gross margins. The +principal competitive factors in the market for personal computers include relative price/performance, product quality and reliability, design innovation, availability of software, product +features, marketing and distribution capability, service and support, availability of hardware peripherals, and corporate reputation. Further, as the personal computer industry and its customers place +more +reliance on the Internet, an increasing number of Internet devices that are smaller, simpler, and less expensive than traditional personal computers may compete for market share with the Company's +existing products. The +Company is currently taking and will continue to take steps to respond to the competitive pressures being placed on its personal computer sales as a result of innovations in competing platforms. +The Company's future operating results and financial condition are substantially dependent on its ability to continue to develop improvements to the Macintosh platform in order to maintain perceived +functional and design advantages over competing platforms. The +Company's initial success with the development of an end-to-end music offering, which includes the iTunes software, iTunes Music Store and iPod digital music player, has +already encouraged significant competition in this area from other companies, many of whom have greater financial, marketing, and manufacturing resources than those of the Company. The Company +anticipates that competition will intensify requiring the Company to respond as hardware, software and content providers work more collaboratively to offer integrated products that compete against the +Company's offerings. The Company believes it maintains a competitive advantage by more effectively integrating the entire end-to-end music solution, including the hardware +(iPod), software (iTunes) and distribution of third-party music content (iTunes Music Store). Raw Materials Although most components essential to the Company's business are generally available from multiple sources, certain key components (including microprocessors and +application-specific integrated circuits ("ASICs")) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from +multiple sources, are at times subject to industry wide availability constraints and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal +computer and consumer electronics industries, and new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether +there is a need for, and subsequently qualifies, additional suppliers. If the supply of a key or single-sourced component to the Company were to be delayed or curtailed or in the event a key +manufacturing vendor delays shipments of completed products to the Company, the Company's ability to ship related products in desired quantities and in a timely manner could be adversely affected. The +Company did experience such delays during fiscal 2004, which resulted in the constrained availability of certain products. The Company's business and financial performance could also be adversely +affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of +these components may be affected if producers were to decide to concentrate on the production of common components instead of components customized to meet the Company's requirements. The Company +attempts to mitigate these potential risks by working closely with these and other key suppliers on product introduction plans, strategic inventories, coordinated product introductions, and internal +and external manufacturing schedules and levels. Consistent with industry practice, the Company acquires components through a combination of formal purchase orders, supplier 14 contracts, +and open orders based on projected demand information. Such purchase commitments typically cover the Company's requirements for periods ranging from 30 to 130 days. The +Company believes there are several component suppliers and manufacturing vendors whose loss to the Company could have a material adverse effect upon the Company's business and financial position. +At this time, such vendors include Agere Systems, Inc., Ambit Microsystems Corporation, ASUSTeK Corporation, ATI Technologies, Inc., Broadcom Corporation, Freescale +Semiconductor, Inc. (formerly the Semiconductor Products Segment of Motorola, Inc.), Hitachi Global Storage Technologies, Hon Hai Precision Industry Co., Ltd., IBM Corporation, +International Display Technology, Inventec Appliances Corporation, LG. Phillips Co., Ltd., Matsushita, Mitsubishi Electric Corporation, NVIDIA Corp., Portal Player, Inc., Quanta +Computer, Inc., Samsung Electronics, Synaptics, Inc., and Toshiba Corporation. Research and Development Because the personal computer industry is characterized by rapid technological advances, the Company's ability to compete successfully is heavily dependent upon its ability to +ensure a continuing and timely flow of competitive products and technology to the marketplace. The Company continues to +develop new products and technologies and to enhance existing products in the areas of hardware and peripherals, consumer electronic products, system software, applications software, networking and +communications software and solutions, and the Internet. The Company may expand the range of its product offerings and intellectual property through licensing and/or acquisition of third-party +business and technology. The Company's research and development expenditures totaled $489 million, $471 million, and $446 million in 2004, 2003, and 2002, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its computer systems, iPods, peripherals and software. In addition, the Company has +registered, and/or has applied to register, trademarks and service marks in the U.S. and a number of foreign countries for "Apple," the Apple logo, "Macintosh," and numerous other trademarks and +service marks. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an important factor in its business and that its success does depend in part on +the ownership thereof, the Company relies primarily on the innovative skills, technical competence, and marketing abilities of its personnel. Many +of the Company's products are designed to include intellectual property obtained from third-parties. While it may be necessary in the future to seek or renew licenses relating to various aspects +of its products and business methods, the Company believes that, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms; however, +there is no guarantee that such licenses could be obtained at all. Because of technological changes in the computer industry, current extensive patent coverage, and the rapid rate of issuance of new +patents, it is possible certain components of the Company's products and business methods may unknowingly infringe existing patents of others. The Company has from time to time been notified that it +may be infringing certain patents or other intellectual property rights of others. Foreign and Domestic Operations and Geographic Data The U.S. represents the Company's largest geographic marketplace. Approximately 59% of the Company's net sales in fiscal 2004 came from sales to customers inside the U.S. Final +assembly of products sold by the Company is conducted in the Company's manufacturing facility in Cork, Ireland, and by external vendors in Fremont, California, Fullerton, California, Taiwan, Korea, +the Netherlands, the People's Republic of China, and the Czech Republic. Currently, manufacture of many of the components used in the Company's products and final assembly of substantially all of the +Company's portable products including PowerBooks, iBooks, and the iPod are performed by third-party vendors in Taiwan and China. Margins on sales of Apple products in foreign countries, and on sales +of products that include components obtained from foreign 15 suppliers, +can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. Information +regarding financial data by geographic segment is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at +Note 11, "Segment Information and Geographic Data." Seasonal Business The Company has historically experienced increased net sales in its first and fourth fiscal quarters, compared to other quarters in its fiscal year, due to seasonal demand +related to the holiday season and the school year, respectively. Past performance should not be considered a reliable indicator of the Company's future net sales or financial performance. Warranty The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of +purchase by the end-user. The Company also offers a 90-day basic warranty for Apple service parts used to repair Apple hardware products. In addition, consumers may purchase +extended service coverage on most Apple hardware products in all of the Company's major markets. Backlog In the Company's experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog +often increases in anticipation of or immediately following new product introductions because of over-ordering by dealers anticipating shortages. Backlog often is reduced once dealers and +customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company's ability to achieve any particular level of revenue +or financial performance. Environmental Laws Compliance with federal, state, local, and foreign laws enacted for the protection of the environment has to date had no material effect on the Company's capital expenditures, +earnings, or competitive position. In the future, these laws could have a material adverse affect on the Company. Production +and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement that the Company +provide consumers with the ability to return to the Company product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws +and regulations have recently been passed in several jurisdictions in which the Company operates, including various European Union member states, Japan and California. In the future, these laws could +have a material adverse affect on the Company. Employees As of September 25, 2004, Apple and its subsidiaries worldwide had 11,695 employees and an additional 1,731 temporary employees and contractors. Available Information The Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments +to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are available on its website at http://www.apple.com/investor when such reports are available +on the U.S. Securities and Exchange Commission (SEC) website. The public may read and copy any materials filed by the Company with the SEC at the SEC's Public Reference Room at 450 Fifth +Street, NW, Washington, DC 20549. The public may obtain information on the operation of 16 the +Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other +information regarding issuers that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing. Further, the Company's references to +the URLs for these websites are intended to be inactive textual references only. Item 2. Properties The +Company's headquarters are located in Cupertino, California. The Company has manufacturing facilities in Cork, Ireland. As of September 25, 2004, the Company leased approximately +3.3 million square feet of space, primarily in the U.S., and to a lesser extent, in Europe, Japan, and the Asia Pacific region. The major facility leases are for terms of 5 to 10 years +and generally provide renewal options for terms of 2 to 5 additional years. Leased space includes 660,000 square feet of retail space, a majority of which is in the U.S. Lease terms for retail space +range from 5 to 16 years, the majority of which are for 10 years, and often contain multi-year renewal options. The +Company owns its manufacturing facility in Cork, Ireland, which has approximately 352,000 square feet. The Cork facility also houses a customer support call center. The Company also owns a 752,000 +square-foot facility in Sacramento, California, which has a customer support call center and is used for warehousing and distribution. In addition, the Company owns approximately 942,000 +square feet of facilities located in Cupertino, California, used for research and development and corporate functions. Outside the U.S., the Company owns additional facilities totaling approximately +169,000 square feet. The +Company believes its existing facilities and equipment are well maintained and in good operating condition. The Company has invested in internal capacity and strategic relationships with outside +manufacturing vendors, and therefore believes it has adequate manufacturing capacity for the foreseeable future. The Company continues to make investments in capital equipment as needed to meet +anticipated demand for its products. Item 3. Legal Proceedings The +Company is subject to various legal proceedings and claims that are discussed below. The Company is also subject to certain other legal proceedings and claims that have arisen in the ordinary +course of business and which have not been fully adjudicated. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that +would individually or in the aggregate have a material adverse effect on its financial condition, liquidity or results of operations. However, the results of legal proceedings cannot be predicted with +certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results +of a particular reporting period could be materially adversely affected. The Company settled certain matters in 2004, which did not individually or in the aggregate have a material impact on the +Company's results of operations. Antor Media Corporation v. Apple Computer, Inc., et al. Plaintiff Antor Media filed this action on September 5, 2003 in the United States District Court in the Eastern District of Texas alleging infringement by the Company +and other defendants of U.S. patent 5,754,961 relating to a "Method and Apparatus for Transmitting Information Recorded on Information Storage Means from a Central Server to Subscribers via a High +Data Rate Digital Telecommunications Network." The complaint seeks unspecified damages and other relief. The Company has answered the complaint, denying all allegations and asserting numerous +affirmative defenses. The Company also asserted counterclaims requesting declaratory judgment for non-infringement and invalidity. Trial is set for March 2005. The Court held a +Markman hearing on September 16, 2004 but has not yet issued a ruling. 17 Apple Corps Ltd. v. Apple Computer, Inc.; Apple Computer, Inc. v. Apple Corps Ltd. Plaintiff Apple Corps filed this action on July 4, 2003 in the High Court of Justice, Chancery Division, in London alleging that the Company has breached a 1991 +agreement that resolved earlier trademark litigation between the parties regarding use of Apple marks. Plaintiff seeks an injunction, unspecified damages and other relief. The Company filed a motion +on October 13, 2003, challenging jurisdiction in the UK, but the Court denied the motion on April 7, 2004. The Company filed an appeal of the Court's decision but subsequently withdrew +the appeal and is preparing its defense in this matter. On +October 8, 2003, the Company filed a lawsuit in the United States District Court for the Northern District of California requesting a declaratory judgment that the Company has not breached +the 1991 agreement. Apple Corps challenged jurisdiction in the California case but the Court denied that challenge on March 25, 2004. Apple Corps subsequently prevailed on a motion to stay the +California case during the pendency of the UK action. The Company has dismissed the California lawsuit without prejudice. Cagney v. Apple Computer, Inc. Plaintiff filed this purported class action on January 9, 2004 in Los Angeles County Superior Court, alleging improper collection of sales tax in transactions involving +mail-in rebates. The complaint alleges violations of California Civil Code Section 17200 (unfair competition) and seeks unspecified damages and other relief. The Company was served +on January 21, 2004, and filed an answer on February 20, 2004, denying all allegations and asserting numerous affirmative defenses. The Company is investigating these allegations. The +Company filed a motion to disqualify Plaintiff's counsel, which the Court denied. The Company filed a petition for a writ of mandate with respect to this ruling and the Court of Appeal has issued an +order to show cause as to why the writ should not issue. Plaintiffs lead counsel subsequently withdrew. The hearing on the show cause order is scheduled for January 29, 2005. The Company also +has obtained an opinion on the tax issue from the State Board of Equalization. Compression Labs, Inc. v. Apple Computer, Inc., et al.; Apple v. Compression Labs, Inc., et al. Plaintiff Compression Labs, Inc. filed this patent infringement action on April 22, 2004 against the Company and twenty-seven other defendants in the United +States District Court for the Eastern +District of Texas, Marshall Division, alleging infringement of U.S. patent 4,698,672. Plaintiff alleges that the Company infringes the patent by complying with the JPEG standard as defined by CCITT +Recommendation T.81 entitled "Information Technology—Digital Compression and Coding of Continuous Tone Still Images—Requirements and Guidelines." Plaintiff seeks unspecified +damages and other relief. The Company is investigating this claim. Defendants have filed a motion to dismiss or, in the alternative, to transfer the case to Delaware. The case is in discovery and +trial is expected in October 2005. On July 2, 2004, the Company and several other defendants in the Texas action filed a lawsuit in the United States District Court in Delaware +requesting declaratory judgment of noninfringement, invalidity, implied license and unenforceability with respect to the '672 patent. Additional actions regarding this patent have been filed in other +jurisdictions. A petition has been filed with the Panel on Multi-District Litigation (MDL), seeking coordination and transfer of all of these cases to one court for pre-trial proceedings. Craft v. Apple Computer, Inc. (filed December 23, 2003, Santa Clara County Superior Court); Chin v. +Apple Computer, Inc. (filed December 23, 2003, San Mateo County Superior Court); Hughes v. Apple +Computer, Inc. (filed December 23, 2003, Santa Clara County Superior Court); Westley v. Apple +Computer, Inc. (filed December 26, 2003, San Francisco County Superior Court); Keegan v. Apple +Computer, Inc. (filed December 30, 2003, Alameda County Superior Court); Wagya v. Apple +Computer, Inc. (filed February 19, 2004, Alameda County Superior Court); Yamin v. Apple +Computer, Inc. (filed February 24, 2004, Los Angeles County Superior Court); Kieta v. Apple +Computer, Inc. (filed July 8, 2004, Alameda County Superior Court) Eight +separate plaintiffs filed purported class action cases in various California courts alleging misrepresentations by the Company relative to iPod battery life. The complaints include causes of +action 18 for +violation of California Civil Code Section 17200 (unfair competition), the Consumer Legal Remedies Action ("CLRA") and claims for false advertising, fraudulent concealment and breach of +warranty. The complaints seek unspecified damages and other relief. The Company is investigating these claims. The cases have been consolidated in San Mateo County and Plaintiffs have filed a +consolidated complaint. In +addition, a similar complaint relative to iPod battery life, Mosley v. Apple Computer, Inc. was filed in Westchester County, New York +on June 23, 2004 alleging violations of New York General Business Law Sections 349 (unfair competition) and 350 (false advertising). The Company removed the case to Federal Court and Plaintiff +filed a motion for remand, which the Court has not yet decided. Davis v. Apple Computer, Inc. Plaintiff filed this purported class action in San Francisco County Superior Court on December 5, 2002, alleging that the Company engaged in unfair and deceptive +business practices relating to its AppleCare +Extended Service and Warranty Plan. Plaintiff asserts causes of action for violation of the California Business and Professions Code §17200 and §17500, breach of the +Song-Beverly Warranty Act, intentional misrepresentation and concealment. Plaintiff requests unspecified damages and other relief. The Company filed a demurrer and motion to strike which +were granted, in part, and Plaintiff filed an amended complaint. The Company filed an answer on April 17, 2003 denying all allegations and asserting numerous affirmative defenses. Plaintiff +subsequently amended its complaint. On October 29, 2003, the Company filed a motion to disqualify Plaintiff's counsel in his role as counsel to the purported class and to the general public. +The Court granted the motion, but allowed Plaintiff to retain substitute counsel. Plaintiff did engage new counsel for the general public, but not for the class. The Company moved to disqualify +Plaintiff's new counsel and to have the Court dismiss the general public claims for equitable relief. The Court declined to disqualify Plaintiff's new counsel or to dismiss the equitable claims, but +did confirm that the class action claims are dismissed. The case is stayed pending an appeal. East Texas Technology Partners LP v. Apple Computer, Inc. Plaintiff filed this patent infringement action on January 23, 2004 in the United States District Court in the Eastern District of Texas alleging infringement by the +Company and seven other defendants of U.S. patent 6,574,239 relating to "Virtual Connection of a Remote Unit to a Server." The complaint seeks unspecified damages and other relief. The Plaintiff's law +firm withdrew from the case because of a conflict of interest and dismissed the complaint without prejudice. The case was re-filed on February 10, 2004 in the Northern District of +Texas by a new law firm. The Company received service of the new complaint on May 17, 2004 and filed a response on August 6, 2004, denying all allegations and asserting numerous +affirmative defenses. The Company is investigating this claim, and the case is in discovery. Gobeli Research Ltd. v. Apple Computer, Inc., et al. Plaintiff Gobeli Research Ltd. filed this patent infringement action against the Company and Sun Microsystems, Inc. on April 15, 2004 in the United States +District Court for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. patent 5,418,968 related to a "System and Method of Controlling Interrupt Processing." Plaintiff +alleges that the Company's Mac OS 9 and Mac OS X operating systems infringe Plaintiff's patent. Plaintiff seeks unspecified damages and other relief. The Company has answered the complaint, denying +all allegations and asserting numerous defenses. The Company is investigating this claim. Goldberg, et al. v. Apple Computer, Inc., et al. (f.k.a. "Dan v. Apple Computer, Inc.") Plaintiffs filed this purported class action on September 22, 2003 in Los Angeles County Superior Court against the Company and other members of the industry on behalf +of an alleged nationwide class of purchasers of certain computer hard drives. The case alleges violations of Civil Code Section 17200 (unfair competition), the Consumer Legal Remedies Act +("CLRA") and false advertising related to the size of the drives. Plaintiffs allege that calculation of hard drive size using the decimal method misrepresents the 19 actual +size of the drive. The complaint seeks unspecified damages and other relief. Plaintiff filed an amended complaint on March 30, 2004 and the Company filed an answer on +September 23, 2004, denying all allegations and asserting numerous affirmative defenses. The Company is investigating this claim. The parties are conducting discovery related to class +certification. Hawaii Structural Iron Workers and Pension Trust Fund v. Apple Computer, Inc. and Steven P. Jobs; Young v. Apple Computer, Inc., et al.; +Hsu v. Apple Computer Inc., et al. Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the United States District Court for the Northern District of California against +the Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company's publicly traded common stock between +July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company filed +a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. On December 11, 2002, the Court granted the Company's motion to dismiss for failure to +state a cause of action, with leave to Plaintiffs to amend their complaint within thirty days. Plaintiffs filed their amended complaint on January 31, 2003, and on March 17, 2003, the +Company filed a motion to dismiss the amended complaint. The Court heard the Company's motion on July 11, 2003 and dismissed Plaintiffs' claims with prejudice on August 12, 2003. +Plaintiffs have appealed the ruling. Honeywell International, Inc., et al. v. Apple Computer, Inc., et al. Plaintiffs Honeywell International, Inc. and Honeywell Intellectual Properties, Inc. filed this action on October 6, 2004 in the United States District +Court in Delaware alleging infringement by the Company and other defendants of U.S. patent 5,280,371 entitled "Directional Diffuser for a Liquid Crystal Display." Plaintiffs seek unspecified damages +and other relief. The Company is investigating this claim in connection with preparing its response to the complaint. MacTech Systems v. Apple Computer, Inc.; Macadam v. Apple Computer, Inc.; Computer International, Inc. v. Apple Computer, Inc.; +Elite Computers and Software, Inc. v. Apple Computer, Inc.; The Neighborhood Computer Store v. Apple Computer, Inc. (all in Santa Clara +County Superior Court) Five +resellers have filed similar lawsuits against the Company for various causes of action including breach of contract, fraud, negligent and intentional interference with economic relationship, +negligent misrepresentation, trade libel, unfair competition and false advertising. Plaintiffs request unspecified damages and other relief. The Company answered the Computer International complaint +on November 12, 2003 denying all allegations and asserting numerous affirmative defenses. The parties are in discovery in that case. The Company expects the other four plaintiffs to file +amended complaints. On October 1, 2003, one of the resellers, Macadam, was deauthorized as an Apple reseller. Macadam filed a motion for a temporary order to reinstate it as a reseller, which +the Court denied. The Court denied Macadam's motion for a preliminary injunction on December 19, 2003. Teleshuttle Technologies, LLC and BTG International Inc. v. Microsoft and Apple Computer, Inc. Plaintiffs +filed this case on July 20, 2004 in United States District Court for the Northern District of California alleging infringement of U.S. patent 6,557,054, entitled "Method and System +for Distributing Updates by Presenting Directory of Software Available for User Installation That is Not Already Installed on User Station." Plaintiffs seek unspecified damages and other relief. +Plaintiffs filed an amended complaint on September 7, 2004, adding a second patent, US patent 6,769,009 entitled "Method and System for Selecting a Personalized Set of Information Channels." +The Company filed an answer on October 18, 2004, denying all allegations and asserting numerous affirmative defenses. VirginMega/French Competition Council On June 28, 2004, VirginMega filed a complaint with the French Competition Council against Apple Computer France. VirginMega sought "interim measures," requiring the +Company to license its FairPlay 20 digital +rights management ("DRM") technology to VirginMega and all other interested parties within thirty days. A hearing on VirginMega's request for interim measures took place on October 19, +2004. On November 9, 2004, the French Competition Council issued a decision denying VirginMega's request for interim measures and rejecting VirginMega's complaint. Item 4. Submission of Matters to a Vote of Security Holders No +matters were submitted to a vote of security holders during the fourth quarter of the Company's fiscal year ended September 25, 2004. 21 PART II Item 5. Market for the Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities (a) Stock Market Information The +Company's common stock is traded on the over-the-counter market and is quoted on the NASDAQ National Market under the symbol AAPL, on the Tokyo Stock Exchange (TSE) under +the symbol APPLE, and on the Frankfurt Stock Exchange under the symbol APCD. On November 17, 2004, the Company filed an application with the TSE to delist the Company's shares from trading on +the TSE. As of November 19, 2004, there were 28,518 shareholders of record. The +Company did not pay cash dividends in either fiscal 2004 or 2003. The Company anticipates that, for the foreseeable future, it will retain any earnings for use in the operation of its business. +The price range per share of common stock presented below represents the highest and lowest closing prices for the Company's common stock on the NASDAQ National Market during each quarter. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2004 price range per common share $38.01-$29.14 $33.70-$25.78 $27.68-$21.15 $24.82-$19.70 Fiscal 2003 price range per common share $23.10-$19.06 $19.29-$13.12 $15.27-$13.80 $17.22-$13.59 (b)   Related Shareholder Matters None. (c) Issuer Purchases of Equity Securities In +July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. During the fourth quarter of 2001, the Company +entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per share for a total cost of +$25.5 million. In August 2003, the Company settled this agreement prior to its maturity, at which time the Company's common stock had a fair value of $22.81. Since inception of the stock +repurchase plan, the Company has repurchased a total of 6.55 million shares at a cost of $217 million. The Company was authorized to repurchase up to an additional $283 million of +its common stock as of September 25, 2004. The Company did not repurchase any shares of its common stock during the fourth quarter of fiscal 2004. Item 6. Selected Financial Data The +following selected financial information has been derived from the audited consolidated financial statements. The information set forth below is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related +notes thereto included in 22 Item +8 of this Form 10-K in order to fully understand factors that may affect the comparability of the information presented below. Five fiscal years ended September 25, 2004 (In millions, except share and per share amounts) 2004 2003 2002 2001 2000 Net sales $ 8,279 $ 6,207 $ 5,742 $ 5,363 $ 7,983 Net income (loss) $ 276 $ 69 $ 65 $ (25 ) $ 786 Earnings (loss) per common share: Basic $ 0.74 $ 0.19 $ 0.18 $ (0.07 ) $ 2.42 Diluted $ 0.71 $ 0.19 $ 0.18 $ (0.07 ) $ 2.18 Cash dividends declared per common share $ — $ — $ — $ — $ — Shares used in computing earnings (loss) per share (in thousands): Basic 371,590 360,631 355,022 345,613 324,568 Diluted 387,311 363,466 361,785 345,613 360,324 Cash, cash equivalents, and short-term investments $ 5,464 $ 4,566 $ 4,337 $ 4,336 $ 4,027 Total assets $ 8,050 $ 6,815 $ 6,298 $ 6,021 $ 6,803 Long-term debt (including current maturities) $ — $ 304 $ 316 $ 317 $ 300 Total liabilities $ 2,974 $ 2,592 $ 2,203 $ 2,101 $ 2,696 Shareholders' equity $ 5,076 $ 4,223 $ 4,095 $ 3,920 $ 4,107 Net +gains before taxes related to the Company's non-current debt and equity investments of $4 million, $10 million, $75 million, and $367 million were +recognized in 2004, 2003, 2001, and 2000, respectively. A net loss before taxes related to the Company's non-current debt and equity investments of $42 million was recognized in +2002. In 2002, the Company acquired Emagic resulting in a charge of approximately $1 million for acquired in-process technologies with no alternative future use. The Company +recognized a similar charge of $11 million in 2001 related to its acquisition of PowerSchool. Net charges related to Company restructuring actions of $23 million, $26 million, +$30 million, and $8 million were recognized in 2004, 2003, 2002, and 2000, respectively. During 2000, the Company recognized the cost of a special executive bonus for the Company's Chief +Executive Officer for past services in the form of an aircraft with a total cost to the Company of approximately $90 million. In 2002, of the original $90 million accrual, +$2 million remained unspent and was reversed. In 2003, settlement of the Company's forward stock purchase agreement resulted in a gain of $6 million. Favorable cumulative-effect type +adjustments, net of taxes, of $1 million and $12 million were recognized in 2003 and 2001, respectively. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can also +be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future performance and the Company's +actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the +subsection entitled "Factors That May Affect Future Results and Financial Condition" below. The following discussion should be read in conjunction with the consolidated financial statements and notes +thereto included in Item 8 of this Form 10-K. All information presented herein is based on the Company's fiscal calendar. The Company assumes no obligation to revise or update any +forward-looking statements for any reason, except as required by law. Executive Overview Apple designs, manufactures and markets personal computers and related software, services, peripherals and networking solutions. The Company also designs, develops and markets +a line of portable digital music 23 players +along with related accessories and services including the online distribution of third-party music and audio books. The Company's products and services include the Macintosh line of desktop +and notebook computers, the iPod digital music player, the Xserve server and Xserve RAID storage products, a portfolio of consumer and professional software applications, the Mac OS X +operating system, the online iTunes Music Store, a portfolio of peripherals that support and enhance the Macintosh and iPod product lines, and a variety of other service and support offerings. The +Company sells its products worldwide through its online stores, its own retail stores, its direct sales force, and third-party wholesalers, resellers and value added resellers. In addition, the +Company sells a variety of third-party Macintosh compatible products, including computer printers and printing supplies, storage devices, computer memory, digital video and still cameras, personal +digital assistants, and various other computing products and supplies through its online and retail stores. The Company sells to education, consumer, creative professional, business and government +customers. A further description of the Company's products may be found in Part I, Item 1 of this document under the heading "Business." The +Company's business strategy leverages its unique ability, through the design and development of its own operating system, hardware and many software applications and technologies, to bring to its +customers around the world compelling new products and solutions with superior ease-of-use, seamless integration and innovative industrial design. The +Company participates in several highly competitive markets, including personal computers with its Macintosh line of computers, consumer electronics with its iPod line of digital music players and +distribution of third-party digital music through its online iTunes Music Store. While the Company is widely recognized as an innovator in the personal computer market as well as a leader in the +emerging market for distribution of digital music, these are highly competitive markets that are subject to aggressive pricing and increased competition. In order to remain competitive, the Company +believes that increased investment in research and development (R&D) is necessary in order to maintain and extend its position in the markets where it competes. The Company's R&D spending is focused +on delivering timely updates and enhancements to its existing line of personal computers, displays, operating systems, software applications and portable music players; developing new digital +lifestyle consumer and professional software applications; and investing in new product areas such as rack-mount servers, RAID storage systems, and wireless technologies. The +Company utilizes a variety of direct and indirect distribution channels. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons +who can convey the value of the hardware, software and peripheral integration, demonstrate the unique digital lifestyle solutions that are available only on Macintosh computers, and demonstrate the +seamless +compatibility of the Macintosh with the Windows platform and networks. The Company further believes that providing a high-quality sales and after-sales support experience is critical to +attracting and retaining customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company has expanded and improved its +distribution capabilities by opening its own retail stores in the U.S. and internationally. The Company had 86 stores open as of September 25, 2004. The +Company has also staffed selected third-party stores with the Company's own employees to improve the buying experience through reseller channels. The Company has deployed Apple employees in +reseller locations around the world including the U.S., Europe, Japan and Australia. The Company also sells to customers direct through one of its online stores around the world. To +improve the accessibility of its iPod product line, the Company has significantly expanded the number of distribution points where iPods are sold. The iPod product line can now be purchased in +department stores, discount stores and specialty music and audio-visual stores. 24 Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company's discussion and analysis of +its financial condition and results of operations require the Company's management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial +statements and accompanying notes. Note 1 of the Notes to Consolidated Financial Statements of this Form 10-K describes the significant accounting policies and methods used +in the preparation of the Company's consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the +circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be +material. Management +believes the Company's critical accounting policies and estimates are those related to revenue recognition, allowance for doubtful accounts, inventory valuation and exposures related to +inventory purchase commitments, valuation of long-lived assets including acquired intangibles, warranty costs, and income taxes. Management believes these policies to be critical because +they are both important to the portrayal of the Company's financial condition and results, and they require management to make judgments and estimates about matters that are inherently uncertain. The +Company's senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company's Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale of products (i.e., hardware, software, and peripherals), and extended warranty and support contracts. The Company +recognizes revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software Revenue +Recognition , as amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue +Recognition. The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped, and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is +shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the +Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed not to be, +fixed or determinable, revenue is deferred and subsequently recognized as amounts become due and payable. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other +sales programs and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The +Company also records reductions to revenue for expected future product returns based on the Company's historical experience. Future market conditions and product transitions may require the Company to +increase customer incentive programs and incur incremental price protection obligations that could result in additional reductions to revenue at the time such programs are offered. Additionally, +certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and the specific terms and conditions +of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which could have +a material adverse impact on the Company's results of operations. 25 Allowance for Doubtful Accounts The Company distributes its products through third-party resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require +collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe and Asia +and by arranging with +third-party financing companies to provide flooring arrangements and other loan and lease programs to the Company's direct customers. These credit-financing arrangements are directly between the +third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade +receivables that are not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. The +allowance for doubtful accounts is based on management's assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition +of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible. The Company also records an allowance for +all other trade receivables based on multiple factors including historical experience with bad debts, the general economic environment, the financial condition of the Company's distribution channels, +and the aging of such receivables. If there is a deterioration of a major customer's financial condition, if the Company becomes aware of additional information related to the credit worthiness of a +major customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful accounts, which +would affect earnings in the period the adjustments are made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of +components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed +review of inventory each period that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The +personal computer industry is subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company's products are +less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the Company may be required to record additional write-downs which would +negatively affect gross margins in the period when the write-downs are recorded. The +Company accrues necessary reserves for cancellation fees related to component orders that have been cancelled. Consistent with industry practice, the Company acquires components through a +combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company's requirements for periods ranging from +30 to 130 days. If there is an abrupt and substantial decline in demand for one or more of the Company's products or an unanticipated change in technological requirements for any of the +Company's products, the Company may be required to record additional reserves for cancellation fees that would negatively affect gross margins in the period when the cancellation fees are identified. Valuation of Long-Lived Assets Including Acquired Intangibles The Company reviews property, plant, and equipment and certain identifiable intangible assets for impairment when events or changes in circumstances indicate the carrying +amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate. +If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of 26 the +assets exceeds their fair market value. Although the Company has recognized no material impairment adjustments related to its property, plant, and equipment or identifiable intangibles during the +past three fiscal years, except those made in conjunction with restructuring actions, deterioration in the Company's business in a geographic region or business segment in the future, including +deterioration in the performance of individual retail stores, could lead to such impairment adjustments in future periods in which such business issues are identified. In +accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets , the Company performs a +review of goodwill for impairment annually, or earlier if indicators of potential impairment exist. The review of goodwill for potential impairment is highly subjective and requires that: +(1) goodwill be allocated to various reporting units of the Company's business to which it relates; (2) the Company estimate the fair value of those reporting units to which the goodwill +relates; and (3) the Company determine the book value of those reporting units. If the estimated fair value of reporting units with allocated goodwill is determined to be less than their book +value, the Company is required to estimate the fair value of all identifiable assets and liabilities of those reporting units in a manner similar to a purchase price allocation for an acquired +business. This requires independent valuation of certain internally developed and unrecognized assets including in-process research and development and developed technology. Once this +process is complete, the amount of goodwill impairment, if any, can be determined. Based +on the Company's estimates as of September 25, 2004 there was no impairment of goodwill. However, changes in various circumstances including changes in the Company's market +capitalization, changes in the Company's forecasts, and changes in the Company's internal business structure could cause one or more of the Company's reporting units to be valued differently thereby +causing an impairment of goodwill. Additionally, in response to changes in the personal computer industry and changes in global or regional economic conditions, the Company may strategically realign +its resources and consider restructuring, disposing, or otherwise exiting businesses, which could result in an impairment of property, plant, and equipment, identifiable intangibles, or goodwill. Warranty Costs The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized based on historical and projected warranty claim +rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company's typical experience. Each quarter, the Company +reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection, and adjusts the amounts as +necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company's results of +operations. Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, Accounting for Income Taxes , the +provision for income taxes is computed using the asset and liability method, under which deferred tax assets and +liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax +credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected +to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Management +believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the +deferred tax 27 liabilities, +will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the future, an +adjustment to the valuation allowance would be charged to earnings in the period such determination is made. Similarly, if the Company subsequently realizes deferred tax assets that were previously +determined to be unrealizable, the respective valuation allowance would be reversed, resulting in a positive adjustment to earnings or a decrease in goodwill in the period such determination is made. +In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a +manner inconsistent with management's expectations could have a material impact on the Company's results of operations and financial position. Net Sales Net sales and Macintosh unit sales by operating segment and net sales and unit sales by product follow (net sales in millions and Macintosh unit sales in thousands): 2004 Change 2003 Change 2002 Net Sales by Operating Segment: Americas net sales $ 4,019 26 % $ 3,181 2 % $ 3,131 Europe net sales 1,799 37 % 1,309 5 % 1,251 Japan net sales 677 (3 )% 698 (2 )% 710 Retail net sales 1,185 91 % 621 119 % 283 Other segments net sales (a) 599 51 % 398 8 % 367 Total net sales $ 8,279 33 % $ 6,207 8 % $ 5,742 Unit Sales by Operating Segment: Americas Macintosh unit sales 1,682 4 % 1,620 (6 )% 1,728 Europe Macintosh unit sales 773 13 % 684 (5 )% 722 Japan Macintosh unit sales 291 (14 )% 339 (12 )% 386 Retail Macintosh unit sales 314 68 % 187 103 % 92 Other segments Macintosh unit sales (a) 230 26 % 182 5 % 173 Total Macintosh unit sales 3,290 9 % 3,012 (3 )% 3,101 Net Sales by Product: Power Macintosh net sales (b) $ 1,419 15 % $ 1,237 (10 )% $ 1,380 PowerBook net sales 1,589 22 % 1,299 56 % 831 iMac net sales (c) 954 (23 )% 1,238 (15 )% 1,448 iBook net sales 961 34 % 717 (18 )% 875 Total Macintosh net sales 4,923 10 % 4,491 (1 )% 4,534 iPod 1,306 279 % 345 141 % 143 Other Music Products (d) 278 672 % 36 800 % 4 Peripherals and Other Hardware (e) 951 38 % 691 31 % 527 Software (f) 502 39 % 362 18 % 307 Service and other sales 319 13 % 282 24 % 227 Total net sales $ 8,279 33 % $ 6,207 8 % $ 5,742 28 Unit Sales by Product: Power Macintosh unit sales (b) 709 6 % 667 (13 )% 766 PowerBook unit sales 785 30 % 604 69 % 357 iMac unit sales (c) 916 (16 )% 1,094 (16 )% 1,301 iBook unit sales 880 36 % 647 (4 )% 677 Total Macintosh unit sales 3,290 9 % 3,012 (3 )% 3,101 Net sales per Macintosh unit sold (g) $ 1,496 0 % $ 1,491 2 % $ 1,462 iPod unit sales 4,416 370 % 939 146 % 381 Notes: (a) Other +Segments include Asia Pacific and FileMaker. (b) Includes +Xserve product line. (c) Includes +eMac product line. (d) Other +Music Products consists of iTunes Music Store sales, iPod-related services, and Apple-branded and third-party iPod-related accessories. (e) Net +sales of Peripherals and Other Hardware include sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (f) Net +sales of Software include sales of Apple-branded operating system and application software and sales of third-party software. (g) Net +sales per Macintosh unit sold is derived by dividing total Macintosh net sales by total Macintosh unit sales. Fiscal Year 2004 versus 2003 During fiscal 2004, net sales increased 33% or $2.1 billion from fiscal 2003. Several factors have contributed favorably to net sales during 2004: • Net +sales of Macintosh systems increased $432 million or 10% during fiscal 2004 compared to 2003 while net sales per Macintosh unit sold remained relatively flat on a +year-over-year basis. Unit sales of Macintosh systems increased 278,000 units or 9% during fiscal 2004 compared to 2003. These increases in net sales and unit sales were a +result of strong demand for all of the Company's Macintosh systems, except for the iMac. The Company's portable systems, consisting of the PowerBook and iBook, produced the strongest revenue and unit +growth during fiscal 2004 compared to 2003 of approximately 26% and 33%, respectively. Unit sales of portable systems accounted for 51% of all Macintosh systems sold during fiscal 2004 compared to +only 42% during 2003. The Company believes that these results reflect an overall trend in the industry towards portable systems. Performance of the Company's Power Macintosh systems also yielded +positive results in fiscal 2004, including a 15% and 6% increase in net sales and unit sales, respectively. The increase in year-to-date Power Macintosh sales is due primarily +to the introduction of the Power Mac G5, which began shipping at the end of fiscal 2003. Although Power Macintosh sales have increased from the prior year, sales of this product were constrained in +the second half of 2004 as a result of manufacturing problems at IBM, the Company's sole supplier of the PowerPC G5 processor. • Net +sales of iPods rose $961 million or 279% during fiscal 2004 compared to 2003. Unit sales of iPods totaled 4.4 million in fiscal 2004, which represents an +increase of 370% from the 939,000 iPod units sold in fiscal 2003. Strong demand for the iPods during fiscal 2004 continued to be 29 experienced +in all of the Company's operating segments and was driven by enhancements to the iPod, the introduction of the iPod mini, increased expansion of the Company's iPod distribution network, +and continued success of the iTunes Music Store due largely to making it available to both Macintosh and Windows users in the U.S., U.K., France and Germany. Since inception of the iPod product line +in fiscal 2002, the Company has sold approximately 5.7 million iPods. • The +Retail segment's net sales grew 91% to $1.2 billion during fiscal 2004 compared to 2003. This increase is largely attributable to the increase in total stores +from 65 at the end of 2003 to 86 at the end of 2004, as well as a 36% year-over-year increase in average revenue per store. While the Company's customers in areas where the +Retail segment has opened stores may elect to purchase from the Retail segment stores rather than the Company's preexisting sales channels in the U.S. and Japan, the Company believes that a +substantial portion of the Retail segment's net sales is incremental to the Company's total net sales. See additional comments below related to the Retail segment under the heading "Segment Operating +Performance." • Net +sales of peripherals and other hardware rose by 38% during fiscal 2004 compared to 2003 primarily due to an increase in net sales of displays and other computer +accessories. Net sales of other computer accessories include AirPort cards and base stations, iSight digital video cameras, and third party hardware products. The increase in total net sales of +peripherals and other hardware is related to the overall increase in Macintosh unit sales and the introduction of new and updated peripheral products and was experienced predominantly by the Company's +Americas, Europe, and Retail segments. • Other +music products consists of sales associated with the iTunes Music Store and iPod related services and accessories. Net sales of other music products increased +$242 million or 672% during fiscal 2004 compared to 2003. The Company has experienced strong growth in sales of iPod services and accessories consistent with the increase in overall iPod unit +sales for fiscal 2004. The increased sales from the iTunes Music Store, which was originally introduced in April 2003, is primarily due to making the store available for Windows in +October 2003 and the introduction of the store in the U.K., France, and Germany in June 2004. • Net +sales of software rose $140 million or 39% during fiscal 2004 compared to 2003 due primarily to higher net sales of the Company's Apple-branded software and in +particular, higher net sales of the Company's operating system software, Mac OS X version 10.3 "Panther," which was released +in October 2003. Net sales of Panther accounted for approximately $74 million or over 50% of the increase in software net sales for fiscal 2004 compared to 2003. • The +Company's U.S. education channel experienced year-over-year growth in net sales of approximately 19% for fiscal 2004 compared to 2003. Unit sales +also increased by 10% during fiscal 2004 compared to 2003. The increase in U.S. education net sales for fiscal 2004 relates primarily to a 40% year-over-year increase in higher +education net sales and to a lesser extent the Company's 3% growth in K-12 net sales. The +Company believes the U.S. K-12 education market remains challenging due to multiple factors including funding pressures due to weak economic conditions, large budget deficits in many +states, and increased competition particularly for desktop computers. Although the Company has taken steps, and will continue to take steps, to address weakness in the U.S. education channel, it +remains difficult to anticipate when and if this trend will reverse. • Service +and other sales increased $37 million or 13% during fiscal 2004 compared to 2003. These increases are the result of significant +year-over-year increases in net sales associated with AppleCare Protection Plan (APP) extended maintenance and support services, as well as increases in net sales associated +with the Company's .Mac Internet service. Increased net sales associated with APP are primarily the result of higher Macintosh unit sales and higher attach rates on APP over the last several years. 30 Offsetting the favorable factors discussed above, the Company's net sales during fiscal 2004 were negatively impacted by the following: • Net +sales and unit sales of iMac systems were down 23% and 16%, respectively, during fiscal 2004 versus 2003. The decrease in iMac net sales and unit sales was largely due +to the delay in the introduction of the new iMac, based on the PowerPC G5 processor, primarily as a result of manufacturing problems experienced by IBM. The delays in the new iMac resulted in the +depletion of inventory of the old iMac flat panel prior to availability of the new iMac G5. The old flat panel iMac form factor which was available during most of fiscal 2004, was nearly +3 years old by the time the new iMac G5 began shipping in September 2004 and had experienced declines in sales as a result of the age of this product. The Company believes that sales of +iMac systems have also declined due to a shift in consumer preference to portable systems and competitor desktop models with price points below $1,000. The Company introduced a new version of the eMac +in April 2004 with a suggested retail price starting at $799 aimed at the price sensitive customer. • Net +sales and unit sales in the Company's Japan segment decreased 3% and 14%, respectively, during fiscal 2004 versus 2003. The Company believes these declines relate to a +shift in sales from the Japan Segment to the Retail segment as a result of the Tokyo and Osaka store openings in fiscal 2004. Declines in Japan may also relate to delays in computer upgrades by +certain professional and creative customers pending release in Japan of certain Mac OS X native applications, such as Quark Xpress 6, which did not become available until +September 2004. When sales from the Japan retail stores are included in the results for the Japan segment, the combined revenue in Japan resulted in a 3% year-over-year +increase in fiscal 2004 as compared to 2003. See additional comments below related to the Japan segment under the heading "Segment Operating Performance." Fiscal Year 2003 versus 2002 Net sales increased $465 million or 8% during 2003 compared to 2002 while Macintosh unit sales declined 3% year-over-year to approximately +3 million units in 2003. Several factors contributed favorably to net sales during 2003 including: • The +Retail segment's net sales grew to $621 million during 2003 from $283 million in 2002, an increase of 119%. While the Company's customers may have elected +to purchase product from their local Apple Retail store rather than through other preexisting sales channels in the U.S., the Company believes that a substantial portion of the Retail segment's net +sales was incremental to total net sales. See additional comments below related to the Retail segment under the heading "Segment Operating Performance." • Net +sales of iPods rose $202 million or 141% during 2003 compared to 2002. This increase was experienced by all of the Company's operating segments. iPod sales during +2003 were favorably affected by the introduction of substantially redesigned new models, which were compatible with both Macintosh and Windows operating systems. The Company's iPod digital music +player is sold by a variety of resellers, many of which do not currently market the Company's Macintosh systems. The Company expanded this distribution network during 2003, which contributed to the +2003 increase in iPod unit sales of 146%. • The +Company also experienced an increase in net sales of peripherals and other hardware totaling $164 million or 31% during 2003 compared to 2002, reflecting an +overall increase in net sales of other computer accessories including AirPort cards and base stations, which facilitate wireless connectivity; third party digital cameras and printers; and a number of +portable computer related accessories. • Net +sales of other music products, including sales associated with the iTunes Music Store and iPod related services and accessories, increased $32 million or 800% +during 2003 compared to 2002. This increase was due primarily to the introduction of the iTunes Music Store for the Macintosh 31 operating +system in April 2003 and higher sales of iPod services and accessories consistent with the increase in iPod net sales and unit sales during 2003. • Although +total Macintosh unit sales were down 3% in 2003, unit sales of the Company's portable systems were relatively strong primarily due to the 69% or 247,000 unit +increase in PowerBook unit sales, slightly offset by a 4% or 30,000 unit decrease in iBook unit sales. The increase in PowerBook net sales of $468 million or 56% was due primarily to the +success of the Company's new 12-inch, 15-inch and 17-inch models that were introduced during 2003. The decline in iBook consumer portable sales during 2003 was +primarily due to a lower average price per unit. Portable systems represented 42% of all Macintosh systems sold in 2003 versus 33% in 2002, which reflected an overall industry trend towards portable +systems. • The +Company's average net sales per Macintosh unit sold increased 2% to $1,491 in 2003 as a result of various changes in overall unit mix towards relatively higher-priced +PowerBook systems and increases direct sales primarily from the Company's retail and online stores, offset by somewhat lower year-over-year pricing on comparable Macintosh +systems for most of the Company's Macintosh product lines in response to industry pricing pressure, particularly with the Company's iBook consumer portable systems. PowerBook and Power Macintosh +systems accounted for 42% of total unit sales in 2003 versus 36% in 2002. • Net +sales of software increased $55 million or 18% during 2003 compared to the prior year and reflected higher net sales of Apple-branded application and server +software and third-party software. Net sales of Apple-branded application and server software increased due to the introduction of several new software titles during fiscal 2003 including Final Cut +Express, iLife, and Keynote, as well as from higher sales of software related to recent acquisitions including PowerSchool and Emagic. Growth in net sales of third-party software during 2003 was +particularly strong in the Americas Segment due to strong sales of software by the Company's online store and its Retail segment. • Service +and other sales rose $55 million or 24% during 2003 which primarily resulted from significant year-over-year increases in net sales +associated with APP extended maintenance and support services, as well as the Company's Internet related services. Increased net sales associated with APP were primarily the result of increasing +attach rates over the last several years. Increased net sales associated with Internet services were due to increased net sales of the Company's .Mac Internet service. Offsetting +the favorable factors discussed above, the Company's net sales during 2003 were negatively impacted by the following factors: • Total +unit sales of desktop systems fell 15% during 2003 compared to 2002. iMac systems unit sales declined 16% from 2003 to 2002 resulting from a shift in sales away from +desktop systems in favor of portables. Also, the flat panel iMac form factor available during fiscal 2003 was in the eighth quarter of its life cycle by the end of 2003. • Unit +sales of Power Macintosh systems fell 13% during 2003 compared to 2002. For the first nine months of 2003 compared to the same period in 2002, unit sales of Power +Macintosh systems decreased 24%, which was representative of the decline of Power Macintosh systems sales experienced by the Company during recent years and was also believed to be attributable to +delays in purchasing pending the release of the Power Mac G5. As expected, this trend reversed in the fourth quarter of 2003 with unit sales increasing 26% during the quarter as compared to the +same period in the prior year due largely to the new Power Mac G5, which the Company introduced in June 2003 and began shipping at the end of fiscal 2003. The decline in Power Macintosh +sales over the previous several years also reflects the shift in sales to portable systems, particularly PowerBooks. In addition, the Company believes that weak economic conditions over the past 32 several +years had a pronounced negative impact on its professional and creative customers. Additionally, some of the Company's professional and creative customers may have delayed upgrades of their +systems in anticipation of certain software vendors transitioning their professionally oriented Macintosh software applications to run natively on Mac OS X. • The +Company experienced ongoing weakness in its U.S. education channel during 2003. Net sales and unit sales in U.S. education during 2003 were down 4% and 6%, respectively, +as compared to 2002. This decline was due to a decrease in K-12 sales, partially offset by an increase in higher education sales. Net sales declined primarily as a result of a continued +shift in mix away from higher priced Power Macintosh and iMac systems towards lower priced eMac and iBook systems, although the Company did experience a significant increase in sales of its PowerBook +systems primarily to higher education customers. Portable systems accounted for approximately 43% of total unit sales in the education channel during 2003, as compared to approximately 34% in 2002. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company's reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas segment includes both North and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. +The Japan segment includes only Japan and excludes revenue from the Company's own retail stores in Japan, which is included in the Company's Retail segment. The Retail segment operated Apple-owned +retail stores in the U.S. and Japan during fiscal 2004. Each reportable geographic operating segment provides similar hardware and software products and similar services. Further information regarding +the Company's operating segments may be found in Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements at Note 11, "Segment Information and +Geographic Data." Americas During fiscal 2004, net sales in the Americas segment grew 26% or $838 million compared to fiscal 2003. The increase in net sales during 2004 was primarily attributable +to the significant year-over-year increase in iPod sales as well as strong sales of peripherals, software, and services. This increase was partially offset by a shift in sales +to the Retail segment, which had 84 stores in the U.S. as of the end of fiscal 2004. Macintosh unit sales also increased by 4% in fiscal 2004 compared to 2003, driven primarily by strong sales of +portable and Power Macintosh systems, partially offset by continued weakness in iMac sales. During 2004 and 2003, the Americas segment represented approximately 49% and 51%, respectively, of the +Company's total net sales and represented approximately 51% and 54%, respectively, of total Macintosh unit sales. As noted above, the Company experienced an increase in U.S. education channel net +sales of 19% for fiscal 2004 compared to 2003. Strong U.S. education net sales for the current year relate primarily to strength in higher education net sales that resulted from a successful +back-to-school selling season with strong demand for the Company's portables. This strength drove year-over-year growth in net sales of 40% for the +higher education channel during fiscal 2004. The Company's K-12 net sales grew year-over-year by 3% during fiscal 2004, despite the challenges in the +K-12 market from continued budget constraints and increased competition, due to the Company's continued focus and success with delivering 1:1 education solutions. Net +sales in the Americas segment during 2003 increased $50 million or 2% compared to 2002. During 2003 and 2002, the Americas segment represented approximately 51% and 55%, respectively, of +the Company's total net sales and represented approximately 54% and 56%, respectively, of total Macintosh unit sales. The results of the Americas segment are similar to the overall results of the +Company as they reflect substantially lower unit sales and net sales of Power Macintosh systems and iMac systems, partially offset by increases in unit sales and net sales of PowerBooks. The net sales +of the Americas segment, and the Company in total, also reflect substantially higher sales of iPods, peripherals, software, and services during 2003 compared to 2002. The Americas segment had been +negatively affected by weakness in its U.S. education channel during 2003. Total net sales and unit sales in the U.S. education channel during 2003 33 were +down 4% and 6%, respectively, compared to the same period in 2002. The Company believes this decline was caused by increased competition in the education market and by a reduction in spending by +U.S. educational institutions due to federal and state funding concerns and tax revenue shortfalls resulting from the weak economy. Additionally, some of the decline during 2003 in net sales and unit +sales of Macintosh systems in the Americas segment may be the result of the operation of the Company's Retail segment whose net sales, all of which occurred within the U.S., increased significantly +during 2003. Europe Net sales in Europe rebounded in fiscal 2004 increasing $490 million or 37% from 2003. Total Macintosh unit sales in Europe also experienced growth during the current +year by increasing 13% in fiscal 2004 compared to 2003. Consistent with the Americas segment, Europe experienced strong net sales across all product lines, except for the iMac systems. Demand in +Europe during fiscal 2004 was particularly strong for the Company's Power Macintosh systems and portable Macintosh systems, which experienced year-over-year increases of 29% +and 42%, respectively. Similar to the results of the Company's other segments, net sales of iPods, peripherals and software were strong in fiscal 2004. Net +sales in Europe increased $58 million or 5% during 2003 as compared to 2002 while Macintosh unit sales declined by 5% during the same period. Europe's operating results were consistent with +the trend experienced in the Americas and by the Company as a whole. Europe experienced weakened demand for Power Macintosh, iMac and iBook systems in 2003, partially offset by strong demand for +PowerBooks whose net sales increased by 48% or $100 million from 2002. Europe also realized increased sales of iPods, peripherals, software, and services. Japan The Japan segment continues to be a challenge for the Company, with four consecutive years of year-over-year declines in both net sales and Macintosh +unit sales. Japan's net sales and unit sales were down 3% and 14%, respectively during fiscal 2004 compared to 2003, continuing to lag behind all of the Company's other operating segments. These +decreases in net sales and unit sales are believed to be attributable in part to a shift in sales from the Japan segment to the Retail segment as a result of the opening of two stores in Japan in +fiscal 2004. In addition, such decreases may have been related to delayed computer system upgrades by some professional and creative customers who were awaiting the release of Quark XPress 6 +for Mac OS X, which did not occur until September 2004. The decrease in net sales was partially offset by strong iPod and iBook sales during fiscal 2004 compared to 2003. Net +sales in Japan decreased $12 million or 2% during 2003 as compared to the same period in 2002, the weakest year-to-date performance of any of the Company's operating +segments. Japan's Macintosh unit sales were particularly weak in 2003, declining 12%, and were primarily attributable to lower sales of iMac and iBook systems, partially offset by an increase in +PowerBook sales as well as higher sales of iPods, and peripherals and other hardware. Japan's Macintosh unit sales remained significantly below the segment's historic levels due to economic conditions +that remained particularly negative in Japan. Retail The Company opened 21 new retail stores during 2004, including its first two international stores in Tokyo and Osaka, Japan, bringing the total number of open stores to 86 as +of September 25, 2004. This compares to 65 open stores as of September 27, 2003 and 40 open stores as of September 28, 2002. During the first quarter of 2005, the +Company anticipates opening approximately 14 additional stores to end the calendar year at approximately 100 stores. Approximately half of the stores expected to open during the first quarter of 2005 +will be in the new "mini" store design, which is the Company's smallest store format to date; allowing it to be placed in a variety of new locations to introduce the Company's innovative products to +even more customers. The Company also opened its third international store in London, England during the first quarter of 2005. 34 Net +sales of the Retail segment grew to $1.185 billion during 2004 from $621 million and $283 million, in 2003 and 2002, respectively. The increases in net sales during both 2004 +and 2003 reflect the impact of new store openings for each fiscal year, including the opening of 21 new stores in 2004 and 25 new stores in 2003. An increase in average revenue per store also +contributed to the segment's strong sales in fiscal 2004. With an average of 76 stores open during 2004, the Retail segment achieved annualized revenue per store of approximately $15.6 million, +as compared to $11.5 million in 2003 with a 54 store average and $10.2 million in 2002 with a 28 store average. As +measured by the Company's operating segment reporting, the Retail segment reported profit of $39 million during fiscal 2004 as compared to losses of $5 million and $22 million +during 2003 and 2002, respectively. This improvement is primarily attributable to the segment's year-over-year increase in average quarterly revenue per store, the impact of +opening new stores, and the segment's year-over-year increase in net sales, which resulted in higher leverage on occupancy, depreciation and other fixed costs. Expansion +of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease commitments, personnel, and other +operating expenses. Capital expenditures associated with the Retail segment were $104 million in fiscal 2004, bringing the total capital expenditures since inception of the Retail segment to +approximately $394 million. As of September 25, 2004, the Retail segment had approximately 2,100 employees and had outstanding operating lease commitments associated with retail store +space and related facilities of approximately $436 million. The Company would incur substantial costs should it choose to terminate its Retail segment or close individual stores. Such costs +could adversely affect the Company's results of operations and financial condition. Gross Margin Gross margin for the three fiscal years ended September 25, 2004 are as follows (in millions, except gross margin percentages): 2004 2003 2002 Net sales $ 8,279 $ 6,207 $ 5,742 Cost of sales 6,020 4,499 4,139 Gross margin $ 2,259 $ 1,708 $ 1,603 Gross margin percentage 27.3 % 27.5 % 27.9 % Gross +margin declined in fiscal 2004 to 27.3% of net sales from 27.5% of net sales in 2003. The Company's gross margin during fiscal 2004 declined due to an increase in mix towards lower margin iPod +and iBook sales, pricing actions on certain Power Macintosh G5 models that were transitioned during the beginning of 2004, higher warranty costs on certain portable Macintosh products, and higher +freight and duty costs during fiscal 2004. These unfavorable factors were partially offset by an increase in direct sales and a 39% year-over-year increase in higher margin +software sales. The +Company anticipates that its gross margin and the gross margin of the overall personal computer and consumer electronics industries will remain under pressure throughout fiscal 2005 in light of +price competition, especially for the iPod product line. The Company also expects to continue to incur air +freight charges, which negatively impact gross margins on the iMac and other products during the first quarter of 2005 and possibly beyond. The +foregoing statements regarding the Company's expected gross margin during 2005, general demand for personal computers, anticipated air freight charges, and future economic conditions are forward- +looking. There can be no assurance that current gross margins will be maintained or targeted gross margin levels will be achieved. In general, gross margins and margins on individual products, +including iPods, will remain under significant downward pressure due to a variety of factors, including continued industry wide 35 global +pricing pressures, increased competition, compressed product life cycles, potential increases in the cost and availability of raw material and outside manufacturing services, and potential +changes to the Company's product mix, including higher unit sales of consumer products with lower average selling prices and lower gross margins. In response to these downward pressures, the Company +expects it will continue to take pricing actions with respect to its products. Gross margins could also be affected by the Company's ability to effectively manage product quality and warranty costs +and to stimulate demand for certain of its products. The Company's operating strategy and pricing take into account anticipated changes in foreign currency exchange rates over time; however, the +Company's results of operations can be significantly affected in the short-term by fluctuations in exchange rates. The +Company orders components for its products and builds inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, there +is a risk the Company will forecast incorrectly and produce or order from third-parties excess or insufficient inventories of particular products or components. The Company's operating results and +financial condition in the past have been and may in the future be materially adversely affected by the Company's ability to manage its inventory levels and outstanding purchase commitments and to +respond to short-term shifts in customer demand patterns. Gross +margin decreased to 27.5% of net sales in 2003 from 27.9% of net sales in 2002. This decline in gross margin reflects relatively aggressive pricing actions on several Macintosh models instituted +by the Company beginning in late fiscal 2002 as a result of continued pricing pressure throughout the personal computer industry, lower sales of relatively higher margin Power Macintosh systems during +the first three fiscal quarters of 2003, and increased air freight and manufacturing costs associated with the production ramp-up of the new Power Mac G5 and 15-inch PowerBook, +both of which began shipping in volume during September 2003. This decline is also attributable to a rise in certain component costs as the year progressed. The aforementioned negative factors +affecting gross margins during 2003 were partially offset by the increase in higher margin software and direct sales. Operating Expenses Operating expenses for the three fiscal years ended September 25, 2004 are as follows (in millions, except for percentages): 2004 2003 2002 Research and development $ 489 $ 471 $ 446 Percentage of net sales 6 % 8 % 8 % Selling, general, and administrative expenses $ 1,421 $ 1,212 $ 1,109 Percentage of net sales 17 % 20 % 19 % Restructuring costs $ 23 $ 26 $ 30 Purchased in-process research and development — — $ 1 Research and Development (R&D) The Company recognizes that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely +development of new and enhanced products that are central to the Company's core business strategy. The Company has historically relied upon innovation to remain competitive. R&D expense amounted to +approximately 6% of total net sales during fiscal 2004 down from 8% of total net sales in both 2003 and 2002. This decrease is due to the significant increase of 33% in total net sales of the Company +for fiscal 2004. Although R&D expense decreased as a percentage of total net sales in fiscal 2004, actual expenditures for R&D in fiscal 2004 increased $18 million or 4% from fiscal 2003, which +follows a 6% or $25 million increase in 2003 compared to 2002. The overall increase in R&D expense relates primarily to increased headcount and support for new product development activities +and the impact of employee salary merit increases in 2004. R&D spending also included capitalized software development costs of approximately $4.5 million related to the 36 development +of Mac OS X Tiger and $2.3 million related to the development of FileMaker Pro 7 in 2004; $14.7 million related to the development of +Mac OS X Panther in 2003; and approximately $13.3 million associated with the development of Mac OS X Jaguar and approximately $6 million associated with the +PowerSchool enterprise student information system in 2002. Further information related to the Company's capitalization of software development costs may be found in Part II, Item 8 of +this Form 10-K at Note 1 of Notes to Consolidated Financial Statements. Selling, General, and Administrative Expense (SG&A) Expenditures for SG&A increased $209 million or 17% during 2004 compared to 2003. These increases are due primarily to the Company's continued expansion of its Retail +segment in both domestic and international markets, a current year increase in discretionary spending on marketing and advertising, an increase in amortization costs associated with restricted stock +compensation, and higher direct and channel selling expenses resulting from the increase in net sales and employee salary merit increases. SG&A as a percentage of total net sales in 2004 was 17%, down +from 20% in 2003. This decrease is due to the increase of 33% in total net sales of the Company for fiscal 2004, reflecting leverage on the Company's fixed costs. SG&A +increased $103 million or 9% during 2003 as compared to 2002 due primarily to the Company's continued expansion of the Retail segment and increases in headcount. The overall increase was +partially offset by a decrease in 2003 discretionary spending on marketing and advertising and by savings resulting from the 2003 and 2002 restructuring activities described below. Fiscal 2004 Restructuring Actions The Company recorded total restructuring charges of approximately $23 million during the year ended September 25, 2004, including approximately $14 million +in severance costs, $5.5 million in asset impairments, and a $3.5 million charge for lease cancellations. Of the $23 million charge, $14.3 million had been spent by the end +of 2004, with the remaining $8.7 million consisting of $5.2 million for employee severance benefits and $3.5 million for lease cancellations. During +the fourth quarter of 2004, the Company recognized restructuring expense of $5.5 million. In conjunction with the European workforce reduction during the second quarter of 2004, the +Company vacated a leased sales facility during the fourth quarter of 2004 resulting in a charge of $3.7 million for contract termination and asset impairment costs. The Company also recognized +employee termination costs of $1.8 million related to the elimination of non-essential positions, principally in Europe. In addition, the Company reversed $400,000 of excess +restructuring expense from prior periods related primarily to lower than expected disposal costs on Sacramento manufacturing-related fixed assets. The net cost of the restructuring plans for the +fourth quarter of 2004 was $5.1 million, of which $300,000 had been paid prior to the end of 2004. These actions will result in the termination of 54 positions, 4 of which had been +terminated prior to the end of 2004. During +the third quarter of 2004, the Company finalized restructuring plans related to closing Company-owned manufacturing activities in Sacramento. In addition, the Company's management approved +restructuring plans related to certain headcount reductions primarily for various sales and marketing activities principally in the U.S. Total cost of the restructuring plan for the third quarter of +2004 was $7.9 million, of which $7.2 million had been paid prior to the end of 2004. These actions will result in the termination of 83 positions, 77 of which had been terminated prior +to the end of 2004. The +closing of manufacturing operations in Sacramento resulted in the elimination of 67 positions for a severance cost of $1.9 million and write-off of $5.3 million in +manufacturing-related fixed assets whose use ceased during the third quarter of 2004. Termination of sales and marketing activities, principally in the U.S., resulted in severance of +$0.7 million for the elimination of 16 positions. During +the second quarter of 2004, the Company's management approved restructuring plans related to the termination of Company-owned manufacturing activities in Sacramento and headcount reductions 37 related +primarily to various sales and marketing activities in the U.S. and Europe. Total cost of the actions was $9.6 million for the termination of 348 positions. As of the end of the +fourth quarter of 2004, $6.8 million had been spent and 310 positions had been eliminated related to these actions. The +Company estimates the closing of the Sacramento manufacturing operations will result in reduced ongoing quarterly operating expenses of approximately $2 million. In addition, the Company +estimates that the remaining restructuring actions taken in fiscal 2004 will ultimately result in reduced ongoing quarterly operating expenses of approximately $6 million. Fiscal 2003 Restructuring Actions The Company recorded total restructuring charges of approximately $26.8 million during the year ended September 27, 2003, including approximately +$7.4 million in severance costs, a $5.0 million charge to write-off deferred compensation, $7.1 million in asset impairments and a $7.3 million charge for lease +cancellations. Of the $26.8 million charge, all had been spent by the end of 2004, except for approximately $3.0 million related to operating lease costs on abandoned facilities. During +the third quarter of 2003, approximately $500,000 of the amount originally accrued for lease cancellations was determined to be in excess due to the sublease of a property sooner than originally +estimated and an approximately $500,000 shortfall was identified in the severance accrual due to higher than expected severance costs related to the closure of the Company's Singapore manufacturing +operations. These adjustments had no net effect on reported operating expense. During +the second quarter of 2003, the Company's management approved and initiated restructuring actions that resulted in recognition of a total restructuring charge of $2.8 million, including +$2.4 million in severance costs and $400,000 for asset write-offs and lease payments on an abandoned facility. Actions taken in the second quarter were for the most part +supplemental to actions initiated in the prior two quarters and focused on further headcount reductions in various sales and marketing functions in the Company's Americas and Europe operating segments +and further reductions associated with PowerSchool-related activities in the Americas operating segment, including an accrual for asset write-offs and lease payments on an abandoned +facility. The second quarter actions resulted in the termination of 93 employees. During +the first quarter of 2003, the Company's management approved and initiated restructuring actions with a total cost of $24 million that resulted in the termination of manufacturing +operations at the Company-owned facility in Singapore, further reductions in headcount resulting from the shift in PowerSchool product strategy that took place at the end of fiscal 2002, and +termination of various sales and marketing activities in the U.S. and Europe. These restructuring actions resulted in the elimination of 260 positions worldwide. Closure +of the Company's Singapore manufacturing operations resulted in severance costs of $1.8 million and costs of $6.7 million to write-off manufacturing related fixed +assets, whose use ceased during the first quarter. PowerSchool related costs included severance of approximately $550,000 and recognition of $5 million of previously deferred stock compensation +that arose when PowerSchool was acquired by the Company in 2001 related to certain PowerSchool employee stockholders who were terminated in the first quarter of 2003. Termination of sales and +marketing activities and employees, principally in the U.S. and Europe, resulted in severance costs of $2.8 million and accrual of costs associated with operating leases on closed facilities of +$6.7 million. The +total net restructuring charge of $23 million recognized during the first quarter of 2003 also reflects the reversal of $600,000 of unused restructuring accrual originally made during the first +quarter of 2002. Fiscal 2002 Restructuring Actions During fiscal 2002, the Company recorded total restructuring charges of approximately $30 million related to actions intended to eliminate certain activities and better +align the Company's operating expenses with 38 existing +general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company's Retail operating segment. During +the fourth quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $6 million designed to reduce headcount costs in +corporate operations and sales and to adjust its PowerSchool product strategy. These restructuring actions resulted in the elimination of approximately 180 positions worldwide at a cost of +$1.8 million, all of which were eliminated by September 27, 2003. Eliminated positions were primarily in corporate operations, sales, and PowerSchool related research and development in +the Americas operating segment. The shift in product strategy at PowerSchool included discontinuing development and marketing of PowerSchool's PSE product. This shift resulted in the impairment of +previously capitalized development costs associated with the PSE product in the amount of $4.5 million. During +the first quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $24 million. These restructuring actions resulted in +the elimination of approximately 425 positions worldwide at a cost of $8 million. Positions were eliminated primarily in the Company's operations, information systems, and administrative +functions. In addition, these restructuring actions also included significant changes in the Company's information systems strategy resulting in termination of equipment leases and cancellation of +existing projects and activities. The Company ceased using the assets associated with first quarter 2002 restructuring actions during that same quarter. Related lease and contract cancellation charges +totaled $12 million, and charges for asset impairments totaled $4 million. The first quarter 2002 restructuring actions were primarily related to corporate activity not allocated to +operating segments. During the first quarter of 2003, the Company reversed the remaining unused accrual of $600,000. Purchased In-Process Research and Development (IPR&D) During 2002, the Company acquired Emagic GmbH, a provider of professional software solutions for computer based music production, for approximately $30 million in cash; +$551,000 of which was +allocated to IPR&D. The amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of products under development had not been established and +no alternative future uses existed. The fair value of the IPR&D was determined using the income approach, which reflects the projected free cash flows that will be generated by the IPR&D projects and +that are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount rate of 25%. Other Income and Expense Other income and expense for the three fiscal years ended September 25, 2004 are as follows (in millions): 2004 2003 2002 Gains (losses) on non-current investments, net $ 4 $ 10 $ (42 ) Interest income $ 64 $ 69 $ 118 Interest expense (3 ) (8 ) (11 ) Gains on sales of short term investments, net 1 21 7 Other income (expense), net (9 ) (5 ) (2 ) Gain on forward purchase agreement — 6 — Interest and other income, net $ 53 $ 83 $ 112 Total other income and expense $ 57 $ 93 $ 70 39 Gains and Losses on Non-current Investments Over the course of the last three years, the Company has held investments that were classified as available-for-sale in EarthLink Inc. +(EarthLink), Akamai Technologies, Inc. (Akamai), ARM Holdings plc (ARM) and certain investments in private companies. Further information related to the Company's non-current debt +and equity investments may be found in Part II, Item 8 of this Form 10-K at Note 2 of Notes to Consolidated Financial Statements. During +2004, the Company sold its remaining 986,000 shares of Akamai stock. The transaction generated proceeds of approximately $5 million and a gain before taxes of approximately +$4 million. As of September 25, 2004, the Company does not have any non-current public company investments reflected in its consolidated balance sheet. During +2003, the Company sold 1,875,000 shares of Akamai stock for net proceeds of approximately $9 million, and a gain before taxes of approximately $8 million. Additionally, the +Company sold its remaining investment in ARM stock, 278,000 shares, for net proceeds of approximately $295,000, and a gain before taxes of $270,000, and sold its remaining investment in EarthLink +stock, 6,540,000 shares, for net proceeds of approximately $37 million, and a gain before taxes of $2 million. During +2002, the Company determined that declines in the fair value of certain investments were other-than-temporary. As a result, the Company recognized a $44 million +charge to earnings to writedown the basis of its investment in EarthLink, a $6 million charge to earnings to writedown the basis of its investment in Akamai, and a $15 million charge to +earnings to writedown the basis of its investment in a private company investment. These losses in 2002 were partially offset by the sale of 117,000 shares of EarthLink stock for net proceeds of +$2 million and a gain before taxes of $223,000, the sale of 250,000 shares of Akamai stock for net proceeds of $2 million and a gain before taxes of $710,000, and the sale of +approximately 4.7 million shares of ARM stock for both net proceeds and a gain before taxes of $21 million. Interest and Other Income, Net Total interest and other income, net decreased $30 million or 36% to $53 million during fiscal 2004 compared to $83 million in 2003 and $112 million +in 2002. These decreases are attributable primarily to declining investment yields on the Company's cash and short-term investments resulting from lower market interest and a shortening of +the average maturity of the Company's investment portfolio, as well as lower gains on sales of short-term investments in fiscal 2004. The weighted average interest rate earned by the +Company on its cash, cash equivalents and short-term investments fell to 1.38% in 2004 compared to the 1.89% and 2.85% rates earned during 2003 and 2002, respectively. The Company +occasionally sells short-term investments prior to their stated maturities. As a result of such sales, the Company recognized net gains of $1 million, $21 million and +$7 million during fiscal 2004, 2003 and 2002, respectively. The decrease in total interest and other income, net during fiscal 2003 was also offset by the $6 million gain related to the +forward purchase agreement during the fourth quarter of 2003 which is further discussed below under the heading "Cumulative Effects of Accounting Changes." Interest +expense consisted primarily of interest on the Company's $300 million aggregate principal amount unsecured notes, which were repaid upon their maturity in February 2004, +partially offset by amortization of deferred gains realized in 2002 and 2001 that resulted from the closure of swap positions associated with the unsecured notes. The unsecured notes were sold at +99.925% of par for an effective yield to maturity of 6.51%. Total deferred gain resulting from the closure of debt swaps of approximately $23 million was fully amortized as of the notes' +maturity in February 2004. Provision for Income Taxes The Company's effective tax rate for the year ended September 25, 2004 was approximately 28%. The Company's effective rate differs from the statutory federal income tax +rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to 40 be +indefinitely reinvested outside the U.S. As of September 25, 2004, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax credits of +$647 million before being offset against certain deferred tax liabilities and a valuation allowance for presentation on the Company's balance sheet. Management believes it is more likely than +not that forecasted income, including income that may be generated as a result of certain tax planning strategies, will be sufficient to fully recover the remaining net deferred tax assets. As of +September 25, 2004, a valuation allowance of $30 million was recorded against the deferred tax asset for the benefits of tax losses that may not be realized. The valuation allowance +relates principally to the operating loss carryforwards acquired from NeXT and other acquisitions, the utilization of which is subject to certain limitations imposed by the Internal Revenue Code. The +Company will continue to evaluate the realizability of the deferred tax assets quarterly by assessing the need for and amount of the valuation allowance. The +Internal Revenue Service (IRS) has completed its field audit of the Company's federal income tax returns for all years prior to 2001 and proposed certain adjustments. Certain of these adjustments +are being contested through the IRS Appeals Office. Substantially all IRS audit issues for these years have been resolved. In addition, the Company is also subject to audits by state, local, and +foreign tax authorities. Management believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted +with certainty. Should any issues addressed in the Company's tax audits be resolved in a manner not consistent with management's expectations, the Company could be required to adjust its provision for +income tax in the period such resolution occurs. Cumulative Effects of Accounting Changes Financial Instruments with Characteristics of Both Liabilities and Equity On May 15, 2003, the Financial Accounting Standards Board (FASB) issued SFAS No. 150, Accounting for Certain Financial Instruments with +Characteristics of Both Liabilities and Equity . SFAS No. 150 requires issuers to classify as liabilities certain freestanding financial instruments that embody +obligations for the issuer and have characteristics of both liabilities and equity. The Company adopted the provisions of SFAS No. 150 on June 29, 2003, which resulted in a favorable +cumulative effect type adjustment of approximately $3 million. This adjustment represented the mark-to-market adjustment to fair value for a forward purchase agreement +that allowed the Company to acquire 1.5 million shares of its common stock at a price of $16.64 per share. The Company settled this forward purchase agreement in August 2003. The +settlement resulted in an additional gain of approximately $6 million, which is included in interest and other income, net. Accounting for Asset Retirement Obligations On September 29, 2002, the Company adopted SFAS No. 143, Accounting for Asset Retirement Obligations , which +addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. Net of the related +income tax effect of approximately $1 million, adoption of SFAS No. 143 resulted in an unfavorable cumulative-effect type adjustment to net income during 2003 of approximately +$2 million. This adjustment represents cumulative depreciation and accretion that would have been recognized through the date of adoption of SFAS No. 143 had the statement been applied +to the Company's existing asset retirement obligations at the time they were initially incurred. Recent Accounting Pronouncements In December 2003, the Securities and Exchange Commission released Staff Accounting Bulletin (SAB) No. 104, Revenue +Recognition , which supercedes SAB 101, Revenue Recognition in Financial Statements . SAB 104 clarifies existing +guidance regarding revenue contracts that contain multiple deliverables to make it consistent with Emerging Issues Task Force (EITF) No. 00-21. The adoption of SAB 104 did +not have a material impact on the Company's results of operations or financial position. 41 In +December 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. (FIN) 46R, a revision to FIN 46, Consolidation of +Variable Interest Entities. FIN 46R clarifies some of the provisions of FIN 46 and exempts certain entities from its requirements. FIN 46R is effective at the end +of the first interim period ending after March 15, 2004. The adoption of FIN 46R did not have a material impact on the Company's results of operations or financial position. In +March 2004, the FASB issued EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to +Certain Investments . EITF 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure +requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued FASB Staff Position EITF 03-1-1, which delays the +effective date until additional guidance is issued for the application of the recognition and measurement provisions of EITF 03-1 to investments in securities that are impaired; +however, the disclosure requirements are effective for annual periods ending after June 15, 2004. Although the Company will continue to evaluate the application of EITF 03-1, +management does not currently believe adoption will have a material impact on its results of operations or financial position. Accounting for Stock-Based Compensation The Company currently measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board +(APB) Opinion No. 25, Accounting for Stock Issued to Employees and provides pro forma disclosures of the effect on net income and earnings per +share as if the fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB Opinion No. 25 because, as further discussed in Part II, +Item 8 of this Form 10-K at Note 1 of the Notes to Consolidated Financial Statements, the alternative fair value accounting provided for under SFAS No. 123, Accounting for Stock-Based +Compensation , requires use of option valuation models that were not developed for use in valuing employee stock options and +employee stock purchase plan shares. Under APB Opinion +No. 25, when the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of the grant, no compensation expense is recognized. On +March 31, 2004, the FASB issued a proposed Statement, Share-Based Payment, that addresses the accounting for share-based payment transactions +in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity +instruments or that may be settled by the issuance of such equity instruments. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion +No. 25 and generally would require instead that such transactions be accounted for using a fair-value-based method. If adopted, it is currently anticipated that the proposed +Statement would be effective for the Company beginning in its fourth fiscal quarter of 2005. At +the Company's annual shareholders meeting on April 24, 2003, shareholders approved a proposal requesting that the Company's Board of Directors (the Board) establish a policy of expensing the +value of all future employee stock options issued by the Company. The Board and management appreciate and take seriously the views expressed by the Company's shareholders. The Company decided not to +expense the value of employee stock options until the FASB finalizes its new accounting standard on the matter, which may play a significant role in determining the fair value of and accounting for +employee stock options. The Company monitors progress at the FASB and other developments with respect to the general issue of employee stock compensation. The Company is currently reviewing the +potential impact from the guidance of the proposed statement, which may require the Company to recognize substantially more compensation expense in future periods that could have a material adverse +impact on the Company's future results of operations. The accounting impact had the Company chosen to apply the fair-value recognition provisions of SFAS No. 123, instead of the +recognition provisions under APB Opinion No. 25, is described in Part II, Item 8 of this Form 10-K at Note 1 of the Notes to Consolidated Financial Statements. 42 Liquidity and Capital Resources The following table presents selected financial information and statistics for each of the last three fiscal years (dollars in millions): 2004 2003 2002 Cash, cash equivalents, and short-term investments $ 5,464 $ 4,566 $ 4,337 Accounts receivable, net $ 774 $ 766 $ 565 Inventory $ 101 $ 56 $ 45 Working capital $ 4,375 $ 3,530 $ 3,730 Days sales in accounts receivable (DSO) (a) 30 41 36 Days of supply in inventory (b) 5 4 4 Days payables outstanding (DPO) (c) 76 82 77 Annual operating cash flow $ 934 $ 289 $ 89 (a) DSO +is based on ending net trade receivables and most recent quarterly net sales for each period. (b) Days +supply of inventory is based on ending inventory and most recent quarterly cost of sales for each period. (c) DPO +is based on ending accounts payable and most recent quarterly cost of sales adjusted for the change in inventory. As +of September 25, 2004, the Company had $5.464 billion in cash, cash equivalents, and short-term investments, an increase of $898 million over the same balances at +the end of fiscal 2003. The principal components of this increase were cash generated by operating activities of $934 million and proceeds of $427 million from the issuance of common +stock under stock plans, partially offset by cash used to repay the Company's outstanding debt of $300 million and purchases of property, plant, and equipment of $176 million. The +Company's short-term investment portfolio is primarily invested in high credit quality, liquid investments. Approximately $3.2 billion of this cash, cash equivalents, and +short-term investments are held by the Company's foreign subsidiaries and would be subject to U.S. income taxation on repatriation to the U.S. The Company is currently assessing the impact +of the one-time favorable foreign dividend provisions recently enacted as part of the American Jobs Creation Act of 2004, and may decide to repatriate earnings from some of its foreign +subsidiaries. The +Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its working capital needs, capital expenditures, stock +repurchase activity, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. Debt In February 2004, the Company retired $300 million of debt outstanding in the form of 6.5% unsecured notes. The notes were originally issued in 1994 and were sold +at 99.9925% of par for an effective yield to maturity of 6.51%. The Company currently has no long-term debt obligations. Capital Expenditures The Company's total capital expenditures were $176 million during fiscal 2004, $104 million of which were for retail store facilities and equipment related to the +Company's Retail segment and $72 million of which were primarily for corporate infrastructure, including information systems enhancements and operating facilities enhancements and expansions. +The Company currently anticipates it will utilize approximately $240 million for capital expenditures during 2005, approximately $125 million of which is +expected to be utilized for further expansion of the Company's Retail segment and the remainder utilized to support normal replacement of existing capital assets and enhancements to general +information technology infrastructure. 43 Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During +the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per +share for a total cost of $25.5 million. In August 2003, the Company settled this agreement prior to its maturity, at which time the Company's common stock had a fair value of $22.81. +Other than this forward purchase transaction, the Company has not engaged in any transactions to repurchase its common stock since fiscal 2000. Since inception of the stock repurchase plan, the +Company had repurchased a total of 6.55 million shares at a cost of $217 million. The Company was still authorized to repurchase up to an additional $283 million of its common +stock as of September 25, 2004. Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative +instruments or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity +that provides financing, liquidity, market risk or credit risk support to the Company. The +following table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 25, 2004 and excludes amounts already recorded on +the Company's balance sheet as current liabilities (in millions): TOTAL Payments Due in Less Than 1 year Payments Due in 1-3 years Payments Due in 4-5 years Payments Due in More Than 5 years Operating Leases $ 617 $ 89 $ 170 $ 126 $ 232 Purchase Obligations 1,112 1,112 — — — Asset Retirement Obligations 12 — 1 2 9 Other Obligations 24 14 10 — — Total $ 1,765 $ 1,215 $ 181 $ 128 $ 241 Lease Commitments As of September 25, 2004, the Company had total outstanding commitments on noncancelable operating leases of approximately $617 million, $436 million of +which related to the lease of retail space and related facilities. Remaining terms on the Company's existing operating leases range from 2 to 16 years. Purchase Obligations The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Company's products and to perform final assembly and test of finished +products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 30 to 130 days. The +Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of +purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the Company's forecasted component and manufacturing requirements +for periods ranging from 30 to 130 days. The nature of the Company's outstanding third-party manufacturing commitments and component purchase commitments has not changed significantly since the +end of its fiscal 2003. As of September 25, 2004, the Company had 44 outstanding +third-party manufacturing commitments and component purchase commitments of approximately $1.1 billion. Asset Retirement Obligations The Company's asset retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. As of +September 25, 2004, the Company estimates that gross expected future cash flows of approximately $12 million would be required to fulfill these obligations. Other Obligations The Company's other obligations of approximately $24 million are primarily related to telecommunications services. Indemnifications The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party +intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of +an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted +against itself or an indemnified third-party and, in the opinion of management, does not have a liability related to unresolved infringement claims subject to indemnification that would have a +material adverse affect on its financial condition, liquidity or results of operations. Factors That May Affect Future Results and Financial Condition Because of the following factors, as well as other factors affecting the Company's operating results and financial condition, past financial performance should not be +considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. General economic conditions and current economic and political uncertainty could adversely affect the demand for the Company's products and the financial health of its +suppliers, distributors, and resellers. The Company's operating performance depends significantly on general economic conditions in the U.S. and abroad. Over the past several years, demand for the Company's products +has been negatively impacted by difficult global economic conditions. Additionally, some of the Company's education customers appeared to be delaying technology purchases due to concerns about the +overall impact of the weaker economy and state budget deficits on their available funding. Although recent macroeconomic trends seem to indicate an economic recovery, continued uncertainty about +future economic conditions makes it difficult to forecast future demand for the Company's products and related operating results. Should global and/or regional economic conditions deteriorate, demand +for the Company's products could be adversely affected, as could the financial health of its suppliers, distributors, and resellers. War, terrorism, public health issues or other business interruptions could disrupt supply, delivery or demand of products, which could negatively affect the Company's +operations and performance. War, terrorism, public health issues and other business interruptions whether in the U.S. or abroad, have caused and could continue to cause damage or disruption to +international commerce by creating economic and political uncertainties that may have a strong negative impact on the global economy, the Company, and the Company's suppliers or customers. The +Company's major business operations are subject to interruption by earthquake, fire, power shortages, terrorist attacks and other hostile acts, labor disputes, medical conditions, and other events +beyond its control. The majority of the Company's research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including +certain component suppliers and manufacturing vendors, are located near 45 major +seismic faults. Because the Company does not carry earthquake insurance for direct quake-related losses, the Company's operating results and financial condition could be materially adversely +affected in the event of a major earthquake or other natural or manmade disaster. Although +it is impossible to predict the occurrences or consequences of any such events, such events could result in a decrease in demand for the Company's products, make it difficult or impossible to +deliver products to its customers or to receive components from its suppliers, and could create delays and inefficiencies in the Company's supply chain. In addition, should major public health issues, +including epidemics, arise the Company could be negatively impacted by the need for more stringent employee travel restrictions, additional limitations in the availability of freight services, +governmental actions limiting the movement of products between various regions, delays in production ramps of new products, and disruptions in the operations of the Company's manufacturing vendors and +component suppliers. The Company's operating results and financial condition have been, and in the future may continue to be, adversely affected by these events. The market for personal computers and related peripherals and services, as well as digital music devices and related services, is highly competitive. If the Company is unable +to effectively compete in these markets, its results of operations could be adversely affected. The personal computer industry is highly competitive and is characterized by aggressive pricing practices, downward pressure on gross margins, frequent introduction of new +products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by +competitors, price sensitivity on the part of consumers, and a large number of competitors. Over the past several years, price competition in the market for personal computers and related peripherals +has been particularly intense. The Company's competitors who sell Windows and Linux based personal computers have aggressively cut prices and lowered their product margins in order to gain or maintain +market share in response to the weakness in demand that began in the second half of calendar 2000 for personal computing products. The Company's results of operations and financial condition have +been, and in the +future may continue to be, adversely affected by these and other industry-wide pricing pressures and downward pressures on gross margins. The +personal computer industry has also been characterized by rapid technological advances in software functionality, hardware performance, and features based on existing or emerging industry +standards. Further, as the personal computer industry and its customers place more reliance on the Internet, an increasing number of Internet devices that are smaller and simpler than traditional +personal computers may compete for market share with the Company's existing products. Several competitors of the Company have either targeted or announced their intention to target certain of the +Company's key market segments, including consumer, education, professional and consumer digital video editing, and design and publishing. Several of the Company's competitors have introduced or +announced plans to introduce digital music products and/or online stores offering digital music distribution that mimic many of the unique design, technical features, and solutions of the Company's +products. The Company has a significant number of competitors, many of whom have greater financial, marketing, manufacturing, and technological resources, as well as broader product lines and larger +installed customer bases than those of the Company. Additionally, there has been a trend towards consolidation in the personal computer industry that has resulted in larger and potentially stronger +competitors in the Company's markets. The +Company is currently the only maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer market, which is dominated by makers of computers utilizing +other competing operating systems, including Windows and Linux. The Company's future operating results and financial condition are substantially dependent on its ability to continue to develop +improvements to the Macintosh platform in order to maintain perceived design and functional advantages over competing platforms. 46 The +Company is currently focused on market opportunities related to digital music distribution and related consumer electronic devices, including iPods. The Company faces increasing competition from +other companies promoting their own digital music products and distribution services and free peer-to-peer music services. These competitors include both new entrants with +novel market approaches, such as subscription services models, and also larger companies that may have greater technical, marketing, distribution and other resources than those of the Company, as well +as established hardware, software and music content supplier relationships. Failure to effectively compete could negatively affect the Company's operating results and financial position. There can be +no assurance that the Company will be able to continue to provide products and services that effectively compete in these markets or successfully distribute and sell digital music outside the U.S. The +Company may also have to respond to price competition by lowering prices and/or increasing features which could adversely affect the Company's music product gross margins as well as overall Company +gross margins. The +Company also faces increased competition in the U.S. education market. Sales in the U.S. to both elementary and secondary schools, as well as for college and university customers, remain a core +market for the Company. Uncertainty in this channel remains as several competitors of the Company have either targeted or announced their intention to target the education market for personal +computers, which could negatively affect the Company's market share. In an effort to regain market share and remain competitive, the Company has been and will continue to pursue +one-to-one (1:1) learning solutions in education. The Company's 1:1 learning solutions are a complete solution consisting of an iBook portable system for every student and +teacher along with a wireless network connected to a central server. These 1:1 learning solutions and other strategic sales are generally priced more aggressively and could result in significantly +less profitability or even in financial losses, particularly for larger deals. Although the Company believes it has taken certain steps to strengthen its position in the education market, there can be +no assurance that the Company will be able to increase or maintain its share of the education market or execute profitably on large strategic arrangements. Failure to do so may have an adverse impact +on the Company's operating results and financial condition. The Company must successfully manage frequent product introductions and transitions in order to remain competitive and effectively stimulate customer demand. Due to the highly volatile and competitive nature of the personal computer and consumer electronics industries, which are characterized by dynamic customer demand patterns and +rapid technological advances, the Company must continually introduce new products and technologies, enhance existing products in order to remain competitive, and effectively stimulate customer demand +for new products and upgraded versions of the Company's existing products. The success of new product introductions is dependent on a number of factors, including market acceptance; the Company's +ability to manage the risks associated with product transitions, including production ramp issues; the availability of application software for new products; the effective management of inventory +levels in line with anticipated product demand; the availability of products in appropriate quantities to meet anticipated demand; and the risk that new products may have quality or other defects in +the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect that new products will have on its sales or results of operations. The Company's products, from time to time, experience quality problems that can result in decreased net sales and operating profits. The Company sells highly complex hardware and software products that can contain defects in design and manufacture. Sophisticated operating system software and applications, +such as those sold by the Company, often contain "bugs" that can unexpectedly interfere with the operation of the software. Defects may also occur in components and products the Company purchases from +third-parties. There can be no assurance that the Company will be able to detect and fix all defects in the hardware and software it sells. 47 Failure +to do so could result in lost revenue, loss of reputation, and significant warranty and other expense to remedy. Because orders for components, and in some cases commitments to purchase components, must be placed in advance of customer orders, the Company faces substantial inventory risk. The Company records a write-down for inventories of components and products that have become obsolete or are in excess of anticipated demand or net realizable value +and accrues necessary reserves for cancellation fees of orders for inventories that have been cancelled. Although the Company believes its inventory and related provisions are adequate, given the +rapid and unpredictable pace of product obsolescence in the computer and consumer electronics industries, no assurance can be given that the Company will not incur additional inventory and related +charges. In addition, such charges have had, and may have, a material effect on the Company's financial position and results of operations. The +Company must order components for its products and build inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, +there is a risk the Company will forecast incorrectly and produce or order from third parties excess or insufficient inventories of particular products. Consistent with industry practice, components +are normally acquired through a combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the +Company's forecasted component and manufacturing requirements for periods ranging from 30 to 130 days. The Company's operating results and financial condition have been in the past and may in +the future be materially adversely affected by the Company's ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results are dependent upon the Company's ability to obtain a sufficient supply of components, including microprocessors, some of which are in short supply or +available only from limited sources. Although most components essential to the Company's business are generally available from multiple sources, certain key components including microprocessors and ASICs are +currently obtained by the Company from single or limited sources. Some key components (including without limitation DRAM, and TFT-LCD flat-panel displays), while currently +available to the Company from multiple sources, are at times subject to industry-wide availability and pricing pressures. In addition, new products introduced by the Company often +initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. In situations where a +component or product utilizes new technologies, initial capacity constraints may exist until such time as the suppliers' yields have matured. The Company and other producers in the personal computer +industry also compete for various components with other industries that have experienced increased demand for their products. The Company uses some components that are not common to the rest of the +personal computer industry including certain microprocessors and ASICs. Continued availability of these components may be affected if producers were to decide to concentrate on the production of +components other than those customized to meet the Company's requirements. If the supply of a key component were to be delayed or constrained on a new or existing product, the Company's results of +operations and financial condition could be adversely affected. The +Company's ability to produce and market competitive products is also dependent on the ability and desire of IBM and Freescale Semiconductor, Inc. (formerly the Semiconductor Products +Segment of Motorola, Inc.), the sole suppliers of the PowerPC RISC-based microprocessor for the Company's Macintosh computers, to provide the Company with a sufficient supply of +microprocessors with price/performance features that compare favorably to those supplied to the Company's competitors by Intel Corporation and other developers and producers of microprocessors used by +personal computers using other operating systems. Further, despite its efforts to educate the marketplace to the contrary, the Company believes that many of its current and potential customers believe +that the relatively slower MHz 48 rating +or clock speed of the microprocessors it utilizes in its Macintosh systems compares unfavorably to those utilized by other operating systems and translates to slower overall system performance. +There have been instances in recent years where the inability of the Company's suppliers to provide advanced PowerPC microprocessors in sufficient quantity has had significant adverse effects on the +Company's results of operations. In addition, IBM is currently the Company's sole supplier of the PowerPC G5 processor, which is used in the Company's current Power Mac, Xserve, and iMac products. +Freescale Semiconductor, Inc. is the sole supplier of the G4 processor, which is used in the Company's eMac and portable products. IBM has recently experienced manufacturing problems with the +PowerPC G5 processor, which resulted in the Company delaying the shipment of various products and constrained certain product shipments during the second half of 2004. The inability of IBM to remedy +these problems in a timely manner, avoid manufacturing problems in the future, and to deliver to the Company microprocessors in sufficient quantities with competitive price/performance features could +further constrain shipments of products containing the G5 processor and could adversely affect the Company's results of operations and financial condition. The Company is dependent on manufacturing and logistics services provided by third parties, many of whom are located outside of the U.S. Most of the Company's products are manufactured in whole or in part by third-party manufacturers. In addition, the Company has outsourced much of its transportation and +logistics management. While outsourcing arrangements may lower the cost of operations, they also reduce the Company's direct control over production and distribution. It is uncertain what effect such +diminished control will have on the quality or quantity of the products manufactured or services rendered, or the flexibility of the Company to respond to changing market conditions. Moreover, +although arrangements with such manufacturers may contain provisions for warranty expense reimbursement, the Company may remain at least initially responsible to the ultimate consumer for warranty +service in the event of product defects. Any unanticipated product defect or warranty liability, whether pursuant to arrangements with contract manufacturers or otherwise, could adversely affect the +Company's future operating results and financial condition. Final +assembly of products sold by the Company is currently conducted in the Company's manufacturing facility in Cork, Ireland, and by external vendors in Fremont, California, Fullerton, California, +Taiwan, Korea, the Netherlands, the People's Republic of China, and the Czech Republic. Currently, manufacture of many of the components used in the Company's products and final assembly of +substantially all of the Company's portable products including PowerBooks, iBooks, and the iPod is performed by third-party vendors in Taiwan and China. If for any reason manufacturing or logistics in +any of these locations is disrupted by events such as regional economic, business, environmental, medical, political, information technology system failures, or military actions, the Company's results +of operations and financial condition could be adversely affected. The Company's future operating performance is dependent on the performance of distributors and other resellers of the Company's products. The Company distributes its products through wholesalers, resellers, national and regional retailers and cataloguers, many of whom distribute products from competing +manufacturers. In addition, the Company also sells many of its products and resells certain third-party products in most of its major markets directly to end users, certain education customers, and +certain resellers through its online stores around the world and its retail stores. Many of the Company's significant resellers operate on narrow product margins and have been negatively affected by +recent economic conditions. Considerable trade receivables that are not covered by collateral or credit insurance are outstanding with the Company's distribution and retail channel partners. The +Company's business and financial results could be adversely affected if the financial condition of these resellers weaken, if resellers within consumer channels were to cease distribution of the +Company's products, or if uncertainty regarding demand for the Company's products caused resellers to 49 reduce +their ordering and marketing of the Company's products. The Company has invested and will continue to invest in various programs to enhance reseller sales, including staffing selected +resellers' stores with Company employees. These programs could require a substantial investment from the Company, while providing no assurance of return or incremental revenue to offset this +investment. Over +the past several years, an increasing proportion of the Company's net sales have been made by the Company directly to end-users through its online stores around the world and through +its retail stores in the U.S. and Japan. Some of the Company's resellers have perceived this expansion of the Company's direct sales as conflicting with their own business and economic interests as +distributors and resellers of the Company's products. Perception of such a conflict could discourage the Company's resellers from investing additional resources in the distribution and sale of the +Company's products or lead them to limit or cease distribution of the Company's products. The Company's business and financial results could be adversely affected if expansion of its direct sales to +end-users causes some or all of its resellers to cease or limit distribution of the Company's products. Further +information regarding risks associated with Marketing and Distribution may be found in Part I, Item 1 of this Form 10-K under the heading "Markets and Distribution." The Company relies on third-party music content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with third parties to offer their music content to customers through the Company's iTunes Music Store. The Company pays substantial fees to obtain the +rights to offer to its customers this third-party music. Many of the Company's licensing arrangements with these third-party +content providers are short-term in nature and do not guarantee the future renewal of these arrangements at commercially reasonable terms, if at all. Certain parties in the music industry +have announced their intent to consolidate their music distribution operations, which could limit the availability and increase the fees required to offer music content to customers through the iTunes +Music Store. Further, some third-party content providers currently, or may in the future, offer music products and services that compete with the Company's music products and services, and could take +action to make it more difficult or impossible for the Company to license their music content in the future. If the Company is unable to continue to offer a wide variety of music content at reasonable +prices with acceptable usage rules, or continue to expand its geographic reach outside the U.S., then sales and gross margins of the Company's iTunes Music Store as well as related hardware and +peripherals, including iPods, may be adversely affected. Third-party +content providers and artists require that the Company provide certain digital rights management solutions and other security mechanisms. If the requirements from content providers or +artists change, then the Company may be required to further develop or license technology to address such new rights and requirements. There is no assurance that the Company will be able to develop or +license such solutions at a reasonable cost and in a timely manner, if at all, which could have a materially adverse effect on the Company's operating results and financial position. The Company's future performance is dependent upon support from third-party software developers. If third-party software applications cease to be developed or available for the +Company's hardware products, then customers may choose not to buy the Company's products. The Company believes that decisions by customers to purchase the Company's personal computers, as opposed to Windows-based systems, are often based on the availability of +third-party software for particular applications such as Microsoft Office. The Company also believes the availability of third-party application software for the Company's hardware products depends in +part on third-party developers' perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company's products versus software for the larger +Windows market. This analysis is based on factors such as the perceived strength of the Company and its products, the anticipated potential revenue that may be generated, continued acceptance by +customers of Mac OS X, and the costs of developing such 50 software +products. To the extent the Company's financial losses in prior years and the minority market share held by the Company in the personal computer market, as well as the Company's decision to +end its Mac OS licensing program, have caused software developers to question the Company's prospects in the personal computer market, developers could be less inclined to develop new application +software or upgrade existing software for the Company's products and more inclined to devote their resources to developing and upgrading software for the larger Windows market. Moreover, there can be +no assurance software developers will continue to develop software for Mac OS X, the Company's operating system, on a timely basis or at all. In +addition, past and future development by the Company of its own software applications and solutions may negatively impact the decision of software developers to develop, maintain, and upgrade +similar or competitive software for the Company's products. The Company currently markets and sells a variety of software applications for use by professionals, consumers, and education customers that +could influence the decisions of third-party software developers to develop or upgrade Macintosh-compatible software products. Software applications currently marketed by the Company include software +for professional film and video editing, professional compositing and visual effects for large format film and video productions, professional music production and music post production, professional +and consumer DVD encoding and authoring, consumer digital video and digital photo editing and management, digital music management, desktop-based database management, and high-quality +presentations. The Company also markets an integrated productivity application that incorporates word processing, page layout, image manipulation, spreadsheets, databases, and presentations in a +single application. In +August 1997, the Company and Microsoft Corporation entered into patent cross license and technology agreements. In addition, for a period of five years through August 2002, and +subject to certain limitations related to the number of Macintosh computers sold by the Company, Microsoft was required to make versions of its Microsoft Office and Internet Explorer products for the +Mac OS. Although Microsoft has released Microsoft Office and Internet Explorer for Mac OS X, Microsoft has not been obligated to produce future versions of its products subsequent to +August 2002. While the Company believes its relationship with Microsoft has been and will continue to be beneficial to the Company and to its efforts to increase the installed base for the Mac +OS, the Company does compete directly with Microsoft in a number of key areas. Accordingly, Microsoft's interest in producing application software for the Mac OS following expiration of the agreements +may be influenced by Microsoft's perception of its interests as the vendor of the Windows operating system and competing digital media applications, including music distribution service and +technology. In June of 2003, Microsoft stated that it would no longer develop new versions of Internet Explorer for the Mac OS, subsequent to the Company's introduction during 2003 of its own web +browser, Safari. Further discontinuance of products for the Macintosh platform, including Microsoft Office and other Microsoft products could have an adverse effect on the Company's net sales and +results of operations. The Company's business relies on access to patents and intellectual property obtained from third parties, and the Company's future results could be adversely affected if it is +alleged or found to have infringed on the intellectual property rights of others. Many of the Company's products are designed to include intellectual property obtained from third-parties. While it may be necessary in the future to seek or renew licenses +relating to various aspects of its products and business methods, the Company believes that based upon past experience and industry practice, such licenses generally could be obtained on commercially +reasonable terms. However, there can be no assurance that the necessary licenses would be available or available on acceptable terms. Because +of technological changes in the computer and consumer electronics industries, current extensive patent coverage, and the rapid rate of issuance of new patents, it is possible certain +components of the Company's products and business methods may unknowingly infringe existing patents of others. The Company has from time to time been notified that it may be infringing certain patents +or other intellectual 51 property +rights of others. Responding to such claims, regardless of their merit, can be time consuming, result in significant expenses, and cause the diversion of management and technical personnel. +Several pending claims are in various stages of evaluation. The Company may consider the desirability of entering into licensing agreements in certain of these cases. However, no assurance can be +given that such licenses can be obtained on acceptable terms or that litigation will not occur. In the event there is a temporary or permanent injunction entered prohibiting the Company from marketing +or selling certain of its products or a successful claim of infringement against the Company requiring it to pay royalties to a third-party, the Company's future operating results and financial +condition could be adversely affected. Information regarding certain claims and litigation involving the Company related to alleged patent infringement and other matters is set forth in Part I, +Item 3 of this Form 10-K. In the opinion of management, the Company does not have a potential liability for damages or royalties from any current legal proceedings or claims related +to the infringement of patent or other intellectual property rights of others that would individually or in the aggregate have a material adverse effect on its results of operations, or financial +condition. However, the results of such legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of the matters related to infringement of patent or other +intellectual property rights of others described in Part I, Item 3 of this Form 10-K or should several of these matters be resolved against the Company in the same reporting +period, the operating results of a particular reporting period could be materially adversely affected. The Company's retail initiative has required and will continue to require a substantial investment and commitment of resources and is subject to numerous risks and +uncertainties. Through September 2004, the Company has opened 86 retail stores. The Company's retail initiative has required substantial investment in equipment and leasehold +improvements, information systems, inventory, and personnel. The Company has also entered into substantial operating lease commitments for retail space with lease terms ranging from 5 to +16 years, the majority of which are for 10 years. The Company could incur substantial costs should it choose to terminate this initiative or close individual stores. Such costs could +adversely affect the Company's results of operations and financial condition. Additionally, a relatively high proportion of the Retail segment's costs are fixed because of depreciation on store +construction costs and lease expense. As a result, significant losses would result should the Retail segment experience a decline in sales for any reason. Certain +of the Company's stores have been designed and built to serve as high profile venues that function as vehicles for general corporate marketing, corporate events, and brand awareness. Because +of their unique design elements, locations and size, these stores require substantially more investment in equipment and leasehold improvements than the Company's more typical retail stores. The +Company has opened seven such stores through November 2004. Because of their location and size, these high +profile stores also require the Company to enter into substantially larger operating lease commitments compared to those required for its more typical stores. Current leases on such locations have +terms ranging from 10 to 16 years with total commitments per location over the lease terms ranging from $25 million to $50 million. Closure or poor performance of one of these +high profile stores could have a particularly significant negative impact on the Company's results of operations and financial condition. Many +of the general risks and uncertainties the Company faces could also have an adverse impact on its Retail segment. Also, many factors unique to retail operations present risks and uncertainties, +some of which are beyond the Company's control, that could adversely affect the Retail segment's future results, cause its actual results to differ from those currently expected, and/or have an +adverse effect on the Company's consolidated results of operations. Potential risks and uncertainties unique to retail operations that could have an adverse impact on the Retail segment include, among +other things, macro-economic factors that have a negative impact on general retail activity; inability to manage costs associated with store construction and operation; lack of consumer acceptance of +the Company's retail approach; failure to attract new users to the Macintosh platform; inability to sell third-party hardware and software products at adequate margins; failure to manage relationships +with existing retail channel partners; lack of experience 52 in +managing retail operations outside the U.S.; costs associated with unanticipated fluctuations in the value of Apple-branded and third-party retail inventory; and inability to obtain quality retail +locations at reasonable cost. Investment in new business strategies and initiatives could disrupt the Company's ongoing business and may present risks not originally contemplated. The Company may decide to invest in new business strategies or engage in acquisitions that complement the Company's strategic direction and product roadmap. Such endeavors may +involve significant risks and uncertainties, including distraction of management's attention away from normal business operations; insufficient revenue generation to offset liabilities assumed and +expenses associated with the strategy; and unidentified issues not discovered in the Company's due diligence process. Because these new ventures are inherently risky, no assurance can be given that +such strategies and initiatives will be successful and will not materially adversely affect the Company's business, operating results or financial condition. Declines in the sales of the Company's professional products or increases in sales of consumer products, including iPods, may negatively impact the Company's gross margin and +operating margin percentages Unit sales of the Company's professional products, including Power Macintosh and PowerBook systems, generally have higher gross margins than the Company's consumer products, +including iMacs, iBooks, iPods, and content from the iTunes Music Store. A shift in sales mix away from higher margin +professional products towards lower margin consumer products could adversely affect the Company's future gross margin and operating margin percentages. The Company's traditional professional customers +may choose to buy consumer products, specifically the iMac G5 and iBook, instead of professional products. Professional users may choose to buy the iMac G5 due to its relative price performance, use +of the same PowerPC G5 processor used in the Company's Power Macs, and unique design featuring a flat panel screen. Potential PowerBook customers may also choose to purchase iBooks instead due to +their price performance and screen size. Additionally, significant future growth in iPod sales without corresponding growth in higher margin product sales could also reduce gross margin and operating +margin percentages. The +Company believes that weak economic conditions over the past several years are having a pronounced negative impact on its professional and creative customers who are significant users of its +professional systems. Also, it is likely that many of the Company's current and potential professional, creative, and small business customers, who are most likely to utilize professional systems, +believe that the relatively slower MHz rating or clock speed of the microprocessors the Company utilizes in its Macintosh systems compares unfavorably to those utilized by other computer manufacturers +and translates to slower overall system performance. These factors may result in an adverse impact to sales of the Company's professional products as well as to gross margin and operating margin +percentages. The Company expects its quarterly revenue and operating results to fluctuate for a variety of reasons. The Company's profit margins vary among its products and its distribution channels. The Company's direct sales, primarily through its retail and online stores, generally have +higher associated profitability than its indirect sales. Additionally, the Company's direct channels have traditionally had more sales of software and higher priced hardware products, which generally +have higher gross margins, than through its indirect channels. As a result, the Company's gross margin and operating margin percentages as well as overall profitability may be adversely impacted as a +result of a shift in product, geographic or channel mix. In addition, the Company generally sells more products during the third month of each quarter than it does during either of the first two +months, a pattern typical in the personal computer industry. This sales pattern can produce pressure on the Company's internal infrastructure during the third month of a quarter and may adversely +impact the Company's ability to predict its financial results accurately. Developments late in a quarter, such as lower-than-anticipated demand for the Company's products, an +internal systems failure, or failure of one of the Company's key logistics, components suppliers, or manufacturing partners, can have significant adverse impacts on the Company and its results of +operations and financial condition. 53 The Company has higher research and development and selling, general and administrative costs, as a percentage of revenue, than many of its competitors. The Company's ability to compete successfully and maintain attractive gross margins and revenue growth is heavily dependent upon its ability to ensure a continuing and timely +flow of innovative and competitive products and technologies to the marketplace. As a result, the Company incurs higher research and development costs as a percentage of revenue than its competitors +who sell personal computers based on other operating systems. Many of these competitors seek to compete aggressively on price and maintain very low cost structures. Further, as a result of the +expansion of the Company's Retail segment and costs associated with marketing the Company's brand including its unique operating system, the Company incurs higher selling costs as a percentage of +revenue than many of its competitors. If the Company is unable to continue to develop and sell innovative new products with attractive gross margins, its results of operations may be materially +adversely affected by its operating cost structure. The Company is exposed to credit risk on its accounts receivables. This risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party computer resellers and retailers and directly to certain educational institutions and commercial customers. A +substantial majority of the Company's outstanding trade receivables are not covered by collateral or credit insurance. The Company also has unsecured non-trade receivables from certain of +its manufacturing vendors resulting from the sale by the Company of raw material components to these manufacturing vendors who manufacture sub-assemblies or assemble final products for the +Company. While the Company has procedures in place to monitor and limit exposure to credit risk on its trade and non-trade receivables, there can be no assurance that such procedures will +be effective in limiting its credit risk and avoiding losses. Additionally, if the global economy and regional economies fail to improve or continue to deteriorate, it becomes more likely that the +Company will incur a material loss or losses as a result of the weakening financial condition of one or more of its customers or manufacturing vendors. The Company's success depends largely on its ability to attract and retain key personnel. Much of the future success of the Company depends on the continued service and availability of skilled personnel, including its Chief Executive Officer, members of its +executive team, and those in technical, marketing and staff positions. Experienced personnel in the information technology industry are in high demand and competition for their talents is intense, +especially in the Silicon Valley, where the majority of the Company's key employees are located. The Company has relied on its ability to grant stock options as one mechanism for recruiting and +retaining this highly skilled talent. Potential accounting regulations requiring the expensing of stock options may impair the Company's future ability to provide these incentives without incurring +significant compensation costs. There can be no assurance that the Company will continue to successfully attract and retain key personnel. The Company is subject to risks associated with the availability and cost of insurance. The Company has observed rapidly changing conditions in the insurance markets relating to nearly all areas of traditional commercial insurance. Such conditions have and may +continue to result in higher premium costs, higher policy deductibles, lower coverage limits and may also yield possible policy form exclusions. For some risks, because of cost and/or availability, +the Company does not have insurance coverage. Because the Company retains some portion of its insurable risks, and in some cases self insures completely, unforeseen or catastrophic losses in excess of +insured limits may have a material adverse effect on the Company's results of operations and financial position. Failure of information technology systems and breaches in the security of data upon which the Company relies could adversely affect the Company's future operating results. Information technology system failures and breaches of data security could disrupt the Company's ability to function in the normal course of business by potentially causing +delays or cancellation of customer 54 orders, +impeding the manufacture or shipment of products, or resulting in the unintentional disclosure of customer or Company information. Management has taken steps to address these concerns for its +own systems by implementing sophisticated network security and internal control measures. However, there can be no assurance that a system failure or data security breach of the Company or a +third-party vendor will not have a material adverse effect on the Company's results of operations. The Company's business is subject to the risks of international operations. A large portion of the Company's revenue is derived from its international operations. As a result, the Company's operating results and financial condition could be +significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries), and +changes in the value of the U.S. dollar versus the local currency in which the products are sold and goods and services are purchased. The Company's primary exposure to movements in foreign currency +exchange rates relate to non-dollar denominated sales in Europe, Japan, Australia, Canada, and certain parts of Asia and non-dollar denominated operating expenses incurred +throughout the world. Weaknesses in foreign currencies, particularly the Japanese Yen and the Euro, can adversely impact consumer demand for the Company's products and the U.S. dollar value of the +Company's foreign currency denominated sales. Conversely, strengthening in these and other foreign currencies can increase the cost to the Company of product components, negatively affecting the +Company's results of operations. Margins +on sales of the Company's products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency +exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. Derivative +instruments, such as foreign exchange forward and option positions have been utilized by the Company to hedge exposures to fluctuations in foreign currency exchange rates. The use of such +hedging activities may not offset more than a portion of the adverse financial impact resulting from unfavorable movements in foreign exchange rates. Further +information related to the Company's global market risks may be found in Part II, Item 7A of this Form 10-K under the subheading "Foreign Currency Risk" and +may be found in Part II, Item 8 of this Form 10-K at Notes 1 and 2 of Notes to Consolidated Financial Statements. The Company is subject to risks associated with environmental regulations. Production and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and +regulations have recently been passed in several jurisdictions in which the Company operates, including various European Union member countries, Japan and certain states within the U.S. In the future, +these laws could have a material adverse affect on the Company. Changes in accounting rules could adversely affect the Company's future operating results. Financial statements are prepared in accordance with U.S. generally accepted accounting principles. These principles are subject to interpretation by various governing bodies, +including the FASB and the Securities and Exchange Commission (SEC), who interpret and create appropriate accounting regulations. A change from current accounting regulations, including accounting for +stock-based compensation, could have a significant effect on the Company's results of operations and could impact the manner in which the Company conducts business. 55 Unanticipated changes in the Company's tax rates could affect its future results. The Company's future effective tax rates could be favorably or unfavorably affected by unanticipated changes in the mix of earnings in countries with differing statutory tax +rates, changes in the valuation of the Company's deferred tax assets and liabilities, or by changes in tax laws or their interpretation. In addition, the Company is subject to the continuous +examination of its income tax returns by the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of adverse outcomes resulting from these examinations to +determine the adequacy of its provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse effect on the Company's operating +results and financial condition. The Company's stock price may be volatile. The Company's stock has at times experienced substantial price volatility as a result of variations between its actual and anticipated financial results and as a result of +announcements by the Company and its competitors. The stock market has experienced extreme price and volume fluctuations that have affected the market price of many technology companies in ways that +have been unrelated to the operating performance of these companies. These factors, including lack of positive performance in the Company's stock price, as well as general economic and political +conditions and investors' concerns regarding the credibility of corporate financial reporting and integrity of financial markets, may materially adversely affect the market price of the Company's +stock in the future. In addition, increases in the Company's stock price may result in greater dilution of earnings per share. 56 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and its interest rate swap and option positions, both on a stand-alone basis and in conjunction +with its underlying foreign currency and interest rate related exposures. However, given the effective horizons of the Company's risk management activities and the anticipatory nature of the +exposures, there can be no assurance the +hedges will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains +and losses related to mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, +therefore, may adversely affect the Company's operating results and financial position. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world's leading industrialized countries, the Company's interest income and expense is most sensitive +to fluctuations in the general level of U.S. interest rates. In this regard, changes in U.S. interest rates affect the interest earned on the Company's cash, cash equivalents, and +short-term investments as well as costs associated with foreign currency hedges. The +Company's short-term investment policy and strategy is to ensure the preservation of capital, meet liquidity requirements, and optimize return in light of current credit and interest +rate trends. The Company benchmarks its performance by utilizing external money managers to manage a small portion of the aggregate investment portfolio. The external managers adhere to the Company's +investment policies and also provide occasional research and market information that supplements internal research used to make credit decisions in the investment process. The +Company's exposure to market risk for changes in interest rates relates primarily to the Company's investment portfolio. The Company places its short-term investments in highly liquid +securities issued by high credit quality issuers and, by policy, limits the amount of credit exposure to any one issuer. The Company's general policy is to limit the risk of principal loss and ensure +the safety of invested funds by limiting market and credit risk. All highly liquid investments with maturities of three months or less are classified as cash equivalents; highly liquid investments +with maturities greater than three months are classified as short-term investments. As of September 25, 2004, approximately $180 million of the Company's +short-term investments had underlying maturities ranging from 1 to 5 years. As of September 27, 2003, $629 million of the Company's investment portfolio classified as +short-term investments had maturities ranging from 1 to 5 years. The remainder all had underlying maturities between 3 and 12 months. The Company may sell its investments +prior to their stated maturities, due to liquidity needs, in anticipation of credit deterioration, or for duration management. As a result of such activity, the Company recognized net gains of +$1 million in 2004, $21 million in 2003, and $7 million in 2002. In +order to provide a meaningful assessment of the interest rate risk associated with the Company's investment portfolio, the Company performed a sensitivity analysis to determine the impact that a +change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 25, +2004, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $14.4 million decline in the fair market value of the portfolio. As of +September 27, 2003, a similar 100 basis point shift in the yield curve would have resulted in a $12.9 million decline in fair value. Such losses would only be +realized if the Company sold the investments prior to maturity. Except in instances noted above, the Company's policy is to hold investments to maturity. From +time to time, the Company has entered into interest rate derivative transactions with financial institutions in order to better match the Company's floating-rate interest income on +its cash equivalents 57 and +short-term investments with its fixed-rate interest expense on its debt, and/or to diversify a portion of the Company's exposure away from fluctuations in +short-term U.S. interest rates. The Company did not enter into any interest rate derivatives during 2004 or 2003 and had no open interest rate derivatives at September 25, 2004. In +prior years, the Company had entered into interest rate debt swaps with financial institutions. The interest rate debt swaps required the Company to pay a floating interest rate based on the three- +or six-month U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of the underlying notional amounts. These swaps effectively converted the Company's +fixed-rate 10-year debt to floating-rate debt. Due to prevailing market interest rates, during 2001 and 2002 the Company entered into and then subsequently closed +out interest rate debt swap positions realizing gains of $23 million. The gains were deferred, recognized in long-term debt and were amortized to other income and expense over the +remaining life of the debt. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. +dollar, may negatively affect the Company's net sales and gross margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to +competitive pressures when there has been significant volatility in foreign currency exchange rates. The +Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with existing assets and liabilities, certain +firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company's practice is to hedge a majority of its existing material foreign +exchange transaction exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and +limited availability of appropriate hedging instruments. In +order to provide a meaningful assessment of the foreign currency risk associated with certain of the Company's foreign currency derivative positions, the Company performed a sensitivity analysis +using a value-at-risk (VAR) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate 3000 +random market price paths. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company's foreign exchange portfolio due to adverse movements in rates. The VAR +model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments, and assets +and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair +value of $3.2 million as of September 25, 2004 compared to a maximum one-day loss of $7.5 million as of September 27, 2003. Because the Company uses foreign +currency instruments for hedging purposes, losses incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual +gains and losses in the future associated with the Company's investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of +September 25, 2004 due to the inherent limitations associated with predicting the changes in the timing and amount of interest rates, foreign currency exchanges rates, and the Company's actual +exposures and positions. 58 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Financial Statements: Consolidated Balance Sheets as of September 25, 2004 and September 27, 2003 60 Consolidated Statements of Operations for the three fiscal years ended September 25, 2004 61 Consolidated Statements of Shareholders' Equity for the three fiscal years ended September 25, 2004 62 Consolidated Statements of Cash Flows for the three fiscal years ended September 25, 2004 63 Notes to Consolidated Financial Statements 64 Selected Quarterly Financial Information (Unaudited) 102 Report of Independent Registered Public Accounting Firm, KPMG LLP 103 All +financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the Consolidated Financial Statements and Notes thereto. 59 CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 25, 2004 September 27, 2003 ASSETS: Current assets: Cash and cash equivalents $ 2,969 $ 3,396 Short-term investments 2,495 1,170 Accounts receivable, less allowances of $47 and $49, respectively 774 766 Inventories 101 56 Deferred tax assets 231 190 Other current assets 485 309 Total current assets 7,055 5,887 Property, plant, and equipment, net 707 669 Goodwill 80 85 Acquired intangible assets 17 24 Other assets 191 150 Total assets $ 8,050 $ 6,815 LIABILITIES AND SHAREHOLDERS' EQUITY: Current liabilities: Accounts payable $ 1,451 $ 1,154 Accrued expenses 1,229 899 Current debt — 304 Total current liabilities 2,680 2,357 Deferred tax liabilities and other non-current liabilities 294 235 Total liabilities 2,974 2,592 Commitments and contingencies Shareholders' equity: Common stock, no par value; 900,000,000 shares authorized; 391,443,617 and 366,726,584 shares issued and outstanding, respectively 2,514 1,926 Deferred stock compensation (93 ) (62 ) Retained earnings 2,670 2,394 Accumulated other comprehensive income (loss) (15 ) (35 ) Total shareholders' equity 5,076 4,223 Total liabilities and shareholders' equity $ 8,050 $ 6,815 See +accompanying notes to consolidated financial statements. 60 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) Three fiscal years ended September 25, 2004 2004 2003 2002 Net sales $ 8,279 $ 6,207 $ 5,742 Cost of sales 6,020 4,499 4,139 Gross margin 2,259 1,708 1,603 Operating expenses: Research and development 489 471 446 Selling, general, and administrative 1,421 1,212 1,109 Restructuring costs 23 26 30 Purchased in-process research and development — — 1 Total operating expenses 1,933 1,709 1,586 Operating income (loss) 326 (1 ) 17 Other income and expense: Gains (losses) on non-current investments, net 4 10 (42 ) Interest and other income, net 53 83 112 Total other income and expense 57 93 70 Income before provision for income taxes 383 92 87 Provision for income taxes 107 24 22 Income before accounting changes 276 68 65 Cumulative effects of accounting changes, net of income taxes — 1 — Net income $ 276 $ 69 $ 65 Earnings per common share before accounting changes: Basic $ 0.74 $ 0.19 $ 0.18 Diluted $ 0.71 $ 0.19 $ 0.18 Earnings per common share: Basic $ 0.74 $ 0.19 $ 0.18 Diluted $ 0.71 $ 0.19 $ 0.18 Shares used in computing earnings per share (in thousands): Basic 371,590 360,631 355,022 Diluted 387,311 363,466 361,785 See +accompanying notes to consolidated financial statements. 61 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) Common Stock Accumulated Other Comprehensive Income (Loss) Deferred Stock Compensation Retained Earnings Total Shareholders' Equity Shares Amount Balances as of September 29, 2001 350,922 $ 1,693 $ (11 ) $ 2,260 $ (22 ) $ 3,920 Components of comprehensive income: Net income — — — 65 — 65 Change in foreign currency translation — — — — 5 5 Change in unrealized gain on available-for-sale securities, net of tax — — — — (17 ) (17 ) Change in unrealized gain on derivative investments, net of tax — — — — (15 ) (15 ) Total comprehensive income 38 Amortization of deferred stock compensation — — 4 — — 4 Common stock issued under stock plans 8,037 105 — — — 105 Tax benefit related to stock options — 28 — — — 28 Balances as of September 28, 2002 358,959 $ 1,826 $ (7 ) $ 2,325 $ (49 ) $ 4,095 Components of comprehensive income: Net income — — — 69 — 69 Change in foreign currency translation — — — — 31 31 Change in unrealized gain on available-for-sale securities, net of tax — — — — (12 ) (12 ) Change in unrealized gain on derivative investments, net of tax — — — — (5 ) (5 ) Total comprehensive income 83 Amortization of deferred stock compensation — — 15 — — 15 Write-off of deferred stock compensation — — 5 — — 5 Common stock issued under stock plans 9,299 128 (75 ) — — 53 Settlement of forward purchase agreement (1,531 ) (35 ) — — — (35 ) Tax benefit related to stock options — 7 — — — 7 Balances as of September 27, 2003 366,727 $ 1,926 $ (62 ) $ 2,394 $ (35 ) $ 4,223 Components of comprehensive income: Net income — — — 276 — 276 Change in foreign currency translation — — — — 13 13 Change in unrealized gain on available-for-sale securities, net of tax — — — — (5 ) (5 ) Change in unrealized loss on derivative investments, net of tax — — — — 12 12 Total comprehensive income 296 Issuance of restricted stock units — 64 (64 ) — — — Adjustment to common stock related to a prior year acquisition (79 ) (2 ) — — — (2 ) Amortization of deferred stock compensation — — 33 — — 33 Common stock issued under stock plans 24,796 427 — — — 427 Tax benefit related to stock options — 99 — — — 99 Balances as of September 25, 2004 391,444 $ 2,514 $ (93 ) $ 2,670 $ (15 ) $ 5,076 See +accompanying notes to consolidated financial statements. 62 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 25, 2004 2004 2003 2002 Cash and cash equivalents, beginning of the year $ 3,396 $ 2,252 $ 2,310 Operating Activities: Net income 276 69 65 Cumulative effects of accounting changes, net of taxes — (1 ) — Adjustments to reconcile net income to cash generated by operating activities: Depreciation, amortization and accretion 150 113 114 Stock-based compensation expense 33 16 5 Non-cash restructuring 5 12 8 Provision for (benefit from) deferred income taxes 20 (11 ) (34 ) Loss on disposition of property, plant, and equipment 7 2 7 Gains on sales of short-term investments, net (1 ) (21 ) (7 ) (Gains) losses on non-current investments, net (4 ) (10 ) 42 Gain on forward purchase agreement — (6 ) — Purchased in-process research and development — — 1 Changes in operating assets and liabilities: Accounts receivable (8 ) (201 ) (99 ) Inventories (45 ) (11 ) (34 ) Other current assets (176 ) (34 ) (114 ) Other assets (39 ) (30 ) (11 ) Accounts payable 297 243 110 Other liabilities 419 159 36 Cash generated by operating activities 934 289 89 Investing Activities: Purchases of short-term investments (3,270 ) (2,648 ) (4,144 ) Proceeds from maturities of short-term investments 1,141 2,446 2,846 Proceeds from sales of short-term investments 801 1,116 1,254 Proceeds from sales of non-current investments 5 45 25 Purchases of property, plant, and equipment (176 ) (164 ) (174 ) Cash used for business acquisitions — — (52 ) Other 11 33 (7 ) Cash generated by (used for) investing activities (1,488 ) 828 (252 ) Financing Activities: Payment of long-term debt (300 ) — — Proceeds from issuance of common stock 427 53 105 Cash used for repurchase of common stock — (26 ) — Cash generated by financing activities 127 27 105 Increase (decrease) in cash and cash equivalents (427 ) 1,144 (58 ) Cash and cash equivalents, end of the year $ 2,969 $ 3,396 $ 2,252 Supplemental cash flow disclosures: Cash paid during the year for interest $ 10 $ 20 $ 20 Cash paid (received) for income taxes, net $ (7 ) $ 45 $ 11 See +accompanying notes to consolidated financial statements. 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1—Summary of Significant Accounting Policies Apple +Computer, Inc. and subsidiaries (the Company) designs, manufactures and markets personal computers and related software, services, peripherals and networking solutions. The Company also +designs, develops and markets a line of portable digital music players along with related accessories and services including the online distribution of third-party music and audio books. The Company +sells its products worldwide through its online stores, its own retail stores, its direct sales force and third-party wholesalers, resellers and value added resellers. In addition to its own hardware, +software and peripheral products, the Company sells a variety of third-party hardware and software products through its online and retail stores. The Company sells to education, consumer, creative +professional, business and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these +consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these +consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes +thereto have been reclassified to conform to the current year presentation. Typically, +the Company's fiscal year ends on the last Saturday of September. Fiscal years 2004, 2003 and 2002 were each 52-week years. However, approximately every six years, the Company +reports a 53-week fiscal year to align its fiscal quarters with calendar quarters by adding a week to its first fiscal quarter. The Company expects to add this additional week in its first +fiscal quarter of 2006. All information presented herein is based on the Company's fiscal calendar. Financial Instruments Cash Equivalents and Short-term Investments All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Highly liquid investments with maturities +greater than three months are classified as short-term investments. Management determines the appropriate classification of its investments in debt and marketable equity securities at the +time of purchase and reevaluates such designation as of each balance sheet date. The Company's debt and marketable equity securities have been classified and accounted for as +available-for-sale. These securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported as a component of shareholders' equity. The cost of +securities sold is based upon the specific identification method. Financial Instruments with Characteristics of Both Liabilities and Equity On May 15, 2003, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of +Both Liabilities and Equity . SFAS No. 150 requires issuers to classify as +liabilities (or assets in some circumstances) certain freestanding financial instruments that embody obligations for the issuer and have characteristics of both liabilities and equity. The Company +adopted the provisions of SFAS No. 150 on June 29, 2003, which resulted in a favorable cumulative-effect type adjustment of approximately $3 million. This adjustment related to a +forward purchase agreement that allowed the Company to acquire 1.5 million shares of its common stock at an average price of $16.64 per share for a total cost of $25.5 million. The +Company settled this forward purchase agreement in August 2003, which resulted in an additional gain of 64 approximately +$6 million representing the increase in fair value of the agreement from June 29, 2003 through the settlement date. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. Derivatives that are not hedges must be adjusted to fair +value through income. If the derivative is a hedge, depending on the nature of the hedge, changes in fair value will either be offset against the change in fair value of the hedged assets, +liabilities, or firm commitments through earnings, or recognized in other comprehensive income until the hedged item is recognized in earnings. For +derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the net gain or loss on the derivative instrument is reported +as a component of other comprehensive income in shareholders' equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. To receive hedge +accounting treatment, cash flow hedges must be highly effective in achieving offsetting changes to expected future cash flows on hedged transactions. For derivative instruments that hedge the exposure +to changes in the fair value of an asset or a liability and that are designated as fair value hedges, the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the +hedged item attributable to the hedged risk are recognized in earnings in the current period. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic +hedge of the foreign currency translation exposure of the net investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward contracts +designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or +losses related to this component are recognized in current earnings. For derivative instruments not designated as hedging instruments, changes in fair value are recognized in earnings in the current +period. In +accordance with SFAS No. 133, hedges related to probable but not firmly committed transactions of an anticipatory nature are designated and documented at hedge inception as cash flow hedges +and evaluated for hedge effectiveness quarterly. For foreign currency forward contracts designated as cash flow hedges, hedge effectiveness is measured based on changes in the fair value of the +contract attributable to changes in the forward exchange rate. Changes in the expected future cash flows on the forecasted hedged transaction and changes in the fair value of the forward hedge are +both measured from the contract rate to the forward exchange rate associated with the forward contract's maturity date. For currency option contracts, hedge effectiveness is assessed by comparing the +present value of the cumulative change in expected future cash flows on the hedged transaction to changes in expected cash flow of the option hedge at maturity. The net gains or losses on derivative +instruments qualifying as cash flow hedges are reported as components of other comprehensive income in shareholders' equity and reclassified into earnings in the same period or periods during which +the hedged transaction affects earnings. Any hedge ineffectiveness is recognized in current earnings in other income and expense. For interest rate swap agreements qualifying as fair value hedges, the +Company assumes no ineffectiveness because these swaps meet the criteria for accounting under the short-cut method. The +Company may enter into foreign currency forward contracts to hedge the translation and economic exposure of a net investment position in a foreign subsidiary. For such contracts, hedge +effectiveness is measured based on changes in the fair value of the contract attributable to changes in the spot exchange rate. The effective portion of the net gain or loss on a derivative instrument +designated as a hedge of the net investment position in a foreign subsidiary is reported in the same manner as a foreign currency 65 translation +adjustment. Any residual changes in fair value of the forward contract, including changes in fair value based on the differential between the spot and forward exchange rates, are +recognized in current earnings in other income and expense. Inventories Inventories are stated at the lower of cost (first-in, first-out) or market. If the cost of the inventories exceeds their market value, provisions are +made currently for the difference between the cost and the market value. Property, Plant, and Equipment Property, plant, and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which +are 30 years for buildings, from 2 to 5 years for equipment, and the shorter of lease terms or 10 years for leasehold improvements. The Company capitalizes eligible costs to +acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using +the straight-line method over the estimated useful lives of the assets, which range from 3 to 5 years. Asset Retirement Obligations On September 29, 2002, the Company adopted SFAS No. 143, Accounting for Asset Retirement Obligations , which +addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to +legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. SFAS No. 143 +requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of +the liability is added to the carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. All of the Company's existing asset retirement +obligations are +associated with commitments to return property subject to operating leases to original condition upon lease termination. The Company estimated that as of September 29, 2002, gross expected +future cash flows of $9.5 million would be required to fulfill these obligations. As +of the date of adoption, the Company recorded a $6 million long-term asset retirement liability and a corresponding increase in leasehold improvements. This amount represents the +present value of expected future cash flows associated with returning certain of the Company's leased properties to original condition. The difference between the gross expected future cash flow of +$9.5 million and its present value of $6 million at September 29, 2002, is being accreted over the life of the related leases as an operating expense. Net of the related income +tax effect of approximately $1 million, adoption of SFAS No. 143 resulted in an unfavorable cumulative-effect type adjustment to net income during the first quarter of 2003 of +approximately $2 million. This adjustment represents cumulative depreciation and accretion that would have been recognized through the date of adoption of SFAS No. 143 had the statement +been applied to the Company's existing asset retirement obligations at the time they were initially incurred. 66 The +following table reconciles changes in the Company's asset retirement liabilities for fiscal 2003 and 2004 (in millions): Asset retirement liability as of September 29, 2002 $ 5.5 Additional asset retirement obligations recognized 0.5 Accretion recognized 1.2 Asset retirement liability as of September 27, 2003 $ 7.2 Additional asset retirement obligations recognized 0.5 Accretion recognized 0.5 Asset retirement liability as of September 25, 2004 $ 8.2 Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and certain identifiable intangibles, excluding goodwill, for impairment whenever events or changes in circumstances indicate +the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of its carrying amount to future undiscounted cash flows the assets are expected to +generate. If property, plant, and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the +assets exceeds its fair market value. For the three years ended September 25, 2004, September 27, 2003, and September 28, 2002 the Company had no material impairment of its +long-lived assets, except for the impairment of certain assets in connection with the restructuring actions described in Note 5. The +Company adopted SFAS No. 142, Goodwill and Other Intangible Assets , in the first quarter of fiscal 2002. SFAS No. 142 requires that +goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually or sooner whenever events or changes in circumstances +indicate that they may be impaired. Prior to fiscal 2002, goodwill was amortized using the straight-line method over its estimated useful life. The Company completed its transitional +goodwill impairment test as of October 1, 2001, and its annual goodwill impairment tests on August 30 of each year thereafter and found no impairment. The Company established reporting +units based on its current reporting structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. SFAS +No. 142 also requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived +Assets and for Long-Lived Assets to Be Disposed Of . The Company is currently +amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 10 years. Foreign Currency Translation The Company translates the assets and liabilities of its international non-U.S. functional currency subsidiaries into U.S. dollars using exchange rates in effect at +the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are credited +or charged to foreign currency translation included in "accumulated other comprehensive income (loss)" in shareholders' equity. The Company's foreign manufacturing subsidiaries and certain other +international subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, +property, and nonmonetary assets and liabilities at historical rates. Gains and 67 losses +from these translations were insignificant and have been included in the Company's results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale of products (hardware, software, and peripherals), and extended warranty and support contracts. The Company recognizes +revenue pursuant to applicable accounting standards, including Statement of Position (SOP) No. 97-2, Software Revenue Recognition , as +amended, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition . The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is shipped. +For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company +legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed to not be, fixed or +determinable, revenue is deferred and subsequently recognized as amounts become due and payable. Revenue +from extended warranty and support contracts is deferred and recognized ratably over the warranty and support periods. These contracts typically include extended phone support, certain +repairs, web-based support resources, diagnostic tools, and extend the Company's one-year basic limited parts and labor warranty. The +Company sells software and peripheral products obtained from other companies. The Company establishes its own pricing and retains related inventory risk, is the primary obligor in sales +transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company recognizes revenue for the sale of products obtained from other companies at +the gross amount billed. Revenue +on arrangements that include multiple elements such as hardware, software, and services is allocated to each element based on the relative fair value of each element, which is generally +determined by vendor specific objective evidence (VSOE). Allocated revenue for each element is recognized when revenue recognition criteria have been met for each element. VSOE is determined based on +the price charged when each element is sold separately. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end user rebates, and other sales programs +and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The Company also records +reductions to revenue for expected future product returns based on the Company's historical experience. Generally, +the Company does not offer specified or unspecified upgrade rights to its customers in connection with software sales or the sale of extended warranty and support contracts. However, a +limited number of the Company's software products are available with maintenance agreements that grant customers rights to unspecified future upgrades over the maintenance term on a when and if +available basis. Revenue associated with such maintenance is recognized ratably over the maintenance term. 68 Shipping Costs The Company's shipping and handling costs are included in cost of sales for all periods presented. Warranty Expense The Company provides currently for the estimated cost for product warranties at the time the related revenue is recognized. Research and Development Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased or otherwise marketed are subject to capitalization beginning +when a product's technological feasibility has been established and ending when a product is available for general release to customers pursuant to SFAS No. 86, Computer +Software to be Sold, Leased, or Otherwise Marketed . In most instances, the Company's products are released soon after technological feasibility has been established. Therefore, +costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally all software development costs have been expensed. During +the fourth quarter of 2004, the Company incurred substantial development costs associated with the development of Mac OS X version 10.4 (code-named "Tiger"), which enhances the +features and functionality of the previous version of Mac OS X, subsequent to achievement of technological feasibility as evidenced by public demonstration in August 2004 and subsequent release +of a developer beta version of the product, both of which were prior to the planned release of the final version of the product in the first half of calendar year 2005. Therefore, during the fourth +quarter of 2004, the Company capitalized approximately $4.5 million of costs associated with development of Tiger. Amortization of this asset will begin when Tiger begins shipping and will be +recognized straight-line over a 3 year estimated useful life. During +the second quarter of 2004, the Company incurred substantial development costs associated with FileMaker Pro 7 subsequent to achievement of technological feasibility as evidenced by public +demonstration and release of a developer beta version, and prior to the release of the final version of the product in March 2004. Therefore, during the second quarter of 2004, the Company +capitalized approximately $2.3 million of costs associated with the development of FileMaker Pro 7. In accordance with SFAS No. 86, amortization of this asset began in March 2004 +when FileMaker Pro 7 was shipped and is being recognized on a straight-line basis over a 3 year estimated useful life. During +the third and fourth quarters of 2003, the Company incurred substantial development costs associated with the development of Mac OS X version 10.3 (code-named "Panther"), subsequent +to achievement of technological feasibility as evidenced by public demonstration and release of a developer beta in June 2003, and prior to release of the final version of the product in the +first quarter of 2004. Therefore, during 2003 the Company capitalized approximately $14.7 million of development costs associated with the development of Panther. Amortization of this asset +began in the first quarter of 2004 when Panther was shipped and is being recognized on a straight-line basis in accordance with SFAS No. 86 over a 3 year estimated useful +life. During +the third and fourth quarters of 2002, the Company incurred substantial development costs associated with the development of Mac OS X version 10.2 (code-named "Jaguar") subsequent +to achievement of technological feasibility as evidenced by public demonstration and release of a developer beta in May 2002, and prior to release of the final version of the product in the +fourth quarter of 2002. As such, the Company capitalized approximately $13.3 million of development costs associated with development of Jaguar. Amortization of this asset began in the fourth +quarter of 2002 when Jaguar was 69 shipped +and is being recognized on a straight-line basis in accordance with SFAS No. 86 over a 3 year estimated useful life. In addition, during 2002, the Company also began +capitalizing certain costs related to development of its new PowerSchool enterprise student information system. Capitalization of approximately $6 million began upon achievement of +technological feasibility in the first quarter of 2002. The final version of the enterprise student information system was released in July 2002. Total +amortization related to capitalized software development costs was $10.7 million, $5.8 million, and $1.2 million in 2004, 2003 and 2002, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $206 million, $193 million, and $209 million for 2004, 2003, and 2002, respectively. Restructuring Charges In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities . SFAS +No. 146 supersedes Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs +To Exit an Activity (Including Certain Costs Associated with a Restructuring) and requires that a liability for a cost associated with an exit or disposal activity be +recognized when the liability is incurred, as opposed to when management commits to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at +fair value. This Statement was effective for exit or disposal activities initiated after December 31, 2002. The provisions of SFAS No. 146 were required to be applied prospectively after +the adoption date to newly initiated exit activities. Stock-Based Compensation The Company measures compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by Accounting Principles Board (APB) +Opinion No. 25, Accounting for Stock Issued to Employees. The Company applies the disclosure provisions of SFAS No. 123, Accounting for Stock-based +Compensation , as amended by SFAS No. 148 , Accounting for Stock-based +Compensation—Transition and Disclosure as if the fair value-based method had been applied in measuring compensation expense. The Company has elected to follow APB +Opinion No. 25 because, as discussed below, the alternative fair value accounting provided for under SFAS No. 123 requires use of option valuation models that were not developed for use +in valuing employee stock options and employee stock purchase plan shares. Under APB Opinion No. 25, when the exercise price of the Company's employee stock options equals the market price of +the underlying stock on the date of the grant, no compensation expense is recognized. As +required under SFAS No. 123, the pro forma effects of stock-based compensation on net income and earnings per common share for employee stock options granted and employee stock purchase plan +share purchases have been estimated at the date of grant and beginning of the period, respectively, using a Black-Scholes option pricing model. For purposes of pro forma disclosures, the estimated +fair value of the options and shares is amortized to pro forma net income (loss) over the options' vesting period and the shares' plan period. The +Black-Scholes option valuation model was developed for use in estimating the fair value of freely traded options that have no vesting restrictions and are fully transferable. In addition, option +valuation models require the input of highly subjective assumptions including the expected life of options and the Company's expected stock price volatility. Because the Company's employee stock +options and employee 70 stock +purchase plan shares have characteristics significantly different from those of freely traded options, and because changes in the subjective input assumptions can materially affect the fair +value estimate, in management's opinion, the existing models do not provide a reliable measure of the fair value of the Company's employee stock options and employee stock purchase plan shares. For +purposes of pro forma disclosures, the estimated fair value of the options and shares is amortized to pro forma net income (loss) over the options' vesting period and the shares' plan period. The +Company's pro forma information for each of the last three fiscal years follows (in millions, except per share amounts): 2004 2003 2002 Net income—as reported $ 276 $ 69 $ 65 Add: Stock-based employee compensation expense included in reported net income, net of tax 33 15 5 Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of tax (141 ) (181 ) (234 ) Net income (loss)—pro forma $ 168 $ (97 ) $ (164 ) Net income per common share—as reported Basic $ 0.74 $ 0.19 $ 0.18 Diluted $ 0.71 $ 0.19 $ 0.18 Net income (loss) per common share—pro forma Basic $ 0.45 $ (0.27 ) $ (0.46 ) Diluted $ 0.44 $ (0.27 ) $ (0.46 ) Earnings Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the +period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period +increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of +outstanding options, restricted stock and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in +the fair market value of the Company's common stock can result in a greater dilutive effect from outstanding options, restricted stock and restricted stock units. Additionally, the exercise of +employee stock options and the vesting of restricted stock and restricted stock units can result in a greater dilutive effect on earnings per share. 71 The +following table sets forth the computation of basic and diluted earnings per share: For the Years Ended September 25, 2004 September 27, 2003 September 28, 2002 Numerator (in millions): Income before accounting changes $ 276 $ 68 $ 65 Cumulative effects of accounting changes, net of tax — 1 — Net income $ 276 $ 69 $ 65 Denominator (in thousands): Weighted-average shares outstanding, excluding unvested restricted stock 371,590 360,631 355,022 Effect of dilutive options, restricted stock units and restricted stock 15,721 2,835 6,763 Denominator for diluted earnings per share 387,311 363,466 361,785 Basic earnings per share before accounting changes $ 0.74 $ 0.19 $ 0.18 Cumulative effects of accounting changes, net of tax — — — Basic earnings per share after accounting changes $ 0.74 $ 0.19 $ 0.18 Diluted earnings per share before accounting changes $ 0.71 $ 0.19 $ 0.18 Cumulative effects of accounting changes, net of tax — — — Diluted earnings per share after accounting changes $ 0.71 $ 0.19 $ 0.18 Potentially +dilutive securities, including stock options; restricted stock units; and restricted stock, to purchase approximately 4.4 million, 50.8 million, and 58.0 million +shares of common stock for the years ended September 25, 2004, September 27, 2003, and September 28, 2002, respectively, were excluded from the computation of diluted earnings per +share for these periods because their effect would have been antidilutive. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under +generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income is comprised of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Segment Information The Company reports segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions +and assessing performance as the source of the Company's reportable segments. Information about the Company's products, major customers, and geographic areas on a company-wide basis is +also disclosed. 72 Note 2—Financial Instruments The +carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, and accrued liabilities approximate their fair value due to the short maturities of those instruments. Cash, Cash Equivalents and Short-Term Investments The following table summarizes the fair value of the Company's cash and available-for-sale securities held in its short-term investment +portfolio, recorded as cash and cash equivalents or short-term investments as of September 25, 2004, and September 27, 2003 (in millions): September 25, 2004 September 27, 2003 Cash $ 200 $ 158 U.S. Treasury and Agency securities 87 87 U.S. corporate securities 1,795 2,368 Foreign securities 887 783 Total cash equivalents 2,769 3,238 U.S. Treasury and Agency securities 1,080 454 U.S. corporate securities 1,352 623 Foreign securities 63 93 Total short-term investments 2,495 1,170 Total cash, cash equivalents, and short-term investments $ 5,464 $ 4,566 The +Company's short-term investment portfolio consists of investments in U.S. Treasury and Agency securities, U.S. corporate securities, and foreign securities. The Company's U.S. +corporate securities consist primarily of commercial paper, certificates of deposit, time deposits and corporate debt securities. Foreign securities consist primarily of foreign commercial paper, +certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. The Company had net unrealized losses totaling $4 million on its investment +portfolio, primarily related to investments with stated maturities less than 1 year as of September 25, 2004 and net unrealized gains of $1 million on its investment portfolio, +primarily related to investments with stated maturities greater than 1 year, as of September 27, 2003. The Company occasionally sells short-term investments prior to their +stated maturities. As a result of such sales, the Company recognized net gains before taxes of $1 million in 2004, $21 million in 2003 and $7 million in 2002. These net gains were +included in interest and other income, net. As +of September 25, 2004, approximately $180 million of the Company's short-term investments had underlying maturities ranging from 1 to 5 years. The remaining +short-term investments as of September 25, 2004 had maturities of 3 to 12 months. As of September 27, 2003, approximately $629 million of the Company's +short-term investments had underlying maturities ranging from 1 to 5 years. The remaining short-term investments as of September 27, 2003 had maturities of 3 to +12 months. In +accordance with EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain +Investments , the following table shows the gross unrealized losses and fair value of the Company's 73 investments, +aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position as of September 25, 2004 (in millions): Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agencies $ 1,126 $ (4 ) $ — $ — $ 1,126 $ (4 ) Corporate bonds 134 — 144 (1 ) 278 (1 ) Certificate of deposits 420 (1 ) — — 420 (1 ) Asset backed securities 426 — — — 426 — Commercial paper 2,407 (1 ) — — 2,407 (1 ) Total $ 4,513 $ (6 ) $ 144 $ (1 ) $ 4,657 $ (7 ) Market +values were determined for each individual security in the investment portfolio. The declines in value of these investments is primarily related to changes in interest rates and are considered +to be temporary in nature. Investments are reviewed periodically to identify possible impairment. When evaluating the investments, the Company reviews factors such as the length of time and extent to +which fair value has been below cost basis, the financial condition of the investee, and the Company's ability and intent to hold the investment for a period of time which may be sufficient for +anticipated recovery in market value. Accounts Receivable Trade Receivables The Company distributes its products through third-party resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require +collateral from its customers. However, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe and Asia +and by arranging with third-party financing companies to provide flooring arrangements and other loan and lease programs to the Company's direct customers. These credit financing arrangements are +directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. +However, considerable trade +receivables that are not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. No customer +accounted for more than 10% of trade receivables as of September 25, 2004. Trade receivables from a single customer, Ingram Micro, Inc., accounted for approximately 10.3% of net accounts +receivable as of September 27, 2003. The +following table summarizes the activity in the allowance for doubtful accounts (in millions): 2004 2003 2002 Beginning allowance balance $ 49 $ 51 $ 51 Charged to costs and expenses 3 4 10 Deductions (a) (5 ) (6 ) (10 ) Ending allowance balance $ 47 $ 49 $ 51 (a) Represents +amounts written off against the allowance, net of recoveries. 74 Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of raw material components to these manufacturing vendors +who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these raw material components directly from suppliers. These non-trade +receivables, which are included in the consolidated balance sheets in other current assets, totaled $276 million and $184 million as of September 25, 2004 and September 27, +2003, respectively. The Company does not recognize any profits on these sales or reflect the sale of these components in its net sales. Inventory Prepayment In April 2002, the Company made a $100 million prepayment to an Asian supplier for the purchase of components over the following nine months. In return for this +deposit, the supplier agreed to supply the Company with a specified level of components during the three consecutive fiscal quarters ended December 28, 2002. During the first six months of +2003, the remaining $53 million of the deposit balance was fully utilized for the purchase of components. The deposit was unsecured and had no stated interest component. The Company imputed an +amount to cost of sales and interest income during each period the deposit was outstanding at a 3.25% interest rate to reflect the economics of this transaction. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign exchange and interest rate risk. Foreign currency forward and option contracts are used to +offset the foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. From +time to time, the Company enters into interest rate derivative agreements to modify the interest rate profile of certain investments and debt. The Company's accounting policies for these instruments +are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at fair value. The +following table shows the notional principal, net fair value, and credit risk amounts of the Company's foreign currency instruments as of September 25, 2004 and September 27, 2003 +(in millions): September 25, 2004 September 27, 2003 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Credit Risk Amounts Foreign exchange instruments qualifying as accounting hedges: Spot/Forward contracts $ 598 $ (3 ) $ 3 $ 464 $ (21 ) $ — Purchased options $ 482 $ 4 $ 4 $ 512 $ 3 $ 3 Sold options $ 521 $ (3 ) $ — $ 645 $ (8 ) $ — Foreign exchange instruments other than accounting hedges: Spot/Forward contracts $ 609 $ 3 $ 4 $ 445 $ 3 $ 3 Purchased options $ — $ — $ — $ 8 $ — $ — Sold options $ — $ — $ — $ 5 $ — $ — The +notional principal amounts for derivative instruments provide one measure of the transaction volume outstanding as of year-end, and do not represent the amount of the Company's +exposure to credit or market loss. The credit risk amount shown in the table above represents the Company's gross exposure to 75 potential +accounting loss on these transactions if all counterparties failed to perform according to the terms of the contract, based on then-current currency exchange rates at each +respective date. The Company's exposure to credit loss and market risk will vary over time as a function of currency exchange rates. The +estimates of fair value are based on applicable and commonly used pricing models using prevailing financial market information as of September 25, 2004 and September 27, 2003. In +certain instances where judgment is required in estimating fair value, price quotes were obtained from several of the Company's counterparty financial institutions. Although the table above reflects +the notional principal, fair value, and credit risk amounts of the Company's foreign exchange instruments, it does not reflect the gains or losses associated with the exposures and transactions that +the foreign exchange instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, +will depend on actual market conditions during the remaining life of the instruments. Foreign Exchange Risk Management The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risk associated with existing assets +and liabilities, certain firmly committed transactions and forecasted future cash flows. Generally, the Company's practice is to hedge a majority of its existing material foreign exchange transaction +exposures. However, the Company may not hedge certain foreign exchange transaction exposures due to immateriality, prohibitive economic cost of hedging particular exposures, or limited availability of +appropriate hedging instruments. To +protect gross margins from fluctuations in foreign currency exchange rates, the Company's U.S. dollar functional subsidiaries hedge a portion of forecasted foreign currency revenues, and the +Company's non-U.S. dollar functional subsidiaries selling in local currencies hedge a portion of forecasted inventory purchases not denominated in the subsidiaries' functional currency. +Other comprehensive income associated with hedges of foreign currency revenues is recognized as a component of net sales in the same period as the related sales are recognized, and other comprehensive +income related to inventory purchases is recognized as a component of cost of sales in the same period as the related costs are recognized. Typically, the Company hedges portions of its forecasted +foreign currency exposure associated with revenues and inventory purchases over a time horizon of 3 to 9 months. Derivative +instruments designated as cash flow hedges must be dedesignated as hedges when it is probable that the forecasted hedged transaction will not occur in the initially identified time period +or within a subsequent 2 month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are immediately reclassified into earnings in +other income and expense. Any subsequent changes in fair value of such derivative instruments are also reflected in current earnings unless they are redesignated as hedges of other transactions. +During 2004, the Company recorded net losses of $2.8 million in other income and expense related to the loss of hedge designation on discontinued cash flow hedges due to changes in the +Company's forecast of future net sales and cost of sales and due to prevailing market conditions. No net gains, or losses, of a similar nature were recorded in 2003. During 2002, the Company recorded +net gains of $2.5 million in other income and expense related to the loss of hedge designation on discontinued cash flow hedges due to changes in the Company's forecast of future net sales and +cost of sales and due to prevailing market conditions. As of September 25, 2004, the Company had a net deferred loss associated with cash flow hedges of approximately $4.4 million, net +of taxes, substantially all of which is expected to be reclassified to earnings by the end of the second quarter of fiscal 2005. 76 The +Company may enter into foreign currency forward contracts to hedge the translation and economic exposure of a net investment position in a foreign subsidiary. The Company may also enter into +foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the remeasurement of certain recorded assets and liabilities in non-functional +currencies. Changes in the fair value of these derivatives are recognized in current earnings in other income and expense as offsets to the changes in the fair value of the related assets or +liabilities. Due to market movements, changes in option time value can lead to increased volatility in other income and expense. Interest Rate Risk Management From time to time, the Company historically entered into interest rate derivative transactions with financial institutions in order to better match the Company's +floating-rate interest income on its cash equivalents and short-term investments with its fixed-rate interest expense on any outstanding long-term debt, +and/or to +diversify a portion of the Company's exposure away from fluctuations in short-term U.S. interest rates. In +prior years, the Company had entered into interest rate debt swaps with financial institutions in order to better match the Company's floating-rate interest income on cash equivalents +and short term investments with its fixed rate interest expense on its long term debt, and/or to diversify a portion of the Company's exposure away from fluctuations in short term U.S. interest rates. +The interest rate swaps required the Company to pay a floating interest rate based on the three- or six-month U.S. dollar LIBOR and receive a fixed rate of interest without exchanges of +the underlying notional amounts. These swaps effectively converted the Company's fixed-rate 10-year debt to floating-rate debt. Due to prevailing market interest +rates, during 2001 and 2002 the Company entered into and then subsequently closed out interest rate debt swap positions realizing gains of $23 million which were deferred over the remaining +life of the debt. As +of September 25, 2004 and September 27, 2003, the Company had no interest rate derivatives outstanding. Debt In February 2004, the Company retired $300 million of debt outstanding in the form of 6.5% unsecured notes. The notes were originally issued in 1994 and were sold +at 99.9925% of par for an effective yield to maturity of 6.51%. As of September 27, 2003, the carrying amount of these notes, including unamortized deferred gains associated with closed debt +interest rate swaps, was $304 million, respectively, while the fair value was $302 million. The fair value of the notes was based on their listed market values as of September 27, +2003. Non-Current Debt and Equity Investments and Related Gains and Losses The Company has held significant investments in ARM Holdings plc (ARM), Akamai Technologies, Inc. (Akamai) and EarthLink Network, Inc. (EarthLink). These +investments have been reflected in the consolidated balance sheets as long term assets within other assets and have been categorized as available-for-sale requiring that they +be carried at fair value with unrealized gains and losses, net of taxes, reported in equity as a component of accumulated other comprehensive income. All realized gains on the sale of these +investments have been included in other income and expense. In fiscal 2004, the Company sold all of its remaining non-current investments in public companies. 77 EarthLink In January 2000, the Company invested $200 million in EarthLink, an Internet service provider (ISP). The investment was in EarthLink's Series C Convertible +Preferred Stock, which was convertible by the Company after January 4, 2001, into approximately 7.1 million shares of EarthLink common stock. Concurrent with this investment, EarthLink +and the Company entered into a multi-year agreement to deliver ISP service to Macintosh users in the U.S. Under the terms of the agreement, the Company profits from each new Macintosh +customer that subscribes to EarthLink's ISP service for a specified period of time, and EarthLink is the default ISP in the Company's Internet Setup Software included with all Macintosh computers sold +in the U.S. During +the first quarter of 2003, the Company sold 2,580,000 shares of EarthLink stock for net proceeds of approximately $13.7 million, an amount that approximated the Company's carrying value +of the shares. During the third quarter of 2003, the Company sold all of its remaining holdings in EarthLink, consisting of 3,960,000 shares of stock for net proceeds of approximately +$23 million, and a gain before taxes of $2 million. During +the first quarter of 2002, the Company sold 117,000 shares of EarthLink stock for net proceeds of $2 million and a gain before taxes of $223,000. No sales of EarthLink were made in any +of the subsequent quarters of fiscal 2002. However, during the fourth quarter of 2002, the Company determined that the then current decline in the fair value of its investment in EarthLink was +other-than-temporary. As a result, the Company recognized a $44 million charge to earnings to write-down the basis of its investment in EarthLink to +$35 million. This charge was included in gains (losses) on non-current investments, net. As of September 28, 2002, the Company held 6.5 million shares of EarthLink +stock valued at $35 million. Akamai In June 1999, the Company invested $12.5 million in Akamai, a global Internet content delivery service. The investment was in the form of convertible preferred +stock that converted into 4.1 million shares of Akamai common stock (adjusted for subsequent stock splits) at the time of Akamai's initial public offering in October 1999. Beginning in +the first quarter of 2000, the Company categorized its shares in Akamai as available-for-sale. During +2004, the Company sold its remaining 986,000 shares of Akamai stock. The transaction generated proceeds of approximately $5 million and a gain before taxes of approximately +$4 million. During +the fourth quarter of 2003, the Company sold 1,875,000 shares of Akamai stock for net proceeds of $9 million and a gain before taxes of $8 million. As of September 27, +2003, the Company's remaining investment in Akamai consisted of 986,000 shares of Akamai stock valued at $5 million. During +the first quarter of 2002, the Company sold 250,000 shares of Akamai stock for net proceeds of $2 million and a gain before taxes of $710,000. No sales of Akamai were made in any of the +subsequent quarters of fiscal 2002. However, during the fourth quarter of 2002, the Company determined the decline in the fair value of its investment in Akamai was +other-than-temporary. As a result, the Company recognized a $6 million charge to earnings to write-down the basis of its investment in Akamai to +$3 million. This charge was included in gains (losses) on non-current investments, net. 78 ARM ARM is a publicly held company in the U.K. involved in the design and licensing of high performance microprocessors and related technology. During +the third quarter of 2003, the Company sold all of its remaining holdings in ARM stock, consisting of 278,000 shares for net proceeds of approximately $295,000, and a gain before taxes of +$270,000. During +the first quarter of 2002, the Company sold 4.7 million shares of ARM stock for both net proceeds and a gain before taxes of $21 million. No sales of ARM were made in any of the +subsequent quarters of fiscal 2002. Other Strategic Investments The Company has made additional minority debt and equity investments in several privately held technology companies, which were reflected in the consolidated balance sheets in +other assets. These investments were inherently risky because the products and/or markets of these companies were typically not fully developed. During 2002, the Company determined the decline in fair +value of certain of these investments was other-than-temporary and, accordingly, recognized a charge to earnings of $15 million. These charges were included in gains +(losses) on non-current investments, net. As of September 25, 2004, the Company had $1.4 million of equity investments reflected in its consolidated balance sheet. As of +September 27, 2003, the Company had no private debt or equity investments reflected in its consolidated balance sheet. Note 3—Consolidated Financial Statement Details (in millions) Inventories 2004 2003 Purchased parts $ 1 $ 2 Work in process — 4 Finished goods 100 50 Total inventories $ 101 $ 56 Other Current Assets 2004 2003 Vendor non-trade receivables $ 276 $ 184 Other current assets 209 125 Total other current assets $ 485 $ 309 79 Property, Plant, and Equipment 2004 2003 Land and buildings $ 351 $ 350 Machinery, equipment, and internal-use software 422 393 Office furniture and equipment 79 74 Leasehold improvements 446 357 1,298 1,174 Accumulated depreciation and amortization (591 ) (505 ) Net property, plant, and equipment $ 707 $ 669 Other Assets 2004 2003 Non-current deferred tax assets $ 86 $ 60 Capitalized software development costs, net 25 28 Other assets 80 62 Total other assets $ 191 $ 150 Accrued Expenses 2004 2003 Deferred revenue $ 544 $ 368 Accrued marketing and distribution 147 124 Accrued compensation and employee benefits 134 101 Accrued warranty and related costs 105 67 Other current liabilities 299 239 Total accrued expenses $ 1,229 $ 899 Interest and Other Income, Net 2004 2003 2002 Interest income $ 64 $ 69 $ 118 Interest expense (3 ) (8 ) (11 ) Gains on sales of short term investments 1 21 7 Other income (expense), net (9 ) (5 ) (2 ) Gain on forward purchase agreement — 6 — Total interest and other income, net $ 53 $ 83 $ 112 80 Note 4—Acquisitions Goodwill and Other Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 3 to 10 years. The Company ceased amortization of +goodwill at the beginning of fiscal 2002 when it adopted SFAS No. 142. The +following table summarizes the components of gross and net intangible asset balances (in millions): September 25, 2004 September 27, 2003 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Goodwill (a) $ 80 — $ 80 $ 85 — $ 85 Other acquired intangible assets 5 (5 ) — 5 (5 ) — Acquired technology 42 (25 ) 17 42 (18 ) 24 Total acquired intangible assets $ 127 $ (30 ) $ 97 $ 132 $ (23 ) $ 109 (a) Accumulated +amortization related to goodwill of $55 million arising prior to the adoption of SFAS No. 142 has been reflected in the gross carrying amount of goodwill as +of September 25, 2004 and September 27, 2003. During +the third quarter of 2004, the Company recorded an adjustment of approximately $5 million to goodwill related to the acquisition of PowerSchool, Inc (PowerSchool) in fiscal 2001. This +reduction of goodwill included the cancellation of 79,167 shares of Apple common stock, valued at approximately $2 million, that were previously held in escrow and were refunded upon resolution +of certain matters arising out of the acquisition of PowerSchool. This adjustment also included approximately $3 million to adjust the original estimates of the pre-acquisition +PowerSchool restructuring liability to actual costs incurred. Expected +annual amortization expense related to acquired technology is as follows (in millions): Fiscal Years: 2005 $ 6 2006 3 2007 2 2008 1 2009 1 Thereafter 4 Total expected annual amortization expense $ 17 Amortization +expense related to acquired intangible assets is as follows (in millions): 2004 2003 2002 Other acquired intangible assets amortization $ — $ — $ 1 Acquired technology amortization 7 10 5 Total amortization $ 7 $ 10 $ 6 81 Acquisition of Emagic GmbH During the fourth quarter of 2002, the Company acquired Emagic GmbH (Emagic), a provider of professional software solutions for computer based music production, for +approximately $30 million in cash; $26 million of which was paid immediately upon closing of the deal and $4 million of which was held-back for future payment +contingent on continued employment by certain employees that would be allocated to future compensation expense in the appropriate periods over the following 3 years. During fiscal 2003, +contingent consideration totaling $1.3 million was paid. The acquisition has been accounted for as a purchase. The portion of the purchase price allocated to purchased in-process +research and development (IPR&D) was expensed immediately, and the portion of the purchase price allocated to acquired technology and to tradename will be amortized over their estimated useful lives +of 3 years. Goodwill associated with the acquisition of Emagic is not subject to amortization pursuant to the provisions of SFAS No. 142. Total consideration was allocated as follows (in +millions): Net tangible assets acquired $ 2.3 Acquired technology 3.8 Tradename 0.8 In-process research and development 0.5 Goodwill 18.6 Total consideration $ 26.0 The +amount of the purchase price allocated to IPR&D was expensed upon acquisition, because the technological feasibility of products under development had not been established and no alternative +future uses existed. The IPR&D relates primarily to Emagic's Logic series technology and extensions. At the date of the acquisition, the products under development were between 43%-83% +complete, and it was expected that the remaining work would be completed during the Company's fiscal 2003 at a cost of approximately $415,000. The remaining efforts, which were completed in 2003, +included finalizing user interface design and development, and testing. The fair value of the IPR&D was determined using an income approach, which reflects the projected free cash flows that will be +generated by the IPR&D projects and that are attributable to the acquired technology, and discounting the projected net cash flows back to their present value using a discount rate of 25%. Acquisition of certain assets of Zayante, Inc., Prismo Graphics, and Silicon Grail During fiscal 2002 the Company acquired certain technology and patent rights of Zayante, Inc., Prismo Graphics, and Silicon Grail Corporation for a total of +$20 million in cash. These transactions have been accounted for as asset acquisitions. The purchase price for these asset acquisitions, except for $1 million identified as contingent +consideration which would be allocated to compensation expense over the following 3 years, has been allocated to acquired technology and would be amortized on a straight-line basis +over 3 years, except for certain assets acquired from Zayante associated with patent royalty streams that would be amortized over 10 years. Acquisition of Nothing Real, LLC During the second quarter of 2002, the Company acquired certain assets of Nothing Real, LLC (Nothing Real), a privately-held company that develops and markets high +performance tools designed for the digital image creation market. Of the $15 million purchase price, the Company has allocated $7 million to acquired technology, which will be amortized +over its estimated life of 5 years. The remaining $8 million, which has been identified as contingent consideration, rather than recorded as an additional component of 82 the +cost of the acquired assets, would be allocated to future compensation expense in the appropriate periods over the following 3 years. Note 5—Restructuring Charges Fiscal 2004 Restructuring Actions The Company recorded total restructuring charges of approximately $23 million during the year ended September 25, 2004, including approximately $14 million +in severance costs, $5.5 million in asset impairments, and a $3.5 million charge for lease cancellations. Of the $23 million charge, $14.3 million had been spent by the end +of 2004, with the remaining $8.7 million consisting of $5.2 million for employee severance benefits and $3.5 million for lease cancellations. During +the fourth quarter of 2004, the Company recognized restructuring expense of $5.5 million. In conjunction with the European workforce reduction during the second quarter of 2004, the +Company vacated a leased sales facility during the fourth quarter of 2004 resulting in a charge of $3.7 million for contract termination and asset impairment costs. The Company also recognized +employee termination costs of $1.8 million related to the elimination of non-essential positions, principally in Europe. In addition, the Company reversed $400,000 of excess +restructuring expense from prior periods related primarily to lower than expected disposal costs on Sacramento manufacturing-related fixed assets. The net cost of the restructuring plans for the +fourth quarter of 2004 was $5.1 million, of which $300,000 had been paid prior to the end of 2004. These actions will result in the termination of 54 positions, 4 of which had been terminated +prior to the end of 2004. During +the third quarter of 2004, the Company finalized restructuring plans related to closing Company-owned manufacturing activities in Sacramento. In addition, the Company's management approved +restructuring plans related to certain headcount reductions primarily for various sales and marketing activities principally in the U.S. Total cost of the restructuring plan for the third quarter of +2004 was $7.9 million, of which $7.2 million had been paid prior to the end of 2004. These actions will result in the termination of 83 positions, 77 of which had been terminated prior +to the end of 2004. The +closing of manufacturing operations in Sacramento resulted in the elimination of 67 positions for a severance cost of $1.9 million and write-off of $5.3 million in +manufacturing-related fixed assets whose use ceased during the third quarter of 2004. Termination of sales and marketing activities, principally in the U.S., resulted in severance of +$0.7 million for the elimination of 16 positions. During +the second quarter of 2004, the Company's management approved restructuring plans related to the termination of Company-owned manufacturing activities in Sacramento and headcount reductions +related primarily to various sales and marketing activities in the U.S. and Europe. Total cost of the actions was $9.6 million for the termination of 348 positions. As of the end of the fourth +quarter of 2004, $6.8 million had been spent and 310 positions had been eliminated related to these actions. 83 The +following table summarizes activity associated with restructuring actions initiated during fiscal 2004 (in millions): Employee Severance Benefits Asset Impairments Lease Cancellations Totals Total charge $ 14.0 $ 5.5 $ 3.5 $ 23.0 Total spending through September 25, 2004 (8.7 ) — — (8.7 ) Total non-cash items — (5.2 ) — (5.2 ) Adjustments (0.1 ) (0.3 ) — (0.4 ) Accrual at September 25, 2004 $ 5.2 $ — $ 3.5 $ 8.7 Fiscal 2003 Restructuring Actions The Company recorded total restructuring charges of approximately $26.8 million during the year ended September 27, 2003, including approximately +$7.4 million in severance costs, a $5.0 million charge to write-off deferred compensation, $7.1 million in asset impairments and a $7.3 million charge for lease +cancellations. Of the $26.8 million charge, all had been spent by the end of 2004, except for approximately $3.0 million related to operating lease costs on abandoned facilities. During +the third quarter of 2003, approximately $500,000 of the amount originally accrued for lease cancellations was determined to be in excess due to the sublease of a property sooner than originally +estimated and a shortfall of approximately $500,000 was identified in the severance accrual due to higher than expected severance costs related to the closure of the Company's Singapore manufacturing +operations. These adjustments had no net effect on reported operating expense. During +the second quarter of 2003, the Company's management approved and initiated restructuring actions that resulted in recognition of a total restructuring charge of $2.8 million, including +$2.4 million in severance costs and $400,000 for asset write-offs and lease payments on an abandoned facility. Actions taken in the second quarter were for the most part +supplemental to actions initiated in the prior two quarters and focused on further headcount reductions in various sales and marketing functions in the Company's Americas and Europe operating segments +and further reductions associated with PowerSchool-related activities in the Americas operating segment, including an accrual for asset write-offs and lease payments on an abandoned +facility. The second quarter actions resulted in the termination of 93 employees. During +the first quarter of 2003, the Company's management approved and initiated restructuring actions with a total cost of $24 million that resulted in the termination of manufacturing +operations at the Company-owned facility in Singapore, further reductions in headcount resulting from the shift in PowerSchool product strategy that took place at the end of fiscal 2002, and +termination of various sales and marketing activities in the U.S. and Europe. These restructuring actions resulted in the elimination of 260 positions worldwide. Closure +of the Company's Singapore manufacturing operations resulted in severance costs of $1.8 million and costs of $6.7 million to write-off manufacturing related fixed +assets, whose use ceased during the first quarter. PowerSchool related costs included severance of approximately $550,000 and recognition of $5 million of previously deferred stock compensation +that arose when PowerSchool was acquired by the Company in 2001 related to certain PowerSchool employee stockholders who were terminated in the first quarter of 2003. Termination of sales and +marketing activities and employees, principally in the U.S. and Europe, resulted in severance costs of $2.8 million and accrual of costs associated with operating leases on 84 closed +facilities of $6.7 million. The total net restructuring charge of $23 million recognized during the first quarter of 2003 also reflects the reversal of $600,000 of unused +restructuring accrual originally made during the first quarter of 2002. The +following table summarizes activity associated with restructuring actions initiated during fiscal 2003 (in millions): Employee Severance Benefits Deferred Compensation Write-off Asset Impairments Lease Cancellations Totals Total charge $ 7.4 $ 5.0 $ 7.1 $ 7.3 $ 26.8 Total spending through September 25, 2004 (7.9 ) — — (3.8 ) (11.7 ) Total non-cash items — (5.0 ) (7.1 ) — (12.1 ) Adjustments 0.5 — — (0.5 ) — Accrual at September 25, 2004 $ — $ — $ — $ 3.0 $ 3.0 Fiscal 2002 Restructuring Actions During fiscal 2002, the Company recorded total restructuring charges of approximately $30 million related to actions intended to eliminate certain activities and better +align the Company's operating expenses with existing general economic conditions and to partially offset the cost of continuing investments in new product development and investments in the Company's +Retail operating segment. During +the fourth quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $6 million designed to reduce headcount costs in +corporate operations and sales and to adjust its PowerSchool product strategy. These restructuring actions resulted in the elimination of approximately 180 positions worldwide at a cost of +$1.8 million, all of which were eliminated by September 27, 2003. Eliminated positions were primarily in corporate operations, sales, and PowerSchool related research and development in +the Americas operating segment. The shift in product strategy at PowerSchool included discontinuing development and marketing of PowerSchool's PSE product. This shift resulted in the impairment of +previously capitalized development costs associated with the PSE product in the amount of $4.5 million. During +the first quarter of 2002, the Company's management approved and initiated restructuring actions with a total cost of approximately $24 million. These restructuring actions resulted in +the elimination of approximately 425 positions worldwide at a cost of $8 million. Positions were eliminated primarily in the Company's operations, information systems, and administrative +functions. In addition, these restructuring actions also included significant changes in the Company's information systems strategy resulting in termination of equipment leases and cancellation of +existing projects and activities. The Company ceased using the assets associated with first quarter 2002 restructuring actions during that same quarter. Related lease and contract cancellation charges +totaled $12 million, and charges for asset impairments totaled $4 million. The first quarter 2002 restructuring actions were primarily related to corporate activity not allocated to +operating segments. During the first quarter of 2003, the Company reversed the remaining unused accrual of $600,000. All amounts associated with the fiscal 2002 restructuring actions had been spent by +the end of fiscal 2003. 85 Note 6—Income Taxes The +provision for income taxes consisted of the following (in millions): 2004 2003 2002 Federal: Current $ 34 $ 18 $ 12 Deferred 56 (7 ) (32 ) 90 11 (20 ) State: Current 5 4 3 Deferred (18 ) (11 ) 6 (13 ) (7 ) 9 Foreign: Current 46 21 29 Deferred (16 ) (1 ) 4 30 20 33 Provision for income taxes $ 107 $ 24 $ 22 The +foreign provision for income taxes is based on foreign pretax earnings of approximately $384 million, $250 million and $284 million in 2004, 2003, and 2002, respectively. As +of September 25, 2004, approximately $3.2 billion of the Company's cash, cash equivalents, and short-term investments are held by foreign subsidiaries and are generally based +in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The Company's consolidated financial statements +fully provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company's foreign subsidiaries that are intended to be indefinitely +reinvested in operations outside the U.S. U.S. income taxes have not been provided on a cumulative total of $972 million of such earnings. It is not practicable to determine the income tax +liability that might be incurred if these earnings were to be distributed. Deferred +tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts +of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected +to be recovered or settled. 86 As +of September 25, 2004 and September 27, 2003, the significant components of the Company's deferred tax assets and liabilities were (in millions): 2004 2003 Deferred tax assets: Accounts receivable and inventory reserves $ 32 $ 35 Accrued liabilities and other reserves 195 155 Basis of capital assets and investments 65 47 Tax losses and credits 329 204 Other 26 11 Total deferred tax assets 647 452 Less valuation allowance 30 30 Net deferred tax assets 617 422 Deferred tax liabilities: Unremitted earnings of subsidiaries 413 398 Total deferred tax liabilities 413 398 Net deferred tax asset $ 204 $ 24 As +of September 25, 2004, the Company had operating loss carryforwards for federal tax purposes of approximately $446 million, which expire from 2011 through 2024. A portion of these +carryforwards was acquired from NeXT and other acquisitions, the utilization of which is subject to certain limitations imposed by the Internal Revenue Code. The Company also has Federal credit +carryforwards and various state and foreign tax loss and credit carryforwards, the tax effect of which is approximately $132 million and which expire between 2005 and 2024. The remaining +benefits from tax losses and credits do not expire. As of September 25, 2004, a valuation allowance of $30 million was recorded against the deferred tax asset for the benefits of tax +losses that may not be realized. The valuation allowance relates primarily to the operating loss carryforwards acquired from NeXT and other acquisitions. Management believes it is more likely than not +that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to +fully recover the remaining deferred tax assets. 87 A +reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate (35% in 2004, 2003, and 2002) to income before provision for income +taxes, is as follows (in millions): 2004 2003 2002 Computed expected tax $ 134 $ 32 $ 30 State taxes, net of federal effect (5 ) (4 ) 7 Indefinitely invested earnings of foreign subsidiaries (31 ) (13 ) — Nondeductible executive compensation 10 5 (1 ) Stock repurchase — (2 ) — Purchase accounting and asset acquisitions — 4 3 Change in valuation allowance — — (16 ) Research and development credit, net (5 ) (7 ) (8 ) Nondeductible expenses 2 6 4 Other items 2 3 3 Provision for income taxes $ 107 $ 24 $ 22 Effective tax rate 28 % 26 % 25 % The +Internal Revenue Service (IRS) has completed its field audit of the Company's federal income tax returns for all years prior to 2001 and proposed certain adjustments. Certain of these +adjustments are being contested through the IRS Appeals Office. Substantially all IRS audit issues for these years have been resolved. In addition, the Company is also subject to audits by state, +local, and foreign tax authorities. Management believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be +predicted with certainty. Should any issues addressed in the Company's tax audits be resolved in a manner not consistent with management's expectations, the Company could be required to adjust its +provision for income tax in the period such resolution occurs. Note 7—Shareholders' Equity Restricted Stock Units During fiscal 2004, the Company's Board of Directors approved the grant of 2.515 million restricted stock units to selected members of the Company's senior management, +excluding its Chief Executive Officer (CEO). These restricted stock units generally vest in two equal installments on the second and fourth anniversaries of the date of grant. The Company has recorded +the $64.4 million value of these restricted stock units as a component of shareholders' equity and will amortize that amount on a straight-line basis over the 4 year +requisite service period. The value of the restricted stock units was based on the closing market price of the Company's common stock on the date of grant. Quarterly amortization will be approximately +$4.0 million, of which approximately $0.5 million will be included in cost of sales; $1.3 million will be included in research and development expense; and the remaining +$2.2 million will be included in selling, general and administrative expense. The restricted stock units have been included in the calculation of diluted earnings per share utilizing the +treasury stock method. CEO Restricted Stock Award On March 19, 2003, the Company entered into an Option Cancellation and Restricted Stock Award Agreement (the Agreement) with Mr. Steven P. Jobs, its CEO. The +Agreement cancelled stock option 88 awards +for the purchase of 27.5 million shares of the Company's common stock previously granted to Mr. Jobs in 2000 and 2001. Mr. Jobs retained options to purchase 60,000 shares +of the Company's common stock granted in August of 1997 in his capacity as a member of the Company's Board of Directors, prior to becoming the Company's CEO. The Agreement replaced the cancelled +options with a restricted stock award of 5 million shares of the Company's common stock. The restricted stock award generally vests three years from date of grant. Vesting of some or all of the +restricted shares will be accelerated in the event Mr. Jobs is terminated without cause, dies, or has his management role reduced following a change in control of the Company. The +Company has recorded the value of the restricted stock award of $74.75 million as a component of shareholders' equity and is amortizing that amount on a straight-line basis over +the 3 year service period. The value of the restricted stock award was based on the closing market price of the Company's common stock of $14.95 on the date of the award. Amortization expense +for this award, which amounts to approximately $6.2 million per quarter, has been included in selling, general, and administrative expense beginning in March 2003 and will continue to be +included through March 2006. The 5 million restricted shares have been included in the calculation of diluted earnings per share utilizing the treasury stock method. Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. During +the fourth quarter of 2001, the Company entered into a forward purchase agreement to acquire 1.5 million shares of its common stock in September of 2003 at an average price of $16.64 per +share for a total cost of $25.5 million. In August 2003, the Company settled this agreement prior to its maturity, at which time the Company's common stock had a fair value of $22.81. +Other than this forward purchase transaction, the Company has not engaged in any transactions to repurchase its common stock since fiscal 2000. Since inception of the stock repurchase plan, the +Company had repurchased a total of 6.55 million shares at a cost of $217 million. The Company was authorized to repurchase up to an additional $283 million of its common stock as +of September 25, 2004. Preferred Stock The Company has 5 million shares of authorized preferred stock, none of which is outstanding. Under the terms of the Company's Restated Articles of Incorporation, the +Board of Directors is authorized to determine or alter the rights, preferences, privileges and restrictions of the Company's authorized but unissued shares of preferred stock. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under +generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income consists of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. 89 The +following table summarizes the components of accumulated other comprehensive income (loss), net of taxes (in millions): 2004 2003 2002 Unrealized gains (losses) on available-for-sale securities $ (4 ) $ 1 $ 13 Unrealized losses on derivative investments (4 ) (16 ) (11 ) Cumulative foreign currency translation (7 ) (20 ) (51 ) Accumulated other comprehensive income (loss) $ (15 ) $ (35 ) $ (49 ) The +following table summarizes activity in other comprehensive income related to available-for-sale securities, net of taxes (in millions): 2004 2003 2002 Change in fair value of available-for-sale securities $ (1 ) $ 11 $ (49 ) Adjustment for net (gains) losses realized and included in net income (4 ) (23 ) 32 Change in unrealized gain/loss on available-for-sale securities $ (5 ) $ (12 ) $ (17 ) The +tax effect related to the change in unrealized gain on available-for-sale securities was $4 million, $6 million, and $10 million for fiscal 2004, 2003, +and 2002, respectively. The tax effect on the reclassification adjustment for net gains (losses) included in net income was $1 million, $(8) million and $10 million for fiscal 2004, +2003, and 2002, respectively. The +following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company (in millions): 2004 2003 2002 Changes in fair value of derivatives $ (21 ) $ (24 ) $ 4 Adjustment for net gains(losses) realized and included in net income 33 19 (19 ) Change in unrealized gain/loss on derivative instruments $ 12 $ (5 ) $ (15 ) The +tax effect related to the changes in fair value of derivatives was $10 million, $11million and $(2) million for fiscal 2004, 2003, and 2002, respectively. The tax effect related to +derivative gains (losses) reclassified from other comprehensive income was $(13) million, $(7) million and $8 million for fiscal 2004, 2003, and 2002, respectively. Note 8—Employee Benefit Plans 2003 Employee Stock Option Plan At the Annual Meeting of Shareholders held on April 24, 2003, the shareholders approved an amendment to the 1998 Executive Officer Stock Plan to change the name of the +plan to the 2003 Employee Stock Option Plan (the 2003 Plan), to provide for broad-based grants to all employees in addition to executive officers and other key employees and to prohibit future +"repricings" of employee stock options, including 6-months-plus-1-day option exchange programs, without shareholder approval. Based on the terms of +individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of 4 years, based on +continued employment, with 90 either +annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, restricted stock units, stock appreciation rights, and stock purchase +rights. 1997 Employee Stock Option Plan In August 1997, the Company's Board of Directors approved the 1997 Employee Stock Option Plan (the 1997 Plan), a non-shareholder approved plan for grants of +stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire 7 to 10 years after the +grant date and generally become exercisable over a period of 4 years, based on continued employment, with either annual or quarterly vesting. As a result of shareholder approval of amendments +to the 1998 Executive Officer Stock Plan in April 2003, the Company terminated the 1997 Employee Stock Option Plan and cancelled all remaining unissued shares totaling 14,295,351 following the +completion of an employee stock option exchange program in October 2003. Employee Stock Option Exchange Program On March 20, 2003, the Company announced a voluntary employee stock option exchange program (the Exchange Program) whereby eligible employees, other than executive +officers and members of the Board of Directors, had an opportunity to exchange outstanding options with exercise prices at or above $25.00 per share for a predetermined smaller number of new stock +options issued with exercise prices equal to the fair market value of one share of the Company's common stock on the day the new awards are issued, which was to be at least six months plus one day +after the exchange options are cancelled. On April 17, 2003, in accordance with the Exchange Program, the Company cancelled options to purchase 16,569,193 shares of its common stock. On +October 22, 2003, new stock options totaling 6,697,368 shares were issued to employees at an exercise price of $22.76 per share, which is equivalent to the closing price of the Company's stock +on that date. No financial or accounting impact to the Company's financial position, results of operations or cash flow was associated with this transaction. 1997 Director Stock Option Plan In August 1997, the Company's Board of Directors adopted a shareholder approved Director Stock Option Plan (DSOP) for non-employee directors of the Company. +Initial grants of 30,000 options under the DSOP vest in three equal installments on each of the first through third anniversaries of the date of grant, and subsequent annual grants of 10,000 options +are fully vested at grant. Rule 10b5-1 Trading Plans Certain of the Company's executive officers, including Mr. Timothy D. Cook, Mr. Jonathan Rubinstein, Mr. Bertrand Serlet, and Mr. Avadis Tevanian, +Jr., have entered into trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended. A trading plan is a written document that +pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company's stock including the exercise and sale +of employee stock options and shares acquired pursuant to the Company's employee stock purchase plan and upon vesting of restricted stock units. Employee Stock Purchase Plan The Company has a shareholder approved employee stock purchase plan (the Purchase Plan), under which substantially all employees may purchase common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six month offering periods. Stock purchases under the Purchase Plan are limited to 10% of an +employee's compensation, up to a maximum 91 of +$25,000 in any calendar year. Beginning with the six-month offering period that started on June 30, 2003, the number of shares authorized for issuance is limited to a total of +1 million shares per offering period. During 2004, 2003, and 2002, 2.0 million, 2.1 million, and 1.8 million, respectively were issued under the Purchase Plan. As of +September 25, 2004, approximately 2 million shares were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an employee savings plan (the Savings Plan) qualifying as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the +Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the Internal Revenue Service annual contribution limit ($13,000 for calendar year 2004). The +Company matches 50% to 100% of each employee's contributions, depending on length of service, up to a maximum 6% of the employee's earnings. The Company's matching contributions to the Savings Plan +were approximately $24 million, $21 million, and $19 million in 2004, 2003, and 2002, respectively. Stock Option Activity A summary of the Company's stock option activity and related information for the years ended September 25, 2004, September 27, 2003 and September 28, 2002 +follows (option amounts are presented in thousands): Outstanding Options Shares Available for Grant Number of Shares Weighted Average Exercise Price Balance at September 29, 2001 10,075 97,179 $ 29.24 Additional Options Authorized 15,000 — — Options Granted (23,239 ) 23,239 $ 19.89 Options Cancelled 4,737 (4,737 ) $ 30.98 Options Exercised — (6,251 ) $ 11.99 Plan Shares Expired (2 ) — — Balance at September 28, 2002 6,571 109,430 $ 28.17 Restricted Stock Granted (5,000 ) — — Options Granted (4,179 ) 4,179 $ 16.38 Options Cancelled 48,443 (48,443 ) $ 39.61 Options Exercised — (2,154 ) $ 14.04 Plan Shares Expired (5 ) — — Balance at September 27, 2003 45,830 63,012 $ 19.08 Restricted Stock Units Granted (2,515 ) — — Options Granted (18,197 ) 18,197 $ 22.97 Options Cancelled 3,005 (3,005 ) $ 20.70 Options Exercised — (22,843 ) $ 17.20 Plan Shares Expired (16,098 ) — — Balance at September 25, 2004 12,025 55,361 $ 21.05 92 The +options outstanding as of September 25, 2004 have been segregated into five ranges for additional disclosure as follows (option amounts are presented in thousands): Options Outstanding Options Exercisable Options Outstanding as of September 25, 2004 Weighted- Average Remaining Contractual Life in Years Weighted Average Exercise Price Options Exercisable as of September 25, 2004 Weighted Average Exercise Price $0.83-$15.59 6,426 4.65 $ 12.26 4,958 $ 11.59 $15.60-$18.50 15,729 5.87 $ 17.94 12,969 $ 18.04 $18.51-$20.54 9,998 6.91 $ 20.26 5,769 $ 20.25 $20.55-$22.76 15,109 6.23 $ 22.20 1,401 $ 21.77 $22.77-$69.78 8,099 6.24 $ 32.90 4,926 $ 36.46 $0.83-$69.78 55,361 6.07 $ 21.05 30,023 $ 20.59 As +of September 27, 2003, the Company had exercisable options to purchase 38.8 million shares outstanding with a weighted average exercise price of $18.75 per share. As of +September 28, 2002, the Company had exercisable options to purchase 57.9 million shares outstanding with a weighted average exercise price of $30.85 per share. The +Company had 2.515 million restricted stock units outstanding as of September 25, 2004, which were excluded from the options outstanding balances in the preceding tables. None of +these restricted stock units were vested as of September 25, 2004. The grant of these restricted stock units has been deducted from the shares available for grant under the Company's stock +option plans. Note 9—Stock-Based Compensation The +Company has provided pro forma disclosures in Note 1 of these Notes to Consolidated Financial Statements of the effect on net income and earnings per share as if the fair value method of +accounting for stock compensation had been used for its employee stock option grants and employee stock purchase plan purchases. These pro forma effects have been estimated at the date of grant and +beginning of the period, respectively, using the Black-Scholes option pricing model. For +purposes of the pro forma disclosures provided pursuant to SFAS No. 123, the option awards issued in October 2003 and the awards cancelled as part of the Employee Stock Option +Exchange Program have been accounted for using modification accounting. In accordance with SFAS No. 123, the grant date of the awards issued is the date of acceptance of the exchange offer by +participating employees. The cancellation of certain of the Company's CEO's options and replacement with restricted shares in March 2003 is also being accounted for using modification +accounting for purposes of the pro forma disclosures provided pursuant to SFAS No. 123. 93 The +assumptions used for each of the last three fiscal years and the resulting estimate of weighted-average fair value per share of options granted during those years are as follows: 2004 2003 2002 Expected life of stock options 3.5 years 3.5-4 years 4 years Expected life of stock purchases 6 months 6 months 6 months Interest rate—stock options 2.33%-3.15 % 2.14%-2.45 % 2.90 % Interest rate—stock purchases 0.96%-1.67 % 1.10%-1.77 % 2.71 % Volatility—stock options 40 % 40%-63 % 64 % Volatility—stock purchases 32%-44 % 35%-44 % 51 % Dividend yields — — — Weighted-average fair value of options granted during the year $ 7.37 $ 6.63 $ 10.11 Weighted-average fair value of stock purchases during the year $ 5.56 $ 4.24 $ 6.73 For +purposes of the pro forma disclosures provided pursuant to SFAS No. 123, the expected volatility assumptions used by the Company prior to the third quarter of 2003 had been based solely on +the historical volatility of the Company's common stock over the most recent period commensurate with the estimated expected life of the Company's stock options. Beginning in the third quarter of +2003, the Company has modified this approach to consider other relevant factors including implied volatility in market traded options on the Company's common stock and the impact of unusual +fluctuations not reasonably expected to recur on the historical volatility of the Company's common stock. The Company will continue to monitor these and other relevant factors in developing the +expected volatility assumption used to value future awards. Beginning +in the third quarter of 2003, the Company shortened its estimate of the expected life of new options granted to its employees from 4 years to 3.5 years. The Company bases its +expected life assumption on its historical experience and on the terms and conditions of the stock options it grants to employees. The change in the expected life assumption made during the third +quarter of 2003 was the result of the expected impact of shortening the contractual life of new options granted to employees from 10 years to 7 years and changing the vesting provisions +of new options granted to employees from 4 year straight-line annual vesting to 4 year straight-line quarterly vesting. Note 10—Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other +off-balance-sheet financing arrangements. The major facility leases are for terms of 5 to 10 years and generally provide renewal options for terms of 3 to 5 additional years. Leases +for retail space are for terms of 5 to 16 years and often contain multi-year renewal options. As of September 25, 2004, the Company's total future minimum lease payments +under noncancelable operating leases were $617 million, of which $436 million related to leases for retail space. Rent +expense under all operating leases, including both cancelable and noncancelable leases, was $103 million, $97 million, and $92 million in 2004, 2003, and 2002, respectively. +Future minimum lease 94 payments +under noncancelable operating leases having remaining terms in excess of one year as of September 25, 2004, are as follows (in millions): Fiscal Years 2005 $ 89 2006 91 2007 79 2008 65 2009 61 Later years 232 Total minimum lease payments $ 617 Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of +purchase by the end-user. The Company also offers a 90-day basic warranty for Apple service parts used to repair Apple hardware products. The Company provides currently for the +estimated cost that may be incurred under its basic limited product warranties at the time related revenue is recognized. Factors considered in determining appropriate accruals for product warranty +obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, historical and projected +cost-per-claim, and knowledge of specific product failures that are outside of the Company's typical experience. The Company assesses the adequacy of its preexisting warranty +liabilities and adjusts the amounts as necessary based on actual experience and changes in future expectations. The +following table reconciles changes in the Company's accrued warranties and related costs (in millions): 2004 2003 2002 Beginning accrued warranty and related costs $ 67 $ 69 $ 87 Cost of warranty claims (105 ) (71 ) (79 ) Accruals for product warranties 143 69 61 Ending accrued warranty and related costs $ 105 $ 67 $ 69 The +Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property +rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim +against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against itself or an +indemnified third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would have a material adverse +effect on its financial condition, liquidity or results of operations. Therefore, the Company did not record a liability for infringement costs as of either September 25, 2004 or +September 27, 2003. 95 Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company's business are generally available from multiple sources, other key components (including microprocessors and +application-specific integrated circuits, or ("ASICs")) are currently obtained by the Company from single or limited sources. Some other key components, while currently available to the Company from +multiple sources, are at times subject to industry-wide availability and pricing pressures. In addition, the Company uses some components that are not common to the rest of the personal +computer industry, and new products introduced by the Company often initially utilize custom components obtained from only one source until the Company has evaluated whether there is a need for and +subsequently qualifies additional suppliers. If the supply of a key single-sourced component to the Company were to be delayed or curtailed or in the event a key manufacturing vendor delays shipments +of completed products to the Company, the Company's ability to ship related products in desired quantities and in a timely manner could be adversely affected. The Company's business and financial +performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an +alternative source. Continued availability of these components may be affected if producers were to decide to concentrate on the production of common components instead of components customized to +meet the Company's requirements. Finally, significant portions of the Company's CPUs, logic boards, and assembled products are now manufactured by outsourcing partners, the majority of which occurs in +various parts of Asia. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company's operating +results could be adversely affected if its outsourcing partners were unable to meet their production obligations. Contingencies Beginning on September 27, 2001, three shareholder class action lawsuits were filed in the U.S. District Court for the Northern District of California against the +Company and its Chief Executive Officer. These lawsuits are substantially identical, and purport to bring suit on behalf of persons who purchased the Company's publicly traded common stock between +July 19, 2000, and September 28, 2000. The complaints allege violations of the 1934 Securities Exchange Act and seek unspecified compensatory damages and other relief. The Company +believes these claims are without merit and intends to defend them vigorously. The Company filed a motion to dismiss on June 4, 2002, which was heard by the Court on September 13, 2002. +On December 11, 2002, the Court granted the Company's motion to dismiss for failure to state a cause of action, with leave to Plaintiffs to amend their complaint within thirty days. Plaintiffs +filed their amended complaint on January 31, 2003, and on March 17, 2003, the Company filed a motion to dismiss the amended complaint. The Court heard the Company's motion on +July 11, 2003 and dismissed Plaintiffs' claims with prejudice on August 12, 2003. Plaintiffs have appealed the ruling. The +Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. In the opinion of management, the Company +does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial condition, liquidity +or results of operations. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these +legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. Production +and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers 96 the +ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have recently been +passed in several jurisdictions in which the Company operates including various European Union member countries, Japan and certain states within the U.S. Although the Company does not anticipate any +material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not have a material adverse +effect on the Company's results of operations and financial position. Note 11—Segment Information and Geographic Data In +accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , the Company reports segment information +based on the "management" approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company's +reportable segments. The +Company manages its business primarily on a geographic basis. The Company's reportable operating segments are comprised of the Americas, Europe, Japan, and Retail. The Americas segment includes +both North and South America, except for the activities of the Company's Retail segment. The Europe segment includes European countries as well as the Middle East and Africa. The Japan segment +includes only Japan and excludes revenue from the Company's own retail stores in Japan, which is included in the Company's Retail segment. The Retail segment operated Apple-owned retail stores in the +U.S. and Japan during fiscal 2004. Other operating segments include Asia-Pacific, which includes Australia and Asia except for Japan, and the Company's subsidiary, FileMaker, Inc. +Each reportable geographic operating segment provides similar hardware and software products and similar services, and the accounting policies of the various segments are the same as those described +in Note 1, "Summary of Significant Accounting Policies," except as described below for the Retail segment. The +Company evaluates the performance of its operating segments based on net sales. The Retail segment's performance is also evaluated based on operating income. Net sales for geographic segments are +generally based on the location of the customers. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses directly attributable to the +segment. Operating income for each segment excludes other income and expense and certain expenses that are managed outside the operating segments. Costs excluded from segment operating income include +various corporate expenses, manufacturing costs not included in standard costs, income taxes, and various nonrecurring charges. Corporate expenses include research and development, corporate marketing +expenses, and other separately managed general and administrative expenses including certain corporate expenses associated with support of the Retail segment. The Company does not include intercompany +transfers between segments for management reporting purposes. Segment assets exclude corporate assets. Corporate assets include cash, short-term and long-term investments, +manufacturing facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets, and retail store construction-in-progress that is not subject +to depreciation. Except for the Retail segment, capital expenditures for long-lived assets are not reported to management by segment. Capital expenditures by the Retail segment were +$104 million, $92 million and $106 million for 2004, 2003 and 2002, respectively. Operating +income for all segments, except Retail, includes cost of sales at manufacturing standard cost, other cost of sales, related sales and marketing costs, and certain general and administrative +costs. This measure of operating income, which includes manufacturing profit, provides a comparable basis for comparison between the Company's various geographic segments. Certain manufacturing +expenses and 97 related +adjustments not included in segment cost of sales, including variances between standard and actual manufacturing costs and the mark-up above standard cost for product supplied to +the Retail segment, are included in corporate expenses. Management +assesses the operating performance of the Retail segment differently than it assesses the operating performance of the Company's geographic segments. The Retail segment revenue and +operating income is intended to depict a comparable measure to that of the Company's major channel partners in the U.S. operating retail stores so the Company can evaluate the Retail segment +performance as if it were a channel partner. Therefore, the Company makes three significant adjustments to the Retail segment for management reporting purposes that are not included in the results of +the Company's other segments. First, +the Retail segment's operating income includes cost of sales for Apple products at an amount normally charged to major channel partners in the U.S. operating retail stores, less the cost of +sales programs and incentives provided to those channel partners and the Company's cost to support those partners. For the years ended September 25, 2004, September 27, 2003, and +September 28, 2002, this resulted in the recognition of additional cost of sales above standard cost by the Retail segment and an offsetting benefit to corporate expenses of approximately +$213 million, $106 million, and $52 million, respectively. Second, +the Company's extended warranty, support and service contracts are transferred to the Retail segment at the same cost as that charged to the Company's major retail channel partners in the +U.S., resulting in a comparable measure of revenue and gross margin between the Company's Retail stores and those retail channel partners. The Retail segment recognizes the full amount of revenue and +cost of sales at the time of sale of the Company's extended warranty, support and service contracts. Because the Company has not yet earned the revenue or incurred the costs associated with the sale +of these contracts, an offset to these amounts is recognized in other operating segments' net sales and cost of sales. For the year ended September 25, 2004, this resulted in the recognition of +net sales and cost of sales by the Retail segment, with corresponding offsets in other operating segments, of $54 million and $37 million, respectively. For the year ended +September 27, 2003, the net sales and cost of sales recognized by the Retail segment for sales of extended warranty, support and service contracts were $30 million and +$20 million, respectively. For the year ended September 28, 2002, this resulted in the recognition of net sales and cost of sales by the Retail segment of $8 million and +$6 million, respectively. Third, +the Company has opened six high profile stores in New York, Los Angeles, Chicago, San Francisco, Tokyo, Japan and Osaka, Japan as of September 25, 2004 and has an additional store under +development in London, England, which is expected to open by the end of calendar year 2004. These high profile stores are larger than the Company's typical retail stores and were designed to further +promote brand awareness and provide a venue for certain corporate sales and marketing activities, including corporate briefings. As such, the Company allocates certain operating expenses associated +with these stores to corporate marketing expense to reflect the estimated benefit realized Company-wide. The allocation of these operating costs is based on the excess amount incurred for +a high profile store to that of a more typical Company retail location. Expenses allocated to corporate marketing resulting from the operations of these stores were $16 million, +$6 million and $1 million for the years ended September 25, 2004, September 27, 2003, and September 28, 2002 respectively. 98 Summary +information by operating segment follows (in millions): 2004 2003 2002 Americas: Net sales $ 4,019 $ 3,181 $ 3,131 Operating income $ 465 $ 323 $ 278 Depreciation, amortization and accretion $ 6 $ 5 $ 4 Segment assets (a) $ 563 $ 494 $ 395 Europe: Net sales $ 1,799 $ 1,309 $ 1,251 Operating income $ 280 $ 130 $ 122 Depreciation, amortization and accretion $ 4 $ 4 $ 4 Segment assets $ 259 $ 252 $ 165 Japan: Net sales $ 677 $ 698 $ 710 Operating income $ 115 $ 121 $ 140 Depreciation, amortization and accretion $ 2 $ 3 $ 2 Segment assets $ 114 $ 130 $ 50 Retail: Net sales $ 1,185 $ 621 $ 283 Operating income (loss) $ 39 $ (5 ) $ (22 ) Depreciation, amortization and accretion (b) $ 35 $ 25 $ 16 Segment assets (b) $ 351 $ 243 $ 141 Other Segments (c): Net sales $ 599 $ 398 $ 367 Operating income $ 90 $ 51 $ 44 Depreciation, amortization and accretion $ 2 $ 2 $ 2 Segment assets $ 124 $ 78 $ 67 (a) The +Americas asset figures do not include fixed assets held in the U.S. Such fixed assets are not allocated specifically to the Americas segment and are included in the corporate +assets figures below. (b) Retail +segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. Retail store +construction-in-progress, which is not subject to depreciation, is reflected in corporate assets. (c) Other +Segments include Asia-Pacific and FileMaker. 99 A +reconciliation of the Company's segment operating income and assets to the consolidated financial statements follows (in millions): 2004 2003 2002 Segment operating income $ 989 $ 620 $ 562 Corporate expenses, net (640 ) (595 ) (514 ) Purchased in-process research and development — — (1 ) Restructuring costs (23 ) (26 ) (30 ) Consolidated operating income (loss) $ 326 $ (1 ) $ 17 Segment assets $ 1,411 $ 1,197 $ 818 Corporate assets 6,639 $ 5,618 $ 5,480 Consolidated assets $ 8,050 $ 6,815 $ 6,298 Segment depreciation, amortization and accretion $ 49 $ 39 $ 28 Corporate depreciation, amortization and accretion 101 74 86 Consolidated depreciation, amortization and accretion $ 150 $ 113 $ 114 A +large portion of the Company's net sales is derived from its international operations. Also, a majority of the raw materials used in the Company's products is obtained from sources outside of the +U.S., and a majority of the products sold by the Company is assembled internationally in the Company's facility in Cork, Ireland or by third-party vendors in Taiwan, Korea, the Netherlands, the +People's Republic of China, and the Czech Republic. As a result, the Company is subject to risks associated with foreign operations, such as obtaining governmental permits and approvals, currency +exchange fluctuations, currency restrictions, political instability, labor problems, trade restrictions, and changes in tariff and freight charges. No single customer accounted for more than 10% of +net sales in 2004, 2003 or 2002. Net +sales and long-lived assets related to operations in the U.S., Japan, and other foreign countries are as follows (in millions): 2004 2003 2002 Net Sales: U.S. $ 4,893 $ 3,627 $ 3,272 Japan 738 698 710 Other Countries 2,648 1,882 1,760 Total Net Sales $ 8,279 $ 6,207 $ 5,742 Long-Lived Assets: U.S. $ 637 $ 635 $ 561 Japan 52 19 2 Other Countries 72 60 69 Total Long-Lived Assets $ 761 $ 714 $ 632 100 Information +regarding net sales by product is as follows (in millions): 2004 2003 2002 Net Sales: Power Macintosh (a) $ 1,419 $ 1,237 $ 1,380 PowerBook 1,589 1,299 831 iMac (b) 954 1,238 1,448 iBook 961 717 875 Total Macintosh Net Sales $ 4,923 $ 4,491 $ 4,534 iPod 1,306 345 143 Other Music Products (c) 278 36 4 Peripherals and other hardware (d) 951 691 527 Software (e) 502 362 307 Service and other Net Sales 319 282 227 Total Net Sales $ 8,279 $ 6,207 $ 5,742 (a) Includes +Xserve product line. (b) Includes +eMac product line. (c) Other +Music Products includes iTunes Music Store sales and iPod related services, and Apple-branded and third-party iPod-related accessories. (d) Net +sales of peripherals and other hardware include sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (e) Net +sales of software include sales of Apple-branded operating system and application software and sales of third-party software. Note 12—Related Party Transactions and Certain Other Transactions In +March 2002, the Company entered into a Reimbursement Agreement with its CEO, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his +private plane when used for Apple business. The Reimbursement Agreement became effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of the plane in +May 2001. The Company recognized a total of $483,000, $404,000, and $1,168,000 in expenses pursuant to the Reimbursement Agreement during 2004, 2003 and 2002, respectively. All expenses +recognized pursuant to the Reimbursement Agreement have been included in selling, general, and administrative expenses in the consolidated statements of operations. In +connection with a relocation assistance package, the Company in May 2000 loaned Mr. Ronald B. Johnson, Senior Vice President, Retail, $1.5 million for the purchase of his +principal residence. The loan was secured by a deed of trust and was due and payable in May 2004. Under the terms of the loan, Mr. Johnson agreed that should he exercise any of his stock +options prior to the due date of the loan, he would pay the Company an amount equal to the lesser of (1) an amount equal to 50% of the total net gain realized from the exercise of the options; +or (2) $375,000 multiplied by the number of years between the exercise date and the date of the loan. Mr. Johnson repaid $750,000 of this loan in fiscal 2003 and repaid the remaining +balance of $750,000 in fiscal 2004. Mr. Jerome +York, a member of the Board of Directors of the Company, is a member of an investment group that purchased MicroWarehouse, Inc. (MicroWarehouse) in January 2000. Until +September 7, 2003, he also served as Microwarehouse's Chairman, President and Chief Executive Officer. MicroWarehouse was a reseller of computer hardware, software and peripheral products, +including products made by the 101 Company. +On September 8, 2003, CDW Corporation (CDW), acquired selected North American assets of MicroWarehouse. MicroWarehouse subsequently filed for Chapter 11 bankruptcy protection in the +U.S. MicroWarehouse accounted for approximately 0.3%, 2.4% and 3.3% of the Company's net sales for the years ended September 25, 2004, September 27, 2003, and September 28, 2002, +respectively. Trade receivables from MicroWarehouse were $4.3 million and $9.9 million as of September 25, 2004 and September 27, 2003, respectively. The Company has +provided what it believes to be an adequate allowance on the outstanding receivable based on the Company's secured interest position in selected MicroWarehouse assets and the expected payments to +unsecured creditors. Sales to MicroWarehouse and related trade receivables were generally subject to the same terms and conditions as those with the Company's other resellers. In addition, the Company +has purchased miscellaneous equipment and supplies from MicroWarehouse. Total purchases amounted to approximately $2.3 million and $2.9 million for the years ended September 27, +2003 and September 28, 2002, respectively. No purchases were made by the Company from MicroWarehouse in fiscal 2004. Note 13—Selected Quarterly Financial Information (Unaudited) Fourth Quarter Third Quarter Second Quarter First Quarter (Tabular amounts in millions, except per share amounts) 2004 Net sales $ 2,350 $ 2,014 $ 1,909 $ 2,006 Gross margin $ 634 $ 559 $ 530 $ 536 Net income $ 106 $ 61 $ 46 $ 63 Earnings per common share: Basic $ 0.28 $ 0.16 $ 0.13 $ 0.17 Diluted $ 0.26 $ 0.16 $ 0.12 $ 0.17 2003 Net sales $ 1,715 $ 1,545 $ 1,475 $ 1,472 Gross margin $ 456 $ 428 $ 418 $ 406 Net income (loss) $ 44 $ 19 $ 14 $ (8 ) Earnings (loss) per common share: Basic $ 0.12 $ 0.05 $ 0.04 $ (0.02 ) Diluted $ 0.12 $ 0.05 $ 0.04 $ (0.02 ) Basic +and diluted earnings (loss) per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may +not equal annual basic and diluted earnings per share. Net +income during the fourth, third, and second quarters of 2004 included restructuring charges, net of tax, of $4 million, $6 million, and $7 million, respectively. Net +income during the fourth and third quarters of 2003 included after-tax net gains related to non-current investments of $5 million and $1 million, +respectively. Net income for the fourth quarter also included settlement of the Company's forward purchase agreement resulting in a gain of $6 million and a favorable cumulative-effect type +adjustment related to the adoption of SFAS No. 150 of $3 million. Net income (loss) during the second and first quarters of 2003 included restructuring charges, net of tax, of +$2 million and $18 million, respectively. Net loss for the first quarter of 2003 included an after-tax unfavorable cumulative-effect type adjustment for the adoption of SFAS +No.143 of $2 million. 102 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The +Board of Directors and Shareholders Apple Computer, Inc.: We +have audited the accompanying consolidated balance sheets of Apple Computer, Inc. and subsidiaries (the Company) as of September 25, 2004 and September 27, 2003, and the +related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended September 25, 2004. These consolidated +financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We +conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the +consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement +presentation. We believe that our audits provide a reasonable basis for our opinion. In +our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Computer, Inc. and subsidiaries as of +September 25, 2004 and September 27, 2003, and the results of their operations and their cash flows for each of the years in the three-year period ended September 25, +2004, in conformity with U.S. generally accepted accounting principles. As +discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for asset retirement obligations and for financial instruments with characteristics +of both liabilities and equity in 2003 and changed its method of accounting for goodwill in 2002. /s/ KPMG LLP Mountain +View, California October 12, 2004 103 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not +applicable. Item 9A. Controls and Procedures Based +on an evaluation under the supervision and with the participation of the Company's management, the Company's principal executive officer and principal financial officer have concluded that the +Company's disclosure controls and procedures (as defined under the Securities Exchange Act of 1934, as amended ( Exchange Act )) were effective as of +September 25, 2004 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported +within the time periods specified in Securities and Exchange Commission rules and forms. There +were no significant changes in the Company's internal control over financial reporting identified in management's evaluation during the fourth quarter of fiscal 2004 that have materially +affected or are reasonably likely to materially affect the Company's internal control over financial reporting. 104 PART III Item 10. Directors and Executive Officers of the Registrant Directors Listed below are the Company's seven directors whose terms expire at the next annual meeting of shareholders. Name Position With the Company Age Director Since Fred D. Anderson Director 60 2004 William V. Campbell Director 64 1997 Millard S. Drexler Director 60 1999 Albert Gore, Jr. Director 57 2003 Steven P. Jobs Director and Chief Executive Officer 49 1997 Arthur D. Levinson Director 54 2000 Jerome B. York Director 66 1997 Fred D. Anderson has been a founding partner of Elevation Partners, a private equity firm focused on the media and entertainment industry, since +July 2004. Previously, Mr. Anderson served as the Company's Executive Vice President and Chief Financial Officer from April 1996 to June 2004. Mr. Anderson also +serves on the Board of Directors of eBay Inc. and E.piphany, Inc. William V. Campbell has been Chairman of the Board of Directors of Intuit, Inc. ("Intuit") since +August 1998. From September 1999 to January 2000, Mr. Campbell acted as Chief Executive Officer of Intuit. From April 1994 to August 1998, Mr. Campbell +was President and Chief Executive Officer and a director of Intuit. From January 1991 to December 1993, Mr. Campbell was President and Chief Executive Officer of GO Corporation. +Mr. Campbell also serves on the Board of Directors of Opsware, Inc. Millard S. Drexler has been Chairman and Chief Executive Officer of J. Crew Group, Inc. since January 2003. Previously, Mr. Drexler +was Chief Executive Officer of Gap Inc. from 1995 and President from 1987 until September 2002. Mr. Drexler was also a member of the Board of Directors of Gap Inc. from +November 1983 until October 2002. Albert Gore, Jr. has served as a Senior Advisor to Google, Inc. since 2001. He has also served as Executive Chairman of INdTV since 2002 and as +Chairman of Generation Investment Management since 2004. He is a visiting professor at Fisk University and Middle Tennessee State University. Mr. Gore was inaugurated as the 45th Vice President +of the U.S. in 1993. He was re-elected in 1996 and served for a total of eight years as President of the Senate, a member of the Cabinet and the National Security Council. Prior to 1993, +he served eight years in the U.S. Senate and eight years in the U.S. House of Representatives. Steven P. Jobs is one of the Company's co-founders and currently serves as its Chief Executive Officer. Mr. Jobs is also the Chairman +and Chief Executive Officer of Pixar Animation Studios. In addition, Mr. Jobs co-founded NeXT Software, Inc. (" NeXT" ) and +served as the Chairman and Chief Executive Officer of NeXT from 1985 until 1997 when NeXT was acquired by the Company. Arthur D. Levinson, Ph.D. has been Chief Executive Officer and a director of Genentech Inc. +(" Genentech" ) since July 1995. Dr. Levinson has been Chairman of the Board of Directors of Genentech since September 1999. He +joined Genentech in 1980 and served in a number of executive positions, including Senior Vice President of R&D from 1993 to 1995. Mr. Levinson also serves on the Board of Directors of +Google, Inc. Jerome B. York has been Chief Executive Officer of Harwinton Capital Corporation, a private investment company which he controls, since +September 2003. From January 2000 until September 2003, Mr. York was Chairman and Chief Executive Officer of MicroWarehouse, Inc., a reseller of computer hardware, +software and peripheral products. From September 1995 to October 1999, he was Vice Chairman of Tracinda 105 Corporation. +From May 1993 to September 1995 he was Senior Vice President and Chief Financial Officer of IBM Corporation, and served as a member of IBM's Board of Directors from +January 1995 to August 1995. Mr. York is also a director of Tyco International Ltd. and Metro-Goldwyn-Mayer, Inc. Role of the Board; Corporate Governance Matters It is the paramount duty of the Board of Directors to oversee the Chief Executive Officer and other senior management in the competent and ethical operation of the Company on a +day-to-day basis and to assure that the long-term interests of the shareholders are being served. To satisfy this duty, the directors take a proactive, focused +approach to their position, and set standards to ensure that the Company is committed to business success through maintenance of the highest standards of responsibility and ethics. Members +of the Board bring to the Company a wide range of experience, knowledge and judgment. These varied skills mean that good governance depends on far more than a "check the box" approach to +standards or procedures. The governance structure in the Company is designed to be a working structure for principled actions, effective decision-making and appropriate monitoring of both compliance +and performance. The key practices and procedures of the Board are outlined in the Corporate Governance Guidelines available on the Company's website at www.apple.com/investor. Board Committees The Board has a standing Compensation Committee, a Nominating and Corporate Governance Committee (" Nominating Committee" ) and an +Audit and Finance Committee (" Audit Committee "). The +Compensation Committee is primarily responsible for reviewing the compensation arrangements for the Company's executive officers, including the Chief Executive Officer, and for administering the +Company's stock option plans. Members of the Compensation Committee are Messrs. Campbell, Drexler and Gore. The +Nominating Committee assists the Board in identifying qualified individuals to become directors, determines the composition of the Board and its committees, monitors the process to assess Board +effectiveness and helps develop and implement the Company's corporate governance guidelines. Members of the Nominating Committee are Messrs. Drexler and Gore and Dr. Levinson. The +Audit Committee is primarily responsible for overseeing the services performed by the Company's independent auditors and internal audit department, evaluating the Company's accounting policies and +its system of internal controls and reviewing significant financial transactions. Members of the Audit Committee are Messrs. Campbell and York and Dr. Levinson. The +Audit, Compensation and Nominating Committees operate under written charters adopted by the Board. These charters are available on the Company's website at www.apple.com/investor. Audit Committee Financial Expert While more than one member of the Company's Audit Committee qualifies as an "audit committee financial expert" under Item 401(h) of Regulation S-K, +Mr. Jerome B. York, the Committee chairperson, is the designated audit committee financial expert. Mr. York is considered "independent" as the term is used in Item 7(d)(3)(iv) of +Schedule 14A under the Exchange Act. Code of Ethics The Company has a code of ethics that applies to all of the Company's employees, including its principal executive officer, principal financial officer, principal accounting +officer and its Board of Directors. A copy of this code, "Ethics: The Way We Do Business Worldwide" is available on the Company's website at www.apple.com/investor. The Company intends to disclose any +changes in or waivers from its code of ethics by posting such information on its website or by filing a Form 8-K. 106 Executive Officers The following sets forth certain information regarding executive officers of the Company. Information pertaining to Mr. Jobs, who is both a director and an executive +officer of the Company, may be found in the section entitled " Directors ." Timothy D. Cook , Executive Vice President, Worldwide Sales and Operations (age 44), joined the Company in February 1998. Prior to joining the +Company, Mr. Cook held the position of Vice President, Corporate Materials for Compaq Computer Corporation (" Compaq" ). Previous to his work at +Compaq, Mr. Cook was the Chief Operating Officer of the Reseller Division at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, most recently as Director of North +American Fulfillment. Nancy R. Heinen , Senior Vice President, General Counsel and Secretary (age 48), joined the Company in September 1997. Prior to joining the +Company, Ms. Heinen held the position of Vice President, General Counsel and Secretary of the Board of Directors at NeXT from February 1994 until the acquisition of NeXT by the Company +in February 1997. Ronald B. Johnson , Senior Vice President, Retail (age 46), joined the Company in January 2000. Prior to joining the Company, Mr. Johnson +spent 16 years with Target Stores, most recently as Senior Merchandising Executive. Peter Oppenheimer , Senior Vice President and Chief Financial Officer (age 41), joined the Company in July 1996. Mr. Oppenheimer +also served with the Company in the position of Vice President and Corporate Controller and as Senior Director of Finance for the Americas. Prior to joining the Company, Mr. Oppenheimer was CFO +of one of the four business units for Automatic Data +Processing, Inc. (" ADP" ). Prior to joining ADP, Mr. Oppenheimer spent six years in the Information Technology Consulting Practice with +Coopers and Lybrand. Jonathan Rubinstein , Senior Vice President, iPod Division (age 48), joined the Company in February 1997. Mr. Rubinstein also served with +the Company in the position of Senior Vice President, Hardware Engineering. Before joining the Company, Mr. Rubinstein was Executive Vice President and Chief Operating Officer of FirePower +Systems Incorporated, from May 1993 to August 1996. Mr. Rubinstein also serves as a member of the Board of Directors of Immersion Corporation. Philip W. Schiller , Senior Vice President, Worldwide Product Marketing (age 44), rejoined the Company in 1997. Prior to rejoining the Company, +Mr. Schiller was Vice President of Product Marketing at Macromedia, Inc. from December 1995 to March 1997 and was Director of Product Marketing at FirePower +Systems, Inc. from 1993 to December 1995. Prior to that, Mr. Schiller spent six years at the Company in various marketing positions. Bertrand Serlet, Ph.D. , Senior Vice President, Software Engineering (age 43), joined the Company in February 1997 upon the Company's acquisition +of NeXT. At NeXT, Dr. Serlet held several engineering and managerial positions, including Director of Web Engineering. Prior to NeXT, from 1985 to 1989, Dr. Serlet worked as a research +engineer at Xerox PARC. Sina Tamaddon , Senior Vice President, Applications (age 47), joined the Company in September 1997. Mr. Tamaddon has also served with the +Company in the position of Senior Vice President Worldwide Service and Support, and Vice President and General Manager, Newton Group. Before joining the Company, Mr. Tamaddon held the position +of Vice President, Europe with NeXT from September 1996 through March 1997. From August 1994 to August 1996, Mr. Tamaddon held the position of Vice President, +Professional Services with NeXT. Avadis Tevanian, Jr., Ph.D. , Senior Vice President, Chief Software Technology Officer (age 43), joined the Company in February 1997 upon the +Company's acquisition of NeXT. Dr. Tevanian served with the Company in the position of Senior Vice President, Software Engineering from 1997 to July 2003. With NeXT, Dr. Tevanian +held several positions, including Vice President, Engineering, from April 1995 to 107 February 1997. +Prior to April 1995, Dr. Tevanian worked as an engineer with NeXT and held several management positions. Item 11. Executive Compensation Information Regarding Executive Compensation The following table summarizes compensation information for the last three fiscal years for (i) Mr. Jobs, Chief Executive Officer and (ii) the four most +highly compensated executive officers other than the Chief Executive Officer who were serving as executive officers of the Company at the end of the fiscal year (collectively, the +" Named Executive Officers" ). SUMMARY COMPENSATION TABLE Annual Compensation Long-Term Compensation Name and Principal Position Fiscal Year Salary ($) Bonus ($) Restricted Stock Award ($) Securities Underlying Options* (#) All Other Compensation ($) Steven P. Jobs Chief Executive Officer 2004 2003 2002 1 1 1 — — 2,268,698 (2) — 74,750,000 — (1) — — 7,500,000 (1) — — 1,302,795 (2) Timothy D. Cook Executive Vice President, Worldwide Sales and Operations 2004 2003 2002 602,632 617,673 563,829 — — — 7,650,000 — — (3) — — — 12,588 9,929 8,025 (4) (4) (4) Ronald B. Johnson Senior Vice President, Retail 2004 2003 2002 484,836 452,404 452,404 1,500,000 1,500,000 — 6,375,000 — — (3) — — 300,000 — — — Jonathan Rubinstein Senior Vice President, iPod Division 2004 2003 2002 485,216 452,939 452,558 — — — 6,375,000 — — (3) — — — 12,300 11,986 9,996 (4) (4) (4) Avadis Tevanian, Jr. Ph.D Senior Vice President, Chief Software Technology Officer 2004 2003 2002 469,681 456,731 492,212 1,000 — — 5,100,000 — — (3) — — — 12,338 11,962 10,700 (4) (4) (4) (1) In +March 2003, Mr. Jobs voluntarily cancelled all of his outstanding options, excluding those granted to him in his capacity as a director. In March 2003, the +Board awarded Mr. Jobs five million restricted shares of the Company's Common Stock, that generally vest in full on the third anniversary of the grant date. (2) In +December 1999, Mr. Jobs was given a special executive bonus for past services as the Company's interim Chief Executive Officer, in the form of an aircraft with a +total cost to the Company of approximately $90,000,000. In fiscal 2002, approximately $2.27 million paid by the Company towards the purchase of the plane and approximately $1.3 million +in related tax assistance was reported as income to Mr. Jobs. (3) Market +value of restricted stock units granted on March 24, 2004 (based on $25.50 per share, the closing price of the Company's common stock on the NASDAQ National Market on +the day of grant). Restricted stock units generally vest over four years with 50% of the total number of shares vesting on each of the second and fourth anniversary of the grant date. (4) Consists +of matching contributions made by the Company in accordance with the terms of the 401(k) plan. Option Grants in Last Fiscal Year There were no options granted to the Named Executive Officers during fiscal year 2004, although restricted stock units which are shown above in the Summary Compensation Table, +were granted. 108 Options Exercised and Year-End Option Holdings The following table provides information about stock option exercises by the Named Executive Officers during fiscal year 2004 and stock options held by each of them at fiscal +year-end. AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Number of Securities Underlying Unexercised Options at Fiscal Year-End (#) Value of Unexercised In-the-Money Options at Fiscal Year-End ($)(1) Name Shares Acquired on Exercise (#) Value Realized ($) Exercisable Unexercisable Exercisable Unexercisable Steven P. Jobs — — 60,000 (2) — $ 1,547,400 (2) $ — Timothy D. Cook 1,350,000 14,719,950 — 250,000 $ — $ 5,119,375 Ronald B. Johnson — — 1,631,250 168,750 $ 7,359,188 $ 2,426,813 Jonathan J. Rubinstein 1,500,000 26,370,700 650,000 250,000 $ 12,985,375 $ 5,119,375 Avadis Tevanian, Jr. 350,000 8,828,328 1,800,000 250,000 $ 36,652,959 $ 5,119,375 (1) Market +value of securities underlying in-the-money options at the end of fiscal year 2004 (based on $37.29 per share, the closing price of Common Stock on the +NASDAQ National Market on September 24, 2004), minus the exercise price. (2) Consists +of 60,000 options granted to Mr. Jobs in his capacity as a director pursuant to the 1997 Director Stock Option Plan. In March 2003, Mr. Jobs voluntarily +cancelled all of his outstanding options, excluding those granted to him in his capacity as a director. Director Compensation The form and amount of director compensation is determined by the Board after a review of recommendations made by the Nominating Committee. The current practice of the Board is +to base a substantial portion of a director's annual retainer on equity. In 1998, shareholders approved the 1997 Director Stock Option Plan (the " Director +Plan" ) and 800,000 shares were reserved for issuance thereunder. Pursuant to the Director Plan, the Company's non-employee directors are granted an option to +acquire 30,000 shares of Common Stock upon their initial election to the Board (" Initial Options" ). The Initial Options vest and become exercisable in +three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee director's initial election to the Board and +on each subsequent anniversary thereafter, the director will be entitled to receive an option to acquire 10,000 shares of Common Stock (" Annual +Options" ). Annual Options are fully vested and immediately exercisable on their date of grant. As of the end of the fiscal year, there were options for 440,000 shares +outstanding +under the Director Plan. Since accepting the position of CEO, Mr. Jobs is no longer eligible for grants under the Director Plan. Non-employee directors also receive a $50,000 annual +retainer paid in quarterly increments. In addition, directors receive up to two free computer systems per year and are eligible to purchase additional equipment at a discount. Directors do not receive +any additional consideration for serving on committees or as committee chairperson. Compensation Committee Interlocks and Insider Participation The current members of the Compensation Committee are Messrs. William V. Campbell, Millard S. Drexler, and Albert Gore, Jr., none of whom are +employees of the Company and all of whom are considered "independent" directors under the applicable NASDAQ rules. No person who was an employee of the Company in fiscal year 2004 served on the +Compensation Committee. No executive officer of the Company (i) served as a member of the compensation committee (or other board committee performing similar functions or, in the absence of any +such committee, the board of directors) of another entity, one of whose executive officers served on the Company's Compensation Committee, (ii) served as a 109 director +of another entity, one of whose executive officers served on the Company's Compensation Committee, or (iii) served as a member of the compensation committee (or other board committee +performing similar functions or, in the absence of any such committee, the board of directors) of another entity, one of whose executive officers served as a director of the Company. Item 12. Security Ownership of Certain Beneficial Owners and Management The +following table sets forth certain information as of November 10, 2004 (the " Table Date ") with respect to the beneficial ownership of the +Company's Common Stock by (i) each person the Company believes beneficially holds more than 5% of the outstanding shares of Common Stock; (ii) each director; (iii) each Named +Executive Officer listed in the Summary Compensation Table under the heading " Executive Compensation; " and (iv) all directors and executive +officers as a group. On the Table Date, 401,476,094 shares of Common Stock were issued and outstanding. Unless otherwise indicated, all persons named as beneficial owners of Common Stock have sole +voting power and sole investment power with respect to the shares indicated as beneficially owned. In addition, unless otherwise indicated, all persons named below can be reached at Apple +Computer, Inc., 1 Infinite Loop, Cupertino, CA 95014. Security Ownership of 5% Holders, Directors, Nominees and Executive Officers Name of Beneficial Owner Shares of Common Stock Beneficially Owned(1) Percent of Common Stock Outstanding Private Capital Management, Inc. 20,457,156 (2) 5.10 % Steven P. Jobs 5,060,002 (3) 1.26 % Fred D. Anderson 2,672 * William V. Campbell 100,502 (4) * Timothy D. Cook 5,903 * Millard S. Drexler 100,000 (5) * Albert Gore, Jr. 10,000 (6) * Ronald B. Johnson 1,355,903 (7) * Arthur D. Levinson 201,600 (8) * Jonathan J. Rubinstein 161,087 (9) * Avadis Tevanian, Jr. 1,501,252 (10) * Jerome B. York 30,000 (11) * All executive officers and directors as a group (16 persons) 10,203,443 (12) 2.51 % (1) Represents +shares of Common Stock held and/or options held by such individuals that were exercisable at the Table Date or within 60 days thereafter. (2) Based +on a Form 13-F showing holdings as of September 30, 2004 by Private Capital Management, Inc. Private Capital Management, Inc. lists its +address as 8889 Pelican Bay Blvd., Naples, FL, 34108, in such filing. (3) Includes +60,000 shares of Common Stock that Mr. Jobs has the right to acquire by exercise of stock options. (4) Includes +100,000 shares of Common Stock that Mr. Campbell has the right to acquire by exercise of stock options. (5) Includes +80,000 shares of Common Stock that Mr. Drexler has the right to acquire by exercise of stock options. (6) Includes +10,000 shares of Common Stock that Mr. Gore has the right to acquire by exercise of stock options. 110 (7) Includes +1,350,000 shares of Common Stock that Mr. Johnson has the right to acquire by exercise of stock options. (8) Includes +1,400 shares of Common Stock that Dr. Levinson holds indirectly and 40,000 shares of Common Stock that Dr. Levinson has the right to acquire by exercise of +stock options. (9) Includes +150,000 shares of Common Stock that Mr. Rubinstein has the right to acquire by exercise of stock options. (10) Includes +1,500,000 shares of Common Stock that Dr. Tevanian has the right to acquire by exercise of stock options. (11) Includes +10,000 shares of Common Stock that Mr. York has the right to acquire by exercise of stock options. (12) Includes +4,956,148 shares of Common Stock that executive officers or directors have the right to acquire by exercise of stock options. * Represents +less than 1% of the issued and outstanding shares of Common Stock on the Table Date. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's officers and directors, and persons who own more than ten percent of a +registered class of the Company's equity securities, to file reports of securities ownership and changes in such ownership with the Securities and Exchange Commission +(" SEC "). Officers, directors and greater than ten percent shareholders also are required by rules promulgated by the SEC to furnish the Company with +copies of all Section 16(a) forms they file. Based +solely upon a review of the copies of such forms furnished to the Company or written representations that no Forms 5 were required, the Company believes that all Section 16(a) filing +requirements were met during fiscal year 2004. Equity Compensation Plan Information The following table sets forth certain information, as of September 25, 2004, concerning shares of common stock authorized for issuance under all of the Company's equity +compensation plans. (a) Number of Securities to be Issued Upon Exercise of Options (b) Weighted Average Exercise Price of Outstanding Options (c) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) Equity compensation plans approved by shareholders 21,992,912 $ 22.32 14,072,423 (1) Equity compensation plans not approved by shareholders 33,286,253 $ 20.25 — Total equity compensation plans(2) 55,279,165 $ 21.07 14,072,423 (1) This +number includes 2,047,911 shares of common stock reserved for issuance under the Employee Stock Purchase Plan, 240,000 shares available for issuance under the 1997 Director Stock +Option Plan and 14,299,512 shares available for issuance under the 2003 Employee Stock Plan. The grant of 2,515,000 shares of restricted stock units have been deducted from the number of shares +available for future issuance. It does not include shares under the 1990 Stock Option Plan which was terminated in 1997. No new options can be granted under the 1990 Stock Option Plan. 111 (2) This +table does not include 81,642 outstanding options assumed in connection with mergers and acquisitions of the companies which originally established those plans. These assumed +options have a weighted average exercise price of $4.39 per share. No additional options may be granted under those assumed plans. Arrangements with Named Executive Officers Change In Control Arrangements—Stock Options, Restricted Stock, and Restricted Stock Units In the event of a "change in control" of the Company, all outstanding options under the Company's stock option plans, except the Director Plan, will, unless otherwise +determined by the plan +administrator, become exercisable in full, and will be cashed out at an amount equal to the difference between the applicable "change in control price" and the exercise price. The Director Plan +provides that upon a "change in control" of the Company, all unvested options held by non-employee directors will automatically become fully vested and exercisable and will be cashed out +at an amount equal to the difference between the applicable "change in control price" and the exercise price of the options. A "change in control" under these plans is generally defined as +(i) the acquisition by any person of 50% or more of the combined voting power of the Company's outstanding securities or (ii) the occurrence of a transaction requiring shareholder +approval and involving the sale of all or substantially all of the assets of the Company or the merger of the Company with or into another corporation. In +addition, options, restricted stock grants, and restricted stock units granted to the Named Executive Officers generally provide that in the event there is a "change in control," as defined in the +Company's stock option plans, and if in connection with or following such "change in control," their employment is terminated without "Cause" or if they should resign for "Good Reason," those options, +restricted stock, and restricted stock units outstanding that are not yet vested as of the date of such "change in control" shall become fully vested. Further, restricted stock and restricted stock +units granted to the Named Executive Officers also provide that, in the event the Company terminates the Officer without cause at any time, the restricted stock units and restricted stock will vest in +full. Generally, "Cause" is defined to include a felony conviction, willful disclosure of confidential information or willful and continued failure to perform his or her employment duties. "Good +Reason" includes resignation of employment as a result of a substantial diminution in position or duties, or an adverse change in title or reduction in annual base salary. Item 13. Certain Relationships and Related Transactions In +connection with a relocation assistance package, the Company loaned Mr. Johnson (Senior Vice President, Retail) $1,500,000 for the purchase of his principal residence. The loan was secured +by a deed of trust and was due and payable in May 2004. The largest amount of the indebtedness outstanding on this loan during fiscal year 2004 was $750,000. Mr. Johnson repaid the +Company $750,000 during the fiscal year and the loan has been repaid in full. In +March 2002, the Company entered into a Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. Jobs, for the reimbursement of expenses incurred by Mr. Jobs in +the operation of his private plane when used for Apple business. The Reimbursement Agreement is effective for expenses incurred by Mr. Jobs for Apple business purposes since he took delivery of +the plane in May 2001. During 2004, the Company recognized a total of $483,000 in expenses pursuant to this reimbursement agreement related to expenses incurred by Mr. Jobs during 2004. 112 Item 14. Principal Accountant Fees and Services The +following table sets forth the fees paid to the Company's independent registered public accounting firm, KPMG LLP, during fiscal years 2004 and 2003. Audit and Non-Audit Fees 2004 2003 Audit Fees $ 3,402,300 (1) $ 3,028,000 Audit-Related Fees 57,000 (2) 144,600 Tax Fees 784,500 (3) 1,017,100 All Other Fees — — Total $ 4,243,800 $ 4,189,700 (1) Audit +fees relate to professional services rendered in connection with the audit of the Company's annual financial statements, quarterly review of financial statements included in the +Company's Forms 10-Q, and audit services provided in connection with other statutory and regulatory filings. (2) Audit-related +fees include professional services related to the audit of the Company's financial statements, consultation on accounting standards or transactions, and audits of +employee benefit plans. (3) Tax +fees include $667,600 for professional services rendered in connection with tax compliance and preparation relating to the Company's expatriate program, tax audits and +international tax compliance; and $116,900 for tax consulting and planning services relating to interest computations and international tax changes. The Company does not engage KPMG to perform +personal tax services for its executive officers. Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm Prior to the enactment of the Sarbanes-Oxley Act of 2002 (the " Act "), the Company adopted an auditor independence policy that +banned its auditors from performing non-financial consulting services, such as information technology consulting and internal audit services. This auditor policy also mandates that the +audit and non-audit services and the related budget be approved by the Audit Committee in advance, and that the Audit Committee be provided with quarterly reporting on actual spending. +This policy also mandates that no auditor engagements for non-audit services may be entered into without the express approval of the Audit Committee. 113 PART IV Item 15. Exhibits, Financial Statement Schedules. (a) Index +to Exhibits Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/ Period End Date Filed herewith 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on January 27, 1988. S-3 7/27/88 3.2 Amendment to Restated Articles of Incorporation, filed with the Secretary of State of the State of California on May 4, 2000. 10-Q 5/11/00 3.3 By-Laws of the Company, as amended through June 7, 2004. 10-Q 6/26/04 4.2 Indenture dated as of February 1, 1994, between the Company and Morgan Guaranty Trust Company of New York. 10-Q 4/01/94 4.3 Supplemental Indenture dated as of February 1, 1994, among the Company, Morgan Guaranty Trust Company of New York, as resigning trustee, and Citibank, N.A., as successor trustee. 10-Q 4/01/94 4.5 Form of the Company's 6 1 / 2 % Notes due 2004. 10-Q 4/01/94 4.8 Registration Rights Agreement, dated June 7, 1996 among the Company and Goldman, Sachs & Co. and Morgan Stanley & Co. Incorporated. S-3 8/28/96 4.9 Certificate of Determination of Preferences of Series A Non-Voting Convertible Preferred Stock of Apple Computer, Inc. 10-K 9/26/97 10.A.3 Apple Computer, Inc. Savings and Investment Plan, as amended and restated effective as of October 1, 1990. 10-K 9/27/91 10.A.3-1 Amendment of Apple Computer, Inc. Savings and Investment Plan dated March 1, 1992. 10-K 9/25/92 10.A.3-2 Amendment No. 2 to the Apple Computer, Inc. Savings and Investment Plan. 10-Q 3/28/97 10.A.5 1990 Stock Option Plan, as amended through November 5, 1997. 10-Q 12/26/97 10.A.6 Apple Computer, Inc. Employee Stock Purchase Plan, as amended through April 24, 2003. S-8 6/24/03 10.A.8 Form of Indemnification Agreement between the Registrant and each officer of the Registrant. 10-K 9/26/97 10.A.43 NeXT Computer, Inc. 1990 Stock Option Plan, as amended. S-8 3/21/97 114 10.A.49 1997 Employee Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.A.50 1997 Director Stock Option Plan. 10-Q 3/27/98 10.A.51 2003 Employee Stock Option Plan, as amended through April 24, 2003. 10-Q 6/28/03 10.A.52 Reimbursement Agreement dated as of May 25, 2001 by and between the Registrant and Steven P. Jobs. 10-Q 6/29/02 10.A.53 Option Cancellation and Restricted Stock Award Agreement dated as of March 19, 2003 by and between The Registrant and Steven P. Jobs. 10-Q 6/28/03 10.A.54 Form of Restricted Stock Unit Award Agreement 10-Q 3/27/04 10.B.18 Custom Sales Agreement effective October 21, 2002 between the Registrant and International Business Machines Corporation. 10-K 9/27/03 14.1 Code of Ethics of the Company 10-K 9/27/03 21 Subsidiaries of Apple Computer, Inc. X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Rule13a-14(a)/15d-14(a) Certification of Chief Executive Officer X 31.2 Rule13a-14(a)/15d-14(a) Certification of Chief Financial Officer X 32.1 Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer X 115 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the +undersigned, thereunto duly authorized, this 30th day of November 2004. APPLE COMPUTER, INC. By: /s/ PETER OPPENHEIMER Peter Oppenheimer Senior Vice +President and Chief Financial Officer KNOW +ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven P. Jobs and Peter Oppenheimer, jointly and severally, his +attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to +file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said +attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated: Name Title Date /s/ STEVEN P. JOBS STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) November 30, 2004 /s/ PETER OPPENHEIMER PETER OPPENHEIMER Senior Vice President and Chief Financial Officer (Principal Financial and Principal Accounting Officer) November 30, 2004 /s/ FRED ANDERSON FRED ANDERSON Director November 30, 2004 /s/ WILLIAM V. CAMPBELL WILLIAM V. CAMPBELL Director November 30, 2004 /s/ MILLARD S. DREXLER MILLARD S. DREXLER Director November 30, 2004 /s/ ALBERT GORE, JR. ALBERT GORE, JR. Director November 30, 2004 /s/ ARTHUR D. LEVINSON ARTHUR D. LEVINSON Director November 30, 2004 /s/ JEROME B. YORK JEROME B. YORK Director November 30, 2004 116 QuickLinks PART I Item 1. Business Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for the Registrant's Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures PART III Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation SUMMARY COMPENSATION TABLE AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Item 12. Security Ownership of Certain Beneficial Owners and Management Security Ownership of 5% Holders, Directors, Nominees and Executive Officers Item 13. Certain Relationships and Related Transactions Item 14. Principal Accountant Fees and Services Audit and Non-Audit Fees PART IV Item 15. Exhibits, Financial Statement Schedules. SIGNATURES \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-07-009340/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-07-009340/full-submission.txt new file mode 100644 index 0000000..d037b28 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-07-009340/full-submission.txt @@ -0,0 +1,2078 @@ +QuickLinks -- Click here to rapidly navigate through this document UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 29, 2007 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 942404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant's +telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Global Select Market (Title of class) (Name of exchange on which registered) Securities +registered pursuant to Section 12(g) of the Act: None Indicate +by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. +Yes ý No o Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. +Yes o No ý Note —Checking the box above will not relieve any registrant required to file reports pursuant to Section 13 or +15(d) of the Exchange Act from their obligations under those Sections. Indicate +by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding +12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past +90 days. Yes ý No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not +contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this +Form 10-K or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of "accelerated filer +and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ý Accelerated filer o Non-accelerated filer o Indicate +by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the +Act). Yes o No ý The aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant, as of March 31, 2007, was approximately +$74,499,000,000 based upon the closing price reported for such date on the NASDAQ Global Select Market. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of +the outstanding shares of common stock and shares held by executive officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. This determination +of executive officer or affiliate status is not necessarily a conclusive determination for other purposes. 875,540,274 +shares of Common Stock Issued and Outstanding as of November 2, 2007 The Business section and other parts of this Annual Report on Form 10-K ("Form 10-K") contain forward-looking statements that involve +risks and uncertainties. Many of the forward-looking statements are located in "Management's Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements +provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can +also be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future +performance and the Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not +limited to, those discussed in the subsection entitled "Risk Factors" under Part I, Item 1A of this Form 10-K. The Company assumes no obligation to revise or update +any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background Apple Inc. and its wholly-owned subsidiaries (collectively "Apple" or the "Company") design, manufacture, and market personal computers, portable digital music players, +and mobile communication devices and sells a variety of related software, services, peripherals, and networking solutions. The Company sells its products worldwide through its online stores, its +retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Macintosh ("Mac"), iPod and iPhone +compatible products, including application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores. The Company +sells to education, consumer, creative professional, business, and government customers. The Company's fiscal year is the 52 or +53-week period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company's fiscal +calendar. Business Strategy The Company is committed to bringing the best personal computing, portable digital music and mobile communication experience to students, educators, creative professionals, +businesses, government agencies, and consumers through its innovative hardware, software, peripherals, services, and Internet offerings. The Company's business strategy leverages its unique ability to +design and develop its own operating system, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, +seamless integration, and innovative industrial design. The Company believes continual investment in research and development is critical to the development and enhancement of innovative products and +technologies. In addition to evolving its personal computers and related solutions, the Company continues to capitalize on the convergence of the personal computer, digital consumer electronics and +mobile communications by creating and refining innovations, such as the iPod, iPhone, iTunes Store, and Apple TV. The Company's strategy also includes expanding its distribution network to effectively +reach more of its targeted customers and provide them with a high-quality sales and post-sales support experience. Digital Lifestyle The Company believes that for both professionals and consumers the personal computer has become the center of an evolving digital lifestyle by integrating with and enhancing +the utility of advanced digital devices such as the Company's iPods, iPhones, digital video and still cameras, televisions, personal digital assistants, and other digital devices. The attributes of +the personal computer that enable this functionality include a high-quality user interface, easy access to relatively inexpensive data storage, the ability to run complex applications, and +the ability to connect easily to a wide variety of other digital devices and to the Internet. The Company is the only participant in the personal computer industry that controls the design 1 and +development of the entire personal computer—from the hardware and operating system to sophisticated software applications. This, along with its products' creative industrial designs, +intuitive ease-of-use, and built-in graphics, multimedia and networking capabilities, positions the Company to offer innovative integrated digital lifestyle +solutions. Expanded Distribution The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company's products and services greatly +enhances its ability to attract +and retain customers. The Company sells many of its products and resells certain third-party products in most of its major markets directly to consumers, education customers, and businesses through +its retail and online stores. The Company has also invested in programs to enhance reseller sales, including the Apple Sales Consultant Program, which places Apple employees and contractors at +selected third-party reseller locations. The Company believes providing direct contact with its targeted customers is an efficient way to demonstrate the advantages of its Mac computers and other +products over those of its competitors. At +the end of fiscal 2007, the Company had opened a total of 197 of its own retail stores, including 174 stores in the U.S. and a total of 23 stores in Canada, Japan, U.K. and Italy. The +Company has typically located its stores at high-traffic locations in quality shopping malls and urban shopping districts. One +of the goals of the retail initiative is to expand the Company's installed base through sales to customers who currently do not already own the Company's products. By operating its own stores and +locating them in desirable high-traffic locations, the Company is better positioned to control the customer buying experience and attract new customers. The stores are designed to simplify +and enhance the presentation and marketing of the Company's products and related solutions. To that end, retail store configurations have evolved into various sizes in order to accommodate +market-specific demands. The stores employ experienced and knowledgeable personnel who provide product advice and certain support services. The stores offer a wide selection of third-party hardware, +software, and various other accessory products and peripherals selected to complement the Company's own products. Education Throughout its history, the Company has focused on the use of technology in education and has been committed to delivering tools to help educators teach and students learn. The +Company believes effective integration of technology into classroom instruction can result in higher levels of student achievement, especially when used to support collaboration, information access, +and the expression and representation of student thoughts and ideas. The Company has designed a range of products and services to address the needs of education customers. These products and services +include the Company's Mac computers, iPods, iTunes, and Apple TV, in addition to various solutions for video creation and editing, wireless networking, professional development, and +one-to-one (1:1) learning. A 1:1 learning solution typically consists of a portable computer for every student and teacher along with the installation of a wireless network. Creative Professionals Creative professionals constitute one of the Company's most important markets for both hardware and software products. This market is also important to many third-party +developers who provide Mac-compatible hardware and software solutions. Creative customers utilize the Company's products for a variety of activities including digital video and film +production and editing; digital video and film special effects, compositing and titling; digital still photography and workflow +management; graphic design, publishing, and print production; music creation and production; audio production and sound design; and web design, development, and administration. The +Company designs its high-end hardware solutions, including servers, desktops, and portable Mac systems, to incorporate the power, expandability, and features desired by creative +professionals. The Company's operating system, Mac OS X, incorporates powerful graphics and audio technologies and 2 features +developer tools to optimize system and application performance when running creative solutions provided by the Company or third-party developers. Other In addition to consumer, education and creative professional markets, the Company provides hardware and software products and solutions for customers in the information +technology, science, business, and government markets. Business Organization The Company manages its business primarily on a geographic basis. The Company's reportable operating segments consist of the Americas, Europe, Japan, and Retail. The Americas, +Europe, and Japan reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European +countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S., Canada, Japan, the U.K. and Italy. Each reportable geographic operating segment and +the Retail operating segment provide similar hardware and software products and similar services. Further information regarding the Company's operating segments may be found in Part II, +Item 7 of this Form 10-K under the heading "Segment Operating Performance," and in Part II, Item 8 of this Form 10-K in Notes to Consolidated +Financial Statements at Note 9, "Segment Information and Geographic Data." Products The Company offers a range of personal computing products including desktop and portable personal computers, related devices and peripherals, and various third-party hardware +and software products. In addition, the Company offers software products including Mac OS® X, the Company's proprietary operating system software for the Mac®; +server software and related +solutions; professional application software; and consumer, education and business oriented application software. The Company also designs, develops and markets to Mac and Windows users its family of +iPod® digital music players and its iPhone™ mobile communication device, along with related accessories and services including the online distribution of third-party content +through the Company's iTunes Store™. The Company's primary products are discussed below. Hardware Products The Company offers a range of personal computing products including desktop and notebook computers, server and storage products, related devices and peripherals, and various +third-party hardware products. The Company's Mac desktop and portable systems feature Intel microprocessors, the Company's Mac OS X Version 10.5 Leopard™ +("Mac OS X Leopard") operating system that became available in October 2007 and iLife® suite of software for creation and management of digital photography, music, +movies, DVDs, and website. The Company's transition from PowerPC to Intel microprocessors for Mac systems was completed in August 2006, and its transition for Xserve® was completed +in November 2006. There are potential risks and uncertainties associated with the transition to Intel microprocessors, which are further discussed in Item 1A of this +Form 10-K under the heading "Risk Factors." MacBook® Pro The +MacBook Pro family of notebook computers is designed for professionals and advanced consumer users. First introduced in January 2006, the MacBook Pro includes a 15-inch or +17-inch widescreen display, a built-in iSight® video camera, Front Row™ with the Apple Remote, and the MagSafe® magnetic power adapter. In +June 2007, the Company updated its MacBook Pro models to include the latest Intel Core 2 Duo processors and the Nvidia GeForce 8600M GT graphics controller. MacBook Pro includes +up to 4GB of 667MHz DDR2 main memory with an 800 MHz frontside bus, a Serial ATA hard drive, and a slot-loading double-layer SuperDrive®. In addition, every MacBook Pro +features a 1-inch thin aluminum enclosure and includes AirPort Extreme® 802.11n wireless networking, Bluetooth 2.0+EDR, Gigabit 3 Ethernet, +USB 2.0 and FireWire® ports, audio input and output ports, a DVI video-out port, an ExpressCard/34 slot, scrolling trackpad, and backlit keyboard. MacBook® The +MacBook is designed for consumer and education users. First introduced in May 2006, the MacBook includes a 13-inch widescreen display, a built-in iSight video camera +and the MagSafe magnetic power adapter. In May 2007, the Company updated its MacBook +models with faster Intel Core 2 Duo processors running at up to 2.16GHz, Intel integrated graphics, support for up to 4GB of 667MHz DDR2 main memory, a Serial ATA hard drive, and a +slot-loading Combo optical drive or double-layer SuperDrive. In addition, MacBook models include AirPort Extreme 802.11n wireless networking, Bluetooth 2.0+EDR, Gigabit +Ethernet, USB 2.0 and FireWire ports, audio input and output ports, a mini-DVI video output port, and scrolling trackpad. Mac® Pro The +Mac Pro desktop computer is targeted at business and professional users and is designed to meet the performance, expansion, and networking needs of the most demanding Mac user. The Mac Pro +features two Intel Xeon dual-core or quad-core processors running at up to 3.0GHz, with 4MB and 8MB of shared Level 2 cache and independent 1.33GHz +front-side buses, 667MHz fully buffered memory, and a 256-bit wide memory architecture. The Mac Pro also features a direct attach storage solution for snap-in +installation of up to four 750GB Serial ATA hard drives for a total of 3TB of internal storage. Every Mac Pro includes three full-length PCI Express expansion slots and one +double-wide PCI Express graphics slot to support double-wide graphics cards. The Mac Pro also includes dual Ethernet ports, optical digital input and output ports, analog audio +input and output ports, and multiple FireWire 400, FireWire 800 and USB 2.0 ports. iMac® The +iMac desktop computer is targeted at consumer, education and business customers. In August 2007, the Company updated the iMac to include 2.0GHz, 2.4GHz or 2.8GHz Intel Core 2 Duo +processors, up to 4 GB of 667 MHz DDR2 SDRAM, a faster graphics card using ATI Radeon HD 2400 XT or ATI Radeon HD 2600 PRO graphics, and slot-loading +double-layer SuperDrive. All iMac models include a built-in iSight video camera, AirPort Extreme 802.11n wireless networking, Bluetooth 2.0+EDR, built-in Gigabit +Ethernet, USB 2.0 and Fire Wire ports, and mini-DVI video out. Mac® mini In +February 2006, the Company introduced the Intel-based Mac mini that includes Front Row with the Apple Remote. The Mac mini offers 1GB of 667MHz memory expandable to 2GB and either a 1.83GHz +or 2.0GHz Intel processor. Every Mac mini includes built-in Gigabit Ethernet, AirPort Extreme 802.11g wireless networking, Bluetooth 2.0+EDR, a total of four USB 2.0 ports, +and one FireWire 400 port. Mac mini includes a full-size DVI interface and a VGA-out adapter to connect to a variety of displays, including televisions, and features +both analog and digital audio outputs. Xserve® and Xserve RAID Storage System Xserve +is a 1U rack-mount server powered by two dual-core 64-bit Intel Xeon processors running at up to 3.0GHz and features Mac OS® X +Server 10.5, which became available in October 2007. Xserve supports up to 32GB of RAM, remote management and internal serial attached SCSI ("SAS") or serial ATA ("SATA") storage drives +of up to 2.25TB, with optional internal hardware RAID. The Company's Xserve RAID storage system delivers up to 10.5TB of Fiber Channel attached hardware RAID storage capacity and also expanded support +for Mac OS X and heterogeneous environments. 4 Music Products and Services The Company offers its iPod® line of portable digital music players and related accessories to Mac and Windows users. All iPods work with the Company's +iTunes® digital music management software ("iTunes software") available for both Mac and Windows-based computers. The +Company also provides an online service to distribute third-party music, audio books, music videos, short films, television shows, movies, podcasts and iPod games through its iTunes Store. In +addition to the Company's own iPod accessories, thousands of third-party iPod compatible products are available, either through the Company's online and retail stores or from third parties, including +portable and desktop speaker systems, headphones, car radio solutions, voice recorders, cables and docks, power supplies and chargers, and carrying cases and armbands. iPod® shuffle The +iPod shuffle weighs half an ounce and features an aluminum design and a built-in clip. The iPod shuffle contains 1GB of flash memory capable of holding up to 240 songs and provides up +to 12 hours of battery life. The iPod shuffle includes a shuffle switch feature that allows users to listen to their music in random order or in the order of their playlist synced through +iTunes. iPod shuffle works with iTunes' patent-pending AutoFill option that automatically selects songs to fill the iPod shuffle from a user's iTunes library. iPod® nano In +September 2007, the Company introduced a new version of its flash-memory-based iPod nano featuring a larger two-inch display with 204 pixels per inch and a new user interface +featuring Cover Flow®. The new iPod nano comes in an all metal design made with anodized aluminum and polished stainless steel and has up to 24 hours of battery life. The iPod nano +includes the Click Wheel, a smaller and lighter design and brighter color screen than its predecessor, and new iPod games. The iPod nano is available in 4GB and 8GB configurations and in a variety of +colors. iPod® classic In +September 2007, the Company introduced the new iPod classic. The iPod classic is an upgraded version of the original iPod, the Company's hard-drive based portable digital music +player. The iPod classic is available in an 80GB model capable of holding up to 20,000 songs or 100 hours of video and a 160GB model capable of holding up to 40,000 songs or 200 hours of +video. The iPod classic features up to 40 hours of battery life and includes a new all-metal enclosure and a 2.5-inch color screen that can display album artwork, +photos, and video content including music videos, video and audio podcasts, short films, television shows, movies, and games. iPod® touch In +September 2007, the Company introduced the iPod touch, a new flash-memory-based iPod that is 8 mm thin and features the Company's Multi-Touch™ user interface on a +3.5-inch widescreen display. The iPod touch includes Wi-Fi wireless networking and additional applications such as Safari™, Google Search or Yahoo! oneSearch, and +the new iTunes Wi-Fi Music Store. The iPod touch is available in 8GB and 16 GB configurations and features up to 22 hours of audio playback and up to five hours of video +playback. The iPod touch's user interface is based on the Multi-Touch™ display allowing users to control the device with a touchscreen. iTunes® 7 iTunes +is a digital media player application for playing, downloading, and organizing digital music and video files. iTunes is available for both Mac and Windows-based computers. Within iTunes, the +user can connect to the iTunes Store™, a service that allows customers to find, purchase, and download third-party digital music, audio books, music videos, short films, television shows +and movies, and iPod games. In 5 September 2007, +the Company introduced the iTunes Wi-Fi Music Store offering users the ability to browse, search, preview, purchase, and download songs and albums from their iPod +touch or iPhone over a Wi-Fi network. Customers can search the contents of the store catalog to locate works by title, artist, or album, or browse the entire contents of the store by +genre. Originally introduced in the U.S. in April 2003, the iTunes Store now serves customers in 22 countries. iPhone™ In +January 2007, the Company announced iPhone ™ , a handheld device that combines in a single product a mobile phone, a widescreen iPod +with touch controls, and an Internet communications device. iPhone's user interface is based on the Multi-Touch™ display allowing users to control the device with a touchscreen. iPhone +lets users make calls by tapping on a name or number in their address book, a favorites list, or a call log as well as select and listen to voicemail messages in any order. iPhone also allows users to +purchase and download songs and albums from the iTunes Wi-Fi Music Store directly onto their iPhone and play their iTunes® content, including movies, television shows, music, +photos and podcasts, with the touch of a finger. iPhone features desktop-class email, web browsing, searching, and maps. iPhone is compatible with a Mac or PC and automatically syncs content from a +user's iTunes library, as well as contacts, bookmarks, and email accounts. iPhone is a quad-band GSM phone featuring EDGE and Wi-Fi wireless technologies for data networking, +Bluetooth 2.0, a built-in 2 megapixel camera, a 3.5-inch touch screen with 480-by-320 resolution at 160 pixels per inch, and providing up +to 8 hours of talk time, 6 hours of Internet use, 7 hours of video playback or 24 hours of audio playback. AT&T Mobility LLC ("AT&T") is the exclusive +U.S. cellular network carrier for iPhone. The Company began shipping iPhone in the U.S. on June 29, 2007. On November 9, 2007, the Company began shipping iPhone in the U.K. and +Germany, and expects to ship the iPhone in France on November 29, 2007. O2 Limited ("O2"), T-Mobile International AG & Co. KG ("T-Mobile"), and France +Telecom ("Orange") are the exclusive cellular network carriers for iPhone in the U.K., Germany, and France, respectively. The Company has entered into agreements with each exclusive cellular network +carrier related to cellular network services and the purchase and sale of iPhone and iPhone related products. These agreements entitle the Company to receive certain payments from these carriers. In +addition to the Company's own iPhone accessories, third-party iPhone compatible products are available, either through the Company's online and retail stores or from third parties, including +headsets, cables and docks, power supplies, and carrying cases. Peripheral Products The Company sells a variety of Apple-branded and third-party Mac-compatible peripheral products directly to end-users through its retail and online +stores, including printers, storage devices, computer memory, digital video and still cameras, and various other computing products and supplies. Displays The +Company manufactures a family of widescreen flat panel displays including the 30-inch Apple Cinema HD Display™, a widescreen active-matrix LCD with +2560-by-1600 pixel resolution, the 23-inch Apple Cinema HD Display with 1920-by-1200 pixel resolution and the +20-inch Apple Cinema Display® with 1680-by-1050 pixel resolution. These displays feature built-in dual FireWire and dual USB 2.0 +ports and use the industry standard DVI interface for a pure digital connection with the Company's latest Mac Pro, MacBook Pro, Mac mini and MacBook systems. The Cinema Displays feature an aluminum +design with a thin bezel, suspended by an aluminum stand that allows viewing angle adjustment. Apple TV™ In +January 2007, the Company announced Apple TV, a device that permits users to wirelessly play iTunes content on a widescreen television. Compatible with a Mac or Windows-based computer, Apple +TV includes either a 40GB or 160GB hard drive capable of storing up to 200 hours of video, 36,000 songs, 6 25,000 +photos, or a combination of each and is capable of displaying content in high definition resolution up to 720p. Apple TV connects to a broad range of widescreen televisions and home theater +systems and comes standard with high-definition multimedia interface, component video, and both analog and digital optical audio ports. Using high-speed AirPort® +802.11n wireless networking, Apple TV can auto-sync content from one computer or stream content from up to five additional computers directly to a television. The Company began shipping +Apple TV in March 2007. Software Products and Computer Technologies The Company offers a range of software products for education, creative professional, consumer, business and government customers, including Mac OS X, the +Company's proprietary operating system software for the Mac; server software and related solutions; professional application software; and consumer, education, and business oriented application +software. Operating System Software Mac OS® X +is built on an open-source UNIX-based foundation. Mac OS X Leopard is the sixth major release of Mac OS X and +became available in October 2007. Leopard includes 300 new features and introduces a new desktop with Stacks, a new way to easily access files from the Dock; a redesigned Finder™ +that lets users quickly browse and share files between multiple Macs; Quick Look, a new way to instantly see files without opening an application; Spaces™, an intuitive new feature used to +create groups of applications and instantly switch between them; and Time Machine™, an effortless way to automatically back up everything on a Mac. Application Software iLife® '08 In +August 2007, the Company introduced iLife '08, the latest release of its consumer-oriented digital lifestyle application suite, which features iPhoto®, iDVD®, +GarageBand®, iWeb™, iTunes® and iMovie® '08. All of these applications are Universal, meaning that they run natively on both Intel and +PowerPC-based Mac computers ("Universal"). iPhoto® +is the Company's consumer-oriented digital photo software application. iPhoto '08 adds new features for organizing and browsing photos, including event-based grouping, new +professional quality image editing tools, and enables publishing to .Mac Web Gallery. .Mac Web Gallery, is fully integrated with iPhoto '08 and iMovie '08, allowing .Mac users to share +photos and movies over the web. iPhoto '08 features print, photo book, greeting card, and calendar layout tools and integrated online ordering services. iMovie® '08 +is a new version of the Company's consumer-oriented digital video editing software application. iMovie® '08 provides new tools for quick movie +creation and video enhancements, including transitions, titles, music and sound effects. Projects in iMovie® '08 can also be published to .Mac Web Gallery. iDVD® +is the Company's consumer-oriented software application that enables users to turn iMovie files, QuickTime® files, and digital pictures into interactive DVDs that can be +played on most consumer DVD players. iDVD '08 features 10 new Apple-designed menu themes in both widescreen (16:9) and standard (4:3) formats. GarageBand® +is the Company's consumer-oriented music creation software application that allows users to play, record and create music using a simple interface. With GarageBand, software +instruments, digital audio recordings and looping tracks can be arranged and edited to create songs. GarageBand '08 allows users to export finished songs to their iTunes library, or publish a +podcast through iWeb and .Mac that includes artwork, sound effects, and music jingles. 7 iWeb™ +allows users to create online photo albums, blogs and podcasts, and to customize websites using editing tools. iWeb'08 offers new features to make websites more interactive by adding +live web widgets, which are snippets of live content from other websites, such as Google Maps, targeted ads using Google AdSense and photos or movies from .Mac Web Galleries. iLife '08 +also includes iTunes®, the Company's digital music jukebox software application that allows users to purchase a variety of digital content available through the Company's +iTunes Store. iTunes organizes content using searching, browsing, and playlists, and provides integration with the complete family of iPods and iPhone. iWork™ '08 In +August 2007, the Company introduced iWork '08, a new version of the Company's integrated productivity suite designed to help users create, present, and publish documents, +presentations and spreadsheets. iWork '08 includes updates to Pages® '08 for word processing and page layout, Keynote® '08 for presentations, and +introduces Numbers '08 for spreadsheets. All of these programs are Universal and feature advanced image tools, including enhanced photo masking, resizable picture frames and edges, and Instant +Alpha, which easily removes the background of a photo. Final Cut Studio® 2 In +April 2007, the Company introduced Final Cut Studio® 2, an upgraded version of the Company's video production suite designed for professionals. Final Cut Studio 2 +features Final Cut Pro® 6 for video editing, DVD Studio Pro® 4 for DVD authoring, Motion 3 for real-time motion graphics, +Soundtrack® Pro 2 for audio editing and sound design, Color for color grading and finishing, and Compressor 3 for encoding media in multiple formats. All of these +applications are Universal. The Company also offers Final Cut Express HD 3.5, a consumer version of the Company's movie making software. Logic® Studio In +September 2007, the Company introduced Logic Studio, a comprehensive suite of professional tools used by musicians and professionals to create, perform, and record music. Logic Studio +features Logic® Pro 8, an upgraded version of the Company's music creation and audio production software; MainStage™, a new live performance application; +Soundtrack® Pro 2, a professional audio post production software; Studio Instruments, made up of 40 instrument plug-ins; Studio Effects, with 80 professional effect +plug-ins; and studio Sound Library. In addition, the Company offers Logic® Express 8, a standalone version of the Logic® Pro 8 application that +provides an easy entry into professional music production. All of these applications are Universal. FileMaker® Pro The +FileMaker Pro database software is Universal and offers relational databases and desktop-to-web publishing capabilities. In July 2007, the Company introduced +FileMaker Pro 9 featuring a new Quick Start screen, which stores users' favorites and gives them access to the new videos in the FileMaker Learning Center; Conditional Formatting, which +highlights data based on parameters the user sets; and the ability to email a link to other FileMaker users to instantly access a database. Internet Software and Services The Company is focused on delivering seamless integration with and access to the Internet throughout the Company's products and services. The Company's Internet solutions +adhere to many industry standards to provide an optimized user experience. Safari™ In +October 2007, the Company made available Safari 3, a web browser compatible with Windows XP, Windows Vista and Mac OS X. Safari 3 includes +built-in Google search; SnapBack™ to instantly return to 8 search +results; a way to name, organize and present bookmarks; tabbed browsing; and automatic "pop-up" ad blocking. QuickTime® QuickTime, +the Company's multimedia software for Mac or Windows-based computers, features streaming of live and stored video and audio over the Internet and playback of high-quality audio +and video on computers. QuickTime 7 features H.264 encoding and can automatically determine a user's connection speed to ensure they are getting the highest-quality content stream possible. +QuickTime 7 also delivers multi-channel audio and supports audio formats, including AIFF, WAV, MOV, MP4 (AAC only), CAF, and AAC/ADTS. The +Company offers several other QuickTime products. QuickTime 7 Pro, a suite of software tools, allows creation and editing of Internet-ready audio and video files. QuickTime 7 Pro +allows users to create H.264 video, capture audio and video, create multi-channel audio, and export multiple files while playing back or editing video. .Mac® The +Company's .Mac offering is a suite of Internet services that for an annual fee provides Mac users with a powerful set of Internet tools. .Mac services include: internet message access protocol +("IMAP") mail, an ad-free email service; website hosting for publishing web sites from iWeb; iDisk, a virtual hard drive accessible anywhere with Internet access; .Mac Sync, which keeps +Safari bookmarks, iCal® calendars, Address Book information, Keychain®, and Mac OS X Mail preferences up-to-date across multiple Mac computers; and +Groups which allows people to use a group email list and website. The current version of .Mac provides combined iDisk and email storage of up to 10GB for individuals and 20GB for families. In +August 2007, the Company announced updates to its .Mac online service, including .Mac Web Gallery, a new service for .Mac members to share photos and movies on the Internet. .Mac Web Gallery +lets members share photos and movies directly from iLife '08 with anyone on a Mac, PC or iPhone. Wireless Connectivity and Networking AirPort Extreme® AirPort +Extreme is the Company's wireless networking technology. AirPort Extreme Base Station includes 802.11n Wi-Fi wireless networking and supports up to 50 users. Air Port Extreme +operates at either 2.4 GHz or 5 GHz frequencies, providing compatibility with most Wi-Fi devices. The current AirPort Extreme Base Station works with both Mac and Windows +computers, includes multiple Gigabit Ethernet ports and supports USB printer sharing to allow multiple users to wirelessly share USB printers connected directly to the base station. All Macs have +either built-in or optional wireless networking client hardware and software that communicates with Airport Extreme or Airport Express Base Stations. AirPort® Express® AirPort +Express is the first 802.11g standard mobile base station that can be plugged directly into the wall for wireless Internet connections and USB printing. Airport Express also features analog +and digital audio outputs that can be connected to a stereo and AirTunes™ music networking software that works with iTunes, giving users a way to wirelessly stream iTunes music from their +Mac or Windows-based computer to any room in the house. AirPort Express features a single piece design weighing 6.7 ounces. Product Support and Services AppleCare® offers a range of support options for the Company's customers. These options include assistance that is built into software products, printed and +electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare 9 Protection +Plan. The AppleCare Protection Plan is a fee-based service that typically includes three years of phone support and hardware repairs, dedicated web-based support +resources, and user diagnostic tools. Markets and Distribution The Company's customers are primarily in the education, creative professional, consumer, and business markets. The Company distributes its products through wholesalers, +resellers, national and regional retailers and cataloguers. No individual customer accounted for more than 10% of net sales in 2007, 2006, or 2005. The Company also sells many of its products and +resells certain third-party products in most of its major markets directly to consumers, education customers, and businesses through its own sales force and retail and online stores. Competition The Company is confronted by aggressive competition in all areas of its business. The markets for consumer electronics, personal computers, related software and peripheral +products, digital music devices and related services, and mobile communication devices are highly competitive. These markets are characterized by rapid technological advances in both hardware and +software that have substantially increased the capabilities and use of personal computers, other digital electronic devices, and mobile communication devices that have resulted in the frequent +introduction of new products with competitive price, feature, and performance characteristics. Over the past several years, price competition in these markets has been particularly intense. The +Company's competitors who sell personal computers based on other operating systems have aggressively cut prices and lowered their product margins to gain or maintain market share. The Company's +financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. The principal competitive factors include price, +product features, relative price/performance, product quality and reliability, design innovation, availability of software and peripherals, marketing and distribution capability, service and support, +and corporate reputation. Further, as the personal computer industry and its customers place more reliance on the Internet, an increasing number of Internet devices that are smaller, simpler, and less +expensive than traditional personal computers may compete for market share with the Company's products. The +Company's music products and services have faced significant competition from other companies promoting their own digital music and content products and services, including those offering free +peer-to-peer music and video services. The Company believes it currently retains a competitive advantage by offering superior innovation and integration of the entire solution +including the hardware (personal computer and iPod), software (iTunes), and distribution of content (iTunes Store and iTunes Wi-Fi Music Store). However, the Company expects competition in +this space to intensify as competitors attempt to imitate the Company's approach to tightly integrating these elements within their own offerings or, alternatively, collaborate with each other to +offer solutions that are more integrated than those they currently offer. Some of these current and potential competitors have substantial resources and may be able to provide such products and +services at little or no profit or even at a loss to compete with the Company's offerings. The +Company is currently focused on market opportunities related to mobile communication devices including the iPhone. The mobile communications industry is highly competitive with several large, +well-funded, and experienced competitors. The Company faces competition from mobile communication device companies that may attempt to imitate some of the iPhone's functions and +applications within their own smart phones. This industry is characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption +of technological and product advancements by competitors, and price sensitivity on the part of consumers. The +Company's future financial condition and operating results are substantially dependent on the Company's ability to continue to develop improvements to the Mac platform and to the Company's 10 hardware, +software and services related to consumer electronic devices, including iPods, and mobile communication devices, including iPhone. Raw Materials Although most components essential to the Company's business are generally available from multiple sources, certain key components including, but not limited to, +microprocessors, enclosures, certain LCDs, certain optical drives, and application-specific integrated circuits ("ASICs") are currently obtained by the Company from single or limited sources. Some key +components, while currently available to the Company from multiple sources, are at times subject to industry-wide availability constraints and pricing pressures. In addition, the Company +uses some components uncommon to the rest of the personal computer, consumer electronics and mobile communication industries, and new products introduced by the Company often initially utilize custom +components obtained from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. If the supply of a key or single-sourced +component to the Company were to be delayed or curtailed or in the event a key manufacturing vendor delayed shipment of completed products to the Company, the Company's ability to ship related +products in desired +quantities and in a timely manner could be adversely affected. The Company's business and financial performance could also be adversely affected depending on the time required to obtain sufficient +quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components may be affected if suppliers were to decide +to concentrate on the production of common components instead of components customized to meet the Company's requirements. The Company attempts to mitigate these potential risks by working closely +with these and other key suppliers on product introduction plans, strategic inventories, coordinated product introductions, and internal and external manufacturing schedules and levels. Consistent +with industry practice, the Company acquires components through a combination of formal purchase orders, supplier contracts, and open orders based on projected demand information. The Company's +purchase commitments typically cover its requirements for periods ranging from 30 to 150 days. The +Company believes there are several component suppliers and manufacturing vendors whose loss to the Company could have a material adverse effect upon the Company's business and financial condition. +At this time, such vendors include Agere Systems, Inc., Ambit Microsystems Corporation, Amperex Technology Limited, ASUSTeK Corporation, ATI Technologies, Inc., Atheros +Communications Inc., AU Optronics Corporation, Broadcom Corporation, Chi Mei Optoelectronics Corporation, Cypress Semiconductor Corporation, Hitachi Global Storage Technologies, Hon Hai +Precision Industry Co., Ltd., Infineon Technologies AG, Intel Corporation, Inventec Appliances Corporation, LG. Phillips Co., Ltd., Matsushita, Murata Manufacturing Co., Ltd., +National Semiconductor Corporation, NVIDIA Corp., Inc., Quanta Computer, Inc., Renesas Semiconductor Co. Ltd., Samsung Electronics, Sony Corporation, Synaptics, Inc., Texas +Instruments, and Toshiba Corporation. Certain of these vendors are the sole-sourced supplier of components and manufacturing outsourcing for many of the Company's key products, including +but not limited to, assembly of most of the Company's portable Mac computers, iPods, and iPhones. Research and Development Because the personal computer, consumer electronics, and mobile communication industries are characterized by rapid technological advances, the Company's ability to compete +successfully is heavily dependent upon its ability to ensure a continual and timely flow of competitive products, services, and technologies to the marketplace. The Company continues to develop new +products and technologies and to enhance existing products in the areas of computer hardware and peripherals, consumer electronics products, mobile communication devices, system software, applications +software, networking and communications software and solutions, and Internet services and solutions. The Company may expand the range of its product offerings and intellectual property through +licensing and/or acquisition of third-party business and technology. The Company's research and development expenditures totaled $782 million, $712 million, and $535 million in +2007, 2006, and 2005, respectively. 11 Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its computer systems, iPods, iPhone, peripherals, software, and services. In +addition, the Company has registered, and/or has applied to register, trademarks and service marks in the U.S. and a number of foreign countries for "Apple," the Apple logo, "Macintosh," "Mac," +"iPod," "iTunes," "iTunes Store," "iPhone," and numerous other trademarks and service marks. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an +important factor in its business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence, and marketing abilities +of its personnel. Many +of the Company's products are designed to include intellectual property obtained from third-parties. While it may be necessary in the future to seek or renew licenses relating to various aspects +of its products and business methods, the Company believes, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms; however, there +is no guarantee that such licenses could be obtained at all. Because of technological changes in the computer industry, current extensive patent coverage, and the rapid rate of issuance of new +patents, it is possible certain components of the Company's products and business methods may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the +Company has been notified that it may be infringing certain patents or other intellectual property rights of third-parties. Foreign and Domestic Operations and Geographic Data The U.S. represents the Company's largest geographic marketplace. Approximately 60% of the Company's net sales in 2007 came from sales to customers inside the U.S. Final +assembly of products sold by the Company is currently performed in the Company's manufacturing facility in Cork, Ireland, and by external vendors in Fremont, California; Fullerton, California; Taiwan; +the Republic of Korea ("Korea"); the People's Republic of China ("China"); and the Czech Republic. Currently, the supply and manufacture of many critical components used in the Company's products is +performed by sole-sourced third-party vendors in the U.S., China, Japan, Korea, and Singapore. Final assembly of substantially all of the Company's portable products, including MacBook +Pro, MacBook, iPod, and iPhone, is performed by sole-sourced third-party vendors in China. Margins on sales of the Company's products in foreign countries, and on sales of products that +include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping +penalties. Information +regarding financial data by geographic segment is set forth in Part II, Item 8 of this Form 10-K and in Notes to Consolidated Financial Statements at +Note 9, "Segment Information and Geographic Data." Seasonal Business The Company has historically experienced increased net sales in its first and fourth fiscal quarters compared to other quarters in its fiscal year due to seasonal demand +related to the holiday season and the beginning of the school year. This historical pattern should not be considered a reliable indicator of the Company's future net sales or financial performance. Warranty The Company offers a basic limited parts and labor warranty on most of its hardware products, including Mac computers, iPods and iPhones. The basic warranty period is typically +one year from the date of purchase by the end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company's hardware products. In +addition, consumers may purchase extended service coverage on most of the Company's hardware products in all of its major markets. 12 Backlog In the Company's experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog +often increases in anticipation of or immediately following new product introductions as dealers anticipate shortages. Backlog is often reduced once dealers and customers believe they can obtain +sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company's ability to achieve any particular level of revenue or financial performance. Environmental Laws Compliance with federal, state, local, and foreign laws enacted for the protection of the environment has to date had no material effect on the Company's capital expenditures, +earnings, or competitive position. In the future, these laws could have a material adverse effect on the Company. Production +and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers +the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have recently been +passed in several jurisdictions in which the Company operates including various countries within Europe and Asia, certain Canadian provinces and certain states within the U.S. Although the Company +does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not +have a material adverse effect on the Company's financial condition or operating results. Employees As of September 29, 2007, the Company had approximately 21,600 full-time equivalent employees and an additional 2,100 temporary equivalent employees and +contractors. Available Information The Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments +to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are filed with the U.S. Securities and Exchange Commission ("SEC"). Such reports and +other information filed by the Company with the SEC are available on the Company's website at http://www.apple.com/investor when such reports are available on the SEC website. The public may read and +copy any materials filed by the Company with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain +information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy, and +information statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing. +Further, the Company's references to the URLs for these websites are intended to be inactive textual references only. Item 1A. Risk Factors Because of the following factors, as well as other factors affecting the Company's financial condition and operating results, past financial performance should not be +considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. The matters relating to the Company's past stock option practices and the restatement of the Company's consolidated financial statements may result in additional litigation and +government enforcement actions. The findings from the Company's investigation into its past stock option granting practices and the resulting restatement of prior financial statements in its 2006 +Form 10-K have exposed the Company to greater risks associated with litigation, regulatory proceedings and government enforcement actions. As 13 described +in Part I, Item 3, "Legal Proceedings," several derivative complaints and a class action complaint have been filed in state and federal courts against the Company and certain +current and former directors and executive officers pertaining to allegations relating to past stock option grants. The Company has provided the results of its investigation to the SEC and the United +States Attorney's Office for the Northern District of California, and the Company has responded to their requests for documents and additional information. The Company intends to continue to provide +its full cooperation. On +April 24, 2007, the SEC filed an enforcement action against two former officers of the Company. In announcing the lawsuit, the SEC stated that it would not bring an enforcement action +against the Company based in part on the Company's "swift, extensive, and extraordinary cooperation in the Commission's investigation." According to the SEC's statement, the Company's "cooperation +consisted of, among other things, prompt self-reporting, an independent internal investigation, the sharing of the results of that investigation with the government, and the implementation +of new controls designed to prevent the recurrence of fraudulent conduct." No +assurance can be given regarding the outcomes from litigation, regulatory proceedings, or government enforcement actions relating to the Company's past stock option practices. These and related +matters have required, and will continue to require, the Company to incur substantial expenses for legal, accounting, tax, and other professional services, and may divert management's attention from +the Company's business. If the Company is subject to adverse findings, it could be required to pay damages and penalties and might face additional remedies that could harm its financial condition and +operating results. Global markets for personal computers, digital music devices, mobile communication devices, and related peripherals and services are highly competitive and subject to rapid +technological change. If the Company is unable to compete effectively in these markets, its financial condition and operating results could be materially adversely affected. The Company competes in global markets that are highly competitive and characterized by aggressive price cutting, with its resulting downward pressure on gross margins, +frequent introduction of new products and products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of +technological and product advancements by competitors, and price sensitivity on the part of consumers. The +Company's ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of new innovative products and technologies to the marketplace. The Company +believes it is unique in that it designs and develops virtually the entire solution for its personal computers, consumer electronics, and mobile communication devices, including the hardware, +operating system, several software applications, and related services. As a result, the Company must make significant investments in research and development. By contrast, many of the Company's +competitors seek to compete aggressively on price and maintain very low cost structures. If the Company is unable to continue to develop and sell innovative new products with attractive margins, its +financial condition and operating results may be materially adversely affected. In +the market for personal computers and peripherals, the Company faces a significant number of competitors, many of which have broader product lines and larger installed customer bases. There has +also been a trend toward consolidation that has resulted in larger and potentially stronger competitors. Price competition has been particularly intense as competitors selling Windows-based personal +computers have aggressively cut prices and lowered product margins. The Company also faces increased competition in certain of its key market segments, including consumer, education, professional and +consumer digital video editing, and design and publishing. An increasing number of Internet devices that include software applications and are smaller and simpler than traditional personal computers +compete for market share with the Company's existing products. 14 The +Company is currently the only maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer market, which is dominated by makers of computers using competing +operating systems, most notably Windows. The Company's financial condition and operating results substantially depend on its ability to continually develop improvements to the Mac platform to maintain +perceived design and functional advantages. Use of unauthorized copies of the Mac OS on other companies' hardware products may result in decreased demand for the Company's hardware products, and +materially adversely affect its financial condition and operating results. The +Company is currently focused on opportunities related to digital content distribution, consumer electronic devices, including iPod and Apple TV, and mobile communication devices, including iPhone. +The Company faces substantial competition from companies that have significant technical, marketing, distribution, and other resources, as well as established hardware, software, and digital content +supplier relationships, and also competes with illegitimate ways to obtain digital content. The Company expects competition to intensify as competitors attempt to imitate the Company's approach to +providing these components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. Some current and potential competitors have substantial resources and +experience, and they may be able to provide such products and services at little or no profit or even at a loss. There can be no assurance the Company will be able to continue to provide products and +services that effectively compete. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the personal computer, consumer electronics and mobile communication industries, the Company must continually introduce new +products and technologies, enhance existing products, and effectively stimulate customer demand for new and upgraded products. The success of new product introductions depends on a number of factors, +including timely and successful completion of development efforts, market acceptance, the Company's ability to manage the risks associated with new products and production ramp issues, the +availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in +appropriate quantities and costs to meet anticipated demand, and the risk that new products may have quality or +other defects in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect new product introductions and transitions will have on financial condition +and operating results. The Company faces substantial inventory and other asset risk. The Company records a write-down for product and component inventories that have become obsolete or are in excess of anticipated demand or net realizable value and +accrues necessary reserves for cancellation fees for orders of products and components that have been cancelled. The Company also reviews its long-lived assets for impairment whenever +events or changed circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment exists, it records a write-down equal to the +amount by which the carrying value of the assets exceeds its fair market value. Although the Company believes its inventory, asset, and related provisions are currently adequate, given the rapid and +unpredictable pace of product obsolescence in the global personal computer, consumer electronics, and mobile communication industries, no assurance can be given that the Company will not incur +additional inventory or asset related charges. Such charges have had, and may have, a material adverse effect on the Company's financial condition and operating results. The +Company must order components for its products and build inventory in advance of product announcements and shipments. Because the Company's markets are volatile, competitive and subject to rapid +technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient inventories of components or products. Consistent with industry +practice, components are normally acquired through a combination of purchase orders, supplier contracts, and open orders based on projected demand. Such purchase commitments typically cover forecasted +component and 15 manufacturing +requirements for 30 to 150 days. The Company's financial condition and operating results have been in the past and may in the future be materially adversely affected by the +Company's ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results depend upon the Company's ability to obtain key components, including microprocessors and NAND flash memory, at favorable prices and in sufficient +quantities. Because the Company currently obtains certain key components, including microprocessors, enclosures, certain LCDs, certain optical drives, and application-specific integrated +circuits ("ASICs"), from single or limited sources, the Company is subject to significant supply and pricing risks. Many of these and other key components that are available from multiple sources, +including NAND flash memory, DRAM memory, and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. The Company has entered into +certain agreements for the supply of critical components at favorable pricing, but there is no guarantee that the Company will be +able to extend or renew these agreements on favorable terms upon expiration or otherwise obtain favorable pricing in the future. Therefore, the Company remains subject to significant risks of supply +shortages and/or price increases that can have a material adverse effect on its financial condition and operating results. The Company expects to experience decreases in its gross margin percentage in +fiscal year 2008, as compared to levels achieved during fiscal year 2007, due in part to current and expected future price increases for certain components. See "Management's Discussion and Analysis +of Financial Condition and Results of Operations—Gross Margin." The +Company's new products often use custom components from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. Where a +component or product uses new technologies, initial capacity constraints may exist until the suppliers' yields have matured. The Company and other producers in the personal computer, consumer +electronics and mobile communication industries also compete for various components with other industries that have experienced increased demand for their products. The Company uses some custom +components that are not common to the rest of the personal computer, consumer electronics or mobile communication industries. Continued availability of these components at acceptable prices may be +affected if producers decide to concentrate on the production of components other than those customized to meet the Company's requirements. If the supply of a key component for a new or existing +product were delayed or constrained, or if such components were available only at significantly higher prices, the Company's financial condition and operating results could be materially adversely +affected. The Company depends on component and product manufacturing and logistics services provided by third parties, many of whom are located outside of the U.S. Most of the Company's components and products are manufactured in whole or in part by third-party manufacturers, most of which are located outside of the U.S. A significant +concentration of this outsourced manufacturing is currently performed by only a few third-party manufacturers, often in single locations. The Company has also outsourced much of its transportation and +logistics management. While these arrangements may lower operating costs, they also reduce the Company's direct control over production and distribution. It is uncertain what effect such diminished +control will have on the quality or quantity of products or services, or the Company's flexibility to respond to changing conditions. In addition, the Company relies on third-party manufacturers to +adhere to the Company's supplier code of conduct. Although arrangements with such manufacturers may contain provisions for warranty expense reimbursement, the Company may remain responsible to the +consumer for warranty service in the event of product defects. Any unanticipated product defect or warranty liability, whether pursuant to arrangements with contract manufacturers or otherwise, could +have a material adverse effect on the Company's reputation, financial condition and operating results. Final +assembly of the Company's products is currently performed in the Company's manufacturing facility in Cork, Ireland, and by external vendors in California, Korea, China and the Czech Republic. +Currently, 16 the +supply and manufacture of many critical components is performed by sole-sourced third-party vendors in the U.S., China, Japan, Korea, and Singapore. Sole-sourced third- +party vendors in China perform final assembly of substantially all of the Company's portable products, including MacBook Pros, MacBooks, iPods and iPhones. If manufacturing or logistics in these +locations is disrupted for any reason, including natural disasters, information technology system failures, military actions or economic, business, labor, environmental, public health, or political +issues, the Company's financial condition and operating results could be materially adversely affected. The Company relies on third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with third parties to offer their digital content through the Company's iTunes Store. The Company pays substantial fees to obtain the rights to this +content. The Company's licensing arrangements with these third parties are short-term and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. +Some third-party content providers currently or may in the future offer competing products and services, and could take action to make it more difficult or impossible for the Company to license their +content in the future. Other content owners, providers or distributors may seek to limit the Company's access to, or increase the total cost of, such content. If the Company is unable to continue to +offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach, the Company's financial condition and operating results may be materially +adversely affected. Many +third-party content providers require that the Company provide certain digital rights management ("DRM") and other security solutions. If these requirements change, the Company may have to +develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In +addition, certain countries have passed or may propose legislation that would force the Company to license its DRM, which could lessen the protection of content and subject it to piracy and could also +affect arrangements with the Company's content providers. The Company relies on access to third-party patents and intellectual property, and the Company's future results could be materially adversely affected if it is alleged +or found to have infringed intellectual property rights. Many of the Company's products are designed to include third-party intellectual property, and it may be necessary in the future to seek or renew licenses relating to various +aspects of its products and business methods. Although the Company believes that, based on past experience and industry practice, +such licenses generally could be obtained on commercially reasonable terms, there is no assurance that the necessary licenses would be available on acceptable terms or at all. Because +of technological changes in the global personal computer, consumer electronics and mobile communication industries, current extensive patent coverage, and the rapid issuance of new patents, it +is possible that certain components of the Company's products and business methods may unknowingly infringe the patents or other intellectual property rights of third parties. From time to time, the +Company has been notified that it may be infringing such rights. Responding to such claims, regardless of their merit, can consume significant time and expense, and several pending claims are in +various stages of evaluation. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no assurance can be given that such licenses can be obtained +on acceptable terms or that litigation will not occur. If there is a temporary or permanent injunction prohibiting the Company from marketing or selling certain products or a successful claim of +infringement against the Company requires it to pay royalties to a third party, the Company's financial condition and operating results could be materially adversely affected. Information regarding +certain claims and litigation related to alleged patent infringement and other matters is set forth in Part I, Item 3, "Legal Proceedings." In management's opinion, the Company does not have a +potential liability for damages or royalties from any known current legal proceedings or claims related to the infringement of patent or other intellectual property rights that would individually or +in the 17 aggregate +have a material adverse effect on its financial condition and operating results. However, the results of such legal proceedings cannot be predicted with certainty. Should the Company fail to +prevail in any of the matters related to infringement of patent or other intellectual property rights of others described in Part I, Item 3, "Legal Proceedings," or should several of these +matters be resolved against the Company in the same reporting period, the Company's financial condition and operating results could be materially adversely affected. With +the June 2007 introduction of iPhone, the Company has begun to compete with mobile communication device companies that hold significant patent portfolios. Regardless of the scope or validity of +such patents or the merits of any potential patent claims by competitors, the Company may have to engage in protracted litigation, enter into expensive agreements or settlements and/or modify its +products. Any of these events could have a material adverse impact on the Company's financial condition and operating results. The Company's products experience quality problems from time to time that can result in decreased sales and operating margin. The Company sells highly complex hardware and software products that can contain defects in design and manufacture. Sophisticated operating system software and applications, +such as those sold by the Company, often contain "bugs" that can unexpectedly interfere with the software's operation. Defects may also occur in components and products the Company purchases from +third parties. There can be no assurance that the Company will be able to detect and fix all defects in the hardware and software it sells. Failure to do so could result in lost revenue, harm to +reputation, and significant warranty and +other expenses, and could have a material adverse impact on the Company's financial condition and operating results. The Company expects its quarterly revenue and operating results to fluctuate for a variety of reasons. The Company's profit margins vary among its products and its distribution channels. The Company's software, accessories, and service and support contracts generally have higher +gross margins than certain of the Company's other products, including third-party content from the iTunes Store. Gross margins on the Company's hardware products vary across product lines and can +change over time as a result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company's direct sales generally have higher +associated gross margins than its indirect sales through its channel partners. In addition, the Company's gross margin and operating margin percentages, as well as overall profitability, may be +materially adversely impacted as a result of a shift in product, geographic or channel mix, or new product announcements. The Company generally sells more products during the third month of each +quarter than it does during either of the first two months. This sales pattern can produce pressure on the Company's internal infrastructure during the third month of a quarter and may adversely +affect the Company's ability to predict its financial results accurately. Furthermore, the Company has typically experienced greater net sales in the first and fourth fiscal quarters compared to other +quarters in the fiscal year due to seasonal demand related to the holiday season and the beginning of the school year. Developments late in a quarter, such as +lower-than-anticipated demand for the Company's products, an internal systems failure, or failure of one of the Company's key logistics, components supply, or manufacturing +partners, could have a material adverse impact on the Company's financial condition and operating results. The Company currently relies on a single cellular network carrier for iPhone in each of the U.S., U.K., Germany and France. AT&T, O2, T-Mobile and Orange are the Company's cellular network carriers for iPhone in the U.S., U.K., Germany and France, respectively. If these carriers cannot +successfully compete with other carriers in their markets for any reason, including but not limited to the quality and coverage of wireless voice and data services, performance and timely +build-out of advanced wireless networks, and pricing and terms of 18 end-user +contracts, iPhone sales may be adversely affected. Because the Company's agreements require each carrier to make revenue-generating payments to the Company, a carrier's +non-performance under or termination of an agreement, or its inability to attract and retain iPhone customers, could have a material adverse effect on the Company's future financial +condition and operating results. If, contrary to the Company's license agreements or product specifications, an iPhone is "unlocked" from an authorized carrier's network, the Company would not receive +payments related to that iPhone from such carrier, which could have a material adverse effect on the Company's future financial condition and operating results. The Company may choose to enter into +arrangements with carriers in other countries or regions, and the same risks described above would also apply to those arrangements. The Company is subject to risks associated with laws, regulations and industry-imposed standards related to mobile communications devices. Laws and regulations related to mobile communications devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes, which +could include but are not limited to restrictions on production, manufacture, distribution, and use of the device, locking the device to a carrier's network, or mandating the use of the device on more +than one carrier's network, may have a material adverse effect on the Company's financial condition and operating results. Mobile +communication devices, such as iPhone, are subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. +These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications or delays in product shipment dates, which may have a +material adverse effect on the Company's financial condition and operating results. Failure of information technology systems and breaches in data security could adversely affect the Company's financial condition and operating results. Information technology system failures and breaches of data security could disrupt the Company's operations by causing delays or cancellation of customer orders, impeding the +manufacture or shipment of products, or resulting in the unintentional disclosure of customer or Company information. Management has taken steps to address these concerns by implementing sophisticated +network security and internal control measures. There can be no assurance, however, that a system failure or data security breach will not have a material adverse effect on the Company's financial +condition and operating results. The Company's stock price may be volatile. The Company's stock has at times experienced substantial price volatility as a result of variations between its actual and anticipated financial results and as a result of +announcements by the Company and its competitors. The stock market as a whole has also experienced extreme price and volume fluctuations that have affected the market price of many technology +companies in ways that may have been unrelated to these companies' operating performance. Furthermore, the Company believes its stock price reflects high future growth and profitability expectations. +If the Company fails to meet these expectations its stock price may significantly decline. Economic conditions, political events, war, terrorism, public health issues, natural disasters and other circumstances could materially adversely affect the Company. The Company's operations and performance depend significantly on worldwide economic conditions. War, terrorism, geopolitical uncertainties, public health issues, and other +business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus may have a strong negative effect on the Company, its suppliers, +logistics providers, manufacturing vendors and customers. The Company's business operations are subject to interruption by natural disasters, fire, power shortages, terrorist attacks, and other +hostile acts, labor disputes, public health issues, and other events beyond its control. Such events could decrease demand for the Company's products, make it difficult or 19 impossible +for the Company to make and deliver products to its customers or to receive components from its suppliers, and create delays and inefficiencies in the Company's supply chain. Should major +public health issues, including pandemics, arise, the Company could be negatively affected by more stringent employee travel restrictions, additional limitations in freight services, governmental +actions limiting the movement of products between regions, delays in production ramps of new products, and disruptions in the operations of the Company's manufacturing vendors and component suppliers. +The majority of the Company's research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including certain component +suppliers and manufacturing vendors, are located near major seismic faults. Because the Company does not carry earthquake insurance for direct quake-related losses and significant recovery time could +be required to resume operations, the Company's financial condition and operating results could be materially adversely affected in the event of a major earthquake. The Company's success depends largely on its ability to attract and retain key personnel. Much of the Company's future success depends on the continued service and availability of skilled personnel, including its CEO, its executive team and key employees in +technical, marketing and staff positions. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in the Silicon Valley, where the +majority of the Company's key employees are located. The Company has relied on equity awards as one means for recruiting and retaining this highly skilled talent. Recent accounting regulations +requiring the expensing of stock options have resulted in increased stock-based compensation expense, which has caused the Company to reduce the number of stock-based awards issued to employees. There +can be no assurance that the Company will continue to successfully attract and retain key personnel. Unfavorable results of legal proceedings could materially adversely affect the Company. The Company is subject to various legal proceedings and claims that are discussed in Part I, Item 3, "Legal Proceedings." The Company is also subject to other legal +proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. Results of legal proceedings cannot be predicted with certainty. Regardless of its +merit, litigation may be both +time-consuming and disruptive to the Company's operations and cause significant expense and diversion of management attention. Should the Company fail to prevail in certain matters, or +should several of these matters be resolved against the Company in the same reporting period, the Company's financial condition and operating results could be materially adversely affected. The Company's business is subject to the risks of international operations. The Company derives a large portion of its revenue from its international operations. As a result, its financial condition and operating results could be significantly affected +by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries), and changes in the value of +the U.S. dollar versus local currencies. Margins on sales of the Company's products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be +materially adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. The +Company's primary exposure to movements in foreign currency exchange rates relate to non-U.S. dollar denominated sales in Europe, Japan, Australia, Canada, and certain parts of Asia +and non-dollar denominated operating expenses incurred throughout the world. Weaknesses in foreign currencies, particularly the Japanese Yen and the Euro, can adversely affect demand for +the Company's products and the U.S. dollar value of the Company's foreign currency-denominated sales. Conversely, a strengthening in these and other foreign currencies can cause the Company to modify +international pricing and affect the value of the Company's foreign denominated sales and may also increase the cost of product components. 20 The +Company has used derivative instruments, such as foreign exchange forward and option positions, to hedge exposures to fluctuations in foreign currency exchange rates. The use of such hedging +activities may not offset more than a portion of the adverse financial effect resulting from unfavorable movements in foreign exchange rates. Further +information related to the Company's global market risks may be found in Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk," under the subheading "Foreign +Currency Risk," and in Part II, Item 8, "Financial Statements and Supplementary Data," at Note 1, "Summary of Significant Accounting Polices" and Note 2, "Financial Instruments" +of Notes to Consolidated Financial Statements. The Company's retail initiative has required and will continue to require a substantial investment and commitment of resources and is subject to numerous risks and +uncertainties. Through September 29, 2007, the Company had opened 197 retail stores. The Company's retail initiative has required substantial fixed investment in equipment and +leasehold improvements, information systems, inventory, and personnel. The Company has also entered into substantial operating lease commitments for retail space with terms ranging from 5 to +20 years, the majority of which are for 10 years. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles +for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company's more typical retail +stores. A substantial decline in sales, the closure or poor performance of individual or multiple stores, or the termination of the retail initiative could result in significant lease termination +costs, write-offs of equipment and leasehold improvements, and severance costs that could have a material adverse impact on the Company's financial condition and operating results. Many +factors unique to retail operations, some of which are beyond the Company's control, pose risks and uncertainties that could have a material adverse effect on the Retail segment's future results, +cause its actual results to differ from anticipated results and have a material adverse effect on the Company's financial condition and operating results. These risks and uncertainties include, among +other things, macro-economic factors that have a negative effect on general retail activity, inability to manage costs associated with store construction and operation, inability to sell third-party +products at adequate margins, failure to manage relationships with existing retail channel partners; lack of experience in managing retail operations outside the U.S., costs associated with +unanticipated fluctuations in the value of retail inventory, and inability to obtain and renew leases in quality retail locations at a reasonable cost. The Company's future performance depends on support from third-party software developers. If third-party software applications cease to be developed and maintained for the +Company's hardware products, customers may choose not to buy the Company's products. The Company believes decisions by customers to purchase the Company's hardware products are often based on the availability of third-party application software, such as +Microsoft Office. There is no assurance that third-party developers will continue to develop and maintain applications for the Company's hardware products on a timely basis or at all, and +discontinuance or delay of these applications could have a material adverse effect on the Company's financial condition and operating results. The Company believes the availability of third-party +applications depends in part on the developers' perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company's products versus Windows-based +products. This analysis may be based on factors such as the perceived strength of the Company and its products, the anticipated revenue that may be generated, continued acceptance by customers of Mac +OS X, and the costs of developing such applications. If the Company's minority share of the global personal computer market causes developers to question the Company's prospects, developers could be +less inclined to develop or upgrade software for the Company's products and more inclined to devote their resources to developing and upgrading software for the larger Windows market. The Company's +development of its own software applications may also negatively affect 21 the +decisions of third-party developers, such as Microsoft and Adobe, to develop, maintain, and upgrade similar or competitive software for the Company's products. Mac OS X Leopard, which became +available in October 2007, includes a new feature that enables Intel-based Mac systems to run Windows XP and Windows Vista. This feature may deter developers from creating software applications +for Mac OS X if such applications are already available for the Windows platform. During +calendar year 2006, the Company transitioned its Mac line of computers from PowerPC to Intel microprocessors. The Company depends on third-party developers to timely develop current and future +Universal applications. A Universal version of Microsoft Office and certain other important applications are currently not available. The lack of Universal applications that run on Intel-based Mac +systems could have a material adverse effect on the Company's financial condition and operating results. Investment in new business strategies and initiatives could disrupt the Company's ongoing business and present risks not originally contemplated. The Company has invested, and may in the future invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including +distraction of management from current operations, insufficient revenue to offset liabilities assumed and expenses associated with the strategy, inadequate return of capital, and unidentified issues +not discovered in the Company's due diligence. Because these new ventures are inherently risky, no assurance can be given that such strategies and initiatives will be successful and will not have a +material adverse effect on the Company's financial condition and operating results. The Company's future operating performance depends on the performance of distributors and other resellers. The Company distributes its products through wholesalers, resellers, national and regional retailers, value-added resellers, and cataloguers, many of whom distribute products +from competing manufacturers. The Company also sells many of its products and resells third-party products in most of its major markets directly to end-users, certain education customers, +and certain resellers through its online and retail stores. iPhone is distributed through the Company and its exclusive cellular network carriers' distribution channels. Many +resellers operate on narrow product margins and have been negatively affected in the past by weak economic conditions. Some resellers have perceived the expansion of the Company's direct sales as +conflicting with their business interests as distributors and resellers of the Company's products. Such a perception could discourage resellers from investing resources in the distribution and sale of +the Company's products or lead them to limit or cease distribution of those products. The Company's financial condition and operating results could be materially adversely affected if the financial +condition of these resellers weakens, if resellers stopped distributing the Company's products, or if uncertainty regarding demand for the Company's products caused resellers to reduce their ordering +and marketing of the Company's products. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers' stores with Company +employees and contractors and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The Company is exposed to credit risk on its accounts receivable and prepayments related to long-term supply agreements. This risk is heightened during periods when +economic conditions worsen. A substantial majority of the Company's outstanding trade receivables are not covered by collateral or credit insurance. The Company also has unsecured non-trade +receivables resulting from the sale by the Company of components to vendors who manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has entered +into long-term supply agreements to secure supply of NAND flash-memory and has prepaid a total of $1.25 billion under these agreements, of which $208 million had been used as +of September 29, 2007. While the Company has procedures to monitor and 22 limit +exposure to credit risk on its trade and non-trade receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its +credit risk and avoid losses. The Company is subject to risks associated with laws and regulations related to health, safety and environmental protection. The Company's products and services, and the production and distribution of those goods and services, are subject to a variety of laws and regulations. These may require the +Company to offer customers the ability to return a product at the end of its useful life and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and +regulations have recently been passed in several jurisdictions in which the Company operates, including various countries within Europe and Asia, certain Canadian provinces and certain states within +the U.S. Although the Company does not anticipate any material adverse effects based on the nature of its operations and the thrust of such laws, there is no assurance such existing laws or future +laws will not have a material adverse effect on the Company's financial condition and operating results. Changes in the Company's tax rates could affect its future results. The Company's future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of +deferred tax assets and liabilities, or by changes in tax laws or their interpretation. The Company is subject to the continuous examination of its income tax returns by the Internal Revenue Service +and other tax authorities. The Company regularly assesses the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of its provision for taxes. There can be no +assurance that the outcomes from these examinations will not have a material adverse effect on the Company's financial condition and operating results. The Company is subject to risks associated with the availability and coverage of insurance. For certain risks, the Company does not maintain insurance coverage because of cost and/or availability. Because the Company retains some portion of its insurable risks, and in +some cases self-insures completely, unforeseen or catastrophic losses in excess of insured limits may have a material adverse effect on the Company's financial condition and operating +results. Item 1B. Unresolved Staff Comments None. Item 2. Properties The Company's headquarters are located in Cupertino, California. The Company has a manufacturing facility in Cork, Ireland. As of September 29, 2007, the Company leased +approximately 3.7 million square feet of space, primarily in the U.S., and to a lesser extent, in Europe, Japan, Canada, and the Asia Pacific region. The major facility leases are generally for +terms of 3 to 15 years and generally provide renewal options for terms of 3 to 7 additional years. Leased space includes approximately 1.5 million square feet of retail space, a majority +of which is in the U.S. Lease terms for retail space range from 5 to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. The +Company owns a 367,000 square-foot manufacturing facility in Cork, Ireland that also houses a customer support call center. The Company also owns 805,000 square feet of facilities in +Sacramento, California that include warehousing and distribution operations, as well as a customer support call center. In addition, the Company owns approximately 2.4 million square feet of +facilities for research and development and corporate functions in Cupertino, California, including approximately 1.0 million square feet purchased in 2007 and 2006 for the future development +of the Company's second corporate campus in Cupertino, California, and approximately 107,000 square feet for a data center in Newark, California. Outside the U.S., the Company owns additional +facilities totaling approximately 129,000 square feet. The 23 Company +believes its existing facilities and equipment are well maintained and in good operating condition. The +Company has invested in internal capacity and strategic relationships with outside manufacturing vendors, and therefore believes it has adequate manufacturing capacity for the foreseeable future. +The Company continues to make investments in capital equipment as needed to meet anticipated demand for its products. Item 3. Legal Proceedings The Company is subject to various legal proceedings and claims as of September 29, 2007, the end of the annual period covered by this report, that are discussed below. +The Company is also subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and +which have not been fully adjudicated. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in +the aggregate have a material adverse effect on its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to +prevail in any of these legal matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period +could be materially adversely affected. The Company settled certain matters during the fourth quarter of 2007 that did not individually or in the aggregate have a material impact on the Company's +results of operations. Apple Computer, Inc. v. Burst.com, Inc. The Company filed an action for declaratory judgment against defendant Burst.com, Inc. on January 4, 2006 in the United States District Court for the Northern +District of California. The Company seeks declaratory judgment that U.S. Patent Nos. 4,963,995, 5,164,839, 5,057,932 and 5,995,705 ("Burst patents") are invalid and not infringed by the Company. Burst +filed an answer and counterclaim on April 17, 2006 adding infringement allegations relating to U.S. Patent No. 5,995,705. Apple counterclaimed for declaratory judgment that each of these +patents is invalid, not infringed and unenforceable. Burst alleges that the following Apple products and services infringe the four patents at issue: iTunes Store, iPod devices, iTunes software, iLife +software (GarageBand, iMovie, iWeb) separately and in conjunction with the .Mac service and Apple computers sold with or running iTunes or iLife. The Burst patents allegedly relate to methods and +devices used for faster-than-real-time transmission of compressed audio and/or video files. The court issued its claim construction ruling on May 8, 2007. +The Company filed motions for summary judgment of invalidity on January 4, 2007 and July 13, 2007. The court held a hearing on those pending motions on September 18, 2007 and has +not issued a decision. The Company filed motions for summary judgment and partial summary judgment relating to enablement, indefiniteness and laches on October 29, 2007. Trial is set for +February 26, 2008. Bader v. Anderson, et al. Plaintiff filed this purported shareholder derivative action against the Company and each of its then current executive officers and members of its Board of Directors on +May 19, 2005 in Santa Clara County Superior Court asserting claims for breach of fiduciary duty, material misstatements and omissions and violations of California Business & Professions +Code §17200 (unfair competition). The complaint alleged that the Company's March 14, 2005, proxy statement was false and misleading for failure to disclose certain information +relating to the Apple Computer, Inc. Performance Bonus Plan, which was approved by shareholders at the annual meeting held on April 21, 2005. Plaintiff, who ostensibly brings suit on the +Company's behalf, made no demand on the Board of Directors and alleged that such demand was excused. The complaint sought injunctive and other relief for purported injury to the Company. On +July 27, 2005, plaintiff filed an amended complaint alleging that, in addition to the purported derivative claims, adoption of the bonus plan and distribution of the proxy statement describing +that plan also inflicted injury on her directly as an individual shareholder. On January 10, 2006, the Court sustained defendants' demurrer to 24 the +amended complaint, with leave to amend. Plaintiff filed a second amended complaint on February 7, 2006, and the Company filed a demurrer. After a hearing on June 13, 2006, the Court +sustained the demurrer without leave to amend as to the non-director officers and with leave to amend as to the directors. On July 24, 2006, plaintiff filed a third amended +complaint, which purported to bring claims derivatively as well as directly on behalf of a class of common stockholders who have been or will be harmed by virtue of the allegedly misleading proxy +statement. In addition to reasserting prior causes of action, the third amended complaint included a claim that the Company violated the terms of the plan, and a claim for waste related to restricted +stock unit grants to certain officers in 2003 and 2004 and an option grant to the Company's CEO in January 2000. The Company filed a demurrer to the third amended complaint. On +January 30, 2007, the Court sustained the Company's demurrer with leave to amend. On May 8, 2007, plaintiff filed a fourth amended complaint. The Company filed a demurrer to the fourth +amended complaint, which the court sustained, without leave to amend, on October 12, 2007. On October 25, 2007, the Court entered a final judgment in favor of defendant and ordered the +case dismissed with prejudice. Birdsong v. Apple Computer, Inc. This action alleges that the Company's iPod music players, and the ear bud headphones sold with them, are inherently defective in design and are sold without adequate warnings +concerning the risk of noise-induced hearing loss by iPod users. The Birdsong action was initially filed on January 30, 2006 in the United States District Court for the Western District of +Louisiana asserting Louisiana causes of action on behalf of a purported Louisiana class of iPod purchasers. A similar action (Patterson v. Apple +Computer, Inc.) was filed on January 31, 2006 in the United States District Court for the Northern District of California asserting California causes of action on +behalf of a purported class of all iPod purchasers within the four-year period before January 31, 2006. The Birdsong action was transferred to the Northern District of California, +and the Patterson action was dismissed. An amended complaint was subsequently filed in Birdsong, dropping the Louisiana law-based claims and adding California law-based claims +equivalent to those in Patterson. After the Company filed a motion to dismiss on November 3, 2006, plaintiffs agreed not to oppose the motion and filed a second amended complaint on +January 16, 2007. That complaint alleges California +law-based claims for breaches of implied and express warranties, violations of California Business & Professions Code §17200 (unfair competition), California +Business & Professions Code §17500 (false advertising), the Consumer Legal Remedies Act and negligent misrepresentation on behalf of a putative nationwide class and a Louisiana +law-based claim for redhibition for a Louisiana sub-class. On March 1, 2007, the Company filed a motion to dismiss the California law based claims. The court held a +hearing on the motion to dismiss on June 4, 2007 but has not yet issued a ruling. A +similar complaint, Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc., was filed in Montreal, Quebec, Canada, on +February 1, 2006, seeking authorization to institute a class action on behalf of iPod purchasers in Quebec. At the request of plaintiffs' counsel, the court has postponed class certification +proceedings in this action indefinitely. Branning et al. v. Apple Computer, Inc. Plaintiffs originally filed this purported class action in San Francisco County Superior Court on February 17, 2005. The initial complaint alleged violations of +California Business & Professions Code §17200 (unfair competition) and violation of the Consumer Legal Remedies Act ("CLRA") regarding a variety of purportedly unfair and unlawful +conduct including, but not limited to, allegedly selling used computers as new and failing to honor warranties. Plaintiffs also brought causes of action for misappropriation of trade secrets, breach +of contract and violation of the Song-Beverly Consumer Warranty Act. Plaintiffs requested unspecified damages and other relief. On May 9, 2005, the Court granted the Company's +motion to transfer the case to Santa Clara County Superior Court. On May 2, 2005, plaintiffs filed an amended complaint adding two new named plaintiffs and three new causes of action including +a claim for treble damages under the Cartwright Act (California Business & Professions Code § 25 16700 +et seq.) and a claim for false advertising. The Company filed a demurrer to the amended complaint, which the Court sustained in its entirety on November 10, 2005. The Court granted +plaintiffs leave to amend and they filed an amended complaint on December 29, 2005. Plaintiffs' amended complaint added three plaintiffs and alleged many of the same factual claims as the +previous complaints, such as alleged selling of used equipment as new, alleged failure to honor warranties and service contracts for the consumer plaintiffs, and alleged fraud related to the opening +of the Apple retail stores. Plaintiffs continued to assert causes of action for unfair competition (§17200), violations of the CLRA, breach of contract, misappropriation of trade secrets, +violations of the Cartwright Act, and alleged new causes of action for fraud, conversion, and breach of the implied covenant of good faith and fair dealing. The Company filed a demurrer to the amended +complaint on January 31, 2006, which the Court sustained on March 3, 2006 on sixteen of seventeen causes of action. Plaintiffs filed an amended complaint adding one new plaintiff. The +Company filed a demurrer, which was granted in part on September 9, 2006. Plaintiffs filed a further amended complaint on September 21, 2006. On October 2, 2006, the Company filed +an answer denying all allegations and asserting numerous affirmative defenses. European Commission Investigation The European Commission is investigating certain matters relating to the iTunes Stores in Europe. The European Commission had previously notified the Company that it was +investigating claims made by Which?, a United Kingdom ("U.K.") consumer association, that the Company is violating EU competition law by charging more for online music in the U.K. than in Eurozone +countries and preventing U.K. consumers from purchasing online music from the iTunes Stores for Eurozone countries. The Which? claims were originally lodged with the U.K. Office of Fair Trading, which +subsequently referred them to the European Commission. On +March 30, 2007, the European Commission issued Statements of Objections to the major record labels, Apple Inc. and iTunes S.à.r.l. In the Statements of Objections, the +Commission challenges provisions in the agreements pursuant to which each major record company authorizes iTunes S.à.r.l. to distribute digital music downloads through the iTunes Store. +The Commission contends that, because of these provisions, residents of the European Economic Area are only permitted to buy music from the iTunes Store for the country that issued the customer's +credit card. The Commission contends that these provisions are territorial sales restrictions which violate Article 81 of the European Community Treaty. The Commission seeks fines and +behavioral relief. The Company filed its responses to the Statements of Objections on June 20, 2007. A hearing on the Statements of Objections took place in Brussels, Belgium on +September 19, 2007. Gordon v. Apple Computer, Inc. Plaintiff filed this purported class action on August 31, 2006 in the United States District Court for the Northern District of California, San Jose Division, on behalf +of a purported nationwide class of consumers who purchased 65W Power Adapters for iBooks and Powerbooks between November 2002 and the present. The complaint alleges various problems with the +65W Adapter, including fraying, sparking, and premature failure. Plaintiffs allege violations of California Business & Professions Code §17200 (unfair competition), the Consumer +Legal Remedies Act, the Song-Beverly Consumer Warranty Act and breach of warranties. The complaint seeks damages and equitable relief. The Company filed an answer on October 20, +2006 denying the material allegations and asserting numerous affirmative defenses. Harvey v. Apple Inc. Plaintiff filed this action on August 6, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement by the +Company of U.S. Patent No. 6,753,671 entitled "Recharger for use with a portable electronic device and which includes a proximally located light emitting 26 device" and U.S. Patent No. 6,762,584 entitled "Recharger for use with a portable electronic device and which includes a connector terminus for communicating with rechargeable batteries +contained within the device." The complaint seeks unspecified damages and other relief. The Company filed an answer on October 12, 2007 denying all material allegations and asserting numerous +affirmative defenses. The Company also asserted counterclaims for declaratory judgment of noninfringement and invalidity. Honeywell International, Inc., et al. v. Apple Computer, Inc., et al. Plaintiffs Honeywell International, Inc. and Honeywell Intellectual Properties, Inc. filed this action on October 6, 2004 in the United States District +Court in Delaware alleging infringement by the Company and other defendants of U.S. Patent 5,280,371 entitled "Directional Diffuser for a Liquid Crystal Display." Plaintiffs seek unspecified damages +and other relief. The Company filed an answer on December 21, 2004 denying all material allegations and asserting numerous affirmative defenses. The Company has tendered the case to several +liquid crystal display manufacturer suppliers. On May 18, 2005 the Court stayed the case against the Company and the other non-manufacturer defendants. Plaintiffs filed an amended +complaint on November 7, 2005 adding additional defendants and expanding the scope of the accused products. Given the stay, the Company's response to the amended complaint is not yet due. In re Apple Computer, Inc. Derivative Litigation (formerly Karant v. Jobs, et al. and Related Actions) (Federal Action) On June 30, 2006, a putative derivative action captioned Karant v. Jobs, et. al. , was filed in the United States District +Court for the Northern District of California, San Jose Division. A number of related actions were filed in the subsequent weeks and have been consolidated into a single action captioned In re Apple Computer, Inc. +Derivative Litigation , Master File No. C-06-04128-JF before the Hon. Jeremy +Fogel. The actions were filed after the Company's announcement on June 29, 2006 that an internal investigation had discovered irregularities related to the issuance of certain stock option +grants made between 1997 and 2001, that a special committee of the Company's outside directors had retained independent counsel to perform an investigation and that the Company had informed the +Securities and Exchange Commission. The action purports to assert claims on behalf of the Company against several current and former executive officers and members of the Board of Directors alleging +improper backdating of stock option grants to maximize certain defendants' profits, failing to properly account for and take tax deductions for those grants, insider trading, and issuing false +financial statements. The Company is named as a nominal defendant. The consolidated complaint alleges various causes of action under federal and California law, including claims for unjust enrichment, +breach of fiduciary duty, violation of the California Corporations Code, abuse of control, gross mismanagement, rescission, constructive fraud and waste of corporate assets, as well as claims under +Sections 10(b), 14(a) and 20(a) of the Securities Exchange Act. Plaintiffs seek damages, disgorgement, restitution and imposition of a +constructive trust. A Consolidated Shareholder Derivative Complaint was filed on December 18, 2006, and a First Amended Shareholder Derivative Complaint was filed on March 6, 2007. +Defendants filed a motion to dismiss on April 20, 2007, which was heard on September 7, 2007. On +June 12, 2007, the Company's Board of Directors approved a resolution appointing a Special Litigation Committee to make all decisions relating to options litigation. In re Apple Computer, Inc. Derivative Litigation (formerly Plumbers and Pipefitters v. Jobs, et al. and Related Actions) (State Action); Boston Retirement Board v. Apple +Computer, Inc. On July 5, 2006, a putative derivative action captioned Plumbers and Pipefitters v. Jobs, et. al. , was filed in +California Superior Court for the County of Santa Clara. A number of related actions were filed in the subsequent weeks, and have been consolidated into a single action captioned In re Apple Computer, Inc. Derivative +Litigation , No. 1:06CV066692, assigned to the Hon. Joseph Huber. These actions purport to assert +claims on behalf of the Company against several current and former executive officers and members of the Board of Directors alleging improper backdating of stock option grants to maximize certain 27 defendants' +profits, failing to properly account for and take tax deductions for those grants and issuing false financial statements. The Company is named as a nominal defendant. A consolidated +complaint was filed on October 5, 2006, alleging a variety of causes of action under California law, including claims for unjust enrichment, breach of fiduciary duty, violation of the +California Corporations Code, abuse of control, accounting, constructive trust, rescission, deceit, gross mismanagement and waste of corporate assets. On December 7, 2006, the Court granted the +Company's motion to stay these actions. On +November 3, 2006, the Boston Retirement Board, a purported shareholder, filed a petition for writ of mandate against the Company in California Superior Court for the County of Santa Clara +County ( Boston Retirement Board v. Apple Computer Inc. ). The petition sought to compel the Company to allow inspection of certain corporate +records relating to the Company's option practices and the Special Committee's investigation. On January 16, 2007, the Company filed a demurrer to the petition. The Court entered an order +overruling the demurrer on March 13, 2007. The Company filed its answer to the petition on April 5, 2007. The trial took place on September 24, 2007. The Court granted the +petition for inspection but narrowed the scope of the records to be produced. In re Apple iPod Nano Products Liability Litigation (formerly Wimmer v. Apple Computer, Inc.; Moschella, et al., v. Apple Computer, Inc. ; Calado, et al. v. Apple Computer, + Inc. ; Kahan, et al., v. Apple Computer, Inc .; Jennings, et al., v. Apple Computer, Inc. ; Rappel +v. Apple Computer, Inc. ; Mayo v. Apple Computer, Inc. ; Valencia v. Apple Computer, Inc. ; Williamson v. Apple Computer, Inc. ; Sioson v. Apple Computer, Inc. Beginning on October 19, 2005, eight complaints were filed in various United States District Courts and two complaints were filed in California State Court alleging that +the Company's iPod nano was defectively designed so that it scratches excessively during normal use, rendering the screen unreadable. The +federal actions were coordinated in the United States District Court for the Northern District of California and assigned to the Hon. Ronald Whyte pursuant to an April 17, 2006 order of the +Judicial Panel on Multidistrict Litigation. Plaintiffs filed a First Consolidated and Amended Master Complaint on September 21, 2006, alleging violations of California and other states' +consumer protection and warranty laws and claiming unjust enrichment. The Master Complaint alleges two putative plaintiff classes: (1) all U.S. residents (excluding California residents) who +purchased an iPod nano that was not manufactured or designed using processes necessary to ensure normal resistance to scratching of the screen; and (2) all iPod nano purchasers other than U.S. +residents who purchased an iPod nano that was not manufactured or designed using processes necessary to ensure normal resistance to scratching of the screen. The Company answered the Master Complaint +on November 20, 2006. The +two California State Court actions were coordinated on May 4, 2006, and assigned to the Hon. Carl West in Los Angeles Superior Court. Plaintiffs filed a Consolidated Amended Class Action +Complaint on June 8, 2006, alleging violations of California state consumer protection, unfair competition, false advertising and warranty laws and claiming unjust enrichment. The Consolidated +Complaint alleges a putative plaintiff class of all California residents who own an iPod nano containing a manufacturing defect that results in the nano being susceptible to excessive scratching. The +Company answered the Consolidated Amended Complaint on October 6, 2006. Two +similar complaints, Carpentier v. Apple Canada, Inc ., and Royer-Brennan v. Apple Computer, Inc. and Apple Canada, +Inc . were filed in Montreal, Quebec, Canada on October 27, 2005 and November 9, 2005, respectively, seeking authorization to institute class actions on behalf of +iPod nano purchasers in Quebec. The Royer-Brennan file was stayed in May 2006 in favor of the Carpentier file. A similar complaint, Mund v. Apple Canada Inc. and +Apple Computer, Inc. , was filed in Ontario, Canada on January 9, 2006 seeking authorization to institute a class action on behalf of iPod nano purchasers in +Canada. Apple Canada Inc. and Apple Computer, Inc. have served Notices of Intent to Defend. 28 Individual Networks, LLC v. Apple, Inc. Plaintiff filed this action against the Company on April 24, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging +infringement of U.S. Patent No. 7,117,516, entitled "Method and System for Providing a Customized Media List." Plaintiff alleges certain features of the iTunes store infringe the patent. The +complaint seeks unspecified damages and other relief. The Company filed an answer on July 2, 2007, denying all material allegations and asserting numerous affirmative defenses. The Company also +asserted counterclaims for declaratory judgment of noninfringement and invalidity, as well as a counterclaim against Individual Networks LLC for infringement of U.S. Patent No. 5,724,567. The +Markman hearing is set for October 8, 2008, and trial is scheduled for November 9, 2009. Intertainer, Inc. v. Apple Computer, Inc., et al. Plaintiff filed this action on December 29, 2006 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement by the +Company and others of U.S. Patent number 6,925,469 entitled "Digital Entertainment Service Platform." The complaint seeks unspecified damages and other relief. The Company filed an answer on +February 21, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of noninfringement and +invalidity. Lenzi v. Apple Canada, Inc.; Wolfe v. Apple Computer, Inc. and Apple Canada, Inc.; Hirst v. Apple Canada, Inc.; Hamilton v. Apple +Computer, Inc. and Apple Canada, Inc. Plaintiff filed a purported class action on June 7, 2005, in Superior Court, in Montreal, Quebec, Canada allegedly on behalf of Quebec customers claiming false +advertising and breach of warranty relating to iPod battery life. Plaintiff sought authorization to institute a class action on behalf of Generations 1, 2 and 3 iPod owners in Quebec. On +February 2, 2006, the Court dismissed plaintiff's motion for authorization to institute a class action. Plaintiff has appealed this ruling. Two +similar complaints relative to iPod battery life, Wolfe v. Apple and Hirst v. Apple , were filed in +Toronto, Ontario, Canada on August 15, 2005 and September 12, 2005, respectively. Counsel subsequently amended the complaint, now called Waddell vs. +Apple . The Waddell lawsuit is brought on behalf of all Canadian purchasers other than Quebec purchasers. On January 17, 2006, the Company filed its statement of defence +to the Waddell complaint. In addition, a similar complaint regarding iPod battery life, Hamilton v. Apple Computer, Inc. and Apple +Canada, Inc. was filed in Calgary, Alberta, Canada on October 5, 2005, purportedly on behalf of all purchasers of iPods in Alberta, Canada. The complaint was +served on September 27, 2006. The Company has reached a settlement of this matter and the parties have requested preliminary court approval for the settlement. Settlement of this matter will +not have a material effect on the Company's financial condition or operating results. Macadam v. Apple Computer, Inc.; Santos v. Apple Computer, Inc. (Santa Clara County Superior Court) The +Macadam action was filed in late 2002 asserting various causes of action including breach of contract, fraud, negligent and intentional interference with economic relationship, negligent +misrepresentation, trade libel, unfair competition and false advertising. The complaint requested unspecified damages and other relief. The Company filed an answer on December 3, 2004 denying +all allegations and asserting numerous defenses. On +October 1, 2003, Macadam was deauthorized as an Apple reseller. Macadam filed a motion for a temporary order to reinstate it as a reseller, which the Court denied. The Court denied Macadam's +motion for a preliminary injunction on December 19, 2003. On December 6, 2004, Macadam filed for Chapter 11 bankruptcy in the Northern District of California, which placed a stay on the +litigation as to Macadam. The Company filed a claim in the bankruptcy proceedings on February 16, 2005. The Macadam bankruptcy case was converted to Chapter 7 (liquidation) on April 29, +2005. The Company has reached a settlement of Macadam's claims against the Company with the Chapter 7 Bankruptcy Trustee. The Bankruptcy Court 29 approved +the settlement on July 17, 2006 over the objection of Tom Santos, Macadam's principal. Santos appealed the ruling approving the settlement, but the district court denied the appeal. +Santos has appealed to the Ninth Circuit Court of Appeals. On +December 19, 2005, Tom Santos filed a Fifth Amended Complaint on his own behalf (not on behalf of Macadam) alleging fraud, violations of California Business & Professions Code +§17200 (unfair competition), California Business & Professions Code §17500 (false advertising) and the Consumer Legal Remedies Act. The Company filed a demurrer to +Santos' amended complaint and a special motion to strike the defamation cause of action on January 20, 2006. The Court sustained the demurrer in part but denied the special motion to strike. +Santos filed a Sixth Amended Complaint on July 14, 2006. The Company filed a demurrer, which was granted on September 9, 2006. Santos filed a Seventh Amended Complaint in late September, +2006. The Company filed a motion to strike, which was granted in part and denied in part on December 15, 2006. Santos filed an Eighth Amended Complaint on January 29, 2007. The Company +filed a demurrer, which was heard on May 7, 2007. The court sustained the demurrer, and Santos filed a Ninth Amended Complaint on July 11, 2007. The Company filed a demurrer, which was +overruled. The Company also filed a cross complaint against Santos on January 20, 2006 alleging violations of California Business & Professions Code §17200 and California +Penal Code §502, fraud and deceit and breach of contract. Mediostream, Inc. v. Acer America Corp. et al. Plaintiff filed this action against the Company, Acer America Corp., Dell, Inc. and Gateway, Inc. on August 28, 2007 in the United States District Court +for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent No. 7,009,655, entitled "Method and System for Direct Recording +of Video Information onto a Disk Medium." The complaint seeks unspecified damages and other relief. The Company's response to the complaint is not yet due. OPTi Inc. v. Apple Inc. Plaintiff filed this action against the Company on January 16, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging +infringement of U.S. Patent Nos. 5,710,906, 5,813,036 and 6,405,291, all entitled "Predictive Snooping of Cache Memory for Master-Initiated Accesses." The complaint seeks unspecified damages and other +relief. The Company filed an answer on April 17, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory +judgment of noninfringement and invalidity. Premier International Associates LLC v. Apple Computer, Inc. Plaintiff filed this action on November 3, 2005 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement by the +Company of U.S. Patent Nos. 6,243,725 and 6,763,345 both entitled "List Building System." The complaint sought unspecified damages and other relief. The Company filed an answer on January 13, +2006 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for a declaratory judgment of noninfringement and invalidity. A Markman +hearing was held on May 17, 2007 and the court issued its claim construction ruling on May 23, 2007. Trial was scheduled for December 3, 2007. The parties have reached a +settlement and the matter is concluded. Settlement of this matter did not have a material effect on the Company's financial condition or operating results. Quantum Technology Management, Ltd. v. Apple Computer, Inc. Plaintiff filed this action on December 21, 2005 in the United States District Court for the District of Maryland against the Company and Fingerworks, Ltd., +alleging infringement of U.S. Patent No. 5,730,165 entitled "Time Domain Capacitive Field Detector." The complaint seeks unspecified damages and other relief. On May 11, 2006, Quantum +filed an amended complaint adding Cypress Semiconductor/MicroSystems, Inc. as a defendant. On July 31, 2006, the Company filed an answer denying all material 30 allegations +and asserting numerous affirmative defenses and also filed counterclaims for non-infringement and invalidity. On November 30, 2006, plaintiff filed a reply to the +Company's counterclaims and a More Definite Statement. A Markman hearing was held on May 16, 2007. On June 7, 2007, the court issued a claim construction ruling, and also issued an order +invalidating six of plaintiff's asserted patent claims in response to the Company's motion for partial summary judgment of invalidity. Saito Shigeru Kenchiku Kenkyusho (Shigeru Saito Architecture Institute) v. iPod; Apple Japan Inc. v. Shigeru Saito Architecture Institute Plaintiff Saito filed a petition in the Japan Customs Office in Tokyo on January 23, 2007 alleging infringement by the Company of Japanese Patent No. 3852854, +entitled "Touch Operation Input Device and Electronic Parts Thereof." The petition sought an order barring the importation into Japan of fifth generation iPods and second generation iPod nanos. The +Customs Office held a hearing on March 22, 2007. The Customs Office rejected the petition to bar importation and dismissed plaintiff's case. Apple +Japan, Inc. filed a Declaratory Judgment action against Saito on February 6, 2007, seeking a declaration that the '854 patent is invalid and not infringed. Saito filed a Counter +Complaint for infringement seeking damages. SP Technologies LLC v. Apple Inc. Plaintiff filed this action against the Company on August 2, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging +infringement of U.S. Patent No. 6,784,873 entitled "Method and Medium for Computer Readable Keyboard Display Incapable of User Termination." The complaint seeks unspecified damages and other +relief. The Company's response to the complaint is not yet due. St-Germain v. Apple Canada, Inc. Plaintiff filed this case in Montreal, Quebec, Canada, on August 5, 2005, seeking authorization to institute a class action for the refund by the Company of the Canadian +Private Copying Levy that was applied to the iPod purchase price in Quebec between December 12, 2003 and December 14, 2004 but later declared invalid by the Canadian Court. The Company +has completed a refund program for this levy. A class certification hearing took place January 13, 2006. On February 24, 2006, the Court granted class certification and notice was +published during the last week of March 2006. The trial was conducted on October 15 and 16, 2007. The Court has not yet issued a decision. Texas MP3 Technologies Ltd v. Apple Inc. et al. Plaintiff filed this action against the Company and other defendants on February 16, 2007 in the United States District Court for the Eastern District of Texas, Marshall +Division, alleging infringement of U.S. Patent No. 7,065,417 entitled "MPEG Portable Sound Reproducing System and A Reproducing Method Thereof." The complaint seeks unspecified damages and +other relief. On July 12, 2007, the Company filed a petition for reexamination of the patent, which the U.S. Patent and Trademark Office granted. Plaintiff filed an amended complaint on +August 1, 2007, adding the iPhone as an accused device. On August 2, 2007, the Company filed a motion to stay the litigation pending the outcome of the reexamination, which the Court +denied. The Company filed an answer on August 20, 2007, denying all +material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of noninfringement and invalidity. The Apple iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, Inc.); Black v. Apple Inc. The first-listed action is a consolidated case combining two cases previously pending under the names Charoensak v. Apple Computer Inc. (formerly Slattery v. Apple +Computer Inc.) and Tucker v. Apple Computer, Inc. The original plaintiff (Slattery) in the Charoensak case filed a purported class action on 31 January 3, +2005 in the United States District Court for the Northern District of California alleging various claims including alleged unlawful tying of music purchased on the iTunes Store with +the purchase of iPods and unlawful acquisition or maintenance of monopoly market power. Plaintiff's complaint alleged violations of §§1 and 2 of the Sherman Act (15 U.S.C. +§§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California Business & Professions Code §17200 +(unfair competition), common law unjust enrichment and common law monopolization. Plaintiff sought unspecified damages and other relief. The Company filed a motion to dismiss on February 10, +2005. On September 9, 2005, the Court denied the motion in part and granted it in part. Plaintiff filed an amended complaint on September 23, 2005 and the Company filed an answer on +October 18, 2005. In August 2006, the court dismissed Slattery without prejudice and allowed plaintiffs to file an amended complaint naming two new plaintiffs (Charoensak and Rosen). On +November 2, 2006, the Company filed an answer to the amended complaint denying all material allegations and asserting numerous affirmative defenses. The +Tucker case was filed as a purported class action on July 21, 2006 in the United States District Court for the Northern District of California alleging various claims including alleged +unlawful tying of music and videos purchased on the iTunes Store with the purchase of iPods and vice versa and unlawful acquisition or maintenance of monopoly market power. The complaint alleges +violations of §§1 and 2 of the Sherman Act (15 U.S.C. §§1 and 2), California Business & Professions Code §16700 et seq. (the +Cartwright Act), California Business & Professions Code §17200 (unfair competition) and the California Consumer Legal Remedies Act. Plaintiff sought unspecified damages and other +relief. On November 3, 2006, the Company filed a motion to dismiss the complaint. On December 20, 2006, the Court denied the motion to dismiss. On January 11, 2007, The Company +filed an answer denying all material allegations and asserting numerous defenses. On +March 20, 2007, the Court consolidated the two cases. Plaintiffs filed a consolidated complaint on April 19, 2007. On June 6, 2007, the Company filed an answer to the +consolidated complaint denying all material allegations and asserting numerous affirmative defenses. A +related class action complaint, Black v. Apple Inc ., was filed on August 27, 2007 in the Circuit Court in Broward County, Florida, alleging +that the Company is attempting to maintain a monopoly by precluding customers from using non-iTunes downloads on iPods and from using iTunes music on non-iPod MP3 players. +Plaintiff alleges that the Company's alleged monopolization violates the Florida Antitrust Act and the Florida Deceptive and Unfair Trade Practices Act. Plaintiff seeks unspecified damages and other +relief. The Company removed the case to the United States District Court for the Southern District of Florida on September 28, 2007, and filed a motion to transfer the case to the Northern +District of California on October 12, 2007. The Company's motion to transfer was granted on October 17, 2007. Tse v. Apple Computer, Inc. et al. Plaintiff Ho Keung Tse filed this action against the Company and other defendants on August 5, 2005 in the United States District Court for the District of Maryland +alleging infringement of U.S. Patent No. 6,665,797 entitled "Protection of Software Again [sic] Against Unauthorized Use." The complaint seeks unspecified damages and +other relief. The Company filed an answer on October 31, 2005 denying all material allegations and asserting numerous affirmative defenses. On October 28, 2005, the Company and the other +defendants filed a motion to transfer the case to the Northern District of California, which was granted on August 31, 2006. On July 24, 2007, the Company filed a petition for +reexamination of the patent, which the U.S. Patent and Trademark Office granted. On July 25, 2007, the Company filed a motion to stay the litigation pending the outcome of the reexamination, +which the court granted on October 4, 2007. Union Fédérale des Consummateurs—Que Choisir v. Apple Computer France S.à.r.l. and iTunes S.à.r.l. Plaintiff, a consumer association in France, filed this complaint on February 9, 2005 alleging that the above-listed entities are violating consumer law by +(1) omitting to mention that the iPod is allegedly not 32 compatible +with music from online music services other than the iTunes Store and that the music from the iTunes Store is only compatible with the iPod and (2) allegedly tying the sales of iPods +to the iTunes Store and vice versa. Plaintiff seeks damages, injunctive relief and other relief. The first hearing on the case took place on May 24, 2005. The Company's response to the +complaint was served on November 8, 2005. Plaintiff's responsive pleading was filed on February 10, 2006. The Company filed a reply on June 6, 2006 and UFC filed a response on +September 19, 2006. Vitt v. Apple Computer, Inc. Plaintiff filed this purported class action on November 7, 2006 in the United States District Court for the Central District of California on behalf of a purported +nationwide class of all purchasers of the iBook G4 alleging that the computer's logic board fails at an abnormally high rate. The complaint alleges violations of California Business & +Professions Code §17200 (unfair competition) and California Business & Professions Code §17500 (false advertising). Plaintiff seeks unspecified damages and other relief. +The Company filed a motion to dismiss on January 19, 2007, which the court granted on March 13, 2007. Plaintiffs filed an amended complaint on March 26, 2007. The Company filed a +motion to dismiss on August 16, 2007, which was heard on October 4, 2007. Vogel v. Jobs et al. Plaintiff filed this purported class action on August 24, 2006, in the United States District Court for the Northern District of California against the Company and +certain of the Company's current and former officers and directors alleging improper backdating of stock option grants to maximize certain defendants' profits, failing to properly account for those +grants and issuing false financial statements. On January 19, 2007, the Court appointed the New York City Employees' Retirement System as lead plaintiff. On March 23, 2007, plaintiffs +filed a Consolidated Class Action Complaint. The Consolidated Complaint purports to be brought on behalf of several classes of holders of the Company's stock and asserts claims under +Section 14(a) and 20(a) of the Securities Exchange Act as well as state law. The Consolidated Complaint seeks rescission of amendments to various stock option and other incentive compensation +plans, an accounting and damages in an unspecified amount. Defendants filed a motion to dismiss on June 8, 2007, which was heard on September 7, 2007. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of the Company's fiscal year ended September 29, 2007. 33 PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company's common stock is traded on the over-the-counter market and is quoted on the NASDAQ Global Select Market under the symbol AAPL and on the +Frankfurt Stock Exchange under the symbol APCD. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest sales prices for the Company's common stock on the NASDAQ Global Select Market +during each quarter of the two most recent fiscal years. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2007 price range per common share $ 155.00 - $111.62 $ 127.61 - $89.60 $ 97.80 - $81.90 $ 93.16 - $72.60 Fiscal 2006 price range per common share $ 77.78 - $  50.16 $ 73.80 - $55.41 $ 86.40 - $57.67 $ 75.46 - $47.87 Holders As of November 2, 2007, there were 30,336 shareholders of record. Dividends The Company did not declare or pay cash dividends in either fiscal 2007 or 2006. The Company anticipates that, for the foreseeable future, it will retain any earnings for use +in the operation of its business. Purchases of Equity Securities by the Issuer and Affiliated Purchasers None. 34 Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 +Composite Index (the "S&P 500") and the S&P Computers (Hardware) Index (the "Industry Index"). The graph assumes $100 was invested in each of the Company's common stock, the S&P 500, and the Industry +Index on September 30, 2002. Data points on the graph are annual. Note that historic stock price performance is not necessarily indicative of future stock price performance. Item 6. Selected Financial Data The information set forth below is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, "Management's Discussion and +Analysis of Financial Condition and Results of Operations" and the consolidated financial statements and related notes thereto included in Item 8 of this Form 10-K to fully +understand factors that may affect the comparability of the information presented below. Five fiscal years ended September 29, 2007 (In millions, except share and per share amounts) 2007 2006 2005 2004 2003 Net sales $ 24,006 $ 19,315 $ 13,931 $ 8,279 $ 6,207 Net income $ 3,496 $ 1,989 $ 1,328 $ 266 $ 57 Earnings per common share: Basic $ 4.04 $ 2.36 $ 1.64 $ 0.36 $ 0.08 Diluted $ 3.93 $ 2.27 $ 1.55 $ 0.34 $ 0.08 Cash dividends declared per common share $ — $ — $ — $ — $ — Shares used in computing earnings per share (in thousands): Basic 864,595 844,058 808,439 743,180 721,262 Diluted 889,292 877,526 856,878 774,776 723,352 Cash, cash equivalents, and short-term investments $ 15,386 $ 10,110 $ 8,261 $ 5,464 $ 4,566 Total assets $ 25,347 $ 17,205 $ 11,516 $ 8,039 $ 6,817 Long-term debt (including current maturities) $ — $ — $ — $ — $ 304 Total liabilities $ 10,815 $ 7,221 $ 4,088 $ 2,976 $ 2,594 Shareholders' equity $ 14,532 $ 9,984 $ 7,428 $ 5,063 $ 4,223 35 Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. +Forward-looking statements can also be identified by words such as "anticipates," "expects," "believes," "plans," "predicts," and similar terms. Forward-looking statements are not guarantees of future +performance and the Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not +limited to, those discussed in the subsection entitled "Risk Factors" above. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto +included in Item 8 of this Form 10-K. All information presented herein is based on the Company's fiscal calendar. Unless otherwise stated, references in this report to particular +years or quarters refer to the Company's fiscal years ended in September and the associated quarters of those fiscal years. The Company assumes no obligation to revise or update any forward-looking +statements for any reason, except as required by law. Executive Overview The Company designs, manufactures, and markets personal computers, portable digital music players, and mobile communication devices and sells a variety of related software, +services, peripherals, and networking solutions. The Company's products and services include the Mac® line of desktop and portable computers, the iPod line of portable digital music +players, iPhone, Apple TV, Xserve®, and Xserve RAID, a portfolio of consumer and professional software applications, the Mac OS® X operating system, third-party digital content +through the iTunes Store™, and a variety of accessory, service and support offerings. The Company sells its products worldwide through its online stores, its retail stores, its direct +sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Mac, iPod and iPhone compatible products, including application +software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores. The Company sells to education, consumer, creative +professional, business, and government customers. Further discussion of the Company's products may be found in Part I, Item 1 of this Form 10-K under the heading "Business." The +Company believes that for both professionals and consumers the personal computer has become the center of an evolving digital lifestyle by integrating with and enhancing the utility of advanced +digital devices such as the Company's iPods, iPhones, digital video and still cameras, televisions, personal digital assistants, and other digital devices. The attributes of the personal computer that +enable this functionality include a high-quality user interface, easy access to relatively inexpensive data storage, the ability to run complex applications, and the ability to connect +easily to a wide variety of other digital devices and to the Internet. The Company is the only participant in the personal computer industry that controls the design and development of the entire +personal computer—from the hardware and operating system to sophisticated applications. This, along with its products' creative industrial designs, intuitive +ease-of-use, and built-in graphics, multimedia and networking capabilities, uniquely positions the Company to offer innovative integrated digital lifestyle +solutions. The +Company's business strategy leverages its ability, through the design and development of its own operating system, hardware, and many software applications and technologies, to bring to its +customers around the world compelling new products and solutions with superior ease-of-use, seamless integration, and innovative industrial design. The +Company participates in several highly competitive markets, including personal computers with its Mac line of computers, consumer electronics with its iPod product family of portable digital music +players, and distribution of third-party digital content through its online iTunes Store. With the introduction of iPhone, the Company has also begun to compete with mobile communication device +companies that have substantial experience and technological and financial resources. While the Company is widely recognized as a leading innovator in the personal computer and consumer electronics +markets as well as a leader in the emerging market for distribution of digital content, these markets are highly competitive and subject to 36 aggressive +pricing. To remain competitive, the Company believes that increased investment in research and development ("R&D") and marketing and advertising is necessary to maintain or expand its +position in the markets where it competes. The Company's R&D spending is focused on further developing its existing line of personal computers, operating systems, application software, and portable +digital music players; developing new digital lifestyle consumer and professional software applications; and investing in new product areas such as iPhone and wireless technologies. The Company also +believes increased investment in marketing and advertising programs is critical to increasing product and brand awareness. The +Company utilizes a variety of direct and indirect distribution channels. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons +who can convey the value of the hardware, software, and peripheral integration, demonstrate the unique digital lifestyle solutions that are available only on Mac computers, and demonstrate the +compatibility of the Mac with the Windows platform and networks. The Company further believes providing a high-quality sales and after-sales support experience is critical to attracting +and retaining +customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company has expanded and improved its distribution capabilities by +opening its own retail stores in the U.S. and internationally. The Company had 197 stores open as of September 29, 2007. The +Company also staffs selected third-party stores with the Company's own employees to improve the buying experience through reseller channels. The Company has deployed Apple employees and +contractors in reseller locations around the world including the U.S., Canada, Europe, Japan, Asia, Latin America and Australia. The Company also sells to customers directly through its online stores +around the world. To +improve access to the iPod product family, the Company has significantly expanded the number of distribution points where iPods are sold. iPods can be purchased in certain department stores, +member-only warehouse stores, large retail chains, and specialty retail stores, as well as through the channels for Mac distribution listed above. The +Company began shipping iPhone in the U.S. on June 29, 2007, in the U.K. and Germany on November 9, 2007 and expects to begin shipping the iPhone in France on November 29, +2007. AT&T Mobility LLC ("AT&T"), O2 Limited ("O2"), T-Mobile International AG & Co. KG ("T-Mobile"), and France Telecom ("Orange") are the exclusive cellular network +carriers for iPhone in the U.S., U.K., Germany, and France, respectively. iPhone is distributed through the Company and its exclusive cellular network carriers' distribution channels. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the Company's discussion and analysis of +its financial condition and operating results require the Company's management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements +and accompanying notes. Note 1 "Summary of Significant Accounting Policies" of Notes to Consolidated Financial Statements in this Form 10-K describes the significant +accounting policies and methods used in the preparation of the Company's consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it +believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these +estimates and such differences may be material. Management +believes the Company's critical accounting policies and estimates are those related to revenue recognition, allowance for doubtful accounts, inventory valuation and inventory purchase +commitments, warranty costs, stock-based compensation, income taxes, and legal and other contingencies. Management considers these critical policies because they are both important to the portrayal of +the Company's financial condition and operating results, and they require management to make judgments 37 and +estimates about inherently uncertain matters. The Company's senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the +Company's Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, music products, digital content, peripherals, and service and support contracts. The Company +recognizes revenue for software products (operating system software and applications software), or any product that is considered to be software-related in accordance with the guidance in Emerging +Issues Task Force ("EITF") No. 03-5, Applicability of AICPA Statement of Position 97-2 to Non-software Deliverables in an Arrangement +Containing More-Than-Incidental Software , (e.g., Mac computers, iPod portable digital music players and iPhone) pursuant to American Institute of +Certified Public Accountants ("AICPA") Statement of Position ("SOP") No. 97-2, Software Revenue Recognition , as amended. For products +that are not software or software-related, (e.g., digital content sold on the iTunes Store and certain Mac, iPod and iPhone supplies and accessories) the Company recognizes revenue pursuant to SEC +Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition. The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped, and title and risk of loss have been transferred. For most of the Company's product sales, these criteria are met at the time the product is +shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the +Company retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed not to be, fixed or +determinable, revenue is deferred and subsequently recognized as amounts become due and payable and all other criteria for revenue recognition have been met. During +2007, the Company began shipping Apple TV and iPhone. For both Apple TV and iPhone, the Company indicated it may provide future unspecified features and additional software products free of +charge to customers. Therefore, sales of Apple TV and iPhone handsets are recognized under subscription accounting in accordance with SOP No. 97-2. The Company recognizes the +associated revenue and cost of goods sold on a straight-line basis over the currently estimated 24-month economic lives of these products with any loss recognized at the +time of sale. Costs incurred by the Company for engineering, sales, marketing and warranty are expensed as incurred. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other +sales programs and volume-based incentives. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be +reasonably and reliably estimated and the other conditions for revenue recognition have been met. If refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be +made or the price protection lapses. For customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date +at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company's historical experience. Future market conditions and product +transitions may require the Company to increase customer incentive programs and incur incremental price protection obligations that could result in additional reductions to revenue at the time such +programs are offered. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience and +the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company 38 would +be required to record additional reductions to revenue, which would have a negative impact on the Company's results of operations. Allowance for Doubtful Accounts The Company distributes its products through third-party distributors and resellers and directly to certain education, consumer, and commercial customers. The Company generally +does not require collateral from its customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible the Company does attempt to limit +credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe, Asia, and Australia by arranging with third-party financing companies to provide flooring +arrangements and other loan and lease programs to the Company's direct customers. These credit-financing arrangements are directly between the third-party financing company and the end customer. As +such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade receivables that are not covered by collateral, +third-party flooring arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. The +allowance for doubtful accounts is based on management's assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition +of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that is reasonably believed to be collectible. The Company also records an allowance for +all other trade receivables based on multiple factors including historical experience with bad debt, the general economic environment, the financial condition of the Company's distribution channels, +and the +aging of such receivables. If there is a deterioration of a major customer's financial condition, if the Company becomes aware of additional information related to the credit worthiness of a major +customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful accounts, which would +affect earnings in the period the adjustments were made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of +components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed +review of inventory each fiscal quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost +trends. The personal computer, consumer electronics and mobile communications industries are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If +future demand or market conditions for the Company's products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the +Company may be required to record additional write-downs which would negatively affect gross margins in the period when the write-downs were recorded. The +Company accrues reserves for estimated cancellation fees related to component orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company +acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company's requirements +for periods ranging from 30 to 150 days. If there is an abrupt and substantial decline in demand for one or more of the Company's products or an unanticipated change in technological +requirements for any of the Company's products, the Company may be required to record additional reserves for cancellation fees that would negatively affect gross margins in the period when the +cancellation fees are identified and recorded. 39 Warranty Costs The Company provides for the estimated cost for hardware and software warranties at the time the related revenue is recognized based on historical and projected warranty claim +rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company's typical experience. Each quarter, the Company +reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection and adjusts the amounts as +necessary. For products accounted for under subscription accounting pursuant to SOP No. 97-2, the Company recognizes warranty expense as incurred. If actual product failure rates or +repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company's results of operations. The +Company periodically provides updates to its applications and system software to maintain the software's compliance with specifications. The estimated cost to develop such updates is accounted for +as warranty cost that is recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units +delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates. Stock-Based Compensation The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards ("SFAS") No. 123 (revised 2004) ("SFAS +No. 123R"), Share-Based Payment . Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based +on the award's fair-value as calculated by the Black-Scholes-Merton ("BSM") option-pricing model and is recognized as expense ratably on a straight-line basis over the +requisite service period. The BSM model requires various judgmental assumptions including expected volatility, forfeiture rates, and expected option life. If any of the assumptions used in the BSM +model change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period. Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS No. 109, Accounting for Income Taxes , the +provision for income taxes is computed using the asset and liability method, under which deferred tax assets and +liabilities +are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit +carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be +realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Management +believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the +deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that all or part of the net deferred tax assets are determined not to be realizable in the +future, an adjustment to the valuation allowance would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in +estimating the impact of uncertainties in the application of complex tax laws. Resolution of these uncertainties in a manner inconsistent with management's expectations could have a material impact on +the Company's financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading "Legal Proceedings" and in Note 8 "Commitments and Contingencies" in Notes +to Consolidated Financial Statements, the Company is 40 subject +to various legal proceedings and claims that arise in the ordinary course of business. The Company records a contingent liability when it is probable that a loss has been incurred and the +amount is reasonably estimable in accordance with SFAS No. 5, Accounting for Contingencies . There is significant judgment required in both the +probability determination and as to whether an exposure can be reasonably estimated. In management's opinion, the Company does not have a potential liability related to any current legal proceedings +and claims that would individually or in the aggregate have a material adverse effect on its financial condition or operating results. However, the outcomes of legal proceedings and claims brought +against the Company are subject to significant uncertainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against the Company in +the same reporting period, the operating results of a particular reporting period could be materially adversely affected. 41 Net Sales Fiscal years 2007 and 2005 spanned 52 weeks while fiscal year 2006 spanned 53 weeks. This additional week is added to the first fiscal quarter approximately every six years to +realign fiscal quarters with calendar quarters. Net +sales and Mac unit sales by operating segment and net sales and unit sales by product follow (net sales in millions and unit sales in thousands): September 29, 2007 Change September 30, 2006 Change September 24, 2005 Net Sales by Operating Segment (a): Americas net sales $ 11,596 23 % $ 9,415 41 % $ 6,658 Europe net sales 5,460 33 % 4,096 33 % 3,073 Japan net sales 1,082 (11 )% 1,211 31 % 924 Retail net sales 4,115 27 % 3,246 42 % 2,278 Other Segments net sales (b) 1,753 30 % 1,347 35 % 998 Total net sales $ 24,006 24 % $ 19,315 39 % $ 13,931 Unit Sales by Operating Segment: Americas Mac unit sales 3,019 24 % 2,432 11 % 2,184 Europe Mac unit sales 1,816 35 % 1,346 18 % 1,138 Japan Mac unit sales 302 (1 )% 304 (3 )% 313 Retail Mac unit sales 1,386 56 % 886 45 % 609 Other Segments Mac unit sales (b) 528 58 % 335 16 % 290 Total Mac unit sales 7,051 33 % 5,303 17 % 4,534 Net Sales by Product: Desktops (c) $ 4,020 21 % $ 3,319 (3 )% $ 3,436 Portables (d) 6,294 55 % 4,056 43 % 2,839 Total Mac net sales 10,314 40 % 7,375 18 % 6,275 iPod 8,305 8 % 7,676 69 % 4,540 Other music related products and services (e) 2,496 32 % 1,885 110 % 899 iPhone and related products and services (f) 123 NM — NM — Peripherals and other hardware (g) 1,260 15 % 1,100 (2 )% 1,126 Software, service, and other sales (h) 1,508 18 % 1,279 17 % 1,091 Total net sales $ 24,006 24 % $ 19,315 39 % $ 13,931 Unit Sales by Product: Desktops (c) 2,714 12 % 2,434 (3 )% 2,520 Portables (d) 4,337 51 % 2,869 42 % 2,014 Total Mac unit sales 7,051 33 % 5,303 17 % 4,534 Net sales per Mac unit sold (i) $ 1,463 5 % $ 1,391 1 % $ 1,384 iPod unit sales 51,630 31 % 39,409 75 % 22,497 Net sales per iPod unit sold (j) $ 161 (17 )% $ 195 (3 )% $ 202 iPhone unit sales 1,389 NM — NM — Notes: (a) During +2007, the Company revised the way it measures the Retail Segment's operating results to a manner that is generally consistent with the Company's other operating segments. Prior +period results have been reclassified to reflect this change to the Retail Segment's operating results along with the corresponding offsets to the other operating segments. Further information +regarding the Company's operating segments may be found in Notes to Consolidated Financial Statements at Note 9, "Segment Information and Geographic Data." (b) Other +Segments include Asia Pacific and FileMaker. (c) Includes +iMac, eMac, Mac mini, Mac Pro, Power Mac, and Xserve product lines. (d) Includes +MacBook, iBook, MacBook Pro, and PowerBook product lines. (e) Consists +of iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (f) Derived +from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (g) Includes +sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (h) Includes +sales of Apple-branded operating system, application software, third-party software, AppleCare, and Internet services. (i) Derived +by dividing total Mac net sales by total Mac unit sales. (j) Derived +by dividing total iPod net sales by total iPod unit sales. NM = Not Meaningful 42 Fiscal Year 2007 versus 2006 Net sales during 2007 increased 24% or $4.7 billion from 2006 even though the fiscal year of 2007 spanned 52 weeks while the fiscal year of 2006 spanned 53 weeks. +Several factors contributed to these increases including the following: • Mac +net sales increased $3 billion or 40% during 2007 compared to 2006, while Mac unit sales increased by 1.75 million units or 33%. The 33% Mac unit sales +growth rate is significantly greater than the estimated growth rate of the overall personal computer industry during that timeframe. Unit sales of the Company's portable products accounted for 62% of +the Company's personal computer shipments in 2007, up from 54% in 2006. Net sales and unit sales of the Company's portable products increased 55% and 51%, respectively, during 2007 compared to 2006. +This growth was due to strong demand for the MacBook, which increased in each of the Company's operating segments, as well as the MacBook Pro, which increased in each operating segment except Japan. +Mac desktop net sales and unit sales increased by 21% and 12%, respectively, during 2007 due to stronger sales of the iMac in each of the Company's operating segments. The Mac desktop net sales growth +was greater than the unit sales growth primarily due to a shift in desktop product mix away from the lower-price Mac Mini and discontinued eMac and toward the iMac. • Net +sales of iPods increased $629 million or 8% during 2007 compared to 2006. Unit sales of iPods increased 31% compared to 2006. The iPod growth was primarily driven +by increased sales of the iPod shuffle and iPod nano particularly in international markets. iPod unit sales growth was significantly greater than iPod net sales due to a shift in overall iPod product +mix, as well as due to lower selling prices for the iPod classic, iPod nano and iPod shuffle in 2007 compared to 2006. • Net +sales of iPhone and related products and services were $123 million in 2007. iPhone net sales include the portion of iPhone handset revenue recognized in +accordance with subscription accounting over the product's 24-month estimated economic life, as well as sales of iPhone accessory products and revenue from carrier agreements. iPhone unit +sales were 1.39 million in 2007. • Net +sales of other music related products and services increased $611 million or 32% during 2007 compared to 2006 due to increased net sales from the iTunes Store. +The Company believes this growth was the result of heightened consumer interest in downloading digital content and the expansion of third-party audio and video content available for sale via the +iTunes Store. • Net +sales of peripherals and other hardware increased $160 million or 15% compared to 2006 due to an increase in wireless networking products and other hardware +accessories, including printers and scanners, which was partially offset by a decrease in net sales of displays. • Net +sales of software, service, and other sales rose $229 million or 18% during 2007 compared to 2006. This growth was primarily attributable to increased net sales +of AppleCare Protection Plan ("APP") extended service and support contracts and increased sales of Apple branded and third-party developers' software products. Fiscal Year 2006 versus 2005 Net sales during 2006 increased 39% or $5.4 billion from 2005. This increase was due in part to the fact that 2006 spanned 53 weeks while 2005 spanned 52 weeks. Several +other factors contributed to these increases including the following: • Net +sales of iPods increased $3.1 billion or 69% during 2006 compared to 2005. Unit sales of iPods totaled 39.4 million in 2006, which represents an increase +of 75% from the 22.5 million iPod units sold in 2005. Strong iPod sales during 2006 reflected significant sales of both the hard-drive based iPod that supports video, first +introduced in October of 2005 and the iPod nano, introduced in September 2005, as well as continued expansion of iPod distribution points. During 2006, the net 43 sales +per iPod unit sold decreased by 3% compared to 2005 primarily due to an overall decrease in average selling prices for all iPods as well as a shift in product mix to the iPod nano. • Mac +net sales increased $1.1 billion or 18% during 2006 compared to 2005. Mac unit sales increased by 769,000 units or 17% during 2006 compared to 2005. These +increases were mainly due to strong demand for the Intel-based MacBook and MacBook Pro systems and reflect a shift in product mix to portable products in all of the Company's operating segments. Net +sales and unit sales of the Company's portable products increased 43% and 42%, respectively, during 2006 compared to 2005. Mac desktop net sales and unit sales both decreased by 3% during 2006 +compared to 2005. The decrease in sales of the Company's Mac desktops was due to declines in sales of the Company's professional-oriented desktop products. The Company believes the decline in the +Company's professional-oriented desktop products was due to customers delaying purchases of such products in anticipation of the release of the Intel-based Mac Pro, which did not begin shipping until +August 2006, and updated software applications capable of running on Intel-based Mac computers, and the trend +toward portable computers. A slight increase of 1% during 2006 in net sales per Mac unit sold was due to a shift in mix to higher-priced portable products, partially offset by price reductions on +certain Mac systems. • Other +music related products and services consists of sales associated with the iTunes Store and iPod services and accessories. Net sales of other music related products and +services increased $986 million or 110% during 2006 compared to 2005. The increase was primarily due to increased net sales from the iTunes Store and Apple-branded and third-party iPod +accessories and services. The increase in sales from the iTunes Store stemmed from significant growth in U.S. sales and the opening of the iTunes Store in Japan during August 2005 and Australia +during October 2005. The increased sales from the iTunes Store were also attributable to the availability of videos, television shows, and feature-length movie downloads. • Net +sales of software, service, and other sales increased $188 million or 17% during 2006 compared to 2005. The growth was primarily attributable to increased net +sales of AppleCare Protection Plan ("APP") extended service and support contracts and application software, partially offset by a decrease in sales of Mac OS X. Mac OS X sales were particularly high +in 2005 due to the release of Mac OS X Tiger in April 2005. Offsetting +the favorable factors discussed above, the Company's net sales during 2006 were negatively impacted by the following: • Net +sales of peripherals and other hardware declined $26 million or 2% compared to 2005 primarily due to price decreases and a decrease in net sales of displays +relating to a shift in mix from desktop to portable systems. The decrease in net sales of displays for 2006 is consistent with the overall decrease in unit sales of Mac professional desktop systems. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company's reportable operating segments consist of the Americas, Europe, Japan, and Retail. The Americas, +Europe, and Japan reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European +countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S., Canada, Japan, the U.K. and Italy. Each reportable geographic operating segment and +the Retail operating segment provide similar hardware and software products and similar services. During 2007, the Company revised the way it measures the Retail Segment's operating results to a +manner that is generally consistent with the Company's other operating segments. Prior period results have been reclassified to reflect this change to the Retail Segment's operating results along with +the corresponding offsets to the other operating segments. Further information regarding the Company's operating segments may be found in Note 9, 44 "Segment +Information and Geographic Data" in Notes to Consolidated Financial Statements of this Form 10-K. Americas During 2007, net sales in the Americas segment increased $2.2 billion, or 23%, compared to 2006. The main sources of this growth were Mac portable products, iMacs, +iPods, and the sales of third-party content from the iTunes Store. Sales of Mac portable products increased due to the popularity of the MacBook, introduced in May 2006 and updated in +May 2007, as well as the MacBook Pro, introduced in January 2006 and updated in June 2007. Sales of iMacs grew due to a shift in desktop product mix away from the Mac mini and +discontinued eMac as well as the strong reception of the new iMac introduced in August 2007. Sales of iPods grew due to increased demand for the iPod nano and iPod shuffle and the introduction +of the iPod touch in September 2007. The Company believes that the growth in iTunes Store sales was the result of heightened consumer interest in downloading digital content and the expansion +of third-party audio and video content available for sale via the iTunes Store. During 2007, the Americas segment represented 48% of the Company's total net sales as compared to 49% in the same period +of 2006. During 2007, U.S. education channel net sales and Mac unit sales increased by 14% and 18%, respectively, compared to 2006. Net sales from the higher education market grew 17% during 2007 +compared to 2006, while net sales in the K-12 market grew 10% during the same period. During +2006, net sales in the Americas segment increased $2.8 billion, or 41%, compared to 2005. The primary contributors to this increase were iPods, other music related products and services, +Mac portable systems, and APP. Sales of iPods increased primarily due to the introduction of the updated iPod with video-playing capabilities in October 2005 (now referred to as iPod classic) +and the iPod nano during September 2005. The increase in other music related products and services was due to increases in sales of Apple-branded and third-party iPod accessories and sales from +the iTunes Store. The +increase in sales of Mac portable systems in the Americas was due to strong sales of the MacBook and MacBook Pro during 2006. The overall increase in net sales was partially offset by a decline in net +sales of desktops, displays, and Mac OS X. The decrease in desktop products and displays net sales reflects the overall shift in product mix toward portable Mac systems. Mac OS X sales decreased from +2005 since the Company had not released a new version of Mac OS X since Tiger began shipping in April 2005. During 2006, the Americas segment represented 49% of the Company's total net sales as +compared to 48% in the same period of 2005. Europe Europe segment net sales increased $1.4 billion or 33% during 2007 compared to 2006. Consistent with the Americas segment, the primary drivers of this growth were Mac +portable products, iMacs, iPods, and the sales of third-party content from the iTunes Store. Sales of Mac portable products increased due to the popularity of both the MacBook and MacBook Pro. Sales +of iMacs grew due to a shift in desktop product mix away from the Mac mini and discontinued eMac as well as the strong reception of the new iMac introduced in August 2007. Sales of iPods grew +primarily due to increased demand for the iPod nano and iPod shuffle. The Company believes that the growth in iTunes Store sales was the result of heightened consumer interest in downloading digital +content and the expansion of third-party audio and video content available for sale via the iTunes Store. Europe +segment net sales increased $1.0 billion or 33% during 2006 compared to 2005. Consistent with the Americas segment, these increases were a result of strong growth in iPod sales, other +music related products and services, and Mac portable systems. Sales of iPods increased primarily due to the introduction of the updated iPod with video-playing capabilities in October 2005 and +the iPod nano during September 2005. The increase in other music related products and services was due to increases in sales of Apple-branded and third-party iPod accessories and sales from the +iTunes Store. The increase in sales of portable systems in Europe was due to strong sales of the MacBook and MacBook Pro that were introduced during 2006. In addition, Europe also reported increased +sales in APP related to the increase in Mac unit sales. These increases were partially offset by a decrease in desktop and Mac OS X net sales 45 during +2006 compared to 2005. The decrease in desktop net sales was due to the shift in product mix toward portable Mac systems. Mac OS X sales have decreased from 2005 since the Company has not +released a new version of Mac OS X since Tiger began shipping in April 2005. Japan Japan's net sales declined by $129 million or 11% in 2007 compared to 2006. Total Mac unit sales in Japan declined 1% during 2007. The decrease in the Japan segment's +overall net sales was primarily attributable to decreases in iPod and Mac desktop sales, partially offset by an increase in revenue from MacBooks and sales of third-party content from the iTunes +Store. The decline in net sales and Mac unit sales is partially attributable to Japan's declining consumer PC market, and the iPod sales decline +is primarily due to lower average selling prices. The Company is continuing to evaluate ways to improve the future results of its Japan segment. Japan's +net sales increased $287 million or 31% during 2006 compared to 2005. The Japan segment experienced increased net sales in iPods, Mac portable products, and other music related products +and services. Consistent with the Company's other segments, Japan experienced increases in sales of iPods due to the introduction of the iPod with video-playing capabilities (now referred to as the +iPod classic) and the iPod nano in October and September of 2005, respectively. Japan also experienced strong sales of the Intel-based MacBook and increased sales from the iTunes Store. These +increases were partially offset by decreases in net sales of Mac desktop products, displays, and Mac OS X. The decreases in desktop products and displays reflect the overall shift in product mix +toward portable Mac systems. Mac OS X sales have decreased from 2005 since the Company had not released a new version of Mac OS X since Tiger began shipping in April 2005. Total Mac unit sales +during 2006 remained relatively flat compared to 2005. Retail The Company opened 32 new retail stores during 2007, including a total of 5 international stores in the U.K. and Italy, bringing the total number of open stores to 197 as of +September 29, 2007. This compares to 165 open stores as of September 30, 2006 and 124 open stores as of September 24, 2005. The +Retail segment's net sales increased by 27% to $4.1 billion during 2007 compared to 2006. Retail segment Mac unit sales increased 56% during 2007 as compared to 2006. With an average of 178 +stores open during 2007, average revenue per store was $23.1 million, compared to $22.9 million in 2006 and $21.7 million in 2005. The current year increase in Retail segment net +sales was primarily due to stronger sales of Mac portable products, iMacs, accessories and services. The increase was partially offset primarily by lower net sales of iPods and other music related +products due to the expanded availability of those products through third-party resellers. The +Retail segment's net sales increased by 42% to $3.3 billion during 2006 compared to 2005. Retail segment Mac unit sales increased 45% during 2006 compared to 2005. The current year increase +was primarily due to strong sales of Mac portable and desktop products, iPods, and other music related products and services. Sales of iPods increased primarily due to the introduction of the updated +iPod with video-playing capabilities in October 2005 and the iPod nano during September 2005. The increase in other music related products and services was due to increased sales of +Apple-branded and third-party iPod accessories. Mac portable and desktop sales increased due to strong sales of the Intel-based MacBook, MacBook Pro, and iMac. As +measured by the Company's operating segment reporting, the Retail segment reported operating income of $875 million during 2007 as compared to operating income of $600 million and +$396 million during 2006 and 2005, respectively. This improvement in 2007 was primarily attributable to an increase in the Company's overall gross margin percentage. Expansion +of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease commitments, personnel, and other +operating expenses. 46 Capital +asset purchases associated with the Retail segment were $294 million in 2007, bringing the total capital asset purchases since inception of the Retail segment to $1.0 billion. As +of September 29, 2007, the Retail segment had approximately 7,900 employees and had outstanding operating lease commitments associated with retail store space and related facilities of +$1.1 billion. The Company would incur substantial costs if it were to close multiple retail stores. Such costs could adversely affect the Company's financial condition and operating results. Other Segments The Company's Other Segments, which consists of its Asia Pacific and FileMaker operations, experienced an increase in net sales of $406 million, or 30% during 2007 +compared to 2006. This increase related primarily to a 58% increase in sales of Mac portable products and strong iPod sales in the Company's Asia Pacific region. During +2006, net sales in Other Segments increased 35% compared to 2005 primarily due to an increase in sales of iPod and Mac portable products. Strong sales growth was a result of the introduction of +the updated iPods featuring video-playing capabilities and the new Intel-based Mac portable products that translated to a 16% increase in Mac unit sales during 2006 compared to 2005. Gross Margin Gross margin for each of the last three fiscal years are as follows (in millions, except gross margin percentages): September 29, 2007 September 30, 2006 September 24, 2005 Net sales $ 24,006 $ 19,315 $ 13,931 Cost of sales 15,852 13,717 9,889 Gross margin $ 8,154 $ 5,598 $ 4,042 Gross margin percentage 34.0 % 29.0 % 29.0 % Gross +margin percentage of 34.0% in 2007 increased significantly from 29.0% in 2006. The primary drivers of this increase were more favorable costs on certain commodity components, including NAND +flash memory and DRAM memory, higher overall revenue that provided for more leverage on fixed production costs and a higher percentage of revenue from the Company's direct sales channels. The +Company anticipates that its gross margin and the gross margins of the personal computer, consumer electronics and mobile communication industries will be subject to pressure due to price +competition. The Company expects gross margin percentage to decline sequentially in the first quarter of 2008 primarily as a result of the full-quarter impact of product transitions and +reduced pricing that were effected in the fourth quarter of 2007, lower sales of iLife and iWork in their second quarter of availability, seasonally higher component costs, and a higher mix of +indirect sales. These factors are expected to be partially offset by higher sales of the Company's Mac OS X operating system due to the introduction of Mac OS X Version 10.5 Leopard ("Mac OS X +Leopard") that became available in October 2007. The +foregoing statements regarding the Company's expected gross margin percentage are forward-looking. There can be no assurance that current gross margin percentage will be maintained or targeted +gross margin percentage levels will be achieved. In general, gross margins and margins on individual products will remain under downward pressure due to a variety of factors, including continued +industry wide global pricing pressures, increased competition, compressed product life cycles, potential increases in the cost and availability of raw material and outside manufacturing services, and +a potential shift in the Company's sales mix towards products with lower gross margins. In response to these competitive pressures, the Company expects it will continue to take pricing actions with +respect to its products. Gross margins could also be affected by the Company's ability to effectively manage product quality and warranty costs and to stimulate 47 demand +for certain of its products. Due to the Company's significant international operations, financial results can be significantly affected in the short-term by fluctuations in exchange +rates. The +Company orders components for its products and builds inventory in advance of product shipments. Because the Company's markets are volatile and subject to rapid technology and price changes, there +is a risk the Company will forecast incorrectly and produce or order from third-parties excess or insufficient inventories of particular products or components. The Company's financial condition and +operating results in the past have been and may in the future be materially adversely affected by the Company's ability to manage its inventory levels and outstanding purchase commitments and to +respond to short-term shifts in customer demand patterns. Gross +margin percentage of 29.0% in 2006 remained flat compared to 2005. The Company experienced more favorable pricing on certain commodity components including LCD flat-panel displays +and DRAM memory and higher overall revenue that provided for more leverage on fixed production costs, offset by an increase in lower margin iPod sales and other music-related services. Operating Expenses Operating expenses for each of the last three fiscal years are as follows (in millions, except for percentages): September 29, 2007 September 30, 2006 September 24, 2005 Research and development $ 782 $ 712 $ 535 Percentage of net sales 3 % 4 % 4 % Selling, general, and administrative expenses $ 2,963 $ 2,433 $ 1,864 Percentage of net sales 12 % 13 % 13 % Research and Development ("R&D") Expenditures for R&D increased 10% or $70 million to $782 million in 2007 compared to 2006. R&D expense does not include capitalized software development costs of +$75 million related to the development of Mac OS X Leopard and iPhone. The increases in R&D expense were primarily due to an increase in R&D headcount in the current year to support expanded +R&D activities, partially offset by one less week of expenses in the first quarter of 2007 and the capitalized software development costs mentioned above. The Company continues to believe that focused +investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the +Company's core business strategy. As such, the Company expects to increase spending in R&D to remain competitive. Selling, General, and Administrative Expense ("SG&A") Expenditures for SG&A increased $530 million or 22% during 2007 compared to 2006. The increase was primarily due to higher direct and indirect channel variable selling +expenses resulting from the significant year-over-year increase in total net sales in 2007, the Company's continued expansion of its Retail segment in both domestic and +international markets, and a current year increase in spending on marketing and advertising, partially offset by one less week of expenses in the first quarter of 2007. 48 Other Income and Expense Other income and expense for each of the last three fiscal years are as follows (in millions): September 29, 2007 September 30, 2006 September 24, 2005 Interest income $ 647 $ 394 $ 183 Other income (expense), net (48 ) (29 ) (18 ) Total other income and expense $ 599 $ 365 $ 165 Total +other income and expense increased $234 million or 64% to $599 million during 2007 as compared to $365 million and $165 million in 2006 and 2005, respectively. The +increase in 2007 is attributable primarily to increased interest received from higher cash and short-term investment balances and stronger investment yields resulting from higher average +market interest rates partially offset by one less week of interest income earned in 2007. The weighted average interest rate earned by the Company on its cash, cash equivalents, and +short-term investments increased to 5.27% in 2007 as compared to the 4.58% and 2.70% rates earned during 2006 and 2005, respectively. The current year increase in interest income was +partially offset by higher other expense, which was primarily associated with higher foreign currency hedging expenses. During 2007, 2006 and 2005, the Company had no debt outstanding and accordingly +did not incur any interest expense. Provision for Income Taxes The Company's effective tax rate for the year ended September 29, 2007 was 30%. The Company's effective rate differs from the statutory federal income tax rate of 35% +due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S. In addition, the Company +recorded a tax benefit of $63 million due to the settlement of prior year audits in the U.S. As +of September 29, 2007, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax credits of $1.1 billion before being offset against +certain deferred liabilities and a valuation allowance for presentation on the Company's balance sheet. Management believes it is more likely than not that forecasted income, including income that may +be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. As of +September 29, 2007 and September 30, 2006 a valuation allowance of $5 million was recorded against the deferred tax asset for the benefits of state operating losses that may not +be realized. The Company will continue to evaluate the realizability of the deferred tax assets quarterly by assessing the need for and amount of the valuation allowance. The +Internal Revenue Service ("IRS") has completed its field audit of the Company's federal income tax returns for the years 2002 through 2003 and proposed certain adjustments. The Company intends to +contest certain of these adjustments through the IRS Appeals Office. All IRS audit issues for years prior to 2002 have been resolved. In addition, the Company is subject to audits by state, local, and +foreign tax authorities. Management believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted +with certainty. Should any issues addressed in the Company's tax audits be resolved in a manner not consistent with management's expectations, the Company could be required to adjust its provision for +income tax in the period such resolution occurs. Recent Accounting Pronouncements In February 2007, the Financial Accounting Standards Board ("FASB") issued SFAS No. 159, The Fair Value Option for Financial Assets and +Financial Liabilities-including an amendment of FASB Statement No. 115 ("SFAS No. 159"). SFAS No. 159 allows companies to choose to elect measuring +eligible financial instruments and certain other items at fair value that are not required to be measured at fair value. SFAS 49 No. 159 +requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings at each reporting date. SFAS No. 159 is effective for +fiscal years beginning after November 15, 2007 and is required to be adopted by the Company beginning in the first quarter of fiscal 2009. Although the Company will continue to evaluate the +application of SFAS No. 159, management does not currently believe adoption will have a material impact on the Company's financial condition or operating results. In +September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, provides a framework for measuring +fair value, and expands the disclosures required for fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require fair value measurements; it does not require +any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007 and is required to be adopted by the Company beginning in the first quarter +of fiscal 2009. Although the Company will continue to evaluate the application of SFAS No. 157, management does not currently believe adoption will have a material impact on the Company's +financial condition or operating results. In +June 2006, the FASB issued FASB Interpretation No. ("FIN") 48, Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement +No. 109 . FIN 48 clarifies the accounting for uncertainty in income taxes by creating a framework for how companies should recognize, measure, present, and disclose in +their financial statements uncertain tax positions that they have taken or expect to take in a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006 and is required +to be adopted by the Company beginning in the first quarter of fiscal 2008. Although the Company will continue to evaluate the application of FIN 48, management does not currently believe adoption +will have a material impact on the Company's financial condition or operating results. Liquidity and Capital Resources The following table presents selected financial information and statistics for each of the last three fiscal years (dollars in millions): September 29, 2007 September 30, 2006 September 24, 2005 Cash, cash equivalents, and short-term investments $ 15,386 $ 10,110 $ 8,261 Accounts receivable, net $ 1,637 $ 1,252 $ 895 Inventory $ 346 $ 270 $ 165 Working capital $ 12,657 $ 8,066 $ 6,813 Annual operating cash flow $ 5,470 $ 2,220 $ 2,535 As +of September 29, 2007, the Company had $15.4 billion in cash, cash equivalents, and short-term investments, an increase of $5.3 billion over the same balance at the +end of September 30, 2006. The principal components of this net increase were cash generated by operating activities of $5.5 billion, proceeds from the issuance of common stock under +stock plans of $365 million and excess tax benefits from stock-based compensation of $377 million. These increases were partially offset by payments for acquisitions of property, plant, +and equipment of $735 million and payments for acquisitions of intangible assets of $251 million. The Company's short-term investment portfolio is primarily invested in +highly rated, liquid investments. As of September 29, 2007 and September 30, 2006, $6.5 billion and $4.1 billion, respectively, of the Company's cash, cash equivalents, and +short-term investments were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. The +Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its working capital needs, capital expenditures, outstanding +commitments, and other liquidity requirements associated with its existing operations over the next 12 months. 50 Capital Assets The Company's total capital asset purchases were $822 million during 2007, consisting of $294 million for retail store facilities and $528 million for real +estate acquisitions and corporate infrastructure including information systems enhancements. Of the $822 million in total capital asset purchases during 2007, $87 million were not yet +paid for as of September 29, 2007. The Company currently anticipates it will utilize approximately $1.1 billion for capital asset purchases during 2008, including approximately +$400 million for expansion of the Company's Retail segment, and approximately $700 million to support normal replacement of existing capital assets, including manufacturing related +equipment, enhancements to general information technology infrastructure, and real estate acquisitions. Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative +instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated +entity that provides financing, liquidity, market risk, or credit risk support to the Company. The +following table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 29, 2007 and excludes amounts already recorded on +the Company's balance sheet as current liabilities (in millions): Total Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Operating leases $ 1,425 $ 155 $ 345 $ 308 $ 617 Purchase obligations 3,179 3,179 — — — Asset retirement obligations 24 3 3 7 11 Other obligations 50 50 — — — Total $ 4,678 $ 3,387 $ 348 $ 315 $ 628 Lease Commitments As of September 29, 2007, the Company had total outstanding commitments on noncancelable operating leases of $1.4 billion, $1.1 billion of which related to +the lease of retail space and related facilities. Lease terms on the Company's existing major facility operating leases generally range from 3 to 15 years. Purchase Commitments with Contract Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Company's products and to perform final assembly and test of finished +products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 30 to 150 days. The +Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of +purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase commitments typically cover the Company's forecasted component and manufacturing requirements +for periods ranging from 30 to 150 days. In addition, the Company has an off-balance sheet warranty obligation for products accounted for under subscription accounting pursuant to +SOP No. 97-2 whereby the Company recognizes warranty expense as incurred. As of September 29, 2007, the Company had outstanding off-balance sheet third-party +manufacturing commitments, component purchase commitments, and warranty commitments of $3.2 billion. During +the first quarter of 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung +Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010. As part of these 51 agreements, +the Company prepaid $1.25 billion for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective agreement. The +Company utilized $208 million of the prepayment as of September 29, 2007. Asset Retirement Obligations The Company's asset retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. As of +September 29, 2007, the Company estimated that gross expected future cash flows of $24 million would be required to fulfill these obligations. Other Obligations Other outstanding obligations were $50 million as of September 29, 2007, primarily related to Internet and telecommunications services and the estimated cost +related to the $100 store credit the Company offered to customers who purchased an iPhone prior to the Company's September 2007 price reduction. Indemnifications The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party +intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of +an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted +against itself or an indemnified third-party and, in the opinion of management, does not have a liability related to unresolved infringement claims subject to indemnification that would have a +material adverse effect on its financial condition or operating results. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and +interest rate related exposures. However, given the effective horizons of the Company's risk management activities and the anticipatory nature of the exposures, there can be no assurance the hedges +will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains and +losses related to mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, +therefore, may adversely affect the Company's financial condition and operating results. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world's leading industrialized countries, the Company's interest income and expense is most sensitive +to fluctuations in the general +level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on the Company's cash, cash equivalents, and short-term investments, the value of those +investments, as well as costs associated with foreign currency hedges. The +Company's short-term investment policy and strategy is to ensure the preservation of capital, meet liquidity requirements, and optimize return in light of the current credit and +interest rate environment. A portion of the Company's cash is managed by external managers within the guidelines of the Company's investment policy and to an objective market benchmark. The Company's +internal portfolio is benchmarked against external manager performance, allowing for differences in liquidity needs. The +Company's exposure to market risk for changes in interest rates relates primarily to the Company's investment portfolio. The Company places its short-term investments in highly liquid +securities issued by highly rated issuers and, by policy, limits the amount of credit exposure to any one issuer. The Company's 52 general +policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with initial maturities of three months +or less at the date of purchase are classified as cash equivalents; highly liquid investments with initial maturities greater than three months at the date of purchase are classified as +short-term investments. As of September 29, 2007, $1.9 billion of the Company's short-term investments had underlying maturities ranging from 1 to 5 years. +The remainder all had underlying maturities of less than 12 months. The Company may sell its investments prior to their stated maturities for strategic purposes, in anticipation of credit +deterioration, or for duration management. The Company recognized net gains before taxes on short-term investments of approximately $474,000 in 2007 and net losses before taxes of +approximately $434,000 and $137,000 in 2006 and 2005, respectively. To +provide a meaningful assessment of the interest rate risk associated with the Company's investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in +interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 29, 2007, a +hypothetical 100 basis point increase in interest rates across all maturities would result in $16 million incremental decline in the fair market value of the portfolio. As of +September 30, 2006, a similar 100 basis point shift in the yield curve would have resulted in a $15 million incremental decline in the fair market value of the portfolio. Such losses +would only be realized if the Company sold the investments prior to maturity. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. +dollar, may negatively affect the +Company's net sales and gross margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has +been significant volatility in foreign currency exchange rates. The +Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with existing assets and liabilities, certain +firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company's practice is to hedge a majority of its material foreign exchange +exposures. However, the Company may choose not to hedge certain foreign exchange exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and/or limited availability +of appropriate hedging instruments. To +provide a meaningful assessment of the foreign currency risk associated with certain of the Company's foreign currency derivative positions, the Company performed a sensitivity analysis using a +value-at-risk ("VAR") model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate 3,000 random +market price paths. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company's foreign exchange portfolio due to adverse movements in rates. The VAR model is +not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments, and assets and +liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair +value of $12.8 million as of September 29, 2007 compared to a maximum one-day loss of $9.2 million as of September 30, 2006. Because the Company uses foreign +currency instruments for hedging purposes, losses incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual +future gains and losses associated with the Company's investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 29, 2007 +due to the inherent limitations associated with predicting the changes in the timing and amount of interest rates, foreign currency exchanges rates, and the Company's actual exposures and positions. 53 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Balance Sheets as of September 29, 2007 and September 30, 2006 55 Consolidated Statements of Operations for the three fiscal years ended September 29, 2007 56 Consolidated Statements of Shareholders' Equity for the three fiscal years ended September 29, 2007 57 Consolidated Statements of Cash Flows for the three fiscal years ended September 29, 2007 58 Notes to Consolidated Financial Statements 59 Selected Quarterly Financial Information (Unaudited) 90 Reports of Independent Registered Public Accounting Firm, KPMG LLP 91 All +financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the Consolidated Financial Statements and Notes thereto. 54 CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 29, 2007 September 30, 2006 ASSETS: Current assets: Cash and cash equivalents $ 9,352 $ 6,392 Short-term investments 6,034 3,718 Accounts receivable, less allowances of $47 and $52, respectively 1,637 1,252 Inventories 346 270 Deferred tax assets 782 607 Other current assets 3,805 2,270 Total current assets 21,956 14,509 Property, plant, and equipment, net 1,832 1,281 Goodwill 38 38 Acquired intangible assets, net 299 139 Other assets 1,222 1,238 Total assets $ 25,347 $ 17,205 LIABILITIES AND SHAREHOLDERS' EQUITY: Current liabilities: Accounts payable $ 4,970 $ 3,390 Accrued expenses 4,329 3,053 Total current liabilities 9,299 6,443 Non-current liabilities 1,516 778 Total liabilities 10,815 7,221 Commitments and contingencies Shareholders' equity: Common stock, no par value; 1,800,000,000 shares authorized; 872,328,972 and 855,262,568 shares issued and outstanding, respectively 5,368 4,355 Retained earnings 9,101 5,607 Accumulated other comprehensive income 63 22 Total shareholders' equity 14,532 9,984 Total liabilities and shareholders' equity $ 25,347 $ 17,205 See +accompanying Notes to Consolidated Financial Statements. 55 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) Three fiscal years ended September 29, 2007 2007 2006 2005 Net sales $ 24,006 $ 19,315 $ 13,931 Cost of sales (1) 15,852 13,717 9,889 Gross margin 8,154 5,598 4,042 Operating expenses: Research and development (1) 782 712 535 Selling, general, and administrative (1) 2,963 2,433 1,864 Total operating expenses 3,745 3,145 2,399 Operating income 4,409 2,453 1,643 Other income and expense 599 365 165 Income before provision for income taxes 5,008 2,818 1,808 Provision for income taxes 1,512 829 480 Net income $ 3,496 $ 1,989 $ 1,328 Earnings per common share: Basic $ 4.04 $ 2.36 $ 1.64 Diluted $ 3.93 $ 2.27 $ 1.55 Shares used in computing earnings per share (in thousands): Basic 864,595 844,058 808,439 Diluted 889,292 877,526 856,878 (1) Includes +stock-based compensation expense, which was allocated as follows: Cost of sales $ 35 $ 21 $ 3 Research and development $ 77 $ 53 $ 7 Selling, general, and administrative $ 130 $ 89 $ 39 See +accompanying Notes to Consolidated Financial Statements. 56 CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) Common Stock Accumulated Other Comprehensive Income (Loss) Deferred Stock Compensation Retained Earnings Total Shareholders' Equity Shares Amount Balances as of September 25, 2004 782,887 $ 2,582 $ (101 ) $ 2,597 $ (15 ) $ 5,063 Components of comprehensive income: Net income — — — 1,328 — 1,328 Change in foreign currency translation — — — — 7 7 Change in unrealized gain on derivative instruments, net of tax — — — — 8 8 Total comprehensive income 1,343 Issuance of stock-based compensation awards — 7 (7 ) — — — Stock-based compensation — — 47 — — 47 Common stock issued under stock plans 52,132 547 — — — 547 Tax benefit from employee stock plan awards — 428 — — — 428 Balances as of September 24, 2005 835,019 3,564 (61 ) 3,925 — 7,428 Components of comprehensive income: Net income — — — 1,989 — 1,989 Change in foreign currency translation — — — — 19 19 Change in unrealized gain on available-for-sale securities, net of tax — — — — 4 4 Change in unrealized gain on derivative instruments, net of tax — — — — (1 ) (1 ) Total comprehensive income 2,011 Common stock repurchased (4,574 ) (48 ) — (307 ) — (355 ) Stock-based compensation — 163 — — — 163 Deferred compensation — (61 ) 61 — — — Common stock issued under stock plans 24,818 318 — — — 318 Tax benefit from employee stock plan awards — 419 — — — 419 Balances as of September 30, 2006 855,263 4,355 — 5,607 22 9,984 Components of comprehensive income: Net income — — — 3,496 — 3,496 Change in foreign currency translation — — — — 51 51 Change in unrealized loss on available-for-sale securities, net of tax — — — — (7 ) (7 ) Change in unrealized loss on derivative instruments, net of tax — — — — (3 ) (3 ) Total comprehensive income 3,537 Stock-based compensation — 251 — — — 251 Common stock issued under stock plans, net of shares withheld for employee taxes 17,066 364 — (2 ) — 362 Tax benefit from employee stock plan awards — 398 — — — 398 Balances as of September 29, 2007 872,329 $ 5,368 $ — $ 9,101 $ 63 $ 14,532 See accompanying Notes to Consolidated Financial Statements. 57 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 29, 2007 2007 2006 2005 Cash and cash equivalents, beginning of the year $ 6,392 $ 3,491 $ 2,969 Operating Activities: Net income 3,496 1,989 1,328 Adjustments to reconcile net income to cash generated by operating activities: Depreciation, amortization and accretion 317 225 179 Stock-based compensation expense 242 163 49 Provision for deferred income taxes 78 53 50 Excess tax benefits from stock options — — 428 Gain on sale of PowerSchool net assets — (4 ) — Loss on disposition of property, plant, and equipment 12 15 9 Changes in operating assets and liabilities: Accounts receivable, net (385 ) (357 ) (121 ) Inventories (76 ) (105 ) (64 ) Other current assets (1,540 ) (1,626 ) (150 ) Other assets 81 (1,040 ) (35 ) Accounts payable 1,494 1,611 328 Other liabilities 1,751 1,296 534 Cash generated by operating activities 5,470 2,220 2,535 Investing Activities: Purchases of short-term investments (11,719 ) (7,255 ) (11,470 ) Proceeds from maturities of short-term investments 6,483 7,226 8,609 Proceeds from sales of investments 2,941 1,086 586 Purchases of long-term investments (17 ) (25 ) — Proceeds from sale of PowerSchool net assets — 40 — Payment for acquisition of property, plant, and equipment (735 ) (657 ) (260 ) Payment for acquisition of intangible assets (251 ) — — Other 49 (58 ) (21 ) Cash (used for) generated by investing activities (3,249 ) 357 (2,556 ) Financing Activities: Proceeds from issuance of common stock 365 318 543 Excess tax benefits from stock-based compensation 377 361 — Repurchases of common stock (3 ) (355 ) — Cash generated by financing activities 739 324 543 Increase in cash and cash equivalents 2,960 2,901 522 Cash and cash equivalents, end of the year $ 9,352 $ 6,392 $ 3,491 Supplemental cash flow disclosures: Cash paid for income taxes, net $ 863 $ 194 $ 17 See accompanying Notes to Consolidated Financial Statements. 58 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1—Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively "Apple" or the "Company") design, manufacture, and market personal computers, portable digital music players, +and mobile communication devices and sells a variety of related software, services, peripherals, and networking solutions. The Company sells its products worldwide through its online stores, its +retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Mac, iPod and iPhone compatible +products including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to +education, consumer, creative professional, business, and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these +consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these +consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes +thereto have been reclassified to conform to the current year presentation. The +Company's fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company's first quarter of fiscal year 2007 contained 13 weeks and the first quarter +of fiscal year 2006 contained 14 weeks. The Company's fiscal year 2007 ended on September 29, 2007 and included 52 weeks, while fiscal year 2006 included 53 weeks and fiscal year 2005 included +52 weeks. Unless otherwise stated, references to particular years or quarters refer to the Company's fiscal years ended in September and the associated quarters of those fiscal years. Financial Instruments Cash Equivalents and Short-term Investments All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Highly liquid investments with maturities +greater than three months at the date of purchase are classified as short-term investments. The Company's debt and marketable equity securities have been classified and accounted for as +available-for-sale. Management determines the appropriate classification of its investments in debt and marketable equity securities at the time of purchase and reevaluates the +available-for-sale designations as of each balance sheet date. These securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported as a +component of shareholders' equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. Derivatives that are not defined as hedges in Statement of +Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, must be adjusted to +fair value through earnings. For +derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative +instrument is reported as a component of accumulated other comprehensive income in shareholders' equity and reclassified into earnings in the same period or periods during which the hedged transaction +affects 59 earnings. +The ineffective portion of the gain or loss on the derivative instrument is recognized in current earnings. To receive hedge accounting treatment, cash flow hedges must be highly effective +in offsetting changes to expected future cash flows on hedged transactions. For derivative instruments that hedge the exposure to changes in the fair value of an asset or a liability and that are +designated as fair value hedges, the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in earnings +in the current period. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the net +investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward contracts designated as net investment hedges, the Company excludes changes +in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current earnings. Inventories Inventories are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their +market value, provisions are made currently for the difference between the cost and the market value. The Company's inventories consist primarily of finished goods for all periods presented. Property, Plant, and Equipment Property, plant, and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which +for buildings is the lesser of 30 years or the remaining life of the underlying building, up to 5 years for equipment, and the shorter of lease terms or 10 years for leasehold +improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to +internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which range from 3 to 5 years. Depreciation and +amortization expense on property and equipment was $249 million, $180 million, and $141 million during 2007, 2006, and 2005, respectively. Asset Retirement Obligations The Company records obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs in accordance with SFAS +No. 143, Accounting for Asset Retirement Obligations . The Company reviews legal obligations associated with the retirement of +long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. If it is determined that a legal obligation exists, the fair value of the +liability for an asset retirement obligation is recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of the liability is added to the +carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. The difference between the gross expected future cash flow and its present value +is accreted over the life of the related lease as an operating expense. All of the Company's existing asset retirement obligations are associated with commitments to return property subject to +operating leases to original condition upon lease termination. The Company's asset retirement liability was $18 million and $15 million as of September 29, 2007 and +September 30, 2006, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and certain identifiable intangibles, excluding goodwill, for impairment in accordance with SFAS No. 144, Accounting for the Impairment of Long-Lived 60 Assets and for Long-Lived Assets to Be Disposed Of. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate +the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of its carrying amount to future undiscounted cash flows the assets are expected to +generate. If property, plant, and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the +assets exceeds its fair market value. The Company did not record any material impairments during 2007, 2006, and 2005. SFAS +No. 142, Goodwill and Other Intangible Assets requires that goodwill and intangible assets with indefinite useful lives should not be +amortized but rather be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that they may be impaired. The Company performs its goodwill impairment +tests on or about August 31 of each year. The Company did not recognize any goodwill or intangible asset impairment charges in 2007, 2006, or 2005. The Company established reporting units based +on its current reporting structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. SFAS +No. 142 also requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144. The +Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 2 to 10 years. Foreign Currency Translation The Company translates the assets and liabilities of its international non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in +effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations +are credited or charged to foreign currency translation included in "accumulated other comprehensive income" in shareholders' equity. The Company's foreign manufacturing subsidiaries and certain other +international subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, +property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these translations were insignificant and have been included in the Company's results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, music products, digital content, peripherals, and service and support contracts. For any product +within these groups that either is software, or is considered software-related in accordance with the guidance in Emerging Issues Task Force ("EITF") No. 03-5, Applicability of AICPA Statement of Position 97-2 to +Non-Software Deliverables in an Arrangement Containing More-Than-Incidental +Software (e.g., Macintosh computers and iPod portable digital music players), the Company accounts for such products in accordance with the revenue recognition provisions of +American Institute of Certified Public Accountants ("AICPA") Statement of Position ("SOP") No. 97-2, Software Revenue Recognition . +The Company applies Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, for products that are not software or software-related, such +as digital content sold on the iTunes Store and certain Mac, iPod and iPhone supplies and accessories. The +Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped and title and risk of loss have been transferred. For 61 most +of the Company's product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain +other sales, the Company defers revenue until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an +arrangement the Company determines the arrangement fee is not, or is presumed not to be, fixed or determinable, revenue is deferred and subsequently recognized as amounts become due and payable. Revenue +from service and support contracts is deferred and recognized ratably over the service coverage periods. These contracts typically include extended phone support, repair services, +web-based support resources, diagnostic tools, and extend the service coverage offered under the Company's one-year limited warranty. The +Company sells software and peripheral products obtained from other companies. The Company establishes its own pricing and retains related inventory risk, is the primary obligor in sales +transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company recognizes revenue for the sale of products obtained from other companies +based on the gross amount billed. The +Company accounts for multiple element arrangements that consist only of software or software-related products in accordance with SOP No. 97-2. If a multiple-element arrangement +includes deliverables that are neither software nor software-related, the Company applies EITF No. 00-21, Revenue Arrangements with Multiple +Deliverables, to determine if those deliverables constitute separate units of accounting from the SOP No. 97-2 deliverables. If the Company can separate the +deliverables, the Company applies SOP No. 97-2 to the software and software-related deliverables and applies other appropriate guidance (e.g., SAB No. 104) to the +deliverables outside the scope of SOP No. 97-2. Revenue on arrangements that include multiple elements such as hardware, software, and services is allocated to each element based on +the relative fair value of each element. Each element's allocated revenue is recognized when the revenue recognition criteria for that element have been met. Fair value is generally determined by +vendor specific objective evidence ("VSOE"), which is based on the price charged when each element is sold separately. If the Company cannot objectively determine the fair value of any undelivered +element included in a multiple-element arrangement, the Company defers revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for +any remaining undelivered elements. When the fair value of a delivered element has not been established, the Company uses the residual method to recognize revenue if the fair value of all undelivered +elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and +is recognized as revenue. The +Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other +sales programs and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The +Company also records reductions to revenue for expected future product returns based on the Company's historical experience. Revenue is recorded net of taxes collected from customers that are remitted +to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. Generally, +the Company does not offer specified or unspecified upgrade rights to its customers in connection with software sales or the sale of extended warranty and support contracts. When the +Company does offer specified upgrade rights, the Company defers revenue for the fair value of the specified upgrade 62 right +until the future obligation is fulfilled or when the right to the specified upgrade expires. Additionally, a limited number of the Company's software products are available with maintenance +agreements that grant customers rights to unspecified future upgrades over the maintenance term on a when and if available basis. Revenue associated with such maintenance is recognized ratably over +the maintenance term. In +March 2007, the Company began shipping Apple TV and in June 2007 began shipping iPhone. For Apple TV and iPhone, the Company indicated it may provide future unspecified features and +additional software products free of charge to customers. Accordingly, Apple TV and iPhone handsets sales are accounted for under subscription accounting in accordance with SOP +No. 97-2. As such, the Company's policy is to defer the associated revenue and cost of goods sold at the time of sale, and recognize both on a straight-line basis over +the currently estimated 24-month economic life of these products, with any loss recognized at the time of sale. Costs incurred by the Company for engineering, sales, marketing and warranty +are expensed as incurred. Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical experience, the age of the accounts +receivable balances, credit quality of the Company's customers, current economic conditions, and other factors that may affect customers' ability to pay. Shipping Costs For all periods presented, amounts billed to customers related to shipping and handling are classified as revenue, and the Company's shipping and handling costs are included in +cost of sales. Warranty Expense The Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. The Company assesses the adequacy of +its preexisting warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. For products accounted for under subscription accounting pursuant +to SOP No. 97-2, the Company recognizes warranty expense as incurred. Software Development Costs Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization +beginning when a product's technological feasibility has been established and ending when a product is available for general release to customers pursuant to SFAS No. 86, Computer Software to be Sold, Leased, or Otherwise +Marketed . In most instances, the Company's products are released soon after technological feasibility +has been established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally most software development costs have been expensed. In +2007, the Company determined that both Mac OS X Version 10.5 Leopard ("Mac OS X Leopard") and iPhone achieved technological feasibility. During 2007, the Company capitalized $75 million of +costs associated with the development of Leopard and iPhone. In accordance with SFAS No. 86, the capitalized costs related to Mac OS X Leopard and iPhone are amortized to cost of +sales commencing when each respective product begins shipping and are recognized on a straight-line basis over a 3 year estimated useful life of the underlying technology. 63 Total +amortization related to capitalized software development costs was $13 million, $18 million, and $16 million in 2007, 2006, and 2005, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $467 million, $338 million, and $287 million for 2007, 2006, and 2005, respectively. Stock-Based Compensation On September 25, 2005, the Company adopted SFAS No. 123 (revised 2004) ("SFAS No. 123R"), Share-Based +Payment , which addresses the accounting for stock-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of +the enterprise or (b) liabilities that are based on the fair value of the enterprise's equity instruments or that may be settled by the issuance of such equity instruments. In +January 2005, the Securities and Exchange Commission ("SEC") issued SAB No. 107, which provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R +eliminates the ability to account for stock-based compensation transactions using the intrinsic value method under Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to +Employees , and instead generally requires that such transactions be accounted for using a fair-value-based +method. The Company uses the Black-Scholes-Merton ("BSM") option-pricing model to determine the fair-value of stock-based awards under SFAS No. 123R, consistent with that used for +pro forma disclosures under SFAS No. 123, Accounting for Stock-Based Compensation . SFAS +No. 123R prohibits recognition of a deferred tax asset for an excess tax benefit that has not been realized. The Company will recognize a benefit from stock-based compensation in equity if +an incremental tax benefit is realized by following the ordering provisions of the tax law. In addition, the Company accounts for the indirect effects of stock-based compensation on the research tax +credit, the foreign tax credit, and the domestic manufacturing deduction through the income statement. Prior +to the adoption of SFAS No. 123R, the Company measured compensation expense for its employee stock-based compensation plans using the intrinsic value method prescribed by APB Opinion +No. 25. The Company applied the disclosure provisions of SFAS No. 123 as amended by SFAS No. 148, Accounting for Stock-Based +Compensation—Transition and Disclosure, as if the fair-value-based method had been applied in measuring compensation expense. Under APB Opinion +No. 25, when the exercise price of the Company's employee stock options was equal to the market price of the underlying stock on the date of the grant, no compensation expense was recognized. 64 The +following table illustrates the effect on net income after taxes and net income per common share as if the Company had applied the fair value recognition provisions of SFAS No. 123 to +stock-based compensation during 2005 (in millions, except per share amounts): 2005 Net income $ 1,328 Add: Stock-based employee compensation expense included in reported net income, net of tax 45 Deduct: Stock-based employee compensation expense determined under the fair value based method for all awards, net of tax (118 ) Net income—pro forma $ 1,255 Net income per common share Basic $ 1.64 Diluted $ 1.55 Net income per common share—pro forma Basic $ 1.55 Diluted $ 1.47 Further +information regarding stock-based compensation can be found in Notes 6 and 7. Earnings Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the +period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period +increased to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of +outstanding options, shares to be purchased under the employee stock purchase plan, unvested restricted stock and restricted stock units ("RSUs") is reflected in diluted earnings per share by +application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company's common stock can result in a greater dilutive effect from outstanding +options, restricted stock, and RSUs. Additionally, the exercise of employee stock options and the vesting of restricted stock and RSUs can result in a greater dilutive effect on earnings per share. 65 The +following table sets forth the computation of basic and diluted earnings per share (in thousands, except net income and per share amounts): Three fiscal years ended September 29, 2007 2007 2006 2005 Numerator (in millions): Net income $ 3,496 $ 1,989 $ 1,328 Denominator (in thousands): Weighted-average shares outstanding, excluding unvested restricted stock 864,595 844,058 808,439 Effect of dilutive securities 24,697 33,468 48,439 Denominator for diluted earnings per share 889,292 877,526 856,878 Basic earnings per share $ 4.04 $ 2.36 $ 1.64 Diluted earnings per share $ 3.93 $ 2.27 $ 1.55 Potentially +dilutive securities representing 13.7 million, 3.9 million, and 12.7 million shares of common stock for the years ended September 29, 2007, September 30, +2006, and September 24, 2005, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. These +potentially dilutive securities include stock options, unvested restricted stock, and RSUs. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under +U.S. generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income consists of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Segment Information The Company reports segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions +and assessing performance as the source of the Company's reportable segments. Information about the Company's products, major customers, and geographic areas on a company-wide basis is +also disclosed. 66 Note 2—Financial Instruments Cash, Cash Equivalents and Short-Term Investments The following table summarizes the fair value of the Company's cash and available-for-sale securities held in its short-term investment +portfolio, recorded as cash and cash equivalents or short-term investments (in millions): September 29, 2007 September 30, 2006 Cash $ 256 $ 200 U.S. Treasury and Agency securities 670 52 U.S. Corporate securities 5,597 4,309 Foreign securities 2,829 1,831 Total cash equivalents 9,096 6,192 U.S. Treasury and Agency securities 358 447 U.S. Corporate securities 4,718 2,701 Foreign securities 958 570 Total short-term investments 6,034 3,718 Total cash, cash equivalents, and short-term investments $ 15,386 $ 10,110 The +Company's U.S. Corporate securities consist primarily of commercial paper, certificates of deposit, time deposits, and corporate debt securities. Foreign securities consist primarily of foreign +commercial paper issued by foreign companies, and certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. dollars. The Company had $11 million +in net unrealized losses on its investment portfolio, primarily related to investments with stated maturities ranging from 1 to 5 years, as of September 29, 2007, and net unrealized +losses of approximately $687,000 on its investment portfolio, primarily related to investments with stated maturities less than 1 year, as of September 30, 2006. The Company may sell its +investments prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized net gains before taxes of approximately +$474,000 in 2007 and net losses before taxes of approximately $434,000 and $137,000 in 2006 and 2005, respectively. As +of September 29, 2007 and September 30, 2006, $1.9 billion and $921 million, respectively, of the Company's short-term investments had underlying maturities +ranging from 1 to 5 years. The remaining short-term investments as of September 29, 2007 and September 30, 2006 had maturities less than 12 months. In +accordance with FASB Staff Position ("FSP") FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary +Impairment and Its Application to Certain Investments, the following table shows the gross unrealized losses and fair value for those investments that were in an unrealized +loss position as of 67 September 29, +2007 and September 30, 2006, aggregated by investment category and the length of time that individual securities have been in a continuous loss position +(in millions): 2007 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agency securities $ 338 $ — $ — $ — $ 338 $ — U.S. Corporate securities 2,521 (12 ) 32 — 2,553 (12 ) Foreign securities 474 (1 ) 8 — 482 (1 ) Total $ 3,333 $ (13 ) $ 40 $ — $ 3,373 $ (13 ) 2006 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agency securities $ 234 $ — $ 26 $ — $ 260 $ — U.S. Corporate securities 943 — 102 (1 ) 1,045 (1 ) Foreign securities 164 — 34 — 198 — Total $ 1,341 $ — $ 162 $ (1 ) $ 1,503 $ (1 ) The +unrealized losses on the Company's investments during 2007 in U.S. Corporate securities and foreign securities and during 2006 in U.S. Corporate securities were caused primarily by changes in +interest rates. The Company typically invests in highly-rated securities with strong liquidity and with low probabilities of default. The Company's investment policy requires investments to be rated +single-A or better. Therefore, the Company considers the declines to be temporary in nature. During 2007, the Company did not record any material impairment on outstanding securities. As +of September 29, 2007, the Company does not consider the investments to be other-than-temporarily impaired. Market +values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews +factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Company's ability and intent to hold the investment for a +period of time, which may be sufficient for anticipated recovery in market value. Accounts Receivable Trade Receivables The Company distributes its products through third-party distributors and resellers and directly to certain education, consumer, and commercial customers. The Company generally +does not require collateral from its customers; however, the Company requires collateral in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit +risk on trade receivables with credit insurance for certain customers in Latin America, Europe, Asia, and Australia by arranging with third-party financing companies to provide flooring arrangements +and other loan and lease programs to the Company's direct customers. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the +Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade receivables not 68 covered +by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company's distribution and retail channel partners. One customer accounted for approximately 11% +of trade receivables as of September 29, 2007, while no customers accounted for more than 10% of trade receivables as of September 30, 2006. The +following table summarizes the activity in the allowance for doubtful accounts (in millions): September 29, 2007 September 30, 2006 September 24, 2005 Beginning allowance balance $ 52 $ 46 $ 47 Charged to costs and expenses 12 17 8 Deductions (17 ) (11 ) (9 ) Ending allowance balance $ 47 $ 52 $ 46 Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of raw material components to these manufacturing vendors +who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these raw material components directly from suppliers. These non-trade +receivables, which are included in the Consolidated Balance Sheets in other current assets, totaled $2.4 billion and $1.6 billion as of September 29, 2007 and September 30, +2006, respectively. The Company does not reflect the sale of these components in net sales and does not recognize any profits on these sales until the products are sold through to the end customer at +which time the profit is recognized as a reduction of cost of sales. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign exchange risk. Foreign currency forward and option contracts are used to offset the foreign +exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. The Company's accounting +policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at fair +value. 69 The +following table shows the notional principal, net fair value, and credit risk amounts of the Company's foreign currency instruments as of September 29, 2007 and September 30, 2006 +(in millions): September 29, 2007 September 30, 2006 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Credit Risk Amounts Foreign exchange instruments qualifying as accounting hedges: Spot/Forward contracts $ 570 $ (8 ) $ — $ 351 $ 6 $ 6 Purchased options $ 2,564 $ 10 $ 10 $ 1,256 $ 9 $ 9 Sold options $ 1,498 $ (2 ) $ — $ 80 $ (1 ) $ — Foreign exchange instruments other than accounting hedges: Spot/Forward contracts $ 1,768 $ (2 ) $ — $ 1,103 $ 2 $ 2 Purchased options $ 161 $ 1 $ 1 $ 167 $ 1 $ — The +notional principal amounts for derivative instruments provide one measure of the transaction volume outstanding as of year-end, and do not represent the amount of the Company's +exposure to credit or market loss. The credit risk amounts shown in the table above represents the Company's gross exposure to potential accounting loss on these transactions if all counterparties +failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company's exposure to credit loss and market risk will +vary over time as a function of currency exchange rates. The +estimates of fair value are based on applicable and commonly used pricing models and prevailing financial market information as of September 29, 2007 and September 30, 2006. Although +the table above reflects the notional principal, fair value, and credit risk amounts of the Company's foreign exchange instruments, it does not reflect the gains or losses associated with the +exposures and transactions that the foreign exchange instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and +losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. Foreign Exchange Risk Management The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risk associated with existing assets +and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company's practice is to hedge a majority of its +material foreign exchange exposures. However, the Company may choose not to hedge certain foreign exchange exposures due to immateriality, prohibitive economic cost of hedging particular exposures, or +limited availability of appropriate hedging instruments. To +help protect gross margins from fluctuations in foreign currency exchange rates, the Company's U.S. dollar functional subsidiaries hedge a portion of forecasted foreign currency revenue, and the +Company's non-U.S. dollar functional subsidiaries selling in local currencies hedge a portion of forecasted inventory purchases not denominated in the subsidiaries' functional currency. +Other comprehensive income associated with hedges of foreign currency revenue is recognized as a component of net sales in the same period as the related sales are recognized, and other comprehensive +income related to inventory purchases is recognized as a component of cost of sales in the same period as the related costs are recognized. 70 Typically, +the Company hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases over a time horizon of up to 6 months. Derivative +instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time +period or within a subsequent 2 month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are immediately reclassified into earnings +in other income and expense. Any subsequent changes in fair value of such derivative instruments are also reflected in current earnings unless they are re-designated as hedges of other +transactions. The Company recognized net gains of approximately $672,000 and $421,000 in 2007 and 2006, respectively, and a net loss of $1.6 million in 2005 in other income and expense related +to the loss of hedge designation on discontinued cash flow hedges due to changes in the Company's forecast of future net sales and cost of sales and due to prevailing market conditions. As of +September 29, 2007, the Company had a net deferred gain associated with cash flow hedges of approximately $468,000, net of taxes, substantially all of which is expected to be reclassified to +earnings by the end of the second quarter of fiscal 2008. The +net gain or loss on the effective portion of a derivative instrument designated as a net investment hedge is included in the cumulative translation adjustment account of accumulated other +comprehensive income within shareholders' equity. For the years ended September 29, 2007 and September 30, 2006, the Company had a net loss of $2.6 million and a net gain of +$7.4 million, respectively, included in the cumulative translation adjustment. The +Company may also enter into foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the re-measurement of certain assets and +liabilities recorded in non-functional currencies. Changes in the fair value of these derivatives are recognized in current earnings in other income and expense as offsets to the changes +in the fair value of the related assets or liabilities. Due to currency market movements, changes in option time value can lead to increased volatility in other income and expense. Note 3—Consolidated Financial Statement Details (in millions) Other Current Assets 2007 2006 Vendor non-trade receivables $ 2,392 $ 1,593 NAND flash memory prepayments 417 208 Other current assets 996 469 Total other current assets $ 3,805 $ 2,270 71 Property, Plant, and Equipment 2007 2006 Land and buildings $ 762 $ 626 Machinery, equipment, and internal-use software 954 595 Office furniture and equipment 106 94 Leasehold improvements 1,019 760 2,841 2,075 Accumulated depreciation and amortization (1,009 ) (794 ) Net property, plant, and equipment $ 1,832 $ 1,281 Other Assets 2007 2006 Long-term NAND flash memory prepayments $ 625 $ 1,042 Non-current deferred tax assets 88 — Capitalized software development costs, net 83 21 Other assets 426 175 Total other assets $ 1,222 $ 1,238 Accrued Expenses 2007 2006 Deferred revenue—current $ 1,410 $ 718 Deferred margin on component sales 545 324 Other accrued tax liabilities 488 388 Accrued marketing and distribution 288 298 Accrued compensation and employee benefits 254 221 Accrued warranty and related costs 230 284 Other current liabilities 1,114 820 Total accrued expenses $ 4,329 $ 3,053 Non-Current Liabilities 2007 2006 Deferred revenue—non-current $ 830 $ 383 Deferred tax liabilities 619 381 Other non-current liabilities 67 14 Total non-current liabilities $ 1,516 $ 778 72 Other Income and Expense 2007 2006 2005 Interest income $ 647 $ 394 $ 183 Other income (expense), net (48 ) (29 ) (18 ) Total other income and expense $ 599 $ 365 $ 165 Note 4—Goodwill and Other Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 2 to 10 years. The following table summarizes the +components of gross and net intangible asset balances (in millions): September 29, 2007 September 30, 2006 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired technology $ 276 $ (77 ) $ 199 $ 181 $ (42 ) $ 139 Indefinite lived and unamortizable trademarks 100 — 100 — — — Total acquired intangible assets $ 376 $ (77 ) $ 299 $ 181 $ (42 ) $ 139 Goodwill $ 38 $ — $ 38 $ 38 $ — $ 38 As +of September 29, 2007, and September 30, 2006, the weighted-average amortization period for acquired technology was 7.1 years and 8.5 years, respectively. During +2006, the Company sold certain assets related to its PowerSchool web-based student information system operations. In connection with this sale, the Company reduced goodwill by +$31 million for the outstanding balance from the acquisition of PowerSchool, Inc. in 2001 and recognized a $4 million pre-tax gain, which is reflected in other income +and expense in the Consolidated Statement of Operations. Expected +annual amortization expense related to acquired technology is as follows (in millions): Fiscal Years: 2008 $ 52 2009 37 2010 28 2011 25 2012 19 Thereafter 38 Total $ 199 Amortization +expense related to acquired intangible assets was $35 million, $12 million, and $9 million in 2007, 2006, and 2005, respectively. 73 Note 5—Income Taxes The provision for income taxes consisted of the following (in millions): 2007 2006 2005 Federal: Current $ 1,219 $ 619 $ 305 Deferred 85 56 144 1,304 675 449 State: Current 112 56 66 Deferred 9 14 (91 ) 121 70 (25 ) Foreign: Current 103 101 59 Deferred (16 ) (17 ) (3 ) 87 84 56 Provision for income taxes $ 1,512 $ 829 $ 480 The +foreign provision for income taxes is based on foreign pretax earnings of $2.2 billion, $1.5 billion, and $922 million in 2007, 2006, and 2005, respectively. As of +September 29, 2007, $6.5 billion of the Company's cash, cash equivalents, and short-term investments were held by foreign subsidiaries and are generally based in U.S. +dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The Company's consolidated financial statements provide for +any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company's foreign subsidiaries that are intended to be indefinitely reinvested in +operations outside the U.S. U.S. income taxes have not been provided on a cumulative total of $2.4 billion of such earnings. It is not practicable to determine the income tax liability that +might be incurred if these earnings were to be distributed. Deferred +tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts +of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected +to be recovered or settled. 74 As +of September 29, 2007 and September 30, 2006, the significant components of the Company's deferred tax assets and liabilities were (in millions): 2007 2006 Deferred tax assets: Accrued liabilities and other reserves $ 679 $ 485 Tax losses and credits 8 55 Basis of capital assets and investments 146 124 Accounts receivable and inventory reserves 64 45 Other 161 30 Total deferred tax assets 1,058 739 Less valuation allowance 5 5 Net deferred tax assets 1,053 734 Deferred tax liabilities: Unremitted earnings of subsidiaries 803 514 Total deferred tax liabilities 803 514 Net deferred tax asset $ 250 $ 220 As +of September 29, 2007, the Company has tax loss and credit carryforwards in the tax effected amount of $8 million. As of September 29, 2007 and September 30, 2006, a +valuation allowance of $5 million was recorded against the deferred tax asset for the benefits of state operating losses that may not be realized. Management believes it is more likely than not +that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to +fully recover the remaining deferred tax assets. A +reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate (35% in 2007, 2006, and 2005) to income before provision for income +taxes, is as follows (in millions): 2007 2006 2005 Computed expected tax $ 1,753 $ 987 $ 633 State taxes, net of federal effect 140 86 (19 ) Indefinitely invested earnings of foreign subsidiaries (297 ) (224 ) (98 ) Nondeductible executive compensation 6 11 14 Research and development credit, net (54 ) (12 ) (26 ) Other items (36 ) (19 ) (24 ) Provision for income taxes $ 1,512 $ 829 $ 480 Effective tax rate 30 % 29 % 27 % The +Company's income taxes payable have been reduced by the tax benefits from employee stock options. The Company receives an income tax benefit calculated as the difference between the fair market +value of the stock issued at the time of the exercise and the option price, tax effected. The net tax benefits from employee stock option transactions were $398 million, $419 million, +and $428 million in 2007, 2006, and 2005, respectively, and were reflected as an increase to common stock in the Consolidated Statements of Shareholders' Equity. 75 The +Internal Revenue Service ("IRS") has completed its field audit of the Company's federal income tax returns for the years 2002 through 2003 and proposed certain adjustments. The Company intends to +contest certain of these adjustments through the IRS Appeals Office. All IRS audit issues for years prior to 2002 have been resolved. In addition, the Company is also subject to audits by state, +local, and foreign tax authorities. Management believes that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be +predicted with certainty. Should any issues addressed in the Company's tax audits be resolved in a manner not consistent with management's expectations, the Company could be required to adjust its +provision for income tax in the period such resolution occurs. In 2007 and 2006, the Company recorded tax benefits of $63 million and $20 million, respectively, due to the settlement of +prior year tax audits in the U.S. Note 6—Shareholders' Equity Preferred Stock The Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company's Restated Articles of Incorporation, +the Board of Directors is authorized to determine or alter the rights, preferences, privileges and restrictions of the Company's authorized but unissued shares of preferred stock. Restricted Stock Units The Company's Board of Directors has granted RSUs to members of the Company's management team, excluding its CEO. These RSUs generally vest over four years either at the end of +the four-year service period, in two equal installments on the second and fourth anniversaries of the date of grant, or in equal installments on each of the first through fourth +anniversaries of the grant date. Upon vesting, the RSUs will convert into an equivalent number of shares of common stock. The compensation expense incurred by the Company for RSUs is based on the +closing market price of the Company's common stock on the date of grant and is amortized ratably on a straight-line basis over the requisite service period. The RSUs have been reflected in +the calculation of diluted earnings per share utilizing the treasury stock method. During +2007 and 2006, 45,000 and 2.47 million, respectively, previously granted RSUs vested. A majority of these vested RSUs were net-share settled such that the Company withheld +shares with value equivalent to the employees' minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total +shares withheld of approximately 20,000 and 990,000 for 2007 and 2006, respectively, was based on the value of the RSUs on their vesting date as determined by the Company's closing stock price. Total +payments for the employees' tax obligations to the taxing authorities were $3 million and $59 million in 2007 and 2006, respectively, and are reflected as a financing activity within the +Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the number of shares that would have +otherwise been issued as a result of the vesting and did not represent an expense to the Company. CEO Restricted Stock Award On March 19, 2003, the Company's Board of Directors granted 10 million shares of restricted stock to the Company's CEO that vested on March 19, 2006. The +amount of the restricted stock award expensed by the Company was based on the closing market price of the Company's common stock on the date of grant and was amortized ratably on a +straight-line basis over the three-year requisite service period. Upon vesting during 2006, the 10 million shares of restricted stock had a fair value of +$646.6 million and had grant-date fair value of $7.48 per share. The restricted stock award was net-share settled such that the Company withheld shares with value +equivalent to the CEO's minimum statutory obligation for the applicable 76 income +and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld of 4.6 million were based on the value of the restricted stock award on +the vesting date as determined by the Company's closing stock price of $64.66. The remaining shares net of those withheld were delivered to the Company's CEO. Total payments for the CEO's tax +obligations to the taxing authorities was $296 million in 2006 and are reflected as a financing activity within the Consolidated Statements of Cash Flows. The net-share settlement +had the effect of share repurchases by the Company as it reduced and retired the number of shares outstanding and did not represent an expense to the Company. The Company's CEO has no remaining shares +of restricted stock. For the years ended September 30, 2006 and September 24, 2005, compensation expense related to restricted stock was $4.6 million and $24.9 million, +respectively. Stock Repurchase Plan In July 1999, the Company's Board of Directors authorized a plan for the Company to repurchase up to $500 million of its common stock. This repurchase plan does +not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. The Company has repurchased a total of 13.1 million shares at a cost of +$217 million under this plan and was authorized to repurchase up to an additional $283 million of its common stock as of September 29, 2007. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under +U.S. generally accepted accounting principles are recorded as an element of shareholders' equity but are excluded from net income. The Company's other comprehensive income consists of foreign currency +translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. The +following table summarizes the components of accumulated other comprehensive income, net of taxes (in millions): 2007 2006 2005 Unrealized losses on available-for-sale securities $ (7 ) $ — $ (4 ) Unrealized gains on derivative instruments — 3 4 Cumulative foreign currency translation 70 19 — Accumulated other comprehensive income $ 63 $ 22 $ — The +change in fair value of available-for-sale securities included in other comprehensive income was $(7) million, $4 million, and zero, net of taxes in 2007, 2006, and +2005, respectively. The tax effect related to the change in unrealized gain/loss on available-for-sale securities was $4 million, $(2) million, and zero for 2007, 2006, +and 2005, respectively. 77 The +following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by the Company (in millions): 2007 2006 2005 Changes in fair value of derivatives $ (1 ) $ 11 $ 7 Adjustment for net (losses)/gains realized and included in net income (2 ) (12 ) 1 Change in unrealized gains on derivative instruments $ (3 ) $ (1 ) $ 8 The +tax effect related to the changes in fair value of derivatives was $1 million, $(8) million, and $(3) million for 2007, 2006, and 2005, respectively. The tax effect related to derivative +gains/losses reclassified from other comprehensive income to net income was $2 million, $8 million, and $(2) million for 2007, 2006, and 2005, respectively. Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the "2003 Plan") is a shareholder approved plan that provides for broad-based grants to employees, including executive officers. Based on the +terms of individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of four years, based on +continued employment, with either annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock +purchase rights and performance-based awards. +During 2007, the Company's shareholders approved an amendment to the 2003 Plan to increase the number of shares authorized for issuance by 28 million shares. 1997 Employee Stock Option Plan In August 1997, the Company's Board of Directors approved the 1997 Employee Stock Option Plan (the "1997 Plan"), a non-shareholder approved plan for grants +of stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire 7 to 10 years after the +grant date and generally become exercisable over a period of four years, based on continued employment, with either annual or quarterly vesting. In October 2003, the Company terminated the 1997 +Plan and no new options can be granted from this plan. 1997 Director Stock Option Plan In August 1997, the Company's Board of Directors adopted a Director Stock Option Plan (the "Director Plan") for non-employee directors of the Company, which +was approved by shareholders in 1998. Pursuant to the Director Plan, the Company's non-employee directors are granted an option to acquire 30,000 shares of common stock upon their initial +election to the Board ("Initial Options " ). The Initial Options vest and become exercisable in three equal annual installments on each of the first +through third anniversaries of the grant date. On the fourth anniversary of a non-employee director's initial election to the Board and on each subsequent anniversary thereafter, the +director will be entitled to receive an option to acquire 10,000 shares of common stock ("Annual Options"). Annual Options are fully vested and immediately exercisable on their date of grant. Rule 10b5-1 Trading Plans Certain of the Company's executive officers, including Mr. Timothy D. Cook, Mr. Peter Oppenheimer, Mr. Philip W. Schiller, and Dr. Bertrand Serlet, +have entered into trading plans pursuant to 78 Rule 10b5-1(c)(1) +of the Securities Exchange Act of 1934, as amended. A trading plan is a written document that pre-establishes the amounts, prices and dates (or formula +for determining the amounts, prices and dates) of future purchases or sales of the Company's stock including the exercise and sale of employee stock options and shares acquired pursuant to the +Company's employee stock purchase plan and upon vesting of RSUs. Employee Stock Purchase Plan The Company has a shareholder approved employee stock purchase plan (the "Purchase Plan"), under which substantially all employees may purchase common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six-month offering periods. Stock purchases under the Purchase Plan are limited to +10% of an employee's compensation, up to a maximum of $25,000 in any calendar year. During 2007, the Company's shareholders approved an amendment to the Purchase Plan to increase the number of shares +authorized for issuance by 6 million shares and limit the number of shares that may be purchased in any calendar year to 3 million shares. As of September 29, 2007, approximately +7 million shares were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an employee savings plan (the "Savings Plan") qualifying as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the +Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the Internal Revenue Service annual contribution limit ($15,500 for calendar year 2007). The +Company matches 50% to 100% of each employee's contributions, depending on length of service, up to a maximum 6% of the employee's eligible earnings. The Company's matching contributions to the +Savings Plan were $39 million, $33 million, and $28 million in 2007, 2006, and 2005, respectively. 79 Stock Option Activity A summary of the Company's stock option activity and related information for the last three fiscal years follows (stock award amounts and aggregate intrinsic value are +presented in thousands): Outstanding Options Shares Available for Grant Number of Shares Weighted-Average Exercise Price Weighted-Average Remaining Contractual Term Aggregate Intrinsic Value Balance at September 25, 2004 24,050 110,722 $ 10.52 Additional options authorized 49,000 — — Restricted stock units granted (460 ) — — Options granted (16,214 ) 16,214 $ 42.52 Options cancelled 3,844 (3,844 ) $ 13.28 Options exercised — (49,871 ) $ 10.05 Restricted stock units cancelled 230 — — Plan shares expired (1,493 ) — — Balance at September 24, 2005 58,957 73,221 $ 17.79 Restricted stock units granted (2,950 ) — — Options granted (3,881 ) 3,881 $ 65.28 Options cancelled 2,325 (2,325 ) $ 29.32 Restricted stock units cancelled 625 — — Options exercised — (21,795 ) $ 11.78 Plan shares expired (82 ) — — Balance at September 30, 2006 54,994 52,982 $ 23.23 Additional shares authorized 28,000 — — Restricted stock units granted (2,640 ) — — Options granted (14,010 ) 14,010 $ 94.52 Options cancelled 1,471 (1,471 ) $ 55.38 Restricted stock units cancelled 20 — — Options exercised — (15,770 ) $ 18.32 Plan shares expired (8 ) — — Balance at September 29, 2007 67,827 49,751 $ 43.91 4.57 $ 5,450,528 Exercisable at September 29, 2007 27,319 $ 23.13 3.80 $ 3,560,682 Expected to Vest after September 29, 2007 21,260 $ 72.69 5.51 $ 1,717,383 Aggregate intrinsic value represents the value of the Company's closing stock price on the last trading day of the fiscal period in excess of the exercise price +multiplied by the number of options outstanding or exercisable. Total intrinsic value of options at time of exercise was $1.3 billion, $1.2 billion, and $1.1 billion for 2007, +2006, and 2005, respectively. The +Company recognized $242 million, $163 million and $49 million of stock-based compensation expense in 2007, 2006 and 2005, respectively. Capitalized stock-based compensation +costs were $9 million as of September 29, 2007. There were no stock-based compensation costs capitalized as of September 30, 2006. The income tax benefit related to stock-based +compensation expense was $81 million and $39 million for the years ended September 29, 2007 and September 30, 2006, respectively. The total unrecognized compensation cost +related to stock options and RSUs expected to vest was $631 million and $375 million as of September 29, 2007 and September 30, 2006, respectively. The total unrecognized +compensation cost as of September 29, 2007, is expected to be recognized over a weighted-average period of 2.92 years. 80 Note 6—Shareholders' Equity (Continued) As of September 29, 2007, the Company had 4.7 million RSUs outstanding with a total grant-date fair value of $249 million that were excluded +from the options outstanding balances in the preceding table. The weighted-average grant date fair value of RSUs granted during 2007, 2006, and 2005 was $88.51 per share, $70.92 per share, and $45.04 +per share, respectively. Aggregate intrinsic value of RSUs was $701.3 million and $262.5 million at September 29, 2007 and September 30, 2006, respectively. RSUs that +vested during 2007 and 2006 totaled 45,000 and 2.47 million, respectively, and had a fair value of $6.1 million and $148.5 million, respectively, as of the vesting date. Shares of +RSUs granted after April 2005 have been deducted from the shares available for grant under the Company's stock option plans utilizing a factor of two times the number of RSUs granted. Note 7—Stock-Based Compensation The Company has provided pro forma disclosures in Note 1 of the effect on net income and earnings per share for the year ended September 24, 2005 as if the fair +value method of accounting for stock-based compensation had been used for its employee stock option grants and employee stock purchase plan purchases. These pro forma effects have been estimated at +the date of grant and beginning of the period, respectively, using the BSM option-pricing model. The +Company uses the BSM option-pricing model to calculate the fair value of stock-based awards. The BSM option-pricing model incorporates various assumptions including expected volatility, expected +life, and interest rates. The expected volatility is based on the historical volatility of the Company's common stock over the most recent period commensurate with the estimated expected life of the +Company's stock options and other relevant factors including implied volatility in market traded options on the Company's common stock. The Company bases its expected life assumption on its historical +experience and on the terms and conditions of the stock awards it grants to employees. Stock-based compensation cost is estimated at the grant date based on the award's fair-value as +calculated by the BSM option-pricing model and is recognized as expense ratably on a straight-line basis over the requisite service period. The +weighted average assumptions used for 2007, 2006, and 2005 and the resulting estimates of weighted-average fair value per share of options granted and for stock purchases during those periods are +as follows: 2007 2006 2005 Expected life of stock options 3.46 years 3.56 years 3.57 years Expected life of stock purchases 6 months 6 months 6 months Interest rate—stock options 4.61 % 4.60 % 3.73 % Interest rate—stock purchases 5.13 % 4.29 % 2.54 % Volatility—stock options 38.13 % 40.34 % 39.52 % Volatility—stock purchases 39.22 % 39.56 % 40.88 % Dividend yields — — — Weighted-average fair value of options granted during the year $ 31.86 $ 23.16 $ 14.41 Weighted-average fair value of stock purchases during the year $ 20.90 $ 14.06 $ 7.55 Note 8—Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other +off-balance sheet financing arrangements. The major facility leases are generally for terms of 3 to 15 years and generally 81 provide +renewal options for terms of 3 to 7 additional years. Leases for retail space are for terms of 5 to 20 years, the majority of which are for 10 years, and often contain +multi-year renewal options. As of September 29, 2007, the Company's total future minimum lease payments under noncancelable operating leases were $1.4 billion, of which +$1.1 billion related to leases for retail space. Rent +expense under all operating leases, including both cancelable and noncancelable leases, was $151 million, $138 million, and $140 million in 2007, 2006, and 2005, +respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 29, 2007, are as follows (in millions): Fiscal Years 2008 $ 155 2009 172 2010 173 2011 160 2012 148 Thereafter 617 Total minimum lease payments $ 1,425 Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of +purchase by the end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company's hardware products. The Company provides currently +for the estimated cost that may be incurred under its basic limited product warranties at the time related revenue is recognized. Factors considered in determining appropriate accruals for product +warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, historical and projected +cost-per-claim, and knowledge of specific product failures that are outside of the Company's typical experience. The Company assesses the adequacy of its preexisting warranty +liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. For products accounted for under subscription accounting pursuant to SOP +No. 97-2, the Company recognizes warranty expense as incurred. The +Company periodically provides updates to its applications and system software to maintain the software's compliance with specifications. The estimated cost to develop such updates is accounted for +as warranty costs that are recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units +delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates. 82 The +following table reconciles changes in the Company's accrued warranties and related costs (in millions): 2007 2006 2005 Beginning accrued warranty and related costs $ 284 $ 188 $ 105 Cost of warranty claims (281 ) (267 ) (188 ) Accruals for product warranties 227 363 271 Ending accrued warranty and related costs $ 230 $ 284 $ 188 The +Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property +rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim +against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against itself or an +indemnified third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would have a material adverse +effect on its financial condition or operating results. Therefore, the Company did not record a liability for infringement costs as of either September 29, 2007 or September 30, 2006. Concentrations in the Available Sources of Supply of Materials and Product Certain key components including, but not limited to, microprocessors, enclosures, certain LCDs, certain optical drives, and application-specific integrated circuits ("ASICs") +are currently obtained by the Company from single or limited sources which subjects the Company to supply and pricing risks. Many of these and other key components that are available from multiple +sources including, but not limited to, NAND flash memory, DRAM memory, and certain LCDs, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. In +addition, the Company has entered into certain agreements for the supply of critical components at favorable pricing, and there is no guarantee that the Company will be able to extend or renew these +agreements when they expire. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that can adversely affect gross margins and operating margins. In +addition, the Company uses some components that are not common to the rest of the global personal computer, consumer electronics and mobile communication industries, and new products introduced by the +Company often utilize custom components obtained from only one source until the Company has evaluated whether there is a need for and subsequently qualifies additional suppliers. If the supply of a +key single-sourced component to the Company were to be delayed or curtailed, or in the event a key manufacturing vendor delays shipments of completed products to the Company, the Company's ability to +ship related products in desired quantities and in a timely manner could be adversely affected. The Company's business and financial performance could also be adversely affected depending on the time +required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components may be +affected if producers were to decide to concentrate on the production of common components instead of components customized to meet the Company's requirements. Finally, significant portions of the +Company's CPUs, iPods, iPhones, logic boards, and other assembled products are now manufactured by outsourcing partners, primarily in various parts of Asia. A significant concentration of this +outsourced manufacturing is currently performed by only a few of the Company's outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced +supplier of components and manufacturing outsourcing for many of the Company's key products, including but not limited to, assembly 83 of +most of the Company's portable Mac computers, iPods, and iPhones. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company's operating results could +be adversely affected if its outsourcing partners were unable to meet their production commitments. Long-Term Supply Agreements During the first quarter of 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron +Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010. As part of these agreements, the Company +prepaid $1.25 billion for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective agreement. The Company utilized +$208 million of the prepayment as of September 29, 2007. Contingencies The Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. In the opinion of +management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its +financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should +several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. Production +and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers +the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have recently been +passed in several jurisdictions in which the Company operates including various countries within Europe and Asia, certain Canadian provinces and certain states within the U.S. Although the Company +does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not +have a material adverse effect on the Company's financial condition or operating results. Note 9—Segment Information and Geographic Data In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , the Company reports +segment information based on the "management" approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the +Company's reportable segments. The +Company manages its business primarily on a geographic basis. Accordingly, the Company determined its operating segments, which are generally based on the nature and location of its customers, to +be the Americas, Europe, Japan, Asia-Pacific, Retail, and FileMaker operations. The Company's four geographical segments, together with the Retail segment, all sell the same products to +the same types of customers. The Company's reportable operating segments are comprised of the Americas, Europe, Japan, and Retail operations. The Americas, Europe, and Japan reportable segments +exclude activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries as well as the Middle East and Africa. The +Retail segment operates Apple-owned retail stores in the U.S., Canada, Japan, the U.K. and Italy. Other operating segments include 84 Asia-Pacific, +which includes Australia and Asia except for Japan, and the Company's subsidiary, FileMaker, Inc. Each reportable geographic operating segment provides similar +hardware and software products, similar services and the accounting policies of the various segments are the same as those described in Note 1. The +Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of the customers, and net +sales for the Retail segment are based on sales from the Company's retail stores. Operating income for each segment includes net sales to third parties, related cost of sales, and operating expenses +directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other +income and expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses such as manufacturing costs and +variances not included in standard costs, research and development, corporate marketing expenses, stock-based compensation expense, income taxes, various nonrecurring charges, and other separately +managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Segment assets exclude corporate assets such as cash, +short-term and long-term investments, manufacturing facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets, and retail store +construction-in-progress not subject to depreciation. Except for the Retail segment, capital asset purchases for long-lived assets are not reported to management by +segment. Capital asset purchases by the Retail segment were $294 million, $200 million, and $132 million for 2007, 2006, and 2005 respectively. From +the establishment of the Retail segment in fiscal 2001 through the quarter ended March 31, 2007, Company management assessed the segment's operating performance differently from the +Company's other operating segments. Because the Company's Retail initiative was an unproven concept at inception, management chose to measure the Retail segment's performance in a manner that would +allow comparability to the Company's major channel partners operating retail stores in the U.S. There were three significant differences in the measurement of the Retail segment's results relative to +the Company's other operating segments. First, the Retail segment's operating income reflected cost of sales for Apple products at amounts normally charged to Apple's major U.S. channel partners for +the same products, less the cost of the Company's sales programs and other costs to support those partners. Second, the cost of sales of the Company's service and support contracts, including the +AppleCare Protection Plan ("APP") and .Mac, were reflected in the Retail segment's results at the costs charged to major channel partners for such contracts, and all associated revenue was reflected +in the Retail segment's results at the time of sale rather than being amortized over the lives of the respective agreements. Because the Company had not yet earned the revenue or incurred the cost +associated with the sale of such contracts, an offset to these amounts was recognized in other segments' net sales and cost of sales. Third, the Company allocated certain expenses related to the +operation of its high-profile stores to corporate marketing expense. Having +operated the Company's Retail stores successfully for more than six years, management believes its Retail initiative is a proven concept that will continue to be an integral element of the +Company's distribution and marketing strategies. Additionally, the Company expects sales of iPhone by the Company's geographic and Retail operating segments to generate significant levels of deferred +revenue and deferred cost of sales over time. In consideration of these factors, management has determined that beginning with the quarter ended June 30, 2007, aligning measurements for the +performance of the Retail segment with those used for the Company's other operating segments provides the most meaningful information. Accordingly, management has begun to measure the Retail segment's +operating performance in a manner 85 generally +consistent with the Company's other operating segments. The cost of sales of the Company's products sold through the Retail segment is now reflected at amounts similar to the cost of sales +of the same products reflected in the Company's other operating segments. Revenue from APP and .Mac contracts sold through the Retail segment is now being recognized over the lives of the respective +service agreements. Additionally, the Retail segment is applying the same subscription accounting to iPhone net sales and cost of sales that the Company's other operating segments apply. Management +believes aligning measurements for the performance of the Retail segment with those used for the Company's other operating segments will provide greater comparability with the rest of the Company's +segments and allow for more meaningful assessment of the Retail segment's operating results. The Company has reclassified prior period operating segment results to reflect these changes in the +measurement of the operating results for the Retail segment, along with the corresponding offsetting impact to the Company's other operating segments. The +Company will continue to allocate certain operating expenses associated with its high-profile stores to corporate marketing expense to reflect the estimated Company-wide +benefit. These high-profile stores are larger than the Company's typical retail stores and were designed to further promote brand awareness and provide a venue for certain corporate sales +and marketing activities, including corporate briefings. The allocation of these operating costs to corporate expense is based on the amount incurred for a high-profile store in excess of +that incurred by a more typical Company retail location. The Company had opened a total of eight high-profile stores as of September 29, 2007. Expenses allocated to corporate +marketing resulting from the operations of high-profile stores were $39 million, $33 million, and $31 million for the years ended September 29, 2007, +September 30, 2006, and September 24, 2005 respectively. 86 Summary +information by operating segment follows (in millions): 2007 2006 2005 Americas: Net sales $ 11,596 $ 9,415 $ 6,658 Operating income $ 2,949 $ 1,899 $ 970 Depreciation, amortization, and accretion $ 9 $ 6 $ 6 Segment assets (a) $ 1,497 $ 896 $ 705 Europe: Net sales $ 5,460 $ 4,096 $ 3,073 Operating income $ 1,348 $ 627 $ 465 Depreciation, amortization, and accretion $ 6 $ 4 $ 4 Segment assets $ 595 $ 471 $ 289 Japan: Net sales $ 1,082 $ 1,211 $ 924 Operating income $ 232 $ 208 $ 147 Depreciation, amortization, and accretion $ 3 $ 3 $ 3 Segment assets $ 159 $ 181 $ 165 Retail: Net sales $ 4,115 $ 3,246 $ 2,278 Operating income $ 875 $ 600 $ 396 Depreciation, amortization, and accretion (b) $ 88 $ 59 $ 43 Segment assets (b) $ 1,085 $ 651 $ 589 Other Segments (c): Net sales $ 1,753 $ 1,347 $ 998 Operating income $ 388 $ 235 $ 118 Depreciation, amortization, and accretion $ 3 $ 3 $ 2 Segment assets $ 252 $ 180 $ 133 (a) The +Americas asset figures do not include fixed assets held in the U.S. Such fixed assets are not allocated specifically to the Americas segment and are included in the corporate +assets figures below. (b) Retail +segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. Retail store +construction-in-progress, which is not subject to depreciation, is reflected in corporate assets. (c) Other +Segments include Asia-Pacific and FileMaker. 87 A +reconciliation of the Company's segment operating income and assets to the consolidated financial statements follows (in millions): 2007 2006 2005 Segment operating income $ 5,792 $ 3,569 $ 2,096 Other corporate expenses, net (a) (1,141 ) (953 ) (404 ) Stock-based compensation expense (242 ) (163 ) (49 ) Total operating income $ 4,409 $ 2,453 $ 1,643 Segment assets $ 3,588 $ 2,379 $ 1,881 Corporate assets 21,759 14,826 9,635 Consolidated assets $ 25,347 $ 17,205 $ 11,516 Segment depreciation, amortization, and accretion $ 109 $ 75 $ 58 Corporate depreciation, amortization, and accretion 208 150 121 Consolidated depreciation, amortization, and accretion $ 317 $ 225 $ 179 (a) Corporate +expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard costs, and other separately managed +general and administrative expenses including certain corporate expenses associated with support of the Retail segment. No +single customer or single country outside of the U.S. accounted for more than 10% of net sales in 2007, 2006, or 2005. Net sales and long-lived assets related to the U.S. and +international operations are as follows (in millions): 2007 2006 2005 Net sales: U.S. $ 14,128 $ 11,486 $ 8,194 International 9,878 7,829 5,737 Total net sales $ 24,006 $ 19,315 $ 13,931 Long-lived assets: U.S. $ 1,752 $ 1,150 $ 738 International 260 218 175 Total long-lived assets $ 2,012 $ 1,368 $ 913 88 Information +regarding net sales by product is as follows (in millions): 2007 2006 2005 Net sales: Desktops (a) $ 4,020 $ 3,319 $ 3,436 Portables (b) 6,294 4,056 2,839 Total Mac net sales 10,314 7,375 6,275 iPod 8,305 7,676 4,540 Other music related products and services (c) 2,496 1,885 899 iPhone and related products and services (d) 123 — — Peripherals and other hardware (e) 1,260 1,100 1,126 Software, service, and other net sales (f) 1,508 1,279 1,091 Total net sales $ 24,006 $ 19,315 $ 13,931 (a) Includes +iMac, eMac, Mac mini, Power Mac, Mac Pro, and Xserve product lines. (b) Includes +MacBook, iBook, MacBook Pro, and PowerBook product lines. (c) Consists +of iTunes Store sales and iPod services, and Apple-branded and third-party iPod accessories. (d) Derived +from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (e) Includes +sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (f) Includes +sales of Apple-branded operating system and application software, third-party software, AppleCare, and Internet services. Note 10—Related Party Transactions and Certain Other Transactions The Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private plane +when used for Apple business. The Company recognized a total of approximately $776,000, $202,000, and $1,100,000 in expenses pursuant to the Reimbursement Agreement during 2007, 2006, and 2005, +respectively. In +2006, the Company entered into an agreement with Pixar to sell certain of Pixar's short films on the iTunes Store. Mr. Jobs was the CEO, Chairman, and a large shareholder of Pixar. On +May 5, 2006, The Walt Disney Company ("Disney") acquired Pixar, which resulted in Pixar becoming a wholly-owned subsidiary of Disney. Upon Disney's acquisition of Pixar, Mr. Jobs' shares +of Pixar common stock were exchanged for Disney's common stock and he was elected to the Disney Board of Directors. Royalty expense recognized by the Company under the arrangement with Pixar from +September 25, 2005 through May 5, 2006 was less than $1 million. 89 Note 11—Selected Quarterly Financial Information (Unaudited) The following tables set forth a summary of the Company's quarterly financial information for each of the four quarters ended September 29, 2007 and September 30, +2006 (in millions, except share and per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2007 Net sales $ 6,217 $ 5,410 $ 5,264 $ 7,115 Gross margin $ 2,090 $ 1,995 $ 1,849 $ 2,220 Net income $ 904 $ 818 $ 770 $ 1,004 Earnings per common share: Basic $ 1.04 $ 0.94 $ 0.89 $ 1.17 Diluted $ 1.01 $ 0.92 $ 0.87 $ 1.14 2006 Net sales $ 4,837 $ 4,370 $ 4,359 $ 5,749 Gross margin $ 1,412 $ 1,325 $ 1,297 $ 1,564 Net income $ 542 $ 472 $ 410 $ 565 Earnings per common share: Basic $ 0.63 $ 0.55 $ 0.49 $ 0.68 Diluted $ 0.62 $ 0.54 $ 0.47 $ 0.65 Basic +and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic +and diluted earnings per share. 90 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The +Board of Directors and Shareholders Apple Inc.: We +have audited the accompanying consolidated balance sheets of Apple Inc. and subsidiaries (the Company) as of September 29, 2007 and September 30, 2006, and the related +consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended September 29, 2007. These consolidated financial +statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We +conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the +financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. +We believe that our audits provide a reasonable basis for our opinion. In +our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Inc. and subsidiaries as of +September 29, 2007 and September 30, 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended September 29, +2007, in conformity with U.S. generally accepted accounting principles. As +discussed in Note 1 to the Consolidated Financial Statements, effective September 25, 2005, the Company adopted the provisions of Statement of Financial Accounting Standards +No. 123R, Share-Based Payment . We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple Inc.'s internal control over financial reporting as of +September 29, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO), and our report dated November 15, 2007 expressed an unqualified opinion on the effectiveness of the Company's internal control over financial +reporting. /s/ +KPMG LLP Mountain +View, California November 15, 2007 91 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The +Board of Directors and Shareholders Apple Inc.: We +have audited Apple Inc.'s internal control over financial reporting as of September 29, 2007, based on criteria established in Internal +Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) . Apple's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included +in the accompanying Management's Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting +based on our audit. We +conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain +reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over +financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit +also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A +company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements +for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain +to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are +being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because +of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are +subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In +our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 29, 2007, based on criteria established in Internal Control—Integrated +Framework issued by COSO. We +also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Apple Inc. as of September 29, +2007 and September 30, 2006, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the years in the three-year period ended +September 29, 2007, and our report dated November 15, 2007 expressed an unqualified opinion on those consolidated financial statements . /s/ +KPMG LLP Mountain +View, California November 15, 2007 92 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company's management, the Company's principal executive officer and principal financial officer +have concluded that the Company's disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended +("Exchange Act") were effective as of September 29, 2007 to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is +(i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the +Company's management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company's internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of +financial statements for external purposes in accordance with generally accepted accounting principles. The Company's internal control over financial reporting includes those policies and procedures +that: (i) pertain +to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company's assets; (ii) provide +reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, +and that the Company's receipts and expenditures are being made only in accordance with authorizations of the Company's management and directors; and (iii) provide +reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company's assets that could have a material effect on +the financial statements. Management, +including the Company's Chief Executive Officer and Chief Financial Officer, does not expect that the Company's internal controls will prevent or detect all errors and all fraud. A control +system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must +reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation +of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods +are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management's Annual Report on Internal Control Over Financial Reporting The Company's management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) +under the Securities Exchange Act of 1934, as amended). Management conducted an evaluation of the effectiveness of the Company's internal control over financial reporting based on the criteria set +forth in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission ("COSO"). Based on this evaluation, management has concluded +that the Company's internal control over financial reporting was effective as of September 29, 2007. The Company's independent registered public accounting firm, KPMG 93 LLP, +has issued an attestation report on the Company's internal control over financial reporting. The report on the audit of internal control over financial reporting appears on page 92 of this +Form 10-K. Changes in Internal Control Over Financial Reporting There were no changes in the Company's internal control over financial reporting during the fourth quarter of fiscal 2007, which were identified in connection with management's +evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially +affect, the Company's internal control over financial reporting. Item 9B. Other Information On November 13, 2007, the Board of Directors of the Company amended and restated the Company's Amended Bylaws to permit the issuance of uncertificated shares of stock +and to make related conforming and mechanical changes. The foregoing description of the amendments to the Company's Amended and Restated Bylaws is qualified in its entirety by the text of the Amended +and Restated Bylaws, which is attached hereto as Exhibit 3.5 and is incorporated herein by reference. 94 PART III Item 10. Directors, Executive Officers and Corporate Governance Directors Listed below are the Company's seven directors whose terms expire at the next annual meeting of shareholders. Name Position With the Company Age Director Since William V. Campbell Co-lead Director 67 1997 Millard S. Drexler Director 63 1999 Albert A. Gore, Jr. Director 59 2003 Steven P. Jobs Director and Chief Executive Officer 52 1997 Arthur D. Levinson, Ph.D. Co-lead Director 57 2000 Eric E. Schmidt, Ph.D. Director 52 2006 Jerome B. York Director 69 1997 William V. Campbell has been Chairman of the Board of Directors of Intuit, Inc. ("Intuit") since August 1998. From +September 1999 to January 2000, Mr. Campbell acted as Chief Executive Officer of Intuit. From January 1994 to August 1998, Mr. Campbell was President and +Chief Executive Officer and a director of Intuit. From January 1991 to December 1993, Mr. Campbell was President and Chief Executive Officer of GO Corporation. Millard S. Drexler has been Chairman and Chief Executive Officer of J. Crew Group, Inc. since January 2003. Previously, +Mr. Drexler was Chief Executive Officer of Gap Inc. ("Gap") from 1995 and President from 1987 until 1995. Mr. Drexler was also a member of the Board of Directors of Gap from +November 1983 until October 2002. Albert A. Gore, Jr. has served as a Senior Advisor to Google, Inc. ("Google") since 2001. He has also served as Executive Chairman of +Current TV since 2002 and as Chairman of Generation Investment Management since 2004. He is a visiting professor at Middle Tennessee State University. Mr. Gore was inaugurated as the +45th Vice President of the United States in 1993. He was re-elected in 1996 and served for a total of eight years as President of the Senate, a member of the Cabinet and the National +Security Council. Prior to 1993, he served eight years in the U.S. Senate and eight years in the U.S. House of Representatives. Steven P. Jobs is one of the Company's co-founders and currently serves as its Chief Executive Officer. Mr. Jobs is also a director +of The Walt Disney Company. Arthur D. Levinson, Ph.D. has been Chief Executive Officer and a Director of Genentech Inc. ("Genentech") since July 1995. +Dr. Levinson has been Chairman of the Board of Directors of Genentech since September 1999. He joined Genentech in 1980 and served in a number of executive positions, including Senior +Vice President of R&D from 1993 to 1995. Dr. Levinson also serves on the Board of Directors of Google. Eric E. Schmidt, Ph.D. has served as the Chief Executive Officer of Google since July 2001 and as a member of Google's Board of Directors +since March 2001, where he served as Chairman of the Board from March 2001 to April 2004. In April 2004, Dr. Schmidt was named Chairman of the Executive Committee of +Google's Board of Directors. From April 1997 to November 2001, Dr. Schmidt served as Chairman of the Board of Directors of Novell, Inc. ("Novell"), a computer networking +company, and, from April 1997 to July 2001, as the Chief Executive Officer of Novell. Jerome B. York has been Chief Executive Officer of Harwinton Capital LLC (formerly Harwinton Capital Corporation), a private investment company that he +controls, since September 2003. From January 2000 until September 2003, Mr. York was Chairman and Chief Executive Officer of MicroWarehouse, Inc., a reseller of +computer hardware, software and peripheral products. From September 1995 to October 1999, 95 he +was Vice Chairman of Tracinda Corporation. From May 1993 to September 1995 he was Senior Vice President and Chief Financial Officer of IBM Corporation ("IBM"), and served as a member +of IBM's Board of Directors from January 1995 to August 1995. Mr. York is also a director of Tyco International Ltd. Role of the Board; Corporate Governance Matters It is the paramount duty of the Company's Board of Directors (the "Board of Directors") to oversee the Chief Executive Officer and other senior management in the competent and +ethical operation of the Company on a day-to-day basis and to assure that the long-term interests of the shareholders are being served. To satisfy this duty, the +directors take a proactive, focused approach to their position, and set standards to ensure that the Company is committed to business success through maintenance of high standards of responsibility +and ethics. Members +of the Board of Directors bring a wide range of experience, knowledge and judgment to the Company. These varied skills mean that governance is far more than a "check the box" approach to +standards or procedures. The governance structure in the Company is designed to be a working structure for principled actions, effective decision-making and appropriate monitoring of both compliance +and performance. The key practices and procedures of the Board of Directors are outlined in the Corporate Governance Guidelines available on the Company's website at www.apple.com/investor. Board Committees The Board of Directors has a standing Compensation Committee, a Nominating and Corporate Governance Committee ("Nominating Committee") and an Audit and Finance Committee +("Audit Committee"). All committee members are independent under the listing standards of the NASDAQ Global Select Market. The members of the committees are identified in the table below. Director Audit and Finance Committee Compensation Committee Nominating and Corporate Governance Committee William V. Campbell X Chair — Millard S. Drexler — X X Albert A. Gore, Jr. — X X Steven P. Jobs — — — Arthur D. Levinson, Ph.D. X — Chair Eric E. Schmidt, Ph.D. — — — Jerome B. York Chair — — The +Audit Committee is primarily responsible for overseeing the services performed by the Company's independent registered public accounting firm and internal audit department, evaluating the +Company's accounting policies and its system of internal controls and reviewing significant financial transactions. Members of the Audit Committee are Messrs. Campbell and York and +Dr. Levinson. The Audit Committee met a total of 14 times during fiscal year 2007. The +Compensation Committee is primarily responsible for reviewing the compensation arrangements for the Company's executive officers, including the Chief Executive Officer, and for administering the +Company's equity compensation plans. Members of the Compensation Committee are Messrs. Campbell, Drexler, and Gore. The Compensation Committee met a total of five (5) times during fiscal +year 2007. The +Nominating Committee assists the Board of Directors in identifying qualified individuals to become directors, determines the composition of the Board of Directors and its committees, monitors the +process to assess the Board of Directors' effectiveness and helps develop and implement the Company's corporate governance guidelines. The Nominating Committee also considers nominees proposed by +shareholders. 96 Members +of the Nominating Committee are Messrs. Drexler and Gore and Dr. Levinson. The Nominating Committee met a total of three (3) times during fiscal year 2007. The +Audit, Compensation and Nominating Committees operate under written charters adopted by the Board of Directors. These charters are available on the Company's website at www.apple.com/investor. Audit Committee Financial Expert The Board of Directors has determined that all members of the Company's Audit Committee, Messrs. Campbell and York and Dr. Levinson, qualify as "audit committee +financial experts" as defined by the Securities and Exchange Commission (the "SEC") and also meet the additional criteria for independence of Audit Committee members set forth in +Rule 10A-3(b)(l) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Code of Ethics The Company has a code of ethics that applies to all of the Company's employees, including its principal executive officer, principal financial officer and principal accounting +officer, and the Board of Directors. A copy of this code, "Ethics: The Way We Do Business Worldwide," is available on the Company's website at www.apple.com/investor. The Company intends to disclose +any changes in or waivers from its code of ethics by posting such information on its website or by filing a Form 8-K. Executive Officers of the Registrant The following sets forth certain information regarding executive officers of the Company. Information pertaining to Mr. Jobs, who is both a director and an executive +officer of the Company, may be found in the section entitled " Directors ." Name Position With the Company Age Timothy D. Cook Chief Operating Officer 46 Daniel Cooperman Senior Vice President, General Counsel and Secretary 56 Tony Fadell Senior Vice President, iPod Division 38 Ronald B. Johnson Senior Vice President, Retail 49 Peter Oppenheimer Senior Vice President and Chief Financial Officer 44 Philip W. Schiller Senior Vice President, Worldwide Product Marketing 47 Bertrand Serlet, Ph.D. Senior Vice President, Software Engineering 46 Sina Tamaddon Senior Vice President, Applications 50 Timothy D. Cook, Chief Operating Officer, joined the Company in March 1998. Mr. Cook also served in the position of Executive Vice +President, Worldwide Sales and Operations from 2002 to 2005. In 2004, his responsibilities were expanded to include the Company's Macintosh hardware engineering. From 2000 to 2002, Mr. Cook +served in the role of Senior Vice President, Worldwide Operations, Sales, Service and Support. From 1998 to 2000, Mr. Cook served in the position of Senior Vice President, Worldwide Operations. +Prior to joining the Company, Mr. Cook held the position of Vice President, Corporate Materials for Compaq Computer Corporation ("Compaq"). Previous to his work at Compaq, Mr. Cook was +the Chief Operating Officer of the Reseller Division at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, most recently as Director of North American Fulfillment. +Mr. Cook also serves as a member of the Board of Directors of Nike, Inc. Daniel Cooperman , Senior Vice President, General Counsel and Secretary, joined the Company in November 2007. Prior to joining the Company, he +served as Senior Vice President, General Counsel and Secretary of Oracle Corporation since February 1997. Prior to that, he had been associated with the law firm of McCutchen, Doyle, +Brown & Enersen (which is now Bingham McCutchen LLP) since October 1977, and had served as a partner since June 1983. From September 1995 until February 1997, 97 Mr. Cooperman +was Chair of the law firm's Business and Transactions Group and from April 1989 through September 1995, he served as the Managing Partner of the law firm's +San Jose office. Tony Fadell, Senior Vice President, iPod Division, joined the Company in 2001. From 2004 to April 2006, Mr. Fadell was Vice President of +iPod Engineering. From 2001 to 2004, Mr. Fadell was the Senior Director of the Company's iPod Engineering Team. Prior to joining Apple, Mr. Fadell was a co-founder, CTO, and +director of engineering of the Mobile Computing Group at Philips Electronics where he was responsible for all aspects of business and product development for a variety of products. Mr. Fadell +later became VP of Business Development for Philips U.S. Strategy & Ventures, focusing on building the company's digital media strategy and investment portfolio. Ronald B. Johnson, Senior Vice President, Retail, joined the Company in January 2000. Prior to joining the Company, Mr. Johnson spent +16 years with Target Stores, most recently as Senior Merchandising Executive. Peter Oppenheimer, Senior Vice President and Chief Financial Officer, joined the Company in July 1996. Mr. Oppenheimer also served the +Company in the position of Vice President and Corporate Controller, and as Senior Director of Finance for the Americas. Prior to joining the Company, Mr. Oppenheimer was CFO of one of the four +business units for Automatic Data Processing, Inc. ("ADP"). Prior to joining ADP, Mr. Oppenheimer spent six years in the Information Technology Consulting Practice with Coopers and +Lybrand. Philip W. Schiller, Senior Vice President, Worldwide Product Marketing, rejoined the Company in 1997. Prior to rejoining the Company, +Mr. Schiller was Vice President of Product Marketing at Macromedia, Inc. from December 1995 to March 1997, and was Director of Product Marketing at FirePower +Systems, Inc. from 1993 to December 1995. Prior to that, Mr. Schiller spent six years at the Company in various marketing positions. Bertrand Serlet, Ph.D., Senior Vice President, Software Engineering, joined the Company in February 1997 upon the Company's acquisition of +NeXT and also served the Company in the position of Vice President of Platform Technology. At NeXT, Dr. Serlet held several engineering and managerial positions, including Director of Web +Engineering. Prior to NeXT, from 1985 to 1989, Dr. Serlet worked as a research engineer at Xerox PARC. Sina Tamaddon, Senior Vice President, Applications, joined the Company in September 1997. Mr. Tamaddon has also served with the Company in +the position of Senior Vice President, Worldwide Service and Support, and Vice President and General Manager, Newton Group. Before joining the Company, Mr. Tamaddon held the position of Vice +President, Europe with NeXT from September 1996 through March 1997. From August 1994 to August 1996, Mr. Tamaddon held the position of Vice President, Professional +Services with NeXT. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Exchange Act requires the Company's executive officers and directors, and persons who own more than ten percent of a registered class of the +Company's equity securities, to file reports of securities ownership and changes in such ownership with the SEC. Executive officers, directors and greater than ten percent shareholders also are +required by rules promulgated by the SEC to furnish the Company with copies of all Section 16(a) forms they file. Based +solely upon a review of the copies of such forms furnished to the Company or written representations that no Forms 5 were required, the Company believes that all Section 16(a) +filing requirements were met during fiscal year 2007, except that (i) one Form 4 was filed for William Campbell on October 26, 2007 with respect to the purchase by +Mr. Campbell's independent money manager of 3,600, 2,600 and 2,900 shares of the Company's common stock, in February 2006, September 2006 and January 2007, respectively, +and the sale by Mr. Campbell's independent money manager of 2,200, 1,400 98 and +2,600 shares of the Company's common stock in April 2006, June 2006 and July 2007, respectively, and (ii) one Form 4 was filed for Tony Fadell on +November 15, 2007 with respect to the acquisition by Mr. Fadell's spouse of 40,000 restricted stock units in December 2006 and 25,000 restricted stock units in +October 2007. Item 11. Executive Compensation COMPENSATION DISCUSSION AND ANALYSIS A.    EXECUTIVE SUMMARY This +section explains Apple's executive compensation program as it relates to the following "named executive officers:" Steve Jobs Chief Executive Officer Tim Cook Chief Operating Officer Peter Oppenheimer Senior Vice President and Chief Financial Officer Ron Johnson Senior Vice President, Retail Sales Tony Fadell Senior Vice President, iPod Division Apple's +executive compensation program for the named executive officers consists of long-term equity awards in the form of restricted stock units ("RSUs") and cash compensation in the form +of performance-based cash incentives and base salaries. Each year, the Compensation Committee, which is made up entirely of independent directors, determines the compensation for the named executive +officers. Apple +relies heavily on long-term equity awards to attract and retain an outstanding executive team and to ensure a strong connection between executive compensation and financial +performance. An RSU award gives the named executive officer the right to receive, at no cost, a specified number of shares of Apple common stock when the award vests, typically at intervals of two to +four years. Because the value of the RSUs depends on Apple's future share price, the award links compensation to future financial performance. The officer is generally not eligible to receive the +shares if employment is terminated before the RSUs vest. The Compensation Committee reviews annually the outstanding, unvested equity awards of each named executive officer to determine, in the +Committee's discretion, whether additional awards are warranted in light of the officer's performance, the competitive environment and the other factors discussed in Section D3 below. The +performance-based cash incentives compensate the named executive officers for achieving specific financial goals established annually by the Compensation Committee, as described in Section D4. The +Committee sets aggressive performance goals each year based on the revenue and operating income objectives in Apple's internal business plan. Payments are not automatic, however, because the +Committee may exercise its discretion to reduce (but not increase) the amount of any incentive payment based on an officer's overall performance. Based +on the factors discussed in Section D3 below and the Committee's belief that the outstanding, unvested equity awards still had significant retention value, the Committee made no new equity +awards to the named executive officers in fiscal 2007. The officers earned cash incentives in fiscal 2007 at the maximum amount allowed by the plan—100% of base salary—because +Apple's financial performance significantly exceeded the annual performance goals set by the Committee. The Committee assessed both the amount and allocation of the compensation components for each +officer based on Apple's overall annual financial performance and each officer's individual performance. The Committee did not increase base salaries for the named executive officers because it +concluded that the total compensation for each officer was appropriate. 99 Apple's +shareholders have been generously rewarded for Apple's success, with a three-year annualized shareholder return of 101% through the end of fiscal 2007. The Committee believes the +compensation of the named executive officers has been appropriate and fair in light of Apple's performance. B.    EXECUTIVE COMPENSATION OBJECTIVES Apple's +goal for executive compensation is simple: attract and retain an exceptionally talented, entrepreneurial and creative team of executives who will provide the leadership for Apple's success in +dynamic, highly-competitive markets. C.    EXECUTIVE COMPENSATION OVERVIEW 1. Three Components The +compensation program for the named executive officers consists of the following three components, in order of their importance: • Long-term +equity awards in the form of RSUs under the shareholder-approved Employee Stock Plan • Annual +performance-based cash incentives under the shareholder-approved Performance Bonus Plan (the CEO, however, does not participate in this plan and is not eligible for +performance-based cash incentives) • Base +salary The +named executive officers are also eligible to participate in Apple's health and welfare programs, Employee Stock Purchase Plan, 401(k) Plan, patent bonus program and other minor employee +recognition programs on the same basis as other employees. 2. Mix of Equity, Cash Incentives and Salary Apple +relies heavily on long-term equity awards because the Compensation Committee believes they are the most effective compensation element for attracting entrepreneurial, creative +executives and promoting their long-term commitment to Apple. An RSU award generally vests only if the named executive officer continues employment until the specified vesting date, +typically two to four years after the date of grant. Equity awards also help to ensure a strong connection between executive compensation and Apple's financial performance because the value of RSUs +depends on Apple's future share price. Although +the Compensation Committee reviews the compensation practices of its peer companies as described in Section D6 below, the Committee does not adhere to strict formulas or survey data to +determine the mix of compensation elements. Instead, as described in Section D, the Committee considers various factors in exercising its discretion to determine compensation, including the +experience, responsibilities and performance of each named executive officer as well as Apple's overall +financial performance. This flexibility is particularly important in designing compensation arrangements to attract new executives in highly-competitive, rapidly changing markets. 3. Elements of Compensation Not Included In The Compensation Program The +current compensation program for the named executive officers, including the CEO, does not include the following: • Employment +contracts 100 • Cash +bonuses other than the performance-based cash incentives under the Performance Bonus Plan and payments under the patent bonus program • Severance +and change of control arrangements beyond what is available to all U.S. employees (with the exception of rights to accelerated vesting previously granted as part +of equity awards that will fully vest in March 2008) • Perquisites +or personal benefits that are not available to employees generally • Guarantees +of the value of equity awards 4. CEO Compensation Apple's +CEO, Steve Jobs, currently holds approximately 5.5 million shares of Apple common stock. Since rejoining Apple in 1997, Mr. Jobs has never sold a share of Apple stock. His last +equity grant was awarded in 2003, and vested in full in 2006. Mr. Jobs currently holds no unvested equity awards. In fiscal 2007, Mr. Jobs's entire compensation consisted of his $1 +annual salary. Because Mr. Jobs's continued leadership is critical to Apple, the Compensation Committee is considering additional compensation arrangements for him. Mr. Jobs +has received a $1 annual salary since he rejoined Apple in 1997 and began serving as interim CEO. In 1999, Apple awarded Mr. Jobs an aircraft as an executive bonus in +recognition of his outstanding performance during the previous two years. Mr. Jobs also received two stock option grants, one in 2000 and another in 2001. Mr. Jobs never exercised these +grants, and they were both cancelled in March 2003, when Apple awarded Mr. Jobs a grant of 5 million shares of restricted stock. The +2003 restricted stock grant required Mr. Jobs to remain employed by Apple for three more years before it vested. This grant, which increased to 10 million shares when Apple's common +stock split in 2005, vested in full in March 2006. After a portion of these shares was withheld for the payment of taxes, Mr. Jobs received the remaining 5,426,447 shares. Due in large +part to Mr. Jobs's leadership, Apple's stock price (after accounting for a stock split) increased from $7.47 on the March 2003 grant date to $64.66 on the March 2006 vesting +date—more than an eight-fold increase in three years. Under Mr. Jobs's continued leadership, Apple's stock price increased from $64.66 per share in March 2006 to +$189.95 per share as of October 31, 2007—a three-fold increase in approximately 18 months. When +he was elected to Apple's Board of Directors in 1997, Mr. Jobs received the standard director's stock option grant for 30,000 shares. Because Mr. Jobs became employed later that +year as Apple's interim CEO, he was no longer eligible for such director grants. When the 1997 director grant (which increased to 120,000 shares after two stock splits) was due to expire in +August 2007, Mr. Jobs exercised the option and he currently holds these 120,000 shares. D.    EXECUTIVE COMPENSATION PROGRAM DESIGN AND IMPLEMENTATION 1. Team-Based Compensation The +compensation program for the named executive officers rests on two assumptions. First, each officer must demonstrate exceptional personal performance in order to remain part of the executive +team. Second, each officer must contribute as a member of the team to Apple's overall success rather than merely achieve specific objectives within that officer's area of responsibility. 2. Independent Compensation Committee Determines All Executive Compensation The +Compensation Committee determines all compensation for the named executive officers. All three Committee members are independent of Apple's management. 101 During +the first quarter of each fiscal year, the Compensation Committee conducts an evaluation of each named executive officer to determine if any changes in the officer's compensation are +appropriate based on the considerations described below. The CEO does not participate in the Committee's deliberations or decision with regard to his compensation. At the Committee's request, the CEO +reviews with the Committee the performance of the other four named executive officers, but no other named executive officer has any input into executive compensation decisions. The Committee gives +considerable weight to the CEO's evaluation of the other named executive officers because of his direct knowledge of each officer's performance and contributions. For each officer, the Committee +members independently determine each component of compensation based on their collective assessment of the officer's performance as well as Apple's overall financial performance. 3. The Crucial Role of Long-Term Equity Awards Overview. The Committee believes that long-term equity awards are the most effective way to attract and retain a superlative +executive team. Accordingly, executive compensation is heavily weighted toward long-term equity awards rather than cash compensation, and the awards have long vesting intervals to maximize +their retention value. This approach is reflected in the following: • The +CEO's compensation has been generally tied to long-term equity; for example, his last equity award did not vest for three years. • For +the other four named executive officers, equity awards represented approximately 85% of their target total compensation in fiscal 2007. This compares to approximately +70% at Apple's peer companies. • Fiscal +2004 equity awards vested 50% on the second anniversary of the grant date; the remaining 50% will vest on the fourth anniversary of the grant date. • Fiscal +2006 equity awards do not vest at all until 2010, when they vest in full. In +designing long-term equity awards, the Committee seeks to maximize their effectiveness in accomplishing Apple's compensation objectives while recognizing the Board's duty to Apple's +shareholders to limit equity dilution. The Committee believes this balance has been achieved as follows: Restricted Stock Units Minimize Dilution and Support Long-Term Focus. Since fiscal 2004, all equity awards to the named +executive officers have been RSUs rather than stock options. A grant of RSUs gives an officer the right to receive a specified number of shares of Apple common stock, at no cost to the officer, if the +officer remains employed at Apple until the RSUs vest. RSUs granted in 2004 also provide for accelerated vesting if the named executive officer is terminated without cause or on a change of control, +RSUs granted before 2007 provide for accelerated vesting on a change of control, and all RSUs provide for accelerated vesting upon the death of the officer. The compensation value of an RSU does not +depend solely on future stock price increases; at grant, its value is equal to Apple's stock price. Although its value may increase or decrease with changes in the stock price during the period before +vesting, an RSU will have value in the long term, encouraging retention. By contrast, the entire compensation value of a stock option depends on future stock price appreciation. Accordingly, RSUs can +deliver significantly greater share-for-share compensation value at grant than stock options, and Apple can offer comparable grant date compensation value with fewer shares and +less dilution for its shareholders. Long Vesting Intervals to Maximize Retention. All vesting of RSUs is generally subject to continued employment. Except for occasional new +hire grants, vesting occurs at intervals of no 102 less +than two years after the grant date. This ensures that a meaningful portion of a named executive officer's awards will vest every two years—a strong incentive to continue employment +with Apple. The following table shows the grant and vesting patterns for ongoing RSU grants for the named executive officers since fiscal 2004 (excluding those who were not named executive officers at +the time of grant). Equity Awards FY05 vesting FY06 vesting FY07 vesting FY08 vesting FY09 vesting FY10 vesting Fiscal 2004 RSU (excluding CEO) — 50 % — 50 % Fiscal 2006 RSU (excluding CEO) — — — — — 100 % Vesting Conditions. As noted above, the vesting of all RSUs is generally contingent on the named executive officer's continued employment +with Apple, rather than on performance with regard to specific business objectives. From time to time, the Compensation Committee has considered various forms of performance-based vesting. After +careful evaluation, the Committee has concluded that performance-based vesting would not serve Apple's current objectives as effectively as the program described above. The Committee generally grants +RSUs with two to four year vesting periods to maximize the award's retention value. This retention value would be undermined if a named executive officer's equity awards (which represent approximately +85% of the officer's compensation) were at risk based on performance measures that were determined two or even four years prior to the vesting date. Given the intensely dynamic business environment in +which Apple operates, it would be extremely difficult to craft meaningful objectives with such a long horizon. Apple imposes no requirement that the named executive officers hold their common stock +for any period after vesting. Annual Burn Rate Averages Less Than 2.5%. In fiscal 2005, Apple committed to an annual "burn rate" (the total number of all equity award +shares granted during the fiscal year divided by the total shares outstanding at the end of the fiscal year) of 2.5% from fiscal 2005 through fiscal 2007. This commitment represented a significant +reduction from an average burn rate of 4.8% from fiscal 2002 through fiscal 2004. In fact, Apple's average annual burn rate from fiscal 2005 through fiscal 2007 was approximately 1.6%. Overhang from Equity Plans at 12.9%. Overhang (granted and outstanding equity awards plus shares reserved for future awards, divided by the +sum of total shares outstanding, granted and outstanding equity awards, and shares reserved for future awards) is another measure of equity dilution. The efficient use of equity awards, combined with +the substantial exercise of employee stock options due to the significant increase in Apple's stock price over the past few years, has caused Apple's overhang to decline from approximately 14.5% at +the end of fiscal 2005 to approximately 12.9% at the end of fiscal 2007. Frequency and Size of Equity Awards. The named executive officers typically receive equity awards every two years, rather than every year. +This practice is consistent with the long time horizon and lengthy vesting periods of the awards. By making awards less frequently, the Committee can provide larger grants, which in turn promotes +greater retention. To +determine the size of RSU grants, the Compensation Committee first establishes a target compensation value that it wants to deliver to the named executive officers through long-term +equity awards. In doing so, the Committee considers various factors, including the following: • The +practice of granting equity only every two years • The +heavy weight placed on equity in the mix of total compensation 103 • The +officer's experience and performance • The +scope, responsibility and business impact of the officer's position • The +perceived retention value of the total compensation package in light of the competitive environment Once +the target value has been established, the Committee determines the number of shares by reference to the current value of Apple's common stock. 4. The Minor Role of Cash Compensation Base Salaries. The Committee believes that base salaries are significantly less important than performance-based bonuses and +long-term equity awards in meeting Apple's compensation objectives. The minor role of salaries as part of total compensation is reflected in the following: • The +CEO has received an annual base salary of $1 since rejoining Apple in 1997. • The +fiscal 2007 average base salary for the other named executive officers was below median among the peer companies shown in Section D6, despite Apple's +significantly greater financial and business success. • Base +salaries for the named executive officers have not increased since October 2005, except for a promotion-related increase for one officer. Performance-Based Cash Incentives. The Performance Bonus Plan, which has been approved by Apple's shareholders, authorizes the Committee to +issue plan-based cash incentive awards to compensate officers for achieving specific financial objectives that are established annually. The Committee believes that performance-based cash +compensation is an important component of executive compensation; however, it represents a small percentage of total compensation because its effectiveness in meeting Apple's compensation objectives +is limited. It is a less significant factor in attracting new executive talent than equity compensation, and it promotes retention only in the short-term—over the performance +period. Accordingly, the plan is modestly funded, as reflected by the following: • The +CEO does not participate in the Performance Bonus Plan. • Apple's +target payout of 50% of base salary is significantly lower than peer companies as a group, where median target bonus payouts range from 100% to 160% of base salary. • The +maximum payout of 100% for exceptional performance is also lower than peer companies, where 3 times the target range (i.e., 300% to 480% of base salary) is +becoming increasingly common. The +Compensation Committee establishes performance goals each year based on revenue and operating income objectives in Apple's internal business plan. The Committee has selected these performance +goals because they are important indicators of increased shareholder value. These performance goals generally exclude the effects of extraordinary, unusual or infrequently occurring events or changes +in accounting principles. Apple does not publicly disclose specific annual internal revenue or operating income objectives, as its business plan is highly confidential. Disclosing specific objectives +would provide competitors and other third parties with insights into the planning process and would therefore cause competitive harm. The +Committee next determines the maximum amount of any cash incentive payment denominated as a percentage of base salary. The current payment structure is shown in the payout matrix below. Once the +performance goals and payment structure are established, no one has the authority to modify or waive them. 104 Percentage of Salary Payable As Performance-Based Cash Incentives Revenue Operating Income Below Objective Meet Objective Above Objective Below Objective 0 % 25 % up to 50 % Meet Objective 25 % 50 % up to 75 % Above Objective up to 50 % up to 75 % up to 100 % The +performance goals are aggressive. Thus, there is considerable risk that payments will not be made at all or will be made at less than 100%. For the past three years, the performance goals have +reflected double-digit growth in both revenue and operating income. In four of the past eight years, Apple did +not meet one or both performance goals. This uncertainty ensures that any payments under the plan are truly performance-based, consistent with the plan's objectives. At +the end of the year, the Committee determines the amount of the award to be paid to each officer by comparing actual results to the performance goals. The Committee may, in its discretion, reduce +(but not increase) the amount of any individual award based on the officer's overall performance. The plan does not provide for the adjustment or recovery of an award paid to a named executive officer +if the results in a previous year are subsequently restated or adjusted in a manner that would have originally resulted in a smaller award. 5. The Role of Consultants The +Compensation Committee has selected and directly retained the services of Frederic W. Cook & Co., Inc., an executive compensation consulting firm. No member of the +Compensation Committee or any named executive officer has any affiliation with F.W. Cook. The Committee periodically seeks input from F.W. Cook on a range of external market factors, +including evolving compensation trends, appropriate comparison companies and market survey data. F.W. Cook also provides general observations on Apple's compensation programs, but it does not +determine or recommend the amount or form of compensation for any executives. 6. The Role of Peer Groups, Surveys and Benchmarking With +the assistance of F.W. Cook, the Committee identified peer companies for fiscal 2007 that compete with Apple in the labor and capital markets and that follow similar pay models. The Committee +established the two peer groups listed below, one consisting of large technology companies and another consisting of large retailers. The retail peer group is a relevant comparison group for the +Senior Vice President, Retail Sales; the technology peer group is relevant for the other four named executive officers. Technology Companies Retail Companies Adobe Systems Amazon.com Applied Materials Cisco Systems Comcast Dell eBay EMC Google Hewlett-Packard IBM Intel Microsoft Motorola Oracle Qualcomm Sprint Nextel Sun Microsystems Texas Instruments Xerox The Gymboree Corporation Limited Brands Nike Polo Ralph Lauren Restoration Hardware Sharper Image Target Tiffany & Co. Tween Brands Wal-Mart 105 The +Committee reviews compensation practices at peer companies (gathered from SEC filings and the Radford High Technology compensation survey) at a high level to ensure that Apple's total compensation +is within a reasonably competitive range. The Committee, however, does not attempt to set compensation components to meet specific benchmarks, such as salaries "above the median" or equity +compensation "at the 75 th percentile." Furthermore, the Committee believes that excessive reliance on benchmarking is detrimental to shareholder interests because it can result in +compensation that is unrelated to the value delivered by the named executive officers. 7. Tax and Accounting Considerations Tax Deductibility of Compensation Expense. Section 162(m) of the Internal Revenue Code places a limit of $1,000,000 on the amount of +compensation to certain officers that may be deducted by Apple as a business expense in any tax year unless, among other things, the compensation is performance-based and has been approved by the +shareholders. To qualify as performance-based compensation, the amount of compensation must depend on the officer's performance against pre-determined performance goals established by a +committee that consists solely of at least two "outside" directors who have never been employed by Apple or its subsidiaries. Two Compensation Committee members, Mr. Gore and +Mr. Drexler, qualify as outside directors under the IRS definition. Although Mr. Campbell is an independent director under SEC and NASDAQ governance standards, he does not qualify as an +outside director because he was an officer of Apple from 1983 to 1987 and an Apple subsidiary from 1987 to 1991. For this reason, he does not discuss or vote on any Section 162(m)-related +matters. Salaries +for the named executive officers do not qualify as performance-based compensation. Apple's performance-based cash incentives, however, are exempt from the Section 162(m) limit because +they are paid based on predetermined goals established by the Compensation Committee pursuant to the shareholder-approved Performance Bonus Plan. The RSUs do not qualify as performance-based +compensation for purposes of Section 162(m) because vesting is based on continued employment rather than specific performance goals. See page 103 for an explanation of Apple's decision +not to implement performance-based vesting. Tax Implications for Officers. Section 409A of the Internal Revenue Code imposes additional income taxes on executive officers for +certain types of deferred compensation that do not comply with Section 409A. Because Apple does not generally provide deferred compensation to the named executive officers, this limitation has +no impact on the structure of the compensation program for the officers. Section 280G of the Internal Revenue Code imposes an excise tax on payments to executives of severance or change of +control compensation that exceed the levels specified in Section 280G. The named executive officers could receive the amounts shown on the table on page 113 as severance or change of +control payments, but the Committee does not consider their potential impact in compensation program design. Accounting Considerations. The Committee also considers the accounting and cash flow implications of various forms of executive +compensation. In its financial statements, Apple records salaries and performance-based compensation incentives as expenses in the amount paid, or to be paid, to the named executive officers. +Accounting rules also require Apple to record an expense in its financial statements for equity awards, even though equity awards are not paid as cash to employees. The accounting expense of equity +awards to employees is calculated in accordance with SFAS 123R. The Committee believes, however, that the many advantages of equity compensation, as discussed above, more than compensate for +the non-cash accounting expense associated with them. 106 E.    Fiscal 2007 Compensation Decisions 1. No Equity Grants or Salary Changes In +fiscal 2007, the Committee did not grant new equity awards or increase base salaries for the named executive officers. Based on its assessment of the factors discussed above and the Committee's +belief that the outstanding, unvested equity grants at the beginning of fiscal 2007 had significant retention value, the Committee concluded that the compensation packages for the named executive +officers were reasonable without additional equity awards. The outstanding equity grants at the end of fiscal 2007 are shown on the Outstanding Equity Awards table on pages 110 and 111. Based +on a review of competitive practices and the Committee's approach to place less emphasis on cash compensation, the Committee concluded that the total compensation for the officers were appropriate for +fiscal 2007 without a salary increase. 2. 2007 Performance-Based Cash Incentive Plan Payments Apple's +fiscal 2007 performance significantly exceeded the revenue and operating income goals established under the cash incentive plan, so the Committee, in the exercise of its discretion, approved +payouts to the named executive officers at the maximum of 100% of base salary, pursuant to the payout matrix on page 105. The specific payment amounts are shown in the Summary Compensation +Table at page 108. Compensation Committee Report(1) The Compensation Committee has certain duties and powers as described in its charter. The Compensation Committee is currently composed of the three non-employee directors named at the end +of this report, each of whom is independent as defined by the NASDAQ listing standards. (1) SEC +filings sometimes "incorporate information by reference." This means the Company is referring to information that has previously been filed with the SEC, and that this information +should be considered as part of this filing. Unless the Company specifically states otherwise, this report shall not be deemed to be incorporated by reference and shall not constitute soliciting +material or otherwise be considered filed under the Securities Act or the Securities Exchange Act. The +Compensation Committee has reviewed and discussed with management the disclosures contained in the Compensation Discussion and Analysis section of this Form 10-K. Based upon +this review and discussion, the Compensation Committee recommended to the Board of Directors that the Compensation Discussion and Analysis section be included in this Form 10-K and +the Company's Proxy Statement for its 2008 Annual Meeting of Shareholders, to be filed with the SEC. Compensation Committee of the Board of Directors William V. Campbell (Chairman) Millard S. Drexler Albert A. Gore, Jr. 107 Summary Compensation Table The following table presents information regarding compensation of each of the Company's Named Executive Officers for services rendered during fiscal year 2007. Name and Principal Position (a) Year (b) Salary ($) (c) Bonus ($) (d) Stock Awards ($)(1) (e) Option Awards ($)(1) (f) Non-Equity Incentive Plan Compensation ($)(2) (g) Change in Pension Value and Nonqualified Deferred Compensation Earnings ($) (h) All Other Compensation ($) (i) Total ($) (j) Steven P. Jobs Chief Executive Officer 2007 1 — — — — — — 1 Timothy D. Cook Chief Operating Officer 2007 700,014 — 6,943,426 — 700,000 — 13,750 (3) 8,357,190 Peter Oppenheimer Senior Vice President and Chief Financial Officer 2007 600,012 — 4,946,610 — 600,000 — 598,723 (4) 6,745,345 Ronald B. Johnson Senior Vice President, Retail 2007 600,012 — 4,946,610 — 600,000 — 379 (5) 6,147,001 Tony Fadell Senior Vice President, iPod Division 2007 500,009 6,750 (6) 3,705,832 628,628 500,000 — 13,952 (7) 5,355,171 (1) The +amounts reported in Columns (e) and (f) of the table above reflect the aggregate dollar amounts recognized for stock awards and option awards, respectively, for +financial statement reporting purposes with respect to fiscal year 2007 (disregarding any estimate of forfeitures related to service-based vesting conditions). No stock awards or option awards granted +to Named Executive Officers were forfeited during fiscal year 2007. Detailed information about the amount recognized for specific awards is reported in the table under "Outstanding Equity Awards at +Fiscal Year-End" below. For a discussion of the assumptions and methodologies used to value the awards reported in Column (e) and Column (f), please see the discussion of stock +awards and option awards contained in Part II, Item 8, "Financial Statements and Supplementary Data" of this Form 10-K in Notes to Consolidated Financial Statements at +Note 7, "Stock-Based Compensation." (2) As +described in the "Compensation Discussion and Analysis" above, the Named Executive Officers' annual bonuses are derived based on the performance of the Company and the individual +executive relative to pre-established objectives for the fiscal year. The target and maximum amounts for each Named Executive Officer's fiscal year 2007 bonus opportunity are reported in +the "Grants of Plan-Based Awards" table below. (3) This +amount represents the Company's contributions to Mr. Cook's account under its 401(k) plan in the amount of $13,500 and a tax gross-up in the amount of $250 for +an iPhone given by the Company to each of its employees, including the Named Executive Officers, other than Mr. Jobs. (4) This +amount represents (i) the Company's contributions to Mr. Oppenheimer's account under its 401(k) plan in the amount of $13,500; (ii) a tax +gross-up in the amount of $250 for an iPhone given by the Company to each of its employees, including the Named Executive Officers, other than Mr. Jobs; and +(iii) reimbursement by the Company of $584,973 for payment of a tax liability under Internal Revenue Code Section 409A. (5) This +amount represents a tax gross-up in the amount of $379 for an iPhone given by the Company to each of its employees, including the Named Executive Officers, other than +Mr. Jobs. (6) This +amount represents a patent award paid by the Company to Mr. Fadell. (7) This +amount represents (i) the Company's contributions to Mr. Fadell's account under its 401(k) plan in the amount of $13,500; and (ii) a tax gross-up +in the amount of $379 for an iPhone given by the Company to each of its employees, including the Named Executive Officers, other than Mr. Jobs; and (iii) a tax gross-up in +the amount of $73 for an iPod given to him by the Company. Compensation of Named Executive Officers The Summary Compensation Table above quantifies the value of the different forms of compensation earned by or awarded to the Named Executive Officers in fiscal year 2007. The +primary elements of each 108 Named +Executive Officer's total compensation reported in the table are base salary, an annual bonus, and long-term equity incentives consisting of restricted stock units and, in the case +of Mr. Fadell, a patent award and stock options received prior to his appointment as an executive of the Company. Named Executive Officers also earned the other benefits listed in Column +(i) of the Summary Compensation Table, as further described in footnotes 3, 4, 5 and 7 to the table. As noted above, the Company does not have employment agreements with any of the Named +Executive Officers. The +Summary Compensation Table should be read in conjunction with the tables and narrative descriptions that follow. The Grants of Plan-Based Awards table, and the accompanying description +of the material terms of the stock options and restricted stock unit awards granted in fiscal year 2007, provides information regarding the long-term equity incentives awarded to Named +Executive Officers in fiscal year 2007. The Outstanding Equity Awards at Fiscal Year End and Option Exercises and Stock Vested tables provide further information on the Named Executive Officers' +potential realizable value and actual value realized with respect to their equity awards. Grants of Plan-Based Awards The following table presents information regarding the incentive awards granted to the Named Executive Officers for fiscal year 2007. Estimated Future Payouts Under Non-Equity Incentive Plan Awards Estimated Future Payouts Under Equity Incentive Plan Awards All Other Option Awards: Number of Securities Underlying Options (#) (j) Name (a) Grant Date (b) Threshold ($) (c) Target ($) (d) Maximum ($) (e) Threshold (#) (f) Target (#) (g) Maximum (#) (h) All Other Stock Awards: Number of Shares of Stock or Units (#) (i) Exercise or Base Price of Option Awards ($/Sh) (k) Grant Date Fair Value of Stock and Option Awards ($) (l) Steven P. Jobs — — — — — — — — — — — Timothy D. Cook — 0 350,000 700,000 — — — — — — — Peter Oppenheimer — 0 300,000 600,000 — — — — — — — Ronald B. Johnson — 0 300,000 600,000 — — — — — — — Tony Fadell — 0 250,000 500,000 — — — — — — — Description of Plan-Based Awards Each of the "Non-Equity Incentive Plan Awards" reported in the Grants of Plan-Based Awards Table was granted under the Company's Performance Bonus Plan. +The material terms of these incentive awards are described in the "Compensation Discussion and Analysis" above. As noted earlier, the Company did not grant equity incentive plan awards to any of its +Named Executive Officers during fiscal year 2007. Outstanding Equity Awards at Fiscal Year-End The following table presents information regarding the outstanding equity awards held by each of the Named Executive Officers as of September 29, 2007, including the +vesting dates for the portions of these awards that had not vested as of that date. 109 Option Awards Name (a) Option Grant Date (b) Number of Securities Underlying Unexercised Options Exercisable (#) (c) Number of Securities Underlying Unexercised Options Unexercisable (#) (d) Option Exercise Price ($) (e) Option Expiration Date (f) Steven P. Jobs — — — — — Totals — — Timothy D. Cook — — — — — Totals — — Peter Oppenheimer — — — — — Totals — — Ronald B. Johnson 2/14/1999 5/21/2002 1,150,000 150,000 — — 23.72 11.73 2/14/2009 5/21/2012 Totals 1,300,000 — Tony Fadell 2/4/2004 6/1/2004 8/30/2005 19,312 115,250 24,875 12,875 56,250 25,000 (1) (2) (3) 10.90 14.03 46.57 2/4/2011 6/1/2011 8/30/2012 Totals 159,437 94,125 (1) The +unvested portion of this option award is scheduled to vest in two (2) substantially equal installments on November 4, 2007 and February 4, 2008. (2) The +unvested portion of this option award is scheduled to vest in three (3) substantially equal installments on December 1, 2007, March 1, 2008 and June 1, +2008. (3) The +unvested portion of this option award is scheduled to vest in eight (8) substantially equal installments on November 30, 2007 and each successive three +(3) month anniversary of November 30, 2007. 110 Stock Awards Name (a) Award Grant Date (g) Number of Shares or Units of Stock That Have Not Vested (#) (h) Market Value of Shares or Units of Stock That Have Not Vested ($)(1) (i) Equity Incentive Plan Awards: Number of Unearned Shares, Units or Other Rights That Have Not Vested (#) (j) Equity Incentive Plan Awards: Market or Payout Value of Unearned Shares, Units or Other Rights That Have Not Vested ($) (k) Steven P. Jobs — — — — — Totals — — Timothy D. Cook 3/24/2004 12/14/2005 300,000 300,000 (2) (3) 46,041,000 46,041,000 — — — — Totals 600,000 92,082,000 — — Peter Oppenheimer 3/24/2004 12/14/2005 250,000 200,000 (2) (3) 38,367,500 30,694,000 — — — — Totals 450,000 69,061,500 — — Ronald B. Johnson 3/24/2004 12/14/2005 250,000 200,000 (2) (3) 38,367,500 30,694,000 — — — — Totals 450,000 69,061,500 — — Tony Fadell 8/30/2005 2/2/2006 10,000 200,000 (4) (5) 1,534,700 30,694,000 — — — — Totals 210,000 32,228,700 — — (1) The +dollar amounts shown in Column (i) are determined by multiplying (x) the number of shares or units reported in Column (h) by (y) $153.47 (the closing +price of the Company's common stock on September 28, 2007, the last trading day of fiscal year 2007). (2) The +unvested portion of this restricted stock unit award is scheduled to vest in its entirety on March 24, 2008. (3) The +unvested portion of this restricted stock unit award is scheduled to vest in its entirety on March 24, 2010. (4) The +unvested portion of this restricted stock unit award is scheduled to vest in two (2) substantially equal installments on August 30, 2008 and August 30, 2009. (5) The +unvested portion of this restricted stock unit award is scheduled to vest in two (2) substantially equal installments on March 24, 2008 and March 24, 2010. 111 Option Exercises and Stock Vested The following table presents information regarding the exercise of stock options by Named Executive Officers during fiscal year 2007, and on the vesting during fiscal year 2007 +of other stock awards previously granted to the Named Executive Officers. Option Awards Stock Awards Name (a) Number of Shares Acquired on Exercise (#) (b) Value Realized on Exercise ($)(1) (c) Number of Shares Acquired on Vesting (#) (d) Value Realized on Vesting ($)(1) (e) Steven P. Jobs 120,000 (2) 14,644,800 — — Timothy D. Cook — — — — Peter Oppenheimer — — — — Ronald B. Johnson 600,000 36,614,020 — — Tony Fadell 83,313 5,946,344 5,000 681,250 (1) The +dollar amounts shown in Column (c) above for option awards are determined by multiplying (i) the number of shares of the Company's common stock to which the exercise +of the option related, by (ii) the difference between the per-share closing price of the Company's common stock on the date of exercise and the exercise price of the options. The +dollar amounts shown in Column (e) above for stock awards are determined by multiplying the number of shares or units, as applicable, that vested by the per-share closing price of +the Company's common stock on the vesting date. (2) These +shares were acquired by Mr. Jobs on August 13, 2007 through an exercise of stock options granted to him under the 1997 Director Stock Option Plan that were to +expire on August 14, 2007. Mr. Jobs has not sold any of the shares acquired in that exercise. Potential Payments Upon Termination or Change in Control As noted above, the Company does not have employment agreements with any of its Named Executive Officers, nor does the Company maintain any other plans or arrangements that +provide for any Named Executive Officer to receive cash severance or other cash payments in connection with a termination of their employment with the Company and/or a change in control of the +Company. Effective +for grants made after April 9, 2007, the Company's 2003 Employee Stock Plan (the "2003 Plan") was amended to eliminate accelerated vesting of outstanding awards in connection with a +change in control of the Company. With respect to awards granted under the 2003 Plan prior to that date, such awards, to the extent then outstanding and unvested, will generally become fully vested +and, in the case of options, exercisable upon a change in control of the Company, unless the Compensation Committee provides for the substitution, assumption, exchange or other continuation of such +awards. Any options that become vested in connection with a change in control generally must be exercised prior to the change in control, or they will be canceled in exchange for the right to receive +a cash payment in connection with the change in control transaction. The +award agreements evidencing certain grants of restricted stock units to the Company's Named Executive Officers prior to January 1, 2005 generally provide that if, in connection with a +change in control of the Company, the executive's employment is terminated by the Company without cause or by the executive for good reason (as those terms are defined in the applicable award +agreement), the restricted stock units that are then outstanding and unvested will vest in full. The +following table lists the Named Executive Officers and the estimated amounts they would have become entitled to under the terms of stock option and restricted stock unit awards granted to them +under the 2003 Plan prior to April 9, 2007 had a change of control of the Company occurred on September 29, 112 2007, +unless the Compensation Committee had provided for the substitution, assumption, exchange or other continuation of such awards. Name (a) Estimated Total Value of Equity Acceleration ($) (b) Steven P. Jobs — Timothy D. Cook 92,082,000 Peter Oppenheimer 69,061,500 Ronald B. Johnson 69,061,500 Tony Fadell 44,580,353 Director Compensation The following table presents information regarding the compensation paid during fiscal year 2007 to members of the Company's Board of Directors who are not also employees (the +"Non-Employee Directors"). The compensation paid to Mr. Jobs, the Company's Chief Executive Officer, is presented above in the Summary Compensation Table and the related explanatory +tables. Name (a) Fees Earned or Paid in Cash ($) (b) Stock Awards ($)(1)(2)(3) (c) Option Awards ($)(1)(2)(3) (d) Non-Equity Incentive Plan Compensation ($) (e) Change in Pension Value and Nonqualified Deferred Compensation Earnings ($) (f) All Other Compensation ($)(4) (g) Total ($) (h) William V. Campbell 50,000 — 476,200 — — 4,783 530,983 Millard S. Drexler 50,000 — 378,400 — — 7,462 435,862 Albert A. Gore, Jr. 50,000 — 300,300 — — 15,245 365,545 Arthur D. Levinson, Ph.D. 50,000 — 448,000 — — 7,592 505,592 Eric E. Schmidt, Ph.D. — — — — — — — Jerome B. York 50,000 — 476,200 — — 4,724 530,924 (1) The +amounts reported in Columns (c) and (d) of the table above reflect the aggregate dollar amounts recognized for stock awards and option awards, respectively, for +financial statement reporting purposes with respect to fiscal year 2007 (disregarding any estimate of forfeitures related to service-based vesting conditions). For a discussion of the assumptions and +methodologies used to calculate the amounts referred to above, please see the discussion of stock awards and option awards contained in Part II, Item 8, "Financial Statements and Supplementary +Data" of this Form 10-K in Notes to Consolidated Financial Statements at Note 7, "Stock-Based Compensation." (2) The +following table presents the number of outstanding and unexercised option awards and the number of unvested stock awards held by each of the Non-Employee Directors as +of September 29, 2007. Director Number of Shares Subject to Outstanding Options as of 9/29/07 Number of Unvested Shares of Restricted Stock as of 9/29/07 William V. Campbell 110,000 — Millard S. Drexler 190,000 — Albert A. Gore, Jr. 70,000 — Arthur D. Levinson, Ph.D. 110,000 — Eric E. Schmidt, Ph.D. — — Jerome B. York 50,000 — (3) As +described below, the Company granted each of its Non-Employee Directors (other than Dr. Schmidt) an option to purchase 10,000 shares of the Company's common +stock during fiscal year 2007. These grants were made on the anniversary of the director's initial election or appointment to the Board of Directors and had the following fair values on the applicable +grant date: Mr. Campbell, $476,200; Mr. Drexler, $378,400; Mr. Gore, $300,300; Dr. Levinson, $448,000; and Mr. York, $476,200. See footnote (1) for the +assumptions used to value these awards. (4) The +amount reported in column (g) above consists solely of one or more of a limited number of free computer systems and/or additional equipment pursuant to the Board of +Directors Equipment Program. 113 Compensation of Directors The form and amount of director compensation are determined by the Board after a review of recommendations made by the Nominating Committee. The current practice of the Board +is to base a substantial portion of a director's annual retainer on equity. Under the Company's 1997 Director Stock Option Plan (the "Director Plan"), the Company's Non-Employee Directors +are granted an option to acquire 30,000 shares of the Company's common stock upon their initial election to the Board (an "Initial Option"). Initial Options vest and become exercisable in equal +installments on each of the first three anniversaries of the grant date. On the fourth anniversary of a Non-Employee Director's initial election to the Board and on each subsequent +anniversary thereafter, the director is granted an option to acquire 10,000 shares of the Company's common stock (an "Annual Option"). Annual Options are fully vested and immediately exercisable on +the date of grant. Upon +his initial appointment to the Board on August 29, 2006, Dr. Schmidt declined the annual retainer fee and the automatic stock option grant to purchase 30,000 shares to which new +directors are entitled under the Director Plan. Instead, Dr. Schmidt purchased 10,000 shares of the Company's common stock on the open market. Non-Employee +directors also receive a $50,000 annual retainer paid in quarterly installments. Beginning in the 2008 fiscal year, the chairperson of the Audit and Finance Committee will +also be entitled to an annual retainer of $25,000, in addition to the annual retainer paid to all +non-employee directors. Directors do not receive any additional consideration for serving as a member or chairperson of any other committee. In addition, directors receive up to two free +computer systems per year and are eligible to purchase additional equipment at a discount. Compensation Committee Interlocks and Insider Participation The Compensation Committee members whose names appear on the Compensation Committee Report above were committee members during all of fiscal year 2007. Mr. Campbell +formerly served as an officer of the Company and of FileMaker, Inc., a subsidiary of the Company. No other member of the Compensation Committee is or has been a former or current executive +officer of the Company, and no member of the Compensation Committee had any relationships requiring disclosure by the Company under the SEC's rules requiring disclosure of certain relationships and +related-party transactions. None of the Company's executive officers served as a director or a member of a compensation committee (or other committee serving an equivalent function) of any other +entity, the executive officers of which served as a director or member of the Compensation Committee during the fiscal year ended September 29, 2007. 114 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Equity Compensation Plan Information The following table sets forth certain information, as of September 29, 2007, concerning shares of common stock authorized for issuance under all of the Company's equity +compensation plans. Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a) Weighted Average Exercise Price of Outstanding Options, Warrants and Rights (b) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) (c) Equity compensation plans approved by shareholders 37,597,439 $ 54.75 74,851,763 (1) Equity compensation plans not approved by shareholders 12,153,315 $ 10.38 — Total equity compensation plans (2) 49,750,754 $ 43.91 74,851,763 (1) This +number includes 7,025,104 shares of common stock reserved for issuance under the Employee Stock Purchase Plan, 370,000 shares available for issuance under the 1997 Director Stock +Option Plan, and 67,456,659 shares available for issuance under the 2003 Employee Stock Plan. The grant of 4,675,000 restricted stock units has been deducted from the number of shares available for +future issuance. Shares of restricted stock and restricted stock units granted after April 2005 count against the shares available for grant as two shares for every share granted. This number +excludes shares under the 1990 Stock Option Plan that was terminated in 1997. No new options can be granted under the 1990 Stock Option Plan. (2) This +table does not include 350 shares of common stock underlying options assumed in connection with a prior acquisition of a company that originally granted those options. These +assumed options have a weighted average exercise price of $3.42 per share. No additional options may be granted under the assumed plan. Security Ownership of Certain Beneficial Owners The following table sets forth certain information as of September 29, 2007 (the "Table Date") with respect to the beneficial ownership of the Company's common stock by +(i) each person the Company believes beneficially holds more than 5% of the outstanding shares of common stock; (ii) each director; (iii) each Named Executive Officer listed in +the Summary Compensation Table under the heading " Information Regarding Executive Compensation; " and (iv) all directors and executive officers as +a group. On the Table Date, 872,328,972 shares of the Company's common stock were issued and outstanding. Unless otherwise indicated, all persons named as beneficial owners of the Company's common +stock have sole voting power and sole investment power with respect to the shares indicated as beneficially owned. In addition, unless otherwise indicated, all persons named below can be reached at +Apple Inc., 1 Infinite Loop, Cupertino, California 95014. 115 Security Ownership of 5% Holders, Directors, Nominees and Executive Officers Name of Beneficial Owner Shares of Common Stock Beneficially Owned(1) Percent of Common Stock Outstanding Fidelity Investments 56,583,870 (2) 6.49 % Steven P. Jobs 5,546,451 * William V. Campbell 112,900 (3) * Timothy D. Cook 13,327 (4) * Millard S. Drexler 230,000 (5) * Tony Fadell 288,702 (6) * Albert A. Gore, Jr. 70,000 (7) * Ronald B. Johnson 1,450,620 (8) * Arthur D. Levinson 365,015 (9) * Peter Oppenheimer 14,873 (10) * Eric E. Schmidt 12,284 (11) * Jerome B. York 90,000 (12) * All current executive officers and directors as a group (14 persons) 8,352,396 (13) 1.00 % (1) Represents +shares of the Company's common stock held and options held by such individuals that were exercisable at the Table Date or within 60 days thereafter. This does not +include options or restricted stock units that vest more than 60 days after the Table Date. (2) Based +on a Form 13G/A filed February 14, 2007 by FMR Corp. FMR Corp. lists its address as 82 Devonshire Street, Boston, MA 02109, in such filing. (3) Includes +110,000 shares of the Company's common stock that Mr. Campbell has the right to acquire by exercise of stock options. (4) Excludes +600,000 unvested restricted stock units. (5) Includes +40,000 shares of the Company's common stock that Mr. Drexler holds indirectly and 190,000 shares of the Company's common stock that Mr. Drexler has the right to +acquire by exercise of stock options. (6) Includes +275 shares of the Company's common stock that Mr. Fadell holds indirectly, 165,875 shares of the Company's common stock that Mr. Fadell has the right to acquire +by exercise of stock options within 60 days after the Table Date, 1,157 shares of the Company's common stock held by Mr. Fadell's spouse, and 117,375 shares of the Company's common stock +that Mr. Fadell's spouse has the right to acquire by exercise of stock options within 60 days after the Table Date. Excludes 210,000 unvested restricted stock units held by +Mr. Fadell and 40,000 unvested restricted stock units held by Mr. Fadell's spouse. (7) Consists +of 70,000 shares of the Company's common stock that Mr. Gore has the right to acquire by exercise of stock options. (8) Includes +1,300,000 shares of the Company's common stock that Mr. Johnson has the right to acquire by exercise of stock options and excludes 450,000 unvested restricted stock +units. (9) Includes +2,000 shares of the Company's common stock held by Dr. Levinson's spouse and 110,000 shares of the Company's common stock that Dr. Levinson has the right to +acquire by exercise of stock options. (10) Excludes +450,000 unvested restricted stock units. 116 (11) Consists +of 12,284 shares of the Company's common stock that Dr. Schmidt holds indirectly. Dr. Schmidt has declined to participate in the 1997 Director Stock Option +Plan. (12) Includes +40,000 shares of the Company's common stock that Mr. York holds jointly with his spouse and 50,000 shares of the Company's common stock that Mr. York has the +right to acquire by exercise of stock options. (13) Includes +2,146,546 shares of the Company's common stock that executive officers or directors have the right to acquire by exercise of stock options and excludes 2,950,000 unvested +restricted stock units. * Represents +less than 1% of the issued and outstanding shares of the Company's common stock on the Table Date. Item 13. Certain Relationships and Related Transactions, and Director Independence Review, Approval or Ratification of Transactions with Related Persons The Board of Directors has adopted a written policy for approval of transactions between the Company and its directors, director nominees, executive officers, greater than five +percent beneficial owners and their respective immediate family members, where the amount involved in the transaction exceeds or is expected to exceed $120,000 in a single calendar year. A copy of +this policy is available on the Company's website at www.apple.com/investor. The +policy provides that the Audit Committee reviews certain transactions subject to the policy and determines whether or not to approve or ratify those transactions. In doing so, the Audit Committee +takes into account, among other factors it deems appropriate: • the +related person's interest in the transaction; • the +approximate dollar value of the amount involved in the transaction; • the +approximate dollar value of the amount of the related person's interest in the transaction without regard to the amount of any profit or loss; • whether +the transaction was undertaken in the ordinary course of business of the Company; • whether +the transaction with the related person is proposed to be, or was, entered into on terms no less favorable to the Company than terms that could have been reached +with an unrelated third party; • the +purpose of, and the potential benefits to the Company of, the transaction; and • any +other information regarding the transaction or the related person in the context of the proposed transaction that would be material to investors in light of the +circumstances of the particular transaction. In +addition, the Audit Committee has delegated authority to the Chair of the Audit Committee to pre-approve or ratify certain transactions. A summary of any new transactions +pre-approved or ratified by the Chair is provided to the full Audit Committee for its review in connection with its next scheduled Audit Committee meeting. The +Audit Committee has considered and adopted standing pre-approvals under the policy for limited transactions with related persons. Pre-approved transactions include: • employment +of executive officers, subject to certain conditions; • any +compensation paid to a director if the compensation is required to be reported in the Company's proxy statement under Item 402 of Regulation S-K +promulgated by the SEC; 117 • any +transaction with another company at which a related person's only relationship is as an employee (other than an executive officer or director) or beneficial owner of +less than ten percent of that company's equity, if the aggregate amount involved does not exceed the greater of $1,000,000, or two percent of that company's total annual revenue; • any +charitable contribution, grant or endowment by the Company to a charitable organization, foundation or university at which a related person's only relationship is as an +employee (other than an executive officer or director), if the aggregate amount involved does not exceed the lesser of $1,000,000, or two percent of the charitable organization's total annual +receipts; and • any +transaction where the related person's interest arises solely from the ownership of the Company's common stock and all holders of the Company's common stock received the +same benefit on a pro rata basis, such as dividends. A +summary of new transactions covered by the standing pre-approvals described above is provided to the Audit Committee for its review at each regularly scheduled Audit Committee meeting. +The related person transactions described below were approved by the Board of Directors before this policy was adopted. Transactions with Related Persons • The +Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private +plane when used for Apple business. The Company recognized a total of $776,000, $202,000, and $1,100,000 in expenses pursuant to the Reimbursement Agreement during 2007, 2006, and 2005, respectively. • The +Company enters into commercial dealings with The Walt Disney Company, Genentech and Google that it considers arms-length, including sales arrangements and, +in the case of Google, licensing agreements and similar arrangements and, in the case of The Walt Disney Company, iTunes Store content licensing agreements and similar agreements. The Company enters +into these commercial dealings in the ordinary course of its business. Mr. Jobs is a Director of The Walt Disney Company. Dr. Levinson is the Chief Executive Officer and a Director of +Genentech. Dr. Schmidt is the Chief Executive Officer and a Director of Google and Mr. Gore is a Senior Advisor to Google. The Company does not believe that any of Messrs. Jobs or +Gore or Drs. Levinson or Schmidt has a material direct or indirect interest in any of such commercial dealings. The +Board has determined all Board members, excluding Steve Jobs, are independent under the applicable NASDAQ rules. The Board has also determined the members of each committee of the Board are +independent under the listing standards of the NASDAQ Global Select Market. In making these determinations, the Board considered, among other things, the types and amounts of the commercial dealings +between the Company and the companies and organizations with which the directors are affiliated. • Tony +Fadell's spouse is the Vice President, Human Resources of the Company. She earned $318,467 in salary and $218,750 in bonus during fiscal year 2007 and participates in +the +Company's equity award and benefit programs. Her compensation is commensurate with that of her peers. Director Independence The Board has determined all Board members, excluding Steve Jobs, are independent under the applicable NASDAQ rules. The Board has also determined the members of each committee +of the Board are independent under the listing standards of the NASDAQ Global Select Market. In making these determinations, the Board considered, among other things, the types and amounts of the +commercial dealings between the Company and the companies and organizations with which the directors are affiliated. 118 Item 14. Principal Accountant Fees and Services The following table sets forth the fees accrued or paid to the Company's independent registered public accounting firm, KPMG LLP, during fiscal years 2007 and 2006. Audit and Non-Audit Fees 2007 2006 Audit Fees (1) $ 7,943,900 $ 7,912,700 Audit-Related Fees (2) 432,000 28,000 Tax Fees (3) 600,400 820,500 All Other Fees — — Total $ 8,976,300 $ 8,761,200 (1) Audit +fees relate to professional services rendered in connection with the audit of the Company's annual financial statements and internal control over financial reporting, quarterly +review of financial statements included in the Company's Forms 10-Q, and audit services provided in connection with other statutory and regulatory filings. Fiscal years 2007 and 2006 +includes fees incurred in connection with the Special Committee of the Board of Directors' investigation into stock option practices. (2) Audit-related +fees comprise fees for professional services that are reasonably related to the performance of audit or review of the Company's financial statements. (3) The +2007 and 2006 tax fees include $581,200 and $728,600, respectively, for professional services rendered in connection with tax compliance and preparation relating to the Company's +expatriate program, tax audits and international tax compliance; and $19,200 and $91,900, respectively, for international tax consulting and planning services. The Company does not engage KPMG to +perform personal tax services for its executive officers. Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Auditors Prior to the enactment of the Sarbanes-Oxley Act of 2002 (the "Act"), the Company adopted an auditor independence policy that banned its auditors from performing +non-financial consulting services, such as information technology consulting and internal audit services. This auditor independence policy also mandates that the audit and +non-audit services and related budget be approved by the Audit Committee in advance, and that the Audit Committee be provided with quarterly reporting on actual spending. In accordance +with this policy, all services to be performed by KPMG were pre-approved by the Audit Committee. Subsequent +to the enactment of the Act, the Audit Committee met with KPMG to further understand the provisions of the Act as it relates to auditor independence. KPMG previously rotated the lead audit +partner in fiscal year 2005 in compliance with the Act. KPMG also rotated other partners in 2007 and 2006, and will rotate additional partners as appropriate. The Audit Committee will continue to +monitor the activities undertaken by KPMG to comply with the Act. 119 PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Balance Sheets as of September 29, 2007 and September 30, 2006 55 Consolidated Statements of Operations for the three fiscal years ended September 29, 2007 56 Consolidated Statements of Shareholders' Equity for the three fiscal years ended September 29, 2007 57 Consolidated Statements of Cash Flows for the three fiscal years ended September 29, 2007 58 Notes to Consolidated Financial Statements 59 Selected Quarterly Financial Information (Unaudited) 90 Reports of Independent Registered Public Accounting Firm, KPMG LLP 91 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the +schedule, or because the information required is included in the Consolidated Financial Statements and Notes thereto. (4) Exhibits required by Item 601 of Regulation S-K The information required by this item is set forth on the exhibit index that follows the signature page of this report. 120 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the +undersigned, thereunto duly authorized, this 15th day of November 2007. APPLE INC. By: /s/ PETER OPPENHEIMER Peter Oppenheimer Senior Vice President and Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven P. Jobs and Peter Oppenheimer, jointly and severally, his +attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to +file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said +attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated: Name Title Date /s/ STEVEN P. JOBS STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) November 15, 2007 /s/ PETER OPPENHEIMER PETER OPPENHEIMER Senior Vice President and Chief Financial Officer (Principal Financial and Principal Accounting Officer) November 15, 2007 /s/ WILLIAM V. CAMPBELL WILLIAM V. CAMPBELL Director November 15, 2007 /s/ MILLARD S. DREXLER MILLARD S. DREXLER Director November 15, 2007 /s/ ALBERT GORE, JR. ALBERT GORE, JR. Director November 15, 2007 /s/ ARTHUR D. LEVINSON ARTHUR D. LEVINSON Director November 15, 2007 /s/ ERIC E. SCHMIDT ERIC E. SCHMIDT Director November 15, 2007 /s/ JEROME B. YORK JEROME B. YORK Director November 15, 2007 121 EXHIBIT INDEX Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on January 27, 1988. S-3 7/27/88 3.2 Certificate of Amendment to Restated Articles of Incorporation, filed with the Secretary of State of the State of California on May 4, 2000. 10-Q 5/11/00 3.3 Certificate of Amendment to Restated Articles of Incorporation, as amended, filed with the Secretary of State of the State of California on February 25, 2005. 10-Q 3/26/05 3.4 Certificate of Determination of Preferences of Series A Non-Voting Convertible Preferred Stock of the Registrant. 10-K 9/26/97 3.5** By-Laws of the Registrant, as amended through November 13, 2007. 10.1* 1990 Stock Option Plan, as amended through November 5, 1997. 10-Q 12/26/97 10.2* Employee Stock Purchase Plan, as amended through May 10, 2007. 8-K 5/16/07 10.3* Form of Indemnification Agreement between the Registrant and each officer of the Registrant. 10-K 9/26/97 10.4* NeXT Computer, Inc. 1990 Stock Option Plan, as amended. S-8 3/21/97 10.5* 1997 Employee Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.6* 1997 Director Stock Option Plan, as amended through May 10, 2007. 8-K 5/16/07 10.7* 2003 Employee Stock Plan, as amended through May 10, 2007. 8-K 5/16/07 10.8* Reimbursement Agreement dated as of May 25, 2001 by and between the Registrant and Steven P. Jobs. 10-Q 6/29/02 10.9* Form of Restricted Stock Unit Award Agreement. 10-Q 3/27/04 10.10* Alternative Form of Restricted Stock Unit Award Agreement. 10-K 9/24/05 10.11* Performance Bonus Plan dated April 21, 2005. 10-Q 3/26/05 10.12* Form of Election to Satisfy Tax Withholding with Stock. 8-K 8/15/05 10.13* Form of Option Agreements. 10-K 9/24/05 10.14* Consulting Agreement dated as of April 17, 2006 by and between the Registrant and J.R. Ruby Consulting Corp. 10-Q 7/1/06 10.15** Form of Restricted Stock Unit Award Agreement effective as of August 28, 2007. 14.1 Code of Ethics of the Registrant. 10-K 9/27/03 21** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signature Page of this Annual Report on Form 10-K). 31.1** Rule13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. * Indicates +management contract or compensatory plan or arrangement. ** Filed +herewith. *** Furnished +herewith. 122 QuickLinks PART I Item 1. Business Item 1A. Risk Factors Item 1B. Unresolved Staff Comments Item 2. Properties Item 3. Legal Proceedings Item 4. Submission of Matters to a Vote of Security Holders PART II Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In millions, except share amounts which are in thousands) CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 9B. Other Information PART III Item 10. Directors, Executive Officers and Corporate Governance Item 11. Executive Compensation COMPENSATION DISCUSSION AND ANALYSIS Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions, and Director Independence Item 14. Principal Accountant Fees and Services Audit and Non-Audit Fees PART IV SIGNATURES Power of Attorney EXHIBIT INDEX \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-97-006960/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001047469-97-006960/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001104659-05-058421/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001104659-05-058421/full-submission.txt new file mode 100644 index 0000000..72d4465 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001104659-05-058421/full-submission.txt @@ -0,0 +1,4974 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, +D.C. 20549 Form 10-K (Mark One) x ANNUAL +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT +OF 1934 For the fiscal year ended +September 24, 2005 or o TRANSITION +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT +OF 1934 For the transition period from to Commission file number 0-10030 APPLE COMPUTER, INC. (Exact name of registrant +as specified in its charter) CALIFORNIA 942404110 (State or other + jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of + principal executive offices) (Zip Code) Registrant’s telephone +number, including area code: (408) 996-1010 Securities registered +pursuant to Section 12(b) of the Act: None Securities registered +pursuant to Section 12(g) of the Act: Common Stock, no par value (Titles of classes) Indicate by check mark +whether the registrant (1) has filed all reports required to be filed by Section 13 +or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 +months (or for such shorter period that the registrant was required to file +such reports), and (2) has been subject to such filing requirements for +the past 90 days. Yes x No o Indicate by check mark if +disclosure of delinquent filers pursuant to Item 405 of Regulation S-K +(section 229.405 of this chapter) is not contained herein, and will +not be contained, to the best of the registrant’s knowledge, in definitive +proxy or information statements incorporated by reference in Part III of +this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark +whether the registrant is an accelerated filer (as defined in Rule 12b-2 +of the Act). Yes x No o Indicate by check mark +whether the registrant is a shell company (as defined in Rule 12b-2 of the +Act). Yes o No x The aggregate market value +of the voting and non-voting stock held by non-affiliates of the registrant, as +of March 26, 2005, was approximately $29,434,521,480 based upon the +closing price reported for such date on the NASDAQ National Market. For +purposes of this disclosure, shares of Common Stock held by persons who hold +more than 5% of the outstanding shares of Common Stock and shares held by +executive officers and directors of the registrant have been excluded because +such persons may be deemed to be affiliates. This determination of executive +officer or affiliate status is not necessarily a conclusive determination for +other purposes. 842,767,948 shares of Common Stock Issued and +Outstanding as of November 18, 2005 PART I The Business section and other parts of this Annual +Report on Form 10-K (“Form 10-K”) contain forward-looking +statements that involve risks and uncertainties. Many of the forward-looking +statements are located in “Management’s Discussion and Analysis of Financial +Condition and Results of Operations.” Forward-looking statements can also be +identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” +and similar terms. Forward-looking statements are not guarantees of future performance +and the Company’s actual results may differ significantly from the results +discussed in the forward-looking statements. Factors that might cause +such differences include, but are not limited to, those discussed in the +subsection entitled “Factors That May Affect Future Results and Financial +Condition” under Part II, Item 7 of this Form 10-K. The Company +assumes no obligation to revise or update any forward-looking statements for +any reason, except as required by law. Item 1. Business Company Background Apple Computer, Inc. +(“Apple” or the “Company”) was incorporated under the laws of the State of +California on January 3, 1977. The Company designs, manufactures, and +markets personal computers and related software, services, peripherals, and +networking solutions. The Company also designs, develops, and markets a line of +portable digital music players along with related accessories and services +including the online distribution of third-party music, audio books, music +videos, short films, and television shows. The Company’s products and services +include the Macintosh line of desktop and notebook computers, the iPod digital +music player, the Xserve G5 server and Xserve RAID storage products, a +portfolio of consumer and professional software applications, the Mac OS X +operating system, the iTunes Music Store, a portfolio of peripherals that +support and enhance the Macintosh and iPod product lines, and a variety of +other service and support offerings. The Company sells its products worldwide +through its online stores, its own retail stores, its direct sales force, and +third-party wholesalers, resellers, and value added resellers. The Company also +sells a variety of third-party products that are compatible with the Company’s +Macintosh and iPod product lines, including computer printers and printing +supplies, storage devices, computer memory, digital camcorders and still +cameras, personal digital assistants, iPod accessories, and various other +computing products and supplies through its online and retail stores. The +Company’s fiscal year ends on the last Saturday of September. Unless otherwise +stated, all information presented in this Form 10-K is based on the +Company’s fiscal calendar. Business Strategy The Company is committed +to bringing the best personal computing and music experience to students, +educators, creative professionals, businesses, government agencies, and +consumers through its innovative hardware, software, peripherals, services, and +Internet offerings. The Company’s business strategy leverages its unique +ability, through the design and development of its own operating system, +hardware, and many software applications and technologies, to bring to its +customers new products and solutions with superior ease-of-use, seamless +integration, and innovative industrial design. The Company believes continual +investment in research and development is critical to facilitate innovation of +new and improved products and technologies. Besides updates to its existing +line of personal computers and related software, services, peripherals, and +networking solutions, the Company continues to capitalize on the convergence of +digital consumer electronics and the computer by creating innovations like the +iPod and iTunes Music Store. The Company’s strategy also includes expanding its +distribution network to effectively reach more of its targeted customers and +provide them a high-quality sales and after-sales support experience. Digital Hub The Company believes personal computing is in an era +in which the personal computer functions for both professionals and consumers +as the digital hub for advanced new digital devices such as the Company’s 1 iPod digital music players, personal digital +assistants, cellular phones, digital camcorders and still cameras, CD and DVD +players, televisions, and other consumer electronic devices. The attributes of +the personal computer include a high quality user interface, relatively +inexpensive data storage, and the ability to run complex applications and +easily connect to the Internet. Apple is the only company in the personal +computer industry that controls the design and development of the entire +personal computer—from the hardware and operating system to sophisticated +applications. Additionally, the Company’s products provide innovative +industrial design, intuitive ease-of-use, and built-in networking, +graphics and multimedia capabilities. Thus, the Company is uniquely positioned +to offer integrated digital hub products and solutions. The Company develops +products and technologies that adhere to many industry standards in order to +provide an optimized user experience through interoperability with peripherals +and devices from other companies. The Company has played a role in the +development, enhancement, promotion, and/or use of numerous of these industry +standards. Expanded +Distribution The Company believes that a high quality buying +experience with knowledgeable salespersons who can convey the value of the +Company’s products and services is critical to attracting and retaining +customers. The Company sells many of its products and resells certain +third-party products in most of its major markets directly to consumers, +education customers, and businesses through its retail and online stores in the +U.S. and internationally. The Company has also invested in programs to enhance +reseller sales, including the Apple Sales Consultant Program, which consists of +the deployment of Apple employees and contractors to selected third-party +reseller locations. The Company believes providing direct contact with its targeted +customers is an efficient way to demonstrate the advantages of its Macintosh +computer and other products over those of its competitors. The Company has +significantly increased the points of distribution for the iPod product family +in order to make its products available at locations where its customers shop. From inception of the retail initiative in 2001 +through 2005, the Company had opened 116 retail stores in the U.S. and 8 +international stores in Canada, Japan, and the U.K. The Company opened 2 additional +stores in October 2005.  The Company +has typically located its stores at high traffic locations in quality shopping +malls and urban shopping districts. One of the goals of the retail initiative is to bring new customers to +the Company and expand its installed base through sales to computer users who +currently do not own a Macintosh computer and first time personal computer +buyers. By operating its own stores and building them in desirable high traffic +locations, the Company is able to better control the customer retail experience +and attract new customers. The stores are designed to simplify and enhance the +presentation and marketing of personal computing products. To that end, retail +store configurations have evolved into various sizes in order to accommodate +market demands. The stores employ experienced and knowledgeable personnel who +provide product advice and certain hardware support services. The stores offer +a wide selection of third-party hardware, software, and various other computing +products and supplies selected to complement the Company’s own products. Additionally, +the stores provide a forum in which the Company is able to present computing +solutions to users in areas such as digital photography, digital video, music, +children’s software, and home and small business computing. Education For more than 25 years, +the Company has focused on the use of technology in education and has been +committed to delivering tools to help educators teach and students learn. The +Company believes effective integration of technology into classroom instruction +can result in higher levels of student achievement, especially when used to +support collaboration, information access, and the expression and +representation 2 of student thought and +ideas. The Company creates solutions that enable new modes of curriculum +delivery, better ways of conducting research, and opportunities for +professional development of faculty, students, and staff. The Company has +designed a range of products and services to help schools maximize their +investments in technology. This is manifested in many of the Company’s products +and services that are designed to meet the needs of education customers. These +products and services include the eMac™, iMac™, and the iBook®, video creation +and editing solutions, wireless networking, student information systems,  high-quality curriculum and professional +development solutions, and one-to-one (1:1) learning solutions (primarily in +K-12). 1:1 learning solutions typically +consist of iBook portable computers for every student and teacher along with a +wireless network connected to a central server . Creative +Professionals Creative professionals constitute one of the Company’s +most important markets for both hardware and software products. This market is +also important to many third-party developers who provide Macintosh-compatible +hardware and software solutions. Creative customers utilize the Company’s +products for a variety of creative activities including digital video and film +production and editing; digital video and film special effects, compositing, +and titling; digital still photography and workflow management; graphic design, +publishing, and print production; music creation and production; audio +production and sound design; and web design, development, and administration. The Company designs its +high-end hardware solutions, including servers, desktops, and portable +Macintosh systems, to incorporate the power, expandability, and features +desired by creative professionals. The Company’s operating system, Mac OS X, +incorporates powerful graphics and audio technologies and features developer +tools to optimize system and application performance when running powerful +creative solutions provided by the Company or third-party developers. The +Company also offers various software solutions to meet the needs of its +creative customers. Business Organization The Company manages its +business primarily on a geographic basis. The Company’s reportable operating +segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas, Europe, and Japan reportable segments do not include activities +related to the Retail segment. The Americas segment includes both North and +South America. The Europe segment includes European countries as well as the +Middle East and Africa. The Retail segment currently operates Apple-owned +retail stores in the U.S., Canada, Japan, and the U.K. Other operating segments +include Asia-Pacific, which includes Australia and Asia except for Japan, and +the Company’s subsidiary, FileMaker, Inc. Each reportable geographic +operating segment provides similar hardware and software products and similar +services. Further information regarding the Company’s operating segments may be +found in Part II, Item 7 of this Form 10-K under the heading “Segment +Operating Performance,” and in Part II, Item 8 of this Form 10-K +in the Notes to Consolidated Financial Statements at Note 11, “Segment +Information and Geographic Data.” Hardware Products The Company offers a range +of personal computing products including desktop and notebook computers, server +and storage products, related devices and peripherals, and various third-party +hardware products. The Company’s entire line of Macintosh® systems, excluding +servers and storage systems, features the Company’s Mac OS® X Version 10.4 +Tiger™ and iLife® suite of software for digital photography, music, movies, and +music creation. Macintosh® +Computers In June 2005, the +Company announced its plan to begin using Intel microprocessors in its +Macintosh computers. The Company plans to begin shipping certain models with +Intel microprocessors by June 2006 3 and to complete the +transition of all of its Macintosh computers to Intel microprocessors by the +end of calendar year 2007. The Company also announced its new translation +technology, Rosetta™, which will allow most PowerPC-based Macintosh +applications to run on new Intel-based Macintosh computers.  There are potential risks and uncertainties +associated with this transition, which are further discussed in Part II, +Item 7 of this 10-K under the heading “Factors That May Affect Future +Results and Financial Condition.” Power Mac® The Power Mac line of +desktop personal computers is targeted at business and professional users and +is designed to meet the speed, expansion, and networking needs of the most +demanding Macintosh user. Powered by the PowerPC G5 processor, the Power Mac G5 +utilizes 64-bit processing technology for memory expansion up to 16GB and +advanced 64-bit computation while also running existing 32-bit applications +natively. In October 2005, the Company updated the Power Mac G5 product +line, which now comes in three processor configurations—dual 2.0GHz, dual +2.3GHz, and a quad 2.5GHz that features two 2.5GHz dual processors. All Power +Mac G5 desktops feature a SuperDrive™ and a NVIDIA GeForce 6600 graphics card. +In addition, all Power Mac G5 desktops deliver connectivity and +high-performance input/output (I/O), including dual Gigabit Ethernet, FireWire® +800 and FireWire 400 ports, USB 2.0 ports, optical digital I/O, PCI Express +expansion, and optional AirPort® Extreme wireless networking and Bluetooth +connectivity. The new Power Mac G5 product line also includes Mighty Mouse, the +Company’s next generation mouse, featuring up to four programmable buttons and +a Scroll Ball that lets users scroll vertically, horizontally, and diagonally. Xserve® and Xserve +RAID Storage System Xserve is a rack-mount +server product designed for simple setup and remote management of intensive I/O +applications such as digital video, high-resolution digital imagery, and large +databases. In January 2005, the Company upgraded Xserve G5, which is now +available with either a single 2.0GHz or dual 2.3GHz PowerPC G5 processor. +Xserve G5 includes a system controller with up to 16GB of PC3200 error +correcting code memory; three hot-plug Serial ATA drive modules that deliver up +to 1.5TB of storage; and dual on-board Gigabit Ethernet for high-performance +networking. The Company’s Xserve RAID storage system was updated in September 2005 +to deliver up to 7 terabytes of storage capacity and also expanded support for +heterogeneous environments. The dual independent RAID controllers with 512MB +cache per controller offer sustained throughput of over 385 Mbps—high enough to +support  media production environments using +protected RAID level 5. iMac® The iMac line of desktop +computers is targeted at consumer and education markets. In +October 2005, the Company introduced the new iMac G5, featuring the +PowerPC G5 processor, a built-in iSight™ video camera, and a design that +integrates the entire computer into either a 17-inch or 20-inch widescreen LCD +flat-panel display. The 17-inch and 20-inch models come with 1.9GHz and 2.1GHz +PowerPC G5 Processors, respectively. The iMac G5 offers 512MB of 533MHz DDR2 +memory expandable to 2.5GB and 7200 rpm Serial ATA drives expandable up to +500GB. The iMac G5 comes standard with ATI Radeon X600 Pro or XT graphics, +video memory, a SuperDrive, built-in Airport Extreme wireless networking, an +internal Bluetooth module, built-in stereo speakers and microphone, and Mighty +Mouse. The iMac G5 also offers built-in Ethernet (10/100/1000BASE-T), three USB +2.0 and two FireWire 400 ports. The iMac G5 also features Front Row media +experience with the Apple Remote, which allows users to play music and view +photos and videos via a remote control. eMac™ The eMac, a desktop +personal computer targeted at the Company’s education customers, features a +PowerPC G4 processor, a high resolution 17-inch flat cathode ray tube display, +and preserves the all-in-one 4 compact design of the +original iMac. The eMac offers PowerPC G4 processors running at up to 1.42GHz, +333MHz DDR memory, an optional SuperDrive, built-in modem and Ethernet +(10/100BASE-T), ATI Radeon graphics, AirPort Extreme-ready, and USB 2.0 and 1.1 +ports for connectivity to peripherals. Mac® mini In January 2005, the +Company introduced Mac mini, a desktop personal computer with a starting price +of $499 and weighing as little as 2.9 pounds. In July 2005, the Company +updated its Mac mini lineup, expanding to three models and increasing memory to +512MB. The first model includes a 1.25GHz PowerPC G4 processor, a 40GB hard +drive, and a Combo drive. The second model includes a 1.42GHz PowerPC G4 +processor, an 80GB hard drive, and a Combo drive. The third model includes a +1.42GHz PowerPC G4 processor, an 80GB hard drive, and a SuperDrive. All models +include ATI Radeon 9200 graphics with 32MB of dedicated DDR memory, built-in +Ethernet (10/100 BASE-T), one FireWire 400 and two USB 2.0 ports, and a DVI +interface that also supports VGA so consumers can connect to LCD or CRT +displays. The 1.42GHz models of the Mac mini also include built-in AirPort +Extreme for 54 Mbps 802.11g wireless networking along with an internal +Bluetooth module. PowerBook® The PowerBook family of +portable computers is designed to meet the mobile computing needs of +professionals and advanced consumer users. In October 2005, the Company +updated its PowerBook G4 notebooks with extended battery life as well as higher +resolution displays, including 1440 by 960 pixels in the 15-inch model and 1680 +by 1050 pixels in the 17-inch model. Both the 15-inch and 17-inch PowerBook G4 +offer a 1.67GHz PowerPC G4 processor and the ATI Mobility Radeon 9700 graphics +processor. The 12-inch PowerBook G4 features a 1.5GHz PowerPC processor, and +the NVIDIA GeForce FX Go5200 graphics processor. Every PowerBook G4 notebook +comes with a SuperDrive, 512MB of DDR memory, built-in AirPort Extreme wireless +networking, an internal Bluetooth module for wireless connectivity, as well as +a full complement of I/O ports including FireWire 400, USB 2.0, and a built-in +56K V.92 modem and Ethernet (10/100BASE-T), for connectivity to a wide range of +peripherals. The 15-inch and 17-inch PowerBook G4 models also include built-in +Gigabit Ethernet and FireWire 800. iBook® The iBook is designed to +meet the portable computing needs of education and consumer users. In July 2005, +the Company upgraded its iBook® G4 line to include faster PowerPC G4 processors +running up to 1.42GHz, built-in AirPort Extreme 54 Mpbs 802.11g wireless +networking and an available slot-load SuperDrive. The 12-inch model features a +1.33GHz PowerPC G4 processor and a slot-load Combo drive, while the 14-inch +model includes a 1.42GHz G4 processor and a SuperDrive. All iBook G4 models +offer a full complement of I/O ports including FireWire 400, USB 2.0, a +built-in 56K V.92 modem and Ethernet (10/100BASE-T), as well as a built-in +internal wireless Bluetooth module, for connectivity to a wide range of +peripherals. Music Products and +Services The Company offers its +iPod® line of digital music players and related accessories to Macintosh and +Windows users. The Company also provides an online service to distribute +third-party music, audio books, music videos, short films, and television shows +through its iTunes Music Store®. iPod ® The iPod is the Company’s portable digital music +player, featuring the Company’s patent pending Click Wheel, which combines a +touch-sensitive wheel with five push buttons for one-handed navigation. In October 2005, +the Company introduced the new iPod containing a 2.5-inch color screen that can +display album artwork and photos and play video including music videos, video +podcasts, home movies, short films, and television shows.  The iPod lineup includes a 30GB model holding +up to 7,500 songs, 25,000 photos, or 5 75 hours of video, and a 60GB model holding up to +15,000 songs, 25,000 photos, or 150 hours of video. The iPod features the +Company’s patent pending Auto-Sync technology that automatically downloads +digital music, podcasts, photos, audio books, home movies, music videos, short +films, and television shows onto the iPod and keeps it up-to-date whenever it +is plugged into a Macintosh or Windows computer using USB. The iPod also +features Shuffle Songs, which randomly plays songs in a selected playlist or +across the entire library. All iPods work with the Company’s iTunes® digital +music management software on either a Macintosh or Windows computer. The iPod’s functionality +extends beyond playing music, listening to audio books, and watching music +videos, short films, home movies, and television shows. Other key capabilities +include data storage, calendar and contact information utility, and a selection +of games. With the addition of third-party iPod peripherals, the capabilities +of certain iPods can be enhanced to include photo downloading directly from +certain digital cameras. The Company has also entered into alliances with many +automobile manufacturers to offer seamless integration of the iPod in certain +automobiles. Along with the iPod, the Company has developed the iTunes software +and the iTunes Music Store, a service that consumers may use to purchase +third-party music, audio books, music videos, short films, and television shows +over the Internet. iPod® nano In September 2005, +the Company introduced iPod nano, a flash-memory based digital music player. The +iPod nano is available in either a 2GB model holding up to 500 songs or 25,000 +photos, or a 4GB model holding up to 1,000 songs or 25,000 photos. The iPod +nano, which weighs as little as 1.5 ounces and is .27 inches thin, +features a color screen and the Company’s patent pending Click Wheel. iPod® shuffle In January 2005, the +Company introduced iPod shuffle, a flash-memory based digital music player, +which is based on iPod’s shuffle feature that randomly selects songs from the +user’s music library or playlists. iPod shuffle works with iTunes and its +patent-pending AutoFill feature that automatically selects songs to fill iPod +shuffle from a user’s music library on their computer. iPod shuffle can also be +used as a portable USB flash drive with up to 1GB of storage space. It is +available in a 512MB model holding up to 120 songs and a 1GB model holding up +to 240 songs. iTunes Music Store® The Company’s iTunes Music Store, available for both Windows-based +and Macintosh computers, is a service that allows customers to find, purchase, +and download third-party digital music, audio books, music videos, short films, +and television shows. The iTunes Music Store also offers Podcast Directory that +allows users to search for and download audio programs to their computer and +automatically receive new episodes over the Internet. Users can search the +contents of the store catalog to locate works by title, artist, or album, or +browse the entire contents of the store by genre and artist. Users can also +listen to a free 30-second preview of content available through the +store. The iTunes Music Store was originally introduced in the U.S. in April 2003 +and now serves customers in 21 countries. The iTunes Music Store is +fully integrated directly into the iTunes software allowing customers to +preview, purchase, download, organize, share, and transfer digital content to +an iPod using a single software application. Further discussion on the iTunes +software may be found below under the heading “Software Products and Computer +Technologies.” The iTunes Music Store offers customers a broad range of +personal rights to the third-party content they have purchased. Content +purchased through the store may also be used in certain applications such as +iPhoto®, iMovie®, and iDVD®. Additional features of the iTunes Music Store +include gift certificates that can be sent via e-mail; prepaid gift cards; an “allowance” +feature that enables users to automatically deposit funds into an iTunes Music +Store account every month; online gift options that let customers give specific +songs, albums, music videos, or their own playlists to anyone with an email +address; parental controls; and album reviews. 6 Peripheral Products The Company sells various +Apple-branded computer hardware peripherals, including iSight™ digital video +cameras and a range of high quality flat panel TFT active-matrix digital color +displays. The Company also sells a variety of third-party Macintosh compatible +hardware products directly to end users through both its retail and online +stores, including computer printers and printing supplies, storage devices, +computer memory, digital video and still cameras, personal digital assistants, +and various other computing products and supplies. iSight™ The Company’s iSight +digital video camera enables video conferencing over broadband connections. +iSight is a small, portable aluminum alloy camera with all audio, video, and +power provided by a single FireWire cable. iSight is designed to be center-mounted +on the top of a computer screen and uses its integrated tilt and rotate +mechanism to easily position the camera for natural, face-to-face video +conferencing. iSight features an auto focusing auto exposure F/2.8 lens that +captures high-quality pictures and full-motion video. With its on-board +processor, iSight automatically adjusts color, white balance, sharpness and +contrast to provide high-quality images with accurate color reproduction in +most lighting conditions. iSight also includes a dual-element microphone that +suppresses ambient noise for clear digital audio. Displays The Company offers a +family of widescreen flat panel displays featuring the 30-inch Apple Cinema HD +Display™, a widescreen active-matrix LCD with 2560-by-1600 pixel resolution, a +23-inch widescreen Apple Cinema Display with 1920-by-1200 pixel resolution and +a 20-inch widescreen Apple Cinema Display® with 1680-by-1050 pixel resolution. +The displays feature dual FireWire and dual USB 2.0 ports built into the +display and use the industry standard DVI interface for a pure digital +connection with the Company’s latest Power Mac and PowerBook systems. The +Cinema Displays feature an aluminum design with a very thin bezel, suspended by +an aluminum stand that allows viewing angle adjustment. Software +Products and Computer Technologies The Company offers a range +of software products for education, creative, consumer and business customers, +including Mac OS X, the Company’s proprietary operating system software for the +Macintosh; server software and related solutions; professional application +software; and consumer, education and business oriented application software. Operating System +Software In April 2005, the +Company began shipping Mac OS X Tiger, the Company’s fifth major version of Mac +OS X. Tiger incorporates more than 200 new features and innovations including +Spotlight™, a desktop search technology that lets users find items stored on +their Macintosh computers, including documents, emails, contacts and images; +and Dashboard, a new way to instantly access information such as weather +forecasts and stock quotes, using a new class of mini-applications called +widgets. The server version of the Mac OS operating system, Mac OS X Server +version 10.4, also began shipping in April 2005. Server Software and +Server Solutions Apple Remote Desktop™ 2 is the second generation of +the Company’s asset management, software distribution, and help desk support +software. Apple Remote Desktop 2 includes more than 50 features for centrally +managing Mac OS X systems. Apple Remote Desktop 2 can perform a wide range of +desktop management tasks such as installing operating system and application +software, running hardware and software inventory reports, and executing +commands on one or more remote Mac OS X systems on the network. Remote software +installation tools allow IT professionals to install single or multiple +software packages immediately or at specific dates and times. Comprehensive +hardware and software reports based on more than 200 system information +attributes allow administrators to keep track of their Mac OS X 7 systems. In addition, built-in real-time screen +sharing enables help desk professionals to provide online assistance by +observing and controlling the desktops of any remote Macintosh or Virtual +Network Computing-enabled computer, including Windows and Linux systems. Xsan®, the Company’s +enterprise-class Storage Area Network (SAN) file system, began shipping in January 2005. +Xsan is a 64-bit cluster file system for Mac OS X that enables organizations to +consolidate storage resources and provide multiple computers with concurrent +file-level read/write access to shared volumes over Fibre Channel. Advanced +features such as metadata controller failover and Fibre Channel multipathing +ensure high availability; file-level locking allows multiple systems to read +and write concurrently to the same volume which is ideal for complex workflows; +bandwidth reservation provides for effective ingestion of bandwidth-intensive +data streams, such as high resolution video; and flexible volume management +results in more efficient use of storage resources. Since Xsan is interoperable +with ADIC’s StorNext File System, it can be used in heterogeneous environments +that include Windows, UNIX, and Linux server operating system platforms. Professional Application +Software In April 2005, the Company announced Final Cut +Studio™, a High Definition (HD) video production suite that features Final Cut +Pro® 5, the Company’s editing software for Digital Video (DV), Standard +Definition (SD), HD, and film. Final Cut Studio also includes tools that +complement Final Cut Pro 5 such as Soundtrack® Pro, a new application that +gives audio and video professionals a way to create, control and repair audio; +Motion 2, an application that allows real-time motion graphics design; and DVD +Studio Pro® 4, DVD authoring software that burns DVDs, including high +definition DVDs to the latest HD DVD specification. These components of Final +Cut Studio are also sold separately. Final Cut Pro® 5, the latest version of the Company’s +video editing software, which began shipping in April 2005, includes +editing tools that work with most formats, from DV and native High Definition +Video (HDV) to fully uncompressed HD. Final Cut Pro 5 acquires HDV media via +FireWire and keeps it in the original format, transferring it into the system +without any generation loss. With a real-time multi-stream effects +architecture, multicam editing tools, and advanced color correction, Final Cut +Pro 5 enables users to view and cut from multiple sources in real time, group +up to 128 sources together into multi-clips, then add or subtract cameras at +any time. Final Cut Pro 5 allows users to use external audio control surfaces +to mix and record multiple fader automations simultaneously. Soundtrack® Pro is a new audio editing and sound +design application that gives audio and video professionals a way to create, +control, and repair audio. Soundtrack Pro features a waveform editor with +flexible Action Layers that allow users to re-order, bypass, or change any +edit, effect, or process. Find-and-Fix features identify and repair common +audio problems such as background noise, pops, clicks, and hum. An integrated +multitrack mixer allows editors to apply common effects to multiple tracks and +group common tracks using busses. Soundtrack Pro also features over 50 +professional plug-ins for creating sounds, over 5,000 loops, an integrated +mixer, and integration with Final Cut Studio. Motion 2 is a real-time motion graphics software that +enables Final Cut Pro editors to add motion graphics to their projects. Motion +2 features interactive animation of text and graphics for DVD motion menus, +video or film in real time, and quick output rendering by built-in GPU +acceleration at 8-bit, 16-bit, or 32-bit float film quality. With Motion 2’s +new design tool, Replicator, users can automatically generate and animate +multiple copies of a graphic, shape, or movie. DVD Studio Pro® 4 is the latest version of the Company’s +professional DVD authoring application. With DVD Studio Pro 4 and its +integrated, scalable H.264 encoding, users can author SD or HD DVDs. DVD Studio +Pro 4 allows users to preview HD content in real time with a second Digital +Cinema Desktop and audition surround sound using S/PDIF (digital audio) out to +an external DTS or Dolby Digital (AC-3) decoder. Its interactive graphical view +also enables users to edit/display menus, tracks, slideshows, scripts, 8 and stories of a DVD project in a storyboard layout. +DVD Studio Pro 4 includes Compressor 2, a full-featured video and audio +compression application. Compressor gives users control over encoding, +including the ability to encode several clips in one batch operation to a wide +variety of formats and perform advanced format conversions at the same time. In April 2005, the Company announced Shake® 4, an +upgrade to the Company’s compositing software, which began shipping in June 2005. +Used to create visual effects for film and television, Shake 4 features 3D +multi-plane compositing, optical flow image processing and integration with +Final Cut Pro 5. Users can composite live action and 3D CGI layers with added +realism using OpenGL accelerated 3D multi-plane compositing node. Other +features include advanced optical flow technology that uses pixel-by-pixel +image analysis to create smooth retiming and automatic stabilization. Shake 4 +also integrates Truelight monitor calibration to maintain color consistency +between the computer screen and the final look on film. Logic® Pro 7 is used by musicians around the world and +by professionals in music production and film scoring. It combines digital +music composition, notation, and audio production facilities in one +comprehensive product and includes software instruments such as Sculpture, a +component-modeling based synthesizer; UltraBeat™, a drum synthesizer with +built-in step sequencer; and digital signal processing (DSP) plug-ins including +Guitar Amp Pro, a full-featured guitar amplifier simulator. Along with workflow +enhancements, mastering plug-ins, and support for Apple Loops, Logic Pro 7 adds +distributed audio processing, a technology that allows professionals to utilize +multiple Macintosh systems to expand available DSP power via an Ethernet +network. In October 2005, the +Company announced Aperture™, began shipping in November 2005. Aperture is +an application designed to provide professional photographers with +post-production tools to manage, edit, and publish digital pictures. Features include +compare and select tools, nondestructive image processing, color managed +printing, and custom web and book publishing. Compare and select tools in +Aperture allow photographers to sift through photo projects and identify their +final selections. RAW images are maintained natively throughout Aperture +without any intermediate conversion process, and can be retouched using a suite +of adjustment tools designed especially for photographers. Print options +include customizable contact sheets, high-quality local printing, and +color-managed online prints. Aperture also provides a layout environment where +photographers can create and order custom books and publish web galleries. Consumer, Education +and Business Oriented Application Software iLife® ‘05 In January 2005, the Company introduced iLife +‘05, an upgrade to its digital lifestyle suite, which features iPhoto®, iMovie®, +iDVD®, GarageBand™, and iTunes®. iPhoto® 5 is the Company’s consumer-oriented digital +photo software application. iPhoto 5 includes advanced editing tools, adds +support for uncompressed RAW photos, and includes a slideshow builder allowing +users to apply effects, transitions and durations to each individual slide. +iPhoto 5 allows users to create and order hardcover and softcover photo books +using a variety of book layouts with double-sided printing, directly within the +application. iMovie® HD, a consumer-oriented digital video editing +software application, enables users to import HDV from HDV camcorders and edit +digital videos on their Macintosh computers. iMovie HD also includes Magic +iMovie, which automatically imports video into separate clips and adds titles, +transitions and music. iMovie HD imports video from HDV and standard DV +camcorders, and from video cameras that generate MPEG-4 video. 9 iDVD® is a consumer-oriented software application that +enables users to turn iMovie files, QuickTime® files, and digital pictures into +DVDs that can be played on most consumer DVD players. iDVD 5 includes 15 new +themes featuring moving drop zones that can display video clips or photos in +motion across DVD menus. iDVD 5 also features OneStep DVD, which automatically +creates a DVD from footage directly from a user’s camcorder. With a compatible +SuperDrive™, iDVD 5 supports all recordable single-layer and double-layer DVD +format standards. GarageBand™ is a consumer-oriented music creation +software application. GarageBand 2 adds 8-track recording so that users can +record multiple digital audio tracks at once. GarageBand 2 can improve +out-of-tune notes and timing in both vocal and real-instrument recordings. +GarageBand 2 displays and edits musical notation in real time for software +instrument tracks for people who know how to read and write music or want to learn. +With GarageBand Jam Packs, including the latest, Jam Pack 4: Symphony +Orchestra, GarageBand users can create music in their favorite genres. iLife ‘05 also includes iTunes, the Company’s digital +music jukebox software application that allows users to purchase a variety of digital +content available through the Company’s iTunes Music Store. iTunes organizes +content using searching, browsing, and playlists, and also includes features +such as iMix playlist sharing and provides integration with the complete family +of iPods. In October 2005, the Company introduced iTunes 6, the latest +version of its iTunes software. iTunes 6 allows users to purchase and download +music videos, short films, and television shows from the iTunes Music Store, +watch them on their computers, and Auto-Sync them onto their iPod. In September 2005, +the Company, Motorola Inc., and Cingular Wireless LLC announced the +availability of a mobile phone with iTunes software (Motorola ROKR), enabling +users to transfer up to 100 songs from the iTunes library on their Macintosh or +Windows-based computers to their Motorola ROKR mobile phones. iWork™ ‘05 In January 2005, the Company introduced iWork ‘05, +productivity software designed to take advantage of both Mac OS X and iLife ‘05 +to help users create, present, and publish documents and presentations. iWork ‘05 +introduced Pages™, a word processor, and also features Keynote™ 2, an updated +version of the Company’s presentation software. Pages™ gives users the tools to create letters, +newsletters, reports, brochures and resumes with advanced typography, multiple +columns, footnotes, tables of content and styles. With features like dynamic +text wrapping and alignment guides, Pages lets users create free-form +arrangements of text, graphics, photos, tables, and charts. An integrated iLife +media browser lets users drag and drop photos from the iPhoto library directly +into documents. Keynote™ 2 is the Company’s presentation software that +gives users the ability to create presentations, portfolios, interactive +slideshows, and storyboards. Keynote 2 contains slide animations to synchronize +the movement of multiple objects and cinematic real-time animated text. The +iLife media browser within Keynote allows users to insert photos, movies, and +music directly into presentations, and with image masking, users can frame the +exact part of the photo they want to display. Keynote 2 can also work with a second +monitor to display upcoming slides, notes, and a timer. In January 2005, the Company announced Final Cut® +Express HD, an update to Final Cut Express, which began shipping in February 2005. +Final Cut Express HD enables users to capture, edit, and output HDV over a +single FireWire cable, and supports Digital Cinema Desktop with multiple +displays. Final Cut Express HD features sound editing tools including 99 audio +tracks, real-time volume and audio filter adjustment, a voice-over tool, and +Soundtrack music creation software that allows users to compose musical scores +for their videos. Final Cut Express HD includes LiveType™, which can add +HD-quality 10 animated text and motion graphics to videos. In +addition, iMovie projects can be imported directly into Final Cut Express HD +with all of their effects, transitions, and audio levels intact. Logic® Express 7 is a streamlined version of Logic Pro +7 that provides a basic set of professional tools to compose and produce music +for students, educators, and advanced hobbyists. Its high-resolution audio of +up to 24-bit/96kHz, the adaptive self-configuring track mixer, and 32-bit +floating-point math provide professional sound quality. Logic Express 7 comes +with support for projects from GarageBand offering users a smooth migration +path to high-end audio production. FileMaker, Inc., a +wholly owned subsidiary of the Company, develops, publishes, and distributes +desktop-based database management application software for either a Macintosh +or Windows-based computer. The FileMaker ® Pro database +software and related products offer relational databases and desktop-to-web +publishing capabilities. FileMaker Pro 8, the newest version of the desktop +database introduced in August 2005, features new ways to share and manage +information of various types. FileMaker Pro 8 allows users to convert graphic-rich reports +of their data into alternative file formats, which can be emailed for sharing +with non-FileMaker users. Internet Software and Services The Company is focused on +delivering seamless integration with and access to the Internet throughout the +Company’s products and services. The Company’s Internet solutions adhere to +many industry standards in order to provide an optimized user experience +through interoperability. Safari ™ Safari, the Company’s Mac +OS X compatible web browser, uses the advanced interface technologies +underlying Mac OS X and includes built-in Google search; SnapBack™ to instantly +return to search results; a way to name, organize and present bookmarks; tabbed +browsing; and automatic “pop-up” ad blocking. QuickTime ® QuickTime, the Company’s multimedia software for +Macintosh or Windows-based computers, features streaming of live and stored +video and audio over the Internet and playback of high-quality audio and video +on computers. QuickTime 7 features a new video codec called H.264, which +delivers high video quality at low data rates. QuickTime 7 automatically +determines a user’s connection speed to ensure they are getting the +highest-quality content stream possible. QuickTime 7 also delivers +multi-channel audio and supports audio formats, including AIFF, WAV, MOV, MP4 +(AAC only), CAF, and AAC/ADTS. The Company offers several +other QuickTime products. QuickTime 7 Pro, a suite of software tools, allows +creation and editing of Internet-ready audio and video files. QuickTime 7 Pro allows +users to create H.264 video, capture audio and video, create multi-channel +audio, and export multiple files while playing back or editing video. QuickTime +Streaming Server facilitates the broadcasting of streaming digital video. QuickTime +Broadcaster allows users to produce professional-quality live events for online +delivery. .Mac™ The Company’s .Mac offering is a suite of Internet +services that for an annual fee provides Macintosh users with a powerful set of +Internet tools. .Mac services include: HomePage, for personal web sites; iDisk, +a virtual hard drive accessible anywhere with Internet access; .Mac Sync, which +keeps Safari bookmarks, iCal® calendars, Address Book information, Keychain® +(passwords), and Mac OS X Mail preferences up-to-date across multiple Macintosh +computers and available via web browser when users are away from their Mac; +..Mac Mail, an ad-free email service; and Learning Center, featuring tutorials +for certain software applications. The current version of .Mac includes .Mac +Groups, a service that helps members communicate, coordinate schedules, and +stay in sync with private groups of friends or colleagues; an 11 updated version of .Mac +Backup software that allows members to archive the content of their iLife Home +folder; and a four-fold increase in combined iDisk and email storage to 1GB for +individuals and 2GB for families. Wireless +Connectivity and Networking AirPort Extreme® AirPort Extreme is the +Company’s next generation Wi-Fi wireless networking technology. AirPort Extreme +is based on the 802.11g standard, which supports speeds up to 54 Mbps, and is +fully compatible with most Wi-Fi devices that use the 802.11b standard. AirPort +Extreme Base Stations can serve up to 50 Macintosh and Windows users +simultaneously, provide wireless bridging to extend the range beyond just one +base station, and support USB printer sharing to allow multiple users to +wirelessly share USB printers connected directly to the base station. AirPort® Express AirPort® Express is the +first 802.11g mobile base station that can be plugged directly into the wall +for wireless Internet connections and USB printing. Airport Express also +features analog and digital audio outputs that can be connected to a stereo and +AirTunes™ music networking software which works with iTunes, giving users a way +to wirelessly stream iTunes music from their Macintosh or Windows-based +computer to any room in the house. AirPort Express features a single piece +design weighing 6.7 ounces. Other +Connectivity and Networking Solutions Mac OS X includes capabilities for Bluetooth +technology. Bluetooth is an industry standard for wirelessly connecting +computers and peripherals that supports transmission of data at up to 3 Mbps +within a range of approximately 30 feet. The Company’s Bluetooth technology for +Mac OS X lets customers wirelessly share files between Macintosh systems, +synchronize and share contact information with Palm-OS based PDAs, and access +the Internet through Bluetooth-enabled cell phones. A Bluetooth USB adaptor can +Bluetooth-enable any USB-based Macintosh computer running in Mac OS X version +10.1.4 or higher. Bonjour™, the Company’s zero configuration networking +technology, is based on open Internet Engineering Task Force (IETF) Standard Protocols +such as IP, ARP, and DNS and is built into Mac OS X. This technology uses +industry standard networking protocols and zero configuration technology +including Ethernet or 802.11-based wireless networks like the Company’s AirPort +products. The source code for this technology also includes software to support +UNIX, Linux, and Windows-based systems and devices. The Company developed +FireWire technology, also referred to as IEEE 1394, which is a high-speed +serial I/O technology for connecting digital devices such as digital camcorders +and cameras to desktop and portable computers. With its high data-transfer +speed and “hot plug-and-play” capability, FireWire has become an established +cross-platform industry standard for both consumers and professionals. FireWire +is currently integrated in all Macintosh systems. Product Support and Services AppleCare ® offers a range of support options for the Company’s +customers. These options include assistance that is built into software +products, printed and electronic product manuals, online support including +comprehensive product information as well as technical assistance, and the +AppleCare Protection Plan. The AppleCare Protection Plan is a fee-based service +that typically includes three years of phone support and hardware repairs, +dedicated web-based support resources, and user diagnostic tools. Markets and Distribution The Company’s customers +are primarily in the education, creative, consumer, and business markets. The +Company distributes its products through wholesalers, resellers, national and +regional retailers and 12 cataloguers. No individual +customer accounted for more than 10% of net sales in 2005, 2004, or 2003. The +Company also sells many of its products and resells certain third-party +products in most of its major markets directly to consumers, education +customers, and businesses through its retail and online stores in the U.S. and +internationally. Over 12% of the Company’s net sales in 2005 were through its +U.S. education channel, including sales to elementary and secondary schools, +higher education institutions, and individual customers. Competition The Company is confronted by aggressive competition in +all areas of its business. The market for personal computers and related +software and peripheral products is highly competitive. This market continues +to be characterized by rapid technological advances in both hardware and +software that have substantially increased the capabilities and use of personal +computers and have resulted in the frequent introduction of new products with +competitive price, feature, and performance characteristics. Over the past +several years, price competition in the market for personal computers has been +particularly intense. The Company’s competitors who sell personal computers +based on other operating systems have aggressively cut prices and lowered their +product margins to gain or maintain market share. The Company’s results of +operations and financial condition can be adversely affected by these and other +industry-wide downward pressures on gross margins. The principal competitive factors in the market for +personal computers include price, relative price/performance, product quality +and reliability, design innovation, availability of software, product features, +marketing and distribution capability, service and support, availability of +hardware peripherals, and corporate reputation. Further, as the personal +computer industry and its customers place more reliance on the Internet, an +increasing number of Internet devices that are smaller, simpler, and less +expensive than traditional personal computers may compete for market share with +the Company’s existing products. The Company is currently taking and will continue to +take steps to respond to the competitive pressures being placed on its personal +computer sales as a result of innovations from competing platforms. The Company’s +future operating results and financial condition are substantially dependent on +its ability to continue to develop improvements to the Macintosh platform in +order to maintain perceived functional and design advantages over competing +platforms. The Company’s services and +products relating to music and other creative content have already encouraged +significant competition from other companies, many of whom have greater financial, +marketing, and manufacturing resources than those of the Company. The Company +faces increasing competition from other companies promoting their own digital +music products and distribution services, subscription services, and free +peer-to-peer music services. The Company anticipates that competition will +intensify as hardware, software, and content providers work more +collaboratively to offer integrated products competing with the Company’s +offerings. However, the Company believes it currently maintains a competitive +advantage by more effectively integrating an entire solution, including the +hardware (iPod), software (iTunes), and distribution of third-party digital +content (iTunes Music Store). Raw Materials Although most components essential to the Company’s +business are generally available from multiple sources, certain key components +(including microprocessors and application-specific integrated circuits (“ASICs”)) +are currently obtained by the Company from single or limited sources. Some +other key components, while currently available to the Company from multiple +sources, are at times subject to industry-wide availability constraints and +pricing pressures. In addition, the Company uses some components that are not +common to the rest of the personal computer and consumer electronics +industries, and new products introduced by the Company often initially utilize +custom components 13 obtained from only one source until the Company has +evaluated whether there is a need for, and subsequently qualifies, additional +suppliers. If the supply of a key or single-sourced component to the +Company were to be delayed or curtailed or in the event a key manufacturing +vendor delays shipments of completed products to the Company, the Company’s +ability to ship related products in desired quantities and in a timely manner +could be adversely affected. The Company did experience such delays during 2004 +and 2005 related to PowerPC G5 processors, which resulted in the constrained +availability of certain products. The Company’s business and financial +performance could also be adversely affected depending on the time required to +obtain sufficient quantities from the original source, or to identify and +obtain sufficient quantities from an alternative source. Continued availability +of these components may be affected if producers were to decide to concentrate +on the production of common components instead of components customized to meet +the Company’s requirements. In June 2005, the Company announced its +intention to transition its Macintosh computers using the PowerPC G5 and G4 +microprocessors, which are currently single-sourced, to Intel microprocessors +by the end of calendar year 2007. The announcement of this transition may +impact the continued availability on acceptable terms of certain components and +services, including PowerPC G5 and G4 microprocessors. The Company attempts to +mitigate these potential risks by working closely with these and other key +suppliers on product introduction plans, strategic inventories, coordinated product +introductions, and internal and external manufacturing schedules and levels. +Consistent with industry practice, the Company acquires components through a +combination of formal purchase orders, supplier contracts, and open orders +based on projected demand information. The Company’s purchase commitments typically cover its requirements for periods +ranging from 30 to 150 days. The Company believes there +are several component suppliers and manufacturing vendors whose loss to the +Company could have a material adverse effect upon the Company’s business and +financial position. At this time, such vendors include Agere Systems, Inc., +Ambit Microsystems Corporation, ASUSTeK Corporation, ATI Technologies, Inc., +Broadcom Corporation, Cypress Semiconductor Corporation, Freescale +Semiconductor, Inc., Hitachi Global Storage Technologies, Hon Hai +Precision Industry Co., Ltd., IBM Corporation, Intel Corporation, International +Display Technology, Inventec Appliances Corporation, LG. Phillips Co., Ltd., +Matsushita, Mitsubishi Electric Corporation, NVIDIA Corp., PortalPlayer, Inc., +Quanta Computer, Inc., Samsung Electronics, Synaptics, Inc., and +Toshiba Corporation. Research and Development Because the personal +computer and consumer electronics industries are characterized by rapid +technological advances, the Company’s ability to compete successfully is +heavily dependent upon its ability to ensure a continuing and timely flow of +competitive products and technology to the marketplace. The Company continues +to develop new products and technologies and to enhance existing products in +the areas of hardware and peripherals, consumer electronic products, system +software, applications software, networking and communications software and +solutions, and the Internet. The Company may expand the range of its product +offerings and intellectual property through licensing and/or acquisition of +third-party business and technology. The Company’s research and development +expenditures totaled $534 million, $489 million, and +$471 million in 2005, 2004, and 2003, respectively. Patents, +Trademarks, Copyrights and Licenses The Company currently holds rights to patents and +copyrights relating to certain aspects of its computer systems, iPods, +peripherals and software. In addition, the Company has registered, and/or has +applied to register, trademarks and service marks in the U.S. and a number of +foreign countries for “Apple,” the Apple logo, “Macintosh,” “iPod,” “iTunes,” “iTunes +Music Store,” and numerous other trademarks and service marks. Although the +Company believes the ownership of such patents, copyrights, trademarks and +service marks is an important factor in its business and that its success does +depend in part on the 14 ownership thereof, the Company relies primarily on the +innovative skills, technical competence, and marketing abilities of its +personnel. Many of the Company’s +products are designed to include intellectual property obtained from +third-parties. While it may be necessary in the future to seek or renew +licenses relating to various aspects of its products and business methods, the +Company believes that, based upon past experience and industry practice, such +licenses generally could be obtained on commercially reasonable terms; however, +there is no guarantee that such licenses could be obtained at all. Because of +technological changes in the computer industry, current extensive patent +coverage, and the rapid rate of issuance of new patents, it is possible certain +components of the Company’s products and business methods may unknowingly infringe +existing patents of others. From time to time, the Company has been notified +that it may be infringing certain patents or other intellectual property rights +of third-parties. Foreign +and Domestic Operations and Geographic Data The U.S. represents the Company’s largest geographic +marketplace. Approximately 60% of the Company’s net sales in 2005 came from +sales to customers inside the U.S. Final assembly of products sold by the +Company is conducted in the Company’s manufacturing facility in Cork, Ireland, +and by external vendors in Fremont, California, Fullerton, California, Taiwan, +Korea, the People’s Republic of China, and the Czech Republic. Currently, +manufacture of many of the components used in the Company’s products and final +assembly of substantially all of the Company’s portable products including +PowerBooks, iBooks, and iPods are performed by third-party vendors in China. +Margins on sales of the Company’s products in foreign countries, and on sales +of products that include components obtained from foreign suppliers, can be +adversely affected by foreign currency exchange rate fluctuations and by +international trade regulations, including tariffs and antidumping penalties. Information regarding +financial data by geographic segment is set forth in Part II, Item 8 of +this Form 10-K in the Notes to Consolidated Financial Statements at +Note 11, “Segment Information and Geographic Data.” Seasonal Business The Company has +historically experienced increased net sales in its first and fourth fiscal +quarters compared to other quarters in its fiscal year due to seasonal demand +related to the holiday season and the beginning of the school year. This +historical pattern should not be considered a reliable indicator of the Company’s +future net sales or financial performance. Warranty The Company offers a basic +limited parts and labor warranty on its hardware products. The basic warranty +period for hardware products is typically one year from the date of purchase by +the end-user. The Company also offers a 90-day basic warranty for its +service parts used to repair the Company’s hardware products. In addition, +consumers may purchase extended service coverage on most of the Company’s +hardware products in all of its major markets. Backlog In the Company’s +experience, the actual amount of product backlog at any particular time is not +a meaningful indication of its future business prospects. In particular, +backlog often increases in anticipation of or immediately following new product +introductions because of over-ordering by dealers anticipating shortages. +Backlog often is reduced once dealers and customers believe they can obtain +sufficient supply. Because of the foregoing, backlog should not be considered a +reliable indicator of the Company’s ability to achieve any particular level of +revenue or financial performance. 15 Environmental Laws Compliance with federal, state, local, and foreign +laws enacted for the protection of the environment has to date had no material +effect on the Company’s capital expenditures, earnings, or competitive position. +In the future, these laws could have a material adverse effect on the Company. Production and marketing +of products in certain states and countries may subject the Company to +environmental and other regulations including, in some instances, the +requirement that the Company provide consumers with the ability to return to +the Company product at the end of its useful life, and place responsibility for +environmentally safe disposal or recycling with the Company. Such laws and +regulations have recently been passed in several jurisdictions in which the +Company operates, including various European Union member states, Japan, and +California. In the future, these laws could have a material adverse effect on +the Company. Employees As of September 24, +2005, the Company had approximately 14,800 full-time equivalent employees and +an additional 2,020 temporary employees and contractors. Available Information The Company’s Annual +Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports +on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and +15(d) of the Securities Exchange Act of 1934, as amended, are available on +its website at http://www.apple.com/investor when such reports are available on +the U.S. Securities and Exchange Commission (SEC) website. The public may read +and copy any materials filed by the Company with the SEC at the SEC’s Public +Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The +public may obtain information on the operation of the Public Reference Room by +calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that +contains reports, proxy and information statements and other information +regarding issuers that file electronically with the SEC at http://www.sec.gov. The +contents of these websites are not incorporated into this filing. Further, the +Company’s references to the URLs for these websites are intended to be inactive +textual references only. Item 2. Properties The Company’s headquarters are located in Cupertino, +California. The Company has manufacturing facilities in Cork, Ireland. As of +September 24, 2005, the Company leased approximately 3.6 million square +feet of space, primarily in the U.S., and to a lesser extent, in Europe, Japan, +Canada, and the Asia Pacific region. The major facility leases are for terms of +5 to 15 years and generally provide renewal options for terms of 3 to 5 +additional years. Leased space includes approximately 902,000 square feet of +retail space, a majority of which is in the U.S. Lease terms for retail space +range from 5 to 20 years, the majority of which are for 10 years, and often +contain multi-year renewal options. The Company owns a 352,000 square-foot manufacturing +facility in Cork, Ireland that also houses a customer support call center. The +Company also owns a 752,000 square-foot facility in Sacramento, California that +houses warehousing and distribution operations as well as a customer support +call center. In addition, the Company owns approximately 942,000 square feet of +facilities located in Cupertino, California, used for research and development +and corporate functions. Outside the U.S., the Company owns additional +facilities totaling approximately 169,000 square feet. The Company believes its +existing facilities and equipment are well maintained and in good operating +condition. The Company has invested in internal capacity and strategic +relationships with outside manufacturing vendors, and therefore believes it has +adequate manufacturing capacity for the foreseeable future. The Company +continues to make investments in capital equipment as needed to meet +anticipated demand for its products. 16 Item 3. Legal Proceedings The Company is subject to +various legal proceedings and claims that are discussed below. The Company is +also subject to certain other legal proceedings and claims that have arisen in +the ordinary course of business and which have not been fully adjudicated. In +the opinion of management, the Company does not have a potential liability +related to any current legal proceedings and claims that would individually or +in the aggregate have a material adverse effect on its financial condition, +liquidity or results of operations. However, the results of legal proceedings +cannot be predicted with certainty. Should the Company fail to prevail in any +of these legal matters or should several of these legal matters be resolved +against the Company in the same reporting period, the operating results of a +particular reporting period could be materially adversely affected. The Company +settled certain matters during 2005 that did not individually or in the +aggregate have a material impact on the Company’s results of operations. Advanced Audio +Devices LLC v. Apple Computer, Inc. Plaintiff Advanced Audio +Devices (AAD) filed this action on March 3, 2005 in the United States +District Court for the Northern District of Illinois, Eastern Division, +alleging infringement by the Company of U.S. Patent 6,587,403 entitled “Music +Jukebox.” The complaint sought unspecified damages and other relief. The +Company filed an answer on May 4, 2005 denying all material allegations +and asserting numerous affirmative defenses. The parties have reached a +settlement. Settlement of this matter did not have a material effect on the +Company’s financial position or results of operation. Apple +Corps Ltd. v. Apple Computer, Inc.; Apple Computer, Inc. v. +Apple Corps Ltd. Plaintiff Apple Corps filed this action on July 4, +2003 in the High Court of Justice, Chancery Division, in London alleging that +the Company has breached a 1991 agreement that resolved earlier trademark +litigation between the parties regarding use of certain Apple marks. Plaintiff +seeks an injunction, unspecified damages, and other relief. The Company filed a +motion on October 13, 2003, challenging jurisdiction in the U.K. The Court +denied this motion on April 7, 2004. The Company filed an appeal of the +Court’s decision but subsequently withdrew the appeal. In November 2004, +Plaintiff served the Company with an Amended Bill of Particulars and on December 23, +2004 the Company filed a Defence. Plaintiff has indicated its intention to file +a Re-Amended Bill of Particulars. The Company’s Defence to the Re-Amended Bill +of Particulars is not yet due. Trial is set for the week of March 27, +2006. On October 8, 2003, +the Company filed a lawsuit against Apple Corps in the United States District +Court for the Northern District of California requesting a declaratory judgment +that the Company has not breached the 1991 agreement. Apple Corps challenged +jurisdiction in the California case but the Court denied that challenge on March 25, +2004. Apple Corps subsequently prevailed on a motion to stay the California +case during the pendency of the U.K. action. The Company has dismissed the +California lawsuit without prejudice. Bader v. Anderson; +Bader v. Apple Computer, Inc. et. al. Plaintiff filed this +purported shareholder derivative action against the Company and each of its +current executive officers and members of its Board of Directors on May 19, +2005 in Santa Clara County Superior Court asserting claims for breach of +fiduciary duty, material misstatements and omissions, and violations of California +Businesses and Professions Code §17200 (unfair competition). Plaintiff alleges +that the Company’s March 14, 2005 proxy statement was false and misleading +for failure to disclose certain information relating to the Apple Computer, Inc. +Performance Bonus Plan which was approved by shareholders at the annual meeting +held on April 21, 2005. Plaintiff, who ostensibly brings suit on the +Company’s behalf, has made no demand on the Board of Directors and alleges that +such demand is excused. Plaintiff seeks injunctive and other relief for +purported injury to the Company. On July 27, 2005, Plaintiff filed an +amended complaint alleging that, in addition to the purported derivative +claims, adoption of the +bonus plan and distribution of the proxy statement describing that plan also +inflicted injury on her 17 directly +as an individual shareholder. Defendants filed a demurrer which is +scheduled to be heard on December 6, 2005. Baghdasarian, et +al. v. Apple Computer, Inc. Plaintiffs filed this +action in Los Angeles County Superior Court on October 31, 2005, on behalf +of a purported nationwide class of all purchasers of all Apple wireless +products (router, modem, or adaptor) sold at any time. The complaint alleges +that the Company misrepresented the transmission rates of these products. The +complaint alleges causes of action for breach of express warranty and for +violations of the Consumer Legal Remedies Act, California Business & +Professions Code §17200 (unfair competition) and California Business & +Professions Code §17500 (false advertising). The complaint seeks damages and +equitable remedies. The Company’s response to the complaint is not yet due. Branning et al. v. +Apple Computer, Inc. Plaintiffs filed this purported class action in San +Francisco County Superior Court on February 17, 2005. The complaint +alleges violations of California Business & Professions Code §17200 (unfair competition) and +violation of the Consumer Legal Remedies Act (CLRA) regarding a variety of +purportedly unfair and unlawful conduct including, but not limited to, +allegedly selling used computers as new and failing to honor warranties. +Plantiffs also bring causes of action for misappropriation of trade secrets, +breach of contract, and violation of the Song Beverly Act. Plaintiffs request +unspecified damages and other relief. The Company received service of the +complaint on March 12, 2005, and on March 13, 2005 the Company filed +a motion to transfer the case to Santa Clara County Superior Court. On May 9, +2005, the Court granted the motion and transferred the case to Santa Clara +County Superior Court. On May 2, 2005, Plaintiffs filed an amended +complaint adding two new named Plaintiffs and three new causes of action +including a claim for treble damages under the Cartwright Act (California Business +and Professions Code §16700 et +seq.) and a claim for false advertising. The Company filed a demurrer to the +amended complaint which the Court sustained in its entirety on November 10, +2005. The Court granted Plaintiffs leave to amend their complaint. Burrow v. Apple +Computer, Inc. Plaintiff filed this +purported class action in Orange County Superior Court on February 17, +2005 alleging false advertising regarding the copy protection capabilities of +DVD Studio Pro. The Complaint alleged violations of California Business & +Professions Code §17200 +(unfair competition), California Business & Professions Code §17500 (false advertising) and +negligent misrepresentation. Plaintiff requested unspecified damages and other +relief. The Company filed an answer on April 7, 2005 denying all +allegations and asserting numerous affirmative defenses. The parties have +reached a settlement. Settlement of this matter did not have a material effect +on the Company’s financial position or results of operation. Butzer, et +al., v. Apple Computer, Inc. Plaintiffs filed this +action on August 23, 2005, in the United States District Court for the +Northern District of California, San Jose Division, on behalf of a purported +nationwide class of all purchasers of the Company’s PowerBook G4 portable +computers. The complaint alleges defects in the memory of the computers. The +complaint alleges that this purported defect extends to other series of the +Company’s portables and states that plaintiffs reserve the right to amend the +complaint to include these other series. Plaintiffs assert claims for alleged +violations of California Business & Professions Code §17200 (unfair +competition), California Business & Professions Code §17500 (false +advertising), the Consumer Legal Remedies Act and the Song-Beverly Consumer +Warranty Act. The complaint seeks remedies including restitution and/or damages +and injunctive relief. The Company filed an answer on October 19, 2005 +denying the material allegations and asserting numerous affirmative defenses. 18 Cagney v. Apple +Computer, Inc. Plaintiff filed this +purported class action on January 9, 2004 in Los Angeles County Superior +Court, alleging improper collection of sales tax in transactions involving +mail-in rebates. The complaint alleges violations of California Business and +Professions Code §17200 +(unfair competition) and seeks restitution and other relief. The Company filed +an answer on February 20, 2004, denying all allegations and asserting +numerous affirmative defenses. The Company filed a motion to disqualify +Plaintiff’s counsel, which the Court denied. The Company filed a petition for a +writ of mandate with respect to this ruling and the Court of Appeal issued an +order to show cause as to why the writ should not issue. Plaintiff’s lead +counsel subsequently withdrew. On February 17, 2005 the Court of Appeal +ruled that the trial court abused its discretion in failing to grant the +Company’s motion to disqualify and ordered the trial court to disqualify both +of Plaintiff’s law firms upon remand. The trial court issued the +disqualification order on May 12, 2005. On May 9, 2005 Plaintiff +substituted new counsel. The Company has obtained an opinion on the tax issue +from the State Board of Equalization. Discovery is stayed. Clark v. Apple +Computer, Inc. Plaintiff filed this +purported class action on February 2, 2005 in Santa Clara County Superior +Court alleging defects in the Company’s “yo-yo” power adapters. Plaintiffs +request unspecified damages and other relief. The parties reached a tentative +settlement in this matter. The Court granted preliminary approval of the +settlement on April 19, 2005. On November 29, 2005, the Court +continued the hearing on final settlement approval until January 10, 2006, +when all claims will have been received and completely processed and relevant +claim information has been reported to the Court. Settlement of this matter on +the terms preliminarily approved by the Court will not have a material effect +on the Company’s financial position or results of operation. Compression Labs, Inc. +v. Apple Computer, Inc., et al.; Apple v. Compression Labs, Inc., et +al. Plaintiff Compression Labs, Inc. filed this +patent infringement action on April 22, 2004 against the Company and +twenty-seven other defendants in the United States District Court for the +Eastern District of Texas, Marshall Division, alleging infringement of U.S. +patent 4,698,672 (the ‘672 patent). Plaintiff alleges that the Company +infringes the patent by complying with the JPEG standard as defined by CCITT +Recommendation T.81 entitled “Information Technology—Digital Compression and +Coding of Continuous Tone Still Images—Requirements and Guidelines.” Plaintiff +seeks unspecified damages and other relief. On July 2, 2004, the +Company and several other defendants in the Texas action filed a lawsuit in the +United States District Court in Delaware against Compression Labs, Inc. +and two other companies, requesting a declaratory judgment of noninfringement, +invalidity, implied license, and unenforceability with respect to the ‘672 +patent. Additional actions regarding this patent have been filed in other +jurisdictions. On February 16, 2005, the Panel on Multi-District +Litigation (MDL) granted a petition filed by certain defendants, seeking +coordination and transfer of all of these cases to one court for pre-trial +proceedings. The MDL Panel has transferred all of the cases to the Northern +District of California. The defendants in the Texas and Delaware actions had +filed motions to dismiss prior to the transfer and both motions are still +pending. A Markman hearing is set for February 13, 2006. Contois Music +Technology LLC v. Apple Computer, Inc. Plaintiff Contois Music Technology (“Contois”) filed +this action on June 13, 2005 in the United States District Court for +Vermont, alleging infringement by the Company of U.S. Patent No. 5,864,868, +entitled “Computer Control System and User Interface for Media Playing Devices.” +The complaint, which was served on October 4, 2005, seeks unspecified +damages and other relief. The Company filed an answer on November 23, 2005 +denying all material allegations and asserting numerous affirmative defenses. 19 Craft v. Apple +Computer, Inc . (filed December 23, 2003, Santa +Clara County Superior Court); Chin v. Apple Computer, Inc. (filed December 23, +2003, San Mateo County Superior Court); Hughes v. Apple +Computer, Inc. (filed December 23, +2003, Santa Clara County Superior Court); Westley v. Apple +Computer, Inc. (filed December 26, +2003, San Francisco County Superior Court); Keegan v. Apple +Computer, Inc. (filed December 30, +2003, Alameda County Superior Court); Wagya v. Apple Computer, Inc. (filed February 19, +2004, Alameda County Superior Court); Yamin v. Apple Computer, Inc. (filed February 24, 2004, Los +Angeles County Superior Court); Kieta v. Apple Computer, Inc. (filed July 8, 2004, Alameda +County Superior Court) Eight separate plaintiffs +filed purported class action cases in various California courts alleging +misrepresentations by the Company relative to iPod battery life. The complaints +include causes of action for violation of California Business and Professions +Code §17200 +(unfair competition), the Consumer Legal Remedies Action and claims for false +advertising, fraudulent concealment, and breach of warranty. The complaints +seek unspecified damages and other relief. The cases were consolidated in San +Mateo County and Plaintiffs thereafter filed a consolidated complaint. On August 25, +2004, the Company filed an answer denying all allegations and asserting +numerous affirmative defenses. The parties reached a tentative settlement and +the Court granted preliminary approval of the settlement on May 20, 2005. +The trial court entered an order granting final approval to the settlement on August 25, +2005. An appeal challenging the trial +court’s approval of the settlement was filed on October 24, 2005; the +appeal is pending. Settlement of this matter on the terms approved by +the Court will not have a material effect on the Company’s financial position +or results of operations. A similar complaint +relative to iPod battery life, Mosley v. Apple +Computer, Inc. was filed in Westchester County, New York on June 23, +2004 alleging violations of New York General Business Law Sections 349 (unfair +competition) and 350 (false advertising). The Company removed the case to +Federal Court and Plaintiff filed a motion for remand, which the Court has not +yet decided. This case is stayed and is part of the settlement, now on appeal, +referred to above. A similar complaint related +to the iPod battery life, Lenzi v. Apple Canada, Inc. , +was filed in Montreal, Quebec, Canada, on June 7, 2005, seeking +authorization to institute a class action on behalf of Generations 1, 2 and 3 +iPod owners in Quebec. A class certification hearing has been scheduled for January 12, +2006. Two similar complaints +relative to iPod battery life, Wolfe v. Apple and Hirst v. Apple , were filed in Toronto, +Ontario, Canada on August 15, 2005 and September 12, 2005, +respectively. Both actions define the class as a national class consisting of +all persons in Canada who have purchased or who own an iPod. A motion for +certification of the class proceeding has been scheduled for the Spring of +2006. Davis v. Apple +Computer, Inc. Plaintiff filed this +purported class action in San Francisco County Superior Court on December 5, +2002, alleging that the Company engaged in unfair and deceptive business +practices relating to its AppleCare Extended Service and Warranty Plan. +Plaintiff asserts causes of action for violation of the California Business and +Professions Code §17200 +(unfair competition) and §17500 +(false advertising), breach of the Song-Beverly Warranty Act, intentional +misrepresentation and concealment. Plaintiff requests unspecified damages and +other relief. The Company filed a demurrer and motion to strike which were +granted, in part, and Plaintiff filed an amended complaint. The Company filed +an answer on April 17, 2003 denying all allegations and asserting numerous +affirmative defenses. Plaintiff subsequently amended its complaint. On October 29, +2003, the Company filed a motion to disqualify Plaintiff’s counsel in his role +as counsel to the purported class and to the general public. The Court granted +the motion but allowed Plaintiff to retain substitute counsel. Plaintiff did +engage new counsel for the general public, but not for the class. The Company +moved to disqualify Plaintiff’s new counsel and to have the Court dismiss the +general public claims for equitable relief. The Court declined to disqualify Plaintiff’s +new counsel or to dismiss the equitable claims, but did confirm that the class +action claims are dismissed. The Company appealed the ruling and the case was +stayed pending the outcome of the appeal. The Court of Appeal denied the appeal 20 on August 17, 2005, +affirming the trial court’s decision. The Company filed a Petition for review +with the California Supreme Court which was denied on November 23, 2005. European Commission +Investigation The European Commission +has notified the Company that it is investigating certain matters relating to +the iTunes Music Store in the European Union (EU). The European Commission is +investigating claims made by Which?, a United Kingdom (UK) consumer +association, that the Company is violating EU competition law by charging more +for online music in the UK than in Eurozone countries and preventing UK +consumers from purchasing online music from the iTunes Music Store for Eurozone +countries. The Which? claims were originally lodged with the UK Office of Fair +Trading, which subsequently referred them to the European Commission. The +European Commission is investigating the charges under Articles 81 and 82 of +the European Commission Treaty. Gobeli +Research Ltd. v. Apple Computer, Inc., et al. Plaintiff Gobeli +Research Ltd. filed this patent infringement action against the Company +and Sun Microsystems, Inc. on April 15, 2004 in the United States +District Court for the Eastern District of Texas, Marshall Division, alleging +infringement of U.S. patent 5,418,968 related to a “System and Method of +Controlling Interrupt Processing.” Plaintiff alleges that the Company’s Mac OS +9 and Mac OS X operating systems infringe Plaintiff’s patent. Plaintiff seeks +unspecified damages and other relief. The Company filed an answer on June 9, +2004, denying all material allegations and asserting numerous affirmative +defenses. The Company also asserted counterclaims requesting declaratory +judgment of non-infringement and invalidity. A Markman hearing took place August 9, +2005, and the Court issued a ruling on August 26, 2005 invalidating one of +Plantiff’s two claims. On October 18, 2005, a Stipulation entered into by +the parties was filed removing Mac OS 9 from the case. The trial is scheduled +for February 6, 2006. Goldberg, et al. v. +Apple Computer, Inc., et al. (f.k.a. “Dan v. Apple Computer, Inc.”) Plaintiffs filed this +purported class action on September 22, 2003 in Los Angeles County +Superior Court against the Company and other members of the computer industry +on behalf of an alleged nationwide class of purchasers of certain computer hard +drives. The case alleges violations of California Business and Professions Code §17200 (unfair +competition), the Consumer Legal Remedies Act and false advertising related to +the size of the drives. Plaintiffs allege that calculation of hard drive size +using the decimal method misrepresents the actual size of the drive. The +complaint seeks restitution and other relief. Plaintiff filed an amended +complaint on March 30, 2004 and the Company filed an answer on September 23, +2004, denying all allegations and asserting numerous affirmative defenses. Defendants +filed a motion to strike portions of the complaint based on sales by resellers +and filed a motion for judgment on the pleadings based upon Proposition 64. The +Court granted both motions at a hearing on April 6, 2005. Plaintiff filed +an amended complaint on May 6, 2005. The Defendants filed a demurrer on June 6, +2005, which was heard on August 22, 2005. The Court granted the demurrer +in part and denied it in part. Plaintiff filed an amended complaint. The +Company’s response is not yet due. Honeywell +International, Inc., et al. v. Apple Computer, Inc., et al. Plaintiffs Honeywell +International, Inc. and Honeywell Intellectual Properties, Inc. filed +this action on October 6, 2004 in the United States District Court in +Delaware alleging infringement by the Company and other defendants of U.S. +patent 5,280,371 entitled “Directional Diffuser for a Liquid Crystal Display.” +Plaintiffs seek unspecified damages and other relief. The Company filed an +answer on December 21, 2004 denying all material allegations and asserting +numerous affirmative defenses. The Company has tendered the case to several +suppliers. On May 18, 2005 the Court stayed the case against the Company +and the other supplier defendants. Plantiffs filed an amended complaint on +November 7, 2005 adding additional defendants and expanding the scope of the +accused products. Given the stay, the Company’s response to the amended +complaint is not yet due. 21 MacTech Systems v. +Apple Computer, Inc.; Macadam v. Apple Computer, Inc.; Computer +International, Inc. v. Apple Computer, Inc.; Elite Computers and +Software, Inc. v. Apple Computer, Inc.; The Neighborhood +Computer Store v. Apple Computer, Inc. MacAccessory Center, Inc. +v. Apple Computer, Inc.; MacAccessory Center, Inc. v. Apple Computer, Inc. (all in Santa Clara County Superior Court) Six resellers have filed +similar lawsuits against the Company for various causes of action including +breach of contract, fraud, negligent and intentional interference with economic +relationship, negligent misrepresentation, trade libel, unfair competition and +false advertising. Plaintiffs request unspecified damages and other relief. The +Company answered the Computer International complaint on November 12, +2003, denying all allegations and asserting numerous affirmative defenses. The +Company filed an answer in the Macadam case on December 3, 2004 denying +all allegations and asserting numerous defenses. Three of the other plaintiffs +filed amended complaints on February 7, 2005, and on March 16, 2005 +the Company filed answers to these claims denying all allegations and asserting +numerous affirmative defenses. A sixth Plaintiff, MacAccessory Center, filed a +complaint on February 23, 2005. The Company filed an answer to this +complaint on April 20, 2005 denying all allegations and asserting numerous +affirmative defenses. These cases are in discovery. On October 1, 2003, +one of the reseller Plaintiffs, Macadam, was deauthorized as an Apple reseller. +Macadam filed a motion for a temporary order to reinstate it as a reseller, +which the Court denied. The Court denied Macadam’s motion for a preliminary +injunction on December 19, 2003. On December 6, 2004 Macadam filed +for Chapter 11 Bankruptcy in the Northern District of California, which placed +a stay on the litigation as to Macadam only. The Company filed a claim in the +bankruptcy proceedings on February 16, 2005. The Company took Macadam’s +debtor examination in April 2005. The Company, joined by another creditor +of Macadam, filed a motion to convert the bankruptcy to Chapter 7 (liquidation) +on April 29, 2005 and that motion was granted. Plantiffs’ counsel in four +of the six other reseller cases, was recently appointed litigation counsel for +the Macadam Estate by the bankruptcy court. The Company has moved for +reconsideration of that decision. Premier +International Associates LLC v. Apple Computer, Inc. Plaintiff Premier +International Associates LLC (Premier) filed this action on November 3, +2005 in the United States District Court for the Eastern District of Texas, +Marshall Division, alleging infringement by the Company of U.S. Patents +6,243,725 and 6,763,345 both entitled “List Building System.” The complaint +seeks unspecified damages and other relief. The Company’s response is not yet +due. Slattery v. Apple +Computer, Inc. Plaintiff filed this +purported class action on January 3, 2005 in the United States District +Court for the Northern District of California alleging various claims including +alleged unlawful tying of music purchased on the iTunes Music Store with the +purchase of iPods and vice versa and unlawful acquisition or maintenance of +monopoly market power. Plaintiff’s complaint alleged violations of §§1 and 2 of the Sherman Act (15 +U.S.C. §§1 and 2), California Business and Professions Code §16700 et seq. (the Cartwright Act), +California Business and Professions Code §17200 +(unfair competition), common law unjust enrichment and common law +monopolization. Plaintiff seeks unspecified damages and other relief. The +Company filed a motion to dismiss on February 10, 2005. On September 9, +2005, the Court denied the motion in part and granted it in part. Plaintiff +filed an amended complaint on September 23, 2005 and the Company filed an +answer on October 11, 2005. The case is in discovery. Stamm v. Apple +Computer, Inc./Allen v. Apple Computer, Inc. Plaintiff Stamm filed a +purported class action on November 12, 2004 in Circuit Court, Cook County, +Illinois alleging that a defect in Apple’s 17-inch Studio Display monitors +results in dimming of half of the screen and constant blinking of the power +light. The Company removed the case to Federal Court on December 22, 2004. +The Court remanded it to State Court on March 22, 2005 on Plaintiff’s +motion. The Company had filed a motion to dismiss on January 27, 2005 +which was taken off calendar due to the 22 remand. On January 28, +2005 a second plaintiff, Allen, filed a purported nationwide class action in +Los Angeles Superior Court alleging identical claims. Plaintiff Stamm dismissed +the Stamm case on September 2, 2005. An amended complaint in the Allen case was filed on October 24, +2005, adding additional named plaintiffs and expanding the alleged class to +include purchasers of the 20-inch Apple Cinema Display and the 23-inch +Apple Cinema HD Display. The amended complaint alleges that the displays have a +purported defect that causes dimming of one-half of the screen, and that the +Company misrepresented the quality of the displays and/or concealed the +purported defect. Plaintiffs assert claims under California Business & +Professions Code §17200 (unfair competition); California Business & +Professions Code §17500 (false advertising) and the Consumer Legal Remedies Act. +The amended complaint seeks remedies including damages and equitable relief. On +November 14, 2005, the Company filed an answer to the amended complaint as +to the allegations regarding the 17-inch display and a demurrer/motion to +strike as to the allegations regarding the 20-inch and 23-inch +displays on the ground that plaintiffs failed to allege that they purchased +those displays. At a status conference on November 21, 2005, the Court ordered +Plantiffs to amend their complaint. The Company’s demurrer is off calendar +pending this amendment. St-Germain v. Apple +Canada, Inc. Plaintiff filed this case +in Montreal, Quebec, Canada, on August 5, 2005, seeking authorization to +institute a class action for the refund by the Company of the Canadian Private +Copying Levy that was applied to the iPod purchase price in Quebec between December 12, +2003 and December 14, 2004 but later declared invalid by the Canadian +Court. A class certification hearing is scheduled for January 13, 2006. The +Company has already begun a refund program for this levy. Teleshuttle +Technologies, LLC and BTG International Inc. v. Microsoft and Apple +Computer, Inc. Plaintiffs filed this case +on July 20, 2004 in United States District Court for the Northern District +of California alleging infringement of U.S. patent 6,557,054, entitled “Method +and System for Distributing Updates by Presenting Directory of Software +Available for User Installation That is Not Already Installed on User Station.” +Plaintiffs filed an amended complaint on September 7, 2004, adding a +second patent, U.S. patent 6,769,009 entitled “Method and System for Selecting +a Personalized Set of Information Channels.” Plaintiffs seek unspecified +damages and other relief. The Company filed an answer on October 18, 2004, +denying all material allegations and asserting numerous affirmative defenses. +On August 22, 2005, the Company filed an amended answer to add charges of +inequitable conduct. The case is in discovery. Markman briefing is completed. A +technology tutorial and Markman hearing are tentatively scheduled for January 13, +20, and 27, 2006. Tiger Direct, Inc. +v. Apple Computer, Inc. Plaintiff Tiger Direct, Inc. +filed this trademark infringement action in the United States District Court +for the Southern District of Florida on April 26, 2005 alleging +infringement of the word mark TIGER. Plaintiff claims to have a valid +registration in the mark TIGER and alleges that the Company’s use of TIGER in +reference to the latest version of Mac OS X infringes the mark allegedly owned +by Plaintiff. Plaintiff attempted to obtain an ex parte preliminary injunction +barring the Company’s use of the TIGER mark on April 27, 2005 but the +motion was denied. Plaintiff served the Company on April 27, 2005 and +again moved for a preliminary injunction. Plaintiff’s motion was heard on May 3, +2005. On May 11, 2005, the Court denied Plaintiff’s motion. The Company +filed a response to the complaint on May 17, 2005, denying all material +allegations and asserting counterclaims for cancellation of certain marks +registered to Tiger Direct. On June 10, 2005, Plaintiff filed an appeal, +but subsequently withdrew it. Plaintiff filed a response to the Company’s +counterclaims. The parties have reached a settlement. Settlement of this matter +did not have a material effect on the Company’s financial position or results +of operation. 23 Tse v. Apple +Computer, Inc. et al. Plaintiff Ho Keung Tse +filed this action against the Company and other defendants on August 5, +2005 in the United States District Court for the District of Maryland alleging +infringement by the Company of U.S. Patent 6,665,797 entitled “Protection of +Software Again [sic] Against Unauthorized Use.” The complaint seeks unspecified +damages and other relief. The Company filed an answer on October 31, 2005 +denying all material allegations and asserting numerous affirmative defenses. +On October 28, 2005, the Company and the other defendants filed a motion +to transfer the case to the Northern District of California. Wimmer v. Apple Computer, Inc. (originally filed as Tomczak v. Apple Computer, Inc. on October 19, 2005 in the United States +District Court for the Northern District of California, San Jose Division; amended +complaint filed October 26, 2005); Moschella, et al., v. Apple +Computer, Inc. (filed October 26, +2005 United States District Court for the Northern District of California, San +Jose Division); Calado, et al. v. Apple Computer, Inc. (filed October 26, 2005, Los Angeles County +Superior Court); Kahan, et al., v. Apple Computer, Inc. (filed October 31, 2005, United States District +Court for the Southern District of New York); Jennings, et al., v. Apple +Computer, Inc. (filed November 4, +2005, United States District Court for the Northern District of California, San +Jose Division). These federal and state court +complaints allege that the Company’s iPod nano was defectively designed so that +it scratches excessively during normal use which renders the screen unreadable. +The Wimmer and Moschella actions were brought on behalf of purported nationwide +classes of iPod nano purchasers, with the exception of California purchasers, +and allege violations of the consumer protection, express and implied warranty +statutes of each state covered by the putative class definition, as well as +negligent misrepresentation and unjust enrichment under the common laws of +these jurisdictions. The Calado action was brought on behalf of a purported +California class of iPod nano purchasers and asserts claims for alleged +violation of California Business & Professions Code §17200 (unfair +competition), California Business & Professions Code §17500 (false +advertising), the Consumer Legal Remedies Act, breaches of express and implied +warranties, negligent misrepresentation and unjust enrichment. The Jennings +action was filed on behalf of a purported class of all iPod nano purchasers +outside of the United States, based upon alleged violations of the same +California statutes as in the Calado complaint. The Kahan action was brought on +behalf of a purported New York class of iPod nano purchasers and alleges claims +under the New York unfair competition law, breach of express warranty and +unjust enrichment. The complaints seek damages and various other remedies. The +Company’s responses to these complaints are not yet due. Two similar complaints, Carpentier v. Apple Canada, Inc. , and Royer- Brennan v. Apple Computer, Inc. and Apple Canada, Inc. were filed in Montreal, Quebec, Canada, on October 27, 2005 and +November 9, 2005, respectively, seeking authorization to institute a class +action on behalf of iPod nano purchasers in Quebec. Union Federale des +Consummateurs—Que Choisir v. Apple Computer France S.A.R.L. and iTunes S.A.R.L. Plaintiff, a consumer association +in France, filed this complaint on February 9, 2005 alleging that the +entities above are violating consumer law by 1) omitting to mention that the +iPod is allegedly not compatible with music from online music services other +than the iTunes Music Store and that the music from the iTunes Music Store is +only compatible with the iPod and 2) allegedly tying the sales of iPods to the +iTunes Music Store and vice versa. Plaintiff seeks damages, injunctive relief +and other relief. The first hearing on the case took place on May 24, +2005. The Company’s response to the complaint was served on November 8, +2005. Item +4. Submission of Matters to a Vote of Security Holders No matters were submitted +to a vote of security holders during the fourth quarter of the Company’s fiscal +year ended September 24, 2005. 24 PART II Item +5. Market for the Registrant’s Common Equity, Related Shareholder Matters and +Issuer Purchases of Equity Securities (a) Stock +Market Information The Company’s common stock is traded on the over-the-counter +market and is quoted on the NASDAQ National Market under the symbol AAPL and on +the Frankfurt Stock Exchange under the symbol APCD. In December 2004, the +Company delisted its shares from trading on the Tokyo Stock Exchange. As of November 18, +2005, there were 28,333 shareholders of record. The Company did not pay cash dividends in either 2005 +or 2004. The Company anticipates that, for the foreseeable future, it will +retain any earnings for use in the operation of its business. The price range +per share of common stock presented below represents the highest and lowest +closing prices for the Company’s common stock on the NASDAQ National Market +during each quarter. On February 28, +2005, the Company effected a two-for-one stock split to shareholders of record +as of February 18, 2005. All share and per share information has been +retroactively adjusted to reflect the stock split. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2005 price + range per common share $ 53.20-$36.37 $ 43.74-$34.13 $ 45.06-$31.58 $ 34.22-$18.65 Fiscal 2004 price + range per common share $ 19.00-$14.57 $ 16.85-$12.89 $ 13.84-$10.57 $ 12.41-$  9.85 (b) Related +Shareholder Matters None. (c) Issuer +Purchases of Equity Securities None. 25 Item 6. Selected Financial Data The +following selected financial information has been derived from the audited +consolidated financial statements. The information set forth below is not +necessarily indicative of results of future operations, and should be read in +conjunction with Item 7, “Management’s Discussion and Analysis of Financial +Condition and Results of Operations” and the consolidated financial statements +and related notes thereto included in Item 8 of this Form 10-K in +order to fully understand factors that may affect the comparability of the +information presented below. Five fiscal years ended September 24, 2005 (In millions, except share and per share amounts) 2005 2004 2003 2002 2001 Net sales $ 13,931 $ 8,279 $ 6,207 $ 5,742 $ 5,363 Net income (loss) $ 1,335 $ 276 $ 69 $ 65 $ (25 ) Earnings (loss) per + common share: Basic $ 1.65 $ 0.37 $ 0.10 $ 0.09 $ (0.04 ) Diluted $ 1.56 $ 0.36 $ 0.09 $ 0.09 $ (0.04 ) Cash dividends + declared per common share $ — $ — $ — $ — $ — Shares used in computing + earnings (loss) per share (in thousands): Basic 808,439 743,180 721,262 710,044 691,226 Diluted 856,780 774,622 726,932 723,570 691,226 Cash, cash + equivalents, and short-term investments $ 8,261 $ 5,464 $ 4,566 $ 4,337 $ 4,336 Total assets $ 11,551 $ 8,050 $ 6,815 $ 6,298 $ 6,021 Long-term + debt (including current maturities) $ — $ — $ 304 $ 316 $ 317 Total liabilities $ 4,085 $ 2,974 $ 2,592 $ 2,203 $ 2,101 Shareholders’ equity $ 7,466 $ 5,076 $ 4,223 $ 4,095 $ 3,920 Net gains before taxes +related to the Company’s non-current debt and equity investments of $4 million, +$10 million, and $75 million were recognized in 2004, 2003, and 2001, +respectively. A net loss before taxes related to the Company’s non-current debt +and equity investments of $42 million was recognized in 2002. In 2002, the +Company acquired Emagic resulting in a charge of approximately $1 million for +acquired in-process technologies with no alternative future use. The +Company recognized a similar charge of $11 million in 2001 related to its +acquisition of PowerSchool. Net charges related to Company restructuring +actions of $23 million, $26 million, and $30 million were recognized in 2004, +2003, and 2002, respectively. In 2003, settlement of the Company’s forward +stock purchase agreement resulted in a gain of $6 million. Net income during +2005 benefited by $81 million from the reversal of certain tax contingency +reserves and adjustments to net deferred tax assets, including reductions to +valuation allowances. Favorable cumulative-effect type adjustments from the +adoption of new accounting standards, net of taxes, of $1 million and $12 +million were recognized in 2003 and 2001, respectively. Item 7. Management’s +Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K +contain forward-looking statements that involve risks and uncertainties. +Forward-looking statements can also be identified by words such as “anticipates,” +“expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking +statements are not guarantees of future performance and the Company’s actual +results may differ significantly from the results discussed in the forward-looking +statements. Factors that might cause such differences include, but are not +limited to, those discussed in the subsection entitled “Factors That May Affect +Future Results and Financial Condition” below. The following discussion should +be read in conjunction with the consolidated financial statements and notes +thereto included in Item 8 of this Form 10-K. All information +presented herein is based on the Company’s fiscal 26 calendar. The Company assumes no obligation to revise +or update any forward-looking statements for any reason, except as required by +law. Executive Overview The Company designs, manufactures, and markets +personal computers and related software, services, peripherals, and networking +solutions. The Company also designs, develops, and markets a line of portable +digital music players along with related accessories and services including the +online distribution of third-party music, audio books, music videos, +short films, and television shows. The Company’s products and services include +the Macintosh line of desktop and notebook computers, the iPod digital music +player, the Xserve G5 server and Xserve RAID storage products, a portfolio of +consumer and professional software applications, the Mac OS X operating system, +the iTunes Music Store, a portfolio of peripherals that support and enhance the +Macintosh and iPod product lines, and a variety of other service and support +offerings. The Company sells its products worldwide through its online stores, +its own retail stores, its direct sales force, and third-party wholesalers, resellers, +and value added resellers. In addition, the Company sells a variety of +third-party Macintosh compatible products, including computer printers and +printing supplies, storage devices, computer memory, digital camcorders and +still cameras, personal digital assistants, and various other computing +products and supplies through its online and retail stores. The Company sells +to education, consumer, creative professional, business, and government +customers. A further description of the Company’s products may be found in Part I, +Item 1 of this document under the heading “Business.” The Company’s business strategy leverages its ability, +through the design and development of its own operating system, hardware, and +many software applications and technologies, to bring to its customers around +the world compelling new products and solutions with superior ease-of-use, +seamless integration, and innovative industrial design. The Company participates in several highly competitive +markets, including personal computers with its Macintosh line of computers, +consumer electronics with its iPod line of digital music players, and +distribution of third-party digital content through its online iTunes Music +Store. While the Company is widely recognized as an innovator in the personal +computer and consumer electronic markets as well as a leader in the emerging +market for distribution of digital content, these are all highly competitive +markets that are subject to aggressive pricing and increased competition. To +remain competitive, the Company believes that increased investment in research +and development (R&D) and marketing and advertising is necessary to +maintain and extend its position in the markets where it competes. The Company’s +R&D spending is focused on delivering timely updates and enhancements to +its existing line of personal computers, displays, operating systems, software +applications, and portable music players; developing new digital lifestyle +consumer and professional software applications; and investing in new product +areas such as rack-mount servers, RAID storage systems, and wireless +technologies. The Company also believes investment in marketing and advertising +programs is critical to increasing product and brand awareness. In June 2005, the Company announced its plan to +begin using Intel microprocessors in its Macintosh computers. The Company plans +to begin shipping certain models with Intel microprocessors by June 2006 +and to complete the transition of all of its Macintosh computers to Intel +microprocessors by the end of calendar year 2007. There are potential risks and +uncertainties that may occur during this transition, which are further +discussed under the heading “Factors That May Affect Future Results and +Financial Condition.” The Company utilizes a variety of direct and indirect +distribution channels. The Company believes that sales of its innovative and +differentiated products are enhanced by knowledgeable salespersons who can +convey the value of the hardware, software, and peripheral integration, +demonstrate the unique digital lifestyle solutions that are available only on +Macintosh computers, and demonstrate the compatibility of the Macintosh with +the Windows platform and networks. The Company further believes that providing +a 27 high-quality sales and after-sales support experience +is critical to attracting and retaining customers. To ensure a high-quality +buying experience for its products in which service and education are +emphasized, the Company has expanded and improved its distribution capabilities +by opening its own retail stores in the U.S. and internationally. The Company +had 124 stores open as of September 24, 2005. The Company also staffs selected third-party stores +with the Company’s own employees to improve the buying experience through +reseller channels. The Company has deployed Apple employees and contractors in +reseller locations around the world including the U.S., Europe, Japan, and +Australia. The Company also sells to customers directly through its online +stores around the world. To improve access to the +iPod product line, the Company has significantly expanded the number of +distribution points where iPods are sold. The iPod product line can be +purchased in certain department stores, member-only warehouse stores, large +retail chains, and specialty retail stores, as well as through the channels +listed above. Critical +Accounting Policies and Estimates The preparation of financial statements and related +disclosures in conformity with U.S. generally accepted accounting principles +and the Company’s discussion and analysis of its financial condition and +results of operations require the Company’s management to make judgments, +assumptions, and estimates that affect the amounts reported in its consolidated +financial statements and accompanying notes. Note 1 of the Notes to +Consolidated Financial Statements of this Form 10-K describes the +significant accounting policies and methods used in the preparation of the +Company’s consolidated financial statements. Management bases its estimates on +historical experience and on various other assumptions it believes to be +reasonable under the circumstances, the results of which form the basis for +making judgments about the carrying values of assets and liabilities. Actual +results may differ from these estimates and such differences may be material. Management believes the +Company’s critical accounting policies and estimates are those related to +revenue recognition, allowance for doubtful accounts, inventory valuation and +inventory purchase commitments, warranty costs, and income taxes. Management +believes these policies to be critical because they are both important to the +portrayal of the Company’s financial condition and results, and they require +management to make judgments and estimates about matters that are inherently +uncertain. The Company’s senior management has reviewed these critical +accounting policies and related disclosures with the Audit and Finance +Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, peripherals, digital content, and service and support +contracts. The Company recognizes revenue pursuant to applicable accounting +standards, including Statement of Position (SOP) No. 97-2, Software Revenue Recognition , as amended, and Securities and +Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. The Company recognizes revenue when persuasive +evidence of an arrangement exists, delivery has occurred, the sales price is +fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped, and title and risk of loss +have been transferred. For most of the Company’s product sales, these criteria +are met at the time the product is shipped. For online sales to individuals, +for some sales to education customers in the U.S., and for certain other sales, +the Company defers revenue until the customer receives the product because the +Company legally retains a portion of the risk of loss on these sales during +transit. If at the outset of an arrangement the Company determines the +arrangement fee is not, or is presumed not to be, fixed or determinable, +revenue is deferred and subsequently recognized as amounts become due and +payable. 28 The Company records +reductions to revenue for estimated commitments related to price protection and +for customer incentive programs, including reseller and end-user rebates, and +other sales programs and volume-based incentives. The estimated cost of these +programs is accrued as a reduction to revenue in the period the Company has +sold the product and committed to the relevant program. The Company also +records reductions to revenue for expected future product returns based on the +Company’s historical experience. Future market conditions and product +transitions may require the Company to increase customer incentive programs and +incur incremental price protection obligations that could result in additional +reductions to revenue at the time such programs are offered. Additionally, +certain customer incentive programs require management to estimate the number +of customers who will actually redeem the incentive based on historical +experience and the specific terms and conditions of particular incentive +programs. If a greater than estimated proportion of customers redeem such +incentives, the Company would be required to record additional reductions to +revenue, which could have a material adverse impact on the Company’s results of +operations. Allowance for +Doubtful Accounts The Company distributes its products through +third-party resellers and directly to certain education, consumer, and +commercial customers. The Company generally does not require collateral from +its customers. However, when possible the Company does attempt to limit credit +risk on trade receivables with credit insurance for certain customers in Latin +America, Europe, and Asia and by arranging with third-party financing companies +to provide flooring arrangements and other loan and lease programs to the +Company’s direct customers. These credit-financing arrangements are directly +between the third-party financing company and the end customer. As such, the +Company generally does not assume any recourse or credit risk sharing related +to any of these arrangements. However, considerable trade receivables that are +not covered by collateral, third-party flooring arrangements, or credit +insurance are outstanding with the Company’s distribution and retail channel +partners. The +allowance for doubtful accounts is based on management’s assessment of +the collectibility of specific customer accounts and includes consideration of +the credit worthiness and financial condition of those specific customers. The Company records an allowance to reduce +the specific receivables to the amount that is reasonably believed to be +collectible . The Company also records an +allowance for all other trade receivables based on multiple factors including historical +experience with bad debts, the general economic environment, the financial +condition of the Company’s distribution channels, and the aging of such +receivables. If there is a +deterioration of a major customer’s financial condition, if the Company becomes +aware of additional information related to the credit worthiness of a major +customer, or if future actual default rates on trade receivables in general +differ from those currently anticipated, the Company may have to adjust its +allowance for doubtful accounts, which would affect earnings in the period the +adjustments are made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and +build inventory in advance of product shipments. The Company records a +write-down for inventories of components and products, including third-party +products held for resale, which have become obsolete or are in excess of +anticipated demand or net realizable value. The Company performs a detailed +review of inventory each fiscal quarter that considers multiple factors +including demand forecasts, product life cycle status, product development +plans, current sales levels, and component cost trends. The personal computer +and consumer electronic industries are subject to a rapid and unpredictable +pace of product and component obsolescence and demand changes. If future demand +or market conditions for the Company’s products are less favorable than +forecasted or if unforeseen technological changes negatively impact the utility +of component inventory, the Company may be required to record additional +write-downs which would negatively affect gross margins in the period when the +write-downs are recorded. 29 The +Company accrues necessary reserves for cancellation fees related to component +orders that have been cancelled. Consistent with industry practice, the +Company acquires components through a combination of purchase orders, supplier +contracts, and open orders based on projected demand information. These +commitments typically cover the Company’s +requirements for periods ranging from 30 to 150 days. If there is an abrupt and +substantial decline in demand for one or more of the Company’s products or an +unanticipated change in technological requirements for any of the Company’s +products, the Company may be required to record additional reserves for +cancellation fees that would negatively affect gross margins in the period when +the cancellation fees are identified. Warranty Costs The Company provides +currently for the estimated cost for product warranties at the time the related +revenue is recognized based on historical and projected warranty claim rates, +historical and projected cost-per-claim, and knowledge of specific +product failures that are outside of the Company’s typical experience. Each +quarter, the Company reevaluates its estimates to assess the adequacy of its +recorded warranty liabilities considering the size of the installed base of +products subject to warranty protection, and adjusts the amounts as necessary. If actual product failure rates or repair costs +differ from estimates, revisions to the estimated warranty liability would be +required and could negatively affect the Company’s results of +operations. Income Taxes The Company records a tax provision for the +anticipated tax consequences of the reported results of operations. In +accordance with Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes , the +provision for income taxes is computed using the asset and liability method, +under which deferred tax assets and liabilities are recognized for the expected +future tax consequences of temporary differences between the financial +reporting and tax bases of assets and liabilities, and for operating losses and +tax credit carryforwards. Deferred tax assets and liabilities are measured +using the currently enacted tax rates that apply to taxable income in effect +for the years in which those tax assets are expected to be realized or settled. +The Company records a valuation allowance to reduce deferred tax assets to the +amount that is believed more likely than not to be realized. The Company is +currently evaluating the repatriation provisions of the American Jobs Creation +Act of 2004, which, if implemented by the Company, would affect the Company’s +tax provision and deferred tax assets and liabilities. Management believes it is more likely than not that +forecasted income, including income that may be generated as a result of +certain tax planning strategies, together with the tax effects of the deferred +tax liabilities, will be sufficient to fully recover the remaining deferred tax +assets. In the event that all or part of the net deferred tax assets are +determined not to be realizable in the future, an adjustment to the valuation +allowance would be charged to earnings in the period such determination is made. +Similarly, if the Company subsequently realizes deferred tax assets that were +previously determined to be unrealizable, the respective valuation allowance +would be reversed, resulting in a positive adjustment to earnings or a decrease +in goodwill in the period such determination is made. In addition, the calculation +of tax liabilities involves significant judgment in estimating the impact of +uncertainties in the application of complex tax laws. Resolution of these +uncertainties in a manner inconsistent with management’s expectations could +have a material impact on the Company’s results of operations and financial +position. 30 Net Sales Net +sales and Macintosh unit sales by operating segment and net sales and unit +sales by product follow (net sales in millions and unit sales in thousands): September 24, 2005 Change September 25, 2004 Change September 27, 2003 Net Sales by Operating Segment: Americas net sales $ 6,590 64 % $ 4,019 26 % $ 3,181 Europe net sales 3,073 71 % 1,799 37 % 1,309 Japan net sales 920 36 % 677 (3 )% 698 Retail net sales 2,350 98 % 1,185 91 % 621 Other Segments net sales (a) 998 67 % 599 51 % 398 Total net sales $ 13,931 68 % $ 8,279 33 % $ 6,207 Unit + Sales by Operating Segment: Americas Macintosh unit sales 2,184 30 % 1,682 4 % 1,620 Europe Macintosh unit sales 1,138 47 % 773 13 % 684 Japan Macintosh unit sales 313 8 % 291 (14 )% 339 Retail Macintosh unit sales 609 94 % 314 68 % 187 Other Segments Macintosh unit sales (a) 290 26 % 230 26 % 182 Total Macintosh unit sales 4,534 38 % 3,290 9 % 3,012 Net + Sales by Product: Desktops (b) $ 3,436 45 % $ 2,373 (4 )% $ 2,475 Portables (c) 2,839 11 % 2,550 26 % 2,016 Total Macintosh net sales 6,275 27 % 4,923 10 % 4,491 iPod 4,540 248 % 1,306 279 % 345 Other music related products and services (d) 899 223 % 278 672 % 36 Peripherals and other hardware (e) 1,126 18 % 951 38 % 691 Software, service, and other sales (f) 1,091 33 % 821 27 % 644 Total net sales $ 13,931 68 % $ 8,279 33 % $ 6,207 Unit + Sales by Product: Desktops (b) 2,520 55 % 1,625 (8 )% 1,761 Portables (c) 2,014 21 % 1,665 33 % 1,251 Total Macintosh unit sales 4,534 38 % 3,290 9 % 3,012 Net sales per Macintosh unit sold (g) $ 1,384 (7 )% $ 1,496 0 % $ 1,491 iPod unit sales 22,497 409 % 4,416 370 % 939 Net sales per iPod + unit sold (h) $ 202 (32 )% $ 296 (19 )% $ 367 Notes: (a) Other +Segments include Asia Pacific and FileMaker. (b) Includes +iMac, eMac, Mac mini, Power Mac and Xserve product lines. (c) Includes +iBook and PowerBook product lines. (d) Consists +of iTunes Music Store sales, iPod services, and Apple-branded and third-party +iPod accessories. (e) Includes +sales of Apple-branded and third-party displays, wireless connectivity and +networking solutions, and other hardware accessories. (f) Includes +sales of Apple-branded operating system, application software, third-party +software, AppleCare, and Internet services. (g) Derived +by dividing total Macintosh net sales by total Macintosh unit sales. (h)    Derived by +dividing total iPod net sales by total iPod unit sales. 31 Fiscal Year 2005 versus 2004 During 2005, net +sales increased 68% or $5.7 billion from 2004. Several factors contributed +favorably to net sales during 2005: · Net sales of iPods rose $3.2 billion or 248% during 2005 compared +to 2004. Unit sales of iPods totaled 22.5 million in 2005, which represents an +increase of 409% from the 4.4 million iPod units sold in 2004. Strong sales of +iPods during 2005 continued to be experienced in all of the Company’s operating +segments and was driven by strong demand for +the iPod shuffle introduced in January 2005, the release of an updated +version of the iPod mini in February 2005, the release of the iPod nano in +September 2005, and expansion of the iPod’s distribution network . +Net sales per iPod unit sold decreased 32% primarily due to the introduction of +the lower priced iPod shuffle in January 2005 and iPod mini pricing +reductions in February 2005. From the introduction of the iPod in 2002 +through 2005, the Company has sold approximately 28 million iPods. · Other +music related products and services consists of sales associated with the +iTunes Music Store and iPod services and accessories. Net sales of other music +related products and services increased $621 million or 223% during 2005 +compared to 2004. The Company has experienced strong growth in sales of iPod +services and accessories consistent with the increase in overall iPod unit +sales for 2005. The increased sales from the iTunes Music Store is primarily +due to substantial growth of net sales in the U.S. and expansion in Europe, +Canada, and Japan. · Total +Macintosh net sales increased $1.4 billion or 27% during 2005 compared to 2004. +Unit sales of Macintosh systems increased 1.2 million units or 38% during 2005 +compared to 2004. The increases in Macintosh net sales and unit sales relate +primarily to strong demand for the Company’s desktop products, which was +experienced in all of the Company’s operating segments. The Company believes +that the success of the iPod is having a positive impact on Macintosh net sales +by introducing new customers to the Company’s other products. Desktop demand +was stimulated in 2005 due to the new iMac G5 and the introduction of the Mac +mini in January 2005. Net sales and unit sales of desktop products +increased 45% and 55%, respectively, during 2005 compared to 2004. Macintosh +net sales and unit sales also include sales of the Company’s portable products, +which increased 11% and 21%, respectively, compared to 2004. Net sales per Macintosh +unit sold decreased 7% on a year-over-year basis. The decrease was the result +of changes in the overall unit mix towards relatively lower-priced consumer +products, specifically the impact of the Mac mini product, and desktop and +portable price reductions. This decrease was partially offset by an increase in +the proportion of direct sales. · The +Retail segment’s net sales grew 98% to $2.4 billion during 2005 compared to +2004. This increase is largely attributable to the increase in total stores +from 86 at the end of 2004 to 124 at the end of 2005, as well as 44% +year-over-year increase in average revenue per store. While the Company’s +customers in areas where the Retail segment has opened stores may elect to purchase +from the Retail segment stores rather than the Company’s preexisting sales +channels in the U.S., Canada, Japan, and the U.K., the Company believes that a +substantial portion of the Retail segment’s net sales is incremental to the +Company’s total net sales. See additional comments below related to the Retail +segment under the heading “Segment Operating Performance.” · Net +sales of peripherals and other hardware rose by 18% during 2005 compared to +2004 primarily due to an increase in net sales of displays and other computer +accessories. Net sales of other +hardware include AirPort cards and base stations, Xserve RAID storage, iSight +digital video cameras, and third-party hardware products. · The +Company’s U.S. education channel experienced year-over-year growth in both net +sales and unit sales of approximately 21% for 2005. The increase in U.S. +education net sales for 2005 relates 32 primarily to a 32% +year-over-year increase in higher education net sales due to increased iMac +shipments, portable system shipments, and online sales. The Company also +experienced 11% growth in K-12 net sales due to increased iBook sales and +education 1:1 sales. While net sales to the K-12 market were slightly +higher during 2005 than 2004, the Company believes this market continues to be +subject to budget constraints and competitive pressures. · Net sales of software, service and other sales +rose $270 million or 33% during 2005 compared to 2004. This growth was +primarily attributable to increased net sales in AppleCare Protection Plan +(APP) extended service and support contracts, driven primarily by higher +associated Macintosh computer sales. Additionally, the Company experienced +increases in net sales of .Mac Internet service, professional and consumer +applications, third-party software, and Mac OS X that was primarily +attributable to the release of version 10.4 Tiger in April 2005. Fiscal Year 2004 versus 2003 During 2004, net +sales increased 33% or $2.1 billion from 2003. Several factors contributed +favorably to net sales during 2004: · Net sales of Macintosh +systems increased $432 million or 10% during 2004 compared to 2003 while net +sales per Macintosh unit sold remained relatively flat on a year-over-year +basis. Unit sales of Macintosh systems increased 278,000 units or 9% during +2004 compared to 2003. These increases in net sales and unit sales were a +result of strong demand for all of the Company’s Macintosh systems, except the +iMac. The Company’s portable systems, consisting of the PowerBook and iBook, +produced the strongest revenue and unit growth during 2004 compared to 2003 of +approximately 26% and 33%, respectively. Unit sales of portable systems +accounted for 51% of all Macintosh systems sold during 2004 compared to only +42% during 2003. The Company believes that these results reflected an overall +trend in the industry towards portable systems. Performance of the Company’s +Power Macintosh systems also yielded positive results in 2004 over 2003, +including a 15% and 6% increase in net sales and unit sales, respectively. The increase +in Power Macintosh sales in 2004 was due primarily to the introduction of the +Power Mac G5, which began shipping at the end of 2003. Although Power Macintosh +sales increased from 2003, sales of this product were constrained in the second +half of 2004 as a result of manufacturing problems at IBM, the Company’s sole +supplier of the PowerPC G5 processor. · Net sales of iPods rose $961 million or 279% during 2004 compared +to 2003. Unit sales of iPods totaled 4.4 million in 2004, which represents an +increase of 370% from the 939,000 iPod units sold in 2003. Strong demand for +the iPods during 2004 were experienced in all of the Company’s operating +segments and was driven by enhancements to the iPod, the introduction of the +iPod mini, increased expansion of the Company’s iPod distribution network, and +continued success of the iTunes Music Store due largely to making it available +to both Macintosh and Windows users in the U.S., U.K., France, and Germany. · The +Retail segment’s net sales grew 91% to $1.2 billion during 2004 compared to +2003. This increase was largely attributable to the increase in total stores +from 65 at the end of 2003 to 86 at the end of 2004, as well as a 36% +year-over-year increase in average revenue per store. While the Company’s +customers in areas where the Retail segment has opened stores may have elected +to purchase from the Retail segment stores rather than the Company’s +preexisting sales channels in the U.S. and Japan, the Company believes that a +substantial portion of the Retail segment’s net sales is incremental to the +Company’s total net sales. See additional comments below related to the Retail +segment under the heading “Segment Operating Performance.” · Net +sales of peripherals and other hardware rose by 38% during 2004 compared to +2003 primarily due to an increase in net sales of displays and other computer +accessories. Net sales of other 33 computer accessories +include AirPort cards and base stations, iSight digital video cameras, and +third-party hardware products. The increase in total net sales of peripherals +and other hardware was related to the overall increase in Macintosh unit sales +and the introduction of new and updated peripheral products and was experienced +predominantly by the Company’s Americas, Europe, and Retail segments. · Net +sales of other music related products and services increased $242 million or +672% during 2004 compared to 2003. The Company experienced strong growth in +sales of iPod services and accessories consistent with the increase in overall +iPod unit sales for 2004. The increased sales from the iTunes Music Store, +which was originally introduced in April 2003, was primarily due to making +the service available for Windows in October 2003 and the introduction of +the service in the U.K., France, and Germany in June 2004. · Net +sales of software rose $140 million or 39% during 2004 compared to 2003 due +primarily to higher net sales of the Company’s Apple-branded software and in +particular, higher net sales of the Company’s operating system software, +including Mac OS X version 10.3 “Panther,” which was released in October 2003. +Net sales of Panther accounted for approximately $74 million or over 50% of the +increase in software net sales for 2004 compared to 2003. · The +Company’s U.S. education channel experienced year-over-year growth in net sales +of approximately 19% for 2004 compared to 2003. Unit sales also increased by +10% during 2004 compared to 2003. The increase in U.S. education net sales for +2004 related primarily to a 40% year-over-year increase in higher education net +sales and to a lesser extent the Company’s 3% growth in K-12 net sales. · Service +and other sales increased $37 million or 13% during 2004 compared to 2003. These +increases were the result of significant year-over-year increases in net sales +associated with APP extended maintenance and support services, as well as +increased net sales associated with the Company’s .Mac Internet service. +Increased net sales associated with APP were primarily the result of higher +Macintosh unit sales and higher attach rates on APP over the last several +years. Offsetting the +favorable factors discussed above, the Company’s net sales during 2004 were +negatively impacted by the following: · Net +sales and unit sales of iMac systems were down 23% and 16%, respectively, +during 2004 versus 2003. The decrease in iMac net sales and unit sales was +largely due to the delay in the introduction of the new iMac, based on the +PowerPC G5 processor, primarily as a result of manufacturing problems +experienced by IBM. The delays in the new iMac resulted in the depletion of +inventory of the old iMac flat panel prior to availability of the new iMac G5. +The old flat panel iMac form factor, which was available during most of 2004, +was nearly 3 years old by the time the new iMac G5 began shipping in September 2004 +and had experienced declines in sales as a result of the age of this product. The +Company believes that sales of iMac systems have also declined due to a shift +in consumer preference to portable systems and desktop models from competitors +with price points below $1,000. · Net sales and unit sales in +the Company’s Japan segment decreased 3% and 14%, respectively, during 2004 +versus 2003. The Company believes these declines related to a shift in sales +from the Japan segment to the Retail segment as a result of the Tokyo and Osaka +store openings in 2004. Declines in net sales in Japan may have also related to +delays in computer upgrades by certain professional and creative customers +pending release in Japan of certain Mac OS X native applications, such as Quark +Xpress 6, which did not become available until September 2004. When sales +from the Japan retail stores are included in the results for the Japan segment, +the combined revenue in Japan resulted in a 3% year-over-year increase in 2004 +as compared to 2003. See 34 additional comments +below related to the Japan segment under the heading “Segment Operating +Performance.” Segment Operating Performance The Company manages its +business primarily on a geographic basis. The Company’s reportable operating +segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas, Europe, and Japan reportable segments do not include activities +related to the Retail segment. The Americas segment includes both North and +South America. The Europe segment includes European countries as well as the +Middle East and Africa. The Retail segment operated Apple-owned retail stores +in the U.S., Canada, Japan, and the U.K. during 2005. Each reportable +geographic operating segment provides similar hardware and software products +and similar services. Further information regarding the Company’s operating +segments may be found in Item 8 of this Form 10-K in the Notes to +Consolidated Financial Statements at Note 11, “Segment Information and +Geographic Data.” Americas During 2005, net sales in the Americas segment grew +64% or $2.6 billion compared to 2004. The increase in net sales during 2005 was +primarily attributable to the significant year-over-year increase in iPod +sales, sales of other music related products and services, and strong sales of +desktop and portable Macintosh systems. This increase was partially offset by a +shift in sales to the Retail segment, which had 117 stores in the U.S. and +Canada as of the end of 2005. Macintosh unit sales also increased by 30% in +2005 compared to 2004, driven primarily by strong sales of desktop systems +largely attributable to strong sales from the new iMac, which began shipping in +September 2004, and the Mac mini, which was introduced in January 2005. +During 2005 and 2004, the Americas segment represented approximately 47% and +49%, respectively, of the Company’s total net sales and represented +approximately 48% and 51%, respectively, of total Macintosh unit sales. As +noted above, the Company experienced an increase in both U.S. education channel +net sales and unit sales of 21% for 2005 compared to 2004. Strength in higher +education sales related primarily to strong iMac shipments, portable system +shipments, and online sales. This strength drove year-over-year growth in net +sales of 32% for the higher education channel during 2005. Despite challenges +in the K-12 market from continued budget constraints and competitive +pressures, the Company’s K-12 net sales grew year-over-year by 11% during +2005 due to increased iBook sales and 1:1 education sales. During 2004, net sales in +the Americas segment grew 26% or $838 million compared to 2003. The increase in +net sales during 2004 was primarily attributable to the significant +year-over-year increase in iPod sales as well as strong sales of peripherals, +software, and services. This increase was partially offset by a shift in sales +to the Retail segment, which had 84 stores in the U.S. as of the end of 2004. +Macintosh unit sales also increased by 4% in 2004 compared to 2003, driven primarily +by strong sales of portable and Power Macintosh systems, partially offset by +weakness in iMac sales. During 2004 and 2003, the Americas segment represented +approximately 49% and 51%, respectively, of the Company’s total net sales and +represented approximately 51% and 54%, respectively, of total Macintosh unit +sales. The Company experienced an increase in U.S. education channel net sales +of 19% for 2004 compared to 2003. Strong U.S. education net sales for 2004 +related primarily to strength in higher education net sales that resulted from +a successful back-to-school selling season with strong demand for the Company’s +portables. This strength drove year-over-year growth in net sales of 40% for +the higher education channel during 2004. The Company’s K-12 net sales +grew year-over-year by 3% during 2004, despite the challenges in the K-12 +market from continued budget constraints and increased competition. Europe During 2005, net sales in the Europe segment grew $1.3 +billion or 71% from 2004. Total Macintosh unit sales in Europe also experienced +growth during the current year by increasing 47% in 2005 compared to 35 2004. Consistent with the Americas segment, Europe +experienced strong net sales of desktop products, iPod, other music related +products and services, and software and service sales. Demand in Europe during +2005 was particularly strong for the Company’s desktop computers, which +experienced a year-over-year increase of 56%. Similar to the results of the +Company’s other segments, net sales of iPods, peripherals and software were +strong in 2005. Net sales in Europe +rebounded in 2004 increasing $490 million or 37% from 2003. Total Macintosh +unit sales in Europe also experienced growth in 2004 by increasing 13% compared +to 2003. Consistent with the Americas segment, Europe experienced strong net +sales across all product lines, except the iMac systems. Demand in Europe +during 2004 was particularly strong for the Company’s Power Macintosh systems +and portable Macintosh systems, which experienced year-over-year increases of +29% and 42%, respectively. Similar to the results of the Company’s other +segments, net sales of iPods, peripherals and software were strong in 2004 over +2003. Japan Japan’s net sales and Macintosh unit sales were up 36% +and 8%, respectively, during 2005 compared to 2004. Japan experienced increased +net sales in desktop products, iPod, and other music related products and +services. Desktop net sales and unit sales increased by 31% and 41%, +respectively, and iPod sales increased by 220% during 2005 compared to 2004. The +overall increase in net sales was partially offset by a decline in portable +system net sales during 2005 compared to 2004, which the Company believes might +be attributable to a shift in sales from portables to the new iMac G5 and Mac +mini, and a shift to the Retail segment as a result of opening two additional +stores in Japan during 2005. Japan’s net sales and +Macintosh unit sales were down 3% and 14%, respectively, during 2004 compared +to 2003, which lagged behind all of the Company’s other operating segments. These +decreases in net sales and unit sales were believed to be attributable in part +to a shift in sales from the Japan segment to the Retail segment as a result of +the opening of two stores in Japan in 2004. In addition, such decreases may +have been related to delayed computer system upgrades by some professional and +creative customers who were awaiting the release of Quark XPress 6 for Mac OS +X, which did not occur until September 2004. The decrease in net sales was +partially offset by strong iPod and iBook sales during 2004 compared to 2003. Retail The Company opened 38 new retail stores during 2005, +including 6 international stores in the U.K, Japan, and Canada, bringing the +total number of open stores to 124 as of September 24, 2005. This compares +to 86 open stores as of September 25, 2004 and 65 open stores as of September 27, +2003. Net sales of the Retail segment grew to $2.4 billion +during 2005 from $1.2 billion and $621 million in 2004 and 2003, respectively. +The increases in net sales during both 2005 and 2004 reflect the impact of new +store openings for each year, including the opening of 38 new stores in 2005 +and 21 new stores in 2004. An increase in average revenue per store also +contributed to the segment’s strong sales in 2005. With an average of 105 +stores open during 2005, the Retail segment achieved annualized revenue per +store of approximately $22.4 million, as compared to $15.6 million in 2004 with +a 76 store average, and $11.5 million in 2003 with a 54 store average. As measured by the Company’s operating segment +reporting, the Retail segment reported operating income of $151 million during +2005 as compared to operating income of $39 million during 2004 and an +operating loss of $5 million during 2003. This improvement is primarily +attributable to the segment’s year-over-year increase in average revenue per +store, the impact of opening new stores, and the segment’s year-over-year +increase in net sales, which resulted in higher leverage on occupancy, +depreciation, and other fixed costs. 36 Expansion of the Retail +segment has required and will continue to require a substantial investment in +fixed assets and related infrastructure, operating lease commitments, +personnel, and other operating expenses. Capital expenditures associated with +the Retail segment were $132 million in 2005, bringing the total capital +expenditures since inception of the Retail segment to approximately $529 +million. As of September 24, 2005, the Retail segment had approximately +3,673 employees and had outstanding operating lease commitments associated with +retail store space and related facilities of approximately $606 million. The +Company would incur substantial costs should it choose to terminate its Retail +segment or close individual stores. Such costs could adversely affect the +Company’s results of operations and financial condition. Gross Margin Gross +margin for each of the last three fiscal years are as follows (in millions, +except gross margin percentages): September 24, 2005 September 25, 2004 September 27, 2003 Net sales $ 13,931 $ 8,279 $ 6,207 Cost of sales 9,888 6,020 4,499 Gross margin $ 4,043 $ 2,259 $ 1,708 Gross margin percentage 29.0 % 27.3 % 27.5 % Gross margin increased in 2005 to 29.0% of net sales +from 27.3% of net sales in 2004. The Company’s gross margin during 2005 +increased due to more favorable pricing on certain commodity components +including LCD flat-panel displays and DRAM memory; an increase in higher margin +software sales; a favorable shift in direct sales related primarily to the +Company’s Retail and online stores; and higher overall revenue that provided +for more leverage on fixed production costs. These increases to gross margin +were partially offset by an increase in lower margin iPod sales. The Company anticipates that its gross margin and the +gross margin of the overall personal computer and consumer electronics +industries will remain under pressure in light of price competition, especially +for the iPod product line. The Company expects gross margin percentage to +decline in the first quarter of 2006 primarily as a result of a shift in the +mix of revenue toward lower margin products such as the iPod and content from +the iTunes Music Store. The foregoing statements regarding the Company’s +expected gross margin are forward-looking. There can be no assurance that +current gross margins will be maintained or targeted gross margin levels will +be achieved. In general, gross margins and margins on individual products, +including iPods, will remain under significant downward pressure due to a +variety of factors, including continued industry wide global pricing pressures, +increased competition, compressed product life cycles, potential increases in +the cost and availability of raw material and outside manufacturing services, +and potential changes to the Company’s product mix, including higher unit sales +of consumer products with lower average selling prices and lower gross margins. +In response to these downward pressures, the Company expects it will continue +to take pricing actions with respect to its products. Gross margins could also +be affected by the Company’s ability to effectively manage product quality and +warranty costs and to stimulate demand for certain of its products. Due to the +Company’s significant international operations, financial results can be +significantly affected in the short-term by fluctuations in exchange rates. 37 The Company orders components for its products and +builds inventory in advance of product shipments. Because the Company’s markets +are volatile and subject to rapid technology and price changes, there is a risk +the Company will forecast incorrectly and produce or order from third-parties +excess or insufficient inventories of particular products or components. The +Company’s operating results and financial condition in the past have been and +may in the future be materially adversely affected by the Company’s ability to +manage its inventory levels and outstanding purchase commitments and to respond +to short-term shifts in customer demand patterns. Gross margin declined in +2004 to 27.3% of net sales from 27.5% of net sales in 2003. The Company’s gross +margin during 2004 declined due to an increase in mix towards lower margin iPod +and iBook sales, pricing actions on certain Power Macintosh G5 models that were +transitioned during the beginning of 2004, higher warranty costs on certain +portable Macintosh products, and higher freight and duty costs during 2004. These +unfavorable factors were partially offset by an increase in direct sales and a +39% year-over-year increase in higher margin software sales. Operating Expenses Operating +expenses for each of the last three fiscal years are as follows (in millions, +except for percentages): September 24, September 25, September 27, 2005 2004 2003 Research and + development $ 534 $ 489 $ 471 Percentage of net sales 4 % 6 % 8 % Selling, general, + and administrative expenses $ 1,859 $ 1,421 $ 1,212 Percentage of net sales 13 % 17 % 20 % Restructuring costs $ — $ 23 $ 26 Research and +Development (R&D) The Company recognizes +that focused investments in R&D are critical to its future growth and +competitive position in the marketplace and are directly related to timely +development of new and enhanced products that are central to the Company’s core +business strategy. The Company has historically relied upon innovation to remain +competitive. R&D expense amounted to approximately 4% of total net sales +during 2005 down from 6% and 8% of total net sales in 2004 and 2003, +respectively. This decrease is due to the significant increase of 68% in total +net sales of the Company for 2005. Although R&D expense decreased as a +percentage of total net sales in 2005, actual expense for R&D in 2005 +increased $45 million or 9% from 2004, which follows an $18 million or 4% +increase in 2004 compared to 2003. The overall increase in R&D expense +relates primarily to increased headcount and support for new product +development activities and the impact of employee salary increases in 2005. +R&D expense does not include capitalized software development costs of +approximately $29.7 million related to the development of Mac OS X Tiger during +2005; $4.5 million related to the development of Mac OS X Tiger and $2.3 +million related to the development of FileMaker Pro 7 in 2004; and $14.7 +million related to the development of Mac OS X Panther in 2003. Further +information related to the Company’s capitalization of software development +costs may be found in Part II, Item 8 of this Form 10-K at Note +1 of Notes to Consolidated Financial Statements. Selling, General, +and Administrative Expense (SG&A) Expenditures for SG&A increased $438 million or +31% during 2005 compared to 2004. These increases are due primarily to the +Company’s continued expansion of its Retail segment in both domestic and +international markets, a current year increase in discretionary spending on +marketing and advertising, and higher direct and channel selling expenses +resulting from the increase in net sales and employee salary 38 merit increases. SG&A as a percentage of total net +sales in 2005 was 13%, down from 17% in 2004, which is due to the increase in +total net sales of 68% for the Company during 2005. Expenditures for SG&A +increased $209 million or 17% during 2004 compared to 2003. These increases +were due primarily to the Company’s continued expansion of its Retail segment +in both domestic and international markets, an increase in discretionary +spending on marketing and advertising, an increase in amortization costs +associated with restricted stock compensation, and higher direct and channel +selling expenses resulting from the increase in net sales and employee salary +merit increases. SG&A as a percentage of total net sales in 2004 was 17%, +down from 20% in 2003 due to the increase in total net sales for the Company of +33% during 2004. Fiscal 2004 +Restructuring Actions The Company recorded total +restructuring charges of approximately $23 million during 2004, including +approximately $14 million in severance costs, $5.5 million in asset +impairments, and a $3.5 million charge for lease cancellations in conjunction +with the vacating of a leased sales facility in Europe during the fourth +quarter of 2004 related to a European workforce reduction. Of the $23 million +charge, $19.7 million had been utilized by the end of 2005, with the remaining +$3.3 million consisting of $0.7 million for employee severance benefits and +$2.6 million for lease cancellations. These actions will result in the +termination of 461 employees, 448 of which had been terminated prior to the end +of 2005. Fiscal 2003 +Restructuring Actions The Company recorded total +restructuring charges of approximately $26.8 million during 2003, including +approximately $7.4 million in severance costs, a $5.0 million charge to +write-off deferred compensation, $7.1 million in asset impairments, and a $7.3 +million charge for lease cancellations primarily related to the closure of the +Company’s Singapore manufacturing operations during the first quarter of 2003. +Of the $26.8 million charge, all had been utilized by the end of 2005, except +for approximately $1.7 million related to operating lease costs on abandoned +facilities. These actions resulted in the termination of 353 employees. Other Income and Expense Other +income and expense for each of the last three fiscal years are as follows (in +millions): September 24, September 25, September 27, 2005 2004 2003 Gains on + non-current investments, net $ — $ 4 $ 10 Interest income $ 183 $ 64 $ 69 Interest expense — (3 ) (8 ) Gains on sales of + short term investments, net — 1 21 Other income + (expense), net (18 ) (9 ) 1 Interest and + Other Income, net $ 165 $ 53 $ 83 Total other + income and expense $ 165 $ 57 $ 93 Gains and Losses on +Non-current Investments The Company previously +held significant investments in ARM Holdings plc (ARM), Akamai Technologies, Inc. (Akamai), and EarthLink Network, Inc. +(EarthLink). T he Company sold all of the remaining holdings in these +non-current investments in 2004 and 2003. Pretax gains recorded upon the sale +of these non-current investments were $4 million and $10 million in 2004 and +2003, respectively. 39 Interest and Other +Income, Net Total interest and other income, net increased $112 +million or 211% to $165 million during 2005 compared to $53 million in +2004 and $83 million in 2003. These increases are attributable primarily to +increasing investment yields on the Company’s cash and short-term investments +and higher invested balances. The weighted average interest rate earned by the +Company on its cash, cash equivalents, and short-term investments increased to +2.70% in 2005 compared to the 1.38% and 1.89% rates earned during 2004 and +2003, respectively. The Company occasionally sells short-term investments prior +to their stated maturities. As a result of such sales, the Company recognized +net losses of $137,000 in 2005 and net gains of $1 million and $21 million +during 2004 and 2003, respectively. Partially offsetting the increase in other income were higher foreign +currency hedging expenses. Interest expense consisted +primarily of interest on the Company’s $300 million aggregate principal +amount unsecured notes, which were repaid upon their maturity in February 2004. +The unsecured notes were sold at 99.925% of par for an effective yield to +maturity of 6.51%. Total deferred gain resulting from the closure of debt swaps +of approximately $23 million was fully amortized as of the notes’ maturity in February 2004. Provision for Income Taxes The Company’s effective tax rate for the year ended September 24, +2005 was approximately 26%. The Company’s effective rate differs from the +statutory federal income tax rate of 35% due primarily to certain undistributed +foreign earnings for which no U.S. taxes are provided because such earnings are +intended to be indefinitely reinvested outside the U.S., research and development +tax credits, and a reduction of certain tax contingency reserves and +adjustments to net deferred tax assets. The benefit from adjustments to tax +contingency reserves and net deferred tax assets was $67 million. In addition, +the Company recorded a $25 million reduction of the valuation allowance +associated with deferred tax assets that, in management’s opinion, are now more +likely than not to be realized in the future. $14 million of the valuation +allowance reduction was recorded as a credit to income tax expense, and the +remainder was recorded as a credit to goodwill. As of September 24, 2005, the Company had +deferred tax assets arising from deductible temporary differences, tax losses, +and tax credits of $767 million before being offset against certain deferred +tax liabilities and a valuation allowance for presentation on the Company’s +balance sheet. Management believes it is more likely than not that forecasted +income, including income that may be generated as a result of certain tax +planning strategies, will be sufficient to fully recover the remaining net +deferred tax assets. As of September 24, 2005 and September 25, 2004, +a valuation allowance of $5 million and $30 million, respectively, was +recorded against the deferred tax asset for the benefits of tax loss +carryforwards that may not be realized. The remaining valuation allowance at September 24, +2005 relates principally to certain state operating loss carryforwards. The +Company will continue to evaluate the realizability of the deferred tax assets +quarterly by assessing the need for and amount of the valuation allowance. The Internal Revenue Service (IRS) has completed its +field audit of the Company’s federal income tax returns for all years prior to +2002 and proposed certain adjustments. Certain of these adjustments are being +contested through the IRS Appeals Office. Substantially all IRS audit issues +for these years have been resolved. In addition, the Company is also subject to +audits by state, local, and foreign tax authorities. Management believes that +adequate provision has been made for any adjustments that may result from tax +examinations. However, the outcome of tax audits cannot be predicted with +certainty. Should any issues addressed in the Company’s tax audits be resolved +in a manner not consistent with management’s expectations, the Company could be +required to adjust its provision for income tax in the period such resolution +occurs. On October 22, 2004, +the American Jobs Creation Act (AJCA) was signed into law. The AJCA includes a provision +for the deduction of 85% of certain foreign earnings that are repatriated, as +defined in the 40 AJCA. The legislation +provided the Company with the option to apply this provision to repatriations +of qualifying earnings in either 2005 or 2006. The Company is continuing to +evaluate the effects of the repatriation provision and expects to complete the +evaluation in 2006. A maximum of $755 million may be eligible for repatriation +under the reduced tax rate provided by AJCA. However, given the uncertainties +and complexities of the repatriation provision and the Company’s continuing +evaluation, the Company has not yet determined the amount that may be +repatriated or the related potential income tax effects of such repatriation. Recent Accounting Pronouncements In November 2005, the FASB issued FASB Staff +Position (FSP) Nos. FAS 115-1 and FAS 124-1, The Meaning +of Other-Than-Temporary Impairment and its Application to Certain Investments . +FSP Nos. FAS 115-1 and FAS 124-1 amend SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, SFAS +No. 124, Accounting for Certain Investments Held by +Not-for-Profit Organizations, as well as APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. This guidance nullifies certain requirements of EITF 03-1, The Meaning of Other-Than-Temporary Impairment and its Application to +Certain Investments . FSP Nos. FAS 115-1 and FAS 124-1 +include guidance for evaluating and recording impairment losses on debt and +equity investments, as well as new disclosure requirements for investments that +are deemed to be temporarily impaired. FSP Nos. FAS 115-1 and FAS 124-1 +also require other-than-temporary impaired debt securities to be written down +to its impaired value, which becomes the new cost basis. FSP Nos. FAS 115-1 +and FAS 124-1 are effective for fiscal years beginning after December 15, +2005. Although the Company will continue to evaluate the application of FSP +Nos. FAS 115-1 and FAS 124-1, management does not currently +believe adoption will have a material impact on the Company’s results of +operations or financial position. In November 2004, the FASB issued SFAS No. 151, Inventory Costs , which amends the +guidance in Accounting Research Bulletin (ARB) No. 43, Chapter 4, Inventory Pricing , to clarify the accounting for abnormal +amounts of facility expense, freight, handling costs, and wasted material +(spoilage). ARB 43, Chapter 4, previously stated that “under some +circumstances, items such as idle facility expense, excessive spoilage, double +freight, and rehandling costs may be so abnormal as to require treatment as +current period charges.” SFAS 151 requires that those items be recognized as +current-period charges regardless of whether they meet the criterion of “so +abnormal.” In addition, SFAS 151 requires that allocation of fixed production +overhead to the costs of conversion be based on the normal capacity of the +production facilities. SFAS 151 is effective for fiscal years beginning after June 15, +2005. Although the Company will continue to evaluate the application of SFAS +151, management does not currently believe adoption will have a material impact +on the Company’s results of operations or financial position. In December 2004, the FASB issued FSP 109-2, Accounting and Disclosure Guidance for the Foreign +Earnings Repatriation Provision within the American Jobs Creation Act of 2004 . +FSP 109-2 provides additional time to companies beyond the financial +reporting period of enactment to evaluate the effects of the AJCA on their +plans for repatriation of foreign earnings for purposes of applying SFAS 109, Accounting for Income Taxes . The Company is currently +evaluating the repatriation provisions of AJCA, which if implemented by the +Company would affect the Company’s tax provision and deferred tax assets and +liabilities. However, given the uncertainties and complexities of the +repatriation provision and the Company’s continuing evaluation, it is not +possible at this time to determine the amount, if any, that will be repatriated +or the related potential income tax effects of such repatriation. The Company +expects to complete the evaluation in 2006. In December 2004, the FASB issued SFAS No. 123 +(revised 2004) (SFAS No. 123R), Share-Based Payment , +that addresses the accounting for share-based payment transactions in which an +enterprise receives employee services in exchange for (a) equity +instruments of the enterprise or (b) liabilities that are based on the +fair value of the enterprise’s equity instruments or that may be settled by the +issuance of such 41 equity instruments. SFAS No. 123R eliminates the +ability to account for share-based compensation transactions using the +intrinsic value method under Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees , +and instead requires such transactions be accounted for using a +fair-value-based method. The Company will recognize stock-based compensation +expense on all awards on a straight-line basis over the requisite service +period using the modified prospective method. In January 2005, the SEC +issued SAB No. 107, which provides supplemental implementation guidance +for SFAS No. 123R. SFAS No. 123R will be effective for the Company +beginning in the first quarter of fiscal 2006. The Company expects the adoption +of SFAS No. 123R will result in a reduction of diluted earnings per common +share of approximately $0.03 for the first quarter of fiscal 2006. In March 2005, the FASB issued Interpretation No. (FIN) +47, Accounting for Conditional Asset Retirement +Obligations, to clarify the requirement to record liabilities +stemming from a legal obligation to perform an asset retirement activity in +which the timing or method of settlement is conditional on a future event. The +Company plans to adopt FIN 47 in the first quarter of fiscal 2006, and does not +expect the application of FIN 47 to have a material impact on its results of +operations, cash flows or financial position. In May 2005, the FASB +issued SFAS No. 154, Accounting Changes and +Error Corrections which replaces APB Opinion No. 20 Accounting Changes and SFAS No. 3, Reporting +Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion No. 28 . +SFAS No. 154 requires retrospective application to prior periods’ +financial statements of a voluntary change in accounting principal unless it is +not practicable. SFAS No. 154 is effective for accounting changes and +corrections of errors made in fiscal years beginning after December 15, +2005 and is required to be adopted by the Company in the first quarter of +fiscal 2007. Although the Company will continue to evaluate the application of +SFAS No. 154, management does not currently believe adoption will have a +material impact on the Company’s results of operations or financial position. Liquidity and Capital Resources The +following table presents selected financial information and statistics for each +of the last three fiscal years (dollars in millions): September 24, September 25, September 27, 2005 2004 2003 Cash, cash + equivalents, and short-term investments $ 8,261 $ 5,464 $ 4,566 Accounts + receivable, net $ 895 $ 774 $ 766 Inventory $ 165 $ 101 $ 56 Working capital $ 6,816 $ 4,404 $ 3,530 Days sales in + accounts receivable (DSO) (a) 22 30 41 Days of supply in + inventory (b) 6 5 4 Days payables + outstanding (DPO) (c) 62 76 82 Annual operating cash + flow $ 2,535 $ 934 $ 289 (a) DSO is based on ending +net trade receivables and most recent quarterly net sales for each period. (b) Days supply of inventory +is based on ending inventory and most recent quarterly cost of sales for each +period. (c) DPO is based on ending +accounts payable and most recent quarterly cost of sales adjusted for the +change in inventory. As of September 24, 2005, the Company had $8.261 +billion in cash, cash equivalents, and short-term investments, an increase of +$2.797 billion over the same balances at the end of 2004. The principal +components of this increase were ­cash generated by operating activities of +$2.535 billion and proceeds of $543 million from the issuance of common stock +under stock plans, partially offset by cash used to 42 purchase property, plant, and equipment of $260 +million. The Company’s short-term investment portfolio is primarily invested in +high credit quality, liquid investments. As of September 24, 2005, +approximately $4.3 billion of the Company’s cash, cash equivalents, and short-term +investments were held by foreign subsidiaries and are generally based in U.S. +dollar-denominated holdings. Amounts held by foreign subsidiaries are +generally subject to U.S. income taxation on repatriation to the U.S. The +Company is currently assessing the impact of the one-time favorable foreign +dividend provisions recently enacted as part of the American Jobs Creation Act +of 2004, and may decide to repatriate earnings from some of its foreign +subsidiaries. The Company believes its +existing balances of cash, cash equivalents, and short-term investments +will be sufficient to satisfy its working capital needs, capital expenditures, +stock repurchase activity, outstanding commitments, and other liquidity +requirements associated with its existing operations over the next 12 months. Capital +Expenditures The Company’s total +capital expenditures were $260 million during 2005, $132 million of which were +for retail store facilities and equipment related to the Company’s Retail +segment and $128 million of which were primarily for corporate infrastructure, +including information systems enhancements and operating facilities enhancements +and expansions. The Company currently +anticipates it will utilize approximately $390 million for capital +expenditures during 2006, approximately $210 million of which is expected to be +utilized for further expansion of the Company’s Retail segment and the +remainder utilized to support normal replacement of existing capital assets and +enhancements to general information technology infrastructure. Stock Repurchase +Plan In July 1999, the Company’s Board of Directors +authorized a plan for the Company to repurchase up to $500 million of its +common stock. This repurchase plan does not obligate the Company to acquire any +specific number of shares or acquire shares over any specified period of time. Since +inception of the stock repurchase plan, the Company had repurchased a total of +13.1 million shares at a cost of $217 million. The Company has not engaged in +any transactions to repurchase its common stock during 2005 or 2004. The +Company was authorized to repurchase up to an additional $283 million of its common +stock as of September 24, 2005. On February 28, 2005, +the Company effected a two-for-one stock split to shareholders of record as of February 18, +2005. All share and per share information has been retroactively adjusted to +reflect the stock split. Off-Balance +Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with +unconsolidated entities whereby the Company has financial guarantees, +subordinated retained interests, derivative instruments, or other contingent +arrangements that expose the Company to material continuing risks, contingent +liabilities, or any other obligation under a variable interest in an +unconsolidated entity that provides financing, liquidity, market risk, or +credit risk support to the Company. 43 The +following table presents certain payments due by the Company under contractual +obligations with minimum firm commitments as of September 24, 2005 and +excludes amounts already recorded on the Company’s balance sheet as current +liabilities (in millions): Total Payments Due in Less Than 1 year Payments Due in 1-3 years Payments Due in 4-5 years Payments Due in More Than 5 years Operating Leases $ 865 $ 108 $ 211 $ 192 $ 354 Purchase + Obligations 1,994 1,994 — — — Asset Retirement + Obligations 14 — 2 2 10 Other Obligations 4 4 — — — Total $ 2,877 $ 2,106 $ 213 $ 194 $ 364 Lease Commitments As of September 24, +2005, the Company +had total outstanding commitments on noncancelable operating leases of +approximately $865 million, $606 million of which related to the lease of +retail space and related facilities. Lease terms on the Company’s existing +major facility operating leases range from 5 to 20 years. Purchase +Commitments with Contract Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to +manufacture sub-assemblies for the Company’s products and to perform final +assembly and test of finished products. These contract manufacturers acquire +components and build product based on demand information supplied by the +Company, which typically covers periods ranging from 30 to 150 days. The +Company also obtains individual components for its products from a wide variety +of individual suppliers. Consistent with industry practice, the Company +acquires components through a combination of purchase orders, supplier +contracts, and open orders based on projected demand information. Such purchase +commitments typically cover the Company’s forecasted component and +manufacturing requirements for periods ranging from 30 to 150 days. As of September 24, +2005, the Company had outstanding third-party manufacturing commitments and +component purchase commitments of approximately $2.0 billion. Subsequent to September 24, +2005, the Company entered into long-term supply agreements with Hynix +Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., +Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND +flash memory through calendar year 2010. As part of these agreements, the +Company intends to prepay a total of $1.25 billion for flash memory components +by the end of the second quarter of 2006. Asset Retirement +Obligations The Company’s asset +retirement obligations are associated with commitments to return property +subject to operating leases to original condition upon lease termination. As of +September 24, 2005, the Company estimates that gross expected future cash +flows of approximately $14 million will be required to fulfill these obligations. Other Obligations The Company’s other +obligations of approximately $4 million are primarily related to Internet and +telecommunications services. Indemnifications The Company generally does +not indemnify end-users of its operating system and application software +against legal claims that the software infringes third-party intellectual +property rights. Other agreements entered into by the Company sometimes include +indemnification provisions under which the Company 44 could be subject to costs +and/or damages in the event of an infringement claim against the Company or an +indemnified third-party. However, the Company has not been required to make any +significant payments resulting from such an infringement claim asserted against +itself or an indemnified third-party and, in the opinion of management, does +not have a liability related to unresolved infringement claims subject to +indemnification that would have a material adverse effect on its financial +condition, liquidity or results of operations. Factors +That May Affect Future Results and Financial Condition Because of the following +factors, as well as other factors affecting the Company’s operating results and +financial condition, past financial performance should not be considered to be +a reliable indicator of future performance, and investors should not use +historical trends to anticipate results or trends in future periods. General economic conditions and current economic and +political uncertainty could adversely affect the demand for the Company’s +products and the financial health of its suppliers, distributors, and +resellers. The Company’s operating +performance depends significantly on general economic conditions in the U.S. +and abroad. At times in the past, demand for the Company’s products has been +negatively impacted by difficult global economic conditions. Additionally, some +of the Company’s education customers appeared to be delaying technology +purchases due to concerns about the overall impact of the weaker economy and +state budget deficits on their available funding. Although recent macroeconomic +trends seem to indicate an economic recovery, continued uncertainty about +future economic conditions makes it difficult to forecast future demand for the +Company’s products and related operating results. Should global and/or regional +economic conditions deteriorate, demand for the Company’s products could be +adversely affected, as could the financial health of its suppliers, +distributors, and resellers. War, terrorism, public health issues or other business +interruptions could disrupt supply, delivery or demand of products, which could +negatively affect the Company’s operations and performance. War, terrorism, public health issues and other +business interruptions whether in the U.S. or abroad, have caused and could +cause damage or disruption to international commerce +by creating economic and political uncertainties that may have a strong +negative impact on the global economy, the Company, and the Company’s +suppliers or customers. The Company’s major business operations are subject to +interruption by earthquake, other natural disasters, fire, power shortages, +terrorist attacks and other hostile acts, labor disputes, public health issues, +and other events beyond its control. The majority of the Company’s research and +development activities, its corporate headquarters, information technology +systems, and other critical business operations, including certain component +suppliers and manufacturing vendors, are located near major seismic faults. +Because the Company does not carry earthquake insurance for direct +quake-related losses, the Company’s operating results and financial condition +could be materially adversely affected in the event of a major earthquake or +other natural or manmade disaster. Although it is impossible +to predict the occurrences or consequences of any such events, such events +could result in a decrease in demand for the Company’s products, make it +difficult or impossible for the Company to deliver products to its customers or +to receive components from its suppliers, and could create delays and +inefficiencies in the Company’s supply chain. In addition, should major public +health issues, including pandemics, arise, the Company could be negatively +impacted by the need for more stringent employee travel restrictions, +additional limitations in the availability of freight services, governmental +actions limiting the movement of products between various regions, delays in +production ramps of new products, and disruptions in the operations of the +Company’s manufacturing vendors and component suppliers. The Company’s +operating results and financial condition have been, and in the future may be, +adversely affected by these events. 45 The market for personal computers and related +peripherals and services, as well as digital music devices and related +services, is highly competitive. If the Company is unable to effectively +compete in these markets, its results of operations could be adversely +affected. The personal computer industry is highly competitive +and is characterized by aggressive pricing practices, downward pressure on +gross margins, frequent introduction of new products, short product life +cycles, evolving industry standards, continual improvement in product +price/performance characteristics, rapid adoption of technological and product +advancements by competitors, price sensitivity on the part of consumers, and a +large number of competitors. Over the past several years, price competition in +the market for personal computers and related peripherals has been particularly +intense as competitors who sell Windows and Linux based personal computers have +aggressively cut prices and lowered their product margins for personal +computing products. The Company’s results of operations and financial condition +have been, and in the future may continue to be, adversely affected by these +and other industry-wide pricing pressures and downward pressures on gross +margins. The personal computer industry has also been +characterized by rapid technological advances in software functionality, +hardware performance, and features based on existing or emerging industry +standards. Further, as the personal computer industry and its customers place +more reliance on the Internet, an increasing number of Internet devices that +are smaller and simpler than traditional personal computers may compete for +market share with the Company’s existing products. Several competitors of the +Company have either targeted or announced their intention to target certain of +the Company’s key market segments, including consumer, education, professional +and consumer digital video editing, and design and publishing. Several of the +Company’s competitors have introduced or announced plans to introduce digital +music products and/or online stores offering digital music distribution that +mimic many of the unique design, technical features, and solutions of the +Company’s products. The Company has a significant number of competitors, many +of whom have greater financial, marketing, manufacturing, and technological +resources, as well as broader product lines and larger installed customer bases +than those of the Company. Additionally, there has been a trend towards +consolidation in the personal computer industry that has resulted in larger and +potentially stronger competitors in the Company’s markets. The Company is currently the only maker of hardware +using the Mac OS. The Mac OS has a minority market share in the personal +computer market, which is dominated by makers of computers utilizing other +competing operating systems, including Windows and Linux. The Company’s future +operating results and financial condition are substantially dependent on its +ability to continue to develop improvements to the Macintosh platform in order +to maintain perceived design and functional advantages over competing platforms. +Additionally, if unauthorized copies of the Mac OS are used on other companies’ +hardware products and result in decreased demand for the Company’s hardware +products, the Company’s results of operations may be adversely affected. The Company is currently focused on market +opportunities related to digital music distribution and related consumer +electronic devices, including iPods. The Company faces increasing competition +from other companies promoting their own digital music products, including +music enabled cell phones, distribution services, and free peer-to-peer music +services. These competitors include both new entrants with different market +approaches, such as subscription services models, and also larger companies +that may have greater technical, marketing, distribution, and other resources +than those of the Company, as well as established hardware, software, and +digital content supplier relationships. Failure to effectively compete could +negatively affect the Company’s operating results and financial position. There +can be no assurance that the Company will be able to continue to provide +products and services that effectively compete in these markets or successfully +distribute and sell digital music outside the U.S. The Company may also have to +respond to price competition by lowering prices and/or increasing features +which could adversely affect the Company’s music product gross margins as well +as overall Company gross margins. 46 The Company also faces +increased competition in the U.S. education market. U.S. elementary and +secondary schools, as well as college and university customers, remain a core +market for the Company. Uncertainty in this channel remains as several +competitors of the Company have either targeted or announced their intention to +target the education market for personal computers, which could negatively +affect the Company’s market share. In an effort to regain market share and +remain competitive, the Company has been and will continue to pursue one-to-one +(1:1) learning solutions in education. 1:1 learning solutions typically +consist of iBook portable systems for every student and teacher along with a +wireless network connected to a central server. These 1:1 learning solutions +and other strategic sales are generally priced more aggressively and could +result in significantly less profitability or even in financial losses, +particularly for larger deals. Although the Company believes it has taken +certain steps to strengthen its position in the education market, there can be +no assurance that the Company will be able to increase or maintain its share of +the education market or execute profitably on large strategic arrangements. +Failure to do so may have an adverse impact on the Company’s operating results +and financial condition. The Company’s transition from PowerPC microprocessors +used by Macintosh computers to microprocessors built by Intel is subject to +numerous risks. In June 2005, the +Company announced its intention to transition from the use of PowerPC +microprocessors to the use of Intel microprocessors in all of its Macintosh +computers by the end of calendar year 2007. This transition is subject to +numerous risks and uncertainties, including the Company’s ability to timely +develop and deliver new products using Intel microprocessors, the timely +innovation and delivery of related hardware and software products, including +the Company’s applications, to support Intel microprocessors, market acceptance +of Intel-based Macintosh computers, the development and availability on acceptable +terms of components and services essential to enable the Company to timely +deliver Intel-based Macintosh computers, and the effective management of +inventory levels in line with anticipated product demand for both PowerPC and +Intel-based Macintosh computers. In addition, the Company is dependent on +third-party software developers such as Microsoft and Adobe continuing to +support current applications that run on PowerPC-based computers and timely +developing versions of current and future applications that run on Intel and +PowerPC-based Macintosh computers. The Company’s inability to timely deliver +new Intel-based products or obtain developer commitment both to continue +supporting applications that run on PowerPC microprocessors and timely +transition their applications to run natively on Intel-based products may have +an adverse impact on the Company’s results of operations. The Company’s +announcement of its intention to transition to Intel microprocessors may +negatively impact sales of current and future Macintosh products containing +PowerPC microprocessors, as customers may elect to delay purchases until the +Intel-based products are available. Additionally, there can be no assurance +that the Company will be able to maintain its historical gross margin percentages +on its products, including Intel-based Macintosh computers, which may adversely +impact the Company’s results of operations. Future operating results are dependent upon the +Company’s ability to obtain a sufficient supply of components, including microprocessors, +some of which are in short supply or available only from limited sources. Although most components essential to the Company’s +business are generally available from multiple sources, certain key components +including microprocessors and ASICs are currently obtained by the Company from +single or limited sources. Some key components (including without limitation +DRAM, NAND flash-memory, and TFT-LCD flat-panel displays), while currently +available to the Company from multiple sources, are at times subject to +industry-wide availability and pricing pressures. In addition, new products +introduced by the Company often initially utilize custom components obtained +from only one source until the Company has evaluated whether there is a need +for, and subsequently qualifies, additional suppliers. In situations where a +component or product utilizes new technologies, initial capacity constraints +may exist until such time as the suppliers’ yields have matured. The Company +and other producers in the personal computer industry also compete for various +components with other industries that have 47 experienced increased demand for their products. The +Company uses some components that are not common to the rest of the personal +computer industry including certain microprocessors and ASICs. Continued +availability of these components may be affected if producers were to decide to +concentrate on the production of components other than those customized to meet +the Company’s requirements. If the supply of a key component were to be delayed +or constrained on a new or existing product, the Company’s results of +operations and financial condition could be adversely affected. The Company’s ability to +produce and market competitive products is dependent on the ability and desire +of IBM and Freescale Semiconductor, Inc. (Freescale) to supply PowerPC +microprocessors and Intel to supply its microprocessors for the Company’s +Macintosh computers and to provide the Company with a sufficient supply of +microprocessors with price/performance features that compare favorably to those +supplied to the Company’s competitors. While the Company has supply agreements +with IBM and Freescale, the Company’s recent announcement of plans to +transition to Intel microprocessors may impact the continued availability on +acceptable terms of certain components and services, including PowerPC G4 and +G5 microprocessors, which are essential to the Company’s business and are +currently obtained by the Company from sole or limited sources. Additionally, +there have been instances in recent years where the inability of the Company’s +suppliers to provide advanced PowerPC microprocessors in sufficient quantity +has had significant adverse effects on the Company’s results of operations. In +addition, IBM is currently the Company’s sole supplier of the PowerPC G5 +processor, which is used in the Company’s current Power Mac, Xserve, and iMac +G5 products. Freescale is the sole supplier of the G4 processor, which is used +in the Company’s eMac, Mac mini, and portable products. IBM experienced +manufacturing problems with the PowerPC G5 processor, which resulted in the +Company delaying the shipment of various products and constrained certain +product shipments during the second half of 2004 and the first quarter of 2005. +Manufacturing problems experienced by any of the Company’s suppliers in the +future or failure by them to deliver components to the Company in sufficient +quantities with competitive price/performance features could adversely affect +the Company’s results of operations and financial condition. The Company must successfully manage frequent product +introductions and transitions to remain competitive and effectively stimulate +customer demand. Due to the highly volatile +and competitive nature of the personal computer and consumer electronics +industries, which are characterized by dynamic customer demand patterns and +rapid technological advances, the Company must continually introduce new +products and technologies, enhance existing products in order to remain +competitive, and effectively stimulate customer demand for new products and +upgraded versions of the Company’s existing products. The success of new +product introductions is dependent on a number of factors, including market +acceptance; the Company’s ability to manage the risks associated with product +transitions, including the transition to Intel-based Macintosh computers, and +production ramp issues; the availability of application software for new +products; the effective management of inventory levels in line with anticipated +product demand, including anticipated demand for PowerPC-based and Intel-based +Macintosh computers; the availability of products in appropriate quantities to +meet anticipated demand; and the risk that new products may have quality or +other defects in the early stages of introduction. Accordingly, the Company +cannot determine in advance the ultimate effect that new products will have on +its sales or results of operations. The Company’s products from time to time experience +quality problems that can result in decreased net sales and operating profits. The Company sells highly +complex hardware and software products that can contain defects in design and +manufacture. Sophisticated operating system software and applications, such as +those sold by the Company, often contain “bugs” that can unexpectedly interfere +with the operation of the software. Defects may also occur in components and +products the Company purchases from third-parties. There can be no assurance +that the Company will be able to detect and fix all defects in the hardware and +software it sells. 48 Failure to do so could +result in lost revenue, loss of reputation, and significant warranty and other +expense to remedy. Because orders for components, and in some cases +commitments to purchase components, must be placed in advance of customer +orders, the Company faces substantial inventory risk. The Company records a write-down for inventories of +components and products that have become obsolete or are in excess of +anticipated demand or net realizable value and accrues necessary reserves for +cancellation fees of orders for inventories that have been cancelled. Although +the Company believes its inventory and related provisions are currently +adequate, given the rapid and unpredictable pace of product obsolescence in the +computer and consumer electronics industries and the transition to Intel-based +Macintosh computers, no assurance can be given that the Company will not incur +additional inventory and related charges. In addition, such charges have had, +and may have, a material effect on the Company’s financial position and results +of operations. The Company must order +components for its products and build inventory in advance of product +shipments. Because the Company’s markets are volatile and subject to rapid +technology and price changes, and because of the transition to Intel-based +Macintosh computers, there is a risk the Company will forecast incorrectly and +produce or order from third parties excess or insufficient inventories of +particular products. Consistent with industry practice, components are normally +acquired through a combination of purchase orders, supplier contracts, and open +orders based on projected demand information. Such purchase commitments +typically cover the Company’s forecasted component and manufacturing +requirements for periods ranging from 30 to 150 days. The Company’s operating +results and financial condition have been in the past and may in the future be +materially adversely affected by the Company’s ability to manage its inventory +levels and respond to short-term shifts in customer demand patterns. The Company is dependent on manufacturing and +logistics services provided by third parties, many of whom are located outside +of the U.S. Most of the Company’s products are manufactured in +whole or in part by third-party manufacturers. In addition, the Company has +outsourced much of its transportation and logistics management. While +outsourcing arrangements may lower the cost of operations, they also reduce the +Company’s direct control over production and distribution. It is uncertain what +effect such diminished control will have on the quality or quantity of the +products manufactured or services rendered, or the flexibility of the Company +to respond to changing market conditions. Moreover, although arrangements with +such manufacturers may contain provisions for warranty expense reimbursement, +the Company may remain at least initially responsible to the consumer for +warranty service in the event of product defects. Any unanticipated product +defect or warranty liability, whether pursuant to arrangements with contract +manufacturers or otherwise, could adversely affect the Company’s future +operating results and financial condition. Final assembly of products +sold by the Company is currently performed in the Company’s manufacturing +facility in Cork, Ireland, and by external vendors in Fremont, California, +Fullerton, California, Taiwan, Korea, the People’s Republic of China, and the +Czech Republic. Currently, manufacturing of many of the components used in the +Company’s products is performed by third-party vendors in Taiwan, China, Japan, +Korea, and Singapore. Final assembly of substantially all of the Company’s +portable products including PowerBooks, iBooks, and iPods is performed by +third-party vendors in China. If for any reason manufacturing or logistics in +any of these locations is disrupted by regional economic, business, labor, +environmental, public health, or political issues, as well as information +technology system failures or military actions, the Company’s results of +operations and financial condition could be adversely affected. 49 The Company’s future operating performance is +dependent on the performance of distributors and other resellers of the Company’s +products. The Company distributes its products through +wholesalers, resellers, national and regional retailers, and cataloguers, many +of whom distribute products from competing manufacturers. In addition, the +Company sells many of its products and resells certain third-party products in +most of its major markets directly to end users, certain education customers, +and certain resellers through its online stores around the world and its retail +stores. Many of the Company’s resellers operate on narrow product margins and +have been negatively affected by weak economic conditions over the last several +years. Considerable trade receivables that are not covered by collateral or +credit insurance are outstanding with the Company’s distribution and retail +channel partners. The Company’s business and financial results could be +adversely affected if the financial condition of these resellers weakens, if +resellers within consumer channels were to cease distribution of the Company’s +products, or if uncertainty regarding demand for the Company’s products caused +resellers to reduce their ordering and marketing of the Company’s products. The +Company has invested and will continue to invest in various programs to enhance +reseller sales, including staffing selected resellers’ stores with Company +employees and contractors. These programs could require a substantial +investment from the Company, while providing no assurance of return or +incremental revenue to offset this investment. Over the past several years, an increasing proportion +of the Company’s net sales has been made by the Company directly to end-users +through its online stores around the world and through its retail stores in the +U.S., Canada, Japan, and the U.K. Some of the Company’s resellers have +perceived this expansion of the Company’s direct sales as conflicting with +their own businesses and economic interests as distributors and resellers of +the Company’s products. Perception of such a conflict could discourage the +Company’s resellers from investing additional resources in the distribution and +sale of the Company’s products or lead them to limit or cease distribution of +the Company’s products. The Company’s business and financial results could be +adversely affected if expansion of its direct sales to end-users causes some or +all of its resellers to cease or limit distribution of the Company’s products. Further information +regarding risks associated with Marketing and Distribution may be found in Part I, +Item 1 of this Form 10-K under the heading “Markets and +Distribution.” The Company relies on third-party digital content, +which may not be available to the Company on commercially reasonable terms or +at all. The Company contracts with third parties to offer +their digital content to customers through the Company’s iTunes Music Store. +The Company pays substantial fees to obtain the rights to offer to its +customers this third-party digital content. The Company’s licensing +arrangements with these third-party content providers are short-term in nature +and do not guarantee the future renewal of these arrangements at commercially +reasonable terms, if at all. Certain parties in the music industry have consolidated +and formed alliances, which could limit the availability and increase the fees +required to offer digital content to customers through the iTunes Music Store. +Further, some third-party content providers currently, or may in the future, +offer music products and services that compete with the Company’s music +products and services, and could take action to make it more difficult or +impossible for the Company to license their digital content in the future. If +the Company is unable to continue to offer a wide variety of digital content at +reasonable prices with acceptable usage rules, or continue to expand its +geographic reach outside the U.S., then sales and gross margins of the Company’s +iTunes Music Store as well as related hardware and peripherals, including +iPods, may be adversely affected. Third-party content +providers and artists require that the Company provide certain digital rights +management solutions and other security mechanisms. If the requirements from +content providers or artists change, then the Company may be required to +further develop or license technology to address such new rights and +requirements. There is no assurance that the Company will be able to develop or +license 50 such solutions at a +reasonable cost and in a timely manner, if at all, which could have a +materially adverse effect on the Company’s operating results and financial +position. The Company’s future performance is dependent upon +support from third-party software developers. If third-party +software applications cease to be developed or available for the Company’s +hardware products, then customers may choose not to buy the Company’s products. The Company believes that decisions by customers to +purchase the Company’s personal computers, as opposed to Windows-based +systems, are often based on the availability of third-party software for +particular applications such as Microsoft Office. The Company also believes the +availability of third-party application software for the Company’s +hardware products depends in part on third-party developers’ perception +and analysis of the relative benefits of developing, maintaining, and upgrading +such software for the Company’s products versus software for the larger Windows +market or growing Linux market. This analysis may be based on factors such as +the perceived strength of the Company and its products, the anticipated +potential revenue that may be generated, continued acceptance by customers of +Mac OS X, and the costs of developing such software products. To the extent the +minority market share held by the Company in the personal computer market has +caused software developers to question the Company’s prospects in the personal +computer market, developers could be less inclined to develop new application +software or upgrade existing software for the Company’s products and more +inclined to devote their resources to developing and upgrading software for the +larger Windows market or growing Linux market. Moreover, there can be no +assurance software developers will continue to develop software for Mac OS X, +the Company’s operating system, on a timely basis or at all. In June 2005, the Company announced its plan to +begin using Intel microprocessors in its Macintosh computers. The Company plans +to begin shipping certain models with Intel microprocessors by June 2006 +and to complete this transition to Intel microprocessors for all of its +Macintosh computers by the end of calendar year 2007. The Company depends on +third-party software developers to timely develop current and future +applications that run on Intel and PowerPC microprocessors. The Company’s +inability to timely deliver new Intel-based products, or a decline in available +applications that run on the Company’s PowerPC products or the lack of +applications that run on Intel-based Macintosh systems could have a materially +adverse effect on the Company’s operating results and financial position. In addition, past and future development by the +Company of its own software applications and solutions may negatively impact +the decision of software developers, such as Microsoft and Adobe, to develop, +maintain, and upgrade similar or competitive software for the Company’s +products. The Company currently markets and sells a variety of software +applications for use by professionals, consumers, and education customers that +could influence the decisions of third-party software developers to develop or +upgrade Macintosh-compatible software products. Software applications currently +marketed by the Company include software for professional film and video +editing, professional compositing and visual effects for large format film and +video productions, professional music production and music post production, +professional and consumer DVD encoding and authoring, professional digital +photo editing and workflow management, consumer digital video and digital photo +editing and management, digital music management, desktop-based database +management, word processing, and high-quality presentations. The Company also +markets an integrated productivity application that incorporates word +processing, page layout, image manipulation, spreadsheets, databases, and +presentations in a single application. Discontinuance of third-party products +for the Macintosh platform, including Microsoft Office could have an adverse +effect on the Company’s net sales and results of operations. 51 The Company’s business relies on access to patents and +intellectual property obtained from third parties, and the Company’s future +results could be adversely affected if it is alleged or found to have infringed +on the intellectual property rights of others. Many of the Company’s products are designed to include +intellectual property obtained from third parties. While it may be necessary in +the future to seek or renew licenses relating to various aspects of its +products and business methods, the Company believes that based upon past +experience and industry practice, such licenses generally could be obtained on +commercially reasonable terms. However, there can be no assurance that the +necessary licenses would be available or available on acceptable terms. Because of technological +changes in the computer and consumer electronics industries, current extensive +patent coverage, and the rapid rate of issuance of new patents, it is possible +certain components of the Company’s products and business methods may +unknowingly infringe existing patents of others. The Company has from time to +time been notified that it may be infringing certain patents or other +intellectual property rights of others. Responding to such claims, regardless +of their merit, can be time-consuming, result in significant expenses, and +cause the diversion of management and technical personnel. Several pending +claims are in various stages of evaluation. The Company may consider the +desirability of entering into licensing agreements in certain of these cases. +However, no assurance can be given that such licenses can be obtained on +acceptable terms or that litigation will not occur. In the event there is a +temporary or permanent injunction entered prohibiting the Company from +marketing or selling certain of its products or a successful claim of +infringement against the Company requiring it to pay royalties to a +third-party, the Company’s future operating results and financial condition +could be adversely affected. Information regarding certain claims and +litigation involving the Company related to alleged patent infringement and +other matters is set forth in Part I, Item 3 of this Form 10-K. +In the opinion of management, the Company does not have a potential liability +for damages or royalties from any current legal proceedings or claims related +to the infringement of patent or other intellectual property rights of others +that would individually or in the aggregate have a material adverse effect on +its results of operations, or financial condition. However, the results of such +legal proceedings cannot be predicted with certainty. Should the Company fail +to prevail in any of the matters related to infringement of patent or other +intellectual property rights of others described in Part I, Item 3 of this +Form 10-K or should several of these matters be resolved against the +Company in the same reporting period, the operating results of a particular +reporting period could be materially adversely affected. The Company’s retail initiative has required and will +continue to require a substantial investment and commitment of resources and is +subject to numerous risks and uncertainties. Through October 2005, the Company had opened 126 retail +stores. The Company’s retail initiative has required substantial investment in +equipment and leasehold improvements, information systems, inventory, and +personnel. The Company has also entered into substantial operating lease +commitments for retail space with lease terms ranging from 5 to 20 years, the +majority of which are for 10 years. The Company could incur substantial costs +should it choose to terminate this initiative or close individual stores. Such +costs could adversely affect the Company’s results of operations and financial +condition. Additionally, a relatively high proportion of the Retail segment’s +costs are fixed because of depreciation on store construction costs and lease +expense. As a result, significant losses would result should the Retail segment +experience a significant decline in sales for any reason. Certain of the Company’s stores +have been designed and built to serve as high profile venues that function +as vehicles for general corporate marketing, corporate events, and brand +awareness. Because of their unique design elements, locations and size, these +stores require substantially more investment in equipment and leasehold improvements than the Company’s more typical +retail stores. The Company has opened seven such stores through October 2005. +Because of their location and size, these high profile stores also require the +Company to enter into substantially larger operating lease commitments compared +to those required for its more typical stores. Current leases on such locations +have terms ranging from 10 to 14 years with total 52 remaining commitments per +location ranging from $4 million to $46 million. Closure or poor performance of +one of these high profile stores could have a particularly significant negative +impact on the Company’s results of operations and financial condition. Many of the general risks +and uncertainties the Company faces could also have an adverse impact on its +Retail segment. Also, many factors unique to retail operations present risks and uncertainties, some of which +are beyond the Company’s control, that could adversely affect the Retail +segment’s future results, cause its actual results to differ from those +currently expected, and/or have an adverse effect on the Company’s consolidated +results of operations. Potential risks and uncertainties unique to retail +operations that could have an adverse impact on the Retail segment include, +among other things, macro-economic factors that have a negative impact on +general retail activity; inability to manage costs associated with store +construction and operation; failure to attract new users to the Macintosh +platform; inability to sell third-party hardware and software products at +adequate margins; failure to manage relationships with existing retail channel +partners; lack of experience in managing retail operations outside the U.S.; +costs associated with unanticipated fluctuations in the value of Apple-branded +and third-party retail inventory; and inability to obtain quality retail +locations at reasonable cost. Investment in new business strategies and initiatives +could disrupt the Company’s ongoing business and may present risks not +originally contemplated. The Company has and may in +the future invest in new business strategies or engage in acquisitions that +complement the Company’s strategic direction and product roadmap. Such +endeavors may involve significant risks and uncertainties, including +distraction of management’s attention away from normal business operations; +insufficient revenue generation to offset liabilities assumed and expenses +associated with the strategy; and unidentified issues not discovered in the +Company’s due diligence process. Because these new ventures are inherently +risky, no assurance can be given that such strategies and initiatives will be +successful and will not materially adversely affect the Company’s business, +operating results or financial condition. Declines in the sales of the Company’s professional +products, software, accessories, or service and support contracts, or increases +in sales of consumer products, including iPods, may negatively impact the +Company’s gross margin and operating margin percentages. The Company’s professional products, including Power +Macintosh and PowerBook systems, software, accessories, and service and support +contracts, generally have higher gross margins than the Company’s consumer +products, including iMacs, iBooks, iPods, and content from the iTunes Music +Store. A shift in sales mix away from higher margin professional products +towards lower margin consumer products could adversely affect the Company’s +future gross margin and operating margin percentages. The Company’s traditional +professional customers may choose to buy consumer products, specifically the +iMac G5 and iBook, instead of professional products. Professional users may +choose to buy the iMac G5 due to its relative price performance, use of the +same PowerPC G5 processor used in the Company’s Power Macs, and unique design +featuring a flat panel screen. Potential PowerBook customers may also choose to +purchase iBooks instead due to their price performance and screen size. +Additionally, significant future growth in iPod sales without corresponding +growth in higher margin product sales could also reduce gross margin and +operating margin percentages. It is likely that some of +the Company’s current and potential professional, +creative, and small business customers, who are most likely to utilize +professional systems, believe that the relatively slower MHz rating or +clock speed of the microprocessors the Company utilizes in its Macintosh +systems compares unfavorably to those utilized by other computer manufacturers +and translates to slower overall system performance. These factors may result +in an adverse impact to sales of the Company’s professional products as well as +to gross margin and operating margin percentages. 53 The Company expects +its quarterly revenue and operating results to fluctuate for a variety of +reasons. The Company’s profit margins +vary among its products and its distribution channels. The Company’s direct +sales, primarily through its retail and online stores, generally have higher +associated profitability than its indirect sales. Additionally, the Company’s +direct channels have traditionally had more sales of software and higher priced +hardware products, which generally have higher gross margins, than its indirect +channels. As a result, the Company’s gross margin and operating margin +percentages as well as overall profitability may be adversely impacted as a +result of a shift in product, geographic, or channel mix, or new product +announcements, including the transition to Intel-based Macintosh computers. In +addition, the Company generally sells more products during the third month of +each quarter than it does during either of the first two months, a pattern +typical in the personal computer industry. This sales pattern can produce +pressure on the Company’s internal infrastructure during the third month of a +quarter and may adversely impact the Company’s ability to predict its financial +results accurately. Developments late in a quarter, such as lower-than-anticipated +demand for the Company’s products, an internal systems failure, or failure of +one of the Company’s key logistics, components suppliers, or manufacturing +partners, can have significant adverse impacts on the Company and its results +of operations and financial condition. The Company has higher research and development and +selling, general and administrative costs, as a percentage of revenue, than +many of its competitors. The Company’s ability to +compete successfully and maintain attractive gross margins and revenue growth +is heavily dependent upon its ability to ensure a continuing and timely flow of +innovative and competitive products and technologies to the marketplace. As a +result, the Company incurs higher research and development costs as a +percentage of revenue than its competitors who sell personal computers based on +other operating systems. Many of these competitors seek to compete aggressively +on price and maintain very low cost structures. Further, as a result of the +expansion of the Company’s Retail segment and costs associated with marketing +the Company’s brand including its unique operating system, the Company incurs +higher selling costs as a percentage of revenue than many of its competitors. +If the Company is unable to continue to develop and sell innovative new +products with attractive gross margins, its results of operations may be +materially adversely affected by its operating cost structure. The Company is exposed to credit risk on its accounts +receivable and prepayments related to long-term supply agreements. This risk is +heightened during periods when economic conditions worsen. The Company distributes +its products through third-party computer resellers and retailers and directly +to certain educational institutions and commercial customers. A substantial +majority of the Company’s outstanding trade receivables are not covered by +collateral or credit insurance. The Company also has unsecured non-trade +receivables from certain of its manufacturing vendors resulting from the sale +by the Company of raw material components to these manufacturing vendors who +manufacture sub-assemblies or assemble final products for the Company. In +addition, the Company has entered into long-term supply agreements to secure supply +of NAND flash-memory and intends to prepay a total of $1.25 billion under these +agreements. While the Company has procedures in place to monitor and limit +exposure to credit risk on its trade and non-trade receivables as well as +long-term prepayments, there can be no assurance that such procedures will be +effective in limiting its credit risk and avoiding losses. Additionally, if the +global economy and regional economies fail to improve or continue to +deteriorate, it becomes more likely that the Company will incur a material loss +or losses as a result of the weakening financial condition of one or more of +its customers or manufacturing vendors. The Company’s +success depends largely on its ability to attract and retain key personnel. Much of the future success +of the Company depends on the continued service and availability of skilled +personnel, including its Chief Executive Officer, members of its executive team, +and those in technical, marketing and staff positions. Experienced personnel in +the information technology industry are in high demand and competition for +their talents is intense, especially in the Silicon Valley, where the majority +of 54 the Company’s key +employees are located. The Company has relied on its ability to grant stock +options as one mechanism for recruiting and retaining this highly skilled +talent. Recent accounting regulations requiring the expensing of stock options +will impair the Company’s future ability to provide these incentives without +incurring significant compensation costs. There can be no assurance that the +Company will continue to successfully attract and retain key personnel. The Company is +subject to risks associated with the selection, availability, and cost of +insurance. The Company has observed +rapidly changing conditions in the insurance markets relating to nearly all +areas of traditional commercial insurance. Such conditions have and may +continue to result in higher premium costs, higher policy deductibles, lower +coverage limits and may also yield possible policy form exclusions. For some +risks, because of cost and/or availability, the Company does not have insurance +coverage. Because the Company retains some portion of its insurable risks, and +in some cases self insures completely, unforeseen or catastrophic losses in +excess of insured limits may have a material adverse effect on the Company’s +results of operations and financial position. Failure of information technology systems and breaches +in the security of data upon which the Company relies could adversely affect +the Company’s future operating results. Information technology +system failures and breaches of data security could disrupt the Company’s +ability to function in the normal course of business by potentially causing +delays or cancellation of customer orders, impeding the manufacture or shipment +of products, or resulting in the unintentional disclosure of customer or +Company information. Management has taken steps to address these concerns for +its own systems by implementing sophisticated network security and internal +control measures. However, there can be no assurance that a system failure or +data security breach of the Company or a third-party vendor will not have a +material adverse effect on the Company’s results of operations. The Company’s +business is subject to the risks of international operations. A large portion of the Company’s revenue is derived +from its international operations. As a result, the Company’s operating results +and financial condition could be significantly affected by risks associated +with international activities, including economic and labor conditions, +political instability, tax laws (including U.S. taxes on foreign subsidiaries), +and changes in the value of the U.S. dollar versus the local currency in which +the products are sold and goods and services are purchased. The Company’s +primary exposure to movements in foreign currency exchange rates relate to +non-dollar denominated sales in Europe, Japan, Australia, Canada, and certain +parts of Asia and non-dollar denominated operating expenses incurred throughout +the world. Weaknesses in foreign currencies, particularly the Japanese Yen and +the Euro, can adversely impact consumer demand for the Company’s products and +the U.S. dollar value of the Company’s foreign currency denominated sales. Conversely, +a strengthening in these and other foreign currencies can cause the Company to +modify international pricing and affect the value of the Company’s foreign +denominated sales, and in some cases, may also increase the cost to the Company +of some product components. Margins on sales of the Company’s products in foreign +countries, and on sales of products that include components obtained from +foreign suppliers, can be adversely affected by foreign currency exchange rate +fluctuations and by international trade regulations, including tariffs and +antidumping penalties. Derivative instruments, such as foreign exchange +forward and option positions have been utilized by the Company to hedge +exposures to fluctuations in foreign currency exchange rates. The use of such +hedging activities may not offset more than a portion of the adverse financial +impact resulting from unfavorable movements in foreign exchange rates. 55 Further information +related to the Company’s global market risks may be found in Part II, Item +7A of this Form 10-K under the subheading “Foreign Currency Risk” +and may be found in Part II, Item 8 of this Form 10-K at Notes +1 and 2 of Notes to Consolidated Financial Statements. The Company is +subject to risks associated with environmental regulations. Production and marketing +of products in certain states and countries may subject the Company to +environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of +its useful life, and place responsibility for environmentally safe disposal or +recycling with the Company. Such laws and regulations have recently been passed +in several jurisdictions in which the Company operates, including various +European Union member countries, Japan, and certain states within the U.S. In +the future, these laws could have a material adverse effect on the Company’s +results of operations. Changes in accounting +rules could affect the Company’s future operating results. Financial statements are +prepared in accordance with U.S. generally accepted accounting principles. +These principles are subject to interpretation by various governing bodies, +including the FASB and the SEC, who create and interpret appropriate accounting +standards. A change from current accounting standards could have a significant +effect on the Company’s results of operations. In December 2004, the FASB +issued new guidance that addresses the accounting for share-based payments, +SFAS No. 123R. In April 2005, the SEC deferred the effective date of +SFAS No. 123R to years beginning after June 15, 2005. Therefore, +SFAS No. 123R will be effective for the Company beginning in its +first quarter of fiscal 2006. The Company expects the adoption of SFAS No. 123R +will result in a reduction of diluted earnings per common share of +approximately $0.03 for the first quarter of fiscal 2006. Although the effect +from the adoption of SFAS No. 123R is expected to have a material impact +on the Company’s results of operations, future changes to various assumptions +used to determine the fair-value of awards issued or the amount and type of +equity awards granted create uncertainty as to the amount of future stock-based +compensation expense. Changes in the +Company’s tax rates could affect its future results. The Company’s future +effective tax rates could be favorably or unfavorably affected by changes in +the mix of earnings in countries with differing statutory tax rates, changes in +the valuation of the Company’s deferred tax assets and liabilities, or by +changes in tax laws or their interpretation. In addition, the Company is +subject to the continuous examination of its income tax returns by the Internal +Revenue Service and other tax authorities. The Company regularly assesses the +likelihood of adverse outcomes resulting from these examinations to determine +the adequacy of its provision for income taxes. There can be no assurance that +the outcomes from these continuous examinations will not have an adverse affect +on the Company’s net income and financial condition. The Company’s stock +price may be volatile. The Company’s stock has at +times experienced substantial price volatility as a result of variations +between its actual and anticipated financial results and as a result of +announcements by the Company and its competitors. The stock market has +experienced extreme price and volume fluctuations that have affected the market +price of many technology companies in ways that may have been unrelated to the +operating performance of these companies. These factors, including lack of +positive general economic and political conditions and investors’ concerns +regarding the credibility of corporate financial reporting and integrity of financial +markets, may materially adversely affect the market price of the Company’s +stock in the future. In addition, increases in the Company’s stock price may +result in greater dilution of earnings per share. 56 Item 7A. Quantitative and Qualitative Disclosures +About Market Risk Interest Rate and +Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions and its interest rate +swap and option positions, both on a stand-alone basis and in conjunction +with its underlying foreign currency and interest rate related exposures. +However, given the effective horizons of the Company’s risk management +activities and the anticipatory nature of the exposures, there can be no +assurance the hedges will offset more than a portion of the financial impact +resulting from movements in either foreign exchange or interest rates. In +addition, the timing of the accounting for recognition of gains and losses +related to mark-to-market instruments for any given period may not +coincide with the timing of gains and losses related to the underlying economic +exposures and, therefore, may adversely affect the Company’s operating results +and financial position. Interest Rate Risk While the Company is exposed to interest rate +fluctuations in many of the world’s leading industrialized countries, the +Company’s interest income and expense is most sensitive to fluctuations in the +general level of U.S. interest rates. In this regard, changes in U.S. interest +rates affect the interest earned on the Company’s cash, cash equivalents, and +short-term investments as well as costs associated with foreign currency +hedges. The Company’s short-term investment policy and +strategy is to ensure the preservation of capital, meet liquidity requirements, +and optimize return in light of the current credit and interest rate +environment. The Company benchmarks its performance by utilizing external money +managers to manage a small portion of the aggregate investment portfolio. The +external managers adhere to the Company’s investment policies and also provide +occasional research and market information that supplements internal research +used to make credit decisions in the investment process. The Company’s exposure to market risk for changes in +interest rates relates primarily to the Company’s investment portfolio. The +Company places its short-term investments in highly liquid securities issued by +high credit quality issuers and, by policy, limits the amount of credit +exposure to any one issuer. The Company’s general policy is to limit the risk +of principal loss and ensure the safety of invested funds by limiting market +and credit risk. All highly liquid investments with maturities of three months +or less are classified as cash equivalents; highly liquid investments with +maturities greater than three months are classified as short-term +investments. As of September 24, 2005, approximately $287 million of the +Company’s short-term investments had underlying maturities ranging from 1 to 5 +years. As of September 25, 2004, $180 million of the Company’s investment +portfolio classified as short-term investments had maturities ranging from 1 to +5 years. The remainder all had underlying maturities between 3 and 12 months. +The Company may sell its investments prior to their stated maturities, due to +liquidity needs, in anticipation of credit deterioration, or for duration +management. The Company recognized a net loss before taxes of $137,000 in 2005, +and net gains before taxes of $1 million and $21 million in 2004, and 2003, +respectively as a result of such sales. In order to provide a meaningful assessment of the +interest rate risk associated with the Company’s investment portfolio, the +Company performed a sensitivity analysis to determine the impact that a change +in interest rates would have on the value of the investment portfolio assuming +a 100 basis point parallel shift in the yield curve. Based on investment +positions as of September 24, 2005, a hypothetical 100 basis point +increase in interest rates across all maturities would result in a $19.9 +million decline in the fair market value of the portfolio. As of September 25, +2004, a similar 100 basis point shift in the yield curve would have resulted in +a $14.4 million decline in fair value. Such losses would only be realized if +the Company sold the investments prior to maturity. Except in instances noted +above, the Company’s policy is to hold investments to maturity. 57 From time to time, the +Company has entered into interest rate derivative transactions with financial +institutions in order to better match the Company’s floating-rate interest +income on its cash equivalents and short-term investments with its fixed-rate +interest expense on its debt, and/or to diversify a portion of the Company’s exposure +away from fluctuations in short-term U.S. interest rates. The Company did not +enter into any interest rate derivatives during 2005 or 2004 and had no open +interest rate derivatives at September 24, 2005. Foreign Currency +Risk In general, the Company is a net receiver of +currencies other than the U.S. dollar. Accordingly, changes in exchange rates, +and in particular a strengthening of the U.S. dollar, may negatively affect the +Company’s net sales and gross margins as expressed in U.S. dollars. There is +also a risk that the Company will have to adjust local currency product pricing +due to competitive pressures when there has been significant volatility in +foreign currency exchange rates. The Company may enter into foreign currency forward +and option contracts with financial institutions to protect against foreign +exchange risks associated with existing assets and liabilities, certain firmly +committed transactions, forecasted future cash flows, and net investments in +foreign subsidiaries. Generally, the Company’s practice is to hedge a majority +of its existing material foreign exchange transaction exposures. However, the +Company may not hedge certain foreign exchange transaction exposures due to +immateriality, prohibitive economic cost of hedging particular exposures, and +limited availability of appropriate hedging instruments. In order to provide a meaningful assessment of the +foreign currency risk associated with certain of the Company’s foreign currency +derivative positions, the Company performed a sensitivity analysis using a +value-at-risk (VAR) model to assess the potential impact of fluctuations in +exchange rates. The VAR model consisted of using a Monte Carlo simulation to +generate 3000 random market price paths. The VAR is the maximum expected loss in +fair value, for a given confidence interval, to the Company’s foreign exchange +portfolio due to adverse movements in rates. The VAR model is not intended to +represent actual losses but is used as a risk estimation and management tool. The +model assumes normal market conditions. Forecasted transactions, firm +commitments, and assets and liabilities denominated in foreign currencies were +excluded from the model. Based on the results of the model, the Company +estimates with 95% confidence a maximum one-day loss in fair value of $10.0 +million as of September 24, 2005 compared to a maximum one-day loss of +$3.2 million as of September 25, 2004. Because the Company uses foreign +currency instruments for hedging purposes, losses incurred on those instruments +are generally offset by increases in the fair value of the underlying +exposures. Actual future gains and losses associated with the +Company’s investment portfolio and derivative positions may differ materially +from the sensitivity analyses performed as of September 24, 2005 due to +the inherent limitations associated with predicting the changes in the timing +and amount of interest rates, foreign currency exchanges rates, and the Company’s +actual exposures and positions. 58 Item +8. Financial Statements and Supplementary Data Index to Consolidated + Financial Statements Page Financial Statements: Consolidated + Balance Sheets as of September 24, 2005 and September 25, 2004 60 Consolidated + Statements of Operations for the three fiscal years ended September 24, + 2005 61 Consolidated + Statements of Shareholders’ Equity for the three fiscal years ended + September 24, 2005 62 Consolidated + Statements of Cash Flows for the three fiscal years ended September 24, + 2005 63 Notes + to Consolidated Financial Statements 64 Selected + Quarterly Financial Information (Unaudited) 97 Reports + of Independent Registered Public Accounting Firm, KPMG LLP 98 All financial statement schedules have been omitted, +since the required information is not applicable or is not present in amounts +sufficient to require submission of the schedule, or because the information +required is included in the Consolidated Financial Statements and Notes +thereto. 59 CONSOLIDATED +BALANCE SHEETS (In millions, except share amounts) September 24, 2005 September 25, 2004 ASSETS: Current assets: Cash and cash equivalents $ 3,491 $ 2,969 Short-term investments 4,770 2,495 Accounts receivable, less allowances of $46 and $47, + respectively 895 774 Inventories 165 101 Deferred tax assets 331 231 Other current assets 648 485 Total current assets 10,300 7,055 Property, plant, and equipment, net 817 707 Goodwill 69 80 Acquired intangible assets, net 27 17 Other assets 338 191 Total assets $ 11,551 $ 8,050 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current + liabilities: Accounts payable $ 1,779 $ 1,451 Accrued expenses 1,705 1,200 Total current liabilities 3,484 2,651 Non-current + liabilities 601 323 Total liabilities 4,085 2,974 Commitments and + contingencies Shareholders’ + equity: Common stock, no par value; 1,800,000,000 shares + authorized; 835,019,364 and 782,887,234 shares issued and outstanding, + respectively 3,521 2,514 Deferred stock compensation (60 ) (93 ) Retained earnings 4,005 2,670 Accumulated other comprehensive income (loss) — (15 ) Total shareholders’ equity 7,466 5,076 Total liabilities + and shareholders’ equity $ 11,551 $ 8,050 See accompanying notes to consolidated financial statements. 60 CONSOLIDATED +STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) Three fiscal years ended September 24, 2005 2005 2004 2003 Net sales $ 13,931 $ 8,279 $ 6,207 Cost of sales 9,888 6,020 4,499 Gross margin 4,043 2,259 1,708 Operating + expenses: Research and development 534 489 471 Selling, general, and administrative 1,859 1,421 1,212 Restructuring costs — 23 26 Total operating expenses 2,393 1,933 1,709 Operating income + (loss) 1,650 326 (1 ) Other income and expense: Gains on non-current investments, net — 4 10 Interest and other income, net 165 53 83 Total other income and expense 165 57 93 Income before + provision for income taxes 1,815 383 92 Provision for + income taxes 480 107 24 Income before + accounting changes 1,335 276 68 Cumulative + effects of accounting changes, net of income taxes — — 1 Net income $ 1,335 $ 276 $ 69 Earnings per common share before accounting changes: Basic $ 1.65 $ 0.37 $ 0.09 Diluted $ 1.56 $ 0.36 $ 0.09 Earnings per common share: Basic $ 1.65 $ 0.37 $ 0.10 Diluted $ 1.56 $ 0.36 $ 0.09 Shares used in computing earnings per share (in + thousands): Basic 808,439 743,180 721,262 Diluted 856,780 774,622 726,932 See accompanying notes to consolidated financial statements. 61 CONSOLIDATED +STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except share amounts which are in thousands) Accumulated Other Total Common Stock Deferred Stock Retained Comprehensive Shareholders’ Shares Amount Compensation Earnings Income (Loss) Equity Balances as of September 28, 2002 717,918 $ 1,826 $ (7 ) $ 2,325 $ (49 ) $ 4,095 Components of comprehensive income: Net income — — — 69 — 69 Change in foreign + currency translation — — — — 31 31 Change in + unrealized gain on available-for-sale securities, net of tax — — — — (12 ) (12 ) Change in + unrealized gain on derivative investments, net of tax — — — — (5 ) (5 ) Total + comprehensive income 83 Amortization of + deferred stock compensation — — 15 — — 15 Write-off of + deferred stock compensation — — 5 — — 5 Common stock + issued under stock plans 18,598 128 (75 ) — — 53 Settlement of + forward purchase agreement (3,062 ) (35 ) — — — (35 ) Tax benefit + related to stock options — 7 — — — 7 Balances as of September 27, 2003 733,454 $ 1,926 $ (62 ) $ 2,394 $ (35 ) $ 4,223 Components of comprehensive income: Net income — — — 276 — 276 Change in foreign + currency translation — — — — 13 13 Change in + unrealized gain on available-for-sale securities, net of tax — — — — (5 ) (5 ) Change in + unrealized loss on derivative investments, net of tax — — — — 12 12 Total + comprehensive income 296 Issuance of + restricted stock units — 64 (64 ) — — — Adjustment to + common stock related to a prior year acquisition (159 ) (2 ) — — — (2 ) Amortization of + deferred stock compensation — — 33 — — 33 Common stock + issued under stock plans 49,592 427 — — — 427 Tax benefit + related to stock options — 99 — — — 99 Balances as of September 25, 2004 782,887 $ 2,514 $ (93 ) $ 2,670 $ (15 ) $ 5,076 Components + of comprehensive income: Net income — — — 1,335 — 1,335 Change in foreign + currency translation — — — — 7 7 Change in + unrealized gain on derivative investments, net of tax — — — — 8 8 Total + comprehensive income 1,350 Issuance of restricted stock units, net — 7 (7 ) — — — Amortization of deferred stock compensation — — 40 — — 40 Common stock issued under stock plans 52,132 547 — — — 547 Tax benefit related to stock options — 453 — — — 453 Balances as of + September 24, 2005 835,019 $ 3,521 $ (60 ) $ 4,005 $ — $ 7,466 See accompanying notes to consolidated financial statements. 62 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 24, 2005 2005 2004 2003 Cash and cash + equivalents, beginning of the year $ 2,969 $ 3,396 $ 2,252 Operating Activities: Net income 1,335 276 69 Cumulative + effects of accounting changes, net of taxes — — (1 ) Adjustments to reconcile + net income to cash generated by operating activities: Depreciation, amortization and accretion 179 150 113 Stock-based compensation expense 42 33 16 Non-cash restructuring — 5 12 Provision for (benefit from) deferred income taxes 52 20 (11 ) Tax benefit from stock options 453 99 7 Loss on disposition of property, plant, and + equipment 9 7 2 Gains on sales of short-term investments, net — (1 ) (21 ) Gains on non-current investments, net — (4 ) (10 ) Gain on forward purchase agreement — — (6 ) Changes in operating + assets and liabilities: Accounts receivable (121 ) (8 ) (201 ) Inventories (64 ) (45 ) (11 ) Other current assets (150 ) (176 ) (34 ) Other assets (61 ) (39 ) (30 ) Accounts payable 328 297 243 Other liabilities 533 320 152 Cash generated by operating activities 2,535 934 289 Investing + Activities: Purchases of + short-term investments (11,470 ) (3,270 ) (2,648 ) Proceeds from + maturities of short-term investments 8,609 1,141 2,446 Proceeds from + sales of short-term investments 586 801 1,116 Proceeds from + sales of non-current investments — 5 45 Purchases of + property, plant, and equipment (260 ) (176 ) (164 ) Other (21 ) 11 33 Cash (used for) generated by investing activities (2,556 ) (1,488 ) 828 Financing + Activities: Payment of + long-term debt — (300 ) — Proceeds from issuance + of common stock 543 427 53 Cash used for + repurchase of common stock — — (26 ) Cash generated by financing activities 543 127 27 Increase + (decrease) in cash and cash equivalents 522 (427 ) 1,144 Cash and cash + equivalents, end of the year $ 3,491 $ 2,969 $ 3,396 Supplemental cash + flow disclosures: Cash paid during the year for interest $ — $ 10 $ 20 Cash paid + (received) for income taxes, net $ 17 $ (7 ) $ 45 See accompanying notes to consolidated financial statements. 63 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note +1—Summary of Significant Accounting Policies Apple Computer, Inc. +and its subsidiaries (the Company) designs, manufactures, and markets personal +computers and related software, services, peripherals, and networking solutions. +The Company also designs, develops, and markets a line of portable digital +music players along with related accessories and services including the online +distribution of third-party music, audio books, music videos, short films, and +television shows. The Company sells its products worldwide through its online +stores, its own retail stores, its direct sales force, and third-party +wholesalers, resellers, and value-added resellers. In addition to its own +hardware, software, and peripheral products, the Company sells a variety of +third-party hardware and software products through its online and retail stores. +The Company sells to education, consumer, creative professional, business, and +government customers. Basis +of Presentation and Preparation The accompanying +consolidated financial statements include the accounts of the Company. +Intercompany accounts and transactions have been eliminated. The preparation of +these consolidated financial statements in conformity with U.S. generally +accepted accounting principles requires management to make estimates and +assumptions that affect the amounts reported in these consolidated financial +statements and accompanying notes. Actual results could differ materially from +those estimates. Certain prior year amounts in the consolidated financial +statements and notes thereto have been reclassified to conform to the current +year presentation. Typically, the Company’s +fiscal year ends on the last Saturday of September. Fiscal years 2005, 2004, +and 2003 were each 52-week years. However, approximately every six years, +the Company reports a 53-week fiscal year to align its fiscal quarters +with calendar quarters by adding a week to its first fiscal quarter. The +Company will add this additional week in the first fiscal quarter of its fiscal +year 2006. All information presented herein is based on the Company’s fiscal +calendar. Common Stock Split On February 28, 2005, +the Company effected a two-for-one stock split to shareholders of record as of February 18, +2005. All share and per share information has been retroactively adjusted to +reflect the stock split. Financial +Instruments Cash Equivalents +and Short-term Investments All highly liquid +investments with maturities of three months or less at the date of purchase are +classified as cash equivalents. Highly liquid investments with maturities +greater than three months are classified as short-term investments. The +Company’s debt and marketable equity securities have been classified and +accounted for as available-for-sale. Management determines the +appropriate classification of its investments in debt and marketable equity +securities at the time of purchase and reevaluates available-for-sale +designation as of each balance sheet date. These securities are carried at fair +value, with the unrealized gains and losses, net of taxes, reported as a +component of shareholders’ equity. The cost of securities sold is based upon +the specific identification method. Derivative +Financial Instruments The Company accounts for +its derivative instruments as either assets or liabilities and carries them at +fair value. Derivatives that are not defined as hedges in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, must be adjusted to fair value through earnings. If the derivative is a hedge, +depending on the nature of the hedge, changes in fair value will either be +offset against the change in fair value of the 64 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) hedged assets, +liabilities, or firm commitments through earnings, or recognized in other +comprehensive income until the hedged item is recognized in earnings. For derivative instruments that hedge the exposure to +variability in expected future cash flows that are designated as cash flow +hedges, the net gain or loss on the derivative instrument is reported as a +component of accumulated other comprehensive income in shareholders’ equity and +reclassified into earnings in the same period or periods during which the +hedged transaction affects earnings. To receive hedge accounting treatment, +cash flow hedges must be highly effective in offsetting changes to expected +future cash flows on hedged transactions. For derivative instruments that hedge +the exposure to changes in the fair value of an asset or a liability and that +are designated as fair value hedges, the net gain or loss on the derivative +instrument as well as the offsetting gain or loss on the hedged item +attributable to the hedged risk are recognized in earnings in the current +period. The net gain or loss on the effective portion of a derivative +instrument that is designated as an economic hedge of the foreign currency +translation exposure of the net investment in a foreign operation is reported +in the same manner as a foreign currency translation adjustment. For forward +contracts designated as net investment hedges, the Company excludes changes in +fair value relating to changes in the forward carry component from its +definition of effectiveness. Accordingly, any gains or losses related to this +component are recognized in current earnings. The Company may enter into +foreign currency forward contracts to hedge the translation and economic +exposure of a net investment position in a foreign subsidiary. For such +contracts, hedge effectiveness is measured based on changes in the fair value +of the contract attributable to changes in the spot exchange rate. The +effective portion of the net gain or loss on a derivative instrument designated +as a hedge of the net investment position in a foreign subsidiary is reported +in the same manner as a foreign currency translation adjustment. Any residual +changes in fair value of the forward contract, including changes in fair value +based on the differential between the spot and forward exchange rates, are +recognized in current earnings in other income and expense. Inventories Inventories are stated at +the lower of cost, computed using the first-in, first-out method, or market. If +the cost of the inventories exceeds their market value, provisions are made +currently for the difference between the cost and the market value. The Company’s +inventories consist primarily of finished goods for all periods presented. Property, +Plant, and Equipment Property, plant, and +equipment are stated at cost. Depreciation is computed by use of the straight-line +method over the estimated useful lives of the assets, which are 30 years for +buildings, up to 5 years for equipment, and the shorter of lease terms or 10 +years for leasehold improvements. The Company capitalizes eligible costs to +acquire or develop internal-use software that are incurred subsequent to the +preliminary project stage. Capitalized costs related to internal-use software +are amortized using the straight-line method over the estimated useful lives of +the assets, which range from 3 to 5 years. Depreciation and amortization +expense on property and equipment was $141 million, $126 million, and $108 +million during 2005, 2004, and 2003, respectively. 65 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting +Policies (Continued) Asset Retirement +Obligations The Company records obligations associated with the +retirement of tangible long-lived assets and the associated asset retirement +costs in accordance with SFAS No. 143, Accounting for Asset +Retirement Obligations . The Company reviews legal obligations +associated with the retirement of long-lived assets that result from the +acquisition, construction, development and/or normal use of the assets. If it +is determined that a legal obligation exists, the fair value of the liability +for an asset retirement obligation is recognized in the period in which it is +incurred if a reasonable estimate of fair value can be made. The fair value of +the liability is added to the carrying amount of the associated asset and this +additional carrying amount is depreciated over the life of the asset. The +difference between the gross expected future cash flow and its present value is +accreted over the life of the related lease as an operating expense. All of the +Company’s existing asset retirement obligations are associated with commitments +to return property subject to operating leases to original condition upon lease +termination. The following table +reconciles changes in the Company’s asset retirement liabilities for fiscal +2004 and 2005 (in millions): Asset retirement + liability as of September 27, 2003 $ 7.2 Additional asset retirement obligations recognized 0.5 Accretion recognized 0.5 Asset retirement liability as of September 25, + 2004 $ 8.2 Additional asset retirement obligations recognized 2.8 Accretion recognized 0.7 Asset retirement + liability as of September 24, 2005 $ 11.7 Cumulative +Effects of Accounting Changes In 2003, the Company +recognized a net favorable cumulative effect type adjustment of approximately $1 million +from the adoption of SFAS No. 150, Accounting for Certain +Financial Instruments with Characteristic of Both Liabilities and Equity and SFAS No. 143. Long-Lived +Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and +certain identifiable intangibles, excluding goodwill, for impairment whenever +events or changes in circumstances indicate the carrying amount of an asset may +not be recoverable. Recoverability of these assets is measured by comparison of +its carrying amount to future undiscounted cash flows the assets are expected +to generate. If property, plant, and equipment and certain identifiable +intangibles are considered to be impaired, the impairment to be recognized +equals the amount by which the carrying value of the assets exceeds its fair +market value. For the three fiscal years ended September 24, 2005, the +Company had no material impairment of its long-lived assets, except for the +impairment of certain assets in connection with the restructuring actions +described in Note 5 of these Notes to Consolidated Financial Statements. SFAS No. 142, Goodwill and Other +Intangible Assets requires that goodwill and intangible assets with +indefinite useful lives should not be amortized but rather be tested for +impairment at least annually or sooner whenever events or changes in +circumstances indicate that they may be impaired. The Company performs its +goodwill impairment tests on or about August 30 of each year. The Company +did not recognize any goodwill or intangible asset impairment charges in 2005, +2004, or 2003. The Company established reporting units based on its current +reporting structure. For purposes of testing goodwill for 66 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) impairment, +goodwill has been allocated to these reporting units to the extent it relates +to each reporting unit.SFAS No. 142 also requires that intangible assets +with definite lives be amortized over their estimated useful lives and reviewed +for impairment in accordance with SFAS No. 144, Accounting +for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be +Disposed Of . The Company is currently amortizing its acquired +intangible assets with definite lives over periods ranging from 3 to 10 years. Foreign Currency Translation The Company translates the +assets and liabilities of its international non-U.S. functional currency +subsidiaries into U.S. dollars using exchange rates in effect at the end of each +period. Revenue and expenses for these subsidiaries are translated using rates +that approximate those in effect during the period. Gains and losses from these +translations are credited or charged to foreign currency translation included +in “accumulated other comprehensive income (loss)” in shareholders’ equity. The +Company’s foreign manufacturing subsidiaries and certain other international +subsidiaries that use the U.S. dollar as their functional currency remeasure +monetary assets and liabilities at exchange rates in effect at the end of each +period, and inventories, property, and nonmonetary assets and liabilities at +historical rates. Gains and losses from these translations were insignificant +and have been included in the Company’s results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, peripherals, digital content, and service and support +contracts. The Company recognizes revenue pursuant to applicable accounting +standards, including Statement of Position (SOP) No. 97-2, Software Revenue Recognition , as amended, and Securities and +Exchange Commission (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition . The Company recognizes revenue when persuasive +evidence of an arrangement exists, delivery has occurred, the sales price is +fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped and title and risk of loss +have been transferred. For most of the Company’s product sales, these criteria +are met at the time the product is shipped. For online sales to individuals, +for some sales to education customers in the U.S., and for certain other sales, +the Company defers revenue until the customer receives the product because the +Company legally retains a portion of the risk of loss on these sales during +transit. If at the outset of an arrangement the Company determines the +arrangement fee is not, or is presumed to not be, fixed or determinable, +revenue is deferred and subsequently recognized as amounts become due and +payable. Revenue from service and support contracts is deferred +and recognized ratably over the service coverage periods. These contracts +typically include extended phone support, repair services, web-based support resources, +diagnostic tools, and extend the service coverage offered under the Company’s +one-year limited warranty. The Company sells software and peripheral products +obtained from other companies. The Company establishes its own pricing and +retains related inventory risk, is the primary obligor in sales transactions +with its customers, and assumes the credit risk for amounts billed to its +customers. Accordingly, the Company recognizes revenue for the sale of products +obtained from other companies at the gross amount billed. 67 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) Revenue on +arrangements that include multiple elements such as hardware, software, and +services is allocated to each element based on the relative fair value of each +element. Each element’s allocated revenue is recognized when revenue +recognition criteria for that element has been met. Fair value is generally +determined by vendor specific objective evidence (VSOE), which is based on the +price charged when each element is sold separately. If the Company cannot objectively determine +the fair value of any undelivered element included in a multiple-element +arrangement, the Company defers revenue until all elements are delivered and +services have been performed, or until fair value can objectively be determined +for any remaining undelivered elements. When the fair value of a delivered +element has not been established, the Company uses the residual method to +recognize revenue if the fair value of all undelivered elements is +determinable. Under the residual method, the fair value of the undelivered +elements is deferred and the remaining portion of the arrangement fee is +allocated to the delivered elements and is recognized as revenue. The Company records reductions to revenue for +estimated commitments related to price protection and for customer incentive +programs, including reseller and end user rebates, and other sales programs and +volume-based incentives. The estimated cost of these programs is accrued as a +reduction to revenue in the period the Company has sold the product and +committed to a plan. The Company also records reductions to revenue for +expected future product returns based on the Company’s historical experience. Generally, the Company +does not offer specified or unspecified upgrade rights to its customers in +connection with software sales or the sale of extended warranty and support +contracts. When the Company does offer specified upgrade rights, the Company +defers revenue for the fair value of the specified upgrade right until the +future obligation is fulfilled or when the right to the specified upgrade +expires. Additionally, a limited number of the Company’s software products are +available with maintenance agreements that grant customers rights to +unspecified future upgrades over the maintenance term on a when and if +available basis. Revenue associated with such maintenance is recognized ratably +over the maintenance term. Allowance +for Doubtful Accounts The Company records its allowance +for doubtful accounts based upon its assessment of various factors. The Company +considers historical experience, the age of the accounts receivable balances, +credit quality of the Company’s customers, current economic conditions and +other factors that may affect customers’ ability to pay. Shipping Costs The Company’s shipping and +handling costs are included in cost of sales for all periods presented. Warranty Expense The Company provides +currently for the estimated cost for product warranties at the time the related +revenue is recognized. The Company assesses the adequacy of its preexisting +warranty liabilities and adjusts the amounts as necessary based on actual +experience and changes in future estimates. Software Development Costs Research and development costs are expensed as +incurred. Development costs of computer software to be sold, leased, or +otherwise marketed are subject to capitalization beginning when a product’s +technological feasibility has been established and ending when a product is available +for general release to customers 68 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) pursuant to SFAS No. 86, Computer +Software to be Sold, Leased, or Otherwise Marketed . In most +instances, the Company’s products are released soon after technological +feasibility has been established. Therefore, costs incurred subsequent to +achievement of technological feasibility are usually not significant, and +generally all software development costs have been expensed. In the fourth quarter of 2004, the Company began +incurring substantial development costs associated with Mac OS X version 10.4 +Tiger subsequent to achievement of technological feasibility as evidenced by +public demonstration in August 2004 and the subsequent release of a +developer beta version of the product. The Company capitalized approximately +$29.7 and $4.5 million during 2005 and 2004, respectively, of costs associated +with the development of Tiger. In accordance with SFAS No. 86, amortization +of this asset to cost of sales began in April 2005 when the Company began +shipping Tiger and is being recognized on a straight-line basis over a 3 year +estimated useful life. During the second quarter of 2004, the Company +incurred substantial development costs associated with FileMaker Pro 7 +subsequent to achievement of technological feasibility as evidenced by public +demonstration and release of a developer beta version, and prior to the release +of the final version of the product in March 2004. Therefore, during the +second quarter of 2004, the Company capitalized approximately $2.3 million of +costs associated with the development of FileMaker Pro 7. In accordance with +SFAS No. 86, amortization of this asset to cost of sales began in March 2004 +when the Company began shipping FileMaker Pro 7 and is being recognized on a +straight-line basis over a 3 year estimated useful life. During the third and fourth quarters of 2003, the +Company incurred substantial development costs associated with the development +of Mac OS X version 10.3 (code-named “Panther”), subsequent to achievement of +technological feasibility as evidenced by public demonstration and release of a +developer beta in June 2003, and prior to release of the final version of +the product in the first quarter of 2004. Therefore, during 2003 the Company +capitalized approximately $14.7 million of development costs associated with +the development of Panther. Amortization of this asset began in the first +quarter of 2004 when Panther was shipped and is being recognized on a +straight-line basis in accordance with SFAS No. 86 over a 3 year estimated +useful life. Total amortization related +to capitalized software development costs was $15.7 million, $10.7 million, and +$5.8 million in 2005, 2004, and 2003, respectively. Advertising Costs Advertising costs are +expensed as incurred. Advertising expense was $287 million, $206 million, and +$193 million for 2005, 2004, and 2003, respectively. Stock-Based Compensation The Company currently measures compensation expense +for its employee stock-based compensation plans using the intrinsic value +method prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees . The Company +applies the disclosure provisions of SFAS No. 123, Accounting +for Stock-based Compensation , as amended by SFAS No. 148, Accounting for Stock-based Compensation—Transition and Disclosure as if the fair-value-based method had been applied in measuring compensation +expense. Under APB Opinion No. 25, when the exercise price of the Company’s +employee stock options equals the market price of the underlying stock on the +date of the grant, no compensation expense is recognized. 69 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) As required under +SFAS No. 123, the pro forma effects of stock-based compensation on net +income and earnings per common share for employee stock options granted and +employee stock purchase plan share purchases have been estimated at the date of +grant and beginning of the period, respectively, using a Black-Scholes +option pricing model. For purposes of pro forma disclosures, the estimated fair +value of the options and shares is amortized to pro forma net income over the +options’ vesting period and the shares’ plan period. The +Company’s pro forma information for each of the last three fiscal years follows +(in millions, except per share amounts): 2005 2004 2003 Net income—as reported $ 1,335 $ 276 $ 69 Add: Stock-based + employee compensation expense included in reported net income, net of tax 38 33 15 Deduct: Stock-based + employee compensation expense determined under the fair value based method + for all awards, net of tax (114 ) (141 ) (181 ) Net income (loss)—pro + forma $ 1,259 $ 168 $ (97 ) Net income per common + share—as reported Basic $ 1.65 $ 0.37 $ 0.10 Diluted $ 1.56 $ 0.36 $ 0.09 Net income (loss) per + common share—pro forma Basic $ 1.56 $ 0.23 $ (0.13 ) Diluted $ 1.47 $ 0.22 $ (0.13 ) In December 2004, the +FASB issued SFAS No. 123 (revised 2004) (SFAS No. 123R), Share-Based Payment , which addresses the accounting for +share-based payment transactions in which an enterprise receives employee +services in exchange for (a) equity instruments of the enterprise or (b) liabilities +that are based on the fair value of the enterprise’s equity instruments or that +may be settled by the issuance of such equity instruments. SFAS No. 123R +eliminates the ability to account for share-based compensation transactions +using the intrinsic value method under APB Opinion No. 25, and requires +instead that such transactions be accounted for using a fair-value-based +method. In January 2005, the SEC issued SAB No. 107, which +provides supplemental implementation guidance for SFAS No. 123R. SFAS No. 123R +will be effective for the Company beginning in the first quarter of its fiscal +2006. The Company’s assessment of the estimated stock-based compensation +expense is affected by the Company’s stock price as well as assumptions +regarding a number of complex variables and the related tax impact. These +variables include, but are not limited to, the Company’s stock price, +volatility, and employee stock option exercise behaviors and the related tax +impact. The Company will recognize stock-based compensation expense on all +awards on a straight-line basis over the requisite service period using the +modified prospective method. Although the adoption of SFAS No. 123R is +expected to have a material effect on the Company’s results of operations, +future changes to various assumptions used to determine the fair-value of +awards issued or the amount and type of equity awards granted create +uncertainty as to whether future stock-based compensation expense will be +similar to the historical SFAS No. 123 pro forma expense. 70 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting +Policies (Continued) Earnings Per Common +Share Basic earnings per common share is computed by +dividing income available to common shareholders by the weighted-average number +of shares of common stock outstanding during the period. Diluted earnings per +common share is computed by dividing income available to common shareholders by +the weighted-average number of shares of common stock outstanding during +the period increased to include the number of additional shares of common stock +that would have been outstanding if the dilutive potential shares of common +stock had been issued. The dilutive effect of outstanding options, restricted stock +and restricted stock units is reflected in diluted earnings per share by +application of the treasury stock method. Under the treasury stock method, an +increase in the fair market value of the Company’s common stock can result in a +greater dilutive effect from outstanding options, restricted stock and +restricted stock units. Additionally, the exercise of employee stock options +and the vesting of restricted stock and restricted stock units can result in a +greater dilutive effect on earnings per share. The +following table sets forth the computation of basic and diluted earnings per +share: 2005 2004 2003 Numerator (in millions): Income before accounting + changes $ 1,335 $ 276 $ 68 Cumulative effects of + accounting changes, net of tax — — 1 Net income $ 1,335 $ 276 $ 69 Denominator (in + thousands): Weighted-average shares + outstanding, excluding unvested restricted stock 808,439 743,180 721,262 Effect of dilutive + options, restricted stock units and restricted stock 48,341 31,442 5,670 Denominator for diluted + earnings per share 856,780 774,622 726,932 Basic earnings per share + before accounting changes $ 1.65 $ 0.37 $ 0.09 Basic earnings per share + after accounting changes $ 1.65 $ 0.37 $ 0.10 Diluted earnings per + share before accounting changes $ 1.56 $ 0.36 $ 0.09 Diluted earnings per share after accounting changes $ 1.56 $ 0.36 $ 0.09 Potentially dilutive +securities representing approximately 12.4 million, 8.7 million, and 101.6 million +shares of common stock for the years ended September 24, 2005, +September 25, 2004, and September 27, 2003, respectively, were +excluded from the computation of diluted earnings per share for these periods +because their effect would have been antidilutive. These potentially dilutive +securities include stock options, restricted stock, and restricted stock units. Comprehensive +Income Comprehensive income +consists of two components, net income and other comprehensive income. Other +comprehensive income refers to revenue, expenses, gains and losses that under +generally accepted accounting principles are recorded as an element of +shareholders’ equity but are excluded from net income. The Company’s other +comprehensive income is comprised of foreign currency translation adjustments +from those subsidiaries not using the U.S. dollar as their functional currency, +unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative +instruments accounted for as cash flow hedges. 71 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note +1—Summary of Significant Accounting Policies (Continued) Segment Information The Company reports +segment information based on the “management” approach. The management approach +designates the internal reporting used by management for making decisions and +assessing performance as the source of the Company’s reportable segments. +Information about the Company’s products, major customers, and geographic areas +on a company-wide basis is also disclosed. Note 2—Financial +Instruments The carrying amounts of cash +and cash equivalents, accounts receivable, accounts payable, and accrued +expenses approximate their fair value due to the short maturities of those +instruments. Cash, +Cash Equivalents and Short-Term Investments The +following table summarizes the fair value of the Company’s cash and available-for-sale +securities held in its short-term investment portfolio, recorded as cash and +cash equivalents or short-term investments (in millions): September 24, 2005 September 25, 2004 Cash $ 127 $ 200 U.S. Treasury and + Agency securities 89 87 U.S. corporate + securities 2,030 1,795 Foreign + securities 1,245 887 Total cash equivalents 3,364 2,769 U.S. Treasury and Agency securities 216 1,080 U.S. corporate + securities 3,662 1,352 Foreign + securities 892 63 Total short-term investments 4,770 2,495 Total cash, cash + equivalents, and short-term investments $ 8,261 $ 5,464 The Company’s U.S. corporate securities consist +primarily of commercial paper, certificates of deposit, time deposits and +corporate debt securities. Foreign securities consist primarily of foreign +commercial paper, certificates of deposit and time deposits with foreign +institutions, most of which are denominated in U.S. dollars. The Company had +net unrealized losses totaling $5.9 million on its investment portfolio, +approximately half of which related to investments with stated maturities less +than 1 year as of September 24, 2005 and net unrealized losses of $6.3 +million on its investment portfolio, primarily related to investments with +stated maturities less than 1 year as of September 25, 2004. The Company +occasionally sells short-term investments prior to their stated maturities. The +Company recognized a net loss before taxes of $137,000 in 2005 and net gains +before taxes of $1 million and $21 million in 2004 and 2003, respectively, as a +result of such sales. These net gains were included in interest and other +income, net. As of September 24, 2005, approximately $287 million +of the Company’s short-term investments had underlying maturities ranging from +1 to 5 years. The remaining short-term investments as of September 24, +2005 had maturities of 3 to 12 months. As of September 25, 2004, +approximately $180 million of the Company’s short-term investments had +underlying maturities ranging from 1 to 5 years. The remaining short-term +investments as of September 25, 2004 had maturities of 3 to 12 months. 72 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial +Instruments (Continued) In accordance with EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to +Certain Investments , the following table shows gross unrealized +losses and fair value for those investments that were in an unrealized loss position +as of September 24, 2005 and September 25, 2004, aggregated by +investment category and the length of time that individual securities have been +in a continuous loss position (in millions): 2005 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and + Agencies $ 160 $ (1 ) $ 2 $ — $ 162 $ (1 ) Corporate bonds 468 (3 ) 26 — 494 (3 ) Certificate of deposits 288 — — — 288 — Asset backed + securities 60 (1 ) — — 60 (1 ) Commercial paper 4,526 (1 ) — — 4,526 (1 ) Total $ 5,502 $ (6 ) $ 28 $ — $ 5,530 $ (6 ) 2004 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and + Agencies $ 1,126 $ (4 ) $ — $ — $ 1,126 $ (4 ) Corporate bonds 134 — 144 (1 ) 278 (1 ) Certificate of + deposits 420 (1 ) — — 420 (1 ) Asset backed + securities 426 — — — 426 — Commercial paper 2,407 (1 ) — — 2,407 (1 ) Total $ 4,513 $ (6 ) $ 144 $ (1 ) $ 4,657 $ (7 ) Market values were +determined for each individual security in the investment portfolio. The +decline in value of these investments is primarily related to changes in +interest rates and is considered to be temporary in nature. Investments are +reviewed periodically to identify possible impairment. When evaluating the +investments, the Company reviews factors such as the length of time and extent +to which fair value has been below cost basis, the financial condition of the +issuer, and the Company’s ability and intent to hold the investment for a +period of time which may be sufficient for anticipated recovery in market +value. Accounts Receivable Trade Receivables The Company distributes its products through third-party +resellers and directly to certain education, consumer, and commercial +customers. The Company generally does not require collateral from its +customers. However, when possible the Company does attempt to limit credit risk +on trade receivables with credit insurance for certain customers in Latin +America, Europe, and Asia and by arranging with third-party financing companies +to provide flooring arrangements and other loan and lease programs to the +Company’s direct customers. These credit financing arrangements are directly +between the third-party financing company and the end customer. As such, the +Company generally does not assume any recourse or credit risk sharing related +to any of these arrangements. However, considerable trade receivables that 73 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial +Instruments (Continued) are not covered by collateral, third-party flooring +arrangements, or credit insurance are outstanding with the Company’s +distribution and retail channel partners. No customer accounted for more than +10% of trade receivables as of September 24, 2005 or September 25, +2004. The following table +summarizes the activity in the allowance for doubtful accounts (in millions): September 24, 2005 September 25, 2004 September 27, 2003 Beginning + allowance balance $ 47 $ 49 $ 51 Charged to costs + and expenses 8 3 4 Deductions (a) (9 ) (5 ) (6 ) Ending allowance balance $ 46 $ 47 $ 49 (a) Represents +amounts written off against the allowance, net of recoveries. Vendor Non-Trade Receivables The Company has non-trade +receivables from certain of its manufacturing vendors resulting from the sale +of raw material components to these manufacturing vendors who manufacture +sub-assemblies or assemble final products for the Company. The Company +purchases these raw material components directly from suppliers. These +non-trade receivables, which are included in the consolidated balance sheets in +other current assets, totaled $417 million and $276 million as of September 24, +2005 and September 25, 2004, respectively. The Company does not reflect +the sale of these components in net sales and does not recognize any profits on +these sales until the products are sold through to the end customer at which +time the profit is recognized as a reduction of cost of sales. Derivative Financial Instruments The Company uses derivatives to partially offset its +business exposure to foreign exchange and interest rate risk. Foreign currency +forward and option contracts are used to offset the foreign exchange risk on +certain existing assets and liabilities and to hedge the foreign exchange risk +on expected future cash flows on certain forecasted revenue and cost of sales. +From time to time, the Company enters into interest rate derivative agreements +to modify the interest rate profile of certain investments and debt. The +Company’s accounting policies for these instruments are based on whether the +instruments are designated as hedge or non-hedge instruments. The Company +records all derivatives on the balance sheet at fair value. 74 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial +Instruments (Continued) The following table shows +the notional principal, net fair value, and credit risk amounts of the Company’s +foreign currency instruments as of September 24, 2005 and September 25, +2004 (in millions): September 24, 2005 September 25, 2004 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Credit Risk Amounts Foreign exchange + instruments qualifying as accounting hedges: Spot/Forward contracts $ 662 $ 10 $ 10 $ 598 $ (3 ) $ 3 Purchased options $ 1,668 $ 17 $ 17 $ 482 $ 4 $ 4 Sold options $ 1,087 $ (5 ) $ — $ 521 $ (3 ) $ — Foreign exchange + instruments other than accounting hedges: Spot/Forward contracts $ 833 $ (3 ) $ 1 $ 609 $ 3 $ 4 Purchased options $ 115 $ — $ — $ — $ — $ — Sold options $ — $ — $ — $ — $ — $ — The notional principal amounts for derivative +instruments provide one measure of the transaction volume outstanding as of +year-end, and do not represent the amount of the Company’s exposure to credit +or market loss. The credit risk amount shown in the table above represents the +Company’s gross exposure to potential accounting loss on these transactions if +all counterparties failed to perform according to the terms of the contract, +based on then-current currency exchange rates at each respective date. +The Company’s exposure to credit loss and market risk will vary over time as a +function of currency exchange rates. The estimates of fair +value are based on applicable and commonly used pricing models and prevailing +financial market information as of September 24, 2005 and September 25, +2004. Although the table above reflects the notional principal, fair value, and +credit risk amounts of the Company’s foreign exchange instruments, it does not +reflect the gains or losses associated with the exposures and transactions that +the foreign exchange instruments are intended to hedge. The amounts ultimately +realized upon settlement of these financial instruments, together with the +gains and losses on the underlying exposures, will depend on actual market +conditions during the remaining life of the instruments. Foreign Exchange +Risk Management The Company may enter into foreign currency forward +and option contracts with financial institutions to protect against foreign +exchange risk associated with existing assets and liabilities, certain firmly +committed transactions, forecasted future cash flows, and net investments in +foreign subsidiaries. Generally, the Company’s practice is to hedge a majority +of its existing material foreign exchange transaction exposures. However, the +Company may not hedge certain foreign exchange transaction exposures due to +immateriality, prohibitive economic cost of hedging particular exposures, or +limited availability of appropriate hedging instruments. To help protect gross margins from fluctuations in +foreign currency exchange rates, the Company’s U.S. dollar functional +subsidiaries hedge a portion of forecasted foreign currency revenues, and the +Company’s non-U.S. dollar functional subsidiaries selling in local currencies +hedge a portion of forecasted inventory purchases not denominated in the +subsidiaries’ functional currency. Other comprehensive income associated with +hedges of foreign currency revenues is recognized as a component of net sales +in the same 75 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial +Instruments (Continued) period as the related sales are recognized, and other +comprehensive income related to inventory purchases is recognized as a +component of cost of sales in the same period as the related costs are +recognized. Typically, the Company hedges portions of its forecasted foreign +currency exposure associated with revenues and inventory purchases over a time +horizon of 3 to 6 months. Derivative instruments designated as cash flow hedges +must be de-designated as hedges when it is probable that the forecasted hedged +transaction will not occur in the initially identified time period or within a +subsequent 2 month time period. Deferred gains and losses in other +comprehensive income associated with such derivative instruments are immediately +reclassified into earnings in other income and expense. Any subsequent changes +in fair value of such derivative instruments are also reflected in current +earnings unless they are re-designated as hedges of other transactions. The +Company recognized net losses of $1.6 million and $2.8 million in 2005 and +2004, respectively, in other income and expense related to the loss of hedge +designation on discontinued cash flow hedges due to changes in the Company’s +forecast of future net sales and cost of sales and due to prevailing market +conditions. No net gains, or losses, of a similar nature were recorded in 2003. +As of September 24, 2005, the Company had a net deferred gain associated +with cash flow hedges of approximately $3.6 million, net of taxes, substantially +all of which is expected to be reclassified to earnings by the end of the +second quarter of fiscal 2006. The net gain or loss on the effective portion of a +derivative instrument designated as a net investment hedge is included in the +cumulative translation adjustment account of accumulated other comprehensive +income within shareholders’ equity. As of September 24, 2005 and +September 25, 2004, the Company had a net gain of $673,000 and a net loss +of $1.8 million, respectively, included in the cumulative translation +adjustment. The Company may also enter +into foreign currency forward and option contracts to offset the foreign +exchange gains and losses generated by the re-measurement of certain assets and +liabilities recorded in non-functional currencies. Changes in the fair value of +these derivatives are recognized in current earnings in other income and +expense as offsets to the changes in the fair value of the related assets or +liabilities. Due to currency market movements, changes in option time value can +lead to increased volatility in other income and expense. Interest Rate Risk +Management From time to time, the Company historically entered +into interest rate derivative transactions with financial institutions in order +to better match the Company’s floating-rate interest income on its cash +equivalents and short-term investments with its fixed-rate interest expense on +any outstanding long-term debt, and/or to diversify a portion of the Company’s +exposure away from fluctuations in short-term U.S. interest rates. During 2001 and 2002, the Company entered into and +then subsequently terminated various interest rate debt swap agreements +generating a realized gain of $23 million. These gains were deferred and +amortized over the remaining life of the underlying debt, which matured and was +repaid in February 2004. As of September 24, +2005 and September 25, 2004, the Company had no interest rate derivatives +outstanding. 76 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial Instruments (Continued) Non-Current +Debt and Equity Investments and Related Gains and Losses The Company previously +held significant investments in ARM Holdings plc (ARM), Akamai Technologies, Inc. (Akamai), and EarthLink Network, Inc. +(EarthLink). T he Company sold all of the remaining holdings in these +non-current investments in 2004 and 2003. Pretax gains recorded upon the sale +of these non-current investments were $4 million and $10 million in 2004 and +2003, respectively. Note 3—Consolidated Financial Statement Details (in +millions) Other Current Assets 2005 2004 Vendor non-trade + receivables $ 417 $ 276 Other current + assets 231 209 Total other current + assets $ 648 $ 485 Property, Plant, +and Equipment 2005 2004 Land and + buildings $ 361 $ 351 Machinery, + equipment, and internal-use software 494 422 Office furniture + and equipment 81 79 Leasehold + improvements 545 446 1,481 1,298 Accumulated + depreciation and amortization (664 ) (591 ) Net property, plant, and + equipment $ 817 $ 707 Other Assets 2005 2004 Non-current + deferred tax assets $ 183 $ 86 Capitalized + software development costs, net 38 25 Other assets 117 80 Total other assets $ 338 $ 191 Accrued Expenses 2005 2004 Deferred revenue—current $ 501 $ 342 Accrued marketing + and distribution 221 147 Accrued + compensation and employee benefits 167 134 Accrued warranty + and related costs 188 105 Other current + liabilities 628 472 Total accrued expenses $ 1,705 $ 1,200 77 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Consolidated +Financial Statement Details (in millions) (Continued) Non-current +Liabilities 2005 2004 Deferred revenue—non-current $ 281 $ 202 Deferred tax + liabilities 308 113 Other non-current + liabilities 12 8 Total non-current + liabilities $ 601 $ 323 Interest and Other +Income, net 2005 2004 2003 Interest income $ 183 $ 64 $ 69 Interest expense — (3 ) (8 ) Gains on sales of + short term investments — 1 21 Other income + (expense), net (18 ) (9 ) 1 Total interest and other + income, net $ 165 $ 53 $ 83 Note 4—Goodwill and Other intangible Assets The Company is currently amortizing its acquired +intangible assets with definite lives over periods ranging from 3 to 10 years. The +following table summarizes the components of gross and net intangible asset +balances (in millions): September 24, 2005 September 25, 2004 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Goodwill $ 69 $ — $ 69 $ 80 $ — $ 80 Other acquired + intangible assets 5 (5 ) — 5 (5 ) — Acquired + technology 61 (34 ) 27 42 (25 ) 17 Total acquired + intangible assets $ 135 $ (39 ) $ 96 $ 127 $ (30 ) $ 97 During the fourth quarter of 2005, the Company +recorded an adjustment of approximately $11 million to goodwill relating to a +reduction of valuation allowances that were recorded at the time certain net +operating loss carryforwards (NOLs) were acquired in previous business +combinations. During the fourth quarter of 2005, these NOLs were deemed to be +more likely than not to be realized and accordingly the valuation allowances +were reversed against the related goodwill that was recognized at the time of +the acquisitions. During the third quarter of 2004, the Company recorded +an adjustment of approximately $5 million to goodwill related to the +acquisition of PowerSchool, Inc. (PowerSchool) in 2001. This reduction of +goodwill included the cancellation of 158,334 shares of the Company’s common stock, +valued at approximately $2 million, that were previously held in escrow +and were refunded upon resolution of certain matters arising out of the +acquisition of PowerSchool. This adjustment also included approximately $3 +million to adjust the original estimates of the pre-acquisition PowerSchool +restructuring liability to actual costs incurred. 78 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 4—Goodwill +and Other intangible Assets (Continued) Expected annual +amortization expense related to acquired technology is as follows (in +millions): Fiscal Years: 2006 $ 10 2007 8 2008 5 2009 1 2010 1 Thereafter 2 Total expected annual + amortization expense $ 27 Amortization expense +related to acquired intangible assets was $9 million, $7 million, and $10 +million in 2005, 2004, and 2003, respectively. Note 5—Restructuring Charges Fiscal 2004 +Restructuring Actions The Company recorded total restructuring charges of +approximately $23 million during the year ended September 25, 2004, +including approximately $14 million in severance costs, $5.5 million in asset +impairments, and a $3.5 million charge for lease cancellations in conjunction +with the vacating of a leased sales facility related to a European workforce +reduction during the fourth quarter of 2004. Of the $23 million charge, +$19.7 million had been utilized by the end of 2005, with the remaining $3.3 +million consisting of $0.7 million for employee severance benefits and $2.6 +million for lease cancellations. These actions will result in the termination +of 461 employees, 448 of which had been terminated prior to the end of 2005. The +following table summarizes activity associated with restructuring actions +initiated during 2004 (in millions): Employee Severance Asset Lease Benefits Impairments Cancellations Totals Total charge $ 14.0 $ 5.5 $ 3.5 $ 23.0 Total spending + through September 24, 2005 (12.4 ) — (0.9 ) (13.3 ) Total non-cash + items — (5.2 ) — (5.2 ) Adjustments (0.9 ) (0.3 ) — (1.2 ) Accrual at + September 24, 2005 $ 0.7 $ — $ 2.6 $ 3.3 Fiscal 2003 +Restructuring Actions The Company recorded total restructuring charges of +approximately $26.8 million during the year ended September 27, 2003, +including approximately $7.4 million in severance costs, a $5.0 million charge +to write-off deferred compensation, $7.1 million in asset impairments, +and a $7.3 million charge for lease cancellations primarily related to the +closure of the Company’s Singapore manufacturing operations during the first +quarter of 2003. Of the $26.8 million charge, all had been utilized by the end +of 2005, except for approximately $1.7 million related to operating lease costs +on abandoned facilities. During the third quarter of 2003, approximately +$500,000 of the amount originally accrued for lease cancellations was +determined to be in excess due to the sublease of a property sooner than originally +expected and a shortfall 79 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 5—Restructuring +Charges (Continued) of approximately $500,000 was identified in the severance +accrual due to higher than expected severance costs related to the closure of +the Company’s Singapore manufacturing operations. These adjustments had no net +effect on reported operating expense. These actions resulted in the termination +of 353 employees. The +following table summarizes activity associated with restructuring actions +initiated during 2003 (in millions): Employee Deferred Severance Compensation Asset Lease Benefits Write-off Impairments Cancellations Totals Total charge $ 7.4 $ 5.0 $ 7.1 $ 7.3 $ 26.8 Total spending + through September 24, 2005 (7.9 ) — — (5.1 ) (13.0 ) Total non-cash + items — (5.0 ) (7.1 ) — (12.1 ) Adjustments 0.5 — — (0.5 ) — Accrual at September 24, + 2005 $ — $ — $ — $ 1.7 $ 1.7 Note 6—Income Taxes The +provision for income taxes consisted of the following (in millions): 2005 2004 2003 Federal: Current $ 303 $ 34 $ 18 Deferred 146 56 (7 ) 449 90 11 State: Current 66 5 4 Deferred (91 ) (18 ) (11 ) (25 ) (13 ) (7 ) Foreign: Current 59 46 21 Deferred (3 ) (16 ) (1 ) 56 30 20 Provision for income + taxes $ 480 $ 107 $ 24 The foreign provision for income taxes is based on +foreign pretax earnings of approximately $922 million, $384 million, and $250 +million in 2005, 2004, and 2003, respectively. As of September 24, 2005, +approximately $4.3 billion of the Company’s cash, cash equivalents, and short-term +investments were held by foreign subsidiaries and are generally based in U.S. +dollar-denominated holdings. Amounts held by foreign subsidiaries are +generally subject to U.S. income taxation on repatriation to the U.S. The +Company’s consolidated financial statements fully provide for any related tax +liability on amounts that may be repatriated, aside from undistributed earnings +of certain of the Company’s foreign subsidiaries that are intended to be +indefinitely reinvested in operations outside the U.S. U.S. income taxes have +not been provided on a cumulative total of $1.2 billion of such earnings. It is +not practicable to determine the income tax liability that might be incurred if +these earnings were to be distributed. 80 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Income +Taxes (Continued) On October 22, 2004, the American Jobs Creation +Act (AJCA) was signed into law. The AJCA includes a provision for the deduction +of 85% of certain foreign earnings that are repatriated, as defined in the +AJCA. The legislation provided the Company with the option to apply this +provision to repatriations of qualifying earnings in either 2005 or 2006. The +Company is continuing to evaluate the effects of the repatriation provision and +expects to complete the evaluation in 2006. A maximum of $755 million may be +eligible for repatriation under the reduced tax rate provided by AJCA. However, +given the uncertainties and complexities of the repatriation provision and the +Company’s continuing evaluation, the Company has not yet determined the amount +that may be repatriated or the related potential income tax effects of such +repatriation. Deferred tax assets and liabilities reflect the +effects of tax losses, credits, and the future income tax effects of temporary +differences between the consolidated financial statement carrying amounts of +existing assets and liabilities and their respective tax bases and are measured +using enacted tax rates that apply to taxable income in the years in which +those temporary differences are expected to be recovered or settled. As of September 24, +2005 and September 25, 2004, the significant components of the Company’s +deferred tax assets and liabilities were (in millions): 2005 2004 Deferred tax assets: Accrued liabilities and other reserves $ 321 $ 195 Tax losses and credits 305 329 Basis of capital assets and investments 96 65 Accounts receivable and inventory reserves 36 32 Other 9 26 Total deferred tax assets 767 647 Less valuation + allowance 5 30 Net deferred tax + assets 762 617 Deferred tax + liabilities: Unremitted earnings of subsidiaries 557 413 Total deferred tax liabilities 557 413 Net deferred tax asset $ 205 $ 204 As of September 24, 2005, the Company had +operating loss carryforwards for federal tax purposes of approximately +$62 million, which expire from 2011 through 2024. A portion of these +carryforwards was acquired from the Company’s previous acquisitions, the +utilization of which is subject to certain limitations imposed by the Internal +Revenue Code. The Company also has Federal credit carryforwards and various +state and foreign tax loss and credit carryforwards, the tax effect of which is +approximately $206 million and which expire between 2010 and 2025. The +remaining benefits from tax losses and credits do not expire. As of September 24, +2005 and September 25, 2004, a valuation allowance of $5 million and $30 +million, respectively, was recorded against the deferred tax asset for the +benefits of tax losses that may not be realized. The remaining valuation +allowance relates principally to the state operating losses. Management +believes it is more likely than not that forecasted income, including income +that may be generated as a result of certain tax planning strategies, together +with the tax effects of the deferred tax liabilities, will be sufficient to +fully recover the remaining deferred tax assets. 81 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Income +Taxes (Continued) A reconciliation of the +provision for income taxes, with the amount computed by applying the statutory +federal income tax rate (35% in 2005, 2004, and 2003) to income before +provision for income taxes, is as follows (in millions): 2005 2004 2003 Computed expected + tax $ 636 $ 134 $ 32 State taxes, net + of federal effect (19 ) (5 ) (4 ) Indefinitely + invested earnings of foreign subsidiaries (98 ) (31 ) (13 ) Nondeductible + executive compensation 11 10 5 Research and + development credit, net (26 ) (5 ) (7 ) Other items (24 ) 4 11 Provision for + income taxes $ 480 $ 107 $ 24 Effective tax rate 26 % 28 % 26 % During 2005, the Company reversed certain tax +contingency reserves and recorded a corresponding benefit to income tax expense +primarily as a result of a change in the estimated outcome of certain tax +disputes. Additionally, during the fourth quarter of 2005, the Company recorded +a benefit to tax expense to adjust its net deferred tax assets as a result of +the Company’s year-end review of its deferred tax accounts, the impact of which +was not material to the current or prior periods’ results of operations. The +total benefit to income tax expense from the reversal of these tax contingency +reserves and adjustments to net deferred tax assets was $67 million. The +Company also recorded a $14 million credit to income tax expense resulting from +a reduction of the valuation allowance. The Internal Revenue +Service (IRS) has completed its field audit of the Company’s federal income tax +returns for all years prior to 2002 and proposed certain adjustments. Certain +of these adjustments are being contested through the IRS Appeals Office. Substantially +all IRS audit issues for these years have been resolved. In addition, the +Company is also subject to audits by state, local, and foreign tax authorities. +Management believes that adequate provisions have been made for any adjustments +that may result from tax examinations. However, the outcome of tax audits +cannot be predicted with certainty. Should any issues addressed in the Company’s +tax audits be resolved in a manner not consistent with management’s +expectations, the Company could be required to adjust its provision for income +tax in the period such resolution occurs. Note 7—Shareholders’ Equity Preferred Stock The Company has 5 million shares of authorized +preferred stock, none of which is outstanding. Under the terms of the Company’s +Restated Articles of Incorporation, the Board of Directors is authorized to +determine or alter the rights, preferences, privileges and restrictions of the +Company’s authorized but unissued shares of preferred stock. 82 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7—Shareholders’ +Equity (Continued) Restricted Stock Units During 2005 and 2004, the +Company’s Board of Directors approved the grant of 230,000 and 5.03 million +restricted stock units, respectively, to members of the Company’s senior +management team, excluding its CEO. These restricted stock units generally vest +over four years either in two equal installments on the second and fourth +anniversaries of the date of grant or in equal installments on each of the +first through fourth anniversaries of the grant date. Upon vesting, the +restricted stock units will convert into an equivalent number of shares of +common stock. The Company has recorded $10.3 million and $64.4 million in 2005 +and 2004, respectively, in value for these restricted stock units as a component +of shareholders’ equity and is amortizing the amounts on a straight-line basis +over the four-year requisite service period. The value of the restricted stock +units was based on the closing market price of the Company’s common stock on +the date of grant. The restricted stock units have been included in the +calculation of diluted earnings per share utilizing the treasury stock method. CEO Restricted Stock Award On March 19, 2003, the Company entered into an +Option Cancellation and Restricted Stock Award Agreement (the Agreement) with Mr. Steven +P. Jobs, its CEO. The Agreement cancelled stock option awards for the purchase +of 55 million shares of the Company’s common stock previously granted to Mr. Jobs +in 2000 and 2001. Mr. Jobs retained options to purchase 120,000 shares of +the Company’s common stock granted in August of 1997 in his capacity as a +member of the Company’s Board of Directors, prior to becoming the Company’s CEO. +The Agreement replaced the cancelled options with a restricted stock award of 10 +million shares of the Company’s common stock. The restricted stock award +generally vests three years from the date of grant. Vesting of some or all of +the restricted shares will be accelerated in the event Mr. Jobs is +terminated without cause, dies, or has his management role reduced following a +change in control of the Company. The Company determined the +value of the restricted stock award in accordance with APB Opinion No. 25 +and has recorded the value as deferred stock compensation as a component of shareholders’ +equity and is amortizing that amount on a straight-line basis over the 3 year +service period. The value of the restricted stock award was based on the +closing market price of the Company’s common stock on the date of the award. +The 10 million restricted shares have been included in the calculation of +diluted earnings per share utilizing the treasury stock method. Stock Repurchase Plan In July 1999, the Company’s Board of Directors +authorized a plan for the Company to repurchase up to $500 million of its +common stock. This repurchase plan does not obligate the Company to acquire any +specific number of shares or acquire shares over any specified period of time. During the fourth quarter +of 2001, the Company entered into a forward purchase agreement to acquire +3.1 million shares of its common stock in September of 2003 at an +average price of $8.32 per share for a total cost of $25.5 million. In August 2003, +the Company settled this agreement prior to its maturity, at which time the +Company’s common stock had a fair value of $11.41. Other than this forward +purchase transaction, the Company has not engaged in any transactions to +repurchase its common stock since 2000. Since inception of the stock repurchase +plan, the Company had repurchased a total of 13.1 million shares at a cost of +$217 million. The Company was authorized to repurchase up to an additional $283 +million of its common stock as of September 24, 2005. 83 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7—Shareholders’ +Equity (Continued) Comprehensive Income Comprehensive income consists of two components, net +income and other comprehensive income. Other comprehensive income refers to +revenue, expenses, gains and losses that under U.S. generally accepted +accounting principles are recorded as an element of shareholders’ equity but +are excluded from net income. The Company’s other comprehensive income consists +of foreign currency translation adjustments from those subsidiaries not using +the U.S. dollar as their functional currency, unrealized gains and losses on +marketable securities categorized as available-for-sale, and net deferred gains +and losses on certain derivative instruments accounted for as cash flow hedges. The +following table summarizes the components of accumulated other comprehensive +income (loss), net of taxes (in millions): 2005 2004 2003 Unrealized + gains/(losses) on available-for-sale securities $ (4 ) $ (4 ) $ 1 Unrealized + gains/(losses) on derivative investments 4 (4 ) (16 ) Cumulative + foreign currency translation — (7 ) (20 ) Accumulated other + comprehensive income/(loss) $ — $ (15 ) $ (35 ) The +following table summarizes activity in other comprehensive income related to +available-for-sale securities, net of taxes (in millions): 2005 2004 2003 Change in fair + value of available-for-sale securities $ — $ (1 ) $ 11 Adjustment for + net gains realized and included in net income — (4 ) (23 ) Change in unrealized + gain/loss on available-for-sale securities $ — $ (5 ) $ (12 ) The tax effect related to the change in unrealized +gain on available-for-sale securities was $4 million and $6 million for +2004 and 2003, respectively. The tax effect on the reclassification adjustment +for net gains/losses included in net income was $1 million and $(8) million +for 2004 and 2003, respectively. The +following table summarizes activity in other comprehensive income related to +derivatives, net of taxes, held by the Company (in millions): 2005 2004 2003 Changes in fair + value of derivatives $ 7 $ (21 ) $ (24 ) Adjustment for + net gains realized and included in net income 1 33 19 Change in unrealized + gain/loss on derivative instruments $ 8 $ 12 $ (5 ) The tax effect related to +the changes in fair value of derivatives was $(3) million, $10 million, +and $11 million for 2005, 2004, and 2003, respectively. The tax effect +related to derivative gains/losses reclassified from other comprehensive income +to net income was $(2) million, $(13) million, and $(7) million for +2005, 2004, and 2003, respectively. 84 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock +Plan (the 2003 Plan) is a shareholder approved plan that provides for broad-based +grants to employees, including executive officers. Based on the terms of +individual option grants, options granted under the 2003 Plan generally expire +7 to 10 years after the grant date and generally become exercisable over a +period of 4 years, based on continued employment, with either annual or +quarterly vesting. The 2003 Plan permits the granting of incentive stock +options, nonstatutory stock options, restricted stock units, stock appreciation +rights, and stock purchase rights. 1997 Employee Stock Option Plan In August 1997, the +Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the +1997 Plan), a non-shareholder approved plan for grants of stock options to +employees who are not officers of the Company. Based on the terms of individual +option grants, options granted under the 1997 Plan generally expire 7 to 10 +years after the grant date and generally become exercisable over a period of +4 years, based on continued employment, with either annual or quarterly +vesting. In October 2003, the Company terminated the 1997 Employee Stock +Option Plan and cancelled all remaining unissued shares totaling 28,590,702.  No new options can be granted from the 1997 +Plan. Employee Stock Option Exchange Program On March 20, 2003, +the Company announced a voluntary employee stock option exchange program (the +Exchange Program) whereby eligible employees, other than executive officers and +members of the Board of Directors, had an opportunity to exchange outstanding +options with exercise prices at or above $12.50 per share for a +predetermined smaller number of new stock options issued with exercise prices +equal to the fair market value of one share of the Company’s common stock on +the day the new awards were issued, which was to be at least six months plus +one day after the exchange options were cancelled. On April 17, 2003, in accordance +with the Exchange Program, the Company cancelled options to purchase 33,138,386 +shares of its common stock. On October 22, 2003, new stock options +totaling 13,394,736 shares were issued to employees at an exercise price of +$11.38 per share, which is equivalent to the closing price of the Company’s +stock on that date. No financial or accounting impact to the Company’s +financial position, results of operations or cash flow was associated with this +transaction. 1997 Director Stock Option Plan In August 1997, the +Company’s Board of Directors adopted a shareholder approved Director Stock +Option Plan (DSOP) for non-employee directors of the Company. Initial grants of +30,000 options under the DSOP vest in three equal installments on each of the +first through third anniversaries of the date of grant, and subsequent annual +grants of 10,000 options are fully vested at grant. Rule 10b5-1 Trading Plans Certain of the Company’s +executive officers, including Mr. Timothy D. Cook, Mr. Peter +Oppenheimer, Mr. Jonathan Rubinstein, Mr. Philip W. Schiller, Dr. Bertrand +Serlet, and Dr. Avadis Tevanian, Jr., have entered into trading plans +pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of +1934, as amended. A trading plan is a written document that pre-establishes the +amounts, prices and dates (or formula for determining the amounts, prices and +dates) of future purchases or sales of the Company’s stock including the +exercise and sale of employee stock options and shares acquired pursuant to the +Company’s employee stock purchase plan and upon vesting of restricted stock +units. 85 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Employee +Benefit Plans (Continued) Employee Stock Purchase Plan The Company has a +shareholder approved employee stock purchase plan (the Purchase Plan), under +which substantially all employees may purchase common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values as of +the beginning and end of six month offering periods. Stock purchases under the +Purchase Plan are limited to 10% of an employee’s compensation, up to a maximum +of $25,000 in any calendar year. Beginning with the six-month offering period +that started on June 30, 2003, the number of shares authorized for +issuance is limited to a total of 1 million shares per offering period. During +2005, 2004, and 2003, adjusted for the February 2005 stock split 2.3 +million, 3.9 million, and 4.3 million shares, respectively, were issued under +the Purchase Plan. As of September 24, 2005, approximately 3.8 million +shares were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an +employee savings plan (the Savings Plan) qualifying as a deferred salary +arrangement under Section 401(k) of the Internal Revenue Code. Under +the Savings Plan, participating U.S. employees may defer a portion of their +pre-tax earnings, up to the Internal Revenue Service annual contribution limit +($14,000 for calendar year 2005). The Company matches 50% to 100% of each +employee’s contributions, depending on length of service, up to a maximum 6% of +the employee’s earnings. The Company’s matching contributions to the Savings +Plan were approximately $28 million, $24 million, and $21 million in 2005, +2004, and 2003, respectively. 86 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Employee +Benefit Plans (Continued) Stock Option Activity A +summary of the Company’s stock option activity and related information for the +last three fiscal years follows (share amounts are presented in thousands): Shares Outstanding Options Available Number of Weighted Average for Grant Shares Exercise Price Balance at + September 28, 2002 13,142 218,860 $ 14.09 Restricted Stock + Granted (10,000 ) — — Options Granted (8,358 ) 8,358 $ 8.19 Options Cancelled 96,886 (96,886 ) $ 19.80 Options Exercised — (4,308 ) $ 7.02 Plan Shares + Expired (10 ) — — Balance at September 27, 2003 91,660 126,024 $ 9.54 Restricted Stock + Units Granted (5,030 ) — — Options Granted (36,394 ) 36,394 $ 11.48 Options Cancelled 6,010 (6,010 ) $ 10.35 Options Exercised — (45,686 ) $ 8.60 Plan Shares + Expired (32,196 ) — — Balance at September 25, 2004 24,050 110,722 $ 10.52 Additional + Options Authorized 49,000 — — Restricted Stock + Units Granted (460 ) — — Options Granted (16,214 ) 16,214 $ 42.52 Options Cancelled 3,844 (3,844 ) $ 13.28 Restricted Stock Units + Cancelled 230 — — Options Exercised — (49,871 ) $ 10.05 Plan Shares + Expired (1,493 ) — — Balance at + September 24, 2005 58,957 73,221 $ 17.79 In conjunction with the amendments to the 2003 Plan +that were approved at the Annual Meeting of Shareholders held on April 21, +2005, the number of shares available for grant under the 2003 Plan will be +reduced by two times the number of restricted shares and restricted stock units +granted. This amendment is effective for all grants made after April 21, +2005. 87 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Employee +Benefit Plans (Continued) The options outstanding as +of September 24, 2005 have been segregated into eight ranges for +additional disclosure as follows (option amounts are presented in thousands): Options Outstanding Options Exercisable Options Outstanding as of September 24, 2005 Weighted- Average Remaining Contractual Life in Years Weighted Average Exercise Price Options Exercisable as of September 24, 2005 Weighted Average Exercise Price $0.62-$9.13 10,092 4.29 $ 7.33 8,310 $ 7.26 $9.14-$10.20 14,954 5.65 $ 9.76 13,516 $ 9.73 $10.21-$10.80 2,284 5.19 $ 10.31 996 $ 10.37 $10.81-$10.90 11,726 5.36 $ 10.89 2,858 $ 10.89 $10.91-$11.38 9,151 5.10 $ 11.37 2,920 $ 11.37 $11.39-$23.72 9,622 5.39 $ 16.52 5,797 $ 17.50 $23.73-$46.10 4,791 6.38 $ 36.04 406 $ 31.62 $46.11-$49.87 10,601 6.94 $ 46.75 — $ — $0.62-$49.87 73,221 5.53 $ 17.79 34,803 $ 10.94 As of September 25, 2004, the Company had +exercisable options outstanding to purchase 60.0 million shares with a weighted +average exercise price of $10.30 per share. As of September 27, 2003, the +Company had exercisable options outstanding to purchase 77.5 million shares +with a weighted average exercise price of $9.38 per share. The Company had 5.03 +million restricted stock units outstanding as of September 24, 2005, which +were excluded from the options outstanding balances in the preceding tables. +None of these restricted stock units was vested as of September 24, 2005. +These restricted stock units have been deducted from the shares available for grant +under the Company’s stock option plans. Note 9—Stock-Based +Compensation The Company has provided pro forma disclosures in Note +1 of these Notes to Consolidated Financial Statements of the effect on net +income and earnings per share as if the fair value method of accounting for +stock compensation had been used for its employee stock option grants and +employee stock purchase plan purchases. These pro forma effects have been +estimated at the date of grant and beginning of the period, respectively, using +the Black-Scholes option pricing model. For purposes of the pro forma disclosures provided +pursuant to SFAS No. 123, the option awards issued in October 2003 +and the awards cancelled as part of the Employee Stock Option Exchange Program +have been accounted for using modification accounting. In accordance with SFAS +No. 123, the grant date of the awards issued is the date of acceptance of +the exchange offer by participating employees. The cancellation of certain of +the Company’s CEO’s options and replacement with restricted shares in +March 2003 is also being accounted for using modification accounting for +purposes of the pro forma disclosures provided pursuant to SFAS No. 123. 88 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9—Stock-Based +Compensation (Continued) The +assumptions used for each of the last three fiscal years and the resulting +estimate of weighted-average fair value per share of options granted +during those years are as follows: 2005 2004 2003 Expected life of + stock options 3.5 - 3.6 years 3.5 years 3.5 - 4 years Expected life of + stock purchases 6 months 6 months 6 months Interest rate—stock + options 3.13% - 3.88 % 2.33% - 3.15 % 2.14% - 2.45 % Interest rate—stock + purchases 1.67% - 3.30 % 0.96% - 1.67 % 1.10% - 1.77 % Volatility—stock + options 39% - 40 % 40 % 40% - 63 % Volatility—stock + purchases 32% - 48 % 32% - 44 % 35% - 44 % Dividend yields — — — Weighted-average + fair value of options granted during the year $ 14.41 $ 3.69 $ 3.32 Weighted-average fair + value of stock purchases during the year $ 7.55 $ 2.78 $ 2.12 For purposes of the pro +forma disclosures provided pursuant to SFAS No. 123, the expected +volatility assumptions used by the Company are based on the historical +volatility of the Company’s common stock over the most recent period +commensurate with the estimated expected life of the Company’s stock options +and other relevant factors including implied volatility in market traded +options on the Company’s common stock and the impact of unusual fluctuations +not reasonably expected to recur on the historical volatility of the Company’s +common stock. The Company bases its expected life assumption on its historical +experience and on the terms and conditions of the stock options it grants to +employees. Note 10—Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, +including retail space, under noncancelable operating lease arrangements. The +Company does not currently utilize any other off-balance-sheet financing +arrangements. The major facility leases are for terms of 5 to 15 years and +generally provide renewal options for terms of 3 to 5 additional years. Leases +for retail space are for terms of 5 to 20 years, the majority of which are for +10 years, and often contain multi-year renewal options. As of September 24, +2005, the Company’s total future minimum lease payments under noncancelable +operating leases were $865 million, of which $606 million related to leases for +retail space. 89 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10—Commitments +and Contingencies (Continued) Rent expense under all +operating leases, including both cancelable and noncancelable leases, was $140 +million, $103 million, and $97 million in 2005, 2004, and 2003, +respectively. Future minimum lease payments under noncancelable operating +leases having remaining terms in excess of one year as of September 24, +2005, are as follows (in millions): Fiscal Years 2006 $ 108 2007 110 2008 101 2009 97 2010 95 Later years 354 Total minimum lease + payments $ 865 Accrued +Warranty and Indemnifications The Company offers a basic limited parts and labor +warranty on its hardware products. The basic warranty period for hardware products +is typically one year from the date of purchase by the end-user. The Company +also offers a 90-day basic warranty for its service parts used to repair +the Company’s hardware products. The Company provides currently for the +estimated cost that may be incurred under its basic limited product warranties +at the time related revenue is recognized. Factors considered in determining +appropriate accruals for product warranty obligations include the size of the +installed base of products subject to warranty protection, historical and +projected warranty claim rates, historical and projected cost-per-claim, and +knowledge of specific product failures that are outside of the Company’s +typical experience. The Company assesses the adequacy of its preexisting +warranty liabilities and adjusts the amounts as necessary based on actual +experience and changes in future estimates. The +following table reconciles changes in the Company’s accrued warranties and +related costs (in millions): 2005 2004 2003 Beginning accrued + warranty and related costs $ 105 $ 67 $ 69 Cost of warranty + claims (188 ) (105 ) (71 ) Accruals for + product warranties 271 143 69 Ending accrued warranty + and related costs $ 188 $ 105 $ 67 The Company generally does +not indemnify end-users of its operating system and application software +against legal claims that the software infringes third-party intellectual +property rights. Other agreements entered into by the Company sometimes include +indemnification provisions under which the Company could be subject to costs +and/or damages in the event of an infringement claim against the Company or an +indemnified third-party. However, the Company has not been required to make any +significant payments resulting from such an infringement claim asserted against +itself or an indemnified third-party and, in the opinion of management, does +not have a potential liability related to unresolved infringement claims +subject to indemnification that would have a material adverse effect on its +financial condition, liquidity or results of operations. Therefore, the Company +did not record a liability for infringement costs as of either September 24, +2005 or September 25, 2004. 90 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10—Commitments and Contingencies (Continued) Concentrations in +the Available Sources of Supply of Materials and Product Although most components +essential to the Company’s business are generally available from multiple +sources, other key components (including microprocessors and application-specific +integrated circuits (“ASICs”)) are currently obtained by the Company from +single or limited sources. Some other key components, while currently available +to the Company from multiple sources, are at times subject to industry-wide +availability and pricing pressures. In addition, the Company uses some +components that are not common to the rest of the personal computer industry, +and new products introduced by the Company often initially utilize custom +components obtained from only one source until the Company has evaluated +whether there is a need for and subsequently qualifies additional suppliers. If +the supply of a key single-sourced component to the Company were to be +delayed or curtailed, or in the event a key manufacturing vendor delays +shipments of completed products to the Company, the Company’s ability to ship +related products in desired quantities and in a timely manner could be +adversely affected. The Company’s business and financial performance could also +be adversely affected depending on the time required to obtain sufficient +quantities from the original source, or to identify and obtain sufficient +quantities from an alternative source. Continued availability of these +components may be affected if producers were to decide to concentrate on the +production of common components instead of components customized to meet the +Company’s requirements. Finally, significant portions of the Company’s CPUs, +logic boards, and assembled products are now manufactured by outsourcing +partners, primarily in various parts of Asia. Although the Company works +closely with its outsourcing partners on manufacturing schedules, the Company’s +operating results could be adversely affected if its outsourcing partners were +unable to meet their production obligations. Long-Term Supply Agreements Subsequent to September 24, +2005, the Company entered into long-term supply agreements with Hynix +Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., +Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND +flash memory through calendar year 2010. As part of these agreements, the +Company intends to prepay a total of $1.25 billion for flash memory components +by the end of the second quarter of 2006. Contingencies The Company is subject to +certain other legal proceedings and claims that have arisen in the ordinary +course of business and have not been fully adjudicated. In the opinion of +management, the Company does not have a potential liability related to any +current legal proceedings and claims that would individually or in the +aggregate have a material adverse effect on its financial condition, liquidity, +or results of operations. However, the results of legal proceedings cannot be +predicted with certainty. Should the Company fail to prevail in any of these +legal matters or should several of these legal matters be resolved against the +Company in the same reporting period, the operating results of a particular +reporting period could be materially adversely affected. Production and marketing +of products in certain states and countries may subject the Company to +environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of +its useful life, and place responsibility for environmentally safe disposal or +recycling with the Company. Such laws and regulations have recently been passed +in several jurisdictions in which the Company operates including various +European Union member countries, Japan and certain states within the U.S. Although +the Company does not anticipate any material adverse effects in the future +based on the nature of its operations and the thrust of such laws, there is no +assurance that 91 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10—Commitments +and Contingencies (Continued) such existing laws or +future laws will not have a material adverse effect on the Company’s financial +condition, liquidity, or results of operations. Note 11—Segment Information and Geographic Data In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , +the Company reports segment information based on the “management” approach. The +management approach designates the internal reporting used by management for +making decisions and assessing performance as the source of the Company’s +reportable segments. The Company manages its business primarily on a +geographic basis. The Company’s reportable operating segments are comprised of +the Americas, Europe, Japan, and Retail. The Americas, Europe, and Japan +reportable segments do not include activities related to the Retail segment. The +Americas segment includes both North and South America. The Europe segment +includes European countries as well as the Middle East and Africa. The Retail +segment operates Apple-owned retail stores in the U.S., Canada, Japan, and the +U.K. Other operating segments include Asia-Pacific, which includes Australia +and Asia except for Japan, and the Company’s subsidiary, FileMaker, Inc. Each +reportable geographic operating segment provides similar hardware and software +products and similar services, and the accounting policies of the various +segments are the same as those described in Note 1, “Summary of Significant +Accounting Policies,” except as described below for the Retail segment. The Company evaluates the performance of its operating +segments based on net sales. The Retail segment’s performance is also evaluated +based on operating income. Net sales for geographic segments are generally +based on the location of the customers. Operating income for each segment +includes net sales to third parties, related cost of sales, and operating +expenses directly attributable to the segment. Operating income for each +segment excludes other income and expense and certain expenses that are managed +outside the operating segments. Costs excluded from segment operating income +include various corporate expenses, manufacturing costs and variances not +included in standard costs, income taxes, and various nonrecurring charges. +Corporate expenses include research and development, corporate marketing +expenses, manufacturing costs and variances not included in standard costs, and +other separately managed general and administrative expenses including certain +corporate expenses associated with support of the Retail segment. The Company +does not include intercompany transfers between segments for management +reporting purposes. Segment assets exclude corporate assets. Corporate assets +include cash, short-term and long-term investments, manufacturing facilities, miscellaneous +corporate infrastructure, goodwill and other acquired intangible assets, and +retail store construction-in-progress that is not subject to depreciation. +Except for the Retail segment, capital expenditures for long-lived assets are +not reported to management by segment. Capital expenditures by the Retail +segment were $132 million, $104 million, and $92 million for 2005, 2004, and +2003 respectively. Operating income for all segments, except Retail, +includes cost of sales at manufacturing standard cost, other cost of sales, +related sales and marketing costs, and certain general and administrative +costs. This measure of operating income, which includes manufacturing profit, +provides a comparable basis for comparison between the Company’s various geographic +segments. Certain manufacturing expenses and related adjustments not included +in segment cost of sales, including variances between standard and actual +manufacturing costs and the mark-up above standard cost for product supplied to +the Retail segment, are included in corporate expenses. 92 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) Management assesses the operating performance of the +Retail segment differently than it assesses the operating performance of the +Company’s geographic segments. The Retail segment revenue and operating income +is intended to depict a measure comparable to that of the Company’s major +channel partners in the U.S. operating retail stores so the Company can +evaluate the Retail segment performance as if it were a channel partner. +Therefore, the Company makes three significant adjustments to the Retail +segment for management reporting purposes that are not included in the results +of the Company’s other segments. First, the Retail segment’s operating income includes +cost of sales for Apple products at an amount normally charged to major channel +partners in the U.S. operating retail stores, less the cost of sales programs +and incentives provided to those channel partners and the Company’s cost to +support those partners. For the years ended September 24, 2005, September 25, +2004, and September 27, 2003, this resulted in the recognition of +additional cost of sales above standard cost by the Retail segment and an +offsetting benefit to corporate expenses of approximately $435 million, $213 +million, and $106 million, respectively. Second, the Company’s service and support contracts +are transferred to the Retail segment at the same cost as that charged to the +Company’s major retail channel partners in the U.S., resulting in a measure of +revenue and gross margin for those items that is comparable between the Company’s +Retail stores and those retail channel partners. The Retail segment recognizes +the full amount of revenue and cost of sales of the Company’s service and +support contracts at the time of sale. Because the Company has not yet earned +the revenue or incurred the costs associated with the sale of these contracts, +an offset to these amounts is recognized in other operating segments’ net sales +and cost of sales. For the year ended September 24, 2005, this resulted in +the recognition of net sales and cost of sales by the Retail segment, with +corresponding offsets in other operating segments, of $92 million and $64 +million, respectively. For the year ended September 25, 2004, the net +sales and cost of sales recognized by the Retail segment for sales of service +and support contracts were $54 million and $37 million, respectively. For the +year ended September 27, 2003, this resulted in the recognition of net +sales and cost of sales by the Retail segment of $30 million and $20 million, +respectively. Third, the Company has opened seven high profile +stores in New York, Los Angeles, Chicago, San Francisco, Tokyo, Japan, Osaka, +Japan, and London, England as of September 24, 2005. These high profile +stores are larger than the Company’s typical retail stores and were designed to +further promote brand awareness and provide a venue for certain corporate sales +and marketing activities, including corporate briefings. As such, the Company +allocates certain operating expenses associated with these stores to corporate +marketing expense to reflect the estimated benefit realized Company-wide. The +allocation of these operating costs is based on the amount incurred for a high +profile store in excess of that incurred by a more typical Company retail +location. Expenses allocated to corporate marketing resulting from the +operations of these stores were $31 million, $16 million, and $6 million for +the years ended September 24, 2005, September 25, 2004, and September 27, +2003, respectively. 93 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) Summary information by +operating segment follows (in millions): 2005 2004 2003 Americas: Net sales $ 6,590 $ 4,019 $ 3,181 Operating income $ 798 $ 465 $ 323 Depreciation, amortization, and accretion $ 6 $ 6 $ 5 Segment assets (a) $ 705 $ 563 $ 494 Europe: Net sales $ 3,073 $ 1,799 $ 1,309 Operating income $ 454 $ 280 $ 130 Depreciation, amortization, and accretion $ 4 $ 4 $ 4 Segment assets $ 289 $ 259 $ 252 Japan: Net sales $ 920 $ 677 $ 698 Operating income $ 140 $ 115 $ 121 Depreciation, amortization, and accretion $ 3 $ 2 $ 3 Segment assets $ 199 $ 114 $ 130 Retail: Net sales $ 2,350 $ 1,185 $ 621 Operating income (loss) $ 151 $ 39 $ (5 ) Depreciation, amortization, and accretion (b) $ 43 $ 35 $ 25 Segment assets (b) $ 555 $ 351 $ 243 Other Segments (c): Net sales $ 998 $ 599 $ 398 Operating income $ 118 $ 90 $ 51 Depreciation, amortization, and accretion $ 2 $ 2 $ 2 Segment assets $ 133 $ 124 $ 78 (a) The Americas asset +figures do not include fixed assets held in the U.S. Such fixed assets are not +allocated specifically to the Americas segment and are included in the +corporate assets figures below. (b) Retail segment +depreciation and asset figures reflect the cost and related depreciation of its +retail stores and related infrastructure. Retail store +construction-in-progress, which is not subject to depreciation, is reflected in +corporate assets. (c) Other Segments include +Asia-Pacific and FileMaker. 94 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) A reconciliation of the +Company’s segment operating income and assets to the consolidated financial +statements follows (in millions): 2005 2004 2003 Segment operating income $ 1,661 $ 989 $ 620 Retail manufacturing + margin (a) 435 213 106 Corporate expenses, net + (b) (446 ) (853 ) (701 ) Restructuring costs — (23 ) (26 ) Consolidated operating + income (loss) $ 1,650 $ 326 $ (1 ) Segment assets $ 1,881 $ 1,411 $ 1,197 Corporate assets 9,670 6,639 $ 5,618 Consolidated assets $ 11,551 $ 8,050 $ 6,815 Segment depreciation, + amortization, and accretion $ 58 $ 49 $ 39 Corporate depreciation, + amortization, and accretion 121 101 74 Consolidated + depreciation, amortization, and accretion $ 179 $ 150 $ 113 (a) Represents the excess of +the Retail segment’s cost of sales over the Company’s standard cost of sales +for products sold through the Retail segment. (b) Corporate expenses +include research and development, corporate marketing expenses, manufacturing +costs and variances not included in standard costs, and other separately +managed general and administrative expenses including certain corporate +expenses associated with support of the Retail segment. No +single customer accounted for more than 10% of net sales in 2005, 2004, or 2003. +Net sales and long-lived assets related to operations in the U.S., Japan, and +other foreign countries are as follows (in millions): 2005 2004 2003 Net Sales: U.S. $ 8,194 $ 4,893 $ 3,627 Japan 1,021 738 698 Other Countries 4,716 2,648 1,882 Total Net Sales $ 13,931 $ 8,279 $ 6,207 Long-Lived Assets: U.S. $ 738 $ 637 $ 635 Japan 63 52 19 Other Countries 112 72 60 Total Long-Lived + Assets $ 913 $ 761 $ 714 95 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) Information regarding net +sales by product is as follows (in millions): 2005 2004 2003 Net Sales: Desktops (a) $ 3,436 $ 2,373 $ 2,475 Portables (b) 2,839 2,550 2,016 Total Macintosh net sales 6,275 4,923 4,491 iPod 4,540 1,306 345 Other music + related products and services (c) 899 278 36 Peripherals and + other hardware (d) 1,126 951 691 Software, + service, and other net sales (e) 1,091 821 644 Total Net Sales $ 13,931 $ 8,279 $ 6,207 (a) Includes iMac, eMac, Mac +mini, Power Mac and Xserve product lines. (b) Includes iBook and +PowerBook product lines. (c) Consists of iTunes Music +Store sales and iPod services, and Apple-branded and third-party iPod +accessories. (d) Includes sales of +Apple-branded and third-party displays, wireless connectivity and networking +solutions, and other hardware accessories. (e) Includes +sales of Apple-branded operating system, application software, third-party +software, AppleCare, and Internet services. Note 12—Related Party Transactions and Certain Other +Transactions In March 2002, the Company entered into a +Reimbursement Agreement with its CEO, Mr. Steven P. Jobs, for the +reimbursement of expenses incurred by Mr. Jobs in the operation of his +private plane when used for Apple business. The Reimbursement Agreement became +effective for expenses incurred by Mr. Jobs for Apple business purposes +since he took delivery of the plane in May 2001. The Company recognized a +total of $1.1 million, $483,000, and $404,000 in expenses pursuant to the +Reimbursement Agreement during 2005, 2004, and 2003, respectively. All expenses +recognized pursuant to the Reimbursement Agreement have been included in +selling, general, and administrative expenses in the consolidated statements of +operations. Subsequent to September 24, +2005, the Company entered into an agreement with Pixar to sell certain of Pixar’s +short films on the iTunes Music Store. Mr. Steven P. Jobs, the Company’s +CEO is also the CEO, Chairman, and a large shareholder of Pixar. 96 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note +13—Selected Quarterly Financial Information (Unaudited) Fourth Quarter Third Quarter Second Quarter First Quarter (Tabular amounts in millions, except per share amounts) 2005 Net sales $ 3,678 $ 3,520 $ 3,243 $ 3,490 Gross margin $ 1,035 $ 1,044 $ 968 $ 996 Net income $ 430 $ 320 $ 290 $ 295 Earnings per common + share: Basic $ 0.52 $ 0.39 $ 0.36 $ 0.37 Diluted $ 0.50 $ 0.37 $ 0.34 $ 0.35 2004 Net sales $ 2,350 $ 2,014 $ 1,909 $ 2,006 Gross margin $ 634 $ 559 $ 530 $ 536 Net income $ 106 $ 61 $ 46 $ 63 Earnings per common + share: Basic $ 0.14 $ 0.08 $ 0.06 $ 0.09 Diluted $ 0.13 $ 0.08 $ 0.06 $ 0.08 Basic and diluted +earnings per share are computed independently for each of the quarters +presented. Therefore, the sum of quarterly basic and diluted per share +information may not equal annual basic and diluted earnings per share. Net income during +the fourth quarter of 2005 benefited by $81 million from the reversal of +certain tax contingency reserves and adjustments to net deferred tax assets, +including reductions to valuation allowances. Net income during the fourth, third, and second quarters +of 2004 included restructuring charges, net of tax, of $4 million, $6 million, +and $7 million, respectively. Net income during the fourth quarter of 2004 +included after-tax gains related to non-current investments of $3 million. 97 REPORT +OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The +Board of Directors and Shareholders Apple Computer, Inc.: We have audited the accompanying consolidated balance +sheets of Apple Computer, Inc. and subsidiaries (the Company) as of September 24, +2005 and September 25, 2004, and the related consolidated statements of +operations, shareholders’ equity and cash flows for each of the years in the +three-year period ended September 24, 2005. These consolidated financial +statements are the responsibility of the Company’s management. Our +responsibility is to express an opinion on these consolidated financial +statements based on our audits. We conducted our audits in accordance with the +standards of the Public Company Accounting Oversight Board (United States). Those +standards require that we plan and perform the audit to obtain reasonable +assurance about whether the consolidated financial statements are free of +material misstatement. An audit includes examining, on a test basis, evidence +supporting the amounts and disclosures in the consolidated financial +statements. An audit also includes assessing the accounting principles used and +significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. In our opinion, the consolidated financial statements +referred to above present fairly, in all material respects, the financial +position of the Company as of September 24, 2005 and September 25, +2004, and the results of their operations and their cash flows for each of the +years in the three-year period ended September 24, 2005, in conformity +with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards +of the Public Company Accounting Oversight Board (United States), the +effectiveness of the Company’s internal control over financial reporting as of September 24, +2005, based on criteria established in Internal +Control-Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO), and our report dated November 29, +2005 expressed an unqualified opinion on management’s assessment of, and the +effective operation of internal control over financial reporting. As discussed in Note 1 to +the consolidated financial statements, the Company changed its method of +accounting for asset retirement obligations and for financial instruments with +characteristics of both liabilities and equity in 2003. /s/ KPMG LLP Mountain View, + California November 29, 2005 98 REPORT +OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Apple Computer, Inc.: We have audited management’s assessment, included in +the accompanying Management’s Annual Report on Internal Control over Financial +Reporting, that Apple Computer, Inc. and subsidiaries maintained effective +internal control over financial reporting as of September 24, 2005, based +on criteria established in Internal +Control-Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO). Apple Computer, Inc.’s +management is responsible for maintaining effective internal control over +financial reporting and for its assessment of the effectiveness of internal +control over financial reporting. Our responsibility is to express an opinion +on management’s assessment and an opinion on the effectiveness of Apple +Computer, Inc.’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the +standards of the Public Company Accounting Oversight Board (United States). +Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an +understanding of internal control over financial reporting, evaluating +management’s assessment, testing and evaluating the design and operating +effectiveness of internal control, and performing such other procedures as we +considered necessary in the circumstances. We believe that our audit provides a +reasonable basis for our opinion. A company’s internal control over financial reporting +is a process designed to provide reasonable assurance regarding the reliability +of financial reporting and the preparation of financial statements for external +purposes in accordance with generally accepted accounting principles. A company’s +internal control over financial reporting includes those policies and +procedures that (1) pertain to the maintenance of records that, in +reasonable detail, accurately and fairly reflect the transactions and +dispositions of the assets of the company; (2) provide reasonable +assurance that transactions are recorded as necessary to permit preparation of +financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made +only in accordance with authorizations of management and directors of the +company; and (3) provide reasonable assurance regarding prevention or +timely detection of unauthorized acquisition, use, or disposition of the +company’s assets that could have a material effect on the financial statements. Because of inherent limitations, internal control over +financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk +that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Apple +Computer, Inc. maintained effective internal control over financial reporting +as of September 24, 2005, is fairly stated, in all material respects, +based on criteria established in Internal +Control-Integrated Framework issued by COSO. Also, in our opinion, Apple +Computer, Inc. maintained, in all material respects, effective internal control +over financial reporting as of September 24, 2005, based on criteria +established in Internal Control-Integrated Framework issued +by COSO. We also have audited, in +accordance with the standards of the Public Company Accounting Oversight Board +(United States), the consolidated balance sheets of Apple Computer, Inc. as of September 24, +2005 and September 25, 2004, and the related consolidated statements of +operations, shareholders’ equity, and cash flows for each of the years in the +three-year period ended September 24, 2005, and our report dated November 29, +2005 expressed an unqualified opinion on those consolidated financial +statements. /s/ KPMG LLP Mountain View, + California November 29, 2005 99 Item 9. Changes in and Disagreements with Accountants +on Accounting and Financial Disclosure Not applicable. Item 9A. Controls and Procedures Evaluation of +Disclosure Controls and Procedures Based on an evaluation +under the supervision and with the participation of the Company’s management, +the Company’s principal executive officer and principal financial officer have +concluded that the Company’s disclosure controls and procedures as defined in rules 13a-15(e) and +15d-15(e) under the Securities Exchange Act of 1934, as amended (Exchange +Act) were effective as of September 24, 2005 to ensure that information +required to be disclosed by the Company in reports that it files or submits +under the Exchange Act is (i) recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission rules and +forms and (ii) accumulated and communicated to the Company’s management, +including its principal executive officer and principal financial officer, as +appropriate to allow timely decisions regarding required disclosure. Inherent +Limitations Over Internal Controls The Company’s +internal control over financial reporting is designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally +accepted accounting principles. The Company’s internal control over financial +reporting includes those policies and procedures that: (i)    pertain to +the maintenance of records that, in reasonable detail, accurately and fairly +reflect the transactions and dispositions of the Company’s assets; (ii)   provide +reasonable assurance that transactions are recorded as necessary to permit +preparation of financial statements in accordance with generally accepted +accounting principles, and that the Company’s receipts and expenditures are +being made only in accordance with authorizations of the Company’s management +and directors; and (iii)  provide +reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the Company’s assets that could have a +material effect on the financial statements. Management, including the +Company’s Chief Executive Officer and Chief Financial Officer, does not expect that +the Company’s internal controls will prevent or detect all errors and all +fraud. A control system, no matter how well designed and operated, can provide +only reasonable, not absolute, assurance that the objectives of the control +system are met. Further, the design of a control system must reflect the fact +that there are resource constraints, and the benefits of controls must be +considered relative to their costs. Because of the inherent limitations in all +control systems, no evaluation of internal controls can provide absolute +assurance that all control issues and instances of fraud, if any, have been +detected. Also, any evaluation of the effectiveness of controls in future +periods are subject to the risk that those internal controls may become inadequate +because of changes in business conditions, or that the degree of compliance +with the policies or procedures may deteriorate. Management’s Annual +Report on Internal Control Over Financial Reporting The Company’s management +is responsible for establishing and maintaining adequate internal control over +financial reporting (as defined in Rule 13a-15(f) under the +Securities Exchange Act of 1934, as amended). Management conducted an +evaluation of the effectiveness of the Company’s internal control over financial +reporting based on the criteria set forth in Internal Control—Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission (COSO). Based on this evaluation, management has concluded that the +Company’s internal control over financial reporting was 100 effective as of September 24, +2005. The Company’s independent registered public accounting firm, KPMG LLP, +has issued an attestation report on the Company’s assessment of its internal +control over financial reporting. The report on the audit of internal control +over financial reporting appears on page 99 of this Form 10-K. Changes in Internal +Control Over Financial Reporting There were no significant +changes in the Company’s internal control over financial reporting identified +in management’s evaluation during the fourth quarter of fiscal 2005 that have +materially affected, or are reasonably likely to materially affect, the Company’s +internal control over financial reporting. Item 9B. Other Information None. 101 PART III Item 10. Directors and Executive Officers of the +Registrant Directors Listed +below are the Company’s seven directors whose terms expire at the next annual +meeting of shareholders. Name Position With the Company Age Director Since Fred D. Anderson Director 61 2004 William V. + Campbell Co-lead + Director 65 1997 Millard S. + Drexler Director 61 1999 Albert A. + Gore, Jr. Director 57 2003 Steven P. Jobs Director + and Chief Executive Officer 50 1997 Arthur D. + Levinson Co-lead + Director 55 2000 Jerome B. York Director 67 1997 Fred D. Anderson has been a +founding partner of Elevation Partners, a private equity firm focused on the +media and entertainment industry, since July 2004. Previously, Mr. Anderson +served as the Company’s Executive Vice President and Chief Financial Officer +from April 1996 to June 2004. Mr. Anderson also serves on the +Board of Directors of eBay Inc. William V. Campbell has been +Chairman of the Board of Directors of Intuit, Inc. (“Intuit”) since August 1998. From September 1999 to January 2000, Mr. Campbell +acted as Chief Executive Officer of Intuit. From April 1994 to August 1998, +Mr. Campbell was President and Chief Executive Officer and a director of +Intuit. From January 1991 to December 1993, Mr. Campbell was +President and Chief Executive Officer of GO Corporation. Mr. Campbell also +serves on the Board of Directors of Opsware, Inc. Millard S. Drexler has been +Chairman and Chief Executive Officer of J. Crew Group, Inc. since January 2003. +Previously, Mr. Drexler was Chief Executive Officer of Gap Inc. from +1995 and President from 1987 until September 2002. Mr. Drexler was +also a member of the Board of Directors of Gap Inc. from November 1983 +until October 2002. Albert A. Gore, Jr. has +served as a Senior Advisor to Google, Inc. since 2001. He has also served +as Executive Chairman of Current TV since 2002 and as Chairman of Generation +Investment Management since 2004. He is a visiting professor at Middle +Tennessee State University. Mr. Gore was inaugurated as the 45th Vice +President of the U.S. in 1993. He was re-elected in 1996 and served for a total +of eight years as President of the Senate, a member of the Cabinet and the +National Security Council. Prior to 1993, he served eight years in the U.S. +Senate and eight years in the U.S. House of Representatives. Steven P. Jobs is one of the +Company’s co-founders and currently serves as its Chief Executive Officer. Mr. Jobs +is also the Chairman and Chief Executive Officer of Pixar Animation Studios. Arthur D. Levinson, Ph.D. has been Chief Executive Officer and a Director of Genentech Inc. (“ Genentech” ) since July 1995. Dr. Levinson has been +Chairman of the Board of Directors of Genentech since September 1999. He +joined Genentech in 1980 and served in a number of executive positions, +including Senior Vice President of R&D from 1993 to 1995. Dr. Levinson +also serves on the Board of Directors of Google, Inc. Jerome B. +York has been Chief Executive Officer of Harwinton Capital Corporation, +a private investment company that he controls, since September 2003. From January 2000 +until September 2003, Mr. York was Chairman and Chief Executive +Officer of MicroWarehouse, Inc., a reseller of computer hardware, software +and peripheral products. From September 1995 to October 1999, he was +Vice Chairman of Tracinda Corporation. From May 1993 to September 1995 +he was Senior Vice President and Chief 102 Financial Officer of IBM +Corporation, and served as a member of IBM’s Board of Directors from January 1995 +to August 1995. Mr. York is also a director of Tyco +International Ltd. and Exide Technologies. Role +of the Board; Corporate Governance Matters It is the paramount duty of the Board of Directors to +oversee the Chief Executive Officer and other senior management in the +competent and ethical operation of the Company on a day-to-day basis and to +assure that the long-term interests of the shareholders are being served. To +satisfy this duty, the directors take a proactive, focused approach to their position, +and set standards to ensure that the Company is committed to business success +through maintenance of the highest standards of responsibility and ethics. Members of the Board bring +to the Company a wide range of experience, knowledge and judgment. These varied +skills mean that governance is far more than a “check the box” approach to +standards or procedures. The governance structure in the Company is designed to +be a working structure for principled actions, effective decision-making +and appropriate monitoring of both compliance and performance. The key +practices and procedures of the Board are outlined in the Corporate Governance +Guidelines available on the Company’s website at www.apple.com/investor. Board Committees The Board has a standing Compensation Committee, a +Nominating and Corporate Governance Committee (“ Nominating +Committee” ) and an Audit and Finance Committee (“ Audit Committee ”). All committee members are independent +under the listing standards of the NASDAQ Stock Market. The Audit Committee is primarily responsible for +overseeing the services performed by the Company’s independent auditors and +internal audit department, evaluating the Company’s accounting policies and its +system of internal controls and reviewing significant financial transactions. +Members of the Audit Committee are Messrs. Campbell and York and Dr. Levinson. The Compensation Committee is primarily responsible +for reviewing the compensation arrangements for the Company’s executive +officers, including the Chief Executive Officer, and for administering the +Company’s equity compensation plans. Members of the Compensation Committee are Messrs. Campbell, +Drexler, and Gore. The Nominating Committee assists the Board in +identifying qualified individuals to become directors, determines the +composition of the Board and its committees, monitors the process to assess +Board effectiveness and helps develop and implement the Company’s corporate +governance guidelines. The Nominating Committee also considers nominees +proposed by shareholders. Members of the Nominating Committee are Messrs. Drexler +and Gore and Dr. Levinson. The Audit, Compensation +and Nominating Committees operate under written charters adopted by the Board. +These charters are available on Apple’s website at www.apple.com/investor. Audit Committee Financial Expert All members of the Company’s +Audit Committee, Messrs. Campbell and York and Dr. Levinson, qualify +as “audit committee financial experts” under Item 401 (h) of Regulation +S-K and are considered “independent” as the term is used in Item 7(d)(3)(iv) of +Schedule 14A under the Exchange Act. Code of Ethics The Company has a code of +ethics that applies to all of the Company’s employees, including its principal +executive officer, principal financial officer, principal accounting officer +and its Board of Directors. A copy of this code, “Ethics: The Way We Do +Business Worldwide” is available on the Company’s 103 website at www.apple.com/investor. +The Company intends to disclose any changes in or waivers from its code of +ethics by posting such information on its website or by filing a Form 8-K. Executive Officers The following sets forth certain information regarding +executive officers of the Company. Information pertaining to Mr. Jobs, who +is both a director and an executive officer of the Company, may be found in the +section entitled “ Directors. ” Timothy D. Cook , Chief Operating +Officer (age 45), joined the Company in February 1998. Mr. Cook also +served with the Company as Executive Vice President, Worldwide Sales and +Operations from 2002 to 2005. In 2004, his responsibilities were expanded to +include the Company’s Macintosh hardware engineering. From 1998 to 2002, Mr. Cook +served in the position of Senior Vice President, Worldwide Operations, Sales, +Service and Support. Prior to joining the Company, Mr. Cook held the +position of Vice President, Corporate Materials for Compaq Computer Corporation +(“ Compaq” ). Previous to his work at +Compaq, Mr. Cook was the Chief Operating Officer of the Reseller Division +at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, +most recently as Director of North American Fulfillment. Mr. Cook also +serves as a member of the Board of Directors of Nike, Inc. Nancy R. Heinen , Senior Vice +President, General Counsel and Secretary (age 49), joined the Company in September 1997. +Prior to joining the Company, Ms. Heinen held the position of Vice +President, General Counsel and Secretary of the Board of Directors at NeXT +Software, Inc. (“ NeXT ”) from February 1994 +until the acquisition of NeXT by the Company in February 1997. Ronald B. Johnson , Senior Vice +President, Retail (age 47), joined the Company in January 2000. Prior to +joining the Company, Mr. Johnson spent 16 years with Target Stores, +most recently as Senior Merchandising Executive. Peter Oppenheimer , Senior Vice +President and Chief Financial Officer (age 42), joined the Company in July 1996. +Mr. Oppenheimer also served with the Company in the position of Vice +President and Corporate Controller and as Senior Director of Finance for the +Americas. Prior to joining the Company, Mr. Oppenheimer was CFO of one of +the four business units for Automatic Data Processing, Inc. (“ ADP” ). Prior to joining ADP, Mr. Oppenheimer spent six +years in the Information Technology Consulting Practice with Coopers and Lybrand. Jonathan Rubinstein , Senior Vice +President, iPod Division (age 49), joined the Company in February 1997. Mr. Rubinstein +also served with the Company in the position of Senior Vice President, Hardware +Engineering. Before joining the Company, Mr. Rubinstein was Executive Vice +President and Chief Operating Officer of FirePower Systems Incorporated, from May 1993 +to August 1996. Mr. Rubinstein also serves as a member of the Board +of Directors of Immersion Corporation. Philip W. Schiller , Senior Vice +President, Worldwide Product Marketing (age 45), rejoined the Company in 1997. +Prior to rejoining the Company, Mr. Schiller was Vice President of Product +Marketing at Macromedia, Inc. from December 1995 to March 1997 +and was Director of Product Marketing at FirePower Systems, Inc. from 1993 +to December 1995. Prior to that, Mr. Schiller spent six years at the +Company in various marketing positions. Bertrand Serlet, Ph.D. , Senior +Vice President, Software Engineering (age 44), joined the Company in February 1997 +upon the Company’s acquisition of NeXT. At NeXT, Dr. Serlet held several +engineering and managerial positions, including Director of Web Engineering. +Prior to NeXT, from 1985 to 1989, Dr. Serlet worked as a research engineer +at Xerox PARC. Sina Tamaddon , Senior Vice +President, Applications (age 48), joined the Company in September 1997. Mr. Tamaddon +has also served with the Company in the position of Senior Vice President, +Worldwide Service and Support, and Vice President and General Manager, Newton +Group. Before joining the 104 Company, Mr. Tamaddon held the position of Vice +President, Europe with NeXT from September 1996 through March 1997. +From August 1994 to August 1996, Mr. Tamaddon held the position +of Vice President, Professional Services with NeXT. Avadis Tevanian, Jr., +Ph.D. , Senior Vice President, Chief Software Technology +Officer (age 44), joined the Company in February 1997 upon the Company’s +acquisition of NeXT. Dr. Tevanian served with the Company in the position +of Senior Vice President, Software Engineering from 1997 to July 2003. +With NeXT, Dr. Tevanian held several positions, including Vice President, +Engineering, from April 1995 to February 1997. Prior to April 1995, +Dr. Tevanian worked as an engineer with NeXT and held several management +positions. Section 16(a) Beneficial +Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act +of 1934, as amended, requires the Company’s officers and directors, and persons +who own more than ten percent of a registered class of the Company’s equity +securities, to file reports of securities ownership and changes in such +ownership with the Securities and Exchange Commission (“ SEC ”). +Officers, directors and greater than ten percent shareholders also are required +by rules promulgated by the SEC to furnish the Company with copies of all Section 16(a) forms +they file. Based solely upon a review +of the copies of such forms furnished to the Company or written representations +that no Forms 5 were required, the Company believes that all Section 16(a) filing +requirements were met during fiscal year 2005. 105 Item 11. Executive Compensation Information +Regarding Executive Compensation The +following table summarizes compensation information for the last three fiscal +years for (i) Mr. Jobs, Chief Executive Officer and (ii) the +four most highly compensated executive officers other than the Chief Executive +Officer who were serving as executive officers of the Company at the end of the +fiscal year (collectively, the “ Named Executive Officers” ). SUMMARY +COMPENSATION TABLE Annual Compensation Long-Term Compensation Name and Principal Position Fiscal Year Salary ($) Bonus ($) Restricted Stock Award ($) Securities Underlying Options* (#) All Other Compensation ($) Steven P. Jobs 2005 1 — — — — Chief Executive Officer 2004 1 — — — — 2003 1 — 74,750,000 (1) — — Timothy D. Cook 2005 602,434 600,239 — — 12,600 (3) Chief Operating + Officer 2004 602,632 — 7,650,000 (2) — 12,588 (3) 2003 617,673 — — — 9,929 (3) Ronald B. Johnson 2005 552,795 550,202 — — — Senior Vice President, + Retail 2004 484,836 1,500,000 6,375,000 (2) — — 2003 452,404 1,500,000 — — — Peter Oppenheimer 2005 552,189 550,202 — — 21,092 (3) Senior Vice + President and 2004 450,739 — 6,375,000 (2) — 3,808 (3) Chief Financial + Officer 2003 402,237 — — — — Jonathan Rubinstein 2005 552,795 551,239 — — 12,600 (3) Senior Vice President, 2004 485,216 — 6,375,000 (2) — 12,300 (3) iPod Division 2003 452,939 — — — 11,986 (3) (1) In March 2003, Mr. Jobs +voluntarily cancelled all of his outstanding options, excluding those granted +to him in his capacity as a Director. In March 2003, the Board awarded Mr. Jobs +10 million (split-adjusted) restricted shares of the Company’s Common +Stock that generally vest in full on the third anniversary of the grant date. (2) Market value of +restricted stock units granted on March 24, 2004 (based on $12.75 per share, +the closing price of the Company’s common stock on the NASDAQ National Market +on the day of grant). Restricted stock units generally vest over four years +with 50% of the total number of shares vesting on each of the second and fourth +anniversaries of the grant date. (3) Consists +of matching contributions made by the Company in accordance with the terms of +the 401(k) plan. Option Grants in Last Fiscal Year There were no options, restricted stock, or restricted +stock units granted to the Named Executive Officers during fiscal year 2005. 106 Options Exercised +and Year-End Option Holdings The following table +provides information about stock option exercises by the Named Executive +Officers during fiscal year 2005 and stock options held by each of them at +fiscal year-end. The table has been adjusted to reflect the Company’s +two-for-one stock split in February 2005. AGGREGATED +OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Shares Acquired on Exercise Value Realized Number of Securities Underlying Unexercised Options at Fiscal Year-End (#) Value of Unexercised In-the-Money Options at Fiscal Year-End ($)(1) Name (#) ($) Exercisable Unexercisable Exercisable Unexercisable Steven P. Jobs — — 120,000 (2) — (3) $ 5,694,000 (2) — Timothy D. Cook 500,000 $ 13,329,677 — — (3) — — Ronald B. Johnson 1,350,000 $ 32,257,127 2,100,000 150,000 (3) $ 61,910,625 $ 6,220,500 Peter Oppenheimer — — 1,107,500 37,500 (3) $ 45,994,859 $ 1,560,062 Jonathan Rubinstein 1,800,000 $ 31,012,815 — — (3) — — (1) Market value of +securities underlying in-the-money options at the end of fiscal year 2005 +(based on $53.20 per share, the closing price of Common Stock on the NASDAQ +National Market on September 23, 2005), minus the exercise price. (2) Consists +of 120,000 options granted to Mr. Jobs in his capacity as a director +pursuant to the 1997 Director Stock Option Plan. Since accepting the position +of CEO, Mr. Jobs is no longer eligible to receive option grants under the Director +Plan. In March 2003, Mr. Jobs voluntarily cancelled all of his +outstanding options, excluding those granted to him in his capacity as a +director. (3) This +does not include 10 million restricted shares granted to Mr. Jobs, 600,000 +restricted stock units granted to Mr. Cook, and 500,000 restricted stock +units granted to each of Messrs. Johnson, Oppenheimer, and Rubinstein. Director Compensation The form and amount of +director compensation is determined by the Board after a review of +recommendations made by the Nominating Committee. The current practice of the +Board is to base a substantial portion of a director’s annual retainer on +equity. In 1998, shareholders approved the 1997 Director Stock Option Plan (the +“ Director Plan” ) and 1,600,000 shares were +reserved for issuance thereunder. Pursuant to the Director Plan, the Company’s +non-employee directors are granted an option to acquire 30,000 shares of Common +Stock upon their initial election to the Board (“ Initial +Options” ). The Initial Options vest and become exercisable in three +equal annual installments on each of the first through third anniversaries of +the grant date. On the fourth anniversary of a non-employee director’s initial +election to the Board and on each subsequent anniversary thereafter, the +director will be entitled to receive an option to acquire 10,000 shares of +Common Stock (“ Annual Options” ). Annual Options +are fully vested and immediately exercisable on their date of grant. As of the +end of the fiscal year, there were options for 740,000 shares outstanding under +the Director Plan. Since accepting the position of CEO, Mr. Jobs is no +longer eligible for grants under the Director Plan. Non-employee directors also +receive a $50,000 annual retainer paid in quarterly increments. In addition, +directors receive up to two free computer systems per year and are eligible to +purchase additional equipment at a discount. Directors do not receive any +additional consideration for serving on committees or as committee chairperson. Compensation +Committee Interlocks and Insider Participation The current members of the +Compensation Committee are Messrs. Campbell, Drexler and Gore, none of +whom are employees of the Company and all of whom are considered “independent” +directors under the 107 applicable NASDAQ rules. +There were no interlocks or insider participation between any member of the +Board or Compensation Committee and any member of the board of the directors or +compensation committee of another company. Arrangements +with Named Executive Officers Change In Control +Arrangements—Stock Options, Restricted Stock, and Restricted Stock Units In the event of a “change in control” of the Company, +all outstanding options under the Company’s stock option plans, except the +Director Plan, will, unless otherwise determined by the plan administrator, +become fully exercisable, and will be cashed out at an amount equal to the +difference between the applicable “change in control price” and the exercise +price. The Director Plan provides that upon a “change in control” of the Company, +all outstanding options held by non-employee directors will automatically +become fully exercisable and will be cashed out at an amount equal to the +difference between the applicable “change in control price” and the exercise +price of the options. A “change in control” under these plans is generally +defined as (i) the acquisition by any person of 50% or more of the +combined voting power of the Company’s outstanding securities or (ii) the +occurrence of a transaction requiring shareholder approval and involving the +sale of all or substantially all of the assets of the Company or the merger of +the Company with or into another corporation. In addition, options, +restricted stock grants, and restricted stock units granted to the Named +Executive Officers generally provide that in the event there is a “change in +control,” as defined in the Company’s stock option plans, and if in connection +with or following such “change in control,” their employment is terminated +without “Cause” or if they should resign for “Good Reason,” those options, +restricted stock, and restricted stock units outstanding that are not yet +vested as of the date of such “change in control” shall become fully vested. +Further, restricted stock and restricted stock units granted to the Named Executive +Officers also provide that, in the event the Company terminates the Officer +without cause at any time, the restricted stock units and restricted stock will +vest in full. Generally, “Cause” is defined to include a felony conviction, +willful disclosure of confidential information or willful and continued failure +to perform his or her employment duties. “Good Reason” includes resignation of +employment as a result of a substantial diminution in position or duties, or an +adverse change in title or reduction in annual base salary. Item 12. Security Ownership of Certain Beneficial +Owners and Management The following table sets +forth certain information as of October 31, 2005 (the “ Table Date ”) with respect to the beneficial ownership of the +Company’s Common Stock by (i) each person the Company believes +beneficially holds more than 5% of the outstanding shares of Common Stock; (ii) each +director; (iii) each Named Executive Officer listed in the Summary +Compensation Table under the heading “ Executive Compensation; ” +and (iv) all directors and executive officers as a group. On the Table +Date, 839,776,934 shares of Common Stock were issued and outstanding. Unless +otherwise indicated, all persons named as beneficial +owners of Common Stock have sole voting power and sole investment power with +respect to the shares indicated as beneficially owned. In addition, unless +otherwise indicated, all persons named below can be reached at Apple Computer, Inc., +1 Infinite Loop, Cupertino, CA 95014. 108 Security +Ownership of 5% Holders, Directors, Nominees and Executive Officers Name of Beneficial Owner Shares of Common Stock Beneficially Owned(1) Percent of Common Stock Outstanding Fidelity + Investments 58,552,916 (2) 6.97 % Barclays Global + Investors 55,223,982 (3) 6.58 % AXA 47,861,070 (4) 5.70 % Steven P. Jobs 10,120,004 (5) 1.21 % Fred D. Anderson 5,344 * William V. + Campbell 211,004 (6) * Timothy D. Cook 12,597 (7) * Millard S. + Drexler 210,000 (8) * Albert A. + Gore, Jr. 40,000 (9) * Ronald B. Johnson 2,112,597 (10) * Arthur D. + Levinson 352,400 (11) * Peter Oppenheimer 396,643 (12) * Jonathan J. + Rubinstein 22,174 (13) * Jerome B. York 70,000 (14) * All executive officers and + directors as a group (16 persons) 16,307,625 (15) 1.94 % (1) Represents shares of +Common Stock held and/or options held by such individuals that were exercisable +at the Table Date or within 60 days thereafter. This does not include +options or restricted stock units that vest after 60 days. The share numbers +have been adjusted to reflect the Company’s two-for-one stock split in February 2005. (2) Based on a Form 13F +filed November 14, 2005 by FMR Corp. FMR Corp. lists its address as 82 Devonshire +Street, Boston, MA, 02109, in such filing. (3) Based on a Form 13F +filed November 14, 2005, by Barclays Global Investors. Barclays Global +Investors lists its address as 45 Fremont Street, San Francisco, CA 94105. (4) Based on a Form 13F +filed November 14, 2005, by AXA. AXA lists its address as 25, Avenue +Matigon, Paris, France 10. (5) Includes 120,000 shares +of Common Stock that Mr. Jobs has the right to acquire by exercise of +stock options. (6) Includes 210,000 shares +of Common Stock that Mr. Campbell has the right to acquire by exercise of +stock options. (7) Excludes 600,000 +restricted stock units. (8) Includes 170,000 shares +of Common Stock that Mr. Drexler has the right to acquire by exercise of +stock options. (9) Consists of 40,000 +shares of Common Stock that Mr. Gore has the right to acquire by exercise +of stock options. (10) Includes 2,100,000 shares of +Common Stock that Mr. Johnson has the right to acquire by exercise of +stock options and excludes 500,000 restricted stock units. (11) Includes 2,000 shares of Common +Stock that Dr. Levinson holds indirectly and 90,000 shares of Common Stock +that Dr. Levinson has the right to acquire by exercise of stock options. (12) Includes 382,500 shares of +Common Stock that Mr. Oppenheimer has the right to acquire by exercise of +stock options and excludes 500,000 restricted stock units. 109 (13) Excludes 500,000 restricted +stock units. (14) Includes 30,000 shares of +Common Stock that Mr. York has the right to acquire by exercise of stock +options. (15) Includes 5,870,796 shares of +Common Stock that executive officers or directors have the right to acquire by +exercise of stock options. Does not include 4.4 million of restricted stock +units. * Represents +less than 1% of the issued and outstanding shares of Common Stock on the Table +Date. Equity +Compensation Plan Information The +following table sets forth certain information, as of September 24, 2005, +concerning shares of common stock authorized for issuance under all of the +Company’s equity compensation plans. The table has been adjusted to reflect the +Company’s two-for-one stock split in February 2005. (a) Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (b) Weighted Average Exercise Price of Outstanding Options, Warrants and Rights (c) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) Equity + compensation plans approved by shareholders 42,365,700 $ 23.27 62,791,724 (1) Equity compensation + plans not approved by shareholders 30,827,565 $ 10.27 — Total equity + compensation plans(2) 73,193,265 $ 17.79 62,791,724 (1) This number includes +3,834,300 shares of common stock reserved for issuance under the Employee Stock +Purchase Plan, 440,000 shares available for issuance under the 1997 Director +Stock Option Plan, and 58,517,424 shares available for issuance under the 2003 +Employee Stock Plan. The grant of 5,260,000 shares of restricted stock units +has been deducted from the number of shares available for future issuance. +Shares of restricted stock and restricted stock units granted after April 2005 +count against the shares available for grant as two shares for every share +granted. This amount  does not include +shares under the 1990 Stock Option Plan that was terminated in 1997. No new +options can be granted under the 1990 Stock Option Plan. (2) This +table does not include 28,082 outstanding options assumed in connection with a +prior acquisition of a company that originally granted those options. These +assumed options have a weighted average exercise price of $3.39 per share. No +additional options may be granted under the assumed plan. Item 13. Certain Relationships and Related +Transactions In March 2002, the Company entered into a +Reimbursement Agreement with its Chief Executive Officer, Mr. Steven P. +Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the +operation of his private plane when used for Apple business. The Reimbursement +Agreement is effective for expenses incurred by Mr. Jobs for Apple +business purposes since he took delivery of the plane in May 2001. During +2005, the Company recognized a total of $1,075,545 in expenses pursuant to this +reimbursement agreement related to expenses incurred by Mr. Jobs during +2005. In October 2005, the +Company entered into an agreement with Pixar to sell certain of Pixar’s short +films on the iTunes Music Store. Mr. Jobs, the Company’s Chief Executive +Officer is also the Chief Executive Officer, Chairman, and a large shareholder +of Pixar. 110 Item 14. Principal Accountant Fees and Services The following table sets +forth the fees paid to the Company’s independent registered public accounting +firm, KPMG LLP, during fiscal years 2005 and 2004. Audit and Non-Audit +Fees 2005 2004 Audit Fees $ 6,948,800 (1) $ 3,402,300 Audit-Related + Fees 46,700 (2) 57,000 Tax Fees 923,000 (3) 784,500 All Other Fees — — Total $ 7,918,500 $ 4,243,800 (1) Audit fees relate to +professional services rendered in connection with the audit of the Company’s +annual financial statements and internal control over financial reporting, +quarterly review of financial statements included in the Company’s Forms 10-Q, +and audit services provided in connection with other statutory and regulatory +filings. (2) Audit-related fees +primarily relate to professional services for the audits of employee benefit +plans. (3) Tax +fees include $690,000 for professional services rendered in connection with tax +compliance and preparation relating to the Company’s expatriate program, tax +audits and international tax compliance; and $233,000 for international tax +consulting and planning services. The Company does not engage KPMG to perform +personal tax services for its executive officers. Policy +on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by +the Independent Auditors Prior to the enactment of the Sarbanes-Oxley Act +of 2002 (the “ Act ”), the Company adopted an +auditor independence policy that banned its auditors from performing non-financial +consulting services, such as information technology consulting and internal +audit services. This auditor policy also mandates that the audit and non-audit +services and related budget be approved by the Audit Committee in advance, and +that the Audit Committee be provided with quarterly reporting on actual +spending. In accordance with this policy, all services to be performed by KPMG +were pre-approved by the Audit Committee. Subsequent to the enactment of the Act, the Audit +Committee met with KPMG to further understand the provisions of that Act as it +relates to auditor independence. KPMG rotated the lead audit partner for fiscal +year 2005 and will rotate other partners as appropriate in compliance with the +Act. The Audit Committee will continue to monitor the activities undertaken by +KPMG to comply with the Act. 111 PART IV Item 15. Exhibits and Financial Statement Schedules. (a) Index +to Exhibits Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/ Period End Date Filed herewith 3.1 Restated Articles of Incorporation, filed with the + Secretary of State of the State of California on January 27, 1988. S-3 7/27/88 3.2 Amendment to Restated Articles of Incorporation, + filed with the Secretary of State of the State of California on May 4, 2000. 10-Q 5/11/00 3.3 By-Laws of the Company, as amended through June 7, + 2004. 10-Q 6/26/04 3.4 Certificate of Amendment to Restated Articles of + Incorporation, as amended, filed with the Secretary of State of the State of + California on February 25, 2005. 10-Q 3/26/05 4.2 Indenture dated as of February 1, 1994, between the + Company and Morgan Guaranty Trust Company of New York. 10-Q 4/01/94 4.3 Supplemental Indenture dated as of February 1, 1994, + among the Company, Morgan Guaranty Trust Company of New York, as resigning + trustee, and Citibank, N.A., as successor trustee. 10-Q 4/01/94 4.5 Form of the Company’s 6 1/2% Notes due 2004. 10-Q 4/01/94 4.8 Registration Rights Agreement, dated June 7, 1996 + among the Company and Goldman, Sachs & Co. and Morgan Stanley & Co. + Incorporated. S-3 8/28/96 4.9 Certificate of Determination of Preferences of + Series A Non-Voting Convertible Preferred Stock of Apple Computer, Inc. 10-K 9/26/97 10.A.3 Apple Computer, Inc. Savings and Investment Plan, as + amended and restated effective as of October 1, 1990. 10-K 9/27/91 10.A.3-1 Amendment of Apple Computer, Inc. Savings and + Investment Plan dated March 1, 1992. 10-K 9/25/92 10.A.3-2 Amendment No. 2 to the Apple Computer, Inc. Savings + and Investment Plan. 10-Q 3/28/97 10.A.5 1990 Stock Option Plan, as amended through November + 5, 1997. 10-Q 12/26/97 10.A.6 Apple Computer, Inc. Employee Stock Purchase Plan, + as amended through April 21, 2005. 10-Q 3/26/05 10.A.8 Form of Indemnification Agreement between the + Registrant and each officer of the Registrant. 10-K 9/26/97 10.A.43 NeXT Computer, Inc. 1990 Stock Option Plan, as + amended. S-8 3/21/97 112 10.A.49 1997 Employee Stock Option Plan, as amended through + October 19, 2001. 10-K 9/28/02 10.A.50 1997 Director Stock Option Plan. 10-Q 3/27/98 10.A.51 2003 Employee Stock Plan, as amended through + November 9, 2005. ü 10.A.52 Reimbursement Agreement dated as of May 25, 2001 by + and between the Registrant and Steven P. Jobs. 10-Q 6/29/02 10.A.53 Option Cancellation and Restricted Stock Award + Agreement dated as of March 19, 2003 by and between The Registrant and Steven + P. Jobs. 10-Q 6/28/03 10.A.54 Form of Restricted Stock Unit Award Agreement. 10-Q 3/27/04 10.A.54-1 Alternative Form of Restricted Stock Unit Award + Agreement. ü 10.A.55 Apple Computer, Inc. Performance Bonus Plan dated + April 21, 2005. 10-Q 3/26/05 10.A.56 Form of Election to Satisfy Tax Withholding with + Stock. 8-K 8/15/05 10.A.57 Form of Option Agreements. ü 10.B.18* Custom Sales Agreement effective October 21, 2002 + between the Registrant and International Business Machines Corporation. 10-K 9/27/03 10.B.19* Purchase Agreement effective August 10, 2005 between + the Registrant and Freescale Semiconductor, Inc. ü 14.1 Code of Ethics of the Company. 10-K 9/27/03 21 Subsidiaries of Apple Computer, Inc. ü 23.1 Consent of Independent Registered Public Accounting + Firm. ü 31.1 Rule13a-14(a)/15d-14(a) Certification of Chief + Executive Officer. ü 31.2 Rule13a-14(a)/15d-14(a) Certification of Chief + Financial Officer. ü 32.1 Section 1350 Certifications of Chief Executive + Officer and Chief Financial Officer. ü * Confidential Treatment +requested as to certain portions of this exhibit. 113 SIGNATURES Pursuant +to the requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the registrant has duly caused this report to be signed on its +behalf by the undersigned, thereunto duly authorized, this 29 th day +of November 2005. Apple Computer, Inc. By: /s/ PETER  OPPENHEIMER Peter Oppenheimer Senior Vice President and Chief Financial Officer KNOW ALL PERSONS BY THESE PRESENTS, that each person +whose signature appears below constitutes and appoints Steven P. Jobs and Peter +Oppenheimer, jointly and severally, his attorneys-in-fact, each +with the power of substitution, for him in any and all capacities, to sign any +amendments to this Annual Report on Form 10-K, and to file the same, +with exhibits thereto and other documents in connection therewith, with the +Securities and Exchange Commission, hereby ratifying and confirming all that +each of said attorneys-in-fact, or his substitute or substitutes, +may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has +been signed below by the following persons on behalf of the registrant and in +the capacities and on the dates indicated: Name Title Date /s/ STEVEN P. JOBS STEVEN + P. JOBS Chief Executive + Officer and Director (Principal + Executive Officer) November 29, 2005 /s/ PETER  OPPENHEIMER PETER + OPPENHEIMER Senior Vice + President and Chief Financial Officer + (Principal Financial and Principal Accounting Officer) November 29, 2005 /s/ FRED  ANDERSON FRED + ANDERSON Director November 29, 2005 /s/ WILLIAM V. CAMPBELL WILLIAM + V. CAMPBELL Director November 29, 2005 /s/ MILLARD S. DREXLER MILLARD + S. DREXLER Director November 29, 2005 /s/ ALBERT  GORE, JR. ALBERT + GORE, JR. Director November 29, 2005 /s/ ARTHUR D. LEVINSON ARTHUR + D. LEVINSON Director November 29, 2005 /s/ JEROME B. YORK JEROME B. YORK Director November 29, 2005 114 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001104659-06-084288/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001104659-06-084288/full-submission.txt new file mode 100644 index 0000000..e071ea9 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001104659-06-084288/full-submission.txt @@ -0,0 +1,5842 @@ +UNITED +STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT +PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the +fiscal year ended September 30, 2006 or o TRANSITION +REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the +transition period from to Commission +file number 000-10030 APPLE +COMPUTER, INC. (Exact +name of registrant as specified in its charter) CALIFORNIA 942404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s +telephone number, including area code: (408) 996-1010 Securities +registered pursuant to Section 12(b) of the Act: Common Stock, no par value (Title of class) Securities +registered pursuant to Section 12(g) of the Act: None Indicate +by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 +of the Securities Act. Yes o No x Indicate +by check mark if the registrant is not required to file reports pursuant to Section 13 +or Section 15(d) of the Act. Yes o No x Indicate +by check mark whether the registrant (1) has filed all reports required to +be filed by Section 13 or 15(d) of the Securities Exchange Act of +1934 during the preceding 12 months (or for such shorter period that the +registrant was required to file such reports), and (2) has been subject to +such filing requirements for the past 90 days. Yes x No o Indicate +by check mark if disclosure of delinquent filers pursuant to Item 405 of +Regulation S-K (section 229.405 of this chapter) is not contained herein, +and will not be contained, to the best of the registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III +of this Form 10-K or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is a +large accelerated filer, an accelerated filer, or a non-accelerated filer. See +definition of  “accelerated filer and +large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check +one): Large accelerated filer x Accelerated filer o Non-accelerated filer o Indicate +by check mark whether the registrant is a shell company (as defined in Rule 12b-2 +of the Act). Yes o No x The +aggregate market value of the voting and non-voting stock held by +non-affiliates of the registrant, as of April 1, 2006, was approximately +$45,716,583,100 based upon the closing price reported for such date on the NASDAQ +Global Select Market. For purposes of this disclosure, shares of Common Stock +held by persons who hold more than 5% of the outstanding shares of Common Stock +and shares held by executive officers and directors of the registrant have been +excluded because such persons may be deemed to be affiliates. This +determination of executive officer or affiliate status is not necessarily a conclusive +determination for other purposes. 859,273,757 shares of Common +Stock Issued and Outstanding as of December 13, 2006 The Business section and other parts of this Annual +Report on Form 10-K (“Form 10-K”) contain forward-looking +statements that involve risks and uncertainties. Many of the forward-looking +statements are located in “Management’s Discussion and Analysis of Financial +Condition and Results of Operations.” Forward-looking statements provide +current expectations of future events based on certain assumptions and include +any statement that does not directly relate to any historical or current fact. Forward-looking +statements can also be identified by words such as “anticipates,” “believes,” “estimates,” +“expects,” “intends,” “plans,” “predicts,” and similar terms. Forward-looking +statements are not guarantees of future performance and the Company’s actual +results may differ significantly from the results discussed in the forward-looking +statements. Factors that might cause such differences include, but are not +limited to, those discussed in the subsection entitled “Risk Factors” under Part I, +Item 1A of this Form 10-K. The Company assumes no obligation to +revise or update any forward-looking statements for any reason, except as +required by law. Explanatory Note In this Form 10-K, Apple Computer, Inc. +(“Apple” or “the Company”) is restating its consolidated balance sheet as of September 24, +2005, and the related consolidated statements of operations, shareholders’ +equity, and cash flows for each of the fiscal years ended September 24, +2005 and September 25, 2004, and each of the quarters in fiscal year 2005. This Form 10-K also reflects the +restatement of “Selected Consolidated Financial Data” in Item 6 for the fiscal +years ended September 2005, 2004, 2003, and 2002, and “Management’s +Discussion and Analysis of Financial Condition and Results of Operations” in +Item 7 for the fiscal years ended September 24, 2005 and September 25, +2004. Previously filed annual reports on Form 10-K +and quarterly reports on Form 10-Q affected by the restatements have +not been amended and should not be relied on. On June 29, 2006, the Company announced that an +internal review had discovered irregularities related to the issuance of +certain stock option grants made between 1997 and 2001, including a grant to +its Chief Executive Officer (“CEO”) Steve Jobs. The Company also announced that +a Special Committee of outside directors (“Special Committee”) had been formed +and had hired independent counsel to conduct a full investigation of the +Company’s past stock option granting practices. On October 4, 2006, the +Company announced the key results of the Special Committee’s investigation, +which are set forth in the Company’s Form 8-K filed on that date. As a result of the internal review and the independent +investigation, management has concluded, and the Audit and Finance Committee of +the Board of Directors agrees, that incorrect measurement dates were used for +financial accounting purposes for certain stock option grants made in prior +periods. Therefore, the Company has recorded additional non-cash stock-based +compensation expense and related tax effects with regard to past stock option +grants, and the Company is restating previously filed financial statements in +this Form 10-K. These adjustments, after tax, amounted to $4 +million, $7 million, and $10 million in fiscal years 2006, 2005 and 2004, +respectively. The adjustment to 2006 was recorded in the fourth quarter of +fiscal year 2006 due to its insignificance. The independent counsel and its forensic accountants (“Investigative +Team”) reviewed the facts and circumstances surrounding stock option grants +made on 259 dates. The Investigative Team spent over 26,500 person-hours +searching more than one million physical and electronic documents and +interviewing more than 40 current and former directors, officers, employees, +and advisors. Based on a review of the totality of evidence and the applicable +law, the Special Committee found no misconduct by current management. The +Special Committee’s investigation identified a number of grants for which grant +dates were intentionally selected in order to obtain favorable exercise prices. +The terms of these and certain other grants, as discussed below, were finalized +after the originally assigned grant dates. The Special Committee concluded that +the procedures for granting, accounting for, and reporting stock option grants 2 did not include sufficient safeguards to prevent +manipulation. Although the investigation found that CEO Steve Jobs was aware or +recommended the selection of some favorable grant dates, he did not receive or +financially benefit from these grants or appreciate the accounting +implications. The Special Committee also found that the investigation had +raised serious concerns regarding the actions of two former officers in +connection with the accounting, recording and reporting of stock option grants. Based on the evidence and findings from the Company’s +internal review and the Special Committee’s independent investigation, an +analysis was performed of the measurement dates for the 42,077 stock option +grants made on 259 dates between October 1996 and January 2003 (the “relevant +period”). The Company believes that the analysis was properly limited to the +relevant period. In addition to analyzing all grants made during the relevant +period, the Company sampled certain grants between 1994 and 1997 and found none +that required accounting adjustments. The first grants for which stock-based +compensation expense is required are dated December 29, 1997. The Company +also examined grants made after the relevant period and found none that +required accounting adjustments. Moreover, in the years after 2002, Apple made +significant changes in its stock option granting practices in response to +evolving legal, regulatory and accounting requirements. Consistent with the accounting literature and recent +guidance from the Securities and Exchange Commission (“SEC”), the grants during +the relevant period were organized into categories based on grant type and +process by which the grant was finalized. The Company analyzed the evidence +related to each category of grants including, but not limited to, electronic +and physical documents, document metadata, and witness interviews. Based on the +relevant facts and circumstances, the Company applied the controlling +accounting standards to determine, for every grant within each category, the +proper measurement date. If the measurement date is not the originally assigned +grant date, accounting adjustments were made as required, resulting in +stock-based compensation expense and related tax effects. The 42,077 grants were classified as follows: (1) 17 +grants to persons elected or appointed to the Board of Directors (“director +grants”); (2) 3,892 grants to employees under the Monday/Tuesday Plan +described below (“Monday/Tuesday grants”); (3) 27,096 grants made in +broad-based awards to large numbers of employees, usually on an annual basis (“focal +grants”); (4) 9,988 other grants ratified at meetings of the Board or +Compensation Committee (“meeting grants”); (5) 1,082 other grants ratified +by unanimous written consent (“UWC”) of the Board or Compensation Committee (“other +UWC grants”); and (6) two grants to the CEO (“CEO grants”). All references +to the number of option shares, option exercise prices, and share prices in +this Explanatory Note have not been adjusted for any subsequent stock splits. With the exception of director grants, all stock +option grants were subject to ratification by the Board or Compensation +Committee at a meeting or by UWC. Following approval of the grants at a meeting +or by UWC, the Company’s legal staff would prepare a Secretary’s Certificate +certifying the ratification of the grants. Based on the facts and circumstances +described below, the Company has concluded that the recipients and terms of +certain grants were fixed for accounting purposes before ratification pursuant +to parameters previously approved by the Board or Compensation Committee +through the Monday/Tuesday Plan and the focal process. As further discussed +below, within these parameters, management had the authority to determine the +recipients and terms for each grant. Thus, the Company has concluded that the +measurement dates for these grants occurred when management’s process for +allocating these grants was completed and the grants were ready for +ratification, which was considered perfunctory. With regard to all other +grants, the Company has concluded that the grants were finalized and the +measurement dates occurred when the grants were ratified. For many grants, +however, the dates of ratification cannot be established because the dates the +UWCs were executed by the Board or Compensation Committee members or received +by the Company are not available. For such grants, the Company has concluded +that the date of the preparation of the Secretary’s Certificate is the best +alternative for determining the actual date of ratification. 3 As discussed below, the Company’s analysis determined +that the originally assigned grant dates for 6,428 grants on 42 dates are not +the proper measurement dates. Accordingly, after accounting for forfeitures, +the Company has recognized stock-based compensation expense of $105 million on +a pre-tax basis over the respective awards’ vesting terms. No adjustments were +required for the remaining 35,649 grants. The adjustments were determined by +category as follows: Director Grants—Seventeen director grants were made +during the relevant period. Two director grants were made pursuant to a 1997 +plan that dated the grants on the enactment of the plan. The remaining fifteen +grants were automatically made under the Director Stock Option Plan for +non-employee directors, which was approved by shareholders in 1998, on the date +of a director’s election or appointment to the Board and on subsequent +anniversaries, beginning on the fourth anniversary. Accordingly, the analysis +determined that the originally assigned grant date for each director grant is +the measurement date, and no accounting adjustments are required. Monday/Tuesday Grants—Beginning in December 1998, +3,892 new hire grants and grants for promotion and retention purposes (“promotion/retention +grants”) were made during the relevant period under the “Monday/Tuesday Plan.” +Under the Monday/Tuesday Plan, new hire grants made within pre-established +guidelines approved by the Board or Compensation Committee were dated on the +Monday that the recipient started work (or the following Monday, if the +recipient started on another day). The Company’s analysis showed this process +to be reliable with very low error rates. Promotion/retention grants, also +based on pre-established guidelines, were made generally on the first Tuesday +of each month. The Company has concluded that the new hire and +promotion/retention grants made pursuant to the Monday/Tuesday Plan within +pre-established guidelines do not require adjustment, with the exception of six +grants that were erroneously dated before the employees’ start dates. For 120 +new hire and promotion/retention grants made outside the guidelines, however, +the Company has concluded that the measurement dates are the dates of +ratification by the Board or Compensation Committee rather than the dates used +for grants within guidelines. Accordingly, based on the methodology described +above, the Company has recognized stock-based compensation expense of $6 +million from 126 grants. If other dates in the period between the preparation +of the UWC and the preparation of the Secretary’s Certificate had been used as +measurement dates for grants whose actual ratification dates are unknown, the +total stock-based compensation expense would have ranged from approximately $3 +million to $7 million. Focal Grants—During the relevant period, 27,096 focal +grants were made to employees typically on an annual basis as part of an +extensive process that required several months to complete. Pursuant to limits, +guidelines and practices previously approved by the Board or Compensation +Committee, managers throughout the Company would make recommendations for +grants to employees in their areas of responsibility. After senior management +had determined that the grants were made in accordance with these established +limits, guidelines and practices, management treated the grants as final when +they were submitted to the Board or Compensation Committee for ratification. The +Company has concluded that for 5,595 grants on five dates, the originally +assigned grant dates are not the proper measurement dates. For these grants, +management’s process for finalizing the grants was completed after the originally +assigned grant dates. As a result, the Company has recognized $29 million of +stock-based compensation expense. For two of the five grant dates comprising +3,744 grants, the evidence shows that the grants were finalized and the +measurement date occurred one day after the originally assigned grant dates. The +grants on these two dates represent more than $16 million of the total $29 +million of stock-based compensation expense resulting from focal grants. Other Meeting Grants—During the relevant period, +meetings of the Board or Compensation Committee were held to ratify 9,988 +grants that are not Monday/Tuesday, focal or CEO grants. The grant dates and +measurement dates for these grants are the meeting dates when the grants were +ratified, with the exception of 46 grants. Forty-two of these 46 grants are +dated concurrent with a meeting that considered and approved certain grants, +but the evidence indicates that all of the grants may not have been finalized +until a 4 later date. One of the 46 grants was approved and +dated at another meeting, but the recipient, who was becoming employed by the +Company as part of a corporate acquisition, did not start until a later date. +Two other grants were approved before the employees’ start dates. Another grant +was mistakenly cancelled and subsequently reinstated, requiring an accounting +adjustment. Thus, for these 46 grants the Company has concluded that the originally +assigned grant dates are not the proper measurement dates. As a result, the +Company has recognized $2 million of stock-based compensation expense. Other UWC Grants—During the relevant period, 1,082 +grants were approved by UWCs for a variety of purposes, including executive +recruitment, retention, promotion and new hires outside the Monday/Tuesday +process. These grants were not made pursuant to pre-established guidelines +adopted by the Board or Compensation Committee. Therefore, the Company has +concluded that these grants were not finalized for accounting purposes until +ratification by the Board or Compensation Committee. Accordingly, for 660 +grants, the Company has concluded that the originally assigned grant dates are +not the proper measurement dates. As a result, the Company has recognized $48 +million of stock-based compensation expense. If other dates in the period from +the preparation of the UWC to the preparation of the Secretary’s Certificate +had been used as measurement dates for grants whose actual ratification dates +are unknown, the total stock-based compensation would have ranged from +approximately $35 million to $56 million. CEO Grants—During the relevant period, the Company +made two grants to CEO Steve Jobs. The first grant, dated January 12, +2000, was for 10 million option shares. The second grant, dated October 19, +2001, was for 7.5 million option shares. Both grants were cancelled in March 2003 +prior to being exercised, when Mr. Jobs received 5 million shares of +restricted stock. With respect to the grant dated January 12, 2000, +the Board on December 2, 1999, authorized a special “CEO Compensation +Committee” to grant Mr. Jobs up to 15 million shares. The evidence +indicates that the CEO Compensation Committee finalized the terms of the grant +on January 12, 2000, although the Committee’s action was memorialized in a +UWC transmitted on January 18, 2000. Because the measurement date is the originally +assigned grant date, the Company has not recognized any stock-based +compensation expense from this grant. If the Company had determined that the +measurement date was the date when the UWC was executed or received, then +additional stock-based compensation would have been recognized. The grant dated October 19, 2001 was originally +approved at a Board meeting on August 29, 2001, with an exercise price of +$17.83. The terms of the grant, however, were not finalized until December 18, +2001. The grant was dated October 19, 2001, with an exercise price of +$18.30. The approval for the grant was improperly recorded as occurring at a +special Board meeting on October 19, 2001. Such a special Board meeting +did not occur. There was no evidence, however, that any current member of +management was aware of this irregularity. The Company has recognized $20 +million in stock-based compensation expense for this grant, reflecting the +difference between the exercise price of $18.30 and the share price on December 18, +2001 of $21.01. 5 The +incremental impact from recognizing stock-based compensation expense resulting +from the investigation of past stock option grants is as follows (dollars in +millions): Fiscal Year Pre-Tax Expense (Income) After Tax Expense 1998 $ (1 ) $ — 1999 8 6 2000 13 9 2001 19 13 2002 29 23 2003 16 12 Total 1998 – 2003 + impact 84 63 2004 13 10 2005 7 7 2006 1 4 Total $ 105 $ 84 Additionally, the Company has restated the pro forma +expense under Statement of Financial Accounting Standards (“SFAS”) No. 123 +in Note 1 of the Notes to Consolidated Financial Statements of this Form 10-K +to reflect the impact of these adjustments for the years ended September 24, +2005 and September 25, 2004. 6 PART I Item 1. Business Company Background Apple Computer, Inc. +(“Apple” or the “Company”) was incorporated under the laws of the State of +California on January 3, 1977. The Company designs, manufactures, and +markets personal computers and related software, services, peripherals, and +networking solutions. The Company also designs, develops, and markets a line of +portable digital music players along with related accessories and services, +including the online sale of third-party audio and video products. The Company’s +products and services include the Macintosh® line of desktop and portable +computers, the Mac OS® X operating system, the iPod® line of portable digital +music players, the iTunes Store®, a portfolio of peripherals that support and +enhance the Macintosh and iPod product lines, a portfolio of consumer and +professional software applications, a variety of other service and support +offerings, and the Xserve® and Xserve RAID server and storage products. The +Company sells its products worldwide through its online stores, its retail +stores, its direct sales force, and third-party wholesalers, resellers, and +value-added resellers. In addition, the Company sells a variety of third-party +Macintosh and iPod compatible products including application software, printers, +storage devices, speakers, headphones, and various other accessories and +supplies through its online and retail stores. The Company sells to education, +consumer, creative professional, business, and government customers. The +Company’s fiscal year ends on the last Saturday of September. Unless otherwise +stated, all information presented in this Form 10-K is based on the +Company’s fiscal calendar. Business Strategy The Company is committed +to bringing the best personal computing and portable digital music experience +to students, educators, creative professionals, businesses, government +agencies, and consumers through its innovative hardware, software, peripherals, +services, and Internet offerings. The Company’s business strategy leverages its +unique ability to design and develop its own operating system, hardware, +application software, and services to provide its customers new products and +solutions with superior ease-of-use, seamless integration, and innovative +industrial design. The Company believes continual investment in research and +development is critical to facilitate innovation of new and improved products +and technologies. Besides updates to its existing line of personal computers +and related software, services, peripherals, and networking solutions, the +Company continues to capitalize on the convergence of digital consumer +electronics and the personal computer by creating and refining innovations like +the iPod and iTunes Store. The Company’s strategy also includes expanding its +distribution network to effectively reach more of its targeted customers and +provide them with a high-quality sales and after-sales support experience. Digital Lifestyle The Company believes that +for both professionals and consumers the personal computer has become the center +of an evolving digital lifestyle by integrating and enhancing the utility of +advanced digital devices such as the Company’s iPods, digital video and still +cameras, televisions, CD and DVD players, cellular phones, personal digital +assistants, and other consumer electronic devices. The attributes of the +personal computer that enable this functionality include a high-quality user +interface, easy access to relatively inexpensive data storage, the ability to +run complex applications, and the ability to connect easily to a wide variety +of other digital devices and to the Internet. The Company is the only +participant in the personal computer industry that controls the design and +development of the entire personal computer—from the hardware and operating +system to sophisticated applications. This, along with its products’ original +industrial designs, intuitive ease-of-use, built-in graphics, multimedia and +networking capabilities, uniquely positions the Company to offer innovative +integrated digital lifestyle solutions. 7 Expanded +Distribution The Company believes a high-quality buying experience +with knowledgeable salespersons that can convey the value of the Company’s +products and services greatly enhances its ability to attract and retain +customers. The Company sells many of its products and resells certain +third-party products in most of its major markets directly to consumers, +education customers, and businesses through its retail and online stores. The +Company has also invested in programs to enhance reseller sales, including the +Apple Sales Consultant Program, which places Apple employees and contractors at +selected third-party reseller locations. The Company believes providing direct +contact with its targeted customers is an efficient way to demonstrate the advantages +of its Macintosh computer and other products over those of its competitors. The +Company has significantly increased the points of distribution for the iPod +product family in order to make its products available at locations where its +customers shop. By the end of fiscal 2006, the Company had opened a +total of 165 retail stores, including 147 stores in the U.S. and a total of 18 +stores in Canada, Japan, and the U.K. The Company opened 5 additional stores in +October and November 2006. The Company has typically located its +stores at high-traffic locations in quality shopping malls and urban shopping +districts. One of the goals of the retail initiative is to bring new customers to +the Company and expand its installed base through sales to computer users who +currently do not own a Macintosh computer and first time personal computer +buyers. By operating its own stores and building them in desirable high-traffic +locations, the Company is able to better control the customer retail experience +and attract new customers. The stores are designed to simplify and enhance the +presentation and marketing of personal computers and related products. To that +end, retail store configurations have evolved into various sizes in order to +accommodate market demands. The stores employ experienced and knowledgeable +personnel who provide product advice and certain hardware support services. The +stores offer a wide selection of third-party hardware, software, and various +other computing products and supplies selected to complement the Company’s own +products. Additionally, the stores provide a forum in which the Company is able +to offer specialized service and personalized training. Education Throughout its history, +the Company has focused on the use of technology in education and has been +committed to delivering tools to help educators teach and students learn. The +Company believes effective integration of technology into classroom instruction +can result in higher levels of student achievement, especially when used to +support collaboration, information access, and the expression and +representation of student thought and ideas. The Company creates solutions that +enable new modes of curriculum delivery, better ways of conducting research, +and opportunities for professional development of faculty, students, and staff. +The Company has designed a range of products and services to meet the needs of +education customers. These products and services include the iMac™ and the +MacBook®, video creation and editing solutions, wireless networking, +professional development solutions, and one-to-one (1:1) learning solutions. A +1:1 learning solution typically consist of a +portable computer for every student and teacher along with the installation of +a wireless network . Creative +Professionals Creative professionals constitute one of the Company’s +most important markets for both hardware and software products. This market is +also important to many third-party developers who provide Macintosh-compatible +hardware and software solutions. Creative customers utilize the Company’s +products for a variety of activities including digital video and film +production and editing; digital video and film special effects, compositing and +titling; digital still photography and workflow management; graphic design, +publishing, and print production; music creation and production; audio +production and sound design; and web design, development, and administration. 8 The Company designs its +high-end hardware solutions, including servers, desktops, and portable +Macintosh systems, to incorporate the power, expandability, and features +desired by creative professionals. The Company’s operating system, Mac OS X, +incorporates powerful graphics and audio technologies and features developer +tools to optimize system and application performance when running creative +solutions provided by the Company or third-party developers. Business +Organization The Company manages its +business primarily on a geographic basis. The Company’s reportable operating +segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas, Europe, and Japan reportable segments do not include activities +related to the Retail segment. The Americas segment includes both North and +South America. The Europe segment includes European countries as well as the +Middle East and Africa. The Retail segment currently operates Apple-owned +retail stores in the U.S., Canada, Japan, and the U.K. Other operating segments +include Asia-Pacific, which includes Australia and Asia except for Japan, and +the Company’s subsidiary, FileMaker, Inc. Each reportable geographic +operating segment provides similar hardware and software products and similar +services. Further information regarding the Company’s operating segments may be +found in Part II, Item 7 of this Form 10-K under the heading “Segment +Operating Performance,” and in Part II, Item 8 of this Form 10-K +in the Notes to Consolidated Financial Statements at Note 11, “Segment +Information and Geographic Data.” Hardware Products The Company offers a range +of personal computing products including desktop and notebook computers, server +and storage products, related devices and peripherals, and various third-party +hardware products. The Company’s Macintosh® systems, excluding servers and +storage systems, features the Company’s Mac OS® X Version 10.4 Tiger™ and +iLife® suite of software for digital photography, music, movies, and music and +website creation. Macintosh® +Computers In June 2005, the +Company announced its plan to begin using Intel microprocessors in its +computers. During 2006, the Company introduced new Intel-based models of the +MacBook™ Pro, MacBook, Mac® Pro, iMac®, and Mac mini computers. All Intel-based +Macintosh systems feature a fully native version of Mac OS X Version 10.4 +Tiger, including the Rosetta™ translation technology, which allows most +PowerPC-based Macintosh applications to run on Intel-based Macintosh computers. +The Company’s transition to Intel microprocessors for Macintosh systems was +completed in August 2006, and its transition for Xserve® was completed in November 2006. +There are potential risks and uncertainties associated with the transition to +Intel microprocessors, which are further discussed in Item 1A of this 10-K +under the heading “Risk Factors.” MacBook™ Pro The MacBook Pro family of +notebook computers is designed for professionals and advanced consumer users. Introduced +in January 2006, the MacBook Pro includes either a 15-inch or 17-inch +widescreen display, a built-in iSight video camera, Front Row with the Apple +Remote, and the MagSafe™ power adapter. Current MacBook Pro models include +Intel Core 2 Duo processors at 2.16GHz or 2.33GHz, ATI Mobility Radeon X1600 +graphics, 667MHz DDR2 main memory, a Serial ATA hard drive, and a slot-loading +double-layer SuperDrive™. Every MacBook Pro features a 1-inch thin +aluminum enclosure and includes AirPort Extreme wireless networking, Bluetooth +2.0+EDR, Gigabit Ethernet, two or three USB 2.0 ports, FireWire 400 and 800 +ports, combination analog and optical digital audio input and output ports, a +full-sized DVI video-out port, an ExpressCard/34 slot, scrolling trackpad, and +backlit keyboard. 9 MacBook™ The MacBook is designed +for consumer and education users. Introduced in May 2006, the MacBook +includes a 13-inch widescreen display, a built-in iSight video camera, +Front Row with the Apple Remote, and the MagSafe magnetic power adapter. Current +MacBook models include Intel Core 2 Duo processors at 1.83GHz and 2.0GHz, Intel +integrated GMA 950 graphics, 667MHz DDR2 main memory, a Serial ATA hard drive, +and a slot-loading Combo optical drive or double-layer SuperDrive. Available in +either black or white, every MacBook includes built-in AirPort Extreme wireless +networking, Bluetooth 2.0+EDR, Gigabit Ethernet, two USB 2.0 ports, one +FireWire 400 port, combination analog and optical digital audio input and +output ports, a mini-DVI video output port, and scrolling trackpad. Mac® Pro The Mac Pro desktop +computer is targeted at business and professional users and is designed to meet +the performance, expansion, and networking needs of the most demanding +Macintosh user. Introduced in August 2006, the Mac Pro features two Intel +Xeon dual-core processors running up to 3.0GHz, each with 4MB of shared Level 2 +cache and independent 1.33GHz front-side buses, 667MHz fully buffered memory, +and a 256-bit wide memory architecture. The Mac Pro also features a +direct attach storage solution for snap-in installation of up to four 750GB +Serial ATA hard drives for a total of 3TB of internal storage and support for +two optical drives to simultaneously read and/or write to CDs and DVDs. Every +Mac Pro includes three full-length PCI Express expansion slots and one +double-wide PCI Express graphics slot to support double-wide graphics cards. The +Mac Pro also includes dual Gigabit Ethernet ports, optical digital input and +output ports, analog audio input and output ports, and multiple FireWire 400, +FireWire 800 and USB 2.0 ports. iMac® The iMac desktop computer +is targeted at consumer and education markets. Introduced in January 2006 +and updated in September 2006, the Intel-based iMac is currently available +with an integrated 17-inch widescreen LCD display, 512MB or 1GB of 667MHz +DDR2 memory expandable to 2GB or 3GB, a 1.83GHz or 2.0GHz Intel Core 2 Duo +processor, Intel integrated GMA 950 or ATI Radeon X1600 graphics, and a 160GB +Serial ATA hard drive. The iMac is also available with a 20-inch or 24-inch +widescreen LCD display, 1GB of 667MHz memory expandable to 3GB, a 2.16GHz +processor, ATI Radeon X1600 or NVIDIA GeForce 7300 GT graphics, and 250GB +Serial ATA hard drive. All models include a built-in iSight video camera, +mini-DVI video-out port, multiple USB 2.0 and FireWire ports, built-in Gigabit +Ethernet, and AirPort Extreme 802.11g wireless networking. Most models also +include built-in Bluetooth 2.0+EDR, the Apple Remote, and a slot-loading +double-layer SuperDrive. Mac® mini In February 2006, the +Company introduced the Intel-based Mac mini that includes Front Row with the +Apple Remote. The new Mac mini offers 512MB of 667MHz memory expandable to 2GB +and either a 1.66GHz or 1.83GHz Intel Core Duo processor. Every Mac mini now +includes built-in Gigabit Ethernet, AirPort Extreme 802.11g wireless +networking, Bluetooth 2.0+EDR, and a total of four USB 2.0 ports. Mac mini +includes a full-size DVI interface and a VGA-out adapter to connect to a +variety of displays, including televisions, and features both analog and +digital audio outputs. Xserve® and Xserve +RAID Storage System Xserve is a rack-mount +server product designed for simple setup and remote management of intensive +input/output (I/O) applications such as digital video, high-resolution digital +imagery, and large databases. In November 2006, the Company began shipping +Xserve, a 64-bit server featuring Mac OS® X Server 10.4 on two Intel Xeon +dual-core processors running at 2.0GHz, 2.66GHz, or 3.0GHz, with support for up +to 32GB of memory. Xserve includes PCI Express and independent 1.33GHz front +side buses with 4MB of shared Level 2 memory cache. Two eight-lane PCI Express +expansion slots provide up to 2GB of 10 throughput each to support +fibre channel, networking, and graphics cards. Xserve supports up to 2.25TB of +hot-plug storage. The Company’s Xserve RAID storage system delivers up to 7TB +of storage capacity and also expanded support for heterogeneous environments. The +dual independent RAID controllers with 512MB cache per controller offer +sustained throughput of over 385 Mbps. Music Products and Services The Company offers its +iPod® line of portable digital music players and related accessories to +Macintosh and Windows users. The Company also provides an online service to +distribute third-party music, audio books, music videos, short films, +television shows, movies, and iPod games through its iTunes Store. In addition +to the Company’s own iPod accessories, thousands of third-party iPod compatible +products are available, including portable and desktop speaker systems, +headphones, car radio solutions, voice recorders, cables and docks, power +supplies and chargers, and carrying cases and armbands. iPod® The iPod is the Company’s +hard-drive based portable digital music player and was updated in September 2006. +The iPod is available in a 30GB model capable of holding up to 7,500 songs, +25,000 photos, or 75 hours of video, and an 80GB model capable of holding up to +20,000 songs, 25,000 photos, or 100 hours of video. The iPod features up to 20 +hours of battery life and includes a 2.5-inch color screen that can +display album artwork, photos, and video content including music videos, video +and audio podcasts, short films, television shows, movies, and games. Other key +features of the iPod include a calendar , contact +utility, and data storage capability. The iPod features the Company’s +patent-pending Click Wheel, a touch-sensitive wheel with five push buttons for +one-handed navigation. The iPod also includes the Company’s patent-pending +Auto-Sync technology that automatically synchronizes and updates the iPod’s +digital music and other content whenever it is connected to a Macintosh or +Windows computer via USB. All iPods work with the Company’s iTunes digital +music management software (“iTunes software”) available +for both Macintosh and Windows-based computers. iPod® nano In September 2006, +the Company introduced the second-generation version of its flash-memory-based +iPod nano featuring an aluminum body and up to 24 hours of battery life. The +second-generation iPod nano includes the Click Wheel, a smaller and lighter +design, a brighter color screen than its predecessor, and new Search and Quick +Scroll features that make it easier to find content. The iPod nano is available +in 2GB, 4GB and 8GB configurations and in a variety of colors. iPod® shuffle In September 2006, +the Company introduced a new version of its flash-memory-based iPod shuffle. +The new iPod shuffle weighs half an ounce and features an all-new aluminum +design and a built-in clip. The new iPod shuffle contains one gigabyte of flash +memory capable of holding up to 240 songs and provides up to 12 hours of +battery life. The iPod shuffle is based on the Company’s shuffle feature that +allows users to listen to their music in random order. iPod shuffle works with +iTunes and its patent-pending AutoFill option that automatically selects songs +to fill the iPod shuffle from a user’s iTunes library. iTunes® Store The Company’s iTunes Store, available for both +Macintosh and Windows-based computers, is a service that allows customers to +find, purchase, and download third-party digital music, audio books, music +videos, short films, television shows and movies, and iPod games. The iTunes +Store also features the Podcast Directory that allows customers to search for +and download audio programs to their computers and automatically receive new +episodes over the Internet. Customers can search the contents of the store +catalog to locate works by title, artist, or album, or browse the entire +contents of the store by genre and 11 artist. Originally introduced in the U.S. in April 2003, +the iTunes Store now serves customers in 22 countries. The iTunes Store is fully +integrated with iTunes software allowing customers to preview, purchase, +download, organize, share, and transfer digital content to an iPod using a +single software application. Further discussion of the iTunes software may be +found below under the heading “Software Products and Computer Technologies.” +The iTunes Store offers customers a broad range of personal rights to the +third-party content they have purchased. Content purchased through the store +may also be used in certain applications such as iPhoto®, iMovie®, and iDVD®. +Additional features of the iTunes Store include gift certificates that can be +sent via e-mail; prepaid music cards; an “allowance” feature that enables users +to automatically deposit funds into an iTunes Store account every month; online +gift options that let customers give specific content to anyone with an email +address; parental controls; and album reviews. Peripheral Products The Company sells a +variety of Apple-branded and third-party computer hardware peripheral products +directly to end-users through its retail and online stores, including printers, +storage devices, computer memory, digital video and still cameras, and various +other computing products and supplies. Displays The Company manufactures a +family of widescreen flat panel displays including the 30-inch Apple +Cinema HD Display™, a widescreen active-matrix LCD with 2560-by-1600 +pixel resolution, the 23-inch Apple Cinema HD Display with 1920-by-1200 +pixel resolution and the 20-inch Apple Cinema Display® with 1680-by-1050 +pixel resolution. These displays feature built-in dual FireWire and dual USB +2.0 ports and use the industry standard DVI interface for a pure digital +connection with the Company’s latest Mac Pro, MacBook Pro, and MacBook systems. +The Cinema Displays feature an aluminum design with a thin bezel, suspended by +an aluminum stand that allows viewing angle adjustment. Software Products +and Computer Technologies The Company offers a range +of software products for education, creative, consumer, and business customers, +including Mac OS X, the Company’s proprietary operating system software for the +Macintosh; server software and related solutions; professional application +software; and consumer, education, and business oriented application software. Operating System +Software Mac OS X is built on an +open-source UNIX-based foundation. The most recent version, Mac OS X Tiger, is +the fifth major release of Mac OS X. Tiger incorporates innovations including +Spotlight™, a desktop search technology that lets users find items stored on +their Macintosh computers, including documents, emails, contacts, and images; +and Dashboard, a way to instantly access information such as weather forecasts +and stock quotes, using a new class of mini-applications called widgets. Mac OS +X Server version 10.4 is the server version of the Mac OS operating system. Server Software and +Server Solutions In April 2006, the Company introduced Apple +Remote Desktop 3, the Company’s third generation desktop management application. +Apple Remote Desktop 3 is a Universal application, meaning that it runs +natively on both Intel and PowerPC-based Macintosh computers (Universal) for +asset management and remote assistance that enables Spotlight searches across +multiple Tiger systems and includes over 30 Automator actions for automating +repetitive system administration tasks, a Dashboard Widget that provides +observation of remote systems, and AutoInstall for installing software +automatically on mobile systems when they return online. 12 Xsan®, the Company’s +enterprise-class Storage Area Network (“SAN”) file system, is a 64-bit +cluster file system for Mac OS X that enables organizations to consolidate +storage resources and provide multiple computers with concurrent file-level +read/write access to shared volumes over Fibre Channel. Advanced features such +as metadata controller failover and Fibre Channel multipathing ensure high +availability; file-level locking allows multiple systems to read and write +concurrently to the same volume which is ideal for complex workflows; bandwidth +reservation provides for effective ingestion of bandwidth-intensive data +streams, such as high resolution video; and flexible volume management results +in more efficient use of storage resources. Xsan can be used in heterogeneous +environments that include Windows, UNIX, and Linux server operating system +platforms. Professional +Application Software In March 2006, the Company introduced Final Cut +Studio ® 5.1, the Company’s High Definition (“HD”) +video production suite. Final Cut Studio features Final Cut Pro® 5, Soundtrack® +Pro, Motion 2, and DVD Studio Pro® 4. All of these applications are Universal. Final Cut Pro® 5.1, the latest version of the Company’s +video editing software, includes editing tools that work natively with most +formats, from Digital Video (“DV”) and High Definition Video (“HDV”) to fully +uncompressed HD. With a real-time multi-stream effects architecture, multicam +editing tools, and advanced color correction, Final Cut Pro 5.1 enables users +to view and cut from multiple sources in real time, group up to 128 sources +together into multi-clips, then add or subtract cameras at any time. DVD Studio Pro® 4 is the latest version of the Company’s +professional DVD authoring application. With DVD Studio Pro 4 users can author +Standard Definition (“SD”) or HD DVDs in a graphic interactive environment. DVD +Studio Pro 4 includes Compressor 2, a full-featured video and audio compression +application. Compressor gives users control over encoding, including the +ability to encode several clips in one batch operation to a wide variety of +formats including H.264. Motion 2 is a real-time motion graphics software +application that enables Final Cut Pro editors to add motion graphics to their +projects. Motion 2 features interactive animation of text and graphics for DVD +motion menus, video or film in real time, and quick output rendering by +built-in GPU acceleration at 8-bit, 16-bit, or 32-bit float +film quality. With Motion 2’s design tool, Replicator, users can automatically +generate and animate multiple copies of a graphic, shape, or movie. Soundtrack® Pro is an audio editing and sound design +application that gives audio and video professionals a way to edit, mix, and +repair audio. Soundtrack Pro features a waveform editor with flexible Action +Layers that allow users to re-order, bypass, or change any edit, effect, or +process. Find-and-Fix features identify and repair common audio problems such +as background noise, pops, clicks, and hum. An integrated multitrack mixer +allows editors to apply common effects to multiple tracks and group common +tracks. Soundtrack Pro also features over 50 professional plug-ins for +enhancing sounds, and over 5,000 music and sound effect loops. In February 2006, the +Company introduced Logic® Pro 7.2, a Universal version of the Company’s music +creation and audio production software. Logic Pro 7.2 is used by musicians +around the world and by professionals in music production and film scoring. It +combines digital music composition, notation, and audio production facilities +in one comprehensive product and includes software instruments such as +Sculpture®, a component-modeling based synthesizer; UltraBeat®, a drum +synthesizer with built-in step sequencer; and digital signal processing (DSP) +plug-ins including Guitar Amp Pro, a full-featured guitar amplifier simulator. +Along with workflow enhancements, mastering plug-ins, and support for Apple +Loops, Logic Pro 7 adds distributed audio processing, a technology that allows +professionals to utilize multiple Macintosh systems to expand available DSP +power via an Ethernet network. 13 Consumer, +Education, and Business Oriented Application Software iLife® ‘06 In January 2006, the Company introduced iLife ‘06, +an upgrade to its consumer-oriented digital lifestyle application suite, which +features iWeb™, iPhoto® 6, iMovie® HD 6, iDVD® 6, GarageBand™ 3, and iTunes®. All +of these applications are Universal. iWeb™ is a new application in the iLife ‘06 suite. +iWeb allows users to create online photo albums, blogs, and podcasts and +customize websites using editing tools. iPhoto® is the Company’s consumer-oriented digital +photo software application. iPhoto 6 adds new photo management and editing +features, supports up to 250,000 photos, and introduces Photocasting™. +Photocasting allows .Mac users to share and automatically update photo albums +over the Internet with anyone who uses a Macintosh or Windows-based computer. iMovie® HD is the Company’s consumer-oriented digital +video editing software application. iMovie HD 6 includes new real-time effects +that take advantage of Core Video technology, which uses the computer’s video +card’s graphics processing unit to deliver hardware acceleration to quickly +preview video effects. iMovie HD 6 also provides a solution to make video +podcasts, which can be published with iWeb, and includes audio enhancement +tools and sound effects. iDVD® is the Company’s consumer-oriented software +application that enables users to turn iMovie files, QuickTime® files, and +digital pictures into DVDs that can be played on most consumer DVD players. iDVD® +6 allows users to take content shot with HDV and widescreen DV cameras and +author custom DVDs with widescreen menus, movies, and high resolution +slideshows. iDVD 6 features 10 new Apple-designed menu themes in both +widescreen (16:9) and standard (4:3) formats. GarageBand™ is the Company’s consumer-oriented music +creation software application that allows users to play, record and create +music using a simple interface. With GarageBand, recorded performances, digital +audio and looping tracks can be arranged and edited to create songs. GarageBand +3 allows users to record, produce, and publish through iWeb their own podcasts, +including artwork, sound effects, and music jingles. iLife ‘06 also includes +iTunes, the Company’s digital music jukebox software application that allows users +to purchase a variety of digital content available through the Company’s iTunes +Store. iTunes organizes content using searching, browsing, and playlists, and +also includes features such as iMix playlist sharing and provides integration +with the complete family of iPods. In September 2006, the Company +introduced iTunes 7, the latest version of its iTunes software. iTunes 7 +delivers new features such as album and Cover Flow views of music, television +shows, and movies, enabling users to quickly find titles in their library as +well as casually browse through titles they already own. iWork™ ‘06 In January 2006, the Company introduced iWork ‘06, +a new Universal version of the Company’s suite of productivity software +designed to help users create, present, and publish documents and +presentations. iWork ‘06 includes Pages® 2 and Keynote® 3. Pages® gives users the tools to create letters, +newsletters, reports, brochures and resumes with advanced typography, multiple +columns, footnotes, tables of content and styles. Pages 2 features mail +merge with Mac OS X Address Book, which allows users to personalize documents +by dragging and dropping individual contacts into documents using templates +with predefined fields. Pages 2 also features new templates for +newsletters, flyers, posters, school reports, scrapbooks, brochures, business +proposals, and invoices. Pages 2 allows users to insert tables that have +basic calculation functionality within any document and users can export their Pages 2 +document to other formats. 14 Keynote® is the Company’s presentation software that +gives users the ability to create presentations, portfolios, interactive +slideshows, and storyboards. Keynote 3 offers additional ways to create +presentations and interactive slideshows. It features new cinematic transitions +including vertical and horizontal blinds, revolving door, and swoosh. A new +view mode, Light Table, allows users to view an entire presentation and +reorganize slides using drag and drop. Final Cut® Express HD enables users to capture, edit, +and output DV and HDV over a single FireWire cable, and supports Digital Cinema +Desktop with multiple displays. In May 2006, the Company introduced a +Universal version of Final Cut Express HD 3.5. Features introduced in this +version include Dynamic RT for real-time playback of multi-stream effects, +Soundtrack 1.5 with a suite of audio production tools, and LiveType 2.1 with +animated text and titles. In March 2006, the Company introduced Logic® +Express 7.2, a Universal version of the Company’s streamlined version of Logic +Pro 7.2 that provides a basic set of professional tools to compose and produce +music for students, educators, and advanced hobbyists. Its high-resolution +audio of up to 24-bit/96kHz, the adaptive self-configuring track mixer, +and 32-bit floating-point math provides professional sound quality. Logic +Express 7 comes with support for projects from GarageBand, offering users a +smooth migration path to high-end audio production. FileMaker, Inc., a +wholly owned subsidiary of the Company, develops, publishes, and distributes +desktop-based database management application software for both Macintosh and +Windows-based computers. The FileMaker ® Pro database +software and related products offer relational databases and desktop-to-web +publishing capabilities. In July 2006, the Company introduced FileMaker +Pro 8.5, a Universal version of its database management application. New +features of FileMaker Pro 8.5 include FileMaker Web Viewer, which allows for a +live web browser to be put into a database. Internet Software +and Services The Company is focused on +delivering seamless integration with and access to the Internet throughout the +Company’s products and services. The Company’s Internet solutions adhere to +many industry standards to provide an optimized user experience through +interoperability. Safari ™ Safari, the Company’s Mac +OS X compatible web browser, uses the advanced interface technologies +underlying Mac OS X and includes built-in Google search; SnapBack™ to instantly +return to search results; a way to name, organize and present bookmarks; tabbed +browsing; and automatic “pop-up” ad blocking. QuickTime ® QuickTime, the Company’s multimedia software for +Macintosh or Windows-based computers, features streaming of live and stored +video and audio over the Internet and playback of high-quality audio and video +on computers. QuickTime 7 features H.264 encoding and can automatically +determine a user’s connection speed to ensure they are getting the +highest-quality content stream possible. QuickTime 7 also delivers +multi-channel audio and supports audio formats, including AIFF, WAV, MOV, MP4 +(AAC only), CAF, and AAC/ADTS. The Company offers several +other QuickTime products. QuickTime 7 Pro, a suite of software tools, allows +creation and editing of Internet-ready audio and video files. QuickTime 7 Pro +allows users to create H.264 video, capture audio and video, create +multi-channel audio, and export multiple files while playing back or editing +video. .Mac™ The Company’s .Mac +offering is a suite of Internet services that for an annual fee provides +Macintosh users with a powerful set of Internet tools. .Mac services include: +HomePage, for personal web sites; iDisk, a 15 virtual hard drive +accessible anywhere with Internet access; .Mac Sync, which keeps Safari +bookmarks, iCal® calendars, Address Book information, Keychain® (passwords), +and Mac OS X Mail preferences up-to-date across multiple Macintosh computers +and available via web browser when users are away from their Mac; .Mac Mail, an +ad-free email service; and Learning Center, featuring tutorials for certain +software applications. The current version of .Mac includes .Mac Groups, a +service that helps members communicate, coordinate schedules, and stay in sync +with private groups of friends or colleagues; an updated version of .Mac Backup +software that allows members to archive the content of their iLife Home folder; +and combined iDisk and email storage of up to 1GB for individuals and 2GB for +families. Wireless +Connectivity and Networking AirPort Extreme® AirPort Extreme is the +Company’s Wi-Fi wireless networking technology. AirPort Extreme is based on the +802.11g standard, which supports speeds up to 54 Mbps, and is fully compatible +with most Wi-Fi devices that use the 802.11b standard. AirPort Extreme Base +Stations can serve up to 50 Macintosh and Windows users simultaneously, provide +wireless bridging to extend the range beyond just one base station, and support +USB printer sharing to allow multiple users to wirelessly share USB printers +connected directly to the base station. AirPort Extreme client technology is +built into most Macintosh models, and is an available option for all. AirPort® Express™ AirPort Express is the +first 802.11g mobile base station that can be plugged directly into the wall +for wireless Internet connections and USB printing. Airport Express also +features analog and digital audio outputs that can be connected to a stereo and +AirTunes™ music networking software that works with iTunes, giving users a way +to wirelessly stream iTunes music from their Macintosh or Windows-based +computer to any room in the house. AirPort Express features a single piece +design weighing 6.7 ounces. Other Connectivity +and Networking Solutions Mac OS X includes capabilities for Bluetooth +technology. Bluetooth is an industry standard for wirelessly connecting +computers and peripherals that supports transmission of data at up to 3 Mbps +within a range of approximately 30 feet. Bluetooth technology for Mac OS X lets +customers wirelessly share files between Macintosh systems, synchronize and +share contact information with Palm-OS based PDAs, and access the Internet +through Bluetooth-enabled cell phones. Bluetooth is built into most Macintosh +models. Bonjour®, the Company’s zero configuration networking +technology, is based on open Internet Engineering Task Force (“IETF”) Standard +Protocols such as IP, ARP, and DNS and is built into Mac OS X. This +technology uses industry standard networking protocols and zero configuration +technology including Ethernet or 802.11-based wireless networks like the +Company’s AirPort products. The source code for this technology also includes +software to support UNIX, Linux, and Windows-based systems and devices. The Company developed +FireWire, a high-speed serial I/O technology for connecting digital devices +such as digital camcorders and cameras to desktop and portable computers. +FireWire has high data-transfer speed and “hot plug-and-play” capability and is +currently integrated in all Macintosh systems. Product Support and +Services AppleCare ® offers a range of support options for the Company’s +customers. These options include assistance that is built into software +products, printed and electronic product manuals, online support including +comprehensive product information as well as technical assistance, and the +AppleCare Protection Plan. The AppleCare Protection Plan is a fee-based service +that typically includes three years of phone support and hardware repairs, +dedicated web-based support resources, and user diagnostic tools. 16 Markets and +Distribution The Company’s customers +are primarily in the education, creative, consumer, and business markets. The +Company distributes its products through wholesalers, resellers, national and +regional retailers and cataloguers. No individual customer accounted for more +than 10% of net sales in 2006, 2005, or 2004. The Company also sells many of +its products and resells certain third-party products in most of its major +markets directly to consumers, education customers, and businesses through its +own sales force and retail and online stores. Ten percent of the Company’s net +sales in 2006 were through its U.S. education channel, including sales to elementary +and secondary schools, higher education institutions, and individual customers. Competition The Company is confronted by aggressive competition in +all areas of its business. The markets for consumer electronics, personal +computers and related software and peripheral products are highly competitive. +These markets are characterized by rapid technological advances in both +hardware and software that have substantially increased the capabilities and +use of personal computers and other digital electronic devices and have +resulted in the frequent introduction of new products with competitive price, +feature, and performance characteristics. Over the past several years, price +competition in these markets have been particularly intense. The Company’s +competitors who sell personal computers based on other operating systems have +aggressively cut prices and lowered their product margins to gain or maintain +market share. The Company’s results of operations and financial condition can +be adversely affected by these and other industry-wide downward pressures on +gross margins. The principal competitive factors include price, relative +price/performance, product quality and reliability, design innovation, +availability of software, product features, marketing and distribution +capability, service and support, availability of hardware peripherals, and +corporate reputation. Further, as the personal computer industry and its +customers place more reliance on the Internet, an increasing number of Internet +devices that are smaller, simpler, and less expensive than traditional personal +computers may compete for market share with the Company’s existing products. The Company’s music products and services have faced +significant competition from other companies promoting their own digital music +and content products and services, including those offering free peer-to-peer +music and video services. The Company believes it currently retains a +competitive advantage from innovation and by more effectively integrating the +entire solution including the hardware (personal computer and iPod), software +(iTunes), and distribution of content (iTunes Store). However, the Company +expects competition in this space to intensify as competitors attempt to +imitate the Company’s approach to tightly integrate these components within +their individual offerings or, alternatively, collaborate with each other to +offer solutions that are more integrated than those they currently offer. Some +of these current and potential competitors have substantial resources and may +be able to provide such products and services at little or no profit or even at +a loss to compete with the Company’s offerings. The Company’s future +operating results and financial condition are substantially dependent on the +Company’s ability to continue to develop improvements to the Macintosh platform +and to the Company’s hardware, software and services related to digital content +to maintain perceived functional and design advantages over competing +platforms. Raw Materials Although most components essential to the Company’s +business are generally available from multiple sources, certain key components +including microprocessors and application-specific integrated circuits (“ASICs”) +are currently obtained by the Company from single or limited sources. Some key +components, while currently available to the Company from multiple sources, are +at times subject to industry-wide availability constraints and pricing +pressures. In addition, the Company uses some components uncommon to the rest +of the personal computer and consumer electronics industries, and new products +introduced by 17 the Company often initially utilize custom components +obtained from only one source until the Company has evaluated whether there is +a need for, and subsequently qualifies, additional suppliers. If the supply of +a key or single-sourced component to the Company were to be delayed or +curtailed or in the event a key manufacturing vendor delays shipments of +completed products to the Company, the Company’s ability to ship related +products in desired quantities and in a timely manner could be adversely +affected. The Company’s business and financial performance could also be +adversely affected depending on the time required to obtain sufficient +quantities from the original source, or to identify and obtain sufficient +quantities from an alternative source. Continued availability of these +components may be affected if producers were to decide to concentrate on the +production of common components instead of components customized to meet the +Company’s requirements. The Company attempts to mitigate these potential risks +by working closely with these and other key suppliers on product introduction +plans, strategic inventories, coordinated product introductions, and internal +and external manufacturing schedules and levels. Consistent with industry +practice, the Company acquires components through a combination of formal +purchase orders, supplier contracts, and open orders based on projected demand +information. The Company’s purchase commitments typically cover its requirements for periods ranging from 30 to 150 +days. The Company believes there +are several component suppliers and manufacturing vendors whose loss to the +Company could have a material adverse effect upon the Company’s business and +financial position. At this time, such vendors include Agere Systems, Inc., +Ambit Microsystems Corporation, Amperex Technology Limited, ASUSTeK +Corporation, ATI Technologies, Inc., Atheros Communications Inc., AU +Optronics Corporation, Broadcom Corporation, Chi Mei Optoelectronics +Corporation, Cypress Semiconductor Corporation, Hitachi Global Storage +Technologies, Hon Hai Precision Industry Co., Ltd., Intel Corporation, Inventec +Appliances Corporation, LG. Phillips Co., Ltd., Matsushita, NVIDIA Corp., +PortalPlayer, Inc., Quanta Computer, Inc., Renesas Semiconductor Co. +Ltd., Samsung Electronics, Sony Corporation, Synaptics, Inc., Texas +Instruments, and Toshiba Corporation. Research and +Development Because the personal +computer and consumer electronics industries are characterized by rapid +technological advances, the Company’s ability to compete successfully is +heavily dependent upon its ability to ensure a continuing and timely flow of +competitive products, services, and technologies to the marketplace. The +Company continues to develop new products and technologies and to enhance +existing products in the areas of hardware and peripherals, consumer electronic +products, system software, applications software, networking and communications +software and solutions, and the Internet. The Company may expand the range of +its product offerings and intellectual property through licensing and/or +acquisition of third-party business and technology. The Company’s research and +development expenditures totaled $712 million, $535 million (as +restated (1) ), +and $491 million (as restated (1) ) +in 2006, 2005, and 2004, respectively. Patents, +Trademarks, Copyrights and Licenses The Company currently holds rights to patents and +copyrights relating to certain aspects of its computer systems, iPods, +peripherals, software, and services. In addition, the Company has registered, +and/or has applied to register, trademarks and service marks in the U.S. and a +number of foreign countries for “Apple,” the Apple logo, “Macintosh,” “iPod,” “iTunes,” +“iTunes Store,” and numerous other trademarks and service marks. Although the +Company believes the ownership of such patents, copyrights, trademarks and +service marks is an important factor in its business and that its success does +depend in part on the ownership thereof, the Company relies primarily on the +innovative skills, technical competence, and marketing abilities of its +personnel. (1) See the “Explanatory +Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of +Consolidated Financial Statements” in Notes to Consolidated Financial +Statements of this Form 10-K. 18 Many of the Company’s +products are designed to include intellectual property obtained from +third-parties. While it may be necessary in the future to seek or renew +licenses relating to various aspects of its products and business methods, the +Company believes, based upon past experience and industry practice, such +licenses generally could be obtained on commercially reasonable terms; however, +there is no guarantee that such licenses could be obtained at all. Because of +technological changes in the computer industry, current extensive patent +coverage, and the rapid rate of issuance of new patents, it is possible certain +components of the Company’s products and business methods may unknowingly infringe +existing patents of others. From time to time, the Company has been notified +that it may be infringing certain patents or other intellectual property rights +of third-parties. Foreign and +Domestic Operations and Geographic Data The U.S. represents the Company’s largest geographic +marketplace. Approximately 60% of the Company’s net sales in 2006 came from +sales to customers inside the U.S. Final assembly of products sold by the +Company is currently performed in the Company’s manufacturing facility in Cork, +Ireland, and by external vendors in Fremont, California; Fullerton, California; +Taiwan; the Republic of Korea; the People’s Republic of China; and the Czech +Republic. Currently, manufacturing of many of the components used in the +Company’s products is performed by third-party vendors in Taiwan, China, Japan, +Korea, and Singapore. Final assembly of substantially all of the Company’s +portable products, including MacBook Pros, MacBooks, and iPods, is performed by +third-party vendors in China. Margins on sales of the Company’s products in +foreign countries, and on sales of products that include components obtained +from foreign suppliers, can be adversely affected by foreign currency exchange +rate fluctuations and by international trade regulations, including tariffs and +antidumping penalties. Information regarding +financial data by geographic segment is set forth in Part II, Item 8 of +this Form 10-K and in the Notes to Consolidated Financial Statements +at Note 11, “Segment Information and Geographic Data.” Seasonal Business The Company has +historically experienced increased net sales in its first and fourth fiscal +quarters compared to other quarters in its fiscal year due to seasonal demand +related to the holiday season and the beginning of the school year. This +historical pattern should not be considered a reliable indicator of the +Company’s future net sales or financial performance. Warranty The Company offers a basic +limited parts and labor warranty on its hardware products. The basic warranty +period for hardware products is typically one year from the date of purchase by +the end-user. The Company also offers a 90-day basic warranty for its +service parts used to repair the Company’s hardware products. In addition, +consumers may purchase extended service coverage on most of the Company’s +hardware products in all of its major markets. Backlog In the Company’s experience, the actual amount of +product backlog at any particular time is not a meaningful indication of its +future business prospects. In particular, backlog often increases in +anticipation of or immediately following new product introductions as dealers +anticipate shortages. Backlog is often reduced once dealers and customers +believe they can obtain sufficient supply. Because of the foregoing, backlog should +not be considered a reliable indicator of the Company’s ability to achieve any +particular level of revenue or financial performance. 19 Environmental Laws Compliance with federal, state, local, and foreign +laws enacted for the protection of the environment has to date had no material +effect on the Company’s capital expenditures, earnings, or competitive position. +In the future, these laws could have a material adverse effect on the Company. Production and marketing +of products in certain states and countries may subject the Company to +environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of +its useful life, and place responsibility for environmentally safe disposal or +recycling with the Company. Such laws and regulations have recently been passed +in several jurisdictions in which the Company operates including various +European Union member countries, Japan and certain states within the U.S. Although +the Company does not anticipate any material adverse effects in the future +based on the nature of its operations and the thrust of such laws, there is no +assurance that such existing laws or future laws will not have a material +adverse effect on the Company’s financial condition, liquidity, or results of +operations. Employees As of September 30, +2006, the Company had 17,787 full-time equivalent employees and an additional +2,399 temporary equivalent employees and contractors. Available +Information The Company’s Annual +Report on Form 10-K, Quarterly Reports on Form 10-Q, +Current Reports on Form 8-K, and amendments to reports filed +pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act +of 1934, as amended, are filed with the U.S. Securities and Exchange Commission +(SEC). Such reports and other information filed by the Company with the SEC are +available on the Company’s website at http://www.apple.com/investor when such +reports are available on the SEC website. The public may read and copy any +materials filed by the Company with the SEC at the SEC’s Public Reference Room at +100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain +information on the operation of the Public Reference Room by calling the +SEC at 1-800-SEC-0330. The SEC maintains an Internet site +that contains reports, proxy, and information statements and other information +regarding issuers that file electronically with the SEC at http://www.sec.gov. The +contents of these websites are not incorporated into this filing. Further, the +Company’s references to the URLs for these websites are intended to be inactive +textual references only. Item 1A. Risk +Factors Because of the following +factors, as well as other factors affecting the Company’s operating results and +financial condition, past financial performance should not be considered to be +a reliable indicator of future performance, and investors should not use +historical trends to anticipate results or trends in future periods. The matters relating to the investigation by the +Special Committee of the Board of Directors and the restatement of the Company’s +consolidated financial statements may result in additional litigation and governmental +enforcement actions. On June 29, 2006, the Company announced that an +internal review had discovered irregularities related to the issuance of +certain stock option grants made between 1997 and 2001, including a grant to +its Chief Executive Officer (“CEO”), Steve Jobs. The Company also announced a +Special Committee of outside directors (“Special Committee”) had been formed +and had hired independent counsel to conduct a full investigation of the +Company’s past stock option granting practices. As described in the +Explanatory Note immediately preceding Part I, Item 1, and in Note 2 “Restatement +of Consolidated Financial Statements” in Notes to Consolidated Financial +Statements in this Form 10-K, as a result of the internal review and +independent investigation, management has concluded, and the Audit and Finance +Committee agrees, that incorrect measurement dates were used for financial +accounting purposes for stock option grants made in 20 certain prior periods. As a result, the Company has +recorded additional non-cash stock-based compensation expense, and related tax +effects, with regard to certain past stock option grants, and the Company has restated +certain previously filed financial statements included in this Form 10-K. The internal review, the independent investigation, +and related activities have required the Company to incur substantial expenses +for legal, accounting, tax and other professional services, have diverted +management’s attention from the Company’s business, and could in the future harm +its business, financial condition, results of operations and cash flows. While the Company believes it has made appropriate +judgments in determining the correct measurement dates for its stock option +grants, the SEC may disagree with the manner in which the Company has accounted +for and reported, or not reported, the financial impact. Accordingly, there is +a risk the Company may have to further restate its prior financial statements, +amend prior filings with the SEC, or take other actions not currently +contemplated. The Company’s past stock option granting practices and +the restatement of prior financial statements have exposed the Company to +greater risks associated with litigation, regulatory proceedings and government +enforcement actions. As described in Part I, Item 3, “Legal Proceedings”, +several derivative complaints and a class action complaint have been filed in +state and federal courts against the Company’s directors and certain of its +executive officers pertaining to allegations relating to stock option grants. +The Company has provided the results of its internal review and independent +investigation to the SEC and the United States Attorney’s Office for the +Northern District of California, and in that regard the Company has responded +to informal requests for documents and additional information. The Company +intends to continue full cooperation. No assurance can be given regarding the +outcomes from litigation, regulatory proceedings or government enforcement +actions relating to the Company’s past stock option practices. The resolution +of these matters will be time consuming, expensive, and will distract +management from the conduct of the Company’s business. Furthermore, if the +Company is subject to adverse findings in litigation, regulatory proceedings or +government enforcement actions, the Company could be required to pay damages or +penalties or have other remedies imposed, which could harm its business, +financial condition, results of operations and cash flows. In August 2006, the +Company received a NASDAQ Staff Determination letter stating that, as a result +of the delayed filing of the Company’s Form 10-Q for the quarter +ended July 1, 2006 (the “Third Quarter Form 10-Q”), the Company +was not in compliance with the filing requirements for continued listing as set +forth in Marketplace Rule 4310(c)(14) and was therefore subject to +delisting from the NASDAQ Stock Market. On October 24, 2006, the +NASDAQ Listing Qualifications Panel granted the Company’s request for continued +listing, subject to the Company filing the Third Quarter Form 10-Q, +and any required restatements, with the SEC by December 29, 2006. On December 29, +2006, the Company filed the Third Quarter Form 10-Q with the SEC. With +the filing of this Form 10-K, the Company believes that it has +remedied its non-compliance with Marketplace Rule 4310(c)(14), subject to +NASDAQ’s affirmative completion of its compliance protocols and its +notification of the Company accordingly. However, if the SEC disagrees with the +manner in which the Company has accounted for and reported, or not reported, +the financial impact of past stock option grants, there could be further delays +in filing subsequent SEC reports that might result in delisting of the Company’s +common stock from the NASDAQ Global Select Market. Unfavorable results +of legal proceedings could adversely affect the Company’s results of +operations. The Company is subject to +various legal proceedings and claims that are discussed in Part I, Item 3 +of this Form 10-K. The Company is also subject to certain other +legal proceedings and claims that have arisen in the ordinary course of +business and which have not been fully adjudicated. Results of legal +proceedings cannot be predicted with certainty. In addition, litigation may be +disruptive to the Company’s normal 21 business operations. Should +the Company fail to prevail in certain legal matters, the Company’s financial +condition, liquidity, or results of operations could be adversely affected. Economic conditions and political events could +adversely affect the demand for the Company’s products and the financial health +of its suppliers, distributors, and resellers. The Company’s operating +performance depends significantly on economic conditions in the U.S. and +abroad. At times in the past, demand for the Company’s products has been +negatively impacted by difficult global economic conditions. Uncertainty about +future economic conditions makes it difficult to forecast future demand for the +Company’s products and related operating results. Should global and/or regional +economic conditions deteriorate, demand for the Company’s products could be +adversely affected, as could the financial health of its suppliers, +distributors, and resellers. War, terrorism, public health issues, and other +circumstances could disrupt supply, delivery, or demand of products, which +could negatively affect the Company’s operations and performance. War, terrorism, public health issues, and other +business interruptions, whether in the U.S. or abroad, have caused and could +cause damage or disruption to international commerce +and global economy, and thus may have a strong negative impact on the global +economy, the Company, and the Company’s suppliers or customers. The +Company’s major business operations are subject to interruption by earthquake, +other natural disasters, fire, power shortages, terrorist attacks and other +hostile acts, labor disputes, public health issues, and other events beyond its +control. The majority of the Company’s research and development activities, its +corporate headquarters, information technology systems, and other critical +business operations, including certain component suppliers and manufacturing +vendors, are located near major seismic faults. Because the Company does not +carry earthquake insurance for direct quake-related losses, the Company’s +operating results and financial condition could be materially adversely +affected in the event of a major earthquake or other natural or man-made +disaster. Although it is impossible +to predict the occurrences or consequences of any such events, such events +could result in a decrease in demand for the Company’s products, make it +difficult or impossible for the Company to deliver products to its customers or +to receive components from its suppliers, and create delays and inefficiencies +in the Company’s supply chain. In addition, should major public health issues +including pandemics arise, the Company could be negatively affected by more +stringent employee travel restrictions, additional limitations in the +availability of freight services, governmental actions limiting the movement of +products between various regions, delays in production ramps of new products, +and disruptions in the operations of the Company’s manufacturing vendors and +component suppliers. The Company’s operating results and financial condition +have been, and in the future may be, adversely affected by such events. The market for personal computers and related +peripherals and services, as well as digital music devices and related +services, is highly competitive. If the Company is unable to effectively +compete in these markets, its results of operations could be adversely affected. The personal computer industry is highly competitive +and is characterized by aggressive pricing practices, downward pressure on +gross margins, frequent introduction of new products, short product life +cycles, evolving industry standards, continual improvement in product +price/performance characteristics, rapid adoption of technological and product +advancements by competitors, price sensitivity on the part of consumers, and a +large number of competitors. Price competition in the market for personal computers +and related peripherals has been particularly intense as competitors who sell +Windows and Linux based personal computers have aggressively cut prices and +lowered their product margins for personal computing products. The Company’s +results of operations and financial condition have been, and in the future may +continue to be, adversely affected by these and other industry-wide pricing +pressures and downward pressures on gross margins. 22 The personal computer industry has also been +characterized by rapid technological advances in software functionality, +hardware performance, and features based on existing or emerging industry +standards. Further, as the personal computer industry and its customers place +more reliance on the Internet, an increasing number of Internet devices that +are smaller and simpler than traditional personal computers may compete for +market share with the Company’s existing products. Several competitors of the +Company have targeted certain of the Company’s key market segments, including +consumer, education, professional and consumer digital video editing, and +design and publishing. Several of the Company’s competitors have introduced +digital music products and/or online stores offering digital music distribution +that mimic many of the unique design, technical features, and solutions of the +Company’s products. The Company has a significant number of competitors, many +of whom have broader product lines and larger installed customer bases than +those of the Company. Additionally, there has been a trend towards +consolidation in the personal computer industry that has resulted in larger and +potentially stronger competitors in the Company’s markets. The Company is currently the only maker of hardware +using the Mac OS. The Mac OS has a minority market share in the personal +computer market, which is dominated by makers of computers utilizing competing +operating systems, including Windows and Linux. The Company’s future operating +results and financial condition are substantially dependent on its ability to +continue to develop improvements to the Macintosh platform to maintain +perceived design and functional advantages over competing platforms. Additionally, +if unauthorized copies of the Mac OS are used on other companies’ hardware +products and result in decreased demand for the Company’s hardware products, +the Company’s results of operations may be adversely affected. The Company is currently focused on market +opportunities related to digital music distribution and related consumer +electronic devices, including iPods. The Company faces significant competition +from other companies promoting their own digital music products including MP3 +players, music enabled cell phones, free peer-to-peer music and video services, +and free streaming of digital content via the Internet. These competitors +include both new entrants with different market approaches, such as +subscription services models, and also larger companies that may have +significant technical, marketing, distribution, and other resources, as well as +established hardware, software, and digital content supplier relationships. +Failure to effectively compete could negatively affect the Company’s operating +results and financial position. The Company expects competition in this space +to intensify as competitors attempt to imitate the Company’s approach to +tightly integrating these components within their individual offerings or work +more collaboratively with each other to offer solutions that are more +integrated than those they offer currently. Some of these current and potential +competitors have substantial resources and may be able to provide such products +and services at little or no profit or even at a loss to compete with the +Company’s offerings. There can be no assurance the Company will be able to +continue to provide products and services that effectively compete in these +markets. The Company may also have to respond to price competition by lowering +prices and/or increasing features which could adversely affect the Company’s +music product gross margins as well as overall Company gross margins. The Company also faces +significant competition in the U.S. education market. U.S. elementary and +secondary schools, as well as college and university customers, remain a core +market for the Company. In an effort to gain market share and remain +competitive, the Company will continue to pursue one-to-one (1:1) learning +solutions in education. 1:1 learning +solutions typically consist of a +portable computer for every student and teacher along with the installation of +a wireless network . These 1:1 +learning solutions and other strategic sales are generally priced more +aggressively and could result in significantly less profitability or financial +losses, particularly for larger deals. Although the Company believes it has +taken certain steps to strengthen its position in the education market, there +can be no assurance that the Company will be able to increase or maintain its +share of the education market or execute profitably on large strategic 23 arrangements. Failure to +do so may have an adverse impact on the Company’s operating results and +financial condition. Future operating results are dependent upon the +Company’s ability to obtain a sufficient supply of components, including +microprocessors, some of which are in short supply or available only from +limited sources. Although most components +essential to the Company’s business are generally available from multiple +sources, certain key components including microprocessors and ASICs are +currently obtained by the Company from single or limited sources. Some key +components (including without limitation DRAM, NAND flash-memory, and TFT-LCD +flat-panel displays), while currently available to the Company from multiple +sources, are at times subject to industry-wide availability and pricing pressures. +In addition, new products introduced by the Company often initially utilize +custom components obtained from only one source until the Company has evaluated +whether there is a need for, and subsequently qualifies, additional suppliers. +In situations where a component or product utilizes new technologies, initial +capacity constraints may exist until such time as the suppliers’ yields have +matured. The Company and other producers in the personal computer and consumer +electronics industries also compete for various components with other +industries that have experienced increased demand for their products. The +Company uses some components that are not common to the rest of the personal +computer or consumer electronics industries. Continued availability of these +components may be affected if producers decided to concentrate on the +production of components other than those customized to meet the Company’s +requirements. If the supply of a key component were delayed or constrained on a +new or existing product, the Company’s results of operations and financial +condition could be adversely affected. The Company must successfully manage frequent product +introductions and transitions to remain competitive and effectively stimulate +customer demand. Due to the highly volatile and competitive nature of +the personal computer and consumer electronics industries, which are +characterized by dynamic customer demand patterns and rapid technological +advances, the Company must continually introduce new products and technologies, +enhance existing products to remain competitive, and effectively stimulate +customer demand for new products and upgraded versions of the Company’s +existing products. The success of new product introductions is dependent on a +number of factors, including market acceptance; the Company’s ability to manage +the risks associated with product transitions, including the transition to +Intel-based Macintosh computers, and production ramp issues; the availability +of application software for new products; the effective management of purchase +commitments and inventory levels in line with anticipated product demand; the +availability of products in appropriate quantities and costs to meet +anticipated demand; and the risk that new products may have quality or other +defects in the early stages of introduction. Accordingly, the Company cannot +determine in advance the ultimate effect new products will have on its sales or +results of operations. In June 2005, the +Company announced its plan to begin using Intel microprocessors in its +computers. During 2006, the Company introduced new Intel-based models of the +MacBook Pro, MacBook, Mac Pro, iMac, and Mac mini computers. The Company’s +transition to Intel microprocessors for Macintosh systems was completed in August 2006, +and its transition for Xserve was completed in November 2006. This +transition has been and will continue to be subject to numerous risks and +uncertainties including the timely innovation and delivery of related hardware +and software products to support Intel microprocessors, market acceptance of +Intel-based Macintosh computers, and the development and availability on +acceptable terms of components and services essential to enable the Company to +timely deliver Intel-based Macintosh computers. In addition, the Company is +dependent on third-party software developers such as Microsoft and Adobe to +timely develop current and future applications that run on Intel-based +Macintosh computers. Universal versions of Microsoft Office and Adobe’s +Creative Suite applications are not currently available. Additionally, +there can be no assurance that the Company will be able to maintain its 24 historical gross margin +percentages on its products, including Intel-based Macintosh computers, which +may adversely impact the Company’s results of operations. The Company’s products from time to time experience +quality problems that can result in decreased net sales and operating profits. The Company sells highly +complex hardware and software products that can contain defects in design and +manufacture. Sophisticated operating system software and applications, such as +those sold by the Company, often contain “bugs” that can unexpectedly interfere +with the operation of the software. Defects may also occur in components and +products the Company purchases from third-parties. There can be no assurance +that the Company will be able to detect and fix all defects in the hardware and +software it sells. Failure to do so could result in lost revenue, loss of +reputation, and significant warranty and other expense to remedy. Because orders for components, and in some cases +commitments to purchase components, must be placed in advance of customer +orders, the Company faces substantial inventory risk. The Company records a write-down for inventories of +components and products that have become obsolete or are in excess of +anticipated demand or net realizable value and accrues necessary reserves for +cancellation fees for orders of products and components that have been +cancelled. Although the Company believes its inventory and related provisions +are currently adequate, given the rapid and unpredictable pace of product +obsolescence in the computer and consumer electronics industries and the +transition to Intel-based Macintosh computers, no assurance can be given that +the Company will not incur additional inventory and related charges. In +addition, such charges have had, and may have, a material effect on the Company’s +financial position and results of operations. The Company must order +components for its products and build inventory in advance of product +shipments. Because the Company’s markets are volatile and subject to rapid +technology and price changes, and because of the transition to Intel-based +Macintosh computers, there is a risk the Company will forecast incorrectly and +produce or order from third parties excess or insufficient inventories of +particular products. Consistent with industry practice, components are normally +acquired through a combination of purchase orders, supplier contracts, and open +orders based on projected demand information. Such purchase commitments +typically cover the Company’s forecasted component and manufacturing +requirements for periods ranging from 30 to 150 days. The Company’s operating +results and financial condition have been in the past and may in the future be +materially adversely affected by the Company’s ability to manage its inventory +levels and respond to short-term shifts in customer demand patterns. The Company is dependent on manufacturing and +logistics services provided by third parties, many of whom are located outside +of the U.S. Most of the Company’s products are manufactured in +whole or in part by third-party manufacturers. In addition, the Company has +outsourced much of its transportation and logistics management. While outsourcing +arrangements may lower the cost of operations, they also reduce the Company’s +direct control over production and distribution. It is uncertain what effect +such diminished control will have on the quality or quantity of the products +manufactured or services rendered, or the flexibility of the Company to respond +to changing market conditions. In addition, the Company is reliant on +third-party manufacturers to adhere to the Company’s supplier code of conduct. Moreover, +although arrangements with such manufacturers may contain provisions for +warranty expense reimbursement, the Company may remain at least initially +responsible to the consumer for warranty service in the event of product +defects. Any unanticipated product defect or warranty liability, whether +pursuant to arrangements with contract manufacturers or otherwise, could +adversely affect the Company’s future operating results and financial +condition. 25 Final assembly of products +sold by the Company is currently performed in the Company’s manufacturing +facility in Cork, Ireland, and by external vendors in Fremont, California; +Fullerton, California; Taiwan; the Republic of Korea; the People’s Republic of +China; and the Czech Republic. Currently, manufacturing of many of the +components used in the Company’s products is performed by third-party vendors +in Taiwan, China, Japan, Korea, and Singapore. Final assembly of substantially +all of the Company’s portable products, including MacBook Pros, MacBooks, and +iPods, is performed by third-party vendors in China. If for any reason +manufacturing or logistics in any of these locations is disrupted by regional +economic, business, labor, environmental, public health, or political issues, +or due to information technology system failures or military actions, the Company’s +results of operations and financial condition could be adversely affected. The Company’s future operating performance is +dependent on the performance of distributors and other resellers of the Company’s +products. The Company distributes its products through +wholesalers, resellers, national and regional retailers, and cataloguers, many +of whom distribute products from competing manufacturers. In addition, the +Company sells many of its products and resells certain third-party products in +most of its major markets directly to end-users, certain education customers, +and certain resellers through its online stores around the world and its retail +stores. Many of the Company’s resellers operate on narrow product margins and +have been negatively impacted in the past by weak economic conditions. +Considerable trade receivables that are not covered by collateral or credit +insurance are outstanding with the Company’s distribution and retail channel +partners. The Company’s business and financial results could be adversely +affected if the financial condition of these resellers weakens, if resellers +within consumer channels were to cease distribution of the Company’s products, +or if uncertainty regarding demand for the Company’s products caused resellers +to reduce their ordering and marketing of the Company’s products. The Company +has invested and will continue to invest in various programs to enhance +reseller sales, including staffing selected resellers’ stores with Company +employees and contractors. These programs could require a substantial +investment from the Company, while providing no assurance of return or +incremental revenue to offset this investment. Over the past several +years, an increasing proportion of the Company’s net sales have been made by +the Company directly to end-users through its online stores around the world +and through its retail stores in the U.S., Canada, Japan, and the U.K. Some of +the Company’s resellers have perceived this expansion of the Company’s direct +sales as conflicting with their own businesses and economic interests as +distributors and resellers of the Company’s products. Perception of such a +conflict could discourage the Company’s resellers from investing additional +resources in the distribution and sale of the Company’s products or lead them +to limit or cease distribution of the Company’s products. The Company’s +business and financial results could be adversely affected if expansion of its +direct sales to end-users causes some or all of its resellers to cease or limit +distribution of the Company’s products. The Company relies +on third-party digital content, which may not be available to the Company on +commercially reasonable terms or at all. The Company contracts with third parties to offer +their digital content to customers through the Company’s iTunes Store. The +Company pays substantial fees to obtain the rights to offer to its customers +this third-party digital content. The Company’s licensing arrangements with +these third-party content providers are short-term in nature and do not guarantee +the future renewal of these arrangements at commercially reasonable terms, if +at all. Certain parties in the music industry have consolidated and formed +alliances, which could limit the availability and increase the fees required to +offer digital content to customers through the iTunes Store. Some third-party +content providers currently or may in the future offer music products and +services that compete with the Company’s music products and services, and could +take action to make it more difficult or impossible for the Company to license +their digital content in the future. Further, other distributors of third-party +content or third-party content owners may seek to limit 26 the Company’s access to or increase the total cost of +such content. If the Company is unable to continue to offer a wide variety of +digital content at reasonable prices with acceptable usage rules, or continue +to expand its geographic reach outside the U.S., then sales and gross margins +of the Company’s iTunes Store, as well as related hardware and peripherals, +including iPods, may be adversely affected. Third-party content +providers and artists require that the Company provide certain digital rights +management (“DRM”) solutions and other security mechanisms. If the requirements +from content providers or artists change, then the Company may be required to +further develop or license technology to address such new rights and +requirements. In addition, certain countries have passed legislation or may +propose legislation that would force the Company to license its DRM solutions +so that content would be interoperable with competitor devices, which could +lessen the protection of content subjecting it to piracy and could affect +arrangements with the Company’s content suppliers. There is no assurance the +Company will be able to develop or license such solutions at a reasonable cost +and in a timely manner, if at all, which could have a materially adverse effect +on the Company’s operating results and financial position. The Company’s future performance is dependent upon +support from third-party software developers. If third-party software +applications cease to be developed or available for the Company’s hardware +products, then customers may choose not to buy the Company’s products. The Company believes decisions by customers to +purchase the Company’s personal computers, as opposed to Windows-based +systems, are often based on the availability of third-party software +applications such as Microsoft Office. The Company also believes the +availability of third-party application software for the Company’s +hardware products depends in part on third-party developers’ perception +and analysis of the relative benefits of developing, maintaining, and upgrading +such software for the Company’s products versus software for the larger Windows +market or growing Linux market. This analysis may be based on factors such as +the perceived strength of the Company and its products, the anticipated +potential revenue that may be generated, continued acceptance by customers of Mac +OS X, and the costs of developing such software products. To the extent the +minority market share held by the Company in the personal computer market has +caused software developers to question the Company’s prospects in the personal +computer market, developers could be less inclined to develop new application +software or upgrade existing software for the Company’s products and more +inclined to devote their resources to developing and upgrading software for the +larger Windows market or growing Linux market. The Company’s recent +announcement that it plans to add a feature to the next version of Mac OS X +that will enable Intel-based Macintosh systems to run Windows XP may deter +developers from creating software applications for Mac OS X if such +applications are available for the Windows platform. Moreover, there can be no +assurance software developers will continue to develop software for Mac OS X on +a timely basis or at all. In June 2005, the Company announced its plan to +begin using Intel microprocessors in its computers. During 2006, the Company +introduced new Intel-based models of the MacBook Pro, MacBook, Mac Pro, iMac, +and Mac mini computers. The Company’s transition to Intel microprocessors for +Macintosh systems was completed in August 2006, and its transition for +Xserve was completed in November 2006. The Company depends on third-party +software developers to timely develop current and future applications that run +on Intel microprocessors. Universal versions of Microsoft Office and Adobe’s +Creative Suite applications are not currently available. The lack of +applications that run on Intel-based Macintosh systems, including Microsoft +Office and Adobe Creative Suite, could have a materially adverse effect on the +Company’s operating results and financial position. In addition, past and +future development by the Company of its own software applications and +solutions may negatively impact the decision of software developers, such as +Microsoft and Adobe, to develop, maintain, and upgrade similar or competitive software +for the Company’s products. The Company currently markets and sells a variety +of software applications for use by professionals, consumers, and education +customers that could influence the decisions of third-party software developers +to develop or 27 upgrade +Macintosh-compatible software products. Software applications currently +marketed by the Company include software for professional film and video +editing, professional compositing and visual effects for large format film and +video productions, professional music production and music post production, +professional and consumer DVD encoding and authoring, professional digital +photo editing and workflow management, consumer digital video and digital photo +editing and management, digital music management, desktop-based database +management, word processing, and high-quality presentations. Discontinuance of +third-party software products for the Macintosh platform could have an adverse +effect on the Company’s net sales and results of operations. The Company’s business relies on access to patents and +intellectual property obtained from third parties, and the Company’s future +results could be adversely affected if it is alleged or found to have infringed +on the intellectual property rights of others. Many of the Company’s products are designed to include +intellectual property obtained from third parties. While it may be necessary in +the future to seek or renew licenses relating to various aspects of its +products and business methods, the Company believes that based upon past +experience and industry practice, such licenses generally could be obtained on +commercially reasonable terms. However, there can be no assurance that the +necessary licenses would be available or available on acceptable terms. Because of technological +changes in the computer and consumer electronics industries, current extensive +patent coverage, and the rapid rate of issuance of new patents, it is possible +certain components of the Company’s products and business methods may +unknowingly infringe existing patents of others. The Company has from time to +time been notified that it may be infringing certain patents or other +intellectual property rights of others. Responding to such claims, regardless +of their merit, can be time-consuming, result in significant expenses, and +cause the diversion of management and technical personnel. Several pending +claims are in various stages of evaluation. The Company may consider the +desirability of entering into licensing agreements in certain of these cases. +However, no assurance can be given that such licenses can be obtained on +acceptable terms or that litigation will not occur. In the event there is a +temporary or permanent injunction entered prohibiting the Company from +marketing or selling certain of its products or a successful claim of +infringement against the Company requiring it to pay royalties to a +third-party, the Company’s future operating results and financial condition +could be adversely affected. Information regarding certain claims and +litigation involving the Company related to alleged patent infringement and +other matters is set forth in Part I, Item 3 of this Form 10-K. +In the opinion of management, the Company does not have a potential liability +for damages or royalties from any current legal proceedings or claims related +to the infringement of patent or other intellectual property rights of others +that would individually or in the aggregate have a material adverse effect on +its results of operations or financial condition. However, the results of such +legal proceedings cannot be predicted with certainty. Should the Company fail +to prevail in any of the matters related to infringement of patent or other +intellectual property rights of others described in Part I, Item 3 of this +Form 10-K or should several of these matters be resolved against the +Company in the same reporting period, the operating results of a particular +reporting period could be materially adversely affected. The Company’s retail initiative has required and will +continue to require a substantial investment and commitment of resources and is +subject to numerous risks and uncertainties. Through September 30, 2006, the Company had +opened 165 retail stores. The Company’s retail initiative has required +substantial investment in equipment and leasehold improvements, information +systems, inventory, and personnel. The Company has also entered into +substantial operating lease commitments for retail space with lease terms +ranging from 5 to 20 years, the majority of which are for 10 years. The Company +could incur substantial costs should it choose to terminate these commitments +or close individual stores. Such costs could adversely affect the Company’s +results of operations and financial condition. Additionally, a relatively high +proportion of the Retail segment’s costs are fixed because of personnel costs, 28 depreciation of store construction costs, and lease +expense. As a result, significant losses would result should the Retail segment +experience a significant decline in sales for any reason. Certain of the Company’s stores +have been designed and built to serve as high-profile venues that function +as vehicles for general corporate marketing, corporate events, and brand +awareness. Because of their unique design elements, locations and size, these +stores require substantially more investment in equipment and leasehold improvements than the Company’s more typical +retail stores. The Company has opened eight such stores through September 2006. +Because of their location and size, these high-profile stores also require the +Company to enter into substantially larger operating lease commitments compared +to those required for its more typical stores. Current leases on such locations +have terms ranging from 10 to 14 years with total remaining commitments per location +ranging from $4 million to $33 million. Closure or poor performance of one of +these high-profile stores could have a significant negative impact on the +Company’s results of operations and financial condition. Many of the general risks +and uncertainties the Company faces could also have an adverse impact on its +Retail segment. Also, many factors unique to retail operations present risks and uncertainties, some of which +are beyond the Company’s control, that could adversely affect the Retail +segment’s future results, cause its actual results to differ from those +currently expected, and/or have an adverse effect on the Company’s consolidated +results of operations. Potential risks and uncertainties unique to retail +operations that could have an adverse impact on the Retail segment include, +among other things, macro-economic factors that have a negative impact on +general retail activity; inability to manage costs associated with store +construction and operation; inability to sell third-party hardware and software +products at adequate margins; failure to manage relationships with existing +retail channel partners; lack of experience in managing retail operations +outside the U.S.; costs associated with unanticipated fluctuations in the value +of Apple-branded and third-party retail inventory; and inability to obtain and +renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and initiatives +could disrupt the Company’s ongoing business and may present risks not originally +contemplated. The Company has and may in +the future invest in new business strategies or engage in acquisitions that +complement the Company’s strategic direction and product roadmap. Such +endeavors may involve significant risks and uncertainties, including +distraction of management’s attention away from current business operations; +insufficient revenue generation to offset liabilities assumed and expenses +associated with the strategy; and unidentified issues not discovered in the +Company’s due diligence process. Because these new ventures are inherently +risky, no assurance can be given that such strategies and initiatives will be +successful and will not materially adversely affect the Company’s business, +operating results or financial condition. Declines in the sales of the Company’s professional +products, software, accessories, or service and support contracts, or increases +in sales of consumer products, including iPods, may negatively impact the +Company’s gross margin and operating margin percentages. The Company’s professional products, including MacBook +Pro and Mac Pro systems, software, accessories, and service and support +contracts, generally have higher gross margins than the Company’s consumer +products, including the iMac, Mac mini, MacBook, iPod, and content from the +iTunes Store. A shift in sales mix away from higher margin professional +products towards lower margin consumer products could adversely affect the +Company’s future gross margin and operating margin percentages. The Company’s +traditional professional customers may choose to buy consumer products, +specifically the iMac and MacBook, instead of professional products. +Professional users may choose to buy the iMac due to its relative price +performance and unique design featuring a flat panel screen. Professional users +may also choose to purchase MacBooks instead of the Company’s +professional-oriented portable products due to their price performance and +screen size. Additionally, significant future growth in iPod sales without 29 corresponding growth in higher margin product sales +could also reduce gross margin and operating margin percentages. The Company expects +its quarterly revenue and operating results to fluctuate for a variety of +reasons. The Company’s profit +margins vary among its products and its distribution channels. The Company’s +direct sales, primarily through its retail and online stores, generally have +higher associated profitability than its indirect sales. As a result, the +Company’s gross margin and operating margin percentages, as well as overall +profitability may be adversely impacted as a result of a shift in product, +geographic or channel mix, or new product announcements, including the +transition to Intel-based Macintosh computers. In addition, the Company +generally sells more product during the third month of each quarter than it +does during either of the first two months, a pattern typical in the personal +computer and consumer electronics industries. This sales pattern can produce +pressure on the Company’s internal infrastructure during the third month of a +quarter and may adversely impact the Company’s ability to predict its financial +results accurately. Furthermore, the Company has typically experienced greater +net sales in the first and fourth fiscal quarters compared to other quarters in +the fiscal year due to seasonal demand related to the holiday season and the +beginning of the school year. Developments late in a quarter, such as +lower-than-anticipated demand for the Company’s products, an internal systems +failure, or failure of one of the Company’s key logistics, components +suppliers, or manufacturing partners, could have significant adverse impacts on +the Company and its results of operations and financial condition. The Company has higher research and development and +selling, general and administrative costs, as a percentage of revenue, than +many of its competitors. The Company’s ability to +compete successfully and maintain attractive gross margins and revenue growth +is heavily dependent upon its ability to ensure a continuing and timely flow of +innovative and competitive products and technologies to the marketplace. As a +result, the Company generally incurs higher research and development costs as a +percentage of revenue than its competitors who sell personal computers based on +other operating systems. Many of these competitors seek to compete aggressively +on price and maintain very low cost structures. Further, as a result of the +expansion of the Company’s Retail segment and costs associated with marketing +the Company’s brand including its unique operating system, the Company incurs +higher selling costs as a percentage of revenue than many of its competitors. +If the Company is unable to continue to develop and sell innovative new +products with attractive gross margins, its results of operations may be +materially adversely affected by its operating cost structure. The Company is exposed to credit risk on its accounts +receivable and prepayments related to long-term supply agreements. This risk is +heightened during periods when economic conditions worsen. The Company distributes +its products through third-party computer resellers and retailers and directly +to certain educational institutions and commercial customers. A substantial +majority of the Company’s outstanding trade receivables are not covered by +collateral or credit insurance. The Company also has unsecured non-trade +receivables from certain of its manufacturing vendors resulting from the sale +by the Company of raw material components to these manufacturing vendors who manufacture +sub-assemblies or assemble final products for the Company. In addition, the +Company has entered into long-term supply agreements to secure supply of NAND +flash-memory and has prepaid a total of $1.25 billion under these agreements. +While the Company has procedures in place to monitor and limit exposure to +credit risk on its trade and non-trade receivables as well as long-term +prepayments, there can be no assurance such procedures will be effective in +limiting its credit risk and avoiding losses. Additionally, if the global +economy or regional economies deteriorate, the Company would be more likely to +incur a material loss or losses as a result of the weakening financial +condition of one or more of its customers or manufacturing vendors. 30 The Company’s +success depends largely on its ability to attract and retain key personnel. Much of the future success +of the Company depends on the continued service and availability of skilled +personnel, including its Chief Executive Officer, members of its executive +team, and those in technical, marketing and staff positions. Experienced +personnel in the information technology industry are in high demand and +competition for their talents is intense, especially in the Silicon Valley, +where the majority of the Company’s key employees are located. The Company has +relied on its ability to grant stock options as one mechanism for recruiting +and retaining this highly skilled talent. Recent accounting regulations +requiring the expensing of stock options have resulted in increased stock-based +compensation expense, which may cause the Company to reduce the amount of +stock-based awards issued to employees. There can be no assurance that the +Company will continue to successfully attract and retain key personnel. The Company is subject +to risks associated with the availability and coverage of insurance. For certain risks, the +Company does not maintain insurance coverage because of cost and/or +availability. Because the Company retains some portion of its insurable risks, +and in some cases self insures completely, unforeseen or catastrophic losses in +excess of insured limits may have a material adverse effect on the Company’s +results of operations and financial position. Failure of information technology systems and breaches +in the security of data upon which the Company relies could adversely affect the +Company’s future operating results. Information technology +system failures and breaches of data security could disrupt the Company’s +ability to function in the normal course of business by potentially causing +delays or cancellation of customer orders, impeding the manufacture or shipment +of products, or resulting in the unintentional disclosure of customer or +Company information. Management has taken steps to address these concerns for its +own systems by implementing sophisticated network security and internal control +measures. However, there can be no assurance that a system failure or data +security breach of the Company or a third-party vendor will not have a material +adverse effect on the Company’s results of operations. The Company’s +business is subject to the risks of international operations. A large portion of the Company’s revenue is derived +from its international operations. As a result, the Company’s operating results +and financial condition could be significantly affected by risks associated +with international activities, including economic and labor conditions, +political instability, tax laws (including U.S. taxes on foreign subsidiaries), +and changes in the value of the U.S. dollar versus the local currency in which +the products are sold and goods and services are purchased. The Company’s +primary exposure to movements in foreign currency exchange rates relate to +non-U.S. dollar denominated sales in Europe, Japan, Australia, Canada, and +certain parts of Asia and non-dollar denominated operating expenses incurred +throughout the world. Weaknesses in foreign currencies, particularly the +Japanese Yen and the Euro, can adversely impact consumer demand for the +Company’s products and the U.S. dollar value of the Company’s foreign currency +denominated sales. Conversely, a strengthening in these and other foreign +currencies can cause the Company to modify international pricing and affect the +value of the Company’s foreign denominated sales, and in some cases, may also +increase the cost to the Company of some product components. Margins on sales of the Company’s products in foreign +countries, and on sales of products that include components obtained from +foreign suppliers, can be adversely affected by foreign currency exchange rate +fluctuations and by international trade regulations, including tariffs and +antidumping penalties. Derivative instruments, such as foreign exchange +forward and option positions have been utilized by the Company to hedge +exposures to fluctuations in foreign currency exchange rates. The use of such +hedging activities may not offset more than a portion of the adverse financial +impact resulting from unfavorable movements in foreign exchange rates. 31 Further information related +to the Company’s global market risks may be found in Part II, Item 7A of +this Form 10-K under the subheading “Foreign Currency Risk” and may +be found in Part II, Item 8 of this Form 10-K at Notes 1 and 3 +of Notes to Consolidated Financial Statements. The Company is +subject to risks associated with environmental regulations. Production and marketing +of products in certain states and countries may subject the Company to +environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of +its useful life, and place responsibility for environmentally safe disposal or +recycling with the Company. Such laws and regulations have recently been passed +in several jurisdictions in which the Company operates, including various +European Union member countries, Japan and certain states within the U.S. +Although the Company does not anticipate any material adverse effects in the +future based on the nature of its operations and the thrust of such laws, there +is no assurance such existing laws or future laws will not have a material +adverse effect on the Company’s financial condition, liquidity, or results of +operations. Changes in +accounting rules could affect the Company’s future operating results. Financial statements are +prepared in accordance with U.S. generally accepted accounting principles. +These principles are subject to interpretation by various governing bodies, +including the Financial Accounting Standards Board (“FASB”) and the SEC, who +create and interpret appropriate accounting standards. A change from current +accounting standards could have a significant effect on the Company’s results +of operations. In December 2004, the FASB issued new guidance that +addresses the accounting for share-based payments, Statement of Financial +Accounting Standards (“SFAS”) No. 123 (revised 2004) (“SFAS No. 123R”), Share-Based Payment , which the Company +adopted in 2006. In 2006, stock-based compensation expense reduced diluted +earnings per common share by approximately $0.14. Although the adoption of SFAS +No. 123R is expected to continue to have a significant impact on the +Company’s results of operations, future changes to various assumptions used to +determine the fair-value of awards issued or the amount and type of equity +awards granted create uncertainty as to the amount of future stock-based +compensation expense. Changes in the +Company’s tax rates could affect its future results. The Company’s future +effective tax rates could be favorably or unfavorably affected by changes in +the mix of earnings in countries with differing statutory tax rates, changes in +the valuation of the Company’s deferred tax assets and liabilities, or by +changes in tax laws or their interpretation. In addition, the Company is +subject to the continuous examination of its income tax returns by the Internal +Revenue Service and other tax authorities. The Company regularly assesses the +likelihood of adverse outcomes resulting from these examinations to determine +the adequacy of its provision for income taxes. There can be no assurance the +outcomes from these continuous examinations will not have an adverse effect on +the Company’s results of operations and financial condition. The Company’s stock +price may be volatile. The Company’s stock has at +times experienced substantial price volatility as a result of variations +between its actual and anticipated financial results and as a result of +announcements by the Company and its competitors. The stock market has +experienced extreme price and volume fluctuations that have affected the market +price of many technology companies in ways that may have been unrelated to the +operating performance of these companies. Furthermore, the Company believes its +stock price reflects high future growth and profitability expectations. If the +Company fails to meet these expectations its stock price may significantly +decline. In addition, increases in the Company’s stock price may result in +greater dilution of earnings per share. 32 Item 1B. Unresolved +Staff Comments None. Item 2. Properties The Company’s headquarters are located in Cupertino, +California. The Company has a manufacturing facility in Cork, Ireland. As of September 30, +2006, the Company leased approximately 3.6 million square feet of space, +primarily in the U.S., and to a lesser extent, in Europe, Japan, Canada, and +the Asia Pacific region. The major facility leases are for terms of 5 to 15 +years and generally provide renewal options for terms of 3 to 5 additional +years. Leased space includes approximately 1.2 million square feet of retail +space, a majority of which is in the U.S. Lease terms for retail space range +from 5 to 20 years, the majority of which are for 10 years, and often contain +multi-year renewal options. The Company owns a 352,000 square-foot manufacturing +facility in Cork, Ireland that also houses a customer support call center. The +Company also owns 805,000 square feet of facilities in Sacramento, California +that include warehousing and distribution operations as well as a customer +support call center. In addition, the Company owns approximately 1.9 million +square feet of facilities for research and development and corporate functions +in Cupertino, California, including approximately 948,000 square feet purchased +during 2006 for the future development of the Company’s second corporate +campus, and approximately 107,000 square feet for a data center in Newark, +California. Outside the U.S., the Company owns additional facilities totaling +approximately 169,000 square feet. The Company believes its existing facilities +and equipment are well maintained and in good operating condition. The Company has invested +in internal capacity and strategic relationships with outside manufacturing +vendors, and therefore believes it has adequate manufacturing capacity for the +foreseeable future. The Company continues to make investments in capital +equipment as needed to meet anticipated demand for its products. Item 3. Legal +Proceedings The Company is subject to +various legal proceedings and claims that are discussed below. The Company is +also subject to certain other legal proceedings and claims that have arisen in +the ordinary course of business and which have not been fully adjudicated. In +the opinion of management, the Company does not have a potential liability +related to any current legal proceedings and claims that would individually or +in the aggregate have a material adverse effect on its financial condition, +liquidity or results of operations. However, the results of legal proceedings +cannot be predicted with certainty. Should the Company fail to prevail in any +of these legal matters or should several of these legal matters be resolved +against the Company in the same reporting period, the operating results of a +particular reporting period could be materially adversely affected. The Company +settled certain matters during 2006 that did not individually or in the +aggregate have a material impact on the Company’s results of operations. Allen v. Apple +Computer, Inc. On January 28, 2005, +a plaintiff filed a purported nationwide class action in Los Angeles Superior +Court alleging that a defect in the Company’s 17-inch Studio Display +monitors results in dimming of half of the screen and constant blinking of the +power light. Plaintiff filed an amended complaint on October 24, 2005, adding additional named +plaintiffs and expanding the alleged class to include purchasers of the 20-inch +Apple Cinema Display and the 23-inch Apple Cinema HD Display. The amended +complaint alleges that the displays have a purported defect that causes dimming +of one-half of the screen, and that the Company misrepresented the quality of +the displays and/or concealed the purported defect. Plaintiffs assert claims +under California Business & Professions Code §17200 (unfair +competition); California Business & Professions Code §17500 (false +advertising) and the Consumer Legal Remedies Act. The amended complaint seeks +remedies including damages and equitable relief. On November 14, 2005, the +Company 33 filed +an answer to the amended complaint as to the allegations regarding the 17-inch +display and a demurrer/motion to strike as to the allegations regarding the 20-inch +and 23-inch displays on the ground that plaintiffs failed to allege that +they purchased those displays. At a status conference on November 1, 2005, +the Court ordered Plaintiffs to amend their complaint. Plaintiff filed an +amended complaint on December 12, 2005, and the Company answered on January 5, +2006 denying all allegations and asserting numerous affirmative defenses. The +Company has reached a settlement in this matter, which was given preliminary +approval by the Court on September 18, 2006. The final approval hearing is +scheduled for February 15, 2007. Settlement of this matter will not have a +material effect on the Company’s financial position or results of operations. Apple Computer, Inc. +v. Burst.com, Inc. The Company filed an +action for declaratory judgment against Defendant Burst.com, Inc. on January 4, +2006 in the United States District Court for the Northern District of +California. The Company seeks declaratory judgment that U.S. Patent Nos. +4,963,995, 5,164,839, 5,057,932 and 5,995,705 (“Burst patents”) are invalid and +not infringed by the Company. Burst filed an answer and counterclaim on April 17, +2006. Burst alleges that the following Apple products and services infringe +U.S. Patent Nos. 4,963,995, 5,057,932, 5,164,839, and 5,995,705; iTunes Store, +iPod devices, QuickTime products (including QuickTime player and QuickTime +Streaming Server), iTunes software, other Apple software products (Final Cut +Studio, GarageBand, iMovie, iDVD, iWeb), the use of the .Mac services and Apple +computers and servers running iTunes, QuickTime, or the other named Apple +software products. The Burst patents allegedly relate to methods and devices +used for “burst” transmission of audio or video files. The case is in discovery. +A claim construction hearing is set for February 8, 2007. Trial is set for +February 26, 2008. Apple +Corps Ltd. v. Apple Computer, Inc.; Apple Computer, Inc. v. +Apple Corps Ltd. Plaintiff Apple Corps filed this action on July 4, +2003 in the High Court of Justice, Chancery Division, in London alleging that +the Company has breached a 1991 agreement that resolved earlier trademark +litigation between the parties regarding use of certain Apple marks. Plaintiff +seeks an injunction, unspecified damages, and other relief. The Company filed a +motion on October 13, 2003, challenging jurisdiction in the U.K. The Court +denied this motion on April 7, 2004. The Company filed an appeal of the +Court’s decision but subsequently withdrew the appeal. In November 2004, +Plaintiff served the Company with an Amended Bill of Particulars and on December 23, +2004, the Company filed a Defence. On November 24, 2005, Plaintiff filed a +Re-Amended Bill of Particulars and the Company filed its Defence on December 16, +2005. Trial took place from March 29, 2006 through April 5, 2006. Judgment +was given in favor of the Company on May 8, 2006 and Apple Corps was +ordered to pay a portion of the Company’s fees, the amount to be agreed or +determined in a subsequent proceeding. Apple Corps has filed an appeal, which +is scheduled to be heard in late February 2007. On October 8, 2003, +the Company filed a lawsuit against Apple Corps in the United States District +Court for the Northern District of California requesting a declaratory judgment +that the Company has not breached the 1991 agreement. Apple Corps challenged +jurisdiction in the California case but the Court denied that challenge on March 25, +2004. Apple Corps subsequently prevailed on a motion to stay the California +case during the pendency of the U.K. action. The Company has dismissed the +California lawsuit without prejudice. Bader v. Anderson, +et al. Plaintiff filed this +purported shareholder derivative action against the Company and each of its +then current executive officers and members of its Board of Directors on May 19, +2005 in Santa Clara County Superior Court asserting claims for breach of +fiduciary duty, material misstatements and omissions, and violations of +California Businesses & Professions Code §17200 (unfair competition). +Plaintiff alleges that the Company’s March 14, 2005, proxy statement was +false and misleading for failure to disclose certain information relating to +the Apple Computer, Inc. Performance Bonus Plan, which was approved by 34 shareholders at the annual +meeting held on April 21, 2005. Plaintiff, who ostensibly brings suit on +the Company’s behalf, has made no demand on the Board of Directors and alleges +that such demand is excused. Plaintiff seeks injunctive and other relief for +purported injury to the Company. On July 27, 2005, Plaintiff filed an +amended complaint alleging that, in addition to the purported derivative +claims, adoption of the +bonus plan and distribution of the proxy statement describing that plan also +inflicted injury on her directly as an individual shareholder. On January 10, +2006, the Court sustained defendants’ demurrer to the amended complaint, with +leave to amend. Plaintiff filed a second amended complaint on February 7, +2006, and the Company filed a demurrer. After a hearing on June 13, 2006, +the Court sustained the demurrer without leave to amend as to the non-director +officers and with leave to amend as to the directors. On July 24, 2006, +plaintiff filed a third amended complaint, which purports to bring claims +derivatively as well as directly on behalf of a class of common stock holders +who have been or will be harmed by virtue of the allegedly misleading proxy +statement. In addition to reasserting prior causes of action, the third amended +complaint includes a claim that the Company violated the terms of the plan, and +a claim for waste related to restricted stock unit grants to certain officers +in 2003 and 2004 and an option grant to the Company’s CEO in January 2000. +A demurrer that the Company filed to the third amended complaint as well as a +motion to disqualify the Company’s lawyers will be heard on January 30, +2007. Baghdasarian, et +al. v. Apple Computer, Inc. Plaintiffs filed this +action in Los Angeles County Superior Court on October 31, 2005, on behalf +of a purported nationwide class of all purchasers of all Apple wireless +products (router, modem, or adaptor) sold at any time. The complaint alleges +that the Company misrepresented the transmission rates of these products. The +complaint alleges causes of action for breach of express warranty and for +violations of the Consumer Legal Remedies Act, California Business & +Professions Code §17200 (unfair competition) and California Business & +Professions Code §17500 (false advertising). The complaint seeks damages and +equitable remedies. On December 15, 2005, the Company filed an answer +denying all allegations and asserting numerous affirmative defenses. The +parties have reached a tentative settlement, which is not expected to have a +material effect on the Company’s financial position or results of operations. Barry et al. v. +Apple Computer, Inc. Two Plaintiffs filed this +purported class action on May 16, 2006 in the United States District Court +for the Northern District of California, San Jose Division, on behalf of a +nationwide class of iPod purchasers between May 2002 and the present. The +complaint alleged various problems with the iPod hard drive, including skipping +and limited lifespan. Plaintiffs alleged violations of California Business & +Professions Code §17200 (unfair competition), the Consumer Legal Remedies Act, +the Song-Beverly Consumer Warranty Act and breach of warranties. The complaint +sought damages and equitable relief. The plaintiffs voluntarily dismissed this +case, without prejudice, on September 18, 2006. Birdsong v. Apple +Computer, Inc.; Patterson v. Apple Computer, Inc. These federal court complaints allege that the Company’s +iPod music players, and the ear bud headphones sold with them, are inherently +defective in design and are sold without adequate warnings concerning the risk +of noise-induced hearing loss by iPod users. The Birdsong action was initially +filed on January 30, 2006 in the United States District Court for the +Western District of Louisiana on behalf of a purported Louisiana class of iPod +purchasers and alleges violations of the Louisiana Products Liability Act, +breaches of implied warranties, unjust enrichment, and negligent +misrepresentation. The Patterson action was filed on January 31, 2006 in +the United States District Court for the Northern District of California on +behalf of a purported class of all iPod purchasers within the four-year period +before January 31, 2006. That action alleged breaches of implied and express +warranties, violations of California Business & Professions Code +§17200 (unfair competition), California Business & Professions Code +§17500 (false advertising), the Consumer Legal Remedies Act, breaches of +express and implied warranties, negligent misrepresentation and unjust +enrichment. The Birdsong action was transferred to the Northern District of +California, and the 35 Patterson action was dismissed. An amended complaint +was subsequently filed in Birdsong, dropping the Louisiana law-based claims and +adding California law-based claims equivalent to those in Patterson. The +Company filed a motion to dismiss on November 3, 2006. Plaintiffs will not +oppose the motion but instead will file a second amended complaint by January 15, +2007. A similar complaint, Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc., was filed in Montreal, Quebec, Canada, on February 1, 2006, seeking +authorization to institute a class action on behalf of iPod purchasers in +Quebec. A hearing on the motion for class certification is scheduled for February 8 +and 9, 2007, although Plaintiff counsel has now requested that the +hearing be delayed pending a ruling on the motion to dismiss in the U.S. case. Branning et al. v. +Apple Computer, Inc. Plaintiffs originally +filed this purported class action in San Francisco County Superior Court on February 17, +2005. The initial complaint alleged violations of California Business & +Professions Code §17200 +(unfair competition) and violation of the Consumer Legal Remedies Act (CLRA) +regarding a variety of purportedly unfair and unlawful conduct including, but +not limited to, allegedly selling used computers as new and failing to honor +warranties. Plaintiffs also brought causes of action for misappropriation of +trade secrets, breach of contract, and violation of the Song-Beverly Consumer +Warranty Act. Plaintiffs requested unspecified damages and other relief. On May 9, +2005, the Court granted the Company’s motion to transfer the case to Santa +Clara County Superior Court. On May 2, 2005, Plaintiffs filed an amended +complaint adding two new named plaintiffs and three new causes of action +including a claim for treble damages under the Cartwright Act (California +Business & Professions Code §16700 +et seq.) and a claim for false advertising. The Company filed a demurrer to the +amended complaint, which the Court sustained in its entirety on November 10, +2005. The Court granted Plaintiffs leave to amend and they filed an amended +complaint on December 29, 2005. Plaintiffs’ +amended complaint added three plaintiffs and alleged many of the same factual +claims as the previous complaints, such as alleged selling of used equipment as +new, alleged failure to honor warranties and service contracts for the consumer +plaintiffs, and alleged fraud related to the opening of the Apple retail stores. +Plaintiffs continued to assert causes of action for unfair competition +(§17200), violations of the CLRA, breach of contract, misappropriation of trade +secrets, violations of the Cartwright Act and alleged new causes of action for +fraud, conversion and breach of the implied covenant of good faith and fair +dealing. The Company filed a demurrer to the amended complaint on January 31, +2006, which the Court sustained on March 3, 2006 on sixteen of seventeen +causes of action. Plaintiffs filed an amended complaint adding one new +plaintiff. The Company filed a demurrer, which was granted in part on September 9, +2006. Plaintiffs filed a further amended complaint on September 21, 2006. On +October 2, 2006, the Company filed an answer denying all allegations and +asserting numerous affirmative defenses. The case is in discovery. Butzer, et +al. v. Apple Computer, Inc.;Wirges v. Apple Computer, Inc.; +Blackwell v. Apple Computer, Inc. Plaintiffs filed the +Butzer action on August 23, 2005 in the United States District Court for +the Northern District of California, San Jose Division, on behalf of a +purported nationwide class of all purchasers of the Company’s PowerBook G4 +portable computers. The complaint alleged defects in the memory of the computers. +The complaint alleged that this purported defect extends to other series of the +Company’s portables and stated that plaintiffs reserved the right to amend the +complaint to include these other series. Plaintiffs asserted claims for alleged +violations of California Business & Professions Code §17200 (unfair +competition), California Business & Professions Code §17500 (false +advertising), the Consumer Legal Remedies Act (CLRA) and the Song-Beverly +Consumer Warranty Act. The complaint sought remedies including restitution +and/or damages and injunctive relief. The Wirges action was filed on January 20, +2006 in the United States District Court for the Eastern District of Arkansas, +also on behalf of a purported nationwide class, and made similar allegations. +Plaintiffs asserted claims for breach of warranties, violation of the Magnuson—Moss +Act, strict products liability and unjust enrichment. The complaint sought restitution, +damages and other remedies. The Blackwell action was filed on February 10, +2006 in the 36 United States District +Court for the Northern District of California, on behalf of a purported +nationwide class, and made identical allegations to those made in the Butzer +case. Plaintiffs asserted claims for breach of express and implied warranties, +violation of the CLRA, violation of the Song-Beverly Act, false advertising and +unfair competition. The complaint sought restitution, an injunction and other +remedies. The Company filed an answer to the Butzer complaint on October 19, +2005 denying all material allegations and asserting numerous affirmative +defenses. The Company filed an answer to the Wirges action on February 28, +2006, and also filed a motion to transfer the Wirges case to the Northern +District of California. The Company filed an answer to the Blackwell complaint +on March 15, 2006 denying all material allegations and asserting numerous +affirmative defenses. The Company has reached a settlement with the named +plaintiffs in all three cases and these matters are concluded. Settlement of these +matters did not have a material effect on the Company’s financial position or +results of operations. Charoensak v. Apple +Computer, Inc. (formerly Slattery v. Apple Computer, Inc.) The original Plaintiff +(Slattery) filed this purported class action on January 3, 2005 in the +United States District Court for the Northern District of California alleging +various claims including alleged unlawful tying of music purchased on the +iTunes Store with the purchase of iPods and vice versa and unlawful acquisition +or maintenance of monopoly market power. Plaintiff’s complaint alleged +violations of §§1 and 2 of the Sherman Act (15 U.S.C. §§1 and 2), California +Business and Professions Code §16700 et seq. (the Cartwright Act), California +Business and Professions Code §17200 (unfair competition), common law unjust +enrichment and common law monopolization. Plaintiff sought unspecified damages +and other relief. The Company filed a motion to dismiss on February 10, +2005. On September 9, 2005, the Court denied the motion in part and granted +it in part. Plaintiff filed an amended complaint on September 23, 2005 and +the Company filed an answer on October 18, 2005. On May 8, 2006, the +Court heard Plaintiff’s motion for leave to file a second amended complaint to +substitute two new plaintiffs for Slattery. In August 2006, the court +dismissed Slattery without prejudice and allowed plaintiffs to file an amended +complaint naming two new plaintiffs (Charoensak and Rosen). On November 2, +2006, the Company filed an answer to the amended complaint denying all material +allegations and asserting numerous affirmative defenses. The hearing on class +certification is set for April 16, 2007. Contois Music +Technology LLC v. Apple Computer, Inc. Plaintiff Contois Music +Technology filed this action on June 13, 2005 in the United States +District Court for Vermont, alleging infringement by the Company of U.S. Patent +No. 5,864,868, entitled “Computer Control System and User Interface for +Media Playing Devices.” The complaint sought unspecified damages and other +relief. The Company filed an answer on November 23, 2005 denying all +material allegations and asserting numerous affirmative defenses. A Markman +hearing was held on June 13, 2006 and the court issued a claim +construction ruling on July 24, 2006. The parties agreed to a settlement +and the case was dismissed on August 18, 2006. This matter is now +concluded. Settlement of this matter did not have a material effect on the +Company’s financial position or results of operations. Creative Technology Ltd. and Creative Labs, Inc. +v. Apple Computer, Inc. (filed +on May 15, 2006, International Trade Comission), Creative +Technology Ltd. v. Apple Computer, Inc. (filed +on May 15, 2006, United States District Court for the Northern District of +California), Apple Computer, Inc. v. Creative Technology Ltd. and +Creative Labs, Inc. (filed May 15, +2006, United States District Court for the Western District of Wisconsin), Apple Computer, Inc. v. Creative Technology Ltd. and Creative Labs, Inc. (filed on June 1, 2007, International Trade +Comission), Apple Computer, Inc. v. Creative Technology Ltd. and +Creative Labs (filed on June 1, 2006, +United States District Court for the Eastern District of Texas) On May 15, 2006, Creative Labs, Inc., and +Creative Technology Ltd. (collectively “Creative”) filed a complaint with the +U.S. International Trade Commission (“ITC”) alleging that the Company infringed +U.S. patent number 6,928,433 (“‘433 patent”) and seeking an order permanently +barring iPods from importation into the United States. On May 15, 2006, +Creative also brought suit against the Company in 37 the United States District Court for the Northern +District of California, also alleging that the iPod infringed the ‘433 patent. The +District Court action was stayed pending resolution of the Creative ITC Action. On May 15, 2006, the Company brought suit against +Creative in the United States District Court for the Western District of +Wisconsin (“Wisconsin Action”), alleging that Creative infringed U.S. patent +number 5,479,602 (“‘602 patent”), U.S. patent number 5,586,237 (“‘237 patent”), +U.S. patent number 5,898,434 (“‘434 patent”), and U.S. patent number 6,731,312 +(“‘312 patent”). On May 17, 2006, the Company filed an amended complaint +in the Wisconsin Action alleging that Creative also infringed U.S. patent +number 5,341,293 (“‘293 patent”), U.S. patent number 6,047,342 (“‘342 patent”), +and U.S. patent number 5,799,280 (“‘280 patent”). On June 1, 2006, the Company brought suit against +Creative in the United States District Court for the Eastern District of Texas, +(“Texas Action”), alleging that Creative infringed U.S. patent number 6,157,363 +(“‘363 patent”), U.S. patent number 5,640,566 (“‘566 patent”), and U.S. patent +number 5,504,852 (“‘852 patent”). On June 27, 2006, the Company filed an +amended complaint in the Texas Action alleging that Creative also infringed +U.S. patent number 7,046,230 (“‘230 patent”) and U.S. patent number 6,282,646 (“‘646 +patent”). At the suggestion of the District Court, the Company filed separate +actions in the Eastern District of Texas regarding the Company’s allegations +relating to the ‘230 patent and the ‘646 patent. On June 1, 2006, the Company filed a complaint +with the ITC alleging that Creative infringed the ‘230 patent, the ‘293 patent, +and the ‘434 patent. On June 5, 2006, the Company filed an amended +complaint with the ITC alleging that Creative also infringed the ‘646 patent. The parties reached a +settlement of all of the above matters and all cases were dismissed as of October 13, +2006. These matters are concluded. Settlement of these matters did not have a +material effect on the Company’s financial position or results of operations. Davis v. Apple +Computer, Inc. Plaintiff filed this +purported class action in San Francisco County Superior Court on December 5, +2002, alleging that the Company engaged in unfair and deceptive business +practices relating to its AppleCare Extended Service and Warranty Plan. +Plaintiff asserts causes of action for violation of California Business & +Professions Code §17200 +(unfair competition), California Business & Professions Code §17500 (false advertising), breach of +the Song-Beverly Warranty Act, intentional misrepresentation and concealment. +Plaintiff requests unspecified damages and other relief. The Company filed a +demurrer and motion to strike, which were granted, in part, and Plaintiff filed +an amended complaint. The Company filed an answer on April 17, 2003 +denying all allegations and asserting numerous affirmative defenses. Plaintiff +subsequently amended his complaint. On October 29, 2003, the Company filed +a motion to disqualify Plaintiff’s counsel in his role as counsel to the +purported class and to the general public. The Court granted the motion but +allowed Plaintiff to retain substitute counsel. Plaintiff did engage new +counsel for the general public, but not for the class. The Company moved to +disqualify Plaintiff’s new counsel and to have the Court dismiss the general +public claims for equitable relief. The Court declined to disqualify Plaintiff’s +new counsel or to dismiss the equitable claims, but did confirm that the class +action claims were dismissed. The Company appealed the ruling and the case was +stayed pending the outcome of the appeal. The Court of Appeals denied the +appeal on August 17, 2005, affirming the trial court’s decision. The +Company filed a Petition for review with the California Supreme Court, which +was denied on November 23, 2005. The case was remanded back to the trial +court. The parties have reached a settlement and the matter is concluded. Settlement +of this matter did not have a material effect on the Company’s financial +position or results of operations. 38 European Commission +Investigation The European Commission +has notified the Company it is investigating certain matters relating to the +iTunes Store in the European Union (“EU”). The European Commission is +investigating claims made by Which?, a United Kingdom (UK) consumer +association, that the Company is violating EU competition law by charging more +for online music in the UK than in Eurozone countries and preventing UK +consumers from purchasing online music from the iTunes Store for Eurozone +countries. The Which? claims were originally lodged with the UK Office of Fair +Trading, which subsequently referred them to the European Commission. The +European Commission is investigating the charges under Articles 81 and 82 of +the European Commission Treaty. Euro Tec +Enterprises, Inc. et al. v. Apple Computer, Inc. et al. This is a purported class +action copyright infringement case filed on May 16, 2006 in the United States +District Court for the Central District of California by certain independent +music publishers against the Company and several other defendants for allegedly +failing to secure a compulsory license for copyrighted musical compositions +being sold as downloads. Plaintiffs’ complaint seeks an injunction, damages and +other relief. The Company filed an answer on July 28, 2006 denying all +material allegations and asserting numerous affirmative defenses. The case is +in discovery and is set for trial on November 13, 2007 if no class is +certified or on June 10, 2008 if a class is certified. Plaintiffs filed an +amended complaint on October 23, 2006 and the Company filed an amended +answer on November 28, 2006 denying all material allegations and asserting +numerous affirmative defenses. Gillis et al. v. +Apple Computer, Inc. Plaintiffs filed this +purported class action on December 23, 2005 in San Diego County Superior +Court alleging the Company has misrepresented the hard drive capacity of two +Powerbook G4 computers: the 12-inch, 1.5GHz computer with 512MB of memory +and a 100GB hard drive; and the 15-inch, 1.67GHz computer with 1GB of +memory and a 100GB hard drive. Plaintiffs alleged that the Company’s standard +disclosure on its packaging regarding hard drive size was not present on the +packaging for these two models. The complaint alleged violations of the +California Business & Professions Code §17200 (unfair competition), +California Business & Professions Code §17500 (false advertising), the +Consumer Legal Remedies Act, and causes of action for deceit and negligent +misrepresentation. Plaintiffs sought restitution and other relief. On February 28, +2006, the Company filed a demurrer and a motion to strike. The Company withdrew +the demurrer and motion to strike per stipulation. The Company has reached a Court-approved +settlement with the Plaintiffs in this action and the matter is concluded. The +settlement of this matter did not have a material effect on the Company’s +financial position or results of operations. Goldberg, et al. v. +Apple Computer, Inc., et al. Plaintiffs filed this +purported class action on September 22, 2003 in Los Angeles County +Superior Court against the Company and other members of the computer industry +on behalf of an alleged nationwide class of purchasers of certain computer hard +drives. The case alleged violations of California Business & +Professions Code §17200 +(unfair competition), the Consumer Legal Remedies Act and false advertising +related to the size of the drives. Plaintiffs alleged that calculation of hard +drive size using the decimal method misrepresents the actual size of the drive. +The complaint sought restitution and other relief. Plaintiffs filed an amended +complaint on March 30, 2004 and the Company filed an answer on September 23, +2004, denying all allegations and asserting numerous affirmative defenses. Defendants +filed a motion to strike portions of the complaint based on sales by resellers +and filed a motion for judgment on the pleadings based upon Proposition 64. The +Court granted both motions at a hearing on April 6, 2005. Plaintiffs +thereafter filed an amended complaint on May 6, 2005. The Defendants filed +a demurrer on June 6, 2005, which the Court granted in part and denied in +part. Plaintiffs filed an amended complaint and the Company filed an answer on December 15, +2005 denying all allegations and asserting numerous assertive defenses. The +Company reached a Court-approved settlement with the Plaintiffs in this action 39 and the matter is +concluded. The settlement of this matter did not have a material effect on the +Company’s financial position or results of operations. Gordon v. Apple +Computer, Inc. Plaintiff filed this +purported class action on August 31, 2006 in the United States District +Court for the Northern District of California, San Jose Division, on behalf of +a purported nationwide class of consumers who purchased 65W Power Adapters for +iBooks and Powerbooks between November 2002 and the present. The complaint +alleges various problems with the 65W Adapter, including fraying, sparking and +premature failure. Plaintiffs allege violations of California Business & +Professions Code §17200 (unfair competition), the Consumer Legal Remedies Act, +the Song-Beverly Consumer Warranty Act and breach of warranties. The complaint +seeks damages and equitable relief. The Company filed an answer on October 20, +2006 denying the material allegations and asserting numerous affirmative +defenses. Mediation is set for March 13, 2007. Greaves v. Apple +Computer, Inc. On June 30, 2006 +Plaintiff filed this purported class action in San Diego Superior Court on +behalf of a purported class of California purchasers alleging discoloration of +the MacBook case. Plaintiff asserts claims under California Business & +Professions Code §17500 (false advertising), California Business & +Professions Code §17200 (unfair competition), the Consumer Legal Remedies Act +and misrepresentation. Plaintiff’s complaint seeks damages and equitable relief. +Plaintiff filed a First Amended Complaint on August 16, 2006. The Company +filed an answer on October 3, 2006 denying all allegations and asserting +numerous affirmative defenses. Honeywell +International, Inc., et al. v. Apple Computer, Inc., et al. Plaintiffs Honeywell +International, Inc. and Honeywell Intellectual Properties, Inc. filed +this action on October 6, 2004 in the United States District Court in +Delaware alleging infringement by the Company and other defendants of U.S. +Patent 5,280,371 entitled “Directional Diffuser for a Liquid Crystal Display.” +Plaintiffs seek unspecified damages and other relief. The Company filed an +answer on December 21, 2004 denying all material allegations and asserting +numerous affirmative defenses. The Company has tendered the case to several LCD +manufacturer suppliers. On May 18, 2005 the Court stayed the case against +the Company and the other non-manufacturer defendants. Plaintiffs filed an +amended complaint on November 7, 2005 adding additional defendants and +expanding the scope of the accused products. Given the stay, the Company’s +response to the amended complaint is not yet due. In re Apple Computer, Inc. Derivative Litigation +(formerly Karant v. Jobs, et al. and Related Actions) (Federal Action) On June 30, 2006, a +putative derivative action captioned Karant v. Jobs, et. al. , +was filed in the United States District Court for the Northern District of +California, San Jose Division. A number of related actions were filed in the +subsequent weeks and have been consolidated into a single action captioned In re Apple Computer, Inc. Derivative Litigation , +Master File No. C-06-04128-JF before the Hon. Jeremy +Fogel. A Consolidated Shareholder Derivative Complaint was filed on December 18, +2006. The action purports to assert claims on behalf of the Company against +several current and former executive officers and members of the Board of +Directors alleging improper backdating of stock option grants to maximize +certain defendants’ profits, failing to properly account for and take tax +deductions for those grants, insider trading and issuing false financial statements. +The Company is named as a nominal defendant. The consolidated complaint alleges +various causes of action under federal and California law, including claims for +unjust enrichment, breach of fiduciary duty, violation of the California +Corporations Code, abuse of control, gross mismanagement, rescission, +constructive fraud and waste of corporate assets, as well as claims under +Sections 10(b), 14(a) and 20(a) of the Securities Exchange Act. +Plaintiffs seek damages, disgorgement, restitution and imposition of a +constructive trust. The actions were filed after the Company’s 40 announcement on June 29, +2006 that an internal investigation had discovered irregularities related to +the issuance of certain stock option grants made between 1997 and 2001, that a +special committee of the Company’s outside directors had retained independent +counsel to perform an investigation, and that the Company had informed the +Securities and Exchange Commission. The Company’s response to the Consolidated +Complaint is not yet due. In re Apple Computer, Inc. Derivative Litigation +(formerly Plumbers and Pipefitters v. Jobs, et al. and Related Actions) (State +Action); Boston Retirement Board v. Apple Computer, Inc. On July 5, 2006, a putative derivative action +captioned Plumbers and Pipefitters v. Jobs, et. al. , +was filed in California Superior Court for the County of Santa Clara. A number +of related actions were filed in the subsequent weeks, and have been +consolidated into a single action captioned In re Apple Computer, Inc. +Derivative Litigation , No. 1:06CV066692, assigned to the Hon. +Joseph Huber. These actions purport to assert claims on behalf of the Company +against several current and former executive officers and members of the Board +of Directors alleging improper backdating of stock option grants to maximize +certain defendants’ profits, failing to properly account for and take tax +deductions for those grants and issuing false financial statements. The Company +is named as a nominal defendant. A consolidated complaint was filed on October 5, +2006, alleging a variety of causes of action under California law, including +claims for unjust enrichment, breach of fiduciary duty, violation of the +California Corporations Code, abuse of control, accounting, constructive trust, +rescission, deceit, gross mismanagement and waste of corporate assets. On December 7, +2006, the Court granted the Company’s motion to stay these actions. On November 3, 2006, +the Boston Retirement Board, a purported shareholder, filed a petition for writ +of mandate against the Company in California Superior Court for the County of +Santa Clara County ( Boston Retirement Board v. +Apple Computer Inc. ). The petition seeks to compel the Company to +allow inspection of certain corporate records relating to the Company’s option practices +and the Special Committee’s investigation. The Company’s response to the +petition is not yet due. Lenzi v. Apple Canada, Inc.; Wolfe v. Apple +Computer, Inc. and Apple Canada, Inc.; Hirst v. Apple Canada, Inc.; +Hamilton v. Apple Computer, Inc. and Apple Canada, Inc. Plaintiff filed a purported class action on June 7, +2005, in Superior Court, in Montreal, Quebec, Canada allegedly +on behalf of Quebec customers claiming false advertising and breach of warranty +relating to iPod battery life. Plaintiff sought authorization to institute a class action on +behalf of Generations 1, 2 and 3 iPod owners in Quebec. On February 2, +2006, the Court dismissed Plaintiff’s motion for authorization to institute a +class action. Plaintiff has appealed this ruling, and the appeal will be heard +on February 22, 2007. Two similar complaints +relative to iPod battery life, Wolfe v. Apple and Hirst v. Apple , were filed in Toronto, +Ontario, Canada on August 15, 2005 and September 12, 2005, +respectively. Both actions define the purported class as a national class +consisting of all persons in Canada who have purchased or who own an iPod. +Counsel has proposed an amended complaint to which the Company has not +consented. In addition, a similar complaint regarding iPod battery life, Hamilton v. Apple Computer, Inc. and Apple Canada, Inc. was filed in Alberta, Calgary, Canada on October 5, 2005, purportedly on +behalf of all purchasers of iPods in Alberta, Canada. That complaint has not +been served. MacTech Systems v. Apple Computer, Inc.; +Macadam v. Apple Computer, Inc.; Computer International, Inc. v. +Apple Computer, Inc.; Elite Computers and Software, Inc. v. +Apple Computer, Inc.; The Neighborhood Computer Store v. Apple +Computer, Inc.; MacAccessory Center, Inc. v. Apple Computer, Inc.; +Creative Online Computer Services, Inc., DBA MacOnline v. Apple Computer, Inc.; +MacGuys, Inc. v. Apple Computer, Inc. (all in Santa Clara County Superior Court) Eight resellers filed similar lawsuits against the +Company between late 2002 and early 2006 asserting various causes of action +including breach of contract, fraud, negligent and intentional interference +with 41 economic relationship, negligent misrepresentation, +trade libel, unfair competition and false advertising. Plaintiffs requested +unspecified damages and other relief. The Company answered the Computer +International complaint on November 12, 2003, denying all allegations and +asserting numerous affirmative defenses. The Company filed an answer in the +Macadam case on December 3, 2004 denying all allegations and asserting +numerous defenses. Three of the other Plaintiffs filed amended complaints on February 7, +2005, and on March 16, 2005 the Company filed answers to these claims +denying all allegations and asserting numerous affirmative defenses. A sixth +Plaintiff, MacAccessory Center, filed a complaint on February 23, 2005. The +Company filed an answer to this complaint on April 20, 2005 denying all +allegations and asserting numerous affirmative defenses. On February 28, +2006, MacGuys and Creative Online filed complaints against the Company. All of +these cases with the exception of Macadam were coordinated for discovery (along +with the Branning class action) in Santa Clara Superior Court. The Elite, +Neighborhood Computer Store, MacTech and MacAccessory cases were set for trial +on November 27, 2006. The Company has reached settlements with Computer +International, MacTech Systems, Elite Computers and Software, Inc., +MacAccessory Center, Inc., The Neighborhood Computer Store, Creative +Online Computer Services, Inc., and MacGuys, Inc. and these matters +are concluded. These settlements did not have a material effect on the Company’s +financial position or results of operations. On October 1, 2003, one of the reseller +Plaintiffs, Macadam, was deauthorized as an Apple reseller. Macadam filed a +motion for a temporary order to reinstate it as a reseller, which the Court +denied. The Court denied Macadam’s motion for a preliminary injunction on December 19, +2003. On December 6, 2004, Macadam filed for Chapter 11 Bankruptcy in the +Northern District of California, which placed a stay on the litigation as to +Macadam only. The Company filed a claim in the bankruptcy proceedings on February 16, +2005. The Macadam bankruptcy case was converted to Chapter 7 (liquidation) on April 29, +2005. The Company has reached a settlement of the Macadam case with the Chapter +7 Bankruptcy Trustee. The Bankruptcy Court approved the settlement on July 17, +2006 over the objection of Tom Santos, MacAdam’s principal. Santos has appealed +the ruling approving the settlement. On December 19, 2005, +Tom Santos, who was an original plaintiff in the Macadam case, filed a Fifth +Amended Complaint on his own behalf (not on behalf of Macadam) alleging fraud, +violations of California Business & Professions Code §17200 (unfair +competition), California Business & Professions Code §17500 (false +advertising) and the Consumer Legal Remedies Act. The Company filed a demurrer +to Santos’ amended complaint and a special motion to strike the defamation +cause of action on January 20, 2006. Those motions were heard on February 17, +2006, and the Court sustained the demurrer without leave to amend as to one +cause of action, overruled the demurrer as to one cause of action and sustained +the demurrer with leave to amend as to two causes of action. The Court also +denied the special motion to strike. Santos filed a further amended complaint +on July 14, 2006. The Company filed a demurrer, which was granted on September 9, +2006. Santos filed an amended complaint. The Company filed a motion to strike, +which was granted in part and denied in part on December 15, 2006. The +Company also filed a cross complaint against Santos on January 20, 2006 +alleging violations of California Business & Professions Code §17200 +and California Penal Code §502, fraud and deceit, and breach of contract. Macsolutions, Inc. +v. Apple Computer, Inc. Plaintiff Macsolutions, Inc., +a former Apple authorized reseller, filed this lawsuit against the Company on January 20, +2006 alleging breach of contract, fraud, misappropriation of trade secrets, +intentional interference with economic advantage, violation of the Cartwright +Act, violation of California Business & Professions Code §17200 +(unfair competition) and fraudulent concealment. The factual allegations in +this complaint are similar to those in the eight other reseller cases and the +Branning class action. Principally, Plaintiffs allege that the Company treated +Macsolutions unfairly compared to other resellers, that the Company has +competed unfairly in opening the Apple retail stores, and has allegedly sold +used goods as new. Macsolutions filed an amended complaint on June 5, +2006, adding Tech Data Corporation as a 42 defendant. The Company +filed an answer on July 5, 2006 generally denying all allegations and +asserting numerous affirmative defenses. The case is in discovery. The case is +set for trial on June 18, 2007. PhatRat Technology +LLC v. Apple Computer, Inc. Plaintiff PhatRat +Technology LLC filed this action on October 24, 2006 in the United States +District Court for the District of Colorado alleging infringement of U.S. +Patent number 6,499,000 entitled “System and Method for Determining Loft Time, +Speed, Height and Distance,” U.S. Patent number 6,885,971 entitled “Methods and +Systems for Assessing Athletics Performance,” U.S. Patent number 6,963,818 +entitled “Mobile Speedometer Systems and Associated Methods,” and U.S. Patent +number 7,092,846 entitled “Systems and Methods for Determining Performance +Data,” as well as allowed U.S. Patent Application number 11/358,508 entitled “Shoes +Employing Monitoring Devices, and Associated Methods.” Plaintiff asserts that +the Nike+iPod products infringe these patents. The Company’s response to the +complaint is not yet due. Premier +International Associates LLC v. Apple Computer, Inc. Plaintiff Premier +International Associates LLC filed this action on November 3, 2005 in the +United States District Court for the Eastern District of Texas, Marshall +Division, alleging infringement by the Company of U.S. Patent numbers 6,243,725 +and 6,763,345 both entitled “List Building System.” The complaint seeks +unspecified damages and other relief. The Company filed an answer on January 13, +2006 denying all material allegations and asserting numerous affirmative +defenses. The Company also asserted counter claims for a declaratory judgment +of noninfringement and invalidity. A Markman hearing is set for May 17, +2007 and trial is scheduled for December 3, 2007. Quantum Technology +Management, Ltd. v. Apple Computer, Inc. Plaintiff filed this +action on December 21, 2005 in the United States District Court for the +District of Maryland against the Company and Fingerworks, Ltd., alleging +infringement of U.S. Patent number 5,730,165 entitled “Time Domain Capacitive +Field Detector.” The complaint seeks unspecified damages and other relief. On May 11, +2006, Quantum filed an amended complaint adding Cypress +Semiconductor/MicroSystems, Inc. as a defendant. On July 31, 2006, +the Company filed an answer denying all material allegations and asserting +numerous affirmative defenses and also filed counterclaims for non-infringment +and invalidity. On November 30, 2006 Plaintiff filed a reply to the +Company’s counterclaims and a More Definite Statement. St-Germain v. Apple +Canada, Inc. Plaintiff filed this case +in Montreal, Quebec, Canada, on August 5, 2005, seeking authorization to +institute a class action for the refund by the Company of the Canadian Private +Copying Levy that was applied to the iPod purchase price in Quebec between December 12, +2003 and December 14, 2004 but later declared invalid by the Canadian +Court. The Company has completed a refund program for this levy. A class +certification hearing took place January 13, 2006. On February 24, +2006, the Court granted class certification and notice was published during the +last week of March 2006. Discovery is closed and the case is prepared for +trial, which the Company anticipates will take place in 2007. Tse v. Apple +Computer, Inc. et al. Plaintiff Ho Keung Tse +filed this action against the Company and other defendants on August 5, +2005 in the United States District Court for the District of Maryland alleging +infringement by the Company of U.S. Patent number 6,665,797 entitled +“Protection of Software Again [sic] Against Unauthorized Use.” The complaint +seeks unspecified damages and other relief. The Company filed an answer on +October 31, 2005 denying all material allegations and asserting numerous +affirmative defenses. On October 28, 2005, the Company and the other +defendants filed a motion to transfer the case to the Northern District of +California, which was granted on August 31, 2006. 43 Tucker v. Apple Computer, Inc. Plaintiff filed this +purported class action on July 21, 2006 in the United States District +Court for the Northern District of California alleging various claims including +alleged unlawful tying of music and videos purchased on the iTunes Store with +the purchase of iPods and vice versa and unlawful acquisition or maintenance of +monopoly market power. The complaint alleges violations of §§1 and 2 of the +Sherman Act (15 U.S.C. §§1 and 2), California Business & Professions +Code §16700 et seq. (the Cartwright Act), California Business & +Professions Code §17200 (unfair competition), and the California Consumer Legal +Remedies Act. Plaintiff seeks unspecified damages and other relief. On November 3, +2006, the Company filed a motion to dismiss the complaint, which was heard on November 20, +2006. On December 20, 2006, the Court denied the motion to dismiss. Union Federale des +Consummateurs - Que Choisir v. Apple Computer France s.à.r.l. and iTunes +s.à.r.l. Plaintiff, a consumer +association in France, filed this complaint on February 9, 2005 alleging +that the above-listed entities are violating consumer law by (1) omitting +to mention that the iPod is allegedly not compatible with music from online +music services other than the iTunes Store and that the music from the iTunes +Store is only compatible with the iPod and (2) allegedly tying the sales +of iPods to the iTunes Store and vice versa. Plaintiff seeks damages, +injunctive relief and other relief. The first hearing on the case took place on +May 24, 2005. The Company’s response to the complaint was served on November 8, +2005. Plaintiff’s responsive pleading was filed on February 10, 2006. The +Company filed a reply on June 6, 2006 and UFC filed a response on September 19, +2006. Vitt v. Apple Computer, Inc. Plaintiff filed this +purported class action on November 7, 2006 in the United States District +Court for the Central District of California on behalf of a purported +nationwide class of all purchasers of the iBook G4 alleging that the computer’s +logic board fails at an abnormally high rate. The complaint alleges violations +of California Business & Professions Code §17200 (unfair competition) +and California Business & Professions Code §17500 (false advertising). +Plaintiff seeks unspecified damages and other relief. The Company’s response to +the complaint is not yet due. Vogel v. Jobs et +al. Plaintiff filed this purported class action on August 24, +2006, in the United States District Court for the Northern District of +California against the Company and certain of the Company’s current and former +officers and directors alleging improper backdating of stock option grants to +maximize certain defendants’ profits, failing to properly account for those +grants and issuing false financial statements. The lawsuit purports to be +brought on behalf of all purchasers of the Company’s stock from December 1, +2005 through August 11, 2006, and asserts claims under Sections 10(b) and +14(a) of the Securities Exchange Act as well as control person claims. A +motion for appointment of lead plaintiff and counsel was scheduled to be heard +on December 4, 2006 but was taken off calendar when the case was +re-assigned to the Hon. Jeremy Fogel. The motion therefore is still pending. Defendants’ +responses to the complaint are not yet due. Wimmer v. Apple +Computer, Inc. (originally +filed as Tomczak v. Apple Computer, Inc. on October 19, 2005 in the United States District Court for the +Northern District of California, San Jose Division; amended complaint filed October 26, +2005); Moschella, et al., v. Apple Computer, Inc. (filed October 26, 2005 United States District +Court for the Northern District of California, San Jose Division); Calado, et al. v. Apple Computer, Inc. (filed +October 26, 2005, Los Angeles County Superior Court); Kahan, et +al., v. Apple Computer, Inc. (filed October 31, +2005, United States District Court for the Southern District of New York); Jennings, et al., v. Apple Computer, Inc. (filed +November 4, 2005, United States District Court for the Northern District +of California, San Jose Division); Rappel v. Apple Computer, Inc. (filed on November 23, 2005, United States +District Court for the District of New Jersey); Mayo v. Apple Computer, Inc. (filed on December 7, 2005, United States +District Court for the Middle District of Louisiana); Valencia v. Apple +Computer, Inc. (filed on December 22, +2005, United States District Court for 44 the Northern District of +California); Williamson v. Apple Computer, Inc. (filed on December 29, 2005, United States +District Court for the Middle District of Louisiana); Sioson v. Apple +Computer, Inc. (filed on February 9, +2006, San Mateo County Superior Court; First Amended Complaint filed March 16, +2006) These federal and state court complaints allege that +the Company’s iPod nano was defectively designed so that it scratches +excessively during normal use, rendering the screen unreadable. The federal +actions were coordinated in the United States District Court for the Northern +District of California and assigned to the Hon. Ronald Whyte pursuant to an April 17, +2006, order of the Judicial Panel on Multidistrict Litigation. Plaintiffs filed +a First Consolidated and Amended Master Complaint on September 21, 2006, alleging +violations of California and other states’ consumer protection and warranty +laws and claiming unjust enrichment. The Master Complaint alleges two putative +plaintiff classes: (1) all U.S. residents (excluding California residents) +who purchased an iPod nano that was not manufactured or designed using +processes necessary to ensure normal resistance to scratching of the screen; +and (2) all iPod nano purchasers other than U.S. residents who purchased +an iPod nano that was not manufactured or designed using processes necessary to +ensure normal resistance to scratching of the screen. Pursuant to stipulation, +the Wimmer, Valencia, and Rappel federal complaints were dismissed without +prejudice and the Mayo and Williamson complaints were administratively closed +without prejudice. The Company answered the Master Complaint on November 20, +2006. The two California state actions were coordinated on May 4, +2006, and assigned to the Hon. West in Los Angeles Superior Court. Plaintiffs +filed a Consolidated Amended Class Action Complaint on June 8, 2006, +alleging violations of California state consumer protection, unfair +competition, false advertising, and warranty laws and claiming unjust +enrichment. The Consolidated Complaint alleges a putative plaintiff class of +all California residents who own an iPod nano containing a manufacturing defect +that results in the nano being susceptible to excessive scratching. The Company +answered the Consolidated Amended Complaint on October 6, 2006. Two similar complaints, Carpentier v. Apple Canada, Inc. , and Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc. were +filed in Montreal, Quebec, Canada on October 27, 2005 and November 9, +2005, respectively, seeking authorization to institute class actions on behalf +of iPod nano purchasers in Quebec. The Royer-Brennan file was stayed in May 2006 +in favor of the Carpentier file, in which Apple’s preliminary motion for +leave to file evidence will be heard on December 18, 2006. No further +dates have been set. A similar complaint, Mund v. Apple Canada Inc. +and Apple Computer, Inc., was filed in Ontario, Canada on January 9, +2006 seeking authorization to institute a class action on behalf of iPod nano +purchasers in Canada. In the two Quebec class actions, a motion to stay the +Royer-Brennan case is stayed in favor of the previously filed Carpentier case. In +the Ontario Action, Apple Canada Inc. and Apple Computer, Inc., have +served Notices of Intent to defend. On December 18, 2006, plaintiff’s +counsel advised that a substitution of attorneys will occur, most likely in January 2007. +The file is now stayed, and the Company’s motion to examine petitioner and for +leave to file evidence at certification will be set after the new counsel +appears. Item 4. Submission +of Matters to a Vote of Security Holders No matters were submitted to a vote of security +holders during the fourth quarter of the Company’s fiscal year ended September 30, +2006. 45 PART II Item 5. Market for Registrant’s Common Equity, Related +Shareholder Matters and Issuer Purchases of Equity Securities The Company’s common stock +is traded on the over-the-counter market and is quoted on the +NASDAQ Global Select Market under the symbol AAPL and on the Frankfurt Stock +Exchange under the symbol APCD. Price Range of +Common Stock The price range per share of common stock presented +below represents the highest and lowest sales prices for the Company’s common +stock on the NASDAQ Global Select Market during each quarter of the two most +recent fiscal years. On February 28, +2005, the Company effected a two-for-one stock split to shareholders of record +as of February 18, 2005. All share and per share information has been +retroactively adjusted to reflect the stock split. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2006 price + range per common share $ 77.78-$50.16 $ 73.80-$55.41 $ 86.40-$57.67 $ 75.46-$47.87 Fiscal 2005 price + range per common share $ 53.20-$36.37 $ 43.74-$34.13 $ 45.06-$31.58 $ 34.22-$18.65 Holders As of December 13, +2006, there were 29,317 shareholders of record. Dividends The Company did not +declare or pay cash dividends in either 2006 or 2005. The Company anticipates +that, for the foreseeable future, it will retain any earnings for use in the +operation of its business. Securities +Authorized for Issuance under Equity Compensation Plans The description of equity +compensation plans required by Regulation S-K, Item 201(d) is incorporated +herein by reference to Part III, Item 12 of this Form 10-K. Purchases of Equity +Securities by the Issuer and Affiliated Purchasers None. Item 6. Selected +Financial Data The consolidated balance sheet as of September 24, +2005 and the consolidated statements of operations for the fiscal years ended September 24, +2005 and September 25, 2004 have been restated as set forth in the 2006 Form 10-K. +The data for the consolidated balance sheets as of September 2004, 2003, +and 2002 and the consolidated statements of operations for the fiscal years +ended September 2003 and 2002 have been restated to reflect the impact of +the stock-based compensation adjustments, but such restated data have not been +audited and is derived from the books and records of the Company. The information +set forth below is not necessarily indicative of results of future operations, +and should be read in conjunction with Item 7, “Management’s Discussion and +Analysis of Financial Condition and Results of Operations” and the consolidated +financial statements and related notes thereto included in Item 8 of this Form 10-K +to fully understand factors that may affect the comparability of the +information presented below. The information presented in the following tables +has been adjusted to reflect the restatement of the Company’s financial +results, which is more fully described in the “Explanatory Note” immediately +preceding Part I, Item 1 and in Note 2, “Restatement of Consolidated +Financial Statements” in Notes to Consolidated Financial Statements of this Form 10-K. 46 The Company has not +amended its previously-filed Annual Reports on Form 10-K or +Quarterly Reports on Form 10-Q for the periods affected by this +restatement. The financial information that has been previously filed or +otherwise reported for these periods is superseded by the information in this +Annual Report on Form 10-K, and the financial statements and related +financial information contained in such previously-filed reports should no +longer be relied upon. Five fiscal years ended September 30, 2006 (In millions, except share and per share amounts) 2006 2005 2004 2003 2002 As Restated (1) As Restated (1) As Restated (2) As Restated (2) Net sales $ 19,315 $ 13,931 $ 8,279 $ 6,207 $ 5,742 Net income $ 1,989 $ 1,328 $ 266 $ 57 $ 42 Earnings per + common share: Basic $ 2.36 $ 1.64 $ 0.36 $ 0.08 $ 0.06 Diluted $ 2.27 $ 1.55 $ 0.34 $ 0.08 $ 0.06 Cash dividends + declared per common share $ — $ — $ — $ — $ — Shares used in + computing earnings per share (in thousands): Basic 844,058 808,439 743,180 721,262 710,044 Diluted 877,526 856,878 774,776 723,352 721,445 Cash, cash + equivalents, and short-term investments $ 10,110 $ 8,261 $ 5,464 $ 4,566 $ 4,337 Total assets $ 17,205 $ 11,516 $ 8,039 $ 6,817 $ 6,305 Long-term + debt (including current maturities) $ — $ — $ — $ 304 $ 316 Total liabilities $ 7,221 $ 4,088 $ 2,976 $ 2,594 $ 2,205 Shareholders’ equity $ 9,984 $ 7,428 $ 5,063 $ 4,223 $ 4,100 Net gains before +taxes related to the Company’s non-current debt and equity investments of $4 +million and $10 million were recognized in 2004 and 2003, respectively. A net +loss before taxes related to the Company’s non-current debt and equity +investments of $42 million was recognized in 2002. Net charges related to +Company restructuring actions of $23 million, $26 million, and $30 million were +recognized in 2004, 2003, and 2002, respectively. In 2003, settlement of the +Company’s forward stock purchase agreement resulted in a gain of $6 million. +Net income during 2005 benefited by $81 million from the reversal of certain +tax contingency reserves and adjustments to net deferred tax assets, including +reductions to valuation allowances. Favorable cumulative-effect type +adjustments from the adoption of new accounting standards, net of taxes of $1 +million was recognized in 2003. (1) See the “Explanatory +Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of +Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements of this Form 10-K. 47 (2) The Selected Financial +Data for 2003 and 2002 has been restated to reflect adjustments related to +stock-based compensation expense and the associated tax impact as further +described in the “Explanatory Note” immediately preceding Part I, Item 1 +of this Form 10-K. As a result of these adjustments, net income was +reduced by $12 million and $23 million for the years ended September 27, +2003 and September 28, 2002, respectively as follows: Fiscal Year Ended September 27, 2003 Fiscal Year Ended September 28, 2002 As Reported Adjustments As Restated As Reported Adjustments As Restated Net sales $ 6,207 $ — $ 6,207 $ 5,742 $ — $ 5,742 Cost of sales 4,499 1 4,500 4,139 3 4,142 Gross margin 1,708 (1 ) 1,707 1,603 (3 ) 1,600 Total operating expenses 1,709 15 1,724 1,586 26 1,612 Operating income (loss) (1 ) (16 ) (17 ) 17 (29 ) (12 ) Income before accounting + changes 68 (12 ) 56 65 (23 ) 42 Cumulative effects of + accounting changes, net of income taxes 1 — 1 — — — Net income $ 69 $ (12 ) $ 57 $ 65 $ (23 ) $ 42 Earnings (loss) per + common share before accounting changes: Basic $ 0.09 $ (0.01 ) $ 0.08 $ 0.09 $ (0.03 ) $ 0.06 Diluted $ 0.09 $ (0.01 ) $ 0.08 $ 0.09 $ (0.03 ) $ 0.06 Earnings per common + share: Basic $ 0.10 $ (0.02 ) $ 0.08 $ 0.09 $ (0.03 ) $ 0.06 Diluted $ 0.09 $ (0.01 ) $ 0.08 $ 0.09 $ (0.03 ) $ 0.06 Item 7. Management’s Discussion and Analysis of Financial Condition and +Results of Operations This section and +other parts of this Form 10-K contain forward-looking +statements that involve risks and uncertainties. Forward-looking statements can +also be identified by words such as “anticipates,” “expects,” “believes,” “plans,” +“predicts,” and similar terms. Forward-looking statements are not guarantees of +future performance and the Company’s actual results may differ significantly +from the results discussed in the forward-looking statements. Factors +that might cause such differences include, but are not limited to, those +discussed in the subsection entitled “Risk Factors” above. The following +discussion should be read in conjunction with the consolidated financial +statements and notes thereto included in Item 8 of this Form 10-K. +All information presented herein is based on the Company’s fiscal calendar. +Unless otherwise stated, references in this report to particular years or +quarters refer to the Company’s fiscal years ended in September and the +associated quarters of those fiscal years. The Company assumes no obligation to +revise or update any forward-looking statements for any reason, except as +required by law. The following information +has been adjusted to reflect the restatement of the Company’s financial +results, which is more fully described in the “Explanatory Note” immediately +preceding Part I, Item 1 and in Note 2, “Restatement of Consolidated +Financial Statements” in Notes to Consolidated Financial Statements of this Form 10-K. +The net of tax impact of the adjustments, which amounted to $4 million in 2006, +was recorded by the Company in its fourth quarter of 2006. The net of tax +impact of the restatements on the Company’s results of operations amounted to +$7 million and $10 million in 2005 and 2004, 48 respectively. The impact +of these adjustments was not significant to the Company’s operating results, +trends, or liquidity for the annual or quarterly periods in 2006, 2005, and +2004. Executive Overview The Company designs, manufactures, and markets +personal computers and related software, services, peripherals, and networking +solutions. The Company also designs, develops, and markets a line of portable +digital music players along with related accessories and services including the +online distribution of third-party music, audio books, music videos, short +films, television shows, movies, and iPod games. The Company’s products and +services include the Macintosh line of desktop and notebook computers, the iPod +line of portable digital music players, the Xserve server and Xserve RAID +storage products, a portfolio of consumer and professional software +applications, the Mac OS X operating system, the iTunes Store, a portfolio of +peripherals that support and enhance the Macintosh and iPod product lines, and +a variety of other service and support offerings. The Company sells its +products worldwide through its online stores, its retail stores, its direct +sales force, and third-party wholesalers, resellers, and value-added resellers. +In addition, the Company sells a variety of third-party Macintosh and iPod +compatible products including application software, printers, storage devices, +speakers, headphones, and various other accessories and supplies through its +online and retail stores. The Company sells to education, consumer, creative +professional, business, and government customers. A further description of the +Company’s products may be found in Part I, Item 1 of this Form 10-K +under the heading “Business.” The Company believes that for both professionals and +consumers the personal computer has become the center of an evolving digital +lifestyle by integrating and enhancing the utility of advanced digital devices +such as the Company’s iPods, digital video and still cameras, televisions, CD +and DVD players, cellular phones, personal digital assistants, and other +consumer electronic devices. The attributes of the personal computer that +enable this functionality include a high-quality user interface, easy access to +relatively inexpensive data storage, the ability to run complex applications, +and the ability to connect easily to a wide variety of other digital devices +and to the Internet. The Company is the only participant in the personal +computer industry that controls the design and development of the entire +personal computer—from the hardware and operating system to sophisticated +applications. This, along with its products’ innovative industrial designs, +intuitive ease-of-use, built-in graphics, multimedia and networking +capabilities, uniquely positions the Company to offer innovative integrated +digital lifestyle solutions. The Company’s business strategy leverages its ability, +through the design and development of its own operating system, hardware, and many +software applications and technologies, to bring to its customers around the +world compelling new products and solutions with superior ease-of-use, seamless +integration, and innovative industrial design. The Company participates in several highly competitive +markets, including personal computers with its Macintosh line of computers, +consumer electronics with its iPod line of portable digital music players, and +distribution of third-party digital content through its online iTunes Store. While +the Company is widely recognized as an innovator in the personal computer and +consumer electronic markets as well as a leader in the emerging market for +distribution of digital content, these are all highly competitive markets that +are subject to aggressive pricing and increased competition. To remain +competitive, the Company believes increased investment in research and +development (“R&D”) and marketing and advertising is necessary to maintain +and extend its position in the markets where it competes. The Company’s R&D +spending is focused on delivering timely updates and enhancements to its +existing line of personal computers, displays, operating systems, software +applications, and portable digital music players; developing new digital +lifestyle consumer and professional software applications; and investing in new +product areas such as rack-mount servers, RAID storage systems, and wireless +technologies. The Company also believes investment in marketing and advertising +programs is critical to increasing product and brand awareness. 49 In June 2005, the Company announced its plan to +begin using Intel microprocessors in its computers. During 2006, the Company +introduced new Intel-based models of the MacBook Pro, MacBook, Mac Pro, iMac, +and Mac mini computers. The Company’s transition to Intel microprocessors for +Macintosh systems was completed in August 2006, and its transition for +Xserve was completed in November 2006. The MacBook Pro, MacBook, Mac Pro, +iMac, and Mac mini feature Mac OS X version 10.4 Tiger, iLife ‘06, and the +Company’s new translation technology, Rosetta, which allows most PowerPC-based +Macintosh applications to run on Intel-based Macintosh computers. There are +potential risks and uncertainties that may occur due to this transition, which +are further discussed in Item 1A under the heading “Risk Factors.” The Company utilizes a variety of direct and indirect +distribution channels. The Company believes sales of its innovative and +differentiated products are enhanced by knowledgeable salespersons who can +convey the value of the hardware, software, and peripheral integration, +demonstrate the unique digital lifestyle solutions that are available only on +Macintosh computers, and demonstrate the compatibility of the Macintosh with +the Windows platform and networks. The Company further believes providing a +high-quality sales and after-sales support experience is critical to attracting +and retaining customers. To ensure a high-quality buying experience for its +products in which service and education are emphasized, the Company has +expanded and improved its distribution capabilities by opening its own retail +stores in the U.S. and internationally. The Company had 165 stores open as of September 30, +2006. The Company also staffs selected third-party stores +with the Company’s own employees to improve the buying experience through +reseller channels. The Company has deployed Apple employees and contractors in +reseller locations around the world including the U.S., Europe, Japan, and +Australia. The Company also sells to customers directly through its online +stores around the world. To improve access to the +iPod product line, the Company has significantly expanded the number of +distribution points where iPods are sold. The iPod product line can be +purchased in certain department stores, member-only warehouse stores, large +retail chains, and specialty retail stores, as well as through the channels +listed above. Critical Accounting +Policies and Estimates The preparation of financial statements and related +disclosures in conformity with U.S. generally accepted accounting principles +and the Company’s discussion and analysis of its financial condition and +results of operations require the Company’s management to make judgments, +assumptions, and estimates that affect the amounts reported in its consolidated +financial statements and accompanying notes. Note 1 of the Notes to +Consolidated Financial Statements of this Form 10-K describes the +significant accounting policies and methods used in the preparation of the +Company’s consolidated financial statements. Management bases its estimates on +historical experience and on various other assumptions it believes to be +reasonable under the circumstances, the results of which form the basis for +making judgments about the carrying values of assets and liabilities. Actual +results may differ from these estimates and such differences may be material. Management believes the +Company’s critical accounting policies and estimates are those related to +revenue recognition, allowance for doubtful accounts, inventory valuation and +inventory purchase commitments, warranty costs, stock-based compensation, and +income taxes. Management believes these policies to be critical because they +are both important to the portrayal of the Company’s financial condition and +results, and they require management to make judgments and estimates about +matters that are inherently uncertain. The Company’s senior management has +reviewed these critical accounting policies and related disclosures with the +Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, peripherals, digital content, and service and support +contracts. The Company recognizes revenue pursuant to applicable accounting 50 standards, including American Institute of Certified +Public Accountants Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition , as amended, and SEC Staff +Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. The Company recognizes revenue when persuasive +evidence of an arrangement exists, delivery has occurred, the sales price is +fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped, and title and risk of loss +have been transferred. For most of the Company’s product sales, these criteria +are met at the time the product is shipped. For online sales to individuals, +for some sales to education customers in the U.S., and for certain other sales, +the Company defers revenue until the customer receives the product because the +Company retains a portion of the risk of loss on these sales during transit. If +at the outset of an arrangement the Company determines the arrangement fee is +not, or is presumed not to be, fixed or determinable, revenue is deferred and +subsequently recognized as amounts become due and payable and all other +criteria for revenue recognition have been met. The Company records +reductions to revenue for estimated commitments related to price protection and +for customer incentive programs, including reseller and end-user rebates, and +other sales programs and volume-based incentives. For transactions involving +price protection, the Company recognizes revenue net of the estimated amount to +be refunded, provided the refund amount can be reasonably and reliably +estimated and the other conditions for revenue recognition have been met. If +refunds cannot be reliably estimated, revenue is not recognized until reliable +estimates can be made or the price protection lapses. For customer incentive +programs, the estimated cost of these programs is recognized at the later of +the date at which the Company has sold the product or the date at which the +program is offered. The Company also records reductions to revenue for expected +future product returns based on the Company’s historical experience. Future +market conditions and product transitions may require the Company to increase +customer incentive programs and incur incremental price protection obligations +that could result in additional reductions to revenue at the time such programs +are offered. Additionally, certain customer incentive programs require +management to estimate the number of customers who will actually redeem the +incentive based on historical experience and the specific terms and conditions +of particular incentive programs. If a greater than estimated proportion of +customers redeem such incentives, the Company would be required to record +additional reductions to revenue, which could have a material adverse impact on +the Company’s results of operations. Allowance for +Doubtful Accounts The Company distributes its products through +third-party distributors and resellers and directly to certain education, +consumer, and commercial customers. The Company generally does not require +collateral from its customers; however, the Company will require collateral in +certain instances to limit credit risk. In addition, when possible, the Company +does attempt to limit credit risk on trade receivables with credit insurance +for certain customers in Latin America, Europe, Asia, and Australia and by +arranging with third-party financing companies to provide flooring arrangements +and other loan and lease programs to the Company’s direct customers. These +credit-financing arrangements are directly between the third-party financing +company and the end customer. As such, the Company generally does not assume +any recourse or credit risk sharing related to any of these arrangements. +However, considerable trade receivables that are not covered by collateral, +third-party flooring arrangements, or credit insurance are outstanding with the +Company’s distribution and retail channel partners. The +allowance for doubtful accounts is based on management’s assessment of +the collectibility of specific customer accounts and includes consideration of +the credit worthiness and financial condition of those specific customers. The Company records an allowance to reduce +the specific receivables to the amount that is reasonably believed to be +collectible . The Company also records an +allowance for all other trade receivables based on multiple factors including historical +experience with bad debts, the general economic 51 environment, the financial +condition of the Company’s distribution channels, and the aging of such receivables. If there is a deterioration of a major +customer’s financial condition, if the Company becomes aware of additional +information related to the credit worthiness of a major customer, or if future +actual default rates on trade receivables in general differ from those +currently anticipated, the Company may have to adjust its allowance for +doubtful accounts, which would affect earnings in the period the adjustments +were made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and +build inventory in advance of product shipments. The Company records a +write-down for inventories of components and products, including third-party +products held for resale, which have become obsolete or are in excess of anticipated +demand or net realizable value. The Company performs a detailed review of +inventory each fiscal quarter that considers multiple factors including demand +forecasts, product life cycle status, product development plans, current sales +levels, and component cost trends. The personal computer and consumer +electronic industries are subject to a rapid and unpredictable pace of product +and component obsolescence and demand changes. If future demand or market +conditions for the Company’s products are less favorable than forecasted or if +unforeseen technological changes negatively impact the utility of component +inventory, the Company may be required to record additional write-downs which +would negatively affect gross margins in the period when the write-downs were +recorded. The Company accrues +reserves for estimated cancellation fees related to component orders that have +been cancelled or are expected to be cancelled. Consistent with industry +practice, the Company acquires components through a combination of purchase +orders, supplier contracts, and open orders based on projected demand +information. These commitments typically cover the Company’s requirements for +periods ranging from 30 to 150 days. If there is an abrupt and substantial +decline in demand for one or more of the Company’s products or an unanticipated +change in technological requirements for any of the Company’s products, the +Company may be required to record additional reserves for cancellation fees +that would negatively affect gross margins in the period when the cancellation +fees are identified. Warranty Costs The Company provides currently for the estimated cost +for hardware and software warranties at the time the related revenue is +recognized based on historical and projected warranty claim rates, historical +and projected cost-per-claim, and knowledge of specific product failures that +are outside of the Company’s typical experience. Each quarter, the Company +reevaluates its estimates to assess the adequacy of its recorded warranty +liabilities considering the size of the installed base of products subject to +warranty protection and adjusts the amounts as necessary. If actual product failure rates or repair costs +differ from estimates, revisions to the estimated warranty liability would be +required and could negatively affect the Company’s results of +operations. The Company periodically +provides updates to its applications and system software to maintain the +software’s compliance with specifications. The estimated cost to develop such +updates is accounted for as warranty costs that are recognized at the time +related software revenue is recognized. Factors considered in determining +appropriate accruals related to such updates include the number of units +delivered, the number of updates expected to occur, and the historical cost and +estimated future cost of the resources necessary to develop these updates. Stock-Based +Compensation The Company accounts for stock-based compensation in +accordance with SFAS No. 123R. Under the provisions of SFAS No. 123R, +stock-based compensation cost is estimated at the grant date based on the award’s +fair value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing +model and is recognized as expense ratably over the requisite service period. The +BSM model requires various highly 52 judgmental assumptions including volatility, +forfeiture rates, and expected option life. If any of the assumptions used in +the BSM model change significantly, stock-based compensation expense may differ +materially in the future from that recorded in the current period. In connection with the +Company’s restatement of its consolidated financial statements, the Company has +applied judgment in choosing whether to revise measurement dates for prior +option grants. Information regarding the restatement, including ranges of +possible additional stock-based compensation expense if other measurement dates +had been selected for certain grants, is set forth in the “Explanatory Note” +immediately preceding Part I, Item 1 and in Note 2, “Restatement of +Consolidated Financial Statements” in Notes to Consolidated Financial +Statements of this Form 10-K. Income Taxes The Company records a tax provision for the +anticipated tax consequences of the reported results of operations. In +accordance with SFAS No. 109, Accounting for Income +Taxes , the provision for income taxes is computed using the asset +and liability method, under which deferred tax assets and liabilities are +recognized for the expected future tax consequences of temporary differences between +the financial reporting and tax bases of assets and liabilities, and for +operating losses and tax credit carryforwards. Deferred tax assets and +liabilities are measured using the currently enacted tax rates that apply to +taxable income in effect for the years in which those tax assets are expected +to be realized or settled. The Company records a valuation allowance to reduce +deferred tax assets to the amount that is believed more likely than not to be +realized. Management believes it is more likely than not that +forecasted income, including income that may be generated as a result of +certain tax planning strategies, together with the tax effects of the deferred +tax liabilities, will be sufficient to fully recover the remaining deferred tax +assets. In the event that all or part of the net deferred tax assets are +determined not to be realizable in the future, an adjustment to the valuation +allowance would be charged to earnings in the period such determination is made. +Similarly, if the Company subsequently realizes deferred tax assets that were +previously determined to be unrealizable, the respective valuation allowance +would be reversed, resulting in a positive adjustment to earnings in the period +such determination is made. In addition, the calculation of tax liabilities +involves significant judgment in estimating the impact of uncertainties in the +application of complex tax laws. Resolution of these uncertainties in a manner +inconsistent with management’s expectations could have a material impact on the +Company’s results of operations and financial position. 53 Net Sales Net +sales and Macintosh unit sales by operating segment and net sales and unit +sales by product follow (net sales in millions and unit sales in thousands): September 30, September 24, September 25, 2006 Change 2005 Change 2004 Net Sales by Operating Segment: Americas net sales $ 9,307 41 % $ 6,590 64 % $ 4,019 Europe net sales 4,094 33 % 3,073 71 % 1,799 Japan net sales 1,208 31 % 920 36 % 677 Retail net sales 3,359 43 % 2,350 98 % 1,185 Other Segments net sales (a) 1,347 35 % 998 67 % 599 Total net sales $ 19,315 39 % $ 13,931 68 % $ 8,279 Unit + Sales by Operating Segment: Americas Macintosh unit sales 2,432 11 % 2,184 30 % 1,682 Europe Macintosh unit sales 1,346 18 % 1,138 47 % 773 Japan Macintosh unit sales 304 (3 )% 313 8 % 291 Retail Macintosh unit sales 886 45 % 609 94 % 314 Other Segments Macintosh unit sales (a) 335 16 % 290 26 % 230 Total Macintosh unit sales 5,303 17 % 4,534 38 % 3,290 Net + Sales by Product: Desktops (b) $ 3,319 (3 )% $ 3,436 45 % $ 2,373 Portables (c) 4,056 43 % 2,839 11 % 2,550 Total Macintosh net sales 7,375 18 % 6,275 27 % 4,923 iPod 7,676 69 % 4,540 248 % 1,306 Other music related products and services (d) 1,885 110 % 899 223 % 278 Peripherals and other hardware (e) 1,100 (2 )% 1,126 18 % 951 Software, service, and other sales (f) 1,279 17 % 1,091 33 % 821 Total net sales $ 19,315 39 % $ 13,931 68 % $ 8,279 Unit + Sales by Product: Desktops (b) 2,434 (3 )% 2,520 55 % 1,625 Portables (c) 2,869 42 % 2,014 21 % 1,665 Total Macintosh unit sales 5,303 17 % 4,534 38 % 3,290 Net sales per Macintosh unit sold (g) $ 1,391 1 % $ 1,384 (7 )% $ 1,496 iPod unit sales 39,409 75 % 22,497 409 % 4,416 Net sales per iPod + unit sold (h) $ 195 (3 )% $ 202 (32 )% $ 296 Notes: (a) Other Segments include Asia Pacific and FileMaker. (b) Includes iMac, eMac, Mac mini, Mac Pro, Power Mac, and +Xserve product lines. (c) Includes MacBook, iBook, MacBook Pro, and PowerBook +product lines. (d) Consists of iTunes Store sales, iPod services, and +Apple-branded and third-party iPod accessories. (e) Includes sales of Apple-branded and third-party +displays, wireless connectivity and networking solutions, and other hardware +accessories. (f) Includes sales of Apple-branded operating system, +application software, third-party software, AppleCare, and Internet services. (g) Derived by dividing total Macintosh net sales by total +Macintosh unit sales. (h) Derived by dividing total iPod net sales +by total iPod unit sales. 54 Fiscal Year 2006 versus 2005 Net sales during +2006 increased 39% or $5.4 billion from 2005. This increase was due in part to +the fact that 2006 spanned 53 weeks while 2005 spanned 52 weeks. Several other +factors contributed to these increases including the following: · Net sales of iPods increased $3.1 billion or 69% during 2006 +compared to 2005. Unit sales of iPods totaled 39.4 million in 2006, which +represents an increase of 75% from 22.5 million iPod units sold in 2005. Strong +iPod sales during 2006 reflected significant sales of both the hard-drive based iPod that supports video, +first introduced in October of 2005 and the iPod nano, introduced in September 2005, +as well as continued expansion of iPod distribution points. During 2006, +the net sales per iPod unit sold decreased by 3% compared to 2005 primarily due +to an overall decrease in average selling prices for all iPods as well as a +shift in product mix to the iPod nano. From the introduction of the iPod in +2002 through 2006, the Company has sold approximately 68 million iPods. · Macintosh net sales +increased $1.1 billion or 18% during 2006 compared to 2005. Macintosh unit +sales increased by 769,000 units or 17% during 2006 compared to 2005. These increases were mainly due to strong demand +for the Intel-based MacBook and MacBook Pro systems and reflect a shift in +product mix to portable products in all of the Company’s operating segments. Net +sales and unit sales of the Company’s portable products increased 43% and 42%, +respectively, during 2006 compared to 2005. Macintosh desktop net sales and +unit sales both decreased by 3% during 2006 compared to 2005. The decrease in +sales of the Company’s Macintosh desktops was due to declines in sales of the +Company’s professional-oriented desktop products. The Company believes the +decline in the Company’s professional-oriented desktop products was due to +customers delaying purchases of such products in anticipation of the release of +the Intel-based Mac Pro, which did not begin shipping until August 2006, +and updated software applications capable of running on Intel-based Macintosh +computers, and the trend toward portable computers. A slight increase of 1% +during 2006 in net sales per Macintosh unit sold was due to a shift in mix to +higher-priced portable products, partially offset by price reductions on +certain Macintosh systems. · Other +music related products and services consists of sales associated with the +iTunes Store and iPod services and accessories. Net sales of other music +related products and services increased $986 million or 110% during 2006 +compared to 2005. The increase was primarily due to increased net sales from +the iTunes Store and Apple-branded and third-party iPod accessories and +services. The increase in sales from the iTunes Store stemmed from significant +growth in U.S. sales and the opening of The iTunes Store in Japan during August 2005 +and Australia during October 2005. The increased sales from the iTunes +Store were also attributable to the availability of videos, television shows, +and feature-length movie downloads. · Net sales of software, +service, and other sales increased $188 million or 17% during 2006 compared to +2005. The growth was primarily attributable to increased net sales of AppleCare Protection Plan (“APP”) extended service +and support contracts and application software, partially offset by a +decrease in sales of Mac OS X. Mac OS X +sales were particularly high in 2005 due to the release of Mac OS X Tiger in April 2005. Offsetting the +favorable factors discussed above, the Company’s net sales during 2006 were +negatively impacted by the following: · Net sales of peripherals and other hardware declined $26 million +or 2% compared to 2005 primarily due to price decreases and a decrease in net +sales of displays relating to a shift in mix from desktop to portable systems. The +decrease in net sales of displays for 2006 is consistent with the overall +decrease in unit sales of Macintosh professional desktop systems. 55 Fiscal Year 2005 versus 2004 During 2005, net +sales increased 68% or $5.7 billion from 2004. Several factors contributed +favorably to net sales during 2005: · Net sales of iPods rose $3.2 billion or 248% during 2005 compared +to 2004. Unit sales of iPods totaled 22.5 million in 2005, which represented an +increase of 409% from the 4.4 million iPod units sold in 2004. Strong sales of +iPods during 2005 were experienced in all of the Company’s operating segments +and was driven by strong demand for the iPod +shuffle introduced in January 2005, the release of an updated version of +the iPod mini in February 2005, the release of the iPod nano in September 2005, +and expansion of the iPod’s distribution network . Net sales per iPod +unit sold decreased 32% primarily due to the introduction of the lower priced +iPod shuffle in January 2005 and iPod mini pricing reductions in February 2005. +From the introduction of the iPod in 2002 through 2005, the Company had sold +approximately 28 million iPods. · Net +sales of other music related products and services increased $621 million or +223% during 2005 compared to 2004. The Company experienced strong growth in +sales of iPod services and accessories consistent with the increase in overall +iPod unit sales for 2005. The increased sales from the iTunes Store were +primarily due to substantial growth of net sales in the U.S. and expansion in +Europe, Canada, and Japan. · Total +Macintosh net sales increased $1.4 billion or 27% during 2005 compared to 2004. +Unit sales of Macintosh systems increased 1.2 million units or 38% during 2005 +compared to 2004. The increases in Macintosh net sales and unit sales related +primarily to strong demand for the Company’s desktop products, which was +experienced in all of the Company’s operating segments. The Company believes +that the success of the iPod had a positive impact on Macintosh net sales by +introducing new customers to the Company’s other products. Desktop demand was +stimulated in 2005 due to the iMac G5 and the introduction of the Mac mini in January 2005. +Net sales and unit sales of desktop products increased 45% and 55%, +respectively, during 2005 compared to 2004. Macintosh net sales and unit sales +also included sales of the Company’s portable products, which increased 11% and +21%, respectively, compared to 2004. Net sales per Macintosh +unit sold decreased 7% on a year-over-year basis. The decrease was the result +of changes in the overall unit mix towards relatively lower-priced consumer +products, specifically the impact of the Mac mini product, and desktop and +portable price reductions. This decrease was partially offset by an increase in +the proportion of direct sales. · Net +sales of peripherals and other hardware rose by 18% during 2005 compared to +2004 primarily due to an increase in net sales of displays and other computer +accessories. Net sales of other +hardware include AirPort cards and base stations, Xserve RAID storage, iSight +digital video cameras, and third-party hardware products. · Net sales of software, service and other sales +rose $270 million or 33% during 2005 compared to 2004. This growth was +primarily attributable to increased net sales in APP extended service and +support contracts, driven primarily by higher associated Macintosh computer +sales. Additionally, the Company experienced increases in net sales of .Mac +Internet service, professional and consumer applications, third-party software, +and Mac OS X that was primarily attributable to the release of version 10.4 +Tiger in April 2005. Segment Operating +Performance The Company manages its +business primarily on a geographic basis. The Company’s reportable operating +segments are comprised of the Americas, Europe, Japan, and Retail. The +Americas, Europe, and Japan reportable segments do not include activities +related to the Retail segment. The Americas segment includes both North and +South America. The Europe segment includes European countries as well as the 56 Middle East and Africa. +The Retail segment operated Apple-owned retail stores in the U.S., Canada, +Japan, and the U.K. during 2006. Each reportable geographic operating segment +provides similar hardware and software products and similar services. Further +information regarding the Company’s operating segments may be found in Note 11, +“Segment Information and Geographic Data” in Notes to Consolidated Financial +Statements of this Form 10-K. Americas During 2006, net sales in the Americas segment +increased $2.7 billion, or 41%, compared to 2005. The main factors for this +increase were significant increases in net sales of iPods, other music related +products and services, Macintosh portable systems, and APP. Sales of iPods +increased primarily due to the introduction of the updated iPod with +video-playing capabilities in October 2005 and the iPod nano during September 2005. +The increase in other music related products and services was due to increases +in sales of Apple-branded and third-party iPod accessories and sales from the +iTunes Store. The increase in sales of Macintosh portable systems in the +Americas was due to strong sales of the Intel-based MacBook and MacBook Pro +during 2006. The overall increase in net sales was partially offset by a +decline in net sales of desktops, displays, and Mac OS X. The decrease in +desktop products and displays net sales reflects the overall shift in product +mix toward portable Macintosh systems. Mac OS X sales decreased from 2005 since +the Company has not released a new version of Mac OS X since Tiger began +shipping in April 2005. During 2006, the Americas segment represented +approximately 48% of the Company’s total net sales as compared to 47% in the +same period of 2005. During 2006, U.S. education channel net sales and +Macintosh unit sales increased by 13% and 11%, respectively, compared to 2005. +Net sales from the higher education market grew 22% during 2006 compared to +2005 due to strong sales of Macintosh portable products and iPods. Net sales +were relatively flat for K-12 due to continued budget constraints. During 2005, net sales in +the Americas segment grew 64% or $2.6 billion compared to 2004. The increase in +net sales during 2005 was primarily attributable to the significant +year-over-year increase in iPod sales, sales of other music related products +and services, and strong sales of desktop and portable Macintosh systems. This +increase was partially offset by a shift in sales to the Retail segment, which +had 117 stores in the U.S. and Canada as of the end of 2005. Macintosh unit +sales also increased by 30% in 2005 compared to 2004, driven primarily by +strong sales of desktop systems largely attributable to strong sales from the +updated iMac, which began shipping in September 2004, and the Mac mini, +which was introduced in January 2005. During 2005 and 2004, the Americas +segment represented approximately 47% and 49%, respectively, of the Company’s +total net sales and represented approximately 48% and 51%, respectively, of +total Macintosh unit sales. The Company experienced an increase in both U.S. +education channel net sales and unit sales of 21% for 2005 compared to 2004. +Strength in higher education sales related primarily to strong iMac and +portable system shipments. This strength drove year-over-year growth in net +sales of 32% for the higher education channel during 2005. Despite challenges +in the K-12 market from continued budget constraints and competitive +pressures, the Company’s K-12 net sales grew year-over-year by 11% during +2005 due to increased iBook sales and 1:1 education sales. Europe Europe segment net sales increased $1.0 billion or 33% +during 2006 compared to 2005. Consistent with the Americas segment, these +increases were a result of strong growth in iPod sales, other music related +products and services, and Macintosh portable systems. Sales of iPods increased +primarily due to the introduction of the updated iPod with video-playing +capabilities in October 2005 and the iPod nano during September 2005. +The increase in other music related products and services was due to increases +in sales of Apple-branded and third-party iPod accessories and sales from the +iTunes Store. The increase in sales of portable systems in Europe was due to +strong sales of the Intel-based MacBook and MacBook Pro that were introduced +during 2006. In addition, Europe also reported increased sales in APP related +to the increase in Macintosh unit sales. These increases were partially offset +by a decrease in desktop and 57 Mac OS X net sales during 2006 compared to +2005. The decrease in desktop net sales was due to the shift in product mix toward +portable Macintosh systems. Mac OS X sales have decreased from 2005 since the +Company has not released a new version of Mac OS X since Tiger began shipping +in April 2005. During 2005, net sales in +the Europe segment grew $1.3 billion or 71% from 2004. Total Macintosh unit +sales in Europe also experienced growth during the current year by increasing +47% in 2005 compared to 2004. Consistent with the Americas segment, Europe +experienced strong net sales of desktop products, iPod, other music related +products and services, and software and service sales. Demand in Europe during +2005 was particularly strong for the Company’s desktop computers, which +experienced a year-over-year increase of 56% from 2004. Similar to the results +of the Company’s other segments, net sales of iPods, peripherals and software +were strong in 2005. Japan Japan’s net sales increased $288 million or 31% during +2006 compared to 2005. The Japan segment experienced increased net sales in +iPods, Macintosh portable products, and other music related products and services. Consistent with the Company’s +other segments, Japan experienced increases in sales of iPods due to the +introduction of the iPod with video-playing capabilities and the iPod nano in October and +September of 2005, respectively. Japan also experienced strong sales of +the Intel-based MacBook and increased sales from the iTunes Store. These +increases were partially offset by decreases in net sales of Macintosh desktop +products, displays, and Mac OS X. The decreases in desktop products and +displays reflect the overall shift in product mix toward portable Macintosh +systems. Mac OS X sales have decreased from +2005 since the Company has not released a new version of Mac OS X since Tiger +began shipping in April 2005. Total Macintosh unit sales during +2006 remained relatively flat compared to 2005. The relatively flat growth in +Macintosh unit sales is partially attributable to Japan’s overall slow consumer +PC market growth. The Company is continuing to evaluate ways to improve its +indirect and direct channel sales in Japan. Japan’s net sales and +Macintosh unit sales were up 36% and 8%, respectively, during 2005 compared to +2004. Japan experienced increased net sales in desktop products, iPod, and +other music related products and services. Desktop net sales and unit sales +increased by 31% and 41%, respectively, and iPod sales increased by 220% during +2005 compared to 2004. The overall increase in net sales was partially offset +by a decline in portable system net sales during 2005 compared to 2004, which +the Company believes might have been attributable to a shift in sales from +portables to the iMac G5 and Mac mini, and a shift to the Retail segment as a +result of opening two additional stores in Japan during 2005. Retail The Company opened 41 new retail stores during 2006, +including a total of 10 international stores in the U.K., Japan, and Canada, +bringing the total number of open stores to 165 as of September 30, 2006. This +compares to 124 open stores as of September 24, 2005 and 86 open stores as +of September 25, 2004. The Retail segment’s net sales increased by 43% to +$3.4 billion during 2006 compared to 2005. Retail segment Macintosh unit sales +increased 45% during 2006 compared to 2005. With an average of 142 stores open during 2006, average revenue per store +increased to $23.6 million compared to $22.4 million during 2005 and $15.6 +million in 2004. The current year increase was primarily due to strong +sales of Macintosh portable and desktop products, iPods, and other music +related products and services. Sales of +iPods increased primarily due to the introduction of the updated iPod with +video-playing capabilities in October 2005 and the iPod nano during September 2005. +The increase in other music related products and services was due to increased +sales of Apple-branded and third-party iPod accessories. Macintosh portable and +desktop sales increased due to strong sales of the Intel-based MacBook, MacBook +Pro, and iMac. As measured by the Company’s operating segment +reporting, the Retail segment reported operating income of $198 million during +2006 as compared to operating income of $151 million during 2005 and 58 operating income of $39 million during 2004. This +improvement was primarily attributable to the impact of opening new stores and +the segment’s year-over-year increase in average revenue per store, which +resulted in higher leverage on occupancy, depreciation, and other fixed costs. Expansion of the Retail +segment has required and will continue to require a substantial investment in +fixed assets and related infrastructure, operating lease commitments, +personnel, and other operating expenses. Capital expenditures associated with +the Retail segment were $200 million in 2006, bringing the total capital +expenditures since inception of the Retail segment to approximately $729 +million. As of September 30, 2006, the Retail segment had approximately +5,787 employees and had outstanding operating lease commitments associated with +retail store space and related facilities of approximately $887 million. The +Company would incur substantial costs if it were to close its retail stores. +Such costs could adversely affect the Company’s results of operations and +financial condition. Gross Margin Gross +margin for each of the last three fiscal years are as follows (in millions, +except gross margin percentages): September 30, September 24, September 25, 2006 2005 2004 As Restated (1) As Restated (1) Net sales $ 19,315 $ 13,931 $ 8,279 Cost of sales 13,717 9,889 6,022 Gross margin $ 5,598 $ 4,042 $ 2,257 Gross margin percentage 29.0 % 29.0 % 27.3 % (1) See the “Explanatory +Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of +Consolidated Financial Statements” in Notes to Consolidated Financial +Statements of this Form 10-K. Gross margin percentage of 29.0% in 2006 remained flat +as compared to 2005. The Company experienced more favorable pricing on certain +commodity components including LCD flat-panel displays and DRAM memory and +higher overall revenue that provided for more leverage on fixed production +costs, offset by an increase in lower margin iPod sales and other music-related +services. The Company anticipates that its gross margin and the +gross margins of the personal computer and consumer electronics industries will +be under pressure due to price competition. The Company expects gross margin +percentage to decline sequentially in the first quarter of 2007 primarily as a +result of a shift in the mix of revenue toward lower margin products such as +the iPod and content from the iTunes Store. The foregoing statements regarding the Company’s +expected gross margin percentage are forward-looking. There can be no assurance +that current gross margin percentage will be maintained or targeted gross +margin percentage levels will be achieved. In general, gross margins and +margins on individual products, including iPods, will remain under significant +downward pressure due to a variety of factors, including continued industry +wide global pricing pressures, increased competition, compressed product life +cycles, potential increases in the cost and availability of raw material and +outside manufacturing services, and potential changes to the Company’s product +mix, including higher unit sales of consumer products with lower average +selling prices and lower gross margins. In response to these competitive +pressures, the Company expects it will continue to take pricing actions with +respect to its products. Gross margins could also be affected by the Company’s +ability to effectively manage product quality and warranty costs and to +stimulate demand for certain of its products. Due to the Company’s significant +international operations, financial results can be significantly affected in +the short-term by fluctuations in exchange rates. The Company orders components for its products and +builds inventory in advance of product shipments. Because the Company’s markets +are volatile and subject to rapid technology and price changes, there is a 59 risk the Company will forecast incorrectly and produce +or order from third-parties excess or insufficient inventories of particular +products or components. The Company’s operating results and financial condition +in the past have been and may in the future be materially adversely affected by +the Company’s ability to manage its inventory levels and outstanding purchase +commitments and to respond to short-term shifts in customer demand +patterns. Gross margin percentage +increased in 2005 to 29.0% of net sales from 27.3% of net sales in 2004. The +Company’s gross margin during 2005 increased due to more favorable pricing on +certain commodity components including LCD flat-panel displays and DRAM memory; +an increase in higher margin software sales; a favorable shift in direct sales +related primarily to the Company’s retail and online stores; and higher overall +revenue that provided for more leverage on fixed production costs. These +increases to gross margin were partially offset by an increase in lower margin +iPod sales. Operating Expenses Operating +expenses for each of the last three fiscal years are as follows (in millions, +except for percentages): September 30, September 24, September 25, 2006 2005 2004 As Restated (1) As Restated (1) Research and + development $ 712 $ 535 $ 491 Percentage of net sales 4 % 4 % 6 % Selling, general, + and administrative expenses $ 2,433 $ 1,864 $ 1,430 Percentage of net sales 13 % 13 % 17 % Restructuring costs $ — $ — $ 23 (1) See +the “Explanatory Note” immediately preceding Part I, Item 1 and Note 2, “Restatement +of Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements of this Form 10-K. Research and +Development (R&D) Expenditures for R&D +increased 33% or $177 million to $712 million in 2006 compared to $535 million +in 2005. The increase was due primarily to an increase in R&D headcount in +the current year to support expanded R&D activities, an increase of $46 +million in stock-based compensation recognized as R&D expense resulting +from the adoption of SFAS No. 123R, and higher overall expenses due to the 14th week added to the first fiscal quarter of +2006 to realign the Company’s fiscal quarters with calendar quarters . In addition, during 2005, the Company +capitalized approximately $29.7 million of costs associated with the +development of Mac OS X Tiger. No software development costs were capitalized +during 2006. Further information related to the Company’s capitalization of +software development costs may be found in Part II, Item 8 of this Form 10-K +at Note 1 of Notes to Consolidated Financial Statements. Despite the increase +in expenditures, R&D as a percentage of net sales remained relatively flat +in 2006 as compared to 2005 due to the significant increase in revenue. The +Company continues to believe that focused investments in R&D are critical +to its future growth and competitive position in the marketplace and are +directly related to timely development of new and enhanced products that are +central to the Company’s core business strategy. As such, the Company expects +to make further investments in R&D to remain competitive. Selling, General, +and Administrative Expense (SG&A) Expenditures for SG&A increased $569 million or +31% during 2006 compared to 2005. These increases are due primarily to the +Company’s continued expansion of its Retail segment in both domestic and +international markets, an increase of $50 million in stock-based compensation +expense recognized as 60 SG&A expense resulting from the adoption of SFAS No. 123R, +a current year increase in discretionary spending on marketing and advertising, +higher direct and channel selling expenses resulting from the increase in net +sales and employee salary merit increases, and the expenses associated with the 14th week added to the first fiscal +quarter of 2006 . Despite the increase in expenditures, SG&A as a +percentage of total net sales in 2006 remained flat as compared to 2005. Expenditures for SG&A +increased $434 million or 30% during 2005 compared to 2004. These increases are +due primarily to the Company’s continued expansion of its Retail segment in +both domestic and international markets, a current year increase in +discretionary spending on marketing and advertising, and higher direct and +channel selling expenses resulting from the increase in net sales and employee +salary merit increases. SG&A as a percentage of total net sales in 2005 was +13%, down from 17% in 2004, which is due to the increase in total net sales of +68% for the Company during 2005. Fiscal 2004 Restructuring +Actions During 2004, the Company +recorded total restructuring charges of approximately $23.0 million, including +approximately $14.0 million in severance costs, $5.5 million in asset +impairments, and $3.5 million for lease cancellations. The lease cancellations +relate to vacating a leased sales facility as a result of a European workforce +reduction during 2004. Of the $23.0 million charges, $21.3 million had been +utilized by the end of 2006, with the remainder consisting of $1.7 million for +lease cancellations. These actions resulted in the termination of 452 +positions. Other Income and +Expense Other +income and expense for each of the last three fiscal years are as follows (in +millions): September 30, September 24, September 25, 2006 2005 2004 Gains on + non-current investments, net $ — $ — $ 4 Interest income $ 394 $ 183 $ 64 Interest expense — — (3 ) Other income + (expense), net (29 ) (18 ) (8 ) Interest and + other income, net $ 365 $ 165 $ 53 Total other + income and expense $ 365 $ 165 $ 57 Gains and Losses on +Non-current Investments The Company previously +held significant investments in ARM Holdings plc (ARM), Akamai Technologies, Inc. (Akamai), and EarthLink Network, Inc. +(EarthLink). T he Company sold all of the remaining holdings in these +non-current investments in 2004 and 2003. Pretax gains recorded upon the sale +of these non-current investments were $4 million in 2004. Interest and Other +Income, Net Total interest and other income, net increased $200 +million or 121% to $365 million during 2006 compared to $165 million in +2005 and $53 million in 2004. These increases are attributable primarily to +higher cash and short-term investment balances and increasing investment yields +resulting from higher market interest rates and the 14th week added to the first fiscal quarter of 2006 . The +weighted average interest rate earned by the Company on its cash, cash +equivalents, and short-term investments increased to 4.58% in 2006 compared to +the 2.70% and 1.38% rates earned during 2005 and 2004, respectively. The +current year increase in other income was partially offset by higher foreign +currency hedging expenses. Interest expense in 2004 +consisted primarily of interest on the Company’s $300 million aggregate +principal amount unsecured notes, which were repaid upon their maturity in February 2004. +The unsecured notes 61 were sold at 99.925% of +par for an effective yield to maturity of 6.51%. Total deferred gain resulting +from the closure of debt swaps of approximately $23 million was fully amortized +as of the notes’ maturity in February 2004. Provision for +Income Taxes The Company’s effective tax rate for the year ended September 30, +2006 was approximately 29%. The Company’s effective rate differs from the +statutory federal income tax rate of 35% due primarily to certain undistributed +foreign earnings for which no U.S. taxes are provided because such earnings are +intended to be indefinitely reinvested outside the U.S. In addition, the +Company recorded a tax benefit of $20 million due to settlement of prior year +tax audits in the U.S., and a net benefit of $20 million resulting from the +dividend repatriation under the American Jobs Creation Act of 2004 (“AJCA”) and +international tax planning strategies associated with the repatriation as +further discussed below. As of September 30, 2006, the Company had +deferred tax assets arising from deductible temporary differences, tax losses, +and tax credits of $739 million before being offset against certain deferred +liabilities and a valuation allowance for presentation on the Company’s balance +sheet. Management believes it is more likely than not that forecasted income, +including income that may be generated as a result of certain tax planning +strategies, together with the tax effects of the deferred tax liabilities, will +be sufficient to fully recover the remaining deferred tax assets. As of September 30, +2006 and September 24, 2005, a valuation allowance of $5 million was +recorded against the deferred tax asset for the benefits of state operating +losses that may not be realized. The Company will continue to evaluate the +realizability of the deferred tax assets quarterly by assessing the need for +and amount of the valuation allowance. On October 22, 2004, the AJCA was signed into law. +The AJCA included a provision for the deduction of 85% of certain foreign +earnings that were repatriated, as defined in the AJCA, within a specified time +frame. Among other requirements, dividends qualifying for the 85% deduction +must be reinvested in the United States in certain qualified investments +pursuant to a domestic reinvestment plan approved by the CEO and Board of +Directors. During 2006, the Company repatriated approximately $1.6 billion of +foreign earnings. Of the earnings repatriated, $755 million is eligible for the +reduced tax rate provided by the AJCA. Accordingly, the Company recorded a tax +charge of $51 million related to the repatriation of foreign earnings under the +provisions of the AJCA. In addition, the Company recorded a tax benefit of $71 million +resulting from the implementation of tax planning strategies to recognize +deferred tax assets that were previously not recognizable within certain +foreign subsidiaries. The Internal Revenue Service (“IRS”) has substantially +completed its field audit of the Company’s federal income tax returns for the +years 2002 through 2003 and proposed certain adjustments. The Company intends +to contest certain of these adjustments through the IRS Appeals Office. Substantially +all IRS audit issues for years prior to 2002 have been resolved. In addition, +the Company is subject to audits by state, local, and foreign tax authorities. Management +believes that adequate provision has been made for any adjustments that may +result from tax examinations. However, the outcome of tax audits cannot be +predicted with certainty. Should any issues addressed in the Company’s tax +audits be resolved in a manner not consistent with management’s expectations, +the Company could be required to adjust its provision for income tax in the +period such resolution occurs. 62 Quarterly Financial +Information The +following tables set forth a summary of the Company’s quarterly financial +information for each of the four quarters in the years ended September 30, +2006 and September 24, 2005 (in millions, except share and per share amounts): 2006 Fourth Quarter Third Quarter Second Quarter First Quarter Net sales $ 4,837 $ 4,370 $ 4,359 $ 5,749 Cost of sales (1) 3,425 3,045 3,062 4,185 Gross margin 1,412 1,325 1,297 1,564 Operating expenses: Research and development (1) 179 175 176 182 Selling, general, and administrative (1) 625 584 592 632 Total operating expenses 804 759 768 814 Operating income 608 566 529 750 Other income and + expense 113 95 76 81 Income before + provision for income taxes 721 661 605 831 Provision for + income taxes 179 189 195 266 Net income $ 542 $ 472 $ 410 $ 565 Earnings per common + share: Basic $ 0.63 $ 0.55 $ 0.49 $ 0.68 Diluted $ 0.62 $ 0.54 $ 0.47 $ 0.65 Shares used in computing + earnings per share (in thousands): Basic 854,187 851,375 840,910 830,781 Diluted 878,757 876,368 878,537 874,207 (1) Includes stock-based +compensation expense, which was allocated as follows: Cost of sales $ 5 $ 6 $ 5 $ 5 Research and development $ 13 $ 12 $ 13 $ 15 Selling, general, + and administrative $ 22 $ 19 $ 24 $ 24 The net of tax impact of +the stock-based compensation adjustments in 2006, which amounted to $4 million, +was recorded by the Company in its fourth quarter of 2006 and are described in +the Explanatory Note immediately preceding Part I, Item 1 and Note 2, “Restatement +of Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements of this Form 10-K. 63 2005 Fourth Quarter Third Quarter Second Quarter First Quarter As Restated (1) As Restated (1) As Restated (1) As Restated (1) Net sales $ 3,678 $ 3,520 $ 3,243 $ 3,490 Cost of sales (2) 2,643 2,476 2,275 2,495 Gross margin 1,035 1,044 968 995 Operating + expenses: Research and development (2) 147 145 120 123 Selling, general, and administrative (2) 471 473 448 472 Total operating expenses 618 618 568 595 Operating income 417 426 400 400 Other income and + expense 60 46 33 26 Income before + provision for income taxes 477 472 433 426 Provision for + income taxes 49 153 145 133 Net income $ 428 $ 319 $ 288 $ 293 Earnings per common share: Basic $ 0.52 $ 0.39 $ 0.36 $ 0.37 Diluted $ 0.49 $ 0.37 $ 0.34 $ 0.35 Shares used in + computing earnings per share (in thousands): Basic 821,420 815,092 808,172 789,032 Diluted 866,483 860,803 857,568 838,805 (1) See +the “Explanatory Note” immediately preceding Part I, Item 1 and Note 2, +“Restatement of Consolidated Financial Statements,” in Notes to Consolidated +Financial Statements of this Form 10-K. (2) Includes stock-based +compensation expense, which was allocated as follows: Cost of sales $ 1 $ — $ 1 $ 1 Research and development $ 1 $ 2 $ 2 $ 2 Selling, general, + and administrative $ 10 $ 10 $ 9 $ 10 The impact of the stock-based compensation adjustments +as described in the Explanatory Note immediately preceding Part I, Item 1 +and Note 2, “Restatement of Consolidated Financial Statements,” in Notes to +Consolidated Financial Statements of this Form 10-K was not +significant to the interim balance sheets of 2006 and 2005. 64 The following tables +present the effects of adjustments made to the Company’s previously reported +quarterly financial information during 2005 (in millions, except per share +amounts): Three Months Ended September 24, 2005 Three Months Ended June 25, 2005 As Reported Adjustments (1) As Restated As Reported Adjustments (1) As Restated Net sales $ 3,678 $ — $ 3,678 $ 3,520 $ — $ 3,520 Cost of sales (2) 2,643 — 2,643 2,476 — 2,476 Gross margin 1,035 — 1,035 1,044 — 1,044 Operating + expenses: Research and development (2) 147 — 147 145 — 145 Selling, general, and administrative (2) 470 1 471 472 1 473 Total operating expenses 617 1 618 617 1 618 Operating income 418 (1 ) 417 427 (1 ) 426 Other income and expense 60 — 60 46 — 46 Income before + provision for income taxes 478 (1 ) 477 473 (1 ) 472 Provision for + income taxes 48 1 49 153 — 153 Net income $ 430 $ (2 ) $ 428 $ 320 $ (1 ) $ 319 Earnings per + common share: Basic $ 0.52 $ — $ 0.52 $ 0.39 $ — $ 0.39 Diluted $ 0.50 $ (0.01 ) $ 0.49 $ 0.37 $ — $ 0.37 Shares used in computing + earnings per share (in thousands): Basic 821,420 — 821,420 815,092 — 815,092 Diluted 866,404 79 866,483 860,688 115 860,803 (1) See the “Explanatory +Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of +Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements of this Form 10-K. (2) Includes +stock-based compensation expense, which was allocated as follows: Cost of sales $ 1 $ — $ 1 $ — $ — $ — Research and development $ 1 $ — $ 1 $ 2 $ — $ 2 Selling, general, and administrative $ 9 $ 1 $ 10 $ 9 $ 1 $ 10 65 Three Months Ended March 26, 2005 Three Months Ended December 25, 2004 As Reported Adjustments (1) As Restated As Reported Adjustments (1) As Restated Net sales $ 3,243 $ — $ 3,243 $ 3,490 $ — $ 3,490 Cost of sales (2) 2,275 — 2,275 2,494 1 2,495 Gross margin 968 — 968 996 (1 ) 995 Operating + expenses: Research and development (2) 119 1 120 123 — 123 Selling, general, and administrative (2) 447 1 448 470 2 472 Total operating expenses 566 2 568 593 2 595 Operating income 402 (2 ) 400 403 (3 ) 400 Other income and expense 33 — 33 26 — 26 Income before + provision for income taxes 435 (2 ) 433 429 (3 ) 426 Provision for + income taxes 145 — 145 134 (1 ) 133 Net income $ 290 $ (2 ) $ 288 $ 295 $ (2 ) $ 293 Earnings per + common share: Basic $ 0.36 $ — $ 0.36 $ 0.37 $ — $ 0.37 Diluted $ 0.34 $ — $ 0.34 $ 0.35 $ — $ 0.35 Shares used in computing + earnings per share (in thousands): Basic 808,172 — 808,172 789,032 — 789,032 Diluted 857,011 557 857,568 838,174 631 838,805 (1) See the “Explanatory +Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of +Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements of this Form 10-K. (2) Includes +stock-based compensation expense, which was allocated as follows: Cost of sales $ 1 $ — $ 1 $ — $ 1 $ 1 Research and + development $ 1 $ 1 $ 2 $ 2 $ — $ 2 Selling, general, and + administrative $ 8 $ 1 $ 9 $ 8 $ 2 $ 10 Recent Accounting +Pronouncements In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements +when Quantifying Misstatements in Current Year Financial Statements. SAB +No. 108 provides guidance on how prior year misstatements should be +considered when quantifying misstatements in current year financial statements +for purposes of determining whether the current year’s financial statements are +materially misstated. SAB No. 108 is effective for fiscal years ending +after November 15, 2006. Although the Company will continue to evaluate +the application of SAB No. 108, management does not currently believe +adoption will have a material impact on the Company’s results of operations or +financial position. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines +fair value, provides a framework for measuring fair value, and expands the +disclosures required for fair value measurements. SFAS No. 157 applies to +other accounting pronouncements that require fair value measurements; it does +not require any new fair value measurements. SFAS No. 157 is effective for +fiscal years beginning after November 15, 2007 and is required to be +adopted by the Company beginning in the 66 first quarter of fiscal 2009. Although the Company +will continue to evaluate the application of SFAS No. 157, management does +not currently believe adoption will have a material impact on the Company’s +results of operations or financial position. In June 2006, the FASB issued FASB Interpretation +No. (“FIN”) 48, Accounting for Uncertainty +in Income Taxes-an Interpretation of FASB Statement No. 109 . FIN +No. 48 clarifies the accounting for uncertainty in income taxes by +creating a framework for how companies should recognize, measure, present, and +disclose in their financial statements uncertain tax positions that they have +taken or expect to take in a tax return. FIN No. 48 is effective for +fiscal years beginning after December 15, 2006 and is required to be +adopted by the Company beginning in the first quarter of fiscal 2008. Although +the Company will continue to evaluate the application of FIN No. 48, +management does not currently believe adoption will have a material impact on +the Company’s results of operations or financial position. In May 2005, the FASB +issued SFAS No. 154, Accounting Changes and +Error Corrections, which replaces APB Opinion No. 20, Accounting Changes and SFAS No. 3, Reporting +Accounting Changes in Interim Financial Statements—An Amendment of APB Opinion No. 28. SFAS No. 154 requires retrospective application to prior periods’ +financial statements of a voluntary change in accounting principal unless it is +not practicable. SFAS No. 154 is effective for accounting changes and +corrections of errors made in fiscal years beginning after December 15, +2005 and is required to be adopted by the Company in the first quarter of +fiscal 2007. Although the Company will continue to evaluate the application of +SFAS No. 154, management does not currently believe adoption will have a +material impact on the Company’s results of operations or financial position. Liquidity and +Capital Resources The +following table presents selected financial information and statistics for each +of the last three fiscal years (dollars in millions): September 30, September 24, September 25, 2006 2005 2004 As Restated (1) As Restated (1) Cash, cash + equivalents, and short-term investments $ 10,110 $ 8,261 $ 5,464 Accounts + receivable, net $ 1,252 $ 895 $ 774 Inventory $ 270 $ 165 $ 101 Working capital $ 8,038 $ 6,813 $ 4,403 Days sales in + accounts receivable (DSO) (a) 24 22 30 Days of supply in + inventory (b) 7 6 5 Days payables + outstanding (DPO) (c) 89 62 76 Annual operating cash + flow $ 2,220 $ 2,535 $ 934 (1) See the “Explanatory +Note” immediately preceding Part I, Item 1 and Note 2, “Restatement of +Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements of this Form 10-K. (a) DSO is based on ending +net trade receivables and most recent quarterly net sales for each period. (b) Days supply of inventory +is based on ending inventory and most recent quarterly cost of sales for each +period. (c) DPO is based on ending +accounts payable and most recent quarterly cost of sales adjusted for the +change in inventory. As of September 30, +2006, the Company had $10.11 billion in cash, cash equivalents, and short-term +investments, an increase of $1.85 billion over the same balances at the end of +2005. The principal 67 components of this +increase were cash generated by operating activities of $2.22 billion, proceeds +of $318 million from the issuance of common stock under stock plans, and excess +tax benefits from stock-based compensation of $361 million, partially offset by +cash used to purchase property, plant, and equipment of $657 million and +repurchases of common stock of $355 million in conjunction with net-share +settlements on vested restricted stock and restricted stock units. Cash +generated from operating activities includes the impact of the $1.25 billion +prepayment for NAND flash memory components. The Company’s short-term +investment portfolio is primarily invested in high credit quality, liquid +investments. As of September 30, 2006, approximately $4.1 billion of the +Company’s cash, cash equivalents, and short-term investments were held by +foreign subsidiaries and are generally based in U.S. dollar-denominated +holdings. Amounts held by foreign subsidiaries are generally subject to U.S. +income taxation on repatriation to the U.S. The Company believes its +existing balances of cash, cash equivalents, and short-term investments +will be sufficient to satisfy its working capital needs, capital expenditures, +stock repurchase activity, outstanding commitments, and other liquidity +requirements associated with its existing operations over the next 12 months. Capital +Expenditures The Company’s total +capital expenditures were $657 million during 2006, consisting of $200 million +for retail store facilities and equipment related to the Company’s Retail +segment, $263 million for real estate acquisitions for the Company’s second corporate campus and for a new data center , +and $194 million for corporate infrastructure, including information systems +enhancements. The Company currently +anticipates it will utilize approximately $675 million for capital expenditures +during 2007, including approximately $360 million for expansion of the Company’s +Retail segment, approximately $50 million for real estate acquisitions +including the Company’s second corporate campus and its new data center, and +approximately $265 million to support normal replacement of existing capital +assets and enhancements to general information technology infrastructure. Stock Repurchase +Plan In July 1999, the +Company’s Board of Directors authorized a plan for the Company to repurchase up +to $500 million of its common stock. This repurchase plan does not obligate the +Company to acquire any specific number of shares or acquire shares over any +specified period of time. The Company has repurchased a total of 13.1 million +shares at a cost of $217 million under this plan and was authorized to +repurchase up to an additional $283 million of its common stock as of September 30, +2006. Off-Balance Sheet +Arrangements and Contractual Obligations The Company has not entered into any transactions with +unconsolidated entities whereby the Company has financial guarantees, +subordinated retained interests, derivative instruments, or other contingent +arrangements that expose the Company to material continuing risks, contingent +liabilities, or any other obligation under a variable interest in an +unconsolidated entity that provides financing, liquidity, market risk, or +credit risk support to the Company. The +following table presents certain payments due by the Company under contractual +obligations with minimum firm commitments as of September 30, 2006 and +excludes amounts already recorded on the Company’s balance sheet as current +liabilities (in millions): Total Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Operating Leases $ 1,154 $ 134 $ 268 $ 254 $ 498 Purchase + Obligations 2,306 2,306 — — — Asset Retirement + Obligations 19 3 3 7 6 Other Obligations 39 29 10 — — Total $ 3,518 $ 2,472 $ 281 $ 261 $ 504 68 Lease Commitments As of September 30, +2006, the Company had total outstanding commitments on noncancelable operating +leases of approximately $1.2 billion, $887 million of which related to the +lease of retail space and related facilities. Lease terms on the Company’s existing +major facility operating leases range from 5 to 15 years. Purchase +Commitments with Contract Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to +manufacture sub-assemblies for the Company’s products and to perform final +assembly and test of finished products. These contract manufacturers acquire +components and build product based on demand information supplied by the +Company, which typically covers periods ranging from 30 to 150 days. The +Company also obtains individual components for its products from a wide variety +of individual suppliers. Consistent with industry practice, the Company +acquires components through a combination of purchase orders, supplier +contracts, and open orders based on projected demand information. Such purchase +commitments typically cover the Company’s forecasted component and +manufacturing requirements for periods ranging from 30 to 150 days. As of September 30, +2006, the Company had outstanding third-party manufacturing commitments and component +purchase commitments of approximately $2.3 billion. During 2006, the Company +entered into long-term supply agreements with Hynix Semiconductor, Inc., +Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., +and Toshiba Corporation to secure supply of NAND flash memory through calendar +year 2010. As part of these agreements, the Company prepaid $1.25 billion for +flash memory components during 2006. These prepayments will be applied to +inventory purchases made over the life of each respective agreement. Asset Retirement +Obligations The Company’s asset +retirement obligations are associated with commitments to return property +subject to operating leases to original condition upon lease termination. As of +September 30, 2006, the Company estimates that gross expected future cash +flows of approximately $19 million will be required to fulfill these +obligations. Other Obligations The Company’s other +obligations of approximately $39 million are primarily related to Internet and +telecommunications services. Indemnifications The Company generally does not indemnify end-users of +its operating system and application software against legal claims that the +software infringes third-party intellectual property rights. Other agreements +entered into by the Company sometimes include indemnification provisions under +which the Company could be subject to costs and/or damages in the event of an +infringement claim against the Company or an indemnified third-party. However, +the Company has not been required to make any significant payments resulting +from such an infringement claim asserted against itself or an indemnified +third-party and, in the opinion of management, does not have a liability +related to unresolved infringement claims subject to indemnification that would +have a material adverse effect on its financial condition, liquidity or results +of operations. 69 Item 7A. +Quantitative and Qualitative Disclosures About Market Risk Interest Rate and +Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions and its interest rate +swap and option positions, both on a stand-alone basis and in conjunction +with its underlying foreign currency and interest rate related exposures. +However, given the effective horizons of the Company’s risk management +activities and the anticipatory nature of the exposures, there can be no +assurance the hedges will offset more than a portion of the financial impact +resulting from movements in either foreign exchange or interest rates. In +addition, the timing of the accounting for recognition of gains and losses +related to mark-to-market instruments for any given period may not +coincide with the timing of gains and losses related to the underlying economic +exposures and, therefore, may adversely affect the Company’s operating results +and financial position. Interest Rate Risk While the Company is exposed to interest rate +fluctuations in many of the world’s leading industrialized countries, the +Company’s interest income and expense is most sensitive to fluctuations in the +general level of U.S. interest rates. In this regard, changes in U.S. interest +rates affect the interest earned on the Company’s cash, cash equivalents, and +short-term investments as well as costs associated with foreign currency +hedges. The Company’s short-term investment policy and +strategy is to ensure the preservation of capital, meet liquidity requirements, +and optimize return in light of the current credit and interest rate +environment. A portion of the Company’s cash is managed by external managers +within the guidelines of the Company’s investment policy and to an objective +market benchmark. The Company’s internal portfolio is benchmarked against +external manager performance, allowing for differences in liquidity needs. The Company’s exposure to market risk for changes in +interest rates relates primarily to the Company’s investment portfolio. The +Company places its short-term investments in highly liquid securities issued by +high credit quality issuers and, by policy, limits the amount of credit +exposure to any one issuer. The Company’s general policy is to limit the risk of +principal loss and ensure the safety of invested funds by limiting market and +credit risk. All highly liquid investments with initial maturities of three +months or less are classified as cash equivalents; highly liquid investments +with initial maturities greater than three months are classified as short-term +investments. As of September 30, 2006, approximately $921 million of the +Company’s short-term investments had underlying maturities ranging from 1 to 5 +years. As of September 24, 2005, $287 million of the Company’s short-term +investments had underlying maturities ranging from 1 to 5 years. The remainder +all had underlying maturities of less than 12 months. The Company may sell its +investments prior to their stated maturities for strategic purposes, in anticipation +of credit deterioration or for duration management. The Company recognized net +losses before taxes of $434,000 and $137,000 in 2006 and 2005, respectively, +and a net gain before taxes of $1 million in 2004 as a result of such sales. To provide a meaningful +assessment of the interest rate risk associated with the Company’s investment +portfolio, the Company performed a sensitivity analysis to determine the impact +a change in interest rates would have on the value of the investment portfolio +assuming a 100 basis point parallel shift in the yield curve. Based on +investment positions as of September 30, 2006, a hypothetical 100 basis +point increase in interest rates across all maturities would result in a $15.2 +million decline in the fair market value of the portfolio. As of September 24, +2005, a similar 100 basis point shift in the yield curve would have resulted in +a $19.9 million decline in fair value. Such losses would only be realized if +the Company sold the investments prior to maturity. 70 Foreign Currency +Risk In general, the Company is a net receiver of foreign +currencies. Accordingly, changes in exchange rates, and in particular a +strengthening of the U.S. dollar, may negatively affect the Company’s net sales +and gross margins as expressed in U.S. dollars. There is also a risk the +Company will have to adjust local currency product pricing due to competitive +pressures when there has been significant volatility in foreign currency +exchange rates. The Company may enter into foreign currency forward and +option contracts with financial institutions to protect against foreign +exchange risks associated with existing assets and liabilities, certain firmly +committed transactions, forecasted future cash flows, and net investments in +foreign subsidiaries. Generally, the Company’s practice is to hedge a majority +of its existing material foreign exchange transaction exposures. However, the +Company may not hedge certain foreign exchange transaction exposures due to +immateriality, prohibitive economic cost of hedging particular exposures, and +limited availability of appropriate hedging instruments. To provide a meaningful assessment of the foreign +currency risk associated with certain of the Company’s foreign currency +derivative positions, the Company performed a sensitivity analysis using a +value-at-risk (“VAR”) model to assess the potential impact of fluctuations in +exchange rates. The VAR model consisted of using a Monte Carlo simulation to +generate 3,000 random market price paths. The VAR is the maximum expected loss +in fair value, for a given confidence interval, to the Company’s foreign +exchange portfolio due to adverse movements in rates. The VAR model is not +intended to represent actual losses but is used as a risk estimation and +management tool. The model assumes normal market conditions. Forecasted +transactions, firm commitments, and assets and liabilities denominated in +foreign currencies were excluded from the model. Based on the results of the +model, the Company estimates with 95% confidence a maximum one-day loss in fair +value of $9.2 million as of September 30, 2006 compared to a maximum +one-day loss of $10.0 million as of September 24, 2005. Because the +Company uses foreign currency instruments for hedging purposes, losses incurred +on those instruments are generally offset by increases in the fair value of the +underlying exposures. Actual future gains and losses associated with the +Company’s investment portfolio and derivative positions may differ materially +from the sensitivity analyses performed as of September 30, 2006 due to +the inherent limitations associated with predicting the changes in the timing +and amount of interest rates, foreign currency exchanges rates, and the Company’s +actual exposures and positions. 71 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated + Balance Sheets as of September 30, 2006 and September 24, 2005 73 Consolidated + Statements of Operations for the three fiscal years ended September 30, + 2006 74 Consolidated + Statements of Shareholders’ Equity for the three fiscal years ended + September 30, 2006 75 Consolidated + Statements of Cash Flows for the three fiscal years ended September 30, + 2006 76 Notes + to Consolidated Financial Statements 77 Selected + Quarterly Financial Information (Unaudited) 114 Reports of Independent + Registered Public Accounting Firm, KPMG LLP 118 All financial statement schedules have been omitted, +since the required information is not applicable or is not present in amounts +sufficient to require submission of the schedule, or because the information +required is included in the Consolidated Financial Statements and Notes +thereto. 72 CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 30, 2006 September 24, 2005 As Restated(1) ASSETS: Current assets: Cash and cash equivalents $ 6,392 $ 3,491 Short-term investments 3,718 4,770 Accounts receivable, less allowances of $52 and $46, + respectively 1,252 895 Inventories 270 165 Deferred tax assets 607 331 Other current assets 2,270 648 Total current assets 14,509 10,300 Property, plant, and equipment, net 1,281 817 Goodwill 38 69 Acquired intangible assets, net 139 27 Other assets 1,238 303 Total assets $ 17,205 $ 11,516 LIABILITIES + AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 3,390 $ 1,779 Accrued expenses 3,081 1,708 Total current liabilities 6,471 3,487 Non-current + liabilities 750 601 Total liabilities 7,221 4,088 Commitments and + contingencies Shareholders’ + equity: Common stock, no par value; 1,800,000,000 shares + authorized; 855,262,568 and 835,019,364 shares issued and outstanding, + respectively 4,355 3,564 Deferred stock compensation — (61 ) Retained earnings 5,607 3,925 Accumulated other comprehensive income 22 — Total shareholders’ equity 9,984 7,428 Total liabilities + and shareholders’ equity $ 17,205 $ 11,516 (1) See Note 2, “Restatement +of Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements. See accompanying Notes to Consolidated Financial Statements. 73 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share and per share amounts) Three fiscal years ended September 30, 2006 2006 2005 2004 As Restated (1) As Restated (1) Net sales $ 19,315 $ 13,931 $ 8,279 Cost of sales (2) 13,717 9,889 6,022 Gross margin 5,598 4,042 2,257 Operating expenses: Research and development (2) 712 535 491 Selling, general, and administrative (2) 2,433 1,864 1,430 Restructuring costs — — 23 Total operating expenses 3,145 2,399 1,944 Operating income 2,453 1,643 313 Other income and + expense 365 165 57 Income before + provision for income taxes 2,818 1,808 370 Provision for + income taxes 829 480 104 Net income $ 1,989 $ 1,328 $ 266 Earnings per + common share: Basic $ 2.36 $ 1.64 $ 0.36 Diluted $ 2.27 $ 1.55 $ 0.34 Shares used in + computing earnings per share (in thousands): Basic 844,058 808,439 743,180 Diluted 877,526 856,878 774,776 (1) See Note 2, “Restatement +of Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements. (2) Includes +stock-based compensation expense, which was allocated as follows: Cost of sales $ 21 $ 3 $ 3 Research and + development $ 53 $ 7 $ 6 Selling, general, and + administrative $ 89 $ 39 $ 37 See accompanying Notes to Consolidated Financial +Statements. 74 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except share amounts which are in thousands) Accumulated Other Total Common Stock Deferred Stock Retained Comprehensive Shareholders’ Shares Amount Compensation Earnings Income (Loss) Equity As Restated (1) As Restated (1) As Restated (1) As Restated (1) Balances as of September 27, 2003 as previously + reported 733,454 $ 1,926 $ (62 ) $ 2,394 $ (35 ) $ 4,223 Adjustments to opening shareholders’ equity — 85 (22 ) (63 ) — — Balance as of September 27, 2003 as restated 733,454 $ 2,011 $ (84 ) $ 2,331 $ (35 ) $ 4,223 Components + of comprehensive income: Net income — — — 266 — 266 Change in foreign currency translation — — — — 13 13 Change in unrealized gain on available-for-sale + securities, net of tax — — — — (5 ) (5 ) Change in unrealized loss on derivative investments, + net of tax — — — — 12 12 Total comprehensive income 286 Issuance of stock-based compensation awards — 63 (63 ) — — — Adjustment to common stock related to a prior year + acquisition (159 ) (2 ) — — — (2 ) Stock-based compensation — — 46 — — 46 Common stock issued under stock plans 49,592 427 — — — 427 Tax benefit related to stock options — 83 — — — 83 Balances as of September 25, 2004 782,887 $ 2,582 $ (101 ) $ 2,597 $ (15 ) $ 5,063 Components of + comprehensive income: Net income — — — 1,328 — 1,328 Change in foreign currency translation — — — — 7 7 Change in unrealized gain on derivative investments, + net of tax — — — — 8 8 Total comprehensive income 1,343 Issuance of stock-based compensation awards — 7 (7 ) — — — Stock-based compensation — — 47 — — 47 Common stock issued under stock plans 52,132 547 — — — 547 Tax benefit related to stock options — 428 — — — 428 Balances as of September 24, 2005 835,019 $ 3,564 $ (61 ) $ 3,925 $ — $ 7,428 Components of + comprehensive income: Net income — — — 1,989 — 1,989 Change in foreign currency translation — — — — 19 19 Change in unrealized gain on available-for-sale + securities, net of tax — — — — 4 4 Change in unrealized loss on derivative investments, + net of tax — — — — (1 ) (1 ) Total comprehensive income 2,011 Common stock repurchased (4,574 ) (48 ) — (307 ) — (355 ) Stock-based compensation — 163 — — — 163 Deferred compensation — (61 ) 61 — — — Common stock issued under stock plans 24,818 318 — — — 318 Tax benefit related to stock-based compensation — 419 — — — 419 Balances as of + September 30, 2006 855,263 $ 4,355 $ — $ 5,607 $ 22 $ 9,984 (1) See Note 2, “Restatement +of Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements. See accompanying Notes to Consolidated Financial Statements. 75 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 30, 2006 2006 2005 2004 As Restated (1) As Restated (1) Cash and cash equivalents, beginning of the year $ 3,491 $ 2,969 $ 3,396 Operating Activities: Net income 1,989 1,328 266 Adjustments to reconcile + net income to cash generated by operating activities: Depreciation, amortization and accretion 225 179 150 Stock-based compensation expense 163 49 46 Provision for deferred income taxes 53 50 19 Excess tax benefits from stock options — 428 83 Gain on sale of PowerSchool net assets (4 ) — — Loss on disposition of property, plant, and equipment 15 9 7 Gains on sales of investments, net — — (5 ) Changes in operating + assets and liabilities: Accounts receivable (357 ) (121 ) (8 ) Inventories (105 ) (64 ) (45 ) Other current assets (1,626 ) (150 ) (176 ) Other assets (1,040 ) (35 ) (25 ) Accounts payable 1,611 328 297 Other liabilities 1,296 534 325 Cash generated by operating activities 2,220 2,535 934 Investing Activities: Purchases of short-term investments (7,255 ) (11,470 ) (3,270 ) Proceeds from maturities of short-term + investments 7,226 8,609 1,141 Proceeds from sales of investments 1,086 586 806 Purchases of long-term investments (25 ) — — Proceeds from sale of PowerSchool net assets 40 — — Purchases of property, plant, and equipment (657 ) (260 ) (176 ) Other (58 ) (21 ) 11 Cash generated by (used for) investing activities 357 (2,556 ) (1,488 ) Financing Activities: Payment of long-term debt — — (300 ) Proceeds from issuance of common stock 318 543 427 Excess tax benefits from stock-based compensation 361 — — Repurchases of common stock (355 ) — — Cash generated by financing activities 324 543 127 Increase (decrease) in cash and cash equivalents 2,901 522 (427 ) Cash and cash equivalents, end of the year $ 6,392 $ 3,491 $ 2,969 Supplemental cash + flow disclosures: Cash paid during the year for interest $ — $ — $ 10 Cash paid + (received) for income taxes, net $ 194 $ 17 $ (7 ) (1) See Note 2, “Restatement +of Consolidated Financial Statements,” in Notes to Consolidated Financial +Statements. See accompanying Notes to Consolidated Financial Statements. 76 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1—Summary of +Significant Accounting Policies Apple Computer, Inc. +and its wholly-owned subsidiaries (the Company) designs, manufactures, and +markets personal computers and related software, services, peripherals, and +networking solutions. The Company also designs, develops, and markets a line of +portable digital music players along with related accessories and services +including the online sale of third-party audio and video products. The Company +sells its products worldwide through its online stores, its retail stores, its +direct sales force, and third-party wholesalers, resellers, and value-added +resellers. In addition, the Company sells a variety of third-party Macintosh +and iPod compatible products including application software, printers, storage +devices, speakers, headphones, and various other accessories and supplies +through its online and retail stores. The Company sells to education, consumer, +creative professional, business, and government customers. Basis of +Presentation and Preparation The accompanying consolidated financial statements +include the accounts of the Company. Intercompany accounts and transactions +have been eliminated. The preparation of these consolidated financial +statements in conformity with U.S. generally accepted accounting principles +requires management to make estimates and assumptions that affect the amounts +reported in these consolidated financial statements and accompanying notes. +Actual results could differ materially from those estimates. Certain prior year +amounts in the consolidated financial statements and notes thereto have been +reclassified to conform to the current year presentation. Typically, the Company’s +fiscal year ends on the last Saturday of September. Fiscal years 2005 and 2004 were each 52-week +years. However, approximately every six years, the Company reports a 53-week +fiscal year to align its fiscal quarters with calendar quarters by adding a +week to its first fiscal quarter. The Company added this additional week in the +first fiscal quarter of its fiscal year 2006. All information presented herein +is based on the Company’s fiscal calendar. Common Stock Split On February 28, 2005, +the Company effected a two-for-one stock split to shareholders of record as of February 18, +2005. All share and per share information has been retroactively adjusted to +reflect the stock split. Financial +Instruments Cash Equivalents +and Short-term Investments All highly liquid +investments with maturities of three months or less at the date of purchase are +classified as cash equivalents. Highly liquid investments with maturities +greater than three months at the date of purchase are classified as short-term +investments. The Company’s debt and marketable equity securities have been +classified and accounted for as available-for-sale. Management +determines the appropriate classification of its investments in debt and +marketable equity securities at the time of purchase and reevaluates the +available-for-sale designations as of each balance sheet date. These securities +are carried at fair value, with the unrealized gains and losses, net of taxes, +reported as a component of shareholders’ equity. The cost of securities sold is +based upon the specific identification method. Derivative +Financial Instruments The Company accounts for its derivative instruments as +either assets or liabilities and carries them at fair value. Derivatives that +are not defined as hedges in Statement of Financial Accounting Standards (“SFAS”) +No. 133, Accounting for Derivative Instruments and +Hedging Activities, as amended, must be adjusted to fair value +through earnings. If the derivative is a hedge, depending on the nature of the +hedge, 77 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) changes in fair value will either be offset against +the change in fair value of the hedged assets, liabilities, or firm commitments +through earnings, or recognized in other comprehensive income until the hedged +item is recognized in earnings. For derivative instruments +that hedge the exposure to variability in expected future cash flows that are +designated as cash flow hedges, the effective portion of the gain or loss on +the derivative instrument is reported as a component of accumulated other +comprehensive income in shareholders’ equity and reclassified into earnings in +the same period or periods during which the hedged transaction affects +earnings. The ineffective portion of the gain or loss on the derivative +instrument is recognized in current earnings. To receive hedge accounting +treatment, cash flow hedges must be highly effective in offsetting changes to +expected future cash flows on hedged transactions. For derivative instruments +that hedge the exposure to changes in the fair value of an asset or a liability +and that are designated as fair value hedges, the net gain or loss on the +derivative instrument as well as the offsetting gain or loss on the hedged item +attributable to the hedged risk are recognized in earnings in the current +period. The net gain or loss on the effective portion of a derivative +instrument that is designated as an economic hedge of the foreign currency +translation exposure of the net investment in a foreign operation is reported +in the same manner as a foreign currency translation adjustment. For forward contracts +designated as net investment hedges, the Company excludes changes in fair value +relating to changes in the forward carry component from its definition of +effectiveness. Accordingly, any gains or losses related to this component are +recognized in current earnings. Inventories Inventories are stated at +the lower of cost, computed using the first-in, first-out method, or market. If +the cost of the inventories exceeds their market value, provisions are made +currently for the difference between the cost and the market value. The Company’s +inventories consist primarily of finished goods for all periods presented. Property, Plant, +and Equipment Property, plant, and +equipment are stated at cost. Depreciation is computed by use of the straight-line +method over the estimated useful lives of the assets, which for buildings is +the lesser of 30 years or the remaining life of the underlying building, up to +5 years for equipment, and the shorter of lease terms or 10 years for leasehold +improvements. The Company capitalizes eligible costs to acquire or develop +internal-use software that are incurred subsequent to the preliminary project +stage. Capitalized costs related to internal-use software are amortized using +the straight-line method over the estimated useful lives of the assets, which +range from 3 to 5 years. Depreciation and amortization expense on property and +equipment was $180 million, $141 million, and $126 million during 2006, 2005, +and 2004, respectively. Asset Retirement +Obligations The Company records obligations associated with the +retirement of tangible long-lived assets and the associated asset retirement +costs in accordance with SFAS No. 143, Accounting for Asset +Retirement Obligations . The Company reviews legal obligations +associated with the retirement of long-lived assets that result from the +acquisition, construction, development and/or normal use of the assets. If it +is determined that a legal obligation exists, the fair value of the liability +for an asset retirement obligation is recognized in the period in which it is +incurred if a reasonable estimate of fair value can be made. The fair value of +the liability is added to the carrying amount of the associated asset and this +additional carrying amount is depreciated over the life of the asset. The +difference between the gross expected future cash flow and its 78 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) present value is accreted over the life of the related +lease as an operating expense. All of the Company’s existing asset retirement +obligations are associated with commitments to return property subject to +operating leases to original condition upon lease termination. The following table +reconciles changes in the Company’s asset retirement liabilities for fiscal +2006 and 2005 (in millions): Asset retirement + liability as of September 25, 2004 $ 8.2 Additional asset retirement obligations recognized 2.8 Accretion recognized 0.7 Asset retirement liability as of September 24, + 2005 $ 11.7 Additional asset retirement obligations recognized 2.5 Accretion recognized 0.5 Asset retirement + liability as of September 30, 2006 $ 14.7 Long-Lived +Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and +certain identifiable intangibles, excluding goodwill, for impairment in +accordance with SFAS No. 144, Accounting for the +Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Long-lived assets are reviewed for impairment whenever events or changes in +circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability +of these assets is measured by comparison of its carrying amount to future +undiscounted cash flows the assets are expected to generate. If property, +plant, and equipment and certain identifiable intangibles are considered to be +impaired, the impairment to be recognized equals the amount by which the +carrying value of the assets exceeds its fair market value. For the three +fiscal years ended September 30, 2006, the Company had no material +impairment of its long-lived assets, except for the impairment of certain +assets in connection with the restructuring actions described in Note 6 of +these Notes to Consolidated Financial Statements. SFAS No. 142, Goodwill and Other +Intangible Assets requires that goodwill and intangible assets with +indefinite useful lives should not be amortized but rather be tested for +impairment at least annually or sooner whenever events or changes in +circumstances indicate that they may be impaired. The Company performs its +goodwill impairment tests on or about August 30 of each year. The Company +did not recognize any goodwill or intangible asset impairment charges in 2006, +2005, or 2004. The Company established reporting units based on its current +reporting structure. For purposes of testing goodwill for impairment, goodwill +has been allocated to these reporting units to the extent it relates to each +reporting unit. SFAS No. 142 also +requires that intangible assets with definite lives be amortized over their +estimated useful lives and reviewed for impairment in accordance with SFAS No. 144. +The Company is currently amortizing its acquired intangible assets with +definite lives over periods ranging from 3 to 10 years. Foreign Currency +Translation The Company translates the assets and liabilities of +its international non-U.S. functional currency subsidiaries into U.S. dollars +using exchange rates in effect at the end of each period. Revenue and expenses +for these subsidiaries are translated using rates that approximate those in +effect during the period. Gains and losses from these translations are credited +or charged to foreign currency translation 79 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) included in “accumulated +other comprehensive income” in shareholders’ equity. The Company’s foreign +manufacturing subsidiaries and certain other international subsidiaries that +use the U.S. dollar as their functional currency remeasure monetary assets and +liabilities at exchange rates in effect at the end of each  period, and inventories, property, and +nonmonetary assets and liabilities at historical rates. Gains and losses from +these translations were insignificant and have been included in the Company’s +results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, peripherals, digital content, and service and support +contracts. The Company recognizes revenue pursuant to applicable accounting +standards, including American Institute of Certified Public Accountants +Statement of Position (“SOP”) No. 97-2, Software +Revenue Recognition , as amended, and Securities and Exchange +Commission (“SEC”) Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition . The Company recognizes revenue when persuasive +evidence of an arrangement exists, delivery has occurred, the sales price is +fixed or determinable, and collection is probable. Product is considered +delivered to the customer once it has been shipped and title and risk of loss +have been transferred. For most of the Company’s product sales, these criteria +are met at the time the product is shipped. For online sales to individuals, +for some sales to education customers in the U.S., and for certain other sales, +the Company defers revenue until the customer receives the product because the +Company legally retains a portion of the risk of loss on these sales during +transit. If at the outset of an arrangement the Company determines the +arrangement fee is not, or is presumed not to be, fixed or determinable, +revenue is deferred and subsequently recognized as amounts become due and +payable. Revenue from service and support contracts is deferred +and recognized ratably over the service coverage periods. These contracts +typically include extended phone support, repair services, web-based support +resources, diagnostic tools, and extend the service coverage offered under the +Company’s one-year limited warranty. The Company sells software and peripheral products +obtained from other companies. The Company establishes its own pricing and +retains related inventory risk, is the primary obligor in sales transactions +with its customers, and assumes the credit risk for amounts billed to its +customers. Accordingly, the Company recognizes revenue for the sale of products +obtained from other companies based on the gross amount billed. Revenue on arrangements +that include multiple elements such as hardware, software, and services is +allocated to each element based on the relative fair value of each element. +Each element’s allocated revenue is recognized when revenue recognition +criteria for that element have been met. Fair value is generally determined by +vendor specific objective evidence (“VSOE”), which is based on the price +charged when each element is sold separately. If the Company cannot objectively +determine the fair value of any undelivered element included in a +multiple-element arrangement, the Company defers revenue until all elements are +delivered and services have been performed, or until fair value can objectively +be determined for any remaining undelivered elements. When the fair value of a +delivered element has not been established, the Company uses the residual method +to recognize revenue if the fair value of all undelivered elements is +determinable. Under the residual method, the fair value of the undelivered +elements is deferred and the remaining portion of the arrangement fee is +allocated to the delivered elements and is recognized as revenue. 80 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) The Company records reductions to revenue for +estimated commitments related to price protection and for customer incentive +programs, including reseller and end-user rebates, and other sales programs and +volume-based incentives. The estimated cost of these programs is accrued as a +reduction to revenue in the  period the +Company has sold the product and committed to a plan. The Company also records +reductions to revenue for expected future product returns based on the Company’s +historical experience. Generally, the Company +does not offer specified or unspecified upgrade rights to its customers in +connection with software sales or the sale of extended warranty and support +contracts. When the Company does offer specified upgrade rights, the Company +defers revenue for the fair value of the specified upgrade right until the +future obligation is fulfilled or when the right to the specified upgrade +expires. Additionally, a limited number of the Company’s software products are +available with maintenance agreements that grant customers rights to +unspecified future upgrades over the maintenance term on a when and if +available basis. Revenue associated with such maintenance is recognized ratably +over the maintenance term. Allowance for +Doubtful Accounts The Company records its +allowance for doubtful accounts based upon its assessment of various factors. The +Company considers historical experience, the age of the accounts receivable +balances, credit quality of the Company’s customers, current economic +conditions, and other factors that may affect customers’ ability to pay. Shipping Costs For all periods presented, +amounts billed to customers related to shipping and handling are classified as +revenue, and the Company’s shipping and handling costs are included in cost of +sales. Warranty Expense The Company provides for +the estimated cost of hardware and software warranties at the time the related +revenue is recognized. The Company assesses the adequacy of its preexisting +warranty liabilities and adjusts the amounts as necessary based on actual +experience and changes in future estimates. Software +Development Costs Research and development costs are expensed as +incurred. Development costs of computer software to be sold, leased, or +otherwise marketed are subject to capitalization beginning when a product’s +technological feasibility has been established and ending when a product is +available for general release to customers pursuant to SFAS No. 86, Computer Software to be Sold, Leased, or Otherwise Marketed . +In most instances, the Company’s products are released soon after technological +feasibility has been established. Therefore, costs incurred subsequent to +achievement of technological feasibility are usually not significant, and +generally all software development costs have been immediately expensed. In 2004, the Company began +incurring substantial development costs associated with Mac OS X version 10.4 +Tiger (“Tiger”) subsequent to achievement of technological feasibility as +evidenced by public demonstration in August 2004 and the subsequent +release of a developer beta version of the product. The Company capitalized +approximately $29.7 million and $4.5 million during 2005 and 2004, +respectively, of costs associated with the development of Tiger. In accordance +with SFAS No. 86, amortization of this asset to cost of sales began in April 2005 +when the Company began shipping Tiger and is being recognized on a +straight-line basis over a three-year estimated useful life. 81 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) During 2004, the Company incurred substantial +development costs associated with FileMaker Pro 7 subsequent to achievement of +technological feasibility as evidenced by public demonstration and release of a +developer beta version, and prior to the release of the final version of the +product in March 2004. Therefore, during 2004, the Company capitalized +approximately $2.3 million of costs associated with the development of +FileMaker Pro 7. In accordance with SFAS No. 86, amortization of this +asset to cost of sales began in March 2004 when the Company began shipping +FileMaker Pro 7 and is being recognized on a straight-line basis over a +three-year estimated useful life. Total amortization related +to capitalized software development costs was $17.8 million, $15.7 million, and +$10.7 million in 2006, 2005, and 2004, respectively. Advertising Costs Advertising costs are +expensed as incurred. Advertising expense was $338 million, $287 million, and +$206 million for 2006, 2005, and 2004, respectively. Stock-Based +Compensation On September 25, 2005, the Company adopted SFAS No. 123 +(revised 2004) (“SFAS No. 123R”), Share-Based Payment , +which addresses the accounting for stock-based payment transactions in which an +enterprise receives employee services in exchange for (a) equity +instruments of the enterprise or (b) liabilities that are based on the +fair value of the enterprise’s equity instruments or that may be settled by the +issuance of such equity instruments. In January 2005, the SEC issued SAB No. 107, +which provides supplemental implementation guidance for SFAS No. 123R. +SFAS No. 123R eliminates the ability to account for stock-based +compensation transactions using the intrinsic value method under Accounting +Principles Board (“APB”) Opinion No. 25, Accounting +for Stock Issued to Employees , and instead generally requires that +such transactions be accounted for using a fair-value-based method. The Company +uses the Black-Scholes-Merton (“BSM”) option-pricing model to determine the +fair-value of stock-based awards under SFAS No. 123R, consistent with that +used for pro forma disclosures under SFAS No. 123, Accounting +for Stock-Based Compensation . The Company has elected to use the +modified prospective transition method as permitted by SFAS No. 123R and +accordingly prior periods have not been restated to reflect the impact of SFAS No. 123R. +The modified prospective transition method requires that stock-based +compensation expense be recorded for all new and unvested stock options, +restricted stock, restricted stock units, and employee stock purchase plan +shares that are ultimately expected to vest as the requisite service is +rendered beginning on September 25, 2005, the first day of the Company’s +fiscal year 2006. Stock-based compensation expense for awards granted prior to September 25, +2005 is based on the grant-date fair-value as determined under the pro forma +provisions of SFAS No. 123. The Company recognized incremental stock-based +compensation expense of $117 million during 2006 as a result of the adoption of +SFAS No. 123R. Diluted earnings per common share was reduced by $0.10 for +the year ended September 30, 2006 due to the adoption of SFAS +No. 123R. In accordance with SFAS No. 123R, beginning in 2006 the +Company has presented excess tax benefits from the exercise of stock-based +compensation awards as a financing activity in the consolidated statement of +cash flows. No stock-based +compensation costs have been capitalized as of September 30, 2006. The +income tax benefit related to stock-based compensation expense was $39 million +for the year ended September 30, 2006. As of September 30, 2006, +$375.2 million of total unrecognized compensation cost related to stock options +and restricted stock units is expected to be recognized over a weighted-average +period of 2.91 years. 82 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) SFAS No. 123R prohibits recognition of a deferred +tax asset for an excess tax benefit that has not been realized. The Company +will recognize a benefit from stock-based compensation in equity if an +incremental tax benefit is realized by following the ordering provisions of the +tax law. In addition, the Company accounts for the indirect effects of +stock-based compensation on the research tax credit, the foreign tax credit, +and the domestic manufacturing deduction through the income statement. Prior to the adoption of SFAS No. 123R, the +Company measured compensation expense for its employee stock-based compensation +plans using the intrinsic value method prescribed by APB Opinion No. 25. +The Company applied the disclosure provisions of SFAS No. 123 as amended +by SFAS No. 148, Accounting for Stock-Based +Compensation—Transition and Disclosure, as if the fair-value-based +method had been applied in measuring compensation expense. Under APB Opinion No. 25, +when the exercise price of the Company’s employee stock options was equal to +the market price of the underlying stock on the date of the grant, no +compensation expense was recognized. The following table +illustrates the effect on net income after taxes and net income per common +share as if the Company had applied the fair value recognition provisions of +SFAS No. 123 to stock-based compensation during 2005 and 2004 (in +millions, except per share amounts): 2005 2004 As Restated (1) As Restated (1) Net income $ 1,328 $ 266 Add: Stock-based employee compensation expense + included in reported net income, net of tax 45 43 Deduct: + Stock-based employee compensation expense determined under the fair value + based method for all awards, net of tax (118 ) (148 ) Net income—pro + forma $ 1,255 $ 161 Net income per common share Basic $ 1.64 $ 0.36 Diluted $ 1.55 $ 0.34 Net income per common share—pro forma Basic $ 1.55 $ 0.22 Diluted $ 1.47 $ 0.21 (1) See Note 2, “Restatement +of Consolidated Financial Statements.” Further information +regarding stock-based compensation can be found in Note 9. Earnings Per Common +Share Basic earnings per common share is computed by +dividing income available to common shareholders by the weighted-average number +of shares of common stock outstanding during the period. Diluted earnings per +common share is computed by dividing income available to common shareholders by +the weighted-average number of shares of common stock outstanding during the +period increased to include the number of additional shares of common stock +that would have been outstanding if the dilutive potential shares of common +stock had been issued. The dilutive effect of outstanding options, restricted +stock, and restricted stock units is reflected in diluted earnings per share by +application of the treasury stock method. Under the 83 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary +of Significant Accounting Policies (Continued) treasury stock method, an increase in the fair market +value of the Company’s common stock can result in a greater dilutive effect +from outstanding options, restricted stock, and restricted stock units. Additionally, +the exercise of employee stock options and the vesting of restricted stock and +restricted stock units can result in a greater dilutive effect on earnings per +share. The following table sets +forth the computation of basic and diluted earnings per share: Three fiscal years ended September 30, 2006 2006 2005 2004 As Restated (1) As Restated (1) Numerator (in millions): Net income $ 1,989 $ 1,328 $ 266 Denominator (in + thousands): Weighted-average shares outstanding, excluding + unvested restricted stock 844,058 808,439 743,180 Effect of dilutive options, restricted stock units + and unvested restricted stock 33,468 48,439 31,596 Denominator for diluted earnings per share 877,526 856,878 774,776 Basic earnings per share $ 2.36 $ 1.64 $ 0.36 Diluted earnings + per share $ 2.27 $ 1.55 $ 0.34 Potentially +dilutive securities representing approximately 3.9 million, 12.7 million (as +restated(1)), and 8.9 million (as restated(1)) shares of common stock for +the years ended September 30, 2006, September 24, 2005, and +September 25, 2004, respectively, were excluded from the computation of +diluted earnings per share for these periods because their effect would have +been antidilutive. These potentially dilutive securities include stock options, +unvested restricted stock, and restricted stock units. (1) See +Note 2, “Restatement of Consolidated Financial Statements.”. Comprehensive +Income Comprehensive income +consists of two components: net income and other comprehensive income. Other +comprehensive income refers to revenue, expenses, gains, and losses that under +generally accepted accounting principles are recorded as an element of +shareholders’ equity but are excluded from net income. The Company’s other +comprehensive income is comprised of foreign currency translation adjustments +from those subsidiaries not using the U.S. dollar as their functional currency, +unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments +accounted for as cash flow hedges. Segment Information The Company reports segment information based on the +“management” approach. The management approach designates the internal +reporting used by management for making decisions and assessing performance as +the source of the Company’s reportable segments. Information about the +Company’s products, major customers, and geographic areas on a company-wide +basis is also disclosed. 84 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement of +Consolidated Financial Statements The Company is restating its consolidated balance +sheet as of September 24, 2005, and the related consolidated statements of +operations, shareholders’ equity, and cash flows for each of the fiscal years +ended September 24, 2005 and September 25, 2004, and each of the +quarters in fiscal year 2005. Previously filed annual reports on Form 10-K +and quarterly reports on Form 10-Q affected by the restatements have +not been amended and should not be relied on. On June 29, 2006, the Company announced that an +internal review had discovered irregularities related to the issuance of +certain stock option grants made between 1997 and 2001, including a grant to +its Chief Executive Officer (“CEO”) Steve Jobs. The Company also announced that +a Special Committee of outside directors (“Special Committee”) had been formed +and had hired independent counsel to conduct a full investigation of the +Company’s past stock option granting practices. As a result of the internal review and the independent +investigation, management has concluded, and the Audit and Finance Committee of +the Board of Directors agrees, that incorrect measurement dates were used for +financial accounting purposes for certain stock option grants made in prior +periods. Therefore, the Company has recorded additional non-cash stock-based +compensation expense and related tax effects with regard to past stock option +grants, and the Company is restating previously filed financial statements in +this Form 10-K. These adjustments, after tax, amounted to $4 +million, $7 million, and $10 million in fiscal years 2006, 2005 and 2004, +respectively. The adjustment to 2006 was recorded in the fourth quarter of +fiscal year 2006 due to its insignificance. The independent counsel and its forensic accountants (“Investigative +Team”) reviewed the facts and circumstances surrounding stock option grants +made on 259 dates. Based on a review of the totality of evidence and the +applicable law, the Special Committee found no misconduct by current +management. The Special Committee’s investigation identified a number of grants +for which grant dates were intentionally selected in order to obtain favorable +exercise prices. The terms of these and certain other grants, as discussed +below, were finalized after the originally assigned grant dates. The Special +Committee concluded that the procedures for granting, accounting for, and +reporting stock option grants did not include sufficient safeguards to prevent +manipulation. Although the investigation found that CEO Steve Jobs was aware or +recommended the selection of some favorable grant dates, he did not receive or financially +benefit from these grants or appreciate the accounting implications. The +Special Committee also found that the investigation had raised serious concerns +regarding the actions of two former officers in connection with the accounting, +recording and reporting of stock option grants. Based on the evidence and findings from the Company’s +internal review and the Special Committee’s independent investigation, an +analysis was performed of the measurement dates for the 42,077 stock option +grants made on 259 dates between October 1996 and January 2003 (the “relevant +period”). The Company believes that the analysis was properly limited to the +relevant period. In addition to analyzing all grants made during the relevant +period, the Company sampled certain grants between 1994 and 1997 and found none +that required accounting adjustments. The first grants for which stock-based +compensation expense is required are dated December 29, 1997. The Company +also examined grants made after the relevant period and found none that +required accounting adjustments. Moreover, in the years after 2002, Apple made +significant changes in its stock option granting practices in response to +evolving legal, regulatory and accounting requirements. Consistent with the accounting literature and recent +guidance from the Securities and Exchange Commission (“SEC”), the grants during +the relevant period were organized into categories based on grant 85 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement +of Consolidated Financial Statements (Continued) type and process by which the grant was finalized. The +Company analyzed the evidence related to each category of grants including, but +not limited to, electronic and physical documents, document metadata, and +witness interviews. Based on the relevant facts and circumstances, the Company +applied the controlling accounting standards to determine, for every grant +within each category, the proper measurement date. If the measurement date is +not the originally assigned grant date, accounting adjustments were made as +required, resulting in stock-based compensation expense and related tax +effects. The 42,077 grants were classified as follows: (1) 17 +grants to persons elected or appointed to the Board of Directors (“director +grants”); (2) 3,892 grants to employees under the Monday/Tuesday Plan +described below (“Monday/Tuesday grants”); (3) 27,096 grants made in +broad-based awards to large numbers of employees, usually on an annual basis (“focal +grants”); (4) 9,988 other grants ratified at meetings of the Board or +Compensation Committee (“meeting grants”); (5) 1,082 other grants ratified +by unanimous written consent (“UWC”) of the Board or Compensation Committee (“other +UWC grants”); and (6) two grants to the CEO (“CEO grants”). All references +to the number of option shares, option exercise prices, and share prices in +this Note 2 have not been adjusted for any subsequent stock splits. With the exception of director grants, all stock +option grants were subject to ratification by the Board or Compensation +Committee at a meeting or by UWC. Following approval of the grants at a meeting +or by UWC, the Company’s legal staff would prepare a Secretary’s Certificate +certifying the ratification of the grants. Based on the facts and circumstances +described below, the Company has concluded that the recipients and terms of +certain grants were fixed for accounting purposes before ratification pursuant +to parameters previously approved by the Board or Compensation Committee +through the Monday/Tuesday Plan and the focal process. As further discussed +below, within these parameters, management had the authority to determine the +recipients and terms for each grant. Thus, the Company has concluded that the +measurement dates for these grants occurred when management’s process for +allocating these grants was completed and the grants were ready for +ratification, which was considered perfunctory. With regard to all other +grants, the Company has concluded that the grants were finalized and the +measurement dates occurred when the grants were ratified. For many grants, +however, the dates of ratification cannot be established because the dates the UWCs +were executed by the Board or Compensation Committee members or received by the +Company are not available. For such grants, the Company has concluded that the +date of the preparation of the Secretary’s Certificate is the best alternative +for determining the actual date of ratification. As discussed below, the Company’s analysis determined +that the originally assigned grant dates for 6,428 grants on 42 dates are not +the proper measurement dates. Accordingly, after accounting for forfeitures, +the Company has recognized stock-based compensation expense of $105 million on +a pre-tax basis over the respective awards’ vesting terms. No adjustments were +required for the remaining 35,649 grants. The adjustments were determined by +category as follows: Director Grants—Seventeen director grants were made +during the relevant period. Two director grants were made pursuant to a 1997 +plan that dated the grants on the enactment of the plan. The remaining fifteen +grants were automatically made under the Director Stock Option Plan for +non-employee directors, which was approved by shareholders in 1998, on the date +of a director’s election or appointment to the Board and on subsequent +anniversaries, beginning on the fourth anniversary. Accordingly, the analysis +determined that the originally assigned grant date for each director grant is +the measurement date, and no accounting adjustments are required. 86 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement +of Consolidated Financial Statements (Continued) Monday/Tuesday Grants—Beginning in December 1998, +3,892 new hire grants and grants for promotion and retention purposes (“promotion/retention +grants”) were made during the relevant period under the “Monday/Tuesday Plan.” Under +the Monday/Tuesday Plan, new hire grants made within pre-established guidelines +approved by the Board or Compensation Committee were dated on the Monday that +the recipient started work (or the following Monday, if the recipient started +on another day). The Company’s analysis showed this process to be reliable with +very low error rates. Promotion/retention grants, also based on pre-established +guidelines, were made generally on the first Tuesday of each month. The Company +has concluded that the new hire and promotion/retention grants made pursuant to +the Monday/Tuesday Plan within pre-established guidelines do not require +adjustment, with the exception of six grants that were erroneously dated before +the employees’ start dates. For 120 new hire and promotion/retention grants +made outside the guidelines, however, the Company has concluded that the +measurement dates are the dates of ratification by the Board or Compensation +Committee rather than the dates used for grants within guidelines. Accordingly, +based on the methodology described above, the Company has recognized +stock-based compensation expense of $6 million from 126 grants. Focal Grants—During the relevant period, 27,096 focal +grants were made to employees typically on an annual basis as part of an +extensive process that required several months to complete. Pursuant to limits, +guidelines and practices previously approved by the Board or Compensation Committee, +managers throughout the Company would make recommendations for grants to +employees in their areas of responsibility. After senior management had +determined that the grants were made in accordance with these established +limits, guidelines and practices, management treated the grants as final when +they were submitted to the Board or Compensation Committee for ratification. The +Company has concluded that for 5,595 grants on five dates, the originally +assigned grant dates are not the proper measurement dates. For these grants, +management’s process for finalizing the grants was completed after the originally +assigned grant dates. As a result, the Company has recognized $29 million of +stock-based compensation expense. For two of the five grant dates comprising +3,744 grants, the evidence shows that the grants were finalized and the +measurement date occurred one day after the originally assigned grant dates. The +grants on these two dates represent more than $16 million of the total $29 +million of stock-based compensation expense resulting from focal grants. Other Meeting Grants—During the relevant period, +meetings of the Board or Compensation Committee were held to ratify 9,988 +grants that are not Monday/Tuesday, focal or CEO grants. The grant dates and +measurement dates for these grants are the meeting dates when the grants were +ratified, with the exception of 46 grants. Forty-two of these 46 grants are +dated concurrent with a meeting that considered and approved certain grants, +but the evidence indicates that all of the grants may not have been finalized +until a later date. One of the 46 grants was approved and dated at another +meeting, but the recipient, who was becoming employed by the Company as part of +a corporate acquisition, did not start until a later date. Two other grants +were approved before the employees’ start dates. Another grant was mistakenly +cancelled and subsequently reinstated, requiring an accounting adjustment. +Thus, for these 46 grants the Company has concluded that the originally assigned +grant dates are not the proper measurement dates. As a result, the Company has +recognized $2 million of stock-based compensation expense. Other UWC Grants—During the relevant period, 1,082 +grants were approved by UWCs for a variety of purposes, including executive +recruitment, retention, promotion and new hires outside the Monday/Tuesday +process. These grants were not made pursuant to pre-established guidelines +adopted by the Board or Compensation Committee. Therefore, the Company has +concluded that these grants were 87 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement +of Consolidated Financial Statements (Continued) not finalized for accounting purposes until +ratification by the Board or Compensation Committee. Accordingly, for 660 +grants, the Company has concluded that the originally assigned grant dates are +not the proper measurement dates. As a result, the Company has recognized $48 +million of stock-based compensation expense. CEO Grants—During the relevant period, the Company +made two grants to CEO Steve Jobs. The first grant, dated January 12, +2000, was for 10 million option shares. The second grant, dated October 19, +2001, was for 7.5 million option shares. Both grants were cancelled in March 2003 +prior to being exercised, when Mr. Jobs received 5 million shares of +restricted stock. With respect to the grant dated January 12, 2000, +the Board on December 2, 1999, authorized a special “CEO Compensation +Committee” to grant Mr. Jobs up to 15 million shares. The evidence +indicates that the CEO Compensation Committee finalized the terms of the grant +on January 12, 2000, although the Committee’s action was memorialized in a +UWC transmitted on January 18, 2000. Because the measurement date is the originally +assigned grant date, the Company has not recognized any stock-based +compensation expense from this grant. If the Company had determined that the +measurement date was the date when the UWC was executed or received, then +additional stock-based compensation would have been recognized. The grant dated October 19, 2001 was originally +approved at a Board meeting on August 29, 2001, with an exercise price of +$17.83. The terms of the grant, however, were not finalized until December 18, +2001. The grant was dated October 19, 2001, with an exercise price of +$18.30. The approval for the grant was improperly recorded as occurring at a +special Board meeting on October 19, 2001. Such a special Board meeting +did not occur. There was no evidence, however, that any current member of +management was aware of this irregularity. The Company has recognized $20 +million in stock-based compensation expense for this grant, reflecting the +difference between the exercise price of $18.30 and the share price on December 18, +2001 of $21.01. The incremental impact +from recognizing stock-based compensation expense resulting from the +investigation of past stock option grants is as follows (dollars in millions): Fiscal Year Pre-Tax Expense (Income) After Tax Expense 1998 $ (1 ) $ — 1999 8 6 2000 13 9 2001 19 13 2002 29 23 2003 16 12 Total 1998 – 2003 + impact 84 63 2004 13 10 2005 7 7 2006 1 4 Total $ 105 $ 84 Additionally, the Company has restated the pro forma +expense under Statement of Financial Accounting Standards (SFAS) No. 123 +in Note 1 to reflect the impact of these adjustments. 88 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement +of Consolidated Financial Statements (Continued) The following table +presents the effects of the stock-based compensation and related tax adjustments +made to the Company’s previously reported consolidated balance sheet as of September 24, +2005 (in millions, except share amounts): September 24, 2005 As Reported Adjustments As Restated ASSETS: Current assets: Cash and cash equivalents $ 3,491 $ — $ 3,491 Short-term investments 4,770 — 4,770 Accounts receivable, less allowance of $46 895 — 895 Inventories 165 — 165 Deferred tax assets 331 — 331 Other current assets 648 — 648 Total current assets 10,300 — 10,300 Property, plant, and equipment, net 817 — 817 Goodwill 69 — 69 Acquired intangible assets, net 27 — 27 Other assets 338 (35 ) 303 Total assets $ 11,551 (35 ) $ 11,516 LIABILITIES AND SHAREHOLDERS’ + EQUITY: Current + liabilities: Accounts payable $ 1,779 $ — $ 1,779 Accrued expenses 1,705 3 1,708 Total current liabilities 3,484 3 3,487 Non-current + liabilities 601 — 601 Total liabilities 4,085 3 4,088 Commitments and + contingencies Shareholders’ + equity: Common stock, no par value; 1,800,000,000 shares + authorized; 835,019,364 shares issued and outstanding 3,521 43 3,564 Deferred stock compensation (60 ) (1 ) (61 ) Retained earnings 4,005 (80 ) 3,925 Accumulated other comprehensive income — — — Total shareholders’ equity 7,466 (38 ) 7,428 Total liabilities + and shareholders’ equity $ 11,551 (35 ) $ 11,516 89 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement of +Consolidated Financial Statements (Continued) The +following table presents the effects of the stock-based compensation and +related tax adjustments made to the Company’s previously reported consolidated statements +of operations (in millions, except share and per share amounts): Fiscal Year Ended September 24, 2005 Fiscal Year Ended September 25, 2004 As Reported Adjustments As Restated As Reported Adjustments As Restated Net sales $ 13,931 $ — $ 13,931 $ 8,279 $ — $ 8,279 Cost of sales (1) 9,888 1 9,889 6,020 2 6,022 Gross margin 4,043 (1 ) 4,042 2,259 (2 ) 2,257 Operating expenses: Research and development (1) 534 1 535 489 2 491 Selling, general, and administrative (1) 1,859 5 1,864 1,421 9 1,430 Restructuring costs — — — 23 — 23 Total operating expenses 2,393 6 2,399 1,933 11 1,944 Operating income 1,650 (7 ) 1,643 326 (13 ) 313 Other income and expense 165 — 165 57 — 57 Income before + provision for income taxes 1,815 (7 ) 1,808 383 (13 ) 370 Provision for + income taxes 480 — 480 107 (3 ) 104 Net income $ 1,335 $ (7 ) $ 1,328 $ 276 $ (10 ) $ 266 Earnings per + common share: Basic $ 1.65 $ (0.01 ) $ 1.64 $ 0.37 $ (0.01 ) $ 0.36 Diluted $ 1.56 $ (0.01 ) $ 1.55 $ 0.36 $ (0.02 ) $ 0.34 Shares used in computing + earnings per share (in thousands): Basic 808,439 — 808,439 743,180 — 743,180 Diluted 856,780 98 856,878 774,622 154 774,776 (1) Includes +stock-based compensation expense, which was allocated as follows: Cost of sales $ 2 $ 1 $ 3 $ 1 $ 2 $ 3 Research and development $ 6 $ 1 $ 7 $ 4 $ 2 $ 6 Selling, general, + and administrative $ 34 $ 5 $ 39 $ 28 $ 9 $ 37 90 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Restatement of +Consolidated Financial Statements (Continued) The following table presents +the cumulative adjustments of each component of shareholders’ equity at the end +of each fiscal year (in millions): Fiscal Year Common Stock Deferred Stock Compensation Retained Earnings Net Impact to Shareholders’ Equity 1998 $ 26 $ (27 ) $ — $ (1 ) 1999 36 (32 ) (6 ) (2 ) 2000 56 (43 ) (15 ) (2 ) 2001 81 (49 ) (28 ) 4 2002 105 (49 ) (51 ) 5 2003 85 (22 ) (63 ) — 2004 68 (8 ) (73 ) (13 ) 2005 43 (1 ) (80 ) (38 ) Note 3—Financial +Instruments The carrying amounts of +cash and cash equivalents, accounts receivable, accounts payable, and accrued +expenses approximate their fair value due to the short maturities of those +instruments. Cash, Cash +Equivalents and Short-Term Investments The +following table summarizes the fair value of the Company’s cash and available-for-sale +securities held in its short-term investment portfolio, recorded as cash and +cash equivalents or short-term investments (in millions): September 30, 2006 September 24, 2005 Cash $ 200 $ 127 U.S. Treasury and + Agency securities 52 89 U.S. Corporate + Securities 4,309 2,030 Foreign + Securities 1,831 1,245 Total cash equivalents 6,192 3,364 U.S. Treasury and Agency securities 447 216 U.S. Corporate + Securities 2,701 3,662 Foreign + Securities 570 892 Total short-term investments 3,718 4,770 Total cash, cash + equivalents, and short-term investments $ 10,110 $ 8,261 The Company’s U.S. corporate securities consist +primarily of commercial paper, certificates of deposit, time deposits, and +corporate debt securities. Foreign securities consist primarily of foreign +commercial paper, certificates of deposit, and time deposits with foreign +institutions, most of which are denominated in U.S. dollars. The Company had +net unrealized losses totaling $687,000 on its investment portfolio, primarily +related to investments with stated maturities less than 1 year, as of September 30, +2006, and net unrealized losses of $5.9 million on its investment portfolio, +approximately half of which related to investments with stated maturities less +than 1 year, as of September 24, 2005. The Company may sell its +investments prior to their stated maturities for strategic purposes, in +anticipation of credit deterioration, or 91 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Financial +Instruments (Continued) for duration management. +The Company recognized net losses before taxes of $434,000 and $137,000 in 2006 +and 2005, respectively, and a net gain before taxes of $1 million in 2004 as a +result of such sales. These net gains were included in interest and other +income, net. As of September 30, +2006 and September 24, 2005, approximately $921 million and $287 million, +respectively, of the Company’s short-term investments had underlying maturities +ranging from 1 to 5 years. The remaining short-term investments as of September 30, +2006 and September 24, 2005 had maturities less than 12 months. In accordance with FASB +Staff Position (“FSP”) FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to +Certain Investments, the following table shows the gross unrealized +losses and fair value for those investments that were in an unrealized loss +position as of September 30, 2006 and September 24, 2005, aggregated +by investment category and the length of time that individual securities have +been in a continuous loss position (in millions): 2006 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agency + Securities $ 234 $ — $ 26 $ — $ 260 $ — U.S. Corporate + Securities 943 — 102 (1 ) 1,045 (1 ) Foreign Securities 164 — 34 — 198 — Total $ 1,341 $ — $ 162 $ (1 ) $ 1,503 $ (1 ) 2005 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agency + securities $ 160 $ (1 ) $ 2 $ — $ 162 $ (1 ) U.S. corporate + securities 3,960 (4 ) 25 — 3,985 (4 ) Foreign Securities 1,382 (1 ) 1 — 1,383 (1 ) Total $ 5,502 $ (6 ) $ 28 $ — $ 5,530 $ (6 ) The unrealized losses on +the Company’s investments during 2006 in U.S. Government securities and during +2005 in U.S. Government securities, U.S. corporate securities, and foreign +securities were caused primarily by changes in interest rates. The Company +typically invests in highly-rated securities with low probabilities of default. +The Company’s investment policy requires investments to be rated single-A or +better. Therefore, the Company considers the declines to be temporary in nature. +As of September 30, 2006, the Company does not consider the investments to +be other-than-temporarily impaired. Market values were +determined for each individual security in the investment portfolio. When +evaluating the investments for other-than-temporary impairment, the Company +reviews factors such as the length of time and extent to which fair value has +been below cost basis, the financial condition of the issuer, and the Company’s +ability and intent to hold the investment for a period of time, which may be +sufficient for anticipated recovery in market value. 92 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Financial +Instruments (Continued) Accounts Receivable Trade Receivables The Company distributes its products through +third-party distributors and resellers and directly to certain education, +consumer, and commercial customers. The Company generally does not require +collateral from its customers; however, the Company will require collateral in +certain instances to limit credit risk. In addition, when possible, the Company +does attempt to limit credit risk on trade receivables with credit insurance +for certain customers in Latin America, Europe, Asia, and Australia and by +arranging with third-party financing companies to provide flooring arrangements +and other loan and lease programs to the Company’s direct customers. These +credit-financing arrangements are directly between the third-party financing +company and the end customer. As such, the Company generally does not assume +any recourse or credit risk sharing related to any of these arrangements. +However, considerable trade receivables that are not covered by collateral, +third-party flooring arrangements, or credit insurance are outstanding with the +Company’s distribution and retail channel partners. No customer accounted for +more than 10% of trade receivables as of September 30, 2006 or September 24, +2005. The +following table summarizes the activity in the allowance for doubtful accounts +(in millions): September 30, 2006 September 24, 2005 September 25, 2004 Beginning + allowance balance $ 46 $ 47 $ 49 Charged to costs + and expenses 17 8 3 Deductions(a) (11 ) (9 ) (5 ) Ending allowance balance $ 52 $ 46 $ 47 (a) Represents +amounts written off against the allowance, net of recoveries. Vendor Non-Trade +Receivables The Company has non-trade +receivables from certain of its manufacturing vendors resulting from the sale +of raw material components to these manufacturing vendors who manufacture +sub-assemblies or assemble final products for the Company. The Company +purchases these raw material components directly from suppliers. These +non-trade receivables, which are included in the consolidated balance sheets in +other current assets, totaled $1.6 billion and $417 million as of September 30, +2006 and September 24, 2005, respectively. The Company does not reflect +the sale of these components in net sales and does not recognize any profits on +these sales until the products are sold through to the end customer at which +time the profit is recognized as a reduction of cost of sales. Derivative +Financial Instruments The Company uses derivatives to partially offset its +business exposure to foreign exchange risk. Foreign currency forward and option +contracts are used to offset the foreign exchange risk on certain existing +assets and liabilities and to hedge the foreign exchange risk on expected +future cash flows on certain forecasted revenue and cost of sales. From time to +time, the Company enters into interest rate derivative agreements to modify the +interest rate profile of certain investments and debt. The Company’s accounting +policies for these instruments are based on whether the instruments are +designated as hedge or non-hedge instruments. The Company records all +derivatives on the balance sheet at fair value. 93 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Financial +Instruments (Continued) The following table shows +the notional principal, net fair value, and credit risk amounts of the Company’s +foreign currency instruments as of September 30, 2006 and September 24, +2005 (in millions): September 30, 2006 September 24, 2005 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Creit Risk Amounts Foreign exchange + instruments qualifying as accounting hedges: Spot/Forward contracts $ 351 $ 6 $ 6 $ 662 $ 10 $ 10 Purchased options $ 1,256 $ 9 $ 9 $ 1,668 $ 17 $ 17 Sold options $ 80 $ (1 ) $ — $ 1,087 $ (5 ) $ — Foreign exchange instruments other than accounting + hedges: Spot/Forward contracts $ 1,103 $ 2 $ 2 $ 833 $ (3 ) $ 1 Purchased options $ 167 $ 1 $ — $ 115 $ — $ — Sold options $ — $ — $ — $ — $ — $ — The notional principal amounts for derivative +instruments provide one measure of the transaction volume outstanding as of +year-end, and do not represent the amount of the Company’s exposure to credit +or market loss. The credit risk amounts shown in the table above represents the +Company’s gross exposure to potential accounting loss on these transactions if +all counterparties failed to perform according to the terms of the contract, +based on then-current currency exchange rates at each respective date. +The Company’s exposure to credit loss and market risk will vary over time as a +function of currency exchange rates. The estimates of fair +value are based on applicable and commonly used pricing models and prevailing +financial market information as of September 30, 2006 and September 24, +2005. Although the table above reflects the notional principal, fair value, and +credit risk amounts of the Company’s foreign exchange instruments, it does not +reflect the gains or losses associated with the exposures and transactions that +the foreign exchange instruments are intended to hedge. The amounts ultimately +realized upon settlement of these financial instruments, together with the +gains and losses on the underlying exposures, will depend on actual market +conditions during the remaining life of the instruments. Foreign Exchange +Risk Management The Company may enter into foreign currency forward +and option contracts with financial institutions to protect against foreign +exchange risk associated with existing assets and liabilities, certain firmly +committed transactions, forecasted future cash flows, and net investments in +foreign subsidiaries. Generally, the Company’s practice is to hedge a majority +of its existing material foreign exchange transaction exposures. However, the +Company may not hedge certain foreign exchange transaction exposures due to +immateriality, prohibitive economic cost of hedging particular exposures, or +limited availability of appropriate hedging instruments. To help protect gross margins from fluctuations in +foreign currency exchange rates, the Company’s U.S. dollar functional +subsidiaries hedge a portion of forecasted foreign currency revenue, and the +Company’s non-U.S. dollar functional subsidiaries selling in local currencies +hedge a portion of forecasted inventory purchases not denominated in the +subsidiaries’ functional currency. Other comprehensive income 94 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Financial +Instruments (Continued) associated with hedges of foreign currency revenue is +recognized as a component of net sales in the same period as the related sales +are recognized, and other comprehensive income related to inventory purchases +is recognized as a component of cost of sales in the same period as the related +costs are recognized. Typically, the Company hedges portions of its forecasted +foreign currency exposure associated with revenue and inventory purchases over +a time horizon of up to 6 months. Derivative instruments designated as cash flow hedges +must be de-designated as hedges when it is probable that the forecasted hedged +transaction will not occur in the initially identified time period or within a +subsequent 2 month time period. Deferred gains and losses in other +comprehensive income associated with such derivative instruments are +immediately reclassified into earnings in other income and expense. Any +subsequent changes in fair value of such derivative instruments are also +reflected in current earnings unless they are re-designated as hedges of other +transactions. The Company recognized a net gain of approximately $421,000 in +2006 and net losses of $1.6 million and $2.8 million in 2005 and 2004, +respectively, in other income and expense related to the loss of hedge +designation on discontinued cash flow hedges due to changes in the Company’s +forecast of future net sales and cost of sales and due to prevailing market +conditions. As of September 30, 2006, the Company had a net deferred gain +associated with cash flow hedges of approximately $2.8 million, net of taxes, +substantially all of which is expected to be reclassified to earnings by the +end of the second quarter of fiscal 2007. The net gain or loss on the effective portion of a +derivative instrument designated as a net investment hedge is included in the +cumulative translation adjustment account of accumulated other comprehensive +income within shareholders’ equity. For the years ended September 30, 2006 +and September 24, 2005, the Company had net gains of $7.4 million and +$673,000, respectively, included in the cumulative translation adjustment. The Company may also enter +into foreign currency forward and option contracts to offset the foreign +exchange gains and losses generated by the re-measurement of certain assets and +liabilities recorded in non-functional currencies. Changes in the fair value of +these derivatives are recognized in current earnings in other income and +expense as offsets to the changes in the fair value of the related assets or +liabilities. Due to currency market movements, changes in option time value can +lead to increased volatility in other income and expense. Note 4—Consolidated +Financial Statement Details (in millions) Other Current +Assets 2006 2005 Vendor non-trade + receivables $ 1,593 $ 417 NAND flash memory + prepayments 208 — Other current + assets 469 231 Total other + current assets $ 2,270 $ 648 95 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 4—Consolidated +Financial Statement Details (in millions) (Continued) Property, Plant, +and Equipment 2006 2005 Land and + buildings $ 626 $ 361 Machinery, + equipment, and internal-use software 595 470 Office furniture + and equipment 94 81 Leasehold + improvements 760 569 2,075 1,481 Accumulated depreciation and amortization (794 ) (664 ) Net property, + plant, and equipment $ 1,281 $ 817 Other Assets 2006 2005 As Restated(1) Long-term NAND + flash memory prepayments $ 1,042 $ — Non-current + deferred tax assets — 148 Capitalized + software development costs, net 21 38 Other assets 175 117 Total other + assets $ 1,238 $ 303 Accrued Expenses 2006 2005 As Restated(1) Deferred revenue—current $ 746 $ 501 Accrued warranty + and related costs 284 188 Accrued marketing + and distribution 298 221 Accrued + compensation and employee benefits 221 167 Other accrued tax + liability 388 196 Deferred margin + on component sales 324 26 Other current + liabilities 820 409 Total accrued + expenses $ 3,081 $ 1,708 Non-Current +Liabilities 2006 2005 Deferred tax + liabilities $ 381 $ 308 Deferred revenue—non-current 355 281 Other non-current + liabilities 14 12 Total non-current + liabilities $ 750 $ 601 96 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 4—Consolidated +Financial Statement Details (in millions) (Continued) Other Income and +Expense 2006 2005 2004 Gains on + non-current investments, net $ — $ — $ 4 Interest income $ 394 $ 183 $ 64 Interest expense — — (3 ) Other income + (expense), net (29 ) (18 ) (8 ) Total interest + and other income, net 365 165 53 Total other + income and expense $ 365 $ 165 $ 57 (1) See +Note 2, “Restatement of Consolidated Financial Statements.” Note 5—Goodwill and Other +Intangible Assets The Company is currently amortizing its acquired +intangible assets with definite lives over periods ranging from 3 to 10 years. The +following table summarizes the components of gross and net intangible asset +balances (in millions): September 30, 2006 September 24, 2005 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Goodwill $ 38 $ — $ 38 $ 69 $ — $ 69 Acquired + technology 181 (42 ) 139 61 (34 ) 27 Total acquired + intangible assets $ 219 $ (42 ) $ 177 $ 130 $ (34 ) $ 96 As of September 30, 2006, and September 24, +2005, the weighted-average amortization period for acquired technology was 8.5 +years and 5.5 years, respectively. During 2006, the Company sold certain assets related +to its PowerSchool web-based student information system operations. In +connection with this sale, the Company reduced goodwill by $31 million for the +outstanding balance from the acquisition of PowerSchool, Inc. in 2001 and +recognized a $4 million pre-tax gain, which is reflected in other income and +expense in the consolidated statement of operations. During 2005, the Company recorded an adjustment of +approximately $11 million to goodwill relating to a reduction of valuation +allowances that were recorded at the time certain net operating loss +carryforwards (“NOLs”) were acquired in previous business combinations. During +2005, these NOLs were deemed to be more likely than not to be realized and +accordingly the valuation allowances were reversed against the related goodwill +that was recognized at the time of the acquisitions. 97 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 5—Goodwill and Other +Intangible Assets (Continued) Expected +annual amortization expense related to acquired technology is as follows (in +millions): Fiscal Years: 2007 $ 24 2008 21 2009 18 2010 14 2011 13 Thereafter 49 Total $ 139 Amortization expense +related to acquired intangible assets was $12 million, $9 million, and $7 +million in 2006, 2005, and 2004, respectively. Note 6—Restructuring +Charges During 2004, the Company +recorded total restructuring charges of approximately $23.0 million, including +approximately $14.0 million in severance costs, $5.5 million in asset +impairments, and $3.5 million for lease cancellations. The lease cancellations +relate to vacating a leased sales facility from a European workforce reduction +during 2004. Of the $23.0 million charges, $21.3 million had been utilized by +the end of 2006, with the remainder consisting of $1.7 million for lease +cancellations. These actions have resulted in the termination of 452 positions. Note 7—Income Taxes The +provision for income taxes consisted of the following (in millions): 2006 2005 2004 As Restated (1) As Restated (1) Federal: Current $ 619 $ 305 $ 34 Deferred 56 144 53 675 449 87 State: Current 56 66 5 Deferred 14 (91 ) (18 ) 70 (25 ) (13 ) Foreign: Current 101 59 46 Deferred (17 ) (3 ) (16 ) 84 56 30 Provision for income + taxes $ 829 $ 480 $ 104 (1) See +Note 2, “Restatement of Consolidated Financial Statements.” The foreign provision for income taxes is based on +foreign pretax earnings of approximately $1.5 billion, $922 million, and $384 +million in 2006, 2005, and 2004, respectively. As of September 30, 2006, 98 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7—Income +Taxes (Continued) approximately $4.1 billion of the Company’s cash, cash +equivalents, and short-term investments were held by foreign subsidiaries +and are generally based in U.S. dollar-denominated holdings. Amounts held +by foreign subsidiaries are generally subject to U.S. income taxation on +repatriation to the U.S. The Company’s consolidated financial statements +provide for any related tax liability on amounts that may be repatriated, aside +from undistributed earnings of certain of the Company’s foreign subsidiaries +that are intended to be indefinitely reinvested in operations outside the U.S. +U.S. income taxes have not been provided on a cumulative total of $823 million +of such earnings. It is not practicable to determine the income tax liability +that might be incurred if these earnings were to be distributed. On October 22, 2004, the American Jobs Creation +Act of 2004 (“AJCA”) was signed into law. The AJCA included a provision for the +deduction of 85% of certain foreign earnings that were repatriated, as defined +in the AJCA, within a specified time frame. Among other requirements, dividends +qualifying for the 85% deduction must be reinvested in the United States in +certain qualified investments pursuant to a domestic reinvestment plan approved +by the Chief Executive Officer (“CEO”) and Board of Directors. During 2006, the +Company repatriated approximately $1.6 billion of foreign earnings. Of the +earnings repatriated, $755 million is eligible for the reduced tax rate +provided by the AJCA. Accordingly, the Company recorded a tax charge of $51 +million related to the repatriation of foreign earnings under the provisions of +the AJCA. In addition, the Company recorded a tax benefit of $71 million +resulting from the implementation of tax planning strategies to recognize +deferred tax assets that were previously not recognizable within certain +foreign subsidiaries. Deferred tax assets and liabilities reflect the +effects of tax losses, credits, and the future income tax effects of temporary +differences between the consolidated financial statement carrying amounts of +existing assets and liabilities and their respective tax bases and are measured +using enacted tax rates that apply to taxable income in the years in which +those temporary differences are expected to be recovered or settled. As of September 30, +2006 and September 24, 2005, the significant components of the Company’s +deferred tax assets and liabilities were (in millions): 2006 2005 As Restated (1) Deferred tax assets: Accrued liabilities and other reserves $ 485 $ 321 Tax losses and credits 55 262 Basis of capital assets and investments 124 96 Accounts receivable and inventory reserves 45 36 Other 30 17 Total deferred tax assets 739 732 Less valuation + allowance 5 5 Net deferred tax + assets 734 727 Deferred tax + liabilities: Unremitted earnings of subsidiaries 514 557 Total deferred tax liabilities 514 557 Net deferred tax asset $ 220 $ 170 (1) See Note 2, “Restatement +of Consolidated Financial Statements.” 99 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7—Income +Taxes (Continued) As of September 30, 2006, the Company has state +and foreign tax loss and state credit carryforwards, the tax effect of which is +$55 million. Certain of those carryforwards, the tax effect of which is $12 +million, expire between 2016 a nd 2019. A +portion of these carryforwards was acquired from the Company’s previous +acquisitions, the utilization of which is subject to certain limitations +imposed by the Internal Revenue Code. The remaining benefits from tax losses +and credits do not expire. As of September 30, 2006 and September 24, +2005, a valuation allowance of $5 million was recorded against the deferred tax +asset for the benefits of state operating losses that may not be realized. Management +believes it is more likely than not that forecasted income, including income +that may be generated as a result of certain tax planning strategies, together +with the tax effects of the deferred tax liabilities, will be sufficient to +fully recover the remaining deferred tax assets. A +reconciliation of the provision for income taxes, with the amount computed by +applying the statutory federal income tax rate (35% in 2006, 2005, and 2004) to +income before provision for income taxes, is as follows (in millions): 2006 2005 2004 As Restated (1) As Restated (1) Computed expected + tax $ 987 $ 633 $ 129 State taxes, net + of federal effect 86 (19 ) (5 ) Indefinitely + invested earnings of foreign subsidiaries (224 ) (98 ) (31 ) Nondeductible + executive compensation 11 14 12 Research and + development credit, net (12 ) (26 ) (5 ) Other items (19 ) (24 ) 4 Provision for + income taxes $ 829 $ 480 $ 104 Effective tax rate 29 % 27 % 28 % (1) See +Note 2, “Restatement of Consolidated Financial Statements.” The Company’s income taxes +payable has been reduced by the tax benefits from employee stock options. The +Company receives an income tax benefit calculated as the difference between the +fair market value of the stock issued at the time of the exercise and the +option price, tax effected. The net tax benefits from employee stock option +transactions were $419 million, $428 million (as restated(1)), and $83 million +(as restated(1)) in 2006, 2005, and 2004, respectively, and were reflected as +an increase to common stock in the consolidated statements of shareholders’ +equity. 100 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7—Income +Taxes (Continued) The Internal Revenue +Service (“IRS”) has substantially completed its field audit of the Company’s +federal income tax returns for the years 2002 through 2003 and proposed certain +adjustments. The Company intends to contest certain of these adjustments +through the IRS Appeals Office. Substantially all IRS audit issues for years +prior to 2002 have been resolved. In addition, the Company is also subject to +audits by state, local, and foreign tax authorities. Management believes that +adequate provisions have been made for any adjustments that may result from tax +examinations. However, the outcome of tax audits cannot be predicted with +certainty. Should any issues addressed in the Company’s tax audits be resolved +in a manner not consistent with management’s expectations, the Company could be +required to adjust its provision for income tax in the period such resolution +occurs. In 2006, the Company recorded a tax benefit of $20 million due to +the settlement of prior year tax audits in the U.S. Note 8—Shareholders’ +Equity Preferred Stock The Company has five +million shares of authorized preferred stock, none of which is outstanding. +Under the terms of the Company’s Restated Articles of Incorporation, the Board +of Directors is authorized to determine or alter the rights, preferences, +privileges, and restrictions of the Company’s authorized but unissued shares of +preferred stock. Restricted Stock Units The Company’s Board of Directors has granted +restricted stock units to members of the Company’s senior management team, +excluding its CEO. These restricted stock units generally vest over four years +either at the end of the four-year service period, in two equal installments on +the second and fourth anniversaries of the date of grant, or in equal +installments on each of the first through fourth anniversaries of the grant +date. Upon vesting, the restricted stock units will convert into an equivalent +number of shares of common stock. The amounts of the restricted stock units +expensed by the Company are based on the closing market price of the Company’s +common stock on the date of grant and are amortized on a straight-line basis +over the four-year requisite service period. The restricted stock units have +been reflected in the calculation of diluted earnings per share utilizing the +treasury stock method. 2.47 million previously +granted restricted stock units vested during 2006. A majority of these vested +restricted stock units were net-share settled such that the Company withheld +shares with value equivalent to the employees’ minimum statutory obligation for +the applicable income and other employment taxes, and remitted the cash to the +appropriate taxing authorities. The total shares withheld of 985,833 for 2006 +was based on the value of the restricted stock units on their vesting date as +determined by the Company’s closing stock price. Total payments for the +employees’ tax obligations to the taxing authorities were approximately $59 million. +These net-share settlements had the effect of share repurchases by the Company +as they reduced and retired the number of shares that would have otherwise been +issued as a result of the vesting and did not represent an expense to the +Company. CEO Restricted Stock Award On March 19, 2003, +the Company’s Board of Directors granted 10 million shares of restricted stock +to the Company’s CEO that vested on March 19, 2006. The amount of the +restricted stock award expensed by the Company was based on the closing market +price of the Company’s common stock on the date of grant and was amortized on a +straight-line basis over the three-year requisite service period. 101 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Shareholders’ +Equity (Continued) Upon vesting during 2006, +the restricted stock award was net-share settled such that the Company withheld +shares with value equivalent to the CEO’s minimum statutory obligation for the +applicable income and other employment taxes, and remitted the cash to the +appropriate taxing authorities. The total shares withheld of 4.6 million was +based on the value of the restricted stock award on the vesting date as +determined by the Company’s closing stock price of $64.66. The remaining shares +net of those withheld were delivered to the Company’s CEO. Total payments for +the CEO’s tax obligations to the taxing authorities were approximately $296 +million. The net-share settlement had the effect of share repurchases by the +Company as it reduced and retired the number of shares outstanding and did not +represent an expense to the Company. Stock Repurchase Plan In July 1999, the +Company’s Board of Directors authorized a plan for the Company to repurchase up +to $500 million of its common stock. This repurchase plan does not obligate the +Company to acquire any specific number of shares or acquire shares over any +specified period of time. The Company has repurchased a total of 13.1 million +shares at a cost of $217 million under this plan and was authorized to +repurchase up to an additional $283 million of its common stock as of September 30, +2006. Comprehensive Income Comprehensive income consists of two components: net +income and other comprehensive income. Other comprehensive income refers to +revenue, expenses, gains, and losses that under U.S. generally accepted +accounting principles are recorded as an element of shareholders’ equity but +are excluded from net income. The Company’s other comprehensive income consists +of foreign currency translation adjustments from those subsidiaries not using +the U.S. dollar as their functional currency, unrealized gains and losses on +marketable securities categorized as available-for-sale, and net deferred gains +and losses on certain derivative instruments accounted for as cash flow hedges. The +following table summarizes the components of accumulated other comprehensive +income (loss), net of taxes (in millions): 2006 2005 2004 Unrealized losses + on available-for-sale securities $ — $ (4 ) $ (4 ) Unrealized + gains/(losses) on derivative investments 3 4 (4 ) Cumulative + foreign currency translation 19 — (7 ) Accumulated other + comprehensive income/(loss) $ 22 $ — $ (15 ) The following table +summarizes activity in other comprehensive income related to available-for-sale +securities, net of taxes (in millions): 2006 2005 2004 Change in fair + value of available-for-sale securities $ 4 $ — $ (1 ) Adjustment for + net gains/losses realized and included in net income — — (4 ) Change in unrealized + gain/loss on available-for-sale securities $ 4 $ — $ (5 ) The tax effect related to +the change in unrealized gain/loss on available-for-sale securities was $(2) million, +zero, and $4 million for 2006, 2005, and 2004, respectively. The tax effect on +the reclassification adjustment for net gains/losses realized and included in +net income was $1 million for 2004. 102 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Shareholders’ +Equity (Continued) The following table +summarizes activity in other comprehensive income related to derivatives, net +of taxes, held by the Company (in millions): 2006 2005 2004 Changes in fair + value of derivatives $ 11 $ 7 $ (21 ) Adjustment for + net losses realized and included in net income (12 ) 1 33 Change in unrealized + gain/loss on derivative instruments $ (1 ) $ 8 $ 12 The tax effect related to +the changes in fair value of derivatives was $(8) million, $(3) million, +and $10 million for 2006, 2005, and 2004, respectively. The tax effect +related to derivative gains/losses reclassified from other comprehensive income +to net income was $8 million, $(2) million, and $(13) million for 2006, +2005, and 2004, respectively. Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock +Plan (the “2003 Plan”) is a shareholder approved plan that provides for +broad-based grants to employees, including executive officers. Based on the +terms of individual option grants, options granted under the 2003 Plan +generally expire 7 to 10 years after the grant date and generally become +exercisable over a period of 4 years, based on continued employment, with +either annual or quarterly vesting. The 2003 Plan permits the granting of +incentive stock options, nonstatutory stock options, restricted stock units, +stock appreciation rights, and stock purchase rights. 1997 Employee Stock Option Plan In August 1997, the +Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the “1997 +Plan”), a non-shareholder approved plan for grants of stock options to employees +who are not officers of the Company. Based on the terms of individual option +grants, options granted under the 1997 Plan generally expire 7 to 10 years +after the grant date and generally become exercisable over a period of 4 years, +based on continued employment, with either annual or quarterly vesting. In October 2003, +the Company terminated the 1997 Employee Stock Option Plan and cancelled all +remaining unissued shares totaling 28,590,702. No new options can be granted +from the 1997 Plan. Employee Stock Option Exchange Program On March 20, 2003, +the Company announced a voluntary employee stock option exchange program (the “Exchange +Program”) whereby eligible employees, other than executive officers and members +of the Board of Directors, had an opportunity to exchange outstanding options +with exercise prices at or above $12.50 per share for a predetermined smaller +number of new stock options issued with exercise prices equal to the fair +market value of one share of the Company’s common stock on the day the new +awards were issued, which was to be at least six months plus one day after the +exchange options were cancelled. On April 17, 2003, in accordance with the +Exchange Program, the Company cancelled options to purchase 33,138,386 shares +of its common stock. On October 22, 2003, new stock options totaling +13,394,736 shares were issued to employees at an exercise price of $11.38 per +share, which is equivalent to the closing price of the Company’s stock on that +date. No financial or accounting impact to the Company’s financial position, +results of operations or cash flows was associated with this transaction. 103 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Shareholders’ Equity (Continued) 1997 Director Stock Option Plan In August 1997, the +Company’s Board of Directors adopted a Director Stock Option Plan (“Director +Plan”) for non-employee directors of the Company, which was approved by +shareholders in 1998. Pursuant to the +Director Plan, the Company’s non-employee directors are granted an option to +acquire 30,000 shares of Common Stock upon their initial election to the Board +(“Initial Options ” ). The Initial Options vest and +become exercisable in three equal annual installments on each of the first +through third anniversaries of the grant date. On the fourth anniversary of a +non-employee director’s initial election to the Board and on each subsequent +anniversary thereafter, the director will be entitled to receive an option to +acquire 10,000 shares of Common Stock (“Annual Options”). Annual Options are +fully vested and immediately exercisable on their date of grant. Rule 10b5-1 Trading Plans Certain of the Company’s +executive officers, including Mr. Timothy D. Cook, Mr. Peter +Oppenheimer, Mr. Philip W. Schiller, and Dr. Bertrand Serlet, have +entered into trading plans pursuant to Rule 10b5-1(c)(1) of the +Securities Exchange Act of 1934, as amended. A trading plan is a written +document that pre-establishes the amounts, prices and dates (or formula for +determining the amounts, prices and dates) of future purchases or sales of the +Company’s stock including the exercise and sale of employee stock options and +shares acquired pursuant to the Company’s employee stock purchase plan and upon +vesting of restricted stock units. Employee Stock Purchase Plan The Company has a +shareholder approved employee stock purchase plan (the “Purchase Plan”), under +which substantially all employees may purchase common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values as of +the beginning and end of six month offering periods. Stock purchases under the +Purchase Plan are limited to 10% of an employee’s compensation, up to a maximum +of $25,000 in any calendar year. The number of shares authorized for issuance +is limited to a total of 1 million shares per offering period. During 2006, +2005, and 2004, adjusted for the February 2005 stock split, 1.5 million, +2.3 million, and 3.9 million shares, respectively, were issued under the +Purchase Plan. As of September 30, 2006, approximately 2.3 million shares +were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an employee savings plan (the “Savings +Plan”) qualifying as a deferred salary arrangement under +Section 401(k) of the Internal Revenue Code. Under the Savings Plan, +participating U.S. employees may defer a portion of their pre-tax earnings, up +to the Internal Revenue Service annual contribution limit ($15,000 for calendar +year 2006). The Company matches 50% to 100% of each employee’s contributions, +depending on length of service, up to a maximum 6% of the employee’s earnings. +The Company’s matching contributions to the Savings Plan were approximately $33 +million, $28 million, and $24 million in 2006, 2005, and 2004, +respectively. 104 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Shareholders' +Equity (Continued) Stock Option Activity A +summary of the Company’s stock option activity and related information for the +last three fiscal years follows (stock award amounts and aggregate intrinsic +value are presented in thousands): Outstanding Options Shares Available Number of Weighted-Average Weighted-Average Remaining Aggregate for Grant Shares Exercise Price Contractual Term Intrinsic Value Balance at + September 27, 2003 91,660 126,024 $ 9.54 Restricted Stock Granted (5,030 ) — — Options Granted (36,394 ) 36,394 $ 11.48 Options Cancelled 6,010 (6,010 ) $ 10.35 Options Exercised — (45,686 ) $ 8.60 Plan Shares Expired (32,196 ) — — Balance at + September 25, 2004 24,050 110,722 $ 10.52 Additional Options + Authorized 49,000 — — Restricted Stock Units + Granted (460 ) — — Options Granted (16,214 ) 16,214 $ 42.52 Options Cancelled 3,844 (3,844 ) $ 13.28 Restricted Stock Units + Cancelled 230 — — Options Exercised — (49,871 ) $ 10.05 Plan Shares Expired (1,493 ) — — Balance at + September 24, 2005 58,957 73,221 $ 17.79 Restricted Stock Units + Granted (2,950 ) — Options Granted (3,881 ) 3,881 $ 65.28 Options Cancelled 2,325 (2,325 ) $ 29.32 Restricted Stock Units + Cancelled 625 — — Options Exercised — (21,795 ) $ 11.78 Plan Shares Expired (82 ) — — Balance at + September 30, 2006 54,994 52,982 $ 23.23 4.78 $ 2,848,896 Exercisable at + September 30, 2006 31,184 $ 14.69 4.35 $ 1,942,486 Expected to Vest + after September 30, 2006 21,798 $ 35.40 5.40 $ 906,410 In conjunction with the amendments to the 2003 Plan +that were approved at the Annual Meeting of Shareholders held on April 21, +2005, the number of shares available for grant under the 2003 Plan will be +reduced by two times the number of restricted shares and restricted stock units +granted. This amendment is effective for all grants made after April 21, +2005. Aggregate intrinsic value represents the value of the +Company’s closing stock price on the last trading day of the fiscal period in +excess of the exercise price multiplied by the number of options outstanding or +exercisable. Total intrinsic value of options at time of exercise was $1.2 +billion, $1.1 billion, and $266.9 million for 2006, 2005, and 2004, +respectively. As of September 30, 2006, the Company had 3.41 +million restricted stock units outstanding with a total grant-date fair value +of $135.1 million that were excluded from the options outstanding balances in +the preceding table. The weighted-average grant date fair value of restricted +stock units granted during 2006, 2005, and 2004 was $70.92, $45.04, and $12.81, +respectively. Aggregate intrinsic value of unvested restricted stock units at September 30, +2006 was $262.5 million. Restricted stock units that vested during 2006 totaled +2.47 million and had a fair value of $148.5 million as of the vesting date. Granted +restricted stock units have been deducted from the shares available for grant +under the Company’s stock option plans. 105 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Shareholders' +Equity (Continued) The number of shares of restricted +stock that vested during 2006 was 10 million, which had a fair value of $646.6 +million. The grant-date fair value of restricted stock that fully vested during +2006 was $7.48 per share. For the years ended September 30, 2006, September 24, +2005, and September 25, 2004, compensation expense related to restricted +stock was $4.6 million, $24.9 million, and $24.9 million, respectively. Note 9—Stock-Based +Compensation The Company has provided pro forma disclosures in Note +1 of these Notes to Consolidated Financial Statements of the effect on net +income and earnings per share for the years ended September 24, 2005 and September 25, +2004 as if the fair value method of accounting for stock compensation had been +used for its employee stock option grants and employee stock purchase plan +purchases. These pro forma effects have been estimated at the date of grant and +beginning of the period, respectively, using the BSM option pricing model. The +weighted average assumptions used for 2006, 2005, and 2004 and the resulting estimates +of weighted-average fair value per share of options granted and for stock +purchases during those periods are as follows: 2006 2005 2004 Expected life of + stock options 3.56 years 3.57 years 3.50 years Expected life of + stock purchases 6 months 6 months 6 months Interest + rate—stock options 4.60 % 3.73 % 2.40 % Interest + rate—stock purchases 4.29 % 2.54 % 1.18 % Volatility—stock + options 40.34 % 39.52 % 40.00 % Volatility—stock + purchases 39.56 % 40.88 % 35.82 % Dividend yields — — — Weighted-average + fair value of options granted during the year $ 23.16 $ 14.41 $ 3.69 Weighted-average fair + value of stock purchases during the year $ 14.06 $ 7.55 $ 2.78 Pursuant to SFAS No. 123R, +the expected volatility assumptions used by the Company are based on the +historical volatility of the Company’s common stock over the most recent period +commensurate with the estimated expected life of the Company’s stock options +and other relevant factors including implied volatility in market traded +options on the Company’s common stock. The Company bases its expected life +assumption on its historical experience and on the terms and conditions of the +stock options it grants to employees. Note 10—Commitments and +Contingencies Lease Commitments The Company leases various equipment and facilities, +including retail space, under noncancelable operating lease arrangements. The +Company does not currently utilize any other off-balance-sheet financing +arrangements. The major facility leases are for terms of 5 to 15 years and +generally provide 106 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10—Commitments +and Contingencies (Continued) renewal options for +terms of 3 to 5 additional years. Leases for retail space are for terms of 5 to +20 years, the majority of which are for 10 years, and often contain multi-year +renewal options. As of September 30, 2006, the Company’s total future +minimum lease payments under noncancelable operating leases were approximately +$1.2 billion, of which $887 million related to leases for retail space. Rent +expense under all operating leases, including both cancelable and noncancelable +leases, was $138 million, $140 million, and $103 million in 2006, 2005, and +2004, respectively. Future minimum lease payments under noncancelable operating +leases having remaining terms in excess of one year as of September 30, +2006, are as follows (in millions): Fiscal Years 2007 $ 134 2008 134 2009 134 2010 132 2011 122 Thereafter 498 Total minimum lease + payments $ 1,154 Accrued Warranty +and Indemnifications The Company offers a basic limited parts and labor +warranty on its hardware products. The basic warranty period for hardware +products is typically one year from the date of purchase by the end-user. The +Company also offers a 90-day basic warranty for its service parts used to +repair the Company’s hardware products. The Company provides currently for the +estimated cost that may be incurred under its basic limited product warranties +at the time related revenue is recognized. Factors considered in determining +appropriate accruals for product warranty obligations include the size of the +installed base of products subject to warranty protection, historical and +projected warranty claim rates, historical and projected cost-per-claim, and +knowledge of specific product failures that are outside of the Company’s +typical experience. The Company assesses the adequacy of its preexisting +warranty liabilities and adjusts the amounts as necessary based on actual +experience and changes in future estimates. The Company periodically provides updates to its +applications and system software to maintain the software’s compliance with +specifications. The estimated cost to develop such updates is accounted for as +warranty costs that are recognized at the time related software revenue is +recognized. Factors considered in determining appropriate accruals related to +such updates include the number of units delivered, the number of updates +expected to occur, and the historical cost and estimated future cost of the +resources necessary to develop these updates. The +following table reconciles changes in the Company’s accrued warranties and +related costs (in millions): 2006 2005 2004 Beginning accrued + warranty and related costs $ 188 $ 105 $ 67 Cost of warranty + claims (267 ) (188 ) (105 ) Accruals for + product warranties 363 271 143 Ending accrued warranty + and related costs $ 284 $ 188 $ 105 107 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10—Commitments +and Contingencies (Continued) The +Company generally does not indemnify end-users of its operating system and +application software against legal claims that the software infringes +third-party intellectual property rights. Other agreements entered into by the +Company sometimes include indemnification provisions under which the Company +could be subject to costs and/or damages in the event of an infringement claim +against the Company or an indemnified third-party. However, the Company has not +been required to make any significant payments resulting from such an +infringement claim asserted against itself or an indemnified third-party and, +in the opinion of management, does not have a potential liability related to +unresolved infringement claims subject to indemnification that would have a +material adverse effect on its financial condition, liquidity or results of +operations. Therefore, the Company did not record a liability for infringement +costs as of either September 30, 2006 or September 24, 2005. Concentrations in +the Available Sources of Supply of Materials and Product Although most components +essential to the Company’s business are generally available from multiple +sources, other key components (including microprocessors and application-specific +integrated circuits (“ASICs”)) are currently obtained by the Company from +single or limited sources. Some other key components, while currently available +to the Company from multiple sources, are at times subject to industry-wide +availability and pricing pressures. In addition, the Company uses some +components that are not common to the rest of the personal computer industry, +and new products introduced by the Company often initially utilize custom +components obtained from only one source until the Company has evaluated +whether there is a need for and subsequently qualifies additional suppliers. If +the supply of a key single-sourced component to the Company were to be +delayed or curtailed, or in the event a key manufacturing vendor delays +shipments of completed products to the Company, the Company’s ability to ship +related products in desired quantities and in a timely manner could be adversely +affected. The Company’s business and financial performance could also be +adversely affected depending on the time required to obtain sufficient +quantities from the original source, or to identify and obtain sufficient +quantities from an alternative source. Continued availability of these +components may be affected if producers were to decide to concentrate on the +production of common components instead of components customized to meet the +Company’s requirements. Finally, significant portions of the Company’s CPUs, +logic boards, and assembled products are now manufactured by outsourcing +partners, primarily in various parts of Asia. Although the Company works +closely with its outsourcing partners on manufacturing schedules, the Company’s +operating results could be adversely affected if its outsourcing partners were +unable to meet their production obligations. Long-Term Supply +Agreements During 2006, the Company +entered into long-term supply agreements with Hynix Semiconductor, Inc., +Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., +and Toshiba Corporation to secure supply of NAND flash memory through calendar +year 2010. As part of these agreements, the Company prepaid $1.25 billion for +flash memory components during 2006. These prepayments will be applied to +inventory purchases made over the life of each respective agreement. Contingencies The Company is subject to certain other legal +proceedings and claims that have arisen in the ordinary course of business and +have not been fully adjudicated. In the opinion of management, the Company does +not have a potential liability related to any current legal proceedings and +claims that would individually or in the aggregate have a material adverse +effect on its financial condition, liquidity, or results of operations. 108 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 10—Commitments +and Contingencies (Continued) However, the results of legal proceedings cannot be +predicted with certainty. Should the Company fail to prevail in any of these +legal matters or should several of these legal matters be resolved against the +Company in the same reporting period, the operating results of a particular +reporting period could be materially adversely affected. Production and marketing +of products in certain states and countries may subject the Company to +environmental and other regulations including, in some instances, the +requirement to provide customers the ability to return product at the end of +its useful life, and place responsibility for environmentally safe disposal or +recycling with the Company. Such laws and regulations have recently been passed +in several jurisdictions in which the Company operates including various +European Union member countries, Japan and certain states within the U.S. Although +the Company does not anticipate any material adverse effects in the future +based on the nature of its operations and the thrust of such laws, there is no +assurance that such existing laws or future laws will not have a material +adverse effect on the Company’s financial condition, liquidity, or results of +operations. Note 11—Segment +Information and Geographic Data In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , +the Company reports segment information based on the “management” approach. The +management approach designates the internal reporting used by management for +making decisions and assessing performance as the source of the Company’s +reportable segments. The Company manages its business primarily on a geographic +basis. The Company’s reportable operating segments are comprised of the +Americas, Europe, Japan, and Retail. The Americas, Europe, and Japan reportable +segments do not include activities related to the Retail segment. The Americas +segment includes both North and South America. The Europe segment includes +European countries as well as the Middle East and Africa. The Retail segment +operates Apple-owned retail stores in the U.S., Canada, Japan, and the U.K. Other +operating segments include Asia-Pacific, which includes Australia and Asia +except for Japan, and the Company’s subsidiary, FileMaker, Inc. Each +reportable geographic operating segment provides similar hardware and software +products and similar services, and the accounting policies of the various +segments are the same as those described in Note 1, “Summary of Significant +Accounting Policies,” except as described below for the Retail segment. The Company evaluates the performance of its operating +segments based on net sales. The Retail segment’s performance is also evaluated +based on operating income. Net sales for geographic segments are generally +based on the location of the customers. Operating income for each segment +includes net sales to third parties, related cost of sales, and operating expenses +directly attributable to the segment. Operating income for each segment +excludes other income and expense and certain expenses that are managed outside +the operating segments. Costs excluded from segment operating income include +various corporate expenses such as manufacturing costs and variances not +included in standard costs, research and development, corporate marketing +expenses, stock-based compensation expense, income taxes, various nonrecurring +charges, and other separately managed general and administrative expenses +including certain corporate expenses associated with support of the Retail +segment. The Company does not include intercompany transfers between segments +for management reporting purposes. Segment assets exclude corporate assets. +Corporate assets include cash, short-term and long-term investments, +manufacturing facilities, miscellaneous corporate infrastructure, goodwill and +other acquired intangible assets, and retail store construction-in-progress +that is not subject to depreciation. Except for the Retail segment, capital 109 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) expenditures for long-lived assets are not reported to +management by segment. Capital expenditures by the Retail segment were $200 +million, $132 million, and $104 million for 2006, 2005, and 2004, +respectively.Operating income for all segments, except Retail, includes cost of +sales at manufacturing standard cost, other cost of sales, related sales and +marketing costs, and certain general and administrative costs. This measure of +operating income, which includes manufacturing profit, provides a comparable +basis for comparison between the Company’s various geographic segments. Certain +manufacturing expenses and related adjustments not included in segment cost of +sales, including variances between standard and actual manufacturing costs and +the mark-up above standard cost for product supplied to the Retail segment, are +included in corporate expenses. Management assesses the operating performance of the +Retail segment differently than it assesses the operating performance of the +Company’s geographic segments. The Retail segment revenue and operating income +is intended to depict a measure comparable to that of the Company’s major +channel partners in the U.S. operating retail stores so the Company can +evaluate the Retail segment performance as if it were a channel partner. +Therefore, the Company makes three significant adjustments to the Retail +segment for management reporting purposes that are not included in the results +of the Company’s other segments. First, the Retail segment’s operating income includes +cost of sales for Apple products at an amount normally charged to major channel +partners in the U.S. operating retail stores, less the cost of sales programs +and incentives provided to those channel partners and the Company’s cost to +support those partners. For the years ended September 30, 2006, September 24, +2005, and September 25, 2004, this resulted in the recognition of +additional cost of sales above standard cost by the Retail segment and an +offsetting benefit to corporate expenses of approximately $663 million, $435 +million, and $213 million, respectively. Second, the Company’s service and support contracts +are transferred to the Retail segment at the same cost as that charged to the +Company’s major retail channel partners in the U.S., resulting in a measure of +revenue and gross margin for those items that is comparable between the Company’s +retail stores and those retail channel partners. The Retail segment recognizes +the full amount of revenue and cost of sales of the Company’s service and +support contracts at the time of sale. Because the Company has not yet earned +the revenue or incurred the costs associated with the sale of these contracts, +an offset to these amounts is recognized in other operating segments’ net sales +and cost of sales. For the year ended September 30, 2006, this resulted in +the recognition of net sales and cost of sales by the Retail segment, with +corresponding offsets in other operating segments, of $159 million and $109 +million, respectively. For the year ended September 24, 2005, this +resulted in the recognition of net sales and cost of sales by the Retail +segment of $92 million and $64 million, respectively. For the year ended September 25, +2004, this resulted in the recognition of net sales and cost of sales by the +Retail segment of $54 million and $37 million, respectively. Third, the Company had opened a total of eight +high-profile stores as of September 30, 2006. These high-profile stores +are larger than the Company’s typical retail stores and were designed to +further promote brand awareness and provide a venue for certain corporate sales +and marketing activities, including corporate briefings. As such, the Company +allocates certain operating expenses associated with these stores to corporate +marketing expense to reflect the estimated benefit realized Company-wide. The +allocation of these operating costs is based on the amount incurred for a high-profile +store in excess of that incurred by a more typical Company retail location. +Expenses allocated to corporate marketing resulting 110 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) from the operations +of these stores were $33 million, $31 million, and $16 million for the years +ended September 30, 2006, September 24, 2005, and September 25, +2004, respectively.Summary information by operating segment follows (in +millions): 2006 2005 2004 Americas: Net sales $ 9,307 $ 6,590 $ 4,019 Operating income $ 1,665 $ 798 $ 465 Depreciation, amortization, and accretion $ 6 $ 6 $ 6 Segment assets (a) $ 896 $ 705 $ 563 Europe: Net sales $ 4,094 $ 3,073 $ 1,799 Operating income $ 607 $ 454 $ 280 Depreciation, amortization, and accretion $ 4 $ 4 $ 4 Segment assets $ 471 $ 289 $ 259 Japan: Net sales $ 1,208 $ 920 $ 677 Operating income $ 201 $ 140 $ 115 Depreciation, amortization, and accretion $ 3 $ 3 $ 2 Segment assets $ 181 $ 165 $ 114 Retail: Net sales $ 3,359 $ 2,350 $ 1,185 Operating income $ 198 $ 151 $ 39 Depreciation, amortization, and accretion (b) $ 59 $ 43 $ 35 Segment assets (b) $ 651 $ 589 $ 351 Other Segments (c): Net sales $ 1,347 $ 998 $ 599 Operating income $ 235 $ 118 $ 90 Depreciation, amortization, and accretion $ 3 $ 2 $ 2 Segment assets $ 180 $ 133 $ 124 (a) The Americas asset +figures do not include fixed assets held in the U.S. Such fixed assets are not +allocated specifically to the Americas segment and are included in the +corporate assets figures below. (b) Retail segment +depreciation and asset figures reflect the cost and related depreciation of its +retail stores and related infrastructure. Retail store +construction-in-progress, which is not subject to depreciation, is reflected in +corporate assets. (c) Other Segments include +Asia-Pacific and FileMaker. 111 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) A +reconciliation of the Company’s segment operating income and assets to the +consolidated financial statements follows (in millions): 2006 2005 2004 As Restated (1) As Restated (1) Segment operating + income $ 2,906 $ 1,661 $ 989 Retail + manufacturing margin (a) 663 435 213 Other corporate + expenses, net (b) (953 ) (404 ) (820 ) Stock-based + compensation expense (163 ) (49 ) (46 ) Restructuring + costs — — (23 ) Consolidated operating income $ 2,453 $ 1,643 $ 313 Segment assets $ 2,379 $ 1,881 $ 1,411 Corporate assets 14,826 9,635 6,628 Consolidated assets $ 17,205 $ 11,516 $ 8,039 Segment depreciation, amortization, and accretion $ 75 $ 58 $ 49 Corporate + depreciation, amortization, and accretion 150 121 101 Consolidated + depreciation, amortization, and accretion $ 225 $ 179 $ 150 (1) See Note 2, “Restatement +of Consolidated Financial Statements.” (a) Represents the excess of +the Retail segment’s cost of sales over the Company’s standard cost of sales +for products sold through the Retail segment. (b) Corporate expenses +include research and development, corporate marketing expenses, manufacturing +costs and variances not included in standard costs, and other separately +managed general and administrative expenses including certain corporate +expenses associated with support of the Retail segment. No +single customer accounted for more than 10% of net sales in 2006, 2005, or 2004. +Net sales and long-lived assets related to operations in the U.S., Japan, and +other foreign countries are as follows (in millions): 2006 2005 2004 Net sales: U.S. $ 11,486 $ 8,194 $ 4,893 Japan 1,327 1,021 738 Other countries 6,502 4,716 2,648 Total net sales $ 19,315 $ 13,931 $ 8,279 Long-lived + assets: U.S. $ 1,150 $ 738 $ 637 Japan 64 63 52 Other countries 154 112 72 Total long-lived + assets $ 1,368 $ 913 $ 761 112 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Segment +Information and Geographic Data (Continued) Information regarding net +sales by product is as follows (in millions): 2006 2005 2004 Net sales: Desktops (a) $ 3,319 $ 3,436 $ 2,373 Portables (b) 4,056 2,839 2,550 Total Macintosh net sales 7,375 6,275 4,923 iPod 7,676 4,540 1,306 Other music + related products and services (c) 1,885 899 278 Peripherals and + other hardware (d) 1,100 1,126 951 Software, + service, and other net sales (e) 1,279 1,091 821 Total net sales $ 19,315 $ 13,931 $ 8,279 (a) Includes iMac, eMac, Mac +mini, Power Mac, Mac Pro, and Xserve product lines. (b) Includes MacBook, iBook, +MacBook Pro, and PowerBook product lines. (c) Consists of iTunes Store +sales and iPod services, and Apple-branded and third-party iPod accessories. (d) Includes sales of +Apple-branded and third-party displays, wireless connectivity and networking +solutions, and other hardware accessories. (e) Includes +sales of Apple-branded operating system and application software, third-party +software, AppleCare, and Internet services. Note 12—Related Party +Transactions and Certain Other Transactions In March 2002, the Company entered into a +Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of +expenses incurred by Mr. Jobs in the operation of his private plane when +used for Company business. The Reimbursement Agreement became effective for +expenses incurred by Mr. Jobs for Company business purposes since he took +delivery of the plane in May 2001. The Company recognized a total of +$202,000, $1,100,000, and $483,000 in expenses pursuant to the Reimbursement +Agreement during 2006, 2005, and 2004, respectively. All expenses recognized +pursuant to the Reimbursement Agreement have been included in selling, general, +and administrative expenses in the consolidated statements of operations. In 2006, the Company +entered into an agreement with Pixar to sell certain of Pixar’s short films on +the iTunes Store. Mr. Jobs was the CEO, Chairman, and a large shareholder +of Pixar. On May 5, 2006, The Walt Disney Company (“Disney”) acquired +Pixar, which resulted in Pixar becoming a wholly-owned subsidiary of Disney. +Upon Disney’s acquisition of Pixar, Mr. Jobs’ shares of Pixar common stock +were exchanged for Disney’s common stock and he was elected to the Disney Board +of Directors. Royalty expense recognized by the Company under the arrangement +with Pixar from September 25, 2005 through May 5, 2006 was less than +$1 million. 113 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note +13—Selected Quarterly Financial Information (Unaudited) The +following tables set forth a summary of the Company’s quarterly financial +information for each of the four quarters ended September 30, 2006 and September 24, +2005 (in millions, except share and per share amounts): 2006 Fourth Quarter Third Quarter Second Quarter First Quarter Net sales $ 4,837 $ 4,370 $ 4,359 $ 5,749 Cost of sales (1) 3,425 3,045 3,062 4,185 Gross margin 1,412 1,325 1,297 1,564 Operating + expenses: Research and development (1) 179 175 176 182 Selling, general, and administrative (1) 625 584 592 632 Total operating expenses 804 759 768 814 Operating income 608 566 529 750 Other income and + expense 113 95 76 81 Income before + provision for income taxes 721 661 605 831 Provision for + income taxes 179 189 195 266 Net income $ 542 $ 472 $ 410 $ 565 Earnings per common share: Basic $ 0.63 $ 0.55 $ 0.49 $ 0.68 Diluted $ 0.62 $ 0.54 $ 0.47 $ 0.65 Shares used in + computing earnings per share (in thousands): Basic 854,187 851,375 840,910 830,781 Diluted 878,757 876,368 878,537 874,207 (1) Includes stock-based +compensation expense, which was allocated as follows: Cost of sales $ 5 $ 6 $ 5 $ 5 Research and + development $ 13 $ 12 $ 13 $ 15 Selling, general, and + administrative $ 22 $ 19 $ 24 $ 24 The net of tax impact of the stock-based compensation +adjustments in 2006, which amounted to $4 million, was recorded by the Company +in its fourth quarter of 2006 and is described in Note 2, “Restatement of +Consolidated Financial Statements.” Basic and diluted earnings per share are computed +independently for each of the quarters presented. Therefore, the sum of +quarterly basic and diluted per share information may not equal annual basic +and diluted earnings per share. Net income during the third quarter of 2006 benefited +by $20 million resulting from the dividend repatriation under the AJCA and +international tax planning strategies associated with the repatriation. Net 114 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 13—Selected +Quarterly Financial Information (Unaudited) (Continued) income during the fourth +quarter of 2006 benefited by $20 million due to the settlement of prior year +tax audits in the U.S. 2005 Fourth Quarter Third Quarter Second Quarter First Quarter As Restated (1) As Restated (1) As Restated (1) As Restated (1) Net sales $ 3,678 $ 3,520 $ 3,243 $ 3,490 Cost of sales (2) 2,643 2,476 2,275 2,495 Gross margin 1,035 1,044 968 995 Operating + expenses: Research and development (2) 147 145 120 123 Selling, general, and administrative (2) 471 473 448 472 Total operating expenses 618 618 568 595 Operating income 417 426 400 400 Other income and + expense 60 46 33 26 Income before + provision for income taxes 477 472 433 426 Provision for + income taxes 49 153 145 133 Net income $ 428 $ 319 $ 288 $ 293 Earnings per common share: Basic $ 0.52 $ 0.39 $ 0.36 $ 0.37 Diluted $ 0.49 $ 0.37 $ 0.34 $ 0.35 Shares used in + computing earnings per share (in thousands): Basic 821,420 815,092 808,172 789,032 Diluted 866,483 860,803 857,568 838,805 (1) See +Note 2, “Restatement of Consolidated Financial Statements.” (2) Includes +stock-based compensation expense, which was allocated as follows: Cost of sales $ 1 $ — $ 1 $ 1 Research and + development $ 1 $ 2 $ 2 $ 2 Selling, general, and + administrative $ 10 $ 10 $ 9 $ 10 The impact of the stock-based compensation adjustments +was not significant to any of the interim balance sheets for fiscal year 2005. Basic and diluted earnings per share are computed +independently for each of the quarters presented. Therefore, the sum of +quarterly basic and diluted per share information may not equal annual basic +and diluted earnings per share. Net income during the fourth quarter of 2005 benefited +by $81 million from the reversal of certain tax contingency reserves and +adjustments to net deferred tax assets, including reductions to valuation +allowances. 115 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 13—Selected +Quarterly Financial Information (Unaudited) (Continued) The following tables +present the effects of adjustments made to the Company’s previously reported +quarterly financial information as of September 24, 2005 (in millions, +expect per share amounts): Three Months Ended September 24, 2005 Three Months Ended June 25, 2005 As Reported Adjustments (1) As Restated As Reported Adjustments (1) As Restated Net sales $ 3,678 $ — $ 3,678 $ 3,520 $ — $ 3,520 Cost of sales (2) 2,643 — 2,643 2,476 — 2,476 Gross margin 1,035 — 1,035 1,044 — 1,044 Operating + expenses: Research and development (2) 147 — 147 145 — 145 Selling, general, and administrative (2) 470 1 471 472 1 473 Total operating expenses 617 1 618 617 1 618 Operating income 418 (1 ) 417 427 (1 ) 426 Other income and expense 60 — 60 46 — 46 Income before + provision for income taxes 478 (1 ) 477 473 (1 ) 472 Provision for + income taxes 48 1 49 153 — 153 Net income $ 430 $ (2 ) $ 428 $ 320 $ (1 ) $ 319 Earnings per common share: Basic $ 0.52 $ — $ 0.52 $ 0.39 $ — $ 0.39 Diluted $ 0.50 $ (0.01 ) $ 0.49 $ 0.37 $ — $ 0.37 Shares used in + computing earnings per  share (in thousands): Basic 821,420 — 821,420 815,092 — 815,092 Diluted 866,404 79 866,483 860,688 115 860,803 (1) See Note 2, “Restatement of Consolidated +Financial Statements.” (2) Includes stock-based compensation expense, +which was allocated as follows: Cost of sales $ 1 $ — $ 1 $ — $ — $ — Research and + development $ 1 $ — $ 1 $ 2 $ — $ 2 Selling, general, and administrative $ 9 $ 1 $ 10 $ 9 $ 1 $ 10 116 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 13—Selected +Quarterly Financial Information (Unaudited) (Continued) Three Months Ended March 26, 2005 Three Months Ended December 25, 2004 As Reported Adjustments (1) As Restated As Reported Adjustments (1) As Restated Net sales $ 3,243 $ — $ 3,243 $ 3,490 $ — $ 3,490 Cost of sales (2) 2,275 — 2,275 2,494 1 2,495 Gross margin 968 — 968 996 (1 ) 995 Operating + expenses: Research and development (2) 119 1 120 123 — 123 Selling, general, and administrative (2) 447 1 448 470 2 472 Total operating expenses 566 2 568 593 2 595 Operating income 402 (2 ) 400 403 (3 ) 400 Other income and expense 33 — 33 26 — 26 Income before provision for income taxes 435 (2 ) 433 429 (3 ) 426 Provision for income taxes 145 — 145 134 (1 ) 133 Net income $ 290 $ (2 ) $ 288 $ 295 $ (2 ) $ 293 Earnings per common share: Basic $ 0.36 $ — $ 0.36 $ 0.37 $ — $ 0.37 Diluted $ 0.34 $ — $ 0.34 $ 0.35 $ — $ 0.35 Shares used in + computing earnings per share (in thousands): Basic 808,172 — 808,172 789,032 — 789,032 Diluted 857,011 557 857,568 838,174 631 838,805 (1) See Note 2, “Restatement of Consolidated +Financial Statements.” (2) Includes stock-based compensation expense, +which was allocated as follows: Cost of sales $ 1 $ — $ 1 $ — $ 1 $ 1 Research and development $ 1 $ 1 $ 2 $ 2 $ — $ 2 Selling, general, and administrative $ 8 $ 1 $ 9 $ 8 $ 2 $ 10 117 R eport of +Independent Registered Public Accounting Firm The Board of Directors and Shareholders Apple Computer, Inc.: We have audited the accompanying consolidated balance +sheets of Apple Computer, Inc. and subsidiaries (the Company) as of September 30, +2006 and September 24, 2005, and the related consolidated statements of +operations, shareholders’ equity and cash flows for each of the years in the +three-year period ended September 30, 2006. These consolidated financial +statements are the responsibility of the Company’s management. Our +responsibility is to express an opinion on these consolidated financial +statements based on our audits. We conducted our audits in accordance with the +standards of the Public Company Accounting Oversight Board (United States). Those +standards require that we plan and perform the audit to obtain reasonable +assurance about whether the consolidated financial statements are free of +material misstatement. An audit includes examining, on a test basis, evidence +supporting the amounts and disclosures in the consolidated financial +statements. An audit also includes assessing the accounting principles used and +significant estimates made by management, as well as evaluating the overall +financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. In our opinion, the consolidated financial statements +referred to above present fairly, in all material respects, the financial +position of the Company as of September 30, 2006 and September 24, +2005, and the results of their operations and their cash flows for each of the +years in the three-year period ended September 30, 2006, in conformity +with accounting principles generally accepted in the United States of America. As discussed in Note 2 to the Consolidated Financial +Statements, the consolidated financial statements as of September 24, 2005 +and for each of the years in the two-year period ended September 24, 2005 +have been restated. As discussed in Note 1 to the Consolidated Financial +Statements, effective September 25, 2005, the Company adopted the +provision of Statement of Financial Accounting Standards No. 123 (revised +2004), Share-Based Payment . We +also have audited, in accordance with the standards of the Public Company +Accounting Oversight Board (United States), the effectiveness of the Company’s +internal control over financial reporting as of September 30, 2006, based +on criteria established in Internal +Control-Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (COSO), and our report dated December 29, +2006 expressed an unqualified opinion on management’s assessment of, and the +effective operation of internal control over financial reporting. /s/ KPMG LLP Mountain View, + California December 29, + 2006 118 Report +of Independent Registered Public Accounting Firm The Board of Directors and Shareholders Apple Computer, Inc.: We have audited management’s assessment, included in +the accompanying Management’s Annual Report on Internal Control over Financial +Reporting, that Apple Computer, Inc. and subsidiaries maintained effective +internal control over financial reporting as of September 30, 2006, based +on criteria established in Internal Control-Integrated +Framework issued by the Committee of Sponsoring Organizations of the +Treadway Commission (COSO). Apple Computer, Inc.’s management is +responsible for maintaining effective internal control over financial reporting +and for its assessment of the effectiveness of internal control over financial +reporting. Our responsibility is to express an opinion on management’s +assessment and an opinion on the effectiveness of the Apple Computer, Inc.’s +internal control over financial reporting based on our audit. We conducted our audit in accordance with the +standards of the Public Company Accounting Oversight Board (United States). +Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an +understanding of internal control over financial reporting, evaluating +management’s assessment, testing and evaluating the design and operating +effectiveness of internal control, and performing such other procedures as we +considered necessary in the circumstances. We believe that our audit provides a +reasonable basis for our opinion. A company’s internal control over financial reporting +is a process designed to provide reasonable assurance regarding the reliability +of financial reporting and the preparation of financial statements for external +purposes in accordance with generally accepted accounting principles. A company’s +internal control over financial reporting includes those policies and +procedures that (1) pertain to the maintenance of records that, in +reasonable detail, accurately and fairly reflect the transactions and +dispositions of the assets of the company; (2) provide reasonable +assurance that transactions are recorded as necessary to permit preparation of +financial statements in accordance with generally accepted accounting +principles, and that receipts and expenditures of the company are being made +only in accordance with authorizations of management and directors of the +company; and (3) provide reasonable assurance regarding prevention or +timely detection of unauthorized acquisition, use, or disposition of the +company’s assets that could have a material effect on the financial statements. Because of inherent limitations, internal control over +financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk +that controls may become inadequate because of changes in conditions, or that +the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Apple +Computer, Inc. maintained effective internal control over financial +reporting as of September 30, 2006, is fairly stated, in all material +respects, based on criteria established in Internal +Control-Integrated Framework issued by COSO. Also, in our opinion, +Apple Computer, Inc. maintained, in all material respects, effective +internal control over financial reporting as of September 30, 2006, based +on criteria established in Internal +Control-Integrated Framework issued by COSO. We also have audited, in +accordance with the standards of the Public Company Accounting Oversight Board +(United States), the consolidated balance sheets of Apple Computer, Inc. +as of September 30, 2006 and September 24, 2005, and the related +consolidated statements of operations, shareholders’ equity, and cash flows for +each of the years in the three-year period ended September 30, 2006, and +our report dated December 29, 2006 expressed an unqualified opinion on +those consolidated financial statements. /s/ KPMG LLP Mountain View, + California December 29, + 2006 119 Item 9. Changes in +and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. Item 9A. Controls +and Procedures Special Committee +Review into Stock Option Grant Practices and Restatement As discussed in the Explanatory Note preceding Part I +and in Note 2 in Notes to Consolidated Financial Statements of this Form 10-K, the Company on June 29, +2006, announced that an internal review had discovered irregularities related +to the issuance of certain past stock option grants, including a grant to its +CEO Steve Jobs. The Company also announced that a Special Committee of outside +directors (“Special Committee”) had been formed and had hired independent +counsel to conduct a full investigation of the Company’s past stock option +granting practices. As a result of the internal review and the independent +investigation, management has concluded, and the Audit and Finance Committee of +the Board of Directors agrees, that incorrect measurement dates were used for +financial accounting purposes for certain stock option grants made in prior +periods. Therefore, the Company has recorded additional non-cash stock-based +compensation expense and related tax effects with regard to past stock option +grants, and the Company is restating previously filed financial statements in +this Form 10-K. The internal review +and the Special Committee’s independent investigation identified a number of +occasions between October 1996 and January 2003 (the “relevant period”) +when the Company used incorrect measurement dates for stock option grants. The +independent investigation also found that during the relevant period: · Procedures +for granting, accounting, and reporting of stock option grants did not include +sufficient safeguards to prevent manipulation · The +grant dates for a number of grants were intentionally selected in order to +obtain favorable exercise prices · Two +former officers of the Corporation engaged in conduct that raises serious +concerns in connection with the granting, accounting, recording, and reporting +of stock options · CEO +Steve Jobs was aware or recommended the selection of some favorable grant +dates, but he did not receive or financially benefit from these grants or +appreciate the accounting implications From 2003 through +2005, the Company implemented improvements to procedures, processes, and +systems to provide additional safeguards and greater internal control over the +stock option granting and administration function in compliance with the +Sarbanes-Oxley Act (“SOX”) and evolving accounting guidance. These improvements +included: · Documenting +and assessing the design and operation of internal controls · Segregating +responsibilities, adding reviews and reconciliations, and redefining roles and +responsibilities · Upgrading +systems and system controls that support the processes · Obtaining +training in the stock administration function · Implementing +before the adoption of SFAS No. 123R the practice of using the receipt of +the final Board or Compensation Committee approval as the grant and measurement +date for stock option grants · Identifying +key controls, developing test plans, and testing controls in the stock granting +and administration function 120 · Certifying +stock administration and other controls for SOX Section 404 compliance in +fiscal year 2005 The internal review and the independent investigation +discovered no stock option grant after January 2003 that required +accounting adjustments. In coming to the conclusion that the Company’s +disclosure controls and procedures and the Company’s internal control over +financial reporting were effective as of September 30, 2006, management +considered, among other things, the impact of the restatement to the financial +statements and the effectiveness of the internal controls in this area as of +the fiscal years ended 2006 and 2005. Management has concluded, therefore, that +control deficiencies resulting in the restatement of previously issued +financial statements did not constitute a material weakness in disclosure +controls and procedures, or internal controls and procedures over financial +reporting, as of September 30, 2006. In addition to the +significant improvements implemented between 2003 and 2005 discussed above, the +Company will adopt other measures identified by the Special Committee and +management to enhance the oversight of the stock option granting and +administration function and the review and preparation of financial statements, +including: · The +Company will engage experienced General Counsel, increase the resources of the +Corporate Legal Department, and review the adequacy of its procedures and +practices · The +CFO will arrange for senior management to undertake professional training to +enhance awareness and understanding of standards and principles for accounting +and financial reporting, particularly those relevant to stock options · The +Company will review all current policies, practices, and controls related to +the granting of stock options and provide education and training to those who +implement those policies and processes, as needed · The +Company will establish improved procedures for regular communication among the +General Counsel, the CFO, and stock administrators to improve monitoring of all +Company practices with regard to stock option grants, including formal written +confirmation that all grant dates correspond precisely with the dates +authorized · The Company will also +establish improved procedures for the review of the preparation and +presentation of financial statements by senior management Evaluation of +Disclosure Controls and Procedures Based on an evaluation +under the supervision and with the participation of the Company’s management, +the Company’s principal executive officer and principal financial officer have +concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and +15d-15(e) under the Securities Exchange Act of 1934, as amended +(Exchange Act) were effective as of September 30, 2006 to ensure that +information required to be disclosed by the Company in reports that it files or +submits under the Exchange Act is (i) recorded, processed, summarized and +reported within the time periods specified in the Securities and Exchange +Commission rules and forms and (ii) accumulated and communicated to +the Company’s management, including its principal executive officer and +principal financial officer, as appropriate to allow timely decisions regarding +required disclosure. 121 Inherent +Limitations Over Internal Controls The Company’s +internal control over financial reporting is designed to provide reasonable +assurance regarding the reliability of financial reporting and the preparation +of financial statements for external purposes in accordance with generally +accepted accounting principles. The Company’s internal control over financial +reporting includes those policies and procedures that: (i) pertain to the +maintenance of records that, in reasonable detail, accurately and fairly +reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable +assurance that transactions are recorded as necessary to permit preparation of +financial statements in accordance with generally accepted accounting +principles, and that the Company’s receipts and expenditures are being made +only in accordance with authorizations of the Company’s management and directors; +and (iii) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or +disposition of the Company’s assets that could have a material effect on the +financial statements. Management, including the +Company’s CEO and CFO, does not expect that the Company’s internal controls +will prevent or detect all errors and all fraud. A control system, no matter +how well designed and operated, can provide only reasonable, not absolute, +assurance that the objectives of the control system are met. Further, the +design of a control system must reflect the fact that there are resource +constraints, and the benefits of controls must be considered relative to their +costs. Because of the inherent limitations in all control systems, no +evaluation of internal controls can provide absolute assurance that all control +issues and instances of fraud, if any, have been detected. Also, any evaluation +of the effectiveness of controls in future periods are subject to the risk that +those internal controls may become inadequate because of changes in business +conditions, or that the degree of compliance with the policies or procedures +may deteriorate. Management’s Annual +Report on Internal Control Over Financial Reporting The Company’s management +is responsible for establishing and maintaining adequate internal control over +financial reporting (as defined in Rule 13a-15(f) under the +Securities Exchange Act of 1934, as amended). Management conducted an +evaluation of the effectiveness of the Company’s internal control over +financial reporting based on the criteria set forth in Internal Control—Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission (COSO). Based on this evaluation, management has concluded that the +Company’s internal control over financial reporting was effective as of September 30, +2006. The Company’s independent registered public accounting firm, KPMG LLP, +has issued an attestation report on the Company’s assessment of its internal +control over financial reporting. The report on the audit of internal control +over financial reporting appears on page 119 of this Form 10-K. Changes in Internal +Control Over Financial Reporting There were no significant +changes in the Company’s internal control over financial reporting identified +in management’s evaluation during the fourth quarter of fiscal 2006 that have +materially affected, or are reasonably likely to materially affect, the Company’s +internal control over financial reporting. Item 9B. Other Information None. 122 PART III Item 10. Directors +and Executive Officers of the Registrant Directors Listed below are the +Company’s seven directors whose terms expire at the next annual meeting of +shareholders. Name Position With the Company Age Director Since William V. + Campbell Co-lead + Director 66 1997 Millard S. + Drexler Director 62 1999 Albert A. + Gore, Jr. Director 58 2003 Steven P. Jobs Director + and Chief Executive Officer 51 1997 Arthur D. + Levinson Co-lead + Director 56 2000 Eric E. Schmidt Director 51 2006 Jerome B. York Director 68 1997 William +V. Campbell has been Chairman of the Board of +Directors of Intuit, Inc. ( “Intuit” ) since +August 1998. From September 1999 to January 2000, Mr. Campbell +acted as Chief Executive Officer of Intuit. From April 1994 to August 1998, +Mr. Campbell was President and Chief Executive Officer and a director of +Intuit. From January 1991 to December 1993, Mr. Campbell was +President and Chief Executive Officer of GO Corporation. Mr. Campbell also +serves on the Board of Directors of Opsware, Inc. Millard +S. Drexler has been Chairman and Chief Executive +Officer of J. Crew Group, Inc. since January 2003. Previously, Mr. Drexler +was Chief Executive Officer of Gap Inc. from 1995 and President from 1987 +until September 2002. Mr. Drexler was also a member of the Board of +Directors of Gap Inc. from November 1983 until October 2002. Albert +A. Gore, Jr. has served as a Senior Advisor to +Google, Inc. since 2001. He has also served as Executive Chairman of +Current TV since 2002 and as Chairman of Generation Investment Management since +2004. He is a visiting professor at Middle Tennessee State University. Mr. Gore +was inaugurated as the 45th Vice President of the United States in 1993. He was +re-elected in 1996 and served for a total of eight years as President of the +Senate, a member of the Cabinet and the National Security Council. Prior to +1993, he served eight years in the U.S. Senate and eight years in the U.S. +House of Representatives. Steven +P. Jobs is one of the Company’s co-founders and +currently serves as its Chief Executive Officer. Mr. Jobs is also a +director of The Walt Disney Company. Arthur +D. Levinson, Ph.D. has been Chief Executive Officer +and a Director of Genentech Inc. (“ Genentech” ) +since July 1995. Dr. Levinson has been Chairman of the Board of +Directors of Genentech since September 1999. He joined Genentech in 1980 +and served in a number of executive positions, including Senior Vice President +of R&D from 1993 to 1995. Dr. Levinson also serves on the Board of +Directors of Google, Inc. Eric +E. Schmidt, Ph.D. has served as the Chief Executive +Officer of Google, Inc. (“ Google ”) since July 2001 +and as a member of Google’s Board of Directors since March 2001, where he +served as Chairman of the Board from March 2001 to April 2004. In April 2004, +Dr. Schmidt was named Chairman of the Executive Committee of Google’s +Board of Directors. From April 1997 to November 2001, Dr. Schmidt +served as Chairman of the Board of Directors of Novell, Inc., a computer +networking company, and, from April 1997 to July 2001, as the Chief +Executive Officer of Novell. Dr. Schmidt was a director of Siebel Systems +until January 2006. Jerome B. York has +been Chief Executive Officer of Harwinton Capital Corporation, a private +investment company that he controls, since September 2003. From January 2000 +until September 2003, Mr. York was 123 Chairman and Chief +Executive Officer of MicroWarehouse, Inc., a reseller of computer +hardware, software and peripheral products. From September 1995 to October 1999, +he was Vice Chairman of Tracinda Corporation. From May 1993 to September 1995 +he was Senior Vice President and Chief Financial Officer of IBM Corporation, +and served as a member of IBM’s Board of Directors from January 1995 to August 1995. +Mr. York is also a director of Tyco International Ltd. Role of the Board; +Corporate Governance Matters It is the paramount duty of the Board of Directors to +oversee the Chief Executive Officer and other senior management in the +competent and ethical operation of the Company on a day-to-day basis and to +assure that the long-term interests of the shareholders are being served. To +satisfy this duty, the directors take a proactive, focused approach to their +position, and set standards to ensure that the Company is committed to business +success through maintenance of the highest standards of responsibility and +ethics. Members of the Board bring +to the Company a wide range of experience, knowledge and judgment. These varied +skills mean that governance is far more than a “check the box” approach to +standards or procedures. The governance structure in the Company is designed to +be a working structure for principled actions, effective decision-making +and appropriate monitoring of both compliance and performance. The key +practices and procedures of the Board are outlined in the Corporate Governance +Guidelines available on the Company’s website at www.apple.com/investor. Board Committees The Board has a standing Compensation Committee, a +Nominating and Corporate Governance Committee (“Nominating Committee ” ) and an Audit and Finance Committee (“Audit Committee”). +All committee members are independent under the listing standards of the NASDAQ +Global Select Market. The Audit Committee is primarily responsible for +overseeing the services performed by the Company’s independent auditors and +internal audit department, evaluating the Company’s accounting policies and its +system of internal controls and reviewing significant financial transactions. +Members of the Audit Committee are Messrs. Campbell and York and Dr. Levinson. The Compensation Committee is primarily responsible +for reviewing the compensation arrangements for the Company’s executive +officers, including the Chief Executive Officer, and for administering the +Company’s equity compensation plans. Members of the Compensation Committee are Messrs. Campbell, +Drexler, and Gore. The Nominating Committee assists the Board in +identifying qualified individuals to become directors, determines the composition +of the Board and its committees, monitors the process to assess Board +effectiveness and helps develop and implement the Company’s corporate +governance guidelines. The Nominating Committee also considers nominees +proposed by shareholders. Members of the Nominating Committee are Messrs. Drexler +and Gore and Dr. Levinson. The Audit, Compensation +and Nominating Committees operate under written charters adopted by the Board. +These charters are available on Apple’s website at www.apple.com/investor. Audit Committee +Financial Expert All members of the Company’s +Audit Committee, Messrs. Campbell and York and Dr. Levinson, qualify +as “audit committee financial experts” under Item 401(h) of Regulation S-K +and are considered “independent” as the term is used in Item 7(d)(3)(iv) of +Schedule 14A under the Exchange Act. Code of Ethics The Company has a code of +ethics that applies to all of the Company’s employees, including its principal +executive officer, principal financial officer, principal accounting officer and +its Board. A copy of this code, 124 “Ethics: The Way We Do +Business Worldwide,” is available on the Company’s website at +www.apple.com/investor. The Company intends to disclose any changes in or +waivers from its code of ethics by posting such information on its website or +by filing a Form 8-K. Executive Officers The following sets forth certain information regarding +executive officers of the Company. Information pertaining to Mr. Jobs, who +is both a director and an executive officer of the Company, may be found in the +section entitled “ Directors .” Timothy +D. Cook, Chief Operating Officer (age 46), joined the +Company in March 1998. Mr. Cook also served with the Company as +Executive Vice President, Worldwide Sales and Operations from 2002 to 2005. In +2004, his responsibilities were expanded to include the Company’s Macintosh +hardware engineering. From 2000 to 2002, Mr. Cook served in the role of +Senior Vice President, Worldwide Operations, Sales, Service and Support. From +1998 to 2000, Mr. Cook served in the position of Senior Vice President, +Worldwide Operations. Prior to joining the Company, Mr. Cook held the +position of Vice President, Corporate Materials for Compaq Computer Corporation +(“ Compaq” ). Previous to his work at +Compaq, Mr. Cook was the Chief Operating Officer of the Reseller Division +at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, +most recently as Director of North American Fulfillment. Mr. Cook also +serves as a member of the Board of Directors of Nike, Inc. Anthony +Fadell, Senior Vice President, iPod Division (age 37), +joined the Company in 2001. From 2004 to April 2006, Mr. Fadell was +Vice President of iPod Engineering. From 2001 to 2004, Mr. Fadell was the +Senior Director of the Company’s iPod Engineering Team. Prior to joining Apple, +Mr. Fadell was a co-founder, CTO, and director of engineering of the +Mobile Computing Group at Philips Electronics where he was responsible for all +aspects of business and product development for a variety of products. Mr. Fadell +later became VP of Business Development for Philips U.S. Strategy & +Ventures, focusing on building the company’s digital media strategy and +investment portfolio. Prior to joining Philips, Mr. Fadell was a hardware +and software architect at General Magic. Ronald +B. Johnson, Senior Vice President, Retail (age 48), +joined the Company in January 2000. Prior to joining the Company, Mr. Johnson +spent 16 years with Target Stores, most recently as Senior Merchandising +Executive. Peter +Oppenheimer, Senior Vice President and Chief Financial +Officer (age 44), joined the Company in July 1996. Mr. Oppenheimer +also served with the Company in the position of Vice President and Corporate +Controller, and as Senior Director of Finance for the Americas. Prior to +joining the Company, Mr. Oppenheimer was CFO of one of the four business +units for Automatic Data Processing, Inc. (“ ADP” ). +Prior to joining ADP, Mr. Oppenheimer spent six years in the Information +Technology Consulting Practice with Coopers and Lybrand. Donald +J. Rosenberg, Senior Vice President, General Counsel +and Secretary (age 55), joined the Company in December 2006. Prior to +joining the Company Mr. Rosenberg spent 31 years with IBM, most recently +as Senior Vice President and General Counsel. Prior to that he held a number of +senior positions at IBM, including over ten years as Vice President and +Assistant General Counsel for litigation. Philip +W. Schiller, Senior Vice President, Worldwide Product +Marketing (age 46), rejoined the Company in 1997. Prior to rejoining the +Company, Mr. Schiller was Vice President of Product Marketing at +Macromedia, Inc. from December 1995 to March 1997, and was +Director of Product Marketing at FirePower Systems, Inc. from 1993 to December 1995. +Prior to that, Mr. Schiller spent six years at the Company in various +marketing positions. Bertrand +Serlet, Ph.D., Senior Vice President, Software +Engineering (age 46), joined the Company in February 1997 upon the Company’s +acquisition of NeXT. At NeXT, Dr. Serlet held several engineering 125 and managerial positions, including Director of Web +Engineering. Prior to NeXT, from 1985 to 1989, Dr. Serlet worked as a +research engineer at Xerox PARC. Sina Tamaddon, Senior +Vice President, Applications (age 49), joined the Company in September 1997. +Mr. Tamaddon has also served with the Company in the position of Senior +Vice President, Worldwide Service and Support, and Vice President and General +Manager, Newton Group. Before joining the Company, Mr. Tamaddon held the +position of Vice President, Europe with NeXT from September 1996 through March 1997. +From August 1994 to August 1996, Mr. Tamaddon held the position +of Vice President, Professional Services with NeXT. Section 16(a) Beneficial +Ownership Reporting Compliance Section 16(a) of the Securities Exchange Act +of 1934, as amended, requires the Company’s officers and directors, and persons +who own more than ten percent of a registered class of the Company’s equity +securities, to file reports of securities ownership and changes in such +ownership with the Securities and Exchange Commission (“ SEC ”). +Officers, directors and greater than ten percent shareholders also are required +by rules promulgated by the SEC to furnish the Company with copies of all Section 16(a) forms +they file. Based solely upon a review of the copies of such forms +furnished to the Company or written representations that no Forms 5 were +required, the Company believes that all Section 16(a) filing +requirements were met during fiscal year 2006, except for the following: (i) one +Form 4 was filed for Arthur D. Levinson on August 17, 2006 to report +an automatic stock option grant under the Company’s 1997 Director Stock Option +Plan made on August 14, 2006; and (ii) one Form 4 was filed for +Anthony Fadell on September 1, 2006 with respect to the purchase and sale +by Mr. Fadell’s trust of 300 and 25 shares, respectively, of the Company’s +Common Stock in June 2006 and August 2006. 126 Item 11. Executive +Compensation Information +Regarding Executive Compensation The following table +summarizes compensation information for the last three fiscal years for (i) Mr. Jobs, +Chief Executive Officer, and (ii) the four most highly compensated executive +officers other than the Chief Executive Officer who were serving as executive +officers of the Company at the end of the fiscal year (collectively, the “ Named Executive Officers” ). SUMMARY +COMPENSATION TABLE Annual Compensation Long-Term Compensation Name and Principal Position Fiscal Year Salary ($) Bonus ($) Restricted Stock Award ($)(1) Securities Underlying Options* (#) All Other Compensation ($) Steven P. Jobs 2006 1 — — (2) — — Chief Executive Officer 2005 1 — — — — 2004 1 — — — — Timothy D. Cook 2006 696,880 525,000 21,603,000 (3) — 13,200 (5) Chief Operating + Officer 2005 602,434 600,239 — — 12,600 (5) 2004 602,632 — 7,650,000 (4) — 12,588 (5) Peter Oppenheimer 2006 615,006 450,000 14,402,000 (3) — 13,200 (5) Senior Vice President and 2005 552,189 550,202 — — 21,092 (5) Chief Financial Officer 2004 450,739 — 6,375,000 (4) — 3,808 (5) Ronald B. Johnson 2006 592,476 450,000 14,402,000 (3) — — Senior Vice + President, Retail 2005 552,795 550,202 — — — 2004 484,836 1,500,000 6,375,000 (4) — — Philip W. Schiller 2006 494,942 375,000 10,801,500 (3) — 5,769 (5) Senior Vice President, 2005 402,244 400,239 — — 5,539 (5) Worldwide Product Marketing 2004 402,277 — 6,375,000 (4) — 5,308 (5) (1) The +following table reflects the aggregated restricted stock holdings for each of +the Company’s Named Executive Officers as of the end of the 2006 fiscal year +and the value of such restricted stock based on $76.98 per share, the closing +price of the Company’s common stock on the NASDAQ Global Select Market on September 29, +2006 (the last day of trading for the 2006 fiscal year). The table has been +adjusted to reflect the Company’s two-for-one stock split in February 2005. Named Executive Officer Number of Unvested Restricted Shares at September 30, 2006 (#) Value of Unvested Restricted Shares at September 30, 2006 ($) Steven P. Jobs 0 0 Timothy D. Cook (a) 600,000 46,188,000 Peter Oppenheimer + (b) 450,000 34,641,000 Ronald B. Johnson + (b) 450,000 34,641,000 Philip W. Schiller (c) 400,000 30,792,000 (a) Includes 300,000 +unvested restricted stock units that are part of a grant of 600,000 restricted +stock units (split-adjusted) made on March 24, 2004. Fifty percent (50%) +of such units vested in March 2006, and the remainder is scheduled to vest +in March 2008. Also includes 300,000 unvested restricted stock units that +were granted on December 14, 2005, and are scheduled to 127 vest in their entirety in March 2010. +The restricted stock units do not include the right to receive dividends prior to +vesting. (b) Includes 250,000 unvested +restricted stock units that are part of a grant of 500,000 restricted stock +units (split-adjusted) made on March 24, 2004. Fifty percent (50%) of such +units vested in March 2006, and the remainder is scheduled to vest in March 2008. +Also includes 200,000 unvested restricted stock units that were granted on December 14, +2005, and are scheduled to vest in their entirety in March 2010. The +restricted stock units do not include the right to receive dividends prior to +vesting. (c) Includes 250,000 +unvested restricted stock units that are part of a grant of 500,000 restricted +stock units (split-adjusted) made on March 24, 2004. Fifty percent (50%) +of such units vested in March 2006, and the remainder is scheduled to vest +in March 2008. Also includes 150,000 unvested restricted stock units that +were granted on December 14, 2005, and are scheduled to vest in their +entirety in March 2010. The restricted stock units do not include the +right to receive dividends prior to vesting. (2) In March 2003, Mr. Jobs +voluntarily cancelled all of his outstanding options, excluding those granted +to him in his capacity as a Director. In March 2003, the Board awarded Mr. Jobs +10 million (split-adjusted) restricted shares of the Company’s Common +Stock, which vested in full in March 2006. (3) Market value of +restricted stock units granted on December 14, 2005 (based on $72.01 per +share, the closing price of the Company’s common stock on the NASDAQ Global +Select Market on the day of grant). The restricted stock units vest in March 2010. (4) Market value of +restricted stock units granted on March 24, 2004 (based on $12.75 per +share, the split-adjusted closing price of the Company’s common stock on the +NASDAQ Global Select Market on the day of grant). The restricted stock units +granted on this date generally vest over four years with 50% of the total +number of shares vesting on each of the second and fourth anniversaries of the +grant date. (5) Consists +of matching contributions made by the Company in accordance with the terms of +the 401(k) plan. Option Grants in +Last Fiscal Year There were no options +granted to the Named Executive Officers during fiscal year 2006. Grants of +restricted stock units to the Named Executive Officers are disclosed above in the +Summary Compensation Table. Options Exercised +and Year-End Option Holdings The following table +provides information about stock option exercises by the Named Executive +Officers during fiscal year 2006 and stock options held by each of them at +fiscal year-end. The table has been adjusted to reflect the Company’s +two-for-one stock split in February 2005. 128 AGGREGATED +OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES Shares Acquired on Exercise Value Realized Number of Securities Underlying Unexercised Options at Fiscal Year-End (#) Value of Unexercised In-the-Money Options at Fiscal Year-End ($)(1) Name (#) ($) Exercisable Unexercisable Exercisable Unexercisable Steven P. Jobs — — 120,000 (2) — $ 8,547,600 (2) — Timothy D. Cook — — — — (3) — — Peter Oppenheimer 1,145,000 $ 55,851,613 — — (3) — — Ronald B. Johnson 350,000 $ 15,653,210 1,900,000 — (3) $ 102,994,688 — Philip W. Schiller 162,500 $ 9,454,728 — — (3) — — (1) Market value of +securities underlying in-the-money options at the end of fiscal year 2006 +(based on $76.98 per share, the closing price of Common Stock on the NASDAQ +Global Select Market on September 29, 2006), minus the exercise price. (2) Consists +of 120,000 options granted to Mr. Jobs in his capacity as a director +pursuant to the 1997 Director Stock Option Plan. Since accepting the position +of CEO, Mr. Jobs is no longer eligible to receive option grants under the +Director Plan. In March 2003, Mr. Jobs voluntarily cancelled all of +his outstanding options, excluding those granted to him in his capacity as a +director. (3) Excludes +600,000 restricted stock units granted to Mr. Cook that are currently +unvested, 450,000 restricted stock units granted to each of Messrs. Oppenheimer +and Johnson that are currently unvested, and 400,000 restricted stock units +granted to Mr. Schiller that are currently unvested. Director +Compensation The form and amount of +director compensation are determined by the Board after a review of +recommendations made by the Nominating Committee. The current practice of the +Board is to base a substantial portion of a director’s annual retainer on +equity. In 1998, shareholders approved the 1997 Director Stock Option Plan (the +“ Director Plan” ) and 1,600,000 shares +were reserved for issuance thereunder. Pursuant to the Director Plan, the +Company’s non-employee directors are granted an option to acquire 30,000 shares +of Common Stock upon their initial election to the Board (“ Initial +Options” ). The Initial Options vest and become exercisable in three +equal annual installments on each of the first through third anniversaries of +the grant date. On the fourth anniversary of a non-employee director’s initial +election to the Board and on each subsequent anniversary thereafter, the +director will be entitled to receive an option to acquire 10,000 shares of +Common Stock (“ Annual Options” ). Annual Options +are fully vested and immediately exercisable on their date of grant. As of the +end of the fiscal year, there were options for 760,000 shares outstanding under +the Director Plan. Since accepting the position of CEO, Mr. Jobs is no +longer eligible for grants under the Director Plan. Non-employee directors also +receive a $50,000 annual retainer paid in quarterly increments. In addition, +directors receive up to two free computer systems per year and are eligible to +purchase additional equipment at a discount. Directors do not receive any +additional consideration for serving on committees or as committee chairperson. Compensation +Committee Interlocks and Insider Participation The current members of the +Compensation Committee are Messrs. Campbell, Drexler and Gore, none of +whom are employees of the Company and all of whom are considered “independent” +directors under the applicable NASDAQ rules. There were no interlocks or +insider participation between any member of the Board or Compensation Committee +and any member of the board of directors or compensation committee of another +company. 129 Arrangements with Named Executive Officers Change In Control +Arrangements—Stock Options and Restricted Stock Units In the event of a “change in control” of the Company, +all outstanding options under the Company’s stock option plans, except the +Director Plan, and all restricted stock units granted on or after +January 1, 2005, will, unless otherwise determined by the plan +administrator, become fully exercisable, and will be cashed out at an amount +equal to the difference between the applicable “change in control price” and +the exercise price. The Director Plan provides that upon a “change in control” +of the Company, all outstanding options held by non-employee directors will +automatically become fully exercisable and will be cashed out at an amount +equal to the difference between the applicable “change in control price” and +the exercise price of the options. A “change in control” under these plans is +generally defined as (i) the acquisition by any person of 50% or more of +the combined voting power of the Company’s outstanding securities, or (ii) the +occurrence of a transaction requiring shareholder approval and involving the +sale of all or substantially all of the assets of the Company or the merger of +the Company with or into another corporation. Agreements governing +certain restricted stock units granted to the Named Executive Officers and +other officers prior to January 1, 2005 generally provide that in the +event there is a “change in control,” as defined in the Company’s stock option +plans, and if in connection with or following such “change in control,” their +employment is terminated without “Cause” or if they should resign for “Good +Reason,” those options, restricted stock, and restricted stock units +outstanding that are not yet vested as of the date of such “change in control” +shall become fully vested. Further, these restricted stock unit agreements also +provide that, in the event the Company terminates the Officer without cause at +any time, the restricted stock and restricted stock units will vest in full. +Generally, “Cause” is defined to include a felony conviction, willful +disclosure of confidential information, or willful and continued failure to +perform his or her employment duties. “Good Reason” includes resignation of +employment as a result of a substantial diminution in position or duties, or an +adverse change in title or reduction in annual base salary. Item 12. Security +Ownership of Certain Beneficial Owners and Management The following table sets +forth certain information as of November 30, 2006 (the “ Table Date ”) with respect to the beneficial ownership of the +Company’s Common Stock by (i) each person the Company believes +beneficially holds more than 5% of the outstanding shares of Common Stock; (ii) each +director; (iii) each Named Executive Officer listed in the Summary +Compensation Table under the heading “ Executive Compensation; ” +and (iv) all directors and executive officers as a group. On the Table +Date, 859,202,448 shares of Common Stock were issued and outstanding. Unless +otherwise indicated, all persons named as beneficial +owners of Common Stock have sole voting power and sole investment power with +respect to the shares indicated as beneficially owned. In addition, unless +otherwise indicated, all persons named below can be reached at Apple Computer, Inc., +1 Infinite Loop, Cupertino, CA 95014. 130 Security +Ownership of 5% Holders, Directors, Nominees and Executive Officers Name of Beneficial Owner Shares of Common Stock Beneficially Owned(1) Percent of Common Stock Outstanding Fidelity + Investments 57,162,311 (2) 6.65 % AllianceBernstein + LP 48,637,731 (3) 5.66 % Steven P. Jobs 5,546,451 (4) * William V. + Campbell 221,004 (5) * Timothy D. Cook 12,597 (6) * Millard S. + Drexler 220,000 (7) * Albert A. + Gore, Jr. 60,000 (8) * Ronald B. Johnson 2,049,890 (9) * Arthur D. + Levinson 362,400 (10) * Peter Oppenheimer 149,768 (11) * Philip W. + Schiller 256 (12) * Eric E. Schmidt 12,284 (13) * Jerome B. York 80,000 (14) * All current executive + officers and directors as a group (15 persons) 9,378,423 (15) 1.09 % (1) Represents shares of +Common Stock held and/or options held by such individuals that were exercisable +at the Table Date or within 60 days thereafter. This does not include +options or restricted stock units that vest after 60 days. The share numbers +have been adjusted to reflect the Company’s two-for-one stock split in February 2005. (2) Based on a Form 13G/A +filed February 14, 2005 by FMR Corp. FMR Corp. lists its address as 82 Devonshire +Street, Boston, MA 02109, in such filing. (3) Based on a Form 13F +filed January 25, 2006, by Barclays Global Investors. Barclays Global +Investors lists its address as 45 Fremont Street, San Francisco, CA 94105. (4) Includes 120,000 shares +of Common Stock that Mr. Jobs has the right to acquire by exercise of +stock options. (5) Includes 220,000 shares +of Common Stock that Mr. Campbell has the right to acquire by exercise of +stock options. (6) Excludes 600,000 +unvested restricted stock units. (7) Includes 40,000 shares +of Common Stock that Mr. Drexler holds indirectly and 180,000 shares of +Common Stock that Mr. Drexler has the right to acquire by exercise of +stock options. (8) Consists of 60,000 +shares of Common Stock that Mr. Gore has the right to acquire by exercise +of stock options. (9) Includes 1,900,000 +shares of Common Stock that Mr. Johnson has the right to acquire by +exercise of stock options and excludes 450,000 unvested restricted stock units. (10) Includes 2,000 shares of Common +Stock that Dr. Levinson holds indirectly and 100,000 shares of Common +Stock that Dr. Levinson has the right to acquire by exercise of stock +options. (11) Excludes 450,000 unvested +restricted stock units. (12) Excludes 400,000 unvested +restricted stock units. 131 (13) Consists of 12,284 shares of +Common Stock that Dr. Schmidt holds indirectly. Dr. Schmidt has +declined to participate in the 1997 Director Stock Option Plan. (14) Includes 40,000 shares of +Common Stock that Mr. York has the right to acquire by exercise of stock +options. (15) Includes +3,063,371 shares of Common Stock that executive officers or directors have the +right to acquire by exercise of stock options. Does not include 2.7 million +unvested restricted stock units. * Represents +less than 1% of the issued and outstanding shares of Common Stock on the Table +Date. Equity Compensation +Plan Information The +following table sets forth certain information, as of September 30, 2006, +concerning shares of common stock authorized for issuance under all of the +Company’s equity compensation plans. The table has been adjusted to reflect the +Company’s two-for-one stock split in February 2005. Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a) Weighted Average Exercise Price of Outstanding Options, Warrants and Rights (b) Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)) (c) Equity + compensation plans approved by shareholders 34,827,183 $ 30.03 57,290,691 (1) Equity + compensation plans not approved by shareholders 18,137,049 $ 10.19 — Total equity + compensation plans (2) 52,964,232 $ 23.24 57,290,691 (1) This number includes +2,297,225 shares of common stock reserved for issuance under the Employee Stock +Purchase Plan, 400,000 shares available for issuance under the 1997 Director +Stock Option Plan, and 54,593,466 shares available for issuance under the 2003 +Employee Stock Plan. The grant of 3,410,000 restricted stock units has been +deducted from the number of shares available for future issuance. Shares of +restricted stock and restricted stock units granted after April 2005 count +against the shares available for grant as two shares for every share granted. This +amount does not include shares under the 1990 Stock Option Plan that was +terminated in 1997. No new options can be granted under the 1990 Stock Option +Plan. (2) This +table does not include 17,266 shares of Common Stock underlying options assumed +in connection with a prior acquisition of a company that originally granted +those options. These assumed options have a weighted average exercise price of +$4.30 per share. No additional options may be granted under the assumed plan. Item 13. Certain +Relationships and Related Transactions In March 2002, the Company entered into a +Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of +expenses incurred by Mr. Jobs in the operation of his private plane when +used for Company business. The Reimbursement Agreement became effective for +expenses incurred by Mr. Jobs for Company business purposes since he took +delivery of the plane in May 2001. The Company recognized a total of +$202,000 in expenses pursuant to the Reimbursement Agreement during 2006. In 2006, the Company +entered into an agreement with Pixar to sell certain of Pixar’s short films on +the iTunes Store. Mr. Jobs was the CEO, Chairman, and a large shareholder +of Pixar. On May 5, 2006, The Walt Disney Company (“Disney”) acquired +Pixar, which resulted in Pixar becoming a wholly-owned subsidiary of Disney. +Upon Disney’s acquisition of Pixar, Mr. Jobs’ shares of Pixar common stock +were 132 exchanged for Disney’s +common stock and he was elected to the Disney Board of Directors. Royalty +expense recognized by the Company under the arrangement with Pixar from September 25, +2005 through May 5, 2006 was less than $1 million. Item 14. Principal +Accountant Fees and Services The following table sets +forth the fees accrued or paid to the Company’s independent registered public +accounting firm, KPMG LLP, during fiscal years 2006 and 2005. Audit +and Non-Audit Fees 2006 2005 Audit Fees $ 7,912,700 (1) $ 6,948,800 Audit-Related + Fees 28,000 (2) 46,700 Tax Fees 820,500 (3) 923,000 All Other Fees — — Total $ 8,761,200 $ 7,918,500 (1) Audit fees relate to +professional services rendered in connection with the audit of the Company’s +annual financial statements and internal control over financial reporting, +quarterly review of financial statements included in the Company’s Forms 10-Q, +and audit services provided in connection with other statutory and regulatory +filings. Fiscal year 2006 also includes fees incurred in connection with the +Special Committee of the Company’s Board of Directors’ investigation into stock +option practices, no such fees were incurred during 2005. (2) Audit-related fees +primarily relate to professional services for the audits of employee benefit +plans. (3) 2006 +tax fees include $728,600 for professional services rendered in connection with +tax compliance and preparation relating to the Company’s expatriate program, +tax audits and international tax compliance; and $91,900 for international tax +consulting and planning services. The Company does not engage KPMG to perform +personal tax services for its executive officers. Policy on Audit +Committee Pre-Approval of Audit and Non-Audit Services Performed by the +Independent Auditors Prior to the enactment of the Sarbanes-Oxley Act +of 2002 (the “ Act ”), the Company adopted an +auditor independence policy that banned its auditors from performing +non-financial consulting services, such as information technology consulting +and internal audit services. This auditor independence policy also mandates +that the audit and non-audit services and related budget be approved by the +Audit Committee in advance, and that the Audit Committee be provided with +quarterly reporting on actual spending. In accordance with this policy, all +services to be performed by KPMG were pre-approved by the Audit Committee. Subsequent to the enactment of the Act, the Audit +Committee met with KPMG to further understand the provisions of that Act as it +relates to auditor independence. KPMG previously rotated the lead audit partner +in fiscal year 2005, rotated other partners in 2006, and will rotate additional +partners as appropriate in compliance with the Act. The Audit Committee will +continue to monitor the activities undertaken by KPMG to comply with the Act. 133 PART IV Item 15. Exhibits +and Financial Statement Schedules. (a) Documents +filed as part of this report (1) All +financial statements Index to Consolidated Financial Statements Page Consolidated + Balance Sheets as of September 30, 2006 and September 24, 2005 73 Consolidated + Statements of Operations for the three fiscal years ended September 30, + 2006 74 Consolidated + Statements of Shareholders’ Equity for the three fiscal years ended + September 30, 2006 75 Consolidated + Statements of Cash Flows for the three fiscal years ended September 30, + 2006 76 Notes + to Consolidated Financial Statements 77 Selected + Quarterly Financial Information (Unaudited) 114 Reports of Independent + Registered Public Accounting Firm, KPMG LLP 118 All financial statement +schedules have been omitted, since the required information is not applicable +or is not present in amounts sufficient to require submission of the schedule, +or because the information required is included in the Consolidated Financial +Statements and Notes thereto. (2) Index +to Exhibits Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/ Period End Date Filed/ Furnished Herewith 3.1 Restated Articles + of Incorporation, filed with the Secretary of State of the State of + California on January 27, 1988. S-3 7/27/88 3.2 Amendment to + Restated Articles of Incorporation, filed with the Secretary of State of the + State of California on May 4, 2000. 10-Q 5/11/00 3.3 By-Laws of the + Company, as amended through June 7, 2004. 10-Q 6/26/04 3.4 Certificate of + Amendment to Restated Articles of Incorporation, as amended, filed with the + Secretary of State of the State of California on February 25, 2005. 10-Q 3/26/05 4.8 Registration + Rights Agreement, dated June 7, 1996 among the Company and Goldman, + Sachs & Co. and Morgan Stanley & Co. Incorporated. S-3 8/28/96 4.9 Certificate of + Determination of Preferences of Series A Non-Voting Convertible + Preferred Stock of Apple Computer, Inc. 10-K 9/26/97 10.A.3** Apple + Computer, Inc. Savings and Investment Plan, as amended and restated + effective as of October 1, 1990. 10-K 9/27/91 10.A.3-1** Amendment of + Apple Computer, Inc. Savings and Investment Plan dated March 1, + 1992. 10-K 9/25/92 10.A.3-2** Amendment + No. 2 to the Apple Computer, Inc. Savings and Investment Plan. 10-Q 3/28/97 134 10.A.5** 1990 Stock Option + Plan, as amended through November 5, 1997. 10-Q 12/26/97 10.A.6** Apple + Computer, Inc. Employee Stock Purchase Plan, as amended through + April 21, 2005. 10-Q 3/26/05 10.A.8** Form of + Indemnification Agreement between the Registrant and each officer of the + Registrant. 10-K 9/26/97 10.A.43** NeXT Computer, Inc. + 1990 Stock Option Plan, as amended. S-8 3/21/97 10.A.49** 1997 Employee + Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.A.50** 1997 Director + Stock Option Plan. 10-Q 3/27/98 10.A.51** 2003 Employee + Stock Plan, as amended through November 9, 2005. 10-K 9/24/05 10.A.52** Reimbursement + Agreement dated as of May 25, 2001 by and between the Registrant and + Steven P. Jobs. 10-Q 6/29/02 10.A.53** Option + Cancellation and Restricted Stock Award Agreement dated as of March 19, + 2003 by and between the Registrant and Steven P. Jobs. 10-Q 6/28/03 10.A.54** Form of + Restricted Stock Unit Award Agreement. 10-Q 3/27/04 10.A.54-1** Alternative + Form of Restricted Stock Unit Award Agreement. 10-K 9/24/05 10.A.55** Apple + Computer, Inc. Performance Bonus Plan dated April 21, 2005. 10-Q 3/26/05 10.A.56** Form of + Election to Satisfy Tax Withholding with Stock. 8-K 8/15/05 10.A.57** Form of + Option Agreements. 10-K 9/24/05 10.B.18* Custom Sales + Agreement effective October 21, 2002 between the Registrant and + International Business Machines Corporation. 10-K 9/27/03 10.B.19* Purchase + Agreement effective August 10, 2005 between the Registrant and Freescale + Semiconductor, Inc. 10-K 9/24/05 10.B.20 Consulting + Agreement dated as of April 17, 2006 by and between the Registrant and + J.R. Ruby Consulting Corp. 10-Q 7/1/06 14.1 Code of Ethics of + the Company. 10-K 9/27/03 21*** Subsidiaries of + Apple Computer, Inc. ü 23.1*** Consent of + Independent Registered Public Accounting Firm. ü 135 24.1*** Power of Attorney + (included on page 137 of this Annual Report on Form 10-K). ü 31.1*** Rule13a-14(a) / + 15d-14(a) Certification of Chief Executive Officer. ü 31.2*** Rule13a-14(a) / + 15d-14(a) Certification of Chief Financial Officer. ü 32.1**** Section 1350 + Certifications of Chief Executive Officer and Chief Financial Officer. ü * Confidential +Treatment requested as to certain portions of this exhibit. ** Indicates +management contract or compensatory plan or arrangement. *** Filed herewith. **** Furnished herewith. 136 SIGNATURES Pursuant +to the requirements of Section 13 or 15(d) of the Securities Exchange +Act of 1934, the registrant has duly caused this report to be signed on its +behalf by the undersigned, thereunto duly authorized, this 29 th day of December 2006. APPLE COMPUTER, INC. By: /s/ PETER OPPENHEIMER Peter Oppenheimer Senior Vice President and Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person +whose signature appears below constitutes and appoints Steven P. Jobs and Peter +Oppenheimer, jointly and severally, his attorneys-in-fact, each +with the power of substitution, for him in any and all capacities, to sign any +amendments to this Annual Report on Form 10-K, and to file the same, +with exhibits thereto and other documents in connection therewith, with the +Securities and Exchange Commission, hereby ratifying and confirming all that +each of said attorneys-in-fact, or his substitute or substitutes, +may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has +been signed below by the following persons on behalf of the registrant and in +the capacities and on the dates indicated: Name Title Date /s/ STEVEN P. + JOBS Chief Executive + Officer and Director December 29, 2006 STEVEN + P. JOBS (Principal + Executive Officer) /s/ PETER + OPPENHEIMER Senior Vice President and Chief Financial Officer + (Principal Financial and December 29, 2006 PETER + OPPENHEIMER Principal Accounting Officer) /s/ WILLIAM V. + CAMPBELL Director December 29, 2006 WILLIAM + V. CAMPBELL /s/ MILLARD S. + DREXLER Director December 29, 2006 MILLARD + S. DREXLER /s/ ALBERT + GORE, JR. Director December 29, 2006 ALBERT + GORE, JR. /s/ ARTHUR D. + LEVINSON Director December 29, 2006 ARTHUR + D. LEVINSON /s/ ERIC E. + SCHMIDT Director December 29, 2006 ERIC + E. SCHMIDT /s/ JEROME B. + YORK Director December 29, + 2006 JEROME B. YORK 137 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-08-224958/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-08-224958/full-submission.txt new file mode 100644 index 0000000..73d211d --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-08-224958/full-submission.txt @@ -0,0 +1,1316 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 27, 2008 or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number: 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Global Select Market (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by +Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the +past 90 days. Yes x No ¨ Indicate by check mark if disclosure of delinquent +filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by +reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if smaller reporting company) Smaller Reporting Company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). +Yes ¨ No x The aggregate market value of the voting and non-voting stock +held by non-affiliates of the registrant, as of March 29, 2008, was approximately $118,441,000,000 based upon the closing price reported for such date on the NASDAQ Global Select Market. For purposes of this disclosure, shares of common stock +held by persons who hold more than 5% of the outstanding shares of common stock and shares held by executive officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. This determination of +executive officer or affiliate status is not necessarily a conclusive determination for other purposes. 888,935,123 shares of Common Stock +Issued and Outstanding as of October 24, 2008 DOCUMENTS INCORPORATED BY REFERENCE (1) Portions of the registrant’s definitive Proxy Statement relating to its 2009 Annual Meeting of Shareholders, to be held on February 25, 2009, are +incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. Table of Contents The Business section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain +forward-looking statements that involve risks and uncertainties. Many of the forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements +provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as +“anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and the +Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Risk +Factors” under Part I, Item 1A of this Form 10-K, which are incorporated herein by reference. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background Apple Inc. and its wholly-owned subsidiaries +(collectively “Apple” or the “Company”) design, manufacture, and market personal computers, portable digital music players, and mobile communication devices and sell a variety of related software, services, peripherals, and +networking solutions. The Company sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of +third-party Macintosh® (“Mac”), iPod® and iPhone™ compatible products, including application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and +retail stores, and digital content through the iTunes Store®. The Company sells to consumer, small and mid-sized business (“SMB”), education, enterprise, government, and creative customers. The Company’s fiscal year is the 52 or +53-week period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company’s fiscal calendar. Business Strategy The Company is committed to bringing the best personal computing, portable digital music and +mobile communication experience to consumers, students, educators, businesses, and government agencies through its innovative hardware, software, peripherals, services, and Internet offerings. The Company’s business strategy leverages its +unique ability to design and develop its own operating system, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative industrial design. The +Company believes continual investment in research and development is critical to the development and enhancement of innovative products and technologies. In addition to evolving its personal computers and related solutions, the Company continues to +capitalize on the convergence of the personal computer, digital consumer electronics and mobile communications by creating and refining innovations, such as the iPod, iPhone, iTunes Store, and Apple TV®. The Company desires to support a +community for the development of third-party products that complement the Company’s offerings through its developer programs. The Company offers various third-party software applications and hardware accessories for Mac® computers, iPods +and iPhones through its retail and online stores, as well as software applications for the iPhone platform through its iTunes® App Store. The Company’s strategy also includes expanding its distribution network to effectively reach more of +its targeted customers and provide them with a high-quality sales and post-sales support experience. Consumer and Small and Mid-Sized Business The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services +greatly enhances its ability to attract and retain customers. The Company sells many of its products and resells certain third-party products in most of its major markets directly to consumers and businesses through its retail and online stores. The +Company has also invested in programs to 1 Table of Contents enhance reseller sales, including the Apple Sales Consultant Program, which places Apple employees and contractors at selected third-party reseller +locations. The Company believes providing direct contact with its targeted customers is an efficient way to demonstrate the advantages of its Mac computers and other products over those of its competitors. At the end of fiscal 2008, the Company had opened a total of 247 retail stores, including 205 stores in the U.S. and a total of 42 stores internationally. The Company has +typically located its stores at high-traffic locations in quality shopping malls and urban shopping districts. A goal of the Company’s retail business +is to expand its installed base through sales to customers who currently do not already own the Company’s products. By operating its own stores and locating them in desirable high-traffic locations, the Company is better positioned to control +the customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and related solutions. To that end, retail store configurations have evolved into +various sizes in order to accommodate market-specific demands. The stores employ experienced and knowledgeable personnel who provide product advice, service, and training. The stores offer a wide selection of third-party hardware, software, and +various other accessory products and peripherals selected to complement the Company’s own products. Education Throughout its history, the Company has focused on the use of technology in education and has been committed to delivering tools to help educators teach and students +learn. The Company believes effective integration of technology into classroom instruction can result in higher levels of student achievement, especially when used to support collaboration, information access, and the expression and representation +of student thoughts and ideas. The Company has designed a range of products and services to address the needs of education customers. These products and services include the Company’s Mac computers, iPods, and iTunes, in addition to various +solutions for video creation and editing, wireless networking, professional development, and one-to-one (“1:1”) learning. A 1:1 learning solution typically consists of a portable computer for every student and teacher along with the +installation of a wireless network. Enterprise, Government and Creative The Company also sells its hardware and software products to enterprise, government, and creative customers in each of its geographic segments. These markets are also important to many third-party developers who +provide Mac-compatible hardware and software solutions. These customers utilize the Company’s products for their high-powered computing performance and expansion capabilities, networking functionality, and seamless integration with +complementary products. The Company designs its high-end hardware solutions, including desktops such as Mac Pro, portable Mac systems such as MacBook® Pro and MacBook Air™, and servers to incorporate the power, expandability, and other +features desired by these professionals. The Company’s operating system, Mac OS® X, incorporates powerful graphics and audio technologies and features developer tools to optimize system and application performance. Other In addition to consumer, SMB, education, enterprise, +government and creative markets, the Company provides hardware and software products and solutions for customers in the information technology and scientific markets. Business Organization The Company manages its business primarily on a geographic basis. The Company’s +reportable operating segments consist of the Americas, Europe, Japan, and Retail. The Americas, Europe, and Japan reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South +America. The Europe segment includes European countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S. and in international markets. Each reportable geographic operating segment and the +Retail operating segment provide similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Part II, 2 Table of Contents Item 7 of this Form 10-K under the heading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in Notes to +Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.” Products The Company offers a range of personal computing products including desktop and portable personal computers, related devices and peripherals, and various third-party +hardware and software products. In addition, the Company offers its own software products, including Mac OS X, the Company’s proprietary operating system software for the Mac; server software and related solutions; professional application +software; and consumer, education, and business oriented application software. The Company also designs, develops, and markets to Mac and Windows users its family of iPod digital music players and its iPhone mobile communication device, along with +related accessories and services, including the online distribution of third-party content through the Company’s iTunes Store. The Company’s primary products are discussed below. Hardware Products The Company offers a range of personal computing +products including desktop and notebook computers, server and storage products, related devices and peripherals, and various third-party hardware products. The Company’s Mac desktop and portable systems feature Intel microprocessors, the +Company’s Mac OS X Version 10.5 Leopard® (“Mac OS X Leopard”) operating system and iLife® suite of software for creation and management of digital photography, music, movies, DVDs, and website. MacBook® Pro The +MacBook Pro family of notebook computers is designed for professionals and advanced consumer users. First introduced in January 2006, the MacBook Pro includes a 15-inch or 17-inch widescreen display, a built-in iSight® video camera, and the +MagSafe® magnetic power adapter. In October 2008, the Company redesigned its 15-inch MacBook Pro models to include a widescreen light-emitting diode (“LED”) display, the latest Intel Core 2 Duo processors running at up to 2.8GHz, and a +new Nvidia GeForce 9600M graphics processor. The 15-inch MacBook Pro includes up to 4GB of 1066MHz synchronous dynamic random access memory (“SDRAM”) with a 1066MHz frontside bus, up to a 320GB hard drive, a slot-loading double-layer +SuperDrive®, a glass trackpad with Multi-Touch TM gesture support, AirPort Extreme® 802.11n wireless networking, and Bluetooth 2.1. In +addition, the Company updated its 17-inch MacBook Pro models to include larger hard drives of up to 320GB, as well as an optional 128GB solid state drive. MacBook® The MacBook is designed for consumer and education users. First introduced in +May 2006, the MacBook includes a 13-inch widescreen display, a built-in iSight video camera, and the MagSafe magnetic power adapter. In October 2008, the Company introduced new MacBook models with all-metal unibody enclosures, LED-backlit glossy +widescreen displays, Intel Core 2 Duo processors running at up to 2.4GHz, NVIDIA GeForce 9400M graphics processor, support for up to 4GB of 1066MHz SDRAM memory, up to 320GB Serial ATA hard drive, a double-layer SuperDrive, a glass trackpad with +Multi-Touch TM gesture support, and built-in AirPort Extreme 802.11n wireless networking and Bluetooth 2.1. MacBook Air™ In October 2008, the Company updated its MacBook Air, an +ultra-slim notebook computer that measures 0.16-inches at its thinnest point and 0.76-inches at its maximum height. The new MacBook Air includes an Intel Core 2 Duo processor running at up to 1.86GHz with 6MB of Level 2 cache, an NVIDIA GeForce +9400M graphics processor, 2GB of memory, and a 120GB hard drive. The MacBook Air includes a 13.3-inch LED-backlit widescreen display, a full-size backlit keyboard, a built-in iSight video camera, a trackpad with Multi-Touch gesture support, and +built-in AirPort Extreme 802.11n wireless networking and Bluetooth 2.1. 3 Table of Contents Mac® Pro The Mac Pro +desktop computer is targeted at business and professional users and is designed to meet the performance, expansion, and networking needs of the most demanding Mac user. In January 2008, the Company introduced the new Mac Pro featuring up to two +Intel Quad-Core Xeon processors running at up to 3.2GHz, 12MB of Level 2 cache per processor and dual-independent 1.6GHz front-side buses, and up to 32GB of 800MHz fully buffered memory. The Mac Pro also features a direct attach storage solution for +snap-in installation of up to four 1TB hard drives for a total of 4TB of internal storage and optional AirPort Extreme 802.11n wireless networking and Bluetooth 2.0. iMac® The iMac desktop computer is targeted at consumer, education and business customers. In April 2008, the Company +updated the iMac to include Intel Core 2 Duo processors running at up to 3.06GHz, up to 4GB of 800MHz SDRAM memory, a faster graphics card option using NVIDIA GeForce 8800 GS graphics, and a slot-loading double-layer SuperDrive. All iMac models also +include a built-in iSight video camera, AirPort Extreme 802.11n wireless networking, and Bluetooth 2.1. Mac® mini The Mac mini is an Intel-based desktop computer that includes 1GB of 667MHz memory that is expandable to 2GB and either a 1.83GHz or 2.0GHz Intel Core 2 Duo processor. +All Mac mini models include built-in Gigabit Ethernet, AirPort Extreme 802.11g wireless networking, Bluetooth 2.0, a total of four USB 2.0 ports, and one FireWire 400 port. Mac mini includes a full-size digital video interface and a video graphics +array output adapter to connect to a variety of displays. Xserve® Xserve is a 1U rack-mount server powered by up to two Quad-Core 128-bit Intel Xeon processors running at up to 3.0GHz and features Mac OS X Server 10.5 Leopard, which became available in October 2007. Xserve supports up to 32GB of random +access memory, remote management, storage drives of up to 3TB, and an optional internal Xserve RAID card. Music Products and Services The Company offers its iPod line of portable digital music players and related accessories to Mac and Windows users. All iPods work with the Company’s iTunes +digital music management software (“iTunes software”) available for both Mac and Windows-based computers. The Company also provides an online service to distribute third-party music, audio books, music videos, short films, television +shows, movies, podcasts, and applications through its iTunes Store. In July 2008, the Company launched the iTunes App Store that allows a user to browse, search for, or purchase third-party applications through either a Mac or Windows-based computer +or wirelessly download them directly onto an iPhone or iPod touch. In addition to the Company’s own iPod accessories, thousands of third-party iPod compatible products are available, either through the Company’s online and retail stores or +from third parties, including portable and desktop speaker systems, headphones, car radio solutions, voice recorders, cables and docks, power supplies and chargers, and carrying cases and armbands. iPod® shuffle The iPod shuffle weighs half an ounce and features an +aluminum design and a built-in clip. The iPod shuffle is available in 1GB or 2GB flash memory configurations and is capable of holding up to 240 or 500 songs, respectively. The iPod shuffle is available in a variety of colors and provides up to 12 +hours of battery life. The iPod shuffle includes a shuffle switch feature that allows users to listen to their music in random order or in the order of their playlists synced through iTunes. iPod shuffle works with iTunes’ patent-pending +AutoFill option that automatically selects songs to fill the iPod shuffle from a user’s iTunes library. iPod® nano In September 2008, the Company introduced the new iPod nano, a flash-memory-based iPod featuring the thinnest iPod design ever. The iPod nano incorporates a two-inch +display with 204 pixels per inch, a built-in 4 Table of Contents accelerometer, and an updated user interface featuring Cover Flow® and Shake to Shuffle mode. The new iPod nano also features “Genius” +technology allowing users to automatically create playlists from songs in their music libraries. The new iPod nano provides up to 24 hours of audio playback or up to four hours of video playback and is available in 8GB and 16GB configurations in a +variety of colors. iPod® classic The iPod classic is an +upgraded version of the original iPod, the Company’s hard-drive based portable digital music player. In September 2008, the Company introduced the new iPod classic, which has 120GB of storage and is capable of holding up to 30,000 songs, 150 +hours of video, or 25,000 photos. The iPod classic provides up to 36 hours of audio playback or up to six hours of video playback, features “Genius” technology, and includes a 2.5-inch color screen that can display album artwork, photos, +and video content including music videos, video and audio podcasts, short films, television shows, movies, and games. iPod® touch In September 2008, the Company introduced the new iPod touch, a flash-memory-based iPod that is 8.5 mm thin and features a 3.5-inch widescreen display, “Genius” +technology, a built-in speaker, and an accelerometer. The iPod touch’s user interface is based on the Company’s Multi-Touch display allowing users to control the device with a touchscreen. It also includes Wi-Fi wireless networking, which +allows users to access the iTunes Wi-Fi Music Store and iTunes App Store to purchase and/or download audio and video files, as well as a variety of other applications. The iPod touch is available in 8GB, 16GB and 32GB configurations and features up +to 36 hours of audio playback and up to six hours of video playback. iTunes® 8 iTunes is an application for playing, downloading, and organizing digital audio and video files and is available for both Mac and Windows-based computers. iTunes is integrated with the iTunes Store, a service that +allows customers to find, purchase, rent, and download third-party digital music, audio books, music videos, short films, television shows, movies, games, and other applications. Originally introduced in the U.S. in April 2003, the iTunes Store now +serves customers in 22 countries. In September 2008, the Company announced iTunes 8, which includes the new “Genius” technology and features new ways of viewing music and video libraries and allows the purchase of high definition +television programs from the iTunes Store. In July 2008, the Company launched the iTunes App Store that allows users to browse, search, purchase, and wirelessly download third-party applications directly onto their iPhone or iPod touch. In January +2008, the Company announced iTunes Movie Rentals, a service allowing customers to rent movies from the iTunes Store that can be watched on Macs, Windows-based computers, current generation video-enabled iPods, iPhones, and digitally enabled +televisions using Apple TV. iPhone™ In June +2008, the Company announced iPhone ™ 3G, the second-generation iPhone that combines in a single handheld product a mobile phone, a widescreen iPod with touch controls, and an Internet communications device. iPhone +features desktop-class email, web browsing, searching, and maps and is compatible with both Macs and Windows-based computers. iPhone automatically syncs content from users’ iTunes libraries, as well as contacts, bookmarks, and email +accounts. Its user interface is based on the Company’s Multi-Touch display allowing users to control the device with a touchscreen. iPhone 3G combines the features of the original iPhone, which was released in June 2007, with 3G +networking, a built-in global positioning system (“GPS”), and iPhone 2.0 software. iPhone 2.0 software incorporates new enterprise features, including support for Microsoft Exchange ActiveSync and Cisco IPsec virtual private network +(“VPN”). iPhone 3G is a quad-band GSM phone featuring 3G, EDGE and Wi-Fi wireless technologies for data networking, Bluetooth 2.0, a built-in 2.0 megapixel camera, and a 3.5-inch touch widescreen with 480-by-320 resolution +at 163 pixels per inch. iPhone 3G provides up to 10 hours of talk time on 2G networks and five hours using 3G networks, up to five to six hours of web browsing, up to seven hours of video playback, or up to 24 hours of audio playback. It is +available in 8GB and 16GB configurations. 5 Table of Contents In July 2008, the Company began shipping iPhone 3G in certain countries and made iPhone 2.0 software available to all +iPhone customers. The Company has signed multi-year agreements with various cellular network carriers authorizing them to distribute and provide cellular network services for iPhone 3G in over 70 countries. These agreements are generally not +exclusive with a specific carrier, except in the U.S., U.K., France, Germany, Spain, Ireland, and certain other countries. The Company expects to ship iPhone 3G in over 70 countries by the end of calendar year 2008. In addition to the Company’s own iPhone accessories, third-party iPhone compatible products, including headsets, cables and docks, power supplies, and carrying +cases, are available through the Company’s online and retail stores or from third parties. Peripheral Products The Company sells a variety of Apple-branded and third-party Mac-compatible peripheral products directly to end-users through its retail and online stores, including +printers, storage devices, computer memory, digital video and still cameras, and various other computing products and supplies. Displays The Company manufactures a family of widescreen flat panel displays including the 23-inch and 30-inch Apple Cinema High Definition (“HD”) Displays™, and +the 20-inch Apple Cinema Display®. In October 2008, the Company introduced a 24-inch LED Cinema Display that features a built-in iSight camera, microphone, built-in 2.1 speaker system, and MagSafe charger. Apple TV® Apple TV is a device that permits users to wirelessly play +iTunes content on a widescreen television. Compatible with a Mac or Windows-based computer, Apple TV includes either a 40GB or 160GB hard drive capable of storing up to 200 hours of video, 36,000 songs, 25,000 photos, or a combination of each and is +capable of displaying content in high definition resolution up to 720p. Apple TV connects to a broad range of widescreen televisions and home theater systems and comes standard with high-definition multimedia interface, component video, and both +analog and digital optical audio ports. Using high-speed AirPort Extreme 802.11n wireless networking, Apple TV can auto-sync content from one computer or stream content from up to five additional computers directly to a television. Software Products and Computer Technologies The Company offers a +range of software products for consumer, SMB, education, enterprise, government, and creative customers, including the Company’s proprietary operating system software; server software and related solutions; professional application software; +and consumer, education, and business oriented application software. Operating System Software Mac OS® X is built on an open-source UNIX-based foundation. Mac OS X Leopard is the sixth major release of Mac OS X and became available in October 2007. Leopard +includes 300 additional features and introduces an updated desktop with Stacks, a means of easily accessing files from the Dock; a redesigned Finder™ that lets users quickly browse and share files between multiple Macs; Quick Look, a way to +instantly see files without opening an application; Spaces®, a feature used to create groups of applications and instantly switch between them; and Time Machine™, a way to automatically back up all of the contents of a Mac. 6 Table of Contents Application Software iLife® ’08 In August 2007, the Company introduced iLife ’08, the latest release of its consumer-oriented digital lifestyle +application suite, which features iPhoto®, iDVD®, GarageBand®, iWeb™, and iMovie® ’08. All of these applications are Universal, meaning that they run natively on both Intel and PowerPC-based Mac computers +(“Universal”). iPhoto® is the Company’s consumer-oriented digital photo software application. iPhoto ’08 adds new +features for organizing and browsing photos, including event-based grouping, new professional quality image editing tools, and enables publishing to the MobileMe™ Web Gallery. The MobileMe Web Gallery, is fully integrated with iPhoto ’08 +and iMovie ’08, allowing MobileMe users to share photos and movies over the web. iPhoto ’08 features print, photo book, greeting card, and calendar layout tools and integrated online ordering services. iMovie® ’08 is the latest version of the Company’s consumer-oriented digital video editing software application. iMovie ’08 provides +new tools for quick movie creation and video enhancements, including transitions, titles, music and sound effects. Projects in iMovie ’08 can also be published to the MobileMe Web Gallery. iDVD® is the Company’s consumer-oriented software application that enables users to turn iMovie files, QuickTime® files, and digital pictures +into interactive DVDs that can be played on most consumer DVD players. iDVD ’08 features 10 new Apple-designed menu themes in both widescreen (16:9) and standard (4:3) formats. GarageBand® is the Company’s consumer-oriented music creation software application that allows users to play, record and create music using a +simple interface. With GarageBand, software instruments, digital audio recordings and looping tracks can be arranged and edited to create songs. GarageBand ’08 allows users to export finished songs to their iTunes library, or publish a podcast +through iWeb and MobileMe that includes artwork, sound effects, and music jingles. iWeb™ allows users to create online photo albums, +blogs and podcasts, and to customize websites using editing tools. iWeb’08 offers new features to make websites more interactive by adding live web widgets, which are snippets of live content from other websites, such as Google Maps, targeted +ads using Google AdSense, and photos or movies from the MobileMe Web Galleries. iWork® ’08 In August 2007, the Company introduced iWork ’08, the latest version of the Company’s integrated productivity suite designed to help users create, present, and +publish documents, presentations, and spreadsheets. iWork ’08 includes updates to Pages® ’08 for word processing and page layout, Keynote® ’08 for presentations, and introduces Numbers® ’08 for spreadsheets. All of +these programs are Universal and feature advanced image tools, including enhanced photo masking, resizable picture frames and edges, and Instant Alpha, which easily removes the background of a photo. Final Cut Studio® 2 In April 2007, the Company introduced Final Cut +Studio ® 2, an upgraded version of the Company’s video production suite designed for professionals. Final Cut Studio 2 features Final Cut Pro® 6 for video editing, DVD Studio Pro® 4 for DVD authoring, Motion 3 for real-time +motion graphics, Soundtrack® Pro 2 for audio editing and sound design, Color for color grading and finishing, and Compressor 3 for encoding media in multiple formats. All of these applications are Universal. The Company also offers Final Cut +Express HD 3.5, a consumer version of the Company’s movie making software. Logic® Studio In September 2007, the Company introduced Logic Studio, a comprehensive suite of professional tools used by musicians and professionals to create, perform, and record +music. Logic Studio features Logic Pro 8, an upgraded 7 Table of Contents version of the Company’s music creation and audio production software; MainStage®, a new live performance application; Soundtrack Pro 2, a +professional audio post production software; Studio Instruments, made up of 40 instrument plug-ins; Studio Effects, with 80 professional effect plug-ins; and studio Sound Library. In addition, the Company offers Logic Express 8, a standalone version +of the Logic Pro 8 application that provides an easy entry into professional music production. All of these applications are Universal. FileMaker® Pro The FileMaker Pro database software is Universal and offers relational databases and desktop-to-web publishing capabilities. In July 2007, the Company +introduced FileMaker Pro 9 featuring a new Quick Start screen, which stores users’ favorites and gives them access to the new videos in the FileMaker Learning Center; Conditional Formatting, which highlights data based on parameters the user +sets; and the ability to email a link to other FileMaker users to instantly access a database. Internet Software and Services The Company is focused on delivering seamless integration with and access to the Internet throughout the Company’s products and services. The Company’s Internet +solutions adhere to many industry standards to provide an optimized user experience. Safari® In March 2008, the Company made available Safari 3.1, a web browser compatible with Windows XP, Windows Vista, and Mac OS X. Safari 3.1 includes built-in Google search; +SnapBack™ to instantly return to search results; a way to name, organize and present bookmarks; tabbed browsing; and automatic “pop-up” ad blocking. Safari 3.1 supports the new video and audio tags in HTML 5 and supports Cascading +Style Sheets Animations and Web Fonts, which provide designers additional choices of fonts to create web sites. QuickTime® QuickTime, the Company’s multimedia software for Mac or Windows-based computers, features streaming of live and stored video and audio over the Internet and playback +of high-quality audio and video on computers. QuickTime 7 features H.264 encoding and can automatically determine a user’s connection speed to ensure they are getting the highest-quality content stream possible. QuickTime 7 also delivers +multi-channel audio and supports a wide range of industry standard audio formats. The Company offers several other QuickTime products. QuickTime 7 Pro, a +suite of software tools, allows creation and editing of Internet-ready audio and video files. QuickTime 7 Pro allows users to create H.264 video, capture audio and video, create multi-channel audio, and export multiple files while playing back or +editing video. MobileMe™ In June 2008, the Company +introduced MobileMe, an annual subscription-based suite of Internet services that delivers email, contacts and calendars to and from native applications on iPhone, iPod touch, Macs, and Windows-based computers. MobileMe services include Internet +message access protocol (“IMAP”) mail, an ad-free email service; website hosting for publishing websites from iWeb; iDisk, a virtual hard drive accessible anywhere with Internet access; Web Gallery for viewing and sharing photos; MobileMe +Sync, which keeps Safari bookmarks, iCal® calendars, Address Book information, Keychain®, and Mac OS X Mail preferences up-to-date across multiple computers, iPhones, and iPod touches. MobileMe provides combined email and file storage of +20GB for individuals and 40GB for families with additional storage options. Product Support and Services AppleCare ® offers a range of support options for the Company’s customers. These options include assistance that is built into software products, printed +and electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare Protection Plan. The AppleCare Protection Plan is a fee-based service that typically includes two to three +years of phone support and hardware repairs, dedicated web-based support resources, and user diagnostic tools. 8 Table of Contents Markets and Distribution The Company’s customers are primarily in the consumer, SMB, education, enterprise, government, and creative markets. The Company distributes its products through wholesalers, resellers, national and regional retailers, and cataloguers. +No individual customer accounted for more than 10% of net sales in 2008, 2007, or 2006. The Company also sells many of its products and resells certain third-party products in most of its major markets directly to customers through its own sales +force and retail and online stores. Competition The +Company is confronted by aggressive competition in all areas of its business. The markets for consumer electronics, personal computers, related software and peripheral products, digital music devices and related services, and mobile communication +devices are highly competitive. These markets are characterized by rapid technological advances in both hardware and software that have substantially increased the capabilities and use of personal computers, other digital electronic devices, and +mobile communication devices that have resulted in the frequent introduction of new products with competitive price, feature, and performance characteristics. Over the past several years, price competition in these markets has been particularly +intense. The Company’s competitors who sell personal computers based on other operating systems have aggressively cut prices and lowered their product margins to gain or maintain market share. The Company’s financial condition and +operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. The principal competitive factors include price, product features, relative price/performance, product quality and reliability, design +innovation, availability of software and peripherals, marketing and distribution capability, service and support, and corporate reputation. Further, as the personal computer industry and its customers place more reliance on the Internet, an +increasing number of Internet devices that are smaller, simpler, and less expensive than traditional personal computers may compete with the Company’s products. The Company’s music products and services have faced significant competition from other companies promoting their own digital music and content products and services, including those offering free peer-to-peer +music and video services. The Company believes it currently retains a competitive advantage by offering superior innovation and integration of the entire solution including the hardware (personal computer, iPod, and iPhone), software (iTunes), and +distribution of content (iTunes Store and iTunes Wi-Fi Music Store). However, the Company expects competition in this space to intensify as competitors attempt to imitate the Company’s approach to tightly integrating these elements within their +own offerings or, alternatively, collaborate with each other to offer solutions that are more integrated than those they currently offer. Some of these current and potential competitors have substantial resources and may be able to provide such +products and services at little or no profit or even at a loss to compete with the Company’s offerings. The Company is currently focused on market +opportunities related to mobile communication devices including the iPhone. The mobile communications industry is highly competitive with several large, well-funded, and experienced competitors. The Company faces competition from mobile +communication device companies that may attempt to imitate some of the iPhone’s functions and applications within their own smart phones. This industry is characterized by aggressive pricing practices, frequent product introductions, evolving +design approaches and technologies, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers. The Company’s future financial condition and operating results are substantially dependent on the Company’s ability to continue to develop and offer new innovative products and services in each of its markets. Raw Materials Although most components essential to the +Company’s business are generally available from multiple sources, certain key components including, but not limited to microprocessors, enclosures, certain LCDs, certain optical drives, and application-specific integrated circuits +(“ASICs”) are currently obtained by the Company from single or limited sources, which subjects the Company to significant supply and pricing risks. Many of these and other key components that are available from multiple sources including, +but not limited to NAND flash memory, dynamic random access memory (“DRAM”), and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into +certain agreements for 9 Table of Contents the supply of key components including, but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee +that the Company will be able to extend or renew these agreements on similar favorable terms, or at all, upon expiration or otherwise obtain favorable pricing in the future. Therefore, the Company remains subject to significant risks of supply +shortages and/or price increases that can have a material adverse effect on its financial condition and operating results. The Company and other +participants in the personal computer, consumer electronics and mobile communication industries also compete for various components with other industries that have experienced increased demand for their products. In addition, the Company uses some +custom components that are not common to the rest of the personal computer, consumer electronics and mobile communication industries, and new products introduced by the Company often utilize custom components available from only one source until the +Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured. If the +Company’s supply of a key single-sourced component for a new or existing product were delayed or constrained, if such components were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed +products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be adversely affected depending on the time required to +obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided +to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Significant portions of the +Company’s Mac computers, iPods, iPhones, logic boards, and other assembled products are manufactured by outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently +performed by only a few of the Company’s outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturing outsourcing for many of the Company’s key +products, including but not limited to final assembly of substantially all of the Company’s portable Mac computers, iPods, iPhones and most of the Company’s iMacs. Although the Company works closely with its outsourcing partners on +manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover its requirements for +periods ranging from 30 to 150 days. The Company believes there are several component suppliers and manufacturing vendors whose loss to the Company could +have a material adverse effect upon the Company’s business and financial condition. At this time, such vendors include, without limitation, Amperex Technology Limited, ASUSTeK Corporation, ATI Technologies, Inc., Atheros Communications Inc., AU +Optronics Corporation, Broadcom Corporation, Chi Mei Optoelectronics Corporation, Cypress Semiconductor Corporation, Hitachi Global Storage Technologies, Hon Hai Precision Industry Co., Ltd., Infineon Technologies AG, Intel Corporation, Inventec +Appliances Corporation, LG Display, LSI Corporation, Matsushita, Murata Manufacturing Co., Ltd., National Semiconductor Corporation, NVIDIA Corp., Inc., Quanta Computer, Inc., Renesas Semiconductor Co. Ltd., Samsung Electronics, Sony Corporation, +Synaptics, Inc., Texas Instruments, and Toshiba Corporation. Research and Development Because the personal computer, consumer electronics, and mobile communication industries are characterized by rapid technological advances, the Company’s ability to compete successfully is heavily dependent upon +its ability to ensure a continual and timely flow of competitive products, services, and technologies to the marketplace. The Company continues to develop new products and technologies and to enhance existing products in the areas of computer +hardware and peripherals, consumer electronics products, mobile communication devices, system software, applications software, networking and communications software and solutions, and Internet services and solutions. The Company may expand the +range of its product offerings and intellectual property through licensing and/or acquisition of third-party business and technology. The Company’s research and development expenditures totaled $1.1 billion, $782 million, and $712 million +in 2008, 2007, and 2006, respectively. 10 Table of Contents Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its computer systems, iPods, iPhone, peripherals, software, and services. In addition, the Company has registered, and/or has +applied to register, trademarks and service marks in the U.S. and a number of foreign countries for “Apple,” the Apple logo, “Macintosh,” “Mac,” “iPod,” “iTunes,” “iTunes Store,” +“iPhone,” “Apple TV,” “MobileMe” and numerous other trademarks and service marks. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an important factor in its +business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence, and marketing abilities of its personnel. The Company regularly files patent applications to protect inventions arising from its research and development, and is currently pursuing thousands of patent +applications around the world. Over time, the Company has accumulated a portfolio of several thousand issued patents in the U.S. and worldwide. In addition, the Company currently holds copyrights relating to certain aspects of its products and +services. No single patent or copyright is solely responsible for protecting the Company’s products. The Company believes the duration of the applicable patents that it has been granted is adequate relative to the expected lives of its +products. Due to the fast pace of innovation and product development, the Company’s products are often obsolete before the patents related to them expire, and sometimes are obsolete before the patents related to them are even granted. Many of the Company’s products are designed to include intellectual property obtained from third parties. While it may be necessary in the future to +seek or renew licenses relating to various aspects of its products and business methods, the Company believes, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms; however, +there is no guarantee that such licenses could be obtained at all. Because of technological changes in the computer, digital music player and mobile communications industries, current extensive patent coverage, and the rapid rate of issuance of new +patents, it is possible certain components of the Company’s products and business methods may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be +infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data The U.S. represents the Company’s largest geographic marketplace. Approximately 57% of the Company’s net sales in 2008 came from sales to customers inside +the U.S. Final assembly of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by external vendors in California, the Republic of Korea (“Korea”), the People’s Republic of +China (“China”) and the Czech Republic. Currently, the supply and manufacture of many critical components is performed by sole-sourced third-party vendors in the U.S., China, Japan, Korea, Malaysia, Philippines, Taiwan, Thailand, and +Singapore. Sole-sourced third-party vendors in China perform final assembly of substantially all of the Company’s portable products, including MacBook Pro, MacBook, MacBook Air, iPods, iPhone, and most of the Company’s iMacs. Margins on +sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade +regulations, including tariffs and antidumping penalties. Information regarding financial data by geographic segment is set forth in Part II, Item 8 +of this Form 10-K and in Notes to Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.” Seasonal Business The Company has historically experienced increased net sales in its first and fourth fiscal quarters compared to other quarters in its fiscal year due +to seasonal demand related to the holiday season and the beginning of the school year. This historical pattern should not be considered a reliable indicator of the Company’s future net sales or financial performance. Warranty The Company offers a basic limited parts and labor warranty +on most of its hardware products, including Mac computers, iPods and iPhones. The basic warranty period is typically one year from the date of purchase by the 11 Table of Contents original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In addition, +consumers may purchase the AppleCare Protection Plan, which extends service coverage on many of the Company’s hardware products in most of its major markets. Backlog In the Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its +future business prospects. In particular, backlog often increases in anticipation of or immediately following new product introductions as dealers anticipate shortages. Backlog is often reduced once dealers and customers believe they can obtain +sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial performance. Environmental Laws Compliance with federal, state, local, and +foreign laws enacted for the protection of the environment has to date had no material effect on the Company’s capital expenditures, earnings, or competitive position. In the future, these laws could have a material adverse effect on the +Company. Production and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in +some instances, the requirement to provide customers the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in +several jurisdictions in which the Company operates including various countries within Europe and Asia, certain Canadian provinces, and certain states within the U.S. Although the Company does not anticipate any material adverse effects in the +future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not have a material adverse effect on the Company’s financial condition or operating results. Employees As of September 27, 2008, the Company +had approximately 32,000 full-time equivalent employees and an additional 3,100 temporary equivalent employees and contractors. Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to +Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and other information filed by the Company with the SEC are +available on the Company’s website at http://www.apple.com/investor when such reports are available on the SEC website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 +F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy, and information +statements and other information regarding issuers that file electronically with the SEC at http://www.sec.gov. The contents of these websites are not incorporated into this filing. Further, the Company’s references to the URLs for these +websites are intended to be inactive textual references only. 12 Table of Contents Executive Officers of the Registrant The following sets forth certain information regarding executive officers of the Company as of November 1, 2008. Name Position With the Company Age Timothy D. Cook Chief Operating Officer 47 Daniel Cooperman Senior Vice President, General Counsel and Secretary 57 Tony Fadell Senior Vice President, iPod Division 39 Scott Forstall Senior Vice President, iPhone Software Engineering and Platform Experience 39 Steven P. Jobs Director and Chief Executive Officer 53 Ronald B. Johnson Senior Vice President, Retail 50 Robert Mansfield Senior Vice President, Hardware Engineering 47 Peter Oppenheimer Senior Vice President and Chief Financial Officer 45 Philip W. Schiller Senior Vice President, Worldwide Product Marketing 48 Bertrand Serlet Senior Vice President, Software Engineering 47 Sina Tamaddon Senior Vice President, Applications 51 Timothy D. Cook, Chief Operating Officer, joined the Company in March 1998. Mr. Cook also served +as Executive Vice President, Worldwide Sales and Operations from 2002 to 2005. In 2004, his responsibilities were expanded to include the Company’s Macintosh hardware engineering. From 2000 to 2002, Mr. Cook served as Senior Vice +President, Worldwide Operations, Sales, Service and Support. From 1998 to 2000, Mr. Cook served as Senior Vice President, Worldwide Operations. Prior to joining the Company, Mr. Cook was Vice President, Corporate Materials for Compaq +Computer Corporation (“Compaq”). Previous to his work at Compaq, Mr. Cook was the Chief Operating Officer of the Reseller Division at Intelligent Electronics. Mr. Cook also spent 12 years with IBM, most recently as Director +of North American Fulfillment. Mr. Cook also serves as a member of the Board of Directors of Nike, Inc. Daniel Cooperman , Senior +Vice President, General Counsel and Secretary, joined the Company in November 2007. Prior to joining the Company, he served as Senior Vice President, General Counsel and Secretary of Oracle Corporation since February 1997. Prior to that, he had been +associated with the law firm of McCutchen, Doyle, Brown & Enersen (which is now Bingham McCutchen LLP) since October 1977, and had served as a partner since June 1983. From September 1995 until February 1997, Mr. Cooperman was Chair of +the law firm’s Business and Transactions Group, and from April 1989 through September 1995 he served as Managing Partner of the law firm’s San Jose office. Tony Fadell, Senior Vice President, iPod Division, joined the Company in 2001. From 2004 to April 2006, Mr. Fadell was Vice President of iPod Engineering. From 2001 to 2004, Mr. Fadell was the +Senior Director of the Company’s iPod Engineering Team. Prior to joining Apple, Mr. Fadell was a co-founder, CTO, and director of engineering of the Mobile Computing Group at Philips Electronics where he was responsible for all aspects of +business and product development for a variety of products. Mr. Fadell later became VP of Business Development for Philips U.S. Strategy & Ventures, focusing on building the company’s digital media strategy and investment +portfolio. Scott Forstall , Senior Vice President of iPhone Software Engineering and Platform Experience, joined the Company in February 1997 +upon the Company’s acquisition of NeXT. Mr. Forstall also has served the Company as Vice President of Platform Experience while leading several releases of Mac OS X, and as Director of Application Frameworks. Prior to joining the +Company, Mr. Forstall worked at NeXT developing core technologies. Steven P. Jobs is one of the Company’s co-founders and currently serves +as its Chief Executive Officer. Mr. Jobs also is a director of The Walt Disney Company. Ronald B. Johnson, Senior Vice President, Retail, +joined the Company in January 2000. Prior to joining the Company, Mr. Johnson spent 16 years with Target Stores, most recently as Senior Merchandising Executive. 13 Table of Contents Robert Mansfield , Senior Vice President of Hardware Engineering, joined the Company in November 1999 as +Vice President of Development Engineering and assumed his current position in May 2008. Prior to joining the Company, Mr. Mansfield was Vice President of Engineering at Raycer Graphics and a Senior Director at Silicon Graphics, Inc. Peter Oppenheimer, Senior Vice President and Chief Financial Officer, joined the Company in July 1996. Mr. Oppenheimer also served the Company as Vice +President and Corporate Controller and as Senior Director of Finance for the Americas. Prior to joining the Company, Mr. Oppenheimer was Chief Financial Officer of one of the four business units for Automatic Data Processing, Inc. +(“ADP ” ). Prior to joining ADP, Mr. Oppenheimer spent six years in the Information Technology Consulting Practice with Coopers and Lybrand. Philip W. Schiller, Senior Vice President, Worldwide Product Marketing, rejoined the Company in 1997. Prior to rejoining the Company, Mr. Schiller was Vice President of Product Marketing at Macromedia, Inc. from +December 1995 to March 1997 and Director of Product Marketing at FirePower Systems, Inc. from 1993 to December 1995. Prior to that, Mr. Schiller spent six years at the Company in various marketing positions. Bertrand Serlet, Senior Vice President, Software Engineering, joined the Company in February 1997 upon the Company’s acquisition of NeXT and also served +the Company as Vice President of Platform Technology. At NeXT, Mr. Serlet held several engineering and managerial positions, including Director of Web Engineering. Prior to NeXT, Mr. Serlet worked as a research engineer at Xerox PARC from +1985 to 1989. Sina Tamaddon, Senior Vice President, Applications, joined the Company in September 1997. Mr. Tamaddon has also served with +the Company as Senior Vice President, Worldwide Service and Support, and Vice President and General Manager, Newton Group. Before joining the Company, Mr. Tamaddon held the position of Vice President, Europe with NeXT from September 1996 +through March 1997. From August 1994 to August 1996, Mr. Tamaddon was Vice President, Professional Services with NeXT. Item 1A. Risk Factors Because of the following factors, as well as other factors affecting the Company’s financial condition and +operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Economic conditions could materially adversely affect the Company. The Company’s operations and performance depend significantly on worldwide economic conditions. Uncertainty about current global economic conditions poses a risk as consumers and businesses may postpone spending in response to +tighter credit, negative financial news and/or declines in income or asset values, which could have a material negative effect on the demand for the Company’s products and services. Demand could also differ materially from the Company’s +expectations since the Company generally raises prices on goods and services sold outside the U.S. to offset the effect of the strengthening of the U.S. dollar, a trend which has been very pronounced recently. Other factors that could influence +demand include continuing increases in fuel and other energy costs, conditions in the residential real estate and mortgage markets, labor and healthcare costs, access to credit, consumer confidence, and other macroeconomic factors affecting consumer +spending behavior. These and other economic factors could have a material adverse effect on demand for the Company’s products and services and on the Company’s financial condition and operating results. The current financial turmoil affecting the banking system and financial markets and the possibility that financial institutions may consolidate or go out of +business have resulted in a tightening in the credit markets, a low level of liquidity in many financial markets, and extreme volatility in fixed income, credit, currency and equity markets. There could be a number of follow-on +effects from the credit crisis on the Company’s business, including insolvency of key suppliers resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the +Company’s products and/or customer, including channel partner, insolvencies; and failure of derivative counterparties and other financial institutions negatively impacting the Company’s treasury operations. Other income and expense +could also vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges 14 Table of Contents related to debt securities as well as equity and other investments; interest rates; cash balances; and changes in fair value of derivative +instruments. The current volatility in the financial markets and overall economic uncertainty increases the risk that the actual amounts realized in the future on the Company’s financial instruments could differ +significantly from the fair values currently assigned to them. Uncertainty about current global economic conditions could also continue to increase +the volatility of the Company’s stock price. The matters relating to the Company’s past stock option practices and the restatement of the +Company’s consolidated financial statements may result in additional litigation. The findings from the Company’s investigation into its past +stock option granting practices and the resulting restatement of prior financial statements in the Company’s Annual Report on Form 10-K for the fiscal year September 30, 2006 (the “2006 Form 10-K”) have exposed the Company to +greater risks associated with litigation, regulatory proceedings and government enforcement actions. As described in Part I, Item 3, “Legal Proceedings,” several derivative complaints and a class action complaint have been filed in +state and federal courts against the Company and certain current and former directors and executive officers pertaining to allegations relating to past stock option grants. The Company has provided the results of its investigation to the Securities +and Exchange Commission (the “SEC”) and the United States Attorney’s Office for the Northern District of California, and the Company has responded to their requests for documents and additional information. The Company intends to +continue to provide its full cooperation. On April 24, 2007, the SEC filed an enforcement action against two former officers of the Company. In +announcing the lawsuit, the SEC stated that it would not bring an enforcement action against the Company based in part on the Company’s “swift, extensive, and extraordinary cooperation in the Commission’s investigation.” +According to the SEC’s statement, the Company’s “cooperation consisted of, among other things, prompt self-reporting, an independent internal investigation, the sharing of the results of that investigation with the government, and the +implementation of new controls designed to prevent the recurrence of fraudulent conduct.” The enforcement actions against each of these former officers have now been settled. No assurance can be given regarding the outcomes from litigation relating to the Company’s past stock option practices. These and related matters have required, and will continue to require, the Company to incur +substantial expenses for legal, accounting, tax, and other professional services, and may divert management’s attention from the Company’s business. If the Company is subject to adverse findings, it could be required to pay damages and +penalties and might face additional remedies that could harm its financial condition and operating results. Global markets for personal computers, +digital music devices, mobile communication devices, and related peripherals and services are highly competitive and subject to rapid technological change. If the Company is unable to compete effectively in these markets, its financial condition and +operating results could be materially adversely affected. The Company competes in global markets that are highly competitive and characterized by +aggressive price cutting, with its resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid +adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers. The Company’s ability to compete +successfully depends heavily on its ability to ensure a continuing and timely introduction of new innovative products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution +for its personal computers, consumer electronics, and mobile communication devices, including the hardware, operating system, several software applications, and related services. As a result, the Company must make significant investments in research +and development and as such, the Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. By contrast, many of the Company’s +competitors seek to compete primarily through aggressive pricing and very low cost structures. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if other companies 15 Table of Contents infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be negatively affected and have a +materially adverse affect on its financial condition and operating results. In the market for personal computers and peripherals, the Company faces a +significant number of competitors, many of which have broader product lines, lower priced products, and larger installed customer bases. Consolidation in this market has resulted in larger and potentially stronger competitors. Price competition has +been particularly intense as competitors selling Windows-based personal computers have aggressively cut prices and lowered product margins. The Company also faces increased competition in key market segments, including consumer, SMB, education, +enterprise, government, and creative markets. An increasing number of Internet devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s existing +products. The Company is currently the only authorized maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer +market, which is dominated by makers of computers using competing operating systems, most notably Windows. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve the Mac +platform to maintain design and functional advantages. Use of unauthorized copies of the Mac OS on other companies’ hardware products may result in decreased demand for the Company’s hardware products, and could materially adversely affect +the Company’s financial condition and operating results. The Company is currently focused on certain mobile communication devices, such as iPhone; +consumer electronic devices, including the iPod family of digital music players, and digital content distribution. The Company faces substantial competition from companies that have significant technical, marketing, distribution, and other +resources, as well as established hardware, software, and digital content supplier relationships. The Company has only recently entered the mobile communications market, and many of its competitors in the mobile communications market have +significantly greater experience, product breadth, and distribution channels than the Company. The Company also competes with illegitimate ways to obtain digital content. Because some current and potential competitors have substantial resources and +experience and a lower cost structure, they may be able to provide such products and services at little or no profit or even at a loss. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach +to providing these components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. There can be no assurance +the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, +the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the personal +computer, consumer electronics and mobile communication industries, the Company must continually introduce new products and technologies, enhance existing products, and effectively stimulate customer demand for new and upgraded products. The success +of new product introductions depends on a number of factors, including timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new products and production ramp issues, the +availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and costs to meet +anticipated demand, and the risk that new products may have quality or other defects in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions on its +financial condition and operating results. The Company faces substantial inventory and other asset risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand or net realizable value and accrues +necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets for impairment whenever events or changed circumstances indicate the carrying amount of an asset may not be recoverable. +If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying 16 Table of Contents value of the assets exceeds its fair market value. Although the Company believes its inventory, asset, and related provisions are currently adequate, no +assurance can be given that, given the rapid and unpredictable pace of product obsolescence in the global personal computer, consumer electronics, and mobile communication industries, the Company will not incur additional inventory or asset related +charges. Such charges have had, and could have, a material adverse effect on the Company’s financial condition and operating results. The Company must +order components for its products and build inventory in advance of product announcements and shipments. Consistent with industry practice, components are normally acquired through a combination of purchase orders, supplier contracts, and open +orders based on projected demand. Such purchase commitments typically cover forecasted component and manufacturing requirements for 30 to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and +price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient inventories of components or products. The Company’s financial condition and operating results have been in the past and could be +in the future materially adversely affected by the Company’s ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results depend upon the Company’s ability to obtain key components including, but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable prices and in sufficient +quantities. Because the Company currently obtains certain key components including, but not limited to microprocessors, enclosures, certain LCDs, +certain optical drives, and ASICs, from single or limited sources, the Company is subject to significant supply and pricing risks. Many of these and other key components that are available from multiple sources including, but not limited to NAND +flash memory, DRAM and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. The Company has entered into certain agreements for the supply of key components including, but not limited to +microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee that the Company will be able to extend or renew these agreements on similar favorable terms, or at all, upon expiration or otherwise obtain favorable +pricing in the future. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that can have a material adverse effect on its financial condition and operating results. The Company expects to experience +decreases in its gross margin percentage in future periods, as compared to levels achieved during 2008 and 2007, due largely to the anticipated impact of product transitions, flat or reduced pricing on new and innovative products that have higher +cost structures, both expected and potential future cost increases for key components, and higher logistical costs. For additional information refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and +Results of Operations,” under the subheading “Gross Margin,” which is incorporated herein by reference. The Company and other participants +in the personal computer, consumer electronics and mobile communication industries compete for various components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not +common to the rest of the personal computer, consumer electronics or mobile communication industries. The Company’s new products often utilize custom components available from only one source until the Company has evaluated whether there is a +need for, and subsequently qualifies, additional suppliers. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured. Continued availability of these components at +acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the supply of a key single-sourced component +for a new or existing product were delayed or constrained, if such components were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial +condition and operating results could be materially adversely affected. The Company depends on component and product manufacturing and logistical +services provided by third parties, many of whom are located outside of the U.S. Most of the Company’s components and products are manufactured in +whole or in part by a few third-party manufacturers. Many of these manufacturers are located outside of the U.S., and are geographically concentrated 17 Table of Contents in single locations. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, +they also reduce the Company’s direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to +changing conditions. In addition, the Company relies on third-party manufacturers to adhere to the Company’s supplier code of conduct. Although arrangements with such manufacturers may contain provisions for warranty expense reimbursement, the +Company may remain responsible to the consumer for warranty service in the event of product defects. Any unanticipated product defect or warranty liability, whether pursuant to arrangements with contract manufacturers or otherwise, could have a +material adverse effect on the Company’s reputation, financial condition and operating results. Final assembly of the Company’s products is +currently performed in the Company’s manufacturing facility in Ireland, and by external vendors in California, Korea, China and the Czech Republic. Currently, the supply and manufacture of many critical components is performed by sole-sourced +third-party vendors in the U.S., China, Japan, Korea, Malaysia, Philippines, Taiwan, Thailand and Singapore. Sole-sourced third-party vendors in China perform final assembly of substantially all of the Company’s portable products, including +MacBook Pro, MacBook, MacBook Air, iPods, iPhones and most of the Company’s iMacs. If manufacturing or logistics in these locations is disrupted for any reason, including natural disasters, information technology system failures, military +actions or economic, business, labor, environmental, public health, or political issues, the Company’s financial condition and operating results could be materially adversely affected. The Company relies on third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with certain third parties to offer their digital content through the Company’s iTunes Store. The Company pays substantial fees to obtain the +rights to audio and video content. The Company’s licensing arrangements with these third parties are short-term and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content +providers currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license their content in the future. Other content owners, providers or distributors may +seek to limit the Company’s access to, or increase the total cost of, such content. If the Company is unable to continue to offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic +reach, the Company’s financial condition and operating results may be materially adversely affected. Many third-party content providers require that +the Company provide certain digital rights management (“DRM”) and other security solutions. If these requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the +Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose legislation that would force the Company to license its DRM, which could lessen the +protection of content and subject it to piracy and also could affect arrangements with the Company’s content providers. The Company relies on +access to third-party patents and intellectual property, and the Company’s future results could be materially adversely affected if it is alleged or found to have infringed intellectual property rights. Many of the Company’s products are designed to include third-party intellectual property, and in the future the Company may need to seek or renew licenses relating +to various aspects of its products and business methods. Although the Company believes that, based on past experience and industry practice, such licenses generally could be obtained on reasonable terms, there is no assurance that the necessary +licenses would be available on acceptable terms or at all. Because of technological changes in the global personal computer, consumer electronics and +mobile communication industries, current extensive patent coverage, and the rapid issuance of new patents, it is possible that certain components of the Company’s products and business methods may unknowingly infringe the patents or other +intellectual property rights of third parties. From time to time, the Company has been notified that it may be infringing such rights. Regardless of merit, responding to such claims can consume significant time and 18 Table of Contents expense. At present, the Company is vigorously defending more than 21 patent infringement cases, 13 of which were filed during fiscal 2008, and several +pending claims are in various stages of evaluation. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no assurance can be given that such licenses can be obtained on acceptable terms or that +litigation will not occur. If the Company is found to be infringing such rights, it may be required to pay substantial damages. If there is a temporary or permanent injunction prohibiting the Company from marketing or selling certain products or a +successful claim of infringement against the Company requires it to pay royalties to a third party, the Company’s financial condition and operating results could be materially adversely affected, regardless of whether it can develop +non-infringing technology. While in management’s opinion the Company does not have a potential liability for damages or royalties from any known current legal proceedings or claims related to the infringement of patent or other intellectual +property rights that would individually or in the aggregate have a material adverse effect on its financial condition and operating results, the results of such legal proceedings cannot be predicted with certainty. Should the Company fail to prevail +in any of the matters related to infringement of patent or other intellectual property rights of others or should several of these matters be resolved against the Company in the same reporting period, the Company’s financial condition and +operating results could be materially adversely affected. With the June 2007 introduction of iPhone, the Company has begun to compete with mobile +communication device companies that hold significant patent portfolios. Regardless of the scope or validity of such patents or the merits of any potential patent claims by competitors, the Company may have to engage in protracted +litigation, enter into expensive agreements or settlements and/or modify its products. Any of these events could have a material adverse impact on the Company’s financial condition and operating results. The Company’s future performance depends on support from third-party software developers. If third-party software applications and services cease to be developed +and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes decisions by +customers to purchase its hardware products, including its Macs, iPods and iPhones, are often based to a certain extent on the availability of third-party software applications and services. There is no assurance that third-party developers will +continue to develop and maintain applications and services for the Company’s products on a timely basis or at all, and discontinuance or delay of these applications and services could have a material adverse effect on the Company’s +financial condition and operating results. With respect to its Mac products, the Company believes the availability of third-party software applications and +services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company’s products compared to Windows-based products. This analysis may be based +on factors such as the perceived strength of the Company and its products, the anticipated revenue that may be generated, continued acceptance by customers of Mac OS X, and the costs of developing such applications and services. If the +Company’s minority share of the global personal computer market causes developers to question the Company’s prospects, developers could be less inclined to develop or upgrade software for the Company’s products and more inclined to +devote their resources to developing and upgrading software for the larger Windows market. The Company’s development of its own software applications and services may also negatively affect the decisions of third-party developers, such as +Microsoft, Adobe, and Google, to develop, maintain, and upgrade similar or competitive software and services for the Company’s products. Mac OS X Leopard, which became available in October 2007, includes a new feature that enables Intel-based +Mac systems to run Microsoft Windows XP and Windows Vista operating systems. This feature may deter developers from creating software applications for Mac OS X if such applications are already available for the Windows platform. With respect to iPhone and iPod touch, the Company relies on the continued availability and development of compelling and innovative software applications. As with +applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the relative benefits of developing software for the Company’s products rather +than its competitors’, including devices that use competing platforms. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices may suffer. 19 Table of Contents The Company’s products and services experience quality problems from time to time that can result in decreased +sales and operating margin. The Company sells highly complex hardware and software products and services that can contain defects in design and +manufacture. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. Defects may also occur in +components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, harm +to reputation, and significant warranty and other expenses, and could have a material adverse impact on the Company’s financial condition and operating results. The Company expects its quarterly revenue and operating results to fluctuate for a variety of reasons. The +Company’s profit margins vary among its products and its distribution channels. The Company’s software, accessories, and service and support contracts generally have higher gross margins than certain of the Company’s other products. +Gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s +direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition, the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially +adversely impacted as a result of a shift in product, geographic or channel mix, new products, component cost increases, or price competition. The Company has typically experienced greater net sales in the first and fourth fiscal quarters compared +to the second and third fiscal quarters due to seasonal demand related to the holiday season and the beginning of the school year, respectively. Furthermore, the Company sells more products from time-to-time during the third month of a quarter than +it does during either of the first two months. Developments late in a quarter, such as lower-than-anticipated demand for the Company’s products, an internal systems failure, or failure of one of the Company’s key logistics, components +supply, or manufacturing partners, could have a material adverse impact on the Company’s financial condition and operating results. In certain +countries, including the U.S., the Company relies on a single cellular network carrier to provide service for iPhone. In the U.S., U.K., France, +Germany, Spain, Ireland, and certain other countries, the Company has contracted with a single carrier to provide cellular network services for iPhone on an exclusive basis. If these exclusive carriers cannot successfully compete with other carriers +in their markets for any reason, including but not limited to the quality and coverage of wireless voice and data services, performance and timely build-out of advanced wireless networks, and pricing and other terms of conditions of end-user +contracts, or if these exclusive carriers fail to promote iPhone aggressively or favor other handsets in their promotion and sales activities or service plans, sales may be materially adversely affected. The Company is subject to risks associated with laws, regulations and industry-imposed standards related to mobile communications devices. Laws and regulations related to mobile communications devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes, +which could include but are not limited to restrictions on production, manufacture, distribution, and use of the device, locking the device to a carrier’s network, or mandating the use of the device on more than one carrier’s network, +could have a material adverse effect on the Company’s financial condition and operating results. Mobile communication devices, such as iPhone, are +subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in +additional testing requirements, product modifications or delays in product shipment dates, which could have a material adverse effect on the Company’s financial condition and operating results. 20 Table of Contents The Company may be subject to information technology system failures, network disruptions and breaches in data +security. Information technology system failures, network disruptions and breaches of data security could disrupt the Company’s operations by +causing delays or cancellation of customer, including channel partner, orders, negatively affecting the Company’s online offerings and services, impeding the manufacture or shipment of products, processing transactions and reporting financial +results, resulting in the unintentional disclosure of customer or Company information, or damage to the Company’s reputation. While management has taken steps to address these concerns by implementing sophisticated network security and internal +control measures, there can be no assurance that a system failure or data security breach will not have a material adverse effect on the Company’s financial condition and operating results. The Company’s stock price continues to be volatile. The +Company’s stock has at times experienced substantial price volatility as a result of variations between its actual and anticipated financial results, announcements by the Company and its competitors, or uncertainty about current global economic +conditions. The stock market as a whole also has experienced extreme price and volume fluctuations that have affected the market price of many technology companies in ways that may have been unrelated to these companies’ operating performance. +Furthermore, the Company believes its stock price reflects high future growth and profitability expectations. If the Company fails to meet these expectations its stock price may significantly decline. Political events, war, terrorism, public health issues, natural disasters and other circumstances could materially adversely affect the Company. War, terrorism, geopolitical uncertainties, public health issues, and other business interruptions have caused and could cause damage or disruption to international +commerce and the global economy, and thus could have a strong negative effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to +interruption by natural disasters, fire, power shortages, terrorist attacks, and other hostile acts, labor disputes, public health issues, and other events beyond its control. Such events could decrease demand for the Company’s products, make +it difficult or impossible for the Company to make and deliver products to its customers, including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. Should major +public health issues, including pandemics, arise, the Company could be negatively affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between +regions, delays in production ramps of new products, and disruptions in the operations of the Company’s manufacturing vendors and component suppliers. The majority of the Company’s research and development activities, its corporate +headquarters, information technology systems, and other critical business operations, including certain component suppliers and manufacturing vendors, are located near major seismic faults. Because the Company does not carry earthquake insurance for +direct quake-related losses and significant recovery time could be required to resume operations, the Company’s financial condition and operating results could be materially adversely affected in the event of a major earthquake. The Company’s success depends largely on its ability to attract and retain key personnel. Much of the Company’s future success depends on the continued service and availability of skilled personnel, including its CEO, its executive team and key employees in technical, marketing and staff positions. +Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in the Silicon Valley, where most of the Company’s key employees are located. The Company has relied on equity awards +as one means for recruiting and retaining this highly skilled talent. Accounting regulations requiring the expensing of stock options have resulted in increased stock-based compensation expense, which has caused the Company to reduce the number of +stock-based awards issued to employees and could negatively impact the Company’s ability to attract and retain key personnel. Additionally, significant adverse volatility in the Company’s stock price could result in a stock option’s +exercise price exceeding the underlying stock’s market value or a significant deterioration in the value of restricted stock units (“RSUs”) granted, thus lessening the 21 Table of Contents effectiveness of retaining employees through stock-based awards. There can be no assurance that the Company will continue to successfully attract and retain +key personnel. Unfavorable results of legal proceedings could materially adversely affect the Company. The Company is subject to various legal proceedings and claims that have arisen out of the ordinary conduct of its business and are not yet resolved and additional claims +may arise in the future. Results of legal proceedings cannot be predicted with certainty. Regardless of its merit, litigation may be both time-consuming and disruptive to the Company’s operations and cause significant expense and diversion of +management attention. In recognition of these considerations, the Company may enter into material settlements. Should the Company fail to prevail in certain matters, or should several of these matters be resolved against the Company in the same +reporting period, the Company may be faced with significant monetary damages or injunctive relief against it that would materially adversely affect a portion of its business and might materially affect the Company’s financial condition and +operating results. The Company’s business is subject to the risks of international operations. The Company derives a large and growing portion of its revenue and earnings from its international operations. As a result, its financial condition and operating results +could be significantly affected by risks associated with international activities, including economic and labor conditions, political instability, tax laws (including U.S. taxes on foreign subsidiaries), and changes in the value of the U.S. dollar +versus local currencies. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign currency exchange rate +fluctuations and by international trade regulations, including tariffs and antidumping penalties. The Company’s primary exposure to movements in +foreign currency exchange rates relate to non-U.S. dollar denominated sales in Europe, Japan, Australia, Canada, and certain parts of Asia, as well as non-U.S. dollar denominated operating expenses incurred throughout the world. Weakening of foreign +currencies relative to the U.S. dollar will adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally will lead the Company to raise international pricing, potentially reducing demand +for the Company’s products. In some circumstances, due to competition or other reasons, the Company may decide not to raise local prices to the full extent of the dollar’s strengthening, or at all, which would adversely affect the U.S. +dollar value of the Company’s foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies, while generally beneficial to the Company’s foreign currency-denominated sales and earnings, could cause the +Company to reduce international pricing, thereby limiting the benefit. As strengthening of foreign currencies may also increase the Company’s cost of product components denominated in those currencies. The Company has used derivative instruments, such as foreign exchange forward and option positions, to hedge certain exposures to fluctuations in foreign currency +exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company’s retail business has required and will continue to require a substantial investment and commitment of resources and is subject to numerous risks and +uncertainties. Through September 27, 2008, the Company had opened 247 retail stores. The Company’s retail stores have required substantial +fixed investment in equipment and leasehold improvements, information systems, inventory, and personnel. The Company also has entered into substantial operating lease commitments for retail space with terms ranging from 5 to 20 years, the majority +of which are for 10 years. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations +and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high fixed cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of +individual or multiple stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements, and severance costs that could have a material adverse effect on the Company’s financial condition and +operating results. 22 Table of Contents Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and +uncertainties that could have a material adverse effect on the Retail segment’s future results, cause its actual results to differ from anticipated results and have a material adverse effect on the Company’s financial condition and +operating results. These risks and uncertainties include, among other things, macro-economic factors that could have a negative effect on general retail activity, as well as the Company’s inability to manage costs associated with store +construction and operation, inability to sell third-party products at adequate margins, failure to manage relationships with existing retail channel partners, more challenging environment in managing retail operations outside the U.S., costs +associated with unanticipated fluctuations in the value of retail inventory, and inability to obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and initiatives could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, +including distraction of management from current operations, insufficient revenue to offset liabilities assumed and expenses associated with the strategy, inadequate return of capital, and unidentified issues not discovered in the Company’s due +diligence. Because these new ventures are inherently risky, no assurance can be given that such strategies and initiatives will be successful and will not have a material adverse effect on the Company’s financial condition and operating +results. The Company’s future operating performance depends on the performance of distributors, carriers, and other resellers. The Company distributes its products through wholesalers, resellers, national and regional retailers, value-added resellers, and cataloguers, many of whom distribute +products from competing manufacturers. The Company also sells many of its products and resells third-party products in most of its major markets directly to end-users, certain education customers, and certain resellers through its online and retail +stores. iPhone is distributed through the Company, its cellular network carriers’ distribution channels, and certain third-party resellers. Many +resellers operate on narrow product margins and have been negatively affected in the past by weak economic conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as +distributors and resellers of the Company’s products. Such a perception could discourage resellers from investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those +products. The Company’s financial condition and operating results could be materially adversely affected if the financial condition of these resellers weakens, if resellers stopped distributing the Company’s products, or if uncertainty +regarding demand for the Company’s products caused resellers to reduce their ordering and marketing of the Company’s products. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing +selected resellers’ stores with Company employees and contractors and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The Company is exposed to credit risk and fluctuations in the market values of its investment portfolio. Although the Company has not recognized any material losses on its cash, cash equivalents and short-term investments, future declines in their market values could have a +material adverse effect on the Company’s financial condition and operating results. Given the global nature of its business, the Company has investments both domestically and internationally. Additionally, the Company’s overall investment +portfolio is often concentrated in the financial sector, which has been negatively impacted by the recent market liquidity conditions. Credit ratings and pricing of these investments can be negatively impacted by liquidity, credit deterioration or +losses, financial results, or other factors. As a result, the value or liquidity of the Company’s cash, cash equivalents and short-term investments could decline and result in a material impairment, which could have a material adverse effect on +the Company’s financial condition and operating results. 23 Table of Contents The Company is exposed to credit risk on its accounts receivable and prepayments related to long-term supply +agreements. This risk is heightened during periods when economic conditions worsen. A substantial majority of the Company’s outstanding trade +receivables are not covered by collateral or credit insurance. The Company also has unsecured non-trade receivables resulting from the sale by the Company of components to vendors who manufacture sub-assemblies or assemble final products for the +Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of NAND flash memory. While the Company has procedures to monitor and limit exposure to credit risk on its trade and non-trade +receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses, which could have a material adverse effect on the Company’s financial condition and operating +results. The Company is subject to risks associated with laws and regulations related to health, safety and environmental protection. The Company’s products and services, and the production and distribution of those goods and services, are subject to a variety of laws and regulations. These may +require the Company to offer customers the ability to return a product at the end of its useful life and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several +jurisdictions in which the Company operates, including various countries within Europe and Asia, certain Canadian provinces and certain states within the U.S. Although the Company does not anticipate any material adverse effects based on the nature +of its operations and the thrust of such laws, there is no assurance such existing laws or future laws will not have a material adverse effect on the Company’s financial condition and operating results. Changes in the Company’s tax rates could affect its future results. The Company’s future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or +their interpretation. The Company is subject to the continuous examination of its income tax returns by the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of adverse outcomes resulting from these +examinations to determine the adequacy of its provision for taxes. There can be no assurance that the outcomes from these examinations will not have a material adverse effect on the Company’s financial condition and operating results. The Company is subject to risks associated with the availability and coverage of insurance. For certain risks, the Company does not maintain insurance coverage because of cost and/or availability. Because the Company retains some portion of its insurable +risks, and in some cases self-insures completely, unforeseen or catastrophic losses in excess of insured limits could have a material adverse effect on the Company’s financial condition and operating results. Item 1B. Unresolved Staff Comments None. Item 2. Properties The Company’s headquarters are located +in Cupertino, California. The Company has a manufacturing facility in Cork, Ireland. As of September 27, 2008, the Company leased approximately 4.2 million square feet of space, primarily in the U.S., and to a lesser extent, in Europe, +Japan, Canada, and the Asia Pacific region. The major facility leases are generally for terms of 3 to 20 years and generally provide renewal options for terms of 1 to 5 additional years. Leased space includes approximately 1.8 million +square feet of retail space, a majority of which is in the U.S. Lease terms for retail space range from 5 to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 27, 2008, the Company owned a 367,000 square-foot manufacturing facility in Cork, Ireland that also housed a customer support call center. The +Company also owned 805,000 square feet of facilities in 24 Table of Contents Sacramento, California that include warehousing and distribution operations, as well as a customer support call center. In addition, the Company owned +approximately 2.3 million square feet of facilities for research and development and corporate functions in Cupertino, California, including approximately 1.0 million square feet purchased in 2007 and 2006 for the future development of the +Company’s second corporate campus in Cupertino, California, and approximately 107,000 square feet for a data center in Newark, California. Outside the U.S., the Company owned additional facilities totaling approximately 129,000 square feet as +of September 27, 2008. The Company believes its existing facilities and equipment are well maintained and in good operating condition. The Company has +invested in internal capacity and strategic relationships with outside manufacturing vendors, and therefore believes it has adequate manufacturing capacity for the foreseeable future. The Company continues to make investments in capital equipment as +needed to meet anticipated demand for its products. Item 3. Legal Proceedings As of September 27, 2008, the end of the annual period covered by this report, the Company is subject to the various legal proceedings and claims discussed below, as well as certain other legal proceedings and +claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would +individually or in the aggregate have a material adverse effect on its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal +matters or should several of these legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. The Company settled certain matters during +the fourth quarter of 2008 that did not individually or in the aggregate have a material impact on the Company’s results of operations. Bader v. +Anderson, et al. Plaintiff filed this purported shareholder derivative action against the Company and each of its then current executive officers and +members of its Board of Directors on May 19, 2005 in Santa Clara County Superior Court asserting claims for breach of fiduciary duty, material misstatements and omissions and violations of California Business & Professions Code +§17200 (unfair competition). The complaint alleged that the Company’s March 14, 2005, proxy statement was false and misleading for failure to disclose certain information relating to the Apple Computer, Inc. Performance Bonus Plan, +which was approved by shareholders at the annual meeting held on April 21, 2005. Plaintiff, who ostensibly brought suit on the Company’s behalf, made no demand on the Board of Directors and alleged that such demand was excused. The +complaint sought injunctive and other relief for purported injury to the Company. On July 27, 2005, plaintiff filed an amended complaint alleging that, in addition to the purported derivative claims, adoption of the bonus plan and distribution +of the proxy statement describing that plan also inflicted injury on her directly as an individual shareholder. On January 10, 2006, the Court sustained defendants’ demurrer to the amended complaint, with leave to amend. Plaintiff filed a +second amended complaint on February 7, 2006, and the Company filed a demurrer. After a hearing on June 13, 2006, the Court sustained the demurrer without leave to amend as to the non-director officers and with leave to amend as to the +directors. On July 24, 2006, plaintiff filed a third amended complaint, which purported to bring claims derivatively as well as directly on behalf of a class of common stockholders who have been or will be harmed by virtue of the allegedly +misleading proxy statement. In addition to reasserting prior causes of action, the third amended complaint included a claim that the Company violated the terms of the plan, and a claim for waste related to restricted stock unit grants to certain +officers in 2003 and 2004 and an option grant to the Company’s CEO in January 2000. The Company filed a demurrer to the third amended complaint. On January 30, 2007, the Court sustained the Company’s demurrer with leave to amend. On +May 8, 2007, plaintiff filed a fourth amended complaint. The Company filed a demurrer to the fourth amended complaint, which the Court sustained, without leave to amend, on October 12, 2007. On October 25, 2007, the Court entered a +final judgment in favor of defendant and ordered the case dismissed with prejudice. On November 26, 2007, plaintiff filed a notice of appeal. Plaintiffs’ appeal is pending. 25 Table of Contents Birdsong v. Apple Computer, Inc. This action alleges that the Company’s iPod music players, and the ear bud headphones sold with them, are inherently defective in design and are sold without adequate warnings concerning the risk of noise-induced +hearing loss by iPod users. The Birdsong action was initially filed on January 30, 2006 in the United States District Court for the Western District of Louisiana asserting Louisiana causes of action on behalf of a purported Louisiana class of +iPod purchasers. A similar action (Patterson v. Apple Computer, Inc.) was filed on January 31, 2006 in the United States District Court for the Northern District of California asserting California causes of action on behalf of a +purported class of all iPod purchasers within the four-year period before January 31, 2006. The Birdsong action was transferred to the Northern District of California, and the Patterson action was dismissed. An amended complaint was +subsequently filed in Birdsong, dropping the Louisiana law-based claims and adding California law-based claims equivalent to those in Patterson. After the Company filed a motion to dismiss on November 3, 2006, plaintiffs agreed not to oppose +the motion and filed a second amended complaint on January 16, 2007. That complaint alleges California law-based claims for breaches of implied and express warranties, violations of California Business & Professions Code §17200 +(unfair competition), California Business & Professions Code §17500 (false advertising), the Consumer Legal Remedies Act and negligent misrepresentation on behalf of a putative nationwide class and a Louisiana law-based claim for +redhibition for a Louisiana sub-class. On March 1, 2007, the Company filed a motion to dismiss the California law-based claims, which was heard on June 4, 2007. On December 14, 2007, the Court issued an order granting the +Company’s motion, with leave to amend the complaint. Plaintiffs filed a third amended complaint on January 11, 2008. On February 15, 2008, the Company filed a motion to dismiss the third amended complaint. On June 16, 2008, the +Court granted the Company’s motion to dismiss the third amended complaint with prejudice. On July 11, 2008, plaintiffs filed a notice of appeal. Plaintiffs’ appeal is pending. A similar complaint, Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc., was filed in Montreal, Quebec, Canada, on February 1, 2006, seeking +authorization to institute a class action on behalf of iPod purchasers in Quebec. At the request of plaintiffs’ counsel, the Court has postponed class certification proceedings in this action indefinitely. Branning et al. v. Apple Computer, Inc. Plaintiffs originally filed +this purported class action in San Francisco County Superior Court on February 17, 2005. The initial complaint alleged violations of California Business & Professions Code §17200 (unfair competition) and violation of the Consumer +Legal Remedies Act regarding a variety of purportedly unfair and unlawful conduct including, but not limited to, allegedly selling used computers as new and failing to honor warranties. Plaintiffs also brought causes of action for misappropriation +of trade secrets, breach of contract and violation of the Song-Beverly Consumer Warranty Act. Plaintiffs requested unspecified damages and other relief. On May 9, 2005, the Court granted the Company’s motion to transfer the case to Santa +Clara County Superior Court. On May 2, 2005, plaintiffs filed an amended complaint adding two new named plaintiffs and three new causes of action including a claim for treble damages under the Cartwright Act (California Business & +Professions Code §16700 et seq.) and a claim for false advertising. The Company filed a demurrer to the amended complaint, which the Court sustained in its entirety on November 10, 2005. The Court granted plaintiffs leave to amend and they +filed an amended complaint on December 29, 2005. Plaintiffs’ amended complaint added three plaintiffs and alleged many of the same factual claims as the previous complaints, such as alleged selling of used equipment as new, alleged failure +to honor warranties and service contracts for the consumer plaintiffs, and alleged fraud related to the opening of the Apple retail stores. Plaintiffs continued to assert causes of action for unfair competition (§17200), violations of the +Consumer Legal Remedies Act, breach of contract, misappropriation of trade secrets, violations of the Cartwright Act, and alleged new causes of action for fraud, conversion, and breach of the implied covenant of good faith and fair dealing. The +Company filed a demurrer to the amended complaint on January 31, 2006, which the Court sustained on March 3, 2006 on sixteen of seventeen causes of action. Plaintiffs filed an amended complaint adding one new plaintiff. The Company filed a +demurrer, which was granted in part on September 9, 2006. Plaintiffs filed a further amended complaint on September 21, 2006. On October 2, 2006, the Company filed an answer denying all allegations and asserting numerous affirmative +defenses. On November 30, 2007, the Company filed a motion for judgment on the 26 Table of Contents pleadings, which the Court denied. Plaintiffs filed a Fifth Amended Complaint on March 19, 2008 and a Corrected Fifth Amended Complaint on April 1, +2008. The Company filed an answer to the Corrected Fifth Amended Complaint on April 18, 2008. The Company filed a motion for judgment on the pleadings for an order dismissing plaintiffs’ fraud claim based upon the statute of limitations, +which was granted by the Court on June 24, 2008, with leave to amend. Plaintiffs filed a Sixth Amended Complaint on July 14, 2008 and a Seventh Amended Complaint on August 22, 2008, adding three new reseller plaintiffs. On +September 22, 2008, the Company filed its answer to the consumer-related claims denying all allegations and asserting numerous affirmative defenses, and also filed a demurrer to the new reseller claims. The Company has filed motions for summary +adjudication of two named plaintiffs’ claims, which were heard on October 14, 2008. The Court requested further briefing on the motions for summary adjudication. On August 22, 2008, plaintiffs filed a motion to certify the consumer +class and on October 10, 2008, the Company filed its opposition to plaintiffs’ motion. The class certification hearing is set for December 19, 2008. Gordon v. Apple Computer, Inc. Plaintiff filed this purported class action on August 31, 2006 in the United States District Court for +the Northern District of California, San Jose Division, on behalf of a purported nationwide class of consumers who purchased 65W Power Adapters for iBooks and Powerbooks between November 2002 and the present. The complaint alleges various problems +with the 65W Adapter, including fraying, sparking, and premature failure. Plaintiff alleges violations of California Business & Professions Code §17200 (unfair competition), the Consumer Legal Remedies Act, the Song-Beverly Consumer +Warranty Act and breach of warranties. The complaint seeks damages and equitable relief. The Company filed an answer on October 20, 2006 denying the material allegations and asserting numerous affirmative defenses. The Company has reached a +settlement of this matter and the parties have received preliminary court approval for the settlement. The parties await final court approval for the settlement. Harvey v. Apple Inc. Plaintiff filed this action on August 6, 2007 in the United States District Court for the Eastern District of +Texas, Marshall Division, alleging infringement by the Company of U.S. Patent No. 6,753,671 entitled “Recharger for use with a portable electronic device and which includes a proximally located light emitting device” and U.S. Patent +No. 6,762,584 entitled “Recharger for use with a portable electronic device and which includes a connector terminus for communicating with rechargeable batteries contained within the device.” The complaint seeks unspecified damages +and other relief. The Company filed an answer on October 12, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of non-infringement and invalidity. +On April 7, 2008, plaintiff filed an amended complaint further alleging infringement of the reissue patent of U.S. Patent No. 6,753,671. On April 28, 2008, the Company filed an answer denying all material allegations and asserting +numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of non-infringement and invalidity. The Markman hearing is set for October 28, 2009, and trial is scheduled for April 5, 2010. Honeywell International, Inc., et al. v. Apple Computer, Inc., et al. Plaintiffs Honeywell International, Inc. and Honeywell Intellectual Properties, Inc. filed this action on October 6, 2004 in the United States District Court in Delaware alleging infringement by the +Company and other defendants of U.S. Patent 5,280,371 entitled “Directional Diffuser for a Liquid Crystal Display.” Plaintiffs seek unspecified damages and other relief. The Company filed an answer on December 21, 2004 denying all +material allegations and asserting numerous affirmative defenses. The Company has tendered the case to several liquid crystal display manufacturer suppliers. On May 18, 2005 the Court stayed the case against the Company and the other +non-manufacturer defendants. Plaintiffs filed an amended complaint on November 7, 2005 adding additional defendants and expanding the scope of the accused products. The Company’s response to the amended complaint is not yet due. On +April 2, 2008, the Court lifted the stay for the purpose of determining whether the liquid crystal display manufacturer suppliers used by the Company and certain other defendants are licensed under the ‘371 patent. On October 31, +2008, the Company filed a motion for summary judgment of non-infringement based on the contention that its suppliers are licensed under the ‘371 patent. A hearing on the motion is scheduled for December 19, 2008. 27 Table of Contents In re Apple Computer, Inc. Derivative Litigation (formerly Karant v. Jobs, et al. and Related Actions) (Federal +Action) On June 30, 2006, a putative derivative action captioned Karant v. Jobs, et. al. , was filed in the United States District Court for +the Northern District of California, San Jose Division. A number of related actions were filed in the subsequent weeks and have been consolidated into a single action captioned In re Apple Computer, Inc. Derivative Litigation , Master File No. +C-06-04128-JF before the Hon. Jeremy Fogel. The actions were filed after the Company’s announcement on June 29, 2006 that an internal investigation had discovered irregularities related to the issuance of certain stock option grants made +between 1997 and 2001, that a special committee of the Company’s outside directors had retained independent counsel to perform an investigation and that the Company had informed the Securities and Exchange Commission. The action purports to +assert claims on behalf of the Company against several current and former executive officers and members of the Board of Directors alleging improper backdating of stock option grants to maximize certain defendants’ profits, failing to properly +account for and take tax deductions for those grants, insider trading, and issuing false financial statements. The Company is named as a nominal defendant. The consolidated complaint alleges various causes of action under federal and California law, +including claims for unjust enrichment, breach of fiduciary duty, violation of the California Corporations Code, abuse of control, gross mismanagement, rescission, constructive fraud and waste of corporate assets, as well as claims under Sections +10(b), 14(a) and 20(a) of the Securities Exchange Act. Plaintiffs seek damages, disgorgement, restitution and imposition of a constructive trust. A Consolidated Shareholder Derivative Complaint was filed on December 18, 2006, and a +First Amended Shareholder Derivative Complaint was filed on March 6, 2007. On June 12, 2007, the Company’s Board of Directors approved a resolution appointing a Special Litigation Committee to make all decisions relating to +options litigation. Defendants filed a motion to dismiss on April 20, 2007, which was heard on September 7, 2007. On November 19, 2007, the Court granted the defendants’ motion to dismiss with leave to amend. Plaintiffs filed an +amended complaint on December 19, 2007. Defendants filed motions to dismiss the amended complaint on January 25, 2008. The motions to dismiss were originally scheduled to be heard on April 4, 2008. Pursuant to a joint stipulation +filed on April 3, 2008, the Court vacated the hearing date. The parties have reached a settlement, and the Court has granted preliminary approval of the settlement. The parties’ request for final approval of the settlement is pending. In re Apple Computer, Inc. Derivative Litigation (formerly Plumbers and Pipefitters v. Jobs, et al. and Related Actions) (State Action); Boston +Retirement Board v. Apple Computer, Inc. On July 5, 2006, a putative derivative action captioned Plumbers and Pipefitters v. Jobs, et. al. , +was filed in California Superior Court for the County of Santa Clara. A number of related actions were filed in the subsequent weeks, and have been consolidated into a single action captioned In re Apple Computer, Inc. Derivative Litigation , +No. 1:06CV066692, assigned to the Hon. Joseph Huber. These actions purport to assert claims on behalf of the Company against several current and former executive officers and members of the Board of Directors alleging improper backdating of +stock option grants to maximize certain defendants’ profits, failing to properly account for and take tax deductions for those grants and issuing false financial statements. The Company is named as a nominal defendant. A consolidated complaint +was filed on October 5, 2006, alleging a variety of causes of action under California law, including claims for unjust enrichment, breach of fiduciary duty, violation of the California Corporations Code, abuse of control, accounting, +constructive trust, rescission, deceit, gross mismanagement and waste of corporate assets. On December 7, 2006, the Court granted the Company’s motion to stay these actions. The parties have reached a settlement, and the Court has granted +preliminary approval of the settlement. The parties’ request for final approval of the settlement is pending. On November 3, 2006, the Boston +Retirement Board, a purported shareholder, filed a petition for writ of mandate against the Company in California Superior Court for the County of Santa Clara ( Boston Retirement Board v. Apple Computer Inc. ). The petition sought to compel the +Company to allow inspection of certain corporate records relating to the Company’s option practices and the Special Committee’s investigation. Following a trial held on September 24, 2007, the Court granted the petition for inspection +but narrowed the scope of the records to be produced. On April 16, 2008, the Boston Retirement Board filed a derivative action in California Superior Court for the County of Santa Clara. On July 31, 2008, Boston Retirement Board +attempted to serve the new 28 Table of Contents complaint on the Company. On September 15, 2008, defendants filed a motion to quash service of summons. On October 17, 2008, the Court denied +defendants’ motion to quash. On October 20, 2008, defendants requested consolidation of this action with In re Apple Computer, Inc. Derivative Litigation , No. 1:06CV066692, and a stay of the action. In re Apple iPod Nano Products Liability Litigation (formerly Wimmer v. Apple Computer, Inc.; Moschella, et al., v. Apple Computer, Inc. ; Calado, et al. v. +Apple Computer, Inc. ; Kahan, et al., v. Apple Computer, Inc .; Jennings, et al., v. Apple Computer, Inc. ; Rappel v. Apple Computer, Inc. ; Mayo v. Apple Computer, Inc. ; Valencia v. Apple Computer, Inc. ; Williamson v. Apple Computer, Inc. ; Sioson v. Apple Computer, Inc. Beginning on October 19, 2005, eight complaints were filed in +various United States District Courts and two complaints were filed in California State Court alleging that the Company’s iPod nano was defectively designed so that it scratches excessively during normal use, rendering the screen unreadable. The federal actions were coordinated in the United States District Court for the Northern District of California and assigned to the Hon. Ronald Whyte +pursuant to an April 17, 2006 order of the Judicial Panel on Multidistrict Litigation. Plaintiffs filed a First Consolidated and Amended Master Complaint on September 21, 2006, alleging violations of California and other states’ +consumer protection and warranty laws and claiming unjust enrichment. The Master Complaint alleges two putative plaintiff classes: (1) all U.S. residents (excluding California residents) who purchased an iPod nano that was not manufactured or +designed using processes necessary to ensure normal resistance to scratching of the screen; and (2) all iPod nano purchasers other than U.S. residents who purchased an iPod nano that was not manufactured or designed using processes necessary to +ensure normal resistance to scratching of the screen. The Company answered the Master Complaint on November 20, 2006. The two California State Court +actions were coordinated on May 4, 2006, and assigned to the Hon. Carl West in Los Angeles Superior Court. Plaintiffs filed a Consolidated Amended Class Action Complaint on June 8, 2006, alleging violations of California state consumer +protection, unfair competition, false advertising and warranty laws and claiming unjust enrichment. The Consolidated Complaint alleges a putative plaintiff class of all California residents who own an iPod nano containing a manufacturing defect that +results in the nano being susceptible to excessive scratching. The Company answered the Consolidated Amended Complaint on October 6, 2006. The parties have reached a settlement, which is subject to court approval. Two similar complaints, Carpentier v. Apple Canada, Inc ., and Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc . were filed in Montreal, Quebec, +Canada on October 27, 2005 and November 9, 2005, respectively, seeking authorization to institute class actions on behalf of iPod nano purchasers in Quebec. The Royer-Brennan file was stayed in May 2006 in favor of the Carpentier file. A +similar complaint, Mund v. Apple Canada Inc. and Apple Computer, Inc. , was filed in Ontario, Canada on January 9, 2006 seeking authorization to institute a class action on behalf of iPod nano purchasers in Canada. Apple Canada Inc. and +Apple Computer, Inc. have served Notices of Intent to Defend. The parties have reached a settlement of the Quebec cases, and have received final court approval of the settlement. Individual Networks, LLC v. Apple, Inc. Plaintiff filed this action against the Company on April 24, 2007 in +the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent No. 7,117,516, entitled “Method and System for Providing a Customized Media List.” Plaintiff alleges certain +features of the iTunes store infringe the patent. The complaint seeks unspecified damages and other relief. The Company filed an answer on July 2, 2007, denying all material allegations and asserting numerous affirmative defenses. The Company +also asserted counterclaims for declaratory judgment of non-infringement and invalidity, as well as a counterclaim against Individual Networks LLC for infringement of U.S. Patent No. 5,724,567. The trial is scheduled for November 9, 2009. +The Company has filed a petition with the United States Patent and Trademark Office requesting reexamination of U.S. Patent No. 7,117,516. The Markman hearing took place on October 8, 2008. The Company awaits the Court’s Markman +ruling. 29 Table of Contents Macadam v. Apple Computer, Inc.; Santos v. Apple Computer, Inc. The Macadam action was filed in late 2002 in Santa Clara County Superior Court asserting various causes of action including breach of contract, fraud, negligent and +intentional interference with economic relationship, negligent misrepresentation, trade libel, unfair competition and false advertising. The complaint requested unspecified damages and other relief. The Company filed an answer on December 3, +2004 denying all allegations and asserting numerous defenses. On October 1, 2003, Macadam was deauthorized as an Apple reseller. Macadam filed a +motion for a temporary order to reinstate it as a reseller, which the Court denied. The Court denied Macadam’s motion for a preliminary injunction on December 19, 2003. On December 6, 2004, Macadam filed for Chapter 11 bankruptcy in +the Northern District of California, which placed a stay on the litigation as to Macadam. The Company filed a claim in the bankruptcy proceedings on February 16, 2005. The Macadam bankruptcy case was converted to Chapter 7 (liquidation) on +April 29, 2005. The Company reached a settlement of Macadam’s claims against the Company with the Chapter 7 Bankruptcy Trustee, and the Bankruptcy Court approved the settlement on July 17, 2006 over the objection of Tom Santos, +Macadam’s principal. Santos appealed the ruling approving the settlement, but the District Court denied the appeal. Santos appealed to the Ninth Circuit Court of Appeals. Santos’ appeal was dismissed on October 3, 2008. On December 19, 2005, Tom Santos filed a Fifth Amended Complaint on his own behalf (not on behalf of Macadam) alleging fraud, violations of California +Business & Professions Code §17200 (unfair competition), California Business & Professions Code §17500 (false advertising) and the Consumer Legal Remedies Act. The Company filed a demurrer to Santos’ amended +complaint and a special motion to strike the defamation cause of action on January 20, 2006. The Court sustained the demurrer in part but denied the special motion to strike. Santos filed a Sixth Amended Complaint on July 14, 2006. The +Company filed a demurrer, which was sustained on September 9, 2006. Santos filed a Seventh Amended Complaint in late September 2006. The Company filed a motion to strike, which was granted in part and denied in part on December 15, 2006. +Santos filed an Eighth Amended Complaint on January 29, 2007. The Company filed a demurrer, which was heard on May 7, 2007. The court sustained the demurrer, and Santos filed a Ninth Amended Complaint on July 11, 2007. The Company +filed a demurrer, which was overruled. The Company also filed a cross complaint against Santos on January 20, 2006 alleging violations of California Business & Professions Code §17200 and California Penal Code §502, fraud and +deceit and breach of contract. The parties have reached a settlement. Mediostream, Inc. v. Acer America Corp. et al. Plaintiff filed this action against the Company, Acer America Corp., Dell, Inc. and Gateway, Inc. on August 28, 2007 in the United States District Court for the +Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent No. 7,009,655, entitled “Method and System for Direct Recording of Video Information onto a Disk Medium.” An amended complaint was served on +November 7, 2007. The amended complaint seeks unspecified damages and other relief. On January 25, 2008, the Company filed an answer to the complaint denying all material allegations and asserting numerous affirmative defenses and also +filed a motion to transfer the case to the Northern District of California. The Court has scheduled the Markman hearing for August 4, 2010 and trial for January 4, 2011. OPTi Inc. v. Apple Inc. Plaintiff filed this action against the Company on January 16, 2007 in the United +States District Court for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent Nos. 5,710,906, 5,813,036 and 6,405,291, all entitled “Predictive Snooping of Cache Memory for Master-Initiated Accesses.” The +complaint seeks unspecified damages and other relief. The Company filed an answer on April 17, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment +of non-infringement and invalidity. The Markman hearing is set for November 26, 2008, and trial is scheduled for April 6, 2009. 30 Table of Contents Quantum Technology Management, Ltd. v. Apple Computer, Inc. Plaintiff filed this action on December 21, 2005 in the United States District Court for the District of Maryland against the Company and Fingerworks, Ltd., alleging +infringement of U.S. Patent No. 5,730,165 entitled “Time Domain Capacitive Field Detector.” The complaint seeks unspecified damages and other relief. On May 11, 2006, Quantum filed an amended complaint adding Cypress +Semiconductor/MicroSystems, Inc. as a defendant. On July 31, 2006, the Company filed an answer denying all material allegations and asserting numerous affirmative defenses and also filed counterclaims for non-infringement and invalidity. On +November 30, 2006, plaintiff filed a reply to the Company’s counterclaims and a More Definite Statement. A Markman hearing was held on May 16, 2007. On June 7, 2007, the Court issued a claim construction ruling, and also issued +an order invalidating six of plaintiff’s asserted patent claims in response to the Company’s motion for partial summary judgment of invalidity. On November 28, 2007, the Company filed a motion for summary judgment for non-infringement +and invalidity, and a motion for summary judgment related to Quantum’s state-law claims. On December 27, 2007, Quantum filed a motion for summary judgment for infringement on one patent claim. In March 2008, Quantum was acquired by Atmel +Corporation. The parties have reached a settlement. Saito Shigeru Kenchiku Kenkyusho (Shigeru Saito Architecture Institute) v. iPod; Apple Japan Inc. +v. Shigeru Saito Architecture Institute Plaintiff Saito filed a petition in the Japan Customs Office in Tokyo on January 23, 2007 alleging +infringement by the Company of Japanese Patent No. 3852854, entitled “Touch Operation Input Device and Electronic Parts Thereof.” The petition sought an order barring the importation into Japan of fifth generation iPods and +second generation iPod nanos. The Customs Office held a hearing on March 22, 2007. The Customs Office rejected the petition to bar importation and dismissed plaintiff’s case. Apple Japan, Inc. filed a Declaratory Judgment action against Saito on February 6, 2007 in the Tokyo District Court, seeking a declaration that the ‘854 patent is invalid and not infringed. Saito filed a +Counter Complaint for infringement seeking damages. St-Germain v. Apple Canada, Inc. Plaintiff filed this case in Montreal, Quebec, Canada, on August 5, 2005, seeking authorization to institute a class action for the refund by the Company of the Canadian Private Copying Levy that was applied to +the iPod purchase price in Quebec between December 12, 2003 and December 14, 2004 but later declared invalid by the Canadian Court. The Company has completed a refund program for this levy. A class certification hearing took place +January 13, 2006. On February 24, 2006, the Court granted class certification and notice was published during the last week of March 2006. The trial was conducted on October 15 and 16, 2007. On January 11, 2008, the Court issued +a ruling in plaintiff’s favor. The Court ruled that despite the Company’s good faith efforts with the levy refund program, the Company must pay the amount claimed, and that the class is comprised of 20,000 persons who purchased an iPod in +Quebec between December 12, 2003 and December 14, 2004. The Court ordered the Company to submit a statement of account showing the amount received by the Canadian Private Copying Collective, and the amount that has already been paid to +class members in Quebec under the Company’s levy refund program. The Court also ordered the parties to submit further briefing regarding the collective recovery award by February 23, 2008. On February 11, 2008, the Company filed an +appeal. The Company’s appeal is pending. Texas MP3 Technologies Ltd v. Apple Inc. et al. Plaintiff filed this action against the Company and other defendants on February 16, 2007 in the United States District Court for the Eastern District of Texas, +Marshall Division, alleging infringement of U.S. Patent No. 7,065,417 entitled “MPEG Portable Sound Reproducing System and A Reproducing Method Thereof.” The complaint seeks unspecified damages and other relief. On July 12, 2007, +the Company filed a petition for reexamination of the patent, which the U.S. Patent and Trademark Office granted. Plaintiff filed an amended complaint on August 1, 2007, adding the iPhone as an accused device. On August 2, 2007, the +Company filed a motion to stay the litigation pending the outcome of the reexamination, which the Court denied. The Company filed an answer on August 20, 2007, denying all material allegations and asserting numerous affirmative defenses. The +Company also asserted counterclaims for declaratory judgment of non-infringement and invalidity. The Markman hearing is set for March 12, 2009, and trial is scheduled for July 6, 2009. 31 Table of Contents The Apple iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, +Inc.); Somers v. Apple Inc. The first-listed action is a consolidated case combining two cases previously pending under the names Charoensak v. +Apple Computer Inc. (formerly Slattery v. Apple Computer Inc.) and Tucker v. Apple Computer, Inc . The original plaintiff (Slattery) in the Charoensak case filed a purported class action on January 3, 2005 in the United States +District Court for the Northern District of California alleging various claims including alleged unlawful tying of music purchased on the iTunes Store with the purchase of iPods and unlawful acquisition or maintenance of monopoly market power. +Plaintiff’s complaint alleged violations of §§1 and 2 of the Sherman Act (15 U.S.C. §§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California Business & +Professions Code §17200 (unfair competition), common law unjust enrichment and common law monopolization. Plaintiff sought unspecified damages and other relief. The Company filed a motion to dismiss on February 10, 2005. On +September 9, 2005, the Court denied the motion in part and granted it in part. Plaintiff filed an amended complaint on September 23, 2005 and the Company filed an answer on October 18, 2005. In August 2006, the Court dismissed +Slattery without prejudice and allowed plaintiffs to file an amended complaint naming two new plaintiffs (Charoensak and Rosen). On November 2, 2006, the Company filed an answer to the amended complaint denying all material allegations and +asserting numerous affirmative defenses. The Tucker case was filed as a purported class action on July 21, 2006 in the United States District Court +for the Northern District of California alleging various claims including alleged unlawful tying of music and videos purchased on the iTunes Store with the purchase of iPods and vice versa and unlawful acquisition or maintenance of monopoly market +power. The complaint alleges violations of §§1 and 2 of the Sherman Act (15 U.S.C. §§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California Business & Professions +Code §17200 (unfair competition) and the California Consumer Legal Remedies Act. Plaintiff sought unspecified damages and other relief. On November 3, 2006, the Company filed a motion to dismiss the complaint. On December 20, 2006, +the Court denied the motion to dismiss. On January 11, 2007, The Company filed an answer denying all material allegations and asserting numerous defenses. On March 20, 2007, the Court consolidated the two cases. Plaintiffs filed a consolidated complaint on April 19, 2007. On June 6, 2007, the Company filed an answer to the consolidated complaint denying all material allegations +and asserting numerous affirmative defenses. On July 17, 2008, plaintiffs filed a motion for class certification and on October 17, 2008, the Company filed its opposition to plaintiffs’ motion. The class certification hearing is set +for December 15, 2008. A related class action complaint, Somers v. Apple Inc ., was filed on December 31, 2007 in the United States +District Court for the Northern District of California, alleging various claims including alleged unlawful tying of music and videos purchased on the iTunes Store with the purchase of iPods and vice versa and unlawful acquisition or maintenance of +monopoly market power. The complaint alleges violations of §§1 and 2 of the Sherman Act (15 U.S.C. §§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California +Business & Professions Code §17200 (unfair competition) and the California Consumer Legal Remedies Act. Plaintiff seeks unspecified damages and other relief. On February 21, 2008, the Company filed an answer denying all material +allegations and asserting numerous defenses. The Court has scheduled the class certification hearing for April 20, 2009. Tse v. Apple Computer, +Inc. et al. Plaintiff Ho Keung Tse filed this action against the Company and other defendants on August 5, 2005 in the United States District +Court for the District of Maryland alleging infringement of U.S. Patent No. 6,665,797 entitled “Protection of Software Again [sic] Against Unauthorized Use.” The complaint seeks unspecified damages and other relief. The Company filed +an answer on October 31, 2005 denying all material allegations and asserting numerous affirmative defenses. On October 28, 2005, the Company and the other defendants filed a motion to transfer the case to the Northern District of +California, which was granted on August 31, 2006. On July 24, 2007, the Company filed a petition for reexamination of the patent, which the U.S. Patent and Trademark Office granted. On July 25, 2007, the Company filed a motion to stay +the litigation pending the outcome of the reexamination, which the Court granted on October 4, 2007. 32 Table of Contents Union Fédérale des Consummateurs—Que Choisir v. Apple Computer France S.à.r.l. and iTunes +S.à.r.l. Plaintiff, a consumer association in France, filed this complaint on February 9, 2005 alleging that the above-listed entities are +violating consumer law by (1) omitting to mention that the iPod is allegedly not compatible with music from online music services other than the iTunes Store and that the music from the iTunes Store is only compatible with the iPod and +(2) allegedly tying the sales of iPods to the iTunes Store and vice versa. Plaintiff seeks damages, injunctive relief and other relief. The first hearing on the case took place on May 24, 2005. The Company’s response to the complaint +was served on November 8, 2005. Plaintiff’s responsive pleading was filed on February 10, 2006. The Company filed a reply on June 6, 2006 and UFC filed a response on September 19, 2006. Vitt v. Apple Computer, Inc. Plaintiff filed this purported class +action on November 7, 2006 in the United States District Court for the Central District of California on behalf of a purported nationwide class of all purchasers of the iBook G4 alleging that the computer’s logic board fails at an +abnormally high rate. The complaint alleges violations of California Business & Professions Code §17200 (unfair competition) and California Business & Professions Code §17500 (false advertising). Plaintiff seeks +unspecified damages and other relief. The Company filed a motion to dismiss on January 19, 2007, which the Court granted on March 13, 2007. Plaintiffs filed an amended complaint on March 26, 2007. The Company filed a motion to dismiss +on August 16, 2007, which was heard on October 4, 2007. The Court has not yet issued a ruling. Vogel v. Jobs et al. (2006 Action) Plaintiffs filed this purported class action on August 24, 2006, in the United States District Court for the Northern District of California +against the Company and certain of the Company’s current and former officers and directors alleging improper backdating of stock option grants to maximize certain defendants’ profits, failing to properly account for those grants and +issuing false financial statements. On January 19, 2007, the Court appointed the New York City Employees’ Retirement System as lead plaintiff. On March 23, 2007, plaintiffs filed a Consolidated Class Action Complaint. +The Consolidated Complaint purports to be brought on behalf of several classes of holders of the Company’s stock and asserts claims under Section 14(a) and 20(a) of the Securities Exchange Act as well as state law. The +Consolidated Complaint seeks rescission of amendments to various stock option and other incentive compensation plans, an accounting and damages in an unspecified amount. Defendants filed a motion to dismiss on June 8, 2007, which was heard on +September 7, 2007. On November 14, 2007, the Court issued an order dismissing all securities claims with prejudice, and held that any amended complaint could only be styled as a derivative case. On December 14, 2007, plaintiff filed a +motion for leave to file a first amended consolidated class action complaint. On January 23, 2008, defendants filed an opposition to plaintiff’s motion. Plaintiff’s motion was heard on March 21, 2008. On May 14, 2008, the +Court issued an order denying plaintiffs’ motion for leave to amend. The court entered judgment dismissing the case on June 12, 2008. On June 17, 2008, plaintiffs filed a notice of appeal. Plaintiffs’ appeal is pending. Vogel v. Apple Inc., et al. (2008 Action) Plaintiff filed this purported class action on June 27, 2008, in the United States District Court for the Northern District of California against the Company and certain of the Company’s current and former officers and +directors. The allegations, which arise out of the Company’s past stock option practices, are similar to those in the 2006 Vogel v. Jobs et al. action that was dismissed on June 12, 2008, as described above. The +complaint purports to be brought on behalf of several classes of holders of the Company’s stock and asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act. The complaint seeks rescission of amendments to various stock +option and other incentive compensation plans, an accounting and damages in an unspecified amount. On July 22, 2008, the Court stayed this case pending the appeal in the 2006 Action. Item 4. Submission of Matters to a Vote of Security Holders None. 33 Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The +Company’s common stock is traded on the over-the-counter market and is quoted on the NASDAQ Global Select Market under the symbol AAPL and on the Frankfurt Stock Exchange under the symbol APCD. Price Range of Common Stock The price range per share of common +stock presented below represents the highest and lowest sales prices for the Company’s common stock on the NASDAQ Global Select Market during each quarter of the two most recent fiscal years. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2008 price range per common share $  180.91 - $  120.68 $  192.24 - $  142.52 $  200.50 - $  115.44 $  202.96 - $  150.63 Fiscal 2007 price range per common share $  155.00 - $  111.62 $  127.61 - $    89.60 $    97.80 - $    81.90 $    93.16 - $    72.60 Holders As of +October 24, 2008, there were 30,445 shareholders of record. Dividends The Company did not declare or pay cash dividends in either fiscal 2008 or 2007. The Company anticipates that for the foreseeable future it will retain any earnings for use in the operation of its business. Purchases of Equity Securities by the Issuer and Affiliated Purchasers None. 34 Table of Contents Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Composite Index (the “S&P 500”) and the S&P Computers +(Hardware) Index (the “Industry Index”). The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500, and the Industry Index on September 30, 2003. Data points on the graph are annual. Note that +historic stock price performance is not necessarily indicative of future stock price performance. Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Apple Inc. $ 100 $ 187 $ 517 $ 743 $ 1,481 $ 1,097 S&P © 500 $ 100 $ 114 $ 128 $ 142 $ 165 $ 129 S&P © Computer Hardware $ 100 $ 104 $ 119 $ 128 $ 188 $ 158 Copyright © 2008, Standard & +Poor’s, a division of The McGraw-Hill Companies, Inc. All rights reserved. 35 Table of Contents Item 6. Selected Financial Data The information set forth below for the five fiscal years ended September 27, 2008, is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, +“Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and related notes thereto included in Item 8 of this Form 10-K to fully understand factors that may +affect the comparability of the information presented below (in millions, except share amounts which are reflected in thousands and per share amounts). 2008 2007 2006 2005 2004 Net sales $ 32,479 $ 24,006 $ 19,315 $ 13,931 $ 8,279 Net income $ 4,834 $ 3,496 $ 1,989 $ 1,328 $ 266 Earnings per common share: Basic $ 5.48 $ 4.04 $ 2.36 $ 1.64 $ 0.36 Diluted $ 5.36 $ 3.93 $ 2.27 $ 1.55 $ 0.34 Cash dividends declared per common share $ — $ — $ — $ — $ — Shares used in computing earnings per share: Basic 881,592 864,595 844,058 808,439 743,180 Diluted 902,139 889,292 877,526 856,878 774,776 Cash, cash equivalents, and short-term investments $ 24,490 $ 15,386 $ 10,110 $ 8,261 $ 5,464 Total assets $ 39,572 $ 25,347 $ 17,205 $ 11,516 $ 8,039 Long-term debt $ — $ — $ — $ — $ — Total liabilities $ 18,542 $ 10,815 $ 7,221 $ 4,088 $ 2,976 Shareholders’ equity $ 21,030 $ 14,532 $ 9,984 $ 7,428 $ 5,063 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can +also be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and the +Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Risk +Factors” above, which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K. All information presented +herein is based on the Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. +The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Executive Overview The Company designs, manufactures, and markets personal computers, portable digital music players, and mobile communication devices and sells a variety +of related software, services, peripherals, and networking solutions. The Company’s products and services include the Mac line of desktop and portable computers, the iPod line of portable digital music players, iPhone, Apple TV, Xserve, a +portfolio of consumer and professional software applications, the Mac OS X operating system, third-party digital content through the iTunes Store, and a variety of accessory, service and support offerings. The Company sells its products worldwide +through its online stores, its retail stores, its direct sales force, and third-party wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party Mac, iPod and iPhone compatible products, including +application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores. The Company sells to consumer, small and mid-sized business (“SMB”), education, +enterprise, government, and creative markets. 36 Table of Contents The Company is focused on providing innovative products and solutions to consumer, SMB, education, enterprise, government +and creative customers that greatly enhance their evolving digital lifestyles. The Company is the only participant in the personal computer and consumer electronics industries that controls the design and development of the entire personal computer, +including the hardware, operating system, and sophisticated software applications, as well as the design and development of portable digital music players, mobile communication devices, and a variety of products and solutions for obtaining and +enjoying digital content. The Company is therefore uniquely positioned to offer superior and well-integrated digital lifestyle products and solutions, which are further enhanced by the Company’s emphasis on ease-of-use and creative industrial +designs. The Company participates in several highly competitive markets, including personal computers with its Mac line of personal computers, consumer +electronics with its iPod product families, mobile communications with iPhone, and distribution of third-party digital content through its online iTunes Store. While the Company is widely recognized as a leading innovator in the personal computer +and consumer electronics markets as well as a leader in the emerging market for distribution of digital content, these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that increased +investment in research and development and marketing and advertising is necessary to maintain or expand its position in the markets where it competes. The Company’s R&D spending is focused on further developing its existing Mac line of +personal computers, its operating system, application software, iPhone and iPods; developing new digital lifestyle consumer and professional software applications; and investing in new product areas and technologies. The Company also believes +increased investment in marketing and advertising programs is critical to increasing product and brand awareness. The Company utilizes a variety of direct +and indirect distribution channels. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software, and peripheral integration, demonstrate +the unique digital lifestyle solutions that are available only on Mac computers, and demonstrate the compatibility of the Mac with the Windows platform and networks. The Company further believes providing a high-quality sales and after-sales support +experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company continues to expand and improve its distribution +capabilities by opening its own retail stores in the U.S. and internationally. The Company had 247 stores open as of September 27, 2008. The Company +has also invested in programs to enhance reseller sales, including the Apple Sales Consultant Program, which places Apple employees and contractors at selected third-party reseller locations. The Company believes providing direct contact with its +targeted customers is an efficient way to demonstrate the advantages of its Mac computers and other products over those of its competitors. The Company also sells to customers directly through its online stores around the world and through its +direct sales force. The Company’s iPods are sold through a significant number of distribution points to provide broad access. iPods can be purchased +in certain department stores, member-only warehouse stores, large retail chains, and specialty retail stores, as well as through the channels for Mac distribution listed above. iPhone is distributed through the Company, its cellular network carriers’ distribution channels, and certain third-party resellers. The Company has signed multi-year agreements with various cellular network +carriers authorizing them to distribute and provide cellular network services for iPhone 3G in over 70 countries. These agreements are generally not exclusive with a specific carrier, except in the U.S., U.K., France, Germany, Spain, Ireland, and +certain other countries. The Company expects to ship iPhone 3G in over 70 countries by the end of calendar year 2008. Critical Accounting Policies and +Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles and the +Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions, and estimates that affect the amounts 37 Table of Contents reported in its Consolidated Financial Statements and accompanying notes. Note 1 “Summary of Significant Accounting Policies” of Notes to +Consolidated Financial Statements in this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s Consolidated Financial Statements. Management bases its estimates on historical experience +and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and +such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue +recognition, allowance for doubtful accounts, inventory valuation and inventory purchase commitments, warranty costs, stock-based compensation, income taxes, and legal and other contingencies. Management considers these policies critical because +they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has +reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, music products, digital content, +peripherals, and service and support contracts. The Company recognizes revenue for software products (operating system software and applications software), or any product that is considered to be software-related, in accordance with the guidance in +Emerging Issues Task Force (“EITF”) No. 03-5, Applicability of AICPA Statement of Position 97-2 to Non-software Deliverables in an Arrangement Containing More-Than-Incidental Software , (e.g., Mac computers, iPod portable +digital music players and iPhone) pursuant to American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) No. 97-2, Software Revenue Recognition , as amended. For products that are not +software or software-related, (e.g., digital content sold on the iTunes Store and certain Mac, iPod and iPhone supplies and accessories), the Company recognizes revenue pursuant to the Securities and Exchange Commission (“SEC”) Staff +Accounting Bulletin (“SAB”) No. 104, Revenue Recognition. The Company recognizes revenue when persuasive evidence of an arrangement +exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the +Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer +receives the product because the Company retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed not to be, fixed or determinable, +revenue is deferred and subsequently recognized as amounts become due and payable and all other criteria for revenue recognition have been met. For both +Apple TV and iPhone, the Company has indicated that from time-to-time it may provide future unspecified features and additional software products free of charge to customers. Therefore, sales of Apple TV and iPhone handsets are recognized under +subscription accounting in accordance with SOP No. 97-2. The Company recognizes the associated revenue and cost of goods sold on a straight-line basis over the currently estimated 24-month economic lives of these products, with any loss +recognized at the time of sale. Costs incurred by the Company for engineering, sales, marketing, and warranty are expensed as incurred. The Company records +reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. For transactions involving price +protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy +requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For customer incentive programs, the estimated cost of these programs is recognized at the later +of the date at 38 Table of Contents which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future +product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs and incur incremental price protection obligations that could result +in additional reductions to revenue at the time such programs are offered. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive based on historical experience +and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which would have a negative +impact on the Company’s results of operations. Allowance for Doubtful Accounts The Company distributes its products through third-party distributors and resellers and directly to certain education, consumer, and enterprise customers. The Company generally does not require collateral from its +customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible the Company does attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin +America, Europe, Asia, and Australia and by arranging with third-party financing companies to provide flooring arrangements and other loan and lease programs to the Company’s direct customers. These credit-financing arrangements are directly +between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit-risk-sharing related to any of these arrangements. However, considerable trade receivables that are not covered by +collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company’s distribution and retail channel partners. The +allowance for doubtful accounts is based on management’s assessment of the collectibility of specific customer accounts and includes consideration of the credit worthiness and financial condition of those specific customers. The Company records +an allowance to reduce the specific receivables to the amount that it reasonably believes to be collectible. The Company also records an allowance for all other trade receivables based on multiple factors, including historical experience with bad +debts, the general economic environment, the financial condition of the Company’s distribution channels, and the aging of such receivables. If there is a deterioration of a major customer’s financial condition, if the Company becomes aware +of additional information related to the credit-worthiness of a major customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful +accounts, which would affect earnings in the period the adjustments are made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and +products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each fiscal quarter that considers multiple +factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The personal computer, consumer electronics and mobile communications industries are subject to a rapid and +unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the +utility of component inventory, the Company may be required to record additional write-downs, which would negatively affect gross margins in the period when the write-downs were recorded. The Company accrues reserves for estimated cancellation fees related to component orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company acquires components +through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company’s requirements for periods ranging from 30 to 150 days. If there is an abrupt and +substantial decline in demand for one or more of the Company’s products or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional reserves for cancellation +fees that would negatively affect gross margins in the period when the cancellation fees are identified and recorded. 39 Table of Contents Warranty Costs The +Company provides for the estimated cost for hardware and software warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific +product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products +subject to warranty protection and adjusts the amounts as necessary. For products accounted for under subscription accounting pursuant to SOP No. 97-2, the Company recognizes warranty expense as incurred. If actual product failure rates or +repair costs differ from estimates, revisions to the estimated warranty liability would be required and could negatively affect the Company’s results of operations. The Company periodically provides updates to its applications and operating system software to maintain the software’s compliance with specifications. The estimated cost to develop such updates is accounted for +as warranty cost that is recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units delivered, the number of updates expected to occur, +and the historical cost and estimated future cost of the resources necessary to develop these updates. Stock-Based Compensation The Company accounts for stock-based compensation in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share-Based Payment . Under the provisions of SFAS No. 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing +model and is recognized as expense ratably on a straight-line basis over the requisite service period. The BSM option-pricing model requires various judgmental assumptions including expected volatility, forfeiture rates, and expected option life. +Significant changes in any of these assumptions could materially affect the fair value of stock-based awards granted in the future. Income +Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with SFAS +No. 109, Accounting for Income Taxes , the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary +differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable +income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Effective at +the beginning of 2008, the Company adopted Financial Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 . Further information may be found in Note 5, +“Income Taxes” in the Notes to Consolidated Financial Statements of this Form 10-K. Management believes it is more likely than not that +forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the +event that the Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. +In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of FIN 48 and other complex tax laws. Resolution of these uncertainties in a manner inconsistent with +management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other +Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Note 8 “Commitments and +Contingencies” in Notes to Consolidated Financial Statements, the Company is subject to 40 Table of Contents various legal proceedings and claims that arise in the ordinary course of business. In accordance with SFAS No. 5, Accounting for Contingencies , +the Company records a contingent liability when it is probable that a loss has been incurred and the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be +reasonably estimated. In management’s opinion, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial +condition or operating results. However, the outcomes of legal proceedings and claims brought against the Company are subject to significant uncertainty. Should the Company fail to prevail in any of these legal matters or should several of these +legal matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. Net Sales Fiscal years 2008 and 2007 spanned 52 weeks while fiscal year 2006 spanned 53 weeks. An additional week is +included in the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. The following table summarizes net +sales and Mac unit sales by operating segment and net sales and unit sales by product during the three fiscal years ended September 27, 2008 (in millions, except unit sales in thousands and per unit amounts): 2008 Change 2007 Change 2006 Net Sales by Operating Segment: Americas net sales $ 14,573 26 % $ 11,596 23 % $ 9,415 Europe net sales 7,622 40 % 5,460 33 % 4,096 Japan net sales 1,509 39 % 1,082 (11 )% 1,211 Retail net sales 6,315 53 % 4,115 27 % 3,246 Other Segments net sales (a) 2,460 40 % 1,753 30 % 1,347 Total net sales $ 32,479 35 % $ 24,006 24 % $ 19,315 Unit Sales by Operating Segment: Americas Mac unit sales 3,980 32 % 3,019 24 % 2,432 Europe Mac unit sales 2,519 39 % 1,816 35 % 1,346 Japan Mac unit sales 389 29 % 302 (1 )% 304 Retail Mac unit sales 2,034 47 % 1,386 56 % 886 Other Segments Mac unit sales (a) 793 50 % 528 58 % 335 Total Mac unit sales 9,715 38 % 7,051 33 % 5,303 Net Sales by Product: Desktops (b) $ 5,603 39 % $ 4,020 21 % $ 3,319 Portables (c) 8,673 38 % 6,294 55 % 4,056 Total Mac net sales 14,276 38 % 10,314 40 % 7,375 iPod 9,153 10 % 8,305 8 % 7,676 Other music related products and services (d) 3,340 34 % 2,496 32 % 1,885 iPhone and related products and services (e) 1,844 N M 123 N M — Peripherals and other hardware (f) 1,659 32 % 1,260 15 % 1,100 Software, service, and other sales (g) 2,207 46 % 1,508 18 % 1,279 Total net sales $ 32,479 35 % $ 24,006 24 % $ 19,315 Unit Sales by Product: Desktops (b) 3,712 37 % 2,714 12 % 2,434 Portables (c) 6,003 38 % 4,337 51 % 2,869 Total Mac unit sales 9,715 38 % 7,051 33 % 5,303 Net sales per Mac unit sold (h) $ 1,469 — % $ 1,463 5 % $ 1,391 iPod unit sales 54,828 6 % 51,630 31 % 39,409 Net sales per iPod unit sold (i) $ 167 4 % $ 161 (17 )% $ 195 iPhone unit sales 11,627 N M 1,389 N M — 41 Table of Contents (a) Other Segments include Asia Pacific and FileMaker. (b) Includes iMac, Mac mini, Mac Pro, Power Mac, and Xserve product lines. (c) Includes MacBook, iBook, MacBook Air, MacBook Pro, and PowerBook product lines. (d) Consists of iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (e) Derived from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (f) Includes sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (g) Includes sales of Apple-branded operating system and application software, third-party software, AppleCare, and Internet services. (h) Derived by dividing total Mac net sales by total Mac unit sales. (i) Derived by dividing total iPod net sales by total iPod unit sales. NM = +Not Meaningful Fiscal Year 2008 versus 2007 Net sales during 2008 increased 35% or $8.5 billion from 2007. Several factors contributed to these increases including the following: • Mac net sales increased $4.0 billion or 38% during 2008 compared to 2007, while Mac unit sales increased by 2.7 million units or 38%. Net sales related to the +Company’s Mac shipments accounted for 44% of the Company’s total net revenue. Higher Mac unit sales, which contributed to the increases in net sales, were driven by higher sales of all of the Company’s portable products as well as the +popularity of the iMac, which experienced strong growth in net sales and unit sales in all of the Company’s reportable segments. Unit sales of the Company’s portable products accounted for 62% of the Company’s personal computer +shipments in both 2008 and 2007. Net sales and unit sales of the Company’s portable products both increased by 38% during 2008 compared to 2007. This growth was attributable to strong demand for all the portable products, particularly the +MacBook, which had double-digit growth in all of the Company’s operating segments, and the addition of the MacBook Air, which was introduced to the Company’s portable product line in January 2008. Growth of the Company’s desktop +systems was also strong, with increased net sales and unit sales of 39% and 37%, respectively, during 2008 due primarily to strong sales of the iMac in all of the Company’s operating segments. • Net sales of iPods increased $848 million or 10% during 2008 compared to 2007 whereas unit sales of iPods increased 6% compared to 2007. The iPod unit growth was +due to strong demand for the iPod touch, and to a lesser extent, higher unit sales of the iPod shuffle due to a price reduction in February 2008. iPod net sales grew faster than iPod unit sales due to higher average selling prices caused by a shift +in overall iPod product mix to the higher priced iPod touch. • Net sales of iPhone and related products and services were $1.8 billion for 2008, with iPhone handset unit sales totaling 11.6 million. During 2008, sales of iPhone +expanded beyond the U.S. and the Company expects to be shipping iPhones in over 70 countries by the end of December 2008. Net sales of iPhone and related products and services were $123 million in 2007, which represented sales for one fiscal +quarter. iPhone net sales include the portion of handset revenue recognized in accordance with subscription accounting over the product’s 24-month estimated economic life, as well as revenue from sales of iPhone accessories and from carrier +agreements. • Net sales of other music related products and services increased $844 million or 34% during the 2008 compared to 2007, due primarily to significantly increased net +sales from the iTunes Store in each of the Company’s geographic segments. The Company believes this success is the result of heightened consumer interest in downloading third-party digital content, the expansion of third-party audio and video +content available for sale and rent via the iTunes Store, and the launch of the iTunes App Store. The Company continues to expand its iTunes content offerings around the world. • Net sales of peripherals and other hardware increased $399 million or 32% compared to 2007 due to an increase in wireless networking products and other hardware +accessories, including printers and scanners, which was partially offset by a decrease in net sales of displays. 42 Table of Contents • Net sales of software, service, and other sales rose $699 million or 46% during 2008 compared to 2007. This growth was due in large part to increased sales of +Apple-branded and third-party developers’ software products and increased net sales of AppleCare Protection Plan (“APP”) extended service and support contracts. Fiscal Year 2007 versus 2006 Net sales during 2007 increased +24% or $4.7 billion from 2006 even though fiscal year 2007 spanned 52 weeks while fiscal year 2006 spanned 53 weeks. Several factors contributed to these increases including the following: • Mac net sales increased $3 billion or 40% during 2007 compared to 2006, while Mac unit sales increased by 1.75 million units or 33%. The 33% Mac unit sales +growth rate is significantly greater than the estimated growth rate of the overall personal computer industry during that timeframe. Unit sales of the Company’s portable products accounted for 62% of the Company’s personal computer +shipments in 2007, up from 54% in 2006. Net sales and unit sales of the Company’s portable products increased 55% and 51%, respectively, during 2007 compared to 2006. This growth was due to strong demand for the MacBook, which increased in each +of the Company’s operating segments, as well as the MacBook Pro, which increased in each operating segment except Japan. Mac desktop net sales and unit sales increased by 21% and 12%, respectively, during 2007 due to stronger sales of the iMac +in each of the Company’s operating segments. The Mac desktop net sales growth was greater than the unit sales growth due primarily to a shift in desktop product mix away from the lower-price Mac Mini and discontinued eMac and toward the iMac. • Net sales of iPods increased $629 million or 8% during 2007 compared to 2006. Unit sales of iPods increased 31% compared to 2006. The iPod growth was driven +primarily by increased sales of the iPod shuffle and iPod nano particularly in international markets. iPod unit sales growth was significantly greater than iPod net sales due to a shift in overall iPod product mix, as well as due to lower selling +prices for the iPod classic, iPod nano and iPod shuffle in 2007 compared to 2006. • Net sales of iPhone and related products and services were $123 million in 2007. iPhone net sales include the portion of iPhone handset revenue recognized in +accordance with subscription accounting over the product’s 24-month estimated economic life, as well as sales of iPhone accessory products and revenue from carrier agreements. iPhone unit sales were 1.39 million in 2007. • Net sales of other music related products and services increased $611 million or 32% during 2007 compared to 2006 due to increased net sales from the iTunes Store. +The Company believes this growth was the result of heightened consumer interest in downloading digital content and the expansion of third-party audio and video content available for sale via the iTunes Store. • Net sales of peripherals and other hardware increased $160 million or 15% compared to 2006 due to an increase in wireless networking products and other hardware +accessories, including printers and scanners, which was partially offset by a decrease in net sales of displays. • Net sales of software, service, and other sales rose $229 million or 18% during 2007 compared to 2006. This growth was attributable primarily to increased net sales +of APP extended service and support contracts and increased sales of Apple branded and third-party developers’ software products. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating +segments consist of the Americas, Europe, Japan, and Retail. The Americas, Europe, and Japan reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment +includes European countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S. and in international markets. Each reportable geographic operating segment and the Retail operating segment provide +similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Note 9, “Segment Information and Geographic Data” in Notes to Consolidated Financial +Statements of this Form 10-K. 43 Table of Contents Americas During +2008, net sales in the Americas segment increased $3.0 billion or 26% compared to 2007. The primary drivers of this growth were the significant year-over-year increase in sales of the iPod touch, Mac portable systems, content from the iTunes Store, +and iPhone. The Company began shipping iPhone in June 2007 and the growth in iPhone sales in 2008 resulted from a full year of iPhone shipments. The increase in Mac net sales of $1.3 billion or 30% and Mac unit sales of 961 million or 32% is +attributable to growth in all of the Mac portable systems, particularly the MacBook, and higher sales of the iMac. Net sales of iPods increased due to a shift in product mix toward higher priced iPods, particularly the iPod touch, which was upgraded +in June 2008. In 2008, the Americas segment represented 45% of the Company’s total net sales as compared to 48% in the same period of 2007. During 2008, U.S. education channel net sales and Mac unit sales increased by 14% and 19%, respectively, +compared to 2007. Net sales from the higher education market grew 15% during 2008 compared to 2007, while net sales in the K-12 market grew 12% during the same period. During 2007, net sales in the Americas segment increased $2.2 billion, or 23%, compared to 2006. The main sources of this growth were Mac portable products, iMacs, iPods, and the sales of third-party content from the +iTunes Store. Sales of Mac portable products increased due to the popularity of the MacBook, introduced in May 2006 and updated in May 2007, as well as the MacBook Pro, introduced in January 2006 and updated in June 2007. Sales of iMacs grew due to +a shift in desktop product mix away from the Mac mini and discontinued eMac as well as the strong reception of the new iMac introduced in August 2007. Sales of iPods grew due to increased demand for the iPod nano and iPod shuffle and the +introduction of the iPod touch in September 2007. During 2007, the Americas segment represented 48% of the Company’s total net sales as compared to 49% in the same period of 2006. During 2007, U.S. education channel net sales and Mac unit sales +increased by 14% and 18%, respectively, compared to 2006. Net sales from the higher education market grew 17% during 2007 compared to 2006, while net sales in the K-12 market grew 10% during the same period. Europe For 2008, net sales and unit sales in Europe increased 40% +and 39%, respectively, compared to the same period in 2007. The main drivers of this growth were strong sales of Mac portable systems and iMac, increased sales from the iTunes Store, and iPhone. Also contributing to the increase in net sales were +higher iPod net sales due primarily to the iPod touch, which was upgraded in June 2008. Sales of Mac portable products increased due to the MacBook Pro and the MacBook, both updated in February 2008, as well as the MacBook Air, introduced in January +2008. Mac desktop sales also increased due primarily to the popularity of the iMac, which was updated in April 2008. Sales from the iTunes Store grew substantially by 79% from 2007 as a result of heightened consumer interest in downloading digital +content and the expansion of third-party audio and video content available for sale via the iTunes Store. The Europe segment represented 23% of total net sales in 2008, consistent with 2007. Europe segment net sales increased $1.4 billion or 33% during 2007 compared to 2006. Consistent with the Americas segment, the primary drivers of this growth were Mac +portable products, iMacs, iPods, and the sales of third-party content from the iTunes Store. Sales of Mac portable products increased due to the popularity of both the MacBook and MacBook Pro. Sales of iMacs grew due to a shift in desktop product +mix away from the Mac mini and discontinued eMac as well as the strong reception of the new iMac introduced in August 2007. Sales of iPods grew due primarily to increased demand for the iPod nano and iPod shuffle. The Company believes that the +growth in iTunes Store sales was the result of heightened consumer interest in downloading digital content and the expansion of third-party audio and video content available for sale via the iTunes Store. Japan Japan net sales increased $427 million or 39% in 2008 compared +to 2007. The primary contributors to the growth in net sales were increases in sales of iPods, iMac, Mac portable systems, and strong sales from the iTunes Store. Net sales, unit sales and the average selling price of iPods increased during 2008 +compared to 2007, driven by strong demand for iPod touch and iPod nano. Additionally, Mac net sales and unit sales grew 42% and 29%, respectively, in 2008 compared to 2007 due to increase in sales of the iMac and Mac portable systems, particularly +MacBook, as well as the introduction of MacBook Air in January 2008. 44 Table of Contents Japan’s net sales declined by $129 million or 11% in 2007 compared to 2006. Total Mac unit sales in Japan declined +1% during 2007. The decrease in the Japan segment’s overall net sales was attributable primarily to decreases in iPod and Mac desktop sales, partially offset by an increase in revenue from MacBooks and sales of third-party content from the +iTunes Store. The decline in net sales and Mac unit sales is partially attributable to Japan’s declining consumer PC market, and the iPod sales decline is due primarily to lower average selling prices. The Company is continuing to evaluate ways +to improve the future results of its Japan segment. Retail Retail net sales grew by 53% during 2008 compared to 2007, due in large part to increased sales of Mac portable and desktop products, strong demand for the iPhone and iPod touch, and new store openings. The Company opened 50 new retail +stores during 2008, including a total of 19 international stores, bringing the total number of open stores to 247 as of September 27, 2008. This compares to 197 open stores as of September 29, 2007 and 165 open stores as of +September 30, 2006. With an average of 211 stores and 178 stores opened during 2008 and 2007, respectively, average revenue per store increased to $29.9 million for 2008, compared to $23.1 million in 2007. Retail Mac net sales and Mac unit sales grew by 42% and 47%, respectively, during 2008 compared to the 2007, due primarily to strong demand for MacBook, iMac, and MacBook +Air, introduced in January 2008. Net sales of iPods increased due to the popularity of the iPod touch, which was upgraded in June 2008, and a higher average selling price compared to 2007. The higher iPod average selling price was due to strong +demand for the iPod touch. The Retail segment’s net sales increased by 27% to $4.1 billion during 2007 compared to 2006. Retail segment Mac unit sales +increased 56% during 2007 as compared to 2006. With an average of 178 stores open during 2007, average revenue per store was $23.1 million, compared to $22.9 million in 2006. The increase in Retail segment net sales during 2007 compared to 2006 was +due primarily to stronger sales of Mac portable products, iMacs, accessories and services. The increase was partially offset primarily by lower net sales of iPods and other music related products due to the expanded availability of those products +through third-party resellers. As measured by the Company’s operating segment reporting, the Retail segment reported operating income of $1.3 billion +during 2008 as compared to operating income of $875 million and $600 million during 2007 and 2006, respectively. This improvement in 2008 was attributable primarily to the significant Retail net sales growth of 53% as compared to 2007. Expansion of the Retail segment has required and will continue to require a substantial investment in fixed assets and related infrastructure, operating lease +commitments, personnel, and other operating expenses. Capital asset purchases associated with the Retail segment were $389 million in 2008, bringing the total capital asset purchases since inception of the Retail segment to $1.4 billion. As of +September 27, 2008, the Retail segment had approximately 15,900 full-time equivalent employees and had outstanding operating lease commitments associated with retail store space and related facilities of $1.4 billion. The Company would incur +substantial costs if it were to close multiple retail stores. Such costs could adversely affect the Company’s financial condition and operating results. Other Segments The Company’s Other Segments, which consist of its Asia Pacific and FileMaker operations, experienced an increase in +net sales of $707 million, or 40% during 2008 as compared to 2007. These increases are related primarily to strong growth in sales of all Mac portable systems, iPods, the iMac, and content from the iTunes Store in the Company’s Asia Pacific +region. Sales from the iTunes Store in the Company’s Asia Pacific region grew significantly by 109% over 2007. Mac net sales and unit sales grew by 52% and 50%, respectively, due to increased sales of the iMac and all Mac portables. The Company’s Other Segments experienced an increase in net sales of $406 million, or 30% during 2007 compared to 2006. This increase related primarily to a 58% +increase in sales of Mac portable products and strong iPod sales in the Company’s Asia Pacific region. 45 Table of Contents Gross Margin Gross +margin for the three fiscal years ended September 27, 2008, are as follows (in millions, except gross margin percentages): 2008 2007 2006 Net sales $ 32,479 $ 24,006 $ 19,315 Cost of sales 21,334 15,852 13,717 Gross margin $ 11,145 $ 8,154 $ 5,598 Gross margin percentage 34.3% 34.0% 29.0% Gross margin percentage was relatively flat in 2008 as compared to 2007. Gross margin percentage of 34.0% in 2007 +increased significantly from 29.0% in 2006. The primary drivers of this increase were more favorable costs on certain commodity components, including NAND flash memory and DRAM memory, higher overall revenue that provided for more leverage on fixed +production costs and a higher percentage of revenue from the Company’s direct sales channels. The Company expects its gross margin percentage to +decrease in future periods compared to levels achieved during 2008 and 2007, and anticipates gross margin levels of about 30% in 2009. This expected decline is due largely to the anticipated impact of product transitions, flat or reduced pricing on +new and innovative products that have higher cost structures, both expected and potential future cost increases for key components, a stronger U.S. dollar, and higher logistical costs. The foregoing statements regarding the Company’s expected gross margin percentage are forward-looking and could differ from anticipated levels because of several factors, including but not limited to certain of +those set forth below in Part I, Item 1A, “Risk Factors” under the subheading “ Future operating results depend upon the Company’s ability to obtain key components including, but not limited to microprocessors, NAND flash +memory, DRAM and LCDs at favorable prices and in sufficient quantities ,” which is incorporated herein by reference. There can be no assurance that targeted gross margin percentage levels will be achieved. In general, gross margins and +margins on individual products will remain under downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product transitions and +expected increases in the cost of key components including, but not limited to microprocessors, NAND flash memory, dynamic random access memory (“DRAM”) and liquid crystal displays (“LCDs”), as well as potential increases in the +costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to these competitive pressures, the Company expects it will continue to take product pricing +actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due to the +Company’s significant international operations, financial results can be significantly affected in the short-term by fluctuations in exchange rates. Operating Expenses Operating expenses for the three fiscal years ended September 27, 2008, are as follows (in millions, except for +percentages): 2008 2007 2006 Research and development $ 1,109 $ 782 $ 712 Percentage of net sales 3.4% 3.3% 3.7% Selling, general, and administrative $ 3,761 $ 2,963 $ 2,433 Percentage of net sales 11.6% 12.3% 12.6% Research and Development (“R&D”) Expenditures for R&D increased 42% or $327 million to $1.1 billion in 2008 compared to 2007. These increases were due primarily to an increase in R&D headcount in +the current year to support expanded R&D activities and higher stock-based compensation expenses. In 2008, $11 million of software development costs were capitalized 46 Table of Contents related to Mac OS X Version 10.6 Snow Leopard and excluded from R&D expense, while R&D expense for 2007 excluded $75 million of capitalized software +development costs related to Mac OS X Leopard and iPhone. Although total R&D expense increased 42% during 2008, it remained relatively flat as a percentage of net sales given the 35% increase in revenue during 2008. The Company continues to +believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core +business strategy. As such, the Company expects to increase spending in R&D to remain competitive. Expenditures for R&D increased 10% or $70 +million to $782 million in 2007 compared to 2006. The increases in R&D expense were due primarily to an increase in R&D headcount in 2007 to support expanded R&D activities, partially offset by one less week of expenses in the first +quarter of 2007 and the capitalized software development costs mentioned above. Selling, General, and Administrative Expense (“SG&A”) Expenditures for SG&A increased $798 million or 27% to $3.8 billion in 2008 compared to 2007. These increases are due primarily to higher +stock-based compensation expenses, higher variable selling expenses resulting from the significant year-over-year increase in total net sales and the Company’s continued expansion of its Retail segment in both domestic and international +markets. In addition, the Company incurred higher spending on marketing and advertising during 2008 compared to 2007. Expenditures for SG&A increased +$530 million or 22% during 2007 compared to 2006. The increase was due primarily to higher direct and indirect channel variable selling expenses resulting from the significant year-over-year increase in total net sales in 2007, the Company’s +continued expansion of its Retail segment in both domestic and international markets, and higher spending on marketing and advertising, partially offset by one less week of expenses in the first quarter of 2007. Other Income and Expense Other income and expense for the three +fiscal years ended September 27, 2008, are as follows (in millions): 2008 2007 2006 Interest income $ 653 $ 647 $ 394 Other income (expense), net (33 ) (48 ) (29 ) Total other income and expense $ 620 $ 599 $ 365 Total other income and expense increased $21 million to $620 million during 2008 as compared to $599 million +and $365 million in 2007 and 2006, respectively. While the Company’s cash, cash equivalents and short-term investment balances increased by 59% in 2008, other income and expense increased only 4% due to the decline in the weighted average +interest rate earned of 3.44%. The overall increase in other income and expense is attributable to the Company’s higher cash and short-term investment balances, which more than offset the decline in interest rates during 2008 as compared to +2007. The weighted average interest rate earned by the Company on its cash, cash equivalents, and short-term investments was 5.27% and 4.58% during 2007 and 2006, respectively. During 2008, 2007 and 2006, the Company had no debt outstanding and +accordingly did not incur any related interest expense. Provision for Income Taxes The Company’s effective tax rates were 30% for the years ended September 27, 2008 and September 29, 2007, and 29% for the year ended September 30, 2006. The Company’s effective rates differ +from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S. As of September 27, 2008, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax credits of $2.1 billion before being +offset against certain deferred liabilities for presentation on the Company’s balance sheet. Management believes it is more likely than not that forecasted income, including 47 Table of Contents income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be +sufficient to fully recover the remaining deferred tax assets. The Company released a valuation allowance of $5 million since it has been determined that it is more likely than not the associated deferred tax assets will be realized. The Company +will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and amount of the valuation allowance. The Internal +Revenue Service (the “IRS”) has completed its field audit of the Company’s federal income tax returns for the years 2002 through 2003 and proposed certain adjustments. The Company has contested certain of these adjustments through the +IRS Appeals Office. All IRS audit issues for years prior to 2002 have been resolved. In addition, the Company is subject to audits by state, local, and foreign tax authorities. Management believes that adequate provision has been made for any +adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s +expectations, the Company could be required to adjust its provision for income tax in the period such resolution occurs. Recent Accounting +Pronouncements In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, Fair Value Measurements, which defines fair value, provides a framework for measuring fair value, and expands the disclosures required for fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require fair value measurements; it does not +require any new fair value measurements. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-1, Application of FASB Statement No. 157 to FASB Statement No. 13 and Other Accounting Pronouncements That +Address Fair Value Measurements for Purposes of Lease Classification or Measurement under Statement 13 and FSP No. FAS 157-2 , Effective Date of FASB Statement No. 157 . FSP 157-1 amends SFAS No. 157 to remove certain leasing +transactions from its scope. FSP 157-2 delays the effective date of SFAS No. 157 to fiscal years beginning after November 15, 2008 for all non-financial assets and non-financial liabilities, except for items that are recognized +or disclosed at fair value in the financial statements on a recurring basis (at least annually) and will be adopted by the Company beginning in the first quarter of fiscal 2010. In October 2008, the FASB issued FSP No. 157-3, Determining the +Fair Value of a Financial Asset When the Market for That Asset is Not Active , to clarify the application of SFAS 157 in inactive markets for financial assets. FSP 157-3 became effective upon issuance and SFAS No. 157 is effective for fiscal +years beginning after November 15, 2007 and will be adopted by the Company beginning in the first quarter of fiscal 2009. Although the Company will continue to evaluate the application of SFAS No. 157, management does not currently believe +adoption will have a material impact on the Company’s financial condition or operating results. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—including an amendment of FASB Statement No. 115. SFAS No. 159 allows companies to choose to measure eligible financial instruments and certain other items at +fair value that are not required to be measured at fair value. SFAS No. 159 requires that unrealized gains and losses on items for which the fair value option has been elected be reported in earnings at each reporting date. SFAS No. 159 is +effective for fiscal years beginning after November 15, 2007 and will be adopted by the Company beginning in the first quarter of fiscal 2009. Although the Company will continue to evaluate the application of SFAS No. 159, management does +not currently believe adoption will have a material impact on the Company’s financial condition or operating results. In December 2007, the FASB +issued SFAS No. 141 (revised 2007), Business Combinations , which establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, +and any noncontrolling interest in the acquiree in a business combination. SFAS No. 141R also establishes principles around how goodwill acquired in a business combination or a gain from a bargain purchase should be recognized and measured, as +well as provides guidelines on the disclosure requirements on the nature and financial impact of the business combination. SFAS No. 141R is effective for fiscal years beginning on or after December 15, 2008 and will be adopted by the +Company beginning in the first quarter of fiscal 2010. Although the Company will continue to evaluate the application of SFAS No. 141R, management does not currently believe adoption will have a material impact on the Company’s financial +condition or operating results. 48 Table of Contents In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging +Activities—an amendment of FASB Statement No. 133, which requires companies to provide additional disclosures about its objectives and strategies for using derivative instruments, how the derivative instruments and related hedged items +are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , and related interpretations, and how the derivative instruments and related hedged items affect the Company’s financial statements. +SFAS No. 161 also requires companies to disclose information about credit risk-related contingent features in their hedged positions. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008 and +is required to be adopted by the Company beginning in the second quarter of fiscal 2009. Although the Company will continue to evaluate the application of SFAS No. 161, management does not currently believe adoption will have a material impact +on the Company’s financial condition or operating results. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the three fiscal years ended September 27, 2008 (in millions): 2008 2007 2006 Cash, cash equivalents, and short-term investments $ 24,490 $ 15,386 $ 10,110 Accounts receivable, net $ 2,422 $ 1,637 $ 1,252 Inventory $ 509 $ 346 $ 270 Working capital $ 20,598 $ 12,676 $ 8,066 Annual operating cash flow $ 9,596 $ 5,470 $ 2,220 As of September 27, 2008, the Company had $24.5 billion in cash, cash equivalents, and short-term investments, +an increase of $9.1 billion from September 29, 2007. The principal components of this net increase were cash generated by operating activities of $9.6 billion, proceeds from the issuance of common stock under stock plans of $483 million and +excess tax benefits from stock-based compensation of $757 million. These increases were partially offset by payments for acquisitions of property, plant, and equipment of $1.1 billion, payments made in connection with business acquisitions, net of +cash acquired, of $220 million and payments for acquisitions of intangible assets of $108 million. The Company’s cash generated by operating activities significantly exceeded its net income due primarily to the large increase in deferred +revenue, net of deferred costs, associated with subscription accounting for iPhone. The Company’s short-term investment portfolio is invested +primarily in highly rated securities with a minimum rating of single-A. As of September 27, 2008 and September 29, 2007, $11.3 billion and $6.5 billion, respectively, of the Company’s cash, cash equivalents, and short-term investments +were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. The Company had $117 million in net unrealized losses on its investment portfolio, primarily related to investments with stated maturities ranging from +one to five years, as of September 27, 2008, and net unrealized losses of approximately $11 million on its investment portfolio, primarily related to investments with stated maturities from one to five years, as of September 29, 2007. The +Company has the intent and ability to hold such investments for a sufficient period of time to allow for recovery of the principal amounts invested. Accordingly, none of these declines in fair value were recognized in the Company’s +Statement of Operations. The Company believes its existing balances of cash, cash equivalents, and short-term investments will be sufficient to satisfy its +working capital needs, capital expenditures, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. Capital Assets The Company’s cash payments for capital asset purchases were $1.1 billion during 2008, +consisting of $389 million for retail store facilities and $702 million for real estate acquisitions and corporate infrastructure including information systems enhancements. The Company anticipates utilizing approximately $1.5 billion for capital +asset purchases during 2009, including approximately $400 million for Retail facilities and approximately $1.1 billion for corporate facilities and infrastructure. 49 Table of Contents Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative +instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market +risk, or credit risk support to the Company. The following table presents certain payments due by the Company under contractual obligations with minimum +firm commitments as of September 27, 2008 and excludes amounts already recorded on the Company’s balance sheet as current liabilities (in millions): Total Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Operating leases $ 1,760 $ 195 $ 409 $ 368 $ 788 Purchase obligations 5,378 5,378 — — — Asset retirement obligations 28 — 8 7 13 Other obligations 471 242 124 105 — Total $ 7,637 $ 5,815 $ 541 $ 480 $ 801 Lease Commitments As of September 27, 2008, the Company had total outstanding commitments on noncancelable operating leases of $1.8 billion, $1.4 billion of which related to the lease of retail space and related facilities. The Company’s major +facility leases are generally for terms of 3 to 20 years and generally provide renewal options for terms of 1 to 5 additional years. Leases for retail space are for terms of 5 to 20 years, the majority of which are for 10 years, and often contain +multi-year renewal options. Purchase Commitments with Contract Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to manufacture sub-assemblies for the Company’s products and to perform final assembly and test of finished +products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods ranging from 30 to 150 days. The Company also obtains individual components for its +products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. Such +purchase commitments typically cover the Company’s forecasted component and manufacturing requirements for periods ranging from 30 to 150 days. In addition, the Company has an off-balance sheet warranty obligation for products accounted for +under subscription accounting pursuant to SOP No. 97-2 whereby the Company recognizes warranty expense as incurred. As of September 27, 2008, the Company had outstanding off-balance sheet third-party manufacturing commitments, component +purchase commitments, and estimated warranty commitments of $5.4 billion. During 2006, the Company entered into long-term supply agreements with Hynix +Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of NAND flash memory through calendar year 2010. As part of these agreements, the Company prepaid $1.25 billion +for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective agreement. The Company utilized $567 million of the prepayment as of September 27, 2008. Asset Retirement Obligations The Company’s asset retirement +obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. As of September 27, 2008, the Company estimated that gross expected future cash flows of $28 million would +be required to fulfill these obligations. 50 Table of Contents Other Obligations Other outstanding obligations were $471 million as of September 27, 2008, which related to advertising, research and development, Internet and telecommunications services, and other obligations. During the first quarter of 2008, the Company adopted the provisions of FIN 48. The Company had historically classified interest and penalties and unrecognized tax +benefits as current liabilities, but beginning with the adoption of FIN 48 the Company has reclassified gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one year as +non-current liabilities within the Consolidated Balance Sheet. As of September 27, 2008, the Company recorded gross unrecognized tax benefits of $506 million and gross interest and penalties of $219 million, both of which are classified as +non-current liabilities in the Consolidated Balance Sheet. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years due to uncertainties in the timing of tax audit outcomes; therefore, +such amounts are not included in the above contractual obligation table. Indemnifications The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party +intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an +indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified third-party and, in the opinion of management, does not have a +liability related to unresolved infringement claims subject to indemnification that would have a material adverse effect on its financial condition or operating results. Therefore, the Company did not record a liability for infringement costs as of +either September 27, 2008 or September 29, 2007. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company +regularly reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. However, given the effective horizons of the Company’s +risk management activities and the anticipatory nature of the exposures, there can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. In addition, +the timing of the accounting for recognition of gains and losses related to mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may +adversely affect the Company’s financial condition and operating results. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the Company’s interest income and expense is +most sensitive to fluctuations in the general level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents, and short-term investments, the value of those investments, +as well as costs associated with foreign currency hedges. The Company’s short-term investment policy and strategy attempts primarily to preserve +capital and meet liquidity requirements. A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s investment policy and to an objective market benchmark. The Company’s internal portfolio +is benchmarked against external manager performance, allowing for differences in liquidity needs. The Company’s exposure to market risk for changes in +interest rates relates primarily to the Company’s investment portfolio. The Company typically invests in highly rated securities and its policy generally limits the amount of credit exposure to any one issuer. The Company’s investment +policy requires investments to be rated single-A or better with the objective of minimizing the potential risk of principal loss. All highly liquid investments with initial maturities of three months or less at the date of purchase are classified as +cash 51 Table of Contents equivalents, while highly liquid investments with initial maturities greater than three months at the date of purchase are classified as short-term +investments. As of September 27, 2008 and September 29, 2007, approximately $2.4 billion and $1.9 billion, respectively, of the Company’s short-term investments had underlying maturities ranging from one to five years. The remainder +all had underlying maturities of less than 12 months. The Company may sell its investments prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no +material net gains or losses during 2008, 2007 and 2006 related to such sales. To provide a meaningful assessment of the interest rate risk associated with +the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield +curve. Based on investment positions as of September 27, 2008, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $46 million incremental decline in the fair market value of the portfolio. As of +September 29, 2007, a similar 100 basis point shift in the yield curve would have resulted in a $16 million incremental decline in the fair market value of the portfolio. Such losses would only be realized if the Company sold the investments +prior to maturity. Foreign Currency Risk In general, +the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed +in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with existing +assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s practice is to hedge a majority of its material foreign exchange exposures, +typically for three to six months. However, the Company may choose not to hedge certain foreign exchange exposures due to immateriality, prohibitive economic cost of hedging particular exposures, and limited availability of appropriate hedging +instruments. To provide a meaningful assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative +positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate 3,000 +random market price paths. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign exchange portfolio due to adverse movements in rates. The VAR model is not intended to represent actual +losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments, and assets and liabilities denominated in foreign currencies were excluded from the model. Based on +the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $60 million as of September 27, 2008 compared to a maximum one-day loss in fair value of $13 million as of September 29, 2007. +Because the Company uses foreign currency instruments for hedging purposes, losses incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio and derivative positions may differ materially from the sensitivity analyses +performed as of September 27, 2008 due to the inherent limitations associated with predicting the changes in the timing and amount of interest rates, foreign currency exchanges rates, and the Company’s actual exposures and positions. 52 Table of Contents Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Balance Sheets as of September 27, 2008 and September 29, 2007 54 Consolidated Statements of Operations for the three fiscal years ended September 27, 2008 55 Consolidated Statements of Shareholders’ Equity for the three fiscal years ended September 27, +2008 56 Consolidated Statements of Cash Flows for the three fiscal years ended September 27, 2008 57 Notes to Consolidated Financial Statements 58 Selected Quarterly Financial Information (Unaudited) 87 Reports of Independent Registered Public Accounting Firm, KPMG LLP 88 All financial statement schedules have been omitted, since the required information is not applicable or is not +present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements and Notes thereto. 53 Table of Contents CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 27, 2008 September 29, 2007 ASSETS: Current assets: Cash and cash equivalents $ 11,875 $ 9,352 Short-term investments 12,615 6,034 Accounts receivable, less allowances of $47 in each period 2,422 1,637 Inventories 509 346 Deferred tax assets 1,447 782 Other current assets 5,822 3,805 Total current assets 34,690 21,956 Property, plant, and equipment, net 2,455 1,832 Goodwill 207 38 Acquired intangible assets, net 285 299 Other assets 1,935 1,222 Total assets $ 39,572 $ 25,347 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 5,520 $ 4,970 Accrued expenses 8,572 4,310 Total current liabilities 14,092 9,280 Non-current liabilities 4,450 1,535 Total liabilities 18,542 10,815 Commitments and contingencies Shareholders’ equity: Common stock, no par value; 1,800,000,000 shares authorized; 888,325,973 and 872,328,972 shares issued and outstanding, +respectively 7,177 5,368 Retained earnings 13,845 9,101 Accumulated other comprehensive income 8 63 Total shareholders’ equity 21,030 14,532 Total liabilities and shareholders’ equity $ 39,572 $ 25,347 See accompanying Notes to Consolidated Financial Statements. 54 Table of Contents CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share amounts which are reflected in thousands and per share amounts) Three fiscal years ended September 27, 2008 2008 2007 2006 Net sales $ 32,479 $ 24,006 $ 19,315 Cost of sales (1) 21,334 15,852 13,717 Gross margin 11,145 8,154 5,598 Operating expenses: Research and development (1) 1,109 782 712 Selling, general, and administrative (1) 3,761 2,963 2,433 Total operating expenses 4,870 3,745 3,145 Operating income 6,275 4,409 2,453 Other income and expense 620 599 365 Income before provision for income taxes 6,895 5,008 2,818 Provision for income taxes 2,061 1,512 829 Net income $ 4,834 $ 3,496 $ 1,989 Earnings per common share: Basic $ 5.48 $ 4.04 $ 2.36 Diluted $ 5.36 $ 3.93 $ 2.27 Shares used in computing earnings per share: Basic 881,592 864,595 844,058 Diluted 902,139 889,292 877,526 (1)    Includes stock-based compensation expense as follows: Cost of sales $ 80 $ 35 $ 21 Research and development $ 185 $ 77 $ 53 Selling, general, and administrative $ 251 $ 130 $ 89 See accompanying Notes to Consolidated Financial Statements. 55 Table of Contents CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Common Stock Deferred Stock Compensation Retained Earnings Accumulated Other Comprehensive Income Total Shareholders’ Equity Shares Amount Balances as of September 24, 2005 835,019 $ 3,564 $ (61 ) $ 3,925 $ — $ 7,428 Components of comprehensive income: Net income — — — 1,989 — 1,989 Change in foreign currency translation — — — — 19 19 Change in unrealized gain on available-for-sale securities, net of tax — — — — 4 4 Change in unrealized gain on derivative instruments, net of tax — — — — (1 ) (1 ) Total comprehensive income 2,011 Common stock repurchased (4,574 ) (48 ) — (307 ) — (355 ) Stock-based compensation — 163 — — — 163 Deferred compensation — (61 ) 61 — — — Common stock issued under stock plans 24,818 318 — — — 318 Tax benefit from employee stock plan awards — 419 — — — 419 Balances as of September 30, 2006 855,263 4,355 — 5,607 22 9,984 Components of comprehensive income: Net income — — — 3,496 — 3,496 Change in foreign currency translation — — — — 51 51 Change in unrealized loss on available-for-sale securities, net of tax — — — — (7 ) (7 ) Change in unrealized gain on derivative instruments, net of tax — — — — (3 ) (3 ) Total comprehensive income 3,537 Stock-based compensation — 251 — — — 251 Common stock issued under stock plans, net of shares withheld for employee taxes 17,066 364 — (2 ) — 362 Tax benefit from employee stock plan awards — 398 — — — 398 Balances as of September 29, 2007 872,329 5,368 — 9,101 63 14,532 Cumulative effect of change in accounting principle — 45 — 11 — 56 Components of comprehensive income: Net income — — — 4,834 4,834 Change in foreign currency translation — — — — (11 ) (11 ) Change in unrealized loss on available-for-sale securities, net of tax — — — — (63 ) (63 ) Change in unrealized gain on derivative instruments, net of tax — — — — 19 19 Total comprehensive income 4,779 Stock-based compensation — 513 — — — 513 Common stock issued under stock plans, net of shares withheld for employee taxes 15,888 460 — (101 ) — 359 Issuance of common stock in connection with an asset acquisition 109 21 — — — 21 Tax benefit from employee stock plan awards — 770 — — — 770 Balances as of September 27, 2008 888,326 $ 7,177 $ — $ 13,845 $ 8 $ 21,030 See accompanying Notes to Consolidated Financial Statements. 56 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three fiscal years ended September 27, 2008 2008 2007 2006 Cash and cash equivalents, beginning of the year $ 9,352 $ 6,392 $ 3,491 Operating Activities: Net income 4,834 3,496 1,989 Adjustments to reconcile net income to cash generated by operating activities: Depreciation, amortization and accretion 473 317 225 Stock-based compensation expense 516 242 163 Provision for deferred income taxes (368 ) 78 53 Loss on disposition of property, plant, and equipment 22 12 15 Changes in operating assets and liabilities: Accounts receivable, net (785 ) (385 ) (357 ) Inventories (163 ) (76 ) (105 ) Other current assets (1,958 ) (1,540 ) (1,626 ) Other assets (492 ) 81 (1,040 ) Accounts payable 596 1,494 1,611 Deferred revenue 5,642 1,139 319 Other liabilities 1,279 612 973 Cash generated by operating activities 9,596 5,470 2,220 Investing Activities: Purchases of short-term investments (22,965 ) (11,719 ) (7,255 ) Proceeds from maturities of short-term investments 11,804 6,483 7,226 Proceeds from sales of short-term investments 4,439 2,941 1,086 Purchases of long-term investments (38 ) (17 ) (25 ) Payments made in connection with business acquisitions, net of cash acquired (220 ) — — Payment for acquisition of property, plant, and equipment (1,091 ) (735 ) (657 ) Payment for acquisition of intangible assets (108 ) (251 ) (28 ) Other (10 ) 49 10 Cash (used in)/generated by investing activities (8,189 ) (3,249 ) 357 Financing Activities: Proceeds from issuance of common stock 483 365 318 Excess tax benefits from stock-based compensation 757 377 361 Cash used to net share settle equity awards (124 ) (3 ) (355 ) Cash generated by financing activities 1,116 739 324 Increase in cash and cash equivalents 2,523 2,960 2,901 Cash and cash equivalents, end of the year $ 11,875 $ 9,352 $ 6,392 Supplemental cash flow disclosures: Cash paid for income taxes, net $ 1,267 $ 863 $ 194 See accompanying Notes to Consolidated Financial Statements. 57 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1—Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) design, +manufacture, and market personal computers, portable digital music players, and mobile communication devices and sell a variety of related software, services, peripherals, and networking solutions. The Company sells its products worldwide through +its online stores, its retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Mac, iPod and iPhone compatible products including application +software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to consumer, small and mid-sized business (“SMB”), education, enterprise, +government, and creative customers. Basis of Presentation and Preparation The accompanying Consolidated Financial Statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these Consolidated Financial Statements in +conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in these Consolidated Financial Statements and accompanying notes. Actual results could differ +materially from those estimates. Certain prior year amounts in the Consolidated Financial Statements and notes thereto have been reclassified to conform to the current year presentation. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s first quarter of fiscal years 2008 and 2007 contained 13 weeks and the first quarter of fiscal +year 2006 contained 14 weeks. The Company’s fiscal years 2008 and 2007 ended on September 27, 2008 and September 29, 2007, respectively, included 52 weeks, while fiscal year 2006 ended on September 30, 2006 included 53 weeks. +Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. Financial Instruments Cash Equivalents and Short-term Investments All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. Highly liquid investments with +maturities greater than three months at the date of purchase are classified as short-term investments. The Company’s debt and marketable equity securities have been classified and accounted for as available-for-sale. Management determines the +appropriate classification of its investments in debt securities at the time of purchase and reevaluates the available-for-sale designations as of each balance sheet date. These securities are carried at fair value, with the unrealized gains and +losses, net of taxes, reported as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at +fair value. Derivatives that are not defined as hedges in Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended, must be adjusted to fair value +through earnings. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, +the effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income in shareholders’ equity and reclassified into earnings in the same period or periods during which the +hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument is recognized in current earnings. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes +to expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments that hedge +the exposure to changes in the fair value of an asset or a liability and that are designated as fair value hedges, the net 58 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting Policies (Continued) gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in +earnings in the current period. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the net investment in a foreign operation is reported in +the same manner as a foreign currency translation adjustment. For forward contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of +effectiveness. Accordingly, any gains or losses related to this component are recognized in current earnings. Inventories Inventories are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, +provisions are made currently for the difference between the cost and the market value. The Company’s inventories consist primarily of finished goods for all periods presented. Property, Plant, and Equipment Property, plant, and equipment are stated at cost. Depreciation is computed by use of +the straight-line method over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building, up to 5 years for equipment, and the shorter of lease terms or 10 years for +leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using the +straight-line method over the estimated useful lives of the assets, which range from 3 to 5 years. Depreciation and amortization expense on property and equipment was $363 million, $249 million, and $180 million during 2008, 2007, and 2006 +respectively. Asset Retirement Obligations The +Company records obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs in accordance with SFAS No. 143, Accounting for Asset Retirement Obligations . The Company reviews legal +obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. If it is determined that a legal obligation exists, the fair value of the liability for an +asset retirement obligation is recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset and this additional carrying +amount is depreciated over the life of the asset. The difference between the gross expected future cash flow and its present value is accreted over the life of the related lease as an operating expense. All of the Company’s existing asset +retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. The Company’s asset retirement liability was $21 million and $18 million as of +September 27, 2008 and September 29, 2007, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant, and equipment and certain identifiable intangibles, excluding goodwill, for impairment in accordance with SFAS +No. 144, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset +may not be recoverable. Recoverability of these assets is measured by comparison of its carrying amount to future undiscounted cash flows the assets are expected to generate. If property, plant, and equipment and certain identifiable intangibles are +considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value. The Company did not record any material impairments during 2008, 2007, and 2006. 59 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting Policies (Continued) SFAS No. 142, Goodwill and Other Intangible Assets requires that goodwill and intangible assets with +indefinite useful lives should not be amortized but rather be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that they may be impaired. The Company performs its goodwill impairment tests on or +about August 31 of each year. The Company did not recognize any goodwill or intangible asset impairment charges in 2008, 2007, or 2006. The Company established reporting units based on its current reporting structure. For purposes of testing +goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. SFAS No. 142 also +requires that intangible assets with definite lives be amortized over their estimated useful lives and reviewed for impairment in accordance with SFAS No. 144. The Company is currently amortizing its acquired intangible assets with definite +lives over periods ranging from 1 to 10 years. Foreign Currency Translation The Company translates the assets and liabilities of its international non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses +for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are credited or charged to foreign currency translation included in accumulated other comprehensive income +in shareholders’ equity. The Company’s foreign manufacturing subsidiaries and certain other international subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in +effect at the end of each period, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these translations were insignificant and have been included in the Company’s results of operations. Revenue Recognition Net sales consist primarily of +revenue from the sale of hardware, software, music products, digital content, peripherals, and service and support contracts. For any product within these groups that either is software, or is considered software-related in accordance with the +guidance in Emerging Issues Task Force (“EITF”) No. 03-5, Applicability of AICPA Statement of Position 97-2 to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software (e.g., Mac computers, iPod +portable digital music players and iPhones), the Company accounts for such products in accordance with the revenue recognition provisions of American Institute of Certified Public Accountants (“AICPA”) Statement of Position +(“SOP”) No. 97-2, Software Revenue Recognition , as amended. The Company applies Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition, for products that are not software or software-related, such +as digital content sold on the iTunes Store and certain Mac, iPod and iPhone supplies and accessories. The Company recognizes revenue when persuasive +evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been +transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers +revenue until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed not +to be, fixed or determinable, revenue is deferred and subsequently recognized as amounts become due and payable and all other criteria for revenue recognition have been met. Revenue from service and support contracts is deferred and recognized ratably over the service coverage periods. These contracts typically include extended phone support, repair services, web-based support resources, +diagnostic tools, and extend the service coverage offered under the Company’s one-year limited warranty. 60 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting Policies (Continued) The Company sells software and peripheral products obtained from other companies. The Company generally establishes +its own pricing and retains related inventory risk, is the primary obligor in sales transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company generally recognizes revenue for the sale +of products obtained from other companies based on the gross amount billed. The Company accounts for multiple element arrangements that consist only of +software or software-related products in accordance with SOP No. 97-2. If a multiple-element arrangement includes deliverables that are neither software nor software-related, the Company applies EITF No. 00-21, Revenue Arrangements with +Multiple Deliverables, to determine if those deliverables constitute separate units of accounting from the SOP No. 97-2 deliverables. If the Company can separate the deliverables, the Company applies SOP No. 97-2 to the software and +software-related deliverables and applies other appropriate guidance (e.g., SAB No. 104) to the deliverables outside the scope of SOP No. 97-2. Revenue on arrangements that include multiple elements such as hardware, software, and services +is allocated to each element based on the relative fair value of each element. Each element’s allocated revenue is recognized when the revenue recognition criteria for that element have been met. Fair value is generally determined by vendor +specific objective evidence (“VSOE”), which is based on the price charged when each element is sold separately. If the Company cannot objectively determine the fair value of any undelivered element included in a multiple-element +arrangement, the Company defers revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements. When the fair value of a delivered element has not +been established, the Company uses the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of +the arrangement fee is allocated to the delivered elements and is recognized as revenue. The Company records reductions to revenue for estimated +commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in +the period the Company has sold the product and committed to a plan. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected +from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. Generally, the Company does not offer specified or unspecified upgrade rights to its customers in connection with software sales or the sale of extended warranty and support contracts. When the Company does offer +specified upgrade rights, the Company defers revenue for the fair value of the specified upgrade right until the future obligation is fulfilled or when the right to the specified upgrade expires. Additionally, a limited number of the Company’s +software products are available with maintenance agreements that grant customers rights to unspecified future upgrades over the maintenance term on a when and if available basis. Revenue associated with such maintenance is recognized ratably over +the maintenance term. In 2007, the Company began shipping Apple TV and iPhone. For Apple TV and iPhone, the Company indicated it may from time-to-time +provide future unspecified features and additional software products free of charge to customers. Accordingly, Apple TV and iPhone handsets sales are accounted for under subscription accounting in accordance with SOP No. 97-2. As such, the +Company’s policy is to defer the associated revenue and cost of goods sold at the time of sale, and recognize both on a straight-line basis over the currently estimated 24-month economic life of these products, with any loss recognized at the +time of sale. Costs incurred by the Company for engineering, sales, marketing and warranty are expensed as incurred. 61 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting Policies (Continued) Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical experience, the age of the accounts receivable balances, credit quality of the +Company’s customers, current economic conditions, and other factors that may affect customers’ ability to pay. Shipping Costs For all periods presented, amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s shipping and handling costs +are included in cost of sales. Warranty Expense The +Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. The Company assesses the adequacy of its preexisting warranty liabilities and adjusts the amounts as necessary based +on actual experience and changes in future estimates. For products accounted for under subscription accounting pursuant to SOP No. 97-2, the Company recognizes warranty expense as incurred. Software Development Costs Research and development costs are +expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is +available for general release to customers pursuant to SFAS No. 86, Computer Software to be Sold, Leased, or Otherwise Marketed . In most instances, the Company’s products are released soon after technological feasibility has been +established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally most software development costs have been expensed. During 2008, the Company capitalized $11 million of costs associated with the development of Mac OS X Version 10.6 Snow Leopard. In 2007, the Company determined that both +Mac OS X Version 10.5 Leopard (“Mac OS X Leopard”) and iPhone achieved technological feasibility. During 2007, the Company capitalized $75 million of costs associated with the development of Leopard and iPhone. In accordance with SFAS +No. 86, the capitalized costs related to Mac OS X Leopard and iPhone are amortized to cost of sales commencing when each respective product begins shipping and are recognized on a straight-line basis over a 3 year estimated useful life of the +underlying technology. Total amortization related to capitalized software development costs was $27 million, $13 million, and $18 million in 2008, 2007, and +2006, respectively. Advertising Costs Advertising +costs are expensed as incurred. Advertising expense was $486 million, $467 million, and $338 million for 2008, 2007, and 2006, respectively. Stock-Based Compensation The Company applies SFAS No. 123 (revised 2004), Share-Based Payment , for stock-based payment +transactions in which the Company receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by +the issuance of such equity instruments. The Company uses the Black-Scholes-Merton (“BSM”) option-pricing model to determine the fair-value of stock-based awards under SFAS No. 123R. SFAS No. 123R prohibits recognition of a deferred tax asset for an excess tax benefit that has not been realized. The Company will recognize a benefit from +stock-based compensation in equity if an incremental tax benefit is 62 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting Policies (Continued) realized by following the ordering provisions of the tax law. In addition, the Company accounts for the indirect effects of stock-based compensation on the +research tax credit, the foreign tax credit, and the domestic manufacturing deduction through the income statement. Further information regarding +stock-based compensation can be found in Note 6, “Shareholders’ Equity,” and Note 7, “Stock-Based Compensation.” Income Taxes In accordance with SFAS No. 109, Accounting for Income Taxes , the provision for income taxes is computed using the asset and liability +method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit +carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a +valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. During 2008, the Company adopted the +Financial Accounting Standards Board’s (“FASB”) Financial Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 . FIN 48 changes the accounting +for uncertainty in income taxes by creating a new framework for how companies should recognize, measure, present, and disclose uncertain tax positions in their financial statements. Under FIN 48, the Company may recognize the tax benefit from an +uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such +positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. FIN 48 also provides guidance on the reversal of previously recognized tax positions, balance sheet classifications, +accounting for interest and penalties associated with tax positions, and income tax disclosures. See Note 5, “Income Taxes” for additional information, including the effects of adoption on the Company’s Consolidated Financial +Statements. Earnings Per Common Share Basic earnings +per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to +common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities +had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the employee stock purchase plan, and unvested restricted stock units (“RSUs”). The dilutive effect of potentially dilutive +securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from +potentially dilutive securities. 63 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 1—Summary of Significant Accounting Policies (Continued) The following table sets forth the computation of basic and diluted earnings per share for the three fiscal years +ended September 27, 2008 (in thousands, except net income in millions and per share amounts): 2008 2007 2006 Numerator: Net income $ 4,834 $ 3,496 $ 1,989 Denominator: Weighted-average shares outstanding 881,592 864,595 844,058 Effect of dilutive securities 20,547 24,697 33,468 Denominator for diluted earnings per share 902,139 889,292 877,526 Basic earnings per share $ 5.48 $ 4.04 $ 2.36 Diluted earnings per share $ 5.36 $ 3.93 $ 2.27 Potentially dilutive securities representing 10.3 million, 13.7 million, and 3.9 million shares of +common stock for the years ended September 27, 2008, September 29, 2007, and September 30, 2006, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have +been antidilutive. Comprehensive Income Comprehensive +income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that under U.S. generally accepted accounting principles are recorded as an element of +shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized +gains and losses on marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Segment Information The Company reports segment information based on the “management” approach. The +management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. Information about the Company’s products, major customers, and +geographic areas on a company-wide basis is also disclosed. 64 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial Instruments Cash, Cash Equivalents and Short-Term Investments The following table summarizes the fair value of the Company’s cash and available-for-sale securities held in its short-term investment portfolio, recorded as cash +and cash equivalents or short-term investments as of September 27, 2008 and September 29, 2007 (in millions): 2008 2007 Cash $ 368 $ 256 U.S. Treasury and Agency Securities 2,916 670 U.S. Corporate Securities 4,975 5,597 Foreign Securities 3,616 2,829 Total cash equivalents 11,507 9,096 U.S. Treasury and Agency Securities 7,018 358 U.S. Corporate Securities 4,305 4,718 Foreign Securities 1,292 958 Total short-term investments 12,615 6,034 Total cash, cash equivalents, and short-term investments $ 24,490 $ 15,386 The Company’s U.S. Corporate Securities consist primarily of commercial paper, certificates of deposit, time +deposits, and corporate debt securities. Foreign Securities consist primarily of foreign commercial paper issued by foreign companies, and certificates of deposit and time deposits with foreign institutions, most of which are denominated in U.S. +dollars. As of September 27, 2008 and September 29, 2007, approximately $2.4 billion and $1.9 billion, respectively, of the Company’s short-term investments had underlying maturities ranging from one to five years. The remaining +short-term investments had maturities less than 12 months. The Company had $117 million in net unrealized losses on its investment portfolio, primarily related to investments with stated maturities ranging from one to five years, as of +September 27, 2008, and net unrealized losses of approximately $11 million on its investment portfolio, primarily related to investments with stated maturities from one to five years, as of September 29, 2007. The Company may sell its +investments prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no material net gains or losses during 2008, 2007 and 2006 related to such sales. 65 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial Instruments (Continued) In accordance with FASB Staff Position (“FSP”) FAS 115-1 and FAS 124-1, The Meaning of +Other-Than-Temporary Impairment and Its Application to Certain Investments, the following table shows the gross unrealized losses and fair value for those investments that were in an unrealized loss position as of September 27, 2008 and +September 29, 2007, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): 2008 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agency Securities $ 6,850 $ (13 ) $ — $ — $ 6,850 $ (13 ) U.S. Corporate Securities 2,536 (31 ) 1,030 (72 ) 3,566 (103 ) Foreign Securities 321 — 118 (5 ) 439 (5 ) Total $ 9,707 $ (44 ) $ 1,148 $ (77 ) $ 10,855 $ (121 ) 2007 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. Treasury and Agency Securities $ 338 $ — $ — $ — $ 338 $ — U.S. Corporate Securities 2,521 (12 ) 32 — 2,553 (12 ) Foreign Securities 474 (1 ) 8 — 482 (1 ) Total $ 3,333 $ (13 ) $ 40 $ — $ 3,373 $ (13 ) The unrealized losses on the Company’s investments in U.S. Treasury and Agency Securities, U.S. Corporate +Securities, and Foreign Securities were caused primarily by changes in interest rates, specifically, widening credit spreads. The Company’s investment policy requires investments to be rated single-A or better with the objective of minimizing +the potential risk of principal loss. Therefore, the Company considers the declines to be temporary in nature. Fair values were determined for each individual security in the investment portfolio. When evaluating the investments for +other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer, and the Company’s ability and intent to hold the investment +for a period of time, which may be sufficient for anticipated recovery in market value. During 2008, the Company did not record any material impairment charges on its outstanding securities. As of September 27, 2008, the Company does not +consider any of its investments to be other-than-temporarily impaired. Accounts Receivable Trade Receivables The Company distributes its products through +third-party distributors and resellers and directly to certain education, consumer, and commercial customers. The Company generally does not require collateral from its customers. In addition, when possible, the Company attempts to limit credit risk +on trade receivables with credit insurance for certain customers in Latin America, Europe, Asia, and Australia and by arranging with third-party financing companies to provide flooring arrangements and other loan and lease programs to the +Company’s direct customers. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of +these arrangements. However, considerable trade receivables not covered by collateral, third-party flooring arrangements, or credit insurance are outstanding with the Company’s distribution and retail channel partners. Trade receivables from +two of the Company’s customers accounted for 15% and 10% of trade receivables as of September 27, 2008, while one customer accounted for approximately 11% of trade receivables as of September 29, 2007. 66 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial Instruments (Continued) The following table summarizes the activity in the allowance for doubtful accounts for the three fiscal years ended +September 27, 2008 (in millions): 2008 2007 2006 Beginning allowance balance $ 47 $ 52 $ 46 Charged to costs and expenses 3 12 17 Deductions (3 ) (17 ) (11 ) Ending allowance balance $ 47 $ 47 $ 52 Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of raw material components to these manufacturing vendors who manufacture sub-assemblies or assemble final +products for the Company. The Company purchases these raw material components directly from suppliers. These non-trade receivables, which are included in the Consolidated Balance Sheets in other current assets, totaled $2.3 billion and $2.4 billion +as of September 27, 2008 and September 29, 2007, respectively. The Company does not reflect the sale of these components in net sales and does not recognize any profits on these sales until the related products are sold by the Company, at +which time the profit is recognized as a reduction of cost of sales. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign exchange risk. Foreign currency forward and option contracts are used to offset the +foreign exchange risk on certain existing assets and liabilities and to hedge the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales. The Company’s accounting policies for these instruments are +based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the balance sheet at fair value. The following table shows the notional principal, net fair value, and credit risk amounts of the Company’s foreign currency instruments as of September 27, 2008 and September 29, 2007 (in millions): 2008 2007 Notional Principal Fair Value Credit Risk Amounts Notional Principal Fair Value Credit Risk Amounts Foreign exchange instruments qualifying as accounting hedges: Spot/Forward contracts $ 2,782 $ (2 ) $ 43 $ 570 $ (8 ) $ — Purchased options $ 3,120 $ 64 $ 64 $ 2,564 $ 10 $ 10 Sold options $ 2,668 $ (23 ) $ — $ 1,498 $ (2 ) $ — Foreign exchange instruments other than accounting hedges: Spot/Forward contracts $ 2,633 $ 3 $ 5 $ 1,768 $ (2 ) $ — Purchased options $ 235 $ 3 $ 3 $ 161 $ 1 $ 1 The notional principal amounts for derivative instruments provide one measure of the transaction volume outstanding +as of year-end, and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts shown in the table above represents the Company’s gross exposure to potential accounting loss on these transactions +if all counterparties failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company’s exposure to credit loss and market risk will vary over time as a function of +currency exchange rates. 67 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 2—Financial Instruments (Continued) The estimates of fair value are based on applicable and commonly used pricing models and prevailing financial market +information as of September 27, 2008 and September 29, 2007. Although the table above reflects the notional principal, fair value, and credit risk amounts of the Company’s foreign exchange instruments, it does not reflect the gains or +losses associated with the exposures and transactions that the foreign exchange instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying +exposures, will depend on actual market conditions during the remaining life of the instruments. Foreign Exchange Risk Management The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risk associated with existing +assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s practice is to hedge some portion of its material foreign exchange exposures. +However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to, immateriality, prohibitive economic cost of hedging particular exposures, or limited availability of appropriate +hedging instruments. To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s U.S. dollar +functional subsidiaries hedge a portion of forecasted foreign currency revenue, and the Company’s non-U.S. dollar functional subsidiaries selling in local currencies hedge a portion of forecasted inventory purchases not denominated in the +subsidiaries’ functional currency. Other comprehensive income associated with hedges of foreign currency revenue is recognized as a component of net sales in the same period as the related sales are recognized, and other comprehensive income +related to inventory purchases is recognized as a component of cost of sales in the same period as the related costs are recognized. Typically, the Company hedges portions of its forecasted foreign currency exposure associated with revenue and +inventory purchases for three to six months. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the +forecasted hedged transaction will not occur in the initially identified time period or within a subsequent 2 month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are immediately +reclassified into earnings in other income and expense. Any subsequent changes in fair value of such derivative instruments are also reflected in current earnings unless they are re-designated as hedges of other transactions. The Company has not +recognized any material net gains during 2008, 2007 and 2006, related to the loss of a hedge designation on discontinued cash flow hedges. As of September 27, 2008, the Company had a net deferred gain associated with cash flow hedges of +approximately $19 million, net of taxes, substantially all of which is expected to be reclassified to earnings by the end of the second quarter of fiscal 2009. The net gain or loss on the effective portion of a derivative instrument designated as a net investment hedge is included in the cumulative translation adjustment account of accumulated other comprehensive income within shareholders’ +equity. For the years ended September 27, 2008 and September 29, 2007, the Company had a net loss on net investment hedges of $12.2 million and $2.6 million, respectively, included in the cumulative translation adjustment. The Company may also enter into foreign currency forward and option contracts to offset the foreign exchange gains and losses generated by the re-measurement of certain +assets and liabilities recorded in non-functional currencies. Changes in the fair value of these derivatives are recognized in current earnings in other income and expense as offsets to the changes in the fair value of the related assets or +liabilities. Due to currency market movements, changes in option time value can lead to increased volatility in other income and expense. 68 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Consolidated Financial Statement Details The following tables show the Company’s Consolidated Financial Statement details as of September 27, 2008 +and September 29, 2007 (in millions): Other Current Assets 2008 2007 Vendor non-trade receivables $ 2,282 $ 2,392 Deferred costs under subscription accounting—current 1,931 247 NAND flash memory prepayments 475 417 Other current assets 1,134 749 Total other current assets $ 5,822 $ 3,805 Property, Plant, and Equipment 2008 2007 Land and buildings $ 810 $ 762 Machinery, equipment, and internal-use software 1,491 954 Office furniture and equipment 122 106 Leasehold improvements 1,324 1,019 3,747 2,841 Accumulated depreciation and amortization (1,292 ) (1,009 ) Net property, plant, and equipment $ 2,455 $ 1,832 Other Assets 2008 2007 Deferred costs under subscription accounting—non-current $ 1,089 $ 214 Long-term NAND flash memory prepayments 208 625 Deferred tax assets—non-current 138 88 Capitalized software development costs, net 67 83 Other assets 433 212 Total other assets $ 1,935 $ 1,222 Accrued Expenses 2008 2007 Deferred revenue—current $ 4,853 $ 1,391 Deferred margin on component sales 681 545 Accrued marketing and distribution 329 288 Accrued compensation and employee benefits 320 254 Accrued warranty and related costs 267 230 Other accrued tax liabilities 100 488 Other current liabilities 2,022 1,114 Total accrued expenses $ 8,572 $ 4,310 69 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 3—Consolidated Financial Statement Details (Continued) Non-Current Liabilities 2008 2007 Deferred revenue—non-current $ 3,029 $ 849 Deferred tax liabilities 675 619 Other non-current liabilities 746 67 Total non-current liabilities $ 4,450 $ 1,535 Note 4—Goodwill and Other Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from 1 to 10 years. The following table summarizes the +components of gross and net intangible asset balances as of September 27, 2008 and September 29, 2007 (in millions): 2008 2007 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired technology $ 308 $ (123 ) $ 185 $ 276 $ (77 ) $ 199 Indefinite lived and unamortizable trademarks 100 — 100 100 — 100 Total acquired intangible assets $ 408 $ (123 ) $ 285 $ 376 $ (77 ) $ 299 Goodwill $ 207 $ — $ 207 $ 38 $ — $ 38 In June 2008, the Company completed an acquisition of a business for total cash consideration, net of cash +acquired, of $220 million, of which $169 million has been allocated to goodwill, $51 million to deferred tax assets and $7 million to acquired intangible assets. The Company’s goodwill is allocated primarily to the America’s reportable operating segment. Amortization expense related to acquired intangible assets was $46 million, $35 million, and $12 million in 2008, 2007, and 2006, +respectively. As of September 27, 2008, and September 29, 2007, the remaining weighted-average amortization period for acquired technology was 7.0 years and 7.1 years, respectively. Expected annual amortization expense related to acquired technology as of September 27, 2008, is as follows (in millions): Fiscal Years 2009 $ 50 2010 35 2011 32 2012 26 2013 13 Thereafter 29 Total $ 185 70 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 5—Income Taxes The provision for income taxes for the three fiscal years ended September 27, 2008, consisted of the following +(in millions): 2008 2007 2006 Federal: Current $ 1,942 $ 1,219 $ 619 Deferred (155 ) 85 56 1,787 1,304 675 State: Current 210 112 56 Deferred (82 ) 9 14 128 121 70 Foreign: Current 277 103 101 Deferred (131 ) (16 ) (17 ) 146 87 84 Provision for income taxes $ 2,061 $ 1,512 $ 829 The foreign provision for income taxes is based on foreign pretax earnings of $3.5 billion, $2.2 billion, and $1.5 +billion in 2008, 2007, and 2006, respectively. As of September 27, 2008 and September 29, 2007, $11.3 billion and $6.5 billion, respectively, of the Company’s cash, cash equivalents, and short-term investments were held by foreign +subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The Company’s consolidated financial statements provide for +any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company’s foreign subsidiaries that are intended to be indefinitely reinvested in operations outside the U.S. U.S. income taxes +have not been provided on a cumulative total of $3.8 billion of such earnings. It is not practicable to determine the income tax liability that might be incurred if these earnings were to be distributed. Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated +financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be +recovered or settled. 71 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 5—Income Taxes (Continued) As of September 27, 2008 and September 29, 2007, the significant components of the Company’s deferred +tax assets and liabilities were (in millions): 2008 2007 Deferred tax assets: Accrued liabilities and other reserves $ 1,295 $ 679 Basis of capital assets and investments 173 146 Accounts receivable and inventory reserves 126 64 Tax losses and credits 47 8 Other 503 161 Total deferred tax assets 2,144 1,058 Less valuation allowance — 5 Net deferred tax assets 2,144 1,053 Deferred tax liabilities—Unremitted earnings of subsidiaries: 1,234 803 Net deferred tax asset $ 910 $ 250 As of September 27, 2008, the Company has tax loss and credit carryforwards in the tax effected amount of $47 +million. The Company released a valuation allowance of $5 million recorded against the deferred tax asset for the benefit of state operating losses. Management believes it is more likely than not that forecasted income, including income that may be +generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate (35% in 2008, 2007, and 2006) to income +before provision for income taxes for the three fiscal years ended September 27, 2008, is as follows (in millions): 2008 2007 2006 Computed expected tax $ 2,414 $ 1,753 $ 987 State taxes, net of federal effect 159 140 86 Indefinitely invested earnings of foreign subsidiaries (492 ) (297 ) (224 ) Nondeductible executive compensation 6 6 11 Research and development credit, net (21 ) (54 ) (12 ) Other items (5 ) (36 ) (19 ) Provision for income taxes $ 2,061 $ 1,512 $ 829 Effective tax rate 30% 30% 29% The Company’s income taxes payable have been reduced by the tax benefits from employee stock options and +employee stock purchase plan. The Company receives an income tax benefit calculated as the difference between the fair market value of the stock issued at the time of the exercise and the option price, tax effected. The net tax benefits +from employee stock option transactions were $770 million, $398 million, and $419 million in 2008, 2007, and 2006, respectively, and were reflected as an increase to common stock in the Consolidated Statements of Shareholders’ Equity. On October 3, 2008, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 was signed into law. This bill, among other things, retroactively +extended the expired research and development tax credit. As a result, the Company expects to record a tax benefit of approximately $42 million in the first quarter of fiscal year 2009 to account for the retroactive effects of the research credit +extension. 72 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 5—Income Taxes (Continued) FIN 48 In +the first quarter of 2008, the Company adopted FIN 48. Upon adoption of FIN 48, the Company’s cumulative effect of a change in accounting principle resulted in an increase to retained earnings of $11 million. The Company had historically +classified interest and penalties and unrecognized tax benefits as current liabilities. Beginning with the adoption of FIN 48, the Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in +payment or receipt of cash within one year as non-current liabilities in the Consolidated Balance Sheet. The total amount of gross unrecognized tax benefits as of the date of adoption of FIN 48 was $475 million, of which $209 million, if +recognized, would affect the Company’s effective tax rate. As of September 27, 2008, the total amount of gross unrecognized tax benefits was $506 million, of which $253 million, if recognized, would affect the Company’s effective tax +rate. The Company’s total gross unrecognized tax benefits are classified as non-current liabilities in the Consolidated Balance Sheet. The aggregate +changes in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for the fiscal year ended September 27, 2008, is as follows (in millions): Balance as of September 30, 2007 $ 475 Increases related to tax positions taken during a prior period 27 Decreases related to tax positions taken during a prior period (70 ) Increases related to tax positions taken during the current period 85 Decreases related to settlements with taxing authorities — Decreases related to expiration of statute of limitations (11 ) Balance as of September 27, 2008 $ 506 The Company’s policy to include interest and penalties related to unrecognized tax benefits within the +provision for income taxes did not change as a result of adopting FIN 48. As of the date of adoption, the Company had accrued $203 million for the gross interest and penalties relating to unrecognized tax benefits. As of September 27, 2008, the +total amount of gross interest and penalties accrued was $219 million, which is classified as non-current liabilities in the Consolidated Balance Sheet. In 2008, the Company recognized interest expense in connection with tax matters of $16 million. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. For U.S. +federal income tax purposes, all years prior to 2002 are closed. The years 2002-2003 have been examined by the Internal Revenue Service (the “IRS”) and disputed issues have been taken to administrative appeals. The IRS is currently +examining the 2004-2006 years. In addition, the Company is also subject to audits by state, local, and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 1988 and 2000, respectively, generally +remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments +that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the +Company could be required to adjust its provision for income tax in the period such resolution occurs. Although timing of the resolution and/or closure of audits is highly uncertain, the Company does not believe it is reasonably possible that its +unrecognized tax benefits would materially change in the next 12 months. 73 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Shareholders’ Equity Preferred Stock The Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter +the rights, preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock. CEO Restricted Stock +Award On March 19, 2003, the Company’s Board of Directors granted 10 million shares of restricted stock to the Company’s CEO +that vested on March 19, 2006. The amount of the restricted stock award expensed by the Company was based on the closing market price of the Company’s common stock on the date of grant and was amortized ratably on a straight-line basis +over the three-year requisite service period. Upon vesting during 2006, the 10 million shares of restricted stock had a fair value of $646.6 million and had grant-date fair value of $7.48 per share. The restricted stock award was net-share +settled such that the Company withheld shares with value equivalent to the CEO’s minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares +withheld of 4.6 million were based on the value of the restricted stock award on the vesting date as determined by the Company’s closing stock price of $64.66. The remaining shares net of those withheld were delivered to the Company’s +CEO. Total payments for the CEO’s tax obligations to the taxing authorities was $296 million in 2006 and are reflected as a financing activity within the Consolidated Statements of Cash Flows. The net-share settlement had the effect of +share repurchases by the Company as it reduced and retired the number of shares outstanding and did not represent an expense to the Company. The Company’s CEO has no remaining shares of restricted stock. For the year ended September 30, +2006, compensation expense related to restricted stock was $4.6 million. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains, and losses that +under U.S. generally accepted accounting principles are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from +those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as +cash flow hedges. The following table summarizes the components of accumulated other comprehensive income, net of taxes, as of the three fiscal years ended +September 27, 2008 (in millions): 2008 2007 2006 Unrealized losses on available-for-sale securities $ (70 ) $ (7 ) $ — Unrealized gains on derivative instruments 19 — 3 Cumulative foreign currency translation 59 70 19 Accumulated other comprehensive income $ 8 $ 63 $ 22 The change in fair value of available-for-sale securities included in other comprehensive income was $(63) million, +$(7) million, and $4 million, net of taxes in 2008, 2007, and 2006, respectively. The tax effect related to the change in unrealized gain/loss on available-for-sale securities was $42 million, $4 million, and $(2) million for 2008, 2007, and 2006, +respectively. 74 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Shareholders’ Equity (Continued) The following table summarizes activity in other comprehensive income related to derivatives, net of taxes, held by +the Company during the three fiscal years ended September 27, 2008 (in millions): 2008 2007 2006 Changes in fair value of derivatives $ 7 $ (1 ) $ 11 Adjustment for net gains/(losses) realized and included in net income 12 (2 ) (12 ) Change in unrealized gains on derivative instruments $ 19 $ (3 ) $ (1 ) The tax effect related to the changes in fair value of derivatives was $(5) million, $1 million, and $(8) million +for 2008, 2007, and 2006, respectively. The tax effect related to derivative gains/losses reclassified from other comprehensive income to net income was $(9) million, $2 million, and $8 million for 2008, 2007, and 2006, respectively. Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the “2003 Plan”) is a shareholder approved plan that provides for broad-based grants to employees, +including executive officers. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire 7 to 10 years after the grant date and generally become exercisable over a period of four years, based on continued +employment, with either annual or quarterly vesting. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights and performance-based awards. As of +September 27, 2008, approximately 50.3 million shares were reserved for future issuance under the 2003 Plan. 1997 Employee Stock Option +Plan In August 1997, the Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the “1997 Plan”), a +non-shareholder approved plan for grants of stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire 7 to 10 years after the grant date and +generally become exercisable over a period of four years, based on continued employment, with either annual or quarterly vesting. In October 2003, the Company terminated the 1997 Plan and no new options can be granted from this plan. 1997 Director Stock Option Plan In +August 1997, the Company’s Board of Directors adopted a Director Stock Option Plan (the “Director Plan”) for non-employee directors of the Company, which was approved by shareholders in 1998. Pursuant to the Director Plan, the +Company’s non-employee directors are granted an option to acquire 30,000 shares of common stock upon their initial election to the Board (“Initial Options ” ). The Initial Options vest and become +exercisable in three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee director’s initial election to the Board and on each subsequent anniversary +thereafter, the director will be entitled to receive an option to acquire 10,000 shares of common stock (“Annual Options”). Annual Options are fully vested and immediately exercisable on their date of grant. Options granted under the +Director Plan expire 10 years after the grant date. As of September 27, 2008, approximately 290,000 shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans The following executive officers, Timothy D. Cook, Peter Oppenheimer, Philip W. +Schiller, and Bertrand Serlet, have entered into trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), as of November 1, 2008. A trading plan is a written document that 75 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Shareholders’ Equity (Continued) pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s +stock including the exercise and sale of employee stock options and shares acquired pursuant to the Company’s employee stock purchase plan and upon vesting of RSUs. Employee Stock Purchase Plan The Company has a shareholder approved employee stock purchase plan (the +“Purchase Plan”), under which substantially all employees may purchase common stock through payroll deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six-month offering periods. Stock +purchases under the Purchase Plan are limited to 10% of an employee’s compensation, up to a maximum of $25,000 in any calendar year. The number of shares authorized to be purchased in any calendar year is limited to a total of 3 million +shares. As of September 27, 2008, approximately 6.2 million shares were reserved for future issuance under the Purchase Plan. Employee +Savings Plan The Company has an employee savings plan (the “Savings Plan”) qualifying as a deferred salary arrangement under +Section 401(k) of the Internal Revenue Code. Under the Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($15,500 for calendar year 2008). The Company matches 50% +to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. The Company’s matching contributions to the Savings Plan were $50 million, $39 million, and $33 million +in 2008, 2007, and 2006, respectively. 76 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Shareholders’ Equity (Continued) Stock Option Activity A summary of the Company’s stock option activity and related information for the three fiscal years ended September 27, 2008, is as follows (in thousands, except per share amounts and contractual term in +years): Outstanding Options Shares Available for Grant Number of Shares Weighted-Average Exercise Price Weighted-Average Remaining Contractual Term Aggregate Intrinsic Value Balance at September 24, 2005 58,957 73,221 $ 17.79 Restricted stock units granted (2,950 ) — — Options granted (3,881 ) 3,881 $ 65.28 Options cancelled 2,325 (2,325 ) $ 29.32 Restricted stock units cancelled 625 — — Options exercised — (21,795 ) $ 11.78 Plan shares expired (82 ) — — Balance at September 30, 2006 54,994 52,982 $ 23.23 Additional shares authorized 28,000 — — Restricted stock units granted (2,640 ) — — Options granted (14,010 ) 14,010 $ 94.52 Options cancelled 1,471 (1,471 ) $ 55.38 Restricted stock units cancelled 20 — — Options exercised — (15,770 ) $ 18.32 Plan shares expired (8 ) — — Balance at September 29, 2007 67,827 49,751 $ 43.91 Restricted stock units granted (9,834 ) — — Options granted (9,359 ) 9,359 $ 171.36 Options cancelled 1,236 (1,236 ) $ 98.40 Restricted stock units cancelled 714 — — Options exercised — (13,728 ) $ 27.88 Plan shares expired (12 ) — — Balance at September 27, 2008 50,572 44,146 $ 74.39 4.29 $ 2,377,262 Exercisable at September 27, 2008 24,751 $ 40.93 3.42 $ 2,161,010 Expected to Vest after September 27, 2008 18,701 $ 117.09 5.40 $ 208,517 Aggregate intrinsic value represents the value of the Company’s closing stock price on the last trading day of +the fiscal period in excess of the exercise price multiplied by the number of options outstanding or exercisable. Total intrinsic value of options at time of exercise was $2.0 billion, $1.3 billion, and $1.2 billion for 2008, 2007, and 2006, +respectively. Shares of RSUs granted after April 2005 have been deducted from the shares available for grant under the Company’s stock option plans +utilizing a factor of two times the number of RSUs granted. Similarly shares of RSUs granted after April 2005, that are subsequently cancelled have been added back to the shares available for grant under the Company’s stock option plans +utilizing a factor of two times the number of RSUs cancelled. 77 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 6—Shareholders’ Equity (Continued) Restricted Stock Units The Company’s Board of Directors has granted RSUs to members of the Company’s executive management team, excluding its Chief Executive Officer (“CEO”), as well as various employees within the +Company. Outstanding RSU balances were not included in the outstanding options balances in the preceding table. A summary of the Company’s RSU activity and related information for the three fiscal years ended September 27, 2008, is as +follows (in thousands, except per share amounts): Number of Shares Weighted-Average Grant +Date Fair Value Aggregate Intrinsic Value Balance at September 24, 2005 5,030 $ 14.21 Restricted stock units granted 1,475 $ 70.92 Restricted stock units vested (2,470 ) $ 13.37 Restricted stock units cancelled (625 ) $ 12.75 Balance at September 30, 2006 3,410 $ 39.62 Restricted stock units granted 1,320 $ 88.51 Restricted stock units vested (45 ) $ 46.57 Restricted stock units cancelled (10 ) $ 86.14 Balance at September 29, 2007 4,675 $ 52.98 Restricted stock units granted 4,917 $ 162.61 Restricted stock units vested (2,195 ) $ 25.63 Restricted stock units cancelled (357 ) $ 119.12 Balance at September 27, 2008 7,040 $ 134.91 $ 902,749 Upon vesting, the RSUs are generally net share-settled to cover the required withholding tax and the remaining +amount is converted into an equivalent number of shares of common stock. The majority of RSUs vested in 2008, 2007 and 2006, were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory +obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 857,000, 20,000, and 986,000 for 2008, 2007, and 2006, respectively, which was +based on the value of the RSUs on their vesting date as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to the taxing authorities were $124 million, $3 million, and $59 million in 2008, +2007, and 2006, respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the number of +shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. The Company recognized $516 +million, $242 million and $163 million of stock-based compensation expense in 2008, 2007 and 2006, respectively. Stock-based compensation expense capitalized as software development costs was not significant as of September 27, 2008 or +September 29, 2007. The income tax benefit related to stock-based compensation expense was $169 million, $81 million, and $39 million for the years ended September 27, 2008, September 29, 2007, and September 30, 2006, +respectively. The total unrecognized compensation cost related to stock options and RSUs expected to vest was $1.4 billion and $631 million as of September 27, 2008 and September 29, 2007, respectively. The total unrecognized compensation +cost as of September 27, 2008, is expected to be recognized over a weighted-average period of 2.92 years. 78 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 7—Stock-Based Compensation SFAS No. 123R requires the use of a valuation model to calculate the fair value of stock-based awards. The +Company uses the BSM option-pricing model to calculate the fair value of stock-based awards. The BSM option-pricing model incorporates various assumptions including expected volatility, expected life, and interest rates. The expected +volatility is based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options and other relevant factors including implied volatility +in market traded options on the Company’s common stock. The Company bases its expected life assumption on its historical experience and on the terms and conditions of the stock awards it grants to employees. Stock-based compensation cost is +estimated at the grant date based on the award’s fair-value as calculated by the BSM option-pricing model and is recognized as expense ratably on a straight-line basis over the requisite service period. The compensation expense incurred by the Company for RSUs is based on the closing market price of the Company’s common stock on the date of grant and is amortized +ratably on a straight-line basis over the requisite service period. The weighted-average assumptions used for the three fiscal years ended +September 27, 2008, and the resulting estimates of weighted-average fair value per share of options granted and of employee stock purchase plan rights during those periods are as follows: 2008 2007 2006 Expected life of stock options 3.41 years 3.46 years 3.56 years Expected life of stock purchase rights 6 months 6 months 6 months Interest rate—stock options 3.40% 4.61% 4.60% Interest rate—stock purchase rights 3.48% 5.13% 4.29% Volatility—stock options 45.64% 38.13% 40.34% Volatility—stock purchase rights 38.51% 39.22% 39.56% Dividend yields — — — Weighted-average fair value of stock options granted during the year $ 62.73 $ 31.86 $ 23.16 Weighted-average fair value of employee stock purchase plan rights during the year $ 42.27 $ 20.90 $ 14.06 Note 8—Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable +operating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. The major facility leases are generally for terms of 3 to 20 years and generally provide renewal options for terms of 1 to 5 +additional years. Leases for retail space are for terms of 5 to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 27, 2008, the Company’s total future minimum lease payments +under noncancelable operating leases were $1.8 billion, of which $1.4 billion related to leases for retail space. 79 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Commitments and Contingencies (Continued) Rent expense under all operating leases, including both cancelable and noncancelable leases, was $207 million, $151 +million, and $138 million in 2008, 2007, and 2006, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 27, 2008, are as follows (in millions): Fiscal Years 2009 $ 195 2010 209 2011 200 2012 191 2013 177 Thereafter 788 Total minimum lease payments $ 1,760 Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The Company also +offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time related +revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, +historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its preexisting warranty liabilities and adjusts the amounts as +necessary based on actual experience and changes in future estimates. For products accounted for under subscription accounting pursuant to SOP No. 97-2, the Company recognizes warranty expense as incurred. The Company periodically provides updates to its applications and system software to maintain the software’s compliance with published specifications. The estimated +cost to develop such updates is accounted for as warranty costs that are recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units +delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates. The following table reconciles changes in the Company’s accrued warranties and related costs for the three fiscal years ended September 27, 2008 (in millions): 2008 2007 2006 Beginning accrued warranty and related costs $ 230 $ 284 $ 188 Cost of warranty claims (319 ) (281 ) (267 ) Accruals for product warranties 356 227 363 Ending accrued warranty and related costs $ 267 $ 230 $ 284 The Company generally does not indemnify end-users of its operating system and application software against legal +claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of +an infringement claim against the Company or an indemnified third-party. 80 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Commitments and Contingencies (Continued) However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified +third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would have a material adverse effect on its financial condition or operating results. +Therefore, the Company did not record a liability for infringement costs as of either September 27, 2008 or September 29, 2007. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s +business are generally available from multiple sources, certain key components including, but not limited to microprocessors, enclosures, certain liquid crystal displays (“LCDs”), certain optical drives, and application-specific integrated +circuits (“ASICs”) are currently obtained by the Company from single or limited sources, which subjects the Company to significant supply and pricing risks. Many of these and other key components that are available from multiple sources +including, but not limited to NAND flash memory, dynamic random access memory (“DRAM”), and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered +into certain agreements for the supply of key components including, but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee that the Company will be able to extend or renew these +agreements on similar favorable terms, or at all, upon expiration or otherwise obtain favorable pricing in the future. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that can have a material +adverse effect on its financial condition and operating results. The Company and other participants in the personal computer, consumer electronics and +mobile communication industries also compete for various components with other industries that have experienced increased demand for their products. In +addition, the Company uses some custom components that are not common to the rest of the personal computer, consumer electronics and mobile communication industries, and new products introduced by the Company often utilize custom components +available from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. When a component or product uses new technologies, initial capacity constraints may exist until the +suppliers’ yields have matured. If the Company’s supply of a key single-sourced component for a new or existing product were delayed or constrained, if such components were available only at significantly higher prices, or if a key +manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be +adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, +or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Significant portions of the Company’s Mac computers, iPods, iPhones, logic boards, and other assembled products are now manufactured by outsourcing partners, primarily in various parts of Asia. A significant +concentration of this outsourced manufacturing is currently performed by only a few of the Company’s outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced supplier of components and +manufacturing outsourcing for many of the Company’s key products including, but not limited to final assembly of substantially all of the Company’s portable Mac computers, iPods, iPhones and most of the Company’s iMacs. Although the +Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s +purchase commitments typically cover its requirements for periods ranging from 30 to 150 days. 81 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 8—Commitments and Contingencies (Continued) Long-Term Supply Agreements During 2006, the Company entered into long-term supply agreements with Hynix Semiconductor, Inc., Intel Corporation, Micron Technology, Inc., Samsung Electronics Co., Ltd., and Toshiba Corporation to secure supply of +NAND flash memory through calendar year 2010. As part of these agreements, the Company prepaid $1.25 billion for flash memory components during 2006, which will be applied to certain inventory purchases made over the life of each respective +agreement. The Company utilized $567 million of the prepayment as of September 27, 2008. Contingencies The Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been fully adjudicated. In the +opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate have a material adverse effect on its financial condition or operating results. +However, the results of legal proceedings cannot be predicted with certainty. If the Company failed to prevail in any of these legal matters or if several of these legal matters were resolved against the Company in the same reporting period, the +operating results of a particular reporting period could be materially adversely affected. Production and marketing of products in certain states and +countries may subject the Company to environmental, product safety and other regulations including, in some instances, the requirement to provide customers the ability to return product at the end of its useful life, and place responsibility for +environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several jurisdictions in which the Company operates, including various countries within Europe and Asia, certain Canadian provinces and +certain states within the U.S. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will +not have a material adverse effect on the Company’s financial condition or operating results. Note 9—Segment Information and Geographic Data In accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , the Company +reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable +segments. The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its operating segments, which are +generally based on the nature and location of its customers, to be the Americas, Europe, Japan, Asia-Pacific, Retail, and FileMaker operations. The Company’s reportable operating segments consist of Americas, Europe, Japan, and Retail +operations. Other operating segments include Asia Pacific, which encompasses Australia and Asia except for Japan, and the Company’s FileMaker, Inc. subsidiary. The Americas, Europe, Japan, and Asia Pacific segments exclude activities related to +the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S. and in +international markets. Each reportable operating segment provides similar hardware and software products and similar services to the same types of customers. The accounting policies of the various segments are the same as those described in Note 1, +“Summary of Significant Accounting Policies.” The Company evaluates the performance of its operating segments based on net sales and operating +income. Net sales for geographic segments are generally based on the location of customers, while Retail segment net sales are based on sales from the Company’s retail stores. Operating income for each segment includes net sales to third +parties, related cost of sales, and operating expenses directly attributable to the segment. Advertising 82 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9—Segment Information and Geographic Data (Continued) expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and +expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, such as manufacturing costs and variances not included in standard costs, research and development, +corporate marketing expenses, stock-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for +management reporting purposes. Segment assets exclude corporate assets, such as cash, short-term and long-term investments, manufacturing and corporate facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible +assets. Except for the Retail segment, capital asset purchases for long-lived assets are not reported to management by segment. Cash payments for capital asset purchases by the Retail segment were $389 million, $294 million, and $200 million for +2008, 2007, and 2006 respectively. The Company has certain retail stores that have been designed and built to serve as high-profile venues to promote brand +awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. The +Company allocates certain operating expenses associated with its high-profile stores to corporate marketing expense to reflect the estimated Company-wide benefit. The allocation of these operating costs to corporate expense is based on the amount +incurred for a high-profile store in excess of that incurred by a more typical Company retail location. The Company had opened a total of 11 high-profile stores as of September 27, 2008. Expenses allocated to corporate marketing resulting from +the operations of high-profile stores were $53 million, $39 million, and $33 million for the years ended September 27, 2008, September 29, 2007, and September 30, 2006 respectively. 83 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9—Segment Information and Geographic Data (Continued) Summary information by operating segment for the three fiscal years ended September 27, 2008 is as follows (in +millions): 2008 2007 2006 Americas: Net sales $ 14,573 $ 11,596 $ 9,415 Operating income $ 4,051 $ 2,949 $ 1,899 Depreciation, amortization, and accretion $ 9 $ 9 $ 6 Segment assets (a) $ 3,039 $ 1,497 $ 896 Europe: Net sales $ 7,622 $ 5,460 $ 4,096 Operating income $ 2,313 $ 1,348 $ 627 Depreciation, amortization, and accretion $ 6 $ 6 $ 4 Segment assets $ 1,775 $ 595 $ 471 Japan: Net sales $ 1,509 $ 1,082 $ 1,211 Operating income $ 440 $ 232 $ 208 Depreciation, amortization, and accretion $ 2 $ 3 $ 3 Segment assets $ 302 $ 159 $ 181 Retail: Net sales $ 6,315 $ 4,115 $ 3,246 Operating income $ 1,337 $ 875 $ 600 Depreciation, amortization, and accretion (b) $ 108 $ 88 $ 59 Segment assets (b) $ 1,869 $ 1,085 $ 651 Other Segments (c): Net sales $ 2,460 $ 1,753 $ 1,347 Operating income $ 615 $ 388 $ 235 Depreciation, amortization, and accretion $ 4 $ 3 $ 3 Segment assets $ 534 $ 252 $ 180 (a) The Americas asset figures do not include fixed assets held in the U.S. Such fixed assets are not allocated specifically to the Americas segment and are included in the corporate +assets figures below. (b) Retail segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. (c) Other Segments include Asia-Pacific and FileMaker. 84 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9—Segment Information and Geographic Data (Continued) A reconciliation of the Company’s segment operating income and assets to the Consolidated Financial Statements +for the three fiscal years ended September 27, 2008 is as follows (in millions): 2008 2007 2006 Segment operating income $ 8,756 $ 5,792 $ 3,569 Other corporate expenses, net (a) (1,965 ) (1,141 ) (953 ) Stock-based compensation expense (516 ) (242 ) (163 ) Total operating income $ 6,275 $ 4,409 $ 2,453 Segment assets $ 7,519 $ 3,588 $ 2,379 Corporate assets 32,053 21,759 14,826 Consolidated assets $ 39,572 $ 25,347 $ 17,205 Segment depreciation, amortization, and accretion $ 129 $ 109 $ 75 Corporate depreciation, amortization, and accretion 344 208 150 Consolidated depreciation, amortization, and accretion $ 473 $ 317 $ 225 (a) Other corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard costs, and other separately +managed general and administrative expenses, including certain corporate expenses associated with support of the Retail segment. No single +customer or single country outside of the U.S. accounted for more than 10% of net sales in 2008, 2007, or 2006. Net sales and long-lived assets related to the U.S. and international operations for the three fiscal years ended September 27, +2008, are as follows (in millions): 2008 2007 2006 Net sales: U.S. $ 18,469 $ 14,128 $ 11,486 International 14,010 9,878 7,829 Total net sales $ 32,479 $ 24,006 $ 19,315 Long-lived assets: U.S. $ 2,269 $ 1,752 $ 1,150 International 410 260 218 Total long-lived assets $ 2,679 $ 2,012 $ 1,368 85 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 9—Segment Information and Geographic Data (Continued) Information regarding net sales by product for the three fiscal years ended September 27, 2008, is as follows +(in millions): 2008 2007 2006 Net sales: Desktops (a) $ 5,603 $ 4,020 $ 3,319 Portables (b) 8,673 6,294 4,056 Total Mac net sales 14,276 10,314 7,375 iPod 9,153 8,305 7,676 Other music related products and services (c) 3,340 2,496 1,885 iPhone and related products and services (d) 1,844 123 — Peripherals and other hardware (e) 1,659 1,260 1,100 Software, service, and other net sales (f) 2,207 1,508 1,279 Total net sales $ 32,479 $ 24,006 $ 19,315 (a) Includes iMac, Mac mini, Mac Pro, Power Mac, and Xserve product lines. (b) Includes MacBook, iBook, MacBook Air, MacBook Pro, and PowerBook product lines. (c) Consists of iTunes Store sales and iPod services, and Apple-branded and third-party iPod accessories. (d) Derived from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (e) Includes sales of Apple-branded and third-party displays, wireless connectivity and networking solutions, and other hardware accessories. (f) Includes sales of Apple-branded operating system and application software, third-party software, AppleCare, and Internet services. Note 10—Related Party Transactions and Certain Other Transactions The Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs in the operation of his private plane when used for Apple business. The Company recognized a total of +approximately $871,000, $776,000, and $202,000 in expenses pursuant to the Reimbursement Agreement during 2008, 2007, and 2006, respectively. All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general, and +administrative expenses in the Consolidated Statements of Operations. In 2006, the Company entered into an agreement with Pixar to sell certain of +Pixar’s short films on the iTunes Store. Mr. Jobs was the CEO, Chairman, and a large shareholder of Pixar. On May 5, 2006, The Walt Disney Company (“Disney”) acquired Pixar, which resulted in Pixar becoming a wholly-owned +subsidiary of Disney. Upon Disney’s acquisition of Pixar, Mr. Jobs’ shares of Pixar common stock were exchanged for Disney’s common stock and he was elected to the Disney Board of Directors. Royalty expense recognized by the +Company under the arrangement with Pixar from September 25, 2005 through May 5, 2006 was less than $1 million. 86 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Note 11—Selected Quarterly Financial Information (Unaudited) The following tables set forth a summary of the Company’s quarterly financial information for each of the four +quarters ended September 27, 2008 and September 29, 2007 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2008 Net sales $ 7,895 $ 7,464 $ 7,512 $ 9,608 Gross margin $ 2,739 $ 2,600 $ 2,474 $ 3,332 Net income $ 1,136 $ 1,072 $ 1,045 $ 1,581 Earnings per common share: Basic $ 1.28 $ 1.21 $ 1.19 $ 1.81 Diluted $ 1.26 $ 1.19 $ 1.16 $ 1.76 2007 Net sales $ 6,217 $ 5,410 $ 5,264 $ 7,115 Gross margin $ 2,090 $ 1,995 $ 1,849 $ 2,220 Net income $ 904 $ 818 $ 770 $ 1,004 Earnings per common share: Basic $ 1.04 $ 0.94 $ 0.89 $ 1.17 Diluted $ 1.01 $ 0.92 $ 0.87 $ 1.14 Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the +sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. 87 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Apple Inc.: We have audited the accompanying consolidated balance sheets of Apple Inc. and subsidiaries (the Company) as of September 27, 2008 and September 29, 2007, +and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended September 27, 2008. These consolidated financial statements are the responsibility of the +Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our +audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of +material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by +management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In +our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apple Inc. and subsidiaries as of September 27, 2008 and September 29, 2007, and the results of their +operations and their cash flows for each of the years in the three-year period ended September 27, 2008, in conformity with U.S. generally accepted accounting principles. As discussed in note 1 to the Consolidated Financial Statements, effective September 30, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in +Income Taxes—an interpretation of FASB Statement No. 109 . We also have audited, in accordance with the standards of the Public Company +Accounting Oversight Board (United States), Apple Inc.’s internal control over financial reporting as of September 27, 2008, based on criteria established in Internal Control—Integrated Framework issued by the Committee of +Sponsoring Organizations of the Treadway Commission (COSO), and our report dated November 4, 2008 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/ KPMG LLP Mountain View, California November 4, 2008 88 Table of Contents REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders Apple Inc.: We have audited Apple Inc.’s internal control over financial reporting as of September 27, 2008, based on criteria established in Internal +Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Apple’s management is responsible for maintaining effective internal control over financial reporting and for its +assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the +Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our +audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed +risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for +external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable +detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with +generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding +prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk +that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In +our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 27, 2008, based on criteria established in Internal Control—Integrated Framework issued by the COSO. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of +Apple Inc. and subsidiaries as of September 27, 2008 and September 29, 2007, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended +September 27, 2008, and our report dated November 4, 2008 expressed an unqualified opinion on those consolidated financial statements. /s/ KPMG LLP Mountain View, California November 4, 2008 89 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an +evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as +defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”) were effective as of September 27, 2008 to ensure that information required to be disclosed by the Company in reports that +it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the +Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed +to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over +financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, +and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect +on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect +that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are +met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no +evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those +internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is +responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Management conducted an evaluation of the effectiveness of the +Company’s internal control over financial reporting based on the criteria set forth in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this +evaluation, management has concluded that the Company’s internal control over financial reporting was effective as of September 27, 2008. The Company’s independent registered public accounting firm, KPMG LLP, has issued an audit +report on the Company’s internal control over financial reporting. The report on the audit of internal control over financial reporting appears on page 89 of this Form 10-K. 90 Table of Contents Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of fiscal 2008, which were identified in connection with management’s evaluation required by +paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information On November 3, 2008, Tony +Fadell, Senior Vice President, iPod Division of the Company became Special Advisor to the Company’s Chief Executive Officer. In this new position, Mr. Fadell no longer will be an executive officer of the Company. In connection therewith, +Mr. Fadell and the Company have entered into a Transition Agreement and a Settlement Agreement and Release (the “Transition Agreement” and the “Settlement Agreement,” respectively), under which Mr. Fadell will receive a +salary of three hundred thousand dollars annually, and will be entitled to bonus and other health and welfare benefits generally available to other senior managers for the duration of the Transition Agreement, which remains in effect until +March 24, 2010. The Transition Agreement also provides for the cancellation of outstanding and unvested 155,000 restricted stock units held by Mr. Fadell. Upon approval by the Compensation Committee of the Company’s Board of +Directors, Mr. Fadell will be granted 77,500 restricted stock units that will vest in full on March 24, 2010, subject to his continued employment with the Company through the vesting date and further subject to accelerated vesting if the Company +terminates his employment without cause. The restricted stock units are payable upon vesting in shares of the Company’s common stock on a one-for-one basis. The Settlement Agreement includes Mr. Fadell’s release of claims against the +Company and agreement not to solicit the Company’s employees for one year following the termination of his employment. 91 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item under the heading +“Directors” is incorporated herein by reference from the information to be contained in the Company’s 2009 Proxy Statement to be filed with the U.S. Securities and Exchange Commission in connection with the solicitation of proxies for +the Company’s Annual Meeting of Shareholders to be held on February 25, 2009 (“2009 Proxy Statement”). The information under the heading “Executive Officers of the Registrant” in Part I, Item 1 of this Form 10-K is +also incorporated herein by reference. Item 11. Executive Compensation The information required by this Item under the headings “Executive Compensation” and “Compensation Discussion and Analysis” is incorporated herein by reference from the information to be contained +in the Company’s 2009 Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder +Matters The information required by this Item under the headings “Security Ownership of Certain Beneficial Owners and Management” and +“Equity Compensation Plan Information” are incorporated herein by reference from the information to be contained in the Company’s 2009 Proxy Statement. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by +this Item under the heading “Review, Approval or Ratification of Transactions with Related Persons” is incorporated herein by reference from the information to be contained in the Company’s 2009 Proxy Statement. Item 14. Principal Accountant Fees and Services The information +required by this Item under the heading “Fees Paid to Auditors” is incorporated herein by reference from the information to be contained in the Company’s 2009 Proxy Statement. 92 Table of Contents PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Balance Sheets as of September 27, 2008 and September 29, 2007 54 Consolidated Statements of Operations for the three fiscal years ended September 27, 2008 55 Consolidated Statements of Shareholders’ Equity for the three fiscal years ended September 27, +2008 56 Consolidated Statements of Cash Flows for the three fiscal years ended September 27, 2008 57 Notes to Consolidated Financial Statements 58 Selected Quarterly Financial Information (Unaudited) 87 Reports of Independent Registered Public Accounting Firm, KPMG LLP 88 (2) Financial Statement Schedules All financial statement schedules +have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the Consolidated Financial Statements and Notes +thereto. (b) Exhibits required by Item 601 of Regulation S-K The +information required by this Item is set forth on the exhibit index that follows the signature page of this report. 93 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, this 4th day of +November 2008. APPLE INC. By: /s/  P ETER O PPENHEIMER Peter Oppenheimer Senior Vice President and Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven P. Jobs and Peter Oppenheimer, jointly and severally, his attorneys-in-fact, each with the power of +substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby +ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant +to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Name Title Date /s/  S TEVEN P. +J OBS STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) November 4, 2008 /s/  P ETER O PPENHEIMER PETER OPPENHEIMER Senior Vice President and Chief Financial Officer (Principal Financial and Principal Accounting Officer) November 4, 2008 /s/  W ILLIAM V. +C AMPBELL WILLIAM V. CAMPBELL Director November 4, 2008 /s/  M ILLARD S. +D REXLER MILLARD S. DREXLER Director November 4, 2008 /s/  A LBERT G ORE , +J R . ALBERT GORE, JR. Director November 4, 2008 /s/  A NDREA J UNG ANDREA JUNG Director November 4, 2008 /s/  A RTHUR D. +L EVINSON ARTHUR D. LEVINSON Director November 4, 2008 /s/  E RIC E. +S CHMIDT ERIC E. SCHMIDT Director November 4, 2008 /s/  J EROME B. +Y ORK JEROME B. YORK Director November 4, 2008 94 Table of Contents EXHIBIT INDEX Incorporated by Reference Exhibit Number Exhibit Description Form Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on January 27, 1988. S-3 7/27/88 3.2 Certificate of Amendment to Restated Articles of Incorporation, filed with the Secretary of State of the State of California on May 4, 2000. 10-Q 5/11/00 3.3 Certificate of Amendment to Restated Articles of Incorporation, as amended, filed with the Secretary of State of the State of California on February 25, 2005. 10-Q 3/26/05 3.4 Certificate of Determination of Preferences of Series A Non-Voting Convertible Preferred Stock of the Registrant. 10-K 9/26/97 3.5 By-Laws of the Registrant, as amended through August 20, 2008. 8-K 8/25/08 4.1 Form of Stock Certificate of the Registrant. 10-Q 12/30/06 10.1* Employee Stock Purchase Plan, as amended through May 10, 2007. 8-K 5/16/07 10.2* Form of Indemnification Agreement between the Registrant and each officer of the Registrant. 10-K 9/26/97 10.3* 1997 Employee Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.4* 1997 Director Stock Option Plan, as amended through May 10, 2007. 8-K 5/16/07 10.5* 2003 Employee Stock Plan, as amended through May 10, 2007. 8-K 5/16/07 10.6* Reimbursement Agreement dated as of May 25, 2001 by and between the Registrant and Steven P. Jobs. 10-Q 6/29/02 10.7* Performance Bonus Plan dated April 21, 2005. 10-Q 3/26/05 10.8* Form of Option Agreements. 10-K 9/24/05 10.9* Form of Restricted Stock Unit Award Agreement effective as of August 28, 2007. 10-K 9/29/07 14.1 Business Conduct Policy of the Registrant dated January 2008. 10-Q 12/29/07 21** Subsidiaries of the Registrant. 23.1** Consent of Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signature Page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. 95 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-09-214859/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-09-214859/full-submission.txt new file mode 100644 index 0000000..bb0e3b0 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-09-214859/full-submission.txt @@ -0,0 +1,1313 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 26, 2009 Or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period +from to Commission file number: 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Global Select Market (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports +required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such +filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§229.405 +of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (section 229.405 of this chapter) is +not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form +10-K. ¨ Indicate by check mark whether the registrant is a large +accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of +the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if smaller reporting company) Smaller Reporting Company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule +12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting and non-voting stock held by +non-affiliates of the registrant, as of March 28, 2009, was approximately $94,593,000,000 based upon the closing price reported for such date on the NASDAQ Global Select Market. For purposes of this disclosure, shares of common stock held by +persons who hold more than 5% of the outstanding shares of common stock and shares held by executive officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. This determination of executive +officer or affiliate status is not necessarily a conclusive determination for other purposes. 900,678,473 shares of Common +Stock Issued and Outstanding as of October 16, 2009 DOCUMENTS INCORPORATED BY REFERENCE (1) Portions of the registrant’s definitive Proxy Statement relating to its 2010 Annual Meeting of Shareholders are incorporated by +reference into Part III of this Annual Report on Form 10-K where indicated. Such Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Table of Contents The Business section and other parts of this Annual Report on Form 10-K (“Form +10-K”) contain forward-looking statements that involve risks and uncertainties. Many of the forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by +words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future +performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection +entitled “Risk Factors” under Part I, Item 1A of this Form 10-K, which are incorporated herein by reference. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the +“Company”) design, manufacture, and market personal computers, mobile communication devices, and portable digital music and video players and sell a variety of related software, services, peripherals, and networking solutions. The Company +sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers, resellers, and value-added resellers. In addition, the Company sells a variety of third-party Macintosh ® (“Mac”), iPhone ® and iPod ® compatible +products, including application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores, and digital content and applications through the iTunes Store ® . The Company sells to consumer, small and mid-sized business (“SMB”), education, enterprise, government +and creative customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company’s fiscal calendar. The +Company is a California corporation founded in 1977. Business Strategy The Company is committed to bringing the best personal computing, mobile communication and portable digital music and +video experience to consumers, students, educators, businesses, and government agencies through its innovative hardware, software, peripherals, services, and Internet offerings. The Company’s business strategy leverages its unique ability to +design and develop its own operating system, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative industrial design. The Company believes +continual investment in research and development is critical to the development and enhancement of innovative products and technologies. In addition to evolving its personal computers and related solutions, the Company continues to capitalize on the +convergence of the personal computer, mobile communications and digital consumer electronics by creating and refining innovations, such as iPhone, iPod and the iTunes Store. The Company desires to support a community for the development of +third-party products that complement the Company’s offerings through its developer programs. The Company offers various third-party software applications and hardware accessories for Mac ® computers, iPhones and iPods through its retail and online stores, as well as software applications for the iPhone and iPod touch platforms through its App +Store™. The Company’s strategy also includes expanding its distribution network to effectively reach more of its targeted customers and provide them with a high-quality sales and post-sales support experience. Consumer and Small and Mid-Sized Business The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and +retain customers. The Company sells many of its products and resells certain third-party products in most of its major markets directly 1 Table of Contents to consumers and businesses through its retail and online stores. The Company has also invested in programs to enhance reseller sales, including the Apple Sales Consultant Program, which places +Apple employees and contractors at selected third-party reseller locations, and the Apple Premium Reseller Program, through which independently run businesses focus on the Apple platform and provide a high level of customer service and product +expertise. The Company believes providing direct contact with its targeted customers is an efficient way to demonstrate the advantages of its products over those of its competitors. At the end of fiscal 2009, the Company had opened a total of 273 retail stores, including 217 stores in the U.S. and 56 stores internationally. The Company has typically located its +stores at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable high-traffic locations, the Company is better positioned to control the customer buying experience +and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and related solutions. To that end, retail store configurations have evolved into various sizes to accommodate +market-specific demands. The stores employ experienced and knowledgeable personnel who provide product advice, service and training. The stores offer a wide selection of third-party hardware, software, and various other accessories and peripherals +that complement the Company’s products. Education Throughout its history, the Company has focused on the use of technology in education and has been committed to delivering tools to help educators teach and students learn. The Company believes effective +integration of technology into classroom instruction can result in higher levels of student achievement, especially when used to support collaboration, information access, and the expression and representation of student thoughts and ideas. The +Company has designed a range of products and services to address the needs of education customers, which includes one-to-one (“1:1”) learning. A 1:1 learning solution typically consists of a networked environment that includes a portable +computer for every student and teacher. In addition, the Company supports mobile learning and real-time distribution and accessibility of education related materials through iTunes U, which allows students and teachers to share and distribute +educational media directly through their computers and mobile communication devices. Enterprise, Government and Creative The Company also sells its hardware and software products to customers in enterprise, government and creative markets +in each of its geographic segments. These markets are also important to many third-party developers who provide Mac-compatible hardware and software solutions. Customers in these markets utilize the Company’s products because of their +high-powered computing performance and expansion capabilities, networking functionality, and seamless integration with complementary products. The Company designs its high-end hardware solutions, including Mac Pro desktops, MacBook ® Pro and MacBook Air ® portable systems, and Xserve ® servers, to incorporate the power, expandability, and other features desired by these professionals. The Company’s operating system, Mac OS ® X, incorporates powerful graphics and audio technologies and features developer tools to optimize system and application performance. Other In addition to +consumer, SMB, education, enterprise, government and creative markets, the Company provides hardware and software products and solutions for customers in the information technology and scientific markets. Business Organization The +Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Japan and Retail. The Americas, Europe and Japan reportable segments do not include activities related to +the Retail segment. The Americas segment includes both North and 2 Table of Contents South America. The Europe segment includes European countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the U.S. and in international +markets. Each reportable geographic operating segment and the Retail operating segment provide similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Part II, +Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in Notes to Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.” Products The Company offers a range of personal computing products, mobile communication devices, and portable digital music and video players, as well as a variety of related software, services, peripherals, networking solutions and various +third-party hardware and software products. The Company designs, develops, and markets to Mac and Windows users its iPhone mobile communication devices and its family of iPod digital music and video players, along with related accessories and +services, including the online distribution of third-party digital content and applications through the Company’s iTunes Store. In addition, the Company offers its own software products, including Mac OS X, the Company’s proprietary +operating system software for the Mac; server software and related solutions; professional application software; and consumer, education, and business oriented application software. The Company’s primary products are discussed below. Mac Hardware Products The Company offers a range of personal computing products including desktop and notebook computers, servers, related devices and peripherals, and various third-party hardware products. The Company’s +Mac desktop and portable systems feature Intel microprocessors, the Company’s Mac OS X Version 10.6 Snow Leopard ® (“Mac OS X Snow Leopard”) operating system and iLife ® suite of software for creation and +management of digital photography, music, movies, DVDs and websites. MacBook ® Pro The +MacBook Pro family of notebook computers is designed for professionals and consumers. In June 2009, the Company updated its aluminum unibody MacBook Pro line to include 13-inch, 15-inch and 17-inch models. Each MacBook Pro includes an LED-backlit +display, a glass Multi-Touch™ trackpad, an illuminated keyboard, an SD card or ExpressCard slot, a FireWire ® 800 port, built-in AirPort Extreme ® 802.11n wireless networking and Bluetooth 2.1. The 13-inch MacBook Pro includes up to 2.53 GHz in processor speed and an NVIDIA GeForce 9400M graphics processor. The 15-inch and 17-inch MacBook Pro models offer up to 3.06 GHz in processor +speed and the NVIDIA GeForce 9600M GT discrete graphics processor. MacBook ® The +MacBook is designed for consumer and education users. In October 2009, the Company updated its MacBook with a new polycarbonate unibody design that includes an LED-backlit display and a glass Multi-Touch™ trackpad. The MacBook includes up to +2.26 GHz in processor speed, NVIDIA GeForce 9400M graphics processor, support for up to 4GB of 1066 MHz SDRAM memory, up to a 500 GB Serial ATA hard drive, a SuperDrive ® , built-in AirPort Extreme 802.11n wireless networking and Bluetooth 2.1. MacBook Air ® In June 2009, the Company updated its MacBook Air, an ultra-slim notebook computer that measures 0.16-inches at its +thinnest point and 0.76-inches at its maximum height when closed. The MacBook Air includes up to 2.13 GHz processor speed with 6MB of Level 2 cache, NVIDIA GeForce 9400M graphics processor, 2GB of memory, and a 128GB hard drive. The MacBook Air +includes a 13.3-inch LED-backlit widescreen display, a full-size backlit keyboard, a built-in iSight ® video +camera, a trackpad with Multi-Touch gesture support, and built-in AirPort Extreme 802.11n wireless networking and Bluetooth 2.1. 3 Table of Contents Mac ® Pro The Mac Pro desktop computer is +targeted at business and professional customers and is designed to meet the performance, expansion, and networking needs of the most demanding Mac user. In March 2009, the Company introduced an updated Mac Pro featuring up to two Intel Quad-Core +Xeon processors running at up to 2.93 GHz, 8GB of shared Level 3 cache per processor, and up to 32GB of 1066 MHz SDRAM memory. The Mac Pro also features a direct attach storage solution for snap-in installation of up to four 1TB hard drives for a +total of 4TB of internal storage, up to two double-layer SuperDrive disk drives, Bluetooth 2.1 and optional AirPort Extreme 802.11n wireless networking. iMac ® The iMac desktop computer is targeted at consumer, education and business customers. In October 2009, the Company introduced new iMac models, which feature 21.5-inch or 27-inch +LED-backlit displays in a glass and aluminum enclosure. The iMac includes up to 3.33 GHz processor speed, up to 16GB of 1066 MHz SDRAM memory, multiple graphics card options, up to a 2TB Serial ATA hard drive and a slot-loading double-layer +SuperDrive. The 27-inch iMac model also features an Intel Quad-Core i5 or i7 processor running at up to 2.8 GHz, and is expected to be available in November 2009. All iMac models include a built-in iSight video camera, AirPort Extreme 802.11n +wireless networking, Bluetooth 2.1 and come with the new wireless Magic Mouse, the first mouse with Multi-Touch technology. Mac ® mini The Mac mini is a desktop computer measuring 6.5 by 6.5 by 2-inches. In October 2009, the Company updated the Mac mini line to include up to 2.66 GHz processor speed, up to 4GB of 1066 MHz SDRAM memory, +up to a 500GB hard drive and NVIDIA GeForce 9400M integrated graphics. All Mac mini models include built-in AirPort Extreme 802.11n wireless networking, Bluetooth 2.1, a total of five USB 2.0 ports, and one FireWire 800 port. Mac mini includes dual +display support and can operate displays with Mini DisplayPort or DVI connections. The Company also offers a Mac mini that is configured with Mac OS X Snow Leopard Server, featuring two 500GB hard drives for a total of 1TB of server storage. Xserve ® Xserve is a 1U rack-mount server available +with up to two 2.93 GHz Quad-Core Intel Xeon processors and features Mac OS X Server 10.6 Snow Leopard, which became available in August 2009. Xserve supports up to 24GB of random access memory, remote management, storage drives of up to 3TB, an +optional 128GB solid state drive and an optional internal Xserve RAID card. iPhone ® iPhone combines a mobile phone, a widescreen iPod with touch controls, and an Internet communications device in a single handheld product. Based on the Company’s Multi Touch user interface, iPhone features desktop-class email, web +browsing, searching, and maps and is compatible with both Macs and Windows-based computers. iPhone automatically syncs content from users’ iTunes libraries, as well as contacts, bookmarks, and email accounts. iPhone allows users to +wirelessly access the iTunes Store to purchase and/or download audio and video content as well as thousands of applications. In July 2008, the Company launched the App Store that allows a user to browse, search for, or purchase third-party +applications through either a Mac or Windows-based computer or by wirelessly downloading directly to an iPhone or iPod touch. In June 2009, the Company announced iPhone 3GS, the third-generation iPhone. It combines the features of iPhone 3G, which was released in July 2008, with a built-in three megapixel auto-focus camera, video recording and hands free voice +control. iPhone 3GS is a quad-band GSM phone featuring 3G, EDGE and Wi-Fi wireless technologies for data networking, Bluetooth 2.1, and a 3.5-inch touch widescreen with 480-by-320 resolution at 4 Table of Contents 163 pixels per inch. iPhone 3GS provides up to 12 hours of talk time on 2G networks and five hours using 3G networks, up to nine hours of web browsing, up to ten hours of video playback, or up to +30 hours of audio playback. It is available in 16GB and 32GB configurations. The Company also continues to offer the iPhone 3G in a 8GB configuration. In September 2009, the Company released iPhone 3.1 software, which features Genius technology enhancements including Genius Mixes and Genius recommendations for applications. iPhone 3.1 also incorporates +improved syncing capabilities, which allows users to organize their applications in iTunes and sync back to their iPhones. iPhone 3.1 includes Cut, Copy and Paste, Spotlight ® Search, MMS messaging and a landscape keyboard for Mail, Notes and Safari ® . Certain features of the iPhone 3.1 software are not supported by some of iPhone’s cellular network carriers. The Company has signed multi-year agreements with various cellular network carriers authorizing them to distribute and provide cellular +network services for iPhones. These agreements are generally not exclusive with a specific carrier, except in the U.S., Germany, Spain, Ireland, and certain other countries. In addition to the Company’s own iPhone accessories, third-party iPhone compatible products, including headsets, cables and docks, power supplies, and carrying cases, are +available through the Company’s online and retail stores or from third parties. Music Products and Services The Company offers its iPod line of portable digital music and video players and related accessories to Mac and Windows users. All iPods work +with the Company’s iTunes digital music management software (“iTunes”) available for both Mac and Windows-based computers. The Company also provides an online service to distribute third-party music, audio books, music videos, short +films, television shows, movies, podcasts, and applications through its iTunes Store. In addition to the Company’s own iPod accessories, third-party iPod compatible products are available, either through the Company’s online and retail +stores or from third parties, including portable and desktop speaker systems, headphones, car radio solutions, voice recorders, cables and docks, power supplies and chargers, and carrying cases and armbands. iPod ® shuffle In September 2009, the Company updated the third-generation iPod shuffle, a flash-memory-based iPod which is +nearly half the size of the second generation model and is the first music player with the VoiceOver feature enabling it to speak song titles, artists and playlist names. iPod shuffle holds up to 1,000 songs and is the first iPod shuffle to +accommodate playlists. iPod shuffles include a shuffle switch feature that allows users to listen to their music in random order or in the order of their playlists synced through iTunes. iPod shuffle works with iTunes’ patent-pending AutoFill +option that automatically selects songs to fill the iPod shuffle from a user’s iTunes library. The new iPod shuffle is available in 2GB and 4GB configurations in an aluminum design in a variety of colors, or a special edition 4GB configuration +in a stainless steel design. iPod ® nano In September 2009, +the Company introduced the new iPod nano, a flash-memory-based iPod. The new iPod nano includes a video camera, microphone and speaker, a built-in FM radio with live pause functionality, iTunes Tagging, and a built-in pedometer. The new iPod nano +incorporates a larger 2.2-inch display with 204 pixels per inch, a built-in accelerometer, and an updated user interface featuring Cover Flow ® and Shake to Shuffle mode. The new iPod nano also features Genius Mixes, allowing users to automatically create song mixes from their music libraries. The new iPod +nano provides up to 24 hours of audio playback or up to five hours of video playback and is available in 8GB and 16GB configurations in a variety of colors. 5 Table of Contents iPod ® classic The iPod classic is an upgraded +version of the original iPod, the Company’s hard-drive based portable digital music and video player. In September 2009, the Company introduced an updated version of the iPod classic, which has 160 GB of storage and is capable of holding up to +40,000 songs, 200 hours of video, or 25,000 photos. The iPod classic provides up to 36 hours of audio playback or up to six hours of video playback, features “Genius” technology, and includes a 2.5-inch color screen that can display album +artwork, photos, and video content including music videos, video and audio podcasts, short films, television shows, movies, and games. iPod ® touch In September 2009, the Company introduced the third-generation iPod touch, a flash-memory-based iPod that is 0.33-inches thin and features a 3.5-inch widescreen display, Genius +technology, a built-in speaker, and an accelerometer. The new iPod touch features peer-to-peer connections, which gives users the ability to play multi-player games with other users, Genius Mixes, and iPhone 3.1 software. The iPod touch’s user +interface is based on the Company’s Multi-Touch user interface. It also includes Wi-Fi wireless networking, which allows users to access the iTunes Wi-Fi Music Store and the App Store to purchase and/or download audio and video files, as well +as a variety of other applications. The iPod touch is available in 8GB, 32GB and 64GB configurations and features up to 30 hours of audio playback and up to six hours of video playback. iTunes ® 9 iTunes is an application for playing, +downloading, and organizing digital audio and video files and is available for both Mac and Windows-based computers. iTunes is integrated with the iTunes Store, a service that allows customers to find, purchase, rent, and download third-party +digital music, audio books, music videos, short films, television shows, movies, games, and other applications. Originally introduced in the U.S. in April 2003, the iTunes Store now serves customers in 23 countries. In September 2009, the Company +announced iTunes 9, which includes Genius Mixes, a new feature in Genius technology, Home Sharing, which allows users to transfer music, movies and TV shows among up to five authorized computers, and improved syncing functionality that allows users +to organize their iPhone applications in iTunes, to sync music by artist and genre, and to sync photos by Events and Faces. In January 2009, the Company announced it would offer all songs in the iTunes catalog without digital rights management +software and that iTunes songs would be available at three standard price points, beginning in April 2009 in most countries. Peripheral +Products The Company sells a variety of Apple-branded and third-party Mac-compatible peripheral products directly to +end-users through its retail and online stores, including printers, storage devices, computer memory, digital video and still cameras, and various other computing products and supplies. Displays The Company manufactures the Apple Cinema High +Definition Display™, a 30-inch widescreen flat panel display. In October 2008, the Company introduced a 24-inch LED Cinema Display that features a built-in iSight camera, microphone, built-in 2.1 speaker system and MagSafe ® charger. Apple TV ® Apple TV is a device that permits users to wirelessly play iTunes content on a widescreen television. Compatible with a Mac or Windows-based computer, Apple TV includes a 160GB hard +drive capable of storing up to 200 hours of video, 36,000 songs, 25,000 photos, or a combination of each and is compatible with high definition televisions with resolution up to 1080p. Apple TV connects to a broad range of widescreen televisions and +home theater systems and comes standard with high-definition multimedia interface, component video, and both analog 6 Table of Contents and digital optical audio ports. Using AirPort Extreme 802.11n wireless networking, Apple TV can auto-sync content from one computer or stream content from up to five additional computers +directly to a television. Software Products and Computer Technologies The Company offers a range of software products for consumer, SMB, education, enterprise, government, and creative customers, including the Company’s proprietary operating +system software; server software and related solutions; professional application software; and consumer, education, and business oriented application software. Operating System Software Mac OS ® X is built on an open-source UNIX-based foundation. Mac OS X Snow Leopard is the sixth major release of Mac OS X and +became available in August 2009. Mac OS X Snow Leopard features upgraded speed and performance and includes a new version of QuickTime ® X, support for Microsoft Exchange Server 2007 and VoiceOver integration with the Multi-Touch trackpad. Mac OS X Snow Leopard refines 90 percent of the projects in Mac +OS X, is about half the size of the previous version, and frees up to 7GB of drive space once installed. Snow Leopard retains Stacks, a means of easily accessing files from the Dock; Finder™ that lets users quickly browse and share files +between multiple Macs; Quick Look, a way to instantly see files without opening an application; Spaces ® , a +feature used to create groups of applications and instantly switch between them; and Time Machine ® , a way to +automatically back up all of the contents of a Mac. Application Software iLife ® ’09 In January 2009, the Company introduced iLife ’09, the latest release of its +consumer-oriented digital lifestyle application suite, which features iPhoto ® , iMovie ® , iDVD ® , GarageBand ® , and iWeb™. +iPhoto is the Company’s consumer-oriented digital photo software application, which includes new features for organizing and browsing photos, including Faces and Places which use face detection, face recognition and GPS geo-tagging +technologies. iMovie is the Company’s consumer-oriented digital video editing software application and features the new Precision Editor, video stabilization, advanced drag and drop, and animated travel maps. iDVD ® is the Company’s consumer-oriented software application that enables users to turn iMovie files, QuickTime ® files, and digital pictures into interactive DVDs. GarageBand ® is the Company’s consumer-oriented music creation software application that allows users to play, record and create music using a simple interface. iWeb™ +allows users to create online photo albums, blogs and podcasts, and to customize websites using editing tools. iWork ® ’09 In January 2009, the Company introduced iWork ’09, the latest version of the Company’s integrated productivity suite designed to help users create, present, and publish documents, presentations, +and spreadsheets. iWork ’09 includes updates to Pages ® ’09 for word processing and page layout, +Keynote ® ’09 for presentations, and Numbers ® ’09 for spreadsheets. Among the new features in iWork, Keynote introduces advanced object transitions, Pages features a new full screen view, and Numbers +introduces a quick way to group and summarize data and a simplified way to create complex formulas. Final Cut Studio ® In July 2009, the Company updated Final Cut Studio ® , the +Company’s video production suite designed for video professionals. Final Cut Studio 2 features Final Cut Pro ® 7 for video editing, DVD Studio Pro ® 4 for DVD authoring, Motion 4 for real-time motion graphics, Soundtrack ® Pro 3 for audio editing and +sound design, Color 1.5 for color grading and finishing, and Compressor 3.5 for encoding media in multiple formats. The Company also offers Final Cut Express 4, a consumer version of the Company’s movie making software, and Final Cut Server +1.5. 7 Table of Contents Logic Studio ® In July 2009, the +Company updated Logic Studio, a comprehensive suite of professional tools used by musicians and professionals to create, perform, and record music. Logic Studio features Logic ® Pro 9, an upgraded version of the Company’s music creation and audio production software application; MainStage ® 2, a live performance application; Soundtrack ® Pro 3, a professional audio post production software; Compressor 3.5 for encoding in a variety of formats; Studio Instruments, made up of 40 instrument plug-ins; +Studio Effects, with 80 professional effect plug-ins; and studio Sound Library. In addition, the Company offers Logic Express 9, a version that includes many of the features of Logic Studio Pro and provides an easy entry into professional music +production. FileMaker ® Pro The FileMaker Pro database software +offers relational databases and desktop-to-web publishing capabilities. In January 2009, the Company introduced FileMaker Pro 10, which features a new interface, a redesigned and customizable Status Toolbar, the ability to save the results of search +and Script Triggers, which launch scripts triggered by user actions or based on time limits. The Company also offers FileMaker Pro 10 Advanced, FileMaker Server 10 and FileMaker Server 10 Advanced. Internet Software and Services The Company is focused on delivering seamless integration with and access to the Internet throughout the Company’s products and services. The Company’s Internet solutions adhere to many industry standards to provide an optimized +user experience. Safari ® In June 2009, the Company released Safari +4, a web browser compatible with Macs and Windows PCs. Safari 4 features the Nitro engine, which runs JavaScript faster than Safari 3 and includes enhanced browsing functionality with Top Sites, Full History Search and Cover Flow. Safari 4 supports +video and audio tags in HTML 5 and supports CSS 3 Animations and Web Fonts, which provide designers additional choices of fonts to create web sites. QuickTime ® QuickTime, the Company’s multimedia software for Mac or Windows-based computers, features streaming of live and stored video and audio over the Internet and playback of +high-quality audio and video on computers. QuickTime 7 features H.264 encoding and can automatically determine a user’s connection speed to ensure they are getting the highest-quality content stream possible. QuickTime 7 also delivers +multi-channel audio and supports a wide range of industry standard audio formats. The Company also offers QuickTime X, a new version of QuickTime that ships with Mac OS X Snow Leopard, and QuickTime 7 Pro, a suite of software tools, allows creation +and editing of Internet-ready audio and video files. MobileMe™ In June 2008, the Company introduced MobileMe, an annual subscription-based suite of Internet services that delivers +email, contacts and calendars to and from native applications on iPhone, iPod touch, Macs, and Windows-based computers. MobileMe services include Internet message access protocol mail, an ad-free email service; website hosting for publishing +websites from iWeb; iDisk ® , a virtual hard drive accessible anywhere with Internet access; Web Gallery for +viewing and sharing photos that is fully integrated with iPhoto and iMovie; MobileMe Sync, which keeps Safari bookmarks, iCal ® calendars, Address Book information, Keychain ® , and Mac OS X Mail preferences up-to-date across multiple computers, iPhones, and iPod touches. When combined with iPhone, MobileMe features Find My iPhone, which +helps users locate their lost iPhones, and a new Remote Wipe feature that allows users to erase all data and content if their iPhones cannot be located. MobileMe provides combined email and file storage of 20GB for individuals and 40GB for families +with additional storage options. 8 Table of Contents Product Support and Services AppleCare ® offers a range of support options for the Company’s customers. These options include assistance that is built into software products, printed and electronic +product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare Protection Plan. The AppleCare Protection Plan is a fee-based service that typically includes two to three years of phone +support and hardware repairs, dedicated web-based support resources, and user diagnostic tools. Markets and Distribution The Company’s customers are primarily in the consumer, SMB, education, enterprise, government and creative markets. The Company +distributes its products through wholesalers, resellers, national and regional retailers and cataloguers. No individual customer accounted for more than 10% of net sales in 2009, 2008 or 2007. The Company also sells many of its products and resells +certain third-party products in most of its major markets directly to customers through its own sales force and retail and online stores. Competition The Company is confronted by aggressive competition in all areas of its business. The markets for +personal computers, mobile communication devices, consumer electronics, related software, services and peripheral products are highly competitive. These markets are characterized by rapid technological advances in both hardware and software that +have substantially increased the capabilities and use of personal computers, mobile communication devices, and other digital electronic devices that have resulted in the frequent introduction of new products with competitive price, feature, and +performance characteristics. Over the past several years, price competition in these markets has been particularly intense. The Company’s competitors who sell personal computers based on other operating systems have aggressively cut prices and +lowered their product margins to gain or maintain market share. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. The principal competitive +factors include price, product features, relative price/performance, product quality and reliability, design innovation, availability of software and peripherals, marketing and distribution capability, service and support, and corporate reputation. +Further, as the personal computer industry and its customers place more reliance on the Internet, an increasing number of Internet devices that are smaller, simpler and less expensive than traditional personal computers may compete with the +Company’s products. The Company is focused on expanding its market opportunities related to mobile communication devices +including the iPhone. The mobile communications industry is highly competitive and includes several large, well-funded and experienced participants. The Company expects competition in the mobile communication industry to intensify significantly as +competitors attempt to imitate some of the iPhone’s functionality and applications within their own smart phones or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. This +industry is characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of +consumers and businesses. The Company’s music products and services have faced significant competition from other +companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company believes it currently retains a competitive advantage by offering superior innovation and +integration of the entire solution including the hardware (personal computer, iPhone and iPod), software (iTunes), and distribution of digital content and applications (iTunes Store, iTunes Wi-Fi Music Store and App Store). Some of the +Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. Alternatively, these competitors +may collaborate with each other to offer solutions that are more integrated than those they currently offer. 9 Table of Contents The Company’s future financial condition and operating results are substantially +dependent on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets it competes in. Raw Materials Although most components essential to the Company’s business are generally available from +multiple sources, certain key components including but not limited to microprocessors, enclosures, certain liquid crystal displays (“LCDs”), certain optical drives, and application-specific integrated circuits (“ASICs”) are +currently obtained by the Company from single or limited sources, which subjects the Company to significant supply and pricing risks. Many of these and other key components available from multiple sources including but not limited to NAND flash +memory, dynamic random access memory (“DRAM”), and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into certain agreements for the supply of +key components including but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee the Company will be able to extend or renew these agreements on similar favorable terms, or at all, upon +expiration or otherwise obtain favorable pricing in the future. Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its financial condition and operating results. The Company and other participants in the personal computer, mobile communication and consumer electronics industries also +compete for various components with other industries that have experienced increased demand for their products. In addition, the Company uses some custom components that are not common to the rest of the personal computer, mobile communication and +consumer electronics industries, and new products introduced by the Company often utilize custom components available from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. +When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of a key single-sourced component for a new +or existing product were delayed or constrained, if such components were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial condition +and operating results could be materially adversely affected. The Company’s business and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to +identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components +instead of components customized to meet the Company’s requirements. Significant portions of the Company’s Mac +computers, iPhones, iPods, logic boards and other assembled products are manufactured by outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently performed by only a few of +the Company’s outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturing outsourcing for many of the Company’s key products, including but not +limited to final assembly of substantially all of the Company’s portable Mac computers, iPhones, iPods and most of the Company’s desktop products. Although the Company works closely with its outsourcing partners on manufacturing schedules, +the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover the Company’s requirements for periods +ranging from 30 to 150 days. The Company believes there are several component suppliers and manufacturing vendors whose loss +to the Company if they were to encounter financial distress or become insolvent, incur capacity or supply constraints, become unable to obtain credit, or for any other reason could materially adversely affect the Company’s business and +financial condition. At this time, such vendors include, without limitation, 3M Co., Advanced Micro Devices Inc., AKM Semiconductor Inc., Amkor Technology Inc., Analog Devices Inc., Aptina Imaging Corp., ARM Holdings PLC., Atheros Communications +Inc., Atmel Corp., AU Optronics Corp., Avago Technologies Ltd., 10 Table of Contents Broadcom Corp., Cirrus Logic Inc., Corning Inc., Cypress Semiconductor Corp., Dover Corp., Flextronics Inc., Foxconn Technology Co. Ltd., Hon Hai Precision Industry Co. Ltd., Imagination +Technologies Group PLC., Infineon Technologies AG, Intel Corp., Inventec Appliances Corp., LG Display Co. Ltd., Linear Technology Corp., MagnaChip Semiconductor Corp., Maxim Integrated Products Inc., Mitsumi Electric Co. Ltd., Murata Mfg. Co. Ltd., +National Semiconductor Corp., Nichia Corp., NVIDIA Corp., NXP B.V., OmniVision Technologies Inc., Quanta Computer, Inc., Pegatron Corp., Philips Lumileds Lighting Co., Renesas Semiconductor Co. Ltd., RF Micro Devices Inc., ROHM Co. Ltd., Samsung +Electronics Co. Ltd., Skyworks Solutions Inc., STMicroelectronics NV, Sumitomo Chemical Co. Ltd., Texas Instruments Inc., Toshiba Corp., Toyoda Gosei Co. Ltd., and TriQuint Semiconductor Inc. Research and Development Because the personal computer, mobile communication and consumer electronics industries are characterized by rapid technological advances, the Company’s ability to compete successfully is heavily dependent upon its ability to ensure a +continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new products and technologies and to enhance existing products in the areas of computer hardware and peripherals, +mobile communication devices, consumer electronics products, system software, applications software, networking and communications software and solutions, and Internet services and solutions. The Company may expand the range of its product offerings +and intellectual property through licensing and acquisition of third-party business and technology. The Company’s research and development expenditures totaled $1.3 billion, $1.1 billion and $782 million in 2009, 2008 and 2007, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its computer systems, iPhone and iPod devices, peripherals, software and services. In addition, the Company has +registered and/or has applied to register, trademarks and service marks in the U.S. and a number of foreign countries for “Apple,” the Apple logo, “Macintosh,” “Mac,” “iPhone,” “iPod,” +“iTunes,” “iTunes Store,” “Apple TV,” “MobileMe” and numerous other trademarks and service marks. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an +important factor in its business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect inventions arising from its research and development, and is currently pursuing +thousands of patent applications around the world. Over time, the Company has accumulated a portfolio of several thousand issued patents in the U.S. and worldwide. In addition, the Company currently holds copyrights relating to certain aspects +of its products and services. No single patent or copyright is solely responsible for protecting the Company’s products. The Company believes the duration of the applicable patents it has been granted is adequate relative to the expected lives +of its products. Due to the fast pace of innovation and product development, the Company’s products are often obsolete before the patents related to them expire, and sometimes are obsolete before the patents related to them are even granted. Many of the Company’s products are designed to include intellectual property obtained from third parties. While it may +be necessary in the future to seek or renew licenses relating to various aspects of its products and business methods, the Company believes, based upon past experience and industry practice, such licenses generally could be obtained on commercially +reasonable terms; however, there is no guarantee such licenses could be obtained at all. Because of technological changes in the computer, digital music player and mobile communications industries, current extensive patent coverage, and the rapid +rate of issuance of new patents, it is possible certain components of the Company’s products and business methods may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been +notified that it may be infringing certain patents or other intellectual property rights of third parties. 11 Table of Contents Foreign and Domestic Operations and Geographic Data The U.S. represents the Company’s largest geographic marketplace. Approximately 54% of the Company’s net sales in 2009 came from +sales to customers inside the U.S. Final assembly of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by external vendors in California, Texas, the People’s Republic of China +(“China”), the Czech Republic and the Republic of Korea (“Korea”). Currently, the supply and manufacture of many critical components is performed by sole-sourced third-party vendors in the U.S., China, Germany, Ireland, Israel, +Japan, Korea, Malaysia, the Netherlands, the Philippines, Taiwan, Thailand and Singapore. Sole-sourced third-party vendors in China perform final assembly of substantially all of the Company’s portable Mac products, iPhone, iPods and most of +the Company’s desktop products. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate +fluctuations and by international trade regulations, including tariffs and antidumping penalties. Information regarding +financial data by geographic segment is set forth in Part II, Item 7 and Item 8 of this Form 10-K and in Notes to Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.” Seasonal Business The +Company has historically experienced increased net sales in its first and fourth fiscal quarters compared to other quarters in its fiscal year due to seasonal demand related to the holiday season and the beginning of the school year. This historical +pattern should not be considered a reliable indicator of the Company’s future net sales or financial performance. Warranty The Company offers a basic limited parts and labor warranty on most of its hardware products, including Mac computers, +iPhones and iPods. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In +addition, consumers may purchase the AppleCare Protection Plan, which extends service coverage on many of the Company’s hardware products in most of its major markets. Backlog In the Company’s experience, the actual amount of product +backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases in anticipation of or immediately following new product introductions as dealers anticipate shortages. Backlog is +often reduced once dealers and customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial +performance. Environmental Laws Compliance with federal, state, local and foreign laws enacted for the protection of the environment has to date had no material effect on the Company’s capital expenditures, earnings, or competitive +position. In the future, compliance with environmental laws could materially adversely affect the Company. Production and +marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers the ability to return product at the end of its useful life, and +place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several jurisdictions in which the Company operates including various countries within Europe and Asia and certain +states and provinces within North America. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future +laws will not materially adversely affect the Company’s financial condition or operating results. 12 Table of Contents Employees As of September 26, 2009, the Company had approximately 34,300 full-time equivalent employees and an additional 2,500 full-time equivalent temporary employees and contractors. Available Information The +Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange +Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at http://www.apple.com/investor when such reports are available on the SEC website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, +DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information +regarding issuers that file electronically with the SEC at http://www.sec.gov . The contents of these websites are not incorporated into this filing. Further, the Company’s references to the URLs for these websites are intended to be +inactive textual references only. Item 1A. Risk Factors Because of +the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not +use historical trends to anticipate results or trends in future periods. Economic conditions could materially adversely +affect the Company. The Company’s operations and performance depend significantly on worldwide economic conditions. +Uncertainty about current global economic conditions poses a risk as consumers and businesses may continue to postpone spending in response to tighter credit, unemployment, negative financial news and/or declines in income or asset values, +which could have a material negative effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations since the Company generally raises prices on goods and services sold outside +the U.S. to offset the effect of the strengthening of the U.S. dollar, a trend that has been very pronounced recently. Other factors that could influence demand include increases in fuel and other energy costs, conditions in the real estate and +mortgage markets, labor and healthcare costs, access to credit, consumer confidence, and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the +Company’s products and services and on the Company’s financial condition and operating results. In the event of +renewed financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be a new or incremental tightening in +the credit markets, low liquidity, and extreme volatility in fixed income, credit, currency, and equity markets. In addition, the risk remains that there could be a number of follow-on effects from the credit crisis on the +Company’s business, including the insolvency of key suppliers or their inability to obtain credit to finance development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain +credit to finance purchases of the Company’s products and/or customer, including channel partner, insolvencies; and failure of derivative counterparties and other financial institutions negatively impacting the Company’s treasury +operations. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting from revaluations of debt and +equity securities and other investments; interest rates; cash balances; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk +of the actual amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. 13 Table of Contents Uncertainty about current global economic conditions could also continue to increase the +volatility of the Company’s stock price. Global markets for personal computers, mobile communication devices, digital +music and video devices, and related peripherals and services are highly competitive and subject to rapid technological change. If the Company is unable to compete effectively in these markets, its financial condition and operating results could be +materially adversely affected. The Company competes in highly competitive global markets characterized by aggressive price +cutting, with resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of +technological and product advancements by competitors, and price sensitivity on the part of consumers. The Company’s +ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly +the entire solution for its personal computers, mobile communication devices, and consumer electronics, including the hardware, operating system, numerous software applications, and related services. As a result, the Company must make significant +investments in research and development and as such, the Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. By contrast, many of +the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if other companies infringe +on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be negatively affected and its financial condition and operating results could be materially adversely affected. In the market for personal computers and peripherals, the Company faces a significant number of competitors, many of which have broader +product lines, lower priced products, and larger installed customer bases. Consolidation in this market has resulted in larger and potentially stronger competitors. Price competition has been particularly intense as competitors selling Windows-based +personal computers have aggressively cut prices and lowered product margins. The Company also faces increased competition in key market segments, including consumer, SMB, education, enterprise, government and creative markets. An increasing number +of Internet devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s existing products. The Company is currently the only authorized maker of hardware using the Mac OS. The Mac OS has a minority market share in the personal computer market, which is dominated by +computer makers using competing operating systems, most notably Windows. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve the Mac platform to maintain functional +and design advantages. Use of unauthorized copies of the Mac OS on other companies’ hardware products may result in decreased demand for the Company’s hardware products, and could materially adversely affect the Company’s financial +condition and operating results. The Company is currently focused on certain mobile communication devices, such as iPhone, +consumer electronic devices, including the iPod family of digital music and video players and third-party digital content and applications distribution. The Company faces substantial competition from companies that have significant technical, +marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships. The Company also competes with illegitimate ways to obtain third-party digital content and applications. The Company +has only recently entered the mobile communications market, and many of its competitors in the mobile communications market have significantly greater experience, product breadth and distribution channels than the Company. Because some current and +potential competitors have substantial resources and experience and a lower cost structure, they may be able to provide such products and services at little or no profit or even at a loss. The Company also expects competition to intensify as +competitors attempt to 14 Table of Contents imitate the Company’s approach to providing these components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company currently receives subsidies from its exclusive and non-exclusive carriers providing cellular network service for iPhone. There +is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the personal computer, mobile communication and consumer electronics +industries, the Company must continually introduce new products, services and technologies, enhance existing products and services, and effectively stimulate customer demand for new and upgraded products. The success of new product introductions +depends on a number of factors including but not limited to timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new products and production ramp issues, the availability of +application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and costs to meet anticipated demand, and +the risk that new products may have quality or other defects in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions on its financial condition and +operating results. The Company faces substantial inventory and other asset risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand or net +realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets for impairment whenever events or changed circumstances indicate the carrying amount of an +asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the assets exceeds its fair market value. Although the Company believes its inventory +and other asset related provisions are currently adequate, no assurance can be given that, given the rapid and unpredictable pace of product obsolescence in the global personal computer, mobile communication, and consumer electronics industries, the +Company will not incur additional inventory or asset related charges. Such charges have, and could, materially adversely affect the Company’s financial condition and operating results. The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with industry practice, components are normally +acquired through a combination of purchase orders, supplier contracts, open orders and, where appropriate, prepayments, in each case based on projected demand. Such purchase commitments typically cover forecasted component and manufacturing +requirements for 30 to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient +inventories of components or products. The Company’s financial condition and operating results have been in the past and could be in the future materially adversely affected by the Company’s ability to manage its inventory levels and +respond to short-term shifts in customer demand patterns. Future operating results depend upon the Company’s ability +to obtain key components including but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable prices and in sufficient quantities. Because the Company currently obtains certain key components including but not limited to microprocessors, enclosures, certain LCDs, certain optical drives, and ASICs, from single or limited sources, the +Company is 15 Table of Contents subject to significant supply and pricing risks. Many of these and other key components that are available from multiple sources including but not limited to NAND flash memory, DRAM and certain +LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. The Company has entered into certain agreements for the supply of key components including but not limited to microprocessors, NAND flash memory, +DRAM and LCDs at favorable pricing, but there is no guarantee that the Company will be able to extend or renew these agreements on similar favorable terms, or at all, upon expiration or otherwise obtain favorable pricing in the future. The follow-on +effects from the credit crisis on the Company’s key suppliers, referred to in “ Economic conditions could materially adversely affect the Company” above, which is incorporated herein by reference, also could affect the +Company’s ability to obtain key components. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that could materially adversely affect the Company’s financial condition and operating +results. The Company expects to experience decreases in its gross margin percentage in future periods, as compared to levels achieved during 2009 and 2008, due largely to the anticipated impact of product transitions, flat or reduced pricing on new +and innovative products that have higher cost structures, both expected and potential future cost increases for key components, a stronger U.S. dollar and higher logistical costs. For additional information refer to Part II, Item 7, +“Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the subheading “Gross Margin,” which is incorporated herein by reference. The Company and other participants in the personal computer, mobile communication and consumer electronics industries compete for various +components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not common to the rest of the personal computer, mobile communication and consumer electronics industries. +The Company’s new products often utilize custom components available from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. When a component or product uses new +technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected if those +suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the supply of a key single-sourced component for a new or existing product were delayed or +constrained, if such components were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be +materially adversely affected. The Company depends on component and product manufacturing and logistical services provided +by third parties, many of whom are located outside of the U.S. Most of the Company’s components and products are +manufactured in whole or in part by a few third-party manufacturers. Many of these manufacturers are located outside of the U.S., and are concentrated in several general locations. The Company has also outsourced much of its transportation and +logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity +of products or services, or the Company’s flexibility to respond to changing conditions. In addition, the Company relies on third-party manufacturers to adhere to the Company’s supplier code of conduct. Although arrangements with such +manufacturers may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects. Any unanticipated product defect or warranty liability, whether +pursuant to arrangements with contract manufacturers or otherwise, could materially adversely affect the Company’s reputation, financial condition and operating results. Final assembly of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by external vendors in California, Texas, China, the +Czech Republic and Korea. Currently, the supply and manufacture of many critical components is performed by sole-sourced third-party vendors in the U.S., China, Germany, Ireland, Israel Japan, Korea, Malaysia, the Netherlands, the Philippines, +Taiwan, Thailand and Singapore. Sole-sourced third-party vendors in China perform final assembly of substantially all of the 16 Table of Contents Company’s portable Mac products, iPhones, iPods and most of the Company’s desktop products. If manufacturing or logistics in these locations is disrupted for any reason, including +natural disasters, information technology system failures, military actions or economic, business, labor, environmental, public health, or political issues, the Company’s financial condition and operating results could be materially adversely +affected. The Company relies on third-party digital content and applications, which may not be available to the Company on +commercially reasonable terms or at all. The Company contracts with certain third parties to offer their digital content +and applications through the Company’s iTunes Store. The Company pays substantial fees to obtain the rights to audio and video content. The Company’s licensing arrangements with these third parties are short-term and do not guarantee the +continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content providers currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for +the Company to license their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the total cost of, such content. If the Company is unable to continue to offer a wide +variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach, the Company’s financial condition and operating results may be materially adversely affected. Many third-party content providers require that the Company provide certain digital rights management (“DRM”) and other security +solutions. If these requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely +manner. In addition, certain countries have passed or may propose legislation that would force the Company to license its DRM, which could lessen the protection of content and subject it to piracy and also could affect arrangements with the +Company’s content providers. The Company relies on access to third-party patents and intellectual property, and the +Company’s future results could be materially adversely affected if it is alleged or found to have infringed intellectual property rights. Many of the Company’s products are designed to include third-party intellectual property, and in the future the Company may need to seek or renew licenses relating to various aspects of its products +and business methods. Although the Company believes that, based on past experience and industry practice, such licenses generally could be obtained on reasonable terms, there is no assurance that the necessary licenses would be available on +acceptable terms or at all. Because of technological changes in the global personal computer, mobile communication and +consumer electronics industries, current extensive patent coverage, and the rapid issuance of new patents, it is possible that certain components of the Company’s products and business methods may unknowingly infringe the patents or other +intellectual property rights of third parties. From time to time, the Company has been notified that it may be infringing such rights. Regardless of merit, responding to such claims can consume significant time and expense. At present, the Company +is vigorously defending more than 47 patent infringement cases, 27 of which were filed during fiscal 2009, and several pending claims are in various stages of evaluation. In certain cases, the Company may consider the desirability of entering into +licensing agreements, although no assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. If the Company is found to be infringing such rights, it may be required to pay substantial damages. +If there is a temporary or permanent injunction prohibiting the Company from marketing or selling certain products or a successful claim of infringement against the Company requires it to pay royalties to a third party, the Company’s financial +condition and operating results could be materially adversely affected, regardless of whether it can develop non-infringing technology. While in management’s opinion the Company does not have a potential liability for damages or royalties from +any known current legal proceedings or claims related to the infringement of patent or other intellectual property rights that would individually or in the aggregate materially adversely affect its financial condition and operating results, the +results of such legal proceedings cannot be predicted with certainty. Should 17 Table of Contents the Company fail to prevail in any of the matters related to infringement of patent or other intellectual property rights of others or should several of these matters be resolved against the +Company in the same reporting period, the Company’s financial condition and operating results could be materially adversely affected. With the June 2007 introduction of iPhone, the Company has begun to compete with mobile communication device companies that hold significant patent portfolios. Regardless of the scope or validity of +such patents or the merits of any potential patent claims by competitors, the Company may have to engage in protracted litigation, enter into expensive agreements or settlements and/or modify its products. Any of these events could +have a material adverse impact on the Company’s financial condition and operating results. The Company’s future +performance depends on support from third-party software developers. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes decisions by customers to purchase its hardware products, including its Macs, iPhones and iPods, are +often based to a certain extent on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain applications and services for the Company’s products +on a timely basis or at all, and discontinuance or delay of these applications and services could materially adversely affect the Company’s financial condition and operating results. With respect to its Mac products, the Company believes the availability of third-party software applications and services depends in part on the developers’ perception and +analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company’s products compared to Windows-based products. This analysis may be based on factors such as the perceived strength of the Company and its +products, the anticipated revenue that may be generated, continued acceptance by customers of Mac OS X, and the costs of developing such applications and services. If the Company’s minority share of the global personal computer market causes +developers to question the Company’s prospects, developers could be less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing and upgrading software for the larger +Windows market. The Company’s development of its own software applications and services may also negatively affect the decisions of third-party developers, such as Microsoft, Adobe and Google, to develop, maintain, and upgrade similar or +competitive software and services for the Company’s products. Mac OS X Version 10.5 Leopard (“Mac OS X Leopard”), which became available in October 2007, includes a new feature that enables Intel-based Mac systems to run Microsoft +Windows XP and Windows Vista operating systems. This feature may deter developers from creating software applications for Mac OS X if such applications are already available for the Windows platform. With respect to iPhone and iPod touch, the Company relies on the continued availability and development of compelling and innovative +software applications. Unlike third-party software applications for Mac products, the software applications for the iPhone and iPod touch platforms are distributed through a single distribution channel, the App Store. The absence of multiple +distribution channels, which are available for competing platforms, may limit the availability and acceptance of third-party applications by the Company’s customers, thereby causing developers to curtail significantly, or stop, development for +the Company’s platforms. In addition, iPhone and iPod touch are subject to rapid technological change, and, if third-party developers are unable to keep up with this pace of change, third-party applications might not successfully operate and +may result in dissatisfied customers. Further, if the Company develops its own software applications and services, such development may negatively affect the decisions of third-party developers to develop, maintain, and upgrade similar or +competitive applications for the iPhone and iPod touch platforms. As with applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the +relative benefits of developing software for the Company’s products rather than its competitors’ products, including devices that use competing platforms. If developers focus their efforts on these competing platforms, the availability and +quality of applications for the Company’s devices may suffer. 18 Table of Contents The Company’s future operating performance depends on the performance of +distributors, carriers and other resellers. The Company distributes its products through wholesalers, resellers, national +and regional retailers, value-added resellers, and cataloguers, many of whom distribute products from competing manufacturers. The Company also sells many of its products and resells third-party products in most of its major markets directly to +end-users, certain education customers, and certain resellers through its online and retail stores. iPhone is distributed through the Company, its cellular network carriers’ distribution channels and certain third-party resellers. Many resellers operate on narrow operating margins and have been negatively affected in the past by weak economic conditions. Some +resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. Such a perception could discourage resellers from investing +resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company’s financial condition and operating results could be materially adversely affected if the financial +condition of these resellers weakens, if resellers stopped distributing the Company’s products, or if uncertainty regarding demand for the Company’s products caused resellers to reduce their ordering and marketing of the Company’s +products. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors and improving product placement displays. These programs +could require a substantial investment while providing no assurance of return or incremental revenue. The Company’s +retail business has required and will continue to require a substantial investment and commitment of resources and is subject to numerous risks and uncertainties. Through September 26, 2009, the Company had opened 273 retail stores. The Company’s retail stores have required substantial fixed investment in equipment and leasehold improvements, information +systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space with terms ranging from five to 20 years, the majority of which are for ten years. Certain stores have been designed and +built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than +the Company’s more typical retail stores. Due to the high fixed cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease +termination costs, write-offs of equipment and leasehold improvements, and severance costs that could materially adversely affect the Company’s financial condition and operating results. Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and uncertainties that could materially adversely affect the Company’s +financial condition and operating results. These risks and uncertainties include, among other things, macro-economic factors that could have a negative effect on general retail activity, as well as the Company’s inability to manage costs +associated with store construction and operation, inability to sell third-party products at adequate margins, failure to manage relationships with existing retail channel partners, more challenging environment in managing retail operations outside +the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and inability to obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and initiatives could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant +risks and uncertainties, including distraction of management from current operations, insufficient revenue to offset liabilities assumed and expenses associated with the strategy, inadequate return of capital, and unidentified issues not discovered +in the Company’s due diligence. Because 19 Table of Contents these new ventures are inherently risky, no assurance can be given that such strategies and initiatives will be successful and will not materially adversely affect the Company’s financial +condition and operating results. The Company’s products and services experience quality problems from time to time +that can result in decreased sales and operating margin. The Company sells highly complex hardware and software products +and services that can contain defects in design and manufacture. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s +intended operation. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure +to do so could result in lost revenue, harm to reputation, and significant warranty and other expenses, and could have a material adverse impact on the Company’s financial condition and operating results. In certain countries, including the U.S., the Company relies on a single cellular network carrier to provide service for iPhone. In the U.S., Germany, Spain, Ireland and certain other countries, the Company has contracted with a single carrier to provide +cellular network services for iPhone on an exclusive basis. If these exclusive carriers cannot successfully compete with other carriers in their markets on any basis, including but not limited to the quality and coverage of wireless voice and data +services, performance and timely build-out of advanced wireless networks, and pricing and other terms of conditions of end-user contracts, or if these exclusive carriers fail to promote iPhone aggressively or favor other handsets in their promotion +and sales activities or service plans, sales may be materially adversely affected. The Company is subject to risks +associated with laws, regulations and industry-imposed standards related to mobile communications devices. Laws and +regulations related to mobile communications devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes, which could include but are not limited to restrictions on production, manufacture, +distribution, and use of the device, locking the device to a carrier’s network, or mandating the use of the device on more than one carrier’s network, could materially adversely affect the Company’s financial condition and operating +results. Mobile communication devices, such as iPhone, are subject to certification and regulation by governmental and +standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications or delays in +product shipment dates, which could materially adversely affect the Company’s financial condition and operating results. The Company’s success depends largely on the continued service and availability of key personnel. Much of +the Company’s future success depends on the continued availability and service of key personnel, including its CEO, its executive team and highly skilled employees in technical, marketing and staff positions. Experienced personnel in the +technology industry are in high demand and competition for their talents is intense, especially in the Silicon Valley, where most of the Company’s key personnel are located. There can be no assurance that the Company will continue to attract +and retain key personnel. In addition, the Company has relied on equity awards in the form of stock options and restricted +stock units as one means for recruiting and retaining highly skilled talent. Significant adverse volatility in the Company’s stock price could result in a stock option’s exercise price exceeding the underlying stock’s market value or +a significant deterioration in the value of restricted stock units granted, thus lessening the effectiveness of stock-based awards for retaining employees. 20 Table of Contents Political events, war, terrorism, public health issues, natural disasters and other +circumstances could materially adversely affect the Company. War, terrorism, geopolitical uncertainties, public health +issues, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a strong negative effect on the Company, its suppliers, logistics providers, +manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to interruption by natural disasters, fire, power shortages, terrorist attacks, and other hostile acts, labor disputes, public health +issues, and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and deliver products to its customers, including channel partners, or to receive +components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. Should major public health issues, including pandemics, arise, the Company could be negatively affected by more stringent employee travel +restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products, and disruptions in the operations of the Company’s manufacturing +vendors and component suppliers. The majority of the Company’s research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including certain component suppliers and +manufacturing vendors, are located near major seismic faults. Because the Company does not carry earthquake insurance for direct quake-related losses and significant recovery time could be required to resume operations, the Company’s financial +condition and operating results could be materially adversely affected in the event of a major earthquake. The Company may +be subject to information technology system failures, network disruptions and breaches in data security. Information +technology system failures, network disruptions and breaches of data security caused by such factors including without limitation earthquakes, fire, theft, or other causes could disrupt the Company’s operations by causing delays or cancellation +of customer, including channel partner, orders, negatively affecting the Company’s online, iTunes, MobileMe and retail offerings and services, impeding the manufacture or shipment of products, processing transactions and reporting financial +results, resulting in the unintentional disclosure of customer or Company information, or damage to the Company’s reputation. While management has taken steps to address these concerns by implementing sophisticated network security and internal +control measures, there can be no assurance that a system failure or loss or data security breach will not materially adversely affect the Company’s financial condition and operating results. The Company expects its quarterly revenue and operating results to fluctuate for a variety of reasons. The Company’s profit margins vary among its products and its distribution channels. The Company’s software, accessories, and +service and support contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product +transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition, +the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, new products, component cost increases, +strengthening U.S. dollar, or price competition. The Company has typically experienced greater net sales in the first and fourth fiscal quarters compared to the second and third fiscal quarters due to seasonal demand related to the holiday season +and the beginning of the school year, respectively. Furthermore, the Company sells more products from time-to-time during the third month of a quarter than it does during either of the first two months. Developments late in a quarter, such as +lower-than-anticipated demand for the Company’s products, an internal systems failure, or failure of one of the Company’s key logistics, components supply, or manufacturing partners, could have a material adverse impact on the +Company’s financial condition and operating results. 21 Table of Contents The Company’s stock price continues to be volatile. The Company’s stock has at times experienced substantial price volatility due to a number of factors, including but not limited to +variations between its actual and anticipated financial results, announcements by the Company and its competitors, and uncertainty about current global economic conditions. The stock market as a whole also has experienced extreme price and volume +fluctuations that have affected the market price of many technology companies in ways that may have been unrelated to these companies’ operating performance. Furthermore, the Company believes its stock price reflects high future growth and +profitability expectations. If the Company fails to meet these expectations its stock price may significantly decline. The +Company’s business is subject to the risks of international operations. The Company derives a large and growing +portion of its revenue and earnings from its international operations. Compliance with U.S. and foreign laws and regulations that apply to the Company’s international operations, including without limitation import and export requirements, the +Foreign Corrupt Practices Act, tax laws (including U.S. taxes on foreign subsidiaries), foreign exchange controls and cash repatriation restrictions, data privacy requirements, labor laws, and anti-competition regulations, increases the costs of +doing business in foreign jurisdictions, and such costs may rise in the future as a result of changes in these laws and regulations or in their interpretation. Furthermore, the Company has implemented policies and procedures designed to facilitate +compliance with these laws and regulations, but there can be no assurance that the Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies. Any such violations could individually or +in the aggregate materially adversely affect the Company’s financial condition or operating results. The Company’s +financial condition and operating results also could be significantly affected by other risks associated with international activities, including but not limited to, economic and labor conditions, political instability, and changes in the value of +the U.S. dollar versus local currencies. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign +currency exchange rate fluctuations and by international trade regulations, including duties, tariffs and antidumping penalties. The Company’s primary exposure to movements in foreign currency exchange rates relate to non-U.S. dollar denominated sales in Europe, Japan, Australia, Canada and certain parts of Asia, as well as non-U.S. dollar denominated operating +expenses incurred throughout the world. Weakening of foreign currencies relative to the U.S. dollar will adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally will lead the +Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, due to competition or other reasons, the Company may decide not to raise local prices to the full extent of the dollar’s +strengthening, or at all, which would adversely affect the U.S. dollar value of the Company’s foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies, while generally beneficial to the Company’s +foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing, thereby limiting the benefit. Additionally, strengthening of foreign currencies may also increase the Company’s cost of product components +denominated in those currencies, thus adversely affecting gross margins. The Company has used derivative instruments, such as +foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of +unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to +credit risk and fluctuations in the market values of its investment portfolio. Although the Company has not recognized any +material losses on its cash, cash equivalents and marketable securities, any significant future declines in their market values could materially adversely affect the Company’s financial condition and operating results. Given the global nature +of its business, the Company has investments 22 Table of Contents both domestically and internationally. Additionally, the Company’s overall investment portfolio has concentrations in the financial sector, which has been negatively impacted by adverse +market liquidity conditions in the recent past. Credit ratings and pricing of these investments can be negatively impacted by liquidity, credit deterioration or losses, financial results, or other factors. As a result, the value or liquidity of the +Company’s cash, cash equivalents and marketable securities could decline and result in a material impairment, which could materially adversely affect the Company’s financial condition and operating results. The Company is exposed to credit risk on its accounts receivable and prepayments related to long-term supply agreements. This risk is +heightened during periods when economic conditions worsen. A substantial majority of the Company’s outstanding trade +receivables are not covered by collateral or credit insurance. The Company also has unsecured non-trade receivables resulting from purchases of components by contract manufacturers and other vendors that manufacture sub-assemblies or assemble final +products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of certain inventory components. While the Company has procedures to monitor and limit exposure to credit risk on +its trade and non-trade receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses, which could materially adversely affect the Company’s financial condition +and operating results. The matters relating to the Company’s past stock option practices and its restatement of +consolidated financial statements may result in additional litigation. The Company’s investigation into its past +stock option practices and its restatement of prior financial statements in the Annual Report on Form 10-K for the year ended September 30, 2006 gave rise to litigation and government investigations. As described in Part I, Item 3, +“Legal Proceedings,” several derivative and class action complaints regarding stock options were filed against the Company and current and former officers and directors. These actions have been dismissed following a comprehensive +settlement. Two former officers of the Company were also named as defendants in an SEC enforcement action, which has been settled. No assurance can be given that additional actions will not be filed against the Company and current and former officers and directors as a result of past stock option practices. If such actions are filed and result in adverse findings, the +remedies could materially adversely affect the Company’s financial condition and operating results. Unfavorable +results of legal proceedings could materially adversely affect the Company. The Company is subject to various legal +proceedings and claims that have arisen out of the ordinary conduct of its business and are not yet resolved and additional claims may arise in the future. Results of legal proceedings cannot be predicted with certainty. Regardless of merit, +litigation may be both time-consuming and disruptive to the Company’s operations and cause significant expense and diversion of management attention. In recognition of these considerations, the Company may enter into material settlements. +Should the Company fail to prevail in certain matters, or should several of these matters be resolved against the Company in the same reporting period, the Company may be faced with significant monetary damages or injunctive relief against it that +would materially adversely affect a portion of its business and might materially affect the Company’s financial condition and operating results. The Company is subject to risks associated with laws and regulations related to health, safety and environmental protection. The Company’s products and services, and the production and distribution of those goods and services, are subject to a variety of laws and regulations. These may require the +Company to offer customers the ability to return a product at the end of its useful life and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several jurisdictions in +which the Company 23 Table of Contents operates, including various countries within Europe and Asia and certain states and provinces within North America. Although the Company does not anticipate any material adverse effects based on +the nature of its operations and the focus of such laws, there is no assurance such existing laws or future laws will not materially adversely affect the Company’s financial condition and operating results. Changes in the Company’s tax rates, the adoption of new U.S. tax legislation or exposure to additional tax liabilities could affect +its future results. The Company is subject to taxes in the United States and numerous foreign jurisdictions. The +Company’s future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their +interpretation. In addition, the current administration and Congress have recently announced proposals for new U.S. tax legislation that, if adopted, could adversely affect the Company’s tax rate. Any of these changes could have a material +adverse affect on the Company’s profitability. The Company is also subject to the continual examination of its income tax returns by the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of +adverse outcomes resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance that the outcomes from these examinations will not materially adversely affect the Company’s financial condition +and operating results. The Company is subject to risks associated with the availability and coverage of insurance. For certain risks, the Company does not maintain insurance coverage because of cost and/or availability. Because the +Company retains some portion of its insurable risks, and in some cases self-insures completely, unforeseen or catastrophic losses in excess of insured limits could materially adversely affect the Company’s financial condition and operating +results. Item 1B. Unresolved Staff Comments None. Item 2. Properties The +Company’s headquarters are located in Cupertino, California. As of September 26, 2009, the Company owned and leased approximately 19.7 million square feet of space, primarily in the U.S., and to a lesser extent, in Europe, Japan, +Canada, and the Asia Pacific region. The Company’s total leased space was approximately 4.5 million square feet, of which approximately 2.0 million square feet was retail space, a majority of which is in the U.S. As of September 26, 2009, the Company owned a manufacturing facility in Cork, Ireland that also housed a customer support call center +and facilities in Elk Grove, California that included warehousing and distribution operations and a customer support call center. In addition, the Company owned facilities for research and development and corporate functions in Cupertino, +California, including land for the future development of the Company’s second corporate campus. The Company also owned a data center in Newark, California and, during 2009, purchased additional land in North Carolina for a future data center +facility. Outside the U.S., the Company owned additional facilities for various purposes. The Company believes its existing +facilities and equipment are in good operating condition and are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors, and believes it has adequate +manufacturing capacity for the foreseeable future. The Company continues to make investments in capital equipment as needed to meet anticipated demand for its products. 24 Table of Contents Item 3. Legal Proceedings As of +September 26, 2009, the end of the annual period covered by this report, the Company was subject to the various legal proceedings and claims discussed below, as well as certain other legal proceedings and claims that have not been fully +resolved and that have arisen in the ordinary course of business. In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate +materially adversely affect its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal +matters be resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. The Company settled certain matters during the fourth quarter of 2009 that did not +individually or in the aggregate have a material impact on the Company’s financial condition and results of operations. Bader v. Anderson, et al. Plaintiff filed this purported shareholder derivative action against the Company and +each of its then current executive officers and members of its Board of Directors on May 19, 2005 in Santa Clara County Superior Court asserting claims for breach of fiduciary duty, material misstatements and omissions and violations of +California Business & Professions Code §17200 (unfair competition). The complaint alleged that the Company’s March 14, 2005, proxy statement was false and misleading for failure to disclose certain information relating to the +Apple Computer, Inc. Performance Bonus Plan, which was approved by shareholders at the annual meeting held on April 21, 2005. Plaintiff, who ostensibly brought suit on the Company’s behalf, made no demand on the Board of Directors and +alleged that such demand was excused. The complaint sought injunctive and other relief for purported injury to the Company. On July 27, 2005, plaintiff filed an amended complaint alleging that, in addition to the purported derivative claims, +adoption of the bonus plan and distribution of the proxy statement describing that plan also inflicted injury on her directly as an individual shareholder. On January 10, 2006, the Court sustained defendants’ demurrer to the amended +complaint, with leave to amend. Plaintiff filed a second amended complaint on February 7, 2006, and the Company filed a demurrer. After a hearing on June 13, 2006, the Court sustained the demurrer without leave to amend as to the +non-director officers and with leave to amend as to the directors. On July 24, 2006, plaintiff filed a third amended complaint, which purported to bring claims derivatively as well as directly on behalf of a class of common stockholders who +have been or will be harmed by virtue of the allegedly misleading proxy statement. In addition to reasserting prior causes of action, the third amended complaint included a claim that the Company violated the terms of the plan, and a claim for waste +related to restricted stock unit grants to certain officers in 2003 and 2004 and an option grant to the Company’s CEO in January 2000. The Company filed a demurrer to the third amended complaint. On January 30, 2007, the Court sustained +the Company’s demurrer with leave to amend. On May 8, 2007, plaintiff filed a fourth amended complaint. The Company filed a demurrer to the fourth amended complaint, which the Court sustained, without leave to amend, on October 12, +2007. On October 25, 2007, the Court entered a final judgment in favor of defendant and ordered the case dismissed with prejudice. On November 26, 2007, plaintiff filed a notice of appeal. A hearing on plaintiff’s appeal is scheduled +for October 29, 2009. Birdsong v. Apple Computer, Inc. This action alleges that the Company’s iPod music players, and the ear bud headphones sold with them, are inherently defective in design and are sold without adequate warnings +concerning the risk of noise-induced hearing loss by iPod users. The Birdsong action was initially filed on January 30, 2006 in the United States District Court for the Western District of Louisiana asserting Louisiana causes of action on +behalf of a purported Louisiana class of iPod purchasers. A similar action (Patterson v. Apple Computer, Inc.) was filed on January 31, 2006 in the United States District Court for the Northern District of California asserting California +causes of action on behalf of a purported class of all iPod purchasers within the four-year period before January 31, 2006. The Birdsong action was transferred to the Northern District of California, and the Patterson action was dismissed. An +amended complaint was subsequently filed in Birdsong, dropping the Louisiana law-based claims and adding California law-based claims equivalent to those in Patterson. After the Company filed a motion to 25 Table of Contents dismiss on November 3, 2006, plaintiffs agreed not to oppose the motion and filed a second amended complaint on January 16, 2007. That complaint alleges California law-based claims for +breaches of implied and express warranties, violations of California Business & Professions Code §17200 (unfair competition), California Business & Professions Code §17500 (false advertising), the Consumer Legal Remedies +Act and negligent misrepresentation on behalf of a putative nationwide class and a Louisiana law-based claim for redhibition for a Louisiana sub-class. On March 1, 2007, the Company filed a motion to dismiss the California law-based claims, +which was heard on June 4, 2007. On December 14, 2007, the Court issued an order granting the Company’s motion, with leave to amend the complaint. On January 11, 2008, plaintiffs filed a third amended complaint, which seeks +restitution, injunctive relief, unspecified damages and attorneys’ fees. On February 15, 2008, the Company filed a motion to dismiss the third amended complaint. On June 16, 2008, the Court granted the Company’s motion to dismiss +the third amended complaint with prejudice. On July 11, 2008, plaintiffs filed a notice of appeal. A hearing on plaintiffs’ appeal took place on October 8, 2009. A similar complaint, Royer-Brennan v. Apple Computer, Inc. and Apple Canada, Inc., was filed in Montreal, Quebec, Canada, on February 1, 2006, seeking authorization to +institute a class action on behalf of iPod purchasers in Quebec. Plaintiffs filed a motion to amend their complaint to add a minor plaintiff and claims regarding alleged risks of hearing loss to young people. The hearing on the motion to amend took +place on April 24, 2009, and the Court denied plaintiffs’ motion with leave to resubmit it. Branning et al. v. +Apple Computer, Inc. Plaintiffs originally filed this purported class action in San Francisco County Superior Court on +February 17, 2005. The initial complaint alleged violations of California Business & Professions Code §17200 (unfair competition) and violation of the Consumer Legal Remedies Act regarding a variety of purportedly unfair and +unlawful conduct including but not limited to allegedly selling used computers as new and failing to honor warranties. Plaintiffs also brought causes of action for misappropriation of trade secrets, breach of contract and violation of the +Song-Beverly Consumer Warranty Act. Plaintiffs requested unspecified damages and other relief. On May 2, 2005, plaintiffs filed an amended complaint adding two new named plaintiffs and three new causes of action including a claim for treble +damages under the Cartwright Act (California Business & Professions Code §16700 et seq.) and a claim for false advertising. On May 9, 2005, the Court granted the Company’s motion to transfer the case to Santa Clara County +Superior Court. The Company filed a demurrer to the amended complaint, which the Court sustained in its entirety on November 10, 2005. The Court granted plaintiffs leave to amend and they filed an amended complaint on December 29, 2005. +Plaintiffs’ amended complaint added three plaintiffs and alleged many of the same factual claims as the previous complaints, such as alleged selling of used equipment as new, alleged failure to honor warranties and service contracts for the +consumer plaintiffs, and alleged fraud related to the opening of the Apple retail stores. Plaintiffs continued to assert causes of action for unfair competition (§17200), violations of the Consumer Legal Remedies Act, breach of contract, +misappropriation of trade secrets, violations of the Cartwright Act, and alleged new causes of action for fraud, conversion, and breach of the implied covenant of good faith and fair dealing. The Company filed a demurrer to the amended complaint on +January 31, 2006, which the Court sustained on March 3, 2006 on sixteen of seventeen causes of action. Plaintiffs filed an amended complaint adding one new plaintiff. The Company filed a demurrer, which was granted in part on +September 9, 2006. Plaintiffs filed a further amended complaint on September 21, 2006. On October 2, 2006, the Company filed an answer denying all allegations and asserting numerous affirmative defenses. On November 30, 2007, the +Company filed a motion for judgment on the pleadings, which the Court denied. Plaintiffs filed a Fifth Amended Complaint on March 19, 2008 and a Corrected Fifth Amended Complaint on April 1, 2008. The Company filed an answer to the +Corrected Fifth Amended Complaint on April 18, 2008. The Company filed a motion for judgment on the pleadings for an order dismissing plaintiffs’ fraud claim based upon the statute of limitations, which was granted by the Court on +June 24, 2008, with leave to amend. Plaintiffs filed a Sixth Amended Complaint on July 14, 2008 and a Seventh Amended Complaint on August 22, 2008, adding three new reseller plaintiffs. On August 22, 2008, plaintiffs also filed a +motion to certify the consumer class. On September 22, 2008, the Company filed its answer to the consumer-related claims denying all allegations and asserting numerous affirmative defenses, and also filed a 26 Table of Contents demurrer to the new reseller claims, which the Court heard on January 30, 2009. The Court sustained the demurrer as to all plaintiffs except one, with leave to amend. Plaintiffs filed an +Eighth Amended Complaint further amending the reseller claims on February 24, 2009, and on March 26, 2009, the Company filed a demurrer which was overruled, and a motion to strike which was denied. The Company filed motions for summary +adjudication for certain claims of two named plaintiffs, which the Court granted on November 10, 2008. Plaintiffs petitioned the Court of Appeal for a writ of certiorari from the summary adjudication ruling and a motion to stay the class +certification hearing, which the Court of Appeal denied on December 17, 2008. On December 19, 2008, the Court held a hearing on plaintiffs’ class certification motion. The Court requested further briefing and an additional hearing, +which did not take place because on February 23, 2009, Hon. Jamie A. Jacobs-May disqualified herself from the case. The Company filed a petition for a writ of mandate from this order, which the Court of Appeal denied on May 19, 2009. The +case has been reassigned to Hon. Joseph H. Huber. The class certification hearing on the consumer-related claims took place on July 14, 2009. The Company has filed two additional motions for summary adjudication as to all of the named +plaintiffs’ claims. The Company has also filed a motion to sever the consumer class and the reseller class for the purpose of trial. Plaintiffs’ motion for class certification of the reseller class is due November 16, 2009. Harvey v. Apple Inc. Plaintiff filed this action on August 6, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement by the Company of U.S. Patent +No. 6,753,671 entitled “Recharger for use with a portable electronic device and which includes a proximally located light emitting device” and U.S. Patent No. 6,762,584 entitled “Recharger for use with a portable electronic +device and which includes a connector terminus for communicating with rechargeable batteries contained within the device.” The complaint seeks unspecified damages and other relief. The Company filed an answer on October 12, 2007 denying +all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of non-infringement and invalidity. On April 7, 2008, plaintiff filed an amended complaint further alleging +infringement of the reissue patent of U.S. Patent No. 6,753,671. On April 28, 2008, the Company filed an answer denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for +declaratory judgment of non-infringement and invalidity. The Markman hearing is set for October 28, 2009, and trial is scheduled for April 5, 2010. On February 3, 2009, the Court stayed the proceedings pending the U.S. Patent and +Trademark Office’s allowance of the ‘671 reissue patent. On July 7, 2009, the Company filed a motion to transfer the case to the Northern District of California. On September 19, 2009, the Company filed a motion to vacate the +Markman hearing set for October 28, 2009, given the still pending reissue proceeding regarding U.S. Patent No. 6,753,671. Honeywell International, Inc., et al. v. Apple Computer, Inc., et al. Plaintiffs Honeywell +International, Inc. and Honeywell Intellectual Properties, Inc. filed this action on October 6, 2004 in the United States District Court in Delaware alleging infringement by the Company and other defendants of U.S. Patent +No. 5,280,371 entitled “Directional Diffuser for a Liquid Crystal Display.” Plaintiffs seek unspecified damages and other relief. The Company filed an answer on December 21, 2004 denying all material allegations and asserting +numerous affirmative defenses. The Company has tendered the case to several liquid crystal display manufacturer suppliers. On May 18, 2005 the Court stayed the case against the Company and the other non-manufacturer defendants. Plaintiffs filed +an amended complaint on November 7, 2005 adding additional defendants and expanding the scope of the accused products. The Company’s response to the amended complaint is not yet due. On April 2, 2008, the Court lifted the stay for the +purpose of determining whether the liquid crystal display manufacturer suppliers used by the Company and certain other defendants are licensed under the ‘371 patent. On October 31, 2008, the Company filed a motion for summary judgment of +non-infringement based on the contention that its suppliers are licensed under the ‘371 patent. A hearing on the motion has been postponed and has not been rescheduled. 27 Table of Contents In re Apple iPod Nano Products Liability Litigation (formerly Wimmer v. Apple Computer, +Inc.; Moschella, et al., v. Apple Computer, Inc.; Calado, et al. v. Apple Computer, Inc.; Kahan, et al., v. Apple Computer, Inc.; Jennings, et al., v. Apple Computer, Inc.; Rappel v. Apple Computer, Inc.; Mayo v. Apple Computer, Inc.; Valencia v. +Apple Computer, Inc.; Williamson v. Apple Computer, Inc.; Sioson v. Apple Computer, Inc. Beginning on October 19, +2005, eight complaints were filed in various United States District Courts and two complaints were filed in California State Court alleging that the Company’s iPod nano was defectively designed so that it scratches excessively during normal +use, rendering the screen unreadable. The federal actions were coordinated in the United States District Court for the +Northern District of California and assigned to the Hon. Ronald Whyte pursuant to an April 17, 2006 order of the Judicial Panel on Multidistrict Litigation. Plaintiffs filed a First Consolidated and Amended Master Complaint on +September 21, 2006, alleging violations of California and other states’ consumer protection and warranty laws and claiming unjust enrichment. The Master Complaint alleges two putative plaintiff classes: (1) all U.S. residents +(excluding California residents) who purchased an iPod nano that was not manufactured or designed using processes necessary to ensure normal resistance to scratching of the screen; and (2) all iPod nano purchasers other than U.S. residents who +purchased an iPod nano that was not manufactured or designed using processes necessary to ensure normal resistance to scratching of the screen. The Company answered the Master Complaint on November 20, 2006. The two California State Court actions were coordinated on May 4, 2006, and assigned to the Hon. Carl West in Los Angeles County +Superior Court. Plaintiffs filed a Consolidated Amended Class Action Complaint on June 8, 2006, alleging violations of California state consumer protection, unfair competition, false advertising and warranty laws and claiming unjust enrichment. +The Consolidated Complaint alleges a putative plaintiff class of all California residents who own an iPod nano containing a manufacturing defect that results in the nano being susceptible to excessive scratching. The Company answered the +Consolidated Amended Complaint on October 6, 2006. The parties have reached a settlement and on April 28, 2009, the Court granted final approval of the settlement. On May 21, 2009, an objector filed a notice of appeal. Individual Networks, LLC v. Apple, Inc. Plaintiff filed this action against the Company on April 24, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent +No. 7,117,516, entitled “Method and System for Providing a Customized Media List.” Plaintiff alleges certain features of the iTunes store infringe the patent. The complaint seeks unspecified damages and other relief. The Company filed +an answer on July 2, 2007, denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of non-infringement and invalidity, as well as a counterclaim against +Individual Networks LLC for infringement of U.S. Patent No. 5,724,567. The trial is scheduled for November 9, 2009. The Company has filed a petition with the United States Patent and Trademark Office requesting reexamination of U.S. Patent +No. 7,117,516. The Markman hearing took place on October 8, 2008, and the Court issued its Markman ruling on January 12, 2009. The Company filed a motion for summary judgment of inequitable conduct on April 10, 2009, and filed +motions for summary judgment of invalidity and lack of written description on April 30, 2009. The Company has also filed a motion to exclude portions of plaintiff’s expert’s report and testimony regarding damages. Plaintiff has filed +a motion to exclude damages testimony relating to U.S. Patent No. 5,724,567. The Company has also filed a motion for sanctions. Mediostream, Inc. v. Acer America Corp. et al. Plaintiff filed this action against the Company, Acer America +Corp., Dell, Inc. and Gateway, Inc. on August 28, 2007 in the United States District Court for the Eastern District of Texas, Marshall Division, alleging infringement of U.S. Patent No. 7,009,655, entitled “Method and System for +Direct Recording of Video Information onto a Disk Medium.” An amended complaint was served on November 7, 2007. The amended complaint seeks unspecified damages and other relief. On January 25, 2008, the Company filed an answer to the 28 Table of Contents complaint denying all material allegations and asserting numerous affirmative defenses and also filed a motion to transfer the case to the Northern District of California, which the Court denied. +The Markman hearing is set for August 4, 2010 and trial is scheduled for January 4, 2011. Nokia Corporation v. +Apple Inc. Plaintiff Nokia Corporation filed this action against the Company on October 22, 2009 in the United States +District Court for the District of Delaware, alleging infringement of U.S. Patent No. 5,802,465, U.S. Patent No. 5,862,178, U.S. Patent No. 5,946,651, U.S. Patent No. 6,359,904, U.S. Patent No. 6,694,135, U.S. Patent No. 6,755,548, U.S. +Patent No. 6,882,727, U.S. Patent No. 7,009,940, U.S. Patent No. 7,092,672, and U.S. Patent No. 7,403,621. The complaint alleges that these patents are essential to one or more of the GSM, UMTS and 802.11 wireless communications standards, and that +the Company has the right to license these patents from plaintiff on fair, reasonable, and non-discriminatory (“FRAND”) terms and conditions. Plaintiff seeks unspecified FRAND compensation and other relief. The Company’s response to +the complaint is not yet due. The Company intends to defend the case vigorously. OPTi Inc. v. Apple Inc. Plaintiff filed this action against the Company on January 16, 2007 in the United States District Court for the Eastern District of +Texas, Marshall Division, alleging infringement of U.S. Patent Nos. 5,710,906, 5,813,036 and 6,405,291, all entitled “Predictive Snooping of Cache Memory for Master-Initiated Accesses.” The complaint seeks unspecified damages and other +relief. The Company filed an answer on April 17, 2007 denying all material allegations and asserting numerous affirmative defenses. The Company also asserted counterclaims for declaratory judgment of non-infringement and invalidity. The Markman +hearing took place on November 26, 2008 and the Court issued its Markman ruling on December 5, 2008. On April 3, 2009, the Court ruled that the accused computers sold between 2005 and 2007 infringed the ’291 patent. A trial +regarding validity, damages and willfulness commenced on April 17, 2009. On April 23, 2009, the jury returned a verdict that the patent was valid and willfully infringed, and awarded $19 million in damages. On May 1, 2009, plaintiff +filed a motion for entry of judgment, including a request for enhanced damages based on the willfulness finding, seeking a total of $31 million plus attorneys’ fees. The Company has opposed that motion and has filed its own motions for judgment +as a matter of law or, alternatively, for a new trial and/or remittitur, on the issues of validity, willfulness and damages. The Court has not entered a judgment and has not set hearing dates for any of the pending motions. Saito Shigeru Kenchiku Kenkyusho (Shigeru Saito Architecture Institute) v. iPod; Apple Japan Inc. v. Shigeru Saito Architecture Institute Plaintiff Saito filed a petition in the Japan Customs Office in Tokyo on January 23, 2007 alleging infringement +by the Company of Japanese Patent No. 3852854, entitled “Touch Operation Input Device and Electronic Parts Thereof.” The petition sought an order barring the importation into Japan of fifth generation iPods and second generation +iPod nanos. The Customs Office held a hearing on March 22, 2007. The Customs Office rejected the petition to bar importation and dismissed plaintiff’s case. Apple Japan, Inc. filed a Declaratory Judgment action against Saito on February 6, 2007 in the Tokyo District Court, seeking a declaration that the ‘854 patent is invalid and not infringed. +Saito filed a Counter Complaint for infringement seeking damages. Plaintiff filed a motion to add new accused products into the case, which the Court granted at a hearing on June 30, 2009. St-Germain v. Apple Canada, Inc. Plaintiff filed this case in Montreal, Quebec, Canada, on August 5, 2005, seeking authorization to institute a class action for the refund by the Company of the Canadian Private Copying Levy that was +applied to the iPod 29 Table of Contents purchase price in Quebec between December 12, 2003 and December 14, 2004 but later declared invalid by the Canadian Court. The Company has completed a refund program for this levy. A +class certification hearing took place January 13, 2006. On February 24, 2006, the Court granted class certification and notice was published during the last week of March 2006. The trial was conducted on October 15 and 16, 2007. On +January 11, 2008, the Court issued a ruling in plaintiff’s favor. The Court ruled that despite the Company’s good faith efforts with the levy refund program, the Company must pay the amount claimed, and that the class is comprised of +20,000 persons who purchased an iPod in Quebec between December 12, 2003 and December 14, 2004. The Court ordered the Company to submit a statement of account showing the amount received by the Canadian Private Copying Collective, and the +amount that has already been paid to class members in Quebec under the Company’s levy refund program. The Court also ordered the parties to submit further briefing regarding the collective recovery award by February 23, 2008. On +February 11, 2008, the Company filed an appeal. A hearing on the appeal is set for October 27, 2009. The Apple +iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, Inc.); Somers v. Apple Inc. The first-listed action is a consolidated case combining two cases previously pending under the names Charoensak v. Apple Computer Inc. (formerly Slattery v. Apple Computer Inc.) and Tucker v. +Apple Computer, Inc . The original plaintiff (Slattery) in the Charoensak case filed a purported class action on January 3, 2005 in the United States District Court for the Northern District of California alleging various claims including +alleged unlawful tying of music purchased on the iTunes Store with the purchase of iPods and unlawful acquisition or maintenance of monopoly market power. Plaintiff’s complaint alleged violations of §§1 and 2 of the Sherman Act (15 +U.S.C. §§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California Business & Professions Code §17200 (unfair competition), common law unjust enrichment and common law +monopolization. Plaintiff sought unspecified damages and other relief. The Company filed a motion to dismiss on February 10, 2005. On September 9, 2005, the Court denied the motion in part and granted it in part. Plaintiff filed an amended +complaint on September 23, 2005 and the Company filed an answer on October 18, 2005. In August 2006, the Court dismissed Slattery without prejudice and allowed plaintiffs to file an amended complaint naming two new plaintiffs (Charoensak +and Rosen). On November 2, 2006, the Company filed an answer to the amended complaint denying all material allegations and asserting numerous affirmative defenses. The Tucker case was filed as a purported class action on July 21, 2006 in the United States District Court for the Northern District of California alleging various claims including alleged unlawful +tying of music and videos purchased on the iTunes Store with the purchase of iPods and vice versa and unlawful acquisition or maintenance of monopoly market power. The complaint alleges violations of §§1 and 2 of the Sherman Act (15 U.S.C. +§§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California Business & Professions Code §17200 (unfair competition) and the California Consumer Legal Remedies Act. +Plaintiff sought unspecified damages and other relief. On November 3, 2006, the Company filed a motion to dismiss the complaint. On December 20, 2006, the Court denied the motion to dismiss. On January 11, 2007, the Company filed an +answer denying all material allegations and asserting numerous defenses. On March 20, 2007, the Court consolidated the +two cases. Plaintiffs filed a consolidated complaint on April 19, 2007. On June 6, 2007, the Company filed an answer to the consolidated complaint denying all material allegations and asserting numerous affirmative defenses. On +July 17, 2008, plaintiffs filed a motion for class certification and on October 17, 2008, the Company filed its opposition to plaintiffs’ motion. The class certification hearing took place on December 16, 2008. On +December 22, 2008, the Court granted certification of the monopolization claims and denied without prejudice certification of the tying claims pending reconsideration of its denial of the Company’s motion to dismiss. On February 13, +2009, the Company filed a motion for judgment on the pleadings as to plaintiffs’ tying claims. On May 15, 2009, the Court issued an order granting the Company’s motion in part, dismissing the federal per se tying claim and related +state court tying claims and inviting the Company to file another motion for judgment on the pleadings if plaintiffs pursue a rule of reason 30 Table of Contents tying claim. On July 17, 2009, the Court invited the Company to file a motion for reconsideration of the certification of an injunctive-relief class or a motion to strike plaintiffs’ +prayer for the type of injunctive relief sought. On August 3, 2009, the Company filed a motion for judgment on the pleadings as to the plaintiffs’ Rule of Reason tying claim. On August 31, 2009, the Company filed a motion seeking +reconsideration and denial of an injunctive relief class. The Company also filed a motion seeking decertification of the Rule 23(b)(3) damages class or alternatively for leave to move for reconsideration. A hearing on the Company’s motion for +judgment on the pleadings as to plaintiffs’ Rule of Reason tying claim took place on October 5, 2009. A related +complaint, Somers v. Apple Inc ., was filed on December 31, 2007 in the United States District Court for the Northern District of California on behalf of a purported class of indirect purchasers, alleging various claims including alleged +unlawful tying of music and videos purchased on the iTunes Store with the purchase of iPods and vice versa and unlawful acquisition or maintenance of monopoly market power. The complaint alleges violations of §§1 and 2 of the Sherman Act +(15 U.S.C. §§1 and 2), California Business & Professions Code §16700 et seq. (the Cartwright Act), California Business & Professions Code §17200 (unfair competition), the California Consumer Legal Remedies Act +and California monopolization law. Plaintiff seeks unspecified damages and other relief. On February 21, 2008, the Company filed an answer denying all material allegations and asserting numerous defenses. On February 23, 2009, plaintiff +filed a motion for class certification and on April 20, 2009, the Company filed its opposition to that motion. An evidentiary hearing on the class certification motion took place on June 30, 2009. On July 17, 2009, the Court denied +certification of plaintiff’s damage claims and deferred ruling on certification of plaintiff’s injunctive claims pending resolution of the additional briefing requested by the Court, which is described above. Tse v. Apple Computer, Inc. et al. Plaintiff Ho Keung Tse filed this action against the Company and other defendants on August 5, 2005 in the United States District Court for the District of Maryland alleging infringement of U.S. +Patent No. 6,665,797 entitled “Protection of Software Again [sic] Against Unauthorized Use.” The complaint seeks unspecified damages and other relief. The Company filed an answer on October 31, 2005 denying all material +allegations and asserting numerous affirmative defenses. On October 28, 2005, the Company and the other defendants filed a motion to transfer the case to the Northern District of California, which was granted on August 31, 2006. On +July 24, 2007, the Company filed a petition for reexamination of the patent, which the U.S. Patent and Trademark Office granted. On July 25, 2007, the Company filed a motion to stay the litigation pending the outcome of the reexamination, +which the Court granted on October 4, 2007. On July 21, 2009, the U.S. Patent and Trademark Office issued a final Office Action rejecting all asserted claims except for claim 16. On September 20, 2009, plaintiff filed a Notice of +Appeal to the Board of Patent Appeals and Interferences from the final Office Action. The Court action remains stayed pending plaintiff’s appeal. Vitt v. Apple Computer, Inc. Plaintiff filed this purported class action +on November 7, 2006 in the United States District Court for the Central District of California on behalf of a purported nationwide class of all purchasers of the iBook G4 alleging that the computer’s logic board fails at an abnormally high +rate. The complaint alleges violations of California Business & Professions Code §17200 (unfair competition) and California Business & Professions Code §17500 (false advertising). Plaintiff seeks unspecified damages and +other relief. The Company filed a motion to dismiss on January 19, 2007, which the Court granted on March 13, 2007. Plaintiffs filed an amended complaint on March 26, 2007. The Company filed a motion to dismiss on August 16, +2007, which was heard on October 4, 2007. The Court has not yet issued a ruling. Vogel v. Jobs et al. (2006 Action) Plaintiffs filed this purported class action on August 24, 2006, in the United States District Court for the Northern +District of California against the Company and certain of the Company’s current and former officers and 31 Table of Contents directors alleging improper backdating of stock option grants to maximize certain defendants’ profits, failing to properly account for those grants and issuing false financial statements. On +January 19, 2007, the Court appointed the New York City Employees’ Retirement System as lead plaintiff. On March 23, 2007, plaintiffs filed a Consolidated Class Action Complaint. The Consolidated Complaint purports to +be brought on behalf of several classes of holders of the Company’s stock and asserts claims under Section 14(a) and 20(a) of the Exchange Act as well as state law. The Consolidated Complaint seeks rescission of amendments to +various stock option and other incentive compensation plans, an accounting and damages in an unspecified amount. Defendants filed a motion to dismiss on June 8, 2007, which was heard on September 7, 2007. On November 14, 2007, the +Court issued an order dismissing all securities claims with prejudice, and held that any amended complaint could only be styled as a derivative case. On December 14, 2007, plaintiff filed a motion for leave to file a first amended consolidated +class action complaint. On January 23, 2008, defendants filed an opposition to plaintiff’s motion. Plaintiff’s motion was heard on March 21, 2008. On May 14, 2008, the Court issued an order denying plaintiffs’ motion +for leave to amend. The court entered judgment dismissing the case on June 12, 2008. On June 17, 2008, plaintiffs filed a notice of appeal. A hearing on plaintiffs’ appeal took place on October 7, 2009. Vogel v. Apple Inc., et al. (2008 Action) Plaintiff filed this purported class action on June 27, 2008, in the United States District Court for the Northern District of California against the Company and certain of the Company’s current +and former officers and directors. The allegations, which arise out of the Company’s past stock option practices, are similar to those in the 2006 Vogel v. Jobs et al. action that was dismissed on June 12, 2008, as described above. +The complaint purports to be brought on behalf of several classes of holders of the Company’s stock and asserts claims under Sections 10(b) and 20(a) of the Exchange Act. The complaint seeks rescission of amendments to various stock option and +other incentive compensation plans, an accounting and damages in an unspecified amount. On July 22, 2008, the Court stayed this case pending the appeal in the 2006 Action. Item 4. Submission of Matters to a Vote of Security Holders None. 32 Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the over-the-counter market and is quoted on the NASDAQ Global Select Market under the symbol +AAPL and on the Frankfurt Stock Exchange under the symbol APCD. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest sales prices for the Company’s common stock +on the NASDAQ Global Select Market during each quarter of the two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2009 price range per common share $ 188.90 - $134.42 $ 146.40 - $102.61 $ 109.98 - $  78.20 $ 119.68 - $  79.14 Fiscal 2008 price range per common share $ 180.91 - $120.68 $ 192.24 - $142.52 $ 200.50 - $115.44 $ 202.96 - $150.63 Holders As of October 16, 2009, there were 30,573 shareholders of record. Dividends The Company did not declare or pay cash dividends in either 2009 or 2008. The Company anticipates that for the foreseeable +future it will retain any earnings for use in the operation of its business. Purchases of Equity Securities by the Issuer and Affiliated +Purchasers None. 33 Table of Contents Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Composite Index +and the S&P Computer Hardware Index. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Composite Index, and the S&P Computer Hardware Index on September 30, 2004. Data points on the graph +are annual. Note that historic stock price performance is not necessarily indicative of future stock price performance. September 2004 September 2005 September 2006 September 2007 September 2008 September 2009 Apple Inc. $ 100 $ 277 $ 397 $ 792 $ 587 $ 957 S&P 500 Composite +Index $ 100 $ 112 $ 124 $ 145 $ 113 $ 105 S&P Computer Hardware Index $ 100 $ 115 $ 123 $ 181 $ 152 $ 180 34 Table of Contents Item 6. Selected Financial Data The information set forth below for the five years ended September 26, 2009, is not necessarily indicative of results of future operations, and should be read in conjunction with Item 7, “Management’s Discussion and +Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the +information presented below (in millions, except share amounts which are reflected in thousands and per share amounts). 2009 2008 2007 2006 2005 Net sales $ 36,537 $ 32,479 $ 24,006 $ 19,315 $ 13,931 Net income $ 5,704 $ 4,834 $ 3,496 $ 1,989 $ 1,328 Earnings per common share: Basic $ 6.39 $ 5.48 $ 4.04 $ 2.36 $ 1.64 Diluted $ 6.29 $ 5.36 $ 3.93 $ 2.27 $ 1.55 Cash dividends declared per common share $ — $ — $ — $ — $ — Shares used in computing earnings per share: Basic 893,016 881,592 864,595 844,058 808,439 Diluted 907,005 902,139 889,292 877,526 856,878 Cash, cash equivalents and marketable securities $ 33,992 $ 24,490 $ 15,386 $ 10,110 $ 8,261 Total assets $ 53,851 $ 39,572 $ 25,347 $ 17,205 $ 11,516 Long-term debt $ — $ — $ — $ — $ — Total liabilities $ 26,019 $ 18,542 $ 10,815 $ 7,221 $ 4,088 Shareholders’ equity $ 27,832 $ 21,030 $ 14,532 $ 9,984 $ 7,428 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Forward-looking statements can also be identified by words +such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may +differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled “Risk Factors” above, which are +incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K. All information presented herein is based on the +Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. The Company assumes no +obligation to revise or update any forward-looking statements for any reason, except as required by law. Executive Overview The Company designs, manufactures, and markets personal computers, mobile communication devices, and portable digital +music and video players and sells a variety of related software, services, peripherals, and networking solutions. The Company’s products and services include the Mac line of desktop and portable computers, iPhone, the iPod line of portable +digital music and video players, Apple TV, Xserve, a portfolio of consumer and professional software applications, the Mac OS X operating system, third-party digital content and applications through the iTunes Store, and a variety of accessory, +service and support offerings. The Company sells its products worldwide through its online stores, its retail stores, its direct sales force, and third-party wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety +of third-party Mac, iPhone and iPod compatible products, including application software, printers, storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores. The Company sells to +consumer, small and mid-sized business (“SMB”), education, enterprise, government, and creative markets. 35 Table of Contents The Company is focused on providing innovative products and solutions to consumer, SMB, +education, enterprise, government and creative customers that greatly enhance their evolving digital lifestyles and work environments. The Company’s overall business strategy is to control the design and development of the hardware and software +for all of its products, including the personal computer, mobile communications and consumer electronics devices. The Company’s business strategy leverages its unique ability to design and develop its own operating system, hardware, application +software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative industrial design. The Company believes continual investment in research and development is critical to the +development and enhancement of innovative products and technologies. In conjunction with its strategy, the Company continues to build and host a robust platform for the discovery and delivery of third-party digital content and applications through +the iTunes Store. Most recently the Company launched the App Store that allows users to browse, search for, and purchase third-party applications through either a Mac or Windows-based computer or by wirelessly downloading directly to an iPhone or +iPod touch. The Company also desires to support a community for the development of third-party products that complement the Company’s offerings through its developer programs. The Company is therefore uniquely positioned to offer superior and +well-integrated digital lifestyle and productivity solutions. The Company participates in several highly competitive markets, +including personal computers with its Mac line of personal computers, mobile communications with iPhone, consumer electronics with its iPod product families, and distribution of third-party digital content and applications through its online iTunes +Store. While the Company is widely recognized as a leading innovator in the personal computer, mobile communications and consumer electronics markets as well as a leader in the emerging market for distribution of digital content and applications, +these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that increased investment in research and development and marketing and advertising is necessary to maintain or expand its position +in the markets where it competes. The Company’s research and development spending is focused on further developing its existing Mac line of personal computers, its operating system, application software, iPhone and iPods; developing new digital +lifestyle consumer and professional software applications; and investing in new product areas and technologies. The Company also believes increased investment in marketing and advertising programs is critical to increasing product and brand +awareness. The Company utilizes a variety of direct and indirect distribution channels. The Company believes that sales of +its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software, and peripheral integration, demonstrate the unique digital lifestyle solutions that are available on Mac +computers, and demonstrate the compatibility of the Mac with the Windows platform and networks. The Company further believes providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing +customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company continues to expand and improve its distribution capabilities by opening its own retail stores in the U.S. and in +international markets. The Company had 273 stores open as of September 26, 2009. The Company has also invested in +programs to enhance reseller sales, including the Apple Sales Consultant Program, which places Apple employees and contractors at selected third-party reseller locations, and the Apple Premium Reseller Program, through which independently run +businesses focus on the Apple platform and provide a high level of customer service and product expertise. The Company believes providing direct contact with its targeted customers is an efficient way to demonstrate the advantages of its Mac +computers and other products over those of its competitors. The Company also sells to customers directly through its online stores around the world and through its direct sales force. The Company distributes iPhone in over 80 countries, through its direct channels, its cellular network carriers’ distribution channels and certain third-party resellers. The +Company has signed multi-year agreements with various cellular network carriers authorizing them to distribute and provide cellular network services for iPhones. These agreements are generally not exclusive with a specific carrier, except in the +U.S., Germany, Spain, Ireland and certain other countries. 36 Table of Contents The Company’s iPods are sold through a significant number of distribution points to +provide broad access. iPods can be purchased in certain department stores, member-only warehouse stores, large retail chains and specialty retail stores, as well as through the channels for Mac distribution listed above. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its +financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of +Significant Accounting Policies” of Notes to Consolidated Financial Statements in this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. +Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and +liabilities. Actual results may differ from these estimates and such differences may be material. Management believes the +Company’s critical accounting policies and estimates are those related to revenue recognition, valuation of marketable securities, allowance for doubtful accounts, inventory valuation and inventory purchase commitments, warranty costs, income +taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments +and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net +sales consist primarily of revenue from the sale of hardware, software, third-party digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue for software products (operating system software and +applications software), or any product that is considered to be software-related, in accordance with industry specific accounting guidance for software and software related transactions (e.g., Mac computers, iPhones and iPod portable digital music +and video players). For products that are not software or software-related, (e.g., third-party digital content sold on the iTunes Store and certain Mac, iPhone and iPod supplies and accessories), the Company recognizes revenue pursuant to various +revenue-related GAAP as described below. The Company recognizes revenue when persuasive evidence of an arrangement exists, +delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s +product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers recognition of revenue until the customer +receives the product because the Company retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or is presumed not to be, fixed or determinable, +revenue is deferred and subsequently recognized as amounts become due and payable and all other criteria for revenue recognition have been met. For both iPhone and Apple TV, the Company has indicated it may from time-to-time provide future unspecified features and additional software products free of charge to customers. Accordingly, iPhone +handsets and Apple TV sales are accounted for under subscription accounting in accordance with GAAP. As such, the revenue and associated cost of sales are deferred at the time of sale, and are both recognized on a straight-line basis over the +currently estimated 24-month economic lives of these products, with any loss recognized at the time of sale. If the Company’s estimated economic life of a product accounted for under subscription accounting changes, the 37 Table of Contents future rate at which deferred revenue and deferred costs are recognized in the Company’s results of operations will change. Costs incurred by the Company for engineering, sales, marketing +and warranty are expensed as incurred. The Company records reductions to revenue for estimated commitments related to price +protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to +be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not +recognized until reliable estimates can be made or the price protection lapses. For customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at +which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase +customer incentive programs and incur incremental price protection obligations that could result in additional reductions to revenue at the time such programs are offered. Additionally, certain customer incentive programs require management to +estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of +customers redeem such incentives, the Company would be required to record additional reductions to revenue, which would have a negative impact on the Company’s results of operations. Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of investments are included in accumulated +other comprehensive income, net of tax, as reported in the Company’s Consolidated Balance Sheets. Changes in the fair value of investments impact the Company’s net income only when such investments are sold or an other-than-temporary +impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any investment is +other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns, which would require the Company to record an impairment charge in the period any such determination is made. In making this judgment, the Company +evaluates, among other things, the duration and extent to which the fair value of an investment is less than its cost, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely +than not it will be required to sell, the investment before recovery of the investment’s amortized cost basis. The Company’s assessment on whether an investment is other-than-temporarily impaired or not, could change in the future due to +new developments or changes in assumptions related to any particular investment. Allowance for Doubtful Accounts The Company distributes its products through third-party distributors, cellular network carriers, and resellers and directly to certain +education, consumer, and enterprise customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible the Company does +attempt to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe, Asia, and Australia, or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing +arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit-risk-sharing related to any of these arrangements. However, considerable trade +receivables that are not covered by collateral, third-party financing arrangements, or credit insurance are outstanding with the Company’s distribution and retail channel partners. 38 Table of Contents The allowance for doubtful accounts is based on management’s assessment of the ability +to collect specific customer accounts and includes consideration of the credit-worthiness and financial condition of those specific customers. The Company records an allowance to reduce the specific receivables to the amount that it reasonably +believes to be collectible. The Company also records an allowance for all other trade receivables based on multiple factors, including historical experience with bad debts, the general economic environment, the financial condition of the +Company’s distribution channels, and the aging of such receivables. If there is a deterioration of a major customer’s financial condition, if the Company becomes aware of additional information related to the credit-worthiness of a major +customer, or if future actual default rates on trade receivables in general differ from those currently anticipated, the Company may have to adjust its allowance for doubtful accounts, which would affect its results of operations in the period the +adjustments are made. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and products, +including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each fiscal quarter that considers multiple factors +including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The personal computer, mobile communications and consumer electronics industries are subject to a rapid and +unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the +utility of component inventory, the Company may be required to record additional write-downs, which would negatively affect its results of operations in the period when the write-downs were recorded. The Company records accruals for estimated cancellation fees related to component orders that have been cancelled or are expected to be +cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company’s +requirements for periods ranging from 30 to 150 days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products or an unanticipated change in technological requirements for any of the Company’s +products, the Company may be required to record additional accruals for cancellation fees that would negatively affect its results of operations in the period when the cancellation fees are identified and recorded. Warranty Costs The Company +provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product +failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to +warranty protection and adjusts the amounts as necessary. For products accounted for under subscription accounting, the Company recognizes warranty expense as incurred. If actual product failure rates or repair costs differ from estimates, +revisions to the estimated warranty liability would be required and could materially affect the Company’s results of operations. The Company periodically provides updates to its applications and operating system software to maintain the software’s compliance with specifications. The estimated cost to develop such updates is accounted for as warranty cost that is +recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units delivered, the number of updates expected to occur, and the historical cost and +estimated future cost of the resources necessary to develop these updates. 39 Table of Contents Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In accordance with GAAP, the provision for income taxes is computed using the asset and +liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and +tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company +records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes and measures uncertain tax positions in accordance with GAAP, whereby the Company only recognizes the tax benefit from an uncertain tax position if it is more likely than not that the tax position will be sustained on +examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood +of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including +income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred tax assets. In the event that the Company +determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the +calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations +could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Note 8, +“Commitments and Contingencies” in Notes to Consolidated Financial Statements, the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. In accordance with GAAP, the Company records a +liability when it is probable that a loss has been incurred and the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be reasonably estimated. In +management’s opinion, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate materially adversely affect its financial condition or operating results. +However, the outcomes of legal proceedings and claims brought against the Company are subject to significant uncertainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against +the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. Net Sales Fiscal years 2009, 2008 and 2007 spanned 52 weeks. An additional week is included in the first +fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. 40 Table of Contents The following table summarizes net sales and Mac unit sales by operating segment and net +sales and unit sales by product during the three years ended September 26, 2009 (in millions, except unit sales in thousands and per unit amounts): 2009 Change 2008 Change 2007 Net Sales by Operating Segment: Americas net sales $ 16,142 11% $ 14,573 26% $ 11,596 Europe net sales 9,365 23% 7,622 40% 5,460 Japan net sales 1,831 21% 1,509 39% 1,082 Retail net sales 6,574 4% 6,315 53% 4,115 Other Segments net sales (a) 2,625 7% 2,460 40% 1,753 Total net sales $ 36,537 12% $ 32,479 35% $ 24,006 Mac Unit Sales by Operating Segment: Americas Mac unit sales 4,120 4% 3,980 32% 3,019 Europe Mac unit sales 2,840 13% 2,519 39% 1,816 Japan Mac unit sales 395 2% 389 29% 302 Retail Mac unit sales 2,115 4% 2,034 47% 1,386 Other Segments Mac unit sales (a) 926 17% 793 50% 528 Total Mac unit sales 10,396 7% 9,715 38% 7,051 Net Sales by Product: Desktops (b) $ 4,308 (23)% $ 5,603 39% $ 4,020 Portables (c) 9,472 9% 8,673 38% 6,294 Total Mac net sales 13,780 (3)% 14,276 38% 10,314 iPod 8,091 (12)% 9,153 10% 8,305 Other music related products and services (d) 4,036 21% 3,340 34% 2,496 iPhone and related products and services (e) 6,754 266% 1,844 NM 123 Peripherals and other hardware (f) 1,470 (11)% 1,659 32% 1,260 Software, service and other sales (g) 2,406 9% 2,207 46% 1,508 Total net sales $ 36,537 12% $ 32,479 35% $ 24,006 Unit Sales by Product: Desktops (b) 3,182 (14)% 3,712 37% 2,714 Portables (c) 7,214 20% 6,003 38% 4,337 Total Mac unit sales 10,396 7% 9,715 38% 7,051 Net sales per Mac unit sold (h) $ 1,326 (10)% $ 1,469 —% $ 1,463 iPod unit sales 54,132 (1)% 54,828 6% 51,630 Net sales per iPod unit sold (i) $ 149 (11)% $ 167 4% $ 161 iPhone unit sales 20,731 78% 11,627 NM 1,389 (a) Other Segments include Asia Pacific and FileMaker. (b) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (c) Includes MacBook, MacBook Air and MacBook Pro product lines. (d) Consists of iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (e) Derived from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (f) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. 41 Table of Contents (g) Includes sales of Apple-branded operating system and application software, third-party software, AppleCare and Internet services. (h) Derived by dividing total Mac net sales by total Mac unit sales. (i) Derived by dividing total iPod net sales by total iPod unit sales. NM = Not Meaningful Fiscal Year 2009 versus 2008 Net sales during 2009 increased $4.1 billion or 12% compared to 2008. Several factors contributed positively to these increases, including +the following: • iPhone revenue and net sales of related products and services amounted to $6.8 billion in 2009, an increase of $4.9 billion or 266% compared to +2008. iPhone handset unit sales totaled 20.7 million during 2009, which represents an increase of 9.1 million or 78% during 2009 compared to 2008. This growth is attributed primarily to expanded distribution and strong overall demand for +iPhones. iPhone 3GS was released in the U.S. on June 19, 2009 and in many other countries over the remainder of 2009. iPhone revenue includes the portion of handset revenue recognized in the relevant period in accordance with subscription +accounting over the product’s currently estimated 24-month economic life, as well as revenue from sales of iPhone accessories and carrier agreements. The year-over-year iPhone revenue growth is also largely attributable to the year-over-year +increase in iPhone handset unit sales in both 2009 and 2008, which generated significant amounts of deferred revenue that is being recognized over the iPhone’s estimated economic life. • Net sales of other music-related products and services increased $696 million or 21% during 2009 compared to 2008. The increase was due +predominantly to increased net sales of third-party digital content and applications from the iTunes Store, which experienced double-digit growth in each of the Company’s geographic segments during 2009 compared to the same period in 2008. The +Company believes this continued growth is the result of heightened consumer interest in downloading third-party digital content and applications, continued growth in its customer base of iPod and iPhone customers, the expansion of third-party audio +and video content available for sale and rent via the iTunes Store, and the continued interest in and growth of the App Store. The Company continues to expand its iTunes content and applications offerings around the world. Partially offsetting the favorable factors discussed above, net sales during 2009 were negatively impacted +by certain factors, including the following: • Mac net sales declined 3% during 2009 compared to 2008, although Mac unit sales increased by 7% over the same period. Net sales per Mac unit sold +decreased by 10% during 2009 compared to 2008, due primarily to lower average selling prices across all Mac portable and desktop systems and a stronger U.S. dollar. Net sales of Macs accounted for 38% of the Company’s total net sales for 2009. +During 2009, Mac portable systems net sales and unit sales increased by 9% and 20%, respectively, compared to 2008. This growth was driven by strong demand for MacBook Pro, which was updated in June 2009 and October 2008, and experienced double +digit net sales and unit growth in each of the Company’s reportable operating segments compared to the same period in 2008. The Company also had a higher product mix of portable systems, which is consistent with the overall market trends. +However, net sales and unit sales of the Company’s Mac desktop systems decreased by 23% and 14%, respectively, during 2009 compared to 2008. The decrease in net sales of Mac desktop systems was due mainly to a shift in product mix towards +lower-priced desktops, lower average selling prices across all Mac desktop systems and a stronger U.S. dollar. • Net sales of iPods decreased $1.1 billion or 12% during 2009 compared to 2008. iPod unit sales decreased slightly by 1% during 2009 compared to +2008. Net sales per iPod unit sold decreased 11% to $149 in 2009 compared to 2008, resulting from lower average selling prices across all of the iPod product lines, which were due primarily to price reductions taken with the introduction of new +iPods in 42 Table of Contents September 2009 and September 2008 and a stronger U.S. dollar, offset partially by a higher product mix of iPod touch. Fiscal Year 2008 versus 2007 Net sales during 2008 increased 35% or $8.5 billion from 2007. Several factors contributed to these increases including the following: • Mac net sales increased $4.0 billion or 38% during 2008 compared to 2007, while Mac unit sales increased by 2.7 million units or 38%. Net sales +related to the Company’s Mac shipments accounted for 44% of the Company’s total net revenue. Higher Mac unit sales, which contributed to the increases in net sales, were driven by higher sales of all of the Company’s Mac portable +products as well as the popularity of the iMac, which experienced strong growth in net sales and unit sales in all of the Company’s reportable segments. Unit sales of the Company’s Mac portable products accounted for 62% of the +Company’s personal computer shipments in both 2008 and 2007. Net sales and unit sales of the Company’s Mac portable products both increased by 38% during 2008 compared to 2007. This growth was attributable to strong demand for all the Mac +portable products, particularly the MacBook, which had double-digit growth in all of the Company’s operating segments, and the addition of the MacBook Air, which was introduced to the Company’s Mac portable product line in January 2008. +Growth of the Company’s Mac desktop systems was also strong, with increased net sales and unit sales of 39% and 37%, respectively, during 2008 due primarily to strong sales of the iMac in all of the Company’s operating segments. • Net sales of iPods increased $848 million or 10% during 2008 compared to 2007 whereas unit sales of iPods increased 6% compared to 2007. The iPod +unit growth was due to strong demand for the iPod touch, and to a lesser extent, higher unit sales of the iPod shuffle due to a price reduction in February 2008. iPod net sales grew faster than iPod unit sales due to higher average selling prices +caused by a shift in overall iPod product mix to the higher priced iPod touch. • Net sales of iPhone and related products and services were $1.8 billion for 2008, with iPhone handset unit sales totaling 11.6 million. Net sales of +iPhone and related products and services were $123 million in 2007, which represented sales for one fiscal quarter. iPhone revenue includes the portion of handset revenue recognized in the relevant period in accordance with subscription accounting +over the product’s currently estimated 24-month economic life, as well as revenue from sales of iPhone accessories and from carrier agreements. • Net sales of other music related products and services increased $844 million or 34% during 2008 compared to 2007, due primarily to significantly +increased net sales from the iTunes Store in each of the Company’s geographic segments. The Company believes this success is the result of heightened consumer interest in downloading third-party digital content, the expansion of third-party +audio and video content available for sale and rent via the iTunes Store, and the launch of the iTunes App Store. The Company continues to expand its iTunes content offerings around the world. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Japan and Retail. The Americas, Europe and Japan reportable segments do not include +activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries as well as the Middle East and Africa. The Retail segment operates Apple-owned retail stores in the +U.S. and in international markets. Each reportable geographic operating segment and the Retail operating segment provide similar hardware and software products and similar services. Further information regarding the Company’s operating segments +may be found in Note 9, “Segment Information and Geographic Data” in Notes to Consolidated Financial Statements of this Form 10-K. 43 Table of Contents Americas During 2009, net sales in the Americas segment increased $1.6 billion or 11% compared to 2008. The increase in net sales during 2009 was attributable to the significant year-over-year increase in iPhone +revenue, higher sales of third-party digital content and applications from the iTunes Store, and increased sales of Mac portable systems, which were partially offset by a decrease in sales of Mac desktop systems and iPods. Americas Mac net sales +decreased 6% due primarily to lower average selling prices, while Mac unit sales increased by 4% on a year-over-year basis. The increase in Mac unit sales was due primarily to strong demand for the MacBook Pro, which was updated in June 2009 and +October 2008. The Americas segment represented approximately 44% and 45% of the Company’s total net sales in 2009 and 2008, respectively. During 2008, net sales in the Americas segment increased $3.0 billion or 26% compared to 2007. The primary drivers of this growth were the significant year-over-year increase in sales of the iPod touch, +Mac portable systems, content from the iTunes Store, and iPhone. The Company began shipping iPhone in June 2007 and the growth in iPhone sales in 2008 resulted from a full year of iPhone shipments as well as stronger demand for iPhones in the fourth +quarter of 2008. The increase in Mac net sales of $1.3 billion or 30% and Mac unit sales of 961 million or 32% is attributable to growth in sales of all of the Mac portable systems, particularly the MacBook, and higher sales of the iMac. Net +sales of iPods increased due to a shift in product mix toward higher priced iPods, particularly the iPod touch, which was upgraded in June 2008. In 2008, the Americas segment represented 45% of the Company’s total net sales as compared to 48% +in the same period of 2007. Europe During 2009, net sales in Europe increased $1.7 billion or 23% compared to 2008. The increase in net sales was due mainly to increased iPhone revenue and Mac portable systems, offset partially by lower +net sales of Mac desktop systems, iPods, and a stronger U.S. dollar. Mac unit sales increased 13% in 2009 compared to 2008, which was driven primarily by increased sales of Mac portable systems, particularly MacBook Pro, while total Mac net sales +declined as a result of lower average selling prices across all Mac products. Although iPod net sales decreased in Europe year-over-year as a result of lower average selling prices, iPod unit sales increased due to iPod touch and market share +increases. The Europe segment represented 26% and 23% of total net sales in 2009 and 2008, respectively. Europe’s net +sales and Mac unit sales increased 40% and 39%, respectively, during 2008 compared to 2007. The main drivers of this growth were strong sales of Mac portable systems and iMac, increased sales from the iTunes Store, and iPhone. Also contributing to +the increase in net sales were higher iPod net sales due primarily to the iPod touch, which was upgraded in June 2008. Sales of Mac portable products increased due to stronger demand for the MacBook Pro and the MacBook, both updated in February +2008, as well as sales of the MacBook Air, introduced in January 2008. Mac desktop sales also increased due primarily to the popularity of the iMac, which was updated in April 2008. The Europe segment represented 23% of total net sales in 2008, +consistent with 2007. Japan Japan’s net sales increased $322 million or 21% in 2009 compared to 2008. The key contributors to this growth were increased iPhone revenue, stronger demand for certain Mac portable systems and +iPods, and strength in the Japanese Yen, partially offset by decreased sales of Mac desktop systems. Net sales and unit sales of Mac portable systems increased during 2009 compared to 2008, driven primarily by stronger demand for MacBook Pro, which +was updated in June 2009 and October 2008. Net sales and unit sales of iPods increased during 2009 compared to 2008, driven by strong demand for iPod touch and iPod nano. Japan net sales increased $427 million or 39% in 2008 compared to 2007. The primary contributors to the growth in net sales were increases in sales of iPods, iMac, Mac portable systems, and strong sales +from the iTunes Store. Net sales, unit sales and the average selling price of iPods increased during 2008 compared to 2007, driven by 44 Table of Contents strong demand for iPod touch and iPod nano. Additionally, Mac net sales and unit sales grew 42% and 29%, respectively, in 2008 compared to 2007 due to increases in sales of iMac and Mac portable +systems, particularly MacBook, as well as the introduction of MacBook Air in January 2008. Retail Retail net sales increased $259 million or 4% during 2009 compared to 2008. The growth in net sales was driven largely by increased iPhone +revenue and Mac portable systems, offset partially by a decrease in sales of iPods and Mac desktop systems. The Company opened 26 new retail stores during 2009, including a total of 14 international stores, ending the year with 273 stores open. This +compares to 247 stores open as of September 27, 2008 and 197 open stores as of September 29, 2007. The +year-over-year growth rate of Retail net sales was less than the increase in the average number of stores open during the same period, which the Company believes reflects the challenging consumer-spending environment and continued third-party +channel expansion, particularly in the U.S. where most of its stores are located. With an average of 254 stores and 211 stores opened during 2009 and 2008, respectively, average revenue per store decreased to $25.9 million for 2009 from $29.9 +million in 2008. The Retail segment’s net sales grew by 53% during 2008 compared to 2007, due in large part to increased +sales of Mac portable and desktop systems, strong demand for the iPhone and iPod touch, and new store openings. The Company opened 50 new retail stores during 2008, bringing the total number of open stores to 247 as of September 27, 2008. This +compares to 197 open stores as of September 29, 2007. With an average of 211 stores and 178 stores opened during 2008 and 2007, respectively, average revenue per store increased to $29.9 million for 2008 from $23.1 million in 2007. As measured by the Company’s operating segment reporting, the Retail segment reported operating income of $1.4 billion during 2009, +as compared to operating income of $1.3 billion and $875 million during 2008 and 2007, respectively. This increase in operating income in 2009 was driven by increased total Retail net sales attributable to a 20% increase in average stores open and +higher gross margin percentage consistent with that experienced Company-wide. The Retail segment’s operating income increased by $462 million during 2008 as compared to 2007 due primarily to the significant Retail net sales growth of 53% as +compared to 2007. Expansion of the Retail segment has required and will continue to require a substantial investment in fixed +assets and related infrastructure, operating lease commitments, personnel, and other operating expenses. Capital asset purchases associated with the Retail segment were $369 million in 2009, bringing the total capital asset purchases since inception +of the Retail segment to $1.8 billion. As of September 26, 2009, the Retail segment had approximately 16,500 full-time equivalent employees and had outstanding operating lease commitments associated with retail store space and related +facilities of $1.5 billion. The Company would incur substantial costs if it were to close multiple retail stores. Such costs could adversely affect the Company’s financial condition and operating results. Other Segments The +Company’s Other Segments, which consist of its Asia Pacific and FileMaker operations, experienced an increase in net sales of $165 million, or 7%, during 2009 as compared to 2008 reflecting strong growth in sales of iPhone and Mac portable +systems offset partially by a decline in sales related to iPods and Mac desktop systems in the Asia Pacific region, as well as a strengthening of the U.S. dollar against the Australian dollar and other Asian currencies. Mac net sales and unit sales +grew in the Asia Pacific region by 4% and 17%, respectively, due to increased sales of the MacBook Pro. The Company’s +Other Segments experienced an increase in net sales of $707 million, or 40% during 2008 as compared to 2007. These increases are related primarily to strong growth in sales of all Mac portable systems, 45 Table of Contents iPods, the iMac, and content from the iTunes Store in the Company’s Asia Pacific region. Sales from the iTunes Store in the Company’s Asia Pacific region grew 109% compared to 2007. Gross Margin Gross margin for the three years ended September 26, 2009, are as follows (in millions, except gross margin percentages): 2009 2008 2007 Net sales $ 36,537 $ 32,479 $ 24,006 Cost of sales 23,397 21,334 15,852 Gross margin $ 13,140 $ 11,145 $ 8,154 Gross margin percentage 36.0% 34.3% 34.0% The gross margin percentage in 2009 was 36.0% compared to 34.3% in 2008. The primary +drivers of the increase in 2009 as compared to 2008 were significantly lower commodity and other product costs and a favorable sales mix toward products with higher gross margins, which were partially offset by product price reductions. Gross margin +percentage was relatively flat in 2008 as compared to 2007. The Company expects its gross margin percentage to decrease in +future periods compared to levels achieved during 2009 and anticipates gross margin levels of about 34% in the first quarter of 2010. This expected decline is due largely to the anticipated impact of product transitions, flat or reduced pricing on +new and innovative products that have higher cost structures, and both expected and potential future cost increases for key components. The foregoing statements regarding the Company’s expected gross margin percentage are forward-looking and could differ from anticipated levels because of several factors, including but not limited to +certain of those set forth below in Part I, Item 1A, “Risk Factors” under the subheading “ Future operating results depend upon the Company’s ability to obtain key components including but not limited to microprocessors, +NAND flash memory, DRAM and LCDs at favorable prices and in sufficient quantities ,” which is incorporated herein by reference. There can be no assurance that targeted gross margin percentage levels will be achieved. In general, gross +margins and margins on individual products will remain under downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product +transitions and expected increases in the cost of key components including but not limited to microprocessors, NAND flash memory, dynamic random access memory (“DRAM”) and liquid crystal displays (“LCDs”), as well as potential +increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to these competitive pressures, the Company expects it will continue to take +product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due +to the Company’s significant international operations, financial results can be significantly affected in the short-term by fluctuations in exchange rates. Operating Expenses Operating expenses for the three years ended +September 26, 2009, are as follows (in millions, except for percentages): 2009 2008 2007 Research and development $ 1,333 $ 1,109 $ 782 Percentage of net sales 3.6% 3.4% 3.3% Selling, general and administrative $ 4,149 $ 3,761 $ 2,963 Percentage of net sales 11.4% 11.6% 12.3% 46 Table of Contents Research and Development (“R&D”) R&D expenditures increased 20% or $224 million to $1.3 billion in 2009 compared to 2008. These increases were due primarily to an +increase in headcount and higher stock-based compensation expenses in the current year to support expanded R&D activities. In addition, $71 million of software development costs were capitalized related to Mac OS X Snow Leopard and excluded from +R&D expense during 2009, compared to $11 million of software development costs capitalized during 2008. Although total R&D expense increased 20% during 2009, it remained relatively flat as a percentage of net sales given the 12% increase in +revenue in 2009. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are +central to the Company’s core business strategy. As such, the Company expects to make further investments in R&D to remain competitive. Expenditures for R&D increased 42% or $327 million to $1.1 billion in 2008 compared to 2007. These increases were due primarily to an increase in headcount in 2008 and higher stock-based compensation +expenses. In 2008, $11 million of software development costs were capitalized related to Mac OS X Snow Leopard and excluded from R&D expense, while R&D expense for 2007 excluded $75 million of capitalized software development costs related +to Mac OS X Leopard and iPhone software. Although total R&D expense increased 42% during 2008, it remained relatively flat as a percentage of net sales given the 35% increase in revenue during 2008. Selling, General and Administrative Expense (“SG&A”) SG&A expenditures increased $388 million or 10% to $4.1 billion in 2009 compared to 2008. These increases are due primarily to the Company’s continued expansion of its Retail segment in both +domestic and international markets, higher stock-based compensation expenses and higher spending on marketing and advertising. Expenditures for SG&A increased $798 million or 27% to $3.8 billion in 2008 compared to 2007. These increases are due primarily to higher stock-based compensation expenses, higher variable selling expenses resulting from the significant +year-over-year increase in total net sales and the Company’s continued expansion of its Retail segment in both domestic and international markets. In addition, the Company incurred higher spending on marketing and advertising during 2008 +compared to 2007. Other Income and Expense Other income and expense for the three years ended September 26, 2009, are as follows (in millions): 2009 2008 2007 Interest income $ 407 $ 653 $ 647 Other income (expense), net (81 ) (33 ) (48 ) Total other income and expense $ 326 $ 620 $ 599 Total other income and expense decreased $294 million or 47% to $326 million during +2009 compared to $620 million and $599 million in 2008 and 2007, respectively. The overall decrease in other income and expense is attributable to the significant decline in interest rates during 2009 compared to 2008 and 2007, partially offset by +the Company’s higher cash, cash equivalents and marketable securities balances. The weighted average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.43%, 3.44% and 5.27% during 2009, 2008 and +2007, respectively. During 2009, 2008 and 2007, the Company had no debt outstanding and accordingly did not incur any related interest expense. The Company’s investment portfolio had gross unrealized losses of $16 million and $121 million as of September 26, 2009 and September 27, 2008, respectively, which were offset by gross +unrealized gains of $73 million and $4 million as of September 26, 2009 and September 27, 2008, respectively. The net unrealized gains 47 Table of Contents as of September 26, 2009 and the net unrealized losses as of September 27, 2008 related primarily to long-term marketable securities. The Company considers the declines in market value +of its marketable securities investment portfolio to be temporary in nature. The unrealized losses on the Company’s marketable securities were caused primarily by changes in market interest rates, specifically widening credit spreads. The +Company does not have the intent to sell, nor is it more likely than not the Company will be required to sell, any investment before recovery of its amortized cost basis. Accordingly, no material declines in fair value were recognized in the +Company’s Consolidated Statements of Operations during 2009, 2008 and 2007. The Company may sell certain of its marketable securities prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for +duration management. The Company recognized no material net gains or losses during 2009, 2008 and 2007 related to such sales. Provision +for Income Taxes The Company’s effective tax rates were 29%, 30% and 30% for 2009, 2008 and 2007, respectively. The +Company’s effective rates for these periods differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be +indefinitely reinvested outside the U.S. As of September 26, 2009, the Company had deferred tax assets arising from +deductible temporary differences, tax losses, and tax credits of $3.2 billion before being offset against certain deferred liabilities of $1.8 billion for presentation on the Company’s Consolidated Balance Sheet. Management believes it is more +likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with the tax effects of the deferred tax liabilities, will be sufficient to fully recover the remaining deferred +tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and amount of the valuation allowance. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s federal income tax returns for the years 2002 through 2003 and proposed certain adjustments. The +Company has contested certain of these adjustments through the IRS Appeals Office. All IRS audit issues for years prior to 2002 have been resolved. In addition, the Company is subject to audits by state, local, and foreign tax +authorities. Management believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the +Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Recent Accounting Pronouncements In September 2009, the Financial Accounting Standards Boards (“FASB”) amended the Accounting Standards Codification (“ASC”) as summarized in Accounting Standards Update (“ASU”) 2009-14, Software (Topic 985): +Certain Revenue Arrangements That Include Software Elements , and ASU 2009-13, Revenue Recognition (Topic 605): Multiple-Deliverable Revenue Arrangements . As summarized in ASU 2009-14, ASC Topic 985 has been amended to remove from the +scope of industry specific revenue accounting guidance for software and software related transactions, tangible products containing software components and non-software components that function together to deliver the product’s essential +functionality. As summarized in ASU 2009-13, ASC Topic 605 has been amended (1) to provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and the consideration allocated; +(2) to require an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence (“VSOE”) or third-party evidence of selling price; and +(3) to eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method. The accounting changes summarized in ASU 2009-14 and ASU 2009-13 are both effective for fiscal years beginning on +or after June 15, 2010, with early adoption permitted. Adoption may either be on a prospective basis or by retrospective application. 48 Table of Contents The Company is currently assessing the impact of these amendments to the ASC on its +accounting and reporting systems and processes; however, at this time the Company is unable to quantify the impact on its financial statements of its adoption or determine the timing and method of its adoption. As of September 26, 2009, total +iPhone and Apple TV deferred revenue and deferred costs were $12.1 billion and $5.2 billion, respectively. The Company believes that application of these amendments will result in a substantial portion of the revenue associated with the sale of +iPhone and Apple TV and all related cost of sales being recognized at the time of sale. Currently revenue and associated cost of sales for these products are deferred at the time of sale and recognized ratably on a straight-line basis over the +currently estimated 24-month economic life of the products. During the first quarter of 2009, the Company adopted FASB ASC +820, Fair Value Measurements and Disclosures (formerly referenced as Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements ) , which defines fair value, provides a framework for +measuring fair value, and expands the disclosures required for fair value measurements. In February 2008, the FASB issued supplemental guidance that delays the effective date of this new fair value accounting standard to fiscal years beginning after +November 15, 2008 for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) and will be adopted by the +Company beginning in the first quarter of 2010. Although the Company will continue to evaluate the application of this accounting standard, management does not currently believe adoption of this accounting pronouncement will have a material impact +on the Company’s financial condition or operating results. In December 2007, the FASB issued FASB ASC 805, Business +Combinations (formerly referenced as SFAS No. 141 (revised 2007), Business Combinations ), which establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets +acquired, the liabilities assumed, and any noncontrolling interest in the acquiree in a business combination. This new accounting standard also establishes principles regarding how goodwill acquired in a business combination or a gain from a bargain +purchase should be recognized and measured, as well as provides guidelines on the disclosure requirements on the nature and financial impact of the business combination. In April 2009, the FASB amended this new accounting standard to require that +assets acquired and liabilities assumed in a business combination that arise from contingencies be recognized at fair value, if the fair value can be determined during the measurement period. This new business combination accounting standard is +effective for fiscal years beginning on or after December 15, 2008 and will be adopted by the Company beginning in the first quarter of 2010 and will apply prospectively to any business combinations completed on or after that date. The effect +of adoption of this new accounting pronouncement on the Company’s financial condition or operating results will depend on the nature of acquisitions completed after the date of adoption. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the three years ended September 26, 2009 (in millions): 2009 2008 2007 Cash, cash equivalents and marketable securities $ 33,992 $ 24,490 $ 15,386 Accounts receivable, net $ 3,361 $ 2,422 $ 1,637 Inventories $ 455 $ 509 $ 346 Working capital $ 16,983 $ 18,219 $ 10,728 Annual operating cash flow $ 10,159 $ 9,596 $ 5,470 As of September 26, 2009, the Company had $34.0 billion in cash, cash +equivalents and marketable securities, an increase of $9.5 billion from September 27, 2008. The principal component of this net increase was the cash generated by operating activities of $10.2 billion, which was partially offset by payments for +acquisitions of property, plant and equipment of $1.1 billion. The Company’s cash generated by operating activities significantly exceeded its net income due primarily to the increase in deferred revenue, net of deferred costs, associated with +subscription accounting for iPhone. 49 Table of Contents The Company’s marketable securities investment portfolio is invested primarily in +highly rated securities, generally with a minimum rating of single-A or equivalent. As of September 26, 2009 and September 27, 2008, $17.4 billion and $11.3 billion, respectively, of the Company’s cash, cash equivalents and marketable +securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working +capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with its existing operations over the next 12 months. Capital Assets The Company’s cash payments for capital asset +purchases were $1.1 billion during 2009, consisting of $369 million for retail store facilities and $775 million for real estate acquisitions and corporate infrastructure including information systems enhancements. The Company anticipates utilizing +approximately $1.9 billion for capital asset purchases during 2010, including approximately $400 million for Retail facilities and approximately $1.5 billion for corporate facilities, infrastructure, and product tooling and manufacturing process +equipment. Historically the Company has opened between 25 and 50 new retail stores per year. During 2010, the Company expects +to open a number of new stores near the upper end of this range, over half of which are expected to be located outside of the U.S. Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions +with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any +other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company. The following table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 26, 2009 and excludes amounts already recorded on the +Consolidated Balance Sheet as current liabilities (in millions): Total Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Operating leases $ 1,922 $ 222 $ 462 $ 413 $ 825 Purchase obligations 4,783 4,783 — — — Asset retirement obligations 32 4 8 4 16 Other obligations 356 175 129 52 — Total $ 7,093 $ 5,184 $ 599 $ 469 $ 841 Lease Commitments As of September 26, 2009, the Company had total outstanding commitments on noncancelable operating leases of $1.9 billion, $1.5 billion of which related to the lease of retail +space and related facilities. The Company’s major facility leases are generally for terms of one to 20 years and generally provide renewal options for terms of one to five additional years. Leases for retail space are for terms of five to 20 +years, the majority of which are for ten years, and often contain multi-year renewal options. Purchase Commitments with Contract +Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to manufacture sub-assemblies +for the Company’s products and to perform final assembly and test of finished products. These contract manufacturers acquire components 50 Table of Contents and build product based on demand information supplied by the Company, which typically covers periods ranging from 30 to 150 days. The Company also obtains individual components for its products +from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. Such purchase +commitments typically cover the Company’s forecasted component and manufacturing requirements for periods ranging from 30 to 150 days. In addition, the Company has an off-balance sheet warranty obligation for products accounted for under +subscription accounting whereby the Company recognizes warranty expense as incurred. As of September 26, 2009, the Company had outstanding off-balance sheet third-party manufacturing commitments, component purchase commitments and estimated +warranty commitments of $4.8 billion. The Company has entered into prepaid long-term supply agreements to secure the supply +of certain inventory components. During the first quarter of 2009, a long-term supply agreement with Intel Corporation was terminated and the remaining prepaid balance of $167 million was repaid to the Company. During the second and fourth quarters +of 2009, the Company made a prepayment of $500 million to LG Display for the purchase of LCD panels and a prepayment of $500 million to Toshiba to purchase NAND flash memory, respectively. As of September 26, 2009, the Company had a total +of $1.2 billion of inventory component prepayments outstanding. Asset Retirement Obligations The Company’s asset retirement obligations are associated with commitments to return property subject to operating leases to original +condition upon lease termination. As of September 26, 2009, the Company estimated that gross expected future cash flows of $32 million would be required to fulfill these obligations. Other Obligations Other +outstanding obligations were $356 million as of September 26, 2009, which related to advertising, research and development, Internet and telecommunications services and other obligations. As of September 26, 2009, the Company had gross unrecognized tax benefits of $971 million and an additional $291 million for gross interest and penalties classified as +non-current liabilities in the Consolidated Balance Sheet. The Company believes it is reasonably possible that tax audit resolutions could reduce its unrecognized tax benefits by between $105 million and $145 million in the next 12 months. At +this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual +obligation table. Indemnifications The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other +agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, +the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified third-party and, in the opinion of management, does not have a liability related to unresolved +infringement claims subject to indemnification that would materially adversely affect its financial condition or operating results. Therefore, the Company did not record a liability for infringement costs as of either September 26, 2009 or +September 27, 2008. The Company has entered into indemnification agreements with its directors and executive officers. +Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such 51 Table of Contents individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due +to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and +payments made under these agreements historically have not materially adversely affected the Company’s financial condition or operating results. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. However, given the effective horizons of the Company’s risk +management activities and the anticipatory nature of the exposures, there can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. In addition, the +timing of the accounting for recognition of gains and losses related to mark-to-market instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely +affect the Company’s financial condition and operating results. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the Company’s +interest income and expense is most sensitive to fluctuations in the general level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities, the +fair value of those investments, as well as costs associated with foreign currency hedges. The Company’s investment +policy and strategy are focused on preservation of capital and supporting the liquidity requirements of the Company. A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s investment policy +and to objective market benchmarks. The Company’s internal portfolio is benchmarked against external manager performance. The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s investment portfolio. The Company typically invests in highly rated securities and its policy generally limits the amount of +credit exposure to any one issuer. The Company’s investment policy requires investments to be investment grade, primarily rated single-A or better with the objective of minimizing the potential risk of principal loss. All highly liquid +investments with initial maturities of three months or less at the date of purchase are classified as cash equivalents. The Company classifies its marketable securities as either short-term or long-term based on each instrument’s underlying +contractual maturity date. All short-term marketable securities have maturities less than 12 months, while all long-term marketable securities have maturities ranging from one to five years. The Company may sell its investments prior to their stated +maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no material net gains or losses during 2009, 2008 and 2007 related to such sales. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed +a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 26, 2009, +a hypothetical 100 basis point increase in interest rates across all maturities would result in a $176 million incremental decline in the fair market value of the portfolio. As of September 27, 2008, a similar 100 basis point shift in the yield +curve would have resulted in a $46 million incremental decline in the fair market value of the portfolio. Such losses would only be realized if the Company sold the investments prior to maturity. 52 Table of Contents Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the +Company’s net sales and gross margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign +currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions +to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s +practice is to hedge a majority of its material foreign exchange exposures, typically for three to six months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to +immateriality, accounting considerations and the prohibitive economic cost of hedging particular exposures. To provide a +meaningful assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the +potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate 3,000 random market price paths. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the +Company’s foreign exchange portfolio due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted +transactions, firm commitments, and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $44 +million as of September 26, 2009 compared to a maximum one-day loss in fair value of $60 million as of September 27, 2008. Because the Company uses foreign currency instruments for hedging purposes, losses incurred on those instruments are +generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with +the Company’s investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 26, 2009 due to the inherent limitations associated with predicting the changes in the timing and +amount of interest rates, foreign currency exchanges rates and the Company’s actual exposures and positions. 53 Table of Contents Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Balance Sheets as of September 26, 2009 and September 27, 2008 55 Consolidated Statements of Operations for the three years ended September 26, 2009 56 Consolidated Statements of Shareholders’ Equity for the three years ended September 26, 2009 57 Consolidated Statements of Cash Flows for the three years ended September 26, 2009 58 Notes to Consolidated Financial Statements 59 Selected Quarterly Financial Information (Unaudited) 88 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 89 Report of KPMG LLP, Independent Registered Public Accounting Firm 91 All financial statement schedules have been omitted, since the required information +is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. 54 Table of Contents CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 26, 2009 September 27, 2008 ASSETS: Current assets: Cash and cash equivalents $ 5,263 $ 11,875 Short-term marketable securities 18,201 10,236 Accounts receivable, less allowances of $52 and $47, respectively 3,361 2,422 Inventories 455 509 Deferred tax assets 2,101 1,447 Other current assets 6,884 5,822 Total current assets 36,265 32,311 Long-term marketable securities 10,528 2,379 Property, plant and equipment, net 2,954 2,455 Goodwill 206 207 Acquired intangible assets, net 247 285 Other assets 3,651 1,935 Total assets $ 53,851 $ 39,572 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 5,601 $ 5,520 Accrued expenses 3,376 3,719 Deferred revenue 10,305 4,853 Total current liabilities 19,282 14,092 Deferred revenue - non-current 4,485 3,029 Other non-current liabilities 2,252 1,421 Total liabilities 26,019 18,542 Commitments and contingencies Shareholders’ equity: Common stock, no par value; 1,800,000,000 shares authorized; 899,805,500 and 888,325,973 shares issued and outstanding, +respectively 8,210 7,177 Retained earnings 19,538 13,845 Accumulated other comprehensive income 84 8 Total shareholders’ equity 27,832 21,030 Total liabilities and shareholders’ equity $ 53,851 $ 39,572 See accompanying Notes to Consolidated Financial Statements. 55 Table of Contents CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share amounts which are reflected in thousands and per share amounts) Three years ended September 26, 2009 2009 2008 2007 Net sales $ 36,537 $ 32,479 $ 24,006 Cost of sales 23,397 21,334 15,852 Gross margin 13,140 11,145 8,154 Operating expenses: Research and development 1,333 1,109 782 Selling, general and administrative 4,149 3,761 2,963 Total operating expenses 5,482 4,870 3,745 Operating income 7,658 6,275 4,409 Other income and expense 326 620 599 Income before provision for income taxes 7,984 6,895 5,008 Provision for income taxes 2,280 2,061 1,512 Net income $ 5,704 $ 4,834 $ 3,496 Earnings per common share: Basic $ 6.39 $ 5.48 $ 4.04 Diluted $ 6.29 $ 5.36 $ 3.93 Shares used in computing earnings per share: Basic 893,016 881,592 864,595 Diluted 907,005 902,139 889,292 See accompanying Notes to Consolidated Financial Statements. 56 Table of Contents CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Common Stock Retained Earnings Accum- ulated Other Compre- hensive Income Total Share- holders’ Equity Shares Amount Balances as of September 30, 2006 855,263 $ 4,355 $ 5,607 $ 22 $ 9,984 Components of comprehensive income: Net income — — 3,496 — 3,496 Change in foreign currency translation — — — 51 51 Change in unrealized loss on available-for-sale securities, net of tax — — — (7 ) (7 ) Change in unrealized gain on derivative instruments, net of tax — — — (3 ) (3 ) Total comprehensive income 3,537 Stock-based compensation — 251 — — 251 Common stock issued under stock plans, net of shares withheld for employee taxes 17,066 364 (2 ) — 362 Tax benefit from employee stock plan awards — 398 — — 398 Balances as of September 29, 2007 872,329 5,368 9,101 63 14,532 Cumulative effect of change in accounting principle — 45 11 — 56 Components of comprehensive income: Net income — — 4,834 4,834 Change in foreign currency translation — — — (11 ) (11 ) Change in unrealized loss on available-for-sale securities, net of tax — — — (63 ) (63 ) Change in unrealized gain on derivative instruments, net of tax — — — 19 19 Total comprehensive income 4,779 Stock-based compensation — 513 — — 513 Common stock issued under stock plans, net of shares withheld for employee taxes 15,888 460 (101 ) — 359 Issuance of common stock in connection with an asset acquisition 109 21 — — 21 Tax benefit from employee stock plan awards — 770 — — 770 Balances as of September 27, 2008 888,326 7,177 13,845 8 21,030 Components of comprehensive income: Net income — — 5,704 — 5,704 Change in foreign currency translation — — — (54 ) (54 ) Change in unrealized loss on available-for-sale securities, net of tax — — — 118 118 Change in unrealized gain on derivative instruments, net of tax — — — 12 12 Total comprehensive income 5,780 Stock-based compensation — 707 — — 707 Common stock issued under stock plans, net of shares withheld for employee taxes 11,480 404 (11 ) — 393 Tax benefit from employee stock plan awards, including transfer pricing adjustments — (78 ) — — (78 ) Balances as of September 26, 2009 899,806 $ 8,210 $ 19,538 $ 84 $ 27,832 See accompanying Notes to Consolidated Financial Statements. 57 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three years ended September 26, 2009 2009 2008 2007 Cash and cash equivalents, beginning of the year $ 11,875 $ 9,352 $ 6,392 Operating Activities: Net income 5,704 4,834 3,496 Adjustments to reconcile net income to cash generated by operating activities: Depreciation, amortization and accretion 703 473 317 Stock-based compensation expense 710 516 242 Deferred income tax (benefit)/expense (519 ) (368 ) 78 Loss on disposition of property, plant and equipment 26 22 12 Changes in operating assets and liabilities: Accounts receivable, net (939 ) (785 ) (385 ) Inventories 54 (163 ) (76 ) Other current assets (1,050 ) (1,958 ) (1,540 ) Other assets (1,346 ) (492 ) 81 Accounts payable 92 596 1,494 Deferred revenue 6,908 5,642 1,139 Other liabilities (184 ) 1,279 612 Cash generated by operating activities 10,159 9,596 5,470 Investing Activities: Purchases of marketable securities (46,724 ) (22,965 ) (11,719 ) Proceeds from maturities of marketable securities 19,790 11,804 6,483 Proceeds from sales of marketable securities 10,888 4,439 2,941 Purchases of other long-term investments (101 ) (38 ) (17 ) Payments made in connection with business acquisitions, net of cash acquired — (220 ) — Payment for acquisition of property, plant and equipment (1,144 ) (1,091 ) (735 ) Payment for acquisition of intangible assets (69 ) (108 ) (251 ) Other (74 ) (10 ) 49 Cash used in investing activities (17,434 ) (8,189 ) (3,249 ) Financing Activities: Proceeds from issuance of common stock 475 483 365 Excess tax benefits from stock-based compensation 270 757 377 Cash used to net share settle equity awards (82 ) (124 ) (3 ) Cash generated by financing activities 663 1,116 739 (Decrease)/increase in cash and cash equivalents (6,612 ) 2,523 2,960 Cash and cash equivalents, end of the year $ 5,263 $ 11,875 $ 9,352 Supplemental cash flow disclosures: Cash paid for income taxes, net $ 2,997 $ 1,267 $ 863 See accompanying Notes to Consolidated Financial Statements. 58 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) design, manufacture, and market personal computers, mobile communication devices, and portable +digital music and video players and sell a variety of related software, third-party digital content and applications, services, peripherals, and networking solutions. The Company sells its products worldwide through its online stores, its retail +stores, its direct sales force, and third-party wholesalers, resellers and value-added resellers. In addition, the Company sells a variety of third-party Macintosh (“Mac”), iPhone and iPod compatible products including application +software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to consumer, small and mid-sized business (“SMB”), education, enterprise, +government and creative customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these +consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in these consolidated financial statements +and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the +consolidated financial statements and notes thereto have been reclassified to conform to the current year’s presentation. During the first quarter of 2009, the Company reclassified $2.4 billion of certain fixed-income securities from +short-term marketable securities to long-term marketable securities in the September 27, 2008 Consolidated Balance Sheet. The reclassification resulted from a change in accounting presentation for certain investments based on contractual +maturity dates, which more closely reflects the Company’s assessment of the timing of when such securities will be converted to cash. As a result of this change, marketable securities with maturities less than 12 months are classified as +short-term and marketable securities with maturities greater than 12 months are classified as long-term. There have been no changes in the Company’s investment policies or practices associated with this change in accounting presentation. See +Note 2, “Financial Instruments” of this Form 10-K for additional information. The Company’s fiscal year is the +52 or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2009, 2008 and 2007 ended on September 26, 2009, September 27, 2008 and September 29, 2007, respectively, and included 52 weeks +each. An additional week is included in the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal +years ended in September and the associated quarters of those fiscal years. In May 2009, the Financial Accounting Standards +Board (“FASB”) established general accounting standards and disclosure for subsequent events. The Company adopted FASB Accounting Standards Codification (“ASC”) 855, Subsequent Events (formerly referenced as +Statement of Financial Accounting Standards (“SFAS”) No. 165, Subsequent Events ), during the third quarter of 2009. The Company has evaluated subsequent events through the date and time the financial statements were issued on +October 27, 2009. Financial Instruments Cash Equivalents and Marketable Securities All highly liquid investments +with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s debt and marketable equity securities have been classified and accounted for as available-for-sale. Management determines the +appropriate classification of its investments in debt securities at 59 Table of Contents the time of purchase and reevaluates the available-for-sale designations as of each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term +based on each instrument’s underlying contractual maturity date. Marketable securities with maturities of less than 12 months are classified as short-term and marketable securities with maturities greater than 12 months are classified as +long-term. These securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments During the second quarter of 2009, the Company adopted FASB ASC 815, Derivatives and Hedging (formerly referenced as SFAS No. 161, Disclosures about Derivative Instruments and Hedging +Activities – an amendment of FASB Statement No. 133 ), which requires additional disclosures about the Company’s objectives and strategies for using derivative instruments, how the derivative instruments and related hedged items +are accounted for, and how the derivative instruments and related hedged item affect the financial statements. The Company +accounts for its derivative instruments as either assets or liabilities and carries them at fair value. Derivatives that are not defined as hedges must be adjusted to fair value through earnings. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the +effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income in shareholders’ equity and reclassified into earnings in the same period or periods during which the hedged +transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument is recognized in current earnings. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to +expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments that hedge +the exposure to changes in the fair value of an asset or a liability and that are designated as fair value hedges, the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged +risk are recognized in earnings in the current period. The Company did not have a net gain or loss on these derivative instruments during 2009, 2008 and 2007. The net gain or loss on the effective portion of a derivative instrument that is +designated as an economic hedge of the foreign currency translation exposure of the net investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward exchange contracts designated as net +investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current earnings. Fair Value Measurements During the first quarter of 2009, the Company adopted FASB ASC 820, Fair Value Measurements and Disclosures (formerly referenced as SFAS No. 157, Fair Value Measurements ), which +defines fair value, establishes guidelines for measuring fair value and expands disclosures regarding fair value measurements. This new accounting standard does not require any new fair value measurements. The Company applies fair value accounting +for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received +from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair +value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent +risk, transfer restrictions and credit risk. During the first quarter of 2009, the Company adopted FASB ASC +825, Financial Instruments (formerly referenced as SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities – Including 60 Table of Contents an amendment of FASB Statement No. 115 ) , which allows companies to choose to measure eligible financial instruments and certain other items at fair value that are not required +to be measured at fair value. The Company has not elected the fair value option for any eligible financial instruments. Inventories Inventories are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the +inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The Company’s inventories consist primarily of finished goods for all periods presented. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the +underlying building, up to five years for equipment, and the shorter of lease terms or ten years for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the +preliminary project stage. Capitalized costs related to internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Depreciation and amortization expense on +property and equipment was $577 million, $363 million and $249 million during 2009, 2008 and 2007, respectively. Asset Retirement +Obligations The Company records obligations associated with the retirement of tangible long-lived assets and the +associated asset retirement costs. The Company reviews legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or normal use of the assets. If it is determined that a +legal obligation exists, the fair value of the liability for an asset retirement obligation is recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of the liability is added to the +carrying amount of the associated asset and this additional carrying amount is depreciated over the life of the asset. The difference between the gross expected future cash flow and its present value is accreted over the life of the related lease as +an operating expense. All of the Company’s existing asset retirement obligations are associated with commitments to return property subject to operating leases to original condition upon lease termination. The Company’s asset retirement +liability was $25 million and $21 million as of September 26, 2009 and September 27, 2008, respectively. Long-Lived Assets +Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment and certain +identifiable intangibles, excluding goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets +is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be +recognized equals the amount by which the carrying value of the assets exceeds its fair market value. The Company did not record any material impairments during 2009, 2008 and 2007. The Company does not amortize goodwill and intangible assets with indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner +whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible asset impairment tests on or about August 31 of each year. The Company did not recognize any goodwill or +intangible asset impairment charges in 2009, 2008 and 2007. The Company established reporting units based on its current reporting structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to +the extent it relates to each reporting unit. 61 Table of Contents The Company amortizes its intangible assets with definite lives over their estimated useful +lives and reviews these assets for impairment. The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from one to ten years. Foreign Currency Translation and Remeasurement The Company translates the +assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those +in effect during the period. Gains and losses from these translations are credited or charged to foreign currency translation included in accumulated other comprehensive income in shareholders’ equity. The Company’s subsidiaries that use +the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses +from these remeasurements were insignificant and have been included in the Company’s results of operations. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, and +service and support contracts. For any product within these groups that either is software, or is considered software-related (e.g., Mac computers, iPhones and iPod portable digital music and video players), the Company accounts for such products in +accordance with the specific industry accounting guidance for software and software related transactions. The Company applies various revenue-related GAAP for products that are not software or software-related, such as digital content sold on the +iTunes Store and certain Mac, iPhone and iPod supplies and accessories, which is described below. The Company recognizes +revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of +loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the +Company defers revenue until the customer receives the product because the Company legally retains a portion of the risk of loss on these sales during transit. If at the outset of an arrangement the Company determines the arrangement fee is not, or +is presumed not to be, fixed or determinable, revenue is deferred and subsequently recognized as amounts become due and payable and all other criteria for revenue recognition have been met. Revenue from service and support contracts is deferred and recognized ratably over the service coverage periods. These contracts typically include extended phone support, repair +services, web-based support resources, diagnostic tools, and extend the service coverage offered under the Company’s standard limited warranty. The Company sells software and peripheral products obtained from other companies. The Company generally establishes its own pricing and retains related inventory risk, is the primary obligor in sales +transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company generally recognizes revenue for the sale of products obtained from other companies based on the gross amount billed. The Company accounts for multiple element arrangements that consist only of software or software-related products in +accordance with industry specific accounting guidance for software and software related transactions. If a multiple-element arrangement includes deliverables that are neither software nor software-related, the Company applies various revenue-related +GAAP to determine if those deliverables constitute separate units of accounting from the software or software-related deliverables. If the Company can separate the deliverables, the Company applies the industry specific accounting guidance to the +software and software-related deliverables and applies other appropriate guidance to the non-software related deliverables. Revenue on arrangements that include multiple elements such as hardware, software and services is allocated to each element +based on the 62 Table of Contents relative fair value of each element. Each element’s allocated revenue is recognized when the revenue recognition criteria for that element have been met. Fair value is generally determined +by vendor specific objective evidence (“VSOE”), which is based on the price charged when each element is sold separately. If the Company cannot objectively determine the fair value of any undelivered element included in a multiple-element +arrangement, the Company defers revenue until all elements are delivered and services have been performed, or until fair value can objectively be determined for any remaining undelivered elements. When the fair value of a delivered element has not +been established, but fair value exists for the undelivered elements, the Company uses the residual method to recognize revenue if the fair value of all undelivered elements is determinable. Under the residual method, the fair value of the +undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. For both iPhone and Apple TV, the Company has indicated it may from time-to-time provide future unspecified features and additional software products free of charge to customers. Accordingly, iPhone +handsets and Apple TV sales are accounted for under subscription accounting in accordance with GAAP. As such, the revenue and associated cost of sales are deferred at the time of sale, and are both recognized on a straight-line basis over the +currently estimated 24-month economic life of these products, with any loss recognized at the time of sale. Costs incurred by the Company for engineering, sales, marketing and warranty are expensed as incurred. The Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, +including reseller and end-user rebates, and other sales programs and volume-based incentives. The estimated cost of these programs is accrued as a reduction to revenue in the period the Company has sold the product and committed to a plan. The +Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the +collected taxes recorded as current liabilities until remitted to the relevant government authority. Generally, the Company +does not offer specified or unspecified upgrade rights to its customers in connection with software sales or the sale of extended warranty and support contracts. When the Company does offer specified upgrade rights, the Company defers revenue for +the fair value of the specified upgrade right until the future obligation is fulfilled or the right to the specified upgrade expires. A limited number of the Company’s software products are available with maintenance agreements that grant +customers rights to unspecified future upgrades over the maintenance term on a when and if available basis. Revenue associated with such maintenance is recognized ratably over the maintenance term. Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical experience, the age of the accounts receivable balances, credit quality of the Company’s customers, +current economic conditions, and other factors that may affect customers’ ability to pay. Shipping Costs For all periods presented, amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s +shipping and handling costs are included in cost of sales. Warranty Expense The Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. The Company assesses the adequacy of its +preexisting warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. For products accounted for under subscription accounting, the Company recognizes warranty expense as incurred. 63 Table of Contents Software Development Costs Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when +a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been +established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally most software development costs have been expensed. In 2009 and 2008, the Company capitalized $71 million and $11 million, respectively, of costs associated with the development of Mac OS X Version 10.6 Snow Leopard (“Mac OS X +Snow Leopard”), which was released during the fourth quarter of 2009. During 2007, the Company capitalized $75 million of costs associated with the development of Mac OS X Version 10.5 Leopard (“Mac OS X Leopard”) and iPhone software. +The capitalized costs are being amortized to cost of sales on a straight-line basis over a three year estimated useful life of the underlying technology. Total amortization related to capitalized software development costs was $25 million, $27 million and $13 million in 2009, 2008 and 2007, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $501 million, $486 million and $467 million for 2009, 2008 and 2007, respectively. Stock-Based Compensation The Company accounts for stock-based payment +transactions in which the Company receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by +the issuance of such equity instruments. Stock-based compensation cost for restricted stock units (“RSUs”) is measured based on the closing fair market value of the Company’s common stock on the date of grant. Stock-based compensation +cost for stock options is estimated at the grant date based on each option’s fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model. The Company recognizes stock-based compensation cost as expense ratably on +a straight-line basis over the requisite service period. The Company will recognize a benefit from stock-based compensation in equity if an incremental tax benefit is realized by following the ordering provisions of the tax law. In addition, the +Company accounts for the indirect effects of stock-based compensation on the research tax credit, the foreign tax credit and the domestic manufacturing deduction through the income statement. Further information regarding stock-based compensation +can be found in Note 7, “Shareholders’ Equity and Stock-Based Compensation.” Income Taxes The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are +recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are +measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the +amount that is believed more likely than not to be realized. During 2008, the Company adopted FASB Accounting Standards +Codification (“ASC”) 740, Income Taxes (formerly referenced as FASB Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an 64 Table of Contents interpretation of FASB Statement No. 109) , which changed the framework for accounting for uncertainty in income taxes. The Company recognizes the tax benefit from an uncertain tax +position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are +then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. See Note 6, “Income Taxes” for additional information, including the effects of adoption on the Company’s +consolidated financial statements. Earnings Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the +period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of +common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the employee stock purchase plan and unvested RSUs. +The dilutive effect of potentially dilutive securities is reflected in diluted earnings per common share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common +stock can result in a greater dilutive effect from potentially dilutive securities. The following table sets forth the +computation of basic and diluted earnings per common share for the three years ended September 26, 2009 (in thousands, except net income in millions and per share amounts): 2009 2008 2007 Numerator: Net income $ 5,704 $ 4,834 $ 3,496 Denominator: Weighted-average shares outstanding 893,016 881,592 864,595 Effect of dilutive securities 13,989 20,547 24,697 Weighted-average shares diluted 907,005 902,139 889,292 Basic earnings per common share $ 6.39 $ 5.48 $ 4.04 Diluted earnings per common share $ 6.29 $ 5.36 $ 3.93 Potentially dilutive securities representing 12.6 million, 10.3 million and +13.7 million shares of common stock for 2009, 2008 and 2007, respectively, were excluded from the computation of diluted earnings per common share for these periods because their effect would have been antidilutive. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, gains and losses that under GAAP are recorded as an element of shareholders’ equity but +are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on +marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. Segment Information The Company reports segment information based on the +“management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. Information about the +Company’s products, major customers and geographic areas on a company-wide basis is also disclosed. 65 Table of Contents Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following table +summarizes the fair value of the Company’s cash and available-for-sale securities held in its marketable securities investment portfolio, recorded as cash and cash equivalents or short-term or long-term marketable securities as of +September 26, 2009 and September 27, 2008 (in millions): September 26, 2009 September 27, 2008 Cash $ 1,139 $ 368 Money market funds 1,608 1,536 U.S. Treasury securities 289 118 U.S. agency securities 273 2,798 Certificates of deposit and time deposits 572 2,560 Commercial paper 1,381 4,429 Corporate securities — 66 Municipal securities 1 — Total cash equivalents 4,124 11,507 U.S. Treasury securities 2,843 343 U.S. agency securities 8,582 5,823 Non-U.S. government securities 219 83 Certificates of deposit and time deposits 1,142 486 Commercial paper 2,816 1,254 Corporate securities 2,466 2,247 Municipal securities 133 — Total short-term marketable securities 18,201 10,236 U.S. Treasury securities 484 100 U.S. agency securities 2,252 751 Non-U.S. government securities 102 — Certificates of deposit and time deposits — 32 Corporate securities 7,320 1,496 Municipal securities 370 — Total long-term marketable securities 10,528 2,379 Total cash, cash equivalents and marketable securities $ 33,992 $ 24,490 During the first quarter of 2009, the Company changed its accounting presentation for +certain fixed-income investments, which resulted in the reclassification of certain investments from short-term marketable securities to long-term marketable securities. As a result, prior year balances have been reclassified to conform to the +current year’s presentation. The Company classifies its marketable securities as either short-term or long-term based on each instrument’s underlying contractual maturity date, while its prior classifications were based on the nature of +the securities and their availability for use in current operations. As a result of this change, marketable securities with maturities of less than 12 months are classified as short-term and marketable securities with maturities greater than 12 +months are classified as long-term. The Company’s long-term marketable securities’ maturities range from one year to five years. The Company believes this new presentation is preferable as it more closely reflects the Company’s +assessment of the timing of when such securities will be converted to cash. Accordingly, certain fixed-income investments totaling $2.4 billion have been reclassified from short-term marketable securities to long-term marketable securities in +the September 27, 2008 Consolidated Balance Sheet to conform to the current year’s financial statement presentation. There have been no changes in the Company’s investment policies or practices associated with this change in +accounting presentation. 66 Table of Contents The following tables summarize the Company’s available-for-sale securities’ +adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category as of September 26, 2009 and September 27, 2008 (in millions): September 26, 2009 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Money market funds $ 1,608 $ — $ — $ 1,608 U.S. Treasury securities 3,610 6 — 3,616 U.S. agency securities 11,085 22 — 11,107 Non-U.S. government securities 320 1 — 321 Certificates of deposit and time deposits 1,714 — — 1,714 Commercial paper 4,197 — — 4,197 Corporate securities 9,760 42 (16 ) 9,786 Municipal securities 502 2 — 504 Total cash equivalents and marketable securities $ 32,796 $ 73 $ (16 ) $ 32,853 September 27, 2008 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Money market funds $ 1,536 $ — $ — $ 1,536 U.S. Treasury securities 559 2 — 561 U.S. agency securities 9,383 2 (13 ) 9,372 Non-U.S. government securities 83 — — 83 Certificates of deposit and time deposits 3,078 — — 3,078 Commercial paper 5,683 — — 5,683 Corporate securities 3,917 — (108 ) 3,809 Total cash equivalents and marketable securities $ 24,239 $ 4 $ (121 ) $ 24,122 The Company had net unrealized gains on its investment portfolio of $57 million as of +September 26, 2009 and net unrealized losses on its investment portfolio of $117 million as of September 27, 2008. The net unrealized gains as of September 26, 2009 and the net unrealized losses as of September 27, 2008 related +primarily to long-term marketable securities. The Company may sell certain of its marketable securities prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company +recognized no material net gains or losses during 2009, 2008 and 2007 related to such sales. The following table shows the +gross unrealized losses and fair value for investments in an unrealized loss position as of September 26, 2009 and September 27, 2008, aggregated by investment category and the length of time that individual securities have been in a +continuous loss position (in millions): September 26, 2009 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Loss Corporate securities $ 1,667 $ (3 ) $ 719 $       (13) $   2,386 $ (16 ) Total $ 1,667 $ (3 ) $ 719 $       (13) $   2,386 $ (16 ) September 27, 2008 Less than 12 Months 12 Months or Greater Total Security Description Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Loss U.S. agency securities $ 6,822 $ (13 ) $ — $      — $   6,822 $ (13 ) Corporate securities 2,147 (31 ) 1,148 (77 ) 3,295 (108 ) Total $ 8,969 $ (44 ) $ 1,148 $       (77 ) $ 10,117 $ (121 ) 67 Table of Contents The Company considers the declines in market value of its marketable securities investment +portfolio to be temporary in nature. The unrealized losses on the Company’s marketable securities were caused primarily by changes in market interest rates, specifically, widening credit spreads. The Company typically invests in highly-rated +securities, and its policy generally limits the amount of credit exposure to any one issuer. The Company’s investment policy requires investments to be investment grade, primarily rated single-A or better, with the objective of minimizing the +potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and +extent to which fair value has been below cost basis, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before +recovery of the investment’s amortized cost basis. During the years ended September 26, 2009 and September 27, 2008, the Company did not recognize any material impairment charges. As of September 26, 2009, the Company does not +consider any of its investments to be other-than-temporarily impaired. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign currency exchange risk. The Company may enter into foreign +currency forward and option contracts to offset some of the foreign exchange risk of expected future cash flows on certain forecasted revenue and cost of sales, of net investments in certain foreign subsidiaries, and on certain existing assets and +liabilities. To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar, hedge a portion of forecasted foreign currency revenue. The +Company’s subsidiaries whose functional currency is not the U.S. dollar and who sell in local currencies, may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company +typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases for three to six months. To help protect the net investment in a foreign operation from adverse changes in foreign currency +exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. The Company may also enter into +foreign currency forward and option contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. However, the Company may +choose not to hedge certain foreign currency exchange exposures for a variety of reasons, including but not limited to immateriality, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no +assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange rates. The Company’s accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the Consolidated +Balance Sheets at fair value. The effective portions of cash flow hedges are recorded in other comprehensive income until the hedged item is recognized in earnings. The effective portions of net investment hedges are recorded in other comprehensive +income as a part of the cumulative translation adjustment. Derivatives that are not designated as hedging instruments and the ineffective portions of cash flow hedges and net investment hedges are adjusted to fair value through earnings in other +income and expense. The Company had a net deferred gain associated with cash flow hedges of approximately $31 million and $19 +million, net of taxes, recorded in other comprehensive income as of September 26, 2009 and September 27, 2008, respectively. Other comprehensive income associated with cash flow hedges of foreign currency revenue is recognized as a +component of net sales in the same period as the related revenue is recognized, and other comprehensive income related to cash flow hedges of inventory purchases is recognized as a component of cost of sales in the same period as the related costs +are recognized. The portion of the Company’s net deferred gain related to products under subscription accounting is expected to be recorded in earnings ratably over the related products’ estimated economic lives beginning when the hedged +transactions occur, while the portion of the net deferred gain related to other products is expected to be recorded in earnings at the time the hedged transactions occur. As of September 26, 2009, the hedged transactions are expected to occur +within six months. 68 Table of Contents Derivative instruments designated as cash flow hedges must be de-designated as hedges when +it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments +are reclassified immediately into earnings through other income and expense. Any subsequent changes in fair value of such derivative instruments also are reflected in current earnings unless they are re-designated as hedges of other transactions. +The Company did not recognize any material net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during 2009, 2008 and 2007. The Company had an unrealized net loss on net investment hedges of $2 million and $1 million, net of taxes, included in the cumulative translation adjustment account of accumulated other comprehensive +income (“AOCI”) as of September 26, 2009 and September 27, 2008, respectively. The ineffective portions and amounts excluded from the effectiveness test of net investment hedges are recorded in current earnings in other income +and expense. The Company recognized in earnings a net gain of $133 million on foreign currency forward and option contracts +not designated as hedging instruments during the year ended September 26, 2009. The following table shows the notional +principal and credit risk amounts of the Company’s derivative instruments outstanding as of September 26, 2009 and September 27, 2008 (in millions): 2009 2008 Notional Principal Credit Risk Amounts Notional Principal Credit Risk Amounts Instruments qualifying as accounting hedges: Foreign exchange contracts $ 4,422 $ 31 $ 5,902 $ 107 Instruments other than accounting hedges: Foreign exchange contracts $ 3,416 $ 10 $ 2,868 $ 8 The notional principal amounts for derivative instruments provide one measure of the +transaction volume outstanding as of September 26, 2009, and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss +on these transactions if all counterparties failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company’s gross exposure on these transactions may be further +mitigated by collateral received from certain counterparties. The Company’s exposure to credit loss and market risk will vary over time as a function of currency exchange rates. Although the table above reflects the notional principal and +credit risk amounts of the Company’s foreign exchange instruments, it does not reflect the gains or losses associated with the exposures and transactions that the foreign exchange instruments are intended to hedge. The amounts ultimately +realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. The Company generally enters into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with +the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received when the net fair value of certain financial instruments exceeds contractually +established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values. The Company did not record a material amount of cash collateral related to the derivative instruments under its master +netting arrangements as of September 26, 2009. The Company did not have any derivative instruments with credit risk-related contingent features that would require it to post additional collateral as of September 26, 2009. The estimates of fair value are based on applicable and commonly used pricing models and prevailing financial market information as of +September 26, 2009. Refer to Note 3, “Fair Value Measurements” of this Form 10-K, 69 Table of Contents for additional information on the fair value measurements for all financial assets and liabilities, including derivative assets and derivative liabilities, that are measured at fair value in the +consolidated financial statements on a recurring basis. The following tables shows the Company’s derivative instruments measured at gross fair value as reflected in the Consolidated Balance Sheets as of September 26, 2009 and +September 27, 2008 (in millions): September 26, 2009 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 27 $ 10 $ 37 Derivative liabilities (b): Foreign exchange contracts $ 24 $ 1 $ 25 September 27, 2008 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 107 $ 8 $ 115 Derivative liabilities (b): Foreign exchange contracts $ 68 $ 2 $ 70 (a) All derivative assets are recorded as other current assets in the Consolidated Balance Sheets. (b) All derivative liabilities are recorded as accrued expenses in the Consolidated Balance Sheets. The following table shows the effect of the Company’s derivative instruments designated as cash flow and net investment hedges in the +Consolidated Statements of Operations for the year ended September 26, 2009 (in millions): Year Ended September 26, 2009 Gain or (Loss) Recognized in AOCI - Effective Portion (a) Location of Gain or (Loss) Reclassified from AOCI into Income - Effective +Portion Gain or (Loss) Reclassified from AOCI into Income - Effective +Portion (a) Location of Gain or (Loss) Recognized - Ineffective Portion and Amount Excluded +from Effectiveness Testing Gain or (Loss) Recognized - Ineffective Portion and Amount Excluded +from Effectiveness Testing Cash flow hedges: Foreign exchange contracts $ 283 Net sales $ 251 Other income and expense $ (83 ) Foreign exchange contracts 55 Cost of sales 72 Other income and expense (14 ) Net investment hedges: Foreign exchange contracts (44 ) Other income and expense — Other income and expense 3 Total $ 294 $ 323 $ (94 ) (a) Refer to Note 7, “Shareholders’ Equity and Stock-Based Compensation” of this Form 10-K, which summarizes the activity in accumulated +other comprehensive income related to derivatives. 70 Table of Contents Accounts Receivable Trade Receivables The Company distributes its products through third-party +distributors, cellular network carriers, and resellers and directly to certain education, consumer and enterprise customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in +certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers in Latin America, Europe, Asia, and Australia, or by requiring third-party +financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk +sharing related to any of these arrangements. However, considerable trade receivables not covered by collateral, third-party financing arrangements, or credit insurance are outstanding with the Company’s distribution and retail channel +partners. Trade receivables from one of the Company’s customers accounted for 16% of trade receivables as of September 26, 2009 and two of the Company’s customers accounted for 15% and 10%, respectively, of trade receivables as of +September 27, 2008. The following table summarizes the activity in the allowance for doubtful accounts for the three +years ended September 26, 2009 (in millions): 2009 2008 2007 Beginning allowance balance $ 47 $ 47 $ 52 Charged to costs and expenses 25 3 12 Deductions (20 ) (3 ) (17 ) Ending allowance balance $ 52 $ 47 $ 47 Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of raw material components to these manufacturing vendors who manufacture +sub-assemblies or assemble final products for the Company. The Company purchases these raw material components directly from suppliers. These non-trade receivables, which are included in the Consolidated Balance Sheets in other current assets, +totaled $1.7 billion and $2.3 billion as of September 26, 2009 and September 27, 2008, respectively. Vendor non-trade receivables from two of the Company’s vendors accounted for 40% and 36%, respectively, of non-trade receivables as +of September 26, 2009 and two of the Company’s vendors accounted for 47% and 38%, respectively, of non-trade receivables as of September 27, 2008. The Company does not reflect the sale of these components in net sales and does not +recognize any profits on these sales until the related products are sold by the Company, at which time any profit is recognized as a reduction of cost of sales. Note 3 – Fair Value Measurements The Company defines fair value as +the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are +required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset +or liability, such as inherent risk, transfer restrictions and credit risk. 71 Table of Contents The Company applies the following fair value hierarchy, which prioritizes the inputs used to +measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, +or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity +securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of all other financial instruments, all of which have counterparties with high credit ratings, +were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by observable market data. Assets/Liabilities Measured at Fair Value on a Recurring Basis The following table presents the Company’s +assets and liabilities measured at fair value on a recurring basis as of September 26, 2009 (in millions): September 26, 2009 Quoted Prices in Active Markets for Identical Instruments (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total (a) Assets: Money market funds $ 1,608 $ — $ — $ 1,608 U.S. Treasury securities — 3,616 — 3,616 U.S. agency securities — 11,107 — 11,107 Non-U.S. government securities — 321 — 321 Certificates of deposit and time deposits — 1,714 — 1,714 Commercial paper — 4,197 — 4,197 Corporate securities — 9,786 — 9,786 Municipal securities — 504 — 504 Marketable equity securities 61 — — 61 Derivative assets — 37 — 37 Total assets measured at fair value $ 1,669 $ 31,282 $ — $ 32,951 Liabilities: Derivative liabilities $ — $ 25 $ — $ 25 Total liabilities measured at fair value $ — $ 25 $ — $ 25 (a) The total fair value amounts for assets and liabilities also represent the related carrying amounts. 72 Table of Contents The following table summarizes the Company’s assets and liabilities measured at fair +value on a recurring basis as presented in the Company’s Consolidated Balance Sheet as of September 26, 2009 (in millions): September 26, 2009 Quoted Prices in Active Markets for Identical Instruments (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total (a) Assets: Cash equivalents $ 1,608 $ 2,516 $ — $ 4,124 Short-term marketable securities — 18,201 — 18,201 Long-term marketable securities — 10,528 — 10,528 Other current assets — 37 — 37 Other assets 61 — — 61 Total assets measured at fair value $ 1,669 $ 31,282 $ — $ 32,951 Liabilities: Other current liabilities $ — $ 25 $ — $ 25 Total liabilities measured at fair value $ — $ 25 $ — $ 25 (a) The total fair value amounts for assets and liabilities also represent the related carrying amounts. Note 4 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 26, 2009 and September 27, 2008 (in millions): Other Current Assets 2009 2008 Deferred costs under subscription accounting - current $ 3,703 $ 1,931 Vendor non-trade receivables 1,696 2,282 Inventory component prepayments - current 309 475 Other current assets 1,176 1,134 Total other current assets $ 6,884 $ 5,822 Property, Plant and Equipment 2009 2008 Land and buildings $    955 $    810 Machinery, equipment and internal-use software 1,932 1,491 Office furniture and equipment 115 122 Leasehold improvements 1,665 1,324 Gross property, plant and equipment 4,667 3,747 Accumulated depreciation and amortization (1,713 ) (1,292 ) Net property, plant and equipment $ 2,954 $ 2,455 73 Table of Contents Other Assets 2009 2008 Deferred costs under subscription accounting - non-current $ 1,468 $ 1,089 Inventory component prepayments - non-current 844 208 Deferred tax assets - non-current 259 138 Capitalized software development costs, net 106 67 Other assets 974 433 Total other assets $ 3,651 $ 1,935 Accrued Expenses 2009 2008 Income taxes payable $ 439 $ 502 Accrued marketing and distribution 359 329 Accrued compensation and employee benefits 357 320 Deferred margin on component sales 225 681 Accrued warranty and related costs 210 267 Other current liabilities 1,786 1,620 Total accrued expenses $ 3,376 $ 3,719 Non-Current Liabilities 2009 2008 Deferred tax liabilities $ 966 $ 675 Other non-current liabilities 1,286 746 Total other non-current liabilities $ 2,252 $ 1,421 Note 5 – Goodwill and Other Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods ranging from one to ten years. The +following table summarizes the components of gross and net intangible asset balances as of September 26, 2009 and September 27, 2008 (in millions): 2009 2008 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired technology $ 323 $ (176 ) $ 147 $ 308 $ (123 ) $ 185 Indefinite lived and unamortizable trademarks 100 — 100 100 — 100 Total acquired intangible assets $ 423 $ (176 ) $ 247 $ 408 $ (123 ) $ 285 Goodwill $ 206 $ — $ 206 $ 207 $ — $ 207 In 2008, the Company completed an acquisition of a business for total cash +consideration, net of cash acquired, of $220 million, of which $169 million has been allocated to goodwill, $51 million to deferred tax assets and $7 million to acquired intangible assets. 74 Table of Contents The Company’s goodwill is allocated primarily to the America’s reportable +operating segment. Amortization expense related to acquired intangible assets was $53 million, $46 million and $35 million in 2009, 2008 and 2007, respectively. As of September 26, 2009 and September 27, 2008, the remaining +weighted-average amortization period for acquired technology was 7.2 years and 7.0 years, respectively. Expected annual +amortization expense related to acquired technology as of September 26, 2009, is as follows (in millions): Years 2010 $ 40 2011 37 2012 28 2013 13 2014 10 Thereafter 19 Total $ 147 Note 6 – Income Taxes The provision for income taxes for the three years ended September 26, 2009, consisted of the following (in millions): 2009 2008 2007 Federal: Current $ 2,162 $ 1,942 $ 1,219 Deferred (207 ) (155 ) 85 1,955 1,787 1,304 State: Current 279 210 112 Deferred (113 ) (82 ) 9 166 128 121 Foreign: Current 358 277 103 Deferred (199 ) (131 ) (16 ) 159 146 87 Provision for income taxes $ 2,280 $ 2,061 $ 1,512 The foreign provision for income taxes is based on foreign pretax earnings of $4.4 +billion, $3.5 billion and $2.2 billion in 2009, 2008 and 2007, respectively. As of September 26, 2009 and September 27, 2008, $17.4 billion and $11.3 billion, respectively, of the Company’s cash, cash equivalents and marketable +securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The Company’s consolidated +financial statements provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company’s foreign subsidiaries that are intended to be indefinitely reinvested in operations +outside the U.S. U.S. income taxes have not been provided on a cumulative total of $5.1 billion of such earnings. It is not practicable to determine the income tax liability that might be incurred if these earnings were to be distributed. 75 Table of Contents Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the +future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income +in the years in which those temporary differences are expected to be recovered or settled. As of September 26, 2009 and +September 27, 2008, the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2009 2008 Deferred tax assets: Accrued liabilities and other reserves $ 2,133 $ 1,295 Basis of capital assets and investments 180 173 Accounts receivable and inventory reserves 172 126 Other 683 550 Total deferred tax assets 3,168 2,144 Less valuation allowance — — Deferred tax assets, net of valuation allowance 3,168 2,144 Deferred tax liabilities - Unremitted earnings of foreign subsidiaries 1,778 1,234 Net deferred tax assets $ 1,390 $ 910 A reconciliation of the provision for income taxes, with the amount computed by +applying the statutory federal income tax rate (35% in 2009, 2008 and 2007) to income before provision for income taxes for the three years ended September 26, 2009, is as follows (in millions): 2009 2008 2007 Computed expected tax $ 2,795 $ 2,414 $ 1,753 State taxes, net of federal effect 228 159 140 Indefinitely invested earnings of foreign subsidiaries (658 ) (492 ) (297 ) Nondeductible executive compensation 13 6 6 Research and development credit, net (84 ) (21 ) (54 ) Other (14 ) (5 ) (36 ) Provision for income taxes $ 2,280 $ 2,061 $ 1,512 Effective tax rate 29% 30% 30% The Company’s income taxes payable have been reduced by the tax benefits from +employee stock plan awards. For stock options, the Company receives an income tax benefit calculated as the difference between the fair market value of the stock issued at the time of the exercise and the option price, tax effected. The Company +had net tax benefits from employee stock plan awards of $246 million, $770 million and $398 million in 2009, 2008 and 2007, respectively, which were reflected as increases to common stock. On October 3, 2008, the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 was signed into law. This bill, among other things, retroactively extended the expired +research and development tax credit. As a result, the Company recorded a tax benefit of $42 million in the first quarter of 2009 to account for the retroactive effects of the research credit extension. Uncertain Tax Positions As discussed in Note 1, “Summary of Significant Accounting Policies” the Company adopted new accounting principles on accounting for uncertain tax positions in 2008. Under these new principles, tax positions are evaluated in a +two-step process. The Company first determines whether it is more likely than not that a tax 76 Table of Contents position will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the +financial statements. The tax position is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. Upon adoption of these new principles, the Company’s cumulative effect of a +change in accounting principle resulted in an increase to retained earnings of $11 million. The Company had historically classified interest and penalties and unrecognized tax benefits as current liabilities. Beginning with the adoption of these new +principles, the Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one year as non-current liabilities in the Consolidated Balance Sheets. The total +amount of gross unrecognized tax benefits as of the date of adoption was $475 million, of which $209 million, if recognized, would affect the Company’s effective tax rate. The Company’s total gross unrecognized tax benefits are classified as non-current liabilities in the Consolidated Balance Sheets. As of September 26, 2009, the total amount +of gross unrecognized tax benefits was $971 million, of which $307 million, if recognized, would affect the Company’s effective tax rate. As of September 27, 2008, the total amount of gross unrecognized tax benefits was $506 million, of +which $253 million, if recognized, would affect the Company’s effective tax rate. On May 27, 2009, the United +States Court of Appeals for the Ninth Circuit issued its ruling in the case of Xilinx, Inc. v. Commissioner , holding that stock-based compensation is required to be included in certain transfer pricing arrangements between a U.S. company +and its offshore subsidiary. As a result of the ruling in this case, the Company increased its liability for unrecognized tax benefits by approximately $86 million and decreased shareholders’ equity by approximately $78 million in the year +ended September 26, 2009. The aggregate changes in the balance of gross unrecognized tax benefits, which excludes +interest and penalties, for the two years ended September 26, 2009, is as follows (in millions): Balance as of September 30, 2007 $ 475 Increases related to tax positions taken during a prior period 27 Decreases related to tax positions taken during a prior period (70 ) Increases related to tax positions taken during the current period 85 Decreases related to settlements with taxing authorities — Decreases related to expiration of statute of limitations (11 ) Balance as of September 27, 2008 506 Increases related to tax positions taken during a prior period 341 Decreases related to tax positions taken during a prior period (24 ) Increases related to tax positions taken during the current period 151 Decreases related to settlements with taxing authorities — Decreases related to expiration of statute of limitations (3 ) Balance as of September 26, 2009 $ 971 The Company’s policy to include interest and penalties related to unrecognized +tax benefits within the provision for income taxes did not change as a result of adopting the new accounting principles on accounting for uncertain tax positions in 2008. As of the date of adoption, the Company had accrued $203 million for the gross +interest and penalties relating to unrecognized tax benefits. As of September 26, 2009 and September 27, 2008, the total amount of gross interest and penalties accrued was $291 million and $219 million, respectively, which is classified as +non-current liabilities in the Consolidated Balance Sheets. In 2009 and 2008, the Company recognized interest expense in connection with tax matters of $64 million and $16 million, respectively. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign +jurisdictions. For U.S. federal income tax purposes, all years prior to 2002 are closed. The years 2002-2003 have been examined by the Internal Revenue Service (the “IRS”) and disputed issues have been taken 77 Table of Contents to administrative appeals. The IRS is currently examining the 2004-2006 years. In addition, the Company is also subject to audits by state, local and foreign tax authorities. In major states +and major foreign jurisdictions, the years subsequent to 1988 and 2000, respectively, generally remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues +addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income tax in the period such resolution occurs. Although timing of the +resolution and/or closure of audits is highly uncertain, the Company believes it is reasonably possible that tax audit resolutions could reduce its unrecognized tax benefits by between $105 million and $145 million in the next 12 months. Note 7 – Shareholders’ Equity and Stock-Based Compensation Preferred Stock The Company has five million shares of authorized +preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, preferences, privileges and restrictions of the +Company’s authorized but unissued shares of preferred stock. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, +expenses, gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those +subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash +flow hedges. The following table summarizes the components of accumulated other comprehensive income, net of taxes, as of the +three years ended September 26, 2009 (in millions): 2009 2008 2007 Net unrealized gains/losses on available-for-sale securities $ 48 $ (70 ) $ (7 ) Net unrecognized gains on derivative instruments 31 19 — Cumulative foreign currency translation 5 59 70 Accumulated other comprehensive income $ 84 $ 8 $ 63 The change in fair value of available-for-sale securities included in other +comprehensive income was $118 million, $(63) million and $(7) million, net of taxes in 2009, 2008 and 2007, respectively. The tax effect related to the change in unrealized gain/loss on available-for-sale securities was $(78) million, $42 million +and $4 million for 2009, 2008 and 2007, respectively. The following table summarizes activity in other comprehensive income +related to derivatives, net of taxes, held by the Company during the three years ended September 26, 2009 (in millions): 2009 2008 2007 Changes in fair value of derivatives $ 90 $ 7 $ (1) Adjustment for net gains/losses realized and included in net income (78 ) 12 (2) Change in unrecognized gains/losses on derivative instruments $ 12 $ 19 $ (3) 78 Table of Contents The tax effect related to the changes in fair value of derivatives was $(60) million, $(5) +million and $1 million for 2009, 2008 and 2007, respectively. The tax effect related to derivative gains/losses reclassified from other comprehensive income to net income was $54 million, $(9) million and $2 million for 2009, 2008 and 2007, +respectively. Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the “2003 Plan”) is a shareholder +approved plan that provides for broad-based equity grants to employees, including executive officers. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights +and performance-based awards. Based on the terms of individual option grants, options granted under the 2003 Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years, based on +continued employment, with either annual, semi-annual or quarterly vesting. In general, RSUs granted under the 2003 Plan vest over two to four years, are subject to the employees’ continued employment and do not have an expiration date. As of +September 26, 2009, approximately 37 million shares were reserved for future issuance under the 2003 Plan. 1997 Employee +Stock Option Plan In August 1997, the Company’s Board of Directors approved the 1997 Employee Stock Option +Plan (the “1997 Plan”), a non-shareholder approved plan for grants of stock options to employees who are not officers of the Company. Based on the terms of individual option grants, options granted under the 1997 Plan generally expire +seven to ten years after the grant date. All stock options granted under the 1997 Plan are fully vested. In October 2003, the Company terminated the 1997 Plan, and no new options can be granted from this plan. 1997 Director Stock Option Plan In August 1997, the Company’s Board of Directors adopted a Director Stock Option Plan (the “Director Plan”) for non-employee directors of the Company, which was approved by +shareholders in 1998. Pursuant to the Director Plan, the Company’s non-employee directors are granted an option to acquire 30,000 shares of common stock upon their initial election to the Board (“Initial Options”). The Initial Options +vest and become exercisable in three equal annual installments on each of the first through third anniversaries of the grant date. On the fourth anniversary of a non-employee director’s initial election to the Board and on each subsequent +anniversary thereafter, the director will be entitled to receive an option to acquire 10,000 shares of common stock (“Annual Options”). Annual Options are fully vested and immediately exercisable on their date of grant. Options granted +under the Director Plan expire ten years after the grant date. As of September 26, 2009, approximately 240,000 shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans As of October 16, 2009, executive +officers Timothy D. Cook, Ronald B. Johnson, Peter Oppenheimer, Philip W. Schiller and Bertrand Serlet have entered into trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). A +trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock including the exercise and sale of employee +stock options and shares acquired pursuant to the Company’s employee stock purchase plan and upon vesting of RSUs. Employee Stock +Purchase Plan The Company has a shareholder approved employee stock purchase plan (the “Purchase Plan”), +under which substantially all employees may purchase common stock through payroll deductions at a price equal to 85% of the lower of the fair market values as of the beginning and end of six-month offering periods. Stock purchases 79 Table of Contents under the Purchase Plan are limited to 10% of an employee’s compensation, up to a maximum of $25,000 in any calendar year. The number of shares authorized to be purchased in any calendar +year is limited to a total of 3 million shares. As of September 26, 2009, approximately 4.7 million shares were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an employee savings plan (the +“Savings Plan”) qualifying as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual +contribution limit ($16,500 for calendar year 2009). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. The Company’s matching +contributions to the Savings Plan were $59 million, $50 million and $39 million in 2009, 2008 and 2007, respectively. Restricted Stock +Units Historically, the Company used equity awards in the form of stock options as one of the means for recruiting and +retaining highly skilled talent. In conjunction with the Company’s 2009 equity compensation program changes, it began issuing primarily RSUs rather than stock options for eligible employees as the primary type of long-term equity-based award. A +summary of the Company’s RSU activity and related information for the three years ended September 26, 2009, is as follows (in thousands, except per share amounts): Number of Shares Weighted- Average Grant Date Fair Value Aggregate Intrinsic Value Balance at September 30, 2006 3,410 $ 39.62 Restricted stock units granted 1,320 $ 88.51 Restricted stock units vested (45 ) $ 46.57 Restricted stock units cancelled (10 ) $ 86.14 Balance at September 29, 2007 4,675 $ 52.98 Restricted stock units granted 4,917 $ 162.61 Restricted stock units vested (2,195 ) $ 25.63 Restricted stock units cancelled (357 ) $ 119.12 Balance at September 27, 2008 7,040 $ 134.91 Restricted stock units granted 7,786 $ 111.80 Restricted stock units vested (1,935 ) $ 124.87 Restricted stock units cancelled (628 ) $ 121.28 Balance at September 26, 2009 12,263 $ 122.52 $ 2,236,305 The fair value as of the vesting date of RSUs that vested was $221 million, $320 +million and $6 million for 2009, 2008 and 2007, respectively. Upon vesting, the RSUs are generally net share-settled to cover the required withholding tax and the remaining amount is converted into an equivalent number of shares of common stock. The +majority of RSUs vested in 2009, 2008 and 2007, were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income and other employment taxes, and remitted +the cash to the appropriate taxing authorities. The total shares withheld were approximately 707,000, 857,000 and 20,000 for 2009, 2008 and 2007, respectively, and were based on the value of the RSUs on their vesting date as determined by the +Company’s closing stock price. Total payments for the employees’ tax obligations to the taxing authorities were $82 million, $124 million and $3 million in 2009, 2008 and 2007, respectively, and are reflected as a financing activity within +the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the number of shares that would have otherwise been issued as a result of the vesting and did +not represent an expense to the Company. 80 Table of Contents Stock Option Activity A summary of the Company’s stock option and RSU activity and related information for the three years ended September 26, 2009, is as follows (in thousands, except per share +amounts and contractual term in years): Outstanding Options Shares Available for Grant Number of Shares Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term Aggregate Intrinsic Value Balance at September 30, 2006 54,994 52,982 $ 23.23 Additional shares authorized 28,000 — $ — Restricted stock units granted (2,640 ) — $ — Options granted (14,010) 14,010 $ 94.52 Options cancelled 1,471 (1,471 ) $ 55.38 Restricted stock units cancelled 20 — $ — Options exercised — (15,770 ) $ 18.32 Plan shares expired (8 ) — $ — Balance at September 29, 2007 67,827 49,751 $ 43.91 Restricted stock units granted (9,834 ) — $ — Options granted (9,359 ) 9,359 $ 171.36 Options cancelled 1,236 (1,236 ) $ 98.40 Restricted stock units cancelled 714 — $ — Options exercised — (13,728 ) $ 27.88 Plan shares expired (12 ) — $ — Balance at September 27, 2008 50,572 44,146 $ 74.39 Restricted stock units granted (15,572 ) — $ — Options granted (234 ) 234 $ 106.84 Options cancelled 1,241 (1,241 ) $ 122.98 Restricted stock units cancelled 1,256 — $ — Options exercised — (8,764 ) $ 41.78 Plan shares expired (2 ) — $ — Balance at September 26, 2009 37,261 34,375 $ 81.17 3.52 $ 3,482,530 Exercisable at September 26, 2009 24,685 $ 60.62 3.01 $ 3,006,829 Expected to Vest after September 26, 2009 9,479 $ 133.28 4.82 $ 465,321 Aggregate intrinsic value represents the value of the Company’s closing stock +price on the last trading day of the fiscal period in excess of the weighted-average exercise price multiplied by the number of options outstanding or exercisable. The aggregate intrinsic value excludes the effect of stock options that have a zero +or negative intrinsic value. Total intrinsic value of options at time of exercise was $827 million, $2.0 billion and $1.3 billion for 2009, 2008 and 2007, respectively. RSUs granted are deducted from the shares available for grant under the Company’s stock option plans utilizing a factor of two times the number of RSUs granted. Similarly, RSUs cancelled are added +back to the shares available for grant under the Company’s stock option plans utilizing a factor of two times the number of RSUs cancelled. Outstanding RSU balances are not included in the outstanding options balances in the stock option +activity table. Stock-Based Compensation Stock-based compensation cost for RSUs is measured based on the closing fair market value of the Company’s common stock on the date of grant. Stock-based compensation cost for stock options is +estimated at the grant 81 Table of Contents date based on each option’s fair-value as calculated by the BSM option-pricing model. The BSM option-pricing model incorporates various assumptions including expected volatility, expected +life and interest rates. The expected volatility is based on the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options and other +relevant factors including implied volatility in market traded options on the Company’s common stock. The Company bases its expected life assumption on its historical experience and on the terms and conditions of the stock awards it grants to +employees. The Company recognizes stock-based compensation cost as expense ratably on a straight-line basis over the requisite service period. The weighted-average assumptions used for the three years ended September 26, 2009, and the resulting estimates of weighted-average fair value per share of options granted and of employee stock +purchase plan rights (“stock purchase rights”) during those periods are as follows: 2009 2008 2007 Expected life of stock options 4.54 years (a) 3.41 years 3.46 years Expected life of stock purchase rights 6 months 6 months 6 months Interest rate - stock options 2.04% (a) 3.40% 4.61% Interest rate - stock purchase rights 0.58% 3.48% 5.13% Volatility - stock options 50.98% (a) 45.64% 38.13% Volatility - stock purchase rights 52.16% 38.51% 39.22% Dividend yields — — — Weighted-average fair value of stock options granted during the year $46.71 $62.73 $31.86 Weighted-average fair value of employee stock purchase plan rights during the year $30.62 $42.27 $20.90 (a) In conjunction with the Company’s 2009 equity compensation program changes, it began issuing primarily RSUs rather than stock options to +employees, although the Company continues to grant stock options to non-employee directors. Accordingly the weighted average expected life of stock options was influenced by non-employee director stock option grants, which had a ten-year expected +life. The weighted average expected life of stock options also affects the resulting interest rate and expected volatility assumptions. The following table provides a summary of the stock-based compensation expense included in the Consolidated Statements of Operations for the three years ended September 26, 2009 (in millions): 2009 2008 2007 Cost of sales $ 114 $ 80 $ 35 Research and development 258 185 77 Selling, general and administrative 338 251 130 Total stock-based compensation expense $ 710 $ 516 $ 242 Stock-based compensation expense capitalized as software development costs was not +significant as of September 26, 2009 or September 27, 2008. The income tax benefit related to stock-based compensation expense was $266 million, $169 million and $81 million for 2009, 2008 and 2007, respectively. The total unrecognized +compensation cost related to stock options and RSUs expected to vest was $1.4 billion as of September 26, 2009, which is expected to be recognized over a weighted-average period of 2.53 years. Note 8 – Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, including retail space, under +noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. The 82 Table of Contents major facility leases are generally for terms of one to 20 years and generally provide renewal options for terms of one to five additional years. Leases for retail space are for terms of five to +20 years, the majority of which are for ten years, and often contain multi-year renewal options. As of September 26, 2009, the Company’s total future minimum lease payments under noncancelable operating leases were $1.9 billion, of which +$1.5 billion related to leases for retail space. Rent expense under all operating leases, including both cancelable and +noncancelable leases, was $231 million, $207 million and $151 million in 2009, 2008 and 2007, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 26, +2009, are as follows (in millions): Years 2010 $ 222 2011 234 2012 228 2013 214 2014 199 Thereafter 825 Total minimum lease payments $ 1,922 Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase +by the end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product +warranties at the time related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected +warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its preexisting warranty liabilities and +adjusts the amounts as necessary based on actual experience and changes in future estimates. For products accounted for under subscription accounting, the Company recognizes warranty expense as incurred. The Company periodically provides updates to its applications and system software to maintain the software’s compliance with published +specifications. The estimated cost to develop such updates is accounted for as warranty costs that are recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates +include the number of units delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates. The following table reconciles changes in the Company’s accrued warranties and related costs for the three years ended September 26, 2009 (in millions): 2009 2008 2007 Beginning accrued warranty and related costs $ 267 $ 230 $ 284 Cost of warranty claims (294 ) (319 ) (281 ) Accruals for product warranties 237 356 227 Ending accrued warranty and related costs $ 210 $ 267 $ 230 The Company generally does not indemnify end-users of its operating system and +application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to +costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. 83 Table of Contents However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified third-party and, in the opinion of +management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would materially adversely affect its financial condition or operating results. Therefore, the Company did not record a +liability for infringement costs as of either September 26, 2009 or September 27, 2008. The Company has entered +into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status +as directors or officers and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these +agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such +obligations, and payments made under these agreements historically have not materially adversely affected the Company’s financial condition or operating results. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain key components including but not limited to microprocessors, enclosures, certain liquid crystal displays +(“LCDs”), certain optical drives and application-specific integrated circuits (“ASICs”) are currently obtained by the Company from single or limited sources, which subjects the Company to significant supply and pricing risks. +Many of these and other key components that are available from multiple sources including but not limited to NAND flash memory, dynamic random access memory (“DRAM”) and certain LCDs, are subject at times to industry-wide shortages and +significant commodity pricing fluctuations. In addition, the Company has entered into certain agreements for the supply of key components including but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there +is no guarantee that the Company will be able to extend or renew these agreements on similar favorable terms, or at all, upon expiration or otherwise obtain favorable pricing in the future. Therefore, the Company remains subject to significant risks +of supply shortages and/or price increases that can materially adversely affect its financial condition and operating results. The Company and other participants in the personal computer, mobile communication and consumer electronics industries also compete for various components with other industries that have experienced increased demand for their products. In +addition, the Company uses some custom components that are not common to the rest of the personal computer, mobile communication and consumer electronics industries, and new products introduced by the Company often utilize custom components +available from only one source until the Company has evaluated whether there is a need for, and subsequently qualifies, additional suppliers. When a component or product uses new technologies, initial capacity constraints may exist until the +suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of a key single-sourced component for a new or existing product were delayed or constrained, if such components were available only at +significantly higher prices, or if a key manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business +and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of +these components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Significant portions of the Company’s Mac computers, iPhones, iPods, logic boards and other assembled products are now manufactured by +outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently performed by only a few of the Company’s outsourcing partners, often in single locations. Certain of these +outsourcing partners are the sole-sourced supplier of components and manufacturing outsourcing for many of the Company’s key products including but not limited to final assembly of substantially all of the Company’s portable Mac computers, +iPhones, iPods and most of the Company’s desktop products. Although 84 Table of Contents the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to +meet their production commitments. The Company’s purchase commitments typically cover its requirements for periods ranging from 30 to 150 days. Long-Term Supply Agreements The Company has entered into prepaid long-term supply agreements to secure the +supply of certain inventory components. During the first quarter of 2009, a long-term supply agreement with Intel Corporation was terminated and the remaining prepaid balance of $167 million was repaid to the Company. During the second and fourth +quarters of 2009, the Company made a prepayment of $500 million to LG Display for the purchase of LCD panels and a prepayment of $500 million to Toshiba to purchase NAND flash memory, respectively. As of September 26, 2009, the Company had +a total of $1.2 billion of inventory component prepayments outstanding. Contingencies The Company is subject to certain other legal proceedings and claims that have arisen in the ordinary course of business and have not been +fully adjudicated, which are discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings.” In the opinion of management, the Company does not have a potential liability related to any current legal proceedings +and claims that would individually or in the aggregate materially adversely affect its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. If the Company failed to prevail in any of +these legal matters or if several of these legal matters were resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. Production and marketing of products in certain states and countries may subject the Company to environmental, product safety and other +regulations including, in some instances, the requirement to provide customers the ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and +regulations have been passed in several jurisdictions in which the Company operates, including various countries within Europe and Asia and certain states and provinces within North America. Although the Company does not anticipate any material +adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws or future laws will not materially adversely affect the Company’s financial condition or operating +results. Note 9 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making +decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business +primarily on a geographic basis. Accordingly, the Company determined its operating segments, which are generally based on the nature and location of its customers, to be the Americas, Europe, Japan, Asia-Pacific, Retail and FileMaker operations. The +Company’s reportable operating segments consist of Americas, Europe, Japan and Retail operations. Other operating segments include Asia Pacific, which encompasses Australia and Asia except for Japan and the Company’s FileMaker, Inc. +subsidiary. The Americas, Europe, Japan and Asia Pacific segments exclude activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as the Middle +East and Africa. The Retail segment operates Apple-owned retail stores in the U.S. and in international markets. Each reportable operating segment provides similar hardware and software products and similar services to the same types of customers. +The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers, while Retail +segment net sales are based on sales from the Company’s retail stores. Operating income for each segment includes net sales to 85 Table of Contents third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures +are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, such as manufacturing +costs and variances not included in standard costs, research and development, corporate marketing expenses, stock-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. +The Company does not include intercompany transfers between segments for management reporting purposes. Segment assets exclude corporate assets, such as cash, short-term and long-term investments, manufacturing and corporate facilities, +miscellaneous corporate infrastructure, goodwill and other acquired intangible assets. Except for the Retail segment, capital asset purchases for long-lived assets are not reported to management by segment. Cash payments for capital asset purchases +by the Retail segment were $369 million, $389 million and $294 million for 2009, 2008 and 2007, respectively. The Company has +certain retail stores that have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these +stores require substantially more investment than the Company’s more typical retail stores. The Company allocates certain operating expenses associated with its high-profile stores to corporate marketing expense to reflect the estimated +Company-wide benefit. The allocation of these operating costs to corporate expense is based on the amount incurred for a high-profile store in excess of that incurred by a more typical Company retail location. The Company had opened a total of 11 +high-profile stores as of September 26, 2009. Expenses allocated to corporate marketing resulting from the operations of high-profile stores were $65 million, $53 million and $39 million for 2009, 2008 and 2007, respectively. Summary information by operating segment for the three years ended September 26, 2009 is as follows (in millions): 2009 2008 2007 Americas: Net sales $ 16,142 $ 14,573 $ 11,596 Operating income $ 4,772 $ 4,051 $ 2,949 Depreciation, amortization and accretion $ 11 $ 9 $ 9 Segment assets (a) $ 4,290 $ 3,039 $ 1,497 Europe: Net sales $ 9,365 $ 7,622 $ 5,460 Operating income $ 2,913 $ 2,313 $ 1,348 Depreciation, amortization and accretion $ 7 $ 6 $ 6 Segment assets $ 2,994 $ 1,775 $ 595 Japan: Net sales $ 1,831 $ 1,509 $ 1,082 Operating income $ 657 $ 440 $ 232 Depreciation, amortization and accretion $ 2 $ 2 $ 3 Segment assets $ 638 $ 302 $ 159 Retail: Net sales $ 6,574 $ 6,315 $ 4,115 Operating income $ 1,392 $ 1,337 $ 875 Depreciation, amortization and accretion (b) $ 146 $ 108 $ 88 Segment assets (b) $ 1,929 $ 1,869 $ 1,085 Other Segments (c): Net sales $ 2,625 $ 2,460 $ 1,753 Operating income $ 748 $ 615 $ 388 Depreciation, amortization and accretion $ 4 $ 4 $ 3 Segment assets $ 953 $ 534 $ 252 86 Table of Contents (a) The Americas asset figures do not include fixed assets held in the U.S. Such fixed assets are not allocated specifically to the Americas segment and +are included in the corporate assets figures below. (b) Retail segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. (c) Other Segments include Asia-Pacific and FileMaker. A reconciliation of the Company’s segment operating income and assets to the consolidated financial statements for the three years ended September 26, 2009 is as follows (in millions): 2009 2008 2007 Segment operating income $ 10,482 $ 8,756 $ 5,792 Other corporate expenses, net (a) (2,114 ) (1,965 ) (1,141 ) Stock-based compensation expense (710 ) (516 ) (242 ) Total operating income $ 7,658 $ 6,275 $ 4,409 Segment assets $ 10,804 $ 7,519 $ 3,588 Corporate assets 43,047 32,053 21,759 Consolidated assets $ 53,851 $ 39,572 $ 25,347 Segment depreciation, amortization and accretion $ 170 $ 129 $ 109 Corporate depreciation, amortization and accretion 533 344 208 Consolidated depreciation, amortization and accretion $ 703 $ 473 $ 317 (a) Other corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard +costs, and other separately managed general and administrative expenses, including certain corporate expenses associated with support of the Retail segment. No single customer or single country outside of the U.S. accounted for more than 10% of net sales in 2009, 2008 or 2007. Net sales and long-lived assets related to the U.S. and +international operations for the three years ended September 26, 2009, are as follows (in millions): 2009 2008 2007 Net sales: U.S. $ 19,870 $ 18,469 $ 14,128 International 16,667 14,010 9,878 Total net sales $ 36,537 $ 32,479 $ 24,006 Long-lived assets: U.S. $ 2,698 $ 2,269 $ 1,752 International 495 410 260 Total long-lived assets $ 3,193 $ 2,679 $ 2,012 87 Table of Contents Information regarding net sales by product for the three years ended September 26, +2009, is as follows (in millions): 2009 2008 2007 Net sales: Desktops (a) $ 4,308 $ 5,603 $ 4,020 Portables (b) 9,472 8,673 6,294 Total Mac net sales 13,780 14,276 10,314 iPod 8,091 9,153 8,305 Other music related products and services (c) 4,036 3,340 2,496 iPhone and related products and services (d) 6,754 1,844 123 Peripherals and other hardware (e) 1,470 1,659 1,260 Software, service and other net sales (f) 2,406 2,207 1,508 Total net sales $ 36,537 $ 32,479 $ 24,006 (a) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (b) Includes MacBook, MacBook Air and MacBook Pro product lines. (c) Consists of iTunes Store sales and iPod services, and Apple-branded and third-party iPod accessories. (d) Derived from handset sales, carrier agreements, and Apple-branded and third-party iPhone accessories. (e) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. (f) Includes sales of Apple-branded operating system and application software, third-party software, AppleCare and Internet services. Note 10 – Related Party Transactions and Certain Other Transactions The Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs in +the operation of his private plane when used for Apple business. The Company recognized a total of approximately $4,000, $871,000 and $776,000 in expenses pursuant to the Reimbursement Agreement during 2009, 2008 and 2007, respectively. All expenses +recognized pursuant to the Reimbursement Agreement have been included in selling, general and administrative expenses in the Consolidated Statements of Operations. Note 11 – Selected Quarterly Financial Information (Unaudited) The following tables set forth a summary of the Company’s quarterly financial information for each of the four quarters ended September 26, 2009 and September 27, 2008 (in millions, except +per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2009 Net sales $ 9,870 $ 8,337 $ 8,163 $ 10,167 Gross margin $ 3,614 $ 3,023 $ 2,971 $ 3,532 Net income $ 1,665 $ 1,229 $ 1,205 $ 1,605 Earnings per common share: Basic $ 1.85 $ 1.38 $ 1.35 $ 1.81 Diluted $ 1.82 $ 1.35 $ 1.33 $ 1.78 2008 Net sales $ 7,895 $ 7,464 $ 7,512 $ 9,608 Gross margin $ 2,739 $ 2,600 $ 2,474 $ 3,332 Net income $ 1,136 $ 1,072 $ 1,045 $ 1,581 Earnings per common share: Basic $ 1.28 $ 1.21 $ 1.19 $ 1.81 Diluted $ 1.26 $ 1.19 $ 1.16 $ 1.76 Basic and diluted earnings per share are computed independently for each of the +quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. 88 Table of Contents Report of Ernst & Young LLP, Independent Registered +Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheet of Apple Inc. as of September 26, 2009, and the related consolidated statements of operations, shareholders’ +equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the +financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable +basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, +the consolidated financial position of Apple Inc. at September 26, 2009, and the consolidated results of its operations and its cash flows for the year then ended, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), +Apple Inc.’s internal control over financial reporting as of September 26, 2009, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission +and our report dated October 27, 2009 expressed an unqualified opinion thereon. /s/ Ernst & +Young LLP San Jose, California October 27, 2009 89 Table of Contents Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 26, 2009, based on criteria established in Internal Control – Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the +effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control +over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our +audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, +in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in +accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future +periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 26, 2009, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +consolidated financial statements of Apple Inc. as of and for the year ended September 26, 2009 and our report dated October 27, 2009 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 27, 2009 90 Table of Contents Report of KPMG LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders Apple Inc.: We have audited the accompanying consolidated balance sheet of Apple Inc. and subsidiaries (the Company) +as of September 27, 2008, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the years ended September 27, 2008 and September 29, 2007. These consolidated financial statements are the +responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the +audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing +the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of +Apple Inc. and subsidiaries as of September 27, 2008 and the results of their operations and their cash flows for the years ended September 27, 2008 and September 29, 2007 in conformity with U.S. generally accepted accounting +principles. As discussed in note 1 to the Consolidated Financial Statements, effective September 30, 2007, the +Company adopted Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109. /s/ KPMG LLP Mountain View, California November 4, 2008 91 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of +Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the +Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act +were effective as of September 26, 2009 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as +appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the +Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and +that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets +that could have a material effect on the financial statements. Management, including the Company’s +Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, +not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. +Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of +controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act. +Management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission (“COSO”). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 26, 2009 to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles. The Company’s independent registered public accounting firm, +Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting. The report on the audit of internal control over financial reporting appears on page 90 of this Form 10-K. 92 Table of Contents Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of fiscal 2009, which were +identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal +control over financial reporting. Item 9B. Other Information None. 93 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item under the heading “Directors, Executive Officers and Corporate Governance” is incorporated herein by reference from the information to be contained in the +Company’s 2010 Proxy Statement to be filed with the U.S. Securities and Exchange Commission (“SEC”) in connection with the solicitation of proxies for the Company’s 2010 Annual Meeting of Shareholders (“2010 Proxy +Statement”). Such Proxy Statement will be filed with the SEC within 120 days after the end of the fiscal year to which this report relates. Item 11. Executive Compensation The information required by this Item under the headings “Executive Compensation” and “Compensation Discussion and Analysis” is incorporated herein by reference from the information to be contained in the Company’s +2010 Proxy Statement. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item under the headings “Security Ownership of Certain Beneficial Owners and Management” and +“Equity Compensation Plan Information” is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy Statement. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item under the heading “Review, Approval or Ratification of Transactions with Related Persons” is incorporated herein by reference from the +information to be contained in the Company’s 2010 Proxy Statement. Item 14. Principal Accountant Fees and Services The information required by this Item under the heading “Fees Paid to Auditors” is incorporated herein by reference from the information to be contained in the Company’s 2010 Proxy +Statement. 94 Table of Contents PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Balance Sheets as of September 26, 2009 and September 27, 2008 55 Consolidated Statements of Operations for the three years ended September 26, 2009 56 Consolidated Statements of Shareholders’ Equity for the three years ended September 26, 2009 57 Consolidated Statements of Cash Flows for the three years ended September 26, 2009 58 Notes to Consolidated Financial Statements 59 Selected Quarterly Financial Information (Unaudited) 88 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 89 Report of KPMG LLP, Independent Registered Public Accounting Firm 91 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the consolidated financial statements and notes thereto. (b) Exhibits required by Item 601 of Regulation S-K The information required by this Item is set forth on the exhibit index that follows the signature page of this report. 95 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the +undersigned, thereunto duly authorized, this 27th day of October 2009. APPLE INC. By: /s/  Peter Oppenheimer Peter Oppenheimer Senior Vice President and Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven P. Jobs and Peter +Oppenheimer, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other +documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of +the registrant and in the capacities and on the dates indicated: Name Title Date /s/  Steven P. Jobs STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) October 27, 2009 /s/  Peter +Oppenheimer PETER OPPENHEIMER Senior Vice President and Chief Financial Officer (Principal Financial Officer) October 27, 2009 /s/  Betsy Rafael BETSY RAFAEL Vice President Corporate +Controller (Principal Accounting Officer) October 27, 2009 /s/  William V. +Campbell WILLIAM V. CAMPBELL Director October 27, 2009 /s/  Millard S. +Drexler MILLARD S. DREXLER Director October 27, 2009 /s/  Albert Gore, +Jr. ALBERT GORE, JR. Director October 27, 2009 /s/  Andrea Jung ANDREA JUNG Director October 27, 2009 /s/  Arthur D. +Levinson ARTHUR D. LEVINSON Director October 27, 2009 /s/  Jerome B. York JEROME B. YORK Director October 27, 2009 96 Table of Contents EXHIBIT INDEX Incorporated by +Reference Exhibit Number Exhibit Description Form Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on July 10, 2009. 10-Q 6/27/09 3.2 By-Laws of the Registrant, as amended through May 27, 2009. 8-K 6/2/09 4.1 Form of Stock Certificate of the Registrant. 10-Q 12/30/06 10.1* Employee Stock Purchase Plan, as amended through May 10, 2007. 8-K 5/16/07 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 6/27/09 10.3* 1997 Employee Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.4* 1997 Director Stock Option Plan, as amended through May 10, 2007. 8-K 5/16/07 10.5* 2003 Employee Stock Plan, as amended through May 10, 2007. 8-K 5/16/07 10.6* Reimbursement Agreement dated as of May 25, 2001 by and between the Registrant and Steven P. Jobs. 10-Q 6/29/02 10.7* Form of Option Agreement. 10-K 9/24/05 10.8* Form of Restricted Stock Unit Award Agreement effective as of August 28, 2007. 10-K 9/29/07 10.9* Form of Restricted Stock Unit Award Agreement effective as of November 11, 2008. 10-Q 12/27/08 10.10* Transition Agreement and Settlement Agreement and Release dated as of November 3, 2008 by and between the Registrant and Anthony Fadell. 10-Q 12/27/08 14.1 Business Conduct Policy of the Registrant dated February 2009. 10-Q 3/28/09 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 23.2** Consent of KPMG LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signature Page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS**** XBRL Instance Document 101.SCH**** XBRL Taxonomy Extension Schema Document 101.CAL**** XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF**** XBRL Taxonomy Extension Definition Linkbase Document 101.LAB**** XBRL Taxonomy Extension Label Linkbase Document 101.PRE**** XBRL Taxonomy Extension Presentation Linkbase Document * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. **** Pursuant to applicable securities laws and regulations, the Company is deemed to have complied with the reporting obligation relating to the +submission of interactive data files in such exhibits and is not subject to liability under any anti-fraud provisions of the federal securities laws as long as the Company has made a good faith attempt to comply with the submission +requirements and promptly amends the interactive data files after becoming aware that the interactive data files fails to comply with the submission requirements. Users of this data are advised that, pursuant to Rule 406T, these interactive +data files are deemed not filed and otherwise are not subject to liability. 97 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-10-238044/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-10-238044/full-submission.txt new file mode 100644 index 0000000..8c99bf9 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-10-238044/full-submission.txt @@ -0,0 +1,1192 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 25, 2010 or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period +from to Commission file number: 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Global Select Market (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by +check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports +required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such +filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically +and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the +registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III +of this Form 10-K or any amendment to this Form 10-K. x Indicate by +check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and +“smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if smaller reporting company) Smaller Reporting Company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting and non-voting stock held by non-affiliates of the registrant, as of March 27, 2010, was +approximately $208,565,000,000 based upon the closing price reported for such date on the NASDAQ Global Select Market. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of the outstanding shares of common +stock and shares held by executive officers and directors of the registrant have been excluded because such persons may be deemed to be affiliates. This determination of executive officer or affiliate status is not necessarily a conclusive +determination for other purposes. 917,307,099 shares of Common Stock Issued and Outstanding as of October 15, 2010 DOCUMENTS INCORPORATED BY REFERENCE (1) Portions of the registrant’s definitive Proxy Statement relating to its 2011 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K where +indicated. Such Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Table of Contents The Business +section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements that involve risks and uncertainties. Many of the forward-looking statements are located in “Management’s Discussion and +Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or +current fact. Forward-looking statements can also be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar +terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences +include, but are not limited to, those discussed in the subsection entitled “Risk Factors” under Part I, Item 1A of this Form 10-K, which are incorporated herein by reference. The Company assumes no obligation to revise or update any +forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, +manufactures and markets a range of personal computers, mobile communication and media devices, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content +and applications. The Company’s products and services include Macintosh (“Mac”) computers, iPhone, iPad, iPod, Apple TV, Xserve, a portfolio of consumer and professional software applications, the Mac OS X and iOS operating systems, +third-party digital content and applications through the iTunes Store, and a variety of accessory, service and support offerings. The Company sells its products worldwide through its retail stores, online stores, and direct sales force and +third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party Mac, iPhone, iPad and iPod compatible products, including application software, printers, storage +devices, speakers, headphones, and various other accessories and peripherals, through its online and retail stores. The Company sells to consumer, small and mid-sized business (“SMB”), education, enterprise, government and creative +markets. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company’s fiscal calendar. The Company is a +California corporation founded in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, software, peripherals, services, and Internet offerings. The Company’s business +strategy leverages its unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative +industrial design. The Company believes continual investment in research and development is critical to the development and enhancement of innovative products and technologies. In conjunction with its strategy, the Company continues to build and +host a robust platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. The iTunes Store includes the App Store and iBookstore, which allow customers to discover and download third-party +applications and books through either a Mac or Windows-based computer or wirelessly through an iPhone, iPad or iPod touch. The Company also works to support a community for the development of third-party software and hardware products and digital +content that complement the Company’s offerings. Additionally, the Company’s strategy includes expanding its distribution to effectively reach more customers and provide them with a high-quality sales and post-sales support experience. The +Company is therefore uniquely positioned to offer superior and well-integrated digital lifestyle and productivity solutions. 1 Table of Contents Consumer and Small and Mid-Sized +Business The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of +the Company’s products and services greatly enhances its ability to attract and retain customers. The Company sells many of its products and resells certain third-party products in most of its major markets directly to consumers and businesses +through its retail and online stores. The Company has also invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the +Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a high level of integration and support services, and product expertise. As of September 25, 2010, the Company had opened a total of 317 retail stores, including 233 stores in the U.S. and 84 stores internationally. The Company has typically located its stores at +high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable high-traffic locations, the Company is better positioned to control the customer buying experience and attract +new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and related solutions. To that end, retail store configurations have evolved into various sizes to accommodate +market-specific demands. The Company believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of its products over those of its competitors. The stores employ experienced and knowledgeable +personnel who provide product advice, service and training. The stores offer a wide selection of third-party hardware, software, and various other accessories and peripherals that complement the Company’s products. Education Throughout +its history, the Company has focused on the use of technology in education and has been committed to delivering tools to help educators teach and students learn. The Company believes effective integration of technology into classroom instruction can +result in higher levels of student achievement, especially when used to support collaboration, information access, and the expression and representation of student thoughts and ideas. The Company has designed a range of products, services and +programs to address the needs of education customers, including individual laptop programs and education road shows. In addition, the Company supports mobile learning and real-time distribution and accessibility of education related materials +through iTunes U, which allows students and teachers to share and distribute educational media directly through their computers and mobile communication and media devices. The Company sells its products to the education market through its direct +sales force, select third-party resellers and its online and retail stores. Enterprise, Government and Creative The Company also sells its hardware and software products to customers in enterprise, government and creative markets in each of its +geographic segments. These markets are also important to many third-party developers who provide Mac-compatible hardware and software solutions. Customers in these markets utilize the Company’s products because of their high-powered computing +performance and expansion capabilities, networking functionality, and seamless integration with complementary products. The Company designs its high-end hardware solutions to incorporate the power, expandability, compatibility and other features +desired by these markets. Other In addition to consumer, SMB, education, enterprise, government and creative markets, the Company provides hardware and software products and solutions for customers in the information technology and +scientific markets. Business Organization The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Japan, Asia-Pacific and Retail. The Americas, Europe, +Japan and 2 Table of Contents Asia-Pacific reportable segments do not include activities related to the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European +countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asia, but does not include Japan. The Retail segment operates Apple-owned retail stores in the U.S. and in international markets. Each reportable +operating segment provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Part II, Item 7 of this Form 10-K under the subheading “Segment +Operating Performance,” and in Part II, Item 8 of this Form 10-K in Notes to Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.” Products The Company offers a range of personal +computing products, mobile communication and media devices, and portable digital music players, as well as a variety of related software, services, peripherals, networking solutions and various third-party hardware and software products. In +addition, the Company offers its own software products, including Mac OS ® X, the Company’s proprietary +operating system software for the Macintosh ® (“Mac”); iOS, the Company’s proprietary mobile +operating system; server software and application software for consumer, education, and business customers. The Company’s primary products are discussed below. Mac Hardware Products The Company offers a range of +personal computing products including desktop and portable computers, Xserve ® servers, related devices and +peripherals, and various third-party hardware products. The Company’s Mac desktop and portable systems feature Intel microprocessors, the Company’s Mac OS X Version 10.6 Snow Leopard ® (“Mac OS X Snow Leopard”) operating system and the iLife ® suite of software for creation and management of digital photography, music, movies, DVDs and websites. The Company’s desktop computers include iMac ® , Mac ® Pro and Mac ® mini. The iMac desktop computer is an all-in-one design that incorporates a display, processor, graphics card, hard +drive, optical drive, memory and other components inside a single enclosure. The Mac Pro desktop computer is targeted at business and professional customers and is designed to meet the performance, expansion, and networking needs of the most +demanding Mac user. The Mac mini is a desktop computer in a compact enclosure. The Company’s +portable computers include MacBook ® , MacBook ® Pro and MacBook Air ® . MacBook +is a portable computer designed for consumer and education users. MacBook Pro is a portable computer designed for professionals and consumers. MacBook Air is a high performance, ultra-slim notebook computer designed for professionals and consumers. iTunes ® iTunes digital +music management software (“iTunes”) is an application for playing, downloading, and organizing digital audio and video files and is available for both Mac and Windows-based computers. iTunes 10 features Ping, a music-oriented social +network, AirPlay ® wireless music playback, Genius Mixes, Home Sharing, and improved syncing functionality with +the Company’s mobile communication and media devices. iTunes is integrated with the iTunes Store ® , a service that allows customers to find, purchase, rent, and download third-party digital music, audio books, music +videos, short films, television shows, movies, podcasts, games, and other applications. The iTunes Store currently serves customers in 23 countries. The iTunes Store includes the Company’s App Store™ and iBookstore™. The App Store +allows customers to discover and download third-party applications, and the iBookstore features electronic books from major and independent publishers and provides customers a place to preview and buy books for their mobile communication and media +devices. Customers can access the App Store through either a Mac or Windows-based computer or wirelessly through an +iPhone ® , iPad™ or iPod touch ® . The iBookstore is accessed through the +iBooks ® application on an iPhone, iPad or iPod touch. 3 Table of Contents iPhone iPhone combines a mobile phone, a widescreen iPod ® with touch controls, and an Internet communications device in a single handheld product. Based on the Company’s Multi-Touch™ user interface, iPhone +features desktop-class email, web browsing, searching, and maps and is compatible with both Macs and Windows-based computers. iPhone automatically syncs content from users’ iTunes libraries, as well as contacts, bookmarks, and email +accounts. iPhone allows customers to access the iTunes Store to download audio and video files, as well as a variety of other digital content and applications. In June 2010, the Company introduced the iPhone 4 featuring an all-new design, +FaceTime ® video calling, a new high resolution Retina™ display, a 5 megapixel camera with LED flash and +front facing camera, high definition video recording, Apple’s A4 processor and a 3-axis gyroscope. In addition to the Company’s own iPhone accessories, third-party iPhone compatible products are available through the Company’s online +and retail stores and from third parties. The Company has signed multi-year agreements with various cellular network carriers +authorizing them to distribute and provide cellular network services for iPhones. These agreements are generally not exclusive with a specific carrier, except in the U.S. iPad In January 2010, the Company introduced iPad, a multi-purpose mobile +device for browsing the web, reading and sending email, viewing photos, watching videos, listening to music, playing games, reading e-books and more. iPad is based on the Company’s Multi-Touch technology and allows customers to connect with +their applications and content in a more interactive way. iPad allows customers to access the iTunes Store to download audio and video files, as well as a variety of other digital content and applications. In addition to the Company’s own iPad +accessories, third-party iPad compatible products are available through the Company’s online and retail stores and from third parties. iPod The Company’s iPod line of portable digital music and media players is comprised of iPod touch, iPod nano ® , iPod shuffle ® and iPod classic ® . All iPods +work with iTunes. In addition to the Company’s own iPod accessories, third-party iPod compatible products are available, either through the Company’s online and retail stores or from third parties. The iPod touch is a flash-memory-based iPod with a widescreen display and a Multi-Touch user interface. The Company’s latest iPod +touch, introduced in September 2010, includes features such as a Retina display, FaceTime video calling, high definition video recording and Game Center. iPod touch allows customers to access the iTunes Store to download audio and video files, as +well as a variety of other digital content and applications. The Company’s latest iPod nano, introduced in September 2010, is a flash-memory-based iPod that has been redesigned to feature the Company’s Multi-Touch interface allowing +customers to navigate their music collection by tapping or swiping the display. The new iPod nano features a polished aluminum and glass enclosure with a built-in clip. iPod shuffle, which was updated in September 2010, is a flash-memory-based iPod +that features a clickable control pad to control music playback and VoiceOver technology enabling customers to hear song titles, artists and playlist names. The iPod classic is a hard-drive based portable digital music and video player. Displays & Peripheral Products The Company manufactures the Apple Cinema High Definition Display™ and sells a variety of Apple-branded and third-party Mac-compatible peripheral products, including printers, storage devices, +computer memory, digital video and still cameras, and various other computing products and supplies. 4 Table of Contents Apple TV ® Apple TV is a device that allows customers to rent and watch movies and television shows on their television. Content from Netflix, YouTube, Flickr and MobileMe™, as well as music, photos and videos +from a Mac or Windows-based computer can also be wirelessly streamed to a television through Apple TV. Software Products and Computer +Technologies The Company offers a range of software products for consumer, SMB, education, enterprise, government, and +creative customers, including the Company’s proprietary Mac OS X and iOS operating system software; server software and related solutions; professional application software; and consumer, education, and business oriented application software. Operating System Software Mac OS X Mac OS X is built on an open-source UNIX-based foundation. Mac OS X Snow Leopard is the seventh major +release of Mac OS X and became available in August 2009. Mac OS X Snow Leopard features upgraded speed and performance and includes a new version of QuickTime ® X, support for Microsoft Exchange Server 2007 and VoiceOver integration with the Multi-Touch trackpad. Mac OS X offers Stacks, a means of easily accessing files from +the Dock; Finder ® that lets users quickly browse and share files between multiple Macs; Quick Look, a way to +instantly see files without opening an application; Spaces ® , a feature used to create groups of applications and +instantly switch between them; and Time Machine ® , a way to automatically back up all of the contents of a Mac. iOS iOS is the +Company’s mobile operating system that serves as the foundation for iPhone, iPad and iPod touch. In June 2010, the Company launched iOS 4, the latest version of the Company’s mobile operating system. iOS 4 features Multitasking that allows +customers to move between applications, Folders to organize and easily access applications, a unified Mail inbox, support for the iAd™ mobile advertising platform, and the iBooks reader and iBookstore. The iAd mobile advertising platform +provides media rich advertisements which allows mobile device customers to engage with an ad without being removed from the applications they are currently using. iOS 4 became available for iPhone 3G, iPhone 3GS, iPhone 4, and second and third +generation iPod touch in June 2010, and is expected to be available for iPad in November 2010. Certain features of the iOS 4 software will not function on certain earlier iPhone and iPod touch models. Application Software iLife iLife ’11 is the latest version of the Company’s consumer-oriented digital lifestyle application suite +included with all Mac computers. iLife features iPhoto ® , +iMovie ® , iDVD ® , GarageBand ® , and iWeb™. +iPhoto is the Company’s consumer-oriented digital photo software application and iMovie is the Company’s consumer-oriented digital video editing software application. iDVD is the Company’s consumer-oriented software application that +enables customers to turn iMovie files, QuickTime files, and digital pictures into interactive DVDs. GarageBand is the Company’s consumer-oriented music creation software application that allows customers to play, record and create music. iWeb +allows customers to create online photo albums, blogs and podcasts, and to customize websites using editing tools. iWork ® iWork ’09 is the latest version of the Company’s integrated productivity suite designed to help users create, present, and publish documents, presentations, and spreadsheets. iWork ’09 +includes updates to Pages ® ’09 for 5 Table of Contents word processing and page layout, Keynote ® ’09 for +presentations, and Numbers ® ’09 for spreadsheets. In January 2010, the Company also introduced a new +version of iWork for iPad, a productivity suite including versions of Pages, Keynote and Numbers designed specifically for Multi-Touch. Other +Application Software The Company also sells various other application software, including Final Cut +Studio ® , Final Cut ® Express, Final Cut ® Server, +Logic Studio ® , Logic ® Express 9, Logic Studio ® Pro, +and its FileMaker ® Pro database software. Internet Software and Services The Company is focused +on delivering seamless integration with and access to the Internet throughout the Company’s products and services. The Company’s Internet solutions adhere to many industry standards to provide an optimized user experience. Safari 5 ® is the latest version of the Company’s web browser that is compatible with Macs and Windows-based computers. +MobileMe is an annual subscription-based suite of Internet services that delivers email, contacts and calendars to and from native applications on iPhone, iPad, iPod touch, Macs, and Windows-based computers. Product Support and Services AppleCare ® offers a range of support options for the +Company’s customers. These options include assistance that is built into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare +Protection Plan (“APP”). APP is a fee-based service that typically includes two to three years of phone support and hardware repairs, dedicated web-based support resources, and user diagnostic tools. Markets and Distribution The Company’s customers are primarily in the consumer, SMB, education, enterprise, government and creative markets. The Company +utilizes a variety of direct and indirect distribution channels, such as its retail stores, online stores, and direct sales force, and third-party cellular network carriers, wholesalers, retailers, and value-added resellers. The Company believes +that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software, and peripheral integration, demonstrate the unique digital lifestyle solutions that are available +on its products, and demonstrate the compatibility of the Mac with the Windows platform and networks. The Company further believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of its products +over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and +education are emphasized, the Company continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. Additionally, the Company has invested in programs to enhance reseller sales by placing +high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a high level +of integration and support services, and product expertise. 6 Table of Contents One of the +Company’s customers accounted for 11% of net sales in 2009; there was no single customer that accounted for more than 10% of net sales in 2010 or 2008. Competition The Company is confronted by aggressive competition in all +areas of its business. The markets for the Company’s products and services are highly competitive. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the +capabilities and use of personal computers, mobile communication and media devices, and other digital electronic devices. The Company’s competitors who sell personal computers based on other operating systems have aggressively cut prices and +lowered their product margins to gain or maintain market share. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. The principal competitive +factors include price, product features, relative price/performance, product quality and reliability, design innovation, availability of software and peripherals, marketing and distribution capability, service and support, and corporate reputation. The Company is focused on expanding its market opportunities related to mobile communication and media devices, including +iPhone and iPad. The mobile communications and media device industries are highly competitive and include several large, well-funded and experienced participants. The Company expects competition in these industries to intensify significantly as +competitors attempt to imitate some of the iPhone and iPad features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. These +industries are characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of +consumers and businesses. The Company’s iPod and digital content services have faced significant competition from other +companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company believes it offers superior innovation and integration of the entire solution including +the hardware (personal computer, iPhone, iPad and iPod), software (iTunes), and distribution of digital content and applications (iTunes Store, App Store and iBookstore). Some of the Company’s current and potential competitors have substantial +resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. Alternatively, these competitors may collaborate with each other to offer solutions that are more +integrated than those they currently offer. The Company’s future financial condition and operating results are +substantially dependent on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets it competes in. Supply of Components Although most components essential to the +Company’s business are generally available from multiple sources, certain key components including but not limited to microprocessors, enclosures, certain liquid crystal displays (“LCDs”), certain optical drives, and +application-specific integrated circuits (“ASICs”) are currently obtained by the Company from single or limited sources, which subjects the Company to significant supply and pricing risks. Many of these and other key components that are +available from multiple sources including but not limited to NAND flash memory, dynamic random access memory (“DRAM”), and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. In +addition, the Company has entered into certain agreements for the supply of key components including but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee the Company will be able to +extend or renew these agreements on similar favorable terms, or at all, upon expiration or otherwise obtain favorable pricing in the future. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that +can materially adversely affect its financial condition and operating results. 7 Table of Contents The Company and other +participants in the personal computer, and mobile communication and media device industries also compete for various components with other industries that have experienced increased demand for their products. In addition, the Company uses some +custom components that are not common to the rest of these industries, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity +constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of a key single-sourced component for a new or existing product were delayed or constrained, if such components +were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The +Company’s business and financial performance could also be adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. +Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Substantially all of the Company’s Macs, iPhones, iPads, iPods, logic boards and other assembled products are +manufactured by outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently performed by only a few outsourcing partners of the Company, including Hon Hai Precision Industry Co. +Ltd. and Quanta Computer, Inc. The Company’s outsourced manufacturing is often performed in single locations. Certain of these outsourcing partners are the sole-sourced supplier of components and manufacturing outsourcing for many of the +Company’s key products, including but not limited to final assembly of substantially all of the Company’s Macs, iPhones, iPads and iPods. Although the Company works closely with its outsourcing partners on manufacturing schedules, the +Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover the Company’s requirements for periods ranging +from 30 to 150 days. The Company sources components from a number of suppliers and manufacturing vendors. The loss of supply +from any of these suppliers or vendors, whether temporary or permanent, could materially adversely affect the Company’s business and financial condition. Research and Development Because the industries in which the Company +competes are characterized by rapid technological advances, the Company’s ability to compete successfully is heavily dependent upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the +marketplace. The Company continues to develop new products and technologies and to enhance existing products that expand the range of its product offerings and intellectual property through licensing and acquisition of third-party business and +technology. Total research and development expense was $1.8 billion, $1.3 billion and $1.1 billion in 2010, 2009 and 2008, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its Macs, iPhone, iPad and iPod devices, peripherals, software and services. In addition, the Company has +registered and/or has applied to register, trademarks and service marks in the U.S. and a number of foreign countries for “Apple,” the Apple logo, “Macintosh,” “Mac,” “iPhone,” “iPad,” +“iPod,” “iTunes,” “iTunes Store,” “Apple TV,” “MobileMe” and numerous other trademarks and service marks. Although the Company believes the ownership of such patents, copyrights, trademarks and +service marks is an important factor in its business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect inventions arising from its research and development, and is currently +pursuing thousands of patent applications around the world. Over time, the Company has accumulated a portfolio of several thousand issued patents in the U.S. and worldwide. In addition, the Company currently holds copyrights relating to certain +aspects of its products and services. No single patent or copyright is 8 Table of Contents solely responsible for protecting the Company’s products. The Company believes the duration of the applicable patents it has been granted is adequate relative to the expected lives of its +products. Due to the fast pace of innovation and product development, the Company’s products are often obsolete before the patents related to them expire, and sometimes are obsolete before the patents related to them are even granted. Many of the Company’s products are designed to include intellectual property obtained from third parties. While it may +be necessary in the future to seek or renew licenses relating to various aspects of its products and business methods, the Company believes, based upon past experience and industry practice, such licenses generally could be obtained on commercially +reasonable terms; however, there is no guarantee such licenses could be obtained at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage, and the rapid rate of issuance of new +patents, it is possible certain components of the Company’s products and business methods may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be +infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data The U.S. represents the Company’s largest geographic marketplace. Approximately 44% of the Company’s net sales +in 2010 came from sales to customers inside the U.S. Final assembly of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by external vendors in California, Texas, the People’s +Republic of China (“China”), the Czech Republic and the Republic of Korea (“Korea”). Currently, the supply and manufacture of many critical components is performed by sole-sourced third-party vendors in the U.S., China, Germany, +Ireland, Israel, Japan, Korea, Malaysia, the Netherlands, the Philippines, Taiwan, Thailand and Singapore. Sole-sourced third-party vendors in China perform final assembly of substantially all of the Company’s Macs, iPhones, iPads and iPods. +Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international +trade regulations, including tariffs and antidumping penalties. Information regarding financial data by geographic segment is +set forth in Part II, Item 7 and Item 8 of this Form 10-K and in Notes to Consolidated Financial Statements at Note 9, “Segment Information and Geographic Data.” Seasonal Business The Company has historically experienced increased net +sales in its first and fourth fiscal quarters compared to other quarters in its fiscal year due to seasonal demand of consumer markets related to the holiday season and the beginning of the school year; however, this pattern has been less pronounced +following the introductions of iPhone and iPad. This historical pattern should not be considered a reliable indicator of the Company’s future net sales or financial performance. Warranty The Company offers a basic limited parts and labor warranty on +most of its hardware products, including Macs, iPhones, iPads and iPods. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used +to repair the Company’s hardware products. In addition, consumers may purchase the APP, which extends service coverage on many of the Company’s hardware products in most of its major markets. Backlog In the +Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases in anticipation of or immediately following new product +introductions as dealers anticipate shortages. Backlog is often reduced once dealers and customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s +ability to achieve any particular level of revenue or financial performance. 9 Table of Contents Environmental Laws Compliance with federal, state, local and foreign laws enacted for the protection of the environment has to date had no significant effect +on the Company’s capital expenditures, earnings, or competitive position. In the future, compliance with environmental laws could materially adversely affect the Company. Production and marketing of products in certain states and countries may subject the Company to environmental and other regulations including, in some instances, the requirement to provide customers the +ability to return product at the end of its useful life, and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several jurisdictions in which the Company operates +including various countries within Europe and Asia and certain states and provinces within North America. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of +such laws, there is no assurance that such existing laws or future laws will not materially adversely affect the Company’s financial condition or operating results. Employees As of September 25, 2010, the Company had approximately +46,600 full-time equivalent employees and an additional 2,800 full-time equivalent temporary employees and contractors. Available +Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, +and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and +other information filed by the Company with the SEC are available free of charge on the Company’s website at www.apple.com/investor when such reports are available on the SEC website. The public may read and copy any materials filed by +the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC +maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov . The contents of these websites are not incorporated into this +filing. Further, the Company’s references to the URLs for these websites are intended to be inactive textual references only. Item 1A. Risk Factors Because of +the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not +use historical trends to anticipate results or trends in future periods. Economic conditions could materially adversely +affect the Company. The Company’s operations and performance depend significantly on worldwide economic conditions. +Uncertainty about current global economic conditions poses a risk as consumers and businesses may continue to postpone spending in response to tighter credit, unemployment, negative financial news and/or declines in income or asset values, +which could have a material negative effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations since the Company generally raises prices on goods and services sold outside +the U.S. to offset the effect of a strengthening of the U.S. dollar. Other factors that could influence demand include increases in fuel and other energy costs, conditions in the real estate and mortgage markets, labor and healthcare costs, access +to credit, consumer confidence, and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services and the Company’s +financial condition and operating results. 10 Table of Contents In the event of +renewed financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be a new or incremental tightening in +the credit markets, low liquidity, and extreme volatility in fixed income, credit, currency, and equity markets. In addition, the risk remains that there could be a number of follow-on effects from the credit crisis on the +Company’s business, including the insolvency of key outsourced manufacturing partners or suppliers or their inability to obtain credit to finance development and/or manufacture products resulting in product delays; inability of customers, +including channel partners, to obtain credit to finance purchases of the Company’s products and/or customer, including channel partner, insolvencies; and failure of derivative counterparties and other financial institutions negatively +impacting the Company’s treasury operations. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting +from revaluations of debt and equity securities and other investments; interest rates; cash balances; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall +economic uncertainty would increase the risk of the actual amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. Uncertainty about current global economic conditions could also continue to increase the volatility of the Company’s stock price. Global markets for the Company’s products and services are highly competitive and subject to rapid technological +change. If the Company is unable to compete effectively in these markets, its financial condition and operating results could be materially adversely affected. The Company competes in highly competitive global markets characterized by aggressive price cutting, with resulting downward pressure on gross margins, frequent introduction of new products, short product +life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of +innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications, and +related services. As a result, the Company must make significant investments in research and development and as such, the Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register +numerous patents, trademarks and service marks. By contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures. If the Company is unable to continue to develop and sell +innovative new products with attractive margins or if other companies infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be negatively affected and its financial condition and +operating results could be materially adversely affected. In the market for personal computers and peripherals, the Company +faces a significant number of competitors, many of which have broader product lines, lower priced products, and larger installed customer bases. Consolidation in this market has resulted in larger and potentially stronger competitors. Price +competition has been particularly intense as competitors selling Windows-based personal computers have aggressively cut prices and lowered product margins. The Company also faces increased competition in key market segments, including consumer, SMB, +education, enterprise, government and creative markets. An increasing number of Internet devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s +existing products. The Company is currently the only authorized maker of hardware using the Mac OS. The Mac OS has a minority +market share in the personal computer market, which is dominated by computer makers using competing operating systems, most notably Windows. The Company’s financial condition and operating results depend substantially on the Company’s +ability to continually improve the Mac platform to maintain functional and 11 Table of Contents design advantages. Use of unauthorized copies of the Mac OS on other companies’ hardware products may result in decreased demand for the Company’s hardware products, and could +materially adversely affect the Company’s financial condition and operating results. The Company currently markets +certain mobile communication and media devices, and third-party digital content and applications. The Company faces substantial competition from companies that have significant technical, marketing, distribution and other resources, as well as +established hardware, software and digital content supplier relationships. Additionally, the Company faces significant price competition as competitors reduce their selling prices and attempt to imitate the Company’s product features and +applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company also competes with illegitimate ways to obtain third-party digital +content and applications. The Company has only recently entered the mobile communications and media device markets, and many of its competitors in these markets have significantly greater experience, product breadth and distribution channels than +the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide such products and services at little or no profit or even at a loss. The Company also +expects competition to intensify as competitors attempt to imitate the Company’s approach to providing these components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company currently receives subsidies from its exclusive and non-exclusive carriers providing cellular network service for iPhone. +There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and +transitions. Due to the highly volatile and competitive nature of the industries in which the Company competes, the +Company must continually introduce new products, services and technologies, enhance existing products and services, and effectively stimulate customer demand for new and upgraded products. The success of new product introductions depends on a number +of factors including but not limited to timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new products and production ramp issues, the availability of application software +for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and costs to meet anticipated demand, and the risk that new +products may have quality or other defects in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions on its financial condition and operating results. The Company faces substantial inventory and other asset risk in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated +demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets for impairment whenever events or changed circumstances indicate the carrying +amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the assets exceeds its fair market value. Although the Company believes its +provisions related to inventory, other assets and purchase commitments are currently adequate, no assurance can be given that the Company will not incur additional related charges given the rapid and unpredictable pace of product obsolescence in the +industries in which the Company competes. Such charges could materially adversely affect the Company’s financial condition and operating results. 12 Table of Contents The Company must order +components for its products and build inventory in advance of product announcements and shipments. Consistent with industry practice, components are normally acquired through a combination of purchase orders, supplier contracts, open orders and, +where appropriate, prepayments, in each case based on projected demand. Such purchase commitments typically cover forecasted component and manufacturing requirements for 30 to 150 days. Because the Company’s markets are volatile, competitive +and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient inventories of components or products. The Company’s financial condition and operating results +have been in the past and could be in the future materially adversely affected by the Company’s ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results depend upon the Company’s ability to obtain key components including but not limited to microprocessors, +NAND flash memory, DRAM and LCDs at favorable prices and in sufficient quantities. Because the Company currently obtains +certain key components including but not limited to microprocessors, enclosures, certain LCDs, certain optical drives, and ASICs, from single or limited sources, the Company is subject to significant supply and pricing risks. Many of these and other +key components that are available from multiple sources including but not limited to NAND flash memory, DRAM and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. The Company has entered +into certain agreements for the supply of key components including but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee that the Company will be able to extend or renew these agreements +on similar favorable terms, or at all, upon expiration or otherwise obtain favorable pricing in the future. The follow-on effects from the credit crisis on the Company’s key suppliers, referred to in “ Economic conditions could +materially adversely affect the Company” above, which is incorporated herein by reference, also could affect the Company’s ability to obtain key components . Therefore, the Company remains subject to significant risks of supply +shortages and/or price increases that could materially adversely affect the Company’s financial condition and operating results. The Company expects to experience decreases in its gross margin percentage in future periods, as compared to levels +achieved during 2010, largely due to a higher mix of new and innovative products that have higher cost structures and deliver greater value to customers, and expected and potential future component cost and other cost increases. For additional +information refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the subheading “Gross Margin,” which is incorporated herein by reference. The Company and other participants in the personal computer, and mobile communication and media device industries compete for various +components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not common to the rest of these industries. The Company’s new products often utilize custom components +available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these +components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the supply of a key +single-sourced component for a new or existing product were delayed or constrained, if such components were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed products to the Company, the +Company’s financial condition and operating results could be materially adversely affected. The Company depends on +component and product manufacturing and logistical services provided by third parties, many of whom are located outside of the U.S. Substantially all of the Company’s components and products are manufactured in whole or in part by a few third-party manufacturers. Many of these manufacturers are located outside of the U.S., and +are concentrated in several general locations. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over +production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of 13 Table of Contents products or services, or the Company’s flexibility to respond to changing conditions. In addition, the Company relies on third-party manufacturers to adhere to the Company’s supplier +code of conduct. Although arrangements with such manufacturers may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects. Any unanticipated +product defect or warranty liability, whether pursuant to arrangements with contract manufacturers or otherwise, could materially adversely affect the Company’s reputation, financial condition and operating results. Final assembly of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by +external vendors in California, Texas, China, the Czech Republic and Korea. Currently, the supply and manufacture of many critical components is performed by sole-sourced third-party vendors in the U.S., China, Germany, Ireland, Israel, Japan, +Korea, Malaysia, the Netherlands, the Philippines, Taiwan, Thailand and Singapore. Sole-sourced third-party vendors in China perform final assembly of substantially all of the Company’s Mac products, iPhones, iPads and iPods. If manufacturing +or logistics in these locations is disrupted for any reason, including but not limited to, natural disasters, information technology system failures, military actions or economic, business, labor, environmental, public health, or political issues, +the Company’s financial condition and operating results could be materially adversely affected. The Company relies on +third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The +Company contracts with certain third parties to offer their digital content through the Company’s iTunes Store. The Company’s licensing arrangements with these third parties are short-term and do not guarantee the continuation or renewal +of these arrangements on reasonable terms, if at all. Some third-party content providers currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license +their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the total cost of, such content. If the Company is unable to continue to offer a wide variety of content at +reasonable prices with acceptable usage rules, or continue to expand its geographic reach, the Company’s financial condition and operating results may be materially adversely affected. Many third-party content providers require that the Company provide certain digital rights management (“DRM”) and other +security solutions. If these requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a +timely manner. In addition, certain countries have passed or may propose legislation that would force the Company to license its DRM, which could lessen the protection of content and subject it to piracy and also could affect arrangements with the +Company’s content providers. The Company relies on access to third-party patents and intellectual property, and the +Company’s future results could be materially adversely affected if it is alleged or found to have infringed intellectual property rights. Many of the Company’s products are designed to include third-party intellectual property, and in the future the Company may need to seek or renew licenses relating to various aspects of its products +and business methods. Although the Company believes that, based on past experience and industry practice, such licenses generally could be obtained on reasonable terms, there is no assurance that the necessary licenses would be available on +acceptable terms or at all. Because of technological changes in the industries in which the Company competes, current +extensive patent coverage, and the rapid issuance of new patents, it is possible that certain components of the Company’s products and business methods may unknowingly infringe the patents or other intellectual property rights of third parties. +From time to time, the Company has been notified that it may be infringing such rights. Regardless of merit, responding to such claims can consume significant time and expense. At present, the Company is vigorously defending a number of patent +infringement cases, and several pending claims are in various stages of evaluation. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no 14 Table of Contents assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. If the Company is found to be infringing such rights, it may be required to pay +substantial damages. If there is a temporary or permanent injunction prohibiting the Company from marketing or selling certain products or a successful claim of infringement against the Company requires it to pay royalties to a third party, the +Company’s financial condition and operating results could be materially adversely affected, regardless of whether it can develop non-infringing technology. While in management’s opinion the Company does not have a potential liability for +damages or royalties from any known current legal proceedings or claims related to the infringement of patent or other intellectual property rights that would individually or in the aggregate materially adversely affect its financial condition and +operating results, the results of such legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of the matters related to infringement of patent or other intellectual property rights of others or should several +of these matters be resolved against the Company in the same reporting period, the Company’s financial condition and operating results could be materially adversely affected. With the introduction of iPhones and 3G enabled iPads, the Company has begun to compete with mobile communication and media devices +companies that hold significant patent portfolios. Regardless of the scope or validity of such patents or the merits of any potential patent claims by competitors, the Company may have to engage in protracted litigation, enter into +expensive agreements or settlements and/or modify its products. Any of these events could have a material adverse impact on the Company’s financial condition and operating results. The Company’s future performance depends on support from third-party software developers. If third-party software applications +and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. The Company believes decisions by customers to purchase its hardware products, including its Macs, iPhones, iPads and iPods, are often based to a certain extent on the availability of third-party software +applications and services. There is no assurance that third-party developers will continue to develop and maintain applications and services for the Company’s products on a timely basis or at all, and discontinuance or delay of these +applications and services could materially adversely affect the Company’s financial condition and operating results. With respect to its Mac products, the Company believes the availability of third-party software applications and services depends in part +on the developers’ perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company’s products compared to Windows-based products. This analysis may be based on factors such as the +perceived strength of the Company and its products, the anticipated revenue that may be generated, continued acceptance by customers of Mac OS X, and the costs of developing such applications and services. If the Company’s minority share of the +global personal computer market causes developers to question the Company’s prospects, developers could be less inclined to develop or upgrade software for the Company’s products and more inclined to devote their resources to developing +and upgrading software for the larger Windows market. The Company’s development of its own software applications and services may also negatively affect the decisions of third-party developers, such as Microsoft, Adobe and Google, to develop, +maintain, and upgrade similar or competitive software and services for the Company’s products. With respect to iPhone, +iPad and iPod touch, the Company relies on the continued availability and development of compelling and innovative software applications. Unlike third-party software applications for Mac products, the software applications for the iPhone, iPad and +iPod touch platforms are distributed through a single distribution channel, the App Store. The absence of multiple distribution channels, which are available for competing platforms, may limit the availability and acceptance of third-party +applications by the Company’s customers, thereby causing developers to curtail significantly, or stop, development for the Company’s platforms. In addition, iPhone, iPad and iPod touch are subject to rapid technological change, and, if +third-party developers are unable to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied customers. Further, if the Company develops its own software applications and services, +such development may negatively affect the decisions of third-party developers to develop, maintain, 15 Table of Contents and upgrade similar or competitive applications for the iPhone, iPad and iPod touch platforms. As with applications for the Company’s Mac products, the availability and development of these +applications also depend on developers’ perceptions and analysis of the relative benefits of developing software for the Company’s products rather than its competitors’ products, including devices that use competing platforms. If +developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s devices may suffer. The Company’s future operating performance depends on the performance of distributors, carriers and other resellers. The Company distributes its products through wholesalers, resellers, national and regional retailers, value-added resellers, and cataloguers, many of whom distribute products from competing manufacturers. +The Company also sells many of its products and resells third-party products in most of its major markets directly to customers, certain education customers, cellular network carriers’ distribution channels and certain resellers through its +online and retail stores. Many resellers operate on narrow operating margins and have been negatively affected in the past by +weak economic conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. Such a perception could discourage +resellers from investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company’s financial condition and operating results could be materially adversely +affected if the financial condition of these resellers weakens, if resellers stopped distributing the Company’s products, or if uncertainty regarding demand for the Company’s products caused resellers to reduce their ordering and marketing +of the Company’s products. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors and improving product placement +displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The Company’s Retail business has required and will continue to require a substantial investment and commitment of resources and +is subject to numerous risks and uncertainties. The Company’s retail stores have required substantial fixed +investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space, with terms ranging from five to 20 years, the majority of +which are for ten years. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations +and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high fixed cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of +individual or multiple stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements, and severance costs that could materially adversely affect the Company’s financial condition and operating +results. Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and +uncertainties that could materially adversely affect the Company’s financial condition and operating results. These risks and uncertainties include, but are not limited to, macro-economic factors that could have a negative effect on general +retail activity, as well as the Company’s inability to manage costs associated with store construction and operation, inability to sell third-party products at adequate margins, failure to manage relationships with existing retail channel +partners, more challenging environment in managing retail operations outside the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and inability to obtain and renew leases in quality retail locations at a +reasonable cost. 16 Table of Contents Investment in new +business strategies and initiatives could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from +current operations, insufficient revenue to offset liabilities assumed and expenses associated with the strategy, inadequate return of capital, and unidentified issues not discovered in the Company’s due diligence. Because these new ventures +are inherently risky, no assurance can be given that such strategies and initiatives will be successful and will not materially adversely affect the Company’s financial condition and operating results. The Company’s products and services experience quality problems from time to time that can result in decreased sales and +operating margin. The Company sells highly complex hardware and software products and services that can contain defects in +design and manufacture. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. Defects may also occur +in components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, +harm to reputation, and significant warranty and other expenses, and could have a material adverse impact on the Company’s financial condition and operating results. In the U.S. the Company relies on a single cellular network carrier to provide service for iPhone. In the U.S. the Company has contracted with a single carrier to provide cellular network services for iPhone on an exclusive basis. If this exclusive carrier cannot successfully compete with other +carriers in the U.S. market on any basis, including but not limited to the quality and coverage of wireless voice and data services, performance and timely build-out of advanced wireless networks, and pricing and other terms or conditions of +customer contracts, or if this exclusive carrier fails to promote iPhone aggressively or favor other handsets in their promotion and sales activities or service plans, sales may be materially adversely affected. The Company is subject to risks associated with laws, regulations and industry-imposed standards related to mobile communications and +media devices. Laws and regulations related to mobile communications and media devices in the many jurisdictions in which +the Company operates are extensive and subject to change. Such changes, which could include but are not limited to restrictions on production, manufacture, distribution, and use of the device, locking the device to a carrier’s network, or +mandating the use of the device on more than one carrier’s network, could materially adversely affect the Company’s financial condition and operating results. Mobile communication and media devices, such as iPhones and 3G enabled iPads, are subject to certification and regulation by governmental and standardization bodies, as well as by cellular network +carriers for use on their networks. These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications or delays in product shipment dates, which could materially adversely +affect the Company’s financial condition and operating results. The Company’s success depends largely on the +continued service and availability of key personnel. Much of the Company’s future success depends on the continued +availability and service of key personnel, including its CEO, its executive team and highly skilled employees in technical, marketing and staff positions. Experienced personnel in the technology industry are in high demand and competition for their +talents is intense, especially in the Silicon Valley, where most of the Company’s key personnel are located. There can be no assurance that the Company will continue to attract and retain key personnel. 17 Table of Contents Political events, +war, terrorism, public health issues, natural disasters and other circumstances could materially adversely affect the Company. War, terrorism, geopolitical uncertainties, public health issues, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and +thus could have a strong negative effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to interruption by natural disasters, +fire, power shortages, terrorist attacks, and other hostile acts, labor disputes, public health issues, and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the +Company to make and deliver products to its customers, including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. Should major public health issues, including +pandemics, arise, the Company could be negatively affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps +of new products, and disruptions in the operations of the Company’s manufacturing vendors and component suppliers. The majority of the Company’s research and development activities, its corporate headquarters, information technology +systems, and other critical business operations, including certain component suppliers and manufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, losses and significant recovery time +could be required to resume operations and the Company’s financial condition and operating results could be materially adversely affected. The Company may be subject to information technology system failures, network disruptions and breaches in data security. Information technology system failures, network disruptions and breaches of data security caused by such factors, including but not limited to, earthquakes, fire, theft, fraud, malicious attack or other +causes could disrupt the Company’s operations by causing delays or cancellation of customer, including channel partner, orders, negatively affecting the Company’s online, iTunes, MobileMe and retail offerings and services, impeding the +manufacture or shipment of products, processing transactions and reporting financial results, resulting in the unintentional disclosure of customer or Company information, or damage to the Company’s reputation. While management has taken steps +to address these concerns by implementing sophisticated network security and internal control measures, there can be no assurance that a system failure or loss or data security breach will not materially adversely affect the Company’s financial +condition and operating results. The Company expects its quarterly revenue and operating results to fluctuate for a +variety of reasons. The Company’s profit margins vary among its products and its distribution channels. The +Company’s software, accessories, and service and support contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can +change over time as a result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its indirect sales +through its channel partners. In addition, the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, new +products, component cost increases, strengthening U.S. dollar, or price competition. The Company has typically experienced greater net sales in the first and fourth fiscal quarters compared to the second and third fiscal quarters due to seasonal +demand related to the holiday season and the beginning of the school year, respectively. Furthermore, the Company sells more products from time-to-time during the third month of a quarter than it does during either of the first two months. +Developments late in a quarter, such as lower-than-anticipated demand for the Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the Company’s key logistics, components supply, or +manufacturing partners, could have a material adverse impact on the Company’s financial condition and operating results. 18 Table of Contents The Company’s +stock price continues to be volatile. The Company’s stock has at times experienced substantial price volatility due +to a number of factors, including but not limited to variations between its actual and anticipated financial results, announcements by the Company and its competitors, and uncertainty about current global economic conditions. The stock market as a +whole also has experienced extreme price and volume fluctuations that have affected the market price of many technology companies in ways that may have been unrelated to these companies’ operating performance. Furthermore, the Company believes +its stock price reflects high future growth and profitability expectations. If the Company fails to meet these expectations its stock price may significantly decline, which could have a material adverse impact on investor confidence and employee +retention. The Company’s business is subject to the risks of international operations. The Company derives a significant portion of its revenue and earnings from its international operations. Compliance with U.S. and foreign +laws and regulations that apply to the Company’s international operations, including without limitation import and export requirements, anti-corruption laws, tax laws (including U.S. taxes on foreign subsidiaries), foreign exchange controls and +cash repatriation restrictions, data privacy requirements, labor laws, and anti-competition regulations, increases the costs of doing business in foreign jurisdictions, and any such costs, which may rise in the future as a result of changes in these +laws and regulations or in their interpretation. Furthermore, the Company has implemented policies and procedures designed to ensure compliance with these laws and regulations, but there can be no assurance that the Company’s employees, +contractors, or agents will not violate such laws and regulations or the Company’s policies. Any such violations could individually or in the aggregate materially adversely affect the Company’s financial condition or operating results. The Company’s financial condition and operating results also could be significantly affected by other risks associated +with international activities, including but not limited to, economic and labor conditions, increased duties, taxes and other costs, political instability, and changes in the value of the U.S. dollar versus local currencies. Margins on sales of the +Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign currency exchange rate fluctuations and by international trade +regulations, including duties, tariffs and antidumping penalties. Additionally, the Company is exposed to credit and collectability risk on its trade receivables with customers in certain international markets. There can be no assurance it can +effectively limit its credit risk and avoid losses, which could materially adversely affect the Company’s financial condition and operating results. The Company’s primary exposure to movements in foreign currency exchange rates relate to non-U.S. dollar denominated sales in Europe, Japan, Australia, Canada and certain parts of Asia, as well as +non-U.S. dollar denominated operating expenses incurred throughout the world. Weakening of foreign currencies relative to the U.S. dollar will adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and +earnings, and generally will lead the Company to raise international pricing, potentially reducing demand for the Company’s products. In some circumstances, due to competition or other reasons, the Company may decide not to raise local prices +to the full extent of the dollar’s strengthening, or at all, which would adversely affect the U.S. dollar value of the Company’s foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies, while +generally beneficial to the Company’s foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. +Additionally, strengthening of foreign currencies may also increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company has used derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to +fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in +place. 19 Table of Contents The Company is +exposed to credit risk and fluctuations in the market values of its investment portfolio. Although the Company has not +recognized any significant losses to date on its cash, cash equivalents and marketable securities, any significant future declines in their market values could materially adversely affect the Company’s financial condition and operating results. +Given the global nature of its business, the Company has investments both domestically and internationally. Credit ratings and pricing of these investments can be negatively impacted by liquidity, credit deterioration or losses, financial results, +or other factors. As a result, the value or liquidity of the Company’s cash, cash equivalents and marketable securities could decline and result in a material impairment, which could materially adversely affect the Company’s financial +condition and operating results. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade +receivables and prepayments related to long-term supply agreements. This risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. A substantial majority of the Company’s outstanding trade +receivables are not covered by collateral or credit insurance. The Company’s exposure to credit and collectability risk on its trade receivables are increased in certain international markets and its ability to mitigate such risks may be +limited. Cellular network carriers accounted for a significant potion of the Company’s trade receivables as of September 25, 2010. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by +contract manufacturers and other vendors that manufacture sub-assemblies or assemble final products for the Company. Two vendors accounted for a significant portion of the Company’s non-trade receivables as of September 25, 2010. In +addition, the Company has made prepayments associated with long-term supply agreements to secure supply of certain inventory components. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade +receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses, which could materially adversely affect the Company’s financial condition and operating results. The matters relating to the Company’s past stock option practices and its restatement of consolidated financial +statements may result in additional litigation. The Company’s investigation into its past stock option practices and +its restatement of prior financial statements in the Annual Report on Form 10-K for the year ended September 30, 2006 gave rise to litigation and government investigations. As described in Part I, Item 3, “Legal Proceedings,” +several derivative and class action complaints regarding stock options were filed against the Company and current and former officers and directors. These actions have been dismissed following a comprehensive settlement. Two former officers of the +Company were also named as defendants in an SEC enforcement action, which has been settled. No assurance can be given that +additional actions will not be filed against the Company and current and former officers and directors as a result of past stock option practices. If such actions are filed and result in adverse findings, the remedies could materially adversely +affect the Company’s financial condition and operating results. Unfavorable results of legal proceedings could +materially adversely affect the Company. The Company is subject to various legal proceedings and claims that have arisen +out of the ordinary conduct of its business and are not yet resolved and additional claims may arise in the future. Results of legal proceedings cannot be predicted with certainty. Regardless of merit, litigation may be both time-consuming and +disruptive to the Company’s operations and cause significant expense and diversion of management attention. In recognition of these considerations, the Company may enter into material settlements. Should the Company fail to prevail in certain +matters, or should several of these matters be resolved against the Company in the same reporting period, the Company may be faced with significant monetary damages or injunctive relief against it that would materially adversely affect a portion of +its business and might materially affect the Company’s financial condition and operating results. 20 Table of Contents The Company is +subject to risks associated with laws and regulations related to health, safety and environmental protection. The +Company’s products and services, and the production and distribution of those goods and services, are subject to a variety of laws and regulations. These may require the Company to offer customers the ability to return a product at the end of +its useful life and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several jurisdictions in which the Company operates, including various countries within Europe +and Asia and certain states and provinces within North America. Although the Company does not anticipate any material adverse effects based on the nature of its operations and the focus of such laws, there is no assurance such existing laws or +future laws will not materially adversely affect the Company’s financial condition and operating results. Changes in +the Company’s tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities could affect its future results. The Company is subject to taxes in the United States and numerous foreign jurisdictions. The Company’s future effective tax rates could be affected by changes in the mix of earnings in countries with +differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation. In addition, the current administration and Congress have announced proposals for new U.S. tax +legislation that, if adopted, could adversely affect the Company’s tax rate. Any of these changes could have a material adverse affect on the Company’s profitability. The Company is also subject to the continual examination of its income +tax returns by the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of its provision for taxes. There can be no +assurance that the outcomes from these examinations will not materially adversely affect the Company’s financial condition and operating results. The Company is subject to risks associated with the availability and coverage of insurance. For certain risks, the Company does not maintain insurance coverage because of cost and/or availability. Because the Company retains some portion of its insurable risks, and in some cases +self-insures completely, unforeseen or catastrophic losses in excess of insured limits could materially adversely affect the Company’s financial condition and operating results. Item 1B. Unresolved Staff Comments None. Item 2. Properties The +Company’s headquarters are located in Cupertino, California. As of September 25, 2010, the Company owned or leased approximately 10.6 million square feet of building space, primarily in the U.S., and to a lesser extent, in Europe, +Japan, Canada, and the Asia-Pacific regions. Of that amount, approximately 5.6 million square feet was leased, of which approximately 2.5 million square feet was retail building space. Additionally, the Company owns a total of 480 acres of +land in various locations. As of September 25, 2010, the Company owned a manufacturing facility in Cork, Ireland that +also housed a customer support call center and facilities in Elk Grove, California that included warehousing and distribution operations and a customer support call center. In addition, the Company owned facilities for research and development and +corporate functions in Cupertino, California, including land for the future development of the Company’s second corporate campus. The Company also owned a data center in Newark, California and land in North Carolina for a new data center +facility currently under construction. Outside the U.S., the Company owned additional facilities for various purposes. 21 Table of Contents The Company believes +its existing facilities and equipment are in good operating condition and are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to +make investments in capital equipment as needed to meet anticipated demand for its products. Item 3. Legal Proceedings As of +September 25, 2010, the end of the annual period covered by this report, the Company was subject to the various legal proceedings and claims discussed below, as well as certain other legal proceedings and claims that have not been fully +resolved and that have arisen in the ordinary course of business. In the opinion of management, the Company does not have a potential liability related to any current legal proceeding or claim that would individually or in the aggregate materially +adversely affect its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be +resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. The Company settled certain matters during the fourth quarter of 2010 that did not individually +or in the aggregate have a material impact on the Company’s financial condition and results of operations. Branning +et al. v. Apple Computer, Inc. Plaintiffs originally filed this purported class action against the Company on +February 17, 2005 on behalf of putative classes of consumers and resellers and is currently pending in the Santa Clara Superior Court. In general, the consumer plaintiffs allege that the Company “shorted” the coverage provided under +its warranties and AppleCare Protection Plan extended service contracts and sold plaintiffs used products that were represented to be new. In general, the reseller plaintiffs allege that the Company damaged their businesses by opening the Apple +retail stores and making misrepresentations in connection with doing so. The complaint seeks unspecified damages and other relief. Currently no plaintiff classes are certified, although reseller plaintiffs’ motion to certify a class of Apple +specialist resellers, is set for hearing on November 2, 2010. In re Apple & ATTM Antitrust Litigation This is a purported class action filed against the Company and AT&T Mobility in the United States District Court for +the Northern District of California. The Consolidated Complaint alleges that the Company and AT&T Mobility violated the federal antitrust laws by monopolizing and/or attempting to monopolize the “aftermarket for voice and data +services” for the iPhone and that the Company monopolized and/or attempted to monopolize the “aftermarket for software applications for iPhones.” The Consolidated Complaint also alleges that Apple violated numerous laws by +intentionally “bricking” (rendering inoperable) iPhones through the release of iPhone software update 1.1.1. On July 8, 2010, the Court granted Apple’s motion for summary judgment on all of plaintiffs’ claims related to +the alleged bricking of iPhones. In the same July 8, 2010 order the Court granted in part plaintiffs’ motion for class certification, certifying a class related to plaintiffs’ antitrust claims. The case is currently +stayed until a status conference with the Judge is held on November 15, 2010. Mediostream, Inc. v. Acer America Corp. +et al. Plaintiff filed this action against the Company, Acer America Corp., Dell, Inc. and Gateway, Inc. on +August 28, 2007, in the United States District Court for the Eastern District of Texas alleging infringement of U.S. Patent No. 7,009,655. Plaintiff seeks unspecified damages and other relief. This case is currently pending. Mirror Worlds, LLC. v. Apple Inc. Plaintiff filed this action against the Company on March 14, 2008, in the United States District Court for the Eastern District of Texas, alleging that certain of the Company’s products +infringed U.S. Patent Nos. 6,006,227, 6,638,313 and 6,725,427. On October 1, 2010, a jury returned a verdict finding the Company had infringed all 22 Table of Contents three patents, and awarding damages of $208 million per patent. The jury also found the infringement had been willful. The court has scheduled post verdict motions, and has set a +hearing date of December 9, 2010. The Company is challenging the verdict, and will be filing a request for judgment as a matter of law, remittitur, and in the alternative, a request for a new trial. Motorola Mobility, Inc. v. Apple, Inc. Motorola Mobility Inc. (“Motorola”) filed complaints against the Company in the United States District Court for the Districts of Florida, Illinois, Delaware and in the International Trade +Commission (“ITC”). These complaints include claims of patent infringement related to certain of the Company’s products. Motorola alleges that certain of its asserted patents are essential to one or more of the GSM, UMTS, 802.16e +and 802.11 wireless communications standards, and acknowledges its commitment to license these patents on fair, reasonable, and non-discriminatory (“FRAND”) terms and conditions. Motorola seeks unspecified FRAND compensation, damages and +other declaratory and injunctive relief in these pending district court actions as well as an exclusion order from the ITC. These cases are currently pending. Nokia Corporation v. Apple Inc.; Apple Inc. v. Nokia Corporation Nokia +Corporation (“Nokia”) and the Company have asserted multiple claims against one another in lawsuits pending in the United States District Courts for the Districts of Delaware and Wisconsin, in the ITC, in the United Kingdom High Court of +Justice and the German Patent Court in Dusseldorf. These cases include claims and counterclaims by Nokia and the Company of patent infringement related to iPhones, iPods, iPads and Apple computers, and Nokia’s mobile computing +devices. Nokia alleges that certain of its asserted patents are essential to one or more of the GSM, UMTS and 802.11 wireless communications standards, and acknowledges its commitment to license them on FRAND terms and conditions. Nokia seeks +unspecified FRAND compensation, damages and other declaratory and injunctive relief in these pending District Court actions as well as an exclusion order from the ITC. The Company also has asserted claims and counterclaims for declaratory +judgments of non-infringement and invalidity of Nokia’s asserted patents as well as for breach of contract, promissory estoppel and antitrust violations. The Apple iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, Inc.); Somers v. +Apple Inc. The first-listed action is a consolidated case filed in the United States District Court for the Northern +District of California combining two cases previously pending under the names Charoensak v. Apple Computer Inc. (formerly Slattery v. Apple Computer Inc ., filed on January 3, 2005 ) and Tucker v. Apple Computer, Inc . (filed +on July 21, 2006). The second listed action is a related complaint, Somers v. Apple, Inc., which was filed on December 31, 2007, also in the United States District Court for the Northern District of California. These cases have been +filed on behalf of a purported class of direct and indirect purchasers of iPods and iTunes Store content, alleging various claims including alleged unlawful tying of music and video purchased on the iTunes Store with the purchase of iPods and +unlawful acquisition or maintenance of monopoly market power and unlawful acquisition or maintenance of monopoly market power under §§1 and 2 of the Sherman Act, the Cartwright Act, California Business & Professions Code +§17200 (unfair competition), the California Consumer Legal Remedies Act and California monopolization law. The cases are currently pending. Vogel et al. v. Jobs et al. On August 24, 2006, plaintiffs filed a +purported shareholder class action in the United States District Court for the Northern District of California against the Company and certain current and former officers and directors, alleging improper backdating of stock option grants to maximize +certain defendants’ profits, failing to properly account for those grants and issuing false financial statements. On June 27, 2008, plaintiffs filed another, similar purported shareholder class action in the United States District Court +for the Northern District of California. The parties have reached a settlement and have obtained preliminary court approval. 23 Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the over-the-counter market and is quoted on the NASDAQ Global Select Market under the symbol +AAPL. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest sales prices for the Company’s common stock on the NASDAQ Global Select Market during each quarter of the +two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2010 price range per common share $ 293.53 - $235.56 $ 279.01 - $199.25 $ 231.95 - $190.25 $ 209.35 - $180.70 Fiscal 2009 price range per common share $ 188.90 - $134.42 $ 146.40 - $102.61 $ 109.98 - $  78.20 $ 119.68 - $  79.14 Holders As of October 15, 2010, there were 29,405 shareholders of record. Dividends The Company did not declare or pay cash dividends in either 2010 +or 2009. The Company anticipates that for the foreseeable future it will retain any earnings for use in the operation of its business. Purchases of Equity Securities by the Issuer and Affiliated Purchasers None. 24 Table of Contents Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend +reinvested basis, for the Company, the S&P 500 Composite Index, the S&P Computer Hardware Index, and the Dow Jones U.S. Technology Index. The Company has added the Dow Jones U.S. Technology Index to the graph to capture the stock performance +of companies whose products and services more closely relate to those of the Company. The Dow Jones U.S. Technology Index incorporates software and computer services companies, as well as technology hardware and equipment companies. The graph +assumes $100 was invested in each of the Company’s common stock, the S&P 500 Composite Index, the S&P Computer Hardware Index, and the Dow Jones U.S. Technology Index on September 30, 2005. Data points on the graph are annual. Note +that historic stock price performance is not necessarily indicative of future stock price performance. *$100 invested on 9/30/05 in stock or index, including reinvestment of dividends. Copyright © 2010 S&P, a division of The +McGraw -Hill Companies Inc. All rights reserved. Copyright © 2010 Dow Jones & Co. All rights reserved. September 30, 2005 September 30, 2006 September 30, 2007 September 30, 2008 September 30, 2009 September 30, 2010 Apple Inc. $ 100 $ 144 $ 286 $ 212 $ 346 $ 529 S&P 500 $ 100 $ 111 $ 129 $ 101 $ 94 $ 103 S&P Computer Hardware $ 100 $ 107 $ 158 $ 132 $ 157 $ 186 Dow Jones US Technology $ 100 $ 106 $ 131 $ 100 $ 111 $ 124 25 Table of Contents Item 6. Selected Financial Data The information set forth below for the five years ended September 25, 2010, is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in +Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except share amounts which are reflected in thousands and per share amounts). 2010 2009 2008 2007 2006 Net sales $ 65,225 $ 42,905 $ 37,491 $ 24,578 $ 19,315 Net income $ 14,013 $ 8,235 $ 6,119 $ 3,495 $ 1,989 Earnings per common share: Basic $ 15.41 $ 9.22 $ 6.94 $ 4.04 $ 2.36 Diluted $ 15.15 $ 9.08 $ 6.78 $ 3.93 $ 2.27 Cash dividends declared per common share $ 0 $ 0 $ 0 $ 0 $ 0 Shares used in computing earnings per share: Basic 909,461 893,016 881,592 864,595 844,058 Diluted 924,712 907,005 902,139 889,292 877,526 Total cash, cash equivalents and marketable securities $ 51,011 $ 33,992 $ 24,490 $ 15,386 $ 10,110 Total assets $ 75,183 $ 47,501 $ 36,171 $ 24,878 $ 17,205 Total long-term obligations (a) $ 5,531 $ 3,502 $ 1,745 $ 687 $ 395 Total liabilities $ 27,392 $ 15,861 $ 13,874 $ 10,347 $ 7,221 Total shareholders’ equity $ 47,791 $ 31,640 $ 22,297 $ 14,531 $ 9,984 (a) The Company did not have any long-term debt during the five years ended September 25, 2010. Long-term obligations excludes non-current deferred +revenue. 26 Table of Contents Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Forward-looking +statements can also be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance +and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled +“Risk Factors” above, which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K. All +information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters +of those fiscal years. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Executive Overview The Company designs, manufactures, and markets a range +of personal computers, mobile communication and media devices, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The +Company’s products and services include Mac computers, iPhone, iPad, iPod, Apple TV, Xserve, a portfolio of consumer and professional software applications, the Mac OS X and iOS operating systems, third-party digital content and applications +through the iTunes Store, and a variety of accessory, service and support offerings. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, and third-party cellular network carriers, wholesalers, +retailers, and value-added resellers. In addition, the Company sells a variety of third-party Mac, iPhone, iPad and iPod compatible products, including application software, printers, storage devices, speakers, headphones, and various other +accessories and peripherals through its online and retail stores. The Company sells to SMB, education, enterprise, government, and creative markets. The Company is committed to bringing the best user experience to its customers through its innovative hardware, software, peripherals, services, and Internet offerings. The Company’s business +strategy leverages its unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative +industrial design. The Company believes continual investment in research and development is critical to the development and enhancement of innovative products and technologies. In conjunction with its strategy, the Company continues to build and +host a robust platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. Within the iTunes Store, the Company has expanded its offerings through the App Store and iBookstore, which allow +customers to browse, search for, and purchase third-party applications and books through either a Mac or Windows-based computer or by wirelessly downloading directly to an iPhone, iPad or iPod touch. The Company also works to support a community for +the development of third-party software and hardware products and digital content that complement the Company’s offerings. Additionally, the Company’s strategy includes expanding its distribution network to effectively reach more customers +and provide them with a high-quality sales and post-sales support experience. The Company is therefore uniquely positioned to offer superior and well-integrated digital lifestyle and productivity solutions. The Company participates in several highly competitive markets, including personal computers with its Mac computers; mobile +communications and media devices with its iPhone, iPad and iPod product families; and distribution of third-party digital content and applications with its online iTunes Store. While the Company is widely recognized as a leading innovator in the +markets where it competes, these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that increased investment in research and development and marketing and advertising is necessary to +maintain or expand its position in the markets where it competes. The Company’s research and development spending is focused on further developing its existing Mac line of personal computers; the Mac OS X and iOS operating systems; application +software for 27 Table of Contents the Mac; iPhone, iPad and iPod and related software; development of new digital lifestyle consumer and professional software applications; and investing in new product areas and technologies. The +Company also believes increased investment in marketing and advertising programs is critical to increasing product and brand awareness. The Company utilizes a variety of direct and indirect distribution channels, including its retail stores, online stores, and direct sales force, and third-party cellular network carriers, wholesalers, +retailers, and value-added resellers. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware, software, and peripheral integration, +demonstrate the unique digital lifestyle solutions that are available on its products, and demonstrate the compatibility of the Mac with the Windows platform and networks. The Company further believes providing direct contact with its targeted +customers is an effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure +a high-quality buying experience for its products in which service and education are emphasized, the Company continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. Additionally, the +Company has invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain +third-party resellers focus on the Apple platform by providing a high level of integration and support services, and product expertise. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its +financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of +Significant Accounting Policies” of Notes to Consolidated Financial Statements in this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. +Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and +liabilities. Actual results may differ from these estimates and such differences may be material. Management believes the +Company’s critical accounting policies and estimates are those related to revenue recognition, valuation and impairment of marketable securities, inventory valuation and inventory purchase commitments, warranty costs, income taxes, and legal +and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about +inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net +sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has +occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, +these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers recognition of revenue until the customer receives the +product because the Company retains a portion of the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products (e.g., Macs, iPhones, iPads, iPods and peripherals), software bundled with hardware +that is 28 Table of Contents essential to the functionality of the hardware, and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes +revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled +with hardware not essential to the functionality of the hardware. For multi-element arrangements that include tangible +products containing software essential to the tangible product’s functionality and undelivered software elements relating to the tangible product’s essential software, the Company allocates revenue to all deliverables based on their +relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), +(ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of the selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by +the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For all past and current sales of iPhone, iPad, Apple TV and for sales of iPod touch beginning in June 2010, the Company indicated it +might from time-to-time provide future unspecified software upgrades and features free of charge to customers. The Company has identified two deliverables in arrangements involving the sale of these devices. The first deliverable is the hardware and +software essential to the functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with the purchase of iPhone, iPad, iPod touch and Apple TV to receive on a when-and-if-available +basis, future unspecified software upgrades and features relating to the product’s essential software. The Company has allocated revenue between these two deliverables using the relative selling price method. Because the Company has neither +VSOE nor TPE for the two deliverables, the allocation of revenue has been based on the Company’s ESPs. Amounts allocated to the delivered hardware and the related essential software are recognized at the time of sale provided the other +conditions for revenue recognition have been met. Amounts allocated to the embedded unspecified software upgrade right are deferred and recognized on a straight-line basis over the 24-month estimated life of each of these devices. All product cost +of sales, including estimated warranty costs, are recognized at the time of sale. Costs for engineering and sales and marketing are expensed as incurred. If the estimated life of the hardware product should change, the future rate of amortization of +the revenue allocated to the software upgrade right will also change. The Company’s process for determining its ESP for +deliverables without VSOE or TPE involves management’s judgment. The Company’s process considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable. The Company believes its +customers, particularly consumers, would be reluctant to buy unspecified software upgrade rights related to iPhone, iPad, iPod touch and Apple TV. This view is primarily based on the fact that unspecified upgrade rights do not obligate the Company +to provide upgrades at a particular time or at all, and do not specify to customers which upgrades or features will be delivered. Therefore, the Company has concluded if it were to sell upgrade rights on a standalone basis, including those rights +associated with iPhone, iPad, iPod touch and Apple TV, the selling price would be relatively low. Key factors considered by the Company in developing the ESPs for these upgrade rights include prices charged by the Company for similar offerings, the +Company’s historical pricing practices, the nature of the upgrade rights (e.g., unspecified and when-and-if-available), and the relative ESP of the upgrade rights as compared to the total selling price of the product. The Company may also +consider, when appropriate, the impact of other products and services, including advertising services, on selling price assumptions when developing and reviewing its ESPs for software upgrade rights and related deliverables. The Company may also +consider additional factors as appropriate, including the pricing of competitive alternatives if they exist, and product-specific business objectives. If the facts and circumstances underlying the factors considered change or should future facts and +circumstances lead the Company to consider additional factors, the Company’s ESP for software upgrades related to future sales for these devices could change. 29 Table of Contents Beginning in the third +quarter of 2010 in conjunction with the announcement of iOS 4, the Company’s ESPs for the embedded software upgrade rights included with iPhone, iPad and iPod touch reflect the positive financial impact expected by the Company as a result of +its introduction of a mobile advertising platform for these devices and the expectation of customers regarding software that includes or supports an advertising component. iOS 4 supports iAd, the Company’s new mobile advertising platform, which +enables applications on iPhone, iPad and iPod touch to feature media-rich advertisements within applications. The Company +records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. For transactions involving price +protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy +requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For customer incentive programs, the estimated cost of these programs is recognized at the later +of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market +conditions and product transitions may require the Company to increase customer incentive programs and incur incremental price protection obligations that could result in additional reductions to revenue at the time such programs are offered. +Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of +particular incentive programs. If a greater than estimated proportion of customers redeem such incentives, the Company would be required to record additional reductions to revenue, which would have a negative impact on the Company’s results of +operations. Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of investments are included in accumulated +other comprehensive income, net of tax, as reported in the Company’s Condensed Consolidated Balance Sheets. Changes in the fair value of investments impact the Company’s net income only when such investments are sold or an +other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if +any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns, which would require the Company to record an impairment charge in the period any such determination is made. In making this +judgment, the Company evaluates, among other things, the duration and extent to which the fair value of an investment is less than its cost, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or +whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s amortized cost basis. The Company’s assessment on whether an investment is other-than-temporarily impaired or not, could +change in the future due to new developments or changes in assumptions related to any particular investment. Inventory Valuation and +Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of +product shipments. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company +performs a detailed review of inventory each fiscal quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The industries in which +the Company competes are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen +technological changes negatively impact the utility of component inventory, the Company may be required to record additional write-downs, which would negatively affect its results of operations in the period when the write-downs were recorded. 30 Table of Contents The Company records +accruals for estimated cancellation fees related to component orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier +contracts, and open orders based on projected demand information. These commitments typically cover the Company’s requirements for periods ranging from 30 to 150 days. If there is an abrupt and substantial decline in demand for one or more of +the Company’s products or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional accruals for cancellation fees that would negatively affect its results of +operations in the period when the cancellation fees are identified and recorded. Warranty Costs The Company provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized based on +historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to +assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from +estimates, revisions to the estimated warranty liability would be required and could materially affect the Company’s results of operations. The Company periodically provides updates to its applications and operating system software to maintain the software’s compliance with specifications. The estimated cost to develop such updates is +accounted for as warranty cost that is recognized at the time related software revenue is recognized. Factors considered in determining appropriate accruals related to such updates include the number of units delivered, the number of updates +expected to occur, and the historical cost and estimated future cost of the resources necessary to develop these updates. Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. In +accordance with GAAP, the provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the +financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the +years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company only recognizes the tax benefit from an uncertain tax position if it is more likely than not that the tax position will be +sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% +likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, +including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the +Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, +the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s +expectations could have a material impact on the Company’s financial condition and operating results. 31 Table of Contents Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Note 8 +“Commitments and Contingencies” in Notes to Consolidated Financial Statements, the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. In accordance with GAAP, the Company records a +liability when it is probable that a loss has been incurred and the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be reasonably estimated. In +management’s opinion, the Company does not have a potential liability related to any current legal proceedings and claims that would individually or in the aggregate materially adversely affect its financial condition or operating results. +However, the outcomes of legal proceedings and claims brought against the Company are subject to significant uncertainty. Should the Company fail to prevail in any of these legal matters or should several of these legal matters be resolved against +the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. 32 Table of Contents Net Sales Fiscal years 2010, 2009 and 2008 each spanned 52 weeks. An additional week is included in the first fiscal quarter approximately every six +years to realign fiscal quarters with calendar quarters. The following table summarizes net sales and Mac unit sales by +operating segment and net sales and unit sales by product during the three years ended September 25, 2010 (in millions, except unit sales in thousands and per unit amounts): 2010 Change 2009 Change 2008 Net Sales by Operating Segment: Americas net sales $ 24,498 29% $ 18,981 15% $ 16,552 Europe net sales 18,692 58% 11,810 28% 9,233 Japan net sales 3,981 75% 2,279 32% 1,728 Asia-Pacific net sales 8,256 160% 3,179 18% 2,686 Retail net sales 9,798 47% 6,656 (9)% 7,292 Total net sales $ 65,225 52% $ 42,905 14% $ 37,491 Mac Unit Sales by Operating Segment: Americas Mac unit sales 4,976 21% 4,120 4% 3,980 Europe Mac unit sales 3,859 36% 2,840 13% 2,519 Japan Mac unit sales 481 22% 395 2% 389 Asia-Pacific Mac unit sales 1,500 62% 926 17% 793 Retail Mac unit sales 2,846 35% 2,115 4% 2,034 Total Mac unit sales 13,662 31% 10,396 7% 9,715 Net Sales by Product: Desktops (a) $ 6,201 43% $ 4,324 (23)% $ 5,622 Portables (b) 11,278 18% 9,535 9% 8,732 Total Mac net sales 17,479 26% 13,859 (3)% 14,354 iPod 8,274 2% 8,091 (12)% 9,153 Other music related products and services (c) 4,948 23% 4,036 21% 3,340 iPhone and related products and services (d) 25,179 93% 13,033 93% 6,742 iPad and related products and services (e) 4,958 NM 0 NM 0 Peripherals and other hardware (f) 1,814 23% 1,475 (13)% 1,694 Software, service and other sales (g) 2,573 7% 2,411 9% 2,208 Total net sales $ 65,225 52% $ 42,905 14% $ 37,491 Unit Sales by Product: Desktops (a) 4,627 45% 3,182 (14)% 3,712 Portables (b) 9,035 25% 7,214 20% 6,003 Total Mac unit sales 13,662 31% 10,396 7% 9,715 Net sales per Mac unit sold (h) $ 1,279 (4)% $ 1,333 (10)% $ 1,478 iPod unit sales 50,312 (7)% 54,132 (1)% 54,828 Net sales per iPod unit sold (h) $ 164 10% $ 149 (11)% $ 167 iPhone units sold 39,989 93% 20,731 78% 11,627 iPad units sold 7,458 NM 0 NM 0 (a) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (b) Includes MacBook, MacBook Air and MacBook Pro product lines. 33 Table of Contents (c) Includes iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (d) Includes revenue recognized from iPhone sales, carrier agreements, services, and Apple-branded and third-party iPhone accessories. (e) Includes revenue recognized from iPad sales, services and Apple-branded and third-party iPad accessories. (f) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. (g) Includes sales of Apple-branded operating system and application software, third-party software, Mac and Internet services. (h) Derived by dividing total product-related net sales by total product-related unit sales. NM = Not Meaningful Fiscal Year 2010 versus 2009 Net sales during 2010 increased $22.3 billion or 52% compared to 2009. Several factors contributed positively to these increases, including the following: • Net sales of iPhone and related products and services were $25.2 billion in 2010 representing an increase of $12.1 billion or 93% compared to 2009. +Net sales of iPhone and related products and services accounted for 39% of the Company’s total net sales for the year. iPhone unit sales totaled 40 million in 2010, which represents an increase of 19.3 million or 93% compared to 2009. +iPhone year-over-year growth was attributable primarily to continued growth from existing carriers, expanded distribution with new international carriers and resellers, and strong demand for iPhone 4, which was released in the U.S. in June 2010 and +in many other countries over the remainder of 2010. As of September 25, 2010, the Company distributed iPhone in 89 countries through 166 carriers. • Net sales of iPad and related products and services were $5.0 billion and unit sales of iPad were 7.5 million during 2010. iPad was released in +the U.S. in April 2010 and in various other countries over the remainder of 2010. As of September 25, 2010, the Company distributed iPad in 26 countries. The Company distributes iPad through its direct channels, certain cellular network +carriers’ distribution channels and certain third-party resellers. Net sales of iPad and related products and services accounted for 8% of the Company’s total net sales for 2010, reflecting the strong demand for iPad during the five months +following its release. • Mac net sales increased by $3.6 billion or 26% in 2010 compared to 2009, and Mac unit sales increased by 3.3 million or 31% in 2010 compared to +2009. Net sales per Mac unit sold decreased by 4% in 2010 compared to 2009 due primarily to lower average selling prices of Mac portable systems. Net sales of the Company’s Macs accounted for 27% of the Company’s total net sales in 2010 +compared to 32% in 2009. During 2010, net sales and unit sales of the Company’s Mac portable systems increased by 18% and 25%, respectively, primarily attributable to strong demand for MacBook Pro, which was updated in April 2010. Net sales and +unit sales of the Company’s Mac desktop systems increased by 43% and 45%, respectively, as a result of higher sales of iMac, which was updated in July 2010. • Net sales of other music related products and services increased $912 million or 23% during 2010 compared to 2009. This increase was due primarily +to growth of the iTunes Store which generated total net sales of $4.1 billion for 2010. The results of the iTunes Store reflect growth of the iTunes App Store, continued growth in the installed base of iPhone, iPad, and iPod customers, and the +expansion of third-party audio and video content available for sale and rent via the iTunes Store. The Company continues to expand its iTunes content and applications offerings around the world. Net sales of other music related products and services +accounted for 8% of the Company’s total net sales for 2010. • Net sales of iPods increased $183 million or 2% during 2010, while iPod unit sales declined by 7% during 2010 compared to 2009. Net sales per iPod +unit sold increased by 10% to $164 in 2010 compared to 2009, due to a shift in product mix toward iPod touch. iPod touch had strong growth in each of the Company’s reportable operating segments. Net sales of iPods accounted for 13% of the +Company’s total net sales for the year compared to 19% in 2009. 34 Table of Contents Fiscal Year 2009 versus 2008 Net sales during 2009 increased $5.4 billion or 14% compared to 2008. Several factors contributed positively to these +increases, including the following: • iPhone revenue and net sales of related products and services amounted to $13.0 billion in 2009, an increase of $6.3 billion or 93% compared to +2008. The year-over-year iPhone revenue growth is largely attributable to the year-over-year increase in iPhone handset unit sales. iPhone handset unit sales totaled 20.7 million during 2009, which represents an increase of 9.1 million or +78% during 2009 compared to 2008. This growth is attributed primarily to expanded distribution and strong overall demand for iPhones. iPhone 3GS was released in the U.S. on June 19, 2009 and in many other countries over the remainder of 2009. • Net sales of other music-related products and services increased $696 million or 21% during 2009 compared to 2008. The increase was due +predominantly to increased net sales of third-party digital content and applications from the iTunes Store, which experienced double-digit growth in each of the Company’s geographic segments during 2009 compared to the same period in 2008. The +Company believes this is attributable primarily to continued interest in and growth of the iTunes App Store, continued growth in the Company’s base of iPhone, iPad, and iPod customers, and the expansion of third-party audio and video content +available for sale and rent via the iTunes Store Partially offsetting the favorable factors discussed +above, net sales during 2009 were negatively impacted by certain factors, including the following: • Net sales of iPods decreased $1.1 billion or 12% during 2009 compared to 2008. iPod unit sales decreased by 1% during 2009 compared to 2008. Net +sales per iPod unit sold decreased 11% to $149 in 2009 compared to 2008, resulting from lower average selling prices across all of the iPod product lines, due primarily to price reductions taken with the introduction of new iPods in September 2009 +and September 2008 and a stronger U.S. dollar, offset partially by a higher mix of iPod touch sales. • Mac net sales declined 3% during 2009 compared to 2008, while Mac unit sales increased by 7% over the same period. Net sales per Mac unit sold +decreased by 10% during 2009 compared to 2008, due primarily to lower average selling prices across all Mac portable and desktop systems and a stronger U.S. dollar. Net sales of Macs accounted for 32% of the Company’s total net sales for 2009. +During 2009, Mac portable systems net sales and unit sales increased by 9% and 20%, respectively, compared to 2008. This growth was driven by strong demand for MacBook Pro, which was updated in June 2009 and October 2008, and which experienced +double-digit net sales and unit growth in each of the Company’s reportable operating segments compared to the same period in 2008. The Company also had a higher mix of Mac portable systems sales, which is consistent with overall personal +computer market trends. Net sales and unit sales of the Company’s Mac desktop systems decreased by 23% and 14%, respectively, during 2009 compared to 2008. The decrease in net sales of Mac desktop systems was due mainly to a shift in product +mix towards lower-priced desktops, lower average selling prices across all Mac desktop systems and a stronger U.S. dollar. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating and reporting segments consist of the Americas, Europe, Japan, Asia-Pacific and Retail operations. +The Americas, Europe, Japan and Asia-Pacific reportable segment results do not include the results of the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries as well as the +Middle East and Africa. The Asia-Pacific segment includes Australia and Asia, but does not include Japan. The Retail segment operates Apple retail stores in 11 countries, including the U.S. Each reportable operating segment provides similar hardware +and software products and similar services. Further information regarding the Company’s operating segments may be found in Note 9, “Segment Information and Geographic Data” in Notes to Consolidated Financial Statements of this Form +10-K. 35 Table of Contents Americas During 2010, net sales in the Americas segment increased $5.5 billion or 29% compared to 2009. This increase in net sales was driven by +increased iPhone revenue, strong demand for iPad, continued demand for Mac desktop and portable systems, and higher sales of third-party digital content and applications from the iTunes Store. Americas Mac net sales and unit sales increased 18% and +21%, respectively, during 2010 compared to 2009, largely due to strong demand for MacBook Pro. The Americas segment represented 37% and 44% of the Company’s total net sales in 2010 and 2009, respectively. During 2009, net sales in the Americas segment increased $2.4 billion or 15% compared to 2008. The increase in net sales during 2009 was +attributable to the significant year-over-year increase in iPhone revenue, higher sales of third-party digital content and applications from the iTunes Store, and increased sales of Mac portable systems, partially offset by a decrease in sales of +Mac desktop systems and iPods. Americas Mac net sales decreased 6% due primarily to lower average selling prices, while Mac unit sales increased by 4% on a year-over-year basis. The increase in Mac unit sales was due primarily to strong demand for +the MacBook Pro. The Americas segment represented approximately 44% of the Company’s total net sales in both 2009 and 2008. Europe During 2010, net sales in Europe increased $6.9 billion or 58% compared to 2009. The growth in net sales was due mainly to +a significant increase in iPhone revenue attributable to continued growth from existing carriers and country and carrier expansion, increased sales of Mac desktop and portable systems and strong demand for iPad, partially offset by a stronger U.S. +dollar. Europe Mac net sales and unit sales increased 32% and 36%, respectively, during the year due to strong demand for MacBook Pro and iMac. The Europe segment represented 29% and 28% of the Company’s total net sales in 2010 and 2009, +respectively. During 2009, net sales in Europe increased $2.6 billion or 28% compared to 2008. The increase in net sales was +due mainly to increased iPhone revenue and strong sales of Mac portable systems, offset partially by lower net sales of Mac desktop systems, iPods, and a stronger U.S. dollar. Mac unit sales increased 13% in 2009 compared to 2008, which was driven +primarily by increased sales of Mac portable systems, particularly MacBook Pro, while total Mac net sales declined as a result of lower average selling prices across all Mac products. iPod net sales decreased year-over-year as a result of lower +average selling prices, partially offset by increased unit sales of the higher priced iPod touch. The Europe segment represented 28% and 25% of total net sales in 2009 and 2008, respectively. Japan During 2010, Japan’s net sales increased $1.7 billion or 75% +compared to 2009. The primary contributors to this growth were significant year-over-year increases in iPhone revenue, strong demand for iPad, and to a lesser extent strength in the Japanese Yen. Mac net sales increased by 8% driven by a 22% +increase in unit sales due primarily to strong demand for MacBook Pro and iMac, partially offset by lower average selling prices in Japan on a year-over-year basis. The Japan segment represented 6% and 5% of the Company’s total net sales for +2010 and 2009, respectively. Japan’s net sales increased $551 million or 32% in 2009 compared to 2008. The primary +contributors to this growth were increased iPhone revenue, stronger demand for certain Mac portable systems and iPods, and strength in the Japanese Yen, partially offset by decreased sales of Mac desktop systems. Net sales and unit sales of Mac +portable systems increased during 2009 compared to 2008, driven primarily by stronger demand for MacBook Pro. Net sales and unit sales of iPods increased during 2009 compared to 2008, driven by strong demand for iPod touch and iPod nano. The Japan +segment represented approximately 5% of the Company’s total net sales in both 2009 and 2008. 36 Table of Contents Asia-Pacific Net sales in Asia-Pacific increased $5.1 billion or 160% during 2010 compared to 2009. The significant growth in Asia-Pacific net sales +was due mainly to increased iPhone revenue, which was primarily attributable to country and carrier expansion and continued growth from existing carriers. Asia-Pacific net sales were also favorably affected by strong demand for Mac portable and +desktop systems and for iPad. Particularly strong year-over-year growth was experienced in China, Korea and Australia. The Asia-Pacific segment represented 13% and 7% of the Company’s total net sales for 2010 and 2009, respectively. Net sales in Asia-Pacific increased $493 million or 18% during 2009 compared to 2008 reflecting strong growth in sales of iPhone and Mac +portable systems, offset partially by a decline in sales of iPods and Mac desktop systems, as well as a strengthening of the U.S. dollar against the Australian dollar and other Asian currencies. Mac net sales and unit sales grew in the Asia-Pacific +region by 4% and 17%, respectively, due to increased sales of the MacBook Pro. The Asia-Pacific segment represented approximately 7% of the Company’s total net sales in both 2009 and 2008. Retail Retail net sales +increased $3.1 billion or 47% during 2010 compared to 2009. The increase in net sales was driven primarily by strong demand for iPad, increased sales of Mac desktop and portable systems and a significant year-over-year increase in iPhone revenue. +Mac net sales and unit sales grew in the Retail segment by 25% and 35%, respectively, during 2010. The Company opened 44 new retail stores during the year, 28 of which were international stores, ending the year with 317 stores open compared to 273 +stores at the end of 2009. With an average of 288 stores and 254 stores opened during 2010 and 2009, respectively, average revenue per store increased to $34.1 million in 2010, compared to $26.2 million in 2009. The Retail segment represented 15% +and 16% of the Company’s total net sales in 2010 and 2009, respectively. Retail net sales decreased $636 million or 9% +during 2009 compared to 2008. The decline in net sales was driven largely by a decrease in net sales of iPhones, iPods and Mac desktop systems, offset partially by strong demand for Mac portable systems. The year-over-year decline in Retail net +sales was attributable to continued third-party channel expansion, particularly in the U.S. where most of the Company’s stores are located, and also reflects the challenging consumer-spending environment in 2009. The Company opened 26 new +retail stores during 2009, including 14 international stores, ending the year with 273 stores open. This compares to 247 stores open as of September 27, 2008. With an average of 254 stores and 211 stores opened during 2009 and 2008, +respectively, average revenue per store decreased to $26.2 million for 2009 from $34.6 million in 2008. The Retail segment +reported operating income of $2.4 billion during 2010 and $1.7 billion during both 2009 and 2008. The increase in Retail operating income during 2010 compared to 2009 was attributable to higher overall net sales. Despite the decline in Retail net +sales during 2009 compared to 2008, the Retail segment’s operating income was flat at $1.7 billion in 2009 compared to 2008 due primarily to a higher gross margin percentage in 2009 consistent with that experienced by the overall company. Expansion of the Retail segment has required and will continue to require a substantial investment in fixed assets and +related infrastructure, operating lease commitments, personnel, and other operating expenses. Capital asset purchases associated with the Retail segment since its inception totaled $2.2 billion through the end of 2010. As of September 25, 2010, +the Retail segment had approximately 26,500 full-time equivalent employees and had outstanding lease commitments associated with retail space and related facilities of $1.7 billion. The Company would incur substantial costs if it were to close +multiple retail stores and such costs could adversely affect the Company’s financial condition and operating results. 37 Table of Contents Gross Margin Gross margin for the three years ended September 25, 2010, are as follows (in millions, except gross margin percentages): 2010 2009 2008 Net sales $ 65,225 $ 42,905 $ 37,491 Cost of sales 39,541 25,683 24,294 Gross margin $ 25,684 $ 17,222 $ 13,197 Gross margin percentage 39.4% 40.1% 35.2% The gross margin +percentage in 2010 was 39.4% compared to 40.1% in 2009. This decline in gross margin is primarily attributable to new products that have higher cost structures, including iPad, partially offset by a more favorable sales mix of iPhone, which has a +higher gross margin than the Company average. The gross margin percentage in 2009 was 40.1% compared to 35.2% in 2008. The +primary contributors to the increase in 2009 as compared to 2008 were a favorable sales mix toward products with higher gross margins and lower commodity and other product costs, which were partially offset by product price reductions. The Company expects its gross margin percentage to decrease in future periods compared to levels achieved during 2010 and anticipates +gross margin levels of about 36% in the first quarter of 2011. This expected decline is largely due to a higher mix of new and innovative products that have higher cost structures and deliver greater value to customers, and expected and potential +future component cost and other cost increases. The foregoing statements regarding the Company’s expected gross margin +percentage are forward-looking and could differ from anticipated levels because of several factors, including but not limited to certain of those set forth below in Part I, Item 1A, “Risk Factors” under the subheading “ Future +operating results depend upon the Company’s ability to obtain key components including but not limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable prices and in sufficient quantities ,” which is incorporated herein +by reference. There can be no assurance that targeted gross margin percentage levels will be achieved. In general, gross margins and margins on individual products will remain under downward pressure due to a variety of factors, including continued +industry wide global product pricing pressures, increased competition, compressed product life cycles, product transitions and expected and potential increases in the cost of key components including but not limited to microprocessors, NAND flash +memory, DRAM and LCDs, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to these competitive pressures, the +Company expects it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to +stimulate demand for certain of its products. Due to the Company’s significant international operations, financial results can be significantly affected in the short-term by fluctuations in exchange rates. Operating Expenses Operating expenses for the three years ended September 25, 2010, are as follows (in millions, except for percentages): 2010 2009 2008 Research and development $ 1,782 $ 1,333 $ 1,109 Percentage of net sales 2.7% 3.1% 3.0% Selling, general and administrative $ 5,517 $ 4,149 $ 3,761 Percentage of net sales 8.5% 9.7% 10.0% 38 Table of Contents Research and Development Expense +(“R&D”) R&D expense increased 34% or $449 million to $1.8 billion in 2010 compared to 2009. This +increase was due primarily to an increase in headcount and related expenses in the current year to support expanded R&D activities. Also contributing to this increase in R&D expense in 2010 was the capitalization in 2009 of software +development costs of $71 million related to Mac OS X Snow Leopard. Although total R&D expense increased 34% during 2010, it declined as a percentage of net sales given the 52% year-over-year increase in net sales in 2010. The Company continues +to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core +business strategy. As such, the Company expects to make further investments in R&D to remain competitive. R&D expense +increased 20% or $224 million to $1.3 billion in 2009 compared to 2008. This increase was due primarily to an increase in headcount in 2009 to support expanded R&D activities and higher stock-based compensation expenses. Additionally, $71 +million of software development costs were capitalized related to Mac OS X Snow Leopard and excluded from R&D expense during 2009, compared to $11 million of software development costs capitalized during 2008. Although total R&D expense +increased 20% during 2009, it remained relatively flat as a percentage of net sales given the 14% increase in revenue in 2009. Selling, +General and Administrative Expense (“SG&A”) SG&A expense increased $1.4 billion or 33% to $5.5 billion +in 2010 compared to 2009. This increase was due primarily to the Company’s continued expansion of its Retail segment, higher spending on marketing and advertising programs, increased stock-based compensation expenses and variable costs +associated with the overall growth of the Company’s net sales. SG&A expenses increased $388 million or 10% to $4.1 +billion in 2009 compared to 2008. This increase was due primarily to the Company’s continued expansion of its Retail segment in both domestic and international markets, higher stock-based compensation expense and higher spending on marketing +and advertising. Other Income and Expense Other income and expense for the three years ended September 25, 2010, are as follows (in millions): 2010 2009 2008 Interest income $ 311 $ 407 $ 653 Other income (expense), net (156 ) (81 ) (33 ) Total other income and expense $ 155 $ 326 $ 620 Total other income and expense decreased $171 million or 52% to $155 million during 2010 compared to $326 +million and $620 million in 2009 and 2008, respectively. The overall decrease in other income and expense is attributable to the significant declines in interest rates on a year-over-year basis, partially offset by the Company’s higher cash, +cash equivalents and marketable securities balances. The weighted average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 0.75%, 1.43% and 3.44% during 2010, 2009 and 2008, respectively. Additionally +the Company incurred higher premium expenses on its foreign exchange option contracts, which further reduced the total other income and expense. During 2010, 2009 and 2008, the Company had no debt outstanding and accordingly did not incur any +related interest expense. Provision for Income Taxes The Company’s effective tax rates were 24%, 32% and 32% for 2010, 2009 and 2008, respectively. The Company’s effective rates for these periods differ from the statutory federal income tax rate +of 35% due 39 Table of Contents primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S. The lower effective tax +rate in 2010 as compared to 2009 is due primarily to an increase in foreign earnings on which U.S. income taxes have not been provided as such earnings are intended to be indefinitely reinvested outside the U.S. As of September 25, 2010, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax +credits of $2.4 billion, and deferred tax liabilities of $5.0 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future +reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and amount of a +valuation allowance. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s +federal income tax returns for the years 2004 through 2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2009. All IRS +audit issues for years prior to 2004 have been resolved. During the third quarter of 2010, the Company reached a tax settlement with the IRS for the years 2002 through 2003. In addition, the Company is subject to audits by state, local, and foreign +tax authorities. Management believes that adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the +Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the three years ended September 25, 2010 (in millions): 2010 2009 2008 Cash, cash equivalents and marketable securities $ 51,011 $ 33,992 $ 24,490 Accounts receivable, net $ 5,510 $ 3,361 $ 2,422 Inventories $ 1,051 $ 455 $ 509 Working capital $ 20,956 $ 20,049 $ 18,645 Annual operating cash flow $ 18,595 $ 10,159 $ 9,596 As of +September 25, 2010, the Company had $51 billion in cash, cash equivalents and marketable securities, an increase of $17 billion from September 26, 2009. The principal component of this net increase was the cash generated by operating +activities of $18.6 billion, which was partially offset by payments for acquisition of property, plant and equipment of $2 billion and payments made in connection with business acquisitions, net of cash acquired, of $638 million. The Company’s marketable securities investment portfolio is invested primarily in highly rated securities, generally with a minimum +rating of single-A or equivalent. As of September 25, 2010 and September 26, 2009, $30.8 billion and $17.4 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and +are generally based in U.S. dollar-denominated holdings. The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital needs, capital asset purchases, outstanding +commitments and other liquidity requirements associated with its existing operations over the next 12 months. 40 Table of Contents Capital Assets The Company’s capital expenditures were $2.6 billion during 2010, consisting of approximately $404 million for retail store +facilities and $2.2 billion for other capital expenditures, including product tooling and manufacturing process equipment and corporate facilities and infrastructure. The Company’s actual cash payments for capital expenditures during 2010 were +$2 billion. The Company anticipates utilizing approximately $4.0 billion for capital expenditures during 2011, including +approximately $600 million for retail store facilities and approximately $3.4 billion for product tooling and manufacturing process equipment, and corporate facilities and infrastructure, including information systems hardware, software and +enhancements. Historically the Company has opened between 25 and 50 new retail stores per year. During 2011, the Company +expects to open 40 to 50 new stores, over half of which are expected to be located outside of the U.S. Off-Balance Sheet Arrangements and +Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company +has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an +unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company. The following +table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 25, 2010 and excludes amounts already recorded on the Consolidated Balance Sheet (in millions): Total Payments Due in Less Than 1 +Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 +Years Operating leases $ 2,089 $ 266 $ 527 $ 470 $ 826 Purchase obligations 8,700 8,700 0 0 0 Other obligations 1,096 912 176 6 2 Total $ 11,885 $ 9,878 $ 703 $ 476 $ 828 Lease Commitments As of September 25, 2010, the Company had total outstanding commitments on noncancelable operating leases of $2.1 billion, $1.7 billion of which related to the lease of retail space and related +facilities. The Company’s major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for terms ranging from five to 20 +years, the majority of which are for ten years, and often contain multi-year renewal options. Purchase Commitments with Contract +Manufacturers and Component Suppliers The Company utilizes several contract manufacturers to manufacture sub-assemblies +for the Company’s products and to perform final assembly and test of finished products. These contract manufacturers acquire components and build product based on demand information supplied by the Company, which typically covers periods +ranging from 30 to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, +supplier contracts, and open orders based on projected demand information. 41 Table of Contents Such purchase commitments typically cover the Company’s forecasted component and manufacturing requirements for periods ranging from 30 to 150 days. As of September 25, 2010, the +Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $8.2 billion. The Company has entered into prepaid long-term supply agreements to secure the supply of certain inventory components, which generally expire between 2011 and 2015. In August 2010, the Company entered +into a long-term supply agreement under which it has committed to prepay $500 million in 2011. These prepayments will be applied to certain inventory component purchases made over the life of each respective agreement. Other Obligations Other +outstanding obligations were $1.1 billion as of September 25, 2010, which related to advertising, research and development, product tooling and manufacturing process equipment, Internet and telecommunications services and other obligations. The Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax +liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of September 25, 2010, the Company had non-current deferred tax liabilities of $4.3 billion. Additionally, as of September 25, 2010, the Company +had gross unrecognized tax benefits of $943 million and an additional $247 million for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of +payments in connection with these tax liabilities; therefore, such amounts are not included in the above contractual obligation table. Indemnifications The +Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include +indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant +payments resulting from such an infringement claim asserted against it or an indemnified third-party and, in the opinion of management, does not have a liability related to unresolved infringement claims subject to indemnification that would +materially adversely affect its financial condition or operating results. Therefore, the Company did not record a liability for infringement costs as of either September 25, 2010 or September 26, 2009. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company +has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal +proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances +involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not materially adversely affected the +Company’s financial condition or operating results. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. However, given the effective horizons of the Company’s risk +management activities and the anticipatory nature of the exposures, there can be no assurance the hedges will offset more than a portion of the financial impact resulting from 42 Table of Contents movements in either foreign exchange or interest rates. In addition, the timing of the accounting for recognition of gains and losses related to mark-to-market instruments for any given period +may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the +Company’s interest income and expense is most sensitive to fluctuations in the general level of U.S. interest rates. As such, changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable +securities, the fair value of those investments, as well as costs associated with foreign currency hedges. The Company’s +investment policy and strategy are focused on preservation of capital and supporting the liquidity requirements of the Company. A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s +investment policy and to objective market benchmarks. The Company’s internal portfolio is benchmarked against external manager performance. The Company’s exposure to market risk for changes in interest rates relates primarily to the Company’s investment portfolio. The Company typically invests in highly rated securities and its +policy generally limits the amount of credit exposure to any one issuer. The Company’s investment policy requires investments to be investment grade, primarily rated single-A or better, with the objective of minimizing the potential risk of +principal loss. All highly liquid investments with initial maturities of three months or less at the date of purchase are classified as cash equivalents. The Company classifies its marketable securities as either short-term or long-term based on +each instrument’s underlying contractual maturity date. All short-term marketable securities have maturities less than 12 months, while all long-term marketable securities have maturities ranging from one to five years. The Company may sell its +investments prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no significant net gains or losses during 2010, 2009 and 2008 related to such sales. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the +Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of +September 25, 2010, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $477 million incremental decline in the fair market value of the portfolio. As of September 26, 2009, a similar 100 basis +point shift in the yield curve would have resulted in a $176 million incremental decline in the fair market value of the portfolio. Such losses would only be realized if the Company sold the investments prior to maturity. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in +particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is also a risk that the Company will have to adjust local currency product pricing due to +competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter +into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, +and net investments in foreign subsidiaries. Generally, the Company’s practice is to hedge a majority of its material foreign exchange exposures, typically for three to six months. 43 Table of Contents However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to immateriality, accounting considerations and the prohibitive +economic cost of hedging particular exposures. To provide a meaningful assessment of the foreign currency risk associated +with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model +consisted of using a Monte Carlo simulation to generate thousands of random market price paths. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign exchange portfolio due to adverse +movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments, and assets and liabilities +denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $103 million as of September 25, 2010 compared to a maximum +one-day loss in fair value of $44 million as of September 26, 2009. Because the Company uses foreign currency instruments for hedging purposes, losses incurred on those instruments are generally offset by increases in the fair value of the +underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio and derivative +positions may differ materially from the sensitivity analyses performed as of September 25, 2010 due to the inherent limitations associated with predicting the changes in the timing and amount of interest rates, foreign currency exchanges rates +and the Company’s actual exposures and positions. 44 Table of Contents Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the three years ended September 25, 2010 46 Consolidated Balance Sheets as of September 25, 2010 and September 26, 2009 47 Consolidated Statements of Shareholders’ Equity for the three years ended September 25, +2010 48 Consolidated Statements of Cash Flows for the three years ended September 25, 2010 49 Notes to Consolidated Financial Statements 50 Selected Quarterly Financial Information (Unaudited) 82 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 83 Report of KPMG LLP, Independent Registered Public Accounting Firm 85 All financial +statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial +statements and notes thereto. 45 Table of Contents CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except share amounts which are reflected in thousands and per share amounts) Three years ended September 25, 2010 2010 2009 2008 Net sales $ 65,225 $ 42,905 $ 37,491 Cost of sales 39,541 25,683 24,294 Gross margin 25,684 17,222 13,197 Operating expenses: Research and development 1,782 1,333 1,109 Selling, general and administrative 5,517 4,149 3,761 Total operating expenses 7,299 5,482 4,870 Operating income 18,385 11,740 8,327 Other income and expense 155 326 620 Income before provision for income taxes 18,540 12,066 8,947 Provision for income taxes 4,527 3,831 2,828 Net income $ 14,013 $ 8,235 $ 6,119 Earnings per common share: Basic $ 15.41 $ 9.22 $ 6.94 Diluted $ 15.15 $ 9.08 $ 6.78 Shares used in computing earnings per share: Basic 909,461 893,016 881,592 Diluted 924,712 907,005 902,139 See accompanying Notes +to Consolidated Financial Statements. 46 Table of Contents CONSOLIDATED BALANCE SHEETS (In millions, except share amounts) September 25, 2010 September 26, 2009 ASSETS: Current assets: Cash and cash equivalents $ 11,261 $ 5,263 Short-term marketable securities 14,359 18,201 Accounts receivable, less allowances of $55 and $52, respectively 5,510 3,361 Inventories 1,051 455 Deferred tax assets 1,636 1,135 Vendor non-trade receivables 4,414 1,696 Other current assets 3,447 1,444 Total current assets 41,678 31,555 Long-term marketable securities 25,391 10,528 Property, plant and equipment, net 4,768 2,954 Goodwill 741 206 Acquired intangible assets, net 342 247 Other assets 2,263 2,011 Total assets $ 75,183 $ 47,501 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 12,015 $ 5,601 Accrued expenses 5,723 3,852 Deferred revenue 2,984 2,053 Total current liabilities 20,722 11,506 Deferred revenue – non-current 1,139 853 Other non-current liabilities 5,531 3,502 Total liabilities 27,392 15,861 Commitments and contingencies Shareholders’ equity: Common stock, no par value; 1,800,000,000 shares authorized; 915,970,050 and 899,805,500 shares issued and outstanding, +respectively 10,668 8,210 Retained earnings 37,169 23,353 Accumulated other comprehensive (loss)/income (46 ) 77 Total shareholders’ equity 47,791 31,640 Total liabilities and shareholders’ equity $ 75,183 $ 47,501 See accompanying Notes to Consolidated Financial Statements. 47 Table of Contents CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Common Stock Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders’ Equity Shares Amount Balances as of September 29, 2007 872,329 $ 5,368 $ 9,100 $ 63 $ 14,531 Cumulative effect of change in accounting principle 0 45 11 0 56 Components of comprehensive income: Net income 0 0 6,119 0 6,119 Change in foreign currency translation 0 0 0 (28 ) (28 ) Change in unrealized loss on available-for-sale securities, net of tax 0 0 0 (63 ) (63 ) Change in unrealized gain on derivative instruments, net of tax 0 0 0 19 19 Total comprehensive income 6,047 Stock-based compensation 0 513 0 0 513 Common stock issued under stock plans, net of shares withheld for employee taxes 15,888 460 (101 ) 0 359 Issuance of common stock in connection with an asset acquisition 109 21 0 0 21 Tax benefit from employee stock plan awards 0 770 0 0 770 Balances as of September 27, 2008 888,326 7,177 15,129 (9 ) 22,297 Components of comprehensive income: Net income 0 0 8,235 0 8,235 Change in foreign currency translation 0 0 0 (14 ) (14 ) Change in unrealized loss on available-for-sale securities, net of tax 0 0 0 118 118 Change in unrealized gain on derivative instruments, net of tax 0 0 0 (18 ) (18 ) Total comprehensive income 8,321 Stock-based compensation 0 707 0 0 707 Common stock issued under stock plans, net of shares withheld for employee taxes 11,480 404 (11 ) 0 393 Tax benefit from employee stock plan awards, including transfer pricing adjustments 0 (78 ) 0 0 (78 ) Balances as of September 26, 2009 899,806 8,210 23,353 77 31,640 Components of comprehensive income: Net income 0 0 14,013 0 14,013 Change in foreign currency translation 0 0 0 7 7 Change in unrealized gain on available-for-sale securities, net of tax 0 0 0 123 123 Change in unrealized gain on derivative instruments, net of tax 0 0 0 (253 ) (253 ) Total comprehensive income 13,890 Stock-based compensation 0 876 0 0 876 Common stock issued under stock plans, net of shares withheld for employee taxes 16,164 703 (197 ) 0 506 Tax benefit from employee stock plan awards, including transfer pricing adjustments 0 879 0 0 879 Balances as of September 25, 2010 915,970 $ 10,668 $ 37,169 $ (46 ) $ 47,791 See accompanying Notes to Consolidated Financial Statements. 48 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three years ended September 25, 2010 2010 2009 2008 Cash and cash equivalents, beginning of the year $ 5,263 $ 11,875 $ 9,352 Operating activities: Net income 14,013 8,235 6,119 Adjustments to reconcile net income to cash generated by operating activities: Depreciation, amortization and accretion 1,027 734 496 Stock-based compensation expense 879 710 516 Deferred income tax expense 1,440 1,040 398 Loss on disposition of property, plant and equipment 24 26 22 Changes in operating assets and liabilities: Accounts receivable, net (2,142 ) (939 ) (785 ) Inventories (596 ) 54 (163 ) Vendor non-trade receivables (2,718 ) 586 110 Other current assets (1,514 ) 163 (384 ) Other assets (120 ) (902 ) 289 Accounts payable 6,307 92 596 Deferred revenue 1,217 521 718 Other liabilities 778 (161 ) 1,664 Cash generated by operating activities 18,595 10,159 9,596 Investing activities: Purchases of marketable securities (57,793 ) (46,724 ) (22,965 ) Proceeds from maturities of marketable securities 24,930 19,790 11,804 Proceeds from sales of marketable securities 21,788 10,888 4,439 Purchases of other long-term investments (18 ) (101 ) (38 ) Payments made in connection with business acquisitions, net of cash acquired (638 ) 0 (220 ) Payments for acquisition of property, plant and equipment (2,005 ) (1,144 ) (1,091 ) Payments for acquisition of intangible assets (116 ) (69 ) (108 ) Other (2 ) (74 ) (10 ) Cash used in investing activities (13,854 ) (17,434 ) (8,189 ) Financing activities: Proceeds from issuance of common stock 912 475 483 Excess tax benefits from stock-based compensation 751 270 757 Taxes paid related to net share settlement of equity awards (406 ) (82 ) (124 ) Cash generated by financing activities 1,257 663 1,116 Increase/(decrease) in cash and cash equivalents 5,998 (6,612 ) 2,523 Cash and cash equivalents, end of the year $ 11,261 $ 5,263 $ 11,875 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 2,697 $ 2,997 $ 1,267 See accompanying Notes +to Consolidated Financial Statements. 49 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Summary of Significant Accounting Policies Apple Inc. +and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures, and markets personal computers, mobile communication and media devices, and portable digital music players, and sells a variety of +related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, and third-party cellular +network carriers, wholesalers, resellers and value-added resellers. In addition, the Company sells a variety of third-party Macintosh (“Mac”), iPhone, iPad and iPod compatible products including application software, printers, storage +devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to consumer, small and mid-sized business, education, enterprise, government and creative customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. The preparation of these consolidated financial +statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in these consolidated financial statements and accompanying notes. +Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes thereto have been reclassified to conform to the current year’s presentation. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s fiscal years +2010, 2009 and 2008 ended on September 25, 2010, September 26, 2009 and September 27, 2008, respectively, and included 52 weeks each. An additional week is included in the first fiscal quarter approximately every six years to +realign fiscal quarters with calendar quarters. Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. Retrospective Adoption of New Accounting Principles In September 2009, the Financial Accounting Standards Board (“FASB”) amended the accounting standards related to revenue recognition for arrangements with multiple deliverables and arrangements +that include software elements (“new accounting principles”). The new accounting principles permitted prospective or retrospective adoption, and the Company elected retrospective adoption during the first quarter of 2010. Under the historical accounting principles, the Company was required to account for sales of both iPhone and Apple TV using subscription +accounting because the Company indicated it might from time-to-time provide future unspecified software upgrades and features for those products free of charge. Under subscription accounting, revenue and associated product cost of sales for iPhone +and Apple TV were deferred at the time of sale and recognized on a straight-line basis over each product’s estimated economic life. This resulted in the deferral of significant amounts of revenue and cost of sales related to iPhone and Apple +TV. The new accounting principles affect the Company’s accounting for all past and current sales of iPhone, iPad, Apple +TV and for sales of iPod touch beginning in June 2010. The new accounting principles require the Company to account for the sale of these devices as two deliverables. The first deliverable is the hardware and software essential to the functionality +of the hardware device delivered at the time of sale, and the second deliverable is the right included with the purchase of these devices to receive on a when-and-if-available basis, future unspecified software upgrades and features relating to the +product’s essential software. The new accounting principles result in the recognition of a substantial portion of the revenue and all product costs from 50 Table of Contents the sale of these devices at the time of their sale. Additionally, the Company is required to estimate a standalone selling price for the unspecified software upgrade rights included with the +sale of these devices and recognizes that amount ratably over the 24-month estimated life of the related hardware device. Refer to the “Explanatory Note” and Note 2, “Retrospective Adoption of New Accounting Principles” in the 2009 Form +10-K for additional information on the impact of adoption of the new accounting principles, which sections are incorporated herein by reference. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or +determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the +product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company legally retains a portion of +the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products (e.g., Macs, iPhones, iPads, iPods and peripherals), software bundled with hardware that is essential to the functionality of the +hardware, and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following +types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. The Company sells software and peripheral products obtained from other companies. The Company generally establishes its own pricing and +retains related inventory risk, is the primary obligor in sales transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company generally recognizes revenue for the sale of products obtained +from other companies based on the gross amount billed. For certain sales made through the iTunes Store, including sales of third-party software applications for the Company’s iOS devices, the Company is not the primary obligor to users of the +software, and third-party developers determine the selling price of their software. Therefore, the Company accounts for such sales on a net basis by recognizing only the commission it retains from each sale and including that commission in net sales +in the Consolidated Statements of Operations. The portion of the sales price paid by users that is remitted by the Company to third-party developers is not reflected in the Company’s Consolidated Statement of Operations. The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. +This includes amounts that have been deferred related to embedded unspecified and specified software upgrades rights. The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on the iTunes Store +for the purchase of content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized +ratably over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited +warranty. The Company records reductions to revenue for estimated commitments related to price protection and for customer +incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. The estimated cost of these programs is recognized in the period the Company has sold the product and committed to a plan. The Company +also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected +taxes recorded as current liabilities until remitted to the relevant government authority. 51 Table of Contents Revenue Recognition for +Arrangements with Multiple Deliverables For multi-element arrangements that include tangible products that contain +software that is essential to the tangible product’s functionality and undelivered software elements that relate to the tangible product’s essential software, the Company allocates revenue to all deliverables based on their relative +selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party +evidence of selling price (“TPE”), and (iii) best estimate of the selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that +deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. As described in more detail below, for all past and current sales of iPhone, iPad, Apple TV and for sales of iPod touch beginning in June 2010, the Company has indicated it may from time-to-time provide +future unspecified software upgrades and features free of charge to customers. The Company has identified two deliverables in arrangements involving the sale of these devices. The first deliverable is the hardware and software essential to the +functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with the purchase of iPhone, iPad, iPod touch and Apple TV to receive on a when-and-if-available basis, future unspecified +software upgrades and features relating to the product’s essential software. The Company has allocated revenue between these two deliverables using the relative selling price method. Because the Company has neither VSOE nor TPE for the two +deliverables, the allocation of revenue has been based on the Company’s ESPs. Amounts allocated to the delivered hardware and the related essential software are recognized at the time of sale provided the other conditions for revenue +recognition have been met. Amounts allocated to the embedded unspecified software upgrade rights are deferred and recognized on a straight-line basis over the 24-month estimated life of each of these devices. All product cost of sales, including +estimated warranty costs, are recognized at the time of sale. Costs for engineering and sales and marketing are expensed as incurred. The Company’s process for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each +deliverable. The Company believes its customers, particularly consumers, would be reluctant to buy unspecified software upgrade rights related to iPhone, iPad, iPod touch and Apple TV. This view is primarily based on the fact that unspecified +upgrade rights do not obligate the Company to provide upgrades at a particular time or at all, and do not specify to customers which upgrades or features will be delivered. Therefore, the Company has concluded that if it were to sell upgrade rights +on a standalone basis, including those rights associated with iPhone, iPad, iPod touch and Apple TV, the selling price would be relatively low. Key factors considered by the Company in developing the ESPs for these upgrade rights include prices +charged by the Company for similar offerings, the Company’s historical pricing practices, the nature of the upgrade rights (e.g., unspecified and when-and-if-available), and the relative ESP of the upgrade rights as compared to the total +selling price of the product. The Company may also consider, when appropriate, the impact of other products and services, including advertising services, on selling price assumptions when developing and reviewing its ESPs for software upgrade rights +and related deliverables. The Company may also consider additional factors as appropriate, including the pricing of competitive alternatives if they exist, and product-specific business objectives. Beginning in the third quarter of 2010 in conjunction with the announcement of iOS 4, the Company’s ESPs for the embedded software +upgrade rights included with iPhone, iPad and iPod touch reflect the positive financial impact expected by the Company as a result of its introduction of a mobile advertising platform for these devices and the expectation of customers regarding +software that includes or supports an advertising component. iOS 4 supports iAd, the Company’s new mobile advertising platform, which enables applications on iPhone, iPad and iPod touch to embed media-rich advertisements. For all periods presented, the Company’s ESP for the embedded software upgrade right included with each Apple TV sold is $10. The +Company’s ESP for the software upgrade right included with each iPhone sold through the 52 Table of Contents Company’s second quarter of 2010 was $25. Beginning in April 2010 in conjunction with the Company’s announcement of iOS 4 for iPhone, the Company lowered its ESP for the software +upgrade right included with each iPhone to $10. Beginning with initial sales of iPad in April 2010, the Company has also +indicated it may from time-to-time provide future unspecified software upgrades and features free of charge to iPad customers. The Company’s ESP for the embedded software upgrade right included with the sale of each iPad is $10. In June 2010, +the Company announced that certain previously sold iPod touch models would receive an upgrade to iOS 4 free of charge and indicated iPod touch devices running on iOS 4 may from time-to-time receive future unspecified software upgrades and features +free of charge. The Company’s ESP for the embedded software upgrade right included with each iPod touch sold beginning in June 2010 is $5. The Company accounts for multiple element arrangements that consist only of software or software-related products, including the sale of upgrades to previously sold software, in accordance with industry +specific accounting guidance for software and software-related transactions. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair value +is determined by VSOE. If the Company cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements, the Company defers revenue until all elements are delivered and services have been +performed, or until fair value can objectively be determined for any remaining undelivered elements. When the fair value of a delivered element has not been established, but fair value exists for the undelivered elements, the Company uses the +residual method to recognize revenue. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is allocated to the delivered elements and is recognized as revenue. Except as described for iPhone, iPad, iPod touch and Apple TV, the Company generally does not offer unspecified upgrade rights to its +customers in connection with software sales or the sale of AppleCare extended warranty and support contracts. A limited number of the Company’s software products are available with maintenance agreements that grant customers rights to +unspecified future upgrades over the maintenance term on a when and if available basis. Revenue associated with such maintenance is recognized ratably over the maintenance term. Shipping Costs For all periods presented, amounts billed to customers +related to shipping and handling are classified as revenue, and the Company’s shipping and handling costs are included in cost of sales. Warranty Expense The +Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. The Company assesses the adequacy of its pre-existing warranty liabilities and adjusts the amounts as necessary +based on actual experience and changes in future estimates. Software Development Costs Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed +are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon +after technological feasibility has been established. Therefore, costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally most software development costs have been expensed as incurred. The Company did not capitalize any software development costs during 2010. In 2009 and 2008, the Company capitalized $71 +million and $11 million, respectively, of costs associated with the development of Mac OS X 53 Table of Contents Version 10.6 Snow Leopard (“Mac OS X Snow Leopard”), which was released during the fourth quarter of 2009. The capitalized costs are being amortized to cost of sales on a straight-line +basis over a three year estimated useful life of the underlying technology. Total amortization related to capitalized software +development costs was $48 million, $25 million and $27 million in 2010, 2009 and 2008, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $691 million, $501 million and $486 million for 2010, 2009 and 2008, +respectively. Stock-Based Compensation The Company accounts for stock-based payment transactions in which the Company receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are +based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. Stock-based compensation cost for restricted stock units (“RSUs”) is measured based on the closing fair +market value of the Company’s common stock on the date of grant. Stock-based compensation cost for stock options is estimated at the grant date based on each option’s fair-value as calculated by the Black-Scholes-Merton (“BSM”) +option-pricing model. The Company recognizes stock-based compensation cost as expense ratably on a straight-line basis over the requisite service period. The Company will recognize a benefit from stock-based compensation in equity if an incremental +tax benefit is realized by following the ordering provisions of the tax law. In addition, the Company accounts for the indirect effects of stock-based compensation on the research tax credit, the foreign tax credit and the domestic manufacturing +deduction through the income statement. Further information regarding stock-based compensation can be found in Note 7, “Shareholders’ Equity and Stock-Based Compensation” of this Form 10-K. Income Taxes The +provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax +bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax +assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be +sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% +likelihood of being realized upon settlement. See Note 6, “Income Taxes” of this Form 10-K for additional information. Earnings +Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the +weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding +during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. 54 Table of Contents Potentially dilutive securities include outstanding stock options, shares to be purchased under the employee stock purchase plan and unvested RSUs. The dilutive effect of potentially dilutive +securities is reflected in diluted earnings per common share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive +effect from potentially dilutive securities. The following table sets forth the computation of basic and diluted earnings per +common share for the three years ended September 25, 2010 (in thousands, except net income in millions and per share amounts): 2010 2009 2008 Numerator: Net income $ 14,013 $ 8,235 $ 6,119 Denominator: Weighted-average shares outstanding 909,461 893,016 881,592 Effect of dilutive securities 15,251 13,989 20,547 Weighted-average diluted shares 924,712 907,005 902,139 Basic earnings per common share $ 15.41 $ 9.22 $ 6.94 Diluted earnings per common share $ 15.15 $ 9.08 $ 6.78 Potentially dilutive +securities representing 1.6 million, 12.6 million and 10.3 million shares of common stock for 2010, 2009 and 2008, respectively, were excluded from the computation of diluted earnings per common share for these periods because their +effect would have been antidilutive. Financial Instruments Cash Equivalents and Marketable Securities All highly liquid investments +with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s debt and marketable equity securities have been classified and accounted for as available-for-sale. Management determines the +appropriate classification of its investments in debt securities at the time of purchase and reevaluates the available-for-sale designations as of each balance sheet date. The Company classifies its marketable debt securities as either short-term or +long-term based on each instrument’s underlying contractual maturity date. Marketable securities with maturities of less than 12 months are classified as short-term and marketable securities with maturities greater than 12 months are classified +as long-term. These securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. Derivatives that are not defined as hedges must be adjusted to fair value through +earnings. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated +as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income in shareholders’ equity and reclassified into earnings in the same period or +periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument is recognized in current earnings. To receive hedge accounting treatment, cash flow hedges must be highly +effective in offsetting changes to expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For +derivative instruments that hedge the exposure to changes in the fair value of an asset or a liability and that are designated as fair value hedges, the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the +hedged item attributable to 55 Table of Contents the hedged risk are recognized in earnings in the current period. The Company did not have a net gain or loss on these derivative instruments during 2010, 2009 and 2008. The net gain or loss on +the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the net investment in a foreign operation is reported in the same manner as a foreign currency translation +adjustment. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses +related to this component are recognized in current earnings. Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical +experience, the age of the accounts receivable balances, credit quality of the Company’s customers, current economic conditions, and other factors that may affect customers’ ability to pay. Inventories Inventories +are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The +Company’s inventories consist primarily of components and finished goods for all periods presented. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the +estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building, up to five years for equipment, and the shorter of lease terms or ten years for leasehold improvements. The Company +capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using the straight-line method over the estimated +useful lives of the assets, which range from three to five years. Depreciation and amortization expense on property and equipment was $815 million, $606 million and $387 million during 2010, 2009 and 2008, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment and certain identifiable intangibles, excluding goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in +circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, +plant and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value. The Company did not record any +significant impairments during 2010, 2009 and 2008. The Company does not amortize goodwill and intangible assets with +indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible +asset impairment tests on or about August 31 of each year. The Company did not recognize any goodwill or intangible asset impairment charges in 2010, 2009 and 2008. The Company established reporting units based on its current reporting +structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. The Company amortizes its intangible assets with definite lives over their estimated useful lives and reviews these assets for impairment. The Company is currently amortizing its acquired intangible +assets with definite lives over periods ranging from three to ten years. 56 Table of Contents Fair Value Measurements During 2009, the Company adopted the FASB’s new accounting standard on fair value measurements and disclosures for +all financial assets and liabilities. The new accounting principles define fair value, provide a framework for measuring fair value, and expand the disclosures required for fair value measurements. During the first quarter of 2010, the Company +adopted the new fair value accounting principles for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis, which did not have a +material effect on the Company’s financial condition or operating results. The Company applies fair value accounting for +all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from +selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, +the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent risk, +transfer restrictions and credit risk. In accordance with the fair value accounting requirements, companies may choose to measure eligible financial instruments and certain other items at fair value. The Company has not elected the fair value option +for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange +rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are credited or charged to foreign +currency translation included in accumulated other comprehensive income in shareholders’ equity. The Company’s subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates +in effect at the end of each period, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these remeasurements were insignificant and have been included in the Company’s results of +operations. Segment Information The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing +performance as the source of the Company’s reportable segments. Information about the Company’s products, major customers and geographic areas on a company-wide basis is also disclosed. Business Combinations In December 2007, the FASB issued a new accounting standard for business combinations, which established principles and requirements for +how an acquirer is to recognize and measure in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree in a business combination. This new accounting standard also +established principles regarding how goodwill acquired in a business combination or a gain from a bargain purchase should be recognized and measured, requiring the capitalization of in-process research and development at fair value and the expensing +of acquisition-related costs as incurred, as well as providing guidelines on the disclosure requirements. In April 2009, the FASB amended this new accounting standard to require that assets acquired and liabilities assumed in a business combination +that arise from contingencies be recognized at fair value, if the fair value can be determined during the measurement period. The Company adopted the new business combination accounting standard in the first quarter of 2010 and applied these +principles to any business combinations completed in or after the first quarter of 2010. The adoption of the new business combination accounting standard did not have a material effect on the Company’s financial condition or operating results. 57 Table of Contents Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following table summarizes the fair value of the Company’s cash and available-for-sale securities held in its marketable securities investment portfolio, recorded as cash and cash equivalents or +short-term or long-term marketable securities as of September 25, 2010 and September 26, 2009 (in millions): September 25, 2010 September 26, 2009 Cash $ 1,690 $ 1,139 Money market funds 2,753 1,608 U.S. Treasury securities 2,571 289 U.S. agency securities 1,916 273 Non-U.S. government securities 10 0 Certificates of deposit and time deposits 374 572 Commercial paper 1,889 1,381 Corporate securities 58 0 Municipal securities 0 1 Total cash equivalents 9,571 4,124 U.S. Treasury securities 2,130 2,843 U.S. agency securities 4,339 8,582 Non-U.S. government securities 865 219 Certificates of deposit and time deposits 850 1,142 Commercial paper 1,279 2,816 Corporate securities 4,522 2,466 Municipal securities 374 133 Total short-term marketable securities 14,359 18,201 U.S. Treasury securities 5,213 484 U.S. agency securities 2,472 2,252 Non-U.S. government securities 1,786 102 Certificates of deposit and time deposits 1,515 0 Corporate securities 12,862 7,320 Municipal securities 1,543 370 Total long-term marketable securities 25,391 10,528 Total cash, cash equivalents and marketable securities $ 51,011 $ 33,992 58 Table of Contents The following tables +summarize the Company’s available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category as of September 25, 2010 and September 26, 2009 (in +millions): September 25, 2010 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Money market funds $ 2,753 $ 0 $ 0 $ 2,753 U.S. Treasury securities 9,872 42 0 9,914 U.S. agency securities 8,717 10 0 8,727 Non-U.S. government securities 2,648 13 0 2,661 Certificates of deposit and time deposits 2,735 5 (1 ) 2,739 Commercial paper 3,168 0 0 3,168 Corporate securities 17,349 102 (9 ) 17,442 Municipal securities 1,899 19 (1 ) 1,917 Total cash equivalents and marketable securities $ 49,141 $ 191 $ (11 ) $ 49,321 September 26, 2009 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Money market funds $ 1,608 $ 0 $ 0 $ 1,608 U.S. Treasury securities 3,610 6 0 3,616 U.S. agency securities 11,085 22 0 11,107 Non-U.S. government securities 320 1 0 321 Certificates of deposit and time deposits 1,714 0 0 1,714 Commercial paper 4,197 0 0 4,197 Corporate securities 9,760 42 (16 ) 9,786 Municipal securities 502 2 0 504 Total cash equivalents and marketable securities $ 32,796 $ 73 $ (16 ) $ 32,853 The Company had net unrealized gains on its investment portfolio of $180 million and $57 million as of +September 25, 2010 and September 26, 2009, respectively. The net unrealized gains as of September 25, 2010 and September 26, 2009 related primarily to long-term marketable securities. The Company may sell certain of its +marketable securities prior to their stated maturities for strategic purposes, in anticipation of credit deterioration, or for duration management. The Company recognized no significant net realized gains or losses during 2010, 2009 and 2008 related +to such sales. The maturities of the Company’s long-term marketable securities generally range from one year to five years . 59 Table of Contents The following tables +show the gross unrealized losses and fair value for investments in an unrealized loss position as of September 25, 2010 and September 26, 2009, aggregated by investment category and the length of time that individual securities have been +in a continuous loss position (in millions): September 25, 2010 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Loss Certificates of deposit and time deposits $ 802 $ (1 ) $ 54 $ 0 $ 856 $ (1 ) Corporate securities 3,579 (7 ) 275 (2 ) 3,854 (9 ) Municipal securities 298 (1 ) 0 0 298 (1 ) Total $ 4,679 $ (9 ) $ 329 $ (2 ) $ 5,008 $ (11 ) September 26, 2009 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Loss Corporate securities $ 1,667 $ (3 ) $ 719 $ (13 ) $ 2,386 $ (16 ) The Company considers the declines in market value of its marketable securities investment portfolio to be +temporary in nature. The unrealized losses on the Company’s marketable securities were caused primarily by changes in market interest rates or widening credit spreads. The Company typically invests in highly-rated securities, and its policy +generally limits the amount of credit exposure to any one issuer. The Company’s investment policy requires investments to be investment grade, primarily rated single-A or better, with the objective of minimizing the potential risk of principal +loss. Fair values were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value +has been below cost basis, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the +investment’s amortized cost basis. During the years ended September 25, 2010 and September 26, 2009, the Company did not recognize any significant impairment charges. As of September 25, 2010, the Company does not consider any of +its investments to be other-than-temporarily impaired. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign currency exchange risk. The Company may enter into +foreign currency forward and option contracts to offset some of the foreign exchange risk of expected future cash flows on certain forecasted revenue and cost of sales, of net investments in certain foreign subsidiaries, and on certain existing +assets and liabilities. To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar, hedge a portion of forecasted foreign currency +revenue. The Company’s subsidiaries whose functional currency is not the U.S. dollar and who sell in local currencies, may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The +Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases for three to six months. To help protect the net investment in a foreign operation from adverse changes in foreign currency +exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. The Company may also enter into +foreign currency forward and option contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. However, the Company may +choose not to hedge certain foreign currency exchange exposures for a variety of reasons, including but not limited to immateriality, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no +assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange rates. 60 Table of Contents The Company’s +accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The Company records all derivatives on the Consolidated Balance Sheets at fair value. The effective portions of cash +flow hedges are recorded in other comprehensive income until the hedged item is recognized in earnings. The effective portions of net investment hedges are recorded in other comprehensive income as a part of the cumulative translation adjustment. +Derivatives that are not designated as hedging instruments and the ineffective portions of cash flow hedges and net investment hedges are adjusted to fair value through earnings in other income and expense. The Company had a net deferred loss associated with cash flow hedges of approximately $252 million and a net deferred gain of $1 million, +net of taxes, recorded in other comprehensive income as of September 25, 2010 and September 26, 2009, respectively. Other comprehensive income associated with cash flow hedges of foreign currency revenue is recognized as a component of net +sales in the same period as the related revenue is recognized, and other comprehensive income related to cash flow hedges of inventory purchases is recognized as a component of cost of sales in the same period as the related costs are recognized. +Substantially all of the Company’s hedged transactions as of September 25, 2010 are expected to occur within six months. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within +a subsequent two month time period. Deferred gains and losses in other comprehensive income associated with such derivative instruments are reclassified immediately into earnings through other income and expense. Any subsequent changes in fair value +of such derivative instruments also are reflected in current earnings unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses related to the loss of hedge designation on +discontinued cash flow hedges during 2010, 2009 and 2008. The Company had an unrealized net loss on net investment hedges of +$9 million and $2 million, net of taxes, included in the cumulative translation adjustment account of accumulated other comprehensive income (“AOCI”) as of September 25, 2010 and September 26, 2009, respectively. The ineffective +portions and amounts excluded from the effectiveness test of net investment hedges are recorded in current earnings in other income and expense. The Company recognized in earnings a net loss of $123 million and $133 million on foreign currency forward and option contracts not designated as hedging instruments during the year ended +September 25, 2010 and September 26, 2009, respectively. These amounts represent the net gain or loss on the derivative contracts and do not include changes in the related exposures, which generally offset a portion of the gain or loss on +the derivative contracts. The following table shows the notional principal and credit risk amounts of the Company’s +derivative instruments outstanding as of September 25, 2010 and September 26, 2009 (in millions): 2010 2009 Notional Principal Credit Risk Amounts Notional Principal Credit Risk Amounts Instruments qualifying as accounting hedges: Foreign exchange contracts $ 13,957 $ 62 $ 4,422 $ 31 Instruments other than accounting hedges: Foreign exchange contracts $ 10,727 $ 45 $ 3,416 $ 10 The notional +principal amounts for derivative instruments provide one measure of the transaction volume outstanding and does not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s +gross exposure to potential accounting loss on these transactions if all counterparties failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company’s gross +exposure on these transactions may be further mitigated by 61 Table of Contents collateral received from certain counterparties. The Company’s exposure to credit loss and market risk will vary over time as a function of currency exchange rates. Although the table above +reflects the notional principal and credit risk amounts of the Company’s foreign exchange instruments, it does not reflect the gains or losses associated with the exposures and transactions that the foreign exchange instruments are intended to +hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. The Company generally enters into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with +the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuate from +contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values. As of September 25, 2010, the Company has posted cash collateral related to the derivative instruments +under its collateral security arrangements of $445 million and recorded the offsetting balance as other current assets in the Consolidated Balance Sheet. The Company did not record any significant amounts of cash collateral related to the derivative +instruments under its master netting arrangements as of September 26, 2009. The Company did not have any derivative instruments with credit risk-related contingent features that would require it to post additional collateral as of +September 25, 2010 or September 26, 2009. The estimates of fair value are based on applicable and commonly used +pricing models and prevailing financial market information as of September 25, 2010. Refer to Note 3, “Fair Value Measurements” of this Form 10-K, for additional information on the fair value measurements for all financial assets and +liabilities, including derivative assets and derivative liabilities, that are measured at fair value in the consolidated financial statements on a recurring basis. The following tables show the Company’s derivative instruments measured at gross +fair value as reflected in the Consolidated Balance Sheets as of September 25, 2010 and September 26, 2009 (in millions): September 25, 2010 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as  +Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 62 $ 45 $ 107 Derivative liabilities (b): Foreign exchange contracts $ 488 $ 118 $ 606 September 26, 2009 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as  +Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 27 $ 10 $ 37 Derivative liabilities (b): Foreign exchange contracts $ 24 $ 1 $ 25 (a) All derivative assets are recorded as other current assets in the Consolidated Balance Sheets. (b) All derivative liabilities are recorded as accrued expenses in the Consolidated Balance Sheets. 62 Table of Contents The following tables +show the pre-tax effect of the Company’s derivative instruments designated as cash flow and net investment hedges in the Consolidated Statements of Operations for the years ended September 25, 2010 and September 26, 2009 (in +millions): Gains/(Losses) Recognized in OCI - Effective Portion (c) Gains/(Losses) Reclassified  +from AOCI into Income - Effective Portion (c) Gains/(Losses) Recognized – +Ineffective Portion and Amount Excluded from Effectiveness Testing September 25, 2010 September 26, 2009 September 25, 2010 (a) September 26, 2009 (b) Location September 25, 2010 September 26, 2009 Cash flow hedges: Foreign exchange contracts $ (267 ) $ 338 $ 115 $ 370 Other income and expense $ (175 ) $ (97 ) Net investment hedges: Foreign exchange contracts (41 ) (44 ) 0 0 Other income and expense 1 3 Total $ (308 ) $ 294 $ 115 $ 370 $ (174 ) $ (94 ) (a) Includes gains/(losses) reclassified from AOCI into net income for the effective portion of cash flow hedges, of which $158 million and ($43) +million were recognized within net sales and cost of sales, respectively, within the Statement of Operations for the year ended September 25, 2010. There were no amounts reclassified from AOCI into net income for the effective portion of net +investment hedges for the year ended September 25, 2010. (b) Includes gains/(losses) reclassified from AOCI into net income for the effective portion of cash flow hedges, of which $302 million and $68 million +were recognized within net sales and cost of sales, respectively, within the Statement of Operations for the year ended September 26, 2009. There were no amounts reclassified from AOCI into net income for the effective portion of net investment +hedges for the year ended September 26, 2009. (c) Refer to Note 7, “Shareholders’ Equity and Stock-Based Compensation” of this Form 10-K, which summarizes the activity in accumulated +other comprehensive income related to derivatives. Accounts Receivable Trade Receivables The +Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers and directly to certain education, consumer and enterprise customers. The Company generally does not require collateral +from its customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers in +Latin America, Europe, Asia, and Australia, or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, +the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. However, considerable trade receivables not covered by collateral, third-party financing arrangements, or credit insurance are +outstanding with the Company’s third-party cellular network carriers, wholesalers, retailers and value-added resellers. Trade receivables from two of the Company’s customers accounted for 15% and 12% of trade receivables as of +September 25, 2010 and one of the Company’s customers accounted for 16% of trade receivables as of September 26, 2009. The Company’s cellular network carriers accounted for 64% and 51% of trade receivables as of +September 25, 2010 and as of September 26, 2009, respectively. The additions and write-offs to the Company’s allowance for doubtful accounts during 2010, 2009 and 2008 were not significant. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these manufacturing vendors who manufacture sub-assemblies or assemble final +products for the Company. The Company purchases these components directly from suppliers. Vendor non-trade receivables from two of the Company’s vendors accounted for 57% and 24%, respectively, of non-trade receivables as of September 25, +2010 and two of the Company’s vendors accounted for 40% and 36%, respectively, of non-trade receivables as of September 26, 2009. The Company does not reflect the sale of these components in net sales and does not recognize any profits on +these sales until the related products are sold by the Company, at which time any profit is recognized as a reduction of cost of sales. 63 Table of Contents Note 3 – Fair Value +Measurements The Company defines fair value as the price that would be received from selling an asset or paid to transfer +a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, the Company considers the principal +or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent risk, transfer restrictions and credit risk. The Company applies the following fair value hierarchy, which prioritizes the inputs used to measure fair value into three +levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, +or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity +securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of all other financial instruments, all of which have counterparties with high credit ratings, +were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by observable market data. Assets/Liabilities Measured at Fair Value on a Recurring Basis The +following table presents the Company’s assets and liabilities measured at fair value on a recurring basis as of September 25, 2010 and September 26, 2009 (in millions): September 25, 2010 Quoted Prices in Active Markets for Identical Instruments (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total (a) Assets: Money market funds $ 2,753 $ 0 $ 0 $ 2,753 U.S. Treasury securities 0 9,914 0 9,914 U.S. agency securities 0 8,727 0 8,727 Non-U.S. government securities 0 2,661 0 2,661 Certificates of deposit and time deposits 0 2,739 0 2,739 Commercial paper 0 3,168 0 3,168 Corporate securities 0 17,442 0 17,442 Municipal securities 0 1,917 0 1,917 Marketable equity securities 132 0 0 132 Foreign exchange contracts 0 107 0 107 Total assets measured at fair value $ 2,885 $ 46,675 $ 0 $ 49,560 Liabilities: Foreign exchange contracts $ 0 $ 606 $ 0 $ 606 64 Table of Contents September 26, 2009 Quoted Prices in Active Markets for Identical Instruments (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Total (a) Assets: Money market funds $ 1,608 $ 0 $ 0 $ 1,608 U.S. Treasury securities 0 3,616 0 3,616 U.S. agency securities 0 11,107 0 11,107 Non-U.S. government securities 0 321 0 321 Certificates of deposit and time deposits 0 1,714 0 1,714 Commercial paper 0 4,197 0 4,197 Corporate securities 0 9,786 0 9,786 Municipal securities 0 504 0 504 Marketable equity securities 61 0 0 61 Foreign exchange contracts 0 37 0 37 Total assets measured at fair value $ 1,669 $ 31,282 $ 0 $ 32,951 Liabilities: Foreign exchange contracts $ 0 $ 25 $ 0 $ 25 (a) The total fair value amounts for assets and liabilities also represent the related carrying amounts. The following table summarizes the Company’s assets and liabilities measured at fair value on a recurring basis as presented in the +Company’s Consolidated Balance Sheet as of September 25, 2010 and September 26, 2009 (in millions): September 25, 2010 Quoted Prices in Active Markets for Identical Instruments (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level + 3) Total (a) Assets: Cash equivalents $ 2,753 $ 6,818 $ 0 $ 9,571 Short-term marketable securities 0 14,359 0 14,359 Long-term marketable securities 0 25,391 0 25,391 Other current assets 0 107 0 107 Other assets 132 0 0 132 Total assets measured at fair value $ 2,885 $ 46,675 $ 0 $ 49,560 Liabilities: Other current liabilities $ 0 $ 606 $ 0 $ 606 65 Table of Contents September 26, 2009 Quoted Prices in Active Markets for Identical Instruments (Level 1) Significant Other Observable Inputs (Level 2) Significant Unobservable Inputs (Level + 3) Total (a) Assets: Cash equivalents $ 1,608 $ 2,516 $ 0 $ 4,124 Short-term marketable securities 0 18,201 0 18,201 Long-term marketable securities 0 10,528 0 10,528 Other current assets 0 37 0 37 Other assets 61 0 0 61 Total assets measured at fair value $ 1,669 $ 31,282 $ 0 $ 32,951 Liabilities: Other current liabilities $ 0 $ 25 $ 0 $ 25 (a) The total fair value amounts for assets and liabilities also represent the related carrying amounts. Note 4 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 25, 2010 and September 26, 2009 (in millions): Property, Plant and Equipment 2010 2009 Land and buildings $ 1,471 $ 955 Machinery, equipment and internal-use software 3,589 1,932 Office furniture and equipment 144 115 Leasehold improvements 2,030 1,665 Gross property, plant and equipment 7,234 4,667 Accumulated depreciation and amortization (2,466 ) (1,713 ) Net property, plant and equipment $ 4,768 $ 2,954 Accrued Expenses 2010 2009 Accrued warranty and related costs $ 761 $ 577 Deferred margin on component sales 663 225 Accrued compensation and employee benefits 436 357 Accrued marketing and distribution 396 359 Income taxes payable 210 430 Other current liabilities 3,257 1,904 Total accrued expenses $ 5,723 $ 3,852 Non-Current Liabilities 2010 2009 Deferred tax liabilities $ 4,300 $ 2,216 Other non-current liabilities 1,231 1,286 Total other non-current liabilities $ 5,531 $ 3,502 66 Table of Contents Note 5 – Goodwill and Other +Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods +ranging from three to ten years. The following table summarizes the components of gross and net intangible asset balances as of September 25, 2010 and September 26, 2009 (in millions): 2010 2009 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired intangible assets $ 487 $ (245 ) $ 242 $ 323 $ (176 ) $ 147 Indefinite lived and unamortizable trademarks 100 0 100 100 0 100 Total acquired intangible assets $ 587 $ (245 ) $ 342 $ 423 $ (176 ) $ 247 During 2010, the Company completed various business acquisitions for an aggregate cash consideration, net of +cash acquired, of $638 million, of which $535 million was allocated to goodwill and $107 million to acquired intangible assets. The Company’s gross carrying amount of goodwill was $741 million and $206 million as of September 25, 2010 and +September 26, 2009, respectively. The Company did not have any goodwill impairment during 2010, 2009 or 2008. The Company’s goodwill is allocated primarily to the America’s reportable operating segment. Amortization expense related to +acquired intangible assets was $69 million, $53 million and $46 million in 2010, 2009 and 2008, respectively. As of September 25, 2010 and September 26, 2009, the weighted-average amortization period for acquired intangible assets was 5.5 +years and 7.2 years, respectively. Expected annual amortization expense related to acquired intangible assets as of +September 25, 2010, is as follows (in millions): Years 2011 $ 83 2012 74 2013 39 2014 18 2015 17 Thereafter 11 Total $ 242 67 Table of Contents Note 6 – Income Taxes The provision for income taxes for the three years ended September 25, 2010, consisted of the following (in +millions): 2010 2009 2008 Federal: Current $ 2,150 $ 1,922 $ 1,796 Deferred 1,676 1,077 498 3,826 2,999 2,294 State: Current 655 524 359 Deferred (115 ) (2 ) (25 ) 540 522 334 Foreign: Current 282 345 275 Deferred (121 ) (35 ) (75 ) 161 310 200 Provision for income taxes $ 4,527 $ 3,831 $ 2,828 The foreign provision for income taxes is based on foreign pretax earnings of $13.0 billion, $6.6 billion +and $4.6 billion in 2010, 2009 and 2008, respectively. The Company’s consolidated financial statements provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the Company’s +foreign subsidiaries that are intended to be indefinitely reinvested in operations outside the U.S. As of September 25, 2010, U.S. income taxes have not been provided on a cumulative total of $12.3 billion of such earnings. The amount of +unrecognized deferred tax liability related to these temporary differences is estimated to be approximately $4.0 billion. As +of September 25, 2010 and September 26, 2009, $30.8 billion and $17.4 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. +dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of +existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. 68 Table of Contents As of +September 25, 2010 and September 26, 2009, the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2010 2009 Deferred tax assets: Accrued liabilities and other reserves $ 1,300 $ 1,030 Basis of capital assets and investments 179 180 Accounts receivable and inventory reserves 68 172 Stock-based compensation 308 87 Other 558 383 Total deferred tax assets 2,413 1,852 Less valuation allowance 0 0 Deferred tax assets, net of valuation allowance 2,413 1,852 Deferred tax liabilities - Unremitted earnings of foreign subsidiaries 4,979 2,774 Net deferred tax liabilities $ (2,566 ) $ (922 ) A reconciliation of the provision for income taxes, with the amount computed by applying the statutory +federal income tax rate (35% in 2010, 2009 and 2008) to income before provision for income taxes for the three years ended September 25, 2010, is as follows (in millions): 2010 2009 2008 Computed expected tax $ 6,489 $ 4,223 $ 3,131 State taxes, net of federal effect 351 339 217 Indefinitely invested earnings of foreign subsidiaries (2,125 ) (647 ) (500 ) Research and development credit, net (23 ) (84 ) (21 ) Other (165 ) 0 1 Provision for income taxes $ 4,527 $ 3,831 $ 2,828 Effective tax rate 24% 32% 32% The Company’s +income taxes payable have been reduced by the tax benefits from employee stock plan awards. For stock options, the Company receives an income tax benefit calculated as the difference between the fair market value of the stock issued at the time of +the exercise and the option price, tax effected. For RSUs, the Company receives an income tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. The Company had net excess tax +benefits from employee stock plan awards of $742 million, $246 million and $770 million in 2010, 2009 and 2008, respectively, which were reflected as increases to common stock. Uncertain Tax Positions Tax positions are evaluated in a two-step process. +The Company first determines whether it is more likely than not that a tax position will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to +recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax +benefits that are not expected to result in payment or receipt of cash within one year as non-current liabilities in the Consolidated Balance Sheets. As of September 25, 2010, the total amount of gross unrecognized tax benefits was $943 million, of which $404 million, if recognized, would affect the Company’s effective tax rate. As of +September 26, 2009, the total amount of gross unrecognized tax benefits was $971 million, of which $307 million, if recognized, would affect the Company’s effective tax rate. 69 Table of Contents The aggregate changes +in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for the three years ended September 25, 2010, is as follows (in millions): 2010 2009 2008 Beginning Balance $ 971 506 $ 475 Increases related to tax positions taken during a prior year 61 341 27 Decreases related to tax positions taken during a prior year (224 ) (24 ) (70 ) Increases related to tax positions taken during the current year 240 151 85 Decreases related to settlements with taxing authorities (102 ) 0 0 Decreases related to expiration of statute of limitations (3 ) (3 ) (11 ) Ending Balance $ 943 $ 971 $ 506 The Company includes interest and penalties related to unrecognized tax benefits within the provision for +income taxes. As of September 25, 2010 and September 26, 2009, the total amount of gross interest and penalties accrued was $247 million and $291 million, respectively, which is classified as non-current liabilities in the Consolidated +Balance Sheets. In 2010 and 2009, the Company recognized an interest benefit of $43 million and interest expense of $64 million, respectively, in connection with tax matters. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. For U.S. federal income tax purposes, all years prior to 2004 +are closed. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s federal income tax returns for the years 2004 through 2006 and proposed certain adjustments. The Company has contested certain of +these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2009. During the third quarter of 2010, the Company reached a tax settlement with the IRS for the years 2002 through 2003. In connection with the +settlement, the Company reduced its gross unrecognized tax benefits by $100 million and recognized a $52 million tax benefit in the third quarter of 2010. In addition, the Company is also subject to audits by state, local and foreign tax +authorities. In major states and major foreign jurisdictions, the years subsequent to 1988 and 2001, respectively, generally remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the +outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for +income tax in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company does not believe it is reasonably possible that its unrecognized tax benefits would materially change in the next +12 months. Note 7 – Shareholders’ Equity and Stock-Based Compensation Preferred Stock The +Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, +preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income +refers to revenue, expenses, gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists 70 Table of Contents of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities categorized as +available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. The following table summarizes the components of AOCI, net of taxes, as of the three years ended September 25, 2010 (in millions): 2010 2009 2008 Net unrealized gains/losses on marketable securities $ 171 $ 48 $ (70 ) Net unrecognized gains/losses on derivative instruments (252 ) 1 19 Cumulative foreign currency translation 35 28 42 Accumulated other comprehensive income/(loss) $ (46 ) $ 77 $ (9 ) The change in fair value of available-for-sale securities included in other comprehensive income was $123 +million, $118 million and $(63) million, net of taxes in 2010, 2009 and 2008, respectively. The tax effect related to the change in unrealized gains/losses on available-for-sale securities was $(72) million, $(78) million and $42 million for 2010, +2009 and 2008, respectively. The following table summarizes activity in other comprehensive income related to derivatives, +net of taxes, held by the Company during the three years ended September 25, 2010 (in millions): 2010 2009 2008 Changes in fair value of derivatives $ (180 ) $ 204 $ 7 Adjustment for net gains/losses realized and included in net income (73 ) (222 ) 12 Change in unrecognized gains/losses on derivative instruments $ (253 ) $ (18 ) $ 19 The tax effect related to the changes in fair value of derivatives was $97 million, $(135) million and $(5) +million for 2010, 2009 and 2008, respectively. The tax effect related to derivative gains/losses reclassified from other comprehensive income to net income was $43 million, $149 million and $(9) million for 2010, 2009 and 2008, respectively. Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the “2003 Plan”) is a shareholder approved plan that provides for broad-based equity grants to +employees, including executive officers. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights and performance-based awards. Options granted under the 2003 +Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual, semi-annual or quarterly vesting. In general, RSUs granted under the 2003 +Plan vest over two to four years, are subject to the employees’ continued employment and are paid upon vesting in shares of the Company’s common stock on a one-for-one basis. At the Company’s 2010 annual meeting of shareholders, the +2003 Plan was amended to (i) increase the number of shares of the Company’s common stock that may be delivered pursuant to awards granted under the 2003 Plan by an additional 36,000,000 shares and (ii) extend the Company’s +authority to grant awards under the 2003 Plan intended to qualify as “performance-based awards” within the meaning of Section 162(m) of the U.S. Internal Revenue Code through the 2015 annual meeting of shareholders. As of +September 25, 2010, approximately 62.5 million shares were reserved for future issuance under the 2003 Plan. 71 Table of Contents 1997 Employee Stock Option Plan In August 1997, the Company’s Board of Directors approved the 1997 Employee Stock Option Plan (the “1997 +Plan”), a non-shareholder approved plan for grants of stock options to employees who are not officers of the Company. Options granted under the 1997 Plan generally expire seven to ten years after the grant date. All stock options granted under +the 1997 Plan are fully vested. In October 2003, the Company terminated the 1997 Plan, and no new options can be granted from this plan. 1997 Director Stock Plan In August 1997, the Company’s Board of Directors (the “Board”) adopted a Director Stock Option Plan, which was +subsequently renamed the 1997 Director Stock Plan (the “Director Plan”) and has been approved by shareholders. As amended, the Director Plan (i) permits the Company to grant awards of RSUs or stock options to the Company’s +non-employee directors, (ii) beginning February 25, 2010, provides for automatic initial grants of RSUs upon a non-employee director joining the Board and automatic annual grants of RSUs at each annual meeting of shareholders, and +(iii) permits the Board to prospectively change the relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these +grants without shareholder approval. Each share issued with respect to RSUs granted under the plan reduces the number of shares available for grant under the plan by two shares. The Director Plan expires November 9, 2019. As of September 25, +2010, approximately 199,000 shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the fourth quarter of 2010, executive officers Timothy D. Cook, Peter Oppenheimer, D. Bruce Sewell, Philip W. Schiller and Bertrand +Serlet had trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). A trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for +determining the amounts, prices and dates) of future purchases or sales of the Company’s stock including the exercise and sale of employee stock options and shares acquired pursuant to the Company’s employee stock purchase plan and upon +vesting of RSUs. Employee Stock Purchase Plan The Company has a shareholder approved employee stock purchase plan (the “Purchase Plan”), under which substantially all employees may purchase the Company’s common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning and end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10% of the employee’s +compensation and employee’s may not purchase more than $25,000 of stock for any calendar year. Additionally, no more than 1,000,000 shares may be purchased in the aggregate in any one offering period. As of September 25, 2010, +approximately 3.8 million shares were reserved for future issuance under the Purchase Plan. Employee Savings Plan The Company has an employee savings plan (the “Savings Plan”) qualifying as a deferred salary arrangement under +Section 401(k) of the Internal Revenue Code. Under the Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($16,500 for calendar year 2010). The Company matches 50% +to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. The Company’s matching contributions to the Savings Plan were $72 million, $59 million and $50 million +in 2010, 2009 and 2008, respectively. 72 Table of Contents Restricted Stock Units A summary of the Company’s RSU activity and related information for the three years ended September 25, 2010, is +as follows (in thousands, except per share amounts): Number of Shares Weighted- Average Grant Date  +Fair Value Aggregate Intrinsic Value Balance at September 29, 2007 4,675 $ 52.98 Restricted stock units granted 4,917 $ 162.61 Restricted stock units vested (2,195 ) $ 25.63 Restricted stock units cancelled (357 ) $ 119.12 Balance at September 27, 2008 7,040 $ 134.91 Restricted stock units granted 7,786 $ 111.80 Restricted stock units vested (1,935 ) $ 124.87 Restricted stock units cancelled (628 ) $ 121.28 Balance at September 26, 2009 12,263 $ 122.52 Restricted stock units granted 6,178 $ 214.37 Restricted stock units vested (4,685 ) $ 119.85 Restricted stock units cancelled (722 ) $ 147.56 Balance at September 25, 2010 13,034 $ 165.63 $ 3,810,287 The fair value as of the vesting date of RSUs was $1 billion, $221 million and $320 million for +2010, 2009 and 2008, respectively. Upon vesting, the RSUs are generally net share-settled to cover the required withholding tax and the remaining amount is converted into an equivalent number of shares of common stock. The majority of RSUs that +vested in 2010, 2009 and 2008, were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the +appropriate taxing authorities. The total shares withheld were approximately 1.8 million, 707,000 and 857,000 for 2010, 2009 and 2008, respectively, and were based on the value of the RSUs on their vesting date as determined by the +Company’s closing stock price. Total payments for the employees’ tax obligations to the taxing authorities were $406 million, $82 million and $124 million in 2010, 2009 and 2008, respectively, and are reflected as a financing activity +within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the number of shares that would have otherwise been issued as a result of the vesting +and did not represent an expense to the Company. 73 Table of Contents Stock Option Activity A summary of the Company’s stock option and RSU activity and related information for the three years ended +September 25, 2010, is as follows (in thousands, except per share amounts and contractual term in years): Outstanding Options Shares Available for Grant Number of Shares Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term Aggregate Intrinsic Value Balance at September 29, 2007 67,827 49,751 $ 43.91 Restricted stock units granted (9,834 ) 0 $ 0 Options granted (9,359 ) 9,359 $ 171.36 Options cancelled 1,236 (1,236 ) $ 98.40 Restricted stock units cancelled 714 0 $ 0 Options exercised 0 (13,728 ) $ 27.88 Plan shares expired (12 ) 0 $ 0 Balance at September 27, 2008 50,572 44,146 $ 74.39 Restricted stock units granted (15,572 ) 0 $ 0 Options granted (234 ) 234 $ 106.84 Options cancelled 1,241 (1,241 ) $ 122.98 Restricted stock units cancelled 1,256 0 $ 0 Options exercised 0 (8,764 ) $ 41.78 Plan shares expired (2 ) 0 $ 0 Balance at September 26, 2009 37,261 34,375 $ 81.17 Additional shares authorized 36,000 0 $ 0 Restricted stock units granted (12,356 ) 0 $ 0 Options granted (34 ) 34 $ 202.00 Options assumed 0 98 $ 11.99 Options cancelled 430 (430 ) $ 136.27 Restricted stock units cancelled 1,444 0 $ 0 Options exercised 0 (12,352 ) $ 62.69 Plan shares expired (8 ) 0 $ 0 Balance at September 25, 2010 62,737 21,725 $ 90.46 2.85 $ 4,385,291 Exercisable at September 25, 2010 17,791 $ 77.74 2.57 $ 3,817,663 Expected to vest after September 25, 2010 3,880 $ 148.03 4.12 $ 559,882 Aggregate intrinsic +value represents the value of the Company’s closing stock price on the last trading day of the fiscal period in excess of the weighted-average exercise price multiplied by the number of options outstanding or exercisable. The aggregate +intrinsic value excludes the effect of stock options that have a zero or negative intrinsic value. Total intrinsic value of options at time of exercise was $2.0 billion, $827 million and $2.0 billion for 2010, 2009 and 2008, respectively. RSUs granted are deducted from the shares available for grant under the Company’s stock option plans utilizing a factor +of two times the number of RSUs granted. Similarly, RSUs cancelled are added back to the shares available for grant under the Company’s stock option plans utilizing a factor of two times the number of RSUs cancelled. Outstanding RSU balances +are not included in the outstanding options balances in the stock option activity table. 74 Table of Contents Stock-Based Compensation Stock-based compensation cost for RSUs is measured based on the closing fair market value of the Company’s common +stock on the date of grant. Stock-based compensation cost for stock options and employee stock purchase plan rights (“stock purchase rights”) is estimated at the grant date and offering date, respectively, based on the fair-value as +calculated by the BSM option-pricing model. The BSM option-pricing model incorporates various assumptions including expected volatility, expected life and interest rates. The expected volatility is based on the historical volatility of the +Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options and other relevant factors including implied volatility in market traded options on the Company’s common +stock. The Company bases its expected life assumption on its historical experience and on the terms and conditions of the stock awards it grants to employees. The Company recognizes stock-based compensation cost as expense ratably on a straight-line +basis over the requisite service period. The weighted-average assumptions used for stock options granted do not apply to +employee stock options assumed in conjunction with business acquisitions during the year ended September 25, 2010. The weighted-average fair value of stock options assumed during the year ended September 25, 2010 was $216.82. There were no +stock options assumed during 2009 and 2008. The weighted-average assumptions used for the three years ended September 25, 2010, and the resulting estimates of weighted-average fair value per share of options granted and of stock purchase rights +during those periods are as follows: 2010 2009 2008 Expected life of stock options 10 years 4.54 years 3.41 years Expected life of stock purchase rights 6 months 6 months 6 months Interest rate - stock options 3.71% 2.04% 3.40% Interest rate - stock purchase rights 0.25% 0.58% 3.48% Volatility - stock options 36.30% 50.98% 45.64% Volatility - stock purchase rights 33.28% 52.16% 38.51% Dividend yields 0 0 0 Weighted-average fair value of stock options granted during the year $ 108.58 $ 46.71 $ 62.73 Weighted-average fair value of stock purchase plan rights during the year $ 45.03 $ 30.62 $ 42.27 The following table +provides a summary of the stock-based compensation expense included in the Consolidated Statements of Operations for the three years ended September 25, 2010 (in millions): 2010 2009 2008 Cost of sales $ 151 $ 114 $ 80 Research and development 323 258 185 Selling, general and administrative 405 338 251 Total stock-based compensation expense $ 879 $ 710 $ 516 Stock-based compensation expense capitalized as software development costs was not significant as of +September 25, 2010 or September 26, 2009. The income tax benefit related to stock-based compensation expense was $314 million, $266 million and $169 million for 2010, 2009 and 2008, respectively. The total unrecognized compensation cost +related to stock options and RSUs expected to vest was $1.9 billion as of September 25, 2010, which is expected to be recognized over a weighted-average period of 2.73 years. Note 8 – Commitments and Contingencies Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company +does not currently utilize any other off-balance sheet financing arrangements. The 75 Table of Contents major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for terms +ranging from five to 20 years, the majority of which are for ten years, and often contain multi-year renewal options. As of September 25, 2010, the Company’s total future minimum lease payments under noncancelable operating leases were +$2.1 billion, of which $1.7 billion related to leases for retail space. Rent expense under all operating leases, including +both cancelable and noncancelable leases, was $271 million, $231 million and $207 million in 2010, 2009 and 2008, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of +September 25, 2010, are as follows (in millions): Years 2011 $ 266 2012 267 2013 260 2014 244 2015 226 Thereafter 826 Total minimum lease payments $ 2,089 Accrued Warranty and Indemnifications The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The +Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time +related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, +historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its pre-existing warranty liabilities and adjusts the amounts as +necessary based on actual experience and changes in future estimates. The Company periodically provides updates to its +applications and system software to maintain the software’s compliance with published specifications. The estimated cost to develop such updates is accounted for as warranty costs that are recognized at the time related software revenue is +recognized. Factors considered in determining appropriate accruals related to such updates include the number of units delivered, the number of updates expected to occur, and the historical cost and estimated future cost of the resources necessary +to develop these updates. The following table reconciles changes in the Company’s accrued warranty and related costs for +the three years ended September 25, 2010 (in millions): 2010 2009 2008 Beginning accrued warranty and related costs $ 577 $ 671 $ 363 Cost of warranty claims (713 ) (534 ) (493 ) Accruals for product warranty 897 440 801 Ending accrued warranty and related costs $ 761 $ 577 $ 671 The Company generally does not indemnify end-users of its operating system and application software against +legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by 76 Table of Contents the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an +indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified third-party and, in the opinion of management, does not have a +potential liability related to unresolved infringement claims subject to indemnification that would materially adversely affect its financial condition or operating results. Therefore, the Company did not record a liability for infringement costs as +of either September 25, 2010 or September 26, 2009. The Company has entered into indemnification agreements with +its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to +advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited +history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made +under these agreements historically have not materially adversely affected the Company’s financial condition or operating results. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, certain key components +including but not limited to microprocessors, enclosures, certain liquid crystal displays (“LCDs”), certain optical drives and application-specific integrated circuits (“ASICs”) are currently obtained by the Company from single +or limited sources, which subjects the Company to significant supply and pricing risks. Many of these and other key components that are available from multiple sources including but not limited to NAND flash memory, dynamic random access memory +(“DRAM”) and certain LCDs, are subject at times to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into certain agreements for the supply of key components including but not +limited to microprocessors, NAND flash memory, DRAM and LCDs at favorable pricing, but there is no guarantee that the Company will be able to extend or renew these agreements on similar favorable terms, or at all, upon expiration or otherwise obtain +favorable pricing in the future. Therefore, the Company remains subject to significant risks of supply shortages and/or price increases that can materially adversely affect its financial condition and operating results. The Company and other participants in the personal computer, and mobile communication and media device industries also compete for +various components with other industries that have experienced increased demand for their products. In addition, the Company uses some custom components that are not common to the rest of these industries, and new products introduced by the Company +often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the +Company’s supply of a key single-sourced component for a new or existing product were delayed or constrained, if such components were available only at significantly higher prices, or if a key manufacturing vendor delayed shipments of completed +products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be adversely affected depending on the time required to +obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided +to concentrate on the production of common components instead of components customized to meet the Company’s requirements. Substantially all of the Company’s Macs, iPhones, iPads, iPods, logic boards and other assembled products are now manufactured by +outsourcing partners, primarily in various parts of Asia. A significant concentration of this outsourced manufacturing is currently performed by only a few outsourcing partners of the Company, often in single locations. Certain of these outsourcing +partners are the sole-sourced supplier of components and manufacturing outsourcing for many of the Company’s key products including but not limited to final assembly 77 Table of Contents of substantially all of the Company’s Macs, iPhones, iPads and iPods. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s +operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover its requirements for periods ranging from 30 to 150 days. Long-Term Supply Agreements The Company has entered into prepaid long-term supply agreements to secure the supply of certain inventory components, which generally expire between 2011 and 2015. As of September 25, 2010, the +Company had a total of $956 million of inventory component prepayments outstanding, of which $157 million is classified as other current assets and $799 million is classified as other assets in the Consolidated Balance Sheets. In August 2010, the +Company entered into a long-term supply agreement under which it has committed to prepay $500 million in 2011. The Company had a total of $1.2 billion of inventory component prepayments outstanding as of September 26, 2009. These prepayments +will be applied to certain inventory component purchases made over the life of each respective agreement. Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and have not been fully +adjudicated, which are discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings.” In the opinion of management, the Company does not have a potential liability related to any current legal proceedings and +claims that would individually or in the aggregate materially adversely affect its financial condition or operating results. However, the results of legal proceedings cannot be predicted with certainty. If the Company failed to prevail in any of +these legal matters or if several of these legal matters were resolved against the Company in the same reporting period, the operating results of a particular reporting period could be materially adversely affected. On March 14, 2008, Mirror Worlds, LLC filed an action against the Company alleging that certain of its products infringed on +three patents covering technology used to display files. On October 1, 2010, a jury returned a verdict against the Company, and awarded damages of $208 million per patent for each of the three patents asserted. The Company is challenging +the verdict, believes it has valid defenses and has not recorded a loss contingency at this time. Production and marketing of +products in certain states and countries may subject the Company to environmental, product safety and other regulations including, in some instances, the requirement to provide customers the ability to return product at the end of its useful life, +and place responsibility for environmentally safe disposal or recycling with the Company. Such laws and regulations have been passed in several jurisdictions in which the Company operates, including various countries within Europe and Asia and +certain states and provinces within North America. Although the Company does not anticipate any material adverse effects in the future based on the nature of its operations and the thrust of such laws, there is no assurance that such existing laws +or future laws will not materially adversely affect the Company’s financial condition or operating results. Note 9 – Segment Information and Geographic Data The Company reports segment information based on the “management” +approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its operating and reporting +segments, which are generally based on the nature and location of its customers, to be the Americas, Europe, Japan, Asia-Pacific and Retail operations. The Americas, Europe, Japan and Asia-Pacific reportable segment results do not include results of +the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as the Middle East and 78 Table of Contents Africa. The Asia-Pacific segment includes Australia and Asia, but does not include Japan. The Retail segment operates Apple retail stores in 11 countries, including the U.S. Each reportable +operating segment provides similar hardware and software products and similar services. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for geographic +segments are generally based on the location of customers, while Retail segment net sales are based on sales from the Company’s retail stores. Operating income for each segment includes net sales to third parties, related cost of sales and +operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain +expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, such as manufacturing costs and variances not included in standard costs, research and development, corporate marketing +expenses, stock-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting +purposes. Segment assets exclude corporate assets, such as cash, short-term and long-term investments, manufacturing and corporate facilities, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets. Except for the +Retail segment, capital asset purchases for long-lived assets are not reported to management by segment. Cash payments for capital asset purchases by the Retail segment were $392 million, $369 million and $389 million for 2010, 2009 and 2008, +respectively. The Company has certain retail stores that have been designed and built to serve as high-profile venues to +promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail +stores. The Company allocates certain operating expenses associated with its high-profile stores to corporate marketing expense to reflect the estimated Company-wide benefit. The allocation of these operating costs to corporate expense is based on +the amount incurred for a high-profile store in excess of that incurred by a more typical Company retail location. The Company had opened a total of 15 high-profile stores as of September 25, 2010. Amounts allocated to corporate expense +resulting from the operations of high-profile stores were $75 million, $65 million and $53 million for 2010, 2009 and 2008, respectively. 79 Table of Contents Summary information by +operating segment for the three years ended September 25, 2010 is as follows (in millions): 2010 2009 2008 Americas: Net sales $ 24,498 $ 18,981 $ 16,552 Operating income $ 7,590 $ 6,658 $ 4,901 Depreciation, amortization and accretion $ 12 $ 12 $ 10 Segment assets (a) $ 2,809 $ 1,896 $ 1,693 Europe: Net sales $ 18,692 $ 11,810 $ 9,233 Operating income $ 7,524 $ 4,296 $ 3,022 Depreciation, amortization and accretion $ 9 $ 7 $ 6 Segment assets $ 1,926 $ 1,352 $ 1,069 Japan: Net sales $ 3,981 $ 2,279 $ 1,728 Operating income $ 1,846 $ 961 $ 549 Depreciation, amortization and accretion $ 3 $ 2 $ 2 Segment assets $ 991 $ 483 $ 272 Asia-Pacific: Net sales $ 8,256 $ 3,179 $ 2,686 Operating income $ 3,647 $ 1,100 $ 748 Depreciation, amortization and accretion $ 3 $ 3 $ 3 Segment assets $ 1,622 $ 529 $ 390 Retail: Net sales $ 9,798 $ 6,656 $ 7,292 Operating income $ 2,364 $ 1,677 $ 1,661 Depreciation, amortization and accretion (b) $ 163 $ 146 $ 108 Segment assets (b) $ 1,829 $ 1,344 $ 1,139 (a) The Americas asset figures do not include fixed assets held in the U.S. Such fixed assets are not allocated specifically to the Americas segment and +are included in the corporate and Retail assets figures below. (b) Retail segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. A reconciliation of the Company’s segment operating income and assets to the consolidated financial +statements for the three years ended September 25, 2010 is as follows (in millions): 2010 2009 2008 Segment operating income $ 22,971 $ 14,692 $ 10,881 Other corporate expenses, net (a) (3,707 ) (2,242 ) (2,038 ) Stock-based compensation expense (879 ) (710 ) (516 ) Total operating income $ 18,385 $ 11,740 $ 8,327 Segment assets $ 9,177 $ 5,604 $ 4,563 Corporate assets 66,006 41,897 31,608 Consolidated assets $ 75,183 $ 47,501 $ 36,171 Segment depreciation, amortization and accretion $ 190 $ 170 $ 129 Corporate depreciation, amortization and accretion 837 564 367 Consolidated depreciation, amortization and accretion $ 1,027 $ 734 $ 496 80 Table of Contents (a) Other corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard +costs, and other separately managed general and administrative expenses, including certain corporate expenses associated with support of the Retail segment. No single country outside of the U.S. accounted for more than 10% of net sales in 2010, 2009 or 2008. One of the Company’s customers accounted for 11% of net sales in 2009; there was no single +customer that accounted for more than 10% of net sales in 2010 or 2008. Net sales and long-lived assets related to the U.S. and international operations for the three years ended September 25, 2010, are as follows (in millions): 2010 2009 2008 Net sales: U.S. $ 28,633 $ 22,325 $ 20,893 International 36,592 20,580 16,598 Total net sales $ 65,225 $ 42,905 $ 37,491 Long-lived assets: U.S. $ 4,292 $ 2,698 $ 2,269 International 710 495 410 Total long-lived assets $ 5,002 $ 3,193 $ 2,679 Information regarding net sales by product for the three years ended September 25, 2010, is as follows +(in millions): 2010 2009 2008 Desktops (a) $ 6,201 $ 4,324 $ 5,622 Portables (b) 11,278 9,535 8,732 Total Mac net sales 17,479 13,859 14,354 iPod 8,274 8,091 9,153 Other music related products and services (c) 4,948 4,036 3,340 iPhone and related products and services (d) 25,179 13,033 6,742 iPad and related products and services (e) 4,958 0 0 Peripherals and other hardware (f) 1,814 1,475 1,694 Software, service and other net sales (g) 2,573 2,411 2,208 Total net sales $ 65,225 $ 42,905 $ 37,491 (a) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (b) Includes MacBook, MacBook Air and MacBook Pro product lines. (c) Includes iTunes Store sales, iPod services, and Apple-branded and third-party iPod accessories. (d) Includes revenue recognized from iPhone sales, carrier agreements, services, and Apple-branded and third-party iPhone accessories. (e) Includes revenue recognized from iPad sales, services and Apple-branded and third-party iPad accessories. (f) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. (g) Includes sales of Apple-branded operating system and application software, third-party software, Mac and Internet services. Note 10 – Related Party Transactions and Certain Other Transactions The Company entered into a Reimbursement Agreement with its CEO, Steve Jobs, for the reimbursement of expenses incurred by Mr. Jobs +in the operation of his private plane when used for Apple business. The Company recognized a total of approximately $248,000, $4,000 and $871,000 in expenses pursuant to the Reimbursement 81 Table of Contents Agreement during 2010, 2009 and 2008, respectively. All expenses recognized pursuant to the Reimbursement Agreement have been included in selling, general and administrative expenses in the +Consolidated Statements of Operations. Note 11 – Selected Quarterly Financial Information (Unaudited) The following tables set forth a summary of the Company’s quarterly financial information for each of the four +quarters ended September 25, 2010 and September 26, 2009 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2010 Net sales $ 20,343 $ 15,700 $ 13,499 $ 15,683 Gross margin $ 7,512 $ 6,136 $ 5,625 $ 6,411 Net income $ 4,308 $ 3,253 $ 3,074 $ 3,378 Earnings per common share: Basic $ 4.71 $ 3.57 $ 3.39 $ 3.74 Diluted $ 4.64 $ 3.51 $ 3.33 $ 3.67 2009 Net sales $ 12,207 $ 9,734 $ 9,084 $ 11,880 Gross margin $ 5,105 $ 3,983 $ 3,627 $ 4,507 Net income $ 2,532 $ 1,828 $ 1,620 $ 2,255 Earnings per common share: Basic $ 2.82 $ 2.05 $ 1.82 $ 2.54 Diluted $ 2.77 $ 2.01 $ 1.79 $ 2.50 Basic and diluted +earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. 82 Table of Contents Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 25, 2010 and September 26, 2009, and the related consolidated statements of operations, +shareholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). +Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and +disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits +provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all +material respects, the consolidated financial position of Apple Inc. at September 25, 2010 and September 26, 2009, and the consolidated results of its operations and its cash flows for the years then ended, in conformity with +U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), Apple Inc.’s internal control over financial reporting as of September 25, 2010, based on criteria established in Internal Control – Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission and our report dated October 27, 2010 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 27, 2010 83 Table of Contents Report of +Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 25, 2010, based on criteria +established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective +internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our +responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control +over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered +necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s +internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted +accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions +and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that +receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of +September 25, 2010, based on the COSO criteria. We also have audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), the 2010 consolidated financial statements of Apple Inc. and our report dated October 27, 2010 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 27, 2010 84 Table of Contents Report of KPMG LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders Apple +Inc.: We have audited the accompanying consolidated statements of operations, shareholders’ equity, and cash flows for +the year ended September 27, 2008. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards of the Public Company Accounting Oversight +Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit also includes examining, on a test basis, evidence +supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit +provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present +fairly, in all material respects, the results of operations and cash flows of Apple Inc. and subsidiaries for the year ended September 27, 2008 in conformity with U.S. generally accepted accounting principles. As discussed in note 1, the consolidated financial statements for the year ended September 27, 2008 have been restated to give +effect to the retrospective adoption of the Financial Accounting Standards Board’s amended accounting standards related to revenue recognition for arrangements with multiple deliverables and arrangements that include software elements. /s/ KPMG LLP Mountain View, California November 4, 2008, except as to note 1, which is as +of January 25, 2010 85 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of +Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the +Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act +were effective as of September 25, 2010 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as +appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the +Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and +that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets +that could have a material effect on the financial statements. Management, including the Company’s +Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, +not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. +Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of +controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as +defined in Rule 13a-15(f) under the Exchange Act. Management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of +September 25, 2010 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles. The Company’s independent +registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting. The report on the audit of internal control over financial reporting appears on page 84 of +this Form 10-K. 86 Table of Contents Changes in Internal Control Over +Financial Reporting There were no changes in the Company’s internal control over financial reporting during the +fourth quarter of fiscal 2010, which were identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to +materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information Not +applicable. 87 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the heading “Directors, Executive Officers and Corporate Governance” in the Company’s 2011 Proxy Statement to be filed with the U.S. +Securities and Exchange Commission (“SEC”) in connection with the solicitation of proxies for the Company’s 2011 Annual Meeting of Shareholders (“2011 Proxy Statement”) and is incorporated herein by reference. Such Proxy +Statement will be filed with the SEC within 120 days after the end of the fiscal year to which this report relates. Item 11. Executive Compensation The information required by this Item is set forth under the headings “Executive Compensation” and “Compensation Discussion +and Analysis” in the Company’s 2011 Proxy Statement and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Security Ownership of Certain Beneficial Owners and +Management” and “Equity Compensation Plan Information” in the Company’s 2011 Proxy Statement and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the heading “Review, Approval or Ratification of Transactions with Related Persons” in the Company’s 2011 Proxy Statement and is +incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the heading “Fees Paid to Auditors” in the Company’s 2011 Proxy Statement and is incorporated herein by reference. 88 Table of Contents PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the three years ended September 25, 2010 46 Consolidated Balance Sheets as of September 25, 2010 and September 26, 2009 47 Consolidated Statements of Shareholders’ Equity for the three years ended September 25, +2010 48 Consolidated Statements of Cash Flows for the three years ended September 25, 2010 49 Notes to Consolidated Financial Statements 50 Selected Quarterly Financial Information (Unaudited) 82 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 83 Report of KPMG LLP, Independent Registered Public Accounting Firm 85 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the consolidated financial statements and notes thereto. (b) Exhibits required by Item 601 of Regulation S-K The information required by this Item is set forth on the exhibit index that follows the signature page of this report. 89 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has +duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, this 27th day of October 2010. APPLE INC. By: /s/  Peter Oppenheimer Peter Oppenheimer Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person +whose signature appears below constitutes and appoints Steven P. Jobs and Peter Oppenheimer, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual +Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or +substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of +1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated: Name Title Date /s/  Steven P. Jobs STEVEN P. JOBS Chief Executive Officer and Director (Principal Executive Officer) October 27, 2010 /s/  Peter +Oppenheimer PETER OPPENHEIMER Senior Vice President, Chief +Financial Officer (Principal Financial Officer) October 27, 2010 /s/  Betsy Rafael BETSY RAFAEL Vice President Corporate +Controller (Principal Accounting Officer) October 27, 2010 /s/  William V. +Campbell WILLIAM V. CAMPBELL Director October 27, 2010 /s/  Millard S. +Drexler MILLARD S. DREXLER Director October 27, 2010 /s/  Albert Gore, +Jr. ALBERT GORE, JR. Director October 27, 2010 /s/  Andrea Jung ANDREA JUNG Director October 27, 2010 /s/  Arthur D. +Levinson ARTHUR D. LEVINSON Director October 27, 2010 90 Table of Contents EXHIBIT INDEX Exhibit Number Exhibit Description Incorporated by +Reference Form Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on July 10, 2009. 10-Q 6/27/09 3.2 By-Laws of the Registrant, as amended through May 27, 2009. 8-K 6/2/09 4.1 Form of Stock Certificate of the Registrant. 10-Q 12/30/06 10.1* Employee Stock Purchase Plan, as amended through March 8, 2010. 10-Q 3/27/10 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 6/27/09 10.3* 1997 Employee Stock Option Plan, as amended through October 19, 2001. 10-K 9/28/02 10.4* 1997 Director Stock Plan, as amended through February 25, 2010. 8-K 3/1/10 10.5* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 3/1/10 10.6* Reimbursement Agreement dated as of May 25, 2001 by and between the Registrant and Steven P. Jobs. 10-Q 6/29/02 10.7* Form of Option Agreement. 10-K 9/24/05 10.8* Form of Restricted Stock Unit Award Agreement effective as of August 28, 2007. 10-K 9/29/07 10.9* Form of Restricted Stock Unit Award Agreement effective as of November 11, 2008. 10-Q 12/27/08 14.1** Business Conduct Policy of the Registrant dated July 2010. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 23.2** Consent of KPMG LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signature Page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS**** XBRL Instance Document 101.SCH**** XBRL Taxonomy Extension Schema Document 101.CAL**** XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF**** XBRL Taxonomy Extension Definition Linkbase Document 101.LAB**** XBRL Taxonomy Extension Label Linkbase Document 101.PRE**** XBRL Taxonomy Extension Presentation Linkbase Document 91 Table of Contents * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. **** Pursuant to applicable securities laws and regulations, the Company is deemed to have complied with the reporting obligation relating to the +submission of interactive data files in such exhibits and is not subject to liability under any anti-fraud provisions of the federal securities laws as long as the Company has made a good faith attempt to comply with the submission +requirements and promptly amends the interactive data files after becoming aware that the interactive data files fails to comply with the submission requirements. Users of this data are advised that, pursuant to Rule 406T, these interactive +data files are deemed not filed and otherwise are not subject to liability. 92 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-11-282113/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-11-282113/full-submission.txt new file mode 100644 index 0000000..62c94ac --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-11-282113/full-submission.txt @@ -0,0 +1,1065 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 24, 2011 Or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period +from to Commission file +number: 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Global Select Market (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports +pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports +required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such +filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically +and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the +registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III +of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by +check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and +“smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if smaller reporting company) Smaller Reporting Company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting and non-voting stock held by +non-affiliates of the registrant, as of March 25, 2011, the last business day of the Company’s most recently completed second fiscal quarter, was approximately $322,921,000,000 based upon the closing price reported for such date on the +NASDAQ Global Select Market. For purposes of this disclosure, shares of common stock held by persons who hold more than 5% of the outstanding shares of common stock and shares held by executive officers and directors of the registrant have been +excluded because such persons may be deemed to be affiliates. This determination of executive officer or affiliate status is not necessarily a conclusive determination for other purposes. 929,409,000 shares of Common Stock Issued and Outstanding as of October 14, 2011 DOCUMENTS INCORPORATED BY REFERENCE (1) Portions of the registrant’s definitive Proxy Statement relating to its 2012 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-K where +indicated. Such Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. The Business section and other parts of this Annual Report on Form 10-K (“Form +10-K”) contain forward-looking statements that involve risks and uncertainties. Many of the forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” +Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by +words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future +performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection +entitled “Risk Factors” under Part I, Item 1A of this Form 10-K, which are incorporated herein by reference. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by +law. PART I Item 1. Business Company Background Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the +“Company”) designs, manufactures and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and +third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple TV ® , a portfolio of consumer and professional software applications, the iOS and Mac OS ® X operating systems, iCloud ® , and a variety of accessory, service and support offerings. The Company also sells and delivers digital content and applications through the iTunes Store ® , App Store SM , iBookstore SM , and Mac App Store. The Company sells its products worldwide through its retail stores, online stores, and direct +sales force, as well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application +software, printers, storage devices, speakers, headphones, and various other accessories and peripherals, through its online and retail stores. The Company sells to consumers, small and mid-sized businesses (“SMB”), and education, +enterprise and government customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company’s fiscal +calendar. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, +software, peripherals, and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions +with superior ease-of-use, seamless integration, and innovative design. The Company believes continual investment in research and development and marketing and advertising is critical to the development and sale of innovative products and +technologies. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. As part of the iTunes Store, the Company’s App Store +and iBookstore allow customers to discover and download applications and books through either a Mac or Windows-based computer or through “iOS devices,” namely iPhone, iPad and iPod touch ® . In January 2011, the Company opened the Mac App Store to allow customers to easily discover, download and install applications for their Macs. The Company also +supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company’s strategy also includes expanding its distribution network to effectively +reach more customers and provide them with a high-quality sales and post-sales support experience. 1 Consumer and Small and Mid-Sized Business The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s +products and services greatly enhances its ability to attract and retain customers. The Company sells many of its products and resells third-party products in most of its major markets directly to consumers and businesses through its retail and +online stores. The Company has also invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller +Program, certain third-party resellers focus on the Apple platform by providing a high level of product expertise, integration and support services. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable +high-traffic locations, the Company is better positioned to ensure a high quality customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and +related solutions. To that end, retail store configurations have evolved into various sizes to accommodate market-specific demands. The Company believes providing direct contact with its customers is an effective way to demonstrate the advantages of +its products over those of its competitors. The stores employ experienced and knowledgeable personnel who provide product advice, service and training. The stores offer a wide selection of third-party hardware, software, and other accessories and +peripherals that complement the Company’s products. Education Throughout its history, the Company has been committed to delivering solutions to help educators teach and students learn. The Company +believes effective integration of technology into classroom instruction can result in higher levels of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also +supports mobile learning and real-time distribution and accessibility of education related materials through iTunes U™, a platform that allows students and teachers to share and distribute educational media online. The Company sells its +products to the education market through its direct sales force, select third-party resellers and its online and retail stores. Enterprise +and Government The Company also sells its hardware and software products to enterprise and government customers in each of +its geographic segments. The Company’s products are deployed in these markets because of their power, productivity, ease of use and the simplicity of seamless integration into information technology environments. The Company’s products are +compatible with thousands of third-party business applications and services, and its tools enable the development and secure deployment of custom applications as well as remote device administration. Business Organization The Company manages its business primarily on a geographic basis. Accordingly, the Company has determined that its reportable operating +segments, which are generally based on the nature and location of its customers, consist of the Americas, Europe, Japan, Asia-Pacific and Retail. The results of the Americas, Europe, Japan and Asia-Pacific reportable segments do not include the +results of the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asian countries, other +than Japan. The Retail segment operates Apple retail stores worldwide. Each reportable operating segment provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be +found in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in Notes to Consolidated Financial Statements in Note 8, “Segment Information and +Geographic Data.” 2 Products The Company offers a range of mobile communication and media devices, personal computing products, and portable digital music players, as well as a variety of related software, services, peripherals, +networking solutions and third-party hardware and software products. In addition, the Company offers its own software products, including iOS, the Company’s proprietary mobile operating system; Mac OS X, the Company’s proprietary operating +system software for the Mac; server software and application software for consumer, SMB, and education, enterprise and government customers. The Company’s primary products are discussed below. iPhone iPhone combines +a mobile phone, an iPod, and an Internet communications device in a single handheld product. Based on the Company’s Multi-Touch™ user interface, iPhone features desktop-class email, web browsing, searching, and maps and is compatible +with both Macs and Windows-based computers. iPhone automatically syncs content from users’ iTunes libraries, as well as contacts, bookmarks, and email accounts. iPhone allows customers to access the iTunes Store to download audio and video +files, as well as a variety of other digital content and applications. In October 2011, the Company launched iPhone 4S, its latest version of iPhone, which includes Siri™, a voice activated intelligent assistant. In addition to the +Company’s own iPhone accessories, third-party iPhone compatible accessories are available through the Company’s online and retail stores and from third parties. iPad iPad is a multi-purpose mobile device for browsing the web, reading +and sending email, viewing photos, watching videos, listening to music, playing games, reading e-books and more. iPad is based on the Company’s Multi-Touch technology and allows customers to connect with their applications and content in a more +interactive way. iPad allows customers to access the iTunes Store to download audio and video files, as well as a variety of other digital content and applications. In March 2011, the Company introduced iPad 2, its second-generation iPad. In +addition to the Company’s own iPad accessories, third-party iPad compatible accessories are available through the Company’s online and retail stores and from third parties. Mac Hardware Products The Company offers a range of +personal computing products including desktop and portable computers, related devices and peripherals, and third-party hardware products. The Company’s Mac desktop and portable systems feature Intel microprocessors, the Mac OS X Lion operating +system and the iLife ® suite of software for creation and management of digital photography, music, movies, DVDs +and websites. The Company’s desktop computers include iMac ® , Mac Pro and Mac mini. The iMac desktop computer has an all-in-one design that incorporates a display, processor, +graphics card, storage, memory and other components inside a single enclosure. The Mac Pro desktop computer is targeted at business and professional customers and is designed to meet the performance, expansion, and networking needs of the most +demanding Mac user. The Mac mini is a desktop computer in a compact enclosure. The Company’s +portable computers include MacBook ® Pro and MacBook Air ® . MacBook Pro is a portable computer designed for professionals and consumers. MacBook Air is an ultra-slim portable computer designed for professionals and consumers. iPod The Company’s iPod line of portable digital music and media players includes iPod touch, iPod nano ® , iPod shuffle ® and iPod +classic ® . All iPods work with iTunes. In addition to the Company’s own iPod accessories, third-party iPod +compatible accessories are available, through the Company’s online and retail stores or from third parties. 3 The iPod touch, based on iOS, is a flash-memory-based iPod with a widescreen display and a +Multi-Touch user interface. iPod touch allows customers to access the iTunes Store to download audio and video content, as well as a variety of digital applications. The iPod nano is a flash-memory-based iPod that features the Company’s +Multi-Touch interface allowing customers to navigate their music collection by tapping or swiping the display. The iPod nano features a polished aluminum and glass enclosure with a built-in clip. The iPod shuffle is a flash-memory-based iPod that +features a clickable control pad to control music playback and VoiceOver technology enabling customers to hear song titles, artists and playlist names. The iPod classic is a hard-drive based portable digital music and video player. iTunes ® iTunes is an application that supports the purchase, download, organization and playback +of digital audio and video files and is available for both Mac and Windows-based computers. iTunes 10 is the latest version of iTunes and features AirPlay ® wireless music playback, Genius Mixes, Home Sharing, and improved syncing functionality with iOS devices. iTunes is integrated with the iTunes Store ® , a service that allows customers to discover, purchase, rent, and download digital content and applications. The iTunes Store includes the App Store™ and +iBookstore. The App Store allows customers to discover and download applications, and the iBookstore features electronic books from major and independent publishers and allows customers to preview and buy books for their iOS devices. Customers can +access the App Store through either a Mac or Windows-based computer or through an iOS device. The iBookstore is accessed through the iBooks ® application on an iOS device. Mac App Store In January 2011, the Company opened the Mac App Store allowing customers to discover, download and +install applications for their Macs. The Mac App Store offers applications in education, games, graphics and design, lifestyle, productivity, utilities and other categories. The Company’s Mac OS X operating system software and iLife and iWork ® application software are also available on the Mac App Store. iCloud In October 2011, +the Company launched iCloud, its new cloud service, which stores music, photos, applications, contacts, calendars, and documents and wirelessly pushes them to multiple iOS devices, Macs and Windows-based computers. iCloud’s features include +iTunes in the Cloud, Photo Stream, Documents in the Cloud, Contacts, Calendar, Mail, automatic downloads and purchase history for applications and iBooks, and iCloud Backup. Users can sign up for free access to iCloud using a device +running iOS 5 or a Mac running Mac OS X Lion. Software Products and Computer Technologies The Company offers a range of software products for consumer, SMB, education, enterprise and government customers, including the +Company’s proprietary iOS and Mac OS X operating system software; server software; professional application software; and consumer, education, and business oriented application software. Operating System Software iOS iOS is the Company’s mobile operating system that serves as the foundation for iOS devices. In October 2011, the Company released iOS +5, which supports iCloud and includes new features such as Notification Center, a way to view and manage notifications in one place; iMessage™, a messaging service that allows users to send text messages, photos and videos between iOS devices; +and Newsstand, a way to purchase and organize newspaper and magazine subscriptions. 4 Mac OS X Mac OS X, the operating system for Macs, is built on an open-source UNIX-based foundation. Mac OS X Lion is the eighth major release of Mac OS X and became available in July 2011. Mac OS X Lion includes +support for new Multi-Touch gestures; iCloud integration; system-wide support for full screen applications; Mission Control™, a way to view everything running on a user’s Mac; the Mac App Store; Launchpad™, a new home for a +user’s applications; and a redesigned Mail application. Application Software iLife iLife ’11 is the latest version of the +Company’s consumer-oriented digital lifestyle application suite included with all Mac computers. iLife features +iPhoto ® , iMovie ® , iDVD ® , GarageBand ® , and iWeb™. iPhoto is the Company’s consumer-oriented digital photo application and iMovie is the +Company’s consumer-oriented digital video editing software application. iDVD is the Company’s consumer-oriented software application that enables customers to turn iMovie files, QuickTime files, and digital pictures into interactive DVDs. +GarageBand is the Company’s consumer-oriented music creation application that allows customers to play, record and create music. iWeb allows customers to create online photo albums, blogs and podcasts, and to customize websites using editing +tools. iWork iWork ’09 is the latest version of the Company’s integrated productivity suite designed to help users create, present, and publish documents, presentations, and spreadsheets. iWork ’09 +includes Pages ® ’09 for word processing and page layout, Keynote ® ’09 for presentations, and Numbers ® ’09 for spreadsheets. The Company also has a Multi-Touch version of each iWork application designed specifically for use on iOS devices. Other Application Software The Company also sells various other application software, including Final Cut +Pro ® , Logic Studio ® , Logic ® Express 9, Logic +Studio ® Pro, and its FileMaker ® Pro database software. Displays & Peripheral +Products The Company manufactures the Apple LED Cinema Display™ and Thunderbolt Display. The Company also sells a +variety of Apple-branded and third-party Mac-compatible and iOS-compatible peripheral products, including printers, storage devices, computer memory, digital video and still cameras, and various other computing products and supplies. Apple TV Apple TV allows +customers to watch movies and television shows on their high definition television. Content from iTunes, Netflix, YouTube, and Flickr as well as music, photos, videos, and podcasts from a Mac or Windows-based computer can also be wirelessly streamed +to a television through Apple TV. With the release of iCloud in October 2011, content purchased on Apple TV can be re-downloaded on iOS devices. Product Support and Services AppleCare ® offers a range of support options for the Company’s customers. These options include assistance that is +built into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, and the AppleCare Protection Plan (“APP”). APP is a fee-based service that +typically includes two to three years of phone support and hardware repairs and dedicated web-based support resources. 5 Markets and Distribution The Company’s customers are primarily in the consumer, SMB, and education, enterprise and government markets. The Company uses a variety of direct and indirect distribution channels, such as its +retail stores, online stores, and direct sales force, and third-party cellular network carriers, wholesalers, retailers, and value-added resellers. The Company believes that sales of its innovative and differentiated products are enhanced by +knowledgeable salespersons who can convey the value of the hardware and software integration, and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers +is an effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a +high-quality buying experience for its products in which service and education are emphasized, the Company continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. Additionally, the +Company has invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain +third-party resellers focus on the Apple platform by providing a high level of integration and support services, and product expertise. No single customer accounted for more than 10% of net sales in 2011 or 2010. One of the Company’s customers accounted for 11% of net sales in 2009. Competition The markets +for the Company’s products and services are highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological +advances that have substantially increased the capabilities and use of mobile communication and media devices, personal computers, and other digital electronic devices. The Company’s competitors who sell mobile devices and personal computers +based on other operating systems have aggressively cut prices and lowered their product margins to gain or maintain market share. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide +downward pressures on gross margins. Principal competitive factors important to the Company include price, product features, relative price/performance, product quality and reliability, design innovation, a strong third-party software and +peripherals ecosystem, marketing and distribution capability, service and support, and corporate reputation. The Company is +focused on expanding its market opportunities related to mobile communication and media devices. These industries are highly competitive and include several large, well-funded and experienced participants. The Company expects competition in these +industries to intensify significantly as competitors attempt to imitate some of the features of the Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more +competitive than those they currently offer. These industries are characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by +competitors, and price sensitivity on the part of consumers and businesses. The Company’s digital content services have +faced significant competition from other companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company believes it offers superior innovation and +integration of the entire solution including the hardware (iPhone, iPad, Mac, and iPod), software (iTunes), and distribution of digital content and applications (iTunes Store, App Store, iBookstore and Mac App Store). Some of the Company’s +current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. The Company’s future financial condition and operating results depend on the Company’s ability to continue to develop and offer +new innovative products and services in each of the markets it competes in. 6 Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently obtained from single or limited sources, which +subjects the Company to significant supply and pricing risks. Many components are at times subject to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into various agreements for the supply +of components; however there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that +can materially adversely affect its financial condition and operating results. The Company and other participants in the +mobile communication and media device, and personal computer industries compete for various components with other industries that have experienced increased demand for their products. The Company also uses some custom components that are not common +to the rest of these industries, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the +suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if a key manufacturing vendor delayed shipments of completed +products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time +required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those +suppliers concentrated on the production of common components instead of components customized to meet the Company’s requirements. Substantially all of the Company’s hardware products are manufactured by outsourcing partners primarily located in Asia. A significant concentration of this manufacturing is currently performed by a +small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturer for many of the Company’s products. Although the Company works closely with its +outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover +the Company’s requirements for periods up to 150 days. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to +compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and to +expand the range of its product offerings through research and development, licensing of intellectual property and acquisition of third-party businesses and technology. Total research and development expense was $2.4 billion, $1.8 billion and $1.3 +billion in 2011, 2010 and 2009, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its iPhone, iPad, Mac and iPod devices, +peripherals, software and services. The Company has registered or has applied for trademarks and service marks in the U.S. and a number of foreign countries. Although the Company believes the ownership of such patents, copyrights, trademarks and +service marks is an important factor in its business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. 7 The Company regularly files patent applications to protect inventions arising from its +research and development, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents in the U.S. and worldwide. The Company holds copyrights +relating to certain aspects of its products and services. No single patent or copyright is solely responsible for protecting the Company’s products. The Company believes the duration of its patents is adequate relative to the expected lives of +its products. Due to the fast pace of innovation and product development, the Company’s products are often obsolete before the patents related to them expire, and sometimes are obsolete before the patents related to them are even granted. Many of the Company’s products are designed to include intellectual property obtained from third parties. While it may +be necessary in the future to seek or renew licenses relating to various aspects of its products and business methods, based upon past experience and industry practice, the Company believes such licenses generally could be obtained on commercially +reasonable terms; however, there is no guarantee that such licenses could be obtained at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage, and the rapid rate of issuance of new +patents, it is possible that certain components of the Company’s products and business methods may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be +infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data The U.S. represents the Company’s largest geographic market. Approximately 39% of the Company’s net sales in +2011 came from sales to customers inside the U.S. Final assembly of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by outsourcing partners, primarily located in Asia. The supply and +manufacture of a number of components is performed by sole-sourced outsourcing partners in the U.S., Asia and Europe. Single-sourced outsourcing partners in Asia perform final assembly of substantially all of the Company’s hardware products. +Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international +trade regulations, including tariffs and antidumping penalties. Information regarding financial data by geographic segment is set forth in Part II, Item 7 and Item 8 of this Form 10-K and in Notes to Consolidated Financial Statements in +Note 8, “Segment Information and Geographic Data.” Seasonal Business The Company has historically experienced increased net sales in its first fiscal quarter compared to other quarters in its fiscal year due +to increased holiday seasonal demand. This historical pattern should not be considered a reliable indicator of the Company’s future net sales or financial performance. Warranty The Company offers a limited parts and labor warranty on most of +its hardware products. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In +addition, consumers may purchase the APP, which extends service coverage on many of the Company’s hardware products in most of its major markets. Backlog In the Company’s experience, the actual amount of product +backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases in anticipation of or immediately following new product introductions as customers anticipate shortages. Backlog +is often reduced once customers 8 believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue +or financial performance. Employees As of September 24, 2011, the Company had approximately 60,400 full-time equivalent employees and an additional 2,900 full-time equivalent temporary employees and contractors. Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports +filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (“Exchange Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). Such reports and other information filed by +the Company with the SEC are available free of charge on the Company’s website at www.apple.com/investor when such reports are available on the SEC website. The public may read and copy any materials filed by the Company with the SEC at +the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that +contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov . The contents of these websites are not incorporated into this filing. Further, the Company’s +references to the URLs for these websites are intended to be inactive textual references only. Item 1A. Risk Factors Because of +the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not +use historical trends to anticipate results or trends in future periods. Global economic conditions could materially +adversely affect the Company. The Company’s operations and performance depend significantly on worldwide economic +conditions. Uncertainty about global economic conditions poses a risk as consumers and businesses postpone spending in response to tighter credit, unemployment, negative financial news and/or declines in income or asset values, which could have +a material negative effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations because the Company generally raises prices on goods and services sold outside the U.S. to +offset the effect of a strengthening of the U.S. dollar. Other factors that could influence demand include increases in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare costs, access +to credit, consumer confidence, and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services and the Company’s +financial condition and operating results. In the event of financial turmoil affecting the banking system and +financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be a new or incremental tightening in the credit markets, low liquidity, and extreme +volatility in fixed income, credit, currency, and equity markets. This could have a number of effects on the Company’s business, including the insolvency or financial instability of outsourcing partners or suppliers or their inability +to obtain credit to finance development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the Company’s products; and failure of +derivative counterparties and other financial institutions. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges +resulting from revaluations of debt and equity securities and other investments; interest rates; cash balances; and 9 changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk of the actual amounts realized in +the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change. If the Company is unable to compete effectively in these markets, its +financial condition and operating results could be materially adversely affected. The Company’s products and services +compete in highly competitive global markets characterized by aggressive price cutting, with resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual +improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of +innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications, and +related services. As a result, the Company must make significant investments in research and development and as such, the Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register +numerous patents, trademarks and service marks. By contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures. If the Company is unable to continue to develop and sell +innovative new products with attractive margins or if other companies infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be negatively affected and its financial condition and +operating results could be materially adversely affected. The Company markets certain mobile communication and media devices +based on the iOS mobile operating system and also markets related third-party digital content and applications. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and +other resources, as well as established hardware, software and digital content supplier relationships. Additionally, the Company faces significant price competition as competitors reduce their selling prices and attempt to imitate the Company’s +product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company also competes with illegitimate ways to obtain +third-party digital content and applications. The Company has entered the mobile communications and media device markets, and some of its competitors in these markets have greater experience, product breadth and distribution channels than the +Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide such products and services at little or no profit or even at a loss. The Company also +expects competition to intensify as competitors attempt to imitate the Company’s approach to providing these components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company’s +financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to maintain their functional and design advantages. The Company is the only authorized maker of hardware using Mac OS X, which has a minority market share in the personal computer market. +This market is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and peripherals, the Company faces a significant number of competitors, many of which have broader product +lines, lower priced products, and a larger installed customer base. Consolidation in this market has resulted in larger and potentially stronger competitors. Price competition has been particularly intense as competitors selling Windows-based +personal computers have aggressively cut prices and lowered product margins. An increasing number of Internet devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with +the Company’s existing products. The Company’s financial condition and operating results depend substantially on its ability to continually improve the Mac platform to maintain its functional and design advantages. 10 There can be no assurance the Company will be able to continue to provide products and +services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully +manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the industries +in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, and effectively stimulate customer demand for new and upgraded products. The success of new +product introductions depends on a number of factors including but not limited to timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new products and production ramp issues, +the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and costs to meet +anticipated demand, and the risk that new products may have quality or other defects in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions on its +financial condition and operating results. The Company faces substantial inventory and other asset risk in addition to +purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have +become obsolete or exceed anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets for impairment whenever events or +changed circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the assets exceeds its fair +market value. Although the Company believes its provisions related to inventory, other assets and purchase commitments are currently adequate, no assurance can be given that the Company will not incur additional related charges given the rapid and +unpredictable pace of product obsolescence in the industries in which the Company competes. Such charges could materially adversely affect the Company’s financial condition and operating results. The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with +industry practice, components are normally acquired through a combination of purchase orders, supplier contracts, open orders and, where appropriate, inventory component prepayments, in each case based on projected demand. Such purchase commitments +typically cover forecasted component and manufacturing requirements for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast +incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. The Company’s financial condition and operating results have been in the past and could be in the future +materially adversely affected by the Company’s ability to manage its inventory levels and respond to short-term shifts in customer demand patterns. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities. Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components that are available from multiple sources +are at times subject to industry-wide shortages and significant commodity pricing fluctuations. The Company has entered into various agreements for the supply of components; there can be no guarantee that the Company will be able to extend or renew +these agreements on similar terms, or at all. The follow-on effects from the credit crisis on the Company’s suppliers, referred to in “ Economic conditions could materially adversely affect the Company ” above, also could +affect the Company’s ability to obtain components. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect the Company’s 11 financial condition and operating results. The Company expects to experience decreases in its gross margin percentage in future periods, as compared to levels achieved during 2011, largely due to +a higher mix of new and innovative products with flat or reduced pricing that have higher cost structures and deliver greater value to customers, and potential future component cost and other cost increases. The Company and other participants in the mobile communication and media device, and personal computer industries compete for various +components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not common to the rest of these industries. The Company’s new products often utilize custom components +available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these +components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the Company’s requirements. If the supply of components for a +new or existing product were delayed or constrained, or if a key manufacturing vendor delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many +of whom are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in +part by a few outsourcing partners primarily located in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control +over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these +partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects. The Company also relies on its partners to adhere to the Company’s +supplier code of conduct. Any unanticipated product defect or warranty liability, whether pursuant to arrangements with outsourcing partners or otherwise, or material violations of the supplier code of conduct, could materially adversely affect the +Company’s reputation, financial condition and operating results. The supply and manufacture of many critical components +is performed by sole-sourced outsourcing partners in the U.S., Asia and Europe. Single-sourced outsourcing partners in Asia perform final assembly of substantially all of the Company’s hardware products. If manufacturing or logistics in these +locations is disrupted for any reason including, but not limited to, natural and man-made disasters, information technology system failures, military actions or economic, business, labor, environmental, public health, or political issues, the +Company’s financial condition and operating results could be materially adversely affected. The Company relies on +third-party intellectual property and digital content, which may not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products include third-party intellectual property, which requires licenses from those third parties. Based on past experience and industry practice, the Company believes such +licenses generally could be obtained on reasonable terms. There is however no assurance that the necessary licenses could be obtained on acceptable terms or at all. If the Company is unable to obtain or renew critical licenses on reasonable terms, +its financial condition and operating results may be materially adversely affected. The Company also contracts with third +parties to offer their digital content through the iTunes Store. The licensing arrangements with these third parties are short-term and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some +third-party content providers currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the 12 Company to license their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. If the +Company is unable to continue to offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach, the Company’s financial condition and operating results may be materially adversely +affected. Many third-party content providers require the Company to provide digital rights management (“DRM”) and +other security solutions. If these requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost +and in a timely manner. In addition, certain countries have passed or may propose legislation that would force the Company to license its DRM, which could lessen the protection of content and subject it to piracy and also could affect arrangements +with the Company’s content providers. The Company’s future results could be materially adversely affected if it +is found to have infringed on intellectual property rights. Technology companies, including many of the Company’s +competitors, frequently enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or otherwise obtained. +As the Company has grown, the intellectual property rights claims against it have increased and may continue to increase. In particular, the Company’s cellular enabled products compete with mobile communication and media device companies that +hold significant patent portfolios, and the number of patent claims against the Company has significantly increased. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and before the U.S. +International Trade Commission, as well as internationally in Europe and Asia. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the scope or validity of such patents or the merits of any patent claims by potential or actual litigants, the Company may have to engage in protracted litigation. If the Company is +found to infringe one or more patents, it may be required to pay substantial damages. If there is a temporary or permanent injunction prohibiting the Company from marketing or selling certain products or a successful claim of infringement against +the Company requiring it to pay royalties to a third-party, its financial condition and operating results could be materially adversely affected, regardless of whether it can develop non-infringing technology. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no assurance can be given +that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Company’s operating expenses. In management’s opinion there is not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss +contingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or +more of these legal matters were resolved against the Company in the same reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements of a particular reporting period could be +materially adversely affected. The Company’s future performance depends in part on support from third-party software +developers. The Company believes decisions by customers to purchase its hardware products depend in part on the +availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software +applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products, which could materially adversely affect the Company’s financial condition and operating +results. 13 With respect to its Mac products, the Company believes the availability of third-party +software applications and services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company’s products compared to Windows-based products. +This analysis may be based on factors such as the perceived strength of the Company and its products, the anticipated revenue that may be generated, continued acceptance by customers of Mac OS X, and the costs of developing such applications and +services. If the Company’s minority share of the global personal computer market causes developers to question the Company’s prospects, developers could be less inclined to develop or upgrade software for the Company’s products and +more inclined to devote their resources to developing and upgrading software for the larger Windows market. With respect to +iOS devices, the Company relies on the continued availability and development of compelling and innovative software applications, which are distributed through a single distribution channel, the App Store. The absence of multiple distribution +channels, which are available for competing platforms, may limit the availability and acceptance of third-party applications by the Company’s customers, thereby causing developers to reduce or curtail development for the iOS platform. In +addition, iOS devices are subject to rapid technological change, and, if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied +customers. As with applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the relative benefits of developing software for the +Company’s products rather than its competitors’ products, including devices that use competing platforms. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s +devices may suffer. The Company’s future operating performance depends on the performance of distributors, carriers +and other resellers. The Company distributes its products through wholesalers, resellers, national and regional retailers, +and value-added resellers, many of whom distribute products from competing manufacturers. The Company also sells many of its products and third-party products in most of its major markets directly to education customers, cellular network +carriers’ distribution channels, resellers and consumers through its online and retail stores. Carriers providing +cellular network service for iPhone typically subsidize users’ purchase of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers +or in agreements the Company enters into with new carriers. Many resellers have narrow operating margins and have been +negatively affected in the past by weak economic conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. +Such a perception could discourage resellers from investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company has invested and will continue to invest in +programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors and improving product placement displays. These programs could require a substantial investment while providing no +assurance of return or incremental revenue. The Company’s financial condition and operating results could be materially adversely affected if the financial condition of these resellers weakens, if resellers stopped distributing the +Company’s products, or if uncertainty regarding demand for the Company’s products caused resellers to reduce their ordering and marketing of the Company’s products. 14 The Company’s Retail business has required and will continue to require a +substantial investment and commitment of resources and is subject to numerous risks and uncertainties. The Company’s +retail stores have required substantial fixed investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain +stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require +substantially more investment than the Company’s more typical retail stores. Due to the high fixed cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of individual or multiple stores could +result in significant lease termination costs, write-offs of equipment and leasehold improvements, and severance costs that could materially adversely affect the Company’s financial condition and operating results. Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and uncertainties that could +materially adversely affect the Company’s financial condition and operating results. These risks and uncertainties include, but are not limited to, macro-economic factors that could have a negative effect on general retail activity, as well as +the Company’s inability to manage costs associated with store construction and operation, inability to sell third-party products at adequate margins, failure to manage relationships with its existing retail channel partners, more challenging +environment in managing retail operations outside the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and inability to obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and initiatives could disrupt the Company’s ongoing business and present risks not +originally contemplated. The Company has invested, and in the future may invest, in new business strategies or +acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, insufficient revenue to offset liabilities assumed and expenses associated with the strategy, inadequate +return of capital, and unidentified issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. They may materially adversely affect the Company’s financial condition and +operating results. The Company’s products and services experience quality problems from time to time that can result +in decreased sales and operating margin. The Company sells complex hardware and software products and services that can +contain design and manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. The +Company’s online services may from time to time experience outages, service slowdowns, or errors. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company will be able to +detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, harm to reputation, and significant warranty and other expenses, and could have a material adverse impact on the +Company’s financial condition and operating results. The Company is subject to laws and regulations worldwide, +changes to which could increase the Company’s costs and individually or in the aggregate materially adversely affect the Company’s financial condition or operating results. The Company is subject to laws and regulations affecting its domestic and international operations in a number of areas. These U.S. +and foreign laws and regulations affect the Company’s activities including, but not limited to, areas of labor, advertising, content, consumer protection, real estate, billing, e-commerce, promotions, quality of services, telecommunications, +mobile, television, intellectual property ownership and infringement, tax, 15 import and export requirements, anti-corruption, foreign exchange controls and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health, and safety. By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which +the Company operates are extensive and subject to change. Such changes could include, among others, restrictions on the production, manufacture, distribution, and use of the device, locking the device to a carrier’s network, or mandating the +use of the device on more than one carrier’s network. These devices are also subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These +certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications, delays in product shipment dates, or preclude the Company from selling certain products. Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent from +jurisdiction to jurisdiction, further increasing the cost of compliance. This increases the costs of doing business, and any such costs, which may rise in the future as a result of changes in these laws and regulations or in their +interpretation could individually or in the aggregate make the Company’s products and services less attractive to the Company’s customers, delay the introduction of new products in one or more regions, cause the Company to change or limit +its business practices, or affect the Company’s financial condition and operating results. The Company has implemented policies and procedures designed to ensure compliance with these laws and regulations, but there can be no assurance that the +Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies. Any such violations could individually or in the aggregate materially adversely affect the Company’s financial condition +or operating results. The Company’s success depends largely on the continued service and availability of key +personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, +including its CEO, its executive team and highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in the Silicon Valley, where most of the Company’s +key personnel are located. Political events, war, terrorism, public health issues, natural disasters and other +circumstances could materially adversely affect the Company. War, terrorism, geopolitical uncertainties, public health +issues, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a strong negative effect on the Company, its suppliers, logistics providers, +manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to interruption by natural disasters, fire, power shortages, nuclear power plant accidents, terrorist attacks, and other hostile +acts, labor disputes, public health issues, and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and deliver products to its customers, +including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. Should major public health issues, including pandemics, arise, the Company could be negatively affected +by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products, and disruptions in the operations of the +Company’s manufacturing vendors and component suppliers. The majority of the Company’s research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including +certain component suppliers and manufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, losses, significant recovery time and substantial expenditures could be required to resume +operations and the Company’s financial condition and operating results could be materially adversely affected. 16 Please also refer to the discussion of risks related to the March 11, 2011, Japan +earthquake and tsunami and the recent flooding in Thailand in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” under the subheading “Japan Earthquake and Tsunami +and Thailand Flooding,” which is incorporated herein by reference. The Company may be subject to information +technology system failures or network disruptions that could damage the Company’s reputation, business operations, and financial conditions. The Company may be subject to information technology system failures and network disruptions. These may be caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of +terrorism or war, computer viruses, physical or electronic break-ins, or similar events or disruptions. System redundancy may be ineffective or inadequate, and the Company’s disaster recovery planning may not be sufficient for all +eventualities. Such failures or disruptions could prevent access to the Company’s online stores and services, preclude retail store transactions, compromise Company or customer data, and result in delayed or cancelled orders. System failures +and disruptions could also impede the manufacturing and shipping of products, delivery of online services, transactions processing and financial reporting. The Company may be subject to breaches of its information technology systems, which could damage the Company’s reputation, business partner and customer relationships, and access to online stores +and services. Such breaches could subject the Company to significant reputational, financial, legal, and operational consequences. The Company’s business requires it to use and store customer, employee, and business partner personally identifiable information (“PII”). This may include names, addresses, phone numbers, +email addresses, contact preferences, tax identification numbers, and payment account information. Although malicious attacks to gain access to PII affect many companies across various industries, the Company may be at a relatively greater risk of +being targeted because of its high profile and the amount of PII managed. The Company requires user names and passwords in +order to access its information technology systems. The Company also uses encryption and authentication technologies to secure the transmission and storage of data. These security measures may be compromised as a result of third-party security +breaches, employee error, malfeasance, faulty password management, or other irregularity, and result in persons obtaining unauthorized access to Company data or accounts. Third parties may attempt to fraudulently induce employees or customers into +disclosing user names, passwords or other sensitive information, which may in turn be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors accounts and systems for unusual +activity and may freeze accounts under suspicious circumstances, which may result in the delay or loss of customer orders. The Company devotes significant resources to network security, data encryption, and other security measures to protect its systems and +data, but these security measures cannot provide absolute security. The Company may experience a breach of its systems and may be unable to protect sensitive data. Moreover, if a computer security breach affects the Company’s systems or results +in the unauthorized release of PII, the Company’s reputation and brand could be materially damaged and use of the Company’s products and services could decrease. The Company would also be exposed to a risk of loss or litigation and +possible liability, which could result in a material adverse effect on the Company’s business, results of operations and financial condition. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. +In many cases, these laws apply not only to third-party transactions, but also to transfers of information between the Company and its subsidiaries, and among the Company, its subsidiaries and other parties with which the Company has commercial +relations. Several jurisdictions have passed new laws in this 17 area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging +and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in penalties or significant legal liability. The Company’s privacy policies and practices concerning the use and disclosure of data are posted on its website. Any failure by the +Company, its suppliers or other parties with whom the Company does business to comply with its posted privacy policies or with other federal, state or international privacy-related or data protection laws and regulations could result in proceedings +against the Company by governmental entities or others, which could have a material adverse effect on the Company’s business, results of operations and financial condition. The Company is also subject to payment card association rules and obligations under its contracts with payment card processors. Under +these rules and obligations, if information is compromised, the Company could be liable to payment card issuers for the cost of associated expenses and penalties. In addition, if the Company fails to follow payment card industry security standards, +even if no customer information is compromised, the Company could incur significant fines or experience a significant increase in payment card transaction costs. The Company expects its quarterly revenue and operating results to fluctuate. The Company’s profit margins vary among its products and its distribution channels. The Company’s software, accessories, and service and support contracts generally have higher gross margins +than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product transitions, pricing and configuration changes, and component, +warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition, the Company’s gross margin and operating margin +percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, new products, component cost increases, strengthening U.S. dollar, or price competition. The Company +has typically experienced greater net sales in the first fiscal quarter compared to other fiscal quarters due to increased holiday seasonal demand. Furthermore, the Company sells more products from time-to-time during the third month of a quarter +than it does during either of the first two months. Developments late in a quarter, such as lower-than-anticipated demand for the Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the +Company’s logistics, components supply, or manufacturing partners, could have a material adverse impact on the Company’s financial condition and operating results. The Company’s stock price is subject to volatility. The +Company’s stock continues to experience substantial price volatility. Additionally, the stock market as a whole has experienced extreme price and volume fluctuations that have affected the stock price of many technology companies in ways that +may have been unrelated to these companies’ operating performance. The Company believes its stock price reflects high future growth and profitability expectations. If the Company fails to meet these expectations its stock price may +significantly decline, which could have a material adverse impact on investor confidence and employee retention. The +Company’s business is subject to the risks of international operations. The Company derives a significant portion of +its revenue and earnings from its international operations. Compliance with applicable U.S. and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation +restrictions, data privacy requirements, environmental laws, labor laws, and anti-competition regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with +these laws and 18 regulations, a violation by the Company’s employees, contractors, or agents could nevertheless occur. The consequences of such violations could individually or in the aggregate materially +adversely affect the Company’s financial condition or operating results. The Company’s financial condition and +operating results also could be significantly affected by other risks associated with international activities including, but not limited to, economic and labor conditions, increased duties, taxes and other costs, political instability, and changes +in the value of the U.S. dollar versus local currencies. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected +by foreign currency exchange rate fluctuations and by international trade regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its trade receivables with customers in +certain international markets. There can be no assurance it can effectively limit its credit risk and avoid losses, which could materially adversely affect the Company’s financial condition and operating results. The Company’s primary exposure to movements in foreign currency exchange rates relate to non-U.S. dollar denominated sales and +operating expenses worldwide. Weakening of foreign currencies relative to the U.S. dollar will adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally will lead the Company to raise +international pricing, potentially reducing demand for the Company’s products. In some circumstances, due to competition or other reasons, the Company may decide not to raise local prices to the full extent of the dollar’s strengthening, +or at all, which would adversely affect the U.S. dollar value of the Company’s foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies, while generally beneficial to the Company’s foreign +currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may +also increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company has used derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging +activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the market values of its investment portfolio. Although the Company has not recognized any significant losses to date on its cash, cash equivalents and marketable securities, any +significant declines in their market values could materially adversely affect the Company’s financial condition and operating results. Given the global nature of its business, the Company has both domestic and international investments. Credit +ratings and pricing of these investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or other factors. As a result, the value and liquidity of the Company’s +cash, cash equivalents and marketable securities could decline and result in a significant impairment, which could materially adversely affect the Company’s financial condition and operating results. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to +long-term supply agreements. This risk is heightened during periods when economic conditions worsen. The Company +distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral or credit insurance. +The Company’s exposure to credit and collectability risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. Cellular network carriers accounted for a significant portion of +the Company’s trade receivables as of September 24, 2011. The 19 Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products +for the Company. Two vendors accounted for a significant portion of the Company’s non-trade receivables as of September 24, 2011. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of +inventory components. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its +credit risk and avoid losses, which could materially adversely affect the Company’s financial condition and operating results. Unfavorable results of legal proceedings could materially adversely affect the Company. The Company is subject to various legal proceedings and claims that have not yet been fully resolved and that have arisen in the ordinary conduct of business, and additional claims may arise in the +future. Results of legal proceedings are subject to significant uncertainty and, regardless of the merit of the claims, litigation may be expensive, time-consuming, disruptive to the Company’s operations, and distracting to management. In +recognition of these considerations, the Company may enter into arrangements to settle litigation. Although management +considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in the same reporting period for amounts in excess of management’s expectations, the Company’s consolidated +financial statements of a particular reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial +corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. Changes in the Company’s tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities could affect its future results. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions. The Company’s future effective tax rates could be +affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation. Any of these changes could have a material +adverse effect on the Company’s profitability. The Company is also subject to the continual examination of its income tax returns by the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of +adverse outcomes resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance that the outcomes from these examinations will not materially adversely affect the Company’s financial condition +and operating results. Item 1B. Unresolved Staff Comments None. Item 2. Properties The +Company’s headquarters are located in Cupertino, California. As of September 24, 2011, the Company owned or leased approximately 13.2 million square feet of building space, primarily in the U.S., and to a lesser extent, in Europe, +Japan, Canada, and the Asia-Pacific regions. Of that amount approximately 7.0 million square feet was leased building space, which includes approximately 3.0 million square feet related to retail store space. Of the Company’s owned +building space, approximately 2.6 million square feet that is located in Cupertino, California will be demolished to build a second corporate campus. Additionally, the Company owns a total of 584 acres of land in various locations. As of September 24, 2011, the Company owned a manufacturing facility in Cork, Ireland that also housed a customer support call +center and facilities in Elk Grove, California that included warehousing and distribution operations and a customer support call center. In addition, the Company owned facilities for research and 20 development and corporate functions in Cupertino, California, including land for the future development of the Company’s second corporate campus. The Company also owned data centers in +Newark, California and in North Carolina. Outside the U.S., the Company owned additional facilities for various purposes. The +Company believes its existing facilities and equipment are in good operating condition and are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and +continues to make investments in capital equipment as needed to meet anticipated demand for its products. Item 3. Legal Proceedings As of +September 24, 2011, the end of the annual period covered by this report, the Company was subject to the various legal proceedings and claims discussed below, as well as certain other legal proceedings and claims that have not been fully +resolved and that have arisen in the ordinary course of business. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with +respect to loss contingencies. However, the outcome of legal proceedings and claims brought against the Company are subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one +or more of these legal matters were resolved against the Company in the same reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements of a particular reporting period could be +materially adversely affected. See the risk factors “ The Company’s future results could be materially adversely affected if it is found to have infringed on intellectual property rights. ” and “ Unfavorable results of +legal proceedings could materially adversely affect the Company. ” in Part I, Item 1A of this Annual Report on Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2011 +that did not individually or in the aggregate have a material impact on the Company’s financial condition and results of operations. In re Apple & ATTM Antitrust Litigation (brought on behalf of named plaintiffs Kliegerman, Holman, Rivello, Smith, Lee, Macasaddu, Morikawa, Scotti and Sesso) This is a purported class action filed against the Company and AT&T Mobility in the United States District Court for the Northern +District of California. The Consolidated Complaint alleges that the Company and AT&T Mobility violated the federal antitrust laws by monopolizing and/or attempting to monopolize the “aftermarket for voice and data services” for +the iPhone and that the Company monopolized and/or attempted to monopolize the “aftermarket for software applications for iPhones.” Plaintiffs are seeking unspecified compensatory and punitive damages for the class, treble damages, +injunctive relief and attorneys fees. On July 8, 2010 the Court granted in part plaintiffs’ motion for class certification. Following a favorable Supreme Court ruling for AT&T Mobility in its case against Conception, +defendants have filed Motions to Compel Arbitration and to Decertify the Class. The Apple iPod iTunes Antitrust Litigation +(formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, Inc.); Somers v. Apple Inc. These related cases +have been filed on January 3, 2005, July 21, 2006 and December 31, 2007 in the United States District Court for the Northern District of California on behalf of a purported class of direct and indirect purchasers of iPods and +iTunes Store content, alleging various claims including alleged unlawful tying of music and video purchased on the iTunes Store with the purchase of iPods and unlawful acquisition or maintenance of monopoly market power and unlawful acquisition +or maintenance of monopoly market power under §§1 and 2 of the Sherman Act, the Cartwright Act, California Business & Professions Code §17200 (unfair competition), the California Consumer Legal Remedies Act and California +monopolization law. Plaintiffs are seeking unspecified compensatory and punitive damages for the class, treble damages, injunctive relief, disgorgement of revenues and/or profits and attorneys fees. Plaintiffs are also seeking DRM free versions of +any songs downloaded from iTunes or an order requiring the Company to license its DRM to all competing music players. The cases are currently pending. 21 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the over-the-counter market and is quoted on the NASDAQ Global Select Market under the symbol +AAPL. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest sales prices for the Company’s common stock on the NASDAQ Global Select Market during each quarter of the +two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter Fiscal 2011 price range per common share $ 422.86 - $327.25 $ 355.13 - $310.50 $ 364.90 - $321.31 $ 325.72 - $275.00 Fiscal 2010 price range per common share $ 293.53 - $235.56 $ 279.01 - $199.25 $ 231.95 - $190.25 $ 209.35 - $180.70 Holders As of October 14, 2011, there were 28,543 shareholders of record. Dividends The Company did not declare or pay cash dividends in either 2011 or 2010. The Company anticipates that for the foreseeable +future it will retain any earnings for use in the operation of its business. Purchases of Equity Securities by the Issuer and Affiliated +Purchasers None. 22 Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Composite Index, the S&P Computer +Hardware Index, and the Dow Jones U.S. Technology Index. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Composite Index, the S&P Computer Hardware Index, and the Dow Jones U.S. Technology Index on +September 30, 2006. Data points on the graph are annual. Note that historic stock price performance is not necessarily indicative of future stock price performance. September 30, 2006 September 30, 2007 September 30, 2008 September 30, 2009 September 30, 2010 September 30, 2011 Apple Inc. $ 100 $ 199 $ 148 $ 241 $ 369 $ 495 S&P 500 $ 100 $ 116 $ 91 $ 85 $ 93 $ 94 S&P Computer Hardware $ 100 $ 148 $ 124 $ 147 $ 174 $ 197 Dow Jones US Technology $ 100 $ 123 $ 94 $ 104 $ 117 $ 120 23 Item 6. Selected Financial Data The information set forth below for the five years ended September 24, 2011, is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in +Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except share amounts which are reflected in thousands and per share amounts). 2011 2010 2009 2008 2007 Net sales $ 108,249 $ 65,225 $ 42,905 $ 37,491 $ 24,578 Net income $ 25,922 $ 14,013 $ 8,235 $ 6,119 $ 3,495 Earnings per common share: Basic $ 28.05 $ 15.41 $ 9.22 $ 6.94 $ 4.04 Diluted $ 27.68 $ 15.15 $ 9.08 $ 6.78 $ 3.93 Cash dividends declared per common share $ 0 $ 0 $ 0 $ 0 $ 0 Shares used in computing earnings per share: Basic 924,258 909,461 893,016 881,592 864,595 Diluted 936,645 924,712 907,005 902,139 889,292 Total cash, cash equivalents and marketable securities $ 81,570 $ 51,011 $ 33,992 $ 24,490 $ 15,386 Total assets $ 116,371 $ 75,183 $ 47,501 $ 36,171 $ 24,878 Total long-term obligations (a) $ 10,100 $ 5,531 $ 3,502 $ 1,745 $ 687 Total liabilities $ 39,756 $ 27,392 $ 15,861 $ 13,874 $ 10,347 Total shareholders’ equity $ 76,615 $ 47,791 $ 31,640 $ 22,297 $ 14,531 (a) The Company did not have any long-term debt during the five years ended September 24, 2011. Long-term obligations exclude non-current deferred +revenue. 24 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Forward-looking +statements can also be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Forward-looking statements are not guarantees of future performance +and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled +“Risk Factors” above, which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Item 8 of this Form 10-K. All +information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references in this report to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters +of those fiscal years. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Executive Overview The Company designs, manufactures, and markets mobile +communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s +products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and Mac OS X operating systems, iCloud, and a variety of accessory, service and support offerings. The Company +also sells and delivers digital content and applications through the iTunes Store, App Store, iBookstore, and Mac App Store. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as well as +through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application software, printers, +storage devices, speakers, headphones, and various other accessories and peripherals through its online and retail stores. The Company sells to consumers, small and mid-sized businesses, and education, enterprise and government customers. The Company is committed to bringing the best user experience to its customers through its innovative hardware, software, +peripherals, and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions with +superior ease-of-use, seamless integration, and innovative design. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. As part +of the iTunes Store, the Company’s App Store and iBookstore allow customers to discover and download applications and books through either a Mac or Windows-based computer or through “iOS devices,” namely iPhone, iPad and iPod touch. +In January 2011, the Company opened the Mac App Store to allow customers to easily discover, download and install applications for their Macs. The Company also supports a community for the development of third-party software and hardware products +and digital content that complement the Company’s offerings. The Company’s strategy also includes expanding its distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support +experience. The Company participates in several highly competitive markets, including mobile communications and media devices +with its iPhone, iPad and iPod product families; personal computers with its Mac computers; and distribution of third-party digital content and applications through the iTunes Store, App Store, iBookstore, and Mac App Store. While the Company is +widely recognized as a leading innovator in the markets where it competes, these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that continual investment in research and development and +marketing and advertising is critical to the development and sale of innovative products and technologies. The Company’s research and development spending is focused on investing in new hardware and software products, and in further developing +its existing products, including iPhone, iPad, Mac, and iPod hardware; iOS and Mac OS X operating systems; and a variety of application software and online services. 25 The Company uses a variety of direct and indirect distribution channels, such as its retail +stores, online stores, and direct sales force, and third-party cellular network carriers, wholesalers, retailers, and value-added resellers. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable +salespersons who can convey the value of the hardware and software integration, and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an +effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality +buying experience for its products in which service and education are emphasized, the Company continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. Additionally, the Company has +invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party +resellers focus on the Apple platform by providing a high level of integration and support services, and product expertise. Japan +Earthquake and Tsunami and Thailand Flooding On March 11, 2011, the northeast coast of Japan experienced a severe +earthquake followed by a tsunami, with continuing aftershocks. These geological events have caused significant damage in the region, including severe damage to nuclear power plants, and have impacted Japan’s power and other infrastructure as +well as its economy. Certain of the Company’s suppliers are located in Japan, and certain of its other suppliers integrate components or use materials manufactured in Japan in the production of its products. To the extent that component +production has been affected, the Company has generally obtained alternative sources of supply or implemented other measures. The Company does not currently believe these events will have a material impact on its operations in the first quarter of +2012 unless conditions worsen, including, but not limited to, power outages and expansion of evacuation zones around the nuclear power plants. Beyond the first quarter of 2012, uncertainty exists with respect to the availability of electrical power, the damage to nuclear power plants and the impact to other infrastructure. Thus, there is a risk +that the Company could in the future experience delays or other constraints in obtaining key components and products and/or price increases related to such components and products that could materially adversely affect the Company’s financial +condition and operating results. In addition, in recent months several regions of Thailand have experienced severe flooding, +causing damage to infrastructure, housing and factories. A number of the Company’s suppliers are located in Thailand. As with Japan, to the extent that component production has been affected, the Company will work to obtain alternative sources +of supply or implement other measures. Based on the Company’s current assessment of the situation, it does not believe this event will have a material impact on its operations in the first quarter of 2012; however, because the situation in +Thailand is still evolving uncertainty remains regarding the ultimate impact of this event on the Company. Critical Accounting Policies +and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted +accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts +reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of Significant Accounting Policies” of Notes to Consolidated Financial Statements in this Form 10-K describes the significant accounting policies +and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results +of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be material. 26 Management believes the Company’s critical accounting policies and estimates are those +related to revenue recognition, valuation and impairment of marketable securities, inventory valuation and inventory purchase commitments, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical +because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management +has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or +determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the +product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers recognition of revenue until the customer receives the product because the Company retains a +portion of the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold +on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: +(i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, +undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the +Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price +(“TPE”) and (iii) best estimate of the selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect +the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For sales of iPhone, iPad, Apple TV, for sales of iPod touch beginning in June 2010, and for sales of Mac beginning in June 2011, the Company has indicated it may from time-to-time provide future +unspecified software upgrades and features free of charge to customers. In June 2011, the Company announced it would begin providing various non-software services to owners of qualifying versions of iOS devices and Mac. Because the Company has +neither VSOE nor TPE for these unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Amounts allocated to the unspecified software upgrade rights and +non-software services are deferred and recognized on a straight-line basis over the estimated lives of each of these devices, which range from 24 to 48 months. The Company’s process for determining ESPs involves management’s judgment. The +Company’s process considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. If the facts and circumstances underlying the factors considered change, including the estimated +or actual costs incurred to provide non-software services or the estimated lives of the related devices, or should future facts and circumstances lead the Company to consider additional factors, the Company’s ESP for software upgrades and +non-software services related to future sales of these devices could change. If the estimated life of one or more of the devices should change, the future rate of amortization of the revenue allocated to the software upgrade rights would also +change. 27 The Company records reductions to revenue for estimated commitments related to price +protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and volume-based incentives. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to +be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not +recognized until reliable estimates can be made or the price protection lapses. For customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at +which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase +customer incentive programs and incur incremental price protection obligations that could result in additional reductions to revenue at the time such programs are offered. Additionally, certain customer incentive programs require management to +estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of +customers redeem such incentives, the Company would be required to record additional reductions to revenue, which would have a negative impact on the Company’s results of operations. Valuation and Impairment of Marketable Securities The Company’s +investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the Company’s +Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and losses on the +sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company +to record an impairment charge in the period any such determination is made. In making this judgment, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost, the financial +condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the security before recovery of the its amortized cost basis. The Company’s assessment on +whether a security is other-than-temporarily impaired, could change in the future due to new developments or changes in assumptions related to any particular security. Inventory Valuation and Inventory Purchase Commitments The Company must +order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in +excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each fiscal quarter that considers multiple factors including demand forecasts, product life cycle status, product development plans, current +sales levels, and component cost trends. The industries in which the Company competes are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. If future demand or market conditions for the +Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the Company may be required to record additional write-downs, which would negatively affect its +results of operations in the period when the write-downs were recorded. The Company records accruals for estimated +cancellation fees related to component orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders +based on projected demand information. These commitments typically cover the Company’s requirements for periods up to 150 days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products or an +unanticipated change in technological requirements for any of the Company’s products, the Company may be required to 28 record additional accruals for cancellation fees that would negatively affect its results of operations in the period when the cancellation fees are identified and recorded. Warranty Costs The +Company provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific +product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products +subject to warranty protection and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liability would be required and could materially affect the +Company’s results of operations. Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. The provision for income taxes is computed using the asset and liability method, under which +deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. +Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance +to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes tax +benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial +statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing +taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to +the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP +and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Note 7, “Commitments and Contingencies” in Notes to Consolidated Financial +Statements, the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable. There +is significant judgment required in both the probability determination and as to whether an exposure can be reasonably estimated. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material +loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of legal proceedings and claims brought against the Company are subject to significant uncertainty. Therefore, although management +considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in the same reporting period for amounts in excess of management’s expectations, the Company’s consolidated +financial statements of a particular reporting period could be materially adversely affected. 29 Net Sales Fiscal years 2011, 2010 and 2009 each spanned 52 weeks. An additional week is included in the first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. Fiscal +year 2012 will end on September 29, 2012 and will span 53 weeks, with a 14th week added to the first quarter of 2012. The following table summarizes net sales by operating segment and net sales and unit sales by product during the three years ended +September 24, 2011 (in millions, except unit sales in thousands and per unit amounts): 2011 Change 2010 Change 2009 Net Sales by Operating Segment: Americas net sales $ 38,315 56% $ 24,498 29% $ 18,981 Europe net sales 27,778 49% 18,692 58% 11,810 Japan net sales 5,437 37% 3,981 75% 2,279 Asia-Pacific net sales 22,592 174% 8,256 160% 3,179 Retail net sales 14,127 44% 9,798 47% 6,656 Total net sales $ 108,249 66% $ 65,225 52% $ 42,905 Net Sales by Product: Desktops (a) $ 6,439 4% $ 6,201 43% $ 4,324 Portables (b) 15,344 36% 11,278 18% 9,535 Total Mac net sales 21,783 25% 17,479 26% 13,859 iPod 7,453 (10)% 8,274 2% 8,091 Other music related products and services (c) 6,314 28% 4,948 23% 4,036 iPhone and related products and services (d) 47,057 87% 25,179 93% 13,033 iPad and related products and services (e) 20,358 311% 4,958 NM 0 Peripherals and other hardware (f) 2,330 28% 1,814 23% 1,475 Software, service and other sales (g) 2,954 15% 2,573 7% 2,411 Total net sales $ 108,249 66% $ 65,225 52% $ 42,905 Unit Sales by Product: Desktops (a) 4,669 1% 4,627 45% 3,182 Portables (b) 12,066 34% 9,035 25% 7,214 Total Mac unit sales 16,735 22% 13,662 31% 10,396 iPod unit sales 42,620 (15)% 50,312 (7)% 54,132 iPhone units sold 72,293 81% 39,989 93% 20,731 iPad units sold 32,394 334% 7,458 NM 0 (a) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (b) Includes MacBook, MacBook Air and MacBook Pro product lines. (c) Includes sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Apple-branded and third-party iPod +accessories. (d) Includes revenue recognized from iPhone sales, carrier agreements, services, and Apple-branded and third-party iPhone accessories. (e) Includes revenue recognized from iPad sales, services and Apple-branded and third-party iPad accessories. (f) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. (g) Includes sales from the Mac App Store in addition to sales of other Apple-branded and third-party Mac software and Mac and Internet services. NM = Not Meaningful 30 Fiscal Year 2011 versus 2010 Net sales during 2011 increased $43.0 billion or 66% compared to 2010. Several factors contributed positively to this increase, including +the following: • Net sales of iPhone and related products and services were $47.1 billion in 2011, representing an increase of $21.9 billion or 87% compared to 2010. +iPhone handset unit sales totaled 72.3 million during 2011, representing an increase of 32.3 million units or 81% compared to 2010. iPhone year-over-year net sales growth reflected strong demand for iPhone 4 in all of the Company’s +operating segments. The expanded U.S. distribution of iPhone to the Verizon Wireless network beginning in February 2011, continued expansion into new countries, and increased distribution with other new carriers and resellers also contributed to the +year-over-year growth of iPhone. As of September 24, 2011, the Company distributed iPhone in 105 countries through 228 carriers. Additionally, the Company distributes iPhone through its direct channels and certain third-party resellers. Net +sales of iPhone and related products and services accounted for 43% of the Company’s total net sales for 2011. • Net sales of iPad and related products and services, which the Company introduced in the third quarter of 2010, were $20.4 billion in 2011, +representing an increase of $15.4 billion or 311% compared to 2010. Unit sales of iPad were 32.4 million during 2011, an increase of 334% from 2010. The year-over-year unit growth and net sales growth were driven by strong iPad demand in all of +the Company’s operating segments. The Company distributes iPad through its direct channels, certain cellular network carriers’ distribution channels and certain third-party resellers. The Company distributed iPad in 90 countries as of +September 24, 2011 compared to 26 countries as of September 25, 2010. Net sales of iPad and related products and services accounted for 19% of the Company’s total net sales for 2011. • Mac net sales were $21.8 billion in 2011, representing an increase of $4.3 billion or 25% compared to 2010. Mac unit sales increased by +3.1 million or 22% in 2011 compared to 2010. The year-over-year growth in Mac net sales and unit sales was due primarily to higher demand in all of the Company’s operating segments for MacBook Air and MacBook Pro, which were updated in +July 2011 and February 2011, respectively. The year-over-year revenue growth for portables and desktops was 36% and 4%, respectively. Net sales of the Company’s Macs accounted for 20% of the Company’s total net sales for 2011. • Net sales of other music related products and services were $6.3 billion in 2011, representing an increase of $1.4 billion or 28% compared to 2010. +The increase was due primarily to increased net sales from the iTunes Store, which was largely driven by App Store expansion into new countries that contributed to strong growth in all of the Company’s geographic segments. During 2011, the +combined net sales for the iTunes Store, App Store and iBookstore was $5.4 billion, representing an increase of 33% compared to 2010. The Company believes this continued growth is the result of heightened consumer interest in downloading third-party +digital content, continued growth in its customer base of iPhone, iPad and iPod, expansion of third-party audio and video content available via the iTunes Store, and continued interest in and growth of the App Store. Net sales of other music related +products and services accounted for 6% of the Company’s total net sales for 2011. Partially offsetting +the positive factors contributing to the overall increase in net sales was a decrease in iPod net sales of $821 million or 10% during 2011 compared to 2010. Similarly, iPod unit sales decreased by 15% in 2011 compared to 2010. However, net sales per +iPod unit sold increased during 2011 compared to 2010 due primarily to a shift in iPod product mix toward iPod touch. Net sales of iPod accounted for 7% of the Company’s total net sales for 2011. 31 Fiscal Year 2010 versus 2009 Net sales during 2010 increased $22.3 billion or 52% compared to 2009. Several factors contributed positively to this increase, including +the following: • Net sales of iPhone and related products and services were $25.2 billion in 2010 representing an increase of $12.1 billion or 93% compared to 2009. +iPhone unit sales totaled 40 million in 2010, which represents an increase of 19.3 million or 93% compared to 2009. iPhone year-over-year growth was attributable primarily to continued growth from existing carriers, expanded distribution +with new international carriers and resellers, and strong demand for iPhone 4, which was released in the U.S. in June 2010 and in many other countries over the remainder of 2010. As of September 25, 2010, the Company distributed iPhone in 89 +countries through 166 carriers. Net sales of iPhone and related products and services accounted for 39% of the Company’s total net sales for 2010 compared to 30% in 2009. • Net sales of iPad and related products and services were $5.0 billion and unit sales of iPad were 7.5 million during 2010. iPad was released in +the U.S. in April 2010 and in various other countries over the remainder of 2010. As of September 25, 2010, the Company distributed iPad in 26 countries. The Company distributes iPad through its direct channels, certain cellular network +carriers’ distribution channels and certain third-party resellers. Net sales of iPad and related products and services accounted for 8% of the Company’s total net sales for 2010, reflecting the strong demand for iPad during the five months +following its release. • Mac net sales increased by $3.6 billion or 26% in 2010 compared to 2009, and Mac unit sales increased by 3.3 million or 31% in 2010 compared to +2009. Net sales per Mac unit sold decreased by 4% in 2010 compared to 2009 due primarily to lower average selling prices of Mac portable systems. During 2010, net sales and unit sales of the Company’s Mac portable systems increased by 18% and +25%, respectively, primarily attributable to strong demand for MacBook Pro, which was updated in April 2010. Net sales and unit sales of the Company’s Mac desktop systems increased by 43% and 45%, respectively, as a result of higher sales of +iMac, which was updated in July 2010. Net sales of the Company’s Macs accounted for 27% of the Company’s total net sales in 2010 compared to 32% in 2009. • Net sales of other music related products and services increased $912 million or 23% during 2010 compared to 2009. This increase was due primarily +to growth of the iTunes Store which generated total net sales of $4.1 billion for 2010. The results of the iTunes Store reflect growth of the iTunes App Store, continued growth in the installed base of iPhone, iPad, and iPod customers, and the +expansion of third-party audio and video content available for sale and rent via the iTunes Store. The Company continues to expand its iTunes content and applications offerings around the world. Net sales of other music related products and services +accounted for 8% of the Company’s total net sales for 2010 compared to 9% in 2009. • Net sales of iPods increased $183 million or 2% during 2010, while iPod unit sales declined by 7% during 2010 compared to 2009. Net sales per iPod +unit sold increased by 10% to $164 in 2010 compared to 2009, due to a shift in product mix toward iPod touch. iPod touch experienced strong growth in each of the Company’s reportable operating segments. Net sales of iPods accounted for 13% of +the Company’s total net sales for 2010 compared to 19% in 2009. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the +Americas, Europe, Japan, Asia-Pacific and Retail operations. The results of the Americas, Europe, Japan and Asia-Pacific reportable segments do not include the results of the Retail segment. The Americas segment includes both North and South +America. The Europe segment includes European countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asian 32 countries, other than Japan. The Retail segment operates Apple retail stores in 11 countries. Each reportable operating segment provides similar hardware and software products and similar +services. Further information regarding the Company’s operating segments may be found in Note 8, “Segment Information and Geographic Data” in Notes to Consolidated Financial Statements of this Form 10-K. Americas During 2011, +net sales in the Americas segment increased $13.8 billion or 56% compared to 2010. The primary contributors to the growth in net sales was a significant year-over-year increase in iPhone revenue from carrier expansion and strong demand for iPhone 4 +and increased sales of iPad and Macs, partially offset by a decrease in iPod net sales. Higher sales of third-party digital content and applications from the iTunes Store and App Store also drove an increase in sales during 2011. The Americas +segment represented approximately 35% and 37% of the Company’s total net sales for 2011 and 2010, respectively. During +2010, net sales in the Americas segment increased $5.5 billion or 29% compared to 2009. This increase in net sales was driven by increased iPhone revenue, strong demand for iPad, continued demand for Mac desktop and portable systems, and higher +sales of third-party digital content and applications from the iTunes Store. The Americas segment represented 37% and 44% of the Company’s total net sales in 2010 and 2009, respectively. Europe For 2011, net sales in the Europe segment increased $9.1 billion or +49%, compared to 2010. The increase in net sales during 2011 was attributable primarily to the continued year-over-year increase in iPhone revenue from carrier expansion and strong demand for iPhone 4, and increased sales of iPad and Macs, partially +offset by a decrease in iPod net sales. The Europe segment represented 26% and 29% of total net sales for 2011 and 2010, respectively. During 2010, net sales in Europe increased $6.9 billion or 58% compared to 2009. The growth in net sales was due mainly to a significant increase in iPhone revenue attributable to continued growth from +existing carriers and country and carrier expansion, increased sales of Mac desktop and portable systems and strong demand for iPad, partially offset by a stronger U.S. dollar. The Europe segment represented 29% and 28% of the Company’s total +net sales in 2010 and 2009, respectively. Japan Japan’s net sales increased $1.5 billion or 37% during 2011 compared to 2010. The key contributors to Japan’s net sales growth were increased iPhone revenue, strong sales of iPad, increased +sales of Macs, and strength in the Japanese Yen relative to the U.S. dollar. The Japan segment represented 5% and 6% of total net sales for 2011 and 2010, respectively. The recent earthquakes and tsunami that struck the northeast coast of Japan have created uncertainty regarding general economic and market conditions in Japan. Any significant impact of these events on +consumer demand could negatively impact the Company’s net sales in Japan in the future. The Company does not currently believe that the impact of these events will have a material adverse effect on the Company or its results of operations. During 2010, Japan’s net sales increased $1.7 billion or 75% compared to 2009. The primary contributors to this growth +were significant year-over-year increases in iPhone revenue, strong demand for iPad, and to a lesser extent strength in the Japanese Yen. The Japan segment represented 6% and 5% of the Company’s total net sales for 2010 and 2009, respectively. 33 Asia-Pacific Net sales in the Asia Pacific segment increased $14.3 billion or 174% during 2011 compared to 2010. The Company experienced particularly strong year-over-year net sales growth in its Asia Pacific segment +during 2011, especially in Greater China, which includes Hong Kong and Taiwan. Korea and Australia also experienced strong year-over-year revenue growth. Higher net sales in the Asia Pacific segment were due mainly to the increase in iPhone revenue +primarily attributable to the strong demand for iPhone 4 and carrier expansion, strong sales of iPad, and increased sales of Macs. The Asia Pacific segment represented 21% and 13% of total net sales in 2011 and 2010, respectively. Net sales in Asia-Pacific increased $5.1 billion or 160% during 2010 compared to 2009. The significant growth in Asia-Pacific net sales +was due mainly to increased iPhone revenue, which was primarily attributable to country and carrier expansion and continued growth from existing carriers. Asia-Pacific net sales were also favorably affected by strong demand for Mac portable and +desktop systems and for iPad. Particularly strong year-over-year growth was experienced in China, Korea and Australia. The Asia-Pacific segment represented 13% and 7% of the Company’s total net sales for 2010 and 2009, respectively. Retail Retail segment +net sales increased $4.3 billion or 44% during 2011 compared to 2010. The increase in net sales was driven primarily by strong demand for iPad, higher sales of Macs, and an increase in iPhone revenue. The Company opened 40 new retail stores during +2011, 28 of which were outside the U.S., ending the year with 357 stores open compared to 317 stores at the end of 2010. As of September 24, 2011, the Company had a total of 245 U.S. retail stores and 112 international retail stores. During 2011, the Company had an average of 326 stores compared to an average of 288 stores during 2010. The average revenue +per store increased 27% to $43.3 million in 2011 compared to $34.1 million in 2010. The Retail segment represented 13% and 15% of total net sales in 2011 and 2010, respectively. Retail net sales increased $3.1 billion or 47% during 2010 compared to 2009. The increase in net sales was driven primarily by strong +demand for iPad, increased sales of Mac desktop and portable systems and a significant year-over-year increase in iPhone revenue. The Company opened 44 new retail stores during 2010, 28 of which were outside the U.S., ending the year with 317 stores +open compared to 273 stores at the end of 2009. With an average of 288 stores and 254 stores opened during 2010 and 2009, respectively, average revenue per store increased to $34.1 million in 2010, compared to $26.2 million in 2009. The Retail +segment represented 15% and 16% of the Company’s total net sales in 2010 and 2009, respectively. The Retail segment +reported operating income of $3.3 billion during 2011 compared to $2.4 billion during 2010. The year-over-year increase in Retail operating income was primarily attributable to higher overall net sales that resulted in significantly higher average +revenue per store during 2011 compared to 2010. The Retail segment reported operating income of $1.7 billion during 2009. The increase in Retail operating income during 2010 compared to 2009 was attributable to higher overall net sales. Expansion of the Retail segment has required and will continue to require a substantial investment in fixed assets and related +infrastructure, operating lease commitments, personnel, and other operating expenses. Capital asset purchases associated with the Retail segment since inception totaled $2.8 billion through the end of 2011. As of September 24, 2011, the Retail +segment had approximately 36,000 full-time equivalent employees and had outstanding lease commitments associated with retail space and related facilities of $2.4 billion. The Company would incur substantial costs if it were to close multiple retail +stores and such costs could adversely affect the Company’s financial condition and operating results. 34 Gross Margin Gross margin for the three years ended September 24, 2011, are as follows (in millions, except gross margin percentages): 2011 2010 2009 Net sales $ 108,249 $ 65,225 $ 42,905 Cost of sales 64,431 39,541 25,683 Gross margin $ 43,818 $ 25,684 $ 17,222 Gross margin percentage 40.5% 39.4% 40.1% The gross margin percentage in 2011 was 40.5%, compared to 39.4% in 2010. This year-over-year increase in +gross margin was largely driven by lower commodity and other product costs. The gross margin percentage in 2010 was 39.4% +compared to 40.1% in 2009. This year-over-year decline in gross margin was primarily attributable to new products that had higher cost structures, including iPad, partially offset by a more favorable sales mix of iPhone, which had a higher gross +margin than the Company average. The Company expects to experience decreases in its gross margin percentage in future +periods, as compared to levels achieved during 2011, largely due to a higher mix of new and innovative products with flat or reduced pricing that have higher cost structures and deliver greater value to customers, and potential future component cost +and other cost increases. The foregoing statements regarding the Company’s expected gross margin percentage are +forward-looking and could differ from anticipated levels because of several factors including, but not limited to certain of those set forth below in Part I, Item 1A, “Risk Factors” under the subheading “ Future +operating results depend upon the Company’s ability to obtain components in sufficient quantities ,” which is incorporated herein by reference. In general, gross margins and margins on individual products will remain under +downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product transitions and potential increases in the cost of components, as well +as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to these competitive pressures, the Company expects it will continue +to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its +products. Due to the Company’s significant international operations, financial results can be significantly affected in the short-term by fluctuations in exchange rates. Operating Expenses Operating expenses for the three years ended +September 24, 2011, are as follows (in millions, except for percentages): 2011 2010 2009 Research and development $ 2,429 $ 1,782 $ 1,333 Percentage of net sales 2% 3% 3% Selling, general and administrative $ 7,599 $ 5,517 $ 4,149 Percentage of net sales 7% 8% 10% Research and Development Expense (“R&D”) R&D expense increased $647 million or 36% to $2.4 billion in 2011 compared to 2010. This increase was due primarily to an increase in +headcount and related expenses to support expanded R&D activities. Although total 35 R&D expense increased 36% during 2011 compared to 2010, it declined slightly as a percentage of net sales, due to the 66% year-over-year growth in the Company’s net sales during 2011. R&D expense increased 34% or $449 million to $1.8 billion in 2010 compared to 2009. This increase was due primarily to an +increase in headcount and related expenses in the current year to support expanded R&D activities. Also contributing to this increase in R&D expense in 2010 was the capitalization in 2009 of software development costs of $71 million related +to Mac OS X Snow Leopard. Although total R&D expense increased 34% during 2010, it declined as a percentage of net sales given the 52% year-over-year increase in net sales in 2010. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the +marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core business strategy. As such, the Company expects to make further investments in R&D to remain competitive. Selling, General and Administrative Expense (“SG&A”) SG&A expense increased $2.1 billion or 38% to $7.6 billion during 2011 compared to 2010. This increase was due primarily to the +Company’s continued expansion of its Retail segment, increased headcount and related costs, higher spending on professional services and marketing and advertising programs, and increased variable costs associated with the overall growth of the +Company’s net sales. SG&A expense increased $1.4 billion or 33% to $5.5 billion in 2010 compared to 2009. This +increase was due primarily to the Company’s continued expansion of its Retail segment, higher spending on marketing and advertising programs, increased share-based compensation expenses and variable costs associated with the overall growth of +the Company’s net sales. Other Income and Expense Other income and expense for the three years ended September 24, 2011, are as follows (in millions): 2011 2010 2009 Interest and dividend income $ 519 $ 311 $ 407 Other expense, net (104 ) (156 ) (81 ) Total other income and expense $ 415 $ 155 $ 326 Total other income and expense increased $260 million or 168% to $415 million during 2011 compared to +$155 million and $326 million in 2010 and 2009, respectively. The year-over-year increase in other income and expense during 2011 was due primarily to higher interest income and net realized gains on sales of marketable securities. The overall +decrease in other income and expense in 2010 compared to 2009 was attributable to the significant declines in interest rates on a year-over-year basis, partially offset by the Company’s higher cash, cash equivalents and marketable securities +balances. Additionally the Company incurred higher premium expenses on its foreign exchange option contracts, which further reduced the total other income and expense. The weighted average interest rate earned by the Company on its cash, cash +equivalents and marketable securities was 0.77%, 0.75% and 1.43% during 2011, 2010 and 2009, respectively. During 2011, 2010 and 2009, the Company had no debt outstanding and accordingly did not incur any related interest expense. Provision for Income Taxes The Company’s effective tax rates were approximately 24.2%, 24.4% and 31.8% for 2011, 2010 and 2009, respectively. The Company’s effective rates for these periods differ from the statutory +federal income tax rate of 36 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S. As of September 24, 2011, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax +credits of $3.2 billion, and deferred tax liabilities of $9.2 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future +reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and amount of a +valuation allowance. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s +federal income tax returns for the years 2004 through 2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2009. All IRS +audit issues for years prior to 2004 have been resolved. In addition, the Company is subject to audits by state, local, and foreign tax authorities. Management believes that adequate provisions have been made for any adjustments that may result +from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be +required to adjust its provision for income taxes in the period such resolution occurs. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the three years ended September 24, 2011 (in +millions): 2011 2010 2009 Cash, cash equivalents and marketable securities $ 81,570 $ 51,011 $ 33,992 Accounts receivable, net $ 5,369 $ 5,510 $ 3,361 Inventories $ 776 $ 1,051 $ 455 Working capital $ 17,018 $ 20,956 $ 20,049 Annual operating cash flow $ 37,529 $ 18,595 $ 10,159 Cash, cash equivalents and marketable securities increased $30.6 billion or 60% during 2011. The +principal components of this net increase was the cash generated by operating activities of $37.5 billion, which was partially offset by payments for acquisition of property, plant and equipment of $4.3 billion, payments for acquisition of +intangible assets of $3.2 billion and payments made in connection with business acquisitions, net of cash acquired, of $244 million. The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to +satisfy its working capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with its existing operations over the next 12 months. The Company’s marketable securities investment portfolio is invested primarily in highly rated securities and its policy generally +limits the amount of credit exposure to any one issuer. The Company’s investment policy requires investments to generally be investment grade with the objective of minimizing the potential risk of principal loss. As of September 24, 2011 +and September 25, 2010, $54.3 billion and $30.8 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts +held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. Capital Assets The Company’s capital expenditures were $4.6 billion during 2011, consisting of approximately $614 million for retail store +facilities and $4.0 billion for other capital expenditures, including product tooling and manufacturing 37 process equipment, real estate for the future development of the Company’s second corporate campus, and other corporate facilities and infrastructure. The Company’s actual cash payments +for capital expenditures during 2011 were $4.3 billion, of which $612 million relates to retail store facilities. The Company +anticipates utilizing approximately $8.0 billion for capital expenditures during 2012, including approximately $900 million for retail store facilities and approximately $7.1 billion for product tooling and manufacturing process equipment, and +corporate facilities and infrastructure, including information systems hardware, software and enhancements. During 2012, the +Company expects to open about 40 new retail stores, approximately three-quarters of which will be located outside of the U.S. Off-Balance +Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated +entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation +under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company. The following table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 24, 2011 and excludes amounts already recorded on the +Consolidated Balance Sheet (in millions): Total Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Operating leases $ 3,032 $ 338 $ 727 $ 665 $ 1,302 Purchase obligations 13,949 13,949 0 0 0 Other obligations 2,415 2,297 114 4 0 Total $ 19,396 $ 16,584 $ 841 $ 669 $ 1,302 Lease Commitments The Company’s major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for +terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 24, 2011, the Company’s total future minimum lease payments under noncancelable operating leases +were $3.0 billion, of which $2.4 billion related to leases for retail space. Purchase Commitments with Contract Manufacturers and +Component Suppliers The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s +products and to perform final assembly and test of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. The Company +also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based +on projected demand information. As of September 24, 2011, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $13.9 billion. 38 Other Obligations Other outstanding obligations were $2.4 billion as of September 24, 2011, and were comprised mainly of commitments under long-term supply agreements to make additional inventory component prepayments +and to acquire capital equipment, commitments to acquire product tooling and manufacturing process equipment, and commitments related to advertising, research and development, Internet and telecommunications services and other obligations. The Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax +liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of September 24, 2011, the Company had non-current deferred tax liabilities of $8.2 billion. Additionally, as of September 24, 2011, the Company +had gross unrecognized tax benefits of $1.4 billion and an additional $261 million for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of +payments in individual years in connection with these tax liabilities; therefore, such amounts are not included in the above contractual obligation table. Indemnification The Company generally does not indemnify end-users of its +operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company +could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim +asserted against it or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or +application software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of either September 24, 2011 or September 25, 2010. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company +has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal +proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances +involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not been material. Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. Given the effective horizons of the Company’s risk management +activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the +recognition timing of gains and losses related to these instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s +financial condition and operating results. 39 Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the Company’s interest income and expense is most sensitive to fluctuations in +U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities, the fair value of those securities, as well as costs associated with hedging. The Company’s investment policy and strategy are focused on preservation of capital and supporting the liquidity requirements of the +Company. A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s investment policy and to objective market benchmarks. The Company’s internal portfolio is benchmarked against external +manager performance. The Company’s exposure to changes in interest rates relates primarily to the Company’s +investment portfolio. The Company typically invests in highly rated securities and its policy generally limits the amount of credit exposure to any one issuer. The Company’s investment policy generally requires investments to be investment +grade, with the objective of minimizing the potential risk of principal loss. To provide a meaningful assessment of the +interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis +point parallel shift in the yield curve. Based on investment positions as of September 24, 2011, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $913 million incremental decline in the fair +market value of the portfolio. As of September 25, 2010, a similar 100 basis point shift in the yield curve would have resulted in a $477 million incremental decline in the fair market value of the portfolio. Such losses would only be realized +if the Company sold the investments prior to maturity. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in +particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency product pricing due to competitive +pressures when there have been significant volatility in foreign currency exchange rates. The Company may enter into foreign +currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net +investments in foreign subsidiaries. Generally, the Company’s practice is to hedge a majority of its material foreign exchange exposures, typically for up to six months. However, the Company may choose not to hedge certain foreign exchange +exposures for a variety of reasons, including but not limited to accounting considerations and the prohibitive economic cost of hedging particular exposures. To provide a meaningful assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a +value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. +The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used +as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments, and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the +model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $161 million as of September 24, 2011 compared to a 40 maximum one-day loss in fair value of $103 million as of September 25, 2010. Because the Company uses foreign currency instruments for hedging purposes, the loss in fair value incurred on +those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and +losses associated with the Company’s investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 24, 2011 due to the inherent limitations associated with predicting the timing +and amount of changes in interest rates, foreign currency exchanges rates and the Company’s actual exposures and positions. 41 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the three years ended September 24, 2011 43 Consolidated Balance Sheets as of September 24, 2011 and September 25, 2010 44 Consolidated Statements of Shareholders’ Equity for the three years ended September 24, +2011 45 Consolidated Statements of Cash Flows for the three years ended September 24, 2011 46 Notes to Consolidated Financial Statements 47 Selected Quarterly Financial Information (Unaudited) 75 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 76 All financial statement schedules have been omitted, since the required information is not applicable or +is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. 42 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Three years ended September 24, 2011 2011 2010 2009 Net sales $ 108,249 $ 65,225 $ 42,905 Cost of sales 64,431 39,541 25,683 Gross margin 43,818 25,684 17,222 Operating expenses: Research and development 2,429 1,782 1,333 Selling, general and administrative 7,599 5,517 4,149 Total operating expenses 10,028 7,299 5,482 Operating income 33,790 18,385 11,740 Other income and expense 415 155 326 Income before provision for income taxes 34,205 18,540 12,066 Provision for income taxes 8,283 4,527 3,831 Net income $ 25,922 $ 14,013 $ 8,235 Earnings per common share: Basic $ 28.05 $ 15.41 $ 9.22 Diluted $ 27.68 $ 15.15 $ 9.08 Shares used in computing earnings per share: Basic 924,258 909,461 893,016 Diluted 936,645 924,712 907,005 See accompanying Notes to Consolidated Financial Statements. 43 CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands) September 24, 2011 September 25, 2010 ASSETS: Current assets: Cash and cash equivalents $ 9,815 $ 11,261 Short-term marketable securities 16,137 14,359 Accounts receivable, less allowances of $53 and $55, respectively 5,369 5,510 Inventories 776 1,051 Deferred tax assets 2,014 1,636 Vendor non-trade receivables 6,348 4,414 Other current assets 4,529 3,447 Total current assets 44,988 41,678 Long-term marketable securities 55,618 25,391 Property, plant and equipment, net 7,777 4,768 Goodwill 896 741 Acquired intangible assets, net 3,536 342 Other assets 3,556 2,263 Total assets $ 116,371 $ 75,183 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 14,632 $ 12,015 Accrued expenses 9,247 5,723 Deferred revenue 4,091 2,984 Total current liabilities 27,970 20,722 Deferred revenue – non-current 1,686 1,139 Other non-current liabilities 10,100 5,531 Total liabilities 39,756 27,392 Commitments and contingencies Shareholders’ equity: Common stock, no par value; 1,800,000 shares authorized; 929,277 and 915,970 shares issued and outstanding, +respectively 13,331 10,668 Retained earnings 62,841 37,169 Accumulated other comprehensive income/(loss) 443 (46 ) Total shareholders’ equity 76,615 47,791 Total liabilities and shareholders’ equity $ 116,371 $ 75,183 See accompanying Notes to Consolidated Financial Statements. 44 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands) Common Stock Retained Earnings Accum- ulated Other Compre- hensive Income/ (Loss) Total Share- holders’ Equity Shares Amount Balances as of September 27, 2008 888,326 $ 7,177 $ 15,129 $ (9 ) $ 22,297 Components of comprehensive income: Net income 0 0 8,235 0 8,235 Change in foreign currency translation 0 0 0 (14 ) (14 ) Change in unrealized gains/losses on marketable securities, net of tax 0 0 0 118 118 Change in unrecognized gains/losses on derivative instruments, net of tax 0 0 0 (18 ) (18 ) Total comprehensive income 8,321 Share-based compensation 0 707 0 0 707 Common stock issued under stock plans, net of shares withheld for employee taxes 11,480 404 (11 ) 0 393 Tax benefit from equity awards, including transfer pricing adjustments 0 (78 ) 0 0 (78 ) Balances as of September 26, 2009 899,806 8,210 23,353 77 31,640 Components of comprehensive income: Net income 0 0 14,013 0 14,013 Change in foreign currency translation 0 0 0 7 7 Change in unrealized gains/losses on marketable securities, net of tax 0 0 0 123 123 Change in unrecognized gains/losses on derivative instruments, net of tax 0 0 0 (253 ) (253 ) Total comprehensive income 13,890 Share-based compensation 0 876 0 0 876 Common stock issued under stock plans, net of shares withheld for employee taxes 16,164 703 (197 ) 0 506 Tax benefit from equity awards, including transfer pricing adjustments 0 879 0 0 879 Balances as of September 25, 2010 915,970 10,668 37,169 (46 ) 47,791 Components of comprehensive income: Net income 0 0 25,922 0 25,922 Change in foreign currency translation 0 0 0 (12 ) (12 ) Change in unrealized gains/losses on marketable securities, net of tax 0 0 0 (41 ) (41 ) Change in unrecognized gains/losses on derivative instruments, net of tax 0 0 0 542 542 Total comprehensive income 26,411 Share-based compensation 0 1,168 0 0 1,168 Common stock issued under stock plans, net of shares withheld for employee taxes 13,307 561 (250 ) 0 311 Tax benefit from equity awards, including transfer pricing adjustments 0 934 0 0 934 Balances as of September 24, 2011 929,277 $ 13,331 $ 62,841 $ 443 $ 76,615 See accompanying Notes to Consolidated Financial Statements. 45 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Three years ended September 24, 2011 2011 2010 2009 Cash and cash equivalents, beginning of the year $ 11,261 $ 5,263 $ 11,875 Operating activities: Net income 25,922 14,013 8,235 Adjustments to reconcile net income to cash generated by operating activities: Depreciation, amortization and accretion 1,814 1,027 734 Share-based compensation expense 1,168 879 710 Deferred income tax expense 2,868 1,440 1,040 Changes in operating assets and liabilities: Accounts receivable, net 143 (2,142 ) (939 ) Inventories 275 (596 ) 54 Vendor non-trade receivables (1,934 ) (2,718 ) 586 Other current and non-current assets (1,391 ) (1,610 ) (713 ) Accounts payable 2,515 6,307 92 Deferred revenue 1,654 1,217 521 Other current and non-current liabilities 4,495 778 (161 ) Cash generated by operating activities 37,529 18,595 10,159 Investing activities: Purchases of marketable securities (102,317 ) (57,793 ) (46,724 ) Proceeds from maturities of marketable securities 20,437 24,930 19,790 Proceeds from sales of marketable securities 49,416 21,788 10,888 Payments made in connection with business acquisitions, net of cash acquired (244 ) (638 ) 0 Payments for acquisition of property, plant and equipment (4,260 ) (2,005 ) (1,144 ) Payments for acquisition of intangible assets (3,192 ) (116 ) (69 ) Other (259 ) (20 ) (175 ) Cash used in investing activities (40,419 ) (13,854 ) (17,434 ) Financing activities: Proceeds from issuance of common stock 831 912 475 Excess tax benefits from equity awards 1,133 751 270 Taxes paid related to net share settlement of equity awards (520 ) (406 ) (82 ) Cash generated by financing activities 1,444 1,257 663 (Decrease)/increase in cash and cash equivalents (1,446 ) 5,998 (6,612 ) Cash and cash equivalents, end of the year $ 9,815 $ 11,261 $ 5,263 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 3,338 $ 2,697 $ 2,997 See accompanying Notes to Consolidated Financial Statements. 46 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures, and markets mobile communication and media devices, personal computers, and +portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company sells its products worldwide through its retail stores, online +stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac, and iPod compatible products +including application software, printers, storage devices, speakers, headphones, and various other accessories and supplies through its online and retail stores. The Company sells to consumers, small and mid-sized businesses, education, enterprise +and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been +eliminated. The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in +these consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes thereto have been reclassified to conform to +the current year’s presentation. The Company’s fiscal year is the 52 or 53-week period that ends on the last +Saturday of September. The Company’s fiscal years 2011, 2010 and 2009 ended on September 24, 2011, September 25, 2010 and September 26, 2009, respectively, and included 52 weeks each. An additional week is included in the +first fiscal quarter approximately every six years to realign fiscal quarters with calendar quarters. Fiscal year 2012 will end on September 29, 2012, and will span 53 weeks, with a 14th week added to the first quarter of 2012. Unless otherwise +stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. During the first quarter of 2011, the Company adopted the Financial Accounting Standard Board’s (“FASB”) new accounting standard on consolidation of variable interest +entities. This new accounting standard eliminates the mandatory quantitative approach in determining control for evaluating whether variable interest entities need to be consolidated in favor of a qualitative analysis, and requires an +ongoing reassessment of control over such entities. The adoption of this new accounting standard did not impact the Company’s consolidated financial statements. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or +determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the +product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company legally retains a portion of +the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold on the +iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone +sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. 47 The Company sells software and peripheral products obtained from other companies. The +Company generally establishes its own pricing and retains related inventory risk, is the primary obligor in sales transactions with its customers, and assumes the credit risk for amounts billed to its customers. Accordingly, the Company generally +recognizes revenue for the sale of products obtained from other companies based on the gross amount billed. For sales of third-party software applications for iPhone, iPad and iPod touch (“iOS devices”) and Macs made through the App Store +and the Mac App Store, the Company is not the primary obligor to users of the software, and third- party developers determine the selling price of their software. Therefore, the Company accounts for such sales on a net basis by recognizing only the +commission it retains from each sale and including that commission in net sales in the Consolidated Statements of Operations. The portion of the sales price paid by users that is remitted by the Company to third-party developers is not reflected in +the Company’s Consolidated Statements of Operations. The Company records deferred revenue when it receives payments in +advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. +The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on the iTunes Store for the purchase of content and software. The Company records deferred revenue upon the sale of the card, which is +relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone +support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited warranty. The Company records reductions to revenue for estimated commitments related to price protection and for customer incentive programs, including reseller and end-user rebates, and other sales programs and +volume-based incentives. The estimated cost of these programs is recognized in the period the Company has sold the product and committed to a plan. The Company also records reductions to revenue for expected future product returns based on the +Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government +authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, +undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the +Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price +(“TPE”), and (iii) best estimate of the selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect +the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For sales of iPhone, iPad, Apple TV, for sales of iPod touch beginning in June 2010, and for sales of Mac beginning in June 2011, the Company has indicated it may from time-to-time provide future +unspecified software upgrades and features to the essential software bundled with each of these hardware products free of charge to customers. Essential software for iOS devices includes iOS and related applications and for Mac includes Mac OS X and +iLife. In June 2011, the Company announced it would provide various non-software services to owners of qualifying versions of iOS devices and Mac. The Company has identified up to three deliverables in arrangements involving the sale of these +devices. The first deliverable is the hardware and software essential to the functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with the purchase of iOS devices, Mac and Apple TV +to receive on a when-and-if-available basis, future unspecified software upgrades and features relating to the product’s essential software. The third 48 deliverable is the non-software services to be provided to qualifying versions of iOS devices and Mac. The Company allocates revenue between these deliverables using the relative selling price +method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue has been based on the Company’s ESPs. Amounts allocated to the delivered hardware and the related essential software are recognized at the +time of sale provided the other conditions for revenue recognition have been met. Amounts allocated to the embedded unspecified software upgrade rights and the non-software services are deferred and recognized on a straight-line basis over the +estimated lives of each of these devices, which range from 24 to 48 months. Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide +non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses as incurred. The Company’s process for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each +deliverable. The Company believes its customers, particularly consumers, would be reluctant to buy unspecified software upgrade rights related to iOS devices, Mac and Apple TV. This view is primarily based on the fact that unspecified upgrade rights +do not obligate the Company to provide upgrades at a particular time or at all, and do not specify to customers which upgrades or features will be delivered. The Company also believes its customers would be unwilling to pay a significant amount for +access to the non-software services because other companies offer similar services at little or no cost to users. Therefore, the Company has concluded that if it were to sell upgrade rights or access to the non-software services on a standalone +basis, including those rights and services attached to iOS devices, Mac and Apple TV, the selling prices would be relatively low. Key factors considered by the Company in developing the ESPs for software upgrade rights include prices charged by the +Company for similar offerings, market trends for pricing of Mac and iOS compatible software, the Company’s historical pricing practices, the nature of the upgrade rights (e.g., unspecified and when-and-if-available), and the relative ESP of the +upgrade rights as compared to the total selling price of the product. The Company may also consider, when appropriate, the impact of other products and services, including advertising services, on selling price assumptions when developing and +reviewing its ESPs for software upgrade rights and related deliverables. The Company may also consider additional factors as appropriate, including the pricing of competitive alternatives if they exist and product-specific business objectives. When +relevant, the same factors are considered by the Company in developing ESPs for offerings such as the non-software services; however, the primary consideration in developing ESPs for the non-software services is the estimated cost to provide such +services over the estimated life of the related devices, including consideration for a reasonable profit margin. Beginning +with the Company’s June 2011 announcement of the upcoming release of the non-software services and Mac OS X Lion, the Company’s combined ESP for the unspecified software upgrade rights and the right to receive the non-software services are +as follows: $16 for iPhone and iPad, $11 for iPod touch, and $22 for Mac. The Company’s ESP for the embedded unspecified software upgrade right included with each Apple TV is $5 for 2011 and $10 for fiscal years prior to 2011. Amounts allocated +to the embedded unspecified software upgrade rights and the non-software services associated with iOS devices and Apple TV are recognized on a straight-line basis over 24 months, and amounts allocated to the embedded unspecified software upgrade +rights and the non-software services associated with Macs are recognized on a straight-line basis over 48 months. The +Company’s ESP for the software upgrade right included with each iPhone sold beginning with the introduction of iPhone in June 2007 through the Company’s second quarter of 2010 was $25. Beginning in April 2010 in conjunction with the +Company’s announcement of iOS 4 for iPhone, the Company lowered its ESP for the software upgrade right included with each iPhone to $10. Beginning with initial sales of iPad in April 2010, the Company’s ESP for the embedded software +upgrade right included with the sale of each iPad is $10, and the Company’s ESP for the embedded software upgrade right included with each iPod touch sold beginning in June 2010 is $5. The Company accounts for multiple element arrangements that consist only of software or software-related products, including the sale of +upgrades to previously sold software, in accordance with industry specific 49 software accounting guidance. For such transactions, revenue on arrangements that include multiple elements is allocated to each element based on the relative fair value of each element, and fair +value is determined by VSOE. If the Company cannot objectively determine the fair value of any undelivered element included in such multiple-element arrangements, the Company defers revenue until all elements are delivered and services have been +performed, or until fair value can objectively be determined for any remaining undelivered elements. Beginning in July 2011, the sale of certain upgrades to Mac OS X and Mac versions of iLife include when-and-if-available upgrade rights for which +the Company does not have VSOE. Therefore, beginning in July 2011 the Company defers all revenue from the sale of upgrades to the Mac OS and Mac versions of iLife and recognizes it ratably over 36 months. Shipping Costs For all +periods presented, amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s shipping and handling costs are included in cost of sales. Warranty Expense The Company generally provides for the estimated cost of +hardware and software warranties at the time the related revenue is recognized. The Company assesses the adequacy of its pre-existing warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future +estimates. Software Development Costs Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s +technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established. Therefore, +costs incurred subsequent to achievement of technological feasibility are usually not significant, and generally most software development costs have been expensed as incurred. The Company did not capitalize any software development costs during 2011 and 2010. In 2009, the Company capitalized $71 million of costs +associated with the development of Mac OS X Version 10.6 Snow Leopard (“Mac OS X Snow Leopard”), which was released during the fourth quarter of 2009. The capitalized costs are being amortized to cost of sales on a straight-line basis over +a three year estimated useful life of the underlying technology. Total amortization related to capitalized software +development costs was $30 million, $48 million and $25 million in 2011, 2010 and 2009, respectively. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $933 million, $691 million and $501 million for 2011, 2010 and 2009, +respectively. Share-based Compensation The Company recognizes expense related to share-based payment transactions in which it receives employee services in exchange for (a) equity instruments of the Company or (b) liabilities that +are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. Share-based compensation cost for restricted stock units (“RSUs”) is measured based on the closing +fair market value of the Company’s common stock on the date of grant. Share-based compensation cost for stock options is estimated at the grant date based on each option’s fair-value as calculated by the Black-Scholes-Merton +(“BSM”) option-pricing model. The Company recognizes share-based compensation cost as expense ratably on a straight-line 50 basis over the requisite service period. The Company recognizes a benefit from share-based compensation in the Consolidated Statements of Shareholders’ Equity if an incremental tax benefit +is realized. In addition, the Company recognizes the indirect effects of share-based compensation on research and development tax credits, foreign tax credits and domestic manufacturing deductions in the Consolidated Statements of Operations. +Further information regarding share-based compensation can be found in Note 6, “Shareholders’ Equity and Share-based Compensation” of this Form 10-K. Income Taxes The provision for income taxes is computed using the asset +and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses +and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company +records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be +sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% +likelihood of being realized upon settlement. See Note 5, “Income Taxes” of this Form 10-K for additional information. Earnings +Per Common Share Basic earnings per common share is computed by dividing income available to common shareholders by the +weighted-average number of shares of common stock outstanding during the period. Diluted earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding +during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares +to be purchased under the employee stock purchase plan and unvested RSUs. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per common share by application of the treasury stock method. Under the treasury stock +method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. The following table sets forth the computation of basic and diluted earnings per common share for the three years ended September 24, 2011 (in thousands, except net income in millions and per share +amounts): 2011 2010 2009 Numerator: Net income $ 25,922 $ 14,013 $ 8,235 Denominator: Weighted-average shares outstanding 924,258 909,461 893,016 Effect of dilutive securities 12,387 15,251 13,989 Weighted-average diluted shares 936,645 924,712 907,005 Basic earnings per common share $ 28.05 $ 15.41 $ 9.22 Diluted earnings per common share $ 27.68 $ 15.15 $ 9.08 Potentially dilutive securities representing 1.7 million, 1.6 million and 12.6 million +shares of common stock for 2011, 2010 and 2009, respectively, were excluded from the computation of diluted earnings per common share for these periods because their effect would have been antidilutive. 51 Financial Instruments Cash Equivalents and Marketable Securities All highly liquid investments +with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the +appropriate classification of its investments at the time of purchase and reevaluates the designations at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each +instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. +The Company classifies its marketable equity securities, including mutual funds, as either short-term or long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity +securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative +instrument is reported as a component of accumulated other comprehensive income (“AOCI”) in shareholders’ equity and reclassified into income in the same period or periods during which the hedged transaction affects earnings. The +ineffective portion of the gain or loss on the derivative instrument, if any, is recognized in current income. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on +hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in income. For derivative instruments that hedge the exposure to changes in the +fair value of an asset or a liability and that are designated as fair value hedges, both the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in +earnings in the current period. The Company had no fair value hedges in 2011, 2010 and 2009. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation +exposure of the net investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value +relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current income. Derivatives that do not qualify as hedges must be adjusted to fair +value through current income. Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical experience, the age of the accounts receivable balances, credit +quality of the Company’s customers, current economic conditions, and other factors that may affect customers’ ability to pay. Inventories Inventories +are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The +Company’s inventories consist primarily of components and finished goods for all periods presented. 52 Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful +lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building, up to five years for equipment, and the shorter of lease terms or ten years for leasehold improvements. The Company capitalizes +eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using the straight-line method over the estimated useful lives +of the assets, which range from three to five years. Depreciation and amortization expense on property and equipment was $1.6 billion, $815 million and $606 million during 2011, 2010 and 2009, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment and certain identifiable intangibles, excluding goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in +circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, +plant and equipment and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value. The Company did not record any +significant impairments during 2011, 2010 and 2009. The Company does not amortize goodwill and intangible assets with +indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible +asset impairment tests in the fourth quarter of each fiscal year. The Company did not recognize any goodwill or intangible asset impairment charges in 2011, 2010 and 2009. The Company established reporting units based on its current reporting +structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. The Company amortizes its intangible assets with definite lives over their estimated useful lives and reviews these assets for impairment. The Company is currently amortizing its acquired intangible +assets with definite lives over periods generally ranging between three to seven years. Fair Value Measurements The Company applies fair value accounting for all financial assets and liabilities and non-financial assets and liabilities that are +recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market +participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company +would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as risks inherent in valuation techniques, transfer restrictions and credit risk. Fair value is estimated +by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value +measurement: Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices +for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. 53 Level 3 – Inputs that are generally unobservable and typically reflect +management’s estimate of assumptions that market participants would use in pricing the asset or liability. The +Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to +measure the fair value of all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by +observable market data. In accordance with the fair value accounting requirements, companies may choose to measure eligible +financial instruments and certain other items at fair value. The Company has not elected the fair value option for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the +assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those +in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in accumulated other comprehensive income in shareholders’ equity. The Company’s subsidiaries that use the U.S. +dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these +remeasurements were insignificant and have been included in the Company’s results of operations. Segment Information The Company reports segment information based on the “management” approach. The management approach designates the internal +reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. Information about the Company’s products, major customers and geographic areas on a company-wide basis is also +disclosed. 54 Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables +summarize the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short-term or +long-term marketable securities as of September 24, 2011 and September 25, 2010 (in millions): September 24, 2011 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 2,903 $ 0 $ 0 $ 2,903 $ 2,903 $ 0 $ 0 Level 1: Money market funds 1,911 0 0 1,911 1,911 0 0 Mutual funds 1,227 0 (34 ) 1,193 0 1,193 0 Subtotal 3,138 0 (34 ) 3,104 1,911 1,193 0 Level 2: U.S. Treasury securities 10,717 39 (3 ) 10,753 1,250 2,149 7,354 U.S. agency securities 13,467 24 (3 ) 13,488 225 1,818 11,445 Non-U.S. government securities 5,559 11 (2 ) 5,568 551 1,548 3,469 Certificates of deposit and time deposits 4,175 2 (2 ) 4,175 728 977 2,470 Commercial paper 2,853 0 0 2,853 2,237 616 0 Corporate securities 35,241 132 (114 ) 35,259 10 7,241 28,008 Municipal securities 3,411 56 0 3,467 0 595 2,872 Subtotal 75,423 264 (124) 75,563 5,001 14,944 55,618 Total $ 81,464 $ 264 $ (158 ) $ 81,570 $ 9,815 $ 16,137 $ 55,618 September 25, 2010 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 1,690 $ 0 $ 0 $ 1,690 $ 1,690 $ 0 $ 0 Level 1: Money market funds 2,753 0 0 2,753 2,753 0 0 Level 2: U.S. Treasury securities 9,872 42 0 9,914 2,571 2,130 5,213 U.S. agency securities 8,717 10 0 8,727 1,916 4,339 2,472 Non-U.S. government securities 2,648 13 0 2,661 10 865 1,786 Certificates of deposit and time deposits 2,735 5 (1 ) 2,739 374 850 1,515 Commercial paper 3,168 0 0 3,168 1,889 1,279 0 Corporate securities 17,349 102 (9 ) 17,442 58 4,522 12,862 Municipal securities 1,899 19 (1 ) 1,917 0 374 1,543 Subtotal 46,388 191 (11 ) 46,568 6,818 14,359 25,391 Total $ 50,831 $ 191 $ (11 ) $ 51,011 $ 11,261 $ 14,359 $ 25,391 55 The net unrealized gains as of September 24, 2011 and September 25, 2010 related +primarily to long-term marketable securities. The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration +management. The Company recognized net realized gains of $110 million during 2011 and no significant net realized gains or losses during 2010 and 2009 related to such sales. The maturities of the Company’s long-term marketable securities +generally range from one year to five years. As of September 24, 2011 and September 25, 2010, gross unrealized +losses related to individual securities that had been in a continuous loss position for 12 months or longer were not significant. The Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature. The Company typically invests in highly-rated securities, and its policy +generally limits the amount of credit exposure to any one issuer. The Company’s investment policy requires investments to generally be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values +were determined for each individual security in the investment portfolio. When evaluating the investments for other-than-temporary impairment, the Company reviews factors such as the length of time and extent to which fair value has been below cost +basis, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s amortized cost +basis. During 2011, 2010 and 2009, the Company did not recognize any significant impairment charges. As of September 24, 2011, the Company does not consider any of its investments to be other-than-temporarily impaired. Derivative Financial Instruments The Company uses derivatives to partially offset its business exposure to foreign currency exchange risk. The Company may enter into foreign currency forward and option contracts to offset some of the +foreign exchange risk on expected future cash flows on certain forecasted revenue and cost of sales, on net investments in certain foreign subsidiaries, and on certain existing assets and liabilities. To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose +functional currency is the U.S. dollar hedge a portion of forecasted foreign currency revenue. The Company’s subsidiaries whose functional currency is not the U.S. dollar and who sell in local currencies may hedge a portion of forecasted +inventory purchases not denominated in the subsidiaries’ functional currencies. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases generally up to six months. To help protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the +Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. The Company may also enter into foreign currency forward and option contracts to partially offset the foreign currency exchange gains and +losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. However, the Company may choose not to hedge certain foreign currency exchange exposures for a variety of reasons including, but not +limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency +exchange rates. The Company records all derivatives on the Consolidated Balance Sheets at fair value. The Company’s +accounting policies for these instruments are based on whether the instruments are designated as hedge or non-hedge instruments. The effective portions of cash flow hedges are recorded in AOCI until the hedged item is recognized in earnings. The +effective portions of net investment hedges are recorded in other comprehensive income as a part of the cumulative translation adjustment. The ineffective portions of cash flow hedges and net 56 investment hedges are recorded in other income and expense. Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line +item the derivative relates to. The Company had a net deferred gain associated with cash flow hedges of approximately $290 +million and a net deferred loss associated with cash flow hedges of approximately $252 million, net of taxes, recorded in AOCI as of September 24, 2011 and September 25, 2010, respectively. Deferred gains and losses associated with cash +flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a +component of cost of sales in the same period as the related costs are recognized. Substantially all of the Company’s hedged transactions as of September 24, 2011 are expected to occur within six months. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged +transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified immediately into other income and +expense. Any subsequent changes in fair value of such derivative instruments are reflected in other income and expense unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses +related to the loss of hedge designation on discontinued cash flow hedges during 2011, 2010 and 2009. The Company’s +unrealized net gains and losses on net investment hedges, included in the cumulative translation adjustment account of AOCI, were not significant as of September 24, 2011 and September 25, 2010, respectively. The ineffective portions and +amounts excluded from the effectiveness test of net investment hedges are recorded in other income and expense. The Company +recognized in other income and expense a net loss of $158 million, $123 million and $133 million on foreign currency forward and option contracts not designated as hedging instruments during 2011, 2010 and 2009, respectively. These amounts represent +the net gain or loss on the derivative contracts and do not include changes in the related exposures, which generally offset a portion of the gain or loss on the derivative contracts. The following table summarizes the notional principal amounts of the Company’s outstanding derivative instruments and credit risk +amounts associated with outstanding or unsettled derivative instruments as of September 24, 2011 and September 25, 2010 (in millions): 2011 2010 Notional Principal Credit Risk Amounts Notional Principal Credit Risk Amounts Instruments qualifying as accounting hedges: Foreign exchange contracts $ 13,705 $ 537 $ 13,957 $ 62 Instruments other than accounting hedges: Foreign exchange contracts $ 9,891 $ 56 $ 10,727 $ 45 The notional principal amounts for outstanding derivative instruments provide one measure of the +transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that +are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company’s gross exposure on these transactions may be +further mitigated by collateral received from certain counterparties. The Company’s exposure to credit loss and market risk will vary over time as a function of currency exchange rates. Although the table above reflects the notional principal +and credit risk amounts of the Company’s foreign exchange instruments, it does not reflect the gains or losses associated with the exposures and transactions that the foreign 57 exchange instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will +depend on actual market conditions during the remaining life of the instruments. The Company generally enters into master +netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to +be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values. As of +September 24, 2011, the Company received cash collateral related to the derivative instruments under its collateral security arrangements of $288 million, which it recorded as accrued expenses in the Consolidated Balance Sheet. As of +September 25, 2010, the Company posted cash collateral related to the derivative instruments under its collateral security arrangements of $445 million, which it recorded as other current assets in the Consolidated Balance Sheet. The Company +did not have any derivative instruments with credit-risk related contingent features that would require it to post additional collateral as of September 24, 2011 or September 25, 2010. The following tables summarize the gross fair value of the Company’s derivative instruments as reflected in the Consolidated Balance +Sheets as of September 24, 2011 and September 25, 2010 (in millions): September 24, 2011 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 460 $ 56 $ 516 Derivative liabilities (b): Foreign exchange contracts $ 72 $ 37 $ 109 September 25, 2010 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 62 $ 45 $ 107 Derivative liabilities (b): Foreign exchange contracts $ 488 $ 118 $ 606 (a) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the Consolidated Balance +Sheets. (b) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the Consolidated Balance +Sheets. 58 The following table summarizes the pre-tax effect of the Company’s derivative +instruments designated as cash flow and net investment hedges in the consolidated financial statements for the years ended September 24, 2011 and September 25, 2010 (in millions): Year Ended Gains/(Losses) Recognized in OCI - Effective Portion (c) Gains/(Losses) Reclassified from AOCI into Income - Effective Portion (c) Gains/(Losses) Recognized – Ineffective +Portion and Amount Excluded from Effectiveness Testing September 24, 2011 September 25, 2010 September 24, 2011 +(a) September 25, 2010 (b) Location September 24, 2011 September 25, 2010 Cash flow hedges: Foreign exchange contracts $ 153 $ (267) $ (704) $ 115 Other income and expense $ (213) $ (175) Net investment hedges: Foreign exchange contracts (43 ) (41 ) 0 0 Other income and expense 1 1 Total $ 110 $ (308 ) $ (704 ) $ 115 $ (212 ) $ (174 ) (a) Includes gains/(losses) reclassified from AOCI into income for the effective portion of cash flow hedges, of which $(349) million and $(355) million +were recognized within net sales and cost of sales, respectively, within the Consolidated Statement of Operations for the year ended September 24, 2011. There were no amounts reclassified from AOCI into income for the effective portion of net +investment hedges for the year ended September 24, 2011. (b) Includes gains/(losses) reclassified from AOCI into income for the effective portion of cash flow hedges, of which $158 million and $(43) million +were recognized within net sales and cost of sales, respectively, within the Consolidated Statement of Operations for the year ended September 25, 2010. There were no amounts reclassified from AOCI into income for the effective portion of net +investment hedges for the year ended September 25, 2010. (c) Refer to Note 6, “Shareholders’ Equity and Share-based Compensation” of this Form 10-K, which summarizes the activity in AOCI related +to derivatives. Accounts Receivable Trade Receivables The Company has considerable trade receivables +outstanding with its third-party cellular network carriers, wholesalers, retailers, value-added resellers, small and mid-sized businesses, and education, enterprise and government customers. The Company generally does not require collateral from its +customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring +third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit +risk sharing related to any of these arrangements. As of September 24, 2011, there were no customers that accounted for +10% or more of the Company’s total trade receivables. Trade receivables from two of the Company’s customers accounted for 15% and 12% of total trade receivables as of September 25, 2010. The Company’s cellular network carriers +accounted for 52% and 64% of trade receivables as of September 24, 2011 and September 25, 2010, respectively. The additions and write-offs to the Company’s allowance for doubtful accounts during 2011, 2010 and 2009 were not +significant. 59 Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these manufacturing vendors who manufacture sub-assemblies or assemble final +products for the Company. The Company purchases these components directly from suppliers. Vendor non-trade receivables from two of the Company’s vendors accounted for 53% and 29% of total non-trade receivables as of September 24, 2011 and +vendor non-trade receivables from two of the Company’s vendors accounted for 57% and 24% of total non-trade receivables as of September 25, 2010. The Company does not reflect the sale of these components in net sales and does not recognize +any profits on these sales until the related products are sold by the Company, at which time any profit is recognized as a reduction of cost of sales. Note 3 – Consolidated Financial Statement Details The +following tables show the Company’s consolidated financial statement details as of September 24, 2011 and September 25, 2010 (in millions): Property, Plant and Equipment 2011 2010 Land and buildings $ 2,059 $ 1,471 Machinery, equipment and internal-use software 6,926 3,589 Office furniture and equipment 184 144 Leasehold improvements 2,599 2,030 Gross property, plant and equipment 11,768 7,234 Accumulated depreciation and amortization (3,991 ) (2,466 ) Net property, plant and equipment $ 7,777 $ 4,768 Accrued Expenses 2011 2010 Deferred margin on component sales $ 2,038 $ 663 Accrued warranty and related costs 1,240 761 Accrued taxes 1,140 658 Accrued marketing and selling expenses 598 396 Accrued compensation and employee benefits 590 436 Other current liabilities 3,641 2,809 Total accrued expenses $ 9,247 $ 5,723 Non-Current Liabilities 2011 2010 Deferred tax liabilities $ 8,159 $ 4,300 Other non-current liabilities 1,941 1,231 Total other non-current liabilities $ 10,100 $ 5,531 60 Note 4 – Goodwill and Other Intangible Assets The Company is currently amortizing its acquired intangible assets with definite lives over periods generally ranging between three to +seven years. The following table summarizes the components of gross and net intangible asset balances as of September 24, 2011 and September 25, 2010 (in millions): 2011 2010 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired intangible assets $ 3,873 $ (437 ) $ 3,436 $ 487 $ (245 ) $ 242 Indefinite lived and non-amortizable trademarks 100 0 100 100 0 100 Total acquired intangible assets $ 3,973 $ (437 ) $ 3,536 $ 587 $ (245 ) $ 342 During 2011 and 2010, the Company completed various business acquisitions. In 2011, the aggregate cash +consideration, net of cash acquired, was $244 million, of which $167 million was allocated to goodwill and $77 million to acquired intangible assets. In 2010, the aggregate cash consideration, net of cash acquired, was $638 million, of which $535 +million was allocated to goodwill and $107 million to acquired intangible assets. During 2011, the Company, as part of a +consortium, acquired Nortel Networks Corporation’s patent portfolio for an overall purchase price of $4.5 billion, of which the Company’s contribution was approximately $2.6 billion. The majority of the acquisition price has been recorded +in acquired intangible assets, which the Company expects to amortize over seven years. The Department of Justice is reviewing this transaction. The Company’s gross carrying amount of goodwill was $896 million and $741 million as of September 24, 2011 and September 25, 2010, respectively. The Company did not have any goodwill +impairment during 2011, 2010 or 2009. The Company’s goodwill is allocated primarily to the Americas and Europe reportable operating segments. Amortization expense related to acquired intangible assets was $192 million, $69 million and $53 million in 2011, 2010 and 2009, respectively. As of September 24, 2011 the weighted-average +amortization period for acquired intangible assets was 6.2 years. The expected annual amortization expense related to acquired intangible assets as of September 24, 2011, is as follows (in millions): Years 2012 $ 520 2013 596 2014 608 2015 441 2016 426 Thereafter 845 Total $ 3,436 61 Note 5 – Income Taxes The provision for income taxes for the three years ended September 24, 2011, consisted of the following (in millions): 2011 2010 2009 Federal: Current $ 3,884 $ 2,150 $ 1,922 Deferred 2,998 1,676 1,077 6,882 3,826 2,999 State: Current 762 655 524 Deferred 37 (115 ) (2 ) 799 540 522 Foreign: Current 769 282 345 Deferred (167 ) (121 ) (35 ) 602 161 310 Provision for income taxes $ 8,283 $ 4,527 $ 3,831 The foreign provision for income taxes is based on foreign pretax earnings of $24.0 billion, $13.0 +billion and $6.6 billion in 2011, 2010 and 2009, respectively. The Company’s consolidated financial statements provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the +Company’s foreign subsidiaries that are intended to be indefinitely reinvested in operations outside the U.S. As of September 24, 2011, U.S. income taxes have not been provided on a cumulative total of $23.4 billion of such earnings. The +amount of unrecognized deferred tax liability related to these temporary differences is estimated to be approximately $8.0 billion. As of September 24, 2011 and September 25, 2010, $54.3 billion and $30.8 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign +subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax effects of temporary +differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary +differences are expected to be recovered or settled. 62 As of September 24, 2011 and September 25, 2010, the significant components of the +Company’s deferred tax assets and liabilities were (in millions): 2011 2010 Deferred tax assets: Accrued liabilities and other reserves $ 1,610 $ 1,369 Basis of capital assets and investments 390 179 Share-based compensation 355 308 Other 795 707 Total deferred tax assets 3,150 2,563 Less valuation allowance 0 0 Deferred tax assets, net of valuation allowance 3,150 2,563 Deferred tax liabilities: Unremitted earning of foreign subsidiaries 8,896 4,979 Other 272 150 Total deferred tax liabilities 9,168 5,129 Net deferred tax liabilities $ (6,018 ) $ (2,566 ) A reconciliation of the provision for income taxes, with the amount computed by applying the statutory +federal income tax rate (35% in 2011, 2010 and 2009) to income before provision for income taxes for the three years ended September 24, 2011, is as follows (in millions): 2011 2010 2009 Computed expected tax $ 11,973 $ 6,489 $ 4,223 State taxes, net of federal effect 552 351 339 Indefinitely invested earnings of foreign subsidiaries (3,898 ) (2,125 ) (647 ) Research and development credit, net (167 ) (23 ) (84 ) Domestic production activities deduction (168 ) (48 ) (36 ) Other (9 ) (117 ) 36 Provision for income taxes $ 8,283 $ 4,527 $ 3,831 Effective tax rate 24.2% 24.4% 31.8% The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan +awards. For stock options, the Company receives an income tax benefit calculated as the difference between the fair market value of the stock issued at the time of the exercise and the option price, tax effected. For RSUs, the Company receives +an income tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. The Company had net excess tax benefits from equity awards of $1.1 billion, $742 million and $246 million in 2011, 2010 and +2009, respectively, which were reflected as increases to common stock. Uncertain Tax Positions Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position +will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest +amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one +year as non-current liabilities in the Consolidated Balance Sheets. 63 As of September 24, 2011, the total amount of gross unrecognized tax benefits was $1.4 +billion, of which $563 million, if recognized, would affect the Company’s effective tax rate. As of September 25, 2010, the total amount of gross unrecognized tax benefits was $943 million, of which $404 million, if recognized, would +affect the Company’s effective tax rate. The aggregate changes in the balance of gross unrecognized tax benefits, which +excludes interest and penalties, for the three years ended September 24, 2011, is as follows (in millions): 2011 2010 2009 Beginning Balance $ 943 971 $ 506 Increases related to tax positions taken during a prior year 49 61 341 Decreases related to tax positions taken during a prior year (39 ) (224 ) (24 ) Increases related to tax positions taken during the current year 425 240 151 Decreases related to settlements with taxing authorities 0 (102 ) 0 Decreases related to expiration of statute of limitations (3 ) (3 ) (3 ) Ending Balance $ 1,375 $ 943 $ 971 The Company includes interest and penalties related to unrecognized tax benefits within the provision for +income taxes. As of September 24, 2011 and September 25, 2010, the total amount of gross interest and penalties accrued was $261 million and $247 million, respectively, which is classified as non-current liabilities in the Consolidated +Balance Sheets. In connection with tax matters, the Company recognized interest expense in 2011 and 2009 of $14 million and $64 million, respectively, and in 2010 the Company recognized an interest benefit of $43 million. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign +jurisdictions. For U.S. federal income tax purposes, all years prior to 2004 are closed. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s federal income tax returns for the years 2004 through +2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2009. In addition, the Company is also subject to audits by state, +local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 1988 and 2001, respectively, generally remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the +outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for +income tax in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company does not believe it is reasonably possible that its unrecognized tax benefits would materially change in the next +12 months. Note 6 – Shareholders’ Equity and Share-based Compensation Preferred Stock The +Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors is authorized to determine or alter the rights, +preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income +refers to revenue, expenses, gains and losses that under GAAP are recorded as an element 64 of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using +the U.S. dollar as their functional currency, unrealized gains and losses on marketable securities classified as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. The following table summarizes the components of AOCI, net of taxes, as of September 24, 2011, September 25, 2010, and +September 26, 2009 (in millions): 2011 2010 2009 Net unrealized gains/losses on marketable securities $ 130 $ 171 $ 48 Net unrecognized gains/losses on derivative instruments 290 (252 ) 1 Cumulative foreign currency translation 23 35 28 Accumulated other comprehensive income/(loss) $ 443 $ (46 ) $ 77 The change in fair value of available-for-sale securities included in other comprehensive income was +$(41) million, $123 million and $118 million, net of taxes in 2011, 2010 and 2009, respectively. The tax effect related to the change in unrealized gains/losses on available-for-sale securities was $24 million, $(72) million and $(78) million for +2011, 2010 and 2009, respectively. The following table summarizes activity in other comprehensive income related to +derivatives, net of taxes, held by the Company during the three years ended September 24, 2011 (in millions): 2011 2010 2009 Changes in fair value of derivatives $ 92 $ (180 ) $ 204 Adjustment for net gains/losses realized and included in net income 450 (73 ) (222 ) Change in unrecognized gains/losses on derivative instruments $ 542 $ (253 ) $ (18 ) The tax effect related to the changes in fair value of derivatives was $(50) million, $97 million and +$(135) million for 2011, 2010 and 2009, respectively. The tax effect related to derivative gains/losses reclassified from other comprehensive income to income was $(250) million, $43 million and $149 million for 2011, 2010 and 2009, respectively. Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the “2003 Plan”) is a shareholder approved plan that provides for broad-based equity grants to +employees, including executive officers. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights and performance-based awards. Options granted under the 2003 +Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual, semi-annual or quarterly vesting. In general, RSUs granted under the 2003 +Plan vest over two to four years, based on continued employment and are settled upon vesting in shares of the Company’s common stock on a one-for-one basis. Each share issued with respect to an award granted under the 2003 Plan (other than a +stock option or stock appreciation right) reduces the number of shares available for grant under the plan by two shares, whereas shares issued in respect of an option or stock appreciation right count against the number of shares available for grant +on a one-for-one basis. As of September 24, 2011, approximately 50.8 million shares were reserved for future issuance under the 2003 Plan. 65 1997 Director Stock Plan The 1997 Director Stock Plan (the “Director Plan”) is a shareholder approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee +directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board to prospectively change +the relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants without shareholder approval. Each share +issued with respect to RSUs granted under the Director Plan reduces the number of shares available for grant under the plan by two shares. The Director Plan expires November 9, 2019. As of September 24, 2011, approximately 190,000 shares +were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the fourth quarter of 2011, executive officers Timothy D. Cook, Peter Oppenheimer, D. Bruce Sewell, Phil Schiller and Jeffrey E. +Williams, and directors William V. Campbell and Arthur D. Levinson had trading plans pursuant to Rule 10b5-1(c)(1) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). A trading plan is a written document that +pre-establishes the amounts, prices and dates (or a formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including the exercise and sale of employee stock options and shares acquired +pursuant to the Company’s employee stock purchase plan and upon vesting of RSUs. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder approved plan under which substantially all employees +may purchase the Company’s common stock through payroll deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions +under the Purchase Plan are limited to 10% of the employee’s compensation and employees may not purchase more than $25,000 of stock during any calendar year. As of September 24, 2011, approximately 3.1 million shares were reserved for +future issuance under the Purchase Plan. Employee Savings Plan The Employee Savings Plan (the “Savings Plan”) is a deferred salary arrangement under Section 401(k) of the Internal +Revenue Code. Under the Savings Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($16,500 for calendar year 2011). The Company matches 50% to 100% of each employee’s +contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. The Company’s matching contributions to the Savings Plan were $90 million, $72 million and $59 million in 2011, 2010 and 2009, +respectively. 66 Restricted Stock Units A summary of the Company’s RSU activity and related information for the three years ended September 24, 2011, is as follows (in thousands, except per share amounts): Number of RSUs Weighted- Average Grant Date Fair Value Aggregate Intrinsic Value Balance at September 27, 2008 7,040 $ 134.91 RSUs units granted 7,786 $ 111.80 RSUs vested (1,935 ) $ 124.87 RSUs cancelled (628 ) $ 121.28 Balance at September 26, 2009 12,263 $ 122.52 RSUs units granted 6,178 $ 214.37 RSUs vested (4,685 ) $ 119.85 RSUs cancelled (722 ) $ 147.56 Balance at September 25, 2010 13,034 $ 165.63 RSUs units granted 6,667 $ 312.63 RSUs vested (4,513 ) $ 168.08 RSUs cancelled (742 ) $ 189.08 Balance at September 24, 2011 14,446 $ 231.49 $ 5,840,503 The fair value as of the vesting date of RSUs was $1.5 billion, $1.0 billion and $221 million for 2011, +2010 and 2009, respectively. The majority of RSUs that vested in 2011, 2010 and 2009, were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income +and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 1.6 million, 1.8 million and 707,000 for 2011, 2010 and 2009, respectively, and were based on the value +of the RSUs on their vesting date as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to the taxing authorities were $520 million, $406 million and $82 million in 2011, 2010 and 2009, +respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the number of shares that would +have otherwise been issued as a result of the vesting and did not represent an expense to the Company. 67 Stock Option Activity A summary of the Company’s stock option activity and related information for the three years ended September 24, 2011, is as follows (in thousands, except per share amounts and contractual term +in years): Outstanding Options Number of Options Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term Aggregate Intrinsic Value Balance at September 27, 2008 44,146 $ 74.39 Options granted 234 $ 106.84 Options cancelled (1,241 ) $ 122.98 Options exercised (8,764 ) $ 41.78 Balance at September 26, 2009 34,375 $ 81.17 Options granted 34 $ 202.00 Options assumed 98 $ 11.99 Options cancelled (430 ) $ 136.27 Options exercised (12,352 ) $ 62.69 Balance at September 25, 2010 21,725 $ 90.46 Options granted 1 $ 342.62 Options cancelled (163 ) $ 128.42 Options exercised (9,697 ) $ 67.63 Balance at September 24, 2011 11,866 $ 108.64 2.38 $ 3,508,243 Exercisable at September 24, 2011 11,089 $ 104.97 2.31 $ 3,319,374 Expected to vest after September 24, 2011 777 $ 161.23 3.38 $ 188,869 Aggregate intrinsic value represents the value of the Company’s closing stock price on the last +trading day of the fiscal period in excess of the weighted-average exercise price multiplied by the number of options outstanding or exercisable. Total intrinsic value of options at time of exercise was $2.6 billion, $2.0 billion and $827 million +for 2011, 2010 and 2009, respectively. Share-based Compensation Share-based compensation cost for RSUs is measured based on the closing fair market value of the Company’s common stock on the date +of grant. Share-based compensation cost for stock options and employee stock purchase plan rights (“stock purchase rights”) is estimated at the grant date and offering date, respectively, based on the fair-value as calculated by the BSM +option-pricing model. The BSM option-pricing model incorporates various assumptions including expected volatility, expected life and interest rates. The expected volatility is based on the historical volatility of the Company’s common +stock over the most recent period commensurate with the expected life of the Company’s stock options and other relevant factors including implied volatility in market traded options on the Company’s common stock. The Company bases its +expected life assumption on its historical experience and on the terms and conditions of the stock awards it grants to employees. The Company recognizes share-based compensation cost as expense on a straight-line basis over the requisite service +period. The Company granted 1,370 stock options, 34,000 stock options and 234,000 stock options during 2011, 2010 and 2009, +respectively. The weighted-average grant date fair value of stock options granted during 2011, 2010 and 2009 was $181.13, $108.58 and $46.71 per share, respectively. 68 The Company did not assume any stock options in conjunction with business combinations +during 2011 or 2009. During 2010, the Company assumed 98,000 stock options, which had a weighted-average fair value of $216.82 per share. The weighted-average fair value of stock purchase rights per share was $71.47, $45.03 and $30.62 during 2011, 2010 and 2009, respectively. The following table provides a summary of the share-based compensation expense included in the Consolidated Statements of Operations for +the three years ended September 24, 2011 (in millions): 2011 2010 2009 Cost of sales $ 200 $ 151 $ 114 Research and development 450 323 258 Selling, general and administrative 518 405 338 Total share-based compensation expense $ 1,168 $ 879 $ 710 The income tax benefit related to share-based compensation expense was $467 million, $314 million and +$266 million for 2011, 2010 and 2009, respectively. As of September 24, 2011, the total unrecognized compensation cost related to outstanding stock options and RSUs was $2.6 billion, which the Company expects to recognize over a +weighted-average period of 3.7 years. Note 7 – Commitments and Contingencies Accrued Warranty and Indemnification The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The +Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time +related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, +historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its pre-existing warranty liabilities and adjusts the amounts as +necessary based on actual experience and changes in future estimates. The following table reconciles changes in the +Company’s accrued warranty and related costs for the three years ended September 24, 2011 (in millions): 2011 2010 2009 Beginning accrued warranty and related costs $ 761 $ 577 $ 671 Cost of warranty claims (1,147 ) (713 ) (534 ) Accruals for product warranty 1,626 897 440 Ending accrued warranty and related costs $ 1,240 $ 761 $ 577 The Company generally does not indemnify end-users of its operating system and application software +against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in +the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified +third-party. In the opinion of management, there was not 69 at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of +third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of either September 24, 2011 or September 25, 2010. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company +has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal +proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances +involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not been material. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, a number of components +are currently obtained from single or limited sources, which subjects the Company to significant supply and pricing risks. Many components that are available from multiple sources are at times subject to industry-wide shortages and significant +commodity pricing fluctuations. In addition, the Company has entered into various agreements for the supply of components; however there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at +all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its financial condition and operating results. The Company and other participants in the mobile communication and media device, and personal computer industries also compete for +various components with other industries that have experienced increased demand for their products. The Company also uses some custom components that are not common to the rest of these industries, and new products introduced by the Company often +utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the +Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be +materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain +sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components customized to +meet the Company’s requirements. Substantially all of the Company’s hardware products are manufactured by +outsourcing partners that are primarily located in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the +sole-sourced suppliers of components and manufacturer for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely +affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover its requirements for periods up to 150 days. Long-Term Supply Agreements The Company has entered into long-term +agreements to secure the supply of certain inventory components. These agreements generally expire between 2012 and 2022. As of September 24, 2011, the Company had a total of $2.3 billion of inventory component prepayments outstanding, of which +$728 million are classified as other 70 current assets and $1.6 billion are classified as other assets in the Consolidated Balance Sheets. The Company had a total of $956 million of inventory component prepayments outstanding as of +September 25, 2010. The Company’s outstanding prepayments will be applied to certain inventory component purchases made during the term of each respective agreement. Other Off-Balance Sheet Commitments Lease Commitments The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company +does not currently utilize any other off-balance sheet financing arrangements. The major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for +retail space are for terms ranging from five to 20 years, the majority of which are for ten years, and often contain multi-year renewal options. As of September 24, 2011, the Company’s total future minimum lease payments under +noncancelable operating leases were $3.0 billion, of which $2.4 billion related to leases for retail space. Rent expense +under all operating leases, including both cancelable and noncancelable leases, was $338 million, $271 million and $231 million in 2011, 2010 and 2009, respectively. Future minimum lease payments under noncancelable operating leases having remaining +terms in excess of one year as of September 24, 2011, are as follows (in millions): Years 2012 $ 338 2013 365 2014 362 2015 345 2016 320 Thereafter 1,302 Total minimum lease payments $ 3,032 Other Commitments As of September 24, 2011, the Company had outstanding off-balance sheet commitments for outsourced manufacturing and component purchases of $13.9 billion. Additionally, other outstanding obligations were $2.4 billion as of September 24, 2011, and were comprised mainly of commitments +under long-term supply agreements to make additional inventory component prepayments and to acquire capital equipment, commitments to acquire product tooling and manufacturing process equipment, and commitments related to advertising, research and +development, Internet and telecommunications services and other obligations. Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and have not been fully +adjudicated, which are discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part I Item 1A under the heading “Risk Factors.” In the opinion of management, there was not at least a +reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of litigation is inherently uncertain. Therefore, although management +considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in the same reporting period for amounts in excess of management’s expectations, the Company’s consolidated +financial statements of a particular reporting period could be materially adversely affected. 71 Note 8 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal +reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its reportable operating segments, which are generally based on the nature and location of its +customers, to be the Americas, Europe, Japan, Asia-Pacific and Retail operations. The results of the Americas, Europe, Japan and Asia-Pacific reportable segments do not include results of the Retail segment. The Americas segment includes both North +and South America. The Europe segment includes European countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asian countries, other than Japan. The Retail segment operates Apple retail stores in 11 +countries. Each reportable operating segment provides similar hardware and software products and similar services. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting +Policies.” The Company evaluates the performance of its operating segments based on net sales and operating income. Net +sales for geographic segments are generally based on the location of customers, while Retail segment net sales are based on sales from the Company’s retail stores. Operating income for each segment includes net sales to third parties, related +cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and +expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, such as manufacturing costs and variances not included in standard costs, research and development, +corporate marketing expenses, share-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for +management reporting purposes. Segment assets exclude corporate assets, such as cash and cash equivalents, short-term and long-term marketable securities, other long-term investments, manufacturing and corporate facilities, product tooling and +manufacturing process equipment, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets. Except for the Retail segment, capital asset purchases for long-lived assets are not reported to management by segment. Cash +payments for capital asset purchases by the Retail segment were $612 million, $392 million and $369 million for 2011, 2010 and 2009, respectively. The Company has certain retail stores that have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. +Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. The Company allocates certain operating expenses associated with its high-profile +stores to corporate expense to reflect the estimated Company-wide benefit. The allocation of these operating costs to corporate expense is based on the amount incurred for a high-profile store in excess of that incurred by a more typical Company +retail location. The Company had opened a total of 19 high-profile stores as of September 24, 2011. Amounts allocated to corporate expense resulting from the operations of high-profile stores were $102 million, $75 million and $65 million for +2011, 2010 and 2009, respectively. 72 Summary information by operating segment for the three years ended September 24, 2011 +is as follows (in millions): 2011 2010 2009 Americas: Net sales $ 38,315 $ 24,498 $ 18,981 Operating income $ 13,538 $ 7,590 $ 6,658 Depreciation, amortization and accretion $ 15 $ 12 $ 12 Segment assets (a) $ 3,807 $ 2,809 $ 1,896 Europe: Net sales $ 27,778 $ 18,692 $ 11,810 Operating income $ 11,528 $ 7,524 $ 4,296 Depreciation, amortization and accretion $ 9 $ 9 $ 7 Segment assets $ 2,985 $ 1,926 $ 1,352 Japan: Net sales $ 5,437 $ 3,981 $ 2,279 Operating income $ 2,481 $ 1,846 $ 961 Depreciation, amortization and accretion $ 3 $ 3 $ 2 Segment assets $ 804 $ 991 $ 483 Asia-Pacific: Net sales $ 22,592 $ 8,256 $ 3,179 Operating income $ 9,587 $ 3,647 $ 1,100 Depreciation, amortization and accretion $ 3 $ 3 $ 3 Segment assets $ 1,913 $ 1,622 $ 529 Retail: Net sales $ 14,127 $ 9,798 $ 6,656 Operating income $ 3,344 $ 2,364 $ 1,677 Depreciation, amortization and accretion (b) $ 223 $ 163 $ 146 Segment assets (b) $ 2,940 $ 1,829 $ 1,344 (a) The Americas asset figures do not include fixed assets held in the U.S. Such fixed assets are not allocated specifically to the Americas segment and +are included in the corporate and Retail assets figures below. (b) Retail segment depreciation and asset figures reflect the cost and related depreciation of its retail stores and related infrastructure. A reconciliation of the Company’s segment operating income and assets to the consolidated financial +statements for the three years ended September 24, 2011 is as follows (in millions): 2011 2010 2009 Segment operating income $ 40,478 $ 22,971 $ 14,692 Other corporate expenses, net (a) (5,520 ) (3,707 ) (2,242 ) Share-based compensation expense (1,168 ) (879 ) (710 ) Total operating income $ 33,790 $ 18,385 $ 11,740 Segment assets $ 12,449 $ 9,177 $ 5,604 Corporate assets 103,922 66,006 41,897 Consolidated assets $ 116,371 $ 75,183 $ 47,501 Segment depreciation, amortization and accretion $ 253 $ 190 $ 170 Corporate depreciation, amortization and accretion 1,561 837 564 Consolidated depreciation, amortization and accretion $ 1,814 $ 1,027 $ 734 73 (a) Other corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard +costs, and other separately managed general and administrative expenses, including certain corporate expenses associated with support of the Retail segment. The U.S. and China were the only countries that accounted for more than 10% of Company’s net sales in 2011. No single country other than the U.S. accounted for more than 10% of net sales in 2010 or +2009. There was no single customer that accounted for more than 10% of net sales in 2011 or 2010. One of the Company’s customers accounted for 11% of net sales in 2009. Net sales for the three years ended September 24, 2011 and long-lived +assets as of September 24, 2011, September 25, 2010 and September 26, 2009 are as follows (in millions): 2011 2010 2009 Net sales: U.S. $ 41,812 $ 28,633 $ 22,325 China (a) 12,472 2,764 769 Other countries 53,965 33,828 19,811 Total net sales $ 108,249 $ 65,225 $ 42,905 Long-lived assets: U.S. $ 4,375 $ 3,096 $ 2,348 China (a) 2,613 1,245 365 Other countries 1,090 661 480 Total long-lived assets $ 8,078 $ 5,002 $ 3,193 (a) China includes Hong Kong. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets +related to retail stores and related infrastructure. Information regarding net sales by product for the +three years ended September 24, 2011, is as follows (in millions): 2011 2010 2009 Desktops (a) $ 6,439 $ 6,201 $ 4,324 Portables (b) 15,344 11,278 9,535 Total Mac net sales 21,783 17,479 13,859 iPod 7,453 8,274 8,091 Other music related products and services (c) 6,314 4,948 4,036 iPhone and related products and services (d) 47,057 25,179 13,033 iPad and related products and services (e) 20,358 4,958 0 Peripherals and other hardware (f) 2,330 1,814 1,475 Software, service and other net sales (g) 2,954 2,573 2,411 Total net sales $ 108,249 $ 65,225 $ 42,905 (a) Includes iMac, Mac mini, Mac Pro and Xserve product lines. (b) Includes MacBook, MacBook Air and MacBook Pro product lines. (c) Includes sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Apple-branded and third-party iPod +accessories. (d) Includes revenue recognized from iPhone sales, carrier agreements, services, and Apple-branded and third-party iPhone accessories. (e) Includes revenue recognized from iPad sales, services and Apple-branded and third-party iPad accessories. (f) Includes sales of displays, wireless connectivity and networking solutions, and other hardware accessories. (g) Includes sales from the Mac App Store in addition to sales of other Apple-branded and third-party Mac software and Mac and Internet services. 74 Note 9 – Selected Quarterly Financial Information (Unaudited) The following tables set forth a summary of the Company’s quarterly financial information for each of the four +quarters ended September 24, 2011 and September 25, 2010 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2011 Net sales $ 28,270 $ 28,571 $ 24,667 $ 26,741 Gross margin $ 11,380 $ 11,922 $ 10,218 $ 10,298 Net income $ 6,623 $ 7,308 $ 5,987 $ 6,004 Earnings per common share: Basic $ 7.13 $ 7.89 $ 6.49 $ 6.53 Diluted $ 7.05 $ 7.79 $ 6.40 $ 6.43 Fourth Quarter Third Quarter Second Quarter First Quarter 2010 Net sales $ 20,343 $ 15,700 $ 13,499 $ 15,683 Gross margin $ 7,512 $ 6,136 $ 5,625 $ 6,411 Net income $ 4,308 $ 3,253 $ 3,074 $ 3,378 Earnings per common share: Basic $ 4.71 $ 3.57 $ 3.39 $ 3.74 Diluted $ 4.64 $ 3.51 $ 3.33 $ 3.67 Basic and diluted earnings per share are computed independently for each of the quarters presented. +Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. 75 Report of Ernst & Young LLP, Independent Registered +Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 24, 2011 and September 25, 2010, and +the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended September 24, 2011. These financial statements are the responsibility of the Company’s management. +Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in +accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as +well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Inc. at September 24, 2011 and September 25, +2010, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 24, 2011, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple +Inc.’s internal control over financial reporting as of September 24, 2011, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission +and our report dated October 26, 2011 expressed an unqualified opinion thereon. /s/ Ernst & +Young LLP San Jose, California October 26, 2011 76 Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 24, 2011, based on criteria established in Internal Control – Integrated Framework issued by +the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the +effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control +over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our +audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, +in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in +accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of +September 24, 2011, based on the COSO criteria. We also have audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), the 2011 consolidated financial statements of Apple Inc. and our report dated October 26, 2011 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 26, 2011 77 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of +Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the +Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act +were effective as of September 24, 2011 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as +appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the +Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and +that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets +that could have a material effect on the financial statements. Management, including the Company’s +Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, +not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. +Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of +controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as +defined in Rule 13a-15(f) under the Exchange Act. Management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework +issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of +September 24, 2011 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with U.S. generally accepted accounting principles. The Company’s independent +registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Item 15(a) of this Annual Report on Form 10-K. 78 Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of fiscal 2011, which were +identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal +control over financial reporting. Item 9B. Other Information Not +applicable. 79 PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the heading “Directors, Executive Officers and Corporate Governance” in the Company’s 2012 Proxy Statement to be filed with the U.S. +Securities and Exchange Commission (“SEC”) in connection with the solicitation of proxies for the Company’s 2012 Annual Meeting of Shareholders (“2012 Proxy Statement”) and is incorporated herein by reference. Such Proxy +Statement will be filed with the SEC within 120 days after the end of the fiscal year to which this report relates. Item 11. Executive Compensation The information required by this Item is set forth under the headings “Executive Compensation” and “Compensation Discussion +and Analysis” in the Company’s 2012 Proxy Statement and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Security Ownership of Certain Beneficial Owners and +Management” and “Equity Compensation Plan Information” in the Company’s 2012 Proxy Statement and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the heading “Review, Approval or Ratification of Transactions with Related Persons” in the Company’s 2012 Proxy Statement and is +incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the heading “Fees Paid to Auditors” in the Company’s 2012 Proxy Statement and is incorporated herein by reference. 80 PART IV Item 15. Exhibits, Financial Statement Schedules ( a) Documents filed as part of this report ( 1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the three years ended September 24, 2011 43 Consolidated Balance Sheets as of September 24, 2011 and September 25, 2010 44 Consolidated Statements of Shareholders’ Equity for the three years ended September 24, +2011 45 Consolidated Statements of Cash Flows for the three years ended September 24, 2011 46 Notes to Consolidated Financial Statements 47 Selected Quarterly Financial Information (Unaudited) 75 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 76 ( 2) Financial Statement Schedule s All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the consolidated financial statements and notes thereto. ( b) Exhibits required by Item 601 of Regulation S-K The information required by this Item is set forth on the exhibit index that follows the signature page of this report. 81 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized, this 26th day of October 2011. APPLE INC. By: /s/  Peter Oppenheimer Peter Oppenheimer Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Peter Oppenheimer, jointly and severally, his attorneys-in-fact, each with +the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange +Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated: Name Title Date /s/    Timothy D. +Cook TIMOTHY D. COOK Chief Executive Officer and Director (Principal Executive Officer) October 26, 2011 /s/    Peter +Oppenheimer PETER OPPENHEIMER Senior Vice President, Chief +Financial Officer (Principal Financial Officer) October 26, 2011 /s/    Betsy +Rafael BETSY RAFAEL Vice President Corporate +Controller (Principal Accounting Officer) October 26, 2011 /s/    William V. +Campbell WILLIAM V. CAMPBELL Director October 26, 2011 /s/    Millard S. +Drexler MILLARD S. DREXLER Director October 26, 2011 /s/    Albert Gore, +Jr. ALBERT GORE, JR. Director October 26, 2011 /s/    Andrea +Jung ANDREA JUNG Director October 26, 2011 /s/    Arthur D. +Levinson ARTHUR D. LEVINSON Director October 26, 2011 /s/    Ronald D. +Sugar RONALD D. SUGAR Director October 26, 2011 82 EXHIBIT INDEX Exhibit Number Exhibit Description Incorporated +by Reference Form Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on July 10, 2009. 10-Q 6/27/09 3.2 Bylaws of the Registrant, as amended through April 20, 2011. 10-Q 3/26/11 4.1 Form of Stock Certificate of the Registrant. 10-Q 12/30/06 10.1* Employee Stock Purchase Plan, as amended through March 8, 2010. 10-Q 3/27/10 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 6/27/09 10.3* 1997 Director Stock Plan, as amended through February 25, 2010. 8-K 3/1/10 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement effective as of August 28, 2007. 10-K 9/29/07 10.6* Form of Restricted Stock Unit Award Agreement effective as of November 11, 2008. 10-Q 12/27/08 10.7* Form of Restricted Stock Unit Award Agreement effective as of November 16, 2010. 10-Q 12/25/10 14.1** Business Conduct Policy of the Registrant dated July 2011. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signature Page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS XBRL Instance Document 101.SCH XBRL Taxonomy Extension Schema Document 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF XBRL Taxonomy Extension Definition Linkbase Document 101.LAB XBRL Taxonomy Extension Label Linkbase Document 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. 83 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-12-444068/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-12-444068/full-submission.txt new file mode 100644 index 0000000..83fbd1e --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-12-444068/full-submission.txt @@ -0,0 +1,1072 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 29, 2012 or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number: 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 996-1010 Securities registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Stock Market LLC (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports +pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports +required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such +filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically +and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the +registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K (section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III +of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate +by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and +“smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting and non-voting stock held by +non-affiliates of the registrant, as of March 30, 2012, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $560,356,000,000 based upon the closing price reported for such date on the +NASDAQ Stock Market LLC. Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the registrant as of such date have been excluded because such persons may be deemed to be affiliates. This +determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 940,692,000 shares of common stock were issued and outstanding as of October 19, 2012. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s +definitive proxy statement relating to its 2013 annual meeting of shareholders (the “2013 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2013 Proxy Statement will be +filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Table of Contents The Business section and other parts of this Annual Report on Form 10-K (“Form +10-K”) contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in “Management’s +Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any +historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” +“predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ +significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk +Factors,” which are incorporated herein by reference. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company +assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures and markets mobile communication and media devices, personal +computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple TV ® , a portfolio of consumer and professional software applications, the iOS and OS X ® operating systems, iCloud ® , +and a variety of accessory, service and support offerings. The Company also sells and delivers digital content and applications through the iTunes Store ® , App Store SM , +iBookstore SM , and Mac App Store. The Company sells its +products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party +iPhone, iPad, Mac and iPod compatible products, including application software, and various accessories, through its online and retail stores. The Company sells to consumers; small and mid-sized businesses (“SMB”); and education, +enterprise and government customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company’s fiscal +calendar. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, +software, peripherals, and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions +with superior ease-of-use, seamless integration, and innovative design. The Company believes continual investment in research and development, marketing and advertising is critical to the development and sale of innovative products and technologies. +As part of its strategy, the Company continues to expand its platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. As part of the iTunes Store, the Company’s App Store and iBookstore +allow customers to discover and download applications and books through either a Mac or Windows-based computer or through “iOS devices,” namely iPhone, iPad and iPod touch ® . The Company’s Mac App Store allows customers to easily discover, download and install Mac applications. The Company also supports a community for the +development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company’s strategy also includes expanding its distribution network to effectively reach more customers and provide +them with a high-quality sales and post-sales support experience. 1 Table of Contents Consumer and Small and Mid-Sized Business The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s +products and services greatly enhances its ability to attract and retain customers. The Company sells its products and resells third-party products in most of its major markets directly to consumers and SMBs through its retail and online stores. The +Company has also invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain +third-party resellers focus on the Apple platform by providing a high level of product expertise, integration and support services. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable +high-traffic locations the Company is better positioned to ensure a high quality customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and +related solutions. To that end, retail store configurations have evolved into various sizes to accommodate market-specific demands. The Company believes providing direct contact with its customers is an effective way to demonstrate the advantages of +its products over those of its competitors. The stores employ experienced and knowledgeable personnel who provide product advice, service and training. The stores offer a wide selection of third-party hardware, software, and other accessories and +peripherals that complement the Company’s products. Education The Company is committed to delivering solutions to help educators teach and students learn. The Company believes +effective integration of technology into classroom instruction can result in higher levels of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also supports +mobile learning and real-time distribution of, and access to, education related materials through iTunes U ® , a +platform that allows students and teachers to share and distribute educational media online. The Company sells its products to the education market through its direct sales force, select third-party resellers and its online and retail stores. Enterprise and Government The Company also sells its hardware and software products to enterprise and government customers in each of its geographic segments. The Company’s products are deployed in these markets because of +their performance, productivity, ease of use and seamless integration into information technology environments. The Company’s products are compatible with thousands of third-party business applications and services, and its tools enable the +development and secure deployment of custom applications as well as remote device administration. Business Organization The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its reportable operating segments, +which are generally based on the nature and location of its customers, to be the Americas, Europe, Japan, Asia-Pacific and Retail. The results of the Americas, Europe, Japan and Asia-Pacific segments do not include results of the Retail segment. The +Americas segment includes both North and South America. The Europe segment includes European countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asian countries, other than Japan. The Retail segment +operates Apple retail stores in 13 countries, including the U.S. Each operating segment provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Part +II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 8, “Segment Information and Geographic +Data.” 2 Table of Contents Products The Company offers a range of mobile communication and media devices, personal computing products, and portable digital music players, as well as a variety of related software, services, peripherals, +networking solutions and third-party hardware and software products. In addition, the Company offers its own software products, including iOS, the Company’s mobile operating system; OS X, the Company’s Mac operating system; and server and +application software. The Company’s primary products are discussed below. iPhone iPhone combines a mobile phone, an iPod, and an Internet communications device in a single handheld product. Based on the Company’s +Multi-Touch™ user interface, iPhone features desktop-class email, web browsing, searching, and maps and is compatible with both Mac and Windows-based computers. iPhone automatically syncs content from users’ iTunes libraries, as well +as contacts, bookmarks, and email accounts. iPhone allows customers to access the iTunes Store to download audio and video files, as well as a variety of other digital content and applications. In September 2012, the Company launched iPhone 5, +its latest version of iPhone. In addition to the Company’s own iPhone accessories, third-party iPhone compatible accessories are available through the Company’s online and retail stores and from third parties. iPad iPad is a +multi-purpose mobile device for browsing the web, reading and sending email, viewing photos, watching videos, listening to music, playing games, reading e-books and more. iPad is based on the Company’s Multi-Touch technology and allows +customers to connect with their applications and content in a more interactive way. iPad allows customers to access the iTunes Store to download audio and video files, as well as a variety of other digital content and applications. In March 2012, +the Company launched the new iPad, its third generation iPad, and in October 2012, the Company announced its fourth generation iPad and iPad mini, which are expected to be available in November 2012. In addition to the Company’s own iPad +accessories, third-party iPad compatible accessories are available through the Company’s online and retail stores and from third parties. Mac The Company offers a range of personal computing products including desktop and portable computers, related devices +and peripherals, and third-party hardware products. The Company’s Mac desktop and portable systems feature Intel microprocessors, the OS X operating system and the iLife ® suite of software for creation and management of digital photography, music, movies, DVDs and websites. The Company’s desktop computers include iMac ® , Mac Pro ® and Mac mini. The +Company’s portable computers include MacBook Pro ® and MacBook Air ® . iPod The Company’s iPod line of portable digital music and media players includes iPod touch, iPod +nano ® , iPod shuffle ® and iPod classic ® . All iPods +work with iTunes. In addition to the Company’s own iPod accessories, third-party iPod-compatible accessories are available through the Company’s online and retail stores and from third parties. The iPod touch, based on iOS, is a flash-memory-based iPod with a widescreen Retina™ display, a Multi-Touch +user interface, and built-in iSight ® camera. iPod touch allows customers to access the iTunes Store to download +audio and video content, as well as a variety of digital applications. The iPod nano is a flash-memory-based iPod that features the Company’s Multi-Touch interface allowing customers to navigate their music collection by tapping or swiping the +display and built-in Bluetooth for wireless listening. The iPod shuffle is a flash-memory- 3 Table of Contents based iPod that features a clickable control pad to control music playback and VoiceOver +technology enabling customers to hear song titles, artists and playlist names. The iPod classic is a hard-drive based portable digital music and video player. iTunes ® iTunes is an application that supports the purchase, download, organization and playback of digital audio and video +files and is available for both Mac and Windows-based computers. iTunes features integration with iCloud, +AirPlay ® wireless music playback, Genius Mixes, Home Sharing, and syncing functionality with iOS devices . iTunes is integrated with the iTunes Store, a service that allows customers to discover, purchase, +rent, and download digital content and applications. The iTunes Store includes the App Store and iBookstore. The App Store allows customers to discover and download applications, and the iBookstore features electronic books from major and +independent publishers and allows customers to preview and buy books for their iOS devices. Customers can access the App Store through either a Mac or Windows-based computer or through an iOS device. The iBookstore is accessed through the iBooks ® application on an iOS device. Mac App Store The Mac App Store allows customers to +discover, download and install Mac applications. The Mac App Store offers applications in education, games, graphics and design, lifestyle, productivity, utilities and other categories. The Company’s OS X operating system software and its +iLife, iWork ® and other application software titles are also available on the Mac App Store. iCloud iCloud is the +Company’s cloud service, which stores music, photos, applications, contacts, calendars, and documents and wirelessly pushes them to multiple iOS devices, Mac and Windows-based computers. iCloud’s features include iTunes in the Cloud, Photo +Stream, Documents in the Cloud, Contacts, Calendar, Mail, automatic downloads and purchase history for applications and iBooks, and iCloud Backup. Users can sign up for free access to iCloud using a device running qualifying versions of +iOS or OS X. Software Products The Company offers a range of software products for consumers and for SMB, education, enterprise and government customers, including the Company’s iOS and OS X operating system software; server +software; professional application software; and consumer, education, and business oriented application software. Operating System Software iOS iOS is the Company’s mobile operating system that serves as the foundation for iOS devices. In September 2012, the Company released iOS 6, the latest version of its mobile operating system. iOS +supports iCloud and includes features such as Notification Center, a way to view and manage notifications in one place; iMessage™, a messaging service that allows users to send text messages, photos and videos between iOS devices; and Maps, +with turn-by-turn navigation. iOS supports Siri ® , a voice activated intelligent assistant, which is available on +qualifying iOS devices. 4 Table of Contents OS X OS X, the Company’s Mac operating system, is built on an open-source UNIX-based foundation. OS X Mountain Lion is the ninth major release of OS X and became available in July 2012. OS X Mountain Lion +includes iCloud integration, Notification Center, iMessage, and system-wide support for full screen applications. Application Software iLife iLife is the Company’s consumer-oriented digital lifestyle application suite included with all Mac computers. iLife features iPhoto ® , iMovie ® , iDVD ® , GarageBand ® , and iWeb™. iPhoto is the Company’s consumer-oriented digital photo application and iMovie is the Company’s consumer-oriented digital video editing +software application. iDVD is the Company’s consumer-oriented software application that enables customers to turn iMovie files, QuickTime files, and digital pictures into interactive DVDs. GarageBand is the Company’s consumer-oriented +music creation application that allows customers to play, record and create music. iWeb allows customers to create online photo albums, blogs and podcasts, and to customize websites using editing tools. iWork iWork is the Company’s integrated productivity suite designed to help users create, present, and publish +documents, presentations, and spreadsheets. iWork includes Pages ® for word processing and page layout, Keynote ® for presentations, and Numbers ® for spreadsheets. The Company also has a Multi-Touch version of each iWork application designed specifically for use on iOS devices. Other Application Software The Company also sells various other application software, including Final Cut +Pro ® , Logic Studio ® , Logic ® Pro, and its +FileMaker ® Pro database software. Displays & Peripheral Products The Company manufactures the Apple +LED Cinema Display™ and Thunderbolt Display. The Company also sells a variety of Apple-branded and third-party Mac-compatible and iOS-compatible peripheral products, including printers, storage devices, computer memory, digital video and still +cameras, and various other computing products and supplies. Apple TV Apple TV allows customers to watch movies and television shows on their high definition television. Content from iTunes, Netflix, YouTube, and Flickr as well as music, photos, videos, and podcasts from a +Mac or Windows-based computer can also be wirelessly streamed to a television through Apple TV. Product Support and Services AppleCare ® offers a range of support options for the Company’s customers. These include assistance that is built into software products, printed and electronic product +manuals, online support including comprehensive product information as well as technical assistance, the AppleCare Protection Plan (“APP”) and the AppleCare+ Protection Plan (“APP+”). APP is a fee-based service that typically +includes two to three years of phone support, hardware repairs and dedicated web-based support resources. APP+ is a fee-based service available in certain countries for iPhone and iPad. APP+ offers coverage for two instances of accidental damage in +addition to the services offered by APP. 5 Table of Contents Markets and Distribution The Company’s customers are primarily in the consumer, SMB, education, enterprise and government markets. The Company uses a variety of direct and indirect distribution channels, such as its retail +stores, online stores, and direct sales force, and third-party cellular network carriers, wholesalers, retailers, and value-added resellers. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable +salespersons who can convey the value of the hardware and software integration, and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an +effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality +buying experience for its products in which service and education are emphasized, the Company continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. Additionally, the Company has +invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party +resellers focus on the Apple platform by providing a high level of integration and support services, and product expertise. No single +customer accounted for more than 10% of net sales in 2012, 2011 or 2010. Competition The markets for the Company’s products and services are highly competitive and the Company is confronted by aggressive competition in +all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the capabilities and use of mobile communication and media devices, personal computers, +and other digital electronic devices. The Company’s competitors who sell mobile devices and personal computers based on other operating systems have aggressively cut prices and lowered their product margins to gain or maintain market share. The +Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. Principal competitive factors important to the Company include price, product features, relative +price/performance, product quality and reliability, design innovation, a strong third-party software and peripherals ecosystem, marketing and distribution capability, service and support, and corporate reputation. The Company is focused on expanding its market opportunities related to personal computers and mobile communication and media devices. +These markets are highly competitive and include several large, well-funded and experienced participants. The Company expects competition in these markets to intensify significantly as competitors attempt to imitate some of the features of the +Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. These markets are characterized by aggressive pricing +practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers and businesses. The Company’s digital content services have faced significant competition from other companies promoting their own digital music and +content products and services, including those offering free peer-to-peer music and video services. The Company’s future +financial condition and operating results depend on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets in which it competes. The Company believes it offers superior innovation and +integration of the entire solution including the hardware (iPhone, iPad, Mac, and iPod), software (iTunes), online services (iCloud), and distribution of digital content and applications (iTunes Store, App Store, iBookstore and Mac App Store). Some +of the Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. 6 Table of Contents Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently obtained from single or limited sources, which +subjects the Company to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. In addition, the +Company has entered into various agreements for the supply of components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to +significant risks of supply shortages and price increases that can materially adversely affect its financial condition and operating results. The Company and other participants in the markets for mobile communication and media devices and personal computers also compete for various components with other industries that have experienced +increased demand for their products. The Company also uses some custom components that are not common to the rest of these industries, and new products introduced by the Company often utilize custom components available from only one source. When a +component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were +delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and +financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued +availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components customized to meet the Company’s requirements. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia. A +significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for +many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their +production commitments. The Company’s purchase commitments typically cover its requirements for periods up to 150 days. Research and +Development Because the industries in which the Company competes are characterized by rapid technological advances, the +Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance +existing products and to expand the range of its product offerings through research and development, licensing of intellectual property and acquisition of third-party businesses and technology. Total research and development expense was $3.4 +billion, $2.4 billion, and $1.8 billion in 2012, 2011, and 2010, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its iPhone, iPad, Mac and iPod +devices, peripherals, software and services. The Company has registered or has applied for trademarks and service marks in the U.S. and a number of foreign countries. Although the Company believes the ownership of such patents, copyrights, +trademarks and service marks is an important factor in its business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its +personnel. The Company regularly files patent applications to protect innovations arising from its research, development and +design, and is currently pursuing thousands of patent applications around the world. Over time, the Company 7 Table of Contents has accumulated a large portfolio of issued patents in the U.S. and worldwide. The Company holds copyrights relating to certain aspects of its products and services. No single patent or +copyright is solely responsible for protecting the Company’s products. The Company believes the duration of its patents is adequate relative to the expected lives of its products. Many of the Company’s products are designed to include intellectual property obtained from third parties. It may be necessary in the +future to seek or renew licenses relating to various aspects of its products and business methods. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such +licenses could be obtained in the future on reasonable terms or at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage, and the rapid rate of issuance of new patents, it is +possible that certain components of the Company’s products and business methods may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing +certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data During 2012, the Company’s domestic and international net sales accounted for 39% and 61%, respectively, of +total net sales. Information regarding financial data by geographic segment is set forth in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in +the Notes to Consolidated Financial Statements in Note 8, “Segment Information and Geographic Data.” Final assembly +of the Company’s products is currently performed in the Company’s manufacturing facility in Ireland, and by outsourcing partners located primarily in Asia. The supply and manufacture of a number of components is performed by sole-sourced +outsourcing partners in the U.S., Asia and Europe. Outsourcing partners in Asia perform final assembly of substantially all of the Company’s hardware products. Margins on sales of the Company’s products in foreign countries, and on sales +of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. Information regarding +concentration in the available sources of supply of materials and products is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 7, “Commitments and Contingencies.” Seasonal Business The +Company has historically experienced higher net sales in its first fiscal quarter compared to other quarters in its fiscal year due in part to holiday seasonal demand. Actual and anticipated timing of new product introductions by the Company can +also significantly impact the level of net sales experienced by the Company in any particular quarter. However, neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the +Company’s future net sales or financial performance. Warranty The Company offers a limited parts and labor warranty on most of its hardware products. The basic warranty period is typically one year +from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In addition, where available, consumers may purchase APP or APP+, which +extends service coverage on many of the Company’s hardware products. Backlog In the Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future +business prospects. In particular, backlog often increases in anticipation of or immediately 8 Table of Contents following new product introductions as customers anticipate shortages. Backlog is often reduced once customers believe they can obtain sufficient supply. Because of the foregoing, backlog should +not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial performance. Employees As of +September 29, 2012, the Company had approximately 72,800 full-time equivalent employees and an additional 3,300 full-time equivalent temporary employees and contractors. Approximately 42,400 of the total full-time equivalent employees worked in +the Company’s Retail segment. Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange +Act of 1934, as amended (the “Exchange Act”), are filed with the U.S. Securities and Exchange Commission (the “SEC”). The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, +proxy statements, and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at www.apple.com/investor when such reports are available on the +SEC’s website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the +Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov. The +contents of these websites are not incorporated into this filing. Further, the Company’s references to the URLs for these websites are intended to be inactive textual references only. Item 1A. Risk Factors Because of +the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not +use historical trends to anticipate results or trends in future periods. Global economic conditions could materially +adversely affect the Company. The Company’s operations and performance depend significantly on worldwide economic +conditions. Uncertainty about global economic conditions poses a risk as consumers and businesses postpone spending in response to tighter credit, unemployment, negative financial news and/or declines in income or asset values. For example, the +continuing sovereign debt crisis, financial market volatility, and other factors in Europe have resulted in reduced consumer and business confidence and spending in many countries. These worldwide and regional economic conditions could have a +material adverse effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations because the Company generally raises prices on goods and services sold outside the U.S. to +correspond with the effect of a strengthening of the U.S. dollar. Other factors that could influence demand include increases in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare +costs, access to credit, consumer confidence, and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services. In the event of financial turmoil affecting the banking system and financial markets, additional consolidation of the financial +services industry, or significant financial service institution failures, there could be a new or incremental tightening in the credit markets, low liquidity, and extreme volatility in fixed income, credit, currency, and equity markets. +This could have a number of effects on the Company’s business, including the insolvency or financial instability of outsourcing partners or suppliers or their inability to obtain credit to finance 9 Table of Contents development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the Company’s +products; and failure of derivative counterparties and other financial institutions. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial +instruments; impairment charges resulting from revaluations of debt and equity securities and other investments; interest rates; cash balances; and changes in fair value of derivative instruments. Increased volatility in the financial +markets and overall economic uncertainty would increase the risk of the actual amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. Global markets for the Company’s products and services are highly competitive and subject to rapid technological +change, and the Company may be unable to compete effectively in these markets. The Company’s products and services +compete in highly competitive global markets characterized by aggressive price cutting and resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual +improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors, and price sensitivity on the part of consumers. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of +innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications, and +related services. As a result, the Company must make significant investments in research and development and currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, +trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company’s products and +infringing its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s +ability to maintain a competitive advantage could be adversely affected. The Company markets certain mobile communication and +media devices based on the iOS mobile operating system and also markets related third-party digital content and applications. The Company faces substantial competition in these markets from companies that have significant technical, marketing, +distribution and other resources, as well as established hardware, software and digital content supplier relationships. Additionally, the Company faces significant price competition as competitors reduce their selling prices and attempt to imitate +the Company’s product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company also competes with illegitimate +ways to obtain third-party digital content and applications. The Company has entered the mobile communications and media device markets, and some of its competitors in these markets have greater experience, product breadth and distribution channels +than the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide such products and services at little or no profit or even at a loss. The Company +also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing these components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company’s +financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to maintain their functional and design advantages. The Company is the only authorized maker of hardware using OS X, which has a minority market share in the personal computer market. This +market is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and peripherals, the Company faces a significant number of competitors, many of which have broader product lines, +lower priced products, and a larger installed customer base. Historically, consolidation in this market has resulted in larger competitors. Price competition has 10 Table of Contents been particularly intense as competitors selling Windows-based personal computers have aggressively cut prices and lowered product margins. An increasing number of Internet-enabled devices that +include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s existing products. The Company’s financial condition and operating results depend substantially on +its ability to continually improve the Mac platform to maintain its functional and design advantages. There can be no +assurance the Company will be able to continue to provide products and services that compete effectively. To remain +competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products +and services, and effectively stimulate customer demand for new and upgraded products. The success of new product introductions depends on a number of factors including, but not limited to, timely and successful product development, market +acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in +line with anticipated product demand, the availability of products in appropriate quantities and costs to meet anticipated demand, and the risk that new products may have quality or other defects in the early stages of introduction. Accordingly, the +Company cannot determine in advance the ultimate effect of new product introductions and transitions. The Company faces +substantial inventory and other asset risk in addition to purchase commitment cancellation risk. The Company records a +write-down for product and component inventories that have become obsolete or exceed anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews +its long-lived assets, including capital assets held at its suppliers’ facilities, for impairment whenever events or circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment has +occurred, it records a write-down equal to the amount by which the carrying value of the assets exceeds its fair market value. Although the Company believes its provisions related to inventory, capital assets, other assets and purchase commitments +are currently adequate, no assurance can be given that the Company will not incur additional related charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with +industry practice, components are normally acquired through a combination of purchase orders, supplier contracts, open orders and, where appropriate, inventory component prepayments, in each case based on projected demand. Such purchase commitments +typically cover forecasted component and manufacturing requirements for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast +incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities. Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing +risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. While the Company has entered into various agreements for the supply of +components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. The follow-on effects from 11 Table of Contents global economic conditions on the Company’s suppliers, described in “ Global economic conditions could materially adversely affect the Company” above, also could affect +the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases. The Company expects to experience decreases in its gross margin percentage in future +periods, as compared to levels achieved during 2012, largely due to a higher mix of new and innovative products with flat or reduced pricing that have higher cost structures and deliver greater value to customers and anticipated component cost and +other cost increases. Future strengthening of the U.S. dollar could also negatively impact gross margin. The Company and +other participants in the markets for mobile communication and media devices and personal computers also compete for various components with other industries that have experienced increased demand for their products. The Company uses some custom +components that are not common to the rest of these industries. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist +until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common +components instead of components customized to meet the Company’s requirements. The supply of components for a new or existing product could be delayed or constrained, or a key manufacturing vendor could delay shipments of completed products to +the Company. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of +whom are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in +part by a few outsourcing partners located primarily in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control +over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these +partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect or warranty liability. +While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The supply and manufacture of many critical components is performed by sole-sourced outsourcing partners in the U.S., Asia and Europe. Outsourcing partners in Asia perform final assembly of substantially +all of the Company’s hardware products. Manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information +technology system failures, military actions or economic, business, labor, environmental, public health, or political issues. The Company relies on third-party intellectual property and digital content, which may not be available to the Company on commercially +reasonable terms or at all. Many of the Company’s products include third-party intellectual property, which requires +licenses from those third parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on +acceptable terms or at all. The Company also contracts with third parties to offer their digital content through the iTunes +Store. The licensing arrangements with these third parties are short-term and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content providers and distributors currently or in the +future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license their content in the future. Other content owners, providers or distributors 12 Table of Contents may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at reasonable prices with +acceptable usage rules, or continue to expand its geographic reach. Many third-party content providers require the Company to +provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such +solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of +content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company is frequently involved in intellectual property litigation, and could be found to have infringed on intellectual property +rights. Technology companies, including many of the Company’s competitors, frequently enter into litigation based on +allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or otherwise obtained. As the Company has grown, the intellectual property +rights claims against it have increased and may continue to increase. In particular, the Company’s cellular enabled products compete with mobile communication and media device companies that hold significant patent portfolios, and the number of +patent claims against the Company has significantly increased. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and before the U.S. International Trade Commission, as well as internationally +in Europe and Asia. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the +scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or actual litigants, the Company may have to engage in protracted litigation. Such litigation is often expensive, time-consuming, +disruptive to the Company’s operations, and distracting to management. If the Company is found to infringe one or more patents or other intellectual property rights, regardless of whether it can develop non-infringing technology, it may be +required to pay substantial damages or royalties to a third-party, or it may be subject to a temporary or permanent injunction prohibiting the Company from marketing or selling certain products. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no assurance can be given +that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Company’s operating expenses. In management’s opinion, there is not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss +contingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or +more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely +affected. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software +applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be +developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. 13 Table of Contents With respect to its Mac products, the Company believes the availability of third-party +software applications and services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company’s products compared to Windows-based products. +This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, continued growth of Mac sales, and the costs of developing such applications and services. If the +Company’s minority share of the global personal computer market causes developers to question the Company’s prospects, developers could be less inclined to develop or upgrade software for the Company’s products and more inclined to +devote their resources to developing and upgrading software for the larger Windows market. With respect to iOS devices, the +Company relies on the continued availability and development of compelling and innovative software applications, which are distributed through a single distribution channel, the App Store. The absence of multiple distribution channels, which are +available for competing platforms, may limit the availability and acceptance of third-party applications by the Company’s customers, thereby causing developers to reduce or curtail development for the iOS platform. In addition, iOS devices are +subject to rapid technological change, and, if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied customers. As with +applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the relative benefits of developing software for the Company’s products rather +than its competitors’ platforms, such as Android. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s iOS devices may suffer. The Company depends on the performance of distributors, carriers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers, and value-added +resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers, and consumers and small +and mid-sized businesses through its online and retail stores. Carriers providing cellular network service for iPhone +typically subsidize users’ purchase of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters +into with new carriers. Many resellers have narrow operating margins and have been adversely affected in the past by weak +economic conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. Such a perception could discourage +resellers from investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company has invested and will continue to invest in programs to enhance reseller sales, +including staffing selected resellers’ stores with Company employees and contractors and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. +The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for the Company’s products could cause resellers to reduce their ordering and +marketing of the Company’s products. The Company’s Retail segment has required and will continue to require a +substantial investment and commitment of resources and is subject to numerous risks and uncertainties. The Company’s +retail stores have required substantial fixed investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain +stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require +substantially more investment than the 14 Table of Contents Company’s more typical retail stores. Due to the high fixed cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of individual or multiple +stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements, and severance costs. Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and uncertainties. These risks and uncertainties include, but are not limited to, macro-economic +factors that could have an adverse effect on general retail activity, as well as the Company’s inability to manage costs associated with store construction and operation, failure to manage relationships with its existing retail channel +partners, more challenging environments in managing retail operations outside the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and inability to obtain and renew leases in quality retail locations at a +reasonable cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business +and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business +strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital, and unidentified +issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. The Company’s products and services may experience quality problems from time to time that can result in decreased sales and +operating margin. The Company sells complex hardware and software products and services that can contain design and +manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. The Company’s online +services may from time to time experience outages, service slowdowns, or errors. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all +defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, significant warranty and other expenses, and harm to the Company’s reputation. The Company is subject to laws and regulations worldwide, changes to which could increase the Company’s costs and individually or +in the aggregate adversely affect the Company’s business. The Company is subject to laws and regulations affecting +its domestic and international operations in a number of areas. These U.S. and foreign laws and regulations affect the Company’s activities including, but not limited to, areas of labor, advertising, digital content, consumer protection, +real estate, billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import and export requirements, anti-corruption, foreign +exchange controls and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health, and safety. By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes could +include, among others, restrictions on the production, manufacture, distribution, and use of the device, locking the device to a carrier’s network, or mandating the use of the device on more than one carrier’s network. These devices are +also subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in +additional testing requirements, product modifications, delays in product shipment dates, or preclude the Company from selling certain products. Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent from jurisdiction to jurisdiction, further increasing the cost of +compliance. This increases the costs of doing business, and any such costs, which may rise in the future as a result of changes in these laws and 15 Table of Contents regulations or in their interpretation could individually or in the aggregate make the Company’s products and services less attractive to the Company’s customers, delay the introduction +of new products in one or more regions, or cause the Company to change or limit its business practices. The Company has implemented policies and procedures designed to ensure compliance with these laws and regulations, but there can be no assurance +that the Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies. The +Company’s success depends largely on the continued service and availability of key personnel. Much of the +Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high +demand and competition for their talents is intense, especially in the Silicon Valley, where most of the Company’s key personnel are located. The Company’s business may be impacted by political events, war, terrorism, public health issues, natural disasters and other circumstances. War, terrorism, geopolitical uncertainties, public health issues, and other business interruptions have caused and could cause damage or +disruption to international commerce and the global economy, and thus could have a material adverse effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channel partners. The Company’s +business operations are subject to interruption by natural disasters, fire, power shortages, nuclear power plant accidents, terrorist attacks, and other hostile acts, labor disputes, public health issues, and other events beyond its control. Such +events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and deliver products to its customers, including channel partners, or to receive components from its suppliers, and create delays +and inefficiencies in the Company’s supply chain. Should major public health issues, including pandemics, arise, the Company could be adversely affected by more stringent employee travel restrictions, additional limitations in freight services, +governmental actions limiting the movement of products between regions, delays in production ramps of new products, and disruptions in the operations of the Company’s manufacturing vendors and component suppliers. The majority of the +Company’s research and development activities, its corporate headquarters, information technology systems, and other critical business operations, including certain component suppliers and manufacturing vendors, are in locations that could be +affected by natural disasters. In the event of a natural disaster, the Company could incur significant losses, require substantial recovery time and experience significant expenditures in order to resume operations. The Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company may be subject to information technology system failures and network disruptions. These may be caused by +natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or similar events or disruptions. System redundancy may be ineffective or inadequate, and the +Company’s disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could prevent access to the Company’s online stores and services, preclude retail store transactions, compromise Company or +customer data, and result in delayed or cancelled orders. System failures and disruptions could also impede the manufacturing and shipping of products, delivery of online services, transactions processing and financial reporting. The Company may be subject to breaches of its information technology systems, which could damage business partner and customer +relationships, curtail or otherwise adversely impact access to online stores and services, and could subject the Company to significant reputational, financial, legal, and operational consequences. The Company’s business requires it to use and store customer, employee, and business partner personally identifiable information +(“PII”). This may include names, addresses, phone numbers, email addresses, contact 16 Table of Contents preferences, tax identification numbers, and payment account information. Although malicious attacks to gain access to PII affect many companies across various industries, the Company may be at a +relatively greater risk of being targeted because of its high profile and the amount of PII managed. The Company requires +user names and passwords in order to access its information technology systems. The Company also uses encryption and authentication technologies to secure the transmission and storage of data. These security measures may be compromised as a result +of third-party security breaches, employee error, malfeasance, faulty password management, or other irregularity, and result in persons obtaining unauthorized access to Company data or accounts. Third parties may attempt to fraudulently induce +employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors +accounts and systems for unusual activity and may freeze accounts under suspicious circumstances, which may result in the delay or loss of customer orders. The Company devotes significant resources to network security, data encryption, and other security measures to protect its systems and data, but these security measures cannot provide absolute security. +The Company may experience a breach of its systems and may be unable to protect sensitive data. Moreover, if a computer security breach affects the Company’s systems or results in the unauthorized release of PII, the Company’s reputation +and brand could be materially damaged and use of the Company’s products and services could decrease. The Company would also be exposed to a risk of loss or litigation and possible liability. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding +data protection. The Company is subject to federal, state and international laws relating to the collection, use, +retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also to transfers of information between the Company and its subsidiaries, and among the Company, its subsidiaries and other parties +with which the Company has commercial relations. Several jurisdictions have passed new laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from +jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in penalties or +significant legal liability. The Company’s privacy policy and related practices concerning the use and disclosure of +data are posted on its website. Any failure by the Company, its suppliers or other parties with whom the Company does business to comply with its posted privacy policy or with other federal, state or international privacy-related or data protection +laws and regulations could result in proceedings against the Company by governmental entities or others. The Company is also +subject to payment card association rules and obligations under its contracts with payment card processors. Under these rules and obligations, if information is compromised, the Company could be liable to payment card issuers for the cost of +associated expenses and penalties. In addition, if the Company fails to follow payment card industry security standards, even if no customer information is compromised, the Company could incur significant fines or experience a significant increase +in payment card transaction costs. The Company expects its quarterly revenue and operating results to fluctuate. The Company’s profit margins vary among its products and its distribution channels. The Company’s software, +accessories, and service and support contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can change over time as a +result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its 17 Table of Contents indirect sales through its channel partners. In addition, the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted +as a result of a shift in product, geographic or channel mix, new products, component cost increases, strengthening U.S. dollar, or price competition. The Company has typically experienced higher net sales in the first fiscal quarter compared to +other fiscal quarters due in part to holiday seasonal demand. Actual and anticipated timing of new product introductions by the Company can also significantly impact the level of net sales experienced by the Company in any particular quarter. The +Company could be subject to unexpected developments late in a quarter, such as lower-than-anticipated demand for the Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the Company’s +logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock continues to experience substantial price volatility. Additionally, the Company, the technology +industry, and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. The Company believes its +stock price reflects high future growth and profitability expectations. If the Company fails to meet these expectations its stock price may significantly decline, which could have a material adverse impact on investor confidence and employee +retention. The Company’s business is subject to the risks of international operations. The Company derives a significant portion of its revenue and earnings from its international operations. Compliance with applicable U.S. +and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy requirements, environmental laws, labor laws, and anti-competition +regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with these laws and regulations, a violation by the Company’s employees, contractors, or agents +could nevertheless occur. The Company also could be significantly affected by other risks associated with international +activities including, but not limited to, economic and labor conditions, increased duties, taxes and other costs, political instability, and changes in the value of the U.S. dollar versus local currencies. Margins on sales of the Company’s +products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including +duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its trade receivables with customers in certain international markets. There can be no assurance the Company can effectively limit its credit +risk and avoid losses. The Company’s primary exposure to movements in foreign currency exchange rates relates to +non-U.S. dollar denominated sales and operating expenses worldwide. For example, the uncertainty regarding the ability of certain European countries to continue to service their sovereign debt obligations and the related financial restructuring +efforts by European governments may cause the value of several European currencies, including the euro, to fluctuate, which could adversely affect the Company’s non-U.S. dollar sales and operating expenses in the impacted jurisdictions. +Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally leads the Company to raise international pricing, potentially +reducing demand for the Company’s products. In some circumstances, for competitive or other reasons, the Company may decide not to raise local prices to fully offset the dollar’s strengthening, or at all, which would adversely affect the +U.S. dollar value of the Company’s foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency-denominated +sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may also increase the +Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. 18 Table of Contents The Company uses derivative instruments, such as foreign currency forward and option +contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange +rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the market +values of its investment portfolio. The Company has not recognized any significant losses on its cash, cash equivalents +and marketable securities, but could experience significant declines in the market value of its investment portfolio. Given the global nature of its business, the Company has both domestic and international investments. Credit ratings and pricing of +these investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents and +marketable securities could decline and result in a significant impairment. The Company is exposed to credit risk on its +trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. A +substantial majority of the Company’s outstanding trade receivables are not covered by collateral or credit insurance. The Company’s exposure to credit and collectability risk on its trade receivables is higher in certain international +markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble +final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 29, 2012, a significant portion of the Company’s trade +receivables were concentrated within cellular network carriers, and its non-trade receivables and long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and +limit exposure to credit risk on its trade and vendor non-trade receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be impacted by unfavorable results of legal proceedings. The Company is subject to various legal proceedings and claims that have not yet been fully resolved and that have arisen in the ordinary +course of business, and additional claims may arise in the future. Results of legal proceedings are subject to significant uncertainty and, regardless of the merit of the claims, litigation may be expensive, time-consuming, disruptive to the +Company’s operations, and distracting to management. In recognition of these considerations, the Company may enter into arrangements to settle litigation. Although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of +management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary +damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to +additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions. Current +economic and political conditions make tax rates in any jurisdiction, including the U.S., subject to significant change. The Company’s future effective tax rates could be affected by changes in the mix of earnings in countries with differing +statutory 19 Table of Contents tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation. The Company is also subject to the examination of its tax returns by +the Internal Revenue Service and other tax authorities. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the +outcome of these examinations. Item 1B. Unresolved Staff Comments None. Item 2. Properties The +Company’s headquarters are located in Cupertino, California. As of September 29, 2012, the Company owned or leased approximately 17.3 million square feet of building space, primarily in the U.S., and to a lesser extent, in Europe, +Japan, Canada, and the Asia-Pacific regions. Of that amount approximately 10.9 million square feet was leased building space, which includes approximately 4.1 million square feet related to retail store space. Of the Company’s owned +building space, approximately 2.6 million square feet that is located in Cupertino, California will be demolished to build a second corporate campus. Additionally, the Company owns a total of 1,077 acres of land in various locations. As of September 29, 2012, the Company owned a manufacturing facility in Cork, Ireland that also housed a customer +support call center and facilities in Elk Grove, California that included warehousing and distribution operations and a customer support call center. The Company also owned land in Austin, Texas where it will build office space and a customer +support call center. In addition, the Company owned facilities for research and development and corporate functions in Cupertino, California, including land for the future development of the Company’s second corporate campus. The Company also +owned data centers in Newark, California; Maiden, North Carolina; and Prineville, Oregon. Outside the U.S., the Company owned additional facilities for various purposes. The Company believes its existing facilities and equipment, which are used by all operating segments, are in good operating condition and are suitable for the conduct of its business. The Company has +invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to make investments in capital equipment as needed to meet anticipated demand for its products. Item 3. Legal Proceedings The +Company is subject to the various legal proceedings and claims, including those discussed below as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the +opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of legal proceedings +and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a +reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. See the risk factors “ The Company is frequently +involved in intellectual property litigation, and could be found to have infringed on intellectual property rights ” and “ The Company could be impacted by unfavorable results of legal proceedings ” in Part I, Item 1A of +this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2012 that did not individually or in the aggregate have a material impact on the Company’s financial condition and +results of operations. 20 Table of Contents The Apple iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. +and Tucker v. Apple Computer, Inc.); Somers v. Apple Inc. These related cases have been filed on January 3, +2005, July 21, 2006 and December 31, 2007 in the United States District Court for the Northern District of California on behalf of a purported class of direct and indirect purchasers of iPods and iTunes Store content, alleging +various claims including alleged unlawful tying of music and video purchased on the iTunes Store with the purchase of iPods and unlawful acquisition or maintenance of monopoly market power under §§1 and 2 of the Sherman Act, the Cartwright +Act, California Business & Professions Code §17200 (unfair competition), the California Consumer Legal Remedies Act and California monopolization law. Plaintiffs are seeking unspecified compensatory and punitive damages for the class, +treble damages, injunctive relief, disgorgement of revenues and/or profits and attorneys fees. Plaintiffs are also seeking digital rights management free versions of any songs downloaded from iTunes or an order requiring the Company to license its +digital rights management to all competing music players. The cases are currently pending. Apple eBooks Antitrust Litigation (United +States of America v. Apple Inc., et al.) On April 11, 2012, the U.S. Department of Justice (the “DOJ”) +filed a civil antitrust action against the Company and five major book publishers in the U.S. District Court for the Southern District of New York, alleging an unreasonable restraint of interstate trade and commerce in violation of §1 of the +Sherman Act and seeking, among other things, injunctive relief, the District Court’s declaration that the Company’s agency agreements with the publishers are null and void and/or the District Court’s reformation of such agreements. +The DOJ’s complaint asserts, among other things, that the decision by the five publishers to shift to an agency model to sell eBooks and their agreements with the Company were an attempt to “raise, fix and stabilize retail e-book prices, +to end price competition among e-book retailers, and to limit retail price competition.” The Company filed a response to the DOJ complaint in late May 2012, denying the DOJ’s allegations, and it intends to vigorously contest the lawsuit. +The lawsuit is now in discovery, with an initial trial date set for June 2013. Three of the five publishers have reached a settlement with the DOJ, which requires the publishers to terminate their agreements with the Company and renegotiate new +agreements pursuant to the terms of their settlements with the DOJ. The District Court approved the settlement on September 6, 2012 and, accordingly, these three publishers terminated their original agreements and have entered into new +agreements with the Company. Item 4. Mine Safety Disclosures Not applicable. 21 Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the NASDAQ Stock Market LLC under the symbol AAPL. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest intraday sales prices for the Company’s common stock on the NASDAQ Stock Market LLC during each quarter of +the two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter 2012 price range per share $ 705.07 - $570.00 $ 644.00 - $522.18 $ 621.45 - $409.00 $ 426.70 - $354.24 2011 price range per share $ 422.86 - $327.25 $ 355.13 - $310.50 $ 364.90 - $321.31 $ 325.72 - $275.00 Holders As of October 19, 2012, there were 27,696 shareholders of record. Dividends During the fourth quarter of 2012, the Company paid a quarterly dividend of $2.65 per share and expects to pay quarterly +dividends in the future, subject to declaration by its Board of Directors. There were no dividends declared or paid during the first three quarters of 2012 or during 2011. Purchases of Equity Securities by the Issuer and Affiliated Purchasers None. 22 Table of Contents Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Composite Index, the S&P +Computer Hardware Index, and the Dow Jones U.S. Technology Index. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Composite Index, the S&P Computer Hardware Index, and the Dow Jones U.S. Technology +Index as of the market close on September 30, 2007. Data points on the graph are annual. Note that historic stock price performance is not necessarily indicative of future stock price performance . *$100 invested on 9/30/07 in stock or index, including reinvestment of dividends. Fiscal year ending September 30. Copyright © 2012 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. September  +30, 2007 September  +30, 2008 September  +30, 2009 September  +30, 2010 September  +30, 2011 September  +30, 2012 Apple Inc. $ 100 $ 74 $ 121 $ 185 $ 248 $ 437 S&P 500 $ 100 $ 78 $ 73 $ 80 $ 81 $ 105 S&P Computer Hardware $ 100 $ 84 $ 99 $ 118 $ 134 $ 214 Dow Jones US Technology $ 100 $ 76 $ 85 $ 95 $ 98 $ 127 23 Table of Contents Item 6. Selected Financial Data The information set forth below for the five years ended September 29, 2012, is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in +Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in thousands and per share amounts). 2012 2011 2010 2009 2008 Net sales $ 156,508 $ 108,249 $ 65,225 $ 42,905 $ 37,491 Net income $ 41,733 $ 25,922 $ 14,013 $ 8,235 $ 6,119 Earnings per share: Basic $ 44.64 $ 28.05 $ 15.41 $ 9.22 $ 6.94 Diluted $ 44.15 $ 27.68 $ 15.15 $ 9.08 $ 6.78 Cash dividends declared per share (a) $ 2.65 $ 0 $ 0 $ 0 $ 0 Shares used in computing earnings per share: Basic 934,818 924,258 909,461 893,016 881,592 Diluted 945,355 936,645 924,712 907,005 902,139 Total cash, cash equivalents and marketable securities $ 121,251 $ 81,570 $ 51,011 $ 33,992 $ 24,490 Total assets $ 176,064 $ 116,371 $ 75,183 $ 47,501 $ 36,171 Total long-term obligations (b) $ 16,664 $ 10,100 $ 5,531 $ 3,502 $ 1,745 Total liabilities $ 57,854 $ 39,756 $ 27,392 $ 15,861 $ 13,874 Total shareholders’ equity $ 118,210 $ 76,615 $ 47,791 $ 31,640 $ 22,297 (a) The Company declared a dividend of $2.65 per share in the fourth quarter of 2012. (b) The Company did not have any long-term debt during the five years ended September 29, 2012. Long-term obligations exclude non-current deferred +revenue. 24 Table of Contents Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and other +parts of this Form 10-K contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events +based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” +“believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. +Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but +are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated +financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years or quarters refer to +the Company’s fiscal years ended in September and the associated quarters of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, +unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Executive Overview The Company designs, manufactures, and markets mobile +communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s +products and services include iPhone, iPad, Mac, iPod, Apple TV, a portfolio of consumer and professional software applications, the iOS and OS X operating systems, iCloud, and a variety of accessory, service and support offerings. The Company also +sells and delivers digital content and applications through the iTunes Store, App Store, iBookstore, and Mac App Store. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as well as through +third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application software, and various accessories +through its online and retail stores. The Company sells to consumers; small and mid-sized businesses; and education, enterprise and government customers. The Company is committed to bringing the best user experience to its customers through its innovative hardware, software, peripherals, and services. The Company’s business strategy leverages its +unique ability to design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative design. As part of its +strategy, the Company continues to expand its platform for the discovery and delivery of third-party digital content and applications through the iTunes Store. As part of the iTunes Store, the Company’s App Store and iBookstore allow customers +to discover and download applications and books through either a Mac or Windows-based computer or through “iOS devices,” namely iPhone, iPad and iPod touch. The Company’s Mac App Store allows customers to easily discover, download and +install Mac applications. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company’s strategy also includes expanding +its distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience. The Company participates in several highly competitive markets, including the market for mobile communications and media devices with its iOS devices; personal computers with its Mac computers; portable +digital players with iPod; and distribution of third-party digital content and applications with the iTunes Store, App Store, iBookstore, and Mac App Store. While the Company is widely recognized as a leading innovator in 25 Table of Contents the markets where it competes, these markets are highly competitive and subject to aggressive pricing. To remain competitive, the Company believes that continual investment in research and +development and marketing and advertising is critical to the development and sale of innovative products and technologies. The Company’s research and development spending is focused on investing in new hardware and software products, and in +further developing its existing products, including iPhone, iPad, Mac, and iPod hardware; iOS and OS X operating systems; and a variety of application software and online services. The Company uses a variety of direct and indirect distribution channels, such as its retail stores, online stores, and direct sales +force, and third-party cellular network carriers, wholesalers, retailers, and value-added resellers. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of +the hardware and software integration, and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of +its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which +service and education are emphasized, the Company continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. Additionally, the Company has invested in programs to enhance reseller sales +by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a +high level of integration and support services, and product expertise. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles +(“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its +consolidated financial statements and accompanying notes. Note 1, “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting +policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the +results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation and +impairment of marketable securities, inventory valuation and inventory purchase commitments, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the +portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting +policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, +and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the +customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education +customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. The Company recognizes revenue from the +sale of hardware products, 26 Table of Contents software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold on the iTunes Store in accordance with general revenue recognition +accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades +and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element +arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software, and/or undelivered non-software +services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: +(i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the +Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a +stand-alone basis. For sales of qualifying versions of iOS devices, Mac and Apple TV, the Company has indicated it may from +time to time provide future unspecified software upgrades and features free of charge to customers. The Company also provides various non-software services to owners of qualifying versions of iOS devices and Mac. Because the Company has neither VSOE +nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software +services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided for each of these devices, which ranges from two to +four years. The Company’s process for determining ESPs involves management’s judgment and considers multiple +factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. If the facts and circumstances underlying the factors considered change, including the estimated or actual costs incurred to provide +non-software services or the estimated period the software upgrades and non-software services are expected to be provided, or should future facts and circumstances lead the Company to consider additional factors, the Company’s ESPs and the +future rate of related amortization for software upgrades and non-software services related to future sales of these devices could change. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes +revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy requires that, if refunds cannot be +reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, the estimated cost is recognized at the later of the date at which the +Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product +transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually +redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company +would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s results of operations. Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated +other comprehensive income, net 27 Table of Contents of tax, in the Company’s Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an +other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if +any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the period any such determination is made. In making this judgment, the Company evaluates, among other things, the duration and extent +to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before +recovery of the its amortized cost basis. The Company’s assessment on whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security. Inventory Valuation and Inventory Purchase Commitments The Company must order components for its products and build inventory in advance of product shipments. The Company records a write-down for inventories of components and products, including third-party +products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory each fiscal quarter that considers multiple factors including demand forecasts, +product life cycle status, product development plans, current sales levels, and component cost trends. The industries in which the Company competes are subject to a rapid and unpredictable pace of product and component obsolescence and demand +changes. If future demand or market conditions for the Company’s products are less favorable than forecasted or if unforeseen technological changes negatively impact the utility of component inventory, the Company may be required to record +additional write-downs, which would adversely affect its results of operations in the period when the write-downs were recorded. The Company records accruals for estimated cancellation fees related to component orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company acquires +components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. These commitments typically cover the Company’s requirements for periods up to 150 days. If there is an abrupt and +substantial decline in demand for one or more of the Company’s products or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional accruals for cancellation +fees that would adversely affect its results of operations in the period when the cancellation fees are identified and recorded. Warranty +Costs The Company provides for the estimated cost of hardware and software warranties at the time the related revenue is +recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates +its estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection and adjusts the amounts as necessary. If actual product failure rates or repair costs +differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect the Company’s results of operations. Income Taxes The Company records a tax provision for the anticipated tax +consequences of the reported results of operations. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary +differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable +income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a 28 Table of Contents valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical +merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax +planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all or part of the net deferred tax assets are not +realizable in the future, the Company will make an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in +estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial +condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this +Form 10-K in the Notes to Consolidated Financial Statements in Note 7, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims, including those that arise in the ordinary course of business. The +Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be reasonably +estimated. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for legal and other +contingencies. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these +legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Fiscal Period The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company’s fiscal years 2012, 2011 and 2010 ended on September 29, +2012, September 24, 2011, and September 25, 2010, respectively. Fiscal year 2012 spanned 53 weeks, with a 14 th week included in the first quarter of 2012, as is done approximately every six years to realign the Company’s +fiscal quarters more closely to calendar quarters. Inclusion of the additional week in 2012 increased the Company’s overall net sales and operating expenses for the year. Fiscal years 2011 and 2010 spanned 52 +weeks each. Unless otherwise stated, references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. 29 Table of Contents Net Sales The following table shows net sales by operating segment and net sales and unit sales by product during 2012, 2011, and 2010 (dollars in millions and units in thousands): 2012 Change 2011 Change 2010 Net Sales by Operating Segment: Americas net sales $ 57,512 50 % $ 38,315 56 % $ 24,498 Europe net sales 36,323 31 % 27,778 49 % 18,692 Japan net sales 10,571 94 % 5,437 37 % 3,981 Asia-Pacific net sales 33,274 47 % 22,592 174 % 8,256 Retail net sales 18,828 33 % 14,127 44 % 9,798 Total net sales $ 156,508 45 % $ 108,249 66 % $ 65,225 Net Sales by Product: Desktops (a)(i) $ 6,040 (6 )% $ 6,439 4 % $ 6,201 Portables (b)(i) 17,181 12 % 15,344 36 % 11,278 Total Mac net sales 23,221 7 % 21,783 25 % 17,479 iPod (c)(i) 5,615 (25 )% 7,453 (10 )% 8,274 Other music related products and services (d) 8,534 35 % 6,314 28 % 4,948 iPhone and related products and services (e)(i) 80,477 71 % 47,057 87 % 25,179 iPad and related products and services (f)(i) 32,424 59 % 20,358 311 % 4,958 Peripherals and other hardware (g) 2,778 19 % 2,330 28 % 1,814 Software, service and other sales (h) 3,459 17 % 2,954 15 % 2,573 Total net sales $ 156,508 45 % $ 108,249 66 % $ 65,225 Unit Sales by Product: Desktops (a) 4,656 0 % 4,669 1 % 4,627 Portables (b) 13,502 12 % 12,066 34 % 9,035 Total Mac unit sales 18,158 9 % 16,735 22 % 13,662 iPod unit sales 35,165 (17 )% 42,620 (15 )% 50,312 iPhone units sold 125,046 73 % 72,293 81 % 39,989 iPad units sold 58,310 80 % 32,394 334 % 7,458 (a) Includes revenue from iMac, Mac mini and Mac Pro sales. (b) Includes revenue from MacBook, MacBook Air and MacBook Pro sales. (c) Includes revenue from iPod sales. (d) Includes revenue from sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Apple-branded and third-party +iPod accessories. (e) Includes revenue from sales of iPhone, iPhone services, and Apple-branded and third-party iPhone accessories. (f) Includes revenue from sales of iPad, iPad services, and Apple-branded and third-party iPad accessories. (g) Includes revenue from sales of displays, networking products, and other hardware. (h) Includes revenue from sales of Apple-branded and third-party Mac software, and services. (i) Includes amortization of related revenue deferred for non-software services and embedded software upgrade rights. 30 Table of Contents Fiscal Year 2012 versus 2011 Net sales during 2012 increased $48.3 billion or 45% compared to 2011. Several factors contributed positively to this +increase, including the addition of a 14 th week in the +first quarter of 2012, as well as the following: • Net sales of iPhone and related products and services were $80.5 billion in 2012, representing an increase of $33.4 billion or 71% compared to 2011. +iPhone unit sales totaled 125.0 million during 2012, representing an increase of 52.8 million units or 73% compared to 2011. The year-over-year growth in iPhone net sales and unit sales during 2012 reflects strong demand for iPhone in all +of the Company’s operating segments, which is primarily a result of the launches of iPhone 4S in the first quarter of 2012 and iPhone 5 in the fourth quarter of 2012, ongoing demand for iPhone 4 and iPhone 3GS, and expanded distribution with +new carriers and resellers. Net sales of iPhone and related products and services were 51% and 43% of the Company’s total net sales for 2012 and 2011, respectively. • Net sales of iPad and related products and services were $32.4 billion in 2012, representing an increase of $12.1 billion or 59% compared to 2011. +Unit sales of iPad were 58.3 million during 2012, an increase of 80% from 2011. The year-over-year increase in iPad net sales and unit sales during 2012 was driven by strong demand for iPad in all of the Company’s operating segments as a +result of the launch of the new iPad in March 2012, continued demand for iPad 2, and expanded distribution with new resellers. The year-over-year growth rate of iPad unit sales was higher than the growth rate of iPad net sales during 2012 due to a +reduction of average selling prices as a result of a shift in product mix toward lower-priced iPad models, the price reduction for iPad 2 and an increase in indirect sales due to expanded distribution through third-party resellers. Net sales of iPad +and related products and services were 21% and 19% of the Company’s total net sales for 2012 and 2011, respectively. • Mac net sales were $23.2 billion in 2012, representing an increase of $1.4 billion or 7% compared to 2011. Mac unit sales totaled 18.2 million +during 2012, representing an increase of 1.4 million or 9% compared to 2011. The year-over-year growth in Mac net sales and unit sales during 2012 reflects increased demand for Mac portables in all of the Company’s operating segments +driven by 2012 releases of updated models of MacBook Air and MacBook Pro, including the new MacBook Pro with Retina display in June 2012. Partially offsetting the increase in net sales of Mac portables was a decline in net sales of Mac desktops that +reflected the overall decline in the market for desktop personal computers during 2012. Additionally, the Company did not introduce updated versions of its Mac desktop products in 2012. Mac net sales were 15% and 20% of the Company’s total net +sales for 2012 and 2011, respectively. • Net sales of other music related products and services were $8.5 billion in 2012, representing an increase of $2.2 billion or 35% compared to 2011. +The increase was due primarily to growth of the iTunes Store, which generated total net sales of $7.5 billion for 2012 compared to net sales of $5.4 billion during 2011. The strong results of the iTunes Store reflect growth of the App Store; +growth of the Company’s customer base; and the continued expansion of third-party audio, video and book content available for sale or rent via the iTunes Store. The Company continues to expand its iTunes content and applications offerings +around the world. Net sales of other music related products and services were 5% and 6% of the Company’s total net sales for 2012 and 2011, respectively. Partially offsetting the positive factors contributing to the overall increase in net sales was a decrease in iPod net sales experienced +across all operating segments. iPod net sales were $5.6 billion in 2012, a decrease of $1.8 billion or 25% compared to 2011. Similarly, iPod unit sales decreased by 17% in 2012 compared to 2011. Declines in net sales and unit sales of iPod +reflect the continuing contraction of the overall market for MP3 players. Net sales of iPod were 4% and 7% of the Company’s total net sales for 2012 and 2011, respectively. The Company has historically experienced higher net sales in its first fiscal quarter compared to other quarters in its fiscal year due +in part to holiday seasonal demand. Actual and anticipated timing of new product introductions 31 Table of Contents by the Company can also significantly impact the level of net sales experienced by the Company in any particular quarter. However, neither historical seasonal patterns nor historical patterns of +product introductions should be considered reliable indicators of the Company’s future net sales or financial performance. Growth in total net sales was particularly strong during the first six months of 2012, rising $34.1 billion or 66% compared to the same period in 2011. The net sales growth during the first six months of +2012 reflects the launch of iPhone 4S in the first quarter of 2012 and the Company’s ability to meet demand more quickly for iPhone 4S when compared to the iPhone 4 launch. Growth during the first half of 2012 was also favorably impacted by the +addition of a 14 th week in the first quarter of 2012 and +strong unit sales of iPad during the holiday season, resulting in a 111% increase in iPad unit sales during the first quarter of 2012 compared to the same quarter in 2011. Fiscal Year 2011 versus 2010 Net sales during 2011 increased $43.0 +billion or 66% compared to 2010. Several factors contributed positively to this increase, including the following: • Net sales of iPhone and related products and services were $47.1 billion in 2011, representing an increase of $21.9 billion or 87% compared to 2010. +iPhone unit sales totaled 72.3 million during 2011, representing an increase of 32.3 million units or 81% compared to 2010. iPhone year-over-year net sales growth reflected strong demand for iPhone 4 in all of the Company’s operating +segments. The expanded U.S. distribution of iPhone to the Verizon Wireless network beginning in February 2011, continued expansion into new countries, and increased distribution with other new carriers and resellers also contributed to the +year-over-year growth of iPhone. Net sales of iPhone and related products and services accounted for 43% and 39% of the Company’s total net sales for 2011 and 2010, respectively. • Net sales of iPad and related products and services, which the Company introduced in the third quarter of 2010, were $20.4 billion in 2011, +representing an increase of $15.4 billion or 311% compared to 2010. Unit sales of iPad were 32.4 million during 2011, an increase of 334% from 2010. The year-over-year unit growth and net sales growth were driven by strong iPad demand in all of +the Company’s operating segments. Net sales of iPad and related products and services accounted for 19% and 8% of the Company’s total net sales for 2011 and 2010, respectively. • Mac net sales were $21.8 billion in 2011, representing an increase of $4.3 billion or 25% compared to 2010. Mac unit sales increased by +3.1 million or 22% in 2011 compared to 2010. The year-over-year growth in Mac net sales and unit sales was due primarily to higher demand in all of the Company’s operating segments for MacBook Air and MacBook Pro, which were updated in +July 2011 and February 2011, respectively. The year-over-year revenue growth for portables and desktops was 36% and 4%, respectively. Mac net sales accounted for 20% and 27% of the Company’s total net sales for 2011 and 2010, respectively. • Net sales of other music related products and services were $6.3 billion in 2011, representing an increase of $1.4 billion or 28% compared to 2010. +The increase was due primarily to increased net sales from the iTunes Store, which was largely driven by App Store expansion into new countries that contributed to strong growth in all of the Company’s geographic segments. During 2011, net +sales for the iTunes Store, App Store and iBookstore was $5.4 billion, representing an increase of 33% compared to 2010. The Company believes this continued growth was the result of heightened consumer interest in downloading third-party digital +content, continued growth in its customer base of iOS devices, expansion of third-party audio and video content available via the iTunes Store, and continued interest in and growth of the App Store. Net sales of other music related products and +services accounted for 6% and 8% of the Company’s total net sales for 2011 and 2010, respectively. Partially offsetting the positive factors contributing to the overall increase in net sales was a decrease in iPod net sales of $821 +million or 10% during 2011 compared to 2010. Similarly, iPod unit sales decreased by 15% in 2011 compared to 2010. However, net sales per iPod unit sold increased during 2011 compared to 2010 due primarily 32 Table of Contents to a shift in iPod product mix toward iPod touch. Net sales of iPod accounted for 7% and 13% of the Company’s total net sales for 2011 and 2010, respectively. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Japan, Asia-Pacific and Retail operations. The results +of the Americas, Europe, Japan and Asia-Pacific segments do not include results of the Retail segment. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as the Middle East and Africa. +The Asia-Pacific segment includes Australia and Asian countries, other than Japan. The Retail segment operates Apple retail stores in 13 countries, including the U.S. Each operating segment provides similar hardware and software products and similar +services. Further information regarding the Company’s operating segments may be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 8, “Segment Information and Geographic Data.” Americas Net sales in the Americas segment increased $19.2 billion or 50% during 2012 compared to 2011. The growth in net sales during 2012 was +primarily driven by increased demand for iPhone following the launches of iPhone 4S and iPhone 5, strong demand for the new iPad and iPad 2, and higher sales from the iTunes Store. The Americas segment represented approximately 37% and 35% of the +Company’s total net sales for 2012 and 2011, respectively. Net sales in the Americas segment increased $13.8 billion or +56% during 2011 compared to 2010. The primary contributors to the growth in net sales was a significant year-over-year increase in iPhone sales from carrier expansion and strong demand for iPhone 4 and increased sales of iPad and Mac, partially +offset by a decrease in iPod sales. Higher sales of third-party digital content and applications from the iTunes Store also drove an increase in net sales during 2011. The Americas segment represented approximately 35% and 37% of the Company’s +total net sales for 2011 and 2010, respectively. Europe Net sales in the Europe segment increased $8.5 billion or 31% during 2012 compared to 2011. The growth in net sales during 2012 was primarily driven by strong demand for the new iPad and iPad 2, higher +sales from the iTunes Store and increased demand for iPhone from the launch of iPhone 4S. iPhone 5 was launched in a limited number of countries in the Europe segment at the end of the fourth quarter of 2012 and did not contribute to the growth in +net sales in the Europe segment to the extent it did in other segments. Lower year-over-year growth in net sales in the Europe segment during 2012 compared to the Company’s other geographic segments reflects growth in iPhone unit sales that was +well below the growth rates experienced by the Company’s other operating segments, partially offset by strong growth in iPad unit sales. Net sales in the Europe segment were also negatively impacted by the region’s uncertain economic +conditions and the strength in the U.S. dollar relative to several European currencies, including the euro. The Europe segment represented approximately 23% and 26% of the Company’s total net sales for 2012 and 2011, respectively. Net sales in the Europe segment increased $9.1 billion or 49% during 2011 compared to 2010. The increase in net sales during 2011 was +attributable primarily to the continued year-over-year increase in iPhone sales from carrier expansion and strong demand for iPhone 4, and increased sales of iPad and Mac, partially offset by a decrease in iPod sales. The Europe segment represented +26% and 29% of the Company’s total net sales for 2011 and 2010, respectively. 33 Table of Contents Japan Net sales in the Japan segment increased $5.1 billion or 94% during 2012 compared to 2011. The growth in net sales during 2012 was primarily driven by increased demand for iPhone following the launches of +iPhone 4S and iPhone 5, expanded distribution with a new iPhone carrier, strong demand for the new iPad and iPad 2, higher sales from the iTunes Store, and strength in the Japanese Yen relative to the U.S. dollar. The Japan segment represented +approximately 7% and 5% of the Company’s total net sales for 2012 and 2011, respectively. Net sales in the Japan segment +increased $1.5 billion or 37% during 2011 compared to 2010. The key contributors to Japan’s net sales growth were increased iPhone sales, strong sales of iPad, increased sales of Mac, and strength in the Japanese Yen relative to the U.S. +dollar. The Japan segment represented 5% and 6% of the Company’s total net sales for 2011 and 2010, respectively. Asia-Pacific Net sales in the Asia-Pacific segment increased $10.7 billion or 47% during 2012 compared to 2011. The growth in net sales +during 2012 was mainly due to increased demand for iPhone from the launch of iPhone 4S, strong demand for the new iPad and iPad 2, and higher Mac sales. Growth in the Asia Pacific segment was affected by the timing of iPhone and iPad product +launches. iPhone 5 was launched in a limited number of countries in the Asia Pacific segment during the fourth quarter of 2012 and was not launched in China during 2012, and the new iPad that was introduced by the Company in March 2012 was not +launched in China until the fourth quarter of 2012. The Asia-Pacific segment represented approximately 21% of the Company’s total net sales in both 2012 and 2011. Net sales in the Asia Pacific segment increased $14.3 billion or 174% during 2011 compared to 2010. The Company experienced particularly strong year-over-year net sales growth in its Asia Pacific segment +during 2011, especially in Greater China, which includes Hong Kong and Taiwan. Korea and Australia also experienced strong year-over-year revenue growth. Higher net sales in the Asia Pacific segment were due mainly to the increase in iPhone sales +primarily attributable to the strong demand for iPhone 4 and carrier expansion, strong sales of iPad, and increased Mac sales. The Asia Pacific segment represented 21% and 13% of the Company’s total net sales in 2011 and 2010, respectively. Retail Net +sales in the Retail segment increased $4.7 billion or 33% during 2012 compared to 2011. The growth in net sales during 2012 was driven primarily by increased demand for iPhone following the launches of iPhone 4S and iPhone 5, strong demand for the +new iPad and iPad 2, and higher Mac net sales. Lower year-over-year growth in net sales in the Retail segment during 2012 compared to the Company’s other segments reflects the significant growth in iPad indirect distribution channel +expansion. The Retail segment accounted for 12% and 13% of the Company’s total net sales for 2012 and 2011, respectively. The Company opened 33 new retail stores during 2012, 28 of which were outside the U.S., ending the year with 390 stores open compared to 357 stores at the end of 2011. As of September 29, 2012, the +Company had a total of 250 U.S. retail stores and 140 international retail stores. With an average of 365 stores and 326 stores during 2012 and 2011, respectively, average revenue per store increased 19% to $51.5 million in 2012 compared to $43.3 +million in 2011. Net sales in the Retail segment increased $4.3 billion or 44% during 2011 compared to 2010. The increase in +net sales was driven primarily by strong demand for iPad, higher Mac sales, and an increase in iPhone sales. The Company opened 40 new retail stores during 2011, 28 of which were outside the U.S., ending the year with 357 stores open compared +to 317 stores at the end of 2010. As of September 24, 2011, the Company had a total of 245 U.S. retail stores and 112 international retail stores. During 2011, the Company had an average of 326 stores compared to an average of 288 stores +during 2010. The average revenue per store increased 27% to 34 Table of Contents $43.3 million in 2011 compared to $34.1 million in 2010. The Retail segment represented 13% and 15% of the Company’s total net sales in 2011 and 2010, respectively. The Retail segment’s operating income was $4.7 billion, $3.2 billion, and $2.3 billion during 2012, 2011, and 2010 respectively. +These year-over-year increases in Retail operating income were primarily attributable to higher overall net sales that resulted in significantly higher average revenue per store during the respective years. Gross Margin Gross +margin for 2012, 2011 and 2010 are as follows (in millions, except gross margin percentages): 2012 2011 2010 Net sales $ 156,508 $ 108,249 $ 65,225 Cost of sales 87,846 64,431 39,541 Gross margin $ 68,662 $ 43,818 $ 25,684 Gross margin percentage 43.9% 40.5% 39.4% The gross margin percentage in 2012 was 43.9%, compared to 40.5% in 2011. This year-over-year increase in +gross margin was largely driven by lower commodity and other product costs, a higher mix of iPhone sales, and improved leverage on fixed costs from higher net sales. The increase in gross margin was partially offset by the impact of a stronger U.S. +dollar. The gross margin percentage during the first half of 2012 was 45.9% compared to 41.4% during the second half of 2012. The primary drivers of higher gross margin in the first half of 2012 compared to the second half are a higher mix of iPhone +sales and improved leverage on fixed costs from higher net sales. Additionally, gross margin in the second half of 2012 was also affected by the introduction of new products with flat pricing that have higher cost structures and deliver +greater value to customers, price reductions on certain existing products, higher transition costs associated with product launches, and continued strengthening of the U.S. dollar; partially offset by lower commodity costs. The gross margin percentage in 2011 was 40.5%, compared to 39.4% in 2010. This year-over-year increase in gross margin was largely driven +by lower commodity and other product costs. The Company expects to experience decreases in its gross margin percentage in +future periods, as compared to levels achieved during 2012, and the Company anticipates gross margin of about 36% during the first quarter of 2013. Expected future declines in gross margin are largely due to a higher mix of new and innovative +products with flat or reduced pricing that have higher cost structures and deliver greater value to customers and anticipated component cost and other cost increases. Future strengthening of the U.S. dollar could further negatively impact gross +margin. The foregoing statements regarding the Company’s expected gross margin percentage in future periods, including +the first quarter of 2013, are forward-looking and could differ from actual results because of several factors including, but not limited to those set forth above in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” +and those described in this paragraph. In general, gross margins and margins on individual products will remain under downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased +competition, compressed product life cycles, product transitions and potential increases in the cost of components, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix +towards products with lower gross margins. In response to competitive pressures, the Company expects it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the +Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due to the Company’s significant international operations, financial results can be significantly affected in +the short-term by fluctuations in exchange rates. 35 Table of Contents Operating Expenses Operating expenses for 2012, 2011, and 2010 are as follows (in millions, except for percentages): 2012 2011 2010 Research and development $ 3,381 $ 2,429 $ 1,782 Percentage of net sales 2% 2% 3% Selling, general and administrative $ 10,040 $ 7,599 $ 5,517 Percentage of net sales 6% 7% 8% Research and Development (“R&D”) Expense R&D expense increased $952 million or 39% in 2012 compared to 2011 and $647 million or 36% in 2011 compared to 2010. The growth in +R&D expense was driven by an increase in headcount and related expenses to support expanded R&D activities. Although total R&D expense increased 39% and 36% in 2012 and 2011, respectively, it remained fairly consistent as a percentage of +net sales. The Company continues to believe that focused investments in R&D are critical to its future growth and +competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core business strategy. As such, the Company expects to make further investments in R&D to +remain competitive. Selling, General and Administrative (“SG&A”) Expense SG&A expense increased $2.4 billion or 32% during 2012 compared to 2011 and $2.1 billion or 38% during 2011 compared to 2010. These +increases were primarily due to the Company’s continued expansion of its Retail segment, increased headcount and related expenses, higher spending on professional services, marketing and advertising programs, and increased variable costs +associated with the overall growth of the Company’s net sales. Other Income and Expense Other income and expense for 2012, 2011, and 2010 are as follows (in millions): 2012 2011 2010 Interest and dividend income $ 1,088 $ 519 $ 311 Other expense, net (566 ) (104 ) (156 ) Total other income/(expense), net $ 522 $ 415 $ 155 Total other income and expense increased $107 million or 26% to $522 million during 2012 compared to +$415 million and $155 million in 2011 and 2010, respectively. The year-over-year increase in other income and expense during 2012 was due primarily to higher interest and dividend income on the Company’s higher cash, cash equivalents and +marketable securities balances, partially offset by higher premium expenses on foreign exchange contracts. The overall increase in other income and expense in 2011 compared to 2010 was attributable to higher interest income and net realized gains on +sales of marketable securities. The weighted average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.03%, 0.77%, and 0.75% during 2012, 2011, and 2010, respectively. During 2012, 2011, and 2010, the +Company had no debt outstanding and accordingly did not incur any related interest expense. Provision for Income Taxes The Company’s effective tax rates were approximately 25.2%, 24.2%, and 24.4% for 2012, 2011, and 2010, respectively. The +Company’s effective rates for these periods differ from the statutory federal income tax rate of 36 Table of Contents 35% due primarily to certain undistributed foreign earnings for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested outside the U.S. As of September 29, 2012, the Company had deferred tax assets arising from deductible temporary differences, tax losses, and tax +credits of $4.0 billion, and deferred tax liabilities of $14.9 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with +future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and amount of +a valuation allowance. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s +federal income tax returns for the years 2004 through 2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2009. All IRS +audit issues for years prior to 2004 have been resolved. In addition, the Company is subject to audits by state, local, and foreign tax authorities. Management believes that adequate provisions have been made for any adjustments that may result +from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be +required to adjust its provision for income taxes in the period such resolution occurs. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended September 29, +2012, September 24, 2011, and September 25, 2010 (in millions): 2012 2011 2010 Cash, cash equivalents and marketable securities $ 121,251 $ 81,570 $ 51,011 Accounts receivable, net $ 10,930 $ 5,369 $ 5,510 Inventories $ 791 $ 776 $ 1,051 Working capital $ 19,111 $ 17,018 $ 20,956 Annual operating cash flow $ 50,856 $ 37,529 $ 18,595 As of September 29, 2012, the Company had $121.3 billion in cash, cash equivalents and marketable +securities, an increase of $39.7 billion or 49% from September 24, 2011. The principal components of this net increase was the cash generated by operating activities of $50.9 billion, which was partially offset by payments for acquisition of +property, plant and equipment of $8.3 billion, payments for acquisition of intangible assets of $1.1 billion and payments of dividends and dividend equivalent rights of $2.5 billion. The Company’s marketable securities investment portfolio is invested primarily in highly-rated securities and its investment policy +generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade with the objective of minimizing the potential risk of principal loss. As of September 29, 2012 and +September 24, 2011, $82.6 billion and $54.3 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts +held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital +needs, capital asset purchases, outstanding commitments, common stock repurchases, dividends on its common stock, and other liquidity requirements associated with its existing operations over the next 12 months. Capital Assets The +Company’s capital expenditures were $10.3 billion during 2012, consisting of $865 million for retail store facilities and $9.5 billion for other capital expenditures, including product tooling and manufacturing process 37 Table of Contents equipment, and other corporate facilities and infrastructure. The Company’s actual cash payments for capital expenditures during 2012 were $8.3 billion. The Company anticipates utilizing approximately $10 billion for capital expenditures during 2013, including approximately $850 million +for retail store facilities and approximately $9.15 billion for other capital expenditures, including product tooling and manufacturing process equipment, and corporate facilities and infrastructure, including information systems hardware, software +and enhancements. During 2013, the Company expects to open about 30 to 35 new retail stores, with approximately +three-quarters located outside of the U.S. Dividend and Stock Repurchase Program In March 2012, the Board of Directors of the Company approved a dividend policy pursuant to which it plans to pay, subject to subsequent +declaration, quarterly dividends of $2.65 per share. The Company expects to pay approximately $2.5 billion each quarter in conjunction with the quarterly declared dividends. In March 2012, the Company’s Board of Directors authorized a program to repurchase up to $10 billion of the Company’s common stock beginning in 2013. The repurchase program is expected to be +executed over a three-year period with the primary objective of neutralizing the impact of dilution from future employee equity grants and employee stock purchase programs. The repurchase program does not obligate the Company to acquire any specific +number of shares. The Company anticipates that it will utilize approximately $45 billion of domestic cash to pay dividends, repurchase shares, and to remit withheld taxes related to net share settlement of restricted stock units in the first three +years of the dividend and stock repurchase programs. The Company anticipates the cash used for future dividends and the repurchase program will come primarily from current domestic cash and from on-going U.S. operating activities and the cash +generated from such activities. Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated +retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides +financing, liquidity, market risk, or credit risk support to the Company. The following table presents certain payments due +by the Company under contractual obligations with minimum firm commitments as of September 29, 2012 and excludes amounts already recorded on the Consolidated Balance Sheet (in millions): Total Payments Due  +in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 +Years Payments Due  +in More Than 5 Years Operating leases $ 4,414 $ 516 $ 1,098 $ 999 $ 1,801 Purchase obligations 21,053 21,053 0 0 0 Other obligations 988 937 49 2 0 Total $ 26,455 $ 22,506 $ 1,147 $ 1,001 $ 1,801 Lease Commitments The Company’s major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for +terms ranging from 38 Table of Contents five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 29, 2012, the Company’s total future minimum lease payments under +noncancelable operating leases were $4.4 billion, of which $3.1 billion related to leases for retail space. Purchase Commitments with +Outsourcing Partners and Component Suppliers The Company utilizes several outsourcing partners to manufacture +sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically +covers periods up to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, +supplier contracts, and open orders based on projected demand information. As of September 29, 2012, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $21.1 billion. Other Obligations In addition to the off-balance sheet commitments mentioned above, the Company had outstanding obligations of $988 million as of September 29, 2012, that were comprised mainly of commitments to +acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to advertising, research and development, Internet and telecommunications services and other obligations. The Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross +unrecognized tax benefits and the related gross interest and penalties. As of September 29, 2012, the Company had non-current deferred tax liabilities of $13.8 billion. Additionally, as of September 29, 2012, the Company had gross +unrecognized tax benefits of $2.1 billion and an additional $401 million for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in +individual years in connection with these tax liabilities; therefore, such amounts are not included in the above contractual obligation table. Indemnification The +Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include +indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant +payments resulting from such an infringement claim asserted against it or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to +indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of +September 29, 2012 or September 24, 2011. The Company has entered into indemnification agreements with its +directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance +expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of +prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these +agreements historically have not been material. 39 Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. Given the effective horizons of the Company’s risk management +activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the +recognition timing of gains and losses related to these instruments for any given period may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s +financial condition and operating results. Interest Rate Risk While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the Company’s interest income and expense is most sensitive to fluctuations in +U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities, the fair value of those securities, as well as costs associated with hedging. The Company’s investment policy and strategy are focused on preservation of capital and supporting the liquidity requirements of the +Company. A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s investment policy and to objective market benchmarks. The Company’s internal portfolio is benchmarked against external +manager performance. The Company’s exposure to changes in interest rates relates primarily to the Company’s +investment portfolio. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the +primary objective of minimizing the potential risk of principal loss. To provide a meaningful assessment of the interest rate +risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel +shift in the yield curve. Based on investment positions as of September 29, 2012, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $2.1 billion incremental decline in the fair market value of the +portfolio. As of September 24, 2011, a similar 100 basis point shift in the yield curve would result in a $913 million incremental decline in the fair market value of the portfolio. Such losses would only be realized if the Company sold the +investments prior to maturity. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the +Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there have been significant volatility in foreign currency +exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to +protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. Generally, the Company’s practice +is to hedge a majority of its material foreign exchange exposures, typically for up to six months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to accounting +considerations and the prohibitive economic cost of hedging particular exposures. 40 Table of Contents To provide a meaningful assessment of the foreign currency risk associated with certain of +the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a +Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative +positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments, and +assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $200 million as of September 29, 2012 +compared to a maximum one-day loss in fair value of $161 million as of September 24, 2011. Because the Company uses foreign currency instruments for hedging purposes, the loss in fair value incurred on those instruments are generally offset by +increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s +investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 29, 2012 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, +foreign currency exchanges rates and the Company’s actual exposures and positions. 41 Table of Contents Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 29, 2012, September  +24, 2011, and September 25, 2010 43 Consolidated Balance Sheets as of September 29, 2012 and September 24, 2011 44 Consolidated Statements of Shareholders’ Equity for the years ended September 29, 2012,  +September 24, 2011, and September 25, 2010 45 Consolidated Statements of Cash Flows for the years ended September 29, 2012, September  +24, 2011, and September 25, 2010 46 Notes to Consolidated Financial Statements 47 Selected Quarterly Financial Information (Unaudited) 74 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 75 All financial statement schedules have been omitted, since the required information is not applicable or +is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. 42 Table of Contents CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 29, 2012 September 24, 2011 September 25, 2010 Net sales $ 156,508 $ 108,249 $ 65,225 Cost of sales 87,846 64,431 39,541 Gross margin 68,662 43,818 25,684 Operating expenses: Research and development 3,381 2,429 1,782 Selling, general and administrative 10,040 7,599 5,517 Total operating expenses 13,421 10,028 7,299 Operating income 55,241 33,790 18,385 Other income/(expense), net 522 415 155 Income before provision for income taxes 55,763 34,205 18,540 Provision for income taxes 14,030 8,283 4,527 Net income $ 41,733 $ 25,922 $ 14,013 Earnings per share: Basic $ 44.64 $ 28.05 $ 15.41 Diluted $ 44.15 $ 27.68 $ 15.15 Shares used in computing earnings per share: Basic 934,818 924,258 909,461 Diluted 945,355 936,645 924,712 Cash dividends declared per common share $ 2.65 $ 0.00 $ 0.00 See accompanying Notes to Consolidated Financial Statements. 43 Table of Contents CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands) September 29, 2012 September 24, 2011 ASSETS: Current assets: Cash and cash equivalents $ 10,746 $ 9,815 Short-term marketable securities 18,383 16,137 Accounts receivable, less allowances of $98 and $53, respectively 10,930 5,369 Inventories 791 776 Deferred tax assets 2,583 2,014 Vendor non-trade receivables 7,762 6,348 Other current assets 6,458 4,529 Total current assets 57,653 44,988 Long-term marketable securities 92,122 55,618 Property, plant and equipment, net 15,452 7,777 Goodwill 1,135 896 Acquired intangible assets, net 4,224 3,536 Other assets 5,478 3,556 Total assets $ 176,064 $ 116,371 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 21,175 $ 14,632 Accrued expenses 11,414 9,247 Deferred revenue 5,953 4,091 Total current liabilities 38,542 27,970 Deferred revenue - non-current 2,648 1,686 Other non-current liabilities 16,664 10,100 Total liabilities 57,854 39,756 Commitments and contingencies Shareholders’ equity: Common stock, no par value; 1,800,000 shares authorized; 939,208 and 929,277 shares issued and outstanding, +respectively 16,422 13,331 Retained earnings 101,289 62,841 Accumulated other comprehensive income 499 443 Total shareholders’ equity 118,210 76,615 Total liabilities and shareholders’ equity $ 176,064 $ 116,371 See accompanying Notes to Consolidated Financial Statements. 44 Table of Contents CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands) Common Stock Retained Earnings Accum- ulated Other Compre- hensive Income/ (Loss) Total Share- holders’ Equity Shares Amount Balances as of September 26, 2009 899,806 $ 8,210 $ 23,353 $ 77 $ 31,640 Components of comprehensive income: Net income 0 0 14,013 0 14,013 Change in foreign currency translation 0 0 0 7 7 Change in unrealized gains/losses on marketable securities, net of tax 0 0 0 123 123 Change in unrecognized gains/losses on derivative instruments, net of tax 0 0 0 (253 ) (253 ) Total comprehensive income 13,890 Share-based compensation 0 876 0 0 876 Common stock issued under stock plans, net of shares withheld for employee taxes 16,164 703 (197 ) 0 506 Tax benefit from equity awards, including transfer pricing adjustments 0 879 0 0 879 Balances as of September 25, 2010 915,970 10,668 37,169 (46 ) 47,791 Components of comprehensive income: Net income 0 0 25,922 0 25,922 Change in foreign currency translation 0 0 0 (12 ) (12 ) Change in unrealized gains/losses on marketable securities, net of tax 0 0 0 (41 ) (41 ) Change in unrecognized gains/losses on derivative instruments, net of tax 0 0 0 542 542 Total comprehensive income 26,411 Share-based compensation 0 1,168 0 0 1,168 Common stock issued under stock plans, net of shares withheld for employee taxes 13,307 561 (250 ) 0 311 Tax benefit from equity awards, including transfer pricing adjustments 0 934 0 0 934 Balances as of September 24, 2011 929,277 13,331 62,841 443 76,615 Components of comprehensive income: Net income 0 0 41,733 0 41,733 Change in foreign currency translation 0 0 0 (15 ) (15 ) Change in unrealized gains/losses on marketable securities, net of tax 0 0 0 601 601 Change in unrecognized gains/losses on derivative instruments, net of tax 0 0 0 (530 ) (530 ) Total comprehensive income 41,789 Dividends and dividend equivalent rights declared 0 0 (2,523 ) 0 (2,523 ) Share-based compensation 0 1,740 0 0 1,740 Common stock issued under stock plans, net of shares withheld for employee taxes 9,931 200 (762 ) 0 (562 ) Tax benefit from equity awards, including transfer pricing adjustments 0 1,151 0 0 1,151 Balances as of September 29, 2012 939,208 $ 16,422 $ 101,289 $ 499 $ 118,210 See accompanying Notes to Consolidated Financial Statements. 45 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 29, 2012 September 24, 2011 September 25, 2010 Cash and cash equivalents, beginning of the year $ 9,815 $ 11,261 $ 5,263 Operating activities: Net income 41,733 25,922 14,013 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 3,277 1,814 1,027 Share-based compensation expense 1,740 1,168 879 Deferred income tax expense 4,405 2,868 1,440 Changes in operating assets and liabilities: Accounts receivable, net (5,551 ) 143 (2,142 ) Inventories (15 ) 275 (596 ) Vendor non-trade receivables (1,414 ) (1,934 ) (2,718 ) Other current and non-current assets (3,162 ) (1,391 ) (1,610 ) Accounts payable 4,467 2,515 6,307 Deferred revenue 2,824 1,654 1,217 Other current and non-current liabilities 2,552 4,495 778 Cash generated by operating activities 50,856 37,529 18,595 Investing activities: Purchases of marketable securities (151,232 ) (102,317 ) (57,793 ) Proceeds from maturities of marketable securities 13,035 20,437 24,930 Proceeds from sales of marketable securities 99,770 49,416 21,788 Payments made in connection with business acquisitions, net of cash acquired (350 ) (244 ) (638 ) Payments for acquisition of property, plant and equipment (8,295 ) (4,260 ) (2,005 ) Payments for acquisition of intangible assets (1,107 ) (3,192 ) (116 ) Other (48 ) (259 ) (20 ) Cash used in investing activities (48,227 ) (40,419 ) (13,854 ) Financing activities: Proceeds from issuance of common stock 665 831 912 Excess tax benefits from equity awards 1,351 1,133 751 Dividends and dividend equivalent rights paid (2,488 ) 0 0 Taxes paid related to net share settlement of equity awards (1,226 ) (520 ) (406 ) Cash (used in)/generated by financing activities (1,698 ) 1,444 1,257 Increase/(decrease) in cash and cash equivalents 931 (1,446 ) 5,998 Cash and cash equivalents, end of the year $ 10,746 $ 9,815 $ 11,261 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 7,682 $ 3,338 $ 2,697 See accompanying Notes to Consolidated Financial Statements. 46 Table of Contents NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, +manufactures, and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and +applications. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the +Company sells a variety of third-party iPhone, iPad, Mac, and iPod compatible products including application software, and various accessories through its online and retail stores. The Company sells to consumers, small and mid-sized businesses, and +education, enterprise and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been +eliminated. The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in +these consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior year amounts in the consolidated financial statements and notes thereto have been reclassified to conform to +the current year’s presentation. Prior period costs associated with the Company’s high-profile retail stores have been reclassified to conform to the current period’s presentation. Refer to Note 8, “Segment Information and +Geographic Data” of this Form 10-K. The Company’s fiscal year is the 52 or 53-week period that ends on the last +Saturday of September. The Company’s fiscal years 2012, 2011 and 2010 ended on September 29, 2012, September 24, 2011, and September 25, 2010, respectively. An additional week is included in the first fiscal quarter +approximately every six years to realign fiscal quarters with calendar quarters. Fiscal year 2012 spanned 53 weeks, with a 14th week included in the first quarter of 2012. Fiscal years 2011 and 2010 spanned 52 weeks each. Unless otherwise stated, +references to particular years or quarters refer to the Company’s fiscal years ended in September and the associated quarters of those fiscal years. Revenue Recognition Net sales consist primarily of revenue from the sale +of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or +determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the +product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk +of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold on the iTunes Store +in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software +products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For the sale of most third-party products, the Company recognizes revenue based on the gross amount billed to customers because the Company establishes its own pricing for such products, retains related +inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its 47 Table of Contents customers. For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of +the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers +that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and +specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on the iTunes Store for +the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and +recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited +warranty. The Company records reductions to revenue for estimated commitments related to price protection and other customer +incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For the Company’s other customer incentive programs, the estimated cost of these programs is recognized +at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. +Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware +product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to +be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”), and (iii) best estimate of selling price +(“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of +elements would be if they were sold regularly on a stand-alone basis. For multi-element arrangements accounted for in accordance with industry specific software accounting guidance, the Company allocates revenue to all deliverables based on the VSOE +of each element, and if VSOE does not exist revenue is recognized when elements lacking VSOE are delivered. For sales of +qualifying versions of iPhone, iPad and iPod touch (“iOS devices”), Mac and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades and features to the essential software bundled with each +of these hardware products free of charge to customers. Essential software for iOS devices includes iOS and related applications and for Mac includes OS X, related applications and iLife. The Company also provides various non-software services to +owners of qualifying versions of iOS devices and Mac. The Company has identified up to three deliverables regularly included in arrangements involving the sale of these devices. The first deliverable is the hardware and software essential to the +functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with the purchase of iOS devices, Mac and Apple TV to receive on a when-and-if-available basis, future unspecified software +upgrades and features relating to the product’s essential software. The third deliverable is the non-software services to be provided to qualifying versions of iOS devices and Mac. The Company allocates revenue between 48 Table of Contents these deliverables using the relative selling price method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based on the Company’s ESPs. +Revenue allocated to the delivered hardware and the related essential software is recognized at the time of sale provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded unspecified software upgrade +rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided for each of these devices, which ranges from two to four +years. Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, +and engineering and sales and marketing costs are recognized as operating expenses as incurred. The Company’s process +for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable. The Company believes its customers would be reluctant to buy +unspecified software upgrade rights for the essential software included with its qualifying hardware products. This view is primarily based on the fact that unspecified software upgrade rights do not obligate the Company to provide upgrades at a +particular time or at all, and do not specify to customers which upgrades or features will be delivered. The Company also believes its customers would be unwilling to pay a significant amount for access to the non-software services because other +companies offer similar services at little or no cost to users. Therefore, the Company has concluded that if it were to sell upgrade rights or access to the non-software services on a standalone basis, including those rights and services attached to +iOS devices, Mac and Apple TV, the selling prices would be relatively low. Key factors considered by the Company in developing the ESPs for software upgrade rights include prices charged by the Company for similar offerings, market trends in the +pricing of Apple-branded and third-party Mac and iOS compatible software, the nature of the upgrade rights (e.g., unspecified versus specified), and the relative ESP of the upgrade rights as compared to the total selling price of the product. The +Company may also consider additional factors as appropriate, including the impact of other products and services provided to customers, the pricing of competitive alternatives if they exist, product-specific business objectives, and the length of +time a particular version of a device has been available. When relevant, the same factors are considered by the Company in developing ESPs for offerings such as the non-software services; however, the primary consideration in developing ESPs for the +non-software services is the estimated cost to provide such services, including consideration for a reasonable profit margin. For the three years ended September 29, 2012, the Company’s combined ESPs for the unspecified software upgrade rights and the +rights to receive the non-software services included with its qualifying hardware devices have ranged from $5 to $25. Revenue allocated to such rights included with iOS devices and Apple TV is recognized on a straight-line basis over two years, and +revenue allocated to such rights included with Mac is recognized on a straight-line basis over four years. Shipping Costs For all periods presented, amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s +shipping and handling costs are included in cost of sales. Warranty Expense The Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. +The Company assesses the adequacy of its pre-existing warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. Software Development Costs Research and development costs are expensed as +incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility 49 Table of Contents has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has +been established. Costs incurred subsequent to achievement of technological feasibility were not significant, and generally software development costs were expensed as incurred during 2012, 2011 and 2010. Advertising Costs Advertising costs are expensed as incurred. Advertising expense was $1.0 billion, $933 million and $691 million for 2012, 2011 and 2010, +respectively. Share-based Compensation The Company recognizes expense related to share-based payment transactions in which it receives employee services in exchange for (a) equity instruments of the Company or (b) liabilities that +are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. Share-based compensation cost for restricted stock units (“RSUs”) is measured based on the closing +fair market value of the Company’s common stock on the date of grant. Share-based compensation cost for stock options is estimated at the grant date based on each option’s fair-value as calculated by the Black-Scholes-Merton +(“BSM”) option-pricing model. The Company recognizes share-based compensation cost as expense ratably on a straight-line basis over the requisite service period. The Company recognizes a benefit from share-based compensation in the +Consolidated Statements of Shareholders’ Equity if an incremental tax benefit is realized. In addition, the Company recognizes the indirect effects of share-based compensation on research and development tax credits, foreign tax credits and +domestic manufacturing deductions in the Consolidated Statements of Operations. Further information regarding share-based compensation can be found in Note 6, “Shareholders’ Equity and Share-based Compensation” of this Form 10-K. Income Taxes The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are +recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are +measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the +amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax +position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are +then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. See Note 5, “Income Taxes” of this Form 10-K for additional information. Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of +common stock outstanding during the period. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the +number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the Company’s +employee stock purchase plan and unvested RSUs. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in 50 Table of Contents the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. The following table shows the computation of basic and diluted earnings per share for 2012, 2011, and 2010 (in thousands, except net +income in millions and per share amounts): 2012 2011 2010 Numerator: Net income $ 41,733 $ 25,922 $ 14,013 Denominator: Weighted-average shares outstanding 934,818 924,258 909,461 Effect of dilutive securities 10,537 12,387 15,251 Weighted-average diluted shares 945,355 936,645 924,712 Basic earnings per share $ 44.64 $ 28.05 $ 15.41 Diluted earnings per share $ 44.15 $ 27.68 $ 15.15 Potentially dilutive securities representing 1.0 million, 1.7 million and 1.6 million +shares of common stock for 2012, 2011 and 2010, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. Financial Instruments Cash +Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of +purchase are classified as cash equivalents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time +of purchase and reevaluates the designations at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt +securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. The Company classifies its marketable equity securities, including mutual +funds, as either short-term or long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity securities are carried at fair value, with the unrealized gains and +losses, net of taxes, reported as a component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as +either assets or liabilities and carries them at fair value. For derivative instruments that hedge the exposure to +variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income (“AOCI”) in +shareholders’ equity and reclassified into income in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized in current +income. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded +from the assessment of hedge effectiveness and are recognized in income. For derivative instruments that hedge the exposure to changes in the fair value of an asset or a liability and that are designated as fair value hedges, both the net gain or +loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk are recognized in earnings in the current period. The Company had no fair value 51 Table of Contents hedges in 2012, 2011 and 2010. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency translation exposure of the +net investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in +the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current income. Derivatives that do not qualify as hedges must be adjusted to fair value through current +income. Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical experience, the age of the accounts receivable balances, credit +quality of the Company’s customers, current economic conditions, and other factors that may affect customers’ ability to pay. Inventories Inventories +are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. The +Company’s inventories consist primarily of components and finished goods for all periods presented. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the +estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between two to five years for machinery and equipment, including product tooling and manufacturing process +equipment; and the shorter of lease terms or ten years for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs +related to internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Depreciation and amortization expense on property and equipment was $2.6 billion, $1.6 +billion and $815 million during 2012, 2011 and 2010, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible +Assets The Company reviews property, plant and equipment, inventory component prepayments, and certain identifiable +intangibles, excluding goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by +comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment, inventory component prepayments, and certain identifiable intangibles are considered to be impaired, the +impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair market value. The Company did not record any significant impairments during 2012, 2011 and 2010. The Company does not amortize goodwill and intangible assets with indefinite useful lives, rather such assets are required to be tested +for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible asset impairment tests in the fourth quarter of each fiscal year. The +Company did not recognize any impairment charges related to goodwill or indefinite lived intangible assets during 2012, 2011 and 2010. The Company established reporting units based on its current reporting structure. For purposes of testing goodwill +for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. In 2012 and 2011, the Company’s goodwill was allocated to the Americas and Europe reportable operating segments. 52 Table of Contents The Company amortizes its intangible assets with definite lives over their estimated useful +lives and reviews these assets for impairment. The Company is currently amortizing its acquired intangible assets with definite lives over periods typically from three to seven years. Fair Value Measurements The Company applies fair value accounting for all +financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from +selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, +the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as risks inherent in +valuation techniques, transfer restrictions and credit risk. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy +upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active +markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active +markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of +the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect +management’s estimate of assumptions that market participants would use in pricing the asset or liability. The +Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to +measure the fair value of all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by +observable market data. In accordance with the fair value accounting requirements, companies may choose to measure eligible +financial instruments and certain other items at fair value. The Company has not elected the fair value option for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the +assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those +in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in accumulated other comprehensive income in shareholders’ equity. The Company’s subsidiaries that use the U.S. +dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these +remeasurements were not significant and have been included in the Company’s results of operations. 53 Table of Contents Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category +recorded as cash and cash equivalents or short- or long-term marketable securities as of September 29, 2012 and September 24, 2011 (in millions): 2012 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 3,109 $ 0 $ 0 $ 3,109 $ 3,109 $ 0 $ 0 Level 1: Money market funds 1,460 0 0 1,460 1,460 0 0 Mutual funds 2,385 79 (2 ) 2,462 0 2,462 0 Subtotal 3,845 79 (2 ) 3,922 1,460 2,462 0 Level 2: U.S. Treasury securities 20,088 21 (1 ) 20,108 2,608 3,525 13,975 U.S. agency securities 19,540 58 (1 ) 19,597 1,460 1,884 16,253 Non-U.S. government securities 5,483 183 (2 ) 5,664 84 1,034 4,546 Certificates of deposit and time deposits 2,189 2 0 2,191 1,106 202 883 Commercial paper 2,112 0 0 2,112 909 1,203 0 Corporate securities 46,261 568 (8 ) 46,821 10 7,455 39,356 Municipal securities 5,645 74 0 5,719 0 618 5,101 Mortgage- and asset-backed securities 11,948 66 (6 ) 12,008 0 0 12,008 Subtotal 113,266 972 (18 ) 114,220 6,177 15,921 92,122 Total $ 120,220 $ 1,051 $ (20 ) $ 121,251 $ 10,746 $ 18,383 $ 92,122 2011 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 2,903 $ 0 $ 0 $ 2,903 $ 2,903 $ 0 $ 0 Level 1: Money market funds 1,911 0 0 1,911 1,911 0 0 Mutual funds 1,227 0 (34 ) 1,193 0 1,193 0 Subtotal 3,138 0 (34 ) 3,104 1,911 1,193 0 Level 2: U.S. Treasury securities 10,717 39 (3 ) 10,753 1,250 2,149 7,354 U.S. agency securities 13,467 24 (3 ) 13,488 225 1,818 11,445 Non-U.S. government securities 5,559 11 (2 ) 5,568 551 1,548 3,469 Certificates of deposit and time deposits 4,175 2 (2 ) 4,175 728 977 2,470 Commercial paper 2,853 0 0 2,853 2,237 616 0 Corporate securities 35,241 132 (114 ) 35,259 10 7,241 28,008 Municipal securities 3,411 56 0 3,467 0 595 2,872 Subtotal 75,423 264 (124 ) 75,563 5,001 14,944 55,618 Total $ 81,464 $ 264 $ (158 ) $ 81,570 $ 9,815 $ 16,137 $ 55,618 54 Table of Contents The net unrealized gains as of September 29, 2012 and September 24, 2011 are +related primarily to long-term marketable securities. The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration +management. The net realized gains or losses recognized during 2012 and 2011 were $183 million and $110 million, respectively, and no significant net realized gains or losses during 2010 related to such sales. The maturities of the Company’s +long-term marketable securities generally range from one to five years. As of September 29, 2012 and September 24, +2011, gross unrealized losses related to individual securities that had been in a continuous loss position for 12 months or longer were not significant. As of September 29, 2012, the Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature and does not consider any of its investments +other-than-temporarily impaired. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, +with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment, the Company +reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it +will be required to sell, the investment before recovery of the investment’s cost basis. During 2012, 2011 and 2010, the Company did not recognize any significant impairment charges. Derivative Financial Instruments The Company uses derivatives to partially +offset its business exposure to foreign currency exchange risk. The Company may enter into foreign currency forward and option contracts to offset some of the foreign exchange risk on expected future cash flows on certain forecasted revenue and cost +of sales, on net investments in certain foreign subsidiaries, and on certain existing assets and liabilities. To help protect +gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar hedge a portion of forecasted foreign currency revenue. The Company’s subsidiaries whose +functional currency is not the U.S. dollar and who sell in local currencies may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company typically hedges portions of its +forecasted foreign currency exposure associated with revenue and inventory purchases generally up to six months. To help +protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments +due to fluctuations in foreign currency exchange rates. The Company may also enter into foreign currency forward and option +contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. However, the Company may choose not to hedge certain foreign +currency exchange exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of +the financial impact resulting from movements in foreign currency exchange rates. The Company records all derivatives in the +Consolidated Balance Sheets at fair value. The Company’s accounting treatment of these instruments is based on whether the instruments are designated as hedge or non-hedge instruments. The effective portions of cash flow hedges are recorded in +AOCI until the hedged item is recognized in earnings. The effective portions of net investment hedges are recorded in other comprehensive income as a part of the cumulative translation adjustment. The ineffective portions of cash flow hedges and net 55 Table of Contents investment hedges are recorded in other income and expense. Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line +item to which the derivative relates. The Company had a net deferred loss associated with cash flow hedges of approximately +$240 million and a net deferred gain of approximately $290 million, net of taxes, recorded in AOCI as of September 29, 2012 and September 24, 2011, respectively. Deferred gains and losses associated with cash flow hedges of foreign +currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in +the same period as the related costs are recognized. The majority of the Company’s hedged transactions as of September 29, 2012 are expected to occur within six months. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged +transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified immediately into other income and +expense. Any subsequent changes in fair value of such derivative instruments are reflected in other income and expense unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses +related to the loss of hedge designation on discontinued cash flow hedges during 2012, 2011 and 2010. The Company’s +unrealized net gains and losses on net investment hedges, included in the cumulative translation adjustment account of AOCI, were not significant as of September 29, 2012 and September 24, 2011, respectively. The ineffective portions of +and amounts excluded from the effectiveness test of net investment hedges are recorded in other income and expense. The +gain/loss recognized in other income and expense for foreign currency forward and option contracts not designated as hedging instruments was not significant during 2012, 2011 and 2010, respectively. These amounts represent the net gain or loss on +the derivative contracts and do not include changes in the related exposures, which generally offset a portion of the gain or loss on the derivative contracts. The following table shows the notional principal amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as +of September 29, 2012 and September 24, 2011 (in millions): 2012 2011 Notional Principal Credit Risk Amounts Notional Principal Credit Risk Amounts Instruments designated as accounting hedges: Foreign exchange contracts $ 41,970 $ 140 $ 13,705 $ 537 Instruments not designated as accounting hedges: Foreign exchange contracts $ 13,403 $ 12 $ 9,891 $ 56 The notional principal amounts for outstanding derivative instruments provide one measure of the +transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that +are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency exchange rates at each respective date. The Company’s gross exposure on these transactions may be +further mitigated by collateral received from certain counterparties. The Company’s exposure to credit loss and market risk will vary over time as a function of currency exchange rates. Although the table above reflects the notional principal +and credit risk amounts of the Company’s foreign exchange 56 Table of Contents instruments, it does not reflect the gains or losses associated with the exposures and transactions that the foreign exchange instruments are intended to hedge. The amounts ultimately realized +upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. The Company generally enters into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with +the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from +contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values. As of September 29, 2012, the Company posted cash collateral related to the derivative instruments under its +collateral security arrangements of $278 million, which it recorded as other current assets in the Consolidated Balance Sheet. As of September 24, 2011, the Company received cash collateral related to the derivative instruments under +its collateral security arrangements of $288 million, which it recorded as accrued expenses in the Consolidated Balance Sheet. The Company did not have any derivative instruments with credit-risk related contingent features that would require it to +post additional collateral as of September 29, 2012 or September 24, 2011. The following tables show the +Company’s derivative instruments at gross fair value as reflected in the Consolidated Balance Sheets as of September 29, 2012 and September 24, 2011 (in millions): 2012 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 138 $ 12 $ 150 Derivative liabilities (b): Foreign exchange contracts $ 516 $ 41 $ 557 2011 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (a): Foreign exchange contracts $ 460 $ 56 $ 516 Derivative liabilities (b): Foreign exchange contracts $ 72 $ 37 $ 109 (a) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the Consolidated Balance +Sheets. (b) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the Consolidated Balance +Sheets. 57 Table of Contents The following table shows the pre-tax effect of the Company’s derivative instruments +designated as cash flow and net investment hedges in the Consolidated Statements of Operations for the years ended September 29, 2012 and September 24, 2011 (in millions): Years Ended Gains/(Losses) Recognized in OCI - Effective Portion (c) Gains/(Losses) Reclassified from AOCI into Net Income - Effective  +Portion (c) Gains/(Losses) Recognized – Ineffective Portion and Amount Excluded from Effectiveness +Testing September 29, 2012 September 24, 2011 September 29, 2012 (a) September 24, 2011 (b) Location September 29, 2012 September 24, 2011 Cash flow hedges: Foreign exchange contracts $ (175 ) $ 153 $ 607 $ (704 ) Other income and expense $ (658 ) $ (213 ) Net investment hedges: Foreign exchange contracts (5 ) (43 ) 0 0 Other income and expense 3 1 Total $ (180 ) $ 110 $ 607 $ (704 ) $ (655 ) $ (212 ) (a) Includes gains/(losses) reclassified from AOCI into net income for the effective portion of cash flow hedges, of which $537 million and $70 million +were recognized within net sales and cost of sales, respectively, within the Consolidated Statement of Operations for the year ended September 29, 2012. There were no amounts reclassified from AOCI into income for the effective portion of net +investment hedges for the year ended September 29, 2012. (b) Includes gains/(losses) reclassified from AOCI into income for the effective portion of cash flow hedges, of which $(349) million and $(355) million +were recognized within net sales and cost of sales, respectively, within the Consolidated Statement of Operations for the year ended September 24, 2011. There were no amounts reclassified from AOCI into income for the effective portion of net +investment hedges for the year ended September 24, 2011. (c) Refer to Note 6, “Shareholders’ Equity and Share-based Compensation” of this Form 10-K, which summarizes the activity in AOCI related +to derivatives. Accounts Receivable Trade Receivables The Company has considerable trade receivables +outstanding with its third-party cellular network carriers, wholesalers, retailers, value-added resellers, small and mid-sized businesses, and education, enterprise and government customers. The Company generally does not require collateral from its +customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring +third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit +risk sharing related to any of these arrangements. As of September 29, 2012, the Company had two customers that +represented 10% or more of total trade receivables, one of which accounted for 14% and the other 10%. As of September 24, 2011, there were no customers that accounted for 10% or more of the Company’s total trade receivables. The +Company’s cellular network carriers accounted for 66% and 52% of trade receivables as of September 29, 2012 and September 24, 2011, respectively. The additions and write-offs to the Company’s allowance for doubtful accounts +during 2012, 2011 and 2010 were not significant. 58 Table of Contents Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these manufacturing vendors who manufacture sub-assemblies or assemble final +products for the Company. The Company purchases these components directly from suppliers. Vendor non-trade receivables from three of the Company’s vendors accounted for 45%, 21% and 12% of total non-trade receivables as of September 29, +2012 and vendor non-trade receivables from two of the Company’s vendors accounted for 53% and 29% of total non-trade receivables as of September 24, 2011. The Company does not reflect the sale of these components in net sales and does not +recognize any profits on these sales until the related products are sold by the Company, at which time any profit is recognized as a reduction of cost of sales. Note 3 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 29, 2012 and +September 24, 2011 (in millions): Property, Plant and Equipment 2012 2011 Land and buildings $ 2,439 $ 2,059 Machinery, equipment and internal-use software 15,743 6,926 Office furniture and equipment 241 184 Leasehold improvements 3,464 2,599 Gross property, plant and equipment 21,887 11,768 Accumulated depreciation and amortization (6,435 ) (3,991 ) Net property, plant and equipment $ 15,452 $ 7,777 Accrued Expenses 2012 2011 Accrued warranty and related costs $ 1,638 $ 1,240 Accrued taxes 1,535 1,140 Deferred margin on component sales 1,492 2,038 Accrued marketing and selling expenses 910 598 Accrued compensation and employee benefits 735 590 Other current liabilities 5,104 3,641 Total accrued expenses $ 11,414 $ 9,247 Non-Current Liabilities 2012 2011 Deferred tax liabilities $ 13,847 $ 8,159 Other non-current liabilities 2,817 1,941 Total other non-current liabilities $ 16,664 $ 10,100 59 Table of Contents Note 4 – Goodwill and Other Intangible Assets The Company’s acquired intangible assets with definite lives primarily consist of patents and licenses and +are amortized over periods typically from three to seven years. The following table summarizes the components of gross and net intangible asset balances as of September 29, 2012 and September 24, 2011 (in millions): 2012 2011 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired intangible assets $ 5,166 $ (1,042 ) $ 4,124 $ 3,873 $ (437 ) $ 3,436 Indefinite lived and non-amortizable trademarks 100 0 100 100 0 100 Total acquired intangible assets $ 5,266 $ (1,042 ) $ 4,224 $ 3,973 $ (437 ) $ 3,536 During 2012 and 2011, the Company completed various business acquisitions. In 2012, the aggregate cash +consideration, net of cash acquired, was $350 million, of which $245 million was allocated to goodwill, $113 million to acquired intangible assets and $8 million to liabilities assumed. In 2011, the aggregate cash consideration, net of cash +acquired, was $244 million, of which $167 million was allocated to goodwill and $77 million to acquired intangible assets. The Company’s gross carrying amount of goodwill was $1.1 billion and $896 million as of September 29, 2012 and +September 24, 2011, respectively. The Company did not have any goodwill impairment during 2012, 2011 or 2010. Amortization expense related to acquired intangible assets was $605 million, $192 million and $69 million in 2012, 2011 and 2010, +respectively. As of September 29, 2012 the remaining weighted-average amortization period for acquired intangible assets is 5.2 years. The expected annual amortization expense related to acquired intangible assets as of September 29, 2012, +is as follows (in millions): 2013 $ 673 2014 737 2015 753 2016 758 2017 635 Thereafter 568 Total $ 4,124 60 Table of Contents Note 5 – Income Taxes The provision for income taxes for 2012, 2011, and 2010, consisted of the following (in millions): 2012 2011 2010 Federal: Current $ 7,240 $ 3,884 $ 2,150 Deferred 5,018 2,998 1,676 12,258 6,882 3,826 State: Current 1,182 762 655 Deferred (123 ) 37 (115 ) 1,059 799 540 Foreign: Current 1,203 769 282 Deferred (490 ) (167 ) (121 ) 713 602 161 Provision for income taxes $ 14,030 $ 8,283 $ 4,527 The foreign provision for income taxes is based on foreign pretax earnings of $36.8 billion, $24.0 +billion and $13.0 billion in 2012, 2011 and 2010, respectively. The Company’s consolidated financial statements provide for any related tax liability on amounts that may be repatriated, aside from undistributed earnings of certain of the +Company’s foreign subsidiaries that are intended to be indefinitely reinvested in operations outside the U.S. As of September 29, 2012, U.S. income taxes have not been provided on a cumulative total of $40.4 billion of such earnings. The +amount of unrecognized deferred tax liability related to these temporary differences is estimated to be approximately $13.8 billion. As of September 29, 2012 and September 24, 2011, $82.6 billion and $54.3 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign +subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate (35% in +2012, 2011 and 2010) to income before provision for income taxes for 2012, 2011, and 2010, is as follows (in millions): 2012 2011 2010 Computed expected tax $ 19,517 $ 11,973 $ 6,489 State taxes, net of federal effect 677 552 351 Indefinitely invested earnings of foreign subsidiaries (5,895 ) (3,898 ) (2,125 ) Research and development credit, net (103 ) (167 ) (23 ) Domestic production activities deduction (328 ) (168 ) (48 ) Other 162 (9 ) (117 ) Provision for income taxes $ 14,030 $ 8,283 $ 4,527 Effective tax rate 25.2% 24.2% 24.4% The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan +awards. For stock options, the Company receives an income tax benefit calculated as the tax effect of the difference 61 Table of Contents between the fair market value of the stock issued at the time of the exercise and the exercise price. For RSUs, the Company receives an income tax benefit upon the award’s vesting equal +to the tax effect of the underlying stock’s fair market value. The Company had net excess tax benefits from equity awards of $1.4 billion, $1.1 billion and $742 million in 2012, 2011 and 2010, respectively, which were reflected as increases to +common stock. As of September 29, 2012 and September 24, 2011, the significant components of the Company’s +deferred tax assets and liabilities were (in millions): 2012 2011 Deferred tax assets: Accrued liabilities and other reserves $ 2,101 $ 1,610 Basis of capital assets and investments 447 390 Share-based compensation 395 355 Other 1,094 795 Total deferred tax assets 4,037 3,150 Less valuation allowance 0 0 Deferred tax assets, net of valuation allowance 4,037 3,150 Deferred tax liabilities: Unremitted earnings of foreign subsidiaries 14,712 8,896 Other 193 272 Total deferred tax liabilities 14,905 9,168 Net deferred tax liabilities $ (10,868 ) $ (6,018 ) Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax +effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in +which those temporary differences are expected to be recovered or settled. Uncertain Tax Positions Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position +will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest +amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one +year as non-current liabilities in the Consolidated Balance Sheets. As of September 29, 2012, the total amount of gross +unrecognized tax benefits was $2.1 billion, of which $889 million, if recognized, would affect the Company’s effective tax rate. As of September 24, 2011, the total amount of gross unrecognized tax benefits was $1.4 billion, of which +$563 million, if recognized, would affect the Company’s effective tax rate. 62 Table of Contents The aggregate changes in the balance of gross unrecognized tax benefits, which excludes +interest and penalties, for 2012, 2011, and 2010, is as follows (in millions): 2012 2011 2010 Beginning Balance $ 1,375 $ 943 $ 971 Increases related to tax positions taken during a prior year 340 49 61 Decreases related to tax positions taken during a prior year (107 ) (39 ) (224 ) Increases related to tax positions taken during the current year 467 425 240 Decreases related to settlements with taxing authorities (3 ) 0 (102 ) Decreases related to expiration of statute of limitations (10 ) (3 ) (3 ) Ending Balance $ 2,062 $ 1,375 $ 943 The Company includes interest and penalties related to unrecognized tax benefits within the provision for +income taxes. As of September 29, 2012 and September 24, 2011, the total amount of gross interest and penalties accrued was $401 million and $261 million, respectively, which is classified as non-current liabilities in the Consolidated +Balance Sheets. In connection with tax matters, the Company recognized interest expense in 2012 and 2011 of $140 million and $14 million, respectively, and in 2010 the Company recognized an interest benefit of $43 million. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign +jurisdictions. For U.S. federal income tax purposes, all years prior to 2004 are closed. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s federal income tax returns for the years 2004 through +2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2009. In addition, the Company is also subject to audits by state, +local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 1989 and 2002, respectively, generally remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the +outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for +income tax in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that tax audit resolutions could reduce its unrecognized tax benefits by +between $120 million and $170 million in the next 12 months. Note 6 – Shareholders’ Equity and Share-based Compensation Preferred Stock The Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors +is authorized to determine or alter the rights, preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock. Dividend and Stock Repurchase Program In 2012, the Board of Directors of +the Company approved a dividend policy pursuant to which it plans to make, subject to subsequent declaration, quarterly dividends of $2.65 per share. On July 24, 2012, the Board of Directors declared a dividend of $2.65 per share to +shareholders of record as of the close of business on August 13, 2012. The Company paid $2.5 billion in conjunction with this dividend on August 16, 2012. No dividends were declared in the first three quarters of 2012 or in 2011 and +2010 . 63 Table of Contents In 2012, the Company’s Board of Directors authorized a program to repurchase up to $10 +billion of the Company’s common stock beginning in 2013. The repurchase program is expected to be executed over a three-year period with the primary objective of neutralizing the impact of dilution from future employee equity grants and +employee stock purchase programs. The repurchase program does not obligate the Company to acquire any specific number of shares. In August 2012, the Company entered into a Rule 10b5-1 compliant accelerated share repurchase (“ASR”) +program with a financial institution to purchase up to $2 billion of the Company’s common stock during 2013. The total number of shares to be purchased under the ASR program will be based on the volume-weighted average price of the +Company’s common stock during the purchase period and will be reflected as a reduction of shares outstanding on the date of purchase. The Company may also purchase its common stock in open market transactions, in compliance with all +applicable securities laws. Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income refers to revenue, expenses, and gains and losses that under GAAP are recorded as an +element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, +unrealized gains and losses on marketable securities classified as available-for-sale, and net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges. The following table shows the components of AOCI, net of taxes, as of September 29, 2012 and September 24, 2011 (in millions): 2012 2011 Net unrealized gains/losses on marketable securities $ 731 $ 130 Net unrecognized gains/losses on derivative instruments (240 ) 290 Cumulative foreign currency translation 8 23 Accumulated other comprehensive income $ 499 $ 443 The change in fair value of available-for-sale securities included in other comprehensive income was +$601 million, $(41) million and $123 million, net of taxes in 2012, 2011 and 2010, respectively. The tax effect related to the change in unrealized gains/losses on available-for-sale securities was $(353) million, $24 million and $(72) million +for 2012, 2011 and 2010, respectively. The following table shows activity in other comprehensive income related to +derivatives, net of taxes, held by the Company during 2012, 2011, and 2010 (in millions): 2012 2011 2010 Change in fair value of derivatives $ (131 ) $ 92 $ (180 ) Adjustment for net gains/losses realized and included in net income (399 ) 450 (73 ) Change in unrecognized gains/losses on derivative instruments $ (530 ) $ 542 $ (253 ) The tax effect related to the changes in fair value of derivatives was $73 million, $(50) million and $97 +million for 2012, 2011 and 2010, respectively. The tax effect related to derivative gains/losses reclassified from other comprehensive income to income was $220 million, $(250) million and $43 million for 2012, 2011 and 2010, respectively. 64 Table of Contents Employee Benefit Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the “2003 +Plan”) is a shareholder approved plan that provides for broad-based equity grants to employees, including executive officers. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation +rights, stock purchase rights and performance-based awards. Options granted under the 2003 Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years, based on continued employment, +with either annual, semi-annual or quarterly vesting. In general, RSUs granted under the 2003 Plan vest over two to four years, based on continued employment and are settled upon vesting in shares of the Company’s common stock on a one-for-one +basis. Each share issued with respect to an award granted under the 2003 Plan (other than a stock option or stock appreciation right) reduces the number of shares available for grant under the plan by two shares, whereas shares issued in respect of +an option or stock appreciation right count against the number of shares available for grant on a one-for-one basis. All RSUs, other than RSUs held by the Chief Executive Officer, granted under the 2003 Plan have dividend equivalent rights +(“DER”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DER are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DER are accumulated and paid +when the underlying shares vest. As of September 29, 2012, approximately 37.1 million shares were reserved for future issuance under the 2003 Plan. 1997 Director Stock Plan The 1997 Director Stock Plan (the “Director +Plan”) is a shareholder approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director +joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the relative mixture of stock options and RSUs for the initial and +annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants without shareholder approval. Each share issued with respect to RSUs granted under the Director Plan reduces the +number of shares available for grant under the plan by two shares. The Director Plan expires November 9, 2019. All RSUs granted under the Director Plan are entitled to DER. As of September 29, 2012, approximately 184,000 shares were +reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the fourth quarter of 2012, executive officers Timothy D. Cook, Peter Oppenheimer, D. Bruce Sewell, Phillip W. Schiller and Jeffrey +E. Williams, and directors William V. Campbell and Arthur D. Levinson had equity trading plans adopted in accordance with Rule 10b5-1(c)(1) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). An equity trading plan +is a written document that pre-establishes the amounts, prices and dates (or a formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired pursuant to the Company’s +employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder approved plan under which substantially all employees +may purchase the Company’s common stock through payroll deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions +under the Purchase Plan are limited to 10% of the employee’s compensation and employees may not purchase more than $25,000 of stock during any calendar year. As of September 29, 2012, approximately 2.5 million shares were reserved for +future issuance under the Purchase Plan. 65 Table of Contents 401(k) Plan The Company’s 401(k) Plan (the “401(k) Plan”) is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees +may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($17,000 for calendar year 2012). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the +employee’s eligible earnings. The Company’s matching contributions to the 401(k) Plan were $114 million, $90 million and $72 million in 2012, 2011 and 2010, respectively. Restricted Stock Units A summary of the Company’s RSU activity and +related information for 2012, 2011, and 2010, is as follows: Number +of RSUs (in thousands) Weighted- Average Grant Date  +Fair Value Aggregate Intrinsic Value (in millions) Balance at September 26, 2009 12,263 $ 122.52 RSUs granted 6,178 $ 214.37 RSUs vested (4,685 ) $ 119.85 RSUs cancelled (722 ) $ 147.56 Balance at September 25, 2010 13,034 $ 165.63 RSUs granted 6,667 $ 312.63 RSUs vested (4,513 ) $ 168.08 RSUs cancelled (742 ) $ 189.08 Balance at September 24, 2011 14,446 $ 231.49 RSUs granted 7,799 $ 431.35 RSUs vested (6,305 ) $ 205.27 RSUs cancelled (935 ) $ 256.01 Balance at September 29, 2012 15,005 $ 344.87 $ 10,010 The fair value as of the respective vesting dates of RSUs was $3.3 billion, $1.5 billion and $1.0 billion +for 2012, 2011 and 2010, respectively. The majority of RSUs that vested in 2012, 2011 and 2010 were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable +income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 2.3 million, 1.6 million and 1.8 million for 2012, 2011 and 2010, respectively, and were +based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $1.2 billion, $520 million and $406 million +in 2012, 2011 and 2010, respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the +number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. 66 Table of Contents Stock Option Activity A summary of the Company’s stock option activity and related information for 2012, 2011, and 2010, is as follows: Outstanding Options Number of Options (in thousands) Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value (in millions) Balance at September 26, 2009 34,375 $ 81.17 Options granted 34 $ 202.00 Options assumed 98 $ 11.99 Options cancelled (430 ) $ 136.27 Options exercised (12,352 ) $ 62.69 Balance at September 25, 2010 21,725 $ 90.46 Options granted 1 $ 342.62 Options cancelled (163 ) $ 128.42 Options exercised (9,697 ) $ 67.63 Balance at September 24, 2011 11,866 $ 108.64 Options assumed 41 $ 30.86 Options cancelled (25 ) $ 103.22 Options exercised (5,337 ) $ 84.85 Balance at September 29, 2012 6,545 $ 127.56 1.9 $ 3,531 Exercisable at September 29, 2012 6,505 $ 128.03 1.8 $ 3,507 Expected to vest after September 29, 2012 40 $ 51.07 6.7 $ 24 Aggregate intrinsic value represents the value of the Company’s closing stock price on the last +trading day of the fiscal period in excess of the weighted-average exercise price multiplied by the number of options outstanding or exercisable. Total intrinsic value of options at time of exercise was $2.3 billion, $2.6 billion and $2.0 billion +for 2012, 2011 and 2010, respectively. Share-based Compensation Share-based compensation cost for RSUs is measured based on the closing fair market value of the Company’s common stock on the date +of grant. Share-based compensation cost for stock options and employee stock purchase plan rights (“stock purchase rights”) is estimated at the grant date and offering date, respectively, based on the fair-value as calculated by the BSM +option-pricing model. The BSM option-pricing model incorporates various assumptions including expected volatility, estimated expected life and interest rates. The Company recognizes share-based compensation cost as expense on a straight-line +basis over the requisite service period. The Company did not grant any stock options during 2012. The Company granted 1,370 +and 34,000 stock options during 2011 and 2010, respectively. The weighted-average grant date fair value per share of stock options granted during 2011 and 2010 was $181.13 and $108.58, respectively. During 2012 and 2010, in conjunction with certain business combinations, the Company assumed 41,000 and 98,000 stock options, +respectively, which had a weighted-average fair value per share of $405.39 and $216.82, respectively. The Company did not assume any stock options during 2011. The weighted-average fair value of stock purchase rights per share was $108.44, $71.47 and $45.03 during 2012, 2011 and 2010, respectively. 67 Table of Contents The following table shows a summary of the share-based compensation expense included in the +Consolidated Statements of Operations for 2012, 2011, and 2010 (in millions): 2012 2011 2010 Cost of sales $ 265 $ 200 $ 151 Research and development 668 450 323 Selling, general and administrative 807 518 405 Total share-based compensation expense $ 1,740 $ 1,168 $ 879 The income tax benefit related to share-based compensation expense was $567 million, $467 million and +$314 million for 2012, 2011 and 2010, respectively. As of September 29, 2012, the total unrecognized compensation cost related to outstanding stock options and RSUs was $4.2 billion, which the Company expects to recognize over a +weighted-average period of 3.3 years. Note 7 – Commitments and Contingencies Accrued Warranty and Indemnification The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The +Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. The Company provides currently for the estimated cost that may be incurred under its basic limited product warranties at the time +related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, historical and projected warranty claim rates, +historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its pre-existing warranty liabilities and adjusts the amounts as +necessary based on actual experience and changes in future estimates. The following table shows changes in the Company’s +accrued warranties and related costs for 2012, 2011, and 2010 (in millions): 2012 2011 2010 Beginning accrued warranty and related costs $ 1,240 $ 761 $ 577 Cost of warranty claims (1,786 ) (1,147 ) (713 ) Accruals for product warranty 2,184 1,626 897 Ending accrued warranty and related costs $ 1,638 $ 1,240 $ 761 The Company generally does not indemnify end-users of its operating system and application software +against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in +the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified +third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would materially adversely affect its financial condition or operating results. Therefore, +the Company did not record a liability for infringement costs related to indemnification as of either September 29, 2012 or September 24, 2011. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent +permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such 68 Table of Contents individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due +to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and +payments made under these agreements historically have not been material. Concentrations in the Available Sources of Supply of Materials +and Product Although most components essential to the Company’s business are generally available from multiple +sources, a number of components are currently obtained from single or limited sources, which subjects the Company to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times +subject to industry-wide shortages and significant commodity pricing fluctuations. In addition, the Company has entered into various agreements for the supply of components; however there can be no guarantee that the Company will be able to extend +or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that can materially adversely affect its financial condition and operating results. The Company and other participants in the markets for mobile communication and media devices and personal computers also +compete for various components with other industries that have experienced increased demand for their products. The Company also uses some custom components that are not common to the rest of these industries, and new products introduced by the +Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. +If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results +could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and +obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components +customized to meet the Company’s requirements. Substantially all of the Company’s hardware products are +manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing +partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could +be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover its requirements for periods up to 150 days. Long-Term Supply Agreements The Company has entered into long-term agreements to secure the supply of certain inventory components. Under certain of these agreements, which expire between 2012 and 2022, the Company has made +prepayments for the future purchase of inventory components and has acquired capital equipment to use in the manufacturing of such components. As of September 29, 2012, the Company had a total of $4.2 billion of inventory component prepayments outstanding, of which $1.2 billion are classified as other current assets and $3.0 billion are +classified as other assets in the Consolidated Balance Sheets. The Company had a total of $2.3 billion of inventory component prepayments outstanding as of September 24, 2011. The Company’s outstanding prepayments will be applied to +certain inventory component purchases made during the term of each respective agreement. The Company utilized $943 million and $173 million of inventory component prepayments during 2012 and 2011, respectively. 69 Table of Contents Other Off-Balance Sheet Commitments Lease Commitments The Company leases various equipment and facilities, +including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. The major facility leases are typically for terms not exceeding 10 years and +generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of +September 29, 2012, the Company’s total future minimum lease payments under noncancelable operating leases were $4.4 billion, of which $3.1 billion related to leases for retail space. Rent expense under all operating leases, including both cancelable and noncancelable leases, was $488 million, $338 million and $271 +million in 2012, 2011 and 2010, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 29, 2012, are as follows (in millions): 2013 $ 516 2014 556 2015 542 2016 513 2017 486 Thereafter 1,801 Total minimum lease payments $ 4,414 Other Commitments As of September 29, 2012, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $21.1 billion. In addition to the off-balance sheet commitments mentioned above, the Company had outstanding obligations of $988 million as of +September 29, 2012, which were comprised mainly of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to advertising, research and development, Internet and +telecommunications services and other obligations. Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and have not been fully +adjudicated, certain of which are discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” In the opinion of +management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of litigation is inherently +uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s +expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple +Inc. vs Samsung Electronics Co., Ltd, et al. On August 24, 2012, a jury returned a verdict awarding the Company $1.05 +billion in its lawsuit against Samsung Electronics and affiliated parties in the United States District Court, Northern District of California, San Jose Division. Because the award is subject to entry of final judgment and may be subject to +appeal, the Company has not recognized the award in its consolidated financial statements for the year ended September 29, 2012. 70 Table of Contents Note 8 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach +designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its reportable operating segments, which are generally based on the nature and location of its +customers, to be the Americas, Europe, Japan, Asia-Pacific and Retail. The results of the Americas, Europe, Japan and Asia-Pacific segments do not include results of the Retail segment. The Americas segment includes both North and South America. The +Europe segment includes European countries, as well as the Middle East and Africa. The Asia-Pacific segment includes Australia and Asian countries, other than Japan. The Retail segment operates Apple retail stores in 13 countries, including the U.S. +Each operating segment provides similar hardware and software products and similar services. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its operating segments based on net sales and operating income. Net sales for +geographic segments are generally based on the location of customers, while Retail segment net sales are based on sales from the Company’s retail stores. Operating income for each segment includes net sales to third parties, related cost of +sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and +certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses, such as manufacturing costs and variances not included in standard costs, research and development, corporate +marketing expenses, share-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs. Prior to 2012, the Company allocated to corporate expenses certain costs associated with +its high-profile retail stores that have been designed and built to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Beginning in 2012, the Company no longer allocates these costs to corporate expenses and +reclassified $102 million and $75 million of such costs from corporate to Retail segment expenses for 2011 and 2010, respectively. The Company does not include intercompany transfers between segments for management reporting purposes. Segment assets include receivables and inventories, and for the Retail segment also includes capital assets. Segment assets exclude +corporate assets, such as cash and cash equivalents, short-term and long-term marketable securities, vendor non-trade receivables, other long-term investments, manufacturing and corporate facilities, product tooling and manufacturing process +equipment, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets. Except for the Retail segment, capital asset purchases for long-lived assets are not reported to management by segment and therefore are excluded from +the geographic segment assets and instead included in corporate assets. Cash payments for capital asset purchases by the Retail segment were $858 million, $612 million and $392 million for 2012, 2011 and 2010, respectively. The Company’s total +depreciation and amortization was $3.3 billion, $1.8 billion and $1.0 billion in 2012, 2011 and 2010, respectively, of which $319 million, $273 million and $198 million was related to the Retail segment in the respective years. Depreciation and +amortization on segment assets included in the geographic segments was not significant. 71 Table of Contents The following table shows information by operating segment for 2012, 2011, and 2010 (in +millions): 2012 2011 2010 Americas: Net sales $ 57,512 $ 38,315 $ 24,498 Operating income $ 23,733 $ 13,538 $ 7,590 Europe: Net sales $ 36,323 $ 27,778 $ 18,692 Operating income $ 15,015 $ 11,528 $ 7,524 Japan: Net sales $ 10,571 $ 5,437 $ 3,981 Operating income $ 5,915 $ 2,481 $ 1,846 Asia-Pacific: Net sales $ 33,274 $ 22,592 $ 8,256 Operating income $ 14,234 $ 9,587 $ 3,647 Retail: Net sales $ 18,828 $ 14,127 $ 9,798 Operating income $ 4,719 $ 3,242 $ 2,289 A reconciliation of the Company’s segment operating income to the consolidated financial statements +for 2012, 2011, and 2010, is as follows (in millions): 2012 2011 2010 Segment operating income $ 63,616 $ 40,376 $ 22,896 Other corporate expenses, net (a) (6,635 ) (5,418 ) (3,632 ) Share-based compensation expense (1,740 ) (1,168 ) (879 ) Total operating income $ 55,241 $ 33,790 $ 18,385 (a) Other corporate expenses include research and development, corporate marketing expenses, manufacturing costs and variances not included in standard +costs, and other separately managed general and administrative expenses. The following table shows total +assets by segment and a reconciliation to the consolidated financial statements as of September 29, 2012 and September 24, 2011 (in millions): 2012 2011 Segment assets: Americas $ 5,525 $ 2,782 Europe 3,095 1,520 Japan 1,698 637 Asia-Pacific 2,234 1,710 Retail 2,725 2,151 Total segment assets 15,277 8,800 Corporate assets 160,787 107,571 Total assets $ 176,064 $ 116,371 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net +sales in 2012 and 2011. No single country other than the U.S. accounted for more than 10% of net sales in 2010. There was no single customer that accounted for more than 10% of net sales in 2012, 2011 or 2010. Net sales for 2012, 72 Table of Contents 2011, and 2010 and long-lived assets as of September 29, 2012 and September 24, 2011 are as follows (in millions): 2012 2011 2010 Net sales: U.S. $ 60,949 $ 41,812 $ 28,633 China (a) 22,797 12,472 2,764 Other countries 72,762 53,965 33,828 Total net sales $ 156,508 $ 108,249 $ 65,225 2012 2011 Long-lived assets: U.S. $ 6,012 $ 4,375 China (a) 7,314 2,613 Other countries 2,560 1,090 Total long-lived assets $ 15,886 $ 8,078 (a) China includes Hong Kong. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets +related to retail stores and related infrastructure. Information regarding net sales by product for 2012, +2011, and 2010, is as follows (in millions): 2012 2011 2010 Mac desktops (a)(i) $ 6,040 $ 6,439 $ 6,201 Mac portables (b)(i) 17,181 15,344 11,278 Total Mac net sales 23,221 21,783 17,479 iPod(c)(i) 5,615 7,453 8,274 Other music related products and services (d) 8,534 6,314 4,948 iPhone and related products and services (e)(i) 80,477 47,057 25,179 iPad and related products and services (f)(i) 32,424 20,358 4,958 Peripherals and other hardware (g) 2,778 2,330 1,814 Software, service and other net sales (h) 3,459 2,954 2,573 Total net sales $ 156,508 $ 108,249 $ 65,225 (a) Includes revenue from iMac, Mac mini and Mac Pro sales. (b) Includes revenue from MacBook, MacBook Air and MacBook Pro sales. (c) Includes revenue from iPod sales. (d) Includes revenue from sales from the iTunes Store, App Store, and iBookstore in addition to sales of iPod services and Apple-branded and third-party +iPod accessories. (e) Includes revenue from sales of iPhone, iPhone services, and Apple-branded and third-party iPhone accessories. (f) Includes revenue from sales of iPad, iPad services, and Apple-branded and third-party iPad accessories. (g) Includes revenue from sales of displays, networking products, and other hardware. (h) Includes revenue from sales of Apple-branded and third-party Mac software, and services. (i) Includes amortization of related revenue deferred for non-software services and embedded software upgrade rights. 73 Table of Contents Note 9 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters +of 2012 and 2011 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2012 Net sales $ 35,966 $ 35,023 $ 39,186 $ 46,333 Gross margin $ 14,401 $ 14,994 $ 18,564 $ 20,703 Net income $ 8,223 $ 8,824 $ 11,622 $ 13,064 Earnings per share: Basic $ 8.76 $ 9.42 $ 12.45 $ 14.03 Diluted $ 8.67 $ 9.32 $ 12.30 $ 13.87 Fourth Quarter Third Quarter Second Quarter First Quarter 2011 Net sales $ 28,270 $ 28,571 $ 24,667 $ 26,741 Gross margin $ 11,380 $ 11,922 $ 10,218 $ 10,298 Net income $ 6,623 $ 7,308 $ 5,987 $ 6,004 Earnings per share: Basic $ 7.13 $ 7.89 $ 6.49 $ 6.53 Diluted $ 7.05 $ 7.79 $ 6.40 $ 6.43 Basic and diluted earnings per share are computed independently for each of the quarters presented. +Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. 74 Table of Contents Report of Ernst & Young LLP, Independent Registered +Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 29, 2012 and September 24, 2011, and +the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended September 29, 2012. These financial statements are the responsibility of the Company’s management. +Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in +accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material +misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as +well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Inc. at September 29, 2012 and September 24, +2011, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 29, 2012, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple +Inc.’s internal control over financial reporting as of September 29, 2012, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission +and our report dated October 31, 2012 expressed an unqualified opinion thereon. /s/ Ernst & +Young LLP San Jose, California October 31, 2012 75 Table of Contents Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 29, 2012, based on criteria established in Internal Control – Integrated Framework issued by +the Committee of Sponsoring Organizations of the Treadway Commission (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the +effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control +over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our +audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, +and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, +in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in +accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of +September 29, 2012, based on the COSO criteria. We also have audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), the 2012 consolidated financial statements of Apple Inc. and our report dated October 31, 2012 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 31, 2012 76 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of +Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the +Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act +were effective as of September 29, 2012 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported +within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as +appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of +financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those +policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the +Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and +that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets +that could have a material effect on the financial statements. Management, including the Company’s +Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, +not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. +Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of +controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as +defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 29, 2012 +to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has +issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. 77 Table of Contents Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of fiscal 2012, which were +identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal +control over financial reporting. Item 9B. Other Information Effective October 29, 2012, Scott Forstall, the Company’s Senior Vice President of Mobile Software, has transitioned from that +position into a new role as Special Advisor to the Chief Executive Officer. Effective October 30, 2012, the Company +appointed Peter Oppenheimer as the Principal Accounting Officer of the Company. Mr. Oppenheimer also serves as the Company’s Senior Vice President, Chief Financial Officer and is the Company’s Principal Financial Officer. 78 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Directors, Executive Officers and Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting +Compliance” in the Company’s 2013 Proxy Statement to be filed with the U.S. Securities and Exchange Commission (“SEC”) within 120 days after September 29, 2012 in connection with the solicitation of proxies for the +Company’s 2013 annual meeting of shareholders and is incorporated herein by reference. Item 11. Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation” and under the subheadings +“Board Oversight of Risk Management,” “Compensation of Directors,” “Director Compensation-2012” and “Compensation Committee Interlocks and Insider Participation” under the heading “Directors, Executive +Officers and Corporate Governance” in the Company’s 2013 Proxy Statement to be filed with the SEC within 120 days after September 29, 2012 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Security Ownership of Certain Beneficial Owners and +Management” and “Equity Compensation Plan Information” in the Company’s 2013 Proxy Statement to be filed with the SEC within 120 days after September 29, 2012 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the heading “Review, Approval or Ratification of Transactions with Related Persons” and under the subheading “Board Committees” +under the heading “Directors, Executive Officers and Corporate Governance” in the Company’s 2013 Proxy Statement to be filed with the SEC within 120 days after September 29, 2012 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the +Independent Registered Public Accounting Firm” under “Proposal No. 2 Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2013 Proxy Statement to be filed with the SEC within 120 +days after September 29, 2012 and is incorporated herein by reference. 79 Table of Contents PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 29, 2012, September  +24, 2011, and September 25, 2010 43 Consolidated Balance Sheets as of September 29, 2012 and September 24, 2011 44 Consolidated Statements of Shareholders’ Equity for the years ended September 29, 2012,  +September 24, 2011, and September 25, 2010 45 Consolidated Statements of Cash Flows for the years ended September 29, 2012, September  +24, 2011, and September 25, 2010 46 Notes to Consolidated Financial Statements 47 Selected Quarterly Financial Information (Unaudited) 74 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 75 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the consolidated financial statements and notes thereto included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K The information required by this Section (a)(3) of Item 15 is set forth on the exhibit index that follows the Signatures page of this +Form 10-K. 80 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized. Date: October 31, 2012 APPLE INC. By: /s/  Peter Oppenheimer Peter Oppenheimer Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Peter Oppenheimer, jointly and severally, his attorneys-in-fact, each with +the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange +Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated: Name Title Date /s/    Timothy D. +Cook TIMOTHY D. COOK Chief Executive Officer and Director (Principal Executive Officer) October 31, 2012 /s/    Peter +Oppenheimer PETER OPPENHEIMER Senior Vice President, Chief Financial Officer (Principal Financial Officer +and Principal Accounting Officer) October 31, 2012 /s/    William V. +Campbell WILLIAM V. CAMPBELL Director October 31, 2012 /s/    Millard S. +Drexler MILLARD S. DREXLER Director October 31, 2012 /s/    Al +Gore AL GORE Director October 31, 2012 /s/    Robert A. +Iger ROBERT A. IGER Director October 31, 2012 /s/    Andrea +Jung ANDREA JUNG Director October 31, 2012 /s/    Arthur D. +Levinson ARTHUR D. LEVINSON Director October 31, 2012 /s/    Ronald D. +Sugar RONALD D. SUGAR Director October 31, 2012 81 Table of Contents EXHIBIT INDEX Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on July 10, 2009. 10-Q 3.1 6/27/09 3.2 Amended Bylaws of the Registrant, as of April 20, 2011. 10-Q 3.2 3/26/11 4.1 Form of Common Stock Certificate of the Registrant. 10-Q 4.1 12/30/06 10.1* Amended Employee Stock Purchase Plan, effective as of March 8, 2010. 10-Q 10.1 3/27/10 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* 1997 Director Stock Plan, as amended through May 24, 2012. 10-Q 10.3 6/30/12 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement effective as of November 11, 2008. 10-Q 10.10 12/27/08 10.6* Form of Restricted Stock Unit Award Agreement effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.7* Form of Restricted Stock Unit Award Agreement effective as of April 6, 2012. 10-Q 10.8 3/31/12 10.8* Summary Description of Amendment, effective as of May 24, 2012, to certain Restricted Stock Unit Award Agreements outstanding as of April 5, 2012. 10-Q 10.8 6/30/12 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS** XBRL Instance Document. 101.SCH** XBRL Taxonomy Extension Schema Document. 101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document. 101.DEF** XBRL Taxonomy Extension Definition Linkbase Document. 101.LAB** XBRL Taxonomy Extension Label Linkbase Document. 101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. 82 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-13-416534/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-13-416534/full-submission.txt new file mode 100644 index 0000000..239ad6a --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-13-416534/full-submission.txt @@ -0,0 +1,1112 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 28, 2013 Or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period +from to Commission file number: 000-10030 APPLE INC. (Exact name of registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code: (408) 996-1010 Securities +registered pursuant to Section 12(b) of the Act: Common Stock, no par value The NASDAQ Stock Market LLC (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports +pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports +required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such +filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically +and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the +registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements +incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller +reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting and non-voting stock held by +non-affiliates of the registrant, as of March 29, 2013, the last business day of the registrant’s most recently completed second fiscal quarter, was approximately $416,005,000,000. Solely for purposes of this disclosure, shares of common +stock held by executive officers and directors of the registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a +conclusive determination for any other purposes. 899,738,000 shares of common stock were issued and outstanding as of +October 18, 2013. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s definitive proxy statement relating to its 2014 annual meeting of shareholders (the “2014 Proxy +Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2014 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year +to which this report relates. Table of Contents Apple Inc. Form 10-K For the Fiscal Year Ended September 28, 2013 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 9 Item 1B. Unresolved Staff Comments 20 Item 2. Properties 20 Item 3. Legal Proceedings 21 Item 4. Mine Safety Disclosures 21 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases + of Equity Securities 22 Item 6. Selected Financial Data 24 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 25 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 42 Item 8. Financial Statements and Supplementary Data 44 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 81 Item 9A. Controls and Procedures 81 Item 9B. Other Information 82 Part III Item 10. Directors, Executive Officers and Corporate Governance 83 Item 11. Executive Compensation 83 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 83 Item 13. Certain Relationships and Related Transactions and Director Independence 83 Item 14. Principal Accounting Fees and Services 83 Part IV Item 15. Exhibits, Financial Statement Schedules 84 Table of Contents The Business section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and +uncertainties. Many of the forward-looking statements are located in “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events +based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” +“believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. +Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that +might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. +Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking +statements for any reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures, and markets mobile communication and media devices, personal +computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple TV ® , a portfolio of consumer and professional software applications, the iOS and OS X ® operating systems, iCloud ® , +and a variety of accessory, service and support offerings. The Company also sells and delivers digital content and applications through the iTunes Store ® , App Store™, iBooks Store™, and Mac App Store. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as +well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including application software, and +various accessories, through its online and retail stores. The Company sells to consumers; small and mid-sized businesses (“SMB”); and education, enterprise and government customers. The Company’s fiscal year is the 52 or 53-week +period that ends on the last Saturday of September. Unless otherwise stated, all information presented in this Form 10-K is based on the Company’s fiscal calendar. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to +design and develop its own operating systems, hardware, application software, and services to provide its customers new products and solutions with superior ease-of-use, seamless integration, and innovative design. The Company believes continual +investment in research and development, marketing and advertising is critical to the development and sale of innovative products and technologies. As part of its strategy, the Company continues to expand its platform for the discovery and delivery +of third-party digital content and applications through the iTunes Store. As part of the iTunes Store, the Company’s App Store and iBooks Store allow customers to discover and download applications and books through either a Mac or +Windows-based computer or through “iOS devices,” namely iPhone, iPad and iPod touch ® . The +Company’s Mac App Store allows customers to easily discover, download and install Mac applications. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the +Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. +Therefore, the Company’s strategy also includes enhancing and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales +support experience. 1 Table of Contents Business Organization The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its reportable operating segments, which are generally based on the nature and location of its +customers, to be the Americas, Europe, Japan, Greater China, Rest of Asia Pacific and Retail. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. +The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and Asian countries, other than those countries included in the Company’s other operating segments. The Retail segment operates +Apple retail stores in 13 countries, including the U.S. Each operating segment provides similar hardware and software products and similar services. The results of the Company’s geographic segments do not include results of the Retail segment. +Further information regarding the Company’s operating segments may be found in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, +Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Products iPhone iPhone is the Company’s line of smartphones that combines a phone, music player, and internet device in one +product, and is based on Apple’s iOS Multi-Touch™ operating system. iPhone has an integrated photo and video camera and photo library app, and on qualifying devices, also includes Siri ® , a voice activated intelligent assistant. iPhone works with the iTunes Store, the App Store and iBooks Store for purchasing, organizing and playing music, movies, TV +shows, podcasts, books, and apps. In addition to apps delivered with iOS, beginning in September 2013, free downloads of +iPhoto ® , iMovie ® and iWork ® apps for iOS +became available with all new iPhones. iPhone is compatible with both Mac and Windows personal computers and Apple’s iCloud services which provide synchronization of mail, contacts, calendars, apps, music, photos, documents, and more across +users’ devices. The latest versions, introduced in September 2013, are iPhone 5c and iPhone 5s. iPad iPad and iPad mini™ are the Company’s line of multi-purpose tablets based on Apple’s iOS Multi-Touch +operating system. iPad has an integrated photo and video camera and photo library app, and on qualifying devices, also includes Siri. iPad works with the iTunes Store, the iBooks Store, and the App Store for purchasing and playing music, movies, TV +shows, podcasts, books, and apps. In addition to apps delivered with iOS for qualifying devices, beginning in September 2013, iPhoto, iMovie and iWork apps for iOS became available as free downloads with all new iPads. iPad is compatible with both +Mac and Windows personal computers and Apple’s iCloud services. In October 2013, the Company announced iPad Air™, its fifth generation iPad, and iPad mini with Retina ® display. Mac Mac is the Company’s line of desktop and portable personal computers. Macs feature Intel microprocessors, the OS +X operating system and include Mail, Safari web browser, Messages, Calendars, Reminders, Contacts and the iLife ® suite of software apps. The Company’s desktop computers include iMac ® , Mac Pro ® and Mac mini. The Company’s portable computers include MacBook Pro ® and MacBook Air ® . Beginning in October 2013, the Company’s iWork productivity suite of apps for OS X became available as free downloads with all new Macs. iPod The Company’s iPod line of portable digital music and media players includes iPod touch, iPod nano ® , iPod shuffle ® and iPod +classic ® . All iPods work with iTunes to purchase and synchronize content. iPod touch, based on the +Company’s iOS Multi-Touch operating system, is a flash-memory-based iPod with an integrated photo 2 Table of Contents and video camera and photo library app, and also includes Siri. iPod touch works with the iTunes Store, the App Store, and the iBooks Store for purchasing and playing music, movies, TV shows, +podcasts, books, and apps. In addition to apps delivered with iOS, beginning in September 2013, iPhoto, iMovie and iWork apps for iOS became available as free downloads for all new iPod touches. iPod touch is compatible with both Mac and Windows +personal computers and Apple’s iCloud services. iTunes and the iTunes Store Apple’s iTunes app, available for both Mac and Windows personal computers, keeps users’ music, movies, and +TV shows organized in one place. iTunes is integrated with the iTunes Store, the App Store and the iBooks Store. The iTunes Store allows users to purchase and download music and TV shows and to rent or purchase movies. The iTunes Store also includes +hundreds of thousands of free Podcasts on a multitude of subjects. The App Store allows customers to discover and download apps and purchase in-app content. The iBooks Store features e-books from major and independent publishers. iTunes U ® allows users to download free lectures, videos, and more from top universities, museums, and other institutions. +iTunes also features Genius mixes to find songs that go together and organize them into genre-based mixes and Home Sharing to allow users to stream content from one computer to another computer as well as to iOS devices and newer versions of the +Company’s Apple TV. In September 2013, Apple introduced iTunes Radio™, a free Internet streaming service that allows users of iOS devices, Mac and Windows personal computers and Apple TV to personalize radio stations featuring music from +the iTunes Store. Mac App Store The Mac App Store allows customers to discover, download and install Mac apps. The Mac App Store offers applications in education, games, graphics and design, lifestyle, productivity, utilities and other +categories. The Company’s OS X operating system software and its iLife, iWork and other application software titles are also available on the Mac App Store. iCloud iCloud is the Company’s cloud service, which stores music, +photos, applications, contacts, calendars, documents and more, keeping them up-to-date and available to multiple iOS devices and Mac and Windows personal computers. iCloud’s features include iTunes in the Cloud; Photo Stream; Documents in the +Cloud; Contacts; Calendar; Mail; automatic downloads and purchase history for content, applications and books; and iCloud Backup for iOS devices. Users can sign up for free access to iCloud using a device running qualifying versions of iOS +or OS X. Operating System Software iOS iOS is the Company’s Multi-Touch operating system that serves as the +foundation for iOS devices. iOS 7 is the current version and was released in September 2013. Apps delivered with iOS for qualifying devices include Safari web browser, FaceTime video calling, Maps with turn-by-turn directions, Mail, Contacts, +Calendar, Clock, Weather, Calculator, Notes, Reminders, Stocks, Compass, and Messages. Devices running iOS are compatible with both Mac and Windows personal computers and Apple’s iCloud services. OS X OS X, the Company’s +Mac operating system, is built on an open-source UNIX-based foundation and provides an intuitive and integrated computer experience. OS X Mavericks, released in October 2013, is the tenth major release of OS X. Support for iCloud is built into OS X +so users can access content and information from their other Macs, their iOS devices and other supported devices and access downloaded content and apps from the 3 Table of Contents iTunes Store. In addition to Mail, Safari web browser, Messages, Calendars, Reminders, Contacts and the iLife ® suite of software apps, Mavericks also includes a new Maps app and a new iBooks app that both work with their iOS counterparts. Application Software iLife iLife for Mac is the Company’s consumer-oriented digital lifestyle software application suite included with all +Mac computers. iLife features iPhoto, a digital photo application for storing, viewing, editing and sharing photos; iMovie, a digital video editing application; and GarageBand ® , a music creation application that allows customers to play, record and create music. The Company also has Multi-Touch versions of these iLife applications designed +specifically for use on iPhone and iPad, and beginning in September 2013, both iPhoto and iMovie for iOS became available as free downloads with all new iOS devices. iWork iWork for Mac is the Company’s integrated +productivity suite designed to help users create, present, and publish documents, presentations, and spreadsheets. iWork includes Pages ® for word processing and page layout, +Keynote ® for presentations, and Numbers ® for spreadsheets. Beginning in October 2013, the iWork suite of apps for OS X will be available as free downloads with all new Macs. The Company also has iOS +Multi-Touch versions of each iWork application designed specifically for use on iOS devices and, beginning in September 2013, they all became available as free downloads with all new iOS devices. Other Application Software The Company also sells various other application software, including its professional line of applications, Final Cut +Pro ® , Logic ® Pro X, and +its FileMaker ® Pro database software. Displays & Peripheral Products The Company manufactures the Apple +LED Cinema Display™ and Thunderbolt Display. The Company also sells a variety of Apple-branded and third-party Mac-compatible and iOS-compatible peripheral products, including printers, storage devices, computer memory, digital video and still +cameras, pointing devices, and various other computing products and supplies. Apple TV Apple TV connects to consumers’ high definition TVs and enables them to access iTunes content directly for +streaming HD video, playing music and viewing photos. Content from Netflix, YouTube, Flickr, MLB, Hulu Plus, iTunes Radio and other media services is also available. Apple TV allows streaming iTunes content from Macs and Windows personal computers +through Home Share and through AirPlay ® from compatible Mac and iOS devices. Compatible Mac and iOS devices can +also mirror their device screens as well as stream and play games on Apple TV. iOS and Mac Developer Programs The Company’s iOS and Mac Developer Programs support app developers with the development, testing and +distribution of iOS and Mac apps through the App Store and the Mac App Store. Development tools included with the Company’s Developer Programs include Xcode ® , the Company’s integrated development environment for creating apps for iOS devices, including iPhone and iPad, and Mac. Xcode includes project management tools; +analysis tools to collect, display and compare app performance data; simulation tools to locally run, test, and debug apps; tools to simplify the design and development of user interfaces; and the latest software 4 Table of Contents development kits for iOS and OS X. The Company’s Developer Programs also provide access to multiple development resources including the Company’s Developer Forums, extensive technical +documentation, and sample code. The Company’s Developer Programs also provide developers with access tools and information for submitting their apps to the App Store and the Mac App Store. Product Support and Services AppleCare ® offers a range of support options for the Company’s customers. These include assistance that is built +into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, the AppleCare Protection Plan (“APP”) and the AppleCare+ Protection Plan +(“AC+”). APP is a fee-based service that typically includes two to three years of phone support, hardware repairs and dedicated web-based support resources. AC+ is a fee-based service available in certain countries for iPhone and iPad. AC+ +offers additional coverage under some circumstances for instances of accidental damage in addition to the services offered by APP. Markets +and Distribution The Company’s customers are primarily in the consumer, SMB, education, enterprise and government +markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers and SMBs through its retail and online stores and its direct sales force. The Company also employs a variety of indirect +distribution channels, such as third-party cellular network carriers, wholesalers, retailers, and value-added resellers. During 2013, the Company’s net sales through its direct and indirect distribution channels accounted for 30% +and 70%, respectively, of total net sales. The Company believes that sales of its innovative and differentiated products +are enhanced by knowledgeable salespersons who can convey the value of the hardware and software integration, and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its +targeted customers is an effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company +continues to expand and improve its distribution capabilities by expanding the number of its own retail stores worldwide. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping +districts. By operating its own stores and locating them in desirable high-traffic locations the Company is better positioned to ensure a high quality customer buying experience and attract new customers. The stores are designed to simplify and +enhance the presentation and marketing of the Company’s products and related solutions. The retail stores employ experienced and knowledgeable personnel who provide product advice, service and training and offer a wide selection of third-party +hardware, software, and other accessories and peripherals that complement the Company’s products. The Company has also +invested in programs to enhance reseller sales by placing high quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party +resellers focus on the Apple platform by providing a high level of product expertise, integration and support services. The Company is committed to delivering solutions to help educators teach and students learn. The Company believes effective integration of technology into classroom instruction can result in higher levels +of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also supports mobile learning and real-time distribution of, and access to, education related materials +through iTunes U ® , a platform that allows students and teachers to share and distribute educational media +online. The Company sells its products to the education market through its direct sales force, select third-party resellers and its online and retail stores. 5 Table of Contents The Company also sells its hardware and software products to enterprise and government +customers in each of its geographic segments. The Company’s products are deployed in these markets because of their performance, productivity, ease of use and seamless integration into information technology environments. The Company’s +products are compatible with thousands of third-party business applications and services, and its tools enable the development and secure deployment of custom applications as well as remote device administration. No single customer accounted for more than 10% of net sales in 2013, 2012 or 2011. Competition The markets for the Company’s products and services are +highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the +capabilities and use of mobile communication and media devices, personal computers, and other digital electronic devices. The Company’s competitors who sell mobile devices and personal computers based on other operating systems have +aggressively cut prices and lowered their product margins to gain or maintain market share. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. +Principal competitive factors important to the Company include price, product features, relative price/performance, product quality and reliability, design innovation, a strong third-party software and peripherals ecosystem, marketing and +distribution capability, service and support, and corporate reputation. The Company is focused on expanding its market +opportunities related to personal computers and mobile communication and media devices. These markets are highly competitive and include many large, well-funded and experienced participants. The Company expects competition in these markets to +intensify significantly as competitors attempt to imitate some of the features of the Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than +those they currently offer. These markets are characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors, and +price sensitivity on the part of consumers and businesses. The Company’s digital content services have faced significant +competition from other companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company’s future financial condition and operating results depend on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets in +which it competes. The Company believes it offers superior innovation and integration of the entire solution including the hardware (iPhone, iPad, Mac, and iPod), software (iOS, OS X and iTunes), online services, and distribution of digital content +and applications (iTunes Store, App Store, iBooks Store and Mac App Store). Some of the Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even +at a loss to compete with the Company’s offerings. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, a number of components +are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used +by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that can materially adversely affect the Company’s financial condition and operating +results. 6 Table of Contents The Company uses some custom components that are not commonly used by its competitors, and +new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or +manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s +financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from +the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common +components instead of components customized to meet the Company’s requirements. The Company has entered into various +agreements for the supply of components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply +shortages and price increases that can materially adversely affect its financial condition and operating results. While the +Company has announced plans to begin manufacturing some Macs in the United States, substantially all of the Company’s hardware products are currently manufactured by outsourcing partners that are located primarily in Asia. A significant +concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the +Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production +commitments. The Company’s purchase commitments typically cover its requirements for periods up to 150 days. Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s +ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing +products and to expand the range of its product offerings through research and development, licensing of intellectual property and acquisition of third-party businesses and technology. Total research and development expense was $4.5 billion, $3.4 +billion and $2.4 billion in 2013, 2012 and 2011, respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its iPhone, iPad, Mac and iPod devices, +peripherals, software and services. The Company has registered or has applied for trademarks and service marks in the U.S. and a number of foreign countries. Although the Company believes the ownership of such patents, copyrights, trademarks and +service marks is an important factor in its business and that its success does depend in part on the ownership thereof, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is +currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents in the U.S. and worldwide. The Company holds copyrights relating to certain aspects of its +products and services. No single patent or copyright is solely responsible for protecting the Company’s products. The Company believes the duration of its patents is adequate relative to the expected lives of its products. 7 Table of Contents Many of the Company’s products are designed to include intellectual property obtained +from third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of its products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms +in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage, and the rapid +rate of issuance of new patents, it is possible that certain components of the Company’s products, processes and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has +been notified that it may be infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic +Operations and Geographic Data During 2013, the Company’s domestic and international net sales accounted for 39% +and 61%, respectively, of total net sales. Information regarding financial data by geographic segment is set forth in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, +Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” While substantially all of the Company’s hardware products are currently manufactured by outsourcing partners that are located +primarily in Asia, the Company also performs final assembly of certain products at its manufacturing facility in Ireland. The supply and manufacture of a number of components is performed by sole-sourced outsourcing partners in the U.S., Asia and +Europe. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by +international trade regulations, including tariffs and antidumping penalties. Information regarding concentration in the available sources of supply of materials and products is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies.” Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product introductions +can significantly impact net sales, product costs and operating expenses. Product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new product inventory following a +product introduction, and often, channel inventory of a particular product declines as the next related major product launch approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. However, +neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, future net sales or financial performance. Warranty The Company +offers a limited parts and labor warranty on most of its hardware products. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In addition, where available, consumers may purchase APP or AC+, which extends service coverage on many of the Company’s hardware products. Backlog In the +Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases in anticipation of or immediately following new product +introductions as customers anticipate shortages. Backlog is often reduced once customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to +achieve any particular level of revenue or financial performance. 8 Table of Contents Employees As of September 28, 2013, the Company had approximately 80,300 full-time equivalent employees and an additional 4,100 full-time equivalent temporary employees and contractors. Approximately 42,800 of +the total full-time equivalent employees worked in the Company’s Retail segment. Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports +filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities Exchange Commission (the “SEC”). The Company is subject to the informational +requirements of the Exchange Act and files or furnishes reports, proxy statements, and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at investor.apple.com/sec.cfm when such reports are available on the SEC’s website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, +Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements and other +information regarding issuers that file electronically with the SEC at www.sec.gov . The contents of these websites are not incorporated into this filing. Further, the Company’s references to the URLs for these websites are intended to be +inactive textual references only. Item 1A. Risk Factors The +following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding any statement in this Form 10-K or elsewhere. The following information should be read in conjunction with Part II, +Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes in Part II, Item 8, “Financial Statements and Supplementary +Data” of this Form 10-K. Because of the following factors, as well as other factors affecting the Company’s +financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Global and regional economic conditions could materially adversely affect the Company. The Company’s operations and performance depend significantly on global and regional economic conditions. Uncertainty about global +and regional economic conditions poses a risk as consumers and businesses postpone spending in response to tighter credit, higher unemployment, financial market volatility, government austerity programs, negative financial news, declines in +income or asset values and/or other factors. These worldwide and regional economic conditions could have a material adverse effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s +expectations because the Company generally raises prices on goods and services sold outside the U.S. to correspond with the effect of a strengthening of the U.S. dollar. Other factors that could influence worldwide or regional demand include +increases in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare costs, access to credit, consumer confidence, and other macroeconomic factors affecting consumer spending behavior. +These and other economic factors could materially adversely affect demand for the Company’s products and services. In +the event of further financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be a new or incremental +tightening in the credit markets, low liquidity, and extreme volatility in fixed income, credit, currency, and equity markets. This could have a number of effects on the Company’s business, including the insolvency or +financial instability of outsourcing partners or suppliers or their inability to obtain credit to 9 Table of Contents finance development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the +Company’s products; failure of derivative counterparties and other financial institutions; and restricting the Company’s ability to issue new debt. Other income and expense also could vary materially from expectations depending on +gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting from revaluations of debt and equity securities and other investments; interest rates; cash balances; volatility in foreign +exchange rates; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk of the actual amounts realized in the future on the +Company’s financial instruments differing significantly from the fair values currently assigned to them. Global +markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services compete in highly competitive global markets characterized by aggressive price cutting and +resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and +product advancements by competitors, and price sensitivity on the part of consumers. The Company’s ability to compete +successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution +for its products, including the hardware, operating system, numerous software applications, and related services. As a result, the Company must make significant investments in research and development. The Company currently holds a significant +number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low +cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors +infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. The Company markets certain mobile communication and media devices based on the iOS mobile operating system and also markets related third-party digital content and applications. The Company faces +substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships; and the Company has a +minority market share in the smartphone market. Additionally, the Company faces significant price competition as competitors reduce their selling prices and attempt to imitate the Company’s product features and applications within their own +products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company also competes with illegitimate ways to obtain third-party digital content and applications. Some of +the Company’s competitors have greater experience, product breadth and distribution channels than the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be +able to provide products and services at little or no profit or even at a loss. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing components seamlessly within their +individual offerings or work collaboratively to offer integrated solutions. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to +maintain their functional and design advantages. The Company is the only authorized maker of hardware using OS X, which has a +minority market share in the personal computer market. This market is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and peripherals, the Company faces a significant number +of competitors, many of which have broader product lines, lower priced products, and a larger installed 10 Table of Contents customer base. Historically, consolidation in this market has resulted in larger competitors. Price competition has been particularly intense as competitors selling Windows-based personal +computers have aggressively cut prices and lowered product margins. An increasing number of Internet-enabled devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the +Company’s existing products. The Company’s financial condition and operating results also depend on its ability to continually improve the Mac platform to maintain its functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and +transitions. Due to the highly volatile and competitive nature of the industries in which the Company competes, the +Company must continually introduce new products, services and technologies, enhance existing products and services, and effectively stimulate customer demand for new and upgraded products. The success of new product introductions depends on a number +of factors including, but not limited to, timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software +for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and costs to meet anticipated demand, and the risk that new +products may have quality or other defects or deficiencies in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions. The Company depends on the performance of distributors, carriers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers, and value-added +resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers, and consumers and small +and mid-sized businesses through its online and retail stores. Carriers providing cellular network service for iPhone +typically subsidize users’ purchases of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters +into with new carriers. Many resellers have narrow operating margins and have been adversely affected in the past by weak +economic conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. Such a perception could discourage +resellers from investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company has invested and will continue to invest in programs to enhance reseller sales, +including staffing selected resellers’ stores with Company employees and contractors and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. +The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for the Company’s products could cause resellers to reduce their ordering and +marketing of the Company’s products. The Company faces substantial inventory and other asset risk in addition to +purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have +become obsolete or exceed anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets, including capital assets held at its +suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the 11 Table of Contents carrying amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the assets +exceeds its fair value. Although the Company believes its provisions related to inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently adequate, no assurance can be given that the Company will not +incur additional related charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with industry practice, components are normally acquired through a +combination of purchase orders, supplier contracts, and open orders, in each case based on projected demand. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with +the respective supplier. Purchase commitments typically cover forecasted component and manufacturing requirements for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price +changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities. Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing +risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. While the Company has entered into various agreements for the supply of +components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. The follow-on effects from global economic conditions on the Company’s suppliers, described in +“ Global economic conditions could materially adversely affect the Company” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply +shortages and price increases. The Company and other participants in the markets for mobile communication and media devices +and personal computers also compete for various components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not common to the rest of these industries. The +Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing +capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers decided to concentrate on the production of common components instead of components customized to meet the +Company’s requirements. The supply of components for a new or existing product could be delayed or constrained, or a key manufacturing vendor could delay shipments of completed products to the Company. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of whom are +located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by a +few outsourcing partners located primarily in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over +production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these +partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect or warranty liability. +While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on sole-sourced outsourcing partners in the U.S., Asia and Europe to supply and manufacture many critical components, and on outsourcing partners in Asia for final assembly of +substantially all 12 Table of Contents of the Company’s hardware products. Any failure of these partners to perform may have a negative impact on the Company’s cost or supply of components or finished goods. In addition, +manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, +military actions or economic, business, labor, environmental, public health, or political issues. The Company has invested in +manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of +components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, the net realizable value of these assets could be negatively impacted. The Company’s products and services may experience quality problems from time to time that can result in decreased sales and +operating margin and harm to the Company’s reputation. The Company sells complex hardware and software products and +services that can contain design and manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended +operation. The Company’s online services may from time to time experience outages, service slowdowns, or errors. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company +will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, significant warranty and other expenses, and harm to the Company’s reputation. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable +terms or at all. The Company contracts with numerous third parties to offer their digital content through the iTunes +Store. This includes the right to make available music, movies, TV shows and books currently available through the iTunes Store. The licensing arrangements with these third parties are short-term and do not guarantee the continuation or renewal of +these arrangements on reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the +Company to license their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of +content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make available third-party digital content, or to make available such content on commercially reasonable terms, +could have a material adverse impact on the Company’s financial condition and operating results. Some third-party +digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the +Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights +management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If +third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. 13 Table of Contents With respect to its Mac products, the Company believes the availability of third-party software applications and services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining, and upgrading such software for the Company’s +products compared to Windows-based products. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, continued growth of Mac sales, and the costs of developing +such applications and services. If the Company’s minority share of the global personal computer market causes developers to question the Company’s prospects, developers could be less inclined to develop or upgrade software for the +Company’s products and more inclined to devote their resources to developing and upgrading software for the larger Windows market. With respect to iOS devices, the Company relies on the continued availability and development of compelling and innovative software applications, which are distributed through a single distribution +channel, the App Store. The absence of multiple distribution channels, which are available for competing platforms, may limit the availability and acceptance of third-party applications by the Company’s customers, thereby causing developers to +reduce or curtail development for the iOS platform. In addition, iOS devices are subject to rapid technological change, and, if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might +not successfully operate and may result in dissatisfied customers. As with applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the +relative benefits of developing software for the Company’s products rather than its competitors’ platforms, such as Android. If developers focus their efforts on these competing platforms, the availability and quality of applications for +the Company’s iOS devices may suffer. The Company relies on access to third-party intellectual property, which may +not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products include +third-party intellectual property, which requires licenses from those third parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance +that the necessary licenses can be obtained on acceptable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from +selling certain products or otherwise have a material adverse impact on the Company’s financial condition and operating results. The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights. The Company is subject to various legal proceedings and claims that have not yet been fully resolved and that have arisen in the ordinary +course of business, and additional claims may arise in the future. For example, technology companies, including many of the +Company’s competitors, frequently enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or +otherwise obtained. As the Company has grown, the intellectual property rights claims against it have increased and may continue to increase. In particular, the Company’s cellular enabled products compete with mobile communication and media +device companies that hold significant patent portfolios, and the number of patent claims against the Company has significantly increased. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and +before the U.S. International Trade Commission, as well as internationally in Europe and Asia. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential +or actual litigants, the Company may have to engage in protracted litigation. If the Company is found to infringe one or more patents or other intellectual property rights, regardless of whether it can develop non-infringing technology, it may be +required to pay substantial damages or royalties to a third-party, or it may be subject to a temporary or permanent injunction prohibiting the Company from marketing or selling certain products. 14 Table of Contents In certain cases, the Company may consider the desirability of entering into licensing +agreements, although no assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Company’s operating expenses. Regardless of the merit of particular claims, litigation may be expensive, time-consuming, disruptive to the Company’s operations, +and distracting to management. In recognition of these considerations, the Company may enter into arrangements to settle litigation. In management’s opinion, there is not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss +contingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain. Although management considers the likelihood of such an outcome to be remote, if one or more legal matters were resolved against the Company in a reporting period for amounts in excess of +management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary +damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. The Company is subject to laws and regulations worldwide, changes to which could increase the Company’s costs and individually or +in the aggregate adversely affect the Company’s business. The Company is subject to laws and regulations affecting +its domestic and international operations in a number of areas. These U.S. and foreign laws and regulations affect the Company’s activities including, but not limited to, areas of labor, advertising, digital content, consumer protection, +real estate, billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import and export requirements, anti-corruption, foreign +exchange controls and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health, and safety. By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes could +include, among others, restrictions on the production, manufacture, distribution, and use of devices, locking devices to a carrier’s network, or mandating the use of devices on more than one carrier’s network. These devices are also +subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in +additional testing requirements, product modifications, delays in product shipment dates, or preclude the Company from selling certain products. Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent from jurisdiction to jurisdiction, further increasing the cost of compliance and +doing business. Any such costs, which may rise in the future as a result of changes in these laws and regulations or in their interpretation could individually or in the aggregate make the Company’s products and services less attractive to the +Company’s customers, delay the introduction of new products in one or more regions, or cause the Company to change or limit its business practices. The Company has implemented policies and procedures designed to ensure compliance with +applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies and procedures. The Company’s business is subject to the risks of international operations. The Company derives a significant portion of its revenue and earnings from its international operations. Compliance with applicable U.S. +and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy requirements, 15 Table of Contents environmental laws, labor laws, and anti-competition regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to +comply with these laws and regulations, a violation by the Company’s employees, contractors, or agents could nevertheless occur. The Company also could be significantly affected by other risks associated with international activities including, but not limited to, economic and labor conditions, increased duties, taxes and other +costs, and political instability. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by international trade +regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its trade receivables with customers in certain international markets. There can be no assurance the Company can +effectively limit its credit risk and avoid losses. The Company’s Retail segment has required and will continue to +require a substantial investment and commitment of resources and is subject to numerous risks and uncertainties. The +Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. +Certain stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores +require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Retail segment, a decline in sales or the closure or poor performance of individual or multiple stores could +result in significant lease termination costs, write-offs of equipment and leasehold improvements, and severance costs. Many +factors unique to retail operations, some of which are beyond the Company’s control, pose risks and uncertainties. These risks and uncertainties include, but are not limited to, macro-economic factors that could have an adverse effect on +general retail activity, as well as the Company’s inability to manage costs associated with store construction and operation, the Company’s failure to manage relationships with its existing retail channel partners, more challenging +environments in managing retail operations outside the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and the Company’s inability to obtain and renew leases in quality retail locations at a reasonable +cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present +risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or +acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital, and unidentified issues not +discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. The +Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company may be subject to information technology system failures and network disruptions. These may be caused by natural disasters, +accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. System redundancy may be ineffective or inadequate, and the Company’s +disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could prevent access to the Company’s online stores and services, preclude retail store transactions, compromise Company or customer data, and +result in delayed or cancelled orders. System failures and disruptions could also impede the manufacturing and shipping of products, delivery of online services, transactions processing and financial reporting. 16 Table of Contents There may be breaches of the Company’s information technology systems that +materially damage business partner and customer relationships, curtail or otherwise adversely impact access to online stores and services, or subject the Company to significant reputational, financial, legal, and operational consequences. The Company’s business requires it to use and store customer, employee, and business partner personally identifiable +information (“PII”). This may include, among other information, names, addresses, phone numbers, email addresses, contact preferences, tax identification numbers, and payment account information. Although malicious attacks to gain access +to PII affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the amount of PII it manages. The Company requires user names and passwords in order to access its information technology systems. The Company also uses encryption and +authentication technologies to secure the transmission and storage of data and prevent access to Company data or accounts. As with all companies, these security measures are subject to third-party security breaches, employee error, malfeasance, +faulty password management, or other irregularities. For example, third parties may attempt to fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used to access the +Company’s information technology systems. To help protect customers and the Company, the Company monitors accounts and systems for unusual activity and may freeze accounts under suspicious circumstances, which may result in the delay or loss of +customer orders. The Company devotes significant resources to network security, data encryption, and other security measures +to protect its systems and data, but these security measures cannot provide absolute security. To the extent the Company was to experience a breach of its systems and was unable to protect sensitive data, such a breach could materially damage +business partner and customer relationships, and curtail or otherwise adversely impact access to online stores and services. Moreover, if a computer security breach affects the Company’s systems or results in the unauthorized release of PII, +the Company’s reputation and brand could be materially damaged, use of the Company’s products and services could decrease, and the Company could be exposed to a risk of loss or litigation and possible liability. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding +data protection. The Company is subject to federal, state and international laws relating to the collection, use, +retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also to transfers of information between the Company and its subsidiaries, and among the Company, its subsidiaries and other parties +with which the Company has commercial relations. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction +to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in penalties or significant legal +liability. The Company’s privacy policy and related practices concerning the use and disclosure of data are posted on +its website. Any failure by the Company, its suppliers or other parties with whom the Company does business to comply with its posted privacy policy or with other federal, state or international privacy-related or data protection laws and +regulations could result in proceedings against the Company by governmental entities or others. The Company is also subject +to payment card association rules and obligations under its contracts with payment card processors. Under these rules and obligations, if information is compromised, the Company could be liable to payment card issuers for associated expenses and +penalties. In addition, if the Company fails to follow payment card industry security standards, even if no customer information is compromised, the Company could incur significant fines or experience a significant increase in payment card +transaction costs. 17 Table of Contents The Company’s success depends largely on the continued service and availability of +key personnel. Much of the Company’s future success depends on the continued availability and service of key +personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, +where most of the Company’s key personnel are located. The Company’s business may be impacted by political +events, war, terrorism, public health issues, natural disasters and other circumstances. War, terrorism, geopolitical +uncertainties, public health issues, and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a material adverse effect on the Company, its suppliers, +logistics providers, manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to interruption by, among others, natural disasters, fire, power shortages, nuclear power plant accidents, +terrorist attacks and other hostile acts, labor disputes, public health issues, and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and +deliver products to its customers, including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. Should major public health issues, including pandemics, arise, the +Company could be adversely affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products, and +disruptions in the operations of the Company’s manufacturing vendors and component suppliers. The majority of the Company’s research and development activities, its corporate headquarters, information technology systems, and other critical +business operations, including certain component suppliers and manufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, the Company could incur significant losses, require substantial +recovery time and experience significant expenditures in order to resume operations. The Company expects its quarterly +revenue and operating results to fluctuate. The Company’s profit margins vary across its products and distribution +channels. The Company’s software, accessories, and service and support contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product +lines and can change over time as a result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its +indirect sales through its channel partners. In addition, the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or +channel mix, component cost increases, the strengthening U.S. dollar, price competition, or the introduction of new products, including those that have higher cost structures with flat or reduced pricing. The Company has typically experienced higher net sales in its first quarter compared to other quarters due in part to seasonal holiday +demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. The Company could be subject to unexpected developments late in a quarter, such as lower-than-anticipated demand for the +Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock continues to experience substantial price volatility. Additionally, the Company, the technology industry, and the stock market as a whole have experienced extreme stock price and +volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its own stock +to exceed the stock’s price at a given point in time. The Company believes its stock price reflects 18 Table of Contents expectations of future growth and profitability. The Company also believes its stock price reflects expectations that its cash dividend will continue at current levels or grow and that its +current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of +shares. If the Company fails to meet any of these expectations related to future growth, profitability, dividends, share repurchases or other market expectations its stock price may decline significantly, which could have a material adverse impact +on investor confidence and employee retention. The Company’s financial performance is subject to risks associated +with changes in the value of the U.S. dollar versus local currencies. The Company’s primary exposure to movements in +foreign currency exchange rates relates to non-U.S. dollar denominated sales and operating expenses worldwide. Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign +currency-denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. Margins on sales of the Company’s products in foreign countries, and on sales +of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign currency exchange rate fluctuations. In some circumstances, for competitive or other reasons, the Company may decide not to raise +local prices to fully offset the dollar’s strengthening, or at all, which would adversely affect the U.S. dollar value of the Company’s foreign currency denominated sales and earnings. Conversely, a strengthening of foreign currencies +relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, +thereby limiting the benefit. Additionally, strengthening of foreign currencies may also increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to +fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in +place. The Company is exposed to credit risk and fluctuations in the market values of its investment portfolio. Given the global nature of its business, the Company has both domestic and international investments. Credit ratings and +pricing of the Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or other factors. As a result, the value and liquidity of the Company’s +cash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents and marketable securities, future fluctuations in their value could +result in a significant realized loss. The Company is exposed to credit risk on its trade accounts receivable, vendor +non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. A substantial majority of the Company’s outstanding trade +receivables are not covered by collateral or credit insurance. The Company’s exposure to credit and collectability risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. +The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has +made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 28, 2013, a significant portion of the Company’s trade receivables was 19 Table of Contents concentrated within cellular network carriers, and its non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located +primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables as well as long-term prepayments, there can be no assurance such procedures will effectively limit its +credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or +international tax legislation or exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and +numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s +future effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, +including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the Internal Revenue Service and other tax authorities and governmental bodies. The Company regularly assesses the +likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, +particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s operating results, cash flows, and financial condition could be +adversely affected. Item 1B. Unresolved Staff Comments None. Item 2. Properties The +Company’s headquarters are located in Cupertino, California. As of September 28, 2013, the Company owned or leased approximately 19.1 million square feet of building space, primarily in the U.S., and to a lesser extent, in Europe, +Japan, Canada, and the Asia-Pacific regions. Of that amount approximately 12.0 million square feet was leased building space, which includes approximately 4.6 million square feet related to retail store space. Of the Company’s owned +building space, approximately 2.6 million square feet that is located in Cupertino, California will be demolished to build a second corporate campus. Additionally, the Company owns a total of 1,428 acres of land in various locations. As of September 28, 2013, the Company owned a manufacturing facility in Cork, Ireland that also housed a customer +support call center and facilities in Elk Grove, California that included warehousing and distribution operations and a customer support call center. The Company also owned land in Austin, Texas where it is building office space and a customer +support call center. In addition, the Company owned facilities for research and development and corporate functions in Cupertino, California, including land for the future development of the Company’s second corporate campus. The Company also +owned data centers in Newark, California; Maiden, North Carolina; Prineville, Oregon; and Reno, Nevada. Outside the U.S., the Company owned additional facilities for various purposes. The Company believes its existing facilities and equipment, which are used by all operating segments, are in good operating condition and +are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to make investments in capital equipment as needed to meet anticipated demand +for its products. 20 Table of Contents Item 3. Legal Proceedings The +Company is subject to the various legal proceedings and claims discussed below as well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of +management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the outcome of legal proceedings and claims +brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period +for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. See the risk factor “ The Company could be impacted by unfavorable +results of legal proceedings, such as being found to have infringed on intellectual property rights ” in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth +quarter of 2013 that did not individually or in the aggregate have a material impact on the Company’s financial condition and results of operations. The Apple iPod iTunes Antitrust Litigation (formerly Charoensak v. Apple Computer, Inc. and Tucker v. Apple Computer, Inc.); Somers v. Apple Inc. These related cases were filed on January 3, 2005, July 21, 2006 and December 31, 2007 in the United States District +Court for the Northern District of California on behalf of a purported class of direct and indirect purchasers of iPods and iTunes Store content, alleging various claims including alleged unlawful tying of music and video purchased on the iTunes +Store with the purchase of iPods and unlawful acquisition or maintenance of monopoly market power under §§1 and 2 of the Sherman Act, the Cartwright Act, California Business & Professions Code §17200 (unfair competition), the +California Consumer Legal Remedies Act and California monopolization law. Plaintiffs are seeking unspecified compensatory and punitive damages for the class, treble damages, injunctive relief, disgorgement of revenues and/or profits and attorneys +fees. Plaintiffs are also seeking digital rights management free versions of any songs downloaded from iTunes or an order requiring the Company to license its digital rights management to all competing music players. On September 3, 2013, the +U.S. Ninth Circuit Court of Appeals upheld the District Court’s dismissal of the indirect purchaser case, Somers v. Apple Inc. The remaining direct purchaser cases are currently pending. Apple eBooks Antitrust Litigation (United States of America v. Apple Inc., et al.) On April 11, 2012, the U.S. Department of Justice (the “DOJ”) filed a civil antitrust action against the Company and five +major book publishers in the U.S. District Court for the Southern District of New York, alleging an unreasonable restraint of interstate trade and commerce in violation of §1 of the Sherman Act and seeking, among other things, injunctive +relief, the District Court’s declaration that the Company’s agency agreements with the publishers are null and void and/or the District Court’s reformation of such agreements. The DOJ’s complaint asserted, among other things, +that the decision by the five publishers to shift to an agency model to sell eBooks and their agreements with the Company were an attempt to “raise, fix and stabilize retail e-book prices, to end price competition among e-book retailers, and to +limit retail price competition.” The Company filed a response to the DOJ complaint in late May 2012, denying the DOJ’s allegations. All five publishers reached a settlement with the DOJ, which required the publishers to terminate their +agreements with the Company and renegotiate new agreements pursuant to the terms of their settlement with the DOJ. On July 10, 2013, the District Court found, following a bench trial, that the Company conspired to restrain trade in violation of +§1 of the Sherman Act and relevant state statutes to the extent those laws are congruent with §1 of the Sherman Act. The District Court entered a permanent injunction, which took effect on October 6, 2013 and will be in effect +for five years unless the judgment is overturned on appeal. A damages trial is set for May 2014. The Company has appealed the District Court’s decision. Item 4. Mine Safety Disclosures Not applicable. 21 Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the NASDAQ Stock Market LLC under the symbol AAPL. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest intraday sales prices for the Company’s common stock on the NASDAQ Stock Market LLC during each quarter of +the two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter 2013 price range per share $ 513.74 - $401.22 $ 465.75 - $385.10 $ 555.00 - $419.00 $ 676.75 - $501.23 2012 price range per share $ 705.07 - $570.00 $ 644.00 - $522.18 $ 621.45 - $409.00 $ 426.70 - $354.24 Holders As of October 18, 2013, there were 24,710 shareholders of record. Dividends The Company paid a total of $10.5 billion and $2.5 billion in dividends during 2013 and 2012, respectively, and expects to +pay quarterly dividends of $3.05 per common share each quarter, subject to declaration by the Board of Directors. Purchases of Equity +Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended +September 28, 2013 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Q4 Fiscal Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans +or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans +or Programs (a) June 30, 2013 to August 3, 2013 2,193 $ 451.49 2,193 August 4, 2013 to August 31, 2013 7,061 $ 487.17 7,061 September 1, 2013 to September 28, 2013 1,184 $ 481.33 1,184 Total 10,438 $ 37,050 (a) In 2012, the Company’s Board of Directors authorized a program to repurchase up to $10 billion of the Company’s common stock beginning in +2013. In April 2013, the Company’s Board of Directors increased the share repurchase program authorization from $10 billion to $60 billion. The Company’s share repurchase program does not obligate it to acquire any specific number of +shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 of the Exchange Act. The $37.1 billion represents the remaining amount available to +repurchase shares under the authorized repurchase program. 22 Table of Contents Company Stock Performance The following graph shows a five-year comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Index, the S&P Computer Hardware +Index, and the Dow Jones U.S. Technology Supersector Index. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Computer Hardware Index, and the Dow Jones U.S. Technology Supersector +Index as of the market close on September 30, 2008. Data points on the graph are annual. Note that historic stock price performance is not necessarily indicative of future stock price performance. *$100 invested on 9/30/08 in stock or index, including reinvestment of dividends. Fiscal year ending September 30. Copyright © 2013 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. Copyright © 2013 Dow Jones & Co. All rights +reserved. September 30, 2008 September 30, 2009 September 30, 2010 September 30, 2011 September 30, 2012 September 30, 2013 Apple Inc. $100 $163 $250 $335 $589 $431 S&P 500 Index $100 $ 93 $103 $104 $135 $161 S&P Computer Hardware Index $100 $118 $140 $159 $255 $197 Dow Jones US Technology Supersector Index $100 $111 $124 $128 $166 $175 23 Table of Contents Item 6. Selected Financial Data The information set forth below for the five years ended September 28, 2013, is not necessarily indicative of results of future +operations, and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in +Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in +thousands, and per share amounts). 2013 2012 2011 2010 2009 Net sales $ 170,910 $ 156,508 $ 108,249 $ 65,225 $ 42,905 Net income $ 37,037 $ 41,733 $ 25,922 $ 14,013 $ 8,235 Earnings per share: Basic $ 40.03 $ 44.64 $ 28.05 $ 15.41 $ 9.22 Diluted $ 39.75 $ 44.15 $ 27.68 $ 15.15 $ 9.08 Cash dividends declared per share $ 11.40 $ 2.65 $ 0 $ 0 $ 0 Shares used in computing earnings per share: Basic 925,331 934,818 924,258 909,461 893,016 Diluted 931,662 945,355 936,645 924,712 907,005 Total cash, cash equivalents and marketable securities $ 146,761 $ 121,251 $ 81,570 $ 51,011 $ 33,992 Total assets $ 207,000 $ 176,064 $ 116,371 $ 75,183 $ 47,501 Long-term debt $ 16,960 $ 0 $ 0 $ 0 $ 0 Long-term obligations (a) $ 20,208 $ 16,664 $ 10,100 $ 5,531 $ 3,502 Total liabilities $ 83,451 $ 57,854 $ 39,756 $ 27,392 $ 15,861 Total shareholders’ equity $ 123,549 $ 118,210 $ 76,615 $ 47,791 $ 31,640 (a) Long-term obligations exclude non-current deferred revenue. 24 Table of Contents Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and other +parts of this Form 10-K contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and +uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be +identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “will,” “would,” +“could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are +incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. All +information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated +quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no +obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview and Highlights The Company designs, manufactures, and markets mobile communication and media devices, personal computers, and portable +digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and applications. The Company sells its products worldwide through its retail stores, online stores, and +direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers, and value-added resellers. In addition, the Company sells a variety of third-party iPhone, iPad, Mac and iPod compatible products, including +application software, and various accessories through its online and retail stores. The Company sells to consumers; small and mid-sized businesses; and education, enterprise and government customers. Fiscal 2013 Highlights Net sales rose 9% or $14.4 billion during 2013 compared to 2012. This resulted from growth in net sales of iPhone; iTunes, software, and services; and iPad. Growth in 2013 reflects strong sales of iPhone +5, strong continuing sales of iPhone 4 and 4s, the introduction of iPhone 5c and 5s, strong performance of the iPad Mini and fourth generation iPad, and continued growth in the Company’s online sales of apps, digital content, and services. +Growth in these areas was partially offset by declines in net sales of Mac and iPod. All of the Company’s operating segments experienced increased net sales in 2013, with net sales growth being particularly strong in the Americas, Greater China +and Japan operating segments. Similar to 2012, growth in total net sales was higher during the first half of 2013, rising $12.6 billion or 14.7% over the same period in 2012. First half growth in 2013 was driven by iPhone and iPad introductions at +or near the beginning of 2013. During the first quarter of 2013, the Company introduced the fourth generation iPad and iPad +Mini, a new MacBook Pro with Retina display, a new iPod touch, a new iMac, and expanded the rollout of iPhone 5 which began in September 2012. In June 2013 at its Worldwide Developer Conference, the Company announced iOS 7 and OS X Mavericks, +announced iTunes Radio, introduced a significant upgrade to MacBook Air, and provided a preview of all new Mac Pro desktops expected to be introduced during 2014. In September 2013, the Company introduced iPhone 5s and iPhone 5c, released iOS 7, +launched iTunes Radio, and announced that beginning in September 2013 iPhoto, iMovie and iWork apps for iOS would be available as free downloads with all new “iOS devices,” namely iPhone, iPad and iPod touch. In October 2013, the Company +announced iPad Air™, its fifth generation iPad, and iPad mini with Retina display. 25 Table of Contents In April 2013 the Company announced a significant increase to its program to return capital +to shareholders by raising the total amount it expected to utilize for the program through December 2015 to $100 billion. This included increasing its share repurchase authorization to $60 billion and raising its quarterly dividend to $3.05 per +common share beginning in May 2013. During 2013, the Company utilized $23.0 billion to repurchase common shares and paid dividends of $10.5 billion or $11.40 per common share. In conjunction with its capital return program, in May 2013 the Company +issued $17.0 billion of notes with varying maturities through 2043. Fiscal 2012 Highlights Overall net sales during 2012 increased $48.3 billion or 45% compared to 2011. All of the Company’s operating segments experienced +increased net sales during 2012, primarily a result of strong demand for iPhone and iPad. Growth in total net sales was particularly strong during the first six months of 2012, rising $34.1 billion or 66% compared to the same period in 2011. The net +sales growth during the first six months of 2012 reflected the launch of iPhone 4s in the first quarter of 2012 and the Company’s ability to meet demand more quickly for iPhone 4s when compared to the iPhone 4 launch. Growth during the first +half of 2012 was also favorably impacted by strong unit sales of iPad during the holiday season, resulting in a 111% increase in iPad unit sales during the first quarter of 2012 compared to the same quarter in 2011. Partially offsetting these +positive factors was a decrease in iPod net sales experienced across all operating segments. In October 2011, the Company +introduced iPhone 4s and launched iCloud, the Company’s cloud service that stores user data and keeps it up to date and available on multiple iOS devices and Mac and Windows personal computers. The Company introduced the third generation iPad +with Retina display in March 2012 and in June 2012 introduced the MacBook Pro with Retina display and an updated MacBook Air During the fourth quarter of 2012, OS X Mountain Lion was released and iPhone 5 was introduced. In March 2012, the Company announced a $10 billion share repurchase program that would be executed over three years and announced plans +to initiate a quarterly dividend commencing in the fourth quarter of 2012. During the fourth quarter, the Company paid dividends of $2.5 billion or $2.65 per common share. 26 Table of Contents Sales Data The following table shows net sales by operating segment and net sales and unit sales by product during 2013, 2012 and 2011 (dollars in millions and units in thousands): 2013 Change 2012 Change 2011 Net Sales by Operating Segment: Americas $ 62,739 9% $ 57,512 50% $ 38,315 Europe 37,883 4% 36,323 31% 27,778 Greater China (a) 25,417 13% 22,533 78% 12,690 Japan 13,462 27% 10,571 94% 5,437 Rest of Asia Pacific 11,181 4% 10,741 8% 9,902 Retail 20,228 7% 18,828 33% 14,127 Total net sales $ 170,910 9% $ 156,508 45% $ 108,249 Net Sales by Product: iPhone (b) $ 91,279 16% $ 78,692 71% $ 45,998 iPad (b) 31,980 3% 30,945 61% 19,168 Mac (b) 21,483 (7)% 23,221 7% 21,783 iPod (b) 4,411 (21)% 5,615 (25)% 7,453 iTunes, software and services (c) 16,051 25% 12,890 38% 9,373 Accessories (d) 5,706 11% 5,145 15% 4,474 Total net sales $ 170,910 9% $ 156,508 45% $ 108,249 Unit Sales by Product: iPhone 150,257 20% 125,046 73% 72,293 iPad 71,033 22% 58,310 80% 32,394 Mac 16,341 (10)% 18,158 9% 16,735 iPod 26,379 (25)% 35,165 (17)% 42,620 (a) Greater China includes China, Hong Kong and Taiwan. (b) Includes deferrals and amortization of related non-software services and software upgrade rights. (c) Includes revenue from sales on the iTunes Store, the App Store, the Mac App Store, and the iBooks Store, and revenue from sales of AppleCare, +licensing and other services. (d) Includes sales of hardware peripherals and Apple-branded and third-party accessories for iPhone, iPad, Mac and iPod. The Company’s fiscal year is the 52 or 53-week period that ends on the last +Saturday of September. The Company’s fiscal years 2013, 2012 and 2011 ended on September 28, 2013, September 29, 2012 and September 24, 2011, respectively. Both fiscal years 2013 and 2011 spanned 52 weeks. +Fiscal year 2012 spanned 53 weeks, with a 14 th week +added to the first quarter of 2012, as is done approximately every six years to realign the Company’s fiscal quarters more closely to calendar quarters. Inclusion of the additional week in 2012 increased the Company’s overall net +sales and operating expenses for the year. 27 Table of Contents Product Performance iPhone The following table presents iPhone net sales and unit sales +information for 2013, 2012 and 2011 (net sales in millions and units in thousands): 2013 Change 2012 Change 2011 Net sales $ 91,279 16% $ 78,692 71% $ 45,998 Percentage of total net sales 53% 50% 42% Unit sales 150,257 20% 125,046 73% 72,293 The growth in iPhone net sales and unit sales during 2013 resulted from increased demand for iPhone in +all of the Company’s operating segments primarily due to the launch of iPhone 5 beginning in September 2012 and strong ongoing demand for iPhone 4 and 4s. All of the Company’s operating segments experienced increases in net sales and unit +sales of iPhone during 2013 compared to 2012. The year-over-year impact of higher iPhone unit sales in 2013 was partially offset by a 3% decline in iPhone average selling prices (“ASPs”) in 2013 compared to 2012 primarily as a result of a +shift in product mix towards lower-priced iPhone models, particularly iPhone 4. All of the Company’s geographic operating segments experienced a decline in iPhone ASPs during 2013. The year-over-year growth in iPhone net sales and unit sales during 2012 reflects strong demand for iPhone in all of the Company’s +operating segments, except for the Rest of Asia Pacific segment. Growth in iPhone sales during 2012 is primarily a result of the launches of iPhone 4s in the first quarter of 2012 and iPhone 5 in the fourth quarter of 2012, ongoing demand during +2012 for iPhone 4 and iPhone 3GS, and expanded distribution with new carriers and resellers. iPad The following table presents iPad net sales and unit sales information for 2013, 2012 and 2011 (net sales in millions and units in +thousands): 2013 Change 2012 Change 2011 Net sales $ 31,980 3% $ 30,945 61% $ 19,168 Percentage of total net sales 19% 20% 18% Unit sales 71,033 22% 58,310 80% 32,394 The growth in net sales and unit sales of iPad during 2013 resulted from growth in iPad unit sales in all +of the Company’s operating segments. This growth was driven by the launch of iPad mini and the fourth generation iPad beginning in the first quarter of 2013. The year-over-year growth rate of total iPad unit sales was significantly higher than +the growth rate of total iPad net sales for 2013 due to a reduction in iPad ASPs of 15% in 2013 compared to 2012. This decline resulted primarily from introduction of the lower priced iPad mini and the full year impact of the price reduction on iPad +2 made in 2012. The decline in iPad ASPs was experienced to various degrees by all of the Company’s operating segments. The year-over-year increase in iPad net sales and unit sales during 2012 was driven by strong demand for iPad in all of the +Company’s operating segments as a result of the launch of the third generation iPad in March 2012, continued demand for iPad 2, and expanded distribution with new resellers. The year-over-year growth rate of iPad unit sales was higher than the +growth rate of iPad net sales during 2012 due to a 10% reduction in ASPs as a result of a shift in product mix toward lower-priced iPad models, a price reduction on iPad 2 and an increase in indirect sales due to expanded distribution through +third-party resellers. 28 Table of Contents Mac The following table presents Mac net sales and unit sales information for 2013, 2012 and 2011 (net sales in millions and units in thousands): 2013 Change 2012 Change 2011 Net sales $ 21,483 (7)% $ 23,221 7% $ 21,783 Percentage of total net sales 13% 15% 20% Unit sales 16,341 (10)% 18,158 9% 16,735 Mac net sales and unit sales for 2013 were down or relatively flat in all of the Company’s operating +segments. Mac ASPs increased slightly partially offsetting the impact of lower unit sales on net sales. The decline in Mac unit sales and net sales reflects the overall weakness in the market for personal computers. The year-over-year growth in Mac net sales and unit sales during 2012 reflects increased demand for Mac portables in all of the +Company’s operating segments driven by 2012 releases of updated models of MacBook Air and MacBook Pro, including MacBook Pro with Retina display in June 2012. Partially offsetting the increase in net sales of Mac portables was a decline in net +sales of Mac desktops that reflected the overall decline in the market for desktop personal computers during 2012. Additionally, the Company did not introduce updated versions of its Mac desktop products in 2012. iTunes, Software and Services The following table presents net sales information of iTunes, software and services for 2013, 2012 and 2011 (in millions): 2013 Change 2012 Change 2011 iTunes, software and services $ 16,051 25% $ 12,890 38% $ 9,373 Percentage of total net sales 9% 8% 9% The increase in net sales of iTunes, software and services in 2013 compared to 2012 was primarily due to +growth in net sales from the iTunes Store, AppleCare and licensing. The iTunes Store generated a total of $9.3 billion in net sales during 2013, a 24% increase from 2012. Growth in the iTunes Store, which includes the App Store, the Mac App Store +and the iBooks Store, reflects continued growth in the installed base of iOS devices, expanded offerings of iOS apps and related in-App purchases, and expanded offerings of iTunes digital content. The increase in net sales of iTunes, software and services in 2012 compared to 2011 was due primarily to growth of the iTunes Store, +which generated total net sales of $7.5 billion for 2012 compared to net sales of $5.4 billion during 2011. The strong results of the iTunes Store in 2012 reflect growth of the App Store; growth of the Company’s customer base; and the continued +expansion of third-party audio, video and book content available for sale or rent via the iTunes Store. 29 Table of Contents Segment Operating Performance The Company manages its business primarily on a geographic basis. Accordingly, the Company determined its reportable operating segments, +which are generally based on the nature and location of its customers, to be the Americas, Europe, Greater China, Japan, Rest of Asia Pacific and Retail. The Americas segment includes both North and South America. The Europe segment includes +European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and Asian countries, other than those countries included in the +Company’s other operating segments. The Retail segment operates Apple retail stores in 13 countries, including the U.S. The results of the Company’s geographic segments do not include results of the Retail segment. Each operating segment +provides similar hardware and software products and similar services. Further information regarding the Company’s operating segments may be found in Note 11, “Segment Information and Geographic Data.” Americas The following table presents Americas net sales information for 2013, 2012 and 2011 (in millions): 2013 Change 2012 Change 2011 Net sales $ 62,739 9% $ 57,512 50% $ 38,315 Percentage of total net sales 37% 37% 35% The growth in the Americas segment net sales during 2013 was driven by increased sales of iPhone +following the introduction of iPhone 5 in September 2012 and iPhone 5s and 5c in September 2013, increased sales from the iTunes Store, and increased sales of iPad, particularly iPad mini. These increases were partially offset by a decrease in net +sales of iPod and Mac and a decline in iPad ASPs. The growth in net sales during 2012 was primarily driven by increased +demand for iPhone following the launches of iPhone 4s and iPhone 5, strong demand for the third generation iPad and iPad 2, and higher sales from the iTunes Store. Europe The following table presents Europe net sales information for 2013, +2012 and 2011 (in millions): 2013 Change 2012 Change 2011 Net sales $ 37,883 4% $ 36,323 31% $ 27,778 Percentage of total net sales 22% 23% 26% Similar to the Americas segment, growth in net sales in the Europe segment during 2013 was primarily +driven by increased sales of iPhone, iPad and higher net sales from iTunes. These increases were partially offset by decreases in net sales of Mac and iPod and a decline in iPad ASPs. Net sales in the Europe segment continue to be negatively +impacted by unfavorable economic conditions in parts of the region reflected by second half 2013 net sales falling 4% compared to the second half of 2012, which followed an 11% increase in net sales during the first half of 2013. The growth in net sales during 2012 was primarily driven by strong demand for the third generation iPad and iPad 2, higher sales from the +iTunes Store and increased demand for iPhone from the launch of iPhone 4s. iPhone 5 was launched in a limited number of countries in the Europe segment at the end of the fourth quarter of 2012 and did not contribute to the growth in net sales in the +Europe segment to the extent it did in other segments. Lower year-over-year growth in net sales in the Europe segment during 2012 compared to the Company’s other geographic segments reflects growth in iPhone unit sales that was well below the +growth rates experienced by the Company’s other operating segments, partially offset by strong growth in iPad unit sales. Net sales in the Europe 30 Table of Contents segment were also negatively impacted by the region’s uncertain economic conditions and the strength in the U.S. dollar relative to several European currencies, including the euro. Greater China The following table presents Greater China net sales information for 2013, 2012 and 2011 (in millions): 2013 Change 2012 Change 2011 Net sales $ 25,417 13% $ 22,533 78% $ 12,690 Percentage of total net sales 15% 14% 12% The growth in net sales in the Greater China segment during 2013 resulted from two major iPhone +introductions during the year, iPhone 5 in December 2012 and iPhone 5c and iPhone 5s in September 2013. Further contributing to the growth in 2013 was the introduction of the fourth generation iPad and iPad mini during the second quarter of 2013 and +an increase in iPhone channel inventory as of the end of 2013 compared to the end of 2012. While net sales in the China segment were up 13% for all of 2013, net sales for the second half of 2013 declined 4% compared to the second half of 2012. The growth in net sales during 2012 was mainly due to increased demand for iPhone following the launch of iPhone 4s and +strong demand for the third generation iPad and iPad 2. Growth in the Greater China segment was affected by the timing of iPhone and iPad product launches. iPhone 5 was not launched in China during 2012, and the third generation iPad that was +introduced by the Company in March 2012 was not launched in China until the fourth quarter of 2012. Japan The following table presents Japan net sales information for 2013, 2012 and 2011 (in millions): 2013 Change 2012 Change 2011 Net sales $ 13,462 27% $ 10,571 94% $ 5,437 Percentage of total net sales 8% 7% 5% The increase in net sales in the Japan segment during 2013 reflects significant increases in unit volumes +of iPhone and iPad, strong growth of iTunes Store net sales and an increase in iPhone channel inventory as of the end of 2013 compared to the end of 2012. These positive factors were partially offset by declines in ASPs for iPhone and iPad and by +weakness in the Japanese Yen relative to the U.S. dollar. The growth in net sales during 2012 was primarily driven by +increased demand for iPhone following the launches of iPhone 4s and iPhone 5, expanded distribution with a new iPhone carrier, strong demand for the third generation iPad and iPad 2, higher sales from the iTunes Store, and strength in the Japanese +Yen relative to the U.S. dollar. Rest of Asia Pacific The following table presents Rest of Asia Pacific net sales information for 2013, 2012 and 2011 (in millions): 2013 Change 2012 Change 2011 Net sales $ 11,181 4% $ 10,741 8% $ 9,902 Percentage of total net sales 7% 7% 9% The growth in net sales during 2013 was primarily driven by the launch of iPhone 5 and higher sales from +iTunes, partially offset by a decrease in net sales of iPad and Mac. 31 Table of Contents The growth in net sales during 2012 was mainly due to strong demand for the third generation +iPad. The Rest of Asia Pacific segment experienced significantly lower year-over-year growth in net sales compared to all of the Company’s other operating segments due primarily to a decrease in iPhone sales. This decrease reflects the timing +of iPhone 5 launches in the Rest of Asia Pacific segment, which only occurred in a limited number of countries during the fourth quarter of 2012. Retail The following table presents Retail net sales information for 2013, +2012 and 2011 (in millions, except for store counts): 2013 Change 2012 Change 2011 Net sales $ 20,228 7% $ 18,828 33% $ 14,127 Percentage of total net sales 12% 12% 13% U.S. stores 254 250 245 International stores 162 140 112 Total store count 416 390 357 The growth in net sales during 2013 was primarily driven by increased unit sales of iPhone and iPad +following the new product introductions in the first half of 2013 and increased sales of services. With an average of 403 and 365 open stores during 2013 and 2012, respectively, average revenue per store decreased to $50.2 million in 2013, compared +to $51.5 million in 2012. The growth in net sales during 2012 was driven primarily by increased demand for iPhone following +the launches of iPhone 4s and iPhone 5, strong demand for the third generation iPad and iPad 2, and higher Mac net sales. Lower year-over-year growth in net sales in the Retail segment during 2012 compared to the Company’s other segments +reflects the significant growth in iPad indirect distribution channel expansion. With an average of 365 stores and 326 stores during 2012 and 2011, respectively, average revenue per store increased 19% to $51.5 million in 2012 compared to $43.3 +million in 2011. The Retail segment’s operating income was $4.0 billion, $4.6 billion and $3.1 billion during 2013, +2012, and 2011, respectively. The year-over-year decrease in Retail operating income in 2013 is primarily attributable to lower gross margin similar to that experienced by the Company overall, partially offset by higher net sales. The year-over-year +increase in Retail operating income in 2012 is primarily attributable to higher overall net sales that resulted in significantly higher average revenue per store during 2012. Gross Margin Gross margin for 2013, 2012 and 2011 are as follows (in +millions, except gross margin percentages): 2013 2012 2011 Net sales $ 170,910 $ 156,508 $ 108,249 Cost of sales 106,606 87,846 64,431 Gross margin $ 64,304 $ 68,662 $ 43,818 Gross margin percentage 37.6% 43.9% 40.5% The gross margin percentage in 2013 was 37.6% compared to 43.9% in 2012. The year-over-year decrease in +gross margin in 2013 compared to 2012 was driven by multiple factors including introduction of new versions of existing products with higher cost structures and flat or reduced pricing; a shift in sales mix to products with lower margins; +introduction of iPad mini with gross margin significantly below the Company’s average product margins; higher expenses associated with changes to certain of the Company’s service policies and other 32 Table of Contents warranty costs; price reductions on certain products, including iPad 2 and iPhone 4; and unfavorable impact from foreign exchange fluctuations. The gross margin percentage in 2012 was 43.9%, compared to 40.5% in 2011. This year-over-year increase in gross margin was largely driven +by lower commodity and other product costs, a higher mix of iPhone sales, and improved leverage on fixed costs from higher net sales. The increase in gross margin was partially offset by the impact of a stronger U.S. dollar. The gross margin +percentage during the first half of 2012 was 45.9% compared to 41.4% during the second half of 2012. The primary drivers of higher gross margin in the first half of 2012 compared to the second half are a higher mix of iPhone sales and improved +leverage on fixed costs from higher net sales. Additionally, gross margin in the second half of 2012 was also affected by the introduction of new products with flat pricing that have higher cost structures and deliver greater value to +customers, price reductions on certain existing products, higher transition costs associated with product launches, and continued strengthening of the U.S. dollar; partially offset by lower commodity costs. The Company anticipates gross margin during the first quarter of 2014 to be between 36.5% and 37.5%. The foregoing statement regarding +the Company’s expected gross margin percentage in the first quarter of 2014 is forward-looking and could differ from actual results. The Company’s future gross margin can be impacted by multiple factors including, but not limited to those +set forth above in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and those described in this paragraph. In general, gross margins and margins on individual products will remain under downward pressure due to a variety +of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product transitions, potential increases in the cost of components, and potential strengthening of the U.S. +dollar, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to competitive pressures, the Company expects +it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for +certain of its products. Due to the Company’s significant international operations, financial results can be significantly affected in the short-term by fluctuations in exchange rates. Operating Expenses Operating expenses for 2013, 2012 and 2011 are as +follows (in millions, except for percentages): 2013 Change 2012 Change 2011 Research and development $ 4,475 32% $ 3,381 39% $ 2,429 Percentage of total net sales 3% 2% 2% Selling, general and administrative $ 10,830 8% $ 10,040 32% $ 7,599 Percentage of total net sales 6% 6% 7% Total operating expenses $ 15,305 14% $ 13,421 34% $ 10,028 Percentage of total net sales 9% 9% 9% Research and Development (“R&D”) Expense The growth in R&D expense was driven by an increase in headcount and related expenses to support expanded R&D activities. Although +total R&D expense increased 32% and 39% in 2013 and 2012, respectively, it remained fairly consistent as a percentage of net sales. The Company continues to believe that focused investments in R&D are critical to its future growth and +competitive position in the marketplace and are directly related to timely development of new and enhanced products that are central to the Company’s core business strategy. As such, the Company expects to make further investments in R&D to +remain competitive. Selling, General and Administrative (“SG&A”) Expense The growth in SG&A during 2013 was primarily due to the Company’s continued expansion of its Retail segment and increased +headcount and related expenses, partially offset by decreased spending on professional 33 Table of Contents services. The growth in SG&A during 2012 was primarily due to the Company’s continued expansion of its Retail segment, increased headcount and related expenses, higher spending on +professional services, marketing and advertising programs, and increased variable costs associated with the overall growth of the Company’s net sales. Other Income and Expense Other income and expense for 2013, 2012 and 2011 +are as follows (in millions): 2013 Change 2012 Change 2011 Interest and dividend income $ 1,616 $ 1,088 $ 519 Interest expense (136 ) 0 0 Other expense, net (324 ) (566 ) (104 ) Total other income/(expense), net $ 1,156 121% $ 522 26% $ 415 The year-over-year increase in other income and expense during 2013 was due primarily to higher interest +and dividend income resulting from the Company’s higher cash, cash equivalents and marketable securities balances and lower premium expenses on foreign exchange contracts, partially offset by interest expense on debt issued in the third quarter +of 2013 and remeasurement losses from foreign exchange rate movements. The overall increase in other income and expense in 2012 compared to 2011 was attributable to higher interest and dividend income on the Company’s higher cash, cash +equivalents and marketable securities balances, partially offset by higher premium expenses on foreign exchange contracts. The weighted average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.03% +during 2013 and 2012 and 0.77% during 2011. The Company had no debt outstanding during 2012 and 2011 and accordingly did not incur any related interest expense. Provision for Income Taxes Provision for income taxes and effective tax +rates for 2013, 2012 and 2011 are as follows (in millions): 2013 2012 2011 Provision for income taxes $ 13,118 $ 14,030 $ 8,283 Effective tax rate 26.2% 25.2% 24.2% The Company’s effective tax rates for all periods differ from the statutory federal income tax rate +of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided because such earnings are intended to be indefinitely reinvested +outside the U.S. As of September 28, 2013, the Company had deferred tax assets arising from deductible temporary +differences, tax losses, and tax credits of $4.2 billion, and deferred tax liabilities of $16.5 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax +planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by +assessing the need for and amount of a valuation allowance. The Internal Revenue Service (the “IRS”) has completed +its field audit of the Company’s federal income tax returns for the years 2004 through 2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining +the years 2007 through 2012. All IRS audit issues for years prior to 2004 have been resolved. In addition, the Company is subject to audits by state, local, and foreign tax authorities. Management believes that adequate provisions have been +made for any 34 Table of Contents adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in +a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Liquidity and Capital Resources The following table presents selected +financial information and statistics as of and for the years ended September 28, 2013, September 29, 2012 and September 24, 2011 (in millions): 2013 2012 2011 Cash, cash equivalents and marketable securities $ 146,761 $ 121,251 $ 81,570 Property, plant and equipment, net $ 16,597 $ 15,452 $ 7,777 Long-term debt $ 16,960 $ 0 $ 0 Working capital $ 29,628 $ 19,111 $ 17,018 Cash generated by operating activities $ 53,666 $ 50,856 $ 37,529 Cash used in investing activities $ (33,774 ) $ (48,227 ) $ (40,419 ) Cash generated/(used in) by financing activities $ (16,379 ) $ (1,698 ) $ 1,444 The Company believes its existing balances of cash, cash equivalents and marketable securities will be +sufficient to satisfy its working capital needs, capital asset purchases, outstanding commitments, and other liquidity requirements associated with its existing operations over the next 12 months. The Company anticipates the cash used for future +dividends and the share repurchase program will come from its current domestic cash, cash generated from on-going U.S. operating activities and from borrowings. As of September 28, 2013 and September 29, 2012, $111.3 billion and $82.6 billion, respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign +subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. The Company’s +marketable securities investment portfolio is invested primarily in highly-rated securities and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade +with the objective of minimizing the potential risk of principal loss. During 2013, cash generated from operating activities +of $53.7 billion was a result of $37.0 billion of net income, non-cash adjustments to net income of $10.2 billion and an increase in net change in operating assets and liabilities of $6.5 billion. Cash used in investing activities of $33.8 billion +during 2013 consisted primarily of net purchases, sales and maturities of marketable securities of $24.0 billion and cash used to acquire property, plant and equipment of $8.2 billion. Cash used in financing activities during 2013 consisted +primarily of cash used to repurchase common stock of $22.9 billion and cash used to pay dividends and dividend equivalent rights of $10.6 billion, partially offset by net proceeds from the issuance of long-term debt of $16.9 billion. During 2012, cash generated from operating activities of $50.9 billion was a result of $41.7 billion of net income and non-cash +adjustments to net income of $9.4 billion, partially offset by a decrease in net operating assets and liabilities of $299 million. Cash used in investing activities during 2012 of $48.2 billion consisted primarily of net purchases, sales and +maturities of marketable securities of $38.4 billion and cash used to acquire property, plant and equipment of $8.3 billion. Cash used in financing activities during 2012 of $1.7 billion consisted primarily of cash used to pay dividends and dividend +equivalent rights of $2.5 billion. Capital Assets The Company’s capital expenditures were $7.0 billion during 2013, consisting of $499 million for retail store facilities and $6.5 +billion for other capital expenditures, including product tooling and manufacturing process equipment, and other corporate facilities and infrastructure. The Company’s actual cash payments for capital expenditures during 2013 were $8.2 billion. 35 Table of Contents The Company anticipates utilizing approximately $11.0 billion for capital expenditures +during 2014, including approximately $550 million for retail store facilities and approximately $10.5 billion for other capital expenditures, including product tooling and manufacturing process equipment, and corporate facilities and infrastructure, +including information systems hardware, software and enhancements. During 2014, the Company expects to open about 30 new +retail stores, with approximately two-thirds located outside of the U.S. During 2014, the Company also expects to remodel approximately 20 of its existing stores. Long-Term Debt In the third quarter of 2013, the Company issued $17.0 +billion of long-term debt, which included $3.0 billion of floating-rate notes. To manage the risk of adverse fluctuations in interest rates associated with the floating-rate notes, the Company entered into interest rate swaps with an aggregate +notional amount of $3.0 billion, which, in effect, fixed the interest rate of the floating-rate notes. Of the aggregate principal amount of $17.0 billion, $2.5 billion is due in 2016 and $14.5 billion is due in 2018 through 2043. Dividend and Stock Repurchase Program In the third quarter of 2013, the Company raised its cash dividend by 15% to $3.05 per common share. The Company expects to continue to pay quarterly dividends of $3.05 per common share each quarter, +subject to declaration by the Board of Directors. In 2012, the Company’s Board of Directors authorized a program to +repurchase up to $10 billion of the Company’s common stock. In April 2013, the Company’s Board of Directors increased the share repurchase program authorization from $10 billion to $60 billion, of which $23.0 billion had been utilized as +of September 28, 2013. The share repurchase program is expected to be completed by December 2015. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be +repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 of the Exchange Act. Beginning in August 2012 through December 2015, the Company anticipates it will utilize approximately $100 billion to pay dividends and dividend equivalent rights, repurchase shares, and remit withheld +taxes related to net share settlement of restricted stock units, of which $37.1 billion had been utilized through September 28, 2013. The following table presents the Company’s dividends, share repurchases and net share settlement activity +for 2013 and 2012 since the start of the program (in millions): Dividends and Dividend Equivalent Rights Paid Accelerated Share Repurchases Open Market Share Repurchases Taxes Related to Settlement of Equity Awards Total 2012 $ 2,488 $ 0 $ 0 $ 56 $ 2,544 2013 10,564 13,950 9,000 1,082 34,596 Total $ 13,052 $ 13,950 $ 9,000 $ 1,138 $ 37,140 Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated +retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides +financing, liquidity, market risk, or credit risk support to the Company. 36 Table of Contents The following table presents certain payments due by the Company under contractual +obligations with minimum firm commitments as of September 28, 2013 and excludes amounts already recorded on the Consolidated Balance Sheet, except for long-term debt (in millions): Payments Due in Less Than +1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than +5 Years Total Long-term debt $ 0 $ 2,500 $ 6,000 $ 8,500 $ 17,000 Operating leases 610 1,200 1,056 1,855 4,721 Purchase obligations 18,616 0 0 0 18,616 Other obligations 1,081 248 16 3 1,348 Total $ 20,307 $ 3,948 $ 7,072 $ 10,358 $ 41,685 Lease Commitments The Company’s major facility leases are typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for +terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 28, 2013, the Company’s total future minimum lease payments under noncancelable operating leases +were $4.7 billion, of which $3.5 billion related to leases for retail space. Purchase Commitments with Outsourcing +Partners and Component Suppliers The Company utilizes several outsourcing partners to manufacture sub-assemblies for the +Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 +days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and +open orders based on projected demand information. Where appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. As of September 28, 2013, the +Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $18.6 billion. Other Obligations In addition to the off-balance sheet commitments +mentioned above, the Company had outstanding obligations of $1.3 billion as of September 28, 2013, that consisted mainly of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments +related to advertising, research and development, Internet and telecommunications services and other obligations. The +Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of September 28, 2013, the Company +had non-current deferred tax liabilities of $16.5 billion. Additionally, as of September 28, 2013, the Company had gross unrecognized tax benefits of $2.7 billion and an additional $590 million for gross interest and penalties classified as +non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years in connection with these tax liabilities; therefore, such amounts are not included in the above +contractual obligation table. Indemnification The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other +agreements entered into by 37 Table of Contents the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an +indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified third-party. In the opinion of management, there was not at least a +reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company did not +record a liability for infringement costs related to indemnification as of September 28, 2013 or September 29, 2012. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company +has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal +proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances +involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and payments made under these agreements historically have not been material. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its +financial condition and operating results require the Company’s management to make judgments, assumptions, and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of +Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated +financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values +of assets and liabilities. Actual results may differ from these estimates and such differences may be material. Management +believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation and impairment of marketable securities, inventory valuation and valuation of manufacturing-related assets and estimated +purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and +operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and +Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, and service and +support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it +has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the +U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware +products, software bundled with hardware that is essential to the functionality of the hardware, and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The 38 Table of Contents Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, +(ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware +product’s essential software, and/or undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price +to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price +(“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of +elements would be if they were sold regularly on a stand-alone basis. For sales of qualifying versions of iOS devices, Mac +and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades and features free of charge to customers. The Company also provides various non-software services to owners of qualifying versions of iOS +devices and Mac. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the +unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided +for each of these devices, which ranges from two to four years. The Company’s process for determining ESPs involves +management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s ESPs and the future +rate of related amortization for software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the unspecified software upgrade rights offered, the estimated value of unspecified +software upgrade rights, the estimated or actual costs incurred to provide non-software services, and the estimated period software upgrades and non-software services are expected to be provided. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. +For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been +met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, the +estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the +Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive +programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a +greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s results of operations. Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated +other comprehensive income, net of tax, in the Company’s Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities 39 Table of Contents impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by +specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the +period any such determination is made. In making this judgment, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes +thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company’s assessment on whether a security is other-than-temporarily +impaired could change in the future due to new developments or changes in assumptions related to any particular security. Inventory Valuation and Valuation of Manufacturing-Related Assets and Estimated Purchase Commitment Cancellation Fees The Company must order components for its products and build inventory in advance of product shipments and has invested in manufacturing +process equipment, including capital assets held at its suppliers’ facilities. In addition, the Company has made prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory components. The +Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed +review of inventory that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels, and component cost trends. The Company also reviews its manufacturing-related capital assets +and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the +amount by which the carrying value of such an asset exceeds its fair value. The industries in which the Company competes are +subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. In certain circumstances the Company may be required to record additional write-downs of inventory, inventory prepayments and/or +manufacturing-related capital assets. These circumstances include future demand or market conditions for the Company’s products being less favorable than forecasted, unforeseen technological changes or changes to the Company’s product +development plans that negatively impact the utility of any of these assets, or significant deterioration in the financial condition of one or more of the Company’s suppliers that hold any of the Company’s manufacturing process equipment +or to whom the Company has made an inventory prepayment. Such write-downs would adversely affect the Company’s results of operations in the period when the write-downs were recorded. The Company records accruals for estimated cancellation fees related to component orders that have been cancelled or are expected to be +cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders in each case based on projected demand. Where appropriate, the purchases are +applied to inventory component prepayments that are outstanding with the respective supplier. Purchase commitments typically cover the Company’s forecasted component and manufacturing requirements for periods up to 150 days. +If there is an abrupt and substantial decline in demand for one or more of the Company’s products, if the Company’s product development plans change, or if there is an unanticipated change in technological requirements for any of the +Company’s products, then the Company may be required to record additional accruals for cancellation fees that would adversely affect its results of operations in the period when the cancellation fees are identified and recorded. Warranty Costs The Company provides for the estimated cost of warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim, and +knowledge of specific product failures that are outside of the Company’s typical experience. Each quarter, the Company reevaluates 40 Table of Contents these estimates to assess the adequacy of its recorded warranty liabilities considering the size of the installed base of products subject to warranty protection and adjusts the amounts as +necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect the Company’s results of operations. Income Taxes The Company records a tax provision for the anticipated tax consequences of the reported results of operations. The provision for income taxes is computed using the asset and liability method, under which +deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. +Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance +to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes tax +benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial +statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing +taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will make an adjustment to +the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP +and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in +Note 10, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and +the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be reasonably estimated. In the opinion of management, there was not at least a reasonable possibility +the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for legal and other contingencies. However, the outcome of legal proceedings and claims brought against the Company +is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of +management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. 41 Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly +reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. Given +the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in +either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely +affect the Company’s financial condition and operating results. Interest Rate Risk Investments While the Company is exposed to interest rate fluctuations in many of the world’s leading industrialized countries, the Company’s interest income is most sensitive to fluctuations in U.S. +interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities, the fair value of those securities, as well as costs associated with hedging. The Company’s investment policy and strategy are focused on preservation of capital and supporting the liquidity requirements of the +Company. A portion of the Company’s cash is managed by external managers within the guidelines of the Company’s investment policy and to objective market benchmarks. The Company’s internal portfolio is benchmarked against external +manager performance. The Company’s exposure to changes in interest rates relates primarily to the Company’s +investment portfolio. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the +primary objective of minimizing the potential risk of principal loss. To provide a meaningful assessment of the interest rate +risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel +shift in the yield curve. Based on investment positions as of September 28, 2013, a hypothetical 100 basis point increase in interest rates across all maturities would result in a $2.7 billion incremental decline in the fair market value of the +portfolio. As of September 29, 2012, a similar 100 basis point increase in the yield curve would have resulted in a $2.1 billion incremental decline in the fair market value of the portfolio. Such losses would only be realized if the Company +sold the investments prior to maturity. Long-Term Debt In the third quarter of 2013, the Company issued $17.0 billion of long-term debt, which included $3.0 billion of floating-rate notes. To +manage the risk of fluctuations in interest rates associated with the floating-rate notes, the Company entered into interest rate swaps with an aggregate notional amount of $3.0 billion, which, in effect, fixed the interest rate of the floating-rate +notes. Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the +Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local 42 Table of Contents currency product pricing due to competitive pressures when there have been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange +risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows, and net investments in foreign subsidiaries. The Company’s practice is to hedge a portion of its material +foreign exchange exposures, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to accounting considerations and the prohibitive economic +cost of hedging particular exposures. To provide a meaningful assessment of the foreign currency risk associated with certain +of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of +using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency +derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm +commitments, and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $201 million as of +September 28, 2013 compared to a maximum one-day loss in fair value of $200 million as of September 29, 2012. Because the Company uses foreign currency instruments for hedging purposes, the loss in fair value incurred on those instruments +are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated +with the Company’s investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 28, 2013 due to the inherent limitations associated with predicting the timing and amount of +changes in interest rates, foreign currency exchanges rates and the Company’s actual exposures and positions. 43 Table of Contents Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 28, 2013, September  +29, 2012, and September 24, 2011 45 Consolidated Statements of Comprehensive Income for the years ended September  +28, 2013, September 29, 2012, and September 24, 2011 46 Consolidated Balance Sheets as of September 28, 2013 and September 29, 2012 47 Consolidated Statements of Shareholders’ Equity for the years ended September 28, 2013,  +September 29, 2012, and September 24, 2011 48 Consolidated Statements of Cash Flows for the years ended September 28, 2013, September  +29, 2012, and September 24, 2011 49 Notes to Consolidated Financial Statements 50 Selected Quarterly Financial Information (Unaudited) 78 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 79 All financial statement schedules have been omitted, since the required information is not applicable or +is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. 44 Table of Contents CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 28, 2013 September 29, 2012 September 24, 2011 Net sales $ 170,910 $ 156,508 $ 108,249 Cost of sales 106,606 87,846 64,431 Gross margin 64,304 68,662 43,818 Operating expenses: Research and development 4,475 3,381 2,429 Selling, general and administrative 10,830 10,040 7,599 Total operating expenses 15,305 13,421 10,028 Operating income 48,999 55,241 33,790 Other income/(expense), net 1,156 522 415 Income before provision for income taxes 50,155 55,763 34,205 Provision for income taxes 13,118 14,030 8,283 Net income $ 37,037 $ 41,733 $ 25,922 Earnings per share: Basic $ 40.03 $ 44.64 $ 28.05 Diluted $ 39.75 $ 44.15 $ 27.68 Shares used in computing earnings per share: Basic 925,331 934,818 924,258 Diluted 931,662 945,355 936,645 Cash dividends declared per common share $ 11.40 $ 2.65 $ 0.00 See accompanying Notes to Consolidated Financial Statements. 45 Table of Contents CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September  +28, 2013 September  +29, 2012 September  +24, 2011 Net income $ 37,037 $ 41,733 $ 25,922 Other comprehensive income/(loss): Change in foreign currency translation, net of tax effects of $35, $13 and $18, respectively (112 ) (15 ) (12 ) Change in unrecognized gains/losses on derivative instruments: Change in fair value of derivatives, net of tax benefit/(expense) of $(351), $73 and $(50), respectively 522 (131 ) 92 Adjustment for net losses/(gains) realized and included in net income, net of tax expense/(benefit) of $255, $220 and $(250), +respectively (458 ) (399 ) 450 Total change in unrecognized gains/losses on derivative instruments, net of tax 64 (530 ) 542 Change in unrealized gains/losses on marketable securities: Change in fair value of marketable securities, net of tax benefit/(expense) of $458, $(421) and $17, respectively (791 ) 715 29 Adjustment for net losses/(gains) realized and included in net income, net of tax expense/(benefit) of $82, $68 and $(40), +respectively (131 ) (114 ) (70 ) Total change in unrealized gains/losses on marketable securities, net of tax (922 ) 601 (41 ) Total other comprehensive income/(loss) (970 ) 56 489 Total comprehensive income $ 36,067 $ 41,789 $ 26,411 See accompanying Notes to Consolidated Financial Statements. 46 Table of Contents CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands) September 28, 2013 September 29, 2012 ASSETS: Current assets: Cash and cash equivalents $ 14,259 $ 10,746 Short-term marketable securities 26,287 18,383 Accounts receivable, less allowances of $99 and $98, respectively 13,102 10,930 Inventories 1,764 791 Deferred tax assets 3,453 2,583 Vendor non-trade receivables 7,539 7,762 Other current assets 6,882 6,458 Total current assets 73,286 57,653 Long-term marketable securities 106,215 92,122 Property, plant and equipment, net 16,597 15,452 Goodwill 1,577 1,135 Acquired intangible assets, net 4,179 4,224 Other assets 5,146 5,478 Total assets $ 207,000 $ 176,064 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 22,367 $ 21,175 Accrued expenses 13,856 11,414 Deferred revenue 7,435 5,953 Total current liabilities 43,658 38,542 Deferred revenue – non-current 2,625 2,648 Long-term debt 16,960 0 Other non-current liabilities 20,208 16,664 Total liabilities 83,451 57,854 Commitments and contingencies Shareholders’ equity: Common stock, no par value; 1,800,000 shares authorized; 899,213 and 939,208 shares issued and outstanding, +respectively 19,764 16,422 Retained earnings 104,256 101,289 Accumulated other comprehensive income/(loss) (471 ) 499 Total shareholders’ equity 123,549 118,210 Total liabilities and shareholders’ equity $ 207,000 $ 176,064 See accompanying Notes to Consolidated Financial Statements. 47 Table of Contents CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands) Common Stock Retained Earnings Accum- ulated Other Compre- hensive Income/ (Loss) Total Share- holders’ Equity Shares Amount Balances as of September 25, 2010 915,970 $ 10,668 $ 37,169 $ (46 ) $ 47,791 Net income 0 0 25,922 0 25,922 Other comprehensive income/(loss) 0 0 0 489 489 Share-based compensation 0 1,168 0 0 1,168 Common stock issued under stock plans, net of shares withheld for employee taxes 13,307 561 (250 ) 0 311 Tax benefit from equity awards, including transfer pricing adjustments 0 934 0 0 934 Balances as of September 24, 2011 929,277 13,331 62,841 443 76,615 Net income 0 0 41,733 0 41,733 Other comprehensive income/(loss) 0 0 0 56 56 Dividends and dividend equivalent rights declared 0 0 (2,523 ) 0 (2,523 ) Share-based compensation 0 1,740 0 0 1,740 Common stock issued under stock plans, net of shares withheld for employee taxes 9,931 200 (762 ) 0 (562 ) Tax benefit from equity awards, including transfer pricing adjustments 0 1,151 0 0 1,151 Balances as of September 29, 2012 939,208 16,422 101,289 499 118,210 Net income 0 0 37,037 0 37,037 Other comprehensive income/(loss) 0 0 0 (970 ) (970 ) Dividends and dividend equivalent rights declared 0 0 (10,676 ) 0 (10,676 ) Repurchase of common stock (46,976 ) 0 (22,950 ) 0 (22,950 ) Share-based compensation 0 2,253 0 0 2,253 Common stock issued under stock plans, net of shares withheld for employee taxes 6,981 (143 ) (444 ) 0 (587 ) Tax benefit from equity awards, including transfer pricing adjustments 0 1,232 0 0 1,232 Balances as of September 28, 2013 899,213 $ 19,764 $ 104,256 $ (471 ) $ 123,549 See accompanying Notes to Consolidated Financial Statements. 48 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September  +28, 2013 September  +29, 2012 September  +24, 2011 Cash and cash equivalents, beginning of the year $ 10,746 $ 9,815 $ 11,261 Operating activities: Net income 37,037 41,733 25,922 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 6,757 3,277 1,814 Share-based compensation expense 2,253 1,740 1,168 Deferred income tax expense 1,141 4,405 2,868 Changes in operating assets and liabilities: Accounts receivable, net (2,172 ) (5,551 ) 143 Inventories (973 ) (15 ) 275 Vendor non-trade receivables 223 (1,414 ) (1,934 ) Other current and non-current assets 1,080 (3,162 ) (1,391 ) Accounts payable 2,340 4,467 2,515 Deferred revenue 1,459 2,824 1,654 Other current and non-current liabilities 4,521 2,552 4,495 Cash generated by operating activities 53,666 50,856 37,529 Investing activities: Purchases of marketable securities (148,489 ) (151,232 ) (102,317 ) Proceeds from maturities of marketable securities 20,317 13,035 20,437 Proceeds from sales of marketable securities 104,130 99,770 49,416 Payments made in connection with business acquisitions, net (496 ) (350 ) (244 ) Payments for acquisition of property, plant and equipment (8,165 ) (8,295 ) (4,260 ) Payments for acquisition of intangible assets (911 ) (1,107 ) (3,192 ) Other (160 ) (48 ) (259 ) Cash used in investing activities (33,774 ) (48,227 ) (40,419 ) Financing activities: Proceeds from issuance of common stock 530 665 831 Excess tax benefits from equity awards 701 1,351 1,133 Taxes paid related to net share settlement of equity awards (1,082 ) (1,226 ) (520 ) Dividends and dividend equivalent rights paid (10,564 ) (2,488 ) 0 Repurchase of common stock (22,860 ) 0 0 Proceeds from issuance of long-term debt, net 16,896 0 0 Cash generated by/(used in) financing activities (16,379 ) (1,698 ) 1,444 Increase/(decrease) in cash and cash equivalents 3,513 931 (1,446 ) Cash and cash equivalents, end of the year $ 14,259 $ 10,746 $ 9,815 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 9,128 $ 7,682 $ 3,338 See accompanying Notes to Consolidated Financial Statements. 49 Table of Contents Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, +manufactures, and markets mobile communication and media devices, personal computers, and portable digital music players, and sells a variety of related software, services, peripherals, networking solutions, and third-party digital content and +applications. The Company sells its products worldwide through its retail stores, online stores, and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the +Company sells a variety of third-party iPhone, iPad, Mac, and iPod compatible products, including application software, and various accessories through its online and retail stores. The Company sells to consumers, small and mid-sized businesses, and +education, enterprise and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been +eliminated. The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in +these consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements and notes thereto have been reclassified to conform to +the current period’s presentation. The Company’s fiscal year is the 52 or 53-week period that ends on the last +Saturday of September. The Company’s fiscal years 2013, 2012 and 2011 ended on September 28, 2013, September 29, 2012 and September 24, 2011, respectively. An additional week is included in the first fiscal quarter +approximately every six years to realign fiscal quarters with calendar quarters. Fiscal year 2012 spanned 53 weeks, with a 14th week included in the first quarter of 2012. Fiscal years 2013 and 2011 spanned 52 weeks each. Unless otherwise stated, +references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. During the first quarter of 2013, the Company adopted amended accounting standards that changed the presentation of comprehensive income. +These standards increased the prominence of other comprehensive income (“OCI”) by eliminating the option to present components of OCI as part of the statement of changes in shareholders’ equity and required the components of OCI to be +presented either in a single continuous statement of comprehensive income or in two consecutive statements. The amended accounting standards only impacted the financial statement presentation of OCI and did not change the components that are +recognized in net income or OCI; accordingly, the adoption had no impact on the Company’s financial position or results of operations. Revenue Recognition Net +sales consist primarily of revenue from the sale of hardware, software, digital content and applications, peripherals, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has +occurred, the sales price is fixed or determinable, and collection is probable. Product is considered delivered to the customer once it has been shipped and title and risk of loss have been transferred. For most of the Company’s product sales, +these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because +the Company retains a portion of the risk of loss on these sales during transit. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware, and +third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the 50 Table of Contents following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to +the functionality of the hardware. For the sale of most third-party products, the Company recognizes revenue based on the +gross amount billed to customers because the Company establishes its own pricing for such products, retains related inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its +customers. For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the +customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app +developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. +This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online +stores, and also sells gift cards redeemable on the iTunes Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue +from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic +tools offered under the Company’s standard limited warranty. The Company records reductions to revenue for estimated +commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For the Company’s other customer incentive +programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product +returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the +relevant government authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, +undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the +Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price +(“TPE”), and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the +Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For multi-element arrangements accounted for in accordance with industry specific software accounting guidance, the +Company allocates revenue to all deliverables based on the VSOE of each element, and if VSOE does not exist revenue is recognized when elements lacking VSOE are delivered. For sales of qualifying versions of iPhone, iPad and iPod touch (“iOS devices”), Mac and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades +and features to the essential software bundled with each of these hardware products free of charge to customers. Essential software for iOS devices includes iOS and related applications and for Mac includes OS X and related applications. The Company +also provides various non-software services to owners of qualifying versions of iOS devices and Mac. 51 Table of Contents The Company has identified up to three deliverables regularly included in arrangements involving the sale of these devices. The first deliverable is the hardware and software essential to the +functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with the purchase of iOS devices, Mac and Apple TV to receive on a when-and-if-available basis, future unspecified software +upgrades and features relating to the product’s essential software. The third deliverable is the non-software services to be provided to qualifying versions of iOS devices and Mac. The Company allocates revenue between these deliverables using +the relative selling price method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based on the Company’s ESPs. Revenue allocated to the delivered hardware and the related essential software is +recognized at the time of sale provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line +basis over the estimated period the software upgrades and non-software services are expected to be provided for each of these devices, which ranges from two to four years. Cost of sales related to delivered hardware and related essential software, +including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses +as incurred. The Company’s process for determining its ESP for deliverables without VSOE or TPE considers multiple +factors that may vary depending upon the unique facts and circumstances related to each deliverable. The Company believes its customers would be reluctant to buy unspecified software upgrade rights for the essential software included with its +qualifying hardware products. This view is primarily based on the fact that unspecified software upgrade rights do not obligate the Company to provide upgrades at a particular time or at all, and do not specify to customers which upgrades or +features will be delivered. The Company also believes its customers would be unwilling to pay a significant amount for access to the non-software services because other companies offer similar services at little or no cost to users. Therefore, the +Company has concluded that if it were to sell upgrade rights or access to the non-software services on a standalone basis, including those rights and services attached to iOS devices, Mac and Apple TV, the selling prices would be relatively low. Key +factors considered by the Company in developing the ESPs for software upgrade rights include prices charged by the Company for similar offerings, market trends in the pricing of Apple-branded and third-party Mac and iOS compatible software, the +nature of the upgrade rights (e.g., unspecified versus specified), and the relative ESP of the upgrade rights as compared to the total selling price of the product. The Company may also consider additional factors as appropriate, including the +impact of other products and services provided to customers, the pricing of competitive alternatives if they exist, product-specific business objectives, and the length of time a particular version of a device has been available. When relevant, the +same factors are considered by the Company in developing ESPs for offerings such as the non-software services with additional consideration given to the estimated cost to provide such services. In 2013, 2012 and 2011, the Company’s combined ESPs for the unspecified software upgrade rights and the rights to receive the +non-software services included with its qualifying hardware devices have ranged from $5 to $25. Beginning in September 2013, the combined ESPs for iPhone and iPad were increased by up to $5 to reflect additions to unspecified software upgrade rights +due to expansion of essential software bundled with these devices. Accordingly, the range of combined ESPs for iPhone and iPad as of September 2013 is $15 to $25. Beginning in October 2013, the Company anticipates increasing the combined ESPs for +Mac from $20 to $40 to reflect additions to unspecified software upgrade rights related to expansion of bundled essential software. Revenue allocated to such rights is deferred and recognized on a straight-line basis over the estimated period the +rights are expected to be provided for each device, which ranges from two to four years. Shipping Costs For all periods presented, amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s +shipping and handling costs are included in cost of sales. 52 Table of Contents Warranty Expense The Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. The Company assesses the adequacy of its pre-existing warranty +liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. Software Development Costs Research and development costs are expensed as incurred. Development costs of computer software to be sold, leased, or +otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products +are released soon after technological feasibility has been established. Costs incurred subsequent to achievement of technological feasibility were not significant, and software development costs were expensed as incurred during 2013, 2012 and 2011. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Advertising expense was $1.1 billion, $1.0 billion and $933 million for 2013, 2012 and 2011, +respectively. Share-based Compensation The Company recognizes expense related to share-based payment transactions in which it receives employee services in exchange for (a) equity instruments of the Company or (b) liabilities that +are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. Share-based compensation cost for restricted stock units (“RSUs”) is measured based on the closing +fair market value of the Company’s common stock on the date of grant. Share-based compensation cost for stock options and employee stock purchase plan rights (“stock purchase rights”) is measured at the grant date and offering date, +respectively, based on the fair-value as calculated by the Black-Scholes-Merton (“BSM”) option-pricing model. The BSM option-pricing model incorporates various assumptions including expected volatility, estimated expected life and interest +rates. The Company recognizes share-based compensation cost over the award’s requisite service period on a straight-line basis for time-based RSUs and on a graded basis for RSUs that are contingent on the achievement of performance metrics. The +Company recognizes a benefit from share-based compensation in the Consolidated Statements of Shareholders’ Equity if an incremental tax benefit is realized. In addition, the Company recognizes the indirect effects of share-based compensation on +research and development tax credits, foreign tax credits and domestic manufacturing deductions in the Consolidated Statements of Operations. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans” of +this Form 10-K. Income Taxes The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary +differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable +income in effect for the years in which those tax assets are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be +sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% +likelihood of being realized upon settlement. See Note 5, “Income Taxes” of this Form 10-K for additional information. 53 Table of Contents Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share +is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been +outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the Company’s employee stock purchase plan and unvested RSUs. The dilutive +effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in +a greater dilutive effect from potentially dilutive securities. The following table shows the computation of basic and +diluted earnings per share for 2013, 2012, and 2011 (in thousands, except net income in millions and per share amounts): 2013 2012 2011 Numerator: Net income $ 37,037 $ 41,733 $ 25,922 Denominator: Weighted-average shares outstanding 925,331 934,818 924,258 Effect of dilutive securities 6,331 10,537 12,387 Weighted-average diluted shares 931,662 945,355 936,645 Basic earnings per share $ 40.03 $ 44.64 $ 28.05 Diluted earnings per share $ 39.75 $ 44.15 $ 27.68 Potentially dilutive securities representing 4.2 million, 1.0 million and 1.7 million +shares of common stock for 2013, 2012 and 2011, respectively, were excluded from the computation of diluted earnings per share for these periods because their effect would have been antidilutive. Financial Instruments Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s marketable debt and equity securities have been +classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the +designations at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 +months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. The Company classifies its marketable equity securities, including mutual funds, as either short-term or +long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity securities are carried at fair value, with the unrealized gains and losses, net of taxes, reported as a +component of shareholders’ equity. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative +instrument is reported as a component of accumulated other comprehensive income (“AOCI”) in shareholders’ equity and reclassified into income in the same period or periods during which the hedged transaction affects earnings. The +ineffective portion of the gain or 54 Table of Contents loss on the derivative instrument, if any, is recognized in current income. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected +future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in income. For derivative instruments that hedge the exposure +to changes in the fair value of an asset or a liability and that are designated as fair value hedges, both the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item attributable to the hedged risk +are recognized in earnings in the current period. The Company had no fair value hedges in 2013, 2012 and 2011. The net gain or loss on the effective portion of a derivative instrument that is designated as an economic hedge of the foreign currency +translation exposure of the net investment in a foreign operation is reported in the same manner as a foreign currency translation adjustment. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair +value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this component are recognized in current income. Derivatives that do not qualify as hedges are adjusted to +fair value through current income. Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors. The Company considers historical +experience, the age of the accounts receivable balances, credit quality of the Company’s customers, current economic conditions, and other factors that may affect customers’ ability to pay. Inventories Inventories +are stated at the lower of cost, computed using the first-in, first-out method, or market. If the cost of the inventories exceeds their market value, provisions are made currently for the difference between the cost and the market value. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which +for buildings is the lesser of 30 years or the remaining life of the underlying building; between two to five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease terms or ten +years for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized +using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Depreciation and amortization expense on property and equipment was $5.8 billion, $2.6 billion and $1.6 billion during 2013, 2012 and +2011, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment, inventory component prepayments, and certain identifiable intangibles, excluding +goodwill, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their +carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment, inventory component prepayments, and certain identifiable intangibles are considered to be impaired, the impairment to be +recognized equals the amount by which the carrying value of the assets exceeds its fair value. The Company did not record any significant impairments during 2013, 2012 and 2011. The Company does not amortize goodwill and intangible assets with indefinite useful lives, rather such assets are required to be tested +for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible asset impairment tests in the fourth quarter of each year. The Company +did not recognize any impairment charges related to 55 Table of Contents goodwill or indefinite lived intangible assets during 2013, 2012 and 2011. The Company established reporting units based on its current reporting structure. For purposes of testing goodwill for +impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. In 2013 and 2012, the Company’s goodwill was allocated to the Americas and Europe reportable operating segments. The Company amortizes its intangible assets with definite useful lives over their estimated useful lives and reviews these assets for +impairment. The Company is currently amortizing its acquired intangible assets with definite useful lives over periods typically from three to seven years. Fair Value Measurements The Company applies fair value accounting for all +financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from +selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, +the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as risks inherent in +valuation techniques, transfer restrictions and credit risk. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy +upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active +markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active +markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of +the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect +management’s estimate of assumptions that market participants would use in pricing the asset or liability. The +Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to +measure the fair value of all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by +observable market data. In accordance with the fair value accounting requirements, companies may choose to measure eligible +financial instruments and certain other items at fair value. The Company has not elected the fair value option for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the +assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those +in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in AOCI in shareholders’ equity. The Company’s subsidiaries that use the U.S. dollar as their functional currency +remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property, and nonmonetary assets and liabilities at historical rates. Gains and losses from these remeasurements were not significant +and have been included in the Company’s results of operations. 56 Table of Contents Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized +gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short- or long-term marketable securities as of September 28, 2013 and September 29, 2012 (in millions): 2013 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 8,705 $ 0 $ 0 $ 8,705 $ 8,705 $ 0 $ 0 Level 1: Money market funds 1,793 0 0 1,793 1,793 0 0 Mutual funds 3,999 0 (197 ) 3,802 0 3,802 0 Subtotal 5,792 0 (197 ) 5,595 1,793 3,802 0 Level 2: U.S. Treasury securities 27,642 24 (47 ) 27,619 431 7,554 19,634 U.S. agency securities 16,878 12 (52 ) 16,838 177 3,412 13,249 Non-U.S. government securities 5,545 35 (137 ) 5,443 50 313 5,080 Certificates of deposit and time deposits 2,344 0 0 2,344 1,264 844 236 Commercial paper 2,998 0 0 2,998 1,835 1,163 0 Corporate securities 54,586 275 (252 ) 54,609 0 8,077 46,532 Municipal securities 6,257 45 (22 ) 6,280 4 1,114 5,162 Mortgage- and asset-backed securities 16,396 23 (89 ) 16,330 0 8 16,322 Subtotal 132,646 414 (599 ) 132,461 3,761 22,485 106,215 Total $ 147,143 $ 414 $ (796 ) $ 146,761 $ 14,259 $ 26,287 $ 106,215 2012 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 3,109 $ 0 $ 0 $ 3,109 $ 3,109 $ 0 $ 0 Level 1: Money market funds 1,460 0 0 1,460 1,460 0 0 Mutual funds 2,385 79 (2 ) 2,462 0 2,462 0 Subtotal 3,845 79 (2 ) 3,922 1,460 2,462 0 Level 2: U.S. Treasury securities 20,088 21 (1 ) 20,108 2,608 3,525 13,975 U.S. agency securities 19,540 58 (1 ) 19,597 1,460 1,884 16,253 Non-U.S. government securities 5,483 183 (2 ) 5,664 84 1,034 4,546 Certificates of deposit and time deposits 2,189 2 0 2,191 1,106 202 883 Commercial paper 2,112 0 0 2,112 909 1,203 0 Corporate securities 46,261 568 (8 ) 46,821 10 7,455 39,356 Municipal securities 5,645 74 0 5,719 0 618 5,101 Mortgage- and asset-backed securities 11,948 66 (6 ) 12,008 0 0 12,008 Subtotal 113,266 972 (18 ) 114,220 6,177 15,921 92,122 Total $ 120,220 $ 1,051 $ (20 ) $ 121,251 $ 10,746 $ 18,383 $ 92,122 The net unrealized losses as of September 28, 2013 and the net unrealized gains as of +September 29, 2012 are related primarily to long-term marketable securities. The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit +deterioration and duration management. During 2013, 2012 and 2011, the net realized gains recognized by the Company were not significant. The maturities of the Company’s long-term marketable securities generally range from one to five years. 57 Table of Contents As of September 28, 2013 and September 29, 2012, gross unrealized losses related +to individual securities that had been in a continuous loss position for 12 months or longer were not significant. As of +September 28, 2013, the Company considered the declines in market value of its marketable securities investment portfolio to be temporary in nature and did not consider any of its investments other-than-temporarily impaired. The Company +typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the primary objective of minimizing the +potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment, the Company reviews factors such as the length of time and +extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates, and the Company’s intent to sell, or whether it is more likely than not it will be +required to sell, the investment before recovery of the investment’s cost basis. During 2013, 2012 and 2011 the Company did not recognize any significant impairment charges. Derivative Financial Instruments The Company uses derivatives to partially +offset its business exposure to foreign currency and interest rate risk. The Company may enter into forward contracts, option contracts, swaps, or other derivative instruments to offset some of the risk on expected future cash flows, on net +investments in certain foreign subsidiaries, and on certain existing assets and liabilities. To help protect gross margins +from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar hedge a portion of forecasted foreign currency revenue. The Company’s subsidiaries whose functional +currency is not the U.S. dollar and who sell in local currencies may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company hedges a portion of its forecasted foreign currency +exposure associated with revenue and inventory purchases, typically for up to 12 months. To help protect the net investment +in a foreign operation from adverse changes in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in +foreign currency exchange rates. To help protect against adverse fluctuations in interest rates, the Company may enter into +interest rate swaps, options, or other instruments to offset a portion of the changes in income or expense due to fluctuations in interest rates. The Company may also enter into foreign currency forward and option contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and +liabilities denominated in non-functional currencies. However, the Company may choose not to hedge certain foreign currency exchange exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive +economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange rates. The Company records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment of these +instruments is based on whether the instruments are designated as hedge or non-hedge instruments. The effective portions of cash flow hedges are recorded in AOCI until the hedged item is recognized in +earnings. The effective portions of net investment hedges are recorded in OCI as a part of the cumulative translation adjustment. The ineffective portions of cash flow hedges and net investment hedges are recorded in other income and expense. +Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. 58 Table of Contents The Company had net deferred losses of $175 million and $240 million associated with cash +flow hedges, net of taxes, recorded in AOCI as of September 28, 2013 and September 29, 2012, respectively. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in +the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred +gains and losses associated with cash flow hedges of interest income or expense are recognized as a component of other income/(expense), net in the same period as the related income or expense is recognized. The Company’s hedged foreign +currency transactions and hedged interest rate transactions as of September 28, 2013 are expected to occur within 12 months and five years, respectively. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within +a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified immediately into other income and expense. Any subsequent changes in fair value of such derivative instruments are +reflected in other income and expense unless they are re-designated as hedges of other transactions. The Company did not recognize any significant net gains or losses related to the loss of hedge designation on discontinued cash flow hedges during +2013, 2012 and 2011. The Company’s unrealized net gains and losses on net investment hedges, included in the cumulative +translation adjustment account of AOCI, were not significant as of September 28, 2013 and September 29, 2012. The ineffective portions of and amounts excluded from the effectiveness test of net investment hedges are recorded in other +income and expense. The gain/loss recognized in other income and expense for foreign currency forward and option contracts +not designated as hedging instruments was not significant during 2013, 2012 and 2011, respectively. These amounts represent the net gain or loss on the derivative contracts and do not include changes in the related exposures, which generally offset +a portion of the gain or loss on the derivative contracts. The following table shows the notional principal amounts of the +Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of September 28, 2013 and September 29, 2012 (in millions): 2013 2012 Notional Principal Credit Risk Amounts Notional Principal Credit Risk Amounts Instruments designated as accounting hedges: Foreign exchange contracts $ 35,013 $ 159 $ 41,970 $ 140 Interest rate contracts $ 3,000 $ 44 $ 0 $ 0 Instruments not designated as accounting hedges: Foreign exchange contracts $ 16,131 $ 25 $ 13,403 $ 12 The notional principal amounts for outstanding derivative instruments provide one measure of the +transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that +are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s gross +exposure on these transactions may be further mitigated by collateral received from certain counterparties. The Company’s exposure to credit loss and market risk will vary over time as a function of currency and interest rates. Although the +table above reflects the notional principal and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The +amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. 59 Table of Contents The Company generally enters into master netting arrangements, which are designed to reduce +credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net +fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values. As of September 28, 2013 and September 29, +2012, the Company posted $164 million and $278 million, respectively, of cash collateral related to the derivative instruments under its collateral security arrangements, which were recorded as other current assets in the Consolidated Balance +Sheet. The Company did not have any derivative instruments with credit-risk related contingent features that would require it to post additional collateral as of September 28, 2013 or September 29, 2012. The following tables show the Company’s derivative instruments at gross fair value as reflected in the Consolidated Balance Sheets +as of September 28, 2013 and September 29, 2012 (in millions): 2013 Fair Value of Derivatives Designated as Hedge  +Instruments Fair Value of Derivatives Not Designated as Hedge  +Instruments Total Fair  +Value Derivative assets (a): Foreign exchange contracts $ 145 $ 25 $ 170 Interest rate contracts $ 44 $ 0 $ 44 Derivative liabilities (b): Foreign exchange contracts $ 389 $ 46 $ 435 2012 Fair Value of Derivatives Designated as Hedge  +Instruments Fair Value of Derivatives Not Designated +as Hedge Instruments Total Fair  +Value Derivative assets (a): Foreign exchange contracts $ 138 $ 12 $ 150 Derivative liabilities (b): Foreign exchange contracts $ 516 $ 41 $ 557 (a) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the Consolidated Balance +Sheets. (b) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the Consolidated Balance +Sheets. 60 Table of Contents The following table shows the pre-tax effect of the Company’s derivative instruments +designated as cash flow and net investment hedges in the Consolidated Statements of Operations for the years ended September 28, 2013 and September 29, 2012 (in millions): Gains/(Losses) Recognized in OCI – Effective Portion Gains/(Losses) Reclassified from AOCI into Net Income – Effective +Portion Gains/(Losses) Recognized – Ineffective Portion and Amount  +Excluded from Effectiveness Testing September 28, 2013 September 29, 2012 September 28, 2013 (a) September 29, 2012 (b) Location September 28, 2013 September 29, 2012 Cash flow hedges: Foreign exchange contracts $ 891 $ (175 ) $ 676 $ 607 Other income/ (expense), net $ (301 ) $ (658 ) Interest rate contracts 12 0 (6 ) 0 Other income/ (expense), net 0 0 Net investment hedges: Foreign exchange contracts 143 (5 ) 0 0 Other income/ (expense), net 1 3 Total $ 1,046 $ (180 ) $ 670 $ 607 $ (300 ) $ (655 ) (a) Includes gains/(losses) reclassified from AOCI into net income for the effective portion of cash flow hedges, of which $44 million, $632 million and +$(6) million were recognized within net sales, cost of sales and other income/(expense), net, respectively, within the Consolidated Statement of Operations for the year ended September 28, 2013. (b) Includes gains/(losses) reclassified from AOCI into income for the effective portion of cash flow hedges, of which $537 million and $70 million were +recognized within net sales and cost of sales, respectively, within the Consolidated Statement of Operations for the year ended September 29, 2012. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, +value-added resellers, small and mid-sized businesses, and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in certain instances to +limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These +credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 28, 2013, the Company had two customers that represented 10% or more of total trade receivables, one of which +accounted for 13% and the other 10%. As of September 29, 2012, the Company had two customers that represented 10% or more of total trade receivables, one of which accounted for 14% and the other 10%. The Company’s cellular network carriers +accounted for 68% and 66% of trade receivables as of September 28, 2013 and September 29, 2012, respectively. The additions and write-offs to the Company’s allowance for doubtful accounts during 2013, 2012 and 2011 were not +significant. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these manufacturing vendors who manufacture sub-assemblies or assemble final +products for the Company. The Company purchases these components directly from suppliers. Vendor non-trade receivables from three of the Company’s vendors accounted for 47%, 21% and 15% of total non-trade receivables as of September 28, +2013 and vendor non-trade receivables from three of the Company’s vendors accounted for 45%, 21% and 12% of total non-trade receivables as of September 29, 2012. The Company does not reflect the sale of these components in net sales and +does not recognize any profits on these sales until the related products are sold by the Company, at which time any profit is recognized as a reduction of cost of sales. 61 Table of Contents Note 3 – Consolidated Financial Statement Details The following tables show the Company’s consolidated balance sheet details as of September 28, 2013 and +September 29, 2012 (in millions): Inventories 2013 2012 Components $ 683 $ 124 Finished goods 1,081 667 Total inventories $ 1,764 $ 791 Property, Plant and Equipment 2013 2012 Land and buildings $ 3,309 $ 2,439 Machinery, equipment and internal-use software 21,242 15,984 Leasehold improvements 3,968 3,464 Gross property, plant and equipment 28,519 21,887 Accumulated depreciation and amortization (11,922 ) (6,435 ) Net property, plant and equipment $ 16,597 $ 15,452 Accrued Expenses 2013 2012 Accrued warranty and related costs $ 2,967 $ 1,638 Accrued taxes 1,200 1,535 Deferred margin on component sales 1,262 1,492 Accrued marketing and selling expenses 1,291 910 Accrued compensation and employee benefits 959 735 Other current liabilities 6,177 5,104 Total accrued expenses $ 13,856 $ 11,414 Non-Current Liabilities 2013 2012 Deferred tax liabilities $ 16,489 $ 13,847 Other non-current liabilities 3,719 2,817 Total other non-current liabilities $ 20,208 $ 16,664 Other Income and Expense The following table shows the detail of other income and expense for 2013, 2012 and 2011 (in millions): 2013 2012 2011 Interest and dividend income $ 1,616 $ 1,088 $ 519 Interest expense (136 ) 0 0 Other expense, net (324 ) (566 ) (104 ) Total other income/(expense), net $ 1,156 $ 522 $ 415 62 Table of Contents Note 4 – Goodwill and Other Intangible Assets The Company’s acquired intangible assets with definite useful lives primarily consist of patents and licenses +and are amortized over periods typically from three to seven years. The following table summarizes the components of gross and net intangible asset balances as of September 28, 2013 and September 29, 2012 (in millions): 2013 2012 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite lived and amortizable acquired intangible assets $ 6,081 $ (2,002 ) $ 4,079 $ 5,166 $ (1,042 ) $ 4,124 Indefinite lived and non-amortizable trademarks 100 0 100 100 0 100 Total acquired intangible assets $ 6,181 $ (2,002 ) $ 4,179 $ 5,266 $ (1,042 ) $ 4,224 During 2013 and 2012, the Company completed various business acquisitions. In 2013, the aggregate cash +consideration, net of cash acquired, was $496 million, of which $419 million was allocated to goodwill, $179 million to acquired intangible assets and $102 million to net liabilities assumed. In 2012, the aggregate cash consideration, net of cash +acquired, was $350 million, of which $245 million was allocated to goodwill, $113 million to acquired intangible assets and $8 million to net liabilities assumed. The Company’s gross carrying amount of goodwill was $1.6 billion and $1.1 billion as of September 28, 2013 and September 29, 2012, respectively. The Company did not have any goodwill +impairment during 2013, 2012 or 2011. Amortization expense related to acquired intangible assets was $960 million, $605 +million and $192 million in 2013, 2012 and 2011, respectively. As of September 28, 2013 the remaining weighted-average amortization period for acquired intangible assets is 4.5 years. The expected annual amortization expense related to acquired +intangible assets as of September 28, 2013, is as follows (in millions): 2014 $ 1,050 2015 985 2016 833 2017 606 2018 434 Thereafter 171 Total $ 4,079 63 Table of Contents Note 5 – Income Taxes The provision for income taxes for 2013, 2012 and 2011, consisted of the following (in millions): 2013 2012 2011 Federal: Current $ 9,334 $ 7,240 $ 3,884 Deferred 1,878 5,018 2,998 11,212 12,258 6,882 State: Current 1,084 1,182 762 Deferred (311 ) (123 ) 37 773 1,059 799 Foreign: Current 1,559 1,203 769 Deferred (426 ) (490 ) (167 ) 1,133 713 602 Provision for income taxes $ 13,118 $ 14,030 $ 8,283 The foreign provision for income taxes is based on foreign pre-tax earnings of $30.5 billion, $36.8 +billion and $24.0 billion in 2013, 2012 and 2011, respectively. The Company’s consolidated financial statements provide for any related tax liability on undistributed earnings that the Company does not intend to be indefinitely reinvested +outside the U.S. Substantially all of the Company’s undistributed international earnings intended to be indefinitely reinvested in operations outside the U.S. were generated by subsidiaries organized in Ireland, which has a statutory tax rate +of 12.5%. As of September 28, 2013, U.S. income taxes have not been provided on a cumulative total of $54.4 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be +approximately $18.4 billion. As of September 28, 2013 and September 29, 2012, $111.3 billion and $82.6 billion, +respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign +subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. A reconciliation of the provision for +income taxes, with the amount computed by applying the statutory federal income tax rate (35% in 2013, 2012 and 2011) to income before provision for income taxes for 2013, 2012 and 2011, is as follows (in millions): 2013 2012 2011 Computed expected tax $ 17,554 $ 19,517 $ 11,973 State taxes, net of federal effect 508 677 552 Indefinitely invested earnings of foreign subsidiaries (4,614 ) (5,895 ) (3,898 ) Research and development credit, net (287 ) (103 ) (167 ) Domestic production activities deduction (308 ) (328 ) (168 ) Other 265 162 (9 ) Provision for income taxes $ 13,118 $ 14,030 $ 8,283 Effective tax rate 26.2% 25.2% 24.2% The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan +awards. For stock options, the Company receives an income tax benefit calculated as the tax effect of the difference 64 Table of Contents between the fair market value of the stock issued at the time of the exercise and the exercise price. For RSUs, the Company receives an income tax benefit upon the award’s vesting equal +to the tax effect of the underlying stock’s fair market value. The Company had net excess tax benefits from equity awards of $643 million, $1.4 billion and $1.1 billion in 2013, 2012 and 2011, respectively, which were reflected as increases to +common stock. As of September 28, 2013 and September 29, 2012, the significant components of the Company’s +deferred tax assets and liabilities were (in millions): 2013 2012 Deferred tax assets: Accrued liabilities and other reserves $ 1,892 $ 1,346 Deferred revenue 1,475 1,145 Basis of capital assets and investments 1,020 451 Share-based compensation 458 411 Other 1,029 947 Total deferred tax assets 5,874 4,300 Less valuation allowance 0 0 Deferred tax assets, net of valuation allowance 5,874 4,300 Deferred tax liabilities: Unremitted earnings of foreign subsidiaries 18,044 14,712 Other 112 456 Total deferred tax liabilities 18,156 15,168 Net deferred tax liabilities $ (12,282 ) $ (10,868 ) Deferred tax assets and liabilities reflect the effects of tax losses, credits, and the future income tax +effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in +which those temporary differences are expected to be recovered or settled. Uncertain Tax Positions Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position +will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest +amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one +year as non-current liabilities in the Consolidated Balance Sheets. As of September 28, 2013, the total amount of gross +unrecognized tax benefits was $2.7 billion, of which $1.4 billion, if recognized, would affect the Company’s effective tax rate. As of September 29, 2012, the total amount of gross unrecognized tax benefits was $2.1 billion, of which $889 +million, if recognized, would affect the Company’s effective tax rate. 65 Table of Contents The aggregate changes in the balance of gross unrecognized tax benefits, which excludes +interest and penalties, for 2013, 2012 and 2011, is as follows (in millions): 2013 2012 2011 Beginning Balance $ 2,062 $ 1,375 $ 943 Increases related to tax positions taken during a prior year 745 340 49 Decreases related to tax positions taken during a prior year (118 ) (107 ) (39 ) Increases related to tax positions taken during the current year 626 467 425 Decreases related to settlements with taxing authorities (592 ) (3 ) 0 Decreases related to expiration of statute of limitations (9 ) (10 ) (3 ) Ending Balance $ 2,714 $ 2,062 $ 1,375 The Company includes interest and penalties related to unrecognized tax benefits within the provision for +income taxes. As of September 28, 2013 and September 29, 2012, the total amount of gross interest and penalties accrued was $590 million and $401 million, respectively, which is classified as non-current liabilities in the Consolidated +Balance Sheets. In connection with tax matters, the Company recognized interest and penalty expense in 2013, 2012 and 2011 of $189 million, $140 million and $14 million, respectively. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign +jurisdictions. For U.S. federal income tax purposes, all years prior to 2004 are closed. The Internal Revenue Service (the “IRS”) has completed its field audit of the Company’s federal income tax returns for the years 2004 through +2006 and proposed certain adjustments. The Company has contested certain of these adjustments through the IRS Appeals Office. The IRS is currently examining the years 2007 through 2012. In addition, the Company is also subject to audits by state, +local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 1989 and 2002, respectively, generally remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the +outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for +income tax in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that tax audit resolutions could reduce its unrecognized tax benefits by +between $125 million and $225 million in the next 12 months. Note 6 – Long-Term Debt In May 2013, the Company issued floating- and fixed-rate notes with varying maturities for an aggregate principal +amount of $17.0 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and interest is payable in arrears, quarterly for the floating-rate notes and semi-annually for the fixed-rate notes. The principal amounts and associated interest rates of the Notes as of September 28, 2013, are as follows: Amount (in  +millions) Effective Rate Floating-rate notes, due 2016 $ 1,000 0.51 % Floating-rate notes, due 2018 2,000 1.10 % Fixed-rate 0.45% notes due 2016 1,500 0.51 % Fixed-rate 1.00% notes due 2018 4,000 1.08 % Fixed-rate 2.40% notes due 2023 5,500 2.44 % Fixed-rate 3.85% notes due 2043 3,000 3.91 % Total $ 17,000 66 Table of Contents The floating-rate notes due 2016 and 2018 bear interest at the three-month London InterBank +Offered Rate (“LIBOR”) plus 0.05% and 0.25%, respectively. To manage the risk of fluctuations in interest rates associated with the floating-rate notes, the Company entered into interest rate swaps with an aggregate notional amount of $3.0 +billion designated as cash flow hedges of its floating-rate notes. These hedges effectively convert the floating interest rate on the floating-rate notes to a fixed interest rate. The gains and losses related to changes in the fair value of the +interest rate swaps are recorded in OCI with a portion reclassified to interest expense each period to offset changes in interest rates on the floating-rate notes. The effective rates for the Notes include the interest on the Notes, amortization of +the discount and, if applicable, adjustments related to hedging. The Company recognized $136 million of interest expense for the year ended September 28, 2013. As of September 28, 2013, the aggregate unamortized discount for the +Company’s Notes was $40 million. Future principal payments for the Company’s Notes as of September 28, 2013, +are as follows (in millions): 2014 $ 0 2015 0 2016 2,500 2017 0 2018 6,000 Thereafter 8,500 Total $ 17,000 As of September 28, 2013, the fair value of the Company’s Notes, based on Level 2 inputs, was +$15.9 billion. Note 7 – Shareholders’ Equity Preferred Stock The Company has five million shares of authorized preferred stock, none of which is issued or outstanding. Under the terms of the Company’s Restated Articles of Incorporation, the Board of Directors +is authorized to determine or alter the rights, preferences, privileges and restrictions of the Company’s authorized but unissued shares of preferred stock. Dividend and Stock Repurchase Program The Company declared and paid cash +dividends per common share during the periods presented as follows: 2013 Dividends Per Share Amount (in  +millions) First quarter $ 2.65 $ 2,486 Second quarter $ 2.65 2,490 Third quarter $ 3.05 2,789 Fourth quarter $ 3.05 2,763 $ 10,528 The Company paid cash dividends of $2.65 per share, totaling $2.5 billion, during the fourth quarter of +2012. Future dividends are subject to declaration by the Board of Directors. In 2012, the Company’s Board of Directors +authorized a program to repurchase up to $10 billion of the Company’s common stock beginning in 2013. In April 2013, the Company’s Board of Directors increased the share repurchase program authorization from $10 billion to $60 billion, of +which $23.0 billion had been utilized 67 Table of Contents as of September 28, 2013. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately +negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). In August 2012, the Company entered into an accelerated share repurchase arrangement (“ASR”) with a financial institution to purchase up to $1.95 billion of the Company’s common stock in +2013. In the first quarter of 2013, 2.6 million shares were initially delivered to the Company. In April 2013, the purchase period for the ASR ended and an additional 1.5 million shares were delivered to the Company. In total, +4.1 million shares were delivered under the ASR at an average repurchase price of $478.20 per share. The shares were retired in the quarters they were delivered, and the up-front payment of $1.95 billion was accounted for as a reduction to +shareholders’ equity in the Company’s Consolidated Balance Sheet in the first quarter of 2013. In April 2013, the +Company entered into a new ASR program with two financial institutions to purchase up to $12 billion of the Company’s common stock. In exchange for up-front payments totaling $12 billion, the financial institutions committed to deliver shares +during the ASR’s purchase periods, which will end during 2014. The total number of shares ultimately delivered, and therefore the average price paid per share, will be determined at the end of the applicable purchase period based on the volume +weighted average price of the Company’s stock during that period. During the third quarter of 2013, 23.5 million shares were initially delivered to the Company and retired. This does not represent the final number of shares to be delivered +under the ASR. The up-front payments of $12 billion were accounted for as a reduction to shareholders’ equity in the Company’s Consolidated Balance Sheet. The Company reflected the ASRs as a repurchase of common stock for purposes of calculating earnings per share and as forward contracts indexed to its own common stock. The forward contracts met all of the +applicable criteria for equity classification, and, therefore, were not accounted for as derivative instruments. During 2013, +the Company repurchased 19.4 million shares of its common stock in the open market at an average price of $464.11 per share for a total of $9.0 billion. These shares were retired upon repurchase. Note 8 – Comprehensive Income Comprehensive income consists of two components, net income and other comprehensive income. Other comprehensive income +refers to revenue, expenses, and gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s other comprehensive income consists of foreign currency translation +adjustments from those subsidiaries not using the U.S. dollar as their functional currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges, and unrealized gains and losses on marketable securities +classified as available-for-sale. The following table shows the components of AOCI, net of taxes, as of September 28, +2013 and September 29, 2012 (in millions): 2013 2012 Cumulative foreign currency translation $ (105 ) $ 8 Net unrecognized gains/losses on derivative instruments (175 ) (240 ) Net unrealized gains/losses on marketable securities (191 ) 731 Accumulated other comprehensive income/(loss) $ (471 ) $ 499 68 Table of Contents Note 9 – Benefit Plans Stock Plans 2003 Employee Stock Plan The 2003 Employee Stock Plan (the “2003 +Plan”) is a shareholder approved plan that provides for broad-based equity grants to employees, including executive officers. The 2003 Plan permits the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation +rights, stock purchase rights and performance-based awards. Options granted under the 2003 Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years, based on continued employment, +with either annual, semi-annual or quarterly vesting. RSUs granted under the 2003 Plan generally vest over two to four years, based on continued employment and are settled upon vesting in shares of the Company’s common stock on a one-for-one +basis. Each share issued with respect to an award granted under the 2003 Plan (other than a stock option or stock appreciation right) reduces the number of shares available for grant under the plan by two shares, whereas shares issued in respect of +an option or stock appreciation right count against the number of shares available for grant on a one-for-one basis. All RSUs, other than RSUs held by the Chief Executive Officer, granted under the 2003 Plan have dividend equivalent rights +(“DER”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DER are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DER are accumulated and paid +when the underlying shares vest. As of September 28, 2013, approximately 28.3 million shares were reserved for future issuance under the 2003 Plan. 1997 Director Stock Plan The 1997 Director Stock Plan (the “Director +Plan”) is a shareholder approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director +joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the relative mixture of stock options and RSUs for the initial and +annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants without shareholder approval. Each share issued with respect to RSUs granted under the Director Plan reduces the +number of shares available for grant under the plan by two shares. The Director Plan expires November 9, 2019. All RSUs granted under the Director Plan are entitled to DER. As of September 28, 2013, approximately 176,000 shares were +reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the fourth quarter of 2013, executive officers Timothy D. Cook, Peter Oppenheimer, D. Bruce Sewell, Philip W. Schiller, Daniel +Riccio and Jeffrey E. Williams and director William V. Campbell had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and +dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired pursuant to the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder approved plan under which substantially all employees may purchase the Company’s common stock through payroll +deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10% of the +employee’s compensation and employees may not purchase more than $25,000 of stock during any calendar year. As of September 28, 2013, approximately 1.8 million shares were reserved for future issuance under the Purchase Plan. 69 Table of Contents 401(k) Plan The Company’s 401(k) Plan (the “401(k) Plan”) is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees +may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ($17,500 for calendar year 2013). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the +employee’s eligible earnings. The Company’s matching contributions to the 401(k) Plan were $135 million, $114 million and $90 million in 2013, 2012 and 2011, respectively. Restricted Stock Units A summary of the Company’s RSU activity and +related information for 2013, 2012 and 2011, is as follows: Number +of RSUs (in thousands) Weighted- Average Grant Date +Fair Value Aggregate Intrinsic Value (in millions) Balance at September 25, 2010 13,034 $ 165.63 RSUs granted 6,667 $ 312.63 RSUs vested (4,513 ) $ 168.08 RSUs cancelled (742 ) $ 189.08 Balance at September 24, 2011 14,446 $ 231.49 RSUs granted 7,799 $ 431.35 RSUs vested (6,305 ) $ 205.27 RSUs cancelled (935 ) $ 256.01 Balance at September 29, 2012 15,005 $ 344.87 RSUs granted 5,631 $ 547.62 RSUs vested (6,042 ) $ 321.73 RSUs cancelled (1,268 ) $ 401.17 Balance at September 28, 2013 13,326 $ 435.70 $ 6,433 The fair value as of the respective vesting dates of RSUs was $3.1 billion, $3.3 billion and $1.5 billion +for 2013, 2012 and 2011, respectively. The majority of RSUs that vested in 2013, 2012 and 2011 were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable +income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 2.2 million, 2.3 million and 1.6 million for 2013, 2012 and 2011, respectively, and were +based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $1.1 billion, $1.2 billion and $520 million +in 2013, 2012 and 2011, respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced and retired the +number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. 70 Table of Contents Stock Options A summary of the Company’s stock option activity and related information for 2013, 2012 and 2011, is as follows: Outstanding Options Number of Options (in thousands) Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value (in millions) Balance at September 25, 2010 21,725 $ 90.46 Options granted 1 $ 342.62 Options cancelled (163 ) $ 128.42 Options exercised (9,697 ) $ 67.63 Balance at September 24, 2011 11,866 $ 108.64 Options assumed 41 $ 30.86 Options cancelled (25 ) $ 103.22 Options exercised (5,337 ) $ 84.85 Balance at September 29, 2012 6,545 $ 127.56 Options granted 8 $ 30.36 Options assumed 29 $ 210.08 Options cancelled (8 ) $ 108.87 Options exercised (2,480 ) $ 108.33 Balance at September 28, 2013 4,094 $ 139.65 1.1 $ 1,405 Exercisable at September 28, 2013 4,072 $ 140.07 1.0 $ 1,396 Expected to vest after September 28, 2013 22 $ 61.93 7.8 $ 9 Aggregate intrinsic value represents the value of the Company’s closing stock price on the last +trading day of the period in excess of the weighted-average exercise price multiplied by the number of options outstanding or exercisable. Total intrinsic value of options at time of exercise was $1.0 billion, $2.3 billion and $2.6 billion for 2013, +2012 and 2011, respectively. Share-based Compensation The Company granted 8,000 and 1,370 stock options during 2013 and 2011, respectively. The weighted-average grant date fair value per share of stock options granted during 2013 and 2011 was $294.84 and +$181.13, respectively. The Company did not grant any stock options during 2012. During 2013 and 2012, in conjunction with +certain business combinations, the Company assumed 29,000 and 41,000 stock options, respectively, which had a weighted-average fair value per share of $407.80 and $405.39, respectively. The Company did not assume any stock options during 2011. The weighted-average fair value of stock purchase rights per share was $115.19, +$108.44 and $71.47 during 2013, 2012 and 2011, respectively. 71 Table of Contents The following table shows a summary of the share-based compensation expense included in the +Consolidated Statements of Operations for 2013, 2012 and 2011 (in millions): 2013 2012 2011 Cost of sales $ 350 $ 265 $ 200 Research and development 917 668 450 Selling, general and administrative 986 807 518 Total share-based compensation expense $ 2,253 $ 1,740 $ 1,168 The income tax benefit related to share-based compensation expense was $816 million, $567 million and +$467 million for 2013, 2012 and 2011, respectively. As of September 28, 2013, the total unrecognized compensation cost related to outstanding stock options and RSUs was $4.7 billion, which the Company expects to recognize over a +weighted-average period of 3.0 years. Note 10 – Commitments and Contingencies Accrued Warranty and Indemnification The Company offers a basic limited parts and labor warranty on its hardware products. The basic warranty period for hardware products is typically one year from the date of purchase by the end-user. The +Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. The Company provides currently for the estimated cost that may be incurred under its basic +limited product warranties at the time related revenue is recognized. Factors considered in determining appropriate accruals for product warranty obligations include the size of the installed base of products subject to warranty protection, +historical and projected warranty claim rates, historical and projected cost-per-claim, and knowledge of specific product failures that are outside of the Company’s typical experience. The Company assesses the adequacy of its pre-existing +warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. The +following table shows changes in the Company’s accrued warranties and related costs for 2013, 2012 and 2011 (in millions): 2013 2012 2011 Beginning accrued warranty and related costs $ 1,638 $ 1,240 $ 761 Cost of warranty claims (3,703 ) (1,786 ) (1,147 ) Accruals for product warranty 5,032 2,184 1,626 Ending accrued warranty and related costs $ 2,967 $ 1,638 $ 1,240 The Company generally does not indemnify end-users of its operating system and application software +against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in +the event of an infringement claim against the Company or an indemnified third-party. However, the Company has not been required to make any significant payments resulting from such an infringement claim asserted against it or an indemnified +third-party and, in the opinion of management, does not have a potential liability related to unresolved infringement claims subject to indemnification that would materially adversely affect its financial condition or operating results. Therefore, +the Company did not record a liability for infringement costs related to indemnification as of either September 28, 2013 or September 29, 2012. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent +permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such 72 Table of Contents individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due +to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations, and +payments made under these agreements historically have not been material. Concentrations in the Available Sources of Supply of Materials +and Product Although most components essential to the Company’s business are generally available from multiple +sources, a number of components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. +Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that can materially adversely affect the Company’s +financial condition and operating results. The Company uses some custom components that are not commonly used by its +competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have +matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the +Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient +quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the +production of common components instead of components customized to meet the Company’s requirements. The Company has +entered into various agreements for the supply of components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant +risks of supply shortages and price increases that can materially adversely affect its financial condition and operating results. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently +performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works +closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments +typically cover its requirements for periods up to 150 days. Other Off-Balance Sheet Commitments Lease Commitments The +Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. The major facility leases are +typically for terms not exceeding 10 years and generally provide renewal options for terms not exceeding five additional years. Leases for retail space are for terms ranging from five to 20 years, the majority of which are for 10 years, and often +contain multi-year renewal options. As of September 28, 2013, the Company’s total future minimum lease payments under noncancelable operating leases were $4.7 billion, of which $3.5 billion related to leases for retail space. 73 Table of Contents Rent expense under all operating leases, including both cancelable and noncancelable leases, +was $645 million, $488 million and $338 million in 2013, 2012 and 2011, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 28, 2013, are as follows (in +millions): 2014 $ 610 2015 613 2016 587 2017 551 2018 505 Thereafter 1,855 Total minimum lease payments $ 4,721 Other Commitments As of September 28, 2013, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $18.6 billion. In addition to the off-balance sheet commitments mentioned above, the Company had outstanding obligations of $1.3 billion as of +September 28, 2013, which consisted mainly of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to advertising, research and development, Internet and +telecommunications services and other obligations. Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been +fully adjudicated. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies. However, the +outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in +excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. v. Samsung Electronics Co., Ltd, et al. On August 24, +2012, a jury returned a verdict awarding the Company $1.05 billion in its lawsuit against Samsung Electronics Co., Ltd and affiliated parties in the United States District Court, Northern District of California, San Jose Division. On March 1, +2013, the District Court upheld $599 million of the jury’s award and ordered a new trial as to the remainder. Because the award is subject to entry of final judgment, partial re-trial and appeal, the Company has not recognized the award in +its results of operations. VirnetX, Inc. v. Apple Inc. et al. On August 11, 2010, VirnetX, Inc. filed an action against the Company alleging that certain of its products infringed on four patents +relating to network communications technology. On November 6, 2012, a jury returned a verdict against the Company, and awarded damages of $368 million. The Company is challenging the verdict, believes it has valid defenses and has not recorded +a loss accrual at this time. 74 Table of Contents Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach +designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable segments. The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Greater China, Japan, Rest of Asia Pacific and Retail +operations. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia +Pacific segment includes Australia and Asian countries, other than those countries included in the Company’s other operating segments. The Retail segment operates Apple retail stores in 13 countries, including the U.S. The results of the +Company’s geographic segments do not include results of the Retail segment. Each operating segment provides similar hardware and software products and similar services. The accounting policies of the various segments are the same as those +described in Note 1, “Summary of Significant Accounting Policies.” The Company evaluates the performance of its +operating segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers, while Retail segment net sales are based on sales through the Company’s retail stores. Operating +income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are +incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the operating segments. Costs excluded from segment operating income include various corporate expenses such as research and +development, corporate marketing expenses, share-based compensation expense, income taxes, various nonrecurring charges, and other separately managed general and administrative costs and certain manufacturing period expenses. The Company does not +include intercompany transfers between segments for management reporting purposes. Segment assets include receivables and +inventories, and for the Retail segment also includes capital assets. Segment assets exclude corporate assets, such as cash and cash equivalents, short-term and long-term marketable securities, vendor non-trade receivables, other long-term +investments, manufacturing and corporate facilities, product tooling and manufacturing process equipment, miscellaneous corporate infrastructure, goodwill and other acquired intangible assets. Except for the Retail segment, capital asset purchases +for long-lived assets are not reported to management by segment and therefore are excluded from the geographic segment assets and instead included in corporate assets. Cash payments for capital asset purchases by the Retail segment were $495 +million, $858 million and $612 million for 2013, 2012 and 2011, respectively. The Company’s total depreciation and amortization was $6.8 billion, $3.3 billion and $1.8 billion in 2013, 2012 and 2011, respectively, of which $382 million, $319 +million and $273 million was related to the Retail segment in the respective years. Depreciation and amortization on segment assets included in the geographic segments was not significant. 75 Table of Contents The following table shows information by operating segment for 2013, 2012 and 2011 (in +millions): 2013 2012 2011 Americas: Net sales $ 62,739 $ 57,512 $ 38,315 Operating income $ 22,817 $ 23,414 $ 13,111 Europe: Net sales $ 37,883 $ 36,323 $ 27,778 Operating income $ 13,025 $ 14,869 $ 11,209 Greater China: Net sales $ 25,417 $ 22,533 $ 12,690 Operating income $ 8,541 $ 9,843 $ 5,246 Japan: Net sales $ 13,462 $ 10,571 $ 5,437 Operating income $ 6,819 $ 5,861 $ 2,415 Rest of Asia Pacific: Net sales $ 11,181 $ 10,741 $ 9,902 Operating income $ 3,753 $ 4,253 $ 4,004 Retail: Net sales $ 20,228 $ 18,828 $ 14,127 Operating income $ 4,025 $ 4,613 $ 3,075 A reconciliation of the Company’s segment operating income to the consolidated financial statements +for 2013, 2012 and 2011, is as follows (in millions): 2013 2012 2011 Segment operating income $ 58,980 $ 62,853 $ 39,060 Other corporate expenses, net (7,728 ) (5,872 ) (4,102 ) Share-based compensation expense (2,253 ) (1,740 ) (1,168 ) Total operating income $ 48,999 $ 55,241 $ 33,790 The following table shows total assets by segment and a reconciliation to the consolidated financial +statements as of September 28, 2013 and September 29, 2012 (in millions): 2013 2012 Segment assets: Americas $ 5,653 $ 5,525 Europe 3,134 3,095 Greater China 2,943 1,321 Japan 2,932 1,698 Rest of Asia-Pacific 923 913 Retail 3,329 2,725 Total segment assets 18,914 15,277 Corporate assets 188,086 160,787 Total assets $ 207,000 $ 176,064 76 Table of Contents The U.S. and China were the only countries that accounted for more than 10% of the +Company’s net sales in 2013, 2012 and 2011. There was no single customer that accounted for more than 10% of net sales in 2013, 2012 or 2011. Net sales for 2013, 2012 and 2011 and long-lived assets as of September 28, 2013 and +September 29, 2012 are as follows (in millions): 2013 2012 2011 Net sales: U.S. $ 66,197 $ 60,949 $ 41,812 China (a) 25,946 22,797 12,472 Other countries 78,767 72,762 53,965 Total net sales $ 170,910 $ 156,508 $ 108,249 2013 2012 Long-lived assets: U.S. $ 7,399 $ 6,012 China (a) 7,403 7,314 Other countries 2,786 2,560 Total long-lived assets $ 17,588 $ 15,886 (a) China includes Hong Kong. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets +related to retail stores and related infrastructure. Information regarding net sales by product for 2013, +2012 and 2011, is as follows (in millions): 2013 2012 2011 Net Sales by Product: iPhone (a) $ 91,279 $ 78,692 $ 45,998 iPad (a) 31,980 30,945 19,168 Mac (a) 21,483 23,221 21,783 iPod (a) 4,411 5,615 7,453 iTunes, Software and Services (b) 16,051 12,890 9,373 Accessories (c) 5,706 5,145 4,474 Total net sales $ 170,910 $ 156,508 $ 108,249 (a) Includes deferrals and amortization of related non-software services and software upgrade rights. (b) Includes revenue from sales on the iTunes Store, the App Store, the Mac App Store, and the iBooks Store, and revenue from sales of AppleCare, +licensing and other services. (c) Includes sales of hardware peripherals and Apple-branded and third-party accessories for iPhone, iPad, Mac and iPod. 77 Table of Contents Note 12 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters +of 2013 and 2012 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2013 Net sales $ 37,472 $ 35,323 $ 43,603 $ 54,512 Gross margin $ 13,871 $ 13,024 $ 16,349 $ 21,060 Net income $ 7,512 $ 6,900 $ 9,547 $ 13,078 Earnings per share (a): Basic $ 8.31 $ 7.51 $ 10.16 $ 13.93 Diluted $ 8.26 $ 7.47 $ 10.09 $ 13.81 Fourth Quarter Third Quarter Second Quarter First Quarter 2012 Net sales $ 35,966 $ 35,023 $ 39,186 $ 46,333 Gross margin $ 14,401 $ 14,994 $ 18,564 $ 20,703 Net income $ 8,223 $ 8,824 $ 11,622 $ 13,064 Earnings per share (a): Basic $ 8.76 $ 9.42 $ 12.45 $ 14.03 Diluted $ 8.67 $ 9.32 $ 12.30 $ 13.87 (a) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and +diluted per share information may not equal annual basic and diluted earnings per share. 78 Table of Contents REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED +PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 28, 2013 and September 29, 2012, and +the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 28, 2013. These financial statements are the responsibility of the +Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We +conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements +are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates +made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Inc. at September 28, 2013 and September 29, +2012, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 28, 2013, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple +Inc.’s internal control over financial reporting as of September 28, 2013, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission +(1992 framework) and our report dated October 29, 2013 expressed an unqualified opinion thereon. /s/ +Ernst & Young LLP San Jose, California October 29, 2013 79 Table of Contents REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 28, 2013, based on criteria established in Internal Control – Integrated Framework issued by +the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework) (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its +assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s +internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the +Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material +respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the +assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial +statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, +in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in +accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance +regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections +of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of +September 28, 2013, based on the COSO criteria. We also have audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), the 2013 consolidated financial statements of Apple Inc. and our report dated October 29, 2013 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 29, 2013 80 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of +Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the +Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities +Exchange Act of 1934, as amended (“Exchange Act”) were effective as of September 28, 2013 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange +Act is (i) recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its +principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for +external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the +Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and +that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets +that could have a material effect on the financial statements. Management, including the Company’s +Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, +not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. +Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of +controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as +defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (1992 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of +September 28, 2013 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, +Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. 81 Table of Contents Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2013, which were +identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to +materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information Not +applicable. 82 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Directors, Executive Officers and Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting +Compliance” in the Company’s 2014 Proxy Statement to be filed with the U.S. Securities and Exchange Commission (“SEC”) within 120 days after September 28, 2013 in connection with the solicitation of proxies for the +Company’s 2014 annual meeting of shareholders and is incorporated herein by reference. Item 11. Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation” and under the subheadings +“Board Oversight of Risk Management,” “Compensation of Directors,” “Director Compensation-2013” and “Compensation Committee Interlocks and Insider Participation” under the heading “Directors, Executive +Officers and Corporate Governance” in the Company’s 2014 Proxy Statement to be filed with the SEC within 120 days after September 28, 2013 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Security Ownership of Certain Beneficial Owners and +Management” and “Equity Compensation Plan Information” in the Company’s 2014 Proxy Statement to be filed with the SEC within 120 days after September 28, 2013 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the heading “Review, Approval or Ratification of Transactions with Related Persons” and under the subheading “Board Committees” +under the heading “Directors, Executive Officers and Corporate Governance” in the Company’s 2014 Proxy Statement to be filed with the SEC within 120 days after September 28, 2013 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the +Independent Registered Public Accounting Firm” under the proposal “Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2014 Proxy Statement to be filed with the SEC within 120 days after +September 28, 2013 and is incorporated herein by reference. 83 Table of Contents PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 28, 2013, September  +29, 2012 and September 24, 2011 45 Consolidated Statements of Comprehensive Income for the years ended September  +28, 2013, September 29, 2012, and September 24, 2011 46 Consolidated Balance Sheets as of September 28, 2013 and September 29, 2012 47 Consolidated Statements of Shareholders’ Equity for the years ended September 28, 2013,  +September 29, 2012 and September 24, 2011 48 Consolidated Statements of Cash Flows for the years ended September 28, 2013, September  +29, 2012 and September 24, 2011 49 Notes to Consolidated Financial Statements 50 Selected Quarterly Financial Information (Unaudited) 78 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 79 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the +information required is included in the consolidated financial statements and notes thereto included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K The information required by this Section (a)(3) of Item 15 is set forth on the exhibit index that follows the Signatures page of this +Form 10-K. 84 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto +duly authorized. APPLE INC. Date: October 29, 2013 By: /s/  Peter +Oppenheimer Peter Oppenheimer Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Peter Oppenheimer, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates +indicated: Name Title Date /s/    Timothy D. +Cook TIMOTHY D. COOK Chief Executive Officer and Director (Principal Executive Officer) October 29, 2013 /s/    Peter +Oppenheimer PETER OPPENHEIMER Senior Vice President, Chief Financial Officer (Principal Financial Officer) October 29, 2013 /s/    Luca +Maestri LUCA MAESTRI Vice President and Corporate Controller (Principal Accounting Officer) October 29, 2013 /s/    William V. +Campbell WILLIAM V. CAMPBELL Director October 29, 2013 /s/    Millard S. +Drexler MILLARD S. DREXLER Director October 29, 2013 /s/    Al +Gore AL GORE Director October 29, 2013 /s/    Robert A. +Iger ROBERT A. IGER Director October 29, 2013 /s/    Andrea +Jung ANDREA JUNG Director October 29, 2013 85 Table of Contents Name Title Date /s/    Arthur D. +Levinson ARTHUR D. LEVINSON Director October 29, 2013 /s/    Ronald D. +Sugar RONALD D. SUGAR Director October 29, 2013 86 Table of Contents EXHIBIT INDEX Exhibit Number Exhibit Description Incorporated +by Reference Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation, filed with the Secretary of State of the State of California on July 10, 2009. 10-Q 3.1 6/27/09 3.2 Amended Bylaws of the Registrant, as of April 20, 2011. 10-Q 3.2 3/26/11 4.1 Form of Common Stock Certificate of the Registrant. 10-Q 4.1 12/30/06 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, +0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 10.1* Amended Employee Stock Purchase Plan, effective as of March 8, 2010. 10-Q 10.1 3/27/10 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* 1997 Director Stock Plan, as amended through May 24, 2012. 10-Q 10.3 6/30/12 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement effective as of November 11, 2008. 10-Q 10.10 12/27/08 10.6* Form of Restricted Stock Unit Award Agreement effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.7* Form of Restricted Stock Unit Award Agreement effective as of April 6, 2012. 10-Q 10.8 3/31/12 10.8* Summary Description of Amendment, effective as of May 24, 2012, to certain Restricted Stock Unit Award Agreements outstanding as of April 5, 2012. 10-Q 10.8 6/30/12 12.1** Computation of Ratio of Earnings to Fixed Charges. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 87 Table of Contents Exhibit Number Exhibit Description Incorporated +by Reference Form Exhibit Filing Date/ Period End Date 101.INS** XBRL Instance Document. 101.SCH** XBRL Taxonomy Extension Schema Document. 101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document. 101.DEF** XBRL Taxonomy Extension Definition Linkbase Document. 101.LAB** XBRL Taxonomy Extension Label Linkbase Document. 101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. 88 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-15-356351/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-15-356351/full-submission.txt new file mode 100644 index 0000000..cafb3c8 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001193125-15-356351/full-submission.txt @@ -0,0 +1,1115 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 26, 2015 or ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE +SECURITIES EXCHANGE ACT OF 1934 For the transition period +from to Commission File +Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) (408) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant +to Section 12(b) of the Act: Common Stock, $0.00001 par value per share 1.000%  Notes due 2022 1.625%  +Notes due 2026 3.05%    Notes due 2029 3.60%    Notes due 2042 1.375%  Notes due 2024 2.000%  +Notes due 2027 The NASDAQ Stock Market LLC New York Stock Exchange LLC New York Stock +Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock +Exchange LLC New York Stock Exchange LLC (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the +Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the Registrant +(1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and +(2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File +required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent +filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or +information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, +a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x The aggregate market value of the voting and non-voting +stock held by non-affiliates of the Registrant, as of March 27, 2015, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $709,923,000,000. Solely for purposes of this disclosure, +shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not +necessarily a conclusive determination for any other purposes. 5,575,331,000 shares of common stock were issued and outstanding as of October 9, +2015. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2016 annual meeting of shareholders (the “2016 Proxy Statement”) +are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2016 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this +report relates. Table of Contents Apple Inc. Form 10-K For the Fiscal Year Ended +September 26, 2015 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 8 Item 1B. Unresolved Staff Comments 18 Item 2. Properties 18 Item 3. Legal Proceedings 18 Item 4. Mine Safety Disclosures 18 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity +Securities 19 Item 6. Selected Financial Data 22 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 23 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 36 Item 8. Financial Statements and Supplementary Data 38 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 71 Item 9A. Controls and Procedures 71 Item 9B. Other Information 71 Part III Item 10. Directors, Executive Officers and Corporate Governance 72 Item 11. Executive Compensation 72 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 72 Item 13. Certain Relationships and Related Transactions and Director Independence 72 Item 14. Principal Accounting Fees and Services 72 Part IV Item 15. Exhibits, Financial Statement Schedules 73 Table of Contents This Annual Report on Form 10-K (“Form 10-K”) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, +Item 7 of this Form 10-K under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Forward-looking statements provide current expectations of future events based on certain +assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” +“estimates,” “expects,” “intends,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the +Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed +in Part I, Item 1A of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. All information presented herein is based on the Company’s fiscal +calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the +“Company” and “Apple” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any +reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players, and sells a +variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple +Watch ® , Apple TV ® , a portfolio of consumer and professional software applications, iOS, OS X ® and watchOS™ operating systems, iCloud ® , Apple Pay ® and a variety of +accessory, service and support offerings. In September 2015, the Company announced a new Apple TV, tvOS™ operating system and Apple TV App Store ® , which are expected to be available by +the end of October 2015. The Company sells and delivers digital content and applications through the iTunes Store ® , App Store, Mac App Store, iBooks Store™ and Apple Music™ +(collectively “Internet Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added +resellers. In addition, the Company sells a variety of third-party Apple compatible products, including application software and various accessories through its online and retail stores. The Company sells to consumers, small and mid-sized businesses +and education, enterprise and government customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the +best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software and +services to provide its customers products and solutions with innovative design, superior ease-of-use and seamless integration. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of digital content +and applications through its Internet Services, which allows customers to discover and download digital content, iOS, Mac and Apple Watch applications, and books through either a Mac or Windows-based computer or through iPhone, iPad and iPod touch ® devices (“iOS devices”) and Apple Watch. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the +Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. +Therefore, the Company’s strategy also includes building and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales +support experience. The Company believes ongoing investment in research and development (“R&D”), marketing and advertising is critical to the development and sale of innovative products and technologies. Apple Inc. | 2015 Form 10-K | 1 Table of Contents Business Organization The Company manages its business primarily on a geographic basis. In 2015, the Company changed its reportable operating segments as management began +reporting business performance and making decisions primarily on a geographic basis, including the results of its retail stores in each respective geographic segment. Accordingly, the Company’s reportable operating segments consist of the +Americas, Europe, Greater China, Japan and Rest of Asia Pacific. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment +includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and those Asian countries not included in the Company’s other reportable operating segments. Although each reportable operating segment provides similar +hardware and software products and similar services, they are managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further +information regarding the Company’s reportable operating segments may be found in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, +Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Products iPhone iPhone is the Company’s line of +smartphones based on its iOS operating system. iPhone includes Siri ® , a voice activated intelligent assistant, and Apple Pay and Touch ID™ on qualifying devices. In September 2015, the +Company introduced iPhone 6s and 6s Plus, featuring 3D Touch, which senses force to access features and interact with content and apps. iPhone works with the iTunes Store, App Store and iBooks Store for purchasing, organizing and playing digital +content and apps. iPhone is compatible with both Mac and Windows personal computers and Apple’s iCloud services, which provide synchronization across users’ devices. iPad iPad is the Company’s line of multi-purpose tablets +based on its iOS operating system, which includes iPad Air ® and iPad mini™. iPad includes Siri and also includes Touch ID on qualifying devices. In September 2015, the Company announced +the new iPad Pro™, featuring a 12.9-inch Retina ® display, which is expected to be available in November 2015. iPad works with the iTunes Store, App Store and iBooks Store for purchasing, +organizing and playing digital content and apps. iPad is compatible with both Mac and Windows personal computers and Apple’s iCloud services. Mac Mac is the Company’s line of desktop and portable personal computers based on its OS X operating system. The Company’s desktop computers include +iMac ® , 21.5” iMac with Retina 4K Display, 27” iMac with Retina 5K Display, Mac Pro ® and Mac mini. The Company’s portable +computers include MacBook ® , MacBook Air ® , MacBook Pro ® and MacBook Pro with +Retina display. Operating System Software iOS iOS is the Company’s Multi-Touch™ operating system that serves as the foundation for iOS devices. Devices running iOS are compatible with both +Mac and Windows personal computers and Apple’s iCloud services. In September 2015, the Company released iOS 9, which provides more search abilities and improved Siri features. iOS 9 also introduced new multitasking features designed +specifically for iPad, including Slide Over and Split View, which allow users to work with two apps simultaneously, and Picture-in-Picture that allows users to watch a video while using another application. OS X OS X is the Company’s Mac operating system and is built on +an open-source UNIX-based foundation and provides an intuitive and integrated computer experience. Support for iCloud is built into OS X so users can access content and information from Mac, iOS devices and other supported devices and access +downloaded content and apps from the iTunes Store. OS X El Capitan, released in September 2015, is the 12 th major release of OS X and incorporates additional window management features, including +Split View and the new Spaces Bar in Mission Control ® , which provides users an intuitive way to group applications. Apple Inc. | 2015 Form 10-K | 2 Table of Contents watchOS watchOS is the +Company’s operating system for Apple Watch. Released in September 2015, watchOS 2 is the first major software update for Apple Watch, providing users with new features, including new watch faces, the ability to add third-party app information +on watch faces, Time Travel, and additional communication capabilities in Mail, Friends and Digital Touch. watchOS 2 also gives developers the ability to build native apps for Apple Watch. tvOS In September 2015, the Company announced tvOS, its operating +system for the new Apple TV, which is expected to be available at the end of October 2015. The tvOS operating system is based on the Company’s iOS platform and will enable developers to create new apps and games specifically for Apple TV and +deliver them to customers through the new Apple TV App Store. Application Software The Company’s application software includes iLife ® , iWork ® and various other software, including Final Cut Pro ® , Logic ® Pro X and +FileMaker ® Pro. iLife is the Company’s consumer-oriented digital lifestyle software application suite included with all Mac computers and features iMovie ® , a digital video editing application, and GarageBand ® , a music creation application that allows users to play, record and create music. +iWork is the Company’s integrated productivity suite included with all Mac computers and is designed to help users create, present and publish documents through Pages ® , presentations +through Keynote ® and spreadsheets through Numbers ® . The Company also has Multi-Touch versions of iLife and iWork applications designed +specifically for use on iOS devices, which are available as free downloads for all new iPhones and iPads. Services Internet Services The iTunes Store, available for iOS devices, Mac and +Windows personal computers and Apple TV, allows customers to purchase and download music and TV shows, rent or purchase movies and download free podcasts. The App Store, available for iOS devices, allows customers to discover and download apps and +purchase in-app content. The Mac App Store, available for Mac computers, allows customers to discover, download and install Mac applications. The iBooks Store, available for iOS devices and Mac computers, features e-books from major and independent +publishers. Apple Music offers users a curated listening experience with on-demand radio stations that evolve based on a user’s play or download activity and a subscription-based internet streaming service that also provides unlimited access to +the Apple Music library. In September 2015, the Company announced the Apple TV App Store, which provides customers access to apps and games specifically for the new Apple TV. iCloud iCloud is the Company’s cloud service which stores music, +photos, contacts, calendars, mail, documents and more, keeping them up-to-date and available across multiple iOS devices, Mac and Windows personal computers and Apple TV. iCloud services include iCloud Drive SM , iCloud Photo Library, Family Sharing, Find My iPhone, Find My Friends, Notes, iCloud Keychain ® and iCloud Backup for iOS devices. AppleCare AppleCare ® offers a range of support options for the Company’s customers. These +include assistance that is built into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, the AppleCare Protection Plan (“APP”) and the +AppleCare+ Protection Plan (“AC+”). APP is a fee-based service that typically extends the service coverage of phone support, hardware repairs and dedicated web-based support resources for Mac, Apple TV and display products. AC+ is a +fee-based service offering additional coverage under some circumstances for instances of accidental damage in addition to the services offered by APP and is available in certain countries for iPhone, iPad, Apple Watch and iPod. Apple Pay Apple Pay is the Company’s mobile payment service +available in the U.S. and U.K. that offers an easy, secure and private way to pay. Apple Pay allows users to pay for purchases in stores accepting contactless payments and to pay for purchases within participating apps on qualifying devices. Apple +Pay accepts credit and debit cards across major card networks and also supports reward programs and store-issued credit and debit cards. Apple Inc. | 2015 Form 10-K | 3 Table of Contents Other Products Accessories The Company sells a variety of Apple-branded and third-party Mac-compatible and iOS-compatible accessories, including Apple TV, Apple Watch, headphones, +displays, storage devices, Beats products, and various other connectivity and computing products and supplies. Apple TV Apple TV connects to consumers’ TVs and enables them to access digital content directly for streaming high definition video, playing music and games, +and viewing photos. Content from Apple Music and other media services are also available on Apple TV. Apple TV allows streaming digital content from Mac and Windows personal computers through Home Share and through AirPlay ® from compatible Mac and iOS devices. In September 2015, the Company announced the new Apple TV running on the Company’s tvOS operating system and based on apps built for the television. +Additionally, the new Apple TV remote features Siri, allowing users to search and access content with their voice. The new Apple TV is expected to be available at the end of October 2015. Apple Watch Apple Watch is a personal electronic device that combines +the watchOS user interface and technologies created specifically for a smaller device, including the Digital Crown, a unique navigation tool that allows users to seamlessly scroll, zoom and navigate, and Force Touch, a technology that senses the +difference between a tap and a press and allows users to access controls within apps. Apple Watch enables users to communicate in new ways from their wrist, track their health and fitness through activity and workout apps, and includes Siri and +Apple Pay. iPod iPod is the Company’s line of portable +digital music and media players, which includes iPod touch, iPod nano ® and iPod shuffle ® . All iPods work with iTunes to purchase and +synchronize content. iPod touch, based on the Company’s iOS operating system, is a flash-memory-based iPod that works with the iTunes Store, App Store and iBooks Store for purchasing and playing digital content and apps. Developer Programs The Company’s developer programs +support app developers with building, testing and distributing apps for iOS, Mac, Apple Watch and the new Apple TV. Developer program membership provides access to beta software, the ability to integrate advanced app capabilities (e.g., +iCloud, Game Center and Apple Pay), distribution on the App Store, access to App Analytics, and code-level technical support. Developer programs also exist for businesses creating apps for internal use (the Apple Developer Enterprise +Program) and developers creating accessories for Apple devices (the MFi Program). All developers, even those who are not developer program members, can sign in with their Apple ID to post on the Apple Developer Forums and use Xcode ® , the Company’s integrated development environment for creating apps for Apple platforms. Xcode includes project management tools; analysis tools to collect, display and compare app +performance data; simulation tools to locally run, test and debug apps; and tools to simplify the design and development of user interfaces. All developers also have access to extensive technical documentation and sample code. Markets and Distribution The Company’s customers are +primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers and small and mid-sized +businesses through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and value-added resellers. During +2015, the Company’s net sales through its direct and indirect distribution channels accounted for 26% and 74%, respectively, of total net sales. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the +hardware and software integration and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of its +products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company continues to build and improve its +distribution capabilities by expanding the number of its own retail stores worldwide. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own +stores and locating them in desirable high-traffic locations the Company is better positioned to ensure a high quality customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and +marketing of the Company’s products and related solutions. The retail stores employ experienced and knowledgeable personnel who provide product advice, service and training and offer a wide selection of third-party hardware, software and other +accessories that complement the Company’s products. Apple Inc. | 2015 Form 10-K | 4 Table of Contents The Company has also invested in programs to enhance reseller sales by placing high-quality Apple fixtures, +merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a high level of product expertise, +integration and support services. The Company is committed to delivering solutions to help educators teach and students learn. The Company believes +effective integration of technology into classroom instruction can result in higher levels of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also supports +mobile learning and real-time distribution of, and access to, education related materials through iTunes U, a platform that allows students and teachers to share and distribute educational media online. The Company sells its products to the +education market through its direct sales force, select third-party resellers and its online and retail stores. The Company also sells its hardware +and software products to enterprise and government customers in each of its reportable operating segments. The Company’s products are deployed in these markets because of their performance, productivity, ease of use and seamless integration +into information technology environments. The Company’s products are compatible with thousands of third-party business applications and services, and its tools enable the development and secure deployment of custom applications as well as +remote device administration. No single customer accounted for more than 10% of net sales in 2015, 2014 or 2013. Competition The markets for the Company’s products and +services are highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially +increased the capabilities and use of mobile communication and media devices, personal computers and other digital electronic devices. The Company’s competitors that sell mobile devices and personal computers based on other operating systems +have aggressively cut prices and lowered their product margins to gain or maintain market share. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross +margins. Principal competitive factors important to the Company include price, product features (including security features), relative price and performance, product quality and reliability, design innovation, a strong third-party software and +accessories ecosystem, marketing and distribution capability, service and support and corporate reputation. The Company is focused on expanding its +market opportunities related to personal computers and mobile communication and media devices. These markets are highly competitive and include many large, well-funded and experienced participants. The Company expects competition in these markets to +intensify significantly as competitors attempt to imitate some of the features of the Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than +those they currently offer. These markets are characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors and +price sensitivity on the part of consumers and businesses. The Company’s digital content services have faced significant competition from other +companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company’s future financial condition and operating results depend on the Company’s ability to continue to develop and offer new innovative +products and services in each of the markets in which it competes. The Company believes it offers superior innovation and integration of the entire solution including the hardware (iOS devices, Mac, Apple Watch and Apple TV), software (iOS, OS X, +watchOS and tvOS), online services and distribution of digital content and applications (Internet Services). Some of the Company’s current and potential competitors have substantial resources and may be able to provide such products and +services at little or no profit or even at a loss to compete with the Company’s offerings. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently +obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the +Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Company’s financial condition and operating +results. Apple Inc. | 2015 Form 10-K | 5 Table of Contents The Company uses some custom components that are not commonly used by its competitors, and the Company often +utilizes custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the +Company’s supply of components were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely +affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from +an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components customized to meet the Company’s +requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be +able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating +results. While some Mac computers are manufactured in the U.S. and Ireland, substantially all of the Company’s hardware products are currently +manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing +partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could +be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover its requirements for periods up to 150 days. Research and Development Because the industries in which the +Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the +marketplace. The Company continues to develop new technologies to enhance existing products and to expand the range of its product offerings through R&D, licensing of intellectual property and acquisition of third-party businesses and +technology. Total R&D expense was $8.1 billion, $6.0 billion and $4.5 billion in 2015, 2014 and 2013, respectively. Patents, Trademarks, Copyrights and +Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its hardware devices, accessories, software +and services. The Company has registered or has applied for trademarks and service marks in the U.S. and a number of foreign countries. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an +important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing +thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents around the world. The Company holds copyrights relating to certain aspects of its products and services. No +single patent or copyright is solely responsible for protecting the Company’s products. The Company believes the duration of its patents is adequate relative to the expected lives of its products. Many of the Company’s products are designed to include intellectual property obtained from third parties. It may be necessary in the future to seek +or renew licenses relating to various aspects of its products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be +obtained in the future on reasonable terms or at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage and the rapid rate of issuance of new patents, it is possible that certain +components of the Company’s products, processes and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or +other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data During 2015, the Company’s domestic and international net sales accounted for 35% and 65%, respectively, of total net +sales. Information regarding financial data by geographic segment is set forth in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Apple Inc. | 2015 Form 10-K | 6 Table of Contents While some Mac computers are manufactured in the U.S. and Ireland, substantially all of the Company’s +hardware products are currently manufactured by outsourcing partners that are located primarily in Asia. The supply and manufacture of a number of components is performed by sole-sourced outsourcing partners in the U.S., Asia and Europe. Margins on +sales of the Company’s products in foreign countries and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade +regulations, including tariffs and antidumping penalties. Information regarding concentration in the available sources of supply of materials and products is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies.” Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal +holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Product introductions can also impact the Company’s net sales to its indirect distribution channels as these +channels are filled with new product inventory following a product introduction, and often, channel inventory of a particular product declines as the next related major product launch approaches. Net sales can also be affected when consumers and +distributors anticipate a product introduction. However, neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, +future net sales or financial performance. Warranty The +Company offers a limited parts and labor warranty on most of its hardware products. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In certain jurisdictions, local law requires that manufacturers guarantee their products for a period prescribed +by statute, typically at least two years. In addition, where available, consumers may purchase APP or AC+, which extends service coverage on many of the Company’s hardware products. Backlog In the Company’s experience, the actual amount of +product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases immediately following new product introductions as customers anticipate shortages. Backlog is often +reduced once customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial performance. Employees As of September 26, 2015, the Company had +approximately 110,000 full-time equivalent employees. Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to +Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities and Exchange Commission (the “SEC”). The Company is subject to the informational requirements of the +Exchange Act and files or furnishes reports, proxy statements and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at investor.apple.com/sec.cfm when such reports are available on the SEC’s website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, +Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other +information regarding issuers that file electronically with the SEC at www.sec.gov . The contents of these websites are not incorporated into this filing. Further, the Company’s references to website URLs are intended to be inactive +textual references only. Apple Inc. | 2015 Form 10-K | 7 Table of Contents Item 1A. Risk Factors The following discussion of risk factors contains forward-looking statements. These +risk factors may be important to understanding other statements in this Form 10-K. The following information should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results +of Operations” and the consolidated financial statements and related notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, +including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial +condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price. Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial +performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Global and regional economic conditions could materially adversely affect the Company. The Company’s operations and performance depend significantly on global and regional economic conditions. Uncertainty about global and regional +economic conditions poses a risk as consumers and businesses may postpone spending in response to tighter credit, higher unemployment, financial market volatility, government austerity programs, negative financial news, declines in income or +asset values and/or other factors. These worldwide and regional economic conditions could have a material adverse effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations +as a result of currency fluctuations because the Company generally raises prices on goods and services sold outside the U.S. to correspond with the effect of a strengthening of the U.S. dollar. Other factors that could influence worldwide or +regional demand include changes in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare costs, access to credit, consumer confidence and other macroeconomic factors affecting consumer +spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services. In the +event of financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be tightening in the +credit markets, low liquidity and extreme volatility in fixed income, credit, currency and equity markets. This could have a number of effects on the Company’s business, including the insolvency or financial instability of +outsourcing partners or suppliers or their inability to obtain credit to finance development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases +of the Company’s products; failure of derivative counterparties and other financial institutions; and restrictions on the Company’s ability to issue new debt. Other income and expense also could vary materially from expectations +depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting from revaluations of debt and equity securities and other investments; changes in interest rates; increases or +decreases in cash balances; volatility in foreign exchange rates; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk of the actual +amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the +Company may be unable to compete effectively in these markets. The Company’s products and services compete in highly competitive global +markets characterized by aggressive price cutting and resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance +characteristics, rapid adoption of technological and product advancements by competitors and price sensitivity on the part of consumers. The +Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it +designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. The Company +currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through +aggressive pricing and very low cost structures, and emulating the Company’s products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with +attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. Apple Inc. | 2015 Form 10-K | 8 Table of Contents The Company markets certain mobile communication and media devices based on the iOS mobile operating system +and also markets related third-party digital content and applications. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established +hardware, software and digital content supplier relationships; and the Company has a minority market share in the global smartphone market. Additionally, the Company faces significant price competition as competitors reduce their selling prices and +attempt to imitate the Company’s product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company competes with +business models that include content provided to users for free. The Company also competes with illegitimate ways to obtain third-party digital content and applications. Some of the Company’s competitors have greater experience, product breadth +and distribution channels than the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide products and services at little or no profit or even at a +loss. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The +Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to maintain their functional and design advantages. The Company is the only authorized maker of hardware using OS X, which has a minority market share in the personal computer market. This market has been +contracting and is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and accessories, the Company faces a significant number of competitors, many of which have broader product +lines, lower priced products and a larger installed customer base. Historically, consolidation in this market has resulted in larger competitors. Price competition has been particularly intense as competitors selling Windows-based personal computers +have aggressively cut prices and lowered product margins. An increasing number of internet-enabled devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the +Company’s existing products. The Company’s financial condition and operating results also depend on its ability to continually improve the Mac platform to maintain its functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new +products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and successfully manage the transition to these new and upgraded products. The success of new product +introductions depends on a number of factors including, but not limited to, timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the +availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to +meet anticipated demand and the risk that new products may have quality or other defects or deficiencies in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and +transitions. The Company depends on the performance of distributors, carriers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers and value-added resellers, many of +whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers and consumers and small and mid-sized +businesses through its online and retail stores. Carriers providing cellular network service for iPhone typically subsidize users’ purchases of +the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. Apple Inc. | 2015 Form 10-K | 9 Table of Contents Many resellers have narrow operating margins and have been adversely affected in the past by weak economic +conditions. Some resellers have perceived the expansion of the Company’s direct sales as conflicting with their business interests as distributors and resellers of the Company’s products. Such a perception could discourage resellers from +investing resources in the distribution and sale of the Company’s products or lead them to limit or cease distribution of those products. The Company has invested and will continue to invest in programs to enhance reseller sales, including +staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The +financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering +and marketing of the Company’s products. The Company faces substantial inventory and other asset risk in addition to purchase +commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed +anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets, including capital assets held at its suppliers’ facilities +and inventory prepayments, for impairment whenever events or circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which +the carrying value of the assets exceeds its fair value. Although the Company believes its provisions related to inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently adequate, no assurance can be +given that the Company will not incur additional related charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with industry +practice, components are normally acquired through a combination of purchase orders, supplier contracts and open orders, in each case based on projected demand. Where appropriate, the purchases are applied to inventory component +prepayments that are outstanding with the respective supplier. Purchase commitments typically cover forecasted component and manufacturing requirements for periods up to 150 days. Because the Company’s markets are volatile, +competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities. Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing risks. Many +components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. While the Company has entered into agreements for the supply of many components, +there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. A number of suppliers of components may suffer from poor financial conditions, which can lead to business failure for the +supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components. The effects of global or regional economic conditions on the Company’s suppliers, described +in “ Global and regional economic conditions could materially adversely affect the Company” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks +of supply shortages and price increases. The Company and other participants in the markets for mobile communication and media devices and personal +computers also compete for various components with other industries that have experienced increased demand for their products. The Company uses some custom components that are not common to the rest of these industries. The Company’s new +products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. +Continued availability of these components at acceptable prices, or at all, may be affected for any number of reasons, including if those suppliers decide to concentrate on the production of common components instead of components customized to meet +the Company’s requirements. The supply of components for a new or existing product could be delayed or constrained, or a key manufacturing vendor could delay shipments of completed products to the Company. Apple Inc. | 2015 Form 10-K | 10 Table of Contents The Company depends on component and product manufacturing and logistical services provided by +outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in +whole or in part by a few outsourcing partners located primarily in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s +direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although +arrangements with these partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect +or warranty liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on sole-sourced outsourcing partners in the U.S., Asia and Europe to supply and manufacture many critical components, and on +outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform may have a negative impact on the Company’s cost or supply of components +or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system +failures, commercial disputes, military actions or economic, business, labor, environmental, public health, or political issues. The Company has +invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the +supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply could be reduced or terminated and the net realizable value of +these assets could be negatively impacted. The Company’s products and services may experience quality problems from time to time +that can result in decreased sales and operating margin and harm to the Company’s reputation. The Company sells complex hardware and +software products and services that can contain design and manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the +software’s intended operation. The Company’s online services may from time to time experience outages, service slowdowns, or errors. Defects may also occur in components and products the Company purchases from third parties. There can be +no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, significant warranty and other expenses and harm to the Company’s reputation. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms +or at all. The Company contracts with numerous third parties to offer their digital content. This includes the right to sell currently +available music, movies, TV shows and books. The licensing or other distribution arrangements with these third parties are for relatively short terms and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at +all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license or otherwise distribute their +content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at reasonable +prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make available third-party digital content, or to make available such content on commercially reasonable terms, could have a material +adverse impact on the Company’s financial condition and operating results. Some third-party digital content providers require the Company to +provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such +solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of +content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. Apple Inc. | 2015 Form 10-K | 11 Table of Contents The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware +products depend in part on the availability of third-party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and +services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. With respect to its Mac products, the Company believes the availability of third-party software applications and +services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software for the Company’s products compared to Windows-based products. This analysis may be based +on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of Mac sales and the costs of developing such applications and services. If the Company’s minority +share of the global personal computer market causes developers to question the Mac’s prospects, developers could be less inclined to develop or upgrade software for the Company’s Mac products and more inclined to devote their resources to +developing and upgrading software for the larger Windows market. With respect to iOS devices, the Company relies on the continued availability and +development of compelling and innovative software applications, which are distributed through a single distribution channel, the App Store. iOS devices are subject to rapid technological change, and, if third-party developers are unable to or choose +not to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied customers. As with applications for the Company’s Mac products, the availability and development of these +applications also depend on developers’ perceptions and analysis of the relative benefits of developing, maintaining or upgrading software for the Company’s iOS devices rather than its competitors’ platforms, such as Android. If +developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s iOS devices may suffer. The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable +terms or at all. Many of the Company’s products include third-party intellectual property, which requires licenses from those third +parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on acceptable terms or at all. +Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products or otherwise have a material adverse impact on the +Company’s financial condition and operating results. The Company could be impacted by unfavorable results of legal proceedings, +such as being found to have infringed on intellectual property rights. The Company is subject to various legal proceedings and claims that +have not yet been fully resolved and that have arisen in the ordinary course of business, and additional claims may arise in the future. For +example, technology companies, including many of the Company’s competitors, frequently enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies +seek to monetize patents they have purchased or otherwise obtained. As the Company has grown, the intellectual property rights claims against it have increased and may continue to increase. In particular, the Company’s cellular enabled products +compete with products from mobile communication and media device companies that hold significant patent portfolios, and the number of patent claims against the Company has significantly increased. The Company is vigorously defending +infringement actions in courts in a number of U.S. jurisdictions and before the U.S. International Trade Commission, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial +damages. Regardless of the scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or +actual litigants, the Company may have to engage in protracted litigation. If the Company is found to infringe one or more patents or other intellectual property rights, regardless of whether it can develop non-infringing technology, it may be +required to pay substantial damages or royalties to a third-party, or it may be subject to a temporary or permanent injunction prohibiting the Company from marketing or selling certain products. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no assurance can be given that such licenses +can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Company’s operating expenses. Apple Inc. | 2015 Form 10-K | 12 Table of Contents Regardless of the merit of particular claims, litigation may be expensive, time-consuming, disruptive to the +Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into arrangements to settle litigation. In management’s opinion, there is not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess +of a recorded accrual, with respect to loss contingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain. Although management considers the likelihood of such an outcome to be remote, if one or more legal matters were resolved against the Company in a +reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Further, such an outcome could result in significant +compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. The Company is subject to laws and regulations worldwide, changes to which could increase the Company’s costs and individually or in +the aggregate adversely affect the Company’s business. The Company is subject to laws and regulations affecting its domestic and +international operations in a number of areas. These U.S. and foreign laws and regulations affect the Company’s activities including, but not limited to, in areas of labor, advertising, digital content, consumer protection, real estate, +billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import and export requirements, anti-corruption, foreign exchange controls +and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health and safety. By way of example, laws and +regulations related to mobile communications and media devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes could include, among others, restrictions on the production, manufacture, +distribution and use of devices, locking devices to a carrier’s network, or mandating the use of devices on more than one carrier’s network. These devices are also subject to certification and regulation by governmental and standardization +bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications, or delays in product shipment +dates, or could preclude the Company from selling certain products. Compliance with these laws, regulations and similar requirements may be onerous +and expensive, and they may be inconsistent from jurisdiction to jurisdiction, further increasing the cost of compliance and doing business. Any such costs, which may rise in the future as a result of changes in these laws and regulations or in +their interpretation, could individually or in the aggregate make the Company’s products and services less attractive to the Company’s customers, delay the introduction of new products in one or more regions, or cause the Company to change +or limit its business practices. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors, or agents will not +violate such laws and regulations or the Company’s policies and procedures. The Company’s business is subject to the risks of +international operations. The Company derives a significant portion of its revenue and earnings from its international operations. Compliance +with applicable U.S. and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy requirements, environmental laws, labor laws +and anti-competition regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with these laws and regulations, a violation by the Company’s employees, +contractors, or agents could nevertheless occur. Violations of these laws and regulations could materially adversely affect the Company’s brand, international growth efforts and business. The Company also could be significantly affected by other risks associated with international activities including, but not limited to, economic and +labor conditions, increased duties, taxes and other costs and political instability. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be +materially adversely affected by international trade regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its trade receivables with customers in certain international +markets. There can be no assurance the Company can effectively limit its credit risk and avoid losses. Apple Inc. | 2015 Form 10-K | 13 Table of Contents The Company’s retail stores have required and will continue to require a substantial +investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required +substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain stores have been designed and built to +serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than the +Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease +termination costs, write-offs of equipment and leasehold improvements and severance costs. Many factors unique to retail operations, some of which +are beyond the Company’s control, pose risks and uncertainties. These risks and uncertainties include, but are not limited to, macro-economic factors that could have an adverse effect on general retail activity, as well as the Company’s +inability to manage costs associated with store construction and operation, the Company’s failure to manage relationships with its existing retail partners, more challenging environments in managing retail operations outside the U.S., costs +associated with unanticipated fluctuations in the value of retail inventory, and the Company’s inability to obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present risks not originally +contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve +significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital and unidentified issues not discovered in the Company’s due +diligence. These new ventures are inherently risky and may not be successful. The Company’s business and reputation may be +impacted by information technology system failures or network disruptions. The Company may be subject to information technology system +failures and network disruptions. These may be caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. +System redundancy may be ineffective or inadequate, and the Company’s disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could, among other things, prevent access to the Company’s online +stores and services, preclude retail store transactions, compromise Company or customer data, and result in delayed or cancelled orders. System failures and disruptions could also impede the manufacturing and shipping of products, delivery of online +services, transactions processing and financial reporting. There may be breaches of the Company’s information technology systems +that materially damage business partner and customer relationships, curtail or otherwise adversely impact access to online stores and services, or subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store customer, employee and business partner personally identifiable information +(“PII”). This may include, among other information, names, addresses, phone numbers, email addresses, contact preferences, tax identification numbers and payment account information. Although malicious attacks to gain access to PII affect +many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the amount of PII it manages. The Company requires user names and passwords in order to access its information technology systems. The Company also uses encryption and authentication +technologies designed to secure the transmission and storage of data and prevent access to Company data or accounts. As with all companies, these security measures are subject to third-party security breaches, employee error, malfeasance, faulty +password management, or other irregularities. For example, third parties may attempt to fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used to access the +Company’s information technology systems. To help protect customers and the Company, the Company monitors accounts and systems for unusual activity and may freeze accounts under suspicious circumstances, which may result in the delay or loss of +customer orders. Apple Inc. | 2015 Form 10-K | 14 Table of Contents The Company devotes significant resources to network security, data encryption and other security measures +to protect its systems and data, but these security measures cannot provide absolute security. To the extent the Company was to experience a breach of its systems and was unable to protect sensitive data, such a breach could materially damage +business partner and customer relationships, and curtail or otherwise adversely impact access to online stores and services. Moreover, if a computer security breach affects the Company’s systems or results in the unauthorized release of PII, +the Company’s reputation and brand could be materially damaged, use of the Company’s products and services could decrease, and the Company could be exposed to a risk of loss or litigation and possible liability. While the Company maintains +insurance coverage that, subject to policy terms and conditions and subject to a significant self-insured retention, is designed to address certain aspects of cyber risks, such insurance coverage may be insufficient to cover all losses or all types +of claims that may arise in the continually evolving area of cyber risk. The Company’s business is subject to a variety of U.S. +and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and +international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also to transfers of information between the Company and its subsidiaries, and +among the Company, its subsidiaries and other parties with which the Company has commercial relations. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue +to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. +Noncompliance could result in penalties or significant legal liability. The Company’s privacy policy, which includes related practices +concerning the use and disclosure of data, is posted on its website. Any failure by the Company, its suppliers or other parties with whom the Company does business to comply with its posted privacy policy or with other federal, state or +international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others. The Company is also subject to payment card association rules and obligations under its contracts with payment card processors. Under these rules and +obligations, if information is compromised, the Company could be liable to payment card issuers for associated expenses and penalties. In addition, if the Company fails to follow payment card industry security standards, even if no customer +information is compromised, the Company could incur significant fines or experience a significant increase in payment card transaction costs. The Company’s success depends largely on the continued service and availability of key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, +executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are +located. The Company’s business may be impacted by political events, war, terrorism, public health issues, natural disasters and +other business interruptions. War, terrorism, geopolitical uncertainties, public health issues and other business interruptions have caused +and could cause damage or disruption to international commerce and the global economy, and thus could have a material adverse effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channel partners. +The Company’s business operations are subject to interruption by, among others, natural disasters, whether as a result of climate change or otherwise, fire, power shortages, nuclear power plant accidents, terrorist attacks and other hostile +acts, labor disputes, public health issues and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and deliver products to its customers, +including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. Should major public health issues, including pandemics, arise, the Company could be adversely affected +by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products and disruptions in the operations of the +Company’s manufacturing vendors and component suppliers. The majority of the Company’s R&D activities, its corporate headquarters, information technology systems and other critical business operations, including certain component +suppliers and manufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, the Company could incur significant losses, require substantial recovery time and experience significant +expenditures in order to resume operations. Apple Inc. | 2015 Form 10-K | 15 Table of Contents The Company expects its quarterly revenue and operating results to fluctuate. The Company’s profit margins vary across its products and distribution channels. The Company’s software, accessories, and service and support +contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product transitions, pricing and +configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition, the Company’s gross +margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, component cost increases, the strengthening U.S. dollar, price competition, +or the introduction of new products, including those that have higher cost structures with flat or reduced pricing. The Company has typically +experienced higher net sales in its first quarter compared to other quarters due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Further, the +Company generates a majority of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments late in a quarter, such as +lower-than-anticipated demand for the Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock price has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the +Company, the technology industry and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price +volatility over a given period may cause the average price at which the Company repurchases its own stock to exceed the stock’s price at a given point in time. The Company believes its stock price should reflect expectations of future growth +and profitability. The Company also believes its stock price should reflect expectations that its cash dividend will continue at current levels or grow and that its current share repurchase program will be fully consummated. Future dividends are +subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, +profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employee retention. The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar versus local +currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non-U.S. dollar-denominated sales +and operating expenses worldwide. Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally leads the Company to raise +international pricing, potentially reducing demand for the Company’s products. Margins on sales of the Company’s products in foreign countries and on sales of products that include components obtained from foreign suppliers, could be +materially adversely affected by foreign currency exchange rate fluctuations. In some circumstances, for competitive or other reasons, the Company may decide not to raise local prices to fully offset the dollar’s strengthening, or at all, which +would adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s +foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies +may also increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company +uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any, or more than a portion, of the +adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company +is exposed to credit risk and fluctuations in the market values of its investment portfolio. Given the global nature of its business, the +Company has both domestic and international investments. Credit ratings and pricing of the Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or +other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash +equivalents and marketable securities, future fluctuations in their value could result in a significant realized loss. Apple Inc. | 2015 Form 10-K | 16 Table of Contents The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade +receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. The Company also +sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party financing +arrangements or credit insurance. The Company’s exposure to credit and collectability risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured +vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with +long-term supply agreements to secure supply of inventory components. As of September 26, 2015, a significant portion of the Company’s trade receivables was concentrated within cellular network carriers, and its vendor non-trade +receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor +non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to +additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number +of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of +earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. For example, in June 2014, the European +Commission opened a formal investigation of Ireland to examine whether decisions by the tax authorities with regard to the corporate income tax to be paid by two of the Company’s Irish subsidiaries comply with European Union rules on state aid. +If the European Commission were to conclude against Ireland, it could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid, and such amount could be material. The Company is also subject to the examination of its tax returns and other tax matters by the Internal Revenue Service and other tax authorities and +governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If +the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial +condition, operating results and cash flows could be adversely affected. Apple Inc. | 2015 Form 10-K | 17 Table of Contents Item 1B. Unresolved Staff Comments None. Item 2. Properties The Company’s headquarters are located in Cupertino, California. As of +September 26, 2015, the Company owned or leased 25.6 million square feet of building space, primarily in the U.S. The Company also owned or leased building space in various locations, including throughout Europe, China, Singapore and +Japan. Of the total owned or leased building space 18.5 million square feet was leased building space, which includes approximately 5.3 million square feet related to retail store space. Additionally, the Company owns a total of 1,757 +acres of land in various locations. As of September 26, 2015, the Company owned a manufacturing facility in Cork, Ireland that also housed a +customer support call center; facilities in Elk Grove, California that included warehousing and distribution operations and a customer support call center; and a facility in Mesa, Arizona. The Company also owned land in Austin, Texas where it is +expanding its existing office space and customer support call center. In addition, the Company owned facilities and land for R&D and corporate functions in San Jose, California and Cupertino, California, including land that is being developed +for the Company’s second corporate campus. The Company also owned data centers in Newark, California; Maiden, North Carolina; Prineville, Oregon; and Reno, Nevada. Outside the U.S., the Company owned additional facilities for various purposes. The Company believes its existing facilities and equipment, which are used by all operating segments, are in good operating condition and are +suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to make investments in capital equipment as needed to meet anticipated demand for +its products. Item 3. Legal Proceedings The Company is subject to the legal proceedings and claims discussed below as +well as certain other legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred +a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of legal proceedings and claims brought against the Company is subject to significant +uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s +expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. See the risk factor “ The Company could be impacted by unfavorable results of legal proceedings, such as +being found to have infringed on intellectual property rights ” in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2015 that did not +individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Apple eBooks +Antitrust Litigation (United States of America v. Apple Inc., et al.) On April 11, 2012, the U.S. Department of Justice filed a civil +antitrust action against the Company and five major book publishers in the U.S. District Court for the Southern District of New York, alleging an unreasonable restraint of interstate trade and commerce in violation of §1 of the Sherman Act and +seeking, among other things, injunctive relief, the District Court’s declaration that the Company’s agency agreements with the publishers are null and void and/or the District Court’s reformation of such agreements. On July 10, +2013, the District Court found, following a bench trial, that the Company conspired to restrain trade in violation of §1 of the Sherman Act and relevant state statutes to the extent those laws are congruent with §1 of the Sherman +Act. The District Court entered a permanent injunction, which took effect on October 6, 2013 and will be in effect for five years unless the judgment is overturned on appeal. The Company has taken the necessary steps to comply with the +terms of the District Court’s order, including renegotiating agreements with the five major eBook publishers, updating its antitrust training program and completing a two-year monitorship with a court-appointed antitrust compliance monitor, +whose appointment the District Court ended in October 2015. The Company appealed the District Court’s decision. Pursuant to a settlement agreement reached in June 2014, any damages the Company may be obligated to pay will be determined by the +outcome of the final adjudication following exhaustion of all appeals. Item 4. Mine Safety Disclosures Not applicable. Apple Inc. | 2015 Form 10-K | 18 Table of Contents PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the NASDAQ Stock Market LLC (“NASDAQ”) under the symbol AAPL. Price Range of Common Stock The price range per share of +common stock presented below represents the highest and lowest intraday sales prices for the Company’s common stock on the NASDAQ during each quarter of the two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter 2015 price range per share $ 132.97 - $    92.00 $ 134.54 - $  123.10 $ 133.60 - $  104.63 $ 119.75 - $    95.18 2014 price range per share $ 103.74 - $    92.09 $ 95.05 - $    73.05 $ 80.18 - $    70.51 $ 82.16 - $    67.77 Holders As of October 9, +2015, there were 25,924 shareholders of record. Dividends The Company paid a total of $11.4 billion and $11.0 billion in dividends during 2015 and 2014, respectively, and expects to pay quarterly dividends of +$0.52 per common share each quarter, subject to declaration by the Board of Directors. The Company also plans to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Apple Inc. | 2015 Form 10-K | 19 Table of Contents Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 26, 2015 was as follows (in millions, except number of shares, which are reflected +in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans +or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans +or Programs (1) June 28, 2015 to August 1, 2015: May 2015 ASR 9,973 (2) (2) 9,973 (2) Open market and privately negotiated purchases 15,882 $ 124.66 15,882 August 2, 2015 to August 29, 2015: Open market and privately negotiated purchases 68,526 $ 114.15 68,526 August 30, 2015 to September 26, 2015: Open market and privately negotiated purchases 37,394 $ 112.94 37,394 Total 131,775 $ 36,024 (1) In 2012, the Company’s Board of Directors authorized a program to repurchase up to $10 billion of the Company’s common stock beginning in 2013. The +Company’s Board of Directors increased the authorization to repurchase the Company’s common stock to $60 billion in April 2013, to $90 billion in April 2014 and to $140 billion in April 2015. As of September 26, 2015, $104 billion of +the $140 billion had been utilized. The remaining $36 billion in the table represents the amount available to repurchase shares under the authorized repurchase program as of September 26, 2015. The Company’s share repurchase program +does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In May 2015, the Company entered into an accelerated share repurchase arrangement (“ASR”) to purchase up to $6.0 billion of the Company’s +common stock. In July 2015, the purchase period for this ASR ended and an additional 10.0 million shares were delivered and retired. In total, 48.3 million net shares were delivered under this ASR at an average repurchase price of $124.24. Apple Inc. | 2015 Form 10-K | 20 Table of Contents Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 +Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 26, 2015. The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 +Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 24, 2010. Note that historic stock price performance is not necessarily indicative of future stock price +performance. * $100 invested on 9/25/10 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s +common stock and September 30th for indexes. Copyright © 2015 +S&P, a division of McGraw Hill Financial. All rights reserved. Copyright © 2015 Dow Jones & Co. All rights reserved. September 2010 September 2011 September 2012 September 2013 September 2014 September 2015 Apple Inc. $ 100 $ 138 $ 229 $ 170 $ 254 $ 294 S&P 500 Index $ 100 $ 101 $ 132 $ 157 $ 188 $ 187 S&P Information Technology Index $ 100 $ 104 $ 137 $ 147 $ 190 $ 194 Dow Jones U.S. Technology Supersector Index $ 100 $ 103 $ 134 $ 141 $ 183 $ 183 Apple Inc. | 2015 Form 10-K | 21 Table of Contents Item 6. Selected Financial Data The information set forth below for the five years ended +September 26, 2015, is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of +Operations” and the consolidated financial statements and related notes thereto included in Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the +information presented below (in millions, except number of shares, which are reflected in thousands, and per share amounts). 2015 2014 2013 2012 2011 Net sales $ 233,715 $ 182,795 $ 170,910 $ 156,508 $ 108,249 Net income $ 53,394 $ 39,510 $ 37,037 $ 41,733 $ 25,922 Earnings per share: Basic $ 9.28 $ 6.49 $ 5.72 $ 6.38 $ 4.01 Diluted $ 9.22 $ 6.45 $ 5.68 $ 6.31 $ 3.95 Cash dividends declared per share $ 1.98 $ 1.82 $ 1.64 $ 0.38 $ 0 Shares used in computing earnings per share: Basic 5,753,421 6,085,572 6,477,320 6,543,726 6,469,806 Diluted 5,793,069 6,122,663 6,521,634 6,617,483 6,556,514 Total cash, cash equivalents and marketable securities $ 205,666 $ 155,239 $ 146,761 $ 121,251 $ 81,570 Total assets $ 290,479 $ 231,839 $ 207,000 $ 176,064 $ 116,371 Commercial paper $ 8,499 $ 6,308 $ 0 $ 0 $ 0 Total term debt (2) $ 55,963 $ 28,987 $ 16,960 $ 0 $ 0 Other long-term obligations (1) $ 33,427 $ 24,826 $ 20,208 $ 16,664 $ 10,100 Total liabilities $ 171,124 $ 120,292 $ 83,451 $ 57,854 $ 39,756 Total shareholders’ equity $ 119,355 $ 111,547 $ 123,549 $ 118,210 $ 76,615 (1) Other long-term obligations exclude non-current deferred revenue. (2) Includes current and long-term portion of term debt. Apple Inc. | 2015 Form 10-K | 22 Table of Contents Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This +section and other parts of this Annual Report on Form 10-K (“Form 10-K”) contain forward-looking statements, within the +meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not +directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “future,” “anticipates,” “believes,” “estimates,” “expects,” “intends,” +“plans,” “predicts,” “will,” “would,” “could,” “can,” “may,” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual +results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A +of this Form 10-K under the heading “Risk Factors,” which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, +Item 8 of this Form 10-K. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the +Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “Company” and “Apple” as used herein refers collectively to Apple Inc. and its +wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview and Highlights The Company designs, manufactures and +markets mobile communication and media devices, personal computers and portable digital music players, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company +sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of +third-party Apple compatible products, including application software and various accessories through its online and retail stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Fiscal 2015 Highlights Net sales rose 28% or $50.9 +billion during 2015 compared to 2014, driven by a 52% year-over-year increase in iPhone ® net sales. iPhone net sales and unit sales in 2015 increased in all of the Company’s reportable +operating segments. The Company also experienced year-over-year net sales increases in Mac ® , Services and Other Products. Apple Watch ® , +which launched during the third quarter of 2015, accounted for more than 100% of the year-over-year growth in net sales of Other Products. Net sales growth during 2015 was partially offset by the effect of weakness in most foreign currencies +relative to the U.S. dollar and lower iPad ® net sales. Total net sales increased in each of the Company’s reportable operating segments, with particularly strong growth in Greater China +where year-over-year net sales increased 84%. In April 2015, the Company announced a significant increase to its capital return program by raising +the expected total size of the program to $200 billion through March 2017. This included increasing its share repurchase authorization to $140 billion and raising its quarterly dividend to $0.52 per share beginning in May 2015. During 2015, the +Company spent $36.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $11.6 billion. Additionally, the Company issued $14.5 billion of U.S. dollar-denominated, € 4.8 billion of euro-denominated, SFr1.3 billion of Swiss franc-denominated, £1.3 billion of British pound-denominated, A$2.3 billion of Australian dollar-denominated and ¥250.0 billion +of Japanese yen-denominated term debt during 2015. Fiscal 2014 Highlights Net sales rose 7% or $11.9 billion during 2014 compared to 2013. This was driven by increases in net sales of iPhone, Mac and Services. Net sales and unit +sales increased for iPhone primarily due to the successful introduction of iPhone 5s and 5c in the latter half of calendar year 2013, the successful launch of iPhone 6 and 6 Plus beginning in the fourth quarter of 2014, and expanded distribution. +Mac net sales and unit sales increased primarily due to strong demand for MacBook Air ® and MacBook Pro ® which were updated in 2014 with +faster processors and offered at lower prices. Net sales of Services grew primarily due to increased revenue from sales through the App Store ® , AppleCare ® and licensing. Growth in these areas was partially offset by the year-over-year decline in net sales for iPad due to lower unit sales in many markets, and a decline in net sales of Other +Products. All of the Company’s operating segments other than the Rest of Asia Pacific segment experienced increased net sales in 2014, with growth being strongest in the Greater China and Japan operating segments. During 2014, the Company completed various business acquisitions, including the acquisitions of Beats Music, LLC, which offers a subscription streaming +music service, and Beats Electronics, LLC, which makes Beats ® headphones, speakers and audio software. Apple Inc. | 2015 Form 10-K | 23 Table of Contents In April 2014, the Company increased its share repurchase authorization to $90 billion and the quarterly +dividend was raised to $0.47 per common share, resulting in an overall increase in its capital return program from $100 billion to over $130 billion. During 2014, the Company utilized $45 billion to repurchase its common stock and paid dividends and +dividend equivalents of $11.1 billion. The Company also issued $12.0 billion of long-term debt during 2014, with varying maturities through 2044, and launched a commercial paper program, with $6.3 billion outstanding as of September 27, 2014. Sales Data The following table shows net sales by +operating segment and net sales and unit sales by product during 2015, 2014 and 2013 (dollars in millions and units in thousands): 2015 Change 2014 Change 2013 Net Sales by Operating Segment: Americas $ 93,864 17% $ 80,095 4% $ 77,093 Europe 50,337 14% 44,285 8% 40,980 Greater China 58,715 84% 31,853 18% 27,016 Japan 15,706 3% 15,314 11% 13,782 Rest of Asia Pacific 15,093 34% 11,248 (7)% 12,039 Total net sales $ 233,715 28% $ 182,795 7% $ 170,910 Net Sales by Product: iPhone (1) $ 155,041 52% $ 101,991 12% $ 91,279 iPad (1) 23,227 (23)% 30,283 (5)% 31,980 Mac (1) 25,471 6% 24,079 12% 21,483 Services (2) 19,909 10% 18,063 13% 16,051 Other Products (1)(3) 10,067 20% 8,379 (17)% 10,117 Total net sales $ 233,715 28% $ 182,795 7% $ 170,910 Unit Sales by Product: iPhone 231,218 37% 169,219 13% 150,257 iPad 54,856 (19)% 67,977 (4)% 71,033 Mac 20,587 9% 18,906 16% 16,341 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from the iTunes Store ® , App Store, Mac App Store, iBooks Store™ and Apple +Music™ (collectively “Internet Services”), AppleCare, Apple Pay ® , licensing and other services. (3) Includes sales of Apple TV ® , Apple Watch, Beats products, iPod and Apple-branded and third-party +accessories. Apple Inc. | 2015 Form 10-K | 24 Table of Contents Product Performance iPhone The following table presents iPhone net sales and unit sales information for 2015, 2014 and 2013 (dollars in millions and units in thousands): 2015 Change 2014 Change 2013 Net sales $ 155,041 52% $ 101,991 12% $ 91,279 Percentage of total net sales 66% 56% 53% Unit sales 231,218 37% 169,219 13% 150,257 The year-over-year growth in iPhone net sales and unit sales during 2015 primarily resulted from strong demand for iPhone +6 and 6 Plus during 2015. Overall average selling prices (“ASPs”) for iPhone increased by 11% during 2015 compared to 2014, due primarily to the introduction of iPhone 6 and 6 Plus in September 2014, partially offset by the effect of +weakness in most foreign currencies relative to the U.S. dollar. The year-over-year growth in iPhone net sales and unit sales in 2014 resulted +primarily from the successful introduction of new iPhones in the latter half of calendar year 2013, the successful launch of iPhone 6 and 6 Plus beginning in September 2014, and expanded distribution. iPhone unit sales grew in all of the +Company’s operating segments, while iPhone net sales grew in all segments except Rest of Asia Pacific. Overall ASPs for iPhone were relatively flat in 2014 compared to 2013, with growth in ASPs in the Americas segment being offset by a decline +in ASPs in the Greater China, Japan and Rest of Asia Pacific segments. iPad The following table presents iPad net sales and unit sales information for 2015, 2014 and 2013 (dollars in millions and units in thousands): 2015 Change 2014 Change 2013 Net sales $ 23,227 (23)% $ 30,283 (5)% $ 31,980 Percentage of total net sales 10% 17% 19% Unit sales 54,856 (19)% 67,977 (4)% 71,033 Net sales and unit sales for iPad declined during 2015 compared to 2014. The Company believes the decline in iPad sales +is due in part to a longer repurchase cycle for iPads and some level of cannibalization from the Company’s other products. iPad ASPs declined by 5% during 2015 compared to 2014, primarily as a result of the effect of weakness in most foreign +currencies relative to the U.S. dollar and a shift in mix to lower-priced iPads. Net sales and unit sales for iPad declined in 2014 compared to +2013. iPad net sales and unit sales grew in the Greater China and Japan segments but this growth was more than offset by a decline in all other segments. Overall iPad ASPs were relatively flat in 2014 compared to 2013 with a shift in mix to +higher-priced iPads being offset by the October 2013 price reduction of iPad mini™. ASPs increased in the Japan and Rest of Asia Pacific segments but were slightly down in other segments. Mac The following table presents Mac net sales and unit sales +information for 2015, 2014 and 2013 (dollars in millions and units in thousands): 2015 Change 2014 Change 2013 Net sales $ 25,471 6% $ 24,079 12% $ 21,483 Percentage of total net sales 11% 13% 13% Unit sales 20,587 9% 18,906 16% 16,341 The year-over-year growth in Mac net sales and unit sales during 2015 was driven by strong demand for Mac portables. Mac +ASPs declined 3% during 2015 compared to 2014 largely due to the effect of weakness in most foreign currencies relative to the U.S. dollar. The +year-over-year growth in Mac net sales and unit sales for 2014 was primarily driven by increased sales of MacBook Air, MacBook Pro and Mac Pro. Mac net sales and unit sales increased in all of the Company’s operating segments. Mac ASPs +decreased during 2014 compared to 2013 primarily due to price reductions on certain Mac models and a shift in mix towards Mac portable systems. Apple Inc. | 2015 Form 10-K | 25 Table of Contents Services The following table +presents net sales information of Services for 2015, 2014 and 2013 (dollars in millions): 2015 Change 2014 Change 2013 Net sales $ 19,909 10% $ 18,063 13% $ 16,051 Percentage of total net sales 9% 10% 9% The increase in net sales of Services during 2015 compared to 2014 was primarily due to growth from Internet Services and +licensing. The App Store, included within Internet Services, generated strong year-over-year net sales growth of 29%. The increase in net sales of +Services in 2014 compared to 2013 was primarily due to growth in net sales from Internet Services, AppleCare and licensing. Internet Services generated a total of $10.2 billion in net sales during 2014 compared to $9.3 billion during 2013. Growth in +net sales from Internet Services was driven by increases in revenue from app sales reflecting continued growth in the installed base of iOS devices and the expanded offerings of iOS apps and related in-app purchases. This was partially offset by a +decline in sales of digital music. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, +Greater China, Japan and Rest of Asia Pacific. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong +Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and those Asian countries not included in the Company’s other reportable operating segments. Although, each reportable operating segment provides similar hardware and software +products and similar services, they are managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the +Company’s reportable operating segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Americas The following table presents Americas net sales +information for 2015, 2014 and 2013 (dollars in millions): 2015 Change 2014 Change 2013 Net sales $ 93,864 17% $ 80,095 4% $ 77,093 Percentage of total net sales 40% 44% 45% The year-over-year growth in Americas net sales during 2015 was driven primarily by growth in net sales and unit sales of +iPhone, partially offset by a decline in net sales and unit sales of iPad. The growth in the Americas segment in 2014 was due to increased net sales +of iPhone, Mac and Services that was partially offset by a decline in net sales of iPad and Other Products and weakness in foreign currencies relative to the U.S. dollar compared to 2013. iPhone growth resulted primarily from the successful +introduction of iPhone 5s and 5c in September 2013 and the successful launch of iPhone 6 and 6 Plus in September 2014. Mac growth was driven primarily by increased net sales and unit sales of MacBook Air and Mac Pro. Europe The following table presents Europe net sales +information for 2015, 2014 and 2013 (dollars in millions): 2015 Change 2014 Change 2013 Net sales $ 50,337 14% $ 44,285 8% $ 40,980 Percentage of total net sales 22% 24% 24% The year-over-year increase in Europe net sales during 2015 was driven primarily by growth in net sales and unit sales of +iPhone, partially offset by the effect of weakness in foreign currencies relative to the U.S. dollar and a decline in net sales and unit sales of iPad. The growth in the Europe segment in 2014 was due to increased net sales of iPhone, Mac and Services, as well as strength in European currencies relative +to the U.S. dollar, partially offset by a decline in net sales of iPad. iPhone growth resulted primarily from the successful introduction of iPhone 5s and 5c in the second half of calendar 2013 and the successful launch of iPhone 6 and 6 Plus in +over 20 countries in Europe in September 2014. Mac growth was driven primarily by increased net sales and unit sales of MacBook Air, MacBook Pro and Mac Pro. Apple Inc. | 2015 Form 10-K | 26 Table of Contents Greater China The +following table presents Greater China net sales information for 2015, 2014 and 2013 (dollars in millions): 2015 Change 2014 Change 2013 Net sales $ 58,715 84% $ 31,853 18% $ 27,016 Percentage of total net sales 25% 17% 16% Greater China experienced strong year-over-year increases in net sales during 2015 driven primarily by iPhone sales. The Greater China segment experienced year-over-year growth in net sales in 2014 that was significantly higher than the growth rate for the Company +overall. Greater China growth was driven by higher unit sales and net sales of all major product categories, in addition to higher net sales of Services. Growth in net sales and unit sales of iPhone was especially strong, driven by the successful +launch of iPhone 5s and 5c in Mainland China and Hong Kong in September 2013, the successful launch of iPhone 6 and 6 Plus in Hong Kong in September 2014, increased demand for the Company’s entry-priced iPhones and the addition of a significant +new carrier in the second quarter of 2014. Japan The +following table presents Japan net sales information for 2015, 2014 and 2013 (dollars in millions): 2015 Change 2014 Change 2013 Net sales $ 15,706 3% $ 15,314 11% $ 13,782 Percentage of total net sales 7% 8% 8% The year-over-year increase in Japan net sales during 2015 was driven primarily by growth in Services largely associated +with strong App Store sales, partially offset by the effect of weakness in the Japanese yen relative to the U.S. dollar. In 2014 the Japan segment +generated year-over-year increases in net sales and unit sales of every major product category and experienced growth in net sales of Services. The year-over-year growth in iPhone was driven by the successful launch of iPhone 5s and 5c in September +2013, the successful launch of iPhone 6 and 6 Plus in September 2014, increased demand for the Company’s entry-priced iPhones and the addition of a significant new carrier in the fourth quarter of 2013. These positive factors were partially +offset by weakness in the Japanese Yen relative to the U.S. dollar. Rest of Asia Pacific The following table presents Rest of Asia Pacific net sales information for 2015, 2014 and 2013 (dollars in millions): 2015 Change 2014 Change 2013 Net sales $ 15,093 34% $ 11,248 (7)% $ 12,039 Percentage of total net sales 6% 6% 7% The year-over-year increase in Rest of Asia Pacific net sales during 2015 primarily reflects strong growth in net sales +and unit sales of iPhone, partially offset by the effect of weakness in foreign currencies relative to the U.S. dollar and a decline in net sales and unit sales of iPad. Net sales in the Rest of Asia Pacific segment declined in 2014 compared to 2013 due to year-over-year reductions in net sales in all major product +categories except Mac and reductions in unit sales of iPad. Net sales in 2014 were also negatively affected by the weakness in several foreign currencies relative to the U.S. dollar, including the Australian dollar. Apple Inc. | 2015 Form 10-K | 27 Table of Contents Gross Margin Gross margin for 2015, 2014 and 2013 is as follows (dollars in millions): 2015 2014 2013 Net sales $ 233,715 $ 182,795 $ 170,910 Cost of sales 140,089 112,258 106,606 Gross margin $ 93,626 $ 70,537 $ 64,304 Gross margin percentage 40.1% 38.6% 37.6% The year-over-year increase in the gross margin percentage in 2015 was driven primarily by a favorable shift in mix to +products with higher margins and, to a lesser extent, by improved leverage on fixed costs from higher net sales. These positive factors were partially offset primarily by higher product cost structures and, to a lesser extent, by the effect of +weakness in most foreign currencies relative to the U.S. dollar. The year-over-year increase in the gross margin percentage in 2014 was driven by +multiple factors including lower commodity costs, a favorable shift in mix to products with higher margins and improved leverage on fixed costs from higher net sales, which was partially offset by the weakness in several foreign currencies relative +to the U.S. dollar, price reductions on select products and higher cost structures on certain new products. The Company anticipates gross margin +during the first quarter of 2016 to be between 39% and 40%. The foregoing statement regarding the Company’s expected gross margin percentage in the first quarter of 2016 is forward-looking and could differ from actual results. The +Company’s future gross margins can be impacted by multiple factors including, but not limited to, those set forth in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and those described in this paragraph. In +general, the Company believes gross margins will remain under downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product +transitions, potential increases in the cost of components, and potential strengthening of the U.S. dollar, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards +products with lower gross margins. In response to competitive pressures, the Company expects it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s +ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due to the Company’s significant international operations, its financial condition and operating results, including gross +margins, could be significantly affected by fluctuations in exchange rates. Operating Expenses Operating expenses for 2015, 2014 and 2013 are as follows (dollars in millions): 2015 Change 2014 Change 2013 Research and development $ 8,067 34% $ 6,041 35% $ 4,475 Percentage of total net sales 3% 3% 3% Selling, general and administrative $ 14,329 19% $ 11,993 11% $ 10,830 Percentage of total net sales 6% 7% 6% Total operating expenses $ 22,396 24% $ 18,034 18% $ 15,305 Percentage of total net sales 10% 10% 9% Research and Development The +year-over-year growth in R&D expense in 2015 and 2014 was driven primarily by an increase in headcount and related expenses, including share-based compensation costs, and material costs to support expanded R&D activities. The Company +continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace and are directly related to timely development of new and updated products that are central to the Company’s +core business strategy. Selling, General and Administrative The year-over-year growth in selling, general and administrative expense in 2015 and 2014 was primarily due to increased headcount and related expenses, +including share-based compensation costs, and higher spending on marketing and advertising. Apple Inc. | 2015 Form 10-K | 28 Table of Contents Other Income/(Expense), Net Other income/(expense), net for 2015, 2014 and 2013 are as follows (dollars in millions): 2015 Change 2014 Change 2013 Interest and dividend income $ 2,921 $ 1,795 $ 1,616 Interest expense (733 ) (384 ) (136 ) Other expense, net (903 ) (431 ) (324 ) Total other income/(expense), net $ 1,285 31% $ 980 (15)% $ 1,156 The increase in other income/(expense), net during 2015 compared to 2014 was due primarily to higher interest income, +partially offset by higher expenses associated with foreign exchange activity and higher interest expense on debt. The decrease in other income and expense during 2014 compared to 2013 was due primarily to higher interest expense on debt and higher +expenses associated with foreign exchange rate movements, partially offset by lower premium expenses on foreign exchange contracts and higher interest income. The weighted-average interest rate earned by the Company on its cash, cash equivalents and +marketable securities was 1.49%, 1.11% and 1.03% in 2015, 2014 and 2013, respectively. Provision for Income Taxes Provision for income taxes and effective tax rates for 2015, 2014 and 2013 are as follows (dollars in millions): 2015 2014 2013 Provision for income taxes $ 19,121 $ 13,973 $ 13,118 Effective tax rate 26.4% 26.1% 26.2% The Company’s effective tax rates for 2015, 2014 and 2013 differ from the statutory federal income tax rate of 35% +due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided when such earnings are intended to be indefinitely reinvested outside +the U.S. The higher effective tax rate during 2015 compared to 2014 was due primarily to higher foreign taxes. The effective tax rate in 2014 compared to 2013 was relatively flat. As of September 26, 2015, the Company had deferred tax assets arising from deductible temporary differences, tax losses and tax credits of $7.8 +billion and deferred tax liabilities of $24.1 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of +existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and the amount of a valuation +allowance. The U.S. Internal Revenue Service is currently examining the years 2010 through 2012, and all years prior to 2010 are closed. In +addition, the Company is subject to audits by state, local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 2003 generally remain open and could be subject to examination by the taxing +authorities. Management believes that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s +tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. On June 11, 2014, the European Commission issued an opening decision initiating a formal investigation against Ireland for alleged state aid to the +Company. The opening decision concerns the allocation of profits for taxation purposes of the Irish branches of two subsidiaries of the Company. The Company believes the European Commission’s assertions are without merit. If the European +Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount could be material, as of +September 26, 2015 the Company is unable to estimate the impact. Apple Inc. | 2015 Form 10-K | 29 Table of Contents Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue +from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to +be entitled when products are transferred to customers. The original effective date for ASU 2014-09 would have required the Company to adopt +beginning in its first quarter of 2018. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) – Deferral of the Effective Date, which defers the effective date of ASU 2014-09 for one year and +permits early adoption as early as the original effective date of ASU 2014-09. Accordingly, the Company may adopt the standard in either its first quarter of 2018 or 2019. The new revenue standard may be applied retrospectively to each prior period +presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company is currently evaluating the timing of its adoption and the impact of adopting the new revenue standard on its consolidated financial +statements. Liquidity and Capital Resources The following +table presents selected financial information and statistics as of and for the years ended September 26, 2015, September 27, 2014 and September 28, 2013 (in millions): 2015 2014 2013 Cash, cash equivalents and marketable securities $ 205,666 $ 155,239 $ 146,761 Property, plant and equipment, net $ 22,471 $ 20,624 $ 16,597 Commercial paper $ 8,499 $ 6,308 $ 0 Total term debt $ 55,963 $ 28,987 $ 16,960 Working capital $ 8,768 $ 5,083 $ 29,628 Cash generated by operating activities $ 81,266 $ 59,713 $ 53,666 Cash used in investing activities $ (56,274 ) $ (22,579 ) $ (33,774 ) Cash used in financing activities $ (17,716 ) $ (37,549 ) $ (16,379 ) The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to +satisfy its working capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with its existing operations over the next 12 months. The Company currently anticipates the cash used for future +dividends, the share repurchase program and debt repayments will come from its current domestic cash, cash generated from on-going U.S. operating activities and from borrowings. As of September 26, 2015 and September 27, 2014, the Company’s cash, cash equivalents and marketable securities held by foreign +subsidiaries were $186.9 billion and $137.1 billion, respectively, and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income +taxation on repatriation to the U.S. The Company’s marketable securities investment portfolio is invested primarily in highly-rated securities and its investment policy generally limits the amount of credit exposure to any one issuer. The +policy requires investments generally to be investment grade with the objective of minimizing the potential risk of principal loss. During 2015, +cash generated from operating activities of $81.3 billion was a result of $53.4 billion of net income, non-cash adjustments to net income of $16.2 billion and an increase in the net change in operating assets and liabilities of $11.7 billion. Cash +used in investing activities of $56.3 billion during 2015 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $44.4 billion and cash used to acquire property, plant and equipment of $11.2 billion. +Cash used in financing activities of $17.7 billion during 2015 consisted primarily of cash used to repurchase common stock of $35.3 billion and cash used to pay dividends and dividend equivalents of $11.6 billion, partially offset by net proceeds +from the issuance of term debt of $27.1 billion. During 2014, cash generated from operating activities of $59.7 billion was a result of $39.5 +billion of net income, non-cash adjustments to net income of $13.2 billion and an increase in net change in operating assets and liabilities of $7.0 billion. Cash used in investing activities of $22.6 billion during 2014 consisted primarily of cash +used for purchases of marketable securities, net of sales and maturities, of $9.0 billion; cash used to acquire property, plant and equipment of $9.6 billion; and cash paid for business acquisitions, net of cash acquired, of $3.8 billion. Cash used +in financing activities of $37.5 billion during 2014 consisted primarily of cash used to repurchase common stock of $45.0 billion and cash used to pay dividends and dividend equivalents of $11.1 billion, partially offset by net proceeds from the +issuance of term debt and commercial paper of $12.0 billion and $6.3 billion, respectively. Apple Inc. | 2015 Form 10-K | 30 Table of Contents Capital Assets The Company’s capital expenditures were $11.2 billion during 2015. The Company anticipates utilizing approximately $15.0 billion for capital +expenditures during 2016, which includes product tooling and manufacturing process equipment; data centers; corporate facilities and infrastructure, including information systems hardware, software and enhancements; and retail store facilities. Debt In 2014, the Board of Directors authorized the Company to +issue unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company intends to use the net proceeds from the commercial paper program for general corporate purposes, including dividends and +share repurchases. As of September 26, 2015, the Company had $8.5 billion of Commercial Paper outstanding, with a weighted-average interest rate of 0.14% and maturities generally less than nine months. As of September 26, 2015, the Company has outstanding floating- and fixed-rate notes for an aggregate principal amount of $55.7 billion +(collectively the “Notes”). The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on the Notes. In addition, the Company has entered, and in the future may enter, into currency swaps to +manage foreign currency risk on the Notes. The future principal payments for the Company’s Notes as of September 26, 2015 are as follows (in millions): 2016 $ 2,500 2017 3,500 2018 6,000 2019 3,775 2020 5,581 Thereafter 34,345 Total term debt $ 55,701 Further information regarding the Company’s debt issuances and related hedging activity can be found in Part II, +Item 8 of this Form 10-K in the Notes to the Consolidated Financial Statements in Note 2, “Financial Instruments” and Note 6, “Debt.” Capital Return Program In April 2015, the Company’s Board +of Directors increased the share repurchase program authorization from $90 billion to $140 billion of the Company’s common stock, increasing the expected total size of the capital return program to $200 billion. The Company expects to execute +the capital return program by the end of March 2017 by paying dividends and dividend equivalents, repurchasing shares and remitting withheld taxes related to net share settlement of restricted stock units. To assist in funding its capital return +program, the Company expects to continue to access the debt markets, both domestically and internationally. As of September 26, 2015, $104 billion of the share repurchase program has been utilized. The Company’s share repurchase program +does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of +1934, as amended. In April 2015, the Company’s Board of Directors raised the quarterly cash dividend by 11%. The Company plans to increase its +dividend on an annual basis subject to declaration by the Board of Directors. The following table presents the Company’s dividends, dividend +equivalents, share repurchases and net share settlement activity from the start of the capital return program in August 2012 through September 26, 2015 (in millions): Dividends and Dividend Equivalents Paid Accelerated Share Repurchases Open Market Share Repurchases Taxes Related to Settlement of Equity Awards Total 2015 $ 11,561 $ 6,000 $ 30,026 $ 1,499 $ 49,086 2014 11,126 21,000 24,000 1,158 57,284 2013 10,564 13,950 9,000 1,082 34,596 2012 2,488 0 0 56 2,544 Total $ 35,739 $ 40,950 $ 63,026 $ 3,795 $ 143,510 Apple Inc. | 2015 Form 10-K | 31 Table of Contents Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained +interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, +liquidity, market risk, or credit risk support to the Company, or engages in leasing, hedging, or R&D services with the Company. The following +table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 26, 2015, and excludes amounts already recorded on the Consolidated Balance Sheet, except for term debt (in +millions): Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Total Term debt $ 2,500 $ 9,500 $ 9,356 $ 34,345 $ 55,701 Operating leases 772 1,518 1,389 2,592 6,271 Purchase commitments 29,464 0 0 0 29,464 Other obligations 4,553 1,898 53 757 7,261 Total $ 37,289 $ 12,916 $ 10,798 $ 37,694 $ 98,697 Operating Leases The +Company’s major facility leases are typically for terms not exceeding 10 years and generally contain multi-year renewal options. As of September 26, 2015, the Company had a total of 463 retail stores. Leases for retail space are for terms +ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 26, 2015, the Company’s total future minimum lease payments under noncancelable operating leases were $6.3 +billion, of which $3.6 billion related to leases for retail space. Purchase Commitments The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing +of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. The Company also obtains individual components for its products +from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. Where +appropriate, the purchases are applied to inventory component prepayments that are outstanding with the respective supplier. As of September 26, 2015, the Company had outstanding off-balance sheet third-party +manufacturing commitments and component purchase commitments of $29.5 billion. Other Obligations The Company’s other off-balance sheet obligations were comprised of commitments to acquire capital assets, including product tooling and +manufacturing process equipment, and commitments related to inventory prepayments, advertising, licensing, R&D, internet and telecommunications services, energy and other obligations. The Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross unrecognized tax +benefits and the related gross interest and penalties. As of September 26, 2015, the Company had non-current deferred tax liabilities of $24.1 billion. Additionally, as of September 26, 2015, the Company had gross unrecognized tax benefits +of $6.9 billion and an additional $1.3 billion for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments in individual years in +connection with these tax liabilities; therefore, such amounts are not included in the above contractual obligation table. Indemnification The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes +third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the +Company or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application +software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of September 26, 2015 or September 27, 2014. Apple Inc. | 2015 Form 10-K | 32 Table of Contents In September 2015, the Company introduced the iPhone Upgrade Program, which is available to customers who +purchase an iPhone 6s and 6s Plus in one of its U.S. physical retail stores and activate the purchased iPhone with one of the four national carriers. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a new iPhone, +provided certain conditions are met. One of the conditions of this program requires the customer to finance the initial purchase price of the iPhone with a third-party lender. Upon exercise of the trade-in right and purchase of a new iPhone, the +Company satisfies the customer’s outstanding balance due to the third-party lender on the original device. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such +right with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its +directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance +expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of +prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations. Critical Accounting Policies and Estimates The preparation of +financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the +Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of Significant Accounting Policies,” of the Notes to +Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on +historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from +these estimates, and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those +related to revenue recognition, valuation and impairment of marketable securities, inventory valuation and valuation of manufacturing-related assets and estimated purchase commitment cancellation fees, warranty costs, income taxes, and legal and +other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about +inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Revenue Recognition Net sales consist primarily of revenue +from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed +or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria +are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company +retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price +is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the +functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software accounting +guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, +undelivered software elements that relate to the hardware product’s essential software and/or undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, +the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price +(“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the +Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. Apple Inc. | 2015 Form 10-K | 33 Table of Contents For sales of qualifying versions of iOS devices, Mac, Apple Watch and Apple TV, the Company has indicated it +may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the +non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and +recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. The +Company’s process for determining ESPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and +circumstances change, the Company’s ESPs and the future rate of related amortization for unspecified software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the +unspecified software upgrade rights and non-software services offered, the estimated value of unspecified software upgrade rights and non-software services and the estimated period unspecified software upgrades and non-software services are expected +to be provided. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive +programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition +have been met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, +the estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the +Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive +programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a +greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s operating results. Valuation and Impairment of Marketable Securities The +Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the +Company’s Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and +losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would +require the Company to record an impairment charge in the period any such determination is made. In making this judgment, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; +the financial condition of the issuer and any changes thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company’s +assessment on whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security, which would have an adverse impact on the Company’s operating +results. Inventory Valuation and Valuation of Manufacturing-Related Assets and Estimated Purchase Commitment Cancellation Fees The Company must purchase components and build inventory in advance of product shipments and has invested in manufacturing-related assets, including +capital assets held at its suppliers’ facilities. In addition, the Company has made prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory components. The Company records a write-down +for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory that considers +multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels and component cost trends. The Company also reviews its manufacturing-related capital assets and inventory prepayments for +impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value +of such an asset exceeds its fair value. The industries in which the Company competes are subject to a rapid and unpredictable pace of product and +component obsolescence and demand changes. In certain circumstances the Company may be required to record additional write-downs of inventory and/or manufacturing-related assets. These circumstances include future demand or market conditions for the +Company’s products being less favorable than forecasted, unforeseen technological changes or changes to the Company’s product development plans that negatively impact the utility of any of these assets, or significant deterioration in the +financial condition of one or more of the Company’s suppliers that hold any of the Company’s manufacturing-related assets or to whom the Company has made an inventory prepayment. Such write-downs would adversely affect the Company’s +financial condition and operating results in the period when the write-downs were recorded. Apple Inc. | 2015 Form 10-K | 34 Table of Contents The Company accrues for estimated cancellation fees related to inventory orders that have been cancelled or +are expected to be cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders in each case based on projected demand. Where appropriate, the purchases +are applied to inventory component prepayments that are outstanding with the respective supplier. Purchase commitments typically cover the Company’s forecasted component and manufacturing requirements for periods up to 150 +days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products, a change in the Company’s product development plans, or an unanticipated change in technological requirements for any of the +Company’s products, the Company may be required to record additional accruals for cancellation fees that would adversely affect its results of operations in the period when the cancellation fees are identified and recorded. Warranty Costs The Company accrues for the estimated cost of +warranties at the time the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim and knowledge of specific product failures that are outside of the Company’s typical +experience. The Company regularly reviews these estimates to assess the adequacy of its recorded warranty liabilities or the current installed base of products subject to warranty protection and adjusts the amounts as necessary. If actual product +failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect the Company’s financial condition and operating results. Income Taxes The Company records a tax provision for the +anticipated tax consequences of its reported operating results. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences +of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that +apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than +not to be realized. The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will +be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than +50% likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including income +that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all +or part of the net deferred tax assets are not realizable in the future, the Company will record an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax +liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material +impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the +Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it +is probable that a loss has been incurred and the amount is reasonably estimable. There is significant judgment required in both the probability determination and as to whether an exposure can be reasonably estimated. In the opinion of management, +there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of legal +proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the +Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. | 2015 Form 10-K | 35 Table of Contents Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory +nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses +related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in +interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in +U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid +on the Company’s debt. The Company’s investment policy and strategy are focused on preservation of capital and supporting the +Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly-rated securities, and its +investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the primary objective of minimizing the potential risk of principal loss. To provide a +meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment +portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 26, 2015 and September 27, 2014, a hypothetical 100 basis point increase in interest rates across all maturities would +result in a $4.3 billion and $3.4 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. As of September 26, 2015 and September 27, 2014, the Company had outstanding floating- and fixed-rate notes with varying maturities for an +aggregate carrying amount of $56.0 billion and $29.0 billion, respectively. The Company has entered, and may enter in the future, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the +Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on these instruments are generally offset by the corresponding losses and gains on the related +hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 26, 2015 and September 27, 2014 to increase by $200 million and $110 million on an annualized +basis, respectively. Further details regarding the Company’s debt is provided in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 6, “Debt.” Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a +strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency product pricing due to competitive pressures +when there have been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option +contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. +In addition, the Company has entered, and may enter in the future, into non-designated foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign-denominated debt issuances. The Company’s +practice is to hedge a portion of its material foreign exchange exposures, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to +accounting considerations and the prohibitive economic cost of hedging particular exposures. Apple Inc. | 2015 Form 10-K | 36 Table of Contents To provide a meaningful assessment of the foreign currency risk associated with certain of the +Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a +Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative +positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments and +assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence a maximum one-day loss in fair value of $342 million as of September 26, 2015 +compared to a maximum one-day loss in fair value of $240 million as of September 27, 2014. Because the Company uses foreign currency instruments for hedging purposes, the loss in fair value incurred on those instruments are generally offset by +increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio and +derivative positions may differ materially from the sensitivity analyses performed as of September 26, 2015 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency +exchanges rates and the Company’s actual exposures and positions. Apple Inc. | 2015 Form 10-K | 37 Table of Contents Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 26, 2015, September  +27, 2014, and September 28, 2013 39 Consolidated Statements of Comprehensive Income for the years ended September 26, 2015, September  +27, 2014, and September 28, 2013 40 Consolidated Balance Sheets as of September 26, 2015 and September 27, 2014 41 Consolidated Statements of Shareholders’ Equity for the years ended September 26, 2015, September  +27, 2014, and September 28, 2013 42 Consolidated Statements of Cash Flows for the years ended September 26, 2015, September  +27, 2014, and September 28, 2013 43 Notes to Consolidated Financial Statements 44 Selected Quarterly Financial Information (Unaudited) 68 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 69 All financial statement schedules have been omitted, since the required information is not applicable or is not present +in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. Apple Inc. | 2015 Form 10-K | 38 Table of Contents CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 26, 2015 September 27, 2014 September 28, 2013 Net sales $ 233,715 $ 182,795 $ 170,910 Cost of sales 140,089 112,258 106,606 Gross margin 93,626 70,537 64,304 Operating expenses: Research and development 8,067 6,041 4,475 Selling, general and administrative 14,329 11,993 10,830 Total operating expenses 22,396 18,034 15,305 Operating income 71,230 52,503 48,999 Other income/(expense), net 1,285 980 1,156 Income before provision for income taxes 72,515 53,483 50,155 Provision for income taxes 19,121 13,973 13,118 Net income $ 53,394 $ 39,510 $ 37,037 Earnings per share: Basic $ 9.28 $ 6.49 $ 5.72 Diluted $ 9.22 $ 6.45 $ 5.68 Shares used in computing earnings per share: Basic 5,753,421 6,085,572 6,477,320 Diluted 5,793,069 6,122,663 6,521,634 Cash dividends declared per share $ 1.98 $ 1.82 $ 1.64 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2015 Form 10-K | 39 Table of Contents CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 26, 2015 September 27, 2014 September 28, 2013 Net income $ 53,394 $ 39,510 $ 37,037 Other comprehensive income/(loss): Change in foreign currency translation, net of tax effects of $201, $50 and $35, respectively (411 ) (137 ) (112 ) Change in unrealized gains/losses on derivative instruments: Change in fair value of derivatives, net of tax benefit/(expense) of $(441), $(297) and $(351), respectively 2,905 1,390 522 Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $630, $(36) and $255, respectively (3,497 ) 149 (458 ) Total change in unrealized gains/losses on derivative instruments, net of tax (592 ) 1,539 64 Change in unrealized gains/losses on marketable securities: Change in fair value of marketable securities, net of tax benefit/(expense) of $264, $(153) and $458, respectively (483 ) 285 (791 ) Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $(32), $71 and $82, respectively 59 (134 ) (131 ) Total change in unrealized gains/losses on marketable securities, net of tax (424 ) 151 (922 ) Total other comprehensive income/(loss) (1,427 ) 1,553 (970 ) Total comprehensive income $ 51,967 $ 41,063 $ 36,067 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2015 Form 10-K | 40 Table of Contents CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 26, 2015 September 27, 2014 ASSETS: Current assets: Cash and cash equivalents $ 21,120 $ 13,844 Short-term marketable securities 20,481 11,233 Accounts receivable, less allowances of $82 and $86, respectively 16,849 17,460 Inventories 2,349 2,111 Deferred tax assets 5,546 4,318 Vendor non-trade receivables 13,494 9,759 Other current assets 9,539 9,806 Total current assets 89,378 68,531 Long-term marketable securities 164,065 130,162 Property, plant and equipment, net 22,471 20,624 Goodwill 5,116 4,616 Acquired intangible assets, net 3,893 4,142 Other assets 5,556 3,764 Total assets $ 290,479 $ 231,839 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 35,490 $ 30,196 Accrued expenses 25,181 18,453 Deferred revenue 8,940 8,491 Commercial paper 8,499 6,308 Current portion of long-term debt 2,500 0 Total current liabilities 80,610 63,448 Deferred revenue, non-current 3,624 3,031 Long-term debt 53,463 28,987 Other non-current liabilities 33,427 24,826 Total liabilities 171,124 120,292 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 5,578,753 and 5,866,161 shares issued and +outstanding, respectively 27,416 23,313 Retained earnings 92,284 87,152 Accumulated other comprehensive income (345 ) 1,082 Total shareholders’ equity 119,355 111,547 Total liabilities and shareholders’ equity $ 290,479 $ 231,839 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2015 Form 10-K | 41 Table of Contents CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands) Common Stock and Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders’ Equity Shares Amount Balances as of September 29, 2012 6,574,458 $ 16,422 $ 101,289 $ 499 $ 118,210 Net income 0 0 37,037 0 37,037 Other comprehensive income/(loss) 0 0 0 (970 ) (970 ) Dividends and dividend equivalents declared 0 0 (10,676 ) 0 (10,676 ) Repurchase of common stock (328,837 ) 0 (22,950 ) 0 (22,950 ) Share-based compensation 0 2,253 0 0 2,253 Common stock issued, net of shares withheld for employee taxes 48,873 (143 ) (444 ) 0 (587 ) Tax benefit from equity awards, including transfer pricing adjustments 0 1,232 0 0 1,232 Balances as of September 28, 2013 6,294,494 19,764 104,256 (471 ) 123,549 Net income 0 0 39,510 0 39,510 Other comprehensive income/(loss) 0 0 0 1,553 1,553 Dividends and dividend equivalents declared 0 0 (11,215 ) 0 (11,215 ) Repurchase of common stock (488,677 ) 0 (45,000 ) 0 (45,000 ) Share-based compensation 0 2,863 0 0 2,863 Common stock issued, net of shares withheld for employee taxes 60,344 (49 ) (399 ) 0 (448 ) Tax benefit from equity awards, including transfer pricing adjustments 0 735 0 0 735 Balances as of September 27, 2014 5,866,161 23,313 87,152 1,082 111,547 Net income 0 0 53,394 0 53,394 Other comprehensive income/(loss) 0 0 0 (1,427 ) (1,427 ) Dividends and dividend equivalents declared 0 0 (11,627 ) 0 (11,627 ) Repurchase of common stock (325,032 ) 0 (36,026 ) 0 (36,026 ) Share-based compensation 0 3,586 0 0 3,586 Common stock issued, net of shares withheld for employee taxes 37,624 (231 ) (609 ) 0 (840 ) Tax benefit from equity awards, including transfer pricing adjustments 0 748 0 0 748 Balances as of September 26, 2015 5,578,753 $ 27,416 $ 92,284 $ (345 ) $ 119,355 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2015 Form 10-K | 42 Table of Contents CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 26, 2015 September 27, 2014 September 28, 2013 Cash and cash equivalents, beginning of the year $ 13,844 $ 14,259 $ 10,746 Operating activities: Net income 53,394 39,510 37,037 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 11,257 7,946 6,757 Share-based compensation expense 3,586 2,863 2,253 Deferred income tax expense 1,382 2,347 1,141 Changes in operating assets and liabilities: Accounts receivable, net 611 (4,232 ) (2,172 ) Inventories (238 ) (76 ) (973 ) Vendor non-trade receivables (3,735 ) (2,220 ) 223 Other current and non-current assets (179 ) 167 1,080 Accounts payable 5,400 5,938 2,340 Deferred revenue 1,042 1,460 1,459 Other current and non-current liabilities 8,746 6,010 4,521 Cash generated by operating activities 81,266 59,713 53,666 Investing activities: Purchases of marketable securities (166,402 ) (217,128 ) (148,489 ) Proceeds from maturities of marketable securities 14,538 18,810 20,317 Proceeds from sales of marketable securities 107,447 189,301 104,130 Payments made in connection with business acquisitions, net (343 ) (3,765 ) (496 ) Payments for acquisition of property, plant and equipment (11,247 ) (9,571 ) (8,165 ) Payments for acquisition of intangible assets (241 ) (242 ) (911 ) Other (26 ) 16 (160 ) Cash used in investing activities (56,274 ) (22,579 ) (33,774 ) Financing activities: Proceeds from issuance of common stock 543 730 530 Excess tax benefits from equity awards 749 739 701 Taxes paid related to net share settlement of equity awards (1,499 ) (1,158 ) (1,082 ) Dividends and dividend equivalents paid (11,561 ) (11,126 ) (10,564 ) Repurchase of common stock (35,253 ) (45,000 ) (22,860 ) Proceeds from issuance of term debt, net 27,114 11,960 16,896 Change in commercial paper, net 2,191 6,306 0 Cash used in financing activities (17,716 ) (37,549 ) (16,379 ) Increase/(decrease) in cash and cash equivalents 7,276 (415 ) 3,513 Cash and cash equivalents, end of the year $ 21,120 $ 13,844 $ 14,259 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 13,252 $ 10,026 $ 9,128 Cash paid for interest $ 514 $ 339 $ 0 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2015 Form 10-K | 43 Table of Contents Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures and +markets mobile communication and media devices, personal computers and portable digital music players, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company +sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of +third-party Apple-compatible products, including application software and various accessories through its online and retail stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have +been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these +consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in these consolidated financial statements +and accompanying notes. Actual results could differ materially from those estimates. The Company’s fiscal year is the 52 or 53-week period that +ends on the last Saturday of September. The Company’s fiscal years 2015, 2014 and 2013 ended on September 26, 2015, September 27, 2014 and September 28, 2013, respectively. An additional week is included in the first fiscal +quarter approximately every six years to realign fiscal quarters with calendar quarters. Fiscal years 2015, 2014 and 2013 each spanned 52 weeks. Unless otherwise stated, references to particular years, quarters, months and periods refer to the +Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service +and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once +it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to +education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of +the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on +comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance +with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, +(ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For +the sale of most third-party products, the Company recognizes revenue based on the gross amount billed to customers because the Company establishes its own pricing for such products, retains related inventory risk for physical products, is the +primary obligor to the customer and assumes the credit risk for amounts billed to its customers. For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does +not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of +the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. Apple Inc. | 2015 Form 10-K | 44 Table of Contents The Company records deferred revenue when it receives payments in advance of the delivery of products or the +performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at +its retail and online stores, and also sells gift cards redeemable on iTunes Store, App Store, Mac App Store and iBooks Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is +relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone +support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited warranty. The Company +records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For +the Company’s other customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records +reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded +as current liabilities until remitted to the relevant government authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered +software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses +a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and +(iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best +estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For multi-element arrangements accounted for in accordance with industry specific software accounting guidance, the Company allocates +revenue to all deliverables based on the VSOE of each element, and if VSOE does not exist revenue is recognized when elements lacking VSOE are delivered. For sales of qualifying versions of iPhone, iPad and iPod touch (“iOS devices”), Mac, Apple Watch and Apple TV, the Company has indicated it +may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. The Company has identified up to three deliverables regularly included in arrangements involving +the sale of these devices. The first deliverable, which represents the substantial portion of the allocated sales price, is the hardware and software essential to the functionality of the hardware device delivered at the time of sale. The second +deliverable is the embedded right included with qualifying devices to receive on a when-and-if-available basis, future unspecified software upgrades relating to the product’s essential software. The third deliverable is the non-software +services to be provided to qualifying devices. The Company allocates revenue between these deliverables using the relative selling price method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based +on the Company’s ESPs. Revenue allocated to the delivered hardware and the related essential software is recognized at the time of sale provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded +unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. Cost of sales related to +delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and +marketing costs are recognized as operating expenses as incurred. The Company’s process for determining its ESP for deliverables without VSOE +or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable including, where applicable, prices charged by the Company and market trends in the pricing for similar offerings, product +specific business objectives, length of time a particular version of a device has been available, estimated cost to provide the non-software services and the relative ESP of the upgrade rights and non-software services as compared to the total +selling price of the product. Beginning in September 2015, the Company reduced the combined ESPs for iOS devices and Mac between $5 and $10 to +reflect the increase in competitive offers for similar products at little to no cost for users, which reduces the amount the Company could reasonably charge for these deliverables on a standalone basis. Shipping Costs Amounts billed to customers related to shipping +and handling are classified as revenue, and the Company’s shipping and handling costs are classified as cost of sales. Apple Inc. | 2015 Form 10-K | 45 Table of Contents Warranty Costs The Company generally provides for the estimated cost of hardware and software warranties at the time the related revenue is recognized. The Company +assesses the adequacy of its accrued warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. Software Development Costs Research and development +(“R&D”) costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and +ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established and as a result software development costs were expensed as +incurred. Advertising Costs Advertising costs are +expensed as incurred and included in selling, general and administrative expenses. Advertising expense was $1.8 billion, $1.2 billion and $1.1 billion for 2015, 2014 and 2013, respectively. Share-based Compensation The Company recognizes expense +related to share-based payment transactions in which it receives employee services in exchange for (a) equity instruments of the Company or (b) liabilities that are based on the fair value of the Company’s equity instruments or that +may be settled by the issuance of such equity instruments. Share-based compensation cost for restricted stock and restricted stock units (“RSUs”) is measured based on the closing fair market value of the Company’s common stock on the +date of grant. The Company recognizes share-based compensation cost over the award’s requisite service period on a straight-line basis for time-based RSUs and on a graded basis for RSUs that are contingent on the achievement of performance +conditions. The Company recognizes a benefit from share-based compensation in the Consolidated Statements of Shareholders’ Equity if an excess tax benefit is realized. In addition, the Company recognizes the indirect effects of share-based +compensation on R&D tax credits, foreign tax credits and domestic manufacturing deductions in the Consolidated Statements of Operations. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Income Taxes The provision for income taxes is computed +using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and for +operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be +realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on +examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood +of being realized upon settlement. See Note 5, “Income Taxes” for additional information. Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock +outstanding during the period. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of +additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased under the Company’s employee +stock purchase plan, unvested restricted stock and unvested RSUs. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an +increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. Apple Inc. | 2015 Form 10-K | 46 Table of Contents The following table shows the computation of basic and diluted earnings per share for 2015, 2014 and 2013 +(net income in millions and shares in thousands): 2015 2014 2013 Numerator: Net income $ 53,394 $ 39,510 $ 37,037 Denominator: Weighted-average shares outstanding 5,753,421 6,085,572 6,477,320 Effect of dilutive securities 39,648 37,091 44,314 Weighted-average diluted shares 5,793,069 6,122,663 6,521,634 Basic earnings per share $ 9.28 $ 6.49 $ 5.72 Diluted earnings per share $ 9.22 $ 6.45 $ 5.68 Potentially dilutive securities whose effect would have been antidilutive are excluded from the computation of diluted +earnings per share. Financial Instruments Cash Equivalents and +Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash +equivalents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the appropriate +classification of its investments at the time of purchase and reevaluates the classifications at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s +underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. Marketable equity +securities, including mutual funds, are classified as either short-term or long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity securities are carried at +fair value, with unrealized gains and losses, net of taxes, reported as a component of accumulated other comprehensive income (“AOCI”) in shareholders’ equity, with the exception of unrealized losses believed to be +other-than-temporary which are reported in earnings in the current period. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its +derivative instruments as either assets or liabilities and carries them at fair value. For derivative instruments that hedge the exposure to +variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of AOCI in shareholders’ equity and reclassified into earnings +in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized in earnings in the current period. To receive hedge accounting +treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge +effectiveness and are recognized in earnings. For derivative instruments that hedge the exposure to changes in the fair value of an asset or a +liability and that are designated as fair value hedges, both the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item are recognized in earnings in the current period. For derivative instruments and foreign currency debt that hedge the exposure to changes in foreign currency exchange rates used for translation of the +net investment in a foreign operation and that are designated as a net investment hedge, the net gain or loss on the effective portion of the derivative instrument is reported in the same manner as a foreign currency translation adjustment. For +forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this +forward carry component are recognized in earnings in the current period. Derivatives that do not qualify as hedges are adjusted to fair value +through earnings in the current period. Apple Inc. | 2015 Form 10-K | 47 Table of Contents Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors, including historical experience, age of the accounts +receivable balances, credit quality of the Company’s customers, current economic conditions and other factors that may affect the customers’ ability to pay. Inventories Inventories are stated at the lower of cost, +computed using the first-in, first-out method and net realizable value. Any adjustments to reduce the cost of inventories to their net realizable value are recognized in earnings in the current period. As of September 26, 2015 and +September 27, 2014, the Company’s inventories consist primarily of finished goods. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over +the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between one to five years for machinery and equipment, including product tooling and manufacturing process +equipment; and the shorter of lease terms or ten years for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs +related to internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which range from three to five years. Depreciation and amortization expense on property and equipment was $9.2 billion, $6.9 +billion and $5.8 billion during 2015, 2014 and 2013, respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment, inventory component prepayments and certain identifiable intangibles, excluding goodwill, for +impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts +to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment, inventory component prepayments and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the +amount by which the carrying value of the assets exceeds its fair value. The Company does not amortize goodwill and intangible assets with +indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible +asset impairment tests in the fourth quarter of each year. The Company did not recognize any impairment charges related to goodwill or indefinite lived intangible assets during 2015, 2014 and 2013. The Company established reporting units based on +its current reporting structure. For purposes of testing goodwill for impairment, goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. In 2015 and 2014, the Company’s goodwill was primarily +allocated to the Americas and Europe reporting units. The Company amortizes its intangible assets with definite useful lives over their estimated +useful lives and reviews these assets for impairment. The Company typically amortizes its acquired intangible assets with definite useful lives over periods from three to seven years. Fair Value Measurements The Company applies fair value +accounting for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be +received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded +at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as +risks inherent in valuation techniques, transfer restrictions and credit risk. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within +the hierarchy upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active markets +for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and +liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants +would use in pricing the asset or liability. Apple Inc. | 2015 Form 10-K | 48 Table of Contents The Company’s valuation techniques used to measure the fair value of money market funds and certain +marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, +all of which have counterparties with high credit ratings, were valued based on quoted market prices or model driven valuations using significant inputs derived from or corroborated by observable market data. In accordance with the fair value accounting requirements, companies may choose to measure eligible financial instruments and certain other items at fair +value. The Company has not elected the fair value option for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect +at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in +AOCI in shareholders’ equity. The Company’s subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property and +nonmonetary assets and liabilities at historical rates. Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short- or long-term marketable securities as of September 26, 2015 and +September 27, 2014 (in millions): 2015 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 11,389 $ 0 $ 0 $ 11,389 $ 11,389 $ 0 $ 0 Level 1: Money market funds 1,798 0 0 1,798 1,798 0 0 Mutual funds 1,772 0 (144 ) 1,628 0 1,628 0 Subtotal 3,570 0 (144 ) 3,426 1,798 1,628 0 Level 2: U.S. Treasury securities 34,902 181 (1 ) 35,082 0 3,498 31,584 U.S. agency securities 5,864 14 0 5,878 841 767 4,270 Non-U.S. government securities 6,356 45 (167 ) 6,234 43 135 6,056 Certificates of deposit and time deposits 4,347 0 0 4,347 2,065 1,405 877 Commercial paper 6,016 0 0 6,016 4,981 1,035 0 Corporate securities 116,908 242 (985 ) 116,165 3 11,948 104,214 Municipal securities 947 5 0 952 0 48 904 Mortgage- and asset-backed securities 16,121 87 (31 ) 16,177 0 17 16,160 Subtotal 191,461 574 (1,184 ) 190,851 7,933 18,853 164,065 Total $ 206,420 $ 574 $ (1,328 ) $ 205,666 $ 21,120 $ 20,481 $ 164,065 Apple Inc. | 2015 Form 10-K | 49 Table of Contents 2014 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 10,232 $ 0 $ 0 $ 10,232 $ 10,232 $ 0 $ 0 Level 1: Money market funds 1,546 0 0 1,546 1,546 0 0 Mutual funds 2,531 1 (132 ) 2,400 0 2,400 0 Subtotal 4,077 1 (132 ) 3,946 1,546 2,400 0 Level 2: U.S. Treasury securities 23,140 15 (9 ) 23,146 12 607 22,527 U.S. agency securities 7,373 3 (11 ) 7,365 652 157 6,556 Non-U.S. government securities 6,925 69 (69 ) 6,925 0 204 6,721 Certificates of deposit and time deposits 3,832 0 0 3,832 1,230 1,233 1,369 Commercial paper 475 0 0 475 166 309 0 Corporate securities 85,431 296 (241 ) 85,486 6 6,298 79,182 Municipal securities 940 8 0 948 0 0 948 Mortgage- and asset-backed securities 12,907 26 (49 ) 12,884 0 25 12,859 Subtotal 141,023 417 (379 ) 141,061 2,066 8,833 130,162 Total $ 155,332 $ 418 $ (511 ) $ 155,239 $ 13,844 $ 11,233 $ 130,162 The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons +including, but not limited to, anticipation of credit deterioration and duration management. The maturities of the Company’s long-term marketable securities generally range from one to five years. As of September 26, 2015, the Company considers the declines in market value of its marketable securities investment portfolio to be temporary in +nature and does not consider any of its investments other-than-temporarily impaired. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy +generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment +for other-than-temporary impairment the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates +and the Company’s intent to sell, or whether it is more likely than not it will be required to sell the investment before recovery of the investment’s cost basis. Derivative Financial Instruments The Company may use +derivatives to partially offset its business exposure to foreign currency and interest rate risk on expected future cash flows, on net investments in certain foreign subsidiaries and on certain existing assets and liabilities. However, the Company +may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than +a portion of the financial impact resulting from movements in foreign currency exchange or interest rates. To help protect gross margins from +fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar may hedge a portion of forecasted foreign currency revenue, and subsidiaries whose functional currency is not +the U.S. dollar and who sell in local currencies may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company may enter into forward contracts, option contracts or other +instruments to manage this risk and may designate these instruments as cash flow hedges. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 +months. To help protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the Company may enter +into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. In addition, the Company may use non-derivative financial instruments, such +as its foreign currency-denominated debt, as economic hedges of its net investments in certain foreign subsidiaries. In both of these cases, the Company designates these instruments as net investment hedges. Apple Inc. | 2015 Form 10-K | 50 Table of Contents The Company may also enter into non-designated foreign currency contracts to partially offset the foreign +currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. The +Company may enter into interest rate swaps, options, or other instruments to manage interest rate risk. These instruments may offset a portion of changes in income or expense, or changes in fair value of the Company’s term debt or investments. +The Company designates these instruments as either cash flow or fair value hedges. The Company’s hedged interest rate transactions as of September 26, 2015 are expected to be recognized within 10 years. Cash Flow Hedges The effective portions of cash flow hedges +are recorded in AOCI until the hedged item is recognized in earnings. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is +recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow +hedges of interest income or expense are recognized in other income/(expense), net in the same period as the related income or expense is recognized. The ineffective portions and amounts excluded from the effectiveness testing of cash flow hedges +are recognized in other income/(expense), net. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is +probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified +immediately into other income/(expense), net. Any subsequent changes in fair value of such derivative instruments are reflected in other income/(expense), net unless they are re-designated as hedges of other transactions. Net Investment Hedges The effective portions of net investment +hedges are recorded in other comprehensive income (“OCI”) as a part of the cumulative translation adjustment. The ineffective portions and amounts excluded from the effectiveness testing of net investment hedges are recognized in other +income/(expense), net. Fair Value Hedges Gains and losses +related to changes in fair value hedges are recognized in earnings along with a corresponding loss or gain related to the change in value of the underlying hedged item. Non-Designated Derivatives Derivatives that are not designated +as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. The Company +records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these derivative instruments is based on its hedge designation. The following tables show the Company’s derivative instruments +at gross fair value as of September 26, 2015 and September 27, 2014 (in millions): 2015 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,442 $ 109 $ 1,551 Interest rate contracts $ 394 $ 0 $ 394 Derivative liabilities (2) : Foreign exchange contracts $ 905 $ 94 $ 999 Interest rate contracts $ 13 $ 0 $ 13 Apple Inc. | 2015 Form 10-K | 51 Table of Contents 2014 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,332 $ 222 $ 1,554 Interest rate contracts $ 81 $ 0 $ 81 Derivative liabilities (2) : Foreign exchange contracts $ 41 $ 40 $ 81 (1) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the Consolidated Balance Sheets. (2) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the Consolidated Balance Sheets. The following table shows the pre-tax gains and losses of the Company’s derivative and non-derivative +instruments designated as cash flow, net investment and fair value hedges on OCI and the Consolidated Statements of Operations for 2015, 2014 and 2013 (in millions): 2015 2014 2013 Gains/(Losses) recognized in OCI – effective portion: Cash flow hedges: Foreign exchange contracts $ 3,592 $ 1,750 $ 891 Interest rate contracts (111 ) (15 ) 12 Total $ 3,481 $ 1,735 $ 903 Net investment hedges: Foreign exchange contracts $ 167 $ 53 $ 143 Foreign currency debt (71 ) 0 0 Total $ 96 $ 53 $ 143 Gains/(Losses) reclassified from AOCI into net income – effective portion: Cash flow hedges: Foreign exchange contracts $ 4,092 $ (154 ) $ 676 Interest rate contracts (17 ) (16 ) (6 ) Total $ 4,075 $ (170 ) $ 670 Gains/(Losses) on derivative instruments: Fair value hedges: Interest rate contracts $ 337 $ 39 $ 0 Gains/(Losses) related to hedged items: Fair value hedges: Interest rate contracts $ (337 ) $ (39 ) $ 0 The following table shows the notional amounts of the Company’s outstanding derivative instruments and credit risk +amounts associated with outstanding or unsettled derivative instruments as of September 26, 2015 and September 27, 2014 (in millions): 2015 2014 Notional Amount Credit Risk Amount Notional Amount Credit Risk Amount Instruments designated as accounting hedges: Foreign exchange contracts $ 70,054 $ 1,385 $ 42,945 $ 1,333 Interest rate contracts $ 18,750 $ 394 $ 12,000 $ 89 Instruments not designated as accounting hedges: Foreign exchange contracts $ 49,190 $ 109 $ 38,510 $ 222 Apple Inc. | 2015 Form 10-K | 52 Table of Contents The notional amounts for outstanding derivative instruments provide one measure of the transaction volume +outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or +unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s exposure to credit loss +and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with +the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market +conditions during the remaining life of the instruments. The Company generally enters into master netting arrangements, which are designed to reduce +credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net +fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values in its Consolidated Balance Sheets. The net cash +collateral received by the Company related to derivative instruments under its collateral security arrangements was $1.0 billion as of September 26, 2015 and $2.1 billion as of September 27, 2014. Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net +settle transactions with a single net amount payable by one party to the other. As of September 26, 2015 and September 27, 2014, the potential effects of these rights of set-off associated with the Company’s derivative contracts, +including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $2.2 billion and $1.6 billion, respectively, resulting in net derivative liabilities of $78 million and $549 +million, respectively. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, value-added resellers, +small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in certain instances to limit credit risk. In +addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing +arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 26, 2015, the Company had one customer that represented 10% or more of total trade receivables, which accounted for 12%. As of +September 27, 2014, the Company had two customers that represented 10% or more of total trade receivables, one of which accounted for 16% and the other 13%. The Company’s cellular network carriers accounted for 71% and 72% of trade +receivables as of September 26, 2015 and September 27, 2014, respectively. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture +sub-assemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. Vendor non-trade receivables from three of the Company’s vendors accounted for 38%, 18% and 14% of total vendor non-trade +receivables as of September 26, 2015 and three of the Company’s vendors accounted for 51%, 16% and 14% of total vendor non-trade receivables as of September 27, 2014. Note 3 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 26, 2015 and +September 27, 2014 (in millions): Property, Plant and Equipment, Net 2015 2014 Land and buildings $ 6,956 $ 4,863 Machinery, equipment and internal-use software 37,038 29,639 Leasehold improvements 5,263 4,513 Gross property, plant and equipment 49,257 39,015 Accumulated depreciation and amortization (26,786 ) (18,391 ) Total property, plant and equipment, net $ 22,471 $ 20,624 Apple Inc. | 2015 Form 10-K | 53 Table of Contents Other Non-Current Liabilities 2015 2014 Deferred tax liabilities $ 24,062 $ 20,259 Other non-current liabilities 9,365 4,567 Total other non-current liabilities $ 33,427 $ 24,826 Other Income/(Expense), Net The following table shows the detail of other income/(expense), net for 2015, 2014 and 2013 (in millions): 2015 2014 2013 Interest and dividend income $ 2,921 $ 1,795 $ 1,616 Interest expense (733 ) (384 ) (136 ) Other expense, net (903 ) (431 ) (324 ) Total other income/(expense), net $ 1,285 $ 980 $ 1,156 Note 4 – Goodwill and Other Intangible Assets On July 31, 2014, the Company completed the acquisitions of Beats Music, LLC, which offers a subscription streaming music service, +and Beats Electronics, LLC, which makes Beats ® headphones, speakers and audio software (collectively, “Beats”). The total purchase price consideration for these acquisitions was $2.6 +billion, which consisted primarily of cash, of which $2.2 billion was allocated to goodwill, $636 million to acquired intangible assets and $258 million to net liabilities assumed. Concurrent with the close of the acquisitions, the Company repaid +$295 million of existing Beats outstanding debt to third-party creditors. In conjunction with the Beats acquisitions, the Company issued approximately 5.1 million shares of its common stock to certain former equity holders of Beats. The +restricted stock was valued at approximately $485 million based on the Company’s common stock on the acquisition date. The majority of these shares, valued at approximately $417 million, will vest over time based on continued employment with +Apple. The Company also completed various other business acquisitions during 2014 for an aggregate cash consideration, net of cash acquired, of $957 +million, of which $828 million was allocated to goodwill, $257 million to acquired intangible assets and $128 million to net liabilities assumed. The Company’s acquired intangible assets with definite useful lives primarily consist of patents and licenses and are amortized over periods +typically from three to seven years. The following table summarizes the components of gross and net intangible asset balances as of September 26, 2015 and September 27, 2014 (in millions): 2015 2014 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite-lived and amortizable acquired intangible assets $ 8,125 $ (4,332 ) $ 3,793 $ 7,127 $ (3,085 ) $ 4,042 Indefinite-lived and non-amortizable acquired intangible assets 100 0 100 100 0 100 Total acquired intangible assets $ 8,225 $ (4,332 ) $ 3,893 $ 7,227 $ (3,085 ) $ 4,142 Amortization expense related to acquired intangible assets was $1.3 billion, $1.1 billion and $960 million in 2015, 2014 +and 2013, respectively. As of September 26, 2015, the remaining weighted-average amortization period for acquired intangible assets is 3.6 years. The expected annual amortization expense related to acquired intangible assets as of +September 26, 2015, is as follows (in millions): 2016 $ 1,288 2017 1,033 2018 786 2019 342 2020 166 Thereafter 178 Total $ 3,793 Apple Inc. | 2015 Form 10-K | 54 Table of Contents Note 5 – Income Taxes The provision for income taxes for 2015, 2014 and 2013, consisted of the following (in millions): 2015 2014 2013 Federal: Current $ 11,730 $ 8,624 $ 9,334 Deferred 3,408 3,183 1,878 15,138 11,807 11,212 State: Current 1,265 855 1,084 Deferred (220 ) (178 ) (311 ) 1,045 677 773 Foreign: Current 4,744 2,147 1,559 Deferred (1,806 ) (658 ) (426 ) 2,938 1,489 1,133 Provision for income taxes $ 19,121 $ 13,973 $ 13,118 The foreign provision for income taxes is based on foreign pre-tax earnings of $47.6 billion, $33.6 billion and $30.5 +billion in 2015, 2014 and 2013, respectively. The Company’s consolidated financial statements provide for any related tax liability on undistributed earnings that the Company does not intend to be indefinitely reinvested outside the U.S. +Substantially all of the Company’s undistributed international earnings intended to be indefinitely reinvested in operations outside the U.S. were generated by subsidiaries organized in Ireland, which has a statutory tax rate of 12.5%. As of +September 26, 2015, U.S. income taxes have not been provided on a cumulative total of $91.5 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be $30.0 billion. As of September 26, 2015 and September 27, 2014, $186.9 billion and $137.1 billion, respectively, of the Company’s cash, cash +equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income +taxation on repatriation to the U.S. A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal +income tax rate (35% in 2015, 2014 and 2013) to income before provision for income taxes for 2015, 2014 and 2013, is as follows (dollars in millions): 2015 2014 2013 Computed expected tax $ 25,380 $ 18,719 $ 17,554 State taxes, net of federal effect 680 469 508 Indefinitely invested earnings of foreign subsidiaries (6,470 ) (4,744 ) (4,614 ) Domestic production activities deduction (426 ) (495 ) (308 ) Research and development credit, net (171 ) (88 ) (287 ) Other 128 112 265 Provision for income taxes $ 19,121 $ 13,973 $ 13,118 Effective tax rate 26.4% 26.1% 26.2% The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan awards. For stock +options, the Company receives an income tax benefit calculated as the tax effect of the difference between the fair market value of the stock issued at the time of the exercise and the exercise price. For RSUs, the Company receives an income +tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. The Company had net excess tax benefits from equity awards of $748 million, $706 million and $643 million in 2015, 2014 and 2013, +respectively, which were reflected as increases to common stock. Apple Inc. | 2015 Form 10-K | 55 Table of Contents As of September 26, 2015 and September 27, 2014, the significant components of the Company’s +deferred tax assets and liabilities were (in millions): 2015 2014 Deferred tax assets: Accrued liabilities and other reserves $ 4,205 $ 3,326 Basis of capital assets and investments 2,238 898 Deferred revenue 1,941 1,787 Deferred cost sharing 667 0 Share-based compensation 575 454 Unrealized losses 564 130 Other 721 227 Total deferred tax assets, net of valuation allowance of $0 10,911 6,822 Deferred tax liabilities: Unremitted earnings of foreign subsidiaries 26,868 21,544 Other 303 398 Total deferred tax liabilities 27,171 21,942 Net deferred tax liabilities $ (16,260 ) $ (15,120 ) Deferred tax assets and liabilities reflect the effects of tax losses, credits and the future income tax effects of +temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those +temporary differences are expected to be recovered or settled. Uncertain Tax Positions Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position will be sustained +upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit +that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one year as +non-current liabilities in the Consolidated Balance Sheets. As of September 26, 2015, the total amount of gross unrecognized tax benefits was +$6.9 billion, of which $2.5 billion, if recognized, would affect the Company’s effective tax rate. As of September 27, 2014, the total amount of gross unrecognized tax benefits was $4.0 billion, of which $1.4 billion, if recognized, would +affect the Company’s effective tax rate. The aggregate changes in the balance of gross unrecognized tax benefits, which excludes interest and +penalties, for 2015, 2014 and 2013, is as follows (in millions): 2015 2014 2013 Beginning Balance $ 4,033 $ 2,714 $ 2,062 Increases related to tax positions taken during a prior year 2,056 1,295 745 Decreases related to tax positions taken during a prior year (345 ) (280 ) (118 ) Increases related to tax positions taken during the current year 1,278 882 626 Decreases related to settlements with taxing authorities (109 ) (574 ) (592 ) Decreases related to expiration of statute of limitations (13 ) (4 ) (9 ) Ending Balance $ 6,900 $ 4,033 $ 2,714 The Company includes interest and penalties related to unrecognized tax benefits within the provision for income taxes. +As of September 26, 2015 and September 27, 2014, the total amount of gross interest and penalties accrued was $1.3 billion and $630 million, respectively, which is classified as non-current liabilities in the Consolidated Balance Sheets. +In connection with tax matters, the Company recognized interest and penalty expense in 2015, 2014 and 2013 of $709 million, $40 million and $189 million, respectively. Apple Inc. | 2015 Form 10-K | 56 Table of Contents The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many +state and foreign jurisdictions. The U.S. Internal Revenue Service (the “IRS”) is currently examining the years 2010 through 2012, and all years prior to 2010 are closed. In addition, the Company is subject to audits by state, local and +foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 2003 generally remain open and could be subject to examination by the taxing authorities. Management believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax +audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes +in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company does not believe it is reasonably possible that its unrecognized tax benefits would materially change in the next +12 months. On June 11, 2014, the European Commission issued an opening decision initiating a formal investigation against Ireland for +alleged state aid to the Company. The opening decision concerns the allocation of profits for taxation purposes of the Irish branches of two subsidiaries of the Company. The Company believes the European Commission’s assertions are without +merit. If the European Commission were to conclude against Ireland, the European Commission could require Ireland to recover from the Company past taxes covering a period of up to 10 years reflective of the disallowed state aid. While such amount +could be material, as of September 26, 2015 the Company is unable to estimate the impact. Note 6 – Debt Commercial Paper In 2014, the Board of +Directors authorized the Company to issue unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company intends to use net proceeds from the commercial paper program for general corporate +purposes, including dividends and share repurchases. As of September 26, 2015 and September 27, 2014, the Company had $8.5 billion and $6.3 billion of Commercial Paper outstanding, respectively, with a weighted-average interest rate of +0.14% and 0.12%, respectively, and maturities generally less than nine months. The following table provides a summary of cash flows associated with +the issuance and maturities of Commercial Paper for 2015 and 2014 (in millions): 2015 2014 Maturities less than 90 days: Proceeds from (repayments of) commercial paper, net $ 5,293 $ 1,865 Maturities greater than 90 days: Proceeds from commercial paper 3,851 4,771 Repayments of commercial paper (6,953 ) (330 ) Maturities greater than 90 days, net (3,102 ) 4,441 Total change in commercial paper, net $ 2,191 $ 6,306 Long-Term Debt As of +September 26, 2015, the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $55.7 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and +interest is payable in arrears, quarterly for the U.S. dollar-denominated and Australian dollar-denominated floating-rate notes, semi-annually for the U.S. dollar-denominated, Australian dollar-denominated, British pound-denominated and Japanese +yen-denominated fixed-rate notes and annually for the euro-denominated and Swiss franc-denominated fixed-rate notes. Apple Inc. | 2015 Form 10-K | 57 Table of Contents The following table provides a summary of the Company’s term debt as of September 26, 2015 and +September 27, 2014: 2015 2014 Maturities Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 debt issuance of $17.0 billion: Floating-rate notes 2016 – 2018 $ 3,000 0.51% – 1.10% $ 3,000 0.51% – 1.10% Fixed-rate 0.45% – 3.85% notes 2016 – 2043 14,000 0.51% – 3.91% 14,000 0.51% – 3.91% 2014 debt issuance of $12.0 billion: Floating-rate notes 2017 – 2019 2,000 0.37% – 0.60% 2,000 0.31% – 0.54% Fixed-rate 1.05% – 4.45% notes 2017 – 2044 10,000 0.37% – 4.48% 10,000 0.30% – 4.48% First quarter 2015 euro-denominated debt issuance of € 2.8 billion: Fixed-rate 1.000% notes 2022 1,558 2.94% 0 0 Fixed-rate 1.625% notes 2026 1,558 3.45% 0 0 Second quarter 2015 debt issuance of $6.5 billion: Floating-rate notes 2020 500 0.56% 0 0 Fixed-rate 1.55% notes 2020 1,250 0.56% 0 0 Fixed-rate 2.15% notes 2022 1,250 0.87% 0 0 Fixed-rate 2.50% notes 2025 1,500 2.60% 0 0 Fixed-rate 3.45% notes 2045 2,000 3.58% 0 0 Second quarter 2015 Swiss franc-denominated debt issuance of SFr1.25 billion: Fixed-rate 0.375% notes 2024 895 0.28% 0 0 Fixed-rate 0.750% notes 2030 384 0.74% 0 0 Third quarter 2015 debt issuance of $8.0 billion: Floating-rate notes 2017 250 0.36% 0 0 Floating-rate notes 2020 500 0.61% 0 0 Fixed-rate 0.900% notes 2017 750 0.35% 0 0 Fixed-rate 2.000% notes 2020 1,250 0.61% 0 0 Fixed-rate 2.700% notes 2022 1,250 0.99% 0 0 Fixed-rate 3.200% notes 2025 2,000 1.22% 0 0 Fixed-rate 4.375% notes 2045 2,000 4.40% 0 0 Third quarter 2015 Japanese yen-denominated debt issuance of ¥250.0 billion: Fixed-rate 0.35% notes 2020 2,081 0.35% 0 0 Fourth quarter 2015 British pound-denominated debt issuance of £1.25 billion: Fixed-rate 3.05% notes 2029 1,148 3.79% 0 0 Fixed-rate 3.60% notes 2042 766 4.51% 0 0 Fourth quarter 2015 Australian dollar-denominated debt issuance of A$2.25 billion: Floating-rate notes 2019 493 1.87% 0 0 Fixed-rate 2.85% notes 2019 282 1.89% 0 0 Fixed-rate 3.70% notes 2022 810 2.79% 0 0 Fourth quarter 2015 euro-denominated debt issuance of € 2.0 billion: Fixed-rate 1.375% notes 2024 1,113 3.30% 0 0 Fixed-rate 2.000% notes 2027 1,113 3.85% 0 0 Total term debt 55,701 29,000 Unamortized discount (114 ) (52 ) Hedge accounting fair value adjustments 376 39 Less: Current portion of long-term debt (2,500 ) 0 Total long-term debt $ 53,463 $ 28,987 To manage foreign currency risk associated with the euro-denominated notes issued in the first quarter of 2015 and the +British pound-denominated, Australian dollar-denominated and euro-denominated notes issued in the fourth quarter of 2015, the Company entered into currency swaps with an aggregate notional amount of $3.5 billion, $1.9 billion, $1.6 billion and $2.2 +billion, respectively, which effectively converted these notes to U.S. dollar-denominated notes. Apple Inc. | 2015 Form 10-K | 58 Table of Contents To manage interest rate risk on the U.S. dollar-denominated fixed-rate notes issued in the second quarter of +2015 and maturing in 2020 and 2022, the Company entered into interest rate swaps with an aggregate notional amount of $2.5 billion. To manage interest rate risk on the U.S. dollar-denominated fixed-rate notes issued in the third quarter of 2015 and +maturing in 2017, 2020, 2022 and 2025, the Company entered into interest rate swaps with an aggregate notional amount of $4.3 billion. These interest rate swaps effectively converted the fixed interest rates on the U.S. dollar-denominated notes to a +floating interest rate. As of September 26, 2015, ¥250.0 billion of the Japanese yen-denominated notes was designated as a hedge of the +foreign currency exposure of its net investment in a foreign operation. The foreign currency transaction gain or loss on the Japanese yen-denominated debt designated as a hedge is recorded in OCI as a part of the cumulative translation adjustment. +As of September 26, 2015, the carrying value of the debt designated as a net investment hedge was $2.1 billion. For further discussion +regarding the Company’s use of derivative instruments see the Derivative Financial Instruments section of Note 2, “Financial Instruments.” The effective interest rates for the Notes include the interest on the Notes, amortization of the discount and, if applicable, adjustments related to +hedging. The Company recognized $722 million, $381 million and $136 million of interest expense on its term debt for 2015, 2014 and 2013, respectively. The future principal payments for the Company’s Notes as of September 26, 2015 are as follows (in millions): 2016 $ 2,500 2017 3,500 2018 6,000 2019 3,775 2020 5,581 Thereafter 34,345 Total term debt $ 55,701 As of September 26, 2015 and September 27, 2014, the fair value of the Company’s Notes, based on +Level 2 inputs, was $54.9 billion and $28.5 billion, respectively. Note 7 – Shareholders’ Equity Dividends The Company declared and paid cash +dividends per share during the periods presented as follows: Dividends Per Share Amount (in millions) 2015: Fourth quarter $ 0.52 $ 2,950 Third quarter 0.52 2,997 Second quarter 0.47 2,734 First quarter 0.47 2,750 Total cash dividends declared and paid $ 1.98 $ 11,431 2014: Fourth quarter $ 0.47 $ 2,807 Third quarter 0.47 2,830 Second quarter 0.44 2,655 First quarter 0.44 2,739 Total cash dividends declared and paid $ 1.82 $ 11,031 Future dividends are subject to declaration by the Board of Directors. Apple Inc. | 2015 Form 10-K | 59 Table of Contents Share Repurchase Program In the third quarter of 2015, the Company’s Board of Directors increased the share repurchase authorization to $140 billion of the Company’s +common stock, of which $104 billion had been utilized as of September 26, 2015. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately +negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company has entered, and in the future may enter, into accelerated share repurchase arrangements (“ASRs”) with financial institutions. In +exchange for up-front payments, the financial institutions deliver shares of the Company’s common stock during the purchase periods of each ASR. The total number of shares ultimately delivered, and therefore the average repurchase price paid +per share, is determined at the end of the applicable purchase period of each ASR based on the volume weighted-average price of the Company’s common stock during that period. The shares received are retired in the periods they are delivered, +and the up-front payments are accounted for as a reduction to shareholders’ equity in the Company’s Consolidated Balance Sheets in the periods the payments are made. The Company reflects the ASRs as a repurchase of common stock in the +period delivered for purposes of calculating earnings per share and as forward contracts indexed to its own common stock. The ASRs met all of the applicable criteria for equity classification, and therefore were not accounted for as derivative +instruments. The following table shows the Company’s ASR activity and related information during the years ended September 26, 2015 and +September 27, 2014: Purchase Period End Date Number of Shares (in thousands) Average Repurchase Price Per Share ASR Amount (in millions) May 2015 ASR July 2015 48,293 (1) $ 124.24 $ 6,000 August 2014 ASR February 2015 81,525 (2) $ 110.40 $ 9,000 January 2014 ASR December 2014 134,247 $ 89.39 $ 12,000 April 2013 ASR March 2014 172,548 $ 69.55 $ 12,000 (1) Includes 38.3 million shares delivered and retired at the beginning of the purchase period, which began in the third quarter of 2015 and +10.0 million shares delivered and retired at the end of the purchase period, which concluded in the fourth quarter of 2015. (2) Includes 59.9 million shares delivered and retired at the beginning of the purchase period, which began in the fourth quarter of 2014, 8.3 million +net shares delivered and retired in the first quarter of 2015 and 13.3 million shares delivered and retired at the end of the purchase period, which concluded in the second quarter of 2015. Additionally, the Company repurchased shares of its common stock in the open market, which were retired upon +repurchase, during the periods presented as follows: Number of Shares (in thousands) Average Repurchase Price Per Share Amount (in millions) 2015: Fourth quarter 121,802 $ 115.15 $ 14,026 Third quarter 31,231 $ 128.08 4,000 Second quarter 56,400 $ 124.11 7,000 First quarter 45,704 $ 109.40 5,000 Total open market common stock repurchases 255,137 $ 30,026 2014: Fourth quarter 81,255 $ 98.46 $ 8,000 Third quarter 58,661 $ 85.23 5,000 Second quarter 79,749 $ 75.24 6,000 First quarter 66,847 $ 74.79 5,000 Total open market common stock repurchases 286,512 $ 24,000 Apple Inc. | 2015 Form 10-K | 60 Table of Contents Note 8 – Comprehensive Income Comprehensive income consists of two components, net income and OCI. OCI refers to revenue, expenses, and gains and losses that under +GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional +currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and unrealized gains and losses on marketable securities classified as available-for-sale. The following table shows the pre-tax amounts reclassified from AOCI into the Consolidated Statements of Operations, and the associated financial +statement line item, for 2015 and 2014 (in millions): Comprehensive Income Components Financial Statement Line Item 2015 2014 Unrealized (gains)/losses on derivative instruments: Foreign exchange contracts Revenue $ (2,432 ) $ 449 Cost of sales (2,168 ) (295 ) Other income/(expense), net 456 15 Interest rate contracts Other income/(expense), net 17 16 (4,127 ) 185 Unrealized (gains)/losses on marketable securities Other income/(expense), net 91 (205 ) Total amounts reclassified from AOCI $ (4,036 ) $ (20 ) The following table shows the changes in AOCI by component for 2015 (in millions): Cumulative Foreign Currency Translation Unrealized Gains/Losses on Derivative Instruments Unrealized Gains/Losses on Marketable Securities Total Balance at September 28, 2013 $ (105 ) $ (175 ) $ (191 ) $ (471 ) Other comprehensive income/(loss) before reclassifications (187 ) 1,687 438 1,938 Amounts reclassified from AOCI 0 185 (205 ) (20 ) Tax effect 50 (333 ) (82 ) (365 ) Other comprehensive income/(loss) (137 ) 1,539 151 1,553 Balance at September 27, 2014 (242 ) 1,364 (40 ) 1,082 Other comprehensive income/(loss) before reclassifications (612 ) 3,346 (747 ) 1,987 Amounts reclassified from AOCI 0 (4,127 ) 91 (4,036 ) Tax effect 201 189 232 622 Other comprehensive income/(loss) (411 ) (592 ) (424 ) (1,427 ) Balance at September 26, 2015 $ (653 ) $ 772 $ (464 ) $ (345 ) Apple Inc. | 2015 Form 10-K | 61 Table of Contents Note 9 – Benefit Plans 2014 Employee Stock Plan In the second +quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides +for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the +2014 Plan generally vest over four years, based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one-for-one basis. Each share issued with respect to RSUs granted under the 2014 Plan reduces the +number of shares available for grant under the plan by two shares. RSUs cancelled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the +number of RSUs cancelled or shares withheld. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are +subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 385 million shares plus the +number of shares remaining that were reserved but not issued under the 2003 Plan. Shares subject to outstanding awards under the 2003 Plan that expire, are cancelled or otherwise terminate, or are withheld to satisfy tax withholding obligations with +respect to RSUs, will also be available for awards under the 2014 Plan. As of September 26, 2015, approximately 442.9 million shares were reserved for future issuance under the 2014 Plan. 2003 Employee Stock Plan The 2003 Plan is a shareholder +approved plan that provided for broad-based equity grants to employees, including executive officers. The 2003 Plan permitted the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights +and performance-based awards. Options granted under the 2003 Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years, based on continued employment, with either annual, semi-annual +or quarterly vesting. RSUs granted under the 2003 Plan generally vest over two to four years, based on continued employment and are settled upon vesting in shares of the Company’s common stock on a one-for-one basis. All RSUs, other than RSUs +held by the Chief Executive Officer, granted under the 2003 Plan have DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. In the +second quarter of 2014, the Company terminated the authority to grant new awards under the 2003 Plan. 1997 Director Stock Plan The 1997 Director Stock Plan (the “Director Plan”) is a shareholder approved plan that (i) permits the Company to grant awards of RSUs or +stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of +shareholders, and (iii) permits the Board of Directors to prospectively change the relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s +common stock subject to these grants without shareholder approval. Each share issued with respect to RSUs granted under the Director Plan reduces the number of shares available for grant under the plan by two shares. The Director Plan expires +November 9, 2019. All RSUs granted under the Director Plan are entitled to DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares +vest. As of September 26, 2015, approximately 1.2 million shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the fourth quarter of 2015, Section 16 officers Timothy D. Cook, Angela Ahrendts, Luca Maestri, Daniel Riccio, Philip Schiller and +Jeffrey Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, +prices and dates) of future purchases or sales of the Company’s stock, including shares acquired pursuant to the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan +(the “Purchase Plan”) is a shareholder approved plan under which substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85% of the lower of the fair market values of the +stock as of the beginning or the end of six-month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10% of the employee’s compensation and employees may not purchase more than $25,000 of stock during +any calendar year. As of September 26, 2015, approximately 53.0 million shares were reserved for future issuance under the Purchase Plan. Apple Inc. | 2015 Form 10-K | 62 Table of Contents 401(k) Plan The +Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution +limit ($18,000 for calendar year 2015). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. The Company’s matching contributions to +the 401(k) Plan were $200 million, $163 million and $135 million in 2015, 2014 and 2013, respectively. Restricted Stock Units A summary of the Company’s RSU activity and related information for 2015, 2014 and 2013, is as follows: Number +of RSUs (in thousands) Weighted-Average Grant +Date Fair Value Per Share Aggregate Intrinsic Value (in millions) Balance at September 29, 2012 105,037 $ 49.27 RSUs granted 39,415 $ 78.23 RSUs vested (42,291 ) $ 45.96 RSUs cancelled (8,877 ) $ 57.31 Balance at September 28, 2013 93,284 $ 62.24 RSUs granted 59,269 $ 74.54 RSUs vested (43,111 ) $ 57.29 RSUs cancelled (5,620 ) $ 68.47 Balance at September 27, 2014 103,822 $ 70.98 RSUs granted 45,587 $ 105.51 RSUs vested (41,684 ) $ 71.32 RSUs cancelled (6,258 ) $ 80.34 Balance at September 26, 2015 101,467 $ 85.77 $ 11,639 The fair value as of the respective vesting dates of RSUs was $4.8 billion, $3.4 billion and $3.1 billion for 2015, 2014 +and 2013, respectively. The majority of RSUs that vested in 2015, 2014 and 2013 were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income and +other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 14.1 million, 15.6 million and 15.5 million for 2015, 2014 and 2013, respectively, and were based on the +value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $1.6 billion, $1.2 billion and $1.1 billion in 2015, 2014 +and 2013, respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced the number of shares that would +have otherwise been issued as a result of the vesting and did not represent an expense to the Company. Stock Options The Company had 1.2 million stock options outstanding as of September 26, 2015, with a weighted-average exercise price per share of $15.08 and +weighted-average remaining contractual term of 4.1 years, substantially all of which are exercisable. The aggregate intrinsic value of the stock options outstanding as of September 26, 2015 was $120 million, which represents the value of the +Company’s closing stock price on the last trading day of the period in excess of the weighted-average exercise price multiplied by the number of options outstanding. Total intrinsic value of options at time of exercise was $479 million, $1.5 +billion and $1.0 billion for 2015, 2014 and 2013, respectively. Apple Inc. | 2015 Form 10-K | 63 Table of Contents Share-based Compensation The following table shows a summary of the share-based compensation expense included in the Consolidated Statements of Operations for 2015, 2014 and 2013 +(in millions): 2015 2014 2013 Cost of sales $ 575 $ 450 $ 350 Research and development 1,536 1,216 917 Selling, general and administrative 1,475 1,197 986 Total share-based compensation expense $ 3,586 $ 2,863 $ 2,253 The income tax benefit related to share-based compensation expense was $1.2 billion, $1.0 billion and $816 million for +2015, 2014 and 2013, respectively. As of September 26, 2015, the total unrecognized compensation cost related to outstanding stock options, RSUs and restricted stock was $6.8 billion, which the Company expects to recognize over a +weighted-average period of 2.7 years. Note 10 – Commitments and Contingencies Accrued Warranty and Indemnification The +following table shows changes in the Company’s accrued warranties and related costs for 2015, 2014 and 2013 (in millions): 2015 2014 2013 Beginning accrued warranty and related costs $ 4,159 $ 2,967 $ 1,638 Cost of warranty claims (4,401 ) (3,760 ) (3,703 ) Accruals for product warranty 5,022 4,952 5,032 Ending accrued warranty and related costs $ 4,780 $ 4,159 $ 2,967 The Company generally does not indemnify end-users of its operating system and application software against legal claims +that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an +infringement claim against the Company or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its +operating system or application software for infringement of third-party intellectual property rights. The Company did not record a liability for infringement costs related to indemnification as of September 26, 2015 or September 27, 2014. In September 2015, the Company introduced the iPhone Upgrade Program, which is available to customers who purchase an iPhone 6s and 6s Plus in one +of its U.S. physical retail stores and activate the purchased iPhone with one of the four national carriers. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a new iPhone, provided certain conditions are met. One +of the conditions of this program requires the customer to finance the initial purchase price of the iPhone with a third-party lender. Upon exercise of the trade-in right and purchase of a new iPhone, the Company satisfies the customer’s +outstanding balance due to the third-party lender on the original device. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right with subsequent changes to the +guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. +Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such +individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification +claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently +obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the +Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Company’s financial condition and operating +results. Apple Inc. | 2015 Form 10-K | 64 Table of Contents The Company uses some custom components that are not commonly used by its competitors, and new products +introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing +capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition +and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, +or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of +components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, +there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially +adversely affect its financial condition and operating results. Substantially all of the Company’s hardware products are manufactured by +outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the +sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely +affected if its outsourcing partners were unable to meet their production commitments. The Company’s purchase commitments typically cover its requirements for periods up to 150 days. Other Off-Balance Sheet Commitments Operating Leases The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not +currently utilize any other off-balance sheet financing arrangements. The major facility leases are typically for terms not exceeding 10 years and generally contain multi-year renewal options. As of September 26, 2015, the Company had a total +of 463 retail stores. Leases for retail space are for terms ranging from five to 20 years, the majority of which are for 10 years, and often contain multi-year renewal options. As of September 26, 2015, the Company’s total future minimum +lease payments under noncancelable operating leases were $6.3 billion, of which $3.6 billion related to leases for retail space. Rent expense under +all operating leases, including both cancelable and noncancelable leases, was $794 million, $717 million and $645 million in 2015, 2014 and 2013, respectively. Future minimum lease payments under noncancelable operating leases having remaining terms +in excess of one year as of September 26, 2015, are as follows (in millions): 2016 $ 772 2017 774 2018 744 2019 715 2020 674 Thereafter 2,592 Total $ 6,271 Other Commitments The Company +utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand +information supplied by the Company, which typically covers periods up to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires +components through a combination of purchase orders, supplier contracts and open orders based on projected demand information. Where appropriate, the purchases are applied to inventory component prepayments that +are outstanding with the respective supplier. As of September 26, 2015, the Company had outstanding off-balance sheet third-party manufacturing commitments and component purchase commitments of $29.5 billion. Apple Inc. | 2015 Form 10-K | 65 Table of Contents In addition to the commitments mentioned above, the Company had other off-balance sheet obligations of $7.3 +billion as of September 26, 2015 that consisted of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to inventory prepayments, advertising, licensing, R&D, internet +and telecommunications services, energy and other obligations. Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully +adjudicated, certain of which are discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings.” In the opinion of +management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the +outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in +excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. v. Samsung Electronics Co., Ltd, et al. On +August 24, 2012, a jury returned a verdict awarding the Company $1.05 billion in its lawsuit against Samsung Electronics Co., Ltd and affiliated parties in the United States District Court, Northern District of California, San Jose Division. On +March 6, 2014, the District Court entered final judgment in favor of the Company in the amount of approximately $930 million. On May 18, 2015, the U.S. Court of Appeals for the Federal Circuit affirmed in part, and reversed in part, +the decision of the District Court. As a result, the Court of Appeals ordered entry of final judgment on damages in the amount of approximately $548 million, with the District Court to determine supplemental damages and interest, as well as damages +owed for products subject to the reversal in part. Because the ruling remains subject to further proceedings, the Company has not recognized the award in its results of operations. Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal +reporting used by management for making decisions and assessing performance as the source of the Company’s reportable operating segments. The +Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. The Americas segment includes both North and South +America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and those Asian countries not +included in the Company’s other reportable operating segments. Although each reportable operating segment provides similar hardware and software products and similar services, they are managed separately to better align with the location of the +Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting +Policies.” The Company evaluates the performance of its reportable operating segments based on net sales and operating income. Net sales for +geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of +sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and +certain expenses managed outside the reportable operating segments. Costs excluded from segment operating income include various corporate expenses such as R&D, corporate marketing expenses, certain share-based compensation expenses, income +taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. Apple Inc. | 2015 Form 10-K | 66 Table of Contents The following table shows information by reportable operating segment for 2015, 2014 and 2013 (in millions): 2015 2014 2013 Americas: Net sales $ 93,864 $ 80,095 $ 77,093 Operating income $ 31,186 $ 26,158 $ 24,829 Europe: Net sales $ 50,337 $ 44,285 $ 40,980 Operating income $ 16,527 $ 14,434 $ 12,767 Greater China: Net sales $ 58,715 $ 31,853 $ 27,016 Operating income $ 23,002 $ 11,039 $ 8,499 Japan: Net sales $ 15,706 $ 15,314 $ 13,782 Operating income $ 7,617 $ 6,904 $ 6,668 Rest of Asia Pacific: Net sales $ 15,093 $ 11,248 $ 12,039 Operating income $ 5,518 $ 3,674 $ 3,762 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2015, +2014 and 2013 is as follows (in millions): 2015 2014 2013 Segment operating income $ 83,850 $ 62,209 $ 56,525 Research and development expense (8,067 ) (6,041 ) (4,475 ) Other corporate expenses, net (4,553 ) (3,665 ) (3,051 ) Total operating income $ 71,230 $ 52,503 $ 48,999 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2015, 2014 +and 2013. There was no single customer that accounted for more than 10% of net sales in 2015, 2014 or 2013. Net sales for 2015, 2014 and 2013 and long-lived assets as of September 26, 2015 and September 27, 2014 are as follows (in +millions): 2015 2014 2013 Net sales: U.S. $ 81,732 $ 68,909 $ 66,197 China (1) 56,547 30,638 25,946 Other countries 95,436 83,248 78,767 Total net sales $ 233,715 $ 182,795 $ 170,910 2015 2014 Long-lived assets: U.S. $ 12,022 $ 9,108 China (1) 8,722 9,477 Other countries 3,040 2,917 Total long-lived assets $ 23,784 $ 21,502 (1) China includes Hong Kong. Long-lived assets located in China consist primarily of product tooling and +manufacturing process equipment and assets related to retail stores and related infrastructure. Apple Inc. | 2015 Form 10-K | 67 Table of Contents Net sales by product for 2015, 2014 and 2013 are as follows (in millions): 2015 2014 2013 Net Sales by Product: iPhone (1) $ 155,041 $ 101,991 $ 91,279 iPad (1) 23,227 30,283 31,980 Mac (1) 25,471 24,079 21,483 Services (2) 19,909 18,063 16,051 Other Products (1)(3) 10,067 8,379 10,117 Total net sales $ 233,715 $ 182,795 $ 170,910 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from the iTunes Store, App Store, Mac App Store, iBooks Store, Apple Music, AppleCare, Apple Pay, licensing and other services. (3) Includes sales of Apple TV, Apple Watch, Beats products, iPod and Apple-branded and third-party accessories. Note 12 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters of 2015 and +2014 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2015: Net sales $ 51,501 $ 49,605 $ 58,010 $ 74,599 Gross margin $ 20,548 $ 19,681 $ 23,656 $ 29,741 Net income $ 11,124 $ 10,677 $ 13,569 $ 18,024 Earnings per share (1) : Basic $ 1.97 $ 1.86 $ 2.34 $ 3.08 Diluted $ 1.96 $ 1.85 $ 2.33 $ 3.06 Fourth Quarter Third Quarter Second Quarter First Quarter 2014: Net sales $ 42,123 $ 37,432 $ 45,646 $ 57,594 Gross margin $ 16,009 $ 14,735 $ 17,947 $ 21,846 Net income $ 8,467 $ 7,748 $ 10,223 $ 13,072 Earnings per share (1) : Basic $ 1.43 $ 1.29 $ 1.67 $ 2.08 Diluted $ 1.42 $ 1.28 $ 1.66 $ 2.07 (1) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per +share information may not equal annual basic and diluted earnings per share. Apple Inc. | 2015 Form 10-K | 68 Table of Contents Report of Ernst & Young LLP, Independent Registered Public Accounting +Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 26, 2015 and September 27, 2014, and the related +consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 26, 2015. These financial statements are the responsibility of the Company’s +management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance +with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. +An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as +evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the +financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Inc. at September 26, 2015 and September 27, 2014, and the consolidated results of its operations and its cash +flows for each of the three years in the period ended September 26, 2015, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple Inc.’s internal +control over financial reporting as of September 26, 2015, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 +framework) and our report dated October 28, 2015 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 28, 2015 Apple Inc. | 2015 Form 10-K | 69 Table of Contents Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 26, 2015, based on criteria established in Internal +Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal +control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility +is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance +with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was +maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of +internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any +evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 26, 2015, based +on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +2015 consolidated financial statements of Apple Inc. and our report dated October 28, 2015 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, +California October 28, 2015 Apple Inc. | 2015 Form 10-K | 70 Table of Contents Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer +and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) were effective +as of September 26, 2015 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the +time periods specified in the Securities and Exchange Commission rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate +to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting +and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and +procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s +assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the +Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could +have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief +Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the +objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations +in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject +to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule +13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the +Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 26, 2015 to +provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has +issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in +Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth +quarter of 2015, which were identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, +the Company’s internal control over financial reporting. Item 9B. Other Information Not applicable. Apple Inc. | 2015 Form 10-K | 71 Table of Contents PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is +set forth under the headings “Directors, Corporate Governance and Executive Officers” in the Company’s 2016 Proxy Statement to be filed with the U.S. Securities and Exchange Commission (the “SEC”) within 120 days after +September 26, 2015 in connection with the solicitation of proxies for the Company’s 2016 annual meeting of shareholders and is incorporated herein by reference. The Company has a code of ethics, “Business Conduct: The way we do business worldwide,” that applies to all employees, including the +Company’s principal executive officer, principal financial officer, and principal accounting officer, as well as to the members of the Board of Directors of the Company. The code is available at investor.apple.com/corporate-governance.cfm. The +Company intends to disclose any changes in, or waivers from, this code by posting such information on the same website or by filing a Form 8-K, in each case to the extent such disclosure is required by rules of the SEC or the NASDAQ Stock Market +LLC. Item 11. Executive Compensation The information required by this Item is set forth under the heading +“Executive Compensation” and under the subheadings “Board Oversight of Risk Management,” “Compensation Committee Interlocks and Insider Participation,” “Compensation of Directors” and “Director +Compensation-2015” under the heading “Directors, Corporate Governance and Executive Officers” in the Company’s 2016 Proxy Statement to be filed with the SEC within 120 days after September 26, 2015 and is incorporated herein +by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The +information required by this Item is set forth under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the Company’s 2016 Proxy Statement to be filed +with the SEC within 120 days after September 26, 2015 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required +by this Item is set forth under the subheadings “Board Committees”, “Review, Approval or Ratification of Transactions with Related Persons” and “Transactions with Related Persons” under the heading “Directors, +Corporate Governance and Executive Officers” in the Company’s 2016 Proxy Statement to be filed with the SEC within 120 days after September 26, 2015 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under +the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm” under the proposal “Ratification of +Appointment of Independent Registered Public Accounting Firm” in the Company’s 2016 Proxy Statement to be filed with the SEC within 120 days after September 26, 2015 and is incorporated herein by reference. Apple Inc. | 2015 Form 10-K | 72 Table of Contents PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 26, 2015, September  +27, 2014 and September 28, 2013 39 Consolidated Statements of Comprehensive Income for the years ended September 26, 2015, September  +27, 2014 and September 28, 2013 40 Consolidated Balance Sheets as of September 26, 2015 and September 27, 2014 41 Consolidated Statements of Shareholders’ Equity for the years ended September 26, 2015, September  +27, 2014 and September 28, 2013 42 Consolidated Statements of Cash Flows for the years ended September 26, 2015, September  +27, 2014 and September 28, 2013 43 Notes to Consolidated Financial Statements 44 Selected Quarterly Financial Information (Unaudited) 68 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 69 (2) Financial Statement Schedules All +financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated +financial statements and notes thereto included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K The information required by this Section (a)(3) of Item 15 is set forth on the exhibit index that follows the Signatures page of this Form 10-K. Apple Inc. | 2015 Form 10-K | 73 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned, thereunto duly authorized. Date: October 28, 2015 Apple Inc. By: /s/  Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and +severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on +Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the +Registrant and in the capacities and on the dates indicated: Name Title Date /s/    Timothy D. +Cook TIMOTHY D. COOK Chief Executive Officer and Director (Principal Executive +Officer) October 28, 2015 /s/    Luca +Maestri LUCA MAESTRI Senior Vice President, Chief Financial Officer (Principal Financial +Officer) October 28, 2015 /s/    Chris +Kondo CHRIS KONDO Senior Director of Corporate Accounting (Principal Accounting +Officer) October 28, 2015 /s/    Al +Gore AL GORE Director October 28, 2015 /s/    Robert A. +Iger ROBERT A. IGER Director October 28, 2015 /s/    Andrea +Jung ANDREA JUNG Director October 28, 2015 /s/    Arthur D. +Levinson ARTHUR D. LEVINSON Director October 28, 2015 /s/    Ronald D. +Sugar RONALD D. SUGAR Director October 28, 2015 /s/    Susan L. +Wagner SUSAN L. WAGNER Director October 28, 2015 Apple Inc. | 2015 Form 10-K | 74 Table of Contents EXHIBIT INDEX (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period  +End Date 3.1 Restated Articles of Incorporation of the Registrant effective as of June 6, 2014. 8-K 3.1 6/6/14 3.2 Amended and Restated Bylaws of the Registrant effective as of February 28, 2014. 8-K 3.2 3/5/14 4.1 Form of Common Stock Certificate of the Registrant. 10-Q 4.1 12/30/06 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due +2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due +2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, +2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due +2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of June 10, 2015, including forms of global notes representing the 0.35% Notes due 2020. 8-K 4.1 6/10/15 4.9 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.10 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* 1997 Director Stock Plan, as amended through August 23, 2012. 10-Q 10.3 12/28/13 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.6* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of April 6, 2012. 10-Q 10.8 3/31/12 Apple Inc. | 2015 Form 10-K | 75 Table of Contents Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period  +End Date 10.7* Summary Description of Amendment, effective as of May 24, 2012, to certain Restricted Stock Unit Award Agreements outstanding as of April 5, 2012. 10-Q 10.8 6/30/12 10.8* 2014 Employee Stock Plan. 8-K 10.1 3/5/14 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan as of February 28, 2014. 8-K 10.2 3/5/14 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of February 28, 2014. 8-K 10.3 3/5/14 10.11* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.11 9/27/14 10.12* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.12 9/27/14 10.13* Form of Amendment, effective as of August 26, 2014, to Restricted Stock Unit Award Agreements and Performance Award Agreements outstanding as of August 26, 2014. 10-K 10.13 9/27/14 10.14* Offer Letter, dated August 1, 2013, from the Registrant to Angela Ahrendts. 10-Q 10.14 12/27/14 12.1** Computation of Ratio of Earnings to Fixed Charges. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual +Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS** XBRL Instance Document. 101.SCH** XBRL Taxonomy Extension Schema Document. 101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document. 101.DEF** XBRL Taxonomy Extension Definition Linkbase Document. 101.LAB** XBRL Taxonomy Extension Label Linkbase Document. 101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation +S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Apple Inc. | 2015 Form 10-K | 76 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001628280-16-020309/full-submission.txt b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001628280-16-020309/full-submission.txt new file mode 100644 index 0000000..de85d4c --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/AAPL/10-K/0001628280-16-020309/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-K (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended September 24, 2016 or ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number: 001-36743 Apple Inc. (Exact name of Registrant as specified in its charter) California 94-2404110 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1 Infinite Loop Cupertino, California 95014 (Address of principal executive offices) (Zip Code) (408) 996-1010 (Registrant’s telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, $0.00001 par value per share 1.000%  Notes due 2022 1.375%  Notes due 2024 1.625%  Notes due 2026 2.000%  Notes due 2027 3.050%  Notes due 2029 3.600%  Notes due 2042 The NASDAQ Stock Market LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC New York Stock Exchange LLC (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes ☒ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐ Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ (Do not check if a smaller reporting company) Smaller reporting company ☐ Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ The aggregate market value of the voting and non-voting stock held by non-affiliates of the Registrant, as of March 25, 2016, the last business day of the Registrant’s most recently completed second fiscal quarter, was approximately $578,807,000,000. Solely for purposes of this disclosure, shares of common stock held by executive officers and directors of the Registrant as of such date have been excluded because such persons may be deemed to be affiliates. This determination of executive officers and directors as affiliates is not necessarily a conclusive determination for any other purposes. 5,332,313,000 shares of common stock were issued and outstanding as of October 14, 2016 . DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant’s definitive proxy statement relating to its 2017 annual meeting of shareholders (the “ 2017 Proxy Statement”) are incorporated by reference into Part III of this Annual Report on Form 10-K where indicated. The 2017 Proxy Statement will be filed with the U.S. Securities and Exchange Commission within 120 days after the end of the fiscal year to which this report relates. Apple Inc. Form 10-K For the Fiscal Year Ended September 24, 2016 TABLE OF CONTENTS Page Part I Item 1. Business 1 Item 1A. Risk Factors 8 Item 1B. Unresolved Staff Comments 17 Item 2. Properties 17 Item 3. Legal Proceedings 17 Item 4. Mine Safety Disclosures 17 Part II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 18 Item 6. Selected Financial Data 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 36 Item 8. Financial Statements and Supplementary Data 38 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 72 Item 9A. Controls and Procedures 72 Item 9B. Other Information 72 Part III Item 10. Directors, Executive Officers and Corporate Governance 73 Item 11. Executive Compensation 73 Item 12 . Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 73 Item 13 . Certain Relationships and Related Transactions and Director Independence 73 Item 14. Principal Accounting Fees and Services 73 Part IV Item 15. Exhibits, Financial Statement Schedules 74 This Annual Report on Form 10-K ( “ Form 10-K ” ) contains forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Many of the forward-looking statements are located in Part II, Item 7 of this Form 10-K under the heading “ Management’s Discussion and Analysis of Financial Condition and Results of Operations. ” Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “ future, ” “ anticipates, ” “ believes, ” “ estimates, ” “ expects, ” “ intends, ” “ plans, ” “ predicts, ” “ will, ” “ would, ” “ could, ” “ can, ” “ may, ” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “ Risk Factors, ” which are incorporated herein by reference. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “ Company ” and “ Apple ” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. PART I Item 1. Business Company Background The Company designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple Watch ® , Apple TV ® , a portfolio of consumer and professional software applications, iOS, macOS™, watchOS ® and tvOS™ operating systems, iCloud ® , Apple Pay ® and a variety of accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store ® , App Store ® , Mac App Store, TV App Store, iBooks Store™ and Apple Music ® (collectively “Internet Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party Apple compatible products, including application software and various accessories through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. The Company’s fiscal year is the 52 or 53-week period that ends on the last Saturday of September. The Company is a California corporation established in 1977. Business Strategy The Company is committed to bringing the best user experience to its customers through its innovative hardware, software and services. The Company’s business strategy leverages its unique ability to design and develop its own operating systems, hardware, application software and services to provide its customers products and solutions with innovative design, superior ease-of-use and seamless integration. As part of its strategy, the Company continues to expand its platform for the discovery and delivery of digital content and applications through its Internet Services, which allows customers to discover and download digital content, iOS, Mac, Apple Watch and Apple TV applications, and books through either a Mac or Windows personal computer or through iPhone, iPad and iPod touch ® devices (“iOS devices”), Apple TV and Apple Watch. The Company also supports a community for the development of third-party software and hardware products and digital content that complement the Company’s offerings. The Company believes a high-quality buying experience with knowledgeable salespersons who can convey the value of the Company’s products and services greatly enhances its ability to attract and retain customers. Therefore, the Company’s strategy also includes building and expanding its own retail and online stores and its third-party distribution network to effectively reach more customers and provide them with a high-quality sales and post-sales support experience. The Company believes ongoing investment in research and development (“R&D”), marketing and advertising is critical to the development and sale of innovative products and technologies. Business Organization The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and those Asian countries not included in the Company’s other reportable operating segments. Although the reportable operating segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable operating segments may be found in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Apple Inc. | 2016 Form 10-K | 1 Products iPhone iPhone is the Company’s line of smartphones based on its iOS operating system. iPhone includes Siri ® , a voice activated intelligent assistant, and Apple Pay and Touch ID ® on qualifying devices. In September 2016, the Company introduced iPhone 7 and 7 Plus, featuring new camera systems, immersive stereo speakers and water and dust resistance. During the third quarter of 2016, the Company also began selling iPhone SE, which has a 4-inch Retina ® display. iPhone works with the iTunes Store, App Store, iBooks Store and Apple Music for purchasing, organizing and playing digital content and apps. iPad iPad is the Company’s line of multi-purpose tablets based on its iOS operating system, which includes iPad Pro™, iPad Air ® and iPad mini™. iPad includes Siri and also includes Touch ID on qualifying devices. iPad works with the iTunes Store, App Store, iBooks Store and Apple Music for purchasing, organizing and playing digital content and apps. Mac Mac is the Company’s line of desktop and portable personal computers based on its macOS operating system. The Company’s desktop computers include iMac ® , 21.5” iMac with Retina 4K display, 27” iMac with Retina 5K display, Mac Pro ® and Mac mini ® . The Company’s portable computers include MacBook ® , MacBook Air ® , MacBook Pro ® and MacBook Pro with Retina display. Operating System Software iOS iOS is the Company’s Multi-Touch™ operating system that serves as the foundation for iOS devices. Devices running iOS are compatible with both Mac and Windows personal computers and Apple’s iCloud services. In September 2016, the Company released iOS 10, which introduces the ability for Siri to do more by working with apps, updates Messages, includes redesigned Maps, Photos, Apple Music and News apps, and the Home app, which provides a way to manage home automation products in one place. macOS macOS is the Company’s Mac operating system and is built on an open-source UNIX-based foundation and provides an intuitive and integrated computer experience. Support for iCloud is built into macOS so users can access content and information from Mac, iOS devices and other supported devices and access downloaded content and apps from the iTunes Store. macOS Sierra, released in September 2016, is the 13th major release of macOS and incorporates Siri and Apple Pay on the Mac, improves continuity and document access across Apple devices and includes the new Memories feature in Photos. watchOS watchOS is the Company’s operating system for Apple Watch. Released in September 2016, watchOS 3 provides improved performance with the ability to launch favorite apps instantly, enhanced navigation with the new Dock and new fitness and health capabilities for Apple Watch, including the Breathe app designed to promote exercises for relaxation and stress reduction. tvOS tvOS is the Company's operating system for Apple TV. The tvOS operating system is based on the Company’s iOS platform and enables developers to create new apps and games specifically for Apple TV and deliver them to customers through the Apple TV App Store. The new tvOS, released in September 2016, incorporates new Siri capabilities that allow searching across more apps and services. Application Software The Company’s application software includes iLife ® , iWork ® and various other software, including Final Cut Pro ® , Logic ® Pro X and FileMaker ® Pro. iLife is the Company’s consumer-oriented digital lifestyle software application suite included with all Mac computers and features iMovie ® , a digital video editing application, and GarageBand ® , a music creation application that allows users to play, record and create music. iWork is the Company’s integrated productivity suite included with all Mac computers and is designed to help users create, present and publish documents through Pages ® , presentations through Keynote ® and spreadsheets through Numbers ® . The Company also has Multi-Touch versions of iLife and iWork applications designed specifically for use on iOS devices, which are available as free downloads for all new iOS devices. Apple Inc. | 2016 Form 10-K | 2 Services Internet Services The iTunes Store, available for iOS devices, Mac and Windows personal computers and Apple TV, allows customers to purchase and download music and TV shows, rent or purchase movies and download free podcasts. The App Store, available for iOS devices, allows customers to discover and download apps and purchase in-app content. The Mac App Store, available for Mac computers, allows customers to discover, download and install Mac applications. The TV App Store allows customers access to apps and games specifically for the Apple TV. The iBooks Store, available for iOS devices and Mac computers, features e-books from major and independent publishers. Apple Music offers users a curated listening experience with on-demand radio stations that evolve based on a user’s play or download activity and a subscription-based internet streaming service that also provides unlimited access to the Apple Music library. iCloud iCloud is the Company’s cloud service which stores music, photos, contacts, calendars, mail, documents and more, keeping them up-to-date and available across multiple iOS devices, Mac and Windows personal computers and Apple TV. iCloud services include iCloud Drive ® , iCloud Photo Library, Family Sharing, Find My iPhone, iPad or Mac, Find My Friends, Notes, iCloud Keychain ® and iCloud Backup for iOS devices. AppleCare AppleCare ® offers a range of support options for the Company’s customers. These include assistance that is built into software products, printed and electronic product manuals, online support including comprehensive product information as well as technical assistance, the AppleCare Protection Plan (“APP”) and the AppleCare+ Protection Plan (“AC+”). APP is a fee-based service that typically extends the service coverage of phone support, hardware repairs and dedicated web-based support resources for Mac, Apple TV and display products. AC+ is a fee-based service offering additional coverage under some circumstances for instances of accidental damage in addition to the services offered by APP and is available in certain countries for iPhone, iPad, Apple Watch and iPod. Apple Pay Apple Pay is the Company’s mobile payment service available in certain countries that offers an easy, secure and private way to pay. Apple Pay allows users to pay for purchases in stores accepting contactless payments and to pay for purchases within participating apps on qualifying devices. Apple Pay accepts credit and debit cards across major card networks and also supports reward programs and store-issued credit and debit cards. Other Products Accessories The Company sells a variety of Apple-branded and third-party Mac-compatible and iOS-compatible accessories, including Apple TV, Apple Watch, Beats products, iPod, headphones, displays, storage devices, and various other connectivity and computing products and supplies. In September 2016, the Company introduced AirPods™, new wireless headphones that interact with Siri. Apple TV Apple TV connects to consumers’ TVs and enables them to access digital content directly for streaming high definition video, playing music and games, and viewing photos. Content from Apple Music and other media services are also available on Apple TV. Apple TV allows streaming digital content from Mac and Windows personal computers through Home Share and from compatible Mac and iOS devices through AirPlay ® . The Company's Apple TV runs on its tvOS operating system and is based on apps built for the television. Additionally, the Apple TV remote features Siri, allowing users to search and access content with their voice. Apple Watch Apple Watch is a personal electronic device that combines the watchOS user interface and technologies created specifically for a smaller device, including the Digital Crown™, a unique navigation tool that allows users to seamlessly scroll, zoom and navigate, and Force Touch, a technology that senses the difference between a tap and a press and allows users to access controls within apps. Apple Watch enables users to communicate in new ways from their wrist, track their health and fitness through activity and workout apps, and includes Siri and Apple Pay. In September 2016, the Company introduced Apple Watch Series 2, featuring new fitness and health capabilities, built-in GPS and a 50-meter water resistance rating for swimming. Apple Inc. | 2016 Form 10-K | 3 iPod iPod is the Company’s line of portable digital music and media players, which includes iPod touch, iPod nano ® and iPod shuffle ® . All iPods work with iTunes to purchase and synchronize content. iPod touch, based on the Company’s iOS operating system, is a flash-memory-based iPod that works with the iTunes Store, App Store and iBooks Store for purchasing and playing digital content and apps. Developer Programs The Company’s developer programs support app developers with building, testing and distributing apps for iOS, macOS, watchOS and tvOS. Developer program membership provides access to beta software and advanced app capabilities (e.g., CloudKit ® , HealthKit™ and Apple Pay), the ability to test apps using TestFlight ® , distribution on the App Store, access to App Analytics and code-level technical support. Developer programs also exist for businesses creating apps for internal use (the Apple Developer Enterprise Program) and developers creating accessories for Apple devices (the MFi Program). All developers, even those who are not developer program members, can sign in with their Apple ID to post on the Apple Developer Forums and use Xcode ® , the Company’s integrated development environment for creating apps for Apple platforms. Xcode includes project management tools; analysis tools to collect, display and compare app performance data; simulation tools to locally run, test and debug apps; and tools to simplify the design and development of user interfaces. All developers also have access to extensive technical documentation and sample code. Markets and Distribution The Company’s customers are primarily in the consumer, small and mid-sized business, education, enterprise and government markets. The Company sells its products and resells third-party products in most of its major markets directly to consumers and small and mid-sized businesses through its retail and online stores and its direct sales force. The Company also employs a variety of indirect distribution channels, such as third-party cellular network carriers, wholesalers, retailers and value-added resellers. During 2016 , the Company’s net sales through its direct and indirect distribution channels accounted for 25% and 75%, respectively, of total net sales. The Company believes that sales of its innovative and differentiated products are enhanced by knowledgeable salespersons who can convey the value of the hardware and software integration and demonstrate the unique solutions that are available on its products. The Company further believes providing direct contact with its targeted customers is an effective way to demonstrate the advantages of its products over those of its competitors and providing a high-quality sales and after-sales support experience is critical to attracting new and retaining existing customers. To ensure a high-quality buying experience for its products in which service and education are emphasized, the Company continues to build and improve its distribution capabilities by expanding the number of its own retail stores worldwide. The Company’s retail stores are typically located at high-traffic locations in quality shopping malls and urban shopping districts. By operating its own stores and locating them in desirable high-traffic locations the Company is better positioned to ensure a high quality customer buying experience and attract new customers. The stores are designed to simplify and enhance the presentation and marketing of the Company’s products and related solutions. The retail stores employ experienced and knowledgeable personnel who provide product advice, service and training and offer a wide selection of third-party hardware, software and other accessories that complement the Company’s products. The Company has also invested in programs to enhance reseller sales by placing high-quality Apple fixtures, merchandising materials and other resources within selected third-party reseller locations. Through the Apple Premium Reseller Program, certain third-party resellers focus on the Apple platform by providing a high level of product expertise, integration and support services. The Company is committed to delivering solutions to help educators teach and students learn. The Company believes effective integration of technology into classroom instruction can result in higher levels of student achievement and has designed a range of products, services and programs to address the needs of education customers. The Company also supports mobile learning and real-time distribution of, and access to, education related materials through iTunes U, a platform that allows students and teachers to share and distribute educational media online. The Company sells its products to the education market through its direct sales force, select third-party resellers and its retail and online stores. The Company also sells its hardware and software products to enterprise and government customers in each of its reportable operating segments. The Company’s products are deployed in these markets because of their performance, productivity, ease of use and seamless integration into information technology environments. The Company’s products are compatible with thousands of third-party business applications and services, and its tools enable the development and secure deployment of custom applications as well as remote device administration. No single customer accounted for more than 10% of net sales in 2016 , 2015 and 2014 . Apple Inc. | 2016 Form 10-K | 4 Competition The markets for the Company’s products and services are highly competitive and the Company is confronted by aggressive competition in all areas of its business. These markets are characterized by frequent product introductions and rapid technological advances that have substantially increased the capabilities and use of mobile communication and media devices, personal computers and other digital electronic devices. The Company’s competitors that sell mobile devices and personal computers based on other operating systems have aggressively cut prices and lowered their product margins to gain or maintain market share. The Company’s financial condition and operating results can be adversely affected by these and other industry-wide downward pressures on gross margins. Principal competitive factors important to the Company include price, product features (including security features), relative price and performance, product quality and reliability, design innovation, a strong third-party software and accessories ecosystem, marketing and distribution capability, service and support and corporate reputation. The Company is focused on expanding its market opportunities related to personal computers and mobile communication and media devices. These markets are highly competitive and include many large, well-funded and experienced participants. The Company expects competition in these markets to intensify significantly as competitors attempt to imitate some of the features of the Company’s products and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. These markets are characterized by aggressive pricing practices, frequent product introductions, evolving design approaches and technologies, rapid adoption of technological and product advancements by competitors and price sensitivity on the part of consumers and businesses. The Company’s digital content services have faced significant competition from other companies promoting their own digital music and content products and services, including those offering free peer-to-peer music and video services. The Company’s future financial condition and operating results depend on the Company’s ability to continue to develop and offer new innovative products and services in each of the markets in which it competes. The Company believes it offers superior innovation and integration of the entire solution including the hardware (iOS devices, Mac, Apple Watch and Apple TV), software (iOS, macOS, watchOS and tvOS), online services and distribution of digital content and applications (Internet Services). Some of the Company’s current and potential competitors have substantial resources and may be able to provide such products and services at little or no profit or even at a loss to compete with the Company’s offerings. Supply of Components Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. The Company uses some custom components that are not commonly used by its competitors, and the Company often utilizes custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. While some Mac computers are manufactured in the U.S. and Ireland, substantially all of the Company’s hardware products are currently manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s manufacturing purchase obligations typically cover its requirements for periods up to 150 days. Apple Inc. | 2016 Form 10-K | 5 Research and Development Because the industries in which the Company competes are characterized by rapid technological advances, the Company’s ability to compete successfully depends heavily upon its ability to ensure a continual and timely flow of competitive products, services and technologies to the marketplace. The Company continues to develop new technologies to enhance existing products and to expand the range of its product offerings through R&D, licensing of intellectual property and acquisition of third-party businesses and technology. Total R&D expense was $ 10.0 billion , $ 8.1 billion and $ 6.0 billion in 2016 , 2015 and 2014 , respectively. Patents, Trademarks, Copyrights and Licenses The Company currently holds rights to patents and copyrights relating to certain aspects of its hardware devices, accessories, software and services. The Company has registered or has applied for trademarks and service marks in the U.S. and a number of foreign countries. Although the Company believes the ownership of such patents, copyrights, trademarks and service marks is an important factor in its business and that its success does depend in part on such ownership, the Company relies primarily on the innovative skills, technical competence and marketing abilities of its personnel. The Company regularly files patent applications to protect innovations arising from its research, development and design, and is currently pursuing thousands of patent applications around the world. Over time, the Company has accumulated a large portfolio of issued patents around the world. The Company holds copyrights relating to certain aspects of its products and services. No single patent or copyright is solely responsible for protecting the Company’s products. The Company believes the duration of its patents is adequate relative to the expected lives of its products. Many of the Company’s products are designed to include intellectual property obtained from third parties. It may be necessary in the future to seek or renew licenses relating to various aspects of its products, processes and services. While the Company has generally been able to obtain such licenses on commercially reasonable terms in the past, there is no guarantee that such licenses could be obtained in the future on reasonable terms or at all. Because of technological changes in the industries in which the Company competes, current extensive patent coverage and the rapid rate of issuance of new patents, it is possible that certain components of the Company’s products, processes and services may unknowingly infringe existing patents or intellectual property rights of others. From time to time, the Company has been notified that it may be infringing certain patents or other intellectual property rights of third parties. Foreign and Domestic Operations and Geographic Data During 2016 , the Company’s domestic and international net sales accounted for 35% and 65%, respectively, of total net sales. Information regarding financial data by geographic segment is set forth in Part II, Item 7 of this Form 10-K under the subheading “Segment Operating Performance,” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” While some Mac computers are manufactured in the U.S. and Ireland, substantially all of the Company’s hardware products are currently manufactured by outsourcing partners that are located primarily in Asia. The supply and manufacture of a number of components is performed by sole-sourced outsourcing partners in the U.S., Asia and Europe. Margins on sales of the Company’s products in foreign countries and on sales of products that include components obtained from foreign suppliers, can be adversely affected by foreign currency exchange rate fluctuations and by international trade regulations, including tariffs and antidumping penalties. Information regarding concentration in the available sources of supply of materials and products is set forth in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies.” Business Seasonality and Product Introductions The Company has historically experienced higher net sales in its first quarter compared to other quarters in its fiscal year due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Product introductions can also impact the Company’s net sales to its indirect distribution channels as these channels are filled with new product inventory following a product introduction, and often, channel inventory of a particular product declines as the next related major product launch approaches. Net sales can also be affected when consumers and distributors anticipate a product introduction. However, neither historical seasonal patterns nor historical patterns of product introductions should be considered reliable indicators of the Company’s future pattern of product introductions, future net sales or financial performance. Warranty The Company offers a limited parts and labor warranty on most of its hardware products. The basic warranty period is typically one year from the date of purchase by the original end-user. The Company also offers a 90-day basic warranty for its service parts used to repair the Company’s hardware products. In certain jurisdictions, local law requires that manufacturers guarantee their products for a period prescribed by statute, typically at least two years. In addition, where available, consumers may purchase APP or AC+, which extends service coverage on many of the Company’s hardware products. Apple Inc. | 2016 Form 10-K | 6 Backlog In the Company’s experience, the actual amount of product backlog at any particular time is not a meaningful indication of its future business prospects. In particular, backlog often increases immediately following new product introductions as customers anticipate shortages. Backlog is often reduced once customers believe they can obtain sufficient supply. Because of the foregoing, backlog should not be considered a reliable indicator of the Company’s ability to achieve any particular level of revenue or financial performance. Employees As of September 24, 2016 , the Company had approximately 116,000 full-time equivalent employees. Available Information The Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are filed with the Securities and Exchange Commission (the “SEC”). The Company is subject to the informational requirements of the Exchange Act and files or furnishes reports, proxy statements and other information with the SEC. Such reports and other information filed by the Company with the SEC are available free of charge on the Company’s website at investor.apple.com/sec.cfm when such reports are available on the SEC’s website. The public may read and copy any materials filed by the Company with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC at www.sec.gov . The contents of these websites are not incorporated into this filing. Further, the Company’s references to website URLs are intended to be inactive textual references only. Apple Inc. | 2016 Form 10-K | 7 Item 1A. Risk Factors The following discussion of risk factors contains forward-looking statements. These risk factors may be important to understanding other statements in this Form 10-K. The following information should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes in Part II, Item 8, “Financial Statements and Supplementary Data” of this Form 10-K. The business, financial condition and operating results of the Company can be affected by a number of factors, whether currently known or unknown, including but not limited to those described below, any one or more of which could, directly or indirectly, cause the Company’s actual financial condition and operating results to vary materially from past, or from anticipated future, financial condition and operating results. Any of these factors, in whole or in part, could materially and adversely affect the Company’s business, financial condition, operating results and stock price. Because of the following factors, as well as other factors affecting the Company’s financial condition and operating results, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Global and regional economic conditions could materially adversely affect the Company. The Company’s operations and performance depend significantly on global and regional economic conditions. Uncertainty about global and regional economic conditions poses a risk as consumers and businesses may postpone spending in response to tighter credit, higher unemployment, financial market volatility, government austerity programs, negative financial news, declines in income or asset values and/or other factors. These worldwide and regional economic conditions could have a material adverse effect on demand for the Company’s products and services. Demand also could differ materially from the Company’s expectations as a result of currency fluctuations because the Company generally raises prices on goods and services sold outside the U.S. to correspond with the effect of a strengthening of the U.S. dollar. Other factors that could influence worldwide or regional demand include changes in fuel and other energy costs, conditions in the real estate and mortgage markets, unemployment, labor and healthcare costs, access to credit, consumer confidence and other macroeconomic factors affecting consumer spending behavior. These and other economic factors could materially adversely affect demand for the Company’s products and services. In the event of financial turmoil affecting the banking system and financial markets, additional consolidation of the financial services industry, or significant financial service institution failures, there could be tightening in the credit markets, low liquidity and extreme volatility in fixed income, credit, currency and equity markets. This could have a number of effects on the Company’s business, including the insolvency or financial instability of outsourcing partners or suppliers or their inability to obtain credit to finance development and/or manufacture products resulting in product delays; inability of customers, including channel partners, to obtain credit to finance purchases of the Company’s products; failure of derivative counterparties and other financial institutions; and restrictions on the Company’s ability to issue new debt. Other income and expense also could vary materially from expectations depending on gains or losses realized on the sale or exchange of financial instruments; impairment charges resulting from revaluations of debt and equity securities and other investments; changes in interest rates; increases or decreases in cash balances; volatility in foreign exchange rates; and changes in fair value of derivative instruments. Increased volatility in the financial markets and overall economic uncertainty would increase the risk of the actual amounts realized in the future on the Company’s financial instruments differing significantly from the fair values currently assigned to them. Global markets for the Company’s products and services are highly competitive and subject to rapid technological change, and the Company may be unable to compete effectively in these markets. The Company’s products and services compete in highly competitive global markets characterized by aggressive price cutting and resulting downward pressure on gross margins, frequent introduction of new products, short product life cycles, evolving industry standards, continual improvement in product price/performance characteristics, rapid adoption of technological and product advancements by competitors and price sensitivity on the part of consumers. The Company’s ability to compete successfully depends heavily on its ability to ensure a continuing and timely introduction of innovative new products, services and technologies to the marketplace. The Company believes it is unique in that it designs and develops nearly the entire solution for its products, including the hardware, operating system, numerous software applications and related services. As a result, the Company must make significant investments in R&D. The Company currently holds a significant number of patents and copyrights and has registered and/or has applied to register numerous patents, trademarks and service marks. In contrast, many of the Company’s competitors seek to compete primarily through aggressive pricing and very low cost structures, and emulating the Company's products and infringing on its intellectual property. If the Company is unable to continue to develop and sell innovative new products with attractive margins or if competitors infringe on the Company’s intellectual property, the Company’s ability to maintain a competitive advantage could be adversely affected. Apple Inc. | 2016 Form 10-K | 8 The Company markets certain mobile communication and media devices based on the iOS mobile operating system and also markets related services, including third-party digital content and applications. The Company faces substantial competition in these markets from companies that have significant technical, marketing, distribution and other resources, as well as established hardware, software and digital content supplier relationships; and the Company has a minority market share in the global smartphone market. Additionally, the Company faces significant price competition as competitors reduce their selling prices and attempt to imitate the Company’s product features and applications within their own products or, alternatively, collaborate with each other to offer solutions that are more competitive than those they currently offer. The Company competes with business models that provide content to users for free. The Company also competes with illegitimate means to obtain third-party digital content and applications. Some of the Company’s competitors have greater experience, product breadth and distribution channels than the Company. Because some current and potential competitors have substantial resources and/or experience and a lower cost structure, they may be able to provide products and services at little or no profit or even at a loss. The Company also expects competition to intensify as competitors attempt to imitate the Company’s approach to providing components seamlessly within their individual offerings or work collaboratively to offer integrated solutions. The Company’s financial condition and operating results depend substantially on the Company’s ability to continually improve iOS and iOS devices in order to maintain their functional and design advantages. The Company is the only authorized maker of hardware using macOS, which has a minority market share in the personal computer market. This market has been contracting and is dominated by computer makers using competing operating systems, most notably Windows. In the market for personal computers and accessories, the Company faces a significant number of competitors, many of which have broader product lines, lower priced products and a larger installed customer base. Historically, consolidation in this market has resulted in larger competitors. Price competition has been particularly intense as competitors have aggressively cut prices and lowered product margins. An increasing number of internet-enabled devices that include software applications and are smaller and simpler than traditional personal computers compete for market share with the Company’s existing products. The Company’s financial condition and operating results also depend on its ability to continually improve the Mac platform to maintain its functional and design advantages. There can be no assurance the Company will be able to continue to provide products and services that compete effectively. To remain competitive and stimulate customer demand, the Company must successfully manage frequent product introductions and transitions. Due to the highly volatile and competitive nature of the industries in which the Company competes, the Company must continually introduce new products, services and technologies, enhance existing products and services, effectively stimulate customer demand for new and upgraded products and successfully manage the transition to these new and upgraded products. The success of new product introductions depends on a number of factors including, but not limited to, timely and successful product development, market acceptance, the Company’s ability to manage the risks associated with new product production ramp-up issues, the availability of application software for new products, the effective management of purchase commitments and inventory levels in line with anticipated product demand, the availability of products in appropriate quantities and at expected costs to meet anticipated demand and the risk that new products may have quality or other defects or deficiencies in the early stages of introduction. Accordingly, the Company cannot determine in advance the ultimate effect of new product introductions and transitions. The Company depends on the performance of distributors, carriers and other resellers. The Company distributes its products through cellular network carriers, wholesalers, national and regional retailers and value-added resellers, many of whom distribute products from competing manufacturers. The Company also sells its products and third-party products in most of its major markets directly to education, enterprise and government customers and consumers and small and mid-sized businesses through its online and retail stores. Some carriers providing cellular network service for iPhone subsidize users’ purchases of the device. There is no assurance that such subsidies will be continued at all or in the same amounts upon renewal of the Company’s agreements with these carriers or in agreements the Company enters into with new carriers. Many resellers have been adversely affected in the past by weak economic conditions. The Company has invested and will continue to invest in programs to enhance reseller sales, including staffing selected resellers’ stores with Company employees and contractors, and improving product placement displays. These programs could require a substantial investment while providing no assurance of return or incremental revenue. The financial condition of these resellers could weaken, these resellers could stop distributing the Company’s products, or uncertainty regarding demand for some or all of the Company’s products could cause resellers to reduce their ordering and marketing of the Company’s products. Apple Inc. | 2016 Form 10-K | 9 The Company faces substantial inventory and other asset risk in addition to purchase commitment cancellation risk. The Company records a write-down for product and component inventories that have become obsolete or exceed anticipated demand or net realizable value and accrues necessary cancellation fee reserves for orders of excess products and components. The Company also reviews its long-lived assets, including capital assets held at its suppliers’ facilities and inventory prepayments, for impairment whenever events or circumstances indicate the carrying amount of an asset may not be recoverable. If the Company determines that impairment has occurred, it records a write-down equal to the amount by which the carrying value of the assets exceeds its fair value. Although the Company believes its provisions related to inventory, capital assets, inventory prepayments and other assets and purchase commitments are currently adequate, no assurance can be given that the Company will not incur additional related charges given the rapid and unpredictable pace of product obsolescence in the industries in which the Company competes. The Company must order components for its products and build inventory in advance of product announcements and shipments. Consistent with industry practice, components are normally acquired through a combination of purchase orders, supplier contracts and open orders, in each case based on projected demand. Manufacturing purchase obligations typically cover forecasted component and manufacturing requirements for periods up to 150 days. Because the Company’s markets are volatile, competitive and subject to rapid technology and price changes, there is a risk the Company will forecast incorrectly and order or produce excess or insufficient amounts of components or products, or not fully utilize firm purchase commitments. Future operating results depend upon the Company’s ability to obtain components in sufficient quantities on commercially reasonable terms. Because the Company currently obtains components from single or limited sources, the Company is subject to significant supply and pricing risks. Many components, including those that are available from multiple sources, are at times subject to industry-wide shortages and significant commodity pricing fluctuations. While the Company has entered into agreements for the supply of many components, there can be no assurance that the Company will be able to extend or renew these agreements on similar terms, or at all. A number of suppliers of components may suffer from poor financial conditions, which can lead to business failure for the supplier or consolidation within a particular industry, further limiting the Company’s ability to obtain sufficient quantities of components on commercially reasonable terms. The effects of global or regional economic conditions on the Company’s suppliers, described in “ Global and regional economic conditions could materially adversely affect the Company” above, also could affect the Company’s ability to obtain components . Therefore, the Company remains subject to significant risks of supply shortages and price increases. The Company’s new products often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. Continued availability of these components at acceptable prices, or at all, may be affected for any number of reasons, including if those suppliers decide to concentrate on the production of common components instead of components customized to meet the Company’s requirements. The supply of components for a new or existing product could be delayed or constrained, or a key manufacturing vendor could delay shipments of completed products to the Company. The Company depends on component and product manufacturing and logistical services provided by outsourcing partners, many of which are located outside of the U.S. Substantially all of the Company’s manufacturing is performed in whole or in part by a few outsourcing partners located primarily in Asia. The Company has also outsourced much of its transportation and logistics management. While these arrangements may lower operating costs, they also reduce the Company’s direct control over production and distribution. It is uncertain what effect such diminished control will have on the quality or quantity of products or services, or the Company’s flexibility to respond to changing conditions. Although arrangements with these partners may contain provisions for warranty expense reimbursement, the Company may remain responsible to the consumer for warranty service in the event of product defects and could experience an unanticipated product defect or warranty liability. While the Company relies on its partners to adhere to its supplier code of conduct, material violations of the supplier code of conduct could occur. The Company relies on sole-sourced outsourcing partners in the U.S., Asia and Europe to supply and manufacture many critical components, and on outsourcing partners primarily located in Asia, for final assembly of substantially all of the Company’s hardware products. Any failure of these partners to perform may have a negative impact on the Company’s cost or supply of components or finished goods. In addition, manufacturing or logistics in these locations or transit to final destinations may be disrupted for a variety of reasons including, but not limited to, natural and man-made disasters, information technology system failures, commercial disputes, military actions or economic, business, labor, environmental, public health, or political issues. The Company has invested in manufacturing process equipment, much of which is held at certain of its outsourcing partners, and has made prepayments to certain of its suppliers associated with long-term supply agreements. While these arrangements help ensure the supply of components and finished goods, if these outsourcing partners or suppliers experience severe financial problems or other disruptions in their business, such continued supply could be reduced or terminated and the net realizable value of these assets could be negatively impacted. Apple Inc. | 2016 Form 10-K | 10 The Company’s products and services may experience quality problems from time to time that can result in decreased sales and operating margin and harm to the Company’s reputation. The Company sells complex hardware and software products and services that can contain design and manufacturing defects. Sophisticated operating system software and applications, such as those sold by the Company, often contain “bugs” that can unexpectedly interfere with the software’s intended operation. The Company’s online services may from time to time experience outages, service slowdowns, or errors. Defects may also occur in components and products the Company purchases from third parties. There can be no assurance the Company will be able to detect and fix all defects in the hardware, software and services it sells. Failure to do so could result in lost revenue, significant warranty and other expenses and harm to the Company’s reputation. The Company relies on access to third-party digital content, which may not be available to the Company on commercially reasonable terms or at all. The Company contracts with numerous third parties to offer their digital content to customers. This includes the right to sell currently available music, movies, TV shows and books. The licensing or other distribution arrangements with these third parties are for relatively short terms and do not guarantee the continuation or renewal of these arrangements on reasonable terms, if at all. Some third-party content providers and distributors currently or in the future may offer competing products and services, and could take action to make it more difficult or impossible for the Company to license or otherwise distribute their content in the future. Other content owners, providers or distributors may seek to limit the Company’s access to, or increase the cost of, such content. The Company may be unable to continue to offer a wide variety of content at reasonable prices with acceptable usage rules, or continue to expand its geographic reach. Failure to obtain the right to make available third-party digital content, or to make available such content on commercially reasonable terms, could have a material adverse impact on the Company’s financial condition and operating results. Some third-party digital content providers require the Company to provide digital rights management and other security solutions. If requirements change, the Company may have to develop or license new technology to provide these solutions. There is no assurance the Company will be able to develop or license such solutions at a reasonable cost and in a timely manner. In addition, certain countries have passed or may propose and adopt legislation that would force the Company to license its digital rights management, which could lessen the protection of content and subject it to piracy and also could negatively affect arrangements with the Company’s content providers. The Company’s future performance depends in part on support from third-party software developers. The Company believes decisions by customers to purchase its hardware products depend in part on the availability of third‑party software applications and services. There is no assurance that third-party developers will continue to develop and maintain software applications and services for the Company’s products. If third-party software applications and services cease to be developed and maintained for the Company’s products, customers may choose not to buy the Company’s products. With respect to its Mac products, the Company believes the availability of third‑party software applications and services depends in part on the developers’ perception and analysis of the relative benefits of developing, maintaining and upgrading such software for the Company’s products compared to Windows-based products. This analysis may be based on factors such as the market position of the Company and its products, the anticipated revenue that may be generated, expected future growth of Mac sales and the costs of developing such applications and services. If the Company’s minority share of the global personal computer market causes developers to question the Mac’s prospects, developers could be less inclined to develop or upgrade software for the Company’s Mac products and more inclined to devote their resources to developing and upgrading software for the larger Windows market. With respect to iOS devices, the Company relies on the continued availability and development of compelling and innovative software applications, which are distributed through a single distribution channel, the App Store. iOS devices are subject to rapid technological change, and, if third-party developers are unable to or choose not to keep up with this pace of change, third-party applications might not successfully operate and may result in dissatisfied customers. As with applications for the Company’s Mac products, the availability and development of these applications also depend on developers’ perceptions and analysis of the relative benefits of developing, maintaining or upgrading software for the Company’s iOS devices rather than its competitors’ platforms, such as Android. If developers focus their efforts on these competing platforms, the availability and quality of applications for the Company’s iOS devices may suffer. Apple Inc. | 2016 Form 10-K | 11 The Company relies on access to third-party intellectual property, which may not be available to the Company on commercially reasonable terms or at all. Many of the Company’s products include third-party intellectual property, which requires licenses from those third parties. Based on past experience and industry practice, the Company believes such licenses generally can be obtained on reasonable terms. There is, however, no assurance that the necessary licenses can be obtained on acceptable terms or at all. Failure to obtain the right to use third-party intellectual property, or to use such intellectual property on commercially reasonable terms, could preclude the Company from selling certain products or otherwise have a material adverse impact on the Company’s financial condition and operating results. The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights. The Company is subject to various legal proceedings and claims that have not yet been fully resolved and that have arisen in the ordinary course of business, and additional claims may arise in the future. For example, technology companies, including many of the Company’s competitors, frequently enter into litigation based on allegations of patent infringement or other violations of intellectual property rights. In addition, patent holding companies seek to monetize patents they have purchased or otherwise obtained. The intellectual property rights claims against the Company have generally increased over time and may continue to increase. In particular, the Company's cellular enabled products compete with products from mobile communication and media device companies that hold significant patent portfolios, and the Company has faced a significant number of patent claims against it. The Company is vigorously defending infringement actions in courts in a number of U.S. jurisdictions and before the U.S. International Trade Commission, as well as internationally in various countries. The plaintiffs in these actions frequently seek injunctions and substantial damages. Regardless of the scope or validity of such patents or other intellectual property rights, or the merits of any claims by potential or actual litigants, the Company may have to engage in protracted litigation. If the Company is found to infringe one or more patents or other intellectual property rights, regardless of whether it can develop non-infringing technology, it may be required to pay substantial damages or royalties to a third-party, or it may be subject to a temporary or permanent injunction prohibiting the Company from marketing or selling certain products. In certain cases, the Company may consider the desirability of entering into licensing agreements, although no assurance can be given that such licenses can be obtained on acceptable terms or that litigation will not occur. These licenses may also significantly increase the Company’s operating expenses. Regardless of the merit of particular claims, litigation may be expensive, time-consuming, disruptive to the Company’s operations and distracting to management. In recognition of these considerations, the Company may enter into arrangements to settle litigation. In management’s opinion, there is not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies, including matters related to infringement of intellectual property rights. However, the outcome of litigation is inherently uncertain. Although management considers the likelihood of such an outcome to be remote, if one or more legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Further, such an outcome could result in significant compensatory, punitive or trebled monetary damages, disgorgement of revenue or profits, remedial corporate measures or injunctive relief against the Company that could materially adversely affect its financial condition and operating results. The Company is subject to laws and regulations worldwide, changes to which could increase the Company’s costs and individually or in the aggregate adversely affect the Company’s business. The Company is subject to laws and regulations affecting its domestic and international operations in a number of areas. These U.S. and foreign laws and regulations affect the Company’s activities including, but not limited to, in areas of labor, advertising, digital content, consumer protection, real estate, billing, e-commerce, promotions, quality of services, telecommunications, mobile communications and media, television, intellectual property ownership and infringement, tax, import and export requirements, anti-corruption, foreign exchange controls and cash repatriation restrictions, data privacy requirements, anti-competition, environmental, health and safety. By way of example, laws and regulations related to mobile communications and media devices in the many jurisdictions in which the Company operates are extensive and subject to change. Such changes could include, among others, restrictions on the production, manufacture, distribution and use of devices, locking devices to a carrier’s network, or mandating the use of devices on more than one carrier’s network. These devices are also subject to certification and regulation by governmental and standardization bodies, as well as by cellular network carriers for use on their networks. These certification processes are extensive and time consuming, and could result in additional testing requirements, product modifications, or delays in product shipment dates, or could preclude the Company from selling certain products. Apple Inc. | 2016 Form 10-K | 12 Compliance with these laws, regulations and similar requirements may be onerous and expensive, and they may be inconsistent from jurisdiction to jurisdiction, further increasing the cost of compliance and doing business. Any such costs, which may rise in the future as a result of changes in these laws and regulations or in their interpretation, could individually or in the aggregate make the Company’s products and services less attractive to the Company’s customers, delay the introduction of new products in one or more regions, or cause the Company to change or limit its business practices. The Company has implemented policies and procedures designed to ensure compliance with applicable laws and regulations, but there can be no assurance that the Company’s employees, contractors, or agents will not violate such laws and regulations or the Company’s policies and procedures. The Company’s business is subject to the risks of international operations. The Company derives a significant portion of its revenue and earnings from its international operations. Compliance with applicable U.S. and foreign laws and regulations, such as import and export requirements, anti-corruption laws, tax laws, foreign exchange controls and cash repatriation restrictions, data privacy requirements, environmental laws, labor laws and anti-competition regulations, increases the costs of doing business in foreign jurisdictions. Although the Company has implemented policies and procedures to comply with these laws and regulations, a violation by the Company’s employees, contractors, or agents could nevertheless occur. In some cases, compliance with the laws and regulations of one country could violate the laws and regulations of another country. Violations of these laws and regulations could materially adversely affect the Company’s brand, international growth efforts and business. The Company also could be significantly affected by other risks associated with international activities including, but not limited to, economic and labor conditions, increased duties, taxes and other costs and political instability. Margins on sales of the Company’s products in foreign countries, and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by international trade regulations, including duties, tariffs and antidumping penalties. The Company is also exposed to credit and collectability risk on its trade receivables with customers in certain international markets. There can be no assurance the Company can effectively limit its credit risk and avoid losses. The Company’s retail stores have required and will continue to require a substantial investment and commitment of resources and are subject to numerous risks and uncertainties. The Company’s retail stores have required substantial investment in equipment and leasehold improvements, information systems, inventory and personnel. The Company also has entered into substantial operating lease commitments for retail space. Certain stores have been designed and built to serve as high-profile venues to promote brand awareness and serve as vehicles for corporate sales and marketing activities. Because of their unique design elements, locations and size, these stores require substantially more investment than the Company’s more typical retail stores. Due to the high cost structure associated with the Company’s retail stores, a decline in sales or the closure or poor performance of individual or multiple stores could result in significant lease termination costs, write-offs of equipment and leasehold improvements and severance costs. Many factors unique to retail operations, some of which are beyond the Company’s control, pose risks and uncertainties. These risks and uncertainties include, but are not limited to, macro-economic factors that could have an adverse effect on general retail activity, as well as the Company’s inability to manage costs associated with store construction and operation, the Company’s failure to manage relationships with its existing retail partners, more challenging environments in managing retail operations outside the U.S., costs associated with unanticipated fluctuations in the value of retail inventory, and the Company’s inability to obtain and renew leases in quality retail locations at a reasonable cost. Investment in new business strategies and acquisitions could disrupt the Company’s ongoing business and present risks not originally contemplated. The Company has invested, and in the future may invest, in new business strategies or acquisitions. Such endeavors may involve significant risks and uncertainties, including distraction of management from current operations, greater than expected liabilities and expenses, inadequate return of capital and unidentified issues not discovered in the Company’s due diligence. These new ventures are inherently risky and may not be successful. The Company’s business and reputation may be impacted by information technology system failures or network disruptions. The Company may be subject to information technology system failures and network disruptions. These may be caused by natural disasters, accidents, power disruptions, telecommunications failures, acts of terrorism or war, computer viruses, physical or electronic break-ins, or other events or disruptions. System redundancy may be ineffective or inadequate, and the Company’s disaster recovery planning may not be sufficient for all eventualities. Such failures or disruptions could, among other things, prevent access to the Company’s online stores and services, preclude retail store transactions, compromise Company or customer data, and result in delayed or cancelled orders. System failures and disruptions could also impede the manufacturing and shipping of products, delivery of online services, transactions processing and financial reporting. Apple Inc. | 2016 Form 10-K | 13 There may be breaches of the Company’s information technology systems that materially damage business partner and customer relationships, curtail or otherwise adversely impact access to online stores and services, or subject the Company to significant reputational, financial, legal and operational consequences. The Company’s business requires it to use and store customer, employee and business partner personally identifiable information (“PII”). This may include, among other information, names, addresses, phone numbers, email addresses, contact preferences, tax identification numbers and payment account information. Although malicious attacks to gain access to PII affect many companies across various industries, the Company is at a relatively greater risk of being targeted because of its high profile and the amount of PII it manages. The Company requires user names and passwords in order to access its information technology systems. The Company also uses encryption and authentication technologies designed to secure the transmission and storage of data and prevent access to Company data or accounts. As with all companies, these security measures are subject to third-party security breaches, employee error, malfeasance, faulty password management, or other irregularities. For example, third parties may attempt to fraudulently induce employees or customers into disclosing user names, passwords or other sensitive information, which may in turn be used to access the Company’s information technology systems. To help protect customers and the Company, the Company monitors accounts and systems for unusual activity and may freeze accounts under suspicious circumstances, which may result in the delay or loss of customer orders. The Company devotes significant resources to network security, data encryption and other security measures to protect its systems and data, but these security measures cannot provide absolute security. To the extent the Company was to experience a breach of its systems and was unable to protect sensitive data, such a breach could materially damage business partner and customer relationships, and curtail or otherwise adversely impact access to online stores and services. Moreover, if a computer security breach affects the Company’s systems or results in the unauthorized release of PII, the Company’s reputation and brand could be materially damaged, use of the Company’s products and services could decrease, and the Company could be exposed to a risk of loss or litigation and possible liability. While the Company maintains insurance coverage that, subject to policy terms and conditions and subject to a significant self-insured retention, is designed to address certain aspects of cyber risks, such insurance coverage may be insufficient to cover all losses or all types of claims that may arise in the continually evolving area of cyber risk. The Company is also subject to payment card association rules and obligations under its contracts with payment card processors. Under these rules and obligations, if information is compromised, the Company could be liable to payment card issuers for associated expenses and penalties. In addition, if the Company fails to follow payment card industry security standards, even if no customer information is compromised, the Company could incur significant fines or experience a significant increase in payment card transaction costs. The Company’s business is subject to a variety of U.S. and international laws, rules, policies and other obligations regarding data protection. The Company is subject to federal, state and international laws relating to the collection, use, retention, security and transfer of PII. In many cases, these laws apply not only to third-party transactions, but also may restrict transfers of PII among the Company and its international subsidiaries. Several jurisdictions have passed laws in this area, and other jurisdictions are considering imposing additional restrictions. These laws continue to develop and may be inconsistent from jurisdiction to jurisdiction. Complying with emerging and changing international requirements may cause the Company to incur substantial costs or require the Company to change its business practices. Noncompliance could result in significant penalties or legal liability. The Company makes statements about its use and disclosure of PII through its privacy policy, information provided on its website and press statements. Any failure by the Company to comply with these public statements or with other federal, state or international privacy-related or data protection laws and regulations could result in proceedings against the Company by governmental entities or others. Penalties could include ongoing audit requirements or significant legal liability. The Company’s success depends largely on the continued service and availability of key personnel. Much of the Company’s future success depends on the continued availability and service of key personnel, including its Chief Executive Officer, executive team and other highly skilled employees. Experienced personnel in the technology industry are in high demand and competition for their talents is intense, especially in Silicon Valley, where most of the Company’s key personnel are located. Apple Inc. | 2016 Form 10-K | 14 The Company’s business may be impacted by political events, war, terrorism, public health issues, natural disasters and other business interruptions. War, terrorism, geopolitical uncertainties, public health issues and other business interruptions have caused and could cause damage or disruption to international commerce and the global economy, and thus could have a material adverse effect on the Company, its suppliers, logistics providers, manufacturing vendors and customers, including channel partners. The Company’s business operations are subject to interruption by, among others, natural disasters, whether as a result of climate change or otherwise, fire, power shortages, nuclear power plant accidents and other industrial accidents, terrorist attacks and other hostile acts, labor disputes, public health issues and other events beyond its control. Such events could decrease demand for the Company’s products, make it difficult or impossible for the Company to make and deliver products to its customers, including channel partners, or to receive components from its suppliers, and create delays and inefficiencies in the Company’s supply chain. While the Company's suppliers are required to maintain safe working environments and operations, an industrial accident could occur and could result in disruption to the Company's business and harm to the Company's reputation. Should major public health issues, including pandemics, arise, the Company could be adversely affected by more stringent employee travel restrictions, additional limitations in freight services, governmental actions limiting the movement of products between regions, delays in production ramps of new products and disruptions in the operations of the Company’s manufacturing vendors and component suppliers. The majority of the Company’s R&D activities, its corporate headquarters, information technology systems and other critical business operations, including certain component suppliers and manufacturing vendors, are in locations that could be affected by natural disasters. In the event of a natural disaster, the Company could incur significant losses, require substantial recovery time and experience significant expenditures in order to resume operations. The Company expects its quarterly revenue and operating results to fluctuate. The Company’s profit margins vary across its products and distribution channels. The Company’s software, accessories, and service and support contracts generally have higher gross margins than certain of the Company’s other products. Gross margins on the Company’s hardware products vary across product lines and can change over time as a result of product transitions, pricing and configuration changes, and component, warranty, and other cost fluctuations. The Company’s direct sales generally have higher associated gross margins than its indirect sales through its channel partners. In addition, the Company’s gross margin and operating margin percentages, as well as overall profitability, may be materially adversely impacted as a result of a shift in product, geographic or channel mix, component cost increases, the strengthening U.S. dollar, price competition, or the introduction of new products, including those that have higher cost structures with flat or reduced pricing. The Company has typically experienced higher net sales in its first quarter compared to other quarters due in part to seasonal holiday demand. Additionally, new product introductions can significantly impact net sales, product costs and operating expenses. Further, the Company generates a majority of its net sales from a single product and a decline in demand for that product could significantly impact quarterly net sales. The Company could also be subject to unexpected developments late in a quarter, such as lower-than-anticipated demand for the Company’s products, issues with new product introductions, an internal systems failure, or failure of one of the Company’s logistics, components supply, or manufacturing partners. The Company’s stock price is subject to volatility. The Company’s stock price has experienced substantial price volatility in the past and may continue to do so in the future. Additionally, the Company, the technology industry and the stock market as a whole have experienced extreme stock price and volume fluctuations that have affected stock prices in ways that may have been unrelated to these companies’ operating performance. Price volatility over a given period may cause the average price at which the Company repurchases its own stock to exceed the stock’s price at a given point in time. The Company believes its stock price should reflect expectations of future growth and profitability. The Company also believes its stock price should reflect expectations that its cash dividend will continue at current levels or grow and that its current share repurchase program will be fully consummated. Future dividends are subject to declaration by the Company’s Board of Directors, and the Company’s share repurchase program does not obligate it to acquire any specific number of shares. If the Company fails to meet expectations related to future growth, profitability, dividends, share repurchases or other market expectations, its stock price may decline significantly, which could have a material adverse impact on investor confidence and employee retention. Apple Inc. | 2016 Form 10-K | 15 The Company’s financial performance is subject to risks associated with changes in the value of the U.S. dollar versus local currencies. The Company’s primary exposure to movements in foreign currency exchange rates relates to non-U.S. dollar-denominated sales and operating expenses worldwide. Weakening of foreign currencies relative to the U.S. dollar adversely affects the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings, and generally leads the Company to raise international pricing, potentially reducing demand for the Company’s products. Margins on sales of the Company’s products in foreign countries and on sales of products that include components obtained from foreign suppliers, could be materially adversely affected by foreign currency exchange rate fluctuations. In some circumstances, for competitive or other reasons, the Company may decide not to raise local prices to fully offset the dollar’s strengthening, or at all, which would adversely affect the U.S. dollar value of the Company’s foreign currency-denominated sales and earnings. Conversely, a strengthening of foreign currencies relative to the U.S. dollar, while generally beneficial to the Company’s foreign currency-denominated sales and earnings, could cause the Company to reduce international pricing and incur losses on its foreign currency derivative instruments, thereby limiting the benefit. Additionally, strengthening of foreign currencies may also increase the Company’s cost of product components denominated in those currencies, thus adversely affecting gross margins. The Company uses derivative instruments, such as foreign currency forward and option contracts, to hedge certain exposures to fluctuations in foreign currency exchange rates. The use of such hedging activities may not offset any, or more than a portion, of the adverse financial effects of unfavorable movements in foreign exchange rates over the limited time the hedges are in place. The Company is exposed to credit risk and fluctuations in the market values of its investment portfolio. Given the global nature of its business, the Company has both domestic and international investments. Credit ratings and pricing of the Company’s investments can be negatively affected by liquidity, credit deterioration, financial results, economic risk, political risk, sovereign risk or other factors. As a result, the value and liquidity of the Company’s cash, cash equivalents and marketable securities may fluctuate substantially. Therefore, although the Company has not realized any significant losses on its cash, cash equivalents and marketable securities, future fluctuations in their value could result in a significant realized loss. The Company is exposed to credit risk on its trade accounts receivable, vendor non-trade receivables and prepayments related to long-term supply agreements, and this risk is heightened during periods when economic conditions worsen. The Company distributes its products through third-party cellular network carriers, wholesalers, retailers and value-added resellers. The Company also sells its products directly to small and mid-sized businesses and education, enterprise and government customers. A substantial majority of the Company’s outstanding trade receivables are not covered by collateral, third-party financing arrangements or credit insurance. The Company’s exposure to credit and collectability risk on its trade receivables is higher in certain international markets and its ability to mitigate such risks may be limited. The Company also has unsecured vendor non-trade receivables resulting from purchases of components by outsourcing partners and other vendors that manufacture sub-assemblies or assemble final products for the Company. In addition, the Company has made prepayments associated with long-term supply agreements to secure supply of inventory components. As of September 24, 2016 , a significant portion of the Company’s trade receivables was concentrated within cellular network carriers, and its vendor non-trade receivables and prepayments related to long-term supply agreements were concentrated among a few individual vendors located primarily in Asia. While the Company has procedures to monitor and limit exposure to credit risk on its trade and vendor non-trade receivables, as well as long-term prepayments, there can be no assurance such procedures will effectively limit its credit risk and avoid losses. The Company could be subject to changes in its tax rates, the adoption of new U.S. or international tax legislation or exposure to additional tax liabilities. The Company is subject to taxes in the U.S. and numerous foreign jurisdictions, including Ireland, where a number of the Company’s subsidiaries are organized. Due to economic and political conditions, tax rates in various jurisdictions may be subject to significant change. The Company’s effective tax rates could be affected by changes in the mix of earnings in countries with differing statutory tax rates, changes in the valuation of deferred tax assets and liabilities, or changes in tax laws or their interpretation, including in the U.S. and Ireland. The Company is also subject to the examination of its tax returns and other tax matters by the U.S. Internal Revenue Service (the "IRS") and other tax authorities and governmental bodies. The Company regularly assesses the likelihood of an adverse outcome resulting from these examinations to determine the adequacy of its provision for taxes. There can be no assurance as to the outcome of these examinations. If the Company’s effective tax rates were to increase, particularly in the U.S. or Ireland, or if the ultimate determination of the Company’s taxes owed is for an amount in excess of amounts previously accrued, the Company’s financial condition, operating results and cash flows could be adversely affected. Apple Inc. | 2016 Form 10-K | 16 Item 1B. Unresolved Staff Comments None. Item 2. Properties The Company’s headquarters are located in Cupertino, California. As of September 24, 2016 , the Company owned 7.1 million square feet and leased 22.3 million square feet of building space, primarily in the U.S. Additionally, the Company owned a total of 2,583 acres of land primarily in the U.S. As of September 24, 2016 , the Company owned facilities and land for R&D, corporate functions and data centers at various locations throughout the U.S., including land in California that is being developed for the Company’s second corporate campus. Outside the U.S., the Company owned additional facilities and land for various purposes. The Company believes its existing facilities and equipment, which are used by all operating segments, are in good operating condition and are suitable for the conduct of its business. The Company has invested in internal capacity and strategic relationships with outside manufacturing vendors and continues to make investments in capital equipment as needed to meet anticipated demand for its products. Item 3. Legal Proceedings The Company is subject to legal proceedings and claims that have not been fully resolved and that have arisen in the ordinary course of business. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. See the risk factor “ The Company could be impacted by unfavorable results of legal proceedings, such as being found to have infringed on intellectual property rights ” in Part I, Item 1A of this Form 10-K under the heading “Risk Factors.” The Company settled certain matters during the fourth quarter of 2016 that did not individually or in the aggregate have a material impact on the Company’s financial condition or operating results. Item 4. Mine Safety Disclosures Not applicable. Apple Inc. | 2016 Form 10-K | 17 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities The Company’s common stock is traded on the NASDAQ Stock Market LLC (“NASDAQ”) under the symbol AAPL. Price Range of Common Stock The price range per share of common stock presented below represents the highest and lowest intraday sales prices for the Company’s common stock on the NASDAQ during each quarter of the two most recent years. Fourth Quarter Third Quarter Second Quarter First Quarter 2016 price range per share $116.18 - $91.50 $112.39 - $89.47 $109.43 - $92.39 $123.82 - $105.57 2015 price range per share $132.97 - $92.00 $134.54 - $123.10 $133.60 - $104.63 $119.75 - $95.18 Holders As of October 14, 2016 , there were 25,641 shareholders of record. Dividends The Company paid a total of $12.0 billion and $11.4 billion in dividends during 2016 and 2015 , respectively, and expects to pay quarterly dividends of $0.57 per common share each quarter, subject to declaration by the Board of Directors. The Company also plans to increase its dividend on an annual basis, subject to declaration by the Board of Directors. Apple Inc. | 2016 Form 10-K | 18 Purchases of Equity Securities by the Issuer and Affiliated Purchasers Share repurchase activity during the three months ended September 24, 2016 was as follows (in millions, except number of shares, which are reflected in thousands, and per share amounts): Periods Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (1) June 26, 2016 to July 30, 2016: Open market and privately negotiated purchases 9,036 $ 96.83 9,036 July 31, 2016 to August 27, 2016: May 2016 ASR 12,269 (2) 12,269 Open market and privately negotiated purchases 11,919 $ 108.11 11,919 August 28, 2016 to September 24, 2016: August 2016 ASR 22,468 (3) (3) 22,468 (3) Open market and privately negotiated purchases 7,624 $ 109.71 7,624 Total 63,316 $ 42,024 (1) In April 2016, the Company’s Board of Directors increased the Company's share repurchase program authorization from $140 billion to $175 billion of the Company’s common stock. As of September 24, 2016 , $133 billion of the $175 billion had been utilized. The remaining $42 billion in the table represents the amount available to repurchase shares under the authorized repurchase program as of September 24, 2016 . The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. (2) In May 2016, the Company entered into an accelerated share repurchase arrangement ("ASR") to purchase up to $6.0 billion of the Company's common stock. In August 2016, the purchase period for this ASR ended and an additional 12.3 million shares were delivered and retired. In total, 60.5 million shares were delivered under this ASR at an average repurchase price of $99.25. (3) In August 2016, the Company entered into a new ASR to purchase up to $3.0 billion of the Company’s common stock. In exchange for an up-front payment of $3.0 billion, the financial institution party to the arrangement committed to deliver shares to the Company during the ASR’s purchase period, which will end in or before November 2016. The total number of shares ultimately delivered, and therefore the average price paid per share, will be determined at the end of the applicable purchase period based on the volume weighted-average price of the Company’s common stock during that period. Apple Inc. | 2016 Form 10-K | 19 Company Stock Performance The following graph shows a comparison of cumulative total shareholder return, calculated on a dividend reinvested basis, for the Company, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index for the five years ended September 24, 2016 . The graph assumes $100 was invested in each of the Company’s common stock, the S&P 500 Index, the S&P Information Technology Index and the Dow Jones U.S. Technology Supersector Index as of the market close on September 23, 2011. Note that historic stock price performance is not necessarily indicative of future stock price performance. * $100 invested on 9/23/11 in stock or index, including reinvestment of dividends. Data points are the last day of each fiscal year for the Company’s common stock and September 30th for indexes. Copyright © 2016 S&P, a division of McGraw Hill Financial. All rights reserved. Copyright © 2016 Dow Jones & Co. All rights reserved. September 2011 September 2012 September 2013 September 2014 September 2015 September 2016 Apple Inc. $ 100 $ 166 $ 123 $ 183 $ 212 $ 213 S&P 500 Index $ 100 $ 130 $ 155 $ 186 $ 185 $ 213 S&P Information Technology Index $ 100 $ 132 $ 142 $ 183 $ 187 $ 230 Dow Jones U.S. Technology Supersector Index $ 100 $ 130 $ 137 $ 178 $ 177 $ 217 Apple Inc. | 2016 Form 10-K | 20 Item 6. Selected Financial Data The information set forth below for the five years ended September 24, 2016 , is not necessarily indicative of results of future operations, and should be read in conjunction with Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes thereto included in Part II, Item 8 of this Form 10-K to fully understand factors that may affect the comparability of the information presented below (in millions, except number of shares, which are reflected in thousands, and per share amounts). 2016 2015 2014 2013 2012 Net sales $ 215,639 $ 233,715 $ 182,795 $ 170,910 $ 156,508 Net income $ 45,687 $ 53,394 $ 39,510 $ 37,037 $ 41,733 Earnings per share: Basic $ 8.35 $ 9.28 $ 6.49 $ 5.72 $ 6.38 Diluted $ 8.31 $ 9.22 $ 6.45 $ 5.68 $ 6.31 Cash dividends declared per share $ 2.18 $ 1.98 $ 1.82 $ 1.64 $ 0.38 Shares used in computing earnings per share: Basic 5,470,820 5,753,421 6,085,572 6,477,320 6,543,726 Diluted 5,500,281 5,793,069 6,122,663 6,521,634 6,617,483 Total cash, cash equivalents and marketable securities $ 237,585 $ 205,666 $ 155,239 $ 146,761 $ 121,251 Total assets $ 321,686 $ 290,345 $ 231,839 $ 207,000 $ 176,064 Commercial paper $ 8,105 $ 8,499 $ 6,308 $ — $ — Total term debt (1) $ 78,927 $ 55,829 $ 28,987 $ 16,960 $ — Other long-term obligations (2) $ 36,074 $ 33,427 $ 24,826 $ 20,208 $ 16,664 Total liabilities $ 193,437 $ 170,990 $ 120,292 $ 83,451 $ 57,854 Total shareholders’ equity $ 128,249 $ 119,355 $ 111,547 $ 123,549 $ 118,210 (1) Includes current and long-term portion of term debt. (2) Other long-term obligations excludes non-current deferred revenue. Apple Inc. | 2016 Form 10-K | 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations This section and other parts of this Annual Report on Form 10-K ( “ Form 10-K ” ) contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995, that involve risks and uncertainties. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Forward-looking statements can also be identified by words such as “ future, ” “ anticipates, ” “ believes, ” “ estimates, ” “ expects, ” “ intends, ” “ plans, ” “ predicts, ” “ will, ” “ would, ” “ could, ” “ can, ” “ may, ” and similar terms. Forward-looking statements are not guarantees of future performance and the Company’s actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in Part I, Item 1A of this Form 10-K under the heading “ Risk Factors, ” which are incorporated herein by reference. The following discussion should be read in conjunction with the consolidated financial statements and notes thereto included in Part II, Item 8 of this Form 10-K. All information presented herein is based on the Company’s fiscal calendar. Unless otherwise stated, references to particular years, quarters, months or periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. Each of the terms the “ Company ” and “ Apple ” as used herein refers collectively to Apple Inc. and its wholly-owned subsidiaries, unless otherwise stated. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law. Overview and Highlights The Company designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company’s products and services include iPhone ® , iPad ® , Mac ® , iPod ® , Apple Watch ® , Apple TV ® , a portfolio of consumer and professional software applications, iOS, macOS™, watchOS ® and tvOS™ operating systems, iCloud ® , Apple Pay ® and a variety of accessory, service and support offerings. The Company sells and delivers digital content and applications through the iTunes Store ® , App Store ® , Mac App Store, TV App Store, iBooks Store™ and Apple Music ® (collectively “Internet Services”). The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party Apple compatible products, including application software and various accessories through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Fiscal 2016 Highlights Net sales declined 8% or $18.1 billion during 2016 compared to 2015, primarily driven by a year-over-year decrease in iPhone net sales and the effect of weakness in most foreign currencies relative to the U.S. dollar, partially offset by an increase in Services. In April 2016, the Company announced a significant increase to its capital return program by raising the expected total size of the program from $200 billion to $250 billion through March 2018. This included increasing its share repurchase authorization from $140 billion to $175 billion and raising its quarterly dividend from $0.52 to $0.57 per share beginning in May 2016. During 2016, the Company spent $29.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $12.2 billion. Additionally, the Company issued $23.9 billion of U.S. dollar-denominated term debt and A$1.4 billion of Australian dollar-denominated term debt during 2016. Fiscal 2015 Highlights Net sales rose 28% or $50.9 billion during 2015 compared to 2014, driven by a year-over-year increase in iPhone net sales. iPhone net sales and unit sales in 2015 increased in all of the Company’s reportable operating segments. The Company also experienced year-over-year net sales increases in Mac, Services and Other Products. Apple Watch, which launched during the third quarter of 2015, accounted for more than 100% of the year-over-year growth in net sales of Other Products. Net sales growth during 2015 was partially offset by the effect of weakness in most foreign currencies relative to the U.S. dollar and lower iPad net sales. Total net sales increased in each of the Company’s reportable operating segments, with particularly strong growth in Greater China where year-over-year net sales increased 84%. In April 2015, the Company announced a significant increase to its capital return program by raising the expected total size of the program to $200 billion through March 2017. This included increasing its share repurchase authorization to $140 billion and raising its quarterly dividend to $0.52 per share beginning in May 2015. During 2015, the Company spent $36.0 billion to repurchase shares of its common stock and paid dividends and dividend equivalents of $11.6 billion. Additionally, the Company issued $14.5 billion of U.S. dollar-denominated, €4.8 billion of euro-denominated, SFr1.3 billion of Swiss franc-denominated, £1.3 billion of British pound-denominated, A$2.3 billion of Australian dollar-denominated and ¥250.0 billion of Japanese yen-denominated term debt during 2015. Apple Inc. | 2016 Form 10-K | 22 Sales Data The following table shows net sales by operating segment and net sales and unit sales by product during 2016 , 2015 and 2014 (dollars in millions and units in thousands): 2016 Change 2015 Change 2014 Net Sales by Operating Segment: Americas $ 86,613 (8 )% $ 93,864 17 % $ 80,095 Europe 49,952 (1 )% 50,337 14 % 44,285 Greater China 48,492 (17 )% 58,715 84 % 31,853 Japan 16,928 8 % 15,706 3 % 15,314 Rest of Asia Pacific 13,654 (10 )% 15,093 34 % 11,248 Total net sales $ 215,639 (8 )% $ 233,715 28 % $ 182,795 Net Sales by Product: iPhone (1) $ 136,700 (12 )% $ 155,041 52 % $ 101,991 iPad (1) 20,628 (11 )% 23,227 (23 )% 30,283 Mac (1) 22,831 (10 )% 25,471 6 % 24,079 Services (2) 24,348 22 % 19,909 10 % 18,063 Other Products (1)(3) 11,132 11 % 10,067 20 % 8,379 Total net sales $ 215,639 (8 )% $ 233,715 28 % $ 182,795 Unit Sales by Product: iPhone 211,884 (8 )% 231,218 37 % 169,219 iPad 45,590 (17 )% 54,856 (19 )% 67,977 Mac 18,484 (10 )% 20,587 9 % 18,906 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from Internet Services, AppleCare ® , Apple Pay, licensing and other services. (3) Includes sales of Apple TV, Apple Watch, Beats ® products, iPod and Apple-branded and third-party accessories. Apple Inc. | 2016 Form 10-K | 23 Product Performance iPhone The following table presents iPhone net sales and unit sales information for 2016 , 2015 and 2014 (dollars in millions and units in thousands): 2016 Change 2015 Change 2014 Net sales $ 136,700 (12 )% $ 155,041 52 % $ 101,991 Percentage of total net sales 63 % 66 % 56 % Unit sales 211,884 (8 )% 231,218 37 % 169,219 iPhone net sales and unit sales decreased during 2016 compared to 2015. The Company believes the sales decline is due primarily to a lower rate of iPhone upgrades during 2016 compared to 2015 and challenging macroeconomic conditions in a number of major markets in 2016. Average selling prices (“ASPs”) for iPhone were lower year-over-year during 2016 due primarily to a different mix of iPhones, including the iPhone SE introduced in 2016, and the effect of weakness in most foreign currencies relative to the U.S. dollar. The year-over-year growth in iPhone net sales and unit sales during 2015 primarily resulted from strong demand for iPhone 6 and 6 Plus during 2015. Overall ASPs for iPhone increased during 2015 compared to 2014, due primarily to the introduction of iPhone 6 and 6 Plus in September 2014, partially offset by the effect of weakness in most foreign currencies relative to the U.S. dollar. iPad The following table presents iPad net sales and unit sales information for 2016 , 2015 and 2014 (dollars in millions and units in thousands): 2016 Change 2015 Change 2014 Net sales $ 20,628 (11 )% $ 23,227 (23 )% $ 30,283 Percentage of total net sales 10 % 10 % 17 % Unit sales 45,590 (17 )% 54,856 (19 )% 67,977 iPad net sales decreased during 2016 compared to 2015 primarily due to lower unit sales and the effect of weakness in most foreign currencies relative to the U.S. dollar, partially offset by higher ASPs due to a shift in mix to higher-priced iPads. The Company believes the decline in iPad sales is due in part to a longer repurchase cycle for iPads and some level of cannibalization from the Company's other products. Net sales and unit sales for iPad declined during 2015 compared to 2014. The Company believes the decline in iPad sales is due in part to a longer repurchase cycle for iPads and some level of cannibalization from the Company's other products. iPad ASPs declined during 2015 compared to 2014, primarily as a result of the effect of weakness in most foreign currencies relative to the U.S. dollar and a shift in mix to lower-priced iPads. Mac The following table presents Mac net sales and unit sales information for 2016 , 2015 and 2014 (dollars in millions and units in thousands): 2016 Change 2015 Change 2014 Net sales $ 22,831 (10 )% $ 25,471 6 % $ 24,079 Percentage of total net sales 11 % 11 % 13 % Unit sales 18,484 (10 )% 20,587 9 % 18,906 Mac net sales and unit sales decreased during 2016 compared to 2015. The year-over-year decline in Mac unit sales during 2016 was at rates similar to the overall market. The effect of weakness in most foreign currencies relative to the U.S. dollar also negatively impacted Mac net sales. The year-over-year growth in Mac net sales and unit sales during 2015 was driven by strong demand for Mac portables. Mac ASPs declined during 2015 compared to 2014 largely due to the effect of weakness in most foreign currencies relative to the U.S. dollar. Apple Inc. | 2016 Form 10-K | 24 Services The following table presents net sales information of Services for 2016 , 2015 and 2014 (dollars in millions): 2016 Change 2015 Change 2014 Net sales $ 24,348 22 % $ 19,909 10 % $ 18,063 Percentage of total net sales 11 % 9 % 10 % The year-over-year increase in net sales of Services in 2016 was due primarily to growth from the App Store, licensing and AppleCare sales, partially offset by the effect of weakness in most foreign currencies relative to the U.S. dollar. During the first quarter of 2016, the Company received $548 million from Samsung Electronics Co., Ltd. related to its patent infringement lawsuit, which was recorded as licensing net sales within Services. The increase in net sales of Services during 2015 compared to 2014 was primarily due to growth from the App Store and licensing. Segment Operating Performance The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and those Asian countries not included in the Company’s other reportable operating segments. Although the reportable operating segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. Further information regarding the Company’s reportable operating segments can be found in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 11, “Segment Information and Geographic Data.” Americas The following table presents Americas net sales information for 2016 , 2015 and 2014 (dollars in millions): 2016 Change 2015 Change 2014 Net sales $ 86,613 (8 )% $ 93,864 17 % $ 80,095 Percentage of total net sales 40 % 40 % 44 % Americas net sales decreased during 2016 compared to 2015 due primarily to lower net sales and unit sales of iPhone. The year-over-year growth in Americas net sales during 2015 was driven primarily by growth in net sales and unit sales of iPhone, partially offset by a decline in net sales and unit sales of iPad. Europe The following table presents Europe net sales information for 2016 , 2015 and 2014 (dollars in millions): 2016 Change 2015 Change 2014 Net sales $ 49,952 (1 )% $ 50,337 14 % $ 44,285 Percentage of total net sales 23 % 22 % 24 % Europe net sales decreased during 2016 compared to 2015 driven primarily by the effect of weakness in foreign currencies relative to the U.S. dollar and a decrease in unit sales of Mac, largely offset by an increase in iPhone unit sales and Services. The year-over-year increase in Europe net sales during 2015 was driven primarily by growth in net sales and unit sales of iPhone, partially offset by the effect of weakness in foreign currencies relative to the U.S. dollar and a decline in net sales and unit sales of iPad. Apple Inc. | 2016 Form 10-K | 25 Greater China The following table presents Greater China net sales information for 2016 , 2015 and 2014 (dollars in millions): 2016 Change 2015 Change 2014 Net sales $ 48,492 (17 )% $ 58,715 84 % $ 31,853 Percentage of total net sales 22 % 25 % 17 % Greater China net sales decreased during 2016 compared to 2015 due primarily to lower net sales and unit sales of iPhone and the effect of weakness in foreign currencies relative to the U.S. dollar. Greater China experienced strong year-over-year increases in net sales during 2015 driven primarily by iPhone sales. Japan The following table presents Japan net sales information for 2016 , 2015 and 2014 (dollars in millions): 2016 Change 2015 Change 2014 Net sales $ 16,928 8 % $ 15,706 3 % $ 15,314 Percentage of total net sales 8 % 7 % 8 % Japan net sales increased during 2016 compared to 2015 due primarily to higher net sales of Services and the strength in the Japanese yen relative to the U.S. dollar. The year-over-year increase in Japan net sales during 2015 was driven primarily by growth in Services largely associated with strong App Store sales, partially offset by the effect of weakness in the Japanese yen relative to the U.S. dollar. Rest of Asia Pacific The following table presents Rest of Asia Pacific net sales information for 2016 , 2015 and 2014 (dollars in millions): 2016 Change 2015 Change 2014 Net sales $ 13,654 (10 )% $ 15,093 34 % $ 11,248 Percentage of total net sales 6 % 6 % 6 % Rest of Asia Pacific net sales decreased during 2016 compared to 2015 due primarily to lower net sales and unit sales of iPhone and the effect of weakness in foreign currencies relative to the U.S. dollar. The year-over-year increase in Rest of Asia Pacific net sales during 2015 primarily reflects strong growth in net sales and unit sales of iPhone, partially offset by the effect of weakness in foreign currencies relative to the U.S. dollar and a decline in net sales and unit sales of iPad. Gross Margin Gross margin for 2016 , 2015 and 2014 is as follows (dollars in millions): 2016 2015 2014 Net sales $ 215,639 $ 233,715 $ 182,795 Cost of sales 131,376 140,089 112,258 Gross margin $ 84,263 $ 93,626 $ 70,537 Gross margin percentage 39.1 % 40.1 % 38.6 % Gross margin decreased in 2016 compared to 2015 due primarily to the effect of weakness in most foreign currencies relative to the U.S. dollar and, to a lesser extent, unfavorable leverage on fixed costs from lower net sales, partially offset by a favorable shift in mix to Services. The year-over-year increase in the gross margin percentage in 2015 was driven primarily by a favorable shift in mix to products with higher margins and, to a lesser extent, by improved leverage on fixed costs from higher net sales. These positive factors were partially offset primarily by higher product cost structures and, to a lesser extent, by the effect of weakness in most foreign currencies relative to the U.S. dollar. Apple Inc. | 2016 Form 10-K | 26 The Company anticipates gross margin during the first quarter of 2017 to be between 38% and 38.5%. The foregoing statement regarding the Company’s expected gross margin percentage in the first quarter of 2017 is forward-looking and could differ from actual results. The Company’s future gross margins can be impacted by multiple factors including, but not limited to, those set forth in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and those described in this paragraph. In general, the Company believes gross margins will remain under downward pressure due to a variety of factors, including continued industry wide global product pricing pressures, increased competition, compressed product life cycles, product transitions, potential increases in the cost of components, and potential strengthening of the U.S. dollar, as well as potential increases in the costs of outside manufacturing services and a potential shift in the Company’s sales mix towards products with lower gross margins. In response to competitive pressures, the Company expects it will continue to take product pricing actions, which would adversely affect gross margins. Gross margins could also be affected by the Company’s ability to manage product quality and warranty costs effectively and to stimulate demand for certain of its products. Due to the Company’s significant international operations, its financial condition and operating results, including gross margins, could be significantly affected by fluctuations in exchange rates. Operating Expenses Operating expenses for 2016 , 2015 and 2014 are as follows (dollars in millions): 2016 Change 2015 Change 2014 Research and development $ 10,045 25 % $ 8,067 34 % $ 6,041 Percentage of total net sales 5 % 3 % 3 % Selling, general and administrative $ 14,194 (1 )% $ 14,329 19 % $ 11,993 Percentage of total net sales 7 % 6 % 7 % Total operating expenses $ 24,239 8 % $ 22,396 24 % $ 18,034 Percentage of total net sales 11 % 10 % 10 % Research and Development The year-over-year growth in R&D expense in 2016 and 2015 was driven primarily by an increase in headcount and related expenses, and material costs to support expanded R&D activities. The Company continues to believe that focused investments in R&D are critical to its future growth and competitive position in the marketplace, and to the development of new and updated products that are central to the Company’s core business strategy. Selling, General and Administrative The decrease in selling, general and administrative expense in 2016 compared to 2015 was due primarily to lower discretionary expenditures and advertising costs, partially offset by an increase in headcount and related expenses. The year-over-year growth in selling, general and administrative expense in 2015 was primarily due to increased headcount and related expenses, and higher spending on marketing and advertising. Other Income/(Expense), Net Other income/(expense), net for 2016 , 2015 and 2014 are as follows (dollars in millions): 2016 Change 2015 Change 2014 Interest and dividend income $ 3,999 $ 2,921 $ 1,795 Interest expense (1,456 ) (733 ) (384 ) Other expense, net (1,195 ) (903 ) (431 ) Total other income/(expense), net $ 1,348 5 % $ 1,285 31 % $ 980 The year-over-year increase in other income/(expense), net during 2016 and 2015 was due primarily to higher interest income, partially offset by higher interest expense on debt and higher expenses associated with foreign exchange activity. The weighted-average interest rate earned by the Company on its cash, cash equivalents and marketable securities was 1.73%, 1.49% and 1.11% in 2016, 2015 and 2014, respectively. Apple Inc. | 2016 Form 10-K | 27 Provision for Income Taxes Provision for income taxes and effective tax rates for 2016 , 2015 and 2014 are as follows (dollars in millions): 2016 2015 2014 Provision for income taxes 15,685 $ 19,121 $ 13,973 Effective tax rate 25.6 % 26.4 % 26.1 % The Company’s effective tax rates for 2016 , 2015 and 2014 differ from the statutory federal income tax rate of 35% due primarily to certain undistributed foreign earnings, a substantial portion of which was generated by subsidiaries organized in Ireland, for which no U.S. taxes are provided when such earnings are intended to be indefinitely reinvested outside the U.S. The lower effective tax rate in 2016 compared to 2015 was due primarily to greater R&D tax credits. The higher effective tax rate during 2015 compared to 2014 was due primarily to higher foreign taxes. As of September 24, 2016 , the Company had deferred tax assets arising from deductible temporary differences, tax losses and tax credits of $4.1 billion and deferred tax liabilities of $26.0 billion. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. The Company will continue to evaluate the realizability of deferred tax assets quarterly by assessing the need for and the amount of a valuation allowance. During the fourth quarter of 2016, the Company reached a partial settlement with the IRS on its examination of the years 2010 through 2012. In connection with this settlement, the Company recognized a tax benefit in the fourth quarter of 2016 that was not significant to its consolidated financial statements. All years prior to 2013 are closed, except for the years 2010 through 2012 relating to R&D tax credits. In addition, the Company is subject to audits by state, local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 2003 generally remain open and could be subject to examination by the taxing authorities. Management believes that adequate provisions have been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with management’s expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the "State Aid Decision"). The State Aid Decision orders Ireland to calculate and recover additional taxes from the Company for the period June 2003 through September 2014. Irish legislative changes, effective as of the beginning of 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and intends to appeal to the General Court of the Court of Justice of the European Union. Ireland has also announced its intention to appeal the State Aid Decision. While the European Commission announced a recovery amount of up to €13 billion, plus interest, the actual amount of additional taxes subject to recovery is to be calculated by Ireland in accordance with the European Commission's guidance. Once the recovery amount is computed by Ireland, the Company anticipates funding it, including interest, out of foreign cash into escrow, pending conclusion of all appeals. The Company believes that any incremental Irish corporate income taxes potentially due would be creditable against U.S. taxes. Recent Accounting Pronouncements Income Taxes In October 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-16, Income Taxes (Topic 740): Intra-Entity Transfer of Assets Other than Inventory ("ASU 2016-16"), which requires the recognition of the income tax consequences of an intra-entity transfer of an asset, other than inventory, when the transfer occurs. ASU 2016-06 will be effective for the Company in its first quarter of 2019. The Company is currently evaluating the impact of adopting ASU 2016-16 on its consolidated financial statements. Stock Compensation In March 2016, the FASB issued ASU No. 2016-09, Compensation – Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting (“ASU 2016-09”), which simplified certain aspects of the accounting for share-based payment transactions, including income taxes, classification of awards and classification on the statement of cash flows. ASU 2016-09 will be effective for the Company beginning in its first quarter of 2018. The Company is currently evaluating the impact of adopting ASU 2016-09 on its consolidated financial statements. Apple Inc. | 2016 Form 10-K | 28 Leases In February 2016, the FASB issued ASU No. 2016-02, Leases (Topic 842) (“ASU 2016-02”), which modified lease accounting for both lessees and lessors to increase transparency and comparability by recognizing lease assets and lease liabilities by lessees for those leases classified as operating leases under previous accounting standards and disclosing key information about leasing arrangements. ASU 2016-02 will be effective for the Company beginning in its first quarter of 2020, and early adoption is permitted. The Company is currently evaluating the timing of its adoption and the impact of adopting ASU 2016-02 on its consolidated financial statements. Financial Instruments In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments – Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities (“ASU 2016-01”), which updates certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01 will be effective for the Company beginning in its first quarter of 2019. The Company does not believe the adoption of ASU 2016-01 will have a material impact on its consolidated financial statements. In June 2016, the FASB issued ASU No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (“ASU 2016-13”), which modifies the measurement of expected credit losses of certain financial instruments. ASU 2016-13 will be effective for the Company beginning in its first quarter of 2021 and early adoption is permitted. The Company does not believe the adoption of ASU 2016-13 will have a material impact on its consolidated financial statements. Revenue Recognition In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), which amends the existing accounting standards for revenue recognition. ASU 2014-09 is based on principles that govern the recognition of revenue at an amount an entity expects to be entitled when products are transferred to customers. ASU 2014-09 will be effective for the Company beginning in its first quarter of 2019, and early adoption is permitted. Subsequently, the FASB has issued the following standards related to ASU 2014-09: ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (“ASU 2016-08”); ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing (“ASU 2016-10”); and ASU No. 2016-12, Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and Practical Expedients (“ASU 2016-12”). The Company must adopt ASU 2016-08, ASU 2016-10 and ASU 2016-12 with ASU 2014-09 (collectively, the “new revenue standards”). The new revenue standards may be applied retrospectively to each prior period presented or retrospectively with the cumulative effect recognized as of the date of adoption. The Company currently expects to adopt the new revenue standards in its first quarter of 2018 utilizing the full retrospective transition method. The Company does not expect adoption of the new revenue standards to have a material impact on its consolidated financial statements. Liquidity and Capital Resources The following table presents selected financial information and statistics as of and for the years ended September 24, 2016 , September 26, 2015 and September 27, 2014 (in millions): 2016 2015 2014 Cash, cash equivalents and marketable securities $ 237,585 $ 205,666 $ 155,239 Property, plant and equipment, net $ 27,010 $ 22,471 $ 20,624 Commercial paper $ 8,105 $ 8,499 $ 6,308 Total term debt $ 78,927 $ 55,829 $ 28,987 Working capital $ 27,863 $ 8,768 $ 5,083 Cash generated by operating activities $ 65,824 $ 81,266 $ 59,713 Cash used in investing activities $ (45,977 ) $ (56,274 ) $ (22,579 ) Cash used in financing activities $ (20,483 ) $ (17,716 ) $ (37,549 ) The Company believes its existing balances of cash, cash equivalents and marketable securities will be sufficient to satisfy its working capital needs, capital asset purchases, outstanding commitments and other liquidity requirements associated with its existing operations over the next 12 months. The Company currently anticipates the cash used for future dividends, the share repurchase program and debt repayments will come from its current domestic cash, cash generated from on-going U.S. operating activities and from borrowings. Apple Inc. | 2016 Form 10-K | 29 As of September 24, 2016 and September 26, 2015 , the Company’s cash, cash equivalents and marketable securities held by foreign subsidiaries were $216.0 billion and $186.9 billion , respectively, and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. In connection with the State Aid Decision, the European Commission announced a recovery amount of up to €13 billion, plus interest. The actual amount of additional taxes subject to recovery is to be calculated by Ireland in accordance with the European Commission's guidance. Once the recovery amount is computed by Ireland, the Company anticipates funding it, including interest, out of foreign cash into escrow, pending conclusion of all appeals. The Company’s marketable securities investment portfolio is invested primarily in highly-rated securities and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade with the objective of minimizing the potential risk of principal loss. During 2016, cash generated from operating activities of $65.8 billion was a result of $45.7 billion of net income, non-cash adjustments to net income of $19.7 billion and an increase in the net change in operating assets and liabilities of $484 million. Cash used in investing activities of $46.0 billion during 2016 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $30.6 billion and cash used to acquire property, plant and equipment of $12.7 billion. Cash used in financing activities of $20.5 billion during 2016 consisted primarily of cash used to repurchase common stock of $29.7 billion, cash used to pay dividends and dividend equivalents of $12.2 billion and cash used to repay term debt of $2.5 billion, partially offset by net proceeds from the issuance of term debt of $25.0 billion. During 2015, cash generated from operating activities of $81.3 billion was a result of $53.4 billion of net income, non-cash adjustments to net income of $16.2 billion and an increase in the net change in operating assets and liabilities of $11.6 billion. Cash used in investing activities of $56.3 billion during 2015 consisted primarily of cash used for purchases of marketable securities, net of sales and maturities, of $44.4 billion and cash used to acquire property, plant and equipment of $11.2 billion. Cash used in financing activities of $17.7 billion during 2015 consisted primarily of cash used to repurchase common stock of $35.3 billion and cash used to pay dividends and dividend equivalents of $11.6 billion, partially offset by net proceeds from the issuance of term debt of $27.1 billion. Capital Assets The Company’s capital expenditures were $12.8 billion during 2016 . The Company anticipates utilizing approximately $16.0 billion for capital expenditures during 2017 , which includes product tooling and manufacturing process equipment; data centers; corporate facilities and infrastructure, including information systems hardware, software and enhancements; and retail store facilities. Debt The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses the net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 24, 2016 , the Company had $8.1 billion of Commercial Paper outstanding, with a weighted-average interest rate of 0.45% and maturities generally less than nine months. As of September 24, 2016 , the Company has outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $78.4 billion (collectively the “Notes”). During 2016, the Company repaid $2.5 billion of its Notes upon maturity. The Company has entered, and in the future may enter, into interest rate swaps to manage interest rate risk on the Notes. In addition, the Company has entered, and in the future may enter, into currency swaps to manage foreign currency risk on the Notes. The future principal payments for the Company’s Notes as of September 24, 2016 are as follows (in millions): 2017 $ 3,500 2018 6,500 2019 6,834 2020 6,454 2021 7,750 Thereafter 47,346 Total term debt $ 78,384 Further information regarding the Company’s debt issuances and related hedging activity can be found in Part II, Item 8 of this Form 10-K in the Notes to the Consolidated Financial Statements in Note 2, “Financial Instruments” and Note 6, “Debt.” Apple Inc. | 2016 Form 10-K | 30 Capital Return Program In April 2016, the Company’s Board of Directors increased the share repurchase program authorization from $140 billion to $175 billion of the Company’s common stock, increasing the expected total size of the capital return program from $200 billion to $250 billion. Additionally in April 2016, the Company announced that the Board of Directors raised the rate of the Company's quarterly cash dividend by 10% from $0.52 to $0.57 per share, beginning with the dividend paid during the third quarter of 2016. The Company intends to increase its dividend on an annual basis subject to declaration by the Board of Directors. As of September 24, 2016 , $133 billion of the share repurchase program has been utilized. The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated or open market transactions, including under plans complying with Rule 10b5-1 under the Exchange Act. The following table presents the Company’s dividends, dividend equivalents, share repurchases and net share settlement activity from the start of the capital return program in August 2012 through September 24, 2016 (in millions): Dividends and Dividend Equivalents Paid Accelerated Share Repurchases Open Market Share Repurchases Taxes Related to Settlement of Equity Awards Total 2016 $ 12,150 $ 12,000 $ 17,000 $ 1,570 $ 42,720 2015 11,561 6,000 30,026 1,499 49,086 2014 11,126 21,000 24,000 1,158 57,284 2013 10,564 13,950 9,000 1,082 34,596 2012 2,488 — — 56 2,544 Total $ 47,889 $ 52,950 $ 80,026 $ 5,365 $ 186,230 The Company expects to execute its capital return program by the end of March 2018 by paying dividends and dividend equivalents, repurchasing shares and remitting withheld taxes related to net share settlement of restricted stock units. The Company plans to continue to access the domestic and international debt markets to assist in funding its capital return program. Off-Balance Sheet Arrangements and Contractual Obligations The Company has not entered into any transactions with unconsolidated entities whereby the Company has financial guarantees, subordinated retained interests, derivative instruments, or other contingent arrangements that expose the Company to material continuing risks, contingent liabilities, or any other obligation under a variable interest in an unconsolidated entity that provides financing, liquidity, market risk, or credit risk support to the Company, or engages in leasing, hedging, or R&D services with the Company. The following table presents certain payments due by the Company under contractual obligations with minimum firm commitments as of September 24, 2016 , and excludes amounts already recorded on the Consolidated Balance Sheet, except for term debt (in millions): Payments Due in Less Than 1 Year Payments Due in 1-3 Years Payments Due in 4-5 Years Payments Due in More Than 5 Years Total Term debt $ 3,500 $ 13,334 $ 14,204 $ 47,346 $ 78,384 Operating leases 929 1,834 1,725 3,139 7,627 Manufacturing purchase obligations 24,695 939 1,830 1,127 28,591 Other purchase obligations 3,503 1,732 653 732 6,620 Total $ 32,627 $ 17,839 $ 18,412 $ 52,344 $ 121,222 Operating Leases As of September 24, 2016 , the Company’s total future minimum lease payments under noncancelable operating leases were $7.6 billion . The Company’s retail store and other facility leases are typically for terms not exceeding 10 years and generally contain multi-year renewal options. Apple Inc. | 2016 Form 10-K | 31 Manufacturing Purchase Obligations The Company utilizes several outsourcing partners to manufacture sub-assemblies for the Company’s products and to perform final assembly and testing of finished products. These outsourcing partners acquire components and build product based on demand information supplied by the Company, which typically covers periods up to 150 days. The Company also obtains individual components for its products from a wide variety of individual suppliers. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders based on projected demand information. As of September 24, 2016 , the Company had manufacturing purchase obligations of $28.6 billion. Other Purchase Obligations The Company’s other purchase obligations were comprised of commitments to acquire capital assets, including product tooling and manufacturing process equipment, and commitments related to advertising, licensing, R&D, internet and telecommunications services, energy and other obligations. As of September 24, 2016 , the Company had other purchase obligations of $6.6 billion. The Company’s other non-current liabilities in the Consolidated Balance Sheets consist primarily of deferred tax liabilities, gross unrecognized tax benefits and the related gross interest and penalties. As of September 24, 2016 , the Company had non-current deferred tax liabilities of $26.0 billion. Additionally, as of September 24, 2016 , the Company had gross unrecognized tax benefits of $7.7 billion and an additional $1.0 billion for gross interest and penalties classified as non-current liabilities. At this time, the Company is unable to make a reasonably reliable estimate of the timing of payments due to uncertainties in the timing of tax audit outcomes; therefore, such amounts are not included in the above contractual obligation table. Indemnification The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations. Critical Accounting Policies and Estimates The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles (“GAAP”) and the Company’s discussion and analysis of its financial condition and operating results require the Company’s management to make judgments, assumptions and estimates that affect the amounts reported in its consolidated financial statements and accompanying notes. Note 1, “Summary of Significant Accounting Policies,” of the Notes to Consolidated Financial Statements in Part II, Item 8 of this Form 10-K describes the significant accounting policies and methods used in the preparation of the Company’s consolidated financial statements. Management bases its estimates on historical experience and on various other assumptions it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates, and such differences may be material. Management believes the Company’s critical accounting policies and estimates are those related to revenue recognition, valuation and impairment of marketable securities, inventory valuation, valuation of manufacturing-related assets and estimation of purchase commitment cancellation fees, warranty costs, income taxes, and legal and other contingencies. Management considers these policies critical because they are both important to the portrayal of the Company’s financial condition and operating results, and they require management to make judgments and estimates about inherently uncertain matters. The Company’s senior management has reviewed these critical accounting policies and related disclosures with the Audit and Finance Committee of the Company’s Board of Directors. Apple Inc. | 2016 Form 10-K | 32 Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry-specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software and/or undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For sales of qualifying versions of iOS devices, Mac, Apple Watch and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. Because the Company has neither VSOE nor TPE for the unspecified software upgrade rights or the non-software services, revenue is allocated to these rights and services based on the Company’s ESPs. Revenue allocated to the unspecified software upgrade rights and non-software services based on the Company’s ESPs is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. The Company’s process for determining ESPs involves management’s judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Should future facts and circumstances change, the Company’s ESPs and the future rate of related amortization for unspecified software upgrades and non-software services related to future sales of these devices could change. Factors subject to change include the unspecified software upgrade rights and non-software services offered, the estimated value of unspecified software upgrade rights and non-software services and the estimated period unspecified software upgrades and non-software services are expected to be provided. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded, provided the refund amount can be reasonably and reliably estimated and the other conditions for revenue recognition have been met. The Company’s policy requires that, if refunds cannot be reliably estimated, revenue is not recognized until reliable estimates can be made or the price protection lapses. For the Company’s other customer incentive programs, the estimated cost is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Future market conditions and product transitions may require the Company to increase customer incentive programs that could result in reductions to future revenue. Additionally, certain customer incentive programs require management to estimate the number of customers who will actually redeem the incentive. Management’s estimates are based on historical experience and the specific terms and conditions of particular incentive programs. If a greater than estimated proportion of customers redeems such incentives, the Company would be required to record additional reductions to revenue, which would have an adverse impact on the Company’s operating results. Apple Inc. | 2016 Form 10-K | 33 Valuation and Impairment of Marketable Securities The Company’s investments in available-for-sale securities are reported at fair value. Unrealized gains and losses related to changes in the fair value of securities are recognized in accumulated other comprehensive income, net of tax, in the Company’s Consolidated Balance Sheets. Changes in the fair value of available-for-sale securities impact the Company’s net income only when such securities are sold or an other-than-temporary impairment is recognized. Realized gains and losses on the sale of securities are determined by specific identification of each security’s cost basis. The Company regularly reviews its investment portfolio to determine if any security is other-than-temporarily impaired, which would require the Company to record an impairment charge in the period any such determination is made. In making this determination, the Company evaluates, among other things, the duration and extent to which the fair value of a security is less than its cost; the financial condition of the issuer and any changes thereto; and the Company’s intent to sell, or whether it will more likely than not be required to sell, the security before recovery of its amortized cost basis. The Company’s assessment of whether a security is other-than-temporarily impaired could change in the future due to new developments or changes in assumptions related to any particular security, which would have an adverse impact on the Company’s operating results. Inventory Valuation, Valuation of Manufacturing-Related Assets and Estimation of Purchase Commitment Cancellation Fees The Company must purchase components and build inventory in advance of product shipments and has invested in manufacturing-related assets, including capital assets held at its suppliers’ facilities. In addition, the Company has made prepayments to certain of its suppliers associated with long-term supply agreements to secure supply of inventory components. The Company records a write-down for inventories of components and products, including third-party products held for resale, which have become obsolete or are in excess of anticipated demand or net realizable value. The Company performs a detailed review of inventory that considers multiple factors including demand forecasts, product life cycle status, product development plans, current sales levels and component cost trends. The Company also reviews its manufacturing-related capital assets and inventory prepayments for impairment whenever events or circumstances indicate the carrying amount of such assets may not be recoverable. If the Company determines that an asset is not recoverable, it records an impairment loss equal to the amount by which the carrying value of such an asset exceeds its fair value. The industries in which the Company competes are subject to a rapid and unpredictable pace of product and component obsolescence and demand changes. In certain circumstances the Company may be required to record additional write-downs of inventory and/or impairments of manufacturing-related assets or inventory prepayments. These circumstances include future demand or market conditions for the Company’s products being less favorable than forecasted, unforeseen technological changes or changes to the Company’s product development plans that negatively impact the utility of any of these assets, or significant deterioration in the financial condition of one or more of the Company’s suppliers that hold any of the Company’s manufacturing-related assets or to whom the Company has made an inventory prepayment. Such write-downs would adversely affect the Company’s financial condition and operating results in the period when the additional write-downs were recorded. The Company accrues for estimated purchase commitment cancellation fees related to inventory orders that have been cancelled or are expected to be cancelled. Consistent with industry practice, the Company acquires components through a combination of purchase orders, supplier contracts, and open orders in each case based on projected demand. Manufacturing purchase obligations typically cover the Company’s forecasted component and manufacturing requirements for periods up to 150 days. If there is an abrupt and substantial decline in demand for one or more of the Company’s products, a change in the Company’s product development plans, or an unanticipated change in technological requirements for any of the Company’s products, the Company may be required to record additional accruals for cancellation fees that would adversely affect its results of operations in the period when the cancellation fees were identified and recorded. Warranty Costs The Company accrues for the estimated cost of warranties in the period the related revenue is recognized based on historical and projected warranty claim rates, historical and projected cost-per-claim and knowledge of specific product failures that are outside of the Company’s typical experience. The Company regularly reviews these estimates and the current installed base of products subject to warranty protection to assess the appropriateness of its recorded warranty liabilities and adjusts the amounts as necessary. If actual product failure rates or repair costs differ from estimates, revisions to the estimated warranty liabilities would be required and could materially affect the Company’s financial condition and operating results. Apple Inc. | 2016 Form 10-K | 34 Income Taxes The Company records a tax provision for the anticipated tax consequences of its reported operating results. The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities, and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes tax benefits from uncertain tax positions only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Management believes it is more likely than not that forecasted income, including income that may be generated as a result of certain tax planning strategies, together with future reversals of existing taxable temporary differences, will be sufficient to fully recover the deferred tax assets. In the event that the Company determines all or part of the net deferred tax assets are not realizable in the future, the Company will record an adjustment to the valuation allowance that would be charged to earnings in the period such determination is made. In addition, the calculation of tax liabilities involves significant judgment in estimating the impact of uncertainties in the application of GAAP and complex tax laws. Resolution of these uncertainties in a manner inconsistent with management’s expectations could have a material impact on the Company’s financial condition and operating results. Legal and Other Contingencies As discussed in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings” and in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 10, “Commitments and Contingencies,” the Company is subject to various legal proceedings and claims that arise in the ordinary course of business. The Company records a liability when it is probable that a loss has been incurred and the amount is reasonably estimable, the determination of which requires significant judgment. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of legal proceedings and claims brought against the Company is subject to significant uncertainty. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. | 2016 Form 10-K | 35 Item 7A. Quantitative and Qualitative Disclosures About Market Risk Interest Rate and Foreign Currency Risk Management The Company regularly reviews its foreign exchange forward and option positions and interest rate swaps, both on a stand-alone basis and in conjunction with its underlying foreign currency and interest rate related exposures. Given the effective horizons of the Company’s risk management activities and the anticipatory nature of the exposures, there can be no assurance these positions will offset more than a portion of the financial impact resulting from movements in either foreign exchange or interest rates. Further, the recognition of the gains and losses related to these instruments may not coincide with the timing of gains and losses related to the underlying economic exposures and, therefore, may adversely affect the Company’s financial condition and operating results. Interest Rate Risk The Company’s exposure to changes in interest rates relates primarily to the Company’s investment portfolio and outstanding debt. While the Company is exposed to global interest rate fluctuations, the Company’s interest income and expense are most sensitive to fluctuations in U.S. interest rates. Changes in U.S. interest rates affect the interest earned on the Company’s cash, cash equivalents and marketable securities and the fair value of those securities, as well as costs associated with hedging and interest paid on the Company’s debt. The Company’s investment policy and strategy are focused on preservation of capital and supporting the Company’s liquidity requirements. The Company uses a combination of internal and external management to execute its investment strategy and achieve its investment objectives. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy requires investments generally to be investment grade, with the primary objective of minimizing the potential risk of principal loss. To provide a meaningful assessment of the interest rate risk associated with the Company’s investment portfolio, the Company performed a sensitivity analysis to determine the impact a change in interest rates would have on the value of the investment portfolio assuming a 100 basis point parallel shift in the yield curve. Based on investment positions as of September 24, 2016 and September 26, 2015 , a hypothetical 100 basis point increase in interest rates across all maturities would result in a $4.9 billion and $4.3 billion incremental decline in the fair market value of the portfolio, respectively. Such losses would only be realized if the Company sold the investments prior to maturity. As of September 24, 2016 and September 26, 2015 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate carrying amount of $78.9 billion and $55.8 billion, respectively. The Company has entered, and may enter in the future, into interest rate swaps to manage interest rate risk on its outstanding term debt. Interest rate swaps allow the Company to effectively convert fixed-rate payments into floating-rate payments or floating-rate payments into fixed-rate payments. Gains and losses on these instruments are generally offset by the corresponding losses and gains on the related hedging instrument. A 100 basis point increase in market interest rates would cause interest expense on the Company’s debt as of September 24, 2016 and September 26, 2015 to increase by $271 million and $200 million on an annualized basis, respectively. Further details regarding the Company’s debt is provided in Part II, Item 8 of this Form 10-K in the Notes to Consolidated Financial Statements in Note 6, “Debt.” Foreign Currency Risk In general, the Company is a net receiver of currencies other than the U.S. dollar. Accordingly, changes in exchange rates, and in particular a strengthening of the U.S. dollar, will negatively affect the Company’s net sales and gross margins as expressed in U.S. dollars. There is a risk that the Company will have to adjust local currency product pricing due to competitive pressures when there has been significant volatility in foreign currency exchange rates. The Company may enter into foreign currency forward and option contracts with financial institutions to protect against foreign exchange risks associated with certain existing assets and liabilities, certain firmly committed transactions, forecasted future cash flows and net investments in foreign subsidiaries. In addition, the Company has entered, and may enter in the future, into non-designated foreign currency contracts to partially offset the foreign currency exchange gains and losses on its foreign-denominated debt issuances. The Company’s practice is to hedge a portion of its material foreign exchange exposures, typically for up to 12 months. However, the Company may choose not to hedge certain foreign exchange exposures for a variety of reasons, including but not limited to accounting considerations and the prohibitive economic cost of hedging particular exposures. Apple Inc. | 2016 Form 10-K | 36 To provide a meaningful assessment of the foreign currency risk associated with certain of the Company’s foreign currency derivative positions, the Company performed a sensitivity analysis using a value-at-risk (“VAR”) model to assess the potential impact of fluctuations in exchange rates. The VAR model consisted of using a Monte Carlo simulation to generate thousands of random market price paths assuming normal market conditions. The VAR is the maximum expected loss in fair value, for a given confidence interval, to the Company’s foreign currency derivative positions due to adverse movements in rates. The VAR model is not intended to represent actual losses but is used as a risk estimation and management tool. The model assumes normal market conditions. Forecasted transactions, firm commitments and assets and liabilities denominated in foreign currencies were excluded from the model. Based on the results of the model, the Company estimates with 95% confidence, a maximum one-day loss in fair value of $434 million as of September 24, 2016 compared to a maximum one-day loss in fair value of $342 million as of September 26, 2015 . Because the Company uses foreign currency instruments for hedging purposes, the loss in fair value incurred on those instruments are generally offset by increases in the fair value of the underlying exposures. Actual future gains and losses associated with the Company’s investment portfolio and derivative positions may differ materially from the sensitivity analyses performed as of September 24, 2016 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates, foreign currency exchanges rates and the Company’s actual exposures and positions. Apple Inc. | 2016 Form 10-K | 37 Item 8. Financial Statements and Supplementary Data Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 39 Consolidated Statements of Comprehensive Income for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 40 Consolidated Balance Sheets as of September 24, 2016 and September 26, 2015 41 Consolidated Statements of Shareholders’ Equity for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 42 Consolidated Statements of Cash Flows for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 43 Notes to Consolidated Financial Statements 44 Selected Quarterly Financial Information (Unaudited) 69 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 70 All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto. Apple Inc. | 2016 Form 10-K | 38 CONSOLIDATED STATEMENTS OF OPERATIONS (In millions, except number of shares which are reflected in thousands and per share amounts) Years ended September 24, 2016 September 26, 2015 September 27, 2014 Net sales $ 215,639 $ 233,715 $ 182,795 Cost of sales 131,376 140,089 112,258 Gross margin 84,263 93,626 70,537 Operating expenses: Research and development 10,045 8,067 6,041 Selling, general and administrative 14,194 14,329 11,993 Total operating expenses 24,239 22,396 18,034 Operating income 60,024 71,230 52,503 Other income/(expense), net 1,348 1,285 980 Income before provision for income taxes 61,372 72,515 53,483 Provision for income taxes 15,685 19,121 13,973 Net income $ 45,687 $ 53,394 $ 39,510 Earnings per share: Basic $ 8.35 $ 9.28 $ 6.49 Diluted $ 8.31 $ 9.22 $ 6.45 Shares used in computing earnings per share: Basic 5,470,820 5,753,421 6,085,572 Diluted 5,500,281 5,793,069 6,122,663 Cash dividends declared per share $ 2.18 $ 1.98 $ 1.82 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2016 Form 10-K | 39 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Years ended September 24, 2016 September 26, 2015 September 27, 2014 Net income $ 45,687 $ 53,394 $ 39,510 Other comprehensive income/(loss): Change in foreign currency translation, net of tax effects of $8, $201 and $50, respectively 75 (411 ) (137 ) Change in unrealized gains/losses on derivative instruments: Change in fair value of derivatives, net of tax benefit/(expense) of $(7), $(441) and $(297), respectively 7 2,905 1,390 Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $131, $630 and $(36), respectively (741 ) (3,497 ) 149 Total change in unrealized gains/losses on derivative instruments, net of tax (734 ) (592 ) 1,539 Change in unrealized gains/losses on marketable securities: Change in fair value of marketable securities, net of tax benefit/(expense) of $(863), $264 and $(153), respectively 1,582 (483 ) 285 Adjustment for net (gains)/losses realized and included in net income, net of tax expense/(benefit) of $(31), $(32) and $71, respectively 56 59 (134 ) Total change in unrealized gains/losses on marketable securities, net of tax 1,638 (424 ) 151 Total other comprehensive income/(loss) 979 (1,427 ) 1,553 Total comprehensive income $ 46,666 $ 51,967 $ 41,063 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2016 Form 10-K | 40 CONSOLIDATED BALANCE SHEETS (In millions, except number of shares which are reflected in thousands and par value) September 24, 2016 September 26, 2015 ASSETS: Current assets: Cash and cash equivalents $ 20,484 $ 21,120 Short-term marketable securities 46,671 20,481 Accounts receivable, less allowances of $53 and $63, respectively 15,754 16,849 Inventories 2,132 2,349 Vendor non-trade receivables 13,545 13,494 Other current assets 8,283 15,085 Total current assets 106,869 89,378 Long-term marketable securities 170,430 164,065 Property, plant and equipment, net 27,010 22,471 Goodwill 5,414 5,116 Acquired intangible assets, net 3,206 3,893 Other non-current assets 8,757 5,422 Total assets $ 321,686 $ 290,345 LIABILITIES AND SHAREHOLDERS’ EQUITY: Current liabilities: Accounts payable $ 37,294 $ 35,490 Accrued expenses 22,027 25,181 Deferred revenue 8,080 8,940 Commercial paper 8,105 8,499 Current portion of long-term debt 3,500 2,500 Total current liabilities 79,006 80,610 Deferred revenue, non-current 2,930 3,624 Long-term debt 75,427 53,329 Other non-current liabilities 36,074 33,427 Total liabilities 193,437 170,990 Commitments and contingencies Shareholders’ equity: Common stock and additional paid-in capital, $0.00001 par value: 12,600,000 shares authorized; 5,336,166 and 5,578,753 shares issued and outstanding, respectively 31,251 27,416 Retained earnings 96,364 92,284 Accumulated other comprehensive income/(loss) 634 (345 ) Total shareholders’ equity 128,249 119,355 Total liabilities and shareholders’ equity $ 321,686 $ 290,345 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2016 Form 10-K | 41 CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (In millions, except number of shares which are reflected in thousands) Common Stock and Additional Paid-In Capital Retained Earnings Accumulated Other Comprehensive Income/(Loss) Total Shareholders’ Equity Shares Amount Balances as of September 28, 2013 6,294,494 $ 19,764 $ 104,256 $ (471 ) $ 123,549 Net income — — 39,510 — 39,510 Other comprehensive income/(loss) — — — 1,553 1,553 Dividends and dividend equivalents declared — — (11,215 ) — (11,215 ) Repurchase of common stock (488,677 ) — (45,000 ) — (45,000 ) Share-based compensation — 2,863 — — 2,863 Common stock issued, net of shares withheld for employee taxes 60,344 (49 ) (399 ) — (448 ) Tax benefit from equity awards, including transfer pricing adjustments — 735 — — 735 Balances as of September 27, 2014 5,866,161 23,313 87,152 1,082 111,547 Net income — — 53,394 — 53,394 Other comprehensive income/(loss) — — — (1,427 ) (1,427 ) Dividends and dividend equivalents declared — — (11,627 ) — (11,627 ) Repurchase of common stock (325,032 ) — (36,026 ) — (36,026 ) Share-based compensation — 3,586 — — 3,586 Common stock issued, net of shares withheld for employee taxes 37,624 (231 ) (609 ) — (840 ) Tax benefit from equity awards, including transfer pricing adjustments — 748 — — 748 Balances as of September 26, 2015 5,578,753 27,416 92,284 (345 ) 119,355 Net income — — 45,687 — 45,687 Other comprehensive income/(loss) — — — 979 979 Dividends and dividend equivalents declared — — (12,188 ) — (12,188 ) Repurchase of common stock (279,609 ) — (29,000 ) — (29,000 ) Share-based compensation — 4,262 — — 4,262 Common stock issued, net of shares withheld for employee taxes 37,022 (806 ) (419 ) — (1,225 ) Tax benefit from equity awards, including transfer pricing adjustments — 379 — — 379 Balances as of September 24, 2016 5,336,166 $ 31,251 $ 96,364 $ 634 $ 128,249 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2016 Form 10-K | 42 CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Years ended September 24, 2016 September 26, 2015 September 27, 2014 Cash and cash equivalents, beginning of the year $ 21,120 $ 13,844 $ 14,259 Operating activities: Net income 45,687 53,394 39,510 Adjustments to reconcile net income to cash generated by operating activities: Depreciation and amortization 10,505 11,257 7,946 Share-based compensation expense 4,210 3,586 2,863 Deferred income tax expense 4,938 1,382 2,347 Changes in operating assets and liabilities: Accounts receivable, net 1,095 611 (4,232 ) Inventories 217 (238 ) (76 ) Vendor non-trade receivables (51 ) (3,735 ) (2,220 ) Other current and non-current assets 1,090 (179 ) 167 Accounts payable 1,791 5,400 5,938 Deferred revenue (1,554 ) 1,042 1,460 Other current and non-current liabilities (2,104 ) 8,746 6,010 Cash generated by operating activities 65,824 81,266 59,713 Investing activities: Purchases of marketable securities (142,428 ) (166,402 ) (217,128 ) Proceeds from maturities of marketable securities 21,258 14,538 18,810 Proceeds from sales of marketable securities 90,536 107,447 189,301 Payments made in connection with business acquisitions, net (297 ) (343 ) (3,765 ) Payments for acquisition of property, plant and equipment (12,734 ) (11,247 ) (9,571 ) Payments for acquisition of intangible assets (814 ) (241 ) (242 ) Payments for strategic investments (1,388 ) — (10 ) Other (110 ) (26 ) 26 Cash used in investing activities (45,977 ) (56,274 ) (22,579 ) Financing activities: Proceeds from issuance of common stock 495 543 730 Excess tax benefits from equity awards 407 749 739 Payments for taxes related to net share settlement of equity awards (1,570 ) (1,499 ) (1,158 ) Payments for dividends and dividend equivalents (12,150 ) (11,561 ) (11,126 ) Repurchases of common stock (29,722 ) (35,253 ) (45,000 ) Proceeds from issuance of term debt, net 24,954 27,114 11,960 Repayments of term debt (2,500 ) — — Change in commercial paper, net (397 ) 2,191 6,306 Cash used in financing activities (20,483 ) (17,716 ) (37,549 ) Increase/(Decrease) in cash and cash equivalents (636 ) 7,276 (415 ) Cash and cash equivalents, end of the year $ 20,484 $ 21,120 $ 13,844 Supplemental cash flow disclosure: Cash paid for income taxes, net $ 10,444 $ 13,252 $ 10,026 Cash paid for interest $ 1,316 $ 514 $ 339 See accompanying Notes to Consolidated Financial Statements. Apple Inc. | 2016 Form 10-K | 43 Notes to Consolidated Financial Statements Note 1 – Summary of Significant Accounting Policies Apple Inc. and its wholly-owned subsidiaries (collectively “Apple” or the “Company”) designs, manufactures and markets mobile communication and media devices, personal computers and portable digital music players, and sells a variety of related software, services, accessories, networking solutions and third-party digital content and applications. The Company sells its products worldwide through its retail stores, online stores and direct sales force, as well as through third-party cellular network carriers, wholesalers, retailers and value-added resellers. In addition, the Company sells a variety of third-party Apple-compatible products, including application software and various accessories through its retail and online stores. The Company sells to consumers, small and mid-sized businesses and education, enterprise and government customers. Basis of Presentation and Preparation The accompanying consolidated financial statements include the accounts of the Company. Intercompany accounts and transactions have been eliminated. In the opinion of the Company’s management, the consolidated financial statements reflect all adjustments, which are normal and recurring in nature, necessary for fair financial statement presentation. The preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires management to make estimates and assumptions that affect the amounts reported in these consolidated financial statements and accompanying notes. Actual results could differ materially from those estimates. Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period’s presentation. The Company’s fiscal year is the 52 or 53 -week period that ends on the last Saturday of September. The Company’s fiscal years 2016 , 2015 and 2014 ended on September 24, 2016 , September 26, 2015 and September 27, 2014 , respectively, and each spanned 52 weeks. An additional week is included in the first fiscal quarter approximately every five or six years to realign fiscal quarters with calendar quarters, which will next occur in the first quarter of the Company's fiscal year ending September 30, 2017. Unless otherwise stated, references to particular years, quarters, months and periods refer to the Company’s fiscal years ended in September and the associated quarters, months and periods of those fiscal years. During 2016, the Company adopted an accounting standard that simplified the presentation of deferred income taxes by requiring deferred tax assets and liabilities be classified as noncurrent in a classified statement of financial position. The Company has adopted this accounting standard prospectively; accordingly, the prior period amounts in the Company’s Consolidated Balance Sheets within this Annual Report on Form 10-K were not adjusted to conform to the new accounting standard. The adoption of this accounting standard was not material to the Company’s consolidated financial statements. Revenue Recognition Net sales consist primarily of revenue from the sale of hardware, software, digital content and applications, accessories, and service and support contracts. The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the sales price is fixed or determinable and collection is probable. Product is considered delivered to the customer once it has been shipped and title, risk of loss and rewards of ownership have been transferred. For most of the Company’s product sales, these criteria are met at the time the product is shipped. For online sales to individuals, for some sales to education customers in the U.S., and for certain other sales, the Company defers revenue until the customer receives the product because the Company retains a portion of the risk of loss on these sales during transit. For payment terms in excess of the Company’s standard payment terms, revenue is recognized as payments become due unless the Company has positive evidence that the sales price is fixed or determinable, such as a successful history of collection, without concession, on comparable arrangements. The Company recognizes revenue from the sale of hardware products, software bundled with hardware that is essential to the functionality of the hardware and third-party digital content sold on the iTunes Store in accordance with general revenue recognition accounting guidance. The Company recognizes revenue in accordance with industry specific software accounting guidance for the following types of sales transactions: (i) standalone sales of software products, (ii) sales of software upgrades and (iii) sales of software bundled with hardware not essential to the functionality of the hardware. For the sale of most third-party products, the Company recognizes revenue based on the gross amount billed to customers because the Company establishes its own pricing for such products, retains related inventory risk for physical products, is the primary obligor to the customer and assumes the credit risk for amounts billed to its customers. For third-party applications sold through the App Store and Mac App Store and certain digital content sold through the iTunes Store, the Company does not determine the selling price of the products and is not the primary obligor to the customer. Therefore, the Company accounts for such sales on a net basis by recognizing in net sales only the commission it retains from each sale. The portion of the gross amount billed to customers that is remitted by the Company to third-party app developers and certain digital content owners is not reflected in the Company’s Consolidated Statements of Operations. Apple Inc. | 2016 Form 10-K | 44 The Company records deferred revenue when it receives payments in advance of the delivery of products or the performance of services. This includes amounts that have been deferred for unspecified and specified software upgrade rights and non-software services that are attached to hardware and software products. The Company sells gift cards redeemable at its retail and online stores, and also sells gift cards redeemable on iTunes Store, App Store, Mac App Store, TV App Store and iBooks Store for the purchase of digital content and software. The Company records deferred revenue upon the sale of the card, which is relieved upon redemption of the card by the customer. Revenue from AppleCare service and support contracts is deferred and recognized over the service coverage periods. AppleCare service and support contracts typically include extended phone support, repair services, web-based support resources and diagnostic tools offered under the Company’s standard limited warranty. The Company records reductions to revenue for estimated commitments related to price protection and other customer incentive programs. For transactions involving price protection, the Company recognizes revenue net of the estimated amount to be refunded. For the Company’s other customer incentive programs, the estimated cost of these programs is recognized at the later of the date at which the Company has sold the product or the date at which the program is offered. The Company also records reductions to revenue for expected future product returns based on the Company’s historical experience. Revenue is recorded net of taxes collected from customers that are remitted to governmental authorities, with the collected taxes recorded as current liabilities until remitted to the relevant government authority. Revenue Recognition for Arrangements with Multiple Deliverables For multi-element arrangements that include hardware products containing software essential to the hardware product’s functionality, undelivered software elements that relate to the hardware product’s essential software, and undelivered non-software services, the Company allocates revenue to all deliverables based on their relative selling prices. In such circumstances, the Company uses a hierarchy to determine the selling price to be used for allocating revenue to deliverables: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence of selling price (“TPE”) and (iii) best estimate of selling price (“ESP”). VSOE generally exists only when the Company sells the deliverable separately and is the price actually charged by the Company for that deliverable. ESPs reflect the Company’s best estimates of what the selling prices of elements would be if they were sold regularly on a stand-alone basis. For multi-element arrangements accounted for in accordance with industry specific software accounting guidance, the Company allocates revenue to all deliverables based on the VSOE of each element, and if VSOE does not exist revenue is recognized when elements lacking VSOE are delivered. For sales of qualifying versions of iPhone, iPad, iPod touch, Mac, Apple Watch and Apple TV, the Company has indicated it may from time to time provide future unspecified software upgrades to the device’s essential software and/or non-software services free of charge. The Company has identified up to three deliverables regularly included in arrangements involving the sale of these devices. The first deliverable, which represents the substantial portion of the allocated sales price, is the hardware and software essential to the functionality of the hardware device delivered at the time of sale. The second deliverable is the embedded right included with qualifying devices to receive on a when-and-if-available basis, future unspecified software upgrades relating to the product’s essential software. The third deliverable is the non-software services to be provided to qualifying devices. The Company allocates revenue between these deliverables using the relative selling price method. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based on the Company’s ESPs. Revenue allocated to the delivered hardware and the related essential software is recognized at the time of sale provided the other conditions for revenue recognition have been met. Revenue allocated to the embedded unspecified software upgrade rights and the non-software services is deferred and recognized on a straight-line basis over the estimated period the software upgrades and non-software services are expected to be provided. Cost of sales related to delivered hardware and related essential software, including estimated warranty costs, are recognized at the time of sale. Costs incurred to provide non-software services are recognized as cost of sales as incurred, and engineering and sales and marketing costs are recognized as operating expenses as incurred. The Company’s process for determining its ESP for deliverables without VSOE or TPE considers multiple factors that may vary depending upon the unique facts and circumstances related to each deliverable including, where applicable, prices charged by the Company and market trends in the pricing for similar offerings, product specific business objectives, length of time a particular version of a device has been available, estimated cost to provide the non-software services and the relative ESP of the upgrade rights and non-software services as compared to the total selling price of the product. Shipping Costs Amounts billed to customers related to shipping and handling are classified as revenue, and the Company’s shipping and handling costs are classified as cost of sales. Warranty Costs The Company generally provides for the estimated cost of hardware and software warranties in the period the related revenue is recognized. The Company assesses the adequacy of its accrued warranty liabilities and adjusts the amounts as necessary based on actual experience and changes in future estimates. Apple Inc. | 2016 Form 10-K | 45 Software Development Costs Research and development (“R&D”) costs are expensed as incurred. Development costs of computer software to be sold, leased, or otherwise marketed are subject to capitalization beginning when a product’s technological feasibility has been established and ending when a product is available for general release to customers. In most instances, the Company’s products are released soon after technological feasibility has been established and as a result software development costs were expensed as incurred. Advertising Costs Advertising costs are expensed as incurred and included in selling, general and administrative expenses. Share-based Compensation The Company recognizes expense related to share-based payment transactions in which it receives employee services in exchange for (a) equity instruments of the Company or (b) liabilities that are based on the fair value of the Company’s equity instruments or that may be settled by the issuance of such equity instruments. Share-based compensation cost for restricted stock and restricted stock units (“RSUs”) is measured based on the closing fair market value of the Company’s common stock on the date of grant. The Company recognizes share-based compensation cost over the award’s requisite service period on a straight-line basis for time-based RSUs and on a graded basis for RSUs that are contingent on the achievement of performance conditions. The Company recognizes a benefit from share-based compensation in the Consolidated Statements of Shareholders’ Equity if an excess tax benefit is realized. In addition, the Company recognizes the indirect effects of share-based compensation on R&D tax credits, foreign tax credits and domestic manufacturing deductions in the Consolidated Statements of Operations. Further information regarding share-based compensation can be found in Note 9, “Benefit Plans.” Income Taxes The provision for income taxes is computed using the asset and liability method, under which deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and for operating losses and tax credit carryforwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates that apply to taxable income in effect for the years in which those tax assets and liabilities are expected to be realized or settled. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. The Company recognizes the tax benefit from an uncertain tax position only if it is more likely than not the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such positions are then measured based on the largest benefit that has a greater than 50% likelihood of being realized upon settlement. See Note 5, “Income Taxes” for additional information. Earnings Per Share Basic earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings per share is computed by dividing income available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased to include the number of additional shares of common stock that would have been outstanding if the potentially dilutive securities had been issued. Potentially dilutive securities include outstanding stock options, shares to be purchased by employees under the Company’s employee stock purchase plan, unvested restricted stock and unvested RSUs. The dilutive effect of potentially dilutive securities is reflected in diluted earnings per share by application of the treasury stock method. Under the treasury stock method, an increase in the fair market value of the Company’s common stock can result in a greater dilutive effect from potentially dilutive securities. Apple Inc. | 2016 Form 10-K | 46 The following table shows the computation of basic and diluted earnings per share for 2016 , 2015 and 2014 (net income in millions and shares in thousands): 2016 2015 2014 Numerator: Net income $ 45,687 $ 53,394 $ 39,510 Denominator: Weighted-average shares outstanding 5,470,820 5,753,421 6,085,572 Effect of dilutive securities 29,461 39,648 37,091 Weighted-average diluted shares 5,500,281 5,793,069 6,122,663 Basic earnings per share $ 8.35 $ 9.28 $ 6.49 Diluted earnings per share $ 8.31 $ 9.22 $ 6.45 Potentially dilutive securities whose effect would have been antidilutive are excluded from the computation of diluted earnings per share. Financial Instruments Cash Equivalents and Marketable Securities All highly liquid investments with maturities of three months or less at the date of purchase are classified as cash equivalents. The Company’s marketable debt and equity securities have been classified and accounted for as available-for-sale. Management determines the appropriate classification of its investments at the time of purchase and reevaluates the classifications at each balance sheet date. The Company classifies its marketable debt securities as either short-term or long-term based on each instrument’s underlying contractual maturity date. Marketable debt securities with maturities of 12 months or less are classified as short-term and marketable debt securities with maturities greater than 12 months are classified as long-term. Marketable equity securities, including mutual funds, are classified as either short-term or long-term based on the nature of each security and its availability for use in current operations. The Company’s marketable debt and equity securities are carried at fair value, with unrealized gains and losses, net of taxes, reported as a component of accumulated other comprehensive income (“AOCI”) in shareholders’ equity, with the exception of unrealized losses believed to be other-than-temporary which are reported in earnings in the current period. The cost of securities sold is based upon the specific identification method. Derivative Financial Instruments The Company accounts for its derivative instruments as either assets or liabilities and carries them at fair value. For derivative instruments that hedge the exposure to variability in expected future cash flows that are designated as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is reported as a component of AOCI in shareholders’ equity and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the gain or loss on the derivative instrument, if any, is recognized in earnings in the current period. To receive hedge accounting treatment, cash flow hedges must be highly effective in offsetting changes to expected future cash flows on hedged transactions. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments that hedge the exposure to changes in the fair value of an asset or a liability and that are designated as fair value hedges, both the net gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item are recognized in earnings in the current period. For derivative instruments and foreign currency debt that hedge the exposure to changes in foreign currency exchange rates used for translation of the net investment in a foreign operation and that are designated as a net investment hedge, the net gain or loss on the effective portion of the derivative instrument is reported in the same manner as a foreign currency translation adjustment. For forward exchange contracts designated as net investment hedges, the Company excludes changes in fair value relating to changes in the forward carry component from its definition of effectiveness. Accordingly, any gains or losses related to this forward carry component are recognized in earnings in the current period. Derivatives that do not qualify as hedges are adjusted to fair value through earnings in the current period. Apple Inc. | 2016 Form 10-K | 47 Allowance for Doubtful Accounts The Company records its allowance for doubtful accounts based upon its assessment of various factors, including historical experience, age of the accounts receivable balances, credit quality of the Company’s customers, current economic conditions and other factors that may affect the customers’ abilities to pay. Inventories Inventories are stated at the lower of cost, computed using the first-in, first-out method and net realizable value. Any adjustments to reduce the cost of inventories to their net realizable value are recognized in earnings in the current period. As of September 24, 2016 and September 26, 2015 , the Company’s inventories consist primarily of finished goods. Property, Plant and Equipment Property, plant and equipment are stated at cost. Depreciation is computed by use of the straight-line method over the estimated useful lives of the assets, which for buildings is the lesser of 30 years or the remaining life of the underlying building; between one to five years for machinery and equipment, including product tooling and manufacturing process equipment; and the shorter of lease terms or useful life for leasehold improvements. The Company capitalizes eligible costs to acquire or develop internal-use software that are incurred subsequent to the preliminary project stage. Capitalized costs related to internal-use software are amortized using the straight-line method over the estimated useful lives of the assets, which range from three to five years . Depreciation and amortization expense on property and equipment was $8.3 billion , $9.2 billion and $6.9 billion during 2016 , 2015 and 2014 , respectively. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets The Company reviews property, plant and equipment, inventory component prepayments and identifiable intangibles, excluding goodwill and intangible assets with indefinite useful lives, for impairment. Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amounts to future undiscounted cash flows the assets are expected to generate. If property, plant and equipment, inventory component prepayments and certain identifiable intangibles are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the assets exceeds its fair value. The Company does not amortize goodwill and intangible assets with indefinite useful lives, rather such assets are required to be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate that the assets may be impaired. The Company performs its goodwill and intangible asset impairment tests in the fourth quarter of each year. The Company did not recognize any impairment charges related to goodwill or indefinite lived intangible assets during 2016 , 2015 and 2014 . For purposes of testing goodwill for impairment, the Company established reporting units based on its current reporting structure. Goodwill has been allocated to these reporting units to the extent it relates to each reporting unit. In 2016 and 2015 , the Company’s goodwill was primarily allocated to the Americas and Europe reporting units. The Company amortizes its intangible assets with definite useful lives over their estimated useful lives and reviews these assets for impairment. The Company typically amortizes its acquired intangible assets with definite useful lives over periods from three to seven years . Fair Value Measurements The Company applies fair value accounting for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities, which are required to be recorded at fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use to price the asset or liability, such as risks inherent in valuation techniques, transfer restrictions and credit risk. Fair value is estimated by applying the following hierarchy, which prioritizes the inputs used to measure fair value into three levels and bases the categorization within the hierarchy upon the lowest level of input that is available and significant to the fair value measurement: Level 1 – Quoted prices in active markets for identical assets or liabilities. Level 2 – Observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 – Inputs that are generally unobservable and typically reflect management’s estimate of assumptions that market participants would use in pricing the asset or liability. Apple Inc. | 2016 Form 10-K | 48 The Company’s valuation techniques used to measure the fair value of money market funds and certain marketable equity securities were derived from quoted prices in active markets for identical assets or liabilities. The valuation techniques used to measure the fair value of the Company’s debt instruments and all other financial instruments, all of which have counterparties with high credit ratings, were valued based on quoted market prices or model-driven valuations using significant inputs derived from or corroborated by observable market data. In accordance with the fair value accounting requirements, companies may choose to measure eligible financial instruments and certain other items at fair value. The Company has not elected the fair value option for any eligible financial instruments. Foreign Currency Translation and Remeasurement The Company translates the assets and liabilities of its non-U.S. dollar functional currency subsidiaries into U.S. dollars using exchange rates in effect at the end of each period. Revenue and expenses for these subsidiaries are translated using rates that approximate those in effect during the period. Gains and losses from these translations are recognized in foreign currency translation included in AOCI in shareholders’ equity. The Company’s subsidiaries that use the U.S. dollar as their functional currency remeasure monetary assets and liabilities at exchange rates in effect at the end of each period, and inventories, property and nonmonetary assets and liabilities at historical rates. Note 2 – Financial Instruments Cash, Cash Equivalents and Marketable Securities The following tables show the Company’s cash and available-for-sale securities’ adjusted cost, gross unrealized gains, gross unrealized losses and fair value by significant investment category recorded as cash and cash equivalents or short- or long-term marketable securities as of September 24, 2016 and September 26, 2015 (in millions): 2016 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 8,601 $ — $ — $ 8,601 $ 8,601 $ — $ — Level 1: Money market funds 3,666 — — 3,666 3,666 — — Mutual funds 1,407 — (146 ) 1,261 — 1,261 — Subtotal 5,073 — (146 ) 4,927 3,666 1,261 — Level 2: U.S. Treasury securities 41,697 319 (4 ) 42,012 1,527 13,492 26,993 U.S. agency securities 7,543 16 — 7,559 2,762 2,441 2,356 Non-U.S. government securities 7,609 259 (27 ) 7,841 110 818 6,913 Certificates of deposit and time deposits 6,598 — — 6,598 1,108 3,897 1,593 Commercial paper 7,433 — — 7,433 2,468 4,965 — Corporate securities 131,166 1,409 (206 ) 132,369 242 19,599 112,528 Municipal securities 956 5 — 961 — 167 794 Mortgage- and asset-backed securities 19,134 178 (28 ) 19,284 — 31 19,253 Subtotal 222,136 2,186 (265 ) 224,057 8,217 45,410 170,430 Total $ 235,810 $ 2,186 $ (411 ) $ 237,585 $ 20,484 $ 46,671 $ 170,430 Apple Inc. | 2016 Form 10-K | 49 2015 Adjusted Cost Unrealized Gains Unrealized Losses Fair Value Cash and Cash Equivalents Short-Term Marketable Securities Long-Term Marketable Securities Cash $ 11,389 $ — $ — $ 11,389 $ 11,389 $ — $ — Level 1: Money market funds 1,798 — — 1,798 1,798 — — Mutual funds 1,772 — (144 ) 1,628 — 1,628 — Subtotal 3,570 — (144 ) 3,426 1,798 1,628 — Level 2: U.S. Treasury securities 34,902 181 (1 ) 35,082 — 3,498 31,584 U.S. agency securities 5,864 14 — 5,878 841 767 4,270 Non-U.S. government securities 6,356 45 (167 ) 6,234 43 135 6,056 Certificates of deposit and time deposits 4,347 — — 4,347 2,065 1,405 877 Commercial paper 6,016 — — 6,016 4,981 1,035 — Corporate securities 116,908 242 (985 ) 116,165 3 11,948 104,214 Municipal securities 947 5 — 952 — 48 904 Mortgage- and asset-backed securities 16,121 87 (31 ) 16,177 — 17 16,160 Subtotal 191,461 574 (1,184 ) 190,851 7,933 18,853 164,065 Total $ 206,420 $ 574 $ (1,328 ) $ 205,666 $ 21,120 $ 20,481 $ 164,065 The Company may sell certain of its marketable securities prior to their stated maturities for strategic reasons including, but not limited to, anticipation of credit deterioration and duration management. The maturities of the Company’s long-term marketable securities generally range from one to five years . The Company considers the declines in market value of its marketable securities investment portfolio to be temporary in nature. The Company typically invests in highly-rated securities, and its investment policy generally limits the amount of credit exposure to any one issuer. The policy generally requires investments to be investment grade, with the primary objective of minimizing the potential risk of principal loss. Fair values were determined for each individual security in the investment portfolio. When evaluating an investment for other-than-temporary impairment the Company reviews factors such as the length of time and extent to which fair value has been below its cost basis, the financial condition of the issuer and any changes thereto, changes in market interest rates and the Company’s intent to sell, or whether it is more likely than not it will be required to sell the investment before recovery of the investment’s cost basis. As of September 24, 2016 , the Company does not consider any of its investments to be other-than-temporarily impaired. Derivative Financial Instruments The Company may use derivatives to partially offset its business exposure to foreign currency and interest rate risk on expected future cash flows, on net investments in certain foreign subsidiaries and on certain existing assets and liabilities. However, the Company may choose not to hedge certain exposures for a variety of reasons including, but not limited to, accounting considerations and the prohibitive economic cost of hedging particular exposures. There can be no assurance the hedges will offset more than a portion of the financial impact resulting from movements in foreign currency exchange or interest rates. To help protect gross margins from fluctuations in foreign currency exchange rates, certain of the Company’s subsidiaries whose functional currency is the U.S. dollar may hedge a portion of forecasted foreign currency revenue, and subsidiaries whose functional currency is not the U.S. dollar and who sell in local currencies may hedge a portion of forecasted inventory purchases not denominated in the subsidiaries’ functional currencies. The Company may enter into forward contracts, option contracts or other instruments to manage this risk and may designate these instruments as cash flow hedges. The Company typically hedges portions of its forecasted foreign currency exposure associated with revenue and inventory purchases, typically for up to 12 months . Apple Inc. | 2016 Form 10-K | 50 To help protect the net investment in a foreign operation from adverse changes in foreign currency exchange rates, the Company may enter into foreign currency forward and option contracts to offset the changes in the carrying amounts of these investments due to fluctuations in foreign currency exchange rates. In addition, the Company may use non-derivative financial instruments, such as its foreign currency-denominated debt, as economic hedges of its net investments in certain foreign subsidiaries. In both of these cases, the Company designates these instruments as net investment hedges. The Company may also enter into non-designated foreign currency contracts to partially offset the foreign currency exchange gains and losses generated by the re-measurement of certain assets and liabilities denominated in non-functional currencies. The Company may enter into interest rate swaps, options, or other instruments to manage interest rate risk. These instruments may offset a portion of changes in income or expense, or changes in fair value of the Company’s term debt or investments. The Company designates these instruments as either cash flow or fair value hedges. The Company’s hedged interest rate transactions as of September 24, 2016 are expected to be recognized within 10 years . Cash Flow Hedges The effective portions of cash flow hedges are recorded in AOCI until the hedged item is recognized in earnings. Deferred gains and losses associated with cash flow hedges of foreign currency revenue are recognized as a component of net sales in the same period as the related revenue is recognized, and deferred gains and losses related to cash flow hedges of inventory purchases are recognized as a component of cost of sales in the same period as the related costs are recognized. Deferred gains and losses associated with cash flow hedges of interest income or expense are recognized in other income/(expense), net in the same period as the related income or expense is recognized. The ineffective portions and amounts excluded from the effectiveness testing of cash flow hedges are recognized in other income/(expense), net. Derivative instruments designated as cash flow hedges must be de-designated as hedges when it is probable the forecasted hedged transaction will not occur in the initially identified time period or within a subsequent two-month time period. Deferred gains and losses in AOCI associated with such derivative instruments are reclassified immediately into other income/(expense), net. Any subsequent changes in fair value of such derivative instruments are reflected in other income/(expense), net unless they are re-designated as hedges of other transactions. Net Investment Hedges The effective portions of net investment hedges are recorded in other comprehensive income (“OCI”) as a part of the cumulative translation adjustment. The ineffective portions and amounts excluded from the effectiveness testing of net investment hedges are recognized in other income/(expense), net. Fair Value Hedges Gains and losses related to changes in fair value hedges are recognized in earnings along with a corresponding loss or gain related to the change in value of the underlying hedged item. Non-Designated Derivatives Derivatives that are not designated as hedging instruments are adjusted to fair value through earnings in the financial statement line item to which the derivative relates. The Company records all derivatives in the Consolidated Balance Sheets at fair value. The Company’s accounting treatment for these derivative instruments is based on its hedge designation. The following tables show the Company’s derivative instruments at gross fair value as of September 24, 2016 and September 26, 2015 (in millions): 2016 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 518 $ 153 $ 671 Interest rate contracts $ 728 $ — $ 728 Derivative liabilities (2) : Foreign exchange contracts $ 935 $ 134 $ 1,069 Interest rate contracts $ 7 $ — $ 7 Apple Inc. | 2016 Form 10-K | 51 2015 Fair Value of Derivatives Designated as Hedge Instruments Fair Value of Derivatives Not Designated as Hedge Instruments Total Fair Value Derivative assets (1) : Foreign exchange contracts $ 1,442 $ 109 $ 1,551 Interest rate contracts $ 394 $ — $ 394 Derivative liabilities (2) : Foreign exchange contracts $ 905 $ 94 $ 999 Interest rate contracts $ 13 $ — $ 13 (1) The fair value of derivative assets is measured using Level 2 fair value inputs and is recorded as other current assets in the Consolidated Balance Sheets. (2) The fair value of derivative liabilities is measured using Level 2 fair value inputs and is recorded as accrued expenses in the Consolidated Balance Sheets. The following table shows the pre-tax gains and losses of the Company’s derivative and non-derivative instruments designated as cash flow, net investment and fair value hedges on OCI and the Consolidated Statements of Operations for 2016 , 2015 and 2014 (in millions): 2016 2015 2014 Gains/(Losses) recognized in OCI – effective portion: Cash flow hedges: Foreign exchange contracts $ 109 $ 3,592 $ 1,750 Interest rate contracts (57 ) (111 ) (15 ) Total $ 52 $ 3,481 $ 1,735 Net investment hedges: Foreign exchange contracts $ — $ 167 $ 53 Foreign currency debt (258 ) (71 ) — Total $ (258 ) $ 96 $ 53 Gains/(Losses) reclassified from AOCI into net income – effective portion: Cash flow hedges: Foreign exchange contracts $ 885 $ 4,092 $ (154 ) Interest rate contracts (11 ) (17 ) (16 ) Total $ 874 $ 4,075 $ (170 ) Gains/(Losses) on derivative instruments: Fair value hedges: Interest rate contracts $ 341 $ 337 $ 39 Gains/(Losses) related to hedged items: Fair value hedges: Interest rate contracts $ (341 ) $ (337 ) $ (39 ) Apple Inc. | 2016 Form 10-K | 52 The following table shows the notional amounts of the Company’s outstanding derivative instruments and credit risk amounts associated with outstanding or unsettled derivative instruments as of September 24, 2016 and September 26, 2015 (in millions): 2016 2015 Notional Amount Credit Risk Amount Notional Amount Credit Risk Amount Instruments designated as accounting hedges: Foreign exchange contracts $ 44,678 $ 518 $ 70,054 $ 1,385 Interest rate contracts $ 24,500 $ 728 $ 18,750 $ 394 Instruments not designated as accounting hedges: Foreign exchange contracts $ 54,305 $ 153 $ 49,190 $ 109 The notional amounts for outstanding derivative instruments provide one measure of the transaction volume outstanding and do not represent the amount of the Company’s exposure to credit or market loss. The credit risk amounts represent the Company’s gross exposure to potential accounting loss on derivative instruments that are outstanding or unsettled if all counterparties failed to perform according to the terms of the contract, based on then-current currency or interest rates at each respective date. The Company’s exposure to credit loss and market risk will vary over time as currency and interest rates change. Although the table above reflects the notional and credit risk amounts of the Company’s derivative instruments, it does not reflect the gains or losses associated with the exposures and transactions that the instruments are intended to hedge. The amounts ultimately realized upon settlement of these financial instruments, together with the gains and losses on the underlying exposures, will depend on actual market conditions during the remaining life of the instruments. The Company generally enters into master netting arrangements, which are designed to reduce credit risk by permitting net settlement of transactions with the same counterparty. To further limit credit risk, the Company generally enters into collateral security arrangements that provide for collateral to be received or posted when the net fair value of certain financial instruments fluctuates from contractually established thresholds. The Company presents its derivative assets and derivative liabilities at their gross fair values in its Consolidated Balance Sheets. The net cash collateral received by the Company related to derivative instruments under its collateral security arrangements was $163 million as of September 24, 2016 and $1.0 billion as of September 26, 2015 , which were recorded as accrued expenses in the Consolidated Balance Sheets. Under master netting arrangements with the respective counterparties to the Company’s derivative contracts, the Company is allowed to net settle transactions with a single net amount payable by one party to the other. As of September 24, 2016 and September 26, 2015 , the potential effects of these rights of set-off associated with the Company’s derivative contracts, including the effects of collateral, would be a reduction to both derivative assets and derivative liabilities of $1.5 billion and $2.2 billion , respectively, resulting in a net derivative asset of $160 million and a net derivative liability of $78 million , respectively. Accounts Receivable Trade Receivables The Company has considerable trade receivables outstanding with its third-party cellular network carriers, wholesalers, retailers, value-added resellers, small and mid-sized businesses and education, enterprise and government customers. The Company generally does not require collateral from its customers; however, the Company will require collateral in certain instances to limit credit risk. In addition, when possible, the Company attempts to limit credit risk on trade receivables with credit insurance for certain customers or by requiring third-party financing, loans or leases to support credit exposure. These credit-financing arrangements are directly between the third-party financing company and the end customer. As such, the Company generally does not assume any recourse or credit risk sharing related to any of these arrangements. As of September 24, 2016 and September 26, 2015 , the Company had one customer that represented 10% or more of total trade receivables, which accounted for 10% and 12% , respectively. The Company’s cellular network carriers accounted for 63% and 71% of trade receivables as of September 24, 2016 and September 26, 2015 , respectively. Vendor Non-Trade Receivables The Company has non-trade receivables from certain of its manufacturing vendors resulting from the sale of components to these vendors who manufacture sub-assemblies or assemble final products for the Company. The Company purchases these components directly from suppliers. Vendor non-trade receivables from two of the Company’s vendors accounted for 47% and 21% of total vendor non-trade receivables as of September 24, 2016 and three of the Company’s vendors accounted for 38% , 18% and 14% of total vendor non-trade receivables as of September 26, 2015 . Apple Inc. | 2016 Form 10-K | 53 Note 3 – Consolidated Financial Statement Details The following tables show the Company’s consolidated financial statement details as of September 24, 2016 and September 26, 2015 (in millions): Property, Plant and Equipment, Net 2016 2015 Land and buildings $ 10,185 $ 6,956 Machinery, equipment and internal-use software 44,543 37,038 Leasehold improvements 6,517 5,263 Gross property, plant and equipment 61,245 49,257 Accumulated depreciation and amortization (34,235 ) (26,786 ) Total property, plant and equipment, net $ 27,010 $ 22,471 Other Non-Current Liabilities 2016 2015 Deferred tax liabilities $ 26,019 $ 24,062 Other non-current liabilities 10,055 9,365 Total other non-current liabilities $ 36,074 $ 33,427 Other Income/(Expense), Net The following table shows the detail of other income/(expense), net for 2016 , 2015 and 2014 (in millions): 2016 2015 2014 Interest and dividend income $ 3,999 $ 2,921 $ 1,795 Interest expense (1,456 ) (733 ) (384 ) Other expense, net (1,195 ) (903 ) (431 ) Total other income/(expense), net $ 1,348 $ 1,285 $ 980 Note 4 – Acquired Intangible Assets The Company’s acquired intangible assets with definite useful lives primarily consist of patents and licenses. The following table summarizes the components of gross and net acquired intangible asset balances as of September 24, 2016 and September 26, 2015 (in millions): 2016 2015 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Definite-lived and amortizable acquired intangible assets $ 8,912 $ (5,806 ) $ 3,106 $ 8,125 $ (4,332 ) $ 3,793 Indefinite-lived and non-amortizable acquired intangible assets 100 — 100 100 — 100 Total acquired intangible assets $ 9,012 $ (5,806 ) $ 3,206 $ 8,225 $ (4,332 ) $ 3,893 Apple Inc. | 2016 Form 10-K | 54 Amortization expense related to acquired intangible assets was $1.5 billion , $1.3 billion and $1.1 billion in 2016 , 2015 and 2014 , respectively. As of September 24, 2016 , the remaining weighted-average amortization period for acquired intangible assets is 3.4 years . The expected annual amortization expense related to acquired intangible assets as of September 24, 2016 , is as follows (in millions): 2017 $ 1,197 2018 902 2019 449 2020 255 2021 175 Thereafter 128 Total $ 3,106 Note 5 – Income Taxes The provision for income taxes for 2016 , 2015 and 2014 , consisted of the following (in millions): 2016 2015 2014 Federal: Current $ 7,652 $ 11,730 $ 8,624 Deferred 5,043 3,408 3,183 12,695 15,138 11,807 State: Current 990 1,265 855 Deferred (138 ) (220 ) (178 ) 852 1,045 677 Foreign: Current 2,105 4,744 2,147 Deferred 33 (1,806 ) (658 ) 2,138 2,938 1,489 Provision for income taxes $ 15,685 $ 19,121 $ 13,973 The foreign provision for income taxes is based on foreign pre-tax earnings of $41.1 billion , $47.6 billion and $33.6 billion in 2016, 2015 and 2014, respectively. The Company’s consolidated financial statements provide for any related tax liability on undistributed earnings that the Company does not intend to be indefinitely reinvested outside the U.S. Substantially all of the Company’s undistributed international earnings intended to be indefinitely reinvested in operations outside the U.S. were generated by subsidiaries organized in Ireland, which has a statutory tax rate of 12.5% . As of September 24, 2016 , U.S. income taxes have not been provided on a cumulative total of $109.8 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be $35.9 billion . As of September 24, 2016 and September 26, 2015 , $216.0 billion and $186.9 billion , respectively, of the Company’s cash, cash equivalents and marketable securities were held by foreign subsidiaries and are generally based in U.S. dollar-denominated holdings. Amounts held by foreign subsidiaries are generally subject to U.S. income taxation on repatriation to the U.S. Apple Inc. | 2016 Form 10-K | 55 A reconciliation of the provision for income taxes, with the amount computed by applying the statutory federal income tax rate ( 35% in 2016 , 2015 and 2014 ) to income before provision for income taxes for 2016 , 2015 and 2014 , is as follows (dollars in millions): 2016 2015 2014 Computed expected tax $ 21,480 $ 25,380 $ 18,719 State taxes, net of federal effect 553 680 469 Indefinitely invested earnings of foreign subsidiaries (5,582 ) (6,470 ) (4,744 ) Domestic production activities deduction (382 ) (426 ) (495 ) Research and development credit, net (371 ) (171 ) (88 ) Other (13 ) 128 112 Provision for income taxes $ 15,685 $ 19,121 $ 13,973 Effective tax rate 25.6 % 26.4 % 26.1 % The Company’s income taxes payable have been reduced by the tax benefits from employee stock plan awards. For RSUs, the Company receives an income tax benefit upon the award’s vesting equal to the tax effect of the underlying stock’s fair market value. The Company had net excess tax benefits from equity awards of $379 million , $748 million and $706 million in 2016 , 2015 and 2014 , respectively, which were reflected as increases to common stock. As of September 24, 2016 and September 26, 2015 , the significant components of the Company’s deferred tax assets and liabilities were (in millions): 2016 2015 Deferred tax assets: Accrued liabilities and other reserves $ 4,135 $ 4,205 Basis of capital assets 2,107 2,238 Deferred revenue 1,717 1,941 Deferred cost sharing 667 667 Share-based compensation 601 575 Unrealized losses — 564 Other 788 721 Total deferred tax assets, net of valuation allowance of $0 10,015 10,911 Deferred tax liabilities: Unremitted earnings of foreign subsidiaries 31,436 26,868 Other 485 303 Total deferred tax liabilities 31,921 27,171 Net deferred tax liabilities $ (21,906 ) $ (16,260 ) Deferred tax assets and liabilities reflect the effects of tax losses, credits and the future income tax effects of temporary differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and are measured using enacted tax rates that apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Uncertain Tax Positions Tax positions are evaluated in a two-step process. The Company first determines whether it is more likely than not that a tax position will be sustained upon examination. If a tax position meets the more-likely-than-not recognition threshold it is then measured to determine the amount of benefit to recognize in the financial statements. The tax position is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. The Company classifies gross interest and penalties and unrecognized tax benefits that are not expected to result in payment or receipt of cash within one year as non-current liabilities in the Consolidated Balance Sheets. As of September 24, 2016 , the total amount of gross unrecognized tax benefits was $7.7 billion , of which $2.8 billion , if recognized, would affect the Company’s effective tax rate. As of September 26, 2015 , the total amount of gross unrecognized tax benefits was $6.9 billion , of which $2.5 billion , if recognized, would affect the Company’s effective tax rate. Apple Inc. | 2016 Form 10-K | 56 The aggregate changes in the balance of gross unrecognized tax benefits, which excludes interest and penalties, for 2016 , 2015 and 2014 , is as follows (in millions): 2016 2015 2014 Beginning Balance $ 6,900 $ 4,033 $ 2,714 Increases related to tax positions taken during a prior year 1,121 2,056 1,295 Decreases related to tax positions taken during a prior year (257 ) (345 ) (280 ) Increases related to tax positions taken during the current year 1,578 1,278 882 Decreases related to settlements with taxing authorities (1,618 ) (109 ) (574 ) Decreases related to expiration of statute of limitations — (13 ) (4 ) Ending Balance $ 7,724 $ 6,900 $ 4,033 The Company includes interest and penalties related to unrecognized tax benefits within the provision for income taxes. As of September 24, 2016 and September 26, 2015 , the total amount of gross interest and penalties accrued was $1.0 billion and $1.3 billion , respectively, which is classified as non-current liabilities in the Consolidated Balance Sheets. In connection with tax matters, the Company recognized interest and penalty expense in 2016 , 2015 and 2014 of $295 million , $709 million and $40 million , respectively. The Company is subject to taxation and files income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. During the fourth quarter of 2016, the Company reached a partial settlement with the U.S. Internal Revenue Service (the “IRS”) on its examination of the years 2010 through 2012. In connection with this settlement, the Company recognized a tax benefit in the fourth quarter of 2016 that was not significant to its consolidated financial statements. All years prior to 2013 are closed, except for the years 2010 through 2012 relating to R&D tax credits. In addition, the Company is subject to audits by state, local and foreign tax authorities. In major states and major foreign jurisdictions, the years subsequent to 2003 generally remain open and could be subject to examination by the taxing authorities. The Company believes that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in the Company’s tax audits are resolved in a manner not consistent with its expectations, the Company could be required to adjust its provision for income taxes in the period such resolution occurs. Although timing of the resolution and/or closure of audits is not certain, the Company believes it is reasonably possible that its gross unrecognized tax benefits could decrease (whether by payment, release or a combination of both) in the next 12 months by up to $850 million . On August 30, 2016, the European Commission announced its decision that Ireland granted state aid to the Company by providing tax opinions in 1991 and 2007 concerning the tax allocation of profits of the Irish branches of two subsidiaries of the Company (the "State Aid Decision"). The State Aid Decision orders Ireland to calculate and recover additional taxes from the Company for the period June 2003 through September 2014. Irish legislative changes, effective as of the beginning of 2015, eliminated the application of the tax opinions from that date forward. The Company believes the State Aid Decision to be without merit and intends to appeal to the General Court of the Court of Justice of the European Union. Ireland has also announced its intention to appeal the State Aid Decision. While the European Commission announced a recovery amount of up to €13 billion , plus interest, the actual amount of additional taxes subject to recovery is to be calculated by Ireland in accordance with the European Commission's guidance. Once the recovery amount is computed by Ireland, the Company anticipates funding it, including interest, out of foreign cash into escrow, pending conclusion of all appeals. The Company believes that any incremental Irish corporate income taxes potentially due would be creditable against U.S. taxes. Apple Inc. | 2016 Form 10-K | 57 Note 6 – Debt Commercial Paper The Company issues unsecured short-term promissory notes (“Commercial Paper”) pursuant to a commercial paper program. The Company uses net proceeds from the commercial paper program for general corporate purposes, including dividends and share repurchases. As of September 24, 2016 and September 26, 2015 , the Company had $8.1 billion and $8.5 billion of Commercial Paper outstanding, respectively, with maturities generally less than nine months . The weighted-average interest rate of the Company’s Commercial Paper was 0.45% as of September 24, 2016 and 0.14% as of September 26, 2015 . The following table provides a summary of cash flows associated with the issuance and maturities of Commercial Paper for 2016 and 2015 (in millions): 2016 2015 Maturities less than 90 days: Proceeds from (repayments of) commercial paper, net $ (869 ) $ 5,293 Maturities greater than 90 days: Proceeds from commercial paper 3,632 3,851 Repayments of commercial paper (3,160 ) (6,953 ) Maturities greater than 90 days, net 472 (3,102 ) Total change in commercial paper, net $ (397 ) $ 2,191 Long-Term Debt As of September 24, 2016 , the Company had outstanding floating- and fixed-rate notes with varying maturities for an aggregate principal amount of $78.4 billion (collectively the “Notes”). The Notes are senior unsecured obligations, and interest is payable in arrears, quarterly for the U.S. dollar-denominated and Australian dollar-denominated floating-rate notes, semi-annually for the U.S. dollar-denominated, Australian dollar-denominated, British pound-denominated and Japanese yen-denominated fixed-rate notes and annually for the euro-denominated and Swiss franc-denominated fixed-rate notes. Apple Inc. | 2016 Form 10-K | 58 The following table provides a summary of the Company’s term debt as of September 24, 2016 and September 26, 2015 : Maturities 2016 2015 Amount (in millions) Effective Interest Rate Amount (in millions) Effective Interest Rate 2013 debt issuance of $17.0 billion: Floating-rate notes 2018 $ 2,000 1.10% $ 3,000 0.51% - 1.10% Fixed-rate 1.000% - 3.850% notes 2018 - 2043 12,500 1.08% - 3.91% 14,000 0.51% - 3.91% 2014 debt issuance of $12.0 billion: Floating-rate notes 2017 - 2019 2,000 0.86% - 1.09% 2,000 0.37% - 0.60% Fixed-rate 1.050% - 4.450% notes 2017 - 2044 10,000 0.85% - 4.48% 10,000 0.37% - 4.48% 2015 debt issuances of $27.3 billion: Floating-rate notes 2017 - 2020 1,781 0.87% - 1.87% 1,743 0.36% - 1.87% Fixed-rate 0.350% - 4.375% notes 2017 - 2045 25,144 0.28% - 4.51% 24,958 0.28% - 4.51% Second quarter 2016 debt issuance of $15.5 billion: Floating-rate notes 2019 500 1.64 % — — Floating-rate notes 2021 500 1.95 % — — Fixed-rate 1.300% notes 2018 500 1.32 % — — Fixed-rate 1.700% notes 2019 1,000 1.71 % — — Fixed-rate 2.250% notes 2021 3,000 1.91 % — — Fixed-rate 2.850% notes 2023 1,500 2.58 % — — Fixed-rate 3.250% notes 2026 3,250 2.51 % — — Fixed-rate 4.500% notes 2036 1,250 4.54 % — — Fixed-rate 4.650% notes 2046 4,000 4.58 % — — Third quarter 2016 Australian dollar-denominated debt issuance of A$1.4 billion: Fixed-rate 2.650% notes 2020 493 1.92 % — — Fixed-rate 3.350% notes 2024 342 2.61 % — — Fixed-rate 3.600% notes 2026 247 2.84 % — — Third quarter 2016 debt issuance of $1.4 billion: Fixed-rate 4.150% notes 2046 1,377 4.15 % — — Fourth quarter 2016 debt issuance of $7.0 billion: Floating-rate notes 2019 350 0.91 % — — Fixed-rate 1.100% notes 2019 1,150 1.13 % — — Fixed-rate 1.550% notes 2021 1,250 1.40 % — — Fixed-rate 2.450% notes 2026 2,250 2.15 % — — Fixed-rate 3.850% notes 2046 2,000 3.86 % — — Total term debt 78,384 55,701 Unamortized premium/(discount) and issuance costs, net (174 ) (248 ) Hedge accounting fair value adjustments 717 376 Less: Current portion of long-term debt, net (3,500 ) (2,500 ) Total long-term debt $ 75,427 $ 53,329 To manage foreign currency risk associated with the Australian dollar-denominated notes issued in the third quarter of 2016, the Company entered into currency swaps with an aggregate notional amount of $1.0 billion , which effectively converted these notes to U.S. dollar-denominated notes. To manage interest rate risk on the U.S. dollar-denominated fixed-rate notes issued in the second quarter of 2016 and maturing in 2021, 2023 and 2026, the Company entered into interest rate swaps with an aggregate notional amount of $5.0 billion . To manage interest rate risk on the U.S. dollar-denominated fixed-rate notes issued in the fourth quarter of 2016 and maturing in 2021 and 2026, the Company entered into interest rate swaps with an aggregate notional amount of $1.8 billion . These interest rate swaps effectively converted a portion of the U.S. dollar-denominated fixed-rate notes to floating interest rate notes. Apple Inc. | 2016 Form 10-K | 59 As of September 24, 2016 , ¥195.5 billion of the Japanese yen-denominated notes was designated as a hedge of the foreign currency exposure of its net investment in a foreign operation. The foreign currency transaction gain or loss on the Japanese yen-denominated debt designated as a hedge is recorded in OCI as a part of the cumulative translation adjustment. As of September 24, 2016 , the carrying value of the debt designated as a net investment hedge was $1.9 billion . For further discussion regarding the Company’s use of derivative instruments see the Derivative Financial Instruments section of Note 2, “Financial Instruments.” The effective interest rates for the Notes include the interest on the Notes, amortization of the discount and, if applicable, adjustments related to hedging. The Company recognized $1.4 billion , $722 million and $381 million of interest expense on its term debt for 2016 , 2015 and 2014 , respectively. The future principal payments for the Company’s Notes as of September 24, 2016 are as follows (in millions): 2017 $ 3,500 2018 6,500 2019 6,834 2020 6,454 2021 7,750 Thereafter 47,346 Total term debt $ 78,384 As of September 24, 2016 and September 26, 2015 , the fair value of the Company’s Notes, based on Level 2 inputs, was $81.7 billion and $54.9 billion , respectively. Note 7 – Shareholders’ Equity Dividends The Company declared and paid cash dividends per share during the periods presented as follows: Dividends Per Share Amount (in millions) 2016: Fourth quarter $ 0.57 $ 3,071 Third quarter 0.57 3,117 Second quarter 0.52 2,879 First quarter 0.52 2,898 Total cash dividends declared and paid $ 2.18 $ 11,965 2015: Fourth quarter $ 0.52 $ 2,950 Third quarter 0.52 2,997 Second quarter 0.47 2,734 First quarter 0.47 2,750 Total cash dividends declared and paid $ 1.98 $ 11,431 Future dividends are subject to declaration by the Board of Directors. Share Repurchase Program In April 2016, the Company’s Board of Directors increased the share repurchase authorization from $140 billion to $175 billion of the Company’s common stock, of which $133 billion had been utilized as of September 24, 2016 . The Company’s share repurchase program does not obligate it to acquire any specific number of shares. Under the program, shares may be repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Apple Inc. | 2016 Form 10-K | 60 The Company has entered, and in the future may enter, into accelerated share repurchase arrangements (“ASRs”) with financial institutions. In exchange for up-front payments, the financial institutions deliver shares of the Company’s common stock during the purchase periods of each ASR. The total number of shares ultimately delivered, and therefore the average repurchase price paid per share, is determined at the end of the applicable purchase period of each ASR based on the volume weighted-average price of the Company’s common stock during that period. The shares received are retired in the periods they are delivered, and the up-front payments are accounted for as a reduction to shareholders’ equity in the Company’s Consolidated Balance Sheets in the periods the payments are made. The Company reflects the ASRs as a repurchase of common stock in the period delivered for purposes of calculating earnings per share and as forward contracts indexed to its own common stock. The ASRs met all of the applicable criteria for equity classification, and therefore were not accounted for as derivative instruments. The following table shows the Company’s ASR activity and related information during the years ended September 24, 2016 and September 26, 2015 : Purchase Period End Date Number of Shares (in thousands) Average Repurchase Price Per Share ASR Amount (in millions) August 2016 ASR November 2016 22,468 (1) (1) $ 3,000 May 2016 ASR August 2016 60,452 (2) $ 99.25 $ 6,000 November 2015 ASR April 2016 29,122 $ 103.02 $ 3,000 May 2015 ASR July 2015 48,293 $ 124.24 $ 6,000 August 2014 ASR February 2015 81,525 $ 110.40 $ 9,000 January 2014 ASR December 2014 134,247 $ 89.39 $ 12,000 (1) “Number of Shares” represents those shares delivered in the beginning of the purchase period and does not represent the final number of shares to be delivered under the ASR. The total number of shares ultimately delivered, and therefore the average repurchase price paid per share, will be determined at the end of the purchase period based on the volume-weighted average price of the Company’s common stock during that period. The August 2016 ASR purchase period will end in or before November 2016. (2) Includes 48.2 million shares delivered and retired at the beginning of the purchase period, which began in the third quarter of 2016, and 12.3 million shares delivered and retired at the end of the purchase period, which concluded in the fourth quarter of 2016. Additionally, the Company repurchased shares of its common stock in the open market, which were retired upon repurchase, during the periods presented as follows: Number of Shares (in thousands) Average Repurchase Price Per Share Amount (in millions) 2016: Fourth quarter 28,579 $ 104.97 $ 3,000 Third quarter 41,238 $ 97.00 4,000 Second quarter 71,766 $ 97.54 7,000 First quarter 25,984 $ 115.45 3,000 Total open market common stock repurchases 167,567 $ 17,000 2015: Fourth quarter 121,802 $ 115.15 $ 14,026 Third quarter 31,231 $ 128.08 4,000 Second quarter 56,400 $ 124.11 7,000 First quarter 45,704 $ 109.40 5,000 Total open market common stock repurchases 255,137 $ 30,026 Note 8 – Comprehensive Income Comprehensive income consists of two components, net income and OCI. OCI refers to revenue, expenses, and gains and losses that under GAAP are recorded as an element of shareholders’ equity but are excluded from net income. The Company’s OCI consists of foreign currency translation adjustments from those subsidiaries not using the U.S. dollar as their functional currency, net deferred gains and losses on certain derivative instruments accounted for as cash flow hedges and unrealized gains and losses on marketable securities classified as available-for-sale. Apple Inc. | 2016 Form 10-K | 61 The following table shows the pre-tax amounts reclassified from AOCI into the Consolidated Statements of Operations, and the associated financial statement line item, for 2016 and 2015 (in millions): Comprehensive Income Components Financial Statement Line Item 2016 2015 Unrealized (gains)/losses on derivative instruments: Foreign exchange contracts Revenue $ (865 ) $ (2,432 ) Cost of sales (130 ) (2,168 ) Other income/(expense), net 111 456 Interest rate contracts Other income/(expense), net 12 17 (872 ) (4,127 ) Unrealized (gains)/losses on marketable securities Other income/(expense), net 87 91 Total amounts reclassified from AOCI $ (785 ) $ (4,036 ) The following table shows the changes in AOCI by component for 2016 and 2015 (in millions): Cumulative Foreign Currency Translation Unrealized Gains/Losses on Derivative Instruments Unrealized Gains/Losses on Marketable Securities Total Balance at September 27, 2014 $ (242 ) $ 1,364 $ (40 ) $ 1,082 Other comprehensive income/(loss) before reclassifications (612 ) 3,346 (747 ) 1,987 Amounts reclassified from AOCI — (4,127 ) 91 (4,036 ) Tax effect 201 189 232 622 Other comprehensive income/(loss) (411 ) (592 ) (424 ) (1,427 ) Balance at September 26, 2015 (653 ) 772 (464 ) (345 ) Other comprehensive income/(loss) before reclassifications 67 14 2,445 2,526 Amounts reclassified from AOCI — (872 ) 87 (785 ) Tax effect 8 124 (894 ) (762 ) Other comprehensive income/(loss) 75 (734 ) 1,638 979 Balance at September 24, 2016 $ (578 ) $ 38 $ 1,174 $ 634 Note 9 – Benefit Plans 2014 Employee Stock Plan In the second quarter of 2014, shareholders approved the 2014 Employee Stock Plan (the “2014 Plan”) and terminated the Company’s authority to grant new awards under the 2003 Employee Stock Plan (the “2003 Plan”). The 2014 Plan provides for broad-based equity grants to employees, including executive officers, and permits the granting of RSUs, stock grants, performance-based awards, stock options and stock appreciation rights, as well as cash bonus awards. RSUs granted under the 2014 Plan generally vest over four years , based on continued employment, and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. Each share issued with respect to RSUs granted under the 2014 Plan reduces the number of shares available for grant under the plan by two shares. RSUs cancelled and shares withheld to satisfy tax withholding obligations increase the number of shares available for grant under the 2014 Plan utilizing a factor of two times the number of RSUs cancelled or shares withheld. Currently, all RSUs granted under the 2014 Plan have dividend equivalent rights (“DERs”), which entitle holders of RSUs to the same dividend value per share as holders of common stock. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. Upon approval of the 2014 Plan, the Company reserved 385 million shares plus the number of shares remaining that were reserved but not issued under the 2003 Plan. Shares subject to outstanding awards under the 2003 Plan that expire, are cancelled or otherwise terminate, or are withheld to satisfy tax withholding obligations with respect to RSUs, will also be available for awards under the 2014 Plan. As of September 24, 2016 , approximately 386.4 million shares were reserved for future issuance under the 2014 Plan. Apple Inc. | 2016 Form 10-K | 62 2003 Employee Stock Plan The 2003 Plan is a shareholder approved plan that provided for broad-based equity grants to employees, including executive officers. The 2003 Plan permitted the granting of incentive stock options, nonstatutory stock options, RSUs, stock appreciation rights, stock purchase rights and performance-based awards. Options granted under the 2003 Plan generally expire seven to ten years after the grant date and generally become exercisable over a period of four years , based on continued employment, with either annual, semi-annual or quarterly vesting. RSUs granted under the 2003 Plan generally vest over two to four years , based on continued employment and are settled upon vesting in shares of the Company’s common stock on a one -for-one basis. All RSUs, other than RSUs held by the Chief Executive Officer, granted under the 2003 Plan have DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. In the second quarter of 2014, the Company terminated the authority to grant new awards under the 2003 Plan. 1997 Director Stock Plan The 1997 Director Stock Plan (the “Director Plan”) is a shareholder approved plan that (i) permits the Company to grant awards of RSUs or stock options to the Company’s non-employee directors, (ii) provides for automatic initial grants of RSUs upon a non-employee director joining the Board of Directors and automatic annual grants of RSUs at each annual meeting of shareholders, and (iii) permits the Board of Directors to prospectively change the relative mixture of stock options and RSUs for the initial and annual award grants and the methodology for determining the number of shares of the Company’s common stock subject to these grants without shareholder approval. Each share issued with respect to RSUs granted under the Director Plan reduces the number of shares available for grant under the plan by two shares. The Director Plan expires November 9, 2019 . All RSUs granted under the Director Plan are entitled to DERs. DERs are subject to the same vesting and other terms and conditions as the corresponding unvested RSUs. DERs are accumulated and paid when the underlying shares vest. As of September 24, 2016 , approximately 1.1 million shares were reserved for future issuance under the Director Plan. Rule 10b5-1 Trading Plans During the three months ended September 24, 2016 , Section 16 officers Timothy D. Cook, Angela Ahrendts, Luca Maestri, Daniel Riccio, Philip Schiller and Jeffrey Williams had equity trading plans in place in accordance with Rule 10b5-1(c)(1) under the Exchange Act. An equity trading plan is a written document that pre-establishes the amounts, prices and dates (or formula for determining the amounts, prices and dates) of future purchases or sales of the Company’s stock, including shares acquired pursuant to the Company’s employee and director equity plans. Employee Stock Purchase Plan The Employee Stock Purchase Plan (the “Purchase Plan”) is a shareholder approved plan under which substantially all employees may purchase the Company’s common stock through payroll deductions at a price equal to 85% of the lower of the fair market values of the stock as of the beginning or the end of six -month offering periods. An employee’s payroll deductions under the Purchase Plan are limited to 10% of the employee’s compensation and employees may not purchase more than $25,000 of stock during any calendar year. As of September 24, 2016 , approximately 47.0 million shares were reserved for future issuance under the Purchase Plan. 401(k) Plan The Company’s 401(k) Plan is a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. Under the 401(k) Plan, participating U.S. employees may defer a portion of their pre-tax earnings, up to the IRS annual contribution limit ( $18,000 for calendar year 2016). The Company matches 50% to 100% of each employee’s contributions, depending on length of service, up to a maximum 6% of the employee’s eligible earnings. Apple Inc. | 2016 Form 10-K | 63 Restricted Stock Units A summary of the Company’s RSU activity and related information for 2016 , 2015 and 2014 , is as follows: Number of RSUs (in thousands) Weighted-Average Grant Date Fair Value Per Share Aggregate Intrinsic Value (in millions) Balance at September 28, 2013 93,284 $ 62.24 RSUs granted 59,269 $ 74.54 RSUs vested (43,111 ) $ 57.29 RSUs cancelled (5,620 ) $ 68.47 Balance at September 27, 2014 103,822 $ 70.98 RSUs granted 45,587 $ 105.51 RSUs vested (41,684 ) $ 71.32 RSUs cancelled (6,258 ) $ 80.34 Balance at September 26, 2015 101,467 $ 85.77 RSUs granted 49,468 $ 109.28 RSUs vested (46,313 ) $ 84.44 RSUs cancelled (5,533 ) $ 96.48 Balance at September 24, 2016 99,089 $ 97.54 $ 11,168 The fair value as of the respective vesting dates of RSUs was $5.1 billion , $4.8 billion and $3.4 billion for 2016 , 2015 and 2014 , respectively. The majority of RSUs that vested in 2016 , 2015 and 2014 were net-share settled such that the Company withheld shares with value equivalent to the employees’ minimum statutory obligation for the applicable income and other employment taxes, and remitted the cash to the appropriate taxing authorities. The total shares withheld were approximately 15.9 million , 14.1 million and 15.6 million for 2016 , 2015 and 2014 , respectively, and were based on the value of the RSUs on their respective vesting dates as determined by the Company’s closing stock price. Total payments for the employees’ tax obligations to taxing authorities were $1.7 billion , $1.6 billion and $1.2 billion in 2016 , 2015 and 2014 , respectively, and are reflected as a financing activity within the Consolidated Statements of Cash Flows. These net-share settlements had the effect of share repurchases by the Company as they reduced the number of shares that would have otherwise been issued as a result of the vesting and did not represent an expense to the Company. Share-based Compensation The following table shows a summary of the share-based compensation expense included in the Consolidated Statements of Operations for 2016 , 2015 and 2014 (in millions): 2016 2015 2014 Cost of sales $ 769 $ 575 $ 450 Research and development 1,889 1,536 1,216 Selling, general and administrative 1,552 1,475 1,197 Total share-based compensation expense $ 4,210 $ 3,586 $ 2,863 The income tax benefit related to share-based compensation expense was $1.4 billion , $1.2 billion and $1.0 billion for 2016 , 2015 and 2014 , respectively. As of September 24, 2016 , the total unrecognized compensation cost related to outstanding stock options, RSUs and restricted stock was $7.5 billion , which the Company expects to recognize over a weighted-average period of 2.6 years . Apple Inc. | 2016 Form 10-K | 64 Note 10 – Commitments and Contingencies Accrued Warranty and Indemnification The following table shows changes in the Company’s accrued warranties and related costs for 2016 , 2015 and 2014 (in millions): 2016 2015 2014 Beginning accrued warranty and related costs $ 4,780 $ 4,159 $ 2,967 Cost of warranty claims (4,663 ) (4,401 ) (3,760 ) Accruals for product warranty 3,585 5,022 4,952 Ending accrued warranty and related costs $ 3,702 $ 4,780 $ 4,159 The Company generally does not indemnify end-users of its operating system and application software against legal claims that the software infringes third-party intellectual property rights. Other agreements entered into by the Company sometimes include indemnification provisions under which the Company could be subject to costs and/or damages in the event of an infringement claim against the Company or an indemnified third-party. In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss with respect to indemnification of end-users of its operating system or application software for infringement of third-party intellectual property rights. The Company offers an iPhone Upgrade Program, which is available to customers who purchase a qualifying iPhone in the U.S., the U.K. and mainland China. The iPhone Upgrade Program provides customers the right to trade in that iPhone for a specified amount when purchasing a new iPhone, provided certain conditions are met. The Company accounts for the trade-in right as a guarantee liability and recognizes arrangement revenue net of the fair value of such right with subsequent changes to the guarantee liability recognized within revenue. The Company has entered into indemnification agreements with its directors and executive officers. Under these agreements, the Company has agreed to indemnify such individuals to the fullest extent permitted by law against liabilities that arise by reason of their status as directors or officers and to advance expenses incurred by such individuals in connection with related legal proceedings. It is not possible to determine the maximum potential amount of payments the Company could be required to make under these agreements due to the limited history of prior indemnification claims and the unique facts and circumstances involved in each claim. However, the Company maintains directors and officers liability insurance coverage to reduce its exposure to such obligations. Concentrations in the Available Sources of Supply of Materials and Product Although most components essential to the Company’s business are generally available from multiple sources, a number of components are currently obtained from single or limited sources. In addition, the Company competes for various components with other participants in the markets for mobile communication and media devices and personal computers. Therefore, many components used by the Company, including those that are available from multiple sources, are at times subject to industry-wide shortage and significant pricing fluctuations that could materially adversely affect the Company’s financial condition and operating results. The Company uses some custom components that are not commonly used by its competitors, and new products introduced by the Company often utilize custom components available from only one source. When a component or product uses new technologies, initial capacity constraints may exist until the suppliers’ yields have matured or manufacturing capacity has increased. If the Company’s supply of components for a new or existing product were delayed or constrained, or if an outsourcing partner delayed shipments of completed products to the Company, the Company’s financial condition and operating results could be materially adversely affected. The Company’s business and financial performance could also be materially adversely affected depending on the time required to obtain sufficient quantities from the original source, or to identify and obtain sufficient quantities from an alternative source. Continued availability of these components at acceptable prices, or at all, may be affected if those suppliers concentrated on the production of common components instead of components customized to meet the Company’s requirements. The Company has entered into agreements for the supply of many components; however, there can be no guarantee that the Company will be able to extend or renew these agreements on similar terms, or at all. Therefore, the Company remains subject to significant risks of supply shortages and price increases that could materially adversely affect its financial condition and operating results. Substantially all of the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company’s products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company’s operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company’s manufacturing purchase obligations typically cover its requirements for periods up to 150 days . Apple Inc. | 2016 Form 10-K | 65 Other Off-Balance Sheet Commitments Operating Leases The Company leases various equipment and facilities, including retail space, under noncancelable operating lease arrangements. The Company does not currently utilize any other off-balance sheet financing arrangements. As of September 24, 2016 , the Company’s total future minimum lease payments under noncancelable operating leases were $7.6 billion . The Company's retail store and other facility leases are typically for terms not exceeding 10 years and generally contain multi-year renewal options. Rent expense under all operating leases, including both cancelable and noncancelable leases, was $939 million , $794 million and $717 million in 2016 , 2015 and 2014 , respectively. Future minimum lease payments under noncancelable operating leases having remaining terms in excess of one year as of September 24, 2016 , are as follows (in millions): 2017 $ 929 2018 919 2019 915 2020 889 2021 836 Thereafter 3,139 Total $ 7,627 Contingencies The Company is subject to various legal proceedings and claims that have arisen in the ordinary course of business and that have not been fully adjudicated, as further discussed in Part I, Item 1A of this Form 10-K under the heading “Risk Factors” and in Part I, Item 3 of this Form 10-K under the heading “Legal Proceedings.” In the opinion of management, there was not at least a reasonable possibility the Company may have incurred a material loss, or a material loss in excess of a recorded accrual, with respect to loss contingencies for asserted legal and other claims. However, the outcome of litigation is inherently uncertain. Therefore, although management considers the likelihood of such an outcome to be remote, if one or more of these legal matters were resolved against the Company in a reporting period for amounts in excess of management’s expectations, the Company’s consolidated financial statements for that reporting period could be materially adversely affected. Apple Inc. v. Samsung Electronics Co., Ltd., et al. On August 24, 2012, a jury returned a verdict awarding the Company $1.05 billion in its lawsuit against Samsung Electronics Co., Ltd. and affiliated parties in the United States District Court, Northern District of California, San Jose Division. On March 6, 2014, the District Court entered final judgment in favor of the Company in the amount of approximately $930 million . On May 18, 2015, the U.S. Court of Appeals for the Federal Circuit affirmed in part, and reversed in part, the decision of the District Court. As a result, the Court of Appeals ordered entry of final judgment on damages in the amount of approximately $548 million , with the District Court to determine supplemental damages and interest, as well as damages owed for products subject to the reversal in part. Samsung paid $548 million to the Company in December 2015, which was included in net sales in the Condensed Consolidated Statement of Operations. Because the case remains subject to further proceedings, the Company has not recognized any further amounts in its results of operations. On October 11, 2016, the United States Supreme Court heard arguments in Samsung’s request for appeal related to the $548 million in damages. Note 11 – Segment Information and Geographic Data The Company reports segment information based on the “management” approach. The management approach designates the internal reporting used by management for making decisions and assessing performance as the source of the Company’s reportable operating segments. The Company manages its business primarily on a geographic basis. The Company’s reportable operating segments consist of the Americas, Europe, Greater China, Japan and Rest of Asia Pacific. The Americas segment includes both North and South America. The Europe segment includes European countries, as well as India, the Middle East and Africa. The Greater China segment includes China, Hong Kong and Taiwan. The Rest of Asia Pacific segment includes Australia and those Asian countries not included in the Company’s other reportable operating segments. Although the reportable operating segments provide similar hardware and software products and similar services, each one is managed separately to better align with the location of the Company’s customers and distribution partners and the unique market dynamics of each geographic region. The accounting policies of the various segments are the same as those described in Note 1, “Summary of Significant Accounting Policies.” Apple Inc. | 2016 Form 10-K | 66 The Company evaluates the performance of its reportable operating segments based on net sales and operating income. Net sales for geographic segments are generally based on the location of customers and sales through the Company’s retail stores located in those geographic locations. Operating income for each segment includes net sales to third parties, related cost of sales and operating expenses directly attributable to the segment. Advertising expenses are generally included in the geographic segment in which the expenditures are incurred. Operating income for each segment excludes other income and expense and certain expenses managed outside the reportable operating segments. Costs excluded from segment operating income include various corporate expenses such as R&D, corporate marketing expenses, certain share-based compensation expenses, income taxes, various nonrecurring charges and other separately managed general and administrative costs. The Company does not include intercompany transfers between segments for management reporting purposes. The following table shows information by reportable operating segment for 2016 , 2015 and 2014 (in millions): 2016 2015 2014 Americas: Net sales $ 86,613 $ 93,864 $ 80,095 Operating income $ 28,172 $ 31,186 $ 26,158 Europe: Net sales $ 49,952 $ 50,337 $ 44,285 Operating income $ 15,348 $ 16,527 $ 14,434 Greater China: Net sales $ 48,492 $ 58,715 $ 31,853 Operating income $ 18,835 $ 23,002 $ 11,039 Japan: Net sales $ 16,928 $ 15,706 $ 15,314 Operating income $ 7,165 $ 7,617 $ 6,904 Rest of Asia Pacific: Net sales $ 13,654 $ 15,093 $ 11,248 Operating income $ 4,781 $ 5,518 $ 3,674 A reconciliation of the Company’s segment operating income to the Consolidated Statements of Operations for 2016 , 2015 and 2014 is as follows (in millions): 2016 2015 2014 Segment operating income $ 74,301 $ 83,850 $ 62,209 Research and development expense (10,045 ) (8,067 ) (6,041 ) Other corporate expenses, net (4,232 ) (4,553 ) (3,665 ) Total operating income $ 60,024 $ 71,230 $ 52,503 Apple Inc. | 2016 Form 10-K | 67 The U.S. and China were the only countries that accounted for more than 10% of the Company’s net sales in 2016, 2015 and 2014 . There was no single customer that accounted for more than 10% of net sales in 2016, 2015 or 2014 . Net sales for 2016 , 2015 and 2014 and long-lived assets as of September 24, 2016 and September 26, 2015 are as follows (in millions): 2016 2015 2014 Net sales: U.S. $ 75,667 $ 81,732 $ 68,909 China (1) 46,349 56,547 30,638 Other countries 93,623 95,436 83,248 Total net sales $ 215,639 $ 233,715 $ 182,795 2016 2015 Long-lived assets: U.S. $ 16,364 $ 12,022 China (1) 7,807 8,722 Other countries 2,839 3,040 Total long-lived assets $ 27,010 $ 23,784 (1) China includes Hong Kong. Long-lived assets located in China consist primarily of product tooling and manufacturing process equipment and assets related to retail stores and related infrastructure. Net sales by product for 2016 , 2015 and 2014 are as follows (in millions): 2016 2015 2014 iPhone (1) $ 136,700 $ 155,041 $ 101,991 iPad (1) 20,628 23,227 30,283 Mac (1) 22,831 25,471 24,079 Services (2) 24,348 19,909 18,063 Other Products (1)(3) 11,132 10,067 8,379 Total net sales $ 215,639 $ 233,715 $ 182,795 (1) Includes deferrals and amortization of related software upgrade rights and non-software services. (2) Includes revenue from iTunes Store, App Store, Mac App Store, TV App Store, iBooks Store, Apple Music, AppleCare, Apple Pay, licensing and other services. (3) Includes sales of Apple TV, Apple Watch, Beats products, iPod and Apple-branded and third-party accessories. Apple Inc. | 2016 Form 10-K | 68 Note 12 – Selected Quarterly Financial Information (Unaudited) The following tables show a summary of the Company’s quarterly financial information for each of the four quarters of 2016 and 2015 (in millions, except per share amounts): Fourth Quarter Third Quarter Second Quarter First Quarter 2016: Net sales $ 46,852 $ 42,358 $ 50,557 $ 75,872 Gross margin $ 17,813 $ 16,106 $ 19,921 $ 30,423 Net income $ 9,014 $ 7,796 $ 10,516 $ 18,361 Earnings per share (1) : Basic $ 1.68 $ 1.43 $ 1.91 $ 3.30 Diluted $ 1.67 $ 1.42 $ 1.90 $ 3.28 Fourth Quarter Third Quarter Second Quarter First Quarter 2015: Net sales $ 51,501 $ 49,605 $ 58,010 $ 74,599 Gross margin $ 20,548 $ 19,681 $ 23,656 $ 29,741 Net income $ 11,124 $ 10,677 $ 13,569 $ 18,024 Earnings per share (1) : Basic $ 1.97 $ 1.86 $ 2.34 $ 3.08 Diluted $ 1.96 $ 1.85 $ 2.33 $ 3.06 (1) Basic and diluted earnings per share are computed independently for each of the quarters presented. Therefore, the sum of quarterly basic and diluted per share information may not equal annual basic and diluted earnings per share. Apple Inc. | 2016 Form 10-K | 69 Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited the accompanying consolidated balance sheets of Apple Inc. as of September 24, 2016 and September 26, 2015, and the related consolidated statements of operations, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended September 24, 2016 . These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Apple Inc. at September 24, 2016 and September 26, 2015, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 24, 2016 , in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Apple Inc.’s internal control over financial reporting as of September 24, 2016 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated October 26, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 26, 2016 Apple Inc. | 2016 Form 10-K | 70 Report of Ernst & Young LLP, Independent Registered Public Accounting Firm The Board of Directors and Shareholders of Apple Inc. We have audited Apple Inc.’s internal control over financial reporting as of September 24, 2016 , based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (“the COSO criteria”). Apple Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Apple Inc. maintained, in all material respects, effective internal control over financial reporting as of September 24, 2016 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2016 consolidated financial statements of Apple Inc. and our report dated October 26, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California October 26, 2016 Apple Inc. | 2016 Form 10-K | 71 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure None. Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Based on an evaluation under the supervision and with the participation of the Company’s management, the Company’s principal executive officer and principal financial officer have concluded that the Company’s disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act were effective as of September 24, 2016 to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is (i) recorded, processed, summarized and reported within the time periods specified in the SEC rules and forms and (ii) accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. Inherent Limitations Over Internal Controls The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s internal control over financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the Company’s assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that the Company’s receipts and expenditures are being made only in accordance with authorizations of the Company’s management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements. Management, including the Company’s Chief Executive Officer and Chief Financial Officer, does not expect that the Company’s internal controls will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of internal controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Also, any evaluation of the effectiveness of controls in future periods are subject to the risk that those internal controls may become inadequate because of changes in business conditions, or that the degree of compliance with the policies or procedures may deteriorate. Management’s Annual Report on Internal Control Over Financial Reporting The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act). Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on the Company’s assessment, management has concluded that its internal control over financial reporting was effective as of September 24, 2016 to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with GAAP. The Company’s independent registered public accounting firm, Ernst & Young LLP, has issued an audit report on the Company’s internal control over financial reporting, which appears in Part II, Item 8 of this Form 10-K. Changes in Internal Control Over Financial Reporting There were no changes in the Company’s internal control over financial reporting during the fourth quarter of 2016 , which were identified in connection with management’s evaluation required by paragraph (d) of rules 13a-15 and 15d-15 under the Exchange Act, that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Item 9B. Other Information Not applicable. Apple Inc. | 2016 Form 10-K | 72 PART III Item 10. Directors, Executive Officers and Corporate Governance The information required by this Item is set forth under the headings “Directors, Corporate Governance and Executive Officers” in the Company’s 2017 Proxy Statement to be filed with the SEC within 120 days after September 24, 2016 in connection with the solicitation of proxies for the Company’s 2017 annual meeting of shareholders and is incorporated herein by reference. The Company has a code of ethics, “Business Conduct: The way we do business worldwide,” that applies to all employees, including the Company’s principal executive officer, principal financial officer, and principal accounting officer, as well as to the members of the Board of Directors of the Company. The code is available at investor.apple.com/corporate-governance.cfm. The Company intends to disclose any changes in, or waivers from, this code by posting such information on the same website or by filing a Form 8-K, in each case to the extent such disclosure is required by rules of the SEC or NASDAQ. Item 11. Executive Compensation The information required by this Item is set forth under the heading “Executive Compensation” and under the subheadings “Board Oversight of Risk Management,” “Compensation Committee Interlocks and Insider Participation,” “Compensation of Directors” and “Director Compensation- 2016 ” under the heading “Directors, Corporate Governance and Executive Officers” in the Company’s 2017 Proxy Statement to be filed with the SEC within 120 days after September 24, 2016 and is incorporated herein by reference. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information required by this Item is set forth under the headings “Security Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the Company’s 2017 Proxy Statement to be filed with the SEC within 120 days after September 24, 2016 and is incorporated herein by reference. Item 13. Certain Relationships and Related Transactions, and Director Independence The information required by this Item is set forth under the subheadings “Board Committees”, “Review, Approval or Ratification of Transactions with Related Persons” and “Transactions with Related Persons” under the heading “Directors, Corporate Governance and Executive Officers” in the Company’s 2017 Proxy Statement to be filed with the SEC within 120 days after September 24, 2016 and is incorporated herein by reference. Item 14. Principal Accounting Fees and Services The information required by this Item is set forth under the subheadings “Fees Paid to Auditors” and “Policy on Audit Committee Pre-Approval of Audit and Non-Audit Services Performed by the Independent Registered Public Accounting Firm” under the proposal “Ratification of Appointment of Independent Registered Public Accounting Firm” in the Company’s 2017 Proxy Statement to be filed with the SEC within 120 days after September 24, 2016 and is incorporated herein by reference. Apple Inc. | 2016 Form 10-K | 73 PART IV Item 15. Exhibits, Financial Statement Schedules (a) Documents filed as part of this report (1) All financial statements Index to Consolidated Financial Statements Page Consolidated Statements of Operations for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 39 Consolidated Statements of Comprehensive Income for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 40 Consolidated Balance Sheets as of September 24, 2016 and September 26, 2015 41 Consolidated Statements of Shareholders’ Equity for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 42 Consolidated Statements of Cash Flows for the years ended September 24, 2016, September 26, 2015 and September 27, 2014 43 Notes to Consolidated Financial Statements 44 Selected Quarterly Financial Information (Unaudited) 69 Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 70 (2) Financial Statement Schedules All financial statement schedules have been omitted, since the required information is not applicable or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements and notes thereto included in this Form 10-K. (3) Exhibits required by Item 601 of Regulation S-K The information required by this Section (a)(3) of Item 15 is set forth on the exhibit index that follows the Signatures page of this Form 10-K. Apple Inc. | 2016 Form 10-K | 74 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: October 26, 2016 Apple Inc. By: /s/  Luca Maestri Luca Maestri Senior Vice President, Chief Financial Officer Power of Attorney KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Timothy D. Cook and Luca Maestri, jointly and severally, his or her attorneys-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated: Name Title Date /s/    Timothy D. Cook Chief Executive Officer and Director (Principal Executive Officer) October 26, 2016 TIMOTHY D. COOK /s/    Luca Maestri Senior Vice President, Chief Financial Officer (Principal Financial Officer) October 26, 2016 LUCA MAESTRI /s/    Chris Kondo Senior Director of Corporate Accounting (Principal Accounting Officer) October 26, 2016 CHRIS KONDO /s/    James A. Bell Director October 26, 2016 JAMES A. BELL /s/    Al Gore Director October 26, 2016 AL GORE /s/    Robert A. Iger Director October 26, 2016 ROBERT A. IGER /s/    Andrea Jung Director October 26, 2016 ANDREA JUNG /s/    Arthur D. Levinson Director October 26, 2016 ARTHUR D. LEVINSON /s/    Ronald D. Sugar Director October 26, 2016 RONALD D. SUGAR /s/    Susan L. Wagner Director October 26, 2016 SUSAN L. WAGNER Apple Inc. | 2016 Form 10-K | 75 EXHIBIT INDEX (1) Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 3.1 Restated Articles of Incorporation of the Registrant effective as of June 6, 2014. 8-K 3.1 6/6/14 3.2 Amended and Restated Bylaws of the Registrant effective as of December 21, 2015. 8-K 3.2 12/22/15 4.1 Form of Common Stock Certificate of the Registrant. 10-Q 4.1 12/30/06 4.2 Indenture, dated as of April 29, 2013, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee. S-3 4.1 4/29/13 4.3 Officer’s Certificate of the Registrant, dated as of May 3, 2013, including forms of global notes representing the Floating Rate Notes due 2016, Floating Rate Notes due 2018, 0.45% Notes due 2016, 1.00% Notes due 2018, 2.40% Notes due 2023 and 3.85% Notes due 2043. 8-K 4.1 5/3/13 4.4 Officer’s Certificate of the Registrant, dated as of May 6, 2014, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2019, 1.05% Notes due 2017, 2.10% Notes due 2019, 2.85% Notes due 2021, 3.45% Notes due 2024 and 4.45% Notes due 2044. 8-K 4.1 5/6/14 4.5 Officer’s Certificate of the Registrant, dated as of November 10, 2014, including forms of global notes representing the 1.000% Notes due 2022 and 1.625% Notes due 2026. 8-K 4.1 11/10/14 4.6 Officer’s Certificate of the Registrant, dated as of February 9, 2015, including forms of global notes representing the Floating Rate Notes due 2020, 1.55% Notes due 2020, 2.15% Notes due 2022, 2.50% Notes due 2025 and 3.45% Notes due 2045. 8-K 4.1 2/9/15 4.7 Officer’s Certificate of the Registrant, dated as of May 13, 2015, including forms of global notes representing the Floating Rate Notes due 2017, Floating Rate Notes due 2020, 0.900% Notes due 2017, 2.000% Notes due 2020, 2.700% Notes due 2022, 3.200% Notes due 2025, and 4.375% Notes due 2045. 8-K 4.1 5/13/15 4.8 Officer’s Certificate of the Registrant, dated as of June 10, 2015, including forms of global notes representing the 0.35% Notes due 2020. 8-K 4.1 6/10/15 4.9 Officer’s Certificate of the Registrant, dated as of July 31, 2015, including forms of global notes representing the 3.05% Notes due 2029 and 3.60% Notes due 2042. 8-K 4.1 7/31/15 4.10 Officer’s Certificate of the Registrant, dated as of September 17, 2015, including forms of global notes representing the 1.375% Notes due 2024 and 2.000% Notes due 2027. 8-K 4.1 9/17/15 4.11 Officer’s Certificate of the Registrant, dated as of February 23, 2016, including forms of global notes representing the Floating Rate Notes due 2019, Floating Rate Notes due 2021, 1.300% Notes due 2018, 1.700% Notes due 2019, 2.250% Notes due 2021, 2.850% Notes due 2023, 3.250% Notes due 2026, 4.500% Notes due 2036 and 4.650% Notes due 2046. 8-K 4.1 2/23/16 4.12 Supplement No. 1 to the Officer's Certificate of the Registrant, dated as of March 24, 2016. 8-K 4.1 3/24/16 4.13 Officer’s Certificate of the Registrant, dated as of June 22, 2016, including form of global note representing 4.150% Notes due 2046. 10-Q 4.1 6/22/16 4.14 Officer’s Certificate of the Registrant, dated as of August 4, 2016, including forms of global notes representing the Floating Rate Notes due 2019, 1.100% Notes due 2019, 1.550% Notes due 2021, 2.450% Notes due 2026 and 3.850% Notes due 2046. 8-K 4.1 8/4/16 10.1* Employee Stock Purchase Plan, as amended and restated as of March 10, 2015. 8-K 10.1 3/13/15 10.2* Form of Indemnification Agreement between the Registrant and each director and executive officer of the Registrant. 10-Q 10.2 6/27/09 10.3* 1997 Director Stock Plan, as amended through August 23, 2012. 10-Q 10.3 12/28/13 10.4* 2003 Employee Stock Plan, as amended through February 25, 2010. 8-K 10.1 3/1/10 10.5* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of November 16, 2010. 10-Q 10.10 12/25/10 10.6* Form of Restricted Stock Unit Award Agreement under 2003 Employee Stock Plan effective as of April 6, 2012. 10-Q 10.8 3/31/12 Apple Inc. | 2016 Form 10-K | 76 Incorporated by Reference Exhibit Number Exhibit Description Form Exhibit Filing Date/ Period End Date 10.7* Summary Description of Amendment, effective as of May 24, 2012, to certain Restricted Stock Unit Award Agreements outstanding as of April 5, 2012. 10-Q 10.8 6/30/12 10.8* 2014 Employee Stock Plan, as amended and restated as of February 26, 2016. 8-K 10.1 3/1/16 10.9* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan as of February 28, 2014. 8-K 10.2 3/5/14 10.10* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of February 28, 2014. 8-K 10.3 3/5/14 10.11* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.1 9/27/14 10.12* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of August 26, 2014. 10-K 10.1 9/27/14 10.13* Form of Amendment, effective as of August 26, 2014, to Restricted Stock Unit Award Agreements and Performance Award Agreements outstanding as of August 26, 2014. 10-K 10.1 9/27/14 10.14* Offer Letter, dated August 1, 2013, from the Registrant to Angela Ahrendts. 10-Q 10.1 12/27/14 10.15* Form of Restricted Stock Unit Award Agreement under the 1997 Director Stock Plan as of November 17, 2015. 10-Q 10.15 12/26/15 10.16* Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.16 3/26/16 10.17* Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of October 5, 2015. 10-Q 10.17 3/26/16 10.18*, ** Form of Restricted Stock Unit Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 10.19*, ** Form of Performance Award Agreement under 2014 Employee Stock Plan effective as of October 14, 2016. 12.1** Computation of Ratio of Earnings to Fixed Charges. 21.1** Subsidiaries of the Registrant. 23.1** Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm. 24.1** Power of Attorney (included on the Signatures page of this Annual Report on Form 10-K). 31.1** Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. 31.2** Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. 32.1*** Section 1350 Certifications of Chief Executive Officer and Chief Financial Officer. 101.INS** XBRL Instance Document. 101.SCH** XBRL Taxonomy Extension Schema Document. 101.CAL** XBRL Taxonomy Extension Calculation Linkbase Document. 101.DEF** XBRL Taxonomy Extension Definition Linkbase Document. 101.LAB** XBRL Taxonomy Extension Label Linkbase Document. 101.PRE** XBRL Taxonomy Extension Presentation Linkbase Document. * Indicates management contract or compensatory plan or arrangement. ** Filed herewith. *** Furnished herewith. (1) Certain instruments defining the rights of holders of long-term debt securities of the Registrant are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. The Registrant hereby undertakes to furnish to the SEC, upon request, copies of any such instruments. Apple Inc. | 2016 Form 10-K | 77 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-16-000012/full-submission.txt b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-16-000012/full-submission.txt new file mode 100644 index 0000000..6ca5c2b --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-16-000012/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2015 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . ___________________________________________ State or Other Jurisdiction of Incorporation Exact Name of Registrant as specified in its Charter, Address of Principal Executive Offices, Zip Code and Telephone Number (Including Area Code) Commission File Number IRS Employer Identification No. Delaware Alphabet Inc. 1600 Amphitheatre Parkway Mountain View, CA 94043 (650) 253-0000 001-37580 61-1767919 Delaware Google Inc. 1600 Amphitheatre Parkway Mountain View, CA 94043 (650) 253-0000 001-36380 77-0493581 ___________________________________________ Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Alphabet Inc.: Class A Common Stock $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Google Inc.: None Securities registered pursuant to Section 12(g) of the Act: Title of each class Alphabet Inc.: None Google Inc.: None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Alphabet Inc. Yes ý No ¨ Google Inc. Yes ¨ No ý Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Alphabet Inc. Yes ¨ No ý Google Inc. Yes ý No ¨ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Alphabet Inc. Yes ý No ¨ Google Inc. Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Alphabet Inc. Yes ý No ¨ Google Inc. Yes ý No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Alphabet Inc. ¨ Google Inc. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Alphabet Inc. Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨ Google Inc. Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Alphabet Inc. Yes ¨ No ý Google Inc. Yes ¨ No ý As of June 30, 2015 , the aggregate market value of shares held by non-affiliates of Google Inc. (the predecessor issuer pursuant to Rule 12g-3(a) under the Securities Exchange Act) (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 30, 2015 ) was approximately $311.0 billion . For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of February 1, 2016 , the following amounts were outstanding for Alphabet Inc. (the successor issuer pursuant to Rule 12g-3(a) under the Exchange Act as of October 2, 2015) (Alphabet): 292,580,627 shares of Alphabet's Class A common stock; 50,199,837 shares of Alphabet’s Class B common stock; and 345,539,303 shares of Alphabet’s Class C capital stock outstanding. ____________________________________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2016 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2015 . Table of Contents Alphabet Inc. and Google Inc. Explanatory Note This Annual Report on Form 10-K is a combined report being separately filed by Google Inc. ("Google") and Alphabet Inc. ("Alphabet"), the successor issuer to, and parent holding company of, Google. Alphabet owns all of the equity interests in Google, and Google meets the conditions set forth in General Instruction I(1)(a), (b) and (d) of Form 10-K and is therefore filing its information within this Form 10-K with the reduced disclosure format. Each of Alphabet and Google is filing on its own behalf the information contained in this report that relates to itself, and neither registrant makes any representation as to information relating to the other registrant. Where information or an explanation is provided that is substantially the same for each registrant, such information or explanation has been combined in this report. Where information or an explanation is not substantially the same for each registrant, separate information and explanation has been provided. In addition, separate consolidated financial statements for each registrant, along with notes to the consolidated financial statements, are included in this report. Unless indicated otherwise, throughout this Annual Report on Form 10-K, we refer to Alphabet and its consolidated subsidiaries, including Google and its consolidated subsidiaries, as "we," "us," and "our;" Alphabet Inc. and its subsidiaries as "Alphabet;" and Google Inc. and its subsidiaries as "Google." Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. and Google Inc. Form 10-K For the Fiscal Year Ended December 31, 2015 TABLE OF CONTENTS Page Note About Forward-Looking Statements 1 PART I Item 1. Business 2 Item 1A. Risk Factors 6 Item 1B. Unresolved Staff Comments 17 Item 2. Properties 17 Item 3. Legal Proceedings 18 Item 4. Mine Safety Disclosures 18 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 18 Item 6. Selected Financial Data 20 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 41 Item 8. Financial Statements and Supplementary Data 43 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 98 Item 9A. Controls and Procedures 98 Item 9B. Other Information 99 PART III Item 10. Directors, Executive Officers and Corporate Governance 100 Item 11. Executive Compensation 100 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 100 Item 13. Certain Relationships and Related Transactions, and Director Independence 100 Item 14. Principal Accountant Fees and Services 100 PART IV Item 15. Exhibits, Financial Statement Schedules 101 i Table of Contents Alphabet Inc. and Google Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding: • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • our plans to continue to invest in new businesses, products and technologies, systems, facilities, and infrastructure, to continue to hire aggressively and provide competitive compensation programs, as well as to continue to invest in acquisitions; • seasonal fluctuations in internet usage and advertiser expenditures, traditional retail seasonality and macroeconomic conditions, which are likely to cause fluctuations in our quarterly results; • the potential for declines in our revenue growth rate; • our expectation that growth in advertising revenues from our websites will continue to exceed that from our Google Network Members' websites, which will have a positive impact on our operating margins; • our expectation that we will continue to take steps to improve the relevance of the ads we deliver and to reduce the number of accidental clicks; • fluctuations in the rate of change in revenue and revenue growth, as well as the rate of change in paid clicks and average cost-per-click and various factors contributing to such fluctuations; • our belief that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected increase of costs related to hedging activities under our foreign exchange risk management program; • our expectation that our cost of revenues, research and development expenses, sales and marketing expenses, and general and administrative expenses will increase in dollars and may increase as a percentage of revenues; • our potential exposure in connection with pending investigations, proceedings, and other contingencies; • our expectation that our traffic acquisition costs will fluctuate in the future; • our continued investments in international markets; • estimates of our future compensation expenses; • fluctuations in our effective tax rate; • the sufficiency of our sources of funding; • our payment terms to certain advertisers, which may increase our working capital requirements; • fluctuations in our capital expenditures; • our expectations related to the new operating structure implemented pursuant to the holding company reorganization and the associated disclosure implications; • the expected timing and amount of Alphabet Inc.'s stock repurchase; • our intention to align our capital structure so that debt is held at the holding company level; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Item 1 "Business," Item 1A "Risk Factors," and Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially and adversely from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed under the caption "Risk Factors" in Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission (SEC). We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "our company," "we," "us," "our," and similar terms refer collectively to Alphabet Inc. and Google Inc., together with their subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. 1 Table of Contents Alphabet Inc. and Google Inc. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders letter, "Google is not a conventional company. We do not intend to become one." As part of that, they also explained that you could expect us to make "smaller bets in areas that might seem very speculative or even strange when compared to our current businesses." From the start, the company has always strived to do more, and to do important and meaningful things with the resources we have. To help accelerate this, we announced plans in August 2015 to create a new public holding company, called Alphabet. Alphabet is a collection of businesses -- the largest of which, of course, is Google. It also includes businesses that we combine as Other Bets and generally are pretty far afield of our main Internet products such as Verily, Calico, X, Nest, GV, Google Capital and Access/Google Fiber. Our Alphabet structure is about helping businesses within Alphabet prosper through strong leaders and independence. At Google, our innovations in search and advertising have made our website widely used and our brand one of the most recognized in the world. We generate revenues primarily by delivering online advertising that consumers find relevant and that advertisers find cost-effective. Google's core products such as Search, Android, Maps, Chrome, YouTube, Google Play and Gmail each have over one billion monthly active users. And we believe we are just beginning to scratch the surface. Google's vision is to remain a place of incredible creativity and innovation that uses our technical expertise to tackle big problems. Our Other Bets are also making important strides in their industries, and our goal is for them to become thriving, successful businesses in the long term. Serving Our Users In many ways Google search -- and the clean white page with the blinking cursor -- is a metaphor for how we think about innovation. Imagining the ways things could be -- without constraint -- is the process we use to look for better answers to some of life's everyday problems. It's about starting with the "What if?" and then working relentlessly to see if we can find the answer. It's been that way from the beginning; providing ways to access knowledge and information has been core to Google and our products have come a long way in the last decade. We used to show just ten blue links in our results. You had to click through to different websites to get your answers, which took time. Now we are increasingly able to provide direct answers -- even if you're speaking your question using Voice Search -- which makes it quicker, easier and more natural to find what you're looking for. Over time, we have added other services that let you access information quickly and easily. What if we could develop a smarter email service with plenty of storage? That's Gmail. What if we could make a simpler, speedier, safer browser? That's Chrome. What if we could provide easy access to movies, books, music and apps, no matter which device you're on? That's Google Play. What if developers could use Google's infrastructure to easily build and scale applications? And what if people could collaborate and get work done from anywhere on any device? That's cloud and apps. As devices proliferate, it's more and more important to ensure that you can navigate effortlessly across them -- that the technology gets out of the way, so you can move through this multi-screen world as easily as possible. It's why we're investing so much in platforms like our Chrome browser, Chrome OS and our Android mobile operating system. Ultimately, we want you to have speedy, secure access to whatever you need, wherever you happen to be, and on whatever device you may be using at the time. Ads as Answers We asked, what if ads weren't intrusive and annoying? What if we could deliver a relevant ad at just the right time and give people useful commercial information? What if we could provide products that allow for better attribution and measurement across screens so that we show great ads for the right people? Our advertising solutions help millions of companies grow their businesses, and we offer a wide range of products across screens and devices. We generate revenues primarily by delivering both performance advertising and brand advertising. • Performance advertising creates and delivers relevant ads that users will click, leading to direct engagement with advertisers. Most of our performance advertisers pay us when a user engages in their ads. Performance advertising lets our advertisers connect with users while driving measurable results. 2 Table of Contents Alphabet Inc. and Google Inc. For performance advertisers, AdWords, our primary auction-based advertising program, helps create simple text-based ads that appear on Google websites and the websites of Google Network Members, who use our advertising programs to deliver relevant ads alongside their search results and content. In addition, our partners that comprise the Google Network use our AdSense program to deliver relevant ads that generate revenues and enhance the user experience. These programs let both small and large businesses connect with users looking for a specific item, say a pair of shoes or a plane ticket back home. To that end, we continue to invest in our advertising programs and to make significant upgrades, including Estimated Total Conversions, which help advertisers measure the effectiveness of their campaigns in a multi-screen world. • Brand advertising helps enhance users' awareness of and affinity with advertisers' products and services, through videos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns and in turn, generate revenue by distributing their ads such as the TrueView ads displayed on our YouTube videos. We have built a world-class ad technology platform for brand advertisers, agencies, and publishers to power their digital marketing businesses. We aim to ensure great user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. We also seek to improve the measurability of the effectiveness of brand advertising. Furthermore, we have invested significantly in programmatic advertising to help advertisers reach users when and where it matters, giving them access to top-tier inventory across screens and formats, as well as the real-time insights that advertisers need to make their buys count. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, ranging from removing hundreds of millions of bad ads from our systems every year to closely monitoring the sites and apps that show our ads and blacklisting them when necessary to ensure that our ads do not fund bad content. Bringing the Next 5 Billion Online Fast search and high-quality ads matter only if you have access to the Internet. Right now, only a fraction of the seven billion people in the world are fortunate enough to be able to get online. That leaves out billions of people. With so much useful and life-changing information available today, it is unfortunate that such a significant portion of the world's population lacks even the most basic Internet connection. Those people will be able to learn and start businesses, to grow and prosper in ways they simply could not without an Internet connection. Creating platforms for other people's success is a huge part of who we are. We want the world to join us online and to be greeted with the best possible experience once they get there. Connection is powerful; and we are working hard to make it a reality for everyone. The opportunities to improve lives on a grand scale are endless. And there are people around the world whose lives we can improve every day by bringing information into their homes, into their schools, and into their pockets -- showing them just how powerful the simple idea of "getting online" can be. At Google, we are helping people get online by tailoring hardware and software experiences that suit the needs of emerging markets, primarily through Android and Chrome. We're also making sure our core Google apps are fast and useful, especially for users in areas where speed, size and connectivity are central concerns. Other Alphabet companies are pursuing initiatives with similar goals too. That's why we're investing in new projects, like Project Loon. We asked, what if we could use a network of balloons that could fly at the edge of space and provide connectivity in rural and remote areas? Loon has helped students in Brazil and farmers in New Zealand experience the power of an internet connection for the first time. And as the program expands, we hope to bring this to more and more people -- creating opportunities that simply did not exist before for millions of people, all around the world. Moonshots The idea of trying new things is reflected in some of our new, ambitious projects both within Google and Other Bets. Everything might not fit into a neat little box. We believe that is exactly how to stay relevant. Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android, and when we launched Chrome. But as those efforts have matured into major platforms for digital video and mobile devices, and a safer, popular browser, respectively, we continue to look towards the future and continue to invest for the long-term. 3 Table of Contents Alphabet Inc. and Google Inc. We won't become complacent, relying solely on small tweaks as the years wear on. As we said in the 2004 Founders' IPO Letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. We won't stop asking "What if?" and then working hard to find the answer. As explained in the letter from our CEO in August 2015, our Alphabet reorganization was implemented to better allow us to structure teams in ways that we believe will produce the fastest, most focused innovation possible for moonshot projects. Research We continue to invest in our existing products and services, including search and advertising, as well as developing new products and services through research and product development. We often release early-stage products. We then use data and user feedback to decide if and how to invest further in those products. Our research and development expenses, which includes the vast majority of engineering and technical headcount responsible for research and development, as well as their associated costs, were $7.1 billion , $9.8 billion , and $12.3 billion in 2013, 2014 and 2015, respectively, which included stock-based compensation expense of $1.6 billion , $2.2 billion , and $2.7 billion , respectively. We expect to continue investing in hiring talented employees and building systems to develop new products and services and improve existing ones. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from: • General purpose search engines and information services, such as Yahoo, Microsoft's Bing, Yandex, Baidu, Naver, WebCrawler, and MyWebSearch. • Vertical search engines and e-commerce websites, such as Kayak (travel queries), LinkedIn (job queries), WebMD (health queries), and Amazon and eBay (e-commerce). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks, such as Facebook and Twitter. Some users are increasingly relying on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other forms of advertising, such as television, radio, newspapers, magazines, billboards, and yellow pages. Our advertisers typically advertise in multiple media, both online and offline. • Other online advertising platforms and networks, including Criteo, AppNexus, and Facebook, that compete for advertisers with AdWords, our primary auction-based advertising program. • Other operating systems and mobile device companies. • Providers of online products and services that provide answers, information, and services. A number of our online products and services, including Gmail, YouTube, and Google Docs, compete directly with new and established companies, which offer communication, information, storage and entertainment services, either on a stand-alone basis or integrated into other offerings. Competing successfully depends heavily on our ability to rapidly deliver innovative products and technologies to the marketplace so that we can attract and retain: • Users, for whom other products and services are literally one click away, primarily on the basis of the relevance and usefulness of our search results and the features, availability, and ease of use of our products and services. • Advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels. • Content providers (Google Network Members, the parties who use our advertising programs to deliver relevant ads alongside their search results and content, as well as other content providers for whom we distribute or license content), primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign 4 Table of Contents Alphabet Inc. and Google Inc. countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. Culture and Employees We take great pride in our culture. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex technical challenges. Transparency and open dialogue are central to how we work, and we like to ensure that company news reaches our employees first through internal channels. Despite our rapid growth, we still cherish our roots as a startup and wherever possible empower employees to act on great ideas regardless of their role or function within the company. We strive to hire great employees, with backgrounds and perspectives as diverse as those of our global users. We work to provide an environment where these talented people can have fulfilling careers addressing some of the biggest challenges in technology and society. Our employees are among our best assets and are critical for our continued success. We expect to continue investing in hiring talented employees and to provide competitive compensation programs to our employees. As of December 31, 2015 , we had 61,814 full-time employees: 23,336 in research and development, 19,082 in sales and marketing, 10,944 in operations, and 8,452 in general and administrative functions. Although we have work councils and statutory employee representation obligations in certain countries, our U.S. employees are not represented by a labor union. Competition for qualified personnel in our industry is intense, particularly for software engineers, computer scientists, and other technical staff. Seasonality Our business is affected by both seasonal fluctuations in Internet usage and traditional retail seasonality. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. Information about Segments and Geographic Areas Please refer to Note 16 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Other Matters As part of the Alphabet reorganization, we expect to convert Google Inc. into a limited liability company. Available Information Our websites are located at www.google.com and www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and our Proxy Statements are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. You may read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. You can get information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance, including SEC filings, investor events, press and earnings releases, and blogs. Further corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The content of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. 5 Table of Contents Alphabet Inc. and Google Inc. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, which could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common and capital stock. Risks Related to Our Businesses and Industries We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could be adversely affected. Our businesses are rapidly evolving, intensely competitive, and subject to changing technologies, shifting user needs, and frequent introductions of new products and services. Competing successfully depends heavily on our ability to deliver innovative products and technologies to the marketplace rapidly and, for Google, provide products and services that make our search results and ads relevant and useful for our users. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services, including products and services that may be outside of our historical core business. We have many competitors in different industries, including general purpose search engines and information services, vertical search engines and e-commerce websites, social networks, providers of online products and services, other forms of advertising and online advertising platforms and networks, other operating systems, and wireless mobile device companies. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Established companies have longer operating histories and more established relationships with customers and users, and they can use their experiences and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in research and development, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for advertisers and websites. Emerging start-ups may be able to innovate and provide products and services faster than we can or may foresee the consumer need for products and services before us. Our competitors are constantly developing innovations in search, online advertising, wireless mobile devices, operating systems, and many other web-based products and services. The research and development of new, technologically advanced products is also a complex and uncertain process requiring high levels of innovation and investment, as well as the accurate anticipation of technology, market trends, and consumer needs. As a result, we must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our search technology and our existing products and services, and introduce new products and services that people can easily and effectively use. If we are unable to provide quality products and services, then acceptance rates for our products and services could decline. In addition, these new products and services may present new and difficult technological and legal challenges, and we may be subject to claims if users of these offerings experience service disruptions or failures or other issues. Our operating results would also suffer if our innovations are not responsive to the needs of our users, advertisers, and Google Network Members, are not appropriately timed with market opportunities, or are not effectively brought to market. As technology continues to develop, our competitors may be able to offer user experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, and content providers, our revenues and operating results could be adversely affected. Our ongoing investment in new businesses and new products, services, and technologies is inherently risky, and could disrupt our ongoing businesses. We have invested and expect to continue to invest in new businesses, products, services, and technologies. Such endeavors may involve significant risks and uncertainties, including insufficient revenues from such investments to offset any new liabilities assumed and expenses associated with these new investments, inadequate return of capital on our investments, distraction of management from current operations, and unidentified issues not discovered in our due diligence of such strategies and offerings that could cause us to fail to realize the anticipated benefits of such investments and incur unanticipated liabilities. Because these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not adversely affect our reputation, financial condition, and operating results. 6 Table of Contents Alphabet Inc. and Google Inc. More people are using devices other than desktop computers to access the Internet and accessing new devices to make search queries. If manufacturers and users do not widely adopt versions of our search technology, products, or operating systems developed for these devices, our business could be adversely affected. The number of people who access the Internet through devices other than desktop computers, including mobile phones, smartphones, handheld computers such as netbooks and tablets, video game consoles, and television set-top devices, is increasing dramatically. The functionality and user experience associated with some alternative devices may make the use of our products and services through such devices more difficult (or just different) and the versions of our products and services developed for these devices may not be compelling to users, manufacturers, or distributors of alternative devices. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not work or be viewable on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via “apps” tailored to particular devices or social media platforms, which could affect our search and advertising business over time. As new devices and platforms are continually being released, it is difficult to predict the problems we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to the creation, support, and maintenance of products and services across multiple platforms and devices. If we are unable to attract and retain a substantial number of alternative device manufacturers, distributors, developers, and users to our products and services, or if we are slow to develop products and technologies that are more compatible with alternative devices and platforms, we will fail to capture the opportunities available as consumers and advertisers transition to a dynamic, multi-screen environment. We generate a significant portion of our revenues from advertising, and reduced spending by advertisers or a loss of partners could seriously harm our business. We generated 90% of total Google segment revenues from advertising in 2015. Many of our advertisers, companies that distribute our products and services, digital publishers, and content partners can terminate their contracts with us at any time. Those partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. If we do not provide superior value or deliver advertisements efficiently and competitively, we could see a decrease in revenue and other adverse impacts to our business. Adverse macroeconomic conditions can also have a material negative impact on advertising revenues, which could adversely affect our revenues and business. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions can also have a material negative impact on the demand for advertising and cause our advertisers to reduce the amounts they spend on advertising, which could adversely affect our revenues and business. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including: • increasing competition, • changes in property mix, platform mix, and geographical mix • the challenges in maintaining our growth rate as our revenues increase to higher levels, • the evolution of the online advertising market, including the increasing variety of online platforms for advertising, and the other markets in which we participate, and • the rate of user adoption of our products, services, and technologies. We believe our margins could experience downward pressure as a result of increasing competition and increased costs for many aspects of our business. For instance, the margin on revenues we generate from our Google Network Members is significantly less than the margin on revenues we generate from advertising on Google websites. Consequently, our margins will experience downward pressure if a greater percentage of our revenues comes from ads placed on our Google Network Members' websites compared to revenues generated through ads placed on Google websites. Additionally, the margin we earn on revenues generated from our Google Network Members could decrease in the future if we pay an even larger percentage of advertising fees to our Google Network Members. Additionally, our margins could experience downward pressure because the margin on the sale of digital content and apps, advertising revenues from mobile devices and newer advertising formats are generally less than the margin on revenues we generate from advertising on our websites or traditional formats. Further, our margins could be impacted 7 Table of Contents Alphabet Inc. and Google Inc. adversely if we spend a proportionately larger amount to promote or distribute certain products or if we invest more heavily in our R&D efforts across the Company (such as our Other Bets businesses) than we have historically. We are subject to increased regulatory scrutiny that may negatively impact our business. The growth of our company and our expansion into a variety of new fields involves a variety of new regulatory issues, and we have experienced increased regulatory scrutiny as we have grown. For instance, several regulatory agencies have sought to review our search and other businesses on potential competition concerns. We continue to cooperate with the European Commission (EC) and other regulatory authorities around the world in investigations they are conducting with respect to our business and its impact on competition. Legislators and regulators may make legal and regulatory changes, or interpret and apply existing laws, in ways that make our products and services less useful to our users, require us to incur substantial costs, expose us to unanticipated civil or criminal liability, or cause us to change our business practices. These changes or increased costs could negatively impact our business and results of operations in material ways. We are regularly subject to claims, suits, government investigations, and other proceedings that may result in adverse outcomes. We are regularly subject to claims, suits, and government investigations involving competition, intellectual property, privacy, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. The sale of hardware products also exposes us to the risk of product liability and other litigation involving assertions about product defects, as well as health and safety, hazardous materials usage, and other environmental concerns. In addition, our businesses face intellectual property litigation, as further discussed later, that exposes us to the risk of exclusion and cease and desist orders, which could limit our ability to sell products and services. Such claims, suits, and government investigations are inherently uncertain and their results cannot be predicted with certainty. Regardless of the outcome, any of these types of legal proceedings can have an adverse impact on us because of legal costs, diversion of management resources, and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. It is possible that a resolution of one or more such proceedings could result in substantial fines and penalties that could adversely affect our business, consolidated financial position, results of operations, or cash flows in a particular period. These proceedings could also result in reputational harm, criminal sanctions, consent decrees, or orders preventing us from offering certain features, functionalities, products, or services, requiring a change in our business practices or product recalls or other field action, or requiring development of non-infringing or otherwise altered products or technologies. Any of these consequences could adversely affect our business and results of operations. Acquisitions could result in operating difficulties, dilution, and other consequences that may adversely impact our business and results of operations. Acquisitions are an important element of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and results of operations. We expect to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions. The process of integrating an acquired company, business, or technology has created, and will continue to create, unforeseen operating difficulties and expenditures. The areas where we face risks include: • Diversion of management time and focus from operating our business to acquisition integration challenges. • Failure to successfully further develop the acquired business or technology. • Implementation or remediation of controls, procedures, and policies at the acquired company. • Integration of the acquired company's accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions. • Transition of operations, users, and customers onto our existing platforms. • Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval, under competition laws which could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of an acquisition or investment. • In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. 8 Table of Contents Alphabet Inc. and Google Inc. • Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire. • Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, privacy issues, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities. • Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and investments could cause us to fail to realize the anticipated benefits of such acquisitions or investments, incur unanticipated liabilities, and harm our business generally. Our acquisitions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or results. Also, the anticipated benefits or value of our acquisitions or investments may not materialize. Our business depends on a strong brand, and failing to maintain and enhance our brand would hurt our ability to expand our base of users, advertisers, Google Network Members, and other partners. Our strong Google brand has significantly contributed to the success of our business. Maintaining and enhancing the brands of both Google and Other Bets increases our ability to enter new categories and launch new and innovative products that better serve the needs of our users. Our brands may be negatively impacted by a number of factors, including, among others, reputational issues and product/technical performance failures. Further, if we fail to maintain and enhance equity in the Google brand, our business, operating results, and financial condition may be materially and adversely affected. Maintaining and enhancing our brand will depend largely on our ability to remain a technology leader and continue to provide high-quality, innovative products and services that are truly useful and play a meaningful role in people’s everyday lives. A variety of new and existing laws could subject us to claims or otherwise harm our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations of existing laws and regulations) may also impact our business. For example, current and new patent laws such as U.S. patent laws and European patent laws may affect the ability of companies, including us, to protect their innovations and defend against claims of patent infringement. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Claims have been, or may be, threatened and filed against us under both U.S. and foreign laws for defamation, invasion of privacy and other tort claims, unlawful activity, patent, copyright and trademark infringement, product liability, or other theories based on the nature and content of the materials searched and the ads posted by our users, our products and services, or content generated by our users. Furthermore, many of these laws do not contemplate or address the unique issues raised by a number of our new businesses, products, services and technologies. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain. For example, the laws relating to the liability of providers of online services are currently unsettled both within the U.S. and abroad. In addition, other laws that could subject us to claims or otherwise harm our business include, among others: • The Digital Millennium Copyright Act, which has provisions that limit in the U.S., but do not necessarily eliminate, our liability for caching or hosting, or for listing or linking to, third-party websites that include materials that infringe copyrights or other rights, so long as we comply with the statutory requirements of this act. Any future legislation impacting these safe harbors may adversely impact us. • Court decisions such as the ‘right to be forgotten’ ruling issued by the European court, which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users. • Various U.S. and international laws that restrict the distribution of materials considered harmful to children and impose additional restrictions on the ability of online services to collect information from minors. • Data protection laws passed by many states that require notification to users when there is a security breach for personal data, such as California’s Information Practices Act. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. 9 Table of Contents Alphabet Inc. and Google Inc. We face risks and costs overseas as our products and services are offered in international markets and may be subject to additional regulations. Any failure on our part to comply with these laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are, and may in the future be, subject to intellectual property or other claims, which are costly to defend, could result in significant damage awards, and could limit our ability to use certain technologies in the future. Internet, technology, media, and other companies own large numbers of patents, copyrights, trademarks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent holding companies may continue to seek to monetize patents they have purchased or otherwise obtained. As we have grown, the intellectual property rights claims against us have increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Third parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease and desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities. In addition, many of our agreements with our customers and partners, including certain suppliers, require us to indemnify them for certain intellectual property infringement claims against them, which could increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers from covered products. Regardless of the merits of the claims, intellectual property claims are often time consuming, expensive to litigate or settle, and cause significant diversion of management attention. To the extent such intellectual property infringement claims are successful, they may have an adverse effect on our business, consolidated financial position, results of operations, or cash flows. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brand. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy could be compromised by outside parties, or by our employees, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. 10 Table of Contents Alphabet Inc. and Google Inc. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. We may be subject to legal liability associated with providing online services or content. We host and provide a wide variety of services and products that enable users to exchange information, advertise products and services, conduct business, and engage in various online activities both domestically and internationally. The law relating to the liability of providers of these online services and products for activities of their users is still somewhat unsettled both within the U.S. and internationally. Claims have been threatened and have been brought against us for defamation, negligence, breaches of contract, copyright or trademark infringement, unfair competition, unlawful activity, tort, including personal injury, fraud, or other theories based on the nature and content of information that we publish or to which we provide links or that may be posted online or generated by us or by third parties, including our users. In addition, we are and have been and may again in the future be subject to domestic or international actions alleging that certain content we have generated or third-party content that we have made available within our services violates U.S. and non-U.S. law. We also arrange for the distribution of third-party advertisements to third-party publishers and advertising networks, and we offer third-party products, services, or content. We may be subject to claims concerning these products, services, or content by virtue of our involvement in marketing, branding, broadcasting, or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services, or content. Defense of any such actions could be costly and involve significant time and attention of our management and other resources, may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Privacy concerns relating to our technology could damage our reputation and deter current and potential users from using our products and services. From time to time, concerns have been expressed about whether our products, services, or processes compromise the privacy of users and others. Concerns about our practices with regard to the collection, use, disclosure, or security of personal information or other privacy related matters, even if unfounded, could damage our reputation and adversely affect our operating results. In addition, as nearly all of our products and services are web-based, the amount of data we store for our users on our servers (including personal information) has been increasing. Any systems failure or compromise of our security that results in the release of our users’ data could seriously limit the adoption of our products and services, as well as harm our reputation and brand and, therefore, our business. We expect to continue to expend significant resources to protect against security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand the number of web-based products and services we offer, and operate in more countries. Regulatory authorities around the world are considering a number of legislative and regulatory proposals concerning data protection, including measures to ensure that our encryption of users’ data does not hinder law enforcement agencies’ access to that data. In addition, the interpretation and application of consumer and data protection laws in the U.S., Europe and elsewhere are often uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. If so, in addition to the possibility of fines, this could result in an order requiring that we change our data practices, which could have an adverse effect on our business and results of operations. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business. Recent legal developments in Europe have created compliance uncertainty regarding certain transfers of information from Europe to the U.S. A preliminary agreement has been reached between the U.S. and European governments to allow for legal certainty regarding transfers of data. However, given the preliminary nature of the agreement, some uncertainty remains, and compliance obligations could cause us to incur costs or require us to change our business practices in a manner adverse to our business. If our security measures are breached, or if our services are subject to attacks that degrade or deny the ability of users to access our products and services, our products and services may be perceived as not being secure, users and customers may curtail or stop using our products and services, and we may incur significant legal and financial exposure. Our products and services involve the storage and transmission of users’ and customers’ proprietary information, and security breaches expose us to a risk of loss of this information, litigation, and potential liability. We experience cyber attacks of varying degrees on a regular basis. Our security measures may also be breached due to employee error, malfeasance, system errors or vulnerabilities, or otherwise. Additionally, outside parties may attempt to fraudulently induce employees, users, or customers to disclose sensitive information in order to gain access to our 11 Table of Contents Alphabet Inc. and Google Inc. data or our users’ or customers’ data. Any such breach or unauthorized access could result in significant legal and financial exposure, damage to our reputation, and a loss of confidence in the security of our products and services that could potentially have an adverse effect on our business. Because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and often are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose users and customers. We face a number of manufacturing and supply chain risks that, if not properly managed, could adversely impact our financial results and prospects. We face a number of risks related to manufacturing and supply chain management. For instance, the products we sell may have quality issues resulting from the design or manufacture of the product, or from the software used in the product. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products does not meet our customers' expectations or our products are found to be defective, then our sales and operating earnings, and ultimately our reputation, could be negatively impacted. We rely on third parties to manufacture many of our assemblies and finished products, and we have third-party arrangements for the design of some components and parts. Our business could be negatively affected if we are not able to engage third parties with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We have in the past, and may experience in the future, supply shortages and price increases driven by raw material availability, manufacturing capacity, labor shortages, industry allocations, natural disasters and significant changes in the financial or business condition of our suppliers. Workaround plans to address shortages could entail increased freight costs for expedited shipments. We may experience shortages or other supply chain disruptions in the future that could negatively impact our operations. In addition, some of the components we use in our products are available only from a single source or limited sources, and we may not be able to find replacement vendors on favorable terms or at all in the event of a supply chain disruption. Additionally, because many of our supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our hardware products more costly per unit to manufacture and therefore less competitive and negatively impact our financial results. Further, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may impact our supply. We also require our suppliers and business partners to comply with law and company policies regarding workplace and employment practices, data security, environmental compliance and intellectual property licensing, but we do not control them or their practices. If any of them violates laws or implements practices regarded as unethical, we could experience supply chain disruptions, canceled orders, terminations of or damage to key relationships, and damage to our reputation. If any of them fails to procure necessary license rights to third-party intellectual property, legal action could ensue that could impact the saleability of our products and expose us to financial obligations to third parties. The Dodd-Frank Wall Street Reform and Consumer Protection Act includes disclosure requirements regarding the use of certain minerals mined from the Democratic Republic of Congo and adjoining countries (DRC) and procedures pertaining to a manufacturer's efforts regarding the source of such minerals. SEC rules implementing these requirements may have the effect of reducing the pool of suppliers who can supply DRC “conflict free” components and parts, and we may not be able to obtain DRC conflict free products or supplies in sufficient quantities for our operations. Since our supply chain is complex, we may face reputational challenges with our customers, stockholders and other stakeholders if we are unable to sufficiently verify the origins for the minerals used in our products. Web spam and content farms could decrease our search quality, which could damage our reputation and deter our current and potential users from using our products and services. “Web spam” refers to websites that attempt to violate a search engine's quality guidelines or that otherwise seek to rank higher in search results than a search engine's assessment of their relevance and utility would rank them. Although English-language web spam in our search results has been significantly reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek ways to improve their rankings inappropriately. We continuously combat web spam, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We face challenges from low-quality and irrelevant content websites, including “content farms”, which are websites that generate large quantities of low-quality content to help them improve 12 Table of Contents Alphabet Inc. and Google Inc. their search rankings. We are continually launching algorithmic changes focused on low-quality websites. If our search results display an increasing number of web spam and content farms, this could hurt our reputation for delivering relevant information or reduce user traffic to our websites. In addition, as we continue to take actions to improve our search quality and reduce low-quality content, this may in the short run reduce our AdSense revenues, since some of these websites are AdSense partners. Interruption or failure of our information technology and communications systems could hurt our ability to effectively provide our products and services, which could damage our reputation and harm our operating results. The availability of our products and services depends on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage or interruption from earthquakes, terrorist attacks, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, computer denial of service attacks, or other attempts to harm our systems. Some of our data centers are located in areas with a high risk of major earthquakes. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and to potential disruptions if the operators of certain of these facilities have financial difficulties. Some of our systems are not fully redundant, and our disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster, a decision to close a facility we are using, or other unanticipated problems at our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and may contain errors or vulnerabilities, which could result in interruptions in our services or the failure of our systems. Our international operations expose us to additional risks that could harm our business, operating results, and financial condition. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 54% of our consolidated revenues in 2015. In certain international markets, we have limited operating experience and may not benefit from any first-to-market advantages or otherwise succeed. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • Changes in local political, economic, regulatory, tax, social, and labor conditions, which may adversely harm our business. • Restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S. • Import and export requirements, tariffs, trade disputes and barriers, and customs classifications that may prevent us from offering products or providing services to a particular market and may increase our operating costs. • Longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud. • Still developing foreign laws and legal systems. • Uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent. • Different employee/employer relationships, existence of workers' councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. In addition, compliance with complex foreign and U.S. laws and regulations that apply to our international operations increases our cost of doing business. These numerous and sometimes conflicting laws and regulations include internal control and disclosure rules, privacy and data protection requirements, anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting corrupt payments to governmental officials, and competition regulations, among others. Violations of these laws and regulations could result in fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business and on our ability to offer our products and services in one or more countries, and could also materially affect our brand, our international growth efforts, our ability to attract and retain employees, our business, and our operating results. Although we have implemented policies and procedures designed to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors, or agents will not violate our policies. 13 Table of Contents Alphabet Inc. and Google Inc. Finally, since we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we face exposure to fluctuations in currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Additionally, hedging programs are inherently risky and could expose us to additional risks that could adversely affect our financial condition and results of operations. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results may fluctuate as a result of a number of factors, many outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our quarterly, year-to-date, and annual expenses as a percentage of our revenues may differ significantly from our historical or projected rates. Our operating results in future quarters may fall below expectations. Any of these events could cause our stock price to fall. Each of the risk factors listed in this section in addition to the following factors may affect our operating results: • Our ability to continue to attract users to our websites and retain existing users on our websites. • Our ability to monetize (or generate revenues from) traffic on Google websites and our Google Network Members' websites both on desktop and mobile devices. • Revenue fluctuations caused by changes in property mix, platform mix, and geographical mix. • The amount of revenues and expenses generated and incurred in currencies other than U.S. dollars, and our ability to manage the resulting risk through our foreign exchange risk management program. • The amount and timing of operating costs and expenses and capital expenditures related to the maintenance and expansion of our businesses, operations, and infrastructure. • Our focus on long-term goals over short-term results. • The results of our acquisitions and our investments in risky projects, including new businesses, products, services, and technologies. • Our ability to keep our websites operational at a reasonable cost and without service interruptions. • Our ability to generate significant revenues from new products and services in which we have invested considerable time and resources. Because our business is changing and evolving, our historical operating results may not be useful to you in predicting our future operating results. In addition, advertising spending has historically been cyclical in nature, reflecting overall economic conditions, as well as budgeting and buying patterns. Also, user traffic tends to be seasonal. Our rapid growth has tended to mask the cyclicality and seasonality of our business. As our growth rate has slowed, the cyclicality and seasonality in our business has become more pronounced and caused our operating results to fluctuate. If we were to lose the services of Larry, Sergey, Eric, Sundar, or other key personnel, we may not be able to execute our business strategy. Our future success depends in a large part upon the continued service of key members of our senior management team. In particular, Larry Page and Sergey Brin are critical to the overall management of Alphabet and its subsidiaries, and they, along with Sundar Pichai, the Chief Executive Officer of Google, play an important role in the development of our technology. Along with our Executive Chairman Eric E. Schmidt, they also play a key role in maintaining our culture and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees. 14 Table of Contents Alphabet Inc. and Google Inc. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows, and we are required to implement more complex organizational management structures, particularly in light of our holding company reorganization and new operating structure, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future success. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures, including legal actions, that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, or by charging increased fees to us or our users to provide our offerings. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. Such interference could result in a loss of existing users and advertisers, and increased costs, and could impair our ability to attract new users and advertisers, thereby harming our revenues and growth. New technologies could block online ads, which would harm our Google business. Technologies have been developed that can block the display of our ads and that provide tools to users to opt out of our advertising products. Most of our Google revenues are derived from fees paid to us by advertisers in connection with the display of ads on web pages for our users. As a result, such technologies and tools could adversely affect our operating results. We are exposed to fluctuations in the market values of our investments. Given the global nature of our business, we have investments both domestically and internationally. Credit ratings and market values of these investments can be negatively impacted by liquidity, credit deterioration or losses, financial results, foreign exchange rates, or other factors. As a result, the value or liquidity of our cash equivalents and marketable securities could decline and result in a material impairment, which could materially adversely affect our financial condition and operating results. We may have exposure to greater than anticipated tax liabilities. Our future income taxes could be adversely affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. We are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions on various tax-related assertions, including transfer pricing adjustments or permanent establishment. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations where the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made. Risks Related to Ownership of Our Stock The trading price for our Class A common stock and non-voting Class C capital stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. For example, from January 1, 2015 through December 31, 2015, the closing price of our Class A common stock ranged from $497.06 per share to $793.96 per share, and the closing price of our Class C capital stock ranged from $492.55 to $776.60 per share. The trading price of our Class A common stock and Class C capital stock may fluctuate widely in response to various factors, some of which are beyond our control. These factors include, among others: • Quarterly variations in our results of operations or those of our competitors. 15 Table of Contents Alphabet Inc. and Google Inc. • Announcements by us or our competitors of acquisitions, new products, significant contracts, commercial relationships, or capital commitments. • Recommendations by securities analysts or changes in earnings estimates. • Announcements about our earnings that are not in line with analyst expectations, the risk of which is enhanced because it is our policy not to give guidance on earnings. • Announcements by our competitors of their earnings that are not in line with analyst expectations. • Commentary by industry and market professionals about our products, strategies, and other matters affecting our business and results, regardless of its accuracy. • The volume of shares of Class A common stock and Class C capital stock available for public sale. • Sales of Class A common stock and Class C capital stock by us or by our stockholders (including sales by our directors, executive officers, and other employees). • Short sales, hedging, and other derivative transactions on shares of our Class A common stock and Class C capital stock. • The perceived values of Class A common stock and Class C capital stock relative to one another. • Our stock repurchase program. In addition, the stock market in general, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may harm the market price of our Class A common stock and our Class C capital stock regardless of our actual operating performance. We cannot guarantee that our recently announced stock repurchase program will be fully consummated or that our stock repurchase program will enhance long-term stockholder value, and stock repurchases could increase the volatility of the price of our stock and could diminish our cash reserves. In October 2015, our board of directors authorized our company to repurchase up to $5,099,019,513.59 of our Class C capital stock and in January 2016, our board of directors authorized our Company to repurchase an additional amount of approximately 514 thousand shares. The repurchase program does not have an expiration date. Although our board of directors has authorized a stock repurchase program, the share repurchase program does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. The stock repurchase program could affect the price of our stock and increase volatility and may be suspended or terminated at any time, which may result in a decrease in the trading price of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B common stock has 10 votes per share, our Class A common stock has one vote per share, and our Class C capital stock has no voting rights. As of December 31, 2015, Larry, Sergey, and Eric beneficially owned approximately 92.5% of our outstanding Class B common stock, which represented approximately 58.5% of the voting power of our outstanding capital stock. Larry, Sergey, and Eric therefore have significant influence over management and affairs and over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C capital stock carries no voting rights (except as required by applicable law), the issuance of the Class C capital stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could prolong the duration of Larry and Sergey’s current relative ownership of our voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. Together with Eric, they would also continue to be able to control any required stockholder vote with respect to certain change in control transactions involving Alphabet (including an acquisition of Alphabet by another company). This concentrated control limits or severely restricts our stockholders’ ability to influence corporate matters and, as a result, we may take actions that our stockholders do not view as beneficial. As a result, the market price of our Class A common stock and our Class C capital stock could be adversely affected. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: 16 Table of Contents Alphabet Inc. and Google Inc. • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry, Sergey, and Eric have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. As noted above, the issuance of the Class C capital stock could have the effect of prolonging the influence of Larry, Sergey, and Eric. • Our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death, or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors. • Our stockholders may not act by written consent. As a result, a holder, or holders, controlling a majority of our capital stock would not be able to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our board of directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to issue undesignated preferred stock makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us. Risks Related to Our Holding Company Reorganization As a holding company, Alphabet will be dependent on the operations and funds of its subsidiaries. On October 2, 2015, we completed a reorganization pursuant to which Alphabet became a holding company with no business operations of its own. Alphabet’s only significant assets are the outstanding equity interests in Google and any other future subsidiaries of Alphabet. As a result, we rely on cash flows from subsidiaries to meet our obligations, including to service any debt obligations of Alphabet. We may not obtain the anticipated benefits of our reorganization into a holding company structure. We believe that our holding company reorganization and a new operating structure will increase management scale and allow us to focus on running our diverse businesses independently with the goal of maximizing each of the business’ potential. The anticipated benefits of this reorganization may not be obtained if circumstances prevent us from taking advantage of the strategic and business opportunities that we expect it may afford us. As a result, we may incur the costs of a holding company structure without realizing the anticipated benefits, which could adversely affect our reputation, financial condition, and operating results. Alphabet’s management is dedicating significant effort to the new operating structure. These efforts may divert management’s focus and resources from Alphabet’s business, corporate initiatives, or strategic opportunities, which could have an adverse effect on our businesses, results of operations, financial condition, or prospects. Additionally, our subsidiaries may be restricted in their ability to pay cash dividends or to make other distributions to Alphabet, as the new holding company. ITEM 1B. UNRESOLVED STAFF COMMENTS There are no unresolved staff comments at December 31, 2015. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California, where we own approximately 4.8 million square feet of office and building space and approximately fifteen acres of developable land to accommodate anticipated future growth. In addition, we own and lease office and building space, research and development, and sales and support offices primarily in North America, Europe, South America, and Asia. We operate and own data centers in the U.S., 17 Table of Contents Alphabet Inc. and Google Inc. Europe, South America, and Asia pursuant to various lease agreements and co-location arrangements. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, please see Note 11 “Commitments and Contingencies - Legal Matters” of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES During the fourth quarter of 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act as of October 2, 2015. Price Range of Common Stock and Capital Stock Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. The following table sets forth for the indicated periods the high and low sales prices per share for our Class A common stock on the Nasdaq Global Select Market. Fiscal Year 2015 Quarters Ended: High Low March 31, 2015 $ 581.44 $ 497.06 June 30, 2015 573.66 532.74 September 30, 2015 699.62 541.70 December 31, 2015 793.96 642.00 Fiscal Year 2014 Quarters Ended: High Low March 31, 2014 $ 610.70 $ 551.17 June 30, 2014 585.93 518.00 September 30, 2014 605.40 571.81 December 31, 2014 587.78 498.16 Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. Prior to that time, there was no public market for our Class C capital stock. The following table sets forth for the indicated periods the high and low sales prices per share for our Class C capital stock on the Nasdaq Global Select Market. Fiscal Year 2015 Quarters Ended: High Low March 31, 2015 $ 575.33 $ 492.55 June 30, 2015 565.06 520.51 September 30, 2015 672.93 516.83 December 31, 2015 776.60 611.29 Fiscal Year 2014 Quarters Ended: High Low March 31, 2014 $ — $ — June 30, 2014 578.65 509.96 September 30, 2014 596.08 562.73 December 31, 2014 577.35 495.39 18 Table of Contents Alphabet Inc. and Google Inc. Holders of Record As of December 31, 2015 , there were approximately, 2,279 and 2,173 stockholders of record of our Class A common stock and Class C capital stock, respectively, and the closing prices of our Class A common stock and Class C capital stock were $778.01 and $758.88 per share, respectively, as reported by the NASDAQ Global Select Market. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2015 , there were approximately 68 stockholders of record of our Class B common stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. We intend to retain any future earnings and do not expect to pay any cash dividends in the foreseeable future. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class C capital stock during the quarter ended December 31, 2015. Period Total Number of Shares Purchased (in thousands) (1) Average Price Paid per Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 0 $ 0.00 0 $ 5,099 November 1 - 30 1,500 $ 737.72 1,500 $ 3,934 December 1 - 31 891 $ 757.04 891 $ 3,319 Total 2,391 $ 744.68 2,391 (1) In October 2015, the board of directors of Alphabet authorized the company to repurchase up to $5,099,019,513.59 of its Class C capital stock, commencing in the fourth quarter of 2015. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through the use of 10b5-1 plans. The repurchase program does not have an expiration date. Refer to Note 13 in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. Unregistered Sales of Equity Securities On December 17, 2015, we issued an aggregate of approximately 514 thousand shares of our Class C capital stock in connection with our acquisition of bebop Technologies, Inc. The issuance of our shares was made in reliance upon an exemption from the registration requirements of the Securities Act provided by Regulation D. Stock Performance Graph The following graph compares the 5-year cumulative total return to shareholders on Alphabet Inc.’s common stock relative to the cumulative total returns of the S&P 500 index, the RDG Internet Composite index, and the NASDAQ Composite index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in the company’s Class A common stock, Class C capital stock, and in each index on December 31, 2010 and its relative performance is tracked through December 31, 2015 . The returns shown are based on historical results and are not intended to suggest future performance. 19 Table of Contents Alphabet Inc. and Google Inc. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2010 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2015 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. This performance graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the Exchange Act), or incorporated by reference into any filing of Alphabet under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such filing. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing in Item 8 “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results to be expected in any future period. 20 Table of Contents Alphabet Inc. and Google Inc. The consolidated statements of income data of Alphabet and Google were as follows for the periods presented: Year Ended December 31, 2011 (1) 2012 (1) 2013 (1) 2014 (1) 2015 (in millions) Consolidated Statements of Income Data: Revenues $ 37,905 $ 46,039 $ 55,519 $ 66,001 $ 74,989 Income from operations 11,742 13,834 15,403 16,496 19,360 Net income from continuing operations 9,706 11,435 13,160 13,620 16,348 Net income (loss) from discontinued operations 0 (816 ) (427 ) 516 0 Net income 9,706 10,619 12,733 14,136 16,348 (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. The basic and diluted income per share data as included on the consolidated statements of income of Alphabet were as follows for the periods presented (not required for Google pursuant to Rule 12g-3(a)): Year Ended December 31, 2011 (1) 2012 (1) 2013 (1) 2014 (1) 2015 (in millions, except per share amounts) Basic net income (loss) per share of Class A and B common stock: Continuing operations $ 15.04 $ 17.47 $ 19.77 $ 20.15 $ 23.11 Discontinued operations 0.00 (1.25 ) (0.64 ) 0.76 0.00 Basic net income per share of Class A and B common stock $ 15.04 $ 16.22 $ 19.13 $ 20.91 $ 23.11 Basic net income (loss) per share of Class C capital stock: Continuing operations $ 15.04 $ 17.47 $ 19.77 $ 20.15 $ 24.63 Discontinued operations 0.00 (1.25 ) (0.64 ) 0.76 0.00 Basic net income per share of Class C capital stock $ 15.04 $ 16.22 $ 19.13 $ 20.91 $ 24.63 Diluted net income (loss) per share of Class A and B common stock: Continuing operations $ 14.83 $ 17.21 $ 19.42 $ 19.82 $ 22.84 Discontinued operations 0.00 (1.23 ) (0.63 ) 0.75 0.00 Diluted net income per share of Class A and B common stock $ 14.83 $ 15.98 $ 18.79 $ 20.57 $ 22.84 Diluted net income (loss) per share of Class C capital stock: Continuing operations $ 14.83 $ 17.21 $ 19.42 $ 19.82 $ 24.34 Discontinued operations 0.00 (1.23 ) (0.63 ) 0.75 0.00 Diluted net income per share of Class C capital stock $ 14.83 $ 15.98 $ 18.79 $ 20.57 $ 24.34 (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K 21 Table of Contents Alphabet Inc. and Google Inc. The consolidated balance sheets of Alphabet and Google were as follows for the periods presented: As of December 31, 2011 (1)(2) 2012 (1)(2) 2013 (1)(2) 2014 (1)(2) 2015 (in millions) Consolidated Balance Sheet Data: Cash, cash equivalents, and marketable securities $ 44,626 $ 48,088 $ 58,717 $ 64,395 $ 73,066 Total assets 72,359 92,711 109,050 129,187 147,461 Total long-term liabilities 5,294 6,662 6,165 8,548 7,820 Total stockholders’ equity 58,118 71,570 86,977 103,860 120,331 (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (2) Includes reclassifications of deferred tax assets and liabilities related to ASU 2015-17 “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” Please refer to Note 1 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Item 8 of this Annual Report on Form 10-K. Trends in Our Business The following trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to impact our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, resulting in increasing revenues, and we expect that this online shift will continue to benefit our business. • As online advertising evolves, we continue to expand our product offerings which may impact our monetization. As interactions between users and advertisers change, we continue to expand our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube engagement ads, which monetize at a lower rate than traditional search desktop ads. Additionally, advertisers are beginning to shift to programmatic buying which presents opportunities for advertisers to connect with the right user, in the right moment, in the right context. This may also have different monetization profiles to our existing advertising business. These trends will continue to affect our monetization in the future. • Users are increasingly using multiple devices to access our products and services, and our advertising revenues are increasingly coming from mobile phones and other new formats. Our users are accessing the Internet via multiple devices. Mobile computing power continues to grow and users want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of this shift in order to maintain and grow our business. In this multi-device world, we generate our advertising revenues increasingly from mobile phones and newer advertising formats, and the margins from the advertising revenues from these sources have generally been lower than those from desktop computers and tablets. Our traffic acquisition cost (TAC) may also be impacted because the rates at which we share mobile revenues with our partners may differ from our traditional desktop and tablet formats. We expect both of these trends to continue to put pressure on our overall margins, particularly if we fail to realize the opportunities presented during the transition to a dynamic multi-screen environment. • As users in developing economies increasingly come online, we generate increasing revenues from international markets, and movements in foreign exchange rates impact such revenues. 22 Table of Contents Alphabet Inc. and Google Inc. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., especially in emerging markets, and we continue to develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time and we expect that our results will continue to be impacted by our performance in these markets, particularly as low-cost mobile devices become more available. Our international revenues represent a significant proportion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. • The portion of our revenues that we derive from non-advertising revenues is increasing. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our Google offerings to our users through products like Google Play, cloud and apps and hardware products. Across these initiatives, we currently derive non-advertising revenues primarily from sales of digital content products, hardware sales, service and licensing fees; the margins on these non-advertising businesses vary significantly and may be lower than the margins on our advertising business. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues themselves could be volatile. • As we continue to look for new ways to serve our users and expand our businesses, we will invest heavily in R&D and our capital expenditures will continue to fluctuate. We continue to make significant research and development (R&D) investments in areas of strategic focus for Google, such as search and advertising, as well as in new products and services across both Google and Other Bets. The amount of our capital expenditures has fluctuated and may continue to fluctuate in the long term as we invest heavily in our systems, data centers, real estate and facilities, and information technology infrastructure. In addition, acquisitions remain an important part of our strategy and use of capital, and we expect to continue to spend cash on acquisitions and other investments. These acquisitions generally enhance the breadth and depth of our offerings, as well as expanding our expertise in engineering and other functional areas. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. Their energy and talent drive Alphabet and create our success. We expect to continue hiring talented employees and to provide competitive compensation programs to our employees. As of December 31, 2015 , we had 61,814 full-time employees: 23,336 in research and development, 19,082 in sales and marketing, 10,944 in operations, and 8,452 in general and administrative, an increase of 8,214 total headcount from December 31, 2014 . Executive Overview of Results Here are our key financial results for the fiscal year ended December 31, 2015 (consolidated unless otherwise noted): • Revenues of $75.0 billion and revenue growth of 14% year over year, constant currency revenue growth of 20% year over year. • Google segment revenues of $74.5 billion with revenue growth of 14% and Other Bets revenues of $0.4 billion. • Revenues from the United States, the United Kingdom, and Rest of World were $34.8 billion , $7.1 billion , and $33.1 billion , respectively. • Cost of revenues was $28.2 billion , consisting of traffic acquisition costs of $14.4 billion and other cost of revenues of $13.8 billion . Our traffic acquisition costs as a percentage of advertising revenues was 21% . • Operating expenses (excluding cost of revenues) were $27.5 billion . • Income from operations was $19.4 billion . • Effective tax rate of 17% . • Net income was $16.3 billion with diluted net income per share for Class A and B common stock of $22.84 and for Class C capital stock of $24.34 . • Operating cash flow was $26.0 billion . • Capital expenditures were $9.9 billion . 23 Table of Contents Alphabet Inc. and Google Inc. • Headcount was 61,814 as of December 31, 2015 . Information about Segments In conjunction with the Alphabet reorganization, in the fourth quarter of 2015, we implemented legal and operational changes in how our Chief Operating Decision Maker (CODM) manages our businesses, including resource allocation and performance assessment. Consequently, we have multiple operating segments, representing the individual businesses that are run separately under the Alphabet structure. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the operating segments are combined and disclosed below as Other Bets. All prior-period amounts have been adjusted retrospectively to reflect the reportable segment change. Our reported segments are described below: • Google – Google includes our main internet products such as Search, Ads, Commerce, Maps, YouTube, Apps, Cloud, Android, Chrome, Google Play as well as hardware products we sell, such as Chromecast, Chromebooks and Nexus. Our technical infrastructure and newer efforts like Virtual Reality are also included in Google. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access/Google Fiber, Calico, Nest, Verily, GV, Google Capital, X, and other initiatives. Please refer to Note 16 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K for further information. Consolidated Results of Operations The following table presents our operating results as a percentage of revenues for the periods presented: Year Ended December 31, 2013 (1)(2) 2014 (1)(2) 2015 Consolidated Statements of Income Data: Revenues 100.0 % 100.0 % 100.0 % Costs and expenses: Cost of revenues 39.6 38.9 37.6 Research and development 12.9 14.9 16.3 Sales and marketing 11.8 12.3 12.1 General and administrative 8.0 8.9 8.2 Total costs and expenses 72.3 % 75.0 % 74.2 % Income from operations 27.7 25.0 25.8 Other income (expense), net 0.9 1.1 0.4 Income from continuing operations before income taxes 28.6 26.1 26.2 Provision for income taxes 4.9 5.5 4.4 Net income from continuing operations 23.7 20.6 21.8 Net income (loss) from discontinued operations (0.8 ) 0.8 0.0 Net income 22.9 % 21.4 % 21.8 % (1) Financial results of Motorola Home were included in net income (loss) from discontinued operations for the year ended December 31, 2013. Financial results of Motorola Mobile were included in net income (loss) from discontinued operations for the years ended December 31, 2013 and 2014. (2) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. 24 Table of Contents Alphabet Inc. and Google Inc. Consolidated Revenues The following table presents our consolidated revenues, by segment and revenue source (in millions), for the periods presented: Year Ended December 31, 2013 2014 2015 Google segment Google websites $ 37,422 $ 45,085 $ 52,357 Google Network Members' websites (1) 13,650 14,539 15,033 Google advertising revenues 51,072 59,624 67,390 Google other revenues (1) 4,435 6,050 7,151 Google segment revenues $ 55,507 $ 65,674 $ 74,541 Other Bets Other Bets revenues $ 12 $ 327 $ 448 Consolidated revenues $ 55,519 $ 66,001 $ 74,989 (1) Prior period amounts have been adjusted to reflect the reclassification primarily related to DoubleClick ad serving software revenues from Google other revenues to Advertising Revenues from Google Network Members' websites to conform with the current period presentation. Google segment The following table presents our Google segment revenues (in millions), those revenues expressed as a percentage of consolidated revenues, and changes in our aggregate paid clicks and cost-per-click (expressed as a percentage) for the periods presented: Year Ended December 31, 2013 2014 2015 Google segment revenues $ 55,507 $ 65,674 $ 74,541 Google segment revenues as a percentage of consolidated revenues 100.0 % 99.5 % 99.4 % Aggregate paid clicks change 20 % 22 % Aggregate cost-per-click change (5 )% (11 )% Use of Monetization Metrics When assessing our advertising revenue performance, we present information regarding the number of "paid clicks" and "cost-per-click" for our Google websites and Google Network Members websites. Management views these as important metrics for understanding our business. We periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks and for identifying the revenues generated by click activity. Paid clicks for our Google websites represent engagement by users and include clicks on advertisements by end-users related to searches on Google.com, clicks related to advertisements on other owned and operated properties including Gmail, Finance, Maps, and Google Play; and viewed YouTube engagement ads like TrueView (counted as an engagement when the user chooses not to skip the ad). Paid clicks for our Google Network Members' websites include clicks by end-users related to advertisements served on Google Network Members' properties participating in our AdSense for Search, AdSense for Content and AdMob businesses. In some cases, such as programmatic and reservation based advertising buying, we charge advertisers by impression; while growing, this represents a small part of our revenue base. Cost-per-click is defined as click-driven revenue divided by our total number of paid clicks and represents the average cost of each engagement by users we charge advertisers. The rate of change in revenue and revenue growth, as well as the rate of change in paid clicks and cost-per-click on Google websites and Google Network Members' websites and their correlation with the rate of change in revenues, has fluctuated and may fluctuate in the future because of various factors, including: 25 Table of Contents Alphabet Inc. and Google Inc. • growth rates of our revenues from Google websites, including YouTube, compared to those of our revenues from Google Network Members' websites; • advertiser competition for keywords; • changes in foreign currency exchange rates; • seasonality; • the fees advertisers are willing to pay based on how they manage their advertising costs; • changes in advertising quality or formats; • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels; • a shift in the proportion of non-click based revenue generated in Google websites and Google Network Members' websites, including an increase in programmatic and reservation based advertising buying; and • general economic conditions. Our revenue growth rate has generally declined over time as a result of a number of factors, including increasing competition, query growth rates, challenges in maintaining our growth rate as our revenues increase to higher levels, the evolution of the online advertising market, our investments in new business strategies, changes in our product mix, and shifts in the geographic mix of our revenues. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates. Google websites The following table presents our Google websites revenues (in millions), those revenues expressed as a percentage of Google segment revenues, and changes in our paid clicks and cost-per-click (expressed as a percentage) for the periods presented: Year Ended December 31, 2013 2014 2015 Google websites $ 37,422 $ 45,085 $ 52,357 Google websites as a percentage of Google segment revenues 67.4 % 68.6 % 70.2 % Paid clicks change 29 % 33 % Cost-per-click change (7 )% (15 )% Google websites revenues consist primarily of: • AdWords revenue that is generated on Google.com. This includes revenue from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.; • Advertising revenue generated on YouTube, including, but not limited to YouTube TrueView and Google Preferred; and • Advertising revenue generated from other Google owned and operated properties like Gmail, Finance, Maps, and Google Play. Our Google websites revenues increased $7,272 million from 2014 to 2015 and also increased as a percentage of Google segment revenues. Our Google websites revenue growth was primarily driven by increases in mobile search due to ongoing improvements in ad formats, as well as growth in YouTube video advertising across TrueView and Google Preferred, partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. The number of paid clicks through our advertising programs increased from 2014 to 2015 due to an increase in aggregate traffic on Google owned properties, the adoption of advertising formats such as YouTube engagement ads, and continued global expansion of our products, advertisers and user base across all platforms, particularly mobile. The positive impact on our revenues from paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other platforms, as well as changes in property and device mix, product mix, geographic mix, and ongoing product changes, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Our Google websites revenues increased $7,663 million from 2013 to 2014 and also increased as a percentage of Google segment revenues. Our Google websites revenue growth was driven primarily by growth across all platforms due to ongoing improvements in ad formats, as well as growth in YouTube engagement ads, partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. 26 Table of Contents Alphabet Inc. and Google Inc. The increase in the number of paid clicks generated through our advertising programs from 2013 to 2014 was due to certain monetization improvements including new and richer ad formats, an increase in aggregate traffic across all platforms, the continued global expansion of our products, advertisers, and user base, partially offset by certain advertising policy changes. The positive impact on our revenues from paid clicks was partially offset by a decrease in the average cost-per-click paid by our advertisers. The decrease was due to various factors, such as the geographic mix, device mix, property mix, ongoing product and policy changes, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Google Network Members' websites The following table presents our Google Network Members' websites revenues (in millions), those revenues expressed as a percentage of Google segment revenues, and changes in our paid clicks and cost-per-click for the periods presented (in percentage terms): Year Ended December 31, 2013 2014 2015 Google Network Members' websites (1) $ 13,650 $ 14,539 $ 15,033 Google Network Members' websites revenues as a percentage of Google segment revenues (1) 24.6 % 22.1 % 20.2 % Paid clicks change 2 % (7 )% Cost-per-click change (6 )% (3 )% (1) Prior period amounts have been adjusted to reflect the reclassification primarily related to DoubleClick ad serving software revenues from Google other revenues to Advertising Revenues from Google Network Members' websites to conform with the current period presentation. Google Network Members' websites revenues consist primarily of: • AdSense (such as AdSense for Search, AdSense for Content, etc.); • AdExchange; • AdMob; • All DoubleClick-related revenues including DoubleClick Bid Manager revenues; and • Other Network products including AdSense for Domains. Our Google Network Members' websites revenues increased $494 million from 2014 to 2015 . The increase was primarily driven by strength in programmatic advertising buying, offset by our continued AdSense advertising policy changes aimed at enriching the experience for users and the general strengthening of the U.S. dollar compared to certain foreign currencies. The decrease in Network Members' websites revenues as a percentage of Google segment revenues is due to relatively slower growth of Network Members' websites revenues compared to that of Google websites revenues as well as Google other revenues. The decreases in both paid clicks and cost-per-click paid by our advertisers from 2014 to 2015 were primarily driven by ongoing product and policy changes designed to reduce lower quality inventory on AdSense for Search, changes in property and device mix, product mix, and geographic mix, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Our Google Network Members' websites revenues increased $889 million from 2013 to 2014 . The increase was mainly due to certain monetization improvements including new and richer ad formats and an increase in the number of Google Network Members, partially offset by certain AdSense advertising policy changes aimed at enriching the experience for users. The decrease in Network Members' websites revenues as a percentage of Google segment revenues is due to relatively slower growth of Network Members' websites revenues compared to that of Google websites revenues as well as Google other revenues. The increase in paid clicks from 2013 to 2014 was due to certain monetization improvements including new and richer ad formats, an increase in aggregate traffic across all platforms, the continued global expansion of our products, advertisers, and user base, and an increase in the number of Google Network Members, partially offset by certain advertising policy changes. The decrease in the average cost-per-click from 2013 to 2014 was due to various factors, such as the geographic mix, device mix, property mix, ongoing product and policy changes, and the general strengthening of the U.S. dollar compared to certain foreign currencies. 27 Table of Contents Alphabet Inc. and Google Inc. Google other revenues The following table presents our Google other revenues (in millions), and those revenues expressed as a percentage of Google segment revenues, for the periods presented: Year Ended December 31, 2013 2014 2015 Google other revenues (1) $ 4,435 $ 6,050 $ 7,151 Google other revenues as a percentage of Google segment revenues (1) 8.0 % 9.3 % 9.6 % (1) Prior period amounts have been adjusted to reflect the reclassification primarily related to DoubleClick ad serving software revenues from Google other revenues to Advertising Revenues from Google Network Members' websites to conform with the current period presentation. Google other revenues consist primarily of: • Sales of apps and media content in the Google Play store; • Sales of certain Google branded hardware, such as Chromecast; • Service fees received for cloud and apps and our Maps API; and • Licensing-related revenue. Google other revenues increased $1,101 million from 2014 to 2015 and increased as a percentage of Google segment revenues. These increases were primarily due to the growth of our sales of digital content products in the Google Play store, primarily apps (revenues which we recognize net of payout to partners). In addition, there was an increase in revenues from service fees received for cloud and apps offerings. These increases were partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. Google other revenues increased $1,615 million from 2013 to 2014 and increased as a percentage of Google segment revenues. The increase was primarily due to growth of our sales of digital content products in the Google Play store, primarily apps. Other Bets The following table presents our Other Bets revenues (in millions), and those revenues expressed as a percentage of consolidated revenues, for the periods presented: Year Ended December 31, 2013 2014 2015 Other Bets revenues $ 12 $ 327 $ 448 Other Bets revenues as a percentage of consolidated revenues 0.0 % 0.5 % 0.6 % Other Bets revenues consist primarily of: • Sales of Nest branded hardware; • Revenues from internet and TV services; and • Revenues from licensing and R&D services. Our Other Bets revenues increased $121 million from 2014 to 2015 and remained relatively flat as a percentage of consolidated revenues. The increase was primarily due to increases in revenues from sales of Nest branded hardware and revenues from internet and TV services, partially offset by a decrease in licensing revenues. As Nest was acquired in February 2014, the increase in our Nest revenues is impacted by a partial year of revenues in 2014 as compared to a full year in 2015. Our Other Bets revenues increased $315 million from 2013 to 2014 and increased as a percentage of consolidated revenues. This is primarily due to the acquisition of Nest in 2014 as well as an increase of licensing revenues. 28 Table of Contents Alphabet Inc. and Google Inc. Consolidated Revenues by Geography The following table presents our domestic and international revenues as a percentage of consolidated revenues, determined based on the billing addresses of our customers: Year Ended December 31, 2013 2014 2015 United States 46 % 45 % 46 % United Kingdom 10 % 10 % 10 % Rest of the world 44 % 45 % 44 % For the amounts of revenues by geography, please refer to Note 16 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Use of Constant Currency and Constant Currency Growth The impact of exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably impacted as the U.S. dollar weakens relative to other foreign currencies, and unfavorably impacted as the U.S dollar strengthens relative to other foreign currencies. We believe the presentation of results on a constant currency basis in addition to reported results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the impact of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue growth on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging gains realized in the current period. Constant currency revenue growth (expressed as a percentage) is calculated by determining the increase in current period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging benefits are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. The following table presents our foreign exchange impact on United Kingdom revenues for the periods presented (in millions; unaudited): Year Ended December 31, 2013 2014 2015 United Kingdom revenues $ 5,600 $ 6,483 $ 7,067 Exclude: Foreign exchange impact on current year revenues using prior period rates 67 (304 ) 538 Exclude: Hedging gains recognized (63 ) (3 ) (133 ) Constant currency United Kingdom revenues $ 5,604 $ 6,176 $ 7,472 United Kingdom revenue growth rate 16 % 9 % United Kingdom constant currency revenue growth rate 12 % 15 % In 2015 , our revenues from the United Kingdom were unfavorably impacted by changes in foreign currency exchange rates over the prior year, primarily as the U.S. dollar strengthened relative to the British pound. In 2014 , our revenues from the United Kingdom were favorably impacted by changes in foreign currency exchange rates over the prior year, primarily as the U.S. dollar weakened relative to the British pound. 29 Table of Contents Alphabet Inc. and Google Inc. The following table presents our foreign exchange impact on Rest of the world and total revenues for the periods presented (in millions; unaudited): Year Ended December 31, 2013 2014 2015 Rest of the world revenues (1) $ 24,332 $ 30,036 $ 33,112 Exclude: Foreign exchange impact on current year revenues using prior period rates 535 857 5,052 Exclude: Hedging gains recognized (32 ) (169 ) (1,267 ) Constant currency Rest of the world revenues $ 24,835 $ 30,724 $ 36,897 Rest of the world revenue growth rate 23 % 10 % Rest of the world constant currency revenue growth rate 26 % 24 % United States revenues (1) $ 25,587 $ 29,482 $ 34,810 United States revenue growth rate 15 % 18 % Total consolidated revenues $ 55,519 $ 66,001 $ 74,989 Constant currency total consolidated revenues $ 56,026 $ 66,382 $ 79,179 Total consolidated revenue growth rate 19 % 14 % Constant currency total consolidated revenue growth rate 20 % 20 % (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities. We revised the classification of such revenues between Rest of the world and U.S. for prior periods. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual report t on Form 10-K for further information. In 2015 , our revenues from the Rest of the world (excluding the United Kingdom) were unfavorably impacted by changes in foreign currency exchange rates, primarily because the U.S. dollar strengthened relative to the Euro, Brazilian real, Australian dollar and Japanese yen. In 2014 , our revenues from the Rest of the world (excluding the United Kingdom) were unfavorably impacted by changes in foreign currency exchange rates, as the U.S. dollar strengthened relative to certain currencies, most notably the Japanese yen and the Australian dollar, and partially offset by the favorable impact of the U.S. dollar weakening against certain currencies, most notably the Euro. Consolidated Costs and Expenses Cost of Revenues Cost of revenues consists primarily of traffic acquisition costs which are the advertising revenues shared with our Google Network Members and the amounts paid to our distribution partners who distribute our browser or otherwise direct search queries to our website. Additionally, other cost of revenues (which is the cost of revenues excluding traffic acquisition costs) includes the following: • The expenses associated with the operation of our data centers (including depreciation, labor, energy, and bandwidth costs); • Content acquisition costs primarily related to payments to certain content providers from whom we license their video and other content for distribution on YouTube and Google Play (we share the fees these sales generate with content providers or pay a fixed fee to these content providers); • Credit card and other transaction fees related to processing customer transactions; • Stock-based compensation expense; • Revenue share payments to mobile carriers; • Inventory costs for hardware we sell; and • Amortization of certain intangible assets. The following tables present our cost of revenues and cost of revenues as a percentage of revenues, and our traffic acquisition costs and traffic acquisition costs as a percentage of advertising revenues, for the periods presented (in millions): 30 Table of Contents Alphabet Inc. and Google Inc. Year Ended December 31, 2013 2014 2015 Traffic acquisition costs $ 12,258 $ 13,497 $ 14,343 Other cost of revenues 9,735 12,194 13,821 Total cost of revenues $ 21,993 $ 25,691 $ 28,164 Total cost of revenues as a percentage of revenues 39.6 % 38.9 % 37.6 % Year Ended December 31, 2013 2014 2015 Traffic acquisition costs to Google Network Members $ 9,293 $ 9,864 $ 10,242 Traffic acquisition costs to distribution partners 2,965 3,633 4,101 Traffic acquisition costs $ 12,258 $ 13,497 $ 14,343 Traffic acquisition costs as a percentage of advertising revenues 24.0 % 22.6 % 21.3 % The cost of revenues that we incur related to revenues generated from ads placed through our AdSense program on the websites of our Google Network Members are significantly higher than the costs of revenues we incur related to revenues generated from ads placed on Google websites because most of the advertiser fees from ads served on Google Network Members’ websites are shared with our Google Network Members. For the past five years, growth in advertising revenues from Google websites has generally exceeded that from our Google Network Members’ websites. This had a positive impact on our income from operations during this period. Cost of revenues increased $2,473 million from 2014 to 2015 . The increase was primarily due to data center costs and an increase in content acquisition costs as a result of increased activities related to YouTube and digital content. The remaining increase was driven by increases in traffic acquisition costs of $846 million , resulting from more advertiser fees generated through our AdSense program driven primarily by an increase in advertising revenues, as well as more fees paid to our distribution partners for additional traffic directed to our websites. Additionally, there was an impairment charge of $378 million recognized in 2014 related to a patent licensing royalty asset acquired in connection with the Motorola acquisition that did not recur in 2015. The decrease in aggregate traffic acquisition costs as a percentage of advertising revenues was primarily a result of a shift of mix from Google Network Members' websites revenue to Google websites revenue. Cost of revenues increased $3,698 million from 2013 to 2014 . The increase was partially due to increases in traffic acquisition costs of $1,239 million resulting from more distribution fees paid for additional traffic directed to Google websites, as well as more advertiser fees paid to Google Network Members, driven primarily by an increase in advertising revenues. The remaining increase was primarily driven by an increase in data center costs, content acquisition costs as a result of increased usage activities related to YouTube and digital content by our users, and revenue share payments to mobile carriers and original equipment manufacturers (OEMs). In addition, the increase was also driven by the impairment charge described above. The decrease in traffic acquisition costs as a percentage of advertising revenues was primarily a result of a shift of mix between Google websites revenue and Google Network Members' websites revenue. We expect cost of revenues will increase in dollar amount and fluctuate as a percentage of total revenues in 2016 and future periods, based on a number of factors, including the following: • The relative growth rates of revenues from Google websites and from our Google Network Members' website; • The growth rates of expenses associated with our data center operations, as well as our hardware inventory costs; • Increased proportion of other non-advertising revenues as part of our total revenues; • Whether we are able to enter into more revenue share arrangements with Google Network Members and distribution partners that provide for lower revenue share obligations or whether increased competition for arrangements with existing and potential Google Network Members and distribution partners results in less favorable revenue share arrangements; • Whether we are able to continue to improve the monetization of traffic on Google websites and our Google Network Members' websites; and • The relative growth rates of expenses associated with distribution arrangements and the related revenues generated. 31 Table of Contents Alphabet Inc. and Google Inc. Research and Development The following table presents our R&D expenses, and those expenses as a percentage of revenues, for the periods presented (in millions): Year Ended December 31, 2013 2014 2015 Research and development expenses $ 7,137 $ 9,832 $ 12,282 Research and development expenses as a percentage of revenues 12.9 % 14.9 % 16.3 % R&D expenses consist primarily of: • Labor and facilities-related costs for employees responsible for R&D of our existing and new products and services; • Depreciation and equipment-related expenses; and • Stock-based compensation expense. R&D expenses increased $2,450 million and increased as a percentage of revenues from 2014 to 2015 . These increase s were primarily due to an increase in labor and facilities-related costs of $1,502 million and an increase in stock-based compensation expense of $487 million, both largely as a result of a 16% increase in R&D headcount. The increase in labor and facilities-related costs was also impacted by expenses resulting from project milestones in Other Bets established several years ago. In addition, there was an increase in depreciation and equipment-related expenses of approximately $248 million and an increase in professional services of $174 million due to additional expenses incurred for consulting and outsourced services. R&D expenses increased $2,695 million and increased as a percentage of revenues from 2013 to 2014 . These increases were primarily due to an increase in labor and facilities-related costs of $1,289 million and an increase in stock-based compensation expense of $559 million, both largely as a result of a 27% increase in R&D headcount. In addition, there was an increase in depreciation and equipment-related expenses of $425 million and an increase in professional services of $371 million due to additional expenses incurred for consulting and outsourced services. We expect that R&D expenses will increase in dollar amount and may fluctuate as a percentage of revenues in 2016 and future periods. Sales and Marketing The following table presents our sales and marketing expenses, and those expenses as a percentage of revenues, for the periods presented (in millions): Year Ended December 31, 2013 2014 2015 Sales and marketing expenses $ 6,554 $ 8,131 $ 9,047 Sales and marketing expenses as a percentage of revenues 11.8 % 12.3 % 12.1 % Sales and marketing expenses consist primarily of: • Labor and facilities-related costs for our personnel engaged in sales and marketing, sales support, and certain customer service functions; • Advertising and promotional expenditures related to our products and services; and • Stock-based compensation expense. Sales and marketing expenses increased $916 million and remained relatively flat as a percentage of revenues from 2014 to 2015 . The increase in dollar amount was primarily due to an increase in labor and facilities-related costs of $329 million and an increase in stock-based compensation expense of $184 million, largely resulting from a 12% increase in sales and marketing headcount. In addition, there was an increase in advertising and promotional expenses of $184 million and an increase in professional service fees of $158 million due to additional expenses incurred for consulting and outsourced services. Sales and marketing expenses increased $1,577 million from 2013 to 2014 and increased as a percentage of revenues from 2013 to 2014 . These increases were primarily due to an increase in advertising and promotional expenses of $614 million. In addition, there was an increase in labor and facilities-related costs of $571 million and an increase in stock-based compensation expense of $163 million, both largely resulting from a 15% increase in sales and marketing headcount. 32 Table of Contents Alphabet Inc. and Google Inc. We expect that sales and marketing expenses will increase in dollar amount and may fluctuate as a percentage of revenues in 2016 and future periods. General and Administrative The following table presents our general and administrative expenses, and those expenses as a percentage of revenues, for the periods presented (in millions): Year Ended December 31, 2013 2014 2015 General and administrative expenses $ 4,432 $ 5,851 $ 6,136 General and administrative expenses as a percentage of revenues 8.0 % 8.9 % 8.2 % General and administrative expenses consist primarily of: • Labor and facilities-related costs for personnel in our facilities, finance, human resources, information technology, and legal organizations; • Depreciation and equipment-related expenses; • Professional services fees primarily related to outside legal, audit, information technology consulting, and outsourcing services; • Amortization of certain intangible assets; and • Stock-based compensation expense. General and administrative expenses increased $285 million and decreased as a percentage of revenues from 2014 to 2015 . The increase in dollar amount was primarily due to an increase in stock-based compensation expense of $136 million and an increase in labor and facilities-related costs of $69 million, both largely resulting from a 15% increase in general and administrative headcount. In addition, there was an increase in depreciation and equipment-related expenses of $121 million and an increase of $80 million of miscellaneous general and administrative expenses. These factors were partially offset by a decrease in professional service fees and expenses of $128 million, primarily due to lower legal-related costs. General and administrative expenses increased $1,419 million and increased as a percentage of revenues from 2013 to 2014 . The increase s were primarily due to an increase in labor and facilities-related costs of $576 million and an increase in stock-based compensation expense of $260 million, both largely resulting from a 24% increase in general and administrative headcount. In addition, there was an increase in professional services related expense of $314 million due to higher legal related costs, as well as additional consulting and outsourced services. We expect general and administrative expenses will increase in dollar amount and may fluctuate as a percentage of revenues in 2016 and future periods. Stock-Based Compensation The following table presents our equity settled stock-based compensation expense, and equity settled stock-based compensation as a percentage of revenues, as reflected in our consolidated results from continuing operations for the periods presented (in millions): Year Ended December 31, 2013 2014 2015 Stock-based compensation $ 3,127 $ 4,175 $ 5,203 Stock-based compensation as a percentage of revenues 5.6 % 6.3 % 6.9% Stock-based compensation related to equity settled awards increased $1,028 million from 2014 to 2015 and $1,048 million from 2013 to 2014 , and increased as a percentage of revenues in both periods. These increase s were primarily driven by headcount growth. Additionally, we recognized stock-based compensation expense associated with awards ultimately settled in cash of $0 million , $0 million , and $50 million in the years ended December 31, 2013 , 2014 , and 2015 , respectively. We estimate equity settled stock-based compensation expense to be approximately $5.3 billion in 2016 and $5.8 billion thereafter related to stock awards outstanding as of December 31, 2015 . This estimate does not include expenses to be recognized related to stock-based awards granted after December 31, 2015 . If forfeiture rates are different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations. 33 Table of Contents Alphabet Inc. and Google Inc. Consolidated Other Income (Expense), Net The following table presents other income (expense), net, and other income (expense), net, as a percentage of revenues (in millions): Year Ended December 31, 2013 2014 2015 Other income (expense), net $ 496 $ 763 $ 291 Other income (expense), net, as a percentage of revenues 0.9 % 1.1 % 0.4% Other income (expense), net, decreased $472 million from 2014 to 2015 . This decrease was primarily related to a writedown of securities received in conjunction with the sale of a business, as well as, reduced gains on non-marketable investments as compared to 2014. These decreases were partially offset by an increase in interest income as a result of increased cash and fixed income investments. Other income (expense), net, increased $267 million from 2013 to 2014 . This increase was primarily driven by realized gains on non-marketable equity investments of $159 million and previously-held equity interests of $126 million, as well as a loss recognized on divestiture of businesses (other than Motorola Home) in 2013. These increases were partially offset by an increase in foreign currency exchange loss of $23 million and a decrease in interest income of $20 million. The costs of our foreign exchange hedging activities recognized to other income, net, are primarily a function of the notional amount of the option and forward contracts and their related duration, the movement of the foreign exchange rates relative to the strike prices of the contracts, and the volatility of foreign exchange rates. As we expand our international business, costs related to hedging activities under our foreign exchange risk management program may increase in 2016 and future periods. Consolidated Provision for Income Taxes The following table presents our provision for income taxes, and effective tax rate for the periods presented (in millions): Year Ended December 31, 2013 (1) 2014 (1) 2015 Provision for income taxes $ 2,739 $ 3,639 $ 3,303 Effective tax rate 17.2 % 21.1 % 16.8 % (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Our provision for income taxes and our effective tax rate decreased from 2014 to 2015 , largely due to a discrete benefit recognized in 2015 as a result of the resolution of a multi-year audit in the U.S. and proportionately more earnings realized in countries that have lower statutory tax rates. Our provision for income taxes and our effective tax rate increased from 2013 to 2014 , largely due to proportionately more earnings realized in countries that have higher statutory tax rates and more benefit recognized in 2013 relative to 2014 due to the retroactive extension of the 2012 federal research and development credit, offset by a benefit taken on a valuation allowance release related to a capital loss carryforward in 2014. A reconciliation of the federal statutory income tax rate to our effective tax rate is set forth in Note 15 of Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. We are subject to the continuous examination of our income tax returns by the Internal Revenue Service (IRS) and other domestic and foreign tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the impact, if any, of the expected expiration of the statute of limitations 34 Table of Contents Alphabet Inc. and Google Inc. in various taxing jurisdictions. Further information on these issues, the treatment of undistributed foreign earnings and a reconciliation of the federal statutory income tax rate to our effective tax rate can be found in Notes 11 and 15 of Part II, Item 8 of this Annual Report on Form 10-K. See Critical Accounting Policies and Estimates below for additional information about our provision for income taxes. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2015 . This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for fair presentation of our consolidated financial position and operating results for the quarters presented. Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31, 2014 (1) Jun 30, 2014 (1) Sep 30, 2014 (1) Dec 31, 2014 (1) Mar 31, 2015 (1) Jun 30, 2015 Sep 30, 2015 Dec 31, 2015 (In millions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues $ 15,420 $ 15,955 $ 16,523 $ 18,103 $ 17,258 $ 17,727 $ 18,675 $ 21,329 Costs and expenses: Cost of revenues 5,961 6,114 6,695 6,921 6,356 6,583 7,037 8,188 Research and development 2,126 2,238 2,655 2,813 2,753 2,789 3,230 3,510 Sales and marketing 1,729 1,941 2,084 2,377 2,065 2,080 2,223 2,679 General and administrative 1,489 1,404 1,365 1,593 1,637 1,450 1,477 1,572 Total costs and expenses 11,305 11,697 12,799 13,704 12,811 12,902 13,967 15,949 Income from operations 4,115 4,258 3,724 4,399 4,447 4,825 4,708 5,380 Other income (expense), net 357 145 133 128 157 131 183 (180 ) Income from continuing operations before income taxes 4,472 4,403 3,857 4,527 4,604 4,956 4,891 5,200 Provision for income taxes 903 984 933 819 1,089 1,025 912 277 Net income from continuing operations $ 3,569 $ 3,419 $ 2,924 $ 3,708 $ 3,515 $ 3,931 $ 3,979 $ 4,923 Net income (loss) from discontinued operations (198 ) (68 ) (185 ) 967 0 0 0 0 Net income $ 3,371 $ 3,351 $ 2,739 $ 4,675 $ 3,515 $ 3,931 $ 3,979 $ 4,923 Less: Adjustment Payment to Class C capital stockholders 0 0 0 0 0 522 0 0 Net income available to all stockholders $ 3,371 $ 3,351 $ 2,739 $ 4,675 $ 3,515 $ 3,409 $ 3,979 $ 4,923 (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. 35 Table of Contents Alphabet Inc. and Google Inc. The basic and diluted income per share data as included on the consolidated statements of income of Alphabet Inc. were as follows for the periods presented (not required for Google pursuant to Rule 12g-3(a)): Quarter Ended Mar 31, 2014 (1) Jun 30, 2014 (1) Sep 30, 2014 (1) Dec 31, 2014 (1) Mar 31, 2015 (1) Jun 30, 2015 Sep 30, 2015 Dec 31, 2015 (unaudited) Basic net income (loss) per share of Class A and B common stock: Continuing operations $ 5.30 $ 5.06 $ 4.32 $ 5.46 $ 5.16 $ 4.99 $ 5.80 $ 7.16 Discontinued operations (0.29 ) (0.10 ) (0.27 ) 1.43 0.00 0.00 0.00 0.00 Basic net income per share of Class A and B common stock $ 5.01 $ 4.96 $ 4.05 $ 6.89 $ 5.16 $ 4.99 $ 5.80 $ 7.16 Basic net income (loss) per share of Class C capital stock: Continuing operations $ 5.30 $ 5.06 $ 4.32 $ 5.46 $ 5.16 $ 6.51 $ 5.80 $ 7.16 Discontinued operations (0.29 ) (0.10 ) (0.27 ) 1.43 0.00 0.00 0.00 0.00 Basic net income per share of Class C capital stock $ 5.01 $ 4.96 $ 4.05 $ 6.89 $ 5.16 $ 6.51 $ 5.80 $ 7.16 Diluted net income (loss) per share of Class A and B common stock: Continuing operations $ 5.21 $ 4.98 $ 4.25 $ 5.38 $ 5.10 $ 4.93 $ 5.73 $ 7.06 Discontinued operations (0.29 ) (0.10 ) (0.27 ) 1.41 0.00 0.00 0.00 0.00 Diluted net income per share of Class A and B common stock $ 4.92 $ 4.88 $ 3.98 $ 6.79 $ 5.10 $ 4.93 $ 5.73 $ 7.06 Diluted net income (loss) per share of Class C capital stock: Continuing operations $ 5.21 $ 4.98 $ 4.25 $ 5.38 $ 5.10 $ 6.43 $ 5.73 $ 7.06 Discontinued operations (0.29 ) (0.10 ) (0.27 ) 1.41 0.00 0.00 0.00 0.00 Diluted net income per share of Class C capital stock $ 4.92 $ 4.88 $ 3.98 $ 6.79 $ 5.10 $ 6.43 $ 5.73 $ 7.06 (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. 36 Table of Contents Alphabet Inc. and Google Inc. The following table presents our unaudited quarterly results of operations as a percentage of revenues for the eight quarters ended December 31, 2015 : Quarter Ended Mar 31, 2014 (1) Jun 30, 2014 (1) Sep 30, 2014 (1) Dec 31, 2014 (1) Mar 31, 2015 (1) Jun 30, 2015 Sep 30, 2015 Dec 31, 2015 (unaudited) Revenues 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % 100.0 % Costs and expenses: Cost of revenues 38.7 38.3 40.5 38.2 36.8 37.1 37.7 38.4 Research and development 13.8 14.0 16.1 15.5 16.0 15.7 17.3 16.4 Sales and marketing 11.2 12.2 12.6 13.1 12.0 11.8 11.9 12.6 General and administrative 9.6 8.8 8.3 8.9 9.4 8.2 7.9 7.4 Total costs and expenses 73.3 73.3 77.5 75.7 74.2 72.8 74.8 74.8 Income from operations 26.7 26.7 22.5 24.3 25.8 27.2 25.2 25.2 Other income (expense), net 2.3 0.9 0.8 0.7 0.9 0.8 1.0 (0.8 ) Income from continuing operations before income taxes 29.0 27.6 23.3 25.0 26.7 28.0 26.2 24.4 Provision for income taxes 5.8 6.2 5.6 4.5 6.3 5.8 4.9 1.3 Net income from continuing operations 23.2 21.4 17.7 20.5 20.4 22.2 21.3 23.1 Net income (loss) from discontinued operations (1.3 ) (0.4 ) (1.1 ) 5.3 0.0 0.0 0.0 0.0 Net income 21.9 % 21.0 % 16.6 % 25.8 % 20.4 % 22.2 % 21.3 % 23.1 % Less: Adjustment Payment to Class C capital stockholders 0.0 % 0.0 % 0.0 % 0.0 % 0.0 % 2.9 % 0.0 % 0.0 % Net income available to all stockholders 21.9 % 21.0 % 16.6 % 25.8 % 20.4 % 19.2 % 21.3 % 23.1 % (1) In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015. Please refer to Note 1 and Note 17 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Capital Resources and Liquidity As of December 31, 2015 , we had $73.1 billion of cash, cash equivalents, and marketable securities. Cash equivalents and marketable securities a re comprised of time deposits, money market and other funds, including cash collateral received related to our securities lending program, fixed-income bond funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, agency mortgage-backed securities, and asset-backed securities. From time to time, we may hold marketable equity securities obtained through acquisitions or strategic investments in private companies that subsequently go public. As of December 31, 2015 , $42.9 billion of the $73.1 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds were needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. As of December 31, 2015 , we had unused letters of credit of approximately $752 million . We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Our liquidity could be negatively affected by a decrease in demand for our products and services. In addition, we may make acquisitions, increase our capital expenditures, or license products and technologies complementary to our business and may need to raise additional capital through future 37 Table of Contents Alphabet Inc. and Google Inc. debt or equity financing to provide for greater flexibility to fund these activities. Additional financing may not be available or on terms favorable to us. We have a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2015 , we had $2.0 billion of commercial paper outstanding recorded as short-term debt, with a weighted-average interest rate of 0.2% that matures at various dates through February 2016. In conjunction with this program, we have a $3.0 billion revolving credit facility expiring in July 2016. The interest rate for the credit facility is determined based on a formula using certain market rates. As of December 31, 2015 , we were in compliance with the financial covenant in the credit facility and no amounts were outstanding. We intend to align our capital structure so that debt is held at the holding company level. In January 2016, the board of directors of Alphabet authorized the company to issue up to $5.0 billion of commercial paper from time to time and to enter into a $4.0 billion revolving credit facility to replace Google's existing $3.0 billion revolving credit facility. In May 2011, we issued $3.0 billion of unsecured senior notes (2011 Notes) in three equal tranches, due in 2014, 2016, and 2021. The net proceeds from the sale of the 2011 Notes were used to repay a portion of our outstanding commercial paper and for general corporate purposes. In February 2014, we issued $1.0 billion of unsecured senior notes (2014 Notes) due in 2024, which was used to repay $1.0 billion of the first tranche of our 2011 Notes that matured in May 2014 and for general corporate purposes. As of December 31, 2015 , the outstanding notes had a total carrying value of $3.0 billion and a total estimated fair value of $3.1 billion. We are not subject to any financial covenants under the notes. In August 2013, we entered into a $258 million capital lease obligation on certain property expiring in 2028. We intend to exercise the option to purchase the property in 2016. The effective rate of the capital lease obligation approximates the market rate. In October 2015, the board of directors of Alphabet authorized the company to repurchase up to $5,099,019,513.59 of its Class C capital stock, commencing in the fourth quarter of 2015. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through the use of 10b5-1 plans. The repurchase program does not have an expiration date. As of December 31, 2015 , Alphabet repurchased and subsequently retired $1.8 billion of its Class C capital stock. Alphabet's share repurchases in the year ended December 31, 2015 were funded by Google via a return of capital to Alphabet. In January 2016, the board of directors of Alphabet authorized the company to repurchase an additional amount of approximately 514 thousand shares. For 2013, 2014 and 2015, our cash flows were as follows (in millions): Year Ended December 31, 2013 2014 2015 Net cash provided by operating activities $ 18,659 $ 22,376 $ 26,024 Net cash used in investing activities (13,679 ) (21,055 ) (23,711 ) Net cash used in financing activities (857 ) (1,439 ) (3,677 ) Cash Provided by Operating Activities Our largest source of cash provided by our operations is advertising revenues generated by Google websites and Google Network Members' websites. Additionally, we generate cash through sales of apps and digital content, hardware products, licensing arrangements, and s ervice fees received for cloud and apps and our Maps API . Prior to its divestiture in October 2014, we also generated cash from sales of hardware products related to the Motorola Mobile business. Our primary uses of cash from our operating activities include payments to our Google Network Members and distribution partners, and payments for content acquisition costs. Prior to the sale of the Motorola Mobile business, our use of cash also included payment for manufacturing and inventory-related costs in the Motorola Mobile business. In addition, uses of cash from operating activities include compensation and related costs, other general corporate expenditures, and income taxes. Net cash provided by operating activities increased from 2014 to 2015 primarily due to increased net income adjusted for depreciation and stock-based compensation expense, and loss on sales of marketable and non-marketable securities. This is partially offset by a net decrease in cash from changes in working capital. 38 Table of Contents Alphabet Inc. and Google Inc. Net cash provided by operating activities increased from 2013 to 2014 primarily due to increased net income adjusted for depreciation and loss on disposal of property and equipment and stock-based compensation expense, and a net increase in cash from changes in working capital primarily driven by changes in prepaid revenue share, expenses, and other assets. Cash Used in Investing Activities Cash provided by or used in investing activities primarily consists of purchases of property and equipment, purchases, maturities, and sales of marketable securities in our investment portfolio, investments in reverse repurchase agreements and the cash collateral received or returned from our securities lending program, as well as acquisitions and divestitures of businesses and intangible assets. Cash used in investing activities increased from 2014 to 2015 primarily due to net increases in purchases of marketable securities, activities related to security lending and purchases of non-marketable investments. This increase was partially offset by lower spend related to acquisitions, lower investments in reverse repurchase agreements, and a decrease in capital expenditures related to our production equipment, data centers, and real estate purchases. Cash used in investing activities increased from 2013 to 2014 primarily due to increases in capital expenditures related to our production equipment, data centers, and real estate purchases, higher spend related to acquisitions, and lower proceeds received in 2014 from divestiture of businesses compared to 2013. This increase was partially offset by a net decrease in purchases of marketable securities. Cash Used in Financing Activities Cash used in financing activities consists primarily of net proceeds or payments from issuance or repayments of debt, repurchases of capital stock, and net proceeds or payments and excess tax benefits from stock-based award activities. In Alphabet, cash used in financing activities increased from 2014 to 2015 primarily driven by the repurchases of capital stock and an increase in net payments related to stock-based award activities. In Google, cash used in financing activities increased from 2014 to 2015 is primarily driven by capital transactions with Alphabet, partially offset by net payments related to stock-based award activities. Cash used in financing activities increased from 2013 to 2014 is primarily driven by an increase in net payments related to stock-based award activities, offset partially by a decrease in net cash payments related to debt. Contractual Obligations as of December 31, 2015 The following summarizes our contractual obligations, excluding open orders for purchases that support normal operations, as of December 31, 2015 (in millions): Payments Due By Period Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating lease obligations, net of sublease income amounts (1) $ 7,406 $ 646 $ 1,573 $ 1,482 $ 3,705 Purchase obligations (2) 1,697 946 298 150 303 Long-term debt obligations, including capital lease obligations (3) 3,722 1,306 140 140 2,136 Other long-term liabilities reflected on our balance sheet (4) 1,580 356 430 367 427 Total contractual obligations $ 14,405 $ 3,254 $ 2,441 $ 2,139 $ 6,571 (1) For further information, refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (2) Purchase obligations represent non-cancelable contractual obligations primarily related to data center operations and facility build-outs, video and other content licensing revenue sharing arrangements, as well as purchases of inventory. (3) For further information, refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (4) Other long-term liabilities represent cash obligations recorded on our consolidated balance sheets, including the short-term portion of these long-term liabilities and consist primarily of payments owed in connection with certain commercial agreements, investments and asset retirement obligations. In addition to the amounts above, we had long-term tax payable of $3.7 billion as of December 31, 2015 primarily related to uncertain tax positions. At this time, we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. As a result, this amount is not included in the above table. 39 Table of Contents Alphabet Inc. and Google Inc. Off-Balance Sheet Arrangements As of December 31, 2015 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. Please see Note 1 of Part II, Item 8 of this Annual Report on Form 10-K for the summary of significant accounting policies. Income Taxes We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, indirect taxes, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred, and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, consolidated financial position, results of operations, or cash flows. See Note 11 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding contingencies. Business Combinations We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values 40 Table of Contents Alphabet Inc. and Google Inc. of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include but are not limited to future expected cash flows from customer relationships and acquired patents and developed technology; and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Other estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed, as more fully discussed in Note 6 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Goodwill Goodwill is allocated to reporting units expected to benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test goodwill for impairment at the reporting unit level at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairment tests require judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. As of December 31, 2015 , no impairment of goodwill has been identified. Long-lived Assets Long-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Impairment of Marketable and Non-Marketable Securities We periodically review our marketable and non-marketable securities for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For marketable debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as other income (expense), net. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in currency exchange rates and interest rates. Foreign Currency Exchange Risk We transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. We are a net receiver of foreign currencies and therefore benefit from a weakening of the U.S. dollar and are adversely affected by a strengthening of the U.S. dollar relative to the foreign currency. As of December 31, 2015 , our most significant currency exposures are the British pound, Euro, and Japanese yen. We use foreign exchange option contracts to protect our forecasted U.S. dollar-equivalent earnings from adverse changes in foreign currency exchange rates. These hedging contracts reduce, but do not entirely eliminate the impact of adverse currency exchange rate movements. We designate these option contracts as cash flow hedges for accounting purposes.  The fair value of the option contract is separated into its intrinsic and time values. Changes in the time value are recorded in other income (expense), net. Changes in the intrinsic value are recorded as a component of accumulated other comprehensive income (AOCI) and subsequently reclassified into revenues to offset the hedged exposures as they occur. We considered the historical trends in currency exchange rates and determined that it was reasonably possible that changes in exchange rates of 20% could be experienced in the near term. If the U.S. dollar weakened by 20% as of December 31, 2014 and December 31, 2015 , the amount recorded in AOCI reflecting intrinsic value related to our 41 Table of Contents Alphabet Inc. and Google Inc. foreign exchange options before tax effect would have been approximately $686 million and $280 million lower as of December 31, 2014 and December 31, 2015 , and the total amount of expense recorded as other income (expense), net, would have been approximately $90 million and $275 million higher in the years ended December 31, 2014 and December 31, 2015 . If the U.S. dollar strengthened by 20% as of December 31, 2014 and December 31, 2015 , the amount recorded in accumulated AOCI related to our foreign exchange options before tax effect would have been approximately $2.5 billion and $3.1 billion higher as of December 31, 2014 and December 31, 2015 , and the total amount of expense recorded as other income (expense), net, would have been approximately $164 million and $372 million higher in the years ended December 31, 2014 and December 31, 2015 . In both scenarios, the change in the intrinsic value would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. In addition, we use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the local currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate the impact of currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. We considered the historical trends in currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 20% for all currencies could be experienced in the near term. These reasonably possible adverse changes in exchange rates of 20% were applied to total monetary assets and liabilities denominated in currencies other than the local currencies at the balance sheet dates to compute the adverse impact these changes would have had on our income before income taxes in the near term. These changes would have resulted in an adverse impact on income before income taxes of approximately $93 million and $122 million as of December 31, 2014 and December 31, 2015 . The adverse impact as of December 31, 2014 and December 31, 2015 is after consideration of the offsetting effect of approximately $948 million and $1.1 billion from foreign exchange contracts in place for the months of December 31, 2014 and December 31, 2015 . Interest Rate Risk Our investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity requirements. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, agency mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. As of December 31, 2014 and December 31, 2015 , unrealized losses on our marketable debt securities were primarily due to temporary interest rate fluctuations as a result of higher market interest rates compared to interest rates at the time of purchase. We account for both fixed and variable rate securities at fair value with changes on gains and losses recorded in AOCI until the securities are sold. We use interest rate derivative contracts to hedge gains and losses on our securities. These derivative contracts are accounted for as hedges at fair value with changes in fair value recorded in other income (expense), net. We considered the historical volatility of short-term interest rates and determined that it was reasonably possible that an adverse change of 100 basis points could be experienced in the near term. A hypothetical 1.00% (100 basis points) increase in interest rates would have resulted in a decrease in the fair value of our marketable securities of approximately $1.2 billion and $1.3 billion as of December 31, 2014 and December 31, 2015 . 42 Table of Contents Alphabet Inc. and Google Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. and Google Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 45 Financial Statements of Alphabet Inc.: Consolidated Balance Sheets 48 Consolidated Statements of Income 49 Consolidated Statements of Comprehensive Income 50 Consolidated Statements of Stockholders’ Equity 51 Consolidated Statements of Cash Flows 52 Financial Statements of Google Inc.: Consolidated Balance Sheets 53 Consolidated Statements of Income 54 Consolidated Statements of Comprehensive Income 55 Consolidated Statements of Stockholders’ Equity 56 Consolidated Statements of Cash Flows 57 Notes to Consolidated Financial Statements (Alphabet Inc. and Google Inc.) 58 The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” 43 Table of Contents Alphabet Inc. and Google Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Alphabet Inc. We have audited the accompanying consolidated balance sheets of Alphabet Inc. as of December 31, 2014 and 2015 , and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2015 . Our audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Alphabet Inc. as of December 31, 2014 and 2015 , and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2015 , in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Alphabet Inc.’s internal control over financial reporting as of December 31, 2015 , based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 11, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California February 11, 2016 44 Table of Contents Alphabet Inc. and Google Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Google Inc. We have audited the accompanying consolidated balance sheets of Google Inc. as of December 31, 2014 and 2015 , and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2015 . Our audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Google Inc. as of December 31, 2014 and 2015 , and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2015 , in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Google Inc.’s internal control over financial reporting as of December 31, 2015 , based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 11, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California February 11, 2016 45 Table of Contents Alphabet Inc. and Google Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Alphabet Inc. We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2015 , based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). Alphabet Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Alphabet Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Alphabet Inc. as of December 31, 2014 and 2015 , and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2015 of Alphabet Inc. and our report dated February 11, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California February 11, 2016 46 Table of Contents Alphabet Inc. and Google Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Google Inc. We have audited Google Inc.’s internal control over financial reporting as of December 31, 2015 , based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). Google Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Google Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Google Inc. as of December 31, 2014 and 2015 , and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2015 of Google Inc. and our report dated February 11, 2016 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California February 11, 2016 47 Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share and par value amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2014 As of December 31, 2015 Assets Current assets: Cash and cash equivalents $ 18,347 $ 16,549 Marketable securities 46,048 56,517 Total cash, cash equivalents, and marketable securities (including securities loaned of $4,058 and $4,531) 64,395 73,066 Accounts receivable, net of allowance of $225 and $296 9,383 11,556 Receivable under reverse repurchase agreements 875 450 Income taxes receivable, net 591 1,903 Prepaid revenue share, expenses and other assets 3,412 3,139 Total current assets 78,656 90,114 Prepaid revenue share, expenses and other assets, non-current 3,187 3,181 Non-marketable investments 3,079 5,183 Deferred income taxes 176 251 Property and equipment, net 23,883 29,016 Intangible assets, net 4,607 3,847 Goodwill 15,599 15,869 Total assets $ 129,187 $ 147,461 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 1,715 $ 1,931 Short-term debt 2,009 3,225 Accrued compensation and benefits 3,069 3,539 Accrued expenses and other current liabilities 4,408 4,768 Accrued revenue share 1,952 2,329 Securities lending payable 2,778 2,428 Deferred revenue 752 788 Income taxes payable, net 96 302 Total current liabilities 16,779 19,310 Long-term debt 3,228 1,995 Deferred revenue, non-current 104 151 Income taxes payable, non-current 3,340 3,663 Deferred income taxes 758 189 Other long-term liabilities 1,118 1,822 Commitments and contingencies (Note 11) Stockholders’ equity: Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 680,172 (Class A 286,560, Class B 53,213, Class C 340,399) and par value of $680 (Class A $287, Class B $53, Class C $340) and 687,348 (Class A 292,297, Class B 50,295, Class C 344,756) and par value of $687 (Class A $292, Class B $50, Class C $345) shares issued and outstanding 28,767 32,982 Accumulated other comprehensive income (loss) 27 (1,874 ) Retained earnings 75,066 89,223 Total stockholders’ equity 103,860 120,331 Total liabilities and stockholders’ equity $ 129,187 $ 147,461 See accompanying notes. 48 Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2013 2014 2015 Revenues $ 55,519 $ 66,001 $ 74,989 Costs and expenses: Cost of revenues 21,993 25,691 28,164 Research and development 7,137 9,832 12,282 Sales and marketing 6,554 8,131 9,047 General and administrative 4,432 5,851 6,136 Total costs and expenses 40,116 49,505 55,629 Income from operations 15,403 16,496 19,360 Other income (expense), net 496 763 291 Income from continuing operations before income taxes 15,899 17,259 19,651 Provision for income taxes 2,739 3,639 3,303 Net income from continuing operations $ 13,160 $ 13,620 $ 16,348 Net income (loss) from discontinued operations (427 ) 516 0 Net income $ 12,733 $ 14,136 $ 16,348 Less: Adjustment Payment to Class C capital stockholders 0 0 522 Net income available to all stockholders $ 12,733 $ 14,136 $ 15,826 Basic net income (loss) per share of Class A and B common stock: Continuing operations $ 19.77 $ 20.15 $ 23.11 Discontinued operations (0.64 ) 0.76 0.00 Basic net income per share of Class A and B common stock $ 19.13 $ 20.91 $ 23.11 Basic net income (loss) per share of Class C capital stock: Continuing operations $ 19.77 $ 20.15 $ 24.63 Discontinued operations (0.64 ) 0.76 0.00 Basic net income per share of Class C capital stock $ 19.13 $ 20.91 $ 24.63 Diluted net income (loss) per share of Class A and B common stock: Continuing operations $ 19.42 $ 19.82 $ 22.84 Discontinued operations (0.63 ) 0.75 0.00 Diluted net income per share of Class A and B common stock $ 18.79 $ 20.57 $ 22.84 Diluted net income (loss) per share of Class C capital stock: Continuing operations $ 19.42 $ 19.82 $ 24.34 Discontinued operations (0.63 ) 0.75 0.00 Diluted net income per share of Class C capital stock $ 18.79 $ 20.57 $ 24.34 See accompanying notes. 49 Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2013 2014 2015 Net income $ 12,733 $ 14,136 $ 16,348 Other comprehensive income (loss): Change in foreign currency translation adjustment 89 (996 ) (1,067 ) Available-for-sale investments: Change in net unrealized gains (losses) (392 ) 505 (715 ) Less: reclassification adjustment for net (gains) losses included in net income (162 ) (134 ) 208 Net change (net of tax effect of $212, $60, and $29) (554 ) 371 (507 ) Cash flow hedges: Change in net unrealized gains 112 651 676 Less: reclassification adjustment for net gains included in net income (60 ) (124 ) (1,003 ) Net change (net of tax effect of $30, $196, and $115) 52 527 (327 ) Other comprehensive loss (413 ) (98 ) (1,901 ) Comprehensive income $ 12,320 $ 14,038 $ 14,447 See accompanying notes. 50 Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2012 659,958 $ 22,835 $ 538 $ 48,197 $ 71,570 Common stock issued 11,706 1,174 0 0 1,174 Stock-based compensation expense 3,343 0 0 3,343 Stock-based compensation tax benefits 449 0 0 449 Tax withholding related to vesting of restricted stock units (1,879 ) 0 0 (1,879 ) Net income 0 0 12,733 12,733 Other comprehensive loss 0 (413 ) 0 (413 ) Balance as of December 31, 2013 671,664 25,922 125 60,930 86,977 Common and capital stock issued 8,508 465 0 0 465 Stock-based compensation expense 4,279 0 0 4,279 Stock-based compensation tax benefits 625 0 0 625 Tax withholding related to vesting of restricted stock units (2,524 ) 0 0 (2,524 ) Net income 0 0 14,136 14,136 Other comprehensive loss 0 (98 ) 0 (98 ) Balance as of December 31, 2014 680,172 28,767 27 75,066 103,860 Common and capital stock issued 8,714 664 0 0 664 Stock-based compensation expense 5,151 0 0 5,151 Stock-based compensation tax benefits 815 0 0 815 Tax withholding related to vesting of restricted stock units (2,779 ) 0 0 (2,779 ) Repurchases of capital stock (2,391 ) (111 ) 0 (1,669 ) (1,780 ) Adjustment Payment to Class C capital stockholders 853 475 0 (522 ) (47 ) Net income 0 0 16,348 16,348 Other comprehensive loss 0 (1,901 ) 0 (1,901 ) Balance as of December 31, 2015 687,348 $ 32,982 $ (1,874 ) $ 89,223 $ 120,331 See accompanying notes. 51 Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2013 2014 2015 Operating activities Net income $ 12,733 $ 14,136 $ 16,348 Adjustments: Depreciation and impairment of property and equipment 2,781 3,523 4,132 Amortization and impairment of intangible assets 1,158 1,456 931 Stock-based compensation expense 3,343 4,279 5,203 Excess tax benefits from stock-based award activities (481 ) (648 ) (548 ) Deferred income taxes (437 ) (104 ) (179 ) Gain on divestiture of business (700 ) (740 ) 0 (Gain) loss on marketable and non-marketable investments, net (166 ) (390 ) 334 Other 272 192 212 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable (1,307 ) (1,641 ) (2,094 ) Income taxes, net 588 591 (179 ) Prepaid revenue share, expenses and other assets (930 ) 459 (318 ) Accounts payable 605 436 203 Accrued expenses and other liabilities 713 757 1,597 Accrued revenue share 254 245 339 Deferred revenue 233 (175 ) 43 Net cash provided by operating activities 18,659 22,376 26,024 Investing activities Purchases of property and equipment (7,358 ) (10,959 ) (9,915 ) Purchases of marketable securities (45,444 ) (56,310 ) (74,368 ) Maturities and sales of marketable securities 38,314 51,315 62,905 Purchases of non-marketable investments (569 ) (1,227 ) (2,172 ) Cash collateral related to securities lending (299 ) 1,403 (350 ) Investments in reverse repurchase agreements 600 (775 ) 425 Proceeds from divestiture of business 2,525 386 0 Acquisitions, net of cash acquired, and purchases of intangibles and other assets (1,448 ) (4,888 ) (236 ) Net cash used in investing activities (13,679 ) (21,055 ) (23,711 ) Financing activities Net payments related to stock-based award activities (781 ) (2,069 ) (2,375 ) Excess tax benefits from stock-based award activities 481 648 548 Adjustment Payment to Class C capital stockholders 0 0 (47 ) Repurchases of capital stock 0 0 (1,780 ) Proceeds from issuance of debt, net of costs 10,768 11,625 13,705 Repayments of debt (11,325 ) (11,643 ) (13,728 ) Net cash used in financing activities (857 ) (1,439 ) (3,677 ) Effect of exchange rate changes on cash and cash equivalents (3 ) (433 ) (434 ) Net increase (decrease) in cash and cash equivalents 4,120 (551 ) (1,798 ) Cash and cash equivalents at beginning of period 14,778 18,898 18,347 Cash and cash equivalents at end of period $ 18,898 $ 18,347 $ 16,549 Supplemental disclosures of cash flow information Cash paid for taxes $ 1,932 $ 2,819 $ 3,338 Cash paid for interest 72 86 96 See accompanying notes. 52 Table of Contents Alphabet Inc. and Google Inc. Google Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share and par value amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2014 As of December 31, 2015 Assets Current assets: Cash and cash equivalents $ 18,347 $ 16,549 Marketable securities 46,048 56,517 Total cash, cash equivalents, and marketable securities (including securities loaned of $4,058 and $4,531) 64,395 73,066 Accounts receivable, net of allowance of $225 and $296 9,383 11,556 Receivable under reverse repurchase agreements 875 450 Income taxes receivable, net 591 1,903 Prepaid revenue share, expenses and other assets 3,412 3,139 Total current assets 78,656 90,114 Prepaid revenue share, expenses and other assets, non-current 3,187 3,181 Non-marketable investments 3,079 5,183 Deferred income taxes 176 251 Property and equipment, net 23,883 29,016 Intangible assets, net 4,607 3,847 Goodwill 15,599 15,869 Total assets $ 129,187 $ 147,461 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 1,715 $ 1,931 Short-term debt 2,009 3,225 Accrued compensation and benefits 3,069 3,539 Accrued expenses and other current liabilities 4,408 4,768 Accrued revenue share 1,952 2,329 Securities lending payable 2,778 2,428 Deferred revenue 752 788 Income taxes payable, net 96 302 Total current liabilities 16,779 19,310 Long-term debt 3,228 1,995 Deferred revenue, non-current 104 151 Income taxes payable, non-current 3,340 3,663 Deferred income taxes 758 189 Other long-term liabilities 1,118 1,822 Commitments and contingencies (Note 11) Stockholders’ equity: Convertible preferred stock, $0.001 par value per share; 100,000 shares authorized, no shares issued and outstanding; 0.5 shares authorized, no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 680,172 (Class A 286,560, Class B 53,213, Class C 340,399), and par value of $680 (Class A $287, Class B $53, Class C $340); and 1.5 shares authorized (Class A 0.5, Class B 0.5, Class C 0.5); 0.3 (Class A 0.1, Class B 0.1, Class C 0.1), and par value of $0, shares issued and outstanding 28,767 31,313 Accumulated other comprehensive income (loss) 27 (1,874 ) Retained earnings 75,066 90,892 Total stockholders’ equity 103,860 120,331 Total liabilities and stockholders’ equity $ 129,187 $ 147,461 See accompanying notes. 53 Table of Contents Alphabet Inc. and Google Inc. Google Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions) Year Ended December 31, 2013 2014 2015 Revenues $ 55,519 $ 66,001 $ 74,989 Costs and expenses: Cost of revenues 21,993 25,691 28,164 Research and development 7,137 9,832 12,282 Sales and marketing 6,554 8,131 9,047 General and administrative 4,432 5,851 6,136 Total costs and expenses 40,116 49,505 55,629 Income from operations 15,403 16,496 19,360 Other income (expense), net 496 763 291 Income from continuing operations before income taxes 15,899 17,259 19,651 Provision for income taxes 2,739 3,639 3,303 Net income from continuing operations $ 13,160 $ 13,620 $ 16,348 Net income (loss) from discontinued operations (427 ) 516 0 Net income $ 12,733 $ 14,136 $ 16,348 Less: Adjustment Payment to Class C capital stockholders 0 0 522 Net income available to all stockholders $ 12,733 $ 14,136 $ 15,826 See accompanying notes. 54 Table of Contents Alphabet Inc. and Google Inc. Google Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2013 2014 2015 Net income $ 12,733 $ 14,136 $ 16,348 Other comprehensive income (loss): Change in foreign currency translation adjustment 89 (996 ) (1,067 ) Available-for-sale investments: Change in net unrealized gains (losses) (392 ) 505 (715 ) Less: reclassification adjustment for net (gains) losses included in net income (162 ) (134 ) 208 Net change (net of tax effect of $212, $60, and $29) (554 ) 371 (507 ) Cash flow hedges: Change in net unrealized gains 112 651 676 Less: reclassification adjustment for net gains included in net income (60 ) (124 ) (1,003 ) Net change (net of tax effect of $30, $196, and $115) 52 527 (327 ) Other comprehensive loss (413 ) (98 ) (1,901 ) Comprehensive income $ 12,320 $ 14,038 $ 14,447 See accompanying notes. 55 Table of Contents Alphabet Inc. and Google Inc. Google Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2012 659,958 $ 22,835 $ 538 $ 48,197 $ 71,570 Common stock issued 11,706 1,174 0 0 1,174 Stock-based compensation expense 3,343 0 0 3,343 Stock-based compensation tax benefits 449 0 0 449 Tax withholding related to vesting of restricted stock units (1,879 ) 0 0 (1,879 ) Net income 0 0 12,733 12,733 Other comprehensive loss 0 (413 ) 0 (413 ) Balance as of December 31, 2013 671,664 25,922 125 60,930 86,977 Common and capital stock issued 8,508 465 0 0 465 Stock-based compensation expense 4,279 0 0 4,279 Stock-based compensation tax benefits 625 0 0 625 Tax withholding related to vesting of restricted stock units (2,524 ) 0 0 (2,524 ) Net income 0 0 14,136 14,136 Other comprehensive loss 0 (98 ) 0 (98 ) Balance as of December 31, 2014 680,172 28,767 27 75,066 103,860 Common and capital stock issued 6,659 331 0 0 331 Stock-based compensation expense 5,151 0 0 5,151 Stock-based compensation tax benefits 815 0 0 815 Tax withholding related to vesting of restricted stock units (1,954 ) 0 0 (1,954 ) Alphabet share exchange (687,684 ) 0 0 0 0 Capital transactions with Alphabet (2,272 ) 0 0 (2,272 ) Adjustment Payment to Class C capital stockholders 853 475 0 (522 ) (47 ) Net income 0 0 16,348 16,348 Other comprehensive loss 0 (1,901 ) 0 (1,901 ) Balance as of December 31, 2015 0 $ 31,313 $ (1,874 ) $ 90,892 $ 120,331 See accompanying notes. 56 Table of Contents Alphabet Inc. and Google Inc. Google Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2013 2014 2015 Operating activities Net income $ 12,733 $ 14,136 $ 16,348 Adjustments: Depreciation and impairment of property and equipment 2,781 3,523 4,132 Amortization and impairment of intangible assets 1,158 1,456 931 Stock-based compensation expense 3,343 4,279 5,203 Excess tax benefits from stock-based award activities (481 ) (648 ) (548 ) Deferred income taxes (437 ) (104 ) (179 ) Gain on divestiture of business (700 ) (740 ) 0 (Gain) loss on marketable and non-marketable investments, net (166 ) (390 ) 334 Other 272 192 212 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable (1,307 ) (1,641 ) (2,094 ) Income taxes, net 588 591 (179 ) Prepaid revenue share, expenses and other assets (930 ) 459 (318 ) Accounts payable 605 436 203 Accrued expenses and other liabilities 713 757 1,597 Accrued revenue share 254 245 339 Deferred revenue 233 (175 ) 43 Net cash provided by operating activities 18,659 22,376 26,024 Investing activities Purchases of property and equipment (7,358 ) (10,959 ) (9,915 ) Purchases of marketable securities (45,444 ) (56,310 ) (74,368 ) Maturities and sales of marketable securities 38,314 51,315 62,905 Purchases of non-marketable investments (569 ) (1,227 ) (2,172 ) Cash collateral related to securities lending (299 ) 1,403 (350 ) Investments in reverse repurchase agreements 600 (775 ) 425 Proceeds from divestiture of business 2,525 386 0 Acquisitions, net of cash acquired, and purchases of intangibles and other assets (1,448 ) (4,888 ) (236 ) Net cash used in investing activities (13,679 ) (21,055 ) (23,711 ) Financing activities Net payments related to stock-based award activities (781 ) (2,069 ) (1,612 ) Excess tax benefits from stock-based award activities 481 648 548 Adjustment Payment to Class C capital stockholders 0 0 (47 ) Capital transactions with Alphabet 0 0 (2,543 ) Proceeds from issuance of debt, net of costs 10,768 11,625 13,705 Repayments of debt (11,325 ) (11,643 ) (13,728 ) Net cash used in financing activities (857 ) (1,439 ) (3,677 ) Effect of exchange rate changes on cash and cash equivalents (3 ) (433 ) (434 ) Net increase (decrease) in cash and cash equivalents 4,120 (551 ) (1,798 ) Cash and cash equivalents at beginning of period 14,778 18,898 18,347 Cash and cash equivalents at end of period $ 18,898 $ 18,347 $ 16,549 Supplemental disclosures of cash flow information Cash paid for taxes $ 1,932 $ 2,819 $ 3,338 Cash paid for interest 72 86 96 See accompanying notes. 57 Table of Contents Alphabet Inc. and Google Inc. Alphabet Inc. and Google Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations We were incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. We generate revenues primarily by delivering relevant, cost-effective online advertising. On April 17, 2013, we sold the Motorola Home business (Motorola Home) to Arris Group, Inc. (Arris). The financial results of Motorola Home are presented as net income (loss) from discontinued operations on the Consolidated Statements of Income for the year ended December 31, 2013. See Note 9 for further discussion of the sale. On April 2, 2014, we completed a two -for-one stock split effected in the form of a stock dividend (the Stock Split). All references made to share or per share amounts in the accompanying consolidated financial statements and applicable disclosures have been retroactively adjusted to reflect the Stock Split. See Note 12 for additional information about the Stock Split. On October 29, 2014, we sold the Motorola Mobile business (Motorola Mobile) to Lenovo Group Limited (Lenovo). The financial results of Motorola Mobile are presented as net income (loss) from discontinued operations on the Consolidated Statements of Income for the years ended December 31, 2013 and 2014. See Note 9 for further discussion of the sale. On August 10, 2015, we announced plans to create a new public holding company, Alphabet Inc. (Alphabet), and a new operating structure. On October 2, 2015, we implemented the holding company reorganization, and as a result, Alphabet became the successor issuer to Google Inc. (Google). The implementation of the holding company reorganization on October 2, 2015 was accounted for as a merger under common control. Alphabet has recognized the assets and liabilities of Google at carryover basis. The consolidated financial statements of Alphabet present comparative information for prior years on a combined basis, as if both Alphabet and Google were under common control for all periods presented. The consolidated financial statements and notes thereto are being presented in a combined report being filed by two separate registrants: Alphabet and Google. The Consolidated Statements of Stockholders’ Equity and Consolidated Statements of Cash Flows are the only statements with differences between Alphabet and Google.  The differences relate to transactions between Alphabet and Google which are accounted for as capital transactions. Refer to Note 13 for additional information. Basis of Consolidation The consolidated financial statements of Alphabet and Google include the accounts of Alphabet and Google, respectively, and all wholly owned subsidiaries as well as all variable interest entities where we are the primary beneficiary. All intercompany balances and transactions have been eliminated. Use of Estimates The preparation of consolidated financial statements in conformity with U.S. Generally Accepted Accounting Principles (GAAP) requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. 58 Table of Contents Alphabet Inc. and Google Inc. Revenue Recognition The following table presents our revenues by segment and revenue source (in millions): Year Ended December 31, 2013 2014 2015 Google segment Google websites $ 37,422 $ 45,085 $ 52,357 Google Network Members' websites (1) 13,650 14,539 15,033 Google advertising revenues 51,072 59,624 67,390 Google other revenues (1) 4,435 6,050 7,151 Google segment revenues $ 55,507 $ 65,674 $ 74,541 Other Bets Other Bets revenues $ 12 $ 327 $ 448 Consolidated revenues $ 55,519 $ 66,001 $ 74,989 (1) Prior period amounts have been adjusted to reflect the reclassification primarily related to DoubleClick ad serving software revenues from Google other revenues to Advertising Revenues from Google Network Members' websites to conform with current period presentation. We generate revenues primarily by delivering performance and brand advertising. Performance advertising creates and delivers relevant ads that users will click, leading to direct engagement with advertisers. Brand advertising enhances users’ awareness of and affinity with advertisers’ products and services, through videos, text, images, and other ads that run across various devices. Google AdWords is our auction-based advertising program that enables performance advertisers to place text-based and display ads on Google websites and our Google Network Members’ websites. Google AdSense refers to the online programs through which we distribute our advertisers’ AdWords ads for display on our Google Network Members’ websites. Most of our customers pay us on a cost-per-click basis, which means that an advertiser pays us only when a user engages with the ads by clicking on an ad on Google websites or Google Network Members' websites or by viewing YouTube engagement ads like TrueView (counted as an engagement when the user chooses not to skip the ad). We also offer advertising on a cost-per-impression basis that enables our brand advertisers to pay us based on the number of times their ads display on Google websites and our Google Network Members’ websites as specified by the advertisers. Revenue from advertising is recognized when the services have been provided or delivered, the fees we charge are fixed or determinable, we and our advertisers or other customers understand the specific nature and terms of the agreed upon transactions, and collectability is reasonably assured. We recognize as revenues the fees charged to advertisers each time a user clicks on one of the ads that appears next to the search results or content on Google websites or our Google Network Members’ websites. For those advertisers using our cost-per-impression pricing, we recognize as revenues the fees charged to advertisers each time their ads are displayed on Google websites or our Google Network Members’ websites. We report our Google AdSense revenues and traffic acquisition costs due to our Google Network Members on a gross basis principally because we are the primary obligor to our advertisers. Revenue from hardware sales to end customers or through distribution channels is generally recognized when products have been shipped, risk of loss has transferred to the customer, objective evidence exists that customer acceptance provisions have been met, no significant obligations remain and allowances for discounts, price protection, returns and customer incentives can be reasonably and reliably estimated. Revenues are reported net of these allowances. Where these allowances cannot be reasonably and reliably estimated, we recognize revenue at the time the product sells through the distribution channel to the end customer or when the return period elapsed, as applicable. For the sale of certain third-party products and services, we evaluate whether it is appropriate to recognize revenue based on the gross amount billed to the customers or the net amount earned as revenue share. Generally, when we record revenue on a gross basis, we are the primary obligor in a transaction, and have also considered other factors, including whether we are subject to inventory risk or have latitude in establishing prices. For multi-element arrangements, including those that contain software essential to hardware products’ functionality and services, we allocate revenue to each unit of accounting based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling prices to be used for allocating revenue: (i) vendor-specific objective 59 Table of Contents Alphabet Inc. and Google Inc. evidence of fair value (VSOE), (ii) third-party evidence of selling price, and (iii) best estimate of the selling price (ESP). VSOE generally exists only when we sell the deliverable separately and is the price actually charged by us for that deliverable. ESPs reflect our best estimates of what the selling price of the deliverable would be if it was sold regularly on a stand-alone basis. We record deferred revenues when cash payments are received in advance of our performance in the underlying agreement on the accompanying Consolidated Balance Sheets. Cost of Revenues Cost of revenues consists of traffic acquisition costs which are the advertising revenues shared with our Google Network Members and the amounts paid to our distribution partners who distribute our browser or otherwise direct search queries to our website. Additionally, other costs of revenues includes the following: • The expenses associated with the operation of our data centers (including depreciation, labor, energy, and bandwidth costs); • Content acquisition costs primarily related to payments to certain content providers from whom we license their video and other content for distribution on YouTube and Google Play (we share most of the fees these sales generate with content providers or pay a fixed fee to these content providers); • Credit card and other transaction fees related to processing customer transactions; • Stock-based compensation expense; • Revenue share payments to mobile carriers; • Inventory costs for hardware we sell; and • Amortization of certain intangible assets. Stock-based Compensation Restricted stock units (RSUs) are measured based on the fair market value of the underlying stock on the date of grant. Shares are issued on the vesting dates net of the minimum statutory tax withholding to be paid by us on behalf of our employees. As a result, the actual number of shares issued will be fewer than the actual number of RSUs outstanding. We record the liability for withholding amounts to be paid by us primarily as a reduction to additional paid-in capital when paid. For stock option awards, we determined fair value using the Black-Scholes-Merton (BSM) option pricing model on the date of grant . Stock-based compensation includes awards we expect to settle in Alphabet stock as well as awards we will ultimately settle in cash. We recognize stock-based compensation, less an estimate for forfeitures, using the straight-line method over the requisite service period. Additionally, stock-based compensation for liability classified awards reflect changes in fair value during the requisite service period. We include as part of cash flows from financing activities the benefits of tax deductions in excess of the tax-effected compensation of the related stock-based awards for options exercised and RSUs vested during the period. During the years ended December 31, 2013 , 2014 , and 2015 , the amount of cash received from the exercise of stock options was $1,174 million , $465 million , and $393 million , respectively. We have elected to account for the indirect effects of stock-based awards -- primarily the research and development tax credit -- through the Consolidated Statements of Income. Total direct tax benefit realized, including the excess tax benefit, from stock-based award activities during the years ended December 31, 2013 , 2014 , and 2015 , was $1,195 million , $1,356 million , and $1,544 million , respectively. Certain Risks and Concentrations Our revenues are primarily derived from online advertising, the market for which is highly competitive and rapidly changing. In addition, our revenues are generated from a multitude of vertical market segments in countries around the world. Significant changes in this industry or changes in customer buying or advertiser spending behavior could adversely affect our operating results. We are subject to concentrations of credit risk principally from cash and cash equivalents, marketable securities, foreign exchange contracts, and accounts receivable. Cash equivalents and marketable securities consist primarily of time deposits, money market and other funds, including cash collateral received related to our securities lending program, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments and municipalities in the U.S., corporate securities, agency mortgage-backed securities, and asset-backed securities. Foreign exchange contracts are transacted with various financial institutions with high credit standing. 60 Table of Contents Alphabet Inc. and Google Inc. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. In 2013 , 2014 , and 2015 , we generated approximately 46% , 45% , and 46% of our revenues from customers based in the U.S., with the majority of revenues from customers outside of the U.S. located in Europe and Japan. We perform ongoing evaluations to determine customer credit and we limit the amount of credit we extend, but generally we do not require collateral from our customers. We maintain reserves for estimated credit losses and these losses have generally been within our expectations. No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2013 , 2014 , or 2015 . Fair Value of Financial Instruments Our financial assets and financial liabilities that include cash equivalents, marketable securities, foreign currency and interest rate derivative contracts, and non-marketable debt securities are measured and recorded at fair value on a recurring basis. We measure certain financial assets at fair value for disclosure purposes, as well as, on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. Our other current financial assets and our other current financial liabilities have fair values that approximate their carrying value. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Include other inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash, Cash Equivalents, and Marketable Securities We invest all excess cash primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, agency mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. We classify all investments that are readily convertible to known amounts of cash and have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities. We determine the appropriate classification of our investments in marketable securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these securities prior to their stated maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities in the accompanying Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for unrealized losses determined to be other-than-temporary, which we record within other income (expense), net. We determine any realized gains or losses on the sale of marketable securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Non-Marketable Investments We have accounted for non-marketable equity investments either under the equity or cost method. Investments through which we exercise significant influence but do not have control over the investee are accounted for under the equity method. Investments through which we are not able to exercise significant influence over the investee are accounted for under the cost method. 61 Table of Contents Alphabet Inc. and Google Inc. We have accounted for our non-marketable investments that meet the definition of a debt security as available-for-sale securities. Since these securities do not have contractual maturity dates and we do not intend to liquidate them in the next 12 months, we have classified them as non-current assets on the accompanying Consolidated Balance Sheet. Variable Interest Entities We make a determination at the start of each arrangement whether an entity in which we have made an investment is considered a Variable Interest Entity (“VIE”). We consolidate VIEs in which we have a controlling financial interest. If we do not have a controlling financial interest in a VIE, we account for the investment under either the equity or cost method. Impairment of Marketable and Non-Marketable Investments We periodically review our marketable and non-marketable investments for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as other income (expense), net. Accounts Receivable We record accounts receivable at the invoiced amount and we normally do not charge interest. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables. We review the accounts receivable by amounts due by customers which are past due to identify specific customers with known disputes or collectability issues. In determining the amount of the reserve, we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. We also maintain a sales allowance to reserve for potential credits issued to customers. We determine the amount of the reserve based on historical credits issued. Property and Equipment We account for property and equipment at cost less accumulated depreciation and amortization. We compute depreciation using the straight-line method over the estimated useful lives of the assets, generally two to five years. We depreciate buildings over periods up to 25 years. We amortize leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed in service for our intended use. Depreciation for equipment commences once it is placed in service and depreciation for buildings and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Business Combinations We include the results of operations of the businesses that we acquire as of the respective dates of acquisition. We allocate the fair value of the purchase price of our acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the fair value of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. Long-Lived Assets Including Goodwill and Other Acquired Intangible Assets We review property and equipment, long-term prepayments and intangible assets, excluding goodwill, for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be 62 Table of Contents Alphabet Inc. and Google Inc. recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the assets are considered to be impaired, the impairment to be recognized equals the amount by which the carrying value of the asset exceeds its fair market value. In 2014, we recorded impairments of intangible assets, including an impairment of $378 million in the third quarter of 2014 related to a patent licensing royalty asset. Impairments of intangible assets were not material in 2015. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. No goodwill impairment has been identified in any of the years presented. Intangible assets with definite lives are amortized over their estimated useful lives. We amortize our acquired intangible assets on a straight-line basis with definite lives over periods ranging from one to twelve years. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more-likely-than-not that they will not be realized. We recognize the financial statement effects of a tax position when it is more-likely-than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Foreign Currency Generally, the functional currency of our international subsidiaries is the local currency. We translate the financial statements of these subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in accumulated other comprehensive income as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange losses in other income (expense), net. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2013 , 2014 and 2015 , advertising and promotional expenses totaled approximately $2,389 million , $3,004 million , and $3,186 million . Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09 (ASU 2014-09) "Revenue from Contracts with Customers." ASU 2014-09 supersedes the revenue recognition requirements in “Revenue Recognition (Topic 605)”, and requires entities to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. As currently issued and amended, ASU 2014-09 is effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period, though early adoption is permitted for annual reporting periods beginning after December 15, 2016. We are currently in the process of evaluating the impact of the adoption of ASU 2014-09 on our consolidated financial statements, implementing accounting system changes related to the adoption, and considering additional disclosure requirements. In June 2014, the FASB issued Accounting Standards Update No. 2014-10 (ASU 2014-10) "Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation." ASU 2014-10 removes the definition of a development stage entity from the Master Glossary of the Accounting Standards Codification (ASC) thereby removing the financial reporting distinction between development stage entities and other reporting entities. The additional elimination of related consolidation guidance will require companies with interests in development stage entities to reassess whether such entities are variable interest entities under ASC Topic 810, Consolidation. We will adopt this standard in the first quarter 63 Table of Contents Alphabet Inc. and Google Inc. of 2016 on a retrospective basis. We do not expect the adoption of this standard to have a material impact on our consolidated financial statements. In February 2015, the FASB issued Accounting Standards Update No. 2015-02 (ASU 2015-02) "Consolidation (Topic 810): Amendments to the Consolidation Analysis." ASU 2015-02 changes the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. We will adopt this standard in the first quarter of 2016 on a retrospective basis. We do not expect the adoption of this standard to have a material impact on our consolidated statement of operations or consolidated balance sheet, but it may result in additional disclosures. In November 2015, the FASB issued Accounting Standards Update No. 2015-17 (ASU 2015-17) “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes”.  ASU 2015-17 simplifies the presentation of deferred income taxes by eliminating the separate classification of deferred income tax liabilities and assets into current and noncurrent amounts in the consolidated balance sheet statement of financial position. The amendments in the update require that all deferred tax liabilities and assets be classified as noncurrent in the consolidated balance sheet. The amendments in this update are effective for annual periods beginning after December 15, 2016, and interim periods therein and may be applied either prospectively or retrospectively to all periods presented. Early adoption is permitted. We have early adopted this standard in the fourth quarter of 2015 on a retrospective basis. Prior periods have been retrospectively adjusted. As a result of the adoption of ASU 2015-17, the Company made the following adjustments to the 2014 balance sheet: a $1,322 million decrease to current deferred tax assets, a $83 million increase to noncurrent deferred tax asset, a $26 million decrease to current deferred tax liability, and a decrease of $1,213 million to noncurrent deferred tax liability. In January 2016, the FASB issued Accounting Standards Update No. 2016-01 (ASU 2016-01) "Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities." ASU 2016-01 amends various aspects of the recognition, measurement, presentation, and disclosure for financial instruments. With respect to our consolidated financial statements, the most significant impact relates to the accounting for equity investments. It will impact the disclosure and presentation of financial assets and liabilities. ASU 2016-01 is effective for annual reporting periods, and interim periods within those years beginning after December 15, 2017. Early adoption by public entities is permitted only for certain provisions. We are currently in the process of evaluating the impact of the adoption of this standard on our consolidated financial statements. Revision of Previously Issued Financial Statements In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015 in the cumulative amount of $711 million . We evaluated the materiality of the income tax expense impact quantitatively and qualitatively and concluded it was not material to any of the prior periods impacted and that correction of income tax expense as an out of period adjustment in the quarter ended June 30, 2015 would not be material to our consolidated financial statements for the year ending December 31, 2015. Consolidated revenues are not impacted. We elected to revise previously issued consolidated financial statements for the periods impacted. Refer to Note 17 for additional information. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. Note 2. Financial Instruments We classify our cash equivalents and marketable securities within Level 1 or Level 2 in the fair value hierarchy because we use quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. We classify our foreign currency and interest rate derivative contracts primarily within Level 2 in the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments. Cash, Cash Equivalents, and Marketable Securities The following tables summarize our cash, cash equivalents and marketable securities by significant investment categories as of December 31, 2014 and 2015 (in millions): 64 Table of Contents Alphabet Inc. and Google Inc. As of December 31, 2014 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Cash $ 9,863 $ 0 $ 0 $ 9,863 $ 9,863 $ 0 Level 1: Money market and other funds 2,532 0 0 2,532 2,532 0 U.S. government notes 15,320 37 (4 ) 15,353 1,128 14,225 Marketable equity securities 988 428 (64 ) 1,352 0 1,352 18,840 465 (68 ) 19,237 3,660 15,577 Level 2: Time deposits (1) 2,409 0 0 2,409 2,309 100 Money market and other funds (2) 1,762 0 0 1,762 1,762 0 Fixed-income bond funds (3) 385 0 (38 ) 347 0 347 U.S. government agencies 2,327 8 (1 ) 2,334 750 1,584 Foreign government bonds 1,828 22 (10 ) 1,840 0 1,840 Municipal securities 3,370 33 (6 ) 3,397 3 3,394 Corporate debt securities 11,499 114 (122 ) 11,491 0 11,491 Agency mortgage-backed securities 8,196 109 (42 ) 8,263 0 8,263 Asset-backed securities 3,456 1 (5 ) 3,452 0 3,452 35,232 287 (224 ) 35,295 4,824 30,471 Total $ 63,935 $ 752 $ (292 ) $ 64,395 $ 18,347 $ 46,048 As of December 31, 2015 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Cash $ 7,380 $ 0 $ 0 $ 7,380 $ 7,380 $ 0 Level 1: Money market and other funds 5,623 0 0 5,623 5,623 0 U.S. government notes 20,922 27 (48 ) 20,901 258 20,643 Marketable equity securities 692 155 0 847 0 847 27,237 182 (48 ) 27,371 5,881 21,490 Level 2: Time deposits (1) 3,223 0 0 3,223 2,012 1,211 Money market and other funds (2) 1,140 0 0 1,140 1,140 0 Fixed-income bond funds (3) 219 0 0 219 0 219 U.S. government agencies 1,367 2 (3 ) 1,366 0 1,366 Foreign government bonds 2,242 14 (23 ) 2,233 0 2,233 Municipal securities 3,812 47 (4 ) 3,855 0 3,855 Corporate debt securities 13,809 53 (278 ) 13,584 136 13,448 Agency mortgage-backed securities 9,680 48 (57 ) 9,671 0 9,671 Asset-backed securities 3,032 0 (8 ) 3,024 0 3,024 38,524 164 (373 ) 38,315 3,288 35,027 Total $ 73,141 $ 346 $ (421 ) $ 73,066 $ 16,549 $ 56,517 (1) The majority of our time deposits are foreign deposits. (2) The balances as of December 31, 2014 and 2015 were related to cash collateral received in connection with our securities lending program, which was invested in reverse repurchase agreements maturing within three months. See section titled "Securities Lending Program" below for further discussion of this program. (3) Fixed-inco me bond funds consist of mutual funds that primarily invest in corporate and government bonds. We determine realized gains or losses on the marketable securities on a specific identification method. We recognized gross realized gains of $416 million , $238 million , and $357 million for the years ended December 31, 65 Table of Contents Alphabet Inc. and Google Inc. 2013, 2014, and 2015. We recognized gross realized losses of $258 million , $85 million , and $565 million for the years ended December 31, 2013, 2014, and 2015. We reflect these gains and losses as a component of other income (expense), net, in the accompanying Consolidated Statements of Income. The following table summarizes the estimated fair value of our investments in marketable debt securities, accounted for as available-for-sale securities and classified by the contractual maturity date of the securities (in millions): As of December 31, 2015 Due in 1 year $ 7,900 Due in 1 year through 5 years 30,141 Due in 5 years through 10 years 7,199 Due after 10 years 10,211 Total $ 55,451 The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2014 and 2015 , aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2014 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. government notes $ 4,490 $ (4 ) $ 0 $ 0 $ 4,490 $ (4 ) U.S. government agencies 830 (1 ) 0 0 830 (1 ) Foreign government bonds 255 (7 ) 43 (3 ) 298 (10 ) Municipal securities 877 (3 ) 174 (3 ) 1,051 (6 ) Corporate debt securities 5,851 (112 ) 225 (10 ) 6,076 (122 ) Agency mortgage-backed securities 609 (1 ) 2,168 (41 ) 2,777 (42 ) Asset-backed securities 2,388 (4 ) 174 (1 ) 2,562 (5 ) Fixed-income bond funds 347 (38 ) 0 0 347 (38 ) Marketable equity securities 690 (64 ) 0 0 690 (64 ) Total $ 16,337 $ (234 ) $ 2,784 $ (58 ) $ 19,121 $ (292 ) As of December 31, 2015 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. government notes $ 13,757 $ (48 ) $ 0 $ 0 $ 13,757 $ (48 ) U.S. government agencies 864 (3 ) 0 0 864 (3 ) Foreign government bonds 885 (18 ) 36 (5 ) 921 (23 ) Municipal securities 1,116 (3 ) 41 (1 ) 1,157 (4 ) Corporate debt securities 9,192 (202 ) 784 (76 ) 9,976 (278 ) Agency mortgage-backed securities 5,783 (34 ) 721 (23 ) 6,504 (57 ) Asset-backed securities 2,508 (7 ) 386 (1 ) 2,894 (8 ) Total $ 34,105 $ (315 ) $ 1,968 $ (106 ) $ 36,073 $ (421 ) During the years ended December 31, 2013 and 2014 , we did not recognize any other-than-temporary impairment loss. During the year ended December 31, 2015 , we recognized $281 million of other-than-temporary impairment losses related to our marketable equity securities and fixed-income bond funds. Those losses are included in gains (losses) on marketable securities, net as a component of other income (expense), net, in the accompanying Consolidated Statements of Income. See Note 10 for further details on other income (expense), net. Securities Lending Program 66 Table of Contents Alphabet Inc. and Google Inc. From time to time, we enter into securities lending agreements with financial institutions to enhance investment income. We loan certain securities which are collateralized in the form of cash or securities. Cash collateral is usually invested in reverse repurchase agreements which are collateralized in the form of securities. We classify loaned securities as cash equivalents or marketable securities and record the cash collateral as an asset with a corresponding liability in the accompanying Consolidated Balance Sheets. We classify reverse repurchase agreements maturing within three months as cash equivalents and those longer than three months as receivable under reverse repurchase agreements in the accompanying Consolidated Balance Sheets. For security collateral received, we do not record an asset or liability except in the event of counterparty default. Our securities lending transactions were accounted for as secured borrowings with significant investment categories as follows (in millions): As of December 31, 2015 Remaining Contractual Maturity of the Agreements Securities Lending Transactions Overnight and Continuous Up to 30 days 30 - 90 Days Greater Than 90 Days Total U.S. government notes $ 1,322 $ 31 $ 0 $ 306 $ 1,659 U.S. government agencies 504 77 0 0 581 Corporate debt securities 188 0 0 0 188 Total $ 2,014 $ 108 $ 0 $ 306 $ 2,428 Gross amount of recognized liabilities for securities lending in offsetting disclosure $ 2,428 Amounts related to agreements not included in securities lending in offsetting disclosure $ 0 Derivative Financial Instruments We recognize derivative instruments as either assets or liabilities in the accompanying Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the accompanying Consolidated Statements of Income as other income (expense), net, as part of revenues, or as a component of accumulated other comprehensive income (AOCI) in the accompanying Consolidated Balance Sheets, as discussed below. We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. We use certain interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and debt. Our program is not used for trading or speculative purposes. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further reduce credit risk, we enter into collateral security arrangements under which the counterparty is required to provide collateral when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We can take possession of the collateral in the event of counterparty default. As of December 31, 2014 and 2015 , we received cash collateral related to the derivative instruments under our collateral security arrangements of $268 million and $192 million . Cash Flow Hedges We use options designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. The notional principal of these contracts was approximately $13.6 billion and $16.4 billion as of December 31, 2014 and 2015 . These foreign exchange contracts have maturities of 36 months or less. In 2012, we entered into forward-starting interest rate swaps with a total notional amount of $1.0 billion and terms calling for us to receive interest at a variable rate and to pay interest at a fixed rate, that effectively locked in an interest rate on our anticipated debt issuance of $1.0 billion in 2014. We issued $1.0 billion of unsecured senior notes in February 2014 (See details in Note 4 ). As a result, we terminated the forward-starting interest rate swaps upon the debt issuance. The cash gain associated with the termination is reported within Operating Activities in the Consolidated Statement of Cash Flows for the year ended December 31, 2014, consistent with the impact of the hedged item. We reflect gain or loss on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify cumulative gains and losses to revenues or interest expense when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI would be immediately reclassified to other income (expense), net. Further, we exclude the change in the time value of the options from our 67 Table of Contents Alphabet Inc. and Google Inc. assessment of hedge effectiveness. We record the premium paid or time value of an option on the date of purchase as an asset. Thereafter, we recognize changes to this time value in other income (expense), net. As of December 31, 2015 , the effective portion of our cash flow hedges before tax effect was $375 million , of which $293 million is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. We exclude changes in the time value for forward contracts from the assessment of hedge effectiveness. The notional principal of these contracts was $1.5 billion and $1.8 billion as of December 31, 2014 and 2015 . We use interest rate swaps designated as fair value hedges to hedge interest rate risk for certain fixed rate securities. The notional principal of these contracts was $175 million and $295 million as of December 31, 2014 and 2015 . Gains and losses on these forward contracts and interest rate swaps are recognized in other income (expense), net, along with the offsetting losses and gains of the related hedged items. Other Derivatives Other derivatives not designated as hedging instruments consist of forward and option contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts, as well as the related costs in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. The notional principal of foreign exchange contracts outstanding was $6.2 billion and $7.5 billion as of December 31, 2014 and 2015 . We also use exchange-traded interest rate futures contracts and “To Be Announced” (TBA) forward purchase commitments of mortgage-backed assets to hedge interest rate risks on certain fixed income securities. The TBA contracts meet the definition of derivative instruments in cases where physical delivery of the assets is not taken at the earliest available delivery date. Our interest rate futures and TBA contracts (together interest rate contracts) are not designated as hedging instruments. We recognize gains and losses on these contracts, as well as the related costs, in other income (expense), net. The gains and losses are generally economically offset by unrealized gains and losses in the underlying available-for-sale securities, which are recorded as a component of AOCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from AOCI into other income (expense), net. The total notional amounts of interest rate contracts outstanding were $150 million and $50 million as of December 31, 2014 and 2015 . 68 Table of Contents Alphabet Inc. and Google Inc. The fair values of our outstanding derivative instruments were as follows (in millions): As of December 31, 2014 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Prepaid revenue share, expenses and other assets, current and non-current $ 851 $ 0 $ 851 Interest rate contracts Prepaid revenue share, expenses and other assets, current and non-current 1 0 1 Total $ 852 $ 0 $ 852 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other current liabilities $ 0 $ 3 $ 3 Interest rate contracts Accrued expenses and other liabilities, current and non-current 1 0 1 Total $ 1 $ 3 $ 4 As of December 31, 2015 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Prepaid revenue share, expenses and other assets, current and non-current $ 626 $ 2 $ 628 Total $ 626 $ 2 $ 628 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other current liabilities $ 1 $ 13 $ 14 Interest rate contracts Accrued expenses and other liabilities, current and non-current 2 0 2 Total $ 3 $ 13 $ 16 69 Table of Contents Alphabet Inc. and Google Inc. The effect of derivative instruments in cash flow hedging relationships on income and other comprehensive income (OCI) is summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect (Effective Portion) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship 2013 2014 2015 Foreign exchange contracts $ 92 $ 929 $ 964 Interest rate contracts 86 (31 ) 0 Total $ 178 $ 898 $ 964 Gains Reclassified from AOCI into Income (Effective Portion) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship Location 2013 2014 2015 Foreign exchange contracts Revenues $ 95 $ 171 $ 1,399 Interest rate contracts Other income (expense), net 0 4 5 Total $ 95 $ 175 $ 1,404 Gains (Losses) Recognized in Income on Derivatives (Amount Excluded from  Effectiveness Testing and Ineffective Portion) (1) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship Location 2013 2014 2015 Foreign exchange contracts Other income (expense), net $ (280 ) $ (279 ) $ (297 ) Interest rate contracts Other income (expense), net 0 4 0 Total $ (280 ) $ (275 ) $ (297 ) (1) Gains (losses) related to the ineffective portion of the hedges were not material in all periods presented. The effect of derivative instruments in fair value hedging relationships on income is summarized below (in millions): Gains (Losses) Recognized in Income on Derivatives (2) Year Ended December 31, Derivatives in Fair Value Hedging Relationship Location 2013 2014 2015 Foreign Exchange Hedges: Foreign exchange contracts Other income (expense), net $ 16 $ 115 $ 170 Hedged item Other income (expense), net (25 ) (123 ) (176 ) Total $ (9 ) $ (8 ) $ (6 ) Interest Rate Hedges: Interest rate contracts Other income (expense), net $ 0 $ 0 $ (2 ) Hedged item Other income (expense), net 0 0 2 Total $ 0 $ 0 $ 0 (2) Losses related to the amount excluded from effectiveness testing of the hedges were $9 million , $8 million , and $6 million for the years ended December 31, 2013 , 2014 , and 2015 . 70 Table of Contents Alphabet Inc. and Google Inc. The effect of derivative instruments not designated as hedging instruments on income is summarized below (in millions): Gains (Losses) Recognized in Income on Derivatives Year Ended December 31, Derivatives Not Designated As Hedging Instruments Location 2013 2014 2015 Foreign exchange contracts Other income (expense), net, and net loss from discontinued operations $ 118 $ 237 $ 198 Interest rate contracts Other income (expense), net 4 2 1 Total $ 122 $ 239 $ 199 Offsetting of Derivatives, Securities Lending, and Reverse Repurchase Agreements We present our derivatives, securities lending and reverse repurchase agreements at gross fair values in the Consolidated Balance Sheets. However, our master netting and other similar arrangements allow net settlements under certain conditions. As of December 31, 2014 and 2015 , information related to these offsetting arrangements was as follows (in millions): Offsetting of Assets As of December 31, 2014 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 852 $ 0 $ 852 $ (1 ) (1) $ (251 ) $ (412 ) $ 188 Reverse repurchase agreements 2,637 0 2,637 (2) 0 0 (2,637 ) 0 Total $ 3,489 $ 0 $ 3,489 $ (1 ) $ (251 ) $ (3,049 ) $ 188 As of December 31, 2015 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 628 $ 0 $ 628 $ (13 ) (1) $ (189 ) $ (214 ) $ 212 Reverse repurchase agreements 1,590 0 1,590 (2) 0 0 (1,590 ) 0 Total $ 2,218 $ 0 $ 2,218 $ (13 ) $ (189 ) $ (1,804 ) $ 212 (1) The balances as of December 31, 2014 and 2015 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. (2) The balances as of December 31, 2014 and 2015 included $1,762 million and $1,140 million recorded in cash and cash equivalents, respectively, and $875 million and $450 million recorded in receivable under reverse repurchase agreements, respectively. 71 Table of Contents Alphabet Inc. and Google Inc. Offsetting of Liabilities As of December 31, 2014 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 4 $ 0 $ 4 $ (1 ) (3) $ 0 $ 0 $ 3 Securities lending agreements 2,778 0 2,778 0 0 (2,740 ) 38 Total $ 2,782 $ 0 $ 2,782 $ (1 ) $ 0 $ (2,740 ) $ 41 As of December 31, 2015 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 16 $ 0 $ 16 $ (13 ) (3) $ (3 ) $ 0 $ 0 Securities lending agreements 2,428 0 2,428 0 0 (2,401 ) 27 Total $ 2,444 $ 0 $ 2,444 $ (13 ) $ (3 ) $ (2,401 ) $ 27 (3) The balances as of December 31, 2014 and 2015 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 3. Non-Marketable Investments Our non-marketable investments include non-marketable equity investments and non-marketable debt securities. Non-Marketable Equity Investments Our non-marketable equity investments are investments we have made in privately-held companies accounted for under the equity or cost method and are not required to be consolidated under the variable interest or voting models. As of December 31, 2014 and 2015 , these investments accounted for under the equity method had a carrying value of approximately $1.3 billion and $1.6 billion , respectively, and those investments accounted for under the cost method had a carrying value of $1.8 billion and $2.6 billion , respectively. For investments accounted for under the cost method, the fair value was approximately $7.5 billion as of December 31, 2015 . The fair value of the cost method investments are primarily determined from data leveraging private-market transactions and are classified within Level 3 in the fair value hierarchy. We periodically review our non-marketable equity investments for impairment. No material impairments were recognized for the years ended December 31, 2013 , 2014 , and 2015 . Our share of gains and losses in equity method investments for the year ended December 31, 2015 was a net loss of approximately $227 million and not material for the years ended December 31, 2013 and 2014 . We reflect these losses as a component of other income (expense), net, in the accompanying Consolidated Statements of Income. We determined that certain renewable energy investments included in our non-marketable equity investments are VIEs. However, we do not consolidate these entities in our financial statements because we do not have the power to direct the activities of the VIE that most significantly impact the VIE's economic performance and account for those investments under the equity method. Our involvement with investments in renewable energy relate to our equity investments in entities whose activities involve power generation. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly impact the entity's economic performance such as setting operating budgets. The carrying value of our renewable energy investments accounted for under the equity method that are VIEs is $302 million as of December 31, 2015 with the maximum exposure of $316 million . The maximum exposure is based on current investments to date plus future funding commitments.  We have determined the single source of our exposure to these VIE’s is our capital investment in these entities. We periodically reassess whether we are the primary beneficiary of a VIE. The reassessment process considers whether we have acquired the power to direct the most significant activities of the VIE through changes in governing documents or other circumstances. We also reconsider whether entities previously determined not to be VIEs have become VIEs, based on changes in facts and circumstances including changes in contractual arrangements and capital structure. 72 Table of Contents Alphabet Inc. and Google Inc. Non-Marketable Debt Securities Our non-marketable debt securities are primarily preferred stock that are redeemable at our option and convertible notes issued by private companies. These debt securities do not have readily determinable market values and are categorized accordingly as Level 3 in the fair value hierarchy. To estimate the fair value of these securities, we use a combination of valuation methodologies, including market and income approaches based on prior transaction prices; estimated timing, probability, and amount of cash flows; and illiquidity considerations. Financial information of private companies may not be available and consequently we will estimate the value based on the best available information at the measurement date. We estimate a range of fair values based on valuation approaches noted above and as of December 31, 2014 and 2015 , the fair value recorded on the Consolidated Balance Sheets for individual investments is within the range. No material impairments were recognized for the years ended December 31, 2013 , 2014 , and 2015 . The following table presents a reconciliation for our assets measured and recorded at fair value on a recurring basis, using significant unobservable inputs (Level 3) (in millions): Level 3 Balance as of December 31, 2014 $ 90 Purchases, issuances, and settlements (1) 934 Balance as of December 31, 2015 $ 1,024 (1) Purchases of securities included our $900 million investment in SpaceX, a space exploration and space transport company, made during January 2015. Note 4. Debt Short-Term Debt We have a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2014 and 2015 , we had $2.0 billion of outstanding commercial paper recorded as short-term debt with a weighted-average interest rate of 0.1% and 0.2% , respectively. In conjunction with this program, we have a $3.0 billion revolving credit facility expiring in July 2016. The interest rate for the credit facility is determined based on a formula using certain market rates. As of December 31, 2014 and 2015 , we were in compliance with the financial covenant in the credit facility, and no amounts were outstanding under the credit facility as of December 31, 2014 and 2015 . The estimated fair value of the short-term debt approximated its carrying value as of December 31, 2014 and 2015 . 73 Table of Contents Alphabet Inc. and Google Inc. Long-Term Debt We issued $1.0 billion of unsecured senior notes (the "2014 Notes") in February 2014 and $3.0 billion of unsecured senior notes in three tranches (collectively, the "2011 Notes") in May 2011. We used the net proceeds from the issuance of the 2011 Notes to repay a portion of our outstanding commercial paper and for general corporate purposes. We used the net proceeds from the issuance of the 2014 Notes for the repayment of the portion of the principal amount of our 2011 Notes which matured on May 19, 2014 and for general corporate purposes. The total outstanding Notes are summarized below (in millions): As of December 31, 2014 As of December 31, 2015 Short-Term Portion of Long-Term Debt 2.125% Notes due on May 19, 2016 $ 0 $ 1,000 Capital Lease Obligation 10 225 Total Short-Term Portion of Long-Term Debt $ 10 $ 1,225 Long-Term Debt 2.125% Notes due on May 19, 2016 $ 1,000 $ 0 3.625% Notes due on May 19, 2021 1,000 1,000 3.375% Notes due on February 25, 2024 1,000 1,000 Unamortized discount for the Notes above (8 ) (5 ) Subtotal 2,992 1,995 Capital Lease Obligation 236 0 Total Long-Term Debt $ 3,228 $ 1,995 The effective interest yields of the Notes due in 2016, 2021, and 2024 were 2.241% , 3.734% , and 3.377% , respectively. Interest on the 2011 and 2014 Notes is payable semi-annually. The 2011 and 2014 Notes rank equally with each other and with all of our other senior unsecured and unsubordinated indebtedness from time to time outstanding. We may redeem the 2011 and 2014 Notes at any time in whole or in part at specified redemption prices. We are not subject to any financial covenants under the 2011 Notes or the 2014 Notes. The total estimated fair value of the 2011 and 2014 Notes was approximately $3.1 billion at both December 31, 2014 and 2015 . The fair value of the outstanding 2011 and 2014 Notes was determined based on observable market prices in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. In August 2013, we entered into a capital lease obligation on certain property expiring in 2028. We intend to exercise the option to purchase the property in 2016, and as such the long term portion of the capital lease obligation was reclassified as short term. The effective rate of the capital lease obligation approximates the market rate. The estimated fair value of the capital lease obligation approximated its carrying value as of December 31, 2014 and 2015 . As of December 31, 2015 , aggregate future principal payments for long-term debt (including short-term portion of long-term debt) and capital lease obligation were as follows (in millions): Years Ending 2016 $ 1,225 2017 0 2018 0 2019 0 Thereafter 2,000 Total $ 3,225 In January 2016, the board of directors of Alphabet authorized the company to issue up to $5.0 billion of commercial paper from time to time and to enter into a $4.0 billion revolving credit facility to replace Google's existing $3.0 billion revolving credit facility. 74 Table of Contents Alphabet Inc. and Google Inc. Note 5. Balance Sheet Components Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2014 As of December 31, 2015 Land and buildings $ 13,326 $ 16,518 Information technology assets 10,918 13,645 Construction in progress 6,555 7,324 Leasehold improvements 1,868 2,576 Furniture and fixtures 79 83 Property and equipment, gross 32,746 40,146 Less: accumulated depreciation and amortization (8,863 ) (11,130 ) Property and equipment, net $ 23,883 $ 29,016 Property under capital lease with a cost basis of $258 million was included in land and buildings as of December 31, 2015 . Prepaid Revenue Share, Expenses and Other Assets, Non-Current Note Receivable In connection with the sale of our Motorola Mobile business on October 29, 2014 (see Note 9 for additional information), we received an interest-free, three -year prepayable promissory note (the "Note Receivable") due October 2017 from Lenovo. The Note Receivable is included in prepaid revenue share, expenses and other assets, non-current, on our Consolidated Balance Sheets. Based on the general market conditions and the credit quality of Lenovo, we discounted the Note Receivable at an effective interest rate of 4.5% . The outstanding balances are shown in the table below (in millions): As of December 31, 2014 As of December 31, 2015 Principal of the Note Receivable $ 1,500 $ 1,448 Less: unamortized discount for the Note Receivable (175 ) (112 ) Total $ 1,325 $ 1,336 As of December 31, 2014 and 2015 , we did not recognize a valuation allowance on the Note Receivable. Accumulated Other Comprehensive Income The components of AOCI, net of tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains on Cash Flow Hedges Total Balance as of December 31, 2012 $ (73 ) $ 604 $ 7 $ 538 Other comprehensive income (loss) before reclassifications 89 (392 ) 112 (191 ) Amounts reclassified from AOCI 0 (162 ) (60 ) (222 ) Other comprehensive income (loss) 89 (554 ) 52 (413 ) Balance as of December 31, 2013 $ 16 $ 50 $ 59 $ 125 75 Table of Contents Alphabet Inc. and Google Inc. Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains on Cash Flow Hedges Total Balance as of December 31, 2013 $ 16 $ 50 $ 59 $ 125 Other comprehensive income (loss) before reclassifications (996 ) 505 651 160 Amounts reclassified from AOCI 0 (134 ) (124 ) (258 ) Other comprehensive income (loss) (996 ) 371 527 (98 ) Balance as of December 31, 2014 $ (980 ) $ 421 $ 586 $ 27 Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains on Cash Flow Hedges Total Balance as of December 31, 2014 $ (980 ) $ 421 $ 586 $ 27 Other comprehensive income (loss) before reclassifications (1,067 ) (715 ) 676 (1,106 ) Amounts reclassified from AOCI 0 208 (1,003 ) (795 ) Other comprehensive income (loss) (1,067 ) (507 ) (327 ) (1,901 ) Balance as of December 31, 2015 $ (2,047 ) $ (86 ) $ 259 $ (1,874 ) The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statement of Income Year Ended December 31, AOCI Components Location 2013 2014 2015 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ 158 $ 153 $ (208 ) Net Income (loss) from discontinued operations 43 0 0 Provision for income taxes (39 ) (19 ) 0 Net of tax $ 162 $ 134 $ (208 ) Unrealized gains on cash flow hedges Foreign exchange contracts Revenue $ 95 $ 171 $ 1,399 Interest rate contracts Other income (expense), net 0 4 5 Provision for income taxes (35 ) (51 ) (401 ) Net of tax $ 60 $ 124 $ 1,003 Total amount reclassified, net of tax $ 222 $ 258 $ 795 Note 6. Acquisitions 2015 Acquisitions bebop Technologies In December 2015, we completed the acquisition of bebop Technologies Inc. (bebop), a company with a cloud-based development platform focused on enterprise applications. The fair value of total consideration transferred in connection with the close was $272 million , of which $1 million was paid in cash and $271 million was paid in the form of Alphabet Class C capital stock. We issued a total of approximately 514 thousand shares of Alphabet Class C capital 76 Table of Contents Alphabet Inc. and Google Inc. stock in relation to this acquisition, part of which will be accounted for as compensation expense. The fair value of the shares of capital stock issued was determined based on the closing market price of Alphabet's Class C capital stock as of the close date. The Class C capital stock issued by Alphabet in connection with the acquisition was treated as a capital contribution from Alphabet to Google. We expect the acquisition will help us provide a new platform to build and maintain enterprise applications. As part of the acquisition, Diane Greene, the former CEO of bebop and a member of our Board of Directors, has joined Google. Of the total purchase price of $272 million , $28 million was cash acquired, $59 million was attributed to intangible assets, $206 million was attributed to goodwill, and $21 million was attributed to net liabilities assumed . The goodwill of $206 million is primarily attributable to the synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. Other Acquisitions During the year ended December 31, 2015 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $263 million . In aggregate, $4 million was cash acquired, $88 million was attributed to intangible assets, $138 million was attributed to goodwill, and $33 million was attributed to net assets acquired . These acquisitions generally enhance the breadth and depth of our offerings, as well as expanding our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $20 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all acquisitions and purchases completed during the year ended December 31, 2015 , patents and developed technology have a weighted-average useful life of 4.1 years, customer relationships have a weighted-average useful life of 4.0 years, and trade names and other have a weighted-average useful life of 6.8 years. 2014 Acquisitions Nest In February 2014, we completed the acquisition of Nest Labs, Inc. (Nest), a company whose mission is to reinvent devices in the home such as thermostats and smoke alarms. Prior to this transaction, we had an approximately 12% ownership interest in Nest. The acquisition is expected to enhance Google's suite of products and services and allow Nest to continue to innovate upon devices in the home, making them more useful, intuitive, and thoughtful, and to reach more users in more countries. Of the total $2.6 billion purchase price and the fair value of our previously held equity interest of $152 million , $51 million was cash acquired, $430 million was attributed to intangible assets, $2.3 billion was attributed to goodwill, and $84 million was attributed to net liabilities assumed . The goodwill of $2.3 billion is primarily attributable to synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. This transaction is considered a “step acquisition” under GAAP whereby our ownership interest in Nest held before the acquisition was remeasured to fair value at the date of the acquisition. Such fair value was estimated by using discounted cash flow valuation methodologies. Inputs used in the methodologies primarily included projected future cash flows, discounted at a rate commensurate with the risk involved. The gain of $103 million as a result of remeasurement is included in other income (expense), net, on our Consolidated Statements of Income for the year ended December 31, 2014. Dropcam In July 2014, Nest completed the acquisition of Dropcam, Inc. (Dropcam), a company that enables consumers and businesses to monitor their homes and offices via video, for approximately $517 million in cash. With Dropcam on board, Nest expects to continue to reinvent products that will help shape the future of the connected home. Of the total purchase price of $517 million , $11 million was cash acquired, $55 million was attributed to intangible assets, $452 million was attributed to goodwill, and $1 million was attributed to net liabilities assumed . The goodwill of $452 million is primarily attributable to synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. Skybox In August 2014, we completed the acquisition of Skybox Imaging, Inc. (Skybox), a satellite imaging company, for approximately $478 million in cash. We expect the acquisition to keep Google Maps accurate with up-to-date imagery and, over time, improve internet access and disaster relief. Of the total purchase price of $478 million , $6 million was cash acquired, $69 million was attributed to intangible assets, $388 million was attributed to goodwill, and $15 million 77 Table of Contents Alphabet Inc. and Google Inc. was attributed to net assets acquired . The goodwill of $388 million is primarily attributable to the synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. Other Acquisitions During the year ended December 31, 2014 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $1,466 million , which includes the fair value of our previously held equity interest of $33 million . In aggregate, $65 million was cash acquired, $405 million was attributed to intangible assets, $1,045 million was attributed to goodwill, and $49 million was attributed to net liabilities assumed . These acquisitions generally enhance the breadth and depth of our offerings, as well as expanding our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $55 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all acquisitions and purchases completed during the year ended December 31, 2014 , patents and developed technology have a weighted-average useful life of 5.1 years, customer relationships have a weighted-average useful life of 4.5 years, and trade names and other have a weighted-average useful life of 6.9 years. Note 7. Collaboration Agreement On September 18, 2013, we announced the formation of Calico, a life science company with a mission to harness advanced technologies to increase our understanding of the biology that controls lifespan. Calico's results of operations and statement of financial position are included in our consolidated financial statements. As of December 31, 2015 , Google has contributed $240 million to Calico in exchange for Calico convertible preferred units. As of December 31, 2015 , Google has also committed to fund an additional $490 million on an as-needed basis. In September 2014, AbbVie Inc. (AbbVie) and Calico announced a research and development collaboration intended to help both companies discover, develop, and bring to market new therapies for patients with age-related diseases, including neurodegeneration and cancer. As of December 31, 2015 , AbbVie has contributed $750 million to fund the collaboration pursuant to the agreement, which reflects its total commitment. As of December 31, 2015 , Calico has contributed $ 250 million and committed up to an additional $ 500 million . Calico will use its scientific expertise to establish a world-class research and development facility, with a focus on drug discovery and early drug development; and AbbVie will provide scientific and clinical development support and its commercial expertise to bring new discoveries to market. Both companies will share costs and profits equally. AbbVie's contribution has been recorded as a liability on Calico's financial statements, which is reduced and reflected as a reduction to research and development expense as eligible research and development costs are incurred by Calico over the next few years. Note 8. Goodwill and Other Intangible Assets Goodwill In conjunction with the Alphabet reorganization we are implementing a new operating structure. Consequently, beginning in the fourth quarter of 2015, we have multiple operating segments and reporting units, representing the individual businesses run separately under the Alphabet structure. Refer to Note 16 for further information. In conjunction with the changes to reporting units, we allocated goodwill to each reporting unit based on their relative fair values. The changes in the carrying amount of goodwill allocated to our disclosed segments for the years ended December 31, 2014 and 2015 were as follows (in millions): 78 Table of Contents Alphabet Inc. and Google Inc. Google Other Bets Total Consolidated Balance as of December 31, 2013 $ 11,492 $ — $ 11,492 Acquisitions 4,208 — 4,208 Dispositions (43 ) — (43 ) Foreign currency translation and other adjustments (58 ) — (58 ) Balance as of December 31, 2014 $ 15,599 $ — $ 15,599 Acquisitions 139 — 139 Foreign currency translation and other adjustments (71 ) — (71 ) Allocation in the fourth quarter of 2015 (416 ) 416 — Acquisitions 201 4 205 Foreign currency translation and other adjustments 4 (7 ) (3 ) Balance as of December 31, 2015 $ 15,456 $ 413 $ 15,869 Other Intangible Assets Information regarding our purchased intangible assets is as follows (in millions): As of December 31, 2014 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 6,547 $ 2,513 $ 4,034 Customer relationships 1,410 1,168 242 Trade names and other 696 365 331 Total $ 8,653 $ 4,046 $ 4,607 As of December 31, 2015 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 6,592 $ 3,213 $ 3,379 Customer relationships 1,343 1,201 142 Trade names and other 795 469 326 Total $ 8,730 $ 4,883 $ 3,847 Patents and developed technology, customer relationships, and trade names and other have weighted-average useful lives from the date of purchase of 7.8 years, 6.0 years, and 5.4 years, respectively. Amortization expense relating to our purchased intangible assets was $1,011 million , $1,079 million , and $892 million for the years ended December 31, 2013 , 2014 , and 2015 . During the year ended December 31, 2014, we recorded an impairment charge in other cost of revenues of $378 million related to a patent licensing royalty asset acquired in connection with the Motorola acquisition, which we retained subsequent to the sale of Motorola Mobile. The asset was determined to be impaired due to prolonged decreased royalty payments and unpaid interest owed and was written down to its fair value. Fair value was determined based on a discounted cash flow method and reflects estimated future cash flows associated with the patent licensing royalty asset at the measurement date and falls within level 3 in fair value hierarchy. Impairments of intangible assets were not material for the year ended December 31, 2015 . 79 Table of Contents Alphabet Inc. and Google Inc. As of December 31, 2015 , expected amortization expense for our purchased intangible assets for each of the next five years and thereafter was as follows (in millions): 2016 $ 806 2017 724 2018 637 2019 528 2020 434 Thereafter 718 $ 3,847 Note 9. Discontinued Operations Motorola Mobile On October 29, 2014, we closed the sale of the Motorola Mobile business to Lenovo for a total purchase price of approximately $2.9 billion , including $1.4 billion paid at close, comprised of $660 million in cash and $750 million in Lenovo ordinary shares ( 519.1 million shares). The remaining $1.5 billion was paid in the form of an interest-free, three -year prepayable promissory note. We maintain ownership of the vast majority of the Motorola Mobile patent portfolio, including pre-closing patent applications and invention disclosures, which we licensed to Motorola Mobile for its continued operations. Additionally, in connection with the sale, we agreed to indemnify Lenovo for certain potential liabilities of the Motorola Mobile business, for which we recorded an indemnification liability of $130 million . The sale resulted in a gain of $740 million , net of tax, which was presented as part of net income from discontinued operations in the Consolidated Statements of Income for the year ended December 31, 2014. Incremental to this net gain, we recognized additional income of $254 million , net of tax, in connection with certain IP licensing arrangements between the parties, included as part of net income from discontinued operations on the Consolidated Statements of Income for the year ended December 31, 2014. The financial results of Motorola Mobile through the date of divestiture are presented as net income (loss) from discontinued operations on the Consolidated Statements of Income. The following table presents financial results of the Motorola Mobile business included in net income (loss) from discontinued operations for the years ended December 31, 2013 and 2014 (in millions): Year Ended December 31, 2013 2014 (1) Revenues $ 4,306 $ 5,486 Loss from discontinued operations before income taxes (1,403 ) (177 ) Benefits from/(Provision for) income taxes 270 (47 ) Gain on disposal 0 740 Net (loss) income from discontinued operations $ (1,133 ) $ 516 (1) The operating results of Motorola Mobile were included in our Consolidated Statements of Income from January 1, 2014 through October 29, 2014, the date of divestiture. 80 Table of Contents Alphabet Inc. and Google Inc. The following table presents the aggregate carrying amounts of the major classes of assets and liabilities divested (in millions): Assets: Cash and cash equivalents $ 160 Accounts receivable 1,103 Inventories 217 Prepaid expenses and other current assets 357 Prepaid expenses and other assets, non-current 290 Property and equipment, net 542 Intangible assets, net 985 Goodwill 43 Total assets $ 3,697 Liabilities: Accounts payable $ 1,238 Accrued compensation and benefits 163 Accrued expenses and other current liabilities 10 Deferred revenue, current 165 Other long-term liabilities 250 Total liabilities $ 1,826 Motorola Home On April 17, 2013, we sold the Motorola Home business to Arris for consideration of approximately $2,412 million in cash, including cash of $2,238 million received at the date of close and certain post-close adjustments of $174 million received in the third quarter of 2013, and approximately $175 million in Arris' common stock ( 10.6 million shares). Subsequent to the transaction, we own approximately 7.8% of the outstanding shares of Arris. Additionally, in connection with the disposition, we agreed to indemnify Arris for potential liability from certain intellectual property infringement litigation, for which we recorded an indemnification liability of $175 million , the majority of which was settled subsequent to the disposition. The disposition resulted in a net gain of $757 million , which was presented as part of net income from discontinued operations in the Consolidated Statements of Income for the year ended December 31, 2013. The financial results of Motorola Home through the date of divestiture are presented as net income (loss) from discontinued operations on the Consolidated Statement of Income. The following table presents financial results of the Motorola Home business included in net income (loss) from discontinued operations for the year ended December 31, 2013 (in millions): Year Ended December 31, 2013 (1) Revenues $ 804 Loss from discontinued operations before income taxes (67 ) Benefits from income taxes 16 Gain on disposal 757 Net income from discontinued operations $ 706 (1) The operating results of Motorola Home were included in our Consolidated Statements of Income from January 1, 2013 through April 17, 2013, the date of divestiture. 81 Table of Contents Alphabet Inc. and Google Inc. The following table presents the aggregate carrying amounts of the major classes of assets and liabilities divested (in millions): Assets: Accounts receivable $ 424 Inventories 228 Deferred income taxes, net 144 Prepaid and other current assets 152 Property and equipment, net 282 Intangible assets, net 701 Other assets, non-current 182 Total assets $ 2,113 Liabilities: Accounts payable $ 169 Accrued expenses and other liabilities 289 Total liabilities $ 458 Note 10. Other Income (Expense), Net The components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2013 2014 2015 Interest income $ 766 $ 746 $ 999 Interest expense (81 ) (101 ) (104 ) Gain (loss) on marketable securities, net 158 153 (208 ) Foreign currency exchange losses, net (1) (379 ) (402 ) (422 ) Gain (loss) on non-marketable investments, net 8 237 (126 ) Loss on divestiture of businesses (2) (57 ) 0 0 Other 81 130 152 Other income (expense), net $ 496 $ 763 $ 291 (1) Our foreign currency exchange losses,net are related to the option premium costs and forward points for our foreign currency hedging contracts, our foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contract losses and gains. The net foreign currency transaction losses were $121 million , $107 million , and $123 million in 2013 , 2014 , and 2015 , respectively. (2) Gain on divestiture of Motorola Home business was included in net income (loss) from discontinued operations for the year ended December 31, 2013. Gain on divestiture of Motorola Mobile business was included in net income (loss) from discontinued operations for the year ended December 31, 2014. Note 11. Commitments and Contingencies Operating Leases We have entered into various non-cancelable operating lease agreements for certain of our offices, facilities, land, and data centers throughout the world with original lease periods expiring primarily between 2016 and 2063 . We are committed to pay a portion of the actual operating expenses under certain of these lease agreements. These operating expenses are not included in the table below. Certain of these arrangements have free or escalating rent payment provisions. We recognize rent expense under such arrangements on a straight-line basis. 82 Table of Contents Alphabet Inc. and Google Inc. As of December 31, 2015 , future minimum payments under non-cancelable operating leases, net of sublease income amounts, were as follows over each of the next five years and thereafter (in millions): Operating Leases Sub-lease Income Net Operating Leases 2016 672 26 646 2017 794 13 781 2018 796 4 792 2019 769 3 766 2020 719 3 716 Thereafter 3,706 1 3,705 Total minimum payments $ 7,456 $ 50 $ 7,406 Certain leases have adjustments for market provisions. Amounts in the above table represent our best estimates of future payments to be made under these leases. We entered into certain non-cancelable lease agreements with original lease periods expiring between 2021 and 2032 where we are the deemed owner for accounting purposes of new construction projects. Future minimum lease payments under such leases total approximately $678 million , of which $422 million is included on the Consolidated Balance Sheet as of December 31, 2015 . These amounts are presented as an asset and corresponding non-current liability, which represents our estimate of construction costs incurred to date. They have been excluded from the table above. Rent expense under operating leases, including co-location arrangements, was $465 million , $570 million , and $734 million in 2013 , 2014 , and 2015 . Purchase Obligations As of December 31, 2015 , we had $1.7 billion of other non-cancelable contractual obligations, primarily related to data center operations and facility build-outs, video and other content licensing revenue sharing arrangements, as well as certain inventory purchase commitments. Letters of Credit As of December 31, 2015 , we had unused letters of credit for $752 million . Indemnifications In the normal course of business, to facilitate transactions in our services and products, we indemnify certain parties, including advertisers, Google Network Members, and lessors with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2015 , we did not have any material indemnification claims that were probable or reasonably possible. As part of the sale of Motorola Home and Motorola Mobile businesses, we issued indemnifications for certain potential liabilities. Please see Note 9 for additional information. Legal Matters Antitrust Investigations On November 30, 2010, the European Commission's (EC) Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On April 15, 2015, the EC issued a Statement of 83 Table of Contents Alphabet Inc. and Google Inc. Objections (SO) regarding the display and ranking of shopping search results. The EC also opened a formal investigation into Android. We responded to the SO on August 27, 2015 and will continue to cooperate with the EC. The Comision Nacional de Defensa de la Competencia in Argentina, the Competition Commission of India (CCI), Brazil's Council for Economic Defense (CADE), the Canadian Competition Bureau (CCB), and the Federal Antimonopoly Service (FAS) of the Russian Federation have also opened investigations into certain of our business practices. In August 2015, we received the CCI Director General's report with interim findings of competition law infringements regarding search and ads. In September 2015, FAS found that there has been a competition law infringement in Android mobile distribution. We will respond to the CCI's report and have filed an appeal of the FAS decision. In July 2015, the Taiwan Fair Trade Commission informed us that it was closing its antitrust investigations of our business practices. The state attorney general from Mississippi issued subpoenas in 2011 and 2012 in an antitrust investigation of our business practices. We have responded to those subpoenas, and we remain willing to cooperate with them if they have any further information requests. Patent and Intellectual Property Claims We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss for a company or its suppliers in an ITC action could result in a prohibition on importing infringing products into the U.S. Since the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them for certain intellectual property infringement claims against them, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Other We are also regularly subject to claims, suits, government investigations, and other proceedings involving competition (such as the pending EC investigations described above), intellectual property, privacy, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. Such claims, suits, government investigations, and other proceedings could result in fines, civil or criminal penalties, or other adverse consequences. Certain of our outstanding legal matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. With respect to our outstanding legal matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in the aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such legal matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Taxes We are under audit by the Internal Revenue Service (IRS) and various other domestic and foreign tax authorities with regards to income tax and indirect tax matters. We have reserved for potential adjustments to our provision for income taxes and accrual of indirect taxes that may result from examinations by, or any negotiated agreements with, these tax authorities, and we believe that the final outcome of these examinations or agreements will not have a 84 Table of Contents Alphabet Inc. and Google Inc. material effect on our results of operations. If events occur which indicate payment of these amounts is unnecessary, the reversal of the liabilities would result in the recognition of benefits in the period we determine the liabilities are no longer necessary. If our estimates of the federal, state, and foreign income tax liabilities and indirect tax liabilities are less than the ultimate assessment, it would result in a further charge to expense. Please see Note 15 for additional information regarding contingencies related to our income taxes. Note 12. Net Income Per Share Alphabet We compute net income per share of Class A and Class B common stock and Class C capital stock using the two-class method. Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of stock options, restricted stock units, and other contingently issuable shares. The dilutive effect of outstanding stock options, restricted stock units, and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A common stock assumes the conversion of Class B common stock, while the diluted net income per share of Class B common stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A and Class B common stock and Class C capital stock are identical, except with respect to voting. Further, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our board of directors from declaring or paying unequal per share dividends on our Class A and Class B common stock and Class C capital stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our board of directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A and Class B common shares and Class C capital stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. The net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are legally entitled to equal per share distributions whether through dividends or in liquidation. Further, as we assume the conversion of Class B common stock in the computation of the diluted net income per share of Class A common stock, the undistributed earnings are equal to net income for that computation. Stock Split Effected In Form of Stock Dividend In January 2014, our board of directors approved the distribution of shares of Class C capital stock as a dividend to our holders of Class A and Class B common stock (the Stock Split). The Stock Split had a record date of March 27, 2014 and a payment date of April 2, 2014. In the second quarter of 2015, in accordance with a settlement of litigation involving the authorization to distribute Class C capital stock, at the close of trading on April 2, 2015, the last trading day of the 365 day period following the first date the Class C shares traded on NASDAQ (Lookback Period), we determined that a payment (the Adjustment Payment) in the amount of $522 million was due to Class C capital stockholders. The amount of the Adjustment Payment was based on the percentage difference that developed between the volume-weighted average price of Class A and Class C shares during the Lookback Period, as supplied by NASDAQ Data-on-Demand, and was payable to holders of Class C capital stock as of the end of the Lookback Period in cash, Class A common stock, Class C capital stock, or a combination thereof, at the discretion of our board of directors. On April 22, 2015, our board of directors approved the Adjustment Payment in shares of Class C capital stock, and cash in lieu of any fractional shares of Class C capital stock. In May 2015, the Adjustment Payment was made, resulting in the issuance of approximately 853 thousand shares of Class C capital stock, with $475 million reflected in additional-paid in capital and $47 million of cash in lieu of fractional shares of Class C capital stock. In the year ended December 31, 2015, the Adjustment Payment was allocated to the numerator for calculating net income per share of Class C capital stock from net income available to all stockholders and the remaining undistributed earnings were allocated on a pro rata basis to Class A and Class B common stock and Class C capital stock based on the number of shares used in the per share computation for each class of stock. The weighted-average share impact of the Adjustment Payment is included in the denominator of both basic and diluted net income per share computations for the year ended December 31, 2015. 85 Table of Contents Alphabet Inc. and Google Inc. In the years ended December 31, 2013 and 2014, the net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with our Amended and Restated Certificate of Incorporation of Alphabet Inc. The par value per share of our shares of Class A and Class B common stock remained unchanged at $0.001 per share after the Stock Split. On the effective date of the Stock Split, a transfer between retained earnings and common stock occurred in an amount equal to the $0.001 par value of the Class C capital stock that was issued. Share and per share amounts for the prior periods presented below have been retroactively adjusted to reflect the Stock Split. Computation of Net Income Per Share The following table sets forth the computation of basic and diluted net income per share of Class A and Class B common stock and Class C capital stock (in millions, except share amounts which are reflected in thousands and per share amounts): Year Ended December 31, 2013 Class A Class B Class C Basic net income (loss) per share: Numerator Allocation of undistributed earnings - continuing operations $ 5,407 $ 1,173 $ 6,580 Allocation of undistributed earnings - discontinued operations (175 ) (38 ) (214 ) Total $ 5,232 $ 1,135 $ 6,366 Denominator Number of shares used in per share computation 273,518 59,328 332,846 Basic net income (loss) per share: Continuing operations $ 19.77 $ 19.77 $ 19.77 Discontinued operations (0.64 ) (0.64 ) (0.64 ) Basic net income per share $ 19.13 $ 19.13 $ 19.13 Diluted net income (loss) per share: Numerator Allocation of undistributed earnings for basic computation - continuing operations $ 5,407 $ 1,173 $ 6,580 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,173 0 0 Reallocation of undistributed earnings 0 (21 ) 0 Allocation of undistributed earnings - continuing operations $ 6,580 $ 1,152 $ 6,580 Allocation of undistributed earnings for basic computation - discontinued operations (175 ) (38 ) (214 ) Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares (38 ) 0 0 Reallocation of undistributed earnings (1 ) 1 1 Allocation of undistributed earnings - discontinued operations $ (214 ) $ (37 ) $ (213 ) Denominator Number of shares used in basic computation 273,518 59,328 332,846 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 59,328 0 0 Employee stock options 2,748 4 2,748 Restricted stock units and other contingently issuable shares 3,215 0 3,215 Number of shares used in per share computation 338,809 59,332 338,809 Diluted net income (loss) per share: Continuing operations $ 19.42 $ 19.42 $ 19.42 Discontinued operations (0.63 ) (0.63 ) (0.63 ) Diluted net income per share $ 18.79 $ 18.79 $ 18.79 86 Table of Contents Alphabet Inc. and Google Inc. Year Ended December 31, 2014 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings - continuing operations $ 5,700 $ 1,107 $ 6,813 Allocation of undistributed earnings - discontinued operations 216 42 258 Total $ 5,916 $ 1,149 $ 7,071 Denominator Number of shares used in per share computation 282,877 54,928 338,130 Basic net income per share: Continuing operations $ 20.15 $ 20.15 $ 20.15 Discontinued operations 0.76 0.76 0.76 Basic net income per share $ 20.91 $ 20.91 $ 20.91 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation - continuing operations $ 5,700 $ 1,107 $ 6,813 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,107 0 0 Reallocation of undistributed earnings (20 ) (18 ) 20 Allocation of undistributed earnings - continuing operations $ 6,787 $ 1,089 $ 6,833 Allocation of undistributed earnings for basic computation - discontinued operations 216 42 258 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 42 0 0 Reallocation of undistributed earnings (1 ) (1 ) 1 Allocation of undistributed earnings - discontinued operations $ 257 $ 41 $ 259 Denominator Number of shares used in basic computation 282,877 54,928 338,130 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 54,928 0 0 Employee stock options 2,057 0 2,038 Restricted stock units and other contingently issuable shares 2,515 0 4,525 Number of shares used in per share computation 342,377 54,928 344,693 Diluted net income per share: Continuing operations $ 19.82 $ 19.82 $ 19.82 Discontinued operations 0.75 0.75 0.75 Diluted net income per share $ 20.57 $ 20.57 $ 20.57 87 Table of Contents Alphabet Inc. and Google Inc. Year Ended December 31, 2015 Class A Class B Class C Basic net income per share: Numerator Adjustment Payment to Class C capital stockholders - continuing operations $ 0 $ 0 $ 522 Allocation of undistributed earnings - continuing operations 6,695 1,196 7,935 Allocation of undistributed earnings - discontinued operations 0 0 0 Total $ 6,695 $ 1,196 $ 8,457 Denominator Number of shares used in per share computation 289,640 51,745 343,241 Basic net income per share: Continuing operations $ 23.11 $ 23.11 $ 24.63 Discontinued operations 0.00 0.00 0.00 Basic net income per share $ 23.11 $ 23.11 $ 24.63 Diluted net income per share: Numerator Adjustment Payment to Class C capital stockholders - continuing operations $ 0 $ 0 $ 522 Allocation of undistributed earnings for basic computation - continuing operations $ 6,695 $ 1,196 $ 7,935 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,196 0 0 Reallocation of undistributed earnings (39 ) (14 ) 39 Allocation of undistributed earnings - continuing operations 7,852 1,182 7,974 Allocation of undistributed earnings for basic computation - discontinued operations 0 0 0 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 0 0 0 Reallocation of undistributed earnings 0 0 0 Allocation of undistributed earnings - discontinued operations $ 0 $ 0 $ 0 Denominator Number of shares used in basic computation 289,640 51,745 343,241 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 51,745 0 0 Employee stock options 1,475 0 1,428 Restricted stock units and other contingently issuable shares 920 0 4,481 Number of shares used in per share computation 343,780 51,745 349,150 Diluted net income per share: Continuing operations $ 22.84 $ 22.84 $ 24.34 Discontinued operations 0.00 0.00 0.00 Diluted net income per share $ 22.84 $ 22.84 $ 24.34 Google Net income per share for Google is not required as its shares are not publicly traded. Note 13. Stockholders’ Equity Alphabet Reorganization On October 2, 2015, Google implemented a legal reorganization, which resulted in Alphabet owning all of the outstanding stock of Google. Consequently, Google became a direct, wholly owned subsidiary of Alphabet. Each share of each class of Google stock issued and outstanding immediately prior to the legal reorganization automatically converted into an equivalent corresponding share of Alphabet stock, and Google’s stockholders immediately prior to the consummation of the legal reorganization became stockholders of Alphabet. As a result of the reorganization, on October 2, 2015, the Fourth Amended and Restated Certificate of Incorporation of Google was amended to decrease the authorized number of shares of Class A common stock, Class B common 88 Table of Contents Alphabet Inc. and Google Inc. stock and Class C capital stock, par value $0.001 per share, from 9 billion shares, 3 billion shares and 3 billion shares, respectively, to 500 shares of each class of stock, respectively. Additionally, the authorized number of shares of preferred stock, par value $0.001 per share, was decreased from 100 million shares to 500 shares. As of December 31, 2015 , Google had 100 shares of Class A common stock, 100 shares of Class B common stock, and 100 shares of Class C capital stock outstanding, of which Alphabet was the sole owner. Alphabet Convertible Preferred Stock Our board of directors has authorized 100 million shares of convertible preferred stock, $0.001 par value, issuable in series. As of December 31, 2014 and 2015 , there were no shares issued or outstanding. Alphabet Class A and Class B Common Stock and Class C Capital Stock Our board of directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Stock Plans As a result of the Alphabet reorganization, on October 2, 2015, Google transferred to Alphabet, and Alphabet assumed, sponsorship of all of Google's stock plans along with all of Google's rights and obligations under each plan. During the year ended December 31, 2014 , shares reserved for future grants under the 2004 Stock Plan expired and we began granting awards from the 2012 Stock Plan (“Stock Plan”). Under our Stock Plan, RSUs or stock options may be granted. An RSU award is an agreement to issue shares of our publicly traded stock at the time the award vests. Incentive and non-qualified stock options, or rights to purchase common stock, are generally granted for a term of 10 years. Options and RSUs granted to participants under the Stock Plan generally vest over four years contingent upon employment or service with us on the vesting date. As of December 31, 2015 , there were 23,336,944 shares of stock reserved for future issuance under our Stock Plan. Stock-Based Compensation The following table presents our aggregate stock-based compensation expense by type of costs and expenses per the Consolidated Statements of Income (in millions): Year Ended December 31, 2013 2014 2015 Cost of revenues $ 469 $ 535 $ 806 Research and development 1,641 2,200 2,687 Sales and marketing 552 715 899 General and administrative 465 725 861 Discontinued operations 216 104 0 Total stock-based compensation expense $ 3,343 $ 4,279 $ 5,253 For the years ended December 31, 2013 , 2014 , and 2015 , we recognized tax benefits on total stock-based compensation expense from continuing operations of $685 million , $867 million , and $1,133 million , respectively, and from discontinued operations of $59 million , $30 million and $0 million , respectively. In addition, as a result of the Tax Court ruling in Altera Corp. v. Commissioner, we have recorded a tax benefit of $522 million related to 2015 stock-based compensation expense that will be subject to reimbursement of cost share payments if the tax court's opinion is sustained. Refer to Note 15 for more detail regarding the Altera case. Of the total stock-based compensation expense from continuing operations recognized in the years ended December 31, 2013 , 2014 , and 2015 , $0 million , $0 million , and $50 million , respectively, was associated with awards ultimately settled in cash. Awards which will be ultimately settled in cash are classified as liabilities in our Consolidated Balance Sheets. Stock-based compensation associated with Alphabet equity awards granted to Google employees in the fourth quarter ended December 31, 2015, was treated as a capital contribution from Alphabet to Google. Stock-based 89 Table of Contents Alphabet Inc. and Google Inc. compensation associated with equity awards for the years ended December 31, 2013 , 2014 and 2015 are presented as stock-based compensation expense in Alphabet's and Google's Consolidated Statements of Stockholders' Equity. Alphabet Stock-Based Award Activities The following table summarizes the activities for our options for the year ended December 31, 2015 : Options Outstanding Number of Shares Weighted- Average Exercise Price Weighted- Average Remaining Contractual Term (in years) Aggregate Intrinsic Value (in millions) (1) Balance as of December 31, 2014 7,240,419 $ 215.56 Granted 0 N/A Exercised (2,072,550 ) $ 189.64 Forfeited/canceled (268,886 ) $ 310.47 Balance as of December 31, 2015 4,898,983 $ 221.31 3.7 $ 2,682 Exercisable as of December 31, 2015 4,462,847 $ 212.02 3.4 $ 2,484 Exercisable as of December 31, 2015 and expected to vest thereafter (2) 4,846,996 $ 220.29 3.6 $ 2,658 (1) The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the closing stock prices of $778.01 and $758.88 of our Class A common stock and Class C capital stock, respectively, on December 31, 2015 . (2) Options expected to vest reflect an estimated forfeiture rate. The total grant date fair value of stock options vested during 2013 , 2014 and 2015 was $223 million , $94 million , and $33 million . The aggregate intrinsic value of all options and warrants exercised during 2013 , 2014 and 2015 was $1,793 million , $589 million , and $867 million . These amounts do not include the aggregate sales price of options sold under our Transferable Stock Options (TSO) program, which was discontinued as of November 29, 2013. As of December 31, 2015 , there was $12 million of unrecognized compensation cost related to outstanding employee stock options. This amount is expected to be recognized over a weighted-average period of 0.6 years . To the extent the actual forfeiture rate is different from what we have estimated, stock-based compensation expense related to these awards will be different from our expectations. The following table summarizes the activities for our unvested RSUs for the year ended December 31, 2015 : Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2014 24,619,549 $ 487.80 Granted 14,415,740 $ 546.46 Vested (11,182,606 ) $ 442.01 Forfeited/canceled (2,111,497 ) $ 481.37 Unvested as of December 31, 2015 25,741,186 $ 531.74 Expected to vest after December 31, 2015 (1) 22,672,837 $ 531.74 (1) RSUs expected to vest reflect an estimated forfeiture rate. As of December 31, 2015 , there was $11.1 billion of unrecognized compensation cost related to unvested RSUs. This amount is expected to be recognized over a weighted-average period of 2.7 years . To the extent the actual forfeiture rate is different from what we have estimated, stock-based compensation expense related to these awards will be different from our expectations. Share Repurchases In October 2015, the board of directors of Alphabet authorized the company to repurchase up to $5,099,019,513.59 of its Class C capital stock, commencing in the fourth quarter of 2015. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market 90 Table of Contents Alphabet Inc. and Google Inc. purchases or privately negotiated transactions, including through the use of 10b5-1 plans. The repurchase program does not have an expiration date. As of December 31, 2015 , we repurchased and subsequently retired approximately 2,391 thousand shares of Alphabet Class C capital stock for an aggregate amount of approximately $1,780 million . Alphabet's share repurchases in the year ended December 31, 2015 were funded by Google via a return of capital to Alphabet. In January 2016, the board of directors of Alphabet authorized the company to repurchase an additional amount of approximately 514 thousand shares. Google Stockholders' Equity As a result of the Alphabet reorganization, Google has recorded various intercompany activities during the fourth quarter ended December 31, 2015 as capital transactions, which are reflected in Google's Consolidated Statements of Stockholders' Equity. Refer to Stock-Based Compensation and Share Repurchases section above, and Note 6 , for descriptions of certain activities. Additionally, subsequent to the reorganization, shares withheld to satisfy employee withholding tax obligations and cash received from the exercise of stock options were recorded as capital transactions between Alphabet and Google and are reflected as such in Google's Consolidated Statements of Stockholders' Equity. Note 14. 401(k) Plans We have two 401(k) Savings Plans (401(k) Plans) that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We contributed approximately $202 million , $259 million , and $309 million for the years ended December 31, 2013 , 2014 , and 2015 . Note 15. Income Taxes Income from continuing operations before income taxes included income from domestic operations of $7,651 million , $8,894 million , and $8,271 million for the years ended December 31, 2013 , 2014 , and 2015 , and income from foreign operations of $8,248 million , $8,365 million , and $11,380 million for the years ended December 31, 2013 , 2014 , and 2015 . The provision for income taxes consists of the following (in millions): Year Ended December 31, 2013 2014 2015 Current: Federal $ 2,394 $ 2,716 $ 3,235 State 127 157 (397 ) Foreign 711 774 723 Total 3,232 3,647 3,561 Deferred: Federal (421 ) 29 (198 ) State 0 6 (43 ) Foreign (72 ) (43 ) (17 ) Total (493 ) (8 ) (258 ) Provision for income taxes $ 2,739 $ 3,639 $ 3,303 91 Table of Contents Alphabet Inc. and Google Inc. The reconciliation of federal statutory income tax rate to our effective income tax rate is as follows (in millions): Year Ended December 31, 2013 2014 2015 Expected provision at federal statutory tax rate (35%) $ 5,567 $ 6,041 $ 6,878 State taxes, net of federal benefit 133 132 (291 ) Change in valuation allowance (641 ) (164 ) (65 ) Foreign rate differential (2,482 ) (2,109 ) (2,624 ) Federal research credit (433 ) (318 ) (407 ) Basis difference in investment of Arris 644 0 0 Other adjustments (49 ) 57 (188 ) Provision for income taxes $ 2,739 $ 3,639 $ 3,303 A retroactive and permanent reinstatement of the federal research credit was signed into law on December 18, 2015 in accordance with the Protecting Americans from Tax Hikes Act of 2015. As such, our effective tax rate for 2015 reflects the benefit of the 2015 federal research and development tax credit. A retroactive extension of the 2012 federal research and development credit was signed into law on January 2, 2013 in accordance with The American Taxpayer Act of 2012. The benefit of $189 million related to the 2012 federal research and development credit is included in the year ended December 31, 2013. Our effective tax rate for 2015 included a discrete tax benefit related to refunds and reductions in uncertain tax positions due to the resolution of a multi-year tax audit in the U.S. Our effective tax rate is impacted by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. Substantially all of the income from foreign operations was earned by an Irish subsidiary. We have not provided U.S. income taxes and foreign withholding taxes on the undistributed earnings of foreign subsidiaries as of December 31, 2015 because we intend to permanently reinvest such earnings outside the U.S. If these foreign earnings were to be repatriated in the future, the related U.S. tax liability may be reduced by any foreign income taxes previously paid on these earnings. As of December 31, 2015 , the cumulative amount of earnings upon which U.S. income taxes have not been provided is approximately $58.3 billion . Determination of the amount of unrecognized deferred tax liability related to these earnings is not practicable. On July 27, 2015, the United States Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. The government has 90 days from the final decision date to file a notice of appeal. At this time, the U.S. Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. We have evaluated the opinion and have recorded a tax benefit of $3.5 billion related to reimbursement of cost share payments for the previously shared stock-based compensation costs. In addition, we have recorded a tax liability of $3.5 billion for the U.S. tax cost of potential repatriation of the associated contingent foreign earnings because at this time we cannot reasonably conclude that the Company has the ability and the intent to indefinitely reinvest these contingent earnings. The net impact to our consolidated financial statements is not material. We will continue to monitor developments related to the case and the potential impact on our consolidated financial statements. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities are as follows (in millions): 92 Table of Contents Alphabet Inc. and Google Inc. As of December 31, 2014 2015 Deferred tax assets: Stock-based compensation expense $ 376 $ 534 State taxes 133 119 Investment loss 133 144 Legal settlement accruals 175 101 Accrued employee benefits 671 832 Accruals and reserves not currently deductible 175 245 Net operating losses 207 230 Tax credits 262 503 Basis difference in investment of Arris 1,347 1,357 Prepaid cost sharing 0 3,468 Other 243 337 Total deferred tax assets 3,722 7,870 Valuation allowance (1,659 ) (1,732 ) Total deferred tax assets net of valuation allowance 2,063 6,138 Deferred tax liabilities: Depreciation and amortization (852 ) (1,126 ) Identified intangibles (965 ) (787 ) Mark-to-market investments (273 ) (93 ) Renewable energy investments (430 ) (529 ) Foreign earnings 0 (3,468 ) Other (125 ) (73 ) Total deferred tax liabilities (2,645 ) (6,076 ) Net deferred tax liabilities $ (582 ) $ 62 As of December 31, 2015 , our federal and state net operating loss carryforwards for income tax purposes were approximately $482 million and $443 million . If not utilized, the federal net operating loss carryforwards will begin to expire in 2021 and the state net operating loss carryforwards will begin to expire in 2016. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. Our foreign net operating loss carryforwards for income tax purposes were $263 million that can be carried over indefinitely. As of December 31, 2015 , our California research and development credit carryforwards for income tax purposes were approximately $1,044 million that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. Our foreign tax credit carryforwards for income tax purposes were approximately $223 million that will start to expire in 2025. We believe it is more likely than not that all of the foreign tax credit will be realized. As of December 31, 2015 , we maintained a valuation allowance with respect to certain of our deferred tax assets relating primarily to investment losses that are capital in nature, California deferred tax assets, and certain foreign net operating losses that we believe are not likely to be realized. We established a deferred tax asset for the book-to-tax basis difference in our investments in Arris shares received from the sale of the Motorola Home business to Arris in 2013. Since any future losses to be recognized upon the sale of Arris shares will be capital losses, a valuation allowance has been recorded against this deferred tax asset to the extent such deferred tax asset is not covered by capital gains generated as of 2015. We reassess the valuation allowance quarterly and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. As a result of the Altera opinion, we have recorded a deferred tax asset of $3.5 billion and a deferred tax liability of $3.5 billion . Refer to above for more details on the Altera case. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits from January 1, 2013 to December 31, 2015 (in millions): 93 Table of Contents Alphabet Inc. and Google Inc. Balance as of January 1, 2013 $ 1,907 Increases related to prior year tax positions 158 Decreases related to prior year tax positions (37 ) Decreases related to settlement with tax authorities (78 ) Increases related to current year tax positions 552 Balance as of December 31, 2013 2,502 Increases related to prior year tax positions 66 Decreases related to prior year tax positions (44 ) Decreases related to settlement with tax authorities (1 ) Increases related to current year tax positions 771 Balance as of December 31, 2014 3,294 Increases related to prior year tax positions 224 Decreases related to prior year tax positions (176 ) Decreases related to settlement with tax authorities (27 ) Increases related to current year tax positions 852 Balance as of December 31, 2015 $ 4,167 The total amount of gross unrecognized tax benefits was $2,502 million , $3,294 million , and $4,167 million as of December 31, 2013 , 2014 , and 2015 , respectively, of which, $2,309 million , $2,909 million , and $3,614 million , if recognized, would affect our effective tax rate. As of December 31, 2014 and 2015 , we had accrued $239 million and $348 million in interest and penalties in provision for income taxes. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions, our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS completed its examination of our 2003 through 2006 tax years; all issues have been settled except for one which we have filed an appeal with the IRS and plan to litigate in court. The IRS is currently in examination of our 2007 through 2012 tax years. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. Our 2013, 2014, and 2015 tax years remain subject to examination by the IRS for U.S. federal tax purposes, and our 2011 through 2015 tax years remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the impact, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, closure of audits is not certain, we do not believe it is reasonably possible that our unrecognized tax benefits will materially change in the next 12 months. Note 16. Information about Segments and Geographic Areas In conjunction with the Alphabet reorganization, in the fourth quarter of 2015, we implemented legal and operational changes in how our Chief Operating Decision Maker (CODM) manages our businesses, including resource allocation and performance assessment. Consequently, we have multiple operating segments, representing the individual businesses run separately under the Alphabet structure. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the operating segments are combined and disclosed below as Other Bets. All prior-period amounts have been adjusted retrospectively to reflect the reportable segment change. Our reported segments are described below: 94 Table of Contents Alphabet Inc. and Google Inc. • Google – Google includes our main internet products such as Search, Ads, Commerce, Maps, YouTube, Apps, Cloud, Android, Chrome, Google Play as well as hardware products we sell, such as Chromecast, Chromebooks and Nexus. Our technical infrastructure and newer efforts like Virtual Reality are also included in Google. Google generates revenues primarily from advertising, sales of digital content, apps and cloud services, as well as sales of Google branded hardware. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access/Google Fiber, Calico, Nest, Verily, GV, Google Capital, X, and other initiatives. Revenues from the Other Bets is derived primarily through the sales of Nest hardware products, internet and TV services through Google Fiber and licensing and R&D services through Verily. Revenue, cost of revenue, and operating expenses are generally directly attributed to our segments. Inter-segment revenues are not presented separately, as these amounts are immaterial. Our CODM does not evaluate operating segments using asset information. Information about segments during the periods presented were as follows (in millions): Year Ended December 31, 2013 2014 2015 Revenues: Google $ 55,507 $ 65,674 $ 74,541 Other Bets 12 327 448 Total revenues $ 55,519 $ 66,001 $ 74,989 Year Ended December 31, 2013 2014 2015 Segment operating income (loss): Google $ 16,260 $ 19,011 $ 23,425 Other Bets (527 ) (1,942 ) (3,567 ) Reconciling items (1) (330 ) (573 ) (498 ) Total income from operations $ 15,403 $ 16,496 $ 19,360 (1) Reconciling items are primarily related to corporate administrative costs and other miscellaneous items that are not allocated to individual segments. Year Ended December 31, 2013 2014 2015 Capital expenditures: Google $ 7,006 $ 11,173 $ 8,849 Other Bets 187 501 869 Reconciling items (2) 165 (715 ) 197 Total capital expenditures as presented in Consolidated Statements of Cash Flow $ 7,358 $ 10,959 $ 9,915 (2) Reconciling items are primarily related to timing differences of payments as segment capital expenditures are on accrual basis while total capital expenditures shown on the Consolidated Statements of Cash Flow are on cash basis, capital expenditures of Motorola Mobile and Home, and other miscellaneous differences. 95 Table of Contents Alphabet Inc. and Google Inc. Stock-based compensation and depreciation, amortization and impairment are included in segment operating income (loss) as below (in millions): Year Ended December 31, 2013 2014 2015 Stock-based compensation: Google $ 2,911 $ 3,677 $ 4,587 Other Bets 124 347 498 Reconciling items (3) 92 151 118 Total stock based compensation, excluding discontinued operations (4) $ 3,127 $ 4,175 $ 5,203 Depreciation, amortization and impairment: Google $ 3,668 $ 4,778 $ 4,839 Other Bets 24 148 203 Reconciling items (5) 247 53 21 Total depreciation, amortization and impairment as presented in Consolidated Statements of Cash Flow $ 3,939 $ 4,979 $ 5,063 (3) Reconciling items represent corporate administrative costs that are not allocated to individual segments. (4) For purposes of segment reporting, we define SBC as awards accounted for under FASB ASC Topic 718 that we expect to settle in stock. SBC does not include expenses related to awards that we will ultimately settle in cash. Amounts exclude SBC from discontinued operations . (5) Reconciling items primarily represent depreciation, amortization and impairment related to Motorola Mobile and Motorola Home. Revenues by geography are based on the billing addresses of our customers. The following tables set forth revenues and long-lived assets by geographic area (in millions): Year Ended December 31, 2013 2014 2015 Revenues: United States $ 25,587 $ 29,482 $ 34,810 United Kingdom 5,600 6,483 7,067 Rest of the world 24,332 30,036 33,112 Total revenues $ 55,519 $ 66,001 $ 74,989 As of December 31, 2014 As of December 31, 2015 Long-lived assets: United States $ 37,421 $ 43,686 International 13,110 13,661 Total long-lived assets $ 50,531 $ 57,347 Note 17. Revision of Previously Issued Financial Statements In the second quarter of 2015, we identified an incorrect classification of certain revenues between legal entities, and as a consequence, we revised our income tax expense for periods beginning in 2008 through the first quarter of 2015 in the cumulative amount of $711 million . We have evaluated the materiality of the income tax expense impact quantitatively and qualitatively and concluded it was not material to any of the prior periods impacted and that correction of income tax expense as an out of period adjustment in the quarter ended June 30, 2015 is not material to our consolidated financial statements for the year ended December 31, 2015. Consolidated revenues are not impacted. We elected to revise previously issued consolidated financial statements contained within this Annual Report on Form 10-K for the periods impacted to correct the effect of this immaterial income tax expense underaccrual for the corresponding periods. 96 Table of Contents Alphabet Inc. and Google Inc. The following table presents the impact of these corrections on affected Consolidated Balance Sheet line items as of December 31, 2014 (in millions): As of December 31, 2014 As Previously Reported (1) Adjustment As Revised Selected Balance Sheets Data: Income tax receivable, net $ 1,298 $ (707 ) $ 591 Total current assets 79,363 (707 ) 78,656 Total assets 129,894 (707 ) 129,187 Income taxes payable, non-current 3,407 (67 ) 3,340 Retained earnings 75,706 (640 ) 75,066 Total stockholders' equity 104,500 (640 ) 103,860 Total liabilities and stockholders' equity $ 129,894 $ (707 ) $ 129,187 (1) Includes reclassifications of deferred tax assets and liabilities related to ASU 2015-17 “Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes.” Refer to Note 1 for further information. The following table presents the impact of these corrections on affected Consolidated Statements of Income line items, including net income per share amounts for Class A and B common stock and Class C capital stock, for the years ended December 31, 2013 and 2014 (in millions, except per share amounts): Year Ended December 31, 2013 Year Ended December 31, 2014 As Previously Reported Adjustment As Revised As Previously Reported Adjustment As Revised Selected Statements of Income Data: Provision for income taxes $ 2,552 $ 187 $ 2,739 $ 3,331 $ 308 $ 3,639 Net income from continuing operations 13,347 (187 ) $ 13,160 13,928 (308 ) $ 13,620 Net income 12,920 (187 ) $ 12,733 14,444 (308 ) $ 14,136 Basic net income per share from continuing operations $ 20.05 $ (0.28 ) $ 19.77 $ 20.61 $ (0.46 ) $ 20.15 Basic net income per share 19.41 (0.28 ) 19.13 21.37 (0.46 ) 20.91 Diluted net income per share from continuing operations 19.70 (0.28 ) 19.42 20.27 (0.45 ) 19.82 Diluted net income per share $ 19.07 $ (0.28 ) $ 18.79 $ 21.02 $ (0.45 ) $ 20.57 The following table presents the impact of these corrections on affected Consolidated Statements of Comprehensive Income line items for the years ended December 31, 2013 and 2014 (in millions): Year Ended December 31, 2013 Year Ended December 31, 2014 As Previously Reported Adjustment As Revised As Previously Reported Adjustment As Revised Selected Statements of Comprehensive Income Data: Net income 12,920 (187 ) 12,733 14,444 (308 ) 14,136 Comprehensive income 12,507 (187 ) 12,320 14,346 (308 ) 14,038 97 Table of Contents Alphabet Inc. and Google Inc. The following table presents the impact of these corrections on affected Consolidated Statements of Cash Flows line items for the years ended December 31, 2013 and 2014 (in millions): Year Ended December 31, 2013 Year Ended December 31, 2014 As Previously Reported Adjustment As Revised As Previously Reported Adjustment As Revised Selected Statements of Cash Flows Data: Net income $ 12,920 $ (187 ) 12,733 $ 14,444 $ (308 ) $ 14,136 Changes in income taxes, net 401 187 588 283 308 591 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Alphabet Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2015 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2015 . Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2015 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. 98 Table of Contents Alphabet Inc. and Google Inc. Google Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2015 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2015 . Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2015 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION On February 11, 2016, we announced the appointment of James G. Campbell as our Alphabet Corporate Controller, effective February 16, 2016. Jim, age 60, most recently held the position of Vice President of Finance and Corporate Controller at Intel Corporation (from 2004 to 2016) where he was responsible for global accounting, financial services and financial reporting. Previously, Jim was based in Europe, responsible for Intel's international finance operations. He has also been manager of Intel's Financial Information Systems, responsible for designing, developing and implementing Intel's internally used financial applications. In addition, he has served as Asia regional audit manager, Microprocessor Group controller and European Controller. Jim was at Intel for over 30 years and also led and managed the international controllers responsible for financial services, statutory compliance and business support. Jim received his bachelor's degree in business and accounting from California State University, Hayward. He holds a CPA license and is a member of the Financial Executives Committee on Corporate Reporting (CCR), the Executive Committee of CCR, the FASB Emerging Issues Task Force (EITF), the PCAOB Standing Advisory Group (Emeritus), the Portland State University Graduate School of Business Advisory Board and serves on the Board of Trustees Portland Chapter of World Affairs Council. 99 Table of Contents Alphabet Inc. and Google Inc. The material terms of Jim's compensation are as follows: • Salary: $475,000 • Equity: ◦ $3.5 million equity grant (Initial Grant) made shortly after hire vesting monthly over 12 months ◦ $3.5 million equity grant to be made in Q1 2017, to start vesting monthly over 12 months upon the full vest of the Initial Grant • $250,000 sign-on bonus, subject to a pro-rated repayment if employment ends within the first 12 months Jim will also be eligible to participate in the compensation and benefit programs generally available to Google's officers. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for 2016 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2015 (2016 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2016 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance — Corporate Governance and Board Matters — Compensation Committee Interlocks and Insider Participation” in the 2016 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in 2016 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance — Corporate Governance and Board Matters — Director Independence” in the 2016 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2016 Proxy Statement and is incorporated herein by reference. 100 Table of Contents Alphabet Inc. and Google Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 45 Financial Statements of Alphabet Inc.: Consolidated Balance Sheets 48 Consolidated Statements of Income 49 Consolidated Statements of Comprehensive Income 50 Consolidated Statements of Stockholders’ Equity 51 Consolidated Statements of Cash Flows 52 Financial Statements of Google Inc.: Google Balance Sheets 53 Google Statements of Income 54 Google Statements of Comprehensive Income 55 Google Statements of Stockholders’ Equity 56 Google Statements of Cash Flows 57 Notes to Consolidated Financial Statements 58 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for doubtful accounts for the three years ended December 31, 2015 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year (In millions) Year ended December 31, 2013 $ 581 $ 1,128 $ (1,078 ) $ 631 Year ended December 31, 2014 $ 631 $ 1,240 $ (1,646 ) $ 225 Year ended December 31, 2015 $ 225 $ 579 $ (508 ) $ 296 Note: Additions to the allowance for doubtful accounts are charged to expense. Additions to the allowance for sales credits are charged against revenues. For the year ended December 31, 2013 and 2014, additions included the impact from the Motorola acquisition. For the years ended December 31, 2013 and 2014, usages include the impact from the sale of Motorola Home and Mobile businesses, respectively. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits See the Exhibit Index immediately following the signature page of this Annual Report on Form 10-K. 101 Table of Contents Alphabet Inc. and Google Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 11, 2016 ALPHABET INC. By: / S /    L ARRY P AGE Larry Page Chief Executive Officer (Principal Executive Officer of Alphabet Inc.) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Larry Page and Ruth Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Table of Contents Alphabet Inc. and Google Inc. Signature Title Date / S /    L ARRY P AGE Chief Executive Officer, Co-Founder and Director (Principal Executive Officer of Alphabet Inc.) February 11, 2016 Larry Page / S /    R UTH P ORAT Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer of Alphabet Inc.) February 11, 2016 Ruth Porat / S /    E RIC E. S CHMIDT Executive Chairman February 11, 2016 Eric E. Schmidt / S /    S ERGEY B RIN President, Co-Founder and Director February 11, 2016 Sergey Brin / S /    L. J OHN D OERR Director February 11, 2016 L. John Doerr / S /    D IANE B. G REENE Director February 11, 2016 Diane B. Greene / S /    J OHN L. H ENNESSY Director February 11, 2016 John L. Hennessy / S /   A NN M ATHER Director February 11, 2016 Ann Mather / S /    A LAN R . M ULALLY Director February 11, 2016 Alan R. Mulally / S /    P AUL S. O TELLINI Director February 11, 2016 Paul S. Otellini / S /    K. R AM S HRIRAM Director February 11, 2016 K. Ram Shriram / S /    S HIRLEY M. T ILGHMAN Director February 11, 2016 Shirley M. Tilghman Table of Contents Alphabet Inc. and Google Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 11, 2016 GOOGLE INC. By: / S /    S UNDAR P ICHAI Sundar Pichai Chief Executive Officer (Principal Executive Officer of Google Inc.) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Sundar Pichai and Ruth Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Table of Contents Alphabet Inc. and Google Inc. Signature Title Date / S /    S UNDAR P ICHAI Chief Executive Officer (Principal Executive Officer of Google Inc.) February 11, 2016 Sundar Pichai / S /    R UTH P ORAT Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer of Google Inc.) February 11, 2016 Ruth Porat / S /    E RIC E. S CHMIDT Executive Chairman February 11, 2016 Eric E. Schmidt / S /    L ARRY P AGE Co-Founder and Director February 11, 2016 Larry Page / S /    S ERGEY B RIN Co-Founder and Director February 11, 2016 Sergey Brin / S /    L. J OHN D OERR Director February 11, 2016 L. John Doerr / S /    D IANE B. G REENE Director February 11, 2016 Diane B. Greene / S /    J OHN L. H ENNESSY Director February 11, 2016 John L. Hennessy / S /   A NN M ATHER Director February 11, 2016 Ann Mather / S /    A LAN R . M ULALLY Director February 11, 2016 Alan R. Mulally / S /    P AUL S. O TELLINI Director February 11, 2016 Paul S. Otellini / S /    K. R AM S HRIRAM Director February 11, 2016 K. Ram Shriram / S /    S HIRLEY M. T ILGHMAN Director February 11, 2016 Shirley M. Tilghman Table of Contents Alphabet Inc. and Google Inc. EXHIBIT INDEX Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., Alphabet Inc. and Maple Technologies Inc. Current Report on Form 8-K (File No. 000-36380) and Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of Alphabet Inc., dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of Alphabet Inc., dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.03 Fourth Amended and Restated Certificate of Incorporation of Google Inc. Quarterly Report on Form 10-Q (File No. 000-50726) July 24, 2012 3.04 Amended and Restated Bylaws of Google Inc. Quarterly Report on Form 10-Q (File No. 000-50726) July 24, 2012 3.05 Certificate of Merger, dated October 2, 2015 Current Report on Form 8-K (File No. 000-36380) October 2, 2015 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Indenture, dated as of May 19, 2011 between Google Inc. and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 000-50726) May 19, 2011 4.04 Form of 2.125% Note due 2016 Current Report on Form 8-K (File No. 000-50726) May 19, 2011 4.05 Form of 3.625% Note due 2021 Current Report on Form 8-K (File No. 000-50726) May 19, 2011 4.06 Form of 3.375% Note due 2024 Current Report on Form 8-K (File No. 000-50726) February 25, 2014 4.07 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Terms of Revised Stipulation of Compromise and Settlement of In Re: Google Inc. Class C Shareholder Litigation (Consol. C.A. No. 7469-CS) Registration Statement on Form 8-A (File No. 001-36380) March 26, 2014 4.09 Transfer Restriction Agreement, dated October 2, 2015, between Alphabet Inc. and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.10 Transfer Restriction Agreement, dated October 2, 2015, between Alphabet Inc. and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.11 Transfer Restriction Agreement, dated October 2, 2015, between Alphabet Inc. and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.12 Class C Undertaking, dated October 2, 2015, executed by Alphabet Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.01 Form of Indemnification Agreement entered into between Alphabet Inc., its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Offer Letter, dated March 20, 2015, between Ruth Porat and Google Inc. Current Report on Form 8-K (File No. 001-36380) March 26, 2015 Table of Contents Alphabet Inc. and Google Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.03 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and Alphabet Inc. Current Report on Form 8-K (File No. 000-36380) and Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.04 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and Alphabet Inc. Current Report on Form 8-K (File No. 000-36380) and Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Google Restricted Stock Unit Agreement, dated September 9, 2015, between Google Inc. and Omid Kordestani Quarterly Report on Form 10-Q (File No. 001-36380) October 29, 2015 10.06 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.06.1 u Google Inc. 2004 Stock Plan-Form of Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.06.2 u Google Inc. 2004 Stock Plan-Form of Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.06.3 u Google Inc. 2004 Stock Plan-Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.07 u Alphabet Inc. 2012 Stock Plan Current Report on Form 8-K (File No. 333-00050726) June 26, 2012 10.07.1 u * Alphabet Inc. 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement 10.08 u Motorola Mobility Holdings, Inc. 2011 Incentive Compensation Plan Registration Statement on Form S-8 (File No. 333-181661) May 24, 2012 10.09 u AdMob, Inc. 2006 Stock Plan and UK Sub-Plan of the AdMob, Inc. 2006 Stock Plan Registration Statement on Form S-8 filed (File No. 333-167411) June 9, 2010 10.10 u Click Holding Corp. 2005 Stock Incentive Plan Registration Statement on Form S-8 (File No. 333-149956) March 28, 2008 12 * Computation of Earnings to Fixed Charge Ratios 14.01 Code of Conduct of Alphabet Inc. dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 21.01 * Subsidiaries of the Registrants 23.01 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer of Alphabet Inc. pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer of Alphabet Inc. pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 Table of Contents Alphabet Inc. and Google Inc. Exhibit Number Description Incorporated by reference herein Form Date 31.03 * Certification of Chief Executive Officer of Google Inc. pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.04 * Certification of Chief Financial Officer of Google Inc. pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer of Alphabet Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.02 ‡ Certifications of Chief Executive Officer and Chief Financial Officer of Google Inc. pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101.INS XBRL Instance Document 101.SCH XBRL Taxonomy Extension Schema Document 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF XBRL Taxonomy Extension Definition Linkbase Document 101.LAB XBRL Taxonomy Extension Label Linkbase Document 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-17-000008/full-submission.txt b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-17-000008/full-submission.txt new file mode 100644 index 0000000..52f719f --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-17-000008/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________________________ FORM 10-K ___________________________________________ (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2016 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View, CA 94043 (Address of principal executive offices) (Zip Code) (650) 253-0000 (Registrant’s telephone number, including area code) ___________________________________________ Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Class A Common Stock, $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ý No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ¨ No ý Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ý No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer (Do not check if a smaller reporting company) ¨ Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨ No ý As of June 30, 2016 , the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 30, 2016 ) was approximately $413.8 billion . For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 26, 2017 , there were 297,117,506 shares of the registrant’s Class A common stock outstanding, 47,369,687 shares of the registrant’s Class B common stock outstanding, and 346,933,134 shares of the registrant’s Class C capital stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2017 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2016 . Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2016 TABLE OF CONTENTS Page Note About Forward-Looking Statements 1 PART I Item 1. Business 3 Item 1A. Risk Factors 7 Item 1B. Unresolved Staff Comments 18 Item 2. Properties 18 Item 3. Legal Proceedings 18 Item 4. Mine Safety Disclosures 19 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 19 Item 6. Selected Financial Data 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 37 Item 8. Financial Statements and Supplementary Data 39 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 82 Item 9A. Controls and Procedures 82 Item 9B. Other Information 82 PART III Item 10. Directors, Executive Officers and Corporate Governance 83 Item 11. Executive Compensation 83 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 83 Item 13. Certain Relationships and Related Transactions, and Director Independence 83 Item 14. Principal Accountant Fees and Services 83 PART IV Item 15. Exhibits, Financial Statement Schedules 84 i Table of Contents Alphabet Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding: • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • our plans to continue to invest in new businesses, products, services and technologies, systems, facilities, and infrastructure, to continue to hire aggressively and provide competitive compensation programs, as well as to continue to invest in acquisitions; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality, and macroeconomic conditions, which are likely to cause fluctuations in our quarterly results; • our expectation related to our renewable energy efforts; • the potential for declines in our revenue growth rate; • our expectation that we will continue to take steps to improve the relevance of the ads we deliver and to reduce the number of accidental clicks; • fluctuations in the rate of change in revenue and revenue growth, as well as the rate of change in paid clicks and average cost-per-click and various factors contributing to such fluctuations; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of costs related to hedging activities under our foreign exchange risk management program; • our expectation that our cost of revenues, research and development expenses, sales and marketing expenses, and general and administrative expenses will increase in dollars and may increase as a percentage of revenues; • our potential exposure in connection with pending investigations, proceedings, and other contingencies; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins in the future; • our expectation that our traffic acquisition costs will increase in the future; • our expectation that our results will be impacted by our performance in international markets as users in developing economies increasingly come online; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase; • our expectation that our other income (loss), net, will fluctuate in the future as it is largely driven by market dynamics; • estimates of our future compensation expenses; • fluctuations in our effective tax rate; • the sufficiency of our sources of funding; • our payment terms to certain advertisers, which may increase our working capital requirements; • fluctuations in our capital expenditures; • our expectations related to the new operating structure implemented pursuant to the Alphabet holding company reorganization; • the expected timing and amount of Alphabet Inc.'s stock repurchases; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Item 1 "Business," Item 1A "Risk Factors," and Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed under the caption "Risk Factors" in Item 1A of this report and those discussed in other documents we file with the Securities and Exchange Commission (SEC). We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. 1 Table of Contents Alphabet Inc. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. 2 Table of Contents Alphabet Inc. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history -- inspiring us to do things like rethink the mobile device ecosystem with Android and map the world with Google Maps. As part of that, our founders also explained that you could expect us to make "smaller bets in areas that might seem very speculative or even strange when compared to our current businesses." From the start, the company has always strived to do more, and to do important and meaningful things with the resources we have. Alphabet is a collection of businesses -- the largest of which, of course, is Google. It also includes businesses that are generally pretty far afield of our main Internet products such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. We report all non-Google businesses collectively as Other Bets. Our Alphabet structure is about helping each of our businesses prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers, and we see it as our job to make it available to as many people as possible. At its core, Google has always been an information company. We believe that technology is a democratizing force, empowering people through information. We are helping people get online by tailoring hardware and software experiences that suit the needs of emerging markets, primarily through Android and Chrome. We're also making sure our core Google products are fast and useful, especially for users in areas where speed and connectivity are central concerns. Other Alphabet companies are also pursuing initiatives with similar goals. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and continue to invest for the long-term. We won't become complacent, relying solely on small tweaks. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. The power of machine learning Across the company, machine learning and artificial intelligence (AI) are increasingly driving many of our latest innovations. Within Google, our investments in machine learning over a decade are what have enabled us to build Google products that get better over time, making them smarter and more useful -- it's what allows you to use your voice to search for information, to translate the web from one language to another, to see better YouTube recommendations, and to search for people and events that are important to you in Google Photos. Machine learning is also showing great promise in helping us tackle big issues, like dramatically improving the energy efficiency of our data centers. Across Other Bets, machine learning helps self-driving cars better detect and respond to others on the road, and can also aid clinicians in detecting diabetic retinopathy. Google Serving our users We have always been a company committed to making big bets that have the potential to improve the lives of millions of people. As the majority of Alphabet’s big bets continue to reside within Google, an important benefit of the shift to Alphabet has been the tremendous focus that we’re able to have on Google’s many extraordinary opportunities. Our innovations in areas like search and advertising have made our services widely used, and our brand one of the most recognized in the world. We generate revenues primarily by delivering online advertising that consumers find relevant and that advertisers find cost-effective. Google's core products such as Search, Android, Maps, Chrome, YouTube, Google Play, and Gmail each have over one billion monthly active users. But most important, we believe we are just beginning to scratch the surface. Our vision is to remain a place of incredible creativity and innovation that uses our technical expertise to tackle big problems. Google’s mission to organize the world’s information and make it universally accessible and useful has always been our North Star, and our products have come a long way since the company was founded nearly two decades 3 Table of Contents Alphabet Inc. ago. We used to show just ten blue links in our results, which you had to click through to find your answers. Now we are increasingly able to provide direct answers -- even if you're speaking your question using Voice Search -- which makes it quicker, easier and more natural to find what you're looking for. We also introduced the Google Assistant, which allows you to type or talk with Google in a natural conversational way to help you get things done. Over time, we have also added other services that let you access information quickly and easily -- like Google Maps, which helps you navigate to a store while showing you current traffic conditions, or Google Photos, which helps you store and organize all of your photos. This drive to make information more accessible has led us over the years to improve the discovery and creation of digital content, on the web and through platforms like Google Play and YouTube. And with the migration to mobile, people are consuming more digital content by watching more videos, playing more games, listening to more music, reading more books, and using more apps than ever before. Fueling all of these great digital experiences are powerful platforms and hardware. That’s why we continue to invest in platforms like our Chrome browser, Android mobile operating system, Chrome operating system, and Daydream virtual reality platform, as well as a new family of great hardware devices like the Pixel phone and Google Home. Google was a company built in the cloud and has been investing in infrastructure, data management, analytics, and AI from the very beginning. We’ve taken those long-term investments and offer many of the same cloud services to our enterprise customers. Because more and more of today’s great digital experiences are being built in the cloud, our enterprise cloud products help businesses of all sizes take advantage of the latest technology advances to operate more efficiently. How we make money The goal of our advertising business is to deliver relevant ads at just the right time and to give people useful commercial information, regardless of the device they’re using. We also provide advertisers with tools that help them better attribute and measure their advertising campaigns across screens. Our advertising solutions help millions of companies grow their businesses, and we offer a wide range of products across screens and devices. We generate revenues primarily by delivering both performance advertising and brand advertising. • Perf ormance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Most of our performance advertisers pay us when a user engages in their ads. Performance advertising lets our advertisers connect with users while driving measurable results. For performance advertisers, AdWords, our primary auction-based advertising program, helps create simple text-based ads that appear on Google properties and the properties of Google Network Members. In addition, Google Network Members use our AdSense program to display relevant ads on their properties, generating revenues when site visitors view or click on the ads. We continue to invest in our advertising programs and make significant upgrades. • Brand advertising helps enhance users' awareness of and affinity with advertisers' products and services, through v ideos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. We have built a world-class ad technology platform for brand advertisers, agencies, and publishers to power their digital marketing businesses. We aim to ensure great user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. We also seek to improve the measurability of brand advertising so advertisers know when their campaigns are effective. Furthermore, we have invested significantly in programmatic advertising to help advertisers reach users when and where it matters through automated ad buying, giving them access to top-tier inventory across screens and formats, as well as the real-time insights that advertisers need to make their buys count. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, ranging from removing hundreds of millions of bad ads from our systems every year to closely monitoring the sites and apps that show our ads and blacklisting them when necessary to ensure that our ads do not fund bad content. Beyond our advertising business, we also generate revenues in emerging areas, such as digital content, cloud services, and hardware. 4 Table of Contents Alphabet Inc. Other Bets Throughout Alphabet, we are also using technology to try and solve big problems across many industries. Alphabet’s Other Bets are early-stage businesses, which come with considerable uncertainty, but they are already making important strides in their industries. Our goal is for them to become thriving, successful businesses in the medium to long term. For instance, Nest products, led by their learning thermostat, remain top sellers in their categories, and the team continues to successfully launch new products like the Nest Cam Outdoor. Also, life sciences and healthcare company Verily has forged several partnerships with industry leaders as it works to create new solutions in areas including diabetes and robotic surgery. Our self-driving car company, Waymo, is also making important progress and is currently testing cars in four cities. We continue to build out these businesses thoughtfully and systematically to capitalize on the opportunities ahead. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from: • General purpose search engines and information services, such as Microsoft's Bing, Yahoo, Yandex, Baidu, Naver, and Seznam. • Vertical search engines and e-commerce websites, such as Amazon and eBay (e-commerce), Kayak (travel queries), LinkedIn (job queries), and WebMD (health queries). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks, such as Facebook and Twitter. Some users are increasingly relying on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other forms of advertising, such as television, radio, newspapers, magazines, and billboards. Our advertisers typically advertise in multiple media, both online and offline. • Other online advertising platforms and networks, including Facebook, Criteo, and AppNexus, that compete for advertisers with AdWords, our primary auction-based advertising program. • Providers of digital video services, such as Facebook, Netflix, Amazon, and Hulu. • Companies that design, manufacture, and market consumer electronics products, including businesses that have developed proprietary platforms. • Providers of enterprise cloud services, including Amazon and Microsoft. • Digital assistant providers, such as Apple, Amazon, Facebook, and Microsoft. Competing successfully in our advertising-related businesses depends heavily on our ability to deliver and distribute innovative products and technologies to the marketplace so that we can attract and retain: • Users, for whom other products and services are literally one click away, primarily on the basis of the relevance and usefulness of our search results and the features, availability, and ease of use of our products and services. • Advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels. • Content providers (Google Network Members, the parties who use our advertising programs to deliver relevant ads alongside their search results and content, as well as other content providers for whom we distribute or license content), primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. 5 Table of Contents Alphabet Inc. Culture and Employees We take great pride in our culture. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex technical challenges. Transparency and open dialogue are central to how we work, and we like to ensure that company news reaches our employees first through internal channels. Despite our rapid growth, we still cherish our roots as a startup and wherever possible empower employees to act on great ideas regardless of their role or function within the company. We strive to hire great employees, with backgrounds and perspectives as diverse as those of our global users. We work to provide an environment where these talented people can have fulfilling careers addressing some of the biggest challenges in technology and society. Our employees are among our best assets and are critical for our continued success. We expect to continue investing in hiring talented employees and to provide competitive compensation programs to our employees. As of December 31, 2016 , we had 72,053 full-time employees: 27,169 in research and development, 20,902 in sales and marketing, 14,287 in operations, and 9,695 in general and administrative functions. Although we have work councils and statutory employee representation obligations in certain countries, our U.S. employees are not represented by a labor union. Competition for qualified personnel in our industry is intense, particularly for software engineers, computer scientists, and other technical staff. Seasonality Our business is affected by seasonal fluctuations in Internet usage, advertising expenditures, and underlying business trends such as traditional retail seasonality (e.g., commercial queries typically increase in the fourth quarter of each year). Other Items Climate change is one of the most significant global challenges of our time, and we’ve long been committed to improving our energy consumption. In 2012, we set a long term goal to reach 100% renewable energy for our operations, and we expect to achieve that goal in 2017. We continue to invest in our existing products and services as well as developing new products and services through research and product development. We often release early-stage products. We then use data and user feedback to decide if and how to invest further in those products. Research and development expenses include the vast majority of engineering and technical headcount responsible for research and development of our existing and new products and services, as well as their associated costs. For more information please refer to the Consolidated Statements of Income included in Part II of this Annual Report on Form 10-K. For information about segments and geographic areas, please refer to Note 15 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. As part of the Alphabet reorganization, we expect to convert Google Inc. into a limited liability company. Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and our Proxy Statements are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. You may read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. You can get information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance, including SEC filings, investor events, press and earnings releases, and blogs. Further corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The content of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. 6 Table of Contents Alphabet Inc. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common and capital stock. Risks Related to Our Businesses and Industries We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could be adversely affected. Our businesses are rapidly evolving, intensely competitive, and subject to changing technologies, shifting user needs, and frequent introductions of new products and services. Competing successfully depends heavily on our ability to accurately anticipate technology developments and deliver innovative products and technologies to the marketplace rapidly and, for Google, provide products and services that make our search results and ads relevant and useful for our users. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services, including products and services that may be outside of our historical core business. As a result, we must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our search technology and our existing products and services, and introduce new products and services that people can easily and effectively use. We have many competitors in different industries, including general purpose search engines and information services; vertical search engines and e-commerce websites; social networks; other forms of advertising and online advertising platforms and networks; companies that design, manufacture, and market consumer electronic products; providers of enterprise cloud services and digital video services; and digital assistant providers. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some large companies have longer operating histories and more established relationships with customers and users, and they can use their experiences and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in research and development, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for advertisers and websites. Emerging start-ups may be able to innovate and provide products and services faster than we can or may foresee the consumer need for products and services before us. In addition, new products and services can sometimes present new and difficult technological and legal challenges, which may negatively impact our brands and demand for our products and services and adversely impact our revenues and operating results. Our operating results would also suffer if our innovations are not responsive to the needs of our users, advertisers, and Google Network Members; are not appropriately timed with market opportunities; or are not effectively brought to market. As technology continues to develop, our competitors may be able to offer user experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, and content providers, our revenues and operating results could be adversely affected. We generate substantially all of our revenues from advertising, and reduced spending by advertisers or a loss of partners could harm our business. We generated 88% of total revenues from advertising in 2016. Many of our advertisers, companies that distribute our products and services, digital publishers, and content partners can terminate their contracts with us at any time. Those partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. If we do not provide superior value or deliver advertisements efficiently and competitively, we could see a decrease in revenue and other adverse impacts to our business. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions can also have a material negative impact on user activity and the demand for advertising and cause our advertisers to reduce the amounts they spend on advertising, which could adversely affect our revenues and business. Our ongoing investment in new businesses and new products, services, and technologies is inherently risky, and could disrupt our current operations. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The creation of Alphabet as a new holding company in 2015 and the investments that we are making across various areas in Google and Other Bets are a reflection of our ongoing efforts to innovate and provide products and services that 7 Table of Contents Alphabet Inc. are useful to users. Such endeavors may involve significant risks and uncertainties, including insufficient revenues from such investments to offset any new liabilities assumed and expenses associated with these new investments, inadequate return of capital on our investments, distraction of management from current operations, use of alternative investment or compensation structures, and unidentified issues not discovered in our due diligence of such strategies and offerings that could cause us to fail to realize the anticipated benefits of such investments and incur unanticipated liabilities. Because these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not adversely affect our reputation, financial condition, and operating results. More people are using devices other than desktop computers to access the Internet and accessing new devices to make search queries. If manufacturers and users do not widely adopt versions of our search technology, products, or operating systems developed for these devices, our business could be adversely affected. The number of people who access the Internet through devices other than desktop computers, including mobile phones, smartphones, handheld computers such as laptops and tablets, video game consoles, digital assistants, and television set-top devices, is increasing dramatically. The functionality and user experience associated with some alternative devices may make the use of our products and services through such devices more difficult (or just different) and the versions of our products and services developed for these devices may not be compelling to users, manufacturers, or distributors of alternative devices. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not work or be viewable on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via “apps” tailored to particular devices or social media platforms, which could affect our search and advertising business over time. As new devices and platforms are continually being released, it is difficult to predict the problems we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to the creation, support, and maintenance of products and services across multiple platforms and devices. If we are unable to attract and retain a substantial number of alternative device manufacturers, suppliers, distributors, developers, and users to our products and services, or if we are slow to develop products and technologies that are more compatible with alternative devices and platforms, we will fail to capture the opportunities available as consumers and advertisers continue to exist in a dynamic, multi-screen environment. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including: • increasing competition, • changes in property mix, platform mix, device mix, and geographical mix, • the challenges in maintaining our growth rate as our revenues increase to higher levels, • the evolution of the online advertising market, including the increasing variety of online platforms for advertising, and the other markets in which we participate, and • the rate of user adoption of our products, services, and technologies. We believe our margins could experience downward pressure as a result of increasing competition and increased costs for many aspects of our business as well as the continuing shift to mobile, changes in device mix, and the contribution of new businesses to overall revenue. For instance, the margin on revenues we generate from our Google Network Members is significantly less than the margin on revenues we generate from advertising on Google properties. Consequently, our margins will experience downward pressure if a greater percentage of our revenues comes from ads placed on our Google Network Members' properties compared to revenues generated through ads placed on Google properties. Additionally, the margin we earn on revenues generated from our Google Network Members could decrease in the future if we pay an even larger percentage of advertising fees to our Google Network Members. Furthermore, in our multi-device world, we generate our advertising revenues increasingly from mobile and newer advertising formats, and the margins from the advertising revenues from these sources have generally been lower than those from traditional desktop search. We also expect our traffic acquisition costs (TAC) paid to our distribution partners to increase due to changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms, and the percentage of queries channeled through paid access points. Additionally, our margins could experience downward pressure because the margin on the sale of digital content, hardware products, and cloud-based services have generally been lower than those from traditional desktop search . Further, our margins could be impacted adversely if we spend a proportionately larger amount to promote new products and services or distribute certain products or if we invest more heavily in our innovation efforts across the Company (such as our Other Bets businesses) than we have historically. 8 Table of Contents Alphabet Inc. We are subject to increasing regulatory scrutiny that may negatively impact our business. Additionally, changes in policies governing a wide range of topics may adversely affect our business. The growth of our company and our expansion into a variety of new fields involves a variety of new regulatory issues, and we have experienced increased regulatory scrutiny as we have grown. For instance, various regulatory agencies are reviewing aspects of our search and other businesses. We continue to cooperate with the European Commission and other regulatory authorities around the world in investigations they are conducting with respect to our business. Legislators and regulators may make legal and regulatory changes, or interpret and apply existing laws or policies, in ways that make our products and services less useful to our users, require us to incur substantial costs, expose us to unanticipated civil or criminal liability, or cause us to change our business practices. Additionally, changes in social, political, and regulatory conditions or in laws and policies governing a wide range of topics may disrupt our business practices. These changes could negatively impact our business and results of operations in material ways. A variety of new and existing laws could subject us to claims or otherwise harm our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations of existing laws and regulations) may also impact our business. For example, current and new patent laws such as U.S. patent laws and European patent laws may affect the ability of companies, including us, to protect their innovations and defend against claims of patent infringement. Similarly, changes to copyright laws being considered in Europe and elsewhere may increase costs or require companies, including us, to change or cease offering certain existing services. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Claims have been, or may be, threatened and filed against us under both U.S. and foreign laws for defamation, invasion of privacy and other tort claims, unlawful activity, patent, copyright and trademark infringement, product liability, or other theories based on the nature and content of the materials searched and the ads posted by our users, our products and services, or content generated by our users. Furthermore, many of these laws do not contemplate or address the unique issues raised by a number of our new businesses, products, services and technologies. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain. For example, the laws relating to the liability of providers of online services are currently unsettled both within the U.S. and abroad. In addition, other laws that could subject us to claims or otherwise harm our business include, among others: • We rely on statutory safe harbors, as set forth in the Digital Millennium Copyright Act in the United States and the E-Commerce Directive in Europe, against copyright liability for various linking, caching, and hosting activities. Any legislation or court rulings impacting these safe harbors may adversely impact us. • The General Data Protection Regulation, coming into effect in Europe in May of 2018, which creates a range of new compliance obligations, and increases financial penalties for noncompliance significantly. • Court decisions such as the ‘right to be forgotten’ ruling issued by the European court, which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users and impose significant operational burdens. • Various U.S. and international laws that restrict the distribution of materials considered harmful to children and impose additional restrictions on the ability of online services to collect information from minors. • Data protection laws passed by many states and by certain countries outside the U.S. that require notification to users when there is a security breach for personal data, such as California’s Information Practices Act. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. We face risks and costs overseas as our products and services are offered in international markets and may be subject to additional regulations. Any failure on our part to comply with these laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are regularly subject to claims, suits, government investigations, and other proceedings that may result in adverse outcomes. We are regularly subject to claims, suits, and government investigations involving competition, intellectual property, privacy, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. The manufacturing and sale of an expanded suite of hardware products further exposes us to the risk of product liability and other litigation as well as consumer protection concerns related to product defects, as well as health and safety, hazardous materials usage, and other environmental concerns. We may also be subject to claims, including product warranty claims, if users experience service disruptions, failures, or other issues. In addition, our businesses face intellectual property litigation, 9 Table of Contents Alphabet Inc. as further discussed later, that exposes us to the risk of exclusion and cease and desist orders, which could limit our ability to sell products and services. Such claims, suits, and government investigations are inherently uncertain and their results cannot be predicted with certainty. Regardless of the outcome, any of these types of legal proceedings can have an adverse impact on us because of legal costs, diversion of management resources, and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. It is possible that a resolution of one or more such proceedings could result in substantial fines and penalties that could adversely affect our business, consolidated financial position, results of operations, or cash flows in a particular period. These proceedings could also result in reputational harm, criminal sanctions, consent decrees, or orders preventing us from offering certain features, functionalities, products, or services, requiring a change in our business practices or product recalls or corrections, or requiring development of non-infringing or otherwise altered products or technologies. Any of these consequences could adversely affect our business and results of operations. We may be subject to legal liability associated with providing online services or content. We host and provide a wide variety of services and products that enable users to exchange information, advertise products and services, conduct business, and engage in various online activities both domestically and internationally. The law relating to the liability of providers of these online services and products for activities of their users is still somewhat unsettled both within the U.S. and internationally. Claims have been threatened and have been brought against us for defamation, negligence, breaches of contract, copyright or trademark infringement, unfair competition, unlawful activity, tort, including personal injury, fraud, or other theories based on the nature and content of information that we publish or to which we provide links or that may be posted online or generated by us or by third parties, including our users. In addition, we are and have been and may again in the future be subject to domestic or international actions alleging that certain content we have generated or third-party content that we have made available within our services violates U.S. and non-U.S. law. We also place advertisements which are displayed on third-party publishers and advertising networks properties, and we offer third-party products, services, or content. We may be subject to claims concerning these products, services, or content by virtue of our involvement in marketing, branding, broadcasting, or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services, or content. Defense of any such actions could be costly and involve significant time and attention of our management and other resources, may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Privacy concerns relating to our technology could damage our reputation and deter current and potential users from using our products and services. From time to time, concerns have been expressed about whether our products, services, or processes compromise the privacy of users and others. Concerns about our practices with regard to the collection, use, disclosure, or security of personal information or other privacy related matters, even if unfounded, could damage our reputation and adversely affect our operating results. In addition, as nearly all of our products and services are web-based, the amount of data we store for our users on our servers (including personal information) has been increasing. Any systems failure or compromise of our security that results in the release of our users’ data could seriously harm our reputation and brand and, therefore, our business, and impair our ability to attract and retain users. We expect to continue to expend significant resources to create world-class security protections that shield against theft and security breaches. The risk that these types of events could seriously harm our business is likely to increase as we expand the number of web-based products and services we offer and operate in more countries, and as cyber attacks by third parties become more sophisticated and targeted. Regulatory authorities around the world are considering a number of legislative and regulatory proposals concerning data protection, including measures to ensure that our encryption of users’ data does not hinder law enforcement agencies’ access to that data. In addition, the interpretation and application of consumer and data protection laws in the U.S., Europe and elsewhere are often uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. If so, in addition to the possibility of fines, this could result in an order requiring that we change our data practices, which could have an adverse effect on our business and results of operations. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business. Recent legal developments in Europe have created compliance uncertainty regarding certain transfers of information from Europe to the U.S. For example, the European Union and U.S. Privacy Shield framework was designed to allow for legal certainty regarding transfers of data. However, the agreement itself faces a number of legal challenges 10 Table of Contents Alphabet Inc. and is subject to annual review. This has resulted in some uncertainty, and compliance obligations could cause us to incur costs or require us to change our business practices in a manner adverse to our business. If our security measures are breached resulting in the improper use and disclosure of user data, or if our services are subject to attacks that degrade or deny the ability of users to access our products and services, our products and services may be perceived as not being secure, users and customers may curtail or stop using our products and services, and we may incur significant legal and financial exposure. Our products and services involve the storage and transmission of users’ and customers’ proprietary information, and theft and security breaches expose us to a risk of loss of this information, improper use and disclosure of such information, litigation, and potential liability. We experience cyber attacks of varying degrees on a regular basis. Our security measures may also be breached due to employee error, malfeasance, system errors or vulnerabilities, including vulnerabilities of our vendors, or otherwise. Such breach or unauthorized access, increased government surveillance, or attempts by outside parties to fraudulently induce employees, users, or customers to disclose sensitive information in order to gain access to our data or our users’ or customers’ data could result in significant legal and financial exposure, damage to our reputation, and a loss of confidence in the security of our products and services that could potentially have an adverse effect on our business. Because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently and often are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose users and customers. We are, and may in the future be, subject to intellectual property or other claims, which are costly to defend, could result in significant damage awards, and could limit our ability to use certain technologies in the future. Internet, technology, media, and other companies own large numbers of patents, copyrights, trademarks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent holding companies may continue to seek to monetize patents they have purchased or otherwise obtained. As we have grown, the intellectual property rights claims against us have increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Third parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease and desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to indemnify them for certain intellectual property infringement claims against them, which could increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers from covered products. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities. Regardless of the merits of the claims, intellectual property claims are often time consuming, expensive to litigate or settle, and cause significant diversion of management attention. To the extent such intellectual property infringement claims are successful, they may have an adverse effect on our business, consolidated financial position, results of operations, or cash flows. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brand. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services and technologies. For example, effective intellectual property protection may not be available in every country 11 Table of Contents Alphabet Inc. in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy could be compromised by outside parties, or by our employees, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that may adversely impact our business and results of operations. Acquisitions, joint ventures, investments and divestitures, are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and results of operations. We expect to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions. Effecting these potential strategic transactions could create unforeseen operating difficulties and expenditures. The areas where we face risks include: • Diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions. • Failure to successfully further develop the acquired business or technology. • Implementation or remediation of controls, procedures, and policies at the acquired company. • Integration of the acquired company's accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions. • Transition of operations, users, and customers onto our existing platforms. • Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of an acquisition or other strategic transaction. • In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. • Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire. • Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, privacy issues, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities. • Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or results. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which may adversely impact our financial condition or results. 12 Table of Contents Alphabet Inc. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, Google Network Members, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands of both Google and Other Bets increases our ability to enter new categories and launch new and innovative products that better serve the needs of our users. Our brands may be negatively impacted by a number of factors, including, among others, reputational issues and product/technical performance failures. Further, if we fail to maintain and enhance equity in the Google brand, our business, operating results, and financial condition may be materially and adversely affected. Maintaining and enhancing our brands will depend largely on our ability to remain a technology leader and continue to provide high-quality, innovative products and services that are truly useful and play a meaningful role in people’s everyday lives. We face a number of manufacturing and supply chain risks that, if not properly managed, could adversely impact our financial results and prospects. We face a number of risks related to manufacturing and supply chain management. We may enter into long term contracts that commit us to significant terms and conditions of supply. We may be liable for material and product that is not consumed due to market acceptance, technological change, obsolescences, quality, product recalls, and warranty issues. For instance, the products we sell may have quality issues resulting from the design or manufacture of the product, or from the software used in the product. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products does not meet our customers' expectations or our products are found to be defective, then our sales and operating earnings, and ultimately our reputation, could be negatively impacted. We rely on third parties to manufacture many of our assemblies and finished products, and we have third-party arrangements for the design of some components and parts. Our business could be negatively affected if we are not able to engage third parties with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We have in the past, and may experience in the future, supply shortages and price increases driven by raw material availability, manufacturing capacity, labor shortages, industry allocations, natural disasters and significant changes in the financial or business condition of our suppliers. We may experience shortages or other supply chain disruptions in the future that could negatively impact our operations. In addition, some of the components we use in our products are available only from a single source or limited sources, and we may not be able to find replacement vendors on favorable terms or at all in the event of a supply chain disruption. Additionally, because many of our supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and therefore less competitive and negatively impact our financial results. Further, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may impact our supply. We also require our suppliers and business partners to comply with law and company policies regarding workplace and employment practices, data security, environmental compliance and intellectual property licensing, but we do not control them or their practices. If any of them violates laws or implements practices regarded as unethical, we could experience supply chain disruptions, canceled orders, terminations of or damage to key relationships, and damage to our reputation. If any of them fails to procure necessary license rights to third-party intellectual property, legal action could ensue that could impact the saleability of our products and expose us to financial obligations to third parties. The Dodd-Frank Wall Street Reform and Consumer Protection Act includes disclosure requirements regarding the use of certain minerals mined from the Democratic Republic of Congo and adjoining countries (DRC) and procedures pertaining to a manufacturer's efforts regarding the source of such minerals. SEC rules implementing these requirements may have the effect of reducing the pool of suppliers who can supply DRC “conflict free” components and parts, and we may not be able to obtain DRC conflict free products or supplies in sufficient quantities for our operations. Since our supply chain is complex, we may face reputational challenges with our customers, stockholders and other stakeholders if we are unable to sufficiently verify the origins for the minerals used in our products. Web spam and content farms could decrease our search quality, which could damage our reputation and deter our current and potential users from using our products and services. “Web spam” refers to websites that attempt to violate a search engine's quality guidelines or that otherwise seek to rank higher in search results than a search engine's assessment of their relevance and utility would rank them. 13 Table of Contents Alphabet Inc. Although English-language web spam in our search results has been significantly reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek ways to improve their rankings inappropriately. We continuously combat web spam, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We face challenges from low-quality and irrelevant content websites, including “content farms”, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes focused on low-quality websites. If our search results display an increasing number of web spam and content farms, this could hurt our reputation for delivering relevant information or reduce user traffic to our websites. In addition, as we continue to take actions to improve our search quality and reduce low-quality content, this may in the short run reduce our AdSense revenues, since some of these websites are AdSense partners. Interruption or failure of our information technology and communications systems could hurt our ability to effectively provide our products and services, which could damage our reputation and harm our operating results. The availability of our products and services depends on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage or interruption from earthquakes, terrorist attacks, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, computer denial of service attacks, or other attempts to harm our systems. Some of our data centers are located in areas with a high risk of major earthquakes. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and to potential disruptions if the operators of certain of these facilities have financial difficulties. Some of our systems are not fully redundant, and our disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster, a decision to close a facility we are using, or other unanticipated problems at our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and may contain errors or vulnerabilities, which could result in interruptions in our services or the failure of our systems. Our international operations expose us to additional risks that could harm our business, operating results, and financial condition. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 53% of our consolidated revenues in 2016. In certain international markets, we have limited operating experience and may not benefit from any first-to-market advantages or otherwise succeed. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • Restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S. • Import and export requirements, tariffs, trade disputes and barriers, and customs classifications that may prevent us from offering products or providing services to a particular market and may increase our operating costs. • Longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud. • Still developing foreign laws and legal systems. • Uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent. • Different employee/employer relationships, existence of workers' councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Additionally, changes in international local political, economic, regulatory, tax, social, and labor conditions may adversely harm our business and compliance with complex foreign and U.S. laws and regulations that apply to our international operations increases our cost of doing business. These numerous and sometimes conflicting laws and regulations include, among others, internal control and disclosure rules, privacy and data protection requirements, anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting corrupt payments to governmental officials, and competition regulations, among others. Violations of these laws and regulations could result in fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business and on our ability to offer our products and services in one or more countries, and could also materially affect our brand, our international growth efforts, our ability to attract and retain employees, our business, and our operating results. Although we have implemented policies and procedures designed to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors, or agents will not violate our policies. 14 Table of Contents Alphabet Inc. Finally, since we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we face exposure to fluctuations in currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Additionally, hedging programs are inherently risky and could expose us to additional risks that could adversely affect our financial condition and results of operations. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results may fluctuate as a result of a number of factors, many outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our quarterly, year-to-date, and annual expenses as a percentage of our revenues may differ significantly from our historical or projected rates. Our operating results in future quarters may fall below expectations. Any of these events could cause our stock price to fall. Each of the risk factors listed in this section in addition to the following factors may affect our operating results: • Our ability to continue to attract users to our websites and retain existing users on our websites. • Our ability to monetize (or generate revenues from) traffic on Google properties and our Google Network Members' properties across various devices. • Advertising revenue fluctuations caused by changes in property mix, platform mix, device mix, and geographical mix. • The amount of revenues and expenses generated and incurred in currencies other than U.S. dollars, and our ability to manage the resulting risk through our foreign exchange risk management program. • The amount and timing of operating costs and expenses and capital expenditures related to the maintenance and expansion of our businesses, operations, and infrastructure. • Our focus on long-term goals over short-term results. • The results of our acquisitions, divestitures, and our investments in risky projects, including new businesses, products, services, and technologies. • Our ability to keep our websites operational at a reasonable cost and without service interruptions. • Our ability to generate significant revenues from new products and services in which we have invested considerable time and resources. Because our businesses are changing and evolving, our historical operating results may not be useful to you in predicting our future operating results. In addition, advertising spending has historically been cyclical in nature, reflecting overall economic conditions, as well as budgeting and buying patterns. Also, user traffic tends to be seasonal. Our rapid growth has tended to mask the cyclicality and seasonality of our business. As our growth rate has slowed, the cyclicality and seasonality in our business has become more pronounced and caused our operating results to fluctuate. If we were to lose the services of Larry, Sergey, Eric, Sundar, or other key personnel, we may not be able to execute our business strategy. Our future success depends in a large part upon the continued service of key members of our senior management team. In particular, Larry Page and Sergey Brin are critical to the overall management of Alphabet and its subsidiaries, and they, along with Sundar Pichai, the Chief Executive Officer of Google, play an important role in the development of our technology. Along with our Executive Chairman Eric E. Schmidt, they also play a key role in maintaining our culture and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows, and we are required to implement more complex organizational management structures, particularly in light of our holding company structure, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future success. 15 Table of Contents Alphabet Inc. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures, including legal actions, that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, or by charging increased fees to us or our users to provide our offerings. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. Such interference could result in a loss of existing users and advertisers, and increased costs, and could impair our ability to attract new users and advertisers, thereby harming our revenues and growth. New and existing technologies could block ads online, which would harm our business. Technologies have been developed that can block the display of ads online and that provide tools to users to opt out of seeing ads online. Most of our Google revenues are derived from fees paid to us in connection with the display of ads online. As a result, such technologies and tools could adversely affect our operating results. We are exposed to fluctuations in the market values of our investments. Given the global nature of our business, we have investments both domestically and internationally. Credit ratings and market values of these investments can be negatively impacted by liquidity, credit deterioration or losses, financial results, foreign exchange rates, changes in interest rates, or other factors. As a result, the value or liquidity of our cash equivalents and marketable securities could decline and result in a material impairment, which could materially adversely affect our financial condition and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. Our future income taxes could be adversely affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. Due to shifting economic and political conditions, tax policies or rates in various jurisdictions may be subject to significant change. In addition, we are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions on various tax-related assertions, including transfer pricing adjustments or permanent establishment. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations where the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made. Risks Related to Ownership of Our Stock The trading price for our Class A common stock and non-voting Class C capital stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. For example, from January 1, 2016 through December 31, 2016, the closing price of our Class A common stock ranged from $681.14 per share to $835.74 per share, and the closing price of our Class C capital stock ranged from $668.26 to $813.11 per share. In addition to the factors discussed in this Annual Report on Form 10-K, the trading price of our Class A common stock and Class C capital stock may fluctuate widely in response to various factors, many of which are beyond our control, including, among others: • Quarterly variations in our results of operations or those of our competitors. • Announcements by us or our competitors of acquisitions, divestitures, investments, new products, significant contracts, commercial relationships, or capital commitments. • Recommendations by securities analysts or changes in earnings estimates. 16 Table of Contents Alphabet Inc. • Announcements about our earnings that are not in line with analyst expectations, the risk of which is enhanced because it is our policy not to give guidance on earnings. • Announcements by our competitors of their earnings that are not in line with analyst expectations. • Commentary by industry and market professionals about our products, strategies, and other matters affecting our business and results, regardless of its accuracy. • The volume of shares of Class A common stock and Class C capital stock available for public sale. • Sales of Class A common stock and Class C capital stock by us or by our stockholders (including sales by our directors, executive officers, and other employees). • Short sales, hedging, and other derivative transactions on shares of our Class A common stock and Class C capital stock. • The perceived values of Class A common stock and Class C capital stock relative to one another. • Our stock repurchase program. In addition, the stock market in general, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may harm the market price of our Class A common stock and our Class C capital stock regardless of our actual operating performance. We cannot guarantee that our stock repurchase program will be fully consummated or that our stock repurchase program will enhance long-term stockholder value, and stock repurchases could increase the volatility of the price of our stock and could diminish our cash reserves. In October 2016, our board of directors authorized our company to repurchase up to $7,019,340,976.83 of our Class C capital stock. The repurchase program does not have an expiration date. Although our board of directors has authorized a stock repurchase program, the share repurchase program does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. The stock repurchase program could affect the price of our stock and increase volatility and may be suspended or terminated at any time, which may result in a decrease in the trading price of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B common stock has 10 votes per share, our Class A common stock has one vote per share, and our Class C capital stock has no voting rights. As of December 31, 2016, Larry, Sergey, and Eric beneficially owned approximately 92.4% of our outstanding Class B common stock, which represented approximately 56.8% of the voting power of our outstanding capital stock. Larry, Sergey, and Eric therefore have significant influence over management and affairs and over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C capital stock carries no voting rights (except as required by applicable law), the issuance of the Class C capital stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could prolong the duration of Larry and Sergey’s current relative ownership of our voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. Together with Eric, they would also continue to be able to control any required stockholder vote with respect to certain change in control transactions involving Alphabet (including an acquisition of Alphabet by another company). This concentrated control limits or severely restricts our stockholders’ ability to influence corporate matters and, as a result, we may take actions that our stockholders do not view as beneficial. As a result, the market price of our Class A common stock and our Class C capital stock could be adversely affected. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry, Sergey, and Eric have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. As noted above, the issuance of the Class C capital stock could have the effect of prolonging the influence of Larry, Sergey, and Eric. • Our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death, or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors. 17 Table of Contents Alphabet Inc. • Our stockholders may not act by written consent. As a result, a holder, or holders, controlling a majority of our capital stock would not be able to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our board of directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to issue undesignated preferred stock makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us. Risks Related to Our Holding Company Reorganization As a holding company, Alphabet is dependent on the operations and funds of its subsidiaries. On October 2, 2015, we completed a reorganization pursuant to which Alphabet became a holding company with no business operations of its own. Alphabet’s only significant assets are the outstanding equity interests in Google and any other current or future subsidiaries of Alphabet. As a result, we rely on cash flows from subsidiaries to meet our obligations, including to service any debt obligations of Alphabet. We may not obtain the anticipated benefits of our reorganization into a holding company structure. We believe that our holding company reorganization and the current operating structure increases management scale and allows us to focus on running our diverse businesses independently with the goal of maximizing each of the business’ potential. The benefits of this reorganization may not be obtained if circumstances prevent us from taking advantage of the strategic and business opportunities that we expect it may afford us. As a result, we may incur the costs of a holding company structure without realizing the benefits, which could adversely affect our reputation, financial condition, and operating results. Alphabet’s management is dedicating significant effort to the Alphabet operating structure. These efforts may divert management’s focus and resources from Alphabet’s business, corporate initiatives, or strategic opportunities, which could have an adverse effect on our businesses, results of operations, financial condition, or prospects. Additionally, our subsidiaries may be restricted in their ability to pay cash dividends or to make other distributions to Alphabet, as the new holding company. ITEM 1B. UNRESOLVED STAFF COMMENTS There are no unresolved staff comments at December 31, 2016 . ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We also own and lease office and building space in the surrounding areas near our headquarters, which in the aggregate (including our headquarters) represent approximately 7.86 million square feet of office/building space and approximately forty-five acres of developable land to accommodate anticipated future growth. In addition, we own and lease office/building space and research and development sites, around the world - primarily in North America, Europe, South America, and Asia. We operate and own data centers in the U.S., Europe, South America, and Asia pursuant to various lease agreements and co-location arrangements. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, please see Note 10 “Commitments and Contingencies - Legal Matters” of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. 18 Table of Contents Alphabet Inc. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Price Range of Common Stock and Capital Stock Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. The following table sets forth for the indicated periods the high and low sales prices per share for our Class A common stock on the Nasdaq Global Select Market. Fiscal Year 2016 Quarters Ended: High Low March 31, 2016 $ 780.91 $ 701.02 June 30, 2016 787.68 681.14 September 30, 2016 815.95 704.89 December 31, 2016 835.74 753.22 Fiscal Year 2015 Quarters Ended: High Low March 31, 2015 $ 581.44 $ 497.06 June 30, 2015 573.66 532.74 September 30, 2015 699.62 541.70 December 31, 2015 793.96 642.00 Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. The following table sets forth for the indicated periods the high and low sales prices per share for our Class C capital stock on the Nasdaq Global Select Market. Fiscal Year 2016 Quarters Ended: High Low March 31, 2016 $ 764.65 $ 678.11 June 30, 2016 766.61 668.26 September 30, 2016 787.21 694.49 December 31, 2016 813.11 736.08 Fiscal Year 2015 Quarters Ended: High Low March 31, 2015 $ 575.33 $ 492.55 June 30, 2015 565.06 520.51 September 30, 2015 672.93 516.83 December 31, 2015 776.60 611.29 Holders of Record As of December 31, 2016 , there were approximately 2,178 and 2,183 stockholders of record of our Class A common stock and Class C capital stock, respectively, and the closing prices of our Class A common stock and Class C capital stock were $792.45 and $771.82 per share, respectively, as reported by the NASDAQ Global Select Market. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2016 , there were approximately 67 stockholders of record of our Class B common stock. 19 Table of Contents Alphabet Inc. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. We intend to retain any future earnings and do not expect to pay any cash dividends in the foreseeable future. Stock Performance Graph The following graph compares the 5-year cumulative total return to shareholders on Alphabet Inc.’s common stock relative to the cumulative total returns of the S&P 500 index, the RDG Internet Composite index, and the NASDAQ Composite index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in the company’s Class A common stock and in each index on December 31, 2011 and its relative performance is tracked through December 31, 2016 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2011 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2015 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. This performance graph shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the Exchange Act), or incorporated by reference into any filing of Alphabet under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such filing. 20 Table of Contents Alphabet Inc. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing in Item 8 “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results to be expected in any future period. Year Ended December 31, 2012 2013 2014 2015 2016 (in millions, except per share amounts) Consolidated Statements of Income Data: Revenues $ 46,039 $ 55,519 $ 66,001 $ 74,989 $ 90,272 Income from operations 13,834 15,403 16,496 19,360 23,716 Net income from continuing operations 11,435 13,160 13,620 16,348 19,478 Net income (loss) from discontinued operations (816 ) (427 ) 516 0 0 Net income 10,619 12,733 14,136 16,348 19,478 Basic net income (loss) per share of Class A and B common stock: Continuing operations $ 17.47 $ 19.77 $ 20.15 $ 23.11 $ 28.32 Discontinued operations (1.25 ) (0.64 ) 0.76 0.00 0.00 Basic net income per share of Class A and B common stock $ 16.22 $ 19.13 $ 20.91 $ 23.11 $ 28.32 Basic net income (loss) per share of Class C capital stock: Continuing operations $ 17.47 $ 19.77 $ 20.15 $ 24.63 $ 28.32 Discontinued operations (1.25 ) (0.64 ) 0.76 0.00 0.00 Basic net income per share of Class C capital stock $ 16.22 $ 19.13 $ 20.91 $ 24.63 $ 28.32 Diluted net income (loss) per share of Class A and B common stock: Continuing operations $ 17.21 $ 19.42 $ 19.82 $ 22.84 $ 27.85 Discontinued operations (1.23 ) (0.63 ) 0.75 0.00 0.00 Diluted net income per share of Class A and B common stock $ 15.98 $ 18.79 $ 20.57 $ 22.84 $ 27.85 Diluted net income (loss) per share of Class C capital stock: Continuing operations $ 17.21 $ 19.42 $ 19.82 $ 24.34 $ 27.85 Discontinued operations (1.23 ) (0.63 ) 0.75 0.00 0.00 Diluted net income per share of Class C capital stock $ 15.98 $ 18.79 $ 20.57 $ 24.34 $ 27.85 As of December 31, 2012 2013 2014 2015 2016 (in millions) Consolidated Balance Sheet Data: Cash, cash equivalents, and marketable securities $ 48,088 $ 58,717 $ 64,395 $ 73,066 $ 86,333 Total assets 92,711 109,050 129,187 147,461 167,497 Total long-term liabilities 6,662 6,165 8,548 7,820 11,705 Total stockholders’ equity 71,570 86,977 103,860 120,331 139,036 21 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Item 8 of this Annual Report on Form 10-K. Trends in Our Business The following trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to impact our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, resulting in increasing revenues, and we expect that this online shift will continue to benefit our business. • As online advertising evolves, we continue to expand our product offerings which may impact our monetization. As interactions between users and advertisers change, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube engagement ads, which monetize at a lower rate than traditional desktop search ads. Additionally, we continue to see a shift to programmatic buying which presents opportunities for advertisers to connect with the right user, in the right moment, in the right context. Programmatic buying has a different monetization profile than traditional advertising buying on Google properties. These trends will continue to affect our revenues and margins in the future. • Users are increasingly using multiple devices to access our products and services, and our advertising revenues are increasingly coming from mobile and other new formats. Our users are accessing the Internet via multiple devices and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of this shift in order to maintain and grow our business. In this multi-device world, we generate our advertising revenues increasingly from mobile and newer advertising formats, and the margins from the advertising revenues from these sources have generally been lower than those from traditional desktop search. We also expect traffic acquisition costs (TAC) paid to our distribution partners to increase due to changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms, and the percentage of queries channeled through paid access points. We expect these trends to continue to put pressure on our overall margins. • As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates impact such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, and we continue to develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time and we expect that our results will continue to be impacted by our performance in these markets, particularly as low-cost mobile devices become more available. Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. • The portion of our revenues that we derive from non-advertising revenues is increasing. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our Google offerings to our users through products and services like Google Cloud, Google Play, and hardware products. Across these initiatives, we currently derive non-advertising revenues primarily from hardware sales, sales of apps, in-app purchases and digital content products, and service and licensing fees; the margins on these non-advertising businesses vary significantly and may be lower than the margins on our advertising business. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile. 22 Table of Contents Alphabet Inc. • As we continue to look for new ways to serve our users and expand our businesses, we will invest heavily in R&D and our capital expenditures will continue to fluctuate. We continue to make significant research and development (R&D) investments in areas of strategic focus for Google, such as search, advertising, and machine learning, as well as in new products and services across both Google and Other Bets. The amount of our capital expenditures has fluctuated and may continue to fluctuate in the long term as we invest heavily in our systems, data centers, real estate and facilities, and information technology infrastructure. In addition, acquisitions remain an important part of our strategy and use of capital, and we expect to continue to spend cash on acquisitions and other investments. These acquisitions generally enhance the breadth and depth of our offerings, as well as expand our expertise in engineering and other functional areas. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. Their energy and talent drive Alphabet and create our success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees. Executive Overview of Results Here are our key financial results for the fiscal year ended December 31, 2016 (consolidated unless otherwise noted): • Revenues of $90.3 billion and revenue growth of 20% year over year, constant currency revenue growth of 24% year over year. • Google segment revenues of $89.5 billion with revenue growth of 20% year over year and Other Bets revenues of $0.8 billion with revenue growth of 82% year over year. • Revenues from the United States, the United Kingdom, and Rest of the world were $42.8 billion , $7.8 billion , and $39.7 billion , respectively. • Cost of revenues was $35.1 billion , consisting of traffic acquisition costs of $16.8 billion and other cost of revenues of $18.3 billion . Our traffic acquisition costs as a percentage of advertising revenues was 21% . • Operating expenses (excluding cost of revenues) were $31.4 billion . • Income from operations was $23.7 billion . • Effective tax rate was 19% . • Net income was $19.5 billion with diluted net income per share of $27.85 . • Operating cash flow was $36.0 billion . • Capital expenditures were $10.2 billion . • Headcount increased to 72,053 as of December 31, 2016 . Information about Segments We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed below as Other Bets. Our reported segments are described below: • Google – Google includes our main internet products such as Search, Ads, Commerce, Maps, YouTube, Google Cloud, Android, Chrome, and Google Play as well as our hardware initiatives. Our technical infrastructure and some newer efforts like virtual reality are also included in Google. Google generates revenues primarily from advertising, sales of digital content, apps and cloud offerings, and sales of hardware products. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Google Fiber, sales of Nest products and services, and licensing and R&D services through Verily. Please refer to Note 15 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K for further information. Prior period segment information has been recast to conform to the current period segment presentation. 23 Table of Contents Alphabet Inc. Consolidated Revenues The following table presents our consolidated revenues, by segment and revenue source, for the periods presented (in millions): Year Ended December 31, 2014 2015 2016 Google segment Google properties $ 45,085 $ 52,357 $ 63,785 Google Network Members' properties 14,539 15,033 15,598 Google advertising revenues 59,624 67,390 79,383 Google other revenues 6,050 7,154 10,080 Google segment revenues $ 65,674 $ 74,544 $ 89,463 Other Bets Other Bets revenues $ 327 $ 445 $ 809 Consolidated revenues $ 66,001 $ 74,989 $ 90,272 Google segment The following table presents our Google segment revenues (in millions), and changes in our aggregate paid clicks and cost-per-click (expressed as a percentage) for the periods presented: Year Ended December 31, 2014 2015 2016 Google segment revenues $ 65,674 $ 74,544 $ 89,463 Google segment revenues as a percentage of consolidated revenues 99.5 % 99.4 % 99.1 % Aggregate paid clicks change 22 % 32 % Aggregate cost-per-click change (11 )% (11 )% Use of Monetization Metrics When assessing our advertising revenue performance, we present information regarding the percentage change in the number of "paid clicks" and "cost-per-click" for our Google properties and Google Network Members' properties. Management views these as important metrics for understanding our business. We periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks and for identifying the revenues generated by click activity. Paid clicks for our Google properties represent engagement by users and include clicks on advertisements by end-users related to searches on Google.com, clicks related to advertisements on other owned and operated properties including Gmail, Maps, and Google Play; and viewed YouTube engagement ads like TrueView (counted as an engagement when the user chooses not to skip the ad) and certain trial ad formats. Paid clicks for our Google Network Members' properties include clicks by end-users related to advertisements served on Google Network Members' properties participating in our AdSense for Search, AdSense for Content and AdMob businesses. In some cases, such as programmatic and reservation based advertising buying, we charge advertisers by impression; while growing, this represents a small part of our revenue base. Cost-per-click is defined as click-driven revenue divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. Revenue growth and the change in revenue growth, as well as the change in paid clicks and cost-per-click on Google properties and Google Network Members' properties and the correlation between these items, has fluctuated and may continue to fluctuate because of various factors, including: • growth rates of our revenues from Google properties, including YouTube, compared to those of our revenues from Google Network Members' properties; • advertiser competition for keywords; • changes in foreign currency exchange rates; • seasonality; 24 Table of Contents Alphabet Inc. • the fees advertisers are willing to pay based on how they manage their advertising costs; • changes in advertising quality or formats; • changes in device mix; • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels; • a shift in the proportion of non-click based revenue generated on Google properties and Google Network Members' properties, including an increase in programmatic and reservation based advertising buying; and • general economic conditions. Our advertising revenue growth rate has fluctuated over time as a result of a number of factors, including increasing competition, query growth rates, challenges in maintaining our growth rate as our revenues increase to higher levels, the evolution of the online advertising market, our investments in new business strategies, changes in our product mix, and shifts in the geographic mix of our revenues. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates. Google properties The following table presents our Google properties revenues (in millions), and changes in our paid clicks and cost-per-click (expressed as a percentage) for the periods presented: Year Ended December 31, 2014 2015 2016 Google properties $ 45,085 $ 52,357 $ 63,785 Google properties as a percentage of Google segment revenues 68.6 % 70.2 % 71.3 % Paid clicks change 33 % 40 % Cost-per-click change (15 )% (13 )% Google properties revenues consist primarily of advertising revenue that is generated on: • Google search properties. This includes revenue from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.; • Other Google owned and operated properties like Gmail, Maps, and Google Play; and • YouTube, including but not limited to, YouTube TrueView and Google Preferred. Our Google properties revenues increased $11,428 million from 2015 to 2016 and also increased as a percentage of Google segment revenues. The growth was primarily driven by increases in mobile search most notably due to ongoing improvements in ad formats and delivery launched during 2016. We also experienced growth in YouTube revenue driven primarily by video advertising across TrueView with a growing contribution from ad buying on DoubleClick Bid Manager, as well as improvements in ad formats and delivery. The growth was partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. The number of paid clicks through our advertising programs on Google properties increased from 2015 to 2016 due to growth in the adoption of YouTube engagement ads, improvements we have made in ad formats and delivery, and continued global expansion of our products, advertisers and user base across all platforms, particularly mobile. The positive impact on our revenues from paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms, and also impacted by changes in device mix, property mix, product mix, geographic mix, and ongoing product changes, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Our Google properties revenues increased $7,272 million from 2014 to 2015 and also increased as a percentage of Google segment revenues. Our Google properties revenue growth was primarily driven by increases in mobile search due to ongoing improvements in ad formats, as well as growth in YouTube video advertising across TrueView and Google Preferred, partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. The number of paid clicks through our advertising programs on Google properties increased from 2014 to 2015 due to an increase in aggregate traffic on Google owned properties, the adoption of advertising formats such as YouTube engagement ads, and continued global expansion of our products, advertisers, and user base across all platforms, particularly mobile. The positive impact on our revenues from paid clicks was partially offset by a decrease 25 Table of Contents Alphabet Inc. in the cost-per-click paid by our advertisers. The decrease was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms, as well as changes in property and device mix, product mix, geographic mix, and ongoing product changes, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Google Network Members' properties The following table presents our Google Network Members' properties revenues (in millions) and changes in our paid clicks and cost-per-click (expressed as a percentage) for the periods presented: Year Ended December 31, 2014 2015 2016 Google Network Members' properties $ 14,539 $ 15,033 $ 15,598 Google Network Members' properties revenues as a percentage of Google segment revenues 22.1 % 20.2 % 17.4 % Paid clicks change (7 )% 3 % Cost-per-click change (3 )% (13 )% Google Network Members' properties revenues consist primarily of advertising revenues generated from ads placed on Google Network Member properties through: • AdSense (such as AdSense for Search, AdSense for Content, etc.); • AdMob; and • DoubleClick AdExchange. Our Google Network Members' properties revenues increased $565 million from 2015 to 2016 . The growth was primarily driven by strength in programmatic advertising buying as well as strength in AdMob, offset by a decline in our traditional AdSense business and the general strengthening of the U.S. dollar compared to certain foreign currencies. The increase in paid clicks from 2015 to 2016 resulted from the growth in AdMob offset by declines in AdSense. The decrease in cost-per-click paid by our advertisers from 2015 to 2016 resulted from changes in the product mix of Google Network Members advertising revenues, ongoing product and policy changes, changes in property and device mix, geographic mix, and relative fluctuations of the U.S. dollar compared to certain foreign currencies. Our Google Network Members' properties revenues increased $494 million from 2014 to 2015 . The increase was primarily driven by strength in programmatic advertising buying, offset by our continued AdSense advertising policy changes aimed at enriching the experience for users and the general strengthening of the U.S. dollar compared to certain foreign currencies. The decrease in Google Network Members' properties revenues as a percentage of Google segment revenues is due to relatively slower growth of Google Network Members' properties revenues compared to that of Google properties revenues as well as Google other revenues. The decreases in both paid clicks and cost-per-click paid by our advertisers from 2014 to 2015 were primarily driven by ongoing product and policy changes designed to reduce lower quality inventory on AdSense for Search, changes in property and device mix, product mix, and geographic mix, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Google other revenues The following table presents our Google other revenues (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 Google other revenues $ 6,050 $ 7,154 $ 10,080 Google other revenues as a percentage of Google segment revenues 9.3 % 9.6 % 11.3 % Google other revenues consist primarily of revenues and sales from: • Apps, in-app purchases, and digital content in the Google Play store; • Hardware; • Licensing-related revenue; and • Service fees received for our Google Cloud offerings. 26 Table of Contents Alphabet Inc. Our Google other revenues increased $2,926 million from 2015 to 2016 and increased as a percentage of Google segment revenues. These increases were primarily due to the growth in revenues from Google Play, primarily relating to in-app purchases (revenues which we recognize net of payout to developers), hardware sales, and Google Cloud offerings. Our Google other revenues increased $1,104 million from 2014 to 2015 and increased as a percentage of Google segment revenues. These increases were primarily due to the growth of our sales of digital content products in the Google Play store, primarily apps (revenues which we recognize net of payout to partners). In addition, there was an increase in revenues from service fees received for Google Cloud offerings. These increases were partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. Other Bets The following table presents our Other Bets revenues (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 Other Bets revenues $ 327 $ 445 $ 809 Other Bets revenues as a percentage of consolidated revenues 0.5 % 0.6 % 0.9 % Other Bets revenues consist primarily of revenues and sales from: • Internet and TV services; • Licensing and R&D services; and • Nest branded hardware. Our Other Bets revenues increased $364 million from 2015 to 2016 and increased as a percentage of consolidated revenues. These increases were primarily driven by sales of Nest branded hardware and revenues from Fiber internet and TV services. There was also an increase in revenues from Verily licensing and R&D services from 2015 to 2016 . Our Other Bets revenues increased $118 million from 2014 to 2015 and remained relatively flat as a percentage of consolidated revenues. The increase was primarily due to increases in revenues from sales of Nest branded hardware and revenues from internet and TV services, partially offset by a decrease in licensing revenues. As Nest was acquired in February 2014, the increase in our Nest revenues is impacted by a partial year of revenues in 2014 as compared to a full year in 2015. Due to the early stage of our Other Bets businesses and because their revenues aggregates a number of businesses operating in different industries, our Other Bets revenues may fluctuate in future periods. Additionally, our Other Bets revenues may fluctuate due to one-time items. Consolidated Revenues by Geography The following table presents our domestic and international revenues as a percentage of consolidated revenues, determined based on the billing addresses of our customers: Year Ended December 31, 2014 2015 2016 United States 45 % 46 % 47 % United Kingdom 10 % 10 % 9 % Rest of the world 45 % 44 % 44 % For the amounts of revenues by geography, please refer to Note 15 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Use of Constant Currency Revenues and Constant Currency Revenue Growth The impact of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably impacted as the U.S. dollar weakens relative to other foreign currencies, and unfavorably impacted as the U.S dollar strengthens relative to other foreign currencies. We use non-GAAP constant currency revenues and constant currency revenue growth for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to GAAP results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results. 27 Table of Contents Alphabet Inc. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the impact of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue growth on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging impacts realized in the current period. Constant currency revenue growth (expressed as a percentage) is calculated by determining the increase in current period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging benefits are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. The following table presents our foreign exchange impact on United Kingdom revenues, Rest of the world revenues, and total consolidated revenues for the current period (in millions): Year Ended December 31, 2014 2015 2016 United Kingdom revenues $ 6,483 $ 7,067 $ 7,787 Exclude: Foreign exchange impact on current year revenues using prior period rates N/A N/A $ 826 Exclude: Hedging (gains) recognized $ (3 ) $ (133 ) $ (297 ) Constant currency United Kingdom revenues $ 6,480 $ 6,934 $ 8,316 United Kingdom revenue growth rate 9 % 10 % United Kingdom constant currency revenue growth rate 15 % 20 % Rest of the world revenues $ 30,036 $ 33,112 $ 39,704 Exclude: Foreign exchange impact on current year revenues using prior period rates N/A N/A 447 Exclude: Hedging (gains) recognized (169 ) (1,267 ) (242 ) Constant currency Rest of the world revenues $ 29,867 $ 31,845 $ 39,909 Rest of the world revenue growth rate 10 % 20 % Rest of the world constant currency revenue growth rate 24 % 25 % United States revenues $ 29,482 $ 34,810 $ 42,781 United States revenue growth rate 18 % 23 % Total consolidated revenues $ 66,001 $ 74,989 $ 90,272 Constant currency total consolidated revenues $ 65,829 $ 73,589 $ 91,006 Total consolidated revenue growth rate 14 % 20 % Constant currency total consolidated revenue growth rate 20 % 24 % In 2016 and in 2015 , our revenues from the United Kingdom were unfavorably impacted by changes in foreign currency exchange rates over the prior year, primarily as the British pound weakened relative to the U.S. dollar. In 2016 , our revenues from the Rest of the world (excluding the United Kingdom) were unfavorably impacted by changes in foreign currency exchange rates, primarily because the U.S. dollar strengthened relative to certain currencies including the Euro and Argentine peso, partially offset by the impact of the U.S. dollar weakening relative to the Japanese yen. In 2015 , our revenues from the Rest of the world (excluding the United Kingdom) were unfavorably impacted by changes in foreign currency exchange rates, primarily because the U.S. dollar strengthened relative to the Euro, Brazilian real, Australian dollar, and Japanese yen. 28 Table of Contents Alphabet Inc. Consolidated Costs and Expenses Cost of Revenues Cost of revenues consists of traffic acquisition costs ​(TAC) which are ​paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. Additionally, other cost of revenues (which is the cost of revenues excluding traffic acquisition costs) includes the following: • The expenses associated with the operation of our data centers (including depreciation, labor, energy, bandwidth, and other equipment costs); • Content acquisition costs primarily related to payments to certain content providers from whom we license their video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Credit card and other transaction fees related to processing customer transactions; • Stock-based compensation expense; • Inventory related costs for hardware we sell; and • Amortization of certain intangible assets. The following tables present our cost of revenues, including traffic acquisition costs, for the periods presented (in millions): Year Ended December 31, 2014 2015 2016 Traffic acquisition costs $ 13,497 $ 14,343 $ 16,793 Other cost of revenues 12,194 13,821 18,345 Total cost of revenues $ 25,691 $ 28,164 $ 35,138 Total cost of revenues as a percentage of revenues 38.9 % 37.6 % 38.9 % Year Ended December 31, 2014 2015 2016 Traffic acquisition costs to distribution partners $ 3,633 $ 4,101 $ 5,894 Traffic acquisition costs to distribution partners as a percentage of Google properties revenues (Google properties TAC rate) 8.1 % 7.8 % 9.2 % Traffic acquisition costs to Google Network Members $ 9,864 $ 10,242 $ 10,899 Traffic acquisition costs to Google Network Members as a percentage of Google Network Members' properties revenues (Network Members TAC rate) 67.8 % 68.1 % 69.9 % Traffic acquisition costs $ 13,497 $ 14,343 $ 16,793 Traffic acquisition costs as a percentage of advertising revenues (Aggregate TAC rate) 22.6 % 21.3 % 21.2 % The cost of revenues that we incur related to revenues generated from ads placed on the properties of our Google Network Members are significantly higher than the costs of revenues we incur related to revenues generated from ads placed on Google properties because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members. Cost of revenues increased $6,974 million from 2015 to 2016 due to various factors including traffic acquisition costs, data center costs, content acquisition costs, and hardware costs. The increase in traffic acquisition costs of $2,450 million was due to increases in advertising revenues primarily from the growth of mobile search and programmatic ad buying which carry higher TAC. The increase in other cost of revenues of $4,524 million was primarily due to increases in (1) data centers costs including depreciation, labor, energy, bandwidth, and other equipment costs as a result of business growth, (2) content acquisition costs as a result of increased activities related to YouTube, (3) hardware costs associated with new hardware launches, and (4) stock-based compensation. 29 Table of Contents Alphabet Inc. The aggregate TAC rate remained relatively flat from 2015 to 2016 primarily as a result of a shift of mix from Google Network Members' properties revenue to Google properties revenue. Our aggregate TAC rate was also impacted by the increase in mobile and programmatic advertising buying, which generally carry overall higher TAC. The increase in Google properties TAC rate was primarily driven by a shift to mobile and more mobile searches are subject to TAC. The increase in Network Members' TAC rate was primarily driven by the shift in advertising buying from our traditional network business to programmatic advertising buying. Cost of revenues increased $2,473 million from 2014 to 2015 . The increase was primarily due to data center costs and an increase in content acquisition costs as a result of increased activities related to YouTube and digital content. The remaining increase was driven by increases in traffic acquisition costs of $846 million, resulting from more advertiser fees generated through our AdSense program driven primarily by an increase in advertising revenues, as well as more fees paid to our distribution partners for additional traffic directed to our websites. Additionally, there was an impairment charge of $378 million recognized in 2014 related to a patent licensing royalty asset acquired in connection with the Motorola acquisition that did not recur in 2015. The decrease in aggregate TAC rate from 2014 to 2015 was primarily a result of a shift of mix from Google Network Members' properties revenue to Google properties revenue. We expect cost of revenues to increase in dollar amount and as a percentage of total revenues in 2017 and future periods based on a number of factors, including the following: • The relative revenue growth rates of Google properties and our Google Network Members' properties; • Traffic acquisition costs paid to our distribution partners, which are affected by changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points; • Traffic acquisition costs paid to Google Network Members, which are affected by ongoing adoption of programmatic advertising buying and changes in partner agreement terms; • The growth rates of expenses associated with our data center operations, content acquisition costs, as well as our hardware inventory and related costs; and • Increased proportion of non-advertising revenues as part of our total revenues. Research and Development The following table presents our R&D expenses (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 Research and development expenses $ 9,832 $ 12,282 $ 13,948 Research and development expenses as a percentage of revenues 14.9 % 16.3 % 15.5 % R&D expenses consist primarily of: • Labor and facilities-related costs for employees responsible for R&D of our existing and new products and services; • Depreciation and equipment-related expenses; and • Stock-based compensation expense. R&D expenses increased $1,666 million from 2015 to 2016 . The increase was primarily due to an increase in stock-based compensation expense of $667 million and an increase in labor and facilities-related costs of $326 million both largely as a result of a 16% increase in R&D headcount partially offset by higher expenses resulting from project milestones in Other Bets in 2015. In addition, there was an increase in depreciation and equipment-related expenses of approximately $388 million and an increase in professional services of $267 million due to additional expenses incurred for consulting, outsourced services, and temporary services. R&D expenses increased $2,450 million and increased as a percentage of revenues from 2014 to 2015 . These increases were primarily due to an increase in labor and facilities-related costs of $1,502 million and an increase in stock-based compensation expense of $487 million, both largely as a result of a 16% increase in R&D headcount. The increase in labor and facilities-related costs was also impacted by expenses resulting from project milestones in Other Bets established several years ago. In addition, there was an increase in depreciation and equipment-related expenses of approximately $248 million and an increase in professional services of $174 million due to additional expenses incurred for consulting and outsourced services. 30 Table of Contents Alphabet Inc. We expect that R&D expenses will increase in dollar amount and may fluctuate as a percentage of revenues in 2017 and future periods. Sales and Marketing The following table presents our sales and marketing expenses (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 Sales and marketing expenses $ 8,131 $ 9,047 $ 10,485 Sales and marketing expenses as a percentage of revenues 12.3 % 12.1 % 11.6 % Sales and marketing expenses consist primarily of: • Labor and facilities-related costs for employees engaged in sales and marketing, sales support, and certain customer service functions; • Advertising and promotional expenditures related to our products and services; and • Stock-based compensation expense. Sales and marketing expenses increased $1,438 million from 2015 to 2016 . The increase was primarily due to an increase in advertising and promotional expenses of $679 million largely due to increases in marketing and promotion related expenses for our hardware products. Additionally, there was an increase in labor and facilities-related costs of $482 million and stock-based compensation expense of $179 million, both largely resulting from a 10% increase in sales and marketing headcount. Sales and marketing expenses increased $916 million and remained relatively flat as a percentage of revenues from 2014 to 2015 . The increase in dollar amount was primarily due to an increase in labor and facilities-related costs of $329 million and an increase in stock-based compensation expense of $184 million, largely resulting from a 12% increase in sales and marketing headcount. In addition, there was an increase in advertising and promotional expenses of $184 million and an increase in professional service fees of $158 million due to additional expenses incurred for consulting and outsourced services. We expect that sales and marketing expenses will increase in dollar amount and may fluctuate as a percentage of revenues in 2017 and future periods. General and Administrative The following table presents our general and administrative expenses (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 General and administrative expenses $ 5,851 $ 6,136 $ 6,985 General and administrative expenses as a percentage of revenues 8.9 % 8.2 % 7.7 % General and administrative expenses consist primarily of: • Labor and facilities-related costs for employees in our facilities, finance, human resources, information technology, and legal organizations; • Depreciation and equipment-related expenses; • Professional services fees primarily related to outside legal, audit, information technology consulting, and outsourcing services; • Amortization of certain intangible assets; and • Stock-based compensation expense. General and administrative expenses increased $849 million from 2015 to 2016 . The increase was primarily due to increases in labor and facilities-related costs of $460 million and stock-based compensation expense of $421 million, both largely resulting from a 15% increase in general and administrative headcount, as well as increases in other miscellaneous expenses. These increases were offset by a decrease in professional service fees of $194 million due to lower legal-related costs. General and administrative expenses increased $285 million and decreased as a percentage of revenues from 2014 to 2015 . The increase in dollar amount was primarily due to an increase in stock-based compensation expense of $136 million and an increase in labor and facilities-related costs of $69 million, both largely resulting from a 15% increase in general and administrative headcount. In addition, there was an increase in depreciation and equipment- 31 Table of Contents Alphabet Inc. related expenses of $121 million and an increase of $80 million of miscellaneous general and administrative expenses. These factors were partially offset by a decrease in professional services fees and expenses of $128 million, primarily due to lower legal-related costs. We expect general and administrative expenses will increase in dollar amount and may fluctuate as a percentage of revenues in 2017 and future periods. Stock-Based Compensation The following table presents stock-based compensation expense for awards we expect to settle in equity (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 Stock-based compensation $ 4,175 $ 5,203 $ 6,703 Stock-based compensation as a percentage of revenues 6.3 % 6.9 % 7.4 % Stock-based compensation related to awards we expected to settle in equity increased $1,500 million from 2015 to 2016 and $1,028 million from 2014 to 2015 . These increase s were primarily driven by headcount growth. We estimate stock-based compensation expense related to awards we expect to settle in equity to be approximately $6.3 billion in 2017 and $8.3 billion thereafter related to stock-based awards outstanding as of December 31, 2016 . These estimates do not include expense related to stock-based awards granted after December 31, 2016 . Consolidated Other Income (Expense), Net The following table presents other income (expense), net, (in millions) for the periods presented: Year Ended December 31, 2014 2015 2016 Other income (expense), net $ 763 $ 291 $ 434 Other income (expense), net, as a percentage of revenues 1.1 % 0.4 % 0.5 % Other income (expense), net, increased $143 million from 2015 to 2016 . This increase was primarily driven by an increase in interest income and decreased losses on non-marketable investments, partially offset by increased losses from our foreign currency transactions and impairments for certain assets. Other income (expense), net, decreased $472 million from 2014 to 2015 . This decrease was primarily related to a writedown of securities received in conjunction with the sale of a business as well as reduced gains on non-marketable investments as compared to 2014. These decreases were partially offset by an increase in interest income as a result of increased cash and fixed income investments. The costs of our foreign exchange hedging activities recognized in other income (expense), net, are primarily a function of the notional amount of the option and forward contracts and their related duration, the movement of foreign exchange rates relative to the contract prices, the volatility of foreign exchange rates and forward points. As we began using foreign currency forward contracts to hedge our forecasted revenues in the fourth quarter of 2016, we expect the hedging costs expensed in other income (expense), net, will decrease in 2017 and future periods as a result of less option premiums paid. Consolidated Provision for Income Taxes The following table presents our provision for income taxes (in millions) and effective tax rate for the periods presented: Year Ended December 31, 2014 2015 2016 Provision for income taxes $ 3,639 $ 3,303 $ 4,672 Effective tax rate 21.1 % 16.8 % 19.3 % Our provision for income taxes and our effective tax rate increased from 2015 to 2016 , largely due to proportionately more earnings generated in jurisdictions that have higher statutory tax rates and discrete items in 2015 and 2016, partially offset by the stock-based compensation benefits recognized resulting from the adoption of Accounting Standards Update No. 2016-09 (ASU 2016-09). 32 Table of Contents Alphabet Inc. Our provision for income taxes and our effective tax rate decreased from 2014 to 2015 , largely due to a discrete benefit recognized in 2015 as a result of the resolution of a multi-year U.S. tax audit related to prior years and proportionately more earnings generated in jurisdictions that have lower statutory tax rates. Our future effective tax rate could be adversely affected by earnings being lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2016 . This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Both seasonal fluctuations in internet usage, advertising expenditures and underlying business trends such as traditional retail seasonality have affected, and are likely to continue to affect, our business. Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31, 2015 Jun 30, 2015 Sep 30, 2015 Dec 31, 2015 Mar 31, 2016 Jun 30, 2016 Sep 30, 2016 Dec 31, 2016 (In millions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues $ 17,258 $ 17,727 $ 18,675 $ 21,329 $ 20,257 $ 21,500 $ 22,451 $ 26,064 Costs and expenses: Cost of revenues 6,356 6,583 7,037 8,188 7,648 8,130 8,699 10,661 Research and development 2,753 2,789 3,230 3,510 3,367 3,363 3,596 3,622 Sales and marketing 2,065 2,080 2,223 2,679 2,387 2,415 2,565 3,118 General and administrative 1,637 1,450 1,477 1,572 1,513 1,624 1,824 2,024 Total costs and expenses 12,811 12,902 13,967 15,949 14,915 15,532 16,684 19,425 Income from operations 4,447 4,825 4,708 5,380 5,342 5,968 5,767 6,639 Other income (expense), net 157 131 183 (180 ) (213 ) 151 278 218 Income from continuing operations before income taxes 4,604 4,956 4,891 5,200 5,129 6,119 6,045 6,857 Provision for income taxes 1,089 1,025 912 277 922 1,242 984 1,524 Net income $ 3,515 $ 3,931 $ 3,979 $ 4,923 $ 4,207 $ 4,877 $ 5,061 $ 5,333 Less: Adjustment Payment to Class C capital stockholders 0 522 0 0 0 0 0 0 Net income available to all stockholders $ 3,515 $ 3,409 $ 3,979 $ 4,923 $ 4,207 $ 4,877 $ 5,061 $ 5,333 Basic net income per share of Class A and B common stock $ 5.16 $ 4.99 $ 5.80 $ 7.16 $ 6.12 $ 7.11 $ 7.36 $ 7.73 Basic net income per share of Class C capital stock $ 5.16 $ 6.51 $ 5.80 $ 7.16 $ 6.12 $ 7.11 $ 7.36 $ 7.73 Diluted net income per share of Class A and B common stock $ 5.10 $ 4.93 $ 5.73 $ 7.06 $ 6.02 $ 7.00 $ 7.25 $ 7.56 Diluted net income per share of Class C capital stock $ 5.10 $ 6.43 $ 5.73 $ 7.06 $ 6.02 $ 7.00 $ 7.25 $ 7.56 33 Table of Contents Alphabet Inc. Capital Resources and Liquidity As of December 31, 2016 , we had $86.3 billion of cash, cash equivalents, and marketable securities. Cash equivalents and marketable securities a re comprised of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, agency mortgage-backed securities, and asset-backed securities. From time to time, we may hold marketable equity securities obtained through acquisitions or strategic investments in private companies that subsequently go public. As of December 31, 2016 , $52.2 billion of the $86.3 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds were needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2016 . In conjunction with this program, we have a $4.0 billion revolving credit facility expiring in February 2021. The interest rate for the credit facility is determined based on a formula using certain market rates. As of December 31, 2016 , no amounts were outstanding under the credit facility. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions and other liquidity requirements through at least the next 12 months. As of December 31, 2016 , we have unsecured senior notes outstanding due in 2021, 2024, and 2026 with a total carrying value of $3.9 billion and a total estimated fair value of $3.9 billion . In August 2013, we entered into a capital lease obligation on certain property expiring in 2028. In September 2016, we exercised our option to purchase the property for approximately $220 million . In October 2015, the board of directors of Alphabet authorized the company to repurchase up to $5,099,019,513.59 of its Class C capital stock, commencing in the fourth quarter of 2015. In January 2016, the board of directors of Alphabet authorized the company to repurchase an additional amount of approximately 514 thousand shares. We completed all authorized share repurchases under this repurchase program. In October 2016, the board of directors of Alphabet authorized the company to repurchase up to $7,019,340,976.83 of its Class C capital stock. The repurchases are expected to be executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. No shares were repurchased in 2016 under this program. In January 2017, Temasek, a Singapore-based investment company, signed a binding commitment to purchase a non-controlling interest in Verily for an aggregate of $800 million in cash. We closed the first tranche of the investment in February 2017 and anticipate closing the second and final tranche upon completion of certain terms in the second half of 2017. The following table presents our cash flows (in millions) for the periods presented. Year Ended December 31, 2014 (1) 2015 (1) 2016 Net cash provided by operating activities $ 23,024 $ 26,572 $ 36,036 Net cash used in investing activities (21,055 ) (23,711 ) (31,165 ) Net cash used in financing activities (2,087 ) (4,225 ) (8,332 ) (1) Prior period amounts have been adjusted for the impact of the adoption of ASU 2016-09. Refer to Note 1 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K for further information. Cash Provided by Operating Activities Our largest source of cash provided by our operations are advertising revenues generated by Google properties and Google Network Members' properties. Additionally, we generate cash through sales of apps, in-app purchases and digital content, hardware products, licensing arrangements, and s ervice fees received for Google Cloud offerings. Our primary uses of cash from our operating activities include payments to our Google Network Members and distribution partners, and payments for content acquisition costs. In addition, uses of cash from operating activities include compensation and related costs, hardware costs, other general corporate expenditures, and income taxes. 34 Table of Contents Alphabet Inc. Net cash provided by operating activities increased from 2015 to 2016 primarily due to increases in cash received from advertising revenues and Google other revenues, offset by increases in cash paid for cost of revenues and operating expenses. Additionally, the timing of tax payments and refunds had a favorable impact to our cash flows from operations for 2016 compared to 2015 . Net cash provided by operating activities increased from 2014 to 2015 primarily due to increased net income adjusted for depreciation and stock-based compensation expense, and loss on sales of marketable and non-marketable securities. This was partially offset by a net decrease in cash from changes in working capital. Cash Used in Investing Activities Cash provided by or used in investing activities primarily consists of purchases of property and equipment, purchases, maturities, and sales of marketable securities in our investment portfolio, investments in reverse repurchase agreements and the cash collateral received or returned from our securities lending program, as well as acquisitions and divestitures of businesses and intangible assets. Net cash used in investing activities increased from 2015 to 2016 primarily due to increases in purchases of marketable securities, increases in cash collateral paid related to securities lending and increases in spend related to acquisitions partially offset by increases in maturities and sales of marketable securities and decreases in purchases of non-marketable investments. Net cash used in investing activities increased from 2014 to 2015 primarily due to net increases in purchases of marketable securities, activities related to securities lending and purchases of non-marketable investments. This increase was partially offset by lower spend related to acquisitions, lower investments in reverse repurchase agreements, and a decrease in capital expenditures related to our production equipment, data centers, and real estate purchases. Cash Used in Financing Activities Cash used in financing activities consists primarily of net proceeds or payments from issuance or repayments of debt, repurchases of capital stock, and net proceeds or payments from stock-based award activities. Net cash used in financing activities increased from 2015 to 2016 primarily driven by decreases in proceeds from issuance of debt, and increases in the repurchases of capital stock and net payments related to stock-based award activities, partially offset by a decrease in debt repayments. Net cash used in financing activities increased from 2014 to 2015 primarily driven by the repurchases of capital stock and an increase in net payments related to stock-based award activities. Contractual Obligations as of December 31, 2016 The following summarizes our contractual obligations, excluding open orders for purchases that support normal operations, as of December 31, 2016 (in millions): Payments Due By Period Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating lease obligations, net of sublease income amounts (1) $ 7,937 $ 828 $ 1,801 $ 1,615 $ 3,693 Purchase obligations (2) 2,494 1,907 274 99 214 Long-term debt obligations (3) 4,816 110 220 1,202 3,284 Other long-term liabilities reflected on our balance sheet (4) 2,093 261 601 525 706 Total contractual obligations $ 17,340 $ 3,106 $ 2,896 $ 3,441 $ 7,897 (1) For further information, refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (2) Purchase obligations represent non-cancelable contractual obligations primarily related to data center operations and facility build-outs, video and other content licensing revenue sharing arrangements, as well as purchases of inventory. (3) For further information, refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (4) Other long-term liabilities represent cash obligations recorded on our consolidated balance sheets, including the short-term portion of these long-term liabilities and consist primarily of payments owed in connection with certain commercial agreements, investments, and asset retirement obligations. In addition to the amounts above, we had long-term tax payable of $4.7 billion as of December 31, 2016 primarily related to uncertain tax positions. At this time, we are unable to make a reasonably reliable 35 Table of Contents Alphabet Inc. estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. As a result, this amount is not included in the above table. Off-Balance Sheet Arrangements As of December 31, 2016 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K promulgated by the SEC, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. Please see Note 1 of Part II, Item 8 of this Annual Report on Form 10-K for the summary of significant accounting policies. Income Taxes We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate, as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, indirect taxes, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, consolidated financial position, results of operations, or cash flows. See Note 10 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding contingencies. 36 Table of Contents Alphabet Inc. Business Combinations We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include but are not limited to future expected cash flows from customer relationships and acquired patents and developed technology and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Other estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed, as more fully discussed in Note 6 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Goodwill Goodwill is allocated to reporting units expected to benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test goodwill for impairment at the reporting unit level at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairment tests require judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. Long-lived Assets Long-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Impairment of Marketable and Non-Marketable Securities We periodically review our marketable and non-marketable securities for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For marketable debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as other income (expense), net. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in currency exchange rates and interest rates. Foreign Currency Exchange Risk We transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. We are a net receiver of foreign currencies and therefore benefit from a weakening of the U.S. dollar and are adversely affected by a strengthening of the U.S. dollar relative to the foreign currency. As of December 31, 2016 , our most significant currency exposures are the British pound, Euro, and Japanese yen. In the fourth quarter of 2016, we began using foreign exchange forward contracts in addition to the existing foreign exchange option contracts, to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the impact of currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We record spot-to-spot foreign currency exchange rate changes of these 37 Table of Contents Alphabet Inc. contracts as a component of accumulated other comprehensive income (AOCI) and subsequently reclassify them into revenues to offset the hedged exposures as they occur. We exclude the change in the time value and forward points of these contracts from our assessment of hedge effectiveness. These excluded components are recognized in other income (expense), net. We considered the historical trends in currency exchange rates and determined that it was reasonably possible that changes in exchange rates of 10% could be experienced in the near term. If the U.S. dollar weakened by 10% as of December 31, 2015 and December 31, 2016 , the amount recorded in AOCI reflecting spot-to-spot foreign currency rate changes related to our foreign exchange contracts before tax effect would have been approximately $221 million and $920 million lower as of December 31, 2015 and December 31, 2016 , and the total amount of expense recorded as other income (expense), net, would have been approximately $203 million higher in the year ended December 31, 2015 and $14 million lower in the year ended December 31, 2016 . If the U.S. dollar strengthened by 10% as of December 31, 2015 and December 31, 2016 , the amount recorded in accumulated AOCI related to our foreign exchange contracts before tax effect would have been approximately $1.5 billion and $1.0 billion higher as of December 31, 2015 and December 31, 2016 , and the total amount of expense recorded as other income (expense), net, would have been approximately $313 million and $13 million higher in the years ended December 31, 2015 and December 31, 2016 . In both scenarios, the change in the value recorded in in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. In addition, we use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the local currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the impact of currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. We considered the historical trends in currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% for all currencies could be experienced in the near term. These reasonably possible adverse changes in exchange rates of 10% were applied to total monetary assets and liabilities denominated in currencies other than the local currencies at the balance sheet dates to compute the adverse impact these changes would have had on our income before income taxes in the near term. These changes would have resulted in an adverse impact on income before income taxes of approximately $61 million and $40 million as of December 31, 2015 and December 31, 2016 . The adverse impact as of December 31, 2015 and December 31, 2016 is after consideration of the offsetting effect of approximately $539 million and $554 million from foreign exchange contracts in place for the months of December 31, 2015 and December 31, 2016 . Interest Rate Risk Our investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity requirements. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, agency mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. As of December 31, 2015 and December 31, 2016 , unrealized losses on our marketable debt securities were primarily due to temporary interest rate fluctuations as a result of higher market interest rates compared to interest rates at the time of purchase. We account for both fixed and variable rate securities at fair value with changes on gains and losses recorded in AOCI until the securities are sold. We use interest rate derivative contracts to hedge gains and losses on our securities. These derivative contracts are accounted for as hedges at fair value with changes in fair value recorded in other income (expense), net. We considered the historical volatility of short-term interest rates and determined that it was reasonably possible that an adverse change of 100 basis points could be experienced in the near term. A hypothetical 1.00% (100 basis points) increase in interest rates would have resulted in a decrease in the fair value of our marketable securities of approximately $1.3 billion and $2.2 billion as of December 31, 2015 and December 31, 2016 . 38 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 40 Financial Statements: Consolidated Balance Sheets 42 Consolidated Statements of Income 43 Consolidated Statements of Comprehensive Income 44 Consolidated Statements of Stockholders’ Equity 45 Consolidated Statements of Cash Flows 46 Notes to Consolidated Financial Statements 47 The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” 39 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Alphabet Inc. We have audited the accompanying consolidated balance sheets of Alphabet Inc. as of December 31, 2015 and 2016 , and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2016 . Our audits also included the financial statement schedule listed in the Index at Item 15(a)2. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Alphabet Inc. at December 31, 2015 and 2016 , and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2016 , in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Notes 1 and 14 to the consolidated financial statements, the Company changed its method of accounting for share-based payments to employees as a result of the adoption of the amendments to the FASB Accounting Standards Codification resulting from Accounting Standards Update No. 2016-09, "Improvements to Employee Share-Based Payment Accounting," effective January 1, 2016. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Alphabet Inc.’s internal control over financial reporting as of December 31, 2016 , based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 2, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California February 2, 2017 40 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Stockholders of Alphabet Inc. We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2016 , based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). Alphabet Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, Alphabet Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2016 consolidated financial statements of Alphabet Inc. and our report dated February 2, 2017 expressed an unqualified opinion thereon. /s/ Ernst & Young LLP San Jose, California February 2, 2017 41 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share and par value amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2015 As of December 31, 2016 Assets Current assets: Cash and cash equivalents $ 16,549 $ 12,918 Marketable securities 56,517 73,415 Total cash, cash equivalents, and marketable securities (including securities loaned of $4,531 and $0) 73,066 86,333 Accounts receivable, net of allowance of $296 and $467 11,556 14,137 Receivable under reverse repurchase agreements 450 0 Income taxes receivable, net 1,903 95 Inventory 491 268 Prepaid revenue share, expenses and other assets 2,648 4,575 Total current assets 90,114 105,408 Prepaid revenue share, expenses and other assets, non-current 3,181 1,819 Non-marketable investments 5,183 5,878 Deferred income taxes 251 383 Property and equipment, net 29,016 34,234 Intangible assets, net 3,847 3,307 Goodwill 15,869 16,468 Total assets $ 147,461 $ 167,497 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 1,931 $ 2,041 Short-term debt 3,225 0 Accrued compensation and benefits 3,539 3,976 Accrued expenses and other current liabilities 4,768 6,144 Accrued revenue share 2,329 2,942 Securities lending payable 2,428 0 Deferred revenue 788 1,099 Income taxes payable, net 302 554 Total current liabilities 19,310 16,756 Long-term debt 1,995 3,935 Deferred revenue, non-current 151 202 Income taxes payable, non-current 3,663 4,677 Deferred income taxes 189 226 Other long-term liabilities 1,822 2,665 Total liabilities 27,130 28,461 Commitments and Contingencies (Note 10) Stockholders’ equity: Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 687,348 (Class A 292,297, Class B 50,295, Class C 344,756) and 691,293 (Class A 296,992, Class B 47,437, Class C 346,864) shares issued and outstanding 32,982 36,307 Accumulated other comprehensive loss (1,874 ) (2,402 ) Retained earnings 89,223 105,131 Total stockholders’ equity 120,331 139,036 Total liabilities and stockholders’ equity $ 147,461 $ 167,497 See accompanying notes. 42 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2014 2015 2016 Revenues $ 66,001 $ 74,989 $ 90,272 Costs and expenses: Cost of revenues 25,691 28,164 35,138 Research and development 9,832 12,282 13,948 Sales and marketing 8,131 9,047 10,485 General and administrative 5,851 6,136 6,985 Total costs and expenses 49,505 55,629 66,556 Income from operations 16,496 19,360 23,716 Other income (expense), net 763 291 434 Income before income taxes 17,259 19,651 24,150 Provision for income taxes 3,639 3,303 4,672 Net income from continuing operations $ 13,620 $ 16,348 $ 19,478 Net income from discontinued operations 516 0 0 Net income $ 14,136 $ 16,348 $ 19,478 Less: Adjustment Payment to Class C capital stockholders 0 522 0 Net income available to all stockholders $ 14,136 $ 15,826 $ 19,478 Basic net income per share of Class A and B common stock: Continuing operations $ 20.15 $ 23.11 $ 28.32 Discontinued operations 0.76 0.00 0.00 Basic net income per share of Class A and B common stock $ 20.91 $ 23.11 $ 28.32 Basic net income per share of Class C capital stock: Continuing operations $ 20.15 $ 24.63 $ 28.32 Discontinued operations 0.76 0.00 0.00 Basic net income per share of Class C capital stock $ 20.91 $ 24.63 $ 28.32 Diluted net income per share of Class A and B common stock: Continuing operations $ 19.82 $ 22.84 $ 27.85 Discontinued operations 0.75 0.00 0.00 Diluted net income per share of Class A and B common stock $ 20.57 $ 22.84 $ 27.85 Diluted net income per share of Class C capital stock: Continuing operations $ 19.82 $ 24.34 $ 27.85 Discontinued operations 0.75 0.00 0.00 Diluted net income per share of Class C capital stock $ 20.57 $ 24.34 $ 27.85 See accompanying notes. 43 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2014 2015 2016 Net income $ 14,136 $ 16,348 $ 19,478 Other comprehensive (loss) income: Change in foreign currency translation adjustment (996 ) (1,067 ) (599 ) Available-for-sale investments: Change in net unrealized gains (losses) 505 (715 ) (314 ) Less: reclassification adjustment for net (gains) losses included in net income (134 ) 208 221 Net change (net of tax effect of $60, $29, and $0) 371 (507 ) (93 ) Cash flow hedges: Change in net unrealized gains (losses) 651 676 515 Less: reclassification adjustment for net (gains) losses included in net income (124 ) (1,003 ) (351 ) Net change (net of tax effect of $196, $115, and $64) 527 (327 ) 164 Other comprehensive (loss) income (98 ) (1,901 ) (528 ) Comprehensive income $ 14,038 $ 14,447 $ 18,950 See accompanying notes. 44 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2013 671,664 $ 25,922 $ 125 $ 60,930 $ 86,977 Common and capital stock issued 8,508 465 0 0 465 Stock-based compensation expense 4,279 0 0 4,279 Stock-based compensation tax benefits 625 0 0 625 Tax withholding related to vesting of restricted stock units (2,524 ) 0 0 (2,524 ) Net income 0 0 14,136 14,136 Other comprehensive loss 0 (98 ) 0 (98 ) Balance as of December 31, 2014 680,172 28,767 27 75,066 103,860 Common and capital stock issued 8,714 664 0 0 664 Stock-based compensation expense 5,151 0 0 5,151 Stock-based compensation tax benefits 815 0 0 815 Tax withholding related to vesting of restricted stock units (2,779 ) 0 0 (2,779 ) Repurchases of capital stock (2,391 ) (111 ) 0 (1,669 ) (1,780 ) Adjustment Payment to Class C capital stockholders 853 475 0 (522 ) (47 ) Net income 0 0 16,348 16,348 Other comprehensive loss 0 (1,901 ) 0 (1,901 ) Balance as of December 31, 2015 687,348 32,982 (1,874 ) 89,223 120,331 Cumulative effect of accounting change 0 180 0 (133 ) 47 Common and capital stock issued 9,106 298 0 0 298 Stock-based compensation expense 6,700 0 0 6,700 Tax withholding related to vesting of restricted stock units (3,597 ) 0 0 (3,597 ) Repurchases of capital stock (5,161 ) (256 ) 0 (3,437 ) (3,693 ) Net income 0 0 19,478 19,478 Other comprehensive loss 0 (528 ) 0 (528 ) Balance as of December 31, 2016 691,293 $ 36,307 $ (2,402 ) $ 105,131 $ 139,036 See accompanying notes. 45 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2014 2015 2016 Operating activities Net income $ 14,136 $ 16,348 $ 19,478 Adjustments: Depreciation and impairment of property and equipment 3,523 4,132 5,267 Amortization and impairment of intangible assets 1,456 931 877 Stock-based compensation expense 4,279 5,203 6,703 Deferred income taxes (104 ) (179 ) (38 ) Gain on divestiture of business (740 ) 0 0 (Gain) loss on marketable and non-marketable investments, net (390 ) 334 275 Other 192 212 174 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable (1,641 ) (2,094 ) (2,578 ) Income taxes, net 591 (179 ) 3,125 Prepaid revenue share, expenses and other assets 459 (318 ) 312 Accounts payable 436 203 110 Accrued expenses and other liabilities 757 1,597 1,515 Accrued revenue share 245 339 593 Deferred revenue (175 ) 43 223 Net cash provided by operating activities 23,024 26,572 36,036 Investing activities Purchases of property and equipment (11,014 ) (9,950 ) (10,212 ) Proceeds from disposals of property and equipment 55 35 240 Purchases of marketable securities (56,310 ) (74,368 ) (84,509 ) Maturities and sales of marketable securities 51,315 62,905 66,895 Purchases of non-marketable investments (1,440 ) (2,326 ) (1,109 ) Maturities and sales of non-marketable investments 213 154 494 Cash collateral related to securities lending 1,403 (350 ) (2,428 ) Investments in reverse repurchase agreements (775 ) 425 450 Proceeds from divestiture of business 386 0 0 Acquisitions, net of cash acquired, and purchases of intangible assets (4,888 ) (236 ) (986 ) Net cash used in investing activities (21,055 ) (23,711 ) (31,165 ) Financing activities Net payments related to stock-based award activities (2,069 ) (2,375 ) (3,304 ) Adjustment Payment to Class C capital stockholders 0 (47 ) 0 Repurchases of capital stock 0 (1,780 ) (3,693 ) Proceeds from issuance of debt, net of costs 11,625 13,705 8,729 Repayments of debt (11,643 ) (13,728 ) (10,064 ) Net cash used in financing activities (2,087 ) (4,225 ) (8,332 ) Effect of exchange rate changes on cash and cash equivalents (433 ) (434 ) (170 ) Net decrease in cash and cash equivalents (551 ) (1,798 ) (3,631 ) Cash and cash equivalents at beginning of period 18,898 18,347 16,549 Cash and cash equivalents at end of period $ 18,347 $ 16,549 $ 12,918 Supplemental disclosures of cash flow information Cash paid for taxes, net of refunds $ 3,138 $ 3,651 $ 1,643 Cash paid for interest 86 96 84 See accompanying notes. 46 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. We generate revenues primarily by delivering relevant, cost-effective online advertising. On August 10, 2015, we announced plans to create a new public holding company, Alphabet Inc. (Alphabet), and a new operating structure. On October 2, 2015, we implemented the holding company reorganization, and as a result, Alphabet became the successor issuer to Google Inc. (Google). The implementation of the holding company reorganization on October 2, 2015 was accounted for as a merger under common control. Alphabet has recognized the assets and liabilities of Google at carryover basis. The consolidated financial statements of Alphabet present comparative information for prior years on a combined basis, as if both Alphabet and Google were under common control for all periods presented. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and all wholly owned subsidiaries as well as all variable interest entities where we are the primary beneficiary. All intercompany balances and transactions have been eliminated. Use of Estimates The preparation of consolidated financial statements in conformity with U.S. Generally Accepted Accounting Principles (GAAP) requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Revenue Recognition The following table presents our revenues by segment and revenue source (in millions): Year Ended December 31, 2014 2015 2016 Google segment Google properties $ 45,085 $ 52,357 $ 63,785 Google Network Members' properties 14,539 15,033 15,598 Google advertising revenues 59,624 67,390 79,383 Google other revenues 6,050 7,154 10,080 Google segment revenues $ 65,674 $ 74,544 $ 89,463 Other Bets Other Bets revenues $ 327 $ 445 $ 809 Consolidated revenues $ 66,001 $ 74,989 $ 90,272 We generate revenues primarily by delivering performance and brand advertising. Performance advertising creates and delivers relevant ads that users will click, leading to direct engagement with advertisers. Brand advertising enhances users’ awareness of and affinity with advertisers’ products and services, through videos, text, images, and other ads that run across various devices. Google properties revenues consist primarily of advertising revenues generated on Google.com, the Google app, YouTube, and other Google owned and operated properties like Gmail, Maps and Google Play. Google Network Members’ properties revenues consist primarily of revenues generated from placing ads on Google Network Members’ 47 Table of Contents Alphabet Inc. properties. Our customers generally purchase ads through AdWords, DoubleClick Bid Manager, and DoubleClick AdExchange, among others. Most of our customers pay us on a cost-per-click basis, which means that an advertiser pays us only when a user engages with the ads by clicking on an ad on Google properties or Google Network Members' properties or by viewing YouTube engagement ads like TrueView (counted as an engagement when the user chooses not to skip the ad). We also offer advertising on other bases such as cost-per-impression, which enables our brand advertisers to pay us based on the number of times their ads are displayed on Google properties and Google Network Members’ properties. Revenue from advertising is recognized when the goods or services have been delivered or provided, the amounts we charge are fixed or determinable, we and our advertisers or other customers understand the specific nature and terms of the agreed upon transactions, and collectability is reasonably assured. We recognize as revenues the amounts charged to advertisers each time a user engages with ads that appears next to the search results or content on Google properties or Google Network Members’ properties. For those advertisers using our cost-per-impression pricing, we recognize as revenues the amounts charged to advertisers each time their ads are displayed on Google properties or Google Network Members’ properties. We generally report revenues from ads placed on Google Network Members' properties on a gross basis principally because we are the primary obligor to our advertisers. Revenue from hardware sales to end customers or through distribution channels is generally recognized when the product has been shipped, risk of loss has transferred to the customer, objective evidence exists that customer acceptance provisions have been met, no significant obligations remain and allowances for discounts, price protection, returns and customer incentives, if applicable, can be reasonably and reliably estimated. Revenues are reported net of these allowances. For the sale of certain third-party products and services, we evaluate whether it is appropriate to recognize revenue based on the gross amount billed to the customers or the net amount earned as revenue share. Generally, when we record revenue on a gross basis, we are the primary obligor in a transaction, and have also considered other factors, including whether we are subject to inventory risk or have latitude in establishing prices. For multi-element arrangements, including those that contain software essential to hardware products’ functionality and services, we allocate revenue to each unit of accounting based on their relative selling prices. In such circumstances, we use a hierarchy to determine the selling prices to be used for allocating revenue: (i) vendor-specific objective evidence of fair value (VSOE), (ii) third-party evidence of selling price, and (iii) best estimate of the selling price (ESP). VSOE generally exists only when we sell the deliverable separately and is the price actually charged by us for that deliverable. ESPs reflect our best estimates of what the selling price of the deliverable would be if it was sold regularly on a stand-alone basis. We record deferred revenues when cash payments are received in advance of our performance in the underlying agreement on the accompanying Consolidated Balance Sheets. Cost of Revenues Cost of revenues consists of traffic acquisition costs which are ​paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. Additionally, other costs of revenues include the following: • The expenses associated with the operation of our data centers (including depreciation, labor, energy, and bandwidth costs); • Content acquisition costs primarily related to payments to certain content providers from whom we license their video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Credit card and other transaction fees related to processing customer transactions; • Stock-based compensation expense; • Inventory related costs for hardware we sell; and • Amortization of certain intangible assets. Stock-based Compensation Stock-based compensation includes restricted stock units (RSUs) that will be settled in Alphabet stock as well as awards we expect to ultimately settle in cash. RSUs are measured at the fair market value of the underlying stock at the grant date. Liability classified awards are remeasured at fair value through settlement. We recognize stock- 48 Table of Contents Alphabet Inc. based compensation using the straight-line method over the requisite service period. With the adoption of ASU 2016-09 on January 1, 2016, we account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the minimum statutory tax withholding to be paid by us on behalf of our employees. As a result, the actual number of shares issued will be fewer than the actual number of RSUs outstanding. We record a liability for withholding amounts to be paid by us primarily as a reduction to additional paid-in capital. Certain Risks and Concentrations Our revenues are primarily derived from online advertising, the market for which is highly competitive and rapidly changing. In addition, our revenues are generated from a multitude of vertical market segments in countries around the world. Significant changes in this industry or changes in customer buying or advertiser spending behavior could adversely affect our operating results. We are subject to concentrations of credit risk principally from cash and cash equivalents, marketable securities, foreign exchange contracts, and accounts receivable. Cash equivalents and marketable securities consist primarily of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, agency mortgage-backed securities, and asset-backed securities. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. In 2014 , 2015 , and 2016 , we generated approximately 45% , 46% , and 47% of our revenues from customers based in the U.S., with the majority of revenues from customers outside of the U.S. located in Europe and Japan. We perform ongoing evaluations to determine customer credit and we limit the amount of credit we extend, but generally we do not require collateral from our customers. We maintain reserves for estimated credit losses and these losses have generally been within our expectations. No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2014 , 2015 , or 2016 . Fair Value of Financial Instruments Our financial assets and financial liabilities including cash equivalents, marketable securities, foreign currency and interest rate derivative contracts, and non-marketable debt securities are measured and recorded at fair value on a recurring basis. We measure certain financial assets at fair value for disclosure purposes, as well as on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. Our other current financial assets and our other current financial liabilities have fair values that approximate their carrying value. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Include other inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash, Cash Equivalents, and Marketable Securities We invest all excess cash primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, agency mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. 49 Table of Contents Alphabet Inc. We classify all investments that are readily convertible to known amounts of cash and have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities. We determine the appropriate classification of our investments in marketable securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these securities prior to their stated maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities in the accompanying Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for unrealized losses determined to be other-than-temporary, which we record within other income (expense), net. We determine any realized gains or losses on the sale of marketable securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Non-Marketable Investments We have accounted for non-marketable equity investments either under the equity or cost method. Investments through which we exercise significant influence but do not have control over the investee are accounted for under the equity method. Investments through which we are not able to exercise significant influence over the investee are accounted for under the cost method. We have accounted for our non-marketable investments that meet the definition of a debt security as available-for-sale securities. Since these securities do not have contractual maturity dates and we do not intend to liquidate them in the next 12 months, we have classified them as non-current assets on the accompanying Consolidated Balance Sheet. Variable Interest Entities We make a determination at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a Variable Interest Entity (“VIE”). We consolidate VIEs when we are deemed to be the primary beneficiary. The primary beneficiary of a VIE is the party that meets both of the following criteria: (i) has the power to make decisions that most significantly affect the economic performance of the VIE; and (ii) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. Periodically, we determine whether any changes occurred requiring a reassessment of whether we are the primary beneficiary of a VIE. If we are not deemed to be the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Impairment of Marketable and Non-Marketable Investments We periodically review our marketable and non-marketable investments for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as other income (expense), net. Accounts Receivable We record accounts receivable at the invoiced amount and we normally do not charge interest. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables. We review the accounts receivable by amounts due by customers which are past due to identify specific customers with known disputes or collectability issues. In determining the amount of the reserve, we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. We also maintain a sales allowance to reserve for potential credits issued to customers. We determine the amount of the reserve based on historical credits issued. Property and Equipment We account for property and equipment at cost less accumulated depreciation and amortization. We compute depreciation using the straight-line method over the estimated useful lives of the assets. We depreciate buildings over periods up to 25 years. We generally depreciate information technology assets over periods up to 7 years. We amortize leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed 50 Table of Contents Alphabet Inc. in service for our intended use. Depreciation for equipment commences once it is placed in service and depreciation for buildings and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of our acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment, long-term prepayments and intangible assets, excluding goodwill, for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets are not recoverable, the impairment recognized is measured as the amount by which the carrying value of the asset exceeds its fair market value. In 2014, we recorded impairments of intangible assets, including an impairment of $378 million in the third quarter of 2014 related to a patent licensing royalty asset. Impairments of intangible assets were not material in 2015 or 2016. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. No goodwill impairment has been identified in any of the years presented. Intangible assets with definite lives are amortized over their estimated useful lives. We amortize intangible assets on a straight-line basis with definite lives over periods ranging from one to twelve years. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more-likely-than-not that they will not be realized. We recognize the financial statement effects of a tax position when it is more-likely-than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. 51 Table of Contents Alphabet Inc. Foreign Currency Generally, the functional currency of our international subsidiaries is the local currency. We translate the financial statements of these subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in accumulated other comprehensive income as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange losses in other income (expense), net. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2014 , 2015 and 2016 , advertising and promotional expenses totaled approximately $3,004 million , $3,186 million , and $3,868 million , respectively. Recent Accounting Pronouncements Recently issued accounting pronouncements not yet adopted In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2014-09 (Topic 606) "Revenue from Contracts with Customers." Topic 606 supersedes the revenue recognition requirements in Accounting Standards Codification Topic 605, “Revenue Recognition”, and requires entities to recognize revenue when they transfer control of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. We intend to early adopt Topic 606 as of January 1, 2017, using the modified retrospective transition method applied to those contracts which were not completed as of that date. Upon adoption, we will recognize the cumulative effect of adopting this guidance as an adjustment to our opening balance of retained earnings. Prior periods will not be retrospectively adjusted. We expect the adoption of Topic 606 will not have a material impact to our consolidated financial statements, including the presentation of revenues in our Consolidated Statements of Income. In January 2016, the FASB issued Accounting Standards Update No. 2016-01 (ASU 2016-01) "Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities." ASU 2016-01 amends various aspects of the recognition, measurement, presentation, and disclosure for financial instruments. ASU 2016-01 is effective for annual reporting periods and interim periods within those years beginning after December 15, 2017. The most significant impact relates to the recognition and measurement of equity investments at fair value in the consolidated statement of income. While we continue to evaluate the effect of the standard, we anticipate that the adoption of ASU 2016-01 will increase the volatility of our other income (expense), net, resulting from the remeasurement of our equity investments. In February 2016, the FASB issued Accounting Standards Update No. 2016-02 (Topic 842) "Leases". Topic 842 supersedes the lease recognition requirements in Accounting Standards Codification Topic 840, "Leases". Under Topic 842, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures. Leases will continue to be classified as either finance or operating. Topic 842 is effective for annual reporting periods, and interim periods within those years beginning after December 15, 2018. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements, and there are certain optional practical expedients that an entity may elect to apply. Full retrospective application is prohibited and early adoption by public entities is permitted. We anticipate that the adoption of ASU 2016-02 will materially affect our statement of financial position and will require changes to our systems and processes. We have not yet made any decision on the timing of adoption or method of adoption with respect to the optional practical expedients. In June 2016, the FASB issued Accounting Standards Update No. 2016-13 (ASU 2016-13) "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. ASU 2016-13 replaces the existing incurred loss impairment model with an expected loss methodology, which will result in more timely recognition of credit losses. ASU 2016-13 is effective for annual reporting periods, and interim periods within those years beginning after December 15, 2019. We are currently in the process of evaluating the impact of the adoption of this standard on our consolidated financial statements. Recently adopted accounting pronouncements In June 2014, the FASB issued Accounting Standards Update No. 2014-10 (ASU 2014-10) "Development Stage Entities (Topic 915): Elimination of Certain Financial Reporting Requirements, Including an Amendment to Variable Interest Entities Guidance in Topic 810, Consolidation." ASU 2014-10 removes the definition of a development stage 52 Table of Contents Alphabet Inc. entity from the Master Glossary of the Accounting Standards Codification (ASC), thereby removing the financial reporting distinction between development stage entities and other reporting entities. The additional elimination of related consolidation guidance requires companies with interests in development stage entities to reassess whether such entities are variable interest entities under ASC Topic 810, Consolidation. We adopted this standard in the first quarter of 2016 on a retrospective basis. The adoption of this standard did not have a material impact on our consolidated financial statements. Additional disclosures have been made related to certain entities that are now considered variable interest entities under this standard. See Note 7 for details. In February 2015, the FASB issued Accounting Standards Update No. 2015-02 (ASU 2015-02) "Consolidation (Topic 810): Amendments to the Consolidation Analysis." ASU 2015-02 changes the analysis that a reporting entity must perform to determine whether it should consolidate certain types of legal entities. We adopted this standard in the first quarter of 2016 on a retrospective basis. The adoption of this standard did not have a material impact on our consolidated financial statements but resulted in additional investments being considered variable interest entities. In March 2016, the FASB issued Accounting Standards Update No. 2016-09 (ASU 2016-09) "Compensation—Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting." We have elected to early adopt these amendments beginning in the first quarter of 2016. Stock-based compensation excess tax benefits or deficiencies are now reflected in the Consolidated Statements of Income as a component of the provision for income taxes, whereas they previously were recognized in equity. Additionally, our Consolidated Statements of Cash Flows now include excess tax benefits as an operating activity, with the prior periods adjusted accordingly. Finally, we have elected to account for forfeitures as they occur, rather than estimate expected forfeitures. As a result of the adoption of ASU 2016-09, the Consolidated Statements of Cash Flows for the twelve months ended December 31, 2014 and 2015 were adjusted as follows: $648 million and $548 million increases to net cash provided by operating activities, respectively, and $648 million and $548 million increases to net cash used in financing activities, respectively. Revision of Previously Disclosed Information During the third quarter of 2016, we identified an omission in our supplemental disclosure of cash paid for income taxes in the Consolidated Statements of Cash Flows. We have evaluated the materiality of the impact quantitatively and qualitatively and concluded it was not material to any of the prior periods impacted. We elected to revise the supplemental disclosure for the comparable periods presented. The revision only impacted our supplemental disclosures included in the Consolidated Statements of Cash Flows. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. Note 2. Financial Instruments We classify our cash equivalents and marketable securities within Level 1 or Level 2 in the fair value hierarchy because we use quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. We classify our foreign currency and interest rate derivative contracts primarily within Level 2 in the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments. 53 Table of Contents Alphabet Inc. Cash, Cash Equivalents, and Marketable Securities The following tables summarize our cash, cash equivalents and marketable securities by significant investment categories as of December 31, 2015 and 2016 (in millions): As of December 31, 2015 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Cash $ 7,380 $ 0 $ 0 $ 7,380 $ 7,380 $ 0 Level 1: Money market and other funds 5,623 0 0 5,623 5,623 0 U.S. government notes 20,922 27 (48 ) 20,901 258 20,643 Marketable equity securities 692 155 0 847 0 847 27,237 182 (48 ) 27,371 5,881 21,490 Level 2: Time deposits (1) 3,223 0 0 3,223 2,012 1,211 Money market and other funds (2) 1,140 0 0 1,140 1,140 0 Fixed-income bond funds (3) 219 0 0 219 0 219 U.S. government agencies 1,367 2 (3 ) 1,366 0 1,366 Foreign government bonds 2,242 14 (23 ) 2,233 0 2,233 Municipal securities 3,812 47 (4 ) 3,855 0 3,855 Corporate debt securities 13,809 53 (278 ) 13,584 136 13,448 Agency mortgage-backed securities 9,680 48 (57 ) 9,671 0 9,671 Asset-backed securities 3,032 0 (8 ) 3,024 0 3,024 38,524 164 (373 ) 38,315 3,288 35,027 Total $ 73,141 $ 346 $ (421 ) $ 73,066 $ 16,549 $ 56,517 As of December 31, 2016 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Cash $ 7,078 $ 0 $ 0 $ 7,078 $ 7,078 $ 0 Level 1: Money market and other funds 4,783 0 0 4,783 4,783 0 U.S. government notes 38,454 46 (215 ) 38,285 613 37,672 Marketable equity securities 160 133 0 293 0 293 43,397 179 (215 ) 43,361 5,396 37,965 Level 2: Time deposits (1) 142 0 0 142 140 2 Mutual funds (4) 204 7 0 211 0 211 U.S. government agencies 1,826 0 (11 ) 1,815 300 1,515 Foreign government bonds 2,345 18 (7 ) 2,356 0 2,356 Municipal securities 4,757 15 (65 ) 4,707 2 4,705 Corporate debt securities 12,993 114 (116 ) 12,991 2 12,989 Agency mortgage-backed securities 12,006 26 (216 ) 11,816 0 11,816 Asset-backed securities 1,855 2 (1 ) 1,856 0 1,856 36,128 182 (416 ) 35,894 444 35,450 Total $ 86,603 $ 361 $ (631 ) $ 86,333 $ 12,918 $ 73,415 (1) The majority of our time deposits are foreign deposits. (2) The balance related to cash collateral received in connection with our securities lending program, which was invested in reverse repurchase agreements maturing within three months. See section titled "Securities Lending Program" below for further discussion of this program. 54 Table of Contents Alphabet Inc. (3) Fixed-inco me bond funds consist of mutual funds that primarily invest in corporate and government bonds. (4) The fair value option was elected for mutual funds with gains (losses) recognized in other income (expense), net. We determine realized gains or losses on the marketable securities on a specific identification method. We recognized gross realized gains of $238 million , $357 million , and $272 million for the years ended December 31, 2014 , 2015 , and 2016 . We recognized gross realized losses of $85 million , $565 million , and $482 million for the years ended December 31, 2014 , 2015 , and 2016 . We reflect these gains and losses as a component of other income (expense), net, in the accompanying Consolidated Statements of Income. The following table summarizes the estimated fair value of our investments in marketable debt securities, accounted for as available-for-sale securities and classified by the contractual maturity date of the securities (in millions): As of December 31, 2016 Due in 1 year $ 13,066 Due in 1 year through 5 years 38,762 Due in 5 years through 10 years 8,382 Due after 10 years 12,701 Total $ 72,911 The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2015 and 2016 , aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2015 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. government notes $ 13,757 $ (48 ) $ 0 $ 0 $ 13,757 $ (48 ) U.S. government agencies 864 (3 ) 0 0 864 (3 ) Foreign government bonds 885 (18 ) 36 (5 ) 921 (23 ) Municipal securities 1,116 (3 ) 41 (1 ) 1,157 (4 ) Corporate debt securities 9,192 (202 ) 784 (76 ) 9,976 (278 ) Agency mortgage-backed securities 5,783 (34 ) 721 (23 ) 6,504 (57 ) Asset-backed securities 2,508 (7 ) 386 (1 ) 2,894 (8 ) Total $ 34,105 $ (315 ) $ 1,968 $ (106 ) $ 36,073 $ (421 ) As of December 31, 2016 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. government notes $ 26,411 $ (215 ) $ 0 $ 0 $ 26,411 $ (215 ) U.S. government agencies 1,014 (11 ) 0 0 1,014 (11 ) Foreign government bonds 956 (7 ) 0 0 956 (7 ) Municipal securities 3,461 (63 ) 46 (2 ) 3,507 (65 ) Corporate debt securities 6,184 (111 ) 166 (5 ) 6,350 (116 ) Agency mortgage-backed securities 10,184 (206 ) 259 (10 ) 10,443 (216 ) Asset-backed securities 391 (1 ) 0 0 391 (1 ) Total $ 48,601 $ (614 ) $ 471 $ (17 ) $ 49,072 $ (631 ) During the years ended December 31, 2014 and 2016 , we did not recognize any other-than-temporary impairment loss. During the year ended December 31, 2015 , we recognized $281 million of other-than-temporary impairment losses related to our marketable equity securities and fixed-income bond funds. Those losses are included in gain (loss) on marketable securities, net as a component of other income (expense), net, in the accompanying Consolidated Statements of Income. See Note 5 for further details on other income (expense), net. 55 Table of Contents Alphabet Inc. Securities Lending Program We entered into securities lending agreements with financial institutions to enhance investment income. We loaned certain securities which were collateralized in the form of cash or securities. Cash collateral was usually invested in reverse repurchase agreements which were collateralized in the form of securities. We classified loaned securities as cash equivalents or marketable securities and recorded the cash collateral as an asset with a corresponding liability in the accompanying Consolidated Balance Sheets. We classified reverse repurchase agreements maturing within three months as cash equivalents and those longer than three months as receivable under reverse repurchase agreements in the accompanying Consolidated Balance Sheets. For security collateral received, we did not record an asset or liability except in the event of counterparty default. Our securities lending transactions were accounted for as secured borrowings with significant investment categories as follows (in millions): As of December 31, 2015 Remaining Contractual Maturity of the Agreements Securities Lending Transactions Overnight and Continuous Up to 30 days 30 - 90 Days Greater Than 90 Days Total U.S. government notes $ 1,322 $ 31 $ 0 $ 306 $ 1,659 U.S. government agencies 504 77 0 0 581 Corporate debt securities 188 0 0 0 188 Total $ 2,014 $ 108 $ 0 $ 306 $ 2,428 Gross amount of recognized liabilities for securities lending in offsetting disclosure $ 2,428 Amounts related to agreements not included in securities lending in offsetting disclosure $ 0 As of December 31, 2016 , we ended our securities lending program resulting in no cash collateral outstanding. Derivative Financial Instruments We recognize derivative instruments as either assets or liabilities in the accompanying Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the accompanying Consolidated Statements of Income as other income (expense), net, revenues, or accumulated other comprehensive income (AOCI) in the accompanying Consolidated Balance Sheets, as discussed below. We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. We use certain interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and debt issuances. Our program is not used for trading or speculative purposes. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further reduce credit risk, we enter into collateral security arrangements under which the counterparty is required to provide collateral when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We can take possession of the collateral in the event of counterparty default. As of December 31, 2015 and 2016 , we received cash collateral related to the derivative instruments under our collateral security arrangements of $192 million and $362 million . Cash Flow Hedges We use foreign currency option and forward contracts designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar and at times we use interest rate swaps to effectively lock interest rates on anticipated debt issuances. These transactions are designated as cash flow hedges. The notional principal of these contracts was approximately $16.4 billion and $10.7 billion as of December 31, 2015 and 2016 . These contracts have maturities of 36 months or less. We reflect gain or loss on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify cumulative gains and losses to revenues or interest expense when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI is immediately reclassified to other income (expense), net. Further, we exclude the change in the time value and forward points of foreign currency options and forward contracts from our assessment of hedge effectiveness. We recognize changes of the excluded components in other income (expense), net. 56 Table of Contents Alphabet Inc. As of December 31, 2016 , the effective portion of our cash flow hedges before tax effect was a net accumulated gain of $603 million , of which $567 million is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. We exclude changes in forward points for the forward contracts from the assessment of hedge effectiveness. The notional principal of these contracts was $1.8 billion and $2.4 billion as of December 31, 2015 and 2016 . We have used interest rate swaps designated as fair value hedges to hedge interest rate risk for certain fixed rate securities. The notional principal of these contracts was $295 million and $0 million as of December 31, 2015 and 2016 . Gains and losses on these forward contracts and interest rate swaps are recognized in other income (expense), net, along with the offsetting losses and gains of the related hedged items. Other Derivatives Other derivatives not designated as hedging instruments consist of foreign currency forward contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts, as well as the related costs in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. The notional principal of these foreign exchange contracts outstanding was $7.5 billion and $7.9 billion as of December 31, 2015 and 2016 . We also use exchange-traded interest rate futures contracts and “To Be Announced” (TBA) forward purchase commitments of mortgage-backed assets to hedge interest rate risks on certain fixed income securities. The TBA contracts meet the definition of derivative instruments in cases where physical delivery of the assets is not taken at the earliest available delivery date. Our interest rate futures and TBA contracts (together interest rate contracts) are not designated as hedging instruments. We recognize gains and losses on these contracts, as well as the related costs, in other income (expense), net. The gains and losses are generally economically offset by unrealized gains and losses in the underlying available-for-sale securities, which are recorded as a component of AOCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from AOCI into other income (expense), net. The total notional amounts of interest rate contracts outstanding were $50 million and $0 million as of December 31, 2015 and 2016 . The fair values of our outstanding derivative instruments were as follows (in millions): As of December 31, 2015 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Prepaid revenue share, expenses and other assets, current and non-current $ 626 $ 2 $ 628 Total $ 626 $ 2 $ 628 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 1 $ 13 $ 14 Interest rate contracts Accrued expenses and other liabilities, current and non-current 2 0 2 Total $ 3 $ 13 $ 16 57 Table of Contents Alphabet Inc. As of December 31, 2016 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Prepaid revenue share, expenses and other assets, current and non-current $ 539 $ 57 $ 596 Total $ 539 $ 57 $ 596 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 4 $ 9 $ 13 Interest rate contracts Accrued expenses and other liabilities, current and non-current 0 0 0 Total $ 4 $ 9 $ 13 The effect of derivative instruments in cash flow hedging relationships on income and other comprehensive income (OCI) is summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect (Effective Portion) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship 2014 2015 2016 Foreign exchange contracts $ 929 $ 964 $ 773 Interest rate contracts (31 ) 0 0 Total $ 898 $ 964 $ 773 Gains (Losses) Reclassified from AOCI into Income (Effective Portion) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship Location 2014 2015 2016 Foreign exchange contracts Revenues $ 171 $ 1,399 $ 539 Interest rate contracts Other income (expense), net 4 5 5 Total $ 175 $ 1,404 $ 544 Gains (Losses) Recognized in Income on Derivatives (Amount Excluded from  Effectiveness Testing and Ineffective Portion) (1) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship Location 2014 2015 2016 Foreign exchange contracts Other income (expense), net $ (279 ) $ (297 ) $ (381 ) Interest rate contracts Other income (expense), net 4 0 0 Total $ (275 ) $ (297 ) $ (381 ) (1) Gains (losses) related to the ineffective portion of the hedges were not material in all periods presented. 58 Table of Contents Alphabet Inc. The effect of derivative instruments in fair value hedging relationships on income is summarized below (in millions): Gains (Losses) Recognized in Income on Derivatives (2) Year Ended December 31, Derivatives in Fair Value Hedging Relationship Location 2014 2015 2016 Foreign Exchange Hedges: Foreign exchange contracts Other income (expense), net $ 115 $ 170 $ 145 Hedged item Other income (expense), net (123 ) (176 ) (139 ) Total $ (8 ) $ (6 ) $ 6 Interest Rate Hedges: Interest rate contracts Other income (expense), net $ 0 $ (2 ) $ (3 ) Hedged item Other income (expense), net 0 2 3 Total $ 0 $ 0 $ 0 (2) Amounts excluded from effectiveness testing and the ineffective portion of the fair value hedging relationships were not material in all periods presented The effect of derivative instruments not designated as hedging instruments on income is summarized below (in millions): Gains (Losses) Recognized in Income on Derivatives Year Ended December 31, Derivatives Not Designated As Hedging Instruments Location 2014 2015 2016 Foreign exchange contracts Other income (expense), net, and net income from discontinued operations $ 237 $ 198 $ 130 Interest rate contracts Other income (expense), net 2 1 (11 ) Total $ 239 $ 199 $ 119 Offsetting of Derivatives, Securities Lending, and Reverse Repurchase Agreements We present our derivatives, securities lending and reverse repurchase agreements at gross fair values in the Consolidated Balance Sheets. However, our master netting and other similar arrangements allow net settlements under certain conditions. As of December 31, 2015 and 2016 , information related to these offsetting arrangements was as follows (in millions): 59 Table of Contents Alphabet Inc. Offsetting of Assets As of December 31, 2015 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 628 $ 0 $ 628 $ (13 ) (1) $ (189 ) $ (214 ) $ 212 Reverse repurchase agreements 1,590 0 1,590 (2) 0 0 (1,590 ) 0 Total $ 2,218 $ 0 $ 2,218 $ (13 ) $ (189 ) $ (1,804 ) $ 212 As of December 31, 2016 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 596 $ 0 $ 596 $ (11 ) (1) $ (337 ) $ (73 ) $ 175 (1) The balances as of December 31, 2015 and 2016 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. (2) The balances as of December 31, 2015 included $1,140 million recorded in cash and cash equivalents and $450 million recorded in receivable under reverse repurchase agreements. Offsetting of Liabilities As of December 31, 2015 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 16 $ 0 $ 16 $ (13 ) (3) $ (3 ) $ 0 $ 0 Securities lending agreements 2,428 0 2,428 0 0 (2,401 ) 27 Total $ 2,444 $ 0 $ 2,444 $ (13 ) $ (3 ) $ (2,401 ) $ 27 As of December 31, 2016 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Description Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 13 $ 0 $ 13 $ (11 ) (3) $ 0 $ 0 $ 2 (3) The balances as of December 31, 2015 and 2016 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 3. Non-Marketable Investments Our non-marketable investments include non-marketable equity investments and non-marketable debt securities. Non-Marketable Equity Investments Our non-marketable equity investments are investments we have made in privately-held companies accounted for under the equity or cost method and are not required to be consolidated under the variable interest or voting models. As of December 31, 2015 and 2016 , investments accounted for under the equity method had a carrying value of approximately $1.6 billion and $1.7 billion , respectively. Our share of equity method investee earnings and losses 60 Table of Contents Alphabet Inc. including impairment was a net loss of $48 million , $227 million , and $202 million for the years ended December 31, 2014 , 2015 , and 2016 , respectively. As of December 31, 2015 and 2016 , investments accounted for under the cost method had a carrying value of $2.6 billion and $3.0 billion , respectively, and a fair value of approximately $7.5 billion and $8.1 billion , respectively. The fair value of the cost method investments are primarily determined from data leveraging private-market transactions and are classified within Level 3 in the fair value hierarchy. We reflect our share of equity method investee earnings and losses and impairments of non-marketable equity investments as a component of other income (expense), net, in the accompanying Consolidated Statements of Income. Certain renewable energy investments included in our non-marketable equity investments accounted for under the equity method are variable interest entities ("VIE"). These entities' activities involve power generation using renewable sources. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly impact VIE's economic performance such as setting operating budgets. Therefore, we do not consolidate these VIEs in our financial statements. The carrying value of these VIEs was $1.3 billion with a maximum exposure of $1.3 billion as of December 31, 2015 and $1.2 billion with a maximum exposure of $1.2 billion as of December 31, 2016 . The maximum exposure is based on current investments to date.  We have determined the single source of our exposure to these VIEs is our capital investment in these entities. We periodically reassess whether we are the primary beneficiary of a VIE. The reassessment process considers whether we have acquired the power to direct the most significant activities of the VIE through changes in governing documents or other circumstances. We also reconsider whether entities previously determined not to be VIEs have become VIEs, and vice versa, based on changes in facts and circumstances including changes in contractual arrangements and capital structure. Non-Marketable Debt Securities Our non-marketable debt securities are primarily preferred stock that are redeemable at our option and convertible notes issued by private companies. The cost of these securities was $1.0 billion and $1.1 billion as of December 31, 2015 and 2016 , respectively. These debt securities do not have readily determinable market values and are categorized accordingly as Level 3 in the fair value hierarchy. To estimate the fair value of these securities, we use a combination of valuation methodologies, including market and income approaches based on prior transaction prices; estimated timing, probability, and amount of cash flows; and illiquidity considerations. Financial information of private companies may not be available and consequently we will estimate the value based on the best available information at the measurement date. No significant impairments were recognized for the years ended December 31, 2014 , 2015 , and 2016 . The following table presents a reconciliation for our non-marketable debt securities measured and recorded at fair value on a recurring basis, using significant unobservable inputs (Level 3) (in millions): Year Ended December 31 2015 2016 Beginning balance $ 90 $ 1,024 Total net gains or losses Included in other comprehensive income 0 106 Purchases 960 78 Sales (6 ) (18 ) Settlements (20 ) (25 ) Ending balance $ 1,024 $ 1,165 Note 4. Debt Short-Term Debt Google had a short-term debt financing program of up to $3.0 billion through the issuance of commercial paper and a $3.0 billion revolving credit facility as of December 31, 2015. In February 2016, we replaced this program with a new short-term debt financing program of up to $5.0 billion of commercial paper and a $4.0 billion revolving credit facility, which expires in February 2021. Net proceeds from these programs are used for general corporate purposes. We had $2.0 billion of outstanding commercial paper recorded as short-term debt with a weighted-average interest rate of 0.2% as of December 31, 2015 and no commercial paper outstanding as of December 31, 2016 . The estimated fair value of the short-term debt approximated its carrying value as of December 31, 2015 . The interest rate for the credit facility is determined based on a formula using certain market rates. No amounts were outstanding under the credit facility as of December 31, 2015 and December 31, 2016 . 61 Table of Contents Alphabet Inc. In August 2013, we entered into a capital lease obligation on certain property expiring in 2028. In September 2016, we exercised our option to purchase the property for approximately $220 million . Long-Term Debt Google issued $3.0 billion of unsecured senior notes in three tranches (collectively, the "2011 Notes") in May 2011, due in 2014, 2016, and 2021, as well as $1.0 billion of unsecured senior notes (the "2014 Notes") in February 2014 due 2024. In April 2016, we completed an exchange offer with eligible holders of Google’s 2011 Notes due 2021 and 2014 Notes due 2024 (collectively, the "Google Notes"). An aggregate principal amount of approximately $1.7 billion of the Google Notes was exchanged for approximately $1.7 billion of Alphabet notes with identical interest rate and maturity. Because the exchange was between a parent and the subsidiary company and for substantially identical notes, the change was treated as a debt modification for accounting purposes with no gain or loss recognized. In August 2016, Alphabet issued $2.0 billion of unsecured senior notes (the "2016 Notes") due 2026. The net proceeds from the issuance of the 2016 Notes were used for general corporate purposes, including the repayment of outstanding commercial paper. The Alphabet notes due in 2021, 2024, and 2026 rank equally with each other and are structurally subordinated to the outstanding Google Notes. The total outstanding long-term debt is summarized below (in millions): As of December 31, 2015 As of December 31, 2016 Short-Term Portion of Long-Term Debt 2.125% Notes due on May 19, 2016 $ 1,000 $ 0 Capital Lease Obligation 225 0 Total Short-Term Portion of Long-Term Debt $ 1,225 $ 0 Long-Term Debt 3.625% Notes due on May 19, 2021 $ 1,000 $ 1,000 3.375% Notes due on February 25, 2024 1,000 1,000 1.998% Notes due on August 15, 2026 0 2,000 Unamortized discount for the Notes above (5 ) (65 ) Total Long-Term Debt (1) $ 1,995 $ 3,935 (1) Includes the outstanding (and unexchanged) Google Notes issued in 2011 and 2014 and the Alphabet notes exchanged in 2016. The effective interest yields based on proceeds received from the outstanding notes due in 2021, 2024 and 2026 were 3.734% , 3.377% and 2.231% respectively, with interest payable semi-annually. We may redeem these notes at any time in whole or in part at specified redemption prices. The total estimated fair value of all outstanding notes was approximately $3.1 billion as of December 31, 2015 and $3.9 billion as of December 31, 2016 . The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. As of December 31, 2016 , aggregate future principal payments for long-term debt were as follows (in millions): Years Ending 2017 $ 0 2018 0 2019 0 2020 0 Thereafter 4,000 Total $ 4,000 62 Table of Contents Alphabet Inc. Note 5. Supplemental Financial Statement Information Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2015 As of December 31, 2016 Land and buildings $ 16,518 $ 19,804 Information technology assets 13,645 16,084 Construction in progress 7,324 8,166 Leasehold improvements 2,576 3,415 Furniture and fixtures 83 58 Property and equipment, gross 40,146 47,527 Less: accumulated depreciation and amortization (11,130 ) (13,293 ) Property and equipment, net $ 29,016 $ 34,234 As of December 31, 2016 , assets under capital lease with a cost basis of $299 million were included in property and equipment. Note Receivable In connection with the sale of our Motorola Mobile business on October 29, 2014 (see Note 9 for additional information), we received an interest-free, three -year prepayable promissory note (the "Note Receivable") due October 2017. The Note Receivable was included on our Consolidated Balance Sheets in prepaid revenue share, expenses and other assets, non-current, as of December 31, 2015, and in current assets, prepaid revenue share, expenses and other assets, as of December 31, 2016. Based on the general market conditions and the credit quality of Lenovo at the time of the sale, we discounted the Note Receivable at an effective interest rate of 4.5% . The outstanding balances are shown in the table below (in millions): As of December 31, 2015 As of December 31, 2016 Principal of the Note Receivable $ 1,448 $ 1,448 Less: unamortized discount for the Note Receivable (112 ) (51 ) Total $ 1,336 $ 1,397 As of December 31, 2015 and 2016 , we did not recognize a valuation allowance on the Note Receivable. Accrued expenses and other current liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2015 As of December 31, 2016 Accrued customer liabilities $ 908 $ 1,256 Other accrued expenses and current liabilities 3,860 4,888 Accrued expenses and other current liabilities $ 4,768 $ 6,144 63 Table of Contents Alphabet Inc. Accumulated Other Comprehensive Income (Loss) The components of AOCI, net of tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2013 $ 16 $ 50 $ 59 $ 125 Other comprehensive income (loss) before reclassifications (996 ) 505 651 160 Amounts reclassified from AOCI 0 (134 ) (124 ) (258 ) Other comprehensive income (loss) (996 ) 371 527 (98 ) Balance as of December 31, 2014 $ (980 ) $ 421 $ 586 $ 27 Other comprehensive income (loss) before reclassifications (1,067 ) (715 ) 676 (1,106 ) Amounts reclassified from AOCI 0 208 (1,003 ) (795 ) Other comprehensive income (loss) (1,067 ) (507 ) (327 ) (1,901 ) Balance as of December 31, 2015 $ (2,047 ) $ (86 ) $ 259 $ (1,874 ) Other comprehensive income (loss) before reclassifications (599 ) (314 ) 515 (398 ) Amounts reclassified from AOCI 0 221 (351 ) (130 ) Other comprehensive income (loss) (599 ) (93 ) 164 (528 ) Balance as of December 31, 2016 $ (2,646 ) $ (179 ) $ 423 $ (2,402 ) The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statement of Income Year Ended December 31, AOCI Components Location 2014 2015 2016 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ 153 $ (208 ) $ (221 ) Provision for income taxes (19 ) 0 0 Net of tax $ 134 $ (208 ) $ (221 ) Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue $ 171 $ 1,399 $ 539 Interest rate contracts Other income (expense), net 4 5 5 Provision for income taxes (51 ) (401 ) (193 ) Net of tax $ 124 $ 1,003 $ 351 Total amount reclassified, net of tax $ 258 $ 795 $ 130 64 Table of Contents Alphabet Inc. Other Income (Expense), Net The components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2014 2015 2016 Interest income $ 746 $ 999 $ 1,220 Interest expense (101 ) (104 ) (124 ) Foreign currency exchange losses, net (1) (402 ) (422 ) (475 ) Gain (loss) on marketable securities, net 153 (208 ) (210 ) Gain (loss) on non-marketable investments, net 237 (126 ) (65 ) Other 130 152 88 Other income (expense), net $ 763 $ 291 $ 434 (1) Our foreign currency exchange losses, net, are related to the option premium costs and forward points for our foreign currency hedging contracts, our foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contract losses and gains. The net foreign currency transaction losses were $107 million , $123 million , and $112 million in 2014 , 2015 , and 2016 , respectively. Note 6. Acquisitions 2016 Acquisitions Apigee In October 2016, we completed the acquisition of Apigee Corp., a provider of application programming interface (API) management, for approximately $571 million in cash. We expect the acquisition to accelerate our Google Cloud customers’ move to supporting their businesses with high quality digital interactions. Of the total purchase price of $571 million , $41 million was cash acquired, $127 million was attributed to intangible assets, $376 million was attributed to goodwill, and $27 million was attributed to net assets acquired . Goodwill, which was recorded in the Google segment, is primarily attributable to synergies expected to arise after the acquisition and is not deductible for tax purposes. Other Acquisitions During the year ended December 31, 2016 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $448 million . In aggregate, $12 million was cash acquired, $143 million was attributed to intangible assets, $288 million was attributed to goodwill, and $5 million was attributed to net assets acquired . These acquisitions generally enhance the breadth and depth of our offerings, as well as expanding our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $67 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2016 , patents and developed technology have a weighted-average useful life of 4.5 years, customer relationships have a weighted-average useful life of 3.4 years, and trade names and other have a weighted-average useful life of 6.2 years. 2015 Acquisitions bebop Technologies In December 2015, we completed the acquisition of bebop Technologies Inc. (bebop), a company with a cloud-based development platform focused on enterprise applications. The fair value of total consideration transferred in connection with the close was $272 million , of which $1 million was paid in cash and $271 million was paid in the form of Alphabet Class C capital stock. We issued a total of approximately 514 thousand shares of Alphabet Class C capital stock in relation to this acquisition, part of which will be accounted for as compensation expense. The fair value of the shares of capital stock issued was determined based on the closing market price of Alphabet's Class C capital stock as of the close date. The Class C capital stock issued by Alphabet in connection with the acquisition was treated as a capital contribution from Alphabet to Google. We expect the acquisition will help us provide a new platform to build and maintain enterprise applications. As part of the acquisition, Diane Greene, the former CEO of bebop and a member of our Board of Directors, has joined Google. 65 Table of Contents Alphabet Inc. Of the total purchase price of $272 million , $28 million was cash acquired, $59 million was attributed to intangible assets, $206 million was attributed to goodwill, and $21 million was attributed to net liabilities assumed . The goodwill, which was recorded in the Google segment, is primarily attributable to the synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. Other Acquisitions During the year ended December 31, 2015 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $263 million , which includes the fair value of our previously held equity interest of $0 million . In aggregate, $4 million was cash acquired, $88 million was attributed to intangible assets, $138 million was attributed to goodwill, and $33 million was attributed to net assets acquired . These acquisitions generally enhance the breadth and depth of our offerings, as well as expanding our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $20 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all intangible assets acquired during the year ended December 31, 2015 , patents and developed technology have a weighted-average useful life of 4.1 years, customer relationships have a weighted-average useful life of 4.0 years, and trade names and other have a weighted-average useful life of 6.8 years. Note 7. Calico On September 18, 2013, we announced the formation of Calico, a life science company with a mission to harness advanced technologies to increase our understanding of the biology that controls lifespan. As of December 31, 2016 , we have contributed $240 million to Calico in exchange for Calico convertible preferred units and are committed to fund an additional $490 million on an as-needed basis. Calico is a VIE and its results of operations and statement of financial position are included in our consolidated financial statements as we have the power to direct the activities that most significantly impact its economic performance. In September 2014, AbbVie Inc. (AbbVie) and Calico announced a research and development collaboration agreement intended to help both companies discover, develop, and bring to market new therapies for patients with age-related diseases, including neurodegeneration and cancer. As of December 31, 2016 , AbbVie has contributed $750 million to fund the collaboration pursuant to the agreement, which reflects its total commitment. As of December 31, 2016 , Calico has contributed $ 250 million and committed up to an additional $ 500 million . Calico has used its scientific expertise to establish a world-class research and development facility, with a focus on drug discovery and early drug development; and AbbVie provides scientific and clinical development support and its commercial expertise to bring new discoveries to market. Both companies share costs and profits equally. AbbVie's contribution has been recorded as a liability on Calico's financial statements, which is reduced and reflected as a reduction to research and development expense as eligible research and development costs are incurred by Calico over the next few years. Note 8. Goodwill and Other Intangible Assets Goodwill The changes in the carrying amount of goodwill allocated to our disclosed segments for the years ended December 31, 2015 and 2016 were as follows (in millions): Google Other Bets Total Consolidated Balance as of December 31, 2014 $ 15,599 $ 0 $ 15,599 Acquisitions 139 0 139 Foreign currency translation and other adjustments (71 ) 0 (71 ) Allocation in the fourth quarter of 2015 (416 ) 416 0 Acquisitions 201 4 205 Foreign currency translation and other adjustments 4 (7 ) (3 ) Balance as of December 31, 2015 $ 15,456 $ 413 $ 15,869 Acquisitions 625 39 664 Foreign currency translation and other adjustments (54 ) (11 ) (65 ) Balance as of December 31, 2016 $ 16,027 $ 441 $ 16,468 66 Table of Contents Alphabet Inc. Other Intangible Assets Information regarding our purchased intangible assets is as follows (in millions): As of December 31, 2015 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 6,592 $ 3,213 $ 3,379 Customer relationships 1,343 1,201 142 Trade names and other 795 469 326 Total $ 8,730 $ 4,883 $ 3,847 As of December 31, 2016 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 5,542 $ 2,710 $ 2,832 Customer relationships 352 197 155 Trade names and other 463 143 320 Total $ 6,357 $ 3,050 $ 3,307 Patents and developed technology, customer relationships, and trade names and other have weighted-average remaining useful lives of 4.6 years, 2.3 years, and 4.7 years, respectively. Amortization expense relating to our purchased intangible assets was $1,079 million , $892 million , and $833 million for the years ended December 31, 2014 , 2015 , and 2016 , respectively. As of December 31, 2016, $2.6 billion of intangible assets that were fully amortized have been removed from gross intangible assets and accumulated amortization. During the year ended December 31, 2014, we recorded an impairment charge in other cost of revenues of $378 million related to a patent licensing royalty asset acquired in connection with the Motorola acquisition, which we retained subsequent to the sale of Motorola Mobile. The asset was determined to be impaired due to prolonged decreased royalty payments and unpaid interest owed and was written down to its fair value. Fair value was determined based on a discounted cash flow method and reflects estimated future cash flows associated with the patent licensing royalty asset at the measurement date and falls within level 3 in fair value hierarchy. Impairments of intangible assets were not material for the years ended December 31, 2015 and 2016 . As of December 31, 2016 , expected amortization expense relating to purchased intangible assets for each of the next five years and thereafter was as follows (in millions): 2017 $ 764 2018 685 2019 579 2020 487 2021 460 Thereafter 332 $ 3,307 Note 9. Discontinued Operations Motorola Mobile On October 29, 2014, we closed the sale of the Motorola Mobile business to Lenovo for a total purchase price of approximately $2.9 billion , including $1.4 billion paid at close, comprised of $660 million in cash and $750 million in Lenovo ordinary shares ( 519.1 million shares). The remaining $1.5 billion was paid in the form of an interest-free, three -year prepayable promissory note. We maintain ownership of the vast majority of the Motorola Mobile patent portfolio, including pre-closing patent applications and invention disclosures, which we licensed to Motorola Mobile for its continued operations. Additionally, 67 Table of Contents Alphabet Inc. in connection with the sale, we agreed to indemnify Lenovo for certain potential liabilities of the Motorola Mobile business, for which we recorded an indemnification liability of $130 million . The sale resulted in a gain of $740 million , net of tax, which was presented as part of net income from discontinued operations in the Consolidated Statements of Income for the year ended December 31, 2014. Incremental to this net gain, we recognized additional income of $254 million , net of tax, in connection with certain IP licensing arrangements between the parties, included as part of net income from discontinued operations on the Consolidated Statements of Income for the year ended December 31, 2014. The financial results of Motorola Mobile through the date of divestiture are presented as net income (loss) from discontinued operations on the Consolidated Statements of Income. The following table presents financial results of the Motorola Mobile business included in net income (loss) from discontinued operations for the year ended December 31, 2014 (in millions): Year Ended December 31, 2014 (1) Revenues $ 5,486 Loss from discontinued operations before income taxes (177 ) Benefits from/(Provision for) income taxes (47 ) Gain on disposal 740 Net (loss) income from discontinued operations $ 516 (1) The operating results of Motorola Mobile were included in our Consolidated Statements of Income from January 1, 2014 through October 29, 2014, the date of divestiture. The following table presents the aggregate carrying amounts of the major classes of assets and liabilities divested (in millions): Assets: Cash and cash equivalents $ 160 Accounts receivable 1,103 Inventories 217 Prepaid expenses and other current assets 357 Prepaid expenses and other assets, non-current 290 Property and equipment, net 542 Intangible assets, net 985 Goodwill 43 Total assets $ 3,697 Liabilities: Accounts payable $ 1,238 Accrued compensation and benefits 163 Accrued expenses and other current liabilities 10 Deferred revenue, current 165 Other long-term liabilities 250 Total liabilities $ 1,826 Note 10. Commitments and Contingencies Operating Leases We have entered into various non-cancelable operating lease agreements for certain of our offices, facilities, land, and data centers throughout the world with original lease periods expiring primarily between 2017 and 2063 . We are committed to pay a portion of the actual operating expenses under certain of these lease agreements. These 68 Table of Contents Alphabet Inc. operating expenses are not included in the table below. Certain of these arrangements have free or escalating rent payment provisions. We recognize rent expense under such arrangements on a straight-line basis. As of December 31, 2016 , future minimum payments under non-cancelable operating leases, net of sublease income amounts, were as follows over each of the next five years and thereafter (in millions): Operating Leases Sub-lease Income Net Operating Leases 2017 843 15 828 2018 902 6 896 2019 910 5 905 2020 854 4 850 2021 767 2 765 Thereafter 3,694 1 3,693 Total minimum payments $ 7,970 $ 33 $ 7,937 Certain leases have adjustments for market provisions. Amounts in the above table represent our best estimates of future payments to be made under these leases. We have entered into certain non-cancelable lease agreements with original lease periods expiring between 2021 and 2035 where we are the deemed owner for accounting purposes of new construction projects. Excluded from the table above are future minimum lease payments under such leases totaling approximately $1.4 billion , for which a $940 million liability is included on the Consolidated Balance Sheet as of December 31, 2016 . Rent expense under operating leases was $570 million , $734 million , and $897 million in 2014 , 2015 , and 2016 , respectively. Purchase Obligations As of December 31, 2016 , we had $2.5 billion of other non-cancelable contractual obligations, primarily related to data center operations and facility build-outs, video and other content licensing revenue sharing arrangements, as well as certain inventory purchase commitments. Letters of Credit As of December 31, 2016 , we had unused letters of credit for $797 million . Indemnifications In the normal course of business, to facilitate transactions in our services and products, we indemnify certain parties, including advertisers, Google Network Members, and lessors with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2016 , we did not have any material indemnification claims that were probable or reasonably possible. As part of the sale of Motorola Mobile, we issued indemnifications for certain potential liabilities. Please see Note 9 for additional information. Legal Matters Antitrust Investigations On November 30, 2010, the European Commission's (EC) Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On April 15, 2015, the EC issued a Statement of 69 Table of Contents Alphabet Inc. Objections (SO) regarding the display and ranking of shopping search results, to which we responded on August 27, 2015. On April 20, 2016, the EC issued an SO regarding certain Android distribution practices. On July 14, 2016, the EC issued a Supplementary SO regarding shopping search results and an SO regarding the syndication of AdSense for Search. We have responded to the SOs and Supplementary SO and continue to respond to the EC's informational requests. We remain committed to working with the EC to resolve these matters. The Comision Nacional de Defensa de la Competencia in Argentina, the Competition Commission of India (CCI), Brazil's Council for Economic Defense (CADE), the Federal Antimonopoly Service (FAS) of the Russian Federation, and the Korean Fair Trade Commission have also opened investigations into certain of our business practices. In November 2016, we responded to the CCI Director General's report with interim findings of competition law infringements regarding search and ads. In September 2015, FAS found that there has been a competition law infringement in Android mobile distribution. The appeal against that decision has so far been rejected, so Google has implemented the ruling to the degree possible and is working on product changes to finalize implementation. The appeals process continues. In April 2016, the Canadian Competition Bureau informed us that it was closing its antitrust investigations of our business practices. Patent and Intellectual Property Claims We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss for a company or its suppliers in an ITC action could result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them for certain intellectual property infringement claims against them, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Oracle America, Inc. (Oracle) brought a copyright lawsuit against Google in the Northern District of California, alleging that Google's Android infringes Oracle's copyrights related to certain Java application programming interfaces. After trial, final judgment was entered by the district court in favor of Google on June 8, 2016, and the court decided post-trial motions in favor of Google. Oracle has filed a notice of appeal. We believe this lawsuit is without merit and are defending ourselves vigorously. Given the nature of this case, we are unable to estimate the reasonably possible loss or range of loss, if any, arising from this matter. Other We are also regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition (such as the pending EC investigations described above), intellectual property, privacy, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. Such claims, suits, regulatory and government investigations, and other proceedings could result in fines, civil or criminal penalties, or other adverse consequences. Certain of our outstanding legal matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. With respect to our outstanding legal matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in the aggregate, have a material adverse effect on 70 Table of Contents Alphabet Inc. our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such legal matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Indirect Taxes We are under audit by various domestic and foreign tax authorities with regards to indirect tax matters. The subject matter of indirect tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions. We accrue indirect taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. For certain matters, while the loss is reasonably possible, the loss or range of loss cannot be estimated. We believe these matters are without merit and are defending ourselves vigorously. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. For information regarding income tax contingencies, see Note 14 . Note 11. Net Income Per Share We compute net income per share of Class A and Class B common stock and Class C capital stock using the two-class method. Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of stock options, restricted stock units, and other contingently issuable shares. The dilutive effect of outstanding stock options, restricted stock units, and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A common stock assumes the conversion of Class B common stock, while the diluted net income per share of Class B common stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A and Class B common stock and Class C capital stock are identical, except with respect to voting. Further, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our board of directors from declaring or paying unequal per share dividends on our Class A and Class B common stock and Class C capital stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our board of directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A and Class B common shares and Class C capital stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. The net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are legally entitled to equal per share distributions whether through dividends or in liquidation. Further, as we assume the conversion of Class B common stock in the computation of the diluted net income per share of Class A common stock, the undistributed earnings are equal to net income for that computation. In the years ended December 31, 2014 and 2016, the net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. In the year ended December 31, 2015, the Class C Adjustment Payment was allocated to the numerator for calculating net income per share of Class C capital stock from net income available to all stockholders and the remaining undistributed earnings were allocated on a pro rata basis to Class A and Class B common stock and Class C capital stock based on the number of shares used in the per share computation for each class of stock. The weighted-average share impact of the Class C Adjustment Payment is included in the denominator of both basic and diluted net income per share computations for the year ended December 31, 2015. The following table sets forth the computation of basic and diluted net income per share of Class A and Class B common stock and Class C capital stock (in millions, except share amounts which are reflected in thousands and per share amounts): 71 Table of Contents Alphabet Inc. Year Ended December 31, 2014 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings - continuing operations $ 5,700 $ 1,107 $ 6,813 Allocation of undistributed earnings - discontinued operations 216 42 258 Total $ 5,916 $ 1,149 $ 7,071 Denominator Number of shares used in per share computation 282,877 54,928 338,130 Basic net income per share: Continuing operations $ 20.15 $ 20.15 $ 20.15 Discontinued operations 0.76 0.76 0.76 Basic net income per share $ 20.91 $ 20.91 $ 20.91 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation - continuing operations $ 5,700 $ 1,107 $ 6,813 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,107 0 0 Reallocation of undistributed earnings (20 ) (18 ) 20 Allocation of undistributed earnings - continuing operations $ 6,787 $ 1,089 $ 6,833 Allocation of undistributed earnings for basic computation - discontinued operations 216 42 258 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 42 0 0 Reallocation of undistributed earnings (1 ) (1 ) 1 Allocation of undistributed earnings - discontinued operations $ 257 $ 41 $ 259 Denominator Number of shares used in basic computation 282,877 54,928 338,130 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 54,928 0 0 Restricted stock units and other contingently issuable shares 4,572 0 6,563 Number of shares used in per share computation 342,377 54,928 344,693 Diluted net income per share: Continuing operations $ 19.82 $ 19.82 $ 19.82 Discontinued operations 0.75 0.75 0.75 Diluted net income per share $ 20.57 $ 20.57 $ 20.57 72 Table of Contents Alphabet Inc. Year Ended December 31, 2015 Class A Class B Class C Basic net income per share: Numerator Adjustment Payment to Class C capital stockholders $ 0 $ 0 $ 522 Allocation of undistributed earnings $ 6,695 $ 1,196 $ 7,935 Total $ 6,695 $ 1,196 $ 8,457 Denominator Number of shares used in per share computation 289,640 51,745 343,241 Basic net income per share $ 23.11 $ 23.11 $ 24.63 Diluted net income per share: Numerator Adjustment Payment to Class C capital stockholders $ 0 $ 0 $ 522 Allocation of undistributed earnings for basic computation $ 6,695 $ 1,196 $ 7,935 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,196 0 0 Reallocation of undistributed earnings (39 ) (14 ) 39 Allocation of undistributed earnings $ 7,852 $ 1,182 $ 7,974 Denominator Number of shares used in basic computation 289,640 51,745 343,241 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 51,745 0 0 Restricted stock units and other contingently issuable shares 2,395 0 5,909 Number of shares used in per share computation 343,780 51,745 349,150 Diluted net income per share $ 22.84 $ 22.84 $ 24.34 73 Table of Contents Alphabet Inc. Year Ended December 31, 2016 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings 8,332 1,384 9,762 Denominator Number of shares used in per share computation 294,217 48,859 344,702 Basic net income per share $ 28.32 $ 28.32 $ 28.32 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 8,332 $ 1,384 $ 9,762 Effect of dilutive securities in equity method investments and subsidiaries (9 ) (2 ) (10 ) Allocation of undistributed earnings for diluted computation 8,323 1,382 9,752 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,382 0 0 Reallocation of undistributed earnings (94 ) (21 ) 94 Allocation of undistributed earnings 9,611 1,361 9,846 Denominator Number of shares used in basic computation 294,217 48,859 344,702 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 48,859 0 0 Restricted stock units and other contingently issuable shares 2,055 0 8,873 Number of shares used in per share computation 345,131 48,859 353,575 Diluted net income per share $ 27.85 $ 27.85 $ 27.85 Note 12. Stockholders’ Equity Convertible Preferred Stock Our board of directors has authorized 100 million shares of convertible preferred stock, $0.001 par value, issuable in series. As of December 31, 2015 and 2016 , there were no shares issued or outstanding. Class A and Class B Common Stock and Class C Capital Stock Our board of directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Stock Plans Under our 2012 Stock Plan, RSUs or stock options may be granted. An RSU award is an agreement to issue shares of our publicly traded stock at the time the award vests. Incentive and non-qualified stock options, or rights to purchase common stock, are generally granted for a term of 10 years. Options and RSUs granted to participants under the 2012 Stock Plan generally vest over four years contingent upon employment or service with us on the vesting date. As of December 31, 2016 , there were 26,206,647 shares of stock reserved for future issuance under our Stock Plan. 74 Table of Contents Alphabet Inc. Stock-Based Compensation The following table presents our aggregate stock-based compensation expense by type of costs and expenses per the Consolidated Statements of Income (in millions): Year Ended December 31, 2014 2015 2016 Cost of revenues $ 535 $ 806 $ 1,157 Research and development 2,200 2,687 3,354 Sales and marketing 715 899 1,078 General and administrative 725 861 1,282 Discontinued operations 104 0 0 Total stock-based compensation expense $ 4,279 $ 5,253 $ 6,871 For the years ended December 31, 2014 , 2015 , and 2016 , we recognized tax benefits on total stock-based compensation expense from continuing operations of $867 million , $1,133 million , and $1,465 million , respectively, and from discontinued operations of $30 million , $0 million and $0 million , respectively. In addition, as a result of the Tax Court ruling in Altera Corp. v. Commissioner, we have recorded a tax benefit of $522 million and $690 million related to 2015 and 2016 stock-based compensation expense, respectively, that will be subject to reimbursement of cost share payments if the tax court's opinion is sustained. Refer to Note 14 for more detail regarding the Altera case. Total direct tax benefit realized, including excess tax benefits, from stock-based awards vested or exercised during the years ended December 31, 2014 , 2015 , and 2016 , was $1,356 million , $1,544 million , and $2,137 million , respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the research and development tax credit. Of the total stock-based compensation expense from continuing operations recognized in the years ended December 31, 2014 , 2015 , and 2016 , $0 million , $50 million , and $168 million , respectively, was associated with awards expected to be ultimately settled in cash. Awards which we expect to be ultimately settled in cash are classified as liabilities in our Consolidated Balance Sheets. Beginning January 1, 2016, we account for forfeitures as they occur, rather than estimate expected forfeitures. The net cumulative effect of this change was recognized as a $133 million reduction to retained earnings as of January 1, 2016. Stock-Based Award Activities The following table summarizes the activities for our unvested restricted stock units (RSUs) for the year ended December 31, 2016 : Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2015 25,741,186 $ 531.74 Granted 13,502,900 $ 713.89 Vested (12,002,071 ) $ 532.87 Forfeited/canceled (1,893,060 ) $ 562.03 Unvested as of December 31, 2016 25,348,955 $ 624.92 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2014 and 2015 , was $573.71 and $546.46 , respectively. Total fair value as of the respective vesting dates of RSUs vested during the years ended December 31, 2014 , 2015 and 2016 was $6.0 billion , $6.9 billion , and $9.0 billion , respectively. As of December 31, 2016 , there was $14.6 billion of unrecognized compensation cost related to unvested employee RSUs. This amount is expected to be recognized over a weighted-average period of 2.7 years . As of December 31, 2016, we had 3.3 million stock options outstanding and exercisable, and $2 million of unrecognized compensation cost related to unvested stock options. During the years ended December 31, 2014 , 2015 , 75 Table of Contents Alphabet Inc. and 2016 , the amount of cash received from the exercise of stock options was $465 million , $393 million , and $298 million , respectively. Share Repurchases In October 2015, the board of directors of Alphabet authorized the company to repurchase up to $5,099,019,513.59 of its Class C capital stock, commencing in the fourth quarter of 2015. In January 2016, the board of directors of Alphabet authorized the company to repurchase an additional amount of approximately 514 thousand shares. The repurchases were executed, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through the use of 10b5-1 plans. During 2016, we repurchased and subsequently retired approximately 5.2 million shares of Alphabet Class C capital stock for an aggregate amount of approximately $3.7 billion . We completed all authorized share repurchases under this repurchase program as of June 30, 2016. In October 2016, the board of directors of Alphabet authorized the company to repurchase up to $7,019,340,976.83 of its Class C capital stock. The repurchases are expected to be executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. No shares were repurchased in 2016 under this program. Note 13. 401(k) Plans We have two 401(k) Savings Plans (401(k) Plans) that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We contributed approximately $259 million , $309 million , and $385 million for the years ended December 31, 2014 , 2015 , and 2016 . Note 14. Income Taxes Income from continuing operations before income taxes included income from domestic operations of $8,894 million , $8,271 million , and $12,020 million for the years ended December 31, 2014 , 2015 , and 2016 , and income from foreign operations of $8,365 million , $11,380 million , and $12,130 million for the years ended December 31, 2014 , 2015 , and 2016 . The provision for income taxes consists of the following (in millions): Year Ended December 31, 2014 2015 2016 Current: Federal $ 2,716 $ 3,235 $ 3,520 State 157 (397 ) 306 Foreign 774 723 966 Total 3,647 3,561 4,792 Deferred: Federal 29 (198 ) (70 ) State 6 (43 ) 0 Foreign (43 ) (17 ) (50 ) Total (8 ) (258 ) (120 ) Provision for income taxes $ 3,639 $ 3,303 $ 4,672 76 Table of Contents Alphabet Inc. The reconciliation of federal statutory income tax rate to our effective income tax rate is as follows: Year Ended December 31, 2014 2015 2016 U.S. federal statutory tax rate 35.0 % 35.0 % 35.0 % Foreign rate differential (12.2 )% (13.4 )% (11.0 )% Federal research credit (1.8 )% (2.1 )% (2.0 )% Stock-based compensation expense 0.1 % 0.3 % (3.4 )% Other adjustments 0.0 % (3.0 )% 0.7 % Effective tax rate 21.1 % 16.8 % 19.3 % We adopted ASU 2016-09 on January 1, 2016, which requires the excess tax benefits or deficiencies to be reflected in the Consolidated Statements of Income as a component of the provision for income taxes whereas they previously were recognized in equity. Total excess tax benefits recognized in 2016 was $1.0 billion . Our effective tax rate is impacted by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. Substantially all of the income from foreign operations was earned by an Irish subsidiary. As of December 31, 2016 , we have not recognized deferred U.S. income taxes and foreign withholding taxes on a cumulative total of $60.7 billion of undistributed earnings and other basis differences in our foreign subsidiaries. We intend to indefinitely reinvest those earnings and other basis differences in operations outside the U.S. If such earnings and other basis differences in our investment foreign subsidiaries were to be repatriated in the future, they would be subject to U.S. income taxes and applicable non-U.S. income and withholding taxes. Determining the unrecognized deferred tax liability related to such investments in foreign subsidiaries that are indefinitely reinvested is not practicable. On July 27, 2015, the United States Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. The IRS served a Notice of Appeal on February 22, 2016. At this time, the U.S. Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. We have evaluated the opinion and continue to record a tax benefit in 2016 related to reimbursement of cost share payments for the previously shared stock-based compensation costs. In addition, we continue to record a tax liability for the U.S. tax cost of potential repatriation of the associated contingent foreign earnings because at this time we cannot reasonably conclude that the Company has the ability and the intent to indefinitely reinvest these contingent earnings. The net impact to our consolidated financial statements is not material. We will continue to monitor developments related to the case and the potential impact on our consolidated financial statements. 77 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities are as follows (in millions): As of December 31, 2015 2016 Deferred tax assets: Stock-based compensation expense $ 534 $ 574 Accrued employee benefits 832 939 Accruals and reserves not currently deductible 245 500 Tax credits 503 631 Basis difference in investment of Arris 1,357 1,327 Prepaid cost sharing 3,468 4,409 Other 931 926 Total deferred tax assets 7,870 9,306 Valuation allowance (1,732 ) (2,076 ) Total deferred tax assets net of valuation allowance 6,138 7,230 Deferred tax liabilities: Depreciation and amortization (1,126 ) (877 ) Identified intangibles (787 ) (844 ) Renewable energy investments (529 ) (788 ) Foreign earnings (3,468 ) (4,409 ) Other (166 ) (155 ) Total deferred tax liabilities (6,076 ) (7,073 ) Net deferred tax assets $ 62 $ 157 As of December 31, 2016 , our federal and state net operating loss carryforwards for income tax purposes were approximately $592 million and $681 million . If not utilized, the federal net operating loss carryforwards will begin to expire in 2021 and the state net operating loss carryforwards will begin to expire in 2017. It is more likely than not that our state net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. Our foreign net operating loss carryforwards for income tax purposes were $304 million that will begin to expire in 2022. As of December 31, 2016 , our California research and development credit carryforwards for income tax purposes were approximately $1,515 million that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. Our foreign tax credit carryforwards for income tax purposes were approximately $166 million that will start to expire in 2025. We believe it is more likely than not that all of the foreign tax credit will be realized. As of December 31, 2016 , we maintained a valuation allowance with respect to certain of our deferred tax assets relating primarily to investment losses that are capital in nature, California deferred tax assets, and certain foreign net operating losses that we believe are not likely to be realized. We established a deferred tax asset for the book-to-tax basis difference in our investments in Arris shares received from the sale of the Motorola Home business to Arris in 2013. Since any future losses to be recognized upon the sale of Arris shares will be capital losses, a valuation allowance has been recorded against this deferred tax asset to the extent such deferred tax asset is not likely to be covered by capital gains generated as of 2016. We reassess the valuation allowance quarterly and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. As a result of the Altera opinion, we have recognized a deferred tax asset of $4.4 billion and a deferred tax liability of $4.4 billion . Refer to above for more details on the Altera case. 78 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits from January 1, 2014 to December 31, 2016 (in millions): 2014 2015 2016 Beginning gross unrecognized tax benefits $ 2,502 $ 3,294 $ 4,167 Increases related to prior year tax positions 66 224 899 Decreases related to prior year tax positions (44 ) (176 ) (157 ) Decreases related to settlement with tax authorities (1 ) (27 ) (196 ) Increases related to current year tax positions 771 852 680 Ending gross unrecognized tax benefits $ 3,294 $ 4,167 $ 5,393 The total amount of gross unrecognized tax benefits was $3,294 million , $4,167 million , and $5,393 million as of December 31, 2014 , 2015 , and 2016 , respectively, of which, $2,909 million , $3,614 million , and $4,258 million if recognized, would affect our effective tax rate. As of December 31, 2015 and 2016 , we had accrued $348 million and $493 million in interest and penalties in provision for income taxes. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions, our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS completed its examination through our 2006 tax years; all issues have been concluded except for one which is currently under review in Tax Court. The IRS is currently examining our 2007 through 2012 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. Our 2013, 2014, 2015, and 2016 tax years remain subject to examination by the IRS for U.S. federal tax purposes, and our 2011 through 2015 tax years remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the impact, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, closure of audits is not certain, it is reasonably possible that certain U.S. federal and non-U.S. tax audits may be concluded within the next 12 months, which could significantly increase or decrease the balance of our gross unrecognized tax benefits. We estimate that our unrecognized tax benefits as of December 31, 2016 could possibly decrease by approximately $200 million to $700 million in the next 12 months. Positions that may be resolved include various U.S. and non-U.S. matters. Note 15. Information about Segments and Geographic Areas We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed below as Other Bets. Our reported segments are described below: • Google – Google includes our main internet products such as Search, Ads, Commerce, Maps, YouTube, Google Cloud, Android, Chrome, and Google Play as well as our hardware initiatives. Our technical infrastructure and some newer efforts like virtual reality are also included in Google. Google generates revenues primarily from advertising, sales of digital content, apps and cloud offerings, and sales of hardware products. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Google Fiber, sales of Nest products and services, and licensing and R&D services through Verily. 79 Table of Contents Alphabet Inc. Revenue, cost of revenue, and operating expenses are generally directly attributed to our segments. Inter-segment revenues are not presented separately, as these amounts are immaterial. Our Chief Operating Decision Maker does not evaluate operating segments using asset information. Prior period segment information has been recast to conform to the current period segment presentation. Information about segments during the periods presented were as follows (in millions): Year Ended December 31, 2014 2015 2016 Revenues: Google $ 65,674 $ 74,544 $ 89,463 Other Bets 327 445 809 Total revenues $ 66,001 $ 74,989 $ 90,272 Year Ended December 31, 2014 2015 2016 Operating income (loss): Google $ 18,965 $ 23,319 $ 27,892 Other Bets (1,893 ) (3,456 ) (3,578 ) Reconciling items (1) (576 ) (503 ) (598 ) Total income from operations $ 16,496 $ 19,360 $ 23,716 (1) Reconciling items are primarily related to corporate administrative costs and other miscellaneous items that are not allocated to individual segments. Year Ended December 31, 2014 2015 2016 Capital expenditures: Google $ 11,178 $ 8,868 $ 9,417 Other Bets 496 850 1,385 Reconciling items (2) (660 ) 232 (590 ) Total capital expenditures as presented on the Consolidated Statements of Cash Flows $ 11,014 $ 9,950 $ 10,212 (2) Reconciling items are related to timing differences of payments as segment capital expenditures are on accrual basis while total capital expenditures shown on the Consolidated Statements of Cash Flow are on cash basis and other miscellaneous differences. For the year ended December 31, 2014, reconciling items included capital expenditures of Motorola Mobile. 80 Table of Contents Alphabet Inc. Stock-based compensation (SBC) and depreciation, amortization, and impairment are included in segment operating income (loss) as below (in millions): Year Ended December 31, 2014 2015 2016 Stock-based compensation: Google $ 3,686 $ 4,610 $ 5,926 Other Bets 338 475 647 Reconciling items (3) 151 118 130 Total stock-based compensation (4) $ 4,175 $ 5,203 $ 6,703 Depreciation, amortization, and impairment: Google $ 4,779 $ 4,839 $ 5,800 Other Bets 147 203 340 Reconciling items (5) 53 21 4 Total depreciation, amortization, and impairment as presented on the Consolidated Statements of Cash Flows $ 4,979 $ 5,063 $ 6,144 (3) Reconciling items represent corporate administrative costs that are not allocated to individual segments. (4) For purposes of segment reporting, we define SBC as awards accounted for under FASB ASC Topic 718 that we expect to settle in stock. SBC for segment reporting does not include expenses related to awards that we expect to ultimately settle in cash. For the year ended December 31, 2014, amounts exclude SBC from discontinued operations. (5) Reconciling items are primarily related to corporate administrative costs and other miscellaneous items that are not allocated to individual segments. For the year ended December 31, 2014, reconciling items primarily represent depreciation, amortization and impairment related to Motorola Mobile. Revenues by geography are based on the billing addresses of our customers. The following tables set forth revenues and long-lived assets by geographic area (in millions): Year Ended December 31, 2014 2015 2016 Revenues: United States $ 29,482 $ 34,810 $ 42,781 United Kingdom 6,483 7,067 7,787 Rest of the world 30,036 33,112 39,704 Total revenues $ 66,001 $ 74,989 $ 90,272 As of December 31, 2015 As of December 31, 2016 Long-lived assets: United States $ 43,686 $ 47,383 International 13,661 14,706 Total long-lived assets $ 57,347 $ 62,089 Note 16. Subsequent Event In January 2017, Temasek, a Singapore-based investment company, signed a binding commitment to purchase a non-controlling interest in Verily for an aggregate of $800 million in cash. We closed the first tranche of the investment in February 2017 and anticipate closing the second and final tranche upon completion of certain terms in the second half of 2017. The transaction will be accounted for as an equity transaction with no gain or loss recognized. 81 Table of Contents Alphabet Inc. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2016 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2016 . Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2016 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION None. 82 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for 2017 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2016 ( 2017 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2017 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2017 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in 2017 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2017 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2017 Proxy Statement and is incorporated herein by reference. 83 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 40 Financial Statements: Consolidated Balance Sheets 42 Consolidated Statements of Income 43 Consolidated Statements of Comprehensive Income 44 Consolidated Statements of Stockholders’ Equity 45 Consolidated Statements of Cash Flows 46 Notes to Consolidated Financial Statements 47 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for doubtful accounts and sales credits for the three years ended December 31, 2016 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year (In millions) Year ended December 31, 2014 $ 631 $ 1,240 $ (1,646 ) $ 225 Year ended December 31, 2015 $ 225 $ 579 $ (508 ) $ 296 Year ended December 31, 2016 $ 296 $ 942 $ (771 ) $ 467 Note: Additions to the allowance for doubtful accounts are charged to expense. Additions to the allowance for sales credits are charged against revenues. For the year ended December 31, 2014, additions included the impact from the Motorola acquisition and usage included the impact from the sale of Motorola Mobile business. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits See the Exhibit Index immediately following the signature page of this Annual Report on Form 10-K. 84 Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 2, 2017 ALPHABET INC. By: / S /    L ARRY P AGE Larry Page Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Larry Page and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Table of Contents Alphabet Inc. Signature Title Date / S /    L ARRY P AGE Chief Executive Officer, Co-Founder and Director (Principal Executive Officer) February 2, 2017 Larry Page / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 2, 2017 Ruth M. Porat / S /    J AMES G. C AMPBELL Vice President, Corporate Controller, and Chief Accounting Officer (Principal Accounting Officer) February 2, 2017 James G. Campbell / S /    E RIC E. S CHMIDT Executive Chairman of the Board of Directors February 2, 2017 Eric E. Schmidt / S /    S ERGEY B RIN President, Co-Founder, and Director February 2, 2017 Sergey Brin / S /    L. J OHN D OERR Director February 2, 2017 L. John Doerr / S /    R OGER W. F ERGUSON, JR. Director February 2, 2017 Roger W. Ferguson, Jr. / S /    D IANE B. G REENE Director February 2, 2017 Diane B. Greene / S /    J OHN L. H ENNESSY Director February 2, 2017 John L. Hennessy / S /   A NN M ATHER Director February 2, 2017 Ann Mather / S /    A LAN R . M ULALLY Director February 2, 2017 Alan R. Mulally / S /    P AUL S. O TELLINI Director February 2, 2017 Paul S. Otellini / S /    K. R AM S HRIRAM Director February 2, 2017 K. Ram Shriram / S /    S HIRLEY M. T ILGHMAN Director February 2, 2017 Shirley M. Tilghman Table of Contents Alphabet Inc. EXHIBIT INDEX Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.07 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.09 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.10 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.11 Form of the Registrant’s 3.625% Notes due 2021 (included in Exhibit 4.10) 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.10) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 10.01 Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Letter Agreement, dated June 22, 2016, between Roger W. Ferguson, Jr. and the Registrant Current Report on Form 8-K (File No. 001-37580) June 29, 2016 10.03 u Offer Letter, dated March 20, 2015, between Ruth Porat and Google Inc., as assumed by the Registrant on October 2, 2015 Current Report on Form 8-K (File No. 001-36380) March 26, 2015 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.04 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.06 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.07 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.07.1 u Google Inc. 2004 Stock Plan - Form of Google Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.07.2 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.07.3 u Google Inc. 2004 Stock Plan - Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.08 u Alphabet Inc. 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 10, 2016 10.08.1 u Amendment to the Alphabet Inc. 2012 Stock Plan Quarterly Report on Form 10-Q (File No. 001-37580) November 3, 2016 10.08.2 u Alphabet Inc. 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Quarterly Report on Form 10-Q (File No. 001-37580) November 3, 2016 10.09 u Motorola Mobility Holdings, Inc. 2011 Incentive Compensation Plan Registration Statement on Form S-8 (File No. 333-181661) May 24, 2012 10.10 u AdMob, Inc. 2006 Stock Plan and UK Sub-Plan of the AdMob, Inc. 2006 Stock Plan Registration Statement on Form S-8 filed (File No. 333-167411) June 9, 2010 10.11 u Apigee Corporation 2015 Equity Incentive Plan Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 10.11.1 u Apigee Corporation 2015 Equity Incentive Plan - Form of Restricted Stock Unit Agreement Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 10.12 u Apigee Corporation 2005 Stock Incentive Plan Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 10.12.1 u Apigee Corporation 2005 Stock Incentive Plan - Form of Restricted Stock Unit Grant Notice and Restricted Stock Unit Agreement Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 12 * Computation of Earnings to Fixed Charge Ratios 14.01 Code of Conduct of the Registrant effective as of October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101.INS XBRL Instance Document 101.SCH XBRL Taxonomy Extension Schema Document 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF XBRL Taxonomy Extension Definition Linkbase Document 101.LAB XBRL Taxonomy Extension Label Linkbase Document 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-18-000007/full-submission.txt b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-18-000007/full-submission.txt new file mode 100644 index 0000000..aa15303 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-18-000007/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________________________ FORM 10-K ___________________________________________ (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2017 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View, CA 94043 (Address of principal executive offices) (Zip Code) (650) 253-0000 (Registrant’s telephone number, including area code) ___________________________________________ Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Class A Common Stock, $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ý No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ¨ No ý Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ý No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer (Do not check if a smaller reporting company) ¨ Smaller reporting company ¨ Emerging growth company ¨ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨ No ý As of June 30, 2017 , the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 30, 2017 ) was approximately $554.3 billion . For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 31, 2018 , there were 298,492,525 shares of the registrant’s Class A common stock outstanding, 46,961,288 shares of the registrant’s Class B common stock outstanding, and 349,843,717 shares of the registrant’s Class C capital stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2018 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2017 . Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2017 TABLE OF CONTENTS Page Note About Forward-Looking Statements 1 PART I Item 1. Business 3 Item 1A. Risk Factors 7 Item 1B. Unresolved Staff Comments 20 Item 2. Properties 20 Item 3. Legal Proceedings 20 Item 4. Mine Safety Disclosures 20 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 21 Item 6. Selected Financial Data 25 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 26 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 43 Item 8. Financial Statements and Supplementary Data 45 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 84 Item 9A. Controls and Procedures 84 Item 9B. Other Information 85 PART III Item 10. Directors, Executive Officers and Corporate Governance 86 Item 11. Executive Compensation 86 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 86 Item 13. Certain Relationships and Related Transactions, and Director Independence 86 Item 14. Principal Accountant Fees and Services 86 PART IV Item 15. Exhibits, Financial Statement Schedules 87 Item 16. Form 10-K Summary 90 i Table of Contents Alphabet Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding: • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • our plans to continue to invest in new businesses, products, services and technologies, systems, facilities, and infrastructure, to continue to hire aggressively and provide competitive compensation programs, as well as to continue to invest in acquisitions; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality, and macroeconomic conditions, which are likely to cause fluctuations in our quarterly results; • our expectation related to our renewable energy efforts; • the potential for declines in our revenue growth rate; • our expectation that we will continue to take steps to improve the relevance of the ads we deliver and to reduce the number of accidental clicks; • fluctuations in the rate of change in revenue and revenue growth, as well as the rate of change in paid clicks and average cost-per-click and various factors contributing to such fluctuations; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of costs related to hedging activities under our foreign exchange risk management program; • our expectation that our cost of revenues, research and development expenses, sales and marketing expenses, and general and administrative expenses will increase in dollars and may increase as a percentage of revenues; • our potential exposure in connection with pending investigations, proceedings, and other contingencies; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins in the future; • our expectation that our traffic acquisition costs (TAC) and the associated TAC rates will increase in the future; • our expectation that our results will be impacted by our performance in international markets as users in developing economies increasingly come online; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase and may impact margins; • our expectation that our other income (expense), net, will fluctuate in the future, as it is largely driven by market dynamics; • estimates of our future compensation expenses; • fluctuations in our effective tax rate; • the impact of the U.S. Tax Cuts and Jobs Act (Tax Act); • the sufficiency of our sources of funding; • our payment terms to certain advertisers, which may increase our working capital requirements; • fluctuations in our capital expenditures; • our expectations related to the operating structure implemented pursuant to the Alphabet holding company reorganization; • the expected timing and amount of Alphabet Inc.'s share repurchases; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report and other documents we file with the Securities and Exchange Commission (SEC), including without limitation, the following sections: Item 1 "Business," Item 1A "Risk Factors," and Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "may," "could," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed under the caption "Risk Factors" in Item 1A of this report and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. 1 Table of Contents Alphabet Inc. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. 2 Table of Contents Alphabet Inc. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history -- inspiring us to do things like rethink the mobile device ecosystem with Android and map the world with Google Maps. As part of that, our founders also explained that you could expect us to make "smaller bets in areas that might seem very speculative or even strange when compared to our current businesses." From the start, the company has always strived to do more, and to do important and meaningful things with the resources we have. Alphabet is a collection of businesses -- the largest of which, of course, is Google. It also includes businesses that are generally pretty far afield of our main Internet products such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. We report all non-Google businesses collectively as Other Bets. Our Alphabet structure is about helping each of our businesses prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers, capable of propelling new ideas and people forward. At Google, our mission is to make sure that information serves everyone, not just a few. So whether you're a child in a rural village or a professor at an elite university, you can access the same information. We are helping people get online by tailoring digital experiences to the needs of emerging markets. We're also making sure our core Google products are fast and useful, especially for users in areas where speed and connectivity are central concerns. Other Alphabet companies are also pursuing initiatives with similar goals. For instance, in October 2017, Project Loon within X deployed its network of stratospheric balloons to deliver basic internet connectivity to more than 100,000 people in Puerto Rico following Hurricane Maria. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and continue to invest for the long-term. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. The power of machine learning Across the company, machine learning and artificial intelligence (AI) are increasingly driving many of our latest innovations. Within Google, our investments in machine learning over a decade have enabled us to build products that are smarter and more useful -- it's what allows you to use your voice to ask the Google Assistant for information, to translate the web from one language to another, to see better YouTube recommendations, and to search for people and events in Google Photos. Machine learning is also showing great promise in helping us tackle big issues, like dramatically improving the energy efficiency of our data centers. Across Other Bets, machine learning helps self-driving cars better detect and respond to others on the road, and can also improve the ability of clinicians to detect diseases such as diabetic retinopathy. Google Serving our users We have always been a company committed to making big bets that have the potential to improve the lives of millions of people. Our product innovations have made our services widely used, and our brand one of the most recognized in the world. Google's core products and platforms such as Android, Chrome, Gmail, Google Maps, Google Play, Search, and YouTube each have over one billion monthly active users. But most important, we believe we are just beginning to scratch the surface. Our vision is to remain a place of incredible creativity and innovation that uses our technical expertise to tackle big problems. As the majority of Alphabet’s big bets continue to reside within Google, an important benefit of the shift to Alphabet has been the tremendous focus that we’re able to have on Google’s many extraordinary opportunities. 3 Table of Contents Alphabet Inc. Google’s mission to organize the world’s information and make it universally accessible and useful has always been our North Star, and our products have come a long way since the company was founded nearly two decades ago. Instead of just showing ten blue links in our search results, we are increasingly able to provide direct answers -- even if you're speaking your question using Voice Search -- which makes it quicker, easier and more natural to find what you're looking for. You can also type or talk with the Google Assistant in a conversational way across multiple devices like phones, speakers, headphones, televisions and more. And with Google Lens, you can now use your phone’s camera to identify an unfamiliar landmark or find a trailer from a movie poster. Over time, we have also added other services that let you access information quickly and easily -- like Google Maps, which helps you navigate to a store while showing you current traffic conditions, or Google Photos, which helps you store and organize your photos. This drive to make information more accessible has led us over the years to improve the discovery and creation of digital content, on the web and through platforms like Google Play and YouTube. And with the migration to mobile, people are consuming more digital content by watching more videos, playing more games, listening to more music, reading more books, and using more apps than ever before. Working with content creators and partners, we continue to build new ways for people around the world to find great digital content. Fueling all of these great digital experiences are powerful platforms and hardware. That’s why we continue to invest in platforms like our Android mobile operating system, Chrome browser, Chrome operating system, and Daydream virtual reality platform, as well as growing our family of great hardware devices. We see tremendous potential for devices to be helpful, make your life easier, and even get better over time, by combining the best of Google's AI, software, and hardware. This is reflected in our latest generation of hardware products like the newest additions to the Google Home family called Mini and Max, Pixel 2 phone, and Pixelbook laptop. Creating beautiful products that people rely on every day is a journey that we are investing in for the long run. Google was a company built in the cloud and has been investing in infrastructure, security, data management, analytics, and AI from the very beginning. We have continued to enhance these strengths with features like data migration, modern development environments and machine learning tools to provide enterprise-ready cloud services, including Google Cloud Platform and G Suite, to our customers. Google Cloud Platform enables developers to build, test, and deploy applications on Google’s highly scalable and reliable infrastructure. Our G Suite productivity tools -- which include apps like Gmail, Docs, Drive, Calendar, Hangouts, and more -- are designed with real-time collaboration and machine intelligence to help people work smarter. Because more and more of today’s great digital experiences are being built in the cloud, our Google Cloud products help businesses of all sizes take advantage of the latest technology advances to operate more efficiently. How we make money The goal of our advertising business is to deliver relevant ads at just the right time and to give people useful commercial information, regardless of the device they’re using. We also provide advertisers with tools that help them better attribute and measure their advertising campaigns across screens. Our advertising solutions help millions of companies grow their businesses, and we offer a wide range of products across screens and formats. We generate revenues primarily by delivering both performance advertising and brand advertising. • Perf ormance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Most of our performance advertisers pay us when a user engages in their ads. Performance advertising lets our advertisers connect with users while driving measurable results. For performance advertisers, AdWords, our primary auction-based advertising program, helps create simple text-based ads that appear on Google properties and the properties of Google Network Members. In addition, Google Network Members use our AdSense program to display relevant ads on their properties, generating revenues when site visitors view or click on the ads. We continue to invest in our advertising programs and make significant upgrades. • Brand advertising helps enhance users' awareness of and affinity with advertisers' products and services, through v ideos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. We have built a world-class ad technology platform for brand advertisers, agencies, and publishers to power their digital marketing businesses. We aim to ensure great user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. We also seek to improve the measurability of brand advertising so advertisers know when their campaigns are effective. 4 Table of Contents Alphabet Inc. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, ranging from filtering out invalid traffic, removing hundreds of millions of bad ads from our systems every year to closely monitoring the sites, apps, and videos where ads appear and blacklisting them when necessary to ensure that ads do not fund bad content. Beyond our advertising business, we also generate revenues in other areas, such as digital content, enterprise cloud services, and hardware. Other Bets Throughout Alphabet, we are also using technology to try and solve big problems across many industries. Alphabet’s Other Bets are early-stage businesses, and our goal is for them to become thriving, successful businesses in the medium to long term. To do this, we make sure we have a strong CEO to run each company while also rigorously handling capital allocation and working to make sure each business is executing well. While these early-stage businesses naturally come with considerable uncertainty, some of them are already generating revenue and making important strides in their industries. For instance, Nest recently expanded its connected home product line by introducing the Nest Thermostat E and a new home security solution that includes the Nest Hello video doorbell, Nest Cam IQ outdoor security camera, and the Nest Secure alarm system. Our self-driving car company, Waymo, continues to progress the development and testing of its technology and now has a fleet of vehicles in Phoenix, Arizona, driving without a person behind the wheel. Life sciences company Verily has also made significant progress on key programs, like the launch of its Project Baseline study with Duke University and Stanford Medicine, and received an $800 million investment in 2017 from Temasek to accelerate its strategic programs. We continue to build these businesses thoughtfully and systematically to capitalize on the opportunities ahead. We are investing for the long term while being very deliberate about the focus, scale and pace of investments. We generate revenues from internet and TV services, licensing and R&D services, and Nest branded hardware. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from: • General purpose search engines and information services, such as Baidu, Microsoft's Bing, Naver, Seznam, Verizon's Yahoo, and Yandex. • Vertical search engines and e-commerce websites, such as Amazon and eBay (e-commerce), Kayak (travel queries), LinkedIn (job queries), and WebMD (health queries). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks, such as Facebook, Snap, and Twitter. Some users increasingly rely on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other forms of advertising, such as billboards, magazines, newspapers, radio, and television. Our advertisers typically advertise in multiple media, both online and offline. • Other online advertising platforms and networks, including Amazon, AppNexus, Criteo, and Facebook, that compete for advertisers that use AdWords, our primary auction-based advertising platform. • Providers of digital video services, such as Amazon, Facebook, Hulu, and Netflix. • Companies that design, manufacture, and market consumer electronics products, including businesses that have developed proprietary platforms. • Providers of enterprise cloud services, including Alibaba, Amazon, and Microsoft. • Digital assistant providers, such as Amazon, Apple, and Microsoft. Competing successfully in our advertising-related businesses depends heavily on our ability to deliver and distribute innovative products and technologies to the marketplace so that we can attract and retain: • Users, for whom other products and services are literally one click away, primarily on the basis of the relevance and usefulness of our search results and the features, availability, and ease of use of our products and services. • Advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels. 5 Table of Contents Alphabet Inc. • Content providers, primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. Culture and Employees We take great pride in our culture. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex technical challenges. Transparency and open dialogue are central to how we work, and we like to ensure that company news reaches our employees first through internal channels. Despite our rapid growth, we still cherish our roots as a startup and wherever possible empower employees to act on great ideas regardless of their role or function within the company. We strive to hire great employees, with backgrounds and perspectives as diverse as those of our global users. We work to provide an environment where these talented people can have fulfilling careers addressing some of the biggest challenges in technology and society. Our employees are among our best assets and are critical for our continued success. We expect to continue investing in hiring talented employees and to provide competitive compensation programs to our employees. As of December 31, 2017 , we had 80,110 full-time employees. Although we have work councils and statutory employee representation obligations in certain countries, our U.S. employees are not represented by a labor union. Competition for qualified personnel in our industry is intense, particularly for software engineers, computer scientists, and other technical staff. Seasonality Our business is affected by seasonal fluctuations in Internet usage, advertising expenditures, and underlying business trends such as traditional retail seasonality. Other Items Climate change is one of the most significant global challenges of our time, and we’ve long been committed to improving our energy consumption. In 2012, we set a goal to reach 100% renewable energy for our operations. While we are still performing final analysis for the year, in 2017, we purchased a total wind and solar capacity of about three gigawatts, which we expect will be enough renewables to match the energy consumption of our global operations. We continue to invest in our existing products and services as well as developing new products and services through research and product development. We often release early-stage products. We then use data and user feedback to decide if and how to invest further in those products. Research and development expenses include the vast majority of engineering and technical headcount responsible for research and development of our existing and new products and services, as well as their associated costs. For more information, please refer to the Consolidated Statements of Income included in Part II of this Annual Report on Form 10-K. For information about segments and geographic areas, please refer to Note 15 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. As part of the Alphabet reorganization, we converted Google Inc. into a limited liability company in September 2017. Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and our Proxy Statements are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. You may read and copy any materials we file with the SEC at the SEC's Public Reference Room at 100 F Street, NE, Washington, D.C. 20549. You can get information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance, including SEC filings, investor events, press and earnings releases, and blogs. Further corporate governance information, including our certificate of incorporation, bylaws, 6 Table of Contents Alphabet Inc. governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The content of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common and capital stock. Risks Related to Our Businesses and Industries We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could be adversely affected. Our businesses are rapidly evolving, intensely competitive, and subject to changing technologies, shifting user needs, and frequent introductions of new products and services. Competing successfully depends heavily on our ability to accurately anticipate technology developments and deliver innovative, relevant and useful products, services, and technologies to the marketplace in a timely manner. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services, including products and services that may be outside of our historical core business. As a result, we must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our technology and our existing products and services, and introduce new products and services that people can easily and effectively use. We have many competitors in different industries. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some companies have longer operating histories and more established relationships with customers and users. They can use their experiences and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in research and development and in hiring talent, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for users, advertisers, and content providers. Emerging start-ups may be able to innovate and provide products and services faster than we can or may foresee the consumer need for products and services before us. In addition, new products and services can sometimes present new and difficult technological and legal challenges, which may negatively impact our brands and demand for our products and services and adversely impact our revenues and operating results. Our operating results would also suffer if our innovations are not responsive to the needs of our users, advertisers, and content providers; are not appropriately timed with market opportunities; or are not effectively brought to market. As technologies continue to develop, our competitors may be able to offer user experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, and content providers, our revenues and operating results could be adversely affected. We generate substantially all of our revenues from advertising, and reduced spending by advertisers or a loss of partners could harm our advertising business. We generated over 86% of total revenues from advertising in 2017. Many of our advertisers, companies that distribute our products and services, digital publishers, and content partners can terminate their contracts with us at any time. Those partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. If we do not provide superior value or deliver advertisements efficiently and competitively, we could see a decrease in revenue and other adverse impacts to our business. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions can also have a material negative impact on user activity and the demand for advertising and cause our advertisers to reduce the amounts they spend on advertising, which could adversely affect our revenues and advertising business. 7 Table of Contents Alphabet Inc. Our ongoing investment in new businesses and new products, services, and technologies is inherently risky, and could disrupt our current operations. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The creation of Alphabet as a holding company in 2015 and the investments that we are making across various areas in Google and Other Bets are a reflection of our ongoing efforts to innovate and provide products and services that are useful to users. Such endeavors may involve significant risks and uncertainties, including insufficient revenues from such investments to offset any new liabilities assumed and expenses associated with these new investments, inadequate return of capital on our investments, distraction of management from current operations, use of alternative investment or compensation structures, and unidentified issues not discovered in our due diligence of such strategies and offerings that could cause us to fail to realize the anticipated benefits of such investments and incur unanticipated liabilities. Because these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not adversely affect our reputation, financial condition, and operating results. The Internet is accessed through a variety of platforms and form factors that continue to evolve with the advancement of technology and user preferences. If manufacturers and users do not widely adopt versions of our search technology, products, or operating systems developed for these devices and modalities, our business could be adversely affected. The number of people who access the Internet through devices other than desktop computers, including mobile phones, smartphones, laptops and tablets, video game consoles, voice-assisted speakers, automobiles, and television set-top devices, is increasing dramatically. The functionality and user experience associated with some alternative devices and modalities may make the use of our products and services or the generation of advertising revenue through such devices more difficult (or just different), and the versions of our products and services developed for these devices may not be compatible or compelling to users, manufacturers, or distributors of alternative devices. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not work or be viewable on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via apps tailored to particular devices or social media platforms, which could affect our search and advertising business over time. As new devices and platforms are continually being released, it is difficult to predict the problems we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to the creation, support, and maintenance of products and services across multiple platforms and devices. If we are unable to attract and retain a substantial number of alternative device manufacturers, suppliers, distributors, developers, and users to our products and services, or if we are slow to develop products and technologies that are more compatible with alternative devices and platforms, we will fail to capture the opportunities available as consumers and advertisers continue to exist in a dynamic, multi-platform environment. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including: • increasing competition, • changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix, • the challenges in maintaining our growth rate as our revenues increase to higher levels, • the evolution of the online advertising market, including the increasing variety of online platforms for advertising, and the other markets in which we participate, and • the rate of user adoption of our products, services, and technologies. We believe our margins could experience downward pressure as a result of increasing competition and increased costs for many aspects of our business as well as the continuing shift to mobile, changes in device mix, and the contribution of new businesses to overall revenue. For instance, the margin on revenues we generate from our Google Network Members is significantly less than the margin on revenues we generate from advertising on Google properties. Consequently, our margins will experience downward pressure if a greater percentage of our revenues comes from ads placed on our Google Network Members' properties compared to revenues generated through ads placed on Google properties. Additionally, the margin we earn on revenues generated from our Google Network Members could decrease in the future if we pay an even larger percentage of advertising fees to our Google Network Members. Furthermore, in our multi-device world, we generate our advertising revenues increasingly from mobile and newer advertising formats, and the margins from the advertising revenues from these sources have generally been lower than those from traditional desktop search. We also expect our TAC paid to our distribution partners to increase due to changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms, and the percentage of queries channeled through paid access points. 8 Table of Contents Alphabet Inc. Additionally, our margins could experience downward pressure as revenues from the sale of hardware products and cloud-based services increase as a percentage of consolidated revenues because the margin on the sale of these products and services have generally been lower than that from Google search. Furthermore, our margins could be impacted adversely if we spend a proportionately larger amount to promote new products and services or distribute certain products or if we invest more heavily in our innovation efforts across the Company (such as our Other Bets businesses) than we have historically. We are subject to increasing regulatory scrutiny that may negatively impact our business. Additionally, changes in public policies governing a wide range of topics may adversely affect our business. The growth of our company and our expansion into a variety of new fields involves a variety of new regulatory issues, and we have experienced increased regulatory scrutiny as we have grown. For instance, various regulatory agencies are reviewing aspects of our search and other businesses, which can lead to increased scrutiny from other regulators and legislators, that may affect our reputation, brand and third-party relationships. Such reviews may also result in substantial regulatory fines, changes to our business practices and other penalties, which could negatively impact our business and results of operations. We continue to cooperate with the European Commission and other regulatory authorities around the world in investigations they are conducting with respect to our business. Additionally, changes in social, political, and regulatory conditions or in laws and policies governing a wide range of topics may disrupt our business practices. These changes could negatively impact our business and results of operations in material ways. A variety of new and existing laws could subject us to claims or otherwise harm our business. We are subject to numerous U.S. and international laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations of existing laws and regulations) may make our products and services less useful, require us to incur substantial costs, expose us to unanticipated civil or criminal liability, or cause us to change our business practices. For example, current and new patent laws such as U.S. patent laws and European patent laws may affect the ability of companies, including us, to protect their innovations and defend against claims of patent infringement. Similarly, changes to copyright laws being considered in Europe and elsewhere may increase costs or require companies, including us, to change or cease offering certain existing services. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Claims have been, or may be, threatened and filed against us under both U.S. and international laws for defamation, invasion of privacy and other tort claims, unlawful activity, patent, copyright and trademark infringement, product liability, or other theories based on the nature and content of the materials searched and the ads posted by our users, our products and services, or content generated by our users. Furthermore, many of these laws do not contemplate or address the unique issues raised by a number of our new businesses, products, services and technologies. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain. Other laws that could subject us to claims or otherwise harm our business include, among others: • We rely on statutory safe harbors, as set forth in the Digital Millennium Copyright Act in the United States and the E-Commerce Directive in Europe, against copyright liability for various linking, caching, and hosting activities. Any legislation or court rulings impacting these safe harbors may adversely impact us. • The General Data Protection Regulation, coming into effect in the European Union in May of 2018, which creates a range of new compliance obligations, which could cause us to change our business practices, and will increase financial penalties for noncompliance significantly. • Court decisions such as the judgment of the Court of Justice of the European Union on May 13, 2014 on the ‘right to be forgotten,’ which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users and impose significant operational burdens. • Court decisions that require Google to suppress content not just in the jurisdiction of the issuing court, but for all of our users worldwide, including locations where the content at issue is lawful. The Supreme Court of Canada issued such a decision against Google in June 2017, and others could treat its decision as persuasive. For instance, with respect to the ‘right to be forgotten,’ a follow-up case is pending before the Court of Justice of the European Union, which could result in an order to apply delisting actions under the ‘right to be forgotten’ worldwide. • Various U.S. and international laws that restrict the distribution of materials considered harmful to children and impose additional restrictions on the ability of online services to collect information from minors. 9 Table of Contents Alphabet Inc. • Various laws with regards to content removal and disclosure obligations, such as the recently enacted Network Enforcement Act in Germany, which may impact our businesses and operations and may subject us to significant fines if such laws are interpreted and applied in a manner inconsistent with our practices. • Data protection laws passed by many states within the U.S. and by certain countries that require notification to users when there is a security breach of personal data. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. • Privacy laws, which could b e interpreted over-broadly to limit some product offerings and increase costs. We face risks and costs overseas as our products and services are offered in international markets and may be subject to additional regulations. Any failure on our part to comply with these laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are regularly subject to claims, suits, government investigations, and other proceedings that may result in adverse outcomes. We are regularly subject to claims, suits, and government investigations involving competition, intellectual property, privacy, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. The manufacturing and sale of an expanded suite of products, including hardware, further exposes us to the risk of product liability and other litigation as well as consumer protection concerns related to product defects, as well as health and safety, hazardous materials usage, and other environmental concerns. We may also be subject to claims, including product warranty claims, if users experience service disruptions, failures, or other issues. In addition, our businesses face intellectual property litigation, as discussed later, that exposes us to the risk of exclusion and cease and desist orders, which could limit our ability to sell products and services. Such claims, suits, and government investigations are inherently uncertain. Regardless of the outcome, any of these types of legal proceedings can have an adverse impact on us because of legal costs, diversion of management resources, and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. It is possible that a resolution of one or more such proceedings could result in substantial fines and penalties that could adversely affect our business, consolidated financial position, results of operations, or cash flows in a particular period. These proceedings could also result in reputational harm, criminal sanctions, consent decrees, or orders preventing us from offering certain features, functionalities, products, or services, requiring a change in our business practices or product recalls or corrections, or requiring development of non-infringing or otherwise altered products or technologies. Any of these consequences could adversely affect our business and results of operations. We may be subject to legal liability associated with providing online services or content. We host and provide a wide variety of services and products that enable users to exchange information, advertise products and services, conduct business, and engage in various online activities both domestically and internationally. The law relating to the liability of providers of these online services and products for activities of their users is still somewhat unsettled both within the U.S. and internationally. Claims have been threatened and have been brought against us for defamation, negligence, breaches of contract, copyright or trademark infringement, unfair competition, unlawful activity, tort, including personal injury, fraud, or other theories based on the nature and content of information that we publish or to which we provide links or that may be posted online or generated by us or by third parties, including our users. In addition, we are and have been and may again in the future be subject to domestic or international actions alleging that certain content we have generated or third-party content that we have made available within our services violates U.S. and international law. We also place advertisements which are displayed on third-party publishers and advertising networks properties, and we offer third-party products, services, or content. We may be subject to claims concerning these products, services, or content by virtue of our involvement in marketing, branding, broadcasting, or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services, or content. Defense of any such actions could be costly and involve significant time and attention of our management and other resources, which may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Privacy concerns relating to our technology could damage our reputation and deter current and potential users or customers from using our products and services. If our security measures are breached resulting in the improper use and disclosure of user data, or if our services are subject to attacks that degrade or deny the ability of users to access our products and services, our products and services may be perceived as not 10 Table of Contents Alphabet Inc. being secure, users and customers may curtail or stop using our products and services, and we may incur significant legal and financial exposure. From time to time, concerns have been expressed about whether our products, services, or processes compromise the privacy of users, customers, and others. Concerns about our practices with regard to the collection, use, disclosure, or security of personal information or other privacy related matters, even if unfounded, could damage our reputation and adversely affect our operating results. Our products and services involve the storage and transmission of users’ and customers’ proprietary information, and theft and security breaches expose us to a risk of loss of this information, improper use and disclosure of such information, litigation, and potential liability. Any systems failure or compromise of our security that results in the release of our users’ data, or in our or our users’ ability to access such data, could seriously harm our reputation and brand and, therefore, our business, and impair our ability to attract and retain users. We expect to continue to expend significant resources to maintain state-of-the-art security protections that shield against theft and security breaches. We experience cyber attacks of varying degrees on a regular basis. Our security measures may also be breached due to employee error, malfeasance, system errors or vulnerabilities, including vulnerabilities of our vendors, suppliers, their products, or otherwise. Such breach or unauthorized access, increased government surveillance, or attempts by outside parties to fraudulently induce employees, users, or customers to disclose sensitive information in order to gain access to our data or our users’ or customers’ data could result in significant legal and financial exposure, damage to our reputation, and a loss of confidence in the security of our products and services that could potentially have an adverse effect on our business. Because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently, become more sophisticated, and often are not recognized until launched against a target, we may be unable to anticipate these techniques or to implement adequate preventative measures. Additionally, cyber attacks could also compromise trade secrets and other sensitive information and result in such information being disclosed to others and becoming less valuable, which could negatively affect our business. If an actual or perceived breach of our security occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose users and customers. Our business is subject to complex and evolving U.S. and international laws and regulation regarding privacy and data protection. Many of these laws and regulations are subject to change and uncertain interpretation and could result in claims, changes to our business practices, penalties, increased cost of operations, or declines in user growth or engagement, or otherwise harm our business. Regulatory authorities around the world are considering a number of legislative and regulatory proposals concerning data protection, including measures to ensure that encryption of users’ data does not hinder law enforcement agencies’ access to that data. In addition, the interpretation and application of consumer and data protection laws in the U.S., Europe and elsewhere are often uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. These legislative and regulatory proposals, if adopted, and such interpretations could, in addition to the possibility of fines, result in an order requiring that we change our data practices, which could have an adverse effect on our business and results of operations. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business. Recent legal developments in Europe have created compliance uncertainty regarding certain transfers of personal data from Europe to the United States. For example, the General Data Protection Regulation (GDPR), coming into application in the European Union (EU) on May 25, 2018, will apply to all of our activities conducted from an establishment in the EU or related to products and services that we offer to EU users. The GDPR will create a range of new compliance obligations, which could cause us to change our business practices, and will significantly increase financial penalties for noncompliance (including possible fines of up to 4% of global annual turnover for the preceding financial year or €20 million (whichever is higher) for the most serious infringements). In addition, the European Commission in July 2016 and the Swiss Government in January 2017 approved the EU-U.S. and the Swiss-U.S. Privacy Shield frameworks, respectively, which are designed to allow U.S. companies that self-certify to the U.S. Department of Commerce and publicly commit to comply with the Privacy Shield requirements to freely import personal data from the EU and Switzerland. However, these frameworks face a number of legal challenges and their validity remains subject to legal, regulatory and political developments in both Europe and the U.S. This has resulted in some uncertainty, and compliance obligations could cause us to incur costs or require us to change our business practices in a manner adverse to our business. 11 Table of Contents Alphabet Inc. We are, and may in the future be, subject to intellectual property or other claims, which are costly to defend, could result in significant damage awards, and could limit our ability to use certain technologies in the future. Internet, technology, media, and other companies own large numbers of patents, copyrights, trademarks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent holding companies may continue to seek to monetize patents they have purchased or otherwise obtained. As we have grown, the number of intellectual property claims against us has increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Third parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease and desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices and require development of non-infringing products, services or technologies, which could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to indemnify them for certain intellectual property infringement claims against them, which could increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers from covered products. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, including those associated with intellectual property claims. Regardless of their merits, intellectual property claims are often time consuming, expensive to litigate or settle, and cause significant diversion of management attention. To the extent such claims are successful, they may have an adverse effect on our business, consolidated financial position, results of operations, or cash flows. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brand. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy of such trade secrets and other sensitive information could be compromised by outside parties, or by our employees, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that may adversely impact our business and results of operations. Acquisitions, joint ventures, investments and divestitures are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and results of operations. We 12 Table of Contents Alphabet Inc. expect to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions. Effecting these strategic transactions could create unforeseen operating difficulties and expenditures. The areas where we face risks include, among others: • Diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions. • Failure to successfully further develop the acquired business or technology. • Implementation or remediation of controls, procedures, and policies at the acquired company. • Integration of the acquired company's accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions. • Transition of operations, users, and customers onto our existing platforms. • Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of an acquisition or other strategic transaction. • In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. • Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire. • Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, privacy issues, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities. • Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or results. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which may adversely impact our financial condition or results. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, content providers, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands within Google and Other Bets increases our ability to enter new categories and launch new and innovative products that better serve the needs of our users. Our brands may be negatively impacted by a number of factors, including, among others, reputational issues, third-party content shared on our platforms, data privacy issues and developments, and product or technical performance failures. For example, if we fail to appropriately respond to the sharing of objectionable content on our services or objectionable practices by advertisers, or to otherwise adequately address user concerns, our users may lose confidence in our brands. Our brands may also be negatively affected by the use of our products or services to disseminate information that is deemed to be misleading. Furthermore, if we fail to maintain and enhance equity in the Google brand, our business, operating results, and financial condition may be materially and adversely affected. Our success will depend largely on our ability to remain a technology leader and continue to provide high-quality, innovative products and services that are truly useful and play a meaningful role in people’s everyday lives. 13 Table of Contents Alphabet Inc. We face a number of manufacturing and supply chain risks that, if not properly managed, could adversely impact our financial results and prospects. We face a number of risks related to manufacturing and supply chain management. These manufacturing and supply chain risks could impact our ability to supply both our products and our internet-based services. We rely on third parties to manufacture many of our assemblies and finished products, third-party arrangements for the design of some components and parts, and third party distributors, including cellular network carriers. Our business could be negatively affected if we are not able to engage third parties with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We have in the past, and may experience in the future, supply shortages and price increases driven by raw material availability, manufacturing capacity, labor shortages, industry allocations, natural disasters and significant changes in the financial or business condition of our suppliers. We may experience shortages or other supply chain disruptions in the future that could negatively impact our operations. In addition, some of the components we use in our technical infrastructure and products are available only from a single source or limited sources, and we may not be able to find replacement vendors on favorable terms or at all in the event of a supply chain disruption. In addition, a significant hardware supply interruption could delay critical data center upgrades or expansions. We may enter into long term contracts that commit us to significant terms and conditions of supply. We may be liable for material and product that is not consumed due to market acceptance, technological change, obsolescences, quality, product recalls, and warranty issues. For instance, because many of our hardware supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and therefore less competitive and negatively impact our financial results. Furthermore, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may impact our supply. Additionally, the products and services we sell or offer may have quality issues resulting from the design or manufacture of the product, or from the software used. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products and services does not meet our customers’ expectations or our products or services are found to be defective, then our sales and operating earnings, and ultimately our reputation, could be negatively impacted. We also require our suppliers and business partners to comply with law and, where applicable, our company policies regarding workplace and employment practices, data security, environmental compliance and intellectual property licensing, but we do not control them or their practices. If any of them violates laws or implements practices regarded as unethical, we could experience supply chain disruptions, canceled orders, terminations of or damage to key relationships, and damage to our reputation. If any of them fails to procure necessary license rights to third-party intellectual property, legal action could ensue that could impact the saleability of our products and expose us to financial obligations to third parties. The Dodd-Frank Wall Street Reform and Consumer Protection Act includes disclosure requirements regarding the use of certain minerals mined from the Democratic Republic of Congo and adjoining countries (DRC) and procedures pertaining to a manufacturer's efforts regarding the source of such minerals. SEC rules implementing these requirements may have the effect of reducing the pool of suppliers who can supply DRC conflict free components and parts, and we may not be able to obtain DRC conflict free products or supplies in sufficient quantities for our operations. Since our supply chain is complex, we may face reputational challenges with our customers, stockholders and other stakeholders if we are unable to sufficiently verify the origins for the minerals used in our products. Web spam and content farms could decrease our search quality, which could damage our reputation and deter our current and potential users from using our products and services. Web spam refers to websites that attempt to violate a search engine's quality guidelines or that otherwise seek to rank higher in search results than a search engine's assessment of their relevance and utility would rank them. Although English-language web spam in our search results has been significantly reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek ways to improve their rankings inappropriately. We continuously combat web spam, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We face challenges from low-quality and irrelevant content websites, including content farms, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes focused on low-quality websites. If our search results display an increasing number of web spam and content farms, this could hurt our reputation for delivering 14 Table of Contents Alphabet Inc. relevant information or reduce user traffic to our websites. In addition, as we continue to take actions to improve our search quality and reduce low-quality content, this may in the short run reduce our Google Network Members' revenues, since some of these websites are Google Network Members. Interruption or failure of our information technology and communications systems could hurt our ability to effectively provide our products and services, which could damage our reputation and harm our operating results. The availability of our products and services depends on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage or interruption from earthquakes, terrorist attacks, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, computer denial of service attacks, or other attempts to harm our systems. Some of our data centers are located in areas with a high risk of major earthquakes or other natural disasters. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and to potential disruptions if the operators of certain of these facilities have financial difficulties. Some of our systems are not fully redundant, and our disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster, a decision to close a facility we are using, or other unanticipated problems at our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and may contain errors or vulnerabilities, which could result in interruptions in our services or the failure of our systems. Our international operations expose us to additional risks that could harm our business, operating results, and financial condition. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 53% of our consolidated revenues in 2017. In certain international markets, we have limited operating experience and may not succeed. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • Restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S. • Import and export requirements, tariffs, trade disputes and barriers, and customs classifications that may prevent us from offering products or providing services to a particular market and may increase our operating costs. • Longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud. • Evolving foreign laws and legal systems. • Uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent. • Different employee/employer relationships, existence of workers' councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Additionally, changes in international local political, economic, regulatory, tax, social, and labor conditions may adversely harm our business, and compliance with complex international and U.S. laws and regulations that apply to our international operations increases our cost of doing business. These numerous and sometimes conflicting laws and regulations include, among others, internal control and disclosure rules, privacy and data protection requirements, anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting corrupt payments to governmental officials, and competition regulations, among others. Violations of these laws and regulations could result in fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business and on our ability to offer our products and services in one or more countries, and could also materially affect our brand, our international growth efforts, our ability to attract and retain employees, our business, and our operating results. Although we have implemented policies and procedures designed to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors, or agents will not violate our policies. Finally, since we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we face exposure to fluctuations in foreign currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Additionally, hedging programs are inherently risky and could expose us to additional risks that could adversely affect our financial condition and results of operations. 15 Table of Contents Alphabet Inc. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results may fluctuate as a result of a number of factors, many outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our quarterly, year-to-date, and annual expenses as a percentage of our revenues may differ significantly from our historical or projected rates. Our operating results in future quarters may fall below expectations. Any of these events could cause our stock price to fall. Each of the risk factors listed in this section in addition to the following factors may affect our operating results: • Our ability to continue to attract and retain users to our products and services. • Our ability to monetize (or generate revenues from) traffic on Google properties and our Google Network Members' properties across various devices. • Revenue fluctuations caused by changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix. • The amount of revenues and expenses generated and incurred in currencies other than U.S. dollars, and our ability to manage the resulting risk through our foreign exchange risk management program. • The amount and timing of operating costs and expenses and capital expenditures related to the maintenance and expansion of our businesses, operations, and infrastructure. • Our focus on long-term goals over short-term results. • The results of our acquisitions, divestitures, and our investments in risky projects, including new businesses, products, services, and technologies. • Our ability to keep our products and services operational at a reasonable cost and without service interruptions. • Our ability to attract user adoption of and generate significant revenues from new products, services, and technologies in which we have invested considerable time and resources. • The seasonal fluctuations in Internet usage, advertising spending, and underlying business trends such as traditional retail seasonality. Our rapid growth has tended to mask the cyclicality and seasonality of our business. As our growth rate has slowed, the cyclicality and seasonality in our business has become more pronounced and caused our operating results to fluctuate. Because our businesses are changing and evolving, our historical operating results may not be useful to you in predicting our future operating results. If we were to lose the services of key personnel, we may not be able to execute our business strategy. Our future success depends in a large part upon the continued service of key members of our senior management team. In particular, Larry Page and Sergey Brin are critical to the overall management of Alphabet and its subsidiaries, and they, along with Sundar Pichai, the Chief Executive Officer of Google, play an important role in the development of our technology. They also play a key role in maintaining our culture and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows, and we are required to implement more complex organizational management structures, particularly in light of our holding company structure, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively impact our future success. 16 Table of Contents Alphabet Inc. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures, including legal actions, that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, or by charging increased fees to us or our users to provide our offerings. Some jurisdictions have adopted regulations prohibiting certain forms of discrimination by Internet access providers, but there is substantial uncertainty in the United States and elsewhere regarding such protections. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. Such interference could result in a loss of existing users, advertisers, and goodwill, and increased costs, and could impair our ability to attract new users and advertisers, thereby harming our revenues and growth. New and existing technologies could block ads online, which would harm our business. Technologies have been developed that enable users to block the display of ads altogether and some providers of online services have integrated technologies that could potentially impair the core functionality of third-party digital advertising. Most of our Google revenues are derived from fees paid to us in connection with the display of ads online. As a result, such technologies and tools could adversely affect our operating results. We are exposed to fluctuations in the market values of our investments. Given the global nature of our business, we have investments both domestically and internationally. Market values of these investments can be negatively impacted by liquidity, credit deterioration or losses, financial results, foreign exchange rates, changes in interest rates, or other factors. As a result, the value or liquidity of our cash equivalents and marketable securities could decline and result in a material impairment, which could materially adversely affect our financial condition and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. Our future income taxes could be adversely affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions on various tax-related assertions, including transfer pricing adjustments or permanent establishment. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations where the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made. Furthermore, due to shifting economic and political conditions, tax policies, laws or rates in various jurisdictions may be subject to significant change, which could materially affect our financial position and results of operations. The ongoing effects of the Tax Act and the refinement of provisional estimates could make our results difficult to predict. Our effective tax rate may fluctuate in the future as a result of the Tax Act, which was enacted on December 22, 2017. The Tax Act introduces significant changes to U.S. income tax law that will have a meaningful impact on our provision for income taxes. Accounting for the income tax effects of the Tax Act requires significant judgments and estimates in the interpretation and calculations of the provisions of the Tax Act. Due to the timing of the enactment and the complexity involved in applying the provisions of the Tax Act, we made reasonable estimates of the effects and recorded provisional amounts in our financial statements for the year ended December 31, 2017. The U.S. Treasury Department, the Internal Revenue Service (IRS), and other standard-setting bodies may issue guidance on how the provisions of the Tax Act will be applied or otherwise administered that is 17 Table of Contents Alphabet Inc. different from our interpretation. As we collect and prepare necessary data, and interpret the Tax Act and any additional guidance issued by the IRS or other standard-setting bodies, we may make adjustments to the provisional amounts that could materially affect our financial position and results of operations as well as our effective tax rate in the period in which the adjustments are made. Risks Related to Ownership of Our Stock The trading price for our Class A common stock and non-voting Class C capital stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. For example, from January 1, 2017 through December 31, 2017, the closing price of our Class A common stock ranged from $807.77 per share to $1,085.09 per share, and the closing price of our Class C capital stock ranged from $786.14 to $1,077.14 per share. In addition to the factors discussed in this Annual Report on Form 10-K, the trading price of our Class A common stock and Class C capital stock may fluctuate widely in response to various factors, many of which are beyond our control, including, among others: • Quarterly variations in our results of operations or those of our competitors. • Announcements by us or our competitors of acquisitions, divestitures, investments, new products, significant contracts, commercial relationships, or capital commitments. • Recommendations by securities analysts or changes in earnings estimates. • Announcements about our earnings that are not in line with analyst expectations, the risk of which is enhanced because it is our policy not to give guidance on earnings. • Announcements by our competitors of their earnings that are not in line with analyst expectations. • Commentary by industry and market professionals about our products, strategies, and other matters affecting our business and results, regardless of its accuracy. • The volume of shares of Class A common stock and Class C capital stock available for public sale. • Sales of Class A common stock and Class C capital stock by us or by our stockholders (including sales by our directors, executive officers, and other employees). • Short sales, hedging, and other derivative transactions on shares of our Class A common stock and Class C capital stock. • The perceived values of Class A common stock and Class C capital stock relative to one another. • Our share repurchase program. In addition, the stock market in general, which can be impacted by various factors, including overall economic and political conditions, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may harm the market price of our Class A common stock and our Class C capital stock regardless of our actual operating performance. We cannot guarantee that our share repurchase program will be fully consummated or that our share repurchase program will enhance long-term stockholder value, and share repurchases could increase the volatility of the price of our stock and could diminish our cash reserves. In October 2016, our board of directors authorized our company to repurchase up to $7,019,340,976.83 of our Class C capital stock. In January 2018, our board of directors authorized the repurchase of up to an additional$8,589,869,056 of our Class C capital stock. The repurchase program does not have an expiration date. The share repurchase program, authorized by our board of directors, does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. The share repurchase program could affect the price of our stock and increase volatility and may be suspended or terminated at any time, which may result in a decrease in the trading price of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B common stock has 10 votes per share, our Class A common stock has one vote per share, and our Class C capital stock has no voting rights. As of December 31, 2017, Larry, Sergey, and Eric E. Schmidt beneficially owned approximately 92.7% of our outstanding Class B common stock, which represented approximately 56.7% of 18 Table of Contents Alphabet Inc. the voting power of our outstanding capital stock. Larry, Sergey, and Eric therefore have significant influence over management and affairs and over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C capital stock carries no voting rights (except as required by applicable law), the issuance of the Class C capital stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could prolong the duration of Larry and Sergey’s current relative ownership of our voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. Together with Eric, they would also continue to be able to control any required stockholder vote with respect to certain change in control transactions involving Alphabet (including an acquisition of Alphabet by another company). This concentrated control limits or severely restricts our stockholders’ ability to influence corporate matters and, as a result, we may take actions that our stockholders do not view as beneficial. As a result, the market price of our Class A common stock and our Class C capital stock could be adversely affected. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry, Sergey, and Eric have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. As noted above, the issuance of the Class C capital stock could have the effect of prolonging the influence of Larry, Sergey, and Eric. • Our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death, or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors. • Our stockholders may not act by written consent. As a result, a holder, or holders, controlling a majority of our capital stock would not be able to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our board of directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to issue undesignated preferred stock makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us. Risks Related to Our Holding Company Reorganization As a holding company, Alphabet is dependent on the operations and funds of its subsidiaries. On October 2, 2015, we completed a reorganization pursuant to which Alphabet became a holding company with no business operations of its own. Alphabet’s only significant assets are the outstanding equity interests in its subsidiaries, including Google. As a result, we rely on cash flows from subsidiaries to meet our obligations, including to service any debt obligations of Alphabet. We may not obtain the anticipated benefits of our reorganization into a holding company structure. We believe that our holding company reorganization and the current operating structure increases management scale and allows us to focus on running our diverse businesses independently with the goal of maximizing each business’ potential. The benefits of this reorganization may not be obtained if circumstances prevent us from taking 19 Table of Contents Alphabet Inc. advantage of the strategic and business opportunities that we expect it may afford us. As a result, we may incur the costs of a holding company structure without realizing the benefits, which could adversely affect our reputation, financial condition, and operating results. Alphabet’s management is dedicating significant effort to the Other Bets' operating structures and business operations. These efforts may divert management’s focus and resources from Alphabet’s overall business, corporate initiatives, or strategic opportunities, which could have an adverse effect on our businesses, results of operations, financial condition, or prospects. Additionally, our subsidiaries may be restricted in their ability to pay cash dividends or to make other distributions to Alphabet, as the new holding company. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We also own and lease office and building space in the surrounding areas near our headquarters, which in the aggregate (including our headquarters) represent approximately 11.1 million square feet of office/building space and approximately forty-five acres of developable land to accommodate anticipated future growth. In addition, we own and lease office/building space and research and development sites around the world, primarily in North America, Europe, South America, and Asia. We own and operate data centers in the U.S., Europe, South America, and Asia. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, please see Note 10 “Commitments and Contingencies - Legal Matters” of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 20 Table of Contents Alphabet Inc. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Price Range of Common Stock and Capital Stock Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. The following table sets forth for the indicated periods the high and low sales prices per share for our Class A common stock on the Nasdaq Global Select Market. Fiscal Year 2017 Quarters Ended: High Low March 31, 2017 $ 872.37 $ 807.77 June 30, 2017 $ 1,004.28 $ 839.88 September 30, 2017 $ 998.31 $ 919.46 December 31, 2017 $ 1,085.09 $ 966.78 Fiscal Year 2016 Quarters Ended: High Low March 31, 2016 $ 780.91 $ 701.02 June 30, 2016 $ 787.68 $ 681.14 September 30, 2016 $ 815.95 $ 704.89 December 31, 2016 $ 835.74 $ 753.22 Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. The following table sets forth for the indicated periods the high and low sales prices per share for our Class C capital stock on the Nasdaq Global Select Market. Fiscal Year 2017 Quarters Ended: High Low March 31, 2017 $ 852.12 $ 786.14 June 30, 2017 $ 983.68 $ 823.35 September 30, 2017 $ 980.34 $ 898.70 December 31, 2017 $ 1,077.14 $ 951.68 Fiscal Year 2016 Quarters Ended: High Low March 31, 2016 $ 764.65 $ 678.11 June 30, 2016 $ 766.61 $ 668.26 September 30, 2016 $ 787.21 $ 694.49 December 31, 2016 $ 813.11 $ 736.08 Holders of Record As of December 31, 2017 , there were approximately 2,100 and 2,101 stockholders of record of our Class A common stock and Class C capital stock, respectively, and the closing prices of our Class A common stock and Class C capital stock were $1,053.40 and $1,046.40 per share, respectively, as reported by the NASDAQ Global Select Market. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2017 , there were approximately 62 stockholders of record of our Class B common stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. We intend to retain any future earnings and do not expect to pay any cash dividends in the foreseeable future. 21 Table of Contents Alphabet Inc. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class C capital stock during the quarter ended December 31, 2017: Period Total Number of Shares Purchased (in thousands) (1) Average Price Paid per Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 0 $ 0.00 0 $ 4,274 November 1 - 30 1,231 $ 1,028.78 1,231 $ 3,008 December 1 - 31 806 $ 1,035.28 806 $ 2,173 Total 2,037 $ 1,031.35 2,037 (1) In October 2016, the board of directors of Alphabet authorized the company to repurchase up to $7.0 billion of its Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. See Note 11 in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. 22 Table of Contents Alphabet Inc. Stock Performance Graphs The following graph compares the 5-year cumulative total return to shareholders on Alphabet Inc.’s Class A common stock relative to the cumulative total returns of the S&P 500 index, the RDG Internet Composite index, and the NASDAQ Composite index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in the company’s Class A common stock and in each index on December 31, 2012 and its relative performance is tracked through December 31, 2017 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2012 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2015 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 23 Table of Contents Alphabet Inc. The following graph compares the cumulative total return to shareholders on Alphabet Inc.’s Class C capital stock relative to the cumulative total returns of the S&P 500 index, the RDG Internet Composite index, and the NASDAQ Composite index. An investment of $100 (with reinvestment of all dividends) is assumed to have been made in the company’s Class C capital stock and in each index on April 3, 2014 and its relative performance is tracked through December 31, 2017 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE TOTAL RETURN* Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on April 3, 2014 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2015 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. These performance graphs shall not be deemed “filed” for purposes of Section 18 of the Securities Exchange Act of 1934, as amended (the Exchange Act), or incorporated by reference into any filing of Alphabet under the Securities Act of 1933, as amended, or the Exchange Act, except as shall be expressly set forth by specific reference in such filing. 24 Table of Contents Alphabet Inc. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing in Item 8 “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results to be expected in any future period. Year Ended December 31, 2013 2014 2015 2016 2017 (in millions, except per share amounts) Consolidated Statements of Income Data: Revenues $ 55,519 $ 66,001 $ 74,989 $ 90,272 $ 110,855 Income from operations 15,403 16,496 19,360 23,716 26,146 Net income from continuing operations 13,160 13,620 16,348 19,478 12,662 Net income (loss) from discontinued operations (427 ) 516 0 0 0 Net income 12,733 14,136 16,348 19,478 12,662 Basic net income (loss) per share of Class A and B common stock: Continuing operations $ 19.77 $ 20.15 $ 23.11 $ 28.32 $ 18.27 Discontinued operations (0.64 ) 0.76 0.00 0.00 0.00 Basic net income per share of Class A and B common stock $ 19.13 $ 20.91 $ 23.11 $ 28.32 $ 18.27 Basic net income (loss) per share of Class C capital stock: Continuing operations $ 19.77 $ 20.15 $ 24.63 $ 28.32 $ 18.27 Discontinued operations (0.64 ) 0.76 0.00 0.00 0.00 Basic net income per share of Class C capital stock $ 19.13 $ 20.91 $ 24.63 $ 28.32 $ 18.27 Diluted net income (loss) per share of Class A and B common stock: Continuing operations $ 19.42 $ 19.82 $ 22.84 $ 27.85 $ 18.00 Discontinued operations (0.63 ) 0.75 0.00 0.00 0.00 Diluted net income per share of Class A and B common stock $ 18.79 $ 20.57 $ 22.84 $ 27.85 $ 18.00 Diluted net income (loss) per share of Class C capital stock: Continuing operations $ 19.42 $ 19.82 $ 24.34 $ 27.85 $ 18.00 Discontinued operations (0.63 ) 0.75 0.00 0.00 0.00 Diluted net income per share of Class C capital stock $ 18.79 $ 20.57 $ 24.34 $ 27.85 $ 18.00 As of December 31, 2013 2014 2015 2016 2017 (in millions) Consolidated Balance Sheet Data: Cash, cash equivalents, and marketable securities $ 58,717 $ 64,395 $ 73,066 $ 86,333 $ 101,871 Total assets $ 109,050 $ 129,187 $ 147,461 $ 167,497 $ 197,295 Total long-term liabilities $ 6,165 $ 8,548 $ 7,820 $ 11,705 $ 20,610 Total stockholders’ equity $ 86,977 $ 103,860 $ 120,331 $ 139,036 $ 152,502 25 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Item 8 of this Annual Report on Form 10-K. Trends in Our Business The following trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to impact our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, resulting in increasing revenues, and we expect that this online shift will continue to benefit our business. • As online advertising evolves, we continue to expand our product offerings which may impact our monetization. As interactions between users and advertisers change and as online user behavior evolves, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube engagement ads, which monetize at a lower rate than traditional desktop search ads. Additionally, we continue to see a shift to programmatic buying which presents opportunities for advertisers to connect with the right user, in the right moment, in the right context. Programmatic buying has a different monetization profile than traditional advertising buying on Google properties. • Users are increasingly using multiple devices and modalities to access our products and services, and our advertising revenues are increasingly coming from mobile and other new formats. Our users are accessing the Internet via multiple devices and modalities and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of this shift in order to maintain and grow our business. We generate our advertising revenues increasingly from mobile and newer advertising formats, and the margins from the advertising revenues from these sources have generally been lower than those from traditional desktop search. Accordingly, we expect TAC paid to our distribution partners to increase due to changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms, and the percentage of queries channeled through paid access points. We expect these trends to continue to put pressure on our overall margins. • As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates impact such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, and we continue to develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time and we expect that our results will continue to be impacted by our performance in these markets, particularly as low-cost mobile devices become more available. Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. • The portion of our revenues that we derive from non-advertising revenues is increasing and may impact margins. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings to our users through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. Across these initiatives, we currently derive non-advertising revenues primarily from sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings. The margins on these non-advertising businesses vary significantly and may be lower than the margins on our advertising business. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile. 26 Table of Contents Alphabet Inc. • As we continue to look for new ways to serve our users and expand our businesses, we will invest heavily in R&D and our capital expenditures will continue to fluctuate. We continue to make significant research and development (R&D) investments in areas of strategic focus such as advertising, cloud, machine learning, and search, as well as in new products and services. The amount of our capital expenditures has fluctuated and may continue to fluctuate in the long term as we invest heavily in our systems, data centers, real estate and facilities, and information technology infrastructure. In addition, acquisitions remain an important part of our strategy and use of capital, and we expect to continue to spend cash on acquisitions and other investments. These acquisitions generally enhance the breadth and depth of our offerings, as well as expand our expertise in engineering and other functional areas. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. Their energy and talent drive Alphabet and create our success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees. Executive Overview of Results Below are our key financial results for the fiscal year ended December 31, 2017 (consolidated unless otherwise noted): • Revenues of $110.9 billion and revenue growth of 23% year over year, constant currency revenue growth of 24% year over year. • Google segment revenues of $109.7 billion with revenue growth of 23% year over year and Other Bets revenues of $1.2 billion with revenue growth of 49% year over year. • Revenues from the United States , EMEA , APAC , and Other Americas were $52.4 billion , $36.0 billion , $16.2 billion , and $6.1 billion , respectively. • Cost of revenues was $45.6 billion , consisting of TAC of $21.7 billion and other cost of revenues of $23.9 billion . Our TAC as a percentage of advertising revenues was 23% . • Operating expenses (excluding cost of revenues) were $39.1 billion . • Income from operations was $26.1 billion . • Effective tax rate was 53% . • Net income was $12.7 billion with diluted net income per share of $18.00 . • Operating cash flow was $37.1 billion . • Capital expenditures were $13.2 billion . • Number of employees was 80,110 as of December 31, 2017 . Information about Segments We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed below as Other Bets. Our reported segments are: • Google – Google includes our main products such as Ads, Android, Chrome, Commerce, Google Cloud, Google Maps, Google Play, Hardware, Search, and YouTube. Our technical infrastructure and some newer efforts like virtual reality are also included in Google. Google generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Fiber, sales of Nest products and services, and licensing and R&D services through Verily. Please refer to Note 15 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K for further information. 27 Table of Contents Alphabet Inc. Revenues The following table presents our revenues, by segment and revenue source (in millions): Year Ended December 31, 2015 2016 2017 Google segment Google properties revenues $ 52,357 $ 63,785 $ 77,788 Google Network Members' properties revenues 15,033 15,598 17,587 Google advertising revenues 67,390 79,383 95,375 Google other revenues 7,154 10,080 14,277 Google segment revenues $ 74,544 $ 89,463 $ 109,652 Other Bets Other Bets revenues $ 445 $ 809 $ 1,203 Revenues $ 74,989 $ 90,272 $ 110,855 Google segment The following table presents our Google segment revenues (in millions), and changes in our aggregate paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 2015 2016 2017 Google segment revenues $ 74,544 $ 89,463 $ 109,652 Google segment revenues as a percentage of total revenues 99.4 % 99.1 % 98.9 % Aggregate paid clicks change 34 % 46 % Aggregate cost-per-click change (11 )% (19 )% Use of Monetization Metrics When assessing our advertising revenues performance, we present information regarding the percentage change in the number of paid clicks and cost-per-click for our Google properties and Google Network Members' properties. Management views these as important metrics for understanding our business. Paid clicks for our Google properties represent engagement by users and include clicks on advertisements by end-users related to searches on Google.com, clicks related to advertisements on other owned and operated properties including Gmail, Google Maps, and Google Play, and viewed YouTube engagement ads. Paid clicks for our Google Network Members' properties include clicks by end-users related to advertisements served on Google Network Members' properties participating in AdMob, AdSense for Content, and AdSense for Search. In some cases, such as programmatic and reservation based advertising buying, we primarily charge advertisers by impression; while growing, this represents a small part of our consolidated revenues base. Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. We periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks and for identifying the revenues generated by click activity. 28 Table of Contents Alphabet Inc. In the first quarter of 2017, we refined our methodology for paid clicks and cost-per-click to include additional categories of TrueView engagement ads and exclude non-engagement based trial ad formats. This change resulted in a modest increase in growth of paid clicks and a modest decrease in growth of cost-per-click. For comparison purposes, we have included updated data for historical periods in the table below: Three Months Ended Year Ended Mar 31, 2016 Jun 30, 2016 Sep 30, 2016 Dec 31, 2016 Dec 31, 2016 Year-over-year change Aggregate paid clicks 29 % 28 % 32 % 39 % 34 % Paid clicks on Google properties 38 % 36 % 41 % 47 % 43 % Paid clicks on Google Network Members' properties 2 % 0 % 1 % 7 % 3 % Aggregate cost-per-click (8 )% (6 )% (10 )% (17 )% (11 )% Cost-per-click on Google properties (11 )% (8 )% (12 )% (18 )% (13 )% Cost-per-click on Google Network Members' properties (8 )% (8 )% (14 )% (19 )% (13 )% Quarter-over-quarter change Aggregate paid clicks (2 )% 7 % 9 % 22 % N/A Paid clicks on Google properties (3 )% 9 % 11 % 25 % N/A Paid clicks on Google Network Members' properties 4 % (3 )% 1 % 6 % N/A Aggregate cost-per-click (1 )% (1 )% (5 )% (10 )% N/A Cost-per-click on Google properties 1 % (2 )% (6 )% (12 )% N/A Cost-per-click on Google Network Members' properties (12 )% (2 )% (6 )% 0 % N/A Our advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google properties and Google Network Members' properties and the correlation between these items, have fluctuated and may continue to fluctuate because of various factors, including: • advertiser competition for keywords; • changes in advertising quality or formats; • changes in device mix; • changes in foreign currency exchange rates; • fees advertisers are willing to pay based on how they manage their advertising costs; • general economic conditions; • growth rates of revenues from Google properties, including YouTube, compared to growth rates of revenues from Google Network Members' properties; • seasonality; • shift in the proportion of non-click based revenues generated on Google properties and Google Network Members' properties, including an increase in programmatic and reservation based advertising buying; and • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels. Our advertising revenue growth rate has fluctuated over time as a result of a number of factors, including challenges in maintaining our growth rate as revenues increase to higher levels, changes in our product mix, increasing competition, query growth rates, our investments in new business strategies, shifts in the geographic mix of our revenues, and the evolution of the online advertising market. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices and modalities, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates. 29 Table of Contents Alphabet Inc. Google properties The following table presents our Google properties revenues (in millions), and changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 2015 2016 2017 Google properties revenues $ 52,357 $ 63,785 $ 77,788 Google properties revenues as a percentage of Google segment revenues 70.2 % 71.3 % 70.9 % Paid clicks change 43 % 54 % Cost-per-click change (13 )% (21 )% Google properties revenues consist primarily of advertising revenues that are generated on: • Google search properties which includes revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.; and • Other Google owned and operated properties like Gmail, Google Maps, Google Play, and YouTube. Our Google properties revenues increased $14,003 million from 2016 to 2017 . The growth was primarily driven by increases in mobile search resulting from ongoing growth in user adoption and usage, as well as continued growth in advertiser activity. We also experienced growth in YouTube driven primarily by video advertising, as well as growth in desktop search due to improvements in ad formats and delivery. The growth was partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. The number of paid clicks through our advertising programs on Google properties increased from 2016 to 2017 due to growth in YouTube engagement ads, increases in mobile search queries, improvements we have made in ad formats and delivery, and continued global expansion of our products, advertisers and user base. The positive impact on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers from 2016 to 2017 . The decrease in cost-per-click was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms. Cost-per-click was also impacted by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Our Google properties revenues increased $11,428 million from 2015 to 2016 and also increased as a percentage of Google segment revenues. The growth was primarily driven by increases in mobile search most notably due to ongoing improvements in ad formats and delivery launched during 2016. We also experienced growth in YouTube revenue driven primarily by video advertising across TrueView with a growing contribution from ad buying on DoubleClick Bid Manager, as well as improvements in ad formats and delivery. The growth was partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. The number of paid clicks through our advertising programs on Google properties increased from 2015 to 2016 due to growth in the adoption of YouTube engagement ads, improvements we have made in ad formats and delivery, and continued global expansion of our products, advertisers, and user base across all platforms, particularly mobile. The positive impact on our revenues from paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms, and also impacted by changes in device mix, property mix, product mix, geographic mix, ongoing product changes, and the general strengthening of the U.S. dollar compared to certain foreign currencies. Google Network Members' properties The following table presents our Google Network Members' properties revenues (in millions) and changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 2015 2016 2017 Google Network Members' properties revenues $ 15,033 $ 15,598 $ 17,587 Google Network Members' properties revenues as a percentage of Google segment revenues 20.2 % 17.4 % 16.0 % Paid clicks change 3 % 10 % Cost-per-click change (13 )% (9 )% 30 Table of Contents Alphabet Inc. Google Network Members' properties revenues consist primarily of advertising revenues generated from ads placed on Google Network Member properties through: • AdMob; • AdSense (such as AdSense for Content, AdSense for Search, etc.); and • DoubleClick AdExchange. Our Google Network Members' properties revenues increased $1,989 million from 2016 to 2017 . The growth was primarily driven by strength in both programmatic advertising buying and AdMob, offset by a decline in our traditional AdSense businesses and the general strengthening of the U.S. dollar compared to certain foreign currencies. The increase in paid clicks from 2016 to 2017 resulted primarily from growth in AdMob and an increase from our traditional AdSense for Search business. The positive impact on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The changes in cost-per-click from 2016 to 2017 was impacted by changes in device mix, geographic mix, ongoing product and policy changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Our Google Network Members' properties revenues increased $565 million from 2015 to 2016 . The growth was primarily driven by strength in programmatic advertising buying as well as strength in AdMob, offset by a decline in our traditional AdSense business and the general strengthening of the U.S. dollar compared to certain foreign currencies. The increase in paid clicks from 2015 to 2016 resulted from the growth in AdMob offset by declines in AdSense. The decrease in cost-per-click paid by our advertisers from 2015 to 2016 resulted from changes in the product mix of Google Network Members advertising revenues, ongoing product and policy changes, changes in property and device mix, geographic mix, and relative fluctuations of the U.S. dollar compared to certain foreign currencies. Google other revenues The following table presents our Google other revenues (in millions): Year Ended December 31, 2015 2016 2017 Google other revenues $ 7,154 $ 10,080 $ 14,277 Google other revenues as a percentage of Google segment revenues 9.6 % 11.3 % 13.0 % Google other revenues consist primarily of revenues from: • Apps, in-app purchases, and digital content in the Google Play store; • Google Cloud offerings; and • Hardware. Our Google other revenues increased $4,197 million from 2016 to 2017 . The increase was primarily driven by revenues from Google Cloud offerings, hardware sales, and revenues from Google Play, largely relating to in-app purchases (revenues which we recognize net of payout to developers). Our Google other revenues increased $2,926 million from 2015 to 2016 and increased as a percentage of Google segment revenues. These increases were primarily due to the growth in revenues from Google Play, primarily relating to in-app purchases (revenues which we recognize net of payout to developers), hardware sales, and Google Cloud offerings. Other Bets The following table presents our Other Bets revenues (in millions): Year Ended December 31, 2015 2016 2017 Other Bets revenues $ 445 $ 809 $ 1,203 Other Bets revenues as a percentage of total revenues 0.6 % 0.9 % 1.1 % Other Bets revenues consist primarily of revenues and sales from: • Internet and TV services; • Licensing and R&D services; and • Nest branded hardware. 31 Table of Contents Alphabet Inc. Our Other Bets revenues increased $394 million from 2016 to 2017 . The increase was primarily driven by revenues from sales of Nest branded hardware, Fiber internet and TV services, and Verily licensing and R&D services. Our Other Bets revenues increased $364 million from 2015 to 2016 and increased as a percentage of consolidated revenues. These increases were primarily driven by sales of Nest branded hardware and revenues from Fiber internet and TV services. There was also an increase in revenues from Verily licensing and R&D services from 2015 to 2016 . Due to the early stage of our Other Bets businesses and because their revenues aggregate a number of businesses operating in different industries, our Other Bets revenues may fluctuate in future periods. Additionally, our Other Bets revenues may fluctuate due to one-time items. Revenues by Geography The following table presents our revenues by geography as a percentage of revenues, determined based on the billing addresses of our customers: Year Ended December 31, 2015 2016 2017 United States 46 % 47 % 47 % EMEA 35 % 34 % 33 % APAC 14 % 14 % 15 % Other Americas 5 % 5 % 5 % For the amounts of revenues by geography, please refer to Note 2 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Use of Constant Currency Revenues and Constant Currency Revenue Growth The impact of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably impacted as the U.S. dollar weakens relative to other foreign currencies, and unfavorably impacted as the U.S. dollar strengthens relative to other foreign currencies. Our international revenues are also favorably impacted by net hedging gains and unfavorably impacted by net hedging losses. We use non-GAAP constant currency revenues and constant currency revenue growth for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to GAAP results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the impact of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue growth on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging impacts realized in the current period. Constant currency revenue growth (expressed as a percentage) is calculated by determining the increase in current period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging impacts are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. 32 Table of Contents Alphabet Inc. The following table presents our foreign exchange impact on our international revenues and total revenues (in millions): Twelve Months Ended December 31, 2015 2016 2017 EMEA revenues $ 26,368 $ 30,304 $ 36,046 Exclude foreign exchange impact on current period revenues using prior year rates 3,802 1,291 (5 ) Exclude hedging impact recognized in current period (989 ) (479 ) 190 EMEA constant currency revenues $ 29,181 $ 31,116 $ 36,231 Prior period EMEA revenues, excluding hedging impact $ 24,497 $ 25,379 $ 29,825 EMEA revenue growth 15 % 19 % EMEA constant currency revenue growth 23 % 21 % APAC revenues $ 9,887 $ 12,559 $ 16,235 Exclude foreign exchange impact on current period revenues using prior year rates 1,076 (362 ) 26 Exclude hedging impact recognized in current period (323 ) (31 ) (43 ) APAC constant currency revenues $ 10,640 $ 12,166 $ 16,218 Prior period APAC revenues, excluding hedging impact $ 8,169 $ 9,564 $ 12,528 APAC revenue growth 27 % 29 % APAC constant currency revenue growth 27 % 29 % Other Americas revenues $ 3,924 $ 4,628 $ 6,125 Exclude foreign exchange impact on current period revenues using prior year rates 712 344 (148 ) Exclude hedging impact recognized in current period (88 ) (29 ) 22 Other Americas constant currency revenues $ 4,548 $ 4,943 $ 5,999 Prior period Other Americas revenues, excluding hedging impact $ 3,681 $ 3,836 $ 4,599 Other Americas revenue growth 18 % 32 % Other Americas constant currency revenue growth 29 % 30 % United States revenues $ 34,810 $ 42,781 $ 52,449 United States revenue growth 23 % 23 % Total revenues $ 74,989 $ 90,272 $ 110,855 Total constant currency revenues $ 79,179 $ 91,006 $ 110,897 Total revenue growth 20 % 23 % Total constant currency revenue growth 24 % 24 % Our EMEA revenues from 2016 to 2017 were unfavorably impacted, primarily as a result of an unfavorable impact from hedging losses, slightly offset by a favorable impact from foreign currency exchange rates. The foreign exchange impact was due to the U.S. dollar weakening relative to the Euro and Russian ruble, partially offset by the impact of the U.S. dollar strengthening relative to the British pound and Turkish lira. Our EMEA revenues from 2015 to 2016 were unfavorably impacted, primarily as a result of an unfavorable impact from foreign currency exchange rates, offset by a favorable impact from hedging benefits. The foreign exchange impact was due to the U.S. dollar strengthening relative to the British pound, Euro, and Russian ruble. Our revenues from APAC from 2016 to 2017 were relatively flat, primarily as a result of a favorable impact from hedging benefits, offset by an unfavorable impact from foreign currency exchange rates. The foreign exchange impact 33 Table of Contents Alphabet Inc. was due to the U.S. dollar strengthening relative to the Japanese yen, partially offset by the impact of the U.S. dollar weakening relative to the Australian dollar, Indian rupee, South Korean won, and Taiwanese dollar. Our revenues from APAC from 2015 to 2016 were relatively flat, primarily as a result of slight favorable impacts from foreign currency exchange rates and hedging benefits. The foreign exchange impact was due to the U.S. dollar weakening relative to the Japanese yen, partially offset by the impact of the U.S. dollar strengthening relative to the Indian rupee and Australian dollar. Our revenues from Other Americas from 2016 to 2017 were favorably impacted, primarily as a result of a favorable impact from foreign currency exchange rates, slightly offset by an unfavorable impact from hedging losses. The foreign exchange impact was due to the U.S. dollar weakening relative to the Brazilian real and Canadian dollar, partially offset by the impact of the U.S. dollar strengthening relative to the Argentine peso. Our revenues from Other Americas from 2015 to 2016 were unfavorably impacted, primarily as a result of an unfavorable impact from foreign currency exchange rates, slightly offset by a favorable impact from hedging benefits. The foreign exchange impact was due to the U.S. dollar strengthening relative to certain currencies including the Argentine peso, Canadian dollar, Brazilian real, and the Mexican peso. Costs and Expenses Cost of Revenues Cost of revenues consists of TAC which are paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. The cost of revenues related to revenues generated from ads placed on Google Network Members' properties are significantly higher than the costs of revenues related to revenues generated from ads placed on Google properties because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members. Additionally, other cost of revenues (which is the cost of revenues excluding TAC) includes the following: • Amortization of certain intangible assets; • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Credit card and other transaction fees related to processing customer transactions; • Expenses associated with our data center and other operations (including bandwidth, compensation expenses (including SBC), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. 34 Table of Contents Alphabet Inc. The following tables present our cost of revenues, including TAC (in millions): Year Ended December 31, 2015 2016 2017 TAC $ 14,343 $ 16,793 $ 21,672 Other cost of revenues 13,821 18,345 23,911 Total cost of revenues $ 28,164 $ 35,138 $ 45,583 Total cost of revenues as a percentage of revenues 37.6 % 38.9 % 41.1 % Year Ended December 31, 2015 2016 2017 TAC to distribution partners $ 4,101 $ 5,894 $ 9,031 TAC to distribution partners as a percentage of Google properties revenues (1) (Google properties TAC rate) 7.8 % 9.2 % 11.6 % TAC to Google Network Members $ 10,242 $ 10,899 $ 12,641 TAC to Google Network Members as a percentage of Google Network Members' properties revenues (1) (Network Members TAC rate) 68.1 % 69.9 % 71.9 % TAC $ 14,343 $ 16,793 $ 21,672 TAC as a percentage of advertising revenues (1) (Aggregate TAC rate) 21.3 % 21.2 % 22.7 % (1) Revenues include hedging gains(losses) which impact TAC rates. Cost of revenues increased $10,445 million from 2016 to 2017 . The increase was due to an increase in TAC of $4,879 million . The increase in TAC to distribution partners was a result of an increase in Google properties revenues and the associated TAC rate. The increase in TAC to Google Network Members was a result of an increase in Google Network Members' properties revenues and the associated TAC rate. The increase in the Google properties TAC rate was driven by changes in partner agreements and the ongoing shift to mobile, which carries higher TAC because more mobile searches are channeled through paid access points. The increase in the Network Members TAC rate was driven by the continued underlying shift in advertising buying from our traditional network business to programmatic advertising buying. The increase in the aggregate TAC rate was also partially offset by a favorable revenue mix shift from Google Network Members' properties to Google properties. Other cost of revenues increased $5,566 million from 2016 to 2017. The increase was due to various factors, including an increase in data center and other operations costs, which include depreciation, compensation expenses (including SBC), energy, bandwidth, and other equipment costs as a result of business growth; hardware costs associated with new hardware launches; and content acquisition costs as a result of increased activities related to YouTube. Cost of revenues increased $6,974 million from 2015 to 2016 due to various factors including traffic acquisition costs, data center costs, content acquisition costs, and hardware costs. The increase in traffic acquisition costs of $2,450 million was due to increases in advertising revenues primarily from the growth of mobile search and programmatic ad buying which carry higher TAC. The increase in other cost of revenues of $4,524 million was primarily due to increases in (1) data center costs including depreciation, labor, energy, bandwidth, and other equipment costs as a result of business growth, (2) content acquisition costs as a result of increased activities related to YouTube, (3) hardware costs associated with new hardware launches, and (4) stock-based compensation. The aggregate TAC rate remained relatively flat from 2015 to 2016 primarily as a result of a shift of mix from Google Network Members' properties revenue to Google properties revenue. Our aggregate TAC rate was also impacted by the increase in mobile and programmatic advertising buying, which generally carry overall higher TAC. The increase in Google properties TAC rate was primarily driven by a shift to mobile and more mobile searches are subject to TAC. The increase in Network Members' TAC rate was primarily driven by the shift in advertising buying from our traditional network business to programmatic advertising buying. 35 Table of Contents Alphabet Inc. We expect cost of revenues to increase in dollar amount and as a percentage of total revenues in future periods based on a number of factors, including the following: • Google Network Members TAC rates, which are affected by the continued underlying shift in advertising buying from our traditional network business to programmatic advertising buying which carries higher TAC; • Google properties TAC rates, which are affected by changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points; • Growth rates of expenses associated with our data center and other operations, content acquisition costs, as well as our hardware inventory and related costs; • Increased proportion of non-advertising revenues, whose costs are generally higher in relation to our advertising revenues; • Relative revenue growth rates of Google properties and our Google Network Members' properties. Research and Development The following table presents our R&D expenses (in millions): Year Ended December 31, 2015 2016 2017 Research and development expenses $ 12,282 $ 13,948 $ 16,625 Research and development expenses as a percentage of revenues 16.4 % 15.5 % 15.0 % R&D expenses consist primarily of: • Compensation expenses, including SBC, and facilities-related costs for employees responsible for R&D of our existing and new products and services; and • Depreciation and equipment-related expenses. R&D expenses increased $2,677 million from 2016 to 2017 . The increase was primarily due to an increase in compensation expenses, including SBC, and facilities-related costs of $1,886 million, largely resulting from a 16% increase in headcount. In addition, there was an increase in depreciation and equipment-related expenses of $569 million. R&D expenses increased $1,666 million from 2015 to 2016 . The increase was primarily due to an increase in stock-based compensation expense of $667 million and an increase in labor and facilities-related costs of $326 million, both largely as a result of a 16% increase in R&D headcount, partially offset by higher expenses resulting from project milestones in Other Bets in 2015. In addition, there was an increase in depreciation and equipment-related expenses of approximately $388 million and an increase in professional services of $267 million due to additional expenses incurred for consulting, outsourced services, and temporary services. We expect that R&D expenses will increase in dollar amount and may fluctuate as a percentage of revenues in future periods. Sales and Marketing The following table presents our sales and marketing expenses (in millions): Year Ended December 31, 2015 2016 2017 Sales and marketing expenses $ 9,047 $ 10,485 $ 12,893 Sales and marketing expenses as a percentage of revenues 12.1 % 11.6 % 11.6 % Sales and marketing expenses consist primarily of: • Advertising and promotional expenditures related to our products and services; and • Compensation expenses, including SBC, and facilities-related costs for employees engaged in sales and marketing, sales support, and certain customer service functions. Sales and marketing expenses increased $2,408 million from 2016 to 2017 . The increase was primarily due to an increase in advertising and promotional expenses of $1,266 million, largely resulting from increases in marketing and promotion-related expenses for our hardware products, Cloud offerings, and YouTube. In addition, there was an increase in compensation expenses, including SBC, and facilities-related costs of $853 million, largely resulting from a 6% increase in headcount. 36 Table of Contents Alphabet Inc. Sales and marketing expenses increased $1,438 million from 2015 to 2016 . The increase was primarily due to an increase in advertising and promotional expenses of $679 million, largely due to increases in marketing and promotion-related expenses for our hardware products. Additionally, there was an increase in labor and facilities-related costs of $482 million, and stock-based compensation expense of $179 million, both largely resulting from a 10% increase in sales and marketing headcount. We expect that sales and marketing expenses will increase in dollar amount and may fluctuate as a percentage of revenues in future periods. General and Administrative The following table presents our general and administrative expenses (in millions): Year Ended December 31, 2015 2016 2017 General and administrative expenses $ 6,136 $ 6,985 $ 6,872 General and administrative expenses as a percentage of revenues 8.2 % 7.7 % 6.2 % General and administrative expenses consist primarily of: • Amortization of certain intangible assets; • Compensation expenses, including SBC, and facilities-related costs for employees in our facilities, finance, human resources, information technology, and legal organizations; • Depreciation and equipment-related expenses; and • Professional services fees primarily related to audit, information technology consulting, outside legal, and outsourcing services. General and administrative expenses decreased $113 million from 2016 to 2017 . The decrease was primarily from reduced allocations to general and administrative expenses with an offsetting increase to costs of revenues and other operating expenses. The decrease was partially offset by an increase in compensation expenses, including SBC, and facilities-related costs of $271 million, largely resulting from a 9% increase in headcount. Additionally, there was an increase in professional service fees of $253 million due to additional expenses incurred for outsourced services and consulting services. General and administrative expenses increased $849 million from 2015 to 2016 . The increase was primarily due to increases in labor and facilities-related costs of $460 million, and stock-based compensation expense of $421 million, both largely resulting from a 15% increase in general and administrative headcount , as well as increases in other miscellaneous expenses. These increases were offset by a decrease in professional service fees of $194 million due to lower legal-related costs. We expect general and administrative expenses will increase in dollar amount and may fluctuate as a percentage of revenues in future periods. European Commission Fine In June 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a €2.42 billion (approximately $2.74 billion as of June 27, 2017) fine, which was accrued in the second quarter of 2017. Other Income (Expense), Net The following table presents other income (expense), net, (in millions): Year Ended December 31, 2015 2016 2017 Other income (expense), net $ 291 $ 434 $ 1,047 Other income (expense), net, as a percentage of revenues 0.4 % 0.5 % 0.9 % Other income (expense), net, increased $613 million from 2016 to 2017 . This increase was primarily driven by reduced costs of our foreign currency hedging activities, decreased losses on marketable securities and an increase in interest income. 37 Table of Contents Alphabet Inc. Other income (expense), net, increased $143 million from 2015 to 2016 . This increase was primarily driven by an increase in interest income and decreased losses on non-marketable investments, partially offset by increased losses from our foreign currency transactions and impairments for certain assets. The costs of our foreign exchange hedging activities recognized in other income (expense), net, are primarily a function of the notional amount of the option and forward contracts and their related duration, the movement of foreign exchange rates relative to the contract prices, the volatility of foreign exchange rates and forward points. The hedging costs expensed in other income (expense), net, decreased as a result of less option premiums paid after we began to use foreign currency forward contracts to hedge our forecasted revenues in the fourth quarter of 2016. We expect that other income (expense), net, will fluctuate in dollar amount in future periods as it is largely driven by market dynamics. Provision for Income Taxes The following table presents our provision for income taxes (in millions) and effective tax rate: Year Ended December 31, 2015 2016 2017 Provision for income taxes $ 3,303 $ 4,672 $ 14,531 Effective tax rate 16.8 % 19.3 % 53.4 % Our provision for income taxes and our effective tax rate increased from 2016 to 2017 , due to the Tax Act that was enacted in December 2017. Please refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K for further information. Our provision for income taxes and our effective tax rate increased from 2015 to 2016 , largely due to proportionately more earnings generated in jurisdictions that have higher statutory tax rates and discrete items in 2015 and 2016 , partially offset by the stock-based compensation benefits recognized resulting from the adoption of Accounting Standards Update No. 2016-09 (ASU 2016-09). Our future effective tax rate will be affected by the Tax Act. Effective in 2018, the Tax Act reduces the U.S. statutory tax rate from 35% to 21% and creates new taxes on certain foreign-sourced earnings and certain related-party payments, which are referred to as the global intangible low-taxed income tax and the base erosion tax, respectively. Our future effective tax rate could be adversely affected by earnings being lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2017 . This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Both seasonal fluctuations in internet usage, advertising expenditures and underlying business trends such as traditional retail seasonality have affected, and are likely to continue to affect, our business. Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. 38 Table of Contents Alphabet Inc. Quarter Ended Mar 31, 2016 Jun 30, 2016 Sep 30, 2016 Dec 31, 2016 Mar 31, 2017 Jun 30, 2017 Sep 30, 2017 Dec 31, 2017 (In millions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues $ 20,257 $ 21,500 $ 22,451 $ 26,064 $ 24,750 $ 26,010 $ 27,772 $ 32,323 Costs and expenses: Cost of revenues 7,648 8,130 8,699 10,661 9,795 10,373 11,148 14,267 Research and development 3,367 3,363 3,596 3,622 3,942 4,172 4,205 4,306 Sales and marketing 2,387 2,415 2,565 3,118 2,644 2,897 3,042 4,310 General and administrative 1,513 1,624 1,824 2,024 1,801 1,700 1,595 1,776 European Commission fine 0 0 0 0 0 2,736 0 0 Total costs and expenses 14,915 15,532 16,684 19,425 18,182 21,878 19,990 24,659 Income from operations 5,342 5,968 5,767 6,639 6,568 4,132 7,782 7,664 Other income (expense), net (213 ) 151 278 218 251 245 197 354 Income from continuing operations before income taxes 5,129 6,119 6,045 6,857 6,819 4,377 7,979 8,018 Provision for income taxes 922 1,242 984 1,524 1,393 853 1,247 11,038 Net income $ 4,207 $ 4,877 $ 5,061 $ 5,333 $ 5,426 $ 3,524 $ 6,732 $ (3,020 ) Basic net income per share of Class A and B common stock and Class C capital stock $ 6.12 $ 7.11 $ 7.36 $ 7.73 $ 7.85 $ 5.09 $ 9.71 $ (4.35 ) Diluted net income per share of Class A and B common stock and Class C capital stock $ 6.02 $ 7.00 $ 7.25 $ 7.56 $ 7.73 $ 5.01 $ 9.57 $ (4.35 ) Capital Resources and Liquidity As of December 31, 2017 , we had $101.9 billion in cash, cash equivalents, and marketable securities with $62.8 billion held by our foreign subsidiaries. Ca sh equivalents and marketable securities a re comprised of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, mortgage-backed securities, and asset-backed securities. From time to time, we may hold marketable equity securities obtained through acquisitions or strategic investments in private companies that subsequently go public. On December 22, 2017, the Tax Act was enacted and we recorded a tax liability for the one-time transition tax on accumulated foreign subsidiary earnings of $10.2 billion , of which $890 million and $9.3 billion were presented within “income tax payable, current” and “income tax payable, non-current,” respectively, on our Consolidated Balance Sheets as of December 31, 2017 . As permitted by the Tax Act, we intend to pay the one-time transition tax in eight annual interest-free installments beginning in 2018. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2017 . We have a $4.0 billion revolving credit facility expiring in February 2021. The interest rate for the credit facility is determined based on a formula using certain market rates. As of December 31, 2017 , no amounts were outstanding under the credit facility. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions and other liquidity requirements through at least the next 12 months. As of December 31, 2017 , we have senior unsecured notes outstanding due in 2021, 2024, and 2026 with a total carrying value of $3.9 billion and a total estimated fair value of $4.0 billion . In October 2016, the Board of Directors of Alphabet authorized the repurchase of up to $7.0 billion of Alphabet Class C capital stock. In 2017, we repurchased and subsequently retired 5.2 million shares of Alphabet Class C capital stock for an aggregate amount of $4.8 billion . In January 2018, the Board of Directors authorized the repurchase of up to an additional $8.6 billion of Alphabet Class C capital stock. The repurchases are expected to be executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. 39 Table of Contents Alphabet Inc. In January 2017, Temasek, a Singapore-based investment company, signed a binding commitment to purchase a non-controlling interest in Verily for an aggregate of $800 million in cash. We received the first tranche of $480 million in the first quarter of 2017 and the final tranche of $320 million in the third quarter of 2017. The following table presents our cash flows (in millions): Year Ended December 31, 2015 2016 2017 Net cash provided by operating activities $ 26,572 $ 36,036 $ 37,091 Net cash used in investing activities $ (23,711 ) $ (31,165 ) $ (31,401 ) Net cash used in financing activities $ (4,225 ) $ (8,332 ) $ (8,298 ) Cash Provided by Operating Activities Our largest source of cash provided by our operations are advertising revenues generated by Google properties and Google Network Members' properties. Additionally, we generate cash through sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings . Our primary uses of cash from our operating activities include payments to our Google Network Members and distribution partners, and payments for content acquisition costs. In addition, uses of cash from operating activities include compensation and related costs, hardware costs, other general corporate expenditures, and income taxes. Net cash provided by operating activities increased from 2016 to 2017 primarily due to increases in cash received from advertising revenues and Google other revenues (net of payouts to app developers), offset by increases in cash paid for cost of revenues, operating expenses, and income taxes. Net cash provided by operating activities increased from 2015 to 2016 primarily due to increases in cash received from advertising revenues and Google other revenues, offset by increases in cash paid for cost of revenues and operating expenses. Additionally, the timing of tax payments and refunds had a favorable impact to our cash flows from operations for 2016 compared to 2015. Cash Used in Investing Activities Cash provided by or used in investing activities primarily consists of purchases of property and equipment, purchases, maturities, and sales of marketable securities in our investment portfolio, cash collateral received or returned from our securities lending program, payments for acquisitions, and the proceeds from the collection of notes receivable. Net cash used in investing activities increased slightly from 2016 to 2017 primarily due to increases in purchases of marketable securities and increases in purchases of property and equipment, offset by increases in the maturities and sales of marketable securities, decreases in cash collateral paid related to securities lending, and increase in proceeds received from collections of notes receivables. Net cash used in investing activities increased from 2015 to 2016 primarily due to increases in purchases of marketable securities, increases in cash collateral paid related to securities lending and increases in spend related to acquisitions, partially offset by increases in maturities and sales of marketable securities and decreases in purchases of non-marketable investments. Cash Used in Financing Activities Cash used in financing activities consists primarily of net proceeds or payments from issuance or repayments of debt, repurchases of capital stock, and net proceeds or payments from stock-based award activities. Net cash used in financing activities decreased slightly from 2016 to 2017 primarily driven by decreases in the net cash outflow from repayments and issuance of debt, offset by increases in the repurchases of capital stock. Net cash used in financing activities increased from 2015 to 2016 primarily driven by decreases in proceeds from issuance of debt, and increases in the repurchases of capital stock and net payments related to stock-based award activities, partially offset by a decrease in debt repayments. 40 Table of Contents Alphabet Inc. Contractual Obligations as of December 31, 2017 The following summarizes our contractual obligations as of December 31, 2017 (in millions): Payments Due By Period Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating lease obligations, net of sublease income amounts (1) $ 8,753 $ 1,160 $ 2,182 $ 1,796 $ 3,615 Purchase obligations (2) 7,154 4,548 1,910 241 455 Long-term debt obligations (3) 4,744 112 224 1,170 3,238 Tax payable (4) 10,233 890 1,746 1,746 5,851 Other long-term liabilities reflected on our balance sheet (5) 2,416 348 619 511 938 Total contractual obligations $ 33,300 $ 7,058 $ 6,681 $ 5,464 $ 14,097 (1) For further information, refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (2) Represents non-cancelable contractual obligations primarily related to data center operations and build-outs; digital media content licensing arrangements; and purchases of inventory. The amounts included above represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2017 . Excluded from the table above are open orders for purchases that support normal operations. (3) Represents our principal and interest payments. For further information on long-term debt, refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. (4) Represents one-time transition tax payable related to known amounts of cash taxes payable in future years as a result of the Tax Act. For further information, refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. Excluded from the table above are long-term taxes payable of $3.5 billion as of December 31, 2017 related to uncertain tax positions. At this time, we are unable to make a reasonably reliable estimate of the timing of payments for uncertain tax positions in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. (5) Represents cash obligations recorded on our consolidated balance sheets, including the short-term portion of these long-term liabilities, and consist primarily of facility build-outs and payments owed in connection with certain commercial agreements. Off-Balance Sheet Arrangements As of December 31, 2017 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. Please see Note 1 of Part II, Item 8 of this Annual Report on Form 10-K for the summary of significant accounting policies. 41 Table of Contents Alphabet Inc. Revenues For the sale of third-party goods and services, we evaluate whether we are the principal, and report revenues on a gross basis, or an agent, and report revenues on a net basis. In this assessment, we consider if we obtain control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment, inventory risk, and discretion in establishing price. Income Taxes We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions, determining our provision for income taxes, and evaluating the impact of the Tax Act. The Tax Act was enacted on December 22, 2017 and introduces significant changes to U.S. income tax law. Effective in 2018, the Tax Act reduces the U.S. statutory tax rate from 35% to 21% and creates new taxes on certain foreign-sourced earnings and certain related-party payments, which are referred to as the global intangible low-taxed income tax and the base erosion tax, respectively. In addition, in 2017 we are subject to a one-time transition tax on accumulated foreign subsidiary earnings not previously subject to U.S. income tax. Accounting for the income tax effects of the Tax Act requires significant judgments and estimates in the interpretation and calculations of the provisions of the Tax Act. Due to the timing of the enactment and the complexity involved in applying the provisions of the Tax Act, we have made reasonable estimates of the effects and recorded provisional amounts in our financial statements for the year ended December 31, 2017. As we collect and prepare necessary data, and interpret any additional guidance issued by the U.S. Treasury Department, the IRS or other standard-setting bodies, we may make adjustments to the provisional amounts. Those adjustments may materially impact the provision for income taxes and the effective tax rate in the period in which the adjustments are made. The accounting for the tax effects of the enactment of the Tax Act will be completed in 2018. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will impact the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the impact of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, non-income taxes, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood of there being, and the estimated amount of, a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material impact on our business, consolidated financial position, results of operations, or cash flows. See Note 10 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information regarding contingencies. Business Combinations We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed, and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values 42 Table of Contents Alphabet Inc. of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing certain intangible assets include but are not limited to future expected cash flows (primarily from customer relationships and acquired patents and developed technology) and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates. Other estimates associated with the accounting for acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed, as more fully discussed in Note 8 of Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Goodwill Goodwill is allocated to reporting units expected to benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test goodwill for impairment at the reporting unit level at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairment tests require judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. Long-lived Assets Long-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Impairment of Securities We periodically review our securities for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For marketable debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as other income (expense), net. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in foreign currency exchange rates and interest rates. Foreign Currency Exchange Risk We transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. In general, we are a net receiver of foreign currencies and therefore benefit from a weakening of the U.S. dollar and are adversely affected by a strengthening of the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro and Japanese yen. We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the impact of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We record the effective portion of these contracts as a component of accumulated other comprehensive income (AOCI) and subsequently reclassify them into revenues to offset the hedged exposures as they occur. For foreign currency collars, we include the change in time value in our assessment of hedge effectiveness. For forwards and all other option contracts, we exclude the change in the forward points and time value 43 Table of Contents Alphabet Inc. from our assessment of hedge effectiveness. We recognize changes of the excluded components in other income (expense), net. We considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that changes in exchange rates of 10% could be experienced in the near term. If the U.S. dollar weakened by 10% as of December 31, 2016 and December 31, 2017 , the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $920 million and $950 million lower as of December 31, 2016 and December 31, 2017 , respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. In addition, we use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the local currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the impact of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. We considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% for all currencies could be experienced in the near term. These reasonably possible adverse changes in exchange rates of 10% were applied to total monetary assets and liabilities denominated in currencies other than the local currencies at the balance sheet dates to compute the adverse impact these changes would have had on our income before income taxes in the near term. These changes would have resulted in an adverse impact on income before income taxes of approximately $40 million and $52 million as of December 31, 2016 and 2017 , respectively. The adverse impact as of December 31, 2016 and 2017 is after consideration of the offsetting effect of approximately $554 million and $374 million, respectively, from foreign exchange contracts in place for the months ended December 31, 2016 and December 31, 2017 . Interest Rate Risk Our investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity requirements. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as a result of higher market interest rates compared to interest rates at the time of purchase. We account for both fixed and variable rate securities at fair value with changes on gains and losses recorded in AOCI until the securities are sold. To enhance our assessment of the interest rate risk associated with our investment portfolio, we use value-at-risk (VaR) analysis to determine the potential impact of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of our marketable debt securities as of December 31, 2016 and 2017 are shown below (in millions): As of December 31, 12-Month Average As of December 31, 2016 2017 2016 2017 Risk Category - Interest Rate $ 107 $ 84 $ 99 $ 87 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2016 and 2017 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation. 44 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 46 Financial Statements: Consolidated Balance Sheets 48 Consolidated Statements of Income 49 Consolidated Statements of Comprehensive Income 50 Consolidated Statements of Stockholders’ Equity 51 Consolidated Statements of Cash Flows 52 Notes to Consolidated Financial Statements 53 The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” 45 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Alphabet Inc. (the Company) as of December 31, 2016 and 2017 , the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017 , and the related notes and financial statement schedule listed in the Index at Item 15(a)2 (collectively referred to as the “financial statements”). In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company at December 31, 2016 and 2017 , and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2017 , in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report February 5, 2018 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ Ernst & Young LLP We have served as the Company's auditor since 1999. San Jose, California February 5, 2018 46 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on Internal Control over Financial Reporting We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2017 , based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Alphabet Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2017 , based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated balance sheets of the Company as of December 31, 2016 and 2017 , and the related consolidated statements of income, comprehensive income, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2017 , and the related notes and financial statement schedule listed in the Index at Item 15(a)2, of the Company and our report dated February 5, 2018 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitation of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California February 5, 2018 47 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share and par value amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2016 As of December 31, 2017 Assets Current assets: Cash and cash equivalents $ 12,918 $ 10,715 Marketable securities 73,415 91,156 Total cash, cash equivalents, and marketable securities 86,333 101,871 Accounts receivable, net of allowance of $467 and $674 14,137 18,336 Income taxes receivable, net 95 369 Inventory 268 749 Other current assets 4,575 2,983 Total current assets 105,408 124,308 Non-marketable investments 5,878 7,813 Deferred income taxes 383 680 Property and equipment, net 34,234 42,383 Intangible assets, net 3,307 2,692 Goodwill 16,468 16,747 Other non-current assets 1,819 2,672 Total assets $ 167,497 $ 197,295 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 2,041 $ 3,137 Accrued compensation and benefits 3,976 4,581 Accrued expenses and other current liabilities 6,144 10,177 Accrued revenue share 2,942 3,975 Deferred revenue 1,099 1,432 Income taxes payable, net 554 881 Total current liabilities 16,756 24,183 Long-term debt 3,935 3,969 Deferred revenue, non-current 202 340 Income taxes payable, non-current 4,677 12,812 Deferred income taxes 226 430 Other long-term liabilities 2,665 3,059 Total liabilities 28,461 44,793 Commitments and Contingencies (Note 10) Stockholders’ equity: Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 691,293 (Class A 296,992, Class B 47,437, Class C 346,864) and 694,783 (Class A 298,470, Class B 46,972, Class C 349,341) shares issued and outstanding 36,307 40,247 Accumulated other comprehensive loss (2,402 ) (992 ) Retained earnings 105,131 113,247 Total stockholders’ equity 139,036 152,502 Total liabilities and stockholders’ equity $ 167,497 $ 197,295 See accompanying notes. 48 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2015 2016 2017 Revenues $ 74,989 $ 90,272 $ 110,855 Costs and expenses: Cost of revenues 28,164 35,138 45,583 Research and development 12,282 13,948 16,625 Sales and marketing 9,047 10,485 12,893 General and administrative 6,136 6,985 6,872 European Commission fine 0 0 2,736 Total costs and expenses 55,629 66,556 84,709 Income from operations 19,360 23,716 26,146 Other income (expense), net 291 434 1,047 Income before income taxes 19,651 24,150 27,193 Provision for income taxes 3,303 4,672 14,531 Net income $ 16,348 $ 19,478 $ 12,662 Less: Adjustment Payment to Class C capital stockholders 522 0 0 Net income available to all stockholders $ 15,826 $ 19,478 $ 12,662 Basic net income per share of Class A and B common stock $ 23.11 $ 28.32 $ 18.27 Basic net income per share of Class C capital stock $ 24.63 $ 28.32 $ 18.27 Diluted net income per share of Class A and B common stock $ 22.84 $ 27.85 $ 18.00 Diluted net income per share of Class C capital stock $ 24.34 $ 27.85 $ 18.00 See accompanying notes. 49 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2015 2016 2017 Net income $ 16,348 $ 19,478 $ 12,662 Other comprehensive income (loss): Change in foreign currency translation adjustment (1,067 ) (599 ) 1,543 Available-for-sale investments: Change in net unrealized gains (losses) (715 ) (314 ) 307 Less: reclassification adjustment for net (gains) losses included in net income 208 221 105 Net change (net of tax effect of $29, $0, and $0) (507 ) (93 ) 412 Cash flow hedges: Change in net unrealized gains (losses) 676 515 (638 ) Less: reclassification adjustment for net (gains) losses included in net income (1,003 ) (351 ) 93 Net change (net of tax effect of $115, $64, and $247) (327 ) 164 (545 ) Other comprehensive income (loss) (1,901 ) (528 ) 1,410 Comprehensive income $ 14,447 $ 18,950 $ 14,072 See accompanying notes. 50 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2014 680,172 $ 28,767 $ 27 $ 75,066 $ 103,860 Common and capital stock issued 8,714 664 0 0 664 Stock-based compensation expense 0 5,151 0 0 5,151 Stock-based compensation tax benefits 0 815 0 0 815 Tax withholding related to vesting of restricted stock units 0 (2,779 ) 0 0 (2,779 ) Repurchases of capital stock (2,391 ) (111 ) 0 (1,669 ) (1,780 ) Adjustment Payment to Class C capital stockholders 853 475 0 (522 ) (47 ) Net income 0 0 0 16,348 16,348 Other comprehensive loss 0 0 (1,901 ) 0 (1,901 ) Balance as of December 31, 2015 687,348 32,982 (1,874 ) 89,223 120,331 Cumulative effect of accounting change 0 180 0 (133 ) 47 Common and capital stock issued 9,106 298 0 0 298 Stock-based compensation expense 0 6,700 0 0 6,700 Tax withholding related to vesting of restricted stock units 0 (3,597 ) 0 0 (3,597 ) Repurchases of capital stock (5,161 ) (256 ) 0 (3,437 ) (3,693 ) Net income 0 0 0 19,478 19,478 Other comprehensive loss 0 0 (528 ) 0 (528 ) Balance as of December 31, 2016 691,293 36,307 (2,402 ) 105,131 139,036 Cumulative effect of accounting change 0 0 0 (15 ) (15 ) Common and capital stock issued 8,652 212 0 0 212 Stock-based compensation expense 0 7,694 0 0 7,694 Tax withholding related to vesting of restricted stock units 0 (4,373 ) 0 0 (4,373 ) Repurchases of capital stock (5,162 ) (315 ) 0 (4,531 ) (4,846 ) Sale of subsidiary shares 0 722 0 0 722 Net income 0 0 0 12,662 12,662 Other comprehensive income 0 0 1,410 0 1,410 Balance as of December 31, 2017 694,783 $ 40,247 $ (992 ) $ 113,247 $ 152,502 See accompanying notes. 51 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2015 2016 2017 Operating activities Net income $ 16,348 $ 19,478 $ 12,662 Adjustments: Depreciation and impairment of property and equipment 4,132 5,267 6,103 Amortization and impairment of intangible assets 931 877 812 Stock-based compensation expense 5,203 6,703 7,679 Deferred income taxes (179 ) (38 ) 258 Loss on marketable and non-marketable investments, net 334 275 194 Other 212 174 137 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable (2,094 ) (2,578 ) (3,768 ) Income taxes, net (179 ) 3,125 8,211 Other assets (318 ) 312 (2,164 ) Accounts payable 203 110 731 Accrued expenses and other liabilities 1,597 1,515 4,891 Accrued revenue share 339 593 955 Deferred revenue 43 223 390 Net cash provided by operating activities 26,572 36,036 37,091 Investing activities Purchases of property and equipment (9,950 ) (10,212 ) (13,184 ) Proceeds from disposals of property and equipment 35 240 99 Purchases of marketable securities (74,368 ) (84,509 ) (92,195 ) Maturities and sales of marketable securities 62,905 66,895 73,959 Purchases of non-marketable investments (2,326 ) (1,109 ) (1,745 ) Maturities and sales of non-marketable investments 154 494 533 Cash collateral related to securities lending (350 ) (2,428 ) 0 Investments in reverse repurchase agreements 425 450 0 Acquisitions, net of cash acquired, and purchases of intangible assets (236 ) (986 ) (287 ) Proceeds from collection of notes receivable 0 0 1,419 Net cash used in investing activities (23,711 ) (31,165 ) (31,401 ) Financing activities Net payments related to stock-based award activities (2,375 ) (3,304 ) (4,166 ) Adjustment Payment to Class C capital stockholders (47 ) 0 0 Repurchases of capital stock (1,780 ) (3,693 ) (4,846 ) Proceeds from issuance of debt, net of costs 13,705 8,729 4,291 Repayments of debt (13,728 ) (10,064 ) (4,377 ) Proceeds from sale of subsidiary shares 0 0 800 Net cash used in financing activities (4,225 ) (8,332 ) (8,298 ) Effect of exchange rate changes on cash and cash equivalents (434 ) (170 ) 405 Net decrease in cash and cash equivalents (1,798 ) (3,631 ) (2,203 ) Cash and cash equivalents at beginning of period 18,347 16,549 12,918 Cash and cash equivalents at end of period $ 16,549 $ 12,918 $ 10,715 Supplemental disclosures of cash flow information Cash paid for taxes, net of refunds $ 3,651 $ 1,643 $ 6,191 Cash paid for interest, net of amounts capitalized $ 96 $ 84 $ 84 See accompanying notes. 52 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. In 2015, we implemented a holding company reorganization, and as a result, Alphabet Inc. (Alphabet) became the successor issuer to Google. We generate revenues primarily by delivering relevant, cost-effective online advertising. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and entities consolidated under the variable interest and voting models. All intercompany balances and transactions have been eliminated. Use of Estimates Preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, and contingent liabilities, among others. We base our estimates on assumptions, both historical and forward looking, that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Revenue Recognition We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. See Note 2 for further discussion on Revenues. Cost of Revenues Cost of revenues consists of TAC and other costs of revenues. TAC represents the amounts paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. Other costs of revenues (which is the cost of revenues excluding TAC) include the following: • Amortization of certain intangible assets; • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Credit card and other transaction fees related to processing customer transactions; • Expenses associated with our data centers and other operations (including bandwidth, compensation expense (including SBC), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. Stock-based Compensation Stock-based compensation primarily consists of Alphabet restricted stock units (RSUs). RSUs are equity classified and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period and account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the applicable statutory tax withholding to be paid by us on behalf of our employees. As a result, fewer shares are issued than the number of RSUs outstanding. We record a liability for the tax withholding to be paid by us as a reduction to additional paid-in capital. Additionally, stock-based compensation includes other types of stock-based awards that may be settled in the stock of our subsidiaries or in cash. Certain awards are liability classified and are remeasured at fair value through settlement. Performance Fees We have compensation arrangements with payouts based on investment returns. We recognize compensation expense based on the estimated payouts. The amounts are recorded in general and administrative expenses and were not material for the years ended December 31, 2015 , 2016 , and 2017 . Certain Risks and Concentrations Our revenues are primarily derived from online advertising, the market for which is highly competitive and rapidly changing. In addition, our revenues are generated from a multitude of vertical market segments in countries around the world. Significant changes in this industry or changes in customer buying or advertiser spending behavior could adversely affect our operating results. We are subject to concentrations of credit risk principally from cash and cash equivalents, marketable securities, foreign exchange contracts, and accounts receivable. Cash equivalents and marketable securities consist primarily of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, mortgage-backed securities, and asset-backed securities. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. We perform ongoing evaluations to determine customer credit and we limit the amount of credit we extend. We generally do not require collateral from our customers. We maintain reserves for estimated credit losses and these losses have generally been within our expectations. No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2015 , 2016 , or 2017 . In 2015 , 2016 , and 2017 , we generated approximately 46% , 47% , and 47% of our revenues, respectively, from customers based in the U.S. See Note 2 for further details. Fair Value of Financial Instruments Our financial assets and liabilities that are measured at fair value on a recurring basis include cash equivalents, marketable securities, derivative contracts, and non-marketable debt securities. Our financial assets that are measured at fair value on a nonrecurring basis when impairment is identified or assets are held for sale include long-lived assets and non-marketable equity securities. Other financial assets and liabilities are carried at cost with fair value disclosed, if required. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Include other inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash, Cash Equivalents, and Marketable Securities We invest all excess cash primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. 53 Table of Contents Alphabet Inc. We classify all investments that are readily convertible to known amounts of cash and have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities. We determine the appropriate classification of our investments in marketable securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these securities prior to their stated maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities in the Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for unrealized losses determined to be other-than-temporary, which we record within other income (expense), net. We determine any realized gains or losses on the sale of marketable securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Non-Marketable Investments We account for non-marketable equity investments either under the equity or cost method. Investments through which we exercise significant influence but do not have control over the investee are accounted for under the equity method. Investments through which we are not able to exercise significant influence over the investee are accounted for under the cost method. We classify non-marketable investments as non-current assets on the Consolidated Balance Sheet as those investments do not have stated contractual maturity dates. We account for our non-marketable investments that meet the definition of a debt security as available-for-sale securities. Variable Interest Entities We determine at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests in is considered a Variable Interest Entity (VIE). We consolidate VIEs when we are deemed to be the primary beneficiary. The primary beneficiary of a VIE is the party that meets both of the following criteria: (1) has the power to make decisions that most significantly affect the economic performance of the VIE; and (2) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. Periodically, we determine whether any changes in our interest or relationship with the entity impact our determination of whether the entity is still a VIE and, if so, whether we are the primary beneficiary. If we are not deemed to be the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Impairment of Investments We periodically review our investments for impairment. If we conclude that any of these investments are impaired, we determine whether such impairment is other-than-temporary. Factors we consider to make such determination include the duration and severity of the impairment, the reason for the decline in value and the potential recovery period and our intent to sell. For debt securities, we also consider whether (1) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis, and (2) the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the asset to its fair value and record the corresponding charge as other income (expense), net. Accounts Receivable We record accounts receivable at the invoiced amount. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables. We review the accounts receivable by amounts due by customers which are past due to identify specific customers with known disputes or collectability issues. In determining the amount of the reserve, we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. We also maintain a sales allowance to reserve for potential credits issued to customers. We determine the amount of the reserve based on historical credits issued. Property and Equipment We account for property and equipment at cost less accumulated depreciation. We compute depreciation using the straight-line method over the estimated useful lives of the assets. We depreciate buildings over periods up to 25 years. We generally depreciate information technology assets over periods up to 7 years. We depreciate leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed in service for 54 Table of Contents Alphabet Inc. our intended use. Depreciation for equipment, buildings, and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of our acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the fair values of these identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment, long-term prepayments and intangible assets, excluding goodwill, for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets are not recoverable, the impairment recognized is measured as the amount by which the carrying value of the asset exceeds its fair value. Intangible asset impairments were not material in 2015, 2016, or 2017. We allocate goodwill to reporting units based on the expected benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. No goodwill impairment occurred in 2015, 2016, or 2017. Intangible assets with definite lives are amortized over their estimated useful lives. We amortize intangible assets on a straight-line basis with definite lives over periods ranging from one to twelve years. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more likely than not that they will not be realized. We recognize the financial statement effects of a tax position when it is more likely than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Foreign Currency Generally, the functional currency of our international subsidiaries is the local currency. We translate the financial statements of these subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record 55 Table of Contents Alphabet Inc. translation gains and losses in accumulated other comprehensive income as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange losses in other income (expense), net. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2015 , 2016 and 2017 , advertising and promotional expenses totaled approximately $3.2 billion , $3.9 billion , and $5.1 billion , respectively. Recent Accounting Pronouncements Recently issued accounting pronouncements not yet adopted In January 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-01 (ASU 2016-01) "Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities." ASU 2016-01 amends various aspects of the recognition, measurement, presentation, and disclosure of financial instruments. The most significant impact to our consolidated financial statements relates to the recognition and measurement of equity investments at fair value in our consolidated statements of income. We have elected to use the measurement alternative, defined as cost, less impairments, adjusted by observable price changes. We anticipate that the adoption of ASU 2016-01 will increase the volatility of our other income (expense), net, as a result of the remeasurement of our equity securities upon the occurrence of observable price changes and impairments. We will adopt ASU 2016-01 effective January 1, 2018. In February 2016, the FASB issued Accounting Standards Update No. 2016-02 (Topic 842) "Leases." Topic 842 supersedes the lease recognition requirements in Accounting Standards Codification (ASC) Topic 840, "Leases." Under Topic 842, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures. Leases will continue to be classified as either finance or operating. As currently issued, entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in the financial statements. There are additional optional practical expedients that an entity may elect to apply. We anticipate that the adoption of Topic 842 will materially affect our Consolidated Balance Sheets. We are in the process of implementing changes to our systems and processes in conjunction with our review of existing lease agreements. We will adopt Topic 842 effective January 1, 2019 and expect to elect certain available transitional practical expedients. In June 2016, the FASB issued Accounting Standards Update No. 2016-13 (ASU 2016-13) "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. ASU 2016-13 replaces the existing incurred loss impairment model with an expected loss methodology, which will result in more timely recognition of credit losses. ASU 2016-13 is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2019. We are currently in the process of evaluating the impact of the adoption of ASU 2016-13 on our consolidated financial statements. In October 2016, the FASB issued Accounting Standards Update No. 2016-16 (ASU 2016-16) "Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other than Inventory." ASU 2016-16 generally accelerates the recognition of income tax consequences for asset transfers between entities under common control. Entities are required to adopt using a modified retrospective approach with a cumulative adjustment to opening retained earnings in the year of adoption for previously unrecognized income tax expense. We anticipate a retained earnings adjustment of approximately $700 million upon adoption related to the unrecognized income tax effects of asset transfers that occurred prior to adoption. We will adopt ASU 2016-16 effective January 1, 2018. In January 2017, the FASB issued Accounting Standards Update No. 2017-04 (ASU 2017-04) “Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” ASU 2017-04 eliminates step two of the goodwill impairment test and specifies that goodwill impairment should be measured by comparing the fair value of a reporting unit with its carrying amount. Additionally, the amount of goodwill allocated to each reporting unit with a zero or negative carrying amount of net assets should be disclosed. ASU 2017-04 is effective for annual or interim goodwill impairment tests performed in fiscal years beginning after December 15, 2019; early adoption is permitted. We currently do not anticipate that the adoption of ASU 2017-04 will have a material impact on our consolidated financial statements. Recently adopted accounting pronouncements In May 2014, the FASB issued Accounting Standards Update No. 2014-09 (Topic 606) "Revenue from Contracts with Customers." Topic 606 supersedes the revenue recognition requirements in Topic 605 “Revenue 56 Table of Contents Alphabet Inc. Recognition” (Topic 605), and requires entities to recognize revenues when control of the promised goods or services is transferred to customers at an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. We adopted Topic 606 as of January 1, 2017 using the modified retrospective transition method. See Note 2 for further details. In January 2017, the FASB issued Accounting Standards Update No. 2017-01 (ASU 2017-01) “Business Combinations (Topic 805): Clarifying the Definition of a Business.” ASU 2017-01 provides guidance to evaluate whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. If substantially all of the fair value of the gross assets acquired (or disposed of) is concentrated in a single asset or a group of similar assets, the assets acquired (or disposed of) are not considered a business. We adopted ASU 2017-01 as of January 1, 2017 on a prospective basis and there was no material impact to our consolidated financial statements. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. Note 2. Revenues Adoption of ASC Topic 606, "Revenue from Contracts with Customers" On January 1, 2017 , we adopted Topic 606 using the modified retrospective method applied to those contracts which were not completed as of January 1, 2017 . Results for reporting periods beginning after January 1, 2017 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under Topic 605. We recorded a net reduction to opening retained earnings of $15 million , net of tax, as of January 1, 2017 due to the cumulative impact of adopting Topic 606, with the impact primarily related to our non-advertising revenues. The impact to revenues as a result of applying Topic 606 was an increase of $34 million for the twelve months ended December 31, 2017 . Revenue Recognition Revenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. The following table presents our revenues disaggregated by revenue source (in millions). Sales and usage-based taxes are excluded from revenues. Twelve Months Ended December 31, 2015 (1) 2016 (1) 2017 Google properties $ 52,357 $ 63,785 $ 77,788 Google Network Members' properties 15,033 15,598 17,587 Google advertising revenues 67,390 79,383 95,375 Google other revenues 7,154 10,080 14,277 Other Bets revenues 445 809 1,203 Total revenues (2) $ 74,989 $ 90,272 $ 110,855 (1) As noted above, prior period amounts have not been adjusted under the modified retrospective method. (2) Revenues include hedging gains (losses) of $1.4 billion , $539 million , and $(169) million for the years ended December 31, 2015 , 2016 , and 2017 , respectively, which do not represent revenues recognized from contracts with customers. 57 Table of Contents Alphabet Inc. The following table presents our revenues disaggregated by geography, based on the billing addresses of our customers (in millions): Twelve Months Ended December 31, 2015 2016 2017 United States $ 34,810 $ 42,781 $ 52,449 EMEA (1) 26,368 30,304 36,046 APAC (1) 9,887 12,559 16,235 Other Americas (1) 3,924 4,628 6,125 Total revenues (2) $ 74,989 $ 90,272 $ 110,855 (1) Regions represent Europe, the Middle East, and Africa (EMEA); Asia-Pacific (APAC); and Canada and Latin America (Other Americas). (2) Revenues include hedging gains (losses) for the the years ended December 31, 2015 , 2016 , and 2017 . Advertising Revenues We generate revenues primarily by delivering advertising on Google properties and Google Network Members’ properties. Google properties revenues consist primarily of advertising revenues generated on Google.com, the Google Search app, and other Google owned and operated properties like Gmail, Google Maps, Google Play, and YouTube. Google Network Members’ properties revenues consist primarily of advertising revenues generated on Google Network Members’ properties. Our customers generally purchase advertising inventory through AdWords, DoubleClick AdExchange, and DoubleClick Bid Manager, among others. Most of our customers pay us on a cost-per-click basis (CPC), which means that an advertiser pays us only when a user clicks on an ad on Google properties or Google Network Members' properties or views certain YouTube engagement ads. For these customers, we recognize revenue each time a user clicks on the ad or when a user views the ad for a specified period of time. We also offer advertising on other bases such as cost-per-impression (CPM), which means an advertiser pays us based on the number of times their ads are displayed on Google properties or Google Network Members’ properties. For these customers, we recognize revenue each time an ad is displayed. Certain customers may receive cash-based incentives or credits, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenues recognized. We believe that there will not be significant changes to our estimates of variable consideration. For ads placed on Google Network Members’ properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues for ads placed on Google Network Members’ properties on a gross basis, that is, the amounts billed to our customers are recorded as revenues, and amounts paid to Google Network Members are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers, and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. Other Revenues Google other revenues and Other Bets revenues consist primarily of revenues from: • Apps, in-app purchases, and digital content in the Google Play store; • Google Cloud offerings; • Hardware; and • Other miscellaneous products and services. As it relates to Google other revenues, the most significant judgment is determining whether we are the principal or agent for app sales and in-app purchases through the Google Play store. We report revenues from these transactions on a net basis because our performance obligation is to facilitate a transaction between app developers and end users, 58 Table of Contents Alphabet Inc. for which we earn a commission. Consequently, the portion of the gross amount billed to end users that is remitted to app developers is not reflected as revenues. Arrangements with Multiple Performance Obligations Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenues to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers or using expected cost plus margin. Deferred Revenues We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. The increase in the deferred revenue balance for the twelve months ended December 31, 2017 is primarily driven by cash payments received or due in advance of satisfying our performance obligations, offset by $985 million of revenues recognized that were included in the deferred revenue balance as of December 31, 2016 . Our payment terms vary by the type and location of our customer and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customer types, we require payment before the products or services are delivered to the customer. Practical Expedients and Exemptions We generally expense sales commissions when incurred because the amortization period would have been one year or less. These costs are recorded within sales and marketing expenses. We do not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. Note 3. Financial Instruments We classify our cash equivalents and marketable securities within Level 1 or Level 2 in the fair value hierarchy because we use quoted market prices or alternative pricing sources and models utilizing market observable inputs to determine their fair value. We classify our foreign currency and interest rate derivative contracts primarily within Level 2 in the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments. 59 Table of Contents Alphabet Inc. Cash, Cash Equivalents, and Marketable Securities The following tables summarize our cash, cash equivalents and marketable securities by significant investment categories as of December 31, 2016 and 2017 (in millions): As of December 31, 2016 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Cash $ 7,078 $ 0 $ 0 $ 7,078 $ 7,078 $ 0 Level 1: Money market and other funds 4,783 0 0 4,783 4,783 0 U.S. government notes 38,454 46 (215 ) 38,285 613 37,672 Marketable equity securities 160 133 0 293 0 293 43,397 179 (215 ) 43,361 5,396 37,965 Level 2: Time deposits (1) 142 0 0 142 140 2 Mutual funds (2) 204 7 0 211 0 211 U.S. government agencies 1,826 0 (11 ) 1,815 300 1,515 Foreign government bonds 2,345 18 (7 ) 2,356 0 2,356 Municipal securities 4,757 15 (65 ) 4,707 2 4,705 Corporate debt securities 12,993 114 (116 ) 12,991 2 12,989 Mortgage-backed securities 12,006 26 (216 ) 11,816 0 11,816 Asset-backed securities 1,855 2 (1 ) 1,856 0 1,856 36,128 182 (416 ) 35,894 444 35,450 Total $ 86,603 $ 361 $ (631 ) $ 86,333 $ 12,918 $ 73,415 As of December 31, 2017 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Cash $ 7,158 $ 0 $ 0 $ 7,158 $ 7,158 $ 0 Level 1: Money market and other funds 1,833 0 0 1,833 1,833 0 U.S. government notes 37,256 2 (310 ) 36,948 1,241 35,707 Marketable equity securities 242 100 (2 ) 340 0 340 39,331 102 (312 ) 39,121 3,074 36,047 Level 2: Time deposits (1) 359 0 0 359 357 2 Mutual funds (2) 232 20 0 252 0 252 U.S. government agencies 3,713 0 (29 ) 3,684 0 3,684 Foreign government bonds 2,948 6 (14 ) 2,940 0 2,940 Municipal securities 7,631 2 (53 ) 7,580 0 7,580 Corporate debt securities 24,269 21 (135 ) 24,155 126 24,029 Mortgage-backed securities 11,157 9 (163 ) 11,003 0 11,003 Asset-backed securities 5,632 4 (17 ) 5,619 0 5,619 55,941 62 (411 ) 55,592 483 55,109 Total $ 102,430 $ 164 $ (723 ) $ 101,871 $ 10,715 $ 91,156 (1) The majority of our time deposits are foreign deposits. (2) The fair value option was elected for mutual funds with gains (losses) recognized in other income (expense), net. We determine realized gains or losses on the sale of marketable securities on a specific identification method. We recognized gross realized gains of $357 million , $272 million , and $207 million for the years ended December 31, 2015 , 2016 , and 2017 , respectively. We recognized gross realized losses of $565 million , $482 million , and $287 million 60 Table of Contents Alphabet Inc. for the years ended December 31, 2015 , 2016 , and 2017 , respectively. We reflect these gains and losses as a component of other income (expense), net, in the Consolidated Statements of Income. The following table summarizes the estimated fair value of our investments in marketable debt securities, accounted for as available-for-sale securities and classified by the contractual maturity date of the securities (in millions): As of December 31, 2017 Due in 1 year $ 19,486 Due in 1 year through 5 years 56,056 Due in 5 years through 10 years 2,676 Due after 10 years 12,346 Total $ 90,564 Impairment Considerations for Marketable Investments The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2016 and 2017 , aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2016 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. government notes $ 26,411 $ (215 ) $ 0 $ 0 $ 26,411 $ (215 ) U.S. government agencies 1,014 (11 ) 0 0 1,014 (11 ) Foreign government bonds 956 (7 ) 0 0 956 (7 ) Municipal securities 3,461 (63 ) 46 (2 ) 3,507 (65 ) Corporate debt securities 6,184 (111 ) 166 (5 ) 6,350 (116 ) Mortgage-backed securities 10,184 (206 ) 259 (10 ) 10,443 (216 ) Asset-backed securities 391 (1 ) 0 0 391 (1 ) Total $ 48,601 $ (614 ) $ 471 $ (17 ) $ 49,072 $ (631 ) As of December 31, 2017 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss U.S. government notes $ 18,325 $ (134 ) $ 16,136 $ (176 ) $ 34,461 $ (310 ) U.S. government agencies 2,913 (22 ) 767 (7 ) 3,680 (29 ) Foreign government bonds 1,932 (8 ) 342 (6 ) 2,274 (14 ) Municipal securities 5,666 (47 ) 415 (6 ) 6,081 (53 ) Corporate debt securities 18,300 (114 ) 1,710 (21 ) 20,010 (135 ) Mortgage-backed securities 7,261 (89 ) 3,314 (74 ) 10,575 (163 ) Asset-backed securities 3,800 (16 ) 135 (1 ) 3,935 (17 ) Marketable equity securities 39 (2 ) 0 0 39 (2 ) Total $ 58,236 $ (432 ) $ 22,819 $ (291 ) $ 81,055 $ (723 ) During the years ended December 31, 2016 and 2017 , there were no other-than-temporary impairment losses. During the year ended December 31, 2015 , we recognized $281 million of other-than-temporary impairment losses related to our marketable equity securities and fixed-income bond funds. Those losses are included in gain (loss) on marketable securities, net as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 7 for further details on other income (expense), net. Derivative Financial Instruments We recognize derivative instruments as either assets or liabilities in the Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the Consolidated Statements of 61 Table of Contents Alphabet Inc. Income as either other income (expense), net, or revenues, or in the Consolidated Balance Sheets in accumulated other comprehensive income (AOCI), as discussed below. We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. We also use interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and debt issuances. Our program is not used for trading or speculative purposes. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further reduce credit risk, we enter into collateral security arrangements under which the counterparty is required to provide collateral when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We can take possession of the collateral in the event of counterparty default. As of December 31, 2016 and 2017 , we received cash collateral related to the derivative instruments under our collateral security arrangements of $362 million and $15 million , respectively. Cash Flow Hedges We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options), designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar and at times we use interest rate swaps to effectively lock interest rates on anticipated debt issuances. These transactions are designated as cash flow hedges. The notional principal of these contracts was approximately $10.7 billion and $11.7 billion as of December 31, 2016 and 2017 , respectively. These contracts have maturities of 2 years or less. We reflect the gains or losses on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify cumulative gains and losses to revenues or interest expense when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI are immediately reclassified to other income (expense), net. For foreign currency collars, we include the change in time value in our assessment of hedge effectiveness. For other foreign currency options and forward contracts, we exclude the change in the forward points and time value from our assessment of hedge effectiveness. We recognize changes of the excluded components in other income (expense), net. As of December 31, 2017 , the effective portion of our cash flow hedges before tax effect was a net accumulated loss of $187 million , of which a net loss of $219 million is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. We exclude changes in forward points for forward contracts from the assessment of hedge effectiveness. The notional principal of these contracts was $2.4 billion and $2.9 billion as of December 31, 2016 and 2017 , respectively. Gains and losses on these forward contracts are recognized in other income (expense), net, along with the offsetting gains and losses of the related hedged items. Other Derivatives Other derivatives not designated as hedging instruments consist of foreign currency forward contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts, as well as the related costs in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. The notional principal of the outstanding foreign exchange contracts was $7.9 billion and $15.2 billion as of December 31, 2016 and 2017 , respectively. 62 Table of Contents Alphabet Inc. The fair values of our outstanding derivative instruments were as follows (in millions): As of December 31, 2016 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 539 $ 57 $ 596 Total $ 539 $ 57 $ 596 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 4 $ 9 $ 13 Total $ 4 $ 9 $ 13 As of December 31, 2017 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 51 $ 29 $ 80 Total $ 51 $ 29 $ 80 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 230 $ 122 $ 352 Total $ 230 $ 122 $ 352 The effect of derivative instruments in cash flow hedging relationships on income and other comprehensive income (OCI) is summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect (Effective Portion) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship 2015 2016 2017 Foreign exchange contracts $ 964 $ 773 $ (955 ) Gains (Losses) Reclassified from AOCI into Income (Effective Portion) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship Location 2015 2016 2017 Foreign exchange contracts Revenues $ 1,399 $ 539 $ (169 ) Interest rate contracts Other income (expense), net 5 5 5 Total $ 1,404 $ 544 $ (164 ) 63 Table of Contents Alphabet Inc. Gains (Losses) Recognized in Income on Derivatives (Amount Excluded from  Effectiveness Testing and Ineffective Portion) (1) Year Ended December 31, Derivatives in Cash Flow Hedging Relationship Location 2015 2016 2017 Foreign exchange contracts Other income (expense), net $ (297 ) $ (381 ) $ 83 (1) Gains (losses) related to the ineffective portion of the hedges were not material in all periods presented. The effect of derivative instruments in fair value hedging relationships on income is summarized below (in millions): Gains (Losses) Recognized in Income on Derivatives (2) Year Ended December 31, Derivatives in Fair Value Hedging Relationship Location 2015 2016 2017 Foreign Exchange Hedges: Foreign exchange contracts Other income (expense), net $ 170 $ 145 $ (174 ) Hedged item Other income (expense), net (176 ) (139 ) 197 Total $ (6 ) $ 6 $ 23 (2) Amounts excluded from effectiveness testing and the ineffective portion of the fair value hedging relationships were not material in all periods presented. The effect of derivative instruments not designated as hedging instruments on income is summarized below (in millions): Gains (Losses) Recognized in Income on Derivatives Year Ended December 31, Derivatives Not Designated As Hedging Instruments Location 2015 2016 2017 Foreign exchange contracts Other income (expense), net $ 198 $ 130 $ (230 ) Offsetting of Derivatives We present our forwards and purchased options at gross fair values in the Consolidated Balance Sheets. For foreign currency collars, we present at net fair values where both purchased and written options are with the same counterparty. Our master netting and other similar arrangements allow net settlements under certain conditions. As of December 31, 2016 and 2017 , information related to these offsetting arrangements were as follows (in millions): 64 Table of Contents Alphabet Inc. Offsetting of Assets As of December 31, 2016 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 596 $ 0 $ 596 $ (11 ) (1) $ (337 ) $ (73 ) $ 175 As of December 31, 2017 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 102 $ (22 ) $ 80 $ (64 ) (1) $ (4 ) $ (2 ) $ 10 (1) The balances as of December 31, 2016 and 2017 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. Offsetting of Liabilities As of December 31, 2016 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 13 $ 0 $ 13 $ (11 ) (2) $ 0 $ 0 $ 2 As of December 31, 2017 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 374 $ (22 ) $ 352 $ (64 ) (2) $ 0 $ 0 $ 288 (2) The balances as of December 31, 2016 and 2017 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 4. Non-Marketable Investments Our non-marketable investments include non-marketable equity investments and non-marketable debt securities. Non-Marketable Equity Investments Our non-marketable equity investments are investments in privately-held companies accounted for under the equity or cost method and are not required to be consolidated under the variable interest or voting models. As of December 31, 2016 and 2017 , investments accounted for under the equity method had a carrying value of approximately $1.7 billion and $1.4 billion , respectively. Our share of gains and losses in equity method investments including impairment was a net loss of $227 million , $202 million , and $156 million for the years ended December 31, 2015 , 2016 , and 2017 , respectively. As of December 31, 2016 and 2017 , investments accounted for under the cost method had a carrying value of $3.0 billion and $4.5 billion , respectively, and a fair value of approximately $8.1 billion and $8.8 billion , respectively. The fair value of the cost method investments are primarily determined from data leveraging private-market transactions and are classified within Level 3 in the fair value hierarchy. We reflect our share of equity 65 Table of Contents Alphabet Inc. method investee earnings and losses and impairments of non-marketable equity investments as a component of other income (expense), net, in the Consolidated Statements of Income. Non-Marketable Debt Securities Our non-marketable debt securities are primarily preferred stock that are redeemable at our option and convertible notes issued by private companies and measured at fair value as available for sale debt securities. The cost of these securities was $1.1 billion as of December 31, 2016 and 2017 . These debt securities do not have readily determinable market values and are categorized accordingly as Level 3 in the fair value hierarchy. To estimate the fair value of these securities, we use a combination of valuation methodologies, including market and income approaches based on prior transaction prices; estimated timing, probability, and amount of cash flows; and illiquidity considerations. Financial information of private companies may not be available and consequently we estimate the value based on the best available information at the measurement date. The following table presents a reconciliation for our non-marketable debt securities measured and recorded at fair value on a recurring basis, using significant unobservable inputs (Level 3) (in millions): Year Ended December 31, 2016 2017 Beginning balance $ 1,024 $ 1,165 Total net gains (losses) Included in earnings 0 (10 ) Included in other comprehensive income 106 707 Purchases 78 88 Sales (18 ) (2 ) Settlements (25 ) (54 ) Ending balance $ 1,165 $ 1,894 Note 5. Variable Interest Entities (VIEs) Consolidated VIEs We consolidate VIEs in which we hold a variable interest and are the primary beneficiary. The results of operations and statements of financial position of these VIEs are included in our consolidated financial statements. For certain consolidated VIEs, their assets are not available to us and their creditors do not have recourse to us. As of December 31, 2016 and 2017 , assets that can only be used to settle obligations of these VIEs were $1.1 billion and $1.7 billion , respectively, and the liabilities for which creditors do not have recourse to us were $668 million and $997 million , respectively. Calico Calico is a life science company with a mission to harness advanced technologies to increase our understanding of the biology that controls lifespan. As of December 31, 2017 , we have contributed $240 million to Calico in exchange for Calico convertible preferred units and are committed to fund an additional $490 million on an as-needed basis. In September 2014, AbbVie Inc. (AbbVie) and Calico announced a research and development collaboration agreement intended to help both companies discover, develop, and bring to market new therapies for patients with age-related diseases, including neurodegeneration and cancer. As of December 31, 2017 , AbbVie has contributed $750 million to fund the collaboration pursuant to the agreement, which reflects its total commitment. As of December 31, 2017 , Calico has contributed $ 250 million and committed up to an additional $ 500 million . Calico has used its scientific expertise to establish a world-class research and development facility, with a focus on drug discovery and early drug development; and AbbVie provides scientific and clinical development support and its commercial expertise to bring new discoveries to market. Both companies share costs and profits equally. AbbVie's contribution has been recorded as a liability on Calico's financial statements, which is reduced and reflected as a reduction to research and development expense as eligible research and development costs are incurred by Calico. Verily Verily is a life science company with a mission to make the world's health data useful so that people enjoy healthier lives. 66 Table of Contents Alphabet Inc. In January 2017 , Temasek, a Singapore-based investment company, signed a binding commitment to purchase a noncontrolling interest in Verily for an aggregate of $800 million in cash. In February 2017, the first tranche of the investment closed and we received $480 million . The second and final tranche of the investment closed in July 2017 and we received the remaining $320 million . The transaction is accounted for as an equity transaction and no gain or loss was recognized. Of the $800 million received, $78 million was recorded as noncontrolling interest and $722 million was recorded as additional paid-in capital. Noncontrolling interest and net loss attributable to noncontrolling interest were not separately presented on our consolidated financial statements as of and for the year ended December 31, 2017 as the amounts were not material. Unconsolidated VIEs Certain renewable energy investments included in our non-marketable equity investments accounted for under the equity method are VIEs. These entities' activities involve power generation using renewable sources. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly impact their economic performance such as setting operating budgets. Therefore, we do not consolidate these VIEs in our consolidated financial statements. The carrying value and maximum exposure of these VIEs were $1.2 billion and $0.9 billion as of December 31, 2016 and 2017 , respectively. The maximum exposure is based on current investments to date.  We have determined the single source of our exposure to these VIEs is our capital investment in them. Other unconsolidated VIEs were not material as of December 31, 2016 and 2017 . Note 6. Debt Short-Term Debt We have a debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2016 and December 31, 2017 , respectively. Long-Term Debt Google issued $3.0 billion of senior unsecured notes in three tranches (collectively, 2011 Notes) in May 2011, due in 2014, 2016, and 2021, as well as $1.0 billion of senior unsecured notes (2014 Notes) in February 2014 due in 2024. In April 2016, we completed an exchange offer with eligible holders of Google’s 2011 Notes due 2021 and 2014 Notes due 2024 (collectively, the Google Notes). An aggregate principal amount of approximately $1.7 billion of the Google Notes was exchanged for approximately $1.7 billion of Alphabet notes with identical interest rate and maturity. Because the exchange was between a parent and the subsidiary company and for substantially identical notes, the change was treated as a debt modification for accounting purposes with no gain or loss recognized. In August 2016, Alphabet issued $2.0 billion of senior unsecured notes (2016 Notes) due 2026. The net proceeds from the issuance of the 2016 Notes were used for general corporate purposes, including the repayment of outstanding commercial paper. The Alphabet notes due in 2021, 2024, and 2026 rank equally with each other and are structurally subordinate to the outstanding Google Notes. The total outstanding long-term debt is summarized below (in millions): As of December 31, 2016 As of December 31, 2017 3.625% Notes due on May 19, 2021 $ 1,000 $ 1,000 3.375% Notes due on February 25, 2024 1,000 1,000 1.998% Notes due on August 15, 2026 2,000 2,000 Unamortized discount for the Notes above (65 ) (57 ) Subtotal (1) $ 3,935 $ 3,943 Capital lease obligation 0 26 Total long-term debt $ 3,935 $ 3,969 (1) Includes the outstanding (and unexchanged) Google Notes issued in 2011 and 2014 and the Alphabet notes exchanged in 2016. The effective interest yields based on proceeds received from the outstanding notes due in 2021, 2024, and 2026 were 3.734% , 3.377% , and 2.231% , respectively, with interest payable semi-annually. We may redeem these notes at any time in whole or in part at specified redemption prices. The total estimated fair value of all outstanding notes 67 Table of Contents Alphabet Inc. was approximately $3.9 billion as of December 31, 2016 and $4.0 billion as of December 31, 2017 . The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. As of December 31, 2017 , the aggregate future principal payments for long-term debt including long-term capital leases for each of the next five years and thereafter are as follows (in millions): 2018 $ 0 2019 1 2020 1 2021 1,001 2022 1 Thereafter 3,022 Total $ 4,026 Credit Facility We have a $4.0 billion revolving credit facility which expires in February 2021. The interest rate for the credit facility is determined based on a formula using certain market rates. No amounts were outstanding under the credit facility as of December 31, 2016 and December 31, 2017 . Note 7. Supplemental Financial Statement Information Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2016 As of December 31, 2017 Land and buildings $ 19,804 $ 23,183 Information technology assets 16,084 21,429 Construction in progress 8,166 10,491 Leasehold improvements 3,415 4,496 Furniture and fixtures 58 48 Property and equipment, gross 47,527 59,647 Less: accumulated depreciation (13,293 ) (17,264 ) Property and equipment, net $ 34,234 $ 42,383 As of December 31, 2016 and 2017 , assets under capital lease with a cost basis of $299 million and $390 million were included in property and equipment, respectively. Note Receivable In connection with the sale of our Motorola Mobile business to Lenovo Group Limited (Lenovo) in October 2014, we received an interest-free, three -year prepayable promissory note (Note Receivable) due October 2017. The Note Receivable was included on our Consolidated Balance Sheets in other current assets as of December 31, 2016. Based on the general market conditions and the credit quality of Lenovo at the time of the sale, we discounted the Note Receivable at an effective interest rate of 4.5% . As of December 31, 2016 , the outstanding principal was $1.4 billion with an unamortized discount of $51 million , and we did not recognize a valuation allowance. The Note Receivable was fully repaid in May 2017. 68 Table of Contents Alphabet Inc. Accrued expenses and other current liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2016 As of December 31, 2017 European Commission fine (1) $ 0 $ 2,874 Accrued customer liabilities 1,256 1,489 Other accrued expenses and current liabilities 4,888 5,814 Accrued expenses and other current liabilities $ 6,144 $ 10,177 (1) Includes the effects of foreign exchange and interest. Accumulated Other Comprehensive Income (Loss) The components of AOCI, net of tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2014 $ (980 ) $ 421 $ 586 $ 27 Other comprehensive income (loss) before reclassifications (1,067 ) (715 ) 676 (1,106 ) Amounts reclassified from AOCI 0 208 (1,003 ) (795 ) Other comprehensive income (loss) (1,067 ) (507 ) (327 ) (1,901 ) Balance as of December 31, 2015 $ (2,047 ) $ (86 ) $ 259 $ (1,874 ) Other comprehensive income (loss) before reclassifications (599 ) (314 ) 515 (398 ) Amounts reclassified from AOCI 0 221 (351 ) (130 ) Other comprehensive income (loss) (599 ) (93 ) 164 (528 ) Balance as of December 31, 2016 $ (2,646 ) $ (179 ) $ 423 $ (2,402 ) Other comprehensive income (loss) before reclassifications 1,543 307 (638 ) 1,212 Amounts reclassified from AOCI 0 105 93 198 Other comprehensive income (loss) 1,543 412 (545 ) 1,410 Balance as of December 31, 2017 $ (1,103 ) $ 233 $ (122 ) $ (992 ) The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statement of Income Year Ended December 31, AOCI Components Location 2015 2016 2017 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ (208 ) $ (221 ) $ (105 ) Provision for income taxes 0 0 0 Net of tax $ (208 ) $ (221 ) $ (105 ) Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue $ 1,399 $ 539 $ (169 ) Interest rate contracts Other income (expense), net 5 5 5 Benefit (provision) for income taxes (401 ) (193 ) 71 Net of tax $ 1,003 $ 351 $ (93 ) Total amount reclassified, net of tax $ 795 $ 130 $ (198 ) 69 Table of Contents Alphabet Inc. Other Income (Expense), Net The components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2015 2016 2017 Interest income $ 999 $ 1,220 $ 1,312 Interest expense (1) (104 ) (124 ) (109 ) Foreign currency exchange losses, net (2) (422 ) (475 ) (121 ) Loss on marketable securities, net (208 ) (210 ) (80 ) Loss on non-marketable investments, net (126 ) (65 ) (114 ) Other 152 88 159 Other income (expense), net $ 291 $ 434 $ 1,047 (1) Interest expense is net of interest capitalized of $0 million , $0 million , and $48 million for the years ended December 31, 2015 , 2016 , and 2017 , respectively. (2) Our foreign currency exchange losses, net, are related to the option premium costs and forward points for our foreign currency hedging contracts, our foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contract losses and gains. The net foreign currency transaction losses were $123 million , $112 million , and $226 million for the years ended December 31, 2015 , 2016 , and 2017 , respectively. Note 8. Acquisitions 2017 Acquisitions During the year ended December 31, 2017 , we completed various acquisitions and purchases of intangible assets for total consideration of approximately $322 million . In aggregate, $12 million was cash acquired, $117 million was attributed to intangible assets, $221 million was attributed to goodwill, and $28 million was attributed to net liabilities assumed . These acquisitions generally enhance the breadth and depth of our offerings and expand our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $60 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2017 , patents and developed technology have a weighted-average useful life of 3.7 years, customer relationships have a weighted-average useful life of 2.0 years, and trade names and other have a weighted-average useful life of 8.8 years. Agreement with HTC Corporation (HTC) In January 2018, we completed the acquisition of a team of engineers and a non-exclusive license of intellectual property from HTC for $1.1 billion in cash. The transaction will be accounted for as a business combination. We expect this transaction to accelerate Google’s ongoing hardware efforts. We are currently in the process of valuing the assets acquired and liabilities assumed in the transaction. We will provide all required disclosures upon the completion of the valuation in the first quarter of 2018. 2016 Acquisitions Apigee In October 2016, we completed the acquisition of Apigee Corp., a provider of application programming interface (API) management, for approximately $571 million in cash. We expect the acquisition to accelerate our Google Cloud customers’ move to supporting their businesses with high quality digital interactions. Of the total purchase price of $571 million , $41 million was cash acquired, $127 million was attributed to intangible assets, $376 million was attributed to goodwill, and $27 million was attributed to net assets acquired . Goodwill, which was recorded in the Google segment, is primarily attributable to synergies expected to arise after the acquisition and is no t deductible for tax purposes. Other Acquisitions During the year ended December 31, 2016 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $448 million . In aggregate, $12 million was cash acquired, $143 million was attributed to intangible assets, $288 million was attributed to goodwill, and $5 million was attributed to net assets acquired . These acquisitions generally enhance the breadth and depth of our offerings, as well as expanding our 70 Table of Contents Alphabet Inc. expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $67 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2016 , patents and developed technology have a weighted-average useful life of 4.5 years, customer relationships have a weighted-average useful life of 3.4 years, and trade names and other have a weighted-average useful life of 6.2 years. Note 9. Goodwill and Other Intangible Assets Goodwill The changes in the carrying amount of goodwill allocated to our disclosed segments for the years ended December 31, 2016 and 2017 were as follows (in millions): Google Other Bets Total Consolidated Balance as of December 31, 2015 $ 15,456 $ 413 $ 15,869 Acquisitions 625 39 664 Foreign currency translation and other adjustments (54 ) (11 ) (65 ) Balance as of December 31, 2016 $ 16,027 $ 441 $ 16,468 Acquisitions 212 9 221 Foreign currency translation and other adjustments 56 2 58 Balance as of December 31, 2017 $ 16,295 $ 452 $ 16,747 Other Intangible Assets Information regarding purchased intangible assets were as follows (in millions): As of December 31, 2016 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 5,542 $ 2,710 $ 2,832 Customer relationships 352 197 155 Trade names and other 463 143 320 Total $ 6,357 $ 3,050 $ 3,307 As of December 31, 2017 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 5,260 $ 3,040 $ 2,220 Customer relationships 359 263 96 Trade names and other 544 168 376 Total $ 6,163 $ 3,471 $ 2,692 Patents and developed technology, customer relationships, and trade names and other have weighted-average remaining useful lives of 3.8 years, 1.4 years, and 4.6 years, respectively. Amortization expense relating to purchased intangible assets was $892 million , $833 million , and $796 million for the years ended December 31, 2015 , 2016 , and 2017 , respectively. 71 Table of Contents Alphabet Inc. As of December 31, 2017 , expected amortization expense relating to purchased intangible assets for each of the next five years and thereafter are as follows (in millions): 2018 $ 728 2019 615 2020 493 2021 459 2022 212 Thereafter 185 $ 2,692 Note 10. Commitments and Contingencies Operating Leases We have entered into various non-cancelable operating lease agreements for certain of our offices, facilities, land, and data centers throughout the world with lease periods expiring between 2018 and 2063 . We are committed to pay a portion of the actual operating expenses under certain of these lease agreements. These operating expenses are not included in the table below. Certain of these arrangements have free or escalating rent payment provisions. We recognize rent expense on a straight-line basis. As of December 31, 2017 , future minimum payments under operating leases having initial or remaining non-cancelable lease terms in excess of one year, net of sublease income amounts, were as follows (in millions): Operating Leases (1) Sub-lease Income Net Operating Leases 2018 $ 1,175 $ 15 $ 1,160 2019 1,133 13 1,120 2020 1,073 11 1,062 2021 975 7 968 2022 831 3 828 Thereafter 3,616 1 3,615 Total minimum payments $ 8,803 $ 50 $ 8,753 (1) Includes future minimum payments for leases which have not yet commenced. We have entered into certain non-cancelable lease agreements with lease periods expiring between 2021 and 2044 where we are the deemed owner for accounting purposes of new construction projects. Excluded from the table above are future minimum lease payments under such leases totaling approximately $2.1 billion , for which a $1.3 billion liability is included on the Consolidated Balance Sheets as of December 31, 2017 . Rent expense under operating leases was $734 million , $897 million , and $1.1 billion for the years ended December 31, 2015 , 2016 , and 2017 , respectively. Purchase Obligations As of December 31, 2017 , we had $7.2 billion of other non-cancelable contractual obligations, primarily related to data center operations and build-outs, digital media content licensing, and purchases of inventory. Indemnifications In the normal course of business, to facilitate transactions in our services and products, we indemnify certain parties, including advertisers, Google Network Members, and lessors with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have 72 Table of Contents Alphabet Inc. a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2017 , we did not have any material indemnification claims that were probable or reasonably possible. Legal Matters Antitrust Investigations On November 30, 2010, the European Commission's (EC) Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On April 15, 2015, the EC issued a Statement of Objections (SO) regarding the display and ranking of shopping search results and ads, to which we responded on August 27, 2015. On July 14, 2016, the EC issued a Supplementary SO regarding shopping search results and ads. On June 27, 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a €2.42 billion (approximately $2.74 billion as of June 27, 2017) fine. On September 11, 2017, we appealed the EC decision and on September 27, 2017, we implemented product changes to bring shopping ads into compliance with the EC's decision. We recognized a charge of approximately $2.74 billion for the fine in the second quarter of 2017. The fine is included in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees in lieu of a cash payment for the fine. On April 20, 2016, the EC issued an SO regarding certain Android distribution practices. On July 14, 2016, the EC issued an SO regarding the syndication of AdSense for Search. We responded to the SOs and continue to respond to the EC's informational requests. There is significant uncertainty as to the outcomes of these investigations; however, adverse decisions could result in fines and directives to alter or terminate certain conduct. Given the nature of these cases, we are unable to estimate the reasonably possible loss or ranges of loss, if any. We remain committed to working with the EC to resolve these matters. The Comision Nacional de Defensa de la Competencia in Argentina, the Competition Commission of India (CCI), Brazil's Council for Economic Defense (CADE), and the Korean Fair Trade Commission have also opened investigations into certain of our business practices. In November 2016, we responded to the CCI Director General's report with interim findings of competition law infringements regarding search and ads. Patent and Intellectual Property Claims We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss for a company or its suppliers in an ITC action could result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them for certain intellectual property infringement claims against them, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. Oracle America, Inc. (Oracle) brought a copyright lawsuit against Google in the Northern District of California, alleging that Google's Android operating system infringes Oracle's copyrights related to certain Java application programming interfaces. After trial, final judgment was entered by the district court in favor of Google on June 8, 2016, and the court decided post-trial motions in favor of Google. Oracle has appealed. We believe this lawsuit is without merit and are defending ourselves vigorously. Given the nature of this case, we are unable to estimate the reasonably possible loss or range of loss, if any, arising from this matter. 73 Table of Contents Alphabet Inc. Other We are also regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition (such as the pending EC investigations described above), intellectual property, privacy, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. Such claims, suits, regulatory and government investigations, and other proceedings could result in fines, civil or criminal penalties, or other adverse consequences. Certain of our outstanding legal matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We evaluate developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being, and the estimated amount of, a loss related to such matters. With respect to our outstanding legal matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in the aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such legal matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Non-Income Taxes We are under audit by various domestic and foreign tax authorities with regards to non-income tax matters. The subject matter of non-income tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions and the tax treatment of certain employee benefits. We accrue non-income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We believe these matters are without merit and we are defending ourselves vigorously. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. For information regarding income tax contingencies, see Note 14 . Note 11. Stockholders’ Equity Convertible Preferred Stock Our board of directors has authorized 100 million shares of convertible preferred stock, $0.001 par value, issuable in series. As of December 31, 2016 and 2017 , no shares were issued or outstanding. Class A and Class B Common Stock and Class C Capital Stock Our board of directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Share Repurchases In October 2015, the board of directors of Alphabet authorized the company to repurchase up to $5.1 billion of its Class C capital stock, commencing in the fourth quarter of 2015. In January 2016, the board of directors of Alphabet authorized the company to repurchase an additional amount of approximately 514,000 shares. The repurchases were executed, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through the use of 10b5-1 plans. During 2016, we repurchased and subsequently retired 5.2 million shares of Alphabet Class C capital stock for an aggregate amount of $3.7 billion . We completed all authorized share repurchases under this repurchase program as of June 2016. In October 2016, the board of directors of Alphabet authorized the company to repurchase up to $7.0 billion of its Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated 74 Table of Contents Alphabet Inc. transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. During 2017, we repurchased and subsequently retired 5.2 million shares of Alphabet Class C capital stock for an aggregate amount of $4.8 billion . Note 12. Net Income Per Share We compute net income per share of Class A and Class B common stock and Class C capital stock using the two-class method. Basic net income per share is computed using the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of restricted stock units and other contingently issuable shares. The dilutive effect of outstanding restricted stock units and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A common stock assumes the conversion of Class B common stock, while the diluted net income per share of Class B common stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A and Class B common stock and Class C capital stock are identical, except with respect to voting. Furthermore, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our board of directors from declaring or paying unequal per share dividends on our Class A and Class B common stock and Class C capital stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our board of directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A and Class B common shares and Class C capital stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. Furthermore, as we assume the conversion of Class B common stock in the computation of the diluted net income per share of Class A common stock, the undistributed earnings are equal to net income for that computation. In the years ended December 31, 2016 and 2017, the net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are legally entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. In the year ended December 31, 2015, the Class C Adjustment Payment was allocated to the numerator for calculating net income per share of Class C capital stock from net income available to all stockholders and the remaining undistributed earnings were allocated on a pro rata basis to Class A and Class B common stock and Class C capital stock based on the number of shares used in the per share computation for each class of stock. The weighted-average share impact of the Class C Adjustment Payment is included in the denominator of both basic and diluted net income per share computations for the year ended December 31, 2015. The following table sets forth the computation of basic and diluted net income per share of Class A and Class B common stock and Class C capital stock (in millions, except share amounts which are reflected in thousands and per share amounts): 75 Table of Contents Alphabet Inc. Year Ended December 31, 2015 Class A Class B Class C Basic net income per share: Numerator Adjustment Payment to Class C capital stockholders $ 0 $ 0 $ 522 Allocation of undistributed earnings 6,695 1,196 7,935 Total $ 6,695 $ 1,196 $ 8,457 Denominator Number of shares used in per share computation 289,640 51,745 343,241 Basic net income per share $ 23.11 $ 23.11 $ 24.63 Diluted net income per share: Numerator Adjustment Payment to Class C capital stockholders $ 0 $ 0 $ 522 Allocation of undistributed earnings for basic computation $ 6,695 $ 1,196 $ 7,935 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,196 0 0 Reallocation of undistributed earnings (39 ) (14 ) 39 Allocation of undistributed earnings $ 7,852 $ 1,182 $ 7,974 Denominator Number of shares used in basic computation 289,640 51,745 343,241 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 51,745 0 0 Restricted stock units and other contingently issuable shares 2,395 0 5,909 Number of shares used in per share computation 343,780 51,745 349,150 Diluted net income per share $ 22.84 $ 22.84 $ 24.34 76 Table of Contents Alphabet Inc. Year Ended December 31, 2016 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 8,332 $ 1,384 $ 9,762 Denominator Number of shares used in per share computation 294,217 48,859 344,702 Basic net income per share $ 28.32 $ 28.32 $ 28.32 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 8,332 $ 1,384 $ 9,762 Effect of dilutive securities in equity method investments and subsidiaries (9 ) (2 ) (10 ) Allocation of undistributed earnings for diluted computation 8,323 1,382 9,752 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,382 0 0 Reallocation of undistributed earnings (94 ) (21 ) 94 Allocation of undistributed earnings $ 9,611 $ 1,361 $ 9,846 Denominator Number of shares used in basic computation 294,217 48,859 344,702 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 48,859 0 0 Restricted stock units and other contingently issuable shares 2,055 0 8,873 Number of shares used in per share computation 345,131 48,859 353,575 Diluted net income per share $ 27.85 $ 27.85 $ 27.85 77 Table of Contents Alphabet Inc. Year Ended December 31, 2017 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 5,438 $ 862 $ 6,362 Denominator Number of shares used in per share computation 297,604 47,146 348,151 Basic net income per share $ 18.27 $ 18.27 $ 18.27 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 5,438 $ 862 $ 6,362 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 862 0 0 Reallocation of undistributed earnings (74 ) (14 ) 74 Allocation of undistributed earnings $ 6,226 $ 848 $ 6,436 Denominator Number of shares used in basic computation 297,604 47,146 348,151 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 47,146 0 0 Restricted stock units and other contingently issuable shares 1,192 0 9,491 Number of shares used in per share computation 345,942 47,146 357,642 Diluted net income per share $ 18.00 $ 18.00 $ 18.00 Note 13. Compensation Plans Stock Plans Under our 2012 Stock Plan, RSUs or stock options may be granted. An RSU award is an agreement to issue shares of our publicly traded stock at the time the award vests. Incentive and non-qualified stock options, or rights to purchase common stock, are generally granted for a term of 10 years. RSUs granted to participants under the 2012 Stock Plan generally vest over four years contingent upon employment or service with us on the vesting date. As of December 31, 2017 , there were 38,505,768 shares of stock reserved for future issuance under our Stock Plan. Stock-Based Compensation For the years ended December 31, 2015 , 2016 and 2017 , total stock-based compensation expense was $5.3 billion , $6.9 billion and $7.9 billion , including amounts associated with awards we expect to settle in Alphabet stock of $5.2 billion , $6.7 billion , and $7.7 billion , respectively. For the years ended December 31, 2015, 2016 and 2017, we recognized tax benefits on total stock-based compensation expense, which are reflected in the provision for income taxes in the Consolidated Statements of Income, of $1.1 billion , $1.5 billion , and $1.6 billion , respectively. For the years ended December 31, 2015 , 2016 and 2017 , tax benefit realized related to awards vested or exercised during the period was $1.5 billion , $2.1 billion and $2.7 billion , respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the research and development tax credit. 78 Table of Contents Alphabet Inc. Stock-Based Award Activities The following table summarizes the activities for our unvested RSUs for the year ended December 31, 2017 : Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2016 25,348,955 $ 624.92 Granted 8,097,708 $ 845.06 Vested (12,071,413 ) $ 623.94 Forfeited/canceled (1,297,904 ) $ 659.61 Unvested as of December 31, 2017 20,077,346 $ 712.45 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2015 and 2016 , was $546.46 and $713.89 , respectively. Total fair value of RSUs, as of their respective vesting dates, during the years ended December 31, 2015 , 2016 , and 2017 were $6.9 billion , $9.0 billion , and $11.3 billion , respectively. As of December 31, 2017 , there was $12.9 billion of unrecognized compensation cost related to unvested employee RSUs. This amount is expected to be recognized over a weighted-average period of 2.4 years . 401(k) Plans We have two 401(k) Savings Plans that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We contributed approximately $309 million , $385 million , and $448 million for the years ended December 31, 2015 , 2016 , and 2017 , respectively. Note 14. Income Taxes Income from continuing operations before income taxes included income from domestic operations of $8.3 billion , $12.0 billion , and $10.7 billion for the years ended December 31, 2015 , 2016 , and 2017 , and income from foreign operations of $11.4 billion , $12.1 billion , and $16.5 billion for the years ended December 31, 2015 , 2016 , and 2017 . The provision for income taxes consists of the following (in millions): Year Ended December 31, 2015 2016 2017 Current: Federal and state $ 2,838 $ 3,826 $ 12,608 Foreign 723 966 1,746 Total 3,561 4,792 14,354 Deferred: Federal and state (241 ) (70 ) 220 Foreign (17 ) (50 ) (43 ) Total (258 ) (120 ) 177 Provision for income taxes $ 3,303 $ 4,672 $ 14,531 The U.S. Tax Cuts and Jobs Act (Tax Act) was enacted on December 22, 2017 and introduces significant changes to U.S. income tax law. Effective in 2018, the Tax Act reduces the U.S. statutory tax rate from 35% to 21% and creates new taxes on certain foreign-sourced earnings and certain related-party payments, which are referred to as the global intangible low-taxed income tax and the base erosion tax, respectively. In addition, in 2017 we were subject to a one-time transition tax on accumulated foreign subsidiary earnings not previously subject to U.S. income tax. Due to the timing of the enactment and the complexity involved in applying the provisions of the Tax Act, we have made reasonable estimates of the effects and recorded provisional amounts in our financial statements as of December 31, 2017. As we collect and prepare necessary data, and interpret the Tax Act and any additional guidance issued by the U.S. Treasury Department, the IRS, and other standard-setting bodies, we may make adjustments to the provisional amounts. Those adjustments may materially impact our provision for income taxes and effective tax rate in the period in which the adjustments are made. The accounting for the tax effects of the Tax Act will be completed in 2018. 79 Table of Contents Alphabet Inc. Provisional amounts for the following income tax effects of the Tax Act have been recorded as of December 31, 2017 and are subject to change during 2018. One-time transition tax The Tax Act requires us to pay U.S. income taxes on accumulated foreign subsidiary earnings not previously subject to U.S. income tax at a rate of 15.5% to the extent of foreign cash and certain other net current assets and 8% on the remaining earnings. We recorded a provisional amount for our one-time transitional tax liability and income tax expense of $10.2 billion . We have recorded provisional amounts based on estimates of the effects of the Tax Act as the analysis requires significant data from our foreign subsidiaries that is not regularly collected or analyzed. Deferred tax effects The Tax Act reduces the U.S. statutory tax rate from 35% to 21% for years after 2017. Accordingly, we have remeasured our deferred taxes as of December 31, 2017 to reflect the reduced rate that will apply in future periods when these deferred taxes are settled or realized. We recognized a deferred tax benefit of $376 million to reflect the reduced U.S. tax rate and other effects of the Tax Act. Although the tax rate reduction is known, we have not collected the necessary data to complete our analysis of the effect of the Tax Act on the underlying deferred taxes and as such, the amounts recorded as of December 31, 2017 are provisional. The net tax expense recognized in 2017 related to the Tax Act was $9.9 billion . As we complete our analysis of the Tax Act and incorporate additional guidance that may be issued by the U.S. Treasury Department, the IRS or other standard-setting bodies, we may identify additional effects not reflected as of December 31, 2017. The reconciliation of federal statutory income tax rate to our effective income tax rate is as follows: Year Ended December 31, 2015 2016 2017 U.S. federal statutory tax rate 35.0 % 35.0 % 35.0 % Foreign income taxed at different rates (13.4 )% (11.0 )% (14.2 )% Impact of the Tax Act One-time transition tax 0.0 % 0.0 % 37.6 % Deferred tax effects 0.0 % 0.0 % (1.4 )% Federal research credit (2.1 )% (2.0 )% (1.8 )% Stock-based compensation expense 0.3 % (3.4 )% (4.5 )% European Commission Fine 0.0 % 0.0 % 3.5 % Other adjustments (3.0 )% 0.7 % (0.8 )% Effective tax rate 16.8 % 19.3 % 53.4 % Our effective tax rate for each of the years presented was impacted by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. Substantially all of the income from foreign operations was earned by an Irish subsidiary. Beginning in 2018, earnings realized in foreign jurisdictions will be subject to U.S. tax in accordance with the Tax Act. On July 27, 2015, the United States Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. The IRS served a Notice of Appeal on February 22, 2016 and the case is being heard by the Ninth Circuit Court of Appeals. At this time, the U.S. Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. We have evaluated the opinion and continue to record a tax benefit related to reimbursement of cost share payments for the previously shared stock-based compensation costs. In accordance with the Tax Act, the Altera tax benefit was remeasured from 35% to 21%.  We also remeasured the tax benefit expected to be realized upon settlement including the expected future new taxes enacted by the Tax Act due upon resolution of the matter. The tax liability recorded as of December 31, 2016 for the U.S. tax cost of the potential repatriation associated with the contingent foreign earnings was reversed due to the Tax Act introducing a territorial tax system and providing a 100% dividend received deduction on certain qualified dividends from foreign subsidiaries. We will continue to monitor developments related to the case and the potential impact on our consolidated financial statements. 80 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We recorded a provisional adjustment to our U.S. deferred income taxes as of December 31, 2017 to reflect the reduction in the U.S. statutory tax rate from 35% to 21% resulting from the Tax Act. Significant components of our deferred tax assets and liabilities are as follows (in millions): As of December 31, 2016 2017 Deferred tax assets: Stock-based compensation expense $ 574 $ 251 Accrued employee benefits 939 285 Accruals and reserves not currently deductible 500 717 Tax credits 631 1,187 Basis difference in investment of Arris 1,327 849 Prepaid cost sharing 4,409 498 Net Operating Losses 305 320 Other 621 379 Total deferred tax assets 9,306 4,486 Valuation allowance (2,076 ) (2,531 ) Total deferred tax assets net of valuation allowance 7,230 1,955 Deferred tax liabilities: Depreciation and amortization (877 ) (551 ) Identified intangibles (844 ) (419 ) Renewable energy investments (788 ) (531 ) Foreign earnings (4,409 ) (68 ) Other (155 ) (136 ) Total deferred tax liabilities (7,073 ) (1,705 ) Net deferred tax assets $ 157 $ 250 As of December 31, 2017 , our federal and state net operating loss carryforwards for income tax purposes were approximately $931 million and $785 million , respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2021 and the state net operating loss carryforwards will begin to expire in 2018. It is more likely than not that certain federal net operating loss carryforwards and our state net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. Our foreign net operating loss carryforwards for income tax purposes were $327 million that will begin to expire in 2021. As of December 31, 2017 , our California research and development credit carryforwards for income tax purposes were approximately $1.8 billion that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. As of December 31, 2017 , we maintained a valuation allowance with respect to certain of our deferred tax assets relating primarily to investment losses that are capital in nature, California deferred tax assets, certain federal net operating losses, and certain foreign net operating losses that we believe are not likely to be realized. We established a deferred tax asset for the book-to-tax basis difference in our investments in Arris shares received from the sale of the Motorola Home business to Arris in 2013. Since any future losses to be recognized upon the sale of Arris shares will be capital losses, a valuation allowance has been recorded against this deferred tax asset to the extent such deferred tax asset is not likely to be covered by capital gains generated as of December 31, 2017. We reassess the valuation allowance quarterly and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. 81 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits from January 1, 2015 to December 31, 2017 (in millions): 2015 2016 2017 Beginning gross unrecognized tax benefits $ 3,294 $ 4,167 $ 5,393 Increases related to prior year tax positions 224 899 685 Decreases related to prior year tax positions (176 ) (157 ) (257 ) Decreases related to settlement with tax authorities (27 ) (196 ) (1,875 ) Increases related to current year tax positions 852 680 750 Ending gross unrecognized tax benefits $ 4,167 $ 5,393 $ 4,696 The total amount of gross unrecognized tax benefits was $4.2 billion , $5.4 billion , and $4.7 billion as of December 31, 2015 , 2016 , and 2017 , respectively, of which, $3.6 billion , $4.3 billion , and $3.0 billion if recognized, would affect our effective tax rate. The decrease in gross unrecognized tax benefits in 2017 was primarily as a result of the resolution of a multi-year U.S. audit. As of December 31, 2016 and 2017 , we had accrued $493 million and $362 million in interest and penalties in provision for income taxes, respectively. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions, our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS completed its examination through our 2012 tax years; all issues have been concluded except for one which is currently under review in the U.S. Tax Court. The IRS is currently examining our 2013 through 2015 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. Our 2016 tax year remains subject to examination by the IRS for U.S. federal tax purposes, and our 2011 through 2016 tax years remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the impact, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, closure of audits is not certain, it is reasonably possible that certain U.S. federal and non-U.S. tax audits may be concluded within the next 12 months, which could significantly increase or decrease the balance of our gross unrecognized tax benefits. We estimate that our unrecognized tax benefits as of December 31, 2017 could possibly decrease by approximately $500 million in the next 12 months. Positions that may be resolved include various U.S. and non-U.S. matters. Note 15. Information about Segments and Geographic Areas We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed as Other Bets. Our reported segments are: • Google – Google includes our main products such as Ads, Android, Chrome, Commerce, Google Cloud, Google Maps, Google Play, Hardware, Search, and YouTube. Our technical infrastructure and some newer efforts like virtual reality are also included in Google. Google generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X. Revenues 82 Table of Contents Alphabet Inc. from the Other Bets are derived primarily through the sales of internet and TV services through Fiber, sales of Nest products and services, and licensing and R&D services through Verily. Revenues, cost of revenues, and operating expenses are generally directly attributed to our segments. Inter-segment revenues are not presented separately, as these amounts are immaterial. Our Chief Operating Decision Maker does not evaluate operating segments using asset information. Information about segments during the periods presented were as follows (in millions): Year Ended December 31, 2015 2016 2017 Revenues: Google $ 74,544 $ 89,463 $ 109,652 Other Bets 445 809 1,203 Total revenues $ 74,989 $ 90,272 $ 110,855 Year Ended December 31, 2015 2016 2017 Operating income (loss): Google $ 23,319 $ 27,892 $ 32,908 Other Bets (3,456 ) (3,578 ) (3,355 ) Reconciling items (1) (503 ) (598 ) (3,407 ) Total income from operations $ 19,360 $ 23,716 $ 26,146 (1) Reconciling items are primarily comprised of the European Commission fine for the year ended December 31, 2017, as well as corporate administrative costs and other miscellaneous items that are not allocated to individual segments for all periods presented. Year Ended December 31, 2015 2016 2017 Capital expenditures: Google $ 8,868 $ 9,417 $ 12,605 Other Bets 850 1,385 507 Reconciling items (2) 232 (590 ) 72 Total capital expenditures as presented on the Consolidated Statements of Cash Flows $ 9,950 $ 10,212 $ 13,184 (2) Reconciling items are related to timing differences of payments as segment capital expenditures are on accrual basis while total capital expenditures shown on the Consolidated Statements of Cash Flow are on cash basis and other miscellaneous differences. 83 Table of Contents Alphabet Inc. Stock-based compensation (SBC) and depreciation, amortization, and impairment are included in segment operating income (loss) as shown below (in millions): Year Ended December 31, 2015 2016 2017 Stock-based compensation: Google $ 4,610 $ 5,926 $ 7,038 Other Bets 475 647 493 Reconciling items (3) 118 130 148 Total stock-based compensation (4) $ 5,203 $ 6,703 $ 7,679 Depreciation, amortization, and impairment: Google $ 4,839 $ 5,800 $ 6,520 Other Bets 203 340 395 Reconciling items (5) 21 4 — Total depreciation, amortization, and impairment as presented on the Consolidated Statements of Cash Flows $ 5,063 $ 6,144 $ 6,915 (3) Reconciling items represent corporate administrative costs that are not allocated to individual segments. (4) For purposes of segment reporting, SBC represents awards that we expect to settle in Alphabet stock. (5) Reconciling items are primarily related to corporate administrative costs and other miscellaneous items that are not allocated to individual segments. The following table presents our long-lived assets by geographic area (in millions): As of December 31, 2016 As of December 31, 2017 Long-lived assets: United States $ 47,383 $ 55,113 International 14,706 17,874 Total long-lived assets $ 62,089 $ 72,987 For revenues by geography, see Note 2 . ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2017 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 84 Table of Contents Alphabet Inc. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2017 . Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2017 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION None. 85 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for 2018 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2017 ( 2018 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2018 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2018 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in 2018 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2018 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2018 Proxy Statement and is incorporated herein by reference. 86 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 46 Financial Statements: Consolidated Balance Sheets 48 Consolidated Statements of Income 49 Consolidated Statements of Comprehensive Income 50 Consolidated Statements of Stockholders’ Equity 51 Consolidated Statements of Cash Flows 52 Notes to Consolidated Financial Statements 53 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for doubtful accounts and sales credits for the three years ended December 31, 2017 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year Year ended December 31, 2015 $ 225 $ 579 $ (508 ) $ 296 Year ended December 31, 2016 $ 296 $ 942 $ (771 ) $ 467 Year ended December 31, 2017 $ 467 $ 1,131 $ (924 ) $ 674 Note: Additions to the allowance for doubtful accounts are charged to expense. Additions to the allowance for sales credits are charged against revenues. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 87 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.07 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.09 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.10 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.11 Form of the Registrant’s 3.625% Notes due 2021 (included in Exhibit 4.10) 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.10) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 10.01 Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.03 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.04 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.05.1 u Google Inc. 2004 Stock Plan - Form of Google Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.2 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.3 u Google Inc. 2004 Stock Plan - Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.06 u Alphabet Inc. 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 9, 2017 10.06.1 u Alphabet Inc. 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Quarterly Report on Form 10-Q (File No. 001-37580) November 3, 2016 10.07 u Motorola Mobility Holdings, Inc. 2011 Incentive Compensation Plan Registration Statement on Form S-8 (File No. 333-181661) May 24, 2012 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.08 u AdMob, Inc. 2006 Stock Plan and UK Sub-Plan of the AdMob, Inc. 2006 Stock Plan Registration Statement on Form S-8 (File No. 333-167411) June 9, 2010 10.09 u Apigee Corporation 2015 Equity Incentive Plan Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 10.09.1 u Apigee Corporation 2015 Equity Incentive Plan - Form of Restricted Stock Unit Agreement Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 12.01 * Computation of Earnings to Fixed Charge Ratios 14.01 * Code of Conduct of the Registrant as amended on September 21, 2017 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.01 Google blog post dated June 27, 2017 Current Report on Form 8-K (File No. 001-37580) June 27, 2017 101.INS * XBRL Instance Document 101.SCH * XBRL Taxonomy Extension Schema Document 101.CAL * XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF * XBRL Taxonomy Extension Definition Linkbase Document 101.LAB * XBRL Taxonomy Extension Label Linkbase Document 101.PRE * XBRL Taxonomy Extension Presentation Linkbase Document _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. Table of Contents Alphabet Inc. ITEM 16. FORM 10-K SUMMARY None. Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 5, 2018 ALPHABET INC. By: / S /    L ARRY P AGE Larry Page Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Larry Page and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Table of Contents Alphabet Inc. Signature Title Date / S /    L ARRY P AGE Chief Executive Officer, Co-Founder, and Director (Principal Executive Officer) February 5, 2018 Larry Page / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 5, 2018 Ruth M. Porat / S /    J AMES G. C AMPBELL Vice President, Corporate Controller, and Chief Accounting Officer (Principal Accounting Officer) February 5, 2018 James G. Campbell /S/    S ERGEY B RIN President, Co-Founder, and Director February 5, 2018 Sergey Brin /S/    J OHN L. H ENNESSY Director, Chair February 5, 2018 John L. Hennessy /s/    E RIC E. S CHMIDT Director February 5, 2018 Eric E. Schmidt / S /    L. J OHN D OERR Director February 5, 2018 L. John Doerr / S /    R OGER W. F ERGUSON, J R . Director February 5, 2018 Roger W. Ferguson, Jr. / S /    D IANE B. G REENE Director February 5, 2018 Diane B. Greene / S /   A NN M ATHER Director February 5, 2018 Ann Mather / S /    A LAN R . M ULALLY Director February 5, 2018 Alan R. Mulally /s/ S UNDAR P ICHAI Director February 5, 2018 Sundar Pichai / S /    K. R AM S HRIRAM Director February 5, 2018 K. Ram Shriram / S /    S HIRLEY M. T ILGHMAN Director February 5, 2018 Shirley M. Tilghman \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-19-000004/full-submission.txt b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-19-000004/full-submission.txt new file mode 100644 index 0000000..d1ba4d0 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/GOOGL/10-K/0001652044-19-000004/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________________________ FORM 10-K ___________________________________________ (Mark One) ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2018 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View, CA 94043 (Address of principal executive offices) (Zip Code) (650) 253-0000 (Registrant’s telephone number, including area code) ___________________________________________ Securities registered pursuant to Section 12(b) of the Act: Title of each class Name of each exchange on which registered Class A Common Stock, $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ý No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ¨ No ý Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes ý No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨ Emerging growth company ¨ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨ No ý As of June 29, 2018 , the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 29, 2018 ) was approximately $680.0 billion . For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 31, 2019 , there were 299,360,029 shares of the registrant’s Class A common stock outstanding, 46,535,019 shares of the registrant’s Class B common stock outstanding, and 349,291,348 shares of the registrant’s Class C capital stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2019 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2018 . Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2018 TABLE OF CONTENTS Page Note About Forward-Looking Statements 1 PART I Item 1. Business 3 Item 1A. Risk Factors 7 Item 1B. Unresolved Staff Comments 20 Item 2. Properties 20 Item 3. Legal Proceedings 20 Item 4. Mine Safety Disclosures 20 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 21 Item 6. Selected Financial Data 24 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 25 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 40 Item 8. Financial Statements and Supplementary Data 43 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 82 Item 9A. Controls and Procedures 82 Item 9B. Other Information 83 PART III Item 10. Directors, Executive Officers and Corporate Governance 84 Item 11. Executive Compensation 84 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 84 Item 13. Certain Relationships and Related Transactions, and Director Independence 84 Item 14. Principal Accountant Fees and Services 84 PART IV Item 15. Exhibits, Financial Statement Schedules 85 Item 16. Form 10-K Summary 87 i Table of Contents Alphabet Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding: • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • our plans to continue to invest in new businesses, products, services and technologies, systems, facilities, and infrastructure, to continue to hire aggressively and provide competitive compensation programs, as well as to continue to invest in acquisitions; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality, and macroeconomic conditions, which are likely to cause fluctuations in our quarterly results; • the potential for declines in our revenue growth rate and operating margin; • our expectation that we will continue to take steps to improve the relevance of the ads we deliver and to reduce the number of accidental clicks; • fluctuations in our revenue growth, as well as the change in paid clicks and cost-per-click on Google properties and the change in impressions and cost-per-impression on Google Network Members’ properties, and various factors contributing to such fluctuations; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of costs related to hedging activities under our foreign exchange risk management program; • the anticipated effect of, and our response to, new accounting pronouncements; • our expectation that our cost of revenues, research and development (R&D) expenses, sales and marketing expenses, and general and administrative expenses will increase in dollars and may increase as a percentage of revenues; • our potential exposure in connection with pending investigations, proceedings, and other contingencies; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins in the future; • our expectation that our traffic acquisition costs (TAC) and the associated TAC rates will increase in the future; • our expectation that our results will be affected by our performance in international markets as users in developing economies increasingly come online; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase and may affect margins; • our expectation that our other income (expense), net, will fluctuate in the future, as it is largely driven by market dynamics; • estimates of our future compensation expenses; • fluctuations in our effective tax rate; • the sufficiency of our sources of funding; • our payment terms to certain advertisers, which may increase our working capital requirements; • fluctuations in our capital expenditures; • our expectations related to the operating structure implemented pursuant to the Alphabet holding company reorganization; • the sufficiency and timing of our proposed remedies in response to the European Commission's (EC) decisions; • the expected timing and amount of Alphabet Inc.'s share repurchases; 1 Table of Contents Alphabet Inc. as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report and other documents we file with the Securities and Exchange Commission (SEC), including without limitation, the following sections: Item 1 "Business," Item 1A "Risk Factors," and Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "may," "could," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed in Item 1A, "Risk Factors" of this report and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. 2 Table of Contents Alphabet Inc. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history -- inspiring us to do things like rethink the mobile device ecosystem with Android and map the world with Google Maps. As part of that, our founders also explained that you could expect us to make "smaller bets in areas that might seem very speculative or even strange when compared to our current businesses." From the start, the company has always strived to do more, and to do important and meaningful things with the resources we have. Alphabet is a collection of businesses -- the largest of which is Google. It also includes businesses that are generally pretty far afield of our main internet products in areas such as self-driving cars, life sciences, internet access and TV services. We report all non-Google businesses collectively as Other Bets. Our Alphabet structure is about helping each of our businesses prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers, capable of propelling new ideas and people forward. At Google, our mission is to make sure that information serves everyone, not just a few. So whether you're a child in a rural village or a professor at an elite university, you can access the same information. We are helping people get online by tailoring digital experiences to the needs of emerging markets. For instance, our digital payments app in India, now called Google Pay, helps tens of millions of people and businesses easily pay with just a few taps. We're also making sure our core Google products are fast and useful, especially for users in areas where speed and connectivity are central concerns. Other Alphabet companies are also pursuing initiatives with similar goals. For instance, Loon announced that it will bring its balloon-powered internet to regions of central Kenya, starting in 2019. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and continue to invest for the long-term. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. The power of machine learning Across the company, machine learning and artificial intelligence (AI) are increasingly driving many of our latest innovations. Within Google, our investments in machine learning over a decade have enabled us to build products that are smarter and more useful -- it's what allows you to use your voice to ask the Google Assistant for information, to translate the web from one language to another, to see better YouTube recommendations, and to search for people and events in Google Photos. Our advertising tools also use machine learning to help marketers find the right audience, deliver the right creative, and optimize their campaigns through better auto-bidding and measurement tools. Machine learning is also showing great promise in helping us tackle big issues, like dramatically improving the energy efficiency of our data centers. Across Other Bets, machine learning helps self-driving cars better detect and respond to others on the road, assists delivery drones in determining whether a location is safe for drop off, and can also help clinicians more accurately detect sight-threatening eye diseases. Google Serving our users We have always been a company committed to building products that have the potential to improve the lives of millions of people. Our product innovations have made our services widely used, and our brand one of the most recognized in the world. Google's core products and platforms such as Android, Chrome, Gmail, Google Drive, Google Maps, Google Play, Search, and YouTube each have over one billion monthly active users. But most important, we believe we are just beginning to scratch the surface. Our vision is to remain a place of incredible creativity and innovation 3 Table of Contents Alphabet Inc. that uses our technical expertise to tackle big problems. As the majority of Alphabet’s big bets continue to reside within Google, an important benefit of the shift to Alphabet has been the tremendous focus that we’re able to have on Google’s many extraordinary opportunities. Google’s mission to organize the world’s information and make it universally accessible and useful has always been our North Star, and our products have come a long way since the company was founded two decades ago. Instead of just showing ten blue links in our search results, we are increasingly able to provide direct answers -- even if you're speaking your question using Voice Search -- which makes it quicker, easier and more natural to find what you're looking for. You can also type or talk with the Google Assistant in a conversational way across multiple devices like phones, speakers, headphones, televisions and more. And with Google Lens, you can use your phone’s camera to identify an unfamiliar landmark or find a trailer from a movie poster. Over time, we have also added other services that let you access information quickly and easily -- like Google Maps, which helps you navigate to a store while showing you current traffic conditions, or Google Photos, which helps you store and organize your photos. This drive to make information more accessible has led us over the years to improve the discovery and creation of digital content, on the web and through platforms like Google Play and YouTube. And with the migration to mobile, people are consuming more digital content by watching more videos, playing more games, listening to more music, reading more books, and using more apps than ever before. Working with content creators and partners, we continue to build new ways for people around the world to find great digital content. Fueling all of these great digital experiences are powerful platforms and hardware. That’s why we continue to invest in platforms like our Android mobile operating system, Chrome browser, Chrome operating system, and Daydream virtual reality platform, as well as growing our family of great hardware devices. We see tremendous potential for devices to be helpful, make your life easier, and get better over time, by combining the best of Google's AI, software, and hardware. This is reflected in our latest generation of hardware products like Pixel 3 phones and the Google Home Hub smart display. Creating beautiful products that people rely on every day is a journey that we are investing in for the long run. Google was a company built in the cloud and has been investing in infrastructure, security, data management, analytics, and AI from the very beginning. We have continued to enhance these strengths with features like data migration, modern development environments and machine learning tools to provide enterprise-ready cloud services, including Google Cloud Platform and G Suite, to our customers. Google Cloud Platform enables developers to build, test, and deploy applications on Google’s highly scalable and reliable infrastructure. Our G Suite productivity tools -- which include apps like Gmail, Docs, Drive, Calendar, Hangouts, and more -- are designed with real-time collaboration and machine intelligence to help people work smarter. Because more and more of today’s great digital experiences are being built in the cloud, our Google Cloud products help businesses of all sizes take advantage of the latest technology advances to operate more efficiently. Key to building helpful products for users is our commitment to keeping their data safe online. As the Internet evolves, we continue to invest in our industry-leading security technologies and privacy tools. How we make money The goal of our advertising business is to deliver relevant ads at just the right time and to give people useful commercial information, regardless of the device they’re using. We also provide advertisers with tools that help them better attribute and measure their advertising campaigns across screens. Our advertising solutions help millions of companies grow their businesses, and we offer a wide range of products across screens and formats. We generate revenues primarily by delivering both performance advertising and brand advertising. • Perf ormance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Most of our performance advertisers pay us when a user engages in their ads. Performance advertising lets our advertisers connect with users while driving measurable results. Our ads tools allow performance advertisers to create simple text-based ads that appear on Google properties and the properties of Google Network Members. In addition, Google Network Members use our platforms to display relevant ads on their properties, generating revenues when site visitors view or click on the ads. We continue to invest in our advertising programs and make significant upgrades. • Brand advertising helps enhance users' awareness of and affinity with advertisers' products and services, through v ideos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. 4 Table of Contents Alphabet Inc. We have built a world-class ad technology platform for brand advertisers, agencies, and publishers to power their digital marketing businesses. We aim to ensure great user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. We also seek to improve the measurability of brand advertising so advertisers know when their campaigns are effective. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, ranging from filtering out invalid traffic, removing billions of bad ads from our systems every year to closely monitoring the sites, apps, and videos where ads appear and blacklisting them when necessary to ensure that ads do not fund bad content. Beyond our advertising business, we also generate revenues in other areas. For instance, we generate revenue when users purchase digital content like apps, movies and music through Google Play or when they purchase our Made by Google hardware devices. Businesses also pay for the use of our cloud services like Google Cloud Platform and G Suite. Other Bets Throughout Alphabet, we are also using technology to try and solve big problems across many industries. Alphabet’s Other Bets are emerging businesses at various stages of development, ranging from those in the research and development phase to those that are in the beginning stages of commercialization, and our goal is for them to become thriving, successful businesses in the medium to long term. To do this, we make sure we have a strong CEO to run each company while also rigorously handling capital allocation and working to make sure each business is executing well. While these early-stage businesses naturally come with considerable uncertainty, some of them are already generating revenue and making important strides in their industries. We continue to build these businesses thoughtfully and systematically to capitalize on the opportunities ahead. We are investing for the long term while being very deliberate about the focus, scale and pace of investments. Other Bets primarily generate revenues from internet and TV services and licensing and R&D services. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from: • General purpose search engines and information services, such as Baidu, Microsoft's Bing, Naver, Seznam, Verizon's Yahoo, and Yandex. • Vertical search engines and e-commerce websites, such as Amazon and eBay (e-commerce), Booking's Kayak (travel queries), Microsoft's LinkedIn (job queries), and WebMD (health queries). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks, such as Facebook, Snapchat, and Twitter. Some users increasingly rely on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other forms of advertising, such as billboards, magazines, newspapers, radio, and television. Our advertisers typically advertise in multiple media, both online and offline. • Other online advertising platforms and networks, including Amazon, AppNexus, Criteo, and Facebook, that compete for advertisers that use Google Ads, our primary auction-based advertising platform. • Providers of digital video services, such as Amazon, Facebook, Hulu, and Netflix. We compete with companies that have longer operating histories and more established relationships with customers and users in businesses that are further afield from our advertising business. We face competition from: • Other digital content and application platform providers, such as Apple. • Companies that design, manufacture, and market consumer electronics products, including businesses that have developed proprietary platforms. • Providers of enterprise cloud services, including Alibaba, Amazon, and Microsoft. • Digital assistant providers, such as Amazon and Apple. Competing successfully depends heavily on our ability to deliver and distribute innovative products and technologies to the marketplace across our businesses. Specifically, for our advertising-related businesses, competing successfully depends on attracting and retaining: 5 Table of Contents Alphabet Inc. • Users, for whom other products and services are literally one click away, largely on the basis of the relevance of our advertising, as well as the general usefulness, security and availability of our products and services. • Advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels. • Content providers, primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. Culture and Employees We take great pride in our culture. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex technical challenges. Transparency and open dialogue are central to how we work, and we aim to ensure that company news reaches our employees first through internal channels. Despite our rapid growth, we still cherish our roots as a startup and wherever possible empower employees to act on great ideas regardless of their role or function within the company. We strive to hire great employees, with backgrounds and perspectives as diverse as those of our global users. We work to provide an environment where these talented people can have fulfilling careers addressing some of the biggest challenges in technology and society. Our employees are among our best assets and are critical for our continued success. We expect to continue investing in hiring talented employees and to provide competitive compensation programs to our employees. As of December 31, 2018 , we had 98,771 full-time employees. Although we have work councils and statutory employee representation obligations in certain countries, our U.S. employees are not represented by a labor union. Competition for qualified personnel in our industry is intense, particularly for software engineers, computer scientists, and other technical staff. Seasonality Our business is affected by seasonal fluctuations in internet usage, advertising expenditures, and underlying business trends such as traditional retail seasonality. Other Items We believe that climate change is one of the most significant global challenges of our time. We have established a climate change strategy based on four dimensions: matching 100% of the electricity consumption of our operations with purchases of renewable energy; understanding the effect of climate change on the resiliency of our core business operations; being a vocal advocate for greening electrical grids worldwide; and empowering everyone—businesses, governments, nonprofit organizations, communities, and individuals—to use Google technology to help create a more sustainable and resource-efficient world. Google's approach to climate change and our broader sustainability efforts are provided in our annual sustainability reports. Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and our Proxy Statements are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance and other items of interest to our investors, including SEC filings, investor events, press and earnings releases, and blogs. We also share Google news and product updates on Google's Keyword blog at https://www.blog.google/, which may be of interest or material to our investors. Further, corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The content of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. 6 Table of Contents Alphabet Inc. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common and capital stock. Risks Related to Our Businesses and Industries We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, and our revenues and operating results could be adversely affected. Our businesses are rapidly evolving, intensely competitive, and subject to changing technologies, shifting user needs, and frequent introductions of new products and services. Competing successfully depends heavily on our ability to accurately anticipate technology developments and deliver innovative, relevant and useful products, services, and technologies to the marketplace in a timely manner. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services. As a result, we must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our technology and our existing products and services, and introduce new products and services that people can easily and effectively use. We have many competitors in different industries. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some companies have longer operating histories and more established relationships with customers and users. They can use their experiences and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in research and development and in hiring talent, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for users, advertisers, customers, and content providers. Our competitors may be able to innovate and provide products and services faster than we can or may foresee the need for products and services before us. In addition, new products and services, including those that incorporate or utilize artificial intelligence and machine learning, can raise new or exacerbate existing ethical, technological, legal, and other challenges, which may negatively affect our brands and demand for our products and services and adversely affect our revenues and operating results. Our operating results may also suffer if our innovations are not responsive to the needs of our users, advertisers, customers, and content providers; are not appropriately timed with market opportunities; or are not effectively brought to market. As technologies continue to develop, our competitors may be able to offer our users and/or customers experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, customers, and content providers, our revenues and operating results could be adversely affected. We generate a significant portion of our revenues from advertising, and reduced spending by advertisers or a loss of partners could harm our advertising business. We generated over 85% of total revenues from advertising in 2018 . Many of our advertisers, companies that distribute our products and services, digital publishers, and content partners can terminate their contracts with us at any time. Those partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. For example, changes to our data privacy practices, as well as changes to third-party advertising policies or practices may affect the type of ads and/or manner of advertising that we are able to provide which could have an adverse effect on our business. If we do not provide superior value or deliver advertisements efficiently and competitively, our reputation could be affected, we could see a decrease in revenue from advertisers and/or experience other adverse effects to our business. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions can also have a material negative effect on user activity and the demand for advertising and cause our advertisers to reduce the amounts they spend on advertising, which could adversely affect our revenues and advertising business. We are subject to increasing regulatory scrutiny as well as changes in public policies governing a wide range of topics that may negatively affect our business. We and other companies in the technology industry have experienced increased regulatory scrutiny recently. For instance, various regulatory agencies are reviewing aspects of our search and other businesses. This can lead to increased scrutiny from other regulators and legislators, that may affect our reputation, brand and third-party 7 Table of Contents Alphabet Inc. relationships. Such reviews have and may in the future also result in substantial regulatory fines, changes to our business practices and other penalties, which could negatively affect our business and results of operations. We continue to cooperate with regulatory authorities around the world in investigations they are conducting with respect to our business. Changes in social, political, and regulatory conditions or in laws and policies governing a wide range of topics may cause us to change our business practices. Further, our expansion into a variety of new fields also raises a number of new regulatory issues. These factors could negatively affect our business and results of operations in material ways. Our ongoing investment in new businesses and new products, services, and technologies is inherently risky, and could disrupt our current operations. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The creation of Alphabet as a holding company in 2015 and the investments that we are making across various areas in Google and Other Bets are a reflection of our ongoing efforts to innovate and provide products and services that are useful to users. Our investments in Google and Other Bets span a wide range of industries. Such endeavors may involve significant risks and uncertainties, including distraction of management from our advertising and related business, use of alternative investment, governance or compensation structures, the fact that such offerings or strategies may not be commercially viable for an indefinite amount of time or at all, or may not result in adequate return of capital on our investments; and unidentified issues may not be discovered in our due diligence of such strategies and offerings which could cause us to fail to realize the anticipated benefits of such investments and incur unanticipated liabilities. Because these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not adversely affect our reputation, financial condition, and operating results. The Internet is accessed through a variety of platforms and form factors that continue to evolve with the advancement of technology and user preferences. If manufacturers and users do not widely adopt versions of our search technology, products, or operating systems developed for these devices and modalities, our business could be adversely affected. The number of people who access the Internet through devices other than desktop computers, including mobile phones, smartphones, laptops and tablets, video game consoles, voice-activated speakers, wearables, automobiles, and television set-top devices, is increasing dramatically. The functionality and user experience associated with some alternative devices and modalities may make the use of our products and services or the generation of advertising revenue through such devices more difficult (or just different), and the versions of our products and services developed for these devices may not be compatible or compelling to users, manufacturers, or distributors of alternative devices. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not be available on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via voice-activated speakers, apps, social media or other platforms, which could affect our search and advertising business over time. As new devices and platforms are continually being released, it is difficult to predict the challenges we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to the creation, support, and maintenance of products and services across multiple platforms and devices. If we are unable to attract and retain a substantial number of alternative device manufacturers, suppliers, distributors, developers, and users to our products and services, or if we are slow to develop products and technologies that are more compatible with alternative devices and platforms, we may fail to capture the opportunities available as consumers and advertisers continue to exist in a dynamic, multi-platform environment. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline and/or vary over time as a result of a number of factors, including increasing competition and the continued expansion of our business into a variety of new fields. Within our advertising business, changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix and an increasing competition for advertising may also affect our revenue growth rate. We may also experience a decline in our revenue growth rate as our revenues increase to higher levels or if there is a decrease in the rate of adoption of our products, services, and technologies, among other factors. In addition to a decline in our revenue growth rate, we may also experience downward pressure on our operating margin resulting from a variety of factors, such as the continued expansion of our business into a variety of new fields, including through products and services such as Google Cloud, Google Play, and hardware products where margins have generally been lower than those we generate from advertising. We may also experience downward pressure on our operating margins from increasing competition and increased costs for many aspects of our business, including within advertising where changes such as device mix and property mix can affect margin. The margin we earn on 8 Table of Contents Alphabet Inc. revenues generated from our Google Network Members could also decrease in the future if we pay a larger percentage of advertising fees to them. We may also pay increased TAC to our distribution partners due to a number of factors. Additionally, our spend to promote new products and services or distribute certain products or an increased investment in our innovation efforts across the Company (within Google as well as our Other Bets businesses) may affect our operating margins. Due to these factors and the evolving nature of our business, our historical revenue growth rate and historical operating margin may not be indicative of our future performance. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results may fluctuate as a result of a number of factors, many outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our quarterly, year-to-date, and annual expenses as a percentage of our revenues may differ significantly from our historical rates. Our operating results in future quarters may fall below expectations. Any of these events could cause our stock price to fall. Each of the risk factors listed in this section in addition to the following factors may affect our operating results: • Our ability to continue to attract and retain users and customers to our products and services. • Our ability to attract user and/or customer adoption of and generate significant revenues from new products, services, and technologies in which we have invested considerable time and resources. • Our ability to monetize (or generate revenues from) traffic on Google properties and our Google Network Members' properties across various devices. • Revenue fluctuations in our advertising business caused by changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix. • The amount of revenues and expenses generated and incurred in currencies other than U.S. dollars, and our ability to manage the resulting risk through our foreign exchange risk management program. • The amount and timing of operating costs and expenses and capital expenditures related to the maintenance and expansion of our businesses, operations, and infrastructure. • Our focus on long-term goals over short-term results. • The results of our acquisitions, divestitures, and our investments in risky projects, including new businesses, products, services, and technologies. • Our ability to keep our products and services operational at a reasonable cost and without service interruptions. • The seasonal fluctuations in internet usage, advertising spending, and underlying business trends such as traditional retail seasonality. Our rapid growth has tended to mask the cyclicality and seasonality of our business. As our growth rate has slowed, the cyclicality and seasonality in our business has become more pronounced and caused our operating results to fluctuate. Because our businesses are changing and evolving, our historical operating results may not be useful to you in predicting our future operating results. A variety of new and existing laws and/or interpretations could harm our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations of existing laws and regulations) may make our products and services less useful, require us to incur substantial costs, expose us to unanticipated civil or criminal liability, or cause us to change our business practices. For example, our products and services are closely scrutinized by competition authorities around the world, which may limit our ability to pursue certain business models or offer certain products or services. Current and new patent laws may also affect the ability of companies, including us, to protect their innovations and defend against claims of patent infringement. Similarly, the Directive on Copyright in the Digital Single Market (DSM) in Europe, if passed in its proposed form, will increase the liability of large hosted platforms with respect to content uploaded by their users. It will also create a new property right in news publications that will limit the ability of online services to interact with or present such content. In addition to the DSM, other changes to copyright laws being considered elsewhere, will, if passed, increase costs and require companies, including us, to change or cease offering certain existing services. Additionally, as the focus on data privacy and security increases globally, we are and will 9 Table of Contents Alphabet Inc. continue to be subject to various and evolving laws. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Furthermore, many of these laws do not contemplate or address the unique issues raised by a number of our new businesses, products, services and technologies. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain. Other recently passed laws and/or certain court decisions that could harm our business include, among others: • We rely on statutory safe harbors, as set forth in the Digital Millennium Copyright Act in the United States and the E-Commerce Directive in Europe, against copyright liability for various linking, caching, and hosting activities. Any legislation or court rulings affecting these safe harbors may adversely affect us. • Court decisions such as the judgment of the Court of Justice of the European Union on May 13, 2014 on the ‘right to be forgotten,’ which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users and impose significant operational burdens. • Court decisions that require Google to suppress content not just in the jurisdiction of the issuing court, but for all of our users worldwide, including locations where the content at issue is lawful. The Supreme Court of Canada issued such a decision against Google in June 2017, and others could treat its decision as persuasive. For instance, with respect to the ‘right to be forgotten,’ a follow-up case is pending before the Court of Justice of the European Union, which could result in an order to apply delisting actions under the ‘right to be forgotten’ worldwide. • Various U.S. and international laws that govern the distribution of certain materials to children and regulate the ability of online services to collect information from minors. • Various laws with regard to content removal and disclosure obligations, such as the Network Enforcement Act in Germany, which may affect our businesses and operations and may subject us to significant fines if such laws are interpreted and applied in a manner inconsistent with our practices. • Data protection laws passed by many states within the U.S. and by certain countries regarding notification to data subjects and/or regulators when there is a security breach of personal data. • The California Consumer Privacy Act of 2018 that comes into effect in January of 2020, and gives new data privacy rights to California residents and regulates the security of data in connection with internet connected devices. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. • Privacy laws, which could be interpreted broadly thereby limiting product offerings and/or increasing costs. Any failure on our part to comply with laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are regularly subject to claims, suits, government investigations, and other proceedings that may adversely affect our business and results of operations. We are regularly subject to claims, suits, and government investigations involving competition, intellectual property, data privacy and security, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Due to our manufacturing and sale of an expanded suite of products, including hardware as well as our Google Cloud offerings, we may also be subject to a variety of claims including product warranty, product liability and consumer protection claims related to product defects, among other litigation. We may also be subject to claims involving health and safety, hazardous materials usage, other environmental concerns or if users or customers experience service disruptions, failures, or other issues. In addition, our businesses face intellectual property litigation, as discussed later, that exposes us to the risk of exclusion and cease and desist orders, which could limit our ability to sell products and services. Such claims, suits, and government investigations are inherently uncertain. Regardless of the outcome, any of these types of legal proceedings can have an adverse effect on us because of legal costs, diversion of management resources, negative publicity and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. The resolution of one or more such proceedings has resulted and may in the future result in additional substantial fines and penalties that could adversely affect our business, consolidated financial position, results of operations, or cash flows in a particular period. These proceedings could also result in 10 Table of Contents Alphabet Inc. reputational harm, criminal sanctions, consent decrees, or orders preventing us from offering certain features, functionalities, products, or services, requiring a change in our business practices or product recalls or corrections, or requiring development of non-infringing or otherwise altered products or technologies. Any of these consequences could adversely affect our business and results of operations. We may be subject to legal liability associated with providing online services or content. We host and provide a wide variety of services and products that enable users to exchange information, advertise products and services, conduct business, and engage in various online activities both domestically and internationally. The law relating to the liability of providers of these online services and products for activities of their users is still somewhat unsettled both within the U.S. and internationally. Claims have been threatened and have been brought against us for defamation, negligence, breaches of contract, copyright or trademark infringement, unfair competition, unlawful activity, tort, including personal injury, fraud, or other theories based on the nature and content of information that we publish or to which we provide links or that may be posted online or generated by us or by third parties, including our users. In addition, we are and have been and may again in the future be subject to domestic or international actions alleging that certain content we have generated or third-party content that we have made available within our products and services violates U.S. and international law. We also place advertisements which are displayed on third-party publishers and advertising networks properties, and we offer third-party products, services, or content. We may be subject to claims concerning these products, services, or content by virtue of our involvement in marketing, branding, broadcasting, or providing access to them, even if we do not ourselves host, operate, provide, or provide access to these products, services, or content. Defense of any such actions could be costly and involve significant time and attention of our management and other resources, which may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Data privacy and security concerns relating to our technology and our practices could damage our reputation and deter current and potential users or customers from using our products and services. Bugs or defects in our products and services have occurred and may occur in the future, or our security measures could be breached, resulting in the improper use and/or disclosure of user data, and our services and systems are subject to attacks that could degrade or deny the ability of users and customers to access, or rely on information received about, our products and services. As a consequence, our products and services may be perceived as being insecure, users and customers may curtail or stop using our products and services, and we may incur significant legal, reputational, and financial exposure. From time to time, concerns are expressed about whether our products, services, or processes compromise the privacy of users, customers, and others. Concerns about our practices with regard to the collection, use, disclosure, or security of personal information or other data privacy related matters, even if unfounded, could damage our reputation and adversely affect our operating results. Our policies and practices may change over time as users’ and customers’ expectations regarding privacy and their data changes. Our products and services involve the storage and transmission of users’ and customers’ proprietary information, and bugs, theft, misuse, defects, vulnerabilities in our products and services, and security breaches expose us to a risk of loss of this information, improper use and disclosure of such information, litigation, and other potential liability. Systems failures, compromises of our security, failure to abide by our privacy policies, inadvertent disclosure that results in the release of our users’ data, or in our or our users’ inability to access such data, could result in government investigations and other liability, legislation or regulation, seriously harm our reputation and brand and, therefore, our business, and impair our ability to attract and retain users. We expect to continue to expend significant resources to maintain state-of-the-art security protections that shield against bugs, theft, misuse or security vulnerabilities or breaches. We experience cyber attacks of varying degrees and other attempts to gain unauthorized access to our systems on a regular basis. Our security measures may in the future be breached due to employee error, malfeasance, system errors or vulnerabilities, including vulnerabilities of our vendors, suppliers, their products, or otherwise. Such breach or other unauthorized access, increased government surveillance, or attempts by outside parties to fraudulently induce employees, users, or customers to disclose sensitive information in order to gain access to our data or our users’ or customers’ data could result in significant legal and financial exposure, damage to our reputation, and a loss of confidence in the security of our products and services that could potentially have an adverse effect on our business. Because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems change frequently, become more sophisticated, and often are not recognized until launched against a target, we may be unable to anticipate or detect these techniques or to implement adequate preventative measures. Cyber attacks could also compromise trade secrets and other sensitive information and result in such information being disclosed to others and becoming less valuable, which could negatively affect our business. If an actual or perceived breach of our security 11 Table of Contents Alphabet Inc. occurs, the market perception of the effectiveness of our security measures could be harmed and we could lose users and customers. While we have dedicated significant resources to privacy and security incident response, including dedicated worldwide incident response teams, our response process may not be adequate, may fail to accurately assess the severity of an incident, may not respond quickly enough, or may fail to sufficiently remediate an incident, among other issues. As a result, we may suffer significant legal, reputational, or financial exposure, which could adversely affect our business and results of operations. Our business is subject to complex and rapidly evolving U.S. and international laws and regulations regarding privacy and data protection. Many of these laws and regulations are subject to change and uncertain interpretation and could result in claims, changes to our business practices, penalties, increased cost of operations, or declines in user growth or engagement, or otherwise harm our business. Companies are under increased regulatory scrutiny relating to data privacy and security. Authorities around the world are considering a number of legislative and regulatory proposals concerning data protection, including measures to ensure that encryption of users’ data does not hinder law enforcement agencies’ access to that data. In addition, the interpretation and application of consumer and data protection laws in the U.S., Europe and elsewhere are often uncertain and in flux. It is possible that these laws may be interpreted and applied in a manner that is inconsistent with our data practices. These legislative and regulatory proposals, if adopted, and such interpretations could, in addition to the possibility of fines, result in an order requiring that we change our data practices, which could have an adverse effect on our business and results of operations. Complying with these various laws could cause us to incur substantial costs or require us to change our business practices in a manner adverse to our business. Recent legal developments in Europe have created compliance uncertainty regarding certain transfers of personal data from Europe to the United States. For example, the General Data Protection Regulation (GDPR), became effective in the European Union (EU) beginning on May 25, 2018, and applies to all of our activities conducted from an establishment in the EU or related to products and services that we offer to EU users or customers, or the monitoring of their behavior in the EU. The GDPR subjects us to a range of new compliance obligations. Ensuring compliance with the GDPR is an ongoing commitment which involves substantial costs, and it is possible that despite our efforts, governmental authorities or third parties will assert that our business practices fail to comply. We have been and may in the future be, subject to lawsuits alleging violations of the GDPR. If our operations are found to be in violation of the GDPR’s requirements, we may be required to change our business practices and/or be subject to significant civil penalties, business disruption, and reputational harm, any of which could have a material adverse effect on our business. In particular, serious breaches of the GDPR can result in administrative fines of up to the higher of 4% of annual worldwide revenues or €20 million. Fines of up to the higher of 2% of annual worldwide revenues or €10 million can be levied for other specified violations. In addition, the European Commission in July 2016 and the Swiss Government in January 2017 approved the EU-U.S. and the Swiss-U.S. Privacy Shield frameworks, respectively, which are designed to allow U.S. companies that self-certify to the U.S. Department of Commerce and publicly commit to comply with the Privacy Shield requirements to freely import personal data from the EU and Switzerland. However, these frameworks face a number of legal challenges and their validity remains subject to legal, regulatory and political developments in both Europe and the U.S. This has resulted in some uncertainty, and compliance obligations could cause us to incur costs or require us to change our business practices in a manner adverse to our business. We are, and may in the future be, subject to intellectual property or other claims, which are costly to defend, could result in significant damage awards, and could limit our ability to use certain technologies in the future. Many companies, in particular those in internet, technology and media own large numbers of patents, copyrights, trademarks, and trade secrets and frequently enter into litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent holding companies may continue to seek to monetize patents they have purchased or otherwise obtained by bringing claims against us, whether such claims are meritorious or not. As we have grown, the number of intellectual property claims against us has increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Third parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease and desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to 12 Table of Contents Alphabet Inc. infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices and require development of non-infringing products, services or technologies, which could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to defend against certain intellectual property infringement claims and/or indemnify them for certain intellectual property infringement claims against them, which could result in increased costs for defending such claims or significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers arising from intellectual property infringement claims brought against us. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, including those associated with intellectual property claims. Regardless of their merits, intellectual property claims are often time consuming, expensive to litigate or settle, and cause significant diversion of management attention. To the extent such claims are successful, they may have an adverse effect on our business, including our product and service offerings, consolidated financial position, results of operations, or cash flows. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand as well as affect our ability to compete. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy of such trade secrets and other sensitive information could be compromised by outside parties, or by our employees, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” Some courts have ruled that "Google" is a protectable trademark, however it is possible that other courts, particularly those outside of the United States, may reach a different determination. If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that may adversely affect our business and results of operations. Acquisitions, joint ventures, investments and divestitures are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and results of operations. We expect to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions. Effecting these strategic transactions could create unforeseen operating difficulties and expenditures. The areas where we face risks include, among others: • Diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions. • Failure to successfully further develop the acquired business or technology. • Implementation or remediation of controls, procedures, and policies at the acquired company. 13 Table of Contents Alphabet Inc. • Integration of the acquired company's accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions. • Transition of operations, users, and customers onto our existing platforms. • Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of an acquisition or other strategic transaction. • In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. • Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire. • Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, privacy issues, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities. • Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions and other strategic transactions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or results. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which may adversely affect our financial condition or results. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, customers, content providers, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands within Google and Other Bets increases our ability to enter new categories and launch new and innovative products that better serve the needs of our users, advertisers, customers, content providers, and other partners. Our brands may be negatively affected by a number of factors, including, among others, reputational issues, third-party content shared on our platforms, data privacy issues and developments, and product or technical performance failures. For example, if we fail to appropriately respond to the sharing of objectionable content on our services or objectionable practices by advertisers, or to otherwise adequately address user concerns, our users may lose confidence in our brands. Our brands may also be negatively affected by the use of our products or services to disseminate information that is deemed to be false or misleading. Furthermore, if we fail to maintain and enhance equity in our brands, our business, operating results, and financial condition may be materially and adversely affected. Our success will depend largely on our ability to remain a technology leader and continue to provide high-quality, innovative products and services that are truly useful and play a meaningful role in people’s everyday lives. We face a number of manufacturing and supply chain risks that, if not properly managed, could adversely affect our financial results and prospects. We face a number of risks related to manufacturing and supply chain management. These manufacturing and supply chain risks could affect our ability to supply both our products and our internet-based services. We rely on third parties to manufacture many of our assemblies and finished products, third-party arrangements for the design of some components and parts, and third party distributors, including cellular network carriers. Our business could be negatively affected if we are not able to engage third parties with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. 14 Table of Contents Alphabet Inc. We may experience supply shortages and price increases driven by raw material availability, manufacturing capacity, labor shortages, industry allocations, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), and significant changes in the financial or business condition of our suppliers. We may experience shortages or other supply chain disruptions in the future that could negatively affect our operations. In addition, some of the components we use in our technical infrastructure and products are available only from a single source or limited sources, and we may not be able to find replacement vendors on favorable terms or at all in the event of a supply chain disruption. In addition, a significant hardware supply interruption could delay critical data center upgrades or expansions. We may enter into long term contracts that commit us to significant terms and conditions of supply. We may be liable for material and product that is not consumed due to market acceptance, technological change, obsolescences, quality, product recalls, and warranty issues. For instance, because many of our hardware supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and therefore less competitive and negatively affect our financial results. Furthermore, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may affect our supply. The products and services we sell or offer may have quality issues resulting from the design or manufacture of the product, or from the software used. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products and services does not meet our users’ and/or customers’ expectations or our products or services are found to be defective, then our sales and operating earnings, and ultimately our reputation, could be negatively affected. We also require our suppliers and business partners to comply with law and, where applicable, our company policies, such as the Google Supplier Code of Conduct, regarding workplace and employment practices, data security, environmental compliance and intellectual property licensing, but we do not control them or their practices. If any of them violates laws or implements practices regarded as unethical, we could experience supply chain disruptions, canceled orders, terminations of or damage to key relationships, and damage to our reputation. If any of them fails to procure necessary license rights to third-party intellectual property, legal action could ensue that could affect the saleability of our products and expose us to financial obligations to third parties. Web spam, including content farms, and other violations of our guidelines could affect the quality of our services, which could damage our reputation and deter our current and potential users from using our products and services. Web spam refers to websites that violate or attempt to violate our guidelines or that otherwise seek to inappropriately rank higher in search results than our search engine's assessment of their relevance and utility would rank them. Web spam may also affect the quality of content posted on our platforms and may manipulate them to display false, misleading or undesirable content. Although English-language web spam in our search results has been significantly reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek ways to improve their rankings inappropriately. We continuously combat web spam in our search results, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We also continue to invest in and deploy proprietary technology to detect and prevent web spam from abusing our platforms. We also face other challenges from web spam such as low-quality and irrelevant content websites, including content farms, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes focused on low-quality websites. We, like others in the industry, face other violations of our guidelines, including sophisticated attempts by bad actors to manipulate our advertising systems to fraudulently generate revenues for themselves or others, or to otherwise generate traffic that does not represent genuine user interest or intent. While we invest significantly in efforts to detect and prevent invalid traffic, including attempts by bad actors to generate income fraudulently, we may be unable to adequately detect and prevent such abuses in the future. If we are subject to an increasing number of web spam, including content farms or other violations of our guidelines, this could hurt our reputation for delivering relevant information or reduce user traffic to our websites or their use of our platforms, which may adversely affect our financial condition or results. Interruption, interference with or failure of our information technology and communications systems could hurt our ability to effectively provide our products and services, which could damage our reputation and harm our operating results. 15 Table of Contents Alphabet Inc. The availability of our products and services depends on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference or interruption from terrorist attacks, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, computer denial of service attacks, or other attempts to harm or access our systems. Some of our data centers are located in areas with a high risk of major earthquakes or other natural disasters. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and to potential disruptions if the operators of certain of these facilities have financial difficulties. Some of our systems are not fully redundant, and our disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster, a decision to close a facility we are using, or other unanticipated problems at our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and may contain errors or vulnerabilities, which could result in interruptions in our services or the failure of our systems. Our international operations expose us to additional risks that could harm our business, operating results, and financial condition. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 54% of our consolidated revenues in 2018 . In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • Restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S. • Import and export requirements, tariffs, trade disputes and barriers, and customs classifications that may prevent us from offering products or providing services to a particular market and may increase our operating costs. • Longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud. • Evolving foreign laws and legal systems, including those that may occur as a result of the United Kingdom's potential withdrawal from the European Union ("Brexit"). Brexit may adversely affect global economic and market conditions and could contribute to volatility in the foreign exchange markets, which we may be unable to effectively manage through our foreign exchange risk management program. Brexit may also adversely affect our revenues and could subject us to new regulatory costs and challenges, in addition to other adverse effects that we are unable to effectively anticipate. • Uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent. • Different employee/employer relationships, existence of workers' councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Changes in international local political, economic, regulatory, tax, social, and labor conditions may also harm our business, and compliance with complex international and U.S. laws and regulations that apply to our international operations increases our cost of doing business. These numerous and sometimes conflicting laws and regulations include, among others, internal control and disclosure rules, privacy and data protection requirements, anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting certain payments to governmental officials, and competition regulations, among others. Violations of these laws and regulations could result in fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business and on our ability to offer our products and services in one or more countries, and could also materially affect our brand, our international growth efforts, our ability to attract and retain employees, our business, and our operating results. Although we have implemented policies and procedures designed to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors, or agents will not violate our policies. Since we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we face exposure to fluctuations in foreign currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Hedging programs are also inherently risky and could expose us to additional risks that could adversely affect our financial condition and results of operations. If we were to lose the services of key personnel, we may not be able to execute our business strategy. 16 Table of Contents Alphabet Inc. Our future success depends in a large part upon the continued service of key members of our senior management team. In particular, Larry Page and Sergey Brin are critical to the overall management of Alphabet and its subsidiaries, and they, along with Sundar Pichai, the Chief Executive Officer of Google, play an important role in the development of our technology. They also play a key role in maintaining our culture and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows, and we are required to implement more complex organizational management structures, particularly in light of our holding company structure, we may find it increasingly difficult to maintain the beneficial aspects of our corporate culture. This could negatively affect our future success. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures, including legal actions, that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, or by charging increased fees to us or our users to provide our offerings. Some jurisdictions have adopted regulations prohibiting certain forms of discrimination by Internet access providers; however, substantial uncertainty exists in the United States and elsewhere regarding such protections. For example, in the United States the Federal Communications Commission repealed net neutrality rules effective June 11, 2018, which could lead internet access providers to restrict, block, degrade, or charge for access to certain of our products and services. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. Such interference could result in a loss of existing users, customers and advertisers, goodwill, and increased costs, and could impair our ability to attract new users, customers and advertisers, thereby harming our revenues and growth. New and existing technologies could affect our ability to customize ads and/or could block ads online, which would harm our business. Technologies have been developed to make customizable ads more difficult or to block the display of ads altogether and some providers of online services have integrated technologies that could potentially impair the core functionality of third-party digital advertising. Most of our Google revenues are derived from fees paid to us in connection with the display of ads online. As a result, such technologies and tools could adversely affect our operating results. We are exposed to fluctuations in the market values of our investments. Given the global nature of our business, we have investments both domestically and internationally. Market values of these investments can be negatively affected by liquidity, credit deterioration or losses, financial results, foreign exchange rates, changes in interest rates, including changes that may result from the implementation of new benchmark rates that replace LIBOR, the effect of new or changing regulations, or other factors. Due to the adoption of ASU 2016-01 “Financial Instruments; Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities” in January 2018, we adjust the carrying value of our non-marketable equity securities to fair value for observable transactions of identical or similar investments of the same issuer and impairment. All gains and losses on non-marketable equity securities, realized and unrealized, are recognized in other income (expense), which increases the volatility of our other income (expense). 17 Table of Contents Alphabet Inc. As a result of these factors, the value or liquidity of our cash equivalents, as well as our marketable and non-marketable securities could decline and result in a material impairment, which could materially adversely affect our financial condition and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. Our future income taxes could be adversely affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions on various tax-related assertions, examples include transfer pricing adjustments or permanent establishment. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations where the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made. Furthermore, due to shifting economic and political conditions, tax policies, laws or rates in various jurisdictions may be subject to significant change, which could materially affect our financial position and results of operations. Risks Related to Ownership of Our Stock The trading price for our Class A common stock and non-voting Class C capital stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. For example, from January 1, 2018 through December 31, 2018, the closing price of our Class A common stock ranged from $984.66 per share to $1,285.50 per share, and the closing price of our Class C capital stock ranged from $976.21 to $1,268.32 per share. In addition to the factors discussed in this report, the trading price of our Class A common stock and Class C capital stock may fluctuate widely in response to various factors, many of which are beyond our control, including, among others: • Quarterly variations in our results of operations or those of our competitors. • Announcements by us or our competitors of acquisitions, divestitures, investments, new products, significant contracts, commercial relationships, or capital commitments. • Recommendations by securities analysts or changes in earnings estimates. • Announcements about our earnings that are not in line with analyst expectations, the risk of which is enhanced because it is our policy not to give guidance on earnings. • Announcements by our competitors of their earnings that are not in line with analyst expectations. • Commentary by industry and market professionals about our products, strategies, and other matters affecting our business and results, regardless of its accuracy. • The volume of shares of Class A common stock and Class C capital stock available for public sale. • Sales of Class A common stock and Class C capital stock by us or by our stockholders (including sales by our directors, executive officers, and other employees). • Short sales, hedging, and other derivative transactions on shares of our Class A common stock and Class C capital stock. • The perceived values of Class A common stock and Class C capital stock relative to one another. • Any share repurchase program. In addition, the stock market in general, which can be affected by various factors, including overall economic and political conditions, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. 18 Table of Contents Alphabet Inc. These broad market and industry factors may harm the market price of our Class A common stock and our Class C capital stock regardless of our actual operating performance. We cannot guarantee that any share repurchase program will be fully consummated or that any share repurchase program will enhance long-term stockholder value, and share repurchases could increase the volatility of the price of our stock and could diminish our cash reserves. In 2016 and 2018, the board of directors of Alphabet authorized the company to repurchase up to $7.0 billion and $8.6 billion of its Class C capital stock, respectively. The 2016 authorization was completed in 2018. As of December 31, 2018 , $1.7 billion remains available for repurchase. In January 2019, our board of directors authorized the repurchase of up to an additional $12.5 billion of our Class C capital stock. Our repurchase program does not have an expiration date and does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. Our share repurchase program could affect the price of our stock and increase volatility and may be suspended or terminated at any time, which may result in a decrease in the trading price of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B common stock has 10 votes per share, our Class A common stock has one vote per share, and our Class C capital stock has no voting rights. As of December 31, 2018, Larry Page, Sergey Brin, and Eric E. Schmidt beneficially owned approximately 92.8% of our outstanding Class B common stock, which represented approximately 56.5% of the voting power of our outstanding common stock. Larry, Sergey, and Eric therefore have significant influence over management and affairs and over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C capital stock carries no voting rights (except as required by applicable law), the issuance of the Class C capital stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could prolong the duration of Larry, Sergey and Eric’s current relative ownership of our voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. This concentrated control limits or severely restricts our stockholders’ ability to influence corporate matters and, as a result, we may take actions that our stockholders do not view as beneficial. As a result, the market price of our Class A common stock and our Class C capital stock could be adversely affected. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry, Sergey, and Eric have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. As noted above, the issuance of the Class C capital stock could have the effect of prolonging the influence of Larry, Sergey, and Eric. • Our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death, or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors. • Our stockholders may not act by written consent. As a result, a holder, or holders, controlling a majority of our capital stock would not be able to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our board of directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to issue undesignated preferred stock makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. 19 Table of Contents Alphabet Inc. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us. Risk Related to Our Holding Company Reorganization As a holding company, Alphabet is dependent on the operations and funds of its subsidiaries. Alphabet is a holding company with no business operations of its own. Alphabet’s most significant assets are the outstanding equity interests in its subsidiaries, including Google, that are each separate and distinct legal entities. As a result of our holding company structure, we rely on cash flows from subsidiaries to meet our obligations, including to service any debt obligations of Alphabet. Our subsidiaries may be restricted in their ability to pay cash dividends or to make other distributions to Alphabet and therefore, our ability to meet our obligations may be adversely affected by such restrictions. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We also own and lease office and building space in the surrounding areas near our headquarters, which in the aggregate (including our headquarters) represent approximately 11.2 million square feet of office/building space and approximately fifty-nine acres of developable land to accommodate anticipated future growth. In addition, we own and lease office/building space and research and development sites around the world, primarily in North America, Europe, South America, and Asia. We own and operate data centers in the U.S., Europe, South America, and Asia. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, please see Note 9 “Commitments and Contingencies - Legal Matters” of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 20 Table of Contents Alphabet Inc. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. Holders of Record As of December 31, 2018 , there were approximately 2,026 and 2,195 stockholders of record of our Class A common stock and Class C capital stock, respectively. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2018 , there were approximately 65 stockholders of record of our Class B common stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. We do not expect to pay any cash dividends in the foreseeable future. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class C capital stock during the quarter ended December 31, 2018 : Period Total Number of Shares Purchased (in thousands) (1) Average Price Paid per Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 830 $ 1,115.81 830 $ 3,412 November 1 - 30 859 $ 1,054.22 859 $ 2,506 December 1 - 31 781 $ 1,048.23 781 $ 1,688 Total 2,470 $ 1,073.02 2,470 (1) In January 2018, the board of directors of Alphabet authorized the company to repurchase up to $8.6 billion of its Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. See Note 10 in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. 21 Table of Contents Alphabet Inc. Stock Performance Graphs The graph below matches Alphabet Inc. Class A's cumulative 5-Year total shareholder return on common stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from December 31, 2013 to December 31, 2018 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* ALPHABET INC. CLASS A COMMON STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2013 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2015 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 22 Table of Contents Alphabet Inc. The graph below matches Alphabet Inc. Class C's cumulative 57-Month total shareholder return on capital stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our Class C capital stock and in each index (with the reinvestment of all dividends) from April 3, 2014 to December 31, 2018 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE TOTAL RETURN* ALPHABET INC. CLASS C CAPITAL STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on April 3, 2014 in stock or in index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2015 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 23 Table of Contents Alphabet Inc. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing in Item 8 “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results to be expected in any future period. Year Ended December 31, 2014 2015 2016 2017 2018 (in millions, except per share amounts) Consolidated Statements of Income Data: Revenues $ 66,001 $ 74,989 $ 90,272 $ 110,855 $ 136,819 Income from operations $ 16,496 $ 19,360 $ 23,716 $ 26,146 $ 26,321 Net income from continuing operations $ 13,620 $ 16,348 $ 19,478 $ 12,662 $ 30,736 Net income from discontinued operations $ 516 $ 0 $ 0 $ 0 $ 0 Net income $ 14,136 $ 16,348 $ 19,478 $ 12,662 $ 30,736 Basic net income per share of Class A and B common stock: Continuing operations $ 20.15 $ 23.11 $ 28.32 $ 18.27 $ 44.22 Discontinued operations 0.76 0.00 0.00 0.00 0.00 Basic net income per share of Class A and B common stock $ 20.91 $ 23.11 $ 28.32 $ 18.27 $ 44.22 Basic net income per share of Class C capital stock: Continuing operations $ 20.15 $ 24.63 $ 28.32 $ 18.27 $ 44.22 Discontinued operations 0.76 0.00 0.00 0.00 0.00 Basic net income per share of Class C capital stock $ 20.91 $ 24.63 $ 28.32 $ 18.27 $ 44.22 Diluted net income per share of Class A and B common stock: Continuing operations $ 19.82 $ 22.84 $ 27.85 $ 18.00 $ 43.70 Discontinued operations 0.75 0.00 0.00 0.00 0.00 Diluted net income per share of Class A and B common stock $ 20.57 $ 22.84 $ 27.85 $ 18.00 $ 43.70 Diluted net income per share of Class C capital stock: Continuing operations $ 19.82 $ 24.34 $ 27.85 $ 18.00 $ 43.70 Discontinued operations 0.75 0.00 0.00 0.00 0.00 Diluted net income per share of Class C capital stock $ 20.57 $ 24.34 $ 27.85 $ 18.00 $ 43.70 As of December 31, 2014 2015 2016 2017 2018 (in millions) Consolidated Balance Sheet Data: Cash, cash equivalents, and marketable securities $ 64,395 $ 73,066 $ 86,333 $ 101,871 $ 109,140 Total assets $ 129,187 $ 147,461 $ 167,497 $ 197,295 $ 232,792 Total long-term liabilities $ 8,548 $ 7,820 $ 11,705 $ 20,610 $ 20,544 Total stockholders’ equity $ 103,860 $ 120,331 $ 139,036 $ 152,502 $ 177,628 24 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K. Trends in Our Business The following trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, contributing to revenue growth, and we expect that this online shift will continue to benefit our business. • As online advertising evolves, we continue to expand our product offerings which may affect our monetization. As interactions between users and advertisers change and as online user behavior evolves, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube engagement ads, which monetize at a lower rate than traditional desktop search ads. Additionally, we continue to see a shift to programmatic buying which presents opportunities for advertisers to connect with the right user, in the right moment, in the right context. Programmatic buying has a different monetization profile than traditional advertising buying on Google properties. • Users are increasingly using diverse devices and modalities to access our products and services, and our advertising revenues are increasingly coming from mobile and other new formats. Our users are accessing the Internet via diverse devices and modalities and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of this shift in order to maintain and grow our business. We generate our advertising revenues increasingly from mobile and newer advertising formats, and the margins from the advertising revenues from these sources have generally been lower than those from traditional desktop search. Accordingly, we expect TAC paid to our distribution partners to increase due to changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms, and the percentage of queries channeled through paid access points. We expect these trends to continue to put pressure on our overall margins. • As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates affect such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, and we continue to develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time and we expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. • The portion of our revenues that we derive from non-advertising revenues is increasing and may affect margins. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings to our users through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. Across these initiatives, we currently derive non-advertising revenues primarily from sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings. The margins on these non-advertising businesses vary significantly and may be lower than the margins on our advertising business. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile. 25 Table of Contents Alphabet Inc. • As we continue to look for new ways to serve our users and expand our businesses, we will invest heavily in R&D and capital expenditures. We continue to make significant R&D investments in areas of strategic focus such as advertising, cloud, machine learning, and search, as well as in new products and services. Our capital expenditures have grown over time. We expect this trend to continue in the long term as we invest heavily in data centers, real estate and facilities, and information technology infrastructure. In addition, acquisitions remain an important part of our strategy and use of capital, and we expect to continue to spend cash on acquisitions and other investments. These acquisitions generally enhance the breadth and depth of our offerings, as well as expand our expertise in engineering and other functional areas. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees. Executive Overview of Results Below are our key financial results for the fiscal year ended December 31, 2018 (consolidated unless otherwise noted): • Revenues of $136.8 billion and revenue growth of 23% year over year, constant currency revenue growth of 22% year over year. • Google segment revenues of $136.2 billion with revenue growth of 23% year over year and Other Bets revenues of $595 million with revenue growth of 25% year over year. • Revenues from the United States , EMEA , APAC , and Other Americas were $63.3 billion , $44.6 billion , $21.4 billion , and $7.6 billion , respectively. • Cost of revenues was $59.5 billion , consisting of TAC of $26.7 billion and other cost of revenues of $32.8 billion . Our TAC as a percentage of advertising revenues was 23% . • Operating expenses (excluding cost of revenues) were $50.9 billion . • Income from operations was $26.3 billion . • Other income (expense), net, was $8.6 billion . • Effective tax rate was 12% . • Net income was $30.7 billion with diluted net income per share of $43.70 . • Operating cash flow was $48.0 billion . • Capital expenditures were $25.1 billion . • Number of employees was 98,771 as of December 31, 2018 . Information about Segments We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed as Other Bets. Our reported segments are: • Google – Google includes our main products such as Ads, Android, Chrome, Google Cloud, Google Maps, Google Play, Hardware (including Nest), Search, and YouTube. Our technical infrastructure is also included in Google. Google generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access, Calico, CapitalG, GV, Verily, Waymo, and X. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Access as well as licensing and R&D services through Verily. In Q1 2018, Nest joined Google’s hardware team. Consequently, the financial results of Nest are reported in the Google segment, with Nest revenues reflected in Google other revenues. Prior period segment information has been recast to conform to the current period segment presentation. Consolidated financial results are not affected. 26 Table of Contents Alphabet Inc. Please refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. Revenues The following table presents our revenues, by segment and revenue source (in millions): Year Ended December 31, 2016 2017 2018 Google segment Google properties revenues $ 63,785 $ 77,788 $ 96,336 Google Network Members' properties revenues 15,598 17,587 19,982 Google advertising revenues 79,383 95,375 116,318 Google other revenues 10,601 15,003 19,906 Google segment revenues $ 89,984 $ 110,378 $ 136,224 Other Bets Other Bets revenues $ 288 $ 477 $ 595 Revenues $ 90,272 $ 110,855 $ 136,819 Google segment The following table presents our Google segment revenues (in millions): Year Ended December 31, 2016 2017 2018 Google segment revenues $ 89,984 $ 110,378 $ 136,224 Google segment revenues as a percentage of total revenues 99.7 % 99.6 % 99.6 % Use of Monetization Metrics When assessing our advertising revenues performance, historically we presented the percentage change in the number of paid clicks and cost-per-click for both our Google properties and our Google Network Members’ properties (Network) revenues. As our impression-based revenues have become a more significant driver of Network revenues growth, the percentage change in paid clicks and cost-per-click cover less of our total Network revenues. As a result, in Q1 2018, we transitioned our Network revenue metrics from the percentage change in paid clicks and cost-per-click to the percentage change in impressions and cost-per-impression. Click-based revenues generated by our Network business are included in impression-based metrics, so that these metrics cover nearly all of our Network business. The monetization metrics for Google properties revenues remain unchanged. Paid clicks for our Google properties represent engagement by users and include clicks on advertisements by end-users related to searches on Google.com, clicks related to advertisements on other owned and operated properties including Gmail, Google Maps, and Google Play; and viewed YouTube engagement ads. Impressions for our Google Network Members' properties include impressions displayed to users served on Google Network Members' properties participating primarily in AdMob, AdSense for Content, AdSense for Search, and Google Ad Manager (includes what was formerly DoubleClick AdExchange). Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions and represents the average amount we charge advertisers for each impression displayed to users. As our business evolves, we periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks on our Google properties and the number of impressions on Google Network Members’ properties and for identifying the revenues generated by click activity on our Google properties and the revenues generated by impression activity on Google Network Members’ properties. Our advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google properties and the change in impressions and cost-per-impression on Google Network Members' properties and the correlation between these items, have fluctuated and may continue to fluctuate because of various factors, including: 27 Table of Contents Alphabet Inc. • advertiser competition for keywords; • changes in advertising quality or formats; • changes in device mix; • changes in foreign currency exchange rates; • fees advertisers are willing to pay based on how they manage their advertising costs; • general economic conditions; • growth rates of revenues within Google properties; • seasonality; and • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels. Our advertising revenue growth rate has fluctuated over time as a result of a number of factors, including challenges in maintaining our growth rate as revenues increase to higher levels, changes in our product mix, increasing competition, query growth rates, our investments in new business strategies, shifts in the geographic mix of our revenues, and the evolution of the online advertising market. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices and modalities, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates. Google properties The following table presents our Google properties revenues (in millions), and changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 2016 2017 2018 Google properties revenues $ 63,785 $ 77,788 $ 96,336 Google properties revenues as a percentage of Google segment revenues 70.9 % 70.5 % 70.7 % Paid clicks change 54 % 62 % Cost-per-click change (21 )% (25 )% Google properties revenues consist primarily of advertising revenues that are generated on: • Google search properties which includes revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.; and • Other Google owned and operated properties like Gmail, Google Maps, Google Play, and YouTube. Our Google properties revenues increased $18,548 million from 2017 to 2018 and increased $14,003 million from 2016 to 2017 . The growth during both periods was primarily driven by increases in mobile search resulting from ongoing growth in user adoption and usage, as well as continued growth in advertiser activity. We also experienced growth in YouTube driven primarily by video advertising, as well as growth in desktop search due to improvements in ad formats and delivery. Additionally, revenue growth from 2017 to 2018 was favorably affected by the general weakening of the U.S. dollar compared to certain foreign currencies. The growth from 2016 to 2017 was partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. The number of paid clicks through our advertising programs on Google properties increased from 2017 to 2018 and from 2016 to 2017 due to growth in YouTube engagement ads, increases in mobile search queries, improvements we have made in ad formats and delivery, and continued global expansion of our products, advertisers and user base. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers from 2017 to 2018 and from 2016 to 2017 . The decreases in cost-per-click were primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms. Cost-per-click was also affected by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. 28 Table of Contents Alphabet Inc. Google Network Members' properties The following table presents our Google Network Members' properties revenues (in millions) and changes in our impressions and cost-per-impression (expressed as a percentage): Year Ended December 31, 2016 2017 2018 Google Network Members' properties revenues $ 15,598 $ 17,587 $ 19,982 Google Network Members' properties revenues as a percentage of Google segment revenues 17.3 % 15.9 % 14.7 % Impressions change 3 % 2 % Cost-per-impression change 8 % 12 % Google Network Members' properties revenues consist primarily of advertising revenues generated from advertisements served on Google Network Members' properties participating in: • AdMob; • AdSense (such as AdSense for Content, AdSense for Search, etc.); and • Google Ad Manager . Our Google Network Members' properties revenues increased $2,395 million from 2017 to 2018 . The growth was primarily driven by strength in both AdMob and programmatic advertising buying, offset by a decline in our traditional AdSense businesses. Additionally, the growth was favorably affected by the general weakening of the U.S. dollar compared to certain foreign currencies. The increase in impressions from 2017 to 2018 resulted primarily from growth in AdMob offset by a decrease from AdSense for Content due to ongoing product changes. The increase in cost-per-impression was primarily due to ongoing product and policy changes and improvements we have made in ad formats and delivery and was also affected by changes in device mix, geographic mix, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Our Google Network Members' properties revenues increased $1,989 million from 2016 to 2017 . The growth was primarily driven by strength in both programmatic advertising buying and AdMob, offset by a decline in our traditional AdSense businesses and the general strengthening of the U.S. dollar compared to certain foreign currencies. The increase in impressions from 2016 to 2017 resulted primarily from growth in programmatic advertising and AdMob, partially offset by a decrease from AdSense for Search. The increase in cost-per-impression from 2016 to 2017 was primarily due to ongoing product and policy changes and improvements we have made in ad formats and delivery and was also affected by changes in device mix, geographic mix, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Google other revenues The following table presents our Google other revenues (in millions): Year Ended December 31, 2016 2017 2018 Google other revenues $ 10,601 $ 15,003 $ 19,906 Google other revenues as a percentage of Google segment revenues 11.8 % 13.6 % 14.6 % Google other revenues consist primarily of revenues from: • Apps, in-app purchases, and digital content in the Google Play store; • Google Cloud offerings; and • Hardware. Our Google other revenues increased $4,903 million from 2017 to 2018 . The increase was primarily driven by revenues from Google Cloud offerings, revenues from Google Play, largely relating to in-app purchases (revenues which we recognize net of payout to developers), and hardware sales. Our Google other revenues increased $4,402 million from 2016 to 2017 . The increase was primarily driven by revenues from Google Cloud offerings, hardware sales, and revenues from Google Play, largely relating to in-app purchases (revenues which we recognize net of payout to developers). 29 Table of Contents Alphabet Inc. Other Bets The following table presents our Other Bets revenues (in millions): Year Ended December 31, 2016 2017 2018 Other Bets revenues $ 288 $ 477 $ 595 Other Bets revenues as a percentage of total revenues 0.3 % 0.4 % 0.4 % Other Bets revenues consist primarily of revenues and sales from internet and TV services as well as licensing and R&D services. Our Other Bets revenues increased $118 million from 2017 to 2018 and increased $189 million from 2016 to 2017 . These increases were primarily driven by revenues from sales of Access internet and TV services and revenues from Verily licensing and R&D services. Revenues by Geography The following table presents our revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 2016 2017 2018 United States 47 % 47 % 46 % EMEA 34 % 33 % 33 % APAC 14 % 15 % 15 % Other Americas 5 % 5 % 6 % For the amounts of revenues by geography, please refer to Note 2 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Use of Constant Currency Revenues and Constant Currency Revenue Growth The effect of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably affected as the U.S. dollar weakens relative to other foreign currencies, and unfavorably affected as the U.S. dollar strengthens relative to other foreign currencies. Our international revenues are also favorably affected by net hedging gains and unfavorably affected by net hedging losses. We use non-GAAP constant currency revenues and constant currency revenue growth for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to GAAP results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the effect of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue growth on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging effects realized in the current period. Constant currency revenue growth (expressed as a percentage) is calculated by determining the increase in current period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging effects are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. 30 Table of Contents Alphabet Inc. The following table presents the foreign exchange effect on our international revenues and total revenues (in millions): Year Ended December 31, 2016 2017 2018 EMEA revenues $ 30,304 $ 36,046 $ 44,567 Exclude foreign exchange effect on current period revenues using prior year rates 1,291 (5 ) (1,325 ) Exclude hedging effect recognized in current period (479 ) 190 172 EMEA constant currency revenues $ 31,116 $ 36,231 $ 43,414 Prior period EMEA revenues, excluding hedging effect $ 25,379 $ 29,825 $ 36,236 EMEA revenue growth 19 % 24 % EMEA constant currency revenue growth 21 % 20 % APAC revenues $ 12,559 $ 16,235 $ 21,374 Exclude foreign exchange effect on current period revenues using prior year rates (362 ) 26 (49 ) Exclude hedging effect recognized in current period (31 ) (43 ) (33 ) APAC constant currency revenues $ 12,166 $ 16,218 $ 21,292 Prior period APAC revenues, excluding hedging effect $ 9,564 $ 12,528 $ 16,192 APAC revenue growth 29 % 32 % APAC constant currency revenue growth 29 % 31 % Other Americas revenues $ 4,628 $ 6,125 $ 7,609 Exclude foreign exchange effect on current period revenues using prior year rates 344 (148 ) 404 Exclude hedging effect recognized in current period (29 ) 22 (1 ) Other Americas constant currency revenues $ 4,943 $ 5,999 $ 8,012 Prior period Other Americas revenues, excluding hedging effect $ 3,836 $ 4,599 $ 6,147 Other Americas revenue growth 32 % 24 % Other Americas constant currency revenue growth 30 % 30 % United States revenues $ 42,781 $ 52,449 $ 63,269 United States revenue growth 23 % 21 % Total revenues $ 90,272 $ 110,855 $ 136,819 Total constant currency revenues $ 91,006 $ 110,897 $ 135,987 Total revenue growth 23 % 23 % Total constant currency revenue growth 24 % 22 % Our EMEA revenues and revenue growth from 2017 to 2018 were favorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Euro and British pound. Our EMEA revenues and revenue growth from 2016 to 2017 were unfavorably affected by hedging losses. Our APAC revenues and revenue growth from 2017 to 2018 were favorably affected by changes in foreign currency exchange rates, as well as hedging benefits, primarily due to the U.S. dollar weakening relative to the Japanese yen, offset by the U.S. dollar strengthening relative to the Australian dollar. Our APAC revenues and revenue growth from 2016 to 2017 were slightly affected by hedging benefits and changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Japanese yen, offset by the U.S. dollar weakening relative to the Australian dollar, Indian rupee, South Korean won, and Taiwanese dollar. 31 Table of Contents Alphabet Inc. Our Other Americas revenues and revenue growth from 2017 to 2018 were unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Brazilian real and Argentine peso. Our Other Americas revenues and revenue growth from 2016 to 2017 were favorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Brazilian real and Canadian dollar, offset by the U.S. dollar strengthening relative to the Argentine peso. Costs and Expenses Cost of Revenues Cost of revenues consists of TAC which are paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. The cost of revenues related to revenues generated from ads placed on Google Network Members' properties are significantly higher than the cost of revenues related to revenues generated from ads placed on Google properties because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members. Additionally, other cost of revenues (which is the cost of revenues excluding TAC) includes the following: • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Expenses associated with our data centers and other operations (including bandwidth, compensation expenses (including stock-based compensation (SBC)), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. The following tables present our cost of revenues, including TAC (in millions): Year Ended December 31, 2016 2017 2018 TAC $ 16,793 $ 21,672 $ 26,726 Other cost of revenues 18,345 23,911 32,823 Total cost of revenues $ 35,138 $ 45,583 $ 59,549 Total cost of revenues as a percentage of revenues 38.9 % 41.1 % 43.5 % Year Ended December 31, 2016 2017 2018 TAC to distribution partners $ 5,894 $ 9,031 $ 12,572 TAC to distribution partners as a percentage of Google properties revenues (1) (Google properties TAC rate) 9.2 % 11.6 % 13.1 % TAC to Google Network Members $ 10,899 $ 12,641 $ 14,154 TAC to Google Network Members as a percentage of Google Network Members' properties revenues (1) (Network Members TAC rate) 69.9 % 71.9 % 70.8 % TAC $ 16,793 $ 21,672 $ 26,726 TAC as a percentage of advertising revenues (1) (Aggregate TAC rate) 21.2 % 22.7 % 23.0 % (1) Revenues include hedging gains (losses) which affect TAC rates. Cost of revenues increased $13,966 million from 2017 to 2018 . The increase was due to increases in TAC and other cost of revenues of $5,054 million and $8,912 million , respectively. The increase in TAC to distribution partners from 2017 to 2018 was a result of an increase in Google properties revenues and the associated TAC rate. The increase in the Google properties TAC rate was driven by changes in partner agreements and the ongoing shift to mobile, which carries higher TAC because more mobile searches are 32 Table of Contents Alphabet Inc. channeled through paid access points. The increase in TAC to Google Network Members from 2017 to 2018 was a result of an increase in Google Network Members' properties revenues offset by a decrease in the associated TAC rate. The decrease in the Network Members TAC rate was primarily due to a shift to lower TAC products within programmatic advertising buying. The increase in the aggregate TAC rate from 2017 to 2018 was a result of an increase in Google properties TAC rate, partially offset by a favorable revenue mix shift from Google Network Members' properties to Google properties. Other cost of revenues increased $8,912 million from 2017 to 2018 . The increase was due to an increase in data center and other operations costs, which was affected by increased allocations primarily from general and administrative expenses; content acquisition costs as a result of increased activities related to YouTube; and hardware costs associated with new hardware launches. Cost of revenues increased $10,445 million from 2016 to 2017 . The increase was due to an increase in TAC of $4,879 million . The increase in TAC to distribution partners was a result of an increase in Google properties revenues and the associated TAC rate. The increase in TAC to Google Network Members was a result of an increase in Google Network Members' properties revenues and the associated TAC rate. The increase in the Google properties TAC rate was driven by changes in partner agreements and the ongoing shift to mobile, which carries higher TAC because more mobile searches are channeled through paid access points. The increase in the Network Members TAC rate was driven by the continued underlying shift in advertising buying from our traditional network business to programmatic advertising buying. The increase in the aggregate TAC rate was also partially offset by a favorable revenue mix shift from Google Network Members' properties to Google properties. Other cost of revenues increased $5,566 million from 2016 to 2017. The increase was due to various factors, including an increase in data center and other operations costs, which include depreciation, compensation expenses (including SBC), energy, bandwidth, and other equipment costs as a result of business growth; hardware costs associated with new hardware launches; and content acquisition costs as a result of increased activities related to YouTube. We expect cost of revenues to increase in dollar amount and as a percentage of total revenues in future periods based on a number of factors, including the following: • Google Network Members TAC rates, which are affected by a combination of factors such as geographic mix, product mix, revenue share terms, and fluctuations of the U.S. dollar compared to certain foreign currencies ; • Google properties TAC rates, which are affected by changes in device mix between mobile, desktop, and tablet, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points; • Growth rates of expenses associated with our data centers and other operations, content acquisition costs, as well as our hardware inventory and related costs; • Higher cost of revenues associated with the increased proportion of non-advertising revenues relative to our advertising revenues; and • Relative revenue growth rates of Google properties and our Google Network Members' properties. Research and Development The following table presents our R&D expenses (in millions): Year Ended December 31, 2016 2017 2018 Research and development expenses $ 13,948 $ 16,625 $ 21,419 Research and development expenses as a percentage of revenues 15.5 % 15.0 % 15.7 % R&D expenses consist primarily of: • Compensation expenses (including SBC) and facilities-related costs for engineering and technical employees responsible for R&D of our existing and new products and services; • Depreciation expenses; • Equipment-related expenses; and • Professional services fees primarily related to consulting and outsourcing services. R&D expenses increased $4,794 million from 2017 to 2018 . The increase was primarily due to an increase in compensation expenses (including SBC) and facilities-related costs of $3,518 million, largely resulting from a 24% increase in headcount. In addition, there was an increase in depreciation and equipment-related expenses of $499 33 Table of Contents Alphabet Inc. million and $318 million, respectively, as well as an increase in professional services fees of $305 million due to additional expenses incurred for outsourced services and consulting. R&D expenses increased $2,677 million from 2016 to 2017 . The increase was primarily due to an increase in compensation expenses (including SBC) and facilities-related costs of $1,886 million, largely resulting from a 16% increase in headcount. In addition, there was an increase in depreciation expenses of $323 million and equipment-related expenses of $246 million. We expect that R&D expenses will increase in dollar amount and may fluctuate as a percentage of revenues in future periods. Sales and Marketing The following table presents our sales and marketing expenses (in millions): Year Ended December 31, 2016 2017 2018 Sales and marketing expenses $ 10,485 $ 12,893 $ 16,333 Sales and marketing expenses as a percentage of revenues 11.6 % 11.6 % 11.9 % Sales and marketing expenses consist primarily of: • Advertising and promotional expenditures related to our products and services; and • Compensation expenses (including SBC) and facilities-related costs for employees engaged in sales and marketing, sales support, and certain customer service functions. Sales and marketing expenses increased $3,440 million from 2017 to 2018 . The increase was primarily due to an increase in compensation expenses (including SBC) and facilities-related costs of $1,418 million, largely resulting from a 12% increase in headcount. In addition, there was an increase in advertising and promotional expenses of $1,233 million, largely resulting from increases in marketing and promotion-related expenses for our Cloud offerings and the Google Assistant. Sales and marketing expenses increased $2,408 million from 2016 to 2017 . The increase was primarily due to an increase in advertising and promotional expenses of $1,266 million, largely resulting from increases in marketing and promotion-related expenses for our hardware products, Cloud offerings, and YouTube. In addition, there was an increase in compensation expenses (including SBC) and facilities-related costs of $853 million, largely resulting from a 6% increase in headcount. We expect that sales and marketing expenses will increase in dollar amount and may fluctuate as a percentage of revenues in future periods. General and Administrative The following table presents our general and administrative expenses (in millions): Year Ended December 31, 2016 2017 2018 General and administrative expenses $ 6,985 $ 6,872 $ 8,126 General and administrative expenses as a percentage of revenues 7.7 % 6.2 % 5.9 % General and administrative expenses consist primarily of: • Compensation expenses (including SBC and accrued performance fees related to gains on securities) and facilities-related costs for employees in our facilities, finance, human resources, information technology, and legal organizations; • Depreciation; • Equipment-related expenses; and • Professional services fees primarily related to audit, information technology consulting, outside legal, and outsourcing services. General and administrative expenses increased $1,254 million from 2017 to 2018 . The increase was primarily due to an increase in compensation expenses (including SBC) and facilities-related costs of $1,660 million, largely resulting from accrued performance fees primarily related to gains on equity securities. The increase was offset by reduced allocations (with a corresponding net increase primarily in cost of revenues). 34 Table of Contents Alphabet Inc. General and administrative expenses decreased $113 million from 2016 to 2017 . The decrease was primarily from reduced allocations to general and administrative expenses with an offsetting increase to cost of revenues and other operating expenses. The decrease was partially offset by an increase in compensation expenses (including SBC) and facilities-related costs of $271 million, largely resulting from a 9% increase in headcount. Additionally, there was an increase in professional service fees of $253 million due to additional expenses incurred for outsourced services and consulting services. We expect general and administrative expenses will increase in dollar amount and may fluctuate as a percentage of revenues in future periods. European Commission Fines In June 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a €2.4 billion ($2.7 billion as of June 27, 2017) fine, which was accrued in the second quarter of 2017. In July 2018, the EC announced its decision that certain provisions in Google's Android-related distribution agreements infringed European competition law. The EC decision imposed a €4.3 billion ($5.1 billion as of June 30, 2018) fine, which was accrued in the second quarter of 2018. Please refer to Note 9 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. Other Income (Expense), Net The following table presents other income (expense), net, (in millions): Year Ended December 31, 2016 2017 2018 Other income (expense), net $ 434 $ 1,047 $ 8,592 Other income (expense), net, as a percentage of revenues 0.5 % 0.9 % 6.3 % Other income (expense), net, increased $7,545 million from 2017 to 2018 . This increase was primarily driven by unrealized gains on equity securities resulting from the adoption of a new accounting standard and the modification of the terms of a non-marketable debt security resulting in a recognized unrealized gain. Other income (expense), net, increased $613 million from 2016 to 2017 . This increase was primarily driven by reduced costs of our foreign currency hedging activities, decreased losses on marketable securities and an increase in interest income. We expect other income (expense), net, will fluctuate in dollar amount and percentage of revenues in future periods as it is largely driven by market dynamics. Beginning in 2018, changes in the value of marketable and non-marketable equity security investments are reflected in OI&E. Equity values generally change daily for marketable equity securities and upon the occurrence of observable price changes or upon impairment of non-marketable equity securities. In addition, volatility in the global economic climate and financial markets could result in a significant change in the value of our equity securities. Fluctuations in the value of these investments could contribute to the volatility of OI&E in future periods. For additional information about equity investments, please see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Provision for Income Taxes The following table presents our provision for income taxes (in millions) and effective tax rate: Year Ended December 31, 2016 2017 2018 Provision for income taxes $ 4,672 $ 14,531 $ 4,177 Effective tax rate 19.3 % 53.4 % 12.0 % Our provision for income taxes and our effective tax rate decreased from 2017 to 2018 , due to the U.S. Tax Cuts and Jobs Act (Tax Act) which was enacted in December 2017. Please refer to Note 13 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. 35 Table of Contents Alphabet Inc. Our provision for income taxes and our effective tax rate increased from 2016 to 2017 , due to the effects of the Tax Act related to the one time-transition tax on accumulated foreign subsidiary earnings not previously subject to U.S. income tax. Effective in 2018, the Tax Act reduces the U.S. statutory tax rate from 35% to 21% and creates new taxes on certain foreign-sourced earnings and certain related-party payments, which are referred to as the global intangible low-taxed income tax and the base erosion tax, respectively. Our future effective tax rate could be adversely affected by earnings being lower than anticipated in countries that have lower statutory rates and higher than anticipated in countries that have higher statutory rates, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2018 . This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Both seasonal fluctuations in internet usage, advertising expenditures and underlying business trends such as traditional retail seasonality have affected, and are likely to continue to affect, our business. Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31, 2017 Jun 30, 2017 Sept 30, 2017 Dec 31, 2017 Mar 31, 2018 Jun 30, 2018 Sept 30, 2018 Dec 31, 2018 (In millions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues $ 24,750 $ 26,010 $ 27,772 $ 32,323 $ 31,146 $ 32,657 $ 33,740 $ 39,276 Costs and expenses: Cost of revenues 9,795 10,373 11,148 14,267 13,467 13,883 14,281 17,918 Research and development 3,942 4,172 4,205 4,306 5,039 5,114 5,232 6,034 Sales and marketing 2,644 2,897 3,042 4,310 3,604 3,780 3,849 5,100 General and administrative 1,801 1,700 1,595 1,776 2,035 2,002 2,068 2,021 European Commission fines 0 2,736 0 0 0 5,071 0 0 Total costs and expenses 18,182 21,878 19,990 24,659 24,145 29,850 25,430 31,073 Income from operations 6,568 4,132 7,782 7,664 7,001 2,807 8,310 8,203 Other income (expense), net 251 245 197 354 3,542 1,408 1,773 1,869 Income from continuing operations before income taxes 6,819 4,377 7,979 8,018 10,543 4,215 10,083 10,072 Provision for income taxes 1,393 853 1,247 11,038 1,142 1,020 891 1,124 Net income (loss) $ 5,426 $ 3,524 $ 6,732 $ (3,020 ) $ 9,401 $ 3,195 $ 9,192 $ 8,948 Basic net income (loss) per share of Class A and B common stock and Class C capital stock $ 7.85 $ 5.09 $ 9.71 $ (4.35 ) $ 13.53 $ 4.60 $ 13.21 $ 12.87 Diluted net income (loss) per share of Class A and B common stock and Class C capital stock $ 7.73 $ 5.01 $ 9.57 $ (4.35 ) $ 13.33 $ 4.54 $ 13.06 $ 12.77 Capital Resources and Liquidity As of December 31, 2018 , we had $109.1 billion in cash, cash equivalents, and marketable securities. Ca sh equivalents and marketable securities a re comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities. From time to time, we may hold 36 Table of Contents Alphabet Inc. marketable equity securities obtained through acquisitions or strategic investments in private companies that subsequently go public. In December 2017, the Tax Act was enacted and resulted in a one-time transition tax on accumulated foreign subsidiary earnings. After 2017, our foreign earnings held by foreign subsidiaries are no longer subject to U.S. tax upon repatriation to the U.S. As of December 31, 2018 , the remaining long-term tax payable related to the Tax Act of $7.4 billion is presented within income tax payable, non-current on our Consolidated Balance Sheets. As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025. During the years ended December 31, 2017 and 2018, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ($2.7 billion as of June 27, 2017) and €4.3 billion ($5.1 billion as of June 30, 2018), respectively. While under appeal, EC fines are included in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees in lieu of a cash payment for the respective fines. Please refer to Note 9 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2018 . We have $4.0 billion of revolving credit facilities expiring in July 2023 with no amounts outstanding. The interest rate for the credit facilities is determined based on a formula using certain market rates. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions and other liquidity requirements through at least the next 12 months. As of December 31, 2018 , we have senior unsecured notes outstanding due in 2021, 2024, and 2026 with a total carrying value of $4.0 billion . In 2016 and 2018, the board of directors of Alphabet authorized the company to repurchase up to $7.0 billion and $8.6 billion of its Class C capital stock, respectively. The 2016 authorization was completed in 2018. As of December 31, 2018 , $1.7 billion remains available for repurchase. In January 2019, our board of directors authorized the repurchase of up to an additional $12.5 billion of our Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Please refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to stock repurchases. The following table presents our cash flows (in millions): Year Ended December 31, 2016 2017 2018 Net cash provided by operating activities $ 36,036 $ 37,091 $ 47,971 Net cash used in investing activities $ (31,165 ) $ (31,401 ) $ (28,504 ) Net cash used in financing activities $ (8,332 ) $ (8,298 ) $ (13,179 ) Cash Provided by Operating Activities Our largest source of cash provided by our operations are advertising revenues generated by Google properties and Google Network Members' properties. Additionally, we generate cash through sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings . Our primary uses of cash from our operating activities include payments to our Google Network Members and distribution partners, and payments for content acquisition costs. In addition, uses of cash from operating activities include compensation and related costs, hardware inventory costs, other general corporate expenditures, and income taxes. Net cash provided by operating activities increased from 2017 to 2018 primarily due to increases in cash received from advertising revenues and Google other revenues (net of payouts to app developers), offset by increases in cash paid for cost of revenues and operating expenses. 37 Table of Contents Alphabet Inc. Net cash provided by operating activities increased from 2016 to 2017 primarily due to increases in cash received from advertising revenues and Google other revenues (net of payouts to app developers), offset by increases in cash paid for cost of revenues, operating expenses, and income taxes. Cash Used in Investing Activities Cash provided by or used in investing activities primarily consists of purchases of property and equipment; purchases, maturities, and sales of marketable and non-marketable securities; and payments for acquisitions. Net cash used in investing activities decreased from 2017 to 2018 primarily due to a decrease in purchases of marketable securities. The decrease was partially offset by higher investments in land and buildings for offices and data centers, as well as, servers to provide capacity for the growth of our businesses. Generally, our investment in office facilities is driven by workforce needs; and our investment in data centers is driven by our compute and storage requirements and has a lead time of up to three years. Further, the decrease was partially offset by an increase in payments for acquisitions and a decrease in maturities and sales of marketable securities. Net cash used in investing activities increased slightly from 2016 to 2017 primarily due to an increase in purchases of marketable securities and an increase in purchases of property and equipment, partially offset by an increase in the maturities and sales of marketable securities, a decrease in cash collateral paid related to securities lending, and an increase in proceeds received from collections of notes receivables. Cash Used in Financing Activities Cash provided by or used in financing activities consists primarily of net proceeds or payments from stock-based award activities, repurchases of capital stock, and net proceeds or payments from issuance or repayments of debt. Net cash used in financing activities increased from 2017 to 2018 primarily due to higher cash payments for repurchases of capital stock and stock-based award activities. Net cash used in financing activities decreased slightly from 2016 to 2017 primarily due to lower net cash payments from repayments and issuance of debt, partially offset by higher cash payments for repurchases of capital stock. Contractual Obligations as of December 31, 2018 The following summarizes our contractual obligations as of December 31, 2018 (in millions): Payments Due By Period Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating lease obligations, net of sublease income amounts (1) $ 10,047 $ 1,303 $ 2,711 $ 2,122 $ 3,911 Purchase obligations (2) 7,433 5,132 1,407 370 524 Long-term debt obligations (3) 4,689 134 1,220 154 3,181 Tax payable (4) 7,440 — 2,029 5,411 — Other long-term liabilities reflected on our balance sheet (5) 2,443 341 638 416 1,048 Total contractual obligations $ 32,052 $ 6,910 $ 8,005 $ 8,473 $ 8,664 (1) For further information, refer to Note 9 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. (2) Represents non-cancelable contractual obligations primarily related to information technology assets and data center operation costs; purchases of inventory; and digital media content licensing arrangements. The amounts included above represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2018 . Excluded from the table above are open orders for purchases that support normal operations. (3) Represents our principal and interest payments. For further information on long-term debt, refer to Note 5 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. (4) Represents one-time transition tax payable incurred as a result of the Tax Act. For further information, refer to Note 13 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Excluded from the table above are long-term taxes payable of $3.9 billion as of December 31, 2018 primarily related to uncertain tax positions, for which we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. (5) Represents cash obligations recorded on our Consolidated Balance Sheets, including the short-term portion of these long-term liabilities, primarily for the construction of offices and certain commercial agreements. These amounts do not include the EC fines which are classified as current liabilities on our Consolidated Balance Sheets. For further information regarding the 38 Table of Contents Alphabet Inc. EC fines, refer to Note 9 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Off-Balance Sheet Arrangements As of December 31, 2018 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP). In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, expenses, gains and losses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. Please see Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements. Revenues For the sale of third-party goods and services, we evaluate whether we are the principal, and report revenues on a gross basis, or an agent, and report revenues on a net basis. In this assessment, we consider if we obtain control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment, inventory risk, and discretion in establishing price. Income Taxes We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services (IRS) and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, non-income taxes, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood of there being, and the estimated amount of, a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any 39 Table of Contents Alphabet Inc. of our estimates and assumptions change or prove to have been incorrect, it could have a material effect on our business, consolidated financial position, results of operations, or cash flows. Long-lived Assets Long-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Valuation of Non-marketable Equity Securities Beginning on January 1, 2018, our non-marketable equity securities not accounted for under the equity method are carried either at fair value or under the measurement alternative upon the adoption of ASU 2016-01. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Determining whether an observed transaction is similar to a security within our portfolio requires judgment based on the rights and obligations of the securities. Recording upward and downward adjustments to the carrying value of our equity securities as a result of observable price changes requires quantitative assessments of the fair value of our securities using various valuation methodologies and involves the use of estimates. Non-marketable equity securities are also subject to periodic impairment reviews. Our quarterly impairment analysis considers both qualitative and quantitative factors that may have a significant effect on the investment's fair value. Qualitative factors considered include industry and market conditions, financial performance, business prospects, and other relevant events and factors. When indicators of impairment exist, we prepare quantitative assessments of the fair value of our equity investments using both the market and income approaches which require judgment and the use of estimates, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When our assessment indicates that an impairment exists, we measure our non-marketable securities at fair value. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange Risk We transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced in the near term. We use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the local currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. If an adverse 10% foreign currency exchange rate change was applied to total monetary assets and liabilities denominated in currencies other than the local currencies at the balance sheet dates, it would have resulted in an adverse effect on income before income taxes of approximately $52 million and $1 million as of December 31, 2017 and 2018 , respectively. The adverse effect as of December 31, 2017 and 2018 is after consideration of the offsetting effect of approximately $374 million for both periods from foreign exchange contracts in place for the months ended December 31, 2017 and December 31, 2018 . We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do 40 Table of Contents Alphabet Inc. not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of AOCI and subsequently reclassify them into revenues to offset the hedged exposures as they occur. If the U.S. dollar weakened by 10% as of December 31, 2017 and December 31, 2018 , the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $950 million and $772 million lower as of December 31, 2017 and December 31, 2018 , respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. During 2018, we entered into foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations. If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment (CTA) within AOCI related to our net investment hedge would have been approximately $635 million lower as of December 31, 2018. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries. Interest Rate Risk Our investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity requirements. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as a result of higher market interest rates compared to interest rates at the time of purchase. We account for both fixed and variable rate securities at fair value with gains and losses recorded in AOCI until the securities are sold. We use value-at-risk (VaR) analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of our marketable debt securities as of December 31, 2017 and 2018 are shown below (in millions): As of December 31, 12-Month Average As of December 31, 2017 2018 2017 2018 Risk Category - Interest Rate $ 84 $ 58 $ 87 $ 66 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2017 and 2018 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation. Equity Investment Risk Our marketable and non-marketable equity securities are subject to a wide variety of market‑related risks that could substantially reduce or increase the fair value of our holdings. Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages. We record our marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $1.2 billion of our investments as of December 31, 2018. A hypothetical adverse price change of 10%, which could be experienced in the near term, would decrease the fair value of our marketable equity securities by $120 million . Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the 41 Table of Contents Alphabet Inc. measurement alternative). The fair value is measured at the time of the observable transaction, which is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize value in our investments through liquidity events such as public offerings, acquisitions, private sales or other favorable market events reflecting appreciation to the cost of our initial investment. As of December 31, 2018, the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $12.3 billion . Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data. Volatility in the global economic climate and financial markets could result in a significant impairment charge on our non-marketable equity securities. The carrying values of our equity method investments generally do not fluctuate based on market price changes, however these investments could be impaired if the carrying value exceeds the fair value. For further information about our equity investments, please refer to Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. 42 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 44 Financial Statements: Consolidated Balance Sheets 46 Consolidated Statements of Income 47 Consolidated Statements of Comprehensive Income 48 Consolidated Statements of Stockholders’ Equity 49 Consolidated Statements of Cash Flows 50 Notes to Consolidated Financial Statements 51 The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” 43 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Alphabet Inc. (the Company) as of December 31, 2017 and 2018, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2018, and the related notes and financial statement schedule listed in the Index at Item 15(a)2 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2017 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 4, 2019 expressed an unqualified opinion thereon. Adoption of New Accounting Standard As discussed in Note 1 to the consolidated financial statements, the Company changed its method for accounting for the recognition, measurement, presentation and disclosure of certain equity securities in the year ended December 31, 2018. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/ Ernst & Young LLP We have served as the Company's auditor since 1999. San Jose, California February 4, 2019 44 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on Internal Control over Financial Reporting We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Alphabet Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2018 consolidated financial statements of the Company and our report dated February 4, 2019 expressed an unqualified opinion thereon that included an explanatory paragraph regarding the Company’s adoption of a new accounting standard for the recognition, measurement, presentation and disclosure of certain equity securities in the year ended December 31, 2018. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitation of Internal Control over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California February 4, 2019 45 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2017 As of December 31, 2018 Assets Current assets: Cash and cash equivalents $ 10,715 $ 16,701 Marketable securities 91,156 92,439 Total cash, cash equivalents, and marketable securities 101,871 109,140 Accounts receivable, net of allowance of $674 and $729 18,336 20,838 Income taxes receivable, net 369 355 Inventory 749 1,107 Other current assets 2,983 4,236 Total current assets 124,308 135,676 Non-marketable investments 7,813 13,859 Deferred income taxes 680 737 Property and equipment, net 42,383 59,719 Intangible assets, net 2,692 2,220 Goodwill 16,747 17,888 Other non-current assets 2,672 2,693 Total assets $ 197,295 $ 232,792 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 3,137 $ 4,378 Accrued compensation and benefits 4,581 6,839 Accrued expenses and other current liabilities 10,177 16,958 Accrued revenue share 3,975 4,592 Deferred revenue 1,432 1,784 Income taxes payable, net 881 69 Total current liabilities 24,183 34,620 Long-term debt 3,969 4,012 Deferred revenue, non-current 340 396 Income taxes payable, non-current 12,812 11,327 Deferred income taxes 430 1,264 Other long-term liabilities 3,059 3,545 Total liabilities 44,793 55,164 Commitments and Contingencies (Note 9) Stockholders’ equity: Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 694,783 (Class A 298,470, Class B 46,972, Class C 349,341) and 695,556 (Class A 299,242, Class B 46,636, Class C 349,678) shares issued and outstanding 40,247 45,049 Accumulated other comprehensive loss (992 ) (2,306 ) Retained earnings 113,247 134,885 Total stockholders’ equity 152,502 177,628 Total liabilities and stockholders’ equity $ 197,295 $ 232,792 See accompanying notes. 46 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2016 2017 2018 Revenues $ 90,272 $ 110,855 $ 136,819 Costs and expenses: Cost of revenues 35,138 45,583 59,549 Research and development 13,948 16,625 21,419 Sales and marketing 10,485 12,893 16,333 General and administrative 6,985 6,872 8,126 European Commission fines 0 2,736 5,071 Total costs and expenses 66,556 84,709 110,498 Income from operations 23,716 26,146 26,321 Other income (expense), net 434 1,047 8,592 Income before income taxes 24,150 27,193 34,913 Provision for income taxes 4,672 14,531 4,177 Net income $ 19,478 $ 12,662 $ 30,736 Basic net income per share of Class A and B common stock and Class C capital stock $ 28.32 $ 18.27 $ 44.22 Diluted net income per share of Class A and B common stock and Class C capital stock $ 27.85 $ 18.00 $ 43.70 See accompanying notes. 47 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2016 2017 2018 Net income $ 19,478 $ 12,662 $ 30,736 Other comprehensive income (loss): Change in foreign currency translation adjustment (599 ) 1,543 (781 ) Available-for-sale investments: Change in net unrealized gains (losses) (314 ) 307 88 Less: reclassification adjustment for net (gains) losses included in net income 221 105 (911 ) Net change (net of tax effect of $0, $0, and $156) (93 ) 412 (823 ) Cash flow hedges: Change in net unrealized gains (losses) 515 (638 ) 290 Less: reclassification adjustment for net (gains) losses included in net income (351 ) 93 98 Net change (net of tax effect of $64, $247, and $103) 164 (545 ) 388 Other comprehensive income (loss) (528 ) 1,410 (1,216 ) Comprehensive income $ 18,950 $ 14,072 $ 29,520 See accompanying notes. 48 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2015 687,348 $ 32,982 $ (1,874 ) $ 89,223 $ 120,331 Cumulative effect of accounting change 0 180 0 (133 ) 47 Common and capital stock issued 9,106 298 0 0 298 Stock-based compensation expense 0 6,700 0 0 6,700 Tax withholding related to vesting of restricted stock units 0 (3,597 ) 0 0 (3,597 ) Repurchases of capital stock (5,161 ) (256 ) 0 (3,437 ) (3,693 ) Net income 0 0 0 19,478 19,478 Other comprehensive loss 0 0 (528 ) 0 (528 ) Balance as of December 31, 2016 691,293 36,307 (2,402 ) 105,131 139,036 Cumulative effect of accounting change 0 0 0 (15 ) (15 ) Common and capital stock issued 8,652 212 0 0 212 Stock-based compensation expense 0 7,694 0 0 7,694 Tax withholding related to vesting of restricted stock units 0 (4,373 ) 0 0 (4,373 ) Repurchases of capital stock (5,162 ) (315 ) 0 (4,531 ) (4,846 ) Sale of subsidiary shares 0 722 0 0 722 Net income 0 0 0 12,662 12,662 Other comprehensive income 0 0 1,410 0 1,410 Balance as of December 31, 2017 694,783 40,247 (992 ) 113,247 152,502 Cumulative effect of accounting change 0 0 (98 ) (599 ) (697 ) Common and capital stock issued 8,975 148 0 0 148 Stock-based compensation expense 0 9,353 0 0 9,353 Tax withholding related to vesting of restricted stock units and other 0 (4,782 ) 0 0 (4,782 ) Repurchases of capital stock (8,202 ) (576 ) 0 (8,499 ) (9,075 ) Sale of subsidiary shares 0 659 0 0 659 Net income 0 0 0 30,736 30,736 Other comprehensive loss 0 0 (1,216 ) 0 (1,216 ) Balance as of December 31, 2018 695,556 $ 45,049 $ (2,306 ) $ 134,885 $ 177,628 See accompanying notes. 49 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2016 2017 2018 Operating activities Net income $ 19,478 $ 12,662 $ 30,736 Adjustments: Depreciation and impairment of property and equipment 5,267 6,103 8,164 Amortization and impairment of intangible assets 877 812 871 Stock-based compensation expense 6,703 7,679 9,353 Deferred income taxes (38 ) 258 778 (Gain) loss on debt and equity securities, net 73 37 (6,650 ) Other 376 294 (189 ) Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable (2,578 ) (3,768 ) (2,169 ) Income taxes, net 3,125 8,211 (2,251 ) Other assets 312 (2,164 ) (1,207 ) Accounts payable 110 731 1,067 Accrued expenses and other liabilities 1,515 4,891 8,614 Accrued revenue share 593 955 483 Deferred revenue 223 390 371 Net cash provided by operating activities 36,036 37,091 47,971 Investing activities Purchases of property and equipment (10,212 ) (13,184 ) (25,139 ) Proceeds from disposals of property and equipment 240 99 98 Purchases of marketable securities (84,509 ) (92,195 ) (50,158 ) Maturities and sales of marketable securities 66,895 73,959 48,507 Purchases of non-marketable investments (1,109 ) (1,745 ) (2,073 ) Maturities and sales of non-marketable investments 494 533 1,752 Cash collateral related to securities lending (2,428 ) 0 0 Investments in reverse repurchase agreements 450 0 0 Acquisitions, net of cash acquired, and purchases of intangible assets (986 ) (287 ) (1,491 ) Proceeds from collection of notes receivable 0 1,419 0 Net cash used in investing activities (31,165 ) (31,401 ) (28,504 ) Financing activities Net payments related to stock-based award activities (3,304 ) (4,166 ) (4,993 ) Repurchases of capital stock (3,693 ) (4,846 ) (9,075 ) Proceeds from issuance of debt, net of costs 8,729 4,291 6,766 Repayments of debt (10,064 ) (4,377 ) (6,827 ) Proceeds from sale of subsidiary shares 0 800 950 Net cash used in financing activities (8,332 ) (8,298 ) (13,179 ) Effect of exchange rate changes on cash and cash equivalents (170 ) 405 (302 ) Net increase (decrease) in cash and cash equivalents (3,631 ) (2,203 ) 5,986 Cash and cash equivalents at beginning of period 16,549 12,918 10,715 Cash and cash equivalents at end of period $ 12,918 $ 10,715 $ 16,701 Supplemental disclosures of cash flow information Cash paid for taxes, net of refunds $ 1,643 $ 6,191 $ 5,671 Cash paid for interest, net of amounts capitalized $ 84 $ 84 $ 69 See accompanying notes. 50 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. In 2015, we implemented a holding company reorganization, and as a result, Alphabet Inc. (Alphabet) became the successor issuer to Google. We generate revenues primarily by delivering relevant, cost-effective online advertising. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and entities consolidated under the variable interest and voting models. Noncontrolling interests are not presented separately as the amounts are not material. All intercompany balances and transactions have been eliminated. Use of Estimates Preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the bad debt allowance, sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, and contingent liabilities, among others. We base our estimates on assumptions, both historical and forward looking, that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Revenue Recognition We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. See Note 2 for further discussion on Revenues. Cost of Revenues Cost of revenues consists of TAC and other costs of revenues. TAC represents the amounts paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. Other costs of revenues (which is the cost of revenues excluding TAC) include the following: • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Expenses associated with our data centers and other operations (including bandwidth, compensation expense (including SBC), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. Stock-based Compensation Stock-based compensation primarily consists of Alphabet restricted stock units (RSUs). RSUs are equity classified and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period and account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the applicable statutory tax withholding to be paid by us on behalf of our employees. As a result, fewer shares are issued than the number of RSUs outstanding. We record a liability for the tax withholding to be paid by us as a reduction to additional paid-in capital. Additionally, stock-based compensation includes other types of stock-based awards that may be settled in the stock of certain of our Other Bets or in cash. Awards that are liability classified are remeasured at fair value through settlement or maturity. The fair value of such awards is based on the valuation of equity of the respective Other Bet. 51 Table of Contents Alphabet Inc. Performance Fees We have compensation arrangements with payouts based on realized investment returns. We recognize compensation expense based on the estimated payouts. Certain Risks and Concentrations Our revenues are primarily derived from online advertising, the market for which is highly competitive and rapidly changing. In addition, our revenues are generated from a multitude of vertical market segments in countries around the world. Significant changes in this industry or changes in customer buying or advertiser spending behavior could adversely affect our operating results. We are subject to concentrations of credit risk principally from cash and cash equivalents, marketable securities, foreign exchange contracts, and accounts receivable. Cash equivalents and marketable securities consist primarily of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, mortgage-backed securities, and asset-backed securities. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. We perform ongoing evaluations to determine customer credit and we limit the amount of credit we extend. We generally do not require collateral from our customers. We maintain reserves for estimated credit losses and these losses have generally been within our expectations. No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2016 , 2017 , or 2018 . In 2016 , 2017 , and 2018 , we generated approximately 47% , 47% , and 46% of our revenues, respectively, from customers based in the U.S. See Note 2 for further details. Fair Value of Financial Instruments Our financial assets and liabilities that are measured at fair value on a recurring basis include cash equivalents, marketable securities, derivative contracts, and non-marketable debt securities. Our financial assets that are measured at fair value on a nonrecurring basis include non-marketable equity securities measured at fair value when observable price changes are identified or when non-marketable equity securities are impaired . Other financial assets and liabilities are carried at cost with fair value disclosed, if required. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash, Cash Equivalents, and Marketable Securities We invest all excess cash primarily in government bonds, corporate debt securities, mortgage-backed and asset-backed securities, time deposits, and money market funds. We classify all investments that are readily convertible to known amounts of cash and have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities. We determine the appropriate classification of our investments in marketable securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable debt securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these debt securities prior to their stated maturities. As we view these securities as available 52 Table of Contents Alphabet Inc. to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities on the Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for unrealized losses determined to be other-than-temporary, which we record within other income (expense), net. We determine any realized gains or losses on the sale of marketable debt securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Non-Marketable Investments We account for non-marketable equity investments through which we exercise significant influence but do not have control over the investee under the equity method. Beginning on January 1, 2018, our non-marketable equity securities not accounted for under the equity method are either carried at fair value or under the measurement alternative upon the adoption of ASU 2016-01. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. Adjustments are determined primarily based on a market approach as of the transaction date. We classify our non-marketable investments as non-current assets on the Consolidated Balance Sheets as those investments do not have stated contractual maturity dates. We account for our non-marketable investments that meet the definition of a debt security as available-for-sale securities. Impairment of Investments We periodically review our debt and equity investments for impairment. For debt securities we consider the duration, severity and the reason for the decline in security value; whether it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis; or if the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the security to its fair value and record the corresponding charge as other income (expense), net. For equity securities we consider impairment indicators such as negative changes in industry and market conditions, financial performance, business prospects, and other relevant events and factors. If indicators exist and the fair value of the security is below the carrying amount, we write down the security to fair value. Variable Interest Entities We determine at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests in is considered a variable interest entity (VIE). We consolidate VIEs when we are the primary beneficiary. The primary beneficiary of a VIE is the party that meets both of the following criteria: (1) has the power to make decisions that most significantly affect the economic performance of the VIE; and (2) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. Periodically, we assess whether any changes in our interest or relationship with the entity affect our determination of whether the entity is still a VIE and, if so, whether we are the primary beneficiary. If we are not the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Accounts Receivable We record accounts receivable at the invoiced amount. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables. We review the accounts receivable by amounts due from customers that are past due to identify specific customers with known disputes or collectability issues. In determining the amount of the reserve, we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Property and Equipment Property and equipment includes the following categories: land and buildings, information technology assets, construction in progress, leasehold improvements, and furniture and fixtures. Land and buildings include land, offices, data centers and related building improvements. Information technology assets include servers and network equipment. We account for property and equipment at cost less accumulated depreciation. We compute depreciation using the straight-line method over the estimated useful lives of the assets. We depreciate buildings over periods of seven to 25 years. We generally depreciate information technology assets over periods of three to five years (specifically, three years for servers and three to five years for network equipment). We depreciate leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed in service for our intended use. Depreciation for equipment, buildings, and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. 53 Table of Contents Alphabet Inc. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of the acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the fair values of identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment, long-term prepayments and intangible assets, excluding goodwill, for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets are not recoverable, the impairment recognized is measured as the amount by which the carrying value of the asset exceeds its fair value. Impairments were not material for the periods presented. We allocate goodwill to reporting units based on the expected benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairments were not material for the periods presented. Intangible assets with definite lives are amortized over their estimated useful lives. We amortize intangible assets on a straight-line basis with definite lives over periods ranging from one to twelve years. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more likely than not that they will not be realized. We recognize the financial statement effects of a tax position when it is more likely than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Foreign Currency Generally, the functional currency of our international subsidiaries is the local currency. We translate the financial statements of these subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in accumulated other comprehensive income (AOCI) as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange losses in other income (expense), net. 54 Table of Contents Alphabet Inc. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2016 , 2017 and 2018 , advertising and promotional expenses totaled approximately $3.9 billion , $5.1 billion , and $6.4 billion , respectively. Recent Accounting Pronouncements Recently issued accounting pronouncements not yet adopted In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-02 (Topic 842) "Leases." Topic 842 supersedes the lease requirements in Accounting Standards Codification (ASC) Topic 840, "Leases." Under Topic 842, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures. Leases will continue to be classified as either finance or operating. We will adopt Topic 842 effective January 1, 2019 using a modified retrospective method and will not restate comparative periods. As permitted under the transition guidance, we will carry forward the assessment of whether our contracts contain or are leases, classification of our leases and remaining lease terms. Based on our portfolio of leases as of December 31, 2018, approximately $9 billion of lease assets and liabilities will be recognized on our balance sheet upon adoption, primarily relating to real estate. We are substantially complete with our implementation efforts. In June 2016, the FASB issued Accounting Standards Update No. 2016-13 (ASU 2016-13) "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments" which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. ASU 2016-13 replaces the existing incurred loss impairment model with an expected loss model which requires the use of forward-looking information to calculate credit loss estimates. It also eliminates the concept of other-than-temporary impairment and requires credit losses related to available-for-sale debt securities to be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. These changes will result in earlier recognition of credit losses. We will adopt ASU 2016-13 effective January 1, 2020. We are currently evaluating the effect of the adoption of ASU 2016-13 on our consolidated financial statements. The effect will largely depend on the composition and credit quality of our investment portfolio and the economic conditions at the time of adoption. Recently adopted accounting pronouncements In January 2016, the FASB issued Accounting Standards Update No. 2016-01 (ASU 2016-01) "Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities," which amends various aspects of the recognition, measurement, presentation, and disclosure of financial instruments. We adopted ASU 2016-01 as of January 1, 2018 using the modified retrospective method for our marketable equity securities and the prospective method for our non-marketable equity securities. This resulted in a $98 million reclassification of net unrealized gains from AOCI to opening retained earnings. We have elected to use the measurement alternative for our non-marketable equity securities, defined as cost adjusted for changes from observable transactions for identical or similar investments of the same issuer, less impairment. The adoption of ASU 2016-01 increases the volatility of our other income (expense), net, as a result of the unrealized gain or loss from the remeasurement of our equity securities. For further information on unrealized gains from equity securities, see Note 3 . In October 2016, the FASB issued Accounting Standards Update No. 2016-16 (ASU 2016-16) "Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other than Inventory." ASU 2016-16 generally accelerates the recognition of income tax consequences for asset transfers between entities under common control. We adopted ASU 2016-16 as of January 1, 2018 using a modified retrospective transition method, resulting in a $701 million reclassification of prepaid income taxes related to asset transfers that occurred prior to adoption from other current and non-current assets to opening retained earnings. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. Note 2. Revenues Adoption of ASC Topic 606, "Revenue from Contracts with Customers" On January 1, 2017 , we adopted Topic 606 using the modified retrospective method applied to those contracts which were not completed as of January 1, 2017 . Results for reporting periods beginning after January 1, 2017 are presented under Topic 606, while prior period amounts are not adjusted and continue to be reported in accordance with our historic accounting under Topic 605. The effect from the adoption of ASC 606 was not material to our financial statements. 55 Table of Contents Alphabet Inc. Revenue Recognition Revenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. The following table presents our revenues disaggregated by revenue source (in millions). Sales and usage-based taxes are excluded from revenues. Year Ended December 31, 2016 (1) 2017 2018 Google properties $ 63,785 $ 77,788 $ 96,336 Google Network Members' properties 15,598 17,587 19,982 Google advertising revenues 79,383 95,375 116,318 Google other revenues 10,601 15,003 19,906 Other Bets revenues 288 477 595 Total revenues (2) $ 90,272 $ 110,855 $ 136,819 (1) As noted above, prior period amounts have not been adjusted under the modified retrospective method. (2) Revenues include hedging gains (losses) of $539 million , $(169) million , and $(138) million for the years ended December 31, 2016 , 2017 , and 2018 , respectively, which do not represent revenues recognized from contracts with customers. The following table presents our revenues disaggregated by geography, based on the addresses of our customers (in millions): Year Ended December 31, 2016 2017 2018 United States $ 42,781 47 % $ 52,449 47 % $ 63,269 46 % EMEA (1) 30,304 34 36,046 33 44,567 33 APAC (1) 12,559 14 16,235 15 21,374 15 Other Americas (1) 4,628 5 6,125 5 7,609 6 Total revenues (2) $ 90,272 100 % $ 110,855 100 % $ 136,819 100 % (1) Regions represent Europe, the Middle East, and Africa (EMEA); Asia-Pacific (APAC); and Canada and Latin America (Other Americas). (2) Revenues include hedging gains (losses) for the years ended December 31, 2016 , 2017 , and 2018 . Advertising Revenues We generate revenues primarily by delivering advertising on Google properties and Google Network Members’ properties. Google properties revenues consist primarily of advertising revenues generated on Google.com, the Google Search app, and other Google owned and operated properties like Gmail, Google Maps, Google Play, and YouTube. Google Network Members’ properties revenues consist primarily of advertising revenues generated on Google Network Members’ properties. Our customers generally purchase advertising inventory through Google Ads (formerly AdWords), Google Ad Manager as part of the Authorized Buyers marketplace (formerly DoubleClick AdExchange), and Google Marketing Platform (includes what was formerly DoubleClick Bid Manager), among others. We offer advertising on a cost-per-click basis, which means that an advertiser pays us only when a user clicks on an ad on Google properties or Google Network Members' properties or when a user views certain YouTube engagement ads. For these customers, we recognize revenue each time a user clicks on the ad or when a user views the ad for a specified period of time. We also offer advertising on other bases such as cost-per-impression, which means an advertiser pays us based on the number of times their ads are displayed on Google properties or Google Network Members’ properties. For these customers, we recognize revenue each time an ad is displayed. For ads placed on Google Network Members’ properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues for ads placed on Google Network Members’ properties on a gross basis, that is, the amounts billed to our customers 56 Table of Contents Alphabet Inc. are recorded as revenues, and amounts paid to Google Network Members are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers, and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. Other Revenues Google other revenues and Other Bets revenues consist primarily of revenues from: • Apps, in-app purchases, and digital content in the Google Play store; • Google Cloud offerings; • Hardware; and • Other miscellaneous products and services. As it relates to Google other revenues, the most significant judgment is determining whether we are the principal or agent for app sales and in-app purchases through the Google Play store. We report revenues from these transactions on a net basis because our performance obligation is to facilitate a transaction between app developers and end users, for which we earn a commission. Consequently, the portion of the gross amount billed to end users that is remitted to app developers is not reflected as revenues. Arrangements with Multiple Performance Obligations Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenues to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers or using expected cost plus margin. Customer Incentives and Credits Certain customers may receive cash-based incentives or credits, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenues recognized. We believe that there will not be significant changes to our estimates of variable consideration. Deferred Revenues We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. The increase in the deferred revenue balance for the twelve months ended December 31, 2018 is primarily driven by cash payments received or due in advance of satisfying our performance obligations, offset by $1.5 billion of revenues recognized that were included in the deferred revenue balance as of December 31, 2017 . Our payment terms vary by the type and location of our customer and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customer types, we require payment before the products or services are delivered to the customer. Practical Expedients and Exemptions We generally expense sales commissions when incurred because the amortization period would have been one year or less. These costs are recorded within sales and marketing expenses. We do not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. Note 3. Financial Instruments Debt Securities We classify our marketable debt securities within Level 2 in the fair value hierarchy because we use quoted market prices to the extent available or alternative pricing sources and models utilizing market observable inputs to determine fair value. In January 2018, we reclassified our U.S. government notes included in marketable debt securities from Level 1 to Level 2 within the fair value hierarchy as these securities are priced based on a combination of quoted prices for identical or similar instruments in active markets and models with significant observable market inputs. Prior period amounts have been reclassified to conform with current period presentation. The vast majority of our government bond holdings are highly liquid U.S. government notes. We classify our non-marketable debt securities within Level 3 in the fair value hierarchy because they are preferred stock and convertible notes issued by private companies without quoted market prices. To estimate the fair value of 57 Table of Contents Alphabet Inc. our non-marketable debt securities, we use a combination of valuation methodologies, including market and income approaches based on prior transaction prices; estimated timing, probability, and amount of cash flows; and illiquidity considerations. Financial information of private companies may not be available and consequently we estimate the fair value based on the best available information at the measurement date. The following tables summarize our debt securities by significant investment categories as of December 31, 2017 and 2018 (in millions): As of December 31, 2017 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Non-Marketable Securities Level 2: Time deposits (1) $ 359 $ 0 $ 0 $ 359 $ 357 $ 2 $ 0 Government bonds (2) 51,548 10 (406 ) 51,152 1,241 49,911 0 Corporate debt securities 24,269 21 (135 ) 24,155 126 24,029 0 Mortgage-backed and asset-backed securities 16,789 13 (180 ) 16,622 0 16,622 0 92,965 44 (721 ) 92,288 1,724 90,564 0 Level 3: Non-marketable debt securities 1,083 811 0 1,894 0 0 1,894 Total $ 94,048 $ 855 $ (721 ) $ 94,182 $ 1,724 $ 90,564 $ 1,894 As of December 31, 2018 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Non-Marketable Securities Level 2: Time deposits (1) $ 2,202 $ 0 $ 0 $ 2,202 $ 2,202 $ 0 $ 0 Government bonds (2) 53,634 71 (414 ) 53,291 3,717 49,574 0 Corporate debt securities 25,383 15 (316 ) 25,082 44 25,038 0 Mortgage-backed and asset-backed securities 16,918 11 (324 ) 16,605 0 16,605 0 98,137 97 (1,054 ) 97,180 5,963 91,217 0 Level 3: Non-marketable debt securities 147 116 0 263 0 0 263 Total $ 98,284 $ 213 $ (1,054 ) $ 97,443 $ 5,963 $ 91,217 $ 263 (1) As of December 31, 2017, the majority of our time deposits were foreign deposits. As of December 31, 2018, the majority of our time deposits are domestic deposits. (2) Government bonds are comprised primarily of U.S. government notes, and also includes U.S. government agencies, foreign government bonds, and municipal securities. We determine realized gains or losses on the sale or extinguishment of debt securities on a specific identification method. We recognized gross realized gains of $251 million , $185 million , and $1.3 billion for the years ended December 31, 2016 , 2017 , and 2018 , respectively. We recognized gross realized losses of $304 million , $295 million , and $143 million for the years ended December 31, 2016 , 2017 , and 2018 , respectively. We reflect these gains and losses as a component of other income (expense), net, in the Consolidated Statements of Income. The following table summarizes the estimated fair value of our investments in marketable debt securities with stated contractual maturity dates, accounted for as available-for-sale securities and classified by the contractual maturity date of the securities (in millions): 58 Table of Contents Alphabet Inc. As of December 31, 2018 Due in 1 year $ 23,669 Due in 1 year through 5 years 54,504 Due in 5 years through 10 years 2,236 Due after 10 years 10,808 Total $ 91,217 The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2017 and 2018 , aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2017 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds (1) $ 28,836 $ (211 ) $ 17,660 $ (195 ) $ 46,496 $ (406 ) Corporate debt securities 18,300 (114 ) 1,710 (21 ) 20,010 (135 ) Mortgage-backed and asset-backed securities 11,061 (105 ) 3,449 (75 ) 14,510 (180 ) Total $ 58,197 $ (430 ) $ 22,819 $ (291 ) $ 81,016 $ (721 ) As of December 31, 2018 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds (1) $ 12,019 $ (85 ) $ 23,877 $ (329 ) $ 35,896 $ (414 ) Corporate debt securities 10,171 (107 ) 11,545 (209 ) 21,716 (316 ) Mortgage-backed and asset-backed securities 5,534 (75 ) 8,519 (249 ) 14,053 (324 ) Total $ 27,724 $ (267 ) $ 43,941 $ (787 ) $ 71,665 $ (1,054 ) (1) Government bonds are comprised primarily of U.S. government notes, and also includes U.S. government agencies, foreign government bonds, and municipal securities. During the years ended December 31, 2016 , 2017 and 2018 , we did not recognize any significant other-than-temporary impairment losses. Losses on impairment are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 6 for further details on other income (expense), net. The following table presents a reconciliation for our non-marketable debt securities measured and recorded at fair value on a recurring basis, using significant unobservable inputs (Level 3) (in millions): Year Ended December 31, 2017 2018 Beginning balance $ 1,165 $ 1,894 Total net gains (losses) Included in earnings (10 ) 603 Included in other comprehensive income 707 (1 ) Purchases 88 47 Sales (2 ) (52 ) Settlements (1) (54 ) (2,228 ) Ending balance $ 1,894 $ 263 (1) During the year ended December 31, 2018 the terms of a non-marketable debt security were modified resulting in an unrealized $1.3 billion gain recognized in other income (expense), net and a reclassification of the security to non-marketable equity securities. 59 Table of Contents Alphabet Inc. Equity Investments The following discusses our marketable equity securities, non-marketable equity securities, realized and unrealized gains and losses on marketable and non-marketable equity securities, as well as our equity securities accounted for under the equity method. Marketable equity securities Our marketable equity securities are publicly traded stocks or funds measured at fair value and classified within Level 1 and 2 in the fair value hierarchy because we use quoted prices for identical assets in active markets or inputs that are based upon quoted prices for similar instruments in active markets. Prior to January 1, 2018, we accounted for the majority of our marketable equity securities at fair value with unrealized gains and losses recognized in accumulated other comprehensive income on the balance sheet. Realized gains and losses on marketable equity securities sold or impaired were recognized in other income (expense), net. Starting January 1, 2018, upon our adoption of ASU 2016-01, unrealized gains and losses during the year are recognized in other income (expense), net. Upon adoption, we reclassified $98 million net unrealized gains related to marketable equity securities from accumulated other comprehensive income to opening retained earnings. The following table summarizes marketable equity securities measured at fair value by significant investment categories as of December 31, 2017 and 2018 (in millions): As of December 31, 2017 Cash and Cash Equivalents Marketable Securities Level 1: Money market funds $ 1,833 $ 0 Marketable equity securities 0 340 1,833 340 Level 2: Mutual funds (1) 0 252 Total $ 1,833 $ 592 (1) The fair value option was elected for mutual funds with gains (losses) recognized in other income (expense), net. As of December 31, 2018 Cash and Cash Equivalents Marketable Securities Level 1: Money market funds $ 3,493 $ 0 Marketable equity securities 0 994 3,493 994 Level 2: Mutual funds 0 228 Total $ 3,493 $ 1,222 Non-marketable equity securities Our non-marketable equity securities are investments in privately held companies without readily determinable market values. Prior to January 1, 2018, we accounted for our non-marketable equity securities at cost less impairment. Realized gains and losses on non-marketable securities sold or impaired were recognized in other income (expense), net. As of December 31, 2017, non-marketable equity securities accounted for under the cost method had a carrying value of $ 4.5 billion and a fair value of approximately $ 8.8 billion . On January 1, 2018, we adopted ASU 2016-01 which changed the way we account for non-marketable securities. The carrying value of our non-marketable equity securities is adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). All gains and losses on non-marketable equity securities, realized and unrealized, are recognized in other income (expense), net. Because we adopted ASU 2016-01 prospectively, we recognize unrealized gains that occurred in prior 60 Table of Contents Alphabet Inc. periods in the first period after January 1, 2018 when there is an observable transaction for our securities. Non-marketable equity securities remeasured during the year ended December 31, 2018 are classified within Level 3 in the fair value hierarchy because we estimate the value based on valuation methods using the observable transaction price at the transaction date and other unobservable inputs including volatility, rights, and obligations of the securities we hold. The following is a summary of unrealized gains and losses recorded in other income (expense), net, and included as adjustments to the carrying value of non-marketable equity securities held as of December 31, 2018 (in millions): Twelve Months Ended December 31, 2018 Upward adjustments $ 4,285 Downward adjustments (including impairment) (178 ) Total unrealized gain (loss) for non-marketable equity securities $ 4,107 The following table summarizes the total carrying value of our non-marketable equity securities held as of December 31, 2018 including cumulative unrealized upward and downward adjustments made to the initial cost basis of the securities (in millions): Initial cost basis (1) $ 8,168 Upward adjustments 4,285 Downward adjustments (including impairment) (178 ) Total carrying value at the end of the period $ 12,275 (1) Includes $2.2 billion for a non-marketable equity security reclassified from a non-marketable debt security during 2018. During the year ended December 31, 2018 , included in the $12.3 billion of non-marketable equity securities, $6.9 billion were measured at fair value based on observable market transactions, resulting in a net unrealized gain of $4.1 billion . Gains and losses on marketable and non-marketable equity securities Realized and unrealized gains and losses for our marketable and non-marketable equity securities for the year ended December 31, 2018 are summarized below (in millions): Twelve Months Ended December 31, 2018 Realized gain (loss) for equity securities sold during the period $ 1,458 Unrealized gain (loss) on equity securities held as of the end of the period (1) 4,002 Total gain (loss) recognized in other income (expense), net $ 5,460 (1) Includes $4,107 million related to non-marketable equity securities for the year ended December 31, 2018 . Equity securities accounted for under the Equity Method As of December 31, 2017 and 2018 , equity securities accounted for under the equity method had a carrying value of approximately $1.4 billion and $1.3 billion , respectively. Our share of gains and losses including impairment are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 6 for further details on other income (expense), net. Derivative Financial Instruments We classify our foreign currency and interest rate derivative contracts primarily within Level 2 in the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments. We recognize derivative instruments as either assets or liabilities in the Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the Consolidated Statements of Income as either other income (expense), net, or revenues, or in the Consolidated Balance Sheets in AOCI, as discussed below. As a result of our adoption of Accounting Standard Update No. 2017-12 (ASU 2017-12) "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities," the components excluded from the assessment of hedge effectiveness are recognized in the same income statement line as the hedged item beginning January 1, 2018. 61 Table of Contents Alphabet Inc. We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows, earnings, and investment in foreign subsidiaries will be adversely affected by foreign currency exchange rate fluctuations. We also use interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and debt issuances. Our program is not used for trading or speculative purposes. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further reduce credit risk, we enter into collateral security arrangements under which the counterparty is required to provide collateral when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We can take possession of the collateral in the event of counterparty default. As of December 31, 2017 and 2018 , we received cash collateral related to the derivative instruments under our collateral security arrangements of $15 million and $327 million , respectively, which was included in other current assets. Cash Flow Hedges We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options), designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. The notional principal of these contracts was approximately $11.7 billion and $11.8 billion as of December 31, 2017 and 2018 , respectively. These contracts have maturities of 24 months or less. For forwards and option contracts, we exclude the change in the forward points and time value from our assessment of hedge effectiveness. The initial value of the excluded component is amortized on a straight-line basis over the life of the hedging instrument and recognized in revenues. The difference between fair value changes of the excluded component and the amount amortized to revenues is recorded in AOCI. We reflect the gains or losses of a cash flow hedge included in our hedge effective assessment as a component of AOCI and subsequently reclassify these gains and losses to revenues when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI are immediately reclassified to other income (expense), net. As of December 31, 2018 , the net gain or loss of our foreign currency cash flow hedges before tax effect was a net accumulated gain of $247 million , of which a net gain of $247 million is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. We exclude changes in forward points for the forward contracts from the assessment of hedge effectiveness. We recognize changes in the excluded component in other income (expense), net. The notional principal of these contracts was $2.9 billion and $2.0 billion as of December 31, 2017 and 2018 , respectively. Gains and losses on these forward contracts are recognized in other income (expense), net, along with the offsetting gains and losses of the related hedged items. Net Investment Hedges During the year ended December 31, 2018 , we entered into forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. We exclude changes in forward points for the forward contracts from the assessment of hedge effectiveness. We recognize changes in the excluded component in other income (expense), net. The notional principal of these contracts was $6.7 billion as of December 31, 2018 . Gains and losses on these forward contracts are recognized in AOCI as part of the foreign currency translation adjustment. Other Derivatives Other derivatives not designated as hedging instruments consist of foreign currency forward contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts, as well as the related costs in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. The notional principal of the outstanding foreign exchange contracts was $15.2 billion and $20.1 billion as of December 31, 2017 and 2018 , respectively. 62 Table of Contents Alphabet Inc. The fair values of our outstanding derivative instruments were as follows (in millions): As of December 31, 2017 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 51 $ 29 $ 80 Total $ 51 $ 29 $ 80 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 230 $ 122 $ 352 Total $ 230 $ 122 $ 352 As of December 31, 2018 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 459 $ 54 $ 513 Total $ 459 $ 54 $ 513 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 5 $ 228 $ 233 Total $ 5 $ 228 $ 233 The gains (losses) on derivatives in cash flow hedging and net investment hedging relationships recognized in other comprehensive income (OCI) are summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect Year Ended December 31, 2016 2017 2018 Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness $ 773 $ (955 ) $ 332 Amount excluded from the assessment of effectiveness 0 0 26 Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness 0 0 136 Total $ 773 $ (955 ) $ 494 63 Table of Contents Alphabet Inc. The effect of derivative instruments on income is summarized below (in millions): Gains (Losses) Recognized in Income Year Ended December 31, 2016 2017 2018 Revenues Other income (expense), net Revenues Other income (expense), net Revenues Other income (expense), net Total amounts presented in the Consolidated Statements of Income in which the effects of cash flow and fair value hedges are recorded $ 90,272 $ 434 $ 110,855 $ 1,047 $ 136,819 $ 8,592 Gains (Losses) on Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount of gains (losses) reclassified from AOCI to income $ 539 $ 0 $ (169 ) $ 0 $ (139 ) $ 0 Amount excluded from the assessment of effectiveness recognized in earnings based on an amortization approach 0 0 0 0 1 0 Amount excluded from the assessment of effectiveness 0 (381 ) 0 83 0 0 Gains (Losses) on Derivatives in Fair Value Hedging Relationship: Foreign exchange contracts Hedged items 0 (139 ) 0 197 0 (96 ) Derivatives designated as hedging instruments 0 139 0 (197 ) 0 96 Amount excluded from the assessment of effectiveness 0 6 0 23 0 37 Gains (Losses) on Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount excluded from the assessment of effectiveness 0 0 0 0 0 78 Gains (Losses) on Derivatives Not Designated as Hedging Instruments: Foreign exchange contracts Derivatives not designated as hedging instruments 0 130 0 (230 ) 0 54 Total gains (losses) $ 539 $ (245 ) $ (169 ) $ (124 ) $ (138 ) $ 169 Offsetting of Derivatives We present our forwards and purchased options at gross fair values in the Consolidated Balance Sheets. For foreign currency collars, we present at net fair values where both purchased and written options are with the same counterparty. Our master netting and other similar arrangements allow net settlements under certain conditions. As of December 31, 2017 and 2018 , information related to these offsetting arrangements were as follows (in millions): 64 Table of Contents Alphabet Inc. Offsetting of Assets As of December 31, 2017 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 102 $ (22 ) $ 80 $ (64 ) (1) $ (4 ) $ (2 ) $ 10 As of December 31, 2018 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 569 $ (56 ) $ 513 $ (90 ) (1) $ (307 ) $ (14 ) $ 102 (1) The balances as of December 31, 2017 and 2018 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. Offsetting of Liabilities As of December 31, 2017 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 374 $ (22 ) $ 352 $ (64 ) (2) $ 0 $ 0 $ 288 As of December 31, 2018 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 289 $ (56 ) $ 233 $ (90 ) (2) $ 0 $ 0 $ 143 (2) The balances as of December 31, 2017 and 2018 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 4. Variable Interest Entities (VIEs) Consolidated VIEs We consolidate VIEs in which we hold a variable interest and are the primary beneficiary. We are the primary beneficiary because we have the power to direct activities that most significantly affect their economic performance and have the obligation to absorb the majority of their losses or benefits. The results of operations and financial position of these VIEs are included in our consolidated financial statements. For certain consolidated VIEs, their assets are not available to us and their creditors do not have recourse to us. As of December 31, 2017 and 2018 , assets that can only be used to settle obligations of these VIEs were $1.7 billion and $2.4 billion , respectively, and the liabilities for which creditors only have recourse to the VIEs were $997 million and $909 million , respectively. Calico Calico is a life science company with a mission to harness advanced technologies to increase our understanding of the biology that controls lifespan. 65 Table of Contents Alphabet Inc. In September 2014, AbbVie Inc. (AbbVie) and Calico entered into a research and development collaboration agreement intended to help both companies discover, develop, and bring to market new therapies for patients with age-related diseases, including neurodegeneration and cancer. In the second quarter of 2018, AbbVie and Calico amended the collaboration agreement resulting in an increase in total commitments. As of December 31, 2018 , AbbVie has contributed $750 million to fund the collaboration pursuant to the agreement and is committed to an additional $500 million which will be paid by the fourth quarter of 2019. As of December 31, 2018 , Calico has contributed $500 million and has committed up to an additional $750 million . Calico has used its scientific expertise to establish a world-class research and development facility, with a focus on drug discovery and early drug development; and AbbVie provides scientific and clinical development support and its commercial expertise to bring new discoveries to market. Both companies share costs and profits for projects covered under this agreement equally. AbbVie's contribution has been recorded as a liability on Calico's financial statements, which is reduced and reflected as a reduction to research and development expense as eligible research and development costs are incurred by Calico. As of December 31, 2018 , we have contributed $480 million to Calico in exchange for Calico convertible preferred units and are committed to fund up to an additional $750 million on an as-needed basis and subject to certain conditions. Verily Verily is a life science company with a mission to make the world's health data useful so that people enjoy healthier lives. In 2017, Temasek, a Singapore-based investment company, purchased a noncontrolling interest in Verily for an aggregate of $800 million in cash. In December 2018, Verily received $900 million in cash from a $1.0 billion investment round. The remaining $100 million is expected to be received in the first quarter of 2019. These transactions were accounted for as equity transactions and no gain or loss was recognized. Unconsolidated VIEs Certain renewable energy investments included in our non-marketable equity investments accounted for under the equity method are VIEs. These entities' activities involve power generation using renewable sources. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly affect their economic performance such as setting operating budgets. Therefore, we do not consolidate these VIEs in our consolidated financial statements. The carrying value and maximum exposure of these VIEs were $896 million and $705 million as of December 31, 2017 and 2018 , respectively. The maximum exposure is based on current investments to date.  We have determined the single source of our exposure to these VIEs is our capital investment in them. Other unconsolidated VIEs were not material as of December 31, 2017 and 2018 . Note 5. Debt Short-Term Debt We have a debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2017 and 2018 . Long-Term Debt Google issued $3.0 billion of senior unsecured notes in three tranches (collectively, 2011 Notes) in May 2011, due in 2014, 2016, and 2021, as well as $1.0 billion of senior unsecured notes (2014 Notes) in February 2014 due in 2024. In April 2016, we completed an exchange offer with eligible holders of Google’s 2011 Notes due 2021 and 2014 Notes due 2024 (collectively, the Google Notes). An aggregate principal amount of approximately $1.7 billion of the Google Notes was exchanged for approximately $1.7 billion of Alphabet notes with identical interest rate and maturity. Because the exchange was between a parent and the subsidiary company and for substantially identical notes, the change was treated as a debt modification for accounting purposes with no gain or loss recognized. In August 2016, Alphabet issued $2.0 billion of senior unsecured notes (2016 Notes) due 2026. The net proceeds from the issuance of the 2016 Notes were used for general corporate purposes, including the repayment of outstanding 66 Table of Contents Alphabet Inc. commercial paper. The Alphabet notes due in 2021, 2024, and 2026 rank equally with each other and are structurally subordinate to the outstanding Google Notes. The total outstanding long-term debt is summarized below (in millions): As of December 31, 2017 As of December 31, 2018 3.625% Notes due on May 19, 2021 $ 1,000 $ 1,000 3.375% Notes due on February 25, 2024 1,000 1,000 1.998% Notes due on August 15, 2026 2,000 2,000 Unamortized discount for the Notes above (57 ) (50 ) Subtotal (1) 3,943 3,950 Capital lease obligation 26 62 Total long-term debt $ 3,969 $ 4,012 (1) Includes the outstanding (and unexchanged) Google Notes issued in 2011 and 2014 and the Alphabet notes exchanged in 2016. The effective interest yields based on proceeds received from the outstanding notes due in 2021, 2024, and 2026 were 3.734% , 3.377% , and 2.231% , respectively, with interest payable semi-annually. We may redeem these notes at any time in whole or in part at specified redemption prices. The total estimated fair value of all outstanding notes was approximately $4.0 billion and $3.9 billion as of December 31, 2017 and 2018 , respectively. The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. As of December 31, 2018 , the aggregate future principal payments for long-term debt including long-term capital leases for each of the next five years and thereafter are as follows (in millions): 2019 $ 0 2020 14 2021 1,003 2022 3 2023 3 Thereafter 3,039 Total $ 4,062 Credit Facility As of December 31, 2018 , we have $4.0 billion of revolving credit facilities which expire in July 2023. The interest rate for the credit facilities is determined based on a formula using certain market rates. No amounts were outstanding under the credit facilities as of December 31, 2017 and 2018 . Note 6. Supplemental Financial Statement Information Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2017 As of December 31, 2018 Land and buildings $ 23,183 $ 30,179 Information technology assets 21,429 30,119 Construction in progress 10,491 16,838 Leasehold improvements 4,496 5,310 Furniture and fixtures 48 61 Property and equipment, gross 59,647 82,507 Less: accumulated depreciation (17,264 ) (22,788 ) Property and equipment, net $ 42,383 $ 59,719 67 Table of Contents Alphabet Inc. As of December 31, 2017 and 2018 , assets under capital lease with a cost basis of $390 million and $648 million , respectively, were included in property and equipment. Accrued Expenses and Other Current Liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2017 As of December 31, 2018 European Commission fines (1) $ 2,874 $ 7,754 Accrued customer liabilities 1,489 1,810 Other accrued expenses and current liabilities 5,814 7,394 Accrued expenses and other current liabilities $ 10,177 $ 16,958 (1) Includes the effects of foreign exchange and interest. See Note 9 for further details Accumulated Other Comprehensive Income (Loss) The components of AOCI, net of tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2015 $ (2,047 ) $ (86 ) $ 259 $ (1,874 ) Other comprehensive income (loss) before reclassifications (599 ) (314 ) 515 (398 ) Amounts reclassified from AOCI 0 221 (351 ) (130 ) Other comprehensive income (loss) (599 ) (93 ) 164 (528 ) Balance as of December 31, 2016 $ (2,646 ) $ (179 ) $ 423 $ (2,402 ) Other comprehensive income (loss) before reclassifications 1,543 307 (638 ) 1,212 Amounts reclassified from AOCI 0 105 93 198 Other comprehensive income (loss) 1,543 412 (545 ) 1,410 Balance as of December 31, 2017 $ (1,103 ) $ 233 $ (122 ) $ (992 ) Other comprehensive income (loss) before reclassifications (1) (781 ) (10 ) 264 (527 ) Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 26 26 Amounts reclassified from AOCI 0 (911 ) 98 (813 ) Other comprehensive income (loss) (781 ) (921 ) 388 (1,314 ) Balance as of December 31, 2018 $ (1,884 ) $ (688 ) $ 266 $ (2,306 ) (1) The change in unrealized gains (losses) on available-for-sale investments included a $98 million adjustment of net unrealized gains related to marketable equity securities from AOCI to opening retained earnings as a result of the adoption of ASU 2016-01 on January 1, 2018. 68 Table of Contents Alphabet Inc. The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statements of Income Year Ended December 31, AOCI Components Location 2016 2017 2018 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ (221 ) $ (105 ) $ 1,190 Provision for income taxes 0 0 (279 ) Net of tax $ (221 ) $ (105 ) $ 911 Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue $ 539 $ (169 ) $ (139 ) Interest rate contracts Other income (expense), net 5 5 6 Benefit (provision) for income taxes (193 ) 71 35 Net of tax $ 351 $ (93 ) $ (98 ) Total amount reclassified, net of tax $ 130 $ (198 ) $ 813 Other Income (Expense), Net The components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2016 2017 2018 Interest income $ 1,220 $ 1,312 $ 1,878 Interest expense (1) (124 ) (109 ) (114 ) Foreign currency exchange losses, net (2) (475 ) (121 ) (80 ) Gain (loss) on debt securities, net (3) (53 ) (110 ) 1,190 Gain (loss) on equity securities, net (20 ) 73 5,460 Loss and impairment from equity method investments, net (202 ) (156 ) (120 ) Other 88 158 378 Other income (expense), net $ 434 $ 1,047 $ 8,592 (1) Interest expense is net of interest capitalized of $0 million , $48 million , and $92 million for the years ended December 31, 2016 , 2017 , and 2018 , respectively. (2) Our foreign currency exchange losses, net, are related to the option premium costs and forwards points for our foreign currency hedging contracts, our foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contract losses and gains. The net foreign currency transaction losses were $112 million , $226 million , and $195 million for the years ended December 31, 2016 , 2017 , and 2018 , respectively. (3) During the year ended December 31, 2018, the terms of a non-marketable debt security were modified resulting in an unrealized $1.3 billion gain. Note 7. Acquisitions 2018 Acquisitions HTC Corporation (HTC) In January 2018, we completed the acquisition of a team of engineers and a non-exclusive license of intellectual property from HTC for $1.1 billion in cash. In aggregate, $10 million was cash acquired, $165 million was attributed to intangible assets, $934 million was attributed to goodwill, and $9 million was attributed to net liabilities assumed. Goodwill, which was included in the Google segment, is not deductible for tax purposes. We expect this transaction to accelerate Google’s ongoing hardware efforts. The transaction was accounted for as a business combination. Other Acquisitions During the year ended December 31, 2018 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $573 million . In aggregate, $10 million was cash acquired, $295 million was attributed to intangible assets, $293 million was attributed to goodwill, and $25 million was attributed to net liabilities 69 Table of Contents Alphabet Inc. assumed . These acquisitions generally enhance the breadth and depth of our offerings and expand our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $81 million . Pro forma results of operations for these acquisitions, including HTC, have not been presented because they are not material to the consolidated results of operations, either individually or in the aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2018 , patents and developed technology have a weighted-average useful life of 3.7 years, customer relationships have a weighted-average useful life of 2.3 years, and trade names and other have a weighted-average useful life of 3.7 years. 2017 Acquisitions During the year ended December 31, 2017 , we completed various acquisitions and purchases of intangible assets for total consideration of approximately $322 million . In aggregate, $12 million was cash acquired, $117 million was attributed to intangible assets, $221 million was attributed to goodwill, and $28 million was attributed to net liabilities assumed . These acquisitions generally enhance the breadth and depth of our offerings and expand our expertise in engineering and other functional areas. The amount of goodwill expected to be deductible for tax purposes is approximately $60 million . Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2017 , patents and developed technology have a weighted-average useful life of 3.7 years, customer relationships have a weighted-average useful life of 2.0 years, and trade names and other have a weighted-average useful life of 8.8 years. Note 8. Goodwill and Other Intangible Assets Goodwill Changes in the carrying amount of goodwill for the years ended December 31, 2017 and 2018 were as follows (in millions): Google Other Bets Total Consolidated Balance as of December 31, 2016 $ 16,027 $ 441 $ 16,468 Acquisitions 212 9 221 Foreign currency translation and other adjustments 56 2 58 Balance as of December 31, 2017 16,295 452 16,747 Acquisitions 1,227 0 1,227 Transfers 80 (80 ) 0 Foreign currency translation and other adjustments (81 ) (5 ) (86 ) Balance as of December 31, 2018 $ 17,521 $ 367 $ 17,888 Other Intangible Assets Information regarding purchased intangible assets were as follows (in millions): As of December 31, 2017 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 5,260 $ 3,040 $ 2,220 Customer relationships 359 263 96 Trade names and other 544 168 376 Total $ 6,163 $ 3,471 $ 2,692 70 Table of Contents Alphabet Inc. As of December 31, 2018 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 5,125 $ 3,394 $ 1,731 Customer relationships 349 308 41 Trade names and other 703 255 448 Total $ 6,177 $ 3,957 $ 2,220 Patents and developed technology, customer relationships, and trade names and other have weighted-average remaining useful lives of 3.0 years, 0.5 years, and 3.8 years, respectively. Amortization expense relating to purchased intangible assets was $833 million , $796 million , and $865 million for the years ended December 31, 2016 , 2017 , and 2018 , respectively. As of December 31, 2018 , expected amortization expense relating to purchased intangible assets for each of the next five years and thereafter is as follows (in millions): 2019 $ 712 2020 585 2021 533 2022 201 2023 7 Thereafter 182 $ 2,220 Note 9. Commitments and Contingencies Operating Leases We have entered into various non-cancelable operating lease agreements for data centers and land and offices throughout the world with lease periods expiring between 2019 and 2063 . We are committed to pay a portion of the actual operating expenses under certain of these lease agreements. These operating expenses are not included in the table below. Certain of these arrangements have free or escalating rent payment provisions. We recognize rent expense on a straight-line basis. As of December 31, 2018 , future minimum payments under operating leases having initial or remaining non-cancelable lease terms in excess of one year, net of sublease income amounts, were as follows (in millions): Operating Leases (1) Sub-lease Income Net Operating Leases 2019 $ 1,319 $ 16 $ 1,303 2020 1,397 13 1,384 2021 1,337 10 1,327 2022 1,153 8 1,145 2023 980 3 977 Thereafter 3,916 5 3,911 Total minimum payments $ 10,102 $ 55 $ 10,047 (1) Includes future minimum payments for leases which have not yet commenced. We have entered into certain non-cancelable lease agreements with lease periods expiring between 2021 and 2044 where we are the deemed owner for accounting purposes of new construction projects. Excluded from the table above are future minimum lease payments under such leases totaling approximately $3.5 billion , for which a $1.5 billion liability is included on the Consolidated Balance Sheets as of December 31, 2018 . Rent expense under operating leases was $897 million , $1.1 billion , and $1.3 billion for the years ended December 31, 2016 , 2017 , and 2018 , respectively. 71 Table of Contents Alphabet Inc. Purchase Obligations As of December 31, 2018 , we had $7.4 billion of other non-cancelable contractual obligations, primarily related to data center operations and build-outs, digital media content licensing, and purchases of inventory. Indemnifications In the normal course of business, to facilitate transactions in our services and products, we indemnify certain parties, including advertisers, Google Network Members, and lessors with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2018 , we did not have any material indemnification claims that were probable or reasonably possible. Legal Matters Antitrust Investigations On November 30, 2010, the EC's Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On April 15, 2015, the EC issued a Statement of Objections (SO) regarding the display and ranking of shopping search results and ads, to which we responded on August 27, 2015. On July 14, 2016, the EC issued a Supplementary SO regarding shopping search results and ads. On June 27, 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a €2.4 billion ( $2.7 billion as of June 27, 2017) fine. On September 11, 2017, we appealed the EC decision and on September 27, 2017, we implemented product changes to bring shopping ads into compliance with the EC's decision. We recognized a charge of $2.7 billion for the fine in the second quarter of 2017. While under appeal, the fine is included in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees in lieu of a cash payment for the fine. On April 20, 2016, the EC issued an SO regarding certain Android distribution practices. We responded to the SO and the EC's informational requests. On July 18, 2018, the EC announced its decision that certain provisions in Google’s Android-related distribution agreements infringed European competition law. The EC decision imposed a €4.3 billion ( $5.1 billion as of June 30, 2018) fine and directed the termination of the conduct at issue. On October 9, 2018, we appealed the EC decision and implemented changes to certain of our Android distribution practices. We recognized a charge of $5.1 billion for the fine in the second quarter of 2018. While under appeal, the fine is included in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees in lieu of a cash payment for the fine. On July 14, 2016, the EC issued an SO regarding the syndication of AdSense for Search. We responded to the SO and continue to respond to the EC's informational requests. There is significant uncertainty as to the outcome of this investigation; however, an adverse decision could result in fines and directives to alter or terminate certain conduct. Given the nature of this case, we are unable to estimate the reasonably possible loss or range of loss, if any. We remain committed to working with the EC to resolve these matters. The Comision Nacional de Defensa de la Competencia in Argentina, the Competition Commission of India (CCI), Brazil's Administrative Council for Economic Defense (CADE), and the Korean Fair Trade Commission have also opened investigations into certain of our business practices. In November 2016, we responded to the CCI Director General's report with interim findings of competition law infringements regarding search and ads. On February 8, 2018, the CCI issued its final decision, including a fine of approximately $21 million , finding no violation of competition law infringement on most of the issues it investigated, but finding violations, including in the display of the “flights unit” in search results, and a contractual provision in certain direct search intermediation agreements. We have appealed the CCI decision. The fine was accrued for in 2018. 72 Table of Contents Alphabet Inc. Patent and Intellectual Property Claims We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss for a company or its suppliers in an ITC action could result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them for certain intellectual property infringement claims against them, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. In 2010, Oracle America, Inc. (Oracle) brought a copyright lawsuit against Google in the Northern District of California, alleging that Google's Android operating system infringes Oracle's copyrights related to certain Java application programming interfaces. After trial, final judgment was entered by the district court in favor of Google on June 8, 2016, and the court decided post-trial motions in favor of Google. Oracle appealed and on March 27, 2018, the appeals court reversed and remanded the case for a trial on damages. On May 29, 2018, we filed a petition for an en banc rehearing at the Federal Circuit, and on August 28, 2018, the Federal Circuit denied the petition. On January 24, 2019, we filed a petition to the Supreme Court of the United States to review this case. We believe this lawsuit is without merit and are defending ourselves vigorously. Given the nature of this case, we are unable to estimate the reasonably possible loss or range of loss, if any, arising from this matter. Other We are also regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition (such as the pending EC investigations described above), intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. Such claims, suits, regulatory and government investigations, and other proceedings could result in fines, civil or criminal penalties, or other adverse consequences. Certain of these outstanding matters include speculative, substantial or indeterminate monetary amounts. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We evaluate developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. With respect to our outstanding matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Non-Income Taxes We are under audit by various domestic and foreign tax authorities with regards to non-income tax matters. The subject matter of non-income tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions and the tax treatment of certain employee benefits. We accrue non-income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We believe these matters are without merit and we are defending ourselves vigorously. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. 73 Table of Contents Alphabet Inc. For information regarding income tax contingencies, see Note 13 . Note 10. Stockholders’ Equity Convertible Preferred Stock Our board of directors has authorized 100 million shares of convertible preferred stock, $0.001 par value, issuable in series. As of December 31, 2017 and 2018 , no shares were issued or outstanding. Class A and Class B Common Stock and Class C Capital Stock Our board of directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Share Repurchases In October 2016, the board of directors of Alphabet authorized the company to repurchase up to $7.0 billion of its Class C capital stock, which was completed during 2018. In January 2018, the board of directors of Alphabet authorized the company to repurchase up to $8.6 billion of its Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. During the years ended December 31, 2017 and 2018 , we repurchased and subsequently retired 5.2 million shares of Alphabet Class C capital stock for an aggregate amount of $4.8 billion and 8.2 million shares of Alphabet Class C capital stock for an aggregate amount of $9.1 billion , respectively. Note 11. Net Income Per Share We compute net income per share of Class A and Class B common stock and Class C capital stock using the two-class method. Basic net income per share is computed using the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of restricted stock units and other contingently issuable shares. The dilutive effect of outstanding restricted stock units and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A common stock assumes the conversion of Class B common stock, while the diluted net income per share of Class B common stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A and Class B common stock and Class C capital stock are identical, except with respect to voting. Furthermore, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our board of directors from declaring or paying unequal per share dividends on our Class A and Class B common stock and Class C capital stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our board of directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A and Class B common shares and Class C capital stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. In the years ended December 31, 2016 , 2017 and 2018 , the net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. 74 Table of Contents Alphabet Inc. The following tables set forth the computation of basic and diluted net income per share of Class A and Class B common stock and Class C capital stock (in millions, except share amounts which are reflected in thousands and per share amounts): Year Ended December 31, 2016 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 8,332 $ 1,384 $ 9,762 Denominator Number of shares used in per share computation 294,217 48,859 344,702 Basic net income per share $ 28.32 $ 28.32 $ 28.32 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 8,332 $ 1,384 $ 9,762 Effect of dilutive securities in equity method investments and subsidiaries (9 ) (2 ) (10 ) Allocation of undistributed earnings for diluted computation 8,323 1,382 9,752 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 1,382 0 0 Reallocation of undistributed earnings (94 ) (21 ) 94 Allocation of undistributed earnings $ 9,611 $ 1,361 $ 9,846 Denominator Number of shares used in basic computation 294,217 48,859 344,702 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 48,859 0 0 Restricted stock units and other contingently issuable shares 2,055 0 8,873 Number of shares used in per share computation 345,131 48,859 353,575 Diluted net income per share $ 27.85 $ 27.85 $ 27.85 Year Ended December 31, 2017 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 5,438 $ 862 $ 6,362 Denominator Number of shares used in per share computation 297,604 47,146 348,151 Basic net income per share $ 18.27 $ 18.27 $ 18.27 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 5,438 $ 862 $ 6,362 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 862 0 0 Reallocation of undistributed earnings (74 ) (14 ) 74 Allocation of undistributed earnings $ 6,226 $ 848 $ 6,436 Denominator Number of shares used in basic computation 297,604 47,146 348,151 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 47,146 0 0 Restricted stock units and other contingently issuable shares 1,192 0 9,491 Number of shares used in per share computation 345,942 47,146 357,642 Diluted net income per share $ 18.00 $ 18.00 $ 18.00 75 Table of Contents Alphabet Inc. Year Ended December 31, 2018 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 13,200 $ 2,072 $ 15,464 Denominator Number of shares used in per share computation 298,548 46,864 349,728 Basic net income per share $ 44.22 $ 44.22 $ 44.22 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 13,200 $ 2,072 $ 15,464 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,072 0 0 Reallocation of undistributed earnings (146 ) (24 ) 146 Allocation of undistributed earnings $ 15,126 $ 2,048 $ 15,610 Denominator Number of shares used in basic computation 298,548 46,864 349,728 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 46,864 0 0 Restricted stock units and other contingently issuable shares 689 0 7,456 Number of shares used in per share computation 346,101 46,864 357,184 Diluted net income per share $ 43.70 $ 43.70 $ 43.70 Note 12. Compensation Plans Stock Plans Under our 2012 Stock Plan, RSUs or stock options may be granted. An RSU award is an agreement to issue shares of our publicly traded stock at the time the award vests. Incentive and non-qualified stock options, or rights to purchase common stock, are generally granted for a term of 10 years. RSUs granted to participants under the 2012 Stock Plan generally vest over four years contingent upon employment or service with us on the vesting date. As of December 31, 2018 , there were 31,848,134 shares of stock reserved for future issuance under our Stock Plan. Stock-Based Compensation For the years ended December 31, 2016 , 2017 and 2018 , total stock-based compensation expense was $6.9 billion , $7.9 billion and $10.0 billion , including amounts associated with awards we expect to settle in Alphabet stock of $6.7 billion , $7.7 billion , and $9.4 billion , respectively. For the years ended December 31, 2016 , 2017 and 2018 , we recognized tax benefits on total stock-based compensation expense, which are reflected in the provision for income taxes in the Consolidated Statements of Income, of $1.5 billion , $1.6 billion , and $1.5 billion , respectively. For the years ended December 31, 2016 , 2017 and 2018 , tax benefit realized related to awards vested or exercised during the period was $2.1 billion , $2.7 billion and $2.1 billion , respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the research and development tax credit. 76 Table of Contents Alphabet Inc. Stock-Based Award Activities The following table summarizes the activities for our unvested RSUs for the year ended December 31, 2018 : Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2017 20,077,346 $ 712.45 Granted 12,669,251 $ 1,095.89 Vested (12,847,910 ) $ 756.45 Forfeited/canceled (1,431,009 ) $ 814.19 Unvested as of December 31, 2018 18,467,678 $ 936.96 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2016 and 2017 , was $713.89 and $845.06 , respectively. Total fair value of RSUs, as of their respective vesting dates, during the years ended December 31, 2016 , 2017 , and 2018 were $9.0 billion , $11.3 billion , and $14.1 billion , respectively. As of December 31, 2018 , there was $16.2 billion of unrecognized compensation cost related to unvested employee RSUs. This amount is expected to be recognized over a weighted-average period of 2.5 years . 401(k) Plans We have two 401(k) Savings Plans that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We recognized expense of approximately $385 million , $448 million , and $691 million for the years ended December 31, 2016 , 2017 , and 2018 , respectively. Performance Fees We have compensation arrangements with payouts based on realized investment returns. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized. For the year ended December 31, 2018 , performance fees of $1.2 billion primarily related to gains on equity securities (for further information on gains on equity securities, see Note 3 ) were accrued and recorded as a component of general and administrative expenses. Note 13. Income Taxes Income from continuing operations before income taxes included income from domestic operations of $12.0 billion , $10.7 billion , and $15.8 billion for the years ended December 31, 2016 , 2017 , and 2018 , respectively, and income from foreign operations of $12.1 billion , $16.5 billion , and $19.1 billion for the years ended December 31, 2016 , 2017 , and 2018 , respectively. The provision for income taxes consists of the following (in millions): Year Ended December 31, 2016 2017 2018 Current: Federal and state $ 3,826 $ 12,608 $ 2,153 Foreign 966 1,746 1,251 Total 4,792 14,354 3,404 Deferred: Federal and state (70 ) 220 907 Foreign (50 ) (43 ) (134 ) Total (120 ) 177 773 Provision for income taxes $ 4,672 $ 14,531 $ 4,177 The Tax Act enacted on December 22, 2017 introduced significant changes to U.S. income tax law. Effective 2018, the Tax Act reduced the U.S. statutory tax rate from 35% to 21% and created new taxes on certain foreign-sourced earnings and certain related-party payments. 77 Table of Contents Alphabet Inc. Due to the timing of the enactment and the complexity involved in applying the provisions of the Tax Act, we made reasonable estimates of the effects and recorded provisional amounts in our consolidated financial statements as of December 31, 2017. As we collected and prepared necessary data, and interpreted the additional guidance issued by the U.S. Treasury Department, the IRS, and other standard-setting bodies, we made adjustments, over the course of the year, to the provisional amounts including refinements to deferred taxes. The accounting for the tax effects of the Tax Act has been completed as of December 31, 2018. One-time transition tax The Tax Act required us to pay U.S. income taxes on accumulated foreign subsidiary earnings not previously subject to U.S. income tax at a rate of 15.5% to the extent of foreign cash and certain other net current assets and 8% on the remaining earnings. We recorded a provisional amount for our one-time transitional tax liability and income tax expense of $10.2 billion as of December 31, 2017. Deferred tax effects Due to the change in the statutory tax rate from the Tax Act, we remeasured our deferred taxes as of December 31, 2017 to reflect the reduced rate that will apply in future periods when these deferred taxes are settled or realized. We recognized a deferred tax benefit of $376 million to reflect the reduced U.S. tax rate and other effects of the Tax Act as of December 31, 2017. The reconciliation of federal statutory income tax rate to our effective income tax rate is as follows: Year Ended December 31, 2016 2017 2018 U.S. federal statutory tax rate 35.0 % 35.0 % 21.0 % Foreign income taxed at different rates (11.0 ) (14.2 ) (4.9 ) Effect of the Tax Act One-time transition tax 0.0 37.6 (0.1 ) Deferred tax effects 0.0 (1.4 ) (1.2 ) Federal research credit (2.0 ) (1.8 ) (2.4 ) Stock-based compensation expense (3.4 ) (4.5 ) (2.2 ) European Commission fine 0.0 3.5 3.1 Deferred tax asset valuation allowance 0.1 0.9 (2.0 ) Other adjustments 0.6 (1.7 ) 0.7 Effective tax rate 19.3 % 53.4 % 12.0 % Our effective tax rate for each of the years presented was affected by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. Substantially all of the income from foreign operations was earned by an Irish subsidiary. Beginning in 2018, earnings realized in foreign jurisdictions are subject to U.S. tax in accordance with the Tax Act. On July 27, 2015, the United States Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. The IRS served a Notice of Appeal on February 22, 2016 and the case is being heard by the Ninth Circuit Court of Appeals. The Ninth Circuit Court of Appeals overturned the Tax Court’s decision in an opinion issued on July 24, 2018, but withdrew that opinion in an order issued on August 7, 2018 to allow time for a reconstituted panel to confer on the appeal. At this time, the Ninth Circuit Court of Appeals has not issued a final decision, and the U.S. Treasury has not withdrawn the requirement to include stock-based compensation from its regulations. We have evaluated the opinion and continue to record a tax benefit related to reimbursement of cost share payments for the previously shared stock-based compensation costs. In accordance with the Tax Act, the Altera tax benefit was remeasured from 35% to 21%. We also remeasured the tax benefit expected to be realized upon settlement including the expected future new taxes enacted by the Tax Act due upon resolution of the matter. The tax liability recorded as of December 31, 2016 for the U.S. tax cost of the potential repatriation associated with the contingent foreign earnings was reversed due to the Tax Act introducing a territorial tax system and providing a 100% dividend received deduction on certain qualified dividends from foreign subsidiaries. We will continue to monitor developments related to the case and the potential effect on our consolidated financial statements. 78 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. We recorded a provisional adjustment to our U.S. deferred income taxes as of December 31, 2017 to reflect the reduction in the U.S. statutory tax rate from 35% to 21% resulting from the Tax Act. Significant components of our deferred tax assets and liabilities are as follows (in millions): As of December 31, 2017 2018 Deferred tax assets: Stock-based compensation expense $ 251 $ 291 Accrued employee benefits 285 387 Accruals and reserves not currently deductible 717 1,062 Tax credits 1,187 1,979 Basis difference in investment in Arris 849 657 Prepaid cost sharing 498 597 Net operating losses 320 557 Other 244 251 Total deferred tax assets 4,351 5,781 Valuation allowance (2,531 ) (2,817 ) Total deferred tax assets net of valuation allowance 1,820 2,964 Deferred tax liabilities: Property and equipment (551 ) (1,382 ) Identified intangibles (419 ) (229 ) Renewable energy investments (531 ) (500 ) Investment gains/losses (22 ) (1,143 ) Other (47 ) (237 ) Total deferred tax liabilities (1,570 ) (3,491 ) Net deferred tax assets (liabilities) $ 250 $ (527 ) As of December 31, 2018 , our federal and state net operating loss carryforwards for income tax purposes were approximately $1.2 billion and $1.4 billion , respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2021 and the state net operating loss carryforwards will begin to expire in 2019. It is more likely than not that certain federal net operating loss carryforwards and our state net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. Our foreign net operating loss carryforwards for income tax purposes were $950 million that will begin to expire in 2021. As of December 31, 2018 , our California research and development credit carryforwards for income tax purposes were approximately $2.4 billion that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. As of December 31, 2018 , we maintained a valuation allowance with respect to California deferred tax assets, certain federal net operating losses, and certain foreign net operating losses that we believe are not likely to be realized. Due to gains from equity securities recognized in 2018, we released the valuation allowance against the deferred tax asset for the book-to-tax basis difference in our investments in Arris shares received from the sale of the Motorola Home business to Arris in 2013. We continue to reassess the remaining valuation allowance quarterly and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. For further information on the unrealized gains related to marketable equity securities recognized in other income (expenses), see Note 1. 79 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits from January 1, 2016 to December 31, 2018 (in millions): 2016 2017 2018 Beginning gross unrecognized tax benefits $ 4,167 $ 5,393 $ 4,696 Increases related to prior year tax positions 899 685 321 Decreases related to prior year tax positions (157 ) (257 ) (623 ) Decreases related to settlement with tax authorities (196 ) (1,875 ) (191 ) Increases related to current year tax positions 680 750 449 Ending gross unrecognized tax benefits $ 5,393 $ 4,696 $ 4,652 The total amount of gross unrecognized tax benefits was $5.4 billion , $4.7 billion , and $4.7 billion as of December 31, 2016 , 2017 , and 2018 , respectively, of which, $4.3 billion , $3.0 billion , and $2.9 billion , if recognized, would affect our effective tax rate, respectively. The decrease in gross unrecognized tax benefits in 2017 was primarily as a result of the resolution of a multi-year U.S. audit. As of December 31, 2017 and 2018 , we had accrued $362 million and $490 million in interest and penalties in provision for income taxes, respectively. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions, our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS is currently examining our 2013 through 2015 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. Our 2016 and 2017 tax years remain subject to examination by the IRS for U.S. federal tax purposes, and our 2011 through 2017 tax years remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the effect, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, and closure of audits is not certain, it is reasonably possible that certain U.S. federal and non-U.S. tax audits may be concluded within the next 12 months, which could significantly increase or decrease the balance of our gross unrecognized tax benefits. We estimate that our unrecognized tax benefits as of December 31, 2018 could possibly decrease by approximately $600 million in the next 12 months. Positions that may be resolved include various U.S. and non-U.S. matters. Note 14. Information about Segments and Geographic Areas We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed as Other Bets. Our reported segments are: • Google – Google includes our main products such as Ads, Android, Chrome, Google Cloud, Google Maps, Google Play, Hardware (including Nest), Search, and YouTube. Our technical infrastructure is also included in Google. Google generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes businesses such as Access, Calico, CapitalG, GV, Verily, Waymo, and X. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Access as well as licensing and R&D services through Verily. 80 Table of Contents Alphabet Inc. Revenues, cost of revenues, and operating expenses are generally directly attributed to our segments. Inter-segment revenues are not presented separately, as these amounts are immaterial. Our Chief Operating Decision Maker does not evaluate operating segments using asset information. In Q1 2018, Nest joined Google’s hardware team. Consequently, the financial results of Nest are reported in the Google segment, with Nest revenues reflected in Google other revenues. Prior period segment information has been recast to conform to the current period segment presentation. Consolidated financial results are not affected. Information about segments during the periods presented were as follows (in millions): Year Ended December 31, 2016 2017 2018 Revenues: Google $ 89,984 $ 110,378 $ 136,224 Other Bets 288 477 595 Total revenues $ 90,272 $ 110,855 $ 136,819 Year Ended December 31, 2016 2017 2018 Operating income (loss): Google $ 27,055 $ 32,287 $ 36,517 Other Bets (2,741 ) (2,734 ) (3,358 ) Reconciling items (1) (598 ) (3,407 ) (6,838 ) Total income from operations $ 23,716 $ 26,146 $ 26,321 (1) Reconciling items are primarily comprised of the European Commission fines for the years ended December 31, 2017 and 2018, and performance fees for the year ended December 31, 2018, as well as corporate administrative costs and other miscellaneous items that are not allocated to individual segments for all periods presented. Year Ended December 31, 2016 2017 2018 Capital expenditures: Google $ 9,437 $ 12,619 $ 25,460 Other Bets 1,365 493 181 Reconciling items (2) (590 ) 72 (502 ) Total capital expenditures as presented on the Consolidated Statements of Cash Flows $ 10,212 $ 13,184 $ 25,139 (2) Reconciling items are related to timing differences of payments as segment capital expenditures are on accrual basis while total capital expenditures shown on the Consolidated Statements of Cash Flow are on cash basis and other miscellaneous differences. 81 Table of Contents Alphabet Inc. Stock-based compensation (SBC) and depreciation, amortization, and impairment are included in segment operating income (loss) as shown below (in millions): Year Ended December 31, 2016 2017 2018 Stock-based compensation: Google $ 6,201 $ 7,168 $ 8,755 Other Bets 372 363 489 Reconciling items (3) 130 148 109 Total stock-based compensation (4) $ 6,703 $ 7,679 $ 9,353 Depreciation, amortization, and impairment: Google $ 5,882 $ 6,608 $ 8,708 Other Bets 258 307 327 Reconciling items (5) 4 — — Total depreciation, amortization, and impairment as presented on the Consolidated Statements of Cash Flows $ 6,144 $ 6,915 $ 9,035 (3) Reconciling items represent corporate administrative costs that are not allocated to individual segments. (4) For purposes of segment reporting, SBC represents awards that we expect to settle in Alphabet stock. (5) Reconciling items are primarily related to corporate administrative costs and other miscellaneous items that are not allocated to individual segments. The following table presents our long-lived assets by geographic area (in millions): As of December 31, 2017 As of December 31, 2018 Long-lived assets: United States $ 55,113 $ 74,882 International 17,874 22,234 Total long-lived assets $ 72,987 $ 97,116 For revenues by geography, see Note 2 . ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2018 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. 82 Table of Contents Alphabet Inc. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2018 . Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2018 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION None. 83 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for 2019 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2018 ( 2019 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2019 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2019 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the 2019 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2019 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2019 Proxy Statement and is incorporated herein by reference. 84 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 44 Financial Statements: Consolidated Balance Sheets 46 Consolidated Statements of Income 47 Consolidated Statements of Comprehensive Income 48 Consolidated Statements of Stockholders’ Equity 49 Consolidated Statements of Cash Flows 50 Notes to Consolidated Financial Statements 51 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for doubtful accounts and sales credits for the years ended December 31, 2016 , 2017 and 2018 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year Year ended December 31, 2016 $ 296 $ 942 $ (771 ) $ 467 Year ended December 31, 2017 $ 467 $ 1,131 $ (924 ) $ 674 Year ended December 31, 2018 $ 674 $ 1,115 $ (1,060 ) $ 729 Note: Additions to the allowance for doubtful accounts are charged to expense. Additions to the allowance for sales credits are charged against revenues. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 85 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.07 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.09 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.10 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.11 Form of the Registrant’s 3.625% Notes due 2021 (included in Exhibit 4.10) 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.10) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 10.01 Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.03 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.04 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.05.1 u Google Inc. 2004 Stock Plan - Form of Google Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.2 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.3 u Google Inc. 2004 Stock Plan - Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.06 u Alphabet Inc. 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 8, 2018 10.06.1 u Alphabet Inc. 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Quarterly Report on Form 10-Q (File No. 001-37580) November 3, 2016 10.07 u Motorola Mobility Holdings, Inc. 2011 Incentive Compensation Plan Registration Statement on Form S-8 (File No. 333-181661) May 24, 2012 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.08 u AdMob, Inc. 2006 Stock Plan and UK Sub-Plan of the AdMob, Inc. 2006 Stock Plan Registration Statement on Form S-8 (File No. 333-167411) June 9, 2010 10.09 u Apigee Corporation 2015 Equity Incentive Plan Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 10.09.1 u Apigee Corporation 2015 Equity Incentive Plan - Form of Restricted Stock Unit Agreement Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 14.01 Code of Conduct of the Registrant as amended on September 21, 2017 Annual Report on Form 10-K (File No. 001-37580) February 6, 2018 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.01 Google blog post dated July 18, 2018 Current Report on Form 8-K (File No. 001-37580) July 18, 2018 101.INS * XBRL Instance Document 101.SCH * XBRL Taxonomy Extension Schema Document 101.CAL * XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF * XBRL Taxonomy Extension Definition Linkbase Document 101.LAB * XBRL Taxonomy Extension Label Linkbase Document 101.PRE * XBRL Taxonomy Extension Presentation Linkbase Document _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. ITEM 16. FORM 10-K SUMMARY None. Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 4, 2019 ALPHABET INC. By: / S /    L ARRY P AGE Larry Page Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Larry Page and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. Table of Contents Alphabet Inc. Signature Title Date / S /    L ARRY P AGE Chief Executive Officer, Co-Founder, and Director (Principal Executive Officer) February 4, 2019 Larry Page / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 4, 2019 Ruth M. Porat / S /    A MIE T HUENER O' TOOLE Vice President and Chief Accounting Officer February 4, 2019 Amie Thuener O'Toole / S /    S ERGEY B RIN President, Co-Founder, and Director February 4, 2019 Sergey Brin / S /    J OHN L. H ENNESSY Director, Chair February 4, 2019 John L. Hennessy / S /    E RIC E. S CHMIDT Director February 4, 2019 Eric E. Schmidt / S /    L. J OHN D OERR Director February 4, 2019 L. John Doerr / S /    R OGER W. F ERGUSON, J R . Director February 4, 2019 Roger W. Ferguson, Jr. / S /    D IANE B. G REENE Director February 4, 2019 Diane B. Greene / S /    A NN M ATHER Director February 4, 2019 Ann Mather / S /    A LAN R . M ULALLY Director February 4, 2019 Alan R. Mulally / S / S UNDAR P ICHAI Director February 4, 2019 Sundar Pichai / S /    K. R AM S HRIRAM Director February 4, 2019 K. 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goog:class UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________________________ FORM 10-K ___________________________________________ (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2019 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View , CA 94043 (Address of principal executive offices, including zip code) ( 650 ) 253-000 (Registrant's telephone number, including) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol(s) Name of each exchange on which registered Class A Common Stock, $0.001 par value GOOGL Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value GOOG Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of June 28, 2019 , the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 28, 2019 ) was approximately $ 663.0 billion . For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 27, 2020 , there were 299,895,185 shares of the registrant’s Class A common stock outstanding, 46,411,073 shares of the registrant’s Class B common stock outstanding, and 340,979,832 shares of the registrant’s Class C capital stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2020 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2019 . Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2019 TABLE OF CONTENTS Page Note About Forward-Looking Statements 3 PART I Item 1. Business 5 Item 1A. Risk Factors 9 Item 1B. Unresolved Staff Comments 22 Item 2. Properties 22 Item 3. Legal Proceedings 22 Item 4. Mine Safety Disclosures 22 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 23 Item 6. Selected Financial Data 26 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 27 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 43 Item 8. Financial Statements and Supplementary Data 46 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 90 Item 9A. Controls and Procedures 90 Item 9B. Other Information 90 PART III Item 10. Directors, Executive Officers and Corporate Governance 91 Item 11. Executive Compensation 91 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 91 Item 13. Certain Relationships and Related Transactions, and Director Independence 91 Item 14. Principal Accountant Fees and Services 91 PART IV Item 15. Exhibits, Financial Statement Schedules 92 Item 16. Form 10-K Summary 95 Signatures 2 Table of Contents Alphabet Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding: • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • the potential for declines in our revenue growth rate and operating margin; • our expectation that the shift from an offline to online world will continue to benefit our business; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase and may affect our margins; • our expectation that our traffic acquisition costs (TAC) and the associated TAC rates will fluctuate, which could affect our overall margins; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins; • fluctuations in our revenue growth, as well as the change in paid clicks and cost-per-click on Google properties and the change in impressions and cost-per-impression on Google Network Members’ properties, and various factors contributing to such fluctuations; • our expectation that we will continue to periodically review, refine, and update our methodologies for monitoring, gathering, and counting the number of paid clicks on Google properties and impressions on Google Network Members’ properties; • our expectation that our results will be affected by our performance in international markets as users in developing economies increasingly come online; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of gains and losses related to hedging activities under our foreign exchange risk management program; • the amount and timing of revenue recognition for commitments in customer contracts with performance obligations, which could impact our estimate of the remaining amount of commitments and when we expect to recognize revenue; • fluctuations in our capital expenditures; • our plans to continue to invest in new businesses, products, services and technologies, systems, land and buildings for data centers and offices, and infrastructure, to continue to hire aggressively and provide competitive compensation programs, as well as to continue to invest in acquisitions; • our expectation that our cost of revenues, research and development (R&D) expenses, sales and marketing expenses, and general and administrative expenses will increase in amount and may increase as a percentage of revenues may be affected by a number of factors; • estimates of our future compensation expenses; • our expectation that our other income (expense), net (OI&E), will fluctuate in the future, as it is largely driven by market dynamics; • fluctuations in our effective tax rate; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality and macroeconomic conditions, which are likely to cause fluctuations in our quarterly results; • the sufficiency of our sources of funding; • our potential exposure in connection with pending investigations, proceedings, and other contingencies; • the sufficiency and timing of our proposed remedies in response to the European Commission's (EC) and others' decisions; • our expectations regarding the timing, design and implementation of our new global enterprise resource planning (ERP) system; 3 Table of Contents Alphabet Inc. • the expected timing and amount of Alphabet Inc.'s share repurchases; • our long-term sustainability goals; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report and other documents we file with the Securities and Exchange Commission (SEC), including without limitation, the following sections: Item 1 "Business," Item 1A "Risk Factors," and Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "may," "could," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed in Item 1A, "Risk Factors" of this report and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. 4 Table of Contents Alphabet Inc. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history — inspiring us to do things like tackling deep computer science problems, such as our investments in artificial intelligence (AI) and quantum computing. Alphabet is a collection of businesses — the largest of which is Google. We report all non-Google businesses collectively as Other Bets. Our Other Bets include earlier stage technologies that are further afield from our core Google business. We take a long term view and manage the portfolio of Other Bets with the discipline and rigor needed to deliver long-term returns. Each of our businesses are designed to prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers, capable of propelling new ideas and people forward. Today, our mission to organize the world’s information and make it universally accessible and useful is as relevant as it was when we were founded in 1998. Since then, we’ve evolved from a company that helps people find answers to a company that helps you get things done. We’re focused on building an even more helpful Google for everyone. We aspire to give everyone the tools they need to increase their knowledge, health, happiness, and success. Across Google, we're focused on continually innovating in areas where technology can have an impact on people’s lives. Our work in AI is helping to produce earlier and more precise flood warnings. We’re also working hard to make sure that our products are accessible to the more than one billion individuals around the world with a disability. For example, Android 10 has automatic Live Captions for videos, podcasts and voicemails to make it easier to consume information on the phone. Our Other Bets are also pursuing initiatives with similar goals. For instance, as a part of our efforts in the Metro Phoenix area, Waymo is working toward our goal of making transportation safer and easier for everyone while Verily is developing tools and platforms to improve health outcomes. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and continue to invest for the long-term. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. The power of machine learning Across the company, machine learning and AI are increasingly driving many of our latest innovations. Within Google, our investments in machine learning over a decade have enabled us to build products that are smarter and more helpful. For example, our investments in AI are enabling doctors to detect cancer earlier. Machine learning powers the Google Assistant and many of our newer technologies. Google Serving our users We have always been a company committed to building products that have the potential to improve the lives of millions of people. Our product innovations have made our services widely used, and our brand one of the most recognized in the world. Google's core products and platforms, such as Android, Chrome, Gmail, Google Drive, Google Maps, Google Play, Search, and YouTube each have over one billion monthly active users. As the majority of Alphabet’s big bets continue to reside within Google, an important benefit of the shift to Alphabet has been the tremendous focus that we’re able to have on Google’s many extraordinary opportunities. Our products have come a long way since the company was founded more than two decades ago. Instead of just showing ten blue links in our search results, we are increasingly able to provide direct answers — even if you're speaking your question using Voice Search — which makes it quicker, easier and more natural to find what you're looking for. With Google Lens, you can use your phone’s camera to identify an unfamiliar landmark or find a trailer 5 Table of Contents Alphabet Inc. from a movie poster. Over time, we have also added other services that let you access information quickly and easily — like Google Maps, which helps you navigate to a store while showing you current traffic conditions, or Google Photos, which helps you store and organize your photos. This drive to make information more accessible and helpful has led us over the years to improve the discovery and creation of digital content, on the web and through platforms like Google Play and YouTube. And with the migration to mobile, people are consuming more digital content by watching more videos, playing more games, listening to more music, reading more books, and using more apps than ever before. Working with content creators and partners, we continue to build new ways for people around the world to find great digital content. Fueling all of these great digital experiences are powerful platforms and hardware. That’s why we continue to invest in platforms like our Android mobile operating system, Chrome browser, Chrome operating system, and Daydream virtual reality platform, as well as growing our family of great hardware devices. We see tremendous potential for devices to be helpful, make your life easier, and get better over time, by combining the best of Google's AI, software, and hardware. This is reflected in our latest generation of hardware products like Pixel 4 phones and the Google Nest Hub smart display. Creating beautiful products that people rely on every day is a journey that we are investing in for the long run. Key to building helpful products for users is our commitment to keeping their data safe online. As the Internet evolves, we continue to invest in our industry-leading security technologies and privacy tools, such as the addition of auto-delete controls to enable users to automatically delete activity after 3 or 18 months and incognito mode in YouTube and Maps. Google was a company built in the cloud. We continue to invest in infrastructure, security, data management, analytics and AI. We see significant opportunity in helping businesses enhance these strengths with features like data migration, modern development environments and machine learning tools to provide enterprise-ready cloud services, including Google Cloud Platform and G Suite. Google Cloud Platform enables developers to build, test, and deploy applications on Google’s highly scalable and reliable infrastructure. Our G Suite productivity tools — which include apps like Gmail, Docs, Drive, Calendar, and more — are designed with real-time collaboration and machine intelligence to help people work smarter. Because more and more of today’s great digital experiences are being built in the cloud, our Google Cloud products help businesses of all sizes take advantage of the latest technology advances to operate more efficiently. How we make money The goal of our advertising products is to deliver relevant ads at just the right time and to give people useful commercial information, regardless of the device they’re using. We also provide advertisers with tools that help them better attribute and measure their advertising campaigns. Our advertising solutions help millions of companies grow their businesses, and we offer a wide range of products across devices and formats. We generate revenues primarily by delivering both performance advertising and brand advertising. • Performance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Most of our performance advertisers pay us when a user engages in their ads. Performance advertising lets our advertisers connect with users while driving measurable results. Our ads tools allow performance advertisers to create simple text-based ads that appear on Google properties and the properties of Google Network Members. In addition, Google Network Members use our platforms to display relevant ads on their properties, generating revenues when site visitors view or click on the ads. We continue to invest in our advertising programs and make significant upgrades. • Brand advertising helps enhance users' awareness of and affinity with advertisers' products and services, through videos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. We have built a world-class ad technology platform for advertisers, agencies, and publishers to power their digital marketing businesses. We aim to ensure great user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. We also seek to improve the measurability of advertising so advertisers know when their campaigns are effective. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, ranging from filtering out invalid traffic, removing billions of bad ads from our systems every year to closely monitoring the sites, apps, and videos where ads appear and blacklisting them when necessary to ensure that ads do not fund bad content. 6 Table of Contents Alphabet Inc. We continue to look to the future and are making long-term investments that will grow revenues beyond advertising, including Google Cloud, Google Play, hardware, and YouTube. We are also investing in research efforts in AI and quantum computing to foster innovation across our businesses and create new opportunities . Other Bets Throughout Alphabet, we are also using technology to try and solve big problems across many industries. Alphabet’s investment in our portfolio of Other Bets include emerging businesses at various stages of development, ranging from those in the research and development phase to those that are in the beginning stages of commercialization, and our goal is for them to become thriving, successful businesses in the medium to long term. While these early-stage businesses naturally come with considerable uncertainty, some of them are already generating revenue and making important strides in their industries. Revenues are primarily generated from internet and TV services, as well as licensing and R&D services. Other Bets operate as independent companies and some of them have their own boards with independent members and outside investors. We are investing in our portfolio of Other Bets and being very deliberate about the focus, scale, and pace of investments. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from: • General purpose search engines and information services, such as Baidu, Microsoft's Bing, Naver, Seznam, Verizon's Yahoo, and Yandex. • Vertical search engines and e-commerce websites, such as Amazon and eBay (e-commerce), Booking's Kayak (travel queries), Microsoft's LinkedIn (job queries), and WebMD (health queries). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks, such as Facebook, Snapchat, and Twitter. Some users increasingly rely on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other forms of advertising, such as billboards, magazines, newspapers, radio, and television. Our advertisers typically advertise in multiple media, both online and offline. • Other online advertising platforms and networks, including Amazon, AppNexus, Criteo, and Facebook, that compete for advertisers that use Google Ads, our primary auction-based advertising platform. • Providers of digital video services, such as Amazon, Apple, AT&T, Disney, Facebook, Hulu, Netflix and TikTok. In businesses that are further afield from our advertising business, we compete with companies that have longer operating histories and more established relationships with customers and users. We face competition from: • Other digital content and application platform providers, such as Amazon and Apple. • Companies that design, manufacture, and market consumer hardware products, including businesses that have developed proprietary platforms. • Providers of enterprise cloud services, including Alibaba, Amazon, and Microsoft. • Digital assistant providers, such as Amazon and Apple. Competing successfully depends heavily on our ability to deliver and distribute innovative products and technologies to the marketplace across our businesses. Specifically, for advertising, competing successfully depends on attracting and retaining: • Users, for whom other products and services are literally one click away, largely on the basis of the relevance of our advertising, as well as the general usefulness, security and availability of our products and services. • Advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels. • Content providers, primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. Intellectual Property 7 Table of Contents Alphabet Inc. We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. Culture and Employees We take great pride in our culture. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex technical challenges. Transparency and open dialogue are central to how we work, and we aim to ensure that company news reaches our employees first through internal channels. Despite our rapid growth, we still cherish our roots as a startup and wherever possible empower employees to act on great ideas regardless of their role or function within the company. We strive to hire great employees, with backgrounds and perspectives as diverse as those of our global users. We work to provide an environment where these talented people can have fulfilling careers addressing some of the biggest challenges in technology and society. Our employees are among our best assets and are critical for our continued success. We expect to continue investing in hiring talented employees and to provide competitive compensation programs to our employees. As of December 31, 2019 , we had 118,899 full-time employees. Although we have work councils and statutory employee representation obligations in certain countries, our U.S. employees are not represented by a labor union. Competition for qualified personnel in our industry is intense, particularly for software engineers, computer scientists, and other technical staff. Ongoing Commitment to Sustainability We strive to build sustainability into everything we do from designing and operating efficient data centers, advancing carbon-free energy, creating sustainable workplaces, building better devices and services, empowering users with technology, and enabling a responsible supply chain. Google has been carbon neutral since 2007 and we are the largest corporate purchaser of renewable energy in the world. In 2018, for the second consecutive year, we matched 100% of our electricity consumption with renewable energy purchases, as reported in our 2019 Environmental Report. Some other 2019 highlights and achievements include: • We made our largest corporate purchase of renewable energy: 18 new energy deals totaling 1,600 megawatts, which is anticipated to spur the construction of more than $2 billion in new energy infrastructure. • 100% of Nest products launched in 2019 include recycled plastic content and we launched carbon neutral shipping for Google’s direct customers who buy a product on Google Shopping or purchase Made by Google hardware. • The Environmental Insights Explorer is enabling municipalities — which represent more than 70% of global greenhouse gas emissions according to the 2016 United Nations Habitat World Cities Report — to estimate emissions and develop climate action plans. In 2019, we expanded this tool to more than 100 cities worldwide. We believe that climate change is one of the most significant global challenges of our time. In 2017, we developed a climate resilience strategy, which included conducting a climate scenario analysis. We have been on CDP’s (formerly the Carbon Disclosure Project) Climate Change A list for five consecutive years. We believe our CDP report reflects the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). More information on Google's approach to sustainability can be found in our annual sustainability reports. The content of our sustainability reports are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. Seasonality Our business is affected by seasonal fluctuations in internet usage, advertising expenditures, and underlying business trends such as traditional retail seasonality. Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and our Proxy Statements, and any amendments to these reports, are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. 8 Table of Contents Alphabet Inc. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance and other items of interest to our investors, including SEC filings, investor events, press and earnings releases, and blogs. We also share Google news and product updates on Google's Keyword blog at https://www.blog.google/, which may be of interest or material to our investors. Further, corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The content of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could harm our business, reputation, financial condition, and operating results. Risks Specific to our Company We generate a significant portion of our revenues from advertising, and reduced spending by advertisers, a loss of partners, or new and existing technologies that block ads online and/or affect our ability to customize ads could harm our business. We generated over 83% of total revenues from the display of ads online in 2019. Many of our advertisers, companies that distribute our products and services, digital publishers, and content providers can terminate their contracts with us at any time. These partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. Changes to our advertising policies and data privacy practices, as well as changes to other companies’ advertising policies or practices may affect the advertising that we are able to provide, which could harm our business. In addition, technologies have been developed that make customized ads more difficult or that block the display of ads altogether and some providers of online services have integrated technologies that could potentially impair the availability and functionality of third-party digital advertising. Failing to provide superior value or deliver advertisements effectively and competitively could harm our reputation, financial condition, and operating results. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions can also have a material negative effect on the demand for advertising and cause our advertisers to reduce the amounts they spend on advertising, which could harm our financial condition and operating results. We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, which could harm our business and operating results. Our business environment is rapidly evolving and intensely competitive. Our businesses face changing technologies, shifting user needs, and frequent introductions of rival products and services. To compete successfully, we must accurately anticipate technology developments and deliver innovative, relevant and useful products, services, and technologies in a timely manner. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services. We must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our technology and new and existing products and services. We have many competitors in different industries. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some competitors have longer operating histories in various sectors. They can use their experience and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in research and development and in talent, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for users, advertisers, customers, and content providers. Our competitors may be able to innovate and provide products and services faster than we can or may foresee the need for products and services before us. For example, we are investing significantly in subscription-based products and services such as YouTube, which face intense competition from large experienced companies with well established relationships with users. Our operating results may also suffer if our products and services are not responsive to the needs of our users, advertisers, publishers, customers, and content providers. As technologies continue to develop, our competitors may be able to offer experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors 9 Table of Contents Alphabet Inc. are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, publishers, customers, and content providers, our operating results could be harmed. Our ongoing investment in new businesses, products, services, and technologies is inherently risky, and could disrupt our current operations and harm our financial condition and operating results. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The investments that we are making across Google and Other Bets reflect our ongoing efforts to innovate and provide products and services that are useful to users, advertisers, publishers, customers, and content providers. Our investments in Google and Other Bets span a wide range of industries beyond online advertising. Such investments ultimately may not be commercially viable or may not result in an adequate return of capital and, in pursuing new strategies, we may incur unanticipated liabilities. These endeavors may involve significant risks and uncertainties, including diversion of management resources and, with respect to Other Bets, the use of alternative investment, governance, or compensation structures that may fail to adequately align incentives across the company or otherwise accomplish their objectives. Within Google, we continue to invest heavily in hardware, including our smartphones and home devices, which is a highly competitive market with frequent introduction of new products and services, rapid adoption of technological advancements by competitors, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, and price and feature sensitivity on the part of consumers and businesses. There can be no assurance we will be able to provide hardware that competes effectively. We are also devoting significant resources to develop and deploy our enterprise-ready cloud services, including Google Cloud Platform and G Suite. We are incurring costs to build and maintain infrastructure to support cloud computing services and hire talent, particularly to support and scale the Cloud salesforce. At the same time, our competitors are rapidly developing and deploying cloud-based services. Pricing and delivery models are competitive and evolving, and we may not attain sufficient scale and profitability to achieve our business objectives. Within Other Bets, we are investing significantly in the areas of health, life sciences, and transportation, among others. These investment areas face intense competition from large experienced and well-funded competitors and our offerings may not be able to compete effectively or to operate at sufficient levels of profitability. In addition, new and evolving products and services, including those that use artificial intelligence and machine learning, raise ethical, technological, legal, regulatory, and other challenges, which may negatively affect our brands and demand for our products and services. Because all of these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not harm our reputation, financial condition , and operating results. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including increasing competition and the continued expansion of our business into a variety of new fields. Changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix and an increasing competition for advertising may also affect our advertising revenue growth rate. We may also experience a decline in our revenue growth rate as our revenues increase to higher levels, if there is a decrease in the rate of adoption of our products, services, and technologies, or due to deceleration or decline in demand for devices used to access our services, among other factors. In addition to a decline in our revenue growth rate, we may also experience downward pressure on our operating margin resulting from a variety of factors, such as the continued expansion of our business into new fields, including products and services such as hardware, Google Cloud, Google Play, gaming, and subscription products, as well as significant investments in Other Bets, all of which may have margins lower than those we generate from advertising. We may also experience downward pressure on our operating margins from increasing competition and increased costs for many aspects of our business, including within advertising where changes such as device mix, property mix, and partner agreements can affect margin. The margin we earn on revenues generated from our Google Network Members could also decrease in the future if we pay a larger percentage of advertising fees to them. We may also pay increased TAC to our distribution partners as well as increased content acquisition costs to content providers. We may also face an increase in infrastructure costs, supporting businesses such as Search, Google Cloud, and YouTube. Additionally, our spend to promote new products and services or distribute certain products and services or increased investment in our innovation efforts across Google and our Other Bets businesses may affect our operating margins. Due to these factors and the evolving nature of our business, our historical revenue growth rate and historical operating margin may not be indicative of our future performance. 10 Table of Contents Alphabet Inc. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brand as well as affect our ability to compete. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services, and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy of such trade secrets and other sensitive information could be compromised, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” Some courts have ruled that "Google" is a protectable trademark, but it is possible that other courts, particularly those outside of the United States, may reach a different determination. If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, customers, content providers, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands within Google and Other Bets increases our ability to enter new categories and launch new and innovative products that better serve the needs of our users, advertisers, customers, content providers, and other partners. Our brands may be negatively affected by a number of factors, including, among others, reputational issues, third-party content shared on our platforms, data privacy and security issues and developments, and product or technical performance failures. For example, if we fail to appropriately respond to the sharing of misinformation or objectionable content on our services or objectionable practices by advertisers, or to otherwise adequately address user concerns, our users may lose confidence in our brands. Our brands may also be negatively affected by the use of our products or services to disseminate information that is deemed to be false or misleading. Furthermore, failure to maintain and enhance equity in our brands may harm our business, financial condition, and operating results. Our success will depend largely on our ability to remain a technology leader and continue to provide high-quality, innovative products and services that are truly useful and play a valuable role in a range of settings. We face a number of manufacturing and supply chain risks that, if not properly managed, could harm our financial condition, operating results, and prospects. We face a number of risks related to manufacturing and supply chain management, which could affect our ability to supply both our products and our internet-based services. We rely on other companies to manufacture many of our assemblies and finished products, to design certain of our components and parts, and to participate in the distribution of our products and services. Our business could be negatively affected if we are not able to engage these companies with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We may experience supply shortages and price increases driven by raw material availability, manufacturing capacity, labor shortages, industry allocations, tariffs, trade disputes and barriers, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), and significant changes in the financial or business condition of our suppliers. We may experience shortages or other supply chain disruptions that could negatively affect our operations. In addition, some of the components we use in our technical infrastructure and products are available only from a single source or limited sources, and we may not be able to find replacement vendors on favorable terms in the event of a supply chain disruption. In addition, a significant hardware supply interruption could delay critical data center upgrades or expansions. 11 Table of Contents Alphabet Inc. We may enter into long term contracts for materials and products that commit us to significant terms and conditions. We may be liable for materials and products that are not consumed due to market acceptance, technological change, obsolescences, quality, product recalls, and warranty issues. For instance, because many of our hardware supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and negatively affect our financial results. Furthermore, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may affect our supply. Our products and services may have quality issues resulting from design, manufacturing, or operations. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products and services does not meet expectations or our products or services are defective, it could harm our reputation, financial condition, and operating results. We require our suppliers and business partners to comply with laws and, where applicable, our company policies, such as the Google Supplier Code of Conduct, regarding workplace and employment practices, data security, environmental compliance and intellectual property licensing, but we do not control them or their practices. Violations of law or unethical business practices could result in supply chain disruptions, canceled orders, harm to key relationships, and damage to our reputation. Their failure to procure necessary license rights to intellectual property, could affect our ability to sell our products or services and expose us to litigation or financial claims. Interruption, interference with, or failure of our information technology and communications systems could hurt our ability to effectively provide our products and services, which could harm our reputation, financial condition, and operating results. In addition, complications with the design or implementation of our new global enterprise resource planning (ERP) system could harm our business and operations. The availability of our products and services and fulfillment of our customer contracts depend on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference, or interruption from terrorist attacks, natural disasters, the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, ransomware attacks, computer denial of service attacks, phishing schemes, or other attempts to harm or access our systems. Some of our data centers are located in areas with a high risk of major earthquakes or other natural disasters. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and, in some cases, to potential disruptions resulting from problems experienced by facility operators. Some of our systems are not fully redundant, and disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster, closure of a facility, or other unanticipated problems at our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and may contain errors or vulnerabilities, which could result in interruptions in or failure of our services or systems. In addition, we rely extensively on information systems and technology to manage our business and summarize operating results. We are in the process of a multi-year implementation of a new ERP system, which will replace much of our existing core financial systems. The ERP system is designed to accurately maintain our financial records, enhance the flow of financial information, improve data management, and provide timely information to our management team. We may not be able to successfully implement the ERP system without experiencing delays, increased costs, and other difficulties. Failure to successfully design and implement the new ERP system as planned could harm our business, financial condition, and operating results. Additionally, if we do not effectively implement the ERP system as planned or the ERP system does not operate as intended, the effectiveness of our internal control over financial reporting could be negatively affected. Our international operations expose us to additional risks that could harm our business, our financial condition, and operating results. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 54% of our consolidated revenues in 2019. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • Restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S. 12 Table of Contents Alphabet Inc. • Import and export requirements, tariffs, trade disputes and barriers, and customs classifications that may prevent us from offering products or providing services to a particular market, or that could limit our ability to source assemblies and finished products from a particular market, and may increase our operating costs. • Longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud. • Evolving foreign events, including Brexit, the United Kingdom's withdrawal from the European Union (EU). Brexit may adversely affect our revenues and could subject us to new regulatory costs and challenges (including the transfer of personal data between the EU and the United Kingdom), in addition to other adverse effects that we are unable to effectively anticipate. • Anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting certain payments to government officials, violations of which could result in civil and criminal penalties. • Uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent. • Different employee/employer relationships, existence of works councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Because we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we face exposure to fluctuations in foreign currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Hedging programs are also inherently risky and could expose us to additional risks that could harm our financial condition and operating results. Risks Related to our Industry People access the Internet through a variety of platforms and devices that continue to evolve with the advancement of technology and user preferences. If manufacturers and users do not widely adopt versions of our products and services developed for these new interfaces, our business could be harmed. People access the Internet through a growing variety of devices such as desktop computers, mobile phones, smartphones, laptops and tablets, video game consoles, voice-activated speakers, wearables, automobiles, and television-streaming devices. Our products and services may be less popular on these new interfaces. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not be available on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via voice-activated speakers, apps, social media or other platforms, which could harm our business. It is hard to predict the challenges we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to creating and supporting products and services across multiple platforms and devices. Failing to attract and retain a substantial number of new device manufacturers, suppliers, distributors, developers, and users, or failing to develop products and technologies that work well on new devices and platforms, could harm our business, financial condition, and operating results and ability to capture future business opportunities. Data privacy and security concerns relating to our technology and our practices could damage our reputation, cause us to incur significant liability, and deter current and potential users or customers from using our products and services. Software bugs or defects, security breaches, and attacks on our systems could result in the improper disclosure and use of user data and interference with our users and customers’ ability to use our products and services, harming our business operations and reputation. Concerns about our practices with regard to the collection, use, disclosure, or security of personal information or other data-privacy-related matters, even if unfounded, could harm our reputation, financial condition, and operating results. Our policies and practices may change over time as expectations regarding privacy and data change. Our products and services involve the storage and transmission of proprietary information, and bugs, theft, misuse, defects, vulnerabilities in our products and services, and security breaches expose us to a risk of loss of this information, improper use and disclosure of such information, litigation, and other potential liability. Systems and control failures, security breaches, failure to comply with our privacy policies, and/or inadvertent disclosure of user data could result in government and legal exposure, seriously harm our reputation and brand and, therefore, our business, and impair our ability to attract and retain users or customers. We expect to continue to expend significant resources to maintain security protections that shield against bugs, theft, misuse, or security vulnerabilities or breaches. We experience cyber attacks and other attempts to gain unauthorized access to our systems on a regular basis. We may experience future security issues, whether due to employee error or malfeasance or system errors or 13 Table of Contents Alphabet Inc. vulnerabilities in our or other parties’ systems, which could result in significant legal and financial exposure. Government inquiries and enforcement actions, litigation, and adverse press coverage could harm our business. We may be unable to anticipate or detect attacks or vulnerabilities or implement adequate preventative measures. Attacks and security issues could also compromise trade secrets and other sensitive information, harming our business. While we have dedicated significant resources to privacy and security incident response capabilities, including dedicated worldwide incident response teams, our response process may not be adequate, may fail to accurately assess the severity of an incident, may not respond quickly enough, or may fail to sufficiently remediate an incident. As a result, we may suffer significant legal, reputational, or financial exposure, which could harm our business, financial condition, and operating results. Our ongoing investments in safety, security, and content review will likely continue to identify abuse of our platforms and misuse of user data. In addition to our efforts to mitigate cyber attacks, we are making significant investments in safety, security, and content review efforts to combat misuse of our services and unauthorized access to user data by third parties, including investigations and review of platform applications that could access the information of users of our services. As a result of these efforts, we could discover incidents of unnecessary access to or misuse of user data or other undesirable activity by third parties. We may not discover all such incidents or activity, whether as a result of our data limitations, including our lack of visibility over our encrypted services, the scale of activity on our platform, or other factors, and we may be notified of such incidents or activity via third parties. Such incidents and activities may include the use of user data or our systems in a manner inconsistent with our terms, contracts or policies, the existence of false or undesirable user accounts, election interference, improper ad purchases, activities that threaten people’s safety on- or offline, or instances of spamming, scraping, or spreading disinformation. We may also be unsuccessful in our efforts to enforce our policies or otherwise remediate any such incidents. Any of the foregoing developments may negatively affect user trust and engagement, harm our reputation and brands, require us to change our business practices in a manner adverse to our business, and adversely affect our business and financial results. Any such developments may also subject us to additional litigation and regulatory inquiries, which could result in monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight. Problematic content, including low-quality user-generated content, web spam, content farms, and other violations of our guidelines could affect the quality of our services, which could damage our reputation and deter our current and potential users from using our products and services. We, like others in the industry, face violations of our content guidelines, including sophisticated attempts by bad actors to manipulate our hosting and advertising systems to fraudulently generate revenues, or to otherwise generate traffic that does not represent genuine user interest or intent. While we invest significantly in efforts to promote high-quality and relevant results and to detect and prevent low-quality content and invalid traffic, we may be unable to adequately detect and prevent such abuses. Many websites violate or attempt to violate our guidelines, including by seeking to inappropriately rank higher in search results than our search engine's assessment of their relevance and utility would rank them. Such efforts (known as “web spam”) may affect the quality of content on our platforms and lead them to display false, misleading or undesirable content. Although English-language web spam in our search results has been reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek inappropriate ways to improve their rankings. We continuously combat web spam in our search results, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We also continue to invest in and deploy proprietary technology to detect and prevent web spam from abusing our platforms. We also face other challenges from low-quality and irrelevant content websites, including content farms, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes focused on low-quality websites. If we fail to detect and prevent an increase in problematic content, it could hurt our reputation for delivering relevant information or reduce use of our platforms, harming our financial condition or operating results. It may also subject us to litigation and regulatory inquiries, which could result in monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight. 14 Table of Contents Alphabet Inc. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, or by charging increased fees to us or our users to provide our offerings. Some jurisdictions have adopted regulations prohibiting certain forms of discrimination by internet access providers; however, substantial uncertainty exists in the United States and elsewhere regarding such protections. For example, in 2018 the United States Federal Communications Commission repealed net neutrality rules, which could lead internet access providers to restrict, block, degrade, or charge for access to certain of our products and services. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. Such interference could result in a loss of existing users, customers and advertisers, goodwill, and increased costs, and could impair our ability to attract new users, customers and advertisers, thereby harming our business. Risks Related to Laws and Regulations We are subject to increasing regulatory scrutiny as well as changes in public policies governing a wide range of topics that may negatively affect our business. We and other companies in the technology industry are experiencing increased regulatory scrutiny. For instance, various regulatory agencies, including competition, consumer protection, and privacy authorities, are reviewing aspects of our products and services. We continue to cooperate with these investigations. Prior, existing, and new investigations have in the past and may in the future result in substantial fines and penalties, changes to our products and services, alterations to our business operations, and civil litigation, all of which could harm our business, reputation, financial condition, and operating results. Changes in international and local social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics may increase our cost of doing business, limit our ability to pursue certain business models or offer certain products or services, and cause us to change our business practices. Further, our investment in a variety of new fields, including the health industry and payment services, also raises a number of new regulatory issues. These factors could harm our business and operating results in material ways. A variety of new and existing laws and/or interpretations could harm our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations or applications of existing laws and regulations in a manner inconsistent with our practices) may make our products and services less useful, limit our ability to pursue certain business models or offer certain products and services, require us to incur substantial costs, expose us to unanticipated civil or criminal liability, or cause us to change our business practices. These laws and regulations are evolving and involve matters central to our business, including, among others: • Competition laws and regulations around the world. • Privacy laws, such as the California Consumer Privacy Act of 2018 that came into effect in January of 2020, which gives new data privacy rights to California residents, and SB-327 in California, which regulates the security of data in connection with internet connected devices. • Data protection laws passed by many states within the U.S. and by certain countries regarding notification to data subjects and/or regulators when there is a security breach of personal data. • Copyright laws, such as the EU Directive on Copyright in the Digital Single Market (EUCD) of April 17, 2019, which increases the liability of content-sharing services with respect to content uploaded by their users. It has also created a new property right in news publications that will limit the ability of some online services to interact with or present such content. Each EU Member State must implement the EUCD by June 7, 2021. In addition, there are new constraining licensing regimes that limit our ability to operate with respect to copyright protected works. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. 15 Table of Contents Alphabet Inc. • Various U.S. and international laws that govern the distribution of certain materials to children and regulate the ability of online services to collect information from minors. • Various laws with regard to content removal and disclosure obligations, such as the Network Enforcement Act in Germany, which may affect our businesses and operations and may subject us to significant fines if such laws are interpreted and applied in a manner inconsistent with our practices or when we may not proactively discover such content due to the scale of third-party content and the limitations of existing technologies. Other countries, including Singapore, Australia, and the United Kingdom, have implemented or are considering similar legislation imposing penalties for failure to remove certain types of content. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain and could harm our business. For example: • We rely on statutory safe harbors, as set forth in the Digital Millennium Copyright Act in the United States and the E-Commerce Directive in Europe, against copyright liability for various linking, caching, and hosting activities. Any legislation or court rulings affecting these safe harbors may adversely affect us. • Court decisions such as the judgment of the Court of Justice of the European Union (CJEU) on May 13, 2014 on the ‘right to be forgotten,’ which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users and impose significant operational burdens. • Court decisions that require Google to remove links not just in the jurisdiction of the issuing court, but for all versions of the search engine worldwide, including in locations where the content at issue is lawful, may limit the content we can show to our users and impose significant operational burdens. The Supreme Court of Canada issued such a decision against Google in June 2017, and others could treat its decision as persuasive. With respect to the ‘right to be forgotten,’ a follow-up case of the CJEU on September 24, 2019 ruled that a search engine operator is not required to remove links from all versions of the search engine worldwide, but the court also noted in some cases, removal of links from all versions of the search engine available from the EU (including non-EU specific versions) may be required. The introduction of new businesses, products, services, and technologies, our activities in certain jurisdictions, or other actions we take may subject us to additional laws and regulations. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Any failure on our part to comply with laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are subject to claims, suits, government investigations, and other proceedings that may harm our business, financial condition, and operating results. We are subject to claims, suits, and government investigations involving competition, intellectual property, data privacy and security, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Due to our manufacturing and sale of an expanded suite of products, including hardware as well as Google Cloud offerings, we may also be subject to a variety of claims including product warranty, product liability, and consumer protection claims related to product defects, among other litigation. We may also be subject to claims involving health and safety, hazardous materials usage, other environmental impacts, or service disruptions or failures. Any of these types of legal proceedings can have an adverse effect on us because of legal costs, diversion of management resources, negative publicity and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. The resolution of one or more such proceedings has resulted in, and may in the future result in, additional substantial fines, penalties, injunctions, and other sanctions that could harm our business, financial condition, and operating results. We may be subject to legal liability associated with providing online services or content. Our products and services let users exchange information, advertise products and services, conduct business, and engage in various online activities. We also place advertisements displayed on other companies’ websites, and we offer third-party products, services, and/or content. The law relating to the liability of online service providers for others’ activities on their services is still somewhat unsettled both within the U.S. and internationally. Claims have been brought against us for defamation, negligence, breaches of contract, copyright and trademark infringement, unfair competition, unlawful activity, torts, fraud, or other legal theories based on the nature and content of information available on or via our services. 16 Table of Contents Alphabet Inc. We may be subject to claims by virtue of our involvement in hosting, transmitting, marketing, branding, or providing access to content created by third parties. Defense of any such actions could be costly and involve significant time and attention of our management and other resources, may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Privacy and data protection regulations are complex and rapidly evolving areas. Adverse interpretations of these laws could harm our business, reputation, financial condition, and operating results. Authorities around the world have adopted and are considering a number of legislative and regulatory proposals concerning data protection and limits on encryption of user data. Adverse legal rulings, legislation, or regulation could result in fines and orders requiring that we change our data practices, which could have an adverse effect on our ability to provide services, harming our business operations. Complying with these evolving laws could result in substantial costs and harm the quality of our products and services, negatively affecting our business. Recent legal developments in Europe have created compliance uncertainty regarding transfers of personal data from Europe to the United States. For example, the General Data Protection Regulation (GDPR) applies to all of our activities conducted from an establishment in the EU or related to products and services that we offer to EU users or customers, or the monitoring of their behavior in the EU. The GDPR creates a range of new compliance obligations. Ensuring compliance with the GDPR is an ongoing commitment that involves substantial costs, and despite our efforts, governmental authorities or others have asserted and may continue to assert that our business practices fail to comply with its requirements. If our operations are found to violate GDPR requirements, we may incur substantial fines, have to change our business practices, and face reputational harm, any of which could have a material adverse effect on our business. In particular, serious breaches of the GDPR can result in administrative fines of up to 4% of annual worldwide revenues. Fines of up to 2% of annual worldwide revenues can be levied for other specified violations. The EU-U.S. and the Swiss-U.S. Privacy Shield frameworks allow U.S. companies that self-certify to the U.S. Department of Commerce and publicly commit to comply with specified requirements to import personal data from the EU and Switzerland. However, these frameworks face a number of legal challenges and their validity remains subject to legal, regulatory, and political developments in both Europe and the U.S. The potential invalidation of data transfer mechanisms could have a significant adverse impact on our ability to process and transfer personal data outside of the EEA. These developments create some uncertainty, and compliance obligations could cause us to incur costs or harm the operations of our products and services in ways that harm our business. We face, and may continue to face intellectual property and other claims that could be costly to defend, result in significant damage awards or other costs (including indemnification awards), and limit our ability to use certain technologies in the future. We, like other internet, technology and media companies, hold large numbers of patents, copyrights, trademarks, and trade secrets and are frequently subject to litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent-holding companies may frequently seek to generate income from patents they have obtained by bringing claims against us. As we have grown, the number of intellectual property claims against us has increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Other parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease-and-desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services. They may also cause us to change our business practices and require development of non-infringing products, services, or technologies, which could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to defend against certain intellectual property infringement claims and in some cases indemnify them for certain intellectual property infringement claims against them, which could result in increased costs for defending such claims or significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers arising from intellectual property 17 Table of Contents Alphabet Inc. infringement claims. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, including those associated with intellectual property claims. Regardless of their merits, intellectual property claims are often time consuming and expensive to litigate or settle. To the extent such claims are successful, they may harm our business, including our product and service offerings, financial condition, or operating results. Risks Related to Ownership of our Stock We cannot guarantee that any share repurchase program will be fully consummated or that any share repurchase program will enhance long-term stockholder value, and share repurchases could increase the volatility of the price of our stock and could diminish our cash reserves. In January 2018, January 2019, and July 2019, the board of directors of Alphabet authorized the company to repurchase up to $8.6 billion , $12.5 billion , and $25.0 billion of its Class C capital stock, respectively. Share repurchases pursuant to the January 2018 and January 2019 authorizations were completed in 2019. As of December 31, 2019, $20.8 billion remains available for repurchase. Our repurchase program does not have an expiration date and does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. Our share repurchase program could affect the price of our stock and increase volatility and may be suspended or terminated at any time, which may result in a decrease in the trading price of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B common stock has 10 votes per share, our Class A common stock has one vote per share, and our Class C capital stock has no voting rights. As of December 31, 2019, Larry Page and Sergey Brin beneficially owned approximately 84.3% of our outstanding Class B common stock, which represented approximately 51.2% of the voting power of our outstanding common stock. Through their stock ownership, Larry and Sergey have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C capital stock carries no voting rights (except as required by applicable law), the issuance of the Class C capital stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could continue Larry and Sergey’s current relative voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. This concentrated control limits or severely restricts other stockholders’ ability to influence corporate matters and we may take actions that some of our stockholders do not view as beneficial, which could reduce the market price of our Class A common stock and our Class C capital stock. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry and Sergey have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. As noted above, the issuance of the Class C capital stock could have the effect of continuing the influence of Larry and Sergey. • Our board of directors has the right to elect directors to fill a vacancy created by the expansion of the board of directors or the resignation, death, or removal of a director, which prevents stockholders from being able to fill vacancies on our board of directors. • Our stockholders may not act by written consent. As a result, a holder, or holders, controlling a majority of our capital stock would not be able to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the board of directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. 18 Table of Contents Alphabet Inc. • Our board of directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to issue undesignated preferred stock makes it possible for our board of directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the board of directors has approved the transaction. Our board of directors could rely on Delaware law to prevent or delay an acquisition of us. General Risks Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results may fluctuate as a result of a number of factors, many outside of our control. As a result, comparing our operating results on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our quarterly, year-to-date, and annual expenses as a percentage of our revenues may differ significantly from our historical rates. Our operating results in future quarters may fall below expectations. Any of these events could cause our stock price to fall. Each of the risk factors listed in this section in addition to the following factors may affect our operating results: • Our ability to continue to attract and retain users and customers to our products and services. • Our ability to attract user and/or customer adoption of, and generate significant revenues from, new products, services, and technologies in which we have invested considerable time and resources. • Our ability to monetize traffic on Google properties and our Google Network Members' properties across various devices. • Revenue fluctuations caused by changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix. • The amount of revenues and expenses generated and incurred in currencies other than U.S. dollars, and our ability to manage the resulting risk through our foreign exchange risk management program. • The amount and timing of operating costs and expenses and capital expenditures related to the maintenance and expansion of our businesses, operations, and infrastructure. • Our focus on long-term goals over short-term results. • The results of our acquisitions, divestitures, and our investments in risky projects, including new businesses, products, services, and technologies. • Our ability to keep our products and services operational at a reasonable cost and without service interruptions. • The seasonal fluctuations in internet usage, advertising spending, and underlying business trends such as traditional retail seasonality. Our rapid growth has tended to mask the cyclicality and seasonality of our business. As our growth rate has slowed, the cyclicality and seasonality in our business has become more pronounced and caused our operating results to fluctuate. • Geopolitical events, including trade disputes. • Changes in global business or macroeconomic conditions. Because our businesses are changing and evolving, our historical operating results may not be useful to you in predicting our future operating results. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that may harm our business, financial condition, and operating results. Acquisitions, joint ventures, investments and divestitures are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and operating results. We expect to continue to evaluate and enter into discussions regarding a wide array of potential strategic transactions, which could create unforeseen operating difficulties and expenditures. Some of the areas where we face risks include: • Diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions. • Failure to successfully integrate and further develop the acquired business or technology. 19 Table of Contents Alphabet Inc. • Implementation or remediation of controls, procedures, and policies at the acquired company. • Integration of the acquired company’s accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions. • Transition of operations, users, and customers onto our existing platforms. • Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of a transaction. • In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. • Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire. • Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, data privacy and security issues, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities. • Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions and other strategic transactions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or operating results. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which may harm our financial condition or operating results. If we were to lose the services of key personnel, we may not be able to execute our business strategy. Our future success depends in large part upon the continued service of key members of our senior management team. For instance, Sundar Pichai is critical to the overall management of Alphabet and its subsidiaries and plays an important role in the development of our technology. He also plays a key role in maintaining our culture and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our future success depends on our continuing ability to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Our continued ability to compete effectively depends on our ability to attract new employees and to retain and motivate our existing employees. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows, and we are required to implement more complex organizational management structures, particularly in light of our holding company structure, adverse changes to our corporate culture could harm our business operations. In preparing our financial statements, we incorporate valuation methodologies that are subjective in nature and valuations may fluctuate over time. We measure certain of our non-marketable equity and debt investments, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves use of appropriate valuation methods and certain unobservable inputs, require management judgment and estimation, and may change over time. 20 Table of Contents Alphabet Inc. As it relates to our non-marketable investments, the market values can be negatively affected by liquidity, credit deterioration or losses, performance and financial results of the underlying companies, foreign exchange rates, changes in interest rates, including changes that may result from the implementation of new benchmark rates that replace LIBOR, the effect of new or changing regulations, the stock market in general, or other factors. Since January 2018, we adjust the carrying value of our non-marketable equity investments to fair value for observable transactions of identical or similar investments of the same issuer or for impairments. All gains and losses on non-marketable equity securities, realized and unrealized, are recognized in other income (expense), which increases the volatility of our other income (expense). As a result of these factors, the value or liquidity of our cash equivalents, as well as our marketable and non-marketable securities could decline and result in a material impairment, which could materially adversely affect our financial condition and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. Our future income taxes could be negatively affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles (including changes in the interpretation of existing laws), as well as certain discrete items. In addition, we are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions, including in Europe, on various tax-related assertions, such as transfer-pricing adjustments or permanent-establishment claims. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition and could require us to change our business practices in a manner adverse to our business. It may also subject us to additional litigation and regulatory inquiries, resulting in the diversion of management’s time and attention. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations for which the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may materially affect our financial results in the period or periods for which such determination is made. Furthermore, due to shifting economic and political conditions, tax policies, laws, or rates in various jurisdictions may be subject to significant changes in ways that impair our financial results. In particular, France, Italy, and other countries have enacted or are considering digital services taxes, which could lead to inconsistent and potentially overlapping international tax regimes. The Organization for Economic Cooperation and Development recently released a proposal relating to its initiative for modernizing international tax rules, with the goal of having different countries enact legislation to implement a modernized and aligned international tax framework, but there can be no guarantee that this will occur. The trading price for our Class A common stock and non-voting Class C capital stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. For example, from January 1, 2019 through December 31, 2019, the closing price of our Class A common stock ranged from $1,025.47 per share to $1,362.47 per share, and the closing price of our Class C capital stock ranged from $1,016.06 to $1,361.17 per share. In addition to the factors discussed in this report, the trading price of our Class A common stock and Class C capital stock may fluctuate widely in response to various factors, many of which are beyond our control, including, among others: • Quarterly variations in our operating results or those of our competitors. • Announcements by us or our competitors of acquisitions, divestitures, investments, new products, significant contracts, commercial relationships, or capital commitments. • Recommendations by securities analysts or changes in earnings estimates. • Announcements about our earnings that are not in line with analyst expectations, the risk of which is enhanced because it is our policy not to give guidance on earnings. • Announcements by our competitors of their earnings that are not in line with analyst expectations. 21 Table of Contents Alphabet Inc. • Commentary by industry and market professionals about our products, strategies, and other matters affecting our business and results, regardless of its accuracy. • The volume of shares of Class A common stock and Class C capital stock available for public sale. • Sales of Class A common stock and Class C capital stock by us or by our stockholders (including sales by our directors, executive officers, and other employees). • Short sales, hedging, and other derivative transactions on shares of our Class A common stock and Class C capital stock. • The perceived values of Class A common stock and Class C capital stock relative to one another. • Any share repurchase program. In addition, the stock market in general, which can be affected by various factors, including overall economic and political conditions, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may harm the market price of our Class A common stock and our Class C capital stock, regardless of our actual operating performance. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We also own and lease office and building space in the surrounding areas near our headquarters, which we believe is sufficient to accommodate anticipated future growth. In addition, we own and lease office/building space and research and development sites around the world, primarily in North America, Europe, South America, and Asia. We own and operate data centers in the U.S., Europe, South America, and Asia. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, please see Note 10 “Commitments and Contingencies - Legal Matters” of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 22 Table of Contents Alphabet Inc. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. Holders of Record As of December 31, 2019 , there were approximately 2,455 and 2,030 stockholders of record of our Class A common stock and Class C capital stock, respectively. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2019 , there were approximately 66 stockholders of record of our Class B common stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. The primary use of capital continues to be to invest for the long term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class C capital stock during the quarter ended December 31, 2019 : Period Total Number of Shares Purchased (in thousands) (1) Average Price Paid per Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 1,970 $ 1,229.02 1,970 $ 24,470 November 1 - 30 1,626 $ 1,304.00 1,626 $ 22,350 December 1 - 31 1,164 $ 1,337.16 1,164 $ 20,793 Total 4,760 4,760 (1) In January and July 2019, the board of directors of Alphabet authorized the company to repurchase up to an additional $12.5 billion and $25.0 billion of its Class C capital stock, respectively. Share repurchases pursuant to the January 2019 authorization were completed during the fourth quarter of 2019. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Please refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. 23 Table of Contents Alphabet Inc. Stock Performance Graphs The graph below matches Alphabet Inc. Class A's cumulative 5-Year total shareholder return on common stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from December 31, 2014 to December 31, 2019 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* ALPHABET INC. CLASS A COMMON STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2014 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2020 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 24 Table of Contents Alphabet Inc. The graph below matches Alphabet Inc. Class C's cumulative 5-Year total shareholder return on capital stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our Class C capital stock and in each index (with the reinvestment of all dividends) from December 31, 2014 to December 31, 2019 . The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE TOTAL RETURN* ALPHABET INC. CLASS C CAPITAL STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2014 in stock or in index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2020 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 25 Table of Contents Alphabet Inc. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing in Item 8 “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results to be expected in any future period. Year Ended December 31, 2015 2016 2017 2018 2019 (in millions, except per share amounts) Consolidated Statements of Income Data: Revenues $ 74,989 $ 90,272 $ 110,855 $ 136,819 $ 161,857 Income from operations $ 19,360 $ 23,737 $ 26,178 $ 27,524 $ 34,231 Net income $ 16,348 $ 19,478 $ 12,662 $ 30,736 $ 34,343 Basic net income per share of Class A and B common stock $ 23.11 $ 28.32 $ 18.27 $ 44.22 $ 49.59 Basic net income per share of Class C capital stock $ 24.63 $ 28.32 $ 18.27 $ 44.22 $ 49.59 Diluted net income per share of Class A and B common stock $ 22.84 $ 27.85 $ 18.00 $ 43.70 $ 49.16 Diluted net income per share of Class C capital stock $ 24.34 $ 27.85 $ 18.00 $ 43.70 $ 49.16 As of December 31, 2015 2016 2017 2018 2019 (in millions) Consolidated Balance Sheet Data: Cash, cash equivalents, and marketable securities $ 73,066 $ 86,333 $ 101,871 $ 109,140 $ 119,675 Total assets $ 147,461 $ 167,497 $ 197,295 $ 232,792 $ 275,909 Total long-term liabilities $ 7,820 $ 11,705 $ 20,610 $ 20,544 $ 29,246 Total stockholders’ equity $ 120,331 $ 139,036 $ 152,502 $ 177,628 $ 201,442 26 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K. We have omitted discussion of 2017 results where it would be redundant to the discussion previously included in Part II, Item 7 of our 2018 Annual Report on Form 10-K, as amended. Trends in Our Business The following trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, contributing to revenue growth, and we expect that this online shift will continue to benefit our business. • Users are increasingly using diverse devices and modalities to access our products and services, and our advertising revenues are increasingly coming from new formats. Our users are accessing the Internet via diverse devices and modalities, such as smartphones, wearables and smart home devices, and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of these trends in order to maintain and grow our business. We generate our advertising revenues increasingly from different channels, including mobile, and newer advertising formats, and the margins from the advertising revenues from these channels and newer products have generally been lower than those from traditional desktop search. Additionally, as the market for a particular device type or modality matures our revenues may be affected. For example, growth in the global smartphone market has slowed due to various factors, including increased market saturation in developed countries, which can affect our mobile advertising revenue growth rates. We expect TAC paid to our distribution partners to increase as our revenues grow and to be affected by changes in device mix; geographic mix; partner mix; partner agreement terms; and the percentage of queries channeled through paid access points. We expect these trends to continue to put pressure on our overall margins and affect our revenue growth rates. • As online advertising evolves, we continue to expand our product offerings which may affect our monetization. As interactions between users and advertisers change and as online user behavior evolves, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube engagement ads, which monetize at a lower rate than traditional search ads. • As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates affect such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, and we continue to develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time and we expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. This trend could impact our margins as developing markets initially monetize at a lower rate than more mature markets. Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. 27 Table of Contents Alphabet Inc. • The portion of our revenues that we derive from non-advertising revenues is increasing and may affect margins. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings to our users through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. Across these initiatives, we currently derive non-advertising revenues primarily from sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings and subscription and other services. The margins on these revenues vary significantly and may be lower than the margins on our advertising revenues. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile. • As we continue to serve our users and expand our businesses, we will invest heavily in operating and capital expenditures. We continue to make significant R&D investments in areas of strategic focus such as advertising, cloud, machine learning, and search, as well as in new products and services. In addition, our capital expenditures have grown over the last several years. We expect this trend to continue in the long term as we invest heavily in land and buildings for data centers and offices, and information technology infrastructure, which includes servers and network equipment . In addition, acquisitions remain an important part of our strategy and use of capital, and we expect to continue to spend cash on acquisitions and other investments. These acquisitions generally enhance the breadth and depth of our offerings, as well as expand our expertise in engineering and other functional areas. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees. Executive Overview of Results Below are our key financial results for the fiscal year ended December 31, 2019 (consolidated unless otherwise noted): • Revenues of $161.9 billion and revenue growth of 18% year over year, constant currency revenue growth of 20% year over year. • Google segment revenues of $160.7 billion with revenue growth of 18% year over year and Other Bets revenues of $659 million with revenue growth of 11% year over year. • Revenues from the United States , EMEA , APAC , and Other Americas were $74.8 billion , $50.6 billion , $26.9 billion , and $9.0 billion , respectively. • Cost of revenues was $71.9 billion , consisting of TAC of $30.1 billion and other cost of revenues of $41.8 billion . Our TAC as a percentage of advertising revenues (TAC rate) was 22.3% . • Operating expenses (excluding cost of revenues) were $55.7 billion . • Income from operations was $34.2 billion . • Other income (expense), net, was $5.4 billion . • Effective tax rate was 13% . • Net income was $34.3 billion with diluted net income per share of $49.16 . • Operating cash flow was $54.5 billion . • Capital expenditures were $23.5 billion . • Number of employees was 118,899 as of December 31, 2019 . The majority of new hires during the year were engineers and product managers. By product area, the largest headcount additions were in Google Cloud and Search. Information about Segments We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed as Other Bets. 28 Table of Contents Alphabet Inc. Our reported segments are: • Google – Google includes our main products such as ads, Android, Chrome, hardware, Google Cloud, Google Maps, Google Play, Search, and YouTube. Our technical infrastructure is also included in Google. Google generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings and subscription-based products. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes Access, Calico, CapitalG, GV, Verily, Waymo, and X, among others. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Access as well as licensing and R&D services through Verily. Revenues The following table presents our revenues by segment and revenue source (in millions). Certain amounts in prior periods have been reclassified to conform with current period presentation. Year Ended December 31, 2017 2018 2019 Google Search & other $ 69,811 $ 85,296 $ 98,115 YouTube ads (1) 8,150 11,155 15,149 Google properties 77,961 96,451 113,264 Google Network Members' properties 17,616 20,010 21,547 Google advertising 95,577 116,461 134,811 Google Cloud 4,056 5,838 8,918 Google other (1) 10,914 14,063 17,014 Google revenues 110,547 136,362 160,743 Other Bets revenues 477 595 659 Hedging gains (losses) (169 ) (138 ) 455 Total revenues $ 110,855 $ 136,819 $ 161,857 (1) YouTube non-advertising revenues are included in Google other revenues. Google advertising revenues Our advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google properties and the change in impressions and cost-per-impression on Google Network Members' properties and the correlation between these items, have been affected and may continue to be affected by various factors, including: • advertiser competition for keywords; • changes in advertising quality, formats, delivery or policy; • changes in device mix; • changes in foreign currency exchange rates; • fees advertisers are willing to pay based on how they manage their advertising costs; • general economic conditions; • seasonality; and • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels. Our advertising revenue growth rate has been affected over time as a result of a number of factors, including challenges in maintaining our growth rate as revenues increase to higher levels; changes in our product mix; changes in advertising quality or formats and delivery; the evolution of the online advertising market; increasing competition; our investments in new business strategies; query growth rates; and shifts in the geographic mix of our revenues. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices and modalities, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates. 29 Table of Contents Alphabet Inc. The following table presents our Google advertising revenues (in millions): Year Ended December 31, 2017 2018 2019 Google Search & other $ 69,811 $ 85,296 $ 98,115 YouTube ads (1) 8,150 11,155 15,149 Google Network Members' properties 17,616 20,010 21,547 Google advertising $ 95,577 $ 116,461 $ 134,811 Google advertising revenues as a percentage of Google segment revenues 86.5 % 85.4 % 83.9 % (1) YouTube non-advertising revenues are included in Google other revenues. Google advertising revenues are generated on our Google properties (including Google Search & other properties and YouTube) and Google Network Members’ properties. Google advertising revenues consist primarily of the following: • Google Search & other consists of revenues generated on Google search properties (including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.) and other Google owned and operated properties like Gmail, Google Maps, and Google Play; • YouTube ads consists of revenues generated primarily on YouTube properties; and • Google Network Members' properties consist of revenues generated primarily on Google Network Members' properties participating in AdMob, AdSense, and Google Ad Manager. Google Search & other Our Google Search & other revenues increased $12,819 million from 2018 to 2019. The growth was primarily driven by interrelated factors including increases in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices, continued growth in advertiser activity, and improvements we have made in ad formats and delivery. Revenue growth was partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. Our Google Search & other revenues increased $15,485 million from 2017 to 2018. The growth was primarily driven by increases in mobile search resulting from ongoing growth in user adoption and usage, as well as continued growth in advertiser activity. Growth was also driven by improvements in ad formats and delivery, primarily on desktop. Additionally, revenue growth was favorably affected by the general weakening of the U.S. dollar compared to certain foreign currencies. YouTube ads YouTube ads revenues increased $3,994 million from 2018 to 2019 and increased $3,005 million from 2017 to 2018. The largest contributors to the growth during both periods were our direct response and brand advertising products, both of which benefited from improvements to ad formats and delivery and increased advertiser spending. Google Network Members' properties Our Google Network Members' properties revenues increased $1,537 million from 2018 to 2019. The growth was primarily driven by strength in both AdManager (included in what was previously referred to as programmatic advertising buying) and AdMob, partially offset by the general strengthening of the U.S. dollar compared to certain foreign currencies. Our Google Network Members' properties revenues increased $2,394 million from 2017 to 2018, primarily driven by strength in both AdMob and AdManager, offset by a decline in our traditional AdSense businesses. Additionally, the growth was favorably affected by the general weakening of the U.S. dollar compared to certain foreign currencies. Use of Monetization Metrics Paid clicks for our Google properties represent engagement by users and include clicks on advertisements by end-users related to searches on Google.com and other owned and operated properties including Gmail, Google Maps, and Google Play; and viewed YouTube engagement ads (certain YouTube ad formats are not included in our click or impression based metrics). Impressions for our Google Network Members' properties include impressions displayed to users served on Google Network Members' properties participating primarily in AdMob, AdSense and Google Ad Manager. Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. 30 Table of Contents Alphabet Inc. Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions and represents the average amount we charge advertisers for each impression displayed to users. As our business evolves, we periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks on our Google properties and the number of impressions on Google Network Members’ properties and for identifying the revenues generated by click activity on our Google properties and the revenues generated by impression activity on Google Network Members’ properties. Google properties The following table presents changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 2018 2019 Paid clicks change 62 % 23 % Cost-per-click change (25 )% (7 )% The number of paid clicks through our advertising programs on Google properties increased from 2018 to 2019 due to growth in views of YouTube engagement ads; increase in clicks due to interrelated factors, including an increase in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was primarily driven by continued growth in YouTube engagement ads where cost-per-click remains lower than on our other advertising platforms. Cost-per-click was also affected by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Google Network Members' properties The following table presents changes in our impressions and cost-per-impression (expressed as a percentage): Year Ended December 31, 2018 2019 Impressions change 2 % 9 % Cost-per-impression change 12 % 1 % Impressions increased from 2018 to 2019 primarily due to growth in AdManager. The cost-per-impression was relatively unchanged due to a combination of factors including ongoing product and policy changes and improvements we have made in ad formats and delivery, changes in device mix, geographic mix, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Google Cloud The following table presents our Google Cloud revenues (in millions): Year Ended December 31, 2017 2018 2019 Google Cloud $ 4,056 $ 5,838 $ 8,918 Google Cloud revenues as a percentage of Google segment revenues 3.7 % 4.3 % 5.5 % Google Cloud revenues consist primarily of revenues from Cloud offerings, including • Google Cloud Platform (GCP), which includes infrastructure, data and analytics, and other services • G Suite productivity tools; and • other enterprise cloud services. Our Google Cloud revenues increased $3,080 million from 2018 to 2019 and increased $1,782 million from 2017 to 2018. The growth during both periods was primarily driven by continued strength in our GCP and G Suite offerings. Our infrastructure and our data and analytics platform products have been the largest drivers of growth in GCP. 31 Table of Contents Alphabet Inc. Google other revenues The following table presents our Google other revenues (in millions): Year Ended December 31, 2017 2018 2019 Google other 10,914 14,063 17,014 Google other revenues as a percentage of Google segment revenues 9.9 % 10.3 % 10.6 % Google other revenues consist primarily of revenues from: • Google Play, which includes revenues from sales of apps and in-app purchases (which we recognize net of payout to developers) and digital content sold in the Google Play store; • hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; • YouTube non-advertising, including YouTube Premium and YouTube TV subscriptions and other services; and • other products and services. Our Google other revenues increased $2,951 million from 2018 to 2019. The growth was primarily driven by Google Play and YouTube subscriptions. Our Google other revenues increased $3,149 million from 2017 to 2018. The growth was primarily driven by Google Play and hardware. Over time, our growth rate for Google Cloud and Google other revenues may be affected by the seasonality associated with new product and service launches and market dynamics. Other Bets The following table presents our Other Bets revenues (in millions): Year Ended December 31, 2017 2018 2019 Other Bets revenues $ 477 $ 595 $ 659 Other Bets revenues as a percentage of total revenues 0.4 % 0.4 % 0.4 % Other Bets revenues consist primarily of revenues from sales of Access internet and TV services and Verily licensing and R&D services. Revenues by Geography The following table presents our revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 2018 2019 United States 46 % 46 % EMEA 33 % 31 % APAC 15 % 17 % Other Americas 6 % 6 % For further details on revenues by geography, see Note 2 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Use of Constant Currency Revenues and Constant Currency Revenue Growth The effect of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably affected as the U.S. dollar weakens relative to other foreign currencies, and unfavorably affected as the U.S. dollar strengthens relative to other foreign currencies. Our revenues are also favorably affected by net hedging gains and unfavorably affected by net hedging losses. We use non-GAAP constant currency revenues and constant currency revenue growth for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to U.S. Generally Accepted Accounting Principles (GAAP) results helps improve 32 Table of Contents Alphabet Inc. the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the effect of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue growth on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging effects realized in the current period. Constant currency revenue growth (expressed as a percentage) is calculated by determining the increase in current period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging effects are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. 33 Table of Contents Alphabet Inc. The following table presents the foreign exchange effect on our international revenues and total revenues (in millions): Year Ended December 31, 2018 2019 EMEA revenues $ 44,739 $ 50,645 Exclude foreign exchange effect on current period revenues using prior year rates (1,325 ) 2,397 EMEA constant currency revenues $ 43,414 $ 53,042 Prior period EMEA revenues $ 36,236 $ 44,739 EMEA revenue growth 23 % 13 % EMEA constant currency revenue growth 20 % 19 % APAC revenues $ 21,341 $ 26,928 Exclude foreign exchange effect on current period revenues using prior year rates (49 ) 388 APAC constant currency revenues $ 21,292 $ 27,316 Prior period APAC revenues $ 16,192 $ 21,341 APAC revenue growth 32 % 26 % APAC constant currency revenue growth 31 % 28 % Other Americas revenues $ 7,608 $ 8,986 Exclude foreign exchange effect on current period revenues using prior year rates 404 541 Other Americas constant currency revenues $ 8,012 $ 9,527 Prior period Other Americas revenues $ 6,147 $ 7,608 Other Americas revenue growth 24 % 18 % Other Americas constant currency revenue growth 30 % 25 % United States revenues $ 63,269 $ 74,843 United States revenue growth 21 % 18 % Hedging gains (losses) (138 ) 455 Total revenues $ 136,819 $ 161,857 Total constant currency revenues $ 135,987 $ 164,728 Prior period revenues, excluding hedging effect (1) $ 111,024 $ 136,957 Total revenue growth 23 % 18 % Total constant currency revenue growth 22 % 20 % (1) Total revenues and hedging gains (losses) for the year ended December 31, 2017 were $110,855 million and $(169) million, respectively. Our EMEA revenue growth from 2018 to 2019 was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Euro and British pound. Our APAC revenue growth from 2018 to 2019 was unfavorably affected by changes in foreign currency exchange rates primarily due to the U.S. dollar strengthening relative to the Australian dollar and South Korean won, partially offset by the U.S. dollar weakening relative to the Japanese yen. Our Other Americas revenue growth from 2018 to 2019 was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Brazilian real and Argentine peso. 34 Table of Contents Alphabet Inc. Costs and Expenses Cost of Revenues Cost of revenues consists of TAC which are paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. The cost of revenues as a percentage of revenues generated from ads placed on Google Network Members' properties are significantly higher than the cost of revenues as a percentage of revenues generated from ads placed on Google properties because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members. Additionally, other cost of revenues (which is the cost of revenues excluding TAC) includes the following: • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube advertising and subscription services and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Expenses associated with our data centers and other operations (including bandwidth, compensation expenses (including stock-based compensation (SBC)), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. The following tables present our cost of revenues, including TAC (in millions): Year Ended December 31, 2018 2019 TAC $ 26,726 $ 30,089 Other cost of revenues 32,823 41,807 Total cost of revenues $ 59,549 $ 71,896 Total cost of revenues as a percentage of revenues 43.5 % 44.4 % Cost of revenues increased $12,347 million from 2018 to 2019 . The increase was due to increases in other cost of revenues and TAC of $8,984 million and $3,363 million , respectively. The increase in other cost of revenues from 2018 to 2019 was due to an increase in data center and other operations costs. Additionally, there was an increase in content acquisition costs for YouTube consistent with the growth in YouTube revenues. The increase in TAC from 2018 to 2019 was due to increases in TAC paid to distribution partners and to Google Network Members, primarily driven by growth in revenues subject to TAC. The TAC rate decreased from 22.9% to 22.3% , primarily due to the favorable revenue mix shift from Google Network Members' properties to Google properties. The TAC rate on Google properties revenues increased primarily due to the ongoing shift to mobile, which carries higher TAC because more mobile searches are channeled through paid access points. The TAC rate on Google Network revenues decreased primarily due to changes in product mix to products that carry a lower TAC rate. Over time, cost of revenues as a percentage of total revenues may be affected by a number of factors, including the following: • The amount of TAC paid to Google Network Members, which is affected by a combination of factors such as geographic mix, product mix, revenue share terms, and fluctuations of the U.S. dollar compared to certain foreign currencies ; • The amount of TAC paid to distribution partners, which is affected by changes in device mix, geographic mix, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points; • Relative revenue growth rates of Google properties and Google Network Members' properties; • Costs associated with our data centers and other operations to support ads, Google Cloud, Search, YouTube and other products ; • Content acquisition costs, which are primarily affected by the relative growth rates in our YouTube advertising and subscription revenues; • Costs related to hardware sales; and • Increased proportion of non-advertising revenues, which generally have higher costs of revenues, relative to our advertising revenues. 35 Table of Contents Alphabet Inc. Research and Development The following table presents our R&D expenses (in millions): Year Ended December 31, 2018 2019 Research and development expenses $ 21,419 $ 26,018 Research and development expenses as a percentage of revenues 15.7 % 16.1 % R&D expenses consist primarily of: • Compensation expenses (including SBC) and facilities-related costs for engineering and technical employees responsible for R&D of our existing and new products and services; • Depreciation expenses; • Equipment-related expenses; and • Professional services fees primarily related to consulting and outsourcing services. R&D expenses increased $4,599 million from 2018 to 2019 . The increase was primarily due to an increase in compensation expenses (including SBC) and facilities-related costs of $3,519 million, largely resulting from a 23% increase in headcount. Over time, R&D expenses as a percentage of revenues may be affected by a number of factors including continued investment in ads, Android, Chrome, Google Cloud, Google Play, hardware, machine learning, Other Bets, and Search. Sales and Marketing The following table presents our sales and marketing expenses (in millions): Year Ended December 31, 2018 2019 Sales and marketing expenses $ 16,333 $ 18,464 Sales and marketing expenses as a percentage of revenues 11.9 % 11.4 % Sales and marketing expenses consist primarily of: • Advertising and promotional expenditures related to our products and services; and • Compensation expenses (including SBC) and facilities-related costs for employees engaged in sales and marketing, sales support, and certain customer service functions. Sales and marketing expenses increased $2,131 million from 2018 to 2019 . The increase was primarily due to an increase in compensation expenses (including SBC) and facilities-related costs of $1,371 million , largely resulting from a 15% increase in headcount. In addition, there was an increase in advertising and promotional expenses of $402 million . Over time, sales and marketing expenses as a percentage of revenues may be affected by a number of factors including the seasonality associated with new product and service launches. General and Administrative The following table presents our general and administrative expenses (in millions): Year Ended December 31, 2018 2019 General and administrative expenses $ 6,923 $ 9,551 General and administrative expenses as a percentage of revenues 5.1 % 5.9 % General and administrative expenses consist primarily of: • Compensation expenses (including SBC) and facilities-related costs for employees in our finance, human resources, information technology, and legal organizations; • Depreciation expenses; • Equipment-related expenses; • Legal-related expenses; and 36 Table of Contents Alphabet Inc. • Professional services fees primarily related to audit, information technology consulting, outside legal, and outsourcing services. General and administrative expenses increased $2,628 million from 2018 to 2019 . The increase was primarily due to an increase in legal-related expenses of $1,157 million , including a charge of $554 million from a legal settlement in 2019 and the effect of a legal settlement gain recorded in 2018. Additionally, there was an increase in compensation expenses (including SBC) and facilities-related costs of $687 million , largely resulting from a 19% increase in headcount. Performance fees of $1,203 million have been reclassified from general and administrative expenses to other income (expense), net, for 2018 to conform with current period presentation. See Note 7 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details. Over time, general and administrative expenses as a percentage of revenues may be affected by discrete items such as legal settlements. European Commission Fines In July 2018, the EC announced its decision that certain provisions in Google's Android-related distribution agreements infringed European competition law. The EC decision imposed a €4.3 billion ( $5.1 billion as of June 30, 2018) fine, which was accrued in the second quarter of 2018. In March 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a €1.5 billion ( $1.7 billion as of March 20, 2019) fine, which was accrued in the first quarter of 2019. Please refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. Other Income (Expense), Net The following table presents other income (expense), net, (in millions): Year Ended December 31, 2018 2019 Other income (expense), net $ 7,389 $ 5,394 Other income (expense), net, as a percentage of revenues 5.4 % 3.3 % Other income (expense), net, decreased $1,995 million from 2018 to 2019 . This decrease was primarily driven by a decrease in gains on equity securities, which were $2,649 million in 2019 as compared to $5,460 million in 2018. The majority of the gains in both periods were unrealized. The effect of the decrease in gains on equity securities was partially offset by a decrease in performance fees. The decrease in other income (expense) was also driven by a decrease in gains on debt securities primarily due to an unrealized gain recognized in 2018 resulting from the modification of the terms of a non-marketable debt security. Performance fees of $1,203 million have been reclassified from general and administrative expenses to other income (expense), net, for 2018 to conform with current period presentation. See Note 7 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further details. Over time, other income (expense), net, as a percentage of revenues may be affected by market dynamics and other factors. Equity values generally change daily for marketable equity securities and upon the occurrence of observable price changes or upon impairment of non-marketable equity securities. In addition, volatility in the global economic climate and financial markets could result in a significant change in the value of our equity securities. Fluctuations in the value of these investments has, and we expect will continue to, contribute to volatility of OI&E in future periods. For additional information about equity investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. 37 Table of Contents Alphabet Inc. Provision for Income Taxes The following table presents our provision for income taxes (in millions) and effective tax rate: Year Ended December 31, 2018 2019 Provision for income taxes $ 4,177 $ 5,282 Effective tax rate 12.0 % 13.3 % Our provision for income taxes and our effective tax rate increased from 2018 to 2019 , due to discrete events in 2018 and 2019. In 2018, we released our deferred tax asset valuation allowance related to gains on equity securities and recognized the benefits of the U.S. Tax Cuts and Jobs Act ("Tax Act"). In 2019, we recognized an increase in discrete benefits related to the resolution of multi-year audits, partially offset by the reversal of Altera tax benefit as a result of the U.S. Court of Appeals decision. See Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. As of December 31, 2019, we have simplified our corporate legal entity structure and now license intellectual property from the U.S. that was previously licensed from Bermuda. This will affect our geographic mix of earnings . We expect our future effective tax rate to be affected by the geographic mix of earnings in countries with different statutory rates. Additionally, our future effective tax rate may be affected by changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. 38 Table of Contents Alphabet Inc. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2019 . This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality and macroeconomic conditions have affected, and are likely to continue to affect, our business. Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31, 2018 Jun 30, 2018 Sept 30, 2018 Dec 31, 2018 Mar 31, 2019 Jun 30, 2019 Sept 30, 2019 Dec 31, 2019 (In millions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues $ 31,146 $ 32,657 $ 33,740 $ 39,276 $ 36,339 $ 38,944 $ 40,499 $ 46,075 Costs and expenses: Cost of revenues 13,467 13,883 14,281 17,918 16,012 17,296 17,568 21,020 Research and development 5,039 5,114 5,232 6,034 6,029 6,213 6,554 7,222 Sales and marketing 3,604 3,780 3,849 5,100 3,905 4,212 4,609 5,738 General and administrative 1,403 1,764 1,753 2,003 2,088 2,043 2,591 2,829 European Commission fines 0 5,071 0 0 1,697 0 0 0 Total costs and expenses 23,513 29,612 25,115 31,055 29,731 29,764 31,322 36,809 Income from operations 7,633 3,045 8,625 8,221 6,608 9,180 9,177 9,266 Other income (expense), net 2,910 1,170 1,458 1,851 1,538 2,967 (549 ) 1,438 Income from continuing operations before income taxes 10,543 4,215 10,083 10,072 8,146 12,147 8,628 10,704 Provision for income taxes 1,142 1,020 891 1,124 1,489 2,200 1,560 33 Net income $ 9,401 $ 3,195 $ 9,192 $ 8,948 $ 6,657 $ 9,947 $ 7,068 $ 10,671 Basic net income per share of Class A and B common stock and Class C capital stock $ 13.53 $ 4.60 $ 13.21 $ 12.87 $ 9.58 $ 14.33 $ 10.20 $ 15.49 Diluted net income per share of Class A and B common stock and Class C capital stock $ 13.33 $ 4.54 $ 13.06 $ 12.77 $ 9.50 $ 14.21 $ 10.12 $ 15.35 Capital Resources and Liquidity As of December 31, 2019 , we had $119.7 billion in cash, cash equivalents, and marketable securities. Ca sh equivalents and marketable securities a re comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities and marketable equity securities. As of December 31, 2019 , we had long-term taxes payable of $7.3 billion related to a one-time transition tax payable incurred as a result of the Tax Act. As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025. In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ( $2.7 billion as of June 27, 2017), €4.3 billion ( $5.1 billion as of June 30, 2018), and €1.5 billion ( $1.7 billion as of March 20, 2019), respectively. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. 39 Table of Contents Alphabet Inc. In November 2019, we entered into an agreement to acquire Fitbit, a leading wearables brand, for $7.35 per share, representing a total purchase price of approximately $2.1 billion as of the date of the agreement. The acquisition of Fitbit is expected to be completed in 2020, subject to customary closing conditions, including the receipt of regulatory approvals. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. The primary use of capital continues to be to invest for the long term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders. We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2019 . We have $4.0 billion of revolving credit facilities expiring in July 2023 with no amounts outstanding as of December 31, 2019 . The interest rate for the credit facilities is determined based on a formula using certain market rates. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements including capital expenditures, working capital requirements, potential acquisitions and other liquidity requirements through at least the next 12 months. As of December 31, 2019 , we have senior unsecured notes outstanding due in 2021, 2024, and 2026 with a total carrying value of $4.0 billion . As of December 31, 2019 , we had remaining authorization of $20.8 billion for repurchase of Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Please refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. We continue to make significant investments in land and buildings for data centers and offices and information technology infrastructure through purchases of property and equipment and lease arrangements to provide capacity for the growth of our business. During the year ended December 31, 2019, we spent $23.5 billion on capital expenditures and recognized total operating lease assets of $4.4 billion . As of December 31, 2019, the amount of total future lease payments under operating leases, which had a weighted average remaining lease term of 10 years , was $13.9 billion . Finance leases were not material for the year ended December 31, 2019. Please refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the leases. The following table presents our cash flows (in millions): Year Ended December 31, 2018 2019 Net cash provided by operating activities $ 47,971 $ 54,520 Net cash used in investing activities $ (28,504 ) $ (29,491 ) Net cash used in financing activities $ (13,179 ) $ (23,209 ) Cash Provided by Operating Activities Our largest source of cash provided by our operations are advertising revenues generated by Google properties and Google Network Members' properties. Additionally, we generate cash through sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings and subscription-based products. Our primary uses of cash from our operating activities include payments to our Google Network Members and distribution partners, and payments for content acquisition costs. In addition, uses of cash from operating activities include compensation and related costs, hardware inventory costs, other general corporate expenditures, and income taxes. Net cash provided by operating activities increased from 2018 to 2019 primarily due to increases in cash received from revenues, offset by increases in cash paid for cost of revenues and operating expenses. Cash Used in Investing Activities Cash provided by investing activities consists primarily of maturities and sales of our investments in marketable and non-marketable securities. Cash used in investing activities consists primarily of purchases of property and 40 Table of Contents Alphabet Inc. equipment, which primarily includes our investments in land and buildings for data centers and offices and information technology infrastructure to provide capacity for the growth of our businesses; purchases of marketable and non-marketable securities; and payments for acquisitions. Net cash used in investing activities increased from 2018 to 2019 primarily due to a net increase in purchases of securities and an increase in payments for acquisitions, partially offset by a decrease in payments for purchases of property and equipment. The decrease in purchases of property and equipment was driven by decreases in purchases of servers as well as land and buildings for offices, partially offset by an increase in data center construction. Cash Used in Financing Activities Cash provided by financing activities consists primarily of proceeds from issuance of debt and proceeds from sale of interest in consolidated entities. Cash used in financing activities consists primarily of net payments related to stock-based award activities, repurchases of capital stock, and repayments of debt. Net cash used in financing activities increased from 2018 to 2019 primarily due to an increase in cash payments for repurchases of capital stock and a decrease in proceeds from sale of interest in consolidated entities. Contractual Obligations as of December 31, 2019 The following summarizes our contractual obligations as of December 31, 2019 (in millions): Payments Due By Period Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating lease obligations (1) $ 13,854 $ 1,757 $ 3,525 $ 2,809 $ 5,763 Obligations for leases that have not yet commenced (1) 7,418 249 850 1,314 5,005 Purchase obligations (2) 5,660 4,212 933 202 313 Long-term debt obligations (3) 5,288 227 1,258 1,224 2,579 Tax payable (4) 7,315 0 1,166 3,661 2,488 Other long-term liabilities reflected on our balance sheet (5) 1,484 245 643 367 229 Total contractual obligations $ 41,019 $ 6,690 $ 8,375 $ 9,577 $ 16,377 (1) For further information, refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. (2) Represents non-cancelable contractual obligations primarily related to information technology assets and data center operation costs; purchases of inventory; and digital media content licensing arrangements. The amounts included above represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2019 . Excluded from the table above are open orders for purchases that support normal operations. (3) Represents our principal and interest payments. For further information on long-term debt, refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. (4) Represents one-time transition tax payable incurred as a result of the Tax Act. For further information, refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Excluded from the table above are long-term taxes payable of $2.6 billion as of December 31, 2019 primarily related to uncertain tax positions, for which we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing of tax audit outcomes. (5) Represents cash obligations recorded on our Consolidated Balance Sheets, including the short-term portion of these long-term liabilities, primarily for the construction of offices and certain commercial agreements. These amounts do not include the EC fines which are classified as current liabilities on our Consolidated Balance Sheets. For further information regarding the EC fines, refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Off-Balance Sheet Arrangements As of December 31, 2019 , we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. 41 Table of Contents Alphabet Inc. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, expenses, gains and losses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit committee of our board of directors. Please see Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements. Revenues For the sale of third-party goods and services, we evaluate whether we are the principal, and report revenues on a gross basis, or an agent, and report revenues on a net basis. In this assessment, we consider if we obtain control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment, inventory risk, and discretion in establishing price. Income Taxes We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services (IRS) and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition and antitrust, intellectual property, privacy, consumer protection, non-income taxes, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood of there being, and the estimated amount of, a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material effect on our business, consolidated financial position, results of operations, or cash flows. Long-lived Assets Long-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated 42 Table of Contents Alphabet Inc. from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Fair Value Measurements We measure certain of our non-marketable equity and debt investments, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves the use of appropriate valuation methods and relevant inputs into valuation models. The fair value hierarchy prioritizes the inputs used to measure fair value whereby it gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. We maximize the use of relevant observable inputs and minimize the use of unobservable inputs. Our use of unobservable inputs reflects the assumptions that market participants would use and may include our own data adjusted based on reasonably available information. We apply judgment in assessing the relevance of observable market data to determine the priority of inputs under the fair value hierarchy, particularly in situations where there is very little or no market activity. In determining the fair values of our non-marketable equity and debt investments, as well as assets acquired (especially with respect to intangible assets) and liabilities assumed in business combinations, we make significant estimates and assumptions, some of which include the use of unobservable inputs. Certain stock-based compensation awards may be settled in the stock of certain of our Other Bets or in cash. These awards are based on the equity values of the respective Other Bet, which requires use of unobservable inputs. We also have compensation arrangements with payouts based on realized investment returns, i.e. performance fees. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized, and may require the use of unobservable inputs. Non-marketable Equity Securities Our non-marketable equity securities not accounted for under the equity method are carried either at fair value or under the measurement alternative. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Determining whether an observed transaction is similar to a security within our portfolio requires judgment based on the rights and obligations of the securities. Recording upward and downward adjustments to the carrying value of our equity securities as a result of observable price changes requires quantitative assessments of the fair value of our securities using various valuation methodologies and involves the use of estimates. Non-marketable equity securities are also subject to periodic impairment reviews. Our quarterly impairment analysis considers both qualitative and quantitative factors that may have a significant effect on the investment's fair value. Qualitative factors considered include industry and market conditions, financial performance, business prospects, and other relevant events and factors. When indicators of impairment exist, we prepare quantitative assessments of the fair value of our equity investments using both the market and income approaches which require judgment and the use of estimates, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When our assessment indicates that an impairment exists, we measure our non-marketable securities at fair value. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange Risk We transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced in the near term. We use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the local currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign 43 Table of Contents Alphabet Inc. currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. If an adverse 10% foreign currency exchange rate change was applied to total monetary assets and liabilities denominated in currencies other than the local currencies at the balance sheet dates, it would have resulted in an adverse effect on income before income taxes of approximately $1 million and $8 million as of December 31, 2018 and 2019 , respectively. The adverse effect as of December 31, 2018 and 2019 is after consideration of the offsetting effect of approximately $374 million and $662 million , respectively, from foreign exchange contracts in place for the years ended December 31, 2018 and 2019 . We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of AOCI and subsequently reclassify them into revenues to offset the hedged exposures as they occur. If the U.S. dollar weakened by 10% as of December 31, 2018 and 2019 , the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $772 million and $1.1 billion lower as of December 31, 2018 and 2019 , respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. We use foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations. If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment (CTA) within AOCI related to our net investment hedge would have been approximately $635 million and $936 million lower as of December 31, 2018 and 2019 , respectively. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries. Interest Rate Risk Our Corporate Treasury investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as a result of higher market interest rates compared to interest rates at the time of purchase. We account for both fixed and variable rate securities at fair value with gains and losses recorded in AOCI until the securities are sold. We use value-at-risk (VaR) analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of our marketable debt securities as of December 31, 2018 and 2019 are shown below (in millions): As of December 31, 12-Month Average As of December 31, 2018 2019 2018 2019 Risk Category - Interest Rate $ 58 $ 104 $ 66 $ 90 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2018 and 2019 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation. 44 Table of Contents Alphabet Inc. Equity Investment Risk Our marketable and non-marketable equity securities are subject to a wide variety of market-related risks that could substantially reduce or increase the fair value of our holdings. Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages. We record our marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $3.3 billion of our investments as of December 31, 2019 . A hypothetical adverse price change of 10%, which could be experienced in the near term, would decrease the fair value of our marketable equity securities by $330 million . Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). The fair value is measured at the time of the observable transaction, which is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize appreciation in the value of our investments through liquidity events such as public offerings, acquisitions, private sales or other favorable market events. As of December 31, 2019 , the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $11.4 billion . Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data. Volatility in the global economic climate and financial markets could result in a significant impairment charge on our non-marketable equity securities. The carrying values of our equity method investments generally do not fluctuate based on market price changes, however these investments could be impaired if the carrying value exceeds the fair value. For further information about our equity investments, please refer to Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. 45 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 47 Financial Statements: Consolidated Balance Sheets 50 Consolidated Statements of Income 51 Consolidated Statements of Comprehensive Income 52 Consolidated Statements of Stockholders’ Equity 53 Consolidated Statements of Cash Flows 54 Notes to Consolidated Financial Statements 55 The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” 46 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Alphabet Inc. (the Company) as of December 31, 2018 and 2019, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2019, and the related notes and financial statement schedule listed in the Index at Item 15 (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2018 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 3, 2020 expressed an unqualified opinion thereon. Adoption of New Accounting Standard As discussed in Note 1 to the financial statements, the Company changed its method for accounting for the recognition, measurement, presentation and disclosure of certain equity securities in the year ended December 31, 2018. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 47 Table of Contents Alphabet Inc. Loss Contingencies Description of the Matter The Company is regularly subject to claims, suits, and government investigations involving competition, intellectual property, privacy, consumer protection, tax, labor and employment, commercial disputes, content generated by its users, goods and services offered by advertisers or publishers using their platforms, and other matters. As described in Note 10 to the financial statements “Commitments and Contingencies” such claims could result in adverse consequences. Significant judgment is required to determine both the likelihood, and the estimated amount, of a loss related to such matters. Auditing management’s accounting for and disclosure of loss contingencies from these matters involved challenging and subjective auditor judgement in assessing the Company’s evaluation of the probability of a loss, and the estimated amount or range of loss. How We Addressed the Matter in Our Audit We tested relevant controls over the identified risks associated with management’s accounting for and disclosure of these matters. This included controls over management’s assessment of the probability of incurrence of a loss and whether the loss or range of loss was reasonably estimable and the development of related disclosures. Our audit procedures included gaining an understanding of previous rulings issued by regulators and the status of ongoing lawsuits, reviewing letters addressing the matters from internal and external legal counsel, meeting with internal legal counsel to discuss the allegations, and obtaining a representation letter from management on these matters. We also evaluated the Company’s disclosures in relation to these matters. /s/ Ernst & Young LLP We have served as the Company's auditor since 1999. San Jose, California February 3, 2020 48 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on Internal Control over Financial Reporting We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2019, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Alphabet Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2019, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2019 consolidated financial statements of the Company and our report dated February 3, 2020 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California February 3, 2020 49 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2018 As of December 31, 2019 Assets Current assets: Cash and cash equivalents $ 16,701 $ 18,498 Marketable securities 92,439 101,177 Total cash, cash equivalents, and marketable securities 109,140 119,675 Accounts receivable, net of allowance of $729 and $753 20,838 25,326 Income taxes receivable, net 355 2,166 Inventory 1,107 999 Other current assets 4,236 4,412 Total current assets 135,676 152,578 Non-marketable investments 13,859 13,078 Deferred income taxes 737 721 Property and equipment, net 59,719 73,646 Operating lease assets 0 10,941 Intangible assets, net 2,220 1,979 Goodwill 17,888 20,624 Other non-current assets 2,693 2,342 Total assets $ 232,792 $ 275,909 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 4,378 $ 5,561 Accrued compensation and benefits 6,839 8,495 Accrued expenses and other current liabilities 16,958 23,067 Accrued revenue share 4,592 5,916 Deferred revenue 1,784 1,908 Income taxes payable, net 69 274 Total current liabilities 34,620 45,221 Long-term debt 4,012 4,554 Deferred revenue, non-current 396 358 Income taxes payable, non-current 11,327 9,885 Deferred income taxes 1,264 1,701 Operating lease liabilities 0 10,214 Other long-term liabilities 3,545 2,534 Total liabilities 55,164 74,467 Commitments and Contingencies (Note 10) Stockholders’ equity: Convertible preferred stock, $0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000, Class B 3,000,000, Class C 3,000,000); 695,556 (Class A 299,242, Class B 46,636, Class C 349,678) and 688,335 (Class A 299,828, Class B 46,441, Class C 342,066) shares issued and outstanding 45,049 50,552 Accumulated other comprehensive loss ( 2,306 ) ( 1,232 ) Retained earnings 134,885 152,122 Total stockholders’ equity 177,628 201,442 Total liabilities and stockholders’ equity $ 232,792 $ 275,909 See accompanying notes. 50 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2017 2018 2019 Revenues $ 110,855 $ 136,819 $ 161,857 Costs and expenses: Cost of revenues 45,583 59,549 71,896 Research and development 16,625 21,419 26,018 Sales and marketing 12,893 16,333 18,464 General and administrative 6,840 6,923 9,551 European Commission fines 2,736 5,071 1,697 Total costs and expenses 84,677 109,295 127,626 Income from operations 26,178 27,524 34,231 Other income (expense), net 1,015 7,389 5,394 Income before income taxes 27,193 34,913 39,625 Provision for income taxes 14,531 4,177 5,282 Net income $ 12,662 $ 30,736 $ 34,343 Basic net income per share of Class A and B common stock and Class C capital stock $ 18.27 $ 44.22 $ 49.59 Diluted net income per share of Class A and B common stock and Class C capital stock $ 18.00 $ 43.70 $ 49.16 See accompanying notes. 51 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2017 2018 2019 Net income $ 12,662 $ 30,736 $ 34,343 Other comprehensive income (loss): Change in foreign currency translation adjustment 1,543 ( 781 ) ( 119 ) Available-for-sale investments: Change in net unrealized gains (losses) 307 88 1,611 Less: reclassification adjustment for net (gains) losses included in net income 105 ( 911 ) ( 111 ) Net change (net of tax effect of $0, $156, and $221) 412 ( 823 ) 1,500 Cash flow hedges: Change in net unrealized gains (losses) ( 638 ) 290 22 Less: reclassification adjustment for net (gains) losses included in net income 93 98 ( 299 ) Net change (net of tax effect of $247, $103, and $42) ( 545 ) 388 ( 277 ) Other comprehensive income (loss) 1,410 ( 1,216 ) 1,104 Comprehensive income $ 14,072 $ 29,520 $ 35,447 See accompanying notes. 52 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2016 691,293 $ 36,307 $ ( 2,402 ) $ 105,131 $ 139,036 Cumulative effect of accounting change 0 0 0 ( 15 ) ( 15 ) Common and capital stock issued 8,652 212 0 0 212 Stock-based compensation expense 0 7,694 0 0 7,694 Tax withholding related to vesting of restricted stock units 0 ( 4,373 ) 0 0 ( 4,373 ) Repurchases of capital stock ( 5,162 ) ( 315 ) 0 ( 4,531 ) ( 4,846 ) Sale of interest in consolidated entities 0 722 0 0 722 Net income 0 0 0 12,662 12,662 Other comprehensive income (loss) 0 0 1,410 0 1,410 Balance as of December 31, 2017 694,783 40,247 ( 992 ) 113,247 152,502 Cumulative effect of accounting change 0 0 ( 98 ) ( 599 ) ( 697 ) Common and capital stock issued 8,975 148 0 0 148 Stock-based compensation expense 0 9,353 0 0 9,353 Tax withholding related to vesting of restricted stock units and other 0 ( 4,782 ) 0 0 ( 4,782 ) Repurchases of capital stock ( 8,202 ) ( 576 ) 0 ( 8,499 ) ( 9,075 ) Sale of interest in consolidated entities 0 659 0 0 659 Net income 0 0 0 30,736 30,736 Other comprehensive income (loss) 0 0 ( 1,216 ) 0 ( 1,216 ) Balance as of December 31, 2018 695,556 45,049 ( 2,306 ) 134,885 177,628 Cumulative effect of accounting change 0 0 ( 30 ) ( 4 ) ( 34 ) Common and capital stock issued 8,120 202 0 0 202 Stock-based compensation expense 0 10,890 0 0 10,890 Tax withholding related to vesting of restricted stock units and other 0 ( 4,455 ) 0 0 ( 4,455 ) Repurchases of capital stock ( 15,341 ) ( 1,294 ) 0 ( 17,102 ) ( 18,396 ) Sale of interest in consolidated entities 0 160 0 0 160 Net income 0 0 0 34,343 34,343 Other comprehensive income (loss) 0 0 1,104 0 1,104 Balance as of December 31, 2019 688,335 $ 50,552 $ ( 1,232 ) $ 152,122 $ 201,442 See accompanying notes. 53 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2017 2018 2019 Operating activities Net income $ 12,662 $ 30,736 $ 34,343 Adjustments: Depreciation and impairment of property and equipment 6,103 8,164 10,856 Amortization and impairment of intangible assets 812 871 925 Stock-based compensation expense 7,679 9,353 10,794 Deferred income taxes 258 778 173 (Gain) loss on debt and equity securities, net 37 ( 6,650 ) ( 2,798 ) Other 294 ( 189 ) ( 592 ) Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable ( 3,768 ) ( 2,169 ) ( 4,340 ) Income taxes, net 8,211 ( 2,251 ) ( 3,128 ) Other assets ( 2,164 ) ( 1,207 ) ( 621 ) Accounts payable 731 1,067 428 Accrued expenses and other liabilities 4,891 8,614 7,170 Accrued revenue share 955 483 1,273 Deferred revenue 390 371 37 Net cash provided by operating activities 37,091 47,971 54,520 Investing activities Purchases of property and equipment ( 13,184 ) ( 25,139 ) ( 23,548 ) Purchases of marketable securities ( 92,195 ) ( 50,158 ) ( 100,315 ) Maturities and sales of marketable securities 73,959 48,507 97,825 Purchases of non-marketable investments ( 1,745 ) ( 2,073 ) ( 1,932 ) Maturities and sales of non-marketable investments 533 1,752 405 Acquisitions, net of cash acquired, and purchases of intangible assets ( 287 ) ( 1,491 ) ( 2,515 ) Proceeds from collection of notes receivable 1,419 0 0 Other investing activities 99 98 589 Net cash used in investing activities ( 31,401 ) ( 28,504 ) ( 29,491 ) Financing activities Net payments related to stock-based award activities ( 4,166 ) ( 4,993 ) ( 4,765 ) Repurchases of capital stock ( 4,846 ) ( 9,075 ) ( 18,396 ) Proceeds from issuance of debt, net of costs 4,291 6,766 317 Repayments of debt ( 4,377 ) ( 6,827 ) ( 585 ) Proceeds from sale of interest in consolidated entities 800 950 220 Net cash used in financing activities ( 8,298 ) ( 13,179 ) ( 23,209 ) Effect of exchange rate changes on cash and cash equivalents 405 ( 302 ) ( 23 ) Net increase (decrease) in cash and cash equivalents ( 2,203 ) 5,986 1,797 Cash and cash equivalents at beginning of period 12,918 10,715 16,701 Cash and cash equivalents at end of period $ 10,715 $ 16,701 $ 18,498 Supplemental disclosures of cash flow information Cash paid for taxes, net of refunds $ 6,191 $ 5,671 $ 8,203 See accompanying notes. 54 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. In 2015, we implemented a holding company reorganization, and as a result, Alphabet Inc. (Alphabet) became the successor issuer to Google. We generate revenues primarily by delivering relevant, cost-effective online advertising. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and entities consolidated under the variable interest and voting models. Noncontrolling interests are not presented separately as the amounts are not material. All intercompany balances and transactions have been eliminated. Use of Estimates Preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the bad debt allowance, sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, and contingent liabilities, among others. We base our estimates on assumptions, both historical and forward looking, that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Revenue Recognition We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. See Note 2 for further discussion on Revenues. Cost of Revenues Cost of revenues consists of TAC and other costs of revenues. TAC represents the amounts paid to Google Network Members primarily for ads displayed on their properties and amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. Other cost of revenues (which is the cost of revenues excluding TAC) includes the following: • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Expenses associated with our data centers and other operations (including bandwidth, compensation expense (including SBC), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. Stock-based Compensation Stock-based compensation primarily consists of Alphabet restricted stock units (RSUs). RSUs are equity classified and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period and account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the applicable statutory tax withholding to be paid by us on behalf of our employees. As a result, fewer shares are issued than the number of RSUs outstanding and the tax withholding is recorded as a reduction to additional paid-in capital. Additionally, stock-based compensation includes stock-based awards, such as performance stock units (PSUs) and awards that may be settled in cash or the stock of certain of our Other Bets. PSUs are equity classified and expense is recognized over the requisite service period. Awards that are liability classified are remeasured at fair value through 55 Table of Contents Alphabet Inc. settlement or maturity (six months and one day after vesting). The fair value of such awards is based on the equity valuation of the respective Other Bet. Performance Fees We have compensation arrangements with payouts based on realized investment returns. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized. Performance fees, which are primarily related to gains on equity securities, are recorded as a component of other income (expense), net. Certain Risks and Concentrations Our revenues are primarily derived from online advertising, the market for which is highly competitive and rapidly changing. In addition, our revenues are generated from a multitude of markets in countries around the world. Significant changes in this industry or changes in customer buying or advertiser spending behavior could adversely affect our operating results. No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2017 , 2018 , or 2019 . In 2017 , 2018 , and 2019 , we generated approximately 47 % , 46 % , and 46 % of our revenues, respectively, from customers based in the U.S. We are subject to concentrations of credit risk principally from cash and cash equivalents, marketable securities, foreign exchange contracts, and accounts receivable. We manage our credit risk exposure through timely assessment of our counterparty creditworthiness, credit limits and use of collateral management. Cash equivalents and marketable securities consist primarily of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, mortgage-backed securities, and asset-backed securities. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. We perform ongoing evaluations to determine customer credit and we limit the amount of credit we extend. We generally do not require collateral from our customers. We maintain reserves for estimated credit losses and these losses have generally been within our expectations. Fair Value of Financial Instruments Our financial assets and liabilities that are measured at fair value on a recurring basis include cash equivalents, marketable securities, derivative contracts, and non-marketable debt securities. Our financial assets measured at fair value on a nonrecurring basis include non-marketable equity securities, which are adjusted to fair value when observable price changes are identified or when the non-marketable equity securities are impaired (referred to as the measurement alternative) . Other financial assets and liabilities are carried at cost with fair value disclosed, if required. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash, Cash Equivalents, and Marketable Securities We invest all excess cash primarily in government bonds, corporate debt securities, mortgage-backed and asset-backed securities, time deposits, and money market funds. 56 Table of Contents Alphabet Inc. We classify all marketable investments that have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities. We determine the appropriate classification of our investments in marketable securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable debt securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these debt securities prior to their stated maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities on the Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for unrealized losses determined to be other-than-temporary, which we record within other income (expense), net. We determine any realized gains or losses on the sale of marketable debt securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Non-Marketable Investments We account for non-marketable equity investments through which we exercise significant influence but do not have control over the investee under the equity method. Our non-marketable equity securities not accounted for under the equity method are primarily accounted for under the measurement alternative in accordance with Accounting Standards Update No. 2016-01, which we adopted on January 1, 2018. Under the measurement alternative, the carrying value of our non-marketable equity investments is adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment. Adjustments are determined primarily based on a market approach as of the transaction date. We account for our non-marketable investments that meet the definition of a debt security as available-for-sale securities. We classify our non-marketable investments that do not have stated contractual maturity dates, as non-current assets on the Consolidated Balance Sheets. Impairment of Investments We periodically review our debt and equity investments for impairment. For debt securities we consider the duration, severity and the reason for the decline in security value; whether it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis; or if the amortized cost basis cannot be recovered as a result of credit losses. If any impairment is considered other-than-temporary, we will write down the security to its fair value and record the corresponding charge as other income (expense), net. For equity securities we consider impairment indicators such as negative changes in industry and market conditions, financial performance, business prospects, and other relevant events and factors. If indicators exist and the fair value of the security is below the carrying amount, we write down the security to fair value. Variable Interest Entities We determine at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests in is considered a variable interest entity (VIE). We consolidate VIEs when we are the primary beneficiary. The primary beneficiary of a VIE is the party that meets both of the following criteria: (1) has the power to make decisions that most significantly affect the economic performance of the VIE; and (2) has the obligation to absorb losses or the right to receive benefits that in either case could potentially be significant to the VIE. Periodically, we assess whether any changes in our interest or relationship with the entity affect our determination of whether the entity is still a VIE and, if so, whether we are the primary beneficiary. If we are not the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Accounts Receivable We record accounts receivable at the invoiced amount. We maintain an allowance for doubtful accounts to reserve for potentially uncollectible receivables. We review the accounts receivable by amounts due from customers that are past due to identify specific customers with known disputes or collectability issues. In determining the amount of the reserve, we make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Our payment terms vary by the type and location of our customer and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customer types, we require payment before the products or services are delivered to the customer. 57 Table of Contents Alphabet Inc. Leases We determine if an arrangement is a lease at inception. Our lease agreements generally contain lease and non-lease components. Payments under our lease arrangements are primarily fixed. Non-lease components primarily include payments for maintenance and utilities. We combine fixed payments for non-lease components with lease payments and account for them together as a single lease component which increases the amount of our lease assets and liabilities. Certain lease agreements contain variable payments, which are expensed as incurred and not included in the lease assets and liabilities. These amounts include payments affected by the Consumer Price Index, payments contingent on wind or solar production for power purchase arrangements, and payments for maintenance and utilities. Lease assets and liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is our incremental borrowing rate, because the interest rate implicit in our leases is not readily determinable. Our incremental borrowing rate is estimated to approximate the interest rate on a collateralized basis with similar terms and payments, and in economic environments where the leased asset is located. Our lease terms include periods under options to extend or terminate the lease when it is reasonably certain that we will exercise that option. We generally use the base, non-cancelable, lease term when determining the lease assets and liabilities. Lease assets also include any prepaid lease payments and lease incentives. Operating lease assets and liabilities are included on our Consolidated Balance Sheet beginning January 1, 2019. The current portion of our operating lease liabilities is included in accrued expenses and other current liabilities and the long term portion is included in operating lease liabilities. Finance lease assets are included in property and equipment, net. Finance lease liabilities are included in accrued expenses and other current liabilities or long-term debt. Operating lease expense is recognized on a straight-line basis over the lease term. Property and Equipment Property and equipment includes the following categories: land and buildings, information technology assets, construction in progress, leasehold improvements, and furniture and fixtures. Land and buildings include land, offices, data centers and related building improvements. Information technology assets include servers and network equipment. We account for property and equipment at cost less accumulated depreciation. We compute depreciation using the straight-line method over the estimated useful lives of the assets. We depreciate buildings over periods of seven to 25 years. We depreciate information technology assets generally over periods of three to five years (specifically, three years for servers and three to five years for network equipment). We depreciate leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed in service for our intended use. Depreciation for equipment, buildings, and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of the acquisitions to the assets acquired and liabilities assumed based on their estimated fair 58 Table of Contents Alphabet Inc. values. The excess of the purchase price over the fair values of identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment, long-term prepayments and intangible assets, excluding goodwill, for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets are not recoverable, the impairment recognized is measured as the amount by which the carrying value of the asset exceeds its fair value. Impairments were not material for the periods presented. We allocate goodwill to reporting units based on the expected benefit from the business combination. We evaluate our reporting units when changes in our operating structure occur, and if necessary, reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairments were not material for the periods presented. Intangible assets with definite lives are amortized over their estimated useful lives. We amortize intangible assets on a straight-line basis with definite lives generally over periods ranging from one to twelve years . Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more likely than not that they will not be realized. We recognize the financial statement effects of a tax position when it is more likely than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Foreign Currency Generally, the functional currency of our international subsidiaries is the local currency. We translate the financial statements of these subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in accumulated other comprehensive income (AOCI) as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange gain (loss) in other income (expense), net. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2017 , 2018 and 2019 , advertising and promotional expenses totaled approximately $ 5.1 billion , $ 6.4 billion , and $ 6.8 billion , respectively. Recent Accounting Pronouncements Recently issued accounting pronouncements not yet adopted In June 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2016-13 (ASU 2016-13) "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments", which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. ASU 2016-13 replaces the existing incurred loss impairment model with an expected loss model which requires the use of forward-looking information to calculate credit loss estimates. It also eliminates the concept of other-than-temporary impairment and requires credit losses related to available-for-sale debt securities to be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. These changes will result in earlier recognition of credit losses. We will adopt ASU 2016-13 effective January 1, 2020 with the cumulative effect of adoption recorded as an adjustment to retained earnings. The effect on our consolidated financial statements and related disclosures is not expected to be material. 59 Table of Contents Alphabet Inc. Recently adopted accounting pronouncements In February 2016, the FASB issued Accounting Standards Update No. 2016-02 (Topic 842) "Leases." Topic 842 supersedes the lease requirements in Accounting Standards Codification Topic 840, "Leases." Under Topic 842, lessees are required to recognize assets and liabilities on the balance sheet for most leases and provide enhanced disclosures. Leases continue to be classified as either finance or operating. We adopted Topic 842 effective January 1, 2019. The most significant effects of Topic 842 were the recognition of $ 8.0 billion of operating lease assets and $ 8.4 billion of operating lease liabilities and the de-recognition of $ 1.5 billion of build-to-suit assets and liabilities upon adoption. We applied Topic 842 to all leases as of January 1, 2019 with comparative periods continuing to be reported under Topic 840. In the adoption of Topic 842, we carried forward the assessment from Topic 840 of whether our contracts contain or are leases, the classification of our leases, and remaining lease terms. Our accounting for finance leases remains substantially unchanged. The standard did not have a significant effect on our consolidated results of operations or cash flows. See Note 4 for further details. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. Hedging gains (losses), which were previously included in Google revenues, are now reported separately as a component of total revenues for all periods presented. See Note 2 for further details. Additionally, performance fees have been reclassified for all periods from general and administrative expenses to other income (expense), net to align with the presentation of the investment gains and losses on which the performance fees are based. See Note 7 for further details. Note 2. Revenues Revenue Recognition Revenues are recognized when control of the promised goods or services is transferred to our customers, in an amount that we expect in exchange for those goods or services. Sales and other similar taxes are excluded from revenues. The following table presents our revenues disaggregated by type (in millions). Certain amounts in prior periods have been reclassified to conform with current period presentation. Year Ended December 31, 2017 2018 2019 Google Search & other $ 69,811 $ 85,296 $ 98,115 YouTube ads (1) 8,150 11,155 15,149 Google properties 77,961 96,451 113,264 Google Network Members' properties 17,616 20,010 21,547 Google advertising 95,577 116,461 134,811 Google Cloud 4,056 5,838 8,918 Google other (1) 10,914 14,063 17,014 Google revenues 110,547 136,362 160,743 Other Bets revenues 477 595 659 Hedging gains (losses) ( 169 ) ( 138 ) 455 Total revenues $ 110,855 $ 136,819 $ 161,857 (1) YouTube non-advertising revenues are included in Google other revenues. 60 Table of Contents Alphabet Inc. The following table presents our revenues disaggregated by geography, based on the addresses of our customers (in millions): Year Ended December 31, 2017 2018 2019 United States $ 52,449 47 % $ 63,269 46 % $ 74,843 46 % EMEA (1) 36,236 33 44,739 33 50,645 31 APAC (1) 16,192 15 21,341 15 26,928 17 Other Americas (1) 6,147 5 7,608 6 8,986 6 Hedging gains (losses) ( 169 ) 0 ( 138 ) 0 455 0 Total revenues $ 110,855 100 % $ 136,819 100 % $ 161,857 100 % (1) Regions represent Europe, the Middle East, and Africa (EMEA); Asia-Pacific (APAC); and Canada and Latin America (Other Americas). Advertising Revenues We generate advertising revenues primarily by delivering advertising on Google properties, including Google.com, the Google Search app, YouTube, Google Play, Gmail and Google Maps; and Google Network Members’ properties. Our customers generally purchase advertising inventory through Google Ads, Google Ad Manager as part of the Authorized Buyers marketplace, and Google Marketing Platform, among others. We offer advertising on a click, impression or view basis. We recognize revenue each time a user clicks on the ad, when the ad is displayed or a user views the ad. For ads placed on Google Network Members’ properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues for ads placed on Google Network Members’ properties on a gross basis, that is, the amounts billed to our customers are recorded as revenues, and amounts paid to Google Network Members are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers, and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. Google Cloud Revenues Google Cloud revenues consist primarily of revenues from Google Cloud Platform (which includes infrastructure and data and analytics platform products, and other services), G Suite productivity tools and other enterprise cloud services. Our cloud revenues are provided on either a consumption or subscription basis. Revenue related to cloud services provided on a consumption basis is recognized when the customer utilizes the services, based on the quantity of services consumed. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract term as the customer receives and consumes the benefits of the cloud services. Other Revenues Google other revenues and Other Bets revenues consist primarily of revenues from: • Google Play, which includes revenues from sale of apps and in-app purchases (which we recognize net of payout to developers) and digital content sold in the Google Play store; • hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; • YouTube non-advertising including, YouTube premium and YouTube TV subscriptions and other services; and • other products and services. As it relates to Google other revenues, the most significant judgment is determining whether we are the principal or agent for app sales and in-app purchases through the Google Play store. We report revenues from these transactions on a net basis because our performance obligation is to facilitate a transaction between app developers and end users, for which we earn a commission. Consequently, the portion of the gross amount billed to end users that is remitted to app developers is not reflected as revenues. Arrangements with Multiple Performance Obligations Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenues to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers or using expected cost plus margin. 61 Table of Contents Alphabet Inc. Customer Incentives and Credits Certain customers receive cash-based incentives or credits, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenues. We believe that there will not be significant changes to our estimates of variable consideration. Deferred Revenues We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. The increase in the deferred revenue balance for the year ended December 31, 2019 was primarily driven by cash payments received or due in advance of satisfying our performance obligations, offset by $ 1.7 billion of revenues recognized that were included in the deferred revenue balance as of December 31, 2018 . Additionally, we have performance obligations associated with commitments in customer contracts, primarily related to Google Cloud, for future services that have not yet been recognized in revenue. This includes related deferred revenue currently recorded and amounts that will be invoiced in future periods. As of December 31, 2019 , the amount not yet recognized in revenue from these commitments is $ 11.4 billion , which reflects our assessment of relevant contract terms. This amount excludes contracts (i) with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. We expect to recognize approximately two thirds over the next 24 months with the remaining thereafter. However, the amount and timing of revenue recognition is largely driven by customer utilization, which could impact our estimate of the remaining amount of commitments and when we expect to recognize such revenues. Sales Commissions We generally expense sales commissions when incurred because the amortization period would have been one year or less. These costs are recorded within sales and marketing expenses. Note 3. Financial Instruments Debt Securities We classify our marketable debt securities within Level 2 in the fair value hierarchy because we use quoted market prices to the extent available or alternative pricing sources and models utilizing market observable inputs to determine fair value. The following tables summarize our debt securities by significant investment categories as of December 31, 2018 and 2019 (in millions): As of December 31, 2018 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Level 2: Time deposits (1) $ 2,202 $ 0 $ 0 $ 2,202 $ 2,202 $ 0 Government bonds 53,634 71 ( 414 ) 53,291 3,717 49,574 Corporate debt securities 25,383 15 ( 316 ) 25,082 44 25,038 Mortgage-backed and asset-backed securities 16,918 11 ( 324 ) 16,605 0 16,605 Total $ 98,137 $ 97 $ ( 1,054 ) $ 97,180 $ 5,963 $ 91,217 62 Table of Contents Alphabet Inc. As of December 31, 2019 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Level 2: Time deposits (1) $ 2,294 $ 0 $ 0 $ 2,294 $ 2,294 $ 0 Government bonds 55,033 434 ( 30 ) 55,437 4,518 50,919 Corporate debt securities 27,164 337 ( 3 ) 27,498 44 27,454 Mortgage-backed and asset-backed securities 19,453 96 ( 41 ) 19,508 0 19,508 Total $ 103,944 $ 867 $ ( 74 ) $ 104,737 $ 6,856 $ 97,881 (1) The majority of our time deposits are domestic deposits. We determine realized gains or losses on the sale or extinguishment of debt securities on a specific identification method. We recognized gross realized gains of $ 185 million , $ 1.3 billion , and $ 292 million for the years ended December 31, 2017 , 2018 , and 2019 , respectively. We recognized gross realized losses of $ 295 million , $ 143 million , and $ 143 million for the years ended December 31, 2017 , 2018 , and 2019 , respectively. We reflect these gains and losses as a component of other income (expense), net, in the Consolidated Statements of Income. The following table summarizes the estimated fair value of our investments in marketable debt securities with stated contractual maturity dates, accounted for as available-for-sale securities and classified by the contractual maturity date of the securities (in millions): As of December 31, 2019 Due in 1 year $ 20,392 Due in 1 year through 5 years 63,151 Due in 5 years through 10 years 2,671 Due after 10 years 11,667 Total $ 97,881 The following tables present gross unrealized losses and fair values for those investments that were in an unrealized loss position as of December 31, 2018 and 2019 , aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2018 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 12,019 $ ( 85 ) $ 23,877 $ ( 329 ) $ 35,896 $ ( 414 ) Corporate debt securities 10,171 ( 107 ) 11,545 ( 209 ) 21,716 ( 316 ) Mortgage-backed and asset-backed securities 5,534 ( 75 ) 8,519 ( 249 ) 14,053 ( 324 ) Total $ 27,724 $ ( 267 ) $ 43,941 $ ( 787 ) $ 71,665 $ ( 1,054 ) As of December 31, 2019 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 6,752 $ ( 20 ) $ 4,590 $ ( 10 ) $ 11,342 $ ( 30 ) Corporate debt securities 1,665 ( 2 ) 978 ( 1 ) 2,643 ( 3 ) Mortgage-backed and asset-backed securities 4,536 ( 13 ) 2,835 ( 28 ) 7,371 ( 41 ) Total $ 12,953 $ ( 35 ) $ 8,403 $ ( 39 ) $ 21,356 $ ( 74 ) 63 Table of Contents Alphabet Inc. During the years ended December 31, 2017 , 2018 and 2019 , we did not recognize any significant other-than-temporary impairment losses. Equity Investments The following discusses our marketable equity securities, non-marketable equity securities, gains and losses on marketable and non-marketable equity securities, as well as our equity securities accounted for under the equity method. Our marketable equity securities are publicly traded stocks or funds measured at fair value and classified within Level 1 and 2 in the fair value hierarchy because we use quoted prices for identical assets in active markets or inputs that are based upon quoted prices for similar instruments in active markets. All gains and losses on marketable equity securities, realized and unrealized, are recognized in other income (expense), net. Our non-marketable equity securities are investments in privately held companies without readily determinable market values. The carrying value of our non-marketable equity securities is adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). All gains and losses on non-marketable equity securities, realized and unrealized, are recognized in other income (expense), net. Non-marketable equity securities that have been remeasured during the period are classified within Level 2 or Level 3 in the fair value hierarchy because we estimate the value based on valuation methods using the observable transaction price at the transaction date and other unobservable inputs including volatility, rights, and obligations of the securities we hold. Gains and losses on marketable and non-marketable equity securities Gains and losses reflected in other income (expense), net, for our marketable and non-marketable equity securities are summarized below (in millions): Year Ended December 31, 2018 2019 Net gain (loss) on equity securities sold during the period $ 1,458 $ ( 301 ) Net unrealized gain (loss) on equity securities held as of the end of the period (1) 4,002 2,950 Total gain (loss) recognized in other income (expense), net $ 5,460 $ 2,649 (1) Includes net gains of $ 4.1 billion and $ 1.8 billion related to non-marketable equity securities for the years ended December 31, 2018 and 2019 , respectively. In the table above, net gain (loss) on equity securities sold during the period reflects the difference between the sale proceeds and the carrying value of the equity securities at the beginning of the period or the purchase date, if later. Cumulative net gains on equity securities sold during the period, which is summarized in the following table (in millions), represents the total net gains (losses) recognized after the initial purchase date of the equity security. While these net gains may have been reflected in periods prior to the period of sale, we believe they are important supplemental information as they reflect the economic realized gain on the securities sold during the period. Cumulative net gains is calculated as the difference between the sale price and the initial purchase price for the equity security sold during the period. Equity Securities Sold During the Year Ended December 31, 2018 2019 Total sale price $ 1,965 $ 3,134 Total initial cost 515 858 Cumulative net gains $ 1,450 $ 2,276 64 Table of Contents Alphabet Inc. Carrying value of marketable and non-marketable equity securities The carrying value is measured as the total initial cost plus the cumulative net gain (loss). The carrying values for our marketable and non-marketable equity securities are summarized below (in millions): As of December 31, 2018 Marketable Securities Non-Marketable Securities Total Total initial cost $ 1,168 $ 8,168 $ 9,336 Cumulative net gain (1) 54 4,107 4,161 Carrying value $ 1,222 $ 12,275 $ 13,497 (1) Non-marketable securities cumulative net gain is comprised of $ 4.3 billion unrealized gains and $ 178 million unrealized losses (including impairment). As of December 31, 2019 Marketable Securities Non-Marketable Securities Total Total initial cost $ 1,935 $ 8,297 $ 10,232 Cumulative net gain (1) 1,361 3,056 4,417 Carrying value $ 3,296 $ 11,353 $ 14,649 (1) Non-marketable securities cumulative net gain is comprised of $ 3.5 billion unrealized gains and $ 445 million unrealized losses (including impairment). Marketable equity securities The following table summarizes marketable equity securities measured at fair value by significant investment categories as of December 31, 2018 and 2019 (in millions): As of December 31, 2018 As of December 31, 2019 Cash and Cash Equivalents Marketable Securities Cash and Cash Equivalents Marketable Securities Level 1: Money market funds $ 3,493 $ 0 $ 4,604 $ 0 Marketable equity securities (1) 0 994 0 3,046 3,493 994 4,604 3,046 Level 2: Mutual funds 0 228 0 250 Total $ 3,493 $ 1,222 $ 4,604 $ 3,296 (1) The balance a s of December 31, 2019 includes investments that were reclassified from non-marketable equity securities following the initial public offering of the issuers. Non-marketable equity securities The following is a summary of unrealized gains and losses recorded in other income (expense), net, and included as adjustments to the carrying value of non-marketable equity securities (in millions): Year Ended December 31, 2018 2019 Unrealized gains $ 4,285 $ 2,163 Unrealized losses (including impairment) ( 178 ) ( 372 ) Total unrealized gain (loss) for non-marketable equity securities $ 4,107 $ 1,791 During the year ended December 31, 2019 , included in the $ 11.4 billion of non-marketable equity securities, $ 7.6 billion were measured at fair value primarily based on observable market transactions, resulting in a net unrealized gain of $ 1.8 billion . 65 Table of Contents Alphabet Inc. Equity securities accounted for under the Equity Method Equity securities accounted for under the equity method had a carrying value of approximately $ 1.3 billion as of December 31, 2018 and 2019 . Our share of gains and losses including impairment are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 7 for further details on other income (expense), net. Derivative Financial Instruments We classify our foreign currency and interest rate derivative contracts primarily within Level 2 in the fair value hierarchy as the valuation inputs are based on quoted prices and market observable data of similar instruments. We recognize derivative instruments as either assets or liabilities in the Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the Consolidated Statements of Income as either other income (expense), net, or revenues, or in the Consolidated Balance Sheets in AOCI, as discussed below. Any components excluded from the assessment of hedge effectiveness are recognized in the same income statement line as the hedged item. We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows, earnings, and investment in foreign subsidiaries will be adversely affected by foreign currency exchange rate fluctuations. We also use interest rate derivative contracts to hedge interest rate exposures on our fixed income securities and debt issuances. Our program is not used for trading or speculative purposes. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. To further reduce credit risk, we enter into collateral security arrangements under which the counterparty is required to provide collateral when the net fair value of certain financial instruments fluctuates from contractually established thresholds. We can take possession of the collateral in the event of counterparty default. As of December 31, 2018 and 2019 , we received cash collateral related to the derivative instruments under our collateral security arrangements of $ 327 million and $ 252 million , respectively, which was included in other current assets. Cash Flow Hedges We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options), designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. The notional principal of these contracts was approximately $ 11.8 billion and $ 13.2 billion as of December 31, 2018 and 2019 , respectively. These contracts have maturities of 24 months or less. For forwards and option contracts, we exclude the change in the forward points and time value from our assessment of hedge effectiveness. The initial value of the excluded component is amortized on a straight-line basis over the life of the hedging instrument and recognized in revenues. The difference between fair value changes of the excluded component and the amount amortized to revenues is recorded in AOCI. We reflect the gains or losses of a cash flow hedge included in our hedge effective assessment as a component of AOCI and subsequently reclassify these gains and losses to revenues when the hedged transactions are recorded. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI are immediately reclassified to other income (expense), net. As of December 31, 2019 , the net accumulated loss on our foreign currency cash flow hedges before tax effect was $ 82 million , of which $ 82 million is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. We exclude changes in forward points for the forward contracts from the assessment of hedge effectiveness. We recognize changes in the excluded component in other income (expense), net. The notional principal of these contracts was $ 2.0 billion and $ 455 million as of December 31, 2018 and 2019 , respectively. Gains and losses on these forward contracts are recognized in other income (expense), net, along with the offsetting gains and losses of the related hedged items. Net Investment Hedges We use forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. We exclude changes in forward points for the forward contracts from the assessment of hedge effectiveness. We recognize changes in the excluded component in other income (expense), 66 Table of Contents Alphabet Inc. net. The notional principal of these contracts was $ 6.7 billion and $ 9.3 billion as of December 31, 2018 and 2019 , respectively. Gains and losses on these forward contracts are recognized in AOCI as part of the foreign currency translation adjustment. Other Derivatives Other derivatives not designated as hedging instruments consist of foreign currency forward contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts, as well as the related costs in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. The notional principal of the outstanding foreign exchange contracts was $ 20.1 billion and $ 43.5 billion as of December 31, 2018 and 2019 , respectively. The fair values of our outstanding derivative instruments were as follows (in millions): As of December 31, 2018 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 459 $ 54 $ 513 Total $ 459 $ 54 $ 513 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 5 $ 228 $ 233 Total $ 5 $ 228 $ 233 As of December 31, 2019 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 91 $ 253 $ 344 Total $ 91 $ 253 $ 344 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 173 $ 196 $ 369 Total $ 173 $ 196 $ 369 67 Table of Contents Alphabet Inc. The gains (losses) on derivatives in cash flow hedging and net investment hedging relationships recognized in other comprehensive income (OCI) are summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect Year Ended December 31, 2017 2018 2019 Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness $ ( 955 ) $ 332 $ 38 Amount excluded from the assessment of effectiveness 0 26 ( 14 ) Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness 0 136 131 Total $ ( 955 ) $ 494 $ 155 68 Table of Contents Alphabet Inc. The effect of derivative instruments on income is summarized below (in millions): Gains (Losses) Recognized in Income Year Ended December 31, 2017 2018 2019 Revenues Other income (expense), net Revenues Other income (expense), net Revenues Other income (expense), net Total amounts presented in the Consolidated Statements of Income in which the effects of cash flow and fair value hedges are recorded $ 110,855 $ 1,015 $ 136,819 $ 7,389 $ 161,857 $ 5,394 Gains (Losses) on Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount of gains (losses) reclassified from AOCI to income $ ( 169 ) $ 0 $ ( 139 ) $ 0 $ 367 $ 0 Amount excluded from the assessment of effectiveness recognized in earnings based on an amortization approach 0 0 1 0 88 0 Amount excluded from the assessment of effectiveness 0 83 0 0 0 0 Gains (Losses) on Derivatives in Fair Value Hedging Relationship: Foreign exchange contracts Hedged items 0 197 0 ( 96 ) 0 ( 19 ) Derivatives designated as hedging instruments 0 ( 197 ) 0 96 0 19 Amount excluded from the assessment of effectiveness 0 23 0 37 0 25 Gains (Losses) on Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount excluded from the assessment of effectiveness 0 0 0 78 0 243 Gains (Losses) on Derivatives Not Designated as Hedging Instruments: Foreign exchange contracts Derivatives not designated as hedging instruments 0 ( 230 ) 0 54 0 ( 413 ) Total gains (losses) $ ( 169 ) $ ( 124 ) $ ( 138 ) $ 169 $ 455 $ ( 145 ) Offsetting of Derivatives We present our forwards and purchased options at gross fair values in the Consolidated Balance Sheets. For foreign currency collars, we present at net fair values where both purchased and written options are with the same counterparty. Our master netting and other similar arrangements allow net settlements under certain conditions. As of December 31, 2018 and 2019 , information related to these offsetting arrangements were as follows (in millions): 69 Table of Contents Alphabet Inc. Offsetting of Assets As of December 31, 2018 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 569 $ ( 56 ) $ 513 $ ( 90 ) (1) $ ( 307 ) $ ( 14 ) $ 102 As of December 31, 2019 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 365 $ ( 21 ) $ 344 $ ( 88 ) (1) $ ( 234 ) $ 0 $ 22 (1) The balances as of December 31, 2018 and 2019 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. Offsetting of Liabilities As of December 31, 2018 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 289 $ ( 56 ) $ 233 $ ( 90 ) (2) $ 0 $ 0 $ 143 As of December 31, 2019 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 390 $ ( 21 ) $ 369 $ ( 88 ) (2) $ 0 $ 0 $ 281 (2) The balances as of December 31, 2018 and 2019 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 4. Leases We have entered into operating and finance lease agreements primarily for data centers, land and offices throughout the world with lease periods expiring between 2020 and 2063 . Components of operating lease expense were as follows (in millions): Year Ended December 31, 2019 Operating lease cost $ 1,820 Variable lease cost 541 Total operating lease cost $ 2,361 70 Table of Contents Alphabet Inc. Supplemental information related to operating leases was as follows (in millions): Year Ended December 31, 2019 Cash payments for operating leases $ 1,661 New operating lease assets obtained in exchange for operating lease liabilities $ 4,391 As of December 31, 2019 , our operating leases had a weighted average remaining lease term of 10 years and a weighted average discount rate of 2.8 % . Future lease payments under operating leases as of December 31, 2019 were as follows (in millions): 2020 $ 1,757 2021 1,845 2022 1,680 2023 1,508 2024 1,301 Thereafter 5,763 Total future lease payments 13,854 Less imputed interest ( 2,441 ) Total lease liability balance $ 11,413 As of December 31, 2019 , we have entered into leases that have not yet commenced with future lease payments of $ 7.4 billion , excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2020 and 2026 with non-cancelable lease terms of 1 to 25 years. Supplemental Information for Comparative Periods As of December 31, 2018, prior to the adoption of Topic 842, future minimum payments under operating leases having initial or remaining non-cancelable lease terms in excess of one year, net of sublease income amounts, were as follows (in millions): Operating Leases (1) Sub-lease Income Net Operating Leases 2019 $ 1,319 $ 16 $ 1,303 2020 1,397 13 1,384 2021 1,337 10 1,327 2022 1,153 8 1,145 2023 980 3 977 Thereafter 3,916 5 3,911 Total minimum payments $ 10,102 $ 55 $ 10,047 (1) Includes future minimum payments for leases which have not yet commenced. Rent expense under operating leases was $ 1.1 billion and $ 1.3 billion for the years ended December 31, 2017, and 2018, respectively. Note 5. Variable Interest Entities (VIEs) Consolidated VIEs We consolidate VIEs in which we hold a variable interest and are the primary beneficiary. We are the primary beneficiary because we have the power to direct activities that most significantly affect their economic performance and have the obligation to absorb the majority of their losses or benefits. The results of operations and financial position of these VIEs are included in our consolidated financial statements. For certain consolidated VIEs, their assets are not available to us and their creditors do not have recourse to us. As of December 31, 2018 and 2019 , assets that can only be used to settle obligations of these VIEs were $ 2.4 billion and $ 3.1 billion , respectively, and the liabilities for which creditors only have recourse to the VIEs were $ 909 million and $ 1.2 billion , respectively. 71 Table of Contents Alphabet Inc. Calico Calico is a life science company with a mission to harness advanced technologies to increase our understanding of the biology that controls lifespan. In September 2014, AbbVie Inc. (AbbVie) and Calico entered into a research and development collaboration agreement intended to help both companies discover, develop, and bring to market new therapies for patients with age-related diseases, including neurodegeneration and cancer. In the second quarter of 2018, AbbVie and Calico amended the collaboration agreement resulting in an increase in total commitments. As of December 31, 2019 , AbbVie has contributed $ 1,250 million to fund the collaboration pursuant to the agreement. As of December 31, 2019 , Calico has contributed $ 500 million and has committed up to an additional $ 750 million . Calico has used its scientific expertise to establish a world-class research and development facility, with a focus on drug discovery and early drug development; and AbbVie provides scientific and clinical development support and its commercial expertise to bring new discoveries to market. Both companies share costs and profits for projects covered under this agreement equally. AbbVie's contribution has been recorded as a liability on Calico's financial statements, which is reduced and reflected as a reduction to research and development expense as eligible research and development costs are incurred by Calico. As of December 31, 2019 , we have contributed $ 480 million to Calico in exchange for Calico convertible preferred units and are committed to fund up to an additional $ 750 million on an as-needed basis and subject to certain conditions. Verily Verily is a life science and healthcare company with a mission to make the world's health data useful so that people enjoy healthier lives. In December 2018, Verily received $ 900 million in cash from a $ 1.0 billion investment round. The remaining $ 100 million was received in the first quarter of 2019. As of December 31, 2019 , Verily has received an aggregate amount of $ 1.8 billion from sales of equity securities to external investors. These transactions were accounted for as equity transactions and no gain or loss was recognized. In the fourth quarter of 2019, Verily obtained a controlling financial interest in Onduo, an existing equity method investment. The transaction resulted in a $ 357 million gain from the revaluation of the previously held economic interest, which was recognized in other income (expense), net. Unconsolidated VIEs Certain of our non-marketable investments, including certain renewable energy investments accounted for under the equity method and certain other investments in private companies, are VIEs. The renewable energy entities' activities involve power generation using renewable sources. Private companies that we invest in are primarily early stage companies. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly affect their economic performance. Therefore, we do not consolidate these VIEs in our consolidated financial statements. The maximum exposure of these unconsolidated VIEs is generally based on the current carrying value of the investments and any future funding commitments. We have determined that the single source of our exposure to these VIEs is our capital investments in them. The carrying value and maximum exposure of these unconsolidated VIEs were not material as of December 31, 2018 and 2019 . Note 6. Debt Short-Term Debt We have a debt financing program of up to $ 5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2018 and 2019 . Long-Term Debt Google issued $ 3.0 billion of senior unsecured notes in three tranches (collectively, 2011 Notes) in May 2011, due in 2014, 2016, and 2021, as well as $ 1.0 billion of senior unsecured notes (2014 Notes) in February 2014 due in 2024. In April 2016, we completed an exchange offer with eligible holders of Google’s 2011 Notes due 2021 and 2014 Notes due 2024 (collectively, the Google Notes). An aggregate principal amount of approximately $ 1.7 billion of the Google Notes was exchanged for approximately $ 1.7 billion of Alphabet notes with identical interest rate and maturity. 72 Table of Contents Alphabet Inc. Because the exchange was between a parent and the subsidiary company and for substantially identical notes, the change was treated as a debt modification for accounting purposes with no gain or loss recognized. In August 2016, Alphabet issued $ 2.0 billion of senior unsecured notes (2016 Notes) due 2026. The net proceeds from the issuance of the 2016 Notes were used for general corporate purposes, including the repayment of outstanding commercial paper. The Alphabet notes due in 2021, 2024, and 2026 rank equally with each other and are structurally subordinate to the outstanding Google Notes. The total outstanding long-term debt is summarized below (in millions): As of December 31, 2018 As of December 31, 2019 3.625% Notes due on May 19, 2021 $ 1,000 $ 1,000 3.375% Notes due on February 25, 2024 1,000 1,000 1.998% Notes due on August 15, 2026 2,000 2,000 Unamortized discount for the Notes above ( 50 ) ( 42 ) Subtotal (1) 3,950 3,958 Total future finance lease payments 62 685 Less: imputed interest for finance leases 0 ( 89 ) Total long-term debt $ 4,012 $ 4,554 (1) Includes the outstanding (and unexchanged) Google Notes issued in 2011 and 2014 and the Alphabet notes exchanged in 2016. The effective interest yields based on proceeds received from the outstanding notes due in 2021, 2024, and 2026 were 3.734 % , 3.377 % , and 2.231 % , respectively, with interest payable semi-annually. We may redeem these notes at any time in whole or in part at specified redemption prices. The total estimated fair value of all outstanding notes was approximately $ 3.9 billion and $ 4.1 billion as of December 31, 2018 and 2019 , respectively. The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. As of December 31, 2019 , the aggregate future principal payments for long-term debt including long-term finance leases for each of the next five years and thereafter are as follows (in millions): 2020 $ 0 2021 1,046 2022 46 2023 46 2024 1,047 Thereafter 2,500 Total $ 4,685 Credit Facility As of December 31, 2019 , we have $ 4.0 billion of revolving credit facilities which expire in July 2023. The interest rate for the credit facilities is determined based on a formula using certain market rates. No amounts were outstanding under the credit facilities as of December 31, 2018 and 2019 . 73 Table of Contents Alphabet Inc. Note 7. Supplemental Financial Statement Information Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2018 As of December 31, 2019 Land and buildings $ 30,179 $ 39,865 Information technology assets 30,119 36,840 Construction in progress 16,838 21,036 Leasehold improvements 5,310 6,310 Furniture and fixtures 61 156 Property and equipment, gross 82,507 104,207 Less: accumulated depreciation ( 22,788 ) ( 30,561 ) Property and equipment, net $ 59,719 $ 73,646 As of December 31, 2018 and 2019, information technology assets and land and buildings under finance leases with a cost basis of $ 648 million and $ 1.6 billion , respectively, were included in property and equipment. Accrued Expenses and Other Current Liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2018 As of December 31, 2019 European Commission fines (1) $ 7,754 $ 9,405 Accrued customer liabilities 1,810 2,245 Accrued purchases of property and equipment 1,603 2,411 Current operating lease liabilities 0 1,199 Other accrued expenses and current liabilities 5,791 7,807 Accrued expenses and other current liabilities $ 16,958 $ 23,067 (1) Includes the effects of foreign exchange and interest. See Note 10 for further details. 74 Table of Contents Alphabet Inc. Accumulated Other Comprehensive Income (Loss) The components of AOCI, net of tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2016 $ ( 2,646 ) $ ( 179 ) $ 423 $ ( 2,402 ) Other comprehensive income (loss) before reclassifications 1,543 307 ( 638 ) 1,212 Amounts reclassified from AOCI 0 105 93 198 Other comprehensive income (loss) 1,543 412 ( 545 ) 1,410 Balance as of December 31, 2017 ( 1,103 ) 233 ( 122 ) ( 992 ) Cumulative effect of accounting change 0 ( 98 ) 0 ( 98 ) Other comprehensive income (loss) before reclassifications ( 781 ) 88 264 ( 429 ) Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 26 26 Amounts reclassified from AOCI 0 ( 911 ) 98 ( 813 ) Other comprehensive income (loss) ( 781 ) ( 823 ) 388 ( 1,216 ) Balance as of December 31, 2018 ( 1,884 ) ( 688 ) 266 ( 2,306 ) Cumulative effect of accounting change 0 0 ( 30 ) ( 30 ) Other comprehensive income (loss) before reclassifications ( 119 ) 1,611 36 1,528 Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 14 ) ( 14 ) Amounts reclassified from AOCI 0 ( 111 ) ( 299 ) ( 410 ) Other comprehensive income (loss) ( 119 ) 1,500 ( 277 ) 1,104 Balance as of December 31, 2019 $ ( 2,003 ) $ 812 $ ( 41 ) $ ( 1,232 ) The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statements of Income Year Ended December 31, AOCI Components Location 2017 2018 2019 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ ( 105 ) $ 1,190 $ 149 Benefit (provision) for income taxes 0 ( 279 ) ( 38 ) Net of tax ( 105 ) 911 111 Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue ( 169 ) ( 139 ) 367 Interest rate contracts Other income (expense), net 5 6 6 Benefit (provision) for income taxes 71 35 ( 74 ) Net of tax ( 93 ) ( 98 ) 299 Total amount reclassified, net of tax $ ( 198 ) $ 813 $ 410 75 Table of Contents Alphabet Inc. Other Income (Expense), Net The components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2017 2018 2019 Interest income $ 1,312 $ 1,878 $ 2,427 Interest expense (1) ( 109 ) ( 114 ) ( 100 ) Foreign currency exchange gain (loss), net (2) ( 121 ) ( 80 ) 103 Gain (loss) on debt securities, net (3) ( 110 ) 1,190 149 Gain (loss) on equity securities, net 73 5,460 2,649 Performance fees (4) ( 32 ) ( 1,203 ) ( 326 ) Gain (loss) and impairment from equity method investments, net ( 156 ) ( 120 ) 390 Other 158 378 102 Other income (expense), net $ 1,015 $ 7,389 $ 5,394 (1) Interest expense is net of interest capitalized of $ 48 million , $ 92 million , and $ 167 million for the years ended December 31, 2017 , 2018 , and 2019 , respectively. (2) Our foreign currency exchange gain (loss), net, are related to the option premium costs and forwards points for our foreign currency hedging contracts, our foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contract losses and gains. The net foreign currency transaction losses were $ 226 million , $ 195 million , and $ 166 million for the years ended December 31, 2017 , 2018 , and 2019 , respectively. (3) During the year ended December 31, 2018, the terms of a non-marketable debt security were modified resulting in an unrealized $ 1.3 billion gain. (4) Performance fees were reclassified for prior periods from general and administrative expenses to other income (expense), net to conform with current period presentation. Note 8. Acquisitions 2019 Acquisitions Looker In December 2019, we obtained all regulatory clearances necessary to close the acquisition of Looker, a unified platform for business intelligence, data applications and embedded analytics for $ 2.4 billion , with integration pending approval from a UK regulatory review. The addition of Looker to Google Cloud is expected to help customers accelerate how they analyze data, deliver business intelligence, and build data-driven applications. The fair value of assets acquired and liabilities assumed was recorded based on a preliminary valuation and our estimates and assumptions are subject to change within the measurement period. The $ 2.4 billion purchase price includes our previously held equity interest and excludes post acquisition compensation arrangements. In aggregate, $ 91 million was cash acquired, $ 290 million was attributed to intangible assets, $ 1.9 billion to goodwill and $ 48 million to net assets acquired . Goodwill was recorded in the Google segment and primarily attributable to synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. Other Acquisitions During the year ended December 31, 2019 , we completed other acquisitions and purchases of intangible assets for total consideration of approximately $ 1.0 billion . In aggregate, $ 28 million was cash acquired, $ 282 million was attributed to intangible assets, $ 904 million to goodwill and $ 185 million to net liabilities assumed . These acquisitions generally enhance the breadth and depth of our offerings and expand our expertise in engineering and other functional areas. Pro forma results of operations for these acquisitions, including Looker, have not been presented because they are not material to the consolidated results of operations, either individually or in the aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2019 , patents and developed technology have a weighted-average useful life of 3.5 years, customer relationships have a weighted-average useful life of 6.3 years, and trade names and other have a weighted-average useful life of 4.5 years. Pending Acquisition of Fitbit In November 2019, we entered into an agreement to acquire Fitbit, a leading wearables brand, for $ 7.35 per share, representing a total purchase price of approximately $ 2.1 billion as of the date of the agreement. The acquisition 76 Table of Contents Alphabet Inc. of Fitbit is expected to be completed in 2020, subject to customary closing conditions, including the receipt of regulatory approvals. Upon the close of the acquisition, Fitbit will be part of Google segment. Note 9. Goodwill and Other Intangible Assets Goodwill Changes in the carrying amount of goodwill for the years ended December 31, 2018 and 2019 were as follows (in millions): Google Other Bets Total Consolidated Balance as of December 31, 2017 $ 16,295 $ 452 $ 16,747 Acquisitions 1,227 0 1,227 Transfers 80 ( 80 ) 0 Foreign currency translation and other adjustments ( 81 ) ( 5 ) ( 86 ) Balance as of December 31, 2018 17,521 367 17,888 Acquisitions 2,353 475 2,828 Transfers 9 ( 9 ) 0 Foreign currency translation and other adjustments 38 ( 130 ) ( 92 ) Balance as of December 31, 2019 $ 19,921 $ 703 $ 20,624 Other Intangible Assets Information regarding purchased intangible assets were as follows (in millions): As of December 31, 2018 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 5,125 $ 3,394 $ 1,731 Customer relationships 349 308 41 Trade names and other 703 255 448 Total $ 6,177 $ 3,957 $ 2,220 As of December 31, 2019 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 4,972 $ 3,570 $ 1,402 Customer relationships 254 30 224 Trade names and other 703 350 353 Total $ 5,929 $ 3,950 $ 1,979 Patents and developed technology, customer relationships, and trade names and other have weighted-average remaining useful lives of 2.3 years, 5.6 years, and 3.0 years, respectively. Amortization expense relating to purchased intangible assets was $ 796 million , $ 865 million , and $ 795 million for the years ended December 31, 2017 , 2018 , and 2019 , respectively. 77 Table of Contents Alphabet Inc. As of December 31, 2019 , expected amortization expense relating to purchased intangible assets for each of the next five years and thereafter is as follows (in millions): 2020 $ 749 2021 665 2022 317 2023 57 2024 45 Thereafter 146 $ 1,979 Note 10. Commitments and Contingencies Purchase Obligations As of December 31, 2019 , we had $ 5.7 billion of other non-cancelable contractual obligations, primarily related to data center operations and build-outs, digital media content licensing, and purchases of inventory. Indemnifications In the normal course of business, to facilitate transactions in our services and products, we indemnify certain parties, including advertisers, Google Network Members, customers of Google Cloud offerings, and lessors with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2019 , we did not have any material indemnification claims that were probable or reasonably possible. Legal Matters Antitrust Investigations On November 30, 2010, the EC's Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On June 27, 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a € 2.4 billion ( $ 2.7 billion as of June 27, 2017) fine. On September 11, 2017, we appealed the EC decision and on September 27, 2017, we implemented product changes to bring shopping ads into compliance with the EC's decision. We recognized a charge of $ 2.7 billion for the fine in the second quarter of 2017. On July 18, 2018, the EC announced its decision that certain provisions in Google’s Android-related distribution agreements infringed European competition law. The EC decision imposed a € 4.3 billion ( $ 5.1 billion as of June 30, 2018) fine and directed the termination of the conduct at issue. On October 9, 2018, we appealed the EC decision. On October 29, 2018, we implemented changes to certain of our Android distribution practices. We recognized a charge of $ 5.1 billion for the fine in the second quarter of 2018. On March 20, 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a fine of € 1.5 billion ( $ 1.7 billion as of March 20, 2019) and directed actions related to AdSense for Search agreements, which we implemented prior to the decision. On June 4, 2019, we appealed the EC decision. We recognized a charge of $ 1.7 billion for the fine in the first quarter of 2019. 78 Table of Contents Alphabet Inc. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. From time to time we are subject to formal and informal inquiries and investigations by competition authorities in the United States, Europe, and other jurisdictions. For example, in August 2019, we began receiving civil investigative demands from the U.S. Department of Justice requesting information and documents relating to our prior antitrust investigations and certain of our business practices. Attorneys general from 51 U.S. states and territories have also opened antitrust investigations into certain of our business practices. We continue to cooperate with federal and state regulators in the United States, and other regulators around the world. Patent and Intellectual Property Claims We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe others' intellectual property rights. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services. As a result, we may have to change our business practices, and develop non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss in an ITC action can result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them against certain intellectual property infringement claims, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. In addition, our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. In 2010, Oracle America, Inc. (Oracle) brought a copyright lawsuit against Google in the Northern District of California, alleging that Google's Android operating system infringes Oracle's copyrights related to certain Java application programming interfaces. After trial, final judgment was entered by the district court in favor of Google on June 8, 2016, and the court decided post-trial motions in favor of Google. Oracle appealed and on March 27, 2018, the appeals court reversed and remanded the case for a trial on damages. On May 29, 2018, we filed a petition for a rehearing at the Federal Circuit, and on August 28, 2018, the Federal Circuit denied the petition. On January 24, 2019, we filed a petition to the Supreme Court of the United States to review this case. On April 29, 2019, the Supreme Court requested the views of the Solicitor General regarding our petition. On September 27, 2019, the Solicitor General recommended denying our petition, and we provided our response on October 16, 2019. On November 15, 2019, the Supreme Court granted our petition and made a decision to review the case. If the Supreme Court does not rule in our favor, the case will be remanded to the district court for further determination of the remaining issues in the case, including damages, if any. We believe this lawsuit is without merit and are defending ourselves vigorously. Given the nature of this case, we are unable to estimate the reasonably possible loss or range of loss, if any, arising from this matter. Other We are also regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. Such claims, suits, regulatory and government investigations, and other proceedings could result in fines, civil or criminal penalties, or other adverse consequences. Certain of these outstanding matters include speculative, substantial or indeterminate monetary amounts. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We evaluate developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. With respect to our outstanding matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in aggregate, have a material adverse effect on our business, 79 Table of Contents Alphabet Inc. consolidated financial position, results of operations, or cash flows. However, the outcome of such matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Non-Income Taxes We are under audit by various domestic and foreign tax authorities with regards to non-income tax matters. The subject matter of non-income tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions and the tax treatment of certain employee benefits. We accrue non-income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We believe these matters are without merit and we are defending ourselves vigorously. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. For information regarding income tax contingencies, see Note 14 . Note 11. Stockholders' Equity Convertible Preferred Stock Our board of directors has authorized 100 million shares of convertible preferred stock, $ 0.001 par value, issuable in series. As of December 31, 2018 and 2019 , no shares were issued or outstanding. Class A and Class B Common Stock and Class C Capital Stock Our board of directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Share Repurchases In January 2018, the board of directors of Alphabet authorized the company to repurchase up to $ 8.6 billion of its Class C capital stock. In January and July 2019, the board of directors of Alphabet authorized the company to repurchase up to an additional $ 12.5 billion and $ 25.0 billion of its Class C capital stock, respectively. Share repurchases pursuant to the January 2018 and January 2019 authorizations were completed in 2019. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. During the years ended December 31, 2018 and 2019 , we repurchased and subsequently retired 8.2 million shares of Alphabet Class C capital stock for an aggregate amount of $ 9.1 billion and 15.3 million shares of Alphabet Class C capital stock for an aggregate amount of $ 18.4 billion , respectively. Note 12. Net Income Per Share We compute net income per share of Class A and Class B common stock and Class C capital stock using the two-class method. Basic net income per share is computed using the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of restricted stock units and other contingently issuable shares. The dilutive effect of outstanding restricted stock units and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A common stock assumes the conversion of Class B common stock, while the diluted net income per share of Class B common stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A and Class B common stock and Class C capital stock are identical, except with respect to voting. Furthermore, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our board of directors from declaring or paying unequal per share dividends on our Class A and Class B common stock and Class C capital stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely 80 Table of Contents Alphabet Inc. affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our board of directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A and Class B common shares and Class C capital stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. In the years ended December 31, 2017 , 2018 and 2019 , the net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. The following tables set forth the computation of basic and diluted net income per share of Class A and Class B common stock and Class C capital stock (in millions, except share amounts which are reflected in thousands and per share amounts): Year Ended December 31, 2017 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 5,438 $ 862 $ 6,362 Denominator Number of shares used in per share computation 297,604 47,146 348,151 Basic net income per share $ 18.27 $ 18.27 $ 18.27 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 5,438 $ 862 $ 6,362 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 862 0 0 Reallocation of undistributed earnings ( 74 ) ( 14 ) 74 Allocation of undistributed earnings $ 6,226 $ 848 $ 6,436 Denominator Number of shares used in basic computation 297,604 47,146 348,151 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 47,146 0 0 Restricted stock units and other contingently issuable shares 1,192 0 9,491 Number of shares used in per share computation 345,942 47,146 357,642 Diluted net income per share $ 18.00 $ 18.00 $ 18.00 81 Table of Contents Alphabet Inc. Year Ended December 31, 2018 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 13,200 $ 2,072 $ 15,464 Denominator Number of shares used in per share computation 298,548 46,864 349,728 Basic net income per share $ 44.22 $ 44.22 $ 44.22 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 13,200 $ 2,072 $ 15,464 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,072 0 0 Reallocation of undistributed earnings ( 146 ) ( 24 ) 146 Allocation of undistributed earnings $ 15,126 $ 2,048 $ 15,610 Denominator Number of shares used in basic computation 298,548 46,864 349,728 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 46,864 0 0 Restricted stock units and other contingently issuable shares 689 0 7,456 Number of shares used in per share computation 346,101 46,864 357,184 Diluted net income per share $ 43.70 $ 43.70 $ 43.70 Year Ended December 31, 2019 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 14,846 $ 2,307 $ 17,190 Denominator Number of shares used in per share computation 299,402 46,527 346,667 Basic net income per share $ 49.59 $ 49.59 $ 49.59 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 14,846 $ 2,307 $ 17,190 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,307 0 0 Reallocation of undistributed earnings ( 126 ) ( 20 ) 126 Allocation of undistributed earnings $ 17,027 $ 2,287 $ 17,316 Denominator Number of shares used in basic computation 299,402 46,527 346,667 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 46,527 0 0 Restricted stock units and other contingently issuable shares 413 0 5,547 Number of shares used in per share computation 346,342 46,527 352,214 Diluted net income per share $ 49.16 $ 49.16 $ 49.16 82 Table of Contents Alphabet Inc. Note 13. Compensation Plans Stock Plans Under our 2012 Stock Plan, RSUs or stock options may be granted. An RSU award is an agreement to issue shares of our publicly traded stock at the time the award vests. Incentive and non-qualified stock options, or rights to purchase common stock, are generally granted for a term of 10 years. RSUs granted to participants under the 2012 Stock Plan generally vest over four years contingent upon employment or service with us on the vesting date. As of December 31, 2019 , there were 37,982,435 shares of stock reserved for future issuance under our Stock Plan. Additionally, we have stock-based awards that may be settled in the stock of certain of our Other Bets. Stock-Based Compensation For the years ended December 31, 2017 , 2018 and 2019 , total stock-based compensation expense was $ 7.9 billion , $ 10.0 billion and $ 11.7 billion , including amounts associated with awards we expect to settle in Alphabet stock of $ 7.7 billion , $ 9.4 billion , and $ 10.8 billion , respectively. For the years ended December 31, 2017 , 2018 and 2019 , we recognized tax benefits on total stock-based compensation expense, which are reflected in the provision for income taxes in the Consolidated Statements of Income, of $ 1.6 billion , $ 1.5 billion , and $ 1.8 billion , respectively. For the years ended December 31, 2017 , 2018 and 2019 , tax benefit realized related to awards vested or exercised during the period was $ 2.7 billion , $ 2.1 billion and $ 2.2 billion , respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the research and development tax credit. Stock-Based Award Activities The following table summarizes the activities for our unvested RSUs in Alphabet stock for the year ended December 31, 2019 : Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2018 18,467,678 $ 936.96 Granted 13,934,041 $ 1,092.36 Vested ( 11,576,766 ) $ 919.28 Forfeited/canceled ( 1,430,717 ) $ 990.56 Unvested as of December 31, 2019 19,394,236 $ 1,055.22 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2017 and 2018 , was $ 845.06 and $ 1,095.89 , respectively. Total fair value of RSUs, as of their respective vesting dates, during the years ended December 31, 2017 , 2018 , and 2019 were $ 11.3 billion , $ 14.1 billion , and $ 15.2 billion , respectively. As of December 31, 2019 , there was $ 19.1 billion of unrecognized compensation cost related to unvested employee RSUs. This amount is expected to be recognized over a weighted-average period of 2.6 years . 401(k) Plans We have two 401(k) Savings Plans that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We recognized expense of approximately $ 448 million , $ 691 million , and $ 724 million for the years ended December 31, 2017 , 2018 , and 2019 , respectively. 83 Table of Contents Alphabet Inc. Note 14. Income Taxes Income from continuing operations before income taxes consists of the following (in millions): Year Ended December 31, 2017 2018 2019 Domestic operations $ 10,680 $ 15,779 $ 16,426 Foreign operations 16,513 19,134 23,199 Total $ 27,193 $ 34,913 $ 39,625 The provision for income taxes consists of the following (in millions): Year Ended December 31, 2017 2018 2019 Current: Federal and state $ 12,608 $ 2,153 $ 2,424 Foreign 1,746 1,251 2,713 Total 14,354 3,404 5,137 Deferred: Federal and state 220 907 286 Foreign ( 43 ) ( 134 ) ( 141 ) Total 177 773 145 Provision for income taxes $ 14,531 $ 4,177 $ 5,282 The Tax Act enacted on December 22, 2017 introduced significant changes to U.S. income tax law. Effective 2018, the Tax Act reduced the U.S. statutory tax rate from 35% to 21% and created new taxes on certain foreign-sourced earnings and certain related-party payments. Due to the timing of the enactment and the complexity involved in applying the provisions of the Tax Act, we made reasonable estimates of the effects and recorded provisional amounts in our consolidated financial statements as of December 31, 2017. As we collected and prepared necessary data, and interpreted the additional guidance issued by the U.S. Treasury Department, the IRS, and other standard-setting bodies, we made adjustments, over the course of 2018, to the provisional amounts including refinements to deferred taxes. The accounting for the tax effects of the Tax Act was completed as of December 31, 2018. Transition tax The Tax Act required us to pay U.S. income taxes on accumulated foreign subsidiary earnings not previously subject to U.S. income tax at a rate of 15.5% to the extent of foreign cash and certain other net current assets and 8% on the remaining earnings. We recorded a provisional amount for our transitional tax liability and income tax expense of $ 10.2 billion as of December 31, 2017. Subsequent adjustments in 2018 and 2019 were not material. Deferred tax effects Due to the change in the statutory tax rate from the Tax Act, we remeasured our deferred taxes as of December 31, 2017 to reflect the reduced rate that will apply in future periods when these deferred taxes are settled or realized. We recognized a deferred tax benefit of $ 376 million to reflect the reduced U.S. tax rate and other effects of the Tax Act as of December 31, 2017. 84 Table of Contents Alphabet Inc. The reconciliation of federal statutory income tax rate to our effective income tax rate is as follows: Year Ended December 31, 2017 2018 2019 U.S. federal statutory tax rate 35.0 % 21.0 % 21.0 % Foreign income taxed at different rates ( 14.2 ) ( 4.9 ) ( 5.6 ) Effect of the Tax Act Transition tax 37.6 ( 0.1 ) ( 0.6 ) Deferred tax effects ( 1.4 ) ( 1.2 ) 0.0 Federal research credit ( 1.8 ) ( 2.4 ) ( 2.5 ) Stock-based compensation expense ( 4.5 ) ( 2.2 ) ( 0.7 ) European Commission fines 3.5 3.1 1.0 Deferred tax asset valuation allowance 0.9 ( 2.0 ) 0.0 State and local income taxes 0.1 ( 0.4 ) 1.1 Other adjustments ( 1.8 ) 1.1 ( 0.4 ) Effective tax rate 53.4 % 12.0 % 13.3 % Our effective tax rate for each of the years presented was affected by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate. Substantially all of the income from foreign operations was earned by an Irish subsidiary. Beginning in 2018, earnings realized in foreign jurisdictions are subject to U.S. tax in accordance with the Tax Act. On July 27, 2015, the United States Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. As a result of that decision, we recorded a tax benefit related to the anticipated reimbursement of cost share payment for previously shared stock-based compensation costs. On June 7, 2019, the United States Court of Appeals for the Ninth Circuit overturned the 2015 Tax Court decision in Altera Corp. v. Commissioner, and upheld the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. As a result of the Ninth Circuit court decision, our cumulative net tax benefit of $ 418 million related to previously shared stock-based compensation costs was reversed in the year ended December 31, 2019. 85 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities are as follows (in millions): As of December 31, 2018 2019 Deferred tax assets: Stock-based compensation expense $ 291 $ 421 Accrued employee benefits 387 463 Accruals and reserves not currently deductible 902 1,047 Tax credits 1,979 3,264 Basis difference in investment in Arris 657 0 Prepaid cost sharing 597 0 Net operating losses 557 771 Operating leases 160 1,876 Other 21 390 Total deferred tax assets 5,551 8,232 Valuation allowance ( 2,817 ) ( 3,502 ) Total deferred tax assets net of valuation allowance 2,734 4,730 Deferred tax liabilities: Property and equipment, net ( 1,382 ) ( 1,798 ) Renewable energy investments ( 500 ) ( 466 ) Foreign Earnings ( 111 ) ( 373 ) Net investment gains ( 1,143 ) ( 1,074 ) Operating leases 0 ( 1,619 ) Other ( 125 ) ( 380 ) Total deferred tax liabilities ( 3,261 ) ( 5,710 ) Net deferred tax assets (liabilities) $ ( 527 ) $ ( 980 ) As of December 31, 2019 , our federal, state and foreign net operating loss carryforwards for income tax purposes were approximately $ 1.8 billion , $ 3.1 billion , and $ 1.9 billion respectively. If not utilized, the federal and foreign net operating loss carryforwards will begin to expire in 2021 and the state net operating loss carryforwards will begin to expire in 2020. It is more likely than not that certain net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. As of December 31, 2019 , our California research and development credit carryforwards for income tax purposes were approximately $ 3.0 billion that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. As of December 31, 2019 , we maintained a valuation allowance with respect to California deferred tax assets, certain federal net operating losses, certain state tax credits and certain foreign net operating losses that we believe are not likely to be realized. Due to gains from equity securities recognized, we released the valuation allowance in 2018 against the deferred tax asset for the book-to-tax basis difference in our investments in Arris shares received from the sale of the Motorola Home business to Arris in 2013. We continue to reassess the remaining valuation allowance quarterly and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. 86 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits (in millions): Year Ended December 31, 2017 2018 2019 Beginning gross unrecognized tax benefits $ 5,393 $ 4,696 $ 4,652 Increases related to prior year tax positions 685 321 938 Decreases related to prior year tax positions ( 257 ) ( 623 ) ( 143 ) Decreases related to settlement with tax authorities ( 1,875 ) ( 191 ) ( 2,886 ) Increases related to current year tax positions 750 449 816 Ending gross unrecognized tax benefits $ 4,696 $ 4,652 $ 3,377 The total amount of gross unrecognized tax benefits was $ 4.7 billion , $ 4.7 billion , and $ 3.4 billion as of December 31, 2017 , 2018 , and 2019 , respectively, of which, $ 3.0 billion , $ 2.9 billion , and $ 2.3 billion , if recognized, would affect our effective tax rate, respectively. The decrease in gross unrecognized tax benefits in 2017 and 2019 was primarily as a result of the resolution of multi-year audits. As of December 31, 2018 and 2019 , we had accrued $ 490 million and $ 130 million in interest and penalties in provision for income taxes, respectively. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions, our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS completed its examination through our 2015 tax years; all issues have been concluded and the IRS will commence its examination of our 2016 through 2018 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. The tax years 2011 through 2018 remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the effect, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, and closure of audits is not certain, we do not believe it is reasonably possible that our unrecognized tax benefits will materially change in the next 12 months. Note 15. Information about Segments and Geographic Areas We operate our business in multiple operating segments. Google is our only reportable segment. None of our other segments meet the quantitative thresholds to qualify as reportable segments; therefore, the other operating segments are combined and disclosed as Other Bets. Our reported segments are: • Google – Google includes our main products such as ads, Android, Chrome, hardware, Google Cloud, Google Maps, Google Play, Search, and YouTube. Our technical infrastructure is also included in Google. Google generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud offerings and subscription-based products. • Other Bets – Other Bets is a combination of multiple operating segments that are not individually material. Other Bets includes Access, Calico, CapitalG, GV, Verily, Waymo, and X, among others. Revenues from the Other Bets are derived primarily through the sales of internet and TV services through Access as well as licensing and R&D services through Verily. 87 Table of Contents Alphabet Inc. Revenues, cost of revenues, and operating expenses are generally directly attributed to our segments. Inter-segment revenues are not presented separately, as these amounts are immaterial. Our Chief Operating Decision Maker does not evaluate operating segments using asset information. Information about segments during the periods presented were as follows (in millions): Year Ended December 31, 2017 2018 2019 Revenues: Google $ 110,547 $ 136,362 $ 160,743 Other Bets 477 595 659 Hedging gains (losses) ( 169 ) ( 138 ) 455 Total revenues $ 110,855 $ 136,819 $ 161,857 Year Ended December 31, 2017 2018 2019 Operating income (loss): Google $ 32,456 $ 36,655 $ 41,673 Other Bets ( 2,734 ) ( 3,358 ) ( 4,824 ) Reconciling items (1) ( 3,544 ) ( 5,773 ) ( 2,618 ) Total income from operations $ 26,178 $ 27,524 $ 34,231 (1) Reconciling items are generally comprised of corporate administrative costs, hedging gains (losses) and other miscellaneous items that are not allocated to individual segments. Reconciling items include t he European Commission fines for the years ended December 31, 2017, 2018 and 2019, and a charge from a legal settlement for the year ended December 31, 2019. Performance fees previously included in reconciling items were reclassified for the years ended December 31, 2017 and 2018 from general and administrative expenses to other income (expense), net to conform with current period presentation. For further information on the reclassification, see Note 1. Year Ended December 31, 2017 2018 2019 Capital expenditures: Google $ 12,619 $ 25,460 $ 25,251 Other Bets 493 181 281 Reconciling items (2) 72 ( 502 ) ( 1,984 ) Total capital expenditures as presented on the Consolidated Statements of Cash Flows $ 13,184 $ 25,139 $ 23,548 (2) Reconciling items are related to timing differences of payments as segment capital expenditures are on accrual basis while total capital expenditures shown on the Consolidated Statements of Cash Flow are on cash basis and other miscellaneous differences. 88 Table of Contents Alphabet Inc. Stock-based compensation (SBC) and depreciation, amortization, and impairment are included in segment operating income (loss) as shown below (in millions): Year Ended December 31, 2017 2018 2019 Stock-based compensation: Google $ 7,168 $ 8,755 $ 10,185 Other Bets 363 489 474 Reconciling items (3) 148 109 135 Total stock-based compensation (4) $ 7,679 $ 9,353 $ 10,794 Depreciation, amortization, and impairment: Google $ 6,608 $ 8,708 $ 11,158 Other Bets 307 327 566 Reconciling items (3) 0 0 57 Total depreciation, amortization, and impairment $ 6,915 $ 9,035 $ 11,781 (3) Reconciling items relate to corporate administrative and other costs that are not allocated to individual segments. (4) For purposes of segment reporting, SBC represents awards that we expect to settle in Alphabet stock. The following table presents our long-lived assets by geographic area (in millions): As of December 31, 2018 As of December 31, 2019 Long-lived assets: United States $ 74,882 $ 94,907 International 22,234 28,424 Total long-lived assets $ 97,116 $ 123,331 For revenues by geography, see Note 2 . 89 Table of Contents Alphabet Inc. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2019 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting We rely extensively on information systems to manage our business and summarize and report operating results. In 2019, we began a multi-year implementation of a new global enterprise resource planning (“ERP”) system, which will replace much of our existing core financial systems. The ERP system is designed to accurately maintain the Company’s financial records, enhance the flow of financial information, improve data management and provide timely information to the Company’s management team. The implementation is expected to occur in phases over the next several years, with initial changes to our general ledger and consolidated financial reporting to take place in 2020. There have been no changes in our internal control over financial reporting during the quarter ended December 31, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, as the phased implementation of the new ERP system continues, we will change our processes and procedures which, in turn, could result in changes to our internal control over financial reporting. As such changes occur, we will evaluate quarterly whether such changes materially affect our internal control over financial reporting. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2019 . Management reviewed the results of its assessment with our Audit Committee. The effectiveness of our internal control over financial reporting as of December 31, 2019 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION None. 90 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for 2020 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2019 ( 2020 Proxy Statement) and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2020 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the 2020 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2020 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2020 Proxy Statement and is incorporated herein by reference. 91 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 47 Financial Statements: Consolidated Balance Sheets 50 Consolidated Statements of Income 51 Consolidated Statements of Comprehensive Income 52 Consolidated Statements of Stockholders’ Equity 53 Consolidated Statements of Cash Flows 54 Notes to Consolidated Financial Statements 55 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for doubtful accounts and sales credits for the years ended December 31, 2017 , 2018 and 2019 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year Year ended December 31, 2017 $ 467 $ 1,131 $ ( 924 ) $ 674 Year ended December 31, 2018 $ 674 $ 1,115 $ ( 1,060 ) $ 729 Year ended December 31, 2019 $ 729 $ 1,481 $ ( 1,457 ) $ 753 Note: Additions to the allowance for doubtful accounts are charged to expense. Additions to the allowance for sales credits are charged against revenues. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 92 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.07 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.09 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.10 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.11 Form of the Registrant’s 3.625% Notes due 2021 (included in Exhibit 4.10) 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.10) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 4.14 * Description of Registrant’s Securities 10.01 u Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Letter Agreement, dated April 24, 2019, between Robin L. Washington and Alphabet Inc. Current Report on Form 8-K (File No. 001-37580) April 30, 2019 10.03 u Letter Agreement, dated December 7, 2019, between Frances H. Arnold and Alphabet Inc. Current Report on Form 8-K (File No. 001-37580) December 9, 2019 10.04 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.06 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.07 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.07.1 u Google Inc. 2004 Stock Plan - Form of Google Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.07.2 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.07.3 u Google Inc. 2004 Stock Plan - Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.08 u Alphabet Inc. Amended and Restated 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 21, 2019 93 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.08.1 * u Alphabet Inc. Amended and Restated 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement 10.08.2 * u Alphabet Inc. Amended and Restated 2012 Stock Plan - Performance Stock Unit Agreement 10.09 u Motorola Mobility Holdings, Inc. 2011 Incentive Compensation Plan Registration Statement on Form S-8 (File No. 333-181661) May 24, 2012 10.10 u Apigee Corporation 2015 Equity Incentive Plan Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 10.10.1 u Apigee Corporation 2015 Equity Incentive Plan - Form of Restricted Stock Unit Agreement Registration Statement on Form S-8 (File No. 333-214573) November 10, 2016 14.01 Code of Conduct of the Registrant as amended on September 21, 2017 Annual Report on Form 10-K (File No. 001-37580) February 6, 2018 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.01 EC AdSense for Search Decision Current Report on Form 8-K (File No. 001-37580) March 20, 2019 99.02 Press Release regarding Alphabet Management Change Current Report on Form 8-K (File No. 001-37580) December 4, 2019 101.INS * Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. 101.SCH * XBRL Taxonomy Extension Schema Document 101.CAL * XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF * XBRL Taxonomy Extension Definition Linkbase Document 101.LAB * XBRL Taxonomy Extension Label Linkbase Document 94 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 101.PRE * XBRL Taxonomy Extension Presentation Linkbase Document 104 Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. ITEM 16. FORM 10-K SUMMARY None. 95 Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 3, 2020 ALPHABET INC. By: / S /    S UNDAR P ICHAI Sundar Pichai Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Sundar Pichai and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. 96 Table of Contents Alphabet Inc. Signature Title Date / S / S UNDAR P ICHAI Chief Executive Officer and Director (Principal Executive Officer) February 3, 2020 Sundar Pichai / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 3, 2020 Ruth M. Porat / S /    A MIE T HUENER O'T OOLE Vice President and Chief Accounting Officer (Principal Accounting Officer) February 3, 2020 Amie Thuener O'Toole / S /    F RANCES H. A RNOLD Director February 3, 2020 Frances H. Arnold / S /    S ERGEY B RIN Co-Founder and Director February 3, 2020 Sergey Brin / S /    L. J OHN D OERR Director February 3, 2020 L. John Doerr / S /    R OGER W. F ERGUSON, J R . Director February 3, 2020 Roger W. Ferguson, Jr. /S/    J OHN L. H ENNESSY Director, Chair February 3, 2020 John L. Hennessy / S /    A NN M ATHER Director February 3, 2020 Ann Mather / S /    A LAN R . M ULALLY Director February 3, 2020 Alan R. Mulally / S /    L ARRY P AGE Co-Founder and Director February 3, 2020 Larry Page / S /    K. R AM S HRIRAM Director February 3, 2020 K. Ram Shriram / S /    Robin L. Washington Director February 3, 2020 Robin L. 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Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View , CA 94043 (Address of principal executive offices, including zip code) ( 650 ) 253-000 0 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol(s) Name of each exchange on which registered Class A Common Stock, $0.001 par value GOOGL Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value GOOG Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C.7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of June 30, 2020, the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 30, 2020) was approximately $ 849.7 billion. For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 26, 2021, there were 300,737,081 shares of the registrant’s Class A common stock outstanding, 45,843,112 shares of the registrant’s Class B common stock outstanding, and 327,556,472 shares of the registrant’s Class C capital stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2021 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2020. Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2020 TABLE OF CONTENTS Page Note About Forward-Looking Statements 3 PART I Item 1. Business 5 Item 1A. Risk Factors 10 Item 1B. Unresolved Staff Comments 24 Item 2. Properties 25 Item 3. Legal Proceedings 25 Item 4. Mine Safety Disclosures 25 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 26 Item 6. Selected Financial Data 29 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 30 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 47 Item 8. Financial Statements and Supplementary Data 50 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 92 Item 9A. Controls and Procedures 92 Item 9B. Other Information 92 PART III Item 10. Directors, Executive Officers and Corporate Governance 93 Item 11. Executive Compensation 93 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 93 Item 13. Certain Relationships and Related Transactions, and Director Independence 93 Item 14. Principal Accountant Fees and Services 93 PART IV Item 15. Exhibits, Financial Statement Schedules 94 Item 16. Form 10-K Summary 97 Signatures 2 Table of Contents Alphabet Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding: • the ongoing effect of the novel coronavirus pandemic ("COVID-19"), including its macroeconomic effects on our business, operations, and financial results; and the effect of governmental lockdowns, restrictions and new regulations on our operations and processes; • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business, including the size and timing of the expected return on our continuing investments in our Google Cloud segment; • the potential for declines in our revenue growth rate and operating margin; • our expectation that the shift from an offline to online world will continue to benefit our business; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase and may affect our margins; • our expectation that our traffic acquisition costs ("TAC") and the associated TAC rate will fluctuate, which could affect our overall margins; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins; • fluctuations in our revenue growth, as well as the change in paid clicks and cost-per-click and the change in impressions and cost-per-impression, and various factors contributing to such fluctuations; • our expectation that we will continue to periodically review, refine, and update our methodologies for monitoring, gathering, and counting the number of paid clicks and impressions; • our expectation that our results will be affected by our performance in international markets as users in developing economies increasingly come online; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of gains and losses related to hedging activities under our foreign exchange risk management program; • the amount and timing of revenue recognition from customer contracts with commitments for performance obligations, including our estimate of the remaining amount of commitments and when we expect to recognize revenue; • fluctuations in our capital expenditures; • our plans to continue to invest in new businesses, products, services and technologies, systems, land and buildings for data centers and offices, and infrastructure, as well as to continue to invest in acquisitions; • our pace of hiring and our plans to provide competitive compensation programs; • our expectation that our cost of revenues, research and development ("R&D") expenses, sales and marketing expenses, and general and administrative expenses may increase in amount and/or may increase as a percentage of revenues and may be affected by a number of factors; • estimates of our future compensation expenses; • our expectation that our other income (expense), net ("OI&E"), will fluctuate in the future, as it is largely driven by market dynamics; • fluctuations in our effective tax rate; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality (including developments and volatility arising from COVID-19), which are likely to cause fluctuations in our quarterly results; • the sufficiency of our sources of funding; • our potential exposure in connection with new and pending investigations, proceedings, and other contingencies; 3 Table of Contents Alphabet Inc. • the sufficiency and timing of our proposed remedies in response to decisions from the European Commission ("EC") and other regulators and governmental entities; • our expectations regarding the timing, design and implementation of our new global enterprise resource planning ("ERP") system; • the expected timing and amount of Alphabet Inc.'s share repurchases; • our long-term sustainability and diversity goals; • our expectation that the estimated useful life of servers and certain network equipment will have a favorable effect on our 2021 operating results; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report and other documents we file with the Securities and Exchange Commission ("SEC"), including without limitation, the following sections: Item 1 "Business," Item 1A "Risk Factors," and Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "may," "could," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed in Item 1A, "Risk Factors" of this report and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. 4 Table of Contents Alphabet Inc. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history, inspiring us to tackle big problems, and invest in moonshots like artificial intelligence ("AI") research and quantum computing. We continue this work under the leadership of Sundar Pichai, who has served as CEO of Google since 2015 and as CEO of Alphabet since 2019. Alphabet is a collection of businesses — the largest of which is Google — which we report as two segments: Google Services and Google Cloud. We report all non-Google businesses collectively as Other Bets. Our Other Bets include earlier stage technologies that are further afield from our core Google business. We take a long term view and manage the portfolio of Other Bets with the discipline and rigor needed to deliver long-term returns. Our Alphabet structure is about helping each of our businesses prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers, capable of propelling new ideas and people forward. Our mission to organize the world’s information and make it universally accessible and useful is as relevant today as it was when we were founded in 1998. Since then, we’ve evolved from a company that helps people find answers to a company that helps you get things done. We’re focused on building an even more helpful Google for everyone, and we aspire to give everyone the tools they need to increase their knowledge, health, happiness and success. Across Alphabet, we're focused on continually innovating in areas where technology can have an impact on people’s lives. Every year, there are trillions of searches on Google, and we continue to invest deeply in AI and other technologies to ensure the most helpful Search experience possible. People come to YouTube for entertainment, information and opportunities to learn something new. And Google Assistant offers the best way to get things done seamlessly across different devices, providing intelligent help throughout your day, no matter where you are. Since the pandemic began, our teams have built new features to help users go about their daily lives, and to support businesses working to serve their customers during an uncertain time. In conjunction with Apple, we launched Exposure Notification apps that are being used by local governments globally. Our COVID-19 Community Mobility Reports are used by public health agencies and researchers around the globe, and we’ve committed hundreds of millions of dollars to help small businesses through a combination of small business loans, grants and ad credits. Importantly, we've made authoritative content a key focus area across both Google Search and YouTube to help users search for trusted public health information. Our Other Bets are also pursuing initiatives with similar goals. For instance, as a part of our efforts in the Metro Phoenix area, Waymo is working toward our goal of making transportation safer and easier for everyone while Verily is developing tools and platforms to improve health outcomes. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and continue to invest for the long-term. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in because they are the key to our long-term success. The power of machine learning Across the company, machine learning and AI are increasingly driving many of our latest innovations. Our investments in machine learning over the past decade have enabled us to build products that are smarter and more helpful. For example, a huge breakthrough in natural language understanding, called BERT, now improves results for almost every English language search query. DeepMind made a significant AI-powered breakthrough, solving a 50-year-old protein folding challenge, which will help us better understand one of life’s fundamental building blocks, and will enable researchers to tackle new and difficult problems, from fighting diseases to environmental sustainability. 5 Table of Contents Alphabet Inc. Google For reporting purposes, Google comprises two segments: Google Services and Google Cloud. Google Services Serving our users We have always been a company committed to building helpful products that can improve the lives of millions of people. Our product innovations have made our services widely used, and our brand one of the most recognized in the world. Google Services' core products and platforms include Android, Chrome, Gmail, Google Drive, Google Maps, Google Photos, Google Play, Search, and YouTube, each with broad and growing adoption by users around the world. Our products and services have come a long way since the company was founded more than two decades ago. Rather than the ten blue links in our early search results, users can now get direct answers to their questions using their computer, mobile device, or their own voice, making it quicker, easier and more natural to find what you're looking for. This drive to make information more accessible and helpful has led us over the years to improve the discovery and creation of digital content, on the web and through platforms like Google Play and YouTube. With the migration to mobile, people are consuming more digital content by watching more videos, playing more games, listening to more music, reading more books, and using more apps than ever before. Working with content creators and partners, we continue to build new ways for people around the world to find great digital content. Fueling all of these great digital experiences are powerful platforms and hardware. That’s why we continue to invest in platforms like our Android mobile operating system, Chrome browser, Chrome operating system, as well as growing our family of great hardware devices. We see tremendous potential for devices to be helpful, make your life easier, and get better over time, by combining the best of our AI, software, and hardware. This is reflected in our latest generation of hardware products like Pixel 4a, Pixel 4a 5G and Pixel 5 phones, Chromecast with Google TV and the Google Nest Hub smart display. Creating beautiful products that people rely on every day is a journey that we are investing in for the long run. Key to building helpful products for users is our commitment to privacy, security and user choice. As the Internet evolves, we continue to invest in keeping data safe, including enhanced malware features in Chrome and improvements to auto-delete controls that will automatically delete web and app searches after 18 months. How we make money Our advertising products deliver relevant ads at just the right time, to give people useful commercial information, regardless of the device they’re using. We also provide advertisers with tools that help them better attribute and measure their advertising campaigns. Our advertising solutions help millions of companies grow their businesses, and we offer a wide range of products across devices and formats. Google Services generates revenues primarily by delivering both performance advertising and brand advertising. • Performance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Most of our performance advertisers pay us when a user engages in their ads. Performance advertising lets our advertisers connect with users while driving measurable results. Our ads tools allow performance advertisers to create simple text-based ads that appear on Google Search & other properties, YouTube and the properties of Google Network Members. In addition, Google Network Members use our platforms to display relevant ads on their properties, generating revenues when site visitors view or click on the ads. We continue to invest in our advertising programs and make significant upgrades. • Brand advertising helps enhance users' awareness of and affinity with advertisers' products and services, through videos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. We have built a world-class ad technology platform for advertisers, agencies, and publishers to power their digital marketing businesses. We aim to ensure great user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. We also seek to improve the measurability of advertising so advertisers know when their campaigns are effective. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, ranging 6 Table of Contents Alphabet Inc. from filtering out invalid traffic, removing billions of bad ads from our systems every year to closely monitoring the sites, apps, and videos where ads appear and blocklisting them when necessary to ensure that ads do not fund bad content. We continue to look to the future and are making long-term investments that will grow revenues beyond advertising, including Google Play, hardware, and YouTube. We are also investing in research efforts in AI and quantum computing to foster innovation across our businesses and create new opportunities. Google Cloud Google was a company built in the cloud. We continue to invest in infrastructure, security, data management, analytics and AI. We see significant opportunity in helping businesses utilize these strengths with features like data migration, modern development environments and machine learning tools to provide enterprise-ready cloud services, including Google Cloud Platform and Google Workspace (formerly known as G Suite). Google Cloud Platform enables developers to build, test, and deploy applications on its highly scalable and reliable infrastructure. Our Google Workspace collaboration tools — which include apps like Gmail, Docs, Drive, Calendar, Meet and more — are designed with real-time collaboration and machine intelligence to help people work smarter. Because more and more of today’s great digital experiences are being built in the cloud, our Google Cloud products help businesses of all sizes take advantage of the latest technology advances to operate more efficiently. Google Cloud generates revenues primarily from fees received for Google Cloud Platform services and Google Workspace collaboration tools. Other Bets Throughout Alphabet, we are also using technology to try and solve big problems across many industries. Alphabet’s investment in our portfolio of Other Bets include emerging businesses at various stages of development, ranging from those in the research and development phase to those that are in the beginning stages of commercialization, and our goal is for them to become thriving, successful businesses in the medium to long term. While these early-stage businesses naturally come with considerable uncertainty, some of them are already generating revenue and making important strides in their industries. Revenues are primarily generated from internet and TV services, as well as licensing and R&D services. Other Bets operate as independent companies and some of them have their own boards with independent members and outside investors. We are investing in our portfolio of Other Bets and being very deliberate about the focus, scale, and pace of investments. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, particularly from companies that seek to connect people with online information and provide them with relevant advertising. We face competition from: • General purpose search engines and information services, such as Baidu, Microsoft's Bing, Naver, Seznam, Verizon's Yahoo, and Yandex. • Vertical search engines and e-commerce websites, such as Amazon and eBay (e-commerce), Booking's Kayak (travel queries), Microsoft's LinkedIn (job queries), and WebMD (health queries). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks, such as Facebook, Snapchat, and Twitter. Some users increasingly rely on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other forms of advertising, such as billboards, magazines, newspapers, radio, and television. Our advertisers typically advertise in multiple media, both online and offline. • Other online advertising platforms and networks, including Amazon, AppNexus, Criteo, and Facebook, that compete for advertisers that use Google Ads, our primary auction-based advertising platform. • Providers of digital video services, such as Amazon, Apple, AT&T, Disney, Facebook, Hulu, Netflix and TikTok. In businesses that are further afield from our advertising business, we compete with companies that have longer operating histories and more established relationships with customers and users. We face competition from: • Other digital content and application platform providers, such as Amazon and Apple. 7 Table of Contents Alphabet Inc. • Companies that design, manufacture, and market consumer hardware products, including businesses that have developed proprietary platforms. • Providers of enterprise cloud services, including Alibaba, Amazon, and Microsoft. • Digital assistant providers, such as Amazon and Apple. Competing successfully depends heavily on our ability to deliver and distribute innovative products and technologies to the marketplace across our businesses. Specifically, for advertising, competing successfully depends on attracting and retaining: • Users, for whom other products and services are literally one click away, largely on the basis of the relevance of our advertising, as well as the general usefulness, security and availability of our products and services. • Advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels. • Content providers, primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. Ongoing Commitment to Sustainability At Google, we build technology that helps people do more for the planet. We strive to build sustainability into everything we do, including designing and operating efficient data centers, advancing carbon-free energy, creating sustainable workplaces, building better devices and services, empowering users with technology, and enabling a responsible supply chain. Google has been carbon neutral since 2007, and in 2019, for the third consecutive year, we matched 100% of our electricity consumption with renewable energy purchases. We are the largest annual corporate purchaser of renewable energy in the world, based on renewable electricity purchased in megawatt-hour (MWh). In 2020, we neutralized our entire legacy carbon footprint since our founding (covering all our operational emissions before we became carbon neutral in 2007), making Google the first major company to achieve carbon neutrality for its entire operating history. In our third decade of climate action, we’ve set our most ambitious goal yet: to run our business on carbon-free energy everywhere, at all times, by 2030. We're also investing in technologies to help our partners and people all over the world make sustainable choices. For example, we intend to enable 5 GW of new carbon-free energy across our key manufacturing regions by 2030 through investment. We anticipate this will spur more than $5 billion in clean energy investments, avoid the amount of emissions equal to taking more than 1 million cars off the road each year, and create more than 8,000 clean energy jobs. With the Environmental Insights Explorer, we're also working to help more than 500 cities and local governments globally reduce a total of 1 gigaton of carbon emissions annually by 2030 — that’s the equivalent of the annual carbon emissions of a country the size of Japan. Google’s products are already helping people make more sustainable choices in their daily lives, whether it’s using Google Maps to find bike-shares and electric vehicle charging stations, or in many European countries, using Google Flights to sort the least carbon-intensive option flights. There are more tools and information we can provide, and our goal is to find new ways that our products can help 1 billion people make more sustainable choices by 2022. Climate change is one of the most significant global challenges of our time. In 2017, we developed a climate resilience strategy, which included conducting a climate scenario analysis. We've earned a spot on the CDP (formerly the Carbon Disclosure Project) Climate Change A List for seven consecutive years. We believe our CDP climate change response reflects the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). In 2020, we issued $5.75 billion in sustainability bonds, the largest sustainability or green bond issuance by any company in history. The net proceeds from the issuance are used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. More information on our approach to sustainability can be found in our annual sustainability reports, including Google’s environmental report. The content of our sustainability reports are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. 8 Table of Contents Alphabet Inc. Culture and Workforce We’re a company of curious, talented and passionate people. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex challenges in technology and society. Our people are critical for our continued success. We work hard to provide an environment where Googlers can have fulfilling careers, and be happy, healthy and productive. We offer industry-leading benefits and programs to take care of the diverse needs of our employees and their families, including access to excellent healthcare choices, opportunities for career growth and development, and resources to support their financial health. Our competitive compensation programs help us to attract and retain top candidates, and we will continue to invest in recruiting talented people to technical and non-technical roles and rewarding them well. Alphabet is committed to making diversity, equity, and inclusion part of everything we do and we’re committed to growing a workforce that’s representative of the users we serve. More information on Google’s approach to diversity can be found in our annual diversity reports, available publicly at diversity.google. The content of our diversity reports is not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. We have work councils and statutory employee representation obligations in certain countries and we are committed to supporting protected labor rights, maintaining an open culture and listening to all Googlers. Supporting healthy and open dialogue is central to how we work, and we communicate information about the company through multiple internal channels to our employees. As of December 31, 2020, Alphabet had 135,301 employees. When necessary, we contract with businesses around the world to provide specialized services where we don’t have appropriate in-house expertise or resources, often in fields that require specialized training like cafe operations, customer support, content moderation and physical security. We also contract with temporary staffing agencies when we need to cover short-term leaves, when we have spikes in business needs, or when we need to quickly incubate special projects. We choose our partners and staffing agencies carefully, and review their compliance with Google’s Supplier Code of Conduct. We continually make improvements to promote a respectful and positive working environment for everyone — employees, vendors and temporary staff alike. Government Regulation We are subject to numerous U.S. federal, state, and foreign laws and regulations covering a wide variety of subject matters. Like other companies in the technology industry, we face heightened scrutiny from both U.S. and foreign governments with respect to our compliance with laws and regulations. Our compliance with these laws and regulations may be onerous and could, individually or in the aggregate, increase our cost of doing business, impact our competitive position relative to our peers, and/or otherwise have an adverse impact on our business, reputation, financial condition, and operating results. For additional information about government regulation applicable to our business, see Risk Factors in Part I, Item 1A, Trends in Our Business in Part II, Item 7, and Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 in this Annual Report on Form 10-K. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. Seasonality Our business is affected by seasonal fluctuations in internet usage, advertising expenditures, and underlying business trends such as traditional retail seasonality (including developments and volatility arising from COVID-19). Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and our Proxy Statements, and any amendments to these reports, are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or 9 Table of Contents Alphabet Inc. announcements regarding our financial performance and other items that may be material or of interest to our investors, including SEC filings, investor events, press and earnings releases, and blogs. We also share Google news and product updates on Google's Keyword blog at https://www.blog.google/, that may be material or of interest to our investors. Further, corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The content of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could harm our business, reputation, financial condition, and operating results. Risks Specific to our Company We generate a significant portion of our revenues from advertising, and reduced spending by advertisers, a loss of partners, or new and existing technologies that block ads online and/or affect our ability to customize ads could harm our business. We generate d over 80% o f total revenues from the display of ads online in 2020. Many of our advertisers, companies that distribute our products and services, digital publishers, and content providers can terminate their contracts with us at any time. These partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. Changes to our advertising policies and data privacy practices, as well as changes to other companies’ advertising and/or data privacy practices may affect the advertising that we are able to provide, which could harm our business. In addition, technologies have been developed that make customized ads more difficult or that block the display of ads altogether and some providers of online services have integrated technologies that could potentially impair the availability and functionality of third-party digital advertising. Failing to provide superior value or deliver advertisements effectively and competitively could harm our reputation, financial condition, and operating results. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions, including COVID-19 and its effects on the global economy (as discussed in greater detail in our COVID-19 risk factor under ‘General Risks’ below), have impacted the demand for advertising and resulted in fluctuations in the amounts our advertisers spend on advertising, and could have an adverse impact on such demand and spend, which could harm our financial condition and operating results. We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, we may not remain competitive, which could harm our business and operating results. Our business environment is rapidly evolving and intensely competitive. Our businesses face changing technologies, shifting user needs, and frequent introductions of rival products and services. To compete successfully, we must accurately anticipate technology developments and deliver innovative, relevant and useful products, services, and technologies in a timely manner. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services. We must continue to invest significant resources in research and development, including through acquisitions, in order to enhance our technology and new and existing products and services. We have many competitors in different industries. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some competitors have longer operating histories and well established relationships in various sectors. They can use their experience and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in research and development and in talent, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for users, advertisers, customers, and content providers. Further, discrepancies in enforcement of existing laws may enable our lesser known competitors to aggressively interpret those laws without commensurate scrutiny, thereby affording them competitive advantages. Our competitors may also be able to innovate and provide products and services faster than we can or may foresee the need for products and services before us. Our operating results may also suffer if our products and services are not responsive to the needs of our users, advertisers, publishers, customers, and content providers. As technologies continue to develop, our competitors may be able to offer experiences that are, or that are seen to be, substantially similar to or better than ours. This 10 Table of Contents Alphabet Inc. may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in developing compelling products or in attracting and retaining users, advertisers, publishers, customers, and content providers, our operating results could be harmed. Our ongoing investment in new businesses, products, services, and technologies is inherently risky, and could disrupt our current operations and harm our financial condition and operating results. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The investments that we are making across Google Services, Google Cloud and Other Bets reflect our ongoing efforts to innovate and provide products and services that are useful to users, advertisers, publishers, customers, and content providers. Our investments in Google Services, Google Cloud and Other Bets span a wide range of industries beyond online advertising. Such investments ultimately may not be commercially viable or may not result in an adequate return of capital and, in pursuing new strategies, we may incur unanticipated liabilities. These endeavors may involve significant risks and uncertainties, including diversion of management resources and, with respect to Other Bets, the use of alternative investment, governance, or compensation structures that may fail to adequately align incentives across the company or otherwise accomplish their objectives. Within Google Services, we continue to invest heavily in hardware, including our smartphones and home devices, which is a highly competitive market with frequent introduction of new products and services, rapid adoption of technological advancements by competitors, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, and price and feature sensitivity on the part of consumers and businesses. There can be no assurance we will be able to provide hardware that competes effectively. Within Google Cloud, we devote significant resources to develop and deploy our enterprise-ready cloud services, including Google Cloud Platform and Google Workspace. We are incurring costs to build and maintain infrastructure to support cloud computing services and hire talent, particularly to support and scale our salesforce. At the same time, our competitors are rapidly developing and deploying cloud-based services. Pricing and delivery models are competitive and evolving, and we may not attain sufficient scale and profitability to achieve our business objectives. Within Other Bets, we are investing significantly in the areas of health, life sciences, and transportation, among others. These investment areas face intense competition from large experienced and well-funded competitors and our offerings may not be able to compete effectively or to operate at sufficient levels of profitability. In addition, new and evolving products and services, including those that use artificial intelligence and machine learning, raise ethical, technological, legal, regulatory, and other challenges, which may negatively affect our brands and demand for our products and services. Because all of these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not harm our reputation, financial condition, and operating results. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including increasing competition and the continued expansion of our business into a variety of new fields. Changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix and an increasing competition for advertising may also affect our advertising revenue growth rate. We may also experience a decline in our revenue growth rate as our revenues increase to higher levels, if there is a decrease in the rate of adoption of our products, services, and technologies, or due to deceleration or decline in demand for devices used to access our services, among other factors. In addition, COVID-19 and its effects on the global economy has impacted and may continue to adversely impact our revenue growth rate (as discussed in greater detail in our COVID-19 risk factor under ‘General Risks’ below). In addition to a decline in our revenue growth rate, we may also experience downward pressure on our operating margin resulting from a variety of factors, such as the continued expansion of our business into new fields, including products and services such as hardware, Google Cloud, and subscription products, as well as significant investments in Other Bets, all of which may have margins lower than those we generate from advertising. We may also experience downward pressure on our operating margins from increasing regulations, increasing competition and increased costs for many aspects of our business, including within advertising where changes such as device mix, property mix, and partner agreements can affect margin. The margin we earn on revenues generated from our Google Network Members could also decrease in the future if we pay a larger percentage of advertising fees to them. We may also pay increased TAC to our distribution partners as well as increased content acquisition 11 Table of Contents Alphabet Inc. costs to content providers. We may also face an increase in infrastructure costs, supporting businesses such as Search, Google Cloud, and YouTube. Many of our expenses are less variable in nature and may not correlate to changes in revenues. Due to these factors and the evolving nature of our business, our historical revenue growth rate and historical operating margin may not be indicative of our future performance. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brands as well as affect our ability to compete. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services, and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. Furthermore, there is always the possibility, despite our efforts, that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy of such trade secrets and other sensitive information could be compromised, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” Some courts have ruled that "Google" is a protectable trademark, but it is possible that other courts, particularly those outside of the United States, may reach a different determination. If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, customers, content providers, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands within Google Services, Google Cloud and Other Bets increases our ability to enter new categories and launch new and innovative products that better serve the needs of our users, advertisers, customers, content providers, and other partners. Our brands may be negatively affected by a number of factors, including, among others, reputational issues, third-party content shared on our platforms, data privacy and security issues and developments, and product or technical performance failures. For example, if we fail to appropriately respond to the sharing of misinformation or objectionable content on our services and/or products or objectionable practices by advertisers, or to otherwise adequately address user concerns, our users may lose confidence in our brands. Furthermore, failure to maintain and enhance equity in our brands may harm our business, financial condition, and operating results. Our success will depend largely on our ability to remain a technology leader and continue to provide high-quality, innovative products and services that are truly useful and play a valuable role in a range of settings. We face a number of manufacturing and supply chain risks that, if not properly managed, could harm our financial condition, operating results, and prospects. We face a number of risks related to manufacturing and supply chain management, which could affect our ability to supply both our products and our internet-based services. We rely on other companies to manufacture many of our finished products, to design certain of our components and parts, and to participate in the distribution of our products and services. Our business could be negatively affected if we are not able to engage these companies with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We have experienced and/or may experience supply shortages and price increases driven by raw material, component or part availability, manufacturing capacity, labor shortages, industry allocations, tariffs, trade disputes 12 Table of Contents Alphabet Inc. and barriers, natural disasters or pandemics (including COVID-19), the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), and significant changes in the financial or business condition of our suppliers. We have experienced and/or may in the future, experience shortages or other supply chain disruptions that could negatively affect our operations. In addition, some of the components we use in our technical infrastructure and products are available from only one or limited sources, and we may not be able to find replacement vendors on favorable terms in the event of a supply chain disruption. In addition, a significant supply interruption could delay critical data center upgrades or expansions and delay product availability. We may enter into long term contracts for materials and products that commit us to significant terms and conditions. We may be liable for materials and products that are not consumed due to market acceptance, technological change, obsolescences, quality, product recalls, and warranty issues. For instance, because certain of our hardware supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and negatively affect our financial results. Furthermore, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may affect our supply. Our products and services may have quality issues resulting from design, manufacturing, or operations. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products and services does not meet expectations or our products or services are defective, it could harm our reputation, financial condition, and operating results. We require our suppliers and business partners to comply with laws and, where applicable, our company policies, such as the Google Supplier Code of Conduct, regarding workplace and employment practices, data security, environmental compliance and intellectual property licensing, but we do not control them or their practices. Violations of law or unethical business practices could result in supply chain disruptions, canceled orders, harm to key relationships, and damage to our reputation. Their failure to procure necessary license rights to intellectual property, could affect our ability to sell our products or services and expose us to litigation or financial claims. Interruption, interference with, or failure of our complex information technology and communications systems could hurt our ability to effectively provide our products and services, which could harm our reputation, financial condition, and operating results. In addition, complications with the design or implementation of our new global enterprise resource planning system could harm our business and operations. The availability of our products and services and fulfillment of our customer contracts depend on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference, or interruption from modifications or upgrades, terrorist attacks, natural disasters or pandemics (including COVID-19), the effects of climate change (such as sea level rise, drought, flooding, wildfires, and increased storm severity), power loss, telecommunications failures, computer viruses, ransomware attacks, computer denial of service attacks, phishing schemes, or other attempts to harm or access our systems. Some of our data centers are located in areas with a high risk of major earthquakes or other natural disasters. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and, in some cases, to potential disruptions resulting from problems experienced by facility operators. Some of our systems are not fully redundant, and disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster or pandemic (including COVID-19), closure of a facility, or other unanticipated problems at, or impacting, our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and may contain errors or vulnerabilities, which could result in interruptions in or failure of our services or systems. In addition, we rely extensively on information systems and technology to manage our business and summarize operating results. We are in the process of a multi-year implementation of a new ERP system, which will replace much of our existing core financial systems. The ERP system is designed to accurately maintain our financial records, enhance the flow of financial information, improve data management, and provide timely information to our management team. We may not be able to successfully implement the ERP system without experiencing delays, increased costs, and other difficulties. Failure to successfully design and implement the new ERP system as planned could harm our business, financial condition, and operating results. Additionally, if we do not effectively implement the ERP system as planned or the ERP system does not operate as intended, the effectiveness of our internal control over financial reporting could be negatively affected. 13 Table of Contents Alphabet Inc. Our international operations expose us to additional risks that could harm our business, our financial condition, and operating results. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 53% of our consolidated revenues in 2020. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • Restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S. • Import and export requirements, tariffs and other market access barriers that may prevent or impede us from offering products or providing services to a particular market, or that could limit our ability to source assemblies and finished products from a particular market, and may increase our operating costs. • Longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud. • Evolving foreign events, including the effect of the United Kingdom's withdrawal from the European Union, may adversely affect our revenues and could subject us to new regulatory costs and challenges (including the transfer of personal data between the EU and the United Kingdom and new customer requirements), in addition to other adverse effects that we are unable to effectively anticipate. • Anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting certain payments to government officials, violations of which could result in civil and criminal penalties. • Uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent. • Different employee/employer relationships, existence of works councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Because we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we face exposure to fluctuations in foreign currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings, particularly in light of market volatilities due to COVID-19. Hedging programs are also inherently risky and could expose us to additional risks that could harm our financial condition and operating results. Risks Related to our Industry People access the Internet through a variety of platforms and devices that continue to evolve with the advancement of technology and user preferences. If manufacturers and users do not widely adopt versions of our products and services developed for these interfaces, our business could be harmed. People access the Internet through a growing variety of devices such as desktop computers, mobile phones, smartphones, laptops and tablets, video game consoles, voice-activated speakers, wearables, automobiles, and television-streaming devices. Our products and services may be less popular on some interfaces. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not be available or may only be available with limited functionality for our users or our advertisers on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via voice-activated speakers, apps, social media or other platforms, which could harm our business. It is hard to predict the challenges we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to creating and supporting products and services across multiple platforms and devices. Failing to attract and retain a substantial number of new device manufacturers, suppliers, distributors, developers, and users, or failing to develop products and technologies that work well on new devices and platforms, could harm our business, financial condition, and operating results and ability to capture future business opportunities. Data privacy and security concerns relating to our technology and our practices could damage our reputation, cause us to incur significant liability, and deter current and potential users or customers from using our products and services. Software bugs or defects, security breaches, and attacks on our systems could result in the improper disclosure and use of user data and interference with our users and customers’ ability to use our products and services, harming our business operations and reputation. 14 Table of Contents Alphabet Inc. Concerns about our practices with regard to the collection, use, disclosure, or security of personal information or other data-privacy-related matters, even if unfounded, could harm our reputation, financial condition, and operating results. Our policies and practices may change over time as expectations regarding privacy and data change. Our products and services involve the storage and transmission of proprietary and other sensitive information, and bugs, theft, misuse, defects, vulnerabilities in our products and services, and security breaches expose us to a risk of loss of this information, improper use and disclosure of such information, litigation, and other potential liability. Systems and control failures, security breaches, failure to comply with our privacy policies, and/or inadvertent disclosure of user data could result in government and legal exposure, seriously harm our reputation and brand and, therefore, our business, and impair our ability to attract and retain users or customers. We expect to continue to expend significant resources to maintain security protections that shield against bugs, theft, misuse, or security vulnerabilities or breaches. We experience cyber attacks and other attempts to gain unauthorized access to our systems on a regular basis. We may experience future security issues, whether due to employee error or malfeasance or system errors or vulnerabilities in our or other parties’ systems, which could result in significant legal and financial exposure. Government inquiries and enforcement actions, litigation, and adverse press coverage could harm our business. We may be unable to anticipate or detect attacks or vulnerabilities or implement adequate preventative measures. Attacks and security issues could also compromise trade secrets and other sensitive information, harming our business. While we have dedicated significant resources to privacy and security incident response capabilities, including dedicated worldwide incident response teams, our response process, particularly during times of a natural disaster or pandemic (including COVID-19), may not be adequate, may fail to accurately assess the severity of an incident, may not respond quickly enough, or may fail to sufficiently remediate an incident. As a result, we may suffer significant legal, reputational, or financial exposure, which could harm our business, financial condition, and operating results. Our ongoing investments in safety, security, and content review will likely continue to identify abuse of our platforms and misuse of user data. In addition to our efforts to mitigate cyber attacks, we are making significant investments in safety, security, and content review efforts to combat misuse of our services and unauthorized access to user data by third parties, including investigations and review of platform applications that could access the information of users of our services. As a result of these efforts, we could discover incidents of unnecessary access to or misuse of user data or other undesirable activity by third parties. We may not discover all such incidents or activity, whether as a result of our data limitations, including our lack of visibility over our encrypted services, the scale of activity on our platform, or other factors, including factors outside of our control such as a natural disaster or pandemic (including COVID-19), and we may be notified of such incidents or activity via third parties. Such incidents and activities may include the use of user data or our systems in a manner inconsistent with our terms, contracts or policies, the existence of false or undesirable user accounts, election interference, improper ad purchases, activities that threaten people’s safety on- or offline, or instances of spamming, scraping, or spreading disinformation. We may also be unsuccessful in our efforts to enforce our policies or otherwise remediate any such incidents. Any of the foregoing developments may negatively affect user trust and engagement, harm our reputation and brands, require us to change our business practices in a manner adverse to our business, and adversely affect our business and financial results. Any such developments may also subject us to additional litigation and regulatory inquiries, which could result in monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight. Problematic content on our platforms, including low-quality user-generated content, web spam, content farms, and other violations of our guidelines could affect the quality of our services, which could damage our reputation and deter our current and potential users from using our products and services. We, like others in the industry, face violations of our content guidelines across our platforms, including sophisticated attempts by bad actors to manipulate our hosting and advertising systems to fraudulently generate revenues, or to otherwise generate traffic that does not represent genuine user interest or intent. While we invest significantly in efforts to promote high-quality and relevant results and to detect and prevent low-quality content and invalid traffic, we may be unable to adequately detect and prevent such abuses or promote high-quality content, particularly during times of a natural disaster or pandemic (including COVID-19). Many websites violate or attempt to violate our guidelines, including by seeking to inappropriately rank higher in search results than our search engine's assessment of their relevance and utility would rank them. Such efforts 15 Table of Contents Alphabet Inc. (known as “web spam”) may affect the quality of content on our platforms and lead them to display false, misleading or undesirable content. Although English-language web spam in our search results has been reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek inappropriate ways to improve their rankings. We continuously combat web spam in our search results, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We also continue to invest in and deploy proprietary technology to detect and prevent web spam from abusing our platforms. We also face other challenges from low-quality and irrelevant content websites, including content farms, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes focused on detecting and preventing abuse from low-quality websites. We also face other challenges on our platforms, including violations of our content guidelines involving incidents such as attempted election interference, activities that threaten the safety and/or well-being of our users on- or offline, and the spreading of disinformation, among other challenges. If we fail to either detect and prevent an increase in problematic content or effectively promote high-quality content, it could hurt our reputation for delivering relevant information or reduce use of our platforms, harming our financial condition or operating results. It may also subject us to litigation and regulatory inquiries, which could result in monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, by charging increased fees to us or our users to provide our offerings, or by providing our competitors preferential access. Some jurisdictions have adopted regulations prohibiting certain forms of discrimination by internet access providers; however, substantial uncertainty exists in the United States and elsewhere regarding such protections. For example, in 2018 the United States Federal Communications Commission repealed net neutrality rules, which could permit internet access providers to restrict, block, degrade, or charge for access to certain of our products and services. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. COVID-19 has also resulted in quarantines, shelter in place orders, and work from home directives, all of which have increased demands for internet access and may create access challenges. These could result in a loss of existing users, customers and advertisers, goodwill, and increased costs, and could impair our ability to attract new users, customers and advertisers, thereby harming our business. Risks Related to Laws and Regulations We face increased regulatory scrutiny as well as changes in regulatory conditions, laws and policies governing a wide range of topics that may negatively affect our business. We and other companies in the technology industry face increased regulatory scrutiny, enforcement action, and other proceedings. For instance, the U.S. Department of Justice, joined by a number of state Attorneys General, filed an antitrust complaint against Google on October 20, 2020, alleging that Google violated U.S. antitrust laws relating to Search and Search advertising. Separately, on December 16, 2020, a number of state Attorneys General filed an antitrust complaint against Google in the United States District Court for the Eastern District of Texas, alleging that Google violated U.S. antitrust laws as well as state deceptive trade laws relating to its advertising technology. Various other regulatory agencies in the United States and around the world, including competition enforcers, consumer protection agencies, data protection authorities, grand juries, inter-agency consultative groups, and a range of other governmental bodies have and continue to review our products and services and their compliance with laws and regulations around the world. We continue to cooperate with these investigations. Various laws, regulations, investigations, enforcement lawsuits, and regulatory actions have in the past and may in the future result in substantial fines and penalties, injunctive relief, ongoing auditing and monitoring 16 Table of Contents Alphabet Inc. obligations, changes to our products and services, alterations to our business models and operations, and collateral litigation, all of which could harm our business, reputation, financial condition, and operating results. Changes in international and local social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics may increase our cost of doing business, limit our ability to pursue certain business models, offer products or services in certain jurisdictions, or cause us to change our business practices. We have in the past had to alter or withdraw certain products and services as a result of laws or regulations that made them unfeasible, and new laws or regulations, such as the News Media Bargaining Code drafted by the Australian Competition and Consumer Commission currently tabled in parliament, could result in our having to alter or withdraw products and services in the future. These additional costs of doing business, new limitations or changes to our business model or practices could harm our business, reputation, financial condition, and operating results. A variety of new and existing laws and/or interpretations could harm our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations (or new interpretations or applications of existing laws and regulations in a manner inconsistent with our practices) may make our products and services less useful, limit our ability to pursue certain business models or offer certain products and services, require us to incur substantial costs, expose us to civil or criminal liability, or cause us to change our business practices. These laws and regulations are evolving and involve matters central to our business, including, among others: • New competition laws and related regulations around the world, that can limit certain business practices, and in some cases, create the risk of significant penalties. • Privacy laws, such as the California Consumer Privacy Act of 2018 that came into effect in January of 2020 and the California Privacy Rights Act which will go into effect in 2023, both of which give new data privacy rights to California residents, and SB-327 in California, which regulates the security of data in connection with internet connected devices. • Data protection laws passed by many states within the U.S. and by certain countries regarding notification to data subjects and/or regulators when there is a security breach of personal data. • New laws further restricting the collection, processing and/or sharing of advertising-related data. • Copyright or similar laws around the world, including the EU Directive on Copyright in the Digital Single Market (EUCD) of April 17, 2019, which EU Member States must implement by June 7, 2021; and the News Media Bargaining Code drafted by the Australian Competition and Consumer Commission. These and similar laws that have been adopted or proposed introduce new constraining licensing regimes that could affect our ability to operate. The EUCD and similar laws could increase the liability of some content-sharing services with respect to content uploaded by their users. Some of these laws, as well as follow-on administrative or judicial actions, have also created or may create a new property right in news publications that limits the ability of some online services to interact with or present such content. They may also impose compensation negotiations with news agencies and publishers for the use of such content, which may result in payment obligations that significantly exceed the value that such content provides to Google and its users. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. • Various U.S. and international laws that govern the distribution of certain materials to children and regulate the ability of online services to collect information from minors. • Various laws with regard to content removal and disclosure obligations, such as the Network Enforcement Act in Germany, which may affect our businesses and operations and may subject us to significant fines if such laws are interpreted and applied in a manner inconsistent with our practices or when we may not proactively discover such content due to the scale of third-party content and the limitations of existing technologies. Other countries, including Singapore, Australia, and the United Kingdom, have implemented or are considering similar legislation imposing penalties for failure to remove certain types of content. • Various legislative, litigation, and regulatory activity regarding our Google Play billing policies and business model, which could result in monetary penalties, damages and/or prohibition. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain and could harm our business. For example: 17 Table of Contents Alphabet Inc. • We rely on statutory safe harbors, as set forth in the Digital Millennium Copyright Act and Section 230 of the Communications Decency Act in the United States and the E-Commerce Directive in Europe, against liability for various linking, caching, and hosting activities. Any legislation or court rulings affecting these safe harbors may adversely affect us. There are legislative proposals in both the US and EU that could reduce our safe harbor protection. • Court decisions such as the judgment of the Court of Justice of the European Union (CJEU) on May 13, 2014 on the ‘right to be forgotten,’ which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users and impose significant operational burdens. The introduction of new businesses, products, services, and technologies, our activities in certain jurisdictions, or other actions we take may subject us to additional laws and regulations. Our investment in a variety of new fields, such as healthcare and payment services, may expand the scope of regulations that apply to our business. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Any failure on our part to comply with laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are subject to claims, suits, government investigations, and other proceedings that may harm our business, financial condition, and operating results. We are subject to claims, suits, and government investigations involving competition, intellectual property, data privacy and security, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Due to our manufacturing and sale of an expanded suite of products, including hardware as well as Google Cloud offerings, we also are subject to a variety of claims including product warranty, product liability, and consumer protection claims related to product defects, among other litigation. We may also be subject to claims involving health and safety, hazardous materials usage, other environmental impacts, or service disruptions or failures. Any of these types of legal proceedings can have an adverse effect on us because of legal costs, diversion of management resources, negative publicity and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. The resolution of one or more such proceedings has resulted in, and may in the future result in, additional substantial fines, penalties, injunctions, and other sanctions that could harm our business, financial condition, and operating results. We may be subject to legal liability associated with providing online services or content. Our products and services let users exchange information, advertise products and services, conduct business, and engage in various online activities. We also place advertisements displayed on other companies’ websites, and we offer third-party products, services, and/or content. The law relating to the liability of online service providers for others’ activities on their services is still somewhat unsettled around the world. Claims have been brought against us for defamation, negligence, breaches of contract, copyright and trademark infringement, unfair competition, unlawful activity, torts, fraud, or other legal theories based on the nature and content of information available on or via our services. We may be subject to claims by virtue of our involvement in hosting, transmitting, marketing, branding, or providing access to content created by third parties. Defense of any such actions could be costly and involve significant time and attention of our management and other resources, may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Privacy and data protection regulations are complex and rapidly evolving areas. Adverse interpretations of these laws could harm our business, reputation, financial condition, and operating results. Authorities around the world have adopted and are considering a number of legislative and regulatory proposals concerning data protection and limits on encryption of user data. Adverse legal rulings, legislation, or regulation could result in fines and orders requiring that we change our data practices, which could have an adverse effect on our ability to provide services, harming our business operations. Complying with these evolving laws could result in substantial costs and harm the quality of our products and services, negatively affecting our business, and may be particularly challenging during certain times, such as a natural disaster or pandemic (including COVID-19). Recent legal developments in Europe have created compliance uncertainty regarding transfers of personal data from Europe to the United States. For example, the General Data Protection Regulation (GDPR) applies to all of our activities conducted from an establishment in the EU or related to products and services that we offer to EU 18 Table of Contents Alphabet Inc. users or customers, or the monitoring of their behavior in the EU. The GDPR creates a range of new compliance obligations. Ensuring compliance with the GDPR is an ongoing commitment that involves substantial costs, and despite our efforts, governmental authorities or others have asserted and may continue to assert that our business practices fail to comply with its requirements. If our operations are found to violate GDPR requirements, we may incur substantial fines, have to change our business practices, and face reputational harm, any of which could have an adverse effect on our business. In particular, serious breaches of the GDPR can result in administrative fines of up to 4% of annual worldwide revenues. Fines of up to 2% of annual worldwide revenues can be levied for other specified violations. The EU-U.S. and the Swiss-U.S. Privacy Shield frameworks allow U.S. companies that self-certify to the U.S. Department of Commerce and publicly commit to comply with specified requirements to import personal data from the EU and Switzerland. Recently, the CJEU ruled that the EU-U.S. Privacy Shield is an invalid transfer mechanism, but upheld Standard Contractual Clauses as a valid transfer mechanism, provided they meet certain requirements. The validity of data transfer mechanisms remains subject to legal, regulatory, and political developments in both Europe and the U.S., such as recent recommendations from the European Data Protection Board, the invalidation of the EU-U.S. Privacy Shield and potential invalidation of other data transfer mechanisms, which could have a significant adverse impact on our ability to process and transfer personal data outside of the EEA. These developments create some uncertainty, and compliance obligations could cause us to incur costs or harm the operations of our products and services in ways that harm our business. We face, and may continue to face intellectual property and other claims that could be costly to defend, result in significant damage awards or other costs (including indemnification awards), and limit our ability to use certain technologies in the future. We, like other internet, technology and media companies, are frequently subject to litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent-holding companies may frequently seek to generate income from patents they have obtained by bringing claims against us. As we have grown, the number of intellectual property claims against us has increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Other parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease-and-desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services. They may also cause us to change our business practices and require development of non-infringing products, services, or technologies, which could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to defend against certain intellectual property infringement claims and in some cases indemnify them for certain intellectual property infringement claims against them, which could result in increased costs for defending such claims or significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers arising from intellectual property infringement claims. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, including those associated with intellectual property claims. Regardless of their merits, intellectual property claims are often time consuming and expensive to litigate or settle. To the extent such claims are successful, they may harm our business, including our product and service offerings, financial condition, or operating results. Risks Related to Ownership of our Stock We cannot guarantee that any share repurchase program will be fully consummated or will enhance long-term stockholder value, and share repurchases could increase the volatility of our stock prices and could diminish our cash reserves . 19 Table of Contents Alphabet Inc. We engage in share repurchases of our Class C capital stock from time to time in accordance with authorizations from the Board of Directors of Alphabet. Our repurchase program does not have an expiration date and does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. Further, our share repurchases could affect our share trading prices, increase their volatility, reduce our cash reserves and may be suspended or terminated at any time, which may result in a decrease in the trading prices of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B common stock has 10 votes per share, our Class A common stock has one vote per share, and our Class C capital stock has no voting rights. As of December 31, 2020, Larry Page and Sergey Brin beneficially owned approximate ly 85.3% of our outstanding Class B common stock, which represented approximate ly 51.5% o f the voting power of our outstanding common stock. Through their stock ownership, Larry and Sergey have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C capital stock carries no voting rights (except as required by applicable law), the issuance of the Class C capital stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could continue Larry and Sergey’s current relative voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. This concentrated control limits or severely restricts other stockholders’ ability to influence corporate matters and we may take actions that some of our stockholders do not view as beneficial, which could reduce the market price of our Class A common stock and our Class C capital stock. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry and Sergey have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. As noted above, the issuance of the Class C capital stock could have the effect of continuing the influence of Larry and Sergey. • Our Board of Directors has the right to elect directors to fill a vacancy created by the expansion of the Board of Directors or the resignation, death, or removal of a director, which prevents stockholders from being able to fill vacancies on our Board of Directors. • Our stockholders may not act by written consent. As a result, a holder, or holders, controlling a majority of our capital stock would not be able to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the Board of Directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our Board of Directors may issue, without stockholder approval, shares of undesignated preferred stock. The ability to issue undesignated preferred stock makes it possible for our Board of Directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the Board of Directors has approved the transaction. Our Board of Directors could rely on Delaware law to prevent or delay an acquisition of us. 20 Table of Contents Alphabet Inc. General Risks The continuing impacts of COVID-19 are highly unpredictable and could be significant, and may have an adverse effect on our business, operations and our future financial performance. Since COVID-19 was declared a global pandemic by the World Health Organization, governments and municipalities around the world have instituted measures in an effort to control the spread of COVID-19, including quarantines, shelter-in-place orders, school closings, travel restrictions, and closure of non-essential businesses. The macroeconomic impacts on our business continue to evolve and be unpredictable and may continue to adversely affect our business, operations and financial performance. As a result of the scale of the ongoing pandemic and the speed at which the global community has been impacted, our revenue growth rate and expense as a percentage of our revenues in future periods may differ significantly from our historical rate, and our future operating results may fall below expectations. The future impacts of the ongoing pandemic on our business, operations and future financial performance could include, but are not limited to: • Significant decline in advertising revenues as advertiser spending slows due to an economic downturn. This decline in advertising revenues could persist through and beyond a recessionary period. In addition, we may experience a significant and prolonged shift in user behavior such as a shift in interests to less commercial topics. • Significant decline in other revenues due to a decline or shifts in customer demand. For example, if consumer demand for electronics significantly declines, our hardware revenues could be significantly impacted. • Adverse impacts to our operating income, operating margin, net income, EPS and respective growth rates - particularly if expenses do not decrease across Alphabet at the same pace as revenue declines. Many of our expenses are less variable in nature and/or may not correlate to changes in revenues, including costs associated with our data centers and facilities as well as employee compensation. As such, we may not be able to decrease them significantly in the short-term, or we may choose not to significantly reduce them in an effort to remain focused on long-term outlook and investment opportunities. • Significant decline in our operating cash flows as a result of decreased advertiser spending and deterioration in the credit quality and liquidity of our customers, which could adversely affect our accounts receivable. Investing cash flows could decrease due to slowing spend on data center and facilities construction projects due to a slowing or stopping of construction or significant restrictions placed on construction. • The prolonged and broad-based shift to a remote working environment continues to create inherent productivity, connectivity, and oversight challenges and could affect our ability to enhance, develop and support existing products and services, detect and prevent spam and problematic content, hold product sales and marketing events, and generate new sales leads, among others. In addition, the changed environment under which we are operating could have an effect on our internal controls over financial reporting as well as our ability to meet a number of our compliance requirements in a timely or quality manner. Additional and/or extended, governmental lockdowns, restrictions or new regulations could significantly impact the ability of our employees and vendors to work productively. Governmental restrictions have been globally inconsistent and it remains unclear when a return to worksite locations or travel will be permitted or what restrictions will be in place in those environments. As we prepare to return our workforce in more locations back to the office in 2021, we may experience increased costs as we prepare our facilities for a safe return to work environment and experiment with hybrid work models, in addition to potential effects on our ability to compete effectively and maintain our corporate culture. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results may fluctuate as a result of a number of factors, many outside of our control. As a result, comparing our operating results (including our expenses as a percentage of our revenues) on a period-to-period basis may not be meaningful, and you should not rely on our past results as an indication of our future performance. Our operating results in future quarters may fall below expectations. Any of these events could cause our stock price to fall. Each of the risk factors listed under this Item 1A in addition to the following factors may affect our operating results: • Our ability to attract user and/or customer adoption of, and generate significant revenues from, new products, services, and technologies in which we have invested considerable time and resources. 21 Table of Contents Alphabet Inc. • Our ability to monetize traffic on Google Search & other properties, YouTube and our Google Network Members' properties across various devices. • The amount and timing of operating costs and expenses and capital expenditures related to the maintenance and expansion of our businesses, operations, and infrastructure. • Our focus on long-term goals over short-term results. • The results of our acquisitions, divestitures, and our investments in risky projects, including new businesses, products, services, and technologies. • Our ability to keep our products and services operational at a reasonable cost and without service interruptions. • The seasonal fluctuations in internet usage, advertising spending, and underlying business trends such as traditional retail seasonality. Our rapid growth has tended to mask the cyclicality and seasonality of our business. As our growth rate has slowed, the cyclicality and seasonality in our business has become more pronounced and caused our operating results to fluctuate. • Geopolitical events, including trade disputes. • Changes in global business or macroeconomic conditions. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that may harm our business, financial condition, and operating results. Acquisitions, joint ventures, investments and divestitures are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and operating results. We expect to continue to evaluate and enter into discussions regarding a wide array of such potential strategic transactions, which could create unforeseen operating difficulties and expenditures. Some of the areas where we face risks include: • Diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions. • Failure to successfully integrate and further develop the acquired business or technology. • Implementation or remediation of controls, procedures, and policies at the acquired company. • Integration of the acquired company’s accounting, human resource, and other administrative systems, and coordination of product, engineering, and sales and marketing functions. • Transition of operations, users, and customers onto our existing platforms. • Failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of a transaction. • In the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries. • Cultural challenges associated with integrating employees from the acquired company into our organization, and retention of employees from the businesses we acquire. • Liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, data privacy and security issues, violations of laws, commercial disputes, tax liabilities, and other known and unknown liabilities. • Litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions and other strategic transactions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or operating results. 22 Table of Contents Alphabet Inc. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which may harm our financial condition or operating results. If we were to lose the services of key personnel, we may not be able to execute our business strategy. Our future success depends in large part upon the continued service of key members of our senior management team. For instance, Sundar Pichai is critical to the overall management of Alphabet and its subsidiaries and plays an important role in the development of our technology, maintaining our culture and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our ability to compete effectively and our future success depends on our continuing to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Restrictive immigration policy and regulatory changes may also impact our ability to hire, mobilize or retain some of our global talent. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows and evolves, we may need to implement more complex organizational management structures or adapt our corporate culture and work environments to ever-changing circumstances, such as during times of a natural disaster or pandemic (including COVID-19), and these changes could impact our ability to compete effectively or have an adverse impact on our corporate culture. We are exposed to fluctuations in the market values of our investments and, in some instances, our financial statements incorporate valuation methodologies that are subjective in nature resulting in fluctuations over time. The market value of our investments can be negatively affected by liquidity, credit deterioration or losses, performance and financial results of the underlying entities, foreign exchange rates, changes in interest rates, including changes that may result from the implementation of new benchmark rates, the effect of new or changing regulations, the stock market in general, or other factors. The effect of COVID-19 on our impairment assessment for non-marketable investments requires significant judgment due to the uncertainty around the duration and severity of the impact. We measure certain of our non-marketable equity and debt investments, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves use of appropriate valuation methods and certain unobservable inputs, require management judgment and estimation, and may change over time. We adjust the carrying value of our non-marketable equity investments to fair value for observable transactions of identical or similar investments of the same issuer or for impairments. All gains and losses on non-marketable equity securities, realized and unrealized, are recognized in other income (expense), which increases the volatility of our other income (expense). The unrealized gains and losses we record on our non-marketable equity securities in any particular period may differ significantly from the realized gains or losses we ultimately experience on such investments. As a result of these factors, the value or liquidity of our cash equivalents, as well as our marketable and non-marketable securities could decline and result in a material impairment, which could adversely affect our financial condition and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. Our future income taxes could be negatively affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, changes in the valuation of our deferred tax 23 Table of Contents Alphabet Inc. assets or liabilities, the application of different provisions of tax laws or changes in tax laws, regulations, or accounting principles (including changes in the interpretation of existing laws), as well as certain discrete items. In addition, we are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions, including in Europe, on various tax-related assertions, such as transfer-pricing adjustments or permanent-establishment claims. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition and could require us to change our business practices in a manner adverse to our business. It may also subject us to additional litigation and regulatory inquiries, resulting in the diversion of management’s time and attention. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations for which the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may affect our financial results in the period or periods for which such determination is made. Furthermore, due to shifting economic and political conditions, tax policies, laws, or rates in various jurisdictions may be subject to significant changes in ways that impair our financial results. Various jurisdictions around the world have enacted or are considering digital services taxes, which could lead to inconsistent and potentially overlapp ing international tax regimes. The Organization for Economic Cooperation and Development (OECD) recently released proposals relating to its initiative for modernizing international tax rules, with the goal of having different countries implement a modernized and aligned international tax framework, but there can be no guarantee that this will occur. In addition, in response to significant market volatility and disruptions to business operations resulting from the global spread of COVID-19, legislatures and taxing authorities in many jurisdictions in which we operate may propose changes to their tax rules. These changes could include modifications that have temporary effect, and more permanent changes. The impact of these potential new rules on us, our long-term tax planning, and our effective tax rate could be material. The trading price for our Class A common stock and non-voting Class C capital stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. In addition to the factors discussed in this report, the trading price of our Class A common stock and Class C capital stock may fluctuate widely in response to various factors, many of which are beyond our control, including, among others announcements by us or our competitors of acquisitions, divestitures, investments, new products, significant contracts, commercial relationships, or capital commitments; recommendations by securities analysts or changes in their earnings estimates; announcements about our or our competitors' earnings that are not in line with analyst expectations, the risk of which is enhanced, in our case, because it is our policy not to give guidance on earnings; commentary by industry and market professionals about our products, strategies, and other matters affecting our business and results, regardless of its accuracy; the volume of shares of Class A common stock and Class C capital stock available for public sale; sales of Class A common stock and Class C capital stock by us or by our stockholders (including sales by our directors, executive officers, and other employees); short sales, hedging, and other derivative transactions on shares of our Class A common stock and Class C capital stock; the size, timing and share class of any share repurchase program; and the perceived values of Class A common stock and Class C capital stock relative to one another. In addition, the stock market in general, which can be affected by various factors, including overall economic and political conditions, and the market for technology companies in particular, have experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of those companies. These broad market and industry factors may harm the market price of our Class A common stock and our Class C capital stock, regardless of our actual operating performance. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. 24 Table of Contents Alphabet Inc. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We also own and lease office and building space in the surrounding areas near our headquarters, which we believe is sufficient to accommodate anticipated future growth. In addition, we own and lease office/building space and research and development sites around the world, primarily in North America, Europe, South America, and Asia. We own and operate data centers in the U.S., Europe, South America, and Asia. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, please see Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 25 Table of Contents Alphabet Inc. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. Holders of Record As of December 31, 2020, there were approximately 4,337 and 1,942 stockholders of record of our Class A common stock and Class C capital stock, respectively. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2020, there were approximately 64 stockholders of record of our Class B common stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. The primary use of capital continues to be to invest for the long term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class C capital stock during the quarter ended December 31, 2020: Period Total Number of Shares Purchased (in thousands) (1) Average Price Paid per Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 1,869 $ 1,540.84 1,869 $ 22,667 November 1 - 30 1,640 $ 1,748.65 1,640 $ 19,799 December 1 - 31 1,205 $ 1,787.62 1,205 $ 17,645 Total 4,714 4,714 (1) The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Please refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. 26 Table of Contents Alphabet Inc. Stock Performance Graphs The graph below matches Alphabet Inc. Class A's cumulative 5-Year total shareholder return on common stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from December 31, 2015 to December 31, 2020. The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* ALPHABET INC. CLASS A COMMON STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2015 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2020 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 27 Table of Contents Alphabet Inc. The graph below matches Alphabet Inc. Class C's cumulative 5-Year total shareholder return on capital stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our Class C capital stock and in each index (with the reinvestment of all dividends) from December 31, 2015 to December 31, 2020. The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE TOTAL RETURN* ALPHABET INC. CLASS C CAPITAL STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2015 in stock or in index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2020 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 28 Table of Contents Alphabet Inc. ITEM 6. SELECTED FINANCIAL DATA The following selected consolidated financial data should be read in conjunction with Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes appearing in Item 8 “Financial Statements and Supplementary Data” of this Annual Report on Form 10-K. The historical results are not necessarily indicative of the results to be expected in any future period. Year Ended December 31, 2016 2017 2018 2019 2020 (in millions, except per share amounts) Consolidated Statements of Income Data: Revenues $ 90,272 $ 110,855 $ 136,819 $ 161,857 $ 182,527 Income from operations $ 23,737 $ 26,178 $ 27,524 $ 34,231 $ 41,224 Net income $ 19,478 $ 12,662 $ 30,736 $ 34,343 $ 40,269 Basic net income per share of Class A and B common stock $ 28.32 $ 18.27 $ 44.22 $ 49.59 $ 59.15 Basic net income per share of Class C capital stock $ 28.32 $ 18.27 $ 44.22 $ 49.59 $ 59.15 Diluted net income per share of Class A and B common stock $ 27.85 $ 18.00 $ 43.70 $ 49.16 $ 58.61 Diluted net income per share of Class C capital stock $ 27.85 $ 18.00 $ 43.70 $ 49.16 $ 58.61 As of December 31, 2016 2017 2018 2019 2020 (in millions) Consolidated Balance Sheet Data: Cash, cash equivalents, and marketable securities $ 86,333 $ 101,871 $ 109,140 $ 119,675 $ 136,694 Total assets $ 167,497 $ 197,295 $ 232,792 $ 275,909 $ 319,616 Total long-term liabilities $ 11,705 $ 20,610 $ 20,544 $ 29,246 $ 40,238 Total stockholders’ equity $ 139,036 $ 152,502 $ 177,628 $ 201,442 $ 222,544 29 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and related notes included under Part II, Item 8 of this Annual Report on Form 10-K. We have omitted discussion of 2018 results where it would be redundant to the discussion previously included in Part II, Item 7 of our 2019 Annual Report on Form 10-K. Trends in Our Business The following long-term trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, contributing to revenue growth, and we expect that this online shift will continue to benefit our business. • Users are increasingly using diverse devices and modalities to access our products and services, and our advertising revenues are increasingly coming from new formats. Our users are accessing the Internet via diverse devices and modalities, such as smartphones, wearables and smart home devices, and want to feel connected no matter where they are or what they are doing. We seek to expand our products and services to stay in front of these trends in order to maintain and grow our business. We generate our advertising revenues increasingly from different channels, including mobile, and newer advertising formats, and the margins from the advertising revenues from these channels and newer products have generally been lower than those from traditional desktop search. Additionally, as the market for a particular device type or modality matures, our revenues may be affected. For example, growth in the global smartphone market has slowed due to various factors, including increased market saturation in developed countries, which can affect our mobile advertising revenue growth rates. We expect TAC paid to our distribution partners and Google Network Members to increase as our revenues grow and to be affected by changes in device mix; geographic mix; partner mix; partner agreement terms; the percentage of queries channeled through paid access points; product mix; the relative revenue growth rates of advertising revenues from different channels; and revenue share terms. We expect these trends to continue to affect our revenue growth rates and put pressure on our overall margins. • As online advertising evolves, we continue to expand our product offerings which may affect our monetization. As interactions between users and advertisers change and as online user behavior evolves, we continue to expand and evolve our product offerings to serve their changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in YouTube ads and Google Play ads, which monetize at a lower rate than our traditional search ads. • As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates affect such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, such as India, where we continue to invest heavily and develop localized versions of our products and relevant advertising programs useful to our users in these markets. This has led to a trend of increased revenues from international markets over time, as regions with emerging markets, such as APAC, have demonstrated higher revenue growth rates. We expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. This trend could impact our margins as developing markets initially monetize at a lower rate than more mature markets. Our international revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. 30 Table of Contents Alphabet Inc. • The portion of our revenues that we derive from non-advertising revenues is increasing and may affect margins. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings to our users through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. Across these initiatives, we currently derive non-advertising revenues primarily from sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud services and subscription and other services. The margins on these revenues vary significantly and may be lower than the margins on our advertising revenues. A number of our Other Bets initiatives are in their initial development stages, and as such, the sources of revenues from these businesses could change over time and the revenues could be volatile. • As we continue to serve our users and expand our businesses, we will invest heavily in operating and capital expenditures. We continue to make significant R&D investments in areas of strategic focus such as advertising, cloud, machine learning, and search, as well as in new products and services. In addition, we expect to continue to invest in land and buildings for data centers and offices, and information technology assets, which includes servers and network equipment, to support the long-term growth of our business. In addition, acquisitions and strategic investments are an important part of our strategy and use of capital, contributing to the breadth and depth of our offerings, expanding our expertise in engineering and other functional areas, and building strong partnerships around strategic initiatives. For example, in 2020 we announced our Google for India Digitization Fund to invest approximately $10 billion into India over the next 5-7 years through a mix of equity investments, partnerships, and operational, infrastructure and ecosystem investments. • We face continuing changes in regulatory conditions, laws and public policies, which could impact our business practices and financial results. Changes in social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics and related legal matters have resulted in fines and caused us to change our business practices. As these global trends continue, for example the recent antitrust complaints filed by the U.S. Department of Justice and a number of state Attorneys General as well as the News Media Bargaining Code drafted by the Australian Competition and Consumer Commission, our cost of doing business may increase and our ability to pursue certain business models or offer certain products or services may be limited. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs to our employees. The Impact of COVID-19 on our Results and Operations In late 2019, an outbreak of COVID-19 emerged and by March 11, 2020 was declared a global pandemic by the World Health Organization. Across the United States and the world, governments and municipalities instituted measures in an effort to control the spread of COVID-19, including quarantines, shelter-in-place orders, school closings, travel restrictions and the closure of non-essential businesses. The macroeconomic impacts of COVID-19 are significant and continue to evolve, as exhibited by, among other things, a rise in unemployment, changes in consumer behavior, and market volatility. We began to observe the impact of COVID-19 and the related reductions in global economic activity on our financial results in March 2020 when, despite an increase in users' search activity, our advertising revenues declined compared to the prior year due to a shift of user search activity to less commercial topics and reduced spending by our advertisers. During the course of the quarter ended June 30, 2020, we observed a gradual return in user search activity to more commercial topics, followed by increased spending by our advertisers that continued throughout the second half of 2020. We continue to assess the realized and potential credit deterioration of our customers due to changes in the macroeconomic environment, which has been reflected in our allowance for credit losses for accounts receivable. Additionally, over the course of the year we experienced variability in our margins as many of our expenses are less variable in nature and/or may not correlate to changes in revenues, including costs associated with our data centers and facilities as well as employee compensation. Also, market volatility has contributed to fluctuations in the valuation of our equity investments. 31 Table of Contents Alphabet Inc. While we continued to make investments in land and buildings for data centers, offices and information technology, in 2020 we slowed the pace of our investments, primarily as it relates to office facilities, as a result of COVID-19. The ongoing impact of COVID-19 on our business continues to evolve and be unpredictable. For example, to the extent the pandemic disrupts economic activity globally we, like other businesses, are not immune to continued adverse impacts to our business, operations and financial results from volatility in advertising spending, changes in user behavior and preferences, credit deterioration and liquidity of our customers, depressed economic activity, or volatility in capital markets. The ongoing impact will depend on a number of factors, including the duration and severity of the pandemic; the uneven impact to certain industries; advances in testing, treatment and prevention including vaccines; and the macroeconomic impact of government measures to contain the spread of the virus and related government stimulus measures. To address the potential impact to our business, over the near-term, we continue to evaluate the pace of our investment plans, including, but not limited to, our hiring, investments in data centers, servers, network equipment, real estate and facilities, marketing and travel spending, as well as taking certain measures to support our customers, our overall workforce, and communities we operate in. As we look to return our workforce in more locations back to the office in 2021, we may experience increased costs as we prepare our facilities for a safe return to work environment and experiment with hybrid work models. At the same time, we believe the current environment is accelerating digital transformation and we remain focused on innovating and investing in the services we offer to consumers and businesses. For example, as it relates to Google Cloud, we continue to invest aggressively around the globe in our go-to-market capabilities, product development and technical infrastructure to support long term growth. The ongoing impact of COVID-19 and the extent of these measures we have taken and the additional measures that we may implement could have a material impact on our financial results. Our past results may not be indicative of our future performance, and historical trends in our financial results may differ materially. Executive Overview The following table summarizes our consolidated financial results for the years ended December 31, 2019 and 2020 (in millions, except for per share information and percentages). Year Ended December 31, 2019 2020 Revenues $161,857 $182,527 Increase in revenues year over year 18 % 13 % Increase in constant currency revenues year over year 20 % 14 % Operating income (1) $ 34,231 $ 41,224 Operating margin (1) 21 % 23 % Other income (expense), net $ 5,394 $ 6,858 Net Income (1) $ 34,343 $ 40,269 Diluted EPS (1) $ 49.16 $ 58.61 (1) Results for 2019 include the effect of the $1.7 billion EC fine. See Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. • Total revenues were $182.5 billion, an increase of 13% year over year, primarily driven by an increase in Google Services segment revenues of $16.8 billion or 11% and an increase in Google Cloud segment revenues of $4.1 billion or 46%. Revenues from the United States, EMEA, APAC, and Other Americas were $85.0 billion, $55.4 billion, $32.6 billion, and $9.4 billion, respectively. • Total cost of revenues was $84.7 billion, an increase of 18% year over year. TAC was $32.8 billion, an increase of 9% year over year, primarily driven by an increase in revenues subject to TAC. Other cost of revenues were $51.9 billion, an increase of 24% year over year, primarily driven by an increase in data centers and other operations costs and content acquisition costs. 32 Table of Contents Alphabet Inc. • Operating expenses were $56.6 billion, an increase of 5% year over year primarily driven by headcount growth and partially offset by declines in advertising and promotional expenses and travel and entertainment expenses. Other information: • Operating cash flow was $65.1 billion. • Capital expenditures, which primarily included investments in technical infrastructure, were $22.3 billion. • Number of employees was 135,301 as of December 31, 2020. The majority of new hires during the year were engineers and product managers. Our Segments Beginning in the fourth quarter of 2020, we report our segment results as Google Services, Google Cloud, and Other Bets: • Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV. • Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Google Cloud generates revenues primarily from fees received for Google Cloud Platform ("GCP") services and Google Workspace (formerly known as G Suite) collaboration tools. • Other Bets is a combination of multiple operating segments that are not individually material. Revenues from the Other Bets are derived primarily through the sale of internet services as well as licensing and R&D services. Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including fines and settlements, as well as costs associated with certain shared research and development activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs. Financial Results Revenues The following table presents our revenues by type (in millions). Year Ended December 31, 2019 2020 Google Search & other $ 98,115 $ 104,062 YouTube ads 15,149 19,772 Google Network Members' properties 21,547 23,090 Google advertising 134,811 146,924 Google other 17,014 21,711 Google Services total 151,825 168,635 Google Cloud 8,918 13,059 Other Bets 659 657 Hedging gains (losses) 455 176 Total revenues $ 161,857 $ 182,527 Google Services Google advertising revenues Our advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google Search & other properties and the change in impressions and cost-per-impression on Google Network Members' properties and the correlation between these items, have been affected and may continue to be affected by various factors, including: • advertiser competition for keywords; • changes in advertising quality, formats, delivery or policy; 33 Table of Contents Alphabet Inc. • changes in device mix; • changes in foreign currency exchange rates; • fees advertisers are willing to pay based on how they manage their advertising costs; • general economic conditions including the impact of COVID-19; • seasonality; and • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels. Our advertising revenue growth rate has been affected over time as a result of a number of factors, including challenges in maintaining our growth rate as revenues increase to higher levels; changes in our product mix; changes in advertising quality or formats and delivery; the evolution of the online advertising market; increasing competition; our investments in new business strategies; query growth rates; and shifts in the geographic mix of our revenues. We also expect that our revenue growth rate will continue to be affected by evolving user preferences, the acceptance by users of our products and services as they are delivered on diverse devices and modalities, our ability to create a seamless experience for both users and advertisers, and movements in foreign currency exchange rates. Google advertising revenues consist primarily of the following: • Google Search & other consists of revenues generated on Google search properties (including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.) and other Google owned and operated properties like Gmail, Google Maps, and Google Play; • YouTube ads consists of revenues generated on YouTube properties; and • Google Network Members' properties consist of revenues generated on Google Network Members' properties participating in AdMob, AdSense, and Google Ad Manager. Google Search & other Google Search & other revenues increased $5,947 million from 2019 to 2020. The overall growth was primarily driven by interrelated factors including increases in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices, growth in advertiser spending primarily in the second half of the year, and improvements we have made in ad formats and delivery. This increase was partially offset by a decline in advertiser spending primarily in the first half of the year driven by the impact of COVID-19. YouTube ads YouTube ads revenues increased $4,623 million from 2019 to 2020. Growth was primarily driven by our direct response advertising products, which benefited from improvements to ad formats and delivery and increased advertiser spending. Brand advertising products also contributed to growth despite revenues being adversely impacted by a decline in advertiser spending primarily in the first half of the year driven by the impact of COVID-19. Google Network Members' properties Google Network Members' properties revenues increased $1,543 million from 2019 to 2020. The growth was primarily driven by strength in AdMob and Google Ad Manager. Use of Monetization Metrics Paid clicks for our Google Search & other properties represent engagement by users and include clicks on advertisements by end-users on Google search properties and other owned and operated properties including Gmail, Google Maps, and Google Play. Historically, we included certain viewed YouTube engagement ads and the related revenues in our paid clicks and cost-per-click monetization metrics. Over time, advertising on YouTube has expanded to multiple advertising formats and the type of viewed engagement ads historically included in paid clicks and cost-per-click metrics have increasingly covered a smaller portion of YouTube advertising revenues. As a result, we removed these ads and the related revenues from the paid clicks and cost-per-click metrics for the current and historical periods presented. The revised metrics provide a better understanding of monetization trends on the properties included within Google Search & other, as they now more closely correlate with the related changes in revenues. Impressions for our Google Network Members' properties include impressions displayed to users served on Google Network Members' properties participating primarily in AdMob, AdSense and Google Ad Manager. Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. 34 Table of Contents Alphabet Inc. Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions and represents the average amount we charge advertisers for each impression displayed to users. As our business evolves, we periodically review, refine and update our methodologies for monitoring, gathering, and counting the number of paid clicks on our Google Search & other properties and the number of impressions on Google Network Members’ properties and for identifying the revenues generated by click activity on our Google Search & other properties and the revenues generated by impression activity on Google Network Members’ properties. Paid clicks and cost-per-click The following table presents changes in our paid clicks and cost-per-click (expressed as a percentage): Year Ended December 31, 2019 2020 Paid clicks change 23 % 19 % Cost-per-click change (6) % (10) % Paid clicks increased from 2019 to 2020 primarily due to an increase in clicks due to interrelated factors, resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. Growth was also driven by an increase in clicks relating to ads on Google Play. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was primarily driven by reduced advertiser spending in response to COVID-19 primarily during the first half of the year. The decrease in cost-per-click was also affected by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Paid clicks increased from 2018 to 2019 primarily due to an increase in clicks due to interrelated factors, including an increase in search queries resulting from ongoing growth in user adoption and usage, primarily on mobile devices; continued growth in advertiser activity; and improvements we have made in ad formats and delivery. Growth was also driven by an increase in clicks relating to ads on Google Play. The positive effect on our revenues from an increase in paid clicks was partially offset by a decrease in the cost-per-click paid by our advertisers. The decrease in cost-per-click was driven by changes in device mix, geographic mix, ongoing product changes, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Impressions and cost-per-impression The following table presents changes in our impressions and cost-per-impression (expressed as a percentage): Year Ended December 31, 2020 Impressions change 15 % Cost-per-impression change (8) % Impressions increased from 2019 to 2020 primarily due to growth in Google Ad Manager. The positive effect on our revenues from an increase in impressions was partially offset by a decrease in the cost-per-impression paid by our advertisers which was driven by a reduction in advertiser spending in response to COVID-19, primarily during the first half of the year, as well as the effect of a combination of factors including ongoing product and policy changes and improvements we have made in ad formats and delivery, changes in device mix, geographic mix, product mix, property mix, and fluctuations of the U.S. dollar compared to certain foreign currencies. Google other revenues Google other revenues consist primarily of revenues from: • Google Play, which includes revenues from sales of apps and in-app purchases (which we recognize net of payout to developers) and digital content sold in the Google Play store; • hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; • YouTube non-advertising, including YouTube Premium and YouTube TV subscriptions and other services; and • other products and services. 35 Table of Contents Alphabet Inc. Google other revenues increased $4,697 million from 2019 to 2020. The growth was primarily driven by Google Play and YouTube non-advertising. Growth for Google Play was primarily driven by sales of apps and in-app purchases, which benefited from elevated user engagement partially due to the impact of COVID-19. Growth for YouTube non-advertising was primarily driven by an increase in paid subscribers. Over time, our growth rate for Google other revenues may be affected by the seasonality associated with new product and service launches as well as market dynamics. Google Cloud Our Google Cloud revenues increased $4,141 million from 2019 to 2020. The growth was primarily driven by GCP followed by our Google Workspace offerings. Our infrastructure and our data and analytics platform products were the largest drivers of growth in GCP. Over time, our growth rate for Google Cloud revenues may be affected by customer usage, market dynamics, as well as new product and service launches. Revenues by Geography The following table presents our revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 2019 2020 United States 46 % 47 % EMEA 31 % 30 % APAC 17 % 18 % Other Americas 6 % 5 % For further details on revenues by geography, see Note 2 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Use of Constant Currency Revenues and Constant Currency Revenue Percentage Change The effect of currency exchange rates on our business is an important factor in understanding period to period comparisons. Our international revenues are favorably affected as the U.S. dollar weakens relative to other foreign currencies, and unfavorably affected as the U.S. dollar strengthens relative to other foreign currencies. Our revenues are also favorably affected by net hedging gains and unfavorably affected by net hedging losses. We use non-GAAP constant currency revenues and non-GAAP percentage change in constant currency revenues for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to U.S. Generally Accepted Accounting Principles ("GAAP") results helps improve the ability to understand our performance because they exclude the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the effect of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue percentage change on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior period exchange rates, as well as excluding any hedging effects realized in the current period. Constant currency revenue percentage change is calculated by determining the change in period revenues over prior period revenues where current period foreign currency revenues are translated using prior period exchange rates and hedging effects are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. 36 Table of Contents Alphabet Inc. The following table presents the foreign exchange effect on our international revenues and total revenues (in millions, except percentages): Year Ended December 31, 2019 2020 EMEA revenues $ 50,645 $ 55,370 Exclude foreign exchange effect on current period revenues using prior year rates 2,397 (111) EMEA constant currency revenues $ 53,042 $ 55,259 Prior period EMEA revenues $ 44,739 $ 50,645 EMEA revenue percentage change 13 % 9 % EMEA constant currency revenue percentage change 19 % 9 % APAC revenues $ 26,928 $ 32,550 Exclude foreign exchange effect on current period revenues using prior year rates 388 11 APAC constant currency revenues $ 27,316 $ 32,561 Prior period APAC revenues $ 21,341 $ 26,928 APAC revenue percentage change 26 % 21 % APAC constant currency revenue percentage change 28 % 21 % Other Americas revenues $ 8,986 $ 9,417 Exclude foreign exchange effect on current period revenues using prior year rates 541 964 Other Americas constant currency revenues $ 9,527 $ 10,381 Prior period Other Americas revenues $ 7,608 $ 8,986 Other Americas revenue percentage change 18 % 5 % Other Americas constant currency revenue percentage change 25 % 16 % United States revenues $ 74,843 $ 85,014 United States revenue percentage change 18 % 14 % Hedging gains (losses) 455 176 Total revenues $ 161,857 $ 182,527 Total constant currency revenues $ 164,728 $ 183,215 Prior period revenues, excluding hedging effect (1) $ 136,957 $ 161,402 Total revenue percentage change 18 % 13 % Total constant currency revenue percentage change 20 % 14 % (1) Total revenues and hedging gains (losses) for the year ended December 31, 2018 were $136,819 million and $(138) million, respectively. EMEA revenue percentage change from 2019 to 2020 was not significantly affected by foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Euro offset by the U.S. dollar strengthening relative to the Turkish lira and Russian ruble. APAC revenue percentage change from 2019 to 2020 was not significantly affected by foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Indian rupee, partially offset by the U.S. dollar weakening relative to the Japanese yen. Other Americas revenue percentage change from 2019 to 2020 was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Brazilian real and Argentine peso. 37 Table of Contents Alphabet Inc. Costs and Operating Expenses Cost of Revenues Cost of revenues includes TAC which are paid to our distribution partners who make available our search access points and services, and amounts paid to Google Network Members primarily for ads displayed on their properties. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. The cost of revenues as a percentage of revenues generated from ads placed on Google Network Members' properties are significantly higher than the cost of revenues as a percentage of revenues generated from ads placed on Google properties (which includes Google Search & other and YouTube ads), because most of the advertiser revenues from ads served on Google Network Members’ properties are paid as TAC to our Google Network Members. Additionally, other cost of revenues (which is the cost of revenues excluding TAC) includes the following: • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube advertising and subscription services and Google Play (we pay fees to these content providers based on revenues generated or a flat fee); • Expenses associated with our data centers (including bandwidth, compensation expenses including stock-based compensation ("SBC"), depreciation, energy, and other equipment costs) as well as other operations costs (such as content review and customer support costs). These costs are generally less variable in nature and may not correlate with related changes in revenues; and • Inventory related costs for hardware we sell. The following tables present our cost of revenues, including TAC (in millions, except percentages): Year Ended December 31, 2019 2020 TAC $ 30,089 $ 32,778 Other cost of revenues 41,807 51,954 Total cost of revenues $ 71,896 $ 84,732 Total cost of revenues as a percentage of revenues 44.4 % 46.4 % Cost of revenues increased $12,836 million from 2019 to 2020. The increase was due to increases in other cost of revenues and TAC of $10,147 million and $2,689 million, respectively. The increase in other cost of revenues from 2019 to 2020 was due to an increase in data center and other operations costs and an increase in content acquisition costs primarily for YouTube. This increase was partially offset by a decline in hardware costs. The increase in TAC from 2019 to 2020 was due to increases in TAC paid to distribution partners and to Google Network Members, driven by growth in revenues subject to TAC. The TAC rate was 22.3% in both 2019 and 2020. The TAC rate on Google properties revenues and the TAC rate on Google Network revenues were both substantially consistent from 2019 to 2020. Over time, cost of revenues as a percentage of total revenues may be affected by a number of factors, including the following: • The amount of TAC paid to distribution partners, which is affected by changes in device mix, geographic mix, partner mix, partner agreement terms such as revenue share arrangements, and the percentage of queries channeled through paid access points; • The amount of TAC paid to Google Network Members, which is affected by a combination of factors such as geographic mix, product mix, and revenue share terms; • Relative revenue growth rates of Google properties and Google Network Members' properties; • Certain costs that are less variable in nature and may not correlate with the related revenues; • Costs associated with our data centers and other operations to support ads, Google Cloud, Search, YouTube and other products; • Content acquisition costs, which are primarily affected by the relative growth rates in our YouTube advertising and subscription revenues; • Costs related to hardware sales; and • Increased proportion of non-advertising revenues, which generally have higher costs of revenues, relative to our advertising revenues. 38 Table of Contents Alphabet Inc. Research and Development The following table presents our R&D expenses (in millions, except percentages): Year Ended December 31, 2019 2020 Research and development expenses $ 26,018 $ 27,573 Research and development expenses as a percentage of revenues 16.1 % 15.1 % R&D expenses consist primarily of: • Compensation expenses (including SBC) for engineering and technical employees responsible for R&D of our existing and new products and services; • Depreciation expenses; • Equipment-related expenses; and • Professional services fees primarily related to consulting and outsourcing services. R&D expenses increased $1,555 million from 2019 to 2020. The increase was primarily due to an increase in compensation expenses of $1,619 million, largely resulting from a 11% increase in headcount and partially offset by higher compensation charges in certain Other Bets in 2019. Additionally, the increase in R&D expenses was partially offset by a decrease in travel and entertainment expenses of $383 million. Over time, R&D expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues. In addition, R&D expenses may be affected by a number of factors including continued investment in ads, Android, Chrome, Google Cloud, Google Play, hardware, machine learning, Other Bets, Search and YouTube. Sales and Marketing The following table presents our sales and marketing expenses (in millions, except percentages): Year Ended December 31, 2019 2020 Sales and marketing expenses $ 18,464 $ 17,946 Sales and marketing expenses as a percentage of revenues 11.4 % 9.8 % Sales and marketing expenses consist primarily of: • Advertising and promotional expenditures related to our products and services; and • Compensation expenses (including SBC) for employees engaged in sales and marketing, sales support, and certain customer service functions. Sales and marketing expenses decreased $518 million from 2019 to 2020. The decrease was primarily due to a decrease in advertising and promotional expenses of $1,395 million, as we reduced spending and paused or rescheduled campaigns and changed some events to digital-only formats as a result of COVID-19, and a decrease in travel and entertainment expenses of $371 million. The decrease was partially offset by an increase in compensation expenses of $1,347 million, largely resulting from an 8% increase in headcount. Over time, sales and marketing expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues. In addition, sales and marketing expenses may be affected by a number of factors including the seasonality associated with new product and service launches and strategic decisions regarding the timing and extent of our spending. General and Administrative The following table presents our general and administrative expenses (in millions, except percentages): Year Ended December 31, 2019 2020 General and administrative expenses $ 9,551 $ 11,052 General and administrative expenses as a percentage of revenues 5.9 % 6.1 % General and administrative expenses consist primarily of: • Compensation expenses (including SBC) for employees in our finance, human resources, information technology, and legal organizations; • Depreciation; 39 Table of Contents Alphabet Inc. • Equipment-related expenses; • Legal-related expenses; and • Professional services fees primarily related to audit, information technology consulting, outside legal, and outsourcing services. General and administrative expenses increased $1,501 million from 2019 to 2020. The increase was primarily due to an increase in compensation expenses of $887 million, largely resulting from a 16% increase in headcount. In addition, there was an increase of $440 million related to allowance for credit losses for accounts receivable. The increase was partially offset by a $554 million charge recognized in 2019 relating to a legal settlement. Over time, general and administrative expenses as a percentage of revenues may fluctuate due to certain expenses that are generally less variable in nature and may not correlate to the changes in revenues, the effect of discrete items such as legal settlements, or allowances for credit losses for accounts receivable. European Commission Fines In March 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a €1.5 billion ( $1.7 billion as of March 20, 2019) fine, which was accrued in the first quarter of 2019. Please refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. Segment Profitability The following table presents our segment operating income (loss) (in millions). For comparative purposes, amounts in prior periods have been recast. Year Ended December 31, 2018 2019 2020 Operating income (loss): Google Services $ 43,137 $ 48,999 $ 54,606 Google Cloud (4,348) (4,645) (5,607) Other Bets (3,358) (4,824) (4,476) Corporate costs, unallocated (1) (7,907) (5,299) (3,299) Total income from operations $ 27,524 $ 34,231 $ 41,224 (1) Corporate costs, unallocated includes a fine of $5.1 billion for the year ended December 31, 2018 and a fine and legal settlement totaling $2.3 billion for the year ended December 31, 2019. Google Services Google services operating income increased $5,607 million from 2019 to 2020. The increase was primarily driven by an increase in revenues partially offset by increases in content acquisition costs primarily for YouTube, data center and other operations costs, and TAC. Additionally, there was an increase in operating expenses primarily driven by an increase in compensation expenses (including SBC) largely due to increases in headcount. Operating income benefited from a decline in hardware costs. Google services operating income increased $5,862 million from 2018 to 2019. The increase was primarily driven by an increase in revenues partially offset by increases in TAC, data center and other operations costs, and content acquisition costs primarily for YouTube. Additionally, there was an increase in operating expenses primarily driven by an increase in compensation expenses (including SBC) largely due to an increase in headcount. Google Cloud Google Cloud operating loss increased $962 million from 2019 to 2020 and increased $297 million from 2018 to 2019. The increase in operating loss in both periods was driven by an increase in total expenses of $5,103 million from 2019 to 2020 and $3,377 million from 2018 to 2019. Operating expenses increased primarily due to compensation expenses (including SBC), largely driven by an increase in headcount. Additionally, data center and other operating costs increased in both periods. Other Bets Other Bets operating loss decreased $348 million from 2019 to 2020 and increased $1,466 million from 2018 to 2019. The fluctuations were primarily driven by compensation expenses (including SBC). 40 Table of Contents Alphabet Inc. Other Income (Expense), Net The following table presents other income (expense), net, (in millions): Year Ended December 31, 2019 2020 Other income (expense), net $ 5,394 $ 6,858 Other income (expense), net, increased $1,464 million from 2019 to 2020. The change was primarily driven by an increase in net gains on equity and debt securities of $3,519 million, partially offset by a $902 million loss resulting from our equity derivatives, which hedged the changes in fair value of certain marketable equity securities, and a decrease in interest income of $562 million. Over time, other income (expense), net, may be affected by market dynamics and other factors. Equity values generally change daily for marketable equity securities and upon the occurrence of observable price changes or upon impairment of non-marketable equity securities. In addition, volatility in the global economic climate and financial markets, including the effects of COVID-19, could result in a significant change in the value of our investments. Fluctuations in the value of these investments has, and we expect will continue to, contribute to volatility of OI&E in future periods. For additional information about our investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Provision for Income Taxes The following table presents our provision for income taxes (in millions, except for effective tax rate): Year Ended December 31, 2019 2020 Provision for income taxes $ 5,282 $ 7,813 Effective tax rate 13.3 % 16.2 % Our provision for income taxes and our effective tax rate increased from 2019 to 2020. The increase in the provision for income taxes and our effective tax rate is primarily due to benefits related to the resolution of multi-year audits in 2019 that did not recur in 2020, higher earnings in countries that have higher statutory rates resulting from the change in our corporate legal entity structure implemented as of December 31, 2019, and an increase in valuation allowance for net deferred tax assets that are not likely to be realized relating to certain of our Other Bets, partially offset by an increase in the U.S. federal Foreign-Derived Intangible Income tax deduction benefits. See Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information. We expect our future effective tax rate to be affected by the geographic mix of earnings in countries with different statutory rates. Additionally, our future effective tax rate may be affected by changes in the valuation of our deferred tax assets or liabilities, or changes in tax laws, regulations, or accounting principles, as well as certain discrete items. 41 Table of Contents Alphabet Inc. Quarterly Results of Operations The following tables presenting our quarterly results of operations should be read in conjunction with the consolidated financial statements and related notes included in Part II, Item 8 of this Annual Report on Form 10-K. We have prepared the unaudited information on the same basis as our audited consolidated financial statements. Our operating results for any quarter are not necessarily indicative of results for any future quarters or for a full year. The following table presents our unaudited quarterly results of operations for the eight quarters ended December 31, 2020. This table includes all adjustments, consisting only of normal recurring adjustments, that we consider necessary for a fair presentation of our consolidated financial position and operating results for the quarters presented. Seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality and macroeconomic conditions have affected, and are likely to continue to affect, our business (including developments and volatility arising from COVID-19). Commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenue growth rates. Quarter Ended Mar 31, 2019 Jun 30, 2019 Sept 30, 2019 Dec 31, 2019 Mar 31, 2020 Jun 30, 2020 Sept 30, 2020 Dec 31, 2020 (In millions, except per share amounts) (unaudited) Consolidated Statements of Income Data: Revenues $ 36,339 $ 38,944 $ 40,499 $ 46,075 $ 41,159 $ 38,297 $ 46,173 56,898 Costs and expenses: Cost of revenues 16,012 17,296 17,568 21,020 18,982 18,553 21,117 26,080 Research and development 6,029 6,213 6,554 7,222 6,820 6,875 6,856 7,022 Sales and marketing 3,905 4,212 4,609 5,738 4,500 3,901 4,231 5,314 General and administrative 2,088 2,043 2,591 2,829 2,880 2,585 2,756 2,831 European Commission fines 1,697 0 0 0 0 0 0 0 Total costs and expenses 29,731 29,764 31,322 36,809 33,182 31,914 34,960 41,247 Income from operations 6,608 9,180 9,177 9,266 7,977 6,383 11,213 15,651 Other income (expense), net 1,538 2,967 (549) 1,438 (220) 1,894 2,146 3,038 Income before income taxes 8,146 12,147 8,628 10,704 7,757 8,277 13,359 18,689 Provision for income taxes 1,489 2,200 1,560 33 921 1,318 2,112 3,462 Net income $ 6,657 $ 9,947 $ 7,068 $ 10,671 $ 6,836 $ 6,959 $ 11,247 15,227 Basic net income per share of Class A and B common stock and Class C capital stock $ 9.58 $ 14.33 $ 10.20 $ 15.49 $ 9.96 $ 10.21 $ 16.55 $ 22.54 Diluted net income per share of Class A and B common stock and Class C capital stock $ 9.50 $ 14.21 $ 10.12 $ 15.35 $ 9.87 $ 10.13 $ 16.40 $ 22.30 Financial Condition Cash, Cash Equivalents, and Marketable Securities As of December 31, 2020, we had $136.7 billion in cash, cash equivalents, and short-term marketable securities. Ca sh equivalents and marketable securities a re comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities and marketable equity securities. Sources, Uses of Cash and Related Trends Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. The primary use of capital continues to be to invest for the long term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders. 42 Table of Contents Alphabet Inc. The following table presents our cash flows (in millions): Year Ended December 31, 2019 2020 Net cash provided by operating activities $ 54,520 $ 65,124 Net cash used in investing activities $ (29,491) $ (32,773) Net cash used in financing activities $ (23,209) $ (24,408) Cash Provided by Operating Activities Our largest source of cash provided by our operations are advertising revenues generated by Google Search & other properties, Google Network Members' properties and YouTube ads. Additionally, we generate cash through sales of apps, in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings and subscription-based products. Our primary uses of cash from our operating activities include compensation and related costs, payments to our distribution partners and Google Network Members, and payments for content acquisition costs. In addition, uses of cash from operating activities include hardware inventory costs, income taxes, and other general corporate expenditures. Net cash provided by operating activities increased from 2019 to 2020 primarily due to the net effect of increases in cash received from revenues and cash paid for cost of revenues and operating expenses, and changes in operating assets and liabilities. Cash Used in Investing Activities Cash provided by investing activities consists primarily of maturities and sales of our investments in marketable and non-marketable securities. Cash used in investing activities consists primarily of purchases of marketable and non-marketable securities, purchases of property and equipment, and payments for acquisitions. Net cash used in investing activities increased from 2019 to 2020 primarily due to a net increase in purchases of securities, partially offset by decreases in payments for acquisitions and purchases of property and equipment. The net decrease in purchases of property and equipment was driven by decreases in purchases of land and buildings for offices as well as data center construction, partially offset by increases in purchases of servers. Cash Used in Financing Activities Cash provided by financing activities consists primarily of proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities. Cash used in financing activities consists primarily of repurchases of capital stock, net payments related to stock-based award activities, and repayments of debt. Net cash used in financing activities increased from 2019 to 2020 primarily due to an increase in cash payments for repurchases of capital stock, partially offset by increases in net proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities. Liquidity and Material Cash Requirements We expect existing cash, cash equivalents, short-term marketable securities, cash flows from operations and financing activities to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities for at least the next 12 months and thereafter for the foreseeable future. As of December 31, 2020, we had long-term taxes payable of $6.5 billion related to a one-time transition tax payable incurred as a result of the U.S. Tax Cuts and Jobs Act ("Tax Act"). As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025. In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ($2.7 billion as of June 27, 2017), €4.3 billion ($5.1 billion as of June 30, 2018), and €1.5 billion ($1.7 billion as of March 20, 2019), respectively. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. In January 2021, we closed the acquisition of Fitbit, a leading wearables brand, for $2.1 billion. We have a short-term debt financing program of up to $5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2020, we had no commercial paper outstanding. As of December 31, 2020, we have $4.0 billion of revolving credit facilities expiring 43 Table of Contents Alphabet Inc. in July 2023 with no amounts outstanding. The interest rate for the credit facilities is determined based on a formula using certain market rates. In August 2020, we issued $10.0 billion of fixed-rate senior unsecured notes in six tranches: $1.0 billion due in 2025, $1.0 billion due in 2027, $2.25 billion due in 2030, $1.25 billion due in 2040, $2.5 billion due in 2050 and $2.0 billion due in 2060. The 2020 Notes had a weighted average duration of 21.5 years and weighted average coupon rate of 1.57%. Of the total issuance, $5.75 billion was designated as Sustainability Bonds, the net proceeds of which are used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. The remaining net proceeds are used for general corporate purposes. As of December 31, 2020, we have senior unsecured notes outstanding with a total carrying value of $13.8 billion. Refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the debts. In accordance with the authorizations of the Board of Directors of Alphabet, in 2020 we repurchased and subsequently retired 21.5 million shares of Alphabet Class C capital stock for an aggregate amount of $31.1 billion. As of December 31, 2020, $17.6 billion remains authorized and available for repurchase. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Refer to Note 11 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Capital Expenditures and Leases We make investments in land and buildings for data centers and offices and information technology assets through purchases of property and equipment and lease arrangements to provide capacity for the growth of our services and products. Our capital investments in property and equipment consist primarily of the following major categories: • Technical infrastructure, which consists of our investments in servers and network equipment for compute, storage and networking requirements for ongoing business activities, including machine learning, (collectively referred to as our information technology assets) and data center land and building construction; and • Office facilities, ground up development projects and related building improvements. Due to the integrated nature of Alphabet, our technical infrastructure and office facilities are managed centrally at a consolidated level. The associated costs, including depreciation and impairment, are allocated to operating segments as a service cost generally based on usage or headcount. Our technical infrastructure investments are designed to support all of Alphabet, including primarily ads, Google Cloud, Search, and YouTube. Construction in progress consists primarily of technical infrastructure and office facilities which have not yet been placed in service for our intended use. The time frame from date of purchase to placement in service of these assets may extend to multiple periods. For example, our data center construction projects are generally multi-year projects with multiple phases, where we acquire qualified land and buildings, construct buildings, and secure and install information technology assets. During the years ended December 31, 2019 and 2020, we spent $23.5 billion and $22.3 billion on capital expenditures and recognized total operating lease assets of $4.4 billion and $2.8 billion, respectively. As of December 31, 2020, the amount of total future lease payments under operating leases, which had a weighted average remaining lease term of 9 years, was $15.1 billion. As of December 31, 2020, we have entered into leases that have not yet commenced with future lease payments of $8.0 billion, excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2021 and 2026 with non-cancelable lease terms of 1 to 25 years. Depreciation of our property and equipment commences when the deployment of such assets are completed and are ready for our intended use. Land is not depreciated. For the years ended December 31, 2019 and 2020, our depreciation and impairment expenses on property and equipment were $10.9 billion and $12.9 billion, respectively. For the years ended December 31, 2019 and 2020, our operating lease expenses (including variable lease costs), were $2.4 billion and $2.9 billion, respectively. Finance leases were not material for the years ended December 31, 2019 and 2020. Please refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for further information on the leases. 44 Table of Contents Alphabet Inc. Contractual Obligations as of December 31, 2020 The following summarizes our contractual obligations as of December 31, 2020 (in millions): Payments Due By Period Total Less than 1 year 1-3 years 3-5 years More than 5 years Operating lease obligations (1) $ 15,091 $ 2,198 $ 4,165 $ 3,127 $ 5,601 Obligations for leases that have not yet commenced (1) 8,049 370 1,198 1,469 5,012 Purchase obligations (2) 10,656 7,368 1,968 354 966 Long-term debt obligations (3) 19,840 1,357 634 2,587 15,262 Tax payable (4) 7,359 834 1,916 4,609 0 Other long-term liabilities reflected on our balance sheet (5) 1,421 532 616 185 88 Total contractual obligations $ 62,416 $ 12,659 $ 10,497 $ 12,331 $ 26,929 (1) For further information, refer to Note 4 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. (2) Represents non-cancelable contractual obligations primarily related to data center operations and build-outs; information technology assets; purchases of inventory; and digital media content licensing arrangements. The amounts included above represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2020. Excluded from the table above are open orders for purchases that support normal operations, which are generally cancelable. (3) Represents our principal and interest payments. For further information on long-term debt, refer to Note 6 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. (4) Represents one-time transition tax payable incurred as a result of the Tax Act. For further information, refer to Note 14 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Excluded from the table above are long-term taxes payable of $2.3 billion as of December 31, 2020 primarily related to uncertain tax positions, for which we are unable to make a reasonably reliable estimate of the timing of payments in individual years beyond 12 months due to uncertainties in the timing and outcomes of tax audits. (5) Represents cash obligations recorded on our Consolidated Balance Sheets, including the short-term portion of these long-term liabilities, primarily for certain commercial agreements. These amounts do not include the EC fines which are classified as current liabilities on our Consolidated Balance Sheets. For further information regarding the EC fines, refer to Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Off-Balance Sheet Arrangements As of December 31, 2020, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K, that have or are reasonably likely to have a current or future effect on our financial condition, changes in our financial condition, revenues, or expenses, results of operations, liquidity, capital expenditures, or capital resources that is material to investors. See Note 10 included in Part II, Item 8 of this annual report on Form 10-K for more information on our commitments and contingencies. Critical Accounting Policies and Estimates We prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, expenses, gains and losses, as well as related disclosure of contingent assets and liabilities. In some cases, we could reasonably have used different accounting policies and estimates. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition or results of operations will be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. We have reviewed our critical accounting policies and estimates with the audit and compliance committee of our Board of Directors. Please see Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements. 45 Table of Contents Alphabet Inc. Revenues For the sale of third-party goods and services, we evaluate whether we are the principal, and report revenues on a gross basis, or an agent, and report revenues on a net basis. In this assessment, we consider if we obtain control of the specified goods or services before they are transferred to the customer, as well as other indicators such as the party primarily responsible for fulfillment, inventory risk, and discretion in establishing price. Income Taxes We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. We adjust these reserves in light of changing facts and circumstances, such as the closing of a tax audit or the refinement of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services ("IRS") and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury consumer protection, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in the Notes to the Consolidated Financial Statements. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood of there being, and the estimated amount of, a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Should any of our estimates and assumptions change or prove to have been incorrect, it could have a material effect on our business, consolidated financial position, results of operations, or cash flows. Long-lived Assets Long-lived assets, including property and equipment, long-term prepayments, and intangible assets, excluding goodwill, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. An impairment loss would be recognized when estimated undiscounted future cash flows generated from the assets are less than their carrying amount. Measurement of an impairment loss would be based on the excess of the carrying amount of the asset group over its fair value. Fair Value Measurements We measure certain of our non-marketable equity and debt investments, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves the use of appropriate valuation methods and relevant inputs into valuation models. The fair value hierarchy prioritizes the inputs used to measure fair value whereby it gives the highest priority to quoted prices (unadjusted) in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. We maximize the use of relevant observable inputs and minimize the use of unobservable inputs. Our use of unobservable inputs reflects the assumptions that market participants would use and may include our own data adjusted based on reasonably available information. We apply judgment in assessing the relevance of observable market data to determine the priority of inputs under the fair value hierarchy, particularly in situations where there is very little or no market activity. 46 Table of Contents Alphabet Inc. In determining the fair values of our non-marketable equity and debt investments, as well as assets acquired (especially with respect to intangible assets) and liabilities assumed in business combinations, we make significant estimates and assumptions, some of which include the use of unobservable inputs. Certain stock-based compensation awards may be settled in the stock of certain of our Other Bets or in cash. These awards are based on the equity values of the respective Other Bet, which requires use of unobservable inputs. We also have compensation arrangements with payouts based on realized investment returns, i.e. performance fees. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized, and may require the use of unobservable inputs. Non-marketable Equity Securities Our non-marketable equity securities not accounted for under the equity method are carried either at fair value or under the measurement alternative. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. Determining whether an observed transaction is similar to a security within our portfolio requires judgment based on the rights and obligations of the securities. Recording upward and downward adjustments to the carrying value of our equity securities as a result of observable price changes requires quantitative assessments of the fair value of our securities using various valuation methodologies and involves the use of estimates. Non-marketable equity securities are also subject to periodic impairment reviews. Our quarterly impairment analysis considers both qualitative and quantitative factors that may have a significant effect on the investment's fair value. Qualitative factors considered include the companies' financial and liquidity position, access to capital resources and the time since the last adjustment to fair value, among others. When indicators of impairment exist, we prepare quantitative assessments of the fair value of our equity investments using both the market and income approaches which require judgment and the use of estimates, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When our assessment indicates that an impairment exists, we write down the investment to its fair value. Change in Accounting Estimate In January 2021, we completed an assessment of the useful lives of our servers and network equipment and determined we should adjust the estimated useful life of our servers from three years to four years and the estimated useful life of certain network equipment from three years to five years. This change in accounting estimate will be effective beginning fiscal year 2021. For assets that are in-service as of December 31, 2020, we expect operating results to be favorably impacted by approximately $2.1 billion for the full fiscal year 2021. The effect of the change may be different due to our capital investments during the fiscal year 2021. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange Risk We transact business globally in multiple currencies. Our international revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced in the near term. We use foreign exchange forward contracts to offset the foreign exchange risk on our assets and liabilities denominated in currencies other than the functional currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on the assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. If an adverse 10% foreign currency exchange rate change was applied to total monetary assets, liabilities, and commitments denominated in currencies other than the functional currencies at the balance sheet date, it would have resulted in an adverse effect on income before income taxes of approximately $8 million and $497 million as of 47 Table of Contents Alphabet Inc. December 31, 2019 and 2020, respectively, after consideration of the effect of foreign exchange contracts in place for the years ended December 31, 2019 and 2020. We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect our forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of AOCI and subsequently reclassify them into revenues to offset the hedged exposures as they occur. If the U.S. dollar weakened by 10% as of December 31, 2019 and 2020, the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $1.1 billion and $912 million lower as of December 31, 2019 and 2020, respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. We use foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations. If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment ("CTA") within AOCI related to our net investment hedge would have been approximately $936 million and $1 billion lower as of December 31, 2019 and 2020, respectively. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries. Interest Rate Risk Our Corporate Treasury investment strategy is to achieve a return that will allow us to preserve capital and maintain liquidity. We invest primarily in debt securities including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as compared to interest rates at the time of purchase. For certain fixed and variable rate debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. We measure securities for which we have not elected the fair value option at fair value with gains and losses recorded in AOCI until the securities are sold, less any expected credit losses. We use value-at-risk ("VaR") analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of our marketable debt securities as of December 31, 2019 and 2020 are shown below (in millions): As of December 31, 12-Month Average As of December 31, 2019 2020 2019 2020 Risk Category - Interest Rate $ 104 $ 144 $ 90 $ 145 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2019 and 2020 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation. Equity Investment Risk Our marketable and non-marketable equity securities are subject to a wide variety of market-related risks that could substantially reduce or increase the fair value of our holdings. Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages. 48 Table of Contents Alphabet Inc. We record our marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $3.3 billion and $5.9 billion of our investments as of December 31, 2019 and 2020, respectively. A hypothetical adverse price change of 30% on our December 31, 2020 balance, which could be experienced in the near term, would decrease the fair value of our marketable equity securities by $1.8 billion. From time to time, we may enter into derivatives to hedge the market price risk on certain of our marketable equity securities. Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). The fair value measured at the time of the observable transaction is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize appreciation in the value of our investments through liquidity events such as public offerings, acquisitions, private sales or other market events. As of December 31, 2019 and 2020, the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $11.4 billion and $18.9 billion, respectively. Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data. Volatility in the global economic climate and financial markets could result in a significant impairment charge relating to our non-marketable equity securities. Changes in valuation of non-marketable equity securities may not directly correlate with changes in valuation of marketable equity securities. Additionally, observable transactions at lower valuations could result in significant losses on our non-marketable equity securities. The effect of COVID-19 on our impairment assessment requires significant judgment due to the uncertainty around the duration and severity of the impact. The carrying values of our equity method investments, which totaled approximately $1.3 billion and $1.4 billion as of December 31, 2019 and 2020, respectively, generally do not fluctuate based on market price changes, however these investments could be impaired if the carrying value exceeds the fair value and is not expected to recover. For further information about our equity investments, please refer to Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II of this Annual Report on Form 10-K. 49 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 51 Financial Statements: Consolidated Balance Sheets 54 Consolidated Statements of Income 55 Consolidated Statements of Comprehensive Income 56 Consolidated Statements of Stockholders’ Equity 57 Consolidated Statements of Cash Flows 58 Notes to Consolidated Financial Statements 59 The supplementary financial information required by this Item 8 is included in Item 7 under the caption “Quarterly Results of Operations.” 50 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Alphabet Inc. (the Company) as of December 31, 2019 and 2020, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2020, and the related notes and financial statement schedule listed in the Index at Item 15 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2019 and 2020, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2020, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 2, 2021 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 51 Table of Contents Alphabet Inc. Loss Contingencies Description of the Matter The Company is regularly subject to claims, suits, and government investigations involving competition, intellectual property, privacy, consumer protection, tax, labor and employment, commercial disputes, content generated by its users, goods and services offered by advertisers or publishers using their platforms, and other matters. As described in Note 10 to the consolidated financial statements “Commitments and Contingencies” such claims could result in adverse consequences. Significant judgment is required to determine both the likelihood, and the estimated amount, of a loss related to such matters. Auditing management’s accounting for and disclosure of loss contingencies from these matters involved challenging and subjective auditor judgment in assessing the Company’s evaluation of the probability of a loss, and the estimated amount or range of loss. How We Addressed the Matter in Our Audit We tested relevant controls over the identified risks associated with management’s accounting for and disclosure of these matters. This included controls over management’s assessment of the probability of incurrence of a loss and whether the loss or range of loss was reasonably estimable and the development of related disclosures. Our audit procedures included gaining an understanding of previous rulings issued by regulators and the status of ongoing lawsuits, reviewing letters addressing the matters from internal and external legal counsel, meeting with internal legal counsel to discuss the allegations, and obtaining a representation letter from management on these matters. We also evaluated the Company’s disclosures in relation to these matters. /s/ Ernst & Young LLP We have served as the Company's auditor since 1999. San Jose, California February 2, 2021 52 Table of Contents Alphabet Inc. REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on Internal Control over Financial Reporting We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2020, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Alphabet Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2020, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2020 consolidated financial statements of the Company and our report dated February 2, 2021 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California February 2, 2021 53 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2019 As of December 31, 2020 Assets Current assets: Cash and cash equivalents $ 18,498 $ 26,465 Marketable securities 101,177 110,229 Total cash, cash equivalents, and marketable securities 119,675 136,694 Accounts receivable, net 25,326 30,930 Income taxes receivable, net 2,166 454 Inventory 999 728 Other current assets 4,412 5,490 Total current assets 152,578 174,296 Non-marketable investments 13,078 20,703 Deferred income taxes 721 1,084 Property and equipment, net 73,646 84,749 Operating lease assets 10,941 12,211 Intangible assets, net 1,979 1,445 Goodwill 20,624 21,175 Other non-current assets 2,342 3,953 Total assets $ 275,909 $ 319,616 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 5,561 $ 5,589 Accrued compensation and benefits 8,495 11,086 Accrued expenses and other current liabilities 23,067 28,631 Accrued revenue share 5,916 7,500 Deferred revenue 1,908 2,543 Income taxes payable, net 274 1,485 Total current liabilities 45,221 56,834 Long-term debt 4,554 13,932 Deferred revenue, non-current 358 481 Income taxes payable, non-current 9,885 8,849 Deferred income taxes 1,701 3,561 Operating lease liabilities 10,214 11,146 Other long-term liabilities 2,534 2,269 Total liabilities 74,467 97,072 Commitments and Contingencies (Note 10) Stockholders’ equity: Convertible preferred stock, $ 0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $ 0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000 , Class B 3,000,000 , Class C 3,000,000 ); 688,335 (Class A 299,828 , Class B 46,441 , Class C 342,066 ) and 675,222 (Class A 300,730 , Class B 45,843 , Class C 328,649 ) shares issued and outstanding 50,552 58,510 Accumulated other comprehensive income (loss) ( 1,232 ) 633 Retained earnings 152,122 163,401 Total stockholders’ equity 201,442 222,544 Total liabilities and stockholders’ equity $ 275,909 $ 319,616 See accompanying notes. 54 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2018 2019 2020 Revenues $ 136,819 $ 161,857 $ 182,527 Costs and expenses: Cost of revenues 59,549 71,896 84,732 Research and development 21,419 26,018 27,573 Sales and marketing 16,333 18,464 17,946 General and administrative 6,923 9,551 11,052 European Commission fines 5,071 1,697 0 Total costs and expenses 109,295 127,626 141,303 Income from operations 27,524 34,231 41,224 Other income (expense), net 7,389 5,394 6,858 Income before income taxes 34,913 39,625 48,082 Provision for income taxes 4,177 5,282 7,813 Net income $ 30,736 $ 34,343 $ 40,269 Basic net income per share of Class A and B common stock and Class C capital stock $ 44.22 $ 49.59 $ 59.15 Diluted net income per share of Class A and B common stock and Class C capital stock $ 43.70 $ 49.16 $ 58.61 See accompanying notes. 55 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2018 2019 2020 Net income $ 30,736 $ 34,343 $ 40,269 Other comprehensive income (loss): Change in foreign currency translation adjustment ( 781 ) ( 119 ) 1,139 Available-for-sale investments: Change in net unrealized gains (losses) 88 1,611 1,313 Less: reclassification adjustment for net (gains) losses included in net income ( 911 ) ( 111 ) ( 513 ) Net change, net of tax benefit (expense) of $ 156 , $( 221 ), and $( 230 ) ( 823 ) 1,500 800 Cash flow hedges: Change in net unrealized gains (losses) 290 22 42 Less: reclassification adjustment for net (gains) losses included in net income 98 ( 299 ) ( 116 ) Net change, net of tax benefit (expense) of $( 103 ), $ 42 , and $ 11 388 ( 277 ) ( 74 ) Other comprehensive income (loss) ( 1,216 ) 1,104 1,865 Comprehensive income $ 29,520 $ 35,447 $ 42,134 See accompanying notes. 56 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2017 694,783 $ 40,247 $ ( 992 ) $ 113,247 $ 152,502 Cumulative effect of accounting change 0 0 ( 98 ) ( 599 ) ( 697 ) Common and capital stock issued 8,975 148 0 0 148 Stock-based compensation expense 0 9,353 0 0 9,353 Tax withholding related to vesting of restricted stock units 0 ( 4,782 ) 0 0 ( 4,782 ) Repurchases of capital stock ( 8,202 ) ( 576 ) 0 ( 8,499 ) ( 9,075 ) Sale of interest in consolidated entities 0 659 0 0 659 Net income 0 0 0 30,736 30,736 Other comprehensive income (loss) 0 0 ( 1,216 ) 0 ( 1,216 ) Balance as of December 31, 2018 695,556 45,049 ( 2,306 ) 134,885 177,628 Cumulative effect of accounting change 0 0 ( 30 ) ( 4 ) ( 34 ) Common and capital stock issued 8,120 202 0 0 202 Stock-based compensation expense 0 10,890 0 0 10,890 Tax withholding related to vesting of restricted stock units and other 0 ( 4,455 ) 0 0 ( 4,455 ) Repurchases of capital stock ( 15,341 ) ( 1,294 ) 0 ( 17,102 ) ( 18,396 ) Sale of interest in consolidated entities 0 160 0 0 160 Net income 0 0 0 34,343 34,343 Other comprehensive income (loss) 0 0 1,104 0 1,104 Balance as of December 31, 2019 688,335 50,552 ( 1,232 ) 152,122 201,442 Common and capital stock issued 8,398 168 0 0 168 Stock-based compensation expense 0 13,123 0 0 13,123 Tax withholding related to vesting of restricted stock units and other 0 ( 5,969 ) 0 0 ( 5,969 ) Repurchases of capital stock ( 21,511 ) ( 2,159 ) 0 ( 28,990 ) ( 31,149 ) Sale of interest in consolidated entities 0 2,795 0 0 2,795 Net income 0 0 0 40,269 40,269 Other comprehensive income (loss) 0 0 1,865 0 1,865 Balance as of December 31, 2020 675,222 $ 58,510 $ 633 $ 163,401 $ 222,544 See accompanying notes. 57 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2018 2019 2020 Operating activities Net income $ 30,736 $ 34,343 $ 40,269 Adjustments: Depreciation and impairment of property and equipment 8,164 10,856 12,905 Amortization and impairment of intangible assets 871 925 792 Stock-based compensation expense 9,353 10,794 12,991 Deferred income taxes 778 173 1,390 Gain on debt and equity securities, net ( 6,650 ) ( 2,798 ) ( 6,317 ) Other ( 189 ) ( 592 ) 1,267 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable ( 2,169 ) ( 4,340 ) ( 6,524 ) Income taxes, net ( 2,251 ) ( 3,128 ) 1,209 Other assets ( 1,207 ) ( 621 ) ( 1,330 ) Accounts payable 1,067 428 694 Accrued expenses and other liabilities 8,614 7,170 5,504 Accrued revenue share 483 1,273 1,639 Deferred revenue 371 37 635 Net cash provided by operating activities 47,971 54,520 65,124 Investing activities Purchases of property and equipment ( 25,139 ) ( 23,548 ) ( 22,281 ) Purchases of marketable securities ( 50,158 ) ( 100,315 ) ( 136,576 ) Maturities and sales of marketable securities 48,507 97,825 132,906 Purchases of non-marketable investments ( 2,073 ) ( 1,932 ) ( 7,175 ) Maturities and sales of non-marketable investments 1,752 405 1,023 Acquisitions, net of cash acquired, and purchases of intangible assets ( 1,491 ) ( 2,515 ) ( 738 ) Other investing activities 98 589 68 Net cash used in investing activities ( 28,504 ) ( 29,491 ) ( 32,773 ) Financing activities Net payments related to stock-based award activities ( 4,993 ) ( 4,765 ) ( 5,720 ) Repurchases of capital stock ( 9,075 ) ( 18,396 ) ( 31,149 ) Proceeds from issuance of debt, net of costs 6,766 317 11,761 Repayments of debt ( 6,827 ) ( 585 ) ( 2,100 ) Proceeds from sale of interest in consolidated entities, net 950 220 2,800 Net cash used in financing activities ( 13,179 ) ( 23,209 ) ( 24,408 ) Effect of exchange rate changes on cash and cash equivalents ( 302 ) ( 23 ) 24 Net increase in cash and cash equivalents 5,986 1,797 7,967 Cash and cash equivalents at beginning of period 10,715 16,701 18,498 Cash and cash equivalents at end of period $ 16,701 $ 18,498 $ 26,465 Supplemental disclosures of cash flow information Cash paid for taxes, net of refunds $ 5,671 $ 8,203 $ 4,990 See accompanying notes. 58 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Nature of Operations and Summary of Significant Accounting Policies Nature of Operations Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. In 2015, we implemented a holding company reorganization, and as a result, Alphabet Inc. ("Alphabet") became the successor issuer to Google. We generate revenues by delivering relevant, cost-effective online advertising, cloud-based solutions that provide customers with platforms, collaboration tools and services, and sales of other products and services, such as apps and in-app purchases, digital content and subscriptions for digital content, and hardware. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and entities consolidated under the variable interest and voting models. All intercompany balances and transactions have been eliminated. Use of Estimates Preparation of consolidated financial statements in conformity with generally accepted accounting principles in the United States ("GAAP") requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the allowance for credit losses, fair values of financial instruments (including non-marketable equity securities), intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, and contingent liabilities, among others. We base our estimates on assumptions, both historical and forward looking, that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. As of December 31, 2020 the impact of COVID-19 continues to unfold and the extent of the impact will depend on a number of factors, including the duration and severity of the pandemic; the uneven impact to certain industries; advances in testing, treatment and prevention; and the macroeconomic impact of government measures to contain the spread of the virus and related government stimulus measures. As a result, certain of our estimates and assumptions, including the allowance for credit losses for accounts receivable, the credit worthiness of customers entering into revenue arrangements, the valuation of non-marketable equity securities, including our impairment assessment, and the fair values of our financial instruments require increased judgment and carry a higher degree of variability and volatility that could result in material changes to our estimates in future periods. In January 2021, we completed an assessment of the useful lives of our servers and network equipment and determined we should adjust the estimated useful life of our servers from three years to four years and the estimated useful life of certain network equipment from three years to five years . This change in accounting estimate will be effective beginning fiscal year 2021. Revenue Recognition Revenues are recognized when control of the promised goods or services is transferred to our customers and the collectibility of an amount that we expect in exchange for those goods or services is probable. Sales and other similar taxes are excluded from revenues. Advertising Revenues We generate advertising revenues primarily by delivering advertising on Google Search & other properties, including Google.com, the Google Search app, Google Play, Gmail and Google Maps; YouTube, and Google Network Members’ properties. Our customers generally purchase advertising inventory through Google Ads, Google Ad Manager and Google Marketing Platform, among others. We offer advertising by delivering both performance and brand advertising. We recognize revenues for performance advertising when a user engages with the advertisement, such as a click, a view, or a purchase. For brand advertising, we recognize revenues when the ad is displayed or a user views the ad. For ads placed on Google Network Members’ properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues 59 Table of Contents Alphabet Inc. for ads placed on Google Network Members’ properties on a gross basis, that is, the amounts billed to our customers are recorded as revenues, and amounts paid to Google Network Members are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers, and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. Google Cloud Revenues Google Cloud revenues consist primarily of fees received for Google Cloud Platform services (which includes infrastructure and data analytics platform products and other services) and Google Workspace (formerly G Suite) collaboration tools and other enterprise services. Our cloud services are generally provided on either a consumption or subscription basis. Revenues related to cloud services provided on a consumption basis are recognized when the customer utilizes the services, based on the quantity of services consumed. Revenues related to cloud services provided on a subscription basis are recognized ratably over the contract term as the customer receives and consumes the benefits of the cloud services. Other Revenues Google other revenues and Other Bets revenues consist primarily of revenues from: • Google Play, which includes revenues from sale of apps and in-app purchases (which we recognize net of payout to developers) and digital content sold in the Google Play store; • hardware, including Google Nest home products, Pixelbooks, Pixel phones and other devices; • YouTube non-advertising services including, YouTube premium and YouTube TV subscriptions and other services; and • other products and services. As it relates to Google other revenues, the most significant judgment is determining whether we are the principal or agent for app sales and in-app purchases through the Google Play store. We report revenues from these transactions on a net basis because our performance obligation is to facilitate a transaction between app developers and end users, for which we earn a commission. Consequently, the portion of the gross amount billed to end users that is remitted to app developers is not reflected as revenues. Arrangements with Multiple Performance Obligations Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenues to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers or using expected cost plus margin. Customer Incentives and Credits Certain customers receive cash-based incentives or credits, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenues. We believe that there will not be significant changes to our estimates of variable consideration. Sales Commissions We expense sales commissions when incurred when the amortization period is one year or less. We recognize an asset for certain sales commissions if we expect the period of benefit of these costs to exceed one year and amortize it over the period of expected benefit. These costs are recorded within sales and marketing expenses. Cost of Revenues Cost of revenues consists of TAC and other costs of revenues. TAC represents the amounts paid to our distribution partners who make available our search access points and services and amounts paid to Google Network Members primarily for ads displayed on their properties. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. Other cost of revenues (which is the cost of revenues excluding TAC) includes the following: • Content acquisition costs primarily related to payments to content providers from whom we license video and other content for distribution on YouTube advertising and subscription services and Google Play. We pay fees to these content providers based on revenues generated or a flat fee; 60 Table of Contents Alphabet Inc. • Expenses associated with our data centers and other operations (including bandwidth, compensation expense (including SBC), depreciation, energy, and other equipment costs); and • Inventory related costs for hardware we sell. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products and as a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Stock-based Compensation Stock-based compensation primarily consists of Alphabet restricted stock units ("RSUs"). RSUs are equity classified and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period and account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the applicable statutory tax withholding to be paid by us on behalf of our employees. As a result, fewer shares are issued than the number of RSUs outstanding and the tax withholding is recorded as a reduction to additional paid-in capital. Additionally, stock-based compensation also includes other stock-based awards, such as performance stock units ("PSUs") and awards that may be settled in cash or the stock of certain Other Bets. PSUs and certain Other Bet awards are equity classified and expense is recognized over the requisite service period. Certain Other Bet awards are liability classified and remeasured at fair value through settlement. The fair value of Other Bet awards is based on the equity valuation of the respective Other Bet. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2018, 2019 and 2020, advertising and promotional expenses totaled approximately $ 6.4 billion, $ 6.8 billion, and $ 5.4 billion, respectively. Performance Fees Performance fees refer to compensation arrangements with payouts based on realized investment returns. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized. Performance fees, which are primarily related to gains on equity securities, are recorded as a component of other income (expense), net. Certain Risks and Concentrations Our revenues are primarily derived from online advertising, the market for which is highly competitive and rapidly changing. In addition, our revenues are generated from a multitude of markets in countries around the world. Significant changes in this industry or changes in customer buying or advertiser spending behavior could adversely affect our operating results. No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2018, 2019, or 2020. In 2018, 2019, and 2020, we generated approximately 46 %, 46 %, and 47 % of our revenues, respectively, from customers based in the U.S. We are subject to concentrations of credit risk principally from cash and cash equivalents, marketable securities, foreign exchange contracts, and accounts receivable. We manage our credit risk exposure through timely assessment of our counterparty creditworthiness, credit limits and use of collateral management. Cash equivalents and marketable securities consist primarily of time deposits, money market and other funds, highly liquid debt instruments of the U.S. government and its agencies, debt instruments issued by foreign governments, debt instruments issued by municipalities in the U.S., corporate debt securities, mortgage-backed securities, and asset-backed securities. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from 61 Table of Contents Alphabet Inc. customers located around the world. We perform ongoing evaluations to determine customer credit and we limit the amount of credit we extend. We generally do not require collateral from our customers. Fair Value of Financial Instruments Our financial assets and liabilities that are measured at fair value on a recurring basis include cash equivalents, marketable securities, derivative contracts, and non-marketable debt securities. Our financial assets measured at fair value on a nonrecurring basis include non-marketable equity securities, which are adjusted to fair value when observable price changes are identified or when the non-marketable equity securities are impaired (referred to as the measurement alternative) . Other financial assets and liabilities are carried at cost with fair value disclosed, if required. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Cash, Cash Equivalents, and Marketable Securities We invest all excess cash primarily in government bonds, corporate debt securities, mortgage-backed and asset-backed securities, time deposits, and money market funds. We classify all marketable debt securities that have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities on our Consolidated Balance Sheets. We determine the appropriate classification of our investments in marketable debt securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable debt securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these debt securities prior to their stated maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities on the Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for the changes in allowance for expected credit losses, which are recorded in other income (expense), net. For certain marketable debt securities we have elected the fair value option, for which changes in fair value are recorded in other income (expense), net. We determine any realized gains or losses on the sale of marketable debt securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Our investments in marketable equity securities are measured at fair value with the related gains and losses, realized and unrealized, recognized in other income (expense), net. Accounts Receivable Our payment terms for accounts receivable vary by the type and location of our customer and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customers, we require payment before the products or services are delivered to the customer. 62 Table of Contents Alphabet Inc. We maintain an allowance for credit losses for accounts receivable, which is recorded as an offset to accounts receivable and changes in such are classified as general and administrative expense in the Consolidated Statements of Income. We assess collectibility by reviewing accounts receivable on a collective basis where similar characteristics exist and on an individual basis when we identify specific customers with known disputes or collectibility issues. In determining the amount of the allowance for credit losses, we consider historical collectibility based on past due status and make judgments about the creditworthiness of customers based on ongoing credit evaluations. We also consider customer-specific information, current market conditions and reasonable and supportable forecasts of future economic conditions to inform adjustments to historical loss data. For the year ended December 31, 2020, our assessment considered the impact of COVID-19 and estimates of expected credit and collectibility trends. Volatility in market conditions and evolving credit trends are difficult to predict and may cause variability and volatility that may have a material impact on our allowance for credit losses in future periods. The allowance for credit losses on accounts receivable was $ 275 million and $ 789 million as of December 31, 2019 and 2020, respectively. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Non-Marketable Investments We account for non-marketable equity investments through which we exercise significant influence but do not have control over the investee under the equity method. Our non-marketable equity securities not accounted for under the equity method are primarily accounted for under the measurement alternative. Under the measurement alternative, the carrying value of our non-marketable equity investments is adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment. Adjustments are determined primarily based on a market approach as of the transaction date and are recorded as a component of other income (expense), net. Non-marketable debt investments are classified as available-for-sale securities. Non-marketable investments that do not have stated contractual maturity dates are classified as non-current assets on the Consolidated Balance Sheets. Impairment of Investments We periodically review our debt and non-marketable equity investments for impairment. For debt securities in an unrealized loss position, we determine whether a credit loss exists. The credit loss is estimated by considering available information relevant to the collectibility of the security and information about past events, current conditions, and reasonable and supportable forecasts. Any credit loss is recorded as a charge to other income (expense), net, not to exceed the amount of the unrealized loss. Unrealized losses other than the credit loss are recognized in accumulated other comprehensive income ("AOCI"). If we have an intent to sell, or if it is more likely than not that we will be required to sell a debt security in an unrealized loss position before recovery of its amortized cost basis, we will write down the security to its fair value and record the corresponding charge as a component of other income (expense), net. For non-marketable equity securities we consider whether impairment indicators exist by evaluating the companies' financial and liquidity position, access to capital resources and the time since the last adjustment to fair value, among others. If the assessment indicates that the investment is impaired, we write down the investment to its fair value by recording the corresponding charge as a component of other income (expense), net. Fair value is estimated using the best information available, which may include cash flow projections or other available market data. Variable Interest Entities We determine at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a variable interest entity ("VIE"). We consolidate VIEs when we are the primary beneficiary. We are the primary beneficiary of a VIE when we have the power to direct activities that most significantly affect the economic performance of the VIE and have the obligation to absorb the majority of their losses or benefits. If we are not the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Periodically, we assess whether any changes in our interest or relationship with the entity affect our determination of whether the entity is a VIE and, if so, whether we are the primary beneficiary. 63 Table of Contents Alphabet Inc. Property and Equipment Property and equipment includes the following categories: land and buildings, information technology assets, construction in progress, leasehold improvements, and furniture and fixtures. Land and buildings include land, offices, data centers and related building improvements. Information technology assets include servers and network equipment. We account for property and equipment at cost less accumulated depreciation. We compute depreciation using the straight-line method over the estimated useful lives of the assets, which we regularly evaluate. We depreciate buildings over periods of seven to 25 years. We depreciate information technology assets generally over periods of three to five years (specifically, three years for servers and three to five years for network equipment). We depreciate leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed in service for our intended use. Depreciation for equipment, buildings, and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Our lease agreements generally contain lease and non-lease components. Payments under our lease arrangements are primarily fixed. Non-lease components primarily include payments for maintenance and utilities. We combine fixed payments for non-lease components with lease payments and account for them together as a single lease component which increases the amount of our lease assets and liabilities. Certain lease agreements contain variable payments, which are expensed as incurred and not included in the lease assets and liabilities. These amounts include payments affected by the Consumer Price Index, payments contingent on wind or solar production for power purchase arrangements, and payments for maintenance and utilities. Lease assets and liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is our incremental borrowing rate, because the interest rate implicit in our leases is not readily determinable. Our incremental borrowing rate is estimated to approximate the interest rate on a collateralized basis with similar terms and payments, and in economic environments where the leased asset is located. Our lease terms include periods under options to extend or terminate the lease when it is reasonably certain that we will exercise that option. We generally use the base, non-cancelable, lease term when determining the lease assets and liabilities. Lease assets also include any prepaid lease payments and lease incentives. Operating lease assets and liabilities are included on our Consolidated Balance Sheet beginning January 1, 2019. The current portion of our operating lease liabilities is included in accrued expenses and other current liabilities and the long term portion is included in operating lease liabilities. Finance lease assets are included in property and equipment, net. Finance lease liabilities are included in accrued expenses and other current liabilities or long-term debt. Operating lease expense (excluding variable lease costs) is recognized on a straight-line basis over the lease term. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment, long-term prepayments and intangible assets, excluding goodwill, for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets or asset group are not recoverable, the impairment recognized is measured as the amount by which the carrying value exceeds its fair value. Impairments were not material for the periods presented. We allocate goodwill to reporting units based on the expected benefit from the business combination. We evaluate our reporting units periodically, as well as when changes in our operating segments occur. For changes in reporting units, we reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairments were no t material for the periods presented. Intangible assets with definite lives are amortized over their estimated useful lives. We amortize intangible assets on a straight-line basis with definite lives generally over periods ranging from one to twelve years . 64 Table of Contents Alphabet Inc. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more likely than not that they will not be realized. We recognize the financial statement effects of a tax position when it is more likely than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of the acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the fair values of identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Foreign Currency Generally, the functional currency of our international subsidiaries is the local currency. We translate the financial statements of these subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in accumulated other comprehensive income (AOCI) as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange gain (loss) in other income (expense), net. Recently Adopted Accounting Pronouncements In June 2016, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update No. 2016-13 ("ASU 2016-13") "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments", which requires the measurement and recognition of expected credit losses for financial assets held at amortized cost. ASU 2016-13 replaces the existing incurred loss impairment model with an expected loss model which requires the use of forward-looking information to calculate credit loss estimates. It also eliminates the concept of other-than-temporary impairment and requires credit losses related to certain available-for-sale debt securities to be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. These changes result in earlier recognition of credit losses. We adopted ASU 2016-13 using the modified retrospective approach as of January 1, 2020. The cumulative effect upon adoption was not material to our consolidated financial statements. See “Impairment of Investments” and "Accounts Receivable" above as well as Note 3 for the effect on our consolidated financial statements. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. See Note 15 for further details. 65 Table of Contents Alphabet Inc. Note 2. Revenues Revenue Recognition The following table presents our revenues disaggregated by type (in millions). Year Ended December 31, 2018 2019 2020 Google Search & other $ 85,296 $ 98,115 $ 104,062 YouTube ads 11,155 15,149 19,772 Google Network Members' properties 20,010 21,547 23,090 Google advertising 116,461 134,811 146,924 Google other 14,063 17,014 21,711 Google Services total 130,524 151,825 168,635 Google Cloud 5,838 8,918 13,059 Other Bets 595 659 657 Hedging gains (losses) ( 138 ) 455 176 Total revenues $ 136,819 $ 161,857 $ 182,527 The following table presents our revenues disaggregated by geography, based on the addresses of our customers (in millions): Year Ended December 31, 2018 2019 2020 United States $ 63,269 46 % $ 74,843 46 % $ 85,014 47 % EMEA (1) 44,739 33 50,645 31 55,370 30 APAC (1) 21,341 15 26,928 17 32,550 18 Other Americas (1) 7,608 6 8,986 6 9,417 5 Hedging gains (losses) ( 138 ) 0 455 0 176 0 Total revenues $ 136,819 100 % $ 161,857 100 % $ 182,527 100 % (1) Regions represent Europe, the Middle East, and Africa ("EMEA"); Asia-Pacific ("APAC"); and Canada and Latin America ("Other Americas"). Deferred Revenues and Remaining Performance Obligations We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. Deferred revenues primarily relate to Google Cloud and Google other. Our total deferred revenue as of December 31, 2019 was $ 2.3 billion, of which $ 1.8 billion was recognized as revenues for the year ending December 31, 2020. Additionally, we have performance obligations associated with commitments in customer contracts, primarily related to Google Cloud, for future services that have not yet been recognized as revenues, also referred to as remaining performance obligations. Remaining performance obligations include related deferred revenue currently recorded as well as amounts that will be invoiced in future periods, and excludes (i) contracts with an original expected term of one year or less, (ii) cancellable contracts, and (iii) contracts for which we recognize revenue at the amount to which we have the right to invoice for services performed. As of December 31, 2020, the amount not yet recognized as revenues from these commitments is $ 29.8 billion. We expect to recognize approximately half over the next 24 months with the remaining thereafter. However, the amount and timing of revenue recognition is largely driven by when the customer utilizes the services and our ability to deliver in accordance with relevant contract terms, which could impact our estimate of the remaining performance obligations and when we expect to recognize such as revenues. 66 Table of Contents Alphabet Inc. Note 3. Financial Instruments Debt Securities We classify our marketable debt securities, which are accounted for as available-for-sale, within Level 2 in the fair value hierarchy because we use quoted market prices to the extent available or alternative pricing sources and models utilizing market observable inputs to determine fair value. For certain marketable debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. The fair value option was elected for these securities to align with the unrealized gains and losses from related derivative contracts. Unrealized net gains related to debt securities still held where we have elected the fair value option were $ 87 million as of December 31, 2020. As of December 31, 2020, the fair value of these debt securities was $ 2 billion. Balances as of December 31, 2019 were not material. The following tables summarize our debt securities, for which we did not elect the fair value option, by significant investment categories as of December 31, 2019 and 2020 (in millions): As of December 31, 2019 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Level 2: Time deposits (1) $ 2,294 $ 0 $ 0 $ 2,294 $ 2,294 $ 0 Government bonds 55,033 434 ( 30 ) 55,437 4,518 50,919 Corporate debt securities 27,164 337 ( 3 ) 27,498 44 27,454 Mortgage-backed and asset-backed securities 19,453 96 ( 41 ) 19,508 0 19,508 Total $ 103,944 $ 867 $ ( 74 ) $ 104,737 $ 6,856 $ 97,881 As of December 31, 2020 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Level 2: Time deposits (1) $ 3,564 $ 0 $ 0 $ 3,564 $ 3,564 $ 0 Government bonds 55,156 793 ( 9 ) 55,940 2,527 53,413 Corporate debt securities 31,521 704 ( 2 ) 32,223 8 32,215 Mortgage-backed and asset-backed securities 16,767 364 ( 7 ) 17,124 0 17,124 Total $ 107,008 $ 1,861 $ ( 18 ) $ 108,851 $ 6,099 $ 102,752 (1) The majority of our time deposits are domestic deposits. We determine realized gains or losses on the sale or extinguishment of debt securities on a specific identification method. We recognized gross realized gains of $ 1.3 billion, $ 292 million, and $ 899 million for the years ended December 31, 2018, 2019, and 2020, respectively. We recognized gross realized losses of $ 143 million, $ 143 million, and $ 184 million for the years ended December 31, 2018, 2019, and 2020, respectively. We reflect these gains and losses as a component of other income (expense), net. The following table summarizes the estimated fair value of our investments in marketable debt securities by stated contractual maturity dates (in millions): As of December 31, 2020 Due in 1 year or less $ 19,795 Due in 1 year through 5 years 69,228 Due in 5 years through 10 years 2,739 Due after 10 years 13,038 Total $ 104,800 67 Table of Contents Alphabet Inc. The following tables present fair values and gross unrealized losses recorded to AOCI as of December 31, 2019 and 2020, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2019 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 6,752 $ ( 20 ) $ 4,590 $ ( 10 ) $ 11,342 $ ( 30 ) Corporate debt securities 1,665 ( 2 ) 978 ( 1 ) 2,643 ( 3 ) Mortgage-backed and asset-backed securities 4,536 ( 13 ) 2,835 ( 28 ) 7,371 ( 41 ) Total $ 12,953 $ ( 35 ) $ 8,403 $ ( 39 ) $ 21,356 $ ( 74 ) As of December 31, 2020 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 5,516 $ ( 9 ) $ 3 $ 0 $ 5,519 $ ( 9 ) Corporate debt securities 1,999 ( 1 ) 0 0 1,999 ( 1 ) Mortgage-backed and asset-backed securities 929 ( 5 ) 242 ( 2 ) 1,171 ( 7 ) Total $ 8,444 $ ( 15 ) $ 245 $ ( 2 ) $ 8,689 $ ( 17 ) During the years ended December 31, 2018, and 2019 we did no t recognize any significant other-than-temporary impairment losses. During the year ended December 31, 2020, with the adoption of ASU 2016-13, we did not recognize significant credit losses and the ending allowance for credit losses was immaterial. See Note 7 for further details on other income (expense), net. Equity Investments The following discusses our marketable equity securities, non-marketable equity securities, gains and losses on marketable and non-marketable equity securities, as well as our equity securities accounted for under the equity method. Our marketable equity securities are publicly traded stocks or funds measured at fair value and classified within Level 1 and 2 in the fair value hierarchy because we use quoted prices for identical assets in active markets or inputs that are based upon quoted prices for similar instruments in active markets. Our non-marketable equity securities are investments in privately held companies without readily determinable market values. The carrying value of our non-marketable equity securities is adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). Non-marketable equity securities that have been remeasured during the period based on observable transactions are classified within Level 2 or Level 3 in the fair value hierarchy because we estimate the value based on valuation methods which may include a combination of the observable transaction price at the transaction date and other unobservable inputs including volatility, rights, and obligations of the securities we hold. The fair value of non-marketable equity securities that have been remeasured due to impairment are classified within Level 3. Gains and losses on marketable and non-marketable equity securities Gains and losses reflected in other income (expense), net, for our marketable and non-marketable equity securities are summarized below (in millions): Year Ended December 31, 2019 2020 Net gain (loss) on equity securities sold during the period $ ( 301 ) $ 1,339 Net unrealized gain (loss) on equity securities held as of the end of the period 2,950 4,253 Total gain (loss) recognized in other income (expense), net $ 2,649 $ 5,592 68 Table of Contents Alphabet Inc. In the table above, net gain (loss) on equity securities sold during the period reflects the difference between the sale proceeds and the carrying value of the equity securities at the beginning of the period or the purchase date, if later. Cumulative net gains (losses) on equity securities sold during the period, which is summarized in the following table (in millions), represents the total net gains (losses) recognized after the initial purchase date of the equity security. While these net gains may have been reflected in periods prior to the period of sale, we believe they are important supplemental information as they reflect the economic realized net gains on the securities sold during the period. Cumulative net gains are calculated as the difference between the sale price and the initial purchase price for the equity security sold during the period. Equity Securities Sold During the Year Ended December 31, 2019 2020 Total sale price $ 3,134 $ 4,767 Total initial cost 858 2,674 Cumulative net gains (losses) $ 2,276 $ 2,093 Carrying value of marketable and non-marketable equity securities The carrying value is measured as the total initial cost plus the cumulative net gain (loss). The carrying values for our marketable and non-marketable equity securities are summarized below (in millions): As of December 31, 2019 Marketable Equity Securities Non-Marketable Equity Securities Total Total initial cost $ 1,935 $ 8,297 $ 10,232 Cumulative net gain (loss) (1) 1,361 3,056 4,417 Carrying value $ 3,296 $ 11,353 $ 14,649 (1) Non-marketable equity securities cumulative net gain (loss) is comprised of $ 3.5 billion unrealized gains and $ 445 million unrealized losses (including impairment). As of December 31, 2020 Marketable Equity Securities Non-Marketable Equity Securities Total Total initial cost $ 2,227 $ 14,616 $ 16,843 Cumulative net gain (loss) (1) 3,631 4,277 7,908 Carrying value (2) $ 5,858 $ 18,893 $ 24,751 (1) Non-marketable equity securities cumulative net gain (loss) is comprised of $ 6.1 billion unrealized gains and $ 1.9 billion unrealized losses (including impairment). (2) The long-term portion of marketable equity securities of $ 429 million is included in other non-current assets. 69 Table of Contents Alphabet Inc. Marketable equity securities The following table summarizes marketable equity securities measured at fair value by significant investment categories as of December 31, 2019 and 2020 (in millions): As of December 31, 2019 As of December 31, 2020 Cash and Cash Equivalents Marketable Equity Securities Cash and Cash Equivalents Marketable Equity Securities Level 1: Money market funds $ 4,604 $ 0 $ 12,210 $ 0 Marketable equity securities (1)(2) 0 3,046 0 5,470 4,604 3,046 12,210 5,470 Level 2: Mutual funds 0 250 0 388 Total $ 4,604 $ 3,296 $ 12,210 $ 5,858 (1) The balance as of December 31, 2019 and 2020 includes investments that were reclassified from non-marketable equity securities following the commencement of public market trading of the issuers or acquisition by public entities. As of December 31, 2020 certain investments are subject to short-term lock-up restrictions. (2) As of December 31, 2020 the long-term portion of marketable equity securities of $ 429 million is included within other non-current assets. Non-marketable equity securities The following is a summary of unrealized gains and losses recorded in other income (expense), net, and included as adjustments to the carrying value of non-marketable equity securities (in millions): Year Ended December 31, 2019 2020 Unrealized gains $ 2,163 $ 3,020 Unrealized losses (including impairment) ( 372 ) ( 1,489 ) Total unrealized gain (loss) for non-marketable equity securities $ 1,791 $ 1,531 During the year ended December 31, 2020, included in the $ 18.9 billion of non-marketable equity securities, $ 9.7 billion were measured at fair value resulting in a net unrealized gain of $ 1.5 billion. Equity securities accounted for under the Equity Method As of December 31, 2019 and 2020, equity securities accounted for under the equity method had a carrying value of approximately $ 1.3 billion and $ 1.4 billion, respectively. Our share of gains and losses including impairment are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 7 for further details on other income (expense), net. Derivative Financial Instruments We enter into derivative instruments to manage risks relating to our ongoing business operations. The primary risk managed with derivative instruments is foreign exchange risk. We use foreign currency contracts to reduce the risk that our cash flows, earnings, and investment in foreign subsidiaries will be adversely affected by foreign currency exchange rate fluctuations. We also enter into derivative instruments to partially offset our exposure to other risks and enhance investment returns. We recognize derivative instruments as either assets or liabilities in the Consolidated Balance Sheets at fair value and classify the derivatives primarily within Level 2 in the fair value hierarchy. We present our collar contracts (an option strategy comprised of a combination of purchased and written options) at net fair values where both the purchased and written options are with the same counterparty. For other derivative contracts, we present at gross fair values. We primarily record changes in the fair value in the Consolidated Statements of Income as either other income (expense), net, or revenues, or in the Consolidated Balance Sheets in AOCI, as discussed below. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. Further, we enter into collateral security arrangements that provide for collateral to be received or pledged when the net fair value of certain financial instruments fluctuates from contractually established thresholds. Cash collateral received related to derivative instruments under our collateral security arrangements are included in other current assets with a corresponding liability. Cash and non-cash 70 Table of Contents Alphabet Inc. collateral pledged related to derivative instruments under our collateral security arrangements are included in other current assets. Cash Flow Hedges We designate foreign currency forward and option contracts (including collars) as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. These contracts have maturities of 24 months or less. Cash flow hedge amounts included in the assessment of hedge effectiveness are deferred in AOCI and subsequently reclassified to revenue when the hedged item is recognized in earnings. We exclude the change in forward points and time value from our assessment of hedge effectiveness. The initial value of the excluded component is amortized on a straight-line basis over the life of the hedging instrument and recognized in revenues. The difference between fair value changes of the excluded component and the amount amortized to revenues is recorded in AOCI. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI are reclassified to other income (expense), net in the period of de-designation. As of December 31, 2020, the net accumulated loss on our foreign currency cash flow hedges before tax effect was $ 124 million, which is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We designate foreign currency forward contracts as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. Fair value hedge amounts included in the assessment of hedge effectiveness are recognized in other income (expense), net, along with the offsetting gains and losses of the related hedged items. We exclude changes in forward points from the assessment of hedge effectiveness and recognize changes in the excluded component in other income (expense), net. Net Investment Hedges We designate foreign currency forward contracts as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. Net investment hedge amounts included in the assessment of hedge effectiveness are recognized in AOCI along with the foreign currency translation adjustment. We exclude changes in forward points from the assessment of hedge effectiveness and recognize changes in the excluded component in other income (expense), net. Other Derivatives Other derivatives not designated as hedging instruments consist primarily of foreign currency forward contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the functional currency of a subsidiary. Gains and losses on these contracts, as well as the related costs, are recognized in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. We also use derivatives not designated as hedging instruments to manage risks relating to interest rates, equity and commodity prices, credit exposures and to enhance investment returns. The gross notional amounts of our outstanding derivative instruments were as follows (in millions): As of December 31, 2019 As of December 31, 2020 Derivatives Designated as Hedging Instruments: Foreign exchange contracts Cash flow hedges $ 13,207 $ 10,187 Fair value hedges $ 455 $ 1,569 Net investment hedges $ 9,318 $ 9,965 Derivatives Not Designated as Hedging Instruments: Foreign exchange contracts $ 43,497 $ 39,861 Other contracts $ 117 $ 2,399 71 Table of Contents Alphabet Inc. The fair values of our outstanding derivative instruments were as follows (in millions): As of December 31, 2019 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 91 $ 253 $ 344 Other contracts Other current and non-current assets 0 1 1 Total $ 91 $ 254 $ 345 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 173 $ 196 $ 369 Other contracts Accrued expenses and other liabilities, current and non-current 0 13 13 Total $ 173 $ 209 $ 382 As of December 31, 2020 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 33 $ 316 $ 349 Other contracts Other current and non-current assets 0 16 16 Total $ 33 $ 332 $ 365 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 395 $ 185 $ 580 Other contracts Accrued expenses and other liabilities, current and non-current 0 942 942 Total $ 395 $ 1,127 $ 1,522 72 Table of Contents Alphabet Inc. The gains (losses) on derivatives in cash flow hedging and net investment hedging relationships recognized in other comprehensive income ("OCI") are summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect Year Ended December 31, 2018 2019 2020 Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness $ 332 $ 38 $ 102 Amount excluded from the assessment of effectiveness 26 ( 14 ) ( 37 ) Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness 136 131 ( 851 ) Total $ 494 $ 155 $ ( 786 ) 73 Table of Contents Alphabet Inc. The effect of derivative instruments on income is summarized below (in millions): Gains (Losses) Recognized in Income Year Ended December 31, 2018 2019 2020 Revenues Other income (expense), net Revenues Other income (expense), net Revenues Other income (expense), net Total amounts presented in the Consolidated Statements of Income in which the effects of cash flow and fair value hedges are recorded $ 136,819 $ 7,389 $ 161,857 $ 5,394 $ 182,527 $ 6,858 Gains (Losses) on Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount of gains (losses) reclassified from AOCI to income $ ( 139 ) $ 0 $ 367 $ 0 $ 144 $ 0 Amount excluded from the assessment of effectiveness recognized in earnings based on an amortization approach 1 0 88 0 33 0 Gains (Losses) on Derivatives in Fair Value Hedging Relationship: Foreign exchange contracts Hedged items 0 ( 96 ) 0 ( 19 ) 0 18 Derivatives designated as hedging instruments 0 96 0 19 0 ( 18 ) Amount excluded from the assessment of effectiveness 0 37 0 25 0 4 Gains (Losses) on Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount excluded from the assessment of effectiveness 0 78 0 243 0 151 Gains (Losses) on Derivatives Not Designated as Hedging Instruments: Foreign exchange contracts 0 54 0 ( 413 ) 0 718 Other Contracts 0 0 0 0 0 ( 906 ) Total gains (losses) $ ( 138 ) $ 169 $ 455 $ ( 145 ) $ 177 $ ( 33 ) Offsetting of Derivatives The gross amounts of our derivative instruments subject to master netting arrangements with various counterparties, and cash and non-cash collateral received and pledged under such agreements were as follows (in millions): 74 Table of Contents Alphabet Inc. Offsetting of Assets As of December 31, 2019 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 366 $ ( 21 ) $ 345 $ ( 88 ) (1) $ ( 234 ) $ 0 $ 23 As of December 31, 2020 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 397 $ ( 32 ) $ 365 $ ( 295 ) (1) $ ( 16 ) $ 0 $ 54 (1) The balances as of December 31, 2019 and 2020 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. Offsetting of Liabilities As of December 31, 2019 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 403 $ ( 21 ) $ 382 $ ( 88 ) (2) $ 0 $ 0 $ 294 As of December 31, 2020 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 1,554 $ ( 32 ) $ 1,522 $ ( 295 ) (2) $ ( 1 ) $ ( 943 ) $ 283 (2) The balances as of December 31, 2019 and 2020 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 4. Leases We have entered into operating and finance lease agreements primarily for data centers, land and offices throughout the world with lease periods expiring between 2021 and 2063. Components of operating lease expense were as follows (in millions): Year Ended December 31, 2019 2020 Operating lease cost $ 1,820 $ 2,267 Variable lease cost 541 619 Total operating lease cost $ 2,361 $ 2,886 75 Table of Contents Alphabet Inc. Supplemental information related to operating leases is as follows (in millions): Year Ended December 31, 2019 2020 Cash payments for operating leases $ 1,661 $ 2,004 New operating lease assets obtained in exchange for operating lease liabilities $ 4,391 $ 2,765 As of December 31, 2020, our operating leases had a weighted average remaining lease term of 9 years and a weighted average discount rate of 2.6 %. Future lease payments under operating leases as of December 31, 2020 were as follows (in millions): 2021 $ 2,198 2022 2,170 2023 1,995 2024 1,738 2025 1,389 Thereafter 5,601 Total future lease payments 15,091 Less imputed interest ( 2,251 ) Total lease liability balance $ 12,840 As of December 31, 2020, we have entered into leases that have not yet commenced with future lease payments of $ 8.0 billion, excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2021 and 2026 with non-cancelable lease terms of 1 to 25 years. Note 5. Variable Interest Entities Consolidated VIEs We consolidate VIEs in which we hold a variable interest and are the primary beneficiary. The results of operations and financial position of these VIEs are included in our consolidated financial statements. For certain consolidated VIEs, their assets are not available to us and their creditors do not have recourse to us. As of December 31, 2019 and 2020, assets that can only be used to settle obligations of these VIEs were $ 3.1 billion and $ 5.7 billion, respectively, and the liabilities for which creditors only have recourse to the VIEs were $ 1.2 billion and $ 2.3 billion, respectively. Total noncontrolling interests ("NCI"), including redeemable noncontrolling interests ("RNCI"), in our consolidated subsidiaries increased from $ 1.2 billion to $ 3.9 billion f rom December 31, 2019 to December 31, 2020, primarily due to external investments in Waymo. NCI and RNCI are included within additional paid-in capital. Net loss attributable to noncontrolling interests was not material for any period presented and is included within other income (expense), net. Waymo Waymo is an autonomous driving technology development company with a mission to make it safe and easy for people and things to get where they're going. In the first half of 2020, Waymo completed an externally led investment round raising in total $ 3.2 billion, which includes investment from Alphabet. No gain or loss was recognized. The investments related to external parties were accounted for as equity transactions and resulted in recognition of noncontrolling interests. Unconsolidated VIEs We have investments in some VIEs in which we are not the primary beneficiary. These VIEs include private companies that are primarily early stage companies and certain renewable energy entities in which activities involve power generation using renewable sources. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly affect their economic performance. Therefore, we are not the primary beneficiary, and the results of operations and financial position of these VIEs are not included in our consolidated financial statements. We account for these investments as non-marketable equity investments or equity method investments. 76 Table of Contents Alphabet Inc. VIEs are generally based on the current carrying value of the investments and any future funding commitments. We have determined that the single source of our exposure to these VIEs is our capital investments in them. The carrying value and maximum exposure of these unconsolidated VIEs were not material as of December 31, 2019 and 2020. Note 6. Debt Short-Term Debt We have a debt financing program of up to $ 5.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2019 and 2020. Our short-term debt balance also includes the current portion of certain long-term debt. Long-Term Debt In August 2020, Alphabet issued $ 10.0 billion of fixed-rate senior unsecured notes in six tranches (collectively, “2020 Notes”): $ 1.0 billion due in 2025, $ 1.0 billion due in 2027, $ 2.25 billion due in 2030, $ 1.25 billion due in 2040, $ 2.5 billion due in 2050 and $ 2.0 billion due in 2060. The 2020 Notes had a weighted average duration of 21.5 years and weighted average coupon rate of 1.57 %. Of the total issuance, $ 5.75 billion was designated as Sustainability Bonds, the net proceeds of which are used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. The remaining net proceeds are used for general corporate purposes. The total outstanding debt is summarized below (in millions, except percentages): Maturity Coupon Rate Effective Interest Rate As of December 31, 2019 As of December 31, 2020 Debt 2011-2016 Notes Issuances 2021 - 2026 2.00 % - 3.63 % 2.23 % - 3.73 % $ 4,000 $ 4,000 2020 Notes Issuance 2025 - 2060 0.45 % - 2.25 % 0.57 % - 2.33 % 0 10,000 Future finance lease payments, net (1) 711 1,201 Total debt 4,711 15,201 Unamortized discount and debt issuance costs ( 42 ) ( 169 ) Less: Current portion of Notes (2) 0 ( 999 ) Less: Current portion future finance lease payments, net (1)(2) ( 115 ) ( 101 ) Total long-term debt $ 4,554 $ 13,932 (1) Net of imputed interest. (2) Total current portion of long-term debt is included within other accrued expenses and current liabilities. See Note 7. The notes in the table above are comprised of fixed-rate senior unsecured obligations and generally rank equally with each other. We may redeem the notes at any time in whole or in part at specified redemption prices. The effective interest rates are based on proceeds received with interest payable semi-annually. The total estimated fair value of the outstanding notes, including the current portion, was approximately $ 4.1 billion and $ 14.0 billion as of December 31, 2019 and December 31, 2020, respectively. The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. 77 Table of Contents Alphabet Inc. As of December 31, 2020, the aggregate future principal payments for long-term debt, including finance lease liabilities, for each of the next five years and thereafter are as follows (in millions): 2021 $ 1,104 2022 86 2023 86 2024 1,087 2025 1,088 Thereafter 11,868 Total $ 15,319 Credit Facility As of December 31, 2020, we have $ 4.0 billion of revolving credit facilities which expire in July 2023. The interest rate for the credit facilities is determined based on a formula using certain market rates. No amounts were outstanding under the credit facilities as of December 31, 2019 and 2020. Note 7. Supplemental Financial Statement Information Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2019 As of December 31, 2020 Land and buildings $ 39,865 $ 49,732 Information technology assets 36,840 45,906 Construction in progress 21,036 23,111 Leasehold improvements 6,310 7,516 Furniture and fixtures 156 197 Property and equipment, gross 104,207 126,462 Less: accumulated depreciation ( 30,561 ) ( 41,713 ) Property and equipment, net $ 73,646 $ 84,749 Accrued expenses and other current liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2019 As of December 31, 2020 European Commission fines (1) $ 9,405 $ 10,409 Accrued customer liabilities 2,245 3,118 Accrued purchases of property and equipment 2,411 2,197 Current operating lease liabilities 1,199 1,694 Other accrued expenses and current liabilities 7,807 11,213 Accrued expenses and other current liabilities $ 23,067 $ 28,631 (1) Includes the effects of foreign exchange and interest. See Note 10 for further details. 78 Table of Contents Alphabet Inc. Accumulated Other Comprehensive Income (Loss) The components of AOCI, net of tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2017 $ ( 1,103 ) $ 233 $ ( 122 ) $ ( 992 ) Cumulative effect of accounting change 0 ( 98 ) 0 ( 98 ) Other comprehensive income (loss) before reclassifications ( 781 ) 88 264 ( 429 ) Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 26 26 Amounts reclassified from AOCI 0 ( 911 ) 98 ( 813 ) Other comprehensive income (loss) ( 781 ) ( 823 ) 388 ( 1,216 ) Balance as of December 31, 2018 ( 1,884 ) ( 688 ) 266 ( 2,306 ) Cumulative effect of accounting change 0 0 ( 30 ) ( 30 ) Other comprehensive income (loss) before reclassifications ( 119 ) 1,611 36 1,528 Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 14 ) ( 14 ) Amounts reclassified from AOCI 0 ( 111 ) ( 299 ) ( 410 ) Other comprehensive income (loss) ( 119 ) 1,500 ( 277 ) 1,104 Balance as of December 31, 2019 ( 2,003 ) 812 ( 41 ) ( 1,232 ) Other comprehensive income (loss) before reclassifications 1,139 1,313 79 2,531 Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 37 ) ( 37 ) Amounts reclassified from AOCI 0 ( 513 ) ( 116 ) ( 629 ) Other comprehensive income (loss) 1,139 800 ( 74 ) 1,865 Balance as of December 31, 2020 $ ( 864 ) $ 1,612 $ ( 115 ) $ 633 The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statements of Income Year Ended December 31, AOCI Components Location 2018 2019 2020 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ 1,190 $ 149 $ 650 Benefit (provision) for income taxes ( 279 ) ( 38 ) ( 137 ) Net of tax 911 111 513 Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue ( 139 ) 367 144 Interest rate contracts Other income (expense), net 6 6 6 Benefit (provision) for income taxes 35 ( 74 ) ( 34 ) Net of tax ( 98 ) 299 116 Total amount reclassified, net of tax $ 813 $ 410 $ 629 79 Table of Contents Alphabet Inc. Other Income (Expense), Net The components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2018 2019 2020 Interest income $ 1,878 $ 2,427 $ 1,865 Interest expense (1) ( 114 ) ( 100 ) ( 135 ) Foreign currency exchange gain (loss), net (2) ( 80 ) 103 ( 344 ) Gain (loss) on debt securities, net (3) 1,190 149 725 Gain (loss) on equity securities, net 5,460 2,649 5,592 Performance fees ( 1,203 ) ( 326 ) ( 609 ) Income (loss) and impairment from equity method investments, net ( 120 ) 390 401 Other (4) 378 102 ( 637 ) Other income (expense), net $ 7,389 $ 5,394 $ 6,858 (1) Interest expense is net of interest capitalized of $ 92 million, $ 167 million, and $ 218 million for the years ended December 31, 2018, 2019, and 2020, respectively. (2) Our foreign currency exchange gain (loss), net, is primarily related to the forward points for our foreign currency hedging contracts and foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contracts' losses and gains. (3) During the year ended December 31, 2018, the terms of a non-marketable debt security were modified resulting in an unrealized $ 1.3 billion gain. (4) During the year ended December 31, 2020, we entered into derivatives that hedged the changes in fair value of certain marketable equity securities, which resulted in a $ 902 million loss. The offsetting recognized gains on the marketable equity securities are reflected in Gain (loss) on equity securities, net. Note 8. Acquisitions 2020 Acquisitions During the year ended December 31, 2020, we completed acquisitions and purchases of intangible assets for total consideration of approximately $ 744 million, net of cash acquired. In aggregate, $ 248 million was attributed to intangible assets, $ 446 million to goodwill and $ 50 million to net assets acquired. These acquisitions generally enhance the breadth and depth of our offerings and expand our expertise in engineering and other functional areas. Pro forma results of operations for these acquisitions have not been presented because they are not material to the consolidated results of operations, either individually or in the aggregate. For all intangible assets acquired and purchased during the year ended December 31, 2020, patents and developed technology have a weighted-average useful life of 4.1 years, customer relationships have a weighted-average useful life of 4.7 years, and trade names and other have a weighted-average useful life of 4.6 years. Acquisition of Fitbit In January 2021, we closed the acquisition of Fitbit, a leading wearables brand for $ 2.1 billion. 80 Table of Contents Alphabet Inc. Note 9. Goodwill and Other Intangible Assets Goodwill Changes in the carrying amount of goodwill for the years ended December 31, 2019 and 2020 were as follows (in millions): Google Google Services Google Cloud Other Bets Total Balance as of December 31, 2018 $ 17,521 $ 0 $ 0 $ 367 $ 17,888 Acquisitions 2,353 0 0 475 2,828 Transfers 9 0 0 ( 9 ) 0 Foreign currency translation and other adjustments 38 0 0 ( 130 ) ( 92 ) Balance as of December 31, 2019 19,921 0 0 703 20,624 Acquisitions 204 0 0 0 204 Foreign currency translation and other adjustments 46 0 0 ( 4 ) 42 Allocation in the fourth quarter of 2020 (1) ( 20,171 ) 18,408 1,763 0 0 Acquisitions 0 53 189 0 242 Foreign currency translation and other adjustments 0 56 5 2 63 Balance as of December 31, 2020 $ 0 $ 18,517 $ 1,957 $ 701 $ 21,175 (1) Represents reallocation of goodwill as a result of our change in segments in the fourth quarter of 2020. See Note 15 for further details Other Intangible Assets Information regarding purchased intangible assets were as follows (in millions): As of December 31, 2019 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 4,972 $ 3,570 $ 1,402 Customer relationships 254 30 224 Trade names and other 703 350 353 Total $ 5,929 $ 3,950 $ 1,979 As of December 31, 2020 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 4,639 $ 3,649 $ 990 Customer relationships 266 49 217 Trade names and other 699 461 238 Total $ 5,604 $ 4,159 $ 1,445 Patents and developed technology, customer relationships, and trade names and other have weighted-average remaining useful lives of 1.6 years, 4.9 years, and 2.1 years, respectively. Amortization expense relating to purchased intangible assets was $ 865 million, $ 795 million, and $ 774 million for the years ended December 31, 2018, 2019, and 2020, respectively. 81 Table of Contents Alphabet Inc. As of December 31, 2020, expected amortization expense relating to purchased intangible assets for each of the next five years and thereafter is as follows (in millions): 2021 $ 719 2022 375 2023 104 2024 78 2025 53 Thereafter 116 $ 1,445 Note 10. Commitments and Contingencies Purchase Obligations As of December 31, 2020, we had $ 10.7 billion of other non-cancelable contractual obligations, primarily related to data center operations and build-outs, digital media content licensing, information technology assets and purchases of inventory. Indemnifications In the normal course of business, to facilitate transactions in our services and products, we indemnify certain parties, including advertisers, Google Network Members, customers of Google Cloud offerings, and lessors with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2020, we did not have any material indemnification claims that were probable or reasonably possible. Legal Matters Antitrust Investigations On November 30, 2010, the EC's Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On June 27, 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a € 2.4 billion ($ 2.7 billion as of June 27, 2017) fine. On September 11, 2017, we appealed the EC decision and on September 27, 2017, we implemented product changes to bring shopping ads into compliance with the EC's decision. We recognized a charge of $ 2.7 billion for the fine in the second quarter of 2017. On July 18, 2018, the EC announced its decision that certain provisions in Google’s Android-related distribution agreements infringed European competition law. The EC decision imposed a € 4.3 billion ($ 5.1 billion as of June 30, 2018) fine and directed the termination of the conduct at issue. On October 9, 2018, we appealed the EC decision. On October 29, 2018, we implemented changes to certain of our Android distribution practices. We recognized a charge of $ 5.1 billion for the fine in the second quarter of 2018. On March 20, 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a fine of € 1.5 billion ($ 1.7 billion as of March 20, 2019) and directed actions related to AdSense for Search partners' agreements, which we implemented prior to the decision. On June 4, 2019, we appealed the EC decision. We recognized a charge of $ 1.7 billion for the fine in the first quarter of 2019. 82 Table of Contents Alphabet Inc. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. From time to time we are subject to formal and informal inquiries and investigations on competition matters by regulatory authorities in the United States, Europe, and other jurisdictions. For example, in August 2019, we began receiving civil investigative demands from the U.S. Department of Justice ("DOJ") requesting information and documents relating to our prior antitrust investigations and certain aspects of our business. The DOJ and a number of state Attorneys General filed a lawsuit on October 20, 2020 alleging that Google violated U.S. antitrust laws relating to Search and Search advertising. Separately, on December 16, 2020, a number of state Attorneys General filed an antitrust complaint against Google in the United States District Court for the Eastern District of Texas, alleging that Google violated U.S. antitrust laws as well as state deceptive trade laws relating to its advertising technology. We believe these complaints are without merit and will defend ourselves vigorously. The DOJ and state Attorneys General continue their investigations into certain aspects of our business. We continue to cooperate with federal and state regulators in the United States, and other regulators around the world. Patent and Intellectual Property Claims We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe others' intellectual property rights. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services. As a result, we may have to change our business practices, and develop non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission ("ITC") has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss in an ITC action can result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them against certain intellectual property infringement claims, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. In addition, our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. In 2010, Oracle America, Inc. ("Oracle") brought a copyright lawsuit against Google in the Northern District of California, alleging that Google's Android operating system infringes Oracle's copyrights related to certain Java application programming interfaces. After trial, final judgment was entered by the district court in favor of Google on June 8, 2016, and the court decided post-trial motions in favor of Google. Oracle appealed and on March 27, 2018, the appeals court reversed and remanded the case for a trial on damages. On May 29, 2018, we filed a petition for a rehearing at the Federal Circuit, and on August 28, 2018, the Federal Circuit denied the petition. On January 24, 2019, we filed a petition to the Supreme Court of the United States to review this case. On April 29, 2019, the Supreme Court requested the views of the Solicitor General regarding our petition. On September 27, 2019, the Solicitor General recommended denying our petition, and we provided our response on October 16, 2019. On November 15, 2019, the Supreme Court granted our petition and made a decision to review the case. The Supreme Court heard oral arguments in our case on October 7, 2020. If the Supreme Court does not rule in our favor, the case will be remanded to the district court for further determination of the remaining issues in the case, including damages, if any. We believe this lawsuit is without merit and are defending ourselves vigorously. Given the nature of this case, we are unable to estimate the reasonably possible loss or range of loss, if any, arising from this matter. Other We are also regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. Such claims, suits, regulatory and government investigations, and other proceedings could result in substantial fines and penalties, injunctive relief, ongoing auditing and monitoring obligations, changes to our products and services, alterations to our business models and operations, and collateral related civil litigation or other adverse consequences, all of which could harm our business, reputation, financial condition, and operating results. Certain of these outstanding matters include speculative, substantial or indeterminate monetary amounts. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we 83 Table of Contents Alphabet Inc. disclose the reasonably possible loss. We evaluate developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both likelihood of there being and the estimated amount of a loss related to such matters. With respect to our outstanding matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Non-Income Taxes We are under audit by various domestic and foreign tax authorities with regards to non-income tax matters. The subject matter of non-income tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions and the tax treatment of certain employee benefits. We accrue non-income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. For information regarding income tax contingencies, see Note 14. Note 11. Stockholders' Equity Convertible Preferred Stock Our Board of Directors has authorized 100 million shares of convertible preferred stock, $ 0.001 par value, issuable in series. As of December 31, 2019 and 2020, no shares were issued or outstanding. Class A and Class B Common Stock and Class C Capital Stock Our Board of Directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Share Repurchases In July 2020, the Board of Directors of Alphabet authorized the company to repurchase up to an additional $ 28.0 billion of its Class C capital stock. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. During the years ended December 31, 2019 and 2020, we repurchased and subsequently retired 15.3 million and 21.5 million shares of Alphabet Class C capital stock for an aggregate amount of $ 18.4 billion and $ 31.1 billion, respectively. Note 12. Net Income Per Share We compute net income per share of Class A and Class B common stock and Class C capital stock using the two-class method. Basic net income per share is computed using the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of restricted stock units and other contingently issuable shares. The dilutive effect of outstanding restricted stock units and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A common stock assumes the conversion of Class B common stock, while the diluted net income per share of Class B common stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A and Class B common stock and Class C capital stock are identical, except with respect to voting. Furthermore, there are a number of 84 Table of Contents Alphabet Inc. safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our Board of Directors from declaring or paying unequal per share dividends on our Class A and Class B common stock and Class C capital stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our Board of Directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A and Class B common shares and Class C capital stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. In the years ended December 31, 2018, 2019 and 2020, the net income per share amounts are the same for Class A and Class B common stock and Class C capital stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. The following tables set forth the computation of basic and diluted net income per share of Class A and Class B common stock and Class C capital stock (in millions, except share amounts which are reflected in thousands and per share amounts): Year Ended December 31, 2018 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 13,200 $ 2,072 $ 15,464 Denominator Number of shares used in per share computation 298,548 46,864 349,728 Basic net income per share $ 44.22 $ 44.22 $ 44.22 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 13,200 $ 2,072 $ 15,464 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,072 0 0 Reallocation of undistributed earnings ( 146 ) ( 24 ) 146 Allocation of undistributed earnings $ 15,126 $ 2,048 $ 15,610 Denominator Number of shares used in basic computation 298,548 46,864 349,728 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 46,864 0 0 Restricted stock units and other contingently issuable shares 689 0 7,456 Number of shares used in per share computation 346,101 46,864 357,184 Diluted net income per share $ 43.70 $ 43.70 $ 43.70 85 Table of Contents Alphabet Inc. Year Ended December 31, 2019 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 14,846 $ 2,307 $ 17,190 Denominator Number of shares used in per share computation 299,402 46,527 346,667 Basic net income per share $ 49.59 $ 49.59 $ 49.59 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 14,846 $ 2,307 $ 17,190 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,307 0 0 Reallocation of undistributed earnings ( 126 ) ( 20 ) 126 Allocation of undistributed earnings $ 17,027 $ 2,287 $ 17,316 Denominator Number of shares used in basic computation 299,402 46,527 346,667 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 46,527 0 0 Restricted stock units and other contingently issuable shares 413 0 5,547 Number of shares used in per share computation 346,342 46,527 352,214 Diluted net income per share $ 49.16 $ 49.16 $ 49.16 Year Ended December 31, 2020 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 17,733 $ 2,732 $ 19,804 Denominator Number of shares used in per share computation 299,815 46,182 334,819 Basic net income per share $ 59.15 $ 59.15 $ 59.15 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 17,733 $ 2,732 $ 19,804 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,732 0 0 Reallocation of undistributed earnings ( 180 ) ( 25 ) 180 Allocation of undistributed earnings $ 20,285 $ 2,707 $ 19,984 Denominator Number of shares used in basic computation 299,815 46,182 334,819 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A common shares outstanding 46,182 0 0 Restricted stock units and other contingently issuable shares 87 0 6,125 Number of shares used in per share computation 346,084 46,182 340,944 Diluted net income per share $ 58.61 $ 58.61 $ 58.61 86 Table of Contents Alphabet Inc. Note 13. Compensation Plans Stock Plans Our stock plans include the Alphabet 2012 Stock Plan and Other Bet stock-based plans. Under our stock plans, RSUs and other types of awards may be granted. An RSU award is an agreement to issue shares of our publicly traded stock at the time the award vests. RSUs granted to participants under the Alphabet 2012 Stock Plan generally vest over four years contingent upon employment or service with us on the vesting date. As of December 31, 2020, there were 38,777,813 shares of stock reserved for future issuance under our Alphabet 2012 Stock Plan. Stock-Based Compensation For the years ended December 31, 2018, 2019 and 2020, total stock-based compensation expense was $ 10.0 billion, $ 11.7 billion and $ 13.4 billion, including amounts associated with awards we expect to settle in Alphabet stock of $ 9.4 billion, $ 10.8 billion, and $ 12.8 billion, respectively. For the years ended December 31, 2018, 2019 and 2020, we recognized tax benefits on total stock-based compensation expense, which are reflected in the provision for income taxes in the Consolidated Statements of Income, of $ 1.5 billion, $ 1.8 billion, and $ 2.7 billion, respectively. For the years ended December 31, 2018, 2019 and 2020, tax benefit realized related to awards vested or exercised during the period was $ 2.1 billion, $ 2.2 billion and $ 3.6 billion, respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the research and development tax credit. Stock-Based Award Activities The following table summarizes the activities for our unvested Alphabet RSUs for the year ended December 31, 2020: Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2019 19,394,236 $ 1,055.22 Granted 12,647,562 1,407.97 Vested ( 11,643,670 ) 1,089.31 Forfeited/canceled ( 1,109,335 ) 1,160.01 Unvested as of December 31, 2020 19,288,793 $ 1,262.13 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2018 and 2019, was $ 1,095.89 and $ 1,092.36 , respectively. Total fair value of RSUs, as of their respective vesting dates, during the years ended December 31, 2018, 2019, and 2020 were $ 14.1 billion, $ 15.2 billion, and $ 17.8 billion, respectively. As of December 31, 2020, there was $ 22.8 billion of unrecognized compensation cost related to unvested employee RSUs. This amount is expected to be recognized over a weighted-average period of 2.6 years. 401(k) Plans We have two 401(k) Savings Plans that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We recognized expense of approximately $ 691 million, $ 724 million, and $ 855 million for the years ended December 31, 2018, 2019, and 2020, respectively. Note 14. Income Taxes Income from continuing operations before income taxes consists of the following (in millions): Year Ended December 31, 2018 2019 2020 Domestic operations $ 15,779 $ 16,426 $ 37,576 Foreign operations 19,134 23,199 10,506 Total $ 34,913 $ 39,625 $ 48,082 87 Table of Contents Alphabet Inc. The provision for income taxes consists of the following (in millions): Year Ended December 31, 2018 2019 2020 Current: Federal and state $ 2,153 $ 2,424 $ 4,789 Foreign 1,251 2,713 1,687 Total 3,404 5,137 6,476 Deferred: Federal and state 907 286 1,552 Foreign ( 134 ) ( 141 ) ( 215 ) Total 773 145 1,337 Provision for income taxes $ 4,177 $ 5,282 $ 7,813 The reconciliation of federal statutory income tax rate to our effective income tax rate is as follows: Year Ended December 31, 2018 2019 2020 U.S. federal statutory tax rate 21.0 % 21.0 % 21.0 % Foreign income taxed at different rates ( 4.4 ) ( 4.9 ) ( 0.3 ) Foreign-derived intangible income deduction ( 0.5 ) ( 0.7 ) ( 3.0 ) Stock-based compensation expense ( 2.2 ) ( 0.7 ) ( 1.7 ) Federal research credit ( 2.4 ) ( 2.5 ) ( 2.3 ) Impact of the Tax Cuts and Jobs Act ( 1.3 ) ( 0.6 ) 0.0 European Commission fines 3.1 1.0 0.0 Deferred tax asset valuation allowance ( 2.0 ) 0.0 1.4 State and local income taxes ( 0.4 ) 1.1 1.1 Other adjustments 1.1 ( 0.4 ) 0.0 Effective tax rate 12.0 % 13.3 % 16.2 % Our effective tax rate for 2018 and 2019 was affected significantly by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate because substantially all of the income from foreign operations was earned by an Irish subsidiary. As of December 31, 2019, we have simplified our corporate legal entity structure and now license intellectual property from the U.S. that was previously licensed from Bermuda resulting in an increase in the portion of our income earned in the U.S. On July 27, 2015, the United States Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. As a result of that decision, we recorded a tax benefit related to the anticipated reimbursement of cost share payment for previously shared stock-based compensation costs. On June 7, 2019, the United States Court of Appeals for the Ninth Circuit overturned the 2015 Tax Court decision in Altera Corp. v. Commissioner, and upheld the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. As a result of the Ninth Circuit court decision, our cumulative net tax benefit of $ 418 million related to previously shared stock-based compensation costs was reversed in the year ended December 31, 2019. In 2020, there was an increase in valuation allowance for net deferred tax assets that are not likely to be realized relating to certain of our Other Bets. 88 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities are as follows (in millions): As of December 31, 2019 2020 Deferred tax assets: Stock-based compensation expense $ 421 $ 518 Accrued employee benefits 463 580 Accruals and reserves not currently deductible 1,047 1,049 Tax credits 3,264 3,723 Net operating losses 771 1,085 Operating leases 1,876 2,620 Intangible assets 164 1,525 Other 226 463 Total deferred tax assets 8,232 11,563 Valuation allowance ( 3,502 ) ( 4,823 ) Total deferred tax assets net of valuation allowance 4,730 6,740 Deferred tax liabilities: Property and equipment, net ( 1,798 ) ( 3,382 ) Renewable energy investments ( 466 ) ( 415 ) Foreign Earnings ( 373 ) ( 383 ) Net investment gains ( 1,074 ) ( 1,901 ) Operating leases ( 1,619 ) ( 2,354 ) Other ( 380 ) ( 782 ) Total deferred tax liabilities ( 5,710 ) ( 9,217 ) Net deferred tax assets (liabilities) $ ( 980 ) $ ( 2,477 ) As of December 31, 2020, our federal, state and foreign net operating loss carryforwards for income tax purposes were approximately $ 3.1 billion, $ 3.1 billion, and $ 1.4 billion respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2023, foreign net operating loss carryforwards will begin to expire in 2024 and the state net operating loss carryforwards will begin to expire in 2028. It is more likely than not that certain net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. As of December 31, 2020, our California research and development credit carryforwards for income tax purposes were approximately $ 3.7 billion that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. As of December 31, 2020, we maintained a valuation allowance with respect to California deferred tax assets, certain federal net operating losses, certain state tax credits, net deferred tax assets relating to certain of our Other Bets, and certain foreign net operating losses that we believe are not likely to be realized. We continue to reassess the remaining valuation allowance quarterly and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. 89 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits (in millions): Year Ended December 31, 2018 2019 2020 Beginning gross unrecognized tax benefits $ 4,696 $ 4,652 $ 3,377 Increases related to prior year tax positions 321 938 372 Decreases related to prior year tax positions ( 623 ) ( 143 ) ( 557 ) Decreases related to settlement with tax authorities ( 191 ) ( 2,886 ) ( 45 ) Increases related to current year tax positions 449 816 690 Ending gross unrecognized tax benefits $ 4,652 $ 3,377 $ 3,837 The total amount of gross unrecognized tax benefits was $ 4.7 billion, $ 3.4 billion, and $ 3.8 billion as of December 31, 2018, 2019, and 2020, respectively, of which, $ 2.9 billion, $ 2.3 billion, and $ 2.6 billion, if recognized, would affect our effective tax rate, respectively. The decrease in gross unrecognized tax benefits in 2019 was primarily as a result of the resolution of multi-year audits. As of December 31, 2019 and 2020, we accrued $ 130 million and $ 222 million in interest and penalties in provision for income taxes, respectively. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions, our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS is currently examining our 2016 through 2018 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. The tax years 2011 through 2019 remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the effect, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, and closure of audits is not certain, we do not believe it is reasonably possible that our unrecognized tax benefits will materially change in the next 12 months. Note 15. Information about Segments and Geographic Areas Beginning in the fourth quarter of 2020, we report our segment results as Google Services, Google Cloud, and Other Bets: • Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps, in-app purchases, digital content products, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV. • Google Cloud includes Google’s infrastructure and data analytics platforms, collaboration tools, and other services for enterprise customers. Google Cloud generates revenues primarily from fees received for Google Cloud Platform services and Google Workspace (formerly known as G Suite) collaboration tools. • Other Bets is a combination of multiple operating segments that are not individually material. Revenues from the Other Bets are derived primarily through the sale of internet services as well as licensing and R&D services. Revenues and certain costs, such as costs associated with content and traffic acquisition, certain engineering, and hardware costs and other operating expenses, are directly attributable to our segments. Due to the integrated nature of Alphabet, other costs and expenses, such as technical infrastructure and office facilities, are managed 90 Table of Contents Alphabet Inc. centrally at a consolidated level. The associated costs, including depreciation and impairment, are allocated to operating segments as a service cost generally based on usage or headcount. Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including fines and settlements, as well as costs associated with certain shared research and development activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs. Our Chief Operating Decision Maker does not evaluate operating segments using asset information. Information about segments during the periods presented were as follows (in millions). For comparative purposes, amounts in prior periods have been recast: Year Ended December 31, 2018 2019 2020 Revenues: Google Services $ 130,524 $ 151,825 $ 168,635 Google Cloud 5,838 8,918 13,059 Other Bets 595 659 657 Hedging gains (losses) ( 138 ) 455 176 Total revenues $ 136,819 $ 161,857 $ 182,527 Operating income (loss): Google Services $ 43,137 $ 48,999 $ 54,606 Google Cloud ( 4,348 ) ( 4,645 ) ( 5,607 ) Other Bets ( 3,358 ) ( 4,824 ) ( 4,476 ) Corporate costs, unallocated (1) ( 7,907 ) ( 5,299 ) ( 3,299 ) Total income from operations $ 27,524 $ 34,231 $ 41,224 (1) Corporate costs, unallocated includes a fine of $ 5.1 billion for the year ended December 31, 2018 and a fine and legal settlement totaling $ 2.3 billion for the year ended December 31, 2019. For revenues by geography, see Note 2. The following table presents certain of our long-lived assets by geographic area, which includes property and equipment, net and operating lease assets (in millions). As of December 31, 2019 As of December 31, 2020 Long-lived assets: United States $ 63,102 $ 69,315 International 21,485 27,645 Total long-lived assets $ 84,587 $ 96,960 91 Table of Contents Alphabet Inc. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2020, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting We rely extensively on information systems to manage our business and summarize and report operating results. In 2019, we began a multi-year implementation of a new global ERP system, which will replace much of our existing core financial systems. The ERP system is designed to accurately maintain our financial records, enhance the flow of financial information, improve data management and provide timely information to our management team. The implementation is expected to occur in phases over the next several years. The initial phase, which included changes to our general ledger and consolidated financial reporting systems, was completed during the third quarter of 2020. There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, as the phased implementation of the new ERP system continues, we will change our processes and procedures, which in turn, could result in changes to our internal control over financial reporting. As such changes occur, we will evaluate quarterly whether such changes materially affect our internal control over financial reporting. As a result of COVID-19, our global workforce continued to operate primarily in a work from home environment for the quarter ended December 31, 2020 . While pre-existing controls were not specifically designed to operate in our current work from home operating environment, we believe that our internal controls over financial reporting continue to be effective. We have continued to re-evaluate and refine our financial reporting process to provide reasonable assurance that we could report our financial results accurately and timely. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2020. Management reviewed the results of its assessment with our Audit and Compliance Committee. The effectiveness of our internal control over financial reporting as of December 31, 2020 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION None. 92 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for 2021 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2020 (2021 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the 2021 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2021 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the 2021 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2021 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2021 Proxy Statement and is incorporated herein by reference. 93 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Ernst & Young LLP, Independent Registered Public Accounting Firm 51 Financial Statements: Consolidated Balance Sheets 54 Consolidated Statements of Income 55 Consolidated Statements of Comprehensive Income 56 Consolidated Statements of Stockholders’ Equity 57 Consolidated Statements of Cash Flows 58 Notes to Consolidated Financial Statements 59 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for credit losses and sales credits for the years ended December 31, 2018, 2019 and 2020 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year Year ended December 31, 2018 $ 674 $ 1,115 $ ( 1,060 ) $ 729 Year ended December 31, 2019 $ 729 $ 1,481 $ ( 1,457 ) $ 753 Year ended December 31, 2020 $ 753 $ 2,013 $ ( 1,422 ) $ 1,344 Note: Additions to the allowance for credit losses are charged to expense. Additions to the allowance for sales credits are charged against revenues. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of the Registrant, dated October 21, 2020 Current Report on Form 8-K (File No. 001-37580) October 27, 2020 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 94 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.07 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.09 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.10 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.11 Form of the Registrant’s 3.625% Notes due 2021 (included in Exhibit 4.10) 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.10) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 4.14 Form of Global Note representing the Registrant’s 0.450% n otes due 2025 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.15 Form of Global Note representing the Registrant’s 0.800% notes due 2027 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.16 Form of Global Note representing the Registrant’s 1.100% notes due 2030 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.17 Form of Global Note representing the Registrant’s 1.900% notes due 2040 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.18 Form of Global Note representing the Registrant’s 2.050% notes due 2050 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.19 Form of Global Note representing the Registrant’s 2.250% notes due 2060 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.20 Description of Registrant’s Securities Annual Report on Form 10-K (File No. 001-37580) February 4, 2020 10.01 u Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.03 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.04 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.05.1 u Google Inc. 2004 Stock Plan - Form of Google Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 95 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.05.2 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.3 u Google Inc. 2004 Stock Plan - Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.06 u Alphabet Inc. Amended and Restated 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 5, 2020 10.06.1 u Alphabet Inc. Amended and Restated 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) February 4, 2020 10.06.2 u Alphabet Inc. Amended and Restated 2012 Stock Plan - Performance Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) February 4, 2020 10.07 u Motorola Mobility Holdings, Inc. 2011 Incentive Compensation Plan Registration Statement on Form S-8 (File No. 333-181661) May 24, 2012 14.01 Code of Conduct of the Registrant as amended on September 21, 2017 Annual Report on Form 10-K (File No. 001-37580) February 6, 2018 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.01 Stipulation and Agreement of Settlement Current Report on Form 8-K (File No. 001-37580) September 5, 2020 99.02 Notice of Pendency and Proposed Settlement of Derivative Actions Current Report on Form 8-K (File No. 001-37580) October 23, 2020 101.INS * Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document. 101.SCH * XBRL Taxonomy Extension Schema Document 101.CAL * XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF * XBRL Taxonomy Extension Definition Linkbase Document 101.LAB * XBRL Taxonomy Extension Label Linkbase Document 96 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 101.PRE * XBRL Taxonomy Extension Presentation Linkbase Document 104 Cover Page Interactive Data File (formatted as Inline XBRL and contained in Exhibit 101) _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. ITEM 16. FORM 10-K SUMMARY None. 97 Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 2, 2021 ALPHABET INC. By: / S /    S UNDAR P ICHAI Sundar Pichai Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Sundar Pichai and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. 98 Table of Contents Alphabet Inc. Signature Title Date / S / S UNDAR P ICHAI Chief Executive Officer and Director (Principal Executive Officer) February 2, 2021 Sundar Pichai / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 2, 2021 Ruth M. Porat / S /    A MIE T HUENER O'T OOLE Vice President and Chief Accounting Officer (Principal Accounting Officer) February 2, 2021 Amie Thuener O'Toole / S /    F RANCES H. A RNOLD Director February 2, 2021 Frances H. Arnold / S /    S ERGEY B RIN Co-Founder and Director February 2, 2021 Sergey Brin / S /    L. J OHN D OERR Director February 2, 2021 L. John Doerr / S /    R OGER W. F ERGUSON, J R . Director February 2, 2021 Roger W. Ferguson, Jr. / S /    J OHN L. H ENNESSY Director, Chair February 2, 2021 John L. Hennessy / S /    A NN M ATHER Director February 2, 2021 Ann Mather / S /    A LAN R . M ULALLY Director February 2, 2021 Alan R. Mulally / S /    L ARRY P AGE Co-Founder and Director February 2, 2021 Larry Page / S /    K. R AM S HRIRAM Director February 2, 2021 K. Ram Shriram / S /    Robin L. Washington Director February 2, 2021 Robin L. 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us-gaap:AllowanceForCreditLossMember 2018-12-31 0001652044 us-gaap:AllowanceForCreditLossMember 2019-01-01 2019-12-31 0001652044 us-gaap:AllowanceForCreditLossMember 2019-12-31 0001652044 us-gaap:AllowanceForCreditLossMember 2020-01-01 2020-12-31 0001652044 us-gaap:AllowanceForCreditLossMember 2020-12-31 0001652044 us-gaap:AllowanceForCreditLossMember 2021-01-01 2021-12-31 0001652044 us-gaap:AllowanceForCreditLossMember 2021-12-31 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ___________________________________________ FORM 10-K ___________________________________________ (Mark One) ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31 , 2021 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View , CA 94043 (Address of principal executive offices, including zip code) ( 650 ) 253-000 0 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol(s) Name of each exchange on which registered Class A Common Stock, $0.001 par value GOOGL Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value GOOG Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C.7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of June 30, 2021, the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 30, 2021) was approximately $ 1,451.1 billion. For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 25, 2022, there were 300,754,904 shares of the registrant’s Class A common stock outstanding, 44,576,938 shares of the registrant’s Class B common stock outstanding, and 315,639,479 shares of the registrant’s Class C capital stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2022 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2021. Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2021 TABLE OF CONTENTS Page Note About Forward-Looking Statements 3 PART I Item 1. Business 4 Item 1A. Risk Factors 10 Item 1B. Unresolved Staff Comments 24 Item 2. Properties 24 Item 3. Legal Proceedings 24 Item 4. Mine Safety Disclosures 24 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 25 Item 6. [Reserved] 27 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 28 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 42 Item 8. Financial Statements and Supplementary Data 45 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 86 Item 9A. Controls and Procedures 86 Item 9B. Other Information 86 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 87 PART III Item 10. Directors, Executive Officers and Corporate Governance 88 Item 11. Executive Compensation 88 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 88 Item 13. Certain Relationships and Related Transactions, and Director Independence 88 Item 14. Principal Accountant Fees and Services 88 PART IV Item 15. Exhibits, Financial Statement Schedules 89 Item 16. Form 10-K Summary 92 Signatures 2 Table of Contents Alphabet Inc. NOTE ABOUT FORWARD-LOOKING STATEMENTS This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include, among other things, statements regarding: • the ongoing effect of the novel coronavirus pandemic ("COVID-19"), including its macroeconomic effects on our business, operations, and financial results; • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • fluctuations in our revenue growth rate and operating margin and various factors contributing to such fluctuations; • our expectation that the continuing shift from an offline to online world will continue to benefit our business; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase and may affect our margins; • our expectation that our traffic acquisition costs (TAC) and the associated TAC rate will fluctuate, which could affect our overall margins; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins; • fluctuations in our revenue growth, as well as the change in paid clicks and cost-per-click and the change in impressions and cost-per-impression, and various factors contributing to such fluctuations; • our expectation that we will continue to periodically review, refine, and update our methodologies for monitoring, gathering, and counting the number of paid clicks and impressions; • our expectation that our results will be affected by our performance in international markets as users in developing economies increasingly come online; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of gains and losses related to hedging activities under our foreign exchange risk management program; • the amount and timing of revenue recognition from customer contracts with commitments for performance obligations, including our estimate of the remaining amount of commitments and when we expect to recognize revenue; • fluctuations in our capital expenditures; • our plans to continue to invest in new businesses, products, services and technologies, systems, land and buildings for data centers and offices, and infrastructure, as well as to continue to invest in acquisitions and strategic investments; • our pace of hiring and our plans to provide competitive compensation programs; • our expectation that our cost of revenues, research and development (R&D) expenses, sales and marketing expenses, and general and administrative expenses may increase in amount and/or may increase as a percentage of revenues and may be affected by a number of factors; • estimates of our future compensation expenses; • our expectation that our other income (expense), net (OI&E), will fluctuate in the future, as it is largely driven by market dynamics; • fluctuations in our effective tax rate; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality, which are likely to cause fluctuations in our quarterly results; • the sufficiency of our sources of funding; • our potential exposure in connection with new and pending investigations, proceedings, and other contingencies; 3 Table of Contents Alphabet Inc. • the sufficiency and timing of our proposed remedies in response to decisions from the European Commission (EC) and other regulators and governmental entities; • our expectations regarding the timing, design, and ongoing phased implementation of our new global enterprise resource planning (ERP) system; • the expected timing, amount, and effect of Alphabet Inc.'s share repurchases; • our long-term sustainability and diversity goals; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report and other documents we file with the Securities and Exchange Commission (SEC), including without limitation, the following sections: Part I, Item 1 "Business;" Part I, Item 1A "Risk Factors;" and Part II, Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "may," "could," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed in Part I, Item 1A, "Risk Factors" of this report and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. This report contains additional trade names and trademarks of other companies. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history, inspiring us to tackle big problems and invest in moonshots like artificial intelligence (AI) research and quantum computing. We continue this work under the leadership of Sundar Pichai, who has served as CEO of Google since 2015 and as CEO of Alphabet since 2019. Alphabet is a collection of businesses — the largest of which is Google. We report Google in two segments, Google Services and Google Cloud; we also report all non-Google businesses collectively as Other Bets. Other Bets include earlier stage technologies that are further afield from our core Google business. We take a long-term view and manage the portfolio of Other Bets with the discipline and rigor needed to deliver long-term returns. Alphabet's structure is about helping each of our businesses prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers; it propels ideas, people and businesses large and small. Our mission to organize the world’s information and make it universally accessible and useful is as relevant today as it was when we were founded in 1998. Since then, we have evolved from a company that helps people find answers to a company that also helps people get things done. We are focused on building an even more helpful Google for everyone, and we aspire to give everyone the tools they need to increase their knowledge, health, happiness, and success. Every year, there are trillions of searches on Google, and 15% of the searches we see every day are new. We continue to invest deeply in AI and other technologies to ensure the most helpful search experience possible. YouTube provides people with entertainment, information, and opportunities to learn something new. And Google Assistant offers the best way to get things done seamlessly across different devices, providing intelligent help throughout a person's day, no matter where they are. We are continually innovating and building new product features that will help our users, partners, customers, and communities. We have invested more than $100 billion in R&D over the last five years. In addition, with the onset of 4 Table of Contents Alphabet Inc. the pandemic, we have focused in particular on features that help people in their daily lives and that support businesses working to serve their customers. For example, we have added live busyness trends in Google Maps that help users instantly spot when a neighborhood or part of town is near or at its busiest. We have also helped businesses navigate uncertainty during an uneven economic recovery, and we have worked to address the complex challenge of distributing critical information about COVID-19 vaccines to billions of people around the world. Importantly, we have made authoritative content a key focus area across both Google Search and YouTube to help users find trusted public health information. Other Bets also remain focused on innovation through technology that can positively affect people's lives. For instance, Waymo is working toward our goal of making transportation safer and easier for everyone and Verily is developing tools and platforms to improve health outcomes. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and to invest for the long term within each of our segments. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in, as they are the key to our long-term success. The power of AI Across the company, investments in AI and machine learning are increasingly driving many of our latest innovations and have enabled us to build products that are smarter and more helpful. For example, in May of 2021, we introduced Multitask Unified Model — or MUM — which has the potential to transform how Google helps with complex tasks. MUM is trained across 75 different languages, which means that it can learn from sources written in one language and help bring that information to people in another. It is also multimodal, so it understands information across text and images and, in the future, can expand to more modalities like video and audio. We are currently experimenting with MUM’s capabilities to make searching more natural and intuitive and even enable entirely new ways to search. DeepMind also made a significant AI-powered breakthrough, solving a 50-year-old protein folding challenge, which will help the world better understand one of life’s fundamental building blocks, and will enable researchers to tackle new and difficult problems, from fighting diseases to environmental sustainability. DeepMind has since shared its new AlphaFold protein structure database, which doubled the number of high-accuracy human protein structures available to researchers. Google For reporting purposes, Google comprises two segments: Google Services and Google Cloud. Google Services Serving our users We have always been a company committed to building helpful products that can improve the lives of millions of people. Our product innovations have made our services widely used, and our brand one of the most recognized in the world. Google Services' core products and platforms include ads, Android, Chrome, hardware, Gmail, Google Drive, Google Maps, Google Photos, Google Play, Search, and YouTube, each with broad and growing adoption by users around the world. Our products and services have come a long way since the company was founded more than two decades ago. Rather than the ten blue links in our early search results, users can now get direct answers to their questions using their computer, mobile device, or their own voice, making it quicker, easier and more natural to find what they are looking for. This drive to make information more accessible and helpful has led us over the years to improve the discovery and creation of digital content both on the web and through platforms like Google Play and YouTube. With the continued adoption of mobile, people are consuming more digital content by watching more videos, playing more games, listening to more music, reading more books, and using more apps than ever before. Working with content creators and partners, we continue to build new ways for people around the world to find great digital content. Fueling all of these great digital experiences are extraordinary platforms and hardware. That is why we continue to invest in platforms like our Android mobile operating system, Chrome browser, and Chrome operating system, as 5 Table of Contents Alphabet Inc. well as growing our family of hardware devices. We see tremendous potential for devices to be helpful and make people's lives easier by combining the best of our AI, software and hardware. This potential is reflected in our latest generation of hardware products such as Pixel 5a 5G and Pixel 6 phones, the Fitbit Charge 5, Chromecast with Google TV, and the new Google Nest Cams and Nest Doorbell. Creating products that people rely on every day is a journey that we are investing in for the long run. The key to building helpful products for users is our commitment to privacy, security, and user choice. We protect user privacy and security with products that are secure by default and private by design, and that keep users in control of their data. Our privacy-preserving technologies safeguard individual privacy and enhance data protection. As the Internet evolves, so does our approach to privacy and security. We continue to enhance our anti-malware features in Chrome and drive improvements such as auto-delete controls that automatically delete web and app searches after 18 months. And we continue to keep users and their passwords safe through advances like our built-in password manager. How we make money We have built world-class advertising technologies for advertisers, agencies, and publishers to power their digital marketing businesses. Our advertising solutions help millions of companies grow their businesses through our wide range of products across devices and formats, and we aim to ensure positive user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. Google Services generates revenues primarily by delivering both performance and brand advertising that appears on Google Search & other properties, YouTube and Google Network partners' properties ("Google Network properties"). We continue to invest in both performance and brand advertising and seek to improve the measurability of advertising so advertisers understand the effectiveness of their campaigns. • Performance advertising creates and delivers relevant ads that users will click on, leading to direct engagement with advertisers. Performance advertising lets our advertisers connect with users while driving measurable results. Our ads tools allow performance advertisers to create simple text-based ads. • Brand advertising helps enhance users' awareness of and affinity for advertisers' products and services, through videos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, including filtering out invalid traffic, removing billions of bad ads from our systems every year, and closely monitoring the sites, apps, and videos where ads appear and blocklisting them when necessary to ensure that ads do not fund bad content. We continue to look to the future and are making long-term investments that we expect to grow revenues beyond advertising, including revenues from Google Play, hardware, and YouTube non-advertising. • Google Play generates revenues from sales of apps and in-app purchases and digital content sold in the Google Play store. • Hardware generates revenues from sales of Fitbit wearable devices, Google Nest home products, Pixel phones, and other devices. • YouTube non-advertising generates revenues from YouTube Premium and YouTube TV subscriptions and other services. Google Cloud Google was a company built in the cloud. We continue to invest in infrastructure, security, data management, analytics, and AI. We see significant opportunity in helping businesses utilize these strengths with features like data migration, modern development environments, and machine learning tools to provide enterprise-ready cloud services, including Google Cloud Platform and Google Workspace. Google Cloud Platform enables developers to build, test, and deploy applications on its highly scalable and reliable infrastructure. Google Workspace collaboration tools — which include apps like Gmail, Docs, Drive, Calendar, Meet and more — are designed with real-time collaboration and machine intelligence to help people work smarter. Because more and more of today’s digital experiences are being built in the cloud, Google Cloud products help businesses of all sizes take advantage of the latest technology advances to operate more efficiently. • Google Cloud Platform generates revenues from infrastructure, platform and other services. 6 Table of Contents Alphabet Inc. • Google Workspace generates revenues from cloud-based collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar and Meet. Our cloud services are generally provided on either a consumption or subscription basis and may have contract terms longer than a year. Other Bets Across Alphabet, we are also using technology to try to solve big problems that affect a wide variety of industries. Alphabet’s investment in the portfolio of Other Bets includes emerging businesses at various stages of development, ranging from those in the R&D phase to those that are in the beginning stages of commercialization, and our goal is for them to become thriving, successful businesses in the medium to long term. While these early-stage businesses naturally come with considerable uncertainty, some of them are already generating revenue and making important strides in their industries. Revenues from Other Bets are generated primarily from the sale of health technology and internet services. Other Bets operate as independent companies and some of them have their own boards with independent members and outside investors. We are investing in the portfolio of Other Bets and being very deliberate about the focus, scale, and pace of investments. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, including from: • General purpose search engines and information services, such as Baidu, Microsoft's Bing, Naver, Seznam, Yahoo, and Yandex. • Vertical search engines and e-commerce providers, such as Amazon and eBay (e-commerce), Booking's Kayak (travel queries), Microsoft's LinkedIn (job queries), and WebMD (health queries). Some users will navigate directly to such content, websites, and apps rather than go through Google. • Social networks offered by ByteDance, Meta, Snap, and Twitter. Some users increasingly rely on social networks for product or service referrals, rather than seeking information through traditional search engines. • Other online advertising platforms and networks, such as Amazon, AppNexus, Criteo, and Meta, that compete for advertisers that use Google Ads, our primary auction-based advertising platform. • Other forms of advertising, such as billboards, magazines, newspapers, radio, and television. Our advertisers typically advertise in multiple media, both online and offline. • Companies that design, manufacture, and market consumer hardware products, including businesses that have developed proprietary platforms, such as Amazon, Apple, and Microsoft. • Digital assistant providers, such as Amazon and Apple. • Providers of enterprise cloud services, such as Alibaba, Amazon, Microsoft, and Salesforce. • Providers of digital video services, such as Amazon, Apple, AT&T, ByteDance, Disney, Hulu, Meta, and Netflix. • Other digital content and application platform providers, such as Amazon and Apple. • Providers of workspace connectivity and productivity products, such as Meta, Microsoft, Salesforce, and Zoom. Competing successfully depends heavily on our ability to develop and distribute innovative products and technologies to the marketplace across our businesses. Specifically, for advertising, competing successfully depends on attracting and retaining: • users, for whom other products and services are literally one click away, largely on the basis of the relevance of our advertising, as well as the general usefulness, security, and availability of our products and services; • advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels; and • content providers, primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. For additional information about competition, see Risk Factors in Item 1A of this Annual Report on Form 10-K. 7 Table of Contents Alphabet Inc. Ongoing Commitment to Sustainability We believe that every business has the opportunity and obligation to protect our planet. Sustainability is one of our core values at Google, and we strive to build sustainability into everything we do. We have been a leader on sustainability and climate change since Google’s founding over 20 years ago. These are some of our key achievements over the past two decades: • In 2007, we became the first major company to be carbon neutral for our operations. • In 2017, we became the first major company to match 100% of our annual electricity use with renewable energy, which we have achieved for four consecutive years. • In 2020, we issued $5.75 billion in sustainability bonds—the largest sustainability or green bond issuance by any company in history at the time. The net proceeds from the issuance are used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. As of December 31, 2020, we have allocated $3.47 billion of the net proceeds, as outlined in our Sustainability Bond Impact Report published in 2021. • Also in 2020, we compensated for our legacy carbon footprint, making Google the first major company to be carbon neutral for its entire operating history. Our sustainability strategy is focused on three key pillars: accelerating the transition to carbon-free energy and a circular economy, empowering everyone with technology, and benefiting the people and places where we operate. To accelerate the transition to a carbon-free economy, in 2020, we launched our third decade of climate action, and we are now working toward a new set of ambitious goals. By 2030, we aim to: • achieve net-zero emissions across all of our operations and value chain; • become the first major company to run on carbon-free energy 24 hours a day, seven days a week, 365 days a year; • enable 5 gigawatts of new carbon-free energy through investments in our key manufacturing regions; and • help more than 500 cities and local governments reduce an aggregate of 1 gigaton of carbon emissions annually. To accelerate the transition to a circular economy, we are working to maximize the reuse of finite resources across our operations, products, and supply chains and to enable others to do the same. We are also working to empower everyone with technology by committing to help 1 billion people make more sustainable choices by the end of 2022 through our core products. To benefit the people and places where we operate, we have set goals to replenish more water than we consume by 2030 and to support water security in communities where we operate. We will focus on three areas: enhancing our stewardship of water resources across Google office campuses and data centers; replenishing our water use and improving watershed health and ecosystems in water-stressed communities; and sharing technology and tools that help everyone predict, prevent, and recover from water stress. We remain steadfast in our commitment to sustainability, and we will continue to lead and encourage others to join us in improving the health of our planet. We are proud of what we have achieved so far, and we are energized to help move the world closer to a more sustainable and carbon-free future for all. More information on our approach to sustainability can be found in our annual sustainability reports, including Google’s Environmental Report and Alphabet’s 2021 Sustainability Bond Impact Report, which outlines the allocation of our net proceeds from our sustainability bonds. The contents of our sustainability reports are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. For additional information about risks and uncertainties applicable to our commitments to attain certain sustainability goals, see Risk Factors in Item 1A of this Annual Report on Form 10-K. Culture and Workforce We are a company of curious, talented, and passionate people. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex challenges in technology and society. Our people are critical for our continued success, so we work hard to create an environment where employees can have fulfilling careers, and be happy, healthy, and productive. We offer industry-leading benefits and programs to take care of the diverse needs of our employees and their families, including opportunities for career growth and 8 Table of Contents Alphabet Inc. development, resources to support their financial health, and access to excellent healthcare choices. Our competitive compensation programs help us to attract and retain top candidates, and we will continue to invest in recruiting talented people to technical and non-technical roles, and rewarding them well. We provide a variety of high quality training and support to our managers to build and strengthen their capabilities-–ranging from courses for new managers, to learning resources that help them provide feedback and manage performance, to coaching and individual support. At Alphabet, we are committed to making diversity, equity, and inclusion part of everything we do and to growing a workforce that is representative of the users we serve. More information on Google’s approach to diversity can be found in our annual diversity reports, available publicly at diversity.google. The contents of our diversity reports are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. As of December 31, 2021, Alphabet had 156,500 employees. We have work councils and statutory employee representation obligations in certain countries, and we are committed to supporting protected labor rights, maintaining an open culture and listening to all employees. Supporting healthy and open dialogue is central to how we work, and we communicate information about the company through multiple internal channels to our employees. When necessary, we contract with businesses around the world to provide specialized services where we do not have appropriate in-house expertise or resources, often in fields that require specialized training like cafe operations, content moderation, customer support, and physical security. We also contract with temporary staffing agencies when we need to cover short-term leaves, when we have spikes in business needs, or when we need to quickly incubate special projects. We choose our partners and staffing agencies carefully, and review their compliance with Google’s Supplier Code of Conduct. We continually make improvements to promote a respectful and positive working environment for everyone — employees, vendors, and temporary staff alike. Government Regulation We are subject to numerous United States (U.S.) federal, state, and foreign laws and regulations covering a wide variety of subject matters. Like other companies in the technology industry, we face heightened scrutiny from both U.S. and foreign governments with respect to our compliance with laws and regulations. Many of these laws and regulations are evolving and their applicability and scope, as interpreted by the courts, remain uncertain. Our compliance with these laws and regulations may be onerous and could, individually or in the aggregate, increase our cost of doing business, make our products and services less useful, limit our ability to pursue certain business models, cause us to change our business practices, affect our competitive position relative to our peers, and/or otherwise have an adverse effect on our business, reputation, financial condition, and operating results. For additional information about government regulation applicable to our business, see Risk Factors in Item 1A, Trends in Our Business and Financial Effect in Part II, Item 7, and Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, domain names and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. For additional information, see Risk Factors in Item 1A of this Annual Report on Form 10-K. Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and our Proxy Statements, and any amendments to these reports, are available through our investor relations website, free of charge, after we file them with the SEC. We also provide a link to the section of the SEC's website at www.sec.gov that has all of the reports that we file or furnish with the SEC. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance and other items that may be material or of interest to our investors, including SEC filings, investor events, press and earnings releases, and blogs. We also share Google news and product updates on Google's Keyword blog at https://www.blog.google/, that may be material or of interest to our investors. Further, corporate governance information, including our certificate of incorporation, bylaws, governance 9 Table of Contents Alphabet Inc. guidelines, board committee charters, and code of conduct, is also available on our investor relations website under the heading "Other." The contents of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could harm our business, reputation, financial condition, and operating results, and affect the trading price of our Class A and Class C stock. Risks Specific to our Company We generate a significant portion of our revenues from advertising, and reduced spending by advertisers, a loss of partners, or new and existing technologies that block ads online and/or affect our ability to customize ads could harm our business. We generated more than 80% of total revenues from the display of ads online in 2021. Many of our advertisers, companies that distribute our products and services, digital publishers, and content providers can terminate their contracts with us at any time. These partners may not continue to do business with us if we do not create more value (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. Changes to our advertising policies and data privacy practices, as well as changes to other companies’ advertising and/or data privacy practices have in the past, and may in the future, affect the advertising that we are able to provide, which could harm our business. In addition, technologies have been developed that make customized ads more difficult or that block the display of ads altogether and some providers of online services have integrated technologies that could potentially impair the availability and functionality of third-party digital advertising. Failing to provide superior value or deliver advertisements effectively and competitively could harm our reputation, financial condition, and operating results. In addition, expenditures by advertisers tend to be cyclical, reflecting overall economic conditions and budgeting and buying patterns. Adverse macroeconomic conditions have affected, and may in the future affect, the demand for advertising, resulting in fluctuations in the amounts our advertisers spend on advertising, which could harm our financial condition and operating results. We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, customers, and other partners, we may not remain competitive, which could harm our business and operating results. Our business environment is rapidly evolving and intensely competitive. Our businesses face changing technologies, shifting user needs, and frequent introductions of rival products and services. To compete successfully, we must accurately anticipate technology developments and deliver innovative, relevant and useful products, services, and technologies in a timely manner. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services. We must continue to invest significant resources in R&D, including through acquisitions, in order to enhance our technology and new and existing products and services. We have many competitors in different industries. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some competitors have longer operating histories and well established relationships in various sectors. They can use their experience and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in R&D and in talent, aggressively initiating intellectual property claims (whether or not meritorious), and continuing to compete aggressively for users, advertisers, customers, and content providers. Further, discrepancies in enforcement of existing laws may enable our lesser known competitors to aggressively interpret those laws without commensurate scrutiny, thereby affording them competitive advantages. Our competitors may also be able to innovate and provide products and services faster than we can or may foresee the need for products and services before us. Our operating results may also suffer if our products and services are not responsive to the needs of our users, advertisers, publishers, customers, and content providers. As technologies continue to develop, our competitors may be able to offer experiences that are, or that are seen to be, substantially similar to or better than ours. This may force us to compete in different ways and expend significant resources in order to remain competitive. If our competitors are more successful than we are in providing compelling products and services or in attracting and retaining users, advertisers, publishers, customers, and content providers, our operating results could be harmed. Our ongoing investment in new businesses, products, services, and technologies is inherently risky, and could divert management attention and harm our financial condition and operating results. 10 Table of Contents Alphabet Inc. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The investments that we are making across Google Services, Google Cloud, and Other Bets reflect our ongoing efforts to innovate and provide products and services that are useful to users, advertisers, publishers, customers, and content providers. Our investments in Google Services, Google Cloud, and Other Bets span a wide range of industries beyond online advertising. Such investments ultimately may not be commercially viable or may not result in an adequate return of capital and, in pursuing new strategies, we may incur unanticipated liabilities. These endeavors may involve significant risks and uncertainties, including diversion of resources and management attention from current operations and, with respect to Other Bets, the use of alternative investment, governance, or compensation structures that may fail to adequately align incentives across the company or otherwise accomplish their objectives. Within Google Services, we continue to invest heavily in hardware, including our smartphones, home devices, and wearables, which is a highly competitive market with frequent introduction of new products and services, rapid adoption of technological advancements by competitors, short product life cycles, evolving industry standards, continual improvement in product price and performance characteristics, and price and feature sensitivity on the part of consumers and businesses. There can be no assurance we will be able to provide hardware that competes effectively. Within Google Cloud, we devote significant resources to develop and deploy our enterprise-ready cloud services, including Google Cloud Platform and Google Workspace. We are incurring costs to build and maintain infrastructure to support cloud computing services and hire talent, particularly to support and scale our salesforce. At the same time, our competitors are rapidly developing and deploying cloud-based services. Pricing and delivery models are competitive and evolving, and we may not attain sufficient scale and profitability to achieve our business objectives. Within Other Bets, we are investing significantly in the areas of health, life sciences, and transportation, among others. These investment areas face intense competition from large, experienced, and well-funded competitors and our offerings may not be able to compete effectively or to operate at sufficient levels of profitability. In addition, new and evolving products and services, including those that use AI and machine learning, raise ethical, technological, legal, regulatory, and other challenges, which may negatively affect our brands and demand for our products and services. Because all of these new ventures are inherently risky, no assurance can be given that such strategies and offerings will be successful and will not harm our reputation, financial condition, and operating results. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including increasing competition. Changes in device mix, geographic mix, ongoing product and policy changes, product mix, and property mix and an increasing competition for advertising may also affect our advertising revenue growth rate. We may also experience a decline in our revenue growth rate as our revenues increase to higher levels, if there is a decrease in the rate of adoption of our products, services, and technologies, or due to deceleration or decline in demand for devices used to access our services, among other factors. In addition, we may also experience downward pressure on our operating margin resulting from a variety of factors, such as the continued expansion of our business into new fields, including products and services such as hardware, Google Cloud, and subscription products, as well as significant investments in Other Bets, all of which may have margins lower than those we generate from advertising. We may also experience downward pressure on our operating margins from increasing regulations, increasing competition, and increased costs for many aspects of our business. Due to these factors and the evolving nature of our business, our historical revenue growth rate and historical operating margin may not be indicative of our future performance. For additional information, see Trends in Our Business and Financial Effect in Part II, Item 7 of this Annual Report on Form 10-K. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brands as well as affect our ability to compete. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services, and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. There is always the possibility that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. 11 Table of Contents Alphabet Inc. We also seek to maintain certain intellectual property as trade secrets. The secrecy of such trade secrets and other sensitive information could be compromised, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” Some courts have ruled that "Google" is a protectable trademark, but it is possible that other courts, particularly those outside of the U.S., may reach a different determination. If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our operating results. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, customers, content providers, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands within Google Services, Google Cloud, and Other Bets increases our ability to enter new categories and launch new and innovative products and services that better serve the needs of our users, advertisers, customers, content providers, and other partners. Our brands have been, and may in the future be, negatively affected by a number of factors, including, among others, reputational issues, third-party content shared on our platforms, data privacy and security issues and developments, and product or technical performance failures. For example, if we fail to respond appropriately to the sharing of misinformation or objectionable content on our services and/or products or objectionable practices by advertisers, or otherwise to adequately address user concerns, our users may lose confidence in our brands. Furthermore, failure to maintain and enhance equity in our brands may harm our business, financial condition, and operating results. Our success will depend largely on our ability to remain a technology leader and continue to provide high-quality, trustworthy, innovative products and services that are truly useful and play a valuable role in a range of settings. We face a number of manufacturing and supply chain risks that could harm our financial condition, operating results, and prospects. We face a number of risks related to manufacturing and supply chain management, which could affect our ability to supply both our products and our internet-based services. We rely on other companies to manufacture many of our finished products; to design certain of our components and parts; to participate in the distribution of our products and services; and to design, manufacture, or assemble certain components and parts in our technical infrastructure. Our business could be negatively affected if we are not able to engage these companies with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We have experienced and/or may in the future experience supply shortages and/or price increases that could negatively affect our operations, driven by raw material, component or part availability, manufacturing capacity, labor shortages, industry allocations, logistics capacity, tariffs, trade disputes and barriers, natural disasters or pandemics, the effects of climate change (such as sea level rise, drought, flooding, heat waves, wildfires and resultant air quality effects and power shutoffs associated with wildfire prevention, and increased storm severity), and significant changes in the financial or business condition of our suppliers. In addition, some of the components we use in our technical infrastructure and products are available from only one or limited sources, and we may not be able to find replacement vendors on favorable terms in the event of a supply chain disruption. In addition, a significant supply interruption that affects us or our vendors could delay critical data center upgrades or expansions and delay product availability. We may enter into long-term contracts for materials and products that commit us to significant terms and conditions. We may be liable for materials and products that are not consumed due to market acceptance, technological change, obsolescences, quality, product recalls, and warranty issues. For instance, because certain of our hardware supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and negatively affect our financial results. Furthermore, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may affect our supply. 12 Table of Contents Alphabet Inc. Our products and services have had, and in the future may have, quality issues resulting from design, manufacturing, or operations. Sometimes, these issues may be caused by components we purchase from other manufacturers or suppliers. If the quality of our products and services does not meet expectations or our products or services are defective, it could harm our reputation, financial condition, and operating results. We require our suppliers and business partners to comply with laws and, where applicable, our company policies, such as the Google Supplier Code of Conduct, regarding workplace and employment practices, data security, environmental compliance, and intellectual property licensing, but we do not control them or their practices. Violations of law or unethical business practices could result in supply chain disruptions, canceled orders, harm to key relationships, and damage to our reputation. Their failure to procure necessary license rights to intellectual property could affect our ability to sell our products or services and expose us to litigation or financial claims. Interruption to, interference with, or failure of our complex information technology and communications systems could hurt our ability to effectively provide our products and services, which could harm our reputation, financial condition, and operating results. In addition, problems with the design or implementation of our new global enterprise resource planning system could harm our business and operations. The availability of our products and services and fulfillment of our customer contracts depend on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference, or interruption from modifications or upgrades, terrorist attacks, natural disasters or pandemics, the effects of climate change (such as sea level rise, drought, flooding, heat waves, wildfires and resultant air quality effects and power shutoffs associated with wildfire prevention, and increased storm severity), power loss, telecommunications failures, computer viruses, ransomware attacks, computer denial of service attacks, phishing schemes, or other attempts to harm or access our systems. Some of our data centers are located in areas with a high risk of major earthquakes or other natural disasters. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and, in some cases, to potential disruptions resulting from problems experienced by facility operators. Some of our systems are not fully redundant, and disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster or pandemic, closure of a facility, or other unanticipated problems affecting our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and have contained in the past, and may contain in the future, errors or vulnerabilities, which could result in interruptions in or failure of our services or systems. In addition, we rely extensively on information systems and technology to manage our business and summarize operating results. We are in the process of a multi-year implementation of a new ERP system, which is designed to accurately maintain our financial records, enhance the flow of financial information, improve data management, and provide timely information to our management team. As the phased implementation continues, we may experience delays, increased costs, and other difficulties. Failure to successfully design and implement the ERP system as planned could harm our business, financial condition, and operating results. Additionally, if we do not effectively implement the ERP system as planned or the ERP system does not operate as intended, the effectiveness of our internal control over financial reporting could be negatively affected. Our international operations expose us to additional risks that could harm our business, our financial condition, and operating results. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 54% of our consolidated revenues in 2021. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S.; • import and export requirements, tariffs and other market access barriers that may prevent or impede us from offering products or providing services to a particular market, or that could limit our ability to source assemblies and finished products from a particular market, and may increase our operating costs; • longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud; • an evolving foreign policy landscape that may adversely affect our revenues and could subject us to new regulatory costs and challenges (including the transfer of personal data between the EU and the United Kingdom and new customer requirements), in addition to other adverse effects that we are unable to effectively anticipate; 13 Table of Contents Alphabet Inc. • anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting certain payments to government officials, violations of which could result in civil and criminal penalties; • uncertainty regarding liability for services and content, including uncertainty as a result of local laws and lack of legal precedent; and • different employee/employer relationships, existence of works councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Because we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we have faced, and will continue to face, exposure to fluctuations in foreign currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Hedging programs are also inherently risky and could expose us to additional risks that could harm our financial condition and operating results. Risks Related to our Industry People access the Internet through a variety of platforms and devices that continue to evolve with the advancement of technology and user preferences. If manufacturers and users do not widely adopt versions of our products and services developed for these interfaces, our business could be harmed. People access the Internet through a growing variety of devices such as desktop computers, mobile phones, smartphones, laptops and tablets, video game consoles, voice-activated speakers, wearables, automobiles, and television-streaming devices. Our products and services may be less popular on some interfaces. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not be available or may only be available with limited functionality for our users or our advertisers on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries are increasingly being undertaken via voice-activated speakers, apps, social media or other platforms, which could harm our business. It is hard to predict the challenges we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to creating and supporting products and services across multiple platforms and devices. Failing to attract and retain a substantial number of new device manufacturers, suppliers, distributors, developers, and users, or failing to develop products and technologies that work well on new devices and platforms, could harm our business, financial condition, and operating results and ability to capture future business opportunities. Data privacy and security concerns relating to our technology and our practices could damage our reputation, cause us to incur significant liability, and deter current and potential users or customers from using our products and services. Software bugs or defects, security breaches, and attacks on our systems could result in the improper disclosure and use of user data and interference with our users’ and customers’ ability to use our products and services, harming our business operations and reputation. Concerns about, including the adequacy of, our practices with regard to the collection, use, governance, disclosure, or security of personal information or other data-privacy-related matters, even if unfounded, could harm our reputation, financial condition, and operating results. Our policies and practices may change over time as expectations and regulations regarding privacy and data change. Our products and services involve the storage, handling, and transmission of proprietary and other sensitive information. Software bugs, theft, misuse, defects, vulnerabilities in our products and services, and security breaches expose us to a risk of loss or improper use and disclosure of such information, which could result in litigation and other potential liability, including regulatory fines and penalties, as well as reputational harm. Additionally, our products incorporate highly technical and complex technologies, and thus our technologies and software have contained, and are likely in the future to contain, undetected errors, bugs, or vulnerabilities. We have in the past discovered, and may in the future discover, some errors in our software code only after we have released the code. Systems and control failures, security breaches, failure to comply with our privacy policies, and/or inadvertent disclosure of user data could result in government and legal exposure, seriously harm our reputation, brand, and business, and impair our ability to attract and retain users or customers. Such incidents have occurred in the past and may continue to occur due to the scale and nature of our products and services. While there is no guarantee that such incidents will not cause significant damage, we expect to continue to expend significant resources to maintain security protections that limit the effect of bugs, theft, misuse, and security vulnerabilities or breaches. We experience cyber attacks and other attempts to gain unauthorized access to our systems on a regular basis. Cyber attacks continue to evolve in sophistication and volume, and inherently may be difficult to detect for long periods of time. We have seen, and will continue to see, industry-wide vulnerabilities, such as the Log4j vulnerability reported in December 2021, which could affect our or other parties’ systems. We expect to continue to experience such 14 Table of Contents Alphabet Inc. incidents or vulnerabilities in the future. Our efforts to address undesirable activity on our platform may also increase the risk of retaliatory attack. We may experience future security issues, whether due to employee error or malfeasance or system errors or vulnerabilities in our or other parties’ systems. While we may not determine some of these issues to be material at the time they occur and may remedy them quickly, there is no guarantee that these issues will not ultimately result in significant legal, financial, and reputational harm, including government inquiries and enforcement actions, litigation, and negative publicity. Because the techniques used to obtain unauthorized access to, disable or degrade service provided by or otherwise sabotage systems change frequently and often are recognized only after being launched against a target, even taking all reasonable precautions, including those required by law, we have been unable in the past and may continue to be unable to anticipate or detect attacks or vulnerabilities or implement adequate preventative measures. Further, if any partners with whom we share user or other customer information fail to implement adequate data-security practices or fail to comply with our terms and policies or otherwise suffer a network or other security breach, our users’ information may be improperly accessed, used, or disclosed. If an actual or perceived breach of our or our business partners’ or service providers’ security occurs, the market perception of the effectiveness of our security measures would be harmed, we could lose users and customers, our trade secrets or those of our business partners may be compromised, and we may be exposed to significant legal and financial risks, including legal claims (which may include class-action litigation) and regulatory action, fines, and penalties. Any of the foregoing consequences could have a material and adverse effect on our business, reputation, and results of operations. While we have dedicated significant resources to privacy and security incident response capabilities, including dedicated worldwide incident response teams, our response process, particularly during times of a natural disaster or pandemic, may not be adequate, may fail to accurately assess the severity of an incident, may not be fast enough to prevent or limit harm, or may fail to sufficiently remediate an incident. As a result, we may suffer significant legal, reputational, or financial exposure, which could harm our business, financial condition, and operating results. For additional information, see also our risk factor on privacy and data protection regulations under ‘Risks Related to Laws and Regulations’ below. Our ongoing investments in safety, security, and content review will likely continue to identify abuse of our platforms and misuse of user data. In addition to our efforts to prevent and mitigate cyber attacks, we are making significant investments in safety, security, and review efforts to combat misuse of our services and unauthorized access to user data by third parties, including investigation and review of platform applications that could access the information of users of our services. As a result of these efforts, we have in the past discovered, and may in the future discover, incidents of unnecessary access to or misuse of user data or other undesirable activity by third parties. However, we may not have discovered, and may in the future not discover, all such incidents or activity, whether as a result of our data limitations, including our lack of visibility over our encrypted services, the scale of activity on our platform, or other factors, including factors outside of our control such as a natural disaster or pandemic, and we may learn of such incidents or activity via third parties. Such incidents and activities may include the use of user data or our systems in a manner inconsistent with our terms, contracts or policies, the existence of false or undesirable user accounts, election interference, improper ad purchases, activities that threaten people’s safety on- or off-line, or instances of spamming, scraping, or spreading disinformation. While we may not determine some of these incidents to be material at the time they occurred and we may remedy them quickly, there is no guarantee that these issues will not ultimately result in significant legal, financial, and reputational harm, including government inquiries and enforcement actions, litigation, and negative publicity. We may also be unsuccessful in our efforts to enforce our policies or otherwise prevent or remediate any such incidents. Any of the foregoing developments may negatively affect user trust and engagement, harm our reputation and brands, require us to change our business practices in ways that harm our business operations and adversely affect our business and financial results. Any such developments may also subject us to additional litigation and regulatory inquiries, which could result in monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight. Problematic content on our platforms, including low-quality user-generated content, web spam, content farms, and other violations of our guidelines could affect the quality of our services, which could damage our reputation and deter our current and potential users from using our products and services. We, like others in the industry, face violations of our content guidelines across our platforms, including sophisticated attempts by bad actors to manipulate our hosting and advertising systems to fraudulently generate revenues, or to otherwise generate traffic that does not represent genuine user interest or intent. While we invest significantly in efforts to promote high-quality and relevant results and to detect and prevent low-quality content and 15 Table of Contents Alphabet Inc. invalid traffic, we have been unable and may continue to be unable to adequately detect and prevent all such abuses or promote uniformly high-quality content. Many websites violate or attempt to violate our guidelines, including by seeking to inappropriately rank higher in search results than our search engine's assessment of their relevance and utility would rank them. Such efforts have affected, and may continue to affect, the quality of content on our platforms and lead them to display false, misleading, or undesirable content. Although English-language web spam in our search results has been reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek inappropriate ways to improve their rankings. We continuously combat web spam in our search results, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We also continue to invest in and deploy proprietary technology to detect and prevent web spam on our platforms. We also face other challenges from low-quality and irrelevant content websites, including content farms, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes designed to detect and prevent abuse from low-quality websites. We also face other challenges on our platforms, including violations of our content guidelines involving incidents such as attempted election interference, activities that threaten the safety and/or well-being of our users on- or off-line, and the spreading of misinformation or disinformation. If we fail to either detect and prevent an increase in problematic content or effectively promote high-quality content, it could hurt our reputation for delivering relevant information or reduce use of our platforms, harming our financial condition or operating results. It may also subject us to litigation and regulatory action, which could result in monetary penalties and damages and divert management’s time and attention. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take measures that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, by charging increased fees to us or our users to provide our offerings, or by providing our competitors preferential access. Some jurisdictions have adopted regulations prohibiting certain forms of discrimination by internet access providers; however, substantial uncertainty exists in the U.S. and elsewhere regarding such protections. For example, in 2018 the U.S. Federal Communications Commission repealed net neutrality rules, which could permit internet access providers to restrict, block, degrade, or charge for access to certain of our products and services. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. These could harm existing key relationships, including with our users, customers, advertisers, and/or content providers, and impair our ability to attract new ones; damage our reputation; and increase costs, thereby negatively affecting our business. Risks Related to Laws, Regulations, and Policies We face increased regulatory scrutiny as well as changes in regulatory conditions, laws, and policies governing a wide range of topics that may negatively affect our business. We and other companies in the technology industry face increased regulatory scrutiny, enforcement action, and other proceedings. For instance, the U.S. Department of Justice, joined by a number of state Attorneys General, filed an antitrust complaint against Google on October 20, 2020, alleging that Google violated U.S. antitrust laws relating to Search and Search advertising. Similarly, on December 16, 2020, a number of state Attorneys General filed an antitrust complaint against Google in the U.S. District Court for the Eastern District of Texas, alleging that Google violated U.S. antitrust laws as well as state deceptive trade laws relating to its advertising technology. Various other regulatory agencies in the U.S. and around the world, including competition enforcers, consumer protection agencies, data protection authorities, grand juries, inter-agency consultative groups, and a range of other governmental bodies have and continue to review and in some cases challenge our products and services and their compliance with laws and regulations around the world. We continue to cooperate with these investigations and defend litigation where appropriate. Various laws, regulations, investigations, enforcement lawsuits, and regulatory actions have in the past, and may in the future, result in substantial fines and penalties, injunctive relief, ongoing auditing and monitoring obligations, changes to our products and services, alterations to our business models and operations, and collateral litigation, all of which could harm our business, reputation, financial condition, and operating results. 16 Table of Contents Alphabet Inc. Changes in international and local social, political, economic, tax, and regulatory conditions or in laws and policies have in the past, and may in the future, increase our cost of doing business and limit our ability to pursue certain business models, offer products or services in certain jurisdictions, or cause us to change our business practices. We have in the past had to alter or stop offering certain products and services as a result of laws or regulations that made them unfeasible, and new laws or regulations could result in our having to terminate, alter, or withdraw products and services in the future. Additional costs of doing business, new limitations, or changes to our business model or practices could harm our business, reputation, financial condition, and operating results. We are subject to regulations, laws, and policies that govern a wide range of topics, including those related to matters beyond our core products and services. For instance, new regulations, laws, policies, and international accords relating to environmental and social matters, including sustainability, climate change, human capital, and diversity, are being developed and formalized in Europe, the U.S., and elsewhere, which may entail specific, target-driven frameworks and/or disclosure requirements. We have implemented robust environmental and social programs, adopted reporting frameworks and principles, and announced a number of goals and initiatives, including those related to environmental sustainability and diversity. The implementation of these goals and initiatives may require considerable investments, and our goals, with all of their contingencies, dependencies, and in certain cases, reliance on third-party verification and/or performance, are complex and ambitious, and we cannot guarantee that we will achieve them. Additionally, there can be no assurance that our current programs, reporting frameworks, and principles will be in compliance with any new environmental and social laws and regulations that may be promulgated in the U.S. and elsewhere, and the costs of changing any of our current practices to comply with any new legal and regulatory requirements in the U.S. and elsewhere may be substantial. Furthermore, industry and market practices may further develop to become even more robust than what is required under any new laws and regulations, and we may have to expend significant efforts and resources to keep up with market trends and stay competitive among our peers. A variety of new and existing laws and/or interpretations could harm our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subject matters. New laws and regulations, or new interpretations or applications of existing laws and regulations in a manner inconsistent with our practices, have made, and may continue to make, our products and services less useful, limit our ability to pursue certain business models or offer certain products and services in certain jurisdictions, require us to incur substantial costs, expose us to civil or criminal liability, or cause us to change our business practices. These laws and regulations are evolving and involve matters central to our business, including, among others: • Laws and regulations around the world focused on large technology platforms, including the Digital Markets Act in the European Union and proposed antitrust legislation on self-preferencing and mergers and acquisitions in the U.S., which may limit certain business practices, and in some cases, create the risk of significant penalties. • Privacy laws, such as the GDPR, CCPA, CPRA, Virginia CDPA, and ColoPA (as defined and discussed further below). • Data protection laws passed by many states within the U.S. and by certain countries regarding notification to data subjects and/or regulators when there is a security breach of personal data. • Consumer protection laws, including EU’s New Deal for Consumers, which could result in monetary penalties and create a range of new compliance obligations. • New laws further restricting the collection, processing and/or sharing of advertising-related data. Copyright or similar laws around the world, including the EU Directive on Copyright in the Digital Single Market (EUCD) and EU member state transpositions. These and similar laws that have been adopted or proposed introduce new licensing regimes that could affect our ability to operate. The EUCD and similar laws could also increase the liability of some content-sharing services with respect to content uploaded by their users. Some of these laws, as well as follow-on administrative or judicial actions, have also created or may create a new property right in news publications that limits the ability of some online services to link to, interact with, or present such content. They may also require individual or collective compensation negotiations with news agencies and publishers for the use of such content, which may result in payment obligations that significantly exceed the value that such content provides to Google and its users, potentially harming our services, commercial operations, and business results. • Data localization laws, which generally mandate that certain types of data collected in a particular country be stored and/or processed within that country. 17 Table of Contents Alphabet Inc. • Various U.S. and international laws that govern the distribution of certain materials to children and regulate the ability of online services to collect information from minors, including the Children’s Online Privacy Protection Act of 1998 and the United Kingdom’s Age-Appropriate Design Code. • Various laws with regard to content moderation and removal, and related disclosure obligations, such as the Network Enforcement Act in Germany and the European Union's pending Digital Services Act, which may affect our businesses and operations and may subject us to significant fines if such laws are interpreted and applied in a manner inconsistent with our practices or when we may not proactively discover such content due to the scale of third-party content and the limitations of existing technologies. Other countries, including Singapore, Australia, and the United Kingdom, have implemented or are considering similar legislation imposing penalties for failure to remove certain types of content. • Various legislative, litigation, and regulatory activity regarding our Google Play billing policies and business model, which could result in monetary penalties, damages and/or prohibition. • Various legislative and regulatory activity requiring disclosure of information about the operation of our services and algorithms, which may make it easier for websites to artificially promote low-quality, deceptive, or harmful content on services like Google Search and YouTube, potentially harming the quality of our services. In addition, the applicability and scope of these laws, as interpreted by the courts, remain uncertain and could harm our business. For example: • We rely on statutory safe harbors, as set forth in the Digital Millennium Copyright Act and Section 230 of the Communications Decency Act in the U.S. and the E-Commerce Directive in Europe, against liability for various linking, caching, and hosting activities. Any legislation or court rulings affecting these safe harbors may adversely affect us. There are legislative proposals in both the U.S. and EU that could reduce our safe harbor protection. • Court decisions such as the judgment of the Court of Justice of the European Union (CJEU) on May 13, 2014 on the ‘right to be forgotten,’ which allows individuals to demand that Google remove search results about them in certain instances, may limit the content we can show to our users and impose significant operational burdens. The introduction of new businesses, products, services, and technologies, our activities in certain jurisdictions, or other actions we take have subjected us, and will likely continue to subject us, to additional laws and regulations. Our investment in a variety of new fields, such as healthcare and payment services, has expanded, and will continue to expand, the scope of regulations that apply to our business. The costs of compliance with these laws and regulations are high and are likely to increase in the future. Any failure on our part to comply with laws and regulations can result in negative publicity and diversion of management time and effort and may subject us to significant liabilities and other penalties. We are subject to claims, suits, government investigations, other proceedings, and consent decrees that may harm our business, financial condition, and operating results. We are subject to claims, suits, government investigations, other proceedings, and consent decrees involving competition, intellectual property, data privacy and security, consumer protection, tax, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, and other matters. Due to our manufacturing and sale of an expanded suite of products and services, including hardware as well as Google Cloud offerings, we also are subject to a variety of claims including product warranty, product liability, and consumer protection claims related to product defects, among other litigation. We may also be subject to claims involving health and safety, hazardous materials usage, other environmental effects, or service disruptions or failures. Any of these types of legal proceedings can have an adverse effect on us because of legal costs, diversion of management resources, negative publicity and other factors. Determining reserves for our pending litigation is a complex, fact-intensive process that requires significant judgment. The resolution of one or more such proceedings has resulted in, and may in the future result in, additional substantial fines, penalties, injunctions, and other sanctions that could harm our business, financial condition, and operating results. We may be subject to legal liability associated with providing online services or content. Our products and services let users exchange information, advertise products and services, conduct business, and engage in various online activities. We also place advertisements displayed on other companies’ websites, and we offer third-party products, services, and/or content. The law relating to the liability of online service providers for others’ activities on their services is still somewhat unsettled around the world. Claims have been brought against us, and we 18 Table of Contents Alphabet Inc. expect will continue to be brought against us, for defamation, negligence, breaches of contract, copyright and trademark infringement, unfair competition, unlawful activity, torts, fraud, or other legal theories based on the nature and content of information available on or via our services. We may be subject to claims by virtue of our involvement in hosting, transmitting, marketing, branding, or providing access to content created by third parties. Defense of such actions could be costly and involve significant time and attention of our management and other resources, may result in monetary liabilities or penalties, and may require us to change our business in an adverse manner. Privacy and data protection regulations are complex and rapidly evolving areas. Any failure or alleged failure to comply with these laws could harm our business, reputation, financial condition, and operating results. Authorities around the world have adopted and are considering a number of legislative and regulatory proposals concerning data protection and limits on encryption of user data. Adverse legal rulings, legislation, or regulation have resulted in, and may continue to result in, fines and orders requiring that we change our data practices, which could have an adverse effect on our ability to provide services, harming our business operations. Complying with these evolving laws could result in substantial costs and harm the quality of our products and services, negatively affecting our business, and may be particularly challenging during certain times, such as a natural disaster or pandemic. Amongst others, we are and will be subject to the following laws and regulations: • The General Data Protection Regulation (GDPR), which applies to all of our activities conducted from an establishment in the EU or related to products and services that we offer to EU users or customers, or the monitoring of their behavior in the EU. Ensuring compliance with the range of obligations created by the GDPR is an ongoing commitment that involves substantial costs. Despite our efforts, governmental authorities or others have asserted and may continue to assert that our business practices fail to comply with its requirements. If our operations are found to violate the GDPR requirements, we may incur substantial fines, have to change our business practices, and face reputational harm, any of which could have an adverse effect on our business. Serious breaches of the GDPR can result in administrative fines of up to 4% of annual worldwide revenues. Fines of up to 2% of annual worldwide revenues can be levied for other specified violations. • Various state privacy laws, such as the California Consumer Privacy Act of 2018 (CCPA), which came into effect in January of 2020; the California Privacy Rights Act (CPRA), which will go into effect in 2023; the Virginia Consumer Data Protection Act (Virginia CDPA), which will go into effect in 2023; and the Colorado Privacy Act (ColoPA), which will go into effect in 2023; all of which give new data privacy rights to their respective residents (including, in California, a private right of action in the event of a data breach resulting from our failure to implement and maintain reasonable security procedures and practices) and impose significant obligations on controllers and processors of consumer data. • SB-327 in California, which regulates the security of data in connection with internet connected devices. Further, we are subject to evolving laws and regulations that dictate whether, how, and under what circumstances we can transfer, process and/or receive personal data. The EU-U.S. and the Swiss-U.S. Privacy Shield frameworks that previously allowed U.S. companies that self-certify to the U.S. Department of Commerce and publicly commit to comply with specified requirements to import personal data from the EU and Switzerland have been invalidated by the CJEU. The CJEU upheld Standard Contractual Clauses (SCCs) as a valid transfer mechanism, provided they meet certain requirements. On June 4, 2021, the European Commission published new SCCs for this purpose, and we may have to adapt our existing contractual arrangements to meet these new requirements. The validity of data transfer mechanisms remains subject to legal, regulatory, and political developments in both Europe and the U.S., such as recent recommendations from the European Data Protection Board, decisions from supervisory authorities, recent proposals for reform of the data transfer mechanisms for transfers of personal data outside the United Kingdom, and potential invalidation of other data transfer mechanisms, which, together with increased enforcement action from supervisory authorities in relation to cross-border transfers of personal data, could have a significant adverse effect on our ability to process and transfer personal data outside of the European Economic Area and/or the United Kingdom. These laws and regulations are evolving and subject to interpretation, including developments which create some uncertainty, and compliance obligations could cause us to incur costs or harm the operations of our products and services in ways that harm our business. For example, in the EU, several supervisory authorities have issued new guidance concerning the ePrivacy Directive’s requirements regarding the use of cookies and similar technologies, including limitations on the use of data across messaging products and specific requirements for enabling users to accept or reject cookies, and have in some cases brought (and may seek to bring in the future) enforcement action in relation to those requirements. In the U.S., certain types of cookies may be deemed sales of personal information 19 Table of Contents Alphabet Inc. within the CCPA and other state laws, such that certain disclosure requirements and limitations apply to the use of such cookies. In addition, some countries are considering or have passed legislation implementing data protection requirements or requiring local storage and processing of data that could increase the cost and complexity of delivering our services and carries the potential of service interruptions in those countries. We face, and may continue to face, intellectual property and other claims that could be costly to defend, result in significant damage awards or other costs (including indemnification awards), and limit our ability to use certain technologies in the future. We, like other internet, technology and media companies, are frequently subject to litigation based on allegations of infringement or other violations of intellectual property rights. In addition, patent-holding companies may frequently seek to generate income from patents they have obtained by bringing claims against us. As we have grown, the number of intellectual property claims against us has increased and may continue to increase as we develop new products, services, and technologies. We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe the intellectual property rights of others. Other parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease-and-desist orders, which could limit our ability to sell our products or services in the U.S. or elsewhere if our products or services or those of our customers or suppliers are found to infringe the intellectual property subject to the claims. Adverse results in any of these lawsuits may include awards of monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders preventing us from offering certain features, functionalities, products, or services. They may also cause us to change our business practices and require development of non-infringing products, services, or technologies, which could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to defend against certain intellectual property infringement claims and in some cases indemnify them for certain intellectual property infringement claims against them, which could result in increased costs for defending such claims or significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers arising from intellectual property infringement claims. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, including those associated with intellectual property claims. Regardless of their merits, intellectual property claims are often time consuming and expensive to litigate or settle. To the extent such claims are successful, they may harm our business, including our product and service offerings, financial condition, or operating results. Risks Related to Ownership of our Stock We cannot guarantee that any share repurchase program will be fully consummated or will enhance long-term stockholder value, and share repurchases could increase the volatility of our stock prices and could diminish our cash reserves. We engage in share repurchases of our Class A and Class C stock from time to time in accordance with authorizations from the Board of Directors of Alphabet. Our repurchase program does not have an expiration date and does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. Further, our share repurchases could affect our share trading prices, increase their volatility, reduce our cash reserves and may be suspended or terminated at any time, which may result in a decrease in the trading prices of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B stock has 10 votes per share, our Class A stock has one vote per share, and our Class C stock has no voting rights. As of December 31, 2021, Larry Page and Sergey Brin beneficially owned approximately 85.9% of our outstanding Class B stock, which represented approximately 51.4% of the voting power of our outstanding common stock. Through their stock ownership, Larry and Sergey have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C stock carries no voting rights (except as required by applicable law), the issuance of the Class C stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could continue Larry and Sergey’s current relative voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. The share repurchases made pursuant to our repurchase program may also 20 Table of Contents Alphabet Inc. affect Larry and Sergey’s relative voting power. This concentrated control limits or severely restricts other stockholders’ ability to influence corporate matters and we may take actions that some of our stockholders do not view as beneficial, which could reduce the market price of our Class A stock and our Class C stock. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our certificate of incorporation provides for a tri-class capital stock structure. As a result of this structure, Larry and Sergey have significant influence over all matters requiring stockholder approval. This concentrated control could discourage others from initiating any potential merger, takeover, or other change of control transaction that other stockholders may view as beneficial. • Our Board of Directors has the right to elect directors to fill a vacancy created by the expansion of the Board of Directors or the resignation, death, or removal of a director. • Our stockholders may not act by written consent, which makes it difficult to take certain actions without holding a stockholders' meeting. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the Board of Directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our Board of Directors may issue, without stockholder approval, shares of undesignated preferred stock, which makes it possible for our Board of Directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the Board of Directors has approved the transaction. Our Board of Directors could rely on Delaware law to prevent or delay an acquisition of us. General Risks The continuing effects of COVID-19 are highly unpredictable and could be significant, and may have an adverse effect on our business, operations and our future financial performance. Since COVID-19 was declared a global pandemic by the World Health Organization, our business, operations and financial performance have been, and may continue to be, affected by the macroeconomic impacts resulting from the efforts to control the spread of COVID-19. As a result of the scale of the ongoing pandemic, including the introduction of new variants of COVID-19 and vaccination and other efforts to control the spread, our revenue growth rate and expenses as a percentage of our revenues in future periods may differ significantly from our historical rates, and our future operating results may fall below expectations. Additionally, we may experience a significant and prolonged shift in user behavior such as a shift in interests to less commercial topics. As a result of the pandemic, our workforce shifted to operating in a primarily remote working environment, which continues to create inherent productivity, connectivity, and oversight challenges. The effects of the ongoing pandemic are dynamic and uneven. As we prepare to return our workforce in more locations back to the office, we may experience increased costs and/or disruption as we experiment with hybrid work models, in addition to potential effects on our ability to operate effectively and maintain our corporate culture. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results have fluctuated, and may in the future fluctuate, as a result of a number of factors, many outside of our control, including the cyclicality and seasonality in our business and geopolitical events. As a result, comparing our operating results (including our expenses as a percentage of our revenues) on a period-to-period basis may not be meaningful, and our past results should not be relied on as an indication of our future performance. Consequently, our operating results in future quarters may fall below expectations. 21 Table of Contents Alphabet Inc. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that may harm our business, financial condition, and operating results. Acquisitions, joint ventures, investments and divestitures are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and operating results. We expect to continue to evaluate and enter into discussions regarding a wide array of such potential strategic transactions, which could create unforeseen operating difficulties and expenditures. Some of the areas where we face risks include: • diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions; • failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of a transaction; • failure to successfully integrate and further develop the acquired business or technology; • implementation or remediation of controls, procedures, and policies at the acquired company; • integration of the acquired company’s accounting, human resource (including cultural integration and retention of employees), and other administrative systems, and coordination of product, engineering, and sales and marketing functions; • transition of operations, users, and customers onto our existing platforms; • in the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries; • liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, data privacy and security issues, violations of laws, commercial disputes, tax liabilities, warranty claims, product liabilities, and other known and unknown liabilities; and • litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions and other strategic transactions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition or operating results. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which may harm our financial condition or operating results. If we were to lose the services of key personnel, we may not be able to execute our business strategy. Our future success depends in large part upon the continued service of key members of our senior management team. For instance, Sundar Pichai is critical to the overall management of Alphabet and its subsidiaries and plays an important role in the development of our technology, maintaining our culture, and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could seriously harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain our corporate culture, we may not be able to grow effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our ability to compete effectively and our future success depends on our continuing to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Restrictive immigration policy and regulatory changes may also affect our ability to hire, mobilize, or retain some of our global talent. 22 Table of Contents Alphabet Inc. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows and evolves, we may need to implement more complex organizational management structures or adapt our corporate culture and work environments to ever-changing circumstances, such as during times of a natural disaster or pandemic, and these changes could affect our ability to compete effectively or have an adverse effect on our corporate culture. We are exposed to fluctuations in the fair values of our investments and, in some instances, our financial statements incorporate valuation methodologies that are subjective in nature resulting in fluctuations over time. The fair value of our investments may in the future be, and certain investments have been in the past, negatively affected by liquidity, credit deterioration or losses, performance and financial results of the underlying entities, foreign exchange rates, changes in interest rates, including changes that may result from the implementation of new benchmark rates, the effect of new or changing regulations, the stock market in general, or other factors. We measure certain of our non-marketable equity and debt securities, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves use of appropriate valuation methods and certain unobservable inputs, requires management judgment and estimation, and may change over time. We adjust the carrying value of our non-marketable equity securities to fair value for observable transactions of identical or similar investments of the same issuer or for impairments. All gains and losses on non-marketable equity securities, are recognized in other income (expense), which increases the volatility of our other income (expense). The unrealized gains and losses we record from fair value remeasurements of our non-marketable equity securities in any particular period may differ significantly from the gains or losses we ultimately experience on such investments. As a result of these factors, the value or liquidity of our cash equivalents, as well as our marketable and non-marketable securities could decline and result in a material impairment, which could adversely affect our financial condition and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. Our future income taxes could be negatively affected by earnings being lower than anticipated in jurisdictions that have lower statutory tax rates and higher than anticipated in jurisdictions that have higher statutory tax rates, the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, decreases in our stock price for shares paid as employee compensation, changes in the valuation of our deferred tax assets or liabilities, the application of different provisions of tax laws or changes in tax laws, regulations, or accounting principles (including changes in the interpretation of existing laws), as well as certain discrete items. In addition, we are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions, including in Europe, on various tax-related assertions, such as transfer-pricing adjustments or permanent-establishment claims. Any adverse outcome of such a review or audit could have a negative effect on our operating results and financial condition and could require us to change our business practices in a manner adverse to our business. It may also subject us to additional litigation and regulatory inquiries, resulting in the diversion of management’s time and attention. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment, and there are many transactions and calculations for which the ultimate tax determination is uncertain. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may affect our financial results in the period or periods for which such determination is made. Furthermore, due to shifting economic and political conditions, tax policies, laws, or rates in various jurisdictions may be subject to significant changes in ways that impair our financial results. Various jurisdictions around the world have enacted or are considering digital services taxes, which could lead to inconsistent and potentially overlapping international tax regimes. The Organization for Economic Cooperation and Development (OECD) continues to advance proposals relating to its initiative for modernizing international tax rules, with the goal of having different countries implement a modernized and aligned international tax framework, but there can be no guarantee that this will occur. In addition, in response to significant market volatility and disruptions to business operations resulting from the global spread of COVID-19, legislatures and taxing authorities in many jurisdictions in which we operate may propose changes to their tax rules. These changes could include modifications that have temporary effect, and more permanent 23 Table of Contents Alphabet Inc. changes. The effect of these potential new rules on us, our long-term tax planning, and our effective tax rate could be material. The trading price for our Class A stock and non-voting Class C stock may continue to be volatile. The trading price of our stock has at times experienced substantial price volatility and may continue to be volatile. In addition to the factors discussed in this report, the trading price of our Class A stock and Class C stock have fluctuated, and may continue to fluctuate widely, in response to various factors, many of which are beyond our control, including, among others, the activities of our peers and changes in broader economic and political conditions around the world. These broad market and industry factors may harm the market price of our Class A stock and our Class C stock, regardless of our actual operating performance. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We also own and lease office and building space in the surrounding areas near our headquarters. In addition, we own and lease office/building space and R&D sites around the world, primarily in North America, Europe, South America, and Asia. We own and operate data centers in the U.S., Europe, South America, and Asia. We believe our existing facilities, both owned and leased, are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, see Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 24 Table of Contents Alphabet Inc. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Our Class A common stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. Our Class B common stock is neither listed nor traded. Our Class C capital stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. Holders of Record As of December 31, 2021, there were approximately 4,907 and 1,733 stockholders of record of our Class A common stock and Class C capital stock, respectively. Because many of our shares of Class A common stock and Class C capital stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2021, there were approximately 64 stockholders of record of our Class B common stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. The primary use of capital continues to be to invest for the long-term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace, and form of capital return to stockholders. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class A common stock and Class C capital stock during the quarter ended December 31, 2021: Period Total Number of Class A Shares Purchased (in thousands) (1) Total Number of Class C Shares Purchased (in thousands) (1) Average Price Paid per Class A Share (2) Average Price Paid per Class C Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 126 1,445 $ 2,812.76 $ 2,794.72 1,571 $ 26,450 November 1 - 30 289 1,393 $ 2,943.97 $ 2,956.73 1,682 $ 21,479 December 1 - 31 250 1,169 $ 2,880.79 $ 2,898.56 1,419 $ 17,371 Total 665 4,007 4,672 (1) The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. 25 Table of Contents Alphabet Inc. Stock Performance Graphs The graph below matches Alphabet Inc. Class A's cumulative 5-year total stockholder return on common stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from December 31, 2016 to December 31, 2021. The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE 5-YEAR TOTAL RETURN* ALPHABET INC. CLASS A COMMON STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2016 in stock or index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2022 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 26 Table of Contents Alphabet Inc. The graph below matches Alphabet Inc. Class C's cumulative 5-year total stockholder return on capital stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our Class C capital stock and in each index (with the reinvestment of all dividends) from December 31, 2016 to December 31, 2021. The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE 5-YEAR TOTAL RETURN* ALPHABET INC. CLASS C CAPITAL STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2016 in stock or in index, including reinvestment of dividends. Fiscal year ending December 31. Copyright © 2022 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. ITEM 6. [Reserved] 27 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with “Note about Forward-Looking Statements,” Part I, Item 1 "Business," Part I, Item 1A "Risk Factors," and our consolidated financial statements and related notes included under Item 8 of this Annual Report on Form 10-K. We have omitted discussion of 2019 results where it would be redundant to the discussion previously included in Item 7 of our 2020 Annual Report on Form 10-K. Understanding Alphabet’s Financial Results Alphabet is a collection of businesses — the largest of which is Google. We report Google in two segments, Google Services and Google Cloud; we also report all non-Google businesses collectively as Other Bets. Other Bets include earlier stage technologies that are further afield from our core Google business. For further details on our segments, see Part I, Item 1 “Business” and Note 15 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Trends in Our Business and Financial Effect The following long-term trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business since inception, contributing to revenue growth, and we expect that this online shift will continue to benefit our business. • Users are increasingly using diverse devices and modalities to access our products and services, and our advertising revenues are increasingly coming from new formats. Our users are accessing the Internet via diverse devices and modalities, such as smartphones, wearables and smart home devices, and want to be able to be connected no matter where they are or what they are doing. We are focused on expanding our products and services to stay in front of these trends in order to maintain and grow our business. We are increasingly generating advertising revenues from different channels, including mobile, and newer advertising formats. The margins on advertising revenues from these channels and newer products have generally been lower than those from traditional desktop search. Additionally, as the market for a particular device type or modality matures, our revenues may be affected. For example, growth in the global smartphone market has slowed due to various factors, including increased market saturation in developed countries, which can affect our mobile advertising revenue growth rates. We expect TAC paid to our distribution partners and Google Network partners to increase as our revenues grow and TAC as a percentage of our advertising revenues ("TAC rate") to be affected by changes in device mix; geographic mix; partner mix; partner agreement terms; the percentage of queries channeled through paid access points; product mix; the relative revenue growth rates of advertising revenues from different channels; and revenue share terms. We expect these trends to continue to affect our revenue growth rates and put pressure on our margins. • As online advertising evolves, we continue to expand our product offerings, which may affect our monetization. As interactions between users and advertisers change, and as online user behavior evolves, we continue to expand and evolve our product offerings to serve these changing needs. Over time, we expect our monetization trends to fluctuate. For example, we have seen an increase in revenues from ads on YouTube and Google Play, which monetize at a lower rate than our traditional search ads. • As users in developing economies increasingly come online, our revenues from international markets continue to increase and movements in foreign exchange rates affect such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, such as India. We continue to invest heavily and develop localized versions of our products and advertising programs relevant to our users in these markets. This has led to a trend of increased revenues from emerging markets. We expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. This trend could affect our revenues as developing markets initially monetize at a lower rate than more mature markets. 28 Table of Contents Alphabet Inc. International revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. • The portion of revenues that we derive from non-advertising revenues is increasing and may adversely affect margins. Non-advertising revenues have grown over time. We expect this trend to continue as we focus on expanding our offerings through products and services like Google Cloud, Google Play, hardware products, and YouTube subscriptions. We currently derive non-advertising revenues primarily from sales of apps and in-app purchases, digital content products, and hardware; and licensing and service fees, including fees received for Google Cloud services and subscription and other services. A number of Other Bets initiatives are in their initial development stages, and as such, revenues from these businesses could be volatile. In addition, the margins on these revenues vary significantly and may be lower than the margins on our advertising revenues. • As we continue to serve our users and expand our businesses, we will invest heavily in operating and capital expenditures. We continue to make significant R&D investments in areas of strategic focus across Google Services, Google Cloud and Other Bets. We also expect to continue to invest in land and buildings for data centers and offices, and information technology assets, which includes servers and network equipment, to support the long-term growth of our business. In addition, acquisitions and strategic investments contribute to the breadth and depth of our offerings, expand our expertise in engineering and other functional areas, and build strong partnerships around strategic initiatives. For example, in January 2021 we closed the acquisition of Fitbit, Inc. for $2.1 billion, which is expected to help spur innovation in wearable devices. • We face continuing changes in regulatory conditions, laws, and public policies, which could affect our business practices and financial results. Changes in social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics and related legal matters have resulted in fines and caused us to change our business practices. As these global trends continue, our cost of doing business may increase, and our ability to pursue certain business models or offer certain products or services may be limited. Examples include the antitrust complaints filed by the U.S. Department of Justice and a number of state Attorneys General, the Digital Markets Act in Europe, and various legislative proposals in the U.S. focused on large technology platforms. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs. For additional information see Culture and Workforce in Part I, Item 1 “Business.” Seasonality and other Our advertising revenues are affected by seasonal fluctuations in internet usage, advertising expenditures, and underlying business trends, such as traditional retail seasonality. Additionally, our non-advertising revenues, including those generated from Google Cloud, Google Play, hardware, and YouTube, may be affected by fluctuations driven by changes in pricing, digital content releases, fee structures, new product and service launches, other market dynamics, as well as seasonality. Revenues and Monetization Metrics Google Services Google Services revenues consist of revenues generated from advertising (“Google advertising”) as well as revenues from other sources (“Google other revenues”). Google Advertising Google advertising revenues are comprised of the following: • Google Search & other, which includes revenues generated on Google search properties (including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.), and other Google owned and operated properties like Gmail, Google Maps, and Google Play; • YouTube ads, which includes revenues generated on YouTube properties; and 29 Table of Contents Alphabet Inc. • Google Network, which includes revenues generated on Google Network properties participating in AdMob, AdSense, and Google Ad Manager. We use certain metrics to track how well traffic across various properties is monetized as it relates to our advertising revenues: paid clicks and cost-per-click pertain to traffic on Google Search & other properties, while impressions and cost-per-impressions pertain to traffic on our Network partners’ properties. Paid clicks represent engagement by users and include clicks on advertisements by end-users on Google search properties and other Google owned and operated properties including Gmail, Google Maps, and Google Play. Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. Impressions include impressions displayed to users on Google Network properties participating primarily in AdMob, AdSense, and Google Ad Manager. Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions, and represents the average amount we charge advertisers for each impression displayed to users. As our business evolves, we periodically review, refine, and update our methodologies for monitoring, gathering, and counting the number of paid clicks and the number of impressions, and for identifying the revenues generated by the corresponding click and impression activity. Our advertising revenue growth, as well as the change in paid clicks and cost-per-click on Google Search & other properties and the change in impressions and cost-per-impression on Google Network properties and the correlation between these items, have been affected and may continue to be affected by various factors, including: • advertiser competition for keywords; • changes in advertising quality, formats, delivery or policy; • changes in device mix; • changes in foreign currency exchange rates; • fees advertisers are willing to pay based on how they manage their advertising costs; • general economic conditions, including the effect of COVID-19; • seasonality; and • traffic growth in emerging markets compared to more mature markets and across various advertising verticals and channels. Google Other Google other revenues are comprised of the following: • Google Play, which includes sales of apps and in-app purchases and digital content sold in the Google Play store; • Devices and Services, which includes sales of hardware, including Fitbit wearable devices, Google Nest home products, and Pixel phones; • YouTube non-advertising, which includes YouTube Premium and YouTube TV subscriptions; and • other products and services. Google Cloud Google Cloud revenues are comprised of the following: • Google Cloud Platform, which includes fees for infrastructure, platform, and other services; • Google Workspace, which includes fees for cloud-based collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar and Meet; and • other enterprise services. Other Bets Revenues from Other Bets are generated primarily from the sale of health technology and internet services. 30 Table of Contents Alphabet Inc. For further details on how we recognize revenue, see Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Costs and Expenses Our cost structure has two components: cost of revenues and operating expenses. Our operating expenses include costs related to R&D, sales and marketing, and general and administrative functions. Certain of these expenses, including those associated with the operation of our technical infrastructure as well as components of our operating expenses, are generally less variable in nature and may not correlate to the changes in revenue. Cost of Revenues Cost of revenues is comprised of TAC and other costs of revenues. • TAC includes: ◦ Amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. ◦ Amounts paid to Google Network partners primarily for ads displayed on their properties. • Other cost of revenues includes: ◦ Content acquisition costs, which are payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee). ◦ Expenses associated with our data centers (including bandwidth, compensation expenses, depreciation, energy, and other equipment costs) as well as other operations costs (such as content review as well as customer and product support costs). ◦ Inventory and other costs related to the hardware we sell. The cost of revenues as a percentage of revenues generated from ads placed on Google Network properties are significantly higher than the cost of revenues as a percentage of revenues generated from ads placed on Google Search & other properties, because most of the advertiser revenues from ads served on Google Network properties are paid as TAC to our Google Network partners. Operating Expenses Operating expenses are generally incurred during our normal course of business, which we categorize as either R&D, sales and marketing, or general and administrative. The main components of our R&D expenses are: • compensation expenses for engineering and technical employees responsible for R&D related to our existing and new products and services; • depreciation; and • professional services fees primarily related to consulting and outsourcing services. The main components of our sales and marketing expenses are: • compensation expenses for employees engaged in sales and marketing, sales support, and certain customer service functions; and • spending relating to our advertising and promotional activities in support of our products and services. The main components of our general and administrative expenses are: • compensation expenses for employees in finance, human resources, information technology, legal, and other administrative support functions; • expenses related to legal matters, including fines and settlements; and • professional services fees, including audit, consulting, outside legal, and outsourcing services. 31 Table of Contents Alphabet Inc. Other Income (Expense), Net Other income (expense), net primarily consists of interest income (expense), the effect of foreign currency exchange gains (losses), net gains (losses) and impairment on our marketable and non-marketable securities, performance fees, and income (loss) and impairment from our equity method investments. For additional details, including how we account for our investments and factors that can drive fluctuations in the value of our investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K as well as Item 7A, “Quantitative and Qualitative Disclosures About Market Risk”. Provision for Income Taxes Provision for income taxes represents the estimated amount of federal, state, and foreign income taxes incurred in the U.S. and the many jurisdictions in which we operate. The provision includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. For additional details, including a reconciliation of the U.S. federal statutory rate to our effective tax rate, see Note 14 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Executive Overview The following table summarizes consolidated financial results for the years ended December 31, 2020 and 2021 unless otherwise specified (in millions, except for per share information and percentages): Year Ended December 31, 2020 2021 $ Change % Change Consolidated revenues $ 182,527 $ 257,637 $ 75,110 41 % Change in consolidated constant currency revenues 39 % Cost of revenues $ 84,732 $ 110,939 $ 26,207 31 % Operating expenses $ 56,571 $ 67,984 $ 11,413 20 % Operating income $ 41,224 $ 78,714 $ 37,490 91 % Operating margin 23 % 31 % 8 % Other income (expense), net $ 6,858 $ 12,020 $ 5,162 75 % Net Income $ 40,269 $ 76,033 $ 35,764 89 % Diluted EPS $ 58.61 $ 112.20 $ 53.59 91 % Number of Employees 135,301 156,500 21,199 16 % • Revenues were $257.6 billion, an increase of 41%. The increase in revenues was primarily driven by Google Services and Google Cloud. The adverse effect of COVID-19 on 2020 advertising revenues also contributed to the year-over-year growth. • Cost of revenues was $110.9 billion, an increase of 31%, primarily driven by increases in TAC and content acquisition costs. An overall increase in data centers and other operations costs was partially offset by a reduction in depreciation expense due to the change in the estimated useful life of our servers and certain network equipment. • Operating expenses were $68.0 billion, an increase of 20%, primarily driven by headcount growth, increases in advertising and promotional expenses and charges related to legal matters. Other information: • Operating cash flow was $91.7 billion, primarily driven by revenues generated from our advertising products. • Share repurchases were $50.3 billion, an increase of 62%. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. 32 Table of Contents Alphabet Inc. • Capital expenditures, which primarily reflected investments in technical infrastructure, were $24.6 billion. • In January 2021, we updated the useful lives of certain of our servers and network equipment, resulting in a reduction in depreciation expense of $2.6 billion recorded primarily in cost of revenues and R&D. See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. • Our acquisition of Fitbit closed in early January 2021, and the related revenues are included in Google other. See Note 8 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. • On February 1, 2022, the Company announced that the Board of Directors had approved and declared a 20-for-one stock split in the form of a one-time special stock dividend on each share of the Company’s Class A, Class B, and Class C stock. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information. The Effect of COVID-19 on our Financial Results We began to observe the effect of COVID-19 on our financial results in March 2020 when, despite an increase in users' search activity, our advertising revenues declined compared to the prior year. This was due to a shift of user search activity to less commercial topics and reduced spending by our advertisers. For the quarter ended June 30, 2020 our advertising revenues declined due to the continued effects of COVID-19 and the related reductions in global economic activity, but we observed a gradual return in user search activity to more commercial topics. This was followed by increased spending by our advertisers, which continued throughout the second half of 2020. Additionally, over the course of 2020, we experienced variability in our margins as many of our expenses are less variable in nature and/or may not correlate to changes in revenues. Market volatility contributed to fluctuations in the valuation of our equity investments. Further, our assessment of the credit deterioration of our customers due to changes in the macroeconomic environment during the period was reflected in our allowance for credit losses for accounts receivable. Throughout 2021 we remained focused on innovating and investing in the services we offer to consumers and businesses to support our long-term growth. The impact of COVID-19 on 2020 financial results affected year-over-year growth trends. The COVID-19 pandemic continues to evolve, be unpredictable and affect our business and financial results. Our past results may not be indicative of our future performance, and historical trends in our financial results may differ materially. Financial Results Revenues The following table presents revenues by type (in millions): Year Ended December 31, 2020 2021 Google Search & other $ 104,062 $ 148,951 YouTube ads 19,772 28,845 Google Network 23,090 31,701 Google advertising 146,924 209,497 Google other 21,711 28,032 Google Services total 168,635 237,529 Google Cloud 13,059 19,206 Other Bets 657 753 Hedging gains (losses) 176 149 Total revenues $ 182,527 $ 257,637 Google Services Google advertising revenues Google Search & other Google Search & other revenues increased $44.9 billion from 2020 to 2021. The overall growth was driven by interrelated factors including increases in search queries resulting from growth in user adoption and usage, primarily 33 Table of Contents Alphabet Inc. on mobile devices, growth in advertiser spending, and improvements we have made in ad formats and delivery. The adverse effect of COVID-19 on 2020 revenues also contributed to the year-over-year increase. YouTube ads YouTube ads revenues increased $9.1 billion from 2020 to 2021. Growth was driven by our direct response and brand advertising products. Growth for our direct response advertising products was primarily driven by increased advertiser spending as well as improvements to ad formats and delivery. Growth for our brand advertising products was primarily driven by increased spending by our advertisers and the adverse effect of COVID-19 on 2020 revenues. Google Network Google Network revenues increased $8.6 billion from 2020 to 2021. The growth was primarily driven by strength in AdMob, Google Ad Manager, and AdSense. The adverse effect of COVID-19 on 2020 revenues also contributed to the year-over-year increase. Monetization Metrics Paid clicks and cost-per-click The following table presents changes in paid clicks and cost-per-click (expressed as a percentage) from 2020 to 2021: Year Ended December 31, 2021 Paid clicks change 23 % Cost-per-click change 15 % Paid clicks increased from 2020 to 2021 driven by a number of interrelated factors, including an increase in search queries resulting from growth in user adoption and usage, primarily on mobile devices; an increase in clicks relating to ads on Google Play; growth in advertiser spending; and improvements we have made in ad formats and delivery. The adverse effect of COVID-19 on 2020 paid clicks also contributed to the increase. The increase in cost-per-click from 2020 to 2021 was driven by a number of interrelated factors including changes in device mix, geographic mix, growth in advertiser spending, ongoing product changes, and property mix, as well as the adverse effect of COVID-19 in 2020. Impressions and cost-per-impression The following table presents changes in impressions and cost-per-impression (expressed as a percentage) from 2020 to 2021: Year Ended December 31, 2021 Impressions change 2 % Cost-per-impression change 35 % Impressions increased from 2020 to 2021 primarily driven by growth in AdMob, partially offset by a decline in impressions related to AdSense. The increase in cost-per-impression was primarily driven by the adverse effect of COVID-19 in 2020 as well as the effect of interrelated factors including ongoing product and policy changes and improvements we have made in ad formats and delivery, changes in device mix, geographic mix, product mix, and property mix. Google other revenues Google other revenues increased $6.3 billion from 2020 to 2021. The growth was primarily driven by YouTube non-advertising and hardware, followed by Google Play. Growth for YouTube non-advertising was primarily due to an increase in paid subscribers. Growth in hardware reflects the inclusion of Fitbit revenues, as the acquisition closed in January 2021, and an increase in phone sales. Growth for Google Play was primarily driven by sales of apps and in-app purchases. 34 Table of Contents Alphabet Inc. Google Cloud Google Cloud revenues increased $6.1 billion from 2020 to 2021. The growth was primarily driven by GCP followed by Google Workspace offerings. Google Cloud's infrastructure and platform services were the largest drivers of growth in GCP. Revenues by Geography The following table presents revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 2020 2021 United States 47 % 46 % EMEA 30 % 31 % APAC 18 % 18 % Other Americas 5 % 5 % For further details on revenues by geography, see Note 2 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Use of Constant Currency Revenues and Constant Currency Revenue Percentage Change The effect of currency exchange rates on our business is an important factor in understanding period to period comparisons. We use non-GAAP constant currency revenues and non-GAAP percentage change in constant currency revenues for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to U.S. Generally Accepted Accounting Principles (GAAP) results helps improve the ability to understand our performance because it excludes the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as total revenues excluding the effect of foreign exchange rate movements and hedging activities, and use it to determine the constant currency revenue percentage change on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior year comparable period exchange rates, as well as excluding any hedging effects realized in the current period. Constant currency revenue percentage change is calculated by determining the change in current period revenues over prior year comparable period revenues where current period foreign currency revenues are translated using prior year comparable period exchange rates and hedging effects are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. 35 Table of Contents Alphabet Inc. The following table presents the foreign exchange effect on international revenues and total revenues (in millions, except percentages): Year Ended December 31, 2020 2021 % Change from Prior Year EMEA revenues $ 55,370 $ 79,107 43 % EMEA constant currency revenues 76,321 38 % APAC revenues 32,550 46,123 42 % APAC constant currency revenues 45,666 40 % Other Americas revenues 9,417 14,404 53 % Other Americas constant currency revenues 14,317 52 % United States revenues 85,014 117,854 39 % Hedging gains (losses) 176 149 Total revenues $ 182,527 $ 257,637 41 % Revenues, excluding hedging effect $ 182,351 $ 257,488 Exchange rate effect (3,330) Total constant currency revenues $ 254,158 39 % EMEA revenue growth from 2020 to 2021 was favorably affected by foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Euro and British pound. APAC revenue growth from 2020 to 2021 was favorably affected by foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Australian dollar, partially offset by the U.S. dollar strengthening relative to the Japanese yen. Other Americas growth change from 2020 to 2021 was favorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar weakening relative to the Canadian dollar, partially offset by the U.S. dollar strengthening relative to the Argentine peso and the Brazilian real. Costs and Expenses Cost of Revenues The following tables present cost of revenues, including TAC (in millions, except percentages): Year Ended December 31, 2020 2021 TAC $ 32,778 $ 45,566 Other cost of revenues 51,954 65,373 Total cost of revenues $ 84,732 $ 110,939 Total cost of revenues as a percentage of revenues 46.4 % 43.1 % Cost of revenues increased $26.2 billion from 2020 to 2021. The increase was due to an increase in other cost of revenues and TAC of $13.4 billion and $12.8 billion, respectively. The increase in TAC from 2020 to 2021 was due to an increase in TAC paid to distribution partners and to Google Network partners, primarily driven by growth in revenues subject to TAC. The TAC rate decreased from 22.3% to 21.8% from 2020 to 2021 primarily due to a revenue mix shift from Google Network properties to Google Search & other properties. The TAC rate on Google Search & other properties revenues and the TAC rate on Google Network revenues were both substantially consistent from 2020 to 2021. The increase in other cost of revenues from 2020 to 2021 was driven by increases in content acquisition costs primarily for YouTube, data center and other operations costs, and hardware costs. The increase in data center and 36 Table of Contents Alphabet Inc. other operations costs was partially offset by a reduction in depreciation expense due to the change in the estimated useful life of our servers and certain network equipment beginning in the first quarter of 2021. Research and Development The following table presents R&D expenses (in millions, except percentages): Year Ended December 31, 2020 2021 Research and development expenses $ 27,573 $ 31,562 Research and development expenses as a percentage of revenues 15.1 % 12.3 % R&D expenses increased $4.0 billion from 2020 to 2021. The increase was primarily due to an increase in compensation expenses of $3.5 billion, largely resulting from an 11% increase in headcount, and an increase in professional service fees of $516 million. This increase was partially offset by a reduction in depreciation expense of $450 million including the effect of our change in the estimated useful life of our servers and certain network equipment. Sales and Marketing The following table presents sales and marketing expenses (in millions, except percentages): Year Ended December 31, 2020 2021 Sales and marketing expenses $ 17,946 $ 22,912 Sales and marketing expenses as a percentage of revenues 9.8 % 8.9 % Sales and marketing expenses increased $5.0 billion from 2020 to 2021, primarily driven by an increase in advertising and promotional activities of $2.5 billion and an increase in compensation expenses of $2.2 billion. The increase in advertising and promotional activities was driven by both increased spending in the current period and a reduction in spending in 2020 due to COVID-19. The increase in compensation expenses was largely due to a 14% increase in headcount. General and Administrative The following table presents general and administrative expenses (in millions, except percentages): Year Ended December 31, 2020 2021 General and administrative expenses $ 11,052 $ 13,510 General and administrative expenses as a percentage of revenues 6.1 % 5.2 % General and administrative expenses increased $2.5 billion from 2020 to 2021. The increase was primarily driven by a $1.7 billion increase in charges relating to legal matters and a $664 million increase in compensation expenses, largely resulting from a 14% increase in headcount. These increases were partially offset by a reduction in expense of $808 million related to a decline in allowance for credit losses for accounts receivable, as 2020 reflected a higher allowance related to the economic effect of COVID-19. 37 Table of Contents Alphabet Inc. Segment Profitability The following table presents segment operating income (loss) (in millions). Year Ended December 31, 2020 2021 Operating income (loss): Google Services $ 54,606 $ 91,855 Google Cloud (5,607) (3,099) Other Bets (4,476) (5,281) Corporate costs, unallocated (1) (3,299) (4,761) Total income from operations $ 41,224 $ 78,714 (1) Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including certain fines and settlements, as well as costs associated with certain shared R&D activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs. Google Services Google services operating income increased $37.2 billion from 2020 to 2021. The increase was due to growth in revenues partially offset by increases in TAC, content acquisition costs, compensation expenses, advertising and promotional expenses, and charges related to certain legal matters. The increase in expenses was partially offset by a reduction in costs driven by the change in the estimated useful life of our servers and certain network equipment. The effect of COVID-19 on 2020 results affected the year-over-year increase in operating income. Google Cloud Google Cloud operating loss decreased $2.5 billion from 2020 to 2021. The decrease in operating loss was primarily driven by growth in revenues, partially offset by an increase in expenses, primarily driven by compensation expenses. The increase in expenses was partially offset by a reduction in costs driven by the change in the estimated useful life of our servers and certain network equipment. Other Bets Other Bets operating loss increased $805 million from 2020 to 2021. The increase in operating loss was primarily driven by increases in compensation expenses, including an increase in valuation-based compensation charges during the second quarter of 2021. Other Income (Expense), Net The following table presents other income (expense), net, (in millions): Year Ended December 31, 2020 2021 Other income (expense), net $ 6,858 $ 12,020 Other income (expense), net, increased $5.2 billion from 2020 to 2021. The increase was primarily driven by increases in net unrealized gains recognized for our marketable and non-marketable equity securities of $6.9 billion, partially offset by an increase in accrued performance fees related to certain investments of $1.3 billion. See Note 3 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. Provision for Income Taxes The following table presents provision for income taxes (in millions, except for effective tax rate): Year Ended December 31, 2020 2021 Provision for income taxes $ 7,813 $ 14,701 Effective tax rate 16.2 % 16.2 % The provision for income taxes increased from 2020 to 2021, primarily due to an increase in pre-tax earnings, including in countries that have higher statutory rates, partially offset by an increase in the stock-based compensation related tax benefit, and the U.S. federal Foreign-Derived Intangible Income tax deduction benefit. Our effective tax rate 38 Table of Contents Alphabet Inc. was substantially consistent from 2020 to 2021. See Note 14 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. Financial Condition Cash, Cash Equivalents, and Marketable Securities As of December 31, 2021, we had $139.6 billion in cash, cash equivalents, and short-term marketable securities. Ca sh equivalents and marketable securities a re comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities, and marketable equity securities. Sources, Uses of Cash and Related Trends Our principal sources of liquidity are cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from operations. The primary use of capital continues to be to invest for the long-term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace and form of capital return to stockholders. The following table presents our cash flows (in millions): Year Ended December 31, 2020 2021 Net cash provided by operating activities $ 65,124 $ 91,652 Net cash used in investing activities $ (32,773) $ (35,523) Net cash used in financing activities $ (24,408) $ (61,362) Cash Provided by Operating Activities Our largest source of cash provided by operations are advertising revenues generated by Google Search & other properties, Google Network properties, and YouTube ads. Additionally, we generate cash through sales of apps and in-app purchases, digital content products, and hardware; and licensing and service fees including fees received for Google Cloud offerings and subscription-based products. Our primary uses of cash from operating activities include payments to distribution and Google Network partners, for compensation and related costs, and for content acquisition costs. In addition, uses of cash from operating activities include hardware inventory costs, income taxes, and other general corporate expenditures. Net cash provided by operating activities increased from 2020 to 2021 primarily due to the net effect of an increase in cash received from revenues and cash paid for cost of revenues and operating expenses, and changes in operating assets and liabilities. Cash Used in Investing Activities Cash provided by investing activities consists primarily of maturities and sales of our investments in marketable and non-marketable securities. Cash used in investing activities consists primarily of purchases of marketable and non-marketable securities, purchases of property and equipment, and payments for acquisitions. Net cash used in investing activities increased from 2020 to 2021 primarily due to a decrease in maturities and sales of marketable securities, an increase in purchases of property and equipment, offset by a decrease in purchases of non-marketable securities. Cash Used in Financing Activities Cash provided by financing activities consists primarily of proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities. Cash used in financing activities consists primarily of repurchases of common and capital stock, net payments related to stock-based award activities, and repayments of debt. Net cash used in financing activities increased from 2020 to 2021 primarily due to repayment of debt and an increase in cash payments for repurchases of common and capital stock. Liquidity and Material Cash Requirements We expect existing cash, cash equivalents, short-term marketable securities, cash flows from operations and financing activities to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities for at least the next 12 months and thereafter for the foreseeable future. 39 Table of Contents Alphabet Inc. Capital Expenditures and Leases We make investments in land and buildings for data centers and offices and information technology assets through purchases of property and equipment and lease arrangements to provide capacity for the growth of our services and products. Capital Expenditures Our capital investments in property and equipment consist primarily of the following major categories: • technical infrastructure, which consists of our investments in servers and network equipment for computing, storage and networking requirements for ongoing business activities, including machine learning (collectively referred to as our information technology assets) and data center land and building construction; and • office facilities, ground up development projects and related building improvements. Construction in progress consists primarily of technical infrastructure and office facilities which have not yet been placed in service for our intended use. The time frame from date of purchase to placement in service of these assets may extend from months to years. For example, our data center construction projects are generally multi-year projects with multiple phases, where we acquire qualified land and buildings, construct buildings, and secure and install information technology assets. During the years ended December 31, 2020 and 2021, we spent $22.3 billion and $24.6 billion on capital expenditures, respectively. Depreciation of our property and equipment commences when the deployment of such assets are completed and are ready for our intended use. Land is not depreciated. For the years ended December 31, 2020 and 2021, our depreciation and impairment expenses on property and equipment were $12.9 billion and $11.6 billion, respectively. Leases For the years ended December 31, 2020 and 2021, we recognized total operating lease assets of $2.8 billion and $3.0 billion, respectively. As of December 31, 2021, the amount of total future lease payments under operating leases, which had a weighted average remaining lease term of 8 years, was $15.5 billion, of which $2.5 billion is short-term. As of December 31, 2021, we have entered into leases that have not yet commenced with future short-term and long-term lease payments of $606 million and $5.2 billion, excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2022 and 2026 with non-cancelable lease terms of 1 to 25 years. For the years ended December 31, 2020 and 2021, our operating lease expenses (including variable lease costs) were $2.9 billion and $3.4 billion, respectively. Finance lease costs were not material for the years ended December 31, 2020 and 2021. See Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information on leases. Financing We have a short-term debt financing program of up to $ 10.0 billion through the issuance of commercial paper, which increased from $5.0 billion in September 2021. Net proceeds from this program are used for general corporate purposes. As of December 31, 2021, we had no commercial paper outstanding. As of December 31, 2021, we had $ 10.0 billion of revolving credit facilities with no amounts outstanding. In April 2021, we terminated the existing revolving credit facilities, which were scheduled to expire in July 2023, and entered into two new revolving credit facilities in the amounts of $ 4.0 billion and $ 6.0 billion, which will expire in April 2022 and April 2026, respectively. The interest rates for the new credit facilities are determined based on a formula using certain market rates, as well as our progress toward the achievement of certain sustainability goals . No amounts have been borrowed under the new credit facilities. As of December 31, 2021, we have senior unsecured notes outstanding with a total carrying value of $12.8 billion with short-term and long-term future interest payments of $231 million and $4.0 billion, respectively. See Note 6 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information on our debt. Share Repurchase Program In April 2021, the Board of Directors of Alphabet authorized the company to repurchase up to $ 50.0 billion of its Class C stock. In July 2021, the Alphabet board approved an amendment to the April 2021 authorization, permitting the company to repurchase both Class A and Class C shares in a manner deemed in the best interest of the company and its stockholders, taking into account the economic cost and prevailing market conditions, including the relative trading 40 Table of Contents Alphabet Inc. prices and volumes of the Class A and Class C shares. In accordance with the authorizations of the Board of Directors of Alphabet, during 2021 we repurchased and subsequently retired 20.3 million aggregate shares for $ 50.3 billion. Of the aggregate amount repurchased and subsequently retired, 1.2 million shares were Class A stock repurchased for $ 3.4 billion. As of December 31, 2021, $ 17.4 billion remains available for Class A and Class C share repurchases under the amended authorization. The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. European Commission Fines In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of € 2.4 billion ($ 2.7 billion as of June 27, 2017), € 4.3 billion ($ 5.1 billion as of June 30, 2018), and € 1.5 billion ($ 1.7 billion as of March 20, 2019), respectively. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. Taxes As of December 31, 2021, we had short-term and long-term income taxes payable of $784 million and $5.7 billion related to a one-time transition tax payable incurred as a result of the U.S. Tax Cuts and Jobs Act ("Tax Act"). As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025. We also have taxes payable of $3.5 billion primarily related to uncertain tax positions as of December 31, 2021. Purchase Commitments We regularly enter into significant non-cancelable contractual obligations primarily related to data center operations and build-outs, information technology assets, office buildings, purchases of inventory, and network capacity arrangements. As of December 31, 2021, such purchase commitments, which do not qualify for recognition on our Consolidated Balance Sheets, amount to $13.7 billion, of which $11.9 billion is short-term. These amounts represent the non-cancelable portion of agreements or the minimum cancellation fee. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2021. Critical Accounting Estimates We prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in them have had or are reasonably likely to have a material effect on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We have reviewed our critical accounting estimates with the audit and compliance committee of our Board of Directors. See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements. Fair Value Measurements of Non-Marketable Equity Securities We measure certain financial instruments at fair value on a nonrecurring basis, consisting primarily of our non-marketable equity securities. These investments are accounted for under the measurement alternative and are measured at cost, less impairment, subject to upward and downward adjustments resulting from observable price changes for identical or similar investments of the same issuer. These adjustments require quantitative assessments of the fair value of our securities, which may require the use of unobservable inputs. Pricing adjustments are determined by using various valuation methodologies and involve the use of estimates using the best information available, which may include cash flow projections or other available market data. Non-marketable equity securities are also evaluated for impairment, based on qualitative factors including the companies' financial and liquidity position and access to capital resources, among others. When indicators of impairment exist, we prepare quantitative measurements of the fair value of our equity investments using a market approach or an income approach, which requires judgment and the use of unobservable inputs, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When our assessment indicates that an impairment exists, we write down the investment to its fair value. 41 Table of Contents Alphabet Inc. We also have compensation arrangements with payouts based on realized returns from certain investments, i.e. performance fees. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized, and may require the use of unobservable inputs. Property and Equipment We assess the reasonableness of the useful lives of our property and equipment periodically as well as when other changes occur, such as when there are changes to ongoing business operations, changes in the planned use and utilization of assets, or technological advancements, that could indicate a change in the period over which we expect to benefit from the assets. Income Taxes We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Recording an uncertain tax position involves various qualitative considerations, including evaluation of comparable and resolved tax exposures, applicability of tax laws, and likelihood of settlement. We evaluate uncertain tax positions periodically, considering changes in facts and circumstances, such as new regulations or recent judicial opinions, as well as the status of audit activities by taxing authorities. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services (IRS) and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury consumer protection, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in Note 10 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Change in Accounting Estimate In January 2021, we completed an assessment of the useful lives of our servers and certain network equipment. In doing so, we determined we should adjust the estimated useful life. This change in accounting estimate was effective beginning fiscal year 2021 and is detailed further in Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange Risk We transact business globally in multiple currencies. International revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro, and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in 42 Table of Contents Alphabet Inc. foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced in the near term. We use foreign exchange forward contracts to offset the foreign exchange risk on assets and liabilities denominated in currencies other than the functional currency of the subsidiary. These forward contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on these assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward contracts. If an adverse 10% foreign currency exchange rate change was applied to total monetary assets, liabilities, and commitments denominated in currencies other than the functional currencies at the balance sheet date, it would have resulted in an adverse effect on income before income taxes of approxima tely $497 million and $285 million as of December 31, 2020 and 2021, respectively, after consideration of the effect of foreign exchange contracts in place for the years ended December 31, 2020 and 2021. We use foreign currency forwards and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency options and forwards reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency collars and forwards offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of AOCI and subsequently reclassify them into revenues to offset the hedged exposures as they occur. I f the U.S. dollar weakened by 10% as of December 31, 2020 and 2021, the amount recorded in AOCI related to our foreign exchange contracts before tax effect would have been approximately $912 million and $1.3 billion lower as of December 31, 2020 and 2021, respectively. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. We use foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations. If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment (CTA) within AOCI related to our net investment hedge would have been approximately $1.0 billion lower as of both December 31, 2020 and 2021. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries. Interest Rate Risk Our Corporate Treasury investment strategy is to achieve a return that w ill allow us to preserve capital and maintain liquidity. We invest primarily in debt securities, including those of the U.S. government and its agencies, corporate debt securities, mortgage-backed securities, money market and other funds, municipal securities, time deposits, asset backed securities, and debt instruments issued by foreign governments. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as compared to interest rates at the time of purchase. For certain fixed and variable rate debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. We measure securities for which we have not elected the fair value option at fair value with gains and losses recorded in AOCI until the securities are sold, less any expected credit losses. We use value-at-risk (VaR) analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of marketable debt securities as of December 31, 2020 and 2021 are shown below (in millions): As of December 31, 12-Month Average As of December 31, 2020 2021 2020 2021 Risk Category - Interest Rate $ 144 $ 139 $ 145 $ 148 43 Table of Contents Alphabet Inc. Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2020 and 2021 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation. Equity Investment Risk Our marketable and non-marketable equity securities are subject to a wide variety of market-related risks that could substantially reduce or increase the fair value of our holdings. Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages. We record marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $5.9 billion and $7.8 billion of our investments as of December 31, 2020 and 2021, respectively. A hypothetical adverse price change of 10% on our December 31, 2021 balance, which could be experienced in the near term, would decrease the fair value of marketable equity securities by $780 million. From time to time, we may enter into derivatives to hedge the market price risk on certain of our marketable equity securities. Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). The fair value measured at the time of the observable transaction is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize, and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize appreciation in the value of investments through liquidity events such as public offerings, acquisitions, private sales or other market events. As of December 31, 2020 and 2021, the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $18.9 billion and $27.6 billion, respectively. Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data. Volatility in the global economic climate and financial markets could result in a significant impairment charge relating to our non-marketable equity securities. Changes in valuation of non-marketable equity securities may not directly correlate with changes in valuation of marketable equity securities. Additionally, observable transactions at lower valuations could result in significant losses on our non-marketable equity securities. The effect of COVID-19 on our impairment assessment requires significant judgment due to the uncertainty around the duration and severity of the effect. The carrying values of our equity method investments, which totaled approximately $1.4 billion and $1.5 billion as of December 31, 2020 and 2021, respectively, generally do not fluctuate based on market price changes. However, these investments could be impaired if the carrying value exceeds the fair value and is not expected to recover. For further information about our equity investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. 44 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Independent Registered Public Accounting Firm (PCAOB ID: 42 ) 46 Financial Statements: Consolidated Balance Sheets 49 Consolidated Statements of Income 50 Consolidated Statements of Comprehensive Income 51 Consolidated Statements of Stockholders’ Equity 52 Consolidated Statements of Cash Flows 53 Notes to Consolidated Financial Statements 54 45 Table of Contents Alphabet Inc. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Alphabet Inc. (the Company) as of December 31, 2020 and 2021, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2021, and the related notes and financial statement schedule listed in the Index at Item 15 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2020 and 2021, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2021, in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated February 1, 2022 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the accounts or disclosures to which it relates. 46 Table of Contents Alphabet Inc. Loss Contingencies Description of the Matter The Company is regularly subject to claims, suits, regulatory and government investigations, and other proceedings involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by its users, goods and services offered by advertisers or publishers using their platforms, personal injury, consumer protection, and other matters. As described in Note 10 to the consolidated financial statements “Contingencies” such claims, suits, regulatory and government investigations, and other proceedings could result in adverse consequences. Significant judgment is required to determine both the likelihood, and the estimated amount, of a loss related to such matters. Auditing management’s accounting for and disclosure of loss contingencies from these matters involved challenging and subjective auditor judgment in assessing the Company’s evaluation of the probability of a loss, and the estimated amount or range of loss. How We Addressed the Matter in Our Audit We tested relevant controls over the identified risks associated with management’s accounting for and disclosure of these matters. This included controls over management’s assessment of the probability of incurrence of a loss and whether the loss or range of loss was reasonably estimable and the development of related disclosures. Our audit procedures included gaining an understanding of previous rulings issued by regulators and the status of ongoing lawsuits, reviewing letters addressing the matters from internal and external legal counsel, meeting with internal legal counsel to discuss the allegations, and obtaining a representation letter from management on these matters. We also evaluated the Company’s disclosures in relation to these matters. /s/ Ernst & Young LLP We have served as the Company's auditor since 1999. San Jose, California February 1, 2022 47 Table of Contents Alphabet Inc. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on Internal Control over Financial Reporting We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2021, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), (the COSO criteria). In our opinion, Alphabet Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2021, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2021 consolidated financial statements of the Company and our report dated February 1, 2022 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California February 1, 2022 48 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (In millions, except share amounts which are reflected in thousands, and par value per share amounts) As of December 31, 2020 2021 Assets Current assets: Cash and cash equivalents $ 26,465 $ 20,945 Marketable securities 110,229 118,704 Total cash, cash equivalents, and marketable securities 136,694 139,649 Accounts receivable, net 30,930 39,304 Income taxes receivable, net 454 966 Inventory 728 1,170 Other current assets 5,490 7,054 Total current assets 174,296 188,143 Non-marketable securities 20,703 29,549 Deferred income taxes 1,084 1,284 Property and equipment, net 84,749 97,599 Operating lease assets 12,211 12,959 Intangible assets, net 1,445 1,417 Goodwill 21,175 22,956 Other non-current assets 3,953 5,361 Total assets $ 319,616 $ 359,268 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 5,589 $ 6,037 Accrued compensation and benefits 11,086 13,889 Accrued expenses and other current liabilities 28,631 31,236 Accrued revenue share 7,500 8,996 Deferred revenue 2,543 3,288 Income taxes payable, net 1,485 808 Total current liabilities 56,834 64,254 Long-term debt 13,932 14,817 Deferred revenue, non-current 481 535 Income taxes payable, non-current 8,849 9,176 Deferred income taxes 3,561 5,257 Operating lease liabilities 11,146 11,389 Other long-term liabilities 2,269 2,205 Total liabilities 97,072 107,633 Contingencies (Note 10) Stockholders’ equity: Preferred stock, $ 0.001 par value per share, 100,000 shares authorized; no shares issued and outstanding 0 0 Class A and Class B common stock, and Class C capital stock and additional paid-in capital, $ 0.001 par value per share: 15,000,000 shares authorized (Class A 9,000,000 , Class B 3,000,000 , Class C 3,000,000 ); 675,222 (Class A 300,730 , Class B 45,843 , Class C 328,649 ) and 662,121 (Class A 300,737 , Class B 44,665 , Class C 316,719 ) shares issued and outstanding 58,510 61,774 Accumulated other comprehensive income (loss) 633 ( 1,623 ) Retained earnings 163,401 191,484 Total stockholders’ equity 222,544 251,635 Total liabilities and stockholders’ equity $ 319,616 $ 359,268 See accompanying notes. 49 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts) Year Ended December 31, 2019 2020 2021 Revenues $ 161,857 $ 182,527 $ 257,637 Costs and expenses: Cost of revenues 71,896 84,732 110,939 Research and development 26,018 27,573 31,562 Sales and marketing 18,464 17,946 22,912 General and administrative 9,551 11,052 13,510 European Commission fines 1,697 0 0 Total costs and expenses 127,626 141,303 178,923 Income from operations 34,231 41,224 78,714 Other income (expense), net 5,394 6,858 12,020 Income before income taxes 39,625 48,082 90,734 Provision for income taxes 5,282 7,813 14,701 Net income $ 34,343 $ 40,269 $ 76,033 Basic net income per share of Class A and B common stock and Class C capital stock $ 49.59 $ 59.15 $ 113.88 Diluted net income per share of Class A and B common stock and Class C capital stock $ 49.16 $ 58.61 $ 112.20 See accompanying notes. 50 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (In millions) Year Ended December 31, 2019 2020 2021 Net income $ 34,343 $ 40,269 $ 76,033 Other comprehensive income (loss): Change in foreign currency translation adjustment ( 119 ) 1,139 ( 1,442 ) Available-for-sale investments: Change in net unrealized gains (losses) 1,611 1,313 ( 1,312 ) Less: reclassification adjustment for net (gains) losses included in net income ( 111 ) ( 513 ) ( 64 ) Net change, net of income tax benefit (expense) of $( 221 ), $( 230 ), and $ 394 1,500 800 ( 1,376 ) Cash flow hedges: Change in net unrealized gains (losses) 22 42 716 Less: reclassification adjustment for net (gains) losses included in net income ( 299 ) ( 116 ) ( 154 ) Net change, net of income tax benefit (expense) of $ 42 , $ 11 , and $( 122 ) ( 277 ) ( 74 ) 562 Other comprehensive income (loss) 1,104 1,865 ( 2,256 ) Comprehensive income $ 35,447 $ 42,134 $ 73,777 See accompanying notes. 51 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In millions, except share amounts which are reflected in thousands) Class A and Class B Common Stock, Class C Capital Stock and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2018 695,556 $ 45,049 $ ( 2,306 ) $ 134,885 $ 177,628 Cumulative effect of accounting change 0 0 ( 30 ) ( 4 ) ( 34 ) Common and capital stock issued 8,120 202 0 0 202 Stock-based compensation expense 0 10,890 0 0 10,890 Income tax withholding related to vesting of restricted stock units and other 0 ( 4,455 ) 0 0 ( 4,455 ) Repurchases of capital stock ( 15,341 ) ( 1,294 ) 0 ( 17,102 ) ( 18,396 ) Sale of interest in consolidated entities 0 160 0 0 160 Net income 0 0 0 34,343 34,343 Other comprehensive income (loss) 0 0 1,104 0 1,104 Balance as of December 31, 2019 688,335 50,552 ( 1,232 ) 152,122 201,442 Common and capital stock issued 8,398 168 0 0 168 Stock-based compensation expense 0 13,123 0 0 13,123 Income tax withholding related to vesting of restricted stock units and other 0 ( 5,969 ) 0 0 ( 5,969 ) Repurchases of capital stock ( 21,511 ) ( 2,159 ) 0 ( 28,990 ) ( 31,149 ) Sale of interest in consolidated entities 0 2,795 0 0 2,795 Net income 0 0 0 40,269 40,269 Other comprehensive income (loss) 0 0 1,865 0 1,865 Balance as of December 31, 2020 675,222 58,510 633 163,401 222,544 Common and capital stock issued 7,225 12 0 0 12 Stock-based compensation expense 0 15,539 0 0 15,539 Income tax withholding related to vesting of restricted stock units and other 0 ( 10,273 ) 0 0 ( 10,273 ) Repurchases of common and capital stock ( 20,326 ) ( 2,324 ) 0 ( 47,950 ) ( 50,274 ) Sale of interest in consolidated entities 0 310 0 0 310 Net income 0 0 0 76,033 76,033 Other comprehensive income (loss) 0 0 ( 2,256 ) 0 ( 2,256 ) Balance as of December 31, 2021 662,121 $ 61,774 $ ( 1,623 ) $ 191,484 $ 251,635 See accompanying notes. 52 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (In millions) Year Ended December 31, 2019 2020 2021 Operating activities Net income $ 34,343 $ 40,269 $ 76,033 Adjustments: Depreciation and impairment of property and equipment 10,856 12,905 11,555 Amortization and impairment of intangible assets 925 792 886 Stock-based compensation expense 10,794 12,991 15,376 Deferred income taxes 173 1,390 1,808 Gain on debt and equity securities, net ( 2,798 ) ( 6,317 ) ( 12,270 ) Other ( 592 ) 1,267 ( 213 ) Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable ( 4,340 ) ( 6,524 ) ( 9,095 ) Income taxes, net ( 3,128 ) 1,209 ( 625 ) Other assets ( 621 ) ( 1,330 ) ( 1,846 ) Accounts payable 428 694 283 Accrued expenses and other liabilities 7,170 5,504 7,304 Accrued revenue share 1,273 1,639 1,682 Deferred revenue 37 635 774 Net cash provided by operating activities 54,520 65,124 91,652 Investing activities Purchases of property and equipment ( 23,548 ) ( 22,281 ) ( 24,640 ) Purchases of marketable securities ( 100,315 ) ( 136,576 ) ( 135,196 ) Maturities and sales of marketable securities 97,825 132,906 128,294 Purchases of non-marketable securities ( 1,932 ) ( 7,175 ) ( 2,838 ) Maturities and sales of non-marketable securities 405 1,023 934 Acquisitions, net of cash acquired, and purchases of intangible assets ( 2,515 ) ( 738 ) ( 2,618 ) Other investing activities 589 68 541 Net cash used in investing activities ( 29,491 ) ( 32,773 ) ( 35,523 ) Financing activities Net payments related to stock-based award activities ( 4,765 ) ( 5,720 ) ( 10,162 ) Repurchases of common and capital stock ( 18,396 ) ( 31,149 ) ( 50,274 ) Proceeds from issuance of debt, net of costs 317 11,761 20,199 Repayments of debt ( 585 ) ( 2,100 ) ( 21,435 ) Proceeds from sale of interest in consolidated entities, net 220 2,800 310 Net cash used in financing activities ( 23,209 ) ( 24,408 ) ( 61,362 ) Effect of exchange rate changes on cash and cash equivalents ( 23 ) 24 ( 287 ) Net increase (decrease) in cash and cash equivalents 1,797 7,967 ( 5,520 ) Cash and cash equivalents at beginning of period 16,701 18,498 26,465 Cash and cash equivalents at end of period $ 18,498 $ 26,465 $ 20,945 Supplemental disclosures of cash flow information Cash paid for income taxes, net of refunds $ 8,203 $ 4,990 $ 13,412 See accompanying notes. 53 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. In 2015, we implemented a holding company reorganization, and as a result, Alphabet Inc. ("Alphabet") became the successor issuer to Google. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and entities consolidated under the variable interest and voting models. All intercompany balances and transactions have been eliminated. Use of Estimates Preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates due to uncertainties, including the effects of COVID-19. On an ongoing basis, we evaluate our estimates, including those related to the allowance for credit losses; fair values of financial instruments, intangible assets, and goodwill; useful lives of intangible assets and property and equipment; income taxes; and contingent liabilities, among others. We base our estimates on assumptions, both historical and forward looking, that are believed to be reasonable, and the results of which form the basis for making judgments about the carrying values of assets and liabilities. In January 2021, we completed an assessment of the useful lives of our servers and network equipment and adjusted the estimated useful life of our servers from three years to four years and the estimated useful life of certain network equipment from three years to five years . This change in accounting estimate was effective beginning in fiscal year 2021. Based on the carrying value of servers and certain network equipment as of December 31, 2020 and those acquired during the year ended December 31, 2021, the effect of this change in estimate was a reduction in depreciation expense of $ 2.6 billion and an increase in net income of $ 2.0 billion, or $ 3.02 per basic share and $ 2.98 per diluted share, for the year ended December 31, 2021. Revenue Recognition Revenues are recognized when control of the promised goods or services is transferred to our customers, and the collectibility of an amount that we expect in exchange for those goods or services is probable. Sales and other similar taxes are excluded from revenues. Advertising Revenues We generate advertising revenues primarily by delivering advertising on: • Google Search and other properties, including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc. and other Google owned and operated properties like Gmail, Google Maps, and Google Play; • YouTube properties; and • Google Network properties, including revenues from Google Network properties participating in AdMob, AdSense, and Google Ad Manager. Our customers generally purchase advertising inventory through Google Ads, Google Ad Manager, and Google Marketing Platform, among others. We offer advertising by delivering both performance and brand advertising. We recognize revenues for performance advertising when a user engages with the advertisement, such as a click, a view, or a purchase. For brand advertising, we recognize revenues when the ad is displayed, or a user views the ad. For ads placed on Google Network properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues for ads placed on Google Network properties on a gross basis, that is, the amounts billed to our customers are recorded as revenues, and amounts paid to Google Network partners are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. 54 Table of Contents Alphabet Inc. Google Cloud Revenues Google Cloud revenues consist of revenues from: • Google Cloud Platform, which includes fees for infrastructure, platform, and other services; • Google Workspace, which includes fees for cloud-based collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar, and Meet; and • other enterprise services. Our cloud services are generally provided on either a consumption or subscription basis and may have contract terms longer than a year. Revenues related to cloud services provided on a consumption basis are recognized when the customer utilizes the services, based on the quantity of services consumed. Revenues related to cloud services provided on a subscription basis are recognized ratably over the contract term as the customer receives and consumes the benefits of the cloud services. Google Other Revenues Google other revenues consist of revenues from: • Google Play, which includes sales of apps and in-app purchases and digital content sold in the Google Play store; • hardware, which includes sales of Fitbit wearable devices, Google Nest home products, and Pixel phones; • YouTube non-advertising, which includes YouTube Premium and YouTube TV subscriptions; and • other products and services. As it relates to Google other revenues, the most significant judgment is determining whether we are the principal or agent for app sales and in-app purchases through the Google Play store. We report revenues from these transactions on a net basis because our performance obligation is to facilitate a transaction between app developers and end users, for which we earn a service fee. Arrangements with Multiple Performance Obligations Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenues to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers or using expected cost plus margin. Customer Incentives and Credits Certain customers receive cash-based incentives or credits, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenues. We believe that there will not be significant changes to our estimates of variable consideration. Sales Commissions We expense sales commissions when incurred and when the amortization period (the period of the expected benefit) is one year or less. We recognize an asset for certain sales commissions if we expect the period of benefit of these costs to exceed one year and recognize the expense over the amortization period. These costs are recorded within sales and marketing expenses. Cost of Revenues Cost of revenues consists of TAC and other costs of revenues. • TAC includes: ◦ Amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. ◦ Amounts paid to Google Network partners primarily for ads displayed on their properties. • Other cost of revenues includes: ◦ Content acquisition costs, which are payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee). 55 Table of Contents Alphabet Inc. ◦ Expenses associated with our data centers (including bandwidth, compensation expenses, depreciation, energy, and other equipment costs) as well as other operations costs (such as content review as well as customer and product support costs). ◦ Inventory and other costs related to the hardware we sell. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products. As a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Stock-based Compensation Stock-based compensation primarily consists of Alphabet restricted stock units (RSUs). RSUs are equity classified and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period and account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the applicable statutory income tax withholding to be paid by us on behalf of our employees. As a result, fewer shares are issued than the number of RSUs outstanding, and the income tax withholding is recorded as a reduction to additional paid-in capital. Additionally, stock-based compensation also includes other stock-based awards, such as performance stock units (PSUs) that include market conditions and awards that may be settled in cash or the stock of certain Other Bets. PSUs and certain Other Bet awards are equity classified and expense is recognized over the requisite service period. Certain Other Bet awards are liability classified and remeasured at fair value through settlement. The fair value of Other Bet awards is based on the equity valuation of the respective Other Bet. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2019, 2020 and 2021, advertising and promotional expenses totaled approximately $ 6.8 billion, $ 5.4 billion, and $ 7.9 billion, respectively. Performance Fees Performance fees refer to compensation arrangements with payouts based on realized returns from certain investments. We recognize compensation expense based on the estimated payouts, which may result in expense recognized before investment returns are realized, and may require the use of unobservable inputs. Performance fees are recorded as a component of other income (expense), net. Fair Value Measurements Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. 56 Table of Contents Alphabet Inc. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Our financial assets and liabilities that are measured at fair value on a recurring basis include cash equivalents, marketable securities, derivative financial instruments, and certain non-marketable debt securities. Our financial assets measured at fair value on a nonrecurring basis include non-marketable equity securities. Other financial assets and liabilities are carried at cost with fair value disclosed, if required. We measure certain other instruments, including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, also at fair value on a nonrecurring basis. The determination of fair value involves the use of appropriate valuation methods and relevant inputs into valuation models. Financial Instruments Our financial instruments include cash, cash equivalents, marketable and non-marketable securities, derivative financial instruments and accounts receivable. Credit Risks We are subject to credit risk from cash equivalents, marketable securities, derivative financial instruments, including foreign exchange contracts, and accounts receivable. We manage our credit risk exposure through timely assessment of our counterparty creditworthiness, credit limits and use of collateral management. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. We manage our credit risk exposure by performing ongoing evaluations to determine customer credit and we limit the amount of credit we extend. We generally do not require collateral from our customers. Cash Equivalents We invest excess cash primarily in government bonds, corporate debt securities, mortgage-backed and asset-backed securities, time deposits, and money market funds. Marketable Securities We classify all marketable debt securities that have stated maturities of three months or less from the date of purchase as cash equivalents and those with stated maturities of greater than three months as marketable securities on our Consolidated Balance Sheets. We determine the appropriate classification of our investments in marketable debt securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable debt securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these debt securities prior to their stated maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities on the Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for the changes in allowance for expected credit losses, which are recorded in other income (expense), net. For certain marketable debt securities we have elected the fair value option, for which changes in fair value are recorded in other income (expense), net. We determine any realized gains or losses on the sale of marketable debt securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Our investments in marketable equity securities are measured at fair value with the related gains and losses, including unrealized, recognized in other income (expense), net. We classify our marketable equity securities subject to long-term lock-up restrictions beyond twelve months as other non-current assets on the Consolidated Balance Sheets. Non-Marketable Securities We account for non-marketable equity securities through which we exercise significant influence but do not have control over the investee under the equity method. Our non-marketable equity securities not accounted for under the equity method are primarily accounted for under the measurement alternative. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. Adjustments are determined primarily based on a market approach as of the transaction date and are recorded as a component of other income (expense), net. Non-marketable debt securities are classified as available-for-sale securities. 57 Table of Contents Alphabet Inc. Non-marketable securities that do not have stated contractual maturity dates are classified as other non-current assets on the Consolidated Balance Sheets. Derivative Financial Instruments See Note 3 for the accounting policy pertaining to derivative financial instruments. Accounts Receivable Our payment terms for accounts receivable vary by the types and locations of our customers and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customers, we require payment before the products or services are delivered to the customer. We maintain an allowance for credit losses for accounts receivable, which is recorded as an offset to accounts receivable, and changes in such are classified as general and administrative expense in the Consolidated Statements of Income. We assess collectibility by reviewing accounts receivable on a collective basis where similar characteristics exist and on an individual basis when we identify specific customers with known disputes or collectibility issues. In determining the amount of the allowance for credit losses, we consider historical collectibility based on past due status and make judgments about the creditworthiness of customers based on ongoing credit evaluations. We also consider customer-specific information, current market conditions (such as the effects caused by COVID-19), and reasonable and supportable forecasts of future economic conditions. The allowance for credit losses on accounts receivable was $ 789 million and $ 550 million as of December 31, 2020 and 2021, respectively. Other Our financial instruments also include debt and equity investments in companies with which we also have commercial arrangements. For these transactions, judgment is required to assess the substance of the arrangements, such as the market value of similar transactions or the fair value of the investment based on stand-alone transactions, and whether the agreements should be accounted for as separate transactions under the applicable GAAP. Impairment of Investments We periodically review our debt and non-marketable equity securities for impairment. For debt securities in an unrealized loss position, we determine whether a credit loss exists. The credit loss is estimated by considering available information relevant to the collectibility of the security and information about past events, current conditions, and reasonable and supportable forecasts. Any credit loss is recorded as a charge to other income (expense), net, not to exceed the amount of the unrealized loss. Unrealized losses other than the credit loss are recognized in accumulated other comprehensive income (AOCI). If we have an intent to sell, or if it is more likely than not that we will be required to sell a debt security in an unrealized loss position before recovery of its amortized cost basis, we will write down the security to its fair value and record the corresponding charge as a component of other income (expense), net. For non-marketable equity securities, including equity method investments, we consider whether impairment indicators exist by evaluating the companies' financial and liquidity position and access to capital resources, among other indicators. If the assessment indicates that the investment is impaired, we write down the investment to its fair value by recording the corresponding charge as a component of other income (expense), net. We prepare quantitative measurements of the fair value of our equity investments using a market approach or an income approach. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Variable Interest Entities We determine at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a variable interest entity (VIE). We consolidate VIEs when we are the primary beneficiary. We are the primary beneficiary of a VIE when we have the power to direct activities that most significantly affect the economic performance of the VIE and have the obligation to absorb the majority of their losses or benefits. If we are not the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Periodically, we assess whether any changes in our interest or relationship with the entity affect our determination of whether the entity is a VIE and, if so, whether we are the primary beneficiary. 58 Table of Contents Alphabet Inc. Property and Equipment Property and equipment includes the following categories: land and buildings, information technology assets, construction in progress, leasehold improvements, and furniture and fixtures. Land and buildings include land, offices, data centers, and related building improvements. Information technology assets include servers and network equipment. We account for property and equipment at cost less accumulated depreciation. We compute depreciation using the straight-line method over the estimated useful lives of the assets, which we regularly evaluate. We depreciate buildings over periods of seven to 25 years. We depreciate information technology assets generally over periods of four to five years (generally, four years for servers and five years for network equipment). We depreciate leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Construction in progress is the construction or development of property and equipment that have not yet been placed in service for our intended use. Depreciation for equipment, buildings, and leasehold improvements commences once they are ready for our intended use. Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Our lease agreements generally contain lease and non-lease components. Payments under our lease arrangements are primarily fixed. Non-lease components primarily include payments for maintenance and utilities. We combine fixed payments for non-lease components with lease payments and account for them together as a single lease component which increases the amount of our lease assets and liabilities. Certain lease agreements contain variable payments, which are expensed as incurred and not included in the lease assets and liabilities. These amounts include payments affected by the Consumer Price Index, payments contingent on wind or solar production for power purchase arrangements, and payments for maintenance and utilities. Lease assets and liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is our incremental borrowing rate, because the interest rate implicit in our leases is not readily determinable. Our incremental borrowing rate is estimated to approximate the interest rate on a collateralized basis with similar terms and payments, and in economic environments where the leased asset is located. Our lease terms include periods under options to extend or terminate the lease when it is reasonably certain that we will exercise that option. We generally use the base, non-cancelable, lease term when determining the lease assets and liabilities. Lease assets also include any prepaid lease payments and lease incentives. Operating lease assets and liabilities are included on our Consolidated Balance Sheet. The current portion of our operating lease liabilities is included in accrued expenses and other current liabilities, and the long-term portion is included in operating lease liabilities. Finance lease assets are included in property and equipment, net. Finance lease liabilities are included in accrued expenses and other current liabilities or long-term debt. Operating lease expense (excluding variable lease costs) is recognized on a straight-line basis over the lease term. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment and intangible assets, excluding goodwill, for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. We measure recoverability of these assets by comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets or asset group is not recoverable, the impairment recognized is measured as the amount by which the carrying value exceeds its fair value. Impairments were not material for the periods presented. We allocate goodwill to reporting units based on the expected benefit from the business combination. We evaluate our reporting units periodically, as well as when changes in our operating segments occur. For changes in reporting units, we reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairments were no t material for the periods presented. Intangible assets with definite lives are amortized over their estimated useful lives on a straight-line basis generally over periods ranging from one to twelve years . 59 Table of Contents Alphabet Inc. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more likely than not that they will not be realized. We recognize the financial statement effects of a tax position when it is more likely than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of the acquisitions to the assets acquired and liabilities assumed based on their estimated fair values. The excess of the purchase price over the fair values of identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Foreign Currency We translate the financial statements of our international subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in AOCI as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange gain (loss) in other income (expense), net. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. Note 2. Revenues Revenue Recognition The following table presents revenues disaggregated by type (in millions): Year Ended December 31, 2019 2020 2021 Google Search & other $ 98,115 $ 104,062 $ 148,951 YouTube ads 15,149 19,772 28,845 Google Network 21,547 23,090 31,701 Google advertising 134,811 146,924 209,497 Google other 17,014 21,711 28,032 Google Services total 151,825 168,635 237,529 Google Cloud 8,918 13,059 19,206 Other Bets 659 657 753 Hedging gains (losses) 455 176 149 Total revenues $ 161,857 $ 182,527 $ 257,637 No individual customer or groups of affiliated customers represented more than 10% of our revenues in 2019, 2020, or 2021. 60 Table of Contents Alphabet Inc. The following table presents revenues disaggregated by geography, based on the addresses of our customers (in millions): Year Ended December 31, 2019 2020 2021 United States $ 74,843 46 % $ 85,014 47 % $ 117,854 46 % EMEA (1) 50,645 31 55,370 30 79,107 31 APAC (1) 26,928 17 32,550 18 46,123 18 Other Americas (1) 8,986 6 9,417 5 14,404 5 Hedging gains (losses) 455 0 176 0 149 0 Total revenues $ 161,857 100 % $ 182,527 100 % $ 257,637 100 % (1) Regions represent Europe, the Middle East, and Africa (EMEA); Asia-Pacific (APAC); and Canada and Latin America ("Other Americas"). Revenue Backlog and Deferred Revenues As of December 31, 2021 we had $ 51.0 billion of remaining performance obligations (“revenue backlog”), primarily related to Google Cloud, a nd expect to recognize approximately half of this amount as revenues over the next 24 months with the remaining thereafter. Our revenue backlog represents commitments in customer contracts for future services that have not yet been recog nized as revenues. The amount and timing of revenue recognition for these commitments is largely driven by when our customers utilize services and our ability to deliver in accordance with relevant contract terms, which could affect our estimate of revenue backlog and when we expect to recognize such as revenues. Revenue backlog includes related deferred revenue currently recorded as well as amounts that will be invoiced in future periods, and excludes contracts with an original expected term of one year or less and cancellable contracts. We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. Deferred revenues primarily relate to Google Cloud and Google other. Total deferred revenue as of December 31, 2020 was $ 3.0 billion, of which $ 2.3 billion was recognized as revenues for the year ending December 31, 2021. Note 3. Financial Instruments Debt Securities We classify our marketable debt securities, which are accounted for as available-for-sale within Level 2 in the fair value hierarchy, because we use quoted market prices to the extent available or alternative pricing sources and models utilizing market observable inputs to determine fair value. For certain marketable debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. The fair value option was elected for these securities to align with the unrealized gains and losses from related derivative contracts. Unrealized net gains (losses) related to debt securities still held where we have elected the fair value option were $ 87 million and $( 35 ) million as of December 31, 2020 and December 31, 2021, respectively. As of December 31, 2020 and December 31, 2021, the fair value of these debt securities was $ 2.0 billion and $ 4.7 billion, respectively. 61 Table of Contents Alphabet Inc. The following tables summarize debt securities, for which we did not elect the fair value option, by significant investment categories as of December 31, 2020 and 2021 (in millions): As of December 31, 2020 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Level 2: Time deposits (1) $ 3,564 $ 0 $ 0 $ 3,564 $ 3,564 $ 0 Government bonds 55,156 793 ( 9 ) 55,940 2,527 53,413 Corporate debt securities 31,521 704 ( 2 ) 32,223 8 32,215 Mortgage-backed and asset-backed securities 16,767 364 ( 7 ) 17,124 0 17,124 Total $ 107,008 $ 1,861 $ ( 18 ) $ 108,851 $ 6,099 $ 102,752 As of December 31, 2021 Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Level 2: Time deposits (1) $ 5,133 $ 0 $ 0 $ 5,133 $ 5,133 $ 0 Government bonds 53,288 258 ( 238 ) 53,308 5 53,303 Corporate debt securities 35,605 194 ( 223 ) 35,576 12 35,564 Mortgage-backed and asset-backed securities 18,829 96 ( 112 ) 18,813 0 18,813 Total $ 112,855 $ 548 $ ( 573 ) $ 112,830 $ 5,150 $ 107,680 (1) The majority of our time deposits are domestic deposits. We determine realized gains or losses on the sale or extinguishment of debt securities on a specific identification method. We recognized gross realized gains of $ 292 million, $ 899 million, and $ 432 million for the years ended December 31, 2019, 2020, and 2021, respectively. We recognized gross realized losses of $ 143 million, $ 184 million, and $ 329 million for the years ended December 31, 2019, 2020, and 2021, respectively. We reflect these gains and losses as a component of other income (expense), net. The following table summarizes the estimated fair value of investments in marketable debt securities by stated contractual maturity dates (in millions): As of December 31, 2021 Due in 1 year or less $ 16,192 Due in 1 year through 5 years 78,625 Due in 5 years through 10 years 4,675 Due after 10 years 12,864 Total $ 112,356 The following tables present fair values and gross unrealized losses recorded to AOCI as of December 31, 2020 and 2021, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2020 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 5,516 $ ( 9 ) $ 3 $ 0 $ 5,519 $ ( 9 ) Corporate debt securities 1,999 ( 1 ) 0 0 1,999 ( 1 ) Mortgage-backed and asset-backed securities 929 ( 5 ) 242 ( 2 ) 1,171 ( 7 ) Total $ 8,444 $ ( 15 ) $ 245 $ ( 2 ) $ 8,689 $ ( 17 ) 62 Table of Contents Alphabet Inc. As of December 31, 2021 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 32,843 $ ( 236 ) $ 71 $ ( 2 ) $ 32,914 $ ( 238 ) Corporate debt securities 22,737 ( 152 ) 303 ( 5 ) 23,040 ( 157 ) Mortgage-backed and asset-backed securities 11,502 ( 106 ) 248 ( 6 ) 11,750 ( 112 ) Total $ 67,082 $ ( 494 ) $ 622 $ ( 13 ) $ 67,704 $ ( 507 ) During the years ended December 31, 2020 and 2021, we did not recognize significant credit losses and the ending allowance for credit losses was immaterial. See Note 7 for further details on other income (expense), net. Equity Investments The following discusses our marketable equity securities, non-marketable equity securities, gains and losses on marketable and non-marketable equity securities, as well as our equity securities accounted for under the equity method. Our marketable equity securities are publicly traded stocks or funds measured at fair value and classified within Level 1 and 2 in the fair value hierarchy because we use quoted prices for identical assets in active markets or inputs that are based upon quoted prices for similar instruments in active markets. Our non-marketable equity securities are investments in privately held companies without readily determinable market values. The carrying value of our non-marketable equity securities is adjusted to fair value upon observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). Non-marketable equity securities that have been remeasured during the period based on observable transactions are classified within Level 2 or Level 3 in the fair value hierarchy because we estimate the value based on valuation methods which may include a combination of the observable transaction price at the transaction date and other unobservable inputs including volatility, rights, and obligations of the securities we hold. The fair value of non-marketable equity securities that have been remeasured due to impairment are classified within Level 3. Gains and losses on marketable and non-marketable equity securities Gains and losses reflected in other income (expense), net, for marketable and non-marketable equity securities are summarized below (in millions): Year Ended December 31, 2020 2021 Net gain (loss) on equity securities sold during the period $ 1,339 $ 1,196 Unrealized gain (loss) on equity securities held as of the end of the period 4,253 11,184 Total gain (loss) recognized in other income (expense), net $ 5,592 $ 12,380 In the table above, net gain (loss) on equity securities sold during the period reflects the difference between the sale proceeds and the carrying value of the equity securities at the beginning of the period or the purchase date, if later. Cumulative net gains (losses) on equity securities sold during the period, which is summarized in the following table (in millions), represents the total net gains (losses) recognized after the initial purchase date of the equity security. While these net gains may have been reflected in periods prior to the period of sale, we believe they are important supplemental information as they reflect the economic net gains recognized on the securities sold during the period. Cumulative net gains are calculated as the difference between the sale price and the initial purchase price for the equity security sold during the period. 63 Table of Contents Alphabet Inc. Equity Securities Sold During the Year Ended December 31, 2020 2021 Total sale price $ 4,767 $ 5,604 Total initial cost 2,674 1,206 Cumulative net gains (1) $ 2,093 $ 4,398 (1) Cumulative net gains excludes cumulative losses of $ 738 million resulting from our equity derivatives, which hedged the changes in fair value of certain marketable equity securities sold during the year ended December 31, 2021. The associated derivative liabilities arising from these losses were settled against our holdings of the underlying equity securities. Carrying value of marketable and non-marketable equity securities The carrying value is measured as the total initial cost plus the cumulative net gain (loss). The carrying values for marketable and non-marketable equity securities are summarized below (in millions): As of December 31, 2020 Marketable Equity Securities Non-Marketable Equity Securities Total Total initial cost $ 2,227 $ 14,616 $ 16,843 Cumulative net gain (loss) (1) 3,631 4,277 7,908 Carrying value (2) $ 5,858 $ 18,893 $ 24,751 (1) Non-marketable equity securities cumulative net gain (loss) is comprised of $ 6.1 billion gains and $ 1.9 billion losses (including impairment). (2) The long-term portion of marketable equity securities (subject to long-term lock-up restrictions) of $ 429 million is included within other non-current assets. As of December 31, 2021 Marketable Equity Securities Non-Marketable Equity Securities Total Total initial cost $ 4,211 $ 15,135 $ 19,346 Cumulative net gain (loss) (1) 3,587 12,436 16,023 Carrying value (2) $ 7,798 $ 27,571 $ 35,369 (1) Non-marketable equity securities cumulative net gain (loss) is comprised of $ 14.1 billion gains and $ 1.7 billion losses (including impairment). (2) The long-term portion of marketable equity securities (subject to long-term lock-up restrictions) of $ 1.4 billion is included within other non-current assets. Marketable equity securities The following table summarizes marketable equity securities measured at fair value by significant investment categories as of December 31, 2020 and 2021 (in millions): As of December 31, 2020 As of December 31, 2021 Cash and Cash Equivalents Marketable Equity Securities Cash and Cash Equivalents Marketable Equity Securities Level 1: Money market funds $ 12,210 $ 0 $ 7,499 $ 0 Marketable equity securities (1)(2) 0 5,470 0 7,447 12,210 5,470 7,499 7,447 Level 2: Mutual funds 0 388 0 351 Total $ 12,210 $ 5,858 $ 7,499 $ 7,798 (1) The balance as of December 31, 2020 and 2021 includes investments that were reclassified from non-marketable equity securities following the commencement of public market trading of the issuers or acquisition by public entities (certain investments are subject to short-term lock-up restrictions). (2) As of December 31, 2020 and 2021, the long-term portion of marketable equity securities (subject to long-term lock-up restrictions) of $ 429 million and $ 1.4 billion, respectively, is included within other non-current assets. 64 Table of Contents Alphabet Inc. Non-marketable equity securities The following is a summary of unrealized gains and losses recorded in other income (expense), net, which are included as adjustments to the carrying value of non-marketable equity securities held as of the end of the period (in millions): Year Ended December 31, 2020 2021 Unrealized gains on non-marketable equity securities $ 3,020 $ 9,971 Unrealized losses on non-marketable equity securities (including impairment) ( 1,489 ) ( 122 ) Total unrealized gain (loss) recognized on non-marketable equity securities $ 1,531 $ 9,849 During the year ended December 31, 2021, included in the $ 27.6 billion of non-marketable equity securities held as of the end of the period, $ 18.6 billion were measured at fair value resulting in a net unrealized gain of $ 9.8 billion. Equity securities accounted for under the Equity Method As of December 31, 2020 and 2021, equity securities accounted for under the equity method had a carrying value of approximately $ 1.4 billion and $ 1.5 billion, respectively. Our share of gains and losses, including impairments, are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 7 for further details on other income (expense), net. Derivative Financial Instruments We enter into derivative instruments to manage risks relating to our ongoing business operations. The primary risk managed with derivative instruments is foreign exchange risk. We use foreign currency contracts to reduce the risk that our cash flows, earnings, and investment in foreign subsidiaries will be adversely affected by foreign currency exchange rate fluctuations. We also enter into derivative instruments to partially offset our exposure to other risks and enhance investment returns. We recognize derivative instruments as either assets or liabilities in the Consolidated Balance Sheets at fair value and classify the derivatives primarily within Level 2 in the fair value hierarchy. We present our collar contracts (an option strategy comprised of a combination of purchased and written options) at net fair values where both the purchased and written options are with the same counterparty. For other derivative contracts, we present at gross fair values. We primarily record changes in the fair value in the Consolidated Statements of Income as either other income (expense), net, or revenues, or in the Consolidated Balance Sheets in AOCI, as discussed below. We enter into master netting arrangements, which reduce credit risk by permitting net settlement of transactions with the same counterparty. Further, we enter into collateral security arrangements that provide for collateral to be received or pledged when the net fair value of certain financial instruments fluctuates from contractually established thresholds. Cash collateral received related to derivative instruments under our collateral security arrangements are included in other current assets with a corresponding liability. Cash and non-cash collateral pledged related to derivative instruments under our collateral security arrangements are included in other current assets. Cash Flow Hedges We designate foreign currency forward and option contracts (including collars) as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. These contracts have maturities of 24 months or less. Cash flow hedge amounts included in the assessment of hedge effectiveness are deferred in AOCI and subsequently reclassified to revenue when the hedged item is recognized in earnings. We exclude the change in forward points and time value from our assessment of hedge effectiveness. The initial value of the excluded component is amortized on a straight-line basis over the life of the hedging instrument and recognized in revenues. The difference between fair value changes of the excluded component and the amount amortized to revenues is recorded in AOCI. If the hedged transactions become probable of not occurring, the corresponding amounts in AOCI are reclassified to other income (expense), net in the period of de-designation. As of December 31, 2021, the net accumulated gain on our foreign currency cash flow hedges before tax effect was $ 518 million, which is expected to be reclassified from AOCI into earnings within the next 12 months. Fair Value Hedges We designate foreign currency forward contracts as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. Fair value hedge amounts included in the 65 Table of Contents Alphabet Inc. assessment of hedge effectiveness are recognized in other income (expense), net, along with the offsetting gains and losses of the related hedged items. We exclude changes in forward points from the assessment of hedge effectiveness and recognize changes in the excluded component in other income (expense), net. Net Investment Hedges We designate foreign currency forward contracts as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. Net investment hedge amounts included in the assessment of hedge effectiveness are recognized in AOCI along with the foreign currency translation adjustment. We exclude changes in forward points from the assessment of hedge effectiveness and recognize changes in the excluded component in other income (expense), net. Other Derivatives Other derivatives not designated as hedging instruments consist primarily of foreign currency forward contracts that we use to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the functional currency of a subsidiary. Gains and losses on these contracts, as well as the related costs, are recognized in other income (expense), net, along with the foreign currency gains and losses on monetary assets and liabilities. We also use derivatives not designated as hedging instruments to manage risks relating to interest rates, commodity prices, credit exposures and to enhance investment returns. Additionally, from time to time, we enter into derivatives to hedge the market price risk on certain of our marketable equity securities. Gains (losses) arising from these derivatives are reflected within the "other" component of other income (expense), net and the offsetting recognized gains (losses) on the marketable equity securities are reflected within the gain (loss) on equity securities, net component of other income (expense), net. See Note 7 for further details on other income (expense), net. The gross notional amounts of outstanding derivative instruments were as follows (in millions): As of December 31, 2020 2021 Derivatives Designated as Hedging Instruments: Foreign exchange contracts Cash flow hedges $ 10,187 $ 16,362 Fair value hedges $ 1,569 $ 2,556 Net investment hedges $ 9,965 $ 10,159 Derivatives Not Designated as Hedging Instruments: Foreign exchange contracts $ 39,861 $ 41,031 Other contracts $ 2,399 $ 4,275 66 Table of Contents Alphabet Inc. The fair values of outstanding derivative instruments were as follows (in millions): As of December 31, 2020 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 33 $ 316 $ 349 Other contracts Other current and non-current assets 0 16 16 Total $ 33 $ 332 $ 365 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 395 $ 185 $ 580 Other contracts Accrued expenses and other liabilities, current and non-current 0 942 942 Total $ 395 $ 1,127 $ 1,522 As of December 31, 2021 Balance Sheet Location Fair Value of Derivatives Designated as Hedging Instruments Fair Value of Derivatives Not Designated as Hedging Instruments Total Fair Value Derivative Assets: Level 2: Foreign exchange contracts Other current and non-current assets $ 867 $ 42 $ 909 Other contracts Other current and non-current assets 0 52 52 Total $ 867 $ 94 $ 961 Derivative Liabilities: Level 2: Foreign exchange contracts Accrued expenses and other liabilities, current and non-current $ 8 $ 452 $ 460 Other contracts Accrued expenses and other liabilities, current and non-current 0 121 121 Total $ 8 $ 573 $ 581 67 Table of Contents Alphabet Inc. The gains (losses) on derivatives in cash flow hedging and net investment hedging relationships recognized in other comprehensive income (OCI) were summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect Year Ended December 31, 2019 2020 2021 Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness $ 38 $ 102 $ 806 Amount excluded from the assessment of effectiveness ( 14 ) ( 37 ) 48 Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount included in the assessment of effectiveness 131 ( 851 ) 754 Total $ 155 $ ( 786 ) $ 1,608 The effect of derivative instruments on income was summarized below (in millions): Gains (Losses) Recognized in Income Year Ended December 31, 2019 2020 2021 Revenues Other income (expense), net Revenues Other income (expense), net Revenues Other income (expense), net Total amounts presented in the Consolidated Statements of Income in which the effects of cash flow and fair value hedges are recorded $ 161,857 $ 5,394 $ 182,527 $ 6,858 $ 257,637 $ 12,020 Gains (Losses) on Derivatives in Cash Flow Hedging Relationship: Foreign exchange contracts Amount of gains (losses) reclassified from AOCI to income $ 367 $ 0 $ 144 $ 0 $ 165 $ 0 Amount excluded from the assessment of effectiveness recognized in earnings based on an amortization approach 88 0 33 0 ( 16 ) 0 Gains (Losses) on Derivatives in Fair Value Hedging Relationship: Foreign exchange contracts Hedged items 0 ( 19 ) 0 18 0 ( 95 ) Derivatives designated as hedging instruments 0 19 0 ( 18 ) 0 95 Amount excluded from the assessment of effectiveness 0 25 0 4 0 8 Gains (Losses) on Derivatives in Net Investment Hedging Relationship: Foreign exchange contracts Amount excluded from the assessment of effectiveness 0 243 0 151 0 82 Gains (Losses) on Derivatives Not Designated as Hedging Instruments: Foreign exchange contracts 0 ( 413 ) 0 718 0 ( 860 ) Other Contracts 0 0 0 ( 906 ) 0 101 Total gains (losses) $ 455 $ ( 145 ) $ 177 $ ( 33 ) $ 149 $ ( 669 ) 68 Table of Contents Alphabet Inc. Offsetting of Derivatives The gross amounts of derivative instruments subject to master netting arrangements with various counterparties, and cash and non-cash collateral received and pledged under such agreements were as follows (in millions): Offsetting of Assets As of December 31, 2020 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 397 $ ( 32 ) $ 365 $ ( 295 ) (1) $ ( 16 ) $ 0 $ 54 As of December 31, 2021 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Assets Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Received Non-Cash Collateral Received Net Assets Exposed Derivatives $ 999 $ ( 38 ) $ 961 $ ( 434 ) (1) $ ( 394 ) $ ( 12 ) $ 121 (1) The balances as of December 31, 2020 and 2021 were related to derivative liabilities which are allowed to be net settled against derivative assets in accordance with our master netting agreements. Offsetting of Liabilities As of December 31, 2020 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 1,554 $ ( 32 ) $ 1,522 $ ( 295 ) (2) $ ( 1 ) $ ( 943 ) $ 283 As of December 31, 2021 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts of Recognized Liabilities Gross Amounts Offset in the Consolidated Balance Sheets Net Presented in the Consolidated Balance Sheets Financial Instruments Cash Collateral Pledged Non-Cash Collateral Pledged Net Liabilities Derivatives $ 619 $ ( 38 ) $ 581 $ ( 434 ) (2) $ ( 4 ) $ ( 110 ) $ 33 (2) The balances as of December 31, 2020 and 2021 were related to derivative assets which are allowed to be net settled against derivative liabilities in accordance with our master netting agreements. Note 4. Leases We have entered into operating lease agreements primarily for data centers, land and offices throughout the world with lease periods expiring between 2022 and 2063. Components of operating lease expense were as follows (in millions): Year Ended December 31, 2020 2021 Operating lease cost $ 2,267 $ 2,699 Variable lease cost 619 726 Total operating lease cost $ 2,886 $ 3,425 69 Table of Contents Alphabet Inc. Supplemental information related to operating leases was as follows (in millions): Year Ended December 31, 2020 2021 Cash payments for operating leases $ 2,004 $ 2,489 New operating lease assets obtained in exchange for operating lease liabilities $ 2,765 $ 2,951 As of December 31, 2021, our operating leases had a weighted average remaining lease term of 8 years and a weighted average discount rate of 2.3 %. Future lease payments under operating leases as of December 31, 2021 were as follows (in millions): 2022 $ 2,539 2023 2,527 2024 2,226 2025 1,815 2026 1,401 Thereafter 4,948 Total future lease payments 15,456 Less imputed interest ( 1,878 ) Total lease liability balance $ 13,578 As of December 31, 2021, we have entered into leases that have not yet commenced with short-term and long-term future lease payments of $ 606 million and $ 5.2 billion, excluding purchase options, that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2022 and 2026 with non-cancelable lease terms of 1 to 25 years. Note 5. Variable Interest Entities Consolidated VIEs We consolidate VIEs in which we hold a variable interest and are the primary beneficiary. The results of operations and financial position of these VIEs are included in our consolidated financial statements. For certain consolidated VIEs, their assets are not available to us and their creditors do not have recourse to us. As of December 31, 2020 and 2021, assets that can only be used to settle obligations of these VIEs were $ 5.7 billion and $ 6.0 billion, respectively, and the liabilities for which creditors only have recourse to the VIEs were $ 2.3 billion and $ 2.5 billion, respectively. Total noncontrolling interests (NCI), including redeemable noncontrolling interests (RNCI), in our consolidated subsidiaries was $ 3.9 billion and $ 4.3 billion as of December 31, 2020 and 2021, respectively. NCI and RNCI are included within additional paid-in capital. Net loss attributable to noncontrolling interests was not material for any period presented and is included within the "other" component of other income (expense), net. See Note 7 for further details on other income (expense), net. Waymo In June 2021, Waymo, a self-driving technology development company and a consolidated VIE, completed an investment round of $ 2.5 billion, the majority of which represented investment from Alphabet. The investments from external parties were accounted for as equity transactions and resulted in recognition of noncontrolling interests. Unconsolidated VIEs We have investments in VIEs in which we are not the primary beneficiary. These VIEs include private companies that are primarily early stage companies and certain renewable energy entities in which activities involve power generation using renewable sources. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly affect their economic performance. Therefore, we are not the primary beneficiary, and the results of operations and financial position of these VIEs are not included in our consolidated financial statements. We account for these investments as non-marketable equity securities or equity method investments. The maximum exposure of these unconsolidated VIEs is generally based on the current carrying value of the investments and any future funding commitments. We have determined that the single source of our exposure to these 70 Table of Contents Alphabet Inc. VIEs is our capital investments in them. The carrying value, and maximum exposure of these unconsolidated VIEs were $ 1.7 billion and $ 1.9 billion, respectively, as of December 31, 2020 and $ 2.7 billion and $ 2.9 billion, respectively, as of December 31, 2021 . Note 6. Debt Short-Term Debt We have a debt financing program of up to $ 10.0 billion through the issuance of commercial paper, which increased from $ 5.0 billion in September 2021. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2020 and 2021. Our short-term debt balance also includes the current portion of certain long-term debt. Long-Term Debt Total outstanding debt is summarized below (in millions, except percentages): Effective Interest Rate As of December 31, Maturity Coupon Rate 2020 2021 Debt 2011-2020 Notes Issuances 2024 - 2060 0.45 % - 3.38 % 0.57 % - 3.38 % $ 14,000 $ 13,000 Future finance lease payments, net (1) 1,201 2,086 Total debt 15,201 15,086 Unamortized discount and debt issuance costs ( 169 ) ( 156 ) Less: Current portion of Notes (2) ( 999 ) — Less: Current portion future finance lease payments, net (1)(2) ( 101 ) ( 113 ) Total long-term debt $ 13,932 $ 14,817 (1) Net of imputed interest. (2) Total current portion of long-term debt is included within other accrued expenses and current liabilities. See Note 7. The notes in the table above are comprised of fixed-rate senior unsecured obligations and generally rank equally with each other. We may redeem the notes at any time in whole or in part at specified redemption prices. The effective interest rates are based on proceeds received with interest payable semi-annually. The total estimated fair value of the outstanding notes, including the current portion, was approximately $ 14.0 billion and $ 12.4 billion as of December 31, 2020 and December 31, 2021, respectively. The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. As of December 31, 2021, the aggregate future principal payments for long-term debt, including finance lease liabilities, for each of the next five years and thereafter were as follows (in millions): 2022 $ 187 2023 146 2024 1,159 2025 1,162 2026 2,165 Thereafter 10,621 Total $ 15,440 Credit Facility As of December 31, 2021, we have $ 10.0 billion of revolving credit facilities. No amounts were outstanding under the credit facilities as of December 31, 2020 and 2021. 71 Table of Contents Alphabet Inc. In April 2021, we terminated the existin g $ 4.0 billion revolving credit facilities, which were scheduled to expire in July 2023, and entered into two new revolving credit facilities in the amounts of $ 4.0 billion and $ 6.0 billion , which will expire in April 2022 and April 2026, respectively. The interest rates for the new credit facilities are determined based on a formula using certain market rates, as well as our progress toward the achievement of certain sustainability goals. No amounts have been borrowed under the new credit facilities. Note 7. Supplemental Financial Statement Information Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2020 2021 Land and buildings $ 49,732 $ 58,881 Information technology assets 45,906 55,606 Construction in progress 23,111 23,171 Leasehold improvements 7,516 9,146 Furniture and fixtures 197 208 Property and equipment, gross 126,462 147,012 Less: accumulated depreciation ( 41,713 ) ( 49,414 ) Property and equipment, net $ 84,749 $ 97,599 Accrued expenses and other current liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2020 2021 European Commission fines (1) $ 10,409 $ 9,799 Payables to brokers for unsettled investment trades 754 397 Accrued customer liabilities 3,118 3,505 Accrued purchases of property and equipment 2,197 2,415 Current operating lease liabilities 1,694 2,189 Other accrued expenses and current liabilities 10,459 12,931 Accrued expenses and other current liabilities $ 28,631 $ 31,236 (1) Includes the effects of foreign exchange and interest. See Note 10 for further details. 72 Table of Contents Alphabet Inc. Accumulated Other Comprehensive Income (Loss) Components of AOCI, net of income tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2018 $ ( 1,884 ) $ ( 688 ) $ 266 $ ( 2,306 ) Cumulative effect of accounting change 0 0 ( 30 ) ( 30 ) Other comprehensive income (loss) before reclassifications ( 119 ) 1,611 36 1,528 Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 14 ) ( 14 ) Amounts reclassified from AOCI 0 ( 111 ) ( 299 ) ( 410 ) Other comprehensive income (loss) ( 119 ) 1,500 ( 277 ) 1,104 Balance as of December 31, 2019 ( 2,003 ) 812 ( 41 ) ( 1,232 ) Other comprehensive income (loss) before reclassifications 1,139 1,313 79 2,531 Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 37 ) ( 37 ) Amounts reclassified from AOCI 0 ( 513 ) ( 116 ) ( 629 ) Other comprehensive income (loss) 1,139 800 ( 74 ) 1,865 Balance as of December 31, 2020 ( 864 ) 1,612 ( 115 ) 633 Other comprehensive income (loss) before reclassifications ( 1,442 ) ( 1,312 ) 668 ( 2,086 ) Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 48 48 Amounts reclassified from AOCI 0 ( 64 ) ( 154 ) ( 218 ) Other comprehensive income (loss) ( 1,442 ) ( 1,376 ) 562 ( 2,256 ) Balance as of December 31, 2021 $ ( 2,306 ) $ 236 $ 447 $ ( 1,623 ) The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statements of Income Year Ended December 31, AOCI Components Location 2019 2020 2021 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ 149 $ 650 $ 82 Benefit (provision) for income taxes ( 38 ) ( 137 ) ( 18 ) Net of income tax 111 513 64 Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue 367 144 165 Interest rate contracts Other income (expense), net 6 6 6 Benefit (provision) for income taxes ( 74 ) ( 34 ) ( 17 ) Net of income tax 299 116 154 Total amount reclassified, net of income tax $ 410 $ 629 $ 218 73 Table of Contents Alphabet Inc. Other Income (Expense), Net Components of other income (expense), net, were as follows (in millions): Year Ended December 31, 2019 2020 2021 Interest income $ 2,427 $ 1,865 $ 1,499 Interest expense (1) ( 100 ) ( 135 ) ( 346 ) Foreign currency exchange gain (loss), net (2) 103 ( 344 ) ( 240 ) Gain (loss) on debt securities, net 149 725 ( 110 ) Gain (loss) on equity securities, net 2,649 5,592 12,380 Performance fees ( 326 ) ( 609 ) ( 1,908 ) Income (loss) and impairment from equity method investments, net 390 401 334 Other (3) 102 ( 637 ) 411 Other income (expense), net $ 5,394 $ 6,858 $ 12,020 (1) Interest expense is net of interest capitalized of $ 167 million, $ 218 million, and $ 163 million for the years ended December 31, 2019, 2020, and 2021, respectively. (2) Our foreign currency exchange gain (loss), net, is primarily related to the forward points for our foreign currency hedging contracts and foreign exchange transaction gains and losses from the conversion of the transaction currency to the functional currency, offset by the foreign currency hedging contracts' losses and gains. (3) During the year ended December 31, 2020, we entered into derivatives that hedged the changes in fair value of certain marketable equity securities, which resulted in losses of $ 902 million and gains of $ 92 million for the years ended December 31, 2020 and 2021, respectively. The offsetting recognized gains and losses on the marketable equity securities are reflected in Gain (loss) on equity securities, net. Note 8. Acquisitions Fitbit In January 2021, we closed the acquisition of Fitbit, a leading wearables brand for $ 2.1 billion. The addition of Fitbit to Google Services is expected to help spur innovation in wearable devices. The assets acquired and liabilities assumed were recorded at fair value. The purchase price excludes post acquisition compensation arrangements. The purchase price was attributed to $ 440 million cash acquired, $ 590 million of intangible assets, $ 1.2 billion of goodwill and $ 92 million of net liabilities assumed. Goodwill was recorded in the Google Services segment and primarily attributable to synergies expected to arise after the acquisition. Goodwill is not expected to be deductible for tax purposes. Other Acquisitions During the year ended December 31, 2021, we completed other acquisitions and purchases of intangible assets for total consideration of approximately $ 885 million, net of cash acquired, of which the total amount of goodwill expected to be deductible for tax purposes is approximately $ 118 million. Pro forma results of operations for these acquisitions have not been presented because they are not material to our consolidated results of operations, either individually or in the aggregate. 74 Table of Contents Alphabet Inc. Note 9. Goodwill and Other Intangible Assets Goodwill Changes in the carrying amount of goodwill for the years ended December 31, 2020 and 2021 were as follows (in millions): Google Google Services Google Cloud Other Bets Total Balance as of December 31, 2019 $ 19,921 $ 0 $ 0 $ 703 $ 20,624 Acquisitions 204 53 189 0 446 Foreign currency translation and other adjustments 46 56 5 ( 2 ) 105 Allocation in the fourth quarter of 2020 (1) ( 20,171 ) 18,408 1,763 0 0 Balance as of December 31, 2020 0 18,517 1,957 701 21,175 Acquisitions 0 1,325 382 103 1,810 Foreign currency translation and other adjustments 0 ( 16 ) ( 2 ) ( 11 ) ( 29 ) Balance as of December 31, 2021 $ 0 $ 19,826 $ 2,337 $ 793 $ 22,956 (1) Represents reallocation of goodwill as a result of our change in segments in the fourth quarter of 2020. See Note 15 for further details. Other Intangible Assets Information regarding purchased intangible assets was as follows (in millions): As of December 31, 2020 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Patents and developed technology $ 4,639 $ 3,649 $ 990 Customer relationships 266 49 217 Trade names and other 624 461 163 Total definite-lived intangible assets 5,529 4,159 1,370 Indefinite-lived intangible assets 75 0 75 Total intangible assets $ 5,604 $ 4,159 $ 1,445 As of December 31, 2021 Gross Carrying Amount Accumulated Amortization Net Carrying Value Patents and developed technology $ 4,786 $ 4,112 $ 674 Customer relationships 506 140 366 Trade names and other 534 295 239 Total definite-lived intangible assets 5,826 4,547 1,279 Indefinite-lived intangible assets 138 0 138 Total intangible assets $ 5,964 $ 4,547 $ 1,417 Patents and developed technology, customer relationships, and trade names and other have weighted-average remaining useful lives of 0.7 years, 3.5 years, and 4.5 years, respectively. For all intangible assets acquired and purchased during the year ended December 31, 2021, patents and developed technology have a weighted-average useful life of 4.1 years, customer relationships have a weighted-average useful life of 4.3 years, and trade names and other have a weighted-average useful life of 9.9 years. Amortization expense relating to purchased intangible assets was $ 795 million, $ 774 million, and $ 875 million for the years ended December 31, 2019, 2020, and 2021, respectively. 75 Table of Contents Alphabet Inc. As of December 31, 2021, expected amortization expense relating to purchased intangible assets for each of the next five years and thereafter was as follows (in millions): 2022 $ 537 2023 255 2024 226 2025 98 2026 61 Thereafter 102 $ 1,279 Note 10. Contingencies Indemnifications In the normal course of business, including to facilitate transactions in our services and products and corporate activities, we indemnify certain parties, including advertisers, Google Network partners, customers of Google Cloud offerings, lessors and service providers with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, we have a limited history of prior indemnification claims, and the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2021, we did not have any material indemnification claims that were probable or reasonably possible. Legal Matters Antitrust Investigations On November 30, 2010, the EC's Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On June 27, 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a € 2.4 billion ($ 2.7 billion as of June 27, 2017) fine. On September 11, 2017, we appealed the EC decision to the General Court, and on September 27, 2017, we implemented product changes to bring shopping ads into compliance with the EC's decision. We recognized a charge of $ 2.7 billion for the fine in the second quarter of 2017. On November 10, 2021, the General Court rejected our appeal, and we subsequently filed an appeal with the European Court of Justice on January 20, 2022. On July 18, 2018, the EC announced its decision that certain provisions in Google’s Android-related distribution agreements infringed European competition law. The EC decision imposed a € 4.3 billion ($ 5.1 billion as of June 30, 2018) fine and directed the termination of the conduct at issue. On October 9, 2018, we appealed the EC decision. On October 29, 2018, we implemented changes to certain of our Android distribution practices. We recognized a charge of $ 5.1 billion for the fine in the second quarter of 2018. On March 20, 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a fine of € 1.5 billion ($ 1.7 billion as of March 20, 2019) and directed actions related to AdSense for Search partners' agreements, which we implemented prior to the decision. On June 4, 2019, we appealed the EC decision. We recognized a charge of $ 1.7 billion for the fine in the first quarter of 2019. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. 76 Table of Contents Alphabet Inc. From time to time we are subject to formal and informal inquiries and investigations on competition matters by regulatory authorities in the U.S., Europe, and other jurisdictions. In August 2019, we began receiving civil investigative demands from the U.S. Department of Justice (DOJ) requesting information and documents relating to our prior antitrust investigations and certain aspects of our business. The DOJ and a number of state Attorneys General filed a lawsuit on October 20, 2020 alleging that Google violated U.S. antitrust laws relating to Search and Search advertising. Separately, on December 16, 2020, a number of state Attorneys General filed an antitrust complaint against Google in the U.S. District Court for the Eastern District of Texas, alleging that Google violated U.S. antitrust laws as well as state deceptive trade laws relating to its advertising technology. On June 22, 2021, the EC opened a formal investigation into Google's advertising technology business practices. On July 7, 2021, a number of state Attorneys General filed an antitrust complaint against us in the U.S. District Court for the Northern District of California, alleging that Google’s operation of Android and Google Play violated U.S. antitrust laws and state antitrust and consumer protection laws. We believe these complaints are without merit and will defend ourselves vigorously. The DOJ and state Attorneys General continue their investigations into certain aspects of our business. We continue to cooperate with federal and state regulators in the U.S., the EC and other regulators around the world. Patent and Intellectual Property Claims We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe others' intellectual property rights. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services. As a result, we may have to change our business practices and develop non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss in an ITC action can result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them against certain intellectual property infringement claims, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. In addition, our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. In 2010, Oracle America, Inc. (Oracle) brought a copyright lawsuit against Google in the Northern District of California, alleging that Google's Android operating system infringes Oracle's copyrights related to certain Java application programming interfaces (Java APIs). After trial, final judgment was entered by the district court in favor of Google on June 8, 2016, and the court decided post-trial motions in favor of Google. Oracle appealed and on March 27, 2018, the Federal Circuit Court of Appeals reversed and remanded the case for a trial on damages. On May 29, 2018, we filed a petition for a rehearing at the Federal Circuit, and on August 28, 2018, the Federal Circuit denied the petition. On January 24, 2019, we filed a petition to the U.S. Supreme Court to review the case. On April 29, 2019, the Supreme Court requested the views of the Solicitor General regarding our petition. On September 27, 2019, the Solicitor General recommended denying our petition, and we provided our response on October 16, 2019. On November 15, 2019, the Supreme Court granted our petition and made a decision to review the case. The Supreme Court heard oral arguments in our case on October 7, 2020. On April 5, 2021, the Supreme Court reversed the Federal Circuit's ruling and found that Google’s use of the Java APIs was a fair use as a matter of law. The Supreme Court remanded the case to the Federal Circuit for further proceedings in conformity with the Supreme Court opinion. On May 14, 2021, the Federal Circuit entered an order affirming the district court’s final judgment in favor of Google. On June 21, 2021, the Federal Circuit issued a mandate returning the case to the district court, and the case is now concluded. Other We are also regularly subject to claims, suits, regulatory and government investigations, other proceedings, and consent decrees involving competition, intellectual property, privacy, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. For example, we have a number of privacy investigations and suits ongoing in multiple jurisdictions. Such claims, suits, regulatory and government investigations, other proceedings, and consent decrees could result in substantial fines and penalties, injunctive relief, ongoing auditing and monitoring obligations, changes to our products and services, alterations to our business models and operations, and collateral related civil litigation or other adverse consequences, all of which could harm our business, reputation, financial condition, and operating results. 77 Table of Contents Alphabet Inc. Certain of these outstanding matters include speculative, substantial or indeterminate monetary amounts. We record a liability when we believe that it is probable that a loss has been incurred, and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We evaluate developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Significant judgment is required to determine both the likelihood of there being and the estimated amount of a loss related to such matters. With respect to our outstanding matters, based on our current knowledge, we believe that the amount or range of reasonably possible loss will not, either individually or in aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, the outcome of such matters is inherently unpredictable and subject to significant uncertainties. We expense legal fees in the period in which they are incurred. Non-Income Taxes We are under audit by various domestic and foreign tax authorities with regards to non-income tax matters. The subject matter of non-income tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions and the tax treatment of certain employee benefits. We accrue non-income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. For information regarding income tax contingencies, see Note 14. Note 11. Stockholders' Equity Preferred Stock Our Board of Directors has authorized 100 million shares of preferred stock, $ 0.001 par value, issuable in series. As of December 31, 2020 and 2021, no shares were issued or outstanding. Class A and Class B Common Stock and Class C Capital Stock Our Board of Directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Share Repurchases In April 2021, the Board of Directors of Alphabet authorized the company to repurchase up to $ 50.0 billion of its Class C stock. In July 2021, the Alphabet board approved an amendment to the April 2021 authorization, permitting the company to repurchase both Class A and Class C shares in a manner deemed in the best interest of the company and its stockholders, taking into account the economic cost and prevailing market conditions, including the relative trading prices and volumes of the Class A and Class C shares. As of December 31, 2021, $ 17.4 billion remains available for Class A and Class C share repurchases under the amended authorization. In accordance with the authorizations of the Board of Directors of Alphabet, during the years ended December 31, 2020 and 2021, we repurchased and subsequently retired 21.5 million and 20.3 million aggregate shares for $ 31.1 billion and $ 50.3 billion, respectively. Of the aggregate amount repurchased and subsequently retired during 2021, 1.2 million shares were Class A stock for $ 3.4 billion. Stock Split Effected in Form of Stock Dividend (“Stock Split”) On February 1, 2022, the Company announced that the Board of Directors had approved and declared a 20-for-one stock split in the form of a one-time special stock dividend on each share of the Company’s Class A, Class B, and Class C stock. The Stock Split is subject to stockholder approval of an amendment to the Company’s Amended and Restated Certificate of Incorporation to increase the number of authorized shares of Class A, Class B, and Class C stock to accommodate the Stock Split. 78 Table of Contents Alphabet Inc. If approval is obtained, each of the Company’s stockholders of record at the close of business on July 1, 2022 (the “Record Date”), will receive, after the close of business on July 15, 2022, a dividend of 19 additional shares of the same class of stock for every share held by such stockholder as of the Record Date. Note 12. Net Income Per Share We compute net income per share of Class A, Class B, and Class C stock using the two-class method. Basic net income per share is computed using the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of restricted stock units and other contingently issuable shares. The dilutive effect of outstanding restricted stock units and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A stock assumes the conversion of Class B stock, while the diluted net income per share of Class B stock does not assume the conversion of those shares. The rights, including the liquidation and dividend rights, of the holders of our Class A, Class B, and Class C stock are identical, except with respect to voting. Furthermore, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our Board of Directors from declaring or paying unequal per share dividends on our Class A, Class B, and Class C stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our Board of Directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A, Class B, and Class C stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. In the years ended December 31, 2019, 2020 and 2021, the net income per share amounts are the same for Class A, Class B, and Class C stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. The following tables set forth the computation of basic and diluted net income per share of Class A, Class B, and Class C stock (in millions, except share amounts which are reflected in thousands and per share amounts): Year Ended December 31, 2019 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 14,846 $ 2,307 $ 17,190 Denominator Number of shares used in per share computation 299,402 46,527 346,667 Basic net income per share $ 49.59 $ 49.59 $ 49.59 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 14,846 $ 2,307 $ 17,190 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,307 0 0 Reallocation of undistributed earnings ( 126 ) ( 20 ) 126 Allocation of undistributed earnings $ 17,027 $ 2,287 $ 17,316 Denominator Number of shares used in basic computation 299,402 46,527 346,667 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A shares outstanding 46,527 0 0 Restricted stock units and other contingently issuable shares 413 0 5,547 Number of shares used in per share computation 346,342 46,527 352,214 Diluted net income per share $ 49.16 $ 49.16 $ 49.16 79 Table of Contents Alphabet Inc. Year Ended December 31, 2020 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 17,733 $ 2,732 $ 19,804 Denominator Number of shares used in per share computation 299,815 46,182 334,819 Basic net income per share $ 59.15 $ 59.15 $ 59.15 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 17,733 $ 2,732 $ 19,804 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,732 0 0 Reallocation of undistributed earnings ( 180 ) ( 25 ) 180 Allocation of undistributed earnings $ 20,285 $ 2,707 $ 19,984 Denominator Number of shares used in basic computation 299,815 46,182 334,819 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A shares outstanding 46,182 0 0 Restricted stock units and other contingently issuable shares 87 0 6,125 Number of shares used in per share computation 346,084 46,182 340,944 Diluted net income per share $ 58.61 $ 58.61 $ 58.61 Year Ended December 31, 2021 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 34,200 $ 5,174 $ 36,659 Denominator Number of shares used in per share computation 300,310 45,430 321,910 Basic net income per share $ 113.88 $ 113.88 $ 113.88 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 34,200 $ 5,174 $ 36,659 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 5,174 0 0 Reallocation of undistributed earnings ( 581 ) ( 77 ) 581 Allocation of undistributed earnings $ 38,793 $ 5,097 $ 37,240 Denominator Number of shares used in basic computation 300,310 45,430 321,910 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A shares outstanding 45,430 0 0 Restricted stock units and other contingently issuable shares 15 0 10,009 Number of shares used in per share computation 345,755 45,430 331,919 Diluted net income per share $ 112.20 $ 112.20 $ 112.20 80 Table of Contents Alphabet Inc. Note 13. Compensation Plans Stock Plans Our stock plans include the Alphabet Amended and Restated 2012 Stock Plan, the Alphabet 2021 Stock Plan and Other Bet stock-based plans. Under our stock plans, RSUs and other types of awards may be granted. An RSU award is an agreement to issue shares of our Class C stock at the time the award vests. RSUs generally vest over four years contingent upon employment on the vesting date. As of December 31, 2021, there were 37,479,707 shares of Class C stock reserved for future issuance under the Alphabet 2021 Stock Plan. Stock-Based Compensation For the years ended December 31, 2019, 2020, and 2021, total stock-based compensation expense was $ 11.7 billion, $ 13.4 billion, and $ 15.7 billion, including amounts associated with awards we expect to settle in Alphabet stock of $ 10.8 billion, $ 12.8 billion, and $ 15.0 billion, respectively. For the years ended December 31, 2019, 2020, and 2021, we recognized tax benefits on total stock-based compensation expense, which are reflected in the provision for income taxes in the Consolidated Statements of Income, of $ 1.8 billion, $ 2.7 billion, and $ 3.1 billion, respectively. For the years ended December 31, 2019, 2020, and 2021, tax benefit realized related to awards vested or exercised during the period was $ 2.2 billion, $ 3.6 billion, and $ 5.9 billion, respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the R&D tax credit. Stock-Based Award Activities The following table summarizes the activities for unvested Alphabet RSUs for the year ended December 31, 2021: Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2020 19,288,793 $ 1,262.13 Granted 10,582,700 $ 1,949.16 Vested ( 11,209,486 ) $ 1,345.98 Forfeited/canceled ( 1,767,294 ) $ 1,425.48 Unvested as of December 31, 2021 16,894,713 $ 1,626.13 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2019 and 2020 was $ 1,092.36 and $ 1,407.97 , respectively. Total fair value of RSUs, as of their respective vesting dates, during the years ended December 31, 2019, 2020, and 2021 were $ 15.2 billion, $ 17.8 billion, and $ 28.8 billion, respectively. As of December 31, 2021, there was $ 25.8 billion of unrecognized compensation cost related to unvested employee RSUs. This amount is expected to be recognized over a weighted-average period of 2.5 years. 401(k) Plans We have two 401(k) Savings Plans that qualify as deferred salary arrangements under Section 401(k) of the Internal Revenue Code. Under these 401(k) Plans, matching contributions are based upon the amount of the employees’ contributions subject to certain limitations. We recognized expense of approximately $ 724 million, $ 855 million, and $ 916 million for the years ended December 31, 2019, 2020, and 2021, respectively. Note 14. Income Taxes Income from continuing operations before income taxes consisted of the following (in millions): Year Ended December 31, 2019 2020 2021 Domestic operations $ 16,426 $ 37,576 $ 77,016 Foreign operations 23,199 10,506 13,718 Total $ 39,625 $ 48,082 $ 90,734 81 Table of Contents Alphabet Inc. Provision for income taxes consisted of the following (in millions): Year Ended December 31, 2019 2020 2021 Current: Federal and state $ 2,424 $ 4,789 $ 10,126 Foreign 2,713 1,687 2,692 Total 5,137 6,476 12,818 Deferred: Federal and state 286 1,552 2,018 Foreign ( 141 ) ( 215 ) ( 135 ) Total 145 1,337 1,883 Provision for income taxes $ 5,282 $ 7,813 $ 14,701 The reconciliation of federal statutory income tax rate to our effective income tax rate was as follows: Year Ended December 31, 2019 2020 2021 U.S. federal statutory tax rate 21.0 % 21.0 % 21.0 % Foreign income taxed at different rates ( 4.9 ) ( 0.3 ) 0.2 Foreign-derived intangible income deduction ( 0.7 ) ( 3.0 ) ( 2.5 ) Stock-based compensation expense ( 0.7 ) ( 1.7 ) ( 2.5 ) Federal research credit ( 2.5 ) ( 2.3 ) ( 1.6 ) Deferred tax asset valuation allowance 0.0 1.4 0.6 State and local income taxes 1.1 1.1 1.0 Effective tax rate 13.3 % 16.2 % 16.2 % Our effective tax rate for 2019 was affected significantly by earnings realized in foreign jurisdictions with statutory tax rates lower than the federal statutory tax rate because substantially all of the income from foreign operations was earned by an Irish subsidiary. As of December 31, 2019, we have simplified our corporate legal entity structure and now license intellectual property from the U.S. that was previously licensed from Bermuda resulting in an increase in the portion of our income earned in the U.S. On July 27, 2015, the U.S. Tax Court, in an opinion in Altera Corp. v. Commissioner, invalidated the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. The U.S. Tax Court issued the final decision on December 28, 2015. As a result of that decision, we recorded a tax benefit related to the anticipated reimbursement of cost share payment for previously shared stock-based compensation costs. On June 7, 2019, the U.S. Court of Appeals for the Ninth Circuit overturned the 2015 Tax Court decision in Altera Corp. v. Commissioner, and upheld the portion of the Treasury regulations issued under IRC Section 482 requiring related-party participants in a cost sharing arrangement to share stock-based compensation costs. As a result of the Ninth Circuit court decision, our cumulative net tax benefit of $ 418 million related to previously shared stock-based compensation costs was reversed in the year ended December 31, 2019. In 2020, there was an increase in valuation allowance for net deferred tax assets that are not likely to be realized relating to certain of our Other Bets. 82 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities were as follows (in millions): As of December 31, 2020 2021 Deferred tax assets: Accrued employee benefits $ 580 $ 549 Accruals and reserves not currently deductible 1,049 1,816 Tax credits 3,723 5,179 Net operating losses 1,085 1,790 Operating leases 2,620 2,503 Intangible assets 1,525 2,034 Other 981 925 Total deferred tax assets 11,563 14,796 Valuation allowance ( 4,823 ) ( 7,129 ) Total deferred tax assets net of valuation allowance 6,740 7,667 Deferred tax liabilities: Property and equipment, net ( 3,382 ) ( 5,237 ) Net investment gains ( 1,901 ) ( 3,229 ) Operating leases ( 2,354 ) ( 2,228 ) Other ( 1,580 ) ( 946 ) Total deferred tax liabilities ( 9,217 ) ( 11,640 ) Net deferred tax assets (liabilities) $ ( 2,477 ) $ ( 3,973 ) As of December 31, 2021, our federal, state, and foreign net operating loss carryforwards for income tax purposes were approximately $ 5.6 billion, $ 4.6 billion, and $ 1.7 billion respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2023, foreign net operating loss carryforwards will begin to expire in 2025 and the state net operating loss carryforwards will begin to expire in 2028. It is more likely than not that certain net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. As of December 31, 2021, our California R&D carryforwards for income tax purposes were approximately $ 5.0 billion that can be carried over indefinitely. We believe the state tax credit is not likely to be realized. As of December 31, 2021, our investment tax credit carryforwards for state income tax purposes were approximately $ 700 million and will begin to expire in 2025. We use the flow-through method of accounting for investment tax credits. We believe this tax credit is not likely to be realized. As of December 31, 2021, we maintained a valuation allowance with respect to California deferred tax assets, certain federal net operating losses, certain state tax credits, net deferred tax assets relating to certain Other Bets, and certain foreign net operating losses that we believe are not likely to be realized. We continue to reassess the remaining valuation allowance quarterly, and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. 83 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits (in millions): Year Ended December 31, 2019 2020 2021 Beginning gross unrecognized tax benefits $ 4,652 $ 3,377 $ 3,837 Increases related to prior year tax positions 938 372 529 Decreases related to prior year tax positions ( 143 ) ( 557 ) ( 263 ) Decreases related to settlement with tax authorities ( 2,886 ) ( 45 ) ( 329 ) Increases related to current year tax positions 816 690 1,384 Ending gross unrecognized tax benefits $ 3,377 $ 3,837 $ 5,158 The total amount of gross unrecognized tax benefits was $ 3.4 billion, $ 3.8 billion, and $ 5.2 billion as of December 31, 2019, 2020, and 2021, respectively, of which $ 2.3 billion, $ 2.6 billion, and $ 3.7 billion, if recognized, would affect our effective tax rate, respectively. As of December 31, 2020 and 2021, we accrued $ 222 million and $ 270 million in interest and penalties in provision for income taxes, respectively. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. Our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS is currently examining our 2016 through 2018 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. The tax years 2014 through 2020 remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the effect, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolution occurs. Although the timing of resolution, settlement, and closure of audits is not certain, it is reasonably possible that our unrecognized tax benefits from certain U.S. federal, state and non U.S. tax positions could decrease by approximately $ 2.0 billion in the next 12 months. Positions that may be resolved include various U.S. and non-U.S. matters. Note 15. Information about Segments and Geographic Areas We report our segment results as Google Services, Google Cloud, and Other Bets: • Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps and in-app purchases, digital content products, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV. • Google Cloud includes Google’s infrastructure and platform services, collaboration tools, and other services for enterprise customers. Google Cloud generates revenues from fees received for Google Cloud Platform services, Google Workspace collaboration tools and other enterprise services. • Other Bets is a combination of multiple operating segments that are not individually material. Revenues from Other Bets are generated primarily from the sale of health technology and internet services. Revenues, certain costs, such as costs associated with content and traffic acquisition, certain engineering activities, and hardware, as well as certain operating expenses are directly attributable to our segments. Due to the integrated nature of Alphabet, other costs and expenses, such as technical infrastructure and office facilities, are managed centrally at a consolidated level. The associated costs, including depreciation and impairment, are allocated to operating segments as a service cost generally based on usage or headcount. 84 Table of Contents Alphabet Inc. Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including certain fines and settlements, as well as costs associated with certain shared R&D activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs. Our operating segments are not evaluated using asset information. Information about segments during the periods presented were as follows (in millions). For comparative purposes, amounts in prior periods have been recast: Year Ended December 31, 2019 2020 2021 Revenues: Google Services $ 151,825 $ 168,635 $ 237,529 Google Cloud 8,918 13,059 19,206 Other Bets 659 657 753 Hedging gains (losses) 455 176 149 Total revenues $ 161,857 $ 182,527 $ 257,637 Operating income (loss): Google Services $ 48,999 $ 54,606 $ 91,855 Google Cloud ( 4,645 ) ( 5,607 ) ( 3,099 ) Other Bets ( 4,824 ) ( 4,476 ) ( 5,281 ) Corporate costs, unallocated (1) ( 5,299 ) ( 3,299 ) ( 4,761 ) Total income from operations $ 34,231 $ 41,224 $ 78,714 (1) Corporate costs, unallocated includes a fine and legal settlement totaling $ 2.3 billion for the year ended December 31, 2019. For revenues by geography, see Note 2. The following table presents long-lived assets by geographic area, which includes property and equipment, net and operating lease assets (in millions): As of December 31, 2020 2021 Long-lived assets: United States $ 69,315 $ 80,207 International 27,645 30,351 Total long-lived assets $ 96,960 $ 110,558 85 Table of Contents Alphabet Inc. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2021, our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting We rely extensively on information systems to manage our business and summarize and report operating results. In 2019, we began a multi-year implementation of a new global ERP system, which will replace much of our existing core financial systems. The ERP system is designed to accurately maintain our financial records, enhance the flow of financial information, improve data management and provide timely information to our management team. The implementation is expected to continue in phases over the next few years. We completed the implementation of certain of our subledgers, which included changes to our processes, procedures and internal controls over financial reporting during the second quarter of 2021. There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. However, as the phased implementation of the new ERP system continues, we will change our processes and procedures, which in turn, could result in changes to our internal control over financial reporting. As such changes occur, we will evaluate quarterly whether such changes materially affect our internal control over financial reporting. As a result of COVID-19, our global workforce continued to operate primarily in a work from home environment for the quarter ended December 31, 2021. While we continue to evolve our work model in response to the uneven effects of the ongoing pandemic around the world, we believe that our internal controls over financial reporting continue to be eff ective. We have continued to re-evaluate and refine our financial reporting process to provide reasonable assurance that we could report our financial results accurately and in a timely manner. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2021. Management reviewed the results of its assessment with our Audit and Compliance Committee. The effectiveness of our internal control over financial reporting as of December 31, 2021 has been audited by Ernst & Young LLP , an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION None. 86 Table of Contents Alphabet Inc. ITEM 9C.     DISCLOSURE REGARDING FOREIGN JURISDICTIONS THAT PREVENT INSPECTIONS Not applicable. 87 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for the 2022 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2021 (2022 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Delinquent Section 16(a) Reports” in the 2022 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2022 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the 2022 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2022 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2022 Proxy Statement and is incorporated herein by reference. 88 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Independent Registered Public Accounting Firm 46 Financial Statements: Consolidated Balance Sheets 49 Consolidated Statements of Income 50 Consolidated Statements of Comprehensive Income 51 Consolidated Statements of Stockholders’ Equity 52 Consolidated Statements of Cash Flows 53 Notes to Consolidated Financial Statements 54 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for credit losses and sales credits for the years ended December 31, 2019, 2020 and 2021 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year Year ended December 31, 2019 $ 729 $ 1,481 $ ( 1,457 ) $ 753 Year ended December 31, 2020 $ 753 $ 2,013 $ ( 1,422 ) $ 1,344 Year ended December 31, 2021 $ 1,344 $ 2,092 $ ( 2,047 ) $ 1,389 Note: Additions to the allowance for credit losses are charged to expense. Additions to the allowance for sales credits are charged against revenues. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant, dated October 2, 2015 Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.02 Amended and Restated Bylaws of the Registrant, dated October 21, 2020 Current Report on Form 8-K/A (File No. 001-37580) October 27, 2020 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 * Joinder Agreement, dated December 31, 2021, among the Registrant, Sergey Brin and certain of his affiliates 89 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 4.07 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.09 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.10 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.11 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.1 1 ) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 4.14 Form of Global Note representing the Registrant’s 0.450% notes due 2025 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.15 Form of Global Note representing the Registrant’s 0.800% notes due 2027 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.16 Form of Global Note representing the Registrant’s 1.100% notes due 2030 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.17 Form of Global Note representing the Registrant’s 1.900% notes due 2040 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.18 Form of Global Note representing the Registrant’s 2.050% notes due 2050 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.19 Form of Global Note representing the Registrant’s 2.250% notes due 2060 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.20 * Description of Registrant’s Securities 10.01 u Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.03 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.04 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.05.1 u Google Inc. 2004 Stock Plan - Form of Google Stock Option Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.2 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.05.3 u Google Inc. 2004 Stock Plan - Amendment to Stock Option Agreements Registration Statement on Form S-3 (File No. 333-142243) April 20, 2007 10.06 u Alphabet Inc. Amended and Restated 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 5, 2020 90 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.06.1 u Alphabet Inc. Amended and Restated 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 001-37580) February 4, 2020 10.06.2 u Alphabet Inc. Amended and Restated 2012 Stock Plan - Performance Stock Unit Agreement Annual Report on Form 10-K (File No. 001-37580) February 4, 2020 10.07 u Alphabet Inc. 2021 Stock Plan Current Report on Form 8-K (file No. 001-37580) June 4, 2021 10.07.1 u Alphabet Inc. 2021 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Quarterly Report on Form 10-Q (file No. 001-37580) July 28, 2021 10.07.2 u * Alphabet Inc. 2021 Stock Plan - Form of Alphabet 2022 Non-CEO Performance Stock Unit Agreement 10.08 u * Alphabet Inc. Company Bonus Plan 14.01 Code of Conduct of the Registrant as amended on September 21, 2017 Annual Report on Form 10-K (File No. 001-37580) February 6, 2018 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101.INS * Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document 101.SCH * Inline XBRL Taxonomy Extension Schema Document 101.CAL * Inline XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF * Inline XBRL Taxonomy Extension Definition Linkbase Document 101.LAB * Inline XBRL Taxonomy Extension Label Linkbase Document 101.PRE * Inline XBRL Taxonomy Extension Presentation Linkbase Document 104 Cover Page Interactive Data File (embedded within the Inline XBRL document and contained in Exhibit 101) 91 Table of Contents Alphabet Inc. _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. ITEM 16. FORM 10-K SUMMARY None. 92 Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 1, 2022 ALPHABET INC. By: / S /    S UNDAR P ICHAI Sundar Pichai Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Sundar Pichai and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. 93 Table of Contents Alphabet Inc. Signature Title Date / S / S UNDAR P ICHAI Chief Executive Officer and Director (Principal Executive Officer) February 1, 2022 Sundar Pichai / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 1, 2022 Ruth M. Porat / S /    A MIE T HUENER O'T OOLE Vice President and Chief Accounting Officer (Principal Accounting Officer) February 1, 2022 Amie Thuener O'Toole / S /    F RANCES H. A RNOLD Director February 1, 2022 Frances H. Arnold / S /    S ERGEY B RIN Co-Founder and Director February 1, 2022 Sergey Brin / S /    L. J OHN D OERR Director February 1, 2022 L. John Doerr / S /    R OGER W. F ERGUSON, J R . Director February 1, 2022 Roger W. Ferguson, Jr. / S /    J OHN L. H ENNESSY Director, Chair February 1, 2022 John L. Hennessy / S /    A NN M ATHER Director February 1, 2022 Ann Mather / S /    A LAN R . M ULALLY Director February 1, 2022 Alan R. Mulally / S /    L ARRY P AGE Co-Founder and Director February 1, 2022 Larry Page / S /    K. R AM S HRIRAM Director February 1, 2022 K. Ram Shriram / S /    Robin L. Washington Director February 1, 2022 Robin L. 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Commission file number: 001-37580 ___________________________________________ Alphabet Inc. (Exact name of registrant as specified in its charter) ___________________________________________ Delaware 61-1767919 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 1600 Amphitheatre Parkway Mountain View , CA 94043 (Address of principal executive offices, including zip code) ( 650 ) 253-0000 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol(s) Name of each exchange on which registered Class A Common Stock, $0.001 par value GOOGL Nasdaq Stock Market LLC (Nasdaq Global Select Market) Class C Capital Stock, $0.001 par value GOOG Nasdaq Stock Market LLC (Nasdaq Global Select Market) Securities registered pursuant to Section 12(g) of the Act: Title of each class None ___________________________________________ Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management's assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C.7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ If securities are registered pursuant to Section 12(b) of the Act, indicate by check mark whether the financial statements of the registrant included in the filing reflect the correction of an error to previously issued financial statements. ☐ Indicate by check mark whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant's executive officers during the relevant recovery period pursuant to §240.10D-1(b). ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of June 30, 2022 , the aggregate market value of shares held by non-affiliates of the registrant (based upon the closing sale prices of such shares on the Nasdaq Global Select Market on June 30, 2022 ) was approximately $ 1,256.1 billion . For purposes of calculating the aggregate market value of shares held by non-affiliates, we have assumed that all outstanding shares are held by non-affiliates, except for shares held by each of our executive officers, directors, and 5% or greater stockholders. In the case of 5% or greater stockholders, we have not deemed such stockholders to be affiliates unless there are facts and circumstances which would indicate that such stockholders exercise any control over our company, or unless they hold 10% or more of our outstanding common stock. These assumptions should not be deemed to constitute an admission that all executive officers, directors, and 5% or greater stockholders are, in fact, affiliates of our company, or that there are not other persons who may be deemed to be affiliates of our company. Further information concerning shareholdings of our officers, directors, and principal stockholders is included or incorporated by reference in Part III, Item 12 of this Annual Report on Form 10-K. As of January 26, 2023 , there were 5,956 million shares of Alphabet’s Class A stock outstanding, 883 million shares of Alphabet’s Class B stock outstanding, and 5,968 million shares of the Alphabet’s Class C stock outstanding. ___________________________________________ DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant’s Proxy Statement for the 2023 Annual Meeting of Stockholders are incorporated herein by reference in Part III of this Annual Report on Form 10-K to the extent stated herein. Such proxy statement will be filed with the Securities and Exchange Commission within 120 days of the registrant’s fiscal year ended December 31, 2022. Table of Contents Alphabet Inc. Alphabet Inc. Form 10-K For the Fiscal Year Ended December 31, 2022 TABLE OF CONTENTS Page Note About Forward-Looking Statements 3 PART I Item 1. Business 4 Item 1A. Risk Factors 9 Item 1B. Unresolved Staff Comments 22 Item 2. Properties 23 Item 3. Legal Proceedings 23 Item 4. Mine Safety Disclosures 23 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters , and Issuer Purchases of Equity Securities 23 Item 6. [Reserved] 25 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 26 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 40 Item 8. Financial Statements and Supplementary Data 43 Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure 84 Item 9A. Controls and Procedures 84 Item 9B. Other Information 84 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 84 PART III Item 10. Directors, Executive Officers , and Corporate Governance 85 Item 11. Executive Compensation 85 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 85 Item 13. Certain Relationships and Related Transactions, and Director Independence 85 Item 14. Principal Accountant Fees and Services 85 PART IV Item 15. Exhibits, Financial Statement Schedules 86 Item 16. Form 10-K Summary 89 Signatures 2 Table of Contents Alphabet Inc. Note About Forward-Looking Statements This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include, among other things, statements regarding: • the growth of our business and revenues and our expectations about the factors that influence our success and trends in our business; • fluctuations in our revenues and margins and various factors contributing to such fluctuations; • our expectation that the continuing shift from an offline to online world will continue to benefit our business; • our expectation that the portion of our revenues that we derive from non-advertising revenues will continue to increase and may affect our margins; • our expectation that our traffic acquisition costs (TAC) and the associated TAC rate will fluctuate, which could affect our overall margins; • our expectation that our monetization trends will fluctuate, which could affect our revenues and margins; • fluctuations in our revenues, as well as the change in paid clicks and cost-per-click and the change in impressions and cost-per-impression, and various factors contributing to such fluctuations; • our expectation that we will continue to periodically review, refine, and update our methodologies for monitoring, gathering, and counting the number of paid clicks and impressions; • our expectation that our results will be affected by our performance in international markets as users in developing economies increasingly come online; • our expectation that our foreign exchange risk management program will not fully offset our net exposure to fluctuations in foreign currency exchange rates; • the expected variability of gains and losses related to hedging activities under our foreign exchange risk management program; • the amount and timing of revenue recognition from customer contracts with commitments for performance obligations, including our estimate of the remaining amount of commitments and when we expect to recognize revenue; • fluctuations in our capital expenditures; • our plans to continue to invest in new businesses, products, services and technologies, systems, land and buildings for data centers, and infrastructure, as well as to continue to invest in acquisitions and strategic investments; • our pace of hiring and our plans to provide competitive compensation programs; • our expectation that our cost of revenues, research and development (R&D) expenses, sales and marketing expenses, and general and administrative expenses may increase in amount and/or may increase as a percentage of revenues and may be affected by a number of factors; • estimates of our future compensation expenses; • our expectation that our other income (expense), net (OI&E), will fluctuate in the future, as it is largely driven by market dynamics; • fluctuations in our effective tax rate; • seasonal fluctuations in internet usage and advertiser expenditures, underlying business trends such as traditional retail seasonality, which are likely to cause fluctuations in our quarterly results; • the sufficiency of our sources of funding; • our potential exposure in connection with new and pending investigations, proceedings, and other contingencies, including the possibility that certain legal proceedings to which we are a party could harm our business, financial condition, and operating results; • our expectation that we will continue to face heightened regulatory scrutiny, and the sufficiency and timing of our proposed remedies in response to decisions from the European Commission (EC) and other regulators and governmental entities; 3 Table of Contents Alphabet Inc. • the expected timing, amount, and effect of Alphabet Inc.'s share repurchases; • our long-term sustainability and diversity goals; • the unpredictability of the ongoing broader economic effects resulting from the war in Ukraine on our future financial results; • the expected financial effect of our announced workforce reduction and office space optimization; • our expectation that the change in estimated useful life of servers and certain network equipment will have a favorable effect on our 2023 operating results; as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report and other documents we file with the Securities and Exchange Commission (SEC), including without limitation, the following sections: Part I, Item 1 "Business;" Part I, Item 1A "Risk Factors;" and Part II, Item 7 "Management’s Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements generally can be identified by words such as "anticipates," "believes," "estimates," "expects," "intends," "plans," "predicts," "projects," "will be," "will continue," "may," "could," "will likely result," and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Annual Report on Form 10-K, and in particular, the risks discussed in Part I, Item 1A, "Risk Factors" of this report and those discussed in other documents we file with the SEC. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements. As used herein, "Alphabet," "the company," "we," "us," "our," and similar terms include Alphabet Inc. and its subsidiaries, unless the context indicates otherwise. "Alphabet," "Google," and other trademarks of ours appearing in this report are our property. We do not intend our use or display of other companies' trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies. PART I ITEM 1. BUSINESS Overview As our founders Larry and Sergey wrote in the original founders' letter, "Google is not a conventional company. We do not intend to become one." That unconventional spirit has been a driving force throughout our history, inspiring us to tackle big problems and invest in moonshots, such as our long-term opportunities in artificial intelligence (AI). We continue this work under the leadership of Alphabet and Google CEO Sundar Pichai. Alphabet is a collection of businesses — the largest of which is Google. We report Google in two segments, Google Services and Google Cloud; we also report all non-Google businesses collectively as Other Bets. Alphabet's structure is about helping each of our businesses prosper through strong leaders and independence. Access and technology for everyone The Internet is one of the world’s most powerful equalizers; it propels ideas, people and businesses large and small. Our mission to organize the world’s information and make it universally accessible and useful is as relevant today as it was when we were founded in 1998. Since then, we have evolved from a company that helps people find answers to a company that also helps people get things done. We are focused on building an even more helpful Google for everyone, and we aspire to give everyone the tools they need to increase their knowledge, health, happiness, and success. Google Search helps people find information and make sense of the world in more natural and intuitive ways, with trillions of searches on Google every year. YouTube provides people with entertainment, information, and opportunities to learn something new. Google Assistant offers the best way to get things done seamlessly across different devices, providing intelligent help throughout a person's day, no matter where they are. Google Cloud helps customers solve today’s business challenges, improve productivity, reduce costs, and unlock new growth engines. We are continually innovating and building new products and features that will help our users, partners, customers, and communities and have invested more than $100 billion in research and development in the last five years in support of these efforts. 4 Table of Contents Alphabet Inc. Moonshots Many companies get comfortable doing what they have always done, making only incremental changes. This incrementalism leads to irrelevance over time, especially in technology, where change tends to be revolutionary, not evolutionary. People thought we were crazy when we acquired YouTube and Android and when we launched Chrome, but those efforts have matured into major platforms for digital video and mobile devices and a safer, popular browser. We continue to look toward the future and to invest for the long term within each of our segments. As we said in the original founders' letter, we will not shy away from high-risk, high-reward projects that we believe in, as they are the key to our long-term success. The power of AI We believe that AI is a foundational and transformational technology that will provide compelling and helpful benefits to people and society through its capacity to assist, complement, empower, and inspire people in almost every field of human endeavor. As an information and computer science company, we will continue to be at the forefront of advancing the frontier of AI. Through our path-breaking and field-defining research and development, we responsibly and boldly develop more capable and useful AI every day. AI already powers Google’s core products that help billions of people every day and has been at the foundation of our core ads quality systems for years, helping large and small businesses all over the world to produce and run effective and efficient ad campaigns that help grow their businesses. AI makes it possible to search in new languages, with multiple inputs, such as using images and text at the same time with the Google App. Some of our most popular products at Google — including Lens and Translate — were built entirely using artificial intelligence technologies such as optical character recognition and machine learning. Google Cloud continues to build AI into numerous solutions that our customers can use to develop AI-powered applications — including processing documents, images, and translation — to understand and analyze data more efficiently, and to use packaged solutions for a variety of industries. In all these examples, AI significantly enhances the usefulness and multiplies the value of these products and services to people and organizations. Our view is that AI is now, and more than ever, critical to delivering on our mission. As we bring our breakthrough AI innovations into the real world to assist people and benefit society everywhere, we are also pursuing further advancements that will help to unlock scientific discoveries and to tackle humanity's greatest challenges and opportunities. Privacy and security We make it a priority to protect the privacy and security of our products, users, and customers, even if there are near-term financial consequences. We do this by continuously investing in building products that are secure by default; strictly upholding responsible data practices that emphasize privacy by design; and building easy-to-use settings that put people in control. We are continually enhancing these efforts over time, whether by enabling users to auto-delete their data, giving them new tools, such as My Ad Center, to control their ad experience, or advancing anti-malware, anti-phishing, and password security features. Google For reporting purposes Google comprises two segments: Google Services and Google Cloud. Google Services Serving our users We have always been committed to building helpful products that can improve the lives of millions of people worldwide. Our product innovations are what make our services widely used, and our brand one of the most recognized in the world. Google Services' core products and platforms include ads, Android, Chrome, hardware, Gmail, Google Drive, Google Maps, Google Photos, Google Play, Search, and YouTube, with broad and growing adoption by users around the world. Our products and services have come a long way since the company was founded more than two decades ago. Rather than the ten blue links in our early search results, users can now get direct answers to their questions using their computer or mobile device, their own voice, a photo, or an image, making it quicker, easier, and more natural to find what they are looking for. Of the searches we see every day, 15% are new. This drive to make information more accessible and helpful has led us over the years to improve the discovery and creation of digital content both on the web and through platforms like Google Play and YouTube. People are consuming many forms of digital content, including watching videos, playing games, listening to music, reading books, 5 Table of Contents Alphabet Inc. and using apps. Working with content creators and partners, we continue to build new ways for people around the world to find great digital content. Fueling all of these great digital experiences are extraordinary platforms and hardware. That is why we continue to invest in platforms like our Android mobile operating system, Chrome browser, and Chrome operating system, as well as growing our family of hardware devices. We see tremendous potential for devices to be helpful and make people's lives easier by combining the best of our AI, software, and hardware. This potential is reflected in our latest generation of hardware products such as the new Pixel 7 and Pixel 7 Pro, and the very first Pixel Watch. Creating products that people rely on every day is a journey that we are investing in for the long-term. How we make money We have built world-class advertising technologies for advertisers, agencies, and publishers to power their digital marketing businesses. Our advertising solutions help millions of companies grow their businesses through our wide range of products across devices and formats, and we aim to ensure positive user experiences by serving the right ads at the right time and by building deep partnerships with brands and agencies. Google Services generates revenues primarily by delivering both performance and brand advertising that appears on Google Search & other properties, YouTube, and Google Network partners' properties ("Google Network properties"). We continue to invest in both performance and brand advertising and seek to improve the measurability of advertising so advertisers understand the effectiveness of their campaigns. • Performance advertising creates and delivers relevant ads that users will click on leading to direct engagement with advertisers. Performance advertising lets our advertisers connect with users while driving measurable results. Our ads tools allow performance advertisers to create simple text-based ads. • Brand advertising helps enhance users' awareness of and affinity for advertisers' products and services, through videos, text, images, and other interactive ads that run across various devices. We help brand advertisers deliver digital videos and other types of ads to specific audiences for their brand-building marketing campaigns. We have allocated substantial resources to stopping bad advertising practices and protecting users on the web. We focus on creating the best advertising experiences for our users and advertisers in many ways, including filtering out invalid traffic, removing billions of bad ads from our systems every year, and closely monitoring the sites, apps, and videos where ads appear and blocklisting them when necessary to ensure that ads do not fund bad content. We continue to focus on growing revenues beyond advertising, from Google Play, hardware, and YouTube subscriptions, such as: • Google Play generates revenues from sales of apps and in-app purchases. • Hardware generates revenues from sales of Fitbit wearable devices, Google Nest home products, and Pixel devices. • YouTube non-advertising generates subscription revenues from services such as YouTube Premium and YouTube TV. Google Cloud Google was a company built in the cloud, and we continue to invest in our Google Cloud offerings, including Google Cloud Platform and Google Workspace. Google Cloud Platform provides leading technology in cybersecurity; data, analytics, AI, and machine learning; and infrastructure. Our cybersecurity products help customers detect, protect, and respond to a broad range of cybersecurity threats. Our data cloud unifies data lakes, data warehouses, data governance, and advanced machine learning into a single platform that can analyze data across any cloud. We provide customers an open, reliable, and scalable infrastructure that enables them to run workloads anywhere — on our Cloud, at the edge, or in their data centers. Additionally, Google Workspace's easy-to-use and secure communication and collaboration tools, which include apps like Gmail, Docs, Drive, Calendar, Meet, and more, enable secure hybrid work, boosting productivity and collaboration. Other Bets Across Alphabet we are also using technology to try to solve big problems that affect a wide variety of industries from improving transportation and health technology to exploring solutions to address climate change. Alphabet’s investment in the portfolio of Other Bets includes businesses that are at various stages of development, ranging from those in the R&D phase to those that are in the beginning stages of commercialization. Our goal is for them to become thriving, successful businesses. Other Bets operate as independent companies and some of them have their own 6 Table of Contents Alphabet Inc. boards with independent members and outside investors. While these early-stage businesses naturally come with considerable uncertainty, some of them are already generating revenue and making important strides in their industries. Revenues from Other Bets are generated primarily from the sale of health technology and internet services. Competition Our business is characterized by rapid change as well as new and disruptive technologies. We face formidable competition in every aspect of our business, including, among others, from: • general purpose search engines and information services; • vertical search engines and e-commerce providers for queries related to travel, jobs, and health, which users may navigate directly to rather than go through Google; • online advertising platforms and networks; • other forms of advertising, such as billboards, magazines, newspapers, radio, and television as our advertisers typically advertise in multiple media, both online and offline; • digital content and application platform providers; • providers of enterprise cloud services; • companies that design, manufacture, and market consumer hardware products, including businesses that have developed proprietary platforms; • providers of digital video services; • social networks, which users may rely on for product or service referrals, rather than seeking information through traditional search engines; • providers of workspace communication and connectivity products; and • digital assistant providers. Competing successfully depends heavily on our ability to develop and distribute innovative products and technologies to the marketplace across our businesses. For example, for advertising, competing successfully depends on attracting and retaining: • users, for whom other products and services are literally one click away, largely on the basis of the relevance of our advertising, as well as the general usefulness, security, and availability of our products and services; • advertisers, primarily based on our ability to generate sales leads, and ultimately customers, and to deliver their advertisements in an efficient and effective manner across a variety of distribution channels; and • content providers, primarily based on the quality of our advertiser base, our ability to help these partners generate revenues from advertising, and the terms of our agreements with them. For additional information about competition, see Risk Factors in Item 1A of this Annual Report on Form 10-K. Ongoing Commitment to Sustainability We believe that every business has the opportunity and obligation to protect our planet. Sustainability is one of our core values at Google, and we strive to build sustainability into everything we do. We have been a leader on sustainability and climate change since Google’s founding more than 20 years ago. These are some of our key achievements over the past two decades: • In 2007, we became the first major company to be carbon neutral for our operations. • In 2017, we became the first major company to match 100% of our annual electricity use with renewable energy, which we have achieved for five consecutive years. • In 2020, we issued $5.75 billion in sustainability bonds—the largest sustainability or green bond issuance by any company in history at the time. The net proceeds from the issuance were used to fund environmentally and socially responsible projects in the following eight areas: energy efficiency, clean energy, green buildings, clean transportation, circular economy and design, affordable housing, commitment to racial equity, and support for small businesses and COVID-19 crisis response. As of 2022, we had fully allocated the net proceeds from our sustainability bonds as outlined in our Sustainability Bond Impact Report published in 2022. Our sustainability strategy is focused on three key pillars: accelerating the transition to carbon-free energy and a circular economy, empowering everyone with technology, and benefiting the people and places where we operate. 7 Table of Contents Alphabet Inc. To accelerate the transition to a carbon-free and circular economy, in 2020, we launched our third decade of climate action, and we are now working toward a new set of ambitious goals. By 2030, we aim to: • achieve net-zero emissions across all of our operations and value chain, including our consumer hardware products; • become the first major company to run on carbon-free energy 24 hours a day, seven days a week, 365 days a year; • enable 5 gigawatts of new carbon-free energy through investments in our key manufacturing regions; and • help more than 500 cities and local governments reduce an aggregate of 1 gigaton (one billion tons) of carbon emissions annually. We also aim to maximize the reuse of finite resources across our operations, products, and supply chains and to enable others to do the same. We are committed to helping people make more sustainable choices by empowering them with technology. We introduced eco-friendly routing in Google Maps; new features to book flights or purchase appliances that have lower carbon footprints; and when people come to Google Search with questions about climate change, we show information from authoritative sources like the United Nations. To benefit the people and places where we operate, we have set goals to replenish more water than we consume by 2030 and to support water security in communities where we operate. We are focused on three areas: enhancing our stewardship of water resources across Google offices and data centers; replenishing our water use and improving watershed health and ecosystems in water-stressed communities; and sharing technology and tools that help everyone predict, prevent, and recover from water stress. At Google we remain steadfast in our commitment to sustainability, and we will continue to lead and encourage others to join us in improving the health of our planet. We are proud of what we have achieved so far, and we are energized to help move the world closer to a more sustainable and carbon-free future for all. More information on our approach to sustainability can be found in our annual sustainability reports, including Google’s Environmental Report. The contents of our sustainability reports are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. For additional information about risks and uncertainties applicable to our commitments to attain certain sustainability goals, see Risk Factors in Item 1A of this Annual Report on Form 10-K. Culture and Workforce We are a company of curious, talented, and passionate people. We embrace collaboration and creativity, and encourage the iteration of ideas to address complex challenges in technology and society. Our people are critical for our continued success, so we work hard to create an environment where employees can have fulfilling careers, and be happy, healthy, and productive. We offer industry-leading benefits and programs to take care of the diverse needs of our employees and their families, including opportunities for career growth and development, resources to support their financial health, and access to excellent healthcare choices. Our competitive compensation programs help us to attract and retain top candidates, and we will continue to invest in recruiting talented people to technical and non-technical roles, and rewarding them well. We provide a variety of high quality training and support to managers to build and strengthen their capabilities-–ranging from courses for new managers, to learning resources that help them provide feedback and manage performance, to coaching and individual support. At Alphabet we are committed to making diversity, equity, and inclusion part of everything we do and to growing a workforce that is representative of the users we serve. More information on Google’s approach to diversity can be found in our annual diversity reports, available publicly at diversity.google. The contents of our diversity reports are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC. As of December 31, 2022, Alphabet had 190,234 employees. We have work councils and statutory employee representation obligations in certain countries, and we are committed to supporting protected labor rights, maintaining an open culture, and listening to all employees. Supporting healthy and open dialogue is central to how we work, and we communicate information about the company through multiple internal channels to our employees. When necessary we contract with businesses around the world to provide specialized services where we do not have appropriate in-house expertise or resources, often in fields that require specialized training like cafe operations, content moderation, customer support, and physical security. We also contract with temporary staffing agencies when we need to cover short-term leaves, when we have spikes in business needs, or when we need to quickly incubate 8 Table of Contents Alphabet Inc. special projects. We choose our partners and staffing agencies carefully, and review their compliance with Google’s Supplier Code of Conduct. We continually make improvements to promote a respectful and positive working environment for everyone — employees, vendors, and temporary staff alike. Government Regulation We are subject to numerous United States (U.S.) federal, state, and local, as well as foreign laws and regulations covering a wide variety of subjects. Like other companies in the technology industry, we face heightened scrutiny from both U.S. and foreign governments with respect to our compliance with laws and regulations. Many of these laws and regulations are evolving and their applicability and scope, as interpreted by the courts, remain uncertain. Particularly with regard to data privacy and security; content moderation; competition; consumer protection; climate change and sustainability; and reporting on human capital and diversity, we have seen an increase in new and evolving laws and regulations, as well as related enforcement actions, being proposed and implemented in recent years by legislative bodies around the world. Our compliance with these laws and regulations may be onerous and could, individually or in the aggregate, increase our cost of doing business, make our products and services less useful, limit our ability to pursue certain business models, cause us to change our business practices, affect our competitive position relative to our peers, and/or otherwise have an adverse effect on our business, reputation, financial condition, and operating results. For additional information about government regulation applicable to our business, see Risk Factors in Item 1A; Trends in Our Business and Financial Effect in Part II, Item 7; and Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K. Intellectual Property We rely on various intellectual property laws, confidentiality procedures and contractual provisions to protect our proprietary technology and our brand. We have registered, and applied for the registration of, U.S. and international trademarks, service marks, domain names, and copyrights. We have also filed patent applications in the U.S. and foreign countries covering certain of our technology, and acquired patent assets to supplement our portfolio. We have licensed in the past, and expect that we may license in the future, certain of our rights to other parties. For additional information, see Risk Factors in Item 1A of this Annual Report on Form 10-K. Available Information Our website is located at www.abc.xyz, and our investor relations website is located at www.abc.xyz/investor. Access to our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and our Proxy Statements, and any amendments to these reports, is available via a link through our investor relations website, free of charge, after we file or furnish them with the SEC and they are available on the SEC's website. We webcast via our investor relations website our earnings calls and certain events we participate in or host with members of the investment community. Our investor relations website also provides notifications of news or announcements regarding our financial performance and other items that may be material or of interest to our investors, including SEC filings, investor events, press and earnings releases, and blogs. We also share Google news and product updates on Google's Keyword blog at https://www.blog.google/, that may be material or of interest to our investors. Further, corporate governance information, including our certificate of incorporation, bylaws, governance guidelines, board committee charters, and code of conduct, is also available on our investor relations website. The contents of our websites are not incorporated by reference into this Annual Report on Form 10-K or in any other report or document we file with the SEC, and any references to our websites are intended to be inactive textual references only. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including but not limited to those described below, which could harm our business, reputation, financial condition, and operating results, and affect the trading price of our Class A and Class C stock. Risks Specific to our Company We generate a significant portion of our revenues from advertising. Reduced spending by advertisers, a loss of partners, or new and existing technologies that block ads online and/or affect our ability to customize ads could harm our business. We generated more than 80% of total revenues from online advertising in 2022. Many of our advertisers, companies that distribute our products and services, digital publishers, and content providers can terminate their contracts with us at any time. These partners may not continue to do business with us if we do not create more value 9 Table of Contents Alphabet Inc. (such as increased numbers of users or customers, new sales leads, increased brand awareness, or more effective monetization) than their available alternatives. Changes to our advertising policies and data privacy practices, as well as changes to other companies’ advertising and/or data privacy practices have in the past, and may in the future, affect the advertising that we are able to provide. In addition, technologies have been developed that make customized ads more difficult or that block the display of ads altogether, and some providers of online services have integrated these technologies that could potentially impair the availability and functionality of third-party digital advertising. Failing to provide superior value or deliver advertisements effectively and competitively could harm our business, reputation, financial condition, and operating results. In addition, expenditures by advertisers tend to correlate with overall economic conditions. Adverse macroeconomic conditions have affected, and may in the future affect, the demand for advertising, resulting in fluctuations in the amounts our advertisers spend on advertising, which could harm our financial condition and operating results. We face intense competition. If we do not continue to innovate and provide products and services that are useful to users, customers, and other partners, we may not remain competitive, which could harm our business, financial condition, and operating results. Our business environment is rapidly evolving and intensely competitive. Our businesses face changing technologies, shifting user needs, and frequent introductions of rival products and services. To compete successfully, we must accurately anticipate technology developments and deliver innovative, relevant and useful products, services, and technologies in a timely manner. As our businesses evolve, the competitive pressure to innovate will encompass a wider range of products and services. We must continue to invest significant resources in R&D, including through acquisitions, in order to enhance our technology and new and existing products and services. We have many competitors in different industries. Our current and potential domestic and international competitors range from large and established companies to emerging start-ups. Some competitors have longer operating histories and well established relationships in various sectors. They can use their experience and resources in ways that could affect our competitive position, including by making acquisitions, continuing to invest heavily in R&D and in talent, initiating intellectual property and competition claims (whether or not meritorious), and continuing to compete for users, advertisers, customers, and content providers. Further, discrepancies in enforcement of existing laws may enable our lesser known competitors to aggressively interpret those laws without commensurate scrutiny, thereby affording them competitive advantages. Our competitors may also be able to innovate and provide products and services faster than we can or may foresee the need for products and services before us. Our financial condition and operating results may also suffer if our products and services are not responsive to the evolving needs and desires of our users, advertisers, publishers, customers, and content providers. As new and existing technologies continue to develop, competitors and new entrants may be able to offer experiences that are, or that are seen to be, substantially similar to or better than ours. These technologies could reduce usage of our products and services, and force us to compete in different ways and expend significant resources to develop and operate equal or better products and services. Competitors’ success in providing compelling products and services or in attracting and retaining users, advertisers, publishers, customers, and content providers could harm our financial condition and operating results. Our ongoing investment in new businesses, products, services, and technologies is inherently risky, and could divert management attention and harm our business, financial condition, and operating results. We have invested and expect to continue to invest in new businesses, products, services, and technologies. The investments that we are making across our businesses, such as in AI, reflect our ongoing efforts to innovate and provide products and services that are useful to users, advertisers, publishers, customers, and content providers. Our investments span a wide range of industries beyond online advertising. Such investments ultimately may not be commercially viable or may not result in an adequate return of capital and, in pursuing new strategies, we may incur unanticipated liabilities. These endeavors may involve significant risks and uncertainties, including diversion of resources and management attention from current operations and the use of alternative investment, governance, or compensation structures that may fail to adequately align incentives across the company or otherwise accomplish their objectives. Within Google Services, we continue to invest heavily in hardware, including our smartphones, home devices, and wearables, which is a highly competitive market with frequent introduction of new products and services, rapid adoption of technological advancements by competitors, short product life cycles, evolving industry standards, continual improvement in performance characteristics, and price and feature sensitivity on the part of consumers and businesses. There can be no assurance we will be able to provide hardware that competes effectively. 10 Table of Contents Alphabet Inc. Within Google Cloud, we devote significant resources to develop and deploy our enterprise-ready cloud services, including Google Cloud Platform and Google Workspace. We are incurring costs to build and maintain infrastructure to support cloud computing services, invest in cybersecurity, and hire talent, particularly to support and scale our sales force. At the same time, our competitors are rapidly developing and deploying cloud-based services. Pricing and delivery models are competitive and constantly evolving, and we may not attain sufficient scale and profitability to achieve our business objectives. Further, our business with public sector customers may present additional risks, including regulatory compliance risks. For instance, we may be subject to government audits and cost reviews, and any failure to comply or any deficiencies found may expose us to legal, financial, and/or reputational risks. Evolving laws and regulations may require us to make new capital investments, build new products, and seek partners to deliver localized services in other countries, and we may not be able to meet sovereign operating requirements. Within Other Bets, we are investing significantly in the areas of health, life sciences, and transportation, among others. These investment areas face intense competition from large, experienced, and well-funded competitors, and our offerings, many of which involve the development of new and emerging technologies, may not be successful, or be able to compete effectively or operate at sufficient levels of profitability. In addition, new and evolving products and services, including those that use AI, require significant investment and raise ethical, technological, legal, regulatory, and other challenges, which may negatively affect our brands and demand for our products and services. Because all of these investment areas are inherently risky, no assurance can be given that such strategies and offerings will be successful or will not harm our reputation, financial condition, and operating results. Our revenue growth rate could decline over time, and we anticipate downward pressure on our operating margin in the future. Our revenue growth rate could decline over time as a result of a number of factors, including changes in the devices and modalities used to access our products and services; changes in geographic mix; deceleration or declines in advertiser spending; competition; customer usage and demand for our products; decreases in our pricing of our products and services; ongoing product and policy changes; and shifts to lower priced products and services. In addition, we may also experience downward pressure on our operating margin resulting from a variety of factors, such as the continued expansion of our business into new fields, including products and services such as hardware, Google Cloud, and subscription products, as well as significant investments in Other Bets, all of which may have margins lower than those we generate from advertising. In particular, margins on our hardware products have had, and may continue to have, an adverse affect on our consolidated margins due to pressures on pricing and higher cost of sales. We may also experience downward pressure on our operating margins from increasing regulations, increasing competition, and increasing costs for many aspects of our business. Further, certain of our costs and expenses are generally less variable in nature and may not correlate to changes in revenue. Additionally, in conjunction with our efforts to re-engineer costs, we may not be able to execute these efforts in a timely manner or these efforts may not be successful. Due to these factors and the evolving nature of our business, our historical revenue growth rate and historical operating margin may not be indicative of our future performance. For additional information, see Trends in Our Business and Financial Effect and Revenues and Monetization Metrics in Part II, Item 7 of this Annual Report on Form 10-K. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services, and brands as well as affect our ability to compete. Our patents, trademarks, trade secrets, copyrights, and other intellectual property rights are important assets for us. Various events outside of our control pose a threat to our intellectual property rights, as well as to our products, services, and technologies. For example, effective intellectual property protection may not be available in every country in which our products and services are distributed or made available through the Internet. Also, the efforts we have taken to protect our proprietary rights may not be sufficient or effective. Although we seek to obtain patent protection for our innovations, it is possible we may not be able to protect some of these innovations. Moreover, we may not have adequate patent or copyright protection for certain innovations that later turn out to be important. There is always the possibility that the scope of the protection gained will be insufficient or that an issued patent may be deemed invalid or unenforceable. We also seek to maintain certain intellectual property as trade secrets. The secrecy of such trade secrets and other sensitive information could be compromised, which could cause us to lose the competitive advantage resulting from these trade secrets. We also face risks associated with our trademarks. For example, there is a risk that the word “Google” could become so commonly used that it becomes synonymous with the word “search.” Some courts have ruled that "Google" is a protectable trademark, but it is possible that other courts, particularly those outside of the U.S., 11 Table of Contents Alphabet Inc. may reach a different determination. If this happens, we could lose protection for this trademark, which could result in other people using the word “Google” to refer to their own products, thus diminishing our brand. Any significant impairment of our intellectual property rights could harm our business and our ability to compete. Also, protecting our intellectual property rights is costly and time consuming. Any increase in the unauthorized use of our intellectual property could make it more expensive to do business and harm our financial condition and operating results. Our business depends on strong brands, and failing to maintain and enhance our brands would hurt our ability to expand our base of users, advertisers, customers, content providers, and other partners. Our strong brands have significantly contributed to the success of our business. Maintaining and enhancing the brands within Google Services, Google Cloud, and Other Bets increases our ability to enter new categories and launch new and innovative products and services that better serve the needs of our users, advertisers, customers, content providers, and other partners. Our brands have been, and may in the future be, negatively affected by a number of factors, including, among others, reputational issues, third-party content shared on our platforms, data privacy and security issues and developments, and product or technical performance failures. For example, if we fail to respond appropriately to the sharing of misinformation or objectionable content on our services and/or products or objectionable practices by advertisers, or otherwise to adequately address user concerns, our users may lose confidence in our brands. Furthermore, failure to maintain and enhance our brands could harm our business, reputation, financial condition, and operating results. Our success will depend largely on our ability to remain a technology leader and continue to provide high-quality, trustworthy, innovative products and services that are truly useful and play a valuable role in a range of settings. We face a number of manufacturing and supply chain risks that could harm our business, financial condition, and operating results. We face a number of risks related to manufacturing and supply chain management, which could affect our ability to supply both our products and our services. We rely on contract manufacturers to manufacture or assemble our hardware products and servers and networking equipment used in our technical infrastructure, and we may supply the contract manufacturers with components to assemble the hardware products and equipment. We also rely on other companies to participate in the distribution of our products and services. Our business could be negatively affected if we are not able to engage these companies with the necessary capabilities or capacity on reasonable terms, or if those we engage fail to meet their obligations (whether due to financial difficulties or other reasons), or make adverse changes in the pricing or other material terms of our arrangements with them. We have experienced and/or may in the future experience supply shortages, price increases, and/or longer lead times that could negatively affect our operations, driven by raw material, component availability, manufacturing capacity, labor shortages, industry allocations, logistics capacity, inflation, foreign currency exchange rates, tariffs, sanctions and export controls, trade disputes and barriers, geopolitical tensions, armed conflicts, natural disasters or pandemics, the effects of climate change (such as sea level rise, drought, flooding, heat waves, wildfires and resultant air quality effects and power shutoffs associated with wildfire prevention, and increased storm severity), power loss, and significant changes in the financial or business condition of our suppliers. In addition, some of the components we use in our technical infrastructure and our hardware products are available from only one or limited sources, and we may not be able to find replacement vendors on favorable terms in the event of a supply chain disruption. A significant supply interruption that affects us or our vendors could delay critical data center upgrades or expansions and delay consumer product availability. We may enter into long-term contracts for materials and products that commit us to significant terms and conditions. We may face costs for materials and products that are not consumed due to market demand, technological change, changed consumer preferences, quality, product recalls, and warranty issues. For instance, because certain of our hardware supply contracts have volume-based pricing or minimum purchase requirements, if the volume of our hardware sales decreases or does not reach projected targets, we could face increased materials and manufacturing costs or other financial liabilities that could make our products more costly per unit to manufacture and harm our financial condition and operating results. Furthermore, certain of our competitors may negotiate more favorable contractual terms based on volume and other commitments that may provide them with competitive advantages and may affect our supply. Our products and services have had, and in the future may have, quality issues resulting from design, manufacturing, or operations. Sometimes, these issues may be caused by components we purchase from other 12 Table of Contents Alphabet Inc. manufacturers or suppliers. If the quality of our products and services does not meet expectations or our products or services are defective, it could harm our reputation, financial condition, and operating results. We require our suppliers and business partners to comply with laws and, where applicable, our company policies and practices, such as the Google Supplier Code of Conduct, regarding workplace and employment practices, data security, environmental compliance, and intellectual property licensing, but we do not control them or their practices. Violations of law or unethical business practices could result in supply chain disruptions, canceled orders, harm to key relationships, and damage to our reputation. Their failure to procure necessary license rights to intellectual property could affect our ability to sell our products or services and expose us to litigation or financial claims. Interruption to, interference with, or failure of our complex information technology and communications systems could hurt our ability to effectively provide our products and services, which could harm our reputation, financial condition, and operating results. The availability of our products and services and fulfillment of our customer contracts depend on the continuing operation of our information technology and communications systems. Our systems are vulnerable to damage, interference, or interruption from modifications or upgrades, terrorist attacks, state-sponsored attacks, natural disasters or pandemics, geopolitical tensions or armed conflicts, the effects of climate change (such as sea level rise, drought, flooding, heat waves, wildfires and resultant air quality effects and power shutoffs associated with wildfire prevention, and increased storm severity), power loss, telecommunications failures, computer viruses, software bugs, ransomware attacks, computer denial of service attacks, phishing schemes, or other attempts to harm or access our systems. Some of our data centers are located in areas with a high risk of major earthquakes or other natural disasters. Our data centers are also subject to break-ins, sabotage, and intentional acts of vandalism, and, in some cases, to potential disruptions resulting from problems experienced by facility operators or disruptions as a result of geopolitical tensions and conflicts happening in the area. Some of our systems are not fully redundant, and disaster recovery planning cannot account for all eventualities. The occurrence of a natural disaster or pandemic, closure of a facility, or other unanticipated problems affecting our data centers could result in lengthy interruptions in our service. In addition, our products and services are highly technical and complex and have contained in the past, and may contain in the future, errors or vulnerabilities, which could result in interruptions in or failure of our services or systems. Any of these incidents could impede or prevent us from effectively offering products and providing services, which could harm our reputation, financial condition, and operating results. Our international operations expose us to additional risks that could harm our business, financial condition, and operating results. Our international operations are significant to our revenues and net income, and we plan to continue to grow internationally. International revenues accounted for approximately 51% of our consolidated revenues in 2022. In addition to risks described elsewhere in this section, our international operations expose us to other risks, including the following: • restrictions on foreign ownership and investments, and stringent foreign exchange controls that might prevent us from repatriating cash earned in countries outside the U.S.; • import and export requirements, tariffs, and other market access barriers that may prevent or impede us from offering products or providing services to a particular market, or that could limit our ability to source assemblies and finished products from a particular market, and may increase our operating costs; • longer payment cycles in some countries, increased credit risk, and higher levels of payment fraud; • an evolving foreign policy landscape that may adversely affect our revenues and could subject us to new regulatory costs and challenges (including new customer requirements), in addition to other adverse effects that we are unable to effectively anticipate; • sanctions, export controls, and trade restrictions that limit our ability to operate in certain jurisdictions or to comply with local laws, including as a result of geopolitical tensions or armed conflicts, such as the ongoing conflict in Ukraine; • political unrest, conflict, and changes in governmental regimes that may adversely affect demand and usage of our products and services, may limit the ability for people in certain areas to access and use our products and services, or may impede us from offering products or providing services to a particular market; • anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and other local laws prohibiting certain payments to government officials, violations of which could result in civil and criminal penalties; 13 Table of Contents Alphabet Inc. • uncertainty regarding regulatory outcomes and other liabilities, including uncertainty as a result of local laws, insufficient due process, and lack of legal precedent; and • different employee/employer relationships, existence of works councils and labor unions, and other challenges caused by distance, language, and cultural differences, making it harder to do business in certain jurisdictions. Because we conduct business in currencies other than U.S. dollars but report our financial results in U.S. dollars, we have faced, and will continue to face, exposure to fluctuations in foreign currency exchange rates. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenues and earnings. Hedging programs are also inherently risky and could expose us to additional risks that could harm our financial condition and operating results. We are exposed to fluctuations in the fair values of our investments and, in some instances, our financial statements incorporate valuation methodologies that are subjective in nature resulting in fluctuations over time. The fair value of our investments may in the future be, and certain investments have been in the past, negatively affected by liquidity, credit deterioration or losses, performance and financial results of the underlying entities, foreign exchange rates, changes in interest rates, including changes that may result from the implementation of new benchmark rates, the effect of new or changing regulations, the stock market in general, or other factors. We measure certain of our non-marketable equity and debt securities, certain other instruments including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, at fair value on a nonrecurring basis. The determination of fair value involves use of appropriate valuation methods and certain unobservable inputs, requires management judgment and estimation, and may change over time. We adjust the carrying value of our non-marketable equity securities to fair value for observable transactions of identical or similar investments of the same issuer or for impairments. All gains and losses on non-marketable equity securities, are recognized in other income (expense), which increases the volatility of our other income (expense). The unrealized gains and losses we record from fair value remeasurements of our non-marketable equity securities in any particular period may differ significantly from the gains or losses we ultimately realize on such investments. As a result of these factors, the value of our investments could decline, which could harm our financial condition and operating results. Risks Related to our Industry People access the Internet through a variety of platforms and devices that continue to evolve with the advancement of technology and user preferences. If manufacturers and users do not widely adopt versions of our products and services developed for these interfaces, our business could be harmed. People access the Internet through a growing variety of devices such as desktop computers, mobile phones, smartphones, laptops and tablets, video game consoles, voice-activated speakers, wearables, automobiles, and television-streaming devices. Our products and services may be less popular on some interfaces. Each manufacturer or distributor may establish unique technical standards for its devices, and our products and services may not be available or may only be available with limited functionality for our users or our advertisers on these devices as a result. Some manufacturers may also elect not to include our products on their devices. In addition, search queries may be undertaken via voice-activated search, apps, social media or other platforms, which could harm our business. It is hard to predict the challenges we may encounter in adapting our products and services and developing competitive new products and services. We expect to continue to devote significant resources to creating and supporting products and services across multiple platforms and devices. Failing to attract and retain a substantial number of new device manufacturers, suppliers, distributors, developers, and users, or failing to develop products and technologies that work well on new devices and platforms, could harm our business, financial condition, and operating results and ability to capture future business opportunities. Data privacy and security concerns relating to our technology and our practices could harm our reputation, cause us to incur significant liability, and deter current and potential users or customers from using our products and services. Computer viruses, software bugs or defects, security breaches, and attacks on our systems could result in the improper disclosure and use of user data and interference with our users’ and customers’ ability to use our products and services, harming our business and reputation. Concerns about, including the adequacy of, our practices with regard to the collection, use, governance, disclosure, or security of personal data or other data-privacy-related matters, even if unfounded, could harm our business, reputation, financial condition, and operating results. Our policies and practices may change over time as expectations and regulations regarding privacy and data change. 14 Table of Contents Alphabet Inc. Our products and services involve the storage, handling, and transmission of proprietary and other sensitive information. Software bugs, theft, misuse, defects, vulnerabilities in our products and services, and security breaches expose us to a risk of loss or improper use and disclosure of such information, which could result in litigation and other potential liabilities, including regulatory fines and penalties, as well as reputational harm. Additionally, our products incorporate highly technical and complex technologies, and thus our technologies and software have contained, and are likely in the future to contain, undetected errors, bugs, and/or vulnerabilities. We have in the past discovered, and may in the future discover, some errors in our software code only after we have released the code. Systems and control failures, security breaches, failure to comply with our privacy policies, and/or inadvertent disclosure of user data could result in government and legal exposure, seriously harm our reputation, brand, and business, and impair our ability to attract and retain users or customers. Such incidents have occurred in the past and may continue to occur due to the scale and nature of our products and services. While there is no guarantee that such incidents will not cause significant damage, we expect to continue to expend significant resources to maintain security protections that limit the effect of bugs, theft, misuse, and security vulnerabilities or breaches. We experience cyber attacks and other attempts to gain unauthorized access to our systems on a regular basis. Cyber attacks continue to evolve in sophistication and volume, and inherently may be difficult to detect for long periods of time. We have seen, and will continue to see, industry-wide software supply chain vulnerabilities, such as the Log4j vulnerability reported in December 2021, which could affect our or other parties’ systems. We expect to continue to experience such incidents or vulnerabilities in the future. Our efforts to address undesirable activity on our platform may also increase the risk of retaliatory attack. In addition, we face the risk of cyber attacks by nation-states and state-sponsored actors. These attacks may target us or our customers, particularly our public sector customers (including federal, state, and local governments). Geopolitical tensions or armed conflicts, such as the ongoing conflict in Ukraine, may increase these risks. We may experience security issues, whether due to employee or insider error or malfeasance, system errors, or vulnerabilities in our or other parties’ systems. While we may not determine some of these issues to be material at the time they occur and may remedy them quickly, there is no guarantee that these issues will not ultimately result in significant legal, financial, and reputational harm, including government inquiries, enforcement actions, litigation, and negative publicity. There is also no guarantee that a series of issues may not be determined to be material at a later date in the aggregate, even if they may not be material individually at the time of their occurrence. Because the techniques used to obtain unauthorized access to, disable or degrade service provided by or otherwise sabotage systems change frequently and often are recognized only after being launched against a target, even taking all reasonable precautions, including those required by law, we have been unable in the past and may continue to be unable to anticipate or detect attacks or vulnerabilities or implement adequate preventative measures. Further, if any partners with whom we share user or other customer information fail to implement adequate data-security practices, fail to comply with our terms and policies, or otherwise suffer a network or other security breach, our users’ data may be improperly accessed, used, or disclosed. If an actual or perceived breach of our or our business partners’ or service providers’ security occurs, the market perception of the effectiveness of our security measures would be harmed, we could lose users and customers, our trade secrets or those of our business partners may be compromised, and we may be exposed to significant legal and financial risks, including legal claims (which may include class-action litigation) and regulatory actions, fines, and penalties. Any of the foregoing consequences could harm our business, reputation, financial condition, and operating results. While we have dedicated significant resources to privacy and security incident response capabilities, including dedicated worldwide incident response teams, our response process, particularly during times of a natural disaster or pandemic, may not be adequate, may fail to accurately assess the severity of an incident, may not be fast enough to prevent or limit harm, or may fail to sufficiently remediate an incident. As a result, we may suffer significant legal, reputational, or financial exposure, which could harm our business, financial condition, and operating results. For additional information, see also our risk factor on privacy and data protection regulations under ‘Risks Related to Laws, Regulations, and Policies’ below. Our ongoing investments in safety, security, and content review will likely continue to identify abuse of our platforms and misuse of user data. In addition to our efforts to prevent and mitigate cyber attacks, we are making significant investments in safety, security, and review efforts to combat misuse of our services and unauthorized access to user data by third parties, including investigation and review of platform applications that could access the information of users of our services. As a result of these efforts, we have in the past discovered, and may in the future discover, incidents of unnecessary access to or misuse of user data or other undesirable activity by third parties. However, we may not have discovered, and may in the future not discover, all such incidents or activity, whether as a result of our data limitations, including 15 Table of Contents Alphabet Inc. our lack of visibility over our encrypted services, the scale of activity on our platform, or other factors, including factors outside of our control such as a natural disaster or pandemic, and we may learn of such incidents or activity via third parties. Such incidents and activities may include the use of user data or our systems in a manner inconsistent with our terms, contracts or policies, the existence of false or undesirable user accounts, election interference, improper ad purchases, activities that threaten people’s safety on- or off-line, or instances of spamming, scraping, or spreading disinformation. While we may not determine some of these incidents to be material at the time they occurred and we may remedy them quickly, there is no guarantee that these issues will not ultimately result in significant legal, financial, and reputational harm, including government inquiries and enforcement actions, litigation, and negative publicity. There is also no guarantee that a series of issues may not be determined to be material at a later date in the aggregate, even if they may not be material individually at the time of their occurrence. We may also be unsuccessful in our efforts to enforce our policies or otherwise prevent or remediate any such incidents. Any of the foregoing developments may negatively affect user trust and engagement, harm our reputation and brands, require us to change our business practices in ways that harm our business operations, and adversely affect our business and financial results. Any such developments may also subject us to additional litigation and regulatory inquiries, which could result in monetary penalties and damages, divert management’s time and attention, and lead to enhanced regulatory oversight. Problematic content on our platforms, including low-quality user-generated content, web spam, content farms, and other violations of our guidelines could affect the quality of our services, which could harm our reputation and deter our current and potential users from using our products and services. We, like others in the industry, face violations of our content guidelines across our platforms, including sophisticated attempts by bad actors to manipulate our hosting and advertising systems to fraudulently generate revenues, or to otherwise generate traffic that does not represent genuine user interest or intent. While we invest significantly in efforts to promote high-quality and relevant results and to detect and prevent low-quality content and invalid traffic, we have been unable and may continue to be unable to detect and prevent all such abuses or promote uniformly high-quality content. Many websites violate or attempt to violate our guidelines, including by seeking to inappropriately rank higher in search results than our search engine's assessment of their relevance and utility would rank them. Such efforts have affected, and may continue to affect, the quality of content on our platforms and lead them to display false, misleading, or undesirable content. Although English-language web spam in our search results has been reduced, and web spam in most other languages is limited, we expect web spammers will continue to seek inappropriate ways to improve their rankings. We continuously combat web spam in our search results, including through indexing technology that makes it harder for spam-like, less useful web content to rank highly. We also continue to invest in and deploy proprietary technology to detect and prevent web spam on our platforms. We also face other challenges from low-quality and irrelevant content websites, including content farms, which are websites that generate large quantities of low-quality content to help them improve their search rankings. We are continually launching algorithmic changes designed to detect and prevent abuse from low-quality websites. We also face other challenges on our platforms, including violations of our content guidelines involving incidents such as attempted election interference, activities that threaten the safety and/or well-being of our users on- or off-line, and the spreading of misinformation or disinformation. If we fail to either detect and prevent an increase in problematic content or effectively promote high-quality content, it could hurt our reputation for delivering relevant information or reduce use of our platforms, harming our financial condition and operating results. It may also subject us to litigation and regulatory actions, which could result in monetary penalties and damages and divert management’s time and attention. Our business depends on continued and unimpeded access to the Internet by us and our users. Internet access providers may be able to restrict, block, degrade, or charge for access to certain of our products and services, which could lead to additional expenses and the loss of users and advertisers. Our products and services depend on the ability of our users to access the Internet, and certain of our products require significant bandwidth to work effectively. Currently, this access is provided by companies that have significant market power in the broadband and internet access marketplace, including incumbent telephone companies, cable companies, mobile communications companies, and government-owned service providers. Some of these providers have taken, or have stated that they may take, measures that could degrade, disrupt, or increase the cost of user access to certain of our products by restricting or prohibiting the use of their infrastructure to support or facilitate our offerings, by charging increased fees to us or our users to provide our offerings, or by providing our competitors preferential access. Some jurisdictions have adopted regulations prohibiting certain forms of discrimination by internet access providers; however, substantial uncertainty exists in the U.S. and elsewhere regarding such protections. For example, in 2018 the U.S. Federal Communications Commission repealed net neutrality rules, which could permit 16 Table of Contents Alphabet Inc. internet access providers to restrict, block, degrade, or charge for access to certain of our products and services. In addition, in some jurisdictions, our products and services have been subject to government-initiated restrictions or blockages. These could harm existing key relationships, including with our users, customers, advertisers, and/or content providers, and impair our ability to attract new ones; harm our reputation; and increase costs, thereby negatively affecting our business. Risks Related to Laws, Regulations, and Policies We are subject to a variety of new, existing, and changing laws and regulations worldwide that could harm our business, and will likely be subject to an even broader scope of laws and regulations as we continue to expand our business. We are subject to numerous U.S. and foreign laws and regulations covering a wide variety of subjects, and our introduction of new businesses, products, services, and technologies will likely continue to subject us to additional laws and regulations. In recent years, governments around the world have proposed and adopted a large number of new laws and regulations relevant to the digital economy, particularly in the areas of data privacy and security, competition, and online content. The costs of compliance with these measures are high and are likely to increase in the future. New or changing laws and regulations, or new interpretations or applications of existing laws and regulations in a manner inconsistent with our practices, have resulted in, and may continue to result in, less useful products and services, altered business practices, limited ability to pursue certain business models or offer certain products and services, substantial costs, and civil or criminal liability. Examples include laws and regulations regarding: • Competition and technology platforms’ business practices: Laws and regulations focused on large technology platforms, including the Digital Markets Act in the European Union (EU); regulations in South Korea and elsewhere that affect Google Play’s billing policies, fees, and business model; as well as regulations under consideration in a range of jurisdictions. • Data privacy, collection, and processing: Laws and regulations further restricting the collection, processing, and/or sharing of user or advertising-related data, including privacy and data protection laws, laws affecting the processing of children's data (as discussed further below), data breach notification laws, and laws limiting data transfers (including data localization laws). • Copyright and other intellectual property : Copyright and related laws, including the EU Directive on Copyright in the Digital Single Market and European Economic Area transpositions, which may introduce new licensing regimes, increase liability with respect to content uploaded by users or linked to from our platforms, or create property rights in news publications that could require payments to news agencies and publishers. • Content moderation : Various laws covering content moderation and removal, and related disclosure obligations, such as the EU's Digital Services Act, Florida’s Senate Bill 7072 and Texas’ House Bill 20, and laws and proposed legislation in Singapore, Australia, and the United Kingdom that impose penalties for failure to remove certain types of content or require disclosure of information about the operation of our services and algorithms, which may make it harder for services like Google Search and YouTube to detect and deal with low-quality, deceptive, or harmful content. • Consumer protection : Consumer protection laws, including the EU’s New Deal for Consumers, which could result in monetary penalties and create a range of new compliance obligations. In addition, the applicability and scope of these and other laws and regulations, as interpreted by the courts, remain uncertain and could be interpreted in ways that harm our business. For example, we rely on statutory safe harbors, like those set forth in the Digital Millennium Copyright Act and Section 230 of the Communications Decency Act in the U.S. and the E-Commerce Directive in Europe, to protect against liability for various linking, caching, ranking, recommending, and hosting activities. Legislation or court rulings affecting these safe harbors may adversely affect us and may impose significant operational challenges. There are legislative proposals and pending litigation in the U.S. (such as Gonzalez v. Google ), EU, and around the world that could diminish or eliminate safe harbor protection for websites and online platforms. We are and may continue to be subject to claims, lawsuits, regulatory and government investigations, enforcement actions, consent orders, and other forms of regulatory scrutiny and legal liability that could harm our business, reputation, financial condition, and operating results. We are subject to claims, lawsuits, regulatory and government investigations, other proceedings, and consent orders involving competition, intellectual property, data privacy and security, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, and other matters. We also are subject to a variety of claims including 17 Table of Contents Alphabet Inc. product warranty, product liability, and consumer protection claims related to product defects, among other litigation, and we may also be subject to claims involving health and safety, hazardous materials usage, other environmental effects, or service disruptions or failures. Claims have been brought, and we expect will continue to be brought, against us for defamation, negligence, breaches of contract, copyright and trademark infringement, unfair competition, unlawful activity, torts, privacy rights violations, fraud, or other legal theories based on the nature and content of information available on or via our services or due to our involvement in hosting, transmitting, marketing, branding, or providing access to content created by third parties. For example, the U.S. Department of Justice, various U.S. states, and other plaintiffs have filed several antitrust lawsuits about various aspects of our business, including our advertising technologies and practices, the operation and distribution of Google Search, and the operation and distribution of the Android operating system and Play Store. Other regulatory agencies in the U.S. and around the world, including competition enforcers, consumer protection agencies, and data protection authorities, have challenged and may continue to challenge our business practices and compliance with laws and regulations. We are cooperating with these investigations and defending litigation where appropriate. Various laws, regulations, investigations, enforcement lawsuits, and regulatory actions have in the past, and may in the future result in substantial fines and penalties, injunctive relief, ongoing monitoring and auditing obligations, changes to our products and services, alterations to our business models and operations, and collateral related civil litigation or other adverse consequences, all of which could harm our business, reputation, financial condition, and operating results. Any of these legal proceedings could result in legal costs, diversion of management resources, negative publicity and other harms to our business. Estimating liabilities for our pending litigation is a complex, fact-intensive process that requires significant judgment, and the amounts we are ultimately liable for may exceed our estimates. The resolution of one or more such proceedings has resulted in, and may in the future result in, additional substantial fines, penalties, injunctions, and other sanctions that could harm our business, reputation, financial condition, and operating results. Privacy, data protection, and data usage regulations are complex and rapidly evolving areas. Any failure or alleged failure to comply with these laws could harm our business, reputation, financial condition, and operating results. Authorities around the world have adopted and are considering a number of legislative and regulatory proposals concerning data protection, data usage, and encryption of user data. Adverse legal rulings, legislation, or regulation have resulted in, and may continue to result in, fines and orders requiring that we change our practices, which have had and could continue to have an adverse effect on how we provide services, harming our business, reputation, financial condition, and operating results. These laws and regulations are evolving and subject to interpretation, and compliance obligations could cause us to incur substantial costs or harm the quality and operations of our products and services in ways that harm our business. Examples of these laws include: • The General Data Protection Regulation and the United Kingdom General Data Protection Regulations, which apply to all of our activities conducted from an establishment in the EU or the United Kingdom, respectively, or related to products and services that we offer to EU or the United Kingdom users or customers, respectively, or the monitoring of their behavior in the EU or the UK, respectively. • Various state and foreign privacy laws and regulations, such as the California Consumer Privacy Act of 2018, the California Privacy Rights Act, the Virginia Consumer Data Protection Act, the Colorado Privacy Act, the Connecticut Data Privacy Act, and the Utah Consumer Privacy Act, all of which give new data privacy rights to their respective residents (including, in California, a private right of action in the event of a data breach resulting from our failure to implement and maintain reasonable security procedures and practices) and impose significant obligations on controllers and processors of consumer data. • State laws governing the processing of biometric information, such as the Illinois Biometric Information Privacy Act and the Texas Capture or Use of Biometric Identifier Act, which impose obligations on businesses that collect or disclose consumer biometric information. • Various federal, state, and foreign laws governing how companies provide age appropriate experiences to children and minors, including the collection and processing of children and minor’s data. These include the Children’s Online Privacy Protection Act of 1998, the United Kingdom Age-Appropriate Design Code, and the California Age Appropriate Design Code, all of which address the use and disclosure of the personal data of children and minors and impose obligations on online services or products directed to or likely to be accessed by children. • The California Internet of Things Security Law, which regulates the security of data used in connection with internet-connected devices. 18 Table of Contents Alphabet Inc. • The EU’s Digital Markets Act, which will require in-scope companies to obtain user consent for combining data across certain products and require search engines to share anonymized data with rival companies, among other changes. Further, we are subject to evolving laws and regulations that dictate whether, how, and under what circumstances we can transfer, process and/or receive personal data. Previously available transfer mechanisms, such as the EU-U.S. and the Swiss-U.S. Privacy Shield frameworks, were invalidated in 2020, and other bases for data transfer and storage, such as Standard Contractual Clauses, remain subject to ongoing review in ways that may require us to adapt our existing contractual arrangements. The validity of various data transfer mechanisms remains subject to legal, regulatory, and political developments in both Europe and the U.S., including the potential adoption of the U.S.-EU Data Privacy Framework. Until the U.S.-EU Data Privacy Framework is adopted by the EU, the legal uncertainty and ongoing enforcement action from supervisory authorities related to cross-border transfers of personal data, could harm our ability to process and transfer personal data outside of the European Economic Area and could in turn harm our ability to provide, and our customers’ ability to use, some of our products and services. We face, and may continue to face, intellectual property and other claims that could be costly to defend, result in significant damage awards or other costs (including indemnification awards), and limit our ability to use certain technologies. We, like other internet, technology, and media companies, are frequently subject to litigation based on allegations of infringement or other violations of intellectual property rights, including patent, copyright, trade secrets, and trademarks. Parties have also sought broad injunctive relief against us by filing claims in U.S. and international courts and the U.S. International Trade Commission (ITC) for exclusion and cease-and-desist orders. In addition, patent-holding companies may frequently seek to generate income from patents they have obtained by bringing claims against us. As we continue to expand our business, the number of intellectual property claims against us has increased and may continue to increase as we develop and acquire new products, services, and technologies. Adverse results in any of these lawsuits may include awards of monetary damages, costly royalty or licensing agreements (if licenses are available at all), or orders limiting our ability to sell our products and services in the U.S. or elsewhere, including by preventing us from offering certain features, functionalities, products, or services in certain jurisdictions. They may also cause us to change our business practices in ways that could result in a loss of revenues for us and otherwise harm our business. Many of our agreements with our customers and partners, including certain suppliers, require us to defend against certain intellectual property infringement claims and in some cases indemnify them for certain intellectual property infringement claims against them, which could result in increased costs for defending such claims or significant damages if there were an adverse ruling in any such claims. Such customers and partners may also discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and harm our business. Moreover, intellectual property indemnities provided to us by our suppliers, when obtainable, may not cover all damages and losses suffered by us and our customers arising from intellectual property infringement claims. Furthermore, in connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, including those associated with intellectual property claims. Regardless of their merits, intellectual property claims are often time consuming and expensive to litigate or settle. To the extent such claims are successful, they could harm our business, including our product and service offerings, financial condition, and operating results. Expectations relating to environmental, social, and governance (ESG) considerations could expose us to potential liabilities, increased costs, and reputational harm. We are subject to laws, regulations, and other measures that govern a wide range of topics, including those related to matters beyond our core products and services. For instance, new laws, regulations, policies, and international accords relating to ESG matters, including sustainability, climate change, human capital, and diversity, are being developed and formalized in Europe, the U.S., and elsewhere, which may entail specific, target-driven frameworks and/or disclosure requirements. We have implemented robust ESG programs, adopted reporting frameworks and principles, and announced a number of goals and initiatives. The implementation of these goals and initiatives may require considerable investments, and our goals, with all of their contingencies, dependencies, and in certain cases, reliance on third-party verification and/or performance, are complex and ambitious, may change, and we cannot guarantee that we will achieve them. Any failure, or perceived failure, by us to adhere to our public statements, comply fully with developing interpretations of ESG laws and regulations, or meet evolving and varied stakeholder expectations and standards could harm our business, reputation, financial condition, and operating results. We could be subject to changes in tax rates, the adoption of new U.S. or international tax legislation, or exposure to additional tax liabilities. 19 Table of Contents Alphabet Inc. We are subject to a variety of taxes and tax collection obligations in the U.S. and numerous foreign jurisdictions. Our effective tax rates are affected by a variety of factors, including changes in the mix of earnings in jurisdictions with different statutory tax rates, net gains and losses on hedges and related transactions under our foreign exchange risk management program, decreases in our stock price for shares issued as employee compensation, changes in the valuation of our deferred tax assets or liabilities, and the application of different provisions of tax laws or changes in tax laws, regulations, or accounting principles (including changes in the interpretation of existing laws). Further, if we are unable or fail to collect taxes on behalf of customers, employees and partners as the withholding agent, we could become liable for taxes that are levied against third parties. We are subject to regular review and audit by both domestic and foreign tax authorities. As a result, we have received, and may in the future receive, assessments in multiple jurisdictions, on various tax-related assertions, such as transfer-pricing adjustments or permanent-establishment claims. Any adverse outcome of such a review or audit could harm our financial condition and operating results, require adverse changes to our business practices, or subject us to additional litigation and regulatory inquiries. In addition, the determination of our worldwide provision for income taxes and other tax liabilities requires significant judgment and often involves uncertainty. Although we believe our estimates are reasonable, the ultimate tax outcome may differ from the amounts recorded in our financial statements and may affect our financial results in the period or periods for which such determination is made. Furthermore, due to shifting economic and political conditions, tax policies, laws, or rates in various jurisdictions may be subject to significant changes in ways that could harm our financial condition and operating results. Various jurisdictions around the world have enacted or are considering revenue-based taxes such as digital services taxes and other targeted taxes, which could lead to inconsistent and potentially overlapping international tax regimes. The Organization for Economic Cooperation and Development continues to advance proposals for modernizing international tax rules. Risks Related to Ownership of our Stock We cannot guarantee that any share repurchase program will be fully consummated or will enhance long-term stockholder value, and share repurchases could increase the volatility of our stock prices and could diminish our cash reserves. We engage in share repurchases of our Class A and Class C stock from time to time in accordance with authorizations from the Board of Directors of Alphabet. Our repurchase program does not have an expiration date and does not obligate Alphabet to repurchase any specific dollar amount or to acquire any specific number of shares. Further, our share repurchases could affect our share trading prices, increase their volatility, reduce our cash reserves and may be suspended or terminated at any time, which may result in a decrease in the trading prices of our stock. The concentration of our stock ownership limits our stockholders’ ability to influence corporate matters. Our Class B stock has 10 votes per share, our Class A stock has one vote per share, and our Class C stock has no voting rights. As of December 31, 2022, Larry Page and Sergey Brin beneficially owned approximately 85.8% of our outstanding Class B stock, which represented approximately 51.2% of the voting power of our outstanding common stock. Through their stock ownership, Larry and Sergey have significant influence over all matters requiring stockholder approval, including the election of directors and significant corporate transactions, such as a merger or other sale of our company or our assets, for the foreseeable future. In addition, because our Class C stock carries no voting rights (except as required by applicable law), the issuance of the Class C stock, including in future stock-based acquisition transactions and to fund employee equity incentive programs, could continue Larry and Sergey’s current relative voting power and their ability to elect all of our directors and to determine the outcome of most matters submitted to a vote of our stockholders. The share repurchases made pursuant to our repurchase program may also affect Larry and Sergey’s relative voting power. This concentrated control limits or severely restricts other stockholders’ ability to influence corporate matters and we may take actions that some of our stockholders do not view as beneficial, which could reduce the market price of our Class A stock and our Class C stock. Provisions in our charter documents and under Delaware law could discourage a takeover that stockholders may consider favorable. Provisions in Alphabet’s certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following: • Our Board of Directors has the right to elect directors to fill a vacancy created by the expansion of the Board of Directors or the resignation, death, or removal of a director. • Our stockholders may not act by written consent, which makes it difficult to take certain actions without holding a stockholders' meeting. 20 Table of Contents Alphabet Inc. • Our certificate of incorporation prohibits cumulative voting in the election of directors. This limits the ability of minority stockholders to elect director candidates. • Stockholders must provide advance notice to nominate individuals for election to the Board of Directors or to propose matters that can be acted upon at a stockholders’ meeting. These provisions may discourage or deter a potential acquirer from conducting a solicitation of proxies to elect the acquirer's own slate of directors or otherwise attempting to obtain control of our company. • Our Board of Directors may issue, without stockholder approval, shares of undesignated preferred stock, which makes it possible for our Board of Directors to issue preferred stock with voting or other rights or preferences that could impede the success of any attempt to acquire us. As a Delaware corporation, we are also subject to certain Delaware anti-takeover provisions. Under Delaware law, a corporation may not engage in a business combination with any holder of 15% or more of its outstanding voting stock unless the holder has held the stock for three years or, among other things, the Board of Directors has approved the transaction. Our Board of Directors could rely on Delaware law to prevent or delay an acquisition of us. The trading price for our Class A stock and non-voting Class C stock may continue to be volatile. The trading price of our stock has at times experienced significant volatility and may continue to be volatile. In addition to the factors discussed in this report, the trading prices of our Class A stock and Class C stock have fluctuated, and may continue to fluctuate widely, in response to various factors, many of which are beyond our control, including, among others, the activities of our peers and changes in broader economic and political conditions around the world. These broad market and industry factors could harm the market price of our Class A stock and our Class C stock, regardless of our actual operating performance. General Risks The continuing effects of the COVID-19 pandemic and its impact are highly unpredictable and could be significant, and could harm our business, financial condition, and operating results. Our business, operations and financial performance have been, and may continue to be, affected by the macroeconomic impacts resulting from COVID-19, and as a result, our revenue growth rate and expenses as a percentage of our revenues in future periods may differ significantly from our historical rates, and our future operating results may fall below expectations. The extent to which our business will continue to be affected will depend on a variety of factors, many of which are outside of our control, including the persistence of the pandemic, impacts on economic activity, and the possibility of recession or continued financial market instability. Our operating results may fluctuate, which makes our results difficult to predict and could cause our results to fall short of expectations. Our operating results have fluctuated, and may in the future fluctuate, as a result of a number of factors, many outside of our control, including the cyclicality and seasonality in our business and geopolitical events. As a result, comparing our operating results (including our expenses as a percentage of our revenues) on a period-to-period basis may not be meaningful, and our past results should not be relied on as an indication of our future performance. Consequently, our operating results in future quarters may fall below expectations. Acquisitions, joint ventures, investments, and divestitures could result in operating difficulties, dilution, and other consequences that could harm our business, financial condition, and operating results. Acquisitions, joint ventures, investments, and divestitures are important elements of our overall corporate strategy and use of capital, and these transactions could be material to our financial condition and operating results. We expect to continue to evaluate and enter into discussions regarding a wide array of such potential strategic transactions, which could create unforeseen operating difficulties and expenditures. Some of the areas where we face risks include: • diversion of management time and focus from operating our business to challenges related to acquisitions and other strategic transactions; • failure to obtain required approvals on a timely basis, if at all, from governmental authorities, or conditions placed upon approval that could, among other things, delay or prevent us from completing a transaction, or otherwise restrict our ability to realize the expected financial or strategic goals of a transaction; • failure to successfully integrate the acquired operations, technologies, services, and personnel (including cultural integration and retention of employees) and further develop the acquired business or technology; • implementation or remediation of controls, procedures, and policies at the acquired company; 21 Table of Contents Alphabet Inc. • integration of the acquired company’s accounting and other administrative systems, and the coordination of product, engineering, and sales and marketing functions; • transition of operations, users, and customers onto our existing platforms; • in the case of foreign acquisitions, the need to integrate operations across different cultures and languages and to address the particular economic, currency, political, and regulatory risks associated with specific countries; • failure to accomplish commercial, strategic or financial objectives with respect to investments and joint ventures; • failure to realize the value of investments and joint ventures due to a lack of liquidity; • liability for activities of the acquired company before the acquisition, including patent and trademark infringement claims, data privacy and security issues, violations of laws, commercial disputes, tax liabilities, warranty claims, product liabilities, and other known and unknown liabilities; and • litigation or other claims in connection with the acquired company, including claims from terminated employees, customers, former stockholders, or other third parties. Our failure to address these risks or other problems encountered in connection with our past or future acquisitions and other strategic transactions could cause us to fail to realize their anticipated benefits, incur unanticipated liabilities, and harm our business generally. Our acquisitions and other strategic transactions could also result in dilutive issuances of our equity securities, the incurrence of debt, contingent liabilities, or amortization expenses, or impairment of goodwill and/or purchased long-lived assets, and restructuring charges, any of which could harm our financial condition and operating results. Also, the anticipated benefits or value of our acquisitions and other strategic transactions may not materialize. In connection with our divestitures, we have agreed, and may in the future agree, to provide indemnification for certain potential liabilities, which could harm our financial condition and operating results. If we were to lose the services of key personnel, we may not be able to execute our business strategy. Our future success depends in large part upon the continued service of key members of our senior management team. For instance, Sundar Pichai is critical to the overall management of Alphabet and its subsidiaries and plays an important role in the development of our technology, maintaining our culture, and setting our strategic direction. All of our executive officers and key employees are at-will employees, and we do not maintain any key-person life insurance policies. The loss of key personnel could harm our business. We rely on highly skilled personnel and, if we are unable to retain or motivate key personnel, hire qualified personnel, or maintain and continue to adapt our corporate culture, we may not be able to grow or operate effectively. Our performance largely depends on the talents and efforts of highly skilled individuals. Our ability to compete effectively and our future success depends on our continuing to identify, hire, develop, motivate, and retain highly skilled personnel for all areas of our organization. Competition in our industry for qualified employees is intense, and certain of our competitors have directly targeted, and may continue to target, our employees. In addition, our compensation arrangements, such as our equity award programs, may not always be successful in attracting new employees and retaining and motivating our existing employees. Restrictive immigration policy and regulatory changes may also affect our ability to hire, mobilize, or retain some of our global talent. In addition, we believe that our corporate culture fosters innovation, creativity, and teamwork. As our organization grows and evolves, we may need to implement more complex organizational management structures or adapt our corporate culture and work environments to ever-changing circumstances, such as during times of a natural disaster or pandemic, and these changes could affect our ability to compete effectively or have an adverse effect on our corporate culture. As we experiment with hybrid work models, we may experience increased costs and/or disruption, in addition to potential effects on our ability to operate effectively and maintain our corporate culture. ITEM 1B. UNRESOLVED STAFF COMMENTS Not applicable. 22 Table of Contents Alphabet Inc. ITEM 2. PROPERTIES Our headquarters are located in Mountain View, California. We own and lease office facilities and data centers around the world, primarily in North America, Europe, and Asia. We believe our existing facilities are in good condition and suitable for the conduct of our business. ITEM 3. LEGAL PROCEEDINGS For a description of our material pending legal proceedings, see Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES As of October 2, 2015, Alphabet Inc. became the successor issuer of Google Inc. pursuant to Rule 12g-3(a) under the Exchange Act. Our Class A stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since August 19, 2004 and under the symbol "GOOGL" since April 3, 2014. Prior to August 19, 2004, there was no public market for our stock. Our Class B stock is neither listed nor traded. Our Class C stock has been listed on the Nasdaq Global Select Market under the symbol “GOOG” since April 3, 2014. Holders of Record As of December 31, 2022 , there were approximately 6,670 and 1,657 stockholders of record of our Class A stock and Class C stock, respectively. Because many of our shares of Class A stock and Class C stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders. As of December 31, 2022, there were approximately 64 stockholders of record of our Class B stock. Dividend Policy We have never declared or paid any cash dividend on our common or capital stock. The primary use of capital continues to be to invest for the long-term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace, and form of capital return to stockholders. Issuer Purchases of Equity Securities The following table presents information with respect to Alphabet's repurchases of Class A and Class C stock during the quarter ended December 31, 2022 : Period Total Number of Class A Shares Purchased (in thousands) (1) Total Number of Class C Shares Purchased (in thousands) (1) Average Price Paid per Class A Share (2) Average Price Paid per Class C Share (2) Total Number of Shares Purchased as Part of Publicly Announced Programs (in thousands) (1) Approximate Dollar Value of Shares that May Yet Be Purchased Under the Program (in millions) October 1 - 31 8,585 46,059 $ 98.92 $ 99.16 54,644 $ 38,069 November 1 - 30 1,968 55,374 $ 95.89 $ 93.51 57,342 $ 32,703 December 1 - 31 4,687 44,649 $ 91.93 $ 93.93 49,336 $ 28,079 Total 15,240 146,082 161,322 (1) The repurchases are being executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information related to share repurchases. (2) Average price paid per share includes costs associated with the repurchases. 23 Table of Contents Alphabet Inc. Stock Performance Graphs The graph below matches Alphabet Inc. Class A's cumulative 5-year total stockholder return on common stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our common stock and in each index (with the reinvestment of all dividends) from December 31, 2017 to December 31, 2022. The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE 5-YEAR TOTAL RETURN* ALPHABET INC. CLASS A COMMON STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2017 in stock or index, including reinvestment of dividends. Copyright © 2023 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. 24 Table of Contents Alphabet Inc. The graph below matches Alphabet Inc. Class C's cumulative 5-year total stockholder return on capital stock with the cumulative total returns of the S&P 500 index, the NASDAQ Composite index, and the RDG Internet Composite index. The graph tracks the performance of a $100 investment in our Class C capital stock and in each index (with the reinvestment of all dividends) from December 31, 2017 to December 31, 2022. The returns shown are based on historical results and are not intended to suggest future performance. COMPARISON OF CUMULATIVE 5-YEAR TOTAL RETURN* ALPHABET INC. CLASS C CAPITAL STOCK Among Alphabet Inc., the S&P 500 Index, the NASDAQ Composite Index, and the RDG Internet Composite Index *$100 invested on December 31, 2017 in stock or in index, including reinvestment of dividends. Copyright © 2023 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved. ITEM 6. [Reserved] 25 Table of Contents Alphabet Inc. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Please read the following discussion and analysis of our financial condition and results of operations together with “Note about Forward-Looking Statements,” Part I, Item 1 "Business," Part I, Item 1A "Risk Factors," and our consolidated financial statements and related notes included under Item 8 of this Annual Report on Form 10-K. We have omitted discussion of 2020 results where it would be redundant to the discussion previously included in Item 7 of our 2021 Annual Report on Form 10-K. Understanding Alphabet’s Financial Results Alphabet is a collection of businesses — the largest of which is Google. We report Google in two segments, Google Services and Google Cloud; we also report all non-Google businesses collectively as Other Bets. For further details on our segments, see Part I, Item 1 “Business” and Note 15 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Trends in Our Business and Financial Effect The following long-term trends have contributed to the results of our consolidated operations, and we anticipate that they will continue to affect our future results: • Users' behaviors and advertising continue to shift online as the digital economy evolves. The continuing shift from an offline to online world has contributed to the growth of our business and our revenues since inception. We expect that this shift to an online world will continue to benefit our business and our revenues, although at a slower pace than we have experienced historically, in particular after the outsized growth in our advertising revenues during the COVID-19 pandemic. In addition, we face increasing competition for user engagement and advertisers, which may affect our revenues. • Users continue to access our products and services using diverse devices and modalities, which allows for new advertising formats that may benefit our revenues but adversely affect our margins. Our users are accessing the Internet via diverse devices and modalities, such as smartphones, wearables, and smart home devices, and want to be able to be connected no matter where they are or what they are doing. We are focused on expanding our products and services to stay in front of these trends in order to maintain and grow our business. We benefit from advertising revenues generated from different channels, including mobile, and newer advertising formats. The margins from these channels and newer products have generally been lower than those from traditional desktop search. Additionally, as the market for a particular device type or modality matures, our advertising revenues may be affected. For example, growth in the global smartphone market has slowed due to various factors, including increased market saturation in developed countries, which can affect our mobile advertising revenues. We expect TAC paid to our distribution partners and Google Network partners to increase as our revenues grow and TAC as a percentage of our advertising revenues ("TAC rate") to be affected by changes in device mix; geographic mix; partner mix; partner agreement terms; the percentage of queries channeled through paid access points; product mix; the relative revenue growth rates of advertising revenues from different channels; and revenue share terms. We expect these trends to continue to affect our revenues and put pressure on our margins. • As online advertising evolves, we continue to expand our product offerings, which may affect our monetization. As interactions between users and advertisers change, and as online user behavior evolves, we continue to expand our product offerings to serve these changing needs, which may affect our monetization. For example, revenues from ads on YouTube and Google Play monetize at a lower rate than our traditional search ads. We also may develop new products incorporating AI innovations that could affect our monetization trends. Additionally, when developing new products and services we generally focus first on user experience before prioritizing monetization. • As users in developing economies increasingly come online, our revenues from international markets continue to increase, and may require continued investments. In addition, movements in foreign exchange rates affect such revenues. The shift to online, as well as the advent of the multi-device world, has brought opportunities outside of the U.S., including in emerging markets, such as India. We continue to invest heavily and develop localized versions of our products and advertising programs relevant to our users in these markets. This has led to a trend of increased 26 Table of Contents Alphabet Inc. revenues from emerging markets. We expect that our results will continue to be affected by our performance in these markets, particularly as low-cost mobile devices become more available. This trend could affect our revenues as developing markets initially monetize at a lower rate than more mature markets. International revenues represent a significant portion of our revenues and are subject to fluctuations in foreign currency exchange rates relative to the U.S. dollar. While we have a foreign exchange risk management program designed to reduce our exposure to these fluctuations, this program does not fully offset their effect on our revenues and earnings. • The revenues that we derive from non-advertising products and services are increasing and may adversely affect our margins. Non-advertising revenues have grown over time, and we expect this trend to continue as we focus on expanding our products and services. The margins on these revenues vary significantly and are generally lower than the margins on our advertising revenues. In particular margins on our hardware products adversely affect our consolidated margins due to pressures on pricing and higher cost of sales. • As we continue to serve our users and expand our businesses, we will invest heavily in operating and capital expenditures. We continue to make significant research and development investments in areas of strategic focus as we seek to develop new, innovative offerings and improve our existing offerings across our businesses. We also expect to continue to invest in our technical infrastructure, including servers, network equipment, and data centers, to support the growth of our business and our long-term initiatives, in particular in support of AI. In addition acquisitions and strategic investments contribute to the breadth and depth of our offerings, expand our expertise in engineering and other functional areas, and build strong partnerships around strategic initiatives. For example, in September 2022 we closed the acquisition of Mandiant to help expand our offerings in dynamic cyber defense and response. • We face continuing changes in regulatory conditions, laws, and public policies, which could affect our business practices and financial results. Changes in social, political, economic, tax, and regulatory conditions or in laws and policies governing a wide range of topics and related legal matters have resulted in fines and caused us to change our business practices. As these global trends continue, our cost of doing business may increase, our ability to pursue certain business models or offer certain products or services may be limited, and we may need to change our business practices. Examples include the antitrust complaints filed by the U.S. Department of Justice and a number of state Attorneys General; pending litigation in the U.S., EU, and around the world that could diminish or eliminate safe harbor protection for websites and online platforms; and the Digital Markets Act and Digital Services Act in Europe and various legislative proposals in the U.S. focused on large technology platforms. For additional information see Item 1A Risk Factors and Legal Matters in Note 10 of the Notes to Consolidated Financial Statements included in Part II, Item 8. • Our employees are critical to our success and we expect to continue investing in them. Our employees are among our best assets and are critical for our continued success. We expect to continue hiring talented employees around the globe and to provide competitive compensation programs. For additional information see Culture and Workforce in Part I, Item 1 “Business.” Revenues and Monetization Metrics We generate revenues by delivering relevant, cost-effective online advertising; cloud-based solutions that provide enterprise customers of all sizes with infrastructure and platform services as well as communication and collaboration tools; sales of other products and services, such as apps and in-app purchases, and hardware; and fees received for subscription-based products. For details on how we recognize revenue, see Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. In addition to the long-term trends and their financial effect on our business noted above, fluctuations in our revenues have been and may continue to be affected by a combination of factors, including: • changes in foreign currency exchange rates; • changes in pricing, such as those resulting from changes in fee structures, discounts, and customer incentives; • general economic conditions and various external dynamics, including geopolitical events, regulations, and other measures and their effect on advertiser, consumer, and enterprise spending; • new product and service launches; and 27 Table of Contents Alphabet Inc. • seasonality. Additionally, fluctuations in our revenues generated from advertising ("Google advertising"), revenues from other sources ("Google other revenues"), Google Cloud, and Other Bets revenues have been and may continue to be affected by other factors unique to each set of revenues, as described below. Google Services Google Services revenues consist of Google advertising as well as Google other revenues. Google Advertising Google advertising revenues are comprised of the following: • Google Search & other, which includes revenues generated on Google search properties (including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc.), and other Google owned and operated properties like Gmail, Google Maps, and Google Play; • YouTube ads, which includes revenues generated on YouTube properties; and • Google Network, which includes revenues generated on Google Network properties participating in AdMob, AdSense, and Google Ad Manager. We use certain metrics to track how well traffic across various properties is monetized as it relates to our advertising revenues: paid clicks and cost-per-click pertain to traffic on Google Search & other properties, while impressions and cost-per-impression pertain to traffic on our Google Network properties. Paid clicks represent engagement by users and include clicks on advertisements by end-users on Google search properties and other Google owned and operated properties including Gmail, Google Maps, and Google Play. Cost-per-click is defined as click-driven revenues divided by our total number of paid clicks and represents the average amount we charge advertisers for each engagement by users. Impressions include impressions displayed to users on Google Network properties participating primarily in AdMob, AdSense, and Google Ad Manager. Cost-per-impression is defined as impression-based and click-based revenues divided by our total number of impressions, and represents the average amount we charge advertisers for each impression displayed to users. As our business evolves, we periodically review, refine, and update our methodologies for monitoring, gathering, and counting the number of paid clicks and the number of impressions, and for identifying the revenues generated by the corresponding click and impression activity. Fluctuations in our advertising revenues, as well as the change in paid clicks and cost-per-click on Google Search & other properties and the change in impressions and cost-per-impression on Google Network properties and the correlation between these items have been and may continue to be affected by additional factors, such as: • advertiser competition for keywords; • changes in advertising quality, formats, delivery or policy; • changes in device mix; • seasonal fluctuations in internet usage, advertising expenditures, and underlying business trends, such as traditional retail seasonality; and • traffic growth in emerging markets compared to more mature markets and across various verticals and channels. Google Other Google other revenues are comprised of the following: • Google Play, which includes sales of apps and in-app purchases; • hardware, which includes sales of Fitbit wearable devices, Google Nest home products, and Pixel devices; • YouTube non-advertising, which includes subscription revenues from services such as YouTube Premium and YouTube TV; and • other products and services. 28 Table of Contents Alphabet Inc. Fluctuations in our Google other revenues have been and may continue to be affected by additional factors, such as changes in customer usage and demand, number of subscribers, and fluctuations in the timing of product launches. Google Cloud Google Cloud revenues are comprised of the following: • Google Cloud Platform, which includes fees for infrastructure, platform, and other services; • Google Workspace, which includes fees for cloud-based communication and collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar and Meet; and • other enterprise services. Fluctuations in our Google Cloud revenues have been and may continue to be affected by additional factors, such as customer usage. Other Bets Revenues from Other Bets are generated primarily from the sale of health technology and internet services. Costs and Expenses Our cost structure has two components: cost of revenues and operating expenses. Our operating expenses include costs related to R&D, sales and marketing, and general and administrative functions. Certain of our costs and expenses, including those associated with the operation of our technical infrastructure as well as components of our operating expenses, are generally less variable in nature and may not correlate to changes in revenue. Cost of Revenues Cost of revenues is comprised of TAC and other costs of revenues. • TAC includes: ◦ Amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. ◦ Amounts paid to Google Network partners primarily for ads displayed on their properties. • Other cost of revenues includes: ◦ Content acquisition costs, which are payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee). ◦ Expenses associated with our data centers (including bandwidth, compensation expenses, depreciation, energy, and other equipment costs) as well as other operations costs (such as content review as well as customer and product support costs). ◦ Inventory and other costs related to the hardware we sell. TAC as a percentage of revenues generated from ads placed on Google Network properties are significantly higher than TAC as a percentage of revenues generated from ads placed on Google Search & other properties, because most of the advertiser revenues from ads served on Google Network properties are paid as TAC to our Google Network partners. Operating Expenses Operating expenses are generally incurred during our normal course of business, which we categorize as either R&D, sales and marketing, or general and administrative. The main components of our R&D expenses are: • compensation expenses for engineering and technical employees responsible for R&D related to our existing and new products and services; • depreciation; and • third-party services fees primarily relating to consulting and outsourced services in support of our engineering and product development efforts. 29 Table of Contents Alphabet Inc. The main components of our sales and marketing expenses are: • compensation expenses for employees engaged in sales and marketing, sales support, and certain customer service functions; and • spending relating to our advertising and promotional activities in support of our products and services. The main components of our general and administrative expenses are: • compensation expenses for employees in finance, human resources, information technology, legal, and other administrative support functions; • expenses relating to legal matters, including fines and settlements; and • third-party services fees, including audit, consulting, outside legal, and other outsourced administrative services. Other Income (Expense), Net Other income (expense), net primarily consists of interest income (expense), the effect of foreign currency exchange gains (losses), net gains (losses) and impairment on our marketable and non-marketable securities, performance fees, and income (loss) and impairment from our equity method investments. For additional details, including how we account for our investments and factors that can drive fluctuations in the value of our investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K as well as Item 7A, “Quantitative and Qualitative Disclosures About Market Risk”. Provision for Income Taxes Provision for income taxes represents the estimated amount of federal, state, and foreign income taxes incurred in the U.S. and the many jurisdictions in which we operate. The provision includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. For additional details, including a reconciliation of the U.S. federal statutory rate to our effective tax rate, see Note 14 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Executive Overview The following table summarizes our consolidated financial results (in millions, except for per share information and percentages): Year Ended December 31, 2021 2022 $ Change % Change Consolidated revenues $ 257,637 $ 282,836 $ 25,199 10 % Change in consolidated constant currency revenues (1) 14 % Cost of revenues $ 110,939 $ 126,203 $ 15,264 14 % Operating expenses $ 67,984 $ 81,791 $ 13,807 20 % Operating income $ 78,714 $ 74,842 $ (3,872) (5) % Operating margin 31 % 26 % (5) % Other income (expense), net $ 12,020 $ (3,514) $ (15,534) (129) % Net income $ 76,033 $ 59,972 $ (16,061) (21) % Diluted EPS $ 5.61 $ 4.56 $ (1.05) (19) % (1) See "Use of Non-GAAP Constant Currency Measures" below for details relating to our use of constant currency information. • Revenues were $282.8 billion, an increase of 10% year over year, primarily driven by an increase in Google Services revenues of $16.0 billion, or 7%, and an increase in Google Cloud revenues of $7.1 billion, or 37%. • Total constant currency revenues, which exclude the effect of hedging, increased 14% year over year. 30 Table of Contents Alphabet Inc. • Cost of revenues was $126.2 billion, an increase of 14% year over year, primarily driven by an increase in other costs of revenues. • Operating expenses were $81.8 billion, an increase of 20% year over year, primarily driven by increases in compensation expenses due to headcount growth, third-party service fees, and advertising and promotional expenses. Other information: • On September 12, 2022, we closed the acquisition of Mandiant for a total purchase price of $6.1 billion and added more than 2,600 employees. Mandiant's financial results are reported within Google Cloud as of the acquisition date. See Note 8 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information. • On July 15, 2022, the company executed a 20-for-one stock split with a record date of July 1, 2022, effected in the form of a one-time special stock dividend on each share of the company's Class A, Class B, and Class C stock. All prior period references made to share or per share amounts throughout this Management's Discussion and Analysis of Financial Condition and Results of Operations prior to the effective date have been retroactively adjusted to reflect the effects of the Stock Split. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information. • Beginning in the first quarter of 2022, we suspended the vast majority of our commercial activities in Russia and effectively ceased business activities of our Russian entity. The ongoing effect of these direct actions on our financial results was not material. The broader economic effects resulting from the war in Ukraine on our future financial results may be unpredictable. • Repurchases of Class A and Class C shares were $59.3 billion for the year ended December 31, 2022 . See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for additional information. • Operating cash flow was $91.5 billion for the year ended December 31, 2022. • Capital expenditures, which primarily reflected investments in technical infrastructure, were $31.5 billion for the year ended December 31, 2022. • As of December 31, 2022, we had 190,234 employees. Additionally, looking ahead to fiscal year 2023: • In January 2023, we announced a reduction of our workforce of approximately 12,000 roles. We expect to incur employee severance and related charges of $1.9 billion to $2.3 billion, the majority of which will be recognized in the first quarter of 2023. In addition, we are taking actions to optimize our global office space. As a result we expect to incur exit costs relating to office space reductions of approximately $0.5 billion in the first quarter of 2023. We may incur additional charges in the future as we further evaluate our real estate needs. • In January 2023, we completed an assessment of the useful lives of our servers and network equipment, resulting in a change in the estimated useful life of our servers and certain network equipment to six years, which we expect to result in a reduction of depreciation of approximately $3.4 billion for the full fiscal year 2023 for assets in service as of December 31, 2022, recorded primarily in cost of revenues and R&D expenses. • As AI is critical to delivering our mission of bringing our breakthrough innovations into the real world, beginning in January 2023, we will update our segment reporting relating to certain of Alphabet's AI activities. DeepMind, previously reported within Other Bets, will be reported as part of Alphabet's corporate costs, reflecting its increasing collaboration with Google Services, Google Cloud, and Other Bets. Prior periods will be recast to conform to the revised presentation. See Note 15 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for information relating to our segments. 31 Table of Contents Alphabet Inc. Financial Results Revenues The following table presents revenues by type (in millions): Year Ended December 31, 2021 2022 Google Search & other $ 148,951 $ 162,450 YouTube ads 28,845 29,243 Google Network 31,701 32,780 Google advertising 209,497 224,473 Google other 28,032 29,055 Google Services total 237,529 253,528 Google Cloud 19,206 26,280 Other Bets 753 1,068 Hedging gains (losses) 149 1,960 Total revenues $ 257,637 $ 282,836 Google Services Google advertising revenues Google Search & other Google Search & other revenues increased $13.5 billion from 2021 to 2022. The growth was driven by interrelated factors including increases in search queries resulting from growth in user adoption and usage, primarily on mobile devices; growth in advertiser spending; and improvements we have made in ad formats and delivery. Growth was adversely affected by the unfavorable effect of foreign currency exchange rates. YouTube ads YouTube ads revenues increased $398 million from 2021 to 2022. The growth was driven by our brand advertising products followed by direct response products, both of which benefited from increased spending by our advertisers as well as improvements to ad formats and delivery. Growth was adversely affected by the unfavorable effect of foreign currency exchange rates. Google Network Google Network revenues increased $1.1 billion from 2021 to 2022. The growth was primarily driven by strength in AdSense and AdMob. Growth was adversely affected by the unfavorable effect of foreign currency exchange rates. Monetization Metrics Paid clicks and cost-per-click The following table presents changes in paid clicks and cost-per-click (expressed as a percentage) from 2021 to 2022: Paid clicks change 10 % Cost-per-click change (1) % Paid clicks increased from 2021 to 2022 driven by a number of interrelated factors, including an increase in search queries resulting from growth in user adoption and usage, primarily on mobile devices; growth in advertiser spending; and improvements we have made in ad formats and delivery. Cost-per-click decreased from 2021 to 2022 driven by a number of interrelated factors including changes in device mix, geographic mix, advertiser spending, ongoing product changes, and property mix, as well as the unfavorable effect of foreign currency exchange rates. 32 Table of Contents Alphabet Inc. Impressions and cost-per-impression The following table presents changes in impressions and cost-per-impression (expressed as a percentage) from 2021 to 2022: Impressions change 3 % Cost-per-impression change 1 % Impressions increased from 2021 to 2022 primarily driven by Google Ad Manager and AdMob. The increase in cost-per-impression from 2021 to 2022 was driven by a number of interrelated factors including ongoing product and policy changes, improvements we have made in ad formats and delivery, changes in device mix, geographic mix, product mix, and property mix, partially offset by the unfavorable effect of foreign currency exchange rates. Google other revenues Google other revenues increased $1.0 billion from 2021 to 2022 primarily driven by growth in YouTube non-advertising and hardware revenues, partially offset by a decrease in Google Play revenues. The growth in YouTube non-advertising was largely due to an increase in paid subscribers. The growth in hardware was primarily driven by increased sales of Pixel devices. The decrease in Google Play revenues was primarily driven by the fee structure changes we announced in 2021 as well as a decrease in buyer spending. Additionally, the overall increase in Google other revenues was adversely affected by the unfavorable effect of foreign currency exchange rates. Google Cloud Google Cloud revenues increased $7.1 billion from 2021 to 2022. The growth was primarily driven by Google Cloud Platform followed by Google Workspace offerings. Google Cloud's infrastructure and platform services were the largest drivers of growth in Google Cloud Platform. Revenues by Geography The following table presents revenues by geography as a percentage of revenues, determined based on the addresses of our customers: Year Ended December 31, 2021 2022 United States 46 % 48 % EMEA 31 % 29 % APAC 18 % 16 % Other Americas 5 % 6 % Hedging gains (losses) 0 % 1 % For further details on revenues by geography, see Note 2 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Use of Non-GAAP Constant Currency Information International revenues, which represent a significant portion of our revenues, are generally transacted in multiple currencies and therefore are affected by fluctuations in foreign currency exchange rates. The effect of currency exchange rates on our business is an important factor in understanding period-to-period comparisons. We use non-GAAP constant currency revenues ("constant currency revenues") and non-GAAP percentage change in constant currency revenues ("percentage change in constant currency revenues") for financial and operational decision-making and as a means to evaluate period-to-period comparisons. We believe the presentation of results on a constant currency basis in addition to U.S. Generally Accepted Accounting Principles (GAAP) results helps improve the ability to understand our performance, because it excludes the effects of foreign currency volatility that are not indicative of our core operating results. Constant currency information compares results between periods as if exchange rates had remained constant period over period. We define constant currency revenues as revenues excluding the effect of foreign exchange rate movements ("FX Effect") as well as hedging activities, which are recognized at the consolidated level. We use constant currency revenues to determine the constant currency revenue percentage change on a year-on-year basis. Constant currency revenues are calculated by translating current period revenues using prior year comparable period exchange rates, as well as excluding any hedging effects realized in the current period. 33 Table of Contents Alphabet Inc. Constant currency revenue percentage change is calculated by determining the change in current period revenues over prior year comparable period revenues where current period foreign currency revenues are translated using prior year comparable period exchange rates and hedging effects are excluded from revenues of both periods. These results should be considered in addition to, not as a substitute for, results reported in accordance with GAAP. Results on a constant currency basis, as we present them, may not be comparable to similarly titled measures used by other companies and are not a measure of performance presented in accordance with GAAP. The following table presents the foreign exchange effect on international revenues and total revenues (in millions, except percentages): Year Ended December 31, 2022 % Change from Prior Period Year Ended December 31, Less FX Effect Constant Currency Revenues As Reported Less Hedging Effect Less FX Effect Constant Currency Revenues 2021 2022 United States $ 117,854 $ 134,814 $ 0 $ 134,814 14 % 0 % 14 % EMEA 79,107 82,062 (8,979) 91,041 4 % (11) % 15 % APAC 46,123 47,024 (3,915) 50,939 2 % (8) % 10 % Other Americas 14,404 16,976 (430) 17,406 18 % (3) % 21 % Revenues, excluding hedging effect 257,488 280,876 (13,324) 294,200 9 % (5) % 14 % Hedging gains (losses) 149 1,960 Total revenues (1) $ 257,637 $ 282,836 $ 294,200 10 % 1 % (5) % 14 % (1) Total constant currency revenues of $294.2 billion for 2022 increased $36.7 billion compared to $257.5 billion in revenues, excluding hedging effect for 2021. EMEA revenue growth was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Euro and the British pound. APAC revenue growth was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Japanese yen and the Australian dollar. Other Americas growth was unfavorably affected by changes in foreign currency exchange rates, primarily due to the U.S. dollar strengthening relative to the Argentine peso. Costs and Expenses Cost of Revenues The following table presents cost of revenues, including TAC (in millions, except percentages): Year Ended December 31, 2021 2022 TAC $ 45,566 $ 48,955 Other cost of revenues 65,373 77,248 Total cost of revenues $ 110,939 $ 126,203 Total cost of revenues as a percentage of revenues 43 % 45 % Cost of revenues increased $15.3 billion from 2021 to 2022. The increase was due to an increase in other cost of revenues and TAC of $11.9 billion and $3.4 billion, respectively. The increase in TAC from 2021 to 2022 was due to an increase in TAC paid to distribution partners and to Google Network partners, primarily driven by growth in revenues subject to TAC. The TAC rate was 22% in both 2021 and 2022. The TAC rate on Google Search & other revenues and the TAC rate on Google Network revenues were both substantially consistent from 2021 to 2022. The increase in other cost of revenues from 2021 to 2022 was primarily due to increases in data center costs and other operations costs as well as hardware costs. 34 Table of Contents Alphabet Inc. Research and Development The following table presents R&D expenses (in millions, except percentages): Year Ended December 31, 2021 2022 Research and development expenses $ 31,562 $ 39,500 Research and development expenses as a percentage of revenues 12 % 14 % R&D expenses increased $7.9 billion from 2021 to 2022 primarily driven by an increase in compensation expenses of $5.4 billion, largely resulting from a 21% increase in average headcount, and an increase in third-party service fees of $704 million. Sales and Marketing The following table presents sales and marketing expenses (in millions, except percentages): Year Ended December 31, 2021 2022 Sales and marketing expenses $ 22,912 $ 26,567 Sales and marketing expenses as a percentage of revenues 9 % 9 % Sales and marketing expenses increased $3.7 billion from 2021 to 2022, primarily driven by an increase in compensation expenses of $1.8 billion, largely resulting from a 19% increase in average headcount, and an increase in advertising and promotional activities of $1.3 billion. General and Administrative The following table presents general and administrative expenses (in millions, except percentages): Year Ended December 31, 2021 2022 General and administrative expenses $ 13,510 $ 15,724 General and administrative expenses as a percentage of revenues 5 % 6 % General and administrative expenses increased $2.2 billion from 2021 to 2022. The increase was primarily driven by an increase in compensation expenses of $1.1 billion, largely resulting from a 21% increase in average headcount, and an increase in third-party services fees of $815 million. In addition, there was a $551 million increase to the allowance for credit losses for accounts receivable, as the prior year comparable period reflected a decline in the allowance. Segment Profitability The following table presents segment operating income (loss) (in millions). Year Ended December 31, 2021 2022 Operating income (loss): Google Services $ 91,855 $ 86,572 Google Cloud (3,099) (2,968) Other Bets (5,281) (6,083) Corporate costs, unallocated (1) (4,761) (2,679) Total income from operations $ 78,714 $ 74,842 (1) Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including certain fines and settlements, as well as costs associated with certain shared R&D activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs and totaled $149 million and $2.0 billion in 2021 and 2022, respectively. Google Services Google Services operating income decreased $5.3 billion from 2021 to 2022. The decrease in operating income was primarily driven by increases in compensation expenses and TAC, partially offset by growth in revenues. 35 Table of Contents Alphabet Inc. Google Cloud Google Cloud operating loss decreased $131 million from 2021 to 2022. The decrease in operating loss was primarily driven by growth in revenues, partially offset by an increase in compensation expenses. Other Bets Other Bets operating loss increased $802 million from 2021 to 2022. The increase in operating loss was primarily driven by increases in compensation expenses, partially offset by growth in revenues. Other Income (Expense), Net The following table presents other income (expense), net, (in millions): Year Ended December 31, 2021 2022 Other income (expense), net $ 12,020 $ (3,514) Other income (expense), net, decreased $15.5 billion from 2021 to 2022 primarily due to changes in gains and losses on equity securities and performance fees. In 2022, $3.2 billion of net unrealized losses were recognized on marketable equity securities and $1.5 billion of net realized losses were recognized on debt securities. These losses were partially offset by interest income of $2.2 billion and reversals of previously accrued performance fees related to certain investments of $798 million. In 2021, $9.8 billion of net unrealized gains were recognized on non-marketable equity securities and $1.5 billion of interest income was recognized, partially offset by $1.9 billion of accrued performance fees related to certain investments. See Note 7 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. Provision for Income Taxes The following table presents provision for income taxes (in millions, except for effective tax rate): Year Ended December 31, 2021 2022 Income before provision for income taxes $ 90,734 $ 71,328 Provision for income taxes $ 14,701 $ 11,356 Effective tax rate 16.2 % 15.9 % The effective tax rate decreased from 2021 to 2022, primarily driven by the effects of capitalization and amortization of R&D expenses in 2022 as required by the 2017 Tax Cuts and Jobs Act generating an increase in the U.S. federal Foreign Derived Intangible Income tax deduction. The decrease was partially offset by a decrease in pre-tax earnings, including in countries that have lower statutory rates and a decrease in the stock-based compensation related tax benefit. See Note 14 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information. Financial Condition Cash, Cash Equivalents, and Marketable Securities As of December 31, 2022 , we had $113.8 billion in cash, cash equivalents, and short-term marketable securities. Ca sh equivalents and marketable securities a re comprised of time deposits, money market funds, highly liquid government bonds, corporate debt securities, mortgage-backed and asset-backed securities, and marketable equity securities. Sources, Uses of Cash, and Related Trends Our principal sources of liquidity are cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from operations. The primary use of capital continues to be to invest for the long-term growth of the business. We regularly evaluate our cash and capital structure, including the size, pace, and form of capital return to stockholders. 36 Table of Contents Alphabet Inc. The following table presents our cash flows (in millions): Year Ended December 31, 2021 2022 Net cash provided by operating activities $ 91,652 $ 91,495 Net cash used in investing activities $ (35,523) $ (20,298) Net cash used in financing activities $ (61,362) $ (69,757) Cash Provided by Operating Activities Our largest source of cash provided by operations are advertising revenues generated by Google Search & other properties, Google Network properties, and YouTube properties. Additionally, we generate cash through sales of apps and in-app purchases, and hardware; and licensing and service fees, including fees received for Google Cloud offerings and subscription-based products. Our primary uses of cash from operating activities include payments to distribution and Google Network partners, to employees for compensation, and to content providers. Other uses of cash from operating activities include payments to suppliers for hardware, to tax authorities for income taxes, and other general corporate expenditures. Net cash provided by operating activities decreased from 2021 to 2022 primarily due to the net effect of an increase in cash received from revenues, offset by increases in cash paid for cost of revenues and operating expenses and an increase in tax payments driven by the effects of capitalization and amortization of R&D expenses beginning in 2022 as required by the 2017 Tax Cuts and Jobs Act. Cash Used in Investing Activities Cash provided by investing activities consists primarily of maturities and sales of investments in marketable and non-marketable securities. Cash used in investing activities consists primarily of purchases of marketable and non-marketable securities, purchases of property and equipment, and payments for acquisitions. Net cash used in investing activities decreased from 2021 to 2022 as a result of a decrease in net purchases of and maturities and sales of marketable securities, partially offset by an increase in purchases of property and equipment. Cash Used in Financing Activities Cash provided by financing activities consists primarily of proceeds from issuance of debt and proceeds from the sale of interest in consolidated entities. Cash used in financing activities consists primarily of repurchases of stock, net payments related to stock-based award activities, and repayments of debt. Net cash used in financing activities increased from 2021 to 2022 primarily due to an increase in repurchases of stock. Liquidity and Material Cash Requirements We expect existing cash, cash equivalents, short-term marketable securities, cash flows from operations and financing activities to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities for at least the next 12 months and thereafter for the foreseeable future. Capital Expenditures and Leases We make investments in land and buildings for data centers and offices and information technology assets through purchases of property and equipment and lease arrangements to provide capacity for the growth of our services and products. Capital Expenditures Our capital investments in property and equipment consist primarily of the following major categories: • technical infrastructure, which consists of our investments in servers and network equipment for computing, storage, and networking requirements for ongoing business activities, including AI, (collectively referred to as our information technology assets) and data center land and building construction; and • office facilities, ground-up development projects, and building improvements (also referred to as "fit-outs"). Construction in progress consists primarily of technical infrastructure and office facilities which have not yet been placed in service. The time frame from date of purchase to placement in service of these assets may extend from months to years. For example, our data center construction projects are generally multi-year projects with multiple 37 Table of Contents Alphabet Inc. phases, where we acquire qualified land and buildings, construct buildings, and secure and install information technology assets. During the years ended December 31, 2021 and 2022, we spent $24.6 billion and $31.5 billion on capital expenditures, respectively. Depreciation of our property and equipment commences when the deployment of such assets are completed and are ready for our intended use. Land is not depreciated. For the years ended December 31, 2021 and 2022, our depreciation and impairment expenses on property and equipment were $11.6 billion and $15.3 billion, respectively. Leases For the years ended December 31, 2021 and 2022, we recognized total operating lease assets of $3.0 billion and $4.4 billion, respectively. As of December 31, 2022, the amount of total future lease payments under operating leases, which had a weighted average remaining lease term of 8 years, was $17.4 billion, of which $3.0 billion is short-term. As of December 31, 2022, we have entered into leases that have not yet commenced with future short-term and long-term lease payments of $630 million and $3.1 billion that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2023 and 2026 with non-cancelable lease terms of 1 to 25 years. For the years ended December 31, 2021 and 2022, our operating lease expenses (including variable lease costs) were $3.4 billion and $3.7 billion, respectively. Finance lease costs were not material for the years ended December 31, 2021 and 2022. See Note 4 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information on leases. Financing We have a short-term debt financing program of up to $10.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. As of December 31, 2022, we had no commercial paper outstanding. As of December 31, 2022, we had $10.0 billion of revolving credit facilities, $4.0 billion expiring in April 2023 and $6.0 billion expiring in April 2026. The interest rates for all credit facilities are determined based on a formula using certain market rates, as well as our progress toward the achievement of certain sustainability goals . No amounts have been borrowed under the credit facilities. As of December 31, 2022, we had senior unsecured notes outstanding with a total carrying value of $12.9 billion with short-term and long-term future interest payments of $231 million and $3.8 billion, respectively. See Note 6 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for further information on our debt. We primarily utilize contract manufacturers for the assembly of our servers used in our technical infrastructure and hardware products we sell. We have agreements where we may purchase components directly from suppliers and then supply these components to contract manufacturers for use in the assembly of the servers and hardware products. Certain of these arrangements result in a portion of the cash received from and paid to the contract manufacturers to be presented as financing activities in the Consolidated Statements of Cash Flows included in Item 8 of this Annual Report on From 10-K. Share Repurchase Program In April 2022, the Board of Directors of Alphabet authorized the company to repurchase up to $70.0 billion of its Class A and Class C shares. As of December 31, 2022, $28.1 billion remains available for Class A and Class C share repurchases. In accordance with the authorization of the Board of Directors of Alphabet, during 2022 we repurchased and subsequently retired 530 million shares for $59.3 billion. Of the aggregate amount repurchased and subsequently retired, 61 million shares were Class A stock for $6.7 billion and 469 million shares were Class C stock for $52.6 billion. See Note 11 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. European Commission Fines In 2017, 2018 and 2019, the EC announced decisions that certain actions taken by Google infringed European competition law and imposed fines of €2.4 billion ($2.7 billion as of June 27, 2017), €4.3 billion ($5.1 billion as of June 30, 2018), and €1.5 billion ($1.7 billion as of March 20, 2019), respectively. On September 14, 2022, the General Court reduced the 2018 fine from €4.3 billion to €4.1 billion. We subsequently filed an appeal to the European Court of Justice. In 2018 we recognized a charge of $5.1 billion for the fine, which we reduced by $217 million in 2022. While each EC decision is under appeal, we included the fines in accrued expenses and other current liabilities on our Consolidated Balance Sheets as we provided bank guarantees (in lieu of a cash payment) for the fines. For 38 Table of Contents Alphabet Inc. further details, see Note 10 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. Taxes As of December 31, 2022 , we had short-term and long-term income taxes payable of $1.6 billion and $4.2 billion related to a one-time transition tax payable incurred as a result of the U.S. Tax Cuts and Jobs Act ("Tax Act"). As permitted by the Tax Act, we will pay the transition tax in annual interest-free installments through 2025. We also have taxes payable of $5.1 billion primarily related to uncertain tax positions as of December 31, 2022 . Purchase Commitments As of December 31, 2022, we had material non-cancelable contractual obligations of $32.0 billion , of which $17.3 billion was short-term. These amounts represent the non-cancelable portion of agreements or the minimum cancellation fee and are primarily related to commitments to purchase licenses, technical infrastructure, inventory, and network capacity. For those agreements with variable terms, we do not estimate the non-cancelable obligation beyond any minimum quantities and/or pricing as of December 31, 2022. In addition we regularly enter into multi-year, non-cancellable agreements to purchase renewable energy and energy attributes, such as renewable energy certificates. These agreements do not include a minimum dollar commitment. The amounts to be paid under these agreements are based on the actual volumes to be generated and are not readily determinable. Critical Accounting Estimates We prepare our consolidated financial statements in accordance with GAAP. In doing so, we have to make estimates and assumptions. Our critical accounting estimates are those estimates that involve a significant level of uncertainty at the time the estimate was made, and changes in them have had or are reasonably likely to have a material effect on our financial condition or results of operations. Accordingly, actual results could differ materially from our estimates. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We have reviewed our critical accounting estimates with the Audit and Compliance Committee of our Board of Directors. See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for a summary of significant accounting policies and the effect on our financial statements. Fair Value Measurements of Non-Marketable Equity Securities We measure certain financial instruments at fair value on a nonrecurring basis, consisting primarily of our non-marketable equity securities. These investments are accounted for under the measurement alternative method ("the measurement alternative") and are measured at cost, less impairment, subject to upward and downward adjustments resulting from observable price changes for identical or similar investments of the same issuer. These adjustments require quantitative assessments of the fair value of our securities, which may require the use of unobservable inputs. Pricing adjustments are determined by using various valuation methodologies and involve the use of estimates using the best information available, which may include cash flow projections or other available market data. Non-marketable equity securities are also evaluated for impairment, based on qualitative factors including the companies' financial and liquidity position and access to capital resources, among others. When indicators of impairment exist, we prepare quantitative measurements of the fair value of our equity investments using a market approach or an income approach, which requires judgment and the use of unobservable inputs, including discount rates, investee revenues and costs, and comparable market data of private and public companies, among others. When the quantitative remeasurements of fair value indicate an impairment exists, we write down the investment to its current fair value. We also have compensation arrangements with payouts based on realized returns from certain investments, i.e. performance fees. We record compensation expense based on the estimated payouts on an ongoing basis, which may result in expense recognized before investment returns are realized and compensation is paid and may require the use of unobservable inputs. Property and Equipment We assess the reasonableness of the useful lives of our property and equipment periodically as well as when other changes occur, such as when there are changes to ongoing business operations, changes in the planned use and utilization of assets, or technological advancements, that could indicate a change in the period over which we expect to benefit from the assets. 39 Table of Contents Alphabet Inc. Income Taxes We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Recording an uncertain tax position involves various qualitative considerations, including evaluation of comparable and resolved tax exposures, applicability of tax laws, and likelihood of settlement. We evaluate uncertain tax positions periodically, considering changes in facts and circumstances, such as new regulations or recent judicial opinions, as well as the status of audit activities by taxing authorities. Although we believe we have adequately reserved for our uncertain tax positions, no assurance can be given that the final tax outcome of these matters will not be different. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes and the effective tax rate in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate as well as the related net interest and penalties. In addition, we are subject to the continuous examination of our income tax returns by the Internal Revenue Services (IRS) and other tax authorities which may assert assessments against us. We regularly assess the likelihood of adverse outcomes resulting from these examinations and assessments to determine the adequacy of our provision for income taxes. Loss Contingencies We are regularly subject to claims, lawsuits, regulatory and government investigations, other proceedings, and consent orders involving competition, intellectual property, data privacy and security, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury consumer protection, and other matters. Certain of these matters include speculative claims for substantial or indeterminate amounts of damages. We record a liability when we believe that it is probable that a loss has been incurred and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the possible loss in Note 10 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. We evaluate, on a regular basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments and changes to our disclosures as appropriate. Significant judgment is required to determine both the likelihood and the estimated amount of a loss related to such matters. Until the final resolution of such matters, there may be an exposure to loss in excess of the amount recorded, and such amounts could be material. Change in Accounting Estimate In January 2023, we completed an assessment of the useful lives of our servers and network equipment, resulting in a change in the estimated useful life of our servers and certain network equipment to six years, which we expect to result in a reduction of depreciation of approximately $3.4 billion for the full fiscal year 2023 for assets in service as of December 31, 2022, recorded primarily in cost of revenues and R&D expenses. See Note 1 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K for information relating to the useful lives of our servers and network equipment. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to financial market risks, including changes in foreign currency exchange rates, interest rates, and equity investment risks. Foreign Currency Exchange Risk We transact business globally in multiple currencies. International revenues, as well as costs and expenses denominated in foreign currencies, expose us to the risk of fluctuations in foreign currency exchange rates against the U.S. dollar. Principal currencies hedged included the Australian dollar, British pound, Canadian dollar, Euro, and Japanese yen. For the purpose of analyzing foreign currency exchange risk, we considered the historical trends in foreign currency exchange rates and determined that it was reasonably possible that adverse changes in exchange rates of 10% could be experienced. We use foreign currency forward and option contracts to offset the foreign exchange risk on assets and liabilities denominated in currencies other than the functional currency of the subsidiary. These forward and option contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements on our assets and liabilities. The foreign currency gains and losses on these assets and liabilities are recorded in other income (expense), net, which are offset by the gains and losses on the forward and option contracts. 40 Table of Contents Alphabet Inc. If an adverse 10% foreign currency exchange rate change was applied to total monetary assets, liabilities, and commitments denominated in currencies other than the functional currencies at the balance sheet date, it would have resulted in an adverse effect on income before income taxes of approxima tely $285 million and $136 million as of December 31, 2021 and 2022, respectively, after consideration of the effect of foreign exchange contracts in place for the years ended December 31, 2021 and 2022. We use foreign currency forward and option contracts, including collars (an option strategy comprised of a combination of purchased and written options) to protect forecasted U.S. dollar-equivalent earnings from changes in foreign currency exchange rates. When the U.S. dollar strengthens, gains from foreign currency forward and option contacts reduce the foreign currency losses related to our earnings. When the U.S. dollar weakens, losses from foreign currency forward and option contracts offset the foreign currency gains related to our earnings. These hedging contracts reduce, but do not entirely eliminate, the effect of foreign currency exchange rate movements. We designate these contracts as cash flow hedges for accounting purposes. We reflect the gains or losses of foreign currency spot rate changes as a component of accumulated other comprehensive income (AOCI) and subsequently reclassify them into revenues to offset the hedged exposures as they occur. I f the U.S. dollar weakened by 10% as of December 31, 2021 and 2022, the amount recorded in AOCI related to our cash flow hedges before tax effect would have been approximately $1.3 billion lower for both December 31, 2021 and 2022. The change in the value recorded in AOCI would be expected to offset a corresponding foreign currency change in forecasted hedged revenues when recognized. We use foreign exchange forward contracts designated as net investment hedges to hedge the foreign currency risks related to investment in foreign subsidiaries. These forward contracts serve to offset the foreign currency translation risk from our foreign operations. If the U.S. dollar weakened by 10%, the amount recorded in cumulative translation adjustment (CTA) within AOCI related to our net investment hedges before tax effect would have been approximately $975 million and $903 million lower as of December 31, 2021 and 2022, respectively. The change in value recorded in CTA would be expected to offset a corresponding foreign currency translation gain or loss from our investment in foreign subsidiaries. Interest Rate Risk Our Corporate Treasury investment strategy is to achieve a return that w ill allow us to preserve capital and maintain liquidity. We invest primarily in debt securities, including government bonds, corporate debt securities, mortgage-backed and asset-backed securities, money market and other funds, time deposits, and interest rate derivatives. By policy, we limit the amount of credit exposure to any one issuer. Our investments in both fixed rate and floating rate interest earning securities carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely affected due to a rise in interest rates, while floating rate securities may produce less income than predicted if interest rates fall. Unrealized gains or losses on our marketable debt securities are primarily due to interest rate fluctuations as compared to interest rates at the time of purchase. For certain fixed and variable rate debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. We measure securities for which we have not elected the fair value option at fair value with gains and losses recorded in AOCI until the securities are sold, less any expected credit losses. We use value-at-risk (VaR) analysis to determine the potential effect of fluctuations in interest rates on the value of our marketable debt security portfolio. The VaR is the expected loss in fair value, for a given confidence interval, for our investment portfolio due to adverse movements in interest rates. We use a variance/covariance VaR model with 95% confidence interval. The estimated one-day loss in fair value of marketable debt securities as of December 31, 2021 and 2022 are shown below (in millions): As of December 31, 12-Month Average As of December 31, 2021 2022 2021 2022 Risk category - interest rate $ 139 $ 256 $ 148 $ 198 Actual future gains and losses associated with our marketable debt security portfolio may differ materially from the sensitivity analyses performed as of December 31, 2021 and 2022 due to the inherent limitations associated with predicting the timing and amount of changes in interest rates and our actual exposures and positions. VaR analysis is not intended to represent actual losses but is used as a risk estimation. Equity Investment Risk Our marketable and non-marketable equity securities are subject to a wide variety of market-related risks that could substantially reduce or increase the fair value of our holdings. 41 Table of Contents Alphabet Inc. Our marketable equity securities are publicly traded stocks or funds and our non-marketable equity securities are investments in privately held companies, some of which are in the startup or development stages. We record marketable equity securities not accounted for under the equity method at fair value based on readily determinable market values, of which publicly traded stocks and mutual funds are subject to market price volatility, and represent $7.8 billion and $5.2 billion of our investments as of December 31, 2021 and 2022, respectively. A hypothetical adverse price change of 10% on our December 31, 2022 balance would decrease the fair value of marketable equity securities by $516 million. From time to time, we may enter into derivatives to hedge the market price risk on certain of our marketable equity securities. Our non-marketable equity securities not accounted for under the equity method are adjusted to fair value for observable transactions for identical or similar investments of the same issuer or impairment (referred to as the measurement alternative). The fair value measured at the time of the observable transaction is not necessarily an indication of the current fair value as of the balance sheet date. These investments, especially those that are in the early stages, are inherently risky because the technologies or products these companies have under development are typically in the early phases and may never materialize, and they may experience a decline in financial condition, which could result in a loss of a substantial part of our investment in these companies. Valuations of our equity investments in private companies are inherently more complex due to the lack of readily available market data and observable transactions at lower valuations could result in significant losses. In addition, global economic conditions could result in additional volatility. The success of our investment in any private company is also typically dependent on the likelihood of our ability to realize appreciation in the value of investments through liquidity events such as public offerings, acquisitions, private sales or other market events. Changes in the valuation of non-marketable equity securities may not directly correlate with changes in valuation of marketable equity securities. As of December 31, 2021 and 2022, the carrying value of our non-marketable equity securities, which were accounted for under the measurement alternative, was $27.6 billion and $28.5 billion, respectively. The carrying values of our equity method investments, which totaled approximately $1.5 billion as of December 31, 2021 and 2022, generally do not fluctuate based on market price changes. However, these investments could be impaired if the carrying value exceeds the fair value and is not expected to recover. For further information about our equity investments, see Note 1 and Note 3 of the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report on Form 10-K. 42 Table of Contents Alphabet Inc. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Alphabet Inc. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Page Reports of Independent Registered Public Accounting Firm (PCAOB ID: 42 ) 44 Financial Statements: Consolidated Balance Sheets 47 Consolidated Statements of Income 48 Consolidated Statements of Comprehensive Income 49 Consolidated Statements of Stockholders’ Equity 50 Consolidated Statements of Cash Flows 51 Notes to Consolidated Financial Statements 52 43 Table of Contents Alphabet Inc. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Alphabet Inc. (the Company) as of December 31, 2021 and 2022, the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 2022, and the related notes and financial statement schedule listed in the Index at Item 15 (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2021 and 2022, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2022 , in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework), and our report dated February 2, 2023 expressed an unqualified opinion thereon. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matter The critical audit matter communicated below is a matter arising from the current period audit of the financial statements that was communicated or required to be communicated to the audit committee and that: (1) relates to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective or complex judgments. The communication of the critical audit matter does not alter in any way our opinion on the consolidated financial statements, taken as a whole, and we are not, by communicating the critical audit matter below, providing a separate opinion on the critical audit matter or on the account or disclosure to which it relates. 44 Table of Contents Alphabet Inc. Loss Contingencies Description of the Matter The Company is regularly subject to claims, lawsuits, regulatory and government investigations, other proceedings, and consent orders involving competition, intellectual property, data privacy and security, tax and related compliance, labor and employment, commercial disputes, content generated by its users, goods and services offered by advertisers or publishers using their platforms, personal injury, consumer protection, and other matters. As described in Note 10 to the consolidated financial statements “Commitments and contingencies” such claims, lawsuits, regulatory and government investigations, other proceedings, and consent orders could result in adverse consequences. Significant judgment is required to determine both the likelihood, and the estimated amount, of a loss related to such matters. Auditing management’s accounting for and disclosure of loss contingencies from these matters involved challenging and subjective auditor judgment in assessing the Company’s evaluation of the probability of a loss, and the estimated amount or range of loss. How We Addressed the Matter in Our Audit We tested relevant controls over the identified risks associated with management’s accounting for and disclosure of these matters. This included controls over management’s assessment of the probability of incurrence of a loss and whether the loss or range of loss was reasonably estimable and the development of related disclosures. Our audit procedures included gaining an understanding of previous rulings issued by regulators and the status of ongoing lawsuits, reviewing letters addressing the matters from internal and external legal counsel, meeting with internal legal counsel to discuss the allegations, and obtaining a representation letter from management on these matters. We also evaluated the Company’s disclosures in relation to these matters. /s/ Ernst & Young LLP We have served as the Company's auditor since 1999. San Jose, California February 2, 2023 45 Table of Contents Alphabet Inc. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Alphabet Inc. Opinion on Internal Control Over Financial Reporting We have audited Alphabet Inc.’s internal control over financial reporting as of December 31, 2022, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) (the COSO criteria). In our opinion, Alphabet Inc. (the Company) maintained, in all material respects, effective internal control over financial reporting as of December 31, 2022, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the 2022 consolidated financial statements of the Company and our report dated February 2, 2023 expressed an unqualified opinion thereon. Basis for Opinion The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the U.S. Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control Over Financial Reporting A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ Ernst & Young LLP San Jose, California February 2, 2023 46 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED BALANCE SHEETS (in millions, except par value per share amounts) As of December 31, 2021 2022 Assets Current assets: Cash and cash equivalents $ 20,945 $ 21,879 Marketable securities 118,704 91,883 Total cash, cash equivalents, and marketable securities 139,649 113,762 Accounts receivable, net 39,304 40,258 Inventory 1,170 2,670 Other current assets 8,020 8,105 Total current assets 188,143 164,795 Non-marketable securities 29,549 30,492 Deferred income taxes 1,284 5,261 Property and equipment, net 97,599 112,668 Operating lease assets 12,959 14,381 Intangible assets, net 1,417 2,084 Goodwill 22,956 28,960 Other non-current assets 5,361 6,623 Total assets $ 359,268 $ 365,264 Liabilities and Stockholders’ Equity Current liabilities: Accounts payable $ 6,037 $ 5,128 Accrued compensation and benefits 13,889 14,028 Accrued expenses and other current liabilities 32,044 37,866 Accrued revenue share 8,996 8,370 Deferred revenue 3,288 3,908 Total current liabilities 64,254 69,300 Long-term debt 14,817 14,701 Deferred revenue, non-current 535 599 Income taxes payable, non-current 9,176 9,258 Deferred income taxes 5,257 514 Operating lease liabilities 11,389 12,501 Other long-term liabilities 2,205 2,247 Total liabilities 107,633 109,120 Commitments and contingencies (Note 10) Stockholders’ equity: Preferred stock, $ 0.001 par value per share, 100 shares authorized; no shares issued and outstanding 0 0 Class A, Class B, and Class C stock and additional paid-in capital, $ 0.001 par value per share: 300,000 shares authorized (Class A 180,000 , Class B 60,000 , Class C 60,000 ); 13,242 (Class A 6,015 , Class B 893 , Class C 6,334 ) and 12,849 (Class A 5,964 , Class B 883 , Class C 6,002 ) shares issued and outstanding 61,774 68,184 Accumulated other comprehensive income (loss) ( 1,623 ) ( 7,603 ) Retained earnings 191,484 195,563 Total stockholders’ equity 251,635 256,144 Total liabilities and stockholders’ equity $ 359,268 $ 365,264 See accompanying notes. 47 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF INCOME (in millions, except per share amounts) Year Ended December 31, 2020 2021 2022 Revenues $ 182,527 $ 257,637 $ 282,836 Costs and expenses: Cost of revenues 84,732 110,939 126,203 Research and development 27,573 31,562 39,500 Sales and marketing 17,946 22,912 26,567 General and administrative 11,052 13,510 15,724 Total costs and expenses 141,303 178,923 207,994 Income from operations 41,224 78,714 74,842 Other income (expense), net 6,858 12,020 ( 3,514 ) Income before income taxes 48,082 90,734 71,328 Provision for income taxes 7,813 14,701 11,356 Net income $ 40,269 $ 76,033 $ 59,972 Basic net income per share of Class A, Class B, and Class C stock $ 2.96 $ 5.69 $ 4.59 Diluted net income per share of Class A, Class B, and Class C stock $ 2.93 $ 5.61 $ 4.56 See accompanying notes. 48 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in millions) Year Ended December 31, 2020 2021 2022 Net income $ 40,269 $ 76,033 $ 59,972 Other comprehensive income (loss): Change in foreign currency translation adjustment 1,139 ( 1,442 ) ( 1,836 ) Available-for-sale investments: Change in net unrealized gains (losses) 1,313 ( 1,312 ) ( 4,720 ) Less: reclassification adjustment for net (gains) losses included in net income ( 513 ) ( 64 ) 1,007 Net change, net of income tax benefit (expense) of $( 230 ), $ 394 , and $ 1,056 800 ( 1,376 ) ( 3,713 ) Cash flow hedges: Change in net unrealized gains (losses) 42 716 1,275 Less: reclassification adjustment for net (gains) losses included in net income ( 116 ) ( 154 ) ( 1,706 ) Net change, net of income tax benefit (expense) of $ 11 , $( 122 ), and $ 110 ( 74 ) 562 ( 431 ) Other comprehensive income (loss) 1,865 ( 2,256 ) ( 5,980 ) Comprehensive income $ 42,134 $ 73,777 $ 53,992 See accompanying notes. 49 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (in millions) Class A and Class B Common Stock, Class C Capital Stock, and Additional Paid-In Capital Accumulated Other Comprehensive Income (Loss) Retained Earnings Total Stockholders’ Equity Shares Amount Balance as of December 31, 2019 13,767 $ 50,552 $ ( 1,232 ) $ 152,122 $ 201,442 Stock issued 167 168 0 0 168 Stock-based compensation expense 0 13,123 0 0 13,123 Tax withholding related to vesting of restricted stock units and other 0 ( 5,969 ) 0 0 ( 5,969 ) Repurchases of stock ( 430 ) ( 2,159 ) 0 ( 28,990 ) ( 31,149 ) Sale of interest in consolidated entities 0 2,795 0 0 2,795 Net income 0 0 0 40,269 40,269 Other comprehensive income (loss) 0 0 1,865 0 1,865 Balance as of December 31, 2020 13,504 58,510 633 163,401 222,544 Stock issued 145 12 0 0 12 Stock-based compensation expense 0 15,539 0 0 15,539 Tax withholding related to vesting of restricted stock units and other 0 ( 10,273 ) 0 0 ( 10,273 ) Repurchases of stock ( 407 ) ( 2,324 ) 0 ( 47,950 ) ( 50,274 ) Sale of interest in consolidated entities 0 310 0 0 310 Net income 0 0 0 76,033 76,033 Other comprehensive income (loss) 0 0 ( 2,256 ) 0 ( 2,256 ) Balance as of December 31, 2021 13,242 61,774 ( 1,623 ) 191,484 251,635 Stock issued 137 8 0 0 8 Stock-based compensation expense 0 19,525 0 0 19,525 Tax withholding related to vesting of restricted stock units and other 0 ( 9,754 ) 0 ( 1 ) ( 9,755 ) Repurchases of stock ( 530 ) ( 3,404 ) 0 ( 55,892 ) ( 59,296 ) Sale of interest in consolidated entities 0 35 0 0 35 Net income 0 0 0 59,972 59,972 Other comprehensive income (loss) 0 0 ( 5,980 ) 0 ( 5,980 ) Balance as of December 31, 2022 12,849 $ 68,184 $ ( 7,603 ) $ 195,563 $ 256,144 See accompanying notes. 50 Table of Contents Alphabet Inc. Alphabet Inc. CONSOLIDATED STATEMENTS OF CASH FLOWS (in millions) Year Ended December 31, 2020 2021 2022 Operating activities Net income $ 40,269 $ 76,033 $ 59,972 Adjustments: Depreciation and impairment of property and equipment 12,905 11,555 15,287 Amortization and impairment of intangible assets 792 886 641 Stock-based compensation expense 12,991 15,376 19,362 Deferred income taxes 1,390 1,808 ( 8,081 ) (Gain) loss on debt and equity securities, net ( 6,317 ) ( 12,270 ) 5,519 Other 1,267 ( 213 ) 1,030 Changes in assets and liabilities, net of effects of acquisitions: Accounts receivable, net ( 6,524 ) ( 9,095 ) ( 2,317 ) Income taxes, net 1,209 ( 625 ) 584 Other assets ( 1,330 ) ( 1,846 ) ( 5,046 ) Accounts payable 694 283 707 Accrued expenses and other liabilities 5,504 7,304 3,915 Accrued revenue share 1,639 1,682 ( 445 ) Deferred revenue 635 774 367 Net cash provided by operating activities 65,124 91,652 91,495 Investing activities Purchases of property and equipment ( 22,281 ) ( 24,640 ) ( 31,485 ) Purchases of marketable securities ( 136,576 ) ( 135,196 ) ( 78,874 ) Maturities and sales of marketable securities 132,906 128,294 97,822 Purchases of non-marketable securities ( 7,175 ) ( 2,838 ) ( 2,531 ) Maturities and sales of non-marketable securities 1,023 934 150 Acquisitions, net of cash acquired, and purchases of intangible assets ( 738 ) ( 2,618 ) ( 6,969 ) Other investing activities 68 541 1,589 Net cash used in investing activities ( 32,773 ) ( 35,523 ) ( 20,298 ) Financing activities Net payments related to stock-based award activities ( 5,720 ) ( 10,162 ) ( 9,300 ) Repurchases of stock ( 31,149 ) ( 50,274 ) ( 59,296 ) Proceeds from issuance of debt, net of costs 11,761 20,199 52,872 Repayments of debt ( 2,100 ) ( 21,435 ) ( 54,068 ) Proceeds from sale of interest in consolidated entities, net 2,800 310 35 Net cash used in financing activities ( 24,408 ) ( 61,362 ) ( 69,757 ) Effect of exchange rate changes on cash and cash equivalents 24 ( 287 ) ( 506 ) Net increase (decrease) in cash and cash equivalents 7,967 ( 5,520 ) 934 Cash and cash equivalents at beginning of period 18,498 26,465 20,945 Cash and cash equivalents at end of period $ 26,465 $ 20,945 $ 21,879 Supplemental disclosures of cash flow information Cash paid for income taxes, net of refunds $ 4,990 $ 13,412 $ 18,892 See accompanying notes. 51 Table of Contents Alphabet Inc. Alphabet Inc. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Summary of Significant Accounting Policies Nature of Operations Google was incorporated in California in September 1998 and re-incorporated in the State of Delaware in August 2003. In 2015, we implemented a holding company reorganization, and as a result, Alphabet Inc. ("Alphabet") became the successor issuer to Google. We generate revenues by delivering relevant, cost-effective online advertising; cloud-based solutions that provide enterprise customers with infrastructure and platform services as well as communication and collaboration tools; sales of other products and services, such as apps and in-app purchases, and hardware; and fees received for subscription-based products. Basis of Consolidation The consolidated financial statements of Alphabet include the accounts of Alphabet and entities consolidated under the variable interest and voting models. Intercompany balances and transactions have been eliminated. Use of Estimates Preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates due to uncertainties. On an ongoing basis, we evaluate our estimates, including those related to the allowance for credit losses; fair values of financial instruments, intangible assets, and goodwill; inventory; useful lives of intangible assets and property and equipment; income taxes; and contingent liabilities, among others. We base our estimates on assumptions, both historical and forward looking, that are believed to be reasonable, and the results of which form the basis for making judgments about the carrying values of assets and liabilities. In January 2023, we completed an assessment of the useful lives of our servers and network equipment and adjusted the estimated useful life of our servers from four years to six years and the estimated useful life of certain network equipment from five years to six years . This change in accounting estimate is effective beginning in fiscal year 2023. Stock Split Effected in the Form of a Stock Dividend (“Stock Split”) On February 1, 2022, the company announced that the Board of Directors had approved and declared a 20 -for-one stock split in the form of a one-time special stock dividend on each share of the company’s Class A, Class B, and Class C stock. The Stock Split had a record date of July 1, 2022 and an effective date of July 15, 2022. The par value per share of our Class A, Class B, and Class C stock remains unchanged at $ 0.001 per share after the Stock Split. All prior period references made to share or per share amounts in the accompanying consolidated financial statements and applicable disclosures prior to the effective date have been retroactively adjusted to reflect the effects of the Stock Split. Revenue Recognition Revenues are recognized when control of the promised goods or services is transferred to our customers, and the collectibility of an amount that we expect in exchange for those goods or services is probable. Sales and other similar taxes are excluded from revenues. Advertising Revenues We generate advertising revenues primarily by delivering advertising on: • Google Search and other properties, including revenues from traffic generated by search distribution partners who use Google.com as their default search in browsers, toolbars, etc. and other Google owned and operated properties like Gmail, Google Maps, and Google Play; • YouTube properties; and • Google Network properties, including revenues from Google Network properties participating in AdMob, AdSense, and Google Ad Manager. Our customers generally purchase advertising inventory through Google Ads, Google Ad Manager, and Google Marketing Platform, among others. 52 Table of Contents Alphabet Inc. We offer advertising by delivering both performance and brand advertising. We recognize revenues for performance advertising when a user engages with the advertisement, such as a click, a view, or a purchase. For brand advertising, we recognize revenues when the ad is displayed, or a user views the ad. For ads placed on Google Network properties, we evaluate whether we are the principal (i.e., report revenues on a gross basis) or agent (i.e., report revenues on a net basis). Generally, we report advertising revenues for ads placed on Google Network properties on a gross basis, that is, the amounts billed to our customers are recorded as revenues, and amounts paid to Google Network partners are recorded as cost of revenues. Where we are the principal, we control the advertising inventory before it is transferred to our customers. Our control is evidenced by our sole ability to monetize the advertising inventory before it is transferred to our customers and is further supported by us being primarily responsible to our customers and having a level of discretion in establishing pricing. Google Cloud Revenues Google Cloud revenues consist of revenues from: • Google Cloud Platform, which includes fees for infrastructure, platform, and other services; • Google Workspace, which includes fees for cloud-based communication and collaboration tools for enterprises, such as Gmail, Docs, Drive, Calendar, and Meet; and • other enterprise services. Our cloud services are generally provided on either a consumption or subscription basis and may have contract terms longer than a year. Revenues related to cloud services provided on a consumption basis are recognized when the customer utilizes the services, based on the quantity of services consumed. Revenues related to cloud services provided on a subscription basis are recognized ratably over the contract term as the customer receives and consumes the benefits of the cloud services. Google Other Revenues Google other revenues consist of revenues from: • Google Play, which includes sales of apps and in-app purchases; • hardware, which includes sales of Fitbit wearable devices, Google Nest home products, and Pixel devices; • YouTube non-advertising, which includes subscription revenues from services such as YouTube Premium and YouTube TV; and • other products and services. We report revenues from Google Play app sales and in-app purchases on a net basis, because our performance obligation is to facilitate a transaction between app developers and end users, for which we earn a service fee. Arrangements with Multiple Performance Obligations Our contracts with customers may include multiple performance obligations. For such arrangements, we allocate revenues to each performance obligation based on its relative standalone selling price. We generally determine standalone selling prices based on the prices charged to customers. Customer Incentives and Credits Certain customers receive cash-based incentives or credits, which are accounted for as variable consideration. We estimate these amounts based on the expected amount to be provided to customers and reduce revenues. We believe that there will not be significant changes to our estimates of variable consideration. Sales Commissions We expense sales commissions when incurred when the amortization period (the period of the expected benefit) is one year or less. We recognize an asset for certain sales commissions if we expect the period of benefit of these costs to exceed one year and recognize the expense over the amortization period. These costs are recorded within sales and marketing expenses. Cost of Revenues Cost of revenues consists of TAC and other costs of revenues. • TAC includes: 53 Table of Contents Alphabet Inc. ◦ Amounts paid to our distribution partners who make available our search access points and services. Our distribution partners include browser providers, mobile carriers, original equipment manufacturers, and software developers. ◦ Amounts paid to Google Network partners primarily for ads displayed on their properties. • Other cost of revenues includes: ◦ Content acquisition costs, which are payments to content providers from whom we license video and other content for distribution on YouTube and Google Play (we pay fees to these content providers based on revenues generated or a flat fee). ◦ Expenses associated with our data centers (including bandwidth, compensation expenses, depreciation, energy, and other equipment costs) as well as other operations costs (such as content review as well as customer and product support costs). ◦ Inventory and other costs related to the hardware we sell. Software Development Costs We expense software development costs, including costs to develop software products or the software component of products to be sold, leased, or marketed to external users, before technological feasibility is reached. Technological feasibility is typically reached shortly before the release of such products. As a result, development costs that meet the criteria for capitalization were not material for the periods presented. Software development costs also include costs to develop software to be used solely to meet internal needs and cloud-based applications used to deliver our services. We capitalize development costs related to these software applications once the preliminary project stage is complete and it is probable that the project will be completed and the software will be used to perform the function intended. Costs capitalized for developing such software applications were not material for the periods presented. Stock-based Compensation Stock-based compensation primarily consists of Alphabet restricted stock units (RSUs). RSUs are equity classified and measured at the fair market value of the underlying stock at the grant date. We recognize RSU expense using the straight-line attribution method over the requisite service period and account for forfeitures as they occur. For RSUs, shares are issued on the vesting dates net of the applicable statutory income tax withholding to be paid by us on behalf of our employees. As a result, fewer shares are issued than the number of RSUs outstanding, and the income tax withholding is recorded as a reduction to additional paid-in capital. Additionally, stock-based compensation includes other stock-based awards, such as performance stock units (PSUs) that include market conditions and awards that may be settled in cash or the stock of certain Other Bets. PSUs and certain Other Bet awards are equity classified and expense is recognized over the requisite service period. Certain Other Bet awards are liability classified and remeasured at fair value through settlement. The fair value of Other Bet awards is based on the equity valuation of the respective Other Bet. Advertising and Promotional Expenses We expense advertising and promotional costs in the period in which they are incurred. For the years ended December 31, 2020 , 2021, and 2022, advertising and promotional expenses totaled approximately $ 5.4 billion, $ 7.9 billion, and $ 9.2 billion, respectively. Performance Fees Performance fees refer to compensation arrangements with payouts based on realized returns from certain investments. We record compensation expense based on the estimated payouts on an ongoing basis, which may result in expense recognized before investment returns are realized and compensation is paid and may require the use of unobservable inputs. Performance fees are recorded as a component of other income (expense), net. Fair Value Measurements Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that is determined based on assumptions that market participants would use in pricing an asset or a liability. Assets and 54 Table of Contents Alphabet Inc. liabilities recorded at fair value are measured and classified in accordance with a three-tier fair value hierarchy based on the observability of the inputs available in the market used to measure fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Inputs that are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant inputs are observable in the market or can be derived from observable market data. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and credit ratings. Level 3 - Unobservable inputs that are supported by little or no market activities. The fair value hierarchy requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The determination of fair value involves the use of appropriate valuation methods and relevant inputs into valuation models. Our financial assets and liabilities that are measured at fair value on a recurring basis include cash equivalents, marketable securities, derivative financial instruments, and certain non-marketable debt securities. Our financial assets measured at fair value on a nonrecurring basis include non-marketable equity securities. Other financial assets and liabilities are carried at cost with fair value disclosed, if required. We measure certain other instruments, including stock-based compensation awards settled in the stock of certain Other Bets, and certain assets and liabilities acquired in a business combination, also at fair value on a nonrecurring basis. Financial Instruments Our financial instruments include cash, cash equivalents, marketable and non-marketable securities, derivative financial instruments and accounts receivable. Credit Risks We are subject to credit risk from cash equivalents, marketable securities, derivative financial instruments, including foreign exchange contracts, and accounts receivable. We manage our credit risk exposure through timely assessment of our counterparty creditworthiness, credit limits and use of collateral management. Foreign exchange contracts are transacted with various financial institutions with high credit standing. Accounts receivable are typically unsecured and are derived from revenues earned from customers located around the world. We manage our credit risk exposure by performing ongoing evaluations to determine customer credit and we limit the amount of credit we extend. We generally do not require collateral from our customers. Cash Equivalents We invest excess cash primarily in government bonds, corporate debt securities, mortgage-backed and asset-backed securities, time deposits, and money market funds. Marketable Securities We classify all marketable debt securities that have effective maturities of three months or less from the date of purchase as cash equivalents and those with effective maturities of greater than three months as marketable securities on our Consolidated Balance Sheets. We determine the appropriate classification of our investments in marketable debt securities at the time of purchase and reevaluate such designation at each balance sheet date. We have classified and accounted for our marketable debt securities as available-for-sale. After consideration of our risk versus reward objectives, as well as our liquidity requirements, we may sell these debt securities prior to their effective maturities. As we view these securities as available to support current operations, we classify highly liquid securities with maturities beyond 12 months as current assets under the caption marketable securities on the Consolidated Balance Sheets. We carry these securities at fair value, and report the unrealized gains and losses, net of taxes, as a component of stockholders’ equity, except for the changes in allowance for expected credit losses, which are recorded in other income (expense), net. For certain marketable debt securities we have elected the fair value option, for which changes in fair value are recorded in other income (expense), net. We determine any realized gains or losses on the sale of marketable debt securities on a specific identification method, and we record such gains and losses as a component of other income (expense), net. Our investments in marketable equity securities are measured at fair value with the related gains and losses, including unrealized, recognized in other income (expense), net. We classify our marketable equity securities subject 55 Table of Contents Alphabet Inc. to long-term lock-up restrictions beyond twelve months as other non-current assets on the Consolidated Balance Sheets. Non-Marketable Securities We account for non-marketable equity securities through which we exercise significant influence but do not have control over the investee under the equity method, All other non-marketable equity securities that we hold are primarily accounted for under the measurement alternative. Under the measurement alternative, the carrying value is measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for identical or similar investments of the same issuer. Adjustments are determined primarily based on a market approach as of the transaction date and are recorded as a component of other income (expense), net. Non-marketable debt securities are classified as available-for-sale securities. Non-marketable securities that do not have effective contractual maturity dates are classified as other non-current assets on the Consolidated Balance Sheets. Derivative Financial Instruments See Note 3 for the accounting policy pertaining to derivative financial instruments. Accounts Receivable Our payment terms for accounts receivable vary by the types and locations of our customers and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customers, we require payment before the products or services are delivered to the customer. Additionally, accounts receivable includes amounts for services performed in advance of the right to invoice the customer. We maintain an allowance for credit losses for accounts receivable, which is recorded as an offset to accounts receivable, and changes in such are classified as general and administrative expense in the Consolidated Statements of Income. We assess collectibility by reviewing accounts receivable on a collective basis where similar characteristics exist and on an individual basis when we identify specific customers with known disputes or collectibility issues. In determining the amount of the allowance for credit losses, we consider historical collectibility based on past due status and make judgments about the creditworthiness of customers based on ongoing credit evaluations. We also consider customer-specific information, current market conditions, and reasonable and supportable forecasts of future economic conditions. Other Our financial instruments also include debt and equity investments in companies with which we also have commercial arrangements. For these transactions, judgment is required to assess the substance of the arrangements, whether the arrangements and each component of the arrangements should be accounted for as separate transactions under the applicable GAAP, as well as the determination of the value of the components of the arrangements, including the fair value of the investments. Impairment of Investments We periodically review our debt and non-marketable equity securities for impairment. For debt securities in an unrealized loss position, we determine whether a credit loss exists. The credit loss is estimated by considering available information relevant to the collectibility of the security and information about past events, current conditions, and reasonable and supportable forecasts. Any credit loss is recorded as a charge to other income (expense), net, not to exceed the amount of the unrealized loss. Unrealized losses other than the credit loss are recognized in AOCI. If we have an intent to sell, or if it is more likely than not that we will be required to sell a debt security in an unrealized loss position before recovery of its amortized cost basis, we will write down the security to its fair value and record the corresponding charge as a component of other income (expense), net. For non-marketable equity securities, including equity method investments, we consider whether impairment indicators exist by evaluating the companies' financial and liquidity position and access to capital resources, among other indicators. If the assessment indicates that the investment is impaired, we write down the investment to its fair value by recording the corresponding charge as a component of other income (expense), net. We prepare quantitative measurements of the fair value of our equity investments using a market approach or an income approach. 56 Table of Contents Alphabet Inc. Inventory Inventory consists primarily of finished goods and is stated at the lower of cost and net realizable value. Cost is computed using the first-in, first-out method. Variable Interest Entities We determine at the inception of each arrangement whether an entity in which we have made an investment or in which we have other variable interests is considered a variable interest entity (VIE). We consolidate VIEs when we are the primary beneficiary. We are the primary beneficiary of a VIE when we have the power to direct activities that most significantly affect the economic performance of the VIE and have the obligation to absorb the majority of their losses or benefits. If we are not the primary beneficiary in a VIE, we account for the investment or other variable interests in a VIE in accordance with applicable GAAP. Periodically, we assess whether any changes in our interest or relationship with the entity affect our determination of whether the entity is a VIE and, if so, whether we are the primary beneficiary. Property and Equipment Property and equipment includes the following categories: land and buildings, information technology assets, construction in progress, leasehold improvements, and furniture and fixtures. Land and buildings include land, offices, data centers, and related building improvements. Information technology assets include servers and network equipment. Construction in progress is the construction or development of property and equipment that have not yet been placed in service. We account for property and equipment at cost less accumulated depreciation. We compute depreciation using the straight-line method over the estimated useful lives of the assets, which we regularly evaluate. Land is not depreciated. We depreciate buildings over periods of seven to 25 years. We depreciate information technology assets generally over periods of four to five years (generally, four years for servers and five years for network equipment). We depreciate leasehold improvements over the shorter of the remaining lease term or the estimated useful lives of the assets. Depreciation for buildings, information technology assets, leasehold improvements, and furniture and fixtures commences once they are ready for our intended use. Leases We determine if an arrangement is a lease at inception. Our lease agreements generally contain lease and non-lease components. Payments under our lease arrangements are primarily fixed. Non-lease components primarily include payments for maintenance and utilities. We combine fixed payments for non-lease components with lease payments and account for them together as a single lease component which increases the amount of our lease assets and liabilities. Certain lease agreements contain variable payments, which are expensed as incurred and not included in the lease assets and liabilities. These amounts include payments affected by the Consumer Price Index, payments contingent on wind or solar production for power purchase arrangements, and payments for maintenance and utilities. Lease assets and liabilities are recognized at the present value of the future lease payments at the lease commencement date. The interest rate used to determine the present value of the future lease payments is our incremental borrowing rate, because the interest rate implicit in our leases is not readily determinable. Our incremental borrowing rate is estimated to approximate the interest rate on a collateralized basis with similar terms and payments, and in economic environments where the leased asset is located. Our lease terms include periods under options to extend or terminate the lease when it is reasonably certain that we will exercise that option. We generally use the base, non-cancelable, lease term when determining the lease assets and liabilities. Lease assets also include any prepaid lease payments and lease incentives. Operating lease assets and liabilities are included on our Consolidated Balance Sheets. The current portion of our operating lease liabilities is included in accrued expenses and other current liabilities, and the long-term portion is included in operating lease liabilities. Finance lease assets are included in property and equipment, net. Finance lease liabilities are included in accrued expenses and other current liabilities or long-term debt. Operating lease expense (excluding variable lease costs) is recognized on a straight-line basis over the lease term. Long-Lived Assets, Goodwill and Other Acquired Intangible Assets We review property and equipment and intangible assets, excluding goodwill, for impairment when events or changes in circumstances indicate the carrying amount may not be recoverable. The evaluation is performed at the lowest level of identifiable cash flows independent of other assets. We measure recoverability of these assets by 57 Table of Contents Alphabet Inc. comparing the carrying amounts to the future undiscounted cash flows that the assets or the asset group are expected to generate. If the carrying value of the assets or asset group is not recoverable, the impairment recognized is measured as the amount by which the carrying value exceeds its fair value. Impairments were not material for the periods presented. We allocate goodwill to reporting units based on the expected benefit from the business combination. We evaluate our reporting units periodically, as well as when changes in our operating segments occur. For changes in reporting units, we reassign goodwill using a relative fair value allocation approach. We test our goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate that the asset may be impaired. Goodwill impairments were no t material for the periods presented. Intangible assets with definite lives are amortized over their estimated useful lives on a straight-line basis generally over periods ranging from one to twelve years , and are subsequently removed from the presentation of gross intangible assets and accumulated amortization once they are fully amortized. Income Taxes We account for income taxes using the asset and liability method, under which we recognize the amount of taxes payable or refundable for the current year and deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. We measure current and deferred tax assets and liabilities based on provisions of enacted tax law. We evaluate the realization of our deferred tax assets based on all available evidence and establish a valuation allowance to reduce deferred tax assets when it is more likely than not that they will not be realized. We have elected to account for the tax effects of the global intangible low tax Income provision as a current period expense. We recognize the financial statement effects of a tax position when it is more likely than not that, based on technical merits, the position will be sustained upon examination. The tax benefits of the position recognized in the financial statements are then measured based on the largest amount of benefit that is greater than 50% likely to be realized upon settlement with a taxing authority. In addition, we recognize interest and penalties related to unrecognized tax benefits as a component of the income tax provision. Business Combinations We include the results of operations of the businesses that we acquire as of the acquisition date. We allocate the purchase price of the acquisitions to the assets acquired and liabilities assumed based on their estimated fair values, except for revenue contracts acquired, which are recognized in accordance with our revenue recognition policy. The excess of the purchase price over the fair values of identifiable assets and liabilities is recorded as goodwill. Acquisition-related expenses are recognized separately from the business combination and are expensed as incurred. Foreign Currency We translate the financial statements of our international subsidiaries to U.S. dollars using month-end exchange rates for assets and liabilities, and average rates for the annual period derived from month-end exchange rates for revenues, costs, and expenses. We record translation gains and losses in AOCI as a component of stockholders’ equity. We reflect net foreign exchange transaction gains and losses resulting from the conversion of the transaction currency to functional currency as a component of foreign currency exchange gain (loss) in other income (expense), net. Prior Period Reclassifications Certain amounts in prior periods have been reclassified to conform with current period presentation. 58 Table of Contents Alphabet Inc. Note 2. Revenues Disaggregated Revenues The following table presents revenues disaggregated by type (in millions): Year Ended December 31, 2020 2021 2022 Google Search & other $ 104,062 $ 148,951 $ 162,450 YouTube ads 19,772 28,845 29,243 Google Network 23,090 31,701 32,780 Google advertising 146,924 209,497 224,473 Google other 21,711 28,032 29,055 Google Services total 168,635 237,529 253,528 Google Cloud 13,059 19,206 26,280 Other Bets 657 753 1,068 Hedging gains (losses) 176 149 1,960 Total revenues $ 182,527 $ 257,637 $ 282,836 No in dividual customer or groups of affiliated customers represented more than 10% of our revenues in 2020, 2021, or 2022. The following table presents revenues disaggregated by geography, based on the addresses of our customers (in millions): Year Ended December 31, 2020 2021 2022 United States $ 85,014 47 % $ 117,854 46 % $ 134,814 48 % EMEA (1) 55,370 30 79,107 31 82,062 29 APAC (1) 32,550 18 46,123 18 47,024 16 Other Americas (1) 9,417 5 14,404 5 16,976 6 Hedging gains (losses) 176 0 149 0 1,960 1 Total revenues $ 182,527 100 % $ 257,637 100 % $ 282,836 100 % (1) Regions represent Europe, the Middle East, and Africa (EMEA); Asia-Pacific (APAC); and Canada and Latin America ("Other Americas"). Revenue Backlog As of December 31, 2022, we had $ 64.3 billion of remaining performance obligations (“revenue backlog”), primarily related to Google Cloud. Our revenue backlog represents commitments in customer contracts for future services that have not yet been recognized as revenue. The amount and timing of revenue recognition for these commitments is largely driven by our ability to deliver in accordance with relevant contract terms and when our customers utilize services, which could affect our estimate of revenue backlog and when we expect to recognize such as revenue. We expect to recognize approximately half of the revenue backlog as revenues over the next 24 months with the remaining to be recognized thereafter. Revenue backlog includes related deferred revenue currently recorded as well as amounts that will be invoiced in future periods, and excludes contracts with an original expected term of one year or less and cancellable contracts. Deferred Revenue We record deferred revenues when cash payments are received or due in advance of our performance, including amounts which are refundable. Deferred revenues primarily relate to Google Cloud and Google other. Total deferred revenue as of December 31, 2021 was $ 3.8 billion, of which $ 2.5 billion was recognized as revenues for the year ending December 31, 2022 . 59 Table of Contents Alphabet Inc. Note 3. Financial Instruments Fair Value Measurements Investments measured at fair value on a recurring basis Cash, cash equivalents, and marketable equity securities are measured at fair value and classified within Level 1 and Level 2 in the fair value hierarchy, because we use quoted prices for identical assets in active markets or inputs that are based upon quoted prices for similar instruments in active markets. Debt securities are classified within Level 2 in the fair value hierarchy, because we use quoted market prices to the extent available or alternative pricing sources and models utilizing market observable inputs to determine fair value. For certain marketable debt securities, we have elected the fair value option for which changes in fair value are recorded in other income (expense), net. The fair value option was elected for these securities to align with the unrealized gains and losses from related derivative contracts. The following tables summarize our cash, cash equivalents, and marketable securities measured at fair value on a recurring basis (in millions): As of December 31, 2021 Fair Value Hierarchy Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Fair value changes recorded in other comprehensive income Time deposits (1) Level 2 $ 5,133 $ 0 $ 0 $ 5,133 $ 5,133 $ 0 Government bonds Level 2 53,288 258 ( 238 ) 53,308 5 53,303 Corporate debt securities Level 2 35,605 194 ( 223 ) 35,576 12 35,564 Mortgage-backed and asset-backed securities Level 2 18,829 96 ( 112 ) 18,813 0 18,813 Total investments with fair value change reflected in Other Comprehensive Income (2) $ 112,855 $ 548 $ ( 573 ) $ 112,830 $ 5,150 $ 107,680 Fair value adjustments recorded in net income Money market funds Level 1 $ 7,499 $ 7,499 $ 0 Current marketable equity securities (3) Level 1 5,998 0 5,998 Mutual funds Level 2 351 0 351 Government bonds Level 2 1,165 0 1,165 Corporate debt securities Level 2 2,503 0 2,503 Mortgage-backed and asset-backed securities Level 2 1,007 0 1,007 Total investments with fair value change recorded in Net Income $ 18,523 $ 7,499 $ 11,024 Cash 0 8,296 0 Total $ 112,855 $ 548 $ ( 573 ) $ 131,353 $ 20,945 $ 118,704 (1) The majority of our time deposits are domestic deposits. (2) Represents gross unrealized gains and losses for debt securities recorded to AOCI. (3) The long-term portion of marketable equity securities (subject to long-term lock-up restrictions) of $ 1.4 billion as of December 31, 2021 is included within other non-current assets. 60 Table of Contents Alphabet Inc. As of December 31, 2022 Fair Value Hierarchy Adjusted Cost Gross Unrealized Gains Gross Unrealized Losses Fair Value Cash and Cash Equivalents Marketable Securities Fair value changes recorded in other comprehensive income Time deposits (1) Level 2 $ 5,297 $ 0 $ 0 $ 5,297 $ 5,293 $ 4 Government bonds Level 2 41,036 64 ( 2,045 ) 39,055 283 38,772 Corporate debt securities Level 2 28,578 8 ( 1,569 ) 27,017 1 27,016 Mortgage-backed and asset-backed securities Level 2 16,176 5 ( 1,242 ) 14,939 0 14,939 Total investments with fair value change reflected in Other Comprehensive Income (2) $ 91,087 $ 77 $ ( 4,856 ) $ 86,308 $ 5,577 $ 80,731 Fair value adjustments recorded in net income Money market funds Level 1 $ 7,234 $ 7,234 $ 0 Current marketable equity securities (3) Level 1 4,013 0 4,013 Mutual funds Level 2 339 0 339 Government bonds Level 2 1,877 440 1,437 Corporate debt securities Level 2 3,744 65 3,679 Mortgage-backed and asset-backed securities Level 2 1,686 2 1,684 Total investments with fair value change recorded in Net Income $ 18,893 $ 7,741 $ 11,152 Cash 0 8,561 0 Total $ 91,087 $ 77 $ ( 4,856 ) $ 105,201 $ 21,879 $ 91,883 (1) The majority of our time deposits are domestic deposits. (2) Represents gross unrealized gains and losses for debt securities recorded to AOCI. (3) The long-term portion of marketable equity securities (subject to long-term lock-up restrictions) of $ 803 million as of December 31, 2022 is included within other non-current assets. Investments measured at fair value on a nonrecurring basis Our non-marketable equity securities are investments in privately held companies without readily determinable market values. The carrying value of our non-marketable equity securities is adjusted to fair value upon observable transactions for identical or similar investments of the same issuer or impairment. Non-marketable equity securities that have been remeasured during the period based on observable transactions are classified within Level 2 or Level 3 in the fair value hierarchy because we estimate the value based on valuation methods which may include a combination of the observable transaction price at the transaction date and other unobservable inputs including volatility, rights, and obligations of the securities we hold. The fair value of non-marketable equity securities that have been remeasured due to impairment are classified within Level 3. During the year ended December 31, 2022, included in the $ 28.5 billion of non-marketable equity securities held as of the end of the period, $ 14.1 billion were measured at fair value and primarily classified as Level 2 investments. 61 Table of Contents Alphabet Inc. Debt Securities The following table summarizes the estimated fair value of investments in available-for-sale marketable debt securities by effective contractual maturity dates (in millions): As of December 31, 2022 Due in 1 year or less $ 8,170 Due in 1 year through 5 years 51,698 Due in 5 years through 10 years 16,083 Due after 10 years 11,580 Total $ 87,531 The following tables present fair values and gross unrealized losses recorded to AOCI, aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions): As of December 31, 2021 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 32,843 $ ( 236 ) $ 71 $ ( 2 ) $ 32,914 $ ( 238 ) Corporate debt securities 22,737 ( 152 ) 303 ( 5 ) 23,040 ( 157 ) Mortgage-backed and asset-backed securities 11,502 ( 106 ) 248 ( 6 ) 11,750 ( 112 ) Total $ 67,082 $ ( 494 ) $ 622 $ ( 13 ) $ 67,704 $ ( 507 ) As of December 31, 2022 Less than 12 Months 12 Months or Greater Total Fair Value Unrealized Loss Fair Value Unrealized Loss Fair Value Unrealized Loss Government bonds $ 21,039 $ ( 1,004 ) $ 13,438 $ ( 1,041 ) $ 34,477 $ ( 2,045 ) Corporate debt securities 11,228 ( 440 ) 15,125 ( 1,052 ) 26,353 ( 1,492 ) Mortgage-backed and asset-backed securities 7,725 ( 585 ) 6,964 ( 657 ) 14,689 ( 1,242 ) Total $ 39,992 $ ( 2,029 ) $ 35,527 $ ( 2,750 ) $ 75,519 $ ( 4,779 ) We determine realized gains or losses on the sale or extinguishment of debt securities on a specific identification method. The following table summarizes gains and losses for debt securities, reflected as a component of other income (expense), net (in millions): Year Ended December 31, 2020 2021 2022 Unrealized gain (loss) on fair value option debt securities (1) $ 86 $ ( 122 ) $ ( 557 ) Gross realized gain on debt securities 899 432 103 Gross realized loss on debt securities ( 184 ) ( 329 ) ( 1,588 ) (Increase)/decrease in allowance for credit losses ( 76 ) ( 91 ) ( 22 ) Total gain (loss) on debt securities recognized in other income (expense), net $ 725 $ ( 110 ) $ ( 2,064 ) (1) Accumulated unrealized net gains (losses) related to debt securities still held where we have elected the fair value option were $ 87 million, $( 35 ) million, and $( 592 ) million as of December 31, 2020, 2021, and 2022, respectively. 62 Table of Contents Alphabet Inc. Equity Investments The carrying value of equity securities is measured as the total initial cost plus the cumulative net gain (loss). Our share of gains and losses, including impairments, are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 7 for further details on other income (expense), net. The carrying values for marketable and non-marketable equity securities are summarized below (in millions): As of December 31, 2021 As of December 31, 2022 Marketable Equity Securities Non-Marketable Equity Securities Total Marketable Equity Securities Non-Marketable Equity Securities Total Total initial cost $ 4,211 $ 15,135 $ 19,346 $ 5,764 $ 16,157 $ 21,921 Cumulative net gain (loss) (1) 3,587 12,436 16,023 ( 608 ) 12,372 11,764 Carrying value $ 7,798 $ 27,571 $ 35,369 $ 5,156 $ 28,529 $ 33,685 (1) Non-marketable equity securities cumulative net gain (loss) is comprised of $ 14.1 billion gains and $ 1.7 billion losses (including impairments) as of December 31, 2021 and $ 16.8 billion gains and $ 4.5 billion losses (including impairments) as of December 31, 2022. Gains and losses on marketable and non-marketable equity securities Gains and losses (including impairments), net, for marketable and non-marketable equity securities included in other income (expense), net are summarized below (in millions): Year Ended December 31, 2020 2021 2022 Realized net gain (loss) on equity securities sold during the period $ 1,339 $ 1,196 $ ( 442 ) Unrealized net gain (loss) on marketable equity securities 2,722 1,335 ( 3,242 ) Unrealized net gain (loss) on non-marketable equity securities (1) 1,531 9,849 229 Total gain (loss) on equity securities in other income (expense), net $ 5,592 $ 12,380 $ ( 3,455 ) (1) Unrealized gain (loss) on non-marketable equity securities accounted for under the measurement alternative is comprised of $ 3.0 billion, $ 10.0 billion, and $ 3.3 billion of upward adjustments as of December 31, 2020, 2021, and 2022, respectively, and $ 1.5 billion, $ 122 million, and $ 3.0 billion of downward adjustments (including impairments) as of December 31, 2020, 2021, and 2022, respectively. In the table above, realized net gain (loss) on equity securities sold during the period reflects the difference between the sale proceeds and the carrying value of the equity securities at the beginning of the period or the purchase date, if later. Cumulative net gains (losses) on equity securities sold during the period, which is summarized in the following table (in millions), represents the total net gains (losses) recognized after the initial purchase date of the equity security sold during the period. While these net gains (losses) may have been reflected in periods prior to the period of sale, we believe they are important supplemental information as they reflect the economic net gains (losses) on the securities sold during the period. Cumulative net gains (losses) are calculated as the difference between the sale price and the initial purchase price for the equity security sold during the period. Equity Securities Sold During the Year Ended December 31, 2021 2022 Total sale price $ 5,604 $ 1,784 Total initial cost 1,206 937 Cumulative net gains (losses) (1) $ 4,398 $ 847 (1) Cumulative net gains excludes cumulative losses of $ 738 million resulting from our equity derivatives, which hedged the changes in fair value of certain marketable equity securities sold during the year ended December 31, 2021. The associated derivative liabilities arising from these losses were settled against our holdings of the underlying equity securities. 63 Table of Contents Alphabet Inc. Equity securities accounted for under the equity method As of December 31, 2021 and 2022, equity securities accounted for under the equity method had a carrying value of approximately $ 1.5 billion for both years. Our share of gains and losses, including impairments, are included as a component of other income (expense), net, in the Consolidated Statements of Income. See Note 7 for further details on other income (expense), net. Derivative Financial Instruments We use derivative instruments to manage risks relating to our ongoing business operations. The primary risk managed is foreign exchange risk. We use foreign currency contracts to reduce the risk that our cash flows, earnings, and investment in foreign subsidiaries will be adversely affected by foreign currency exchange rate fluctuations. We also enter into derivative instruments to partially offset our exposure to other risks and enhance investment returns. We recognize derivative instruments in the Consolidated Balance Sheets at fair value and classify the derivatives primarily within Level 2 in the fair value hierarchy. We present our collar contracts (an option strategy comprised of a combination of purchased and written options) at net fair values and present all other derivatives at gross fair values. The accounting treatment for derivatives is based on the intended use and hedge designation. Cash Flow Hedges We designate foreign currency forward and option contracts (including collars) as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. These contracts have maturities of 24 months or less. Cash flow hedge amounts included in the assessment of hedge effectiveness are deferred in AOCI and subsequently reclassified to revenue when the hedged item is recognized in earnings. We exclude forward points and time value from our assessment of hedge effectiveness and amortize them on a straight-line basis over the life of the hedging instrument in revenues. The difference between fair value changes of the excluded component and the amount amortized to revenues is recorded in AOCI. As of December 31, 2022 , the net accumulated gain on our foreign currency cash flow hedges before tax effect was $ 171 million, which is expected to be reclassified from AOCI into revenues within the next 12 months. Fair Value Hedges We designate foreign currency forward contracts as fair value hedges to hedge foreign currency risks for our marketable securities denominated in currencies other than the U.S. dollar. Fair value hedge amounts included in the assessment of hedge effectiveness are recognized in other income (expense), net, along with the offsetting gains and losses of the related hedged items. We exclude forward points from the assessment of hedge effectiveness and recognize changes in the excluded component in other income (expense), net. Net Investment Hedges We designate foreign currency forward contracts as net investment hedges to hedge the foreign currency risks related to our investment in foreign subsidiaries. Net investment hedge amounts included in the assessment of hedge effectiveness are recognized in AOCI along with the foreign currency translation adjustment. We exclude forward points from the assessment of hedge effectiveness and recognize changes in the excluded component in other income (expense), net. Other Derivatives We enter into foreign currency forward and option contracts that are not designated as hedging instruments to hedge intercompany transactions and other monetary assets or liabilities denominated in currencies other than the functional currency of a subsidiary. Gains and losses on these derivatives that are not designated as accounting hedges are primarily recorded in other income (expense), net along with the foreign currency gains and losses on monetary assets and liabilities. We also use derivatives not designated as hedging instruments to manage risks relating to interest rates, commodity prices, credit exposures, and to enhance investment returns. From time to time, we enter into derivatives to hedge the market price risk on certain of our marketable equity securities. Gains and losses arising from other derivatives are primarily reflected within the “other” component of other income (expense), net. See Note 7 for further details. 64 Table of Contents Alphabet Inc. The gross notional amounts of outstanding derivative instruments were as follows (in millions): As of December 31, 2021 2022 Derivatives designated as hedging instruments: Foreign exchange contracts Cash flow hedges $ 16,362 $ 15,972 Fair value hedges $ 2,556 $ 2,117 Net investment hedges $ 10,159 $ 8,751 Derivatives not designated as hedging instruments: Foreign exchange contracts $ 41,031 $ 34,979 Other contracts $ 4,275 $ 7,932 The fair values of outstanding derivative instruments were as follows (in millions): As of December 31, 2021 As of December 31, 2022 Assets (1) Liabilities (2) Assets (1) Liabilities (2) Derivatives designated as hedging instruments: Foreign exchange contracts $ 867 $ 8 $ 271 $ 556 Derivatives not designated as hedging instruments: Foreign exchange contracts 42 452 365 207 Other contracts 52 121 40 47 Total derivatives not designated as hedging instruments 94 573 405 254 Total $ 961 $ 581 $ 676 $ 810 (1) Derivative assets are recorded as other current and non-current assets in the Consolidated Balance Sheets. (2) Derivative liabilities are recorded as accrued expenses and other liabilities, current and non-current in the Consolidated Balance Sheets. The gains (losses) on derivatives in cash flow hedging and net investment hedging relationships recognized in other comprehensive income (OCI) are summarized below (in millions): Gains (Losses) Recognized in OCI on Derivatives Before Tax Effect Year Ended December 31, 2020 2021 2022 Derivatives in cash flow hedging relationship: Foreign exchange contracts Amount included in the assessment of effectiveness $ 102 $ 806 $ 1,699 Amount excluded from the assessment of effectiveness ( 37 ) 48 ( 188 ) Derivatives in net investment hedging relationship: Foreign exchange contracts Amount included in the assessment of effectiveness ( 851 ) 754 608 Total $ ( 786 ) $ 1,608 $ 2,119 65 Table of Contents Alphabet Inc. The table below presents the gains (losses) of our derivatives on the Consolidated Statements of Income: (in millions): Gains (Losses) Recognized in Income Year Ended December 31, 2020 2021 2022 Revenues Other income (expense), net Revenues Other income (expense), net Revenues Other income (expense), net Total amounts in the Consolidated Statements of Income $ 182,527 $ 6,858 $ 257,637 $ 12,020 $ 282,836 $ ( 3,514 ) Effect of cash flow hedges: Foreign exchange contracts Amount reclassified from AOCI to income $ 144 $ 0 $ 165 $ 0 $ 2,046 $ 0 Amount excluded from the assessment of effectiveness (amortized) 33 0 ( 16 ) 0 ( 85 ) 0 Effect of fair value hedges: Foreign exchange contracts Hedged items 0 18 0 ( 95 ) 0 ( 162 ) Derivatives designated as hedging instruments 0 ( 18 ) 0 95 0 163 Amount excluded from the assessment of effectiveness 0 4 0 8 0 16 Effect of net investment hedges: Foreign exchange contracts Amount excluded from the assessment of effectiveness 0 151 0 82 0 171 Effect of non designated hedges: Foreign exchange contracts 0 718 0 ( 860 ) 0 ( 395 ) Other contracts 0 ( 906 ) 0 101 0 144 Total gains (losses) $ 177 $ ( 33 ) $ 149 $ ( 669 ) $ 1,961 $ ( 63 ) Offsetting of Derivatives We enter into master netting arrangements and collateral security arrangements to reduce credit risk. Cash collateral received related to derivative instruments under our collateral security arrangements are included in other current assets with a corresponding liability . Cash and non-cash collateral pledged related to derivative instruments under our collateral security arrangements are included in other current assets. 66 Table of Contents Alphabet Inc. The gross amounts of derivative instruments subject to master netting arrangements with various counterparties, and cash and non-cash collateral received and pledged under such agreements were as follows (in millions): As of December 31, 2021 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts Recognized Gross Amounts Offset in the Consolidated Balance Sheets Net Amounts Presented in the Consolidated Balance Sheets Financial Instruments (1) Cash and Non-Cash Collateral Received or Pledged Net Amounts Derivatives assets $ 999 $ ( 38 ) $ 961 $ ( 434 ) $ ( 406 ) $ 121 Derivatives liabilities $ 619 $ ( 38 ) $ 581 $ ( 434 ) $ ( 114 ) $ 33 As of December 31, 2022 Gross Amounts Not Offset in the Consolidated Balance Sheets, but Have Legal Rights to Offset Gross Amounts Recognized Gross Amounts Offset in the Consolidated Balance Sheets Net Amounts Presented in the Consolidated Balance Sheets Financial Instruments (1) Cash and Non-Cash Collateral Received or Pledged Net Amounts Derivatives assets $ 760 $ ( 84 ) $ 676 $ ( 463 ) $ ( 132 ) $ 81 Derivatives liabilities $ 894 $ ( 84 ) $ 810 $ ( 463 ) $ ( 28 ) $ 319 (1) The balances as of December 31, 2021 and 2022 were related to derivatives allowed to be net settled in accordance with our master netting agreements. Note 4. Leases We have entered into operating lease agreements primarily for data centers, land, and offices throughout the world with lease periods expiring between 2023 and 2063. Components of operating lease expense were as follows (in millions): Year Ended December 31, 2020 2021 2022 Operating lease cost $ 2,267 $ 2,699 $ 2,900 Variable lease cost 619 726 838 Total operating lease cost $ 2,886 $ 3,425 $ 3,738 Supplemental information related to operating leases was as follows (in millions): Year Ended December 31, 2020 2021 2022 Cash payments for operating leases $ 2,004 $ 2,489 $ 2,722 New operating lease assets obtained in exchange for operating lease liabilities $ 2,765 $ 2,951 $ 4,383 67 Table of Contents Alphabet Inc. As of December 31, 2022 , our operating leases had a weighted average remaining lease term of eight years and a weighted average discount rate of 2.8 %. Future lease payments under operating leases as of December 31, 2022 were as follows (in millions): 2023 $ 2,955 2024 2,771 2025 2,377 2026 1,953 2027 1,502 Thereafter 5,882 Total future lease payments 17,440 Less imputed interest ( 2,462 ) Total lease liability balance $ 14,978 As of December 31, 2022 , we have entered into leases that have not yet commenced with short-term and long-term future lease payments of $ 630 million and $ 3.1 billion that are not yet recorded on our Consolidated Balance Sheets. These leases will commence between 2023 and 2026 with non-cancelable lease terms between 1 and 25 years. Note 5. Variable Interest Entities Consolidated VIEs We consolidate VIEs in which we hold a variable interest and are the primary beneficiary. The results of operations and financial position of these VIEs are included in our consolidated financial statements. For certain consolidated VIEs, their assets are not available to us and their creditors do not have recourse to us. As of December 31, 2021 and 2022, assets that can only be used to settle obligations of these VIEs were $ 6.0 billion and $ 4.1 billion, respectively, and the liabilities for which creditors only have recourse to the VIEs were $ 2.5 billion and $ 2.6 billion, respectively. We may continue to fund ongoing operations of certain VIEs that are included within Other Bets. Total noncontrolling interests (NCI) in our consolidated subsidiaries were $ 4.3 billion and $ 3.8 billion as of December 31, 2021 and 2022, respectively, of which $ 1.1 billion is redeemable noncontrolling interest (RNCI) for both periods. NCI and RNCI are included within additional paid-in capital. Net loss attributable to noncontrolling interests was not material for an y period presented and is included within the "other" component of OI&E. See Note 7 for further details on OI&E. Unconsolidated VIEs We have investments in VIEs in which we are not the primary beneficiary. These VIEs include private companies that are primarily early stage companies and certain renewable energy entities in which activities involve power generation using renewable sources. We have determined that the governance structures of these entities do not allow us to direct the activities that would significantly affect their economic performance. Therefore, we are not the primary beneficiary, and the results of operations and financial position of these VIEs are not included in our consolidated financial statements. We account for these investments as non-marketable equity securities or equity method investments. The maximum exposure of these unconsolidated VIEs is generally based on the current carrying value of the investments and any future funding commitments. We have determined that the single source of our exposure to these VIEs is our capital investments in them. The carrying value and maximum exposure of these unconsolidated VIEs were $ 2.7 billion and $ 2.9 billion, respectively, as of December 31, 2021 and $ 2.7 billion and $ 2.8 billion, respectively, as of December 31, 2022 . Note 6. Debt Short-Term Debt We have a debt financing program of up to $ 10.0 billion through the issuance of commercial paper. Net proceeds from this program are used for general corporate purposes. We had no commercial paper outstanding as of December 31, 2021 and 2022. Our short-term debt balance also includes the current portion of certain long-term debt. 68 Table of Contents Alphabet Inc. Long-Term Debt Total outstanding debt is summarized below (in millions, except percentages): Effective Interest Rate As of December 31, Maturity Coupon Rate 2021 2022 Debt 2014-2020 Notes issuances 2024 - 2060 0.45 % - 3.38 % 0.57 % - 3.38 % $ 13,000 $ 13,000 Future finance lease payments, net and other (1) 2,086 2,142 Total debt 15,086 15,142 Unamortized discount and debt issuance costs ( 156 ) ( 143 ) Less: current portion of future finance lease payments, net and other current debt (1)(2) ( 113 ) ( 298 ) Total long-term debt $ 14,817 $ 14,701 (1) Future finance lease payments are net of imputed interest. (2) Total current portion of long-term debt is included within other accrued expenses and current liabilities. See Note 7 for further details. The notes in the table above are fixed-rate senior unsecured obligations and generally rank equally with each other. We may redeem the notes at any time in whole or in part at specified redemption prices. The effective interest rates are based on proceeds received with interest payable semi-annually. The total estimated fair value of the outstanding notes was approximately $ 12.4 billion and $ 9.9 billion as of December 31, 2021 and December 31, 2022, respectively. The fair value was determined based on observable market prices of identical instruments in less active markets and is categorized accordingly as Level 2 in the fair value hierarchy. As of December 31, 2022, the aggregate future principal payments for long-term debt, including finance lease liabilities, for each of the next five years and thereafter were as follows (in millions): 2023 $ 221 2024 1,156 2025 1,159 2026 2,163 2027 1,166 Thereafter 9,447 Total $ 15,312 Credit Facility As of December 31, 2022, we had $ 10.0 billion of revolving credit facilities, $ 4.0 billion expiring in April 2023 and $ 6.0 billion expiring in April 2026. The interest rates for all credit facilities are determined based on a formula using certain market rates, as well as our progress toward the achievement of certain sustainability goals. No amounts were outstanding under the credit facilities as of December 31, 2021 and 2022 . Note 7. Supplemental Financial Statement Information Accounts Receivable The allowance for credit losses on accounts receivable was $ 550 million and $ 754 million as of December 31, 2021 and 2022, respectively. 69 Table of Contents Alphabet Inc. Property and Equipment, Net Property and equipment, net, consisted of the following (in millions): As of December 31, 2021 2022 Land and buildings $ 58,881 $ 66,897 Information technology assets 55,606 66,267 Construction in progress 23,172 27,657 Leasehold improvements 9,146 10,575 Furniture and fixtures 208 314 Property and equipment, gross 147,013 171,710 Less: accumulated depreciation ( 49,414 ) ( 59,042 ) Property and equipment, net $ 97,599 $ 112,668 Accrued expenses and other current liabilities Accrued expenses and other current liabilities consisted of the following (in millions): As of December 31, 2021 2022 European Commission fines (1) $ 9,799 $ 9,106 Accrued customer liabilities 3,505 3,619 Accrued purchases of property and equipment 2,415 3,019 Current operating lease liabilities 2,189 2,477 Other accrued expenses and current liabilities 14,136 19,645 Accrued expenses and other current liabilities $ 32,044 $ 37,866 (1) While each EC decision is under appeal, the fines are included in accrued expenses and other current liabilities on our Consolidated Balance Sheets, as we provided bank guarantees (in lieu of a cash payment) for the fines. Amounts include the effects of foreign exchange and interest. Se e Note 10 for further details. 70 Table of Contents Alphabet Inc. Accumulated Other Comprehensive Income (Loss) Components of AOCI, net of income tax, were as follows (in millions): Foreign Currency Translation Adjustments Unrealized Gains (Losses) on Available-for-Sale Investments Unrealized Gains (Losses) on Cash Flow Hedges Total Balance as of December 31, 2019 $ ( 2,003 ) $ 812 $ ( 41 ) $ ( 1,232 ) Other comprehensive income (loss) before reclassifications 1,139 1,313 79 2,531 Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 37 ) ( 37 ) Amounts reclassified from AOCI 0 ( 513 ) ( 116 ) ( 629 ) Other comprehensive income (loss) 1,139 800 ( 74 ) 1,865 Balance as of December 31, 2020 ( 864 ) 1,612 ( 115 ) 633 Other comprehensive income (loss) before reclassifications ( 1,442 ) ( 1,312 ) 668 ( 2,086 ) Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 48 48 Amounts reclassified from AOCI 0 ( 64 ) ( 154 ) ( 218 ) Other comprehensive income (loss) ( 1,442 ) ( 1,376 ) 562 ( 2,256 ) Balance as of December 31, 2021 ( 2,306 ) 236 447 ( 1,623 ) Other comprehensive income (loss) before reclassifications ( 1,836 ) ( 4,720 ) 1,463 ( 5,093 ) Amounts excluded from the assessment of hedge effectiveness recorded in AOCI 0 0 ( 188 ) ( 188 ) Amounts reclassified from AOCI 0 1,007 ( 1,706 ) ( 699 ) Other comprehensive income (loss) ( 1,836 ) ( 3,713 ) ( 431 ) ( 5,980 ) Balance as of December 31, 2022 $ ( 4,142 ) $ ( 3,477 ) $ 16 $ ( 7,603 ) The effects on net income of amounts reclassified from AOCI were as follows (in millions): Gains (Losses) Reclassified from AOCI to the Consolidated Statements of Income Year Ended December 31, AOCI Components Location 2020 2021 2022 Unrealized gains (losses) on available-for-sale investments Other income (expense), net $ 650 $ 82 $ ( 1,291 ) Benefit (provision) for income taxes ( 137 ) ( 18 ) 284 Net of income tax 513 64 ( 1,007 ) Unrealized gains (losses) on cash flow hedges Foreign exchange contracts Revenue 144 165 2,046 Interest rate contracts Other income (expense), net 6 6 6 Benefit (provision) for income taxes ( 34 ) ( 17 ) ( 346 ) Net of income tax 116 154 1,706 Total amount reclassified, net of income tax $ 629 $ 218 $ 699 71 Table of Contents Alphabet Inc. Other Income (Expense), Net Components of OI&E were as follows (in millions): Year Ended December 31, 2020 2021 2022 Interest income $ 1,865 $ 1,499 $ 2,174 Interest expense (1) ( 135 ) ( 346 ) ( 357 ) Foreign currency exchange gain (loss), net ( 344 ) ( 240 ) ( 654 ) Gain (loss) on debt securities, net 725 ( 110 ) ( 2,064 ) Gain (loss) on equity securities, net 5,592 12,380 ( 3,455 ) Performance fees ( 609 ) ( 1,908 ) 798 Income (loss) and impairment from equity method investments, net 401 334 ( 337 ) Other ( 637 ) 411 381 Other income (expense), net $ 6,858 $ 12,020 $ ( 3,514 ) (1) Interest expense is net of interest capitalized of $ 218 million, $ 163 million, and $ 128 million for the years ended December 31, 2020, 2021, and 2022, respectively. Note 8. Acquisitions Mandiant Acquisition On September 12, 2022 we closed the acquisition of Mandiant for a total purchase price of $ 6.1 billion, including cash and debt. The purchase price excludes post acquisition compensation arrangements. Mandiant's dynamic cyber defense, threat intelligence and incident response services are expected to enhanc e Google Cloud's security offerings. The financial results of Mandiant have been included within t he Google Cloud segment as of the close of the acquisition. The purchase price was allocated as follows (in millions): Intangible assets $ 840 Goodwill (1) 4,772 Net assets acquired (2) 489 Total purchase price $ 6,101 (1) Goodwill was recorded in the Google Cloud segment and primarily attributable to synergies expected to arise after the acquisition. Goodwill is not deductible for tax purposes. (2) Includes $ 706 million of acquired cash. Intangible assets acquired as of the acquisition date were as follows: Amount (in millions) Weighted-Average Useful Life (in years) Patents and developed technology $ 349 4.8 Customer relationships 366 8.0 Trade names and other 125 5.9 Total intangible assets $ 840 72 Table of Contents Alphabet Inc. Note 9. Goodwill and Other Intangible Assets Goodwill Changes in the carrying amount of goodwill for the years ended December 31, 2021 and 2022 were as follows (in millions): Google Services Google Cloud Other Bets Total Balance as of December 31, 2020 $ 18,517 $ 1,957 $ 701 $ 21,175 Acquisitions 1,325 382 103 1,810 Foreign currency translation and other adjustments ( 16 ) ( 2 ) ( 11 ) ( 29 ) Balance as of December 31, 2021 19,826 2,337 793 22,956 Acquisitions 1,176 4,876 119 6,171 Foreign currency translation and other adjustments ( 155 ) ( 8 ) ( 4 ) ( 167 ) Balance as of December 31, 2022 $ 20,847 $ 7,205 $ 908 $ 28,960 Other Intangible Assets Information regarding intangible assets was as follows (in millions): As of December 31, 2021 As of December 31, 2022 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Value Weighted-Average Remaining Useful Life (in years) Patents and developed technology $ 4,786 $ 4,112 $ 674 $ 1,164 $ 354 $ 810 3.2 Customer relationships 506 140 366 862 235 627 5.0 Trade names and other 534 295 239 527 120 407 6.3 Total definite-lived intangible assets 5,826 4,547 1,279 2,553 709 1,844 Indefinite-lived intangible assets 138 0 138 240 0 240 Total intangible assets $ 5,964 $ 4,547 $ 1,417 $ 2,793 $ 709 $ 2,084 For the year ended December 31, 2022, $ 4.5 billion of intangible assets that were fully amortized have been removed from gross intangible assets and accumulated amortization. Amortization expense relating to intangible assets was $ 774 million, $ 875 million, and $ 642 million for the years ended December 31, 2020, 2021, and 2022, respectively. Expected amortization expense of definite-lived intangible assets held as of December 31, 2022 was as follows (in millions): 2023 $ 463 2024 444 2025 314 2026 235 2027 152 Thereafter 236 $ 1,844 Note 10. Commitments and contingencies Commitments We have content licensing agreements with future fixed or minimum guaranteed commitments of $ 12.3 billion as of December 31, 2022, of which the majority will be paid over seven years commencing in 2023. 73 Table of Contents Alphabet Inc. Indemnifications In the normal course of business, including to facilitate transactions in our services and products and corporate activities, we indemnify certain parties, including advertisers, Google Network partners, distribution partners, customers of Google Cloud offerings, lessors, and service providers with respect to certain matters. We have agreed to hold certain parties harmless against losses arising from a breach of representations or covenants, or out of intellectual property infringement or other claims made against certain parties. Several of these agreements limit the time within which an indemnification claim can be made and the amount of the claim. In addition, we have entered into indemnification agreements with our officers and directors, and our bylaws contain similar indemnification obligations to our agents. It is not possible to make a reasonable estimate of the maximum potential amount under these indemnification agreements due to the unique facts and circumstances involved in each particular agreement. Additionally, the payments we have made under such agreements have not had a material adverse effect on our results of operations, cash flows, or financial position. However, to the extent that valid indemnification claims arise in the future, future payments by us could be significant and could have a material adverse effect on our results of operations or cash flows in a particular period. As of December 31, 2022, we did not have any material indemnification claims that were probable or reasonably possible. Legal Matters We record a liability when we believe that it is probable that a loss has been incurred, and the amount can be reasonably estimated. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. We evaluate developments in our legal matters that could affect the amount of liability that has been previously accrued, and the matters and related reasonably possible losses disclosed, and make adjustments as appropriate. Certain outstanding matters include speculative, substantial or indeterminate monetary amounts. Significant judgment is required to determine both the likelihood of there being a loss and the estimated amount of a loss related to such matters, and we may be unable to estimate the reasonably possible loss or range of losses. The outcomes of outstanding legal matters are inherently unpredictable and subject to significant uncertainties, and could, either individually or in aggregate, have a material adverse effect. We expense legal fees in the period in which they are incurred. Antitrust Investigations On November 30, 2010, the EC's Directorate General for Competition opened an investigation into various antitrust-related complaints against us. On June 27, 2017, the EC announced its decision that certain actions taken by Google regarding its display and ranking of shopping search results and ads infringed European competition law. The EC decision imposed a € 2.4 billion ($ 2.7 billion as of June 27, 2017) fine. On September 11, 2017, we appealed the EC decision to the General Court, and on September 27, 2017, we implemented product changes to bring shopping ads into compliance with the EC's decision. We recognized a charge of $ 2.7 billion for the fine in the second quarter of 2017. On November 10, 2021, the General Court rejected our appeal, and we subsequently filed an appeal with the European Court of Justice on January 20, 2022. On July 18, 2018, the EC announced its decision that certain provisions in Google’s Android-related distribution agreements infringed European competition law. The EC decision imposed a € 4.3 billion ($ 5.1 billion as of June 30, 2018) fine and directed the termination of the conduct at issue. On October 9, 2018, we appealed the EC decision, and on October 29, 2018, we implemented changes to certain of our Android distribution practices. On September 14, 2022, the General Court reduced the fine from € 4.3 billion to € 4.1 billion. We subsequently filed an appeal with the European Court of Justice. In 2018, we recognized a charge of $ 5.1 billion for the fine, which we reduced by $ 217 million in 2022. On March 20, 2019, the EC announced its decision that certain contractual provisions in agreements that Google had with AdSense for Search partners infringed European competition law. The EC decision imposed a fine of € 1.5 billion ($ 1.7 billion as of March 20, 2019) and directed actions related to AdSense for Search partners' agreements, which we implemented prior to the decision. On June 4, 2019, we appealed the EC decision, which remains pending. We recognized a charge of $ 1.7 billion for the fine in the first quarter of 2019. From time to time we are subject to formal and informal inquiries and investigations on various competition matters by regulatory authorities in the U.S., Europe, and other jurisdictions globally. For example: 74 Table of Contents Alphabet Inc. • In August 2019, we began receiving civil investigative demands from the U.S. Department of Justice (DOJ) requesting information and documents relating to our prior antitrust investigations and certain aspects of our business. The DOJ and a number of state Attorneys General filed a lawsuit on October 20, 2020 alleging that Google violated U.S. antitrust laws relating to Search and Search advertising. Further, in June 2022, the Australian Competition and Consumer Commission (ACCC) and the United Kingdom's Competition and Markets Authority (CMA) each opened an investigation into Search distribution practices. • On December 16, 2020, a number of state Attorneys General filed an antitrust complaint in the U.S. District Court for the Eastern District of Texas, alleging that Google violated U.S. antitrust laws as well as state deceptive trade laws relating to its advertising technology. Additionally, on January 24, 2023, the DOJ, along with a number of state Attorneys General, filed an antitrust complaint alleging that Google’s digital advertising technology products violate U.S. antitrust laws. The EC, the CMA, and the ACCC each opened a formal investigation into Google's advertising technology business practices on June 22, 2021, May 25, 2022, and June 29, 2022, respectively. • On July 7, 2021, a number of state Attorneys General filed an antitrust complaint in the U.S. District Court for the Northern District of California, alleging that Google’s operation of Android and Google Play violated U.S. antitrust laws and state antitrust and consumer protection laws. In May 2022, the EC and the CMA each opened investigations into Google Play’s business practices. Korean regulators are investigating Google Play's billing practices, most recently opening a formal review in May 2022 of Google's compliance with the new app store billing regulations. We believe these complaints are without merit and will defend ourselves vigorously. We continue to cooperate with federal and state regulators in the U.S., the EC, and other regulators around the world. Patent and Intellectual Property Claims We have had patent, copyright, trade secret, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies infringe others' intellectual property rights. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services. As a result, we may have to change our business practices and develop non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, the U.S. International Trade Commission (ITC) has increasingly become an important forum to litigate intellectual property disputes because an ultimate loss in an ITC action can result in a prohibition on importing infringing products into the U.S. Because the U.S. is an important market, a prohibition on importation could have an adverse effect on us, including preventing us from importing many important products into the U.S. or necessitating workarounds that may limit certain features of our products. Furthermore, many of our agreements with our customers and partners require us to indemnify them against certain intellectual property infringement claims, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. In addition, our customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely affect our business. Other We are subject to claims, lawsuits, regulatory and government investigations, other proceedings, and consent orders involving competition, intellectual property, data privacy and security, tax and related compliance, labor and employment, commercial disputes, content generated by our users, goods and services offered by advertisers or publishers using our platforms, personal injury, consumer protection, and other matters. For example, we currently have a number of privacy investigations and lawsuits ongoing in multiple jurisdictions. We also periodically have data incidents that we report to relevant regulators as required by law. Such claims, lawsuits, regulatory and government investigations, other proceedings, and consent orders could result in substantial fines and penalties, injunctive relief, ongoing monitoring and auditing obligations, changes to our products and services, alterations to our business models and operations, and collateral related civil litigation or other adverse consequences, all of which could harm our business, reputation, financial condition, and operating results. We have ongoing legal matters relating to Russia. For example, civil judgments that include compounding penalties have been imposed upon us in connection with disputes regarding the termination of accounts, including those of sanctioned parties. We do not believe these ongoing legal matters will have a material adverse effect. 75 Table of Contents Alphabet Inc. Non-Income Taxes We are under audit by various domestic and foreign tax authorities with regards to non-income tax matters. The subject matter of non-income tax audits primarily arises from disputes on the tax treatment and tax rate applied to the sale of our products and services in these jurisdictions and the tax treatment of certain employee benefits. We accrue non-income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities when a loss is probable and reasonably estimable. If we determine that a loss is reasonably possible and the loss or range of loss can be estimated, we disclose the reasonably possible loss. Due to the inherent complexity and uncertainty of these matters and judicial process in certain jurisdictions, the final outcome may be materially different from our expectations. For information regarding income tax contingencies see Note 14. Note 11. Stockholders' Equity Class A and Class B Common Stock and Class C Capital Stock Our Board of Directors has authorized three classes of stock, Class A and Class B common stock, and Class C capital stock. The rights of the holders of each class of our common and capital stock are identical, except with respect to voting. Each share of Class A common stock is entitled to one vote per share. Each share of Class B common stock is entitled to 10 votes per share. Class C capital stock has no voting rights, except as required by applicable law. Shares of Class B common stock may be converted at any time at the option of the stockholder and automatically convert upon sale or transfer to Class A common stock. Stock Split On July 15, 2022, the company executed a 20 -for-one stock split with a record date of July 1, 2022, effected in the form of a one-time special stock dividend on each share of the company's Class A, Class B, and Class C stock. All prior period references made to share or per share amounts in the accompanying consolidated financial statements and applicable disclosures have been retroactively adjusted to reflect the effects of the Stock Split. See Note 1 for further details. Share Repurchases In April 2022, the Board of Directors of Alphabet authorized the company to repurchase up to $ 70.0 billion of its Class A and Class C shares. As of December 31, 2022, $ 28.1 billion remains available for Class A and Class C share repurchases. The following table presents Class A and Class C shares repurchased and subsequently retired (in millions): Year Ended December 31, 2021 Year Ended December 31, 2022 Shares Amount Shares Amount Class A share repurchases 24 $ 3,399 61 $ 6,719 Class C share repurchases 383 46,875 469 52,577 Total share repurchases 407 $ 50,274 530 $ 59,296 Class A and Class C shares are repurchased in a manner deemed in the best interest of the company and its stockholders, taking into account the economic cost and prevailing market conditions, including the relative trading prices and volumes of the Class A and Class C shares. Repurchases are executed from time to time, subject to general business and market conditions and other investment opportunities, through open market purchases or privately negotiated transactions, including through Rule 10b5-1 plans. The repurchase program does not have an expiration date. Note 12. Net Income Per Share We compute net income per share of Class A, Class B, and Class C stock using the two-class method. Basic net income per share is computed using the weighted-average number of shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares and the effect of potentially dilutive securities outstanding during the period. Potentially dilutive securities consist of restricted stock units and other contingently issuable shares. The dilutive effect of outstanding restricted stock units and other contingently issuable shares is reflected in diluted earnings per share by application of the treasury stock method. The computation of the diluted net income per share of Class A stock assumes the conversion of Class B stock, while the diluted net income per share of Class B stock does not assume the conversion of those shares. 76 Table of Contents Alphabet Inc. The rights, including the liquidation and dividend rights, of the holders of our Class A, Class B, and Class C stock are identical, except with respect to voting. Furthermore, there are a number of safeguards built into our certificate of incorporation, as well as Delaware law, which preclude our Board of Directors from declaring or paying unequal per share dividends on our Class A, Class B, and Class C stock. Specifically, Delaware law provides that amendments to our certificate of incorporation which would have the effect of adversely altering the rights, powers, or preferences of a given class of stock must be approved by the class of stock adversely affected by the proposed amendment. In addition, our certificate of incorporation provides that before any such amendment may be put to a stockholder vote, it must be approved by the unanimous consent of our Board of Directors. As a result, the undistributed earnings for each year are allocated based on the contractual participation rights of the Class A, Class B, and Class C stock as if the earnings for the year had been distributed. As the liquidation and dividend rights are identical, the undistributed earnings are allocated on a proportionate basis. In the years ended December 31, 2020, 2021, and 2022, the net income per share amounts are the same for Class A, Class B, and Class C stock because the holders of each class are entitled to equal per share dividends or distributions in liquidation in accordance with the Amended and Restated Certificate of Incorporation of Alphabet Inc. The following tables set forth the computation of basic and diluted net income per share of Class A, Class B, and Class C stock (in millions, except per share amounts): Year Ended December 31, 2020 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 17,733 $ 2,732 $ 19,804 Denominator Number of shares used in per share computation 5,996 924 6,696 Basic net income per share $ 2.96 $ 2.96 $ 2.96 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 17,733 $ 2,732 $ 19,804 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 2,732 0 0 Reallocation of undistributed earnings ( 180 ) ( 25 ) 180 Allocation of undistributed earnings $ 20,285 $ 2,707 $ 19,984 Denominator Number of shares used in basic computation 5,996 924 6,696 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A shares outstanding 924 0 0 Restricted stock units and other contingently issuable shares 2 0 123 Number of shares used in per share computation 6,922 924 6,819 Diluted net income per share $ 2.93 $ 2.93 $ 2.93 77 Table of Contents Alphabet Inc. Year Ended December 31, 2021 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 34,200 $ 5,174 $ 36,659 Denominator Number of shares used in per share computation 6,006 909 6,438 Basic net income per share $ 5.69 $ 5.69 $ 5.69 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 34,200 $ 5,174 $ 36,659 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 5,174 0 0 Reallocation of undistributed earnings ( 581 ) ( 77 ) 581 Allocation of undistributed earnings $ 38,793 $ 5,097 $ 37,240 Denominator Number of shares used in basic computation 6,006 909 6,438 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A shares outstanding 909 0 0 Restricted stock units and other contingently issuable shares 0 0 200 Number of shares used in per share computation 6,915 909 6,638 Diluted net income per share $ 5.61 $ 5.61 $ 5.61 Year Ended December 31, 2022 Class A Class B Class C Basic net income per share: Numerator Allocation of undistributed earnings $ 27,518 $ 4,072 $ 28,382 Denominator Number of shares used in per share computation 5,994 887 6,182 Basic net income per share $ 4.59 $ 4.59 $ 4.59 Diluted net income per share: Numerator Allocation of undistributed earnings for basic computation $ 27,518 $ 4,072 $ 28,382 Reallocation of undistributed earnings as a result of conversion of Class B to Class A shares 4,072 0 0 Reallocation of undistributed earnings ( 230 ) ( 30 ) 230 Allocation of undistributed earnings $ 31,360 $ 4,042 $ 28,612 Denominator Number of shares used in basic computation 5,994 887 6,182 Weighted-average effect of dilutive securities Add: Conversion of Class B to Class A shares outstanding 887 0 0 Restricted stock units and other contingently issuable shares 0 0 96 Number of shares used in per share computation 6,881 887 6,278 Diluted net income per share $ 4.56 $ 4.56 $ 4.56 78 Table of Contents Alphabet Inc. Note 13. Compensation Plans Stock Plans Our stock plans include the Alphabet Amended and Restated 2021 Stock Plan ("Alphabet 2021 Stock Plan") and Other Bet stock-based plans. Under our stock plans, RSUs and other types of awards may be granted. Under the Alphabet 2021 Stock Plan, an RSU award is an agreement to issue shares of our Class C stock at the time the award vests. RSUs generally vest over four years contingent upon employment on the vesting date. As of December 31, 2022, there were 706 million shares of Class C stock reserved for future issuance under the Alphabet 2021 Stock Plan. Stock-Based Compensation For the years ended December 31, 2020, 2021, and 2022, total stock-based compensation expense was $ 13.4 billion, $ 15.7 billion, and $ 19.5 billion, including amounts associated with awards we expect to settle in Alphabet stock of $ 12.8 billion, $ 15.0 billion, and $ 18.8 billion, respectively. For the years ended December 31, 2020, 2021, and 2022, we recognized tax benefits on total stock-based compensation expense, which are reflected in the provision for income taxes in the Consolidated Statements of Income, of $ 2.7 billion, $ 3.1 billion, and $ 3.9 billion, respectively. For the years ended December 31, 2020, 2021, and 2022, tax benefit realized related to awards vested or exercised during the period was $ 3.6 billion, $ 5.9 billion, and $ 4.7 billion, respectively. These amounts do not include the indirect effects of stock-based awards, which primarily relate to the R&D tax credit. Stock-Based Award Activities The following table summarizes the activities for unvested Alphabet RSUs for the year ended December 31, 2022 (in millions, except per share amounts): Unvested Restricted Stock Units Number of Shares Weighted- Average Grant-Date Fair Value Unvested as of December 31, 2021 338 $ 81.31 Granted 227 $ 127.22 Vested ( 213 ) $ 87.53 Forfeited/canceled ( 28 ) $ 97.10 Unvested as of December 31, 2022 324 $ 107.98 The weighted-average grant-date fair value of RSUs granted during the years ended December 31, 2020 and 2021 was $ 70.40 and $ 97.46 , respectively. Total fair value of RSUs, as of their respective vesting dates, during the years ended December 31, 2020, 2021, and 2022, were $ 17.8 billion, $ 28.8 billion, and $ 23.9 billion, respectively. As of December 31, 2022, there was $ 32.8 billion of unrecognized compensation cost related to unvested RSUs. This amount is expected to be recognized over a weighted-average period of 2.6 years. Note 14. Income Taxes Income from continuing operations before income taxes consisted of the following (in millions): Year Ended December 31, 2020 2021 2022 Domestic operations $ 37,576 $ 77,016 $ 61,307 Foreign operations 10,506 13,718 10,021 Total $ 48,082 $ 90,734 $ 71,328 79 Table of Contents Alphabet Inc. Provision for income taxes consisted of the following (in millions): Year Ended December 31, 2020 2021 2022 Current: Federal and state $ 4,789 $ 10,126 $ 17,120 Foreign 1,687 2,692 2,434 Total 6,476 12,818 19,554 Deferred: Federal and state 1,552 2,018 ( 8,052 ) Foreign ( 215 ) ( 135 ) ( 146 ) Total 1,337 1,883 ( 8,198 ) Provision for income taxes $ 7,813 $ 14,701 $ 11,356 The reconciliation of federal statutory income tax rate to our effective income tax rate was as follows: Year Ended December 31, 2020 2021 2022 U.S. federal statutory tax rate 21.0 % 21.0 % 21.0 % Foreign income taxed at different rates ( 0.3 ) 0.2 3.0 Foreign-derived intangible income deduction ( 3.0 ) ( 2.5 ) ( 5.4 ) Stock-based compensation expense ( 1.7 ) ( 2.5 ) ( 1.2 ) Federal research credit ( 2.3 ) ( 1.6 ) ( 2.2 ) Deferred tax asset valuation allowance 1.4 0.6 0.9 State and local income taxes 1.1 1.0 0.8 Other 0.0 0.0 ( 1.0 ) Effective tax rate 16.2 % 16.2 % 15.9 % In 2022, there was an increase in the U.S. Foreign Derived Intangible Income tax deduction from the effects of capitalization and amortization of R&D expenses in 2022 as required by the 2017 Tax Cuts and Jobs Act. 80 Table of Contents Alphabet Inc. Deferred Income Taxes Deferred income taxes reflect the net effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of our deferred tax assets and liabilities were as follows (in millions): As of December 31, 2021 2022 Deferred tax assets: Accruals and reserves not currently deductible $ 1,816 $ 1,956 Tax credits 5,179 6,002 Net operating losses 1,790 2,557 Operating leases 2,503 2,711 Capitalized research and development (1) 1,843 10,381 Other 1,665 3,244 Total deferred tax assets 14,796 26,851 Valuation allowance ( 7,129 ) ( 9,553 ) Total deferred tax assets net of valuation allowance 7,667 17,298 Deferred tax liabilities: Property and equipment, net ( 5,237 ) ( 6,607 ) Net investment gains ( 3,229 ) ( 2,361 ) Operating leases ( 2,228 ) ( 2,491 ) Other ( 946 ) ( 1,092 ) Total deferred tax liabilities ( 11,640 ) ( 12,551 ) Net deferred tax assets (liabilities) $ ( 3,973 ) $ 4,747 (1) As required by the 2017 Tax Cuts and Jobs Act, effective January 1, 2022, our research and development expenditures were capitalized and amortized which resulted in substantially higher cash taxes for 2022 with an equal amount of deferred tax benefit. As of December 31, 2022, our federal, state, and foreign net operating loss carryforwards for income tax purposes were approximately $ 6.4 billion, $ 14.6 billion, and $ 1.8 billion respectively. If not utilized, the federal net operating loss carryforwards will begin to expire in 2023, foreign net operating loss carryforwards will begin to expire in 2025 and the state net operating loss carryforwards will begin to expire in 2028. It is more likely than not that the majority of the net operating loss carryforwards will not be realized; therefore, we have recorded a valuation allowance against them. The net operating loss carryforwards are subject to various annual limitations under the tax laws of the different jurisdictions. As of December 31, 2022 , our Federal and California research and development credit carryforwards for income tax purposes were approximately $ 400 million and $ 5.8 billion, respectively. If not utilized, the Federal R&D credit will begin to expire in 2037 and the California R&D credit can be carried over indefinitely. We believe the majority of the federal tax credit and state tax credit is not likely to be realized. As of December 31, 2022 , our investment tax credit carryforwards for state income tax purposes were approximately $ 931 million and will begin to expire in 2025. We use the flow-through method of accounting for investment tax credits. We believe this tax credit is not likely to be realized. As of December 31, 2022, we maintained a valuation allowance with respect to California deferred tax assets, certain federal net operating losses, certain state net operating losses and tax credits, net deferred tax assets relating to certain Other Bets, and certain foreign net operating losses that we believe are not likely to be realized. We continue to reassess the remaining valuation allowance quarterly, and if future evidence allows for a partial or full release of the valuation allowance, a tax benefit will be recorded accordingly. 81 Table of Contents Alphabet Inc. Uncertain Tax Positions The following table summarizes the activity related to our gross unrecognized tax benefits (in millions): Year Ended December 31, 2020 2021 2022 Beginning gross unrecognized tax benefits $ 3,377 $ 3,837 $ 5,158 Increases related to prior year tax positions 372 529 253 Decreases related to prior year tax positions ( 557 ) ( 263 ) ( 437 ) Decreases related to settlement with tax authorities ( 45 ) ( 329 ) ( 140 ) Increases related to current year tax positions 690 1,384 2,221 Ending gross unrecognized tax benefits $ 3,837 $ 5,158 $ 7,055 We are subject to income taxes in the U.S. and foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. The total amount of gross unrecognized tax benefits was $ 3.8 billion, $ 5.2 billion, and $ 7.1 billion as of December 31, 2020 , 2021, and 2022, respectively, of which $ 2.6 billion, $ 3.7 billion, and $ 5.3 billion, if recognized, would affect our effective tax rate, respectively. As of December 31, 2021 and 2022, we accrued $ 270 million and $ 346 million in interest and penalties in provision for income taxes, respectively. We file income tax returns in the U.S. federal jurisdiction and in many state and foreign jurisdictions. Our two major tax jurisdictions are the U.S. federal and Ireland. We are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. The IRS is currently examining our 2016 through 2018 tax returns. We have also received tax assessments in multiple foreign jurisdictions asserting transfer pricing adjustments or permanent establishment. We continue to defend any and all such claims as presented. The tax years 2015 through 2021 remain subject to examination by the appropriate governmental agencies for Irish tax purposes. There are other ongoing audits in various other jurisdictions that are not material to our financial statements. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. We continue to monitor the progress of ongoing discussions with tax authorities and the effect, if any, of the expected expiration of the statute of limitations in various taxing jurisdictions. We believe that an adequate provision has been made for any adjustments that may result from tax examinations. However, the outcome of tax audits cannot be predicted with certainty. If any issues addressed in our tax audits are resolved in a manner not consistent with management's expectations, we could be required to adjust our provision for income taxes in the period such resolutions occur. Although the timing of resolution, settlement, and closure of audits is not certain, it is reasonably possible that our unrecognized tax benefits from certain U.S. federal, state, and non U.S. tax positions could decrease by approximately $ 1.8 billion in the next 12 months. Positions that may be resolved include various U.S. and non-U.S. matters. Note 15. Information about Segments and Geographic Areas We report our segment results as Google Services, Google Cloud, and Other Bets: • Google Services includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube. Google Services generates revenues primarily from advertising; sales of apps and in-app purchases, and hardware; and fees received for subscription-based products such as YouTube Premium and YouTube TV. • Google Cloud includes infrastructure and platform services, collaboration tools, and other services for enterprise customers. Google Cloud generates revenues from fees received for Google Cloud Platform services, Google Workspace communication and collaboration tools, and other enterprise services. • Other Bets is a combination of multiple operating segments that are not individually material. Revenues from Other Bets are generated primarily from the sale of health technology and internet services. Revenues, certain costs, such as costs associated with content and traffic acquisition, certain engineering activities, and hardware, as well as certain operating expenses are directly attributable to our segments. Due to the integrated nature of Alphabet, other costs and expenses, such as technical infrastructure and office facilities, are managed centrally at a consolidated level. The associated costs, including depreciation and impairment, are allocated to operating segments as a service cost generally based on usage or headcount. 82 Table of Contents Alphabet Inc. Unallocated corporate costs primarily include corporate initiatives, corporate shared costs, such as finance and legal, including certain fines and settlements, as well as costs associated with certain shared R&D activities. Additionally, hedging gains (losses) related to revenue are included in corporate costs. As AI is critical to delivering our mission of bringing our breakthrough innovations into the real world, beginning in January 2023, we will update our segment reporting relating to certain of Alphabet's AI activities. DeepMind, previously reported within Other Bets, will be reported as part of Alphabet's corporate costs, reflecting its increasing collaboration with Google Services, Google Cloud, and Other Bets. Prior periods will be recast to conform to the revised presentation. Our operating segments are not evaluated using asset information. The following table presents information about our segments (in millions): Year Ended December 31, 2020 2021 2022 Revenues: Google Services $ 168,635 $ 237,529 $ 253,528 Google Cloud 13,059 19,206 26,280 Other Bets 657 753 1,068 Hedging gains (losses) 176 149 1,960 Total revenues $ 182,527 $ 257,637 $ 282,836 Operating income (loss): Google Services $ 54,606 $ 91,855 $ 86,572 Google Cloud ( 5,607 ) ( 3,099 ) ( 2,968 ) Other Bets ( 4,476 ) ( 5,281 ) ( 6,083 ) Corporate costs, unallocated ( 3,299 ) ( 4,761 ) ( 2,679 ) Total income from operations $ 41,224 $ 78,714 $ 74,842 For revenues by geography see Note 2. The following table presents long-lived assets by geographic area, which includes property and equipment, net and operating lease assets (in millions): As of December 31, 2021 2022 Long-lived assets: United States $ 80,207 $ 93,565 International 30,351 33,484 Total long-lived assets $ 110,558 $ 127,049 Note 16. Subsequent Event In January 2023, we announced a reduction of our workforce of approximately 12,000 roles. We expect to incur employee severance and related charges of $ 1.9 billion to $ 2.3 billion, the majority of which will be recognized in the first quarter of 2023. In addition, we are taking actions to optimize our global office space. As a result we expect to incur exit costs relating to office space reductions of approximately $ 0.5 billion in the first quarter of 2023. We may incur additional charges in the future as we further evaluate our real estate needs. 83 Table of Contents Alphabet Inc. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act, as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our chief executive officer and chief financial officer concluded that, as of December 31, 2022 , our disclosure controls and procedures are designed at a reasonable assurance level and are effective to provide reasonable assurance that information we are required to disclose in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There have been no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2022 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Management’s Report on Internal Control over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) of the Exchange Act. Our management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework). Based on this evaluation, management concluded that our internal control over financial reporting was effective as of December 31, 2022. Management reviewed the results of its assessment with our Audit and Compliance Committee. The effectiveness of our internal control over financial reporting as of December 31, 2022 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in its report which is included in Item 8 of this Annual Report on Form 10-K. Limitations on Effectiveness of Controls and Procedures In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. In addition, the design of disclosure controls and procedures must reflect the fact that there are resource constraints and that management is required to apply its judgment in evaluating the benefits of possible controls and procedures relative to their costs. ITEM 9B. OTHER INFORMATION As previously disclosed, Google LLC, a subsidiary of Alphabet, filed notifications with the Russian Federal Security Service as required pursuant to Russian encryption product import controls for the purpose of enabling the import of certain software in Russia. The information provided pursuant to Section 13(r) of the Exchange Act in Part II, Item 5 of our Quarterly Report on Form 10-Q for the quarter ended September 30, 2022 is incorporated herein by reference. ITEM 9C.     DISCLOSURE REGARDING FOREIGN JURISDICTIONS THAT PREVENT INSPECTIONS Not applicable. 84 Table of Contents Alphabet Inc. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE The information required by this item will be included under the caption “Directors, Executive Officers, and Corporate Governance” in our Proxy Statement for the 2023 Annual Meeting of Stockholders to be filed with the SEC within 120 days of the fiscal year ended December 31, 2022 (2023 Proxy Statement) and is incorporated herein by reference. The information required by this item regarding delinquent filers pursuant to Item 405 of Regulation S-K will be included under the caption “Delinquent Section 16(a) Reports” in the 2023 Proxy Statement and is incorporated herein by reference. ITEM 11. EXECUTIVE COMPENSATION The information required by this item will be included under the captions “Director Compensation,” “Executive Compensation” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Compensation Committee Interlocks and Insider Participation” in the 2023 Proxy Statement and is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by this item will be included under the captions “Common Stock Ownership of Certain Beneficial Owners and Management” and “Equity Compensation Plan Information” in the 2023 Proxy Statement and is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information required by this item will be included under the captions “Certain Relationships and Related Transactions” and “Directors, Executive Officers, and Corporate Governance—Corporate Governance and Board Matters—Director Independence” in the 2023 Proxy Statement and is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by this item will be included under the caption “Independent Registered Public Accounting Firm” in the 2023 Proxy Statement and is incorporated herein by reference. 85 Table of Contents Alphabet Inc. PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES We have filed the following documents as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements Reports of Independent Registered Public Accounting Firm 44 Financial Statements: Consolidated Balance Sheets 47 Consolidated Statements of Income 48 Consolidated Statements of Comprehensive Income 49 Consolidated Statements of Stockholders’ Equity 50 Consolidated Statements of Cash Flows 51 Notes to Consolidated Financial Statements 52 2. Financial Statement Schedules Schedule II: Valuation and Qualifying Accounts The table below details the activity of the allowance for credit losses and sales credits for the years ended December 31, 2020, 2021, and 2022 (in millions): Balance at Beginning of Year Additions Usage Balance at End of Year Year ended December 31, 2020 $ 753 $ 2,013 $ ( 1,422 ) $ 1,344 Year ended December 31, 2021 $ 1,344 $ 2,092 $ ( 2,047 ) $ 1,389 Year ended December 31, 2022 $ 1,389 $ 2,125 $ ( 2,301 ) $ 1,213 Note: Additions to the allowance for credit losses are charged to expense. Additions to the allowance for sales credits are charged against revenues. All other schedules have been omitted because they are not required, not applicable, or the required information is otherwise included. 3. Exhibits Exhibit Number Description Incorporated by reference herein Form Date 2.01 Agreement and Plan of Merger, dated October 2, 2015, by and among Google Inc., the Registrant and Maple Technologies Inc. Current Report on Form 8-K (File No. 001-37580) October 2, 2015 3.01 Amended and Restated Certificate of Incorporation of the Registrant Current Report on Form 8-K (File No. 001-37580) June 3, 2022 3.02 Amended and Restated Bylaws of the Registrant, dated October 19, 2022 Current Report on Form 8-K (File No. 001-37580) October 25, 2022 4.01 Specimen Class A Common Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.02 Specimen Class C Capital Stock certificate Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.03 Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.04 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Larry Page and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.05 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Sergey Brin and certain of his affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.06 Joinder Agreement, dated December 31, 2021, among the Registrant, Sergey Brin and certain of his affiliates Annual Report on Form 10-K (File No. 001-37580) February 2, 2022 86 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 4.07 Transfer Restriction Agreement, dated October 2, 2015, between the Registrant and Eric E. Schmidt and certain of its affiliates Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.08 Class C Undertaking, dated October 2, 2015, executed by the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 4.09 Indenture, dated February 12, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as Trustee Registration Statement on Form S-3 (File No. 333-209510) February 12, 2016 4.10 Registrant Registration Rights Agreement dated December 14, 2015 Registration Statement on Form S-3 (File No. 333-209518) February 12, 2016 4.11 First Supplemental Indenture, dated April 27, 2016, between the Registrant and The Bank of New York Mellon Trust Company, N.A., as trustee Current Report on Form 8-K (File No. 001-37580) April 27, 2016 4.12 Form of the Registrant’s 3.375% Notes due 2024 (included in Exhibit 4.11) 4.13 Form of the Registrant’s 1.998% Note due 2026 Current Report on Form 8-K (File No. 001-37580) August 9, 2016 4.14 Form of Global Note representing the Registrant’s 0.450% notes due 2025 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.15 Form of Global Note representing the Registrant’s 0.800% notes due 2027 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.16 Form of Global Note representing the Registrant’s 1.100% notes due 2030 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.17 Form of Global Note representing the Registrant’s 1.900% notes due 2040 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.18 Form of Global Note representing the Registrant’s 2.050% notes due 2050 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.19 Form of Global Note representing the Registrant’s 2.250% notes due 2060 Current Report on Form 8-K (File No. 001-37580) August 5, 2020 4.20 * Description of Registrant’s Securities 10.01 u Form of Indemnification Agreement entered into between the Registrant, its affiliates and its directors and officers Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.02 u Letter Agreement dated July 11, 2022, between R. Martin Chávez and Alphabet Inc. Current Report on Form 8-K (File No. 001-37580) July 14, 2022 10.03 u Compensation Plan Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.04 u Director Arrangements Agreement, dated October 2, 2015, between Google Inc. and the Registrant Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.05 u Alphabet Inc. Deferred Compensation Plan Current Report on Form 8-K (File No. 001-37580) October 2, 2015 10.06 u Google Inc. 2004 Stock Plan, as amended Current Report on Form 8-K (File No. 000-50726) June 7, 2011 10.06.1 u Google Inc. 2004 Stock Plan - Form of Google Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 000-50726) March 30, 2005 10.07 u Alphabet Inc. Amended and Restated 2012 Stock Plan Current Report on Form 8-K (File No. 001-37580) June 5, 2020 10.07.1 u Alphabet Inc. Amended and Restated 2012 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Annual Report on Form 10-K (File No. 001-37580) February 4, 2020 87 Table of Contents Alphabet Inc. Exhibit Number Description Incorporated by reference herein Form Date 10.08 u Alphabet Inc. Amended and Restated 2021 Stock Plan Current Report on Form 8-K (file No. 001-37580) June 3, 2022 10.08.1 u Alphabet Inc. Amended and Restated 2021 Stock Plan - Form of Alphabet Restricted Stock Unit Agreement Quarterly Report on Form 10-Q (file No. 001-37580) July 28, 2021 10.08.2 u Alphabet Inc. Amended and Restated 2021 Stock Plan - Form of Alphabet 2022 Non-CEO Performance Stock Unit Agreement Annual Report on Form 10-K (File No. 001-37580) February 4, 2020 10.08.3 u * Alphabet Inc. Amended and Restated 2021 Stock Plan - Form of Alphabet 2022 CEO Performance Stock Unit Agreement 10.09 u * Alphabet Inc. Company Bonus Plan, as amended 21.01 * Subsidiaries of the Registrant 23.01 * Consent of Independent Registered Public Accounting Firm 24.01 * Power of Attorney (incorporated by reference to the signature page of this Annual Report on Form 10-K) 31.01 * Certification of Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.02 * Certification of Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.01 ‡ Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101.INS * Inline XBRL Instance Document - the instance document does not appear in the Interactive Data File because its XBRL tags are embedded within the Inline XBRL document 101.SCH * Inline XBRL Taxonomy Extension Schema Document 101.CAL * Inline XBRL Taxonomy Extension Calculation Linkbase Document 101.DEF * Inline XBRL Taxonomy Extension Definition Linkbase Document 101.LAB * Inline XBRL Taxonomy Extension Label Linkbase Document 101.PRE * Inline XBRL Taxonomy Extension Presentation Linkbase Document 104 Cover Page Interactive Data File (embedded within the Inline XBRL document and contained in Exhibit 101) _________________ u Indicates management compensatory plan, contract, or arrangement. * Filed herewith. ‡ Furnished herewith. 88 Table of Contents Alphabet Inc. ITEM 16. FORM 10-K SUMMARY None. 89 Table of Contents Alphabet Inc. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. Date: February 2, 2023 ALPHABET INC. By: / S /    S UNDAR P ICHAI Sundar Pichai Chief Executive Officer (Principal Executive Officer of the Registrant) POWER OF ATTORNEY KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Sundar Pichai and Ruth M. Porat, jointly and severally, his or her attorney-in-fact, with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof. Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. 90 Table of Contents Alphabet Inc. Signature Title Date / S / S UNDAR P ICHAI Chief Executive Officer and Director (Principal Executive Officer) February 2, 2023 Sundar Pichai / S /    R UTH M. P ORAT Senior Vice President and Chief Financial Officer (Principal Financial Officer) February 2, 2023 Ruth M. Porat / S /    A MIE T HUENER O'T OOLE Vice President and Chief Accounting Officer (Principal Accounting Officer) February 2, 2023 Amie Thuener O'Toole / S /    F RANCES H. A RNOLD Director February 2, 2023 Frances H. Arnold / S /    S ERGEY B RIN Co-Founder and Director February 2, 2023 Sergey Brin / S /   R. M ARTIN C HAVEZ Director February 2, 2023 R. Martin Chávez / S /    L. J OHN D OERR Director February 2, 2023 L. John Doerr / S /    R OGER W. F ERGUSON J R . Director February 2, 2023 Roger W. Ferguson Jr. / S /    J OHN L. H ENNESSY Director, Chair February 2, 2023 John L. Hennessy / S /    A NN M ATHER Director February 2, 2023 Ann Mather / S /    L ARRY P AGE Co-Founder and Director February 2, 2023 Larry Page / S /    K. R AM S HRIRAM Director February 2, 2023 K. Ram Shriram / S /    R OBIN L. W ASHINGTON Director February 2, 2023 Robin L. 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PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From to Commission File Number 001-37845 MICROSOFT CORPORATION Washington 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY , REDMOND , Washington 98052-6399 ( 425 ) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol Name of exchange on which registered Common stock, $ 0.00000625 par value per share MSFT Nasdaq 3.125% Notes due 2028 MSFT Nasdaq 2.625% Notes due 2033 MSFT Nasdaq Securities registered pursuant to Section 12(g) of the Act: N one Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large Accelerated Filer ☒ Accelerated Filer ☐ Non-accelerated Filer ☐ Smaller Reporting Company ☐ Emerging Growth Company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ If securities are registered pursuant to Section 12(b) of the Act, indicate by check mark whether the financial statements of the registrant included in the filing reflect the correction of an error to previously issued financial statements. ☐ Indicate by check mark whether any of those error corrections are restatements that required a recovery analysis of incentive-based compensation received by any of the registrant’s executive officers during the relevant recovery period pursuant to §240.10D-1(b). ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ☐ No ☒ As of December 31, 2022, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $ 1.8 trillion based on the closing sale price as reported on the NASDAQ National Market System. As of July 24, 2023, there were 7,429,763,722 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on December 7, 2023 are incorporated by reference into Part III. MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2023 INDEX Page PART I Item 1. Business 4 Information about our Executive Officers 20 Item 1A. Risk Factors 23 Item 1B. Unresolved Staff Comments 37 Item 2. Properties 37 Item 3. Legal Proceedings 37 Item 4. Mine Safety Disclosures 37 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 38 Item 6. [Reserved] 39 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 57 Item 8. Financial Statements and Supplementary Data 58 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 99 Item 9A. Controls and Procedures 99 Report of Management on Internal Control over Financial Reporting 99 Report of Independent Registered Public Accounting Firm 100 Item 9B. Other Information 101 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 101 PART III Item 10. Directors, Executive Officers, and Corporate Governance 101 Item 11. Executive Compensation 101 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 101 Item 13. Certain Relationships and Related Transactions, and Director Independence 101 Item 14. Principal Accountant Fees and Services 101 PART IV Item 15. Exhibit and Financial Statement Schedules 102 Item 16. Form 10-K Summary 108 Signatures 109 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. 3 PART I Item 1 PART I ITEM 1. B USINESS GENERAL Embracing Our Future Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. We are creating the platforms and tools , powered by artificial intelligence (“ AI ”), that deliver better, faster, and more effective solutions to support small and large business competitiveness, improve educational and health outcomes, grow public-sector efficiency, and empower human ingenuity. From infrastructure and data, to business applications and collaboration, we provide unique, differentiated value to customers. In a world of increasing economic complexity, AI has the power to revolutionize many types of work. Microsoft is now innovating and expanding our portfolio with AI capabilities to help people and organizations overcome today’s challenges and emerge stronger. Customers are looking to unlock value from their digital spend and innovate for this next generation of AI, while simplifying security and management. Those leveraging the Microsoft Cloud are best positioned to take advantage of technological advancements and drive innovation. Our investment in AI spans the entire company, from Microsoft Teams and Outlook, to Bing and Xbox, and we are infusing generative AI capability into our consumer and commercial offerings to deliver copilot capability for all services across the Microsoft Cloud. We’re committed to making the promise of AI real – and doing it responsibly. Our work is guided by a core set of principles: fairness, reliability and safety, privacy and security, inclusiveness, transparency, and accountability. What We Offer Founded in 1975, we develop and support software, services, devices, and solutions that deliver new value for customers and help people and businesses realize their full potential. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. Our products include operating systems, cross-device productivity and collaboration applications, server applications, business solution applications, desktop and server management tools, software development tools, and video games. We also design and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. The Ambitions That Drive Us To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud and intelligent edge platform. • Create more personal computing. Reinvent Productivity and Business Processes At Microsoft, we provide technology and resources to help our customers create a secure, productive work environment. Our family of products plays a key role in the ways the world works, learns, and connects. 4 PART I Item 1 Our growth depends on securely delivering continuous innovation and advancing our leading productivity and collaboration tools and services, including Office 365, Dynamics 365, and LinkedIn. Microsoft 365 brings together Office 365, Windows, and Enterprise Mobility + Security to help organizations empower their employees with AI-backed tools that unlock creativity, increase collaboration, and fuel innovation, all the while enabling compliance coverage and data protection. Microsoft Teams is a comprehensive platform for work, with meetings, calls, chat, collaboration, and business process automation. Microsoft Viva is an employee experience platform that brings together communications, knowledge, learning, resources, and insights. Microsoft 365 Copilot combines next-generation AI with business data in the Microsoft Graph and Microsoft 365 applications. Together with the Microsoft Cloud, Dynamics 365, Microsoft Teams, and our AI offerings bring a new era of collaborative applications that optimize business functions, processes, and applications to better serve customers and employees while creating more business value. Microsoft Power Platform is helping domain experts drive productivity gains with low-code/no-code tools, robotic process automation, virtual agents, and business intelligence. In a dynamic labor market, LinkedIn is helping professionals use the platform to connect, learn, grow, and get hired. Build the Intelligent Cloud and Intelligent Edge Platform As digital transformation and adoption of AI accelerates and revolutionizes more business workstreams, organizations in every sector across the globe can address challenges that will have a fundamental impact on their success. For enterprises, digital technology empowers employees, optimizes operations, engages customers, and in some cases, changes the very core of products and services. We continue to invest in high performance and sustainable computing to meet the growing demand for fast access to Microsoft services provided by our network of cloud computing infrastructure and datacenters. Our cloud business benefits from three economies of scale: datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. The Microsoft Cloud provides the best integration across the technology stack while offering openness, improving time to value, reducing costs, and increasing agility. Being a global-scale cloud, Azure uniquely offers hybrid consistency, developer productivity, AI capabilities, and trusted security and compliance. We see more emerging use cases and needs for compute and security at the edge and are accelerating our innovation across the spectrum of intelligent edge devices, from Internet of Things (“IoT”) sensors to gateway devices and edge hardware to build, manage, and secure edge workloads. Our AI platform, Azure AI, is helping organizations transform, bringing intelligence and insights to the hands of their employees and customers to solve their most pressing challenges. Organizations large and small are deploying Azure AI solutions to achieve more at scale, more easily, with the proper enterprise-level and responsible AI protections. We have a long-term partnership with OpenAI, a leading AI research and deployment company. We deploy OpenAI’s models across our consumer and enterprise products. As OpenAI’s exclusive cloud provider, Azure powers all of OpenAI's workloads. We have also increased our investments in the development and deployment of specialized supercomputing systems to accelerate OpenAI’s research. Our hybrid infrastructure offers integrated, end-to-end security, compliance, identity, and management capabilities to support the real-world needs and evolving regulatory requirements of commercial customers and enterprises. Our industry clouds bring together capabilities across the entire Microsoft Cloud, along with industry-specific customizations. Azure Arc simplifies governance and management by delivering a consistent multi-cloud and on-premises management platform. Nuance, a leader in conversational AI and ambient intelligence across industries including healthcare, financial services, retail, and telecommunications, joined Microsoft in 2022. Microsoft and Nuance enable organizations to accelerate their business goals with security-focused, cloud-based solutions infused with AI. We are accelerating our development of mixed reality solutions with new Azure services and devices. Microsoft Mesh enables organizations to create custom, immersive experiences for the workplace to help bring remote and hybrid workers and teams together. 5 PART I Item 1 The ability to convert data into AI drives our competitive advantage. The Microsoft Intelligent Data Platform is a leading cloud data platform that fully integrates databases, analytics, and governance. The platform empowers organizations to invest more time creating value rather than integrating and managing their data. Microsoft Fabric is an end-to-end, unified analytics platform that brings together all the data and analytics tools that organizations need. GitHub Copilot is at the forefront of AI-powered software development, giving developers a new tool to write code easier and faster so they can focus on more creative problem-solving. From GitHub to Visual Studio, we provide a developer tool chain for everyone, no matter the technical experience, across all platforms, whether Azure, Windows, or any other cloud or client platform. Windows also plays a critical role in fueling our cloud business with Windows 365, a desktop operating system that’s also a cloud service. From another internet-connected device, including Android or macOS devices, users can run Windows 365, just like a virtual machine. Additionally, we are extending our infrastructure beyond the planet, bringing cloud computing to space. Azure Orbital is a fully managed ground station as a service for fast downlinking of data. Create More Personal Computing We strive to make computing more personal, enabling users to interact with technology in more intuitive, engaging, and dynamic ways. Windows 11 offers innovations focused on enhancing productivity, including Windows Copilot with centralized AI assistance and Dev Home to help developers become more productive. Windows 11 security and privacy features include operating system security, application security, and user and identity security. Through our Search, News, Mapping, and Browser services, Microsoft delivers unique trust, privacy, and safety features. In February 2023, we launched an all new, AI-powered Microsoft Edge browser and Bing search engine with Bing Chat to deliver better search, more complete answers, and the ability to generate content. Microsoft Edge is our fast and secure browser that helps protect users’ data. Quick access to AI-powered tools, apps, and more within Microsoft Edge’s sidebar enhance browsing capabilities. We are committed to designing and marketing first-party devices to help drive innovation, create new device categories, and stimulate demand in the Windows ecosystem. The Surface family includes Surface Pro, Surface Laptop, and other Surface products. Microsoft continues to invest in gaming content, community, and cloud services. We have broadened our approach to how we think about gaming end-to-end, from the way games are created and distributed to how they are played, including subscription services like Xbox Game Pass and new devices from third-party manufacturers so players can engage across PC, console, and mobile. In January 2022, we announced plans to acquire Activision Blizzard, Inc., a leader in game development and an interactive entertainment content publisher. Our Future Opportunity We are focused on helping customers use the breadth and depth of the Microsoft Cloud to get the most value out of their digital spend while leading the new AI wave across our solution areas. We continue to develop complete, intelligent solutions for our customers that empower people to be productive and collaborate, while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modern, modular business applications, drive deeper insights, and improve how people communicate, collaborate, learn, work, and interact with one another. • Building and running cloud-based services in ways that utilize ubiquitous computing to unleash new experiences and opportunities for businesses and individuals. • Applying AI and ambient intelligence to drive insights, revolutionize many types of work, and provide substantive productivity gains using natural methods of communication. 6 PART I Item 1 • Tackling security from all angles with our integrated, end-to-end solutions spanning security, compliance, identity, and management, across all clouds and platforms. • Inventing new gaming experiences that bring people together around their shared love for games on any devices and pushing the boundaries of innovation with console and PC gaming. • Using Windows to fuel our cloud business, grow our share of the PC market, and drive increased engagement with our services like Microsoft 365 Consumer, Microsoft Teams, Microsoft Edge, Bing, Xbox Game Pass, and more. Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. Corporate Social Responsibility Commitment to Sustainability Microsoft’s approach to addressing climate change starts with the sustainability of our own business. In 2020, we committed to being a carbon negative, water positive, and zero waste company by 2030. In May 2023, we released our Environmental Sustainability Report which looked back at our progress during fiscal year 2022. We continued to make progress on our goals, with our overall emissions declining by 0.5 percent. While our Scope 1 and Scope 2 emissions continued to decline, Scope 3 emissions increased by 0.5 percent. Scope 3 represented 96 percent of our total emissions, resulting primarily from the operations of our suppliers and the use of our products across our customers. A few examples of our continued progress include: • Signed new power purchase agreements, bringing our total portfolio of carbon-free energy to over 13.5 gigawatts. • Contracted for water replenishment projects that are estimated to provide more than 15.6 million cubic meters in volumetric water benefit over the lifetime of these projects. • Diverted 12,159 metric tons of solid waste from landfills and incinerators across our direct operational footprint. • Protected 12,270 acres of land in Belize – more than the 11,206 acres of land that we use around the world. Microsoft has a role to play in developing and advancing new climate solutions, but we recognize that no solution can be offered by any single company, organization, or government. Our approach helps to support the sustainability needs of our customers and the global community. Our Microsoft Cloud for Sustainability, an environmental sustainability management platform that includes Microsoft Sustainability Manager, enables organizations to record, report, and reduce their Scope 1, 2, and 3 emissions. These digital tools can interoperate with business systems and unify data intelligence for organizations. Addressing Racial Injustice and Inequity We are committed to addressing racial injustice and inequity in the United States for Black and African American communities and helping improve lived experiences at Microsoft, in employees’ communities, and beyond. Our Racial Equity Initiative focuses on three multi-year pillars, each containing actions and progress we expect to make or exceed by 2025. • Strengthening our communities: using data, technology, and partnerships to help improve the lives of Black and African American people in the United States, including our employees and their communities. • Engaging our ecosystem: using our balance sheet and relationships with suppliers and partners to foster societal change and create new opportunities. • Increasing representation and strengthening inclusion: building on our momentum by adding a $150 million investment to strengthen inclusion and double the number of Black, African American, Hispanic, and Latinx leaders in the United States by 2025. 7 PART I Item 1 In fiscal year 2023, we collaborated with partners and worked within neighborhoods and communities to launch and scale a number of projects and programs, including: • Working with 103 unique organizations in 165 cities and counties on our Justice Reform Initiative to empower communities and advance racial equity and fairness in the justice system. • Increasing access to affordable broadband, devices, and digital literacy training across 14 geographies, including 11 cities and three states in the Black Rural south. • Growing our Nonprofit Tech Acceleration for Black and African American Communities program, which uses data, technology, and partnerships to help more than 2,000 local organizations to modernize and streamline operations. • Expanding our Technology Education and Learning Support (“TEALS”) program to reach nearly 400 high schools in 21 communities to increase computer science opportunities for Black and African American students. We exceeded our 2020 goal to double the percentage of our transaction volumes with Black- and African American-owned financial institutions by 2023. We are also increasing investment activity with Black- and African American-owned asset managers, which now represent 45 percent of our external manager group, enabling increased funds into local communities. We also met our goal of creating a $100 million program focused on mission-driven banks. We enriched our supplier pipeline, achieving our goal to spend $500 million with double the number of Black- and African American-owned suppliers. We also increased the number of identified partners in the Black Partner Growth Initiative by more than 250 percent, surpassing our initial goal. We have made meaningful progress on representation and inclusion at Microsoft. As of June 2023, we are 93 percent of the way to our 2025 commitment to double the number of Black and African American people managers in the U.S. (below director level), and 107 percent of the way for Black and African American directors (people managers and individual contributors). We are 28 percent of the way for Hispanic and Latinx people managers (below director level) and 74 percent of the way for Hispanic and Latinx directors. Investing in Digital Skills After helping over 80 million jobseekers around the world access digital skilling resources, we introduced a new Skills for Jobs initiative to support a more skills-based labor market, with greater flexibility and accessible learning paths to develop the right skills needed for the most in-demand jobs. Our Skills for Jobs initiative brings together learning resources, certification opportunities, and job-seeker tools from LinkedIn, GitHub, and Microsoft Learn, and is built on data insights drawn from LinkedIn’s Economic Graph. We also launched a national campaign to help skill and recruit 250,000 people into the cybersecurity workforce by 2025, representing half of the country’s workforce shortage. To that end, we are making curriculum available free of charge to all of the nation’s higher education institutions, providing training for new and existing faculty, and providing scholarships and supplemental resources to 25,000 students. We have expanded the cyber skills initiative to 27 additional countries that show elevated cyberthreat risks coupled with significant gaps in their cybersecurity workforces, partnering with nonprofits and other educational institutions to train the next generation of cybersecurity workers. Generative AI is creating unparalleled opportunities to empower workers globally, but only if everyone has the skills to use it. To address this, in June 2023 we launched a new AI Skills Initiative to help everyone learn how to harness the power of AI. This includes a new LinkedIn learning pathway offering new coursework on learning the foundations of generative AI. We also launched a new global grant challenge to uncover new ways of training workers on generative AI and are providing greater access to digital learning events and resources for everyone to improve their AI fluency. HUMAN CAPITAL RESOURCES Overview Microsoft aims to recruit, develop, and retain world-changing talent from a diversity of backgrounds. To foster their and our success, we seek to create an environment where people can thrive and do their best work. We strive to maximize the potential of our human capital resources by creating a respectful, rewarding, and inclusive work environment that enables our global employees to create products and services that further our mission. 8 PART I Item 1 As of June 30, 2023, we employed approximately 221,000 people on a full-time basis, 120,000 in the U.S. and 101,000 internationally. Of the total employed people, 89,000 were in operations, including manufacturing, distribution, product support, and consulting services; 72,000 were in product research and development; 45,000 were in sales and marketing; and 15,000 were in general and administration. Certain employees are subject to collective bargaining agreements. Our Culture Microsoft’s culture is grounded in growth mindset. This means everyone is on a continuous journey to learn and grow, operating as one company instead of multiple siloed businesses. Our employee listening systems enable us to gather feedback directly from our workforce to inform our programs and employee needs globally. Employees participate in our Employee Signals surveys, which cover a variety of topics such as thriving, inclusion, team culture, wellbeing, and learning and development. We also collect Daily Signals employee survey responses, giving us real-time insights into ways we can support our employees. In addition to Employee Signals and Daily Signals surveys, we gain insights through onboarding, exit surveys, internal Viva Engage channels, employee Q&A sessions, and our internal AskHR Service support. Diversity and inclusion are core to our business model, and we hold ourselves accountable for driving global systemic change in our workforce and creating an inclusive work environment. We support multiple highly active Employee Resource Groups for women, families, racial and ethnic minorities, military, people with disabilities, and employees who identify as LGBTQIA+, where employees can go for support, networking, and community-building. As described in our 2022 Proxy Statement, annual performance and compensation reviews of our senior leadership team include an evaluation of their contributions to employee culture and diversity. To ensure accountability over time, we publicly disclose our progress on a multitude of workforce metrics including: • Detailed breakdowns of gender, racial, and ethnic minority representation in our employee population, with data by job types, levels, and segments of our business. • Our EEO-1 report (equal employment opportunity). • Disability representation. • Pay equity (see details below). Total Rewards and Pay Equity We develop dynamic, sustainable, market-driven, and strategic programs with the goal of providing a highly differentiated portfolio to attract, reward, and retain top talent and enable our employees to thrive. These programs reinforce our culture and values such as collaboration and growth mindset. Managers evaluate and recommend rewards based on, for example, how well we leverage the work of others and contribute to the success of our colleagues. We monitor pay equity and career progress across multiple dimensions. Our total compensation opportunity is highly differentiated and is market competitive. In order to manage our costs in a dynamic, competitive environment, in fiscal year 2023 we announced that base salaries of salaried employees would remain at fiscal year 2022 levels. Pay increases continue to be available for rewards-eligible hourly and equivalent employees. We will continue our practice of investing in stock for all rewards-eligible employees, salaried and hourly, and investing in bonuses for all eligible employees. 9 PART I Item 1 Since 2016, we have reported on pay equity as part of our annual Diversity and Inclusion report. In 2022, we reported that all racial and ethnic minority employees in the U.S. combined earn $1.008 for every $1.000 earned by their white counterparts, that women in the U.S. earn $1.007 for every $1.000 earned by their counterparts who are men, and that women outside the U.S. earn $1.002 for every $1.000 earned by their counterparts outside the U.S. who are men. In this year’s report, we again expanded our pay equity data beyond the U.S. to report on 61 additional countries (up from 12 last year), representing 99.8% of our global Microsoft workforce. In addition, we began reporting on unadjusted median pay in our annual report, comparing total pay amounts for all employees regardless of factors such as job title, level, or tenure. For employees who are eligible for rewards, the analysis showed that total pay for women is 89.6% of total pay for men in the U.S. and 86.2% outside of the U.S., and total pay for racial and ethnic minorities in the U.S. is 89.9% of total pay for white employees. As we continue to increase representation for women and racial and ethnic minorities at more senior levels, and continue to ensure pay equity for all, the gap between the medians will reduce. Our intended result is a global performance and development approach that fosters our culture, and competitive compensation that ensures equitable pay by role while supporting pay for performance. Wellbeing and Hybrid Work Microsoft is committed to supporting our employees’ wellbeing while they are at work and in their personal lives. We have invested significantly in wellbeing, and offer a differentiated benefits package which includes many physical, emotional, and financial wellness programs including counseling through the Microsoft CARES Employee Assistance Program, mental wellbeing support, flexible fitness benefits, disability accommodations, savings and investment tools, adoption assistance, and back-up care for children and elders. Finally, our Occupational Health and Safety program helps ensure employees can stay safe while they are working. We introduced Hybrid Workplace Flexibility Guidance to better support leaders, managers, and employees in hybrid work scenarios. Our ongoing survey data shows that 93% of employees value the flexibility related to work location, work site, and work hours, and 78% are satisfied with the quality of connection with co-workers. There is no one-size-fits-all approach to flexible work at Microsoft. As a company, we will continue to leverage data and research to inform decision making, balancing the needs of business, team, and individual. Learning and Development We offer a range of learning opportunities, including personalized opportunities on our internal and external learning portals, in-classroom learning, required learning on compliance and company culture, on-the-job advancement opportunities, and manager coaching. We also provide customized manager learning, new employee orientation, and tools for operating in a flexible hybrid work environment. All Microsoft employees globally access our single Viva Learning tool for both required and personal choice learning. This includes courses focused on our core principles and compliance matters, such as Business Conduct, Privacy, Security Foundations, and Harassment Prevention. We also deliver skills training for employees based on their profession and role discipline. We have over 27,000 people managers, all of whom must complete between 20-33 hours of compulsory training on leadership and management and are assigned additional targeted training on an ongoing basis related to people management, compliance, and culture. 10 PART I Item 1 OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, Microsoft Viva, and Microsoft 365 Copilot. • Office Consumer, including Microsoft 365 Consumer subscriptions, Office licensed on-premises, and other Office services. • LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions. • Dynamics business solutions, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM (including Customer Insights), Power Apps, and Power Automate; and on-premises ERP and CRM applications. Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users in new markets such as frontline workers, small and medium businesses, and growth markets, as well as add value to our core product and service offerings to span productivity categories such as communication, collaboration, analytics, security, and compliance. Office Commercial revenue is mainly affected by a combination of continued installed base growth and average revenue per user expansion, as well as the continued shift from Office licensed on-premises to Office 365. Office Consumer Office Consumer is designed to increase personal productivity and creativity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift from Office licensed on-premises to Microsoft 365 Consumer subscriptions. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. 11 PART I Item 1 LinkedIn LinkedIn connects the world’s professionals to make them more productive and successful and transforms the way companies hire, market, sell, and learn. Our vision is to create economic opportunity for every member of the global workforce through the ongoing development of the world’s first Economic Graph, a digital representation of the global economy. In addition to LinkedIn’s free services, LinkedIn offers monetized solutions: Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions. Talent Solutions provide insights for workforce planning and tools to hire, nurture, and develop talent. Talent Solutions also includes Learning Solutions, which help businesses close critical skills gaps in times where companies are having to do more with existing talent. Marketing Solutions help companies reach, engage, and convert their audiences at scale. Premium Subscriptions enable professionals to manage their professional identity, grow their network, find jobs, and connect with talent through additional services like premium search. Sales Solutions help companies strengthen customer relationships, empower teams with digital selling tools, and acquire new opportunities. LinkedIn has over 950 million members and has offices around the globe. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions, Sales Solutions, and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. Dynamics Dynamics provides cloud-based and on-premises business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and other application development platforms for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is driven by the number of users licensed and applications consumed, expansion of average revenue per user, and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications, including Power Apps and Power Automate. Competition Competitors to Office include software and global application vendors, such as Apple, Cisco Systems, Meta, Google, Okta, Proofpoint, Slack, Symantec, Zoom, and numerous web-based and mobile application competitors as well as local application developers. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Meta offers communication tools to enable productivity and engagement within organizations. Google provides a hosted messaging and productivity suite. Slack provides teamwork and collaboration software. Zoom offers videoconferencing and cloud phone solutions. Okta, Proofpoint, and Symantec provide security solutions across email security, information protection, identity, and governance. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products and services. We compete by providing powerful, flexible, secure, integrated industry-specific, and easy-to-use productivity and collaboration tools and services that create comprehensive solutions and work well with technologies our customers already have both on-premises or in the cloud. LinkedIn faces competition from online professional networks, recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers, and Sales Solutions competes with online and offline outlets for companies with lead generation and customer intelligence and insights. Dynamics competes with cloud-based and on-premises business solution providers such as Oracle, Salesforce, and SAP. 12 PART I Item 1 Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure and other cloud services; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and Nuance and GitHub. • Enterprise Services, including Enterprise Support Services, Industry Solutions (formerly Microsoft Consulting Services ), and Nuance professional services. Server Products and Cloud Services Azure is a comprehensive set of cloud services that offer developers, IT professionals, and enterprises freedom to build, deploy, and manage applications on any platform or device. Customers can use Azure through our global network of datacenters for computing, networking, storage, mobile and web application services, AI, IoT, cognitive services, and machine learning. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Azure revenue is mainly affected by infrastructure-as-a-service and platform-as-a-service consumption-based services, and per user-based services such as Enterprise Mobility + Security. Azure AI offerings provide a competitive advantage as companies seek ways to optimize and scale their business with machine learning. Azure’s purpose-built, AI-optimized infrastructure allows advanced models, including GPT-4 services designed for developers and data scientists, to do more with less. Customers can integrate large language models and develop the next generation of AI apps and services. Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server products revenue is mainly affected by purchases through volume licensing programs, licenses sold to original equipment manufacturers (“OEM”), and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Nuance and GitHub include both cloud and on-premises offerings. Nuance provides healthcare and enterprise AI solutions. GitHub provides a collaboration platform and code hosting service for developers. Enterprise Services Enterprise Services, including Enterprise Support Services, Industry Solutions, and Nuance Professional Services, assist customers in developing, deploying, and managing Microsoft server solutions, Microsoft desktop solutions, and Nuance conversational AI and ambient intelligent solutions, along with providing training and certification to developers and IT professionals on various Microsoft products. Competition Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, VMware, and open source offerings. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. Our AI offerings compete with AI products from hyperscalers such as Amazon Bedrock, Amazon CodeWhisperer, and Google AI, as well as products from other emerging competitors, many of which are also current or potential partners, including Meta’s LLaMA2 and other open source solutions. Our Enterprise Mobility + Security offerings also compete with products from a range of competitors including identity vendors, security solution vendors, and numerous other security point solution vendors. We believe our cloud’s global scale, coupled with our broad portfolio of identity and security solutions, allows us to effectively solve complex cybersecurity challenges for our customers and differentiates us from the competition. 13 PART I Item 1 Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system , and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, Snowflake, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Our Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; and Windows IoT. • Devices, including Surface, HoloLens, and PC accessories. • Gaming, including Xbox hardware and Xbox content and services, comprising first- and third-party content (including games and in-game content), Xbox Game Pass and other subscriptions, Xbox Cloud Gaming, advertising, third-party disc royalties, and other cloud services. • Search and news advertising, comprising Bing (including Bing Chat), Microsoft News, Microsoft Edge, and third-party affiliates. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and growth markets. • Attachment of Windows to devices shipped. 14 PART I Item 1 • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Constraints in the supply chain of device components. • Piracy. Windows Commercial revenue, which includes volume licensing of the Windows operating system and Windows cloud services such as Microsoft Defender for Endpoint, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance (“SA”), as well as advanced security offerings. Windows Commercial revenue often reflects the number of information workers in a licensed enterprise and is relatively independent of the number of PCs sold in a given year. Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. Devices We design and sell devices, including Surface, HoloLens, and PC accessories. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. Growth in Devices is dependent on total PC shipments, the ability to attract new customers, our product roadmap, and expanding into new categories. Gaming Our gaming platform is designed to provide a variety of entertainment through a unique combination of content, community, and cloud services. Our exclusive game content is created through Xbox Game Studios, a collection of first-party studios creating iconic and differentiated gaming experiences. We continue to invest in new gaming studios and content to expand our intellectual property roadmap and leverage new content creators. These unique gaming experiences are the cornerstone of Xbox Game Pass, a subscription service and gaming community with access to a curated library of over 400 first- and third-party console and PC titles. The gamer remains at the heart of the Xbox ecosystem. We are identifying new opportunities to attract gamers across a variety of different end points through our first- and third-party content and business diversification across subscriptions, ads, and digital stores. We’ve seen new devices from third-party manufacturers along with key PC and mobile end points that help us empower gamers to play in a way that is most convenient to them. We are focused on growing the platform and expanding to new ecosystems to engage as many gamers as possible. Xbox enables people to connect and share online gaming experiences that are accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox revenue is mainly affected by subscriptions and sales of first- and third-party content, as well as advertising. Growth of our Gaming business is determined by the overall active user base through Xbox enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences through first-party content creators. 15 PART I Item 1 Search and News Advertising Our Search and news advertising business is designed to deliver relevant search, native, and display advertising to a global audience. Our Microsoft Edge browser and Bing Chat capabilities are key tools to enable user acquisition and engagement, while our technology platform enables accelerated delivery of digital advertising solutions. In addition to first-party tools, we have several partnerships with companies, such as Yahoo, through which we provide and monetize search offerings. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content on advertising offerings. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. Devices face competition from various computer, tablet, and hardware manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. Xbox and our cloud gaming services face competition from various online gaming ecosystems and game streaming services, including those operated by Amazon, Apple, Meta, and Tencent. We also compete with other providers of entertainment services such as video streaming platforms. Our gaming platform competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. We believe our gaming platform is effectively positioned against, and uniquely differentiated from, competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own first-party game franchises as well as other digital content offerings. Our Search and news advertising business competes with Google and a wide array of websites, social platforms like Meta, and portals that provide content and online offerings to end users. OPERATIONS We have regional operations service centers that support our operations, including customer contract and order processing, billing, credit and collections, information processing, and vendor management and logistics. The center in Ireland supports the African, Asia-Pacific, European, and Middle East regions; and the centers in Arlington, Virginia, Atlanta, Georgia, Charlotte, North Carolina, Fargo, North Dakota, Fort Lauderdale, Florida, Redmond, Washington, Reno, Nevada, and Puerto Rico support the American regions. In addition to our operations centers, we also operate datacenters throughout each of these regions. We continue to identify and evaluate opportunities to expand our datacenter locations and increase our server capacity to meet the evolving needs of our customers, particularly given the growing demand for AI services. Our datacenters depend on the availability of permitted and buildable land, predictable energy, networking supplies, and servers, including graphics processing units (“GPUs”) and other components. Our devices are primarily manufactured by third-party contract manufacturers. For the majority of our products, we have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. However, some of our products contain certain components for which there are very few qualified suppliers. Extended disruptions at these suppliers could impact our ability to manufacture devices on time to meet consumer demand. 16 PART I Item 1 RESEARCH AND DEVELOPMENT Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Cloud and AI – focuses on making IT professionals, developers, partners, independent software vendors, and their systems more productive and efficient through development of Azure AI platform and cloud infrastructure, server, database, CRM, ERP, software development tools and services (including GitHub), AI cognitive services, and other business process applications and services for enterprises. • Strategic Missions and Technologies – focuses on incubating technical products and support solutions with transformative potential for the future of cloud computing and continued company growth across quantum computing, Azure Space & Missions Engineering, telecommunications, and Microsoft Federal Sales and Delivery. • Experiences and Devices – focuses on delivering high value end-user experiences across our products, services, and devices, including Microsoft 365, Windows, Microsoft Teams, Search (including Microsoft Edge and Bing Chat) and other advertising-based services, and the Surface line of devices. • Microsoft Security – focuses on delivering a comprehensive portfolio of services that protect our customers’ digital infrastructure through cloud platform and application security, data protection and governance, identity and network access, and device management. • Technology and Research – focuses on fundamental research, product and business incubations, and forward-looking AI innovations that span infrastructure, services, and applications. • LinkedIn – focuses on our services that transform the way professionals grow their network and find jobs and the way businesses hire, market, sell, and learn. • Gaming – focuses on developing hardware, content, and services across a large range of platforms to help grow our user base through game experiences and social interaction. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software and hardware design. Before releasing new software platforms, and as we make significant modifications to existing platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 70,000 U.S. and international patents issued and over 19,000 pending worldwide. While we employ much of our internally-developed intellectual property in our products and services, we also engage in outbound licensing of specific patented technologies that are incorporated into licensees’ products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We may also purchase or license technology that we incorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, supporting societal and/or environmental efforts, or attracting and enabling our external development community. Our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products and services, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. 17 PART I Item 1 Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, devices, and operating systems. While our main product research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. We plan to continue to make significant investments in a broad range of product research and development activities, and as appropriate we will coordinate our research and development across operating segments and leverage the results across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest corporate research organizations, often working in close collaboration with top universities around the world, and is focused on advancing the state-of-the-art in computer science and a broad range of other disciplines. Our investment in fundamental research provides us a unique perspective on future trends and contributes to our innovation. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales organization performs a variety of functions, including working directly with commercial enterprises and public-sector organizations worldwide to identify and meet their technology and digital transformation requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. OEMs We distribute our products and services through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Dell, Hewlett-Packard, Lenovo, and with many regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors” or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. We also sell commercial and consumer products and services directly to customers, such as cloud services, search, and gaming, through our digital marketplaces and online stores. Additionally, our Microsoft Experience Centers are designed to facilitate deeper engagement with our partners and customers across industries. 18 PART I Item 1 Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers and provide product training and sales support. Our Dynamics business solutions are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and SA. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. SA conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, training, and other licensing benefits to help customers deploy and use software efficiently. SA is included with certain volume licensing agreements and is an optional purchase with others. Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. SA is included. Microsoft Customer Agreement A Microsoft Customer Agreement is a simplified purchase agreement presented, accepted, and stored through a digital experience. A Microsoft Customer Agreement is a non-expiring agreement that is designed to support all customers over time, whether purchasing through a partner or directly from Microsoft. Microsoft Online Subscription Agreement A Microsoft Online Subscription Agreement is designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web. The agreement allows customers to acquire monthly or annual subscriptions for cloud-based services. Microsoft Products and Services Agreement Microsoft Products and Services Agreements are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. SA is optional for customers that purchase perpetual licenses. 19 PART I Item 1 Open Value Open Value agreements are a simple, cost-effective way to acquire the latest Microsoft technology. These agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a three-year period. Under Open Value agreements, organizations can elect to purchase perpetual licenses or subscribe to licenses and SA is included. Select Plus A Select Plus agreement is designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and SA is optional. Partner Programs The Microsoft Cloud Solution Provider Program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, managed services provider, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows hosting service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. The Independent Software Vendor Royalty Program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, Internet service providers, application developers, and OEMs. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. INFORMATION ABOUT OUR EXECUTIV E OFFICERS Our executive officers as of July 27, 2023 were as follows: Name Age Position with the Company Satya Nadella 55 Chairman and Chief Executive Officer Judson B. Althoff 50 Executive Vice President and Chief Commercial Officer Christopher C. Capossela 53 Executive Vice President and Chief Marketing Officer Kathleen T. Hogan 57 Executive Vice President and Chief Human Resources Officer Amy E. Hood 51 Executive Vice President and Chief Financial Officer Bradford L. Smith 64 Vice Chair and President Christopher D. Young 51 Executive Vice President, Business Development, Strategy, and Ventures Mr. Nadella was appointed Chairman of the Board in June 2021 and Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Althoff was appointed Executive Vice President and Chief Commercial Officer in July 2021. He served as Executive Vice President, Worldwide Commercial Business from July 2017 until that time. Prior to that, Mr. Althoff served as the President of Microsoft North America. Mr. Althoff joined Microsoft in March 2013 as President of Microsoft North America. 20 PART I Item 1 Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014.Since joining Microsoft in 1991, Mr. Capossela has held a variety of marketing leadership roles in the Consumer Channels Group, and in the Microsoft Office Division where he was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hogan also serves on the Board of Directors of Alaska Air Group, Inc. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Hood also serves on the Board of Directors of 3M Corporation. Mr. Smith was appointed Vice Chair and President in September 2021. Prior to that, he served as President and Chief Legal Officer since September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. Mr. Young has served as Executive Vice President, Business Development, Strategy, and Ventures since joining Microsoft in November 2020. Prior to Microsoft, he served as the Chief Executive Officer of McAfee, LLC from 2017 to 2020, and served as a Senior Vice President and General Manager of Intel Security Group from 2014 until 2017, when he led the initiative to spin out McAfee into a standalone company. Mr. Young also serves on the Board of Directors of American Express Company. 21 PART I Item 1 AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”) at www.sec.gov. • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts to have information pushed in real time. We publish a variety of reports and resources related to our Corporate Social Responsibility programs and progress on our Reports Hub website, www.microsoft.com/corporate-responsibility/reports-hub, including reports on sustainability, responsible sourcing, accessibility, digital trust, and public policy engagement. The information found on these websites is not part of, or incorporated by reference into, this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 22 PART I Item 1A ITEM 1A. RIS K FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. STRATEGIC AND COMPETITIVE RISKS We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platform-based ecosystems An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, wearables, and other endpoint devices. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on PCs. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users may incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. Competitors’ rules governing their content and applications marketplaces may restrict our ability to distribute products and services through them in accordance with our technical and business model objectives. 23 PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. • We are investing in artificial intelligence (“AI”) across the entire company and infusing generative AI capabilities into our consumer and commercial offerings. We expect AI technology and services to be a highly competitive and rapidly evolving market. We will bear significant development and operational costs to build and support the AI capabilities, products, and services necessary to meet the needs of our customers. To compete effectively we must also be responsive to technological change, potential regulatory developments, and public scrutiny. • Other competitors develop and offer free applications, online services, and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us by modifying and then distributing open source software at little or no cost to end users, using open source AI models, and earning revenue on advertising or integrated products and services. These firms do not bear the full costs of research and development for the open source products. Some open source products mimic the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services that utilize ubiquitous computing and ambient intelligence to drive insights and productivity gains. At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which cloud-based services to use. Certain industries and customers have specific requirements for cloud services and may present enhanced risks. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We embrace cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge offerings are connected to the growth of the Internet of Things (“IoT”), a network of distributed and interconnected devices employing sensors, data, and computing capabilities, including AI. Our success in driving ubiquitous computing and ambient intelligence will depend on the level of adoption of our offerings such as Azure, Azure AI, and Azure IoT Edge. We may not establish market share sufficient to achieve scale necessary to meet our business objectives. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other IoT endpoints. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data as well as help them meet their own compliance needs. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. 24 PART I Item 1A It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. Some users may engage in fraudulent or abusive activities through our cloud-based services. These include unauthorized use of accounts through stolen credentials, use of stolen credit cards or other payment vehicles, failure to pay for services accessed, or other activities that violate our terms of service such as cryptocurrency mining or launching cyberattacks. If our efforts to detect such violations or our actions to control these types of fraud and abuse are not effective, we may experience adverse impacts to our revenue or incur reputational damage. RISKS RELATING TO THE EVOLUTION OF OUR BUSINESS We make significant investments in products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Microsoft 365, Bing, SQL Server, Windows Server, Azure, Office 365, Xbox, LinkedIn, and other products and services. In addition, we are focused on developing new AI platform services and incorporating AI into existing products and services. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment, including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. We may not get engagement in certain features, like Microsoft Edge, Bing, and Bing Chat, that drive post-sale monetization opportunities. Our data handling practices across our products and services will continue to be under scrutiny. Perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or product experiences, could negatively impact product and feature adoption, product design, and product quality. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. For example, in March 2021 we completed our acquisition of ZeniMax Media Inc. for $8.1 billion, and in March 2022 we completed our acquisition of Nuance Communications, Inc. for $18.8 billion. In January 2022 we announced a definitive agreement to acquire Activision Blizzard , Inc. for $68.7 billion. In January 2023 we announced the third phase of our OpenAI strategic partnership. Acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that they raise new compliance-related obligations and challenges, that we have difficulty integrating and retaining new employees, business systems, and technology, that they distract management from our other businesses, or that announced transactions may not be completed. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones, as well as acquired companies’ ability to meet our policies and processes in areas such as data governance, privacy, and cybersecurity. It may take longer than expected to realize the full benefits from these transactions and arrangements such as increased revenue or enhanced efficiencies, or the benefits may ultimately be smaller than we expected. These events could adversely affect our consolidated financial statements. 25 PART I Item 1A If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record, a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. CYBERSECURITY, DATA PRIVACY, AND PLATFORM ABUSE RISKS Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position. Security of our information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities or intentionally designed processes in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Nation-state and state-sponsored actors can deploy significant resources to plan and carry out attacks. Nation-state attacks against us, our customers, or our partners may intensify during periods of intense diplomatic or armed conflict, such as the ongoing conflict in Ukraine. Inadequate account security or organizational security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems or reveal confidential information. Malicious actors may employ the IT supply chain to introduce malware through software updates or compromised supplier accounts or hardware. Cyberthreats are constantly evolving and becoming increasingly sophisticated and complex, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities or new attack methods, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network, or data security could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, subject us to ransomware attacks, require us to allocate more resources to improve technologies or remediate the impacts of attacks, or otherwise adversely affect our business. We are also subject to supply chain cyberattacks where malware can be introduced to a software provider’s customers, including us, through software updates. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Increasing use of generative AI models in our internal systems may create new attack methods for adversaries. Our business policies and internal security controls may not keep pace with these changes as new threats emerge, or emerging cybersecurity regulations in jurisdictions worldwide. 26 PART I Item 1A Security of our products, services, devices, and customers’ data The security of our products and services is important in our customers’ decisions to purchase or use our products or services across cloud and on-premises environments. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. In addition, adversaries can attack our customers’ on-premises or cloud environments, sometimes exploiting previously unknown (“zero day”) vulnerabilities, such as occurred in early calendar year 2021 with several of our Exchange Server on-premises products. Vulnerabilities in these or any product can persist even after we have issued security patches if customers have not installed the most recent updates, or if the attackers exploited the vulnerabilities before patching to install additional malware to further compromise customers’ systems. Adversaries will continue to attack customers using our cloud services as customers embrace digital transformation. Adversaries that acquire user account information can use that information to compromise our users’ accounts, including where accounts share the same attributes such as passwords. Inadequate account security practices may also result in unauthorized access, and user activity may result in ransomware or other malicious software impacting a customer’s use of our products or services. We are increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks. Additionally, we are actively adding new generative AI features to our services. Because generative AI is a new field, understanding of security risks and protection methods continues to develop; features that rely on generative AI may be susceptible to unanticipated security threats from sophisticated adversaries. Our customers operate complex IT systems with third-party hardware and software from multiple vendors that may include systems acquired over many years. They expect our products and services to support all these systems and products, including those that no longer incorporate the strongest current security advances or standards. As a result, we may not be able to discontinue support in our services for a product, service, standard, or feature solely because a more secure alternative is available. Failure to utilize the most current security advances and standards can increase our customers’ vulnerability to attack. Further, customers of widely varied size and technical sophistication use our technology, and consequently may still have limited capabilities and resources to help them adopt and implement state of the art cybersecurity practices and technologies. In addition, we must account for this wide variation of technical sophistication when defining default settings for our products and services, including security default settings, as these settings may limit or otherwise impact other aspects of IT operations and some customers may have limited capability to review and reset these defaults. Cyberattacks may adversely impact our customers even if our production services are not directly compromised. We are committed to notifying our customers whose systems have been impacted as we become aware and have actionable information for customers to help protect themselves. We are also committed to providing guidance and support on detection, tracking, and remediation. We may not be able to detect the existence or extent of these attacks for all of our customers or have information on how to detect or track an attack, especially where an attack involves on-premises software such as Exchange Server where we may have no or limited visibility into our customers’ computing environments. Development and deployment of defensive measures To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security, threat detection, and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide security tools such as firewalls, anti-virus software, and advanced security and information about the need to deploy security measures and the impact of doing so. Customers in certain industries such as financial services, health care, and government may have enhanced or specialized requirements to which we must engineer our products and services. 27 PART I Item 1A The cost of measures to protect products and customer-facing services could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers, and third parties granted access to their systems, may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches, or may otherwise fail to adopt adequate security practices. Any of these could adversely affect our reputation and revenue. Actual or perceived vulnerabilities may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers. Our products operate in conjunction with and are dependent on products and components across a broad ecosystem of third parties. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position. Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number, breadth, and scale of our cloud-based offerings, we store and process increasingly large amounts of personal data of our customers and users. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and third parties on data security, and other practices we follow may not prevent the improper disclosure or misuse of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services. We may not be able to protect information in our products and services from use by others . LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services. Abuse of our platforms may harm our reputation or user engagement. Advertising, professional, marketplace, and gaming platform abuses For platform products and services that provide content or host ads that come from or can be influenced by third parties, including GitHub, LinkedIn, Microsoft Advertising, Microsoft News, Microsoft Store, Bing, and Xbox, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate. This activity may come from users impersonating other people or organizations including through the use of AI technologies, dissemination of information that may be viewed as misleading or intended to manipulate the opinions of our users, or the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing or responding to these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and consolidated financial statements. 28 PART I Item 1A Other digital safety abuses Our hosted consumer services as well as our enterprise services may be used to generate or disseminate harmful or illegal content in violation of our terms or applicable law. We may not proactively discover such content due to scale, the limitations of existing technologies, and conflicting legal frameworks. When discovered by users and others, such content may negatively affect our reputation, our brands, and user engagement. Regulations and other initiatives to make platforms responsible for preventing or eliminating harmful content online have been enacted, and we expect this to continue. We may be subject to enhanced regulatory oversight, civil or criminal liability, or reputational damage if we fail to comply with content moderation regulations, adversely affecting our business and consolidated financial statements. The development of the IoT presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins. Issues in the development and use of AI may result in reputational or competitive harm or liability . We are building AI into many of our offerings, including our productivity services, and we are also making AI available for our customers to use in solutions that they build. This AI may be developed by Microsoft or others, including our strategic partner, OpenAI. We expect these elements of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many innovations, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms or training methodologies may be flawed. Datasets may be overbroad, insufficient, or contain biased information. Content generated by AI systems may be offensive, illegal, or otherwise harmful. Ineffective or inadequate AI development or deployment practices by Microsoft or others could result in incidents that impair the acceptance of AI solutions or cause harm to individuals, customers, or society, or result in our products and services not working as intended. Human review of certain outputs may be required. As a result of these and other challenges associated with innovative technologies, our implementation of AI systems could subject us to competitive harm, regulatory action, legal liability, including under new proposed legislation regulating AI in jurisdictions such as the European Union (“EU”), new applications of existing data protection, privacy, intellectual property, and other laws, and brand or reputational harm. Some AI scenarios present ethical issues or may have broad impacts on society. If we enable or offer AI solutions that have unintended consequences, unintended usage or customization by our customers and partners, or are controversial because of their impact on human rights, privacy, employment, or other social, economic, or political issues, we may experience brand or reputational harm, adversely affecting our business and consolidated financial statements. 29 PART I Item 1A OPERATIONAL RISKS We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. Our datacenters depend on the availability of permitted and buildable land, predictable energy, networking supplies, and servers, including graphics processing units (“GPUs”) and other components. The cost or availability of these dependencies could be adversely affected by a variety of factors, including the transition to a clean energy economy, local and regional environmental regulations, and geopolitical disruptions. These demands continue to increase as we introduce new products and services and support the growth and the augmentation of existing services such as Bing, Azure, Microsoft Account services, Microsoft 365, Microsoft Teams, Dynamics 365, OneDrive, SharePoint Online, Skype, Xbox, and Outlook.com through the incorporation of AI features and/or functionality. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex, and requires development of principles for datacenter builds in geographies with higher safety and reliability risks. It requires that we maintain an Internet connectivity infrastructure and storage and compute capacity that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data, insufficient Internet connectivity, insufficient or unavailable power supply, or inadequate storage and compute capacity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may adversely impact our consolidated financial statements. We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. Our software products and services also may experience quality or reliability problems. The highly sophisticated software we develop may contain bugs and other defects that interfere with their intended operation. Our customers increasingly rely on us for critical business functions and multiple workloads. Many of our products and services are interdependent with one another. Each of these circumstances potentially magnifies the impact of quality or reliability issues. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. There are limited suppliers for certain device and datacenter components. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If components are delayed or become unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes that restrict supply sources, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity to support the delivery and continued development of our products and services. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. LEGAL, REGULATORY, AND LITIGATION RISKS Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. Government agencies closely scrutinize us under U.S. and foreign competition laws. Governments are actively enforcing competition laws and regulations, and this includes scrutiny in potentially large markets such as the EU, the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. 30 PART I Item 1A For example, the European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows can receive significant scrutiny under EU or other competition laws. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices for our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Competition law regulatory actions and court decisions may result in fines or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that comes from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including causing us to withdraw products from or modify products for certain markets, decreasing the value of our assets, adversely affecting our ability to monetize our products, or inhibiting our ability to consummate acquisition or impose conditions on acquisitions that may reduce their value. Laws and regulations relating to anti-corruption and trade could result in increased costs, fines, criminal penalties, or reputational damage. The Foreign Corrupt Practices Act (“FCPA”) and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents, and the accounting provisions of the FCPA require us to maintain accurate books and records and adequate internal controls. From time to time, we receive inquiries from authorities in the U.S. and elsewhere which may be based on reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Periodically, we receive such reports directly and investigate them, and also cooperate with investigations by U.S. and foreign law enforcement authorities. An example of increasing international regulatory complexity is the EU Whistleblower Directive, initiated in 2021, which may present compliance challenges to the extent it is implemented in different forms by EU member states. Most countries in which we operate also have competition laws that prohibit competitors from colluding or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our U.S. and international compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Increasing trade laws, policies, sanctions, and other regulatory requirements also affect our operations in and outside the U.S. relating to trade and investment. Economic sanctions in the U.S., the EU, and other countries prohibit most business with restricted entities or countries. U.S. export controls restrict Microsoft from offering many of its products and services to, or making investments in, certain entities in specified countries. U.S. import controls restrict us from integrating certain information and communication technologies into our supply chain and allow for government review of transactions involving information and communications technology from countries determined to be foreign adversaries. Supply chain regulations may impact the availability of goods or result in additional regulatory scrutiny. Periods of intense diplomatic or armed conflict, such as the ongoing conflict in Ukraine, may result in (1) new and rapidly evolving sanctions and trade restrictions, which may impair trade with sanctioned individuals and countries, and (2) negative impacts to regional trade ecosystems among our customers, partners, and us. Non-compliance with sanctions as well as general ecosystem disruptions could result in reputational harm, operational delays, monetary fines, loss of revenues, increased costs, loss of export privileges, or criminal sanctions. 31 PART I Item 1A Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us, or reputational damage. The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, while the EU-U.S. Data Privacy Framework (“DPF”) has been recognized as adequate under EU law to allow transfers of personal data from the EU to certified companies in the U.S., the DPF is subject to further legal challenge which could cause the legal requirements for data transfers from the EU to be uncertain. EU data protection authorities have and may again block the use of certain U.S.-based services that involve the transfer of data to the U.S. In the EU and other markets, potential new rules and restrictions on the flow of data across borders could increase the cost and complexity of delivering our products and services. In addition, the EU General Data Protection Regulation (“GDPR”), which applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of compliance obligations regarding the handling of personal data. More recently, the EU has been developing new requirements related to the use of data, including in the Digital Markets Act, the Digital Services Act, and the Data Act, that add additional rules and restriction on the use of data in our products and services. Engineering efforts to build and maintain capabilities to facilitate compliance with these laws involve substantial expense and the diversion of engineering resources from other projects. We might experience reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under these and other data regulations, or if our implementation to comply makes our offerings less attractive. Compliance with these obligations depends in part on how particular regulators interpret and apply them. If we fail to comply, or if regulators assert we have failed to comply (including in response to complaints made by customers), it may lead to regulatory enforcement actions, which can result in significant monetary penalties, private lawsuits, reputational damage, blockage of international data transfers, and loss of customers. The highest fines assessed under GDPR have recently been increasing, especially against large technology companies. Jurisdictions around the world, such as China, India, and states in the U.S. have adopted, or are considering adopting or expanding, laws and regulations imposing obligations regarding the collection, handling, and transfer of personal data. Our investment in gaining insights from data is becoming central to the value of the services, including AI services, we deliver to customers, to operational efficiency and key opportunities in monetization, and to customer perceptions of quality. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Ongoing legal analyses, reviews, and inquiries by regulators of Microsoft practices, or relevant practices of other organizations, may result in burdensome or inconsistent requirements, including data sovereignty and localization requirements, affecting the location, movement, collection, and use of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in some jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity, as well as negative publicity and diversion of management time and effort. Existing and increasing legal and regulatory requirements could adversely affect our results of operations. We are subject to a wide range of laws, regulations, and legal requirements in the U.S. and globally, including those that may apply to our products and online services offerings, and those that impose requirements related to user privacy, telecommunications, data storage and protection, advertising, and online content. Laws in several jurisdictions, including EU Member State laws under the European Electronic Communications Code, increasingly define certain of our services as regulated telecommunications services. This trend may continue and will result in these offerings being subjected to additional data protection, security, law enforcement surveillance, and other obligations. Regulators and private litigants may assert that our collection, use, and management of customer data and other information is inconsistent with their laws and regulations, including laws that apply to the tracking of users via technology such as cookies. New environmental, social, and governance laws and regulations are expanding mandatory disclosure, reporting, and diligence requirements. Legislative or regulatory action relating to cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Compliance with evolving digital accessibility laws and standards will require engineering and is important to our efforts to empower all people and organizations to achieve more. Legislative and regulatory action is emerging in the areas of AI and content moderation, which could increase costs or restrict opportunity. For example, in the EU, an AI Act is being considered, and may entail increased costs or decreased opportunities for the operation of our AI services in the European market. 32 PART I Item 1A How these laws and regulations apply to our business is often unclear, subject to change over time, and sometimes may be inconsistent from jurisdiction to jurisdiction. In addition, governments’ approach to enforcement, and our products and services, are continuing to evolve. Compliance with existing, expanding, or new laws and regulations may involve significant costs or require changes in products or business practices that could adversely affect our results of operations. Noncompliance could result in the imposition of penalties or orders we cease the alleged noncompliant activity. In addition, there is increasing pressure from advocacy groups, regulators, competitors, customers, and other stakeholders across many of these areas. If our products do not meet customer expectations or legal requirements, we could lose sales opportunities or face regulatory or legal actions. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows, AI services, significant business transactions, warranty or product claims, employment practices, and regulation. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact in our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. Our business with government customers may present additional uncertainties. We derive substantial revenue from government contracts. Government contracts generally can present risks and challenges not present in private commercial agreements. For instance, we may be subject to government audits and investigations relating to these contracts, we could be suspended or debarred as a governmental contractor, we could incur civil and criminal fines and penalties, and under certain circumstances contracts may be rescinded. Some agreements may allow a government to terminate without cause and provide for higher liability limits for certain losses. Some contracts may be subject to periodic funding approval, reductions, cancellations, or delays which could adversely impact public-sector demand for our products and services. These events could negatively impact our results of operations, financial condition, and reputation. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cuts and Jobs Act (“TCJA”) and possible future legislative changes may require the collection of information not regularly produced within the company, the use of estimates in our consolidated financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to the TCJA or possible future legislative changes, and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our consolidated financial statements. We are regularly under audit by tax authorities in different jurisdictions. Although we believe that our provision for income taxes and our tax estimates are reasonable, tax authorities may disagree with certain positions we have taken. In addition, economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. We are currently under Internal Revenue Service audit for prior tax years, with the primary unresolved issues relating to transfer pricing. The final resolution of those audits, and other audits or litigation, may differ from the amounts recorded in our consolidated financial statements and may materially affect our consolidated financial statements in the period or periods in which that determination is made. We earn a significant amount of our operating income outside the U.S. A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our consolidated financial statements. 33 PART I Item 1A INTELLECTUAL PROPERTY RISKS We face risks related to the protection and utilization of our intellectual property that may result in our business and operating results may be harmed. Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. Additionally, licensees of our patents may fail to satisfy their obligations to pay us royalties or may contest the scope and extent of their obligations. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. If we are unable to protect our intellectual property, our revenue may be adversely affected. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating results. Unauthorized disclosure of source code also could increase the security risks described elsewhere in these risk factors. Third parties may claim that we infringe their intellectual property. From time to time, others claim we infringe their intellectual property rights. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. Adverse outcomes could also include monetary damages or injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. GENERAL RISKS If our reputation or our brands are damaged, our business and operating results may be harmed . Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, our environmental impact and sustainability, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things: • The introduction of new features, products, services, or terms of service that customers, users, or partners do not like. • Public scrutiny of our decisions regarding user privacy, data practices, or content. • Data security breaches, compliance failures, or actions of partners or individual employees. The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees. Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, pandemic, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. 34 PART I Item 1A We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced a decline in fair value, requiring impairment charges that could adversely affect our consolidated financial statements. Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, pandemic, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems, or the infrastructure or systems they rely on, such as power grids, could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans and magnifies the potential impact of prolonged service outages in our consolidated financial statements. Abrupt political change, terrorist activity, and armed conflict, such as the ongoing conflict in Ukraine, pose a risk of general economic disruption in affected countries, which may increase our operating costs and negatively impact our ability to sell to and collect from customers in affected markets. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory systems and requirements and market interventions that could impact our operating strategies, access to national, regional, and global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues. The occurrence of regional epidemics or a global pandemic, such as COVID-19, may adversely affect our operations, financial condition, and results of operations. The extent to which global pandemics impact our business going forward will depend on factors such as the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity, including the possibility of recession or financial market instability. Measures to contain a global pandemic may intensify other risks described in these Risk Factors. We may incur increased costs to effectively manage these aspects of our business. If we are unsuccessful, it may adversely impact our revenues, cash flows, market share growth, and reputation. The long-term effects of climate change on the global economy and the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand, or available sources of energy or other resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in climate where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. 35 PART I Item 1A Our global business exposes us to operational and economic risks. Our customers are located throughout the world and a significant part of our revenue comes from international sales. The global nature of our business creates operational, economic, and geopolitical risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist and protectionist trends and concerns about human rights, the environment, and political expression in specific countries may significantly alter the trade and commercial environments. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, and non-local sourcing restrictions, export controls, investment restrictions, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services, impair our ability to operate in certain regions, or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our results of operations. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees representing diverse backgrounds, experiences, and skill sets. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation, as well as a diverse and inclusive work environment that enables all our employees to thrive, are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. Our global workforce is predominantly non-unionized, although we do have some employees in the U.S. and internationally who are represented by unions or works councils. In the U.S., there has been a general increase in workers exercising their right to form or join a union. The unionization of significant employee populations could result in higher costs and other operational changes necessary to respond to changing conditions and to establish new relationships with worker representatives. 36 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVE D STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our fiscal year 2023 that remain unresolved. ITEM 2. PR OPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 16 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 11 million square feet of owned space situated on approximately 530 acres of land we own at our corporate headquarters, and approximately 5 million square feet of space we lease. We own and lease other facilities domestically and internationally, primarily for offices, datacenters, and research and development. The largest owned international properties include space in the following locations: China, India, Ireland, and the Netherlands. The largest leased international properties include space in the following locations: Australia, Canada, China, France, Germany, India, Ireland, Israel, Japan, the Netherlands, and the United Kingdom. Refer to Research and Development (Part I, Item 1 of this Form 10-K) for further discussion of our research and development facilities. In fiscal year 2023, we made decisions to consolidate our office leases to create higher density across our workspaces, and we may make similar decisions in future periods as we continue to evaluate our real estate needs. The table below shows a summary of the square footage of our properties owned and leased domestically and internationally as of June 30, 2023: (Square feet in millions) Location Owned Leased Total U.S. 27 20 47 International 9 22 31 Total 36 42 78 ITEM 3. LEGAL PROCEEDINGS Refer to Note 15 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFE TY DISCLOSURES Not applicable. 37 PART II Item 5 PAR T II ITEM 5. MARKET FOR REGISTRANT’S COM MON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 24, 2023, there were 83,883 registered holders of record of our common stock. SHARE REPURCHASES AND DIVIDENDS Following are our monthly share repurchases for the fourth quarter of fiscal year 2023: Period Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (In millions) April 1, 2023 – April 30, 2023 5,007,656 $ 287.97 5,007,656 $ 25,467 May 1, 2023 – May 31, 2023 5,355,638 314.26 5,355,638 23,784 June 1, 2023 – June 30, 2023 4,413,960 334.15 4,413,960 22,309 14,777,254 14,777,254 All share repurchases were made using cash resources. Our share repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. Our Board of Directors declared the following dividends during the fourth quarter of fiscal year 2023: Declaration Date Record Date Payment Date Dividend Per Share Amount (In millions) June 13, 2023 August 17, 2023 September 14, 2023 $ 0.68 $ 5,054 We returned $9.7 billion to shareholders in the form of share repurchases and dividends in the fourth quarter of fiscal year 2023. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding share repurchases and dividends. 38 PART II Item 6 ITEM 6. [R ESERVED] 39 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). This section generally discusses the results of our operations for the year ended June 30, 2023 compared to the year ended June 30, 2022. For a discussion of the year ended June 30 , 2022 compared to the year ended June 30, 2021, please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended June 30, 2022. OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. We are creating the platforms and tools, powered by artificial intelligence (“AI”), that deliver better, faster, and more effective solutions to support small and large business competitiveness, improve educational and health outcomes, grow public-sector efficiency, and empower human ingenuity. We generate revenue by offering a wide range of cloud-based solutions, content, and other services to people and businesses; licensing and supporting an array of software products; delivering relevant online advertising to a global audience; and designing and selling devices. Our most significant expenses are related to compensating employees; supporting and investing in our cloud-based services, including datacenter operations; designing, manufacturing, marketing, and selling our other products and services; and income taxes. Highlights from fiscal year 2023 compared with fiscal year 2022 included: • Microsoft Cloud revenue increased 22% to $111.6 billion. • Office Commercial products and cloud services revenue increased 10% driven by Office 365 Commercial growth of 13%. • Office Consumer products and cloud services revenue increased 2% and Microsoft 365 Consumer subscribers increased to 67.0 million. • LinkedIn revenue increased 10%. • Dynamics products and cloud services revenue increased 16% driven by Dynamics 365 growth of 24%. • Server products and cloud services revenue increased 19% driven by Azure and other cloud services growth of 29%. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue decreased 25%. • Devices revenue decreased 24%. • Windows Commercial products and cloud services revenue increased 5%. • Xbox content and services revenue decreased 3%. • Search and news advertising revenue excluding traffic acquisition costs increased 11%. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. 40 PART II Item 7 Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, influencing how users access services in the cloud and, in some cases, the user’s choice of which suite of cloud-based services to use. Aggregate demand for our software, services, and devices is also correlated to global macroeconomic and geopolitical factors, which remain dynamic. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in cloud and AI infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. We continue to identify and evaluate opportunities to expand our datacenter locations and increase our server capacity to meet the evolving needs of our customers, particularly given the growing demand for AI services. Our datacenters depend on the availability of permitted and buildable land, predictable energy, networking supplies, and servers, including graphics processing units (“GPUs”) and other components. Our devices are primarily manufactured by third-party contract manufacturers. For the majority of our products, we have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. However, some of our products contain certain components for which there are very few qualified suppliers. Extended disruptions at these suppliers could impact our ability to manufacture devices on time to meet consumer demand. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Fluctuations in the U.S. dollar relative to certain foreign currencies reduced reported revenue and expenses from our international operations in fiscal year 2023. On January 18, 2023, we announced decisions we made to align our cost structure with our revenue and customer demand, prioritize our investments in strategic areas, and consolidate office space. As a result, we recorded a $1.2 billion charge in the second quarter of fiscal year 2023 (“Q2 charge”), which included employee severance expenses of $800 million, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. First, we reduced our overall workforce by approximately 10,000 jobs through the third quarter of fiscal year 2023 related to the Q2 charge, which represents less than 5% of our total employee base. While we eliminated roles in some areas, we will continue to hire in key strategic areas. Second, we are allocating both our capital and talent to areas of secular growth and long-term competitiveness, while divesting in other areas. Third, we are consolidating our leases to create higher density across our workspaces, which impacted our financial results through the remainder of fiscal year 2023, and we may make similar decisions in future periods as we continue to evaluate our real estate needs. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Seasonality Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period. Change in Accounting Estimate In July 2022, we completed an assessment of the useful lives of our server and network equipment. Due to investments in software that increased efficiencies in how we operate our server and network equipment, as well as advances in technology, we determined we should increase the estimated useful lives of both server and network equipment from four years to six years. This change in accounting estimate was effective beginning fiscal year 2023. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2022, the effect of this change in estimate for fiscal year 2023 was an increase in operating income of $3.7 billion and net income of $3.0 billion, or $0.40 per both basic and diluted share. 41 PART II Item 7 Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. We have recast certain prior period amounts to conform to the way we internally manage and monitor our business. Additional information on our reportable segments is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Metrics We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Financial metrics are calculated based on financial results prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), and growth comparisons relate to the corresponding period of last fiscal year. In the first quarter of fiscal year 2023, we made updates to the presentation and method of calculation for certain metrics, most notably expanding our Surface metric into a broader Devices metric to incorporate additional revenue streams, along with other minor changes to align with how we manage our businesses. Commercial Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance. Commercial remaining performance obligation Commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods Microsoft Cloud revenue Revenue from Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties Microsoft Cloud gross margin percentage Gross margin percentage for our Microsoft Cloud business 42 PART II Item 7 Productivity and Business Processes and Intelligent Cloud Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends. Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and cloud services (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, Microsoft Viva, and Microsoft 365 Copilot Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud services, including Microsoft 365 Consumer subscriptions, Office licensed on-premises, and other Office services Office 365 Commercial seat growth The number of Office 365 Commercial seats at end of period where seats are paid users covered by an Office 365 Commercial subscription Microsoft 365 Consumer subscribers The number of Microsoft 365 Consumer subscribers at end of period Dynamics products and cloud services revenue growth Revenue from Dynamics products and cloud services, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM (including Customer Insights), Power Apps, and Power Automate; and on-premises ERP and CRM applications LinkedIn revenue growth Revenue from LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions Server products and cloud services revenue growth Revenue from Server products and cloud services, including Azure and other cloud services; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and Nuance and GitHub More Personal Computing Metrics related to our More Personal Computing segment assess the performance of key lines of business within this segment. These metrics provide strategic product insights which allow us to assess the performance across our commercial and consumer businesses. As we have diversity of target audiences and sales motions within the Windows business, we monitor metrics that are reflective of those varying motions. Windows OEM revenue growth Revenue from sales of Windows Pro and non-Pro licenses sold through the OEM channel Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and cloud services, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings Devices revenue growth Revenue from Devices, including Surface, HoloLens, and PC accessories Xbox content and services revenue growth Revenue from Xbox content and services, comprising first- and third-party content (including games and in-game content), Xbox Game Pass and other subscriptions, Xbox Cloud Gaming, advertising, third-party disc royalties, and other cloud services Search and news advertising revenue (ex TAC) growth Revenue from search and news advertising excluding traffic acquisition costs (“TAC”) paid to Bing Ads network publishers and news partners 43 PART II Item 7 SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2023 2022 Percentage Change Revenue $ 211,915 $ 198,270 7% Gross margin 146,052 135,620 8% Operating income 88,523 83,383 6% Net income 72,361 72,738 (1)% Diluted earnings per share 9.68 9.65 0% Adjusted gross margin (non-GAAP) 146,204 135,620 8% Adjusted operating income (non-GAAP) 89,694 83,383 8% Adjusted net income (non-GAAP) 73,307 69,447 6% Adjusted diluted earnings per share (non-GAAP) 9.81 9.21 7% Adjusted gross margin, operating income, net income, and diluted earnings per share (“EPS”) are non-GAAP financial measures. Current year non-GAAP financial measures exclude the impact of the Q2 charge, which includes employee severance expenses, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. Prior year non-GAAP financial measures exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results. Fiscal Year 2023 Compared with Fiscal Year 2022 Revenue increased $13.6 billion or 7% driven by growth in Intelligent Cloud and Productivity and Business Processes, offset in part by a decline in More Personal Computing. Intelligent Cloud revenue increased driven by Azure and other cloud services. Productivity and Business Processes revenue increased driven by Office 365 Commercial and LinkedIn. More Personal Computing revenue decreased driven by Windows and Devices. Cost of revenue increased $3.2 billion or 5% driven by growth in Microsoft Cloud , offset in part by the change in accounting estimate. Gross margin increased $10.4 billion or 8% driven by growth in Intelligent Cloud and Productivity and Business Processes and the change in accounting estimate, offset in part by a decline in More Personal Computing. • Gross margin percentage increased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 1 point driven by declines in Intelligent Cloud and More Personal Computing, offset in part by sales mix shift between our segments. • Microsoft Cloud gross margin percentage increased 2 points to 72%. Excluding the impact of the change in accounting estimate, Microsoft Cloud gross margin percentage decreased slightly driven by a decline in Azure and other cloud services and sales mix shift to Azure and other cloud services , offset in part by improvement in Office 365 Commercial. Operating expenses increased $5.3 billion or 10% driven by employee severance expenses, 2 points of growth from the Nuance and Xandr acquisitions, investments in cloud engineering, and LinkedIn. Operating income increased $5.1 billion or 6% driven by growth in Productivity and Business Processes and Intelligent Cloud and the change in accounting estimate, offset in part by a decline in More Personal Computing. Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 4%, 4%, and 6%, respectively. Cost of revenue and operating expenses both included a favorable foreign currency impact of 2%. Current year gross margin, operating income, net income, and diluted EPS were negatively impacted by the Q2 charge, which resulted in decreases of $152 million, $1.2 billion, $946 million, and $0.13, respectively. Prior year net income and diluted EPS were positively impacted by the net tax benefit related to the transfer of intangible properties, which resulted in an increase to net income and diluted EPS of $3.3 billion and $0.44, respectively. 44 PART II Item 7 SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2023 2022 Percentage Change Revenue Productivity and Business Processes $ 69,274 $ 63,364 9% Intelligent Cloud 87,907 74,965 17% More Personal Computing 54,734 59,941 (9)% Total $ 211,915 $ 198,270 7% Operating Income Productivity and Business Processes $ 34,189 $ 29,690 15% Intelligent Cloud 37,884 33,203 14% More Personal Computing 16,450 20,490 (20)% Total $ 88,523 $ 83,383 6% Reportable Segments Fiscal Year 2023 Compared with Fiscal Year 2022 Productivity and Business Processes Revenue increased $5.9 billion or 9%. • Office Commercial products and cloud services revenue increased $3.7 billion or 10%. Office 365 Commercial revenue grew 13% with seat growth of 11%, driven by small and medium business and frontline worker offerings, as well as growth in revenue per user. Office Commercial products revenue declined 21% driven by continued customer shift to cloud offerings. • Office Consumer products and cloud services revenue increased $140 million or 2%. Microsoft 365 Consumer subscribers grew 12% to 67.0 million. • LinkedIn revenue increased $1.3 billion or 10% driven by Talent Solutions. • Dynamics products and cloud services revenue increased $750 million or 16% driven by Dynamics 365 growth of 24%. Operating income increased $4.5 billion or 15%. • Gross margin increased $5.8 billion or 12% driven by growth in Office 365 Commercial and LinkedIn, as well as the change in accounting estimate. Gross margin percentage increased. Excluding the impact of the change in accounting estimate, gross margin percentage increased slightly driven by improvement in Office 365 Commercial, offset in part by sales mix shift to cloud offerings. • Operating expenses increased $1.3 billion or 7% driven by investment in LinkedIn and employee severance expenses. Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 5%, 5%, and 8%, respectively. Intelligent Cloud Revenue increased $12.9 billion or 17%. • Server products and cloud services revenue increased $12.6 billion or 19% driven by Azure and other cloud services. Azure and other cloud services revenue grew 29% driven by growth in our consumption-based services. Server products revenue decreased 1%. • Enterprise Services revenue increased $315 million or 4% driven by growth in Enterprise Support Services, offset in part by a decline in Industry Solutions (formerly Microsoft Consulting Services). 45 PART II Item 7 Operating income increased $4.7 billion or 14%. • Gross margin increased $8.9 billion or 17% driven by growth in Azure and other cloud services and the change in accounting estimate. Gross margin percentage decreased slightly. Excluding the impact of the change in accounting estimate, gross margin percentage decreased 3 points driven by sales mix shift to Azure and other cloud services and a decline in Azure and other cloud services. • Operating expenses increased $4.2 billion or 21% driven by investments in Azure, 4 points of growth from the Nuance acquisition, and employee severance expenses. Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 4%, 4%, and 6%, respectively. Operating expenses included a favorable foreign currency impact of 2%. More Personal Computing Revenue decreased $5.2 billion or 9%. • Windows revenue decreased $3.2 billion or 13% driven by a decrease in Windows OEM. Windows OEM revenue decreased 25% as elevated channel inventory levels continued to drive additional weakness beyond declining PC demand. Windows Commercial products and cloud services revenue increased 5% driven by demand for Microsoft 365. • Devices revenue decreased $1.8 billion or 24% as elevated channel inventory levels continued to drive additional weakness beyond declining PC demand. • Gaming revenue decreased $764 million or 5% driven by declines in Xbox hardware and Xbox content and services. Xbox hardware revenue decreased 11% driven by lower volume and price of consoles sold. Xbox content and services revenue decreased 3% driven by a decline in first-party content, offset in part by growth in Xbox Game Pass. • Search and news advertising revenue increased $617 million or 5%. Search and news advertising revenue excluding traffic acquisition costs increased 11% driven by higher search volume and the Xandr acquisition. Operating income decreased $4.0 billion or 20%. • Gross margin decreased $4.2 billion or 13% driven by declines in Windows and Devices. Gross margin percentage decreased driven by a decline in Devices. • Operating expenses decreased $195 million or 2% driven by a decline in Devices, offset in part by investments in Search and news advertising, including 2 points of growth from the Xandr acquisition. Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 4%, and 6%, respectively. Operating expenses included a favorable foreign currency impact of 2%. 46 PART II Item 7 OPERATING EXPENSES Research and Development (In millions, except percentages) 2023 2022 Percentage Change Research and development $ 27,195 $ 24,512 11% As a percent of revenue 13% 12% 1ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs and the amortization of purchased software code and services content. Fiscal Year 2023 Compared with Fiscal Year 2022 Research and development expenses increased $2.7 billion or 11% driven by investments in cloud engineering and LinkedIn. Sales and Marketing (In millions, except percentages) 2023 2022 Percentage Change Sales and marketing $ 22,759 $ 21,825 4% As a percent of revenue 11% 11% 0ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal Year 2023 Compared with Fiscal Year 2022 Sales and marketing expenses increased $934 million or 4% driven by 3 points of growth from the Nuance and Xandr acquisitions and investments in commercial sales, offset in part by a decline in Windows advertising. Sales and marketing included a favorable foreign currency impact of 2%. General and Administrative (In millions, except percentages) 2023 2022 Percentage Change General and administrative $ 7,575 $ 5,900 28% As a percent of revenue 4% 3% 1ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, employee severance expense incurred as part of a corporate program, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal Year 2023 Compared with Fiscal Year 2022 General and administrative expenses increased $1.7 billion or 28% driven by employee severance expenses and a charge related to a non-public preliminary draft decision provided by the Irish Data Protection Commission. General and administrative included a favorable foreign currency impact of 2%. 47 PART II Item 7 OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2023 2022 Interest and dividends income $ 2,994 $ 2,094 Interest expense (1,968 ) (2,063 ) Net recognized gains on investments 260 461 Net losses on derivatives (456 ) (52 ) Net gains (losses) on foreign currency remeasurements 181 (75 ) Other, net (223 ) (32 ) Total $ 788 $ 333 We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net. Fiscal Year 2023 Compared with Fiscal Year 2022 Interest and dividends income increased due to higher yields, offset in part by lower portfolio balances. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized gains on investments decreased due to lower gains on equity securities and higher losses on fixed income securities. Net losses on derivatives increased due to losses related to managing strategic investments. INCOME TAXES Effective Tax Rate Our effective tax rate for fiscal years 2023 and 2022 was 19% and 13%, respectively. The increase in our effective tax rate was primarily due to a $3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties and a decrease in tax benefits relating to stock-based compensation. In the first quarter of fiscal year 2022, we transferred certain intangible properties from our Puerto Rico subsidiary to the U.S. The transfer of intangible properties resulted in a $3.3 billion net income tax benefit in the first quarter of fiscal year 2022, as the value of future U.S. tax deductions exceeded the current tax liability from the U.S. global intangible low-taxed income tax. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center in Ireland. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2023, our U.S. income before income taxes was $52.9 billion and our foreign income before income taxes was $36.4 billion. In fiscal year 2022, our U.S. income before income taxes was $47.8 billion and our foreign income before income taxes was $35.9 billion. Uncertain Tax Positions We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017. 48 PART II Item 7 As of June 30, 2023, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues. We do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2022, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Adjusted gross margin, operating income, net income, and diluted EPS are non-GAAP financial measures. Current year non-GAAP financial measures exclude the impact of the Q2 charge, which includes employee severance expenses, impairment charges resulting from changes to our hardware portfolio, and costs related to lease consolidation activities. Prior year non-GAAP financial measures exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results: (In millions, except percentages and per share amounts) 2023 2022 Percentage Change Gross margin $ 146,052 $ 135,620 8% Severance, hardware-related impairment, and lease consolidation costs 152 0 * Adjusted gross margin (non-GAAP) $ 146,204 $ 135,620 8% Operating income $ 88,523 $ 83,383 6% Severance, hardware-related impairment, and lease consolidation costs 1,171 0 * Adjusted operating income (non-GAAP) $ 89,694 $ 83,383 8% Net income $ 72,361 $ 72,738 (1)% Severance, hardware-related impairment, and lease consolidation costs 946 0 * Net income tax benefit related to transfer of intangible properties 0 (3,291 ) * Adjusted net income (non-GAAP) $ 73,307 $ 69,447 6% Diluted earnings per share $ 9.68 $ 9.65 0% Severance, hardware-related impairment, and lease consolidation costs 0.13 0 * Net income tax benefit related to transfer of intangible properties 0 (0.44 ) * Adjusted diluted earnings per share (non-GAAP) $ 9.81 $ 9.21 7% * Not meaningful. 49 PART II Item 7 LIQUIDITY AND CAPITAL RESOURCES We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the Tax Cuts and Jobs Act (“TCJA”), for at least the next 12 months and thereafter for the foreseeable future. Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $111.3 billion and $104.8 billion as of June 30, 2023 and 2022, respectively. Equity investments were $9.9 billion and $6.9 billion as of June 30, 2023 and 2022, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Cash from operations decreased $1.5 billion to $87.6 billion for fiscal year 2023, mainly due to an increase in cash paid to employees and suppliers and cash used to pay income taxes, offset in part by an increase in cash received from customers. Cash used in financing decreased $14.9 billion to $43.9 billion for fiscal year 2023, mainly due to a $10.5 billion decrease in common stock repurchases and a $6.3 billion decrease in repayments of debt, offset in part by a $1.7 billion increase in dividends paid. Cash used in investing decreased $7.6 billion to $22.7 billion for fiscal year 2023, due to a $20.4 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, offset in part by a $8.2 billion decrease in cash from net investment purchases, sales, and maturities, and a $4.2 billion increase in additions to property and equipment. 50 PART II Item 7 Debt Proceeds We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. The following table outlines the expected future recognition of unearned revenue as of June 30, 2023: (In millions) Three Months Ending September 30, 2023 $ 19,673 December 31, 2023 15,600 March 31, 2024 10,801 June 30, 2024 4,827 Thereafter 2,912 Total $ 53,813 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Refer to Note 13 – Unearned Revenue of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Material Cash Requirements and Other Obligations Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2023: (In millions) 2024 Thereafter Total Long-term debt: (a) Principal payments $ 5,250 $ 47,616 $ 52,866 Interest payments 1,379 19,746 21,125 Construction commitments (b) 12,237 1,218 13,455 Operating and finance leases, including imputed interest (c) 5,988 73,852 79,840 Purchase commitments (d) 64,703 3,115 67,818 Total $ 89,557 $ 145,547 $ 235,104 (a) Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Refer to Note 7 – Property and Equipment of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (c) Refer to Note 14 – Leases of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (d) Purchase commitments primarily relate to datacenters and include open purchase orders and take-or-pay contracts that are not presented as construction commitments above. 51 PART II Item 7 Income Taxes As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of $7.7 billion, which included $1.5 billion for fiscal year 2023. The remaining transition tax of $10.5 billion is payable over the next three years, with $2.7 billion payable within 12 months. In fiscal year 2023, we paid cash tax of $4.8 billion due to the mandatory capitalization for tax purposes of research and development expenditures enacted by the TCJA and effective on July 1, 2022. Share Repurchases During fiscal years 2023 and 2022, we repurchased 69 million shares and 95 million shares of our common stock for $18.4 billion and $28.0 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. As of June 30, 2023, $22.3 billion remained of our $60 billion share repurchase program. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends During fiscal year 2023 and 2022, our Board of Directors declared quarterly dividends of $0.68 per share and $0.62 per share, totaling $20.2 billion and $18.6 billion, respectively. We intend to continue returning capital to shareholders in the form of dividends, subject to declaration by our Board of Directors. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Other Planned Uses of Capital On January 18, 2022, we entered into a definitive agreement to acquire Activision Blizzard, Inc. (“Activision Blizzard”) for $95.00 per share in an all-cash transaction valued at $68.7 billion, inclusive of Activision Blizzard’s net cash. The acquisition has been approved by Activision Blizzard’s shareholders. We continue to work toward closing the transaction subject to obtaining required regulatory approvals and satisfaction of other customary closing conditions. Microsoft and Activision Blizzard have jointly agreed to extend the merger agreement through October 18, 2023 to allow for additional time to resolve remaining regulatory concerns. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings and our investments in AI infrastructure. We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. CRITICAL ACCOUNTING ESTIMATES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Critical accounting estimates are those estimates that involve a significant level of estimation uncertainty and could have a material impact on our financial condition or results of operations. We have critical accounting estimates in the areas of revenue recognition, impairment of investment securities, goodwill, research and development costs, legal and other contingencies, income taxes, and inventories. 52 PART II Item 7 Revenue Recognition Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Impairment of Investment Securities We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net. 53 PART II Item 7 Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. 54 PART II Item 7 Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 55 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Alice L. Jolla Corporate Vice President and Chief Accounting Officer 56 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions, including hedges. Principal currency exposures include the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices to facilitate portfolio diversification. Equity Securities held in our equity investments portfolio are subject to price risk. SENSITIVITY ANALYSIS The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices: (In millions) Risk Categories Hypothetical Change June 30, 2023 Impact Foreign currency – Revenue 10% decrease in foreign exchange rates $ (8,122 ) Earnings Foreign currency – Investments 10% decrease in foreign exchange rates (29 ) Fair Value Interest rate 100 basis point increase in U.S. treasury interest rates (1,832 ) Fair Value Credit 100 basis point increase in credit spreads (354 ) Fair Value Equity 10% decrease in equity market prices (705 ) Earnings 57 PART II Item 8 ITEM 8. FINANCIAL STATE MENTS AND SUPPLEMENTARY DATA INC OME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2023 2022 2021 Revenue: Product $ 64,699 $ 72,732 $ 71,074 Service and other 147,216 125,538 97,014 Total revenue 211,915 198,270 168,088 Cost of revenue: Product 17,804 19,064 18,219 Service and other 48,059 43,586 34,013 Total cost of revenue 65,863 62,650 52,232 Gross margin 146,052 135,620 115,856 Research and development 27,195 24,512 20,716 Sales and marketing 22,759 21,825 20,117 General and administrative 7,575 5,900 5,107 Operating income 88,523 83,383 69,916 Other income, net 788 333 1,186 Income before income taxes 89,311 83,716 71,102 Provision for income taxes 16,950 10,978 9,831 Net income $ 72,361 $ 72,738 $ 61,271 Earnings per share: Basic $ 9.72 $ 9.70 $ 8.12 Diluted $ 9.68 $ 9.65 $ 8.05 Weighted average shares outstanding: Basic 7,446 7,496 7,547 Diluted 7,472 7,540 7,608 Refer to accompanying notes. 58 PART II Item 8 COMPREHENSIVE IN COME STATEMENTS (In millions) Year Ended June 30, 2023 2022 2021 Net income $ 72,361 $ 72,738 $ 61,271 Other comprehensive income (loss), net of tax: Net change related to derivatives ( 14 ) 6 19 Net change related to investments ( 1,444 ) ( 5,360 ) ( 2,266 ) Translation adjustments and other ( 207 ) ( 1,146 ) 873 Other comprehensive loss ( 1,665 ) ( 6,500 ) ( 1,374 ) Comprehensive income $ 70,696 $ 66,238 $ 59,897 Refer to accompanying notes. 59 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2023 2022 Assets Current assets: Cash and cash equivalents $ 34,704 $ 13,931 Short-term investments 76,558 90,826 Total cash, cash equivalents, and short-term investments 111,262 104,757 Accounts receivable, net of allowance for doubtful accounts of $ 650 and $ 633 48,688 44,261 Inventories 2,500 3,742 Other current assets 21,807 16,924 Total current assets 184,257 169,684 Property and equipment, net of accumulated depreciation of $ 68,251 and $ 59,660 95,641 74,398 Operating lease right-of-use assets 14,346 13,148 Equity investments 9,879 6,891 Goodwill 67,886 67,524 Intangible assets, net 9,366 11,298 Other long-term assets 30,601 21,897 Total assets $ 411,976 $ 364,840 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 18,095 $ 19,000 Current portion of long-term debt 5,247 2,749 Accrued compensation 11,009 10,661 Short-term income taxes 4,152 4,067 Short-term unearned revenue 50,901 45,538 Other current liabilities 14,745 13,067 Total current liabilities 104,149 95,082 Long-term debt 41,990 47,032 Long-term income taxes 25,560 26,069 Long-term unearned revenue 2,912 2,870 Deferred income taxes 433 230 Operating lease liabilities 12,728 11,489 Other long-term liabilities 17,981 15,526 Total liabilities 205,753 198,298 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000 ; outstanding 7,432 and 7,464 93,718 86,939 Retained earnings 118,848 84,281 Accumulated other comprehensive loss ( 6,343 ) ( 4,678 ) Total stockholders’ equity 206,223 166,542 Total liabilities and stockholders’ equity $ 411,976 $ 364,840 Refer to accompanying notes. 60 PART II Item 8 CASH FLOWS S TATEMENTS (In millions) Year Ended June 30, 2023 2022 2021 Operations Net income $ 72,361 $ 72,738 $ 61,271 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other 13,861 14,460 11,686 Stock-based compensation expense 9,611 7,502 6,118 Net recognized losses (gains) on investments and derivatives 196 ( 409 ) ( 1,249 ) Deferred income taxes ( 6,059 ) ( 5,702 ) ( 150 ) Changes in operating assets and liabilities: Accounts receivable ( 4,087 ) ( 6,834 ) ( 6,481 ) Inventories 1,242 ( 1,123 ) ( 737 ) Other current assets ( 1,991 ) ( 709 ) ( 932 ) Other long-term assets ( 2,833 ) ( 2,805 ) ( 3,459 ) Accounts payable ( 2,721 ) 2,943 2,798 Unearned revenue 5,535 5,109 4,633 Income taxes ( 358 ) 696 ( 2,309 ) Other current liabilities 2,272 2,344 4,149 Other long-term liabilities 553 825 1,402 Net cash from operations 87,582 89,035 76,740 Financing Cash premium on debt exchange 0 0 ( 1,754 ) Repayments of debt ( 2,750 ) ( 9,023 ) ( 3,750 ) Common stock issued 1,866 1,841 1,693 Common stock repurchased ( 22,245 ) ( 32,696 ) ( 27,385 ) Common stock cash dividends paid ( 19,800 ) ( 18,135 ) ( 16,521 ) Other, net ( 1,006 ) ( 863 ) ( 769 ) Net cash used in financing ( 43,935 ) ( 58,876 ) ( 48,486 ) Investing Additions to property and equipment ( 28,107 ) ( 23,886 ) ( 20,622 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets ( 1,670 ) ( 22,038 ) ( 8,909 ) Purchases of investments ( 37,651 ) ( 26,456 ) ( 62,924 ) Maturities of investments 33,510 16,451 51,792 Sales of investments 14,354 28,443 14,008 Other, net ( 3,116 ) ( 2,825 ) ( 922 ) Net cash used in investing ( 22,680 ) ( 30,311 ) ( 27,577 ) Effect of foreign exchange rates on cash and cash equivalents ( 194 ) ( 141 ) ( 29 ) Net change in cash and cash equivalents 20,773 ( 293 ) 648 Cash and cash equivalents, beginning of period 13,931 14,224 13,576 Cash and cash equivalents, end of period $ 34,704 $ 13,931 $ 14,224 Refer to accompanying notes. 61 PART II Item 8 STOCKHOLDERS’ EQ UITY STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2023 2022 2021 Common stock and paid-in capital Balance, beginning of period $ 86,939 $ 83,111 $ 80,552 Common stock issued 1,866 1,841 1,963 Common stock repurchased ( 4,696 ) ( 5,688 ) ( 5,539 ) Stock-based compensation expense 9,611 7,502 6,118 Other, net ( 2 ) 173 17 Balance, end of period 93,718 86,939 83,111 Retained earnings Balance, beginning of period 84,281 57,055 34,566 Net income 72,361 72,738 61,271 Common stock cash dividends ( 20,226 ) ( 18,552 ) ( 16,871 ) Common stock repurchased ( 17,568 ) ( 26,960 ) ( 21,879 ) Cumulative effect of accounting changes 0 0 ( 32 ) Balance, end of period 118,848 84,281 57,055 Accumulated other comprehensive income (loss) Balance, beginning of period ( 4,678 ) 1,822 3,186 Other comprehensive loss ( 1,665 ) ( 6,500 ) ( 1,374 ) Cumulative effect of accounting changes 0 0 10 Balance, end of period ( 6,343 ) ( 4,678 ) 1,822 Total stockholders’ equity $ 206,223 $ 166,542 $ 141,988 Cash dividends declared per common share $ 2.72 $ 2.48 $ 2.24 Refer to accompanying notes. 62 PART II Item 8 NOTES TO FINANCI AL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have recast certain prior period amounts to conform to the current period presentation. The recast of these prior period amounts had no impact on our consolidated balance sheets, consolidated income statements, or consolidated cash flows statements. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of uncertain tax positions that have been recognized in our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions due to risks and uncertainties. In July 2022, we completed an assessment of the useful lives of our server and network equipment. Due to investments in software that increased efficiencies in how we operate our server and network equipment, as well as advances in technology, we determined we should increase the estimated useful lives of both server and network equipment from four years to six years . This change in accounting estimate was effective beginning fiscal year 2023. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2022, the effect of this change in estimate for fiscal year 2023 was an increase in operating income of $ 3.7 billion and net income of $ 3.0 billion, or $ 0.40 per both basic and diluted share. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income. Revenue Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems, cross-device productivity and collaboration applications, server applications, business solution applications, desktop and server management tools, software development tools, video games, and hardware such as PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Office 365, Azure, Dynamics 365, and Xbox; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. 63 PART II Item 8 Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental authorities. Nature of Products and Services Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. In cases where we allocate revenue to software updates, primarily because the updates are provided at no additional charge, revenue is recognized as the updates are provided, which is generally ratably over the estimated life of the related device or license. Certain volume licensing programs, including Enterprise Agreements, include on-premises licenses combined with Software Assurance (“SA”). SA conveys rights to new software and upgrades released over the contract period and provides support, tools, and training to help customers deploy and use products more efficiently. On-premises licenses are considered distinct performance obligations when sold with SA. Revenue allocated to SA is generally recognized ratably over the contract period as customers simultaneously consume and receive benefits, given that SA comprises distinct performance obligations that are satisfied over time. Cloud services, which allow customers to use hosted software over the contract period without taking possession of the software, are provided on either a subscription or consumption basis. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract period. Revenue related to cloud services provided on a consumption basis, such as the amount of storage used in a period, is recognized based on the customer utilization of such resources. When cloud services require a significant level of integration and interdependency with software and the individual components are not considered distinct, all revenue is recognized over the period in which the cloud services are provided. Revenue from search advertising is recognized when the advertisement appears in the search results or when the action necessary to earn the revenue has been completed. Revenue from consulting services is recognized as services are provided. Our hardware is generally highly dependent on, and interrelated with, the underlying operating system and cannot function without the operating system. In these cases, the hardware and software license are accounted for as a single performance obligation and revenue is recognized at the point in time when ownership is transferred to resellers or directly to end customers through retail stores and online marketplaces. Refer to Note 19 – Segment Information and Geographic Data for further information, including revenue by significant product and service offering. Significant Judgments Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 64 PART II Item 8 Judgment is required to determine the SSP for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Contract Balances and Other Receivables Timing of revenue recognition may differ from the timing of invoicing to customers. We record a receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For multi-year agreements, we generally invoice customers annually at the beginning of each annual coverage period. We record a receivable related to revenue recognized for multi-year on-premises licenses as we have an unconditional right to invoice and receive payment in the future related to those licenses. Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include SA and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for consulting services to be performed in the future, LinkedIn subscriptions, Office 365 subscriptions, Xbox subscriptions, Windows post-delivery support, Dynamics business solutions, and other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 13 – Unearned Revenue for further information, including unearned revenue by segment and changes in unearned revenue during the period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with revenue recognized upfront. As of June 30, 2023 and 2022, long-term accounts receivable, net of allowance for doubtful accounts, was $ 4.5 billion and $ 3.8 billion, respectively, and is included in other long-term assets in our consolidated balance sheets. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. 65 PART II Item 8 Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2023 2022 2021 Balance, beginning of period $ 710 $ 798 $ 816 Charged to costs and other 258 157 234 Write-offs ( 252 ) ( 245 ) ( 252 ) Balance, end of period $ 716 $ 710 $ 798 Allowance for doubtful accounts included in our consolidated balance sheets: (In millions) June 30, 2023 2022 2021 Accounts receivable, net of allowance for doubtful accounts $ 650 $ 633 $ 751 Other long-term assets 66 77 47 Total $ 716 $ 710 $ 798 As of June 30, 2023 and 2022, other receivables related to activities to facilitate the purchase of server components were $ 9.2 billion and $ 6.1 billion, respectively, and are included in other current assets in our consolidated balance sheets. We record financing receivables when we offer certain of our customers the option to acquire our software products and services offerings through a financing program in a limited number of countries. As of June 30, 2023 and 2022, our financing receivables, net were $ 5.3 billion and $ 4.1 billion, respectively, for short-term and long-term financing receivables, which are included in other current assets and other long-term assets in our consolidated balance sheets. We record an allowance to cover expected losses based on troubled accounts, historical experience, and other currently available evidence. Assets Recognized from Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets in our consolidated balance sheets. We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less. These costs include our internal sales organization compensation program and certain partner sales incentive programs as we have determined annual compensation is commensurate with annual sales activities. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by original equipment manufacturers (“OEM”), to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain cloud-based and other online products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. 66 PART II Item 8 Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 904 million , $ 1.5 billion, and $ 1.5 billion in fiscal years 2023, 2022, and 2021, respectively. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Employee Severance On January 18, 2023, we announced a decision to reduce our overall workforce by approximately 10,000 jobs through the third quarter of fiscal year 2023. During the three months ended December 31, 2022, we recorded $ 800 million of employee severance expenses related to these job eliminations as part of an ongoing employee benefit plan. These employee severance expenses were incurred as part of a corporate program, and were included in general and administrative expenses in our consolidated income statements and allocated to our segments based on relative gross margin. Refer to Note 19 – Segment Information and Geographic Data for further information. Income Taxes Income tax expense includes U.S. and international income taxes, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term in our consolidated balance sheets. 67 PART II Item 8 Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding credit losses and impairments, are recorded in other comprehensive income. Fair value is calculated based on publicly available market information or other estimates determined by management. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. To determine credit losses, we employ a systematic methodology that considers available quantitative and qualitative evidence. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a periodic basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net. Derivatives Derivative instruments are recognized as either assets or liabilities and measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments designated as cash flow hedges, gains and losses are initially reported as a component of other comprehensive income and subsequently recognized in other income (expense), net with the corresponding hedged item. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net. 68 PART II Item 8 Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 investments include commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Our Level 2 derivative assets and liabilities include certain cleared swap contracts and over-the-counter forward, option, and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets and liabilities include investments in corporate notes and bonds, municipal securities, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure equity investments without readily determinable fair values on a nonrecurring basis. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. Our other current financial assets and current financial liabilities have fair values that approximate their carrying values. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three years ; computer equipment, two to six years ; buildings and improvements, five to 15 years ; leasehold improvements, three to 20 years ; and furniture and equipment, one to 10 years . Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets, other current liabilities, and operating lease liabilities in our consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in our consolidated balance sheets. 69 PART II Item 8 ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we generally use our incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. We have lease agreements with lease and non-lease components, which are generally accounted for separately. For certain equipment leases, such as vehicles, we account for the lease and non-lease components as a single lease component. Additionally, for certain equipment leases, we apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets Our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 20 years . We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2023 2022 2021 Net income available for common shareholders (A) $ 72,361 $ 72,738 $ 61,271 Weighted average outstanding shares of common stock (B) 7,446 7,496 7,547 Dilutive effect of stock-based awards 26 44 61 Common stock and common stock equivalents (C) 7,472 7,540 7,608 Earnings Per Share Basic (A/B) $ 9.72 $ 9.70 $ 8.12 Diluted (A/C) $ 9.68 $ 9.65 $ 8.05 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. 70 PART II Item 8 NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Interest and dividends income $ 2,994 $ 2,094 $ 2,131 Interest expense ( 1,968 ) ( 2,063 ) ( 2,346 ) Net recognized gains on investments 260 461 1,232 Net gains (losses) on derivatives ( 456 ) ( 52 ) 17 Net gains (losses) on foreign currency remeasurements 181 ( 75 ) 54 Other, net ( 223 ) ( 32 ) 98 Total $ 788 $ 333 $ 1,186 Net Recognized Gains (Losses) on Investments Net recognized gains (losses) on debt investments were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Realized gains from sales of available-for-sale securities $ 36 $ 162 $ 105 Realized losses from sales of available-for-sale securities ( 124 ) ( 138 ) ( 40 ) Impairments and allowance for credit losses ( 10 ) ( 81 ) ( 2 ) Total $ ( 98 ) $ ( 57 ) $ 63 Net recognized gains (losses) on equity investments were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Net realized gains on investments sold $ 75 $ 29 $ 123 Net unrealized gains on investments still held 303 509 1,057 Impairments of investments ( 20 ) ( 20 ) ( 11 ) Total $ 358 $ 518 $ 1,169 71 PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments were as follows: (In millions) Fair Value Level Adjusted Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2023 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 16,589 $ 0 $ 0 $ 16,589 $ 12,231 $ 4,358 $ 0 Certificates of deposit Level 2 2,701 0 0 2,701 2,657 44 0 U.S. government securities Level 1 65,237 2 ( 3,870 ) 61,369 2,991 58,378 0 U.S. agency securities Level 2 2,703 0 0 2,703 894 1,809 0 Foreign government bonds Level 2 498 1 ( 24 ) 475 0 475 0 Mortgage- and asset-backed securities Level 2 824 1 ( 39 ) 786 0 786 0 Corporate notes and bonds Level 2 10,809 8 ( 583 ) 10,234 0 10,234 0 Corporate notes and bonds Level 3 120 0 0 120 0 120 0 Municipal securities Level 2 285 1 ( 18 ) 268 7 261 0 Municipal securities Level 3 103 0 ( 16 ) 87 0 87 0 Total debt investments $ 99,869 $ 13 $ ( 4,550 ) $ 95,332 $ 18,780 $ 76,552 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 10,138 $ 7,446 $ 0 $ 2,692 Equity investments Other 7,187 0 0 7,187 Total equity investments $ 17,325 $ 7,446 $ 0 $ 9,879 Cash $ 8,478 $ 8,478 $ 0 $ 0 Derivatives, net (a) 6 0 6 0 Total $ 121,141 $ 34,704 $ 76,558 $ 9,879 72 PART II Item 8 (In millions) Fair Value Level Adjusted Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2022 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 2,500 $ 0 $ 0 $ 2,500 $ 2,498 $ 2 $ 0 Certificates of deposit Level 2 2,071 0 0 2,071 2,032 39 0 U.S. government securities Level 1 79,696 29 ( 2,178 ) 77,547 9 77,538 0 U.S. agency securities Level 2 419 0 ( 9 ) 410 0 410 0 Foreign government bonds Level 2 506 0 ( 24 ) 482 0 482 0 Mortgage- and asset-backed securities Level 2 727 1 ( 30 ) 698 0 698 0 Corporate notes and bonds Level 2 11,661 4 ( 554 ) 11,111 0 11,111 0 Corporate notes and bonds Level 3 67 0 0 67 0 67 0 Municipal securities Level 2 368 19 ( 13 ) 374 0 374 0 Municipal securities Level 3 103 0 ( 6 ) 97 0 97 0 Total debt investments $ 98,118 $ 53 $ ( 2,814 ) $ 95,357 $ 4,539 $ 90,818 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 1,590 $ 1,134 $ 0 $ 456 Equity investments Other 6,435 0 0 6,435 Total equity investments $ 8,025 $ 1,134 $ 0 $ 6,891 Cash $ 8,258 $ 8,258 $ 0 $ 0 Derivatives, net (a) 8 0 8 0 Total $ 111,648 $ 13,931 $ 90,826 $ 6,891 (a) Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments. Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of June 30, 2023 and 2022, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $ 4.2 billion and $ 3.8 billion, respectively. 73 PART II Item 8 Unrealized Losses on Debt Investments Debt investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2023 U.S. government and agency securities $ 7,950 $ ( 336 ) $ 45,273 $ ( 3,534 ) $ 53,223 $ ( 3,870 ) Foreign government bonds 77 ( 5 ) 391 ( 19 ) 468 ( 24 ) Mortgage- and asset-backed securities 257 ( 5 ) 412 ( 34 ) 669 ( 39 ) Corporate notes and bonds 2,326 ( 49 ) 7,336 ( 534 ) 9,662 ( 583 ) Municipal securities 111 ( 3 ) 186 ( 31 ) 297 ( 34 ) Total $ 10,721 $ ( 398 ) $ 53,598 $ ( 4,152 ) $ 64,319 $ ( 4,550 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2022 U.S. government and agency securities $ 59,092 $ ( 1,835 ) $ 2,210 $ ( 352 ) $ 61,302 $ ( 2,187 ) Foreign government bonds 418 ( 18 ) 27 ( 6 ) 445 ( 24 ) Mortgage- and asset-backed securities 510 ( 26 ) 41 ( 4 ) 551 ( 30 ) Corporate notes and bonds 9,443 ( 477 ) 786 ( 77 ) 10,229 ( 554 ) Municipal securities 178 ( 12 ) 74 ( 7 ) 252 ( 19 ) Total $ 69,641 $ ( 2,368 ) $ 3,138 $ ( 446 ) $ 72,779 $ ( 2,814 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Adjusted Cost Basis Estimated Fair Value June 30, 2023 Due in one year or less $ 38,182 $ 38,048 Due after one year through five years 47,127 44,490 Due after five years through 10 years 13,262 11,628 Due after 10 years 1,298 1,166 Total $ 99,869 $ 95,332 74 PART II Item 8 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, interest rates, equity prices, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Foreign currency risks related to certain non-U.S. dollar-denominated investments are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. Foreign currency risks related to certain Euro-denominated debt are hedged using foreign exchange forward contracts that are designated as cash flow hedging instruments. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. Interest Rate Interest rate risks related to certain fixed-rate debt are hedged using interest rate swaps that are designated as fair value hedging instruments to effectively convert the fixed interest rates to floating interest rates. Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using option, futures, and swap contracts. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Equity Securities held in our equity investments portfolio are subject to market price risk. At times, we may hold options, futures, and swap contracts. These contracts are not designated as hedging instruments. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $ 1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2023, our long-term unsecured debt rating was AAA , and cash investments were in excess of $ 1.0 billion. As a result, no collateral was required to be posted. 75 PART II Item 8 The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents: (In millions) June 30, 2023 June 30, 2022 Designated as Hedging Instruments Foreign exchange contracts purchased $ 1,492 $ 635 Interest rate contracts purchased 1,078 1,139 Not Designated as Hedging Instruments Foreign exchange contracts purchased 7,874 10,322 Foreign exchange contracts sold 25,159 21,606 Equity contracts purchased 3,867 1,131 Equity contracts sold 2,154 0 Other contracts purchased 1,224 1,642 Other contracts sold 581 544 Fair Values of Derivative Instruments The following table presents our derivative instruments: (In millions) Derivative Assets Derivative Liabilities Derivative Assets Derivative Liabilities June 30, 2023 June 30, 2022 Designated as Hedging Instruments Foreign exchange contracts $ 34 $ ( 67 ) $ 0 $ ( 77 ) Interest rate contracts 16 0 3 0 Not Designated as Hedging Instruments Foreign exchange contracts 249 ( 332 ) 333 ( 362 ) Equity contracts 165 ( 400 ) 5 ( 95 ) Other contracts 5 ( 6 ) 15 ( 17 ) Gross amounts of derivatives 469 ( 805 ) 356 ( 551 ) Gross amounts of derivatives offset in the balance sheet ( 202 ) 206 ( 130 ) 133 Cash collateral received 0 ( 125 ) 0 ( 75 ) Net amounts of derivatives $ 267 $ ( 724 ) $ 226 $ ( 493 ) Reported as Short-term investments $ 6 $ 0 $ 8 $ 0 Other current assets 245 0 218 0 Other long-term assets 16 0 0 0 Other current liabilities 0 ( 341 ) 0 ( 298 ) Other long-term liabilities 0 ( 383 ) 0 ( 195 ) Total $ 267 $ ( 724 ) $ 226 $ ( 493 ) Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $ 442 million and $ 804 million, respectively, as of June 30, 2023, and $ 343 million and $ 550 million, respectively, as of June 30, 2022. The following table presents the fair value of our derivatives instruments on a gross basis: (In millions) Level 1 Level 2 Level 3 Total June 30, 2023 Derivative assets $ 0 $ 462 $ 7 $ 469 Derivative liabilities 0 ( 805 ) 0 ( 805 ) June 30, 2022 Derivative assets 1 349 6 356 Derivative liabilities 0 ( 551 ) 0 ( 551 ) 76 PART II Item 8 Gains (losses) on derivative instruments recognized in other income (expense), net were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Designated as Fair Value Hedging Instruments Foreign exchange contracts Derivatives $ 0 $ 49 $ 193 Hedged items 0 ( 50 ) ( 188 ) Excluded from effectiveness assessment 0 4 30 Interest rate contracts Derivatives ( 65 ) ( 92 ) ( 37 ) Hedged items 38 108 53 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Amount reclassified from accumulated other comprehensive income 61 ( 79 ) 17 Not Designated as Hedging Instruments Foreign exchange contracts ( 73 ) 383 27 Equity contracts ( 420 ) 13 ( 6 ) Other contracts ( 41 ) ( 85 ) 15 Gains (losses), net of tax, on derivative instruments recognized in our consolidated comprehensive income statements were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Included in effectiveness assessment $ 34 $ ( 57 ) $ 34 NOTE 6 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2023 2022 Raw materials $ 709 $ 1,144 Work in process 23 82 Finished goods 1,768 2,516 Total $ 2,500 $ 3,742 77 PART II Item 8 NOTE 7 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2023 2022 Land $ 5,683 $ 4,734 Buildings and improvements 68,465 55,014 Leasehold improvements 8,537 7,819 Computer equipment and software 74,961 60,631 Furniture and equipment 6,246 5,860 Total, at cost 163,892 134,058 Accumulated depreciation ( 68,251 ) ( 59,660 ) Total, net $ 95,641 $ 74,398 During fiscal years 2023, 2022, and 2021, depreciation expense was $ 11.0 billion, $ 12.6 billion, and $ 9.3 billion, respectively. Depreciation expense declined in fiscal year 2023 due to the change in estimated useful lives of our server and network equipment. As of June 30, 2023, we have committed $ 13.5 billion for the construction of new buildings, building improvements, and leasehold improvements, primarily related to datacenters. NOTE 8 — BUSINESS COMBINATIONS Nuance Communications, Inc. On March 4, 2022 , we completed our acquisition of Nuance Communications, Inc. (“Nuance”) for a total purchase price of $ 18.8 billion, consisting primarily of cash. Nuance is a cloud and artificial intelligence (“AI”) software provider with healthcare and enterprise AI experience, and the acquisition will build on our industry-specific cloud offerings. The financial results of Nuance have been included in our consolidated financial statements since the date of the acquisition. Nuance is reported as part of our Intelligent Cloud segment. The allocation of the purchase price to goodwill was completed as of December 31, 2022. The major classes of assets and liabilities to which we have allocated the purchase price were as follows: (In millions) Goodwill (a) $ 16,326 Intangible assets 4,365 Other assets 42 Other liabilities (b) ( 1,972 ) Total $ 18,761 (a) Goodwill was assigned to our Intelligent Cloud segment and was primarily attributed to increased synergies that are expected to be achieved from the integration of Nuance. None of the goodwill is expected to be deductible for income tax purposes. (b) Includes $ 986 million of convertible senior notes issued by Nuance in 2015 and 2017, substantially all of which have been redeemed. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions, except average life) Amount Weighted Average Life Customer-related $ 2,610 9 years Technology-based 1,540 5 years Marketing-related 215 4 years Total $ 4,365 7 years 78 PART II Item 8 ZeniMax Media Inc. On March 9, 2021 , we completed our acquisition of ZeniMax Media Inc. (“ZeniMax”), the parent company of Bethesda Softworks LLC (“Bethesda”), for a total purchase price of $ 8.1 billion, consisting primarily of cash. The purchase price included $ 766 million of cash and cash equivalents acquired. Bethesda is one of the largest, privately held game developers and publishers in the world, and brings a broad portfolio of games, technology, and talent to Xbox. The financial results of ZeniMax have been included in our consolidated financial statements since the date of the acquisition. ZeniMax is reported as part of our More Personal Computing segment. The allocation of the purchase price to goodwill was completed as of December 31, 2021. The major classes of assets and liabilities to which we have allocated the purchase price were as follows: (In millions) Cash and cash equivalents $ 766 Goodwill 5,510 Intangible assets 1,968 Other assets 121 Other liabilities ( 244 ) Total $ 8,121 Goodwill was assigned to our More Personal Computing segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of ZeniMax. None of the goodwill is expected to be deductible for income tax purposes. Following are details of the purchase price allocated to the intangible assets acquired: (In millions, except average life) Amount Weighted Average Life Technology-based $ 1,341 4 years Marketing-related 627 11 years Total $ 1,968 6 years Activision Blizzard, Inc. On January 18, 2022 , we entered into a definitive agreement to acquire Activision Blizzard, Inc. (“Activision Blizzard”) for $ 95.00 per share in an all-cash transaction valued at $ 68.7 billion, inclusive of Activision Blizzard’s net cash. Activision Blizzard is a leader in game development and an interactive entertainment content publisher. The acquisition will accelerate the growth in our gaming business across mobile, PC, console, and cloud gaming. The acquisition has been approved by Activision Blizzard’s shareholders. We continue to work toward closing the transaction subject to obtaining required regulatory approvals and satisfaction of other customary closing conditions. Microsoft and Activision Blizzard have jointly agreed to extend the merger agreement through October 18, 2023 to allow for additional time to resolve remaining regulatory concerns. NOTE 9 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2021 Acquisitions Other June 30, 2022 Acquisitions Other June 30, 2023 Productivity and Business Processes $ 24,317 $ 599 $ ( 105 ) $ 24,811 $ 11 $ ( 47 ) $ 24,775 Intelligent Cloud 13,256 16,879 47 30,182 223 64 30,469 More Personal Computing 12,138 648 ( 255 ) 12,531 0 111 12,642 Total $ 49,711 $ 18,126 $ ( 313 ) $ 67,524 $ 234 $ 128 $ 67,886 79 PART II Item 8 The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2023, May 1, 2022, or May 1, 2021 tests. As of June 30, 2023 and 2022, accumulated goodwill impairment was $ 11.3 billion. NOTE 10 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2023 2022 Technology-based $ 11,245 $ ( 7,589 ) $ 3,656 $ 11,277 $ ( 6,958 ) $ 4,319 Customer-related 7,281 ( 4,047 ) 3,234 7,342 ( 3,171 ) 4,171 Marketing-related 4,935 ( 2,473 ) 2,462 4,942 ( 2,143 ) 2,799 Contract-based 29 ( 15 ) 14 16 ( 7 ) 9 Total $ 23,490 $ ( 14,124 ) $ 9,366 $ 23,577 $ ( 12,279 ) $ 11,298 No material impairments of intangible assets were identified during fiscal years 2023, 2022, or 2021. We estimate that we have no significant residual value related to our intangible assets. The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2023 2022 Technology-based $ 522 7 years $ 2,611 4 years Customer-related 0 0 years 2,837 9 years Marketing-related 7 5 years 233 4 years Contract-based 12 3 years 0 0 years Total $ 541 6 years $ 5,681 7 years Intangible assets amortization expense was $ 2.5 billion, $ 2.0 billion, and $ 1.6 billion for fiscal years 2023, 2022, and 2021, respectively. 80 PART II Item 8 The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2023: (In millions) Year Ending June 30, 2024 $ 2,363 2025 1,881 2026 1,381 2027 929 2028 652 Thereafter 2,160 Total $ 9,366 NOTE 11 — DEBT The components of debt were as follows: (In millions, issuance by calendar year) Maturities (calendar year) Stated Interest Rate Effective Interest Rate June 30, 2023 June 30, 2022 2009 issuance of $ 3.8 billion 2039 5.20 % 5.24 % $ 520 $ 520 2010 issuance of $ 4.8 billion 2040 4.50 % 4.57 % 486 486 2011 issuance of $ 2.3 billion 2041 5.30 % 5.36 % 718 718 2012 issuance of $ 2.3 billion 2042 3.50 % 3.57 % 454 1,204 2013 issuance of $ 5.2 billion 2023 – 2043 3.63 % – 4.88 % 3.73 % – 4.92 % 1,814 2,814 2013 issuance of € 4.1 billion 2028 – 2033 2.63 % – 3.13 % 2.69 % – 3.22 % 2,509 2,404 2015 issuance of $ 23.8 billion 2025 – 2055 2.70 % – 4.75 % 2.77 % – 4.78 % 9,805 10,805 2016 issuance of $ 19.8 billion 2023 – 2056 2.00 % – 3.95 % 2.10 % – 4.03 % 9,430 9,430 2017 issuance of $ 17.0 billion 2024 – 2057 2.88 % – 4.50 % 3.04 % – 4.53 % 8,945 8,945 2020 issuance of $ 10.0 billion 2050 – 2060 2.53 % – 2.68 % 2.53 % – 2.68 % 10,000 10,000 2021 issuance of $ 8.2 billion 2052 – 2062 2.92 % – 3.04 % 2.92 % – 3.04 % 8,185 8,185 Total face value 52,866 55,511 Unamortized discount and issuance costs ( 438 ) ( 471 ) Hedge fair value adjustments (a) ( 106 ) ( 68 ) Premium on debt exchange ( 5,085 ) ( 5,191 ) Total debt 47,237 49,781 Current portion of long-term debt ( 5,247 ) ( 2,749 ) Long-term debt $ 41,990 $ 47,032 (a) Refer to Note 5 – Derivatives for further information on the interest rate swaps related to fixed-rate debt. As of June 30, 2023 and 2022, the estimated fair value of long-term debt, including the current portion, was $ 46.2 billion and $ 50.9 billion, respectively. The estimated fair values are based on Level 2 inputs. Debt in the table above is comprised of senior unsecured obligations and ranks equally with our other outstanding obligations. Interest is paid semi-annually, except for the Euro-denominated debt, which is paid annually. Cash paid for interest on our debt for fiscal years 2023, 2022, and 2021 was $ 1.7 billion, $ 1.9 billion, and $ 2.0 billion, respectively. 81 PART II Item 8 The following table outlines maturities of our long-term debt, including the current portion, as of June 30, 2023: (In millions) Year Ending June 30, 2024 $ 5,250 2025 2,250 2026 3,000 2027 8,000 2028 0 Thereafter 34,366 Total $ 52,866 NOTE 12 — INCOME TAXES Provision for Income Taxes The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Current Taxes U.S. federal $ 14,009 $ 8,329 $ 3,285 U.S. state and local 2,322 1,679 1,229 Foreign 6,678 6,672 5,467 Current taxes $ 23,009 $ 16,680 $ 9,981 Deferred Taxes U.S. federal $ ( 6,146 ) $ ( 4,815 ) $ 25 U.S. state and local ( 477 ) ( 1,062 ) ( 204 ) Foreign 564 175 29 Deferred taxes $ ( 6,059 ) $ ( 5,702 ) $ ( 150 ) Provision for income taxes $ 16,950 $ 10,978 $ 9,831 82 PART II Item 8 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2023 2022 2021 U.S. $ 52,917 $ 47,837 $ 34,972 Foreign 36,394 35,879 36,130 Income before income taxes $ 89,311 $ 83,716 $ 71,102 Effective Tax Rate The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2023 2022 2021 Federal statutory rate 21.0 % 21.0 % 21.0 % Effect of: Foreign earnings taxed at lower rates ( 1.8 )% ( 1.3 )% ( 2.7 )% Impact of intangible property transfers 0 % ( 3.9 )% 0 % Foreign-derived intangible income deduction ( 1.3 )% ( 1.1 )% ( 1.3 )% State income taxes, net of federal benefit 1.6 % 1.4 % 1.4 % Research and development credit ( 1.1 )% ( 0.9 )% ( 0.9 )% Excess tax benefits relating to stock-based compensation ( 0.7 )% ( 1.9 )% ( 2.4 )% Interest, net 0.8 % 0.5 % 0.5 % Other reconciling items, net 0.5 % ( 0.7 )% ( 1.8 )% Effective rate 19.0 % 13.1 % 13.8 % In the first quarter of fiscal year 2022, we transferred certain intangible properties from our Puerto Rico subsidiary to the U.S. The transfer of intangible properties resulted in a $ 3.3 billion net income tax benefit in the first quarter of fiscal year 2022, as the value of future U.S. tax deductions exceeded the current tax liability from the U.S. global intangible low-taxed income (“GILTI”) tax. We have historically paid India withholding taxes on software sales through distributor withholding and tax audit assessments in India. In March 2021, the India Supreme Court ruled favorably in the case of Engineering Analysis Centre of Excellence Private Limited vs The Commissioner of Income Tax for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject to India withholding taxes. Although we were not a party to the appeals, our software sales in India were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of $ 620 million in the third quarter of fiscal year 2021 to reflect the results of the India Supreme Court decision impacting fiscal year 1996 through fiscal year 2016 . The decrease from the federal statutory rate in fiscal year 2023 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center in Ireland. The decrease from the federal statutory rate in fiscal year 2022 is primarily due to the net income tax benefit related to the transfer of intangible properties, earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center in Ireland, and tax benefits relating to stock-based compensation. The decrease from the federal statutory rate in fiscal year 2021 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, tax benefits relating to stock-based compensation, and tax benefits from the India Supreme Court decision on withholding taxes. In fiscal year 2023, our foreign regional operating center in Ireland, which is taxed at a rate lower than the U.S. rate, generated 81 % of our foreign income before tax. In fiscal years 2022 and 2021 , our foreign regional operating centers in Ireland and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 71 % and 82 % of our foreign income before tax. Other reconciling items, net consists primarily of tax credits and GILTI tax, and in fiscal year 2021, includes tax benefits from the India Supreme Court decision on withholding taxes. In fiscal years 2023, 2022, and 2021, there were no individually significant other reconciling items. 83 PART II Item 8 The increase in our effective tax rate for fiscal year 2023 compared to fiscal year 2022 was primarily due to a $ 3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties and a decrease in tax benefits relating to stock-based compensation. The decrease in our effective tax rate for fiscal year 2022 compared to fiscal year 2021 was primarily due to a $ 3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties, offset in part by changes in the mix of our income before income taxes between the U.S. and foreign countries, as well as tax benefits in the prior year from the India Supreme Court decision on withholding taxes, an agreement between the U.S. and India tax authorities related to transfer pricing, and final Tax Cuts and Jobs Act (“TCJA”) regulations. The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2023 2022 Deferred Income Tax Assets Stock-based compensation expense $ 681 $ 601 Accruals, reserves, and other expenses 3,131 2,874 Loss and credit carryforwards 1,441 1,546 Amortization (a) 9,440 10,183 Leasing liabilities 5,041 4,557 Unearned revenue 3,296 2,876 Book/tax basis differences in investments and debt 373 0 Capitalized research and development (a) 6,958 473 Other 489 461 Deferred income tax assets 30,850 23,571 Less valuation allowance ( 939 ) ( 1,012 ) Deferred income tax assets, net of valuation allowance $ 29,911 $ 22,559 Deferred Income Tax Liabilities Book/tax basis differences in investments and debt $ 0 $ ( 174 ) Leasing assets ( 4,680 ) ( 4,291 ) Depreciation ( 2,674 ) ( 1,602 ) Deferred tax on foreign earnings ( 2,738 ) ( 3,104 ) Other ( 89 ) ( 103 ) Deferred income tax liabilities $ ( 10,181 ) $ ( 9,274 ) Net deferred income tax assets $ 19,730 $ 13,285 Reported As Other long-term assets $ 20,163 $ 13,515 Long-term deferred income tax liabilities ( 433 ) ( 230 ) Net deferred income tax assets $ 19,730 $ 13,285 (a) Provisions enacted in the TCJA related to the capitalization for tax purposes of research and development expenditures became effective on July 1, 2022. These provisions require us to capitalize research and development expenditures and amortize them on our U.S. tax return over five or fifteen years, depending on where research is conducted. Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. As of June 30, 2023, we had federal, state, and foreign net operating loss carryforwards of $ 509 million, $ 1.2 billion, and $ 2.3 billion, respectively. The federal and state net operating loss carryforwards have varying expiration dates ranging from fiscal year 2024 to 2043 or indefinite carryforward periods , if not utilized. The majority of our foreign net operating loss carryforwards do not expire. Certain acquired net operating loss carryforwards are subject to an annual limitation but are expected to be realized with the exception of those which have a valuation allowance. As of June 30, 2023, we had $ 456 million federal capital loss carryforwards for U.S. tax purposes from our acquisition of Nuance. The federal capital loss carryforwards are subject to an annual limitation and will expire in fiscal year 2025 . 84 PART II Item 8 The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards, federal capital loss carryforwards, and other net deferred tax assets that may not be realized. Income taxes paid, net of refunds, were $ 23.1 billion, $ 16.0 billion, and $ 13.4 billion in fiscal years 2023, 2022, and 2021, respectively. Uncertain Tax Positions Gross unrecognized tax benefits related to uncertain tax positions as of June 30, 2023, 2022, and 2021, were $ 17.1 billion, $ 15.6 billion, and $ 14.6 billion, respectively, which were primarily included in long-term income taxes in our consolidated balance sheets. If recognized, the resulting tax benefit would affect our effective tax rates for fiscal years 2023, 2022, and 2021 by $ 14.4 billion, $ 13.3 billion, and $ 12.5 billion, respectively. As of June 30, 2023, 2022, and 2021, we had accrued interest expense related to uncertain tax positions of $ 5.2 billion, $ 4.3 billion, and $ 4.3 billion, respectively, net of income tax benefits. The provision for income taxes for fiscal years 2023, 2022, and 2021 included interest expense related to uncertain tax positions of $ 918 million, $ 36 million, and $ 274 million, respectively, net of income tax benefits. The aggregate changes in the gross unrecognized tax benefits related to uncertain tax positions were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Beginning unrecognized tax benefits $ 15,593 $ 14,550 $ 13,792 Decreases related to settlements ( 329 ) ( 317 ) ( 195 ) Increases for tax positions related to the current year 1,051 1,145 790 Increases for tax positions related to prior years 870 461 461 Decreases for tax positions related to prior years ( 60 ) ( 246 ) ( 297 ) Decreases due to lapsed statutes of limitations ( 5 ) 0 ( 1 ) Ending unrecognized tax benefits $ 17,120 $ 15,593 $ 14,550 We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $ 1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017 . As of June 30, 2023, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues. We do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2022 , some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. 85 PART II Item 8 NOTE 13 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2023 2022 Productivity and Business Processes $ 27,572 $ 24,558 Intelligent Cloud 21,563 19,371 More Personal Computing 4,678 4,479 Total $ 53,813 $ 48,408 Changes in unearned revenue were as follows: (In millions) Year Ended June 30, 2023 Balance, beginning of period $ 48,408 Deferral of revenue 123,935 Recognition of unearned revenue ( 118,530 ) Balance, end of period $ 53,813 Revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods, was $ 229 billion as of June 30, 2023, of which $ 224 billion is related to the commercial portion of revenue. We expect to recognize approximately 45 % of this revenue over the next 12 months and the remainder thereafter. NOTE 14 — LEASES We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. Our leases have remaining lease terms of less than 1 year to 18 years, some of which include options to extend the leases for up to 5 years, and some of which include options to terminate the leases within 1 year. The components of lease expense were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Operating lease cost $ 2,875 $ 2,461 $ 2,127 Finance lease cost: Amortization of right-of-use assets $ 1,352 $ 980 $ 921 Interest on lease liabilities 501 429 386 Total finance lease cost $ 1,853 $ 1,409 $ 1,307 Supplemental cash flow information related to leases was as follows: (In millions) Year Ended June 30, 2023 2022 2021 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 2,706 $ 2,368 $ 2,052 Operating cash flows from finance leases 501 429 386 Financing cash flows from finance leases 1,056 896 648 Right-of-use assets obtained in exchange for lease obligations: Operating leases 3,514 5,268 4,380 Finance leases 3,128 4,234 3,290 86 PART II Item 8 Supplemental balance sheet information related to leases was as follows: (In millions, except lease term and discount rate) June 30, 2023 2022 Operating Leases Operating lease right-of-use assets $ 14,346 $ 13,148 Other current liabilities $ 2,409 $ 2,228 Operating lease liabilities 12,728 11,489 Total operating lease liabilities $ 15,137 $ 13,717 Finance Leases Property and equipment, at cost $ 20,538 $ 17,388 Accumulated depreciation ( 4,647 ) ( 3,285 ) Property and equipment, net $ 15,891 $ 14,103 Other current liabilities $ 1,197 $ 1,060 Other long-term liabilities 15,870 13,842 Total finance lease liabilities $ 17,067 $ 14,902 Weighted Average Remaining Lease Term Operating leases 8 years 8 years Finance leases 11 years 12 years Weighted Average Discount Rate Operating leases 2.9 % 2.1 % Finance leases 3.4 % 3.1 % The following table outlines maturities of our lease liabilities as of June 30, 2023: (In millions) Year Ending June 30, Operating Leases Finance Leases 2024 $ 2,784 $ 1,747 2025 2,508 2,087 2026 2,142 1,771 2027 1,757 1,780 2028 1,582 1,787 Thereafter 6,327 11,462 Total lease payments 17,100 20,634 Less imputed interest ( 1,963 ) ( 3,567 ) Total $ 15,137 $ 17,067 As of June 30, 2023, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $ 7.7 billion and $ 34.4 billion, respectively. These operating and finance leases will commence between fiscal year 2024 and fiscal year 2030 with lease terms of 1 year to 18 years. 87 PART II Item 8 NOTE 15 — CONTINGENCIES U.S. Cell Phone Litigation Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 46 lawsuits, including 45 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which were stricken by the court. A hearing on general causation took place in September of 2022. In April of 2023, the court granted defendants’ motion to strike the testimony of plaintiffs’ experts that cell phones cause brain cancer and entered an order excluding all of plaintiffs’ experts from testifying. Irish Data Protection Commission Matter In 2018, the Irish Data Protection Commission (“IDPC”) began investigating a complaint against LinkedIn as to whether LinkedIn’s targeted advertising practices violated the recently implemented European Union General Data Protection Regulation (“GDPR”). Microsoft cooperated throughout the period of inquiry. In April 2023, the IDPC provided LinkedIn with a non-public preliminary draft decision alleging GDPR violations and proposing a fine. Microsoft intends to challenge the preliminary draft decision. There is no set timeline for the IDPC to issue a final decision. Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact in our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2023, we accrued aggregate legal liabilities of $ 617 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $ 600 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact in our consolidated financial statements for the period in which the effects become reasonably estimable. 88 PART II Item 8 NOTE 16 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Balance, beginning of year 7,464 7,519 7,571 Issued 37 40 49 Repurchased ( 69 ) ( 95 ) ( 101 ) Balance, end of year 7,432 7,464 7,519 Share Repurchases On September 18, 2019, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in February 2020 and was completed in November 2021. On September 14, 2021, our Board of Directors approved a share repurchase program authorizing up to $ 60.0 billion in share repurchases. This share repurchase program commenced in November 2021, following completion of the program approved on September 18, 2019, has no expiration date, and may be terminated at any time. As of June 30, 2023, $ 22.3 billion remained of this $ 60.0 billion share repurchase program. We repurchased the following shares of common stock under the share repurchase programs: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2023 2022 2021 First Quarter 17 $ 4,600 21 $ 6,200 25 $ 5,270 Second Quarter 20 4,600 20 6,233 27 5,750 Third Quarter 18 4,600 26 7,800 25 5,750 Fourth Quarter 14 4,600 28 7,800 24 6,200 Total 69 $ 18,400 95 $ 28,033 101 $ 22,970 89 PART II Item 8 All repurchases were made using cash resources. Shares repurchased during fiscal year 2023 and the fourth and third quarters of fiscal year 2022 were under the share repurchase program approved on September 14, 2021. Shares repurchased during the second quarter of fiscal year 2022 were under the share repurchase programs approved on both September 14, 2021 and September 18, 2019. All other shares repurchased were under the share repurchase program approved on September 18, 2019. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards of $ 3.8 billion, $ 4.7 billion, and $ 4.4 billion for fiscal years 2023, 2022, and 2021, respectively. Dividends Our Board of Directors declared the following dividends: Declaration Date Record Date Payment Date Dividend Per Share Amount Fiscal Year 2023 (In millions) September 20, 2022 November 17, 2022 December 8, 2022 $ 0.68 $ 5,066 November 29, 2022 February 16, 2023 March 9, 2023 0.68 5,059 March 14, 2023 May 18, 2023 June 8, 2023 0.68 5,054 June 13, 2023 August 17, 2023 September 14, 2023 0.68 5,054 Total $ 2.72 $ 20,233 Fiscal Year 2022 September 14, 2021 November 18, 2021 December 9, 2021 $ 0.62 $ 4,652 December 7, 2021 February 17, 2022 March 10, 2022 0.62 4,645 March 14, 2022 May 19, 2022 June 9, 2022 0.62 4,632 June 14, 2022 August 18, 2022 September 8, 2022 0.62 4,621 Total $ 2.48 $ 18,550 The dividend declared on June 13, 2023 was included in other current liabilities as of June 30, 2023. 90 PART II Item 8 NOTE 17 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table summarizes the changes in accumulated other comprehensive income (loss) by component : (In millions) Year Ended June 30, 2023 2022 2021 Derivatives Balance, beginning of period $ ( 13 ) $ ( 19 ) $ ( 38 ) Unrealized gains (losses), net of tax of $ 9 , $( 15 ), and $ 9 34 ( 57 ) 34 Reclassification adjustments for (gains) losses included in other income (expense), net ( 61 ) 79 ( 17 ) Tax expense (benefit) included in provision for income taxes 13 ( 16 ) 2 Amounts reclassified from accumulated other comprehensive income (loss) ( 48 ) 63 ( 15 ) Net change related to derivatives, net of tax of $( 4 ) , $ 1 , and $ 7 ( 14 ) 6 19 Balance, end of period $ ( 27 ) $ ( 13 ) $ ( 19 ) Investments Balance, beginning of period $ ( 2,138 ) $ 3,222 $ 5,478 Unrealized losses, net of tax of $( 393 ) , $( 1,440 ), and $( 589 ) ( 1,523 ) ( 5,405 ) ( 2,216 ) Reclassification adjustments for (gains) losses included in other income (expense), net 99 57 ( 63 ) Tax expense (benefit) included in provision for income taxes ( 20 ) ( 12 ) 13 Amounts reclassified from accumulated other comprehensive income (loss) 79 45 ( 50 ) Net change related to investments, net of tax of $( 373 ) , $( 1,428 ), and $( 602 ) ( 1,444 ) ( 5,360 ) ( 2,266 ) Cumulative effect of accounting changes 0 0 10 Balance, end of period $ ( 3,582 ) $ ( 2,138 ) $ 3,222 Translation Adjustments and Other Balance, beginning of period $ ( 2,527 ) $ ( 1,381 ) $ ( 2,254 ) Translation adjustments and other, net of tax of $ 0 , $ 0 , and $( 9 ) ( 207 ) ( 1,146 ) 873 Balance, end of period $ ( 2,734 ) $ ( 2,527 ) $ ( 1,381 ) Accumulated other comprehensive income (loss), end of period $ ( 6,343 ) $ ( 4,678 ) $ 1,822 NOTE 18 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2023 2022 2021 Stock-based compensation expense $ 9,611 $ 7,502 $ 6,118 Income tax benefits related to stock-based compensation 1,651 1,293 1,065 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a service period of four years or five years . 91 PART II Item 8 Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a service period of four years . PSUs generally vest over a performance period of three years . The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for All Stock Plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year ended June 30, 2023 2022 2021 Dividends per share (quarterly amounts) $ 0.62 – 0.68 $ 0.56 – 0.62 $ 0.51 – 0.56 Interest rates 2.0 % – 5.4 % 0.03 % – 3.6 % 0.01 % – 1.5 % During fiscal year 2023, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 93 $ 227.59 Granted (a) 56 252.59 Vested ( 44 ) 206.90 Forfeited ( 9 ) 239.93 Nonvested balance, end of year 96 $ 250.37 (a) Includes 1 million, 1 million, and 2 million of PSUs granted at target and performance adjustments above target levels for fiscal years 2023, 2022, and 2021, respectively. As of June 30, 2023, total unrecognized compensation costs related to stock awards were $ 18.6 billion. These costs are expected to be recognized over a weighted average period of three years . The weighted average grant-date fair value of stock awards granted was $ 252.59 , $ 291.22 , and $ 221.13 for fiscal years 2023, 2022, and 2021, respectively. The fair value of stock awards vested was $ 11.9 billion, $ 14.1 billion, and $ 13.4 billion, for fiscal years 2023, 2022, and 2021, respectively. As of June 30, 2023, an aggregate of 164 million shares were authorized for future grant under our stock plans. Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90 % of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15 % of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2023 2022 2021 Shares purchased 7 7 8 Average price per share $ 245.59 $ 259.55 $ 207.88 As of June 30, 2023, 74 million shares of our common stock were reserved for future issuance through the ESPP. 92 PART II Item 8 Savings Plans We have savings plans in the U.S. that qualify under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Eligible U.S. employees may contribute a portion of their salary into the savings plans, subject to certain limitations. We match a portion of each dollar a participant contributes into the plans. Employer-funded retirement benefits for all plans were $ 1.6 billion, $ 1.4 billion, and $ 1.2 billion in fiscal years 2023, 2022, and 2021, respectively, and were expensed as contributed. NOTE 19 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. We have recast certain prior period amounts to conform to the way we internally manage and monitor our business. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, Microsoft Viva, and Microsoft 365 Copilot. • Office Consumer, including Microsoft 365 Consumer subscriptions, Office licensed on-premises, and other Office services. • LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions. • Dynamics business solutions, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM (including Customer Insights), Power Apps, and Power Automate; and on-premises ERP and CRM applications. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure and other cloud services; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and Nuance and GitHub. • Enterprise Services, including Enterprise Support Services, Industry Solutions (formerly Microsoft Consulting Services), and Nuance professional services. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; and Windows Internet of Things. • Devices, including Surface, HoloLens, and PC accessories. 93 PART II Item 8 • Gaming, including Xbox hardware and Xbox content and services, comprising first- and third-party content (including games and in-game content), Xbox Game Pass and other subscriptions, Xbox Cloud Gaming, advertising, third-party disc royalties, and other cloud services. • Search and news advertising, comprising Bing (including Bing Chat), Microsoft News, Microsoft Edge, and third-party affiliates. Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin. In addition, certain costs are incurred at a corporate level and allocated to our segments. These allocated costs generally include legal, including settlements and fines, information technology, human resources, finance, excise taxes, field selling, shared facilities services, customer service and support , and severance incurred as part of a corporate program. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated and is generally based on relative gross margin or relative headcount. Segment revenue and operating income were as follows during the periods presented: (In millions) Year Ended June 30, 2023 2022 2021 Revenue Productivity and Business Processes $ 69,274 $ 63,364 $ 53,915 Intelligent Cloud 87,907 74,965 59,728 More Personal Computing 54,734 59,941 54,445 Total $ 211,915 $ 198,270 $ 168,088 Operating Income Productivity and Business Processes $ 34,189 $ 29,690 $ 24,351 Intelligent Cloud 37,884 33,203 26,471 More Personal Computing 16,450 20,490 19,094 Total $ 88,523 $ 83,383 $ 69,916 No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for fiscal years 2023, 2022, or 2021. Revenue, classified by the major geographic areas in which our customers were located, was as follows: (In millions) Year Ended June 30, 2023 2022 2021 United States (a) $ 106,744 $ 100,218 $ 83,953 Other countries 105,171 98,052 84,135 Total $ 211,915 $ 198,270 $ 168,088 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. 94 PART II Item 8 Revenue, classified by significant product and service offerings, was as follows: (In millions) Year Ended June 30, 2023 2022 2021 Server products and cloud services $ 79,970 $ 67,350 $ 52,589 Office products and cloud services 48,728 44,862 39,872 Windows 21,507 24,732 22,488 Gaming 15,466 16,230 15,370 LinkedIn 15,145 13,816 10,289 Search and news advertising 12,208 11,591 9,267 Enterprise Services 7,722 7,407 6,943 Devices 5,521 7,306 7,143 Dynamics 5,437 4,687 3,754 Other 211 289 373 Total $ 211,915 $ 198,270 $ 168,088 Our Microsoft Cloud revenue, which includes Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $ 111.6 billion, $ 91.4 billion, and $ 69.1 billion in fiscal years 2023, 2022, and 2021, respectively. These amounts are primarily included in Server products and cloud services, Office products and cloud services, LinkedIn, and Dynamics in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2023 2022 2021 United States $ 114,380 $ 106,430 $ 76,153 Ireland 16,359 15,505 13,303 Other countries 56,500 44,433 38,858 Total $ 187,239 $ 166,368 $ 128,314 95 PART II Item 8 REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2023 and 2022, the related consolidated statements of income, comprehensive income, cash flows, and stockholders' equity, for each of the three years in the period ended June 30, 2023, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2023 and 2022, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2023, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of June 30, 2023, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 27, 2023, expressed an unqualified opinion on the Company's internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. Revenue Recognition – Refer to Note 1 to the financial statements Critical Audit Matter Description The Company recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company offers customers the ability to acquire multiple licenses of software products and services, including cloud-based services, in its customer agreements through its volume licensing programs. 96 PART II Item 8 Significant judgment is exercised by the Company in determining revenue recognition for these customer agreements, and includes the following: • Determination of whether products and services are considered distinct performance obligations that should be accounted for separately versus together, such as software licenses and related services that are sold with cloud-based services. • The pattern of delivery (i.e., timing of when revenue is recognized) for each distinct performance obligation. • Identification and treatment of contract terms that may impact the timing and amount of revenue recognized (e.g., variable consideration, optional purchases, and free services). • Determination of stand-alone selling prices for each distinct performance obligation and for products and services that are not sold separately. Given these factors and due to the volume of transactions, the related audit effort in evaluating management's judgments in determining revenue recognition for these customer agreements was extensive and required a high degree of auditor judgment. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures related to the Company's revenue recognition for these customer agreements included the following: • We tested the effectiveness of controls related to the identification of distinct performance obligations, the determination of the timing of revenue recognition, and the estimation of variable consideration. • We evaluated management's significant accounting policies related to these customer agreements for reasonableness. • We selected a sample of customer agreements and performed the following procedures: - Obtained and read contract source documents for each selection, including master agreements, and other documents that were part of the agreement. - Tested management's identification and treatment of contract terms. - Assessed the terms in the customer agreement and evaluated the appropriateness of management's application of their accounting policies, along with their use of estimates, in the determination of revenue recognition conclusions. • We evaluated the reasonableness of management's estimate of stand-alone selling prices for products and services that are not sold separately. • We tested the mathematical accuracy of management's calculations of revenue and the associated timing of revenue recognized in the financial statements. Income Taxes – Uncertain Tax Positions – Refer to Note 12 to the financial statements Critical Audit Matter Description The Company's long-term income taxes liability includes uncertain tax positions related to transfer pricing issues that remain unresolved with the Internal Revenue Service ("IRS"). The Company remains under IRS audit, or subject to IRS audit, for tax years subsequent to 2003. While the Company has settled a portion of the IRS audits, resolution of the remaining matters could have a material impact on the Company's financial statements. Conclusions on recognizing and measuring uncertain tax positions involve significant estimates and management judgment and include complex considerations of the Internal Revenue Code, related regulations, tax case laws, and prior-year audit settlements. Given the complexity and the subjective nature of the transfer pricing issues that remain unresolved with the IRS, evaluating management's estimates relating to their determination of uncertain tax positions required extensive audit effort and a high degree of auditor judgment, including involvement of our tax specialists. 97 PART II Item 8 How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures to evaluate management's estimates of uncertain tax positions related to unresolved transfer pricing issues included the following: • We evaluated the appropriateness and consistency of management's methods and assumptions used in the identification, recognition, measurement, and disclosure of uncertain tax positions, which included testing the effectiveness of the related internal controls. • We read and evaluated management's documentation, including relevant accounting policies and information obtained by management from outside tax specialists, that detailed the basis of the uncertain tax positions. • We tested the reasonableness of management's judgments regarding the future resolution of the uncertain tax positions, including an evaluation of the technical merits of the uncertain tax positions. • For those uncertain tax positions that had not been effectively settled, we evaluated whether management had appropriately considered new information that could significantly change the recognition, measurement or disclosure of the uncertain tax positions. • We evaluated the reasonableness of management's estimates by considering how tax law, including statutes, regulations and case law, impacted management's judgments. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 27, 2023 We have served as the Company's auditor since 1983. 98 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOU NTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL C ONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our consolidated financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our consolidated financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our consolidated financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of June 30, 2023. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2023 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2023; their report is included in Item 9A. 99 PART II Item 9A REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2023, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2023, based on criteria established in Internal Control — Integrated Framework (2013) issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended June 30, 2023, of the Company and our report dated July 27, 2023, expressed an unqualified opinion on those financial statements. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 27, 2023 100 PART II, III Item 9B, 9C, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION During the three months ended June 30, 2023, none of our directors or officers (as defined in Rule 16a-1(f) of the Securities Exchange Act of 1934) informed us of the adoption or termination of a “ Rule 10b5-1 trading arrangement ” or “ non-Rule 10b5-1 trading arrangement, ” as defined in Item 408 of Regulation S-K. ITEM 9C. DISCLOSURE REGARDING FOREIGN J URISDICTIONS THAT PREVENT INSPECTIONS Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFF ICERS, AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our Director Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held December 7, 2023 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and other finance organization employees. The finance code of ethics is publicly available on our website at https://aka.ms/FinanceCodeProfessionalConduct . If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTI VE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Report,” and, if required, “Compensation Committee Interlocks and Insider Participation,” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWN ERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock Ownership Information,” “Principal Shareholders” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director Independence Guidelines” and “Certain Relationships and Related Transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOU NTANT FEES AND SERVICES Information concerning fees and services provided by our principal accountant, Deloitte & Touche LLP (PCAOB ID No. 34 ), appears in the Proxy Statement under the headings “Fees Billed by Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. 101 PART IV Item 15 PART IV ITEM 15. EXHIBIT AND FINANC IAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Part II, Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 58 Comprehensive Income Statements 59 Balance Sheets 60 Cash Flows Statements 61 Stockholders’ Equity Statements 62 Notes to Financial Statements 63 Report of Independent Registered Public Accounting Firm 96 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/2016 3.2 Bylaws of Microsoft Corporation 8-K 3.2 7/3/2023 4.1 Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 10/29/2015 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/2009 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/2010 102 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/2011 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/2012 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/2013 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/2013 103 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/2013 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/2013 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/12/2015 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 11/3/2015 104 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 8/5/2016 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/2017 4.16 Thirteenth Supplemental Indenture for 2.525% Notes due 2050 and 2.675% Notes due 2060, dated as of June 1, 2020, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 6/1/2020 4.17 Fourteenth Supplemental Indenture for 2.921% Notes due 2052 and 3.041% Notes due 2062, dated as of March 17, 2021, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 3/17/2021 4.18 Description of Securities 10-K 6/30/2019 4.16 8/1/2019 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 9/30/2016 10.1 10/20/2016 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/2012 10.4 7/26/2012 105 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.5* Microsoft Corporation Deferred Compensation Plan 10-K 6/30/2018 10.5 8/3/2018 10.6* Microsoft Corporation 2017 Stock Plan DEF14A Annex C 10/16/2017 10.7* Form of Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.26 4/26/2018 10.8* Form of Performance Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.27 4/26/2018 10.9 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/2016 10.12 10/20/2016 10.10 Assumption of Beneficiaries’ Representative Obligations Under Amended and Restated Officers’ Indemnification Trust Agreement 10-K 6/30/2020 10.25 7/30/2020 10.11 Form of Indemnification Agreement and Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-K 6/30/2019 10.13 8/1/2019 10.12 Assumption of Beneficiaries’ Representative Obligations Under Amended and Restated Directors’ Indemnification Trust Agreement 10-K 6/30/2020 10.26 7/30/2020 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-Q 12/31/2017 10.14 1/31/2018 10.15* Microsoft Corporation Executive Incentive Plan 8-K 10.1 9/19/2018 10.19* Microsoft Corporation Executive Incentive Plan 10-Q 9/30/2016 10.17 10/20/2016 10.20* Form of Executive Incentive Plan (Executive Officer SAs) Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/2016 10.18 10/20/2016 10.21* Form of Executive Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/2016 10.25 10/20/2016 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/2016 10.22 10/20/2016 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/2014 106 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/2014 10.24 1/26/2015 10.25* Offer Letter, dated October 25, 2020, between Microsoft Corporation and Christopher Young 10-Q 9/30/2021 10.27 10/26/2021 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS Inline XBRL Instance Document —the instance document does not appear in the Interactive Data File as its XBRL tags are embedded within the Inline XBRL document X 101.SCH Inline XBRL Taxonomy Extension Schema X 101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase X 101.DEF Inline XBRL Taxonomy Extension Definition Linkbase X 101.LAB Inline XBRL Taxonomy Extension Label Linkbase X 101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase X 104 Cover page formatted as Inline XBRL and contained in Exhibit 101 X * Indicates a management contract or compensatory plan or arrangement. ** Furnished, not filed. 107 PART IV Item 16 ITEM 16. FORM 10-K SUMMARY None. 108 SIGNAT URES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 27, 2023. M ICROSOFT C ORPORATION /s/ A LICE L. J OLLA Alice L. Jolla Corporate Vice President and Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on July 27, 2023. Signature Title /s/ S ATYA N ADELLA Chairman and Chief Executive Officer (Principal Executive Officer) Satya Nadella /s/ R EID H OFFMAN Director Reid Hoffman /s/ H UGH F. J OHNSTON Director Hugh F. Johnston /s/ T ERI L. L IST Director Teri L. List /s/ S ANDRA E. P ETERSON Lead Independent Director Sandra E. Peterson /s/ P ENNY S. P RITZKER Director Penny S. Pritzker /s/ C ARLOS A. R ODRIGUEZ Director Carlos A. Rodriguez /s/ C HARLES W. S CHARF Director Charles W. Scharf /s/ J OHN W. S TANTON Director John W. Stanton /s/ J OHN W. T HOMPSON Director John W. Thompson /s/ E MMA N. W ALMSLEY Director Emma N. Walmsley /s/ P ADMASREE W ARRIOR Director Padmasree Warrior /s/ A MY E. H OOD Executive Vice President and Chief Financial Officer (Principal Financial Officer) Amy E. Hood /s/ A LICE L. J OLLA Corporate Vice President and Chief Accounting Officer (Principal Accounting Officer) Alice L. Jolla 109 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001017062-97-001764/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001017062-97-001764/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-00-001961/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-00-001961/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-01-501099/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-01-501099/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-02-001351/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-02-001351/full-submission.txt new file mode 100644 index 0000000..2a17c24 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-02-001351/full-submission.txt @@ -0,0 +1,619 @@ +Table of Contents United States Securities and Exchange +Commission Washington, D.C. 20549 FORM +10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, +2002 ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON (STATE OF INCORPORATION) 91-1144442 (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 Securities +registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter +period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES x NO ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or +information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ The aggregate market value of common stock held by non-affiliates of the registrant as of July 31, 2002 was $215,553,343,213. The number of shares outstanding of the registrant’s common stock as of July 31, 2002 was 5,378,746,853. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in +connection with the Annual Meeting of Shareholders to be held November 5, 2002 are incorporated by reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2002 INDEX Part I Item 1. Business 1 Item 2. Properties 8 Item 3. Legal Proceedings 8 Item 4. Submission of Matters to a Vote of Security Holders 8 Executive Officers of the Registrant 9 Part II Item 5. Market for Registrant’s Common Stock and Related Stockholder Matters 11 Item 6. Selected Financial Data 11 Item 7. Management’s Discussion and Analysis of Results of Operations and Financial Condition 12 Item 7a. Quantitative and Qualitative Disclosures about Market Risk 18 Item 8. Financial Statements and Supplementary Data 19 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 39 Part III Item 10. Directors of the Registrant 40 Item 11. Executive Compensation 40 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 40 Item 13. Certain Relationships and Related Transactions 40 Part IV Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 41 Signatures 42 Certifications 42 Table of Contents Part I Item 1 PART I ITEM 1.    BUSINESS GENERAL Microsoft Corporation (the “Company” or “Microsoft”) was founded as a partnership in 1975 and incorporated in 1981. Microsoft’s mission is to enable people and businesses +throughout the world to realize their full potential, and the Company’s vision is empowering people through great software—any time, any place, and on any device. Microsoft develops, manufactures, licenses, and supports a wide range of +software products for a multitude of computing devices. Microsoft software products include scalable operating systems for servers, personal computers (PCs), and intelligent devices; server applications for client/server environments; information +worker productivity applications; business solutions applications; and software development tools. During fiscal 2002, Microsoft launched Xbox, the Company’s next-generation video game system. The Company’s online efforts include the MSN +network of Internet products and services and alliances with companies involved with broadband access and various forms of digital interactivity. Microsoft licenses consumer software programs; sells hardware devices; provides consulting services; +and trains and certifies system integrators and developers. Microsoft also researches and develops advanced technologies for future software products. A +significant portion of the Company’s focus is on Microsoft’s .NET architecture. Using common industry standards based on XML, a universal language for describing and exchanging data, the Company’s goal is to enable seamless sharing of +information across many platforms and programming languages, and over the Internet, with XML Web services. In addition, Microsoft has embarked on a long-term initiative called Trustworthy Computing, which aims to bring an enhanced level of security, +privacy, reliability, and business integrity to computer systems. PRODUCTS During fiscal 2002, Microsoft had four operating segments based on its product and service offerings: Desktop and Enterprise Software and Services; Consumer Software, +Services, and Devices; Consumer Commerce Investments; and Other. See Note 20 of the Notes to Financial Statements for financial information regarding segment reporting. DESKTOP AND ENTERPRISE SOFTWARE AND SERVICES Desktop and Enterprise Software and Services includes +Desktop Applications; Desktop Platforms; and Enterprise Software and Services. For segment reporting purposes, Desktop Applications includes revenue from Microsoft Office; Microsoft Project; Visio; client access licenses (CALs) for Windows NT Server +and Windows 2000 Server, Exchange, and BackOffice; Microsoft Great Plains; and bCentral. Desktop Platforms includes revenue from Windows XP Professional and Home; Windows 2000 Professional; Windows NT Workstation; Windows Millennium Edition; Windows +98; and other desktop operating systems. Enterprise Software and Services includes Server Platforms; Server Applications; Developer Tools and Services; and Enterprise Services. DESKTOP APPLICATIONS Microsoft Office. Microsoft Office +is a software product featuring commonly used desktop functionality. The product is based upon a document-centric concept, with common commands and extensive use of cross-application capabilities. Microsoft Office is available in several versions +for the Windows and Macintosh operating systems. Microsoft Office XP, the latest Microsoft Office release, helps users complete common business tasks, including word processing, electronic mail (e-mail), presentations, and data management, with +features like smart tags, task panes, integrated e-mail, document recovery, and send for review. The various versions of Microsoft Office include the word processor Microsoft Word, Microsoft Excel spreadsheet, Microsoft Outlook personal information +management and e-mail communication client, Microsoft PowerPoint presentation graphics program, and may include Microsoft Access database management application,  Microsoft FrontPage Web site creation and management tool, and Microsoft +Publisher business desktop publishing program. Most of these applications are also licensed separately. Other Desktop Application +Products. The Company also offers other stand-alone desktop application products. Microsoft Project is a project management program for scheduling, organizing, and analyzing tasks, deadlines, and resources. Visio is a +diagramming program that helps people visualize and communicate ideas, information, and systems. Client Access +Licenses. A client access license gives its holder the legal right to access a computer running a Microsoft server product and the services supported by the server using a client computer. Microsoft Great Plains. Microsoft Great Plains offers a range of integrated business and accounting products, including Dynamics, Solomon, +and eEnterprise. Dynamics provides Internet-ready accounting and business management capabilities for small- to mid-sized companies. Solomon offers a full range of e-business and accounting applications for small- to mid-sized companies. eEnterprise +supports mid-sized to larger companies by providing a collaborative environment for information management and sharing. 1  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1 bCentral. Microsoft’s small businesses portal, bCentral, +includes Site Manager, a Web site management and hosting service which empowers small businesses to easily create and manage their own Web sites, while allowing for higher-end editing in Microsoft FrontPage, and LinkExchange, which provides services +to small businesses and Web site owners to increase their online traffic and sales with free advertising banner ads on their site in exchange for placing ads on other network sites. DESKTOP PLATFORMS Windows XP. Microsoft launched Windows +XP in October 2001. Windows XP extends the personal computing experience by uniting PCs, devices, and services, while enhancing reliability, security, and performance. Windows XP Home Edition is designed for individuals or families and includes +experiences for digital photo, music, video, home networking, and communications. Windows XP Professional includes all the features of Home Edition, plus remote access, security, performance, manageability, and multilingual features to help users +improve productivity and connectivity. Windows 2000 Professional. The successor to Windows NT Workstation, Windows +2000 Professional operating system combines features to create a mainstream operating system for desktop and notebook computing in all organizations. Windows 2000 Professional contains the enhanced business features of Windows 98 such as Plug and +Play, easy-to-use user interface, and power management and integrates the strengths of Windows NT Workstation including standards-based security, manageability, and reliability. Windows NT Workstation. A fully integrated, multitasking 32-bit PC operating system, Windows NT Workstation provides improved security features, robustness, and portability. Windows +NT Workstation combines the Windows 98 operating system interface and usability features with the reliability and security of Windows NT for the business environment. Windows Millennium Edition. Windows Millennium Edition (Me) operating system is designed specifically for home users, including capabilities to manage digital photos and music, work with video, +create a home network, and communicate with other consumers. Windows 98. The successor to Windows 95, Windows 98 is +a personal computer operating system that provides a Web-oriented user interface and better system performance along with easier system diagnostics and maintenance. Windows 98 supports graphics, sound, and multimedia technologies and provides the +ability to easily add and remove peripheral devices and support for Universal Serial Bus (USB). ENTERPRISE SOFTWARE AND SERVICES Windows 2000 Server, Advanced Server, and Datacenter Server. Windows 2000 Server is a multipurpose network operating +system for businesses of all sizes. Windows 2000 Advanced Server operating system is ideal for e-commerce and line-of-business applications and provides enhanced performance and scalability through symmetric multiprocessing (SMP) and extended memory +support. Windows Datacenter Server operating system is built for large-scale line-of-business and enterprise backend usage and supports server consolidation and enhanced scalability. Microsoft .NET Enterprise Servers. Microsoft .NET Enterprise Servers include Microsoft SQL Server, Exchange Server, Application Center, BizTalk Server, Commerce Server, Content +Management Server, Host Integration Server, Internet Security and Acceleration Server, Microsoft Operations Manager, Mobile Information Server, and SharePoint Portal Server. SQL Server is a comprehensive data management and analysis platform that enables rapid delivery, dependable performance and secure operation of connected applications. Exchange Server is a messaging and collaboration server that provides e-mail, group scheduling, task management, contact management and document routing +capabilities. Application Center is Microsoft’s deployment and management tool for high-availability Web applications built on the +Microsoft Windows 2000 operating system. BizTalk Server enables companies to rapidly build and deploy integrated business processes within +their organizations and with partners. Commerce Server provides a comprehensive set of features for building scalable, user-centric, +business-to-consumer, and business-to-business e-commerce sites. Content Management Server is the enterprise Web content management system +that enables companies to quickly and efficiently build, deploy, and maintain highly dynamic Internet, intranet, and extranet Web sites. Host Integration +Server extends Microsoft Windows applications to other systems by providing application, data, and network integration. Internet Security and +Acceleration Server provides secure, fast, and manageable Internet connectivity. It integrates an extensible, multilayer enterprise firewall and a scalable high-performance Web cache. Microsoft Operations Manager delivers enterprise-class solutions for operations management of Windows 2000, the Microsoft Active Directory service, and other component services in Windows +2000, as well as other Microsoft .NET Enterprise Server applications such as Exchange and SQL Server. Mobile Information Server mobile-enables +the enterprise, extending the reach of Microsoft .NET Enterprise applications, enterprise data, and intranet content to the mobile user. SharePoint Portal +Server extends the capabilities of Microsoft Windows and Microsoft Office by offering information workers a powerful new way to easily organize, find, and share information. It combines the ability to easily create corporate Web +portals with document management, content searching, and team collaboration features. 2  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1 Other Servers. Small Business Server is the flexible network +solution designed to help businesses with up to 50 computers. Systems Management Server helps centrally manage the distributed environment with integrated features, including hardware inventory, software inventory and metering, software distribution +and installation, and remote troubleshooting tools. Developer Tools and Services. Software development tools and +computer languages allow software developers to write programs in a particular computer language and translate programs into a binary machine-readable set of commands that activate and instruct various hardware devices. The Company develops and +markets a number of software development environments and language compilers. In February 2002, Microsoft launched Visual Studio .NET, a comprehensive tool for rapidly building and deploying XML Web services and applications. Visual Studio .NET +provides software developers with powerful tools to rapidly design broad-reach Web applications for any device and any platform, and to build powerful Windows applications. Microsoft Visual C++ is the Company’s development system for +Windows-based application development. Microsoft Visual C# offers beginning and intermediate developers with C++ or Java experience a modern language and robust development environment for creating XML Web services and Microsoft .NET-based +applications for Windows and the Web. The Microsoft Visual Basic development system provides easy access to a wide variety of data sources by integrating the Microsoft Access database engine and the ability to take advantage of investments in +commercial applications. The Microsoft Visual InterDev development system includes integrated, team-based development tools for building Web-based applications based on HTML, Script, and components written in any language. Developers can subscribe +to the Microsoft Developer Network (MSDN) information service and receive periodic updates via CD-ROMs, magazines, and several online information services. In addition, Microsoft receives certification fees through the Microsoft Certified +Professional (MCP) program, a program that provides credentials for those who have demonstrated in-depth knowledge of at least one Microsoft product. Enterprise Services. Microsoft Enterprise Services assist organizations with every stage of technology planning, building, deployment, and support. Specializing in IT solutions for the enterprise, +Microsoft offers a full range of consulting services for advance technology requirements, including custom solutions services, enterprise application planning, architecture and design services, and proof-of-concept  services. The Company +provides product support services aligned to customer segments, partner segments, and communities. CONSUMER SOFTWARE, SERVICES, +AND DEVICES Consumer Software, Services, and Devices includes Xbox video game system, MSN Internet Access, MSN Network Services, PC and Online +Games, Learning and Productivity Software, Mobility, and Embedded Systems. Xbox. Microsoft Xbox, released in fiscal +2002, is Microsoft’s next-generation video game console system that delivers high quality graphics and audio gameplay experiences. For information on Xbox manufacturing, see “Manufacturing” below. Games for the Xbox are developed by +Microsoft Game Studios, such as Halo and Project Gotham Racing, and by third-party game development partners, such as Tecmo’s Dead or Alive 3. Xbox Live, an online service available to owners of Xbox systems, is expected to be launched in the +second quarter of fiscal 2003 and will allow online game play among users of online-enabled Xbox games. MSN Internet +Access. MSN Internet access is Microsoft’s service for accessing the Web and experiencing a wide range of rich online  services and content. MSN Internet access subscribers can access their account from multiple +sources, including a computer, television, Internet appliances, and Personal Data Assistants. MSN Network +Services. The MSN network provides services, content and advertising on the Internet, encompassing MSN Search, Messenger, eShop, Hotmail, Money, and Music, as well as other services and content. MSN Search makes Web +searches more useful by providing users with the most relevant results for the most popular search queries on the Web. MSN Messenger is a free Internet messaging service that enables users to see when others are online and exchange instant messages +with them. MSN eShop is a one-stop online shopping resource. MSN Hotmail is the world’s leading free Web-based e-mail service. MSN Money is a complete online personal financial service that combines finance tools and content from Microsoft with +exclusive investment news and analysis from CNBC. MSN Music provides consumers with one place online to find old favorites, as well as discover new music, and delivers a high quality listening experience. PC and Online Games. The Company offers a line of entertainment products from classic software games to online games, simulations, sport +products, and strategy games. Microsoft Flight Simulator is a popular aircraft flight simulation product. Other games include Age of Empires, Dungeon Siege, MechWarrior, Microsoft Links, Train Simulator, Zoo Tycoon, and other action and sports +titles. Zone.com is a gaming community on the Internet allowing multiplayer gaming competitions of Microsoft’s popular CD-ROM games and classic card, board, and puzzle games. Learning and Productivity Software. Learning titles include Microsoft Encarta Reference Library, a complete research and reference source with a multimedia encyclopedia database +with interactive information, an interactive world atlas with three-dimensional maps, a world  English dictionary, Encarta Africana, Researcher, and an online version with monthly updates. Titles for children include a series of products based +on the popular children’s book and television series, Scholastic’s The Magic School Bus. Microsoft’s productivity offerings include Microsoft Works, an integrated software program that contains basic word processing, spreadsheet, and +database capabilities that allows the easy exchange of information from one tool to another. Microsoft Picture It! brand of products includes Picture It! Photo, with photo editing tools and wizards to easily capture, correct and create photos, and +Picture It! Publishing, used to create greeting cards and other print and Web based products. Microsoft Money offers leading tools and resources to conduct a wide range of financial activities. The 3  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1 Works Suite provides a comprehensive collection of software, including Microsoft Works, Microsoft Word, Microsoft Money, Microsoft Encarta encyclopedia, Microsoft Picture It! Photo, and Microsoft +Streets & Trips. Mobility and Embedded Systems. Microsoft develops a number of software platforms for mobile +computing. Products such as Pocket PC, Pocket PC Phone Edition, and Microsoft Windows Powered Smartphone are designed to enable a variety of mobile scenarios. Microsoft’s embedded offerings include two embedded operating systems, Microsoft +Windows CE and Microsoft Windows NT Embedded, as well as device specific solutions. Microsoft Windows CE, a robust real-time embedded operating system, is targeted at mobile 32-bit devices. Microsoft Windows NT Embedded, based on the desktop and +server versions of Microsoft’s operating systems, is targeted at higher-end embedded products and devices. Both embedded operating systems offer integrated tool sets to enable embedded system developers to quickly create sophisticated embedded +device and application solutions. Microsoft Mobile Information Server is a scalable and reliable mobile applications server that provides enterprise customers and mobile operators with a rich platform for extending .NET Enterprise application and +securely delivering real-time, wireless data to mobile devices. CONSUMER COMMERCE INVESTMENTS Consumer Commerce Investments include the HomeAdvisor online real estate service and the CarPoint online automotive service. HomeAdvisor online real estate service. The HomeAdvisor online real estate service is a complete guide to the home-buying process and +provides comprehensive tools for finding homes and loans on the Internet. The service includes customized search features, worksheets and calculators, and editorial content and home-buying advice. CarPoint online automotive service. The CarPoint online automotive service is the leading online automotive marketplace, visited by more than +7 million consumers each month. With details on more than 10,000 car models and 100,000 used vehicles, users can research and compare cars of virtually every make and model, identify local dealers, and receive instructions for post-purchase service +and maintenance. Expedia, Inc. Expedia was included in the Consumer Commerce Investments segment until Microsoft +sold its interest in Expedia to USA Networks, Inc. in February 2002. Expedia, Inc. operates Expedia.com, a leading online travel service. Expedia.com provides air, car, and hotel booking, vacation package and cruise offerings, destination +information, and mapping. OTHER Hardware. The Hardware Group develops and markets several PC accessories including the Microsoft IntelliMouse family of hand-held pointing devices using the IntelliEye optical technology. Hardware also +markets several types of keyboards including the Microsoft Natural Keyboard, an ergonomically designed keyboard, the Internet Keyboard featuring two USB ports and Internet hot keys, and a new Wireless Desktop product including wireless keyboard and +mouse. Also included in the Hardware Group’s portfolio of devices are SideWinder game controllers and force feedback joysticks with realistic performance technology to use with PC games. Microsoft Press. Microsoft Press offers comprehensive learning and training resources to help new users, power users, and professionals get the most from Microsoft +technology through books, CDs, self-paced training kits, and videos that are created to accommodate different learning styles and preferences. Microsoft Press books are authored by professional and technical writers, both by Microsoft employees and +independent authors. SEGMENT REPORTING In fiscal 2003, the Company will begin reporting the following operating segments: Client; Information Worker; MSN; Home and Entertainment; CE Mobility; Server and Tools; and Business Solutions. These changes are designed to +provide a comprehensive end-to-end financial view of Microsoft’s key businesses; promote better alignment of strategies and objectives between development, sales, marketing, and services organizations; provide for more timely and rational +allocation of development, sales, and marketing resources within businesses; and focus strategic planning efforts on key objectives and initiatives and give business owners more autonomy in detailed planning. EQUITY METHOD INVESTMENTS The Company has +entered into joint venture arrangements to take advantage of creative talent and content from other organizations. For example, Microsoft owns 50 percent of MSNBC Cable L.L.C., a 24-hour cable news and information channel, and 50 percent of MSNBC +Interactive News L.L.C., an interactive online news service. National Broadcasting Company (NBC) owns the remaining 50 percent of these two joint ventures. 4  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1 PRODUCT DEVELOPMENT During fiscal years 2000, 2001, and 2002, research and development expense was $3.77 billion, $4.38 billion, and $4.31 billion, respectively. Those amounts represented 16.4%, 17.3%, and 15.2%, +respectively, of revenue in each of those years. In accordance with Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets, the amortization of goodwill was discontinued in fiscal 2002. The amount of +goodwill amortization included in research and development expense in fiscal years 2000 and 2001 was $232 million and $272 million, respectively. The Company plans to continue significant expenditures for research and product development. Most of the Company’s software products are developed internally. The Company also purchases technology, licenses intellectual property rights, and oversees +third-party development and localization of certain products. Internal development allows Microsoft to maintain closer technical control over its products and gives the Company the freedom to designate which modifications and enhancements are most +important and when they should be implemented. Microsoft works on devising innovative solutions to computer science problems, such as making computers easier to use, designing software for the next generation of hardware, improving the software +design process, and investigating the mathematical underpinnings of computer science. The Company has created a substantial body of proprietary development tools and has evolved development methodologies for creating and enhancing its products. +These tools and methodologies are also designed to simplify a product’s portability among different operating systems, microprocessors, or computing devices. Product documentation is generally created internally. The Company strives to become +informed at the earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, Microsoft provides to software vendors a range of development, training, testing +resources, and guidelines for developing applications. The software industry is characterized by rapid technological change, which requires constant attention to +computing technology trends, shifting consumer demand, and rapid product innovation. The pace of change is accelerating as the computing needs of our customers move beyond the PC toward intelligent devices and appliances, such as the Tablet PC. +Tablet PCs extend the power of laptop computers running Windows XP with enhanced capabilities such as handwriting and speech input. The Company believes that +making its products trustworthy is critical to their success and has launched a company-wide effort called Trustworthy Computing. Trustworthy Computing has four pillars: reliability, security, privacy, and business integrity. Reliability means that +a computer system is dependable, is available when needed, and performs as expected and at appropriate levels. Security means that a system is resilient to attack, and that the confidentiality, integrity and availability of both the system and its +data are protected. Privacy means that individuals have the ability to control data about themselves and that those using such data faithfully adhere to fair information principles. Business integrity, in this context, is about being responsible to +customers and helping them find appropriate solutions for their business issues, addressing problems with products or services, and being open in interactions with customers. While the Company is continuing to invest significantly in delivering new +capabilities that customers ask for, Microsoft is making security improvements a high priority. Microsoft .NET is Microsoft’s platform for XML Web services. +XML Web services allow applications to communicate and share data over the Internet or an intranet, regardless of operating system or programming language. The Microsoft .NET platform includes a comprehensive family of products, built on XML and +other Internet industry standards, which provide for each aspect of developing, managing, using, and experiencing XML Web services. There are five areas where Microsoft is building the .NET platform today: Tools, Servers, XML Web  Services, +Clients, and .NET Experiences. In the Tools area, Visual Studio .NET and the Microsoft .NET framework supply a complete solution for developers to build, deploy, and run XML Web services. They maximize the performance, reliability, and security of +XML Web services. The .NET Enterprise Servers, including the Windows 2000 Server family, make up Microsoft .NET’s server infrastructure for deploying, managing, and orchestrating XML Web services. Designed with mission-critical performance in +mind, they provide enterprises with the agility they need to integrate their systems, applications, and partners through XML Web services, and the flexibility to adapt to changing business requirements. Clients are PCs, laptops, workstations, +phones, handheld computers, Tablet PCs, game consoles, and other smart devices. These smart devices use software that supports XML Web services, which enable users to access their data regardless of the location, type, and number of clients used. +Smart clients and devices leverage XML Web services to create .NET experiences that allow users to access information across the Internet and from stand-alone applications in an integrated way. To best serve the needs of users around the world, Microsoft “localizes” many of its products to reflect local languages and conventions and to improve the quality and usability of the product in +international markets. Localizing a product might require modifying the user interface, altering dialog boxes, and translating text. In Japanese versions, for example, all user messages and documentation are in Japanese with monetary references in +the Japanese yen. Various Microsoft products have been localized into more than 30 languages. MANUFACTURING Microsoft contracts out most of its manufacturing activities to third parties. Outside manufacturers produce the Xbox, various retail software packaged +products, and hardware. There are other custom manufacturers Microsoft could use in the event outsourced manufacturing becomes unavailable from current vendors. The Company generally has multiple sources for raw materials, supplies, and components +and is often able to acquire component parts and materials on a volume discount basis. The graphics processing unit (GPU) for the Xbox was custom designed and is produced by NVIDIA Corporation. Quality control tests are performed on purchased parts, +CD-ROMs, and other products. 5  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1 OPERATIONS The Company has regional operations centers in Ireland, Singapore, and the Greater Seattle area. The regional centers support all operations, including information processing, vendor management and logistics by +geographical regions. The regional center in Dublin, Ireland supports the European, African, and Middle East regions, the center in Singapore supports the Asia Pacific region, and the center in the Greater Seattle area supports North and South +America. Microsoft Licensing, Inc. (MSLI), a wholly-owned subsidiary in Reno,  Nevada, manages the Company’s original equipment manufacturer (OEM) and certain organizational licensing operations. DISTRIBUTION, SALES AND MARKETING Microsoft +distributes its products primarily through the following channels: OEM; volume licensing; online services and products; and distributors and retailers. In fiscal 2002, Microsoft had three major geographic sales and marketing regions: the South +Pacific and Americas Region; the Europe, Middle East, and Africa Region; and the Asia Region. Beginning with fiscal 2003, the Company’s geographic sales and marketing organization was modified to remove the South Pacific region from the +Americas organization, and combine it with Asia. Sales of volume licenses and packaged software products via these channels are primarily to distributors and resellers. OEM. Microsoft operating systems are licensed primarily to OEMs under agreements that grant the OEMs the right to distribute copies of the Company’s products with their computing devices, +principally PCs. The Company also markets and licenses certain server operating systems, desktop applications, hardware devices, and consumer software programs to OEMs under similar arrangements. In almost all cases, the products are distributed +under Microsoft trademarks. The Company has OEM agreements covering one or more of its products with virtually all of the major PC OEMs, including Acer, Actebis, Dell, eMachines, Fujitsu, Fujitsu Siemens Computers, Gateway, HP, IBM, NEC, Samsung, +Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume customized PC vendors. Volume Licensing. The Microsoft Enterprise Agreement program is a licensing program designed to provide a flexible licensing and service solution tailored to customers making a long-term licensing +commitment. The agreements are designed to simplify license administration, payment terms, and the contract process. The Microsoft Select program offers flexible software acquisition, licensing, and maintenance options specially customized to meet +the needs of large multinational organizations. Marketing efforts and fulfillment are generally coordinated with large account resellers. The Microsoft Open program is a licensing program that is targeted for small- and medium-sized + organizations. It is available through the reseller channel and offers discounts based on initial purchase volumes. The Microsoft Enterprise Agreement and Software Assurance under the Select and Open programs provide customers the right to +install any new release of products covered in the licensing agreement during the term of their coverage. Network Service +Providers. Microsoft Network Service Providers (NSP) work with a variety of companies worldwide to help them develop and deploy end-to-end network solutions based on Microsoft platforms. NSPs focus on key network service +industries including telecommunications and wireless companies and hosts. Online Services and Products. Microsoft +distributes online content and services through MSN Access, MSN Network Services, bCentral small business portal, and other online services. MSN Access delivers simple, personalized Internet access, useful content, services and tools using MSN +Internet Explorer. MSN Network Services delivers advertising and other services including online search, shopping, and messaging capabilities to Internet users. bCentral provides the tools and expertise for small-business owners to build, market and +manage their businesses online. Other services delivered online include MSDN subscription content and updates, periodic product updates, and online technical and practice readiness resources to support Microsoft partners in developing and selling +Microsoft products and solutions. Distributors and Resellers. The Company distributes products in the finished goods +channels primarily to independent non-exclusive distributors and resellers. Distributors and resellers include Ingram Micro, Tech Data, Level 3 Communications, SOFTBANK,  Software House International, ASAP Software Express, and Happinet +Corporation. Microsoft has a network of field sales representatives and field support personnel who solicit orders from distributors and resellers and provide product training and sales support. CUSTOMERS The Company’s customers include individual consumers, small- +and medium-sized organizations, enterprises, educational institutions, Internet Service Providers (ISPs), application developers, and OEMs. Consumers and organizations obtain Microsoft products primarily through resellers and OEMs, which include +certain Microsoft products with their computing devices. No single customer accounted for 10% or more of revenue in 2000, 2001, or 2002. 6  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1 COMPETITION The software business is intensely competitive and subject to rapid technological change. As the company pursues its largest strategic initiative, Microsoft .NET, the Company could experience more intense +competition during the transition from the traditional core businesses to its new products based on the .NET architecture. The Company continues to face movement from PC-based applications to server-based applications or Web-based application +hosting services, from proprietary software to open source software such as the Linux operating system, and from PCs to Internet-based devices. A number of Microsoft’s most significant competitors, including IBM, Sun Microsystems,  Oracle, +and AOL-Time Warner, are collaborating with one another on various initiatives directed at competing with Microsoft. These initiatives relate in part to efforts to move software from individual PCs to centrally managed servers, which would present +significant challenges to the Company’s historical business model. Other competitive collaborative efforts include the development of new platform technologies that are intended to replicate much of the value of Microsoft Windows operating +systems. New computing form factors, including non-PC information devices, are gaining popularity and competing with PCs running Microsoft’s software products. Microsoft faces formidable competition in these new areas and in all areas of its current business activities. The rapid pace of technological change, particularly in the area of Internet platforms and services, continually creates +new opportunities for existing competitors and start-ups and can quickly render existing technologies less valuable. Global software piracy—the unlawful copying and distribution of  Microsoft’s copyrighted software +products—deprives the Company of large amounts of revenue on an annual basis. The Company’s competitive position may be adversely affected in the future +by one or more of the factors described in this section, particularly in view of the fast pace of technological change in the computing industry. DESKTOP AND ENTERPRISE SOFTWARE AND SERVICES The Company’s competitors include many software application vendors, such +as IBM, Oracle, Apple, Sun Microsystems, Corel, Qualcomm, and local application developers in Europe and Asia. IBM and Corel have large installed bases with their spreadsheet and word processor products, respectively, and both have aggressive +pricing strategies. Also, IBM and Apple preinstall certain of their application software products on various models of their PCs, competing directly with Microsoft’s desktop application software. Sun Microsystems’ Star Office is +aggressively priced. Additionally, Web-based application hosting services provide an alternative to PC-based applications such as Microsoft Office. Microsoft’s PC and server operating system products face substantial competition from a wide variety of companies. Competitors such as IBM, Apple Computer, Sun Microsystems, and others are vertically integrated in both software +development and hardware manufacturing and have developed operating systems that they preinstall on their own computers. Many of these operating system software products are also licensed to third-party OEMs for preinstallation on their computers. +Microsoft’s operating system products compete with UNIX-based operating systems from a wide range of companies, including IBM, Hewlett-Packard, Sun Microsystems, and others. Variants of UNIX run on a wide variety of computer platforms and have +gained increasing acceptance as desktop operating systems. The Linux open source operating system has gained increasing acceptance as well. Several computer manufacturers preinstall Linux on PC servers and many leading software developers have +written applications that run on Linux. Microsoft Windows operating systems also face competition from alternative platforms such as those based on Internet browsing software and Java technology promoted by AOL-Time Warner and Sun + Microsystems. The Company competes in the business of providing enterprise-wide computing solutions with several competitors who enjoy a larger share of +sales and larger installed bases. Many companies offer operating system software for mainframes and midrange computers, including IBM, HP, and Sun Microsystems. Since legacy business systems are typically support-intensive, these competitors also +offer substantial support services. Software developers that provide competing server applications for PC-based distributed client/server environments include Oracle, IBM, Computer Associates, Sybase, and Informix. There are also several software +vendors who offer connectivity servers. As mentioned above, there are numerous companies and organizations that offer Internet and intranet server software, which compete against the Company’s business systems. Additionally, IBM has a large +installed base of Lotus Notes and cc:Mail, both of which compete with the Company’s collaboration and e-mail products. The Company’s developer products +compete against offerings from BEA Systems, Borland, IBM, Macromedia, Oracle, Sun Microsystems, Sybase, and other companies. CONSUMER SOFTWARE, SERVICES, AND DEVICES Microsoft’s online services network, MSN, faces formidable competition from +AOL-Time Warner, Yahoo!, and a vast array of Web sites and portals that offer content of all types and e-mail, instant messaging, calendaring, chat, and search and shopping services, among other things. Xbox competes head-to-head against game systems from Nintendo and Sony, both of which have a large established base of game system users. Game developers like Activision, Capcom, +Electronic Arts, Sega, Tecmo, and THQ, to name a few, are both partners and  competitors. Microsoft faces many competitors in the mobile devices space, +including Palm, Symbian, Nokia, and Openwave. The embedded operating system market is highly fragmented with many competitive offerings. Key competitors include Wind River and versions of embeddable Linux from commercial Linux vendors such as Red +Hat, Lineo, and MontaVista. 7  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 1, 2, 3, 4 CONSUMER COMMERCE INVESTMENTS Microsoft faces many competitors in the online real estate and online automotive service spaces, including Homestore, AOL’s House and Home channel, Autobytel, AOL +autos, and Yahoo! autos. OTHER PC input devices face substantial competition from computer manufacturers, since computers are typically sold with a keyboard and mouse, and other manufacturers of these devices. Microsoft Press competes in the retail book and +eLearning markets with publishers that also create content on Microsoft technologies. A few of the retail competitors are Pearson, WROX, Sybex, and Wiley. The major eLearning competitors are Smartforce and NetG. EMPLOYEES As of June 30, 2002, the Company +employed approximately 50,500 people on a full-time basis, 34,600 in the United States and 15,900 internationally. Of the total, 20,800 were in product research and development, 23,500 in sales, marketing, and support, 2,200 in manufacturing and +distribution, and 4,000 in finance and administration. Microsoft’s success is highly dependent on its ability to attract and retain qualified employees. Competition for employees is intense in the software industry. To date, the Company +believes it has been successful in its efforts to recruit qualified employees, but there is no assurance that it will continue to be as successful in the future. None of the Company’s employees are subject to collective bargaining agreements. +The Company believes relations with its employees are  excellent. ITEM 2.    PROPERTIES The Company’s corporate offices consist of approximately 8.4 million +square feet of office building space located in King County, Washington, of which 5.7 million square feet of corporate campus space situated on slightly more than 300 acres of land is owned and approximately 2.7 million square feet is leased. The +Company is constructing three buildings with approximately 392,000 square feet of space that will be occupied in the Fall of 2003. To accommodate expansion needs the Company purchased approximately 38 acres, and has an option to purchase +approximately 112 additional acres, of land in Issaquah, Washington, which can accommodate 2.95 million square feet of additional office space. The Company leases many sites domestically totaling approximately 3.0 million square feet of office +building space. The Company leases many sites internationally totaling approximately 4.1 million square feet, including the Company’s European Operations +Center and localization division which leases a 382,000 square-foot campus in Dublin, Ireland, a 45,000 square-foot disk duplication facility in Humacao, Puerto Rico and a 36,000 square-foot facility in Singapore for the Company’s Asia Pacific +Operations Center. Leased office building space includes the following locations: Tokyo, Japan 343,000 square feet; Unterschleissheim, Germany 253,000 square feet; United Kingdom campus 242,000 square feet; Les Ulis, France 229,000 square feet; and +Beijing, China 115,000 square feet. The Company’s facilities are fully used for current operations of all segments and suitable additional space is available +to accommodate expansion needs. ITEM 3.    LEGAL PROCEEDINGS See Note 19—Contingencies of the Notes to Financial Statements (Item +8) for information regarding legal proceedings. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of +security holders during the fourth quarter of fiscal 2002. 8  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 4 EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of Microsoft as of July 31, 2002 were as follows: Name Age Position with the Company William H. Gates, III 46 Chairman of the Board; Chief Software Architect Steven A. Ballmer 46 Chief Executive Officer James E. Allchin 50 Group Vice President, Platforms Group Orlando Ayala 46 Group Vice President, Worldwide Sales, Marketing, and Services Group Robert J. (Robbie) Bach 40 Senior Vice President, Games Division Douglas J. Burgum 46 Senior Vice President, Business Solutions David W. Cole 40 Senior Vice President, MSN and Personal Services Group John G. Connors 43 Senior Vice President; Chief Financial Officer Jean-Philippe Courtois 41 Senior Vice President; President, Microsoft Europe, Middle East, and Africa Jon Stephan DeVaan 41 Senior Vice President, TV Division Richard P. Emerson 40 Senior Vice President, Corporate Development and Strategy Paul Flessner 43 Senior Vice President, .NET Enterprise Servers Kevin R. Johnson 41 Senior Vice President, Microsoft Americas Robert L. Muglia 42 Senior Vice President, Enterprise Storage Division Craig J. Mundie 53 Senior Vice President; Chief Technical Officer, Advanced Strategies and Policy Jeffrey S. Raikes 44 Group Vice President, Productivity and Business Services Richard F. Rashid 50 Senior Vice President, Research Eric D. Rudder 35 Senior Vice President, Developer and Platform Evangelism Steven J. Sinofsky 36 Senior Vice President, Office Bradford L. Smith 43 Senior Vice President and General Counsel Brian Valentine 42 Senior Vice President, Windows David Vaskevitch 49 Senior Vice President; Chief Technical Officer, Business Platform Deborah N. Willingham 46 Senior Vice President, Human Resources Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive +Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates has served as Chairman of the Board since the +Company’s incorporation. Mr. Ballmer was named Chief Executive Officer and a director of the Company in January 2000. He served as President from July 1998 to +February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980. Mr. Allchin was named +Group Vice President, Platforms Group in December 1999. He had been Senior Vice President, Platforms since March 1999. He was previously Senior Vice President, Personal and Business Systems since February 1996. Mr. Allchin joined Microsoft in 1990. Mr. Ayala was named Group Vice President, Worldwide Sales, Marketing, and Services Group in August 2000. He had been Senior Vice President, South Pacific and +Americas since February 1998, and before holding that position, was Vice President of the developing markets of Africa, India, the Mediterranean and Middle East, Latin America, Southeast Asia and the South Pacific. He joined Microsoft in 1991 as +Senior Director of the Latin America Region. Mr. Bach was named Senior Vice President, Games Division in March 2000. He had been Vice President, Home and Retail +since March 1999. Before holding that position, he had been Vice President, Learning, Entertainment and Productivity since 1996. Mr. Bach joined  Microsoft in 1988. Mr. Burgum joined the Company upon Microsoft’s acquisition of Great Plains Software, Inc. in April 2001. Mr. Burgum became Great Plains’ first outside investor in March 1983. He was named President of Great Plains in 1984 +and subsequently named Chairman and Chief Executive Officer. Mr. Cole was named Senior Vice President, MSN and Personal Services Group in November 2001. Before +holding that position, he had been Senior Vice President, Services Platform Division since August 2000. He had been Senior Vice President, Consumer Services since December 1999 and Vice President, Consumer Windows since March 1999. Previously, he +was Vice President, Web Client and Consumer Experience and Vice President, Internet Client and Collaboration. Mr. Cole joined Microsoft in 1986. Mr. Connors was +named Senior Vice President and Chief Financial Officer in December 1999. He had been Vice President, Enterprise since March 1999. Mr. Connors had been Vice President, Information Technology, and Chief Information Officer since July 1996. He joined +Microsoft in 1989. Mr. Courtois was named Senior Vice President and President, Microsoft Europe, Middle East, and Africa in July 2000. He had been Vice President, +Customer Marketing since July 1998. Before holding that position, he had been Vice President of Microsoft Europe since 1997 and General Manager for Microsoft France since 1994. Mr. Courtois joined Microsoft in 1984. Mr. DeVaan was named Senior Vice President, TV Division in December 1999. He had been Senior Vice President, Consumer and Commerce since September 1999. Mr. DeVaan had been Vice +President, Consumer and Commerce since March 1999. He had been Vice President, Desktop Applications since 1995. Mr. DeVaan joined Microsoft in 1985. 9  /  MSFT 2002 FORM 10-K Table of Contents Part I Item 4 Mr. Emerson joined Microsoft in November 2000 as Senior Vice President, Corporate Development and Strategy. Prior +to joining Microsoft, he was Managing Director and co-head of Technology and Telecommunications Advisory Services at international investment bank Lazard Freres & Co. LLC. He spent 12 years in San Francisco and New York with Lazard and Morgan +Stanley, specializing in advising clients in the technology and telecommunications sectors on mergers, acquisitions, and strategic partnerships. Mr. Flessner was +named Senior Vice President, .NET Enterprise Servers in December 1999. He had been Vice President, Database and Data Access. Since joining the Company, Mr. Flessner’s primary responsibilities have been the development of Microsoft’s +database business. He joined Microsoft in 1994. Mr. Johnson was named Senior Vice President, Microsoft Americas in February 2002. He had been Senior Vice +President, U.S. Sales, Marketing, and Services since August 2001, and before that, Vice President, U.S. Sales, Marketing and Services. Mr. Johnson was named Vice President, Product Support Services in July 1998. He joined Microsoft in 1992. Mr. Muglia was named Senior Vice President, Enterprise Storage Division in November 2001. Before holding that position, he had been Group Vice President, Personal +Services Group since August 2000. He had been Group Vice President, Business Productivity since  December 1999. He was named Senior Vice President, Business Productivity in March 1999 and was named Senior Vice President, Applications and Tools +in February 1998. He had been Vice President, Server Applications since 1997. He joined Microsoft in 1988. Mr. Mundie was named Senior Vice President and Chief +Technical Officer, Advanced Strategies and Policy in August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. He joined Microsoft as General Manager, Advanced Consumer Technology in 1992. Mr. Raikes was named Group Vice President, Productivity and Business Services in August 2000. He had been Group Vice President, Sales and Support since July 1998. Before holding that +position, he had been Group Vice President, Sales and Marketing since July 1996. Mr. Raikes joined Microsoft in 1981. Mr. Rashid was named Senior Vice President, +Research in May 2000. He had been Vice President, Research since July 1994. He joined Microsoft in 1991. Mr. Rudder was named Senior Vice President, Developer and +Platform Evangelism in October 2001. He had been Vice President, Technical Strategy. Mr. Rudder joined Microsoft in 1988 and has worked in several areas, including networking, operating systems and developer tools, where he previously served as +General Manager for the Visual Studio development system. Mr. Sinofsky was named Senior Vice President, Office in December 1999. He had been Vice President, Office +since December 1998. Mr. Sinofsky joined the Office team in 1994, increasing his responsibility with each subsequent release of the desktop suite. He joined Microsoft in 1989. Mr. Smith was named Senior Vice President and General Counsel in November 2001. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the Company’s European Law and Corporate Affairs +Group, based in Paris. He joined Microsoft in 1993. Mr. Valentine was named Senior Vice President, Windows in December 1999. He had been Vice President, Business +and Enterprise since March 1999. He had been Vice President, Windows since December 1998. Before managing the Windows group, Mr. Valentine managed the server applications division and had been responsible for the Exchange product unit. He joined +Microsoft in 1987. Mr. Vaskevitch was named Senior Vice President and Chief Technical Officer, Business Platform in August 2001. He was named Senior Vice +President, Business Applications in March 2000. He had been Senior Vice President, Developer since December 1999. Before holding that position, he had been Vice President, Distributed Applications Platform. He joined Microsoft in 1986. Ms. Willingham was named Senior Vice President, Human Resources in February 2001. She had been Vice President, Human Resources since April 2000. Ms. Willingham had been Vice +President, Business and Enterprise Division Marketing and was responsible for Windows operating system client and server marketing strategy and training, as well as for providing centralized marketing services for the Consumer Windows Marketing and +Streaming Media Marketing teams. She joined Microsoft in 1993. 10  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 5, 6 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The Company’s +common stock is traded on The Nasdaq Stock Market under the symbol MSFT. On June 30, 2002, there were 117,730 registered holders of record of the Company’s common stock. The Company has not paid cash dividends on its common stock. The +high and low common stock prices per share were as follows: Quarter Ended Sept. 30 Dec. 31 Mar. 31 June 30 Year Fiscal 2001 Common stock price per share: High $ 82.00 $ 70.88 $ 64.69 $ 73.68 $ 82.00 Low 60.31 41.50 43.38 51.94 41.50 Fiscal 2002 Common stock price per share: High $ 72.57 $ 69.49 $ 69.86 $ 60.38 $ 72.57 Low 49.71 51.79 57.99 48.62 48.62 ITEM 6.    SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS In millions, except earnings per share Year Ended June 30 1998 1999 2000 2001 (1) 2002 (2) Revenue $ 15,262 $ 19,747 $ 22,956 $ 25,296 $ 28,365 Operating income 6,585 10,010 11,006 11,720 11,910 Income before accounting change 4,490 7,785 9,421 7,721 7,829 Net income 4,490 7,785 9,421 7,346 7,829 Diluted earnings per share before accounting change 0.84 1.42 1.70 1.38 1.41 Diluted earnings per share 0.84 1.42 1.70 1.32 1.41 Cash and short-term investments 13,927 17,236 23,798 31,600 38,652 Total assets 22,357 38,321 51,694 58,830 67,646 Stockholders’ equity 16,627 28,438 41,368 47,289 52,180 (1) Fiscal year 2001 includes an unfavorable cumulative effect of accounting change of $375 million or $0.06 per diluted share, reflecting the adoption of SFAS No. 133, and +$4.80 billion (pre-tax) in impairments of certain investments, primarily cable and telecommunication investments. (2) Fiscal year 2002 includes $4.32 billion (pre-tax) in impairments of certain investments, primarily related to the Company’s AT&T investment and further declines +in the fair values of European cable and telecommunications holdings, and a $1.25 billion (pre-tax) gain on the sale of Expedia, Inc. 11  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION RESULTS OF OPERATIONS FOR 2000, 2001, AND 2002 Management’s Discussion and Analysis contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ +materially because of factors discussed in “Issues and Uncertainties.” REVENUE The Company’s revenue growth rate was 16% in fiscal 2000, 10% in fiscal 2001, and 12% in fiscal 2002. Revenue growth in fiscal 2002 was led by the addition of Xbox +video game system revenue and the strong penetration of Microsoft Windows XP Professional and Home operating systems. Revenue growth in fiscal 2001 was driven primarily by licensing of Microsoft Windows 2000 Professional, Microsoft SQL Server, and +the other .NET Enterprise Servers. Revenue growth in fiscal 2000 was driven by strong licensing of Microsoft Windows NT Workstation, Windows 2000 Professional, Windows NT Server, Windows 2000 Server, Microsoft Office 2000, and SQL Server. Microsoft continued to see a mix shift to volume licensing programs. On October 1, 2001, Microsoft launched Licensing 6.0 to simplify and improve its volume +licensing programs, including a simplified approach to software upgrades. One feature of Licensing 6.0 is Software Assurance which gives customers the right to install any new release of products covered in the licensing agreement during the term of +their coverage. The success of Microsoft’s new volume licensing programs will continue to affect the mix of multi-year licensing agreements with a resulting impact on the timing of revenue recognition. In addition, the timing and extent of a +recovery in consumer and corporate spending on PCs and information technology (IT) will be factors affecting revenue growth. PRODUCT REVENUE In fiscal 2002, Microsoft had four segments: Desktop and Enterprise Software and Services; Consumer Software, +Services, and Devices; Consumer Commerce Investments; and Other. The revenue figures in this Management’s Discussion and Analysis (MD&A) differ from those reported in the Company’s Segment Information appearing in Note 20 of the Notes +to Financial Statements. The revenue figures in the Segment Information represent amounts reported internally for management reporting, while the revenue figures in the MD&A reflect revenue recognized in accordance with generally accepted +accounting principles. On July 1, 2002, Microsoft revised its product segments and will begin reporting the new segments in fiscal 2003. Desktop and Enterprise Software and Services .    Desktop and Enterprise Software and Services revenue was $20.40 billion, $22.41 billion, and $24.01 billion in 2000, 2001, and 2002. Desktop and Enterprise +Software and Services includes Desktop Applications; Desktop Platforms; and Enterprise Software and Services. Desktop Applications revenue was $9.30 billion, $9.54 +billion, and $9.60 billion in 2000, 2001, and 2002. Desktop Applications includes revenue from Microsoft Office; Microsoft Project; Visio; client access licenses (CALs) for Windows NT Server and Windows 2000 Server, Exchange, and BackOffice; +Microsoft Great Plains; and bCentral. In fiscal 2002, Office licensing revenue declined during the year due to a strong mix shift to multi-year annuity licensing agreements, which deferred revenue recognition to future years, and a decrease in +consumer purchases in the Asia region, most notably Japan, partially offset by strong OEM licensing. Revenue from client access licenses grew 3% in fiscal 2002 and revenue from Great Plains contributed to the growth in Desktop Applications. In +fiscal 2001, revenue from client access licenses increased 14% reflecting strong licensing growth of Windows NT Server and Windows 2000 Server CALs. Office revenue growth was flat during fiscal 2001. In fiscal 2000, revenue growth from Microsoft +Office integrated suites, including the Premium, Professional, Small Business, and Standard Editions was very solid. Desktop Platforms revenue was $7.02 billion, +$8.04 billion, and $9.30 billion in 2000, 2001, and 2002. Desktop Platforms includes revenue from Windows XP Professional and Home, Windows 2000 Professional, Windows NT Workstation, Windows Me, Windows 98, and other desktop operating systems. In +fiscal 2002, the growth in Desktop Platforms revenue reflected strong multi-year licensing revenue growth and a continued mix shift to the higher priced Windows 2000 and Windows XP Professional operating system through OEMs, despite a decline in +reported OEM unit shipments. Fiscal 2001 revenue growth reflected the strong adoption of Windows 2000 Professional,  partially offset by flat revenue growth from Windows Me and Windows 98 operating systems, reflecting the slowdown in consumer +PC shipments and a higher mix of Windows 2000 Professional and Windows NT Workstation. In fiscal 2000, Desktop Platforms revenue growth was modest due to soft demand for business PCs during most of the year; a slowdown in shipments in anticipation +of the post mid-year availability of Windows 2000 operating systems; and, as expected, a longer business migration cycle for the newest Windows operating system offerings. The rate of growth in PC shipments and the mix of Windows 2000 and Windows XP +Professional as a percentage of all 32-bit operating systems will continue to impact revenue growth in the future. Enterprise Software and Services revenue was +$4.08 billion, $4.83 billion, and $5.11 billion in 2000, 2001, and 2002. Enterprise Software and Services includes Server Platforms, Server Applications, Developer Tools and Services, and Enterprise Services. In fiscal 2002, Server Applications, +including Microsoft SQL Server and .NET Enterprise Servers, increased 10% compared to fiscal 2001. Server Platform revenue, which includes Windows 2000 Server and Windows NT Server operating systems, increased 10% versus fiscal 2001 driven by a +modest overall increase in Windows-based server shipments and increased deployment of Windows 2000 Server. Enterprise Services revenue, representing consulting and product support services, was up 17% compared to fiscal 2001, while revenue from +Developer Tools and Services was down 19% from fiscal 2001. In fiscal 2001, Server Applications revenue increased 31% versus the prior year as a result of 12  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 the continued adoption of Microsoft’s .NET Enterprise Server offerings. Enterprise Services revenue in fiscal 2001, was up 34% compared to fiscal 2000 and Server Platforms increased 10% +while revenue from Developer Tools and Services was flat. In fiscal 2000, Server Platforms revenue growth was particularly strong led by increased adoption by customers of Windows NT Server and Windows 2000 Server. Revenue from Server Applications +grew strongly in fiscal 2000, largely due to the strong success of SQL Server 7.0, while Software Developer Tools and Services revenue declined, due to increased suite licensing versus stand-alone licenses, and the lack of a release upgrade of the +Visual Studio development system. Consumer Software, Services, and Devices. Consumer Software, Services, and Devices +revenue was $1.63 billion, $1.95 billion, and $3.59 billion in 2000, 2001, and 2002. Consumer Software, Services, and Devices includes the Xbox video game system; MSN Internet access; MSN network service; PC and online games; learning and +productivity software; mobility; and embedded systems. The majority of the revenue growth from fiscal 2001 stemmed from sales of the Xbox video game system released in fiscal 2002. MSN Internet access revenue increased as a result of both a higher +subscriber base and higher average revenue per subscriber due to a reduction in promotional subscriber programs. Revenue from MSN network services increased despite a declining Internet advertising market. Revenue from embedded systems in fiscal +2002 grew nicely, however learning and productivity software revenue and PC and online games declined compared to fiscal 2001. In fiscal 2001, revenue from MSN network services grew strongly despite a decline in the online advertising market. MSN +Internet access revenue also grew solidly from fiscal 2000 as a result of an increased subscriber base, partially offset by a decline in the average revenue per subscriber due to a larger mix of subscribers contracted under rebate programs. Revenue +from embedded systems grew strongly from the prior year, while learning and productivity software revenue and PC and online games revenue declined, reflecting softness in the overall consumer market. In fiscal 2000, online revenue growth was very +strong and reflected higher subscriber totals, offset by lower net prices for Internet access subscriptions compared to the prior year. Additionally, strong sales of entertainment software in fiscal 2000 produced robust revenue growth in PC and +online games. Consumer Commerce Investments. Consumer Commerce Investments revenue was $182 million, $299 million, +and $242 million in 2000, 2001, and 2002. Consumer Commerce Investments include Expedia, Inc., the HomeAdvisor online real estate service, and the CarPoint online automotive service. The decline in revenue compared to fiscal 2001 reflects the sale +of Microsoft’s majority ownership of Expedia, Inc. to USA Networks, Inc. on February 4, 2002. Acquisitions of Travelscape.com and VacationSpot.com by Expedia, Inc., and increased product offerings from Expedia led to the strong revenue growth +in fiscal 2001. The increased overall reach of all properties led to the strong revenue growth in fiscal 2000. Other. Other revenue, which primarily includes Hardware and Microsoft Press, was $754 million, $630 million, and $530 million in 2000, 2001, and 2002. In fiscal 2002, continued declines in the IT book +and consumer market led to a decline in Microsoft Press and Hardware sales. Lower sales of gaming devices and other hardware peripherals as a result of weakness in the consumer market caused the decline in revenue in fiscal 2001. Continued success +of the Company’s new hardware device offerings led to revenue growth in fiscal 2000. DISTRIBUTION CHANNELS Microsoft distributes its products primarily through the following channels: OEM; volume licensing; online services and products; and distributors and +retailers. OEM channel revenue represents license fees from original equipment manufacturers who preinstall Microsoft products, primarily on PCs. Microsoft has three major geographic sales and marketing regions: the South Pacific and Americas +Region; the Europe, Middle East, and Africa Region; and the Asia Region. Sales of volume licenses and packaged software products via these channels are primarily to distributors and resellers. OEM revenue was $7.01 billion in 2000, $7.86 billion in 2001, and $9.00 billion in 2002. In fiscal 2002, reported licenses declined compared to fiscal 2001. However, a strong increase in the mix of the higher +priced Windows 2000 and Windows XP Professional licenses, and healthy growth in direct and system builder OEMs licenses, led to higher average revenue per license and contributed to the overall OEM revenue growth over fiscal 2001. In fiscal 2001, +while total licenses were also impacted by a slowdown in PC shipments, the mix of the higher priced Windows 2000 Professional and Windows NT Workstation increased substantially resulting in higher average revenue per license. A relatively low growth +rate in fiscal 2000 was due to lower business PC shipment growth combined with post mid-year availability of Windows 2000 Professional. Average earned revenue per license also declined in fiscal 2000 compared to the prior year, due in part to a mix +shift to the lower-priced Windows 98 operating system reflecting the softness in demand for business PCs and lower prices on  operating systems licensed through certain OEM channel sectors. South Pacific and Americas Region revenue was $8.33 billion, $9.52 billion, and $11.41 billion in 2000, 2001, and 2002. In fiscal 2002, the majority of the revenue growth was driven by sales of the Xbox video +game system released during the year, as well as strong Windows XP Professional licensing, MSN subscription revenue, and revenue from Microsoft Great Plains. In fiscal 2001, revenue growth was led by strong licensing of Windows 2000 Professional and +the family of .NET Enterprise Servers, particularly SQL Server 2000 and Exchange 2000 Server. Revenue from Enterprise services and MSN subscription and services also grew strongly in fiscal 2001. In fiscal 2000, Office 2000 integrated suites, +Windows 2000 Server, online revenue, and SQL Server sales were the primary drivers of the revenue growth. Strong retail sales of hardware devices and consumer software also contributed to the growth over the prior year. Europe, Middle East, and Africa Region revenue was $5.02 billion, $4.86 billion, and $5.13 billion in 2000, 2001, and 2002. In fiscal 2002, the majority of the growth was a result of +strong multi-year licensing revenue of Windows XP Home and Professional operating systems and Enterprise Software, as well as the addition of Xbox video game system revenue in the second half of the year. In fiscal 2001, weakening local currencies +negatively impacted translated revenue compared to the prior year, while revenue from Windows 2000 Professional and the .NET Enterprise Server family of products was very healthy. In fiscal 2000, retail sales of Windows operating systems and 13  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 Office licensing produced moderate growth in the region. Growth from SQL Server licensing, new hardware device offerings, and entertainment software was especially strong. Asia Region revenue was $2.60 billion in 2000, $3.06 billion in 2001, and $2.83 billion in 2002. In fiscal 2002, Asia region revenue declined most notably due to lower consumer PC +shipments, which hampered revenue from localized versions of Microsoft Office 2000 and Microsoft Office XP, especially the Office Personal Edition. Xbox video game system sales partially offset the decline in Office revenue. In fiscal 2001, the +region’s growth rate reflected strong revenue from localized versions of Microsoft Office 2000 and Microsoft Office XP, especially the Office Personal Edition. This growth was also attributable to Windows 2000 Professional and .NET Server +applications licensing. In fiscal 2000, the region’s growth rate reflected strong performance resulting from improved local economic conditions. Revenue growth was also influenced by robust growth of localized versions of Microsoft Office 2000, +especially the Office Personal Edition sold in Japan, Windows platform and server licensing, and strong adoption of SQL Server. The Company’s operating +results are affected by foreign exchange rates. Approximately 30%, 27%, and 25% of the Company’s revenue was collected in foreign currencies during 2000, 2001, and 2002. Since a portion of local currency revenue is hedged and much of the +Company’s international manufacturing costs and operating expenses are also incurred in local currencies, the impact of exchange rates is partially mitigated. OPERATING EXPENSES Cost of Revenue .    Cost of revenue as a percent of +revenue was 13.1% in 2000, 13.7% in 2001, and 18.3% in 2002. Cost of revenue in fiscal 2002 increased primarily due to costs related to Xbox. In fiscal 2001, higher support and service costs associated with the MSN Internet access and MSN network +services were partially offset by the lower relative costs associated with organizational licensing and the drop in the mix of packaged product versus the prior year. Cost of revenue in fiscal 2000 reflected lower costs associated with WebTV +Networks’ operations, partially offset by the growth in hardware peripherals costs. Research and +Development. The discontinuation of goodwill amortization in fiscal 2002 in accordance with Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets, offset the growth in +headcount and development costs. In fiscal 2001, the increase in R&D expense was the result of higher headcount-related costs and investments in new product initiatives. The increase in fiscal 2000 was driven primarily by higher +headcount-related costs. Prospectively, increased headcount and increased spending in Server Platforms, Home & Entertainment, Business Solutions and CE are currently expected to be significant factors affecting future research and development +expense growth. Sales and Marketing. Sales and marketing expense as a percentage of revenue was 18.0% in 2000, 19.3% +in 2001, and 19.1% in 2002. In fiscal 2002, sales and marketing expense as a percentage of revenue decreased due to lower relative MSN customer acquisition marketing and the large relative increase associated with the onset of Xbox video game system +revenue. In fiscal 2001, sales and marketing expenses as a percentage of revenue increased due to higher relative headcount-related costs, higher marketing and sales expenses associated with MSN, the Microsoft Agility advertising campaign, and other +new sales initiatives. In fiscal 2000, sales and marketing expenses as a percentage of revenue increased due to higher relative marketing costs associated with new product releases and online marketing. Microsoft expects that it will increase +spending on Information Worker, Server Platforms, and Business Solutions sales forces and Windows Client, MSN and Home & Entertainment marketing. General and Administrative. General and administrative expenses in fiscal 2002 increased due to a charge of approximately $660 million for estimated expenses related to the Company’s consumer class +action lawsuits and higher legal fees. In fiscal 2001, general and administrative costs decreased due to a charge related to the settlement of the lawsuit with Caldera, Inc. recorded in fiscal 2000. Excluding this charge in fiscal 2000, general and +administrative expenses in fiscal 2001 increased from the prior year due to higher headcount-related costs and legal fees. For fiscal 2000, besides the settlement of the lawsuit, general and administrative expenses also reflected increased legal +fees and certain employee stock option-related expenses. NON-OPERATING ITEMS, INVESTMENT INCOME/(LOSS), AND INCOME TAXES Losses on equity investees and other consists of Microsoft’s share of income or loss from investments accounted for using the equity +method, and income or loss attributable to minority interests. The decrease in losses on equity investees and other in fiscal 2002 was attributed to the divestiture of certain equity investments in fiscal 2002. The increase in losses on equity +investees and other in fiscal 2001 reflects an increase in the number of such investments during the year. In fiscal 2000 losses on equity investees and other decreased reflecting smaller losses from the MSNBC entities. 14  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 The Company recorded net investment income/(loss) in each year as follows: In Millions Year Ended June 30 2000 2001 2002 Dividends $ 363 $ 377 $ 357 Interest 1,231 1,808 1,762 Net recognized gains/(losses) on investments: Net gains on the sales of investments 1,780 3,175 2,379 Other-than-temporary impairments (29 ) (4,804 ) (4,323 ) Net unrealized losses attributable to derivative instruments (19 ) (592 ) (480 ) Net recognized gains/(losses) on investments 1,732 (2,221 ) (2,424 ) Investment income/(loss) $ 3,326 $ (36 ) $ (305 ) In fiscal 2002, other-than-temporary impairments primarily related to the +Company’s investment in AT&T and other cable and telecommunication investments. Net gains on the sales of investments included a $1.25 billion gain on the sale of the Company’s share of Expedia. Interest and dividend income decreased +$66 million from fiscal 2001 as a result of lower interest rates and dividend income. In fiscal 2001, other-than-temporary impairments primarily related to cable +and telecommunication investments. Net gains from the sales of investments in fiscal 2001 included a gain from Microsoft’s investment in Titus Communications (which was merged with Jupiter Telecommunications) and the closing of the sale of +Transpoint to CheckFree Holdings Corp. Interest and dividend income increased $591 million from fiscal 2000, reflecting a larger investment portfolio. In fiscal year 2000, investment income increased primarily as a result of a larger investment +portfolio generated by cash from operations coupled with realized gains from the sale of securities. At June 30, 2002, unrealized losses on Equity and Other +Investments of $623 million were deemed to be temporary in nature. The following, among other factors, could result in some investments being deemed other-than-temporarily impaired in future periods: changes in the duration and extent to which the +fair value is less than cost; the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors; and the Company’s intent and ability +to hold the investment. In connection with the definitive agreement to combine AT&T Broadband with Comcast in a new company to be called AT&T Comcast +Corporation, Microsoft has agreed to exchange its AT&T 5% convertible preferred debt securities for approximately 115 million shares of AT&T Comcast Corporation. It is expected that the transaction will close by December 31, 2002. While it +is possible that Microsoft could incur a loss on this exchange transaction up to the carrying value of the AT&T debt securities, management believes that the ultimate loss, if any, will be significantly less. As management is unable to predict +whether there will be a gain or loss on the exchange, no loss has been recorded related to this contingent exchange transaction as of June 30, 2002. The +Company’s effective tax rate for fiscal 2002 was 32%. The effective tax rate for fiscal 2001 and fiscal 2000 was 33% and 34%, respectively. The decrease in the effective tax rate is due primarily to lower taxes on foreign earnings. ACCOUNTING CHANGES Effective July 1, 2001, Microsoft adopted SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires business combinations to be accounted for using the purchase method of +accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for +impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142. Goodwill amortization (on a pre-tax basis) was $234 million in fiscal 2000 and $311 million in fiscal 2001. Effective July 1, 2000, Microsoft adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including +certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax reduction to other +comprehensive income (OCI) of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million +reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by the reclassifications out of OCI of the approximately +$300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments. FINANCIAL CONDITION The Company’s cash and short-term investment portfolio totaled $38.65 billion at June 30, +2002. The portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Microsoft’s investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar +denominated securities, but also includes foreign currency positions in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and facilitate rapid deployment for immediate cash +needs. 15  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 Cash flow from operations was $14.51 billion for fiscal 2002, an increase of $1.09 billion from fiscal 2001. The +increase reflects strong growth in unearned revenue. Cash used for financing was $4.57 billion in fiscal 2002, a decrease of $1.01 billion from the prior year. The decrease reflects the repurchase of put warrants in the prior year. The Company +repurchased 122.8 million shares of common stock under its share repurchase program in fiscal 2002, compared to 89.0 million shares repurchased in the prior year. In addition, 5.1 million shares of common stock were acquired in fiscal 2002 under a +structured stock repurchase transaction. The Company entered into the structured stock repurchase transaction in fiscal 2001, giving it the right to acquire 5.1 million of its shares in exchange for an up-front net payment of $264 million. Cash used +for investing was $10.85 billion in fiscal 2002, an increase of $2.11 billion from fiscal 2001. Cash flow from operations was $13.42 billion in fiscal 2001, an +increase of $2.00 billion from the prior year. The increase was primarily attributable to the growth in revenue and other changes in working capital, partially offset by the decrease in the stock option income tax benefit, reflecting decreased stock +option exercises by employees. Cash used for financing was $5.59 billion in fiscal 2001, an increase of $3.39 billion from the prior year. The increase primarily reflects the repurchase of put warrants in fiscal 2001, compared to the sale of put +warrants in the prior fiscal year, as well as an increase in common stock repurchased. All outstanding put warrants were either retired or exercised during fiscal 2001. During fiscal 2001, the Company repurchased 89.0 million shares. Cash used for +investing was $8.73 billion in fiscal 2001, a decrease of $658 million from the prior year. In fiscal 2000, cash flow from operations was $11.43 billion, a decrease of $720 million from the prior year, reflecting working capital changes partially +offset by the increase in the stock option income tax benefit. Cash used for financing was $2.19 billion in fiscal 2000, an increase of $1.33 billion from the prior year, reflecting an increase in common stock repurchased versus the prior year. +During fiscal 2000, the Company repurchased 55.2 million shares. Cash used for investing was $9.39 billion in fiscal 2000, a decrease of $808 million from the prior year. Microsoft has no material long-term debt. Stockholders’ equity at June 30, 2002 was $52.18 billion. Microsoft will continue to invest in sales, marketing, and product support infrastructure. Additionally, research and +development activities will include investments in existing and advanced areas of technology, including using cash to acquire technology. Additions to property and equipment will continue, including new facilities and computer systems for R&D, +sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $111 million on June 30, 2002. The Company has not engaged in any transactions or arrangements with unconsolidated entities or other persons that +are reasonably likely to affect materially liquidity or the availability of or requirements for capital resources. Since fiscal 1990, Microsoft has repurchased 982 million common shares while 2.23 billion shares were issued under the Company’s +employee stock option and purchase plans. The Company’s convertible preferred stock matured on December 15, 1999. Each preferred share was converted into 1.1273 common shares. Management believes existing cash and short-term investments together with funds generated from operations should be sufficient to meet operating requirements. The Company’s cash and short-term investments are available +for strategic investments, mergers and acquisitions, other potential large-scale needs and to fund the share repurchase program. Microsoft has not paid cash dividends on its common stock. SUBSEQUENT EVENT On July 11, 2002, Microsoft acquired Navision a/s as a result +of the successful close of a tender offer. Microsoft purchased Navision’s shares for approximately $1.45 billion in stock and cash. Navision is a provider of integrated business software solutions for small and medium-sized companies. APPLICATION OF CRITICAL ACCOUNTING POLICIES Microsoft’s financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States. Preparing financial statements requires management to make estimates +and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for Microsoft include +revenue recognition, impairment of investment securities, accounting for research and development costs, accounting for legal contingencies, and accounting for income taxes. Microsoft accounts for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 +requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. End users receive certain elements of the Company’s +products over a period of time. These elements include browser technologies updates and technical support, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the +ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess +whether future releases of certain software represent new products or upgrades and enhancements to existing products. SFAS 115, Accounting for Certain +Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is +other-than-temporarily impaired, which also requires judgment. In making this judgment, Microsoft evaluates, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the financial health of and +business outlook for the investee, including factors such as industry and sector performance, changes in technology, and operational and financing cash flow; and the Company’s intent and ability to hold the investment. Microsoft accounts for research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development Costs, and SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Other- 16  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 wise Marketed. SFAS 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development until +technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in +determining when the technological feasibility of a product is established. Microsoft has determined that technological feasibility for its products is reached shortly before the products are released to manufacturing. Costs incurred after +technological feasibility is established are not material, and accordingly, the Company expenses all research and development costs when incurred. Microsoft is +subject to various legal proceedings and claims, the outcomes of which are subject to significant uncertainty. SFAS 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be accrued by a charge to +income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has +been incurred. The Company evaluates, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact the Company’s +financial position or its results of operations. SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the +effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been +recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. Fluctuations in the +actual outcome of these future tax consequences could materially impact the Company’s financial position or its results of operations. ISSUES AND UNCERTAINTIES The following issues and uncertainties, among others, should be considered in evaluating the +Company’s financial outlook. Challenges to the Company’s Business Model. Since its inception, the +Company’s business model has been based upon customers agreeing to pay a fee to license software developed and distributed by Microsoft. Under this commercial software development (“CSD”) model, software developers bear the costs of +converting original ideas into software products through investments in research and development, offsetting these costs with the revenues received from the distribution of their products. The Company believes that the CSD model has had substantial +benefits for users of software, allowing them to rely on the expertise of the Company and other software developers that have powerful incentives to develop innovative software that is useful, reliable and compatible with other software and +hardware. In recent years, there has been a growing challenge to the CSD model, often referred to as the Open Source movement. Under the Open Source model, software is produced by global “communities” of programmers, and the resulting +software and the intellectual property contained therein is licensed to end users at little or no cost. The Company believes that there are significant problems with the Open Source model, the principal drawback being that no single entity is +responsible for the Open Source software, and thus users have no recourse if a product does not work properly or at all. Further, without the market incentives associated with the CSD model, the Company believes that the vigorous innovation and +growth of the software industry over the last 25 years would not have occurred. Nonetheless, the popularization of the Open Source movement continues to pose a significant challenge to the Company’s business model, including recent efforts by +proponents of the Open Source model to convince governments worldwide to mandate the use of Open Source software in their purchase and deployment of software products. To the extent the Open Source model gains increasing market acceptance, sales of +the Company’s products may decline, the Company may have to reduce the prices it charges for its products, and revenues and operating margins may consequently decline. New Products and Services. The Company has made significant investments in research and development for new products, services and technologies, including Microsoft .NET, Xbox, +business applications, MSN, mobile and wireless technologies, and television. Significant revenue from these investments may not be achieved for a number of years, if at all. Moreover, these products and services may never be profitable, and even if +they are profitable, operating margins for these businesses are not expected to be as high as the margins historically experienced in our Desktop and Enterprise Software and Services businesses. Declines in Demand for Software. If overall market demand for PCs, servers and other computing devices declines significantly, and consumer and corporate spending for +such products declines, Microsoft’s revenue growth will be adversely affected. Additionally, the Company’s revenues would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products +if such new offerings are not perceived to add significant new functionality or other value to prospective purchasers. Product Development +Schedule. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product +releases or significant problems in creating new products could negatively impact the Company’s revenues. International +Operations. Microsoft develops and sells products throughout the world. The prices of the Company’s products in countries outside of the United States are generally higher than the Company’s prices in the United +States because of the cost incurred in localizing software for non-U.S. markets. The costs of producing and selling the Company’s products in these countries also are higher. Pressure to globalize Microsoft’s pricing structure might +require that the Company reduce the sales price of its software in other countries, even though the costs of the software continue to be higher than in the United States. Unfavorable changes in trade protection laws, policies and measures, and other +regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, political, labor, or economic conditions in a specific country or region, including foreign exchange rates; difficulties in +staffing and managing foreign operations; and potential adverse foreign tax consequences, among other factors, could also have a negative effect on the Company’s business and results of operations outside of the United States. 17  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7 Intellectual Property Rights. Microsoft diligently defends its +intellectual property rights, but unlicensed copying and use of software represents a loss of revenue to the Company. While this adversely affects U.S. revenue, revenue loss is even more significant outside the United States, particularly in +countries where laws are less protective of intellectual property rights. Throughout the world, Microsoft actively educates consumers on the benefits of licensing genuine products and educates lawmakers on the advantages of a business climate where +intellectual property rights are protected. However, continued efforts may not affect revenue positively and further deterioration in compliance with existing legal protections or reductions in the legal protection for intellectual property rights +of software developers could adversely affect revenue. Taxation of Extraterritorial Income. In August 2001, a World +Trade Organization (“WTO”) dispute panel determined that the extraterritorial tax (“ETI”) provisions of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 constitute an export subsidy prohibited by the WTO Agreement +on Subsidies and Countervailing Measures Agreement. The U.S. government appealed the panel’s decision and lost its appeal. On January 29, 2002, the WTO Dispute Settlement Body adopted the Appellate Body report. President Bush has stated the +U.S. will bring its tax laws into compliance with the WTO ruling, but the Administration and Congress have not decided on a solution for this issue. In July 2002, Representative Bill Thomas, Chairman of the House Ways and Means Committee, introduced +the American Competitiveness and Corporate Accountability Act of 2002. If enacted, that bill would repeal the ETI regime and introduce broad-based international reform. The proposed reforms would not materially affect the Company. On August 30, +2002, a WTO arbitration panel determined that the European Union may impose up to $4.04 billion per year in countermeasures if the U.S. rules are not brought into compliance. The WTO decision does not repeal the ETI tax benefit and it does not +require the European Union to impose trade sanctions, so it is not possible to predict what impact the WTO decision will have on future results pending final resolution of these matters. If the ETI exclusion is repealed and replacement legislation +is not enacted, the loss of tax benefit to the Company could be significant. Litigation. As discussed in Note 19—Contingencies of the Notes to +Financial Statements, the Company is subject to a variety of claims and lawsuits. While the Company believes that none of the litigation matters in which the Company is currently involved will have a material adverse impact on the Company’s +financial position or results of operations, it is possible that one or more of these matters could be resolved in a manner that would ultimately have a material adverse impact on the business of the Company, and could negatively impact its revenues +and operating margins. ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to foreign +currency, interest rate, and equity price risks. A portion of these risks is hedged, but fluctuations could impact the Company’s results of operations and financial position. The Company hedges the exposure of accounts receivable and a portion +of anticipated revenue to foreign currency fluctuations, primarily with option contracts. The Company monitors its foreign currency exposures daily to maximize the overall effectiveness of its foreign currency hedge positions. Principal currencies +hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Fixed income securities are subject to interest rate risk. The portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. The +Company routinely uses options to hedge its exposure to interest rate risk in the event of a catastrophic increase in interest rates. Many securities held in the Company’s equity and other investments portfolio are subject to price risk. The +Company uses options to hedge its price risk on certain highly volatile equity securities. The Company uses a value-at-risk (VAR) model to estimate and quantify +its market risks. VAR is the expected loss, for a given confidence level, in fair value of the Company’s portfolio due to adverse market movements over a defined time horizon. The VAR model is not intended to represent actual losses in fair +value, but is used as a risk estimation and management tool. The model used for currencies and equities is geometric Brownian motion, which allow incorporation of optionality of these exposures. For interest rates, the mean reverting geometric +Brownian motion is used to reflect the principle that fixed-income securities prices over time revert to maturity value. Value-at-risk is calculated by, first, +simulating 10,000 market price paths over 20 days for equities, interest rates and foreign exchange rates, taking into account historical correlations among the different rates and prices. Each resulting unique set of equities prices, interest +rates, and foreign exchange rates is applied to substantially all individual holdings to re-price each holding. The 250 th worst performance (out of 10,000) represents the value-at-risk over 20 days at the 97.5 th percentile. +Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. A substantial amount of the +Company’s equity portfolio is held for strategic purposes. The Company attempts to hedge the value of these securities through the use of derivative contracts such as collars. The Company has incurred substantial impairment charges related to +certain of these securities in fiscal 2002 and fiscal 2001. Such impairment charges have been incurred primarily for strategic equity holdings that the Company has not been able to hedge. The VAR amounts disclosed below are not necessarily +reflective of potential accounting losses, as they are used as a risk management tool and reflect an estimate of potential reductions in fair value of the Company’s portfolio. Losses in fair value over a 20-day holding period can exceed the +reported VAR by significant amounts and can also accumulate over a longer time horizon than the 20-day holding period used in the VAR analysis. The VAR numbers are +shown separately for interest rate, currency, and equity risks. These VAR numbers include the underlying portfolio positions and related hedges. Historical data is used to estimate VAR. Given reliance on historical data, VAR is most effective in +estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent limitation in VAR is that the distribution of past changes in market risk factors may not produce accurate predictions of +future market risk. 18  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 7A, 8 The following table sets forth the VAR calculations for substantially all of the Company’s positions: In Millions As of June 30, Year ended June 30, 2002 Risk Categories 2002 2001 Average High Low Interest rates $ 472 $ 363 $ 435 $ 535 $ 333 Currency rates 310 58 162 310 58 Equity prices 602 520 584 757 488 The total VAR for the combined risk categories is $908 million at June 30, 2002 and $759 million at +June 30, 2001. The total VAR is 34% less at June 30, 2002 and 19% less at June, 30 2001 than the sum of the separate risk categories for each of those years in the above table, due to the diversification benefit of the combination of risks. The +reasons for the change in risk in portfolios include: larger investment portfolio size, higher foreign exchange exposure due to stronger non-U.S. currencies, and asset allocation shifts. ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS In millions, except earnings per share Year Ended June 30 2000 2001 2002 Revenue $ 22,956 $ 25,296 $ 28,365 Operating expenses: Cost of revenue 3,002 3,455 5,191 Research and development 3,772 4,379 4,307 Sales and marketing 4,126 4,885 5,407 General and administrative 1,050 857 1,550 Total operating expenses 11,950 13,576 16,455 Operating income 11,006 11,720 11,910 Losses on equity investees and other (57 ) (159 ) (92 ) Investment income/(loss) 3,326 (36 ) (305 ) Income before income taxes 14,275 11,525 11,513 Provision for income taxes 4,854 3,804 3,684 Income before accounting change 9,421 7,721 7,829 Cumulative effect of accounting change (net of income taxes of $185) – (375 ) – Net income $ 9,421 $ 7,346 $ 7,829 Basic earnings per share: Before accounting change $ 1.81 $ 1.45 $ 1.45 Cumulative effect of accounting change – (0.07 ) – $ 1.81 $ 1.38 $ 1.45 Diluted earnings per share: Before accounting change $ 1.70 $ 1.38 $ 1.41 Cumulative effect of accounting change – (0.06 ) – $ 1.70 $ 1.32 $ 1.41 Weighted average shares outstanding: Basic 5,189 5,341 5,406 Diluted 5,536 5,574 5,553 See accompanying notes. 19  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 BALANCE SHEETS In millions June 30 2001 2002 Assets Current assets: Cash and equivalents $ 3,922 $ 3,016 Short-term investments 27,678 35,636 Total cash and short-term investments 31,600 38,652 Accounts receivable, net 3,671 5,129 Inventories 83 673 Deferred income taxes 1,522 2,112 Other 2,334 2,010 Total current assets 39,210 48,576 Property and equipment, net 2,309 2,268 Equity and other investments 14,361 14,191 Goodwill 1,511 1,426 Intangible assets, net 401 243 Other long-term assets 1,038 942 Total assets $ 58,830 $ 67,646 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 1,188 $ 1,208 Accrued compensation 742 1,145 Income taxes 1,468 2,022 Short-term unearned revenue 4,395 5,920 Other 1,461 2,449 Total current liabilities 9,254 12,744 Long-term unearned revenue 1,219 1,823 Deferred income taxes 409 398 Other long-term liabilities 659 501 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital—shares authorized 12,000; Shares issued and outstanding 5,383 and 5,359 28,390 31,647 Retained earnings, including accumulated other comprehensive income of $587 and $583 18,899 20,533 Total stockholders’ equity 47,289 52,180 Total liabilities and stockholders’ equity $ 58,830 $ 67,646 See accompanying notes. 20  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 CASH FLOWS STATEMENTS In millions Year Ended June 30 2000 2001 2002 Operations Net income $ 9,421 $ 7,346 $ 7,829 Cumulative effect of accounting change, net of tax – 375 – Depreciation, amortization, and other noncash items 1,250 1,536 1,084 Net recognized (gains)/losses on investments (1,732 ) 2,221 2,424 Stock option income tax benefits 5,535 2,066 1,596 Deferred income taxes (425 ) (420 ) (416 ) Unearned revenue 6,177 6,970 11,152 Recognition of unearned revenue (5,600 ) (6,369 ) (8,929 ) Accounts receivable (944 ) (418 ) (1,623 ) Other current assets (775 ) (482 ) (264 ) Other long-term assets (864 ) (330 ) (9 ) Other current liabilities (992 ) 774 1,449 Other long-term liabilities 375 153 216 Net cash from operations 11,426 13,422 14,509 Financing Common stock issued 2,245 1,620 1,497 Common stock repurchased (4,896 ) (6,074 ) (6,069 ) Sales/(repurchases) of put warrants 472 (1,367 ) – Preferred stock dividends (13 ) – – Other, net – 235 – Net cash used for financing (2,192 ) (5,586 ) (4,572 ) Investing Additions to property and equipment (879 ) (1,103 ) (770 ) Purchases of investments (42,290 ) (66,346 ) (89,386 ) Maturities of investments 4,025 5,867 8.654 Sales of investments 29,752 52,848 70,657 Net cash used for investing (9,392 ) (8,734 ) (10,845 ) Net change in cash and equivalents (158 ) (898 ) (908 ) Effect of exchange rates on cash and equivalents 29 (26 ) 2 Cash and equivalents, beginning of year 4,975 4,846 3,922 Cash and equivalents, end of year $ 4,846 $ 3,922 $ 3,016 See accompanying notes. 21  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS In millions Year Ended June 30 2000 2001 2002 Convertible preferred stock Balance, beginning of year $ 980 $ – $ – Conversion of preferred to common stock (980 ) – – Balance, end of year – – – Common stock and paid-in capital Balance, beginning of year 13,844 23,195 28,390 Common stock issued 3,554 5,154 1,801 Common stock repurchased (210 ) (394 ) (676 ) Sales/(repurchases) of put warrants 472 (1,367 ) – Stock option income tax benefits 5,535 2,066 1,596 Other, net – (264 ) 536 Balance, end of year 23,195 28,390 31,647 Retained earnings Balance, beginning of year 13,614 18,173 18,899 Net income 9,421 7,346 7,829 Other comprehensive income: Cumulative effect of accounting change – (75 ) – Net gains/(losses) on derivative instruments – 634 (91 ) Net unrealized investment gains/(losses) (283 ) (1,460 ) 5 Translation adjustments and other 23 (39 ) 82 Comprehensive income 9,161 6,406 7,825 Preferred stock dividends (13 ) – – Immaterial pooling of interests 97 – – Common stock repurchased (4,686 ) (5,680 ) (6,191 ) Balance, end of year 18,173 18,899 20,533 Total stockholders’ equity $ 41,368 $ 47,289 $ 52,180 See accompanying notes. 22  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES ACCOUNTING PRINCIPLES The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. PRINCIPLES OF CONSOLIDATION The financial statements include the accounts of Microsoft +Corporation and its subsidiaries (Microsoft). Intercompany transactions and balances have been eliminated. Equity investments in which Microsoft owns at least 20% of the voting securities are accounted for using the equity method, except for +investments in which the Company is not able to exercise significant influence over the investee, in which case, the cost method of accounting is used. Issuances of shares by a subsidiary are accounted for as capital transactions. ESTIMATES AND ASSUMPTIONS Preparing financial statements requires +management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies and product life cycles, and assumptions such as the elements comprising a +software arrangement, including the distinction between upgrades/enhancements and new products; when the Company reaches technological feasibility for its products; the potential outcome of the future tax consequences of events that have been +recognized in the Company’s financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from these estimates and assumptions. FOREIGN CURRENCIES Assets and liabilities recorded in foreign currencies are +translated at the exchange rate on the balance sheet date. Translation adjustments resulting from this process are charged or credited to other comprehensive income (OCI). Revenue and expenses are translated at average rates of exchange prevailing +during the year. REVENUE RECOGNITION Microsoft accounts for +the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The Company recognizes revenue when (i) persuasive evidence of an +arrangement exists; (ii) delivery has occurred or services have been rendered; (iii) the sales price is fixed or determinable; and (iv) collectibility is reasonably assured. For software arrangements with multiple elements, revenue is recognized +dependent upon whether vendor-specific objective evidence (VSOE) of fair value exists for each of the elements. When VSOE does not exist for all the elements of a software arrangement and the only undelivered element is postcontract customer support +(PCS), the entire licensing fee is recognized ratably over the contract period. Revenue attributable to undelivered elements, including technical support and Internet browser technologies, is based on the average sales price of those elements when +sold separately, and is recognized ratably on a straight-line basis over the product’s life cycle. PCS and subscription revenue is recognized ratably over the contract period. Revenue from products licensed to original equipment manufacturers (OEMs) is based on the licensing agreement with an OEM and has historically been recognized when OEMs ship licensed products to their customers. Licensing +provisions were modified with the introduction of Windows XP in 2002 and revenue for certain products is recorded upon shipment of the product to OEMs. The effect of this change in licensing provisions was not material. Revenue from packaged product +sales to distributors and resellers is usually recorded when related products are shipped. However, when the revenue recognition criteria required for distributor and reseller arrangements are not met, revenue is recognized as payments are received. +Revenue related to the Company’s Xbox game console is recognized upon shipment of the product to retailers. Online advertising revenue is recognized as advertisements are displayed. Costs related to insignificant obligations, which include +telephone support for certain products, are accrued. Provisions are recorded for estimated returns, concessions, and bad debts. COST OF REVENUE Cost of revenue includes direct costs to manufacture and distribute product and direct costs to provide online services, consulting, product +support, and training and certification of system integrators. RESEARCH AND DEVELOPMENT Technological feasibility for Microsoft’s software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not +material, and accordingly, the Company expenses all research and development costs when incurred. ADVERTISING COSTS Advertising costs are expensed as incurred. Advertising expense was $1.23 billion in 2000, $1.36 billion in 2001, and $1.27 billion in 2002. 23  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 INCOME TAXES Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are +not reported in tax returns and financial statements in the same year. The tax effect of this difference is reported as deferred income taxes. FINANCIAL INSTRUMENTS The Company considers all liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash +equivalents. Short-term investments generally mature between three months and six years from the purchase date. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such +marketable securities represent the investment of cash that is available for current operations. All cash and short-term investments are classified as available for sale and are recorded at market value using the specific identification method; +unrealized gains and losses are reflected in OCI. Equity and other investments include debt and equity instruments. Debt securities and publicly traded equity +securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and losses (excluding other-than-temporary impairments) are reflected in OCI. All other investments, excluding +those accounted for using the equity method, are recorded at cost. Microsoft lends certain fixed income and equity securities to enhance investment income. +Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. The fair value of collateral that Microsoft is permitted to sell or repledge was $499 million at both June 30, 2001 and +2002. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. The Company employs a systematic methodology +that considers available evidence in evaluating potential impairment of its investments. In the event that the cost of an investment exceeds its fair value, the Company evaluates, among other factors, the duration and extent to which the fair value +is less than cost; the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors; and the Company’s intent and ability to hold +the investment. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. In 2001, the Company recognized $4.80 billion in impairments of certain +investments, primarily in the cable and telecommunication industries. In 2002, Microsoft recognized $4.32 billion in impairments of certain investments, primarily related to further declines in the fair values of U.S. and European cable and +telecommunications holdings. The Company uses derivative instruments to manage exposures to foreign currency, security price, and interest rate risks. The + Company’s objectives for holding derivatives are to minimize these risks using the most effective methods to eliminate or reduce the impact of these exposures. Foreign Currency Risk. Certain forecasted transactions and assets are exposed to foreign currency risk. The Company monitors its foreign currency exposures daily to maximize the overall +effectiveness of its foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Options used to hedge a portion of forecasted international revenue for up to three years in the +future are designated as cash flow hedging instruments. Options and forwards not designated as hedging instruments under SFAS 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections +denominated in certain foreign currencies. Securities Price Risk. Strategic equity investments are subject to market +price risk. From time to time, the Company uses and designates options to hedge fair values and cash flows on certain equity securities. The security, or forecasted sale thereof, selected for hedging is determined by market conditions, up-front +costs, and other relevant factors. Once established, the hedges are not dynamically managed or traded, and are generally not removed until maturity. Interest Rate Risk. Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. The +Company routinely uses options, not designated as hedging instruments, to hedge its exposure to interest rate risk in the event of a catastrophic increase in interest rates. Other Derivatives. In addition, the Company may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are +deemed derivative financial instruments and are not designated as hedging instruments. For options designated either as fair value or cash flow hedges, changes in +the time value are excluded from the assessment of hedge effectiveness. ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts reflects management’s best estimate of probable losses inherent in the account receivable balance. Management determines the allowance based on known troubled +accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows: In Millions Year Ended June 30 Balance at beginning of period Charged to costs and expenses Write-offs and other Balance at end of period 2002 $ 174 $ 192 $ 157 $ 209 2001 186 157 169 174 2000 204 77 95 186 24  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 INVENTORIES Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated using +the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the straight-line method over the estimated +useful life of the software, generally not in excess of three years. GOODWILL Beginning in fiscal 2002 with the adoption of SFAS 142, Goodwill and Other Intangible Assets, goodwill is no longer amortized, but instead tested for impairment at least annually. Prior to fiscal 2002, goodwill was amortized +using the straight-line method over its estimated period of benefit. INTANGIBLE ASSETS Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from three to seven years. The Company periodically evaluates the recoverability of intangible assets and takes +into account events or circumstances that warrant revised estimates of useful lives or that indicate that an impairment exists. All of Microsoft’s intangible assets are subject to amortization. RECLASSIFICATIONS Certain reclassifications have been made for consistent +presentation. NOTE 2    ACCOUNTING CHANGES Effective July 1, 2000, the Company adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative +instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 on July 1, 2000, resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and +a cumulative pre-tax reduction to OCI of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately +$250 million reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by reclassifications out of OCI of the +approximately $300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments. The net derivative losses included in OCI as of July 1, 2000 were reclassified +into earnings during the twelve months ended June 30, 2001. The change in accounting from the adoption of SFAS 133 did not materially affect net income in 2001. Effective July 1, 2001, Microsoft adopted SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets. SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for +using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be +amortized, but instead tested for impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142. Net income and earnings per share +for fiscal 2000 and fiscal 2001 adjusted to exclude amortization expense (net of taxes) is as follows: In Millions, Except Earnings Per Share Year Ended June 30 2000 2001 Net income: Reported net income $ 9,421 $ 7,346 Goodwill amortization 203 252 Equity method goodwill amortization 1 26 Adjusted net income $ 9,625 $ 7,624 Basic earnings per share: Reported basic earnings per share $ 1.81 $ 1.38 Goodwill amortization 0.04 0.05 Equity method goodwill amortization – – Adjusted basic earnings per share $ 1.85 $ 1.43 Diluted earnings per share: Reported diluted earnings per share $ 1.70 $ 1.32 Goodwill amortization 0.04 0.05 Equity method goodwill amortization – – Adjusted diluted earnings per share $ 1.74 $ 1.37 25  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 3    UNEARNED REVENUE A portion of Microsoft’s revenue under volume licensing programs is earned ratably over the period of the license agreement. Also, revenue attributable to undelivered +elements, including technical support and Internet browser technologies, is based on the average sales price of those elements when sold separately, and is recognized ratably on a straight-line basis over the product’s life cycle. The +percentage of revenue recognized ratably for undelivered elements ranges from approximately 20% to 25% for Windows XP Home, approximately 10% to 15% for Windows XP Professional, and approximately 10% to 15% for desktop applications, depending on the +terms and conditions of the  license and prices of the elements. Product life cycles are currently estimated at three years for Windows operating systems and 18 months for desktop applications. The components of unearned revenue were as follows: In Millions June 30 2001 2002 Volume licensing programs $ 1,922 $ 4,158 Undelivered elements 2,818 2,830 Other 874 755 Unearned revenue $ 5,614 $ 7,743 Unearned revenue by product was as follows: In Millions June 30 2001 2002 Desktop Applications $ 2,189 $ 3,489 Desktop Platforms 2,586 3,198 Enterprise Software and Services 391 791 Desktop and Enterprise Software and Services 5,166 7,478 Consumer Software, Services, and Devices, and Other 448 265 Unearned revenue $ 5,614 $ 7,743 Of the $7.74 billion of unearned revenue at June 30, 2002, $2.28 billion is +expected to be recognized in the first quarter of fiscal 2003, $1.64 billion in the second quarter of fiscal 2003, $1.18 billion in the third quarter of fiscal 2003, $817 million in the fourth quarter of fiscal 2003, and $1.82 billion thereafter. 26  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 4    CASH AND SHORT-TERM INVESTMENTS In Millions June 30, 2001 Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and equivalents: Cash $ 1,145 $ – $ – $ 1,145 Commercial paper 894 – – 894 Certificates of deposit 286 – – 286 U.S. government and agency securities 400 – – 400 Corporate notes and bonds 1,130 – – 1,130 Municipal securities 67 – – 67 Cash and equivalents 3,922 – – 3,922 Short-term investments: Commercial paper 635 3 – 638 U.S. government and agency securities 7,355 9 (42 ) 7,322 Corporate notes and bonds 17,256 214 (149 ) 17,321 Municipal securities 1,662 41 – 1,703 Certificates of deposit 694 – – 694 Short-term investments 27,602 267 (191 ) 27,678 Cash and short-term investments $ 31,524 $ 267 $ (191 ) $ 31,600 In Millions June 30, 2002 Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and equivalents: Cash $ 1,114 $ – $ – $ 1,114 Commercial paper 260 – – 260 Certificates of deposit 31 – – 31 Money market mutual funds 714 – – 714 Corporate notes and bonds 560 – – 560 Municipal securities 337 – – 337 Cash and equivalents 3,016 – – 3,016 Short-term investments: Commercial paper 552 – – 552 U.S. government and agency securities 10,726 114 (13 ) 10,827 Corporate notes and bonds 18,822 255 (241 ) 18,836 Municipal securities 4,462 86 – 4,548 Certificates of deposit 873 – – 873 Short-term investments 35,435 455 (254 ) 35,636 Cash and short-term investments $ 38,451 $ 455 $ (254 ) $ 38,652 Realized gains and (losses) from cash and short-term investments were $80 +million and $(226) million in 2000, $541 million and $(369) million in 2001, and $816 million and $(558) million in 2002. 27  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 5    INVENTORIES In Millions June 30 2001 2002 Finished goods $ 78 $ 505 Raw materials and work in process 5 168 Inventories $ 83 $ 673 NOTE 6    PROPERTY AND EQUIPMENT In Millions June 30 2001 2002 Land $ 185 $ 197 Buildings 1,584 1,701 Computer equipment and software 2,292 2,621 Other 1,214 1,372 Property and equipment – at cost 5,275 5,891 Accumulated depreciation (2,966 ) (3,623 ) Property and equipment – net $ 2,309 $ 2,268 During 2000, 2001, and 2002, depreciation expense, of which the majority +related to computer equipment, was $668 million, $764 million, and $820 million. NOTE 7    EQUITY AND OTHER +INVESTMENTS In Millions June 30, 2001 Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Debt securities recorded at market, maturing: Within one year $ 500 $ – $ – $ 500 Between 2 and 10 years 643 12 (3 ) 652 Between 10 and 15 years 513 – (9 ) 504 Beyond 15 years 4,754 – (829 ) 3,925 Debt securities recorded at market 6,410 12 (841 ) 5,581 Common stock and warrants 5,555 2,030 (285 ) 7,300 Preferred stock 881 – – 881 Other investments 599 – – 599 Equity and other investments $ 13,445 $ 2,042 $ (1,126 ) $ 14,361 28  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 In Millions June 30, 2002 Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Debt securities recorded at market, maturing: Within one year $ 485 $ 26 $ – $ 511 Between 2 and 10 years 893 46 (4 ) 935 Between 10 and 15 years 541 19 (2 ) 558 Beyond 15 years 3,036 – – 3,036 Debt securities recorded at market 4,955 91 (6 ) 5,040 Common stock and warrants 6,930 1,287 (617 ) 7,600 Preferred stock 1,382 – – 1,382 Other investments 169 – – 169 Equity and other investments $ 13,436 $ 1,378 $ (623 ) $ 14,191 Debt securities include corporate and government notes and bonds and +derivative securities. Debt securities maturing beyond 15 years are composed entirely of AT&T 5% convertible preferred debt with a contractual maturity of 30 years. The debt is convertible at the Company’s option into AT&T common stock +on or after December 1, 2000, or may be redeemed by AT&T upon satisfaction of certain conditions on or after June 1, 2002. In connection with the definitive agreement to combine AT&T Broadband with Comcast in a new company to be called +AT&T Comcast Corporation, Microsoft has agreed to exchange its AT&T 5% convertible preferred debt securities for approximately 115 million shares of AT&T Comcast Corporation. It is expected that the transaction will close by December 31, +2002. While it is possible that Microsoft could incur a loss on this exchange transaction up to the carrying value of the AT&T debt securities, management believes that the ultimate loss, if any, will be significantly less. As management is +unable to predict whether there will be a gain or loss on the exchange, no loss has been recorded related to this contingent exchange transaction as of June 30, 2002. Equity securities that are restricted for more than one year or not publicly traded are recorded at cost. At June 30, 2001 the estimated fair value of these investments in excess of their recorded basis was $161 million. At June 30, +2002 the recorded basis of these investments in excess of their estimated fair value was $34 million. This excess of cost over estimated fair value was deemed temporary in nature. The estimate of fair value is based on publicly available market +information or other estimates determined by management. Realized gains and (losses) from equity and other investments (excluding impairments discussed previously) were $1.94 billion and $(10) million in 2000, $3.03 billion and $(23) million in +2001, and $2.24 billion and $(121) million in 2002. NOTE 8    GOODWILL During fiscal 2002, goodwill was reduced by $85 million, principally in connection with Microsoft’s exchange of all of its 33.7 million shares and warrants of +Expedia, Inc. to USA Networks, Inc. No goodwill was acquired or impaired during fiscal 2002. As of June 30, 2002, Desktop and Enterprise Software and Services goodwill was $1.1 billion, Consumer Software, Services, and Devices goodwill was $258 +million, and Consumer Commerce Investments goodwill was $72 million. NOTE 9    INTANGIBLE ASSETS During fiscal 2002, changes in intangible assets primarily relates to the Company’s acquisition of $25 million in patents and licenses and +$27 million in existing technology, which will be amortized over approximately 3 years. No significant residual value is estimated for these intangible assets. Intangible assets amortization expense was $202 million for fiscal 2001 and $194 million +for fiscal 2002. The components of intangible assets were as follows: In Millions June 30 2001 2002 Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization Patents and licenses $ 407 $ (177 ) $ 421 $ (290 ) Existing technology 157 (27 ) 172 (71 ) Trademarks, tradenames and other 83 (42 ) 15 (4 ) Intangible assets $ 647 $ (246 ) $ 608 $ (365 ) Amortization expense for the net carrying amount of intangible assets at June +30, 2002 is estimated to be $115 million in fiscal 2003, $90 million in fiscal 2004, $36 million in fiscal 2005, and $2 million in fiscal 2006. 29  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 10    DERIVATIVES For fiscal 2001, investment income included a net unrealized loss of $592 million, comprised of a $214 million gain for changes in the time value of options for fair value +hedges, $211 million loss for changes in the time value of options for cash flow hedges, and $595 million loss for changes in the fair value of derivative instruments not designated as hedging instruments. For fiscal 2002, investment income included +a net unrealized loss of $480 million, comprised of a $30 million gain for changes in the time value of options for fair value hedges, $331 million loss for changes in the time value of options for cash flow hedges, and $179 million net loss for +changes in the fair value of derivative instruments not designated as hedging instruments. Derivative gains and losses included in OCI are reclassified into +earnings at the time forecasted revenue or the sale of an equity investment is recognized. During fiscal 2001, $214 million of derivative gains were reclassified to revenue and $416 million of derivative losses were reclassified to investment +income/(loss). During fiscal 2002, $234 million of derivative gains were reclassified to revenue and $10 million of derivative losses were reclassified to investment income/(loss). The derivative losses reclassified to investment income/(loss) were +offset by gains on the item being hedged. The Company estimates that $63 million of net derivative gains included in other comprehensive income will be reclassified into earnings within the next twelve months. For instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS 133, had no impact on earnings for the fiscal 2001 and 2002. No fair value hedges or +cash flow hedges were derecognized or discontinued for fiscal 2001 and 2002. NOTE 11    INVESTMENT +INCOME/(LOSS) The components of investment income/(loss) are as follows: In Millions Year Ended June 30 2000 2001 2002 Dividends $ 363 $ 377 $ 357 Interest 1,231 1,808 1,762 Net recognized gains/(losses) on investments: Net gains on the sales of investments 1,780 3,175 2,379 Other-than-temporary impairments (29 ) (4,804 ) (4,323 ) Net unrealized losses attributable to derivative instruments (19 ) (592 ) (480 ) Net recognized gains/(losses) on investments 1,732 (2,221 ) (2,424 ) Investment income/(loss) $ 3,326 $ (36 ) $ (305 ) NOTE 12    INCOME TAXES The provision for income taxes consisted of: In Millions Year Ended June 30 2000 2001 2002 Current taxes: U.S. and state $ 4,744 $ 3,243 $ 3,644 International 535 514 575 Current taxes 5,279 3,757 4,219 Deferred taxes (425 ) 47 (535 ) Provision for income taxes $ 4,854 $ 3,804 $ 3,684 U.S. and international components of income before income taxes were: In Millions Year Ended June 30 2000 2001 2002 U.S. $ 11,860 $ 9,189 $ 8,920 International 2,415 2,336 2,593 Income before income taxes $ 14,275 $ 11,525 $ 11,513 30  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 In 2000, the effective tax rate was 34.0%, and included the effect of a +2.5% reduction from the U.S. statutory rate for tax credits and a 1.5% increase for other items. In 2001, the effective tax rate was 33.0%, and included the effect of a 3.1% reduction from the U.S. statutory rate for tax credits and a 1.1% increase +for other items. The effective tax rate in 2002 was 32.0%, and included the effect of a 2.4% reduction from the U.S. statutory rate for the extraterritorial income exclusion tax benefit and a 0.6% reduction for other items. Deferred income taxes were: In Millions June 30 2001 2002 Deferred income tax assets: Revenue items $ 1,469 $ 2,261 Expense items 691 945 Impaired investments 1,070 2,016 Deferred income tax assets $ 3,230 $ 5,222 Deferred income tax liabilities: Unrealized gain on investments $ (395 ) $ (887 ) International earnings (1,667 ) (1,818 ) Other (55 ) (803 ) Deferred income tax liabilities $ (2,117 ) $ (3,508 ) Microsoft has not provided for U.S. deferred income taxes or foreign +withholding taxes on $780 million of its undistributed earnings for certain non-U.S. subsidiaries, all of which relate to fiscal 2002 earnings, since these earnings are intended to be reinvested indefinitely. On September 15, 2000, the U.S. Tax Court issued an adverse ruling with respect to Microsoft’s claim that the Internal Revenue Service (IRS) incorrectly assessed taxes for 1990 +and 1991. The Company has filed an appeal with the Ninth Circuit Court of Appeals on this matter. Income taxes, except for items related to the 1990 and 1991 assessments, have been settled with the IRS for all years through 1996. The IRS +is examining the Company’s 1997 through 1999 U.S. income tax returns. Management believes any adjustments which may be required will not be material to the financial statements. Income taxes paid were $800 million in 2000, $1.3 billion in 2001, +and $1.9 billion in 2002. NOTE 13    STOCKHOLDERS’ EQUITY Shares of common stock outstanding were as follows: In Millions Year Ended June 30 2000 2001 2002 Balance, beginning of year 5,109 5,283 5,383 Issued 229 189 104 Repurchased (55 ) (89 ) (128 ) Balance, end of year 5,283 5,383 5,359 The Company repurchases its common shares in the open market to provide +shares for issuance to employees under stock option and stock purchase plans. In 2002, the Company acquired 5.1 million of its shares as a result of a structured stock repurchase transaction entered into in 2001, which gave it the right to acquire +such shares in exchange for an up-front net payment of $264 million. To enhance its stock repurchase program, Microsoft has sold put warrants to independent third parties. These put warrants entitled the holders to sell shares of Microsoft common +stock to the Company on certain dates at specified prices. In the third quarter of fiscal 2001, the Company issued 2.8 million shares to settle a portion of the outstanding put warrants. At June 30, 2001 and 2002, there were no outstanding put +warrants. During 1996, Microsoft issued 12.5 million shares of 2.75% convertible exchangeable principal-protected preferred stock. The Company’s convertible +preferred stock matured on December 15, 1999. Each preferred share was converted into 1.1273 common shares. 31  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 14    OTHER COMPREHENSIVE INCOME In Millions Year Ended June 30 2000 2001 2002 Cumulative effect of accounting change, net of tax effect of $(37) $ – $ (75 ) $ – Net gains/(losses) on derivative instruments: Unrealized gains, net of tax effect of $246 in 2001 and $30 in 2002 – 499 55 Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $67 in 2001 and $(79) in +2002 – 135 (146 ) Net gains/(losses) on derivative instruments – 634 (91 ) Net unrealized investment gains/(losses): Unrealized holding gains/(losses), net of tax effect of $248 in 2000, $(351) in 2001, and $(955) in 2002 531 (1,200 ) (1,774 ) Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $(420) in 2000, $(128) in 2001, and +$958 in 2002 (814 ) (260 ) 1,779 Net unrealized investment gains/(losses) (283 ) (1,460 ) 5 Translation adjustments and other 23 (39 ) 82 Other comprehensive income/(loss) $ (260 ) $ (940 ) $ (4 ) The components of accumulated other comprehensive income were: In Millions June 30 2001 2002 Net gains on derivative instruments $ 177 $ 86 Net unrealized investment gains 598 603 Translation adjustments and other (188 ) (106 ) Accumulated other comprehensive income $ 587 $ 583 NOTE 15    EMPLOYEE STOCK AND SAVINGS PLANS EMPLOYEE STOCK PURCHASE PLAN The Company has an employee stock purchase +plan for all eligible employees. Under the plan, shares of the Company’s common stock may be purchased at six-month intervals at 85% of the lower of the fair market value on the first or the last day of each six-month period. Employees may +purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During 2000, 2001, and 2002, employees purchased 2.5 million, 5.7 million, and 5.4 million shares at average prices of $72.38, $36.87, and $50.52 +per share. At June 30, 2002, 56.8 million shares were reserved for future issuance. SAVINGS PLAN The Company has a savings plan, which qualifies under Section 401(k) of the Internal Revenue Code. Participating employees may contribute up to 25% of their pretax salary, but not more than statutory limits. The +Company contributes fifty cents for each dollar a participant contributes, with a maximum contribution of 3% of a participant’s earnings. Matching contributions were $47 million, $63 million, and $77 million in 2000, 2001, and 2002. STOCK OPTION PLANS The Company has stock option plans for +directors, officers, and employees, which provide for nonqualified and incentive stock options. Options granted prior to 1995 generally vest over four and one-half years and expire 10 years from the date of grant. Options granted between 1995 and +2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire after 10 years. Options granted during 2002 +vest over four and one-half years and expire 10 years from the date of grant. At June 30, 2002, options for 371 million shares were vested and 543 million shares were available for future grants under the plans. 32  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 Stock options outstanding were as follows: In Millions, Except Per Share Amounts Price per Share Shares Range Weighted Average Balance, June 30, 1999 766 $  0.56 – $  83.28 $  23.87 Granted 304 65.56 –   119.13 79.87 Exercised (198 ) 0.56 –     82.94 9.54 Canceled (40 ) 4.63 –   116.56 36.50 Balance, June 30, 2000 832 0.56 –   119.13 41.23 Granted 224 41.50 –     80.00 60.84 Exercised (123 ) 0.59 –     85.81 11.13 Canceled (35 ) 13.83 –   119.13 63.57 Balance, June 30, 2001 898 0.56 –   119.13 49.54 Granted 41 48.62 –     72.57 62.50 Exercised (99 ) 1.02 –     69.81 12.82 Canceled (38 ) 1.15 –   116.56 68.67 Balance, June 30, 2002 802 0.79 –   119.13 53.75 For various price ranges, weighted average characteristics of outstanding +stock options at June 30, 2002 were as follows: In Millions, Except Per Share Amounts Outstanding Options Exercisable Options Range of Exercise Prices Shares Remaining Life (Years) Weighted Average Price Shares Weighted Average Price $  0.79 –   $    5.97 36 1.6 $            4.83 35 $            4.82 5.98 –       13.62 44 0.5 11.19 42 11.18 13.63 –       29.80 90 2.0 15.02 84 14.97 29.81 –       43.62 73 2.7 32.19 66 32.09 43.63 –       60.00 191 6.9 55.81 41 54.03 60.01 –       69.50 146 6.4 66.24 35 66.53 69.51 –       83.28 80 5.1 71.17 21 71.84 83.29 –     119.13 142 4.2 89.87 47 89.29 The Company follows Accounting Principles Board Opinion 25, Accounting for +Stock Issued to Employees, to account for stock option and employee stock purchase plans. An alternative method of accounting for stock options is SFAS 123, Accounting for Stock-Based Compensation. Employee stock options are valued at +grant date using the Black-Scholes valuation model, and this compensation cost is recognized ratably over the vesting period. 33  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 Had compensation cost for the Company’s stock option and employee stock purchase plans been determined as prescribed by SFAS 123, pro +forma income statements for 2000, 2001, and 2002 would have been as follows: In Millions, Except Per Share Amounts Year Ended June 30 2000 2001 2002 Reported Pro Forma Reported Pro Forma Reported Pro Forma Revenue $ 22,956 $ 22,956 $ 25,296 $ 25,296 $ 28,365 $ 28,365 Operating expenses: Cost of revenue 3,002 3,277 3,455 3,775 5,191 5,699 Research and development 3,772 4,814 4,379 6,106 4,307 6,299 Sales and marketing 4,126 4,468 4,885 5,888 5,407 6,252 General and administrative 1,050 1,284 857 1,184 1,550 1,843 Total operating expenses 11,950 13,843 13,576 16,953 16,455 20,093 Operating income 11,006 9,113 11,720 8,343 11,910 8,272 Losses on equity investees and other (57 ) (57 ) (159 ) (159 ) (92 ) (92 ) Investment income/(loss) 3,326 3,326 (36 ) (36 ) (305 ) (305 ) Income before income taxes 14,275 12,382 11,525 8,148 11,513 7,875 Provision for income taxes 4,854 4,210 3,804 2,689 3,684 2,520 Income before accounting change 9,421 8,172 7,721 5,459 7,829 5,355 Cumulative effect of accounting change – – (375 ) (375 ) – – Net income $ 9,421 $ 8,172 $ 7,346 $ 5,084 $ 7,829 $ 5,355 Basic earnings per share $ 1.81 $ 1.57 $ 1.38 $ 0.95 $ 1.45 $ 0.99 Diluted earnings per share $ 1.70 $ 1.48 $ 1.32 $ 0.91 $ 1.41 $ 0.98 The weighted average Black-Scholes value of options granted under the stock +option plans during 2000, 2001, and 2002 was $36.67, $29.31, and $31.57. Value was estimated using a weighted average expected life of 6.2 years in 2000, 6.4 years in 2001, and 7.0 years in 2002, no dividends, volatility of .33 in 2000, .39 in 2001, +and .39 in 2002, and risk-free interest rates of 6.2%, 5.3%, and 5.4% in 2000, 2001, and 2002. 34  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 16    EARNINGS PER SHARE Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of the +weighted average number of common shares outstanding plus the effect of outstanding preferred shares using the “if-converted” method, outstanding put warrants using the “reverse treasury stock” method, and outstanding stock +options using the “treasury stock” method. The components of basic and diluted earnings per share were as follows: In Millions, Except Per Share Amounts Year Ended June 30 2000 2001 2002 Income before accounting change $ 9,421 $ 7,721 $ 7,829 Preferred stock dividends 13 – – Net income available for common shareholders $ 9,408 $ 7,721 $ 7,829 Weighted average outstanding shares of common stock 5,189 5,341 5,406 Dilutive effect of: Put warrants 2 21 – Preferred stock 7 – – Employee stock options 338 212 147 Common stock and common stock equivalents 5,536 5,574 5,553 Earnings per share before accounting change: Basic $ 1.81 $ 1.45 $ 1.45 Diluted $ 1.70 $ 1.38 $ 1.41 For the years ended June 30, 2000, 2001 and 2002, 45 million, 351 million, +and 373 million shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the effect was antidilutive. NOTE 17    OPERATIONAL TRANSACTIONS In January 2000, the Company acquired Visio +Corporation in a transaction that was accounted for as a pooling of interests. Microsoft issued 14 million shares valued at approximately $1.5 billion in the exchange for the outstanding stock of Visio. Visio’s assets and liabilities, which +were nominal, are included with those of Microsoft as of the merger. Operating results for Visio from periods prior to the merger were not material to the combined results of the two companies. Accordingly, the financial statements for such periods +have not been restated. In April 2001, the Company acquired Great Plains Software, Inc. for approximately $1.1 billion in stock. Great Plains is a leading supplier +of mid-market business applications. The acquisition was accounted for by the purchase method and operating results for Great Plains subsequent to the date of acquisition are included with those of Microsoft. The pro forma impact of Great +Plains’ operating results prior to the date of acquisition was not material. NOTE 18    COMMITMENTS The Company has operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating +leases was $201 million, $281 million, and $318 million in 2000, 2001, and 2002. Future minimum rental commitments under noncancellable leases, in millions of dollars, are: 2003, $260; 2004, $219; 2005, $197; 2006, $170; 2007, $135; and thereafter, +$302. Microsoft has committed $111 million for constructing new buildings. In addition, the Company has guaranteed $536 million in debt of its equity investees. NOTE 19    CONTINGENCIES The Company is a defendant in U.S. v. Microsoft , +a lawsuit filed by the Antitrust Division of the U.S. Department of Justice (DOJ) and a group of eighteen state Attorneys General alleging violations of the Sherman Act and various state antitrust laws. After the trial, the District Court entered +Findings of Fact and Conclusions of Law stating that Microsoft had violated Sections 1 and 2 of the Sherman Act and various state antitrust laws. A Judgment was entered on June 7, 2000 ordering, among other things, the breakup of Microsoft into two +companies. 35  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 The Judgment was stayed pending an appeal. On June 28, 2001, the U.S. Court of Appeals for the District of Columbia Circuit affirmed in part, reversed in part, and vacated the Judgment in its +entirety and remanded the case to the District Court for a new trial on one Section 1 claim and for entry of a new judgment consistent with its ruling. In its ruling, the Court of Appeals substantially narrowed the bases of liability found by the +District Court, but affirmed some of the District Court’s conclusions that Microsoft had violated Section 2. On October 12, 2001, the trial court held a status conference and entered orders requiring the parties to engage in settlement +discussions until November 2, 2001. Microsoft entered into a settlement with the United States on November 2, 2001. Nine states (New York, Ohio, Illinois, Kentucky, Louisiana, Maryland, Michigan, North Carolina and Wisconsin) agreed to +settle on substantially the same terms on November 6, 2001. A hearing on the settlement was held by the Court on March 6, 2002. The Court will now decide whether to approve the settlement as being in the public interest. Nine states and the District +of Columbia continue to litigate the remedies phase of U.S. v. Microsoft . The non-settling states are seeking imposition of a remedy that would impose much broader restrictions on Microsoft’s business than the proposed settlement with +the DOJ and nine other states. The Court conducted an evidentiary hearing related to the non-settling states’ proposed remedies from March 18 to June 19, 2002. A decision is anticipated later in calendar 2002. In other ongoing investigations, the DOJ and several state Attorneys General have requested information from Microsoft concerning various issues. In addition, the European Commission +has instituted proceedings in which it alleges that Microsoft has failed to disclose information that Microsoft competitors claim they need to interoperate fully with Windows 2000 clients and servers and has engaged in discriminatory licensing of +such technology, as well as improper bundling of multimedia playback technology in the Windows operating system. The remedies sought, though not fully defined, include mandatory disclosure of Microsoft Windows operating system technology and +imposition of fines. Microsoft denies the European Commission’s allegations and intends to contest the proceedings vigorously. A large number of overcharge +class action lawsuits have been initiated against Microsoft in various state and Federal courts. These cases allege that Microsoft has competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software +applications and seek to recover alleged overcharges that the complaints contend Microsoft charged for these products. Microsoft believes the claims are without merit and is vigorously defending the cases. To date, Microsoft has won dismissals of +all claims for damages by indirect purchasers under Federal law and in 17 separate state court proceedings, of which seven have been affirmed and one has been reversed. Claims on behalf of foreign purchasers have also been dismissed. Appeals of +several of these rulings are still pending. No trials or other proceedings have been held concerning any liability issues. Courts in several states have ruled that these cases may proceed as class actions, while two courts have denied class +certification status to the claims in that state proceeding and another has ruled that no class action is available for claims in that state. In fiscal 2002, the Company recorded a contingent liability of approximately $660 million representing +management’s estimate of the costs of resolving the contingency. Management’s contingent liability estimate is based upon a proposed settlement between Microsoft and lead counsel for the Federal plaintiffs. While the proposed settlement +was not approved by the District Court, management believes that the proposal represents the best estimate of the costs of resolving the contingency based on currently available information. The Company intends to continue vigorously defending these +lawsuits. Netscape Communications Inc., a subsidiary of AOL-Time Warner Inc., filed suit against Microsoft on January 22, 2002 in Federal court in the District of +Columbia, alleging violations of antitrust and unfair competition laws and other tort claims relating to Netscape and its Navigator browser. The complaint includes claims of unlawful monopolization or attempted monopolization of alleged markets for +operating systems and Web browsers, illegal tying of operating systems and browsers, and tortuous interference with Netscape’s business relations. Netscape seeks injunctive relief, unquantified treble damages and its fees and costs. Microsoft +denies these allegations and will vigorously defend this action. The case has been transferred for pretrial purposes to the District Court in Baltimore, Maryland and is being coordinated with the overcharge class actions described above. Be Incorporated, a former software development company whose assets were acquired by Palm Incorporated in August 2001, filed suit against Microsoft on February 18, +2002 in Federal court in San Francisco, alleging violations of Federal and state antitrust and unfair competition laws and other tort claims. Be alleges that Microsoft’s license agreements with computer manufacturers, pricing policies, and +business practices interfered with Be’s relationships with computer manufacturers and discouraged them from adopting Be’s own operating system for their products. Be is seeking unquantified treble and punitive damages for its alleged +injuries along with its fees and costs. Microsoft denies these allegations and will vigorously defend this action. The case has been transferred for pretrial purposes to the District Court in Baltimore, Maryland and is being coordinated with the +overcharge class actions described above. On March 8, 2002, Sun Microsystems, Inc. filed suit against Microsoft alleging violations of Federal and state antitrust +and unfair competition laws as well as claims under the Federal Copyright Act. Sun seeks injunctive relief and unspecified treble damages along with its fees and costs. Microsoft denies these allegations and will vigorously defend this action. The +case has been transferred for pretrial purposes to the District Court in Baltimore, Maryland and is being coordinated with the overcharge class actions described above. On June 3, 2002, Microsoft and the Securities and Exchange Commission entered into an administrative settlement resolving a non-public investigation of certain of Microsoft’s accounting and record keeping practices during fiscal +years 1995 through 1998 (SEC File No. 3-10789). The settlement provides that Microsoft will not violate securities regulations that require companies to make accurate filings and maintain sufficient records and controls. The settlement has no impact +on the Company’s financial results. The Company is also subject to a variety of other claims and suits that arise from time to time in the ordinary course of +its business. Management currently believes that resolving all of these matters will not have a material adverse impact on the Company’s financial position or +its results of operations. 36  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 NOTE 20    SEGMENT INFORMATION In Millions Year Ended June 30 Desktop and Enterprise Software and Services Consumer Software, Services, and Devices Consumer Commerce Investments Other Reconciling Amounts Consolidated 2000 Revenue $ 20,410 $ 1,654 $ 182 $ 691 $ 19 $ 22,956 Operating income/(loss) 13,210 (1,090 ) (60 ) 86 (1,140 ) 11,006 2001 Revenue $ 22,720 $ 1,961 $ 522 $ 652 $ (559 ) $ 25,296 Operating income/(loss) 14,261 (1,666 ) (222 ) 97 (750 ) 11,720 2002 Revenue $ 23,786 $ 3,531 $ 245 $ 537 $ 266 $ 28,365 Operating income/(loss) 14,671 (1,778 ) 23 59 (1,065 ) 11,910 Desktop and Enterprise Software and Services Revenue: In Millions Year Ended June 30 2000 2001 2002 Desktop Applications $ 9,013 $ 9,580 $ 9,327 Desktop Platforms 7,383 8,265 9,276 Desktop Software 16,396 17,845 18,603 Enterprise Software and Services 4,014 4,875 5,183 Total Desktop and Enterprise Software and Services $ 20,410 $ 22,720 $ 23,786 In fiscal 2002, Microsoft had four segments: Desktop and Enterprise Software +and Services; Consumer Software, Services, and Devices; Consumer Commerce Investments; and Other. Desktop and Enterprise Software and Services operating segment includes Desktop Applications, Desktop Platforms, and Enterprise Software and Services. +Desktop Applications include Microsoft Office; Microsoft Project; Visio; client access licenses for Windows NT Server and Windows 2000 Server, Exchange, and BackOffice; Microsoft Great Plains; and bCentral. Desktop Platforms include Windows XP +Professional and Home, Windows 2000 Professional, Windows NT Workstation, Windows Millennium Edition (Windows Me), Windows 98, and other desktop operating systems. Enterprise Software and Services includes Server Platforms; Server Applications; +developer tools and services; and Enterprise services. Consumer Software, Services, and Devices operating segment includes Xbox video game system, MSN Internet access, MSN network services, PC and online games, learning and productivity software, +mobility, and embedded systems. Consumer Commerce Investments operating segment includes Expedia, Inc., the HomeAdvisor online real estate service, and the CarPoint online automotive service. Other primarily includes Hardware and Microsoft Press. Segment information is presented in accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related Information. This standard is based on +a management approach, which requires segmentation based upon the Company’s internal organization and disclosure of revenue and operating income based upon internal accounting methods. The Company’s financial reporting systems present +various data for management to run the business, including internal profit and loss statements (P&Ls) prepared on a basis not consistent with U.S. generally accepted accounting principles. Assets are not allocated to segments for internal +reporting presentations. Reconciling items for revenue include certain elements of unearned revenue and the treatment of certain channel inventory amounts and +estimates. In addition to the reconciling items for revenue, reconciling items for operating income/(loss) include general and administrative expenses ($1.05 billion in 2000, $857 million in 2001, and $1.55 billion in 2002), certain research +expenses ($141 million in 2000, $154 million in 2001, and $166 million in 2002), and other corporate level adjustments. The internal P&Ls use accelerated methods of depreciation and amortization. Additionally, losses on equity investees and +minority interests are classified in operating income for internal reporting presentations. 37  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8 Revenue attributable to U.S. operations includes shipments to customers in the United States, licensing to OEMs and +certain multinational organizations, and exports of finished goods, primarily to Asia, Latin America, and Canada. Revenue from U.S. operations totaled $15.7 billion, $17.8 billion, and $20.9 billion in 2000, 2001, and 2002. Revenue from outside the +United States, excluding licensing to OEMs and certain multinational organizations and U.S. exports, totaled $7.3 billion, $7.5 billion, and $7.5 billion in 2000, 2001, and 2002. No single customer accounted for 10% or more of revenue in 2000, 2001, +or 2002. Long-lived assets (principally property and equipment) totaled $2.2 billion and $2.0 billion in the United States in 2001 and 2002 and $154 million and +$220 million in other countries in 2001 and 2002. NOTE 21    SUBSEQUENT EVENT On July 11, 2002, Microsoft acquired Navision a/s as a result of the successful close of a tender offer. Microsoft purchased Navision’s shares for approximately $1.45 +billion in stock and cash. Navision is a provider of integrated business software solutions for small and medium-sized companies. The purchase price allocation is currently being developed for this acquisition. QUARTERLY INFORMATION In millions, except per share amounts (Unaudited) Quarter Ended Sept. 30 Dec. 31 Mar. 31 June 30 Year Fiscal 2000 Revenue $ 5,384 $ 6,112 $ 5,656 $ 5,804 $ 22,956 Gross profit 4,672 5,356 4,904 5,022 19,954 Net income 2,191 2,436 2,385 2,409 9,421 Basic earnings per share 0.43 0.47 0.46 0.46 1.81 Diluted earnings per share 0.40 0.44 0.43 0.44 1.70 Fiscal 2001 Revenue $ 5,766 $ 6,550 $ 6,403 $ 6,577 $ 25,296 Gross profit 4,941 5,686 5,504 5,710 21,841 Net income 2,206 (1) 2,624 2,451 65 (2) 7,346 Basic earnings per share 0.42 (1) 0.49 0.46 0.01 1.38 Diluted earnings per share 0.40 (1) 0.47 0.44 0.01 1.32 Fiscal 2002 Revenue $ 6,126 $ 7,741 $ 7,245 $ 7,253 $ 28,365 Gross profit 5,242 6,197 5,850 5,885 23,174 Net income 1,283 (3) 2,283 2,738 (4) 1,525 (5) 7,829 Basic earnings per share 0.24 0.42 0.51 0.28 1.45 Diluted earnings per share 0.23 0.41 0.49 0.28 1.41 (1) Includes an unfavorable cumulative effect of accounting change of $375 million or $0.07 per basic share and $0.06 per diluted share, reflecting the adoption of SFAS No. +133. (2) Includes $3.92 billion (pre-tax) in impairments of certain investments. (3) Includes $1.82 billion (pre-tax) in impairments of certain investments. (4) Includes $1.25 billion (pre-tax) gain on the sale of Expedia, Inc. and $1.19 billion (pre-tax) in impairments of certain investments. (5) Includes $1.19 billion (pre-tax) in impairments of certain investments. 38  /  MSFT 2002 FORM 10-K Table of Contents Part II Item 8, 9 INDEPENDENT AUDITORS’ REPORT To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying +consolidated balance sheets of Microsoft Corporation and subsidiaries (the Company) as of June 30, 2001 and 2002, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period +ended June 30, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about +whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles +used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2001 and 2002, and the results of +their operations and their cash flows for each of the three years in the period ended June 30, 2002 in conformity with accounting principles generally accepted in the United States of America. As described in Note 2 to the financial statements, the Company adopted Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities , effective +July 1, 2000, and Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets , effective July 1, 2001. / S /    D ELOITTE & T OUCHE LLP Deloitte & Touche LLP Seattle, Washington July 18, 2002 ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS  ON ACCOUNTING AND FINANCIAL DISCLOSURES None. 39  /  MSFT 2002 FORM 10-K Table of Contents Part III Item 10, 11, 12, +13 PART III ITEM 10.    DIRECTORS OF THE REGISTRANT Information with respect to Directors may be found under the +caption “Election of Directors and Management Information” of the Company’s Proxy Statement for the Annual Meeting of Shareholders to be held November 5, 2002 (the “Proxy Statement”). Such information is incorporated herein +by reference. ITEM 11.    EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions +“Information Regarding Executive Officer Compensation” and “Information Regarding the Board and its Committees” is incorporated herein by reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS EQUITY COMPENSATION PLAN INFORMATION In Millions, Except Per Share Amounts June 30, 2002 (a) (b) (c) Plan category Number of securities to be issued upon exercise of outstanding options, warrants and rights Weighted-average exercise price of outstanding options, warrants and rights Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in +column (a)) Equity compensation plans approved by security holders 802 $ 53.75 600 Equity compensation plans not approved by security holders – – – Total 802 $ 53.75 600 The information set forth under the caption “Information Regarding +Beneficial Ownership of Principal Shareholders, Directors, and Management” of the Proxy Statement is incorporated herein by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the captions +“Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference. 40  /  MSFT 2002 FORM 10-K Table of Contents Part IV Item 14 PART IV ITEM 14.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Financial Statements +and Schedules The financial statements are set forth under Item 8 of this report on Form 10-K. Financial statement schedules have been omitted since they are +either not required, not applicable, or the information is otherwise included. (b) Reports on Form 8-K The Company filed no reports on Form 8-K during the quarter ended June 30, 2002. (c) Exhibit Listing Exhibit Number Description 3.1 Restated Articles of Incorporation of Microsoft Corporation (1) 3.2 Bylaws of Microsoft Corporation 10.1 Microsoft Corporation 2001 Stock Plan (2) 10.2 Microsoft Corporation 1991 Stock Option Plan (3) 10.3 Microsoft Corporation 1981 Stock Option Plan (4) 10.4 Microsoft Corporation 1999 Stock Option Plan for Non-Employee Directors (5) 10.5 Microsoft Corporation Stock Option Plan for Consultants and Advisors 10.6 Microsoft Corporation 1997 Employee Stock Purchase Plan (6) 10.7 Microsoft Corporation Savings Plus Plan (7) 10.8 Trust Agreement dated June 1, 1993 between Microsoft Corporation and First Interstate Bank of Washington 10.9 Form of Indemnification Agreement 10.10 Resignation Agreement between Richard Belluzzo and Microsoft Corporation 21. Subsidiaries of Registrant 23. Independent Auditors’ Consent 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of +2002 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of +2002 (1) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 1999. (2) Incorporated by reference to Registration Statement 333-52-852 on Form S-8. (3) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 1997. (4) Incorporated by reference to Registration Statement 33-37623 on Form S-8. (5) Incorporated by reference to Registration Statement 333-91755 on Form S-8. (6) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 2001. (7) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 2000. 41  /  MSFT 2002 FORM 10-K Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has +duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on September 5, 2002. MICROSOFT CORPORATION By / S /    J OHN G. C ONNORS John G. Connors Senior Vice President; Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed +below by the following persons on behalf of Registrant and in the capacities indicated on September 5, 2002. Signature Title / S /    W ILLIAM H. G ATES , +III William H. Gates, III Chairman of the Board of Directors and Chief Software Architect / S /    S TEVEN A. +B ALLMER Steven A. Ballmer Chief Executive Officer / S /    J AMES I. C ASH , +J R . James I. Cash, Jr. Director / S /    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director / S /    A NN M C L AUGHLIN K OROLOGOS Ann McLaughlin Korologos Director / S /    D AVID F. +M ARQUARDT David F. Marquardt Director / S /    W M . G. R EED , +J R . Wm. G. Reed, Jr. Director / S /    J ON A. +S HIRLEY Jon A. Shirley Director / S /    J OHN G. +C ONNORS John G. Connors Senior Vice President; Chief Financial Officer (Principal Financial and Accounting Officer) CERTIFICATIONS I, Steven A. Ballmer, certify that: 1. I have reviewed this annual report on Form 10-K of Microsoft Corporation; 2. Based on my knowledge, this +annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the +period covered by this annual report; and 3. Based on my knowledge, the financial statements, and other financial information included in this +annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report. Date: September 5, 2002 / S /    S TEVEN A. +B ALLMER Steven A. Ballmer Chief Executive Officer I, John G. Connors, certify that: 1. I have +reviewed this annual report on Form 10-K of Microsoft Corporation; 2. Based on my knowledge, this annual report does not contain any untrue +statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; and 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material +respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report. Date: September 5, 2002 / S /    J OHN G. C ONNORS John G. Connors Chief Financial Officer 42  /  MSFT 2002 FORM 10-K Table of Contents INDEX TO EXHIBITS Exhibit Number Description 3.1 Restated Articles of Incorporation of Microsoft Corporation (1) 3.2 Bylaws of Microsoft Corporation 10.1 Microsoft Corporation 2001 Stock Plan (2) 10.2 Microsoft Corporation 1991 Stock Option Plan (3) 10.3 Microsoft Corporation 1981 Stock Option Plan (4) 10.4 Microsoft Corporation 1999 Stock Option Plan for Non-Employee Directors (5) 10.5 Microsoft Corporation Stock Option Plan for Consultants and Advisors 10.6 Microsoft Corporation 1997 Employee Stock Purchase Plan (6) 10.7 Microsoft Corporation Savings Plus Plan (7) 10.8 Trust Agreement dated June 1, 1993 between Microsoft Corporation and First Interstate Bank of Washington 10.9 Form of Indemnification Agreement 10.10 Resignation Agreement between Richard Belluzzo and Microsoft Corporation 21. Subsidiaries of Registrant 23. Independent Auditors’ Consent 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of +2002 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of +2002 (1) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 1999. (2) Incorporated by reference to Registration Statement 333-52-852 on Form S-8. (3) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 1997. (4) Incorporated by reference to Registration Statement 33-37623 on Form S-8. (5) Incorporated by reference to Registration Statement 333-91755 on Form S-8. (6) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 2001. (7) Incorporated by reference to Annual Report on Form 10-K For The Fiscal Year Ended June 30, 2000. 2002 FORM 10-K \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-98-001067/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-98-001067/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-99-001375/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001032210-99-001375/full-submission.txt new file mode 100644 index 0000000..e69de29 diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-03-045632/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-03-045632/full-submission.txt new file mode 100644 index 0000000..bda147b --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-03-045632/full-submission.txt @@ -0,0 +1,739 @@ +Table of Contents United States Securities and Exchange Commission Washington, +D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2003 ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, +WASHINGTON 98052-6399 (425) 882-8080 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of +the Act: COMMON STOCK Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 +months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information +statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes x No ¨ The aggregate market value of common stock held by non-affiliates of the registrant as of August 15, 2003 was $235,404,995,887. The number of shares outstanding of the registrant’s common stock as of August 15, 2003 was 10,813,984,831. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held November 11, 2003 are incorporated by +reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The +Fiscal Year Ended June 30, 2003 INDEX PART I Item 1. Business 1 Item 2. Properties 7 Item 3. Legal Proceedings 7 Item 4. Submission of Matters to a Vote of Security Holders 7 Executive Officers of the Registrant 8 PART II Item 5. Market for Registrant’s Common Stock and Related Stockholder Matters 9 Item 6. Selected Financial Data 9 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 9 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 18 Item 8. Financial Statements and Supplementary Data 19 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 41 Item 9A. Control and Procedures 41 PART III Item 10. Directors and Executive Officers of the Registrant 41 Item 11. Executive Compensation 41 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 41 Item 13. Certain Relationships and Related Transactions 41 Item 14. Principal Accounting Fees and Services 41 PART IV Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 42 Signatures 43 Table of Contents Part I, Item 1 PART I ITEM 1. Business GENERAL Microsoft Corporation was founded as a partnership in 1975 and incorporated in 1981. Our mission is to +enable people and businesses throughout the world to realize their full potential, and our vision is empowering people through great software – any time, any place, and on any device. We develop, manufacture, license, and support a wide range +of software products for a multitude of computing devices. Our software products include scalable operating systems for servers, personal computers (PCs), and intelligent devices; server applications for client/server environments; information +worker productivity applications; business solutions applications; and software development tools. We provide consulting services and product support services and we train and certify system integrators and developers. We sell the Xbox video game +console, along with games and peripherals. Our online businesses include the MSN subscription and the MSN network of Internet products and services. Microsoft also researches and develops advanced technologies for future software products. A significant portion of our focus is on our .NET architecture. Using common industry standards based on Extensible Markup Language (XML), a +universal language for describing and exchanging data, our goal is to enable seamless sharing of information across many platforms and programming languages, and over the Internet, with XML Web services. In addition, we have embarked on a long-term +initiative called Trustworthy Computing that aims to bring an enhanced level of security, privacy, reliability, and business integrity to computer systems. PRODUCT SEGMENTS We revised our product segments for fiscal year 2003. Our seven product segments are Client, Server and Tools, Information Worker, Microsoft Business Solutions, MSN, Mobile and Embedded Devices, and Home and Entertainment. Changes in our segments are designed to provide management with a comprehensive financial view of our key businesses; promote better alignment of strategies and +objectives among development, sales, marketing, and services organizations; provide for more timely and rational allocation of development, sales, and marketing resources within businesses; focus strategic planning efforts on key objectives and +initiatives; and give business owners more autonomy in detailed planning. See Note 21 of the Notes to Financial Statements for financial information +regarding segment reporting. Prior year segment information has been restated to conform to the seven new segments. Client Client segment includes Windows XP, Windows 2000, and other standard Windows operating systems. Windows XP extends the personal computing experience by uniting PCs, devices, and services, while enhancing reliability, security, and +performance. Windows XP Home Edition is designed for individuals or families and includes capabilities for digital photo, music, video, home networking, and communications. Windows XP Professional includes all the features of Home Edition, plus +remote access, security, performance, manageability, and multilingual features to help users improve productivity and connectivity. Windows XP was the successor to Windows 2000. Client has overall responsibility for product delivery, engineering and technical architecture for the Microsoft Windows operating system, and new media technology, +as well as our relationships with manufacturers of personal computers and non-PC devices, including multinational and regional original equipment manufacturer (OEM) accounts. The segment includes sales and marketing expenses focused on business +development efforts for the Windows platform, as well as integration of our technologies and products into non-PC devices. Server and Tools Server and Tools segment consists of server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes developer tools, training, certification, +Microsoft Press, Premier product support services, and Microsoft consulting services. Microsoft server products offer a comprehensive range of solutions designed to meet the needs of developers and IT professionals, and are designed to flexibly run +the programs and solutions that enable information workers to obtain, analyze, and share information quickly and easily. Microsoft servers provide capabilities ranging from messaging and collaboration to database management and ranging from +e-commerce to mobile information access. Windows Server 2003 is a multipurpose operating system capable of handling a diverse set of server roles in +either a centralized or a distributed fashion. SQL Server is a Web-enabled database and data analysis package, providing core support for XML and the ability to query across the Internet. Microsoft Exchange delivers a reliable, scalable, and +manageable infrastructure with 24×7 messaging and collaboration. Systems Management Server delivers cost-effective, scalable change and configuration management for Windows–based desktop and server systems. Small Business Server is a +network solution that includes the Windows 2003 Server network operating system and is designed to help small businesses. Developer tools focus on coordinating the overall programming model for the client and server, creating tools for the .NET +platform, and fostering synergies between Windows and the Windows Server System offerings. Server and Tools segment includes the integrated product +development and marketing that delivers Microsoft Windows Server System products. In addition, the segment provides information about the extended Microsoft platform through a variety of content offerings, such as web-based training for developers +and IT managers. Through this segment, we offer a broad range of consulting services for advanced technology requirements, including custom solutions services, enterprise application planning, architecture and design services, and proof-of-concept +services. We also provide product support services aligned to our enterprise customers. The Server and Tools segment includes our Enterprise and Partner Group, which is responsible for enterprise sales 1  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 1 strategy, enterprise sales learning and readiness, enterprise solution selling, enterprise partner sales strategy, and enterprise field communications. This group is +also responsible for technical selling, field competitive strategy, and all competitive sales engagements. Information Worker Information Worker segment is +responsible for developing and delivering technologies that focus on improving productivity for information workers in corporations. It consists of the new Microsoft Office System of programs, servers, services, and solutions. Microsoft Office +System is the successor of Microsoft Office XP and is expected to be released to market in the first half of fiscal 2004. The Microsoft Office System includes the Microsoft Office 2003 Editions, which include (depending on the edition): Microsoft +Office Outlook 2003, Microsoft Office Excel 2003, Microsoft Office PowerPoint 2003, Microsoft Office Word 2003, and Microsoft Office Access 2003. Other products in the Microsoft Office System include Microsoft Office Visio 2003, Microsoft Office +Project 2003, Microsoft Office Project Server 2003, Microsoft Office InfoPath 2003, Microsoft Office OneNote 2003, Microsoft Office Publisher 2003, Microsoft Office FrontPage 2003, and Microsoft Office SharePoint Portal Server 2003. Microsoft Office +has evolved from a suite of personal productivity products to a more comprehensive and integrated system of products for information work designed to increase personal, team, and organization productivity. The Microsoft Office System features +integration with Microsoft intranet collaboration technologies, Information Rights Management, and support for industry standard XML. The Information Worker segment also includes Microsoft Office Live Meeting, resulting from our acquisition of +PlaceWare, Inc., Microsoft Office Live Communications Server 2003, and an allocation for CALs. The segment also includes professional product support. The segment includes the Small and Mid-Market Solutions & Partners (SMS&P) organization, which is responsible for sales, partner management, partner programs, and customer segment marketing for the small and mid-market businesses. +In fiscal year 2004, SMS&P group will integrate the sales and marketing assets of the Microsoft Business Solutions segment with the existing Worldwide Small and Medium Business groups. We believe this combined effort will lead to expanded +opportunity for Microsoft and our customers and partners by making available the complete range of Microsoft products and services to small and mid-market businesses, creating increased growth opportunities for the independent software vendor (ISV) +community. Microsoft Business Solutions Microsoft Business Solutions segment includes the businesses of Great Plains, Microsoft bCentral, and +Navision. Microsoft Business Solutions develops and markets a wide range of business applications designed to help small and mid-market businesses become more connected with customers, employees, partners, and suppliers. Microsoft Business Solutions +applications provide end-to-end automation for financial reporting, distribution, project accounting, electronic commerce, human resources and payroll, manufacturing, supply chain management, business intelligence, sales and marketing management, +and customer service and support. Microsoft Business Solutions products are designed to meet the broad spectrum of business application needs of small to mid-market businesses, a group that generally consist of businesses with $1 million to $800 +million in annual revenue. The business solutions are fully and seamlessly integrated across the application areas of enterprise resource management (ERM), customer relationship management (CRM), supply chain management (SCM) and business +intelligence. These business solutions are sold, implemented, and supported through a partner network consisting of more than 4,500 value added resellers, systems integrators, consultants, ISVs, accounting firms (national, regional, and local), +application service providers (ASPs), and eBuilders. Microsoft Business Solutions partners provide strong distribution, marketing, training, and support in the business application customer segment. MSN MSN segment includes MSN Subscriptions and MSN Network services. MSN Subscription services include MSN Internet access and premium services such as +MSN Extra Storage, MSN Bill Pay, MSN Radio Plus and MSN Mobile, which are offered to consumers regardless of their Internet Service Provider. The MSN Network delivers online communication services such as email and online instant messaging through +its MSN Hotmail and MSN Messenger products. It also delivers popular information services, such as MSN Search and content from top partners like MSNBC, ESPN, Expedia, and Access Hollywood. The segment is responsible for building and operating the MSN Network and for delivering MSN Subscription services. Revenue is principally generated from +subscribers to MSN’s Internet access and premium services and from advertisers on the MSN Network. MSN delivers its services direct via its MSN Network and through partnerships with network operators such as Verizon, Qwest, Charter +Communications, and Bell Canada. Mobile and Embedded Devices Mobile and Embedded Devices segment consists of Windows Mobile software, +Windows Embedded device operating systems, MapPoint, and Windows Automotive. Windows Mobile software powers Pocket PC, Pocket PC Phone Edition, and Smartphone products. Windows Embedded, including Windows CE.NET, Windows XP Embedded and Windows NT +Embedded, is a family of operating system software used in non-PC computing devices. Windows Embedded software is used widely in advanced consumer electronics devices including digital televisions, IP-based set top boxes, network gateways, and +portable media players, as well as in enterprise devices including industrial controllers, retail point of sale systems, and voice-over-IP phones. The MapPoint family of location-enabled products and services includes the MapPoint Web Service, a +hosted programmable XML web service that allows developers to integrate location intelligence in applications, business processes and web sites, and business and consumer oriented mapping CD-ROM products. Windows Automotive is an automotive grade +software platform that provides developers with the building blocks to quickly and reliably create a broad range of advanced telematics solutions. Mobile and Embedded Devices segment develops and markets the product lines described above. Further, the segment manages relationships with device manufacturers and with network service providers, including telecommunications, cable and +wireless companies and host and network equipment providers. 2  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 1 Home and Entertainment Home and Entertainment segment includes the Microsoft Xbox video game system, PC games, the Home Products Division (HPD), and TV platform products. +Microsoft Xbox, released in fiscal 2002, is our next-generation video game console system that delivers high quality graphics and audio experiences. We offer several types of entertainment products, including classic software games, online games, +simulations, and sport and strategy games. HPD includes Microsoft’s line of consumer hardware and software products, such as the Encarta line of learning products and services, the Picture It! consumer publishing and productivity line of +products and services, the Macintosh applications business, and the Microsoft hardware products. Home and Entertainment segment oversees development +and business strategy for the Microsoft Xbox video game system, including hardware, third-party games development, games development published under the Microsoft label, Xbox and Xbox Live operations, marketing, research, and sales and support. The +segment leads the development efforts of our HPD product lines. The segment also carries out all retail sales and marketing for Microsoft Office, the Windows operating systems, Xbox, games, and HPD products. The segment is responsible for the +development, sales, and deployment of Microsoft’s TV platform products for the interactive television industry. INTERNATIONAL OPERATIONS Microsoft develops and sells products throughout the world. Our three major geographic sales and marketing organizations are the Americas Region, the Europe, Middle East, and Africa Region, and the Japan and Asia-Pacific +Region. Pressure to globalize our pricing structure might require that we reduce the sales price of our software in the United States and other countries. A number of other factors could also have a negative effect on our business and results from +operations outside of the United States, including changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, +political, labor, or economic conditions in a specific country or region, including foreign exchange rates; difficulties in staffing and managing foreign operations; and potential adverse foreign tax consequences. A portion of international revenue +is hedged, thus offsetting a portion of the currency translation exposure. EQUITY +METHOD INVESTMENTS We have entered into joint venture arrangements to take +advantage of creative talent and content from other organizations. For example, we own 50 percent of MSNBC Cable L.L.C., a 24-hour cable news and information channel, and 50 percent of MSNBC Interactive News L.L.C., an interactive online news +service. National Broadcasting Company (NBC) owns the remaining 50 percent of each of these joint ventures. PRODUCT DEVELOPMENT During fiscal years 2001, 2002, and +2003, research and development expense was $4.38 billion, $4.31 billion, and $4.66 billion, respectively. Those amounts represented 17.3%, 15.2%, and 14.5%, respectively, of revenue in each of those years. During fiscal year 2001, $272 million of +goodwill amortization was included in research and development expense. No goodwill amortization is included in fiscal years 2002 and 2003, in accordance with Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible +Assets. We plan to continue spending significant amounts for research and product development. Most of our software products are developed +internally. We also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We do not believe we are materially dependent upon licenses and other agreements with third +parties relating to the development of our products. Internal development allows us to maintain closer technical control over our products and gives us the freedom to designate which modifications and enhancements are most important and when they +should be implemented. We work to devise innovative solutions in computer science, such as making computers easier to use, designing software for the next generation of hardware, improving the software design process, and investigating the +mathematical underpinnings of computer science. We have created a substantial body of development tools and have evolved development methodologies for creating and enhancing our products. These tools and methodologies are also designed to simplify a +product’s portability among different operating systems, microprocessors, and computing devices. Product documentation is generally created internally. We strive to obtain information at the earliest possible time about changing usage patterns +and hardware advances that may affect software design. Before releasing new software platforms, we provide to application vendors a range of resources and guidelines for development, training, and testing. Microsoft .NET is our strategy and implementation of connecting people, information, systems and devices through the use of Web services. It includes everything +needed to develop and deploy a Web service-connected IT architecture: servers to host Web services (Windows Server System and Windows Server 2003), development tools to create them (Microsoft Visual Studio .NET 2003 and the .NET Framework), +applications and smart devices that use them (Microsoft Office System, smart phones, Pocket PCs and PCs), and a worldwide network of more than 35,000 Microsoft Certified Partner organizations – people whose skills and experience can help +businesses get the most from their IT investments. Built on industry standards, Web services enable applications to communicate and share data over the Internet or an intranet, regardless of operating system or programming language. We believe that establishing trust in computing will be critical to our future success. Trustworthy Computing means helping ensure a safe and reliable computing +experience that is both expected and taken for granted. Achieving Trustworthy Computing will require the collaboration of hardware and software companies, academic and government research institutions, and policy leaders. For us, Trustworthy +Computing is a company-wide initiative aimed at changing how we do business that will take fundamental research and advances in engineering, as well as changes to business culture and business processes to accomplish. We think there are four factors +that affect the level of trust that people place in computing: Security, Privacy, Reliability, and Business Integrity. Security means the customer can expect that systems are resilient to attack, and that the confidentiality, integrity, and +availability of the system and its data are protected. Privacy means the customer is able to control personal information and feel confident it is not only safe and used appropriately, but in a way that provides value. A reliable system or 3  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 1 service is one the customer can depend on to fulfill its functions. Business Integrity involves being responsive to customers, addressing problems effectively with +products or services, and being transparent and responsive in customer interactions. To serve the needs of users around the world, we +“localize” many of our products to reflect local languages and conventions and to improve the quality and usability of the product in international markets. Localizing a product may require modifying the user interface, altering dialog +boxes, and translating text. MANUFACTURING We contract out most of our manufacturing activities to third parties. Outside manufacturers produce +the Xbox, various retail software packaged products, and hardware. Our products may include some components that are available from only one or from limited sources. Key components that are currently obtained from a single source include the Xbox +central processing unit (CPU) from Intel Corporation and the Xbox graphics processing unit (GPU) from NVIDIA Corporation. With the exception of the Xbox CPU and GPU, we generally have the ability to use other custom manufacturers if the current +manufacturing vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components and are often able to acquire component parts and materials on a volume discount basis. OPERATIONS We have regional operations centers in Ireland, Singapore, and the greater Seattle area. The centers support all operations in their regions, +including information processing and vendor management and logistics. The regional center in Dublin, Ireland supports the Europe, Middle East, and Africa region, the center in Singapore supports the Japan and Asia-Pacific region, and the center in +the greater Seattle area supports North and South America. Microsoft Licensing, Inc., a wholly-owned subsidiary in Reno, Nevada, manages our original equipment manufacturer (OEM) and certain organizational licensing operations. DISTRIBUTION, SALES AND MARKETING We distribute our products primarily through the following channels: OEM; distributors and resellers; and online services and products. Our three +major geographic sales and marketing organizations are the Americas Region; the Europe, Middle East, and Africa Region; and the Japan and Asia-Pacific Region. OEM Microsoft operating systems are licensed primarily to OEMs under agreements that grant the OEMs the right to distribute copies of our products with their computing devices, principally PCs. We also market and license certain server +operating systems, desktop applications, hardware devices, and consumer software products to OEMs under similar arrangements. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, +Actebis, Dell, eMachines, Fujitsu, Fujitsu Gateway, HP, IBM, NEC, Samsung, Siemens Computers, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume customized PC vendors. Distributors and Resellers We distribute our finished goods products primarily through independent non-exclusive distributors, +authorized replicators, resellers and retail outlets. Organizations license our products primarily through Large Account Resellers (LARs), Direct Market Resellers (DMRs), and value added resellers. Many organizations that license products through +Enterprise Agreements (EAs) now transact directly with us with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors are also typically authorized as LARs and operate as resellers for our other +licensing programs. Although all of our types of reselling partners reach organizations of all sizes, LARs are primarily engaged with large organizations and value added resellers typically reach the breadth of small and medium sized organizations. +Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include Software Spectrum, Software House International, Dell, CDW, and Insight Enterprises. Individual consumers obtain our products primarily through +retail outlets including Best Buy, Wal-Mart, and Target. We have a network of field sales representatives and field support personnel who solicit orders from distributors and resellers and provide product training and sales support. We license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of product. These arrangements are designed to +provide organizations with a means of acquiring multiple licenses, without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to +provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they are as follows: Open. Targeted at small to medium organizations, this program allows customers to acquire perpetual licenses and, at the +customer’s election, rights to future versions of software products, over a specified time period (generally two years). The offering that conveys rights to future versions of software product is called Software Assurance. Software Assurance +also provides support, tools, and training to help customers deploy and use software efficiently. Under the Open program, customers can acquire licenses only or licenses with Software Assurance. They can also renew Software Assurance upon the +expiration of existing volume licensing agreements. Select. Targeted at medium to large organizations, this program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future +versions of software products, support, tools, and training, over a specified time period (generally three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software +Assurance upon the expiration of existing volume licensing agreements. Enterprise Agreement. The Enterprise Agreement is targeted at large organizations that want to acquire perpetual licenses to software products for their entire enterprise along with rights to future versions of +software products over a three year period. 4  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 1 Enterprise Subscription Agreement. The Enterprise +Subscription Agreement (ESA) is a time-based, multi-year licensing arrangement. Under an ESA, customers acquire the right to use the current version of software products and the future versions that are released during the three year term of the +arrangement. At the end of the arrangement term, customers may either renew their ESA arrangement or exercise a buy-out option to obtain perpetual licenses for the latest version of the covered products. If they do not elect one of these options, +then all covered software must be uninstalled. Online Services and +Products We distribute online content and services through MSN Subscription +services, MSN Network services, bCentral small business portal, and other online services. MSN Subscription services deliver Internet access and other premium services and tools to consumers. MSN Network services deliver online email and messaging +communication services as well as information services such as online search and premium content. The bCentral portal provides tools and expertise for small business owners to build, market and manage their businesses online. Other services +delivered online include Microsoft Developer Networks (MSDN) subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling Microsoft products and +solutions. CUSTOMERS Our customers include individual consumers, small- and medium-size organizations, enterprises, +governmental institutions, educational institutions, Internet Service Providers, application developers, and OEMs. Consumers and small- and medium-size organizations obtain Microsoft products primarily through resellers and OEMs. No single customer +accounted for 10% or more of revenue in 2001, 2002, or 2003. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. COMPETITION The software business is intensely competitive and subject to rapid technological change, evolving customer requirements, and changing business +models. We face significant competition in all areas of our current business activities. The rapid pace of technological change continually creates new opportunities for existing competitors and start-ups and can quickly render existing technologies +less valuable. Customer requirements and preferences continually change as other information technologies emerge or become less expensive, and as emerging concerns such as security and privacy become of paramount concern. We face direct competition +with firms adopting alternative business models to the commercial software model. Firms adopting the Open Source model typically provide customers with Open Source software at nominal cost and earn revenue on complimentary services and products, +without having to bear the full costs of research and development for the Open Source software. Additionally, global software piracy – the unlawful copying and distribution of our copyrighted software products – deprives us of large +amounts of revenue on an annual basis. Further, the existing versions of our products licensed to our installed base of users compete with future versions. This means that future versions must deliver significant additional value in order to induce +existing customers to purchase a new version of our product. Our competitive position may be adversely affected in the future by one or more of the +factors described in this section. Client Although we are the leader in operating system software products, we face strong competition from well +established companies and entities with differing approaches to the market. Competing commercial software products, including variants of Unix, are supplied by competitors, such as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and others, +who are vertically integrated in both software development and hardware manufacturing and have developed operating systems that they preinstall on their own computers. Personal computer OEMs who preinstall third party operating systems may also +license these firms’ operating systems or Open Source software, especially offerings based on Linux. Variants of Unix run on a wide variety of computer platforms and have gained increasing acceptance as desktop operating systems, in part due to +the increasing performance of standard hardware components at decreasing prices. The Linux open source operating system, which is also derived from Unix and is available without payment under a General Public License, has gained increasing +acceptance as its feature set increasingly resembles the distinct and innovative features of Windows and as competitive pressures on personal computer OEMs to reduce costs continue to increase. The Microsoft Windows operating systems also face +competition from alternative platforms such as those based on Internet browsing software and Java technology promoted by Sun Microsystems, as well as innovative form factors that may reduce consumer demand for traditional personal computers. We +believe our operating system products compete effectively by delivering better innovation, overall value, an easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any +operating system. Server and Tools Our server operating system products face intense competition from a wide variety of competing server +operating systems and server applications offered by firms with a variety of market approaches. Several vertically integrated computer manufacturers, such as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and others offer their own variant +of Unix preinstalled on server hardware, and virtually all computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsement of Linux has accelerated its acceptance as an alternative to both traditional Unix and +Windows server operating systems. Linux’s competitive position has also benefited from the large number of compatible applications now produced by many leading commercial software developers as well as Open Source community developers. A number +of companies supply versions of Linux, including Red Hat and VA Linux. We compete in the business of providing enterprise-wide computing solutions +with several companies that provide competing solutions as well as middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that +provide competing server applications for the PC-based 5  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 1 distributed client/server environments include Oracle, IBM, Computer Associates, Sybase, and Informix. There are also a number of Open Source server applications +available. Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), +security, hosting, and e-business servers. Additionally, IBM has a large installed base of Lotus Notes and cc:Mail, both of which compete with our collaboration and email products. There are also a significant number of Open Source software products +that compete with Microsoft solutions, including Apache Web Server. The Open Source model of Linux and other server programs enables both services +and hardware companies to provide customers with Open Source software at nominal cost and earn revenue on complimentary services and products, without having to bear the full costs of research and development for the Open Source software. For +example, IBM, with the largest hardware and services businesses in the industry, promotes Linux extensively and seeks to earn revenues and profits on the sale of its consulting services to implement the Linux server solution as well as related +hardware and commercial software products that run on Linux. Our developer products compete against offerings from BEA Systems, Borland, IBM, +Macromedia, Oracle, Sun Microsystems, Sybase, and other companies. We believe that our server products provide customers with significant advantages +in innovation, performance (both relative to total costs of ownership and in absolute terms), productivity, applications development tools and environment, compatibility with a broad base of hardware and software applications, security, and +manageability. Information Worker While we are the leader in business productivity software applications, competitors to +the Microsoft Office System include many software application vendors, such as Apple, Corel, IBM, Oracle, QUALCOMM, Sun Microsystems, and local application developers in Europe and Asia. IBM and Corel have significant installed bases with their +spreadsheet and word processor products, respectively, and both have aggressive pricing strategies. Also, Apple and IBM preinstall certain of their application software products on various models of their PCs, competing directly with our +applications. Corel’s suite and Sun Microsystems’ Star Office are aggressively priced and attractive for OEMs to pre-install on low-priced PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that is +gaining popularity in certain market segments. In addition to traditional client-side applications, web-based applications hosting services such as SimDesk provide an alternative to Microsoft Office and are gaining some support. We believe that our +products compete effectively by providing customers significant benefits, such as easy-to-use personal productivity, support for effective teaming and collaboration, and better information management and control. Microsoft Business Solutions The small and mid-market business applications market globally is highly fragmented and is intensely +competitive in all sectors. We face competition from a large number of companies in this business. Well-known vendors focused on small and mid-market business, such as Intuit and Sage, compete against us for a portion of this segment. In addition, +large-enterprise focused vendors, such as Oracle, Peoplesoft and SAP, also compete against us for a portion of this segment. However, the competition for a significant majority of the total business applications market includes thousands of much +smaller vendors in specific localities or industries who offer their own enterprise resource planning, customer relationship management, and/or analytic solutions. MSN MSN competes with AOL-Time Warner, Google, Yahoo!, and a vast array of Web sites and portals that offer content of all types, such as email, instant messaging, calendaring, chat, +search, and shopping services. As the broadband access market grows, we expect to have increasing opportunity to deliver premium subscription services for consumers. AOL and Yahoo! are both pursuing similar strategies and will be competitors in this +emerging category. While the movement to broadband access may cause our Internet Access dial-up business to continue to decline, we will strive to convert customers to MSN premium subscription services via partnerships with network providers and +Internet software services offered directly from MSN. We believe our strengths are our heritage of technology innovation, particularly in communication services, distribution partnerships, and the large base of users of our free MSN Network. +Additionally, while our advertising business has grown considerably over the last year, evolving market conditions, particularly paid search, will impact our strategy over the next year. We currently are building our own search engine and investing +to support the continued growth of our advertising business. Mobile and Embedded +Devices Windows Mobile software faces substantial competition from Nokia, +Openwave Systems, PalmSource, QUALCOMM, and Symbian. The embedded operating system market is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors, +such as Metrowerks and MontaVista Software. MapPoint competitors include DeLorme, MapInfo, Mapquest.com, Rand McNally, Webraska Mobile Technologies, and Yahoo!. The telematics market is also highly fragmented, with competitive offerings from IBM and +automotive suppliers building on various real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others. Home and Entertainment The home and entertainment business is highly competitive and is characterized by limited platform life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our +products are characterized by significant price competition, and we anticipate continued pricing pressure from our competitors. These pressures have, from time to time, required us to reduce prices on certain products. Our competitors vary in size +from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of price, product quality and variety, timing of product releases, and +effectiveness of distribution and marketing. 6  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 1, 2, 3, 4 Our Xbox hardware business competes with console platforms from Nintendo and Sony, +both of which have a large established base of users. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that have been licensed by Microsoft to develop and publish +software for the Xbox console. These competitors include Acclaim Entertainment, Activision, Atari, Capcom, Eidos, Electronic Arts, Sega, Take-Two Interactive, Tecmo, THQ, and Ubi Soft, among others. Success in the games business is increasingly +driven by hit titles, which are difficult to develop and require substantial investments in development and marketing. In addition, other forms of entertainment, such as music, motion pictures, and television, compete against our entertainment +software for consumer spending. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. EMPLOYEES As of June 30, 2003, we employed approximately 55,000 people on a full-time basis, 36,500 in the United States and 18,500 internationally. Of the total, 23,200 were in product +research and development, 25,100 in sales, marketing, and support, 2,400 in manufacturing and distribution, and 4,300 in finance and administration. Our success is highly dependent on our ability to attract and retain qualified employees. +Competition for employees is intense in the software industry. We believe we have been successful in our efforts to recruit qualified employees, but we cannot guarantee that we will continue to be as successful in the future. None of our employees +are subject to collective bargaining agreements. We believe that our relations with our employees are excellent. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to those reports, as soon as +reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Our SEC reports can be accessed through the investor relations section of our Web site. The information found on our Web site is not part of this or +any other report we file with or furnish to the SEC. ITEM 2.    Properties Our corporate +offices consist of approximately 9.0 million square feet of office building space located in King County, Washington, of which 6.1 million square feet is corporate campus space situated on slightly more than 300 acres of land which is owned and +approximately 2.9 million square feet which is leased. We are constructing one building with approximately 302,000 square feet of space that will be occupied in the second quarter of fiscal year 2004. To accommodate future expansion needs we +purchased approximately 38 acres, and have an option to purchase approximately 112 additional acres, of land in Issaquah, Washington, which can accommodate 2.9 million square feet of additional office space. We own approximately 594,000 square feet +of office building space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 3.4 million square feet of office building space. We lease many sites internationally totaling approximately 5.4 million square feet, including our European Operations Center and localization division that leases a +411,000 square-foot campus in Dublin, Ireland, a 54,000 square-foot disk duplication facility in Humacao, Puerto Rico, and a 36,000 square-foot facility in Singapore for our Asia Pacific Operations Center. Leased office building space includes the +following locations: Tokyo, Japan 343,000 square feet; Unterschleissheim, Germany 381,000 square feet; United Kingdom campus 242,000 square feet; Les Ulis, France 229,000 square feet; Vedbaek, Denmark 186,000 square feet; Mississauga, Canada 160,000 +square feet; Taipei, Taiwan 116,000 square feet; Sydney, Australia 116,000 square feet; and Beijing, China 115,000 square feet. Our facilities are +fully used for current operations of all segments and suitable additional space is available to accommodate expansion needs. ITEM 3.    Legal Proceedings See Note +20—Contingencies of the Notes to Financial Statements (Item 8) for information regarding legal proceedings. ITEM 4.    Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2003. 7  /  MSFT 2003 FORM 10-K Table of Contents Part I, Item 4 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as +of September 4, 2003 were as follows: Name Age Position with the Company William H. Gates III 47 Chairman, Chief Software Architect Steven A. Ballmer 47 Chief Executive Officer James E. Allchin 51 Group Vice President, Platforms Group Robert J. (Robbie) Bach 41 Senior Vice President, Home and Entertainment Douglas J. Burgum 47 Senior Vice President, Microsoft Business Solutions David W. Cole 41 Senior Vice President, MSN and Personal Services Group John G. Connors 44 Senior Vice President, Chief Financial Officer Jean-Philippe Courtois 43 Senior Vice President, Chief Executive Officer, Microsoft Europe, Middle East, and Africa Kenneth A. DiPietro 44 Corporate Vice President, Human Resources Kevin R. Johnson 42 Group Vice President, Worldwide Sales, Marketing and Services Michelle (Mich) Mathews 36 Corporate Vice President, Marketing Craig J. Mundie 54 Senior Vice President, Chief Technical Officer, Advanced Strategies and Policy Jeffrey S. Raikes 45 Group Vice President, Productivity and Business Services Eric D. Rudder 36 Senior Vice President, Server and Tools Bradford L. Smith 44 Senior Vice President, General Counsel and Secretary David Vaskevitch 51 Senior Vice President, Chief Technical Officer, Business Platforms Mr. Gates co-founded Microsoft +in 1975 and served as its Chief Executive Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates has +served as Chairman since our incorporation. Mr. Ballmer was named Chief Executive Officer and a director of the Company in January 2000. He served as +President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined  Microsoft in 1980. Mr. Allchin was named Group Vice President, Platforms Group in December 1999. He had been Senior Vice President, Platforms since March 1999. He was previously Senior Vice President, Personal and Business Systems since February +1996. Mr. Allchin joined Microsoft in 1990. Mr. Bach was named Senior Vice President, Home and Entertainment in March 2000. He had been Vice +President, Home and Retail since March 1999. Before holding that position, he had been Vice President, Learning, Entertainment and Productivity and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988. Mr. Burgum joined the Company upon Microsoft’s acquisition of Great Plains Software, Inc. in April 2001. Mr. Burgum became Great Plains’ +first outside investor in March 1983. He was named President of Great Plains in 1984 and subsequently named Chairman and Chief Executive Officer. Mr. +Cole was named Senior Vice President, MSN and Personal Services Group in November 2001. Before holding that position, he had been Senior Vice President, Services Platform Division since August 2000. He had been Senior Vice President, Consumer +Services since December 1999 and Vice President, Consumer Windows since March 1999. Previously, he was Vice President, Web Client and Consumer Experience and Vice President, Internet Client and Collaboration. Mr. Cole joined Microsoft in 1986. Mr. Connors was named Senior Vice President and Chief Financial Officer in December 1999. He had been Vice President, Worldwide Enterprise Group +since March 1999. Mr. Connors had been Vice President, Information Technology Group, and Chief Information Officer since July 1996. He joined Microsoft in 1989. Mr. Courtois was named Senior Vice President and Chief Executive Officer, Microsoft Europe, Middle East, and Africa in March 2003. He had been Senior Vice President and President, Microsoft Europe, Middle East, and Africa since +July 2000. Before holding that position, he had been Vice President, Worldwide Customer Marketing since July 1998. Mr. Courtois joined Microsoft in 1984. Mr. DiPietro joined Microsoft in January 2003 as Corporate Vice President, Human Resources. Prior to joining Microsoft, he was Vice President of Human Resources for the Americas at Dell Computer Corporation. Before joining Dell, he was +Senior Vice President of Human Resources at Pepsi-Cola International. Mr. Johnson was named Group Vice President, Worldwide Sales, Marketing and +Services in March 2003. He had been Senior Vice President, Microsoft Americas since February 2002. Mr. Johnson had been Senior Vice President, U.S. Sales, Marketing, and Services since August 2001, and before that, Vice President, U.S. Sales, +Marketing and Services. He joined Microsoft in 1992. Ms. Mathews was named Corporate Vice President, Marketing in August 2001. Before holding her +current position, Ms. Mathews had been Vice President Corporate Public Relations since 1999. Ms. Mathews joined Microsoft in 1993. Mr. Mundie +was named Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy in August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. He joined Microsoft in 1992. Mr. Raikes was named Group Vice President, Productivity and Business Services in August 2000. He had been Group Vice President, Sales and Support since July 1998. +Mr. Raikes joined Microsoft in 1981. Mr. Rudder was named Senior Vice President, Developer and Platform Evangelism in October 2001. He had been Vice +President, Technical Strategy. Mr. Rudder joined Microsoft in 1988. Mr. Smith was named Senior Vice President, General Counsel and Secretary in +November 2001. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing our European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993. Mr. Vaskevitch was named Senior Vice President and Chief Technical Officer, Business Platform in August 2001. He had been Senior Vice President, Business +Applications since March 2000. Mr. Vaskevitch had been Senior Vice President, Developer since December 1999. Before holding that position, he had been Vice President, Distributed Applications Platform. He joined Microsoft in 1986. 8  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 5, 6, 7 PART II ITEM 5. Market for Registrant’s Common Stock and Related Stockholder Matters Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 15, 2003, there were 131,580 registered holders of record of our common stock. The high and low common stock prices per share were as +follows: Quarter Ended Sept. 30 Dec. 31 Mar. 31 June 30 Year Fiscal 2002 Common stock price per share (1) : High $ 36.29 $ 34.75 $ 34.93 $ 30.19 $ 36.29 Low 24.86 25.90 29.00 24.31 24.31 Fiscal 2003 Common stock price per share (1) : High $ 27.43 $ 29.12 $ 28.49 $ 26.37 $ 29.12 Low 21.42 21.89 22.80 23.67 21.42 (1) Amounts have been restated to reflect a two-for-one stock split in February 2003. In January 2003, our Board of Directors declared our first annual common stock dividend, of $0.08 per share, which was paid in March 2003. Our dividend policy is impacted by, among +other items, our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our +business model. In connection with Microsoft’s acquisition of Navision a/s, pursuant to a voluntary offer to acquire all Navision ordinary +shares, Microsoft issued 29.1 million shares of its common stock to Navision shareholders on July 12, 2002, in exchange for 19.4 million Navision ordinary shares, nominal value DKK 1 per share. The price paid by Microsoft in connection with the +offer was DKK 300 per each Navision share, payable at each Navision shareholder’s election in either cash or Microsoft shares, on the basis of an exchange ratio of 1.49982 shares of Microsoft common stock for each Navision ordinary share. These +issuances of Microsoft common stock were not registered under the Securities Act of 1933 on the basis of the exemption provided by Rule 802 thereunder. Rule 802 exempts offers and sales in an exchange offer for a class of securities of a foreign +private issuer in a business combination transaction, if certain conditions are met. Since the completion of the acquisition, we have issued 23,009 shares of our common stock to 16 employees in exchange for 10,136 ordinary shares of Navision that +were acquired upon exercise of warrants and stock options issued to employees of Navision and its subsidiaries that were outstanding at the time of the acquisition. The issuances were not registered under the Securities Act. ITEM 6. Selected Financial Data Financial Highlights (In millions, except earnings per share) Year Ended June 30 1999 2000 2001 (2) 2002 (3) 2003 (4) Revenue $ 19,747 $ 22,956 $ 25,296 $ 28,365 $ 32,187 Operating income 10,010 11,006 11,720 11,910 13,217 Income before accounting change 7,785 9,421 7,721 7,829 9,993 Net income 7,785 9,421 7,346 7,829 9,993 Diluted earnings per share before accounting change (1) 0.71 0.85 0.69 0.70 0.92 Diluted earnings per share (1) 0.71 0.85 0.66 0.70 0.92 Cash dividends per share – – – – 0.08 Cash and short-term investments 17,236 23,798 31,600 38,652 49,048 Total assets 38,321 51,694 58,830 67,646 79,571 Stockholders’ equity 28,438 41,368 47,289 52,180 61,020 (1) Earnings per share have been restated to reflect a two-for-one stock split in February 2003. (2) Fiscal year 2001 includes an unfavorable cumulative effect of accounting change of $375 million or $0.03 per diluted share, reflecting the adoption of SFAS No. 133, and $4.80 billion +(pre-tax) in impairments of certain investments, primarily cable and telecommunication investments. (3) Fiscal year 2002 includes $4.32 billion (pre-tax) in impairments of certain investments, primarily related to our AT&T investment and further declines in the fair values of European cable +and telecommunications holdings, and a $1.25 billion (pre-tax) gain on the sale of Expedia, Inc. (4) Fiscal year 2003 includes $1.15 billion (pre-tax) in impairments of certain investments. ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Results of Operations for 2001, 2002, and 2003 Management’s Discussion and Analysis (MD&A) contains statements that are forward-looking. These statements are based on current expectations and assumptions that are +subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Issues and Uncertainties” and elsewhere in this report. 9  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 REVENUE Our revenue growth rate was 10% in fiscal 2001, 12% in fiscal 2002, and 13% in fiscal 2003. Revenue growth in fiscal 2003 was driven primarily by +multi-year licensing that occurred before the transition to our new licensing program (Licensing 6.0) in the first quarter of fiscal 2003. Prior to the July 31, 2002 transition date to Licensing 6.0, we experienced significant growth in multi-year +licensing arrangements as customers enrolled in our maintenance programs, including Upgrade Advantage and Software Assurance. The revenue growth also reflected a $933 million or 13% increase associated with OEM licensing of Microsoft Windows +operating systems and a $309 million or 23% increase in revenue from Microsoft Xbox video game consoles. Revenue growth in fiscal 2002 was led by the addition of $1.35 billion of Xbox video game system revenue and $1.20 billion of revenue growth +from Microsoft Windows XP Professional and Home operating systems. Revenue growth in fiscal 2001 was driven primarily by licensing of Microsoft Windows 2000 Professional with $1.01 billion growth in revenue from Professional operating systems, and +Server and Tools revenue growth of $852 million. During the second quarter of fiscal 2002, we launched a new licensing program, Licensing 6.0, for +volume licensing customers. Licensing 6.0 simplifies and improves our volume licensing program with Software Assurance, which gives customers the right to install any new release of products covered in the licensing agreement during the term of +their coverage. The level of customer adoption of our new volume licensing programs will affect the mix of multi-year licensing agreements with a resulting impact on the timing of revenue recognition. In addition, the timing and extent of a recovery +in consumer and corporate spending on PCs and information technology will be factors affecting revenue growth. CONSOLIDATED OPERATING INCOME Operating income grew 6% in +fiscal 2001, 2% in fiscal 2002, and 11% in fiscal 2003. In fiscal 2003, the growth in operating income reflected an increase of $3.82 billion in revenue, partially offset by an increase of $2.52 billion in operating expenses, primarily related to +employee and related costs associated with additional headcount and increased legal settlement expenses. In fiscal 2002, the growth in operating income reflected an increase of $3.07 billion in revenue, substantially offset by an increase of $2.88 +billion in operating expenses, which included the onset of costs related to Xbox video game systems. In fiscal 2001, the growth in operating income reflected an increase of $2.34 billion in revenue, partially offset by an increase of $1.63 billion +in operating expenses. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) We revised our segments for fiscal year 2003. Our seven segments are: · Client · Server and Tools · Information Worker · Microsoft Business Solutions · MSN · Mobile and Embedded Devices · Home and Entertainment The revenue and operating income/(loss) amounts in this MD&A are presented in accordance with U.S. GAAP. Segment Information appearing in Note 21 of the Notes +to Financial Statements are presented in accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related Information . The following table presents our segment revenue and operating income, determined in accordance with U.S. GAAP: (In millions) Revenue Operating Income/(Loss) Year Ended June 30 2002 2003 2002 2003 Client $ 9,360 $ 10,394 $ 7,576 $ 8,400 Server and Tools 6,157 7,140 2,048 2,457 Information Worker 8,212 9,229 6,448 7,037 Microsoft Business Solutions 308 567 (176 ) (254 ) MSN 1,571 1,953 (641 ) (299 ) Mobile and Embedded Devices 112 156 (157 ) (157 ) Home and Entertainment 2,453 2,748 (874 ) (924 ) Other 192 — (2,314 ) (3,043 ) Consolidated $ 28,365 $ 32,187 $ 11,910 $ 13,217 Client Client revenue was $8.17 billion, $9.36 billion, and $10.39 billion in 2001, 2002, and 2003. Client +includes revenue from Windows XP Professional and Home, Windows 2000 Professional, and other standard Windows operating systems. In 2003, Client revenue growth was driven by OEM licensing revenue growth of $933 million and a 9 percentage point +increase of the mix of the higher priced Windows Professional operating systems, the majority of which was in the OEM channel. Windows Professional revenue growth for fiscal 2003 was $1.59 billion or 31% compared to fiscal 2002, partially offset by +a $573 million decline in revenue of 10  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 earlier versions of Windows operating systems. Client operating profit for fiscal 2003 increased 11% primarily as a result of the 11% growth in revenue, partially +offset by an increase in operating expenses, largely attributed to headcount additions and related costs. In fiscal 2002, the growth in Client +revenue reflected strong multi-year licensing revenue growth and a continued shift of sales to the higher priced Windows 2000 and Windows XP Professional operating system licensed through OEMs. OEM revenue grew $939 million, despite a 5% decline in +reported OEM unit shipments. Fiscal 2001 revenue growth reflected the strong adoption of Windows 2000 Professional with professional operating systems revenue growth of $1.01 billion and a 7 percentage point mix increase to the higher priced Windows +2000 Professional and Windows NT Workstation operating systems, and a $91 million increase in revenue from Windows Me and Windows 98 operating systems. We do not expect the revenue growth attributed to the mix toward the higher priced Windows Professional operating system to continue at previous levels into fiscal 2004. Additionally, variability between the reported OEM unit shipments and +the underlying PC Market may continue as a result of the transition to new OEM licensing terms at the beginning of fiscal year 2003, under which OEMs are billed upon their acquisition of Certificates of Authenticity (COAs) rather than upon the +shipment of PCs to their customers. Server and Tools Server and Tools revenue was $5.84 billion, $6.16 billion, and $7.14 billion in 2001, 2002, and 2003. +Server and Tools consists of server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes developer tools, training, certification, Microsoft Press, Premier product +support services, and Microsoft consulting services. Total Server and Tools revenue grew $983 million or 16% in fiscal 2003, driven by an increase in Windows-based server shipments and growth in SQL Server and Exchange revenue. Server revenue, +including CALs, grew $787 million or 18% from fiscal 2002 as a result of increased new and anniversary multi-year licensing agreements. Consulting and Premier product support services increased $91 million or 10% compared to fiscal 2002. Revenue +from developer tools, training, certification, Microsoft Press and other services increased $105 million or 13%. Server operating profit for fiscal 2003 grew 20%, primarily as a result of the 16% increase in revenue. In fiscal 2002, Server and Tools revenue increased 5% compared to fiscal 2001. Server revenue, including CALs, increased 9% versus fiscal 2001, driven by a 5% +overall increase in Windows-based server shipments and increased deployment of Windows 2000 Server. Consulting and Premier product support services revenue was up $137 million or 17% compared to fiscal 2001, while revenue from developer tools, +training, certification, Microsoft Press and other services was down $183 million or 18% from fiscal 2001. In fiscal 2001, Server and Tools revenue increased $852 million or 17% versus the prior year, as a result of the continued adoption of the +Microsoft Enterprise Server offerings. Information Worker Information Worker revenue was $8.42 billion, $8.21 billion, and $9.23 billion in 2001, 2002, and +2003. Information Worker includes revenue from Microsoft Office, Microsoft Project, Visio, other information worker products, SharePoint Portal Server CALs, and professional product support services. The $1.02 billion or 12% increase in Information +Worker revenue in fiscal year 2003 compared to fiscal 2002, was primarily due to growth in Office suites revenue associated with new and anniversary multi-year licensing agreements and a $264 million or 28% increase in revenue from the combined +total of Project, Visio, and other standalone applications. Information Worker operating profit for fiscal year 2003 grew 9% compared to fiscal year 2002 led by the 12% increase in revenue, partially offset by a 24% growth in operating expenses +related to headcount additions and marketing expenses. In fiscal 2002, Information Worker licensing revenue declined $228 million or 3% during the +year due to a shift in the sales mix to multi-year licensing agreements, which deferred revenue recognition to future years, and a $294 million or 14% decrease in consumer purchases in the Asia-Pacific region, most notably Japan, partially offset by +a $189 million or 22% growth in OEM licensing revenue. In fiscal 2001, Information Worker revenue growth was less than 1% or $30 million. Microsoft Business Solutions Microsoft Business Solutions revenue was $106 million, $308 million, and $567 million in 2001, 2002, and 2003. Microsoft Business Solutions includes Microsoft Great Plains, +Navision, and bCentral. Microsoft Business Solutions revenue for fiscal 2003 grew $259 million from fiscal 2002, of which $246 million was attributable to the acquisition of Navision at the beginning of the fiscal year. Microsoft Business +Solutions operating loss for fiscal 2003 increased 44%, primarily due to operating losses associated with Navision, increases in sales and marketing expenses, research and development expenses, and acquisition related costs. MSN MSN revenue was $1.32 billion, $1.57 billion, and $1.95 billion in 2001, 2002, and 2003. MSN includes MSN Subscriptions and MSN Network services. +Although total MSN subscribers at the end of fiscal 2003 were flat compared to the end of fiscal 2002, MSN Subscriptions revenue grew $112 million or 11% in fiscal year 2003 reflecting an increase in the number of non-promotion subscribers. MSN +Network services revenue grew $270 million or 48% in fiscal 2003 as a result of growth in paid search and strong general advertising sales across all geographic regions. MSN operating loss for fiscal 2003 decreased 53%, primarily as a result of the +growth in revenue and lower relative subscription acquisition and support costs. In fiscal 2002, MSN Subscriptions revenue increased $229 million or +29% as a result of both a higher subscriber base and higher average revenue per subscriber due to a reduction in promotional subscriber programs. Revenue from MSN Network services increased $27 million or 5% led by online advertising. In fiscal +2001, revenue from MSN Network services grew $197 million or 58% led by online advertising. MSN Subscriptions revenue also grew $141 million or 22% from fiscal 2000 as a result of an increased subscriber base, partially offset by a decline in the +average revenue per subscriber due to a larger mix of subscribers contracted under rebate programs. 11  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 Mobile and Embedded Devices Mobile and Embedded Devices revenue was $86 million, $112 million, and $156 million in 2001, 2002, and +2003. Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. Revenue for fiscal 2003 grew $44 million driven by increased Pocket PC shipments and MapPoint licensing. +Operating loss for fiscal 2003 was flat with the prior year as higher marketing expenses and headcount-related costs associated with product development offset the growth in revenue. Prior year revenue and operating loss for Mobile and Embedded +Devices have been restated to reflect the reorganizations of MapPoint from Information Worker and Windows embedded device operating systems from Client to Mobile and Embedded Devices. Home and Entertainment Home and Entertainment revenue was $1.14 billion, $2.45 billion, and $2.75 billion in 2001, 2002, and 2003. Home & Entertainment includes the Xbox video game system, PC games, +consumer software and hardware, and TV platform. Home and Entertainment revenue increased $295 million, as a result of sales of Xbox video game systems and related games which were available for all of fiscal 2003. Xbox revenue grew $309 million or +23% in fiscal 2003 reflecting a $779 million increase from higher volumes for Xbox consoles, games, and peripherals partially offset by a $470 million decrease due to price changes. Revenue from consumer hardware and software and PC games declined +$14 million or 1% in fiscal 2003. Operating loss for fiscal 2003 increased 6% from the prior year as the product costs associated with the increased Xbox console sales and increased marketing expense more than offset the 12% increase in revenue. In fiscal 2002, Home and Entertainment revenue growth from fiscal 2001 stemmed from $1.35 billion of sales of the Xbox video game system released in +fiscal 2002. Learning and productivity software revenue and PC and online games declined $39 million or 3% in fiscal 2002 compared to fiscal 2001. In fiscal 2001, Home and Entertainment revenue declined $214 million or 16% from fiscal 2002. Other Revenue in the Other segment represents our majority ownership of Expedia, Inc., which was sold in February 2002, resulting in a decline in revenue +from fiscal 2001. Acquisitions of Travelscape.com and VacationSpot.com by Expedia, Inc. in fiscal 2001 and increased product offerings from Expedia led to the strong revenue growth in fiscal 2001. Operating loss includes Expedia, Inc. revenue and operating expenses, general and administrative expenses ($1.55 billion in 2002 and $2.10 billion in 2003), +broad-based research and development expenses ($202 million in 2002 and $210 million in 2003), and certain corporate level sales and marketing costs ($526 million in 2002 and $688 million in 2003). Foreign Currencies Impact Our operating results are affected by foreign exchange rates. Approximately 27%, 25%, and 28% of our revenue was collected in foreign currencies +during 2001, 2002, and 2003. Had the rates from fiscal 2002 been in effect in fiscal 2003, translated international revenue billed in local currencies would have been approximately $700 million lower. Certain manufacturing, selling distribution and +support costs are disbursed in local currencies, and a portion of international revenue is hedged, thus offsetting a portion of the translation exposure. OPERATING EXPENSES Cost of Revenue Cost of revenue includes manufacturing and +distribution costs for products and programs sold, operation costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with +the delivery of consulting services. Cost of revenue as a percent of revenue was 13.7% in 2001, 18.3% in 2002, and 17.7% in 2003. For fiscal 2003, cost of revenue was $5.69 billion compared to $5.19 billion in fiscal 2002. The primary driver of the +decrease as a percentage of revenue in fiscal 2003 was a 0.2 percentage point decrease from Home and Entertainment products due to lower volumes and improved margins of Xbox video game consoles and a 0.4 percentage point decrease from MSN product +and service costs in fiscal 2003 compared to fiscal 2002. Cost of revenue in fiscal 2002 was $5.19 billion compared to $3.46 billion in fiscal 2001. +The increase as a percentage of revenue in fiscal 2002 was due to an increase of 5.3 percentage points from Home and Entertainment primarily due to costs related to Xbox, partially offset by a 0.7 percentage point decrease due to a higher mix of +revenue from licensing business. In fiscal 2001, cost of revenue was $3.46 billion, an increase of $453 million compared to fiscal 2000. The higher sales associated with MSN Subscription and MSN Network services resulting in increased support and +service costs drove 0.4 of the 0.6 percentage point increase in total costs as a percentage of revenue. Research and Development Research and development +expenses include payroll, employee benefits, and other headcount-related costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to +translate software for international markets, and the amortization of purchased software code and services content. Research and development expenses for fiscal 2003 were $4.66 billion, an increase of 8% compared to fiscal 2002. The increase +reflects a 7% increase in headcount-related costs, a 25% increase in third-party product development costs, and a 29% increase in testing laboratory equipment and expense. In fiscal 2002, research and development expenses were $4.31 billion compared +to $4.38 billion in fiscal 2001. The decrease from fiscal 2001 was due to the discontinuation of amortization of goodwill in accordance with SFAS 142, Goodwill and Other Intangible Assets, $272 million which offset the 15% growth in +headcount-related costs. In fiscal 2001, research and development expenses were $4.38 billion, an increase of 16% compared to fiscal 2000. The increase in research and development expenses resulted from a 11% increase in headcount-related costs and +a 23% increase in investments in new product development. 12  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 Sales and Marketing Sales and marketing expenses include payroll, employee benefits, and other headcount-related costs associated with sales and marketing personnel and +advertising, promotions, tradeshows, seminars, and other programs. Sales and marketing expense as a percentage of revenue was 19.3% in 2001, 19.1% in 2002, and 20.3% in 2003. Sales and marketing expenses were $6.52 billion in 2003, compared to $5.41 +billion in fiscal 2002. The increase in absolute dollars was due to a 20% increase in sales expenses related to headcount additions, principally related to the Enterprise and Small/Medium Business sales forces, and a 21% increase in marketing +expenses. In fiscal 2002, sales and marketing expenses were $5.41 billion, an increase of 11% from fiscal 2001. The sales and marketing expenses in +absolute dollars increased due to a 20% increase in headcount-related costs partially offset by a 25% decline in MSN customer acquisition marketing costs and a 4% decline in all other marketing costs. In fiscal 2001, sales and marketing expenses +were $4.89 billion compared to $4.13 billion in fiscal 2000. The 18% increase in sales and marketing from fiscal 2000 was primarily due to a 21% growth in headcount-related costs, and to a lesser extent, a 3% growth in higher marketing and sales +expenses associated with MSN and other new sales initiatives. General and +Administrative General and administrative costs include payroll, employee +benefits, and other headcount-related costs associated with the finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative costs in fiscal 2003 increased +$554 million due to a charge of $750 million related to a settlement with AOL/Time Warner in the fourth quarter of 2003 and also due to a $256 million charge reflecting an increase in our estimate of costs related to resolving pending state +antitrust and unfair competition consumer class action lawsuits. General and administrative expenses in fiscal 2002 increased due to a charge of approximately $660 million for estimated expenses related to resolving pending state antitrust and +unfair competition consumer class action lawsuits and a 10% increase in headcount-related costs. In fiscal 2001, general and administrative costs decreased due to a lawsuit settlement charge recorded in fiscal 2000, partially offset by a 3% growth +in headcount-related costs. NON-OPERATING ITEMS, INVESTMENT INCOME/(LOSS), AND INCOME +TAXES Non-operating items Losses on equity investees and other consist of our share of income or loss from investments accounted +for using the equity method, and income or loss attributable to minority interests. The decrease in losses on equity investees and other in fiscal 2003 and 2002 was due to the divestiture of certain equity investments in fiscal 2002 in conjunction +with the underlying performance of such entities. The increase in losses on equity investees and other in fiscal 2001 reflected an increase in the number of such investments during the year. Investment Income/(Loss) We recorded net investment income/(loss) in each year as follows: (In millions) Year Ended June 30 2001 2002 2003 Dividends $ 377 $ 357 $ 260 Interest 1,808 1,762 1,697 Net recognized gains/(losses) on investments: Net gains on the sales of investments 3,175 2,379 909 Other-than-temporary impairments (4,804 ) (4,323 ) (1,148 ) Net unrealized losses attributable to derivative instruments (592 ) (480 ) (141 ) Net recognized gains/(losses) on investments (2,221 ) (2,424 ) (380 ) Investment income/(loss) $ (36 ) $ (305 ) $ 1,577 Investments are considered to be impaired when +a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we +evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, as well as our intent and ability to hold the investment. We also consider specific adverse conditions related to the +financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be +other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. In fiscal 2003, other-than-temporary +impairments decreased mainly due to the lack of significant continued impairments in the cable and telecommunications sectors. Interest income decreased $65 million due to declining interest rates partially offset by a larger investment portfolio. +Dividend income decreased $97 million primarily related to the exchange of AT&T 5% convertible preferred debt for common shares of AT&T Corporation during the year. In fiscal 2002, other-than-temporary impairments primarily related to our investment in AT&T and other cable and telecommunication investments. Net gains on the +sales of investments included a $1.25 billion gain on sale of our share of Expedia. Interest and dividend income decreased $66 million from fiscal 2001 as a result of lower interest rates and dividend income. In fiscal 2001, other-than-temporary impairments primarily related to cable and telecommunication investments. Net gains from the sales of investments in fiscal +2001 included a gain from our investment in Titus Communications (which was merged with Jupiter Telecommunications) and the closing of the sale of Transpoint to CheckFree Holdings Corp. Interest and dividend income increased $591 million from fiscal +2000, reflecting a larger investment portfolio. 13  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 Income Taxes Our effective tax rate for fiscal 2003 was 32%, reflecting a one-time benefit in the second quarter of $126 million from the reversal of previously +accrued taxes. The tax reversal stems from a 9th Circuit Court of Appeals ruling in December 2002 overturning a previous Tax Court ruling that had denied tax benefits on certain revenue earned from the distribution of software to foreign customers. +Excluding this reversal, the effective tax rate would have been 33%. The effective tax rate for fiscal 2001 and fiscal 2002 was 33% and 32%, respectively. ACCOUNTING CHANGES Effective July 1, 2001, we adopted SFAS 141, Business Combinations, and SFAS 142, Goodwill and Other Intangible Assets . SFAS 141 requires business combinations to be accounted for using the purchase method of accounting. It +also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for impairment at least +annually. There was no impairment of goodwill upon adoption of SFAS 142. Goodwill amortization (on a pre-tax basis) was $311 million in fiscal 2001. Effective July 1, 2000, we adopted SFAS 133, Accounting for Derivative Instruments and Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments +embedded in other contracts and for hedging activities. The adoption of SFAS 133 resulted in a cumulative pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax reduction to other comprehensive income (OCI) of +$112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI for the time value of options and a loss of approximately $250 million reclassified from OCI for +derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash flow hedges offset by the reclassifications out of OCI of the approximately $300 million loss for the +time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments. STOCK-BASED COMPENSATION On July 8, 2003, we announced changes in employee compensation designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders. Employees will be +granted Stock Awards instead of stock options. The Stock Award program offers employees the opportunity to earn actual shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. As part of the +changes, we announced that a significant portion of stock-based compensation for more than 600 of our senior leaders will depend on growth in the number and satisfaction of our customers. We also indicated that we are working on a plan to enable +employees to realize some value on the portion of their stock options that are currently out-of-the-money, by selling their options to a third-party financial institution. If approved, we expect to implement this plan by the end of 2003. In addition to announcing changes to our employee compensation arrangements, we also indicated that we will adopt the fair value recognition provisions of SFAS +123, Accounting for Stock-Based Compensation, effective July 1, 2003, and will report that change in accounting principle using the retroactive restatement method described in SFAS 148, Accounting for Stock-Based +Compensation—Transition and Disclosure . Note 16 of the Notes to the Financial Statements provides pro forma income statements for 2001, 2002, and 2003 as if compensation cost for our stock option and employee stock purchase plans had been +determined as prescribed by SFAS 123. FINANCIAL CONDITION Our cash and short-term investment portfolio totaled $49.05 billion at June 30, 2003, an increase of +$10.40 billion from fiscal year 2002. The portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested +predominantly in U.S. dollar denominated securities, but also includes foreign currency positions, in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and facilitate rapid +deployment for immediate cash needs. Unearned revenue as of June 30, 2003 was $9.02 billion, increasing $1.27 billion from June 30, 2002, reflecting +the addition of new and anniversary multi-year licensing agreements, partially offset by continued recognition of unearned revenue from multi-year licensing in prior periods. Cash flow from operations was $15.80 billion for fiscal 2003, an increase of $1.29 billion from fiscal 2002. The increase reflects a $2.16 billion increase in net +income from fiscal year 2002 and an increase of $1.37 billion in unearned revenue, offset by an increase of $2.36 billion in recognition of unearned revenue. Cash used for financing was $5.22 billion in fiscal 2003, an increase of $651 million from +the prior year. The increase reflects a cash dividend payment of $857 million in 2003 and an increase of $417 million in common stock repurchase, offsetting $623 million received for common stock issued. We repurchased 238.2 million shares of +common stock under our share repurchase program in fiscal 2003. Cash used for investing was $7.21 billion in fiscal 2003, a decrease of $3.63 billion from fiscal 2002, due to stronger portfolio performance on sold and matured investments. Cash flow from operations was $14.51 billion for fiscal 2002, an increase of $1.09 billion from fiscal 2001. The increase reflected strong growth in +unearned revenue as a result of the significant number of customers that purchased Upgrade Advantage during the Licensing 6.0 transition period. This resulted in an increase in billings and a corresponding increase in the unearned revenue amount. +Cash used for financing was $4.57 billion in fiscal 2002, a decrease of $1.01 billion from the prior year. The decrease reflected the repurchase of put warrants in the prior year. We repurchased 245.6 million shares of common stock under our share +repurchase program in fiscal 2002. In addition, 10.2 million shares of common stock were acquired in fiscal 2002 under a structured stock repurchase transaction. We entered into the structured stock repurchase transaction in fiscal 2001, which gave +us the right to acquire 10.2 million of our shares in exchange for an up-front net payment of $264 million. Cash used for investing was $10.85 billion in fiscal 2002, an increase of $2.11 billion from fiscal 2001. 14  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 Cash flow from operations was $13.42 billion in fiscal 2001, an increase of $2.00 +billion from the prior year. The increase was primarily attributable to the growth in revenue and other changes in working capital, partially offset by a decrease in the stock option income tax benefit, reflecting decreased stock option exercises by +employees. Cash used for financing was $5.59 billion in fiscal 2001, an increase of $3.39 billion from the prior year. The increase primarily reflected the repurchase of put warrants in fiscal 2001, compared to the sale of put warrants in the prior +fiscal year, as well as an increase in common stock repurchased. All outstanding put warrants were either retired or exercised during fiscal 2001. During fiscal 2001, we repurchased 178.1 million shares. Cash used for investing was $8.73 billion in +fiscal 2001, a decrease of $658 million from the prior year. We have no material long-term debt. Stockholders’ equity at June 30, 2003 was +$61.02 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities and computer systems for +R&D, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $117 million on June 30, 2003. We have not engaged in any related party transactions or arrangements with unconsolidated entities or +other persons that are reasonably likely to materially affect liquidity or the availability of or requirements for capital resources. We believe +existing cash and short-term investments together with funds generated from operations should be sufficient to meet operating requirements. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term +investments, as well as equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share +dilution management, legal risks, and challenges to our business model. We continuously assess our investment management approach in view of our current and potential future needs. Off-balance sheet arrangements We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $281 million, $318 million, and +$290 million in 2001, 2002, and 2003, respectively. Future minimum rental commitments under noncancellable leases, in millions of dollars, are: 2004, $218; 2005, $202; 2006, $172; 2007, $134; 2008, $116; and thereafter, $429. We have unconditionally guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a +Japanese cable company (Jupiter). These guarantees arose on February 1, 2003 in conjunction with the expiration of prior financing arrangements, including previous guarantees by us. The financing arrangements were entered into by Jupiter as part of +financing its operations. As part of Jupiter’s new financing agreement, we agreed to guarantee repayment by Jupiter of the loans of approximately $51 million. The estimated fair value and the carrying value of the guarantees was $10.5 million +and did not result in a charge to operations. The guarantees are in effect until the earlier of repayment of the loans, including accrued interest and fees, or February 1, 2009. The maximum amount of the guarantees is limited to the sum of the total +due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the maximum amount of the guarantees, denominated in Japanese yen, will vary based on fluctuations in foreign exchange rates. If we were +required to make payments under the guarantees, we may recover all or a portion of those payments upon liquidation of Jupiter’s assets. The proceeds from such liquidation cannot be accurately estimated due to the multitude of factors that would +affect the valuation and realization of the proceeds in the event of liquidation. In connection with various operating leases, we issued residual +value guarantees, which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the +property and an agreed value. As of June 30, 2003, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation +and therefore no liability to us currently exists. We provide indemnifications of varying scope and size to certain customers against claims of +intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS 5, Accounting for Contingencies , as interpreted by FIN 45. We consider such +factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities +related to such indemnifications in our financial statements. RECENTLY ISSUED +ACCOUNTING STANDARDS In January 2003, the FASB issued Interpretation 46, Consolidation of Variable Interest Entities. In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting +rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. Interpretation 46 requires a variable interest entity to be consolidated by a company if that company is subject to a +majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. The consolidation requirements of Interpretation 46 apply immediately to variable +interest entities created after January 31, 2003. The consolidation requirements apply to transactions entered into prior to February 1, 2003 in the first fiscal year or interim period beginning after June 15, 2003. Certain of the disclosure +requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. The adoption of the Interpretation on July 1, 2003 did not have a material impact on our financial +statements. In April 2003, the FASB issued SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities , which amends +and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS 133. The Statement is effective (with certain exceptions) for contracts entered into or +modified after June 30, 2003. We do not believe the adoption of this Statement will have a material impact on our financial statements. In May 2003, +the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. The Statement establishes standards for how an issuer classifies and measures certain financial instruments with 15  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some +circumstances). It is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. While we do not believe the adoption of +this Statement will have a material impact on our financial statements, we continue to assess the impact this Statement will have on certain of our share repurchase programs. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that +affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, +impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, and accounting for income taxes. We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software +Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. End +users receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available +basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to +a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing +products. SFAS 115, Accounting for Certain Investments in Debt and Equity Securities , and Securities and Exchange Commission (SEC) Staff +Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities , provide guidance on determining when an investment is other-than-temporarily impaired. This determination requires significant judgment. In making this +judgment, we evaluate, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the financial health of and near-term business outlook for the investee, including factors such as industry and +sector performance, changes in technology, and operational and financing cash flow; and our intent and ability to hold the investment. SFAS 142, Goodwill and Other Intangible Assets , requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 1 st for Microsoft) and between +annual tests in certain circumstances. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and +determining the fair value of each reporting unit. Significant judgments required to estimate the fair value of reporting units include estimating future cash flows, determining appropriate discount rates and other assumptions. Changes in these +estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit. We account for +research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development Costs , and SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or +Otherwise Marketed. SFAS 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development until technological feasibility has been established for the +product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is +established. We have determined that technological feasibility for our products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we +expense all research and development costs when incurred. We are subject to various legal proceedings and claims, the outcomes of which are subject +to significant uncertainty. SFAS 5, Accounting for Contingencies , requires that an estimated loss from a loss contingency should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been +incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. We evaluate, among other factors, the degree of probability of an +unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial position or our results of operations. SFAS 109, Accounting for Income Taxes , establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting +for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or +tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially impact +our financial position or our results of operations. ISSUES AND UNCERTAINTIES This Annual Report on Form 10-K contains statements that are forward-looking. These +statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of issues and uncertainties such as those listed below and elsewhere in this report, which, +among others, should be considered in evaluating our financial outlook. Challenges to our Business Model Since our inception, our +business model has been based upon customers agreeing to pay a fee to license software developed and distributed by us. Under this commercial software model, software developers bear the costs of converting original ideas into software products +through investments in research and development, offsetting these costs with the revenues received from the distribution of their products. We believe the commercial software model has had substantial benefits for users of software, allowing them to +rely on our expertise and the expertise of other software developers that have powerful incentives to develop 16  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7 innovative software that is useful, reliable, and compatible with other software and hardware. In recent years, there has been a growing challenge to the commercial +software model, often referred to as the Open Source model. Under the Open Source model, software is produced by loosely associated groups of unpaid programmers, and the resulting software and the intellectual property contained therein is licensed +to end users at substantially no cost. The most notable example of Open Source software is the Linux operating system. While we believe that our products provide customers with significant advantages in security and productivity, and generally have +a lower total cost of ownership than Open Source software, the popularization of the Open Source model continues to pose a significant challenge to our business model, including recent efforts by proponents of the Open Source model to convince +governments worldwide to mandate the use of Open Source software in their purchase and deployment of software products. To the extent the Open Source model gains increasing market acceptance, sales of our products may decline, we may have to reduce +the prices we charge for our products, and revenues and operating margins may consequently decline. Intellectual Property Rights We defend our +intellectual property rights, but unlicensed copying and use of software and intellectual property rights represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more +significant, particularly in countries where laws are less protective of intellectual property rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products and educate lawmakers about the advantages of +a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may not affect revenue positively and further deterioration in compliance with existing legal protections or reductions in +the legal protection for intellectual property rights of software developers could adversely affect revenue. From time to time we receive notices +from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on unfavorable terms, require us to stop selling or to +redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers. We have made and expect to continue +making significant expenditures to acquire the use of technology and intellectual property rights, including via cross-licenses of broad patent portfolios. New Products and Services We have made significant investments in research, development and marketing for new products, services and technologies, including Microsoft .NET, Xbox, business applications, MSN, mobile and wireless technologies, and +television. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, these products and services may never be profitable, and even if they are profitable, operating margins for +these businesses are not expected to be as high as the margins historically experienced by us. Litigation As discussed in Note 20 – Contingencies of the +Notes to Financial Statements, we are subject to a variety of claims and lawsuits. While we believe that none of the litigation matters in which we are currently involved will have a material adverse impact on our financial position or results of +operations, it is possible that one or more of these matters could be resolved in a manner that ultimately would have a material adverse impact on our business, and could negatively impact our revenues, operating margins, and net income. Declines in Demand for Software If overall market demand for PCs, servers and other computing devices declines significantly, or +consumer or corporate spending for such products declines, our revenue will be adversely affected. Additionally, our revenues would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products +because new product offerings are not perceived as adding significant new functionality or other value to prospective purchasers. A significant number of customers purchased license agreements providing upgrade rights to specific licensed products +prior to the transition to Licensing 6.0 in July 2002. These agreements will expire in 2004 and 2005 and the rate at which such customers renew these contracts could adversely affect future revenues. We are also committing significant investments in +the next release of the Windows operating system, codenamed Longhorn. If this system is not perceived as offering significant new functionality or value to prospective purchasers, our revenues and operating margins could be adversely affected. Product Development Schedule The development of software products is a complex and time-consuming process. New products and +enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products, particularly any delays in the Longhorn operating system, could +adversely affect our revenues. General Economic and Geo-Political Risks Continued softness in corporate information technology spending or other changes in +general economic conditions that affect demand for computer hardware or software could adversely affect our revenues. Terrorist activity and armed conflict pose the additional risk of general economic disruption and could require changes in our +international operations and security arrangements, thus increasing our operating costs. These conditions lend additional uncertainty to the timing and budget for technology investment decisions by our customers. Competition We continue to experience intensive competition across all markets for our products and services. These competitive pressures may result in decreased +sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenues, gross margins and operating income. Taxation of Extraterritorial Income In August 2001, a World Trade Organization (“WTO”) dispute panel determined that the tax provisions of the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 +(“ETI”) constitute an export subsidy prohibited by the WTO Agreement on Subsidies 17  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7, 7A and Countervailing Measures. The U.S. government appealed the panel’s decision and lost its appeal. If the ETI provisions are repealed and financially comparable +replacement tax legislation is not enacted, the loss of the ETI tax benefit to us could be significant. Other Potential Tax Liabilities We are subject to +income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations +where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different +than that which is reflected in historical income tax provisions and accruals. Should additional taxes be assessed as a result of an audit or litigation, a material effect on our income tax provision and net income in the period or periods for which +that determination is made could result. Finite Insurance Programs In addition to conventional third party insurance arrangements, we have entered into +captive insurance arrangements for the purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2003, potential coverage available under captive insurance arrangements was $1.0 +billion, subject to deductibles, exclusions, and other restrictions. While we believe these arrangements are an effective way to insure against such risks, the potential liabilities associated with certain of the issues and uncertainties discussed +herein could exceed the coverage provided by such arrangements. Other Other issues and uncertainties may include: · warranty and other claims for hardware products such as Xbox; · the effects of the Consent Decree in U.S. v. Microsoft and Final Judgment in State of New York v. Microsoft on the Windows operating system and server business, including those +associated with protocol and other disclosures required by the Decree and Final Judgment and the ability of PC manufacturers to hide end user access to certain new Windows features; · the continued availability of third party distribution channels for MSN service and other online services; · factors associated with our international operations, as described under International Operations in Part I, Item 1 of this report; and · financial market volatility or other changes affecting the value of our investments, such as the Comcast Corporation securities held by us, that may result in a reduction in carrying value +and recognition of losses including impairment charges. ITEM +7A. Quantitative and Qualitative Disclosures about Market Risk We +are exposed to foreign currency, interest rate, and fixed income and equity price risks. A portion of these risks is hedged, but fluctuations could impact our results of operations and financial position. We hedge a portion of anticipated revenue +and accounts receivable exposure to foreign currency fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies +hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Fixed income securities are subject to interest rate risk. The portfolio is diversified and structured to minimize credit risk. We routinely use options to hedge a portion of +our exposure to interest rate risk in the event of a catastrophic increase in interest rates. Securities held in our equity and other investments portfolio are subject to price risk, and are generally not hedged. However, we use options to hedge our +price risk on certain highly volatile equity securities that are held primarily for strategic purposes. We use a value-at-risk (VAR) model to +estimate and quantify our market risks. VAR is the expected loss, for a given confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VAR model is not intended to represent actual losses in +fair value, but is used as a risk estimation and management tool. The model used for currencies and equities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest rate risk, the +mean reverting geometric Brownian motion is used to reflect the principle that fixed-income securities prices revert to maturity value over time. Value-at-risk is calculated by, first, simulating 10,000 market price paths over 20 days for equities, interest rates and foreign exchange rates, taking into account historical correlations among the different rates and prices. Each +resulting unique set of equities prices, interest rates, and foreign exchange rates is applied to substantially all individual holdings to re-price each holding. The 250 th worst performance (out of 10,000) represents the value-at-risk +over 20 days at the 97.5 th percentile confidence level. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. Certain securities in our equity portfolio are held for strategic purposes. We hedge the value of a portion of these securities through the use of derivative +contracts such as put-call collars. In these arrangements, we hedge a security’s market risk below the purchased put strike and forgo most or all of the benefits of the security’s appreciation above the sold call strike, in exchange for +premium received for the sold call. We also hold equity securities for general investment return purposes. We have incurred material impairment charges related to these securities. The VAR amounts disclosed below are used as a risk management tool +and reflect an estimate of potential reductions in fair value of our portfolio. Losses in fair value over a 20-day holding period can exceed the reported VAR by significant amounts and can also accumulate over a longer time horizon than the 20-day +holding period used in the VAR analysis. VAR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. The VAR numbers are shown separately for interest rate, currency, and equity risks. These VAR numbers include the underlying portfolio positions and related hedges. +We use historical data to estimate VAR. Given reliance on historical data, VAR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent limitation in VAR is that +the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. 18  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 7A, 8 The following table sets forth the VAR calculations for substantially all of our positions: (In millions) As of June 30 Year ended June 30, 2003 Risk Categories 2002 2003 Average High Low Interest rates $ 472 $ 448 $ 609 $ 762 $ 448 Currency rates $ 310 $ 141 $ 156 $ 333 $ 41 Equity prices $ 602 $ 869 $ 838 $ 1,083 $ 523 The total VAR for the combined risk categories +is $987 million at June 30, 2003 and $908 million at June 30, 2002. The total VAR is 32% less at June 30, 2003 and 34% less at June, 30 2002 than the sum of the separate risk categories for each of those years in the above table, due to the +diversification benefit of the combination of risks. The reasons for the change in risk in portfolios include: larger investment portfolio size, asset allocation shifts, and changes in foreign exchange exposures relative to the U.S. dollar. ITEM 8. Financial Statements and Supplementary Data INCOME +STATEMENTS (In millions, except earnings per share) Year Ended June 30 2001 2002 2003 Revenue $ 25,296 $ 28,365 $ 32,187 Operating expenses: Cost of revenue 3,455 5,191 5,686 Research and development 4,379 4,307 4,659 Sales and marketing 4,885 5,407 6,521 General and administrative 857 1,550 2,104 Total operating expenses 13,576 16,455 18,970 Operating income 11,720 11,910 13,217 Losses on equity investees and other (159 ) (92 ) (68 ) Investment income/(loss) (36 ) (305 ) 1,577 Income before income taxes 11,525 11,513 14,726 Provision for income taxes 3,804 3,684 4,733 Income before accounting change 7,721 7,829 9,993 Cumulative effect of accounting change (net of income taxes of $185) (375 ) – – Net income $ 7,346 $ 7,829 $ 9,993 Basic earnings per share (1) : Before accounting change $ 0.72 $ 0.72 $ 0.93 Cumulative effect of accounting change (0.03 ) – – $ 0.69 $ 0.72 $ 0.93 Diluted earnings per share (1) : Before accounting change $ 0.69 $ 0.70 $ 0.92 Cumulative effect of accounting change (0.03 ) – – $ 0.66 $ 0.70 $ 0.92 Weighted average shares outstanding (1) : Basic 10,683 10,811 10,723 Diluted 11,148 11,106 10,882 (1) Earnings per share and weighted average shares outstanding have been restated to reflect a two-for-one stock split in February 2003. See accompanying notes. 19  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 BALANCE SHEETS (In millions) June 30 2002 2003 Assets Current assets: Cash and equivalents $ 3,016 $ 6,438 Short-term investments 35,636 42,610 Total cash and short-term investments 38,652 49,048 Accounts receivable, net 5,129 5,196 Inventories 673 640 Deferred income taxes 2,112 2,506 Other 2,010 1,583 Total current assets 48,576 58,973 Property and equipment, net 2,268 2,223 Equity and other investments 14,191 13,692 Goodwill 1,426 3,128 Intangible assets, net 243 384 Other long-term assets 942 1,171 Total assets $ 67,646 $ 79,571 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 1,208 $ 1,573 Accrued compensation 1,145 1,416 Income taxes 2,022 2,044 Short-term unearned revenue 5,920 7,225 Other 2,449 1,716 Total current liabilities 12,744 13,974 Long-term unearned revenue 1,823 1,790 Deferred income taxes 398 1,731 Other long-term liabilities 501 1,056 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; Shares issued and outstanding 10,718 and 10,771 31,647 35,344 Retained earnings, including accumulated other comprehensive income of $583 and $1,840 20,533 25,676 Total stockholders’ equity 52,180 61,020 Total liabilities and stockholders’ equity $ 67,646 $ 79,571 See accompanying notes. 20  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30 2001 2002 2003 Operations Net income $ 7,346 $ 7,829 $ 9,993 Cumulative effect of accounting change, net of tax 375 – – Depreciation, amortization, and other noncash items 1,536 1,084 1,439 Net recognized losses on investments 2,221 2,424 380 Stock option income tax benefits 2,066 1,596 1,376 Deferred income taxes (420 ) (416 ) 336 Unearned revenue 6,970 11,152 12,519 Recognition of unearned revenue (6,369 ) (8,929 ) (11,292 ) Accounts receivable (418 ) (1,623 ) 187 Other current assets (482 ) (264 ) 412 Other long-term assets (330 ) (9 ) (28 ) Other current liabilities 774 1,449 35 Other long-term liabilities 153 216 440 Net cash from operations 13,422 14,509 15,797 Financing Common stock issued 1,620 1,497 2,120 Common stock repurchased (6,074 ) (6,069 ) (6,486 ) Repurchases of put warrants (1,367 ) – – Common stock dividends – – (857 ) Other, net 235 – – Net cash used for financing (5,586 ) (4,572 ) (5,223 ) Investing Additions to property and equipment (1,103 ) (770 ) (891 ) Acquisitions of companies, net of cash acquired – – (1,063 ) Purchases of investments (66,346 ) (89,386 ) (89,621 ) Maturities of investments 5,867 8,654 9,205 Sales of investments 52,848 70,657 75,157 Net cash used for investing (8,734 ) (10,845 ) (7,213 ) Net change in cash and equivalents (898 ) (908 ) 3,361 Effect of exchange rates on cash and equivalents (26 ) 2 61 Cash and equivalents, beginning of year 4,846 3,922 3,016 Cash and equivalents, end of year $ 3,922 $ 3,016 $ 6,438 See accompanying notes. 21  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30 2001 2002 2003 Common stock and paid-in capital Balance, beginning of year $ 23,195 $ 28,390 $ 31,647 Common stock issued 5,154 1,801 3,012 Common stock repurchased (394 ) (676 ) (691 ) Repurchases of put warrants (1,367 ) – – Stock option income tax benefits 2,066 1,596 1,376 Other, net (264 ) 536 – Balance, end of year 28,390 31,647 35,344 Retained earnings Balance, beginning of year 18,173 18,899 20,533 Net income 7,346 7,829 9,993 Other comprehensive income: Cumulative effect of accounting change (75 ) – – Net gains/(losses) on derivative instruments 634 (91 ) (102 ) Net unrealized investment gains/(losses) (1,460 ) 5 1,243 Translation adjustments and other (39 ) 82 116 Comprehensive income 6,406 7,825 11,250 Common stock repurchased (5,680 ) (6,191 ) (5,250 ) Common stock dividends – – (857 ) Balance, end of year 18,899 20,533 25,676 Total stockholders’ equity $ 47,289 $ 52,180 $ 61,020 See accompanying notes. 22  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 NOTES TO FINANCIAL STATEMENTS Note 1—Accounting Policies Accounting Principles The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Principles of Consolidation The financial statements include the accounts of Microsoft Corporation and its subsidiaries (Microsoft). Intercompany transactions and balances have been eliminated. Equity +investments in which we own at least 20% of the voting securities are accounted for using the equity method, except for investments in which the Company is not able to exercise significant influence over the investee, in which case, the cost method +of accounting is used. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the +reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies and product life cycles, and assumptions such as the elements comprising a software arrangement, including the distinction between +upgrade/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; and determining when +investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation +adjustments resulting from this process are charged or credited to other comprehensive income (OCI). Revenue Recognition Revenue for retail packaged +products, products licensed to original equipment manufacturers (OEMs), and perpetual licenses for current products under our Open and Select volume licensing programs is generally recognized as products are shipped, with a portion of the revenue +recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of +revenue allocated to undelivered elements is based on the sales price of those elements when sold separately (vendor-specific objective evidence) using the residual method. Under the residual method, the total fair value of the undelivered elements, +as indicated by vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded as unearned for the undelivered elements is recognized as revenue related to delivered +elements. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle, which is currently estimated at three and a half years for Windows operating systems and two years for +desktop applications (primarily Office). Revenue from multi-year licensing arrangements are accounted for as subscriptions, with billings recorded as +unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select +volume licensing programs (currently named Software Assurance and, previously, Upgrade Advantage). In addition, other multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions +of software products on a when-and-if-available basis under Open, Select, and Enterprise Agreement volume licensing programs. MSN Internet Access subscriptions, Microsoft bCentral subscriptions, and Microsoft Developer Network subscriptions are also +accounted for as subscriptions. Revenue related to our Xbox game console is recognized upon shipment of the product to retailers. Online advertising +revenue is recognized as advertisements are displayed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Costs related to insignificant obligations, which include telephone support for developer tools software, PC games, computer hardware, and Xbox, are +accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, and bad debts. Cost of Revenue Cost of revenue includes manufacturing and distribution costs for products and programs sold, operation costs related to product support service centers and product distribution centers, costs incurred to support and maintain +Internet-based products and services, and costs associated with the delivery of consulting services. Research and Development Research and development +expenses include payroll, employee benefits, and other headcount-related costs associated with product development. Technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs +incurred after technological feasibility is established are not material, and accordingly, we expense all research and development costs when incurred. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, and other headcount-related costs as well as expenses related to advertising, promotions, tradeshows, seminars, and +other programs. Advertising costs are expensed as incurred. Advertising expense was $1.02 billion in 2001, $1.13 billion in 2002, and $1.06 billion in 2003. 23  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Income Taxes Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international +subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Financial Instruments We consider all highly liquid interest-earning investments with a maturity of three months or less at +the date of purchase to be cash equivalents. Short-term investments generally mature between three months to nine years from the purchase date. Investments with maturities beyond one year may be classified as short-term based on their highly liquid +nature and because such marketable securities represent the investment of cash that is available for current operations. All cash and short-term investments are classified as available for sale and are recorded at market value using the specific +identification method; unrealized gains and losses are reflected in OCI. Equity and other investments include debt and equity instruments. Debt +securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and losses (excluding other-than-temporary impairments) are reflected in OCI. +All other investments, excluding those accounted for using the equity method, are recorded at cost. We lend certain fixed income and equity +securities to enhance investment income. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. The fair value of collateral that we are permitted to sell or repledge was $499 +million at both June 30, 2002 and 2003. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. +We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the +duration and extent to which the fair value is less than cost, as well as our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including +industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost +basis in the investment is established. We use derivative instruments to manage exposures to foreign currency, security price, interest rate, and +credit risks. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the impact of these exposures as effectively as possible. Foreign Currency Risk. Certain forecasted transactions and assets are exposed to foreign currency risk. We +monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Non U.S. dollar denominated +securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments under SFAS 133. Options used to hedge a portion of forecasted international revenue for up to three years in the future are +designated as cash flow hedging instruments. Certain options and forwards not designated as hedging instruments under SFAS 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated +in certain foreign currencies. Securities Price +Risk. Strategic equity investments are subject to market price risk. From time to time, we use and designate options to hedge fair values and cash flows on certain equity securities. We determine the security, or +forecasted sale thereof, selected for hedging by market conditions, up-front costs, and other relevant factors. Once established, the hedges are not dynamically managed or traded, and are generally not removed until maturity. Interest Rate Risk. Fixed-income securities are subject to +interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and future contracts, not designated as hedging instruments under SFAS 133, to +hedge interest rate risk. In addition, we routinely use options, not designated as hedging instruments under SFAS 133, to hedge our exposure to interest rate risk in the event of a catastrophic increase in interest rates. Other Derivatives. Swap contracts, not designated as hedging +instruments under SFAS 133, are used to manage exposures to credit risks. In addition, we may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are deemed derivative +financial instruments and are not designated as hedging instruments. To Be Announced forward purchase commitments of mortgage-backed assets are also considered derivatives in cases where physical delivery of the assets are not taken at the earliest +available delivery date. For options designated either as fair value or cash flow hedges, changes in the time value are excluded from the assessment +of hedge effectiveness. 24  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the +account receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows: (In millions) Year Ended June 30 Balance at beginning of period Charged to costs and expenses Write-offs and +other Balance at end of period 2001 $ 186 $ 157 $ 169 $ 174 2002 174 192 157 209 2003 209 118 85 242 Inventories Inventories are stated at the lower of cost or market, using the average cost method. Cost includes +materials, labor, and manufacturing overhead related to the purchase and production of inventories. Property and Equipment Property and equipment is +stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the +straight-line method over the estimated useful life of the software, generally three years or less. Goodwill Beginning in fiscal 2002 with the adoption +of SFAS 142, Goodwill and Other Intangible Assets, goodwill is no longer amortized, but instead tested for impairment at least annually. Prior to fiscal 2002, goodwill was amortized using the straight-line method over its estimated period of +benefit. Intangible Assets Intangible assets are amortized using the straight-line method over their estimated period of benefit, +ranging from one to ten years. We periodically evaluate the recoverability of intangible assets and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that an impairment exists. All of our +intangible assets are subject to amortization. Employee Stock Plans We follow Accounting Principles Board Opinion 25, Accounting for Stock +Issued to Employees, to account for stock option and employee stock purchase plans, which generally does not require income statement recognition of options granted at the market price on the date of issuance. However, certain events, such as +the accelerated vesting of options and the exchange of options in a business combination, can trigger recording an expense. In addition to announcing changes to our employee compensation arrangements in July 2003, we also indicated that we will +adopt the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation, effective July 1, 2003 and will report that change in accounting principle using the retroactive restatement method described in SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure . The following table illustrates the effect on net income and +earnings per share as if we had applied the fair value recognition provisions of SFAS 123: (In millions, except earnings per share) Year Ended June 30 2001 2002 2003 Net income, as reported $ 7,346 $ 7,829 $ 9,993 Add: Stock-based employee compensation expense included in reported net income, net of tax 144 99 52 Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax (2,406 ) (2,573 ) (2,514 ) Pro forma net income $ 5,084 $ 5,355 $ 7,531 Earnings per share: Basic – as reported $ 0.69 $ 0.72 $ 0.93 Basic – pro forma $ 0.48 $ 0.50 $ 0.70 Diluted – as reported $ 0.66 $ 0.70 $ 0.92 Diluted – pro forma $ 0.46 $ 0.48 $ 0.69 Note 2—Stock Split In February 2003, outstanding shares of our common stock were split two-for-one. All prior share and +per share amounts have been restated to reflect the stock split. Note +3—Accounting Changes Effective July 1, 2000, we adopted SFAS 133 which +establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. The adoption of SFAS 133 on July 1, 2000, resulted in a cumulative +pre-tax reduction to income of $560 million ($375 million after-tax) and a cumulative pre-tax 25  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 reduction to OCI of $112 million ($75 million after-tax). The reduction to income was mostly attributable to a loss of approximately $300 million reclassified from OCI +for the time value of options and a loss of approximately $250 million reclassified from OCI for derivatives not designated as hedging instruments. The reduction to OCI was mostly attributable to losses of approximately $670 million on cash +flow hedges offset by reclassifications out of OCI of the approximately $300 million loss for the time value of options and the approximately $250 million loss for derivative instruments not designated as hedging instruments. The net derivative +losses included in OCI as of July 1, 2000 were reclassified into earnings during the twelve months ended June 30, 2001. The change in accounting from the adoption of SFAS 133 did not materially affect net income in 2001. Effective July 1, 2001, we adopted SFAS 141, Business Combinations, and SFAS 142. SFAS 141 requires business combinations initiated after June 30, 2001 to be +accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separate from goodwill. SFAS 142 requires that goodwill and certain intangibles no +longer be amortized, but instead tested for impairment at least annually. There was no impairment of goodwill upon adoption of SFAS 142. Net income +and earnings per share for fiscal 2001 adjusted to exclude amortization expense (net of taxes) is as follows: (In millions, except earnings per share) Year Ended June 30 2001 Net income: Reported net income $ 7,346 Goodwill amortization 252 Equity method goodwill amortization 26 Adjusted net income $ 7,624 Basic earnings per share: Reported basic earnings per share $ 0.69 Goodwill amortization 0.02 Equity method goodwill amortization – Adjusted basic earnings per share $ 0.71 Diluted earnings per share: Reported diluted earnings per share $ 0.66 Goodwill amortization 0.02 Equity method goodwill amortization – Adjusted diluted earnings per share $ 0.68 Note 4—Unearned Revenue Unearned revenue from volume licensing programs represents customer billings, paid either upfront +or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to undelivered +elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based on the sales price of those elements when sold separately +and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, +approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 5% to 15% of the sales price for desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life cycles are +currently estimated at three and a half years for Windows operating systems and two years for desktop applications. Unearned revenue also includes payments for online advertising for which the advertisement has yet to be displayed and payments for +post-delivery support services to be performed in the future. The components of unearned revenue were as follows: (In millions) June 30 2002 2003 Volume licensing programs $ 4,158 $ 5,472 Undelivered elements 2,830 2,847 Other 755 696 Unearned revenue $ 7,743 $ 9,015 Unearned revenue by segment was as follows: (In millions) June 30 2002 2003 Client $ 3,023 $ 3,165 Server and Tools 1,595 2,185 Information Worker 2,757 3,305 Other segments 368 360 Unearned revenue $ 7,743 $ 9,015 26  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Of the $9.02 billion of unearned revenue at June 30, 2003, $2.65 billion is expected +to be recognized in the first quarter of fiscal 2004, $2.05 billion in the second quarter of fiscal 2004, $1.53 billion in the third quarter of fiscal 2004, $1.00 billion in the fourth quarter of fiscal 2004, and $1.79 billion thereafter. Note 5—Cash and Short-Term Investments (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis June 30, 2002 Cash and equivalents: Cash $ 1,114 $ – $ – $ 1,114 Commercial paper 260 – – 260 Certificates of deposit 31 – – 31 Money market mutual funds 714 – – 714 Corporate notes and bonds 560 – – 560 Municipal securities 337 – – 337 Cash and equivalents 3,016 – – 3,016 Short-term investments: Commercial paper 552 – — 552 U.S. government and agency securities 8,745 91 (12 ) 8,824 Corporate notes and bonds 14,577 255 (241 ) 14,591 Mortgage-backed securities 6,226 23 (1 ) 6,248 Municipal securities 4,462 86 – 4,548 Certificates of deposit 873 – – 873 Short-term investments 35,435 455 (254 ) 35,636 Cash and short-term investments $ 38,451 $ 455 $ (254 ) $ 38,652 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis June 30, 2003 Cash and equivalents: Cash $ 1,308 $ – $ – $ 1,308 Commercial paper 774 – – 774 U.S. government and agency securities 1,889 – – 1,889 Certificates of deposit 28 – – 28 Money market mutual funds 1,263 – – 1,263 Corporate notes and bonds 744 95 (11 ) 828 Municipal securities 348 – – 348 Cash and equivalents 6,354 95 (11 ) 6,438 Short-term investments: Commercial paper 100 – – 100 U.S. government and agency securities 5,316 126 (28 ) 5,414 Foreign government bonds 5,364 79 (16 ) 5,427 Corporate notes and bonds 15,440 735 (86 ) 16,089 Mortgage-backed securities 6,257 65 (3 ) 6,319 Municipal securities 8,733 265 (6 ) 8,992 Certificates of deposit 269 – – 269 Short-term investments 41,479 1,270 (139 ) 42,610 Cash and short-term investments $ 47,833 $ 1,365 $ (150 ) $ 49,048 Realized gains and (losses) from cash and +short-term investments (excluding impairments) were $541 million and $(369) million in 2001, $816 million and $(558) million in 2002 and $1.42 billion and $(957) million in 2003. Note 6—Inventories (In millions) June 30 2002 2003 Finished goods $ 505 $ 393 Raw materials and work in process 168 247 Inventories $ 673 $ 640 27  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Note 7—Property and Equipment (In millions) June 30 2002 2003 Land $ 197 $ 248 Buildings 1,701 1,854 Computer equipment and software 2,621 2,464 Other 1,372 1,512 Property and equipment – at cost 5,891 6,078 Accumulated depreciation (3,623 ) (3,855 ) Property and equipment – net $ 2,268 $ 2,223 During 2001, 2002, and 2003, depreciation +expense, the majority of which related to computer equipment, was $764 million, $820 million, and $929 million. Note 8—Equity and Other Investments (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis June 30, 2002 Debt securities recorded at market, maturing: Within one year $ 485 $ 26 $ – $ 511 Between 2 and 10 years 893 46 (4 ) 935 Between 10 and 15 years 541 19 (2 ) 558 Beyond 15 years 3,036 – – 3,036 Debt securities recorded at market 4,955 91 (6 ) 5,040 Common stock and warrants 6,580 1,287 (617 ) 7,250 Preferred stock 1,382 – – 1,382 Other investments 519 – – 519 Equity and other investments $ 13,436 $ 1,378 $ (623 ) $ 14,191 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis June 30, 2003 Debt securities recorded at market, maturing: Within one year $ 293 $ 9 $ – $ 302 Between 2 and 10 years 1,436 194 (73 ) 1,557 Debt securities recorded at market 1,729 203 (73 ) 1,859 Common stock and warrants 8,395 1,686 (3 ) 10,078 Preferred stock 1,262 – – 1,262 Other investments 493 – – 493 Equity and other investments $ 11,879 $ 1,889 $ (76 ) $ 13,692 Debt securities include corporate and +government notes and bonds and derivative securities. In connection with the definitive agreement to combine AT&T Broadband with Comcast into a new company called Comcast Corporation, Microsoft exchanged its AT&T 5% convertible preferred +debt for 115 million shares of Comcast Corporation on November 18, 2002, resulting in a $20 million net recognized loss. Common and preferred +stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2002 the recorded basis of these investments was $2.31 billion, and their estimated fair value was $2.28 billion. At +June 30, 2003, the recorded basis of these investments was $2.15 billion, and their estimated fair value was $2.56 billion. The estimate of fair value is based on publicly available market information or other estimates determined by +management. Realized gains and (losses) from equity and other investments (excluding impairments) were $3.03 billion and $(23) million in 2001, $2.24 billion and $(121) million in 2002, and $540 million and $(88) million in 2003. Note 9—Goodwill During fiscal 2003, goodwill increased by approximately $1.7 billion. The increase related principally to the following acquisitions: Navision a/s +with $1.2 billion allocated to Microsoft Business Solutions, $281 million for the Rare, Ltd. acquisition allocated to Home and Entertainment, and Placeware, Inc. with $180 million allocated to Information Worker. No impairment was charged to 28  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 goodwill during fiscal 2003. During fiscal 2002, goodwill was reduced by $85 million, principally in connection with our exchange of all of the 33.7 million shares and +warrants we owned of Expedia, Inc. to USA Networks, Inc. No goodwill was acquired or impaired during fiscal 2002. Goodwill by segment was as follows: (In millions) June 30 2002 2003 Client $ 26 $ 37 Server and Tools 97 106 Information Worker – 180 Microsoft Business Solutions 1,021 2,219 MSN 160 154 Mobile and Embedded Devices 5 28 Home and Entertainment 117 404 Goodwill $ 1,426 $ 3,128 Note 10—Intangible Assets During fiscal 2003, we recorded additions of $306 million in intangible assets, +primarily related to the acquisition of Navision a/s and Rare, Ltd., with $19 million allocated to marketing related assets, $97 million to technology-based assets, $162 million to contract based assets, and $28 million to customer-related +assets. Acquired intangibles are amortized over weighted average periods of five years for contract-based assets, four years for technology-based assets, four years for marketing-related assets, and nine years for customer-related assets. No +significant residual value is estimated for these assets. Through the fiscal year 2003 acquisitions, $17 million was assigned to research and development assets that were written off in accordance with FASB Interpretation No. 4 (FIN 4), Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method. Those write-offs are included in Research and Development expenses. During fiscal 2002, changes in intangible assets primarily related to our +acquisition of $25 million in contracts and $27 million in technology, which will be amortized over approximately three years. No significant residual value is estimated for these intangible assets. Intangible assets amortization expense was $194 +million for fiscal 2002 and $161 million for fiscal 2003. The components of intangible assets were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Gross Carrying Amount Accumulated Amortization June 30 2002 2003 Contract-based $ 421 $ (290 ) $ 584 $ (376 ) Technology-based 172 (71 ) 261 (137 ) Marketing-related 15 (4 ) 34 (9 ) Customer-related – – 28 (1 ) Total Intangible Assets $ 608 $ (365 ) $ 907 $ (523 ) Amortization expense is +estimated to be $151 million for fiscal 2004, $103 million for fiscal 2005, $56 million for fiscal 2006, $39 million for fiscal 2007, and $23 million for fiscal 2008. Note 11—Derivatives For fiscal 2001, investment income included a net unrealized loss of $592 million, comprised of a $214 million gain for changes in the time value of options for fair value hedges, +$211 million loss for changes in the time value of options for cash flow hedges, and $595 million loss for changes in the fair value of derivative instruments not designated as hedging instruments. For fiscal 2002, investment income included a net +unrealized loss of $480 million, comprised of a $30 million gain for changes in the time value of options for fair value hedges, a $331 million loss for changes in the time value of options for cash flow hedges, and a $179 million net loss for +changes in the fair value of derivative instruments not designated as hedging instruments. For fiscal 2003, investment income included a net unrealized loss of $141 million, comprised of a $74 million loss for changes in the time value of options +for fair value hedges, a $229 million loss for changes in the time value of options for cash flow hedges, and a $162 million gain for changes in the fair value of derivative instruments not designated as hedging instruments. Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of an equity investment is recognized. During +fiscal 2001, $214 million of derivative gains were reclassified to revenue and $416 million of derivative losses were reclassified to investment income/(loss). During fiscal 2002, $234 million of derivative gains were reclassified to revenue and $10 +million of derivative losses were reclassified to investment income/(loss). During fiscal 2003, $40 million of derivative gains were reclassified to revenue and $2 million of derivative gains were reclassified to investment income/(loss). We +estimate that $22 million of net derivative gains included in other comprehensive income will be reclassified into earnings within the next twelve months. For instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS 133, had no significant impact on earnings for the fiscal years 2001, 2002, and 2003. No significant fair value hedges or cash flow hedges were +derecognized or discontinued for fiscal years 2001, 2002, and 2003. 29  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Note 12—Investment Income/(Loss) The components of investment income/(loss) are as follows: (In millions) Year Ended June 30 2001 2002 2003 Dividends $ 377 $ 357 $ 260 Interest 1,808 1,762 1,697 Net recognized gains/(losses) on investments: Net gains on the sales of investments 3,175 2,379 909 Other-than-temporary impairments (4,804 ) (4,323 ) (1,148) Net unrealized losses attributable to derivative instruments (592 ) (480 ) (141) Net recognized gains/(losses) on investments (2,221 ) (2,424 ) (380) Investment income/(loss) $ (36 ) $ (305 ) $ 1,577 Other than temporary impairments were recorded +as follows for the three most recent fiscal years: (In millions) Year Ended June 30 2001 2002 2003 Due to general market conditions $ 1,692 $ 2,793 $ 943 Due to specific adverse conditions 3,112 1,530 205 Total Impairments $ 4,804 $ 4,323 $ 1,148 Note 13—Income Taxes The provision for income taxes consisted of: (In millions) Year Ended June 30 2001 2002 2003 Current taxes: U.S. and state $ 3,243 $ 3,644 $ 3,861 International 514 575 808 Current taxes 3,757 4,219 4,669 Deferred taxes 47 (535 ) 64 Provision for income taxes $ 3,804 $ 3,684 $ 4,733 U.S. and international components of income +before income taxes were: (In millions) Year Ended June 30 2001 2002 2003 U.S. $ 9,189 $ 8,920 $ 11,346 International 2,336 2,593 3,380 Income before income taxes $ 11,525 $ 11,513 $ 14,726 In 2001, the effective tax rate +was 33.0% and included the effect of a 3.1% reduction from the U.S. statutory rate for tax credits and a 1.1% increase for other items. The effective tax rate in 2002 was 32.0% and included the effect of a 2.4% reduction from the U.S. statutory rate +for the extraterritorial income exclusion tax benefit and a 0.6% reduction for other items. The effective tax rate in 2003 was 32.1% and included the effect of a one-time benefit of $126 million from the reversal of previously accrued taxes related +to a favorable tax court ruling and a 2.0% reduction from the U.S. statutory rate for other items. Excluding this reversal, the effective tax rate in 2003 would have been 33.0%. 30  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Deferred income taxes were: (In millions) June 30 2002 2003 Deferred income tax assets: Revenue items $ 2,261 $ 2,556 Expense items 945 1,048 Impaired investments 2,016 1,525 Deferred income tax assets $ 5,222 $ 5,129 Deferred income tax liabilities: Unrealized gain on investments $ (887 ) $ (1,584 ) International earnings (1,818 ) (1,809 ) Other (803 ) (961 ) Deferred income tax liabilities $ (3,508 ) $ (4,354 ) We have not provided for U.S. deferred income +taxes or foreign withholding taxes on $1.64 billion of our undistributed earnings for certain non-U.S. subsidiaries, all of which relate to fiscal 2002 and 2003 earnings, because these earnings are intended to be reinvested indefinitely. On September 15, 2000, the U.S. Tax Court issued an adverse ruling with respect to our claim that the Internal Revenue Service (IRS) incorrectly assessed taxes +for 1990 and 1991. On December 3, 2002, the Ninth Circuit Court of Appeals substantially reversed the U.S. Tax Court decision. Income taxes, except for one issue remanded to the U.S. Tax Court by the Ninth Circuit Court of Appeals for additional +consideration, have been settled with the IRS for all years through 1996. The IRS is examining our 1997 through 1999 U.S. income tax returns. Management believes any adjustments which may be required will not be material to the financial statements. +Income taxes paid were $1.3 billion in 2001, $1.9 billion in 2002, and $2.8 billion in 2003. Note 14—Stockholders’ Equity Shares of common stock +outstanding were as follows: (In millions) Year Ended June 30 2001 2002 2003 Balance, beginning of year 10,566 10,766 10,718 Issued 378 208 291 Repurchased (178 ) (256 ) (238 ) Balance, end of year 10,766 10,718 10,771 We repurchase our common +shares primarily to manage the dilutive effects of our stock option and stock purchase plans, and other issuances of common shares. In 2002, we acquired 10.2 million of our shares as a result of a structured stock repurchase transaction entered into +in 2001, which gave us the right to acquire such shares in exchange for an up-front net payment of $264 million. To enhance our stock repurchase program, we have sold put warrants to independent third parties. These put warrants entitled the holders +to sell shares of our common stock to us on certain dates at specified prices. In the third quarter of fiscal 2001, we issued 5.6 million shares to settle a portion of the outstanding put warrants. At June 30, 2001, 2002, and 2003 no put warrants +were outstanding. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in Stockholders’ Equity, reflecting timing differences between the recognition of share repurchase +transactions and their settlement for cash. On January 16, 2003, our Board of Directors declared an annual dividend on our common stock of $0.08 per +share, payable March 7, 2003 to shareholders of record at the close of business on February 21, 2003. 31  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Note 15—Other Comprehensive Income (In millions) Year Ended June 30 2001 2002 2003 Cumulative effect of accounting change, net of tax effect of $(37) $ (75 ) $ – $ – Net gains/(losses) on derivative instruments: Unrealized gains/(losses), net of tax effect of $246 in 2001, $30 in 2002, and $(69) in 2003 499 55 (129 ) Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $67 in 2001, $(79) in 2002, and $15 in +2003 135 (146 ) 27 Net gains/(losses) on derivative instruments 634 (91 ) (102 ) Net unrealized investment gains/(losses): Unrealized holding gains/(losses), net of tax effect of $(351) in 2001, $(955) in 2002, and $610 in 2003 (1,200 ) (1,774 ) 1,132 Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $(128) in 2001, $958 in 2002, and $60 in +2003 (260 ) 1,779 111 Net unrealized investment gains/(losses) (1,460 ) 5 1,243 Translation adjustments and other (39 ) 82 116 Other comprehensive income/(loss) $ (940 ) $ (4 ) $ 1,257 The components of accumulated other +comprehensive income were: (In millions) June 30 2002 2003 Net gains/(losses) on derivative instruments $ 86 $ (16 ) Net unrealized investment gains 603 1,846 Translation adjustments and other (106 ) 10 Accumulated other comprehensive income $ 583 $ 1,840 Note 16—Employee Stock and Savings +Plans Employee Stock Purchase Plan We have an employee stock purchase plan for all eligible employees. Under the plan, shares of our +common stock may be purchased at six-month intervals at 85% of the lower of the fair market value on the first or the last day of each six-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation +during an offering period. During 2001, 2002, and 2003 employees purchased 11.4 million, 10.8 million shares and 15.2 million shares at average prices of $18.43, $25.26, and $22.56 per share. At June 30, 2003, 192.2 million shares were reserved for +future issuance. Savings Plan We have a savings plan, which qualifies under Section 401(k) of the Internal Revenue Code. +Participating employees may contribute up to 25% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes, with a maximum contribution of 3% of a participant’s earnings. +Matching contributions were $63 million, $77 million, and $88 million in 2001, 2002, and 2003. Stock Option and Stock Plans We have a stock option plan for directors +and a stock plan for officers, and employees, which provide for nonqualified and incentive stock options and in the case of the stock plan, stock awards. Options granted prior to 1995 generally vest over four and one-half years and expire ten years +from the date of grant. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years +and expire ten years from the date of grant. Options granted during and after 2002 vest over four and one-half years and expire ten years from the date of grant. We have issued stock awards under the plan for officers and employees whereby employees +earn actual shares of stock. In fiscal 2003, the company granted 4 million stock awards, which vest over five years. At June 30, 2003, stock options +for 774 million shares were vested and 866 million shares were available for future grants under the plans. 32  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 Stock options outstanding were as follows: (In millions, except earnings per share) Price per Share Shares Range Weighted Average Balance, June 30, 2000 1,664 $  0.28 – $59.57 $ 20.62 Granted 448 20.75 –   40.00 30.42 Exercised (246 ) 0.30 –   42.91 5.57 Canceled (70 ) 6.92 –   59.57 31.79 Balance, June 30, 2001 1,796 0.28 –   59.57 24.77 Granted 82 24.31 –   36.29 31.25 Exercised (198 ) 0.51 –   34.91 6.41 Canceled (76 ) 0.58 –   58.28 34.34 Balance, June 30, 2002 1,604 0.40 –   59.57 26.88 Granted 254 21.42 –   29.12 24.27 Exercised (234 ) 0.51 –   28.22 6.89 Canceled (75 ) 2.13 –   59.56 34.33 Balance, June 30, 2003 1,549 0.40 –   59.56 29.30 For various price ranges, weighted average +characteristics of outstanding stock options at June 30, 2003 were as follows: (In millions, except earnings per share) Outstanding Options Exercisable Options Range of Exercise Prices Shares Remaining Life (Years) Weighted Average Price Shares Weighted Average Price $  0.39 – $15.00 124 3.7 $ 6.29 117 $ 6.23 15.01 –   25.00 359 5.6 21.30 131 16.54 25.01 –   33.00 415 5.8 28.24 177 27.92 33.01 –   41.00 387 3.2 34.26 196 34.34 41.01 –   59.56 264 2.4 44.90 153 44.73 We follow Accounting Principles +Board Opinion 25 to account for stock option and employee stock purchase plans. An alternative method of accounting for stock options is SFAS 123 . Under SFAS 123, employee stock options are valued at grant date using the Black-Scholes +valuation model, and this compensation cost is recognized ratably over the vesting period. In addition to announcing changes to our employee compensation arrangements in July 2003, we also indicated that we will adopt the fair value recognition +provisions of SFAS 123 effective July 1, 2003 and will report that change in accounting principle using the retroactive restatement method described in SFAS 148. Had compensation cost for our stock option and employee stock purchase plans been determined as prescribed by SFAS 123, pro forma income statements for 2001, 2002, and 2003 would have been as follows: (In millions, except earnings per share) Year Ended June 30 2001 2002 2003 Reported Pro Forma Reported Pro Forma Reported Pro Forma Revenue $ 25,296 $ 25,296 $ 28,365 $ 28,365 $ 32,187 $ 32,187 Operating expenses: Cost of revenue 3,455 3,775 5,191 5,699 5,686 6,059 Research and development 4,379 6,106 4,307 6,299 4,659 6,595 Sales and marketing 4,885 5,888 5,407 6,252 6,521 7,562 General and administrative 857 1,184 1,550 1,843 2,104 2,426 Total operating expenses 13,576 16,953 16,455 20,093 18,970 22,642 Operating income 11,720 8,343 11,910 8,272 13,217 9,545 Losses on equity investees and other (159 ) (159 ) (92 ) (92 ) (68 ) (68 ) Investment income/(loss) (36 ) (36 ) (305 ) (305 ) 1,577 1,577 Income before income taxes 11,525 8,148 11,513 7,875 14,726 11,054 Provision for income taxes 3,804 2,689 3,684 2,520 4,733 3,523 Income before accounting change 7,721 5,459 7,829 5,355 9,993 7,531 Cumulative effect of accounting change (375 ) (375 ) – – – – Net income $ 7,346 $ 5,084 $ 7,829 $ 5,355 $ 9,993 $ 7,531 Basic earnings per share $ 0.69 $ 0.48 $ 0.72 $ 0.50 $ 0.93 $ 0.70 Diluted earnings per share $ 0.66 $ 0.46 $ 0.70 $ 0.48 $ 0.92 $ 0.69 33  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 The weighted average Black-Scholes value of options granted under the stock option +plans during 2001, 2002, and 2003 was $14.66, $15.79, and $12.08. Value was estimated using a weighted average expected life of 6.4 years in 2001 and 7.0 years in 2002 and 2003, no dividends in 2001 and 2002, a $0.08 per share dividend in 2003, +volatility of .39 in 2001, .39 in 2002, and .42 in 2003, and risk-free interest rates of 5.3%, 5.4%, and 3.9% in 2001, 2002, and 2003. Note 17—Earnings Per Share Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding plus +the effect of outstanding put warrants using the “reverse treasury stock” method and outstanding stock options using the “treasury stock” method. The components of basic and diluted earnings per share were as follows: (In millions, except earnings per share) Year Ended June 30 2001 2002 2003 Income before accounting change $ 7,721 $ 7,829 $ 9,993 Weighted average outstanding shares of common stock 10,683 10,811 10,723 Dilutive effect of: Put warrants 42 – – Employee stock options 423 295 159 Common stock and common stock equivalents 11,148 11,106 10,882 Earnings per share before accounting change: Basic $ 0.72 $ 0.72 $ 0.93 Diluted $ 0.69 $ 0.70 $ 0.92 For the years ended June 30, +2001, 2002 and 2003; 702 million, 746 million, and 1.09 billion shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the effect was antidilutive. Note 18—Acquisitions In fiscal year ended June 30, 2003, we acquired all of the outstanding equity interests of Navision a/s, Rare Ltd., and Placeware, Inc. Navision, +headquartered in Vedbaek, Denmark, is a provider of integrated business solutions software for small and mid-sized businesses in the European market and will play a key role in the future development of the Microsoft Business Solutions segment. We +acquired Navision on July 12, 2002 for $1.465 billion consisting primarily of $662 million in cash and the issuance of 29.1 million common shares of Microsoft stock valued at $773 million. The value of the common shares issued was determined based +on the average market price of our common shares over the 2-day period before and after terms of the acquisition were agreed to and approved. Rare is a video game developer located outside Leicestershire, England, that is expected to broaden the +portfolio of games available for the Xbox video game system. Rare was acquired on September 24, 2002 for $377 million consisting primarily of $375 million in cash. Placeware, located in Mountain View, CA, facilitates secure, highly reliable, +cross-firewall web conferencing experiences allowing users to conduct business meetings online from a PC, and will become a part of Microsoft’s Real Time Collaboration business unit within the Information Worker segment. Placeware was acquired +on April 30, 2003 for $202 million, consisting primarily of $189 million in cash. Navision, Rare, and Placeware have been consolidated into our financial statements since their respective acquisition dates. None of the acquisitions, individually or +in the aggregate, are material to our consolidated results of operations. Accordingly, pro forma financial information is not included in this note. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of the acquisitions (in millions): Navision a/s At July 12, 2002 Rare, Ltd. At September 24, 2002 Placeware, Inc. At April 30, 2003 Current assets $ 240 $ 25 $ 30 Property, plant, and equipment 8 8 7 Intangible assets 169 75 30 Goodwill 1,197 281 180 Total assets acquired 1,614 389 247 Current Liabilities (148 ) (12 ) (32 ) Long-term liabilities (1 ) – (13 ) Total liabilities assumed (149 ) (12 ) (45 ) Net Assets Acquired $ 1,465 $ 377 $ 202 Of the $169 million of +acquired intangible assets in the Navision acquisition, $2 million was assigned to research and development assets that were written off in accordance with FIN 4. Those write-offs are included in Research and Development expenses. The remaining $167 +million of acquired intangible assets have a weighted average useful life of approximately five years. The intangible assets that make up that amount include technology of $48 million (four-year weighted-average useful life), contracts of $115 +million (six-year weighted-average useful life), and marketing of $4 million (three-year weighted-average useful 34  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 life). The $1,197 million of goodwill was assigned to the Microsoft Business Solutions segment. Of that total amount, approximately $900 million is expected +to be deductible for tax purposes. Of the $75 million of acquired intangible assets in the Rare acquisition, $13 million was assigned to research and +development assets that were written off in accordance with FIN 4. Those write-offs are included in Research and Development expenses. The remaining $62 million of acquired intangible assets have a weighted average useful life of approximately five +years. The intangible assets that make up that amount include technology of $36 million (five-year weighted average useful life), contracts of $16 million (five-year weighted average useful life), and marketing of $10 million (five-year +weighted average useful life). The $281 million of goodwill was assigned to the Home and Entertainment segment. Of that total amount, approximately $270 million is expected to be deductible for tax purposes. The $30 million of acquired intangible assets in the Placeware acquisition have a weighted average useful life of approximately eight years. The intangible assets +that make up that amount include technology of $4 million (four-year weighted-average useful life), customers of $23 million (ten-year weighted-average useful life), contracts of $1 million (six-year weighted-average useful life), and marketing of +$2 million (one-year weighted average useful life). The $180 million of goodwill was assigned to the Information Worker segment. None of the goodwill is expected to be deductible for tax purposes. Note 19—Commitments and Guarantees We have operating leases for most U.S. and international sales and support offices and certain +equipment. Rental expense for operating leases was $281 million, $318 million, and $290 million in 2001, 2002, and 2003. Future minimum rental commitments under noncancellable leases, in millions of dollars, are: 2004, $218; 2005, $202; 2006, $172; +2007, $134; 2008, $116; and thereafter, $429. We have committed $117 million for constructing new buildings. In November 2002, the FASB issued +Interpretation 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (FIN 45) . FIN 45 elaborates on previously existing disclosure requirements for most +guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a company issues a guarantee, the company must recognize an initial liability for the fair value, or market value, of the obligations it +assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to recognizing a liability at inception of the guarantee for the fair value of the guarantor’s obligations +does not apply to product warranties or to guarantees accounted for as derivatives. The initial recognition and initial measurement provisions apply on a prospective basis to guarantees issued or modified after December 31, 2002. We have unconditionally guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a +Japanese cable company (Jupiter). These guarantees arose on February 1, 2003 in conjunction with the expiration of prior financing arrangements, including previous guarantees by us. The financing arrangements were entered into by Jupiter as part of +financing its operations. As part of Jupiter’s new financing agreement, we agreed to guarantee repayment by Jupiter of the loans of approximately $51 million. The estimated fair value and the carrying value of the guarantees was $10.5 million +and did not result in a charge to operations. The guarantees are in effect until the earlier of repayment of the loans, including accrued interest and fees, or February 1, 2009. The maximum amount of the guarantees is limited to the sum of the total +due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the maximum amount of the guarantees, denominated in Japanese yen, will vary based on fluctuations in foreign exchange rates. If we were +required to make payments under the guarantees, we may recover all or a portion of those payments upon liquidation of the Jupiter’s assets. The proceeds from such liquidation cannot be accurately estimated due to the multitude of factors that +would affect the valuation and realization of the proceeds in the event of liquidation. In connection with various operating leases, we issued +residual value guarantees, which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of +the property and an agreed value. As of June 30, 2003, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment +obligation and therefore no liability to us currently exists. We provide indemnifications of varying scope and size to certain customers against +claims of intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS 5, Accounting for Contingencies , as interpreted by FIN 45. We consider +such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any +liabilities related to such indemnifications in our financial statements. Our product warranty accrual reflects management’s best estimate of +probable liability under its product warranties (primarily relating to the Xbox console). We determine the warranty accrual based on known product failures (if any), historical experience, and other currently available evidence. Changes in the +product warranty accrual for the fiscal year ended June 30, 2003 were as follows (in millions): Balance, beginning of period $ 8 Payments made – Change in liability for warranties issued during the period 29 Change in liability for preexisting warranties (25 ) Balance, end of period $ 12 Note 20—Contingencies We are a defendant in U.S. v. Microsoft and New York v. Microsoft , +companion lawsuits filed by the Antitrust Division of the U.S. Department of Justice (DOJ) and a group of eighteen state Attorneys General alleging violations of the Sherman Act and various state antitrust laws. After the trial, the District Court +entered Findings of Fact and Conclusions of Law stating that we had violated Sections 1 and 2 of the Sherman Act and various state antitrust laws. A Judgment was entered on June 7, 2000 ordering, among 35  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 other things, our breakup into two companies. The Judgment was stayed pending an appeal. On June 28, 2001, the U.S. Court of Appeals for the District of Columbia +Circuit affirmed in part, reversed in part, and vacated the Judgment in its entirety and remanded the case to the District Court for a new trial on one Section 1 claim and for entry of a new judgment consistent with its ruling. In its ruling, the +Court of Appeals substantially narrowed the bases of liability found by the District Court, but affirmed some of the District Court’s conclusions that we had violated Section 2. We entered into a settlement with the United States on November 2, +2001. Nine states (New York, Ohio, Illinois, Kentucky, Louisiana, Maryland, Michigan, North Carolina and Wisconsin) agreed to settle on substantially the same terms on November 6, 2001. On November 1, 2002, the Court approved the settlement as being +in the public interest, conditioned upon the parties’ agreement to a modification to one provision related to the Court’s ongoing jurisdiction. Nine states and the District of Columbia continued to litigate the remedies phase of New +York v. Microsoft . The non-settling states sought remedies that would have imposed much broader restrictions on our business than the settlement with the DOJ and nine other states. On November 1, 2002, the Court entered a Final Judgment in this +part of the litigation that largely mirrored the settlement between us, the DOJ and the settling states, with some modifications and a different regime for enforcing compliance. The Court declined to impose other and broader remedies sought by the +non-settling states. Two states, Massachusetts and West Virginia, appealed from this decision of the trial court, and West Virginia dismissed its appeal as part of a settlement with us of several other cases. The European Commission has instituted proceedings in which it alleges that we have failed to disclose information that our competitors claim they need to +interoperate fully with Windows 2000 clients and servers and that we have engaged in discriminatory licensing of such technology, as well as improper bundling of multimedia playback technology in the Windows operating system. The remedies sought, +though not fully defined, include mandatory disclosure of our Windows operating system technology, either the removal of Windows Media technology from Windows or a “must carry” obligation requiring OEMs to install competitive media players +with Windows, and imposition of fines in an amount that could be as large as 10% of our worldwide annual revenue. We deny the European Commission’s allegations and intend to contest the proceedings vigorously. In other ongoing investigations, +various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, and security issues. A large number of antitrust and unfair competition class action lawsuits have been filed against us in various state and Federal courts. The Federal cases have been consolidated in the U.S. District Court for Maryland. These cases allege +that we have competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software applications, and they seek to recover on behalf of variously defined classes of direct and indirect purchasers overcharges we +allegedly charged for these products. To date, courts have dismissed all claims for damages against us by indirect purchasers under Federal law and in 16 different states. Nine of those state court decisions have been affirmed on appeal. Claims on +behalf of foreign purchasers have also been dismissed. Appeals of several of these rulings are still pending. No trials have been held concerning any liability issues. Courts in ten states have ruled that these cases may proceed as class actions, +while courts in two states have denied class certification status, and another court has ruled that no class action is available for antitrust claims in that state. The Federal District Court has certified a class of direct purchasers of our +operating system software that acquired the software from the shop.Microsoft.com Web site or pursuant to a direct marketing campaign and otherwise denied certification of the proposed classes. Members of the certified class licensed fewer than +550,000 copies of operating system software from Microsoft. In 2003, we reached an agreement with counsel for the California plaintiffs to settle all claims in 27 consolidated cases in that state. Under the proposed settlement, class members will be +able to obtain vouchers with a total face value of up to $1.1 billion that may be redeemed for cash against purchases of a wide variety of platform-neutral computer hardware and software. Two-thirds of the amount unclaimed or unredeemed by class +members then will be made available to certain schools in California in the form of vouchers that also may be redeemed for cash against purchased of a wide variety of platform-neutral computer hardware, software and related services. The court in +California preliminarily approved this proposed settlement, but it still requires final approval by the court. In 2003, we also reached similar agreements to settle all claims in Montana, Florida, West Virginia and North Carolina. The total face +value of the Montana settlement is $12.3 million, the Florida settlement, $202 million, the West Virginia settlement, $21 million, and the North Carolina settlement, $89.2 million. These proposed settlements are structured similar to the California +settlement, except that, among other differences, one-half of the amounts unclaimed by class members will be made available to certain schools in Montana, Florida, West Virginia and North Carolina. The proposed settlements in Montana, Florida and +West Virginia have been preliminarily approved by the courts in those states, but still require final approval. The parties have filed a motion for preliminary approval of the settlement in North Carolina and the Court has scheduled a hearing for +later this year. We intend to continue vigorously defending the remaining lawsuits. We estimate the total cost to resolve all of these cases will range between $916 million and $1.1 billion with the actual cost dependent upon many unknown +factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of +administering the claims process. In accordance with SFAS 5 and FIN 14, Reasonable Estimation of the Amount of a Loss , the Company has recorded a contingent liability of $916 million. Netscape Communications Inc., a subsidiary of AOL-Time Warner Inc., filed suit against us on January 22, 2002 in U.S. District Court for the District of Columbia, +alleging violations of antitrust and unfair competition laws and other tort claims relating to Netscape and its Navigator browser. The case was transferred for pretrial purposes to the District Court in Baltimore, Maryland and was being coordinated +with the antitrust and unfair competition class actions described above. On May 29, 2003, we and AOL Time Warner announced an agreement to settle the case. As part of the settlement, we paid $750 million to AOL Time Warner and provided AOL Time +Warner a royalty-free, seven-year license to use Microsoft Internet Explorer technologies with the AOL client. The parties agreed on various other technical provisions and entered into a separate agreement to collaborate on long-term digital media +initiatives designed to accelerate the adoption of digital content. The two companies entered into a long-term, non-exclusive license agreement allowing AOL Time Warner to use our Windows Media 9 Series and future software for creating, distributing +and playing back high-quality digital media. As a result of the settlement, the case has been dismissed with prejudice. Be Incorporated, a former +software development company whose assets were acquired by Palm, Inc. in August 2001, filed suit against us on February 18, 2002 in the U.S. District Court for Northern California, alleging violations of Federal and state antitrust and unfair +competition laws and other tort claims. Be alleges that our license agreements with computer manufacturers, pricing 36  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 policies, and business practices interfered with Be’s relationships with computer manufacturers and discouraged them from adopting Be’s own operating system +for their products. We believe the total cost to resolve this case will not be material to our financial position or results of operations. On March +8, 2002, Sun Microsystems, Inc. filed suit against us alleging violations of Federal and state antitrust and unfair competition laws as well as claims under the Federal Copyright Act. Sun seeks injunctive relief and unspecified treble damages along +with its fees and costs. We deny these allegations and will vigorously defend this action. The case has been transferred for pretrial purposes to the U.S. District Court in Baltimore, Maryland and is being coordinated with the antitrust and unfair +competition class actions described above. On January 21, 2003, the Court granted Sun’s motion for a preliminary injunction and entered an injunction requiring us to distribute certain Sun Java software with Microsoft Windows XP and certain +other products. The injunction also prohibits us from distributing our version of Java software in a variety of ways. The U.S. Court of Appeals for the Fourth Circuit granted our request for a stay of the preliminary injunction order. On June 26, +2003, a three judge panel of the Fourth Circuit issued a unanimous opinion vacating the preliminary injunction requiring us to distribute Sun Java software and upheld the preliminary injunction prohibiting us from distributing our version of Java +software in certain ways. We are the defendant in more than 30 patent infringement cases. Several of these cases are approaching trial. In the case +of Eolas Technologies, Inc. and University of California v. Microsoft , filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs accused the browser functionality of Windows of infringement. On +August 11, 2003, the jury awarded the plaintiffs approximately $520 million in damages for infringement from the date the plaintiffs’ patent issued through September 2001. The plaintiffs are seeking an equitable accounting for damages from +September 2001 to the present. We will appeal the jury award and any award on the equitable accounting issue upon conclusion of those aspects of the case that remain to be completed before the trial court. While it is not currently possible to +estimate the range of possible loss, we believe the total cost to resolve this case will not be material to our financial position or results of operations. However, the actual costs are dependent upon many unknown factors such as the outcome of +issues remaining to be decided by the trial court, success on appeal, and the events of a retrial of the case should the case be remanded to trial following appeal. The trial of InterTrust v. Microsoft , filed in the U.S. District Court for +Northern California on April 26, 2001, is anticipated in 2005. The plaintiff in this case has accused a large number of products, including Windows and Office, of infringement. In each of Eolas and InterTrust , injunctive relief also +may be awarded that could adversely impact distribution of Windows or Office. Adverse outcomes in some or all of the pending cases may result in significant monetary damages or injunctive relief against us. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. While management currently believes that resolving all of these matters, individually or in aggregate, will not have a material adverse impact on our financial +position or our results of operations, the litigation and other claims noted above are subject to inherent uncertainties and management’s view of these matters may change in the future. Were an unfavorable final outcome to occur, there exists +the possibility of a material adverse impact on our financial position and the results of operations for the period in which the effect becomes reasonably estimable. Note 21—Segment Information (In millions) Year Ended June 30 2002 2003 Revenue Client $ 9,350 $ 10,286 Server and Tools 5,632 6,519 Information Worker 8,328 9,718 Microsoft Business Solutions 308 577 MSN 1,924 2,363 Mobile and Embedded Devices 124 153 Home and Entertainment 2,411 2,779 Reconciling Amounts 288 (208 ) Consolidated Revenue $ 28,365 $ 32,187 Operating Income/(Loss) Client $ 7,529 $ 8,281 Server and Tools 1,409 1,848 Information Worker 6,440 7,393 Microsoft Business Solutions (196 ) (308 ) MSN (746 ) (394 ) Mobile and Embedded Devices (240 ) (175 ) Home and Entertainment (866 ) (940 ) Reconciling Amounts (1,420 ) (2,488 ) Consolidated Operating Income/(Loss) $ 11,910 $ 13,217 Segment information is presented in accordance +with SFAS 131, Disclosures about Segments of an Enterprise and Related Information. This standard is based on a management approach, which requires segmentation based upon our internal organization and reporting of revenue and operating +income based upon internal accounting methods. Our financial reporting systems present various data for management to run the business, including internal profit and loss statements (P&Ls) prepared on a basis not consistent with U.S. GAAP. +Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is 37  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 impracticable for the Company to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. On July 1, 2002, we revised our segments. These changes are designed to promote better alignment of strategies and objectives between development, +sales, marketing, and services organizations; provide for more timely and rational allocation of development, sales, and marketing resources within businesses; and focus long-term planning efforts on key objectives and initiatives. Our seven new +segments are: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. Prior year segment information has been restated to conform to the seven new segments. It is not +practical to discern operating income for 2001 for the current segments or operating income for 2003 for the previous segments due to reorganizations. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Due to our integrated business structure, operating costs included in one segment may benefit other segments, and +therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for +such shared costs and to incent shared efforts. Management will continually evaluate the alignment of development, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations +in future periods. The Client segment includes revenue and operating expenses associated with Windows XP, Windows 2000, and other standard Windows +operating systems. Server and Tools segment consists of revenue and operating expenses associated with server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes +developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Information Worker segment includes Microsoft Office, Microsoft Project, Visio, other information worker products, +SharePoint Portal Server CALs, an allocation for CALs, and professional product support services. Microsoft Business Solutions includes Microsoft Great Plains, Navision, and bCentral. MSN includes MSN Subscription and MSN Network services. Mobile +and Embedded Devices includes Windows Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. Home and Entertainment includes the Xbox video game system, PC games, consumer software and hardware, and TV +platform. Reconciling amounts include adjustments to state revenue and operating income in accordance with U.S. GAAP and corporate level expenses not +specifically attributed to a segment. For revenue, reconciling items include certain undelivered elements of unearned revenue and allowances for certain sales returns and rebates. Reconciling items for operating income/(loss) include general and +administrative expenses ($1.55 billion in 2002 and $2.10 billion in 2003), broad-based research and development expenses ($202 million in 2002 and $210 million in 2003), and certain corporate level sales and marketing costs ($526 million in 2002 and +$688 million in 2003). The internal segment operating income or loss also includes non-GAAP accelerated methods of depreciation and amortization. Additionally, losses on equity investees and minority interest are classified in operating income for +internal reporting presentations. Revenue attributable to U.S. operations includes shipments to customers in the United States, licensing to OEMs and +certain multinational organizations, and exports of finished goods, primarily to Asia, Latin America, and Canada. Revenue from U.S. operations totaled $17.8 billion, $20.9 billion, and $22.1 billion in 2001, 2002, and 2003. Revenue from outside the +United States, excluding licensing to OEMs and certain multinational organizations and U.S. exports, totaled $7.5 billion, $7.5 billion, and $10.1 billion in 2001, 2002, and 2003. No single customer accounted for 10% or more of revenue in 2001, +2002, or 2003. Long-lived assets (principally property and equipment) totaled $2.0 billion and $1.9 billion in the United States in 2002 and 2003 and +$220 million, and $294 million in other countries in 2002 and 2003. 38  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 QUARTERLY INFORMATION (In millions, except earnings per share) (Unaudited) Quarter Ended Sept. 30 Dec. 31 Mar. 31 June 30 Year Fiscal 2001 Revenue $ 5,766 $ 6,550 $ 6,403 $ 6,577 $ 25,296 Gross profit 4,941 5,686 5,504 5,710 21,841 Net income 2,206 (2) 2,624 2,451 65 (3) 7,346 Basic earnings per share (1) 0.21 (2) 0.25 0.23 0.01 0.69 Diluted earnings per share (1) 0.20 (2) 0.24 0.22 0.01 0.66 Fiscal 2002 Revenue $ 6,126 $ 7,741 $ 7,245 $ 7,253 $ 28,365 Gross profit 5,242 6,197 5,850 5,885 23,174 Net income 1,283 (4) 2,283 2,738 (5) 1,525 (6) 7,829 Basic earnings per share (1) 0.12 0.21 0.25 0.14 0.72 Diluted earnings per share (1) 0.12 0.21 0.25 0.14 0.70 Fiscal 2003 Revenue $ 7,746 $ 8,541 $ 7,835 $ 8,065 $ 32,187 Gross profit 6,547 6,507 6,620 6,827 26,501 Net income 2,726 2,552 2,794 1,921 9,993 Basic earnings per share 0.25 0.24 0.26 0.18 0.93 Diluted earnings per share 0.25 0.23 0.26 0.18 0.92 (1) Earnings per share have been restated to reflect a two-for-one stock split in February 2003. (2) Includes an unfavorable cumulative effect of accounting change of $375 million or $0.03 per basic share and diluted share, reflecting the adoption of SFAS No. 133. (3) Includes $3.92 billion (pre-tax) in impairments of certain investments. (4) Includes $1.82 billion (pre-tax) in impairments of certain investments. (5) Includes $1.25 billion (pre-tax) gain on the sale of Expedia, Inc. and $1.19 billion (pre-tax) in impairments of certain investments. (6) Includes $1.19 billion (pre-tax) in impairments of certain investments. 39  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 8 INDEPENDENT AUDITORS’ REPORT To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries as of June 30, 2002 and 2003, and the related +consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2003. These financial statements are the responsibility of the Corporation’s management. Our responsibility is +to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally +accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test +basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement +presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present +fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2002 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2003 +in conformity with accounting principles generally accepted in the United States of America. As described in Note 3 to the financial statements, the +Company adopted Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities , effective July 1, 2000, and Statement of Financial Accounting Standards No. 142, Goodwill and Other +Intangible Assets , effective July 1, 2001. /s/    D ELOITTE & T OUCHE LLP Deloitte & Touche LLP Seattle, Washington July 17, 2003 (September +3, 2003 as to certain information in Note 20) 40  /  MSFT 2003 FORM 10-K Table of Contents Part II, Item 9, 9A, Part III, Item 10, 11, 12, 13, 14 ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures None. ITEM +9A. Controls and Procedures Under the supervision and with the +participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-14(c) as +of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal +control over financial reporting during the quarter ended June 30, 2003 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. PART III ITEM 10. Directors and Executive Officers of the Registrant Information with respect to Directors may be found under the caption “Election of Directors and Management Information” of our Proxy Statement for the Annual Meeting of Shareholders to be held November 11, 2003 (the “Proxy +Statement”). Such information is incorporated herein by reference. The information in the Proxy Statement set forth under the caption +“Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code +of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Corporate Controller and other finance organization employees. The finance code of ethics is +publicly available on our website at www.microsoft.com/msft. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief +Financial Officer or Corporate Controller, we will disclose the nature of such amendment or waiver on that website or in a report on Form 8-K. ITEM 11. Executive Compensation The information in the Proxy Statement +set forth under the captions “Information Regarding Executive Officer Compensation” and “Information Regarding the Board and its Committees – Director Compensation” is incorporated herein by reference. ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters The information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of +Principal Shareholders, Directors, and Management” is incorporated herein by reference. ITEM 13. Certain Relationships and Related Transactions The +information set forth under the captions “Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference. ITEM 14. Principal Accounting Fees and Services Information concerning +principal accountant fees and services appears in the proxy statement under the heading “Fees Paid to Deloitte & Touche LLP” and is incorporated herein by reference. 41  /  MSFT 2003 FORM 10-K Table of Contents Part IV, Item 15 PART IV ITEM 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. Financial +statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included. (b) Reports on Form 8-K We did not file any reports on Form 8-K during the +quarter ended June 30, 2003. We furnished to the SEC reports on Form 8-K on April 15, 2003 and May 12, 2003. The April 15, 2003 Form 8-K was for the purpose of furnishing the press release announcing our financial results for the fiscal quarter +ended March 31, 2003. The May 12, 2003 Form 8-K was for the purpose of furnishing our consolidated balance sheets as of June 30, 2002 and March 31, 2003, and the related consolidated statements of income, cash flows, and stockholders’ equity +for the three and nine months ended March 31, 2002 and 2003 formatted in XBRL (Extensible Business Reporting Language). (c) Exhibit Listing Exhibit Number Description 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation (1) 3.2 Bylaws of Microsoft Corporation (2) 10.1 Microsoft Corporation 2001 Stock Plan, as amended and restated 10.2 Microsoft Corporation 1991 Stock Option Plan (3) 10.3 Microsoft Corporation 1981 Stock Option Plan (4) 10.4 Microsoft Corporation 1999 Stock Option Plan for Non-Employee Directors (5) 10.5 Microsoft Corporation Stock Option Plan for Consultants and Advisors (6) 10.6 Microsoft Corporation 2003 Employee Stock Purchase Plan (7) 10.7 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee) (6) 10.8 Trust Agreement dated as of June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee 10.9 Form of Indemnification Agreement (6) 21. Subsidiaries of Registrant 23. Independent Auditors’ Consent 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32. Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2002. (2) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2003. (3) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 1997. (4) Incorporated by reference to Registration Statement 33-37623 on Form S-8. (5) Incorporated by reference to Registration Statement 333-91755 on Form S-8. (6) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2002. (7) Incorporated by reference to Registration Statement 333-102240 on Form S-8. 42  /  MSFT 2003 FORM 10-K Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or +15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on September 4, 2003. M ICROSOFT C ORPORATION By: /s/    J OHN G. C ONNORS John G. Connors Senior Vice President, Chief Financial +Officer Pursuant to the requirements of the +Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on September 4, 2003. Signature Title /s/    W ILLIAM H. G ATES III William H. Gates III Chairman of the Board of Directors and Chief Software Architect /s/    S TEVEN A. +B ALLMER Steven A. Ballmer Chief Executive Officer /s/    J AMES I. C ASH , J R ., +Ph.D. James I. Cash, Jr., Ph.D. Director /s/    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director /s/    A NN M C L AUGHLIN K OROLOGOS Ann McLaughlin Korologos Director /s/    D AVID F. +M ARQUARDT David F. Marquardt Director /s/    W M . G. R EED , +J R . Wm. G. Reed, Jr. Director /s/    J ON A. +S HIRLEY Jon A. Shirley Director /s/    J OHN G. +C ONNORS John G. Connors Senior Vice President, Chief Financial Officer (Principal Financial and Accounting Officer) 43  /  MSFT 2003 FORM 10-K \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-04-150689/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-04-150689/full-submission.txt new file mode 100644 index 0000000..942b9fd --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-04-150689/full-submission.txt @@ -0,0 +1,960 @@ +Table of Contents United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2004 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE +TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, +WASHINGTON 98052-6399 (425) 882-8080 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section +13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes x No ¨ Indicate by check mark if disclosure of delinquent filers +pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any +amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes x No ¨ The aggregate market value of common stock held by non-affiliates of the registrant as of December 31, +2003 was $252,132,492,030. The number of shares outstanding of the registrant’s +common stock as of August 15, 2004 was 10,872,704,667. DOCUMENTS +INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered +to shareholders in connection with the Annual Meeting of Shareholders to be held November 9, 2004 are incorporated by reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2004 INDEX PART I Item 1. Business 1 Item 2. Properties 10 Item 3. Legal Proceedings 11 Item 4. Submission of Matters to a Vote of Security Holders 11 Executive Officers of the Registrant 11 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 13 Item 6. Selected Financial Data 14 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 15 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 33 Item 8. Financial Statements and Supplementary Data 35 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 65 Item 9A. Controls and Procedures 65 Item 9B. Other Information 65 PART III Item 10. Directors and Executive Officers of the Registrant 66 Item 11. Executive Compensation 66 Item 12. Security Ownership of Certain Beneficial Owners and Management 66 Item 13. Certain Relationships and Related Transactions 66 Item 14. Principal Accountant Fees and Services 66 PART IV Item 15. Exhibits and Financial Statement Schedules 66 Signatures 68 Table of Contents Part I Item 1 PART I ITEM 1.    BUSINESS GENERAL Over the last three decades, technology has transformed the way +people work, play, and communicate. Today, people access information and communicate with individuals from around the world in an instant. Groundbreaking technologies have opened the door to innovations in every field of human endeavor, delivering +new opportunity, convenience, and value to people’s lives. Since our founding in 1975, we have been a leader in this transformation. As a reflection of that role, and to help us focus on the opportunities that lie ahead we have established a +new corporate mission: To enable people and businesses throughout the world to realize their full potential. PRODUCT SEGMENTS Our product segments +provide management with a comprehensive financial view of our key businesses. The segments provide a framework for the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and for the timely +and rational allocation of development, sales, marketing, and services resources within businesses. The segments also help focus strategic planning efforts on key objectives and initiatives across our broad businesses. The product segments are designed to allocate resources internally and provide a framework to determine management responsibility. Due to our integrated business +structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products included in each segment. Inter-segment cost +commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared effort. Due to our integrated business structure, segments should not be viewed as discrete or easily separable +businesses. Our seven product segments are: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded +Devices; and Home and Entertainment. See Note 18 – Segment Information of the Notes to Financial Statements for financial information regarding segment reporting. Client . The Client segment has overall responsibility for product delivery, engineering, and technical +architecture for the Microsoft Windows operating system and new media technology, as well as our relationships with manufacturers of personal computers, including multinational and regional original equipment manufacturer (OEM) accounts. The segment +includes sales and marketing expenses for the Windows Client operating system and product development efforts for the Windows platform. The Client +segment includes Windows XP and other standard Windows operating systems. Windows XP extends the personal computing experience by uniting PCs, devices, and services, while enhancing reliability, security, and performance. With emerging form factors +such as the Tablet PC and Media Center, and with investments in technology such as Windows Media, we believe the “Windows PC” continues to evolve with innovations that enable people to use computers in more ways, in more places, and more +often than ever before. Windows XP Home Edition is designed for individuals or families and includes capabilities for digital photo, music, video, +home networking, and communications. Windows XP Professional, designed for business users and people who demand the most from their computing experience, includes all the features of Home Edition, along with advanced security, performance, +manageability, and multilingual features to help customers improve their productivity and connectivity. Windows XP 64-Bit Edition meets the demands of specialized technical workstation users. The next generation of the Windows operating system, code-named Longhorn, is currently under development. This development phase represents a significant investment +for the Client business and is expected to result in a product that is more manageable and deployable for both our business and consumer markets. While all features and functions have not been finalized, Longhorn will include significant advances in +security, digital media, user interfaces, and other areas that are expected to enhance the user and developer experience. We are targeting broad availability of this operating system in calendar year 2006. We are also developing a Windows storage +subsystem, which will provide advanced data organization and management capabilities, that we plan to deliver subsequent to the Longhorn operating system introduction. PAGE 1 Table of Contents Part I Item 1 Server and Tools . The Server and +Tools segment has overall responsibility for integrated product development and marketing of Windows Server System products, including building and marketing Windows Server operating systems. Windows Server System is integrated server infrastructure +software that is designed to support end-to-end solutions built on the Windows Server 2003 operating system. In addition, the segment provides information about the extended Microsoft platform through a variety of content offerings, such as +Web-based training for developers and IT professionals. Through this segment, we offer a broad range of consulting services for advanced technology requirements, including custom solution services, enterprise application planning, architecture and +design services, and proof-of-concept services. We also provide product support services to corporations and other large customers. The Server and Tools segment also includes: developer tools, training, and certification; Microsoft Press; the +Enterprise and Partner Group, which is responsible for sales, partner management and partner programs for the enterprise business; and the Public Sector sales and marketing organization. Products in Server and Tools provide a wide range of capabilities that include messaging and collaboration, database management, e-commerce, and mobile information +access. These products are designed to work seamlessly with one another and with advancements in applications and development tools. This architecture is designed to help simplify the design, development, deployment, and management of solutions so +that customers can focus less on integrating systems and training users, and more on adding strategic value to their businesses. Windows Server System also readily integrates with customers’ existing non-Microsoft systems, through support for +open standards such as HTTP and XML, and through native support for XML-based Web services. Windows Server delivers a platform for powering connected +applications, networks, and Web services from the work group to the data center. SQL Server is a database-and-analysis offering for rapidly delivering the next generation of scalable e-commerce, line-of-business, and data-warehousing solutions. +Exchange Server, a business tool for e-mail collaboration, enables information workers to gain access to critical business communications. Systems Management Server (SMS) provides a comprehensive solution for change and configuration management of +information systems, which we believe enables organizations to provide relevant software and updates to users quickly and cost-effectively. Small Business Server helps small businesses do more with a business server solution that includes messaging +and collaboration, security-enhanced Internet access, protected data storage, reliable printing, the ability to run line-of-business applications, and faxing. BizTalk Server is designed to help customers efficiently and effectively integrate +systems, employees, and trading partners through manageable business processes, enabling them to automate and orchestrate interactions in a flexible and highly automated manner. Developer tools focus on coordinating the overall programming model for +the client and server, creating tools for developing Microsoft .NET-connected applications and services, and fostering synergies between Windows and the Windows Server System offerings. Information Worker . The Information Worker segment is responsible for developing and delivering technologies that +transform information into impact for people and organizations that create, analyze, communicate, and use information every day. The products in this segment help people to be more productive, with more control over their time and more opportunity +to realize their potential. These applications are a critical part of the application architecture for many enterprises, enabling businesses to liberate information from individual silos, become more agile and flexible, and respond more readily to +new opportunities. The segment consists of the Microsoft Office System of programs, servers, services, and solutions. Microsoft Office System 2003, +the successor to Microsoft Office XP, was released to market in the first half of fiscal 2004 and has evolved from a suite of personal productivity products to a more comprehensive and integrated system of products designed to increase personal, +team, and organization productivity. The Microsoft Office System features integration with Microsoft intranet collaboration technologies, Information Rights Management, and support for industry standard XML. The Microsoft Office System includes the +Microsoft Office 2003 Editions, which include (depending upon the edition): Microsoft Office Outlook 2003; Microsoft Office Excel 2003; Microsoft Office PowerPoint 2003; Microsoft Office Word 2003; and Microsoft Office Access 2003. Other products in +the Microsoft Office System include: Microsoft Office Visio 2003; Microsoft Office Project 2003; Microsoft Office Project Server 2003; Microsoft Office InfoPath 2003; Microsoft Office OneNote 2003; Microsoft Office Publisher 2003; Microsoft Office +FrontPage 2003; and Microsoft Office SharePoint Portal Server 2003. In addition, the Information Worker segment includes Microsoft Office Live Meeting Web conferencing service and professional product support. Historically, approximately 40 percent of Information Worker billed revenue comes from multi-year license agreements with large enterprises. Revenues from these +licenses generally depend upon the number of information workers in a licensed enterprise. Therefore, our revenue from this category of agreements is relatively independent of the number of PCs sold in a given year, but rather depends on the number +of employees in a given enterprise. PAGE 2 Table of Contents Part I Item 1 Consequently, general employment levels, particularly in North America +and EMEA, significantly affect Information Worker revenue. Approximately 40 percent of Information Worker revenue comes from new licenses acquired through fully packaged product and transactional volume licensing programs to individual consumers and +enterprises of all sizes. Most of this revenue is sensitive to information technology budgets, which often depend on general economic conditions. The remaining approximately 20 percent of Information Worker revenue is from licenses to OEMs for new +PCs and through sales of retail packaged products and is affected by the relative level of PC shipments. For fiscal 2004, the segment includes the +Small and Mid-Market Solutions & Partners (SMS&P) organization, which is responsible for sales, partner management, partner programs, and customer segment marketing to small and mid-market businesses. During fiscal 2004, we combined the +existing small and medium business sales force with the sales and marketing assets of the Microsoft Business Solutions segment to form the SMS&P organization. We announced in the fourth quarter of fiscal 2004 a reorganization which, effective +July 1, 2004, will include the SMS&P organization in the Microsoft Business Solutions segment. This change is designed to optimize our focus on delivering business applications to small and mid-market segment businesses. Microsoft Business Solutions . The Microsoft Business Solutions +segment is responsible for developing and marketing integrated, end-to-end business applications and services designed to help small and mid-market businesses achieve success by becoming more connected with customers, employees, partners, and +suppliers. The applications provide integrated, end-to-end automation for financial reporting, distribution, project accounting, electronic commerce, human resources and payroll, manufacturing, supply chain management, business intelligence, sales +and marketing management, customer relationship management, and customer service and support. The segment consists of the businesses generated from +Enterprise Resource Planning (Microsoft Great Plains, Microsoft Navision, Microsoft Solomon and Microsoft Axapta – acquired through our purchase of Great Plains and Navision); Microsoft CRM (Customer Relationship Management); Microsoft RMS +(Retail Management System); and other business applications and services. Microsoft Business Solutions products are sold, implemented, and supported through a partner network consisting of value-added resellers, systems integrators, consultants, +independent software vendors (ISVs), accounting firms (national, regional, and local), application service providers (ASPs), and eBuilders. Microsoft Business Solutions partners provide distribution, marketing, training, and support in the business +application customer segment. As described previously, beginning in the first quarter of fiscal 2005, the SMS&P organization, which was part of the Information Worker segment, will be included in the Microsoft Business Solutions segment. MSN. MSN is responsible for delivering online services +that seek to empower people by bringing them closer to the people and information that matter most to them. MSN provides personal communications services, such as e-mail and instant messaging, and information services such as MSN Search and the MSN +portals and channels around the world. MSN manages many of its own properties, including health, autos, and shopping. MSN also creates alliances with leading third parties for many channels, including top partners like MSNBC.com, a joint venture +between NBC Universal and Microsoft; Foxsports.com, a property of Fox Entertainment Group; Expedia.com and Match.com, operating units of InterActiveCorp and CareerBuilder.com. MSN provides a variety of paid services resulting in revenue for the +segment, including MSN Internet Access, Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus), and MSN Mobile services. The segment generates revenue principally from advertisers on the MSN Web sites, from consumers through subscriptions and transactions generated from MSN Premium +Web Services, and from subscribers to MSN narrowband Internet access. According to studies performed by Nielson Net Ratings and comScore Media Metrix, MSN Web sites are among the most popular on the Internet, visited by more than 350 million unique +users every month. MSN Hotmail is one of the world’s largest e-mail services with more than 187 million accounts, and MSN Messenger is one of the world’s largest instant-messaging services with more than 135 million accounts. Mobile and Embedded Devices . The Mobile and Embedded Devices +segment is responsible for the development and marketing of products that extend the advantages of the Windows platform to many types of devices, including mobile devices that incorporate voice, personal information management, and media +capabilities, and a wide variety of other devices designed to improve people’s personal and work lives. Microsoft’s vision for mobile devices is rooted in the convergence of the computing and wireless industries, which brings new +opportunities to improve communication and information access for customers. We see software as a key differentiator in making smart devices and wireless data services valuable to customers through rich experiences such as location-based services, +media, and speech recognition. We are working closely with mobile operators, hardware and ISV partners to PAGE 3 Table of Contents Part I Item 1 accelerate the development and availability of smart devices and +services, and to provide a broad range of choices for customers. Further, the segment is responsible for managing sales and customer relations with device manufacturers and with network service providers, including telecommunications, cable and +wireless companies, and host and network equipment providers. The segment consists of the Windows Mobile software platform, the Windows Embedded +device operating system family, MapPoint, and Windows Automotive. The Windows Mobile software platform provides a familiar and integrated customer experience that is the basis for specific products like the Pocket PC, Pocket PC Phone Edition, +Smartphone, and new Portable Media Center. Windows Embedded, including Windows CE and Windows XP Embedded, is a family of embedded device software platforms used in non-PC computing devices. Windows Embedded software is used widely in advanced +consumer electronics devices, including digital televisions, Internet Protocol (IP)-based set top boxes, network gateways, and portable media players, as well as in enterprise devices such as industrial controllers, retail point-of-sale systems, and +voice-over-IP phones. The MapPoint family of location-enabled products and services includes the MapPoint Web Service, a hosted programmable XML Web service that allows developers to integrate location intelligence in applications, business +processes and Web sites, and business and consumer oriented mapping CD-ROM products. Windows Automotive is an automotive-grade software platform that provides developers with the building blocks to quickly and reliably create a broad range of +advanced telematics solutions. Home and +Entertainment . The Home and Entertainment segment is primarily responsible for realizing Microsoft’s plans to grow a range of new consumer businesses, building on the Windows platform to offer a broad range of +services and applications running on a wide variety of devices in the home. The Home and Entertainment segment is responsible for the development of and business strategy for the Microsoft Xbox video game system, including hardware, third-party +games development, games development published under the Microsoft label, Xbox and Xbox Live operations, marketing, research, and sales and support. The segment leads the development efforts of our Home Products Division (HPD) product lines. It also +carries out all retail sales and marketing for Microsoft Office, the Windows operating systems, Xbox, games, and HPD products. It is also responsible for the development, sales, and deployment of Microsoft’s TV platform products for the +interactive television industry. Microsoft Xbox, released in fiscal 2002, is our video game console system that delivers high-quality graphics and +audio experiences. We offer several types of entertainment products, including classic software games, online games, simulations, and strategy games. HPD includes Microsoft’s line of consumer hardware and software products, such as the Encarta +line of learning products and services, the Macintosh applications business, and Microsoft hardware products. EQUITY METHOD INVESTMENTS We have +entered into joint venture arrangements to take advantage of creative talent and content from other organizations. The majority of our joint ventures are managed by the MSN segment. MSNBC Cable L.L.C., a 24-hour cable news and information channel +and MSNBC Interactive News L.L.C., an interactive news service, both of which are owned 50% by us and 50% by National Broadcasting Company (NBC); ninemsn Pty Ltd, an Australian internet portal; and T1MSN, an internet portal serving Mexico are some +of our joint venture arrangements. OPERATIONS We develop products for sale throughout the world. Our major geographic sales and marketing +organizations are the North American Region; the Latin American Region; the Europe, Middle East, and Africa Region (EMEA); Japan; the Asia-Pacific Region; Greater China; and the worldwide OEM channel. To serve the needs of customers around the +world, we “localize” many of our products to reflect local languages and conventions, and to improve the quality and usability of the product in international markets. Localizing a product may require modifying the user interface, altering +dialog boxes, and translating text. Our research and development facilities are located primarily in Redmond, with smaller facilities located in Mountain View, California; Fargo, North Dakota; Beijing, China; Dublin, Ireland; Vedbaek, Denmark; +Hyderabad, India; Haifa, Israel; and Cambridge, England. We have regional operations centers in Ireland, Singapore, and the greater Seattle area. The +centers support all operations in their regions, including information processing and vendor management and logistics. The regional center in Dublin, Ireland, supports the Europe, Middle East, and Africa region; the center in Singapore supports the PAGE 4 Table of Contents Part I Item 1 Japan, Greater China and Asia-Pacific region; and the center in the +greater Seattle area supports North America and Latin America. Microsoft Licensing, GP, a wholly-owned entity in Reno, Nevada, manages our original equipment manufacturer (OEM) and certain organizational licensing operations and billing. We contract most of our manufacturing activities to third parties. Outside manufacturers produce the Xbox, various retail software packaged products, and +Microsoft hardware. Our products may include some components that are available from only one or limited sources. Key components that are currently obtained from a single source include the Xbox central processing unit (CPU) from Intel Corporation +and the Xbox graphics processing unit (GPU) from NVIDIA Corporation. With the exception of the Xbox CPU and GPU, we generally have the ability to use other custom manufacturers if the current manufacturing vendor becomes unavailable. We generally +have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume discount basis. Pressure to globalize our pricing structure might require that we reduce the sales price of our software in the United States and other countries. A number of other factors could also have a negative effect on our business and results from +operations outside of the United States, including changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, +political, labor, or economic conditions in a specific country or region, including foreign exchange rates; difficulties in staffing and managing foreign operations; and potential adverse foreign tax consequences. We hedge a portion of our +international currency exposures, thereby reducing our overall translation exposures. PRODUCT DEVELOPMENT During fiscal 2002, 2003, and 2004, +research and development expense was $6.30 billion, $6.60 billion, and $7.78 billion respectively. Those amounts represented 22.2%, 20.5%, and 21.1%, respectively, of revenue in each of those years. Fiscal 2002 and 2003 have been restated to reflect +the retroactive adoption of SFAS 123, Accounting for Stock-Based Compensation . We plan to continue significant investment on a broad range of research and product development. Most of our software products are developed internally. We also purchase technology, license intellectual property rights, and oversee third-party development and +localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control over +our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Product documentation generally is also created internally. We strive to obtain information at the +earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, +and testing. Business and Product Development +Strategy . The key to Microsoft’s growth is innovation. In fiscal 2004, we filed for more than 2,000 patents for new technologies, and we expect that number to increase. We expect these innovations to lead to +revenue growth from market expansion, share growth, new scenarios and market opportunities, and value-added through services. Key areas of focus +include: • PC Market Growth: It took more than 20 years to grow the worldwide base of PC users to 600+ million. By 2010, we expect this base to grow to 1 billion, +due to opportunities in emerging markets and new scenarios and form factors expected to stimulate demand. Our continued success will depend on delivering secure, groundbreaking software and compelling scenarios that capture the imagination of end +users. We are working on new PC and Windows designs to make PCs affordable to millions of additional people around the world. • New Information Worker Scenarios: We believe one of our biggest growth opportunities is with our existing base of Office users. We plan to pursue this market by +delivering new information worker scenarios such as collaboration, authoring, communications, planning and analysis, and expanding the toolset with new technologies such as SharePoint, Live Meeting, OneNote and InfoPath. PAGE 5 Table of Contents Part I Item 1 • Enhanced Server Position: We believe Windows Server 2003 and our other server offerings provide customers with significant advantages in many areas, including +innovation, performance, productivity, applications development tools and environment, security and manageability. In addition, we offer an integrated platform that includes our server and Information Worker applications as well as partner ISV +workloads and applications. • Reducing Complexity and Cost for IT Professionals and Developers: We believe that building applications, integration, and managing information technology are +still too hard for customers. We are working on new ways to further lower costs and speed time to deploy technology for IT professionals and developers. We believe we are already helping reduce costs and increase business value with products such as +Windows Server 2003, Visual Studio .NET, SMS 2003, the Dynamic Systems Initiative, and Microsoft Operations Manager 2005. • IT Services for Smaller Business and Consumers: The MSN, Windows, and Office teams are working together on a set of integrated IT services for smaller businesses +and consumers designed to enhance security, lower costs, and improve the end-user experience in areas such as communication, collaboration, and desktop management. • Business Solutions: Microsoft Business Solutions continues to expand its small and mid-market offerings with key investments in technologies for CRM, online +services, retail management, and small business. We believe we have a significant opportunity to help this underserved market, while creating great opportunities for ISVs and partners. • Non-PC Consumer Electronics: We believe that our work to integrate the richness and intelligence of the PC world with everyday devices such as mobile phones, +handheld devices, home entertainment and TV provides a broad new market opportunity. At the center of our efforts are products such as Pocket PC and Smartphone, Portable Media Center, MSTV, MSN TV, Windows Automotive, the Windows Media Center +Extender, and other electronic devices built on Windows CE and Windows XP Embedded. • Entertainment: Likewise, we believe there is significant opportunity in delivering compelling entertainment experiences in key scenarios such as music, TV, +movies, photos and games. Our vision centers on creating new and exciting ways for people to have fun with friends and family with Media Center PCs, devices like Xbox and Portable Media Center, and many of the other applications and services that +Microsoft and our partners deliver. • Advertising/Information: The value that MSN and our platform bring to advertisers is already significant, as evidenced by the fact that our MSN advertising +business today is a $1 billion-plus business. We believe the potential to expand advertising in all our online offerings is significant. In fiscal 2005, we will invest in and deliver improvements in search, music and other information services that +should continue to provide good growth opportunities. We believe our industry has only scratched the surface in search. We are making significant investments to improve the user experience and deliver the information people want more efficiently and +effectively. • Communications: Broadband and wireless technology is increasing the amount of time people spend online. Younger and savvier Internet users want communications +experiences to build their social network on any device. We believe professionals and information workers want integrated, secure functionality that help them manage their personal and professional lives: personalized email, instant messaging, +contact management, shared calendars, and relationship management. We are pursuing these opportunities by developing communications offerings designed to provide the greatest benefit to consumers and device manufacturers. For example, our Windows +Mobile software is the basis for new mobile smartphones and for Portable Media Center devices from leading consumer electronics companies. DISTRIBUTION, SALES AND MARKETING We distribute our products primarily through the following channels: OEM; distributors and resellers; and online services. Our six major geographic sales and marketing +organizations are the North American Region; the Latin American Region; the Europe, Middle East, and Africa Region; Japan; the Asia-Pacific Region and Greater China. OEM . Our operating systems are licensed primarily to OEMs under agreements that grant the OEMs the right to build +computing devices based on our operating systems, principally PCs. Under similar arrangements, we also market and license certain server operating systems, desktop applications, hardware devices, and consumer software products to OEMs. We have OEM +agreements covering one or more of our products with virtually all of the PAGE 6 Table of Contents Part I Item 1 major PC OEMs, including Acer, Actebis, Dell, eMachines, Fujitsu, +Gateway, HP, IBM, NEC, Samsung, Siemens Computers, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume customized PC vendors operating in local markets. Distributors and Resellers . We distribute our finished goods +products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Organizations license our products primarily through Large Account Resellers (LARs), Direct Market Resellers (DMRs), and +value-added resellers. Many organizations that license products through Enterprise Agreements (EAs) now transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically +are also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations and value-added resellers +typically reach the breadth of small- and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include Software Spectrum, Software House International, Dell, CDW, and Insight +Enterprises. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Wal-Mart, and Target. We have a network of field sales representatives and field support personnel that solicits orders from distributors and +resellers and provides product training and sales support. We license software to organizations under arrangements that allow the end-user customer +to acquire multiple licenses of product. These arrangements are designed to provide organizations with a means of acquiring multiple licenses, without having to acquire separate packaged product through retail channels. In delivering organizational +licensing arrangements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they are as follows: Open. Designed primarily for small-to-medium +organizations (5 to over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years). The offering +that conveys rights to future versions of software product over the contract period is called Software Assurance. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the Open +program, customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing volume licensing agreements. Select. Designed primarily for medium-to-large organizations (greater than 250 licenses), this +program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future versions of software products, support, tools, and training over a specified time period (generally +three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements. Enterprise Agreement. The Enterprise Agreement is +targeted at medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their enterprise, along with rights to future versions of software products, generally over a three-year period. Enterprise Subscription +Agreement. The Enterprise Subscription Agreement (ESA) is a time-based, multi-year licensing agreement. Under an ESA, customers acquire the right to use the current version of software products and the future versions +that are released during the three-year term of the agreement. At the end of the term, customers may either renew their ESA or exercise a buy-out option to obtain perpetual licenses for the latest version of the covered products. If they do not +elect one of these options, then all previously covered software must be uninstalled. Online Services . We distribute online content and services through MSN and other online services. MSN delivers Internet access and other premium services and tools to consumers. MSN also delivers online +e-mail and messaging communication services as well as information services such as online search and premium content. Microsoft Business Solutions operates the bCentral small-business portal, which is delivered online. The bCentral portal provides +tools and expertise for small-business owners to build, market, and manage their businesses online. Other services delivered online include Xbox Live, Microsoft Developer Networks (MSDN) subscription content and updates, periodic product updates, +and online technical and practice readiness resources to support our partners in developing and selling our products and solutions. PAGE 7 Table of Contents Part I Item 1 CUSTOMERS Our customers include individual consumers, small and medium-sized organizations, enterprises, +governmental institutions, educational institutions, Internet Service Providers, application developers, and OEMs. Consumers and small and medium-sized organizations obtain our products primarily through resellers and OEMs. Sales to Dell and its +subsidiaries in the aggregate accounted for approximately 10% of fiscal 2004 revenue. These sales were made primarily through our OEM and volume licensing channels. No single customer accounted for more than 10% of revenue in 2002 or 2003. Our +practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. COMPETITION The software business is intensely competitive and subject to rapid technological change, evolving customer requirements, and changing business models in every segment. We face significant competition in all areas of our +business. The rapid pace of technological change continually creates new opportunities for existing competitors and start-ups and can quickly render existing technologies less valuable. Customer requirements and preferences continually change as +other information technologies emerge or become less expensive, and as concerns such as security and privacy become more important. Our direct competitors include firms adopting alternative business models to the commercial software model. Firms +adopting the non-commercial software model typically provide customers with open source software at nominal cost and earn revenue on complementary services and products, without having to bear the full costs of research and development for the open +source software. Global software piracy – the unlawful copying and distribution of our copyrighted software products – deprives us of significant amounts of revenue on an annual basis. Future versions of our products +compete with the existing versions licensed to our installed base of customers. This means that future versions must deliver significant additional value in order to induce existing customers to purchase a new version of our product. Our competitive position may be adversely affected in the future by one or more of the factors described in this section, or as yet undefined additional factors +that may arise. Client . Although we are the leader +in PC operating system software products, we face strong competition from well-established companies and entities with differing approaches to the market. Competing commercial software products, including variants of Unix, are supplied by +competitors such as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and others, which are vertically integrated in both software development and hardware manufacturing and have developed operating systems that they preinstall on their own +computers. Personal computer OEMs who preinstall third-party operating systems may also license these firms’ operating systems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public +License, has gained increasing acceptance as competitive pressures lead personal computer OEMs to reduce costs. The Microsoft Windows operating systems also face competition from alternative platforms, as well as innovative devices that may reduce +consumer demand for traditional personal computers. We believe our operating system products compete effectively by delivering better innovation, an easy-to-use interface, compatibility with a broad range of hardware and software applications, and +the largest support network for any operating system. Server and +Tools . Our server operating system products face intense competition from a wide variety of competing server operating systems and server applications, offered by firms with a variety of market approaches. +Vertically integrated computer manufacturers such as IBM, Hewlett-Packard, Sun Microsystems and others offer their own variant of Unix preinstalled on server hardware, and nearly all computer manufacturers offer server hardware for the Linux +operating system. IBM’s endorsement of Linux has accelerated its acceptance as an alternative to both traditional Unix and Windows server operating systems. Linux’s competitive position has also benefited from the large number of +compatible applications now produced by many leading commercial software developers as well as non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. We compete in the business of providing enterprise-wide computing solutions with several companies that provide competing solutions as well as middleware technology +platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for the PC-based distributed client/server environments +include Oracle, IBM, and Computer Associates. There are also a number of non-commercial software server applications available. PAGE 8 Table of Contents Part I Item 1 Numerous commercial software vendors offer competing +commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. Additionally, IBM has a large installed base of Lotus Notes and cc:Mail, both of which compete with our collaboration and +e-mail products. There are also a significant number of non-commercial software products that compete with our solutions, including Apache Web Server. Our developer products compete against offerings from BEA Systems, Borland, IBM, Macromedia, Oracle, Sun Microsystems, and other companies. We believe that our server products provide customers with significant advantages in innovation, performance (both relative to total costs of ownership and in absolute terms), productivity, applications development tools and environment, +compatibility with a broad base of hardware and software applications, security, and manageability. Information Worker . While we are the leader in business productivity software applications for personal computers, competitors to the Microsoft Office System include many software +application vendors such as Apple, Corel, IBM, Oracle, Sun Microsystems, and local application developers in Europe and Asia. IBM and Corel have significant installed bases with their office productivity products, and both have aggressive pricing +strategies. Also, Apple and IBM preinstall certain of their application software products on various models of their PCs, competing directly with our applications. Corel’s suite and Sun Microsystems’ Star Office are aggressively priced and +attractive for OEMs to preinstall on low-priced PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that is gaining popularity in certain market segments. In addition to traditional client-side applications, +Web-based offerings such as SimDesk provide an alternative to Microsoft Office System products. In addition, IBM has a significant installed base of messaging and collaboration software. We believe that our products compete effectively by providing +customers significant benefits, such as ease of use, personal productivity, support for effective teaming and collaboration, and better information management and control, and by providing many customers a lower total cost of ownership than +alternatives. Microsoft Business Solutions . The +small and mid-market business applications segment is highly fragmented and is intensely competitive in all sectors where we compete. We face competition from a large number of companies in this business. Well-known vendors focused on small and +mid-market business solutions, such as Intuit and Sage (along with many others), compete against us for a portion of this segment. In addition, large-enterprise focused vendors, such as Oracle, PeopleSoft, and SAP, are repositioning some of their +business applications to focus on small and medium-sized business and thus also compete against us for a portion of this segment. In addition, there are thousands of other vendors in specific localities or industries that offer their own enterprise +resource planning (ERP), customer relationship management (CRM), and/or analytic solutions. We believe that our business applications products across financial management, supply chain management, and CRM compete effectively in our target segments +by offering solutions and services that address multiple segment needs across industries through consistent innovation in product functionality delivered through a growing network of partners. MSN . MSN competes with Yahoo!, Google, AOL, Earthlink, U.S. cable +and DSL providers, and a vast array of Web sites and portals that offer content and online services of all types. MSN also competes with traditional advertising and print media. As the broadband access market grows, we expect to have increasing +opportunities to deliver rich and compelling services and experiences for consumers. MSN’s advertising revenue has grown considerably over the last year, and we expect this trend to continue in display advertising as well as in search-based +advertising, as online advertising continues to gain market acceptance. This growth has led to competitors aggressively pursuing both advertisers and consumers with expanded offerings and new technology. We are building our own algorithmic search +engine and investing to support the continued growth of our advertising business. Due to the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to decline. +We believe our competitive advantage comes from our ability to empower people globally through information software and services that help them find, discover, and experience what they want online. Mobile and Embedded Devices . Windows Mobile software faces +substantial competition from Nokia, Openwave Systems, PalmSource, QUALCOMM, and Symbian. The embedded operating system market is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable +Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. MapPoint competitors include DeLorme, MapInfo, Mapquest.com, Rand McNally, Webraska Mobile Technologies, and Yahoo! The telematics market is also highly fragmented, with +competitive offerings from IBM and automotive suppliers building on various real-time PAGE 9 Table of Contents Part I Item 1, 2 operating system platforms from commercial Linux vendors, QNX +Software Systems, Wind River, and others. We believe that our products compete effectively by providing a familiar development framework that enables developers to easily write and deploy innovative applications for mobile or embedded devices; +providing a flexible platform that allows customers and partners to build differentiated and profitable business models; and providing end users significant benefits such as ease of use, personal productivity, and better information management and +control. Home and Entertainment . The home and +entertainment business is highly competitive and is characterized by limited platform life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by +significant price competition, and we anticipate continued pricing pressure from our competitors. These pressures have, from time to time, required us to reduce prices on certain products. Our competitors vary in size from very small companies with +limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of price, product quality and variety, timing of product releases, and effectiveness of distribution and +marketing. Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of which have a large established base of +customers. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that have been licensed by us to develop and publish software for the Xbox console. These competitors +include Acclaim Entertainment, Activision, Atari, Capcom, Eidos, Electronic Arts, Sega, Take-Two Interactive, Tecmo, THQ, and Ubi Soft, among others. Success in the games business is increasingly driven by hit titles, which are difficult to develop +and require substantial investments in development and marketing. In addition, other forms of entertainment such as music, motion pictures, and television compete against our entertainment software for consumer spending. We believe that our Xbox +products compete effectively by providing customers benefits such as superior game console performance, exclusive game content, and innovative online multiplayer gaming through Xbox Live. Our PC hardware products face aggressive competition from +computer and other hardware manufacturers, many of which are also current or potential partners. EMPLOYEES As of June 30, 2004, we +employed approximately 57,000 people on a full-time basis, 37,000 in the United States and 20,000 internationally. Of the total, 24,000 were in product research and development, 16,000 in sales and marketing, 11,000 in product support and consulting +services, 2,000 in manufacturing and distribution, and 4,000 in general and administration. Our success is highly dependent on our ability to attract and retain qualified employees. Competition for employees is intense in the software industry. We +believe we have been successful in our efforts to recruit qualified employees, but we cannot guarantee that we will continue to be as successful in the future. None of our employees are subject to collective bargaining agreements. We believe that +our relationship with our employees is excellent. AVAILABLE +INFORMATION Our Internet address is www.microsoft.com. There we make available, free +of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. +Our SEC reports can be accessed through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. ITEM 2.    PROPERTIES Our corporate +offices consist of approximately 8.9 million square feet of office building space located in King County, Washington: 7.5 million square feet of that total is corporate campus space situated on slightly more than 300 acres of owned land and +approximately 1.4 million square feet is leased. We are currently renovating two buildings with approximately 392,000 square feet that we plan to occupy in fiscal 2005. To accommodate future expansion needs we purchased approximately 63 acres, and +have an option to purchase approximately 45 additional acres in Issaquah, Washington, which can accommodate 2.1 million square feet of additional office space. We own approximately 576,000 square feet of office building space domestically (outside +of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 2.8 million square feet of office building space. PAGE 10 Table of Contents Part I Item 2, 3, 4 We occupy many sites internationally, totaling +approximately 6.1 million square feet that is leased and approximately 223,000 square feet that is owned. These facilities include our European Operations Center that leases a 187,000 square-foot campus in Dublin, Ireland, a 56,000 square-foot disk +duplication facility in Humacao, Puerto Rico, and a 96,000 square-foot facility in Singapore for our Asia Pacific Operations Center and Regional headquarters. Leased office building space includes the following locations: Tokyo, Japan 459,000 square +feet; Unterschleissheim, Germany 381,000 square feet; Les Ulis, France 261,000 square feet; Reading, England 241,000 square feet; and Mississauga, Canada 235,000 square feet. In addition to the above, we have various product development facilities, +both domestically and internationally, as described in “Operations” above. Our facilities are fully used for current operations of all +segments, and suitable additional space is available to accommodate expansion needs. ITEM 3.    LEGAL PROCEEDINGS See Note 17 +– Contingencies of the Notes to Financial Statements (Item 8) for information regarding legal proceedings. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2004. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as +of August 25, 2004 were as follows: Name Age Position with the Company William H. Gates III 48 Chairman of the Board; Chief Software Architect Steven A. Ballmer 48 Chief Executive Officer James E. Allchin 52 Group Vice President, Platforms Group Robert J. (Robbie) Bach 42 Senior Vice President, Home and Entertainment Douglas J. Burgum 48 Senior Vice President, Microsoft Business Solutions David W. Cole 42 Senior Vice President, MSN and Personal Services Group John G. Connors 45 Senior Vice President; Chief Financial Officer Jean-Philippe Courtois 44 Senior Vice President; CEO, Microsoft Europe, Middle East, and Africa Kenneth A. DiPietro 45 Corporate Vice President, Human Resources Kevin R. Johnson 43 Group Vice President, Worldwide Sales, Marketing and Services Michelle (Mich) Mathews 37 Corporate Vice President, Marketing Craig J. Mundie 55 Senior Vice President; Chief Technical Officer, Advanced Strategies and Policy Jeffrey S. Raikes 46 Group Vice President, Information Worker Business Eric D. Rudder 37 Senior Vice President, Server and Tools Business Bradford L. Smith 45 Senior Vice President, General Counsel and Secretary David Vaskevitch 51 Senior Vice President; Chief Technical Officer, Business Platforms Mr. Gates co-founded Microsoft +in 1975 and served as its Chief Executive Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates has +served as Chairman since our incorporation. Mr. Ballmer was named Chief Executive Officer and a director of the Company in January 2000. He served as +President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980. Mr. Allchin was named Group Vice President, Platforms Group in December 1999. He had been Senior Vice President, Platforms since March 1999. He was previously Senior Vice President, Personal and Business Systems since February +1996. Mr. Allchin joined Microsoft in 1990. Mr. Bach was named Senior Vice President, Home and Entertainment in March 2000. He had been Vice +President, Home and Retail since March 1999. Before holding that position, he had been Vice President, Learning, Entertainment and Productivity, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988. PAGE 11 Table of Contents Part I Item 4 Mr. Burgum joined the Company as Senior Vice President +upon Microsoft’s acquisition of Great Plains Software, Inc. in April 2001. Prior to the acquisition, he had served as the Chairman and Chief Executive Officer of Great Plains. He joined Great Plains in 1983. Mr. Cole was named Senior Vice President, MSN and Personal Services Group in November 2001. Before holding that position, he had been Senior Vice President, +Services Platform Division since August 2000. He had been Senior Vice President, Consumer Services since December 1999 and Vice President, Consumer Windows since March 1999. Previously, he was Vice President, Web Client and Consumer Experience and +Vice President, Internet Client and Collaboration. Mr. Cole joined Microsoft in 1986. Mr. Connors was named Senior Vice President and Chief Financial +Officer in December 1999. He had been Vice President, Worldwide Enterprise Group since March 1999. Mr. Connors had been Vice President, Information Technology Group, and Chief Information Officer since July 1996. He joined Microsoft in 1989. Mr. Courtois was named Senior Vice President and Chief Executive Officer, Microsoft Europe, Middle East, and Africa in March 2003. He had been Senior +Vice President and President, Microsoft Europe, Middle East, and Africa since July 2000. Before holding that position, he had been Vice President, Worldwide Customer Marketing since July 1998. Mr. Courtois joined Microsoft in 1984. Mr. DiPietro joined Microsoft in January 2003 as Corporate Vice President, Human Resources. Prior to joining Microsoft, he was Vice President of Human Resources for +the Americas at Dell Computer Corporation. Before joining Dell, he was Senior Vice President of Human Resources at Pepsi-Cola International. Mr. +Johnson was named Group Vice President, Worldwide Sales, Marketing and Services in March 2003. He had been Senior Vice President, Microsoft Americas since February 2002. Mr. Johnson had been Senior Vice President, U.S. Sales, Marketing, and Services +since August 2001, and before that Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992. Ms. Mathews was named Corporate +Vice President, Marketing in August 2001. Before holding her current position, Ms. Mathews had been Vice President Corporate Public Relations since 1999. Ms. Mathews joined Microsoft in 1993. Mr. Mundie was named Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy in August 2001. He was named Senior Vice President, Consumer +Platforms in February 1996. He joined Microsoft in 1992. Mr. Raikes was named Group Vice President, Information Worker Business in June 2004. He had +been Group Vice President, Productivity and Business Services since August 2000. Mr. Raikes had been Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981. Mr. Rudder was named Senior Vice President, Server and Tools Business in June 2003. Prior to assuming that role, he was responsible for managing Developer and +Platform Evangelism. Mr. Rudder joined Microsoft in 1988. Mr. Smith was named Senior Vice President, General Counsel and Secretary in November 2001. +He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993. Mr. Vaskevitch was named Senior Vice President and Chief Technical Officer, Business Platforms in August 2001. He had been Senior Vice President, Business +Applications since March 2000. Mr. Vaskevitch had been Senior Vice President, Developer since December 1999. Before holding that position, he had been Vice President, Distributed Applications Platform. He joined Microsoft in 1986. PAGE 12 Table of Contents Part II Item 5 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 10, 2004, there were 141,975 registered holders of record of +our common stock. The high and low common stock prices per share were as follows: Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Year Fiscal 2003 Common stock price per share: High $ 27.43 $ 29.12 $ 28.49 $ 26.37 $ 29.12 Low 21.42 21.89 22.80 23.67 21.42 Fiscal 2004 Common stock price per share: High $ 29.96 $ 29.35 $ 28.80 $ 28.57 $ 29.96 Low 25.54 25.10 24.15 25.08 24.15 In September 2003, our board of directors +declared a common stock dividend of $0.16 per share, which was paid in November 2003. That was the only dividend declared or paid in fiscal 2004. Our dividend policy is based on, among other considerations, our views on potential future capital +requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. On July 20, 2004, our board of directors approved a quarterly dividend of $0.08 per share payable on September 14, 2004, to shareholders of record on August +25, 2004. In addition, the board approved a plan to buy back up to $30 billion in Microsoft common stock over the next four years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and +other factors. The repurchases will be made using our cash resources. The repurchase program may be suspended or discontinued at any time without prior notice. The board also approved a one-time special dividend of $3.00 per share, or approximately +$32 billion, subject to shareholder approval of stock plan amendments that will allow certain adjustments to employee equity compensation awards to offset the impact of the special dividend. The special dividend will be payable on December 2, +2004, to shareholders of record on November 17, 2004, conditioned upon shareholder approval of amendments to the employee stock plans at the annual meeting of shareholders scheduled to be held November 9, 2004. We did not repurchase any of our shares in the fourth quarter of fiscal 2004. PAGE 13 Table of Contents Part II Item 6 ITEM 6.    SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30 2000 (1) 2001 (1,2) 2002 (1,3) 2003 (1,4) 2004 Revenue $ 22,956 $ 25,296 $ 28,365 $ 32,187 $ 36,835 Operating income 11,006 11,720 8,272 9,545 9,034 Income before accounting change 9,421 7,721 5,355 7,531 8,168 Net income 9,421 7,346 5,355 7,531 8,168 Diluted earnings per share before accounting change $ 0.85 $ 0.69 $ 0.48 $ 0.69 $ 0.75 Diluted earnings per share $ 0.85 $ 0.66 $ 0.48 $ 0.69 $ 0.75 Cash dividends per share $ – $ – $ – $ 0.08 $ 0.16 Cash and short-term investments 23,798 31,600 38,652 49,048 60,592 Total assets 51,694 58,830 69,910 81,732 92,389 Stockholders’ equity 41,368 47,289 54,842 64,912 74,825 (1) The financial data presented for fiscal 2002 and 2003 has been restated as prescribed by SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure +and amendment of FASB Statement No. 123 , to reflect the retroactive adoption of the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation as discussed in Note 13. The information presented for 2000 and +2001 has not been restated. If fiscal 2000 had been restated, the operating income and net income would have been $9,113 million and $8,172 million. If fiscal 2001 had been restated, the operating income and net income would have been $8,343 million +and $5,084 million. (2) Fiscal 2001 includes an unfavorable cumulative effect of accounting change of $375 million or $0.03 per diluted share, reflecting the adoption of SFAS No. 133. Fiscal 2001 also includes the +acquisition of Great Plains Software, Inc. for approximately $1.1 billion in stock. (3) Fiscal 2002 includes a $1.25 billion (pre-tax) gain on the sale of Expedia, Inc. (4) Fiscal 2003 includes the acquisition of Navision a/s, Rare Ltd. and Placeware, Inc. for a total of $1.23 billion in cash and $788 million in stock and other consideration. PAGE 14 Table of Contents Part II Item 7 ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS FOR 2002, 2003, AND 2004 Management’s Discussion and Analysis (MD&A) contains statements that are forward-looking. +These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Issues and Uncertainties” and elsewhere in this report. OVERVIEW The following Management’s Discussion and Analysis (“MD&A”) is intended to help the +reader understand Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes (“Notes”). We generate revenues, income and cash flows by developing, manufacturing, licensing, and supporting a wide range of software products for many computing devices. +Our software products include operating systems for servers, personal computers (PCs), and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions +applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games and peripherals. Online +communication services and information services are delivered through our MSN portals and channels around the world. We also research and develop +advanced technologies for future software products. Delivering breakthrough innovation and high-value solutions through our integrated platform are the key to meeting customer needs and to our future growth. We believe that over the last few years we have laid a foundation for long-term growth, delivering innovative new products, creating opportunity for partners, +improving customer satisfaction with key audiences, putting some of our most significant legal challenges behind us, and solidifying internal processes. Our focus in fiscal 2005 is building on this foundation and executing well in key areas, +including continuing to innovate on our integrated software platform, delivering compelling value propositions to customers, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business +efficacy, and accountability across the company. Key market opportunities include: • Meeting the needs of a growing worldwide base of PC users, which we project will top 1 billion by 2010; • Delivering new scenarios such as collaboration, authoring, communicating, planning, and analysis for information workers; • Continuing to compete against Linux and Unix for commercial workloads; • Reducing complexity and cost for IT professionals and developers; • Delivering IT services for smaller business, and consumers; • Creating and delivering business solutions for small and mid-market segments; • Creating non-PC consumer electronics in areas such as mobile phones, handheld devices, home entertainment and TV; • Delivering compelling entertainment experiences in areas such as music, TV, movies, photos, and games; • Expanding online advertising, and advances in search, music and other information services; • Delivering integrated communications services for consumers and information workers. For fiscal 2005, we believe industry-wide factors such as PC unit growth and the success of non-commercial software could significantly affect our results of +operations and financial condition. PC unit growth was very strong in fiscal 2004, increasing approximately 13% from fiscal 2003. We do not expect similar growth to occur in fiscal 2005. PAGE 15 Table of Contents Part II Item 7 We believe that PC unit shipments will grow 7% to 9%, resulting in a +forecasted fiscal 2005 Client revenue growth rate that we believe will be between 5% and 7%. We continue to watch the evolution of open source +software development and distribution, and continue to differentiate our products from competitive products including those based on open source software. We believe that Microsoft’s share of server units grew modestly in fiscal 2004, while +Linux distributions rose slightly faster on an absolute basis. The increase in Linux distributions reflects some significant public announcements of support and adoption of open source software in both the server and desktop markets in the last +year. To the extent open source software products gain increasing market acceptance, sales of our products may decline, which could result in a reduction in our revenue and operating margins. Additionally, due primarily to our announced special dividend and quarterly dividend payments, if continued, we expect investment balances and resulting investment +income to decrease significantly in fiscal 2005. We have approximately $1.1 billion in original Upgrade Advantage contract value that will reach +their expiration dates in the first quarter of fiscal 2005. This revenue was recognized over the last two years and in the first quarter of fiscal 2005 the contract period expires. Summary (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 28,365 $ 32,187 13 % $ 36,835 14 % Operating income $ 8,272 $ 9,545 15 % $ 9,034 (5 )% Our revenue growth for fiscal 2004 was driven by +licensing of Windows Client operating systems through OEMs; Windows Server operating systems, Office, and other server applications as a result of growth in PC and server hardware shipments; and the continuing impact from multi-year licensing that +occurred prior to the transition to our Licensing 6.0 program in the first quarter of fiscal 2003. We estimate growth in PC shipments was 13% during fiscal 2004, reflecting global economic improvement, which led to strength in the consumer segment +in the first half of fiscal 2004 and to replacement PC and notebook sales in the enterprise segment in the second half of fiscal 2004. We estimate that total server hardware shipments grew 16%, with Windows Server shipments growing faster than the +overall sector at 18% in fiscal 2004. The net impact of foreign exchange rates on revenue was positive in fiscal 2004, primarily due to a relative strengthening of most foreign currencies versus the U.S. dollar. Had the rates from the prior year +been in effect in fiscal 2004, translated international revenue earned in local currencies would have been approximately $1.10 billion lower. We hedge a portion of our international currency exposures, thereby reducing our overall translation +exposure. Prior to the July 31, 2002 Licensing 6.0 transition date, we experienced a significant increase in multi-year licensing arrangements as customers enrolled in our maintenance programs, primarily Upgrade Advantage. Revenue growth in fiscal +2003 was driven primarily by multi-year licensing that occurred before the Licensing 6.0 transition date in the first quarter of fiscal 2003. The revenue growth also reflected a $933 million or 13% increase associated with OEM licensing of Microsoft +Windows operating systems and a $309 million or 23% increase in revenue from Microsoft Xbox video game consoles. Revenue growth in fiscal 2002 was led by the addition of $1.35 billion of Xbox video game system revenue and $1.20 billion of revenue +growth from Microsoft Windows XP Professional and Home operating systems. For fiscal 2004, the operating income decline of $511 million was primarily +caused by the $2.53 billion of charges related to the Sun Microsystems settlement and a fine imposed by the European Commission in the third quarter of fiscal 2004 and $2.21 billion of stock-based compensation expense related to our employee stock +option transfer program in the second quarter of fiscal 2004. Operating income was positively influenced by the revenue growth described above and operational improvements in our MSN business. In fiscal 2003, the growth in operating income reflected +an increase of $3.82 billion in revenue, partially offset by an increase of $2.55 billion in operating expenses, primarily related to employee and related costs associated with additional headcount and increased legal settlement expenses, primarily +the Time Warner settlement charge of $750 million. In fiscal 2002, the growth in operating income reflected an increase of $3.07 billion in revenue, substantially offset by an increase of $3.14 billion in operating expenses, which included the onset +of costs related to Xbox video game systems. We adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based +Compensation , on July 1, 2003 and restated prior periods to reflect compensation cost under the recognition provisions of SFAS 123 for PAGE 16 Table of Contents Part II Item 7 all awards granted to employees after July 1, 1995. Stock-based +compensation expenses are included in operating expenses as part of headcount-related costs. Total stock-based compensation costs included in operating expenses were $5.73 billion in fiscal 2004, $3.75 billion in fiscal 2003, and $3.78 billion in +fiscal 2002. In fiscal 2005, we do not expect revenue to grow at similarly high rates as fiscal 2004, even if information technology spending +continues to improve. While we expect general economic conditions to remain stable with the improvements seen in the second half of fiscal 2004, we expect PC and server unit shipment growth rates to decline in fiscal 2005 from the high growth rates +in fiscal 2004. We estimate PC shipments will grow from 7% to 9% and Server unit shipments will grow from 13% to 15% in fiscal 2005 compared to fiscal 2004. These lower growth rates may cause slower revenue growth in fiscal 2005. We are anticipating +little or no year-over-year foreign exchange rate benefit in fiscal 2005. We anticipate that we will renew between 10% and 30% of the expiring +Upgrade Advantage program revenue through conversions to Software Assurance or migration to Enterprise Agreements. Total revenue expected to be recognized in our Information Worker, Server and Tools, and Client businesses from previously deferred +Upgrade Advantage revenue is $56 million. MSN had a strong year in fiscal 2004 with revenue growth of 13% driven by over 40% growth in advertising +revenue. In fiscal 2005, we expect MSN to see growth in advertising revenue and subscription and transaction revenue from premium Web services, partially offset by a reduction in access revenue as narrowband subscribers continue to decline. +Accordingly, we do not expect the same level of revenue growth for MSN in fiscal 2005. Home and Entertainment revenue grew moderately in fiscal 2004. +We do not expect significant growth in Home and Entertainment in fiscal 2005 as price reductions in the second half of fiscal 2004 related to the late stage of the Xbox lifecycle are expected to lead to lower revenue for the Xbox business. We expect our operating income growth in fiscal 2005 to exceed our revenue growth. Operating income is expected to reflect lower operating expenses +due to the absence of certain legal settlements which occurred in fiscal 2004, lower stock-based compensation costs, and benefits achieved through continued progress in our previously announced cost efficacy initiative. We expect that our segments +in fiscal 2004 that reported a segment operating loss – Mobile and Embedded Devices, Microsoft Business Solutions, and Home and Entertainment – will make significant progress toward segment profitability in fiscal 2005 +with improved operations. SEGMENT PRODUCT REVENUE/OPERATING INCOME +(LOSS) Our seven segments are: Client; Server and Tools; Information Worker; +Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. The revenue and operating income/(loss) amounts MD&A +are presented on a basis consistent with U.S. GAAP applied at the segment level. Certain corporate level expenses have been excluded. Those expenses primarily include corporate operations related to sales and marketing, product support services, +human resources, legal, finance, IT, corporate development and procurement activities, research and development and other costs, and accrued legal contingencies. Corporate expenses were $3.08 billion, $3.74 billion and $4.66 billion in fiscal 2002, +2003 and 2004 respectively. Segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements is presented in accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related +Information . The tables that follow below for each segment present our segment +revenue and operating income, determined on a basis consistent with U.S. GAAP: Client (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 9,360 $ 10,394 11 % $ 11,546 11 % Operating income $ 7,105 $ 8,017 13 % $ 8,015 nm PAGE 17 Table of Contents Part II Item 7 Client includes revenue from Windows XP Professional and Home, Windows +2000 Professional, and other standard Windows operating systems. The growth of the Client segment’s revenue is largely correlated with the growth of purchases of PCs from OEMs that pre-install versions of Windows operating systems. Client revenue increase was driven by a 14% growth in OEM licenses and 16% growth in OEM revenue on increased consumer PC unit shipments in the first half of the +fiscal year and growth in business PC unit shipments in the second half of fiscal 2004. Revenue from commercial and retail licensing declined 4% due to lower revenue earned from Upgrade Advantage licensing agreements and lower packaged product +sales. In fiscal 2003, Client revenue growth was driven by OEM licensing revenue growth of $933 million and a 9 percentage point increase in the mix of the higher priced Windows Professional operating systems, the majority of which was in the OEM +channel. Windows Professional revenue growth for fiscal 2003 was $1.59 billion, or 31%, compared to fiscal 2002. The Windows Professional growth in fiscal 2003 was partially offset by a $573 million decline in revenue from earlier versions of +Windows operating systems. Client operating income was flat for fiscal 2004 compared to fiscal 2003 due to increased operating expenses primarily +related to the charge for the Sun Microsystems settlement of $700 million in the third quarter of fiscal 2004 and $307 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal 2004, +offset by growth in revenue. Operating income for fiscal 2003 increased primarily as a result of the 11% growth in revenue, partially offset by an increase in operating expenses, largely attributed to headcount additions and related costs. We estimate that PC market growth will be from 7% to 9% in fiscal 2005. We expect emerging markets to continue to outpace mature market growth rates +and we expect to hold our share in these respective markets. The differential market growth rate is expected to result in lower unit license growth in the OEM business and lower revenue growth, as piracy continues to be problematic in emerging +markets, and significant price changes are not anticipated. We plan to continue our efforts to increase premium product mix but expect to see only modest improvements in fiscal 2005. The Client commercial and retail licensing revenues are expected +to continue to lag behind overall Client revenue growth. We expect operating profits as a percentage of Client revenue to improve in fiscal 2005, due to the legal settlements expenses and stock-based compensation expense from the employee stock +option transfer program in fiscal 2004. Major investments in fiscal 2005 include development of the Windows Client next generation operating system (Longhorn), security programs, and marketing initiatives, including those related to Windows XP +Service Pack 2 and other new products. Server and Tools (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 6,157 $ 7,140 16 % $ 8,483 19 % Operating income $ 747 $ 1,121 50 % $ 96 (91 )% Server and Tools consists of server software +licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. It also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting +services. Growth in the overall market for information technology, both hardware and software, is the principal driver for Server and Tools revenue growth. The segment concentrates on licensing products, applications, tools, content, and services +that make information technology professionals and developers more productive and efficient. Products are sold through OEMs, distributors, direct to customers, and through one-time licenses or multi-year volume license agreements. We estimate that overall server hardware shipments grew 16% in fiscal 2004 compared to the prior year. Server and Server applications revenue, including CAL +revenue, grew $1.28 billion or 25% driven primarily by an estimated 18% increase in Windows-based server shipments resulting in 15% growth in new Windows Server licenses, and by favorable conversion of revenue billed in foreign currencies to U.S. +dollars. Consulting and Premier product support services revenue increased $189 million or 19% compared to fiscal 2003 due to increased customer penetration from new product offerings. Revenue from developer tools, training, certification, and +Microsoft Press and other services declined $128 million or 14% compared to fiscal 2003 due to recognition of revenue deferred in prior years. Foreign exchange rates contributed approximately $350 million or 5% of Server and Tools revenue growth. PAGE 18 Table of Contents Part II Item 7 Total Server and Tools revenue grew $983 million or 16% +in fiscal 2003, driven by an increase in Windows-based server shipments and growth in SQL Server and Exchange revenue. Windows Server and CALs revenue grew $787 million or 18% from fiscal 2002 as a result of increased new and anniversary multi-year +licensing agreements. Consulting and Premier product support services increased $91 million or 10% compared to fiscal 2002. Revenue from developer tools, training, certification, Microsoft Press, and other services increased $105 million or 13% from +fiscal 2002. Server and Tools operating income for fiscal 2004 declined primarily due to the charge for the Sun Microsystems settlement of $1.22 +billion in the third quarter of fiscal 2004 and $651 million of stock-based compensation costs from the employee stock option transfer program in the second quarter of fiscal 2004. Server and Tools operating income for fiscal 2003 grew 50%, +primarily as a result of the 16% increase in revenue. We anticipate that overall server hardware shipments will grow from 13% to 15% in fiscal 2005 +and new licenses of Windows Server operating system will grow slightly faster than the overall market. We believe that Windows Server 2003 shipments will create opportunities for sales of Windows Server System products. However, we face strong +competition from the Linux-based, Unix, and other server operating systems. In addition, Server and Tools net revenue for fiscal 2005 will be unfavorably affected by the absence of revenue earned from our Upgrade Advantage program and no anticipated +foreign exchange benefit. Information Worker (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 8,212 $ 9,229 12 % $ 10,800 17 % Operating income $ 5,932 $ 6,486 9 % $ 7,151 10 % Information Worker consists of the Microsoft +Office System of programs, servers, services, and solutions designed to increase personal, team, and organization productivity. Information Worker includes Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CALs, other +information worker products including Microsoft LiveMeeting and OneNote, and professional product support services. Most revenue from this segment comes from licensing our Office System products. Revenue growth depends on the ability to add value to +the core Office product set and expand our product offerings in other Information Worker areas such as document lifecycle and collaboration. Revenue +growth for fiscal 2004 from volume licensing, retail packaged product and pre-installed versions of Office in Japan was 15% in aggregate. This increase was driven by recognition of unearned revenue primarily from a large increase in multi-year +licenses signed prior to the transition to our Licensing 6.0 programs and approximately $110 million related to the launch of Office 2003. OEM licensing revenue grew 29% or $325 million. Foreign exchange rates provided approximately $485 million or +5% of total Information Worker revenue growth. The $1.02 billion or 12% increase in revenue in fiscal 2003 compared to fiscal 2002 was primarily due to growth in Office suites revenue associated with new and anniversary multi-year licensing +agreements and a $264 million or 28% increase in revenue from the combined total of Microsoft Project, Microsoft Visio, and other stand-alone applications. Information Worker operating income in fiscal 2004 increased from the prior year primarily due to growth in revenue, partially offset by an increase in operating expenses, primarily related to $351 million of stock-based compensation +expense from the employee stock option transfer program in the second quarter of fiscal 2004 and higher sales and marketing expenses. Information Worker operating profit for fiscal 2003 grew 9% compared to fiscal 2002, led by the 12% increase in +revenue and partially offset by a 20% growth in operating expenses related to headcount additions and marketing expenses. Fiscal 2005 Information +Worker revenue is expected to be similar to fiscal 2004. We are expecting a reduction in revenue earned from our Upgrade Advantage licensing agreements and no anticipated foreign exchange rate benefit. The significant reduction in Upgrade Advantage +earned revenue is expected to be offset by sustained momentum in our OEM and multi-year licensing offerings and increased purchasing of Office System 2003 as enterprises complete their product evaluations. PAGE 19 Table of Contents Part II Item 7 Microsoft Business Solutions (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 308 $ 567 84 % $ 667 18 % Operating loss $ (301 ) $ (309 ) 3 % $ (255 ) (17 )% Microsoft Business Solutions includes Microsoft +Great Plains, Microsoft Navision, Microsoft Axapta, Microsoft Solomon, Microsoft CRM, MBN/Retail Manager and other business applications and services. Our revenue is generally derived from developing and marketing integrated, end-to-end business +applications and services designed to help small and mid-market businesses. The small and mid-market business applications market is highly fragmented and is intensely competitive in all sectors. Microsoft Business Solutions revenues are affected by +the general economic environment and enterprise information technology spending in particular. The revenue increase in fiscal 2004 was primarily +attributable to continued growth in licensing of Navision and Axapta ERP products, and new sales of Microsoft CRM. Microsoft Business Solutions revenue for fiscal 2003 grew $259 million from fiscal 2002, of which $246 million was attributable to the +acquisition of Navision at the beginning of the fiscal year. The operating loss for fiscal 2004 declined from fiscal 2003 due to the increase in +revenue and lower operating expenses including $42 million of lower amortization costs, partially offset by $27 million in stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal 2004. +Microsoft Business Solutions operating loss for fiscal 2003 increased from fiscal 2002 primarily due to operating losses associated with Navision, increases in sales and marketing expenses, research and development expenses, and acquisition-related +costs. We announced in the fourth quarter of fiscal 2004 a plan to align and include the Small and Mid-Market Solutions & Partners (SMS&P) +organization in the Microsoft Business Solutions segment. This change is designed to optimize our focus on delivering business applications to small and mid-market segment businesses. The SMS&P organization is currently part of the Information +Worker segment. This reorganization will result in a corresponding change to the Microsoft Business Solutions and Information Worker reported results, primarily from the reorganization of approximately $100 million in revenue and costs associated +with our Partner program offerings, which will move from Information Worker segment to Microsoft Business Solutions. In fiscal 2005, we expect continued growth for Microsoft Business Solutions through CRM, Axapta, Navision, and Great Plains product +lines with increased sales and marketing focus from the SMS&P organization, and new product launches for Great Plains and Navision. MSN (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 1,571 $ 1,953 24 % $ 2,216 13 % Operating income/(loss) $ (909 ) $ (567 ) (38 )% $ 121 nm The MSN segment includes personal communications +services, such as e-mail and instant messaging, and information services, such as MSN Search and the MSN portals and channels around the World. MSN also provides a variety of paid services resulting in revenue for the segment including MSN Internet +Access, and MSN Premium Web Services. Revenue is principally generated from advertisers on MSN, from consumers through subscriptions and transactions generated from MSN Premium Web Services and from subscribers to MSN Narrowband Internet Access. In fiscal 2004, MSN advertising revenue increased $360 million or 43% as a result of growth in paid search and growth in the overall Internet +advertising market. This increase was partially offset by a decline of $168 million or 15% in Internet access revenue, primarily from the migration of internet access subscribers to broadband or other competitively priced Internet service providers. +Revenue from subscription and transaction services other than Internet access increased $71 million in fiscal 2004 to $95 million. At the end of the current fiscal year, MSN had 4.3 million internet access subscribers compared to 6.5 million at the +end of the prior fiscal year and 8.8 million total subscribers compared to 8.6 million at the end of the prior year. In addition, MSN has over 350 million unique users PAGE 20 Table of Contents Part II Item 7 monthly, 187 million active Hotmail accounts, and 135 million active +Messenger accounts. Compared to fiscal 2002, MSN advertising revenue grew $270 million or 48% in fiscal 2003 as a result of growth in paid search and strong online advertising sales across all geographic regions. MSN subscription revenue grew $112 +million or 11% in fiscal 2003 reflecting an increase in the number of paying non-promotion subscribers. MSN reached segment profitability in +the first quarter of fiscal 2004 and was profitable for the full fiscal year. The improvement in profitability was primarily driven by an increase in revenue from advertising in both display and paid search, a decline in customer acquisition costs +and other expenses related to the Internet access business, efficiency gains in the operations of the advertising and subscription businesses, and a $48 million refund of prior year taxes, partially offset by $144 million of stock-based compensation +expense related to the employee stock option transfer program in the second quarter of fiscal 2004. MSN operating loss for fiscal 2003 decreased from fiscal 2002, primarily as a result of the growth in revenue and lower relative subscription +acquisition and support costs. MSN expects advertising revenue and revenue from subscriptions and transactions for premium Web services to increase +in fiscal 2005. Advertising revenue should benefit from expected increases in Internet spending and additions to the advertising platform including music download service, communication innovations, and an improved search engine. We expect revenue +from narrowband Internet access to decline in fiscal 2005 as narrowband subscribers continue to migrate to broadband Internet access. We announced in the fourth quarter of fiscal 2004 an increase to the amount of storage we will provide for select +MSN and Hotmail email accounts which will increase operating costs and may impact the revenues from our extra storage customers. However, we expect the segment to increase its profitability in fiscal 2005, led by continued operational efficiencies +and lower unit margin costs in both the subscriber and advertising businesses. Mobile +and Embedded Devices (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 112 $ 156 39 % $ 247 58 % Operating loss $ (275 ) $ (277 ) 1 % $ (224 ) (19 )% Mobile and Embedded Devices includes Windows +Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. The segment’s products extend the advantages of the Windows platform to mobile phones and Pocket PCs. The segment is also responsible for managing +sales and customer relations with device manufacturers and with network service providers, including telecommunications, cable and wireless companies, and host and network equipment providers. The embedded operating system market is highly +fragmented with many competitive offerings and relatively short product life cycles that affect our continuing revenue streams. Unit volume increases +drove revenue growth for fiscal 2004 over fiscal 2003 in all product lines. The growth was primarily due to the increase in the number of OEMs and mobile operators shipping Windows Mobile software for SmartPhones, increases in market share for our +Pocket PC and embedded products and increased usage by existing customers of our MapPoint Web Service. Revenue for fiscal 2003 grew $44 million driven by increased Pocket PC shipments and MapPoint licensing. Mobile and Embedded Devices’ operating loss for fiscal 2004 decreased compared to fiscal 2003 primarily due to growth in revenue and lower marketing expenses, +partially offset by $58 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal 2004. Operating loss for fiscal 2003 grew 1% from the prior year as higher marketing expenses and +headcount-related costs associated with product development offset the growth in revenue. We expect demand for mobile and embedded devices based on +Windows Mobile software to be driven by an overall increase in customer demand for connectivity as well as by an increase in the number of OEMs and mobile operators offering Windows-based devices. PAGE 21 Table of Contents Part II Item 7 Home and Entertainment (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Revenue $ 2,453 $ 2,748 12 % $ 2,876 5 % Operating loss $ (1,135 ) $ (1,191 ) 5 % $ (1,215 ) 2 % Home and Entertainment includes the Microsoft +Xbox video game console system, PC games, the Home Products Division (HPD), and TV platform products for the interactive television industry. The relative success of competing video game consoles is determined by console functionality, the portfolio +of video game content for the console, and the relative market share of the console. We are a relatively new entrant in the video game console businesses with our first release in fiscal 2002, and have established ourselves as one of the leaders. +Revenue and unit volumes have grown quickly since 2002, but revenue growth moderated in fiscal 2004 due to price reductions typical at this stage in the console lifecycle. We believe our competitive position and revenue is bolstered by our +increasing software game attach rates, providing higher margins to offset the decreasing price trend on consoles sold. In fiscal 2004, Xbox revenue +increased $144 million or 9% with $269 million related to higher Xbox software volumes and $117 million due to higher Xbox console volumes, partially offset by a $242 million decline related to price reductions of Xbox consoles and software. +Overall, Xbox console volumes increased 11% in fiscal 2004 compared to fiscal 2003. The Xbox life-to-date U.S. games attach rate increased to 6.9 games per console according to industry analyst NPD as of June 30, 2004. Revenue from consumer hardware +and software, PC games and TV platforms declined $16 million or 1% compared to fiscal 2003 due to lower PC games software and PC gaming devices sales, partially offset by the new release of Mac Office. The increase in Home and Entertainment revenue +in fiscal 2003 from fiscal 2002 was the result of sales of Xbox video game systems and related games which were available for all of fiscal 2003. Xbox revenue grew $309 million or 23% in fiscal 2003 reflecting a $779 million increase from higher +volumes for Xbox consoles, games, and peripherals partially offset by a $470 million decrease due to price changes. Revenue from consumer hardware and software and PC games declined $14 million or 1% in fiscal 2003, driving the decrease in Home +Products revenue. The increase in operating loss in fiscal 2004 was primarily due to $141 million of stock-based compensation expense from the +employee stock option transfer program in the second quarter of fiscal 2004, increased sales of negative margin consoles, and costs associated with the next generation console development efforts, partially offset by increased Xbox and Mac Office +software sales. The operating loss increase from fiscal 2003 also included a lower of cost or market adjustment of approximately $90 million, reflecting the current stage in the lifecycle of the Xbox console. Operating loss in 2003 increased by $56 +million or 5% from the prior year as the product costs associated with the increased Xbox console sales and increased marketing expense more than offset the 12% increase in revenue. In fiscal 2005, we expect Xbox console unit volumes and revenue to decrease from fiscal 2004 consistent with this stage of the Xbox console lifecycle, partially +offset by increased unit volumes driven by the launch of software titles such as Halo2. In fiscal 2005 we expect PC games revenue to decrease from fiscal 2004 driven by fewer new game titles. Other HPD revenue are expected to increase moderately as +a result of the launch of the latest version of Mac Office late in the fourth quarter of fiscal 2004. In fiscal 2005, we expect operating margins to improve from fiscal 2004 driven by lower unit volumes of negative margin consoles and increased +sales of high margin software. We expect development spending to be higher in fiscal 2005 driven by investment in the next generation Xbox platform design. Cost of revenue (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Cost of revenue $ 5,699 $ 6,059 6 % $ 6,716 11 % As a percent of revenue 20.1 % 18.8 % (1.3 )pp 18.2 % (0.6 )pp PAGE 22 Table of Contents Part II Item 7 Cost of revenue includes manufacturing and distribution costs for +products and programs sold, operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with the delivery of +consulting services. The increase in fiscal 2004 was primarily due to increased product support and consulting services costs of $508 million, $214 million of stock-based compensation expense from the employee stock option transfer program, and a +lower of cost or market adjustment in the fourth quarter of fiscal 2004 by approximately $90 million, reflecting the current stage of the life cycle of the Xbox console, partially offset by $365 million decrease in MSN services costs. In fiscal +2003, the primary driver of the increase was a 4.4 percentage point increase from Home and Entertainment products and a 1.6 percentage point decrease from MSN product and service costs in fiscal 2003 compared to fiscal 2002. Research and development (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Research and development $ 6,299 $ 6,595 5 % $ 7,779 18 % As a percent of revenue 22.2 % 20.5 % (1.7 )pp 21.1 % 0.6 pp Research and development expenses include +payroll, employee benefits, equity compensation and other headcount-related costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to +translate software for international markets, and the amortization of purchased software code and services content. The increase in fiscal 2004 was primarily due to $1.31 billion of stock-based compensation expenses related to the option transfer +program in the second quarter of fiscal 2004 as well as other headcount-related payroll and other employee costs related to a 3% growth in research and development headcount from fiscal 2003. In fiscal 2003, the increase reflects an increase in +headcount-related costs, a 25% increase in third-party product development costs, and a 29% increase in testing laboratory equipment and expense. Sales and marketing (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) Sales and marketing $ 6,252 $ 7,562 21 % $ 8,309 10 % As a percent of revenue 22.0 % 23.5 % 1.5 pp 22.6 % (0.9 )pp Sales and marketing expenses include payroll, +employee benefits, equity compensation and other headcount-related costs associated with sales and marketing personnel and advertising, promotions, tradeshows, seminars, and other marketing-related programs. Sales and marketing costs increased in +fiscal 2004 due to $400 million of stock-based compensation expenses related to the option transfer program in the second quarter of fiscal 2004 and other headcount-related costs related to a 9% growth in sales and marketing headcount. In fiscal +2003, the sales and marketing expense increase of $1.31 billion dollars was due to an increase in sales expenses related to headcount additions, principally related to the Enterprise and Small/Medium Business sales forces, and a 21% increase in +marketing expenses. General and administrative (In millions, except percentages) 2002 2003 Percentage inc./ (dec.) 2004 Percentage inc./ (dec.) General and administrative $ 1,843 $ 2,426 32 % $ 4,997 106 % As a percent of revenue 6.5 % 7.5 % 1.0 pp 13.6 % 6.1 pp PAGE 23 Table of Contents Part II Item 7 General and administrative costs include payroll, employee benefits, +equity compensation and other headcount-related costs associated with the finance, legal, facilities, certain human resources, and other administrative headcount, and legal costs and other administrative fees. General and administrative costs +increased in fiscal 2004 primarily due to legal expenses including $1.92 billion of charges related to the Sun Microsystems settlement, a $605 million fine imposed by the European Commission in the third quarter of fiscal 2004, $280 million of +stock-based compensation expense related to the employee stock option transfer program in the second quarter of fiscal 2004, other legal costs of approximately $104 million, and other headcount related costs. General and administrative costs in +fiscal 2003 increased $583 million from fiscal 2002 due to a charge of $750 million related to a settlement with Time Warner in the fourth quarter of 2003 and a $256 million charge reflecting an increase in our estimate of costs related to resolving +pending antitrust and unfair competition consumer class action lawsuits. Investment Income/(Loss), and Income Taxes Investment +Income/(Loss) The components of investment income/(loss) in each fiscal year are as +follows: (In millions) / Year Ended June 30 2002 2003 2004 Dividends and interest $ 2,119 $ 1,957 $ 1,892 Net recognized gains (losses) on investments (1,807 ) 44 1,563 Net losses on derivatives (617 ) (424 ) (268 ) Investment income /(loss) $ (305 ) $ 1,577 $ 3,187 Dividends and interest income decreased $65 +million in fiscal 2004 mainly due to lower dividend income resulting from the exchange of AT&T 5% convertible preferred debt for common shares of Comcast during fiscal 2003 and declining interest rates, partly offset by a larger investment +portfolio. Net recognized gains (losses) on investments include other-than-temporary impairments of $82 million in fiscal 2004 compared to $1.15 billion in the prior year as well as higher net realized gains on sales in fiscal 2004 as we moved to +more liquid investment asset classes. Net realized gains on sales were $1.65 billion in fiscal 2004 and $1.19 billion in fiscal 2003. The decline in impairments was due to improved market conditions. Derivative losses decreased $156 million to $268 +million in fiscal 2004 compared to fiscal 2003 primarily due to the combined effects of interest rate movements on interest rate sensitive instruments and equity market price movements relative to positions used to hedge the fair value of certain +equity securities. In fiscal 2003, dividends and interest income decreased $162 million driven primarily by a reduction in dividend income of $97 +million resulting from the exchange of AT&T 5% convertible preferred debt for common shares of Comcast during the second quarter of fiscal 2003, and declining interest rates partially offset by a larger investment portfolio. Net recognized gains +(losses) on investments includes other-than-temporary impairments of $1.15 billion in fiscal 2003 compared to $4.32 billion in fiscal 2002 and net realized gains on investments of $1.19 billion in fiscal 2003 compared to $2.52 billion in fiscal +2002. The decrease in other-than-temporary impairments in 2003 was also due to the reduced cost-basis of investments resulting from significant 2002 impairments of investments in the cable and telecommunications sectors. In fiscal 2002, other-than-temporary impairments of $4.32 billion primarily related to our investment in AT&T and other cable and telecommunication investments. +Net realized gains on the sales of investments of $2.52 billion included a $1.25 billion gain on sale of our interest in Expedia. Investments are +considered to be impaired when a decline in fair value is judged to be other than temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment +exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions +related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is +determined to be other than temporary, an impairment charge is recorded and a new cost basis in the investment is established. PAGE 24 Table of Contents Part II Item 7 Income Taxes Our effective tax rate for fiscal 2004 was 33%. A benefit of $208 million was recorded during the +fourth quarter from the reversal of previously accrued taxes from resolving the remaining open issue remanded by the 9th Circuit Court of Appeals ruling in December 2002. The effective tax rate for the fourth quarter of fiscal 2004 was approximately +27%. During the third quarter the tax rate increased due to the European Commission fine, which is not tax deductible. The effective tax rate for +fiscal 2003 and fiscal 2002 was 32% each year. The fiscal 2003 rate reflected a benefit in the second quarter of $126 million from the reversal of previously accrued taxes related to the initial items from the 9th Circuit Court of Appeals ruling +referred to above, that reversed, in part, a previous Tax Court ruling that had denied tax benefits on certain revenue earned from the distribution of software to foreign customers. Excluding this reversal, the effective tax rate would have been +33%. Stock-based Compensation. We implemented changes in +fiscal 2004 in employee compensation designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders. Generally, employees are now granted stock awards instead of stock +options. The stock award program offers employees the opportunity to earn shares of our stock over time, rather than options that give employees the right to purchase stock at a set price. We also completed an employee stock option transfer program +in the second quarter of fiscal 2004 whereby employees could elect to transfer all of their vested and unvested stock options with a strike price of $33 or higher (“eligible options”) to JPMorgan Chase Bank (JPMorgan). The unvested +eligible options that were transferred to JPMorgan became vested upon the transfer. The price paid by JPMorgan for the transferred options was determined by reference to the arithmetic average of the closing prices of Microsoft common stock during +the period from November 14, 2003 to December 8, 2003, which was $25.5720. Note 13 – Employee Stock and Savings Plan of the Notes to the Financial Statements provides additional information on employee stock and savings plans. In addition, effective July 1, 2003, we adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation , +using the retroactive restatement method described in SFAS 148, Accounting for Stock-Based Compensation – Transition and Disclosure . Under the fair value recognition provisions of SFAS 123, stock-based compensation cost is +measured at the grant date based on the value of the award and is recognized as expense over the vesting period. The June 30, 2003 balance sheet has been restated for the retroactive adoption of the fair value recognition provisions of SFAS 123, +which resulted in a $13.89 billion increase in common stock and paid-in capital, a $10.00 billion decrease in retained earnings, and a $3.89 billion increase in deferred income taxes. Given these changes the following table provides stock-based compensation expense for fiscal 2002 through 2004 by segment. (In millions, except expense per share) (1) 2002 2003 2004 Client $ 471 $ 450 $ 738 Server and Tools 1,301 1,274 1,862 Information Worker 516 510 848 Microsoft Business Solutions 125 129 147 MSN 268 262 392 Mobile and Embedded Devices 118 129 170 Home and Entertainment 261 257 381 Corporate 724 738 1,196 Stock-based employee compensation expense $ 3,784 $ 3,749 $ 5,734 After-tax stock-based employee compensation expense $ 2,573 $ 2,512 $ 3,842 After-tax stock-based employee compensation expense per diluted share $ 0.23 $ 0.23 $ 0.35 (1) The amounts for fiscal 2004 include $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) due to the completion of the employee stock option transfer program. PAGE 25 Table of Contents Part II Item 7 FINANCIAL CONDITION Our cash and short-term investment portfolio totaled $60.59 billion as of June 30, 2004. Equity and +other investments were $12.21 billion as of June 30, 2004. The portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is +invested predominantly in U.S. dollar denominated securities, but also includes foreign currency positions, in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and +facilitate rapid deployment for immediate cash needs. Unearned revenue from volume licensing programs represents customer billings, paid either +upfront or annually at the beginning of each billing coverage period, that are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to +undelivered elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based on the sales price of those elements when sold +separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows +XP Home, approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 1% to 15% of the sales price for desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life +cycles are currently estimated at three-and-one-half years for Windows operating systems and two years for desktop applications. Unearned revenue also includes payments for online advertising for which the advertisement has yet to be displayed and +payments for post-delivery support services to be performed in the future. Unearned revenue as of June 30, 2004 decreased $838 million from June 30, +2003, reflecting recognition of unearned revenue from multi-year licensing that has outpaced additions by $397 million, primarily due to recognition from Upgrade Advantage licensing agreements and a $489 million decline in revenue deferred for +undelivered elements. Starting April 1, 2003 revenue deferred for undelivered elements reflected lower deferral rates, partially offset by lengthened product life cycles for the underlying products licensed, resulting in a higher proportion of +revenue earned. We earned approximately $1.8 billion and $1.1 billion from the Upgrade Advantage programs for fiscal 2003 and 2004, respectively and expect to earn approximately $56 million in fiscal 2005 from those programs. Cash Flows Cash flow from operations for fiscal 2004 decreased $1.17 billion to $14.63 billion. The decrease primarily reflects the combined cash +outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine mentioned above partially offset by increased cash receipts from customers driven by the rise in revenue billings. Cash used for financing was +$2.36 billion in fiscal 2004, a decrease of $2.86 billion from the prior year. The decrease reflects that we did not repurchase any common stock in the fourth quarter of fiscal 2004 combined with a $628 million increase primarily from stock +issuances related to employee stock options exercises, partially offset by an $872 million increase in cash dividends paid. We repurchased 123.7 million shares of common stock under our share repurchase program in fiscal 2004. Cash used for +investing was $2.75 billion in fiscal 2004, a decrease of $4.47 billion from fiscal 2003, due to a $3.63 billion decrease in net investment purchases and a $1.06 billion decrease in acquisition spending. Cash flow from operations was $15.80 billion for fiscal 2003, an increase of $1.29 billion from fiscal 2002. The increase primarily reflects the rise in cash +receipts from customers driven by the increase in revenue billings and maintenance of relatively stable accounts receivable levels. Cash used for financing was $5.22 billion in fiscal 2003, an increase of $651 million from the prior year. The +increase reflects a cash dividend payment of $857 million in 2003 and an increase of $417 million in common stock repurchase, offsetting $623 million received for common stock issued. We repurchased 238.2 million shares of common stock under our +share repurchase program in fiscal 2003. Cash used for investing was $7.21 billion in fiscal 2003, a decrease of $3.63 billion from fiscal 2002, due to stronger portfolio performance on sold and matured investments. Cash flow from operations was $14.51 billion for fiscal 2002, an increase of $1.09 billion from fiscal 2001. The increase reflected strong growth in unearned +revenue as a result of the significant number of customers that purchased Upgrade Advantage during the Licensing 6.0 transition period. This resulted in an increase in billings and a corresponding increase in the unearned revenue amount. Cash used +for financing was $4.57 billion in fiscal 2002, a decrease of $1.01 billion from the prior year. The decrease reflected the repurchase of put warrants in the prior year. PAGE 26 Table of Contents Part II Item 7 We repurchased 245.6 million shares of common stock under our share +repurchase program in fiscal 2002. In addition, 10.2 million shares of common stock were acquired in fiscal 2002 under a structured stock repurchase transaction. We entered into the structured stock repurchase transaction in fiscal 2001, which gave +us the right to acquire 10.2 million of our shares in exchange for an up-front net payment of $264 million. Cash used for investing was $10.85 billion in fiscal 2002, an increase of $2.11 billion from fiscal 2001. We have no material long-term debt. Stockholders’ equity at June 30, 2004 was $74.8 billion. We will continue to invest in sales, marketing, product support +infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities and computer systems for research and development, sales and marketing, support, and administrative staff. +Commitments for constructing new buildings were $129 million on June 30, 2004. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $318 million, +$290 million, and $331 million in fiscal 2002, 2003, and 2004, respectively. We have issued residual value guarantees in connection with various operating leases. These guarantees provide that if we do not purchase the leased property from the +lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2004, the maximum amount of the residual value +guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability currently exists. We have not engaged in any related party +transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of requirements for capital resources. On July 20, 2004, our board of directors approved a quarterly dividend of $0.08 per share payable on September 14, 2004, to shareholders of record on August +25, 2004. In addition, the board approved a plan to buy back up to $30 billion in Microsoft Common stock over the next four years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and +other factors. The repurchases will be made using our cash resources. The repurchase program may be suspended or discontinued at any time without prior notice. The board also approved a one-time special dividend of $3.00 per share, or approximately +$32 billion, subject to shareholder approval of stock plan amendments that will allow certain adjustments to employee equity compensation awards to offset the impact of the special dividend. The special dividend will be payable on December 2, 2004, +to shareholders of record on November 17, 2004, conditioned upon shareholder approval of amendments to the employee stock plans at the annual meeting of shareholders scheduled to be held November 9, 2004. We believe existing cash and short-term investments, together with funds generated from operations should be sufficient to meet operating requirements and our +special dividend as well as regular quarterly dividends. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, as well as equity and other investments, reflects our views on potential +future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We continuously +assess our investment management approach in view of our current and potential future needs. Off-balance sheet arrangements and contractual obligations Off-balance sheet arrangements We have unconditionally guaranteed the +repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a Japanese cable company (Jupiter). These guarantees arose on February 1, 2003 in conjunction with the expiration of prior +financing arrangements, including previous guarantees by us. The financing arrangements were entered into by Jupiter as part of financing its operations. As part of Jupiter’s new financing agreement, we agreed to guarantee repayment by Jupiter +of the loans of approximately $51 million. The estimated fair value and the carrying value of the guarantees was $11 million and did not result in a charge to operations. The guarantees are in effect until the earlier of either repayment of the +loans, including accrued interest and fees, or February 1, 2009. The maximum amount of the guarantees is limited to the sum of the total due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the +maximum amount of the guarantees, denominated in Japanese yen, will vary based on fluctuations in foreign exchange rates. If we were required to make payments under the guarantees, we might recover all or a portion of those payments upon liquidation +of Jupiter’s assets. The proceeds from an asset liquidation cannot be accurately estimated due to the many factors that would affect the valuation and realization of the proceeds. PAGE 27 Table of Contents Part II Item 7 We provide indemnifications of varying scope and amount +to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS 5, Accounting for Contingencies, as +interpreted by FIN 45. We consider factors such as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such +obligations and have not accrued any liabilities related to such indemnifications in our financial statements. Contractual obligations The following table summarizes our +outstanding contractual obligations as of June 30, 2004: (In millions) (1) Payments due by period 2005 2006-2008 2009-2011 2012 and thereafter Total Long-term debt $ – $ – $ – $ – $ – Construction commitments (2) 127 2 – – 129 Lease obligations: Capital leases 7 17 10 – 34 Operating leases (3) 141 250 86 24 501 Purchase commitments (4) 1,340 130 90 – 1,560 Other long-term liabilities (5) – 204 14 4 222 Total contractual obligations $ 1,615 $ 603 $ 200 $ 28 $ 2,446 (1) We have excluded the recorded $1.04 billion contingent liability related to the antitrust and unfair competition class action lawsuits referred to in the third paragraph of Note 17 – +Contingencies of the Notes to Financial Statements as the timing and amount to be resolved in cash versus vouchers is subject to uncertainty. (2) We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations. (3) Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing +cash and cash flows from operations. (4) Purchase commitments represent obligations under agreements which are not unilaterally cancelable by us, are legally enforceable and specify fixed or minimum amounts or quantities of goods or +services at fixed or minimum prices. We generally require purchase orders for vendor and third-party spending. The amount presented above as purchase commitments includes an analysis of all known contracts exceeding $5 million in the aggregate as +well as all known open purchase orders. We expect to fund these commitments with existing cash and cash flows from operations. (5) We have excluded unearned revenue of $1.66 billion from other long-term liabilities presented above as these will not be settled in cash. We have also excluded the liability recorded for the +Jupiter guarantee of $11 million. RECENTLY ISSUED +ACCOUNTING STANDARDS In December 2003, the Financial Accounting Standards Board +(FASB) issued Interpretation 46R (FIN 46R), a revision to Interpretation 46 (FIN 46), Consolidation of Variable Interest Entities. FIN 46R clarifies some of the provisions of FIN 46 and exempts certain entities from its requirements. FIN 46R +is effective at the end of the first interim period ending after March 15, 2004. Entities that have adopted FIN 46 prior to this effective date can continue to apply the provisions of FIN 46 until the effective date of FIN 46R or elect early +adoption of FIN 46R. The adoption of FIN 46 and FIN 46R did not have a material impact on our financial statements. In March 2004, the FASB ratified +the recognition and measurement guidance and certain disclosure requirements for impaired securities as described in Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain +Investments. The recognition and measurement guidance will be PAGE 28 Table of Contents Part II Item 7 applied to other-than-temporary impairment evaluations in reporting +periods beginning with our first fiscal quarter 2005. We do not believe the adoption of the recognition and measurement guidance in EITF Issue No. 03-1 will have a material impact on our financial statements. In July 2004, the FASB ratified Emerging Issues Task Force (EITF) consensus on Issue No. 02-14, Whether an Investor Should Apply the Equity Method of Accounting +to Investments Other Than Common Stock , which provides guidance regarding application of the equity method of accounting to investments other than common stock. EITF Issue No. 02-14 will be effective beginning with our second quarter of fiscal +2005. We do not believe the adoption of EITF Issue No. 02-14 will have a material impact on our financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that +affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, +impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, and accounting for income taxes. We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software +Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. +Customers receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective +elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and +enhancements to existing products. SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange +Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for +indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we evaluate, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the +financial health of and near-term business outlook for the investee, including factors such as industry and sector performance, changes in technology, and operational and financing cash flow; and our intent and ability to hold the investment. +Investments with an indicator are further evaluated to determine the likelihood of a significant adverse affect on the fair value and amount of the impairment as necessary. In the past, we have had substantial impairments in our portfolio as +discussed in Note 4 – Investment Income/(Loss). If market, industry and/or investee conditions deteriorate, we may incur future impairments. SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 1 for us) and between +annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, +legal factors, operating performance indicators, competition, sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, +assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow +methodology. This requires significant judgments including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, and +determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit. We account for research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development +Costs, and SFAS 86, Accounting for the Costs of Computer PAGE 29 Table of Contents Part II Item 7 Software to be Sold, Leased, or Otherwise Marketed. SFAS 86 +specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all +software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility +for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we expense all research and development costs when +incurred. The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS 5, Accounting for +Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount +of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the +degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial position or our results of operations. SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting +for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or +tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our +financial position or our results of operations. ISSUES AND +UNCERTAINTIES This Annual Report on Form 10-K contains statements that are +forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of issues and uncertainties such as those listed below and elsewhere in +this report, which, among others, should be considered in evaluating our future financial performance. Challenges to our Business Model. Since our inception, our business model has been based upon customers agreeing to pay a fee to license software developed and distributed by us. Under this +commercial software model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their +products. We believe the commercial software model has had substantial benefits for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop innovative software +that is useful, reliable, and compatible with other software and hardware. In recent years, there has been a growing challenge to the commercial software model. Under the non-commercial software model, open source software produced by loosely +associated groups of unpaid programmers and made available for license to end users without charge is distributed by firms at nominal cost that earn revenue on complementary services and products, without having to bear the full costs of research +and development for the open source software. The most notable example of open source software is the Linux operating system. While we believe our products provide customers with significant advantages in security and productivity, and generally +have a lower total cost of ownership than open source software, the popularization of the non-commercial software model continues to pose a significant challenge to our business model, including recent efforts by proponents of open source software +to convince governments worldwide to mandate the use of open source software in their purchase and deployment of software products. To the extent opens source software gains increasing market acceptance, sales of our products may decline, we may +have to reduce the prices we charge for our products, and revenue and operating margins may consequently decline. Intellectual Property Rights . We defend our intellectual property rights, but unlicensed copying and use of software and intellectual property +rights represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more significant, particularly in countries where laws are less protective of intellectual property rights. +Throughout the world, we actively educate consumers about the benefits of PAGE 30 Table of Contents Part II Item 7 licensing genuine products and educate lawmakers about the advantages of +a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may not affect revenue positively, and revenue could be adversely affected by further deterioration in compliance with +existing legal protections or reductions in the legal protection for intellectual property rights of software developers. From time to time we +receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on unfavorable terms, require us to +stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers. If we are required to enter into such agreements or take such actions, our operating margins may decline as a result. We have made and expect to continue making significant expenditures to acquire the use of technology and intellectual property rights, including via +cross-licenses of broad patent portfolios. Unauthorized Disclosure of Source +Code . Source code, the detailed program commands for our operating systems and software programs, is the most significant asset we own. While we license certain portions of our source code for various software +programs and operating systems to a number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially +lose future trade secret protection for that source code. The loss of future trade secret protection could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating +margins. Unauthorized disclosure of source code could also increase certain risks described below under “Security”. New Products and Services. We have made significant investments in research, development and marketing for new products, services, and technologies, +including Longhorn, Microsoft .NET, Xbox, business applications, MSN, and mobile and wireless technologies. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, these products +and services may not be profitable, and even if they are profitable, operating margins for these businesses may not be as high as the margins we have experienced historically. Litigation. As discussed in Note 17 – Contingencies of the Notes to Financial Statements, we are subject +to a variety of claims and lawsuits. Adverse outcomes in some or all of the pending cases may result in significant monetary damages or injunctive relief against us. We are also subject to a variety of other claims and suits that arise from time to +time in the ordinary course of our business. While management currently believes that resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position or results of operations, the +litigation and other claims noted above are subject to inherent uncertainties and management’s view of these matters may change in the future. There exists the possibility of a material adverse impact on our financial position and the results +of operations for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable. Security. Maintaining the security of computers and computer networks is an issue of critical importance for us and our customers. There are malicious +hackers who develop and deploy viruses, worms, and other malicious software programs that attack our products. While this is an industry-wide phenomenon that affects computers across all platforms, our customers in particular have been victims of +such attacks and will likely continue to be so. We are devoting significant resources to addressing these critical issues. We are focusing our efforts on engineering more secure products, optimizing security and reliability options and settings when +we deliver products, and providing guidance to help our customers make the best use of our products and services to protect against computer viruses and other attacks on their computing environment. In addition, we are working to improve the +deployment of software updates to address security vulnerabilities discovered after our products are released. We are also investing in mitigation technologies that help to secure customers from attacks even when such software updates are not +deployed. We are also advising customers on how to help protect themselves from security threats through the use of our online automated security tools, our published security guidance, and the deployment of security software such as firewalls, +antivirus, and other security software. These steps could adversely affect our operating margins. Despite these efforts, actual or perceived security vulnerabilities in our products could lead some customers to seek to return products, to reduce or +delay future purchases, or to purchase competitive products. Customers may also increase their expenditures on protecting their computer systems from attack, which could delay adoption of new technologies. Any of these actions by customers could +adversely affect our revenue. PAGE 31 Table of Contents Part II Item 7 Declines in Demand for Software. If +overall market demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. Additionally, our revenue would be unfavorably impacted +if customers reduce their purchases of new software products or upgrades to existing products because new product offerings are not perceived as adding significant new functionality or other value to prospective purchasers. A significant number of +customers purchased license agreements providing upgrade rights to specific licensed products prior to the transition to Licensing 6.0 in July 2002. These agreements generally expired throughout fiscal 2004 and will largely be expired by the end of +the first fiscal quarter in 2005. The rate at which such customers renew these contracts could adversely affect future revenue. We are making significant investments in the next release of the Windows operating system, code-named Longhorn. If this +system is not perceived as offering significant new functionality or value to prospective purchasers, our revenue and operating margins could be adversely affected. Product Development Schedule. The development of software products is a complex and time-consuming process. New products +and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products, particularly any delays in the Longhorn operating system, could +adversely affect our revenue. General Economic and Geo-Political +Risks. Softness in corporate information technology spending or other changes in general economic conditions that affect demand for computer hardware or software could adversely affect our revenue. Terrorist activity and +armed conflict pose the additional risk of general economic disruption and could require changes in our operations and security arrangements, thus increasing our operating costs. These conditions lend additional uncertainty to the timing and budget +for technology investment decisions by our customers. Competition. We continue to experience intensive competition across all markets for our products and services. These competitive pressures may result in decreased sales volumes, price reductions, and/or +increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins, and operating income. Taxation of Extraterritorial Income. In August 2001, a World Trade Organization (“WTO”) dispute panel determined that the tax provisions of +the FSC Repeal and Extraterritorial Income Exclusion Act of 2000 (“ETI”) constitute an export subsidy prohibited by the WTO Agreement on Subsidies and Countervailing Measures. The U.S. government appealed the panel’s decision and lost +its appeal. On March 1, 2004, the European Union began imposing retaliatory tariffs on a specified list of U.S.-source goods. In May, the U.S. Senate passed the Jumpstart our Business Strength (JOBS) Act that would repeal ETI, provide a three-year +phase-out of current ETI benefits, and would replace ETI with a phased-in 9% domestic production activity deduction that would not be fully effective until 2012. The U.S. House of Representatives passed similar legislation in June that would repeal +ETI effective December 31, 2004, provide a two-year phase-out of ETI benefits, and replace ETI with a 3% tax rate reduction for income from domestic production activities that would be full phased in by 2006. Neither bill will fully replace our +current ETI tax benefits. Both bills must still be reconciled in conference, and significant changes could be made to the final legislation, so we remain unable to assess the ultimate form and financial impact of this legislation, if enacted. If the +ETI provisions are repealed and financially comparable replacement tax legislation is not enacted, the loss of the ETI tax benefit to us could be significant. Other Potential Tax Liabilities. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment +is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax +authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different than that which is reflected in historical income tax provisions and accruals. Should +additional taxes be assessed as a result of an audit or litigation, a material effect on our income tax provision and net income in the period or periods for which that determination is made could result. Insurance Programs. In addition to conventional third-party insurance +arrangements, we have entered into captive insurance arrangements for the purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2004, the face value of captive insurance +arrangements was $2.0 PAGE 32 Table of Contents Part II Item 7, 7A billion. Actual value at any particular time will vary due to +deductibles, exclusions, other restrictions, and claims. While we believe these arrangements are an effective way to insure against such risks, the potential liabilities associated with certain of the issues and uncertainties discussed in this +document or other events could exceed the coverage provided by such arrangements. Business Disruptions in the Event of a Catastrophic Event. We are a highly automated business and a disruption or failure of our systems in the event of a major earthquake, cyber-attack, terrorist attack, or +other catastrophic event could cause delays in completing sales and providing services. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the +Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical +business or information technology systems could severely affect our ability to conduct normal business operations and, as a result, our future operating results could be adversely affected. Other . Other issues and uncertainties may include: • warranty and other claims for hardware products such as Xbox; • sales channel disruption, such as the bankruptcy of a major distributor; • the effects of the Consent Decree in U.S. v. Microsoft and Final Judgment in State of New York v. Microsoft on the Windows operating system and server business, including those +associated with protocol and other disclosures required by the Decree and Final Judgment and the ability of PC manufacturers to hide end-user access to certain new Windows features; • currency fluctuations; • our ability to implement operating cost structures that align with revenue growth; • the continued availability of third-party distribution channels for MSN service and other online services; • factors associated with our international operations, as described under Operations in Part I, Item 1 of this report; and • financial market volatility or other changes affecting the value of our investments, such as the Comcast Corporation securities held by us that may result in a reduction in carrying value and +recognition of losses including impairment charges. ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to foreign currency, interest rate, and fixed income and equity price risks. A portion of these risks is hedged, but fluctuations could impact our results of +operations and financial position. We hedge a portion of anticipated revenue and accounts receivable exposure to foreign currency fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall +effectiveness of our foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Fixed income securities are subject to interest rate risk. The portfolio is diversified and +structured to minimize credit risk. Securities held in our equity and other investments portfolio are subject to price risk, and are generally not hedged. However, we use options to hedge our price risk on certain equity securities that are held +primarily for strategic purposes. We use a value-at-risk (VAR) model to estimate and quantify our market risks. VAR is the expected loss, for a given +confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VAR model is not intended to represent actual losses in fair value, but is used as a risk estimation and management tool. The model +used for currencies and equities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest rate risk, the mean reverting geometric Brownian motion is used to reflect the principle that +fixed-income securities prices revert to maturity value over time. Value-at-risk is calculated by, first, simulating 10,000 market price paths over +20 days for equities, interest rates and foreign exchange rates, taking into account historical correlations among the different rates and prices. Each PAGE 33 Table of Contents Part II Item 7A resulting unique set of equities prices, interest rates, and foreign +exchange rates is then applied to substantially all individual holdings to re-price each holding. The 250 th worst performance (out of +10,000) represents the value-at-risk over 20 days at the 97.5 percentile confidence level. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. Certain securities in our equity portfolio are held for strategic purposes. We hedge the value of a portion of these securities through the use of derivative +contracts such as put-call collars. In these arrangements, we hedge a security’s equity price risk below the purchased put strike and forgo most or all of the benefits of the security’s appreciation above the sold call strike, in exchange +for premium received for the sold call. We also hold equity securities for general investment return purposes. We have incurred material impairment charges related to these securities in prior periods. The VAR amounts disclosed below are used as a +risk management tool and reflect an estimate of potential reductions in fair value of our portfolio. Losses in fair value over a 20-day holding period can exceed the reported VAR by significant amounts and can also accumulate over a longer time +horizon than the 20-day holding period used in the VAR analysis. VAR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. The VAR numbers are shown separately for interest rate, currency, and equity risks. These VAR numbers include the underlying portfolio positions and +related hedges. We use historical data to estimate VAR. Given the reliance on historical data, VAR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent +limitation in VAR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. The following table sets forth the VAR calculations for substantially all of our positions: (In millions) Year ended June 30, 2004 Risk Categories 2003 2004 Average High Low Interest rates $ 448 $ 298 $ 625 $ 817 $ 298 Currency rates $ 141 $ 207 $ 217 $ 326 $ 117 Equity prices $ 869 $ 773 $ 969 $ 1,174 $ 770 The total VAR for the combined risk categories +is $835 million at June 30, 2004 and $987 million at June 30, 2003. The total VAR is 35% less at June 30, 2004 and 32% less at June, 30 2003 than the sum of the separate risk categories for each of those years in the above table, due to the +diversification benefit of the combination of risks. The change in the absolute value of VAR is primarily due to asset allocation shifts and portfolio growth. PAGE 34 Table of Contents Part II Item 8 ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except earnings per share) Year Ended June 30 2002 (1) 2003 (1) 2004 Revenue $ 28,365 $ 32,187 $ 36,835 Operating expenses: Cost of revenue 5,699 6,059 6,716 Research and development 6,299 6,595 7,779 Sales and marketing 6,252 7,562 8,309 General and administrative 1,843 2,426 4,997 Total operating expenses 20,093 22,642 27,801 Operating income 8,272 9,545 9,034 Losses on equity investees and other (92 ) (68 ) (25 ) Investment income/(loss) (305 ) 1,577 3,187 Income before income taxes 7,875 11,054 12,196 Provision for income taxes 2,520 3,523 4,028 Net income $ 5,355 $ 7,531 $ 8,168 Earnings per share: Basic $ 0.50 $ 0.70 $ 0.76 Diluted $ 0.48 $ 0.69 $ 0.75 Weighted average shares outstanding: Basic 10,811 10,723 10,803 Diluted 11,106 10,882 10,894 (1) Income Statements for the years ended June 30, 2002 and 2003 have been restated to reflect the retroactive adoption of the fair value recognition provisions of SFAS 123, Accounting for +Stock-Based Compensation , as discussed in Note 13. See accompanying notes. PAGE 35 Table of Contents Part II Item 8 BALANCE SHEETS (In millions) June 30 2003 (1) 2004 Assets Current assets: Cash and equivalents $ 6,438 $ 15,982 Short-term investments 42,610 44,610 Total cash and short-term investments 49,048 60,592 Accounts receivable, net 5,196 5,890 Inventories 640 421 Deferred income taxes 2,506 2,097 Other 1,583 1,566 Total current assets 58,973 70,566 Property and equipment, net 2,223 2,326 Equity and other investments 13,692 12,210 Goodwill 3,128 3,115 Intangible assets, net 384 569 Deferred income taxes 2,161 1,829 Other long-term assets 1,171 1,774 Total assets $ 81,732 $ 92,389 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 1,573 $ 1,717 Accrued compensation 1,416 1,339 Income taxes 2,044 3,478 Short-term unearned revenue 7,225 6,514 Other 1,716 1,921 Total current liabilities 13,974 14,969 Long-term unearned revenue 1,790 1,663 Other long-term liabilities 1,056 932 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 10,771 and 10,862 49,234 56,396 Retained earnings, including accumulated other comprehensive income of $1,840 and $1,119 15,678 18,429 Total stockholders’ equity 64,912 74,825 Total liabilities and stockholders’ equity $ 81,732 $ 92,389 (1) June 30, 2003 balance sheet has been restated to reflect the retroactive adoption of the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation , as +discussed in Note 13. See accompanying +notes. PAGE 36 Table of Contents Part II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30 2002 (1) 2003 (1) 2004 Operations Net income $ 5,355 $ 7,531 $ 8,168 Depreciation, amortization, and other noncash items 938 1,393 1,186 Stock-based compensation 3,784 3,749 5,734 Net recognized (gains)/losses on investments 2,424 380 (1,296 ) Stock option income tax benefits 1,596 1,365 1,100 Deferred income taxes (1,580 ) (894 ) (1,479 ) Unearned revenue 11,152 12,519 11,777 Recognition of unearned revenue (8,929 ) (11,292 ) (12,527 ) Accounts receivable (1,623 ) 187 (687 ) Other current assets (264 ) 412 478 Other long-term assets (9 ) (28 ) 34 Other current liabilities 1,449 35 2,063 Other long-term liabilities 216 440 75 Net cash from operations 14,509 15,797 14,626 Financing Common stock issued 1,497 2,120 2,748 Common stock repurchased (6,069 ) (6,486 ) (3,383 ) Common stock dividend – (857 ) (1,729 ) Net cash used for financing (4,572 ) (5,223 ) (2,364 ) Investing Additions to property and equipment (770 ) (891 ) (1,109 ) Acquisition of companies, net of cash acquired – (1,063 ) (4 ) Purchases of investments (89,386 ) (89,621 ) (92,495 ) Maturities of investments 8,654 9,205 5,561 Sales of investments 70,657 75,157 85,302 Net cash used for investing (10,845 ) (7,213 ) (2,745 ) Net change in cash and equivalents (908 ) 3,361 9,517 Effect of exchange rates on cash and equivalents 2 61 27 Cash and equivalents, beginning of period 3,922 3,016 6,438 Cash and equivalents, end of period $ 3,016 $ 6,438 $ 15,982 (1) June 30, 2002 and 2003 cash flow statements have been restated for retroactive adoption of the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation , +as discussed in Note 13. See accompanying +notes. PAGE 37 Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30 2002 (1) 2003 (1) 2004 Common stock and paid-in capital Balance, beginning of period $ 28,390 $ 41,845 $ 49,234 Cumulative SFAS 123 retroactive adjustments 6,560 – – Common stock issued 1,655 2,966 2,815 Common stock repurchased (676 ) (691 ) (416 ) Stock-based compensation expense 3,784 3,749 5,734 Stock option income tax benefits/(deficiencies) 1,596 1,365 (989 ) Other, net 536 – 18 Balance, end of period 41,845 49,234 56,396 Retained earnings Balance, beginning of period 18,899 12,997 15,678 Cumulative SFAS 123 retroactive adjustments (5,062 ) – – Net income 5,355 7,531 8,168 Other comprehensive income: Net gains/(losses) on derivative instruments (91 ) (102 ) 101 Net unrealized investments gains/(losses) 5 1,243 (873 ) Translation adjustments and other 82 116 51 Comprehensive income 5,351 8,788 7,447 Common stock dividend – (857 ) (1,729 ) Common stock repurchased (6,191 ) (5,250 ) (2,967 ) Balance, end of period 12,997 15,678 18,429 Total stockholders’ equity $ 54,842 $ 64,912 $ 74,825 (1) June 30, 2002 and 2003 stockholders’ equity statements have been restated for retroactive adoption of the fair value recognition provisions of SFAS 123, Accounting for Stock-Based +Compensation , as discussed in Note 13. See accompanying notes. PAGE 38 Table of Contents Part II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES ACCOUNTING PRINCIPLES The financial statements and accompanying notes are prepared in accordance with accounting principles +generally accepted in the United States of America. PRINCIPLES OF +CONSOLIDATION The financial statements include the accounts of Microsoft +Corporation and its subsidiaries (Microsoft). Intercompany transactions and balances have been eliminated. Equity investments in which we exercised significant influence but do not control and are not the primary beneficiary are accounted for using +the equity method. Investments in which we are not able to exercise significant influence over the investee are accounted for under the cost method. ESTIMATES AND ASSUMPTIONS Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples +include estimates of loss contingencies and product life cycles, and assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is +achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and +outcomes may differ from management’s estimates and assumptions. FOREIGN CURRENCIES Assets and liabilities recorded in foreign +currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are charged or credited to +other comprehensive income (OCI). REVENUE RECOGNITION Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the +fee is fixed or determinable, and collectibility is probable. We enter into certain arrangements where we are obligated to deliver multiple products and/or services (multiple elements). In these transactions, we allocate the total revenue among the +elements based on the sales price of each element when sold separately (vendor-specific objective evidence). Revenue for retail packaged products, +products licensed to original equipment manufacturers (OEMs), and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped, with a portion of the revenue recorded as +unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue +allocated to undelivered elements is based on the vendor-specific objective evidence of fair value for those elements using the residual method. Under the residual method, the total fair value of the undelivered elements, as indicated by +vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded as unearned for the undelivered elements is recognized as revenue related to delivered elements. Unearned +revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle. Revenue from +multi-year licensing arrangements are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing arrangements include rights to receive +future versions of software product on a when-and-if-available basis under Open and Select volume licensing programs (currently named Software Assurance and, previously named Upgrade Advantage). In addition, other multi-year licensing arrangements +include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services +agreements, MSN Internet Access subscriptions, Xbox Live, Microsoft bCentral subscriptions, and Microsoft Developer Network subscriptions are also accounted for as subscriptions. PAGE 39 Table of Contents Part II Item 8 Revenue related to our Xbox game console is recognized +upon shipment of the product to retailers. Revenue related to games published by us is recognized when those games have been delivered to retailers net of allowances for returns and price concessions. Revenue related to games published by third +parties for use on the Xbox platform is recognized when manufactured for the game publishers. Online advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search +results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours +worked during the period. Costs related to insignificant obligations, which include telephone support for developer tools software, PC games, +computer hardware, and Xbox, are accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, and bad debts. RESEARCH AND DEVELOPMENT Research and development expenses include payroll, employee benefits, equity compensation, and other headcount-related costs associated with product development. We have determined +that technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we expense all research +and development costs when incurred. SALES AND MARKETING Sales and marketing expenses include payroll, employee benefits, equity +compensation, and other headcount-related costs as well as expenses related to advertising, promotions, tradeshows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.13 billion in fiscal 2002, $1.06 +billion in fiscal 2003, and $904 million in fiscal 2004. INCOME TAXES Income tax expense includes U.S. and international income taxes, plus the provision +for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such +temporary differences is reported as deferred income taxes. DERIVATIVE +AND FINANCIAL INSTRUMENTS We consider all highly liquid interest-earning +investments with a maturity of three months or less at the date of purchase to be cash equivalents. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable +securities represent the investment of cash that is available for current operations. All cash and short-term investments are classified as available for sale and are recorded at market value using the specific identification method; unrealized +gains and losses (excluding other-than-temporary impairments) are reflected in OCI. Equity and other investments include both debt and equity +instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and losses (excluding other-than-temporary impairments) are +reflected in OCI. All other investments, excluding those accounted for using the equity method, are recorded at cost. We lend certain fixed income +and equity securities to enhance investment income. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. The fair value of collateral that we are permitted to sell or repledge +was $499 million at both June 30, 2003 and 2004. Investments are considered to be impaired when a decline in fair value is judged to be +other-than-temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments on a quarterly basis. If the cost of an investment exceeds its fair value, we evaluate, among other +factors, general market conditions, the duration and extent to which the fair value is less than cost, as well as our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and +business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an +impairment charge is recorded and a new cost basis in the investment is established. PAGE 40 Table of Contents Part II Item 8 We use derivative instruments to manage exposures to +foreign currency, equities price, interest rate, and credit risks. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Derivative +instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative +instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated +as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of OCI and subsequently reclassified into earnings when the hedged exposure affects earnings. The ineffective portion of the gain +or loss is recognized in earnings. For options designated either as fair-value or cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in +fair values of derivatives that are not designated as hedges for accounting purposes are recognized in earnings. Foreign Currency Risk. Certain forecasted transactions and assets are exposed to foreign currency risk. We monitor our foreign currency exposures +daily to maximize the overall effectiveness of our foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments +under Statement of Financial Accounting Standards (SFAS) 133, Accounting for Derivative Instruments and Hedging Activities . Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Certain non-U.S. +dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS 133 . Certain options and forwards not designated as hedging instruments under SFAS 133 are also +used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures. Equities Price Risk. Equity investments are subject to market price risk. +From time to time, we use and designate options to hedge fair values and cash flows on certain equity securities. We determine the security, or forecasted sale thereof, selected for hedging by evaluating market conditions, up-front costs, and other +relevant factors. Once established, the hedges are not dynamically managed or traded, and are generally not removed until maturity. Certain options, futures and swap contracts, not designated as hedging instruments under SFAS 133, are also used to +manage equity exposures. Interest Rate Risk. Fixed-income +securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and future contracts and over-the-counter swap +contracts, not designated as hedging instruments under SFAS 133, to hedge interest rate risk. Other Derivatives. Swap contracts, not designated as hedging instruments under SFAS 133, are used to manage exposures to credit risks. In addition, we may invest in warrants to purchase securities of other +companies as a strategic investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. To Be Announced forward purchase commitments of mortgage-backed assets are also +considered derivatives in cases where physical delivery of the assets are not taken at the earliest available delivery date. All derivative instruments not designated as hedging instruments are recorded at fair value, with changes in value +recognized in the income statement during the period of change. PAGE 41 Table of Contents Part II Item 8 ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the +accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows: (In millions) Year Ended June 30 Balance at beginning of period Charged to costs and expenses Write-offs and other Balance at end of period 2002 $ 174 $ 192 $ (157 ) $ 209 2003 209 118 (85 ) 242 2004 242 44 (120 ) 166 INVENTORIES Inventories are stated at the lower of cost or market, using the average cost method. Cost includes +materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our +review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis. PROPERTY AND EQUIPMENT Property and +equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated +using the straight-line method over the estimated useful life of the software, generally three years or less. GOODWILL Goodwill is tested for +impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No impairment of goodwill has been identified during any of the periods presented. INTANGIBLE ASSETS Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We evaluate the +recoverability of intangible assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. All of our intangible assets are subject to amortization. No +impairments of intangible assets have been identified during any of the periods presented. NOTE 2    UNEARNED REVENUE Unearned +revenue is comprised of the following items: Volume licensing programs – +Represents customer billings, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue +recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 1% to 15% of the sales price for +desktop PAGE 42 Table of Contents Part II Item 8 applications, depending on the terms and conditions of the license and +prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems and two years for desktop applications. Other – Represents primarily payments for online advertising for which the advertisement has yet to be displayed and payments for post-delivery support services to be performed in the future. The components of unearned revenue are as follows: (In millions) June 30 2003 2004 Volume licensing programs $ 5,472 $ 5,075 Undelivered elements 2,847 2,358 Other 696 744 Unearned revenue $ 9,015 $ 8,177 Unearned revenue by segment is as follows: (In millions) June 30 2003 2004 Client $ 3,165 $ 2,822 Server and Tools 2,185 2,370 Information Worker 3,305 2,586 Other segments 360 399 Unearned revenue $ 9,015 $ 8,177 PAGE 43 Table of Contents Part II Item 8 NOTE 3    INVESTMENTS The components of investments are as follows: (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2003 Fixed maturity securities Cash $ 1,308 $ – $ – $ 1,308 $ 1,308 $ – $ – Money market mutual funds 1,263 – – 1,263 1,263 – – Commercial paper 874 – – 874 774 100 – Certificates of deposit 297 – – 297 28 269 – U. S. Government and Agency securities 7,205 126 (28 ) 7,303 1,889 5,414 – Foreign government bonds 5,364 79 (16 ) 5,427 – 5,427 – Mortgage backed securities 6,257 65 (3 ) 6,319 – 6,319 – Corporate notes and bonds 17,913 1,033 (170 ) 18,776 828 16,089 1,859 Municipal securities 9,081 265 (6 ) 9,340 348 8,992 – Fixed maturity securities 49,562 1,568 (223 ) 50,907 6,438 42,610 1,859 Equity securities Common stock and equivalents 8,395 1,686 (3 ) 10,078 – – 10,078 Preferred stock 1,262 – – 1,262 – – 1,262 Other investments 493 – – 493 – – 493 Equity securities 10,150 1,686 (3 ) 11,833 – – 11,833 Total $ 59,712 $ 3,254 $ (226 ) $ 62,740 $ 6,438 $ 42,610 $ 13,692 (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2004 Fixed maturity securities Cash $ 1,812 $ – $ – $ 1,812 $ 1,812 $ – $ – Money market mutual funds 3,595 – – 3,595 3,595 – – Commercial paper 7,286 – – 7,286 4,109 3,177 – Certificates of deposit 415 – – 415 330 85 – U. S. Government and Agency securities 20,565 26 (54 ) 20,537 4,083 16,454 – Foreign government bonds 4,524 41 (60 ) 4,505 – 4,505 – Mortgage backed securities 3,656 21 (42 ) 3,635 – 3,635 – Corporate notes and bonds 15,048 122 (50 ) 15,120 1,010 12,629 1,481 Municipal securities 5,154 39 (25 ) 5,168 1,043 4,125 – Fixed maturity securities 62,055 249 (231 ) 62,073 15,982 44,610 1,481 Equity securities Common stock and equivalents 7,722 1,571 (62 ) 9,231 – – 9,231 Preferred stock 1,290 – – 1,290 – – 1,290 Other investments 208 – – 208 – – 208 Equity securities 9,220 1,571 (62 ) 10,729 – – 10,729 Total $ 71,275 $ 1,820 $ (293 ) $ 72,802 $ 15,982 $ 44,610 $ 12,210 PAGE 44 Table of Contents Part II Item 8 At June 30, 2004 unrealized losses of $293 million consisted of: $188 +million related to investment grade fixed income securities, $43 million related to investments in high yield and emerging market fixed income securities, $49 million related to domestic equity securities and $13 million related to international +equity securities. Unrealized losses from fixed income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Of the unrealized losses of $293 +million at June 30, 2004,$51 million exceeded twelve months. Management does not believe any unrealized losses represent an other-than temporary impairment based on our evaluation of available evidence as of June 30, 2004. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2003, the +recorded basis of these investments was $2.15 billion, and their estimated fair value was $2.56 billion. At June 30, 2004 the recorded basis of these investments was $1.65 billion, and their estimated fair value was $2.12 billion. The estimate of +fair value is based on publicly available market information or other estimates determined by management. The maturities of debt securities at June +30, 2004 were as follows: (In millions) Cost basis Estimated fair value Due in one year or less $ 37,348 $ 37,388 Due after one year through five years 14,077 14,064 Due after five years through ten years 5,636 5,665 Due after ten years 4,994 4,956 Total $ 62,055 $ 62,073 Debt securities include fixed maturity +securities. NOTE 4    INVESTMENT INCOME/(LOSS) The components of investment income/(loss) are as follows: (In millions) Year Ended June 30 2002 2003 2004 Dividends and interest $ 2,119 $ 1,957 $ 1,892 Net recognized gains/(losses) on investments (1,807 ) 44 1,563 Net losses on derivatives (617 ) (424 ) (268 ) Investment income/(loss) $ (305 ) $ 1,577 $ 3,187 Net recognized gains/(losses) on investments +include other-than-temporary impairments of $4.32 billion in fiscal 2002, $1.15 billion in fiscal 2003, and $82 million in fiscal 2004. Realized gains and (losses) from sales of available-for-sale securities (excluding other-than-temporary +impairments) were $3.02 billion and $(504) million in fiscal 2002, $1.44 billion and $(245) million in fiscal 2003, and $2.16 billion and $(518) million in fiscal 2004. NOTE 5    DERIVATIVES For derivative instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS 133, did not have a significant impact on +earnings for fiscal 2002, 2003, and 2004. During fiscal 2002, $30 million in gains on fair value hedges from changes in time value and $331 million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge +effectiveness and included in investment income/(loss). During fiscal 2003, $74 million in losses on fair value hedges from changes in time value and $229 million in losses on cash flow hedges from changes in time value were excluded from the +assessment of hedge effectiveness and included in investment income/(loss). During fiscal 2004, $31 million in gains on fair value hedges from changes in time value and $325 million in losses on cash flow hedges from changes in time value were +excluded from the assessment of hedge effectiveness and included in investment income/(loss). PAGE 45 Table of Contents Part II Item 8 Derivative gains and losses included in OCI are +reclassified into earnings at the time forecasted revenue or the sale of an equity investment is recognized. During fiscal 2002, $234 million of derivative gains were reclassified to revenue and $10 million in derivative losses were reclassified to +investment income/(loss). During fiscal 2003, $40 million of derivative gains were reclassified to revenue and $2 million in derivative gains were reclassified to investment income/(loss). During fiscal 2004, $14 million of derivative gains were +reclassified to revenue and no derivative gains or losses were reclassified to investment income/(loss). We estimate that $119 million of net +derivative gains included in OCI will be reclassified into earnings within the next twelve months. No significant fair value hedges or cash flow hedges were derecognized or discontinued for fiscal 2002, 2003, and 2004 . NOTE 6    INVENTORIES (In millions) Year Ended June 30 2003 2004 Finished goods $ 393 $ 271 Raw materials and work in process 247 150 Inventories $ 640 $ 421 We recorded lower of cost or market adjustments +totaling approximately $90 million in fiscal 2004. NOTE +7    PROPERTY AND EQUIPMENT (In millions) Year Ended June 30 2003 2004 Land $ 248 $ 274 Buildings and improvements 1,854 1,981 Leasehold improvements 768 805 Computer equipment and software 2,464 2,637 Furniture and equipment 744 792 Property and equipment, at cost 6,078 6,489 Accumulated depreciation (3,855 ) (4,163 ) Property and equipment, net $ 2,223 $ 2,326 Property and equipment are stated at cost. +Depreciation is computed principally on the straight-line method over the estimated useful lives of the assets. The useful lives for buildings range from five to fifteen years, leasehold improvements range from the shorter of five years or +applicable lease term, computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated. During fiscal 2002, 2003, and 2004, depreciation expense was $820 million, $929 million, and $647 million, the majority of which related to computer equipment. PAGE 46 Table of Contents Part II Item 8 NOTE 8    GOODWILL Changes in the carrying amount of goodwill for fiscal 2003 and 2004 by segment, are as follows: (In millions) Balance as of June 30, 2002 Acquisitions / purchase accounting adjustments Balance as of June 30, 2003 Acquisitions / purchase accounting adjustments Divestitures Balance as of June 30, 2004 Client $ 26 $ 11 $ 37 $ – $ – $ 37 Server and Tools 97 9 106 – – 106 Information Worker – 180 180 (2 ) – 178 Microsoft Business Solutions 1,021 1,198 2,219 7 (19 ) 2,207 MSN 160 (6 ) 154 – – 154 Mobile and Embedded Devices 5 23 28 2 – 30 Home and Entertainment 117 287 404 (1 ) – 403 Total $ 1,426 $ 1,702 $ 3,128 $ 6 $ (19 ) $ 3,115 We test goodwill for impairment annually during +the first quarter of each fiscal year at the reporting unit level using a fair value approach, in accordance with the provisions of SFAS 142. Our annual testing resulted in no impairment charges to goodwill in fiscal 2003 and 2004. If an event +occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for impairment between annual tests. During fiscal 2004, we had no material acquisitions. Goodwill decreased $13 million primarily as a result of goodwill allocated to a business that was divested in +the current year. The $1.7 billion increase in goodwill during fiscal 2003 related principally to the following acquisitions: Navision a/s with $1.2 +billion allocated to Microsoft Business Solutions; $281 million for the Rare Ltd. acquisition allocated to Home and Entertainment; and Placeware, Inc. with $180 million allocated to Information Worker. NOTE 9    INTANGIBLE ASSETS The components of finite-lived intangible assets are as follows: (In millions) Year Ended June 30 2003 2004 Gross carrying amount Accumulated amortization Net carrying amount Gross carrying amount Accumulated amortization Net carrying amount Contract-based $ 584 $ (376 ) $ 208 $ 908 $ (476 ) $ 432 Technology-based 261 (137 ) 124 278 (183 ) 95 Marketing-related 34 (9 ) 25 35 (19 ) 16 Customer-related 28 (1 ) 27 30 (4 ) 26 Total $ 907 $ (523 ) $ 384 $ 1,251 $ (682 ) $ 569 PAGE 47 Table of Contents Part II Item 8 During fiscal 2004, we recorded additions to intangible assets of $355 +million, of which $266 million was related to a comprehensive intellectual property license that we received in conjunction with the settlement of InterTrust v. Microsoft . No other material intangibles were acquired in fiscal 2004. During +fiscal 2003, we recorded additions to intangible assets of $306 million, primarily related to the acquisition of Navision a/s and Rare Ltd., as described at Note 15 – Acquisitions. The components of intangible assets acquired during +fiscal 2003 and 2004 are as follows – no significant residual value is estimated for these assets: (In millions) Year Ended June 30 2003 2004 Amount Weighted average life Amount Weighted average life Contract-based $ 162 5 years $ 324 9 years Technology-based 97 4 years 28 4 years Marketing-related 19 4 years – – Customer-related 28 9 years 3 3 years Total $ 306 5 years $ 355 9 years During 2003, research and development assets of +$17 million were acquired and written off in accordance with FASB Interpretation No. 4 (FIN 4), Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method . Those write-offs are included in Research and +Development expenses. Acquired finite-lived intangibles are generally amortized on a straight line basis over weighted average periods. Intangible +assets amortization expense was $161 million for fiscal 2003 and $170 million for fiscal 2004. The estimated future amortization expense related to intangible assets as of June 30, 2004 is as follows: (In millions) June 30 Amount 2005 $ 154 2006 104 2007 81 2008 62 2009 38 Total $ 439 NOTE +10    INCOME TAXES The components of the provision for income +taxes are as follows: (In millions) Year Ended June 30 2002 2003 2004 Current taxes: U.S. and state $ 3,644 $ 3,861 $ 3,940 International 575 808 1,056 Current taxes 4,219 4,669 4,996 Deferred taxes (1,699 ) (1,146 ) (968 ) Provision for income taxes $ 2,520 $ 3,523 $ 4,028 PAGE 48 Table of Contents Part II Item 8 U.S. and international components of income before income taxes are as +follows: (In millions) Year Ended June 30 2002 2003 2004 U.S. $ 5,282 $ 7,674 $ 8,088 International 2,593 3,380 4,108 Income before income taxes $ 7,875 $ 11,054 $ 12,196 The items accounting for the difference between +income taxes computed at the federal statutory rate and the provision for income taxes are as follows: (In millions) Year Ended June 30 2002 2003 2004 Federal statutory rate 35.0 % 35.0 % 35.0 % Effect of: Extraterritorial income exclusion tax benefit (3.1 )% (1.6 )% (0.9 )% Permanent reinvestment of foreign earnings (1.8 )% (1.3 )% (1.7 )% Other reconciling items 1.9 % – 0.6 % Total 32.0 % 32.1 % 33.0 % The 2004 other reconciling items include the +$208 million benefit from the resolution of the issue remanded by the 9 th Circuit Court of Appeals and the impact of the non-deductible +European Commission fine. Deferred income taxes were: (In millions) June 30 2003 2004 Deferred income tax assets: Revenue items $ 2,556 $ 2,032 Expense items 1,048 1,308 Impaired investments 1,525 1,246 Stock-based compensation expense 3,892 3,749 Deferred income tax assets $ 9,021 $ 8,335 Deferred income tax liabilities: Unrealized gain on investments $ (1,584 ) $ (1,087 ) International earnings (1,809 ) (2,227 ) Other (961 ) (1,095 ) Deferred income tax liabilities (4,354 ) (4,409 ) Net deferred income taxes $ 4,667 $ 3,926 Reported as: Current deferred tax assets $ 2,506 $ 2,097 Long-term deferred tax assets 2,161 1,829 Net deferred income taxes $ 4,667 $ 3,926 Deferred income tax balances reflect the effects +of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes are actually paid or recovered. We have not provided for U.S. deferred income taxes or foreign withholding taxes on $2.30 billion of our undistributed earnings for certain non-U.S. subsidiaries, +all of which relate to fiscal 2002, 2003, and 2004 earnings, because these earnings are intended to be permanently reinvested in operations outside the United States. PAGE 49 Table of Contents Part II Item 8 On December 3, 2002, the Ninth Circuit Court of Appeals +reversed, in part, an earlier U.S. Tax Court decision. In 2004, the remaining issue remanded by the Ninth Circuit Court of Appeals was resolved closing all tax years with the IRS through 1996. The IRS is currently auditing 1997 through 2003. +Management believes any adjustments that may ultimately be required will not be material to the financial statements. Income taxes paid were $1.9 billion in fiscal 2002, $2.8 billion in fiscal 2003, and $2.5 billion in fiscal 2004. NOTE 11    STOCKHOLDERS’ EQUITY Shares of common stock outstanding are as follows: (In millions) Year Ended June 30 2002 2003 2004 Beginning balance 10,766 10,718 10,771 Issued 208 291 215 Repurchased (256 ) (238 ) (124 ) Balance, end of year 10,718 10,771 10,862 As discussed in Note +13 – Employee Stock and Savings Plans, 344.6 million options were transferred to JPMorgan Chase Bank (JPMorgan) under the stock option transfer program. The options transferred to JPMorgan were amended and restated upon transfer to +contain terms and conditions typical of equity option transactions entered into between sophisticated financial counterparties at arm’s length using standard terms and definitions for equity derivatives. As of June 30, 2004, the options have +strike prices ranging from $33.03 to $101.25 per share and have expiration dates between December 2005 and December 2006. Our board of directors has +approved a program to repurchase shares of our common stock to reduce the dilutive effect of our stock option and stock purchase plans. A total of 618 million shares have been repurchased on open market transactions over the last three fiscal years +for approximately $16.2 billion. We repurchased 256 million shares for $6.9 billion, 238 million shares for $5.9 billion, and 124 million shares for $3.4 billion in fiscal 2002, 2003, and 2004, respectively. Additionally, in 2002, we acquired 10.2 +million of our shares as a result of a structured stock repurchase transaction entered into in 2001, which gave us the right to acquire such shares in exchange for an up-front net payment of $264 million. In any period, cash used in financing +activities related to common stock repurchased may differ from the comparable change in Stockholders’ Equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash. On January 16 and September 12, 2003, our board of directors declared annual dividends on our common stock of $0.08 and $0.16 per share, respectively. The dividends +were paid on March 7 and November 7, 2003, respectively, to shareholders of record at the close of business on February 21, and October 17, 2003. PAGE 50 Table of Contents Part II Item 8 NOTE 12    OTHER COMPREHENSIVE +INCOME The activity in other comprehensive income and related tax effects are as +follows: (In millions) Year Ended June 30 2002 2003 2004 Net gains/ (losses) on derivative instruments: Unrealized gains/ (losses), net of tax effect of $30 in 2002, $(69) in 2003 and $49 in 2004 $ 55 $ (129 ) $ 92 Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $(79) in 2002, $15 in 2003 and $5 in 2004 (146 ) 27 9 Net gains/ (losses) on derivative instruments (91 ) (102 ) 101 Net unrealized investment gains/ (losses): Unrealized holding gains/ (losses), net of tax effect of $(955) in 2002, $610 in 2003 and $(994) in 2004 (1,774 ) 1,132 (1,846 ) Reclassification adjustment for (gains)/losses included in net income, net of tax effect of $958 in 2002, $60 in 2003 and $524 in 2004 1,779 111 973 Net unrealized investment gains/ (losses) 5 1,243 (873 ) Translation adjustments and other 82 116 51 Other comprehensive income / (loss) $ (4 ) $ 1,257 $ (721 ) The components of accumulated other +comprehensive income were: (In millions) 2003 2004 Year Ended June 30 Net gains/ (losses) on derivative instruments $ (16 ) $ 85 Net unrealized investment gains 1,846 973 Translation adjustments and other 10 61 Accumulated other comprehensive income $ 1,840 $ 1,119 NOTE +13    EMPLOYEE STOCK AND SAVINGS PLANS Effective July 1, 2003, +we adopted the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation , using the retroactive restatement method described in SFAS 148, Accounting for Stock-Based Compensation – Transition and +Disclosure . Under the fair value recognition provisions of SFAS 123, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. In connection with the use of +the retroactive restatement method, income statement amounts have been restated for fiscal 2002 and 2003 to reflect results as if the fair-value method of SFAS 123 had been applied from its original effective date. Total compensation cost recognized +in income for stock-based employee compensation awards was $3.78 billion in fiscal 2002, $3.75 billion in fiscal 2003, and $5.73 billion in fiscal 2004. The amounts for fiscal 2004 include $2.21 billion ($1.48 billion after-tax or $0.14 per diluted +share) due to the completion of the employee stock option transfer program. Employee +Stock Purchase Plan. We have an employee stock purchase plan for all eligible employees. Under the plan, shares of our common stock could be purchased at six month intervals at 85% of the lower of the fair market value on +the first or the last day of each six month period. Employees could purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal 2002, 2003, and 2004 employees purchased 10.8 million shares, +15.2 million shares, and 16.7 million shares at average prices of $25.26, $22.56, and $22.74 per share. At June 30, 2004, 175.5 million shares were reserved for future issuance. PAGE 51 Table of Contents Part II Item 8 During the fourth quarter of fiscal 2004, the +administrative committee under the plan approved a change to the common stock purchase discount and approved the elimination of the related look back period and a change to quarterly purchase periods. As a result, effective beginning in fiscal 2005, +shares of our common stock may be purchased by employees at three months intervals at 90% of the fair market value on the last day of each three month period. Savings Plan. We have a savings plan in the United States, that qualifies under Section 401(k) of the Internal Revenue Code, as well as a number of +savings plans in international locations. Participating U.S. employees may contribute up to 25% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a +maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $101 million, $118 million, and $141 million in fiscal 2002, 2003, and 2004. Matching contributions are invested proportionate to each +participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in +Microsoft common stock. Stock Plans . In fiscal 2004 +we implemented changes in employee compensation designed to help us continue to attract and retain the best employees, and to better align employee interests with those of our shareholders. In fiscal 2004, we began granting employees stock awards instead of stock options. The stock award program offers employees the opportunity to earn shares of our +stock over time, rather than options that give employees the right to purchase stock at a set price. We also completed an employee stock option transfer program in the second quarter of fiscal 2004 whereby employees could elect to transfer all of +their vested and unvested stock options with a strike price of $33 or higher (“eligible options”) to JPMorgan. The unvested eligible options that were transferred to JPMorgan became vested upon the transfer. The price paid by JPMorgan for +the transferred options was determined by reference to the arithmetic average of the closing prices of Microsoft common stock during the period from November 14, 2003 to December 8, 2003, which was $25.57. A total of 18,503 (51%) of the 36,539 eligible employees elected to participate in the stock option transfer program and 344.6 million (55%) of the 621.4 million +eligible options were tendered. Under the terms of the program, JPMorgan paid us $382 million for the transferred options. We made an initial payment of $219 million to participating employees for the transferred options, with a remaining portion to +be paid in one or more payments that are subject to participating employees’ continued employment over the next two or three years. The options that were transferred to JPMorgan resulted in stock-based compensation expense of $2.21 billion +($1.48 billion after-tax or $0.14 per diluted share) which is reflected in the results of fiscal 2004. This expense consists of the unrecognized compensation costs of the options that were transferred, less the amounts payable applicable to those +previously unvested options for which payment is contingent upon continued employment of participating employees. The contingent payments applicable to unvested eligible options that are subject to continued employment of participating employees +will be recognized as compensation expense over the vesting period of the contingent payments. The stock option transfer program also resulted in a +decrease to our long-term deferred tax assets due to the excess of recorded compensation expense for these options over the related tax deduction reported on our tax return. For fiscal 2004, deferred tax assets were reduced by approximately $2.01 +billion with an offsetting reduction in paid-in capital, reflecting the reduction of previously recorded deductions reported on our tax return in excess of stock based compensation expense. A description of our stock plans follows. We have stock plans for directors and for officers, employees, consultants and advisors. The plans provide for awards of stock options and stock awards. At June 30, +2004, an aggregate of 807 million shares were available for future grant under our stock plans. Our plans under which awards may be issued do not contain separate limitations on the number of stock awards; all 807 million shares remaining available +for grant at June 30, 2004 could be awarded as stock awards. In addition, awards that expire or are cancelled without delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan have been removed +from our plans; any options transferred to JPMorgan that expire without being exercised will not become available for grant under any of our plans. Stock Awards and Shared Performance Stock Awards . Stock awards are grants that entitle the holder to shares of common stock as the award vests. +During fiscal 2004, 32.6 million stock awards with a weighted-average fair value of $26.12 per share were granted and generally vest ratably over a five-year period. Approximately 787,000 stock awards vested and 1.1 million stock awards were +cancelled during fiscal 2004. PAGE 52 Table of Contents Part II Item 8 Shared Performance Stock Awards are a form of stock +award in which the number of shares ultimately received depends on our performance against specified performance targets. The performance period is July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive +officers). At the end of the performance period, the number of shares of stock and stock awards issued will be determined by adjusting upward or downward from the target in a range between 33% and 150% (0% to 150% for certain executive officers). +The final performance percentage on which the payout will be based, considering performance metrics established for the performance period, will be determined by the board of directors or a committee of the board in its sole discretion. Shares of +stock will be issued at the end of the performance period and as the stock awards vest ratably over the following two years. In fiscal 2004, Shared Performance Stock Awards representing the targeted number of shares for the performance period ending +June 30, 2006 were granted in the aggregate amount of 31.7 million shares with a weighted average fair value of $26.08 per share. Because these awards cover a three-year period, Shared Performance Stock Awards will only be awarded in fiscal 2005 and +2006 to newly hired and promoted employees eligible to receive Shared Performance Stock Awards. No shared performance stock awards vested and 1.2 million shared performance stock awards were cancelled during fiscal 2004. Stock Awards and Shared Performance Stock Awards are amortized over 5 years using the straight line method. Stock Options. Nonqualified stock options have been granted to our +directors under our non-employee director stock plans. Nonqualified and incentive stock options have been granted to our officers and employees under our employee stock plans. Options granted before 1995 generally vest over four and one-half years +and expire ten years from the date of grant. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over +seven and one-half years and expire ten years from the date of grant. Options granted after 2001 vest over four and one-half years and expire ten years from the date of grant. At June 30, 2004, stock options for 569 million shares were vested. The weighted average Black-Scholes value of options granted under the stock plans during fiscal 2002, 2003, and 2004 was $15.79, $12.08, and +$10.13, respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants: Year Ended June 30 2002 2003 2004 Weighted average expected life in years 7 7 7 Dividend per share $ – $ 0.08 $ 0.16 Volatility 39.0 % 42.0 % 29.5 % Risk-free interest rate 5.4 % 3.9 % 4.1 % Employee stock options outstanding are as +follows: (In millions, except per share amounts) Price per Share Shares Range Weighted average Balance, June 30, 2001 1,796 $ 0.28 – $59.57 $ 24.77 Granted 82 24.31 –   36.29 31.25 Exercised (198 ) 0.51 –   34.91 6.41 Canceled (76 ) 0.58 –   58.28 34.34 Balance, June 30, 2002 1,604 0.40 –   59.57 26.88 Granted 254 21.42 –   29.12 24.27 Exercised (234 ) 0.51 –   28.22 6.89 Canceled (75 ) 2.13 –   59.56 34.33 Balance, June 30, 2003 1,549 0.40 –   59.56 29.30 Granted 2 25.46 –   29.96 26.76 Exercised (198 ) 0.51 –   29.38 12.21 Stock Option Transfer Program (345 ) 33.03 –   59.56 38.70 Canceled (59 ) 2.31 –   58.28 31.29 Balance, June 30, 2004 949 0.40 –   59.56 29.26 PAGE 53 Table of Contents Part II Item 8 For various price ranges, weighted average characteristics of +outstanding employee stock options at June 30, 2004 are as follows: (In millions, except per share amounts and years) Outstanding options Exercisable options Range of exercise prices Shares Remaining life (years) Weighted average price Shares Weighted average price $  0.00 – $15.00 37 1.82 $ 6.60 36 $ 6.53 15.01 –   25.00 244 7.24 $ 23.33 75 $ 21.78 25.01 –   33.00 387 5.62 $ 28.24 237 $ 28.17 33.01 –   41.00 169 4.17 $ 34.22 127 $ 34.25 41.01 –   59.56 112 4.40 $ 44.80 94 $ 44.66 949 569 As of June 30, 2004, 345 million transferred +options to JP Morgan remained outstanding and are excluded from the amounts noted as employee options outstanding in the tables above. See Note 11. In addition, the tables above include in the total options outstanding 6.8 million options +outstanding that were granted in conjunction with corporate acquisitions. These options are included in the option totals; however, they are excluded from the exercise price ranges presented. These options had an exercise price range of $0.00 to +$204.09 and a weighted average exercise price of $14.13. NOTE +14    EARNINGS PER SHARE Basic earnings per share is computed on +the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential +common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per +share are as follows: (In millions, except earnings per share) Year Ended June 30 2002 2003 2004 Net income available for common shareholders (A) $ 5,355 $ 7,531 $ 8,168 Weighted average outstanding shares of common stock (B) 10,811 10,723 10,803 Dilutive effect of employee stock options and awards 295 159 91 Common stock and common stock equivalents (C) 11,106 10,882 10,894 Earnings per share: Basic (A/B) $ 0.50 $ 0.70 $ 0.76 Diluted (A/C) $ 0.48 $ 0.69 $ 0.75 For the years ended June 30, 2002, 2003 and +2004, 746 million, 1.09 billion and 1.2 billion shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than or equal to the +average price of the common shares, and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2004, 21.9 million shared performance stock awards, out of 31.7 million targeted amount granted, have been excluded from the +calculation of diluted earnings per share because the number of shares ultimately issued is contingent on our performance against metrics established for the performance period, as discussed in Note 13 – Employee Stock and Savings +Plans. PAGE 54 Table of Contents Part II Item 8 NOTE 15    ACQUISITIONS In fiscal 2004, we had no material acquisitions. In fiscal 2003, we acquired all of +the outstanding equity interests of Navision a/s, Rare Ltd., and Placeware, Inc. Navision, headquartered in Vedbaek, Denmark, is a provider of integrated business solutions software for small and mid-sized businesses in the European market that is +part of the Microsoft Business Solutions segment. We acquired Navision on July 12, 2002 for $1.465 billion consisting primarily of $662 million in cash and the issuance of 29.1 million common shares of our common stock valued at $773 million. The +value of the common shares issued was determined based on the average market price of our common shares over the two-day period before and after terms of the acquisition were agreed to and approved. Rare is a video game developer located outside +Leicestershire, England, that has broaden the portfolio of games available for the Xbox video game system. Rare was acquired on September 24, 2002 for $377 million consisting primarily of $375 million in cash and is included in the Home and +Entertainment segment. Placeware, located in Mountain View, California, facilitates secure, highly reliable, cross-firewall Web conferencing experiences allowing users to conduct business meetings online from a PC, and is part of our Real Time +Collaboration business unit in the Information Worker segment. Placeware was acquired on April 30, 2003 for $202 million, consisting primarily of $189 million in cash. Navision, Rare, and Placeware have been consolidated into our financial +statements since their respective acquisition dates. None of the acquisitions, individually or in the aggregate, are material to our consolidated results of operations. Accordingly, pro forma financial information is not included in this note. The estimated fair values of the assets acquired and liabilities assumed at the date of the acquisitions for fiscal 2003 are as follows: (In millions) Navision a/s at July 12, 2002 Rare Ltd. at September 24, 2002 Placeware, Inc. at April 30, 2003 Current assets $ 240 $ 25 $ 30 Property, plant and equipment 8 8 7 Intangible assets 169 75 30 Goodwill 1,197 281 180 Total assets acquired 1,614 389 247 Current liabilities (148 ) (12 ) (32 ) Long-term liabilities (1 ) – (13 ) Total liabilities assumed (149 ) (12 ) (45 ) Net assets acquired $ 1,465 $ 377 $ 202 The $1.20 billion of goodwill resulting from the +Navision acquisition was assigned to the Microsoft Business Solutions segment. Of that total amount, approximately $900 million is expected to be deductible for tax purposes. The $281 million of goodwill in the Rare acquisition was assigned to the +Home and Entertainment segment. Of that total amount, approximately $270 million is expected to be deductible for tax purposes. The $180 million of goodwill in the Placeware acquisition was assigned to the Information Worker segment. None of the +goodwill is expected to be deductible for tax purposes. The components of intangible assets acquired in the acquisitions above are as follows (no +significant residual value is estimated for these assets): (In millions) Navision a/s Weighted average life Rare Ltd. Weighted average life Placeware, Inc. Weighted average life Contract-based $ 115 6 years $ 16 5 years $ 1 6 years Technology-based 48 4 years 36 5 years 4 4 years Marketing-related 4 3 years 10 5 years 2 1 year Customer-related – – – – 23 10 years Research and Development 2 (1) – 13 (1) – – – Total $ 169 5 years $ 75 5 years $ 30 8 years (1) Amounts assigned to research and development assets were written off in accordance with FIN 4. Those write-offs were included in Research and Development expenses. PAGE 55 Table of Contents Part II Item 8 NOTE 16    COMMITMENTS AND +GUARANTEES We have operating leases for most U.S. and international sales and +support offices and certain equipment. Rental expense for operating leases was $318 million, $290 million, and $331 million in fiscal 2002, 2003, and 2004, respectively. Future minimum rental commitments under noncancellable leases, in millions of +dollars, are as follows: (In millions) Year Ended June 30 Amount 2005 $ 148 2006 124 2007 81 2008 62 2009 and thereafter 120 $ 535 We have committed $129 million for constructing +new buildings. We have unconditionally guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of +Jupiter Telecommunication, Ltd., a Japanese cable company (Jupiter). These guarantees arose on February 1, 2003 in conjunction with the expiration of prior financing arrangements, including previous guarantees by us. The financing arrangements were +entered into by Jupiter as part of financing its operations. As part of Jupiter’s new financing agreement, we agreed to guarantee repayment by Jupiter of the loans of approximately $51 million. The estimated fair value and the carrying value of +the guarantees was $11 million which was added to the carrying value of the related investment. The guarantees are in effect until the earlier of repayment of the loans, including accrued interest and fees, or February 1, 2009. The maximum amount of +the guarantees is limited to the sum of the total due and unpaid principal amounts, accrued and unpaid interest, and any other related expenses. Additionally, the maximum amount of the guarantees, denominated in Japanese yen, will vary based on +fluctuations in foreign exchange rates. If we were required to make payments under the guarantees, we may recover all or a portion of those payments upon liquidation of the Jupiter’s assets. The proceeds from such liquidation cannot be +accurately estimated due to the multitude of factors that would affect the valuation and realization of the proceeds in the event of liquidation. In +connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the +shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2004, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties +under operating leases would exceed the payment obligation and therefore no liability to us currently exists. We provide indemnifications of varying +scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations +to our volume license resellers in case the resellers fail to collect from the end user. Due to the nature of the indemnification provided to our resellers, we can not estimate the fair value, nor determine the total nominal amount of the +indemnification. We evaluate estimated losses for such indemnifications under SFAS 5, Accounting for Contingencies , as interpreted by FIN 45. We consider such factors as the degree of probability of an unfavorable outcome and the ability to +make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our financial statements. Our product warranty accrual reflects management’s best estimate of our probable liability under its product warranties (primarily relating to the Xbox +console). We determine the warranty accrual based on known product failures (if any), historical experience, and other currently available evidence. Our warranty accrual totals $19 million. There has been no significant activity impacting the +results of operations for any period presented. PAGE 56 Table of Contents Part II Item 8 NOTE 17    CONTINGENCIES Government antitrust cases. We are the defendant in U.S. v. Microsoft and New York v. Microsoft , companion lawsuits filed by the Antitrust Division of the U.S. Department of Justice (DOJ) and a group of eighteen state Attorneys General alleging violations of the Sherman Act and various +state antitrust laws. After the trial, the District Court entered Findings of Fact and Conclusions of Law stating that we had violated Sections 1 and 2 of the Sherman Act and various state antitrust laws. A Judgment was entered on June 7, 2000 +ordering, among other things, our breakup into two companies. On June 28, 2001, the U.S. Court of Appeals for the District of Columbia Circuit affirmed in part, reversed in part, and vacated the Judgment in its entirety and remanded the case to the +District Court for a new trial on one Section 1 claim and for entry of a new judgment consistent with its ruling. In its ruling, the Court of Appeals substantially narrowed the bases of liability found by the District Court, but affirmed some of the +District Court’s conclusions that we had violated Section 2. We entered into a settlement with the United States on November 2, 2001. Nine states (New York, Ohio, Illinois, Kentucky, Louisiana, Maryland, Michigan, North Carolina and Wisconsin) +agreed to settle on substantially the same terms on November 6, 2001. On November 1, 2002, the Court approved the settlement as being in the public interest, conditioned upon the parties’ agreement to a modification to one provision related to +the Court’s ongoing jurisdiction. Two trade groups unsuccessfully sought to intervene to challenge the approval of the settlement and have appealed. Nine states and the District of Columbia continued to litigate the remedies phase of New +York v. Microsoft . On November 1, 2002, the Court entered a Final Judgment in this part of the litigation that largely mirrored the settlement between us, the DOJ and the settling states, with some modifications and a different regime for +enforcing compliance. The Court declined to impose other and broader remedies sought by the non-settling states. Two states, Massachusetts and West Virginia, appealed from this decision. West Virginia dismissed its appeal as part of a settlement +with us of several other cases. On June 30, 2004, the U.S. Court of Appeals for the D.C. Circuit unanimously affirmed the settlement and the Final Judgment. European Commission competition law matter. On March 25, 2004 the European Commission announced a decision in its competition law investigation of +Microsoft. The Commission concluded that we infringed European competition law by refusing to provide our competitors with licenses to certain protocol technology in the Windows server operating systems and by including streaming media playback +functionality in Windows desktop operating systems. The Commission ordered us to make the relevant licenses to our technology available to our competitors and to develop and make available a version of the Windows desktop operating system that does +not include specified software relating to media playback. The decision also imposed a fine of € 497 million, which resulted in a +charge of € 497 million ($605 million). We filed an appeal of the decision to the Court of First Instance on June 6, 2004 and will +seek interim measures suspending the operation of certain provisions of the decision. We contest the conclusion that European competition law was infringed and will defend our position vigorously. A hearing on our petition for interim measures will +be held on September 30 – October 1, 2004. In other ongoing investigations, various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, and security issues. Antitrust, unfair competition and overcharge class actions. A large +number of antitrust and unfair competition class action lawsuits have been filed against us in various state and federal courts. The federal cases have been consolidated in the U.S. District Court for Maryland. These cases allege that we have +competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software applications, and they seek to recover on behalf of variously defined classes of direct and indirect purchasers’ alleged overcharges for +these products. To date, courts have dismissed all claims for damages brought against us by indirect purchasers under federal law and in 14 states. Nine of those state court decisions have been affirmed on appeal. Claims on behalf of foreign +purchasers have also been dismissed by the federal court in Maryland. Appeals of these state rulings are pending in two states. Courts in eleven states have ruled that these cases may proceed as class actions, while courts in two states have denied +class certification. The Maryland federal District Court has certified a class of direct purchasers of certain of our operating system software that acquired the software from the shop.Microsoft.com web site or pursuant to a direct marketing +campaign and otherwise denied certification of the proposed classes. The denial of certification of the proposed classes has been appealed and that appeal is still pending. Members of the certified class licensed fewer than 550,000 copies of +at-issue operating system software from us. In September 2003, we reached an agreement with plaintiffs’ counsel to settle that action, which received final approval in April 2004. In 2003, we reached an agreement with counsel for the California +plaintiffs to settle all claims in 27 consolidated cases in that state. Under the proposed settlement, class members will be able to obtain vouchers on a PAGE 57 Table of Contents Part II Item 8 claims made basis that entitle the class members to be reimbursed up to +the face value of their vouchers for purchases of a wide variety of platform-neutral computer hardware and software. The total amount of vouchers issued will depend on the number of class members who claim and are issued vouchers. Two-thirds of the +amount of vouchers unissued or unredeemed by class members will be made available to certain schools in California in the form of vouchers that also may be redeemed for cash against purchases of a wide variety of platform-neutral computer hardware, +software and related services. Since the beginning of 2003, we also reached similar agreements to settle all claims in a number of other states. The proposed settlements in these states are structured similarly to the California settlement, except +that, among other differences, one-half of the amounts of vouchers unissued to class members will be made available to certain schools in the relevant states. The maximum amount of vouchers to be issued in these settlements, including the California +settlement, is $1.55 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools who are issued and redeem vouchers. The settlements in California, Florida, Kansas, +Montana, North Carolina, North Dakota, South Dakota, Tennessee and West Virginia have received final approval by the relevant court. The proposed settlements in Arizona, the District of Columbia, Massachusetts, Minnesota, New Mexico and Vermont have +received preliminary approval by the courts in those states, but still require final approval. We estimate the total cost to resolve all of these cases will range between $1.1 billion and $1.2 billion with the actual cost dependent upon many unknown +factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of +administering the claims process. In accordance with SFAS 5, Accounting for Contingencies , and FIN 14, Reasonable Estimation of the Amount of a Loss , we have recorded a contingent liability of $1.04 billion, net of administrative +expenses and legal fees paid. RealNetworks litigation. On +December 18, 2003, RealNetworks, Inc. filed suit against us alleging violations of federal and state antitrust and unfair competition laws, related to streaming media features of Windows and related technologies. RealNetworks seeks damages and +injunctive relief, including a permanent injunction requiring us to offer a version of Windows products with no streaming media features. We deny the allegations and will vigorously defend the action. RealNetworks filed the case in federal court in +San Jose, California. It has been consolidated for pretrial purposes with other cases pending in the U.S. District Court in Baltimore. Patent cases. We are the defendant in more than 30 patent infringement cases that we are defending vigorously. In the case of Eolas Technologies, +Inc. and University of California v. Microsoft , filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs accused the browser functionality of Windows of infringement. On August 11, 2003, the jury +awarded the plaintiffs approximately $520 million in damages for infringement from the date the plaintiffs’ patent issued through September 2001. The plaintiffs are seeking an equitable accounting for damages from September 2001 to the present. +On January 14, 2004, the trial court entered final judgment of $565 million, including post-trial interest of $45 million, and entered an injunction against distribution of any new products, but stayed execution of the judgment and the injunction +pending our appeal. We filed our notice of appeal on February 12, 2004. On October 30, 2003, the U.S. Patent Office issued a letter stating that it has initiated a Director-ordered re-examination of the Eolas patent. On February 26, 2004, pursuant +to this re-examination proceeding, the Patent Office issued an Office Action rejecting the claims of the Eolas patent. We believe the total cost to resolve this case will not be material to our financial position or results of operations. The actual +costs are dependent upon many unknown factors such as success on appeal and the events of a retrial of the case should the case be remanded to trial following appeal. In Research Corporation Technologies, Inc. v. Microsoft , filed in +U.S. District Court for the District of Arizona, plaintiff has asserted a family of six patents relating to halftoning which it believes are infringed by certain printing and display functionality allegedly present in different versions of Windows +and Office. Plaintiff seeks an as yet unspecified amount of damages in the form of “reasonable royalties” on various Microsoft products dating as far back as Windows and Office 2000. The case is scheduled for trial in April of 2005. In TVI v. Microsoft , filed in U.S. District Court for the Northern District of California, plaintiff accuses the Autoplay feature of Windows of infringement. This case is scheduled for trial in September 2004. In Arendi USA, Inc. and Arendi +Holding Limited v. Microsoft , filed in U.S. District Court for the District of Rhode Island, plaintiff has accused certain Smart Tags features in Microsoft Office XP and Office 2003 of infringing one patent. Trial is scheduled for September, +2004. Adverse outcomes in some or all of the pending cases may result in significant monetary damages or injunctive relief against us adversely affecting distribution of our operating system or application products. The risks associated with an +adverse decision may result in material settlements. PAGE 58 Table of Contents Part II Item 8 Sun Microsystems agreements. On April 1, +2004, we entered into a series of agreements with Sun Microsystems, Inc. to resolve all pending litigation between the parties, attempt to avoid future disputes, and create an environment conducive to future cooperation. These agreements included a +Settlement Agreement, a Patent Covenant and Standstill Agreement, and a Technology Collaboration Agreement. Pursuant to the agreements, we made payments totaling $1.95 billion to Sun. In the Settlement Agreement, Sun agreed to discontinue its participation in proceedings pending against Microsoft instituted by the Commission of the European +Communities and agreed to dismiss with prejudice the action it filed in the Northern District of California, Sun Microsystems, Inc. v. Microsoft Corp. , Civil Action No. C-02-01150 RMW (PVT) (N.D. Cal.), and later transferred to the United +States District Court for the District of Maryland under MDL Docket No. 1332. Sun released Microsoft from any claims that were or could have been asserted in the proceedings pending before the European Communities, its action pending in the U.S., +and any claims based on any actions or events discussed in the Findings of Fact in United States v. Microsoft Corp. and New York, et al. v Microsoft Corp. , 84 F. Supp. 2d 9 (D.D.C. 2002). Pursuant to the terms of the Settlement +Agreement, Microsoft paid Sun $700 million, which was recorded as litigation related expense. The Patent Covenant and Standstill Agreement provides +that neither Sun nor Microsoft will sue the other, or certain authorized channel and end user licensees, for damages for past patent infringement. Microsoft has the option of extending this covenant not to sue each year until 2014 in exchange for an +annual extension payment, so long as certain conditions are met. The agreement provides that on April 1, 2014, provided that certain conditions are met, the companies will grant each other irrevocable, non-exclusive, perpetual patent licenses, with +some reciprocal limitations as to scope and use, as well as an additional ten year covenant not to sue for patent infringement with respect to certain products. Pursuant to the terms of this Agreement, Microsoft paid Sun $900 million, which was +recorded as litigation related expense. Sun and Microsoft also entered into a reciprocal Technology Collaboration Agreement. This collaboration +agreement provides both companies with access to aspects of each other’s server-based technology for use in developing new server software products and/or enhancing existing server software products, in order to improve interoperability. It +provides a perpetual license between Microsoft and Sun pursuant to all subject intellectual property rights (including patents and trade secrets) to enable either company to implement in its server operating system products any server-based +communications protocols that are implemented over a seven year period by the other company in order to interoperate with their respectively identified server and/or client operating system products. Royalty obligations incurred by Microsoft for use +or inclusion of covered Sun technology in Microsoft products will, as incurred, be credited against the $350 million already paid pursuant to the terms of the Technology Collaboration Agreement, based on royalty rates to be determined in the future +by Sun. This license removes concerns under traditional patent and trade secret intellectual property frameworks by enabling Microsoft’s current and future client and server operating system products to interoperate with the most popular Sun +products in a wide range of customer computing environments. The extent and timing of Microsoft’s consumption of this credit is subject to +uncertainty. Much of the technology that the companies agreed to license to each other does not exist in a useable form and the agreement does not specify individual royalty payments for implementation of specifications for particular communications +protocols. After reaching this agreement with Sun, we valued the intellectual property rights received. In determining the fair value of the intellectual property received, we considered the uncertainty associated with the timing and likely use of +Sun’s technology, which included estimating the likelihood of adoption of protocols and potential royalties saved. That valuation resulted in a fair value of $29 million for the right to use Sun’s licensed protocols in certain products, +which we recorded as an intellectual property asset. Reflecting the uncertainty associated with the timing and likely use of Sun’s technology, the remaining amount of $321 million was recorded as litigation related expense. Intertrust settlement. On April 3, 2004, the previously reported case of InterTrust v. Microsoft was settled by agreement of the parties. Under the terms of this agreement, we have taken a comprehensive license to InterTrust’s patent portfolio, including pending patent applications, and agreed to make a +one-time payment to InterTrust of $440 million. The agreement involved a combination of a license of intellectual property assets for which we recorded an intangible asset of $266 million and a payment of $174 million for settlement of legal claims. +Of the total payment, $174 million was recovered through insurance and had no impact on our results of operations. The agreement resolves all outstanding litigation between the parties. Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of +our business. While management currently believes that resolving all of these matters, individually or in aggregate, will not have a material adverse impact on our financial position or our results of operations, the litigation and other claims +noted above are subject to inherent uncertainties and management’s view of these matters may PAGE 59 Table of Contents Part II Item 8 change in the future. Were an unfavorable final outcome to occur, there +exists the possibility of a material adverse impact on our financial position and the results of operations for the period in which the effect becomes reasonably estimable. NOTE 18    SEGMENT INFORMATION Segment revenue and operating income/(loss) is as follows: (1) (In millions) Year Ended June 30 2002 2003 2004 Revenue Client $ 9,350 $ 10,287 $ 11,241 Server and Tools 5,632 6,692 7,881 Information Worker 8,328 9,695 10,924 Microsoft Business Solutions 308 577 660 MSN 1,924 2,396 2,444 Mobile and Embedded Devices 124 153 239 Home and Entertainment 2,411 2,779 2,870 Reconciling amounts 288 (392 ) 576 Consolidated $ 28,365 $ 32,187 $ 36,835 Operating Income/(Loss) Client $ 7,529 $ 8,362 $ 9,005 Server and Tools 1,409 1,841 2,173 Information Worker 6,440 7,495 8,067 Microsoft Business Solutions (196 ) (202 ) (180 ) MSN (746 ) (378 ) 397 Mobile and Embedded Devices (240 ) (162 ) (102 ) Home and Entertainment (866 ) (938 ) (894 ) Reconciling amounts (5,058 ) (6,473 ) (9,432 ) Consolidated $ 8,272 $ 9,545 $ 9,034 (1) Fiscal 2002 and 2003 information has been restated to reflect the retroactive adoption of the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation , as +discussed in Note 13. In addition, fiscal 2003 information has been restated for certain internal reorganizations and changes to certain internal accounting methods to conform to the current period presentation. It was not practicable to restate +fiscal 2002 information for these changes, nor was it practicable to present the current year on a basis consistent with fiscal 2002. SFAS 131, Disclosures about Segments of an Enterprise and Related Information , establishes standards for reporting information about operating segments. This standard +requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present various data for management to run the business, including +internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as +components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our +chief operating decision maker is our Chief Executive Officer. The types of products and services provided by each segment are summarized below: Client – Windows XP Professional and Home, Windows 2000 Professional, and other standard Windows operating systems. PAGE 60 Table of Contents Part II Item 8 Server and Tools – Server software licenses and +client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other servers. Also includes developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft consulting services. Information Worker – Microsoft Office, Microsoft Project, +Microsoft Visio, SharePoint Portal Server CALs, other information worker products including Microsoft LiveMeeting and OneNote, an allocation for Server CALs, and professional product support services. Microsoft Business Solutions – Microsoft Great Plains, Microsoft Navision, +Microsoft Axapta, Microsoft Solomon, Microsoft CRM, MBN/Retail Manager and other business applications and services. MSN – Personal communication services, such as e-mail and instant messaging, information services, such as MSN Search and the MSN portals and channels, and +paid services including MSN Internet access, MSN Premium Web services, and MSN Mobile service. Mobile and Embedded Devices – Windows Mobile software, Windows Embedded device operating systems, MapPoint, and Windows Automotive. Home and Entertainment – Xbox video game system, PC games, the Home Products Division (HPD), and TV platform products. Because of our integrated business structure, operating costs included +in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and +used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment +reporting purposes, which may result in changes to segment allocations in future periods. Assets are not allocated to segments for internal reporting +presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment +that is included in the measure of segment profit or loss. Reconciling amounts include adjustments to conform with U.S. GAAP and corporate level +activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, quarter end cut off timing, and accelerated amortization for +depreciation, stock awards and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate level activity including certain legal settlements and legal contingent liabilities. Significant reconciling items are as follows: (In millions) Year Ended June 30 2002 2003 2004 Operating income reconciling amounts: Legal settlements and contingent liabilities (673 ) (1,079 ) (2,778 ) Stock-based compensation expense (3,784 ) (3,749 ) (4,773 ) Revenue reconciling amounts 288 (392 ) 576 Other (889 ) (1,253 ) (2,457 ) Total $ (5,058 ) $ (6,473 ) $ (9,432 ) Other primarily includes corporate operations +related to sales and marketing, product support services, human resources, legal, finance, IT, corporate development and procurement activities; research and development; and various amounts to conform with U.S. GAAP. PAGE 61 Table of Contents Part II Item 8 Sales to Dell and its subsidiaries in the aggregate +accounted for approximately 10% of total fiscal 2004 revenue. These sales were made primarily through our OEM and volume licensing channels and were included in all operating segments. No single customer accounted for more than 10% of revenue in +2002 or 2003. Revenue, classified by the major geographic areas in which we operate, is as follows: (In millions) Year Ended June 30 2002 2003 2004 United States (1) $ 20,066 $ 22,077 $ 25,046 Other countries 8,299 10,110 11,789 Total $ 28,365 $ 32,187 $ 36,835 (1) Includes shipments to customers in the United States, licensing to certain OEMs and multinational organizations, and exports of finished goods, primarily to Asia, Latin America, and Canada. Long-lived assets, classified by the geographic location of the +controlling statutory company in which that company operates, are as follows: (In millions) Year Ended June 30 2003 2004 United States $ 3,773 $ 5,365 Other countries 1,962 645 Total $ 5,735 $ 6,010 NOTE +19    SUBSEQUENT EVENT On July 20, 2004, our board of directors +approved a quarterly dividend of $0.08 per share payable on September 14, 2004, to shareholders of record on August 25, 2004. In addition, the board approved a plan to buy back up to $30 billion in Microsoft common stock over the next four years. +The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. The repurchases will be made using our cash resources. The repurchase program may be suspended or discontinued at any +time without prior notice. The board also approved a one-time special dividend of $3.00 per share, or approximately $32 billion, subject to shareholder approval of stock plan amendments that will allow certain adjustments to employee equity +compensation awards to offset the impact of the special dividend. The special dividend will be payable on December 2, 2004, to shareholders of record on November 17, 2004, conditioned upon shareholder approval of amendments to the employee stock +plans at the annual meeting of shareholders scheduled to be held November 9, 2004. PAGE 62 Table of Contents Part II Item 8 QUARTERLY INFORMATION (In millions, except per share amounts) (Unaudited) Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Total Fiscal 2003 Revenue $ 7,746 $ 8,541 $ `7,835 $ 8,065 $ 32,187 Gross profit 6,402 6,404 6,561 6,761 26,128 Net income 2,041 1,865 2,142 1,483 (1) 7,531 Basic earnings per share 0.19 0.17 0.20 0.14 0.70 Diluted earnings per share 0.19 0.17 0.20 0.14 0.69 Fiscal 2004 Revenue $ 8,215 $ 10,153 $ 9,175 $ 9,292 $ 36,835 Gross profit 6,735 7,809 7,764 7,811 30,119 Net income 2,614 1,549 (2) 1,315 (3) 2,690 8,168 Basic earnings per share 0.24 0.14 0.12 0.25 0.76 Diluted earnings per share 0.24 0.14 0.12 0.25 0.75 (1) Includes charges of $750 million (pre-tax) related to the Time Warner settlement and $1.15 billion in impairments of investments. (2) Includes stock-based compensation charges of $2.2 billion for the employee stock option transfer program. (3) Includes charges of $2.53 billion (pre-tax) related to the Sun Microsystems Inc. settlement and a fine imposed by the European Commission. PAGE 63 Table of Contents Part II Item 8 REPORT OF INDEPENDENT +REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of +Microsoft Corporation: We have audited the accompanying consolidated balance sheets of +Microsoft Corporation and subsidiaries as of June 30, 2003 and 2004, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2004. These financial +statements are the responsibility of the Corporation’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the +financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and +significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as +of June 30, 2003 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2004 in conformity with accounting principles generally accepted in the United States of America. As described in Note 13 to the financial statements, the Company retroactively adopted Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation , effective July 1, 2003. /s/    D ELOITTE & T OUCHE LLP Deloitte & Touche LLP Seattle, Washington August 24, 2004 PAGE 64 Table of Contents Part II Item 9, 9A, 9B ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A.    CONTROLS AND PROCEDURES Under +the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as +of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal +control over financial reporting during the quarter ended June 30, 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. ITEM 9B.    OTHER INFORMATION None. PAGE 65 Table of Contents Part III Item 10, 11, 12, 13, 14, 15 PART III ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information about our Directors may be found under the caption “Election of Directors and Management Information” of our Proxy Statement for the Annual Meeting of Shareholders to be held November 9, 2004 (the +“Proxy Statement”). That information is incorporated herein by reference. The information in the Proxy Statement set forth under the +caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft +Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Corporate Controller and other finance organization employees. The finance code of +ethics is publicly available on our website at www.microsoft.com/msft. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive +Officer, Chief Financial Officer or Corporate Controller, we will disclose the nature of such amendment or waiver on that website or in a report on Form 8-K. ITEM 11.    EXECUTIVE COMPENSATION The +information in the Proxy Statement set forth under the captions “Information Regarding Executive Officer Compensation” and “Information About the Board and its Committees—Director Compensation” is incorporated herein by +reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of +Principal Shareholders, Directors, and Management” is incorporated herein by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the captions “Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference. ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the heading “Fees Billed by Deloitte & Touche LLP” and is incorporated herein by reference. PART IV ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. +Financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included. PAGE 66 Table of Contents Part IV Item 15 (b) Exhibit Listing Exhibit Number Description 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation (1) 3.2 Bylaws of Microsoft Corporation (2) 4. Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank (3) 10.1* Microsoft Corporation 2001 Stock Plan 10.2* Microsoft Corporation 1991 Stock Option Plan (4) 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10.4* Microsoft Corporation Stock Option Plan for Non-Employee Directors (5) 10.5 Microsoft Corporation Stock Option Plan for Consultants and Advisors (6) 10.6* Microsoft Corporation 2003 Employee Stock Purchase Plan 10.7* Microsoft Corporation 1998 Stock Option Gain and Bonus Deferral Program 10.8* Form of Stock Award Agreement 10.9* Form of Stock Award Agreement for Non-Employee Directors 10.10* Form of Shared Performance Stock Award Agreement for the January 1, 2004 to June 30, 2006 performance period 10.11* Form of Shared Performance Stock Award Agreement for the July 1, 2003 to June 30, 2006 performance period 10.12* Form of Stock Option Agreement 10.13* Form of Stock Option Agreement for Non-Employee Directors 10.14 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of +Washington as trustee) (6) 10.15 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee (7) 10.16 Form of Indemnification Agreement (6) 21. Subsidiaries of Registrant 23. Consent of Independent Registered Public Accounting Firm 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32. Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2002. (2) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2003. (3) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2003. (4) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 1997. (5) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 1994. (6) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2002. (7) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2003. * Indicates a management contract or compensatory plan or arrangement. PAGE 67 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) +of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on September 1, 2004. M ICROSOFT C ORPORATION By: /s/    J OHN G. C ONNORS John G. Connors Senior Vice President; Chief Financial Officer Pursuant to the requirements of the +Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on September 1, 2004. Signature Title /s/    W ILLIAM H. G ATES III William H. Gates III Chairman and Chief Software +Architect /s/    S TEVEN A. B ALLMER Steven A. Ballmer Director and Chief Executive Officer /s/    J AMES I. C ASH , +J R . James I. Cash, Jr. Director /s/    R AYMOND V. G ILMARTIN Raymond V. Gilmartin Director /s/    A NN M C L AUGHLIN K OROLOGOS Ann McLaughlin Korologos Director /s/    D AVID F. M ARQUARDT David F. Marquardt Director /s/    C HARLES H. N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/    W M . G. R EED , +J R . Wm. G. Reed, Jr. Director /s/    J ON A. S HIRLEY Jon A. Shirley Director /s/    J OHN G. C ONNORS John G. Connors Senior Vice President; Chief Financial Officer (Principal Financial and Accounting Officer) PAGE 68 Table of Contents EXHIBIT INDEX Exhibit Number Description 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation (1) 3.2 Bylaws of Microsoft Corporation (2) 4. Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank (3) 10.1* Microsoft Corporation 2001 Stock Plan 10.2* Microsoft Corporation 1991 Stock Option Plan (4) 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10.4* Microsoft Corporation Stock Option Plan for Non-Employee Directors (5) 10.5 Microsoft Corporation Stock Option Plan for Consultants and Advisors (6) 10.6* Microsoft Corporation 2003 Employee Stock Purchase Plan 10.7* Microsoft Corporation 1998 Stock Option Gain and Bonus Deferral Program 10.8* Form of Stock Award Agreement 10.9* Form of Stock Award Agreement for Non-Employee Directors 10.10* Form of Shared Performance Stock Award Agreement for the January 1, 2004 to June 30, 2006 performance period 10.11* Form of Shared Performance Stock Award Agreement for the July 1, 2003 to June 30, 2006 performance period 10.12* Form of Stock Option Agreement 10.13* Form of Stock Option Agreement for Non-Employee Directors 10.14 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of +Washington as trustee) (6) 10.15 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee (7) 10.16 Form of Indemnification Agreement (6) 21. Subsidiaries of Registrant 23. Consent of Independent Registered Public Accounting Firm 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32. Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2002. (2) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2003. (3) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2003. (4) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 1997. (5) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 1994. (6) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2002. (7) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2003. * Indicates a management contract or compensatory plan or arrangement. \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-05-174825/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-05-174825/full-submission.txt new file mode 100644 index 0000000..d30904f --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-05-174825/full-submission.txt @@ -0,0 +1,1062 @@ +Table of Contents United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2005 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE +TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, +WASHINGTON 98052-6399 (425) 882-8080 Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section +13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. +Yes x No ¨ Indicate by check mark if disclosure of delinquent filers +pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any +amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes x No ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the +Exchange Act).    Yes ¨ No x The aggregate market value of common stock held by non-affiliates of the registrant as of December 31, 2004 was $256,094,088,589.78. The number of shares outstanding of the registrant’s common stock as of August 15, 2005 was 10,712,706,028. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held November 9, 2005 are incorporated by +reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2005 INDEX PART I Item 1. Business 3 Risk Factors 13 Executive Officers of the Registrant 17 Item 2. Properties 19 Item 3. Legal Proceedings 19 Item 4. Submission of Matters to a Vote of Security Holders 19 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 20 Item 6. Selected Financial Data 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 39 Item 8. Financial Statements and Supplementary Data 41 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 71 Item 9A. Controls and Procedures 71 Report of Management on Internal Control over Financial Reporting 71 Report of Independent Registered Public Accounting Firm 72 Item 9B. Other Information 73 PART III Item 10. Directors and Executive Officers of the Registrant 73 Item 11. Executive Compensation 73 Item 12. Security Ownership of Certain Beneficial Owners and Management 73 Item 13. Certain Relationships and Related Transactions 73 Item 14. Principal Accountant Fees and Services 73 PART IV Item 15. Exhibits and Financial Statement Schedules 74 Signatures 75 PAGE 2 Table of Contents Part I Item 1 Special Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, +including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the +Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believes,” +“project,” “expects,” “anticipates,” “estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,” “will +continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially +from the forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk +Factors” beginning on page 13 of this report. We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. PART I ITEM 1.    BUSINESS GENERAL Our mission is to enable people and businesses throughout the +world to realize their full potential. We work to achieve our mission through technology that transforms the way people work, play, and communicate. Since our founding in 1975, we have been a leader in this transformation. We develop and market +software, services and solutions that deliver new opportunity, convenience, and value to people’s lives. PRODUCT SEGMENTS Our product segments +provide management with a comprehensive financial view of our key businesses. The segments provide a framework for the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and for the timely +and rational allocation of development, sales, marketing, and services resources within businesses. The segments also help focus strategic planning efforts on key objectives and initiatives across our broad businesses. Due to our integrated business structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure +operating income or loss that is directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to motivate shared effort. +Due to our integrated business structure, segments should not be viewed as discrete or easily separable businesses. Our seven product segments are: +Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. See Note 18 – Segment Information of the Notes to Financial Statements for financial information regarding +segment reporting. Client. The Microsoft Windows operating +system integrates a wide range of applications, services and hardware in a familiar way, enabling people and organizations to use technology with ease and confidence. The Client segment has overall responsibility for product delivery, engineering, +and technical architecture for the Windows product family, and our relationships with personal computer manufacturers, including multinational and regional original equipment manufacturer (OEM) accounts. The segment includes sales and marketing +expenses for the Windows Client operating system and product development efforts for the Windows platform. Client revenue growth is correlated with the growth of purchases of personal computers (PCs) from OEMs that pre-install versions of Windows +operating systems because the OEM channel accounts for over 80% of total Client revenue. The Client segment includes Windows XP and other standard +Windows operating systems. Windows XP extends the personal computing experience by uniting PCs, devices, and services, while enhancing reliability, security, and performance. With emerging form factors such as the Tablet PC and Media Center, and +with investments in technology such as Windows Media, the Windows PC continues to evolve with innovations that enable people to use computers in more ways and in more places. PAGE 3 Table of Contents Part I Item 1 Windows XP Home Edition is designed for individuals or families and includes capabilities for digital photos, music, and video, home networking, and communications. Windows XP Professional, designed for business users and +people who demand the most from their computing experience, includes all the features of Home Edition, along with advanced security, performance, manageability, and multilingual features to help customers improve their productivity and connectivity. +Windows XP 64-Bit Edition meets the demands of specialized technical workstation users. Retail sales and marketing of pre-packaged units of Client products occurs through the Home and Entertainment segment. The next generation of the Windows operating system, Windows Vista, is currently under development. This development phase represents a significant investment for +the Client business and we expect that this will result in the most manageable and powerful operating system product ever released by Microsoft for both our business and consumer markets. While features and functions have not been finalized, Windows +Vista will include significant advances in security, digital media, user interfaces, and other areas that are expected to enhance the user and developer experience. We are targeting broad availability of this operating system for the first half of +fiscal year 2007. Server and Tools. The Server and Tools +segment develops and markets Windows Server System products, including Windows Server operating systems. Windows Server System is integrated server infrastructure software that is designed to support end-to-end software applications and tools built +on the Windows Server 2003 operating system. In addition, the segment provides information to developers and information technology (IT) professionals about the extended Microsoft platform through a variety of content offerings, such as Web-based +training. Through this segment, we offer a broad range of consulting services for advanced technology requirements, including custom solution services, enterprise application planning, architecture and design services, and proof-of-concept services. +We also provide product support services to corporations and other large customers. The Server and Tools segment also includes: developer tools, training, and certification; Microsoft Press; the Enterprise and Partner Group, which is responsible for +sales, partner management and partner programs for the enterprise business; and the Public Sector sales and marketing organization. Products in +Server and Tools provide a wide range of capabilities that include messaging and collaboration, database management, e-commerce, and mobile information access. These products are designed to work seamlessly with one another and with advances in +applications and development tools. This architecture is designed to help simplify the design, development, deployment, and management of software applications and tools so that customers can focus less on integrating systems and training users, and +more on adding strategic value to their businesses. Windows Server System also readily integrates with customers’ existing non-Microsoft systems, through support for open standards such as HTTP and XML, and through on-going support for +XML-based Web services. Windows Server delivers a platform for powering connected applications, networks, and Web services from the work group to the +data center. SQL Server is a relational database management system for rapidly delivering the next generation of scalable e-commerce, line-of-business, and data-warehousing solutions. Exchange Server, a business tool for e-mail collaboration and +messaging, enables information workers to gain access to critical business communications. Systems Management Server (SMS) provides a comprehensive solution for change and configuration management of information systems that enables organizations to +provide relevant software and updates to users quickly and cost-effectively. Small Business Server helps small businesses do more with a business server solution that includes messaging and collaboration, security-enhanced Internet access, protected +data storage, reliable printing, the ability to run line-of-business applications, and faxing. BizTalk Server is designed to help customers efficiently and effectively integrate systems, employees, and trading partners through manageable business +processes, enabling them to automate and orchestrate interactions in a flexible and highly automated manner. Developer tools focus on coordinating the overall programming model for the client and server and creating tools for developing Microsoft +..NET-connected applications and services. During fiscal year 2006, Server and Tools plans to release major updates of several products, including new versions of SQL Server, Visual Studio and BizTalk Server, and the beta version of the next +generation of Windows Server. Server and Tools uses multiple distribution channels including pre-installed OEM versions, licenses through partners, +and licenses directly to end customers. The licenses are sold both as one-time licenses and as multi-year licenses depending upon the needs of different customer segments. Approximately 50% of Server revenue comes from multi-year licensing +agreements, 40% is purchased through fully packaged product and transactional volume licensing programs, and 10% comes from licenses sold to OEMs. PAGE 4 Table of Contents Part I Item 1 Information Worker. The Information Worker +segment is responsible for developing and delivering software solutions that enable organizations to meet core objectives by empowering their people to transform information into impact. These solutions are an important part of an +organization’s application architecture, enabling them to respond more effectively to new opportunities and challenges through more effective use of their people and information. The Information Worker segment has expanded its focus beyond personal productivity to look at how people interact with the flow of information in an organization. +Doing so has provided the opportunity to deliver more value to small, medium, and large organizations and in home, student, and teacher segments through software and software-based services. The most recent wave of Microsoft Office offerings, released to market in the first half of fiscal year 2004, represents an evolution from a suite of personal +productivity products to a more comprehensive and integrated system of programs, servers, and services designed to increase personal, team, and organization productivity. The Microsoft Office system includes the Microsoft Office 2003 Editions, which +include (depending upon the edition): Microsoft Office Outlook 2003; Microsoft Office Excel 2003; Microsoft Office PowerPoint 2003; Microsoft Office Word 2003; Microsoft Office Access 2003; Microsoft Office InfoPath 2003; and Microsoft Office +Publisher 2003. Other products in the Microsoft Office System include: Microsoft Office Visio 2003; Microsoft Office Project 2003; Microsoft Office Project Server 2003; Microsoft Office OneNote 2003; Microsoft Office FrontPage 2003; Microsoft Office +Live Communications Server 2005; Microsoft Office Live Meeting 2005; Microsoft Office Communicator 2005; and Microsoft Office SharePoint Portal Server 2003. The Information Worker business also offers Virtual Office, an ad hoc, peer-to-peer +collaboration solution. Historically, approximately 40% of Information Worker billed revenue comes from multi-year license agreements with large +enterprises. Revenues from these licenses generally depend upon the number of information workers in a licensed enterprise. Therefore, our revenue from this category of agreements is relatively independent of the number of PCs sold in a given year, +but rather depends on the number of employees in a given enterprise. Consequently, general employment levels, particularly in North America and Europe, Middle East, and Africa, significantly affect Information Worker revenue. Approximately 40% of +Information Worker revenue comes from new licenses acquired through fully packaged product and transactional volume licensing programs to individual consumers and enterprises of all sizes. Most of this revenue is sensitive to information technology +budgets, which often depend on general economic conditions. The remaining approximately 20% of Information Worker revenue is from licenses to OEMs for new PCs and through sales of retail packaged products and is affected by the relative level of PC +shipments. The Information Worker segment releases most products in a “wave” approach, with a major release every 24-36 months. New +products and investment areas will occasionally fall outside of the wave cycle. In fiscal year 2006, the Information Worker segment will release solutions outside of the next wave of products in business intelligence, small business accounting, and +real time communications, while also preparing the sales team, partners, and customers for the next full wave of products, code named Office 12, due for release during the first half of fiscal year 2007. Microsoft Business Solutions. The Microsoft Business Solutions segment is +responsible for developing and marketing offerings to manage financial, customer relationship and supply chain management functions for small and midsize businesses, large organizations and divisions of global enterprises. Delivered through a global +network of channel partners providing vertical solutions and specialized services, these integrated, adaptable business solutions work like and with familiar Microsoft software to streamline processes across an entire business. Microsoft Business +Solutions now includes the Small and Mid-Market Solutions & Partners (SMS&P) organization, which previously had been included in Information Worker. SMS&P supports small and mid-market customers for all Microsoft products and services. Microsoft Business Solutions focuses on providing continuous innovation that integrates with solutions across Microsoft Office, Windows Server System +and other Microsoft tools and technologies, and that provides rich functionality with high adaptability at lower costs. The solutions are designed to be easy to use and empower people to be more productive. As a result of our platform approach, the +business solutions category enables a broad ecosystem of vertical partners and independent software vendors that offer tailored functionality to our target customers. The segment consists of Line of Business Solutions to manage financial management and supply chain management functions (Microsoft Great Plains, Microsoft Navision, Microsoft Solomon and Microsoft Axapta); solutions to manage +customer relationships (Microsoft CRM); vertical solutions for small and midsized retailers PAGE 5 Table of Contents Part I Item 1 (Microsoft Point of Sale and Microsoft Retail Management System); and other business applications and services including the Microsoft Partner Program. The Business +Solutions R&D team also develops Office Small Business Accounting and Business Contact Manager for Outlook, which are marketed by Information Worker. In fiscal year 2006, Microsoft Business Solutions will release upgrades and/or updates to its core line of business solutions including releases for Microsoft CRM, Microsoft Axapta, Microsoft Great Plains, Microsoft Navision and Microsoft +Solomon. These releases will focus on user experience, web services, contextual business intelligence, and portals that interoperate with other Microsoft technologies. MSN. MSN is responsible for delivering online services that seek to empower users by bringing them closer to the people +and information that matter most to them. MSN provides personal communications services, such as e-mail and instant messaging, and information services such as MSN Search and the MSN portals and channels around the world. MSN manages many of its own +properties, including health, autos, and shopping. MSN also creates alliances with leading third parties for many channels, including top partners like MSNBC.com, a joint venture between NBC Universal and Microsoft; Foxsports.com, a property of Fox +Entertainment Group; Expedia.com; Match.com, an operating unit of InterActiveCorp; and CareerBuilder.com. MSN provides a variety of paid solutions including MSN Internet Access, Premium Web Services (consisting of MSN Internet Software Subscription, +MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus), and MSN Mobile services. The segment generates revenue primarily from advertisers on MSN, from +consumers and partners, through subscriptions and transactions, and from subscribers to MSN narrowband Internet access. According to studies performed by Nielsen Net Ratings and comScore Media Metrix, MSN Web sites are among the most popular on the +Internet, visited by more than 420 million unique users every month. MSN Hotmail is one of the world’s largest e-mail services with more than 205 million accounts, and MSN Messenger is one of the world’s largest instant-messaging services +with more than 175 million accounts. MSN also provides a variety of paid solutions including MSN Internet Access and MSN Premium Web Services. Mobile and Embedded Devices. The Mobile and Embedded Devices segment is responsible for the development and marketing of products that extend the +advantages of the Windows platform to many types of devices, including mobile devices that incorporate voice, personal information management, and media capabilities, and a wide variety of other devices designed to improve people’s personal and +work lives. Microsoft’s vision for mobile devices is rooted in the convergence of the computing and wireless industries, which brings new opportunities to improve communication and information access for customers. We see software as a key +differentiator in making smart devices and wireless data services valuable to customers through rich experiences such as mobile messaging, location-based services, media, and speech recognition. We are working closely with mobile operators, and +hardware and software partners to accelerate the development and availability of smart devices and services, and to provide a broad range of choices for customers. The segment is also responsible for managing our company-wide sales and customer +relations with mobile device manufacturers, and with host and network equipment and service providers, including telecommunications and cable and wireless companies. The segment consists of the Windows Mobile software platform, the Windows Embedded device operating system family, MapPoint, and Windows Automotive. The Windows Mobile software platform provides a familiar and integrated +customer experience that is the basis for specific devices like the Pocket PC, Pocket PC Phone Edition, Smartphone, and Portable Media Center. Windows Embedded, including Windows CE, Windows XP Embedded, and Windows XP Embedded for Point of Service, +is a family of embedded device software platforms used in non-PC computing devices. Windows Embedded software is used widely in advanced consumer electronics devices, including digital televisions, Internet Protocol (IP)-based set top boxes, network +gateways, and portable media players, and in enterprise devices such as industrial controllers, retail point-of-sale systems, and voice-over-IP phones. The MapPoint family of location-enabled products and services includes the MapPoint Web Service, +a hosted programmable XML Web service that allows developers to integrate location intelligence in applications, business processes and Web sites, and business and consumer oriented mapping CD-ROM products. Windows Automotive is an automotive-grade +software platform that provides developers with the building blocks to quickly and reliably create a broad range of advanced telematics solutions for vehicles. In fiscal year 2006, Mobile and Embedded Devices expects to release added functionality +to the Windows Mobile 5.0 platform through the Microsoft Enterprise Feature Pack and the Exchange Service Pack 2. Effective July 1, 2005, functions +related to MapPoint in Mobile and Embedded Devices have been moved to MSN. This reorganization will result in a corresponding change to the Mobile and Embedded Devices and MSN reported results. PAGE 6 Table of Contents Part I Item 1 Home and Entertainment. The Home and +Entertainment segment is responsible for development, production, and marketing for the Xbox video game system, including hardware, third-party games, games published under the Microsoft label, Xbox and Xbox Live operations, marketing, research, and +sales and support. The segment also leads the development efforts of our Home Products Division (HPD) product lines. In addition. it carries out all retail sales and marketing for Microsoft Office (for which it receives an inter-segment commission), +the Windows operating systems, Xbox, PC games, and HPD products. It is also responsible for the development, sales, and deployment of Microsoft’s TV platform products for the interactive television industry. Microsoft Xbox, released in fiscal year 2002, is a video game console system that delivers high-quality graphics and audio experiences. Xbox 360, unveiled in May +2005, is our next-generation video game and entertainment system that we expect to be available in the first half of fiscal year 2006 in Europe, Japan and North America. In addition to Xbox, we offer several types of entertainment products, +including PC software games, online games, and console games. HPD includes Microsoft’s line of consumer software and hardware products, such as the Encarta line of learning products and services, application software for Macintosh computers, +the Works productivity suite, and Microsoft PC hardware products such as mice, keyboards, and game controllers. The MSTV group develops the MSTV Foundation Edition and Internet Protocol TV (IPTV) products. OPERATIONS To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we +“localize” many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our research and development facilities are located +primarily in Redmond, Washington with smaller facilities located in Mountain View, California; Fargo, North Dakota; Beijing, China; Dublin, Ireland; Vedbaek, Denmark; Hyderabad, India; Haifa, Israel; and Cambridge, England. We have regional operations centers in Ireland; Singapore; Reno, Nevada; Fargo, North Dakota; and Redmond. The centers support all operations in their regions, +including customer contract and order processing, credit and collections, information processing and vendor management and logistics. The regional center in Dublin, Ireland, supports the EMEA region; the center in Singapore supports the Japan, +Greater China and Asia-Pacific region; and the centers in Reno, Fargo, and Redmond support North America and Latin America. We contract most of our +manufacturing activities to third parties. Outside manufacturers produce the Xbox, various retail software packaged products, and Microsoft hardware. Our products may include some components that are available from only one or limited sources. Key +components that are currently obtained from a single source include the Xbox central processing unit (CPU) from Intel Corporation and the Xbox graphics processing unit (GPU) from NVIDIA Corporation. Similarly, our upcoming Xbox 360 console will also +include certain key components that will be supplied at least initially by a single source: the CPU which will be purchased from IBM Corporation and the graphics chips and embedded DRAM chips for the GPU which will be purchased from TSMC and NEC, +respectively. Though we have chosen to initially source these key Xbox 360 components from a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the exceptions noted, we generally +have the ability to use other custom manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume +discount basis. PRODUCT DEVELOPMENT During fiscal years 2003, 2004, and 2005, research and development expense was $6.60 billion, $7.78 +billion, and $6.18 billion respectively. Those amounts represented 20.5%, 21.1%, and 15.5%, respectively, of revenue in each of those years. We plan to continue significant investment in a broad range of research and product development. Most of our software products are developed internally. We also purchase technology, license intellectual property rights, and oversee third-party development +and localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control +over our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Product documentation generally is also created internally. We strive to obtain information at the +earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, +and testing. PAGE 7 Table of Contents Part I Item 1 Business and Product Development Strategy. A key factor affecting Microsoft’s growth is innovation. In fiscal year 2005, we filed for more than 3,000 U.S. patents for new technologies. We continue our +long-term commitment to research and development, including advanced work aimed at important innovations in a wide spectrum of technologies: tools and platform; communication, collaboration and expression; information access and organization; +entertainment; business and e-commerce; and devices. Through innovations in these areas, we expect to grow revenue via three principal strategies: • Growing our anchor businesses. The markets for our Client, Server & Tools, and Information Worker businesses are continuing to grow as a result of growth in +hardware shipments and software upgrades. We believe the growth in our anchor businesses can be accelerated by our forthcoming innovations, including the Windows Vista operating system, the Office 12 upgrade of the Microsoft Office system, and new +products from our Server & Tools business. In addition, we see opportunities to grow these businesses by making inroads against software piracy. As the world’s emerging economies develop and integrate more fully into the global economy, we +expect that intellectual property will be more widely and effectively protected, and the current widespread use of unlicensed software will gradually diminish. At the same time, we are developing new products and services that are specifically +designed to appeal to the unique requirements of emerging markets. Among them are products designed to be readily available and affordable for first-time PC users. We also expect our anchor businesses to grow through successfully competing against +alternative solutions. In servers, for example, we expect to continue gaining customers as a result of migration from UNIX. We particularly see opportunities in the markets for Web servers, data centers, e-mail servers and in high-performance +computing. • Expanding our innovation portfolio. Across each of our businesses, we see opportunities for growth through expansion of the technologies we offer. Within our +anchor businesses, we are working to develop new technologies that offer greater value in meeting many targeted customer needs: workflow management, real-time communications, document management, collaboration, terminal services, search and portals, +unified messaging, media technologies management, anti-spam and anti-malware protection, network edge security, desktop access to enterprise applications, business intelligence, rights management services, and storage. We expect to offer these +technologies as new products and also as higher-value versions of existing products. In our emerging businesses, we are also moving forward with a broad portfolio of products, with a goal of providing best-in-class products in every major market +where we compete, such as gaming, software for mobile devices, small business applications and interactive television. • Delivering software services. During the past several years, we have gained extensive experience in providing a variety of online consumer services, many of them +supported by advertising or subscriptions. These services include the world’s largest email service, one of the world’s most popular online portals, MSN Search for the Web and the PC desktop, and Xbox Live, the world’s largest online +gaming service. We also have begun to develop services for business, such as Outlook Live and Office Live Meeting, which enable workers to collaborate interactively without the cost and disruption of business travel. We expect to pursue +opportunities to offer other new services both to consumers and businesses. Our announced plans to acquire FrontBridge Technologies, for example, will enable us to provide businesses with e-mail filtering and security to help protect the health of +their networks and the security of their data. We expect that services will be an important component of our future growth. DISTRIBUTION, SALES AND MARKETING We distribute our products primarily through the following channels: OEM; distributors and resellers; and online services. Our six major geographic sales and marketing +organizations are the North American Region; the Latin American Region; the Europe, Middle East, and Africa Region (EMEA); Japan; the Asia-Pacific Region; and Greater China. OEM. Our operating systems are licensed primarily to OEMs under agreements that grant the OEMs the right to build +computing devices based on our operating systems, principally PCs. Under similar arrangements, we also market and license certain server operating systems, desktop applications, hardware devices, and consumer software products to OEMs. We have OEM +agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, Dell, Fujitsu, Fujitsu Siemens Computers, Gateway, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba. A substantial amount of OEM +business is also conducted with system builders, which are low-volume customized PC vendors operating in local markets. PAGE 8 Table of Contents Part I Item 1 Distributors and Resellers. We license +software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products primarily through large account resellers (LARs), direct market resellers, and value-added +resellers. Many organizations that license products through enterprise agreements (EAs) now transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are also +authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations and value-added resellers typically reach +the breadth of small- and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include Software Spectrum, Software House International, Dell, CDW, and Insight Enterprises. Our +business solutions software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our finished goods products primarily through independent +non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Wal-Mart, and Target. We have a network of field sales representatives +and field support personnel that solicits orders from distributors and resellers and provides product training and sales support. Our arrangements +for organizations to acquire multiple licenses of products are designed to provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the +market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they are as follows: Open. Designed primarily for small-to-medium +organizations (5 to over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years). The offering +that conveys rights to future versions of certain software product over the contract period is called Software Assurance. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the +Open program, customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing volume licensing agreements. Select. Designed primarily for medium-to-large organizations (greater than 250 licenses), this +program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future versions of certain software products, support, tools, and training over a specified time period +(generally three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements. Enterprise Agreement. The Enterprise Agreement is +targeted at medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their enterprise, along with rights to future versions of software products, support, tools, and training over a +specified time period (generally three years). Enterprise +Subscription Agreement. The Enterprise Subscription Agreement (ESA) is a time-based, multi-year licensing agreement. Under an ESA, customers acquire the right to use the current version of software products and the +future versions that are released during the three-year term of the agreement. At the end of the term, customers may either renew their ESA or exercise a buy-out option to obtain perpetual licenses for the latest version of the covered products. If +they do not elect one of these options, then all previously covered software must be uninstalled. Online Services. We distribute online content and services through MSN and other online services. MSN delivers Internet access and various premium services and tools to consumers. MSN also delivers online +e-mail and messaging communication services and information services such as online search and premium content. Home and Entertainment operates the Xbox Live service which allows customers to participate in the gaming experience with other +subscribers online. Microsoft Business Solutions operates the Microsoft Small Business Center portal, which is delivered online. This portal provides tools and expertise for small-business owners to build, market, and manage their businesses online. +Other services delivered online include Microsoft Developer Networks (MSDN) subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our +products and solutions. PAGE 9 Table of Contents Part I Item 1 CUSTOMERS Our customers include individual consumers, small +and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet Service Providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily through +resellers and OEMs. Sales to Dell and its subsidiaries in the aggregate accounted for approximately 10% of fiscal year 2004 and 2005 revenue. These sales were made primarily through our OEM and volume licensing channels and cover a broad array of +products including Windows PC operating systems, Microsoft Office, and server products. No single customer accounted for more than 10% of revenue in 2003. Our practice is to ship our products promptly upon receipt of purchase orders from customers; +consequently, backlog is not significant. COMPETITION Every segment of the software business is competitive and subject to rapid technological change, +evolving customer requirements, and changing business models. We face significant competition in all areas of our business and intense competition in many of them. Because technology advances rapidly, competitors can quickly render existing +technologies less valuable. Customer requirements and preferences continually change as other information technologies emerge or become less expensive, and as concerns such as security and privacy become more important. Our direct competitors include firms that have adopted the non-commercial software model. These firms typically provide customers with open source software at +nominal cost and earn their revenue on complementary services and products. This approach allows these firms to compete without having to bear the full costs of software research and development. In a sense, we also compete with pirated copies of our own software. Global software piracy – the unlawful copying and distribution of our copyrighted software +products – deprives us of significant amounts of revenue on an annual basis. In addition, future versions of our products compete with the existing versions, which our licensed customers may choose to continue to use indefinitely. This means +that future versions must deliver significant additional value in order to induce existing customers to purchase a new version of our product. Our +competitive position may be adversely affected by one or more of the factors described in this section, or as yet unidentified additional factors that may arise. Client. Although we are the leader in PC operating system software products, we face strong competition from +well-established companies and entities with differing approaches to the market. Competing commercial software products, including variants of Unix, are supplied by competitors such as IBM, Hewlett-Packard, Apple Computer, Sun Microsystems and +others, which are vertically integrated in both software development and hardware manufacturing and have developed operating systems that they preinstall on their own computers. Personal computer OEMs who preinstall third-party operating systems may +also license these firms’ operating systems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained increasing acceptance as competitive pressures lead personal +computer OEMs to reduce costs. The Microsoft Windows operating systems also face competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer software +that competes with the Internet Explorer Web browsing capabilities of our Windows operating system products. Apple Computer, Real Networks, and many others compete with the media playback capabilities (Windows Media Player) of our Windows operating +system products. We believe current and future versions of these and other aspects of Windows will continue to compete effectively with non-Microsoft browsers, media players, and other non-Microsoft programs on important attributes such as features, +functionality, and security. We believe our operating system products compete effectively by delivering innovative software, an easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support +network for any operating system. Server and Tools. Our +server operating system products face intense competition from a wide variety of competing server operating systems and server applications, offered by firms with a variety of market approaches. Vertically integrated computer manufacturers such as +IBM, Hewlett-Packard, Sun Microsystems and others offer their own variant of Unix preinstalled on server hardware, and nearly all computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsement of Linux has +accelerated its acceptance as an alternative to both traditional Unix and Windows server operating systems. Linux’s competitive position has also benefited from the large number of compatible applications now produced by many leading commercial +software developers and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. PAGE 10 Table of Contents Part I Item 1 We compete in the business of providing enterprise-wide +computing solutions with several companies that provide competing solutions and middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software +developers that provide competing server applications for PC-based distributed client/server environments include Oracle, IBM, and Computer Associates. Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. In addition, IBM has a large installed base of Lotus Notes and +cc:Mail, both of which compete with our collaboration and e-mail products. There are also a significant number of non-commercial software products that compete with our solutions, including the widely-deployed Apache Web Server. Our products for software developers compete against offerings from BEA Systems, Borland, IBM, Macromedia, Oracle, Sun Microsystems, and other companies. We believe that our server products provide customers with significant advantages in innovation, performance, total costs of ownership, productivity, +applications development tools and environment, compatibility with a broad base of hardware and software applications, security, and manageability. Information Worker. While we are the leader in business and personal productivity software applications for personal computers, competitors to the +Microsoft Office System include many software application vendors such as Apple, Corel, IBM, Oracle, Sun Microsystems, Novell, Red Hat, and local application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have +significant installed bases with their office productivity products. Apple may preinstall certain of their application software products on various models of their PCs, competing directly with our applications. The OpenOffice.org project provides a +freely downloadable cross-platform application that also has been adapted by various commercial software vendors (Sun, Novell, Red Hat, IBM, and others) to sell under their brand. Corel’s suite, and many different local software suites around +the world are aggressively priced for OEMs to preinstall on low-priced PCs. In addition to traditional client-side applications, Web-based offerings such as SimDesk can also provide an alternative to Microsoft Office System products. Further, as customers have increasingly demanded additional functionality and products, including new server and service offerings, additional vendors are competing +in the Information Worker segment, most notably in document management, collaboration tools, real time messaging and business intelligence. As just one example, Microsoft competes with IBM broadly in messaging and collaboration with our approach +that spans multiple Information Worker products. We believe that our products compete effectively through ease of use, improving users’ personal productivity, providing tools for effective teaming and collaboration, better information +management and control, and for many customers, a lower total cost of ownership than alternatives. Microsoft Business Solutions. The products of Microsoft Business Solutions are targeted at small and midsized businesses (SMB) and larger organizations and divisions of global enterprises. The SMB +segment for business solutions is highly fragmented with many companies in this business. Well-known vendors focused on providing solutions for small and midsized businesses, such as Intuit and Sage, compete against us for a portion of this segment. +The segment consisting of large organizations and divisions of global enterprises continues to be intensely competitive with a small number of primary vendors providing products and services such as SAP, Oracle/Peoplesoft and Siebel. In addition +these large enterprise-focused vendors are repositioning some of their business applications to focus on the SMB segment, and divisions of global enterprises, and thus also compete against us for a portion of the market opportunity. Our business +solution products also compete with hosted solutions offered by companies such as Salesforce.com. In addition, there are thousands of other vendors in specific localities or industries that offer their own solutions. We believe that our business +solutions across financial management, supply chain management, and customer relationship management (CRM) compete effectively in our target segments by offering integrated solutions that address multiple segment needs across industries and vertical +markets through consistent innovation that are delivered through a growing network of partners and Independent Software Vendors (ISVs). MSN. MSN competes with Yahoo!, Google, AOL, and a vast array of Web sites and portals that offer content and online services of all types to end +users, and we compete with these organizations to provide advertising opportunities for merchants to reach their audiences. MSN also competes for narrowband internet access users with Earthlink, AOL and other ISPs for dial-up internet access in the +United States. The global online advertising market has grown significantly over the past several years, and we anticipate this trend to continue especially in display and PAGE 11 Table of Contents Part I Item 1 in search-based advertising. As a result competitors are aggressively developing internet services that provide enhanced functionality for end users in communication +services, improvements in information services such as internet search, and advertising infrastructure and support services including more effective ways of connecting advertisers with audiences. We have built our own algorithmic search engine to +provide end users with more relevant search results, broader selection of content, and expanded set of search services, and we are investing to support the continued growth of our advertising business. We are also investing in our communication +services, and our technology, operations, and sales efforts to support the continued growth of our advertising business. We will continue to introduce new products and services aimed at attracting additional users by improving the user experience in +an effort to increase our satisfaction levels with our end users and merchant customers. Due to the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to +continue to decline. We believe that we can compete effectively across the breadth of our internet services by providing users with software innovation in the form of information and communication services that help them find, discover, and +experience what they want online and by providing merchants with effective advertising results through improved systems and sales support. Mobile and Embedded Devices. Windows Mobile software faces substantial competition from Nokia, Openwave Systems, PalmSource, QUALCOMM, and Symbian. +The embedded operating system segment is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. MapPoint +competitors include DeLorme, MapInfo, Mapquest.com, Rand McNally, Webraska Mobile Technologies, Google, and Yahoo!. The telematics market is also highly fragmented, with competitive offerings from IBM and automotive suppliers building on various +real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others. We believe that our products compete effectively by providing a familiar development framework that enables developers to easily write +and deploy innovative applications for mobile or embedded devices; providing a flexible platform that allows customers and partners to build differentiated and profitable business models; and providing end users significant benefits such as ease of +use, personal productivity, and better information management and control. Home and +Entertainment. The home and entertainment business is highly competitive and is characterized by limited platform life cycles, frequent introductions of new products and titles, and the development of new technologies. The +markets for our products are characterized by significant price competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices on certain products. Our competitors +vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of price, product quality and variety, timing of product +releases, and effectiveness of distribution and marketing. Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of +which have a large established base of customers. The video game consoles have on average 5 to 7 year lifecycles. We have announced the expected release in the first half of fiscal year 2006 of a new console, the Xbox 360. Sony and Nintendo have +also announced new versions of their game consoles. Success in this transition to the next generation of consoles depends on the computational power of the console, the ease of developing games for the console, the ability to provide new revenue +sources such as advertising and downloadable content, and providing exclusive game content that is sought after by gamers. We believe the Xbox 360 is positioned well against competitive console products based on significant innovation in the +hardware architecture, new developer tools, expanded revenue sources, and continued strong exclusive content from our 1 st party game +franchises such as Halo. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous +companies that have been licensed by us to develop and publish software for the Xbox console. These competitors include Acclaim Entertainment, Activision, Atari, Capcom, Eidos, Electronic Arts, Sega, Take-Two Interactive, Tecmo, THQ, and Ubi Soft, +among others. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Our MSTV business faces competition primarily from ad hoc, point-solutions that +address sub-segments of the TV delivery platform, but do not provide end-to-end solutions for the network operator. Our largest MSTV competitors include IBM, Cisco, UTStarcom, and Siemens/Myrio. PAGE 12 Table of Contents Part I Item 1 RISK FACTORS Challenges to our business model may reduce +our revenues and operating margins. Our business model is based upon customers agreeing to pay a fee to license software developed and distributed by us. Under this commercial software model, software developers bear the +costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their products. We believe the commercial software model has had +substantial benefits for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop innovative software that is useful, reliable, and compatible with other +software and hardware. In recent years, a non-commercial software model has evolved that presents a growing challenge to the commercial software model. Under the non-commercial software model, open source software produced by loosely associated +groups of unpaid programmers and made available for license to end users without charge is distributed by firms at nominal cost that earn revenue on complementary services and products, without having to bear the full costs of research and +development for the open source software. The most notable example of open source software is the Linux operating system. There is a wide variety of other open source software available, such as Open Office.org and Eclipse. While we believe our +products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than open source software, the popularization of the non-commercial software model continues to pose a +significant challenge to our business model, including recent efforts by proponents of open source software to convince governments worldwide to mandate the use of open source software in their purchase and deployment of software products. To the +extent open source software gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for our products, and revenue and operating margins may consequently decline. We face intense competition. We continue to experience intense +competition across all markets for our products and services. Our competitors range in size from Fortune 100 companies to small, single-product businesses that are highly specialized and open source community-based projects. While we believe the +breadth of our businesses and product portfolio offers benefits to our customers that are a competitive advantage, our competitors that are focused on a narrower product line may be more effective in devoting technical, marketing, and financial +resources to compete with us. In addition, barriers to entry in our businesses generally are low. The Internet as a distribution channel and non-commercial software model described above have reduced barriers to entry even further. Non-commercial +software vendors are devoting considerable efforts to developing software that mimics the features and functionality of various of our products. In response to competitive factors, we are developing versions of our products with basic functionality +that are sold at lower prices than the standard versions. See Part I, Item 1 of this report for additional information about our competitors. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased +operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins, and operating income. We may not be able to protect our intellectual property rights against piracy, infringement of our patents by third parties, or declining legal protection for intellectual +property. We defend our intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through a variety of techniques. Preventing unauthorized use or infringement of our +rights is difficult. Piracy of our products represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more significant, particularly in countries where laws are less +protective of intellectual property rights. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Moreover, future legal changes could make this even more challenging. Throughout the +world, we actively educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual +property rights are protected. However, continued educational and enforcement efforts may not affect revenue positively, and revenue could be adversely affected by reductions in the legal protection for intellectual property rights for software +developers or by compliance with additional legal obligations impacting the intellectual property rights of software developers. Third parties may claim we infringe their intellectual property rights. From time to time we receive notices from others claiming we infringe their +intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on less favorable terms, require us to stop selling or to redesign affected products, or to +pay damages or to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements. If we are required to enter into such agreements or take such actions, our operating margins may decline as +a result. We have made and expect to PAGE 13 Table of Contents Part I Item 1 continue making significant expenditures to acquire the use of technology and intellectual property rights, including via cross-licenses of broad patent portfolios, as +part of our strategy to manage this risk. We may not be able to protect our source +code from copying if there is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems and other software programs, is the most significant asset we own. While we +license certain portions of our source code for various software programs and operating systems to a number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a +significant portion of our source code occurs, we could potentially lose future trade secret protection for that source code. The loss of future trade secret protection could make it easier for third parties to compete with our products by copying +functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code could also increase certain risks described in the next paragraph. Security vulnerabilities in our products could lead to reduced revenues or to liability claims. Maintaining the security +of computers and computer networks is an issue of critical importance for us and our customers. There are malicious hackers who develop and deploy viruses, worms, and other malicious software programs that attack our products. While this is an +industry-wide phenomenon that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on the most popular operating systems and programs and we expect them to continue to do so. We +devote significant resources to addressing these critical issues. We are focusing our efforts on engineering even more secure products, enhancing security and reliability options and settings when we deliver products, and providing guidance to help +our customers make the best use of our products and services to protect against computer viruses and other attacks on their computing environment. In addition, we are working to improve the deployment of software updates to address security +vulnerabilities discovered after our products are released. We are also investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed. We are also advising customers on how to help +protect themselves from security threats through the use of our online automated security tools, our published security guidance, and the deployment of security software such as firewalls, antivirus, and other security software. The cost of these +steps could adversely affect our operating margins. Despite these efforts, actual or perceived security vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future purchases, or to use competitive +products. Customers may also increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. We devote +significant resources to improving the security design and engineering of our software. Nevertheless, actual or perceived vulnerabilities may lead to claims against us. While our license agreements typically contain provisions that eliminate or +limit our exposure to such liability claims, there is no assurance these provisions will be held effective under applicable laws and judicial decisions. We are subject to government regulatory activity that affects how we design and market our products. Lawsuits brought by the U.S. Department of +Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in November 2001 and a Final Judgment entered in November 2002. These proceedings imposed regulatory constraints on our +Windows operating system businesses, including limits on certain contracting practices, required disclosure of certain software program interfaces, limits on Microsoft’s ability to ensure the visibility of certain Windows features in new PCs, +and required licensing of certain communications protocols. While we believe we currently are in full compliance with the Decree and Judgment, if we fail to comply with them in the future additional restrictions could be imposed on us that would +adversely affect our business. Moreover, there always remains the risk of new legal action, either by governments or private claimants including with respect to products that haven’t been scrutinized in the past. In March 2004, the European Commission determined that we must create new versions of Windows that do not include certain multimedia technologies, many of which are +required for certain Web sites, software applications, and other aspects of Windows to function properly, and we must provide our competitors with specifications for how to implement certain communications protocols supported in Windows. Microsoft +has appealed both determinations to European courts. As a result of the Commission decision, we have incurred and will continue to incur duplicative development costs (absent a court decision to reverse or limit this aspect of the ruling). The +availability of these alternative versions of Windows in the market also may cause confusion that harms our reputation, including among consumers and with third party software and web site developers who rely on the functionality removed from these +alternative versions. The Commission ruling obligates Microsoft to make available specifications for certain Windows communications protocol technologies on licensing terms that are closely regulated by the Commission. The PAGE 14 Table of Contents Part I Item 1 availability of these licenses may enable competitors to develop software products that better mimic the functionality of Microsoft’s own products which could +result in a reduction in sales of our products. Unless reversed or limited on appeal, the ruling of the European Commission may be cited as a precedent in other proceedings that seek to limit our ability to continue to improve Windows by adding new +functionality in response to consumer demand. The ruling also illustrates a risk that competition authorities in Europe or elsewhere may authorize competitors to distribute implementations of Microsoft communications protocols in source code form +without proper contractual provisions to protect our intellectual property. We believe our integrated approach to delivery of product innovation +benefits consumers and business. Current or future government regulatory efforts may hinder our ability to provide these benefits reducing the attractiveness of our products and the revenues that come from them. Our online services are subject to government regulation of the Internet domestically and internationally in areas such as user privacy, data protection, and online +content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant costs or require changes in business practices that result in reduced +revenue. Noncompliance could result in penalties being imposed on us or orders that we cease conducting the noncompliant activity. Our business depends largely on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining +talented employees. The market for highly skilled workers in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting +efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Delays in product development schedules may adversely affect our revenues. The development of software products is a complex and time-consuming +process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products, particularly any delays in the Windows Vista +operating system, could adversely affect our revenue. We make significant investments +in new products and services that may not be profitable. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and technologies, including +Windows Vista, Office 12, MSN Search, SQL Server, Windows Server and Xbox 360. Investments in new technology are inherently speculative. Commercial success depends on many factors including innovativeness, developer support, and effective +distribution and marketing. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating +margins for new products and businesses may not be as high as the margins we have experienced historically. Declines in demand for software could occur. If overall market demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products +declines, our revenue will be adversely affected. In addition, our revenue would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products because new product offerings are not perceived as +providing significant new functionality or other value to prospective purchasers. We are making significant investments in the next release of the Windows operating system (Windows Vista) and the next release of the Microsoft Office System (Office +12). If these products are not perceived as offering significant new functionality or value to prospective purchasers, our revenue and operating margins could be adversely affected. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and +lawsuits. Adverse outcomes in some or all of the claims pending against us may result in significant monetary damages or injunctive relief against us that could adversely affect our ability to conduct our business. While management currently +believes that resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position or results of operations, the litigation and other claims noted above are subject to inherent +uncertainties and management’s view of these matters may change in the future. There exists the possibility of a material adverse impact on our financial position and the results of operations for the period in which the effect of an +unfavorable final outcome becomes probable and reasonably estimable. We may have +additional tax liabilities. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the PAGE 15 Table of Contents Part I Item 1 ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax +authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different than that which is reflected in historical income tax provisions and accruals. Based on +the results of an audit or litigation, a material effect on our income tax provision, net income, or cash flows in the period or periods for which that determination is made could result. We may be at risk of having insufficient supplies of certain Xbox 360 components or console inventory. Some components +of the upcoming Xbox 360 are obtained from a single supplier and others may be subject to an industry- wide supply shortage. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be +unable to obtain replacement supplies on a timely basis resulting in reduced console and game sales. Components are ordered based on forecasted console demand so we may experience component shortages for the Xbox 360. Similarly, if our demand +forecasts for the existing Xbox console are inaccurate and exceed actual demand, we may have excess console inventory that may require us to record charges to cost of revenue for the excess inventory. Xbox 360 consoles will be assembled in Asia; +disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings. Under generally +accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least +annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization, future cash +flows, and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined +resulting in an impact on our results of operations. Changes in accounting may affect +our reported earnings and operating income. Generally accepted accounting principles and accompanying accounting pronouncements, implementation guidelines and interpretations for many aspects of our business, such as +revenue recognition for software, accounting for financial instruments, and treatment of goodwill or amortizable intangible assets, are highly complex and involve subjective judgments. Changes in these rules, their interpretation, or changes in our +products or business could significantly change our reported earnings and operating income and could add significant volatility to those measures, without a comparable underlying change in cash flow from operations. See Note 1 in “Item 8. +Financial Statements and Supplementary Data” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” of this report. We operate a global business that exposes us to additional risks. We +operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the United States and other countries. +Operations outside of the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, +political, labor, or economic conditions in a specific country or region; and difficulties in staffing and managing foreign operations. While we hedge a portion of our international currency exposure, significant fluctuations in exchange rates +between the U.S. dollar and foreign currencies may adversely affect our future net revenues. General economic and geo-political risks may affect our revenue and profitability. Softness in corporate information technology spending or other changes in general economic conditions that affect demand for +computer hardware or software could adversely affect our revenue. Abrupt political change, terrorist activity and armed conflict pose a risk of general economic disruption in affected countries or generally and could require changes in our +operations and security arrangements, thus increasing our operating costs. These conditions may lend additional uncertainty to the timing and budget for technology investment decisions by our customers. Catastrophic events may disrupt our business. We are a highly automated +business and a disruption or failure of our systems in the event of a major earthquake, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales and providing services. Our corporate headquarters, a +significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which +are near major PAGE 16 Table of Contents Part I Item 1 earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or information technology systems could severely +affect our ability to conduct normal business operations and, as a result, our future operating results could be adversely affected. Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions or entering into joint ventures +as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don’t realize a satisfactory return on the investment we +make, or that we may experience difficulty in the integration of new employees, business systems and technology, or diversion of management’s attention from our other businesses. These factors could adversely affect our operating results or +financial condition. We have limited insurance. We +maintain third party insurance coverage against various liability risks and risks of property loss. Because of the unavailability or high cost of conventional insurance arrangements, we have entered into captive insurance arrangements for the +purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2005, the face value of captive insurance arrangements was $2.0 billion. Actual value at any particular time will vary +due to deductibles, exclusions, other restrictions, and claims. While we believe these arrangements are an effective way to insure against liability and property damage risks, the potential liabilities associated with the risks discussed in this +report or other events could exceed the coverage provided by such arrangements. Other +risks that may affect our business. Other factors that may affect our performance may include: • sales channel disruption, such as the bankruptcy of a major distributor; • our ability to implement operating cost structures that align with revenue growth; and • the continued availability of third-party distribution channels for MSN service and other online services. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers +as of August 25, 2005 were as follows: Name Age Position with the Company William H. Gates III 49 Chairman of the Board and Chief Software Architect Steven A. Ballmer 49 Chief Executive Officer James E. Allchin 53 Group Vice President, Platforms Group Robert J. (Robbie) Bach 43 Senior Vice President, Home and Entertainment Lisa Brummel 45 Corporate Vice President, Human Resources Douglas J. Burgum 49 Senior Vice President, Microsoft Business Solutions David W. Cole 43 Senior Vice President, MSN and Personal Services Group Jean-Philippe Courtois 45 Senior Vice President; President, Microsoft International J. Scott Di Valerio 42 Corporate Vice President, Finance and Administration and Chief Accounting Officer Kevin R. Johnson 44 Group Vice President, Worldwide Sales, Marketing and Services Christopher P. Liddell 47 Senior Vice President, Finance and Administration and Chief Financial Officer Michelle (Mich) Mathews 38 Senior Vice President, Marketing Craig J. Mundie 56 Senior Vice President; Chief Technical Officer, Advanced Strategies and Policy Jeffrey S. Raikes 47 Group Vice President, Information Worker Business Eric D. Rudder 38 Senior Vice President, Server and Tools Business Bradford L. Smith 46 Senior Vice President, Legal and Corporate Affairs, General Counsel and Secretary Mr. Gates co-founded Microsoft +in 1975 and served as its Chief Executive Officer from the time the original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. Mr. Gates has +served as Chairman since our incorporation. PAGE 17 Table of Contents Part I Item 1 Mr. Ballmer was named Chief Executive Officer and a director of the Company in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since +February 1992. He joined Microsoft in 1980. Mr. Allchin was named Group Vice President, Platforms in December 1999. He had been Senior Vice +President, Platforms since March 1999. He was previously Senior Vice President, Personal and Business Systems since February 1996. Mr. Allchin joined Microsoft in 1990. Mr. Bach was named Senior Vice President, Home and Entertainment in March 2000. He had been Vice President, Home and Retail since March 1999. Before holding that position, he had been Vice President, Learning, Entertainment and +Productivity, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988. Ms. Brummel was named Corporate Vice +President, Human Resources in April 2005. Previous to this position she had been Corporate Vice President of the Home and Retail Division. She joined Microsoft in 1989. Mr. Burgum joined the Company as Senior Vice President upon Microsoft’s acquisition of Great Plains Software, Inc. in April 2001. Previous to the acquisition, he had served as the Chairman and Chief Executive Officer of +Great Plains. He joined Great Plains in 1983. Mr. Cole was named Senior Vice President, MSN and Personal Services in November 2001. Before holding +that position, he had been Senior Vice President, Services Platform Division since August 2000. He had been Senior Vice President, Consumer Services since December 1999 and Vice President, Consumer Windows since March 1999. Previously, he was Vice +President, Web Client and Consumer Experience and Vice President, Internet Client and Collaboration. Mr. Cole joined Microsoft in 1986. Mr. Courtois +was named Senior Vice President, President of Microsoft International in June 2005. He had been Chief Executive Officer, Microsoft Europe, Middle East, and Africa since March 2003. Previous to that, he had been Senior Vice President and President, +Microsoft Europe, Middle East, and Africa since July 2000. Before holding that position, he had been Vice President, Worldwide Customer Marketing since July 1998. Mr. Courtois joined Microsoft in 1984. Mr. Di Valerio was named Corporate Vice President, Finance and Administration and Chief Accounting Officer in May 2005. He has served as Corporate Vice President +and Corporate Controller since April 2003. Before joining Microsoft, Mr. Di Valerio was the Vice President of Corporate Controllership at The Walt Disney Company from January 2001 to April 2003. Before joining Disney, Mr. Di Valerio was the Chief +Financial Officer of Mindwave Software Inc. from May 2000 to October 2000. Prior to going to Mindwave, Mr. Di Valerio spent 15 years with PricewaterhouseCoopers. Mr. Johnson was named Group Vice President, Worldwide Sales, Marketing and Services in March 2003. He had been Senior Vice President, Microsoft Americas since February 2002. Mr. Johnson had been Senior Vice President, U.S. +Sales, Marketing, and Services since August 2001, and before that Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992. Mr. Liddell was named Senior Vice President, Finance and Administration and Chief Financial Officer in May 2005. Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company since March 2003, and +prior to becoming Chief Financial Officer, he held the positions of Vice President, Finance and Controller. Mr. Liddell held leadership positions in International Paper and its New Zealand affiliate Carter Holt Harvey Limited for the ten years prior +to joining Microsoft. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited from 1999 to 2002 and Chief Financial Officer from 1995 to 1998. Ms. Mathews was named Senior Vice President, Marketing in May 2005. Before holding her current position, Ms. Mathews had been Corporate Vice President, Marketing since August 2001 and Vice President Corporate Public Relations +since 1999. Ms. Mathews joined Microsoft in 1993. Mr. Mundie was named Senior Vice President and Chief Technical Officer, Advanced Strategies and +Policy in August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. He joined Microsoft in 1992. Mr. Raikes was named +Group Vice President, Information Worker Business in June 2004. He had been Group Vice President, Productivity and Business Services since August 2000. Mr. Raikes had been Group Vice President, Sales and Support since July 1998. Mr. Raikes joined +Microsoft in 1981. Mr. Rudder was named Senior Vice President, Server and Tools Business in June 2003. Previous to assuming that role, he was +responsible for managing Developer and Platform Evangelism. Mr. Rudder joined Microsoft in 1988. Mr. Smith was named Senior Vice President, Legal and +Corporate Affairs, General Counsel and Secretary in November 2001. Mr. Smith was also named Chief Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European +Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993. PAGE 18 Table of Contents Part I Item 1, 2, 3, 4 EMPLOYEES As of June 30, 2005, we employed approximately 61,000 people on a full-time basis, 39,000 in the United +States and 22,000 internationally. Of the total, 24,000 were in product research and development, 18,000 in sales and marketing, 12,000 in product support and consulting services, 2,000 in manufacturing and distribution, and 5,000 in general and +administration. Our success is highly dependent on our ability to attract and retain qualified employees. Competition for employees is intense in the software industry. We believe we have been successful in our efforts to recruit qualified +employees, but we cannot guarantee that we will continue to be as successful in the future. None of our employees are subject to collective bargaining agreements. We believe that our relationship with our employees is excellent. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report +on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the SEC. Our SEC reports can be +accessed through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. ITEM 2.    PROPERTIES Our corporate offices +consist of approximately 9.3 million square feet of office building space located in King County, Washington: 7.5 million square feet of owned space that is situated on slightly more than 395 acres of owned land in our corporate campus and +approximately 1.8 million square feet is leased. We own approximately 576,000 square feet of office building space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 2.4 million square +feet of office building space. We occupy many sites internationally, totaling approximately 6.3 million square feet that is leased and approximately +536,000 square feet that is owned. These facilities include our European Operations Center that leases a 187,000 square-foot campus in Dublin, Ireland, a 56,000 square-foot disk duplication facility in Humacao, Puerto Rico, and a 155,100 square-foot +facility in Singapore for our Asia Pacific Operations Center and Regional headquarters. Leased office building space includes the following locations: Tokyo, Japan 511,000 square feet; Unterschleissheim, Germany 381,000 square feet; Les Ulis, France +262,000 square feet; Reading, England 241,000 square feet; and Mississauga, Canada 235,000 square feet. In addition to the above, we have various product development facilities, both domestically and internationally, as described in +“Operations” above. In May 2005, the Redmond, Washington City Council approved our proposed development agreement, which establishes the +framework under which we can develop an additional 2.2 million square feet of facilities at our main campus. We also own 63 acres of land in Issaquah, Washington, which can accommodate 1.2 million square feet of office space. Our facilities are +fully used for current operations of all segments, and suitable additional space is available to accommodate expansion needs. ITEM 3.    LEGAL PROCEEDINGS On July 1, +2005, we announced a settlement with IBM resolving claims asserted by IBM that arose from the circumstances of United States v. Microsoft and findings of fact that identified IBM as having been impacted in its business by practices on which +the U. S. District Court ruled against us, and claims related to IBM’s OS/2 and SmartSuite businesses. Under the agreement, we paid IBM $775 million and extended a $75 million credit for IBM’s internal deployment of Microsoft software. IBM +released all antitrust claims against us based on past conduct except for claims related to its server business as to which IBM will not sue us for at least two years. See Note 17 – Contingencies of the Notes to Financial Statements (Item 8) for information regarding other legal proceedings in which we are +involved. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2005. PAGE 19 Table of Contents Part II Item 5 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 15, 2005, there were 149,668 registered holders of record of +our common stock. The high and low common stock prices per share were as follows: Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Year Fiscal year 2004 Common stock price per share: High $ 29.96 $ 29.35 $ 28.80 $ 28.57 $ 29.96 Low 25.54 25.10 24.15 25.08 24.15 Fiscal year 2005 Common stock price per share: High $ 29.00 $ 29.98 $ 26.84 $ 26.07 $ 29.98 Low 26.88 26.53 23.92 24.12 23.92 In September 2003, our Board of Directors +declared a common stock dividend of $0.16 per share, which was paid in November 2003. That was the only dividend declared or paid in fiscal year 2004. See Note 12 – Stockholders’ Equity of the Notes to Financial Statements (Item 8) for information regarding dividends approved by our Board of Directors in fiscal year +2005. On July 20, 2004, our Board of Directors approved a plan to buy back up to $30 +billion in Microsoft common stock over four years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. The repurchases will be made using our cash resources. The +repurchase program may be suspended or discontinued at any time without prior notice. We repurchased common stock in each quarter of fiscal year 2005 as follows: Period Total number of shares purchased Average price paid per share July 1, 2004 – September 30, 2004 22,826,608 $ 27.38 October 1, 2004 – December 31, 2004 23,595,280 $ 27.75 January 1, 2005 – March 31, 2005 95,122,446 $ 25.44 April 1, 2005 – June 30, 2005 170,656,770 $ 25.21 Common stock repurchases in the fourth quarter +of fiscal year 2005 were as follows: Period (a) Total number of shares purchased (b) Average price paid per share (c) Total number of shares purchased as part of publicly announced plans or programs (d) Maximum number of shares (or approximate dollar value) of shares that may yet be purchased under +the plans or programs (in millions) April 1, 2005 – April 30, 2005 55,331,155 $ 24.77 55,331,155 $ 24,930 May 1, 2005 – May 31, 2005 60,679,509 $ 25.49 60,679,509 $ 23,384 June 1, 2005 – June 30, 2005 54,646,106 $ 25.35 54,646,106 $ 21,998 170,656,770 170,656,770 PAGE 20 Table of Contents Part II Item 6 ITEM 6.    SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Fiscal Year Ended June 30 2001 (1,2) 2002 (1,3) 2003 (1,4) 2004 2005 Revenue $ 25,296 $ 28,365 $ 32,187 $ 36,835 $ 39,788 Operating income 11,720 8,272 9,545 9,034 14,561 Income before accounting change 7,721 5,355 7,531 8,168 12,254 Net income 7,346 5,355 7,531 8,168 12,254 Diluted earnings per share before accounting change $ 0.69 $ 0.48 $ 0.69 $ 0.75 $ 1.12 Diluted earnings per share $ 0.66 $ 0.48 $ 0.69 $ 0.75 $ 1.12 Cash dividends declared per share $ – $ – $ 0.08 $ 0.16 $ 3.40 Cash and short-term investments 31,600 38,652 49,048 60,592 37,751 Total assets 58,830 69,910 81,732 94,368 70,815 Long-term obligations 2,287 2,722 2,846 4,574 5,823 Stockholders’ equity 47,289 54,842 64,912 74,825 48,115 (1) The financial data presented reflects stock-based compensation expense except fiscal year 2001, as prescribed by Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for +Stock-Based Compensation – Transition and Disclosure and amendment of FASB Statement No. 123 , to reflect the retroactive adoption of the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation as discussed in Note 14. If fiscal year 2001 had been restated, the operating income and net income would have been $8,343 million and $5,084 million. (2) Fiscal year 2001 includes an unfavorable cumulative effect of accounting change of $375 million or $0.03 per diluted share, reflecting the adoption of SFAS No. 133, Accounting for +Derivative Instruments and Hedging Activities . Fiscal year 2001 also includes the acquisition of Great Plains Software, Inc. for approximately $1.1 billion in stock. (3) Fiscal year 2002 includes a $1.25 billion (pre-tax) gain on the sale of Expedia, Inc. (4) Fiscal year 2003 includes the acquisition of Navision a/s, Rare Ltd. and Placeware, Inc. for a total of $1.23 billion in cash and $788 million in stock and other consideration. PAGE 21 Table of Contents Part II Item 7 ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS FOR FISCAL YEARS 2003, 2004, AND 2005 OVERVIEW The following Management’s Discussion and Analysis (MD&A) is intended to help the reader +understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with our financial statements and the accompanying notes to the financial statements +(Notes). We develop, manufacture, license, and support a wide range of software products for many computing devices. Our software products include +operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software development tools. We provide +consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games, and PC peripherals. Online communication and information services are delivered through our +MSN portals and channels around the world. Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter +of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Home and Entertainment segment is particularly subject to seasonality as its products are aimed at the consumer +market and are in highest demand during the holiday shopping season. Historically, approximately 40% to 50% of Home and Entertainment revenue has been generated in the second fiscal quarter. We believe the seasonality of revenue is likely to +continue in the future. We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a +commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, +security, and value of Windows operating systems, including versions for new devices such as Tablet PCs, Media Center PCs, Portable Media Centers, and mobile devices such as Smartphones. We are also increasing our focus on emerging markets and +reducing the amount of unlicensed software in those markets. In addition, we develop innovative software applications and solutions to enhance the productivity of information workers, improve communication and collaboration in work groups, aid +business intelligence, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver +products that provide the best platform for network computing – the most advanced, easiest to deploy and manage and most secure – with the lowest total cost of ownership. To take advantage of new market opportunities, we continue to invest in research and development of existing and new lines of business, such as services for +consumers, businesses and large enterprises that we believe can contribute significantly to our long-term growth. We also research and develop advanced technologies for future software products. Delivering breakthrough innovation and high-value +solutions through our integrated platform is the key to meeting customer needs and to our future growth. We believe that over the last few years we +have laid a foundation for long-term growth by delivering innovative new products, creating opportunity for partners, improving customer satisfaction with key audiences, putting some of our most significant legal cases behind us, and improving our +internal business processes. Our focus in fiscal year 2006 is building on this foundation and executing well in key areas, including continuing to innovate on our integrated software platform, delivering compelling value propositions to customers, +responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company. Key market opportunities include: • Growth in our anchor businesses through forthcoming innovations and new product launches and making inroads against software piracy. • Expanding our innovation portfolio by offering extensions of our technologies targeted towards specific customer needs – either as new products or as higher-value versions of +existing products. • Delivering software services through online consumer services and services for businesses that enable workers to collaborate interactively. PAGE 22 Table of Contents Part II Item 7 Worldwide macroeconomic factors have a strong +correlation to business and consumer demand for our software, services, games and Internet service offerings. We expect that general macroeconomic trends will remain stable or experience slight improvement in fiscal year 2006 as compared to fiscal +year 2005. Our optimism is balanced by recent data which revealed slight downward revisions when compared to previous forecasts for Gross Domestic Product growth in the U.S., United Kingdom, France, Germany, Japan and Latin America. The leading +indicators were also revised slightly lower for the major markets. Additionally, recent surveys of chief information officers also reflect slight downward revisions in expected corporate IT spend budgets and short-term purchase intent. As open source software development and distribution evolves, we continue to seek to differentiate our products from competitive products based on open source +software. We believe that Microsoft’s share of server unit operating systems held steady in fiscal year 2005, while Linux distributions rose slightly faster on an absolute basis. Summary (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 32,187 $ 36,835 14 % $ 39,788 8 % Operating income $ 9,545 $ 9,034 (5 )% $ 14,561 61 % Our revenue growth for fiscal year 2005 was +driven by growth in licensing of Windows Server ™ operating systems and other +server applications, licensing of Windows ® Client operating systems through OEMs, +and increased licensing of Office and other Information Worker products. The license revenue growth resulted from growth in server hardware and PC shipments, fluctuations in foreign currency exchange rates, and overall improvements in IT spending. +The November 2004 launch of the “Halo 2 ® ” Xbox game also contributed to +the overall revenue growth for the company. Based on our preliminary estimates, worldwide PC shipments from all sources grew about 11% to 13% and total server hardware shipments grew approximately 13% to 14% during fiscal year 2005 as compared to +fiscal year 2004. The net impact of foreign exchange rates on revenue was positive in 2005, primarily due to relative strengthening of most foreign currencies, particularly the euro and Japanese yen, against the U.S. dollar. Had the exchange rates +from the previous year been in effect in fiscal year 2005, translated international revenue growth earned in local currencies would have been approximately $873 million or two percentage points lower for fiscal year 2005. We hedge a portion of our +international currency exposures, thereby reducing our overall exposure. Fluctuations in foreign currency exchange rates have a greater impact on non-OEM commercial and retail license business as a significant portion of those product revenues are +denominated in foreign currencies. The vast majority of OEM license revenue is denominated in U.S. dollars. Partially offsetting revenue growth rates was a $1.1 billion decline in earned revenue from Upgrade Advantage in fiscal year 2005. The +Upgrade Advantage contract value reached its expiration dates in the first quarter of fiscal year 2005. This revenue was recognized over fiscal year 2003 and fiscal year 2004 and in the first quarter of fiscal year 2005 when the contract period +expired. Revenue growth in fiscal year 2004 was primarily driven by the growth in licensing of Windows Client operating systems through OEMs, Windows +Server operating systems, Office and other server applications as a result of growth in PC and server hardware shipments. The worldwide PC shipment growth rate from all sources was estimated at 13% and the Windows server shipment was estimated at +18% in fiscal year 2004 as compared to fiscal year 2003. The net impact of foreign exchange rates on revenue was positive in fiscal year 2004 due to a relative strengthening of most foreign currencies versus the U.S. dollar. This resulted in +approximately $1.10 billion growth in total revenue. Revenue growth in fiscal year 2003 was driven primarily by multi-year licensing that occurred before the Licensing 6.0 transition date in the first quarter of fiscal year 2003. The fiscal year +2003 revenue growth also reflected a $933 million or 13% increase associated with OEM licensing of Windows operating systems and a $309 million or 23% increase in revenue from Xbox video game consoles. For fiscal year 2005, the operating income increase was driven by a decline in stock-based compensation expense; increased revenue in Server and Tools, Client and +Information Worker, which have higher gross margins as compared to other segments; and a reduction in legal costs associated with major litigation. In addition, strong sales of Halo 2 reduced the overall operating loss for the Home and Entertainment +segment for fiscal year 2005. The $3.29 billion decrease in stock-based compensation expense was partially offset by increased operating expenses of $562 million related to increased salary and benefits for new and existing headcount. General and +administrative expenses related to major litigation declined in fiscal year 2005 due to the $2.53 billion of charges related to the PAGE 23 Table of Contents Part II Item 7 settlement of Sun Microsystems litigation and the fine imposed by the European Commission in fiscal year 2004. This effect was partially offset by legal expenses of +$2.08 billion related to settlements with IBM, Novell, Gateway, and end-user class action plaintiffs to resolve antitrust issues and other matters. In fiscal year 2004, the operating income decline was caused primarily by $2.53 billion of legal +charges and $2.21 billion of stock-based compensation expense related to our employee stock option transfer program, mainly offset by an increase in revenue. In fiscal year 2003, the growth in operating income reflected an increase in revenue, +partially offset by an increase in operating expenses related to employee and related costs associated with headcount and increased legal settlement expenses, primarily the Time Warner settlement charge of $750 million. In fiscal year 2004, we implemented changes in employee compensation whereby employees are granted stock awards rather than stock options. We also completed an +employee stock option transfer program in the second quarter of fiscal year 2004 in which employees could elect to transfer all of their vested and unvested stock options with a strike price of $33 or higher to JPMorgan. The unvested options that +were transferred to JPMorgan became vested upon the transfer. A total of 345 million of the 621 million eligible options were transferred, which resulted in additional stock-based compensation expense of $2.21 billion in the second quarter of fiscal +year 2004. As a result of these changes, we expect stock-based compensation expense to continue to decrease for at least the next three fiscal years. The following table shows total stock-based compensation expense by segment and by income statement classification for fiscal years 2003, 2004 and 2005. (In millions) 2003 2004 Increase/ (Decrease) 2005 Increase/ (Decrease) Client $ 454 $ 754 $ 300 $ 310 $ (444 ) Server and Tools 1,281 1,898 617 826 (1,072 ) Information Worker 407 573 166 269 (304 ) Microsoft Business Solutions 237 324 87 149 (175 ) MSN 263 415 152 174 (241 ) Mobile and Embedded Devices 130 170 40 75 (95 ) Home and Entertainment 261 387 126 168 (219 ) Corporate 716 1,213 497 477 (736 ) Consolidated $ 3,749 $ 5,734 $ 1,985 $ 2,448 $ (3,286 ) Cost of revenue 380 681 301 318 (363 ) Research and development 1,964 3,117 1,153 1,241 (1,876 ) Sales and marketing 1,050 1,272 222 612 (660 ) General and administrative 355 664 309 277 (387 ) Consolidated $ 3,749 $ 5,734 $ 1,985 $ 2,448 $ (3,286 ) In fiscal year 2006, we expect +revenue to grow at a higher rate than fiscal year 2005, mainly due to the launches of new products. We expect higher revenue growth in fiscal year 2006 as compared to fiscal year 2005 in Home and Entertainment primarily driven by the launch of Xbox +360. We estimate worldwide PC shipments will grow between 7% to 9% and worldwide server unit shipments will grow between 11% to 13% in fiscal year 2006 as compared to fiscal year 2005. We do not expect a benefit from year-over-year foreign currency +exchange rates in fiscal year 2006. We expect our operating income growth rate in fiscal year 2006 to exceed our revenue growth rate. Operating +income is expected to reflect lower operating expenses due to lower costs for legal settlements than incurred in fiscal year 2005 and a reduction in stock-based compensation expense. The operating loss for Home and Entertainment is expected to +increase in fiscal year 2006 driven by the launch of and investments in Xbox 360. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) Our seven segments are +Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. The revenue +and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles (GAAP) and include certain reconciling items attributable to each of the PAGE 24 Table of Contents Part II Item 7 segments. The segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements is presented on a basis consistent with the +Company’s internal management reporting, in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information . Certain corporate level expenses have been excluded from our segment operating results and are +analyzed separately. Fiscal years 2003 and 2004 amounts have been restated for certain internal reorganizations and to conform to the current period presentation including reclassifying certain legal settlements from business segments to +corporate-level expense. Client (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 10,394 $ 11,546 11 % $ 12,234 6 % Operating income $ 7,960 $ 8,654 9 % $ 9,442 9 % Client includes revenue from Windows XP +Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems. Client revenue growth is correlated with the growth of corporate and consumer purchases of PCs from OEMs that pre-install versions of +Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The operating results for all periods presented have been restated to reflect the reorganization of the Windows Security group from Server and Tools to +Client. Client revenue increased in fiscal year 2005 driven by 12% growth in OEM license units and $886 million or 10% growth in OEM revenue from +increased PC unit shipments, partially offset by a $198 million or 9% decrease in revenue from commercial and retail licensing of Windows operating systems. This channel-mix shift reflects our customers’ continued preference for upgrading their +PC operating systems through the OEM channel when they replace their PCs versus the purchase of a multi-year licensing agreement. The mix of OEM Windows operating systems licensed with premium edition operating systems as a percentage of total OEM +Windows operating systems licensed during the year remained flat at 50% of total OEM Windows operating systems as compared to the previous year. Revenue earned from Upgrade Advantage declined by $99 million in fiscal year 2005 contributing to the +decrease in commercial and retail licensing revenue. The differences between unit growth rates and revenue growth rates from year to year are affected by the mix of premium versions of operating systems licensed during the year, changes in the +geographical mix, the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders, and previous changes to deferral rates and product lives for undelivered elements of unearned revenue. Client +revenue increase in fiscal year 2004 was driven by 14% growth in OEM licenses and 16% growth in OEM revenue on increased consumer PC unit shipments in the first half of the fiscal year and growth in business PC unit shipments in the second half of +fiscal year 2004. Client operating income increased in fiscal year 2005 primarily due to an increase in OEM revenue and a decrease in stock-based +compensation expense. These factors were partially offset by an increase in sales and marketing expenses associated with “Start Something,” a globally launched advertising campaign, marketing for security initiatives, and an increase in +salary and benefits for new and existing headcount. The additional headcount for research and development was primarily devoted to the continued development of the Windows Client next-generation operating system. The operating income for fiscal year +2004 has been restated for a reclassification of legal settlement charges totaling $700 million from Client to corporate expenses to conform to the current year presentation. Client operating income increased for fiscal year 2004 compared to fiscal +year 2003 mainly due to growth in revenue, partially offset by increased operating expenses primarily related to stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004. We anticipate that worldwide PC shipments will grow at approximately 7% to 9% in fiscal year 2006, continuing to influence our growth in Client revenue. In +addition, we estimate that increasing shipments of laptops as a percentage of total PC systems will continue to positively influence Client revenue growth due to shorter replacement cycles for laptops. The time between operating system releases may +affect our ability to close some multi-year licensing agreements. We expect growth rates in emerging markets to continue to outpace mature market growth rates. Piracy continues to be a challenge in both emerging and mature markets. We intend to +focus on growing OEM licenses faster than the overall market by reducing piracy, particularly in the mature markets, through initiatives such as Windows Genuine Advantage. Client commercial and retail licensing revenues are expected to continue to +lag behind overall Client revenue growth, but we expect to see improvements in these channels in fiscal year 2006 compared to fiscal year 2005. We anticipate a modest increase in our premium product mix in fiscal year 2006, although we PAGE 25 Table of Contents Part II Item 7 anticipate shipments of the premium-priced Media Center Edition will grow as a percentage of the total operating system shipments. Major investments in fiscal year +2006 will focus on development of Windows Vista, the next-generation PC operating system, and will include marketing initiatives such as the global “Start Something” campaign. Server and Tools (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 7,192 $ 8,538 19 % $ 9,885 16 % Operating income $ 1,160 $ 1,418 22 % $ 3,259 130 % Server and Tools consists of server software +licenses and client access licenses (CALs) for Windows Server, Microsoft SQL Server ® , Exchange Server, and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server and +Tools concentrates on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. The segment uses multiple channels for licensing including +pre-installed OEM versions, licenses through partners, and licenses directly to end customers. The licenses are sold both as one-time licenses and as multi-year volume licenses depending upon the needs of different customers. Server and Tools uses +product innovation and partnerships with information technology professionals to drive the adoption and sales growth of its products. Server and Tools growth is driven by performance of the overall market for information technology – both +hardware and software. The operating results for previous years have been restated for the reorganization of the Windows Security group from Server and Tools to Client and the reorganization of Professional product support services from Information +Worker to Server and Tools. Server and Tools revenue growth in fiscal year 2005 was mainly driven by growth in Server and Server application revenue, +including CAL revenue, which grew $1.1 billion or 17% in fiscal year 2005 reflecting broad adoption of Windows Server System ™ products, including Windows Server, SQL Server, Exchange Server, and Management Servers. We estimate that overall server hardware shipments grew 13% to 14% during fiscal year 2005 and that +Windows-based server shipments grew at a comparable rate for the same period. Consulting and Premier and Professional product support services revenue increased $241 million or 19% compared to the previous year, primarily due to increased consultant +utilization and new Premier customers. Foreign currency exchange rate changes accounted for approximately $284 million or three percentage points of total Server and Tools revenue growth, which was offset by a $314 million decline in Upgrade +Advantage revenue earned. In fiscal year 2004, Server and Server applications revenue, including CAL revenue, grew $1.28 billion or 25%. Foreign currency exchange rates contributed approximately $350 million or five percentage points of Server and +Tools revenue growth in fiscal year 2004 compared to fiscal year 2003. Consulting and Premier product support services revenue increased $192 million or 18% compared to fiscal year 2003 due to increased customer penetration from new product +offerings. Server and Tools operating income growth for fiscal year 2005 was primarily due to an increase in revenue and a decrease in stock-based +compensation expense. This was partially offset by an increase in sales and marketing costs and headcount-related costs from increased hiring and increases in salary and benefits. Operating income for the previous year has been restated for a +reclassification of $1.22 billion of legal settlements from Server and Tools to corporate expenses to conform to the current year presentation. Server and Tools operating income for fiscal year 2004 increased slightly due to the revenue increase +offset by increased stock-based compensation charges, including $651 million related to the employee stock option transfer program in the second quarter of fiscal year 2004. We expect worldwide server hardware shipments to grow 11% to 13% in fiscal year 2006. However, we face strong competition from Linux-based, Unix, and other server +operating systems. We anticipate little or no year-over-year foreign currency exchange rate impacts in fiscal year 2006. We also expect Server and Tools operating expenses to increase during fiscal year 2006 due to expected investment in headcount +and new marketing initiatives and upcoming product releases, including SQL Server 2005 and Visual Studio 2005. PAGE 26 Table of Contents Part II Item 7 Information Worker (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 9,113 $ 10,653 17 % $ 11,013 3 % Operating income $ 6,389 $ 7,410 16 % $ 7,915 7 % Information Worker consists of the Microsoft +Office System of programs, servers, services, and solutions designed to increase personal, team, and organization productivity. Information Worker includes Microsoft Office, Microsoft Project, Microsoft Visio ® , SharePoint ® Portal Server CALs, and other information worker products including Microsoft LiveMeeting ® and OneNote ® . Most revenue from this segment comes from licensing our Office System products. Revenue growth depends on the ability to add value to the core Office product set and expand our product offerings in other information +worker areas such as document lifecycle management, collaboration, and business intelligence. Beginning in fiscal year 2005, the Small and Mid-Market Solutions & Partners (SMS&P) organization, which was historically part of Information +Worker, was re-aligned in Microsoft Business Solutions. As a result of this change, Information Worker results have been restated to reflect the reclassification of the SMS&P organization to Microsoft Business Solutions. The results for previous +periods have also been restated due to the reclassification of Professional product support services from Information Worker into Server and Tools. Information Worker revenue increased in fiscal year 2005 primarily due to a 3% or $269 million increase in volume licensing, retail packaged product, and pre-installed versions of Office in Japan, a 6% or $91 million increase in OEM +revenue, and the impact of foreign currency exchange rates, partially offset by reduced Upgrade Advantage earned revenue. Changes in foreign currency exchange rates accounted for approximately $367 million or three percentage points of the revenue +growth for fiscal year 2005 as compared to the previous fiscal year, offset by a $663 million decline in Upgrade Advantage earned revenue. Revenue growth for fiscal year 2004 from volume licensing, retail packaged product and pre-installed versions +of Office in Japan was 15% in aggregate. This increase was driven by recognition of unearned revenue primarily from a large increase in multi-year licenses signed previous to the transition to our Licensing 6.0 programs and approximately $110 +million related to the launch of Office 2003. OEM licensing revenue grew 29% or $325 million. Foreign currency exchange rates provided approximately $485 million or 5% of total Information Worker revenue growth. Information Worker operating income growth for fiscal year 2005 was primarily due to the revenue growth and a decrease in stock-based compensation expense. +Operating expenses were also impacted by a reduction in marketing campaign costs from the previous period associated with the launch of Office 2003. This decline was offset by an increase in headcount-related costs from increased hiring and +increases in salary and benefits. Information Worker operating income in fiscal year 2004 increased from the previous year primarily due to growth in revenue, partially offset by an increase in operating expenses, primarily related to $351 million +of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004 and higher sales and marketing expenses. The revenue growth rate for Information Worker is expected to be higher in fiscal year 2006 than fiscal year 2005. We expect sustained momentum in our OEM and multi-year licensing offerings and increased purchasing of Office +System 2003 as enterprises complete their product evaluations. We expect to see slowing revenue from packaged product late in the year as we approach the next version launch. We anticipate little or no year-over-year foreign currency exchange rate +benefit in fiscal year 2006. Microsoft Business Solutions (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 631 $ 759 20 % $ 803 6 % Operating loss $ (148 ) $ (315 ) (113 )% $ (201 ) 36 % Microsoft Business Solutions provides integrated +and adaptable business management software solutions optimized for small and mid-sized businesses, large organizations and divisions of global enterprises. Microsoft Business Solutions products are developed to deliver affordable and rich +functionality through an adaptable software platform PAGE 27 Table of Contents Part II Item 7 that works like and with other Microsoft technologies. The main products consist of a line of business solutions, customer relationship management software, retail +solutions, and related services. Revenue is derived from software and services sales, with software sales representing a significant amount of total revenue. Software revenues include both new software licenses and enhancement plans, which provide +customers with future software upgrades over the period of the plan. Our solutions are delivered through a worldwide network of channel partners that provide specialized services and local support tailored to customer needs. The market for Microsoft +Business Solutions is highly competitive, with a few strong players in the enterprise segment while the mid-market segment is more fragmented. Microsoft Business Solutions now includes the SMS&P organization, which previously had been included +in Information Worker. SMS&P supports small and mid-market customers for Microsoft including Microsoft Business Solutions. Results have been restated to reflect the reclassification of SMS&P for all periods presented. Also as a result of the +reorganization, the Microsoft Partner Program became a component of Microsoft Business Solutions. The increase in Microsoft Business Solutions +revenue in fiscal year 2005 was mainly due to a 10% revenue growth in software partially offset by a 25% decline in services revenue, which resulted from encouraging our partners to provide more of these types of services. The software revenue +increase was driven by a 9% growth in license revenue and 16% growth in enhancement revenue as compared to the previous year, and is attributed to growth in our line of business solutions and customer relationship management solutions, and increased +Microsoft Partner Program subscriptions. The revenue increase in fiscal year 2004 was primarily attributable to continued growth in licensing of Navision and Axapta line of business solutions, new sales of Microsoft CRM, and Microsoft Partner +Program subscriptions. Microsoft Business Solutions operating loss declined in fiscal year 2005 primarily due to a decline in stock-based +compensation expense, an increase in product revenue, and a decline in acquisition intangibles amortization. The reduction in operating loss was partially offset by a net increase in sales and marketing expense driven by incremental headcount and +marketing costs in the SMS&P organization. In addition, there has been an increase in marketing and product development investments in our portfolio of business solutions. The operating loss for fiscal year 2004 increased from fiscal year 2003 +due to an increase in stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004, partially offset by an increase in revenue and lower operating expenses including $42 million of lower +intangibles amortization costs. Microsoft Business Solutions expects continued revenue growth through its portfolio of business solutions and related +product releases, including newer applications such as Microsoft Office Small Business Accounting and Microsoft CRM. Continued investment in the next generation of solutions, broader geographical coverage, and plans for facilitating our partners to +provide customized vertical solutions should result in improved business performance for Microsoft Business Solutions in fiscal year 2006. MSN (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 1,953 $ 2,216 13 % $ 2,274 3 % Operating income (loss) $ (573 ) $ 87 115 % $ 405 366 % MSN includes personal communications services, +such as e-mail and instant messaging, and online information offerings, such as MSN Search and the MSN portals and channels around the world. MSN also provides a variety of online paid services in addition to MSN Internet Access and MSN Premium Web +Services. Revenue is derived primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions generated from online paid services, and from subscribers to MSN Narrowband Internet Access. In fiscal year 2005, we +launched a new version of our MSN Search engine, which is based on our own technology. This change will help provide the ability to innovate more quickly and the opportunity to develop a long-term competitive advantage in search. In addition to the +launch of MSN Search, we introduced many new products and product enhancements in fiscal year 2005, including a new version of the MSN home page which provides a richer user experience, quicker load times, higher levels of end user customization, +and fewer advertisements and links. MSN launched the clarity in advertising program in fiscal year 2005, which removed paid advertising from inclusion in search results and resulted in a reduced number of advertisements that are returned with search +results. In fiscal year 2005, MSN advertising revenue increased $193 million or 16% primarily as a result of industry and market growth, and +continued growth of MSN display advertising revenue, tempered by the search clarity in PAGE 28 Table of Contents Part II Item 7 advertising program and the impact of the home page redesign. Revenue from subscription and transaction services other than Internet Access increased $84 million or +88% in fiscal year 2005 as a result of growth in the number of MSN Premium subscribers through our carrier partnerships. Offsetting the overall revenue growth was a decline of $219 million or 24% in Internet Access revenue, driven by the continued +migration of Internet Access subscribers to broadband or other competitively priced Internet service providers. At the end of the current fiscal year, MSN had 2.7 million internet access subscribers and 9.1 million total subscribers compared to 4.3 +million and 8.8 million at the end of the previous year. In addition, MSN has over 420 million unique users monthly, over 205 million active Hotmail accounts, and over 175 million active Messenger accounts. In fiscal year 2004, MSN advertising +revenue increased $360 million or 43% as a result of growth in paid search and growth in the overall Internet advertising market. This increase was partially offset by a decline of $168 million or 15% in Internet Access revenue. Revenue from +subscription and transaction services other than Internet Access increased $71 million. In fiscal year 2005, MSN operating income increased mainly +due to a decrease in stock-based compensation expense, reduced online operations and bandwidth costs associated with the Internet Access business as the number of subscribers declines, and increased advertising and subscription revenue. The +operating income increase was partially offset by an increase in headcount-related costs from increased hiring and increases in salary and benefits, and a $48 million tax benefit recorded in the first quarter of fiscal year 2004. MSN reached +profitability in the first quarter of fiscal year 2004 and was profitable for fiscal year 2004. The improvement in profitability in fiscal year 2004 was primarily driven by an increase in revenue, a decline in customer acquisition costs and other +expenses related to the Internet Access business, efficiency gains in the operations of the advertising and subscription businesses, and a $48 million refund of previous year taxes, partially offset by an increase in stock-based compensation +expense. MSN expects increased growth in advertising revenue as it benefits from improvements to its advertising platform and search engine and +continued increases in Internet spending. We expect revenue from narrowband Internet Access to continue to decline in fiscal year 2006. Profitability may decline in fiscal year 2006 as investments are made in the development of new applications and +services, the search and search monetization platform, and growth in the field sales force. MSN may from time to time continue to make investments in improving the user experience and in some cases, the number of advertisements delivered either via +our search tools or via our Internet portals may be reduced to improve the overall user experience thereby helping to sustain and grow our user base. Effective July 1, 2005, functions related to MapPoint in Mobile and Embedded Devices have been +moved to MSN. This reorganization will result in a corresponding change to the Mobile and Embedded Devices and MSN reported results. Mobile and Embedded Devices (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 156 $ 247 58 % $ 337 36 % Operating loss $ (277 ) $ (219 ) 21 % $ (46 ) 79 % Mobile and Embedded Devices includes Windows +Mobile ™ software, Windows Embedded operating systems, MapPoint ® , and Windows Automotive. These products extend the advantages of the Windows platform to mobile +devices such as PDAs, phones, and a wide range of embedded devices. The business is also responsible for managing sales and customer relationships for Microsoft overall with device manufacturers and communication sector customers. The communication +sector includes network service providers (such as wireless, wireline and cable operators), and media and entertainment companies. The market for products in these segments is intensely competitive. Competitive alternatives vary based on product +lines and include product offerings from commercial and non-commercial mobile operating system providers, and proprietary software developed by OEMs and mobile operators. Short product lifecycles in product lines such as Windows Mobile software may +impact our continuing revenue streams. Mobile and Embedded Devices revenue growth for fiscal year 2005 was primarily due to unit volume increases in +all major product lines, especially Windows Mobile software sales and Windows Embedded operating systems. Increased revenue for Windows Mobile software was primarily driven by increased market demand for connected mobile devices such as +phone-enabled PDAs and Smartphones, and strong growth in volume shipments for PAGE 29 Table of Contents Part II Item 7 standalone PDAs. The increase in Windows Embedded revenue was due to our operating system being included in new product designs for both new and existing customers. +Mobile and Embedded Devices also benefited from the increased demand for on-line mapping and the introduction of new MapPoint finished goods products. This new functionality resulted in increased unit sales for Mobile, Embedded, and MapPoint product +categories. In fiscal year 2005, revenue for Windows Mobile software increased $46 million or 45%, revenue for Windows Embedded operating systems increased $19 million or 21% and revenue for MapPoint and Windows Automotive increased $25 million or +45%. Mobile and Embedded Devices realized positive increases in customer satisfaction ratings from both mobile operator partners and the developer community. In fiscal year 2005, Mobile and Embedded Devices released Windows Mobile 5.0 which is the +latest version of our mobile operating software. Unit volume increases drove revenue growth for fiscal year 2004 over fiscal year 2003 in all major product lines. The growth was primarily due to the increased number of OEMs and mobile operators +shipping Windows Mobile software for Smartphones, increases in market share for our Pocket PC and embedded products and increased usage by existing customers of our MapPoint Web Service. Mobile and Embedded Devices operating loss for fiscal year 2005 decreased compared to fiscal year 2004 primarily due to a decrease in stock-based compensation +expense. The growth in revenue and a reduction in sales and marketing expense also contributed to improved operating results in this period compared to the previous year. This improvement has been partially offset by increased salary and benefit +costs from increased hiring and increased investment in research and development. The Mobile and Embedded Devices operating loss for fiscal year 2004 decreased compared to fiscal year 2003 primarily due to growth in revenue and lower marketing +expenses, partially offset by $58 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004. Mobile and Embedded Devices is committed to continuing product innovation to meet the growing needs of our customers and partners. We will continue to invest in research and development and sales and marketing to develop and +market evolving software solutions. In fiscal year 2006 we expect to bring added functionality to the Windows Mobile 5.0 platform through the Windows Mobile 5.0 Messaging and Security Feature Pack and the Exchange Server 2003 Service Pack 2. This +solution enables business users to easily stay connected to their Microsoft Office Outlook Mobile information and helps businesses to better protect device data. We expect sales for Mobile and Embedded Devices to continue to grow in fiscal year +2006. The growth is anticipated to be driven by an overall increase in customer demand for connectivity, and an increase in the number of new devices being offered by OEMs and mobile operators incorporating Windows Mobile software and Windows +Embedded operating systems. Growth is also anticipated due to a strong focus on increasing segment share in the connected device space by working with our partners to bring to market a strong portfolio of Smartphone and mobile computing devices. In +addition, we are focused on bringing to market applications and services on the Windows Mobile platform that fulfill our customers desire for personalized communication devices. Effective July 1, 2005, functions related to MapPoint in Mobile and +Embedded Devices have been moved to MSN. This reorganization will result in a corresponding change to the Mobile and Embedded Devices and MSN reported results. Home and Entertainment (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Revenue $ 2,748 $ 2,876 5% $ 3,242 13% Operating loss $ (1,191 ) $ (1,220 ) (2)% $ (391 ) 68% Home and Entertainment includes the Microsoft +Xbox video game console system, PC games, the Home Products Division (HPD), and TV platform products for the interactive television industry. The success of video game consoles is determined by console functionality, the portfolio of video game +content for the console, and the market share of the console. Revenue and unit volumes have grown quickly since we entered the market in 2002 and we have established ourselves as one of the market leaders. We believe our competitive position and +revenue is bolstered by our increasing software game attach rates, which provides higher margins to offset the declining prices on consoles sold. Xbox consoles have negative gross margins. Home and Entertainment revenue increased in fiscal year 2005 primarily due to significant new product launches, which resulted in a $416 million or 23% increase in +Xbox revenue. In the second quarter of fiscal year 2005, we PAGE 30 Table of Contents Part II Item 7 introduced Halo 2, which generated over $300 million in revenue in the fiscal year. Revenue from consumer hardware and software, PC games, and TV platforms declined +$50 million or 5% compared to fiscal year 2004 due to lower PC games software sales. In fiscal year 2004, Xbox revenue increased $144 million or 9% with $269 million related to higher Xbox software volumes and $117 million due to higher Xbox console +volumes, partially offset by a $242 million decline related to price reductions of Xbox consoles and software. Overall, Xbox console volumes sales increased 11% in fiscal year 2004 compared to fiscal year 2003. Revenue from consumer hardware and +software, PC games and TV platforms declined $16 million or 1% compared to fiscal year 2003 due to lower PC games software and PC gaming devices sales, partially offset by the new release of Mac Office. Home and Entertainment operating loss in fiscal year 2005 decreased primarily due to an increase in high margin Xbox software sales, lower Xbox console unit costs, +the lower-of-cost-or-market inventory adjustment recorded in fiscal year 2004, and a decrease in stock-based compensation expense. The decrease was partially offset by an increase in costs associated with Xbox 360 console development and launch +efforts associated with it. The increase in operating loss in fiscal year 2004 was primarily due to $141 million of stock-based compensation expense from the employee stock option transfer program in the second quarter of fiscal year 2004, increased +sales of negative margin consoles, and costs associated with Xbox 360 console development efforts, partially offset by increased Xbox and Mac Office software sales. The operating loss increase from fiscal year 2003 also included a +lower-of-cost-or-market adjustment of approximately $90 million related to Xbox console inventory. We expect operating expenses to continue to +increase as we near the launch of Xbox 360. As a result of launch-related activities, we expect our operating loss to increase in fiscal year 2006. In fiscal year 2006, we expect Xbox console unit volumes and revenue to increase from fiscal year +2005 due to launch of the Xbox 360. In fiscal year 2006 we expect PC games revenue to increase from fiscal year 2005 driven by more new game titles. Corporate-Level Expenses (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Corporate-level Expenses $ 3,775 $ 6,781 80 % $ 5,822 (14 )% Certain corporate-level expenses are not +allocated to our segments. Those expenses primarily include corporate operations related to broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement +activities, certain research and development and other costs, and all litigation settlements and accrued legal contingencies. In fiscal year 2005, +corporate-level expenses decreased primarily as a result of a reduction in stock-based compensation expense and decreased corporate legal costs. Fiscal year 2005 legal costs were $2.08 billion as compared to $2.53 billion in fiscal year 2004. The +legal costs in both years were primarily related to antitrust and competition law claims brought by competitors, class actions on behalf of end users, and by government regulatory bodies outside the United States. In fiscal year 2004, corporate-level expenses increased primarily due to legal costs including a $1.92 billion charge for a settlement with the Sun Microsystems, +Inc., and the fine of € 497 million ($605 million) imposed by the European Commission. In addition, stock-based compensation +increased by $497 million as compared to fiscal year 2003. Cost of Revenue (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Cost of revenue $ 6,059 $ 6,716 11 % $ 6,200 (8 )% As a percent of revenue 19 % 18 % (1 )ppt 16 % (2 )ppt Cost of revenue includes manufacturing and +distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs +associated with the delivery of consulting services. In PAGE 31 Table of Contents Part II Item 7 addition to a decrease in the cost of revenue in fiscal year 2005 due to lower stock-based compensation expense, the cost of revenue decreased due to a $140 million +reduction in costs primarily associated with provisioning the MSN Internet Access business as subscriptions declined and a $169 million reduction in other product costs mainly due to Xbox consoles cost efficiency in Home and Entertainment, partially +offset by increased costs in product support and consulting services costs. The increase in fiscal year 2004 was primarily due to increased product support and consulting services costs of $508 million, $214 million of stock-based compensation +expense from the employee stock option transfer program, and a lower-of-cost-or-market inventory adjustment in the fourth quarter of fiscal year 2004 of approximately $90 million related to the Xbox console, partially offset by a $365 million +decrease in MSN online operations costs. Research and Development (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Research and development $ 6,595 $ 7,779 18 % $ 6,184 (21 )% As a percent of revenue 21 % 21 % 0 ppt 16 % (5 )ppt Research and development expenses include +payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to +translate software for international markets, and the amortization of purchased software code and services content. Our research and development expenses decreased in fiscal year 2005 due to lower stock-based compensation expense. This expense +decline was partially offset by an increase in headcount-related costs associated with incremental hiring and product development costs associated with upcoming products, primarily the Xbox 360 console and related games, SQL Server 2005, Windows +Vista, and product development in Mobile and Embedded devices. The increase in fiscal year 2004 was primarily due to $1.31 billion of stock-based compensation expenses related to the option transfer program and other headcount-related payroll and +other employee costs associated with a 3% increase in research and development headcount from fiscal year 2003. Sales and Marketing (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change Sales and marketing $ 7,562 $ 8,309 10% $ 8,677 4 % As a percent of revenue 24 % 23 % (1)ppt 22 % (1 )ppt Sales and marketing expenses include payroll, +employee benefits, stock-based compensation, and other headcount-related costs associated with sales and marketing personnel and advertising, promotions, tradeshows, seminars, and other marketing-related programs. For fiscal year 2005, sales and +marketing expense increased slightly due to $470 million higher headcount-related costs from hiring and salary increases; higher sales and marketing costs driven by product planning, reseller marketing, and advertising campaign costs mainly related +to launch of the “Start Something” campaign; launch of Halo 2; and launch arrangements for Xbox 360. The increase was offset mainly by reductions in stock-based compensation expense. Sales and marketing costs increased in fiscal +year 2004 due to $400 million of stock-based compensation expense related to the option transfer program and other headcount-related costs related to a 9% increase in sales and marketing headcount. General and Administrative (In millions, except percentages) 2003 2004 Percent Change 2005 Percent Change General and administrative $ 2,426 $ 4,997 106 % $ 4,166 (17 )% As a percent of revenue 8 % 14 % 6 ppt 10 % (4 )ppt PAGE 32 Table of Contents Part II Item 7 General and administrative costs include payroll, employee benefits, +stock-based compensation, and other headcount-related costs associated with finance, legal, facilities, certain human resources, and other administrative headcount; and legal costs and other administrative fees. General and administrative expenses +decreased in fiscal year 2005 due to lower legal costs and stock-based compensation expense, partially offset by an increase in other headcount-related costs from new and existing employees of $25 million. In fiscal year 2005, our legal expenses +were driven by charges of $2.08 billion, nearly all of which were for settlements of certain antitrust claims with IBM, Novell, Gateway, and end-user class action plaintiffs, and increases in contingency reserves for anti-trust related claims. +General and administrative costs increased in fiscal year 2004 primarily due to legal expenses including $1.92 billion of charges related to the Sun Microsystems settlement, a $605 million fine imposed by the European Commission, and other legal +costs of approximately $104 million; $280 million of stock-based compensation expense related to the employee stock option transfer program in the second quarter of fiscal year 2004; and other headcount-related costs. Investment Income The components of investment income and other in each full fiscal year are as follows: (In millions) 2003 2004 2005 Dividends and interest $ 1,957 $ 1,892 $ 1,460 Net gains on investments 44 1,563 856 Net losses on derivatives (424 ) (268 ) (262 ) Income/(losses) from equity investees and other (68 ) (25 ) 13 Investment income and other $ 1,509 $ 3,162 $ 2,067 Dividends and interest income +declined $432 million in fiscal year 2005 due to the combination of a greater allocation of funds to lower yielding, more liquid asset classes in preparation for the $32.64 billion special dividend paid on December 2, 2004 and a lower portfolio +balance following payment of the special dividend. Net gains on investments declined $707 million in fiscal year 2005 due primarily to greater sales +of investments in the previous fiscal year in preparation for the special dividend paid on December 2, 2004. Net gains on investments also include other-than-temporary impairments of $152 million in fiscal year 2005 compared to $82 million fiscal +year 2004. Investments are considered to be impaired when a decline in fair value is judged to be other than temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If +the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider +specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a +decline in fair value is determined to be other than temporary, an impairment charge is recorded and a new cost basis in the investment is established. Derivative instruments are used to manage exposures to interest rates, equity prices, and foreign currency exchange rates and to facilitate portfolio diversification. Net derivative losses in fiscal year 2005 were primarily related to +losses on equity derivatives, interest rate derivatives, and foreign currency contracts. During fiscal year 2005, losses related to equity derivatives used to economically hedge against a decline in equity prices were $202 million and losses related +to interest rate derivatives were $53 million. These losses were offset by the combination of realized gains on sales of securities and unrealized gains related to increases in the market value of the underlying assets included as a component of +other comprehensive income. Net losses related to foreign currency contracts were $53 million, related in part to hedging anticipated foreign currency revenues while the U.S. dollar generally declined against most currencies during the current +fiscal year, and economically hedging foreign currency based investment exposures. Losses related to hedging foreign currency-based investment exposures were offset by unrealized gains in the underlying assets. Net gains on derivatives also included +gains related to commodity positions used to provide portfolio diversification. Gains on commodity positions were $46 million during fiscal year 2005. In fiscal year 2004, dividends and interest income decreased by $65 million mainly due to lower dividend income resulting from the exchange of AT&T 5% convertible preferred debt for common shares of Comcast during fiscal year 2003 and +declining interest rates, partly offset by a larger investment portfolio. Net gains on investments include PAGE 33 Table of Contents Part II Item 7 other-than-temporary impairments of $82 million in fiscal year 2004 compared to $1.15 billion in fiscal year 2003 and higher net realized gains on sales in fiscal year +2004 as we moved to more liquid investment asset classes. Net realized gains on sales were $1.65 billion in fiscal year 2004 and $1.19 billion in fiscal year 2003. The decline in impairments was due to improved market conditions. Derivative losses +decreased $156 million to $268 million in fiscal year 2004 compared to fiscal year 2003 primarily due to the combined effects of interest rate movements on interest rate sensitive instruments and equity market price movements relative to positions +used to hedge the fair value of certain equity securities. Net losses on equity investees and other for the previous periods were reclassified into +investment income and other to conform to the current period presentation. Income +Taxes Our effective tax rate for the full fiscal year 2005 was 26% compared with +33% for fiscal year 2004. The decreased rate for the full year resulted primarily from the reversal of $776 million of previously accrued taxes upon settling an Internal Revenue Service examination for fiscal years 1997 to 1999 and recording a tax +benefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a temporary incentive provided by the American Jobs Creation Act of 2004. The effective tax rate for fiscal year 2003 was 32%. The fiscal year 2003 +rate reflected a benefit in the second quarter of $126 million which resulted from the reversal of previously accrued taxes that were related to a previous unfavorable Tax Court ruling, portions of which were reversed in 2003 by the Ninth Circuit +Court of Appeals. Financial Condition Cash and short-term investments totaled $37.75 billion as of June 30, 2005 compared to $60.59 billion +as of June 30, 2004. The decline is primarily attributable to the special dividend of $3.00 per share, or $32.64 billion, paid on December 2, 2004, and to common stock repurchases of 312 million shares for $8.0 billion during 2005. Equity and other +investments were $11.00 billion as of June 30, 2005 compared to $12.21 billion as of June 30, 2004. The investment portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are +generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar denominated securities, but also includes foreign currency denominated positions in order to diversify financial risk. The portfolio is primarily invested +in short-term securities to facilitate rapid deployment for immediate cash needs. As a result of the special dividend and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $12.30 billion at June 30, +2005. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position. Unearned Revenue Unearned revenue is attributable to volume licensing programs, undelivered elements of software licensing arrangements, and certain other services. Unearned revenue from volume +licensing programs represents customer billings, paid either upfront or at the beginning of each billing coverage period, that are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other +licensing arrangements revenue attributable to undelivered elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based +on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. Other unearned revenue includes Services, TV Platform, Microsoft Business Solutions, and +advertising and subscription services where we have been paid upfront and earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria. Unearned revenue as of June 30, 2005 increased $990 million from June 30, 2004 reflecting current period billings outpacing the recognition of deferrals from +multi-year licensing arrangements by $925 million and a $304 million increase primarily in unearned revenue for services, MSN advertising and subscriptions, Xbox Live, TV platform, and Microsoft Business Solutions, partially offset by a $239 million +decline in revenue deferred for undelivered elements. PAGE 34 Table of Contents Part II Item 7 The following table outlines the expected recognition of unearned revenue at June 30, 2005: (In millions) Recognition of Unearned Revenue Three months ended: September 30, 2005 $ 2,724 December 31, 2005 2,208 March 31, 2006 1,612 June 30, 2006 958 Thereafter 1,665 Unearned revenue $ 9,167 Cash Flows Cash flow from operations for fiscal year 2005 increased 14% to $16.61 billion due primarily to an +increase in cash receipts from customers driven by our 8% revenue growth combined with a 12% increase in unearned revenue. Cash payments in fiscal year 2005 resulting from significant legal settlements were approximately $1.8 billion lower than in +the previous year, adding to the overall increase in operating cash flow. Partially offsetting these factors were increased payments to employees resulting from a 7% increase in full-time employees. Cash used for financing was $41.08 billion in +fiscal year 2005, driven by $36.11 billion of cash dividends paid in fiscal year 2005 compared to $1.73 billion paid in fiscal year 2004. The increase was also partially driven by $8.0 billion in cash used for common stock repurchases, an increase +of $4.67 billion in cash used for share repurchases compared to the previous year, reflecting 312 million shares repurchased in fiscal year 2005, an increase of 188.5 million shares compared to the previous year. Net cash from investing was $15.03 +billion in fiscal year 2005, an increase of $18.37 billion from fiscal year 2004, primarily due to a $23.59 billion increase in investment maturities that occurred to fund cash dividends paid in fiscal year 2005, partially offset by a $5.32 billion +decrease in cash from combined investment purchase and sale activity. Cash flow from operations for fiscal year 2004 decreased $1.17 billion to +$14.63 billion. The decrease primarily reflects the combined cash outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine partially offset by increased cash receipts from customers driven by the rise in +revenue billings. Cash used for financing was $2.36 billion in fiscal year 2004, a decrease of $2.86 billion from the previous year. The decrease reflects that we did not repurchase common stock in the fourth quarter of fiscal year 2004 combined +with a $628 million increase primarily from stock issuances related to employee stock options exercises, partially offset by an $872 million increase in cash dividends paid. We repurchased 123.7 million shares of common stock under our share +repurchase program in fiscal year 2004. Cash used for investing was $3.34 billion in fiscal year 2004, a decrease of $3.88 billion from fiscal year 2003. Cash flow from operations was $15.80 billion for fiscal year 2003, an increase of $1.29 billion from fiscal year 2002. The increase primarily reflects the rise in cash receipts from customers driven by the increase in revenue billings and +maintenance of relatively stable accounts receivable levels. Cash used for financing was $5.22 billion in fiscal year 2003, an increase of $651 million from the previous year. The increase reflects a cash dividend payment of $857 million in 2003 and +an increase of $417 million in common stock repurchased, offsetting $623 million received from common stock issued. We repurchased 238.2 million shares of common stock under our share repurchase program in fiscal year 2003. Cash used for investing +was $7.50 billion in fiscal year 2003, a decrease of $3.37 billion from fiscal year 2002, due to stronger portfolio performance on sold and matured investments. We have no material long-term debt. Stockholders’ equity at June 30, 2005 was $48.12 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. +Additions to property and equipment will continue, including new facilities and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $152 million on +June 30, 2005. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling, $290 million, $331 million and $299 million in fiscal year 2003, 2004 and 2005, +respectively. We have issued residual value guarantees in connection with various operating leases. These guarantees provide that if we do not purchase the leased property from the PAGE 35 Table of Contents Part II Item 7 lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property +and an agreed value. As of June 30, 2005, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and +therefore no liability currently exists. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of +requirements for capital resources. In fiscal year 2005, our Board of Directors approved $3.40 per share cash dividends, with $3.32 paid as of June +30, 2005. A quarterly dividend of $0.08 per share (or approximately $857 million) was approved by our Board of Directors on June 15, 2005 to be paid to shareholders of record as of August 17, 2005 on September 8, 2005. On July 20, 2004, our Board of Directors approved a plan to buy back up to $30 billion in Microsoft common stock over four years. The specific timing and amount of +repurchases will vary based on market conditions, securities law limitations, and other factors. The repurchases will be made using our cash resources. The repurchase program may be suspended or discontinued at any time without previous notice. In +any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in stockholders’ equity, reflecting timing differences between the recognition of share repurchase transactions and their +settlement for cash. During fiscal year 2005, we repurchased 312 million shares, or $8.0 billion of our common stock under this plan. We believe +existing cash and short-term investments, together with funds generated from operations should be sufficient to meet operating requirements, quarterly dividends and planned share repurchases. Our philosophy regarding the maintenance of a balance +sheet with a large component of cash and short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution +channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs. Off-Balance Sheet Arrangements and Contractual Obligations Off-Balance Sheet Arrangements As of June 30, 2004, we had guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter +Telecommunication, Ltd., a Japanese cable company. The total amount of these guarantees was approximately $51 million. Effective December 21, 2004, the guarantees were terminated. We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising from +the use of our products. We evaluate estimated losses for such indemnifications under SFAS No. 5, Accounting for Contingencies, as interpreted by FASB Interpretation No. (FIN) 45. We consider factors such as the degree of probability of an +unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our +financial statements. Contractual Obligations The following table summarizes our outstanding contractual obligations as of June 30, 2005: (In millions) (1) Payments due by period Fiscal Years 2006 2007-2009 2010-2012 2013 and thereafter Total Long-term debt $ – $ – $ – $ – $ – Construction commitments (2) 122 28 2 – 152 Lease obligations: Capital leases 6 17 11 – 34 Operating leases (3) 230 493 214 96 1,033 Purchase commitments (4) 1,072 1 – – 1,073 Other long-term liabilities (5) – 95 17 12 124 Total contractual obligations $ 1,430 $ 634 $ 244 $ 108 $ 2,416 PAGE 36 Table of Contents Part II Item 7 (1) We have excluded the $1.1 billion contingent liability related to the antitrust and unfair competition class action lawsuits referred to in the third paragraph of Note 17 – Contingencies +of the Notes to Financial Statements as the timing and amount to be resolved in cash versus vouchers is subject to uncertainty. (2) We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations. (3) Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing +cash and cash flows from operations. (4) Purchase commitments represent obligations under agreements which are not unilaterally cancelable by us, are legally enforceable, and specify fixed or minimum amounts or quantities of goods +or services at fixed or minimum prices. We generally require purchase orders for vendor and third-party spending. The amount presented above as purchase commitments includes an analysis of all known contracts exceeding $5 million in the aggregate +and all known open purchase orders. We expect to fund these commitments with existing cash and cash flows from operations. (5) We have excluded unearned revenue of $1.67 billion from other long-term liabilities presented above as these will not be settled in cash. RECENTLY ISSUED ACCOUNTING STANDARDS In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory +Costs , which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We +do not believe the adoption of SFAS No. 151 will have a material impact on our financial statements. In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets , which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS +No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a material impact on our financial statements. In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment , which establishes standards for transactions in which an entity exchanges its equity +instruments for goods or services. This standard requires an issuer to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to +account for such awards using the intrinsic method previously allowable under Accounting Principles Board (APB) Opinion No. 25. In March 2005, the SEC released Staff Accounting Bulletin (SAB) 107, Share-Based Payment, which expresses views of the +SEC Staff about the application of SFAS No. 123(R). In April 2005 the SEC issued a rule that SFAS No. 123(R) will be effective for annual reporting periods beginning on or after June 15, 2005. We previously adopted the fair value recognition +provisions of SFAS No. 123, Accounting for Stock-Based Compensation , on July 1, 2003 and restated previous periods at that time for all awards granted to employees after July 1, 1995. Accordingly we believe SFAS No. 123(R) will not have a +material impact on our financial statements; however, we continue to assess the potential impact that the adoption of SFAS No. 123(R) will have on the classification of tax deductions for stock-based compensation in our statements of cash flows. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing +financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting +policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, accounting for income taxes, +and accounting for stock-based compensation. We account for the licensing of software in accordance with American Institute of Certified Public +Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective +evidence (VSOE) of fair value exists for those elements. Customers receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements +of Microsoft Internet Explorer on a when-and-if-available basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the PAGE 37 Table of Contents Part II Item 7 ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact +the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities , and SEC SAB 59, Accounting for Noncurrent Marketable Equity +Securities , provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making +this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among +other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and +business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an +impairment charge is recorded and a new cost basis in the investment is established. If market, industry and/or investee conditions deteriorate, we may incur future impairments. SFAS No. 142, Goodwill and Other Intangible Assets , requires that goodwill be tested for impairment at the reporting unit level (operating segment or one +level below an operating segment) on an annual basis (July 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events +or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test +requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of +each reporting unit is estimated using a discounted cash flow methodology. This requires significant judgments including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our +business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for +each reporting unit. We account for research and development costs in accordance with several accounting pronouncements, including SFAS No. 2, Accounting for Research and Development Costs , and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed . SFAS No. 86 specifies that costs incurred internally in researching and developing +a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for +general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached shortly before the products are +released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we expense all research and development costs when incurred. The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be +reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of +an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial position or our results of operations. SFAS No. 109, Accounting for Income Taxes , establishes financial accounting and reporting standards for the effect of income taxes. The objectives of +accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial +statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could +materially impact our financial position, results of operations, or cash flows. PAGE 38 Table of Contents Part II Item 7, 7A We account for stock-based compensation in +accordance with the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation. Under the fair value recognition provisions of SFAS No. 123, stock-based compensation cost is measured at the grant date +based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected term of stock options, the expected +volatility of our stock and expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based +compensation expense and our results of operations could be materially impacted. ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to foreign currency, interest rate, fixed income, equity and commodity price risks. A portion of these risks is hedged, but fluctuations could impact our results of +operations and financial position. We hedge a portion of anticipated revenue and accounts receivable exposure to foreign currency fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall +effectiveness of our foreign currency hedge positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Fixed income securities are subject to interest rate risk. The portfolio is diversified and +structured to minimize credit risk. Securities held in our equity and other investments portfolio are subject to price risk, and are generally not hedged. However, we use options to hedge our price risk on certain equity securities that are held +primarily for strategic purposes. We use a value-at-risk (VAR) model to estimate and quantify our market risks. VAR is the expected loss, for a given +confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VAR model is not intended to represent actual losses in fair value, but is used as a risk estimation and management tool. The model +used for currencies and equities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest rate risk, the mean reverting geometric Brownian motion is used to reflect the principle that +fixed-income securities prices revert to maturity value over time. VAR is calculated by, first, simulating 10,000 market price paths over a specified +period of time for equities, interest rates and foreign exchange rates, taking into account historical correlations among the different rates and prices. Each resulting unique set of equities prices, interest rates, and foreign exchange rates is +then applied to substantially all individual holdings to re-price each holding. The 250th worst performance (out of 10,000) represents the VAR over a specified period of time at the 97.5 percentile confidence level. Several risk factors are not +captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. Certain securities in our equity portfolio are held +for strategic purposes. We hedge the value of a portion of these securities through the use of derivative contracts such as put-call collars. In these arrangements, we hedge a security’s equity price risk below the purchased put strike and +forgo most or all of the benefits of the security’s appreciation above the sold call strike, in exchange for the premium received for the sold call. We also hold equity securities for general investment return purposes. We have incurred +material impairment charges related to these securities in previous periods. The VAR amounts disclosed below are used as a risk management tool and reflect an estimate of potential reductions in fair value of our portfolio. Losses in fair value over +the specified holding period can exceed the reported VAR by significant amounts and can also accumulate over a longer time horizon than the specified holding period used in the VAR analysis. VAR amounts are not necessarily reflective of potential +accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. The VAR numbers are shown +separately for interest rate, currency, equity and commodity risks. These VAR numbers include the underlying portfolio positions and related hedges. We use historical data to estimate VAR. Given the reliance on historical data, VAR is most effective +in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent limitation in VAR is that the distribution of past changes in market risk factors may not produce accurate predictions of +future market risk. PAGE 39 Table of Contents Part II Item 7A Management began using a 1-day VAR for internal risk measurement purposes effective for the quarter-ended March 31, 2005. The effect of changing from 20-day VAR to 1-day VAR was not material and there have been no modifications to the +assumptions or parameters within the model. The following table sets forth the 1-day VAR for substantially all of our positions. (In millions) Year ended June 30, 2005 Risk Categories 2004 2005 Average High Low Interest rates $ 67 $ 88 $ 68 $ 94 $ 37 Currency rates 46 52 36 55 12 Equity prices 173 164 166 187 141 Commodity prices – 14 6 14 – The total 1-day VAR for the +combined risk categories was $195 million at June 30, 2005 and $187 million at June 30, 2004. The total VAR is 39% less at June 30, 2005 and 35% less at June, 30 2004 than the sum of the separate risk categories for each of those years in the above +table, due to the diversification benefit of the combination of risks. PAGE 40 Table of Contents Part II Item 8 ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30 2003 2004 2005 Revenue $ 32,187 $ 36,835 $ 39,788 Operating expenses: Cost of revenue 6,059 6,716 6,200 Research and development 6,595 7,779 6,184 Sales and marketing 7,562 8,309 8,677 General and administrative 2,426 4,997 4,166 Total operating expenses 22,642 27,801 25,227 Operating income 9,545 9,034 14,561 Investment income and other 1,509 3,162 2,067 Income before income taxes 11,054 12,196 16,628 Provision for income taxes 3,523 4,028 4,374 Net income $ 7,531 $ 8,168 $ 12,254 Earnings per share: Basic $ 0.70 $ 0.76 $ 1.13 Diluted $ 0.69 $ 0.75 $ 1.12 Weighted average shares outstanding: Basic 10,723 10,803 10,839 Diluted 10,882 10,894 10,906 Cash dividends declared per share $ 0.08 $ 0.16 $ 3.40 See +accompanying notes. PAGE 41 Table of Contents Part II Item 8 BALANCE SHEETS (In millions) June 30 2004 2005 Assets Current assets: Cash and equivalents $ 14,304 $ 4,851 Short-term investments 46,288 32,900 Total cash and short-term investments 60,592 37,751 Accounts receivable, net 5,890 7,180 Inventories 421 491 Deferred income taxes 2,097 1,701 Other 1,566 1,614 Total current assets 70,566 48,737 Property and equipment, net 2,326 2,346 Equity and other investments 12,210 11,004 Goodwill 3,115 3,309 Intangible assets, net 569 499 Deferred income taxes 3,808 3,621 Other long-term assets 1,774 1,299 Total assets $ 94,368 $ 70,815 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 1,717 $ 2,086 Accrued compensation 1,339 1,662 Income taxes 3,478 2,020 Short-term unearned revenue 6,514 7,502 Other 1,921 3,607 Total current liabilities 14,969 16,877 Long-term unearned revenue 1,663 1,665 Other long-term liabilities 2,911 4,158 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 10,862 and 10,710 56,396 60,413 Retained earnings (deficit), including accumulated other comprehensive income of $1,119 and $1,426 18,429 (12,298 ) Total stockholders’ equity 74,825 48,115 Total liabilities and stockholders’ equity $ 94,368 $ 70,815 See +accompanying notes. PAGE 42 Table of Contents Part II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30 2003 2004 2005 Operations Net income $ 7,531 $ 8,168 $ 12,254 Depreciation, amortization, and other noncash items 1,393 1,186 855 Stock-based compensation 3,749 5,734 2,448 Net recognized (gains)/losses on investments 380 (1,296 ) (527 ) Stock option income tax benefits 1,365 1,100 668 Deferred income taxes (1,348 ) (1,479 ) (179 ) Unearned revenue 12,519 11,777 13,831 Recognition of unearned revenue (11,292 ) (12,527 ) (12,919 ) Accounts receivable 187 (687 ) (1,243 ) Other current assets 412 478 (245 ) Other long-term assets (28 ) 34 21 Other current liabilities 35 1,529 396 Other long-term liabilities 894 609 1,245 Net cash from operations 15,797 14,626 16,605 Financing Common stock issued 2,120 2,748 3,109 Common stock repurchased (6,486 ) (3,383 ) (8,057 ) Common stock cash dividends (857 ) (1,729 ) (36,112 ) Other – – (18 ) Net cash used for financing (5,223 ) (2,364 ) (41,078 ) Investing Additions to property and equipment (891 ) (1,109 ) (812 ) Acquisition of companies, net of cash acquired (1,063 ) (4 ) (207 ) Purchases of investments (91,869 ) (95,005 ) (68,045 ) Maturities of investments 9,205 5,561 29,153 Sales of investments 77,123 87,215 54,938 Net cash from investing (7,495 ) (3,342 ) 15,027 Net change in cash and equivalents 3,079 8,920 (9,446 ) Effect of exchange rates on cash and equivalents 61 27 (7 ) Cash and equivalents, beginning of period 2,217 5,357 14,304 Cash and equivalents, end of period $ 5,357 $ 14,304 $ 4,851 See +accompanying notes. PAGE 43 Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30 2003 2004 2005 Common stock and paid-in capital Balance, beginning of period $ 41,845 $ 49,234 $ 56,396 Common stock issued 2,966 2,815 3,223 Common stock repurchased (691 ) (416 ) (1,737 ) Stock-based compensation expense 3,749 5,734 2,448 Stock option income tax benefits/(deficiencies) 1,365 (989 ) 89 Other, net – 18 (6 ) Balance, end of period 49,234 56,396 60,413 Retained earnings (deficit) Balance, beginning of period 12,997 15,678 18,429 Net income 7,531 8,168 12,254 Other comprehensive income: Net gains/(losses) on derivative instruments (102 ) 101 (58 ) Net unrealized investments gains/(losses) 1,243 (873 ) 371 Translation adjustments and other 116 51 (6 ) Comprehensive income 8,788 7,447 12,561 Common stock cash dividends (857 ) (1,729 ) (36,968 ) Common stock repurchased (5,250 ) (2,967 ) (6,320 ) Balance, end of period 15,678 18,429 (12,298 ) Total stockholders’ equity $ 64,912 $ 74,825 $ 48,115 See +accompanying notes. PAGE 44 Table of Contents Part II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES ACCOUNTING PRINCIPLES The financial statements and accompanying notes are prepared in accordance with accounting principles +generally accepted in the United States of America. PRINCIPLES OF +CONSOLIDATION The financial statements include the accounts of Microsoft +Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not control and are not the primary beneficiary are accounted for using the equity +method. Investments in which we are not able to exercise significant influence over the investee are accounted for under the cost method. ESTIMATES AND ASSUMPTIONS Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples +include estimates of loss contingencies and product life cycles, and assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is +achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining +when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. FOREIGN CURRENCIES Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation +adjustments resulting from this process are charged or credited to Other Comprehensive Income (OCI). REVENUE RECOGNITION Revenue is +recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. We enter into certain arrangements where we are obligated to deliver multiple products and/or +services (multiple elements). In these arrangements, we generally allocate the total revenue among the elements based on the sales price of each element when sold separately (vendor-specific objective evidence). Revenue for retail packaged products, products licensed to original equipment manufacturers (OEMs), and perpetual licenses for current products under our Open and +Select volume licensing programs generally is recognized as products are shipped, with a portion of the revenue recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive +unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the vendor-specific objective evidence of fair value for those elements using the +residual method. Under the residual method, the total fair value of the undelivered elements, as indicated by vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded +as unearned for the undelivered elements is recognized as revenue related to delivered elements. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle. Revenue from multi-year licensing arrangements are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over +the billing coverage period. Certain multi-year licensing arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select volume licensing programs (currently named Software Assurance +and, previously named Upgrade Advantage). In addition, other multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis +under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions. PAGE 45 Table of Contents Part II Item 8 Revenue related to our Xbox game console is recognized upon shipment of the product to retailers. Revenue related to games published by us is recognized when those games have been delivered to retailers. Revenue related to +games published by third parties for use on the Xbox platform is recognized when manufactured for the game publishers. Online advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad +appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and +the number of hours worked during the period. Revenue for fixed price services arrangements is recognized based on percentage of completion. Costs +related to insignificant obligations, which include telephone support for developer tools software, PC games, computer hardware, and Xbox, are accrued when the related revenue is recognized. Provisions are recorded for estimated returns, +concessions, and bad debts. RESEARCH AND DEVELOPMENT Research and development expenses include payroll, employee benefits, stock-based compensation, and +other headcount-related costs associated with product development. We have determined that technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological +feasibility is established are not material, and accordingly, we expense all research and development costs when incurred. SALES AND MARKETING Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with sales and marketing personnel and +advertising, promotions, tradeshows, seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising expense was $1.06 billion in fiscal year 2003, $904 million in fiscal year 2004, and $995 million in fiscal +year 2005. INCOME TAXES Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on +undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences +is reported as deferred income taxes. FINANCIAL INSTRUMENTS We consider all highly liquid interest-earning investments with a maturity of three +months or less at the date of purchase to be cash equivalents. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash +that is available for current operations. All cash equivalents and short-term investments are classified as available for sale and are recorded at market value using the specific identification method; unrealized gains and losses (excluding +other-than-temporary impairments) are reflected in OCI. Equity and other investments include both debt and equity instruments. Debt securities and +publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and losses (excluding other-than-temporary impairments) are reflected in OCI. All other +investments, excluding those accounted for using the equity method, are recorded at cost. We lend certain fixed income and equity securities to +enhance investment income. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. The fair value of collateral that we are permitted to sell or re-pledge was $499 million at +both June 30, 2004 and 2005. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a +systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, +general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for +the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is +recorded and a new cost basis in the investment is established. PAGE 46 Table of Contents Part II Item 8 We use derivative instruments to manage exposures to +foreign currency, equities price, interest rate and credit risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of +these exposures as effectively as possible. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the +derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the +risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged +exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and +are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are recognized in earnings. Foreign Currency Risk. Certain forecasted transactions and assets are exposed to foreign currency risk. We monitor our +foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as +cash-flow hedging instruments under Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities . Principal currencies hedged include the euro, Japanese yen, British pound, and +Canadian dollar. Certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS No. 133 . Certain options and forwards not designated as +hedging instruments under SFAS No. 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures. Equities Price Risk. Equity investments are subject to +market price risk. From time to time, we use and designate options to hedge fair values and cash flows on certain equity securities. We determine the security, or forecasted sale thereof, selected for hedging by evaluating market conditions, +up-front costs, and other relevant factors. Certain options, futures and swap contracts, not designated as hedging instruments under SFAS No. 133, are also used to manage equity exposures. Interest Rate Risk. Fixed-income securities are subject to interest rate +risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and future contracts and over-the-counter swap contracts, not designated as hedging +instruments under SFAS No. 133, to hedge interest rate risk. Other +Derivatives. Swap contracts, not designated as hedging instruments under SFAS No. 133, are used to manage exposures to credit risks, enhance returns, and to facilitate portfolio diversification. In addition, we may invest +in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. To Be Announced (TBAs) forward +purchase commitments of mortgage-backed assets are also considered derivatives in cases where physical delivery of the assets are not taken at the earliest available delivery date. All derivative instruments not designated as hedging instruments are +recorded at fair value, with changes in value recognized in earnings during the period of change. PAGE 47 Table of Contents Part II Item 8 ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the +accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts is as follows: (In millions) Year Ended June 30 Balance at beginning of period Charged to costs and expenses Write-offs and other Balance at end of period 2003 $ 209 $ 118 $ (85 ) $ 242 2004 242 44 (120 ) 166 2005 166 48 (43 ) 171 INVENTORIES Inventories are stated at the lower of cost or market, using the average cost method. Cost includes +materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our +review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis. PROPERTY AND EQUIPMENT Property and +equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated +using the straight-line method over the estimated useful life of the software, generally three years or less. GOODWILL Goodwill is tested for +impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No impairment of goodwill has been identified during any of the periods presented. INTANGIBLE ASSETS Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We evaluate the +recoverability of intangible assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. All of our intangible assets are subject to amortization. No +impairments of intangible assets have been identified during any of the periods presented. RECLASSIFICATIONS Certain previous year amounts have been +reclassified to conform to the current year presentation, including the reclassification of auction rate securities (ARS) as short-term investments instead of cash and equivalents in accordance with guidance issued by the Securities and Exchange +Commission and reclassification of non-current tax contingencies from non-current deferred taxes to other non-current liabilities. We reclassified $1.1 billion and $1.7 billion of investments in ARS as of June 30, 2003 and 2004, respectively, that +were previously included in cash and equivalents to short-term investments. We have included purchases and sales of ARS in our statements of cash flows as a component of investing activities. To conform to our current year presentation we have also +reclassified $2.0 billion in our fiscal year 2004 balance sheet from net long-term deferred income taxes to other long-term liabilities, with conforming reclassifications in the statement of cash flows. These reclassifications had no impact on our +results of operations or changes in stockholders’ equity, or cash flows. In addition, net losses on equity investees and other for previous periods were reclassified to investment income and other to conform to the current period presentation. PAGE 48 Table of Contents Part II Item 8 NOTE 2    UNEARNED REVENUE Unearned revenue is comprised of the following items: Volume licensing programs – Represents customer billings for multi-year licensing +arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue +recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 1% to 15% of the sales price for +desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems and two years for desktop applications. Other – Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the +advertisement has yet to be displayed, Microsoft Business Solutions maintenance and enhancement billings, Xbox Live and other billings that are accounted for as subscriptions, and other agreements where Microsoft is committed to the delivery of +future enhancements, products, or services, including the TV platform. The components of +unearned revenue are as follows: (In millions) June 30 2004 2005 Volume licensing programs $ 5,075 $ 6,000 Undelivered elements 2,358 2,119 Other 744 1,048 Unearned revenue $ 8,177 $ 9,167 Unearned revenue by segment is as follows: (In millions) June 30 2004 2005 Client $ 2,822 $ 2,687 Server and Tools 2,370 3,048 Information Worker 2,586 2,814 Other segments 399 618 Unearned revenue $ 8,177 $ 9,167 PAGE 49 Table of Contents Part II Item 8 NOTE 3    INVESTMENTS The components of +investments are as follows: (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2004 Cash and securities Cash $ 1,812 $ – $ – $ 1,812 $ 1,812 $ – $ – Mutual funds 3,595 – – 3,595 3,595 – – Commercial paper 7,286 – – 7,286 4,109 3,177 – Certificates of deposit 415 – – 415 330 85 – U. S. Government and Agency securities 20,565 26 (54 ) 20,537 4,083 16,454 – Foreign government bonds 4,524 41 (60 ) 4,505 – 4,505 – Mortgage backed securities 3,656 21 (42 ) 3,635 – 3,635 – Corporate notes and bonds 15,048 122 (50 ) 15,120 98 13,541 1,481 Municipal securities 5,154 39 (25 ) 5,168 277 4,891 – Common stock and equivalents 7,722 1,571 (62 ) 9,231 – – 9,231 Preferred stock 1,290 – – 1,290 – – 1,290 Other investments 208 – – 208 – – 208 Total $ 71,275 $ 1,820 $ (293 ) $ 72,802 $ 14,304 $ 46,288 $ 12,210 (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2005 Cash and securities Cash $ 1,911 $ – $ – $ 1,911 $ 1,911 $ – $ – Mutual funds 1,636 38 – 1,674 817 857 – Commercial paper 1,566 4 – 1,570 1,570 – – Certificates of deposit 614 – – 614 453 161 – U. S. Government and Agency securities 9,943 29 (59 ) 9,913 – 9,913 – Foreign government bonds 5,486 194 (2 ) 5,678 – 5,678 – Mortgage backed securities 123 – – 123 – 123 – Corporate notes and bonds 8,053 50 (31 ) 8,072 80 7,473 519 Municipal securities 8,579 70 (33 ) 8,616 20 8,596 – Other 99 – – 99 – 99 – Common stock and equivalents 7,273 1,970 (133 ) 9,110 – – 9,110 Preferred stock 1,067 4 – 1,071 – – 1,071 Other investments 304 – – 304 – – 304 Total $ 46,654 $ 2,359 $ (258 ) $ 48,755 $ 4,851 $ 32,900 $ 11,004 At June 30, 2004 unrealized losses of $293 +million consisted of: $188 million related to investment grade fixed income securities, $43 million related to investments in high yield and emerging market fixed income securities, $49 million related to domestic equity securities and $13 million +related to international equity securities. Unrealized losses from fixed income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Of the +unrealized losses of $293 million at PAGE 50 Table of Contents Part II Item 8 June 30, 2004, $51 million exceeded twelve months. At June 30, 2005 unrealized losses of $258 million consisted of: $112 million related to investment grade fixed +income securities, $13 million related to investments in high yield and emerging market fixed income securities, $90 million related to domestic equity securities and $43 million related to international equity securities. Unrealized losses from +fixed income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Of the unrealized losses of $258 million at June 30, 2005, $25 million +exceeded twelve months. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of June 30, 2005. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2004 the +recorded basis of these investments was $1.65 billion, and their estimated fair value was $2.12 billion. At June 30, 2005 the recorded basis of these investments was $1.05 billion, and their estimated fair value was $1.27 billion. The estimate of +fair value is based on publicly available market information or other estimates determined by management. The maturities of debt securities at June +30, 2005 were as follows: (In millions) Cost basis Estimated fair value Due in one year or less $ 6,648 $ 6,647 Due after one year through five years 16,972 16,960 Due after five years through ten years 7,584 7,771 Due after ten years 3,259 3,307 Total $ 34,463 $ 34,685 Debt securities include fixed maturity +securities. NOTE 4    INVESTMENT INCOME AND OTHER The components of investment income and other are as follows: (In millions) Year Ended June 30 2003 2004 2005 Dividends and interest $ 1,957 $ 1,892 $ 1,460 Net gains on investments 44 1,563 856 Net losses on derivatives (424 ) (268 ) (262 ) Income/(losses) from equity investees and other (68 ) (25 ) 13 Investment income and other $ 1,509 $ 3,162 $ 2,067 Net gains on investments include +other-than-temporary impairments of $1.15 billion in fiscal year 2003, $82 million in fiscal year 2004, and $152 million in fiscal year 2005. Realized gains and (losses) from sales of available-for-sale securities (excluding other-than-temporary +impairments) were $1.44 billion and $(245) million in fiscal year 2003, $2.16 billion and $(518) million in fiscal year 2004, and $1.38 billion and $(376) million in fiscal year 2005. NOTE 5    DERIVATIVES For derivative instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS No. 133, did not have a significant +impact on earnings for fiscal years 2003, 2004, and 2005. During fiscal year 2003, $74 million in losses on fair value hedges from changes in time value and $229 million in losses on cash flow hedges from changes in time value were excluded from the +assessment of hedge effectiveness and included in investment income and other. During fiscal year 2004, $31 million in gains on fair value hedges from changes in time value and $325 million in losses on cash flow hedges from changes in time value +were excluded from the PAGE 51 Table of Contents Part II Item 8 assessment of hedge effectiveness and included in investment income and other. During fiscal year 2005, $79 million in gains on fair value hedges from changes in time +value and $116 million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in investment income and other. Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of an equity investment is recognized. During +fiscal year 2003, $40 million of derivative gains were reclassified to revenue and $2 million in derivative gains were reclassified to investment income and other. During fiscal year 2004, $14 million of derivative gains were reclassified to revenue +and no derivative gains or losses were reclassified to investment income and other. During fiscal year 2005, $57 million of derivative gains were reclassified to revenue and $33 million in derivative gains were reclassified to investment income and +other. We estimate that $42 million of net derivative gains included in OCI will be reclassified into earnings within the next twelve months. No +significant fair value hedges or cash flow hedges were derecognized or discontinued for fiscal years 2003, 2004, and 2005 . NOTE 6    INVENTORIES (In millions) June 30 2004 2005 Finished goods $ 271 $ 422 Raw materials and work in process 150 69 Inventories $ 421 $ 491 We recorded lower of cost or market adjustments +totaling approximately $90 million in fiscal year 2004. NOTE +7    PROPERTY AND EQUIPMENT (In millions) June 30 2004 2005 Land $ 274 $ 313 Buildings and improvements 1,981 2,014 Leasehold improvements 805 851 Computer equipment and software 2,637 2,318 Furniture and equipment 792 879 Property and equipment, at cost 6,489 6,375 Accumulated depreciation (4,163 ) (4,029 ) Property and equipment, net $ 2,326 $ 2,346 Property and equipment are stated at cost. +Depreciation is computed principally on the straight-line method over the estimated useful lives of the assets. The useful lives for buildings range from five to fifteen years, leasehold improvements range from two years to ten years – +representing the applicable lease terms plus reasonably assured extensions, computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated. During fiscal years 2003, 2004, and 2005, depreciation expense was $929 million, $647 million, and $723 million, the majority of which related to computer +equipment. PAGE 52 Table of Contents Part II Item 8 NOTE 8    GOODWILL Changes in the carrying amount of goodwill for fiscal years 2004 and 2005 by segment, are as +follows: (In millions) Balance as of June 30, 2003 Acquisitions / purchase accounting adjustments Divestitures Balance as of June 30, 2004 Acquisitions / purchase accounting adjustments Divestitures Balance as of June 30, 2005 Client $ 37 $ – $ – $ 37 $ 6 $ – $ 43 Server and Tools 106 – – 106 135 – 241 Information Worker 180 (2 ) – 178 47 – 225 Microsoft Business Solutions 2,219 7 (19 ) 2,207 3 – 2,210 MSN 154 – – 154 17 – 171 Mobile and Embedded Devices 28 2 – 30 – – 30 Home and Entertainment 404 (1 ) – 403 – (14 ) 389 Total $ 3,128 $ 6 $ (19 ) $ 3,115 $ 208 $ (14 ) $ 3,309 We test goodwill for impairment annually during +the first quarter of each fiscal year at the reporting unit level using a fair value approach, in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets . Our annual testing resulted in no impairment charges to +goodwill in fiscal years 2004 and 2005. If an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for impairment between annual tests. +During fiscal years 2004 and 2005, we had no material acquisitions. NOTE 9    INTANGIBLE ASSETS The components of +finite-lived intangible assets are as follows: (In millions) June 30 2004 2005 Gross carrying amount Accumulated amortization Net carrying amount Gross carrying amount Accumulated amortization Net carrying amount Contract-based $ 908 $ (476 ) $ 432 $ 957 $ (606 ) $ 351 Technology-based 278 (183 ) 95 309 (200 ) 109 Marketing-related 35 (19 ) 16 35 (25 ) 10 Customer-related 30 (4 ) 26 40 (11 ) 29 Total $ 1,251 $ (682 ) $ 569 $ 1,341 $ (842 ) $ 499 PAGE 53 Table of Contents Part II Item 8 During fiscal year 2004, we recorded additions to intangible assets of $355 million, of which $266 million was related to a comprehensive intellectual property license that we received in conjunction with the settlement of InterTrust v. +Microsoft . During fiscal year 2005, we recorded additions to finite-lived intangible assets of approximately $90 million. No other material intangibles were acquired in fiscal year 2004. We estimate that we have no significant residual value +related to our finite-lived intangible assets. The components of finite-lived intangible assets acquired during fiscal years 2004 and 2005 are as follows: (In millions) Year Ended June 30 2004 2005 Amount Weighted average life Amount Weighted average life Contract-based $ 324 9 years $ 16 6 years Technology-based 28 4 years 64 5 years Customer-related 3 3 years 10 5 years Marketing-related – – – – Total $ 355 $ 90 Acquired finite-lived intangibles are generally +amortized on a straight-line basis over weighted average periods. Intangible assets amortization expense was $170 million for fiscal year 2004 and $161 million for fiscal year 2005. The estimated future amortization expense related to intangible +assets as of June 30, 2005 is as follows: (In millions) Year Ended June 30 Amount 2006 $ 123 2007 99 2008 81 2009 50 2010 39 Total $ 392 NOTE +10    INCOME TAXES The components of the provision for income +taxes are as follows: (In millions) Year Ended June 30 2003 2004 2005 Current taxes: U.S. Federal $ 3,708 $ 3,766 $ 3,401 U.S. State and Local 153 174 152 International 808 1,056 911 Current taxes 4,669 4,996 4,464 Deferred taxes (1,146 ) (968 ) (90 ) Provision for income taxes $ 3,523 $ 4,028 $ 4,374 PAGE 54 Table of Contents Part II Item 8 U.S. and international components of income before income taxes are as +follows: (In millions) Year Ended June 30 2003 2004 2005 U.S. $ 7,674 $ 8,088 $ 9,806 International 3,380 4,108 6,822 Income before income taxes $ 11,054 $ 12,196 $ 16,628 The items accounting for the difference between +income taxes computed at the federal statutory rate and the provision for income taxes are as follows: Year Ended June 30 2003 2004 2005 Federal statutory rate 35.0 % 35.0 % 35.0 % Effect of: IRS examination settlement – – (4.7 )% Foreign earnings taxed at lower rates (1.3 )% (1.7 )% (3.1 )% Extraterritorial income exclusion (1.6 )% (0.9 )% (1.3 )% Other reconciling items – 0.6 % 0.4 % Effective rate 32.1 % 33.0 % 26.3 % The 2005 other reconciling items include a $179 +million repatriation tax benefit. The 2004 other reconciling items include the $208 million benefit from the resolution of the issue remanded by the Ninth Circuit Court of Appeals and the impact of the $605 million non-deductible European Commission +fine. The components of the deferred tax assets and liabilities are as follows: (In millions) June 30 2004 2005 Deferred income tax assets: Unearned revenue $ 1,746 $ 915 Impaired investments 1,246 861 Stock-based compensation expense 3,749 3,994 Other revenue items 286 213 Other expense items 1,308 1,751 Other – 173 Deferred income tax assets $ 8,335 $ 7,907 Deferred income tax liabilities: Unrealized gain on investments $ (1,087 ) $ (1,169 ) International earnings (1,327 ) (1,393 ) Other (16 ) (23 ) Deferred income tax liabilities (2,430 ) (2,585 ) Net deferred income tax assets $ 5,905 $ 5,322 Reported as: Current deferred tax assets $ 2,097 $ 1,701 Long-term deferred tax assets 3,808 3,621 Net deferred income tax assets $ 5,905 $ 5,322 PAGE 55 Table of Contents Part II Item 8 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes are actually paid +or recovered. We have not provided for U.S. deferred income taxes or foreign withholding taxes on $4.1 billion of our undistributed earnings for +certain non-U.S. subsidiaries, all of which relate to fiscal 2002 through 2005 earnings, because these earnings are intended to be permanently reinvested in operations outside the United States. The American Jobs Creation Act of 2004 (the “Act”) was enacted in October 2004. The Act creates a temporary incentive for U.S. corporations to repatriate +foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. The deduction is subject to a number of limitations and requirements, including adoption of a specific +domestic reinvestment plan for the repatriated funds. Based on our current understanding of the Act and subsequent guidance published by the U.S. Treasury, we have determined that we are eligible and intend to repatriate approximately $780 million +in dividends subject to the elective 85% dividends received deduction. Accordingly, we recorded a corresponding tax provision benefit of $179 million from the reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign +subsidiary earnings. We intend to pay this dividend in fiscal year 2006. Income taxes paid were $2.8 billion in fiscal year 2003, $2.5 billion in +fiscal year 2004, and $4.3 billion in fiscal year 2005. Tax Contingencies. We are +subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and recording the related assets and liabilities. In the ordinary course of our +business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Accruals for tax contingencies are provided for in accordance with the requirements of SFAS +No. 5, Accounting for Contingencies . The Internal Revenue Service (IRS) has completed and closed its audits of our consolidated federal income +tax returns through 1996. We recently entered into a closing agreement with the IRS for tax years 1997 through 1999 resulting in certain adjustments to our federal income tax liability for those years. Accordingly, our fiscal year 2005 tax provision +has been reduced by $776 million as a result of reversing previously established reserves in excess of the additional tax liability assessed by the IRS for the 1997-1999 tax years. The IRS is currently conducting an audit of our consolidated federal +income tax return for tax years 2000 through 2003. Although we believe we have appropriate support for the positions taken on our tax returns, we +have recorded a liability for our best estimate of the probable loss on certain of these positions, the non-current portion of which is included in other long-term liabilities. We believe that our accruals for tax liabilities are adequate for all +open years, based on our assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter, which matters result primarily from intercompany transfer pricing, tax benefits from the Foreign Sales +Corporation and Extra Territorial Income tax rules and the amount of research and experimentation tax credits claimed. Although we believe our recorded assets and liabilities are reasonable, tax regulations are subject to interpretation and tax +litigation is inherently uncertain; therefore our assessments can involve both a series of complex judgments about future events and rely heavily on estimates and assumptions. Although we believe that the estimates and assumptions supporting our +assessments are reasonable, the final determination of tax audits and any related litigation could be materially different than that which is reflected in historical income tax provisions and recorded assets and liabilities. Based on the results of +an audit or litigation a material effect on our income tax provision, net income, or cash flows in the period or periods for which that determination is made could result. Due to the complexity involved we are not able to estimate the range of +reasonably possible losses in excess of amounts recorded. NOTE +11    OTHER LONG-TERM LIABILITIES (In millions) June 30 2004 2005 Tax contingencies $ 1,979 $ 3,066 Legal contingencies 699 961 Employee stock option transfer program 146 48 Other 87 83 Other long-term liabilities $ 2,911 $ 4,158 PAGE 56 Table of Contents Part II Item 8 NOTE 12    STOCKHOLDERS’ +EQUITY Shares of common stock outstanding are as follows: (In millions) Year Ended June 30 2003 2004 2005 Balance, beginning of year 10,718 10,771 10,862 Issued 291 215 160 Repurchased (238 ) (124 ) (312 ) Balance, end of year 10,771 10,862 10,710 As discussed in Note 14 – Employee Stock +and Savings Plans, 345 million options were transferred to JPMorgan Chase Bank (JPMorgan) under the stock option transfer program. The options transferred to JPMorgan were amended and restated upon transfer to contain terms and conditions typical of +equity option transactions entered into between sophisticated financial counterparties at arm’s length using standard terms and definitions for equity derivatives. As of June 30, 2005, the options have strike prices ranging from $28.83 to +$89.58 per share and have expiration dates between December 2005 and December 2006. On July 20, 2004, our Board of Directors approved a plan to buy +back up to $30 billion of Microsoft common stock over the succeeding four years. The specific timing and amount of repurchases will vary based on market conditions, securities law limitations, and other factors. The repurchases will be made using +our cash resources. The repurchase program may be suspended or discontinued at any time without previous notice. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in +stockholders’ equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash. Our Board of Directors had previously approved a program to repurchase shares of our common stock to +reduce the dilutive effect of our stock option and stock purchase plans. Under these repurchase plans, we have made the following share repurchases: (share amounts in millions, dollars in billions) (1) Fiscal year 2003 2004 2005 (1) Shares Amount Shares Amount Shares Amount First quarter 120.6 $ 3.0 43.3 $ 1.2 22.8 $ 0.6 Second quarter 38.8 1.0 30.5 0.8 23.6 0.7 Third quarter 30.7 0.7 49.9 1.4 95.1 2.4 Fourth quarter 48.1 1.2 – – 170.7 4.3 Total 238.2 $ 5.9 123.7 $ 3.4 312.2 $ 8.0 (1) All amounts repurchased in fiscal year 2005 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004. In addition, as part of our authorized stock repurchase program, we have purchased call +options on 25 million shares of our common stock with strike prices ranging from $27.00 – $27.50. The call options have maturities ranging from July 15, 2005 to January 20, 2006 and are reflected in stockholders’ equity. In fiscal year 2005, our Board of Directors approved the following dividends: Approval Date Per Share Dividend Date of Record Total Amount (in millions) Payment Date July 20, 2004 $ 0.08 August 25, 2004 $ 870 September 14, 2004 July 20, 2004 $ 3.00 November 17, 2004 $ 32,640 December 2, 2004 September 15, 2004 $ 0.08 November 17, 2004 $ 871 December 2, 2004 December 8, 2004 $ 0.08 February 17, 2005 $ 868 March 10, 2005 March 23, 2005 $ 0.08 May 18, 2005 $ 860 June 9, 2005 June 15, 2005 $ 0.08 August 17,2005 (1) September 8, 2005 (1) The dividend approved on June 15, 2005 will be paid after the filing date of this report on Form 10-K. The accrued liability for the dividend approved on June 15, 2005 of $857 million is +included in other current liabilities. PAGE 57 Table of Contents Part II Item 8 On January 16 and September 12, 2003, our Board of Directors declared annual dividends on our common stock of $0.08 and $0.16 per share, respectively. The dividends were paid on March 7 and November 7, 2003, respectively, to +shareholders of record at the close of business on February 21, and October 17, 2003. NOTE 13    OTHER COMPREHENSIVE INCOME The activity in other comprehensive income and related tax effects are as follows: (In millions) Year Ended June 30 2003 2004 2005 Net gains/(losses) on derivative instruments: Unrealized gains/(losses), net of tax effect of $(69) in 2003, $49 in 2004 and $(63) in 2005 $ (129 ) $ 92 $ (116 ) Reclassification adjustment for losses included in net income, net of tax effect of $15 in 2003, $5 in 2004 and $31 in 2005 27 9 58 Net gains/(losses) on derivative instruments (102 ) 101 (58 ) Net unrealized investment gains/(losses): Unrealized holding gains/(losses), net of tax effect of $610 in 2003, $(994) in 2004 and $(69) in 2005 1,132 (1,846 ) (128 ) Reclassification adjustment for losses included in net income, net of tax effect of $60 in 2003, $524 in 2004 and $269 in 2005 111 973 499 Net unrealized investment gains/(losses) 1,243 (873 ) 371 Translation adjustments and other 116 51 (6 ) Other comprehensive income /(loss) $ 1,257 $ (721 ) $ 307 The components of accumulated other +comprehensive income were: (In millions) 2004 2005 Year Ended June 30 Net gains on derivative instruments $ 85 $ 27 Net unrealized investment gains 973 1,344 Translation adjustments and other 61 55 Accumulated other comprehensive income $ 1,119 $ 1,426 NOTE +14    EMPLOYEE STOCK AND SAVINGS PLANS Effective July 1, 2003, +we adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation , using the retroactive restatement method described in SFAS No. 148, Accounting for Stock-Based Compensation – Transition and +Disclosure . Under the fair value recognition provisions of SFAS No. 123, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. In connection with the use +of the retroactive restatement method, income statement amounts were restated for fiscal year 2003 to reflect results as if the fair-value method of SFAS No. 123 had been applied from its original effective date. Total compensation cost recognized +in income for stock-based employee compensation awards was $3.75 billion in fiscal year 2003, $5.73 billion in fiscal year 2004, and $2.45 billion in fiscal year 2005. The amounts for fiscal year 2004 include $2.21 billion ($1.48 billion after-tax +or $0.14 per diluted share) due to the completion of the employee stock option transfer program. Employee Stock Purchase Plan. We have an employee stock purchase plan for all eligible employees. The administrative committee under the plan approved a change to the common stock purchase discount and approved PAGE 58 Table of Contents Part II Item 8 the elimination of the related look back period and a change to quarterly purchase periods that became effective July 1, 2005. As a result, beginning in fiscal year +2005, shares of our common stock may presently be purchased by employees at three months intervals at 90% of the fair market value on the last day of each three month period. Employees may purchase shares having a value not exceeding 15% of their +gross compensation during an offering period. During fiscal year 2005 employees purchased 16.4 million shares at an average price of $23.33 per share. At June 30, 2005, 159.1 million shares were reserved for future issuance. Under the plan in effect previous to fiscal year 2005, shares of our common stock could be purchased at six month intervals at 85% of the lower of the fair market +value on the first or the last day of each six month period. Employees could purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2003 and 2004 employees purchased 15.2 million +and 16.7 million shares at average prices of $22.56, and $22.74 per share. Savings +Plan. We have a savings plan in the United States, that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up +to 50% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all +plans were $118 million, $141 million, and $154 million in fiscal years 2003, 2004, and 2005. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. +Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock. Stock Plans. In fiscal year 2004, we began granting employees stock awards instead of stock options. The stock award program offers employees the opportunity to earn shares of our stock over +time, rather than options that give employees the right to purchase stock at a set price. We also completed an employee stock option transfer program in the second quarter of fiscal year 2004 whereby employees could elect to transfer all of their +vested and unvested stock options with a strike price of $33 or higher (“eligible options”) to JPMorgan. The unvested eligible options that were transferred to JPMorgan became vested upon the transfer. Under the terms of the program, JPMorgan paid us $382 million for the 345 million options transferred. We made an initial payment of $219 million to participating +employees for the transferred options, with a remaining portion to be paid in one or more payments that are subject to participating employees’ continued employment over the two or three years following the transfer. The options that were +transferred to JPMorgan resulted in stock-based compensation expense of $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) which was recorded in the second quarter of fiscal year 2004. The contingent payments applicable to eligible +options that are subject to continued employment of participating employees will be recognized as compensation expense over the vesting period of the contingent payments. The stock option transfer program also resulted in a decrease to our long-term deferred tax assets due to the excess of recorded compensation expense for these options over the related tax deduction reported on our tax return. +For fiscal year 2004, deferred tax assets were reduced by approximately $2.01 billion with an offsetting reduction in paid-in capital, reflecting the reduction of previously recorded deductions reported on our tax return in excess of stock based +compensation expense. A description of our stock plans follows. We have stock plans for directors and for officers, employees, consultants and +advisors. The plans provide for awards of stock options and stock awards. At June 30, 2005, an aggregate of 816 million shares were available for future grant under our stock plans. Our plans under which awards may be issued do not contain separate +limitations on the number of stock awards; all 816 million shares remaining available for grant at June 30, 2005 could be awarded as stock awards. In addition, awards that expire or are cancelled without delivery of shares generally become available +for issuance under the plans. The options transferred to JPMorgan have been removed from our plans; any options transferred to JPMorgan that expire without being exercised will not become available for grant under any of our plans. On November 9, 2004, our shareholders approved amendments to the stock plans that allowed our Board of Directors to adjust eligible options, unvested stock awards, +and shared performance stock awards to maintain their pre-dividend value after the $3.00 special dividend. Additional awards were granted for options, stock awards, and shared performance stock awards by the ratio of post- and pre-special dividend +stock price as of the ex-dividend date. PAGE 59 Table of Contents Part II Item 8 Strike prices for options were decreased by the same ratio. Stock-based compensation was not affected by this adjustment. As a result of this approval and payment of +the $3.00 special dividend on December 2, 2004, an adjustment to the prices and number of shares of existing awards was made resulting in a total of 96 million options and 6.7 million stock awards being issued to adjust the outstanding awards. In +addition, the target shared performance stock awards were increased by 3.5 million shares. Stock Awards and Shared Performance Stock Awards. Stock awards are grants that entitle the holder to shares of common stock as the award vests. Our stock awards generally vest ratably over a five-year period. Shared Performance Stock Awards are a form of stock award in which the number of shares ultimately received depends on our performance against +specified performance targets. The performance period is July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive officers). At the end of the performance period, the number of shares of stock and stock awards +issued will be determined by adjusting upward or downward from the target in a range between 33% and 150% (0% to 150% for certain executive officers). The final performance percentage on which the payout will be based, considering performance +metrics established for the performance period, will be determined by the Board of Directors or a committee of the board in its sole discretion. Shares of stock will be issued following the end of the performance period and as the stock awards vest +ratably over the following two years. Because these awards cover a three-year period, Shared Performance Stock Awards will only be awarded in fiscal year 2005 and 2006 to newly hired and promoted employees eligible to receive Shared Performance +Stock Awards. Stock Awards and Shared Performance Stock Awards are amortized over the vesting period (generally 5 years) using the straight line +method. The following activity has occurred under our existing plans: (share amounts in millions) Year Ended June 30 2004 2005 Stock awards Beginning balance 3.9 34.4 Granted 32.6 41.0 Special dividend adjustment – 6.7 Vested (.8 ) (7.3 ) Cancelled (1.3 ) (3.5 ) Ending balance 34.4 71.3 Weighted-average fair value per share for shares granted during the year* $ 24.09 $ 24.03 Shared performance stock awards Beginning balance – 30.5 Granted 31.7 3.7 Special dividend adjustment – 3.5 Vested – – Cancelled (1.2 ) (2.4 ) Ending balance 30.5 35.3 Weighted-average fair value per share for shares granted during the year* $ 23.62 $ 24.35 * Adjusted for additional awards granted for the $3.00 special dividend. Stock Options. Nonqualified stock options have been granted to our directors under our non-employee director stock plans. Nonqualified and incentive +stock options have been granted to our officers and employees under our employee stock plans. Options granted before 1995 generally vest over four and one-half years and expire ten years from the date of grant. Options granted between 1995 and 2001 +generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options granted +after 2001 vest over four and one-half years and expire ten years from the date of grant. At June 30, 2005, stock options for 662 million shares were vested. PAGE 60 Table of Contents Part II Item 8 The weighted average Black-Scholes value of options +granted under the stock plans during fiscal year 2003 and 2004 was $12.08 and $10.13, respectively. No stock options were granted in fiscal 2005. The fair value of each option grant is estimated on the date of grant using the Black-Scholes +option-pricing model with the following weighted average assumptions used for grants: Year Ended June 30 2003 2004 Weighted average expected life in years 7 7 Dividend per share $ 0.08 $ 0.16 Volatility 42.0 % 29.5 % Risk-free interest rate 3.9 % 4.1 % Employee stock options outstanding are as +follows: (In millions, except per share amounts) Price per Share Shares Range Weighted average Balance, June 30, 2002 1,604 $ 0.40 – $59.57 $ 26.88 Granted 254 21.42 –   29.12 24.27 Exercised (234 ) 0.51 –   28.22 6.89 Canceled/Forfeited (75 ) 2.13 –   59.56 34.33 Balance, June 30, 2003 1,549 $ 0.40 – $59.56 $ 29.30 Granted 2 25.46 –   29.96 26.76 Exercised (198 ) 0.51 –   29.38 12.21 Stock Option Transfer Program (345 ) 33.03 –   59.56 38.70 Canceled/Forfeited (59 ) 2.31 –   58.28 31.29 Balance, June 30, 2004 949 $ 0.40 – $59.56 $ 29.26 Special Dividend Adjustment 96 0.36 –   53.61 26.68 Granted – – – Exercised (138 ) 3.39 –   29.56 20.42 Canceled/Forfeited (43 ) 14.29 –   58.28 28.89 Balance, June 30, 2005 864 $ 0.36 – $59.56 $ 27.41 For various price ranges, weighted average +characteristics of outstanding employee stock options at June 30, 2005 are as follows: (In millions, except per share amounts and years) Outstanding options Exercisable options Range of exercise prices Shares Remaining life (years) Weighted average price Shares Weighted average price $  0.36 – $15.00 24 1.5 $ 8.81 24 $ 8.81 15.01 –    25.00 276 6.56 $ 22.15 136 $ 22.31 25.01 –    33.00 430 4.64 $ 27.88 369 $ 28.10 33.01 –    41.00 125 3.22 $ 39.42 124 $ 39.43 41.01 –    59.56 9 2.58 $ 44.78 9 $ 44.78 864 662 As of June 30, 2005, 345 million +transferred options to JP Morgan remained outstanding and are excluded from the amounts noted as employee options outstanding in the tables above. See Note 12. In addition, the tables above include in the total options outstanding 4.3 million +options outstanding that were granted in conjunction with PAGE 61 Table of Contents Part II Item 8 corporate acquisitions. These options are included in the option totals; however, they are excluded from the exercise price ranges presented. These options had an +exercise price range of $0.00 to $170.87 and a weighted average exercise price of $13.68. NOTE 15    EARNINGS PER SHARE Basic +earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the +effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic +and diluted earnings per share are as follows: (In millions, except earnings per share) Year Ended June 30 2003 2004 2005 Net income available for common shareholders (A) $ 7,531 $ 8,168 $ 12,254 Weighted average outstanding shares of common stock (B) 10,723 10,803 10,839 Dilutive effect of employee stock options and awards 159 91 67 Common stock and common stock equivalents (C) 10,882 10,894 10,906 Earnings per share: Basic (A/B) $ 0.70 $ 0.76 $ 1.13 Diluted (A/C) $ 0.69 $ 0.75 $ 1.12 For the years ended June 30, +2003, 2004, and 2005, 1.09 billion, 1.2 billion and 854 million shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than or +equal to the average price of the common shares, and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2005, 25.24 million shared performance stock awards, out of the 35.3 million targeted amount outstanding, have +been excluded from the calculation of diluted earnings per share because the number of shares ultimately issued is contingent on our performance against metrics established for the performance period, as discussed in Note 14 – Employee Stock +and Savings Plans. NOTE 16    COMMITMENTS AND +GUARANTEES We have operating leases for most U.S. and international sales and +support offices and certain equipment. Rental expense for operating leases was $290 million, $331 million, and $299 million in fiscal years 2003, 2004, and 2005, respectively. Future minimum rental commitments under noncancellable leases are as +follows: (In millions) Year Ended June 30 Amount 2006 $    230 2007 204 2008 167 2009 122 2010 and thereafter 310 $1,033 We have committed $152 million for constructing +new buildings. As of June 30, 2004, we had guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of +Jupiter Telecommunication, Ltd., a Japanese cable company. The total amount of these guarantees was approximately $51 million. Effective December 21, 2004, the unconditional guarantees were terminated. PAGE 62 Table of Contents Part II Item 8 In connection with various operating leases, we issued +residual value guarantees, which provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of +the property and an agreed value. As of June 30, 2005, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment +obligation and therefore no liability to us currently exists. We provide indemnifications of varying scope and size to certain customers against +claims of intellectual property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations to our volume license resellers in case the +resellers fail to collect from the end user. Due to the nature of the indemnification provided to our resellers, we can not estimate the fair value, nor determine the total nominal amount of the indemnification. We evaluate estimated losses for such +indemnifications under SFAS No. 5, Accounting for Contingencies , as interpreted by FIN 45. We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To +date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our financial statements. Our product warranty accrual reflects management’s best estimate of our probable liability under its product warranties (primarily relating to the Xbox +console). We determine the warranty accrual based on known product failures (if any), historical experience, and other currently available evidence. Our warranty accrual totals $14 million as of June 30, 2005. There has been no significant activity +impacting the results of operations for any period presented. NOTE +17    CONTINGENCIES Government competition law +matters. On March 25, 2004, the European Commission announced a decision in its competition law investigation of Microsoft. The Commission concluded that we infringed European competition law by refusing to provide our +competitors with licenses to certain protocol technology in the Windows server operating systems and by including streaming media playback functionality in Windows desktop operating systems. The Commission ordered us to make the relevant licenses to +our technology available to our competitors and to develop and make available a version of the Windows desktop operating system that does not include specified software relating to media playback. The decision also imposed a fine of € 497 million, which resulted in a charge in the third quarter of fiscal year 2004 of € 497 million ($605 million). We filed an appeal of the decision to the Court of First Instance on June 6, 2004. On December 22, 2004, the Court ordered that we must +comply with the decision pending review on appeal and we are taking steps to ensure we are in compliance. The hearing date for the appeal is expected to be determined later in calendar year 2005. We continue to contest the conclusion that European +competition law was infringed and will defend our position vigorously. The Korean Fair Trade Commission (KFTC) is investigating whether we have violated Korean competition law by including Windows Media Player technologies in Windows, by including +Windows Messenger in Windows, or by distributing Windows Media Services as an optional component of Windows Server. Hearings on this issue before the KFTC began on July 13, 2005, continued on August 23, 2005, and may be extended into the fall of +2005. In other ongoing investigations, various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, and security issues. Antitrust, unfair competition, and overcharge class action lawsuits. A +large number of antitrust and unfair competition class action lawsuits have been filed against us in various state and federal courts on behalf of variously defined classes of direct and indirect purchasers of our PC operating system and certain +software applications products. The federal cases have been consolidated in the U.S. District Court for Maryland. These cases allege that we competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software +applications, and they seek to recover alleged overcharges for these products. To date, courts have dismissed all claims for damages in cases brought against us by indirect purchasers under federal law and in 17 states. Nine of those state court +decisions have been affirmed on appeal. Appeals of one of those state rulings is pending. There was no appeal in four states. Claims under federal law brought on behalf of foreign purchasers have been dismissed by the U.S. District Court in Maryland +as have all claims brought on behalf of consumers seeking injunctive relief under federal law. The ruling on the injunctive relief and the ruling dismissing the federal claims of indirect purchasers are currently on appeal to the United States Court +of Appeals for the Fourth Circuit, as is a ruling denying certification of certain proposed classes of U.S. direct purchasers. Courts in eleven states have ruled that indirect PAGE 63 Table of Contents Part II Item 8 purchaser cases may proceed as class actions, while courts in two states have denied class certification. In 2003, we reached an agreement with counsel for the +California plaintiffs to settle all claims in 27 consolidated cases in that state. Under the proposed settlement, class members will be able to obtain vouchers that entitle the class members to be reimbursed up to the face value of their vouchers +for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers issued will depend on the number of class members who make a claim and are issued vouchers. Two-thirds of the value of vouchers unissued +or unredeemed by class members will be made available to certain schools in California in the form of vouchers that also may be redeemed for cash against purchases of a wide variety of platform-neutral computer hardware, software, and related +services. Since the beginning of 2003, we also reached similar agreements to settle all claims in a number of other states. The proposed settlements in these states are structured similarly to the California settlement, except that, among other +differences, one-half of the value of vouchers unissued to class members will be made available to certain schools in the relevant states. The maximum value of vouchers to be issued in these settlements, including the California settlement, is +approximately $1.9 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools who are issued and redeem vouchers. The settlements in Arizona, California, the District of +Columbia, Florida, Kansas, Massachusetts, Minnesota, Montana, New Mexico, North Carolina, North Dakota, South Dakota, Tennessee, Vermont and West Virginia have received final court approval. The proposed settlement in Nebraska has received +preliminary approval by the court in those states, but still requires final approval. We estimate the total cost to resolve all of these cases will range between $1.2 billion and $1.5 billion, with the actual cost dependent upon many unknown factors +such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the +claims process. In accordance with SFAS No. 5, Accounting for Contingencie s, and FASB Interpretation (FIN) 14, Reasonable Estimation of the Amount of a Loss , at June 30, 2005, we have recorded a liability related to these claims of +approximately $1.1 billion, net of payments to date for administrative expenses and legal fees. Other antitrust litigation and claims. On August 27, 2004, the City and County of San Francisco, the City of Los Angeles, and Los Angeles, San Mateo, Contra Costa and Santa Clara Counties filed a putative class +action against us in San Francisco Superior Court. The action was brought on behalf of all governmental entities, agencies and political subdivisions of the State of California who indirectly purchased our operating system or word processing and +spreadsheet software during the period from February 18, 1995 to the date of trial in the action. The plaintiffs seek treble damages under California’s Cartwright Act and disgorgement of unlawful profits under its Unfair Competition Act +resulting from our alleged combinations to restrain trade, deny competition, and monopolize the world markets for PC operating systems and word processing and spreadsheet applications (and productivity suites including these applications). We were +served with the complaint on August 30, 2004 and we removed the case to the U.S. District Court for Maryland. Our motion to dismiss the complaint was granted in its entirety on April 18, 2005 with leave to file an amended complaint alleging claims +under the Cartwright Act based on conduct within the four-year statute of limitation the court ruled applies to the plaintiffs’ claims. Plaintiffs also may seek to appeal the court’s decision. On December 18, 2003, RealNetworks, Inc. filed suit against us alleging violations of federal and state antitrust and unfair competition laws. The alleged +violations relate to streaming media features of Windows and related technologies. RealNetworks seeks damages and injunctive relief, including a permanent injunction requiring us to offer a version of Windows products with no streaming media +features. We deny the allegations and will vigorously defend the action. RealNetworks filed the case in federal court in San Jose, California. It has been consolidated for pretrial purposes with other cases pending in the U.S. District Court for +Maryland. On November 12, 2004, Novell, Inc. filed a complaint in the U.S. District Court for in Utah asserting antitrust and unfair competition +claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. On June 10, 2005, the trial court granted our motion to dismiss four of six claims of the +complaint. The remaining two claims were not dismissed and litigation has proceeded on those claims. We are seeking leave to appeal the decision not to dismiss those claims. In addition, we have been notified of additional antitrust damage claims by +several competitors and several licensees of our products. On July 1, 2005, we announced a settlement with IBM resolving claims asserted by IBM that +arose from the circumstances of United States v. Microsoft and findings of fact that identified IBM as having been impacted in its business by practices on which the U. S. District Court ruled against us, and claims related to IBM’s OS/2 +and SmartSuite businesses. Under the agreement, we paid IBM $775 million and extended a $75 million credit for IBM’s internal deployment of our software. IBM released all antitrust claims against us based on past conduct except for PAGE 64 Table of Contents Part II Item 8 claims related to its server business as to which IBM will not sue us for at least two years. The costs related to this settlement were accrued in other current +liabilities as of June 30, 2005. In addition to the IBM matter, as of June 30, 2005, we have recorded a liability of $455 million for the foregoing +other antitrust lawsuits and claims. While we intend to vigorously defend those matters, there exists the possibility of adverse outcomes which we estimate could be up to $400 million in aggregate beyond recorded amounts. Patent cases. We are a defendant in more than 35 patent infringement +cases that we are defending vigorously. In the case of Eolas Technologies, Inc. and University of California v. Microsoft , filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs alleged +infringement by the browser functionality of Windows. On August 11, 2003, the jury awarded the plaintiffs approximately $520 million in damages for infringement from the date the plaintiffs’ patent was issued through September 2001. The +plaintiffs are seeking an equitable accounting for damages from September 2001 to the present. On January 14, 2004, the trial court entered final judgment of $565 million, including post-trial interest of $45 million, and entered an injunction +against distribution of any new infringing products, but stayed execution of the judgment and the injunction pending our appeal. We appealed and on March 2, 2005 the Court of Appeals for the Federal Circuit reversed the decision and vacated the +judgment, ruling that the trial court had erred in excluding certain previous art evidence and ruling as a matter of law on other evidence. The appellate court also reversed the trial court’s decision that the inventors had not engaged in +inequitable conduct by failing to reveal material previous art while obtaining the patent. In October 2003, the U.S. Patent Office initiated a Director-ordered re-examination of the Eolas patent. On February 26, 2004, the Patent Office issued an +Office Action rejecting the claims of the Eolas patent. We believe the total cost to resolve this case will not be material to our financial position or results of operations. The actual costs are dependent upon many unknown factors such as the +events of a retrial of the plaintiff’s claims. In Research Corporation Technologies, Inc. v. Microsoft , filed in U.S. District Court for the District of Arizona on December 21, 2001, the plaintiff has asserted two patents related to +half-toning, which it believes are infringed by certain printing functionality allegedly present in different versions of Windows. Plaintiff seeks an unspecified amount of damages in the form of “reasonable royalties” on Microsoft’s +Windows products. Microsoft’s defense based on the plaintiff’s inequitable conduct was tried on August 11 and 12, 2005. The remaining issues in the case may be scheduled for trial in the second half of calendar year 2005. In TVI v. +Microsoft , filed in U.S. District Court for the Northern District of California on May 16, 2002, the plaintiff alleges infringement by the Autoplay feature of Windows. The case is scheduled for trial in the second half of 2005. In Microsoft +v. Lucent , filed in the U.S. District Court in San Diego on April 8, 2003, we are seeking a declaratory judgment that we do not infringe any valid patent among a number of patents Lucent has been asserting against computer manufacturers who sell +computers with Microsoft software pre-installed. No trial date has been set. In Arendi USA, Inc. and Arendi Holding Limited v. Microsoft , filed in U.S. District Court for the District of Rhode Island on July 31, 2002, the plaintiffs alleged +infringement of one patent by certain Smart Tags features in Microsoft Office XP and Office 2003. Following trial in September 2004 the jury returned a verdict for us, finding that we did not infringe the patents. The plaintiffs have appealed. In Amado v. Microsoft , filed in U.S. District Court for the Central District of California on March 7, 2003, the plaintiff has accused the link table functionality available in Microsoft Access when used with Microsoft Excel. After a jury trial, +we were found to infringe one claim of the patent and damages were awarded in the amount of $8.9 million. The judge later found for us on its defense of laches, which reduced the damages award to $5.9 million. The court also imposed an injunction +against further distribution of the accused feature as part of Microsoft Access, but stayed the injunction pending appellate review. We have appealed. In BTG v. Microsoft , filed in U.S. District Court for the Northern District of California +on July 2, 2004, the plaintiff has accused our Windows and Office products of infringing several patents. The patents are directed to “update” technology, active desktop concepts and off-line browsing. No trial date has been set. In AVG +v. Microsoft , the plaintiff filed a number of cases in the Eastern District of Texas against us, our major OEMs, other computer game console makers (Sony and Nintendo), and computer game publishers on August 23, 2004. The case concerns graphics +functionality in Windows and Xbox. The first case against us is scheduled for trial in January 2006. Adverse outcomes in some or all of the pending patent cases may result in significant monetary damages or injunctive relief against us, adversely +affecting distribution of our operating system or application products. The risks associated with an adverse decision may result in material settlements. Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. While +management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position or results of operations, these matters are subject to PAGE 65 Table of Contents Part II Item 8 inherent uncertainties and management’s view of them may change in the future. Were an unfavorable final outcome to occur, there exists the possibility of a +material adverse impact on our financial position and on the results of operations for the period in which the effect becomes reasonably estimable. As of June 30, 2005, we had accrued liabilities totaling $1.7 billion in other current liabilities and $961 million in other long-term liabilities for all of the above matters. NOTE 18    SEGMENT INFORMATION Segment revenue and operating income/(loss) is as follows: (In millions) Year Ended June 30 2003 2004 2005 Revenue Client $ 10,304 $ 11,283 $ 12,048 Server and Tools 6,786 8,007 9,143 Information Worker 9,636 10,895 11,523 Microsoft Business Solutions 641 753 793 MSN 2,396 2,444 2,411 Mobile and Embedded Devices 153 239 334 Home and Entertainment 2,779 2,870 3,211 Reconciling amounts (508 ) 344 325 Consolidated $ 32,187 $ 36,835 $ 39,788 Operating Income/(Loss) Client $ 8,306 $ 8,975 $ 9,396 Server and Tools 1,879 2,302 2,888 Information Worker 7,500 8,112 8,616 Microsoft Business Solutions (143 ) (115 ) (163 ) MSN (384 ) 383 469 Mobile and Embedded Devices (162 ) (98 ) (19 ) Home and Entertainment (938 ) (894 ) (359 ) Reconciling amounts (6,513 ) (9,631 ) (6,267 ) Consolidated $ 9,545 $ 9,034 $ 14,561 SFAS No. 131, Disclosures about Segments of +an Enterprise and Related Information , establishes standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon +internal accounting methods. Our financial reporting systems present various data for management to run the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segments are designed to +allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the +chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. The types of products and services provided by each +segment are summarized below: Client – Windows XP Professional and +Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems. Server and Tools – Server software licenses and client access licenses (CALs) for Windows Server, Microsoft SQL Server, Exchange Server, and other server products. Also includes developer tools, training, +certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. PAGE 66 Table of Contents Part II Item 8 Information Worker – Microsoft Office, Microsoft +Project, Microsoft Visio, SharePoint Portal Server CALs, other information worker products including Microsoft LiveMeeting and OneNote, an allocation for Server CALs, and professional product support services. Microsoft Business Solutions – Microsoft Great Plains, Microsoft Navision, +Microsoft Axapta, Microsoft Solomon, Microsoft CRM, Microsoft Retail Management System, Microsoft Point of Sale and other business applications and services including the Microsoft Partner Program. Microsoft Business Solutions also develops +Microsoft Office Small Business Accounting and Business Contact Manager for Outlook, which are marketed by Information Worker. MSN – Personal communication services, such as e-mail and instant messaging, and online information offerings, such as MSN Search and the MSN portals and +channels, and online paid services including MSN Internet Access, MSN Premium Web Services, and MSN Mobile service. Mobile and Embedded Devices – Windows Mobile software, Windows Embedded operating systems, MapPoint, and Windows Automotive. Home and Entertainment – Microsoft Xbox video game console system, PC games, +mice, keyboards, Mac Office, and TV platform products. Because of our +integrated business structure, operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. +Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, +sales organizations, and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to +separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Reconciling +amounts include adjustments to conform with U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement +classification, quarter end cut off timing, and accelerated amortization for depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity +including certain legal settlements and accruals for legal contingencies. Significant reconciling items are as follows: (In millions) Year Ended June 30 2003 2004 2005 Operating income reconciling amounts: Legal settlements and contingent liabilities $ (1,079 ) $ (2,832 ) $ (2,312 ) Stock-based compensation expense (3,749 ) (4,516 ) (1,042 ) Revenue reconciling amounts (508 ) 344 325 Corporate-level expenses (1) (1,980 ) (3,037 ) (3,405 ) Other 803 410 167 Total $ (6,513 ) $ (9,631 ) $ (6,267 ) (1) Corporate-level expenses exclude legal settlements and contingent liabilities, stock-based compensation expense, and revenue reconciling amounts presented separately in those line items. Sales to Dell and its subsidiaries in the aggregate +accounted for approximately 10% of total fiscal year 2004 and 2005 revenue. These sales were made primarily through our OEM and volume licensing channels and were included in all operating segments. No single customer accounted for more than 10% of +revenue in 2003. PAGE 67 Table of Contents Part II Item 8 Revenue, classified by the major geographic areas in which we operate, is as follows: (In millions) Year Ended June 30 2003 2004 2005 United States (1) $ 22,077 $ 25,046 $ 26,949 Other countries 10,110 11,789 12,839 Total $ 32,187 $ 36,835 $ 39,788 (1) Includes shipments to customers in the United States, licensing to certain OEMs and multinational organizations, and exports of finished goods, primarily to Latin America and Canada. Long-lived assets, classified by the geographic location of the +controlling statutory company in which that company operates, are as follows: (In millions) Year Ended June 30 2004 2005 United States $ 5,365 $ 5,506 Other countries 645 648 Total $ 6,010 $ 6,154 PAGE 68 Table of Contents Part II Item 8 QUARTERLY INFORMATION (In millions, except per share amounts) (Unaudited) Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Total Fiscal year 2003 Revenue $ 7,746 $ 8,541 $ 7,835 $ 8,065 $ 32,187 Gross profit 6,402 6,404 6,561 6,761 26,128 Net income 2,041 1,865 2,142 1,483 (1) 7,531 Basic earnings per share 0.19 0.17 0.20 0.14 0.70 Diluted earnings per share 0.19 0.17 0.20 0.14 0.69 Fiscal year 2004 Revenue $ 8,215 $ 10,153 $ 9,175 $ 9,292 $ 36,835 Gross profit 6,735 7,809 7,764 7,811 30,119 Net income 2,614 1,549 (2) 1,315 (3) 2,690 8,168 Basic earnings per share 0.24 0.14 0.12 0.25 0.76 Diluted earnings per share 0.24 0.14 0.12 0.25 0.75 Fiscal year 2005 Revenue $ 9,189 $ 10,818 $ 9,620 $ 10,161 $ 39,788 Gross profit 7,720 8,896 8,221 8,751 33,588 Net income 2,528 (4) 3,463 2,563 (5) 3,700 (6) 12,254 Basic earnings per share 0.23 0.32 0.24 0.34 1.13 Diluted earnings per share 0.23 0.32 0.23 0.34 1.12 (1) Includes charges totaling $750 million (pre-tax) related to the Time Warner settlement and $1.15 billion in impairments of investments. (2) Includes stock-based compensation charges totaling $2.2 billion for the employee stock option transfer program. (3) Includes charges totaling $2.53 billion (pre-tax) related to the Sun Microsystems Inc. settlement and a fine imposed by the European Commission. (4) Includes charges totaling $536 million (pre-tax) related to the settlement of certain litigation with Novell, Inc. (5) Includes charges totaling $768 million (pre-tax) related to the Gateway, Inc. and Burst.com settlements, Sun Microsystems, Inc., and additional charges related to anti-trust and certain other +matters. (6) Includes charges totaling $756 million (pre-tax) related to IBM and other matters. PAGE 69 Table of Contents Part II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of +Directors and Stockholders of Microsoft Corporation: We have audited the accompanying +consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2005 and 2004, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in +the period ended June 30, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and +perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An +audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and +subsidiaries as of June 30, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2005, in conformity with accounting principles generally accepted in the United States of +America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness +of the Company’s internal control over financial reporting as of June 30, 2005, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission, and our report dated August 23, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of +the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 23, 2005 PAGE 70 Table of Contents Part II Item 9, 9A ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A.    CONTROLS AND PROCEDURES Under +the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as +of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. There were no changes in our internal +control over financial reporting during the quarter ended June 30, 2005 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the +reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable +detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company +assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect on our financial statements would be prevented or +detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial +reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control +over financial reporting was effective as of June 30, 2005. Deloitte & Touche LLP has audited this assessment of our internal control over financial reporting; their report is included in Item 9A. PAGE 71 Table of Contents Part II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the +Board of Directors and Stockholders of Microsoft Corporation: We have audited +management’s assessment, included in the accompanying Report of Management on Internal Control over Financial Reporting, that Microsoft Corporation and subsidiaries (the “Company”) maintained effective internal control over financial +reporting as of June 30, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for +maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on +the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the +standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in +all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and +performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected +by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally +accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the +transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and +that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized +acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent +limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, +projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance +with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control +over financial reporting as of June 30, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2005, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, 2005 of the Company and our report dated August 23, 2005 expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 23, 2005 PAGE 72 Table of Contents Part II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B.    OTHER INFORMATION Not +applicable. PART III ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT A list of our executive officers and biographical information appears in Part I, Item 1 of this report. Information about our Directors may be found under the caption “Election of Directors and Management Information” +of our Proxy Statement for the Annual Meeting of Shareholders to be held November 9, 2005 (the “Proxy Statement”). That information is incorporated herein by reference. The information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by +reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies +to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/msft. If we +make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer or Chief Accounting Officer and Corporate +Controller, we will disclose the nature of such amendment or waiver on that website or in a report on Form 8-K. ITEM 11.    EXECUTIVE COMPENSATION The +information in the Proxy Statement set forth under the captions “Information Regarding Executive Officer Compensation” and “Information About the Board and its Committees – Director Compensation” is incorporated herein by +reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of +Principal Shareholders, Directors, and Management” is incorporated herein by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the captions “Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference. ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the heading “Fees Billed by Deloitte & Touche LLP” and is incorporated herein by reference. PAGE 73 Table of Contents Part IV Item 15 PART IV ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. +Financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included. (b) Exhibit Listing Exhibit Number Description 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation (1) 3.2 Bylaws of Microsoft Corporation (2) 4. Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank (3) 10.1* Microsoft Corporation 2001 Stock Plan (4) 10.2* Microsoft Corporation 1991 Stock Option Plan (4) 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors (4) 10.4* Microsoft Corporation Stock Option Plan for Non-Employee Directors (4) 10.5 Microsoft Corporation Stock Option Plan for Consultants and Advisors (4) 10.6* Microsoft Corporation 2003 Employee Stock Purchase Plan (5) 10.7* Microsoft Corporation 1998 Stock Option Gain and Bonus Deferral Program (5) 10.8* Form of Stock Award Agreement (5) 10.9* Form of Stock Award Agreement for Non-Employee Directors (5) 10.10* Form of Shared Performance Stock Award Agreement for the January 1, 2004 to June 30, 2006 performance period (5) 10.11* Form of Shared Performance Stock Award Agreement for the July 1, 2003 to June 30, 2006 performance period (5) 10.12* Form of Stock Option Agreement (5) 10.13* Form of Stock Option Agreement for Non-Employee Directors (5) 10.14 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of +Washington as trustee) (6) 10.15 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee (7) 10.16 Form of Indemnification Agreement (6) 21. Subsidiaries of Registrant 23.1 Consent of Independent Registered Public Accounting Firm 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (1) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2002. (2) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended March 31, 2003. (3) Incorporated by reference to Quarterly Report on Form 10-Q for the Quarterly Period Ended December 31, 2003. (4) Incorporated by reference to Current Report on Form 8-K dated November 15, 2004. (5) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2004. (6) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2002. (7) Incorporated by reference to Annual Report on Form 10-K for the Fiscal Year Ended June 30, 2003. * Indicates a management contract or compensatory plan or arrangement. PAGE 74 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) +of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 25, 2005. M ICROSOFT C ORPORATION By: /s/    C HRISTOPHER P. L IDDELL Christopher P. Liddell Senior Vice President; Chief Financial Officer Pursuant to the requirements of the +Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on August 25, 2005 Signature Title /s/    W ILLIAM H. G ATES III William H. Gates III Chairman and Chief Software +Architect /s/    S TEVEN A. B ALLMER Steven A. Ballmer Director and Chief Executive Officer /s/    J AMES I. C ASH , +J R . James I. Cash, Jr. Director /s/    D INA D UBLON Dina Dublon Director /s/    R AYMOND V. G ILMARTIN Raymond V. Gilmartin Director /s/    A NN M C L AUGHLIN K OROLOGOS Ann McLaughlin Korologos Director /s/    D AVID F. M ARQUARDT David F. Marquardt Director /s/    C HARLES H. N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/    J ON A. S HIRLEY Jon A. Shirley Director /s/    C HRISTOPHER P. L IDDELL Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer (Principal Financial Officer) /s/    J. S COTT D I V ALERIO J. Scott Di Valerio Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) PAGE 75 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-06-180008/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-06-180008/full-submission.txt new file mode 100644 index 0000000..d83b10f --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-06-180008/full-submission.txt @@ -0,0 +1,1054 @@ +Table of Contents United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2006 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE +TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 Securities registered pursuant to +Section 12(b) of the Act: COMMON STOCK Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required +to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the +Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 +days.    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨ No x As of +December 31, 2005, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $233,926,876,964 based on the closing sale price as reported on the NASDAQ National Market System. As of +August 18, 2006, there were 9,969,991,800 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 14, 2006 are +incorporated by reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2006 INDEX PART I Item 1. Business 3 Executive Officers of the Registrant 11 Item 1A. Risk Factors 12 Item 1B. Unresolved Staff Comments 18 Item 2. Properties 18 Item 3. Legal Proceedings 18 Item 4. Submission of Matters to a Vote of Security Holders 18 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 19 Item 6. Selected Financial Data 20 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 21 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 41 Item 8. Financial Statements and Supplementary Data 43 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 74 Item 9A. Controls and Procedures 74 Report of Management on Internal Control over Financial Reporting 74 Report of Independent Registered Public Accounting Firm 75 Item 9B. Other Information 76 PART III Item 10. Directors and Executive Officers of the Registrant 76 Item 11. Executive Compensation 76 Item 12. Security Ownership of Certain Beneficial Owners and Management 76 Item 13. Certain Relationships and Related Transactions 76 Item 14. Principal Accountant Fees and Services 76 PART IV Item 15. Exhibits and Financial Statement Schedules 77 Signatures 79 PAGE 2 Table of Contents Part I Item 1 Special Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, +objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the +Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” +“estimate,” “intend,” “strategy,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar +expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of +these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” (refer to Item 1A). We undertake no +obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. PART I ITEM 1.    BUSINESS GENERAL Our mission is to enable people and businesses throughout the world to realize their full potential. We work to achieve our mission through technology that transforms the way people work, play, and communicate. Since our +founding in 1975, we have been a leader in this transformation. We develop and market software, services, and solutions that we believe deliver new opportunity, convenience, and value to people’s lives. We do business throughout the world and +have offices in more than 100 countries. We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software +products for many computing devices. Our software products include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; +business solution applications; high-performance computing applications, and software development tools. We provide consulting and product support services, and we train and certify computer system integrators and developers. We sell the Xbox 360 +video game console and games, PC games, and peripherals. Online offerings and information are delivered through our Windows Live, Office Live, and MSN portals and channels. We also research and develop advanced technologies for future software products. We believe that delivering breakthrough innovation and high-value solutions through +our integrated software platform is the key to meeting our customers’ needs and to our future growth. We believe that over the past few years we have laid the foundation for long-term growth by delivering innovative new products, creating +opportunities for partners, improving customer satisfaction, putting many of our most significant legal challenges behind us, and improving our internal processes. Our focus is to build on this foundation by continuing to innovate on our integrated +software platform, delivering compelling value propositions to customers, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability. Our research and +development facilities are located primarily in Redmond, Washington. We also have smaller research facilities in other parts of the United States and around the world, including, but not limited to, China, Denmark, England, India, Ireland, and +Israel. OPERATING SEGMENTS Our segments provide +management with a comprehensive financial view of our key businesses. The segments provide a framework for the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and for the timely and +rational allocation of development, sales, marketing, and services resources within businesses. The segments also help focus strategic planning efforts on key objectives and initiatives across our businesses. PAGE 3 Table of Contents Part I Item 1 Due to our integrated business structure, operating +costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products included in each segment. Inter-segment cost commissions are estimated +by management and used to compensate or charge each segment for such shared costs and to motivate shared effort. Segments should not be viewed as discrete or easily separable businesses. For the fiscal years covered by this filing, our seven segments were: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and +Embedded Devices; and Home and Entertainment. See Note 18 – Segment Information of the Notes to Financial Statements for financial information regarding segment reporting. On July 17, 2006, we announced a change in our operating segments +reflecting the culmination of the business realignment announced in September 2005. These changes will be effective for fiscal year 2007; the seven segments discussed in this section are presented in the way we internally managed and monitored +performance at the business group level in fiscal year 2006, 2005, and 2004. Client Client has overall responsibility for the technical architecture, engineering and product delivery of our Windows product family, and is also responsible for our relationships +with personal computer manufacturers, including multinational and regional original equipment manufacturers (“OEMs”). The segment includes sales and marketing expenses for the Windows client operating system and product development efforts +for the Windows platform. Client revenue growth is correlated with the growth of purchases of personal computers from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The next generation of the Windows operating system, Windows Vista, is under development. This development phase represents a major investment that +we expect will result in a significantly more manageable and powerful PC operating system than previously released by Microsoft. Windows Vista will include advances in security, digital media, user interfaces, and other areas that will enhance the +user and developer experience. Products: Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and +other standard Windows operating systems. Competition Client faces +strong competition from well-established companies with differing approaches to the PC market. Competing commercial software products, including variants of Unix, are supplied by competitors such as Apple Computer, Hewlett-Packard, IBM, and Sun +Microsystems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained some acceptance as competitive pressures lead PC OEMs to reduce costs. The Windows operating system +also faces competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer software that competes with the Internet Explorer Web browsing capabilities of +Windows products. Apple Computer, Real Networks, and others compete with Windows Media Player. Our operating system products compete effectively by delivering innovative software, a familiar, easy-to-use interface, compatibility with a broad range +of hardware and software applications, and the largest support network for any operating system. Server and Tools Server and Tools develops and markets Windows Server products, including Windows Server operating systems. Windows Server products are integrated server +infrastructure software that are designed to support end-to-end software applications and tools built on the Windows Server 2003 operating system. Windows Server products include the server platform, operations, security, applications and +collaboration software. The segment also builds standalone and software development lifecycle tools for software architects, developers, testers and project managers. We offer a broad range of consulting services and provide product support services. The segment also provides training and certification to developers and information technology professionals about our Server and PC platform +products. Server and Tools also includes the Enterprise Partner Group, which is responsible for sales, partner management and partner programs for medium and large organizations; and the Public Sector sales and marketing organization. PAGE 4 Table of Contents Part I Item 1 Approximately half of Server revenue comes from +multi-year licensing agreements, one third is purchased through fully packaged product and transactional volume licensing programs, and approximately 10% comes from licenses sold to OEMs. Approximately 15% of revenue comes from consulting and +product support services. Products and Services: Windows Server operating system; Microsoft SQL Server; Exchange +Server; Microsoft Consulting Services; product support services; Visual Studio; System Center products; Forefront security family of products; and Biz Talk Server, among others. Competition Our server operating system products face intense competition from a wide variety of server operating systems and server +applications, offered by companies with a variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Sun Microsystems offer their own variant of Unix preinstalled on server hardware. Nearly all +computer manufacturers offer server hardware for the Linux operating system. IBM’s endorsement of Linux has aided the acceptance of Linux as an alternative to Unix and Windows server operating systems. Linux’s competitive position has also +benefited from the large number of compatible applications now produced by many leading commercial software developers and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. We compete in the business of providing enterprise-wide computing solutions with several companies that provide solutions and middleware technology platforms. +IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for PC-based distributed client/server environments include CA, +IBM, and Oracle. Numerous commercial software vendors offer competing commercial software applications for connectivity (both Internet and intranet), +security, hosting, and e-business servers. System Center competes with BMC, CA, and IBM in the Management of IT infrastructures, while Forefront Security competes with McAfee, Symantec, and Trend Micro in protecting both client and server +applications. In addition, IBM has a large installed base of Lotus Notes and cc:Mail, both of which compete with our collaboration and e-mail products. Non-commercial software products, including the widely-deployed Apache Web Server, also compete +with our solutions. Our products for software developers compete against offerings from Adobe, BEA Systems, Borland, IBM, Oracle, Sun Microsystems, and other companies. We believe that our server products provide customers with advantages in +innovation, performance, total costs of ownership, and productivity, by delivering superior applications development tools and development environment, compatibility with a broad base of hardware and software applications, security, and +manageability. Information Worker Information Worker consists of the Microsoft Office system of programs, services, and software solutions designed to increase personal, team, and organization productivity. The Office system offerings generate over 85% of Information Worker +revenue. Revenue growth depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified messaging, and +business intelligence. Approximately 40% of Information Worker revenue has come from multi-year license agreements with large enterprises. Revenues +from these licenses generally depend upon the number of information workers in a licensed enterprise. Revenue from this category of agreements is therefore relatively independent of the number of PCs sold in a given year. Consequently, general +employment levels, particularly in North America and Europe, significantly affect Information Worker revenue. Approximately 40% of Information Worker revenue comes from new licenses acquired through fully packaged product and volume licensing +programs to individual consumers and enterprises of all sizes. Most of this revenue is sensitive to information technology budgets, which often depend on general economic conditions. The remaining approximately 20% of Information Worker revenue +comes from licenses to OEMs for new PCs and is affected by the level of PC shipments. The next wave of our flagship product, the 2007 Microsoft Office system, is currently under development. Products: Microsoft Office; Microsoft Project; Microsoft Visio; SharePoint Portal Server CAL; Microsoft Live Meeting; One Note; and +Office Communication Server. PAGE 5 Table of Contents Part I Item 1 Competition Competitors to the Microsoft Office system include many software application vendors such as Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Sun Microsystems, and local +application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have measurable installed bases with their office productivity products. Apple may distribute certain of their application software products with various +models of their PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red Hat, and Sun. +Corel’s suite and many local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs. In addition to traditional client-side applications, Web-based offerings such as AjaxWrite, gOffice, iNetOffice, +SimDesk, ThinkFree, wikiCalc, or other small projects competing with individual applications, can also provide an alternative to Microsoft Office system products. Google has announced spreadsheet and word processing applications as web-based +offerings and also provides an enterprise search offering that competes with SharePoint and our new enterprise search product. IBM has many different points of competition with Office system products with its Notes and Workplace offerings. As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in +enterprise content management, collaboration tools, unified messaging, and business intelligence. These competitors include WebEx, and a number of business intelligence vendors such as Business Objects, Cognos, and Hyperion. Microsoft Business Solutions Microsoft Business +Solutions is responsible for Microsoft Dynamics brand business applications for small and mid-size businesses, large organizations and divisions of global enterprises. It offers financial management, customer relationship management, supply chain +management, and analytics applications. Revenue is derived from software and services sales, with software sales representing a large majority of total revenue. Software revenues include both new software licenses and enhancement plans, which +provide customers with future software upgrades and on-line training over the period of the plan. The solutions are delivered through a worldwide network of channel partners and independent software vendors that provide services, additional related +software, and local support. Products: Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft +Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Small Business Accounting. Competition Our competition varies based upon the size and geographic location of the customer for whom we are competing. We compete with well-known +vendors such as Intuit and Sage in the market focused on providing solutions for small and mid-sized businesses. The market for large organizations and divisions of global enterprises continues to be intensely competitive with a small number of +primary vendors including Oracle and SAP. Additionally, these large enterprise-focused vendors are repositioning some of their business applications to focus on small and mid-sized businesses. We believe our products compete effectively with these +vendors based on our strategy of providing integrated, adaptable solutions that work like and with Microsoft technologies our customers already have. MSN MSN provides personal communications services, such as e-mail and instant messaging, and online information offerings such as MSN +Search, MapPoint, and the MSN portals and channels around the world. MSN also provides a variety of online paid offerings. MSN manages many of its own properties, including health, autos, and shopping. MSN also creates alliances with third parties +for many channels, including CareerBuilder.com, Expedia.com, Foxsports.com, Match.com, and MSNBC.com. MSN generates revenue primarily from +advertisers on MSN, from consumers and partners through subscriptions and transactions, and from MSN narrowband Internet access subscribers. In fiscal year 2006, we launched MSN adCenter – our internally developed advertising platform – in +certain international markets and throughout the U.S. where it now serves 100 percent of paid search traffic on our online properties. We believe MSN adCenter will enable us to increase both display and search advertising revenues by reducing our +reliance on third parties for delivering PAGE 6 Table of Contents Part I Item 1 ads. In fiscal year 2006, we announced Windows Live™, a set of Internet services and software designed to improve the users’ connected experience and we +released Windows Live Messenger to consumers in 58 countries. Products: MSN Search; MapPoint; MSN Internet Access; MSN +Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus); Windows Live; and MSN Mobile Services. Competition MSN competes with AOL, Google, Yahoo!, and a wide array of Web sites and portals that provide content and online offerings of all types +to end users. We compete with these organizations to provide advertising opportunities for merchants. MSN also competes for narrowband Internet access users with AOL, Earthlink, and other ISPs for dial-up internet access in the United States. Due to +the continuing trend of consumers migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline as we de-emphasize this portion of our business. The Internet advertising +industry has grown significantly over the past several years, and we anticipate that this trend will continue. Competitors are aggressively developing Internet offerings that seek to provide more effective ways of connecting advertisers with +audiences through enhanced functionality in communication services, improvements in information services such as Internet search, and improved advertising infrastructure and support services. We have developed our own algorithmic search engine to +provide end users with more relevant search results, a broader selection of content, and expanded search services. To support the growth of our advertising business, we also are investing in our communication services, technology, operations, and +sales efforts. We will continue to introduce new products and services, including the Windows Live set of services that are aimed at attracting additional users through improvements in the user online experience. We believe that we can compete +effectively across the breadth of our Internet services by providing users with software innovation in the form of information and communication services that help them find, discover, and experience what they want online and by providing merchants +with effective advertising results through improved systems and sales support. Mobile and Embedded Devices Mobile and Embedded Devices develops and markets products that extend the Windows platform to mobile devices such as PDAs and phones, and to embedded devices. Microsoft’s +vision for mobile devices is rooted in the convergence of the computing and wireless industries, which we believe creates new opportunities to improve communication and information access for customers. We see software as a key differentiator in +making smart devices and wireless data services valuable to customers through rich experiences such as mobile messaging, location-based services, media, and speech recognition. We are working closely with mobile operators and with hardware and +software partners to accelerate the development and availability of smart devices and services, and to provide a broad range of choices for customers. The segment is also responsible for managing our company-wide sales and customer relations with +device manufacturers and other communication-sector customers, which includes network service providers and media and entertainment companies. Windows Embedded is a suite of operating systems, tools, and technologies that are specifically designed +for today’s advanced embedded devices. Products: Windows Mobile software platform; Windows Embedded device +operating system; and Windows Automotive. Competition Windows Mobile +software faces substantial competition from Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system segment is highly fragmented with many competitive offerings. Key competitors include IBM, Wind +River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. The telematics market is also highly fragmented, with competitive offerings from IBM and automotive suppliers building on various +real-time operating system platforms from commercial Linux vendors, QNX Software Systems, Wind River, and others. We believe that our products compete effectively by providing a familiar development framework, which enables developers to easily +write and deploy innovative applications for mobile or embedded devices. We also compete by providing a flexible platform that allows customers and partners to build differentiated and profitable business models, and by providing end users with +benefits such as ease of use, personal productivity, and better information management and control. PAGE 7 Table of Contents Part I Item 1 Home and Entertainment Home and Entertainment is responsible for development, production, and marketing for the Xbox video game system, including consoles and accessories, third-party +games, games published under the Microsoft brand, and Xbox Live operations, research, and sales and support. In addition to Xbox, we offer several types of entertainment products, including PC software games, online games, and other devices. The +segment also leads the development efforts of our Consumer Productivity Experience Group (“CPxG”) which includes Microsoft’s line of consumer software and hardware products, such as the Encarta line of learning products and services, +application software for Macintosh computers, and Microsoft PC hardware products such as mice and keyboards. In addition, the segment carries out all retail sales and marketing for Microsoft Office and the Windows operating systems (for which it +receives an inter-segment commission), Xbox, PC games, and CPxG products. It also is responsible for the development, sales, and deployment of Microsoft’s TV platform products for the interactive television industry, including MSTV Foundation +Edition and Internet Protocol TV products. Products: Xbox 360; Xbox; Xbox Live; CPxG (consumer software and hardware +products); and IPTV. Competition The home and entertainment business is +highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by significant price competition. We +anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices on certain products. Our competitors vary in size from very small companies with limited resources to very large, +diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, quality and variety, timing of product releases, and effectiveness of distribution and marketing. Our Xbox hardware business competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for +video game consoles averages 5 to 7 years. We released Xbox 360, our next generation console in November 2005. Nintendo and Sony have also announced new versions of their game consoles, which have not been released. Success in the transition to the +next generation of consoles will depend on the availability of games for the console, providing exclusive game content that gamers seek, the computational power of the console, and the ability to create new revenue sources such as advertising and +downloadable content. We believe the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new developer tools, expanded revenue sources, and continued strong exclusive content +from our own game franchises such as Halo. In addition to competing against software published for non-Xbox platforms, our games business also +competes with numerous companies that we have licensed to develop and publish software for the Xbox consoles. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or +potential partners. Our MSTV business faces competition primarily from ad hoc solutions that address sub-segments of the TV delivery platform, but that do not provide end-to-end solutions for the network operator. OPERATIONS To serve the needs of customers around the world and to +improve the quality and usability of products in international markets, we “localize” many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, +and translating text. Our operational centers support all operations in their regions, including customer contract and order processing, credit and +collections, information processing and vendor management and logistics. The regional center in Ireland supports the EMEA region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, Puerto +Rico, Reno, and Redmond support North America and Latin America. We contract most of our manufacturing activities to third parties who produce the +Xbox, various retail software packaged products, and Microsoft hardware. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console includes certain key components that are supplied by a single +source. The central processing unit is purchased from IBM and the graphics chips and embedded dynamic random access memory chips for the graphics processing unit are purchased from Taiwan Semiconductor Manufacturing Company and NEC Corporation, +respectively. Although we have chosen to initially source these key Xbox 360 components from PAGE 8 Table of Contents Part I Item 1 a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the exceptions noted, we generally have the +ability to use other custom manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume discount +basis. PRODUCT DEVELOPMENT During fiscal years 2006, +2005, and 2004, research and development expense was $6.58 billion, $6.10 billion, and $7.74 billion, respectively. Those amounts represented 14.9%, 15.3%, and 21.0%, respectively, of revenue in each of those years. We plan to continue significant +investment in a broad range of research and product development. Most of our software products are developed internally. We also purchase technology, +license intellectual property rights, and oversee third-party development and localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our +products. Internal development allows us to maintain closer technical control over our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Generally, we also +create product documentation internally. We strive to obtain information at the earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide +application vendors with a range of resources and guidelines for development, training, and testing. Business and Product Development +Strategy. Innovation is a key factor affecting Microsoft’s growth. In fiscal year 2006, we received our 5,000 th patent. We continue our long-term commitment to research and development, including advanced work aimed at innovations in a wide spectrum of technologies: tools and platforms; communication, collaboration and expression; information +access and organization; entertainment; business and e-commerce; and devices. Through innovations in these areas, we expect to grow revenue via three principal strategies: • Strengthening core businesses. The Client, Server & Tools, and Information Worker segments remain our largest businesses and continue to grow as a +result of growth in personal computer and server shipments, software upgrades and growth in the market for business software and services. We believe the growth in our core businesses will be driven by our forthcoming innovations, including the +Windows Vista operating system, the 2007 Microsoft Office system, and Exchange Server 2007. We also expect these businesses to be impacted by expected growth in the world’s developing countries, as their economies develop and they adopt global +standards for intellectual property protection. In fiscal year 2006, nearly 60 million PCs were sold with pirated versions of Windows. Our Windows Genuine Advantage program and agreements with PC manufacturers in China are just two examples of +our commitment to protect our intellectual property. Meanwhile, new payment options like FlexGo, which enables people to finance their computer use on a pay-as-you-go basis, will help us reach new consumers in emerging markets. • Succeeding in adjacent businesses. In fiscal year 2007, we will deliver new products, services, and technologies that we believe will position us to take +advantage of new opportunities. One example is unified communications, which brings together telephony, email, instant messaging, mobile devices, and Web conferencing, in order to streamline the way workers communicate. We believe new enterprise +information management tools will help knowledge workers create, find, use, and share business information more quickly and more effectively. In addition, we’ll offer new security capabilities, improved management products, and new development +tools. We recently entered the high-performance computing business and we have new offerings and initiatives in industries such as life sciences and manufacturing. • Entering new markets. We believe new markets, such as online gaming and entertainment services, including IPTV, our digital television technology, provide a +number of new opportunities for us. Leading the Software Services Transformation Internet-based services are transforming the way people create, deploy, manage and use technology. We are committed to playing a leadership role in the software services transformation through our efforts to create our services +platform for the next generation of applications, communications, and commerce. Across the company, software services are at the core of our development efforts. PAGE 9 Table of Contents Part I Item 1 In fiscal year 2006, we introduced Windows Live and +Office Live, which provides small businesses with affordable Internet-based business services hosted by Microsoft. We rolled out new search services, including beta releases of Windows Live Search and Windows Live Academic Search. We introduced new +and enhanced services for computer safety and computer maintenance (Windows Live SafetyCenter and Windows Live OneCare), communications (Windows Live Mail and Windows Live Messenger), and entertainment (Xbox Live). We also created Live Labs, an +applied research program that targets Internet products and services. Because software services offer strong opportunities for growth, we will +continue to refine and improve adCenter, our advertising engine for Windows Live, MSN and other online offerings. We will deploy new service-based solutions, including Dynamics CRM Live, which we announced in July 2006. We will also continue to +build out our services infrastructure, providing new tools to help partners and businesses create and host services, and adding new data centers to meet growing consumer demand for services. DISTRIBUTION, SALES AND MARKETING We distribute our products primarily through the following channels: OEM; +distributors and resellers; and online. OEM. Our operating systems are licensed primarily to OEMs under agreements that grant the OEMs +the right to build computing devices based on our operating systems, principally PCs. Under similar arrangements, we also market and license certain server operating systems, desktop applications, hardware devices, and consumer software products to +OEMs. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, Dell, Fujitsu, Fujitsu Siemens Computers, Gateway, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba. A substantial +amount of OEM business is also conducted with system builders, which are low-volume customized PC vendors operating in local markets. Distributors and +Resellers. We license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products primarily through large account resellers +(“LARs”), direct market resellers, and value-added resellers (“VARs”). Many organizations that license products through enterprise agreements (“EAs”) transact directly with us, with sales support from our Enterprise +Software Advisor channel partners. These Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, LARs +are primarily engaged with large organizations and VARs typically reach the breadth of small- and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight +Enterprises, Software House International, and Software Spectrum. Our business solutions software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute +our finished goods products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Target, and +Wal-Mart. We have a network of field sales representatives and field support personnel that solicits orders from distributors and resellers and provides product training and sales support. Our arrangements for organizations to acquire multiple licenses of products are designed to provide them with a means of doing so without having to acquire separate +packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various +parts of the world, generally they include: Open. Designed primarily for small-to-medium +organizations (5 to over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years). The offering +that conveys rights to future versions of certain software product over the contract period is called Software Assurance. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the +Open program, customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing volume licensing agreements. Select. Designed primarily for medium-to-large organizations (greater than 250 licenses), this program allows +customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future versions of certain software products, support, tools, and training over a specified time period (generally three +years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements. PAGE 10 Table of Contents Part I Item 1 Enterprise +Agreement. The Enterprise Agreement is targeted at medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their enterprise, along with rights to +future versions of certain software products, support, tools, and training over a specified time period (generally three years). Online +Services. We distribute online content and services through MSN and other online channels. MSN delivers Internet access and various premium services and tools to consumers. MSN also delivers online e-mail and messaging +communication services and information services such as online search, advertising, and premium content. Home and Entertainment operates the Xbox Live service which allows customers to participate in the gaming experience with other subscribers +online. Microsoft Business Solutions operates the Microsoft Small Business Center portal, which is delivered online. This portal provides tools and expertise for small-business owners to build, market, and manage their businesses online. Other +services delivered online include Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and +solutions. CUSTOMERS Our customers include individual +consumers, small and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet Service Providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products +primarily through resellers and OEMs. Sales to Dell and its subsidiaries in the aggregate accounted for approximately 11% of fiscal year 2006 and 10% in each of fiscal year 2005 and 2004 revenue. These sales were made primarily through our OEM and +volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, +backlog is not significant. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of August 25, 2006 were as follows: Name Age Position with the Company William H. Gates III 50 Chairman of the Board Steven A. Ballmer 50 Chief Executive Officer Robert J. (Robbie) Bach 44 President, Microsoft Entertainment and Devices Division Lisa E. Brummel 46 Senior Vice President, Human Resources Kevin R. Johnson 45 Co-President, Microsoft Platforms and Services Division Christopher P. Liddell 48 Senior Vice President and Chief Financial Officer Jeffrey S. Raikes 48 President, Microsoft Business Division Bradford L. Smith 47 Senior Vice President, Legal and Corporate Affairs; General Counsel and Secretary Brian Kevin Turner 41 Chief Operating Officer Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive Officer from the time the +original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. In June 2006, Mr. Gates stepped down as Chief Software Architect and announced a +two-year transition plan out of a day-to-day role in the Company. Mr. Gates has served as Chairman since our incorporation. Mr. Ballmer was +appointed Chief Executive Officer in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980. Mr. Bach was named President, Microsoft Entertainment and Devices Division in September 2005. He had been Senior Vice President, Home and Entertainment since +March 2000. Before holding that position, he had been Vice President, Home and Retail since March 1999, and Vice President, Learning, Entertainment and Productivity, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined +Microsoft in 1988. PAGE 11 Table of Contents Part I Item 1, 1A Ms. Brummel was named Senior Vice President, +Human Resources in December 2005. She had been Corporate Vice President, Human Resources since April 2005. From 1995 to April 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, +Ms. Brummel has held a number of management positions at Microsoft, including general manager of Consumer Productivity business, product unit manager of the Kids business and product unit manager of Desktop and Decision reference products. Mr. Johnson was named Co-President, Microsoft Platforms and Services Division in September 2005. He had been Group Vice President, Worldwide +Sales, Marketing and Services since March 2003. Before that position, he had been Senior Vice President, Microsoft Americas since February 2002 and Senior Vice President, U.S. Sales, Marketing, and Services since August 2001, and prior to assuming +that role, he had been Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992. Mr. Liddell was named Senior Vice +President and Chief Financial Officer of the Company in May 2005. Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company since March 2003, and prior to becoming Chief Financial Officer, he held +the positions of Vice President-Finance and Controller. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited, an affiliate of International Paper, from 1999 to 2002 and Chief Financial Officer from 1995 to 1998. Mr. Raikes was named President, Microsoft Business Division in September 2005. He had been Group Vice President, Information Worker Business +since June 2004. Before that position, he had been Group Vice President, Productivity and Business Services since August 2000 and Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981. Mr. Smith was appointed Senior Vice President, Legal and Corporate Affairs, General Counsel and Secretary in November 2001. Mr. Smith was also named Chief +Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993. Mr. Turner was appointed Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President and President and Chief Executive +Officer of the Sam’s Club division of Wal-Mart Stores, Inc. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 to September +2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. EMPLOYEES As of June 30, 2006, we employed approximately 71,000 people on a full-time basis, 44,000 in the United States and 27,000 internationally. Of the total, 28,000 were in +product research and development, 21,000 in sales and marketing, 13,000 in product support and consulting services, 2,000 in manufacturing and distribution, and 7,000 in general and administration. Our success is highly dependent on our ability to +attract and retain qualified employees. None of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the Securities and Exchange Commission (“SEC”). Our SEC reports can be accessed +through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. ITEM 1A.    RISK FACTORS Challenges to our business model may reduce our revenues and operating +margins. Our business model has been based upon customers paying a fee to license software that we developed and distributed. Under this license-based software model, software developers bear the costs of converting +original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their products. We believe the license-based software model has had substantial benefits +for users of software, allowing them to rely on our expertise and the expertise of other software developers that have powerful incentives to develop innovative software that is useful, reliable, and compatible with other software and hardware. In +recent years PAGE 12 Table of Contents Part I Item 1A certain “open source” software business models have evolved into a growing challenge to our license-based software model. Open source commonly refers to +software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an open source +business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do not have to bear the full costs of research and development for the +software. A prominent example of open source software is the Linux operating system. While we believe our products provide customers with significant advantages in security and productivity, and generally have a lower total cost of ownership than +open source software, the popularization of the open source software model continues to pose a significant challenge to our business model, including continuing efforts by proponents of open source software to convince governments worldwide to +mandate the use of open source software in their purchase and deployment of software products. To the extent open source software gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for +our products, and revenue and operating margins may consequently decline. Another development is the software-as-a-service business model, by which +companies provide applications, data, and related services over the Internet. Providers use primarily advertising or subscription-based revenue models. Recent advances in computing and communications technologies have made this model viable and +enabled the rapid growth of some of our competitors. We are devoting significant resources toward developing our own software-as-a-service strategies. It is uncertain whether these strategies will prove successful. We face intense competition. We continue to experience intense competition across all markets for our products and services. Our competitors range in +size from Fortune 100 companies to small, specialized single-product businesses and open source community-based projects. While we believe the breadth of our businesses and product portfolio offers benefits to our customers that are a competitive +advantage, our competitors that are focused on a narrower product line may be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low. The +Internet as a distribution channel and the non-commercial software model described above have reduced barriers to entry even further. Open source software vendors are devoting considerable efforts to developing software that mimics the features and +functionality of our products. In response to competitive factors, we are developing versions of our products with basic functionality that are sold at lower prices than the standard versions. These competitive pressures may result in decreased +sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins and operating income. We may not be able to protect our intellectual property rights against piracy, infringement of our patents by third parties, or declining legal protection for intellectual property. We defend our +intellectual property rights and combat unlicensed copying and use of software and intellectual property rights through a variety of techniques. Preventing unauthorized use or infringement of our rights is difficult. Piracy of our products +represents a loss of revenue to us. While this adversely affects U.S. revenue, the impact on revenue from outside the United States is more significant, particularly in countries where laws are less protective of intellectual property rights. +Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Future legal changes could make this even more challenging. Throughout the world, we actively educate consumers about the +benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued +educational and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual property rights or compliance with additional intellectual property obligations impacting the rights of software developers +could both adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time we +receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. Responding to these claims may require us to enter into royalty and licensing agreements on less favorable terms, require us to +stop selling or to redesign affected products, or to pay damages or to satisfy indemnification commitments with our customers including contractual provisions under various license arrangements. If we are required to enter into such agreements or +take such actions, our operating margins may decline as a result. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to +manage this risk. PAGE 13 Table of Contents Part I Item 1A We may not be able to protect our source code from copying if there +is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. While we license certain portions of our source +code for various software programs and operating systems to a number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code +occurs, we could potentially lose future trade secret protection for that source code. The loss of future trade secret protection could make it easier for third parties to compete with our products by copying functionality, which could adversely +affect our revenue and operating margins. Unauthorized disclosure of source code could also increase certain risks described in the next paragraph. Security +vulnerabilities in our products could lead to reduced revenues or to liability claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy +viruses, worms, and other malicious software programs that attack our products. While this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on +the most popular operating systems and programs and we expect them to continue to do so. We devote significant resources to address these critical issues. We focus on engineering even more secure products, enhancing security and reliability options +and settings when we deliver products, and providing guidance to help our customers make the best use of our products and services to protect against computer viruses and other attacks on their computing environment. In addition, we are working to +improve the deployment of software updates to address security vulnerabilities discovered after our products are released. We are also investing in mitigation technologies that help to secure customers from attacks even when such software updates +are not deployed. We advise customers on how to help protect themselves from security threats through the use of our online automated security tools, our published security guidance, and the deployment of security software such as firewalls, +anti-virus, and other security software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security vulnerabilities in our products could lead some customers to seek to return products, to reduce +or delay future purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of new technologies. Any of these actions by customers +could adversely affect our revenue. In addition, actual or perceived vulnerabilities may lead to claims against us. While our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no +assurance these provisions will be held effective under applicable laws and judicial decisions. We are subject to government litigation and regulatory activity +that affects how we design and market our products. As a leading global software maker we receive scrutiny from government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of +action for competitors or consumers based on alleged anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits +brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in November 2001 and a Final Judgment entered in November 2002. These proceedings +imposed regulatory constraints on our Windows operating system businesses, including limits on certain contracting practices, required disclosure of certain software program interfaces, limits on Microsoft’s ability to ensure the visibility of +certain Windows features in new PCs, and required licensing of certain communications protocols. While we believe we currently are in full compliance with the Decree and Judgment, if we fail to comply with them in the future additional restrictions +could be imposed on us that would adversely affect our business. In March 2004, the European Commission determined that we must create new versions +of Windows that do not include certain multimedia technologies, many of which are required for certain Web sites, software applications and other aspects of Windows to function properly, and we must provide our competitors with specifications for +how to implement certain communications protocols supported in Windows. Microsoft has appealed both determinations to European courts. As a result of the Commission decision, we have incurred and will (absent a reversal of this ruling) continue to +incur duplicative development costs. The Commission ruling obligates Microsoft to make available specifications for certain Windows communications protocol technologies on licensing terms that are closely regulated by the Commission. The +availability of these licenses may enable competitors to develop software products that better mimic the functionality of Microsoft’s own products which could result in a reduction in sales of our products. Pending resolution of +Microsoft’s appeal, there will remain uncertainty about the legal principles that govern PAGE 14 Table of Contents Part I Item 1A product design issues for future releases of Microsoft products in Europe. These uncertainties could cause Microsoft to modify product design and delay release dates +for Windows or other products. In December 2005, the Korean Fair Trade Commission (“KFTC”) completed an investigation of whether including +streaming media technology or instant messenger technology in Windows, or including Windows Media Services as an optional component of Windows Server, violates the Korean Fair Trade Law. The KFTC ruled that we had violated the law and issued a +remedial order requiring us to offer two versions of Windows PC operating systems, one with Windows Media Player and Instant Messenger removed and another with those functionalities but also including opportunities for OEMs to install competing +media player and instant messenger programs. If upheld on appeal, these remedies could adversely affect the utility and competitive position of Windows PC operating systems in the Korean market. We believe our integrated approach to delivery of product innovation benefits consumers and business. Current or future government regulatory efforts and court +decisions may hinder or delay our ability to provide these benefits thereby reducing the attractiveness of our products and the revenues that come from them. Moreover, there always remains the risk of new legal action, either by these or other +governments or private claimants including with respect to products or features that haven’t been scrutinized or been the subject of objections in the past. The outcome of such legal actions could adversely affect us in a variety of ways, +including: • We may have to design or develop alternative versions of products for specific geographical markets to remove or limit visibility of certain functionality, resulting in reduced customer +benefits or additional costs and delays in the release of product lines or specific product versions. • Mandated alternative versions of our software may cause confusion that harms our reputation, including among consumers and with third-party software and Web site developers who rely on the +functionality removed from these alternative versions. • Competition authorities may authorize competitors to distribute implementations of Microsoft communications protocols in source code form without proper contractual provisions to protect our +intellectual property. • We may have to disclose otherwise confidential and trade secret information concerning the operation of our software that may facilitate the development of competing software. • If not reversed or limited on appeal, the rulings described above may be cited as a precedent in other proceedings that seek to limit our ability to continue to improve Windows by adding new +functionality in response to consumer demand. Our online offerings are subject to government regulation of the Internet domestically +and internationally in areas such as user privacy, data protection, and online content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve +significant costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we cease conducting the noncompliant activity. Our business depends largely on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining +talented employees. The market for highly skilled workers in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting +efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Delays in +product development schedules may adversely affect our revenues. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development +and testing periods. Significant delays in new product releases or significant problems in creating new products could adversely affect our revenue. We make +significant investments in new products and services that may not be profitable. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and +technologies, including Windows Vista, the 2007 Microsoft Office system, Xbox 360, MSN Search, Windows Server and Windows Live. Investments in new technology are inherently speculative. Commercial success depends on many factors including +innovativeness, developer support, and effective distribution and marketing. Significant revenue from new product and service investments may not be achieved for a number of years, if at all. Moreover, new products and services may not be +profitable, and even if they are profitable, operating margins for new products and businesses may not be as high as the margins we have experienced historically. PAGE 15 Table of Contents Part I Item 1A Declines in demand for software could +occur. If overall market demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. In addition, our +revenue would be unfavorably impacted if customers reduce their purchases of new software products or upgrades to existing products because new product offerings are not perceived as providing significant new functionality or other value to +prospective purchasers. We are making significant investments in Windows Vista and the 2007 Microsoft Office system. If these products are not perceived as offering significant new functionality or value to prospective purchasers, our revenue and +operating margins could be adversely affected. We have claims and lawsuits against us that may result in adverse outcomes. We are +subject to a variety of claims and lawsuits. Adverse outcomes in some or all of the claims pending against us may result in significant monetary damages or injunctive relief against us that could adversely affect our ability to conduct our business. +While management currently believes that resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position or results of operations, the litigation and other claims are subject to +inherent uncertainties and management’s view of these matters may change in the future. There exists the possibility of a material adverse impact on our financial position and the results of operations for the period in which the effect of an +unfavorable final outcome becomes probable and reasonably estimable. We may have additional tax liabilities. We are subject to income +taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where +the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from +our historical income tax provisions and accruals. Based on the results of an audit or litigation, a material effect on our income tax provision, net income or cash flows in the period or periods for which that determination is made could result. We may be at risk of having insufficient supplies of certain Xbox 360 components or console inventory. Some components of the Xbox 360 +are obtained from a single supplier and others may be subject to an industry-wide supply shortage. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain +replacement supplies on a timely basis, resulting in reduced console and game sales. Components are ordered based on forecasted console demand so we may experience component shortages for the Xbox 360 or, alternatively, excess console inventory that +may require us to record charges to cost of revenue. Xbox 360 consoles will be assembled in Asia; disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings. Under generally +accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is required to be tested for impairment at least +annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable include a decline in stock price and market capitalization, reduced future +cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is +determined, negatively impacting our results of operations. Changes in accounting may affect our reported earnings and operating +income. Generally accepted accounting principles and accompanying accounting pronouncements, implementation guidelines, and interpretations for many aspects of our business, such as revenue recognition for software, +accounting for investments, and treatment of goodwill or amortizable intangible assets, are highly complex and involve subjective judgments. Changes in these rules or their interpretation or changes in our products or business could significantly +change our reported earnings and operating income and could add significant volatility to those measures, without a comparable underlying change in cash flow from operations. See Note 1 in “Item 8. Financial Statements and Supplementary +Data” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies” of this report. We operate a global business that exposes us to additional risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing +structure uniform might PAGE 16 Table of Contents Part I Item 1A require that we reduce the sales price of our software in the United States and other countries. Operations outside of the United States may be affected by changes in +trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; unexpected changes in regulatory requirements for software; social, political, labor or economic conditions in a specific country or +region; and difficulties in staffing and managing foreign operations. While we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our +net revenues. General economic and geo-political risks may affect our revenue and profitability. Inflation, softness in corporate +information technology spending, or other changes in general economic conditions that affect demand for computer hardware or software could adversely affect our revenue or our investment portfolio. Abrupt political change, terrorist activity, and +armed conflict pose a risk of general economic disruption in affected countries or generally and could require changes in our operations and security arrangements, thus increasing our operating costs. These conditions may lend additional uncertainty +to the timing and budget for technology investment decisions by our customers. Catastrophic events may disrupt our business. We are a +highly automated business and a disruption or failure of our systems in the event of a major earthquake, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales and providing services. Our corporate +headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of +California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or information technology systems could severely affect our ability to conduct normal +business operations and, as a result, our future operating results could be adversely affected. Acquisitions and joint ventures may have an adverse effect on our +business. We expect to continue making acquisitions or entering into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction +does not advance our business strategy, that we don’t realize a satisfactory return on the investment we make, or that we may experience difficulty in the integration of new employees, business systems, and technology, or diversion of +management’s attention from our other businesses. These factors could adversely affect our operating results or financial condition. We have limited +insurance. We maintain third party insurance coverage against various liability risks and risks of property loss. Because of the unavailability or high cost of conventional insurance arrangements, we have entered into +captive insurance arrangements for the purpose of protecting against possible catastrophic and other risks not covered by traditional insurance markets. As of June 30, 2006, the face value of captive insurance arrangements was $2.0 billion. +Actual value at any particular time will vary due to deductibles, exclusions, other restrictions, and claims. While we believe these arrangements are an effective way to insure against liability and property damage risks, the potential liabilities +associated with the risks discussed in this report or other events could exceed the coverage provided by such arrangements. Improper disclosure of personal data +could result in liability and harm our reputation. We store and process significant amounts of personally identifiable information as we offer a large array of products and services to our customers. It is possible that +our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm our reputation +and subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products also enable our customers to store and process personal data. Perceptions that our products do not adequately +protect the privacy of personal information could inhibit sales of our products. Other risks that may affect our business. Other +factors that may affect our performance may include: • sales channel disruption, such as the bankruptcy of a major distributor; • our ability to implement operating cost structures that align with revenue growth; • the continued availability of third-party distribution channels for MSN service and other online offerings; and • disruption to our operations as a result of weather-related events. PAGE 17 Table of Contents Part I Item 1B, 2, 3, 4 ITEM 1B.    UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports +from the staff of the SEC that were issued 180 days or more preceding the end of our fiscal year 2006 that remain unresolved. ITEM 2.    PROPERTIES Our corporate offices consist of approximately 11.0 million square feet of office building +space located in King County, Washington: 8.5 million square feet of owned space that is situated on approximately 500 acres of land we own in our corporate campus and approximately 2.5 million square feet of space we lease. We own +approximately 533,000 square feet of office building space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 2.7 million square feet of office building space. We occupy many sites internationally, totaling approximately 6.9 million square feet that is leased and approximately 883,000 square feet that is owned. These +facilities include our European Operations Center that leases a 187,000 square foot campus in Dublin, Ireland, a 56,000 square foot disk duplication facility in Humacao, Puerto Rico, and a 159,000 square foot facility in Singapore for our Asia +Pacific Operations Center and Regional headquarters. Leased office building space includes the following locations: Tokyo, Japan 408,000 square feet; Unterschleissheim, Germany 381,000 square feet; Les Ulis, France 262,000 square feet; Reading, +England 241,000 square feet; and Mississauga, Canada 161,000 square feet. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described in “Operations” above. Our facilities are fully used for current operations of all segments, and suitable additional space is available to accommodate expansion needs. We +own 63 acres of land in Issaquah, Washington, which can accommodate 1.2 million square feet of office space and we have an agreement with the City of Redmond under which we may develop an additional 2.2 million square feet of facilities at +our campus in Redmond, Washington. ITEM 3.    LEGAL PROCEEDINGS On May 22, 2006, the Korean Fair Trade Commission (“KFTC”) denied our motion +for reconsideration of the formal written ruling against us in its competition law investigation of the company. As part of its decision, however, the KFTC dropped the requirement prohibiting us from including Windows Media Player or Windows +Messenger, or any feature with similar functionality, in any product other than the Windows client operating system for which we have a 50% or greater market share. Our request to stay the KFTC corrective order was denied on July 31, 2006. Our +appeal of the KFTC’s decision to the Seoul High Court is still pending. On July 12, 2006, the European Commission announced its +determination that we had not complied with the technical documentation requirements in its 2004 Decision against us, and levied a fine of € 281 million ($351 million). We intend to appeal this fine to the Court of First Instance. We have completed the written and oral procedures in our appeal of the Commission’s underlying March 2004 decision finding +Microsoft in violation of European competition law and accompanying € 497 million ($605 million) fine and are awaiting a decision by +the Court of First Instance. See Note 17 – Contingencies in “Item 8. Financial Statements and Supplementary Data” for information +regarding other legal proceedings in which we are involved. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders +during the fourth quarter of fiscal year 2006. PAGE 18 Table of Contents Part II Item 5 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 18, 2006, there were 148,993 registered holders of record of our common stock. The high and low common stock prices per share were as +follows: Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Year Fiscal year 2005 Common stock price per share: High $ 29.00 $ 29.98 $ 26.84 $ 26.07 $ 29.98 Low 26.88 26.53 23.92 24.12 23.92 Fiscal year 2006 Common stock price per share: High $ 27.76 $ 28.16 $ 28.15 $ 27.74 $ 28.16 Low 24.65 24.30 26.28 21.51 21.51 See Note 12 – Stockholders’ Equity of the Notes to Financial Statements (Item 8) for information regarding +dividends approved by our Board of Directors in fiscal years 2006 and 2005. On July 20, 2006, we announced the completion of the repurchase +program approved by our Board of Directors on July 20, 2004, to buy back up to $30 billion in Microsoft common stock. The repurchases were made using our cash resources. We repurchased common stock in each quarter of fiscal year 2006 as +follows: Period Total number of shares purchased Average price paid per share July 1, 2005 – September 30, 2005 114,134,218 $ 26.54 October 1, 2005 – December 31, 2005 283,112,246 $ 27.08 January 1, 2006 – March 31, 2006 180,720,830 $ 27.00 April 1, 2006 – June 30, 2006 175,609,060 $ 23.78 Common stock repurchases in the fourth quarter of fiscal year 2006 were as follows: Period (a) Total number of shares purchased (b) Average price paid per share (c) Total number of shares purchased as part of publicly announced plans or programs (d) Maximum number of shares (or approximate dollar value) of shares that may yet be purchased under +the plans or programs (in millions) April 1, 2006 – April 30, 2006 38,041,415 $ 27.08 38,041,415 $ 5,394 May 1, 2006 – May 31, 2006 8,618,036 $ 24.37 8,618,036 $ 5,184 June 1, 2006 – June 30, 2006 128,949,609 $ 22.76 128,949,609 $ 2,249 175,609,060 175,609,060 On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs: a $20 billion +tender offer which was completed on August 17, 2006; and authorization for up to an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 +million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. PAGE 19 Table of Contents Part II Item 5, 6 On August 18, 2006, we announced that the +authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company is authorized to repurchase additional shares in an amount up to $36.2 billion +through June 30, 2011. ITEM 6.    SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Fiscal Year Ended June 30 2006 2005 2004 2003 2002 Revenue $ 44,282 $ 39,788 $ 36,835 $ 32,187 $ 28,365 Operating income 16,472 14,561 9,034 9,545 8,272 Net income 12,599 12,254 8,168 7,531 5,355 Diluted earnings per share $ 1.20 $ 1.12 $ 0.75 $ 0.69 $ 0.48 Cash dividends declared per share $ 0.35 $ 3.40 $ 0.16 $ 0.08 $ – Cash and short-term investments 34,161 37,751 60,592 49,048 38,652 Total assets 69,597 70,815 94,368 81,732 69,910 Long-term obligations 7,051 5,823 4,574 2,846 2,722 Stockholders’ equity 40,104 48,115 74,825 64,912 54,842 PAGE 20 Table of Contents Part II Item 7 ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF +OPERATIONS RESULTS OF OPERATIONS FOR FISCAL YEARS 2006, 2005, AND 2004 OVERVIEW The following Management’s Discussion and Analysis (“MD&A”) is intended to help the +reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial +statements (“Notes”). We develop, manufacture, license, and support a wide range of software products for many computing devices. Our +software products include operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software +development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games, and PC peripherals. Online communication and information +services are delivered through our MSN portals and channels around the world. Our revenue historically has fluctuated quarterly and has generally +been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Home and Entertainment segment is particularly subject to seasonality as +its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, Home and Entertainment has generated over 40% of its yearly segment revenues in our second fiscal quarter. We believe the +seasonality of revenue is likely to continue in the future. We intend to sustain the long-term growth of our businesses through technological +innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we +continue to advance the functionality, security, and value of Windows operating systems. We also are increasing our focus on emerging markets and reducing the amount of unlicensed software in those markets. In addition, we continue to develop +innovative software applications and solutions that we believe will enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized +businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – the +easiest to deploy and manage and most secure – with the lowest total cost of ownership. We continue to invest in research and development in +existing and new lines of business, including business solutions, mobile computing, communication, entertainment, and others that we believe may contribute to our long-term growth. We also research and develop advanced technologies for future +software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth. We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative products, creating opportunities for partners, +improving customer satisfaction with key audiences, putting some of our most significant legal cases behind us, and improving our internal business processes. Our focus in fiscal year 2007 is building on this foundation and executing well in key +areas, including continuing to innovate on our integrated software platform, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company. Key market opportunities include: • Strengthening core businesses through new product launches, upgrades, making inroads against software piracy, and extending PC accessibility to new consumers in emerging markets. • Succeeding in adjacent businesses by offering extensions of our technologies targeted towards specific customer needs – either as new products or as higher-value versions of +existing products. • Entering new markets as we redefine how people create, deliver, and experience entertainment. • Delivering software services through online consumer services and services for businesses that enable workers to collaborate interactively. PAGE 21 Table of Contents Part II Item 7 Worldwide macroeconomic factors have a strong +correlation to business and consumer demand for our software, services, games and Internet service offerings. We expect a broad continuation in the economic conditions and demand in fiscal year 2007 as compared to fiscal year 2006. As open source software development and distribution evolves, we continue to seek to differentiate our products from competing products that are based on open +source software. We believe that Microsoft’s share of server unit operating systems increased in fiscal year 2006. Summary of Results for Fiscal Years 2006, +2005, and 2004 (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 44,282 $ 39,788 $ 36,835 11% 8% Operating income $ 16,472 $ 14,561 $ 9,034 13% 61% Our revenue growth for fiscal year 2006 was driven primarily by growth in SQL Server following the launch of SQL Server 2005 +in the second quarter, Windows Server and other server applications, increased Xbox revenue resulting from the Xbox 360 launch in the second quarter, growth in licensing of Windows client operating systems through OEMs, and increased licensing of +Office and other Information Worker products. Based on our estimates, total worldwide PC shipments from all sources grew approximately 12% to 14% and total server hardware shipments grew approximately 11% to 13% during fiscal year 2006. Foreign +currency exchange rates did not have a significant impact on consolidated or operating segment revenue during the fiscal year. Revenue growth for +fiscal year 2005 was driven by growth in licensing of Windows Server operating systems and other server applications, licensing of Windows client operating systems through OEMs, and increased licensing of Office and other Information Worker +products. The November 2004 launch of the “Halo 2” Xbox game also contributed to overall revenue growth for the company. Total worldwide PC shipments from all sources grew approximately 11% to 13% and total server hardware shipments grew +approximately 13% to 14% during fiscal year 2005 as compared to fiscal year 2004. The net impact of foreign exchange rates on revenue was positive in 2005, primarily due to relative strengthening of most foreign currencies, particularly the euro and +Japanese yen, against the U.S. dollar. Partially offsetting revenue growth rates was a $1.08 billion decline in earned revenue from Upgrade Advantage in fiscal year 2005. This revenue was recognized over fiscal year 2003 and fiscal year 2004 and in +the first quarter of fiscal year 2005 when the contract period expired. Fiscal year 2004 revenue growth was primarily driven by the growth in licensing of Windows client operating systems through OEMs, Windows Server operating systems, Office and +other server applications as a result of growth in PC and server hardware shipments. The worldwide PC shipment growth rate from all sources was estimated at 13% and the Windows server shipment was estimated at 18% in fiscal year 2004 as compared to +fiscal year 2003. The net impact of foreign exchange rates on revenue was positive in fiscal year 2004 due to a relative strengthening of most foreign currencies versus the U.S. dollar. This resulted in approximately $1.10 billion growth in total +revenue. Operating income for fiscal year 2006 increased primarily reflecting the revenue increase and a $991 million decrease in costs for legal +settlements and legal contingencies. These changes were partially offset by a $1.62 billion increase in cost of revenue primarily related to Xbox 360 and a $1.26 billion increase in sales and marketing expense primarily as a result of increased +investments in partner marketing and product launch-related spending. Headcount-related costs, including stock-based compensation expense, increased $682 million or 7% resulting from both an increase in salaries and benefits for existing headcount +and a 16% growth in headcount over the past twelve months. Stock-based compensation expense decreased $733 million or 30% reflecting a continuing decline in stock option amortization expense. Operating income increased in fiscal year 2005 due to a decline in stock-based compensation expense; increased revenue in Server and Tools, Client and Information +Worker, which have higher gross margins as compared to other segments; and a reduction in legal costs associated with major litigation. In addition, strong sales of Halo 2 reduced the overall operating loss for the Home and Entertainment segment for +fiscal year 2005. The $3.29 billion decrease in stock-based compensation expense was partially offset by increased operating expenses of $562 million related to increased salary and benefits for new and existing headcount. General and administrative +expenses related to major litigation declined in fiscal year 2005 due to the $2.53 billion of charges related to the settlement of Sun PAGE 22 Table of Contents Part II Item 7 Microsystems litigation and the fine imposed by the European Commission in fiscal year 2004. This effect was partially offset by legal expenses of $2.08 billion +related to settlements with IBM, Novell, Gateway, and end-user class action plaintiffs to resolve antitrust issues and other matters. In fiscal year 2004, the operating income decline was caused primarily by $2.53 billion of legal charges and $2.21 +billion of stock-based compensation expense related to our employee stock option transfer program, mainly offset by an increase in revenue. We +implemented changes in employee compensation in fiscal year 2004 whereby employees are granted stock awards rather than stock options. We also completed an employee stock option transfer program in the second quarter of fiscal year 2004 in which +employees could elect to transfer all of their vested and unvested stock options with a strike price of $33.00 or higher to JPMorgan Chase Bank (“JPMorgan”). The unvested options that were transferred to JPMorgan became vested upon the +transfer. A total of 345 million of the 621 million eligible options were transferred, which resulted in additional stock-based compensation expense of $2.21 billion in the second quarter of fiscal year 2004. As a result of these changes, +stock-based compensation expense decreased in fiscal years 2006 and 2005, and we expect stock-based compensation expense related to stock options to continue to decrease in fiscal year 2007. Fiscal Year 2007 Outlook In fiscal year 2007, we expect continued double digit revenue +growth primarily as a result of the upcoming launches of Windows Vista and the 2007 Microsoft Office system. We estimate worldwide PC shipments will grow between 8% and 10%. We expect that PC unit growth rates will be higher in the consumer segment +than in the business segment and higher in emerging markets than in mature markets. We estimate worldwide server unit shipments will grow between 10% and 12% in fiscal year 2007 as compared to fiscal year 2006. We do not expect a significant impact +from year-over-year foreign currency exchange rates in fiscal year 2007. We expect our operating income growth rate to lag our revenue growth rate in +the first half of fiscal year 2007 due to an increasing mix of Xbox 360 console revenue and related costs, coupled with significant investments in preparation for the launches of our flagship products. We expect this trend to reverse in the second +half of the fiscal year when we expect operating income to grow faster than revenue. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) Our seven segments were Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and +Entertainment. On July 17, 2006, we announced a change in our operating segments reflecting the culmination of our realignment announced in September 2005. These changes will be effective for fiscal year 2007; the seven segments discussed in +this analysis are presented the way we internally managed and monitored performance at the business group level in fiscal years 2006, 2005, and 2004. The revenue and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles (“GAAP”) and include certain reconciling items attributable to each of the +segments. The segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements is presented on a basis consistent with the Company’s internal management reporting, in accordance with Statement of +Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information . Certain corporate level expenses have been excluded from our segment operating results and are analyzed +separately. Fiscal years 2005 and 2004 amounts have been restated for certain internal reorganizations and to conform to the fiscal year 2006 presentation. Client (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 13,209 $ 12,151 $ 11,556 9% 5% Operating income $ 10,203 $ 9,464 $ 8,740 8% 8% PAGE 23 Table of Contents Part II Item 7 Client consists of premium edition operating systems, including Windows +XP Professional, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems, including Windows XP Home. Premium offerings are Windows operating systems sold at a premium above Windows XP Home. Client revenue growth +correlates with the growth of purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. Client revenue increased in fiscal year 2006 reflecting $1.18 billion or 12% growth in OEM revenue driven by 17% growth in OEM license units from increased PC unit +shipments, partially offset by a $118 million or 6% decrease in revenue from commercial and retail licensing of Windows operating systems. During the year, the mix of OEM Windows operating systems licensed with premium edition operating systems as a +percentage of total OEM Windows operating systems licensed (“OEM Premium Mix”) increased two percentage points to 52%. OEM revenue growth included an increase to revenue of $89 million resulting from the alignment of our billings +associated with OEM distributors in our system builder channel with both industry standards and other Microsoft channels. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the OEM Premium +Mix, changes in the geographical mix, and the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system builders. Client revenue increased in fiscal year 2005 driven by 12% growth in OEM license units +and $886 million or 10% growth in OEM revenue from increased PC unit shipments, partially offset by a $198 million or 9% decrease in revenue from commercial and retail licensing of Windows operating systems. The OEM Premium Mix remained flat at 50% +of total OEM Windows operating systems as compared to the previous year. Revenue earned from Upgrade Advantage declined by $99 million in fiscal year 2005 contributing to the decrease in commercial and retail licensing revenue. Client operating income increased in fiscal year 2006 reflecting the increase in OEM revenue partially offset by a $224 million increase in sales and marketing +expenses, excluding headcount-related costs, mainly driven by increased investments in partner marketing and Windows Vista pre-launch programs. Headcount-related costs increased 6% in fiscal year 2006 reflecting both a 13% increase in headcount +primarily associated with Windows Vista and further investments in our sales and marketing organization, and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Client +operating income increased in fiscal year 2005 primarily due to an increase in OEM revenue and a $444 million decrease in stock-based compensation expense. These factors were partially offset by an increase in sales and marketing expenses associated +with “Start Something,” a globally launched advertising campaign, marketing for security initiatives, and an increase in salary and benefits for new and existing headcount. The additional headcount for research and development was +primarily devoted to the continued development of Windows Vista. Server and Tools (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 11,467 $ 9,938 $ 8,590 15% 16% Operating income $ 4,323 $ 3,291 $ 1,474 31% 123% Server and Tools consists of server software licenses and client access licenses (“CAL”) for Windows Server, +Microsoft SQL Server, Exchange Server and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server and Tools +concentrates on licensing products, applications, tools, content and services that make information technology professionals and developers more productive and efficient. The segment uses multiple channels for licensing including pre-installed OEM +versions, licenses through partners, and licenses directly to end customers. The licenses are sold both as one-time licenses and as multi-year volume licenses. Server and Tools uses product innovation and partnerships with information technology +professionals to drive the adoption and sales growth of its products. Server and Tools revenue increased during fiscal year 2006 mainly driven by +growth in SQL Server, Windows Server, and Core CAL. SQL Server 2005 and Visual Studio 2005 were launched in the second quarter of fiscal year 2006 and produced revenue growth in these product lines. Revenue is impacted by overall server hardware +shipments which we estimate grew 11% to 13% in fiscal year 2006. Server and Server applications revenue, including CAL revenue, and developer tools, training and certification revenue grew $1.31 billion or 16% during fiscal year 2006. The results +reflect broad adoption of Windows Server products, especially SQL Server, which grew over 30% for PAGE 24 Table of Contents Part II Item 7 the year. Consulting, Premier and Professional product support services revenue increased $218 million or 15% primarily due to higher demand for services. In fiscal +year 2005, Server and Server application revenue, including CAL revenue, grew $1.10 billion or 17%. Consulting, Premier, and Professional product support services revenue increased $241 million or 19% compared to the previous year. Foreign currency +exchange rate changes accounted for $284 million or three percentage points of total Server and Tools revenue growth, which was offset by a $314 million decline in Upgrade Advantage revenue earned. Server and Tools operating income increased during fiscal year 2006 primarily reflecting increased revenue, partially offset by increased sales and marketing +expenses. Excluding headcount-related costs, sales and marketing expenses increased $274 million due to additional spending to support long-term strategies and marketing expenses primarily related to the launch of SQL Server 2005 and Visual Studio +2005. Total Server and Tools headcount-related costs increased 5% related to both an 11% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. In +fiscal year 2005, Server and Tools operating income increased primarily due to increased revenue and a $1.07 billion decrease in stock-based compensation expense. This increase was partially offset by an increase in sales and marketing costs and +headcount-related costs as a result of increased headcount and an increase in salaries and benefits for existing headcount. Information Worker (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 11,756 $ 11,169 $ 10,748 5% 4% Operating income $ 8,285 $ 8,025 $ 7,458 3% 8% Information Worker primarily consists of the Microsoft Office system of programs, servers, solutions, and services designed +to increase personal, team, and organization productivity. Information Worker includes Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CAL, and other information worker products including Office Communications Server +and OneNote. Revenue growth depends on the ability to add value to the core Office product set and expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified communications, and +business intelligence. Information Worker revenue increased in fiscal year 2006 primarily reflecting a $521 million or 5% increase in volume +licensing, retail packaged products, and preinstalled versions of Office in Japan, while OEM revenue increased $66 million or 4%. Information Worker revenue increased in fiscal year 2005 primarily reflecting a $269 million or 3% increase in +volume licensing, retail packaged product, and pre-installed versions of Office in Japan, a $91 million or 6% increase in OEM revenue, and the impact of foreign currency exchange rates, partially offset by reduced Upgrade Advantage earned revenue. +Changes in foreign currency exchange rates accounted for approximately $367 million or three percentage points of the revenue growth for fiscal year 2005, offset by a $663 million decline in Upgrade Advantage earned revenue. Information Worker operating income increased in fiscal year 2006 primarily due to the revenue growth, partially offset by a $283 million or 15% increase in sales +and marketing expenses related to supporting field sales efforts and a $71 million or 10% increase in research and development expenses. Headcount-related costs increased 14% during fiscal year 2006 reflecting both an 18% increase in headcount +related to supporting field sales efforts and research and development investments in future products and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Information +Worker operating income growth for fiscal year 2005 was primarily due to the revenue growth and a $304 million decrease in stock-based compensation expense. Operating expenses were also impacted by a reduction in marketing campaign costs from the +previous period associated with the launch of Office 2003. This decline was offset by an increase in headcount-related costs as a result of an increase in headcount and an increase in salaries and benefits for existing headcount. PAGE 25 Table of Contents Part II Item 7 Microsoft Business Solutions (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 919 $ 784 $ 742 17% 6% Operating income (loss) $ 24 $ (171 ) $ (291 ) * 41% * Not meaningful Microsoft Business Solutions provides business management software +solutions targeted to businesses of varying sizes. The main products consist of enterprise resource planning (“ERP”) solutions, customer relationship management (“CRM”) software, retail solutions, Microsoft Partner Program +(“MSPP”), and related services. Microsoft Business Solutions also includes the Small and Mid-market Solutions and Partners (“SMS&P”), which focuses on sales to customers and partners in the small and mid-market customer +segments. Revenue is derived from software and services sales, with software sales representing a significant amount of total revenue. Software revenues include both new software licenses and enhancement plans, which provide customers with future +software upgrades over the period of the plan. Our solutions are delivered through a worldwide network of channel partners that provide services and local support. Microsoft Business Solutions revenue increased in fiscal year 2006 driven by new users for Microsoft CRM and existing Dynamics ERP customers purchasing functionality and user licenses. The increase in Microsoft Business +Solutions revenue in fiscal year 2005 was mainly due to 10% revenue growth in software partially offset by 25% decline in services revenue. The software revenue increase was driven by 9% growth in license revenue and 16% growth in enhancement +revenue and was attributed to growth in ERP and CRM solutions and an increase in MSPP subscriptions. Microsoft Business Solutions operating income +increased in fiscal year 2006 reflecting the increase in revenue accompanied by a $56 million decrease in sales and marketing expense as a result of decreased net SMS&P spending. Headcount-related costs increased 3% reflecting both a 10% +increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Microsoft Business Solutions operating loss declined in fiscal year 2005 primarily due to a +$175 million decline in stock-based compensation expense, an increase in product revenue, and a decline in amortization of acquired intangibles. The reduction in operating loss was partially offset by a net increase in sales and marketing expense +driven by incremental costs in the SMS&P organization. In addition, we increased our marketing and product development spending in our ERP and CRM portfolios. MSN (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 2,298 $ 2,344 $ 2,270 (2)% 3% Operating income (loss) $ (77 ) $ 412 $ 98 * 320% * Not meaningful MSN includes personal communications services, such as e-mail and +instant messaging, and online information offerings, such as MSN Search, and the MSN portals and channels around the world. MSN also provides a variety of online paid services in addition to MSN Internet Access and MSN Premium Web Services. Revenue +is derived primarily from advertisers on MSN, from consumers and partners through subscriptions and transactions generated from online paid services, and from MSN narrowband Internet access subscribers. In fiscal year 2006, we launched MSN adCenter +– our internally developed advertising platform – in certain international markets and throughout the U.S. where it now serves 100 percent of paid search traffic on our online properties. We believe MSN adCenter will enable us to increase +both display and search advertising revenues by reducing our reliance on third parties for delivering ads. Effective July 1, 2005, functions related to MapPoint previously reported in Mobile and Embedded PAGE 26 Table of Contents Part II Item 7 Devices were moved to MSN. Mobile and Embedded Devices and MSN operating results for the prior periods have been restated for this reorganization. We announced in +fiscal year 2006, Windows Live™, a set of Internet services and software designed to improve the users’ connected experience, including Windows Live™ Local and Windows Live Messenger. MSN revenue decreased in fiscal year 2006 primarily reflecting a $195 million or 28% decline in access revenue, partially offset by a $126 million or 9% increase in +advertising revenue and a $23 million or 9% increase in revenue from subscription and transaction services other than access. As of June 30, 2006, MSN had 2.1 million access subscribers compared with 2.7 million at June 30, 2005. +In addition, MSN had over 261 million active Hotmail accounts and over 243 million active Messenger accounts as of June 30, 2006. The increase in advertising revenue reflects growth in display advertising for portals, channels, email, +and messaging services, which was partially offset by a decline in search revenue due to the transition to adCenter. In fiscal year 2005, MSN revenue increased reflecting $193 million or 16% growth in advertising revenue primarily as a result of +industry and market growth and continued growth of MSN display advertising revenue and $84 million or 88% growth in subscription and transaction services revenue. These increases were partially offset by the search clarity in advertising program, +the impact of the homepage redesign, and a decline of $219 million or 24% in access revenue, driven by the continued migration of Internet Access subscribers to broadband or other competitively priced Internet service providers. MSN operating income decreased in fiscal year 2006 due to a $230 million or 39% increase in research and development costs, a $126 million or 22% increase in sales +and marketing expenses, and a $67 million or 9% increase in cost of revenue as we continue to invest in MSN adCenter, Windows Live, and other new platforms. Headcount-related costs increased 25% reflecting a 44% increase in headcount and increased +salaries and benefits for existing employees, partially offset by a decrease in stock-based compensation. In fiscal year 2005, MSN operating income increased mainly due to a $241 million decrease in stock-based compensation expense, reduced +costs associated with the Internet Access business, and increased advertising and subscription revenue. Partially offsetting the decreased expenses were increased headcount-related costs as a result of increased headcount and an increase in salaries +and benefits for existing headcount. Mobile and Embedded Devices (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 377 $ 262 $ 193 44% 36% Operating income (loss) $ 2 $ (65 ) $ (237 ) * 73% * Not meaningful Mobile and +Embedded Devices includes Windows Mobile software, Windows Embedded operating systems, and Windows Automotive. These products extend the advantages of the Windows platform to mobile devices such as PDAs, phones, and a wide range of embedded devices. +The business is also responsible for managing sales and customer relationships for Microsoft overall with device manufacturers and communication sector customers. The communication sector includes network service providers (such as wireless, +wireline and cable operators) and media and entertainment companies. The market for products in these segments is intensely competitive. Competitive alternatives vary based on product lines and include product offerings from commercial and +non-commercial mobile operating system providers, and proprietary software developed by OEMs and mobile operators. Effective July 1, 2005, functions related to MapPoint previously reported in Mobile and Embedded Devices were moved to MSN. +Mobile and Embedded Devices and MSN operating results for the prior periods have been restated for this reorganization. Mobile and Embedded Devices +revenue increased in fiscal year 2006 primarily due to unit volume increases in major product lines, especially Windows Mobile software sales and Windows Embedded operating systems. Increased revenue for Windows Mobile software was primarily driven +by increased market demand for phone-enabled devices, partially offset by a decline in shipments for stand-alone PDAs. In fiscal year 2006, revenue for Windows Mobile software increased $55 million or 37% while revenue for Windows Embedded operating +systems increased $49 million or 47%, which was primarily due to the product being included in new product designs for both new and existing customers. Unit volume increases in major product lines drove revenue growth for fiscal year 2005 over +fiscal PAGE 27 Table of Contents Part II Item 7 year 2004, primarily driven by increased market demand for phone-enabled devices, and increased growth in shipments for standalone PDAs. In fiscal year 2005, revenue +for Windows Mobile software increased $46 million or 45% and revenue for Windows Embedded operating systems increased $19 million or 21%. Unit volume increases in major product lines drove revenue growth for fiscal year 2005 over fiscal year 2004, +primarily driven by increased market demand for phone-enabled devices, and increased growth in shipments for standalone PDAs. Mobile and Embedded +Devices generated operating income for fiscal year 2006 as opposed to the operating loss in fiscal year 2005 primarily due to increased revenue, partially offset by a $42 million or 21% increase in both research and development and general and +administrative expenses. Headcount-related costs increased 15% reflecting both a 24% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. The +operating loss for fiscal year 2005 decreased compared to fiscal year 2004 primarily due to a $95 million decrease in stock-based compensation, as well as the growth in revenue and a decrease in sales and marketing expense. This improvement was +partially offset by increased salary and benefit costs from increased headcount, and increased investment in research and development. Home and Entertainment (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Revenue $ 4,256 $ 3,140 $ 2,737 36% 15% Operating loss $ (1,262 ) $ (485 ) $ (1,337 ) (160)% 64% Home and Entertainment includes the Microsoft Xbox video game console system, PC games, CPxG (consumer software and hardware +products), and TV platform products for the interactive television industry. The success of video game consoles is determined by console innovation, the portfolio of video game content for the console, online offerings, and the market share of the +console. Our Xbox business is transitioning to a new console, the Xbox 360, which launched in the second quarter of fiscal year 2006. We believe that the functionality of our new console, games portfolio, and online offerings are +well-positioned relative to forthcoming competitive consoles. We also believe launching in advance of competitive consoles will provide a strategic advantage for the long-term success of Xbox 360. Revenue from the first generation of Xbox +products has declined and is expected to continue to decline as a result of the introduction of Xbox 360. Home and Entertainment revenue increased in +fiscal year 2006 primarily due to the launch of the Xbox 360 console partially offset by a decline in first party Xbox game sales primarily resulting from the significant impact of Halo 2 in fiscal year 2005. We sold approximately 5 million +Xbox 360 consoles during fiscal year 2006. The revenue growth was also attributable to $140 million or 15% growth from our other product lines, primarily as a result of an increase in PC games sales due to significant new game releases, especially +“Age of Empires III”, and an increase in MSTV revenue due to deployments in fiscal year 2006. Revenue increased in fiscal year 2005 primarily due to significant new product launches, which resulted in a $416 million or 23% increase in Xbox +revenue. Halo 2 was introduced in the second quarter of fiscal year 2005 and generated over $300 million in revenue in fiscal year 2005. Revenue from consumer hardware and software, PC games, and TV platforms declined $50 million or 5% compared to +fiscal year 2004 due to lower PC games software sales. Home and Entertainment operating loss increased in fiscal year 2006 primarily as a result of a +$1.64 billion increase in cost of revenue resulting from the number of Xbox 360 consoles sold and higher Xbox 360 unit costs, partially offset by the revenue growth. Our fiscal year 2006 operating loss increased due to the significant impact of Halo +2 in fiscal year 2005. Headcount-related costs increased 5% reflecting both a 19% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. The fiscal +year 2005 operating loss decreased primarily due to an increase in high margin Xbox software sales, lower Xbox console units costs, a $90 million lower-of-cost-or-market inventory adjustment recorded in fiscal year 2004, and a $219 million decrease +in stock-based compensation expense. The decrease was partially offset by an increase in costs associated with Xbox 360 console development and related launch efforts. PAGE 28 Table of Contents Part II Item 7 Corporate-Level Activity (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Corporate-level expenses $ 5,026 $ 5,910 $ 6,871 (15 )% (14 )% Certain corporate-level expenses are not allocated to our segments. Those expenses primarily include corporate operations +related to broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and +contingencies. Corporate-level expenses decreased in fiscal year 2006, primarily reflecting a $991 million decrease in costs for legal settlements +and legal contingencies partially offset by an $84 million increase in headcount-related costs. We incurred $1.32 billion in legal charges during fiscal year 2006 including settlement expense of $361 million related to our settlement with +RealNetworks, Inc. as well as other intellectual property and antitrust matters, and the € 281 million ($351 million) fine imposed by +the European Commission in July 2006 related to its 2004 decision in its competition law investigation of Microsoft, as compared to $2.31 billion in legal charges incurred during the prior year primarily related to settlements with Novell, Inc., +Gateway, IBM, and other antitrust and competition law matters. Headcount-related costs increased 5% during the twelve months ended June 30, 2006 reflecting both a 23% increase in headcount and an increase in salaries and benefits for existing +headcount, partially offset by a decrease in stock-based compensation. Corporate-level expenses decreased in fiscal year 2005, primarily as a result +of a $736 million reduction in stock-based compensation expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $2.31 billion in legal charges as compared to $2.53 billion in fiscal year 2004 +which included a $1.92 billion charge for a settlement with the Sun Microsystems, Inc., and the fine of € 497 million ($605 million) +imposed by the European Commission. Change to Financial Reporting Structure On July 17, 2006, we announced that effective the first quarter of fiscal year 2007, we will report our businesses under five operating segments, reflecting completion of the previously announced changes in our organizational structure +and how we will manage our business beginning in fiscal year 2007. Each of the five segments will be organized under one of the three operating divisions announced earlier in fiscal year 2006: • Platforms and Services Division • Microsoft Business Division • Entertainment and Devices Division The five operating segments are described +below. The first three of these will comprise the Platforms and Services Division. Client will include the former +Client segment. Products will include Windows XP Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems. Server and Tools will include the former Server and Tools segment, excluding the Exchange Server business and certain client access licenses related to products residing in the Microsoft Business Division. +Products will include the Windows Server operating system, Microsoft SQL Server, Microsoft Consulting Services, product support services, Visual Studio, System Center products, the Forefront security family of products, and Biz Talk Server, among +others. Online Services Business will include the former MSN segment and Windows Live. Products will include MSN +Search, MapPoint, MSN Internet Access, MSN Premium Web Services, MSN Mobile Services, and Windows Live. Microsoft Business +Division will include the former Information Worker and Microsoft Business Solutions segments, as well as the Exchange Server business and certain client access licenses, formerly included in the Server and Tools segment. +Products will include Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CAL, Microsoft Live Meeting, One Note, Office Communication Server, Microsoft Dynamics AX, Microsoft PAGE 29 Table of Contents Part II Item 7 Dynamics CRM, Microsoft Dynamics GP, Microsoft Dynamics NAV, Microsoft Dynamics SL, Microsoft Dynamics Retail Management System, Microsoft Partner Program, and +Microsoft Office Small Business Accounting. Entertainment and Devices Division will include the former Home and +Entertainment and Mobile and Embedded Devices segments. Products will include Xbox 360, Xbox, Xbox Live, CPxG (consumer software and hardware products), IPTV, Windows Mobile software platform, Windows Embedded device operating system, and Windows +Automotive. Our historical results under this new segmentation for the four quarters in fiscal years 2006 and 2005 were as follows: Revenue For the quarter ended For the quarter ended (In millions) September 30, 2005 December 31, 2005 March 31, 2006 June 30, 2006 Fiscal Year 2006 September 30, 2004 December 31, 2004 March 31, 2005 June 30, 2005 Fiscal Year 2005 Segments Client $ 3,187 $ 3,459 $ 3,187 $ 3,376 $ 13,209 $ 2,980 $ 3,193 $ 2,964 $ 3,014 $ 12,151 Server and Tools 2,127 2,438 2,398 2,690 9,653 1,906 2,161 2,058 2,245 8,370 Online Services Business 564 594 561 580 2,299 559 606 581 598 2,344 Microsoft Business Division 3,283 3,689 3,608 3,908 14,488 3,086 3,413 3,384 3,637 13,520 Entertainment and Devices 580 1,657 1,146 1,250 4,633 658 1,445 633 667 3,403 Total revenue $ 9,741 $ 11,837 $ 10,900 $ 11,804 $ 44,282 $ 9,189 $ 10,818 $ 9,620 $ 10,161 $ 39,788 Operating Income / (Loss) For the quarter ended For the quarter ended (In millions) September 30, 2005 December 31, 2005 March 31, 2006 June 30, 2006 Fiscal Year 2006 September 30, 2004 December 31, 2004 March 31, 2005 June 30, 2005 Fiscal Year 2005 Segments Client $ 2,569 $ 2,638 $ 2,471 $ 2,504 $ 10,182 $ 2,387 $ 2,513 $ 2,331 $ 2,172 $ 9,403 Server and Tools 606 762 746 903 3,017 455 660 515 479 2,109 Online Services Business 81 58 (26 ) (190 ) (77 ) 79 130 101 101 411 Microsoft Business Division 2,251 2,466 2,414 2,544 9,675 2,160 2,355 2,316 2,285 9,116 Entertainment and Devices (182 ) (296 ) (422 ) (437 ) (1,337 ) (202 ) 28 (198 ) (235 ) (607 ) Corporate-Level Activity (1,279 ) (971 ) (1,295 ) (1,443 ) (4,988 ) (1,385 ) (937 ) (1,736 ) (1,813 ) (5,871 ) Total operating income $ 4,046 $ 4,657 $ 3,888 $ 3,881 $ 16,472 $ 3,494 $ 4,749 $ 3,329 $ 2,989 $ 14,561 Our outlook for fiscal year 2007 based on the five operating segments is as follows: Client We expect revenue to grow reflecting improvement in the commercial and retail portion of the business due to our +upcoming launch of Windows Vista. We expect revenue generated from OEMs to grow slower than the PC hardware market due to increased concentration among larger OEMs, consumer hardware shipments growing faster than business shipments, and relatively +faster growth in emerging markets. We expect PC shipments to grow 8% to 10% for fiscal year 2007. We believe that PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in mature +markets. Server and Tools We expect continued momentum from recent product launches and the expansion of our products +in security, management and designer tools will help drive our overall revenue growth in fiscal year 2007. We estimate overall server hardware unit shipments will grow 10% to 12% in fiscal year 2007. However, we face competition from Linux-based, +Unix, and other server operating systems as well as competition in server applications. PAGE 30 Table of Contents Part II Item 7 Online Services +Business We expect increased growth in display advertising revenue as the portals, channels, and communications services continue to expand globally and the overall Internet advertising industry continues to expand. Our +search revenue is expected to grow in fiscal year 2007 as a result of continued ramp up of adCenter. We expect revenue from narrowband Internet Access to continue to decline in fiscal year 2007. Microsoft Business Division We expect Microsoft Business Division revenue to grow in fiscal year 2007. We feel that our +customers’ continued preference to purchase annuity contracts indicates enthusiasm for the 2007 Microsoft Office system. We also expect continued demand for our Dynamics products, building on the fiscal 2006 momentum. Entertainment and Devices Division We expect revenue to increase from fiscal year 2006 due to the increased availability of the Xbox +360 console unit during the entire fiscal year, including the second holiday season after the launch in fiscal year 2006. In fiscal year 2007, we expect to introduce a music and entertainment device, the first in a new family of hardware and +software products for the consumer market. The availability of a commercial IPTV product is expected to drive significant growth in MSTV revenue across several geographies. Revenue from existing mobility and embedded devices is expected to increase +due to unit volume increases of Windows Mobile software driven by increased market demand for phone-enabled devices and Windows Embedded operating systems. Short product life cycles in product lines such as Windows Mobile software may impact our +continuing revenue streams. Xbox 360 console unit costs are expected to decline. As we implement our long-term growth strategy, we expect to increase +our level of spending in four key areas in fiscal year 2007: increased product costs associated with Xbox consoles; marketing and field sales spending including launch costs; quickening the pace of development in growth areas such as business +intelligence, security, management and unified communications (including acquisitions); and increased costs to execute on our online services strategy. While these investments will translate into increased operating expenses in fiscal year 2007, we +believe they will help lay the groundwork for future growth and profitability. Operating Expenses Cost of Revenue (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Cost of revenue $ 7,650 $ 6,031 $ 6,596 27% (9)% As a percent of revenue 17% 15% 18% 2ppt (3)ppt Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs +related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with the delivery of consulting services. Cost of revenue in fiscal year +2006 increased mainly due to a $1.64 billion increase in Home and Entertainment as a result of an increase in the number of total Xbox consoles sold and higher Xbox 360 unit costs. Cost of revenue in fiscal year 2005 decreased due to a $363 million +decrease in stock-based compensation expense, a $140 million reduction in costs associated with a decrease in the MSN Internet Access subscriber base, and a $169 million reduction in other product costs mainly due to Xbox consoles cost efficiency, +partially offset by increased costs in product support and consulting services costs. Research and Development (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Research and development $ 6,584 $ 6,097 $ 7,735 8% (21)% As a percent of revenue 15% 15% 21% –ppt (6)ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related costs associated with product development. Research and development expenses also PAGE 31 Table of Contents Part II Item 7 include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased +software code and services content. Research and development costs increased during fiscal year 2006 primarily due to increased development costs associated with new and upcoming offerings such as MSN adCenter, the 2007 Microsoft Office system, +Windows Vista, Xbox 360, and corporate research activities. Headcount-related costs increased 3% during fiscal year 2006 reflecting both a 17% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by +a decrease in stock-based compensation expense. Our research and development expenses decreased in fiscal year 2005 due to a $1.88 billion decrease in stock-based compensation expense. This expense decline was partially offset by increased headcount +and product development costs associated with the Xbox 360 console and related games, SQL Server 2005, Windows Vista, and product development in Mobile and Embedded Devices. Sales and Marketing (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 Sales and marketing $ 9,818 $ 8,563 $ 8,195 15% 4% As a percent of revenue 22% 22% 22% –ppt –ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense and other +headcount-related costs associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased during fiscal year 2006 primarily due to increased headcount-related +costs, investments in partner marketing and product launch-related spending. Headcount-related costs increased 13% during fiscal year 2006 reflecting both a 20% increase in headcount and an increase in salaries and benefits for existing headcount, +partially offset by a decrease in stock-based compensation expense. For fiscal year 2005, sales and marketing expense increased slightly due to $470 +million higher headcount-related costs from increased headcount and general salary increases; higher sales and marketing costs driven by product planning, reseller marketing, and advertising campaign costs mainly related to launch of the “Start Something” campaign; launch of “Halo 2”; and launch arrangements for Xbox 360. The increase was offset mainly by a $660 million decrease in stock-based compensation expense. General and Administrative (In millions, except percentages) 2006 2005 2004 Percent Change 2006 versus 2005 Percent Change 2005 versus 2004 General and administrative $ 3,758 $ 4,536 $ 5,275 17% 14% As a percent of revenue 8% 11% 14% (3)ppt (3)ppt General and administrative costs include payroll, employee benefits, stock-based compensation expense and other +headcount-related costs associated with finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative costs decreased in fiscal year 2006 primarily reflecting +decreased costs for legal settlements and legal contingencies. We incurred $1.32 billion in legal charges during fiscal year 2006 as compared to $2.31 billion in legal charges incurred during fiscal year 2005. Headcount-related costs increased 7% +during the twelve months ended June 30, 2006 reflecting both an 18% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. General and +administrative costs decreased in fiscal year 2005 primarily reflecting decreased stock-based compensation expense and decreased costs for legal settlements and legal contingencies. In fiscal year 2005, we recognized $277 million of stock-based +compensation expense as compared to $664 million in fiscal year 2004. In fiscal year 2005, we recognized $2.31 billion in legal charges as compared to $2.83 billion in fiscal year 2004. PAGE 32 Table of Contents Part II Item 7 Investment Income and Other The components of investment income and other were as follows: (In millions) 2006 2005 2004 Dividends and interest $ 1,510 $ 1,460 $ 1,892 Net gains on investments 161 856 1,563 Net losses on derivatives (99 ) (262 ) (268 ) Income/(losses) from equity investees and other 218 13 (25 ) Investment income and other $ 1,790 $ 2,067 $ 3,162 For fiscal year 2006, dividends and interest income increased due to higher interest rates received on our fixed-income +investments, partially offset by a decline in the average balance of dividend and interest-bearing investments as a result of the $32.64 billion special dividend paid on December 2, 2004, and stock repurchases made throughout fiscal year 2006. +Dividends and interest income declined $432 million in fiscal year 2005 due to the combination of a greater allocation of funds to lower yielding, more liquid asset classes in preparation for the $32.64 billion special dividend paid on +December 2, 2004, and a lower portfolio balance following payment of the special dividend. For fiscal year 2006, net recognized gains on +investments were comprised of net gains on sales of equity investments, net losses on sales of fixed-income investments and other-than-temporary impairments on both equity and fixed-income investments. Net recognized gains decreased in fiscal +year 2006 primarily due to increased net losses on sales of fixed-income investments, higher other-than-temporary impairments and fewer net gains on equity investments in the current period as compared to fiscal year 2005. For fiscal year 2006, +other-than-temporary impairments were $408 million, as compared to $152 million in fiscal year 2005. The increase in other-than-temporary impairments in fiscal year 2006 was driven by planned sales of certain investments in an unrealized loss +position in order to raise funds for the $20 billion tender offer announced on July 20, 2006. Net gains on investments declined $707 million in fiscal year 2005 primarily due to greater sales of investments in the previous fiscal year in +preparation for the special dividend paid on December 2, 2004. Net gains on investments also include other-than-temporary impairments of $152 million in fiscal year 2005 compared to $82 million in fiscal year 2004. Net realized gains on sales +were $1.65 billion in fiscal year 2004 as we moved to more liquid investment asset classes. Investments are considered to be impaired when a decline +in fair value is judged to be other than temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, among other factors, +we evaluate general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business +outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other than temporary, an impairment +charge is recorded and a new cost basis in the investment is established. We lend certain fixed-income and equity securities to enhance investment +income. The loaned securities continue to be carried as investments on our balance sheet. We use derivative instruments to manage exposures to interest rates, +equity prices, and foreign currency markets and to facilitate portfolio diversification. Net losses on derivatives were as follows: (In millions) 2006 2005 2004 Net gain/(losses) on equity derivatives $ 192 $ (202 ) $ 118 Net gains on commodity derivatives 101 46 – Net losses on interest rate derivatives (79 ) (53 ) (102 ) Net losses on foreign currency contracts (313 ) (53 ) (284 ) Net losses on derivatives $ (99 ) $ (262 ) $ (268 ) During fiscal year 2006, we experienced lower net losses on derivatives as compared to fiscal year 2005 primarily due to net +gains on non-designated equity derivatives in the current fiscal year as compared to net losses in the prior PAGE 33 Table of Contents Part II Item 7 fiscal year and higher net gains on commodity positions in the current fiscal year driven by increases in the related commodity indices. These gains were partially +offset by higher net losses in time value on foreign exchange contracts used to hedge anticipated foreign currency revenues and higher net losses on interest rate derivative contracts. The net gains on equity derivatives during fiscal year 2006 are primarily due to changes in the market value of non-designated equity derivatives. Gains and losses +arising from non-designated derivatives are economically offset by unrealized losses and gains, respectively, in the underlying equity securities which are recorded as a component of other comprehensive income. Commodity derivatives are held for the +purpose of portfolio diversification. Net losses related to foreign currency contracts relate primarily to changes in time value of options used to hedge anticipated foreign currency revenues. Additionally, net gains and losses on foreign exchange +contracts include the changes in the fair value of derivatives used as economic hedges. These gains and losses are partially offset economically by unrealized losses and gains, respectively, in the underlying assets which are included in other +comprehensive income Net derivative losses in fiscal year 2005 were primarily related to losses on equity derivatives, interest rate derivatives, and +foreign currency contracts. During fiscal year 2005, losses related to equity derivatives used to economically hedge against a decline in equity prices were $202 million and losses related to interest rate derivatives were $53 million. These losses +were offset by the combination of realized gains on sales of securities and unrealized gains related to increases in the market value of the underlying assets included as a component of other comprehensive income. Net losses related to foreign +currency contracts were $53 million, related to changes in time value of options used to hedge anticipated foreign currency revenues and economically hedging foreign currency based investment exposures. Losses related to hedging foreign +currency-based investment exposures were offset by unrealized gains in the underlying assets which are included in other comprehensive income. Net losses on derivatives also included gains related to commodity positions used to provide portfolio +diversification. Gains on commodity positions were $46 million during fiscal year 2005. Derivative losses were $268 million in fiscal year 2004 +primarily due to net losses in time value on foreign exchange contracts used to hedge anticipated foreign currency revenues. In the second quarter of +fiscal year 2006, we entered into an agreement with NBC Universal, Inc. (“NBC”) that restructured our joint venture relationships for MSNBC Cable L.L.C. (“CJV”) and MSNBC Interactive News, L.L.C. (“IJV”). As a result, +we divested 32% of CJV for $331 million and NBC acquired the right, exercisable in the following two years, to buy the remaining 18% interest. In addition, we modified our agreement with NBC to grant to IJV a U.S. content license and to remove the +exclusivity obligation on both NBC and Microsoft for local and non-U.S. news content. As part of the MSNBC restructuring agreements, we paid a $200 million fee to effectively terminate IJV’s prior content license agreement and we also prepaid +the remaining $14 million license fee to NBC. In the fourth quarter of fiscal year 2006, NBC exercised its option to buy our remaining 18% interest in CJV. For fiscal year 2006, we recognized a net gain of $195 million related to the above +transactions. Income Taxes Our effective tax rate for fiscal year +2006 was 31% as compared to 26% for fiscal year 2005. During fiscal year 2006, we recorded a tax benefit of $108 million from the resolution of state audits. The increased rate in fiscal year 2006 resulted primarily from the European Commission fine +of € 281 million ($351 million) which is not tax deductible, and a lower rate in fiscal year 2005 as a result of reversal of $776 +million of previously accrued taxes upon settling an Internal Revenue Service examination for fiscal year 1997 – 1999 and a tax benefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a temporary +incentive provided by the American Jobs Creation Act of 2004. Our effective tax rate for fiscal year 2004 was 33%. Financial Condition Cash and equivalents and short-term investments totaled $34.16 billion and $37.75 billion as of June 30, 2006, and 2005, respectively. This investment portfolio consists +primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S.-dollar-denominated securities, but also includes +foreign currency positions in order to diversify financial risk. The portfolio is primarily invested in short-term securities to facilitate rapid deployment for immediate cash needs. Equity and other investments were $9.23 billion and $11.00 billion +as of June 30, 2006, and 2005, respectively. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $18.90 billion +at June 30, 2006. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position. PAGE 34 Table of Contents Part II Item 7 Unearned Revenue Unearned revenue from volume licensing programs represents customer billings, paid either upfront or annually at the beginning of each billing coverage period, that are accounted +for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements revenue attributable to undelivered elements, including free post-delivery telephone support and the right to receive +unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the life cycle of the +related product. Other unearned revenue includes services, TV Platform, Microsoft Business Solutions, advertising, and subscriptions for which we have been paid upfront and earn the revenue when we provide the service or software or otherwise meet +the revenue recognition criteria. Unearned revenue as of June 30, 2006, increased $1.74 billion from June 30, 2005, reflecting additions to +unearned revenue from multi-year licensing that outpaced recognitions by $1.66 billion, a $53 million decrease in revenue deferred for undelivered elements, and a $127 million increase primarily in unearned revenue for services and subscription +services. The following table outlines the expected recognition of $10.9 billion of unearned revenue as of June 30, 2006: (In millions) Recognition of Unearned Revenue Three months ended: September 30, 2006 $ 3,483 December 31, 2006 2,687 March 31, 2007 1,899 June 30, 2007 1,069 Thereafter 1,764 Unearned revenue $ 10,902 Cash Flows Cash flow from +operations for fiscal year 2006 decreased 13% to $14.40 billion primarily due to increased payments to fund a $987 million increase in inventory and product costs related to Xbox 360 and increased payments to employees resulting from a 16% growth in +headcount. These factors were partially offset by increased cash receipts from customers driven by our 11% revenue growth and $1.74 billion increase in unearned revenue. Cash used in financing was $20.56 billion in fiscal year 2006, a decrease of +$20.52 billion from the previous year driven by a $32.57 billion reduction in cash dividend payments. This impact was partially offset by an $11.15 billion increase in common stock repurchases. Net cash from investing was $8.00 billion in fiscal +year 2006, a decrease of $7.02 billion from fiscal year 2005 driven primarily by an $8.93 billion decrease in cash from combined purchase, sales, and maturities of investments and a $766 million increase in additions to property and equipment. These +factors were partially offset by $3.12 billion of cash proceeds from our securities lending program. Cash flow from operations for fiscal year 2005 +increased 14% to $16.61 billion primarily due to an increase in cash receipts from customers driven by our 8% revenue growth combined with a 12% increase in unearned revenue. Cash payments in fiscal year 2005 resulting from significant legal +settlements were approximately $1.8 billion lower than in the previous year, adding to the overall increase in operating cash flow. Partially offsetting these factors were increased payments to employees resulting from a 7% increase in full-time +employees. Cash used for financing was $41.08 billion in fiscal year 2005, driven by $36.11 billion of cash dividends paid in fiscal year 2005 compared to $1.73 billion paid in fiscal year 2004. The increase was also partially driven by $8.06 +billion in cash used for common stock repurchases, an increase of $4.67 billion in cash used for share repurchases compared to the previous year, reflecting 312 million shares repurchased in fiscal year 2005, an increase of 188.5 million +shares compared to the previous year. Net cash from investing was $15.03 billion in fiscal year 2005, an increase of $18.37 billion from fiscal year 2004, primarily due to a $23.59 billion increase in investment maturities that occurred to fund cash +dividends paid in fiscal year 2005, partially offset by a $5.32 billion decrease in cash from combined investment purchase and sale activity. PAGE 35 Table of Contents Part II Item 7 Cash flow from operations for fiscal year 2004 decreased +$1.17 billion to $14.63 billion. The decrease primarily reflects the combined cash outflows of $2.56 billion related to the Sun Microsystems settlement and the European Commission fine partially offset by increased cash receipts from customers +driven by the rise in revenue billings. Cash used for financing was $2.36 billion in fiscal year 2004, a decrease of $2.86 billion from the previous year. The decrease reflects that we did not repurchase common stock in the fourth quarter of fiscal +year 2004 combined with a $628 million increase primarily from stock issuances related to employee stock options exercises, partially offset by an $872 million increase in cash dividends paid. We repurchased 123.7 million shares of common stock +under our share repurchase program in fiscal year 2004. Cash used for investing was $3.34 billion in fiscal year 2004, a decrease of $3.88 billion from fiscal year 2003. We have no material long-term debt. Stockholders’ equity at June 30, 2006, was $40.10 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of +technology. Additions to property and equipment will continue, including new facilities and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $234 +million on June 30, 2006. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $276 million, $299 million, and $331 million fiscal year 2006, +2005 and 2004, respectively. We have issued residual value guarantees in connection with various operating leases. These guarantees provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are +liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2006, the maximum amount of the residual value guarantees was approximately $271 million. +We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability currently exists. We have not engaged in any related party transactions or arrangements with unconsolidated +entities or other persons that are reasonably likely to materially affect liquidity or the availability of requirements for capital resources. In +fiscal year 2006, our Board of Directors declared $0.35 per share cash dividends, with $2.69 billion paid as of June 30, 2006. A quarterly dividend of $0.09 per share (or $906 million) was declared by our Board of Directors on June 21, +2006 to be paid to shareholders of record as of August 17, 2006, on September 14, 2006. On July 20, 2006, we announced the completion +of the repurchase program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30 billion in Microsoft common stock. The repurchases were made using our cash resources. During fiscal year 2006, we repurchased +754 million shares, or $19.75 billion, of our common stock under this plan. On July 20, 2006, we also announced that our Board of Directors authorized new share repurchase programs, comprised of a $20 billion tender offer which was +completed on August 17, 2006, and an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of our common stock, or approximately +1.5% of the common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we announced that the authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been +increased by approximately $16.2 billion. As a result, the company is authorized to repurchase additional shares in an amount up to $36.2 billion through June 30, 2011. We believe existing cash and short-term investments, together with funds generated from operations should be sufficient to meet operating requirements, quarterly dividends and planned share repurchases. Our philosophy regarding +the maintenance of a balance sheet with a large component of cash and short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion +of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs. Off-Balance Sheet Arrangements and Contractual Obligations Off-Balance Sheet Arrangements We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property +infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS No. 5, Accounting for Contingencies, as interpreted by FASB Interpretation No. (“FIN”) +45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others . We consider factors such as the degree of probability of an unfavorable outcome and the PAGE 36 Table of Contents Part II Item 7 ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any +material liabilities related to such indemnifications in our financial statements. Contractual Obligations The following table summarizes our outstanding contractual obligations as of June 30, 2006: (In millions) (1) Payments due by period Fiscal Years 2007 2008-2010 2011-2013 2014 and thereafter Total Long-term debt $ – $ – $ – $ – $ – Construction commitments (2)(4) 234 – – – 234 Lease obligations: Capital leases – – – – – Operating leases (3) 250 436 158 41 885 Purchase commitments (4) 2,219 9 – – 2,228 Other long-term liabilities (5) 4 66 1 – 71 Total contractual obligations $ 2,707 $ 511 $ 159 $ 41 $ 3,418 (1) We have excluded the $970 million long-term contingent liability related to the antitrust and unfair competition class action lawsuits referred to in Note 17 – Contingencies of the +Notes to Financial Statements as the timing and amount to be resolved in cash versus vouchers is subject to uncertainty. (2) We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations. (3) Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing +cash and cash flows from operations. (4) The amount presented above as purchase and construction commitments includes all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to fund these +commitments with existing cash and our cash flows from operations. (5) We have excluded other obligations of $5.22 billion from other long-term liabilities presented above as the amount that will be settled in cash is not known. We have also excluded unearned +revenue of $1.76 billion. RECENTLY ISSUED ACCOUNTING STANDARDS In November 2005, the FASB issued Staff Position (“FSP”) FAS123(R)-3, Transition Election to Accounting for the Tax Effects of Share-Based Payment Awards. This +FSP requires an entity to follow either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R), Share-Based Payment , or the alternative transition method as described in the FSP. An entity that +adopts SFAS No. 123(R) using the modified prospective application may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS +No. 123(R) or the effective date of this FSP to evaluate its available transition alternatives and make its one-time election. We elected to adopt the transition method as described in the FSP as of July 1, 2005. This method change +did not have an impact on our financial statements. In June 2006, the FASB issued FIN No. 48, Accounting for Uncertainty in Income Taxes +– an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, Accounting for +Income Taxes. The interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN No. 48 requires +recognition of tax benefits that satisfy a greater than 50% probability threshold. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN +No. 48 is effective for us beginning July 1, 2007. We are assessing the potential impact that the adoption of FIN No. 48 will have on our financial statements. PAGE 37 Table of Contents Part II Item 7 In June 2006, the FASB ratified the Emerging Issues +Task Force (“EITF”) consensus on EITF Issue No. 06-2, “ Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 ”. EITF Issue No. 06-2 requires companies to accrue the +costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for us beginning July 1, 2007. The cumulative effect of the application of this consensus +on prior period results should be recognized through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. Elective retrospective application is also permitted. We are currently evaluating the financial +impact of this guidance and the method of adoption that will be used. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions +that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, +impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, accounting for income taxes, and accounting for stock-based compensation. We account for the licensing of software in accordance with American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, Software Revenue Recognition . The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists +for those elements. Customers receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective +elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and +enhancements to existing products. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities , and SEC SAB 59, Accounting for Noncurrent Marketable Equity Securities , provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This +determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of +an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific +adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in +fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. SFAS No. 142, Goodwill and Other Intangible Assets , requires that goodwill be tested for impairment at the reporting unit level (operating segment or +one level below an operating segment) on an annual basis (July 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These +events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition or sale or disposition of a significant portion of a reporting unit. Application of the goodwill +impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The +fair value of each reporting unit is estimated using a discounted cash flow methodology. This requires significant judgments including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of +growth for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill +impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected benefit from the combination. We evaluate our reporting units on an annual basis and if necessary, reassign goodwill using a relative +fair value allocation approach. PAGE 38 Table of Contents Part II Item 7 We account for research and development costs in +accordance with several accounting pronouncements, including SFAS No. 2, Accounting for Research and Development Costs , and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise +Marketed . SFAS No. 86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological +feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined +that technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established have not been material, and accordingly, we have expensed +all research and development costs when incurred. The outcomes of legal proceedings and claims brought against us are subject to significant +uncertainty. SFAS No. 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired +or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be +accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial position or our results +of operations. SFAS No. 109, Accounting for Income Taxes , establishes financial accounting and reporting standards for the effect of +income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized +in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future +tax consequences could materially impact our financial position, results of operations, or cash flows. Accruals for tax contingencies are provided for in accordance with the requirements of SFAS No. 5. We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment . Under the fair value recognition provisions of this +statement, share-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of share-based awards at the grant date requires judgment, +including estimating expected dividends. In addition, judgment is also required in estimating the amount of share-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation +expense and our results of operations could be materially impacted. PAGE 39 Table of Contents Part II Item 7 Statement of Management’s Responsibility for Financial +Statements Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The +consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from +unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing +division of responsibilities, careful selection and training of qualified personnel and a program of internal audits. The Company engaged +Deloitte & Touche LLP, independent auditors, to audit and render an opinion on the consolidated financial statements and management’s report on its assessment and the effectiveness of internal control over financial reporting in +accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, +consisting solely of independent directors of the Company, meets periodically with management, internal auditors and our independent auditors to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and +financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief +Executive Officer Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer PAGE 40 Table of Contents Part II Item 7A ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to foreign currency, interest +rate, fixed-income, equity, and commodity price risks. A portion of these risks is hedged, but fluctuations could impact our results of operations and financial position. We hedge a portion of anticipated revenue and accounts receivable exposure to +foreign currency fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies hedged include the euro, Japanese +yen, British pound, and Canadian dollar. Fixed-income securities are subject primarily to interest rate risk. The portfolio is diversified and structured to minimize credit risk. Securities held in our equity and other investments portfolio are +subject to price risk, and are generally not hedged. However, we use options to hedge our price risk on certain equity securities that are held primarily for strategic purposes. Commodity derivatives held for the purpose of portfolio diversification +are subject to commodity price risk. We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected +loss, for a given confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, but is used as a risk estimation and management +tool. The model used for currencies, equities, and commodities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest rate risk, exposures such as key rate durations and spread +durations are used in calculations that reflect the principle that fixed-income security prices revert to maturity value over time. VaR is calculated +by computing the exposures of each holding’s market value to a range of over 1,000 equity, fixed-income, foreign exchange, and commodity risk factors. The exposures are then used to compute the parameters of a distribution of potential changes +in the total market value of all holdings, taking into account the weighted historical volatilities of the different rates and prices and the weighted historical correlations among the different rates and prices. The VaR is then calculated as the +total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, +operational risk, credit risk, and legal risk. Certain securities in our equity portfolio are held for strategic purposes. We hedge the value of a +portion of these securities through the use of derivative contracts such as put-call collars. In these arrangements, we hedge a security’s equity price risk below the purchased put strike and forgo most or all of the benefits of the +security’s appreciation above the sold call strike, in exchange for the premium received for the sold call. We also hold equity securities for general investment return purposes. We have incurred material impairment charges related to these +securities in previous periods. At the beginning of the second fiscal quarter of fiscal year 2006, we changed the methodology we use to calculate +VaR. We previously used a Monte Carlo simulation-based methodology to calculate VaR. In the second quarter of fiscal year 2006, we adopted a factor-based parametric methodology. The factor-based parametric methodology can be performed more +frequently (resulting in more timely data), divides the aggregated VaR into its component risk factor groups, and is incrementally more accurate than the previously used simulation-based methodology in evaluating diversification effects of commodity +risk factors and interactions between equity and currency factors. While we believe the efficiencies gained by changing to the parametric methodology are significant, we do not believe this methodology produces results that are significantly +different from the simulation-based methodology. The VaR amounts disclosed below are used as a risk management tool and reflect an estimate of +potential reductions in fair value of our portfolio. Losses in fair value over the specified holding period can exceed the reported VaR by significant amounts and can also accumulate over a longer time horizon than the specified holding period used +in the VaR analysis. VaR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. VaR numbers are shown separately for interest rate, currency rate, equity price, and commodity price risks. These VaR numbers include the underlying portfolio +positions and related hedges. We use historical data to estimate VaR. Given the reliance on historical data, VaR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An +inherent limitation in VaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. PAGE 41 Table of Contents Part II Item 7A The following table sets forth the one-day VaR for substantially all of +our positions as of June 30, 2006 and 2005, and for the fiscal year ended June 30, 2006: (In millions) Year ended June 30, 2006 Risk Categories 2006 2005 Average High Low Interest rates $ 66 $ 88 $ 82 $ 127 $ 62 Currency rates 91 52 33 91 11 Equity prices 88 164 116 168 84 Commodity prices 12 14 15 18 12 Total one-day VaR for the combined risk categories was $158 million at June 30, 2006 and $195 million +at June 30, 2005. The total VaR is 38% less at June 30, 2006 and 39% less at June, 30 2005 than the sum of the separate risk categories in the above table due to the diversification benefit of the combination of risks. PAGE 42 Table of Contents Part II Item 8 ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30 2006 2005 2004 Revenue $ 44,282 $ 39,788 $ 36,835 Operating expenses: Cost of revenue 7,650 6,031 6,596 Research and development 6,584 6,097 7,735 Sales and marketing 9,818 8,563 8,195 General and administrative 3,758 4,536 5,275 Total operating expenses 27,810 25,227 27,801 Operating income 16,472 14,561 9,034 Investment income and other 1,790 2,067 3,162 Income before income taxes 18,262 16,628 12,196 Provision for income taxes 5,663 4,374 4,028 Net income $ 12,599 $ 12,254 $ 8,168 Earnings per share: Basic $ 1.21 $ 1.13 $ 0.76 Diluted $ 1.20 $ 1.12 $ 0.75 Weighted average shares outstanding: Basic 10,438 10,839 10,803 Diluted 10,531 10,906 10,894 Cash dividends declared per common share $ 0.35 $ 3.40 $ 0.16 See accompanying notes. PAGE 43 Table of Contents Part II Item 8 BALANCE SHEETS (In millions) June 30 2006 2005 Assets Current assets: Cash and equivalents $ 6,714 $ 4,851 Short-term investments (including securities pledged as collateral of $3,065 and $-) 27,447 32,900 Total cash and short-term investments 34,161 37,751 Accounts receivable, net of allowance for doubtful accounts of $142 and $171 9,316 7,180 Inventories, net 1,478 491 Deferred income taxes 1,940 1,701 Other 2,115 1,614 Total current assets 49,010 48,737 Property and equipment, net 3,044 2,346 Equity and other investments 9,232 11,004 Goodwill 3,866 3,309 Intangible assets, net 539 499 Deferred income taxes 2,611 3,621 Other long-term assets 1,295 1,299 Total assets $ 69,597 $ 70,815 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 2,909 $ 2,086 Accrued compensation 1,938 1,662 Income taxes 1,557 2,020 Short-term unearned revenue 9,138 7,502 Securities lending payable 3,117 — Other 3,783 3,607 Total current liabilities 22,442 16,877 Long-term unearned revenue 1,764 1,665 Other long-term liabilities 5,287 4,158 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 10,062 and 10,710 59,005 60,413 Retained earnings (deficit), including accumulated other comprehensive income of $1,229 and $1,426 (18,901 ) (12,298 ) Total stockholders’ equity 40,104 48,115 Total liabilities and stockholders’ equity $ 69,597 $ 70,815 See accompanying notes. PAGE 44 Table of Contents Part II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30 2006 2005 2004 Operations Net income $ 12,599 $ 12,254 $ 8,168 Depreciation, amortization, and other noncash items 903 855 1,186 Stock-based compensation 1,715 2,448 5,734 Net recognized gains on investments (270 ) (527 ) (1,296 ) Stock option income tax benefits – 668 1,100 Excess tax benefits from stock-based payment arrangements (89 ) – – Deferred income taxes 219 (179 ) (1,479 ) Unearned revenue 16,453 13,831 11,777 Recognition of unearned revenue (14,729 ) (12,919 ) (12,527 ) Accounts receivable (2,071 ) (1,243 ) (687 ) Other current assets (1,405 ) (245 ) 478 Other long-term assets (49 ) 21 34 Other current liabilities (145 ) 396 1,529 Other long-term liabilities 1,273 1,245 609 Net cash from operations 14,404 16,605 14,626 Financing Common stock issued 2,101 3,109 2,748 Common stock repurchased (19,207 ) (8,057 ) (3,383 ) Common stock cash dividends (3,545 ) (36,112 ) (1,729 ) Excess tax benefits from stock-based payment arrangements 89 – – Other – (18 ) – Net cash used in financing (20,562 ) (41,078 ) (2,364 ) Investing Additions to property and equipment (1,578 ) (812 ) (1,109 ) Acquisition of companies, net of cash acquired (649 ) (207 ) (4 ) Purchases of investments (51,117 ) (68,045 ) (95,005 ) Maturities of investments 3,877 29,153 5,561 Sales of investments 54,353 54,938 87,215 Net proceeds from securities lending 3,117 – – Net cash from (used in) investing 8,003 15,027 (3,342 ) Net change in cash and equivalents 1,845 (9,446 ) 8,920 Effect of exchange rates on cash and equivalents 18 (7 ) 27 Cash and equivalents, beginning of period 4,851 14,304 5,357 Cash and equivalents, end of period $ 6,714 $ 4,851 $ 14,304 See accompanying notes. PAGE 45 Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30 2006 2005 2004 Common stock and paid-in capital Balance, beginning of period $ 60,413 $ 56,396 $ 49,234 Common stock issued 1,939 3,223 2,815 Common stock repurchased (4,447 ) (1,737 ) (416 ) Stock-based compensation expense 1,715 2,448 5,734 Stock option income tax benefits/(deficiencies) (617 ) 89 (989 ) Other, net 2 (6 ) 18 Balance, end of period 59,005 60,413 56,396 Retained earnings (deficit) Balance, beginning of period (12,298 ) 18,429 15,678 Net income 12,599 12,254 8,168 Other comprehensive income: Net gains/(losses) on derivative instruments 76 (58 ) 101 Net unrealized investments gains/(losses) (282 ) 371 (873 ) Translation adjustments and other 9 (6 ) 51 Comprehensive income 12,402 12,561 7,447 Common stock cash dividends (3,594 ) (36,968 ) (1,729 ) Common stock repurchased (15,411 ) (6,320 ) (2,967 ) Balance, end of period (18,901 ) (12,298 ) 18,429 Total stockholders’ equity $ 40,104 $ 48,115 $ 74,825 See accompanying notes. PAGE 46 Table of Contents Part II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES ACCOUNTING PRINCIPLES The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the +United States of America. PRINCIPLES OF CONSOLIDATION The +financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not control and are not the +primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. ESTIMATES AND ASSUMPTIONS Preparing financial statements +requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies, product life cycles, and stock-based compensation forfeiture +rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax +consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual +results and outcomes may differ from management’s estimates and assumptions. We revised our expense classification policies during fiscal year +2006 which resulted in reclassifications of certain operating expenses. We have reclassified the prior period amounts to conform to the current year presentation. These reclassifications had no impact on total operating expenses, operating income +and our net income. FOREIGN CURRENCIES Assets and +liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this +process are charged or credited to Other Comprehensive Income (“OCI”). REVENUE RECOGNITION Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. We enter into +certain arrangements where we are obligated to deliver multiple products and/or services (multiple elements). In these arrangements, we generally allocate the total revenue among the elements based on the sales price of each element when sold +separately (vendor-specific objective evidence). Revenue for retail packaged products, products licensed to original equipment manufacturers +(“OEM”), and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped, with a portion of the revenue recorded as unearned due to undelivered elements +including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is +based on the vendor-specific objective evidence of fair value for those elements using the residual method. Under the residual method, the total fair value of the undelivered elements, as indicated by vendor-specific objective evidence, is recorded +as unearned, and the difference between the total arrangement fee and the amount recorded as unearned for the undelivered elements is recognized as revenue related to delivered elements. Unearned revenue due to undelivered elements is recognized +ratably on a straight-line basis over the related product’s life cycle. Revenue from multi-year licensing arrangements are accounted for as +subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing PAGE 47 Table of Contents Part II Item 8 arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select volume licensing programs (Software +Assurance). In addition, other multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis under Open, Select, and +Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions. Revenue related to our Xbox game console is recognized upon shipment of the product to retailers. Revenue related to games published by us is recognized when those +games have been delivered to retailers. Revenue related to games published by third parties for use on the Xbox platform is recognized when manufactured for the game publishers. Online advertising revenue is recognized as advertisements are +displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on +the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Revenue for fixed price services arrangements is recognized based on percentage of completion. Costs related to insignificant obligations, which include telephone support for developer tools software, PC games, computer hardware, and Xbox, are accrued when +the related revenue is recognized. Provisions are recorded for estimated returns, concessions, and bad debts. RESEARCH AND DEVELOPMENT Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with product +development. We have determined that technological feasibility for our software products is reached shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established have not been material, and +accordingly, we have expensed all research and development costs when incurred. SALES AND MARKETING Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with sales and marketing personnel and +advertising, promotions, tradeshows, seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising expense was $1.23 billion in fiscal year 2006, $995 million in fiscal year 2005, and $904 million in fiscal +year 2004. INCOME TAXES Income tax expense includes U.S. +and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial +statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. FINANCIAL INSTRUMENTS We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. In general, +investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short term investments. Investments with maturities beyond one year may be classified as short-term based on their +highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available for sale and are recorded at market +value using the specific identification method; unrealized gains and losses (excluding other-than-temporary impairments) are reflected in OCI. Equity +and other investments may include both debt and equity instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Unrealized gains and +losses (excluding other-than-temporary impairments) are reflected in OCI. All other investments, excluding those accounted for using the equity method, are recorded at cost. We lend certain fixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet. +Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability. PAGE 48 Table of Contents Part II Item 8 Investments are considered to be impaired when a decline +in fair value is judged to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an +investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse +conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair +value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. We use +derivative instruments to manage exposures to foreign currency, equity price, interest rate and credit risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and +efficiently managing the economic impact of these exposures as effectively as possible. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a +derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting +loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of OCI and is +subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow hedges, changes in the time value are +excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are recognized in earnings. Foreign Currency Risk. Certain assets, liabilities, and forecasted transactions are exposed to foreign currency risk. We monitor our foreign currency +exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging +instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities . Principal currencies hedged include the euro, Japanese yen, British pound, and +Canadian dollar. Certain non-U.S. dollars denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS No. 133. Certain options and forwards not designated as +hedging instruments under SFAS No. 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures. Equities Price Risk. Equity investments are subject to market price risk. From time to time, we use and designate options to hedge +fair values and cash flows on certain equity securities. We determine the security, or forecasted sale thereof, selected for hedging by evaluating market conditions, up-front costs, and other relevant factors. Certain options, futures and swap +contracts, not designated as hedging instruments under SFAS No. 133, are also used to manage equity exposures. Interest Rate +Risk. Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and +future contracts and over-the-counter swap contracts, not designated as hedging instruments under SFAS No. 133, to hedge interest rate risk. Other +Derivatives. Swap contracts, not designated as hedging instruments under SFAS No. 133, are used to manage exposures to credit risks, enhance returns, and to facilitate portfolio diversification. In addition, we may +invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. “To Be Announced” +forward purchase commitments of mortgage-backed assets are also considered derivatives in cases where physical delivery of the assets are not taken at the earliest available delivery date. All derivative instruments not designated as hedging +instruments are recorded at fair value, with changes in value recognized in earnings during the period of change. PAGE 49 Table of Contents Part II Item 8 ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled +accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30 Balance at beginning of period Charged to costs and expenses Write-offs and other Balance at end of period 2004 $ 242 $ 44 $ (120 ) $ 166 2005 166 48 (43 ) 171 2006 171 40 (69 ) $ 142 INVENTORIES Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities +on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and +depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the straight-line method +over the estimated useful life of the software, generally three years or less. GOODWILL Goodwill is tested for impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No +impairment of goodwill has been identified during any of the periods presented. INTANGIBLE ASSETS Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We evaluate the recoverability of intangible +assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. All of our intangible assets are subject to amortization. No impairments of intangible assets +have been identified during any of the periods presented. NOTE 2    UNEARNED REVENUE Unearned revenue is comprised of the following items: Volume licensing programs – +Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage +period. Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft +Internet Explorer on a when-and-if-available basis. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The +percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 1% to 15% +of the sales price for desktop applications, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems and two years for +desktop applications. PAGE 50 Table of Contents Part II Item 8 Other – Represents payments for post-delivery support and +consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Business Solutions maintenance and enhancement billings, Xbox Live and other billings that are accounted for as +subscriptions, and other agreements where Microsoft is committed to the delivery of future enhancements, products, or services, including the TV platform. The +components of unearned revenue were as follows: (In millions) June 30 2006 2005 Volume licensing programs $ 7,661 $ 6,000 Undelivered elements 2,066 2,119 Other 1,175 1,048 Unearned revenue $ 10,902 $ 9,167 Unearned revenue by segment was as follows: (In millions) June 30 2006 2005 Client $ 2,850 $ 2,687 Server and Tools 3,792 3,048 Information Worker 3,609 2,814 Other segments 651 618 Unearned revenue $ 10,902 $ 9,167 NOTE 3    INVESTMENTS The components of investments were as follows: (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2006 Cash $ 3,248 $ – $ – $ 3,248 $ 3,248 $ – $ – Mutual funds 723 11 (1 ) 733 288 445 – Commercial paper 3,242 – – 3,242 3,150 92 – Certificates of deposit 364 – – 364 – 364 – U. S. Government and Agency securities 4,904 4 (30 ) 4,878 14 4,790 74 Foreign government bonds 6,034 21 (73 ) 5,982 – 5,982 – Mortgage backed securities 4,285 – (42 ) 4,243 – 4,243 – Corporate notes and bonds 7,605 15 (18 ) 7,602 – 7,475 127 Municipal securities 4,008 5 (45 ) 3,968 14 3,954 – Common stock and equivalents 6,933 1,846 (34 ) 8,745 – – 8,745 Preferred stock 41 5 – 46 – – 46 Other investments 342 – – 342 – 102 240 Total $ 41,729 $ 1,907 $ (243 ) $ 43,393 $ 6,714 $ 27,447 $ 9,232 PAGE 51 Table of Contents Part II Item 8 (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2005 Cash $ 1,911 $ – $ – $ 1,911 $ 1,911 $ – $ – Mutual funds 1,636 38 – 1,674 817 857 – Commercial paper 1,566 4 – 1,570 1,570 – – Certificates of deposit 614 – – 614 453 161 – U. S. Government and Agency securities 9,943 29 (59 ) 9,913 – 9,913 – Foreign government bonds 5,486 194 (2 ) 5,678 – 5,678 – Mortgage backed securities 123 – – 123 – 123 – Corporate notes and bonds 8,053 50 (31 ) 8,072 80 7,473 519 Municipal securities 8,579 70 (33 ) 8,616 20 8,596 – Common stock and equivalents 7,273 1,970 (133 ) 9,110 – – 9,110 Preferred stock 1,067 4 – 1,071 – – 1,071 Other investments 403 – – 403 – 99 304 Total $ 46,654 $ 2,359 $ (258 ) $ 48,755 $ 4,851 $ 32,900 $ 11,004 Investments with continuous unrealized losses for less than and greater than 12 months and their related fair values were as +follows: Less than 12 months 12 months or greater Total (In millions) Fair value Unrealized losses Fair value Unrealized losses Fair value Unrealized losses June 30, 2006 Mutual funds $ 14 $ (1 ) $ 4 $ – $ 18 $ (1 ) U. S. Government and Agency securities 2,303 (24 ) 172 (6 ) 2,475 (30 ) Foreign government bonds 2,523 (56 ) 1,749 (17 ) 4,272 (73 ) Mortgage backed securities 2,692 (40 ) 102 (2 ) 2,794 (42 ) Corporate notes and bonds 4,721 (13 ) 359 (5 ) 5,080 (18 ) Municipal securities 1,323 (13 ) 1,192 (32 ) 2,515 (45 ) Common stock and equivalents 266 (33 ) 29 (1 ) 295 (34 ) Total $ 13,842 $ (180 ) $ 3,607 $ (63 ) $ 17,449 $ (243 ) Less than 12 months 12 months or greater Total (In millions) Fair value Unrealized losses Fair value Unrealized losses Fair value Unrealized losses June 30, 2005 U. S. Government and Agency securities $ 7,490 $ (59 ) $ – $ – 7,490 $ (59 ) Foreign government bonds 32 (2 ) – – 32 (2 ) Corporate notes and bonds 4,536 (31 ) – – 4,536 (31 ) Municipal securities 4,339 (30 ) 239 (3 ) 4,578 (33 ) Common stock and equivalents 1,168 (111 ) 89 (22 ) 1,257 (133 ) Total $ 17,565 $ (233 ) $ 328 $ (25 ) $ 17,893 $ (258 ) PAGE 52 Table of Contents Part II Item 8 At June 30, 2006 unrealized losses of $243 million consisted of: +$196 million related to investment grade fixed-income securities, $12 million related to investments in high yield and emerging market fixed-income securities, $2 million related to domestic equity securities and $33 million related to international +equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. At June 30, 2005 unrealized +losses of $258 million consisted of: $112 million related to investment grade fixed-income securities, $13 million related to investments in high yield and emerging market fixed income securities, $90 million related to domestic equity securities +and $43 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price +movements. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of June 30, 2006. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2006 +the recorded basis of these investments was $41 million, and their estimated fair value was $41 million. At June 30, 2005 the recorded basis of these investments was $1.05 billion, and their estimated fair value was $1.27 billion. The estimate +of fair value is based on publicly available market information or other estimates determined by management. The maturities of debt securities, +including fixed maturity securities, at June 30, 2006 were as follows: (In millions) Cost basis Estimated fair value Due in one year or less $ 5,680 $ 5,686 Due after one year through five years 12,011 11,971 Due after five years through ten years 6,111 6,041 Due after ten years 6,741 6,683 Total $ 30,543 $ 30,381 NOTE 4    INVESTMENT INCOME AND OTHER The components of investment income and other were as follows: (In millions) Year Ended June 30 2006 2005 2004 Dividends and interest $ 1,510 $ 1,460 $ 1,892 Net gains on investments 161 856 1,563 Net losses on derivatives (99 ) (262 ) (268 ) Income/(losses) from equity investees and other 218 13 (25 ) Investment income and other $ 1,790 $ 2,067 $ 3,162 Net gains on investments include other-than-temporary impairments of $408 million in fiscal year 2006, $152 million in +fiscal year 2005, and $82 million in fiscal year 2004. The increase in other-than-temporary impairments in fiscal year 2006 was driven by planned sales of certain investments in an unrealized loss position in order to raise funds for the $20 billion +tender offer announced on July 20, 2006. Realized gains and (losses) from sales of available-for-sale securities (excluding other-than-temporary impairments) were $1.11 billion and $(531) million in fiscal year 2006, $1.38 billion and $(376) +million in fiscal year 2005, and $2.16 billion and $(518) million in fiscal year 2004. NOTE 5    DERIVATIVES For derivative instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging +Activities , did not have a significant impact on earnings PAGE 53 Table of Contents Part II Item 8 for fiscal years 2006, 2005, or 2004. During fiscal year 2006, $217 million in gains on fair value hedges from changes in time value and $399 million in losses on cash +flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in investment income and other. During fiscal year 2005, $79 million in gains on fair value hedges from changes in time value and $116 +million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in investment income and other. During fiscal year 2004, $31 million in gains on fair value hedges from changes in +time value and $325 million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in investment income and other. Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of an equity investment is recognized. During +fiscal year 2006, $166 million of derivative gains were reclassified to revenue and $23 million in derivative gains were reclassified to investment income and other. During fiscal year 2005, $57 million of derivative gains were reclassified to +revenue and $33 million in derivative gains were reclassified to investment income and other. During fiscal year 2004, $14 million of derivative gains were reclassified to revenue and no derivative gains or losses were reclassified to investment +income and other. We estimate that $133 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. +No significant amounts of gains or losses were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur for fiscal years 2006, 2005, and 2004. NOTE 6    INVENTORIES (In millions) June 30 2006 2005 Finished goods $ 1,013 $ 422 Raw materials and work in process 465 69 Inventories $ 1,478 $ 491 NOTE 7    PROPERTY AND EQUIPMENT (In millions) June 30 2006 2005 Land $ 362 $ 313 Buildings and improvements 2,228 2,014 Leasehold improvements 918 851 Computer equipment and software 2,682 2,318 Furniture and equipment 1,033 879 Property and equipment, at cost 7,223 6,375 Accumulated depreciation (4,179 ) (4,029 ) Property and equipment, net $ 3,044 $ 2,346 Property and equipment are stated at cost. Depreciation is computed principally on the straight-line method over the +estimated useful lives of the assets. The useful lives for buildings range from five to 15 years, leasehold improvements range from two to ten years – representing the applicable lease terms plus reasonably assured extensions, computer +equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated. During +fiscal years 2006, 2005, and 2004, depreciation expense was $863 million, $723 million, and $647 million, respectively. The majority of depreciation expense in all years related to computer equipment. PAGE 54 Table of Contents Part II Item 8 NOTE 8    GOODWILL Changes in the carrying amount of goodwill for fiscal years 2006 and 2005 by segment were as follows: (In millions) Balance as of June 30, 2004 Acquisitions / purchase accounting adjustments Divestitures Balance as of June 30, 2005 Acquisitions Other Balance as of June 30, 2006 Client $ 37 $ 6 $ – $ 43 $ 31 $ – $ 74 Server and Tools 106 135 – 241 29 (14 ) 256 Information Worker 178 47 – 225 246 – 471 Microsoft Business Solutions 2,207 3 – 2,210 – – 2,210 MSN 154 17 – 171 263 21 455 Mobile and Embedded Devices 30 – – 30 – (24 ) 6 Home and Entertainment 403 – (14 ) 389 23 (18 ) 393 Total $ 3,115 $ 208 $ (14 ) $ 3,309 $ 592 $ (35 ) $ 3,866 We test goodwill for impairment annually during the first quarter of each fiscal year at the reporting unit level using a +fair value approach, in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets . Our annual testing resulted in no impairments of goodwill in fiscal years 2006 and 2005. If an event occurs or circumstances +change that would more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for impairment between annual tests. During fiscal year 2005, we had no material acquisitions. During the fiscal year 2006, we acquired the following entities for a total consideration of $689 million, which was primarily paid in cash: • Frontbridge Technologies, Inc., a California-based provider of managed services that addresses corporate e-mail compliance, security, and availability requirements; • Teleo, Inc., a California-based voice over Internet protocol software and services provider; • MediaStreams.com AG, a Zurich, Switzerland-based developer of PC-based voice over Internet protocol communication systems and peripheral equipment; • Lionhead Studios Ltd., a Guildford, England-based software studio specializing in PC game development; • Vexcel Corporation, a Colorado-based imagery technology and systems provider; • Massive Corporation, a New York-based developer of video game advertising; • ProClarity Corporation, an Idaho-based developer of advanced analysis and visualization technologies for business platforms; and • 14 various other entities specializing in areas such as application security, digital access management, and networking solutions. As a result of these acquisitions, we recorded $592 million of goodwill. None of that amount is expected to be deductible for tax purposes. Goodwill was assigned +to our operating segments as follows: $29 million to Server & Tools, $263 million to MSN, $31 million to Client, $246 million to Information Worker, and $23 million to Home and Entertainment. We also recorded $125 million of +technology-based intangible assets with a weighted-average amortization period of 3.25 years, and $26 million of other intangible assets with a weighted-average amortization period of 4.5 years. All of the entities have been consolidated into our +financial statements since their respective acquisition dates. None of the acquisitions, individually or in the aggregate, are material to our consolidated results of operations. Accordingly, pro forma information has not been included. PAGE 55 Table of Contents Part II Item 8 NOTE 9    INTANGIBLE ASSETS The components of finite-lived intangible assets were as follows: (In millions) June 30 2006 2005 Gross carrying amount Accumulated amortization Net carrying amount Gross carrying amount Accumulated amortization Net carrying amount Contract-based $ 954 $ (661 ) $ 292 $ 957 $ (606 ) $ 351 Technology-based 458 (255 ) 203 309 (200 ) 109 Marketing-related 42 (32 ) 10 35 (25 ) 10 Customer-related 54 (21 ) 33 40 (11 ) 29 Total $ 1,508 $ (969 ) $ 539 $ 1,341 $ (842 ) $ 499 During fiscal year 2006 and 2005, we recorded additions to intangible assets of $189 million and $90 million, respectively. +We estimate that we have no significant residual value related to our intangible assets. The components of finite-lived intangible assets acquired during fiscal years 2006 and 2005 were as follows: (In millions) Year Ended June 30 2006 2005 Amount Weighted average life Amount Weighted average life Contract-based $ 36 4 years $ 16 6 years Technology-based 140 4 years 64 5 years Marketing-related 5 3 years – – Customer-related 8 4 years 10 5 years Total $ 189 $ 90 Acquired intangibles are generally amortized on a straight-line basis over weighted average periods. Intangible assets +amortization expense was $127 million for fiscal year 2006, $161 million for fiscal year 2005, and $170 million for fiscal year 2004. The estimated future amortization expense related to intangible assets as of June 30, 2006 is as follows: (In millions) Year Ended June 30 Amount 2007 $ 150 2008 126 2009 83 2010 60 2011 46 Total $ 465 PAGE 56 Table of Contents Part II Item 8 NOTE 10    INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30 2006 2005 2004 Current taxes: U.S. Federal $ 4,471 $ 3,401 $ 3,766 U.S. State and Local 101 152 174 International 882 911 1,056 Current taxes 5,454 4,464 4,996 Deferred taxes (benefits) 209 (90 ) (968 ) Provision for income taxes $ 5,663 $ 4,374 $ 4,028 U.S. and international components of income before income taxes were as follows: (In millions) Year Ended June 30 2006 2005 2004 U.S. $ 11,404 $ 9,806 $ 8,088 International 6,858 6,822 4,108 Income before income taxes $ 18,262 $ 16,628 $ 12,196 The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for +income taxes were as follows: Year Ended June 30 2006 2005 2004 Federal statutory rate 35.0 % 35.0 % 35.0 % Effect of: Foreign earnings taxed at lower rates (4.6 )% (3.1 )% (1.7 )% Examination settlements (0.6 )% (4.7 )% – Other reconciling items 1.2 % (0.9 )% (0.3 )% Effective rate 31.0 % 26.3 % 33.0 % The 2006 other reconciling items includes the impact of the $351 million non-deductible European Commission fine. The 2005 +other reconciling items include a $179 million repatriation tax benefit under the American Jobs Creation Act of 2004. The 2004 other reconciling items include the $208 million benefit from the resolution of an issue remanded by the Ninth Circuit +Court of Appeals and the impact of the $605 million non-deductible European Commission fine. PAGE 57 Table of Contents Part II Item 8 The components of the deferred tax assets and +liabilities were as follows: (In millions) June 30 2006 2005 Deferred income tax assets: Stock-based compensation expense $ 3,630 $ 3,994 Other expense items 1,451 1,751 Unearned revenue 1,028 915 Impaired investments 989 861 Other revenue items 102 213 Other – 173 Deferred income tax assets $ 7,200 $ 7,907 Deferred income tax liabilities: International earnings $ (1,715 ) $ (1,393 ) Unrealized gain on investments (801 ) $ (1,169 ) Other (133 ) (23 ) Deferred income tax liabilities (2,649 ) (2,585 ) Net deferred income tax assets $ 4,551 $ 5,322 Reported as: Current deferred tax assets $ 1,940 $ 1,701 Long-term deferred tax assets 2,611 3,621 Net deferred income tax assets $ 4,551 $ 5,322 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and +liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes are actually paid or recovered. We have not +provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $505 million resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount +of unrecognized deferred tax liability associated with these temporary differences is approximately $151 million. The American Jobs Creation Act of +2004 (the “Act”) was enacted in October 2004. The Act creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from +controlled foreign corporations. Under these provisions, we repatriated approximately $780 million in dividends subject to the elective 85% dividends received deduction and we recorded a corresponding tax provision benefit of $179 million from the +reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign subsidiary earnings in 2005. The dividend was paid in June 2006. Income taxes paid were $4.8 billion in fiscal year 2006, $4.3 billion in fiscal year 2005, and $2.5 billion in fiscal year 2004. Tax +Contingencies .    We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and recording the related +assets and liabilities. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Accruals for tax contingencies are +provided for in accordance with the requirements of SFAS No. 5, Accounting for Contingencies . Although we believe we have appropriate +support for the positions taken on our tax returns, we have recorded a liability for our best estimate of the probable loss on certain of these positions, the non-current portion of which is included in other long-term liabilities. We believe that +our accruals for tax liabilities are adequate for all open years, based on our assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter, which matters result primarily from inter-company +transfer pricing, restructuring of foreign PAGE 58 Table of Contents Part II Item 8 operations, tax benefits from the Foreign Sales Corporation and Extra Territorial Income tax rules, the amount of research and experimentation tax credits claimed, +state income taxes, and certain other matters. Although we believe our recorded assets and liabilities are reasonable, tax regulations are subject to interpretation and tax litigation is inherently uncertain; therefore our assessments can involve +both a series of complex judgments about future events and rely heavily on estimates and assumptions. Although we believe that the estimates and assumptions supporting our assessments are reasonable, the final determination of tax audit settlements +and any related litigation could be materially different than that which is reflected in historical income tax provisions and recorded assets and liabilities. If we were to settle an audit or a matter under litigation, it could have a material +effect on our income tax provision, net income, or cash flows in the period or periods for which that determination is made. Due to the complexity involved we are not able to estimate the range of reasonably possible losses in excess of amounts +recorded. The Internal Revenue Service (“IRS”) has completed and closed its audits of our consolidated federal income tax returns through +1999. The IRS is currently conducting an audit of our consolidated federal income tax return for tax years 2000 through 2003. NOTE +11    OTHER LONG-TERM LIABILITIES (In millions) June 30 2006 2005 Tax contingencies $ 4,194 $ 3,066 Legal contingencies 1,022 961 Employee stock option transfer program – 48 Other 71 83 Other long-term liabilities $ 5,287 $ 4,158 NOTE 12    STOCKHOLDERS’ EQUITY Shares of common stock outstanding were as follows: (In millions) Year Ended June 30 2006 2005 2004 Balance, beginning of year 10,710 10,862 10,771 Issued 106 160 215 Repurchased (754 ) (312 ) (124 ) Balance, end of year 10,062 10,710 10,862 On July 20, 2006, we announced the completion of the $30 billion Microsoft common stock repurchase program approved by +our Board of Directors on July 20, 2004. The repurchases were made using our cash resources. Our Board of Directors had previously approved a program to repurchase shares of our common stock. Under these repurchase plans, we have made the +following share repurchases: (share amounts in millions, dollars in billions) Fiscal year 2006 (1) 2005 (1) 2004 Shares Amount Shares Amount Shares Amount First quarter 114.1 $ 3.0 22.8 $ 0.6 43.3 $ 1.2 Second quarter 283.1 7.7 23.6 0.7 30.5 0.8 Third quarter 180.7 4.9 95.1 2.4 49.9 1.4 Fourth quarter 175.6 4.1 170.7 4.3 – – Total 753.5 $ 19.7 312.2 $ 8.0 123.7 $ 3.4 (1) All amounts repurchased in fiscal year 2005 and in fiscal year 2006 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004. PAGE 59 Table of Contents Part II Item 8 In fiscal year 2006, our Board of Directors declared the following +dividends: Declaration Date Dividend Per Share Date of Record Total Amount (in millions) Payment Date September 23, 2005 $ 0.08 November 17, 2005 $ 846 December 8, 2005 December 14, 2005 $ 0.09 February 17, 2006 $ 926 March 9, 2006 March 27, 2006 $ 0.09 May 17, 2006 $ 916 June 8, 2006 June 21, 2006 $ 0.09 August 17,2006 $ 906 (1) September 14, 2006 (1) The dividend declared on June 21, 2006 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2006. In fiscal year 2005, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Date of Record Total Amount (in millions) Payment Date July 20, 2004 $ 0.08 August 25, 2004 $ 870 September 14, 2004 July 20, 2004 $ 3.00 November 17, 2004 $ 32,640 December 2, 2004 September 15, 2004 $ 0.08 November 17, 2004 $ 871 December 2, 2004 December 8, 2004 $ 0.08 February 17, 2005 $ 868 March 10, 2005 March 23, 2005 $ 0.08 May 18, 2005 $ 860 June 9, 2005 June 15, 2005 $ 0.08 August 17, 2005 $ 857 (1) September 8, 2005 (1) The dividend declared on June 15, 2005 was included in other current liabilities as of June 30, 2005. NOTE 13    OTHER COMPREHENSIVE INCOME The activity in other comprehensive income and related +tax effects were as follows: (In millions) Year Ended June 30 2006 2005 2004 Net gains/(losses) on derivative instruments: Unrealized gains/(losses), net of tax effect of $(25) in 2006, $(63) in 2005, and $49 in 2004 $ (47 ) $ (116 ) $ 92 Reclassification adjustment for losses included in net income, net of tax effect of $66 in 2006, $31 in 2005, and $5 in 2004 123 58 9 Net gains/(losses) on derivative instruments 76 (58 ) 101 Net unrealized investment gains/(losses): Unrealized holding losses, net of tax effect of $(199) in 2006, $(69) in 2005, and $(994) in 2004 (369 ) (128 ) (1,846 ) Reclassification adjustment for losses included in net income, net of tax effect of $47 in 2006, $269 in 2005, and $524 in 2004 87 499 973 Net unrealized investment gains/(losses) (282 ) 371 (873 ) Translation adjustments and other 9 (6 ) 51 Other comprehensive income /(loss) $ (197 ) $ 307 $ (721 ) PAGE 60 Table of Contents Part II Item 8 The components of accumulated other comprehensive income were as +follows: (In millions) Year Ended June 30 2006 2005 2004 Net gains on derivative instruments $ 103 $ 27 $ 85 Net unrealized investment gains 1,062 1,344 973 Translation adjustments and other 64 55 61 Accumulated other comprehensive income $ 1,229 $ 1,426 $ 1,119 NOTE 14    EMPLOYEE STOCK AND SAVINGS PLANS Effective July 1, 2005, we adopted SFAS No. 123(R), Share-Based Payment, using the modified prospective application transition method. Because the fair value +recognition provisions of SFAS No. 123, Stock-Based Compensation, and SFAS No. 123(R) were materially consistent under our equity plans, the adoption of SFAS No. 123(R) did not have a significant impact on our financial +position or our results of operations. Prior to our adoption of SFAS No. 123(R), benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS No. 123(R) requires excess tax benefits be +reported as a financing cash inflow rather than as a reduction of taxes paid. The stock-based compensation and related income tax benefits were as follows: (In millions) 2006 2005 2004 Total stock-based compensation $ 1,715 $ 2,448 $ 5,734 Income tax benefits related to stock-based compensation $ 600 $ 857 $ 2,007 Employee Stock Purchase Plan. We have an employee stock purchase plan for all eligible +employees. Compensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). The administrative committee under the plan approved a change to the common stock purchase discount and approved the elimination +of the related look back period and a change to quarterly purchase periods that became effective July 1, 2004. As a result, beginning in fiscal year 2005, shares of our common stock may presently be purchased by employees at three-month +intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2006 employees purchased +17.2 million shares at an average price of $23.02 per share. At June 30, 2006, 141.9 million shares were reserved for future issuance. During fiscal year 2005 employees purchased 16.4 million shares at average prices of $23.33 +per share. Under the plan in effect previous to fiscal year 2005, shares of our common stock could be purchased at six month intervals at 85% of the +lower of the fair market value on the first or the last day of each six-month period. Employees could purchase shares having a value not exceeding 15% of their gross compensation during an offering period. During fiscal year 2004 employees purchased +16.7 million shares at average prices of $22.74 per share. Savings Plan. We have a savings plan in the United States that +qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their pretax salary, but not more than statutory limits. We +contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $178 million, $154 million, and $141 million in fiscal years +2006, 2005, and 2004, respectively. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common +stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock. PAGE 61 Table of Contents Part II Item 8 Stock Plans. We have stock plans for +directors and for officers, employees, consultants, and advisors. At June 30, 2006, an aggregate of 812 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance +stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan Chase Bank (“JPMorgan”) (see below) in fiscal year 2004 have been +removed from our plans; any options transferred to JPMorgan that expire without being exercised will not become available for grant under any of our plans. On November 9, 2004, our shareholders approved amendments to the stock plans that allowed our Board of Directors to adjust eligible options, unvested stock awards, and shared performance stock awards to maintain their pre-dividend +value after the $3.00 special dividend. Additional awards were granted for options, stock awards, and shared performance stock awards by the ratio of post- and pre-special dividend stock price as of the ex-dividend date. Strike prices for options +were decreased by the same ratio. Stock-based compensation was not affected by this adjustment. As a result of this approval and payment of the $3.00 special dividend on December 2, 2004, an adjustment to the prices and number of shares of +existing awards was made resulting in a total of 96 million options and 6.7 million stock awards being issued to adjust the outstanding awards. In addition, the target shared performance stock awards were increased by 3.5 million +shares. We issue new shares to satisfy stock option exercises. On July 20, 2006, we announced the completion of the repurchase program initially +approved by our Board of Directors on July 20, 2004 to buy back up to $30 billion in Microsoft common stock. Stock Awards and Shared Performance Stock +Awards. Stock awards are grants that entitle the holder to shares of common stock as the award vests. Our stock awards generally vest over a five-year period. Shared Performance Stock Awards (“SPSAs”) are a form of stock award in which the number of shares ultimately received depends on our business performance +against specified performance targets. The performance period for SPSAs issued in fiscal years 2004, 2005, and 2006 was July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain executive officers). +Following the end of the performance period, the Board of Directors determined that the number of shares of stock awards to be issued was 37.0 million, based on the actual performance against metrics established for the performance period. One-third +of the awards will vest in the first quarter of fiscal year 2007. An additional one-third of the awards will vest over each of the following two years. Because the SPSAs covered a three-year period, SPSAs issued in fiscal year 2005 and 2006 were +given only to newly hired and promoted employees eligible to receive SPSAs. The Company will grant SPSAs for fiscal year 2007 with a performance +period of July 1, 2006 through June 30, 2007. At the end of the performance period, the number of shares of stock subject to the award will be determined by multiplying the target award by a percentage ranging from 0% to 150%. The +percentage will be determined based on performance against metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional 15% of the total stock and stock awards will +be available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award will vest following the end of the performance period, and an additional one-quarter of the shares will vest +over each of the following three years. We measure the fair value of SAs and SPSAs based upon the market price of the underlying common stock as of the date of +grant, reduced by the present value of estimated future dividends. SAs and SPSAs are amortized over their applicable vesting period (generally five years) using the straight-line method. The fair value of each award grant is estimated on the date of +grant using the following assumptions: (In millions) 2006 2005 2004 Dividend per share $0.08 - $0.09 $0.08 $0.16 Interest rates range 3.2% - 5.3% 1.3% - 4.3% 0.9% - 4.2% The dividend per share amounts for fiscal year 2006 and fiscal year 2005 are quarterly dividend amounts. The dividend amount +of $0.16 was the total dividend per share for fiscal year 2004. PAGE 62 Table of Contents Part II Item 8 During fiscal year 2006, the following activity occurred under our +existing plans: Shares (in millions) Weighted Average Grant-Date Fair Value Stock awards: Nonvested balance at July 1, 2005 71.3 $ 23.92 Granted 47.3 24.70 Vested (15.7 ) 23.85 Forfeited (4.8 ) 23.60 Nonvested balance at June 30, 2006 98.1 $ 24.25 Shared performance stock awards: Nonvested balance at July 1, 2005 35.3 $ 23.54 Granted 3.1 24.80 Vested – – Forfeited (1.8 ) 24.92 Nonvested balance at June 30, 2006 36.6 $ 23.57 As of June 30, 2006, there were $1.69 billion and $383 million of total unrecognized compensation costs related to SAs +and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.1 years and 2.2 years, respectively. During the 12 months +ended June 30, 2005 and June 30, 2004, the following activity occurred under our plans: (In millions, except fair values) Fiscal Year 2005 Fiscal Year 2004 Stock awards granted 41.0 32.6 Weighted average grant-date fair value $ 24.03 $ 24.09 Shared performance stock awards granted 3.7 31.7 Weighted average grant-date fair value $ 24.35 $ 23.62 Stock Options. In fiscal year 2004, we began granting employees stock awards rather than stock +options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Nonqualified stock options were granted to our directors under our non-employee +director stock plan. Nonqualified and incentive stock options were granted to our officers and employees under our employee stock plans. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from +the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options granted after 2001 vest over four and one-half years and expire ten years from +the date of grant. Approximately 2.9 million stock options were granted in conjunction with business acquisitions during fiscal year 2006. No stock options were granted during the year ended June 30, 2005. In fiscal year 2004, +approximately two million stock options were granted, nearly all of which were granted in conjunction with business acquisitions. During fiscal +year 2004, we completed an employee stock option transfer program whereby employees could elect to transfer all of their vested and unvested options with a strike price of $33.00 or higher to JPMorgan. The options transferred to JPMorgan were +amended and restated upon transfer to contain terms and conditions typical of equity option transactions entered into between sophisticated financial counterparties at arm’s length using standard terms and definitions for equity derivatives. As +a result of this program, we recorded additional stock-based compensation expense of $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) which was recorded in the second quarter of fiscal year 2004. As of June 30, 2006, +237 million options transferred to JPMorgan remained outstanding but are excluded from the table below. These options have strike prices ranging from $28.60 to $89.58 per share and have expiration dates extending through December 2006. PAGE 63 Table of Contents Part II Item 8 Employee stock options outstanding were as follows: Shares (in millions) Weighted Average Exercise Price Weighted Average Remaining Contractual Term (years) Aggregate Intrinsic Value (in millions) Balance, July 1, 2005 864 $ 27.41 Granted 3 23.54 Exercised (76 ) 20.59 Canceled (33 ) 32.13 Forfeited (8 ) 23.01 Balance, June 30, 2006 750 $ 27.92 4.16 $ 452 Exercisable, June 30, 2006 673 $ 28.55 3.93 $ 343 Included in the options outstanding balance are approximately five million options that were granted in conjunction with +business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise prices presented. These options have an exercise price range of $0 to $150.93 and a weighted average +exercise price of $11.26. As of June 30, 2006, there were $402 million of total unrecognized compensation costs related to stock options. These +costs are expected to be recognized over a weighted average period of approximately one year. During fiscal years 2006, 2005, and 2004 the following activity +occurred under our plans: (In millions) 2006 2005 2004 Total intrinsic value of stock options exercised $ 491 $ 940 $ 2,971 Total fair value of stock awards vested 377 198 20 Cash received and income tax benefit from stock option exercises for fiscal year 2006 were $1.71 billion and $183 million, +respectively. NOTE 15    EARNINGS PER SHARE Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common +stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The +components of basic and diluted earnings per share are as follows: (In millions, except earnings per share) Year Ended June 30 2006 2005 2004 Net income available for common shareholders (A) $ 12,599 $ 12,254 $ 8,168 Weighted average outstanding shares of common stock (B) 10,438 10,839 10,803 Dilutive effect of employee stock options and awards 93 67 91 Common stock and common stock equivalents (C) 10,531 10,906 10,894 Earnings per share: Basic (A/B) $ 1.21 $ 1.13 $ 0.76 Diluted (A/C) $ 1.20 $ 1.12 $ 0.75 PAGE 64 Table of Contents Part II Item 8 For the years ended June 30, 2006, 2005, and 2004, +649 million, 854 million, and 1.2 billion shares, respectively, were attributable to outstanding stock options and were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were +greater than or equal to the average price of the common shares, and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2006, 1.2 million shared performance stock awards, out of the 36.6 million +targeted amount outstanding, have been excluded from the calculation of diluted earnings per share because the number of shares ultimately issued is contingent on our performance against metrics established for the performance period, as discussed +in Note 14 – Employee Stock and Savings Plans. NOTE 16    COMMITMENTS AND GUARANTEES We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $276 million, $299 million, and +$331 million, in fiscal years 2006, 2005, and 2004, respectively. Future minimum rental commitments under noncancellable leases are as follows: (In millions) Year Ended June 30 Amount 2007 $ 250 2008 193 2009 138 2010 105 2011 and thereafter 199 $ 885 We have committed $234 million for constructing new buildings. In connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase the leased property from the lessor at +the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2006, the maximum amount of the residual value +guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability to us currently exists. We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from +the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations to our volume license resellers in case the resellers fail to collect from the end user. Due to the nature of the +indemnification provided to our resellers, we cannot estimate the fair value, nor determine the total nominal amount of the indemnification. We evaluate estimated losses for such indemnifications under SFAS No. 5, Accounting for +Contingencies , as interpreted by FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others . We consider such factors as the degree of probability of an +unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our +financial statements. Our product warranty accrual reflects management’s best estimate of our probable liability under its product warranties +(primarily relating to the Xbox console). We determine the warranty accrual based on known product failures (if any), historical experience, and other currently available evidence. Our warranty accrual totals $10 million as of June 30, 2006. +There has been no significant activity impacting the results of operations for any period presented. NOTE 17    CONTINGENCIES Government competition law matters. On March 25, 2004, the European Commission issued a decision in its competition law +investigation of us. The Commission concluded that we infringed European competition law by refusing to provide our competitors with licenses to certain protocol technology in the Windows server operating systems and by including streaming media +playback functionality in Windows desktop operating systems. The Commission ordered us to make the relevant licenses to our technology available to our competitors and to develop PAGE 65 Table of Contents Part II Item 8 and make available a version of the Windows desktop operating system that does not include specified software relating to media playback. The decision also imposed a +fine of € 497 million, which resulted in a charge in the third quarter of fiscal year 2004 of € 497 million ($605 million). We filed an appeal of the decision to the Court of First Instance on June 6, 2004. On December 22, 2004, the Court ordered that we +must comply with the decision pending review on appeal and we are taking steps to ensure we are in compliance. The hearing on the appeal occurred in April 2006. We continue to contest the conclusion that European competition law was infringed and +will defend our position vigorously. In December 2005, the Commission issued a Statement of Objections that preliminarily concluded we were not in full compliance with the 2004 decree. In March 2006, the Commission conducted an oral hearing on the +Statement of Objections and our response to the Statement. On July 12, 2006, the European Commission announced its determination that we had not complied with the technical documentation requirements of the 2004 Decision, and levied a fine of € 281 million ($351 million). We will appeal this fine to the Court of First Instance. On December 7, 2005, the Korean Fair Trade Commission (“KFTC”) announced a ruling in its investigation of us, holding that we abused a market +dominant position and engaged in unfair trade practices under the Korean Fair Trade Law by incorporating instant messaging and media player functionality into the Windows PC operating system, and streaming media technologies into the Windows server +operating system. The KFTC also announced the imposition of remedies, including a fine of approximately $34 million. The KFTC issued its formal written ruling and corrective order on February 23, 2006. The KFTC held that our integration of +Windows Media Player and Windows Messenger in Windows PC operating systems and integration of Windows Media Services in Windows server operating systems constituted an abuse of monopoly power and unlawful tying in violation of the Korean Fair Trade +Act. Under the order, which became effective August 24, 2006, we can no longer distribute Windows in Korea as currently designed. We are required to develop and distribute in Korea versions of Windows XP and its successors that do not include +Windows Media Player or Windows Messenger functionality. In addition, we also may distribute a second modified version of Windows that contains the removed functionality, provided the second version includes promotional links in the user interface +that will enable consumers to link to and download a select group of competing media players and instant messengers. We have appealed the KFTC’s decision to the Seoul High Court. On May 22, 2006, the KFTC denied our motion for +reconsideration of its ruling. As part of that decision, the KFTC dropped the element of its ruling that prohibited us from including Windows Media Player or Windows Messenger, or any feature with similar functionality, in any product other than the +Windows client operating system for which we have a 50% or greater market share. On August 23, 2006, we announced the release to manufacture of the mandated versions of Windows XP Home Edition and Windows XP Professional Edition. In other ongoing investigations, various foreign governments and several state Attorneys General have requested information from us concerning competition, privacy, +and security issues. Antitrust, and unfair competition, and overcharge class actions. A large number of antitrust and unfair +competition class action lawsuits have been filed against us in various state and federal courts on behalf of variously defined classes of direct and indirect purchasers of our PC operating system and certain software applications products. The +federal cases have been consolidated in the U.S. District Court for Maryland. These cases allege that we competed unfairly and unlawfully monopolized alleged markets for operating systems and certain software applications, and they seek to recover +alleged overcharges for these products. To date, courts have dismissed all claims for damages in cases brought against us by indirect purchasers under federal law and in 18 states. Ten of those state court decisions have been affirmed on appeal. +There was no appeal in five states. In addition, courts in two states refused to certify classes, essentially bringing the litigation to a close. Claims under federal law brought on behalf of foreign purchasers have been dismissed by the U.S. +District Court in Maryland as have all claims brought on behalf of consumers seeking injunctive relief under federal law. The ruling on injunctive relief and the ruling dismissing the federal claims of indirect purchasers were appealed to the United +States Court of Appeals for the Fourth Circuit, together with a ruling denying certification of certain proposed classes of U.S. direct purchasers. On April 18, 2006, the Court of Appeals affirmed the trial court decision dismissing the +indirect purchaser claims. Courts in 18 states have ruled that indirect purchaser cases may proceed as class actions. In 2003, we reached an agreement with counsel for the California plaintiffs to settle all claims in 27 consolidated cases in that +state. Under the settlement, class members will be able to obtain vouchers that entitle the class members to be reimbursed up to the face value of their vouchers for purchases of a wide variety of platform-neutral computer hardware and software. The +total value of vouchers issued will depend on the number of class members who make a claim and are issued vouchers. Two-thirds of the value of vouchers unissued or unredeemed by class members will be made available to certain PAGE 66 Table of Contents Part II Item 8 schools in California in the form of vouchers that also may be redeemed for cash against purchases of a wide variety of platform-neutral computer hardware, software, +and related services. We also have reached similar agreements to settle all claims in a number of other states. The settlements in these states are structured similarly to the California settlement, except that, among other differences, one-half of +the value of vouchers unissued to class members will be made available to certain schools in the relevant states. The maximum value of vouchers to be issued in these settlements, including the California settlement, is approximately $2.5 billion. +The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools who are issued and redeem vouchers. The settlements in Arizona, California, the District of Columbia, Florida, Kansas, +Massachusetts, Minnesota, Montana, Nebraska, New Mexico, New York, North Carolina, North Dakota, South Dakota, Tennessee, Vermont, and West Virginia have received final court approval. We estimate the total cost to resolve all of these cases will +range between $1.5 billion and $1.7 billion, with the actual cost dependent upon many unknown factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the vouchers, the +nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims process. In accordance with SFAS No. 5, Accounting for Contingencies , and FIN No. 14, Reasonable Estimation of the Amount of a Loss, at June 30, 2006, we have recorded a liability related to these claims of approximately $1.2 billion, which reflects our estimated exposure of $1.5 billion less payments made to date of approximately $300 million, +primarily for administrative expenses and legal fees. Other antitrust litigation and claims. On August 27, 2004, the City and +County of San Francisco, the City of Los Angeles, and Los Angeles, San Mateo, Contra Costa, and Santa Clara Counties filed a putative class action against us in San Francisco Superior Court. The action was brought on behalf of all governmental +entities, agencies, and political subdivisions of the State of California that indirectly purchased our operating system or word processing and spreadsheet software during the period from February 18, 1995 to the date of trial in the action. +The plaintiffs sought treble damages under California’s Cartwright Act and disgorgement of unlawful profits under its Unfair Competition Act resulting from our alleged combinations to restrain trade, deny competition, and monopolize the world +markets for PC operating systems and word processing and spreadsheet applications (and productivity suites including these applications). We removed the case to the U.S. District Court for Maryland. Our motion to dismiss the complaint was granted on +April 18, 2005 with leave to file an amended complaint alleging claims under the Cartwright Act based on conduct within the four-year statute of limitation the court ruled applies to the plaintiffs’ claims. We have obtained final approval +of settlement of this case, which resolves all claims asserted in the lawsuit. On November 12, 2004, Novell, Inc. filed a complaint in the U.S. +District Court for Utah asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. On June 10, 2005, the +trial court granted our motion to dismiss four of six claims of the complaint. An appeal of that ruling is now pending and the case is effectively stayed during the appeal. Patent and intellectual property claims. We are a defendant in more than 35 patent infringement cases that we are defending vigorously. In the case of Eolas Technologies, Inc. and University of California v. +Microsoft , filed in the U.S. District Court for the Northern District of Illinois on February 2, 1999, the plaintiffs alleged infringement by the browser functionality of Windows. On August 11, 2003, the jury awarded the plaintiffs +approximately $520 million in damages for infringement from the date the plaintiffs’ patent was issued through September 2001. The plaintiffs are seeking an equitable accounting for damages from September 2001 to the present. On +January 14, 2004, the trial court entered final judgment of $565 million, including post-trial interest of $45 million, and entered an injunction against distribution of any new infringing products, but stayed execution of the judgment and the +injunction pending our appeal. We appealed and on March 2, 2005 the Court of Appeals for the Federal Circuit reversed the decision and vacated the judgment, ruling that the trial court had erred in excluding certain previous art evidence and +ruling as a matter of law on other evidence. The appellate court also reversed the trial court’s decision that the inventors had not engaged in inequitable conduct by failing to reveal material previous art while obtaining the patent. We +believe the total cost to resolve this case will not be material to our financial position or results of operations. The actual costs will be dependent upon many unknown factors such as the events of a retrial of the plaintiff’s claims. In Microsoft v. Lucent , filed in the U.S. District Court in San Diego on April 8, 2003, we are seeking a declaratory judgment that we do not infringe any valid patent among a number of patents Lucent has been asserting against computer +manufacturers that sell computers with our software pre-installed. The first in a series of back-to-back trials on the various patent groupings is currently set to begin on November 20, 2006. On March 28, 2006, Lucent filed a new lawsuit +against us in U.S. District Court in San Diego, claiming that Xbox 360 violates one of the patents that earlier PAGE 67 Table of Contents Part II Item 8 had been dismissed from the older lawsuit. In response to Lucent’s new complaint, we asserted patent infringement counterclaims accusing Lucent of infringing ten +Microsoft patents by its sales of various products. No trial date has been set in the new lawsuit. In Amado v. Microsoft , filed in U.S. District Court for the Central District of California on March 7, 2003, the plaintiff has accused the +link table functionality available in Microsoft Access when used with Microsoft Excel. After a jury trial, we were found to infringe one claim of the patent and damages of $8.9 million were awarded. The judge later found for us on our defense of +laches, which reduced the damages award to $5.9 million. The court also imposed an injunction against further distribution of the accused feature as part of Microsoft Access, but stayed the injunction pending resolution of all appeals. The Court of +Appeals for the Federal Circuit affirmed the judgment on appeal and Microsoft intends to seek review by the U.S. Supreme Court of one issue. In Z4 Technologies, Inc. v. Microsoft, the plaintiff alleged that Microsoft Windows and Office +product activation functionality violates its patent rights. In April 2006, the jury rendered a $115 million verdict against us. In August 2006, the trial court increased damages by $25 million pursuant to the jury’s finding of willful +infringement. We intend to appeal the verdict. In Veritas Operating Corporation v. Microsoft , filed in the U.S. District Court for the Western District of Washington on May 18, 2006, a subsidiary of Symantec has filed an action asserting +claims of trade secret misappropriation, breach of contract, and patent infringement relating to certain storage technologies. Adverse outcomes in some or all of the matters described in this paragraph may result in significant monetary damages or +injunctive relief against us, adversely affecting distribution of our operating system or application products. The risks associated with an adverse decision may result in material settlements. Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. While +management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, our results of operations, or our cash flows, these matters are subject to inherent +uncertainties and management’s view of these matters may change in the future. As of June 30, 2006, we had accrued aggregate liabilities +totaling $1.0 billion in other current liabilities and $1.0 billion in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse +outcomes which we estimate could be up to $1.0 billion in aggregate beyond recorded amounts. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on the Company’s financial position and on the +results of operations for the period in which the effect becomes reasonably estimable. NOTE 18    SEGMENT INFORMATION Segment revenue and operating income/(loss) was as follows: (In millions) Year Ended June 30 2006 2005 2004 Revenue Client $ 13,001 $ 11,972 $ 11,293 Server and Tools 10,542 9,197 8,031 Information Worker 12,380 11,702 10,990 Microsoft Business Solutions 906 776 735 MSN 2,488 2,486 2,498 Mobile and Embedded Devices 365 259 185 Home and Entertainment 4,292 3,110 2,731 Reconciling amounts 308 286 372 Consolidated $ 44,282 $ 39,788 $ 36,835 PAGE 68 Table of Contents Part II Item 8 (In millions) Year Ended June 30 2006 2005 2004 Operating Income/(Loss) Client $ 10,043 $ 9,418 $ 9,061 Server and Tools 3,525 2,922 2,357 Information Worker 8,982 8,726 8,160 Microsoft Business Solutions 14 (134 ) (91 ) MSN 111 477 393 Mobile and Embedded Devices (11 ) (37 ) (116 ) Home and Entertainment (1,283 ) (451 ) (1,011 ) Reconciling amounts (4,909 ) (6,360 ) (9,719 ) Consolidated $ 16,472 $ 14,561 $ 9,034 SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , establishes standards for +reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present +various data for management to operate the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. Fiscal years 2005 and 2004 amounts have been restated for certain internal reorganizations and to +conform to the current period presentation. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Operating segments are defined as components of an enterprise about which separate +financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief +Executive Officer. Our seven segments are Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment. On July 17, 2006 we announced a change in our operating segments +reflecting the culmination of our realignment announced in September 2005. These changes will be effective for fiscal year 2007; the seven segments discussed in this analysis are presented the way we internally managed and monitored performance at +the business group level in fiscal years 2006, 2005, and 2004. The types of products and services provided by each segment are summarized below: Client – Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems. Server and Tools –Windows Server operating system; Microsoft SQL Server; Exchange Server; Microsoft Consulting Services; product support services; Visual Studio; +System Center products, Forefront security family of products; and Biz Talk. Information Worker – Microsoft Office; Microsoft Project; +Microsoft Visio; SharePoint Portal Server client access licenses; Microsoft LiveMeeting; OneNote; and Office Communication Server. Microsoft Business +Solutions – Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Small +Business Accounting. MSN – MSN Search; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software +Subscription, MSN Hotmail Plus, MSN Bill Pay, and MSN Radio Plus); and MSN Mobile Services. Mobile and Embedded Devices – Windows Mobile +software platform; Windows Embedded device operating system; and Windows Automotive. Home and Entertainment – Xbox 360; Xbox; Xbox Live; CPxG +(consumer software and hardware products); and IPTV. Because of our integrated business structure, operating costs included in one segment may +benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or +charge each segment for such shared costs and to incent shared efforts. Management will continually PAGE 69 Table of Contents Part II Item 8 evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in +changes to segment allocations in future periods. Assets are not allocated to segments for internal reporting presentations. A portion of +amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure +of segment profit or loss. Reconciling amounts include adjustments to conform with U.S. GAAP and corporate-level activity not specifically attributed +to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, period-end cut-off timing, and accelerated amortization for depreciation, stock awards, and +performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity including certain legal settlements and accruals for legal contingencies. Significant reconciling items were as follows: (In millions) Year Ended June 30 2006 2005 2004 Operating income reconciling amounts: Legal settlements and contingent liabilities $ (1,321 ) $ (2,312 ) $ (2,832 ) Stock-based compensation expense (127 ) (1,042 ) (4,516 ) Revenue reconciling amounts 308 286 372 Corporate-level expenses (1) (3,742 ) (3,493 ) (3,128 ) Other (27 ) 201 385 Total $ (4,909 ) $ (6,360 ) $ (9,719 ) (1) Corporate-level expenses exclude legal settlements and contingent liabilities, stock-based compensation expense, and revenue reconciling amounts presented separately in those line items. Sales to Dell and its subsidiaries in the aggregate accounted for approximately 11% of fiscal year 2006 and 10% of total fiscal year +2005 and 2004 revenue. These sales were made primarily through our OEM and volume licensing channels and were included in all operating segments. Revenue, +classified by the major geographic areas in which our customers are located, were as follows: (In millions) Year Ended June 30 2006 2005 2004 United States (1) $ 29,730 $ 26,949 $ 25,046 Other countries 14,552 12,839 11,789 Total $ 44,282 $ 39,788 $ 36,835 (1) Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations. Long-lived assets, classified by the geographic location of the controlling statutory company in which that company operates, were as follows: (In millions) Year Ended June 30 2006 2005 United States $ 6,661 $ 5,506 Other countries 788 648 Total $ 7,449 $ 6,154 PAGE 70 Table of Contents Part II Item 8 NOTE 19    SUBSEQUENT EVENTS On July 12, 2006, the European Commission imposed a fine of € 281 million ($351 million) on Microsoft related to the Commission’s March 2004 decision in its competition law investigation. As of June 30, 2006, the total amount of the fine was included in other current +liabilities. On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs, comprised of a $20 billion +tender offer which was completed on August 17, 2006, and an additional $20 billion ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of our common +stock, or approximately 1.5% of our common stock outstanding, for approximately $3.8 billion at a per share price of $24.75. On August 18, 2006, we +announced that the authorization for the ongoing share repurchase program, previously announced on July 20, 2006, had been increased by approximately $16.2 billion. As a result, the company is authorized to repurchase additional shares in an +amount up to $36.2 billion through June 30, 2011. PAGE 71 Table of Contents Part II Item 8 QUARTERLY INFORMATION (In millions, except per share amounts) (Unaudited) Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Total Fiscal year 2006 Revenue $ 9,741 $ 11,837 $ 10,900 $ 11,804 $ 44,282 Gross profit 8,488 9,598 8,872 9,674 36,632 Net income 3,141 (6) 3,653 2,977 (7) 2,828 (8) 12,599 Basic earnings per share 0.29 0.35 0.29 0.28 1.21 Diluted earnings per share 0.29 0.34 0.29 0.28 1.20 Fiscal year 2005 Revenue $ 9,189 $ 10,818 $ 9,620 $ 10,161 $ 39,788 Gross profit 7,784 8,943 8,257 8,773 33,757 Net income 2,528 (3) 3,463 2,563 (4 ) 3,700 (5) 12,254 Basic earnings per share 0.23 0.32 0.24 0.34 1.13 Diluted earnings per share 0.23 0.32 0.23 0.34 1.12 Fiscal year 2004 Revenue $ 8,215 $ 10,153 $ 9,175 $ 9,292 $ 36,835 Gross profit 6,735 7,809 7,764 7,811 30,119 Net income 2,614 1,549 (1) 1,315 (2) 2,690 8,168 Basic earnings per share 0.24 0.14 0.12 0.25 0.76 Diluted earnings per share 0.24 0.14 0.12 0.25 0.75 (1) Includes stock-based compensation charges totaling $2.2 billion for the employee stock option transfer program. (2) Includes charges totaling $2.53 billion (pre-tax) related to the Sun Microsystems Inc. settlement and a fine imposed by the European Commission. (3) Includes charges totaling $536 million (pre-tax) related to the settlement of certain litigation with Novell, Inc. (4) Includes charges totaling $768 million (pre-tax) related to the Gateway, Inc. and Burst.com settlements, Sun Microsystems, Inc., and additional charges related to anti-trust and certain other +matters. (5) Includes charges totaling $756 million (pre-tax) related to IBM and other matters. (6) Includes charge of $361 million (pre-tax) related to the settlement with RealNetworks, Inc. (7) Includes charges of $397 million (pre-tax) related to various legal charges. (8) Includes charge of € 281 million ($351 million)(pre-tax) as a result of the +fine imposed by the European Commission in July 2006. PAGE 72 Table of Contents Part II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2006 and 2005, and the related consolidated statements of income, cash flows, and +stockholders’ equity for each of the three years in the period ended June 30, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial +statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United +States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the +amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that +our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material +respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2006 and 2005, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2006, in conformity +with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public +Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 22, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control +over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 22, 2006 PAGE 73 Table of Contents Part II Item 9, 9A ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A.    CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the +Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, +the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate +internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with +accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance +that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable +assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over +financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of +the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2006. There were no changes in our internal control over financial reporting +during the quarter ended June 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited this assessment of our internal +control over financial reporting; their report is included in Item 9A. PAGE 74 Table of Contents Part II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of +Microsoft Corporation: We have audited management’s assessment, included in the accompanying Report of Management on Internal Control over Financial Reporting, +that Microsoft Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of June 30, 2006, based on criteria established in Internal Control—Integrated Framework issued +by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control +over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and +perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, +evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a +reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the supervision of, +the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the +reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and +procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are +recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management +and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial +statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper +management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future +periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of June 30, 2006, is fairly +stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in +all material respects, effective internal control over financial reporting as of June 30, 2006, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the +Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +consolidated financial statements as of and for the year ended June 30, 2006 of the Company and our report dated August 22, 2006 expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 22, 2006 PAGE 75 Table of Contents Part II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B.    OTHER INFORMATION Effective August 23, 2006, the Board of Directors amended the Company’s bylaws. The +Board added a new Section 1.13 concerning the right of shareholders to amend the bylaws, which they already have pursuant to the Washington Business Corporation Act. The board also added a new paragraph to Section 2.2 to incorporate the Board’s +previous governance policy on election of directors. The Board added additional procedures that would be followed if a director does not receive a majority of shares cast in an uncontested election. PART III ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT A list of our executive officers and biographical +information appears in Part I, Item 1 of this report. Information about our Directors may be found under the caption “Election of Directors and Management Information” of our Proxy Statement for the Annual Meeting of Shareholders to +be held November 14, 2006 (the “Proxy Statement”). That information is incorporated herein by reference. The information in the Proxy +Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We +have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and +other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/msft. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, +from a provision of the code to our Chief Executive Officer, Chief Financial Officer or Chief Accounting Officer and Corporate Controller, we will disclose the nature of such amendment or waiver on that website or in a report on Form 8-K. ITEM 11.    EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions +“Information Regarding Executive Officer Compensation” and “Information About the Board and its Committees – Director Compensation” is incorporated herein by reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information in the Proxy Statement +set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” is incorporated herein by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information set forth under the captions +“Certain Relationships and Related Transactions” of the Proxy Statement is incorporated herein by reference. ITEM 14.    PRINCIPAL ACCOUNTANT FEES AND SERVICES Information concerning principal accountant fees and services +appears in the Proxy Statement under the heading “Fees Billed by Deloitte & Touche LLP” and is incorporated herein by reference. PAGE 76 Table of Contents Part IV Item 15 PART IV ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. Financial statement schedules have been omitted since they are either +not required, not applicable, or the information is otherwise included. (b) Exhibit Listing Incorporated by reference Exhibit number Exhibit description Filed herewith Form Period ending Exhibit Filing date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/02 3.1 1/31/03 3.2 Bylaws of Microsoft Corporation X 4 Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank 10-K 12/31/03 4 2/6/04 10.1* Microsoft Corporation 2001 Stock Plan 8-K 99.2 7/21/06 10.2* Microsoft Corporation 1991 Stock Option Plan 8-K 99.1 7/21/06 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Stock Option Plan for Non-Employee Directors 8-K 10.4 11/15/04 10.5* Microsoft Corporation Stock Option Plan for Consultants and Advisors 8-K 10.5 11/15/04 10.6* Microsoft Corporation 2003 Employee Stock Purchase Plan 10-K 6/30/04 10.6 9/1/04 10.7* Microsoft Corporation Deferred Compensation Plan S-8 99.1 2/28/06 10.8* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan X 10.9* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period 10-K 6/30/04 10.10 9/1/04 PAGE 77 Table of Contents Part IV Item 15 Incorporated by reference Exhibit number Exhibit description Filed herewith Form Period ending Exhibit Filing date 10.11* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period 10-K 6/30/04 10.11 9/1/04 10.12* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.13* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.14 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee) 10-K 6/30/02 10.8 9/6/02 10.15 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee 10-K 6/30/03 10.8 9/5/03 10.16* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X * Indicates a management contract or compensatory plan or arrangement PAGE 78 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused +this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 25, 2006. M ICROSOFT C ORPORATION By: / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on August 25, 2006. Signature Title William H. Gates III Chairman /s/    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer /s/    J AMES I. C ASH , +J R . James I. Cash, Jr. Director /s/    D INA D UBLON Dina Dublon Director /s/    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director /s/    A NN M C L AUGHLIN K OROLOGOS Ann McLaughlin Korologos Director /s/    D AVID F. +M ARQUARDT David F. Marquardt Director /s/    C HARLES H. +N OSKI Charles H. Noski Director Helmut Panke Director /s/    J ON A. +S HIRLEY Jon A. Shirley Director /s/    C HRISTOPHER P. +L IDDELL Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer (Principal Financial Officer) /s/    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) PAGE 79 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-07-170817/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-07-170817/full-submission.txt new file mode 100644 index 0000000..68ceb2a --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-07-170817/full-submission.txt @@ -0,0 +1,962 @@ +Table of Contents United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2007 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 Securities registered pursuant to +Section 12(b) of the Act: COMMON STOCK Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or +Section 15(d) of the Exchange Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or +15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 +days.    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information +statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated +filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Indicate by check +mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨ No x As of December 31, 2006, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $251,464,010,491 based on the closing +sale price as reported on the NASDAQ National Market System. As of August 1, 2007, there were 9,375,492,496 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting +of Shareholders to be held on November 13, 2007 are incorporated by reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2007 INDEX PART I Item 1. Business 3 Executive Officers of the Registrant 11 Item 1A. Risk Factors 12 Item 1B. Unresolved Staff Comments 16 Item 2. Properties 17 Item 3. Legal Proceedings 17 Item 4. Submission of Matters to a Vote of Security Holders 17 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 18 Item 6. Selected Financial Data 19 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 20 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 39 Item 8. Financial Statements and Supplementary Data 40 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 72 Item 9A. Controls and Procedures 72 Report of Management on Internal Control over Financial Reporting 72 Report of Independent Registered Public Accounting Firm 73 Item 9B. Other Information 74 PART III Item 10. Directors, Executive Officers and Corporate Governance 74 Item 11. Executive Compensation 74 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 74 Item 13. Certain Relationships and Related Transactions, and Director Independence 74 Item 14. Principal Accounting Fees and Services 74 PART IV Item 15. Exhibits and Financial Statement Schedules 75 Signatures 77 PAGE 2 Table of Contents Part I Item 1 Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and +expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of +1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” +“intend,” “strategy,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. +Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of these and +other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” (refer to Part I, Item 1A). We undertake no +obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. PART I ITEM 1.    BUSINESS GENERAL Our mission is to enable people and businesses throughout the world to realize their full potential. Since our founding in 1975, we have worked to achieve our mission by creating technology that transforms the way people work, +play, and communicate. We develop and market software, services, and solutions that we believe deliver new opportunities, greater convenience, and enhanced value to people’s lives. We do business throughout the world and have offices in more +than 100 countries. We generate revenue by developing, manufacturing, licensing, and +supporting a wide range of software products for many computing devices. Our software products include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing environments; +information worker productivity applications; business solution applications; high-performance computing applications, and software development tools. We provide consulting and product support services, and we train and certify computer system +integrators and developers. We sell the Xbox 360 video game console and games, the Zune digital music and entertainment device, PC games, and peripherals. Online offerings and information are delivered through our Windows Live, Office Live, and MSN +portals and channels. We enable the delivery of online advertising through our proprietary adCenter ® platform. We also research and develop advanced technologies for future software products. We believe that delivering breakthrough innovation and high-value solutions through our integrated software platform is the key to meeting our +customers’ needs and to our future growth. We believe that we continue to lay the foundation for long-term growth by delivering new products, creating opportunities for partners, improving customer satisfaction, and improving our internal +processes. Our focus is to build on this foundation through ongoing innovation in our integrated software platforms; by delivering compelling value propositions to customers; by responding effectively to customer and partner needs; and by continuing +to emphasize the importance of product excellence, business efficacy, and accountability. OPERATING SEGMENTS Our segments provide management with a comprehensive financial view of our key businesses. The segments provide a framework for the alignment of strategies and objectives across +the development, sales, marketing, and services organizations, and for the timely and rational allocation of development, sales, marketing, and services resources within businesses. The segments also help focus strategic planning efforts on key +objectives and initiatives across our businesses. Due to our integrated business structure, operating costs included in one segment may benefit other +segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge +each segment for such shared costs and to motivate shared effort. Segments should not be viewed as discrete or easily separable businesses. PAGE 3 Table of Contents Part I Item 1 In July 2006, we announced a change in our operating +segments reflecting previously announced reorganizations. We have five operating segments: Client, Server and Tools, the Online Services Business, the Microsoft Business Division, and the Entertainment and Devices Division. Prior fiscal year +information has been recast to conform to the way we internally managed and monitored performance at the business group level in fiscal year 2007. See Note 18 – Segment Information of the Notes to Financial Statements (Part II, +Item 8) for financial information regarding segment reporting. Client Client has overall responsibility for the technical architecture, engineering, and product delivery of our Windows product family, and is responsible for our relationships with +personal computer manufacturers, including multinational and regional original equipment manufacturers (“OEMs”). The segment includes sales and marketing expenses for the Windows client operating system and product development efforts for +the Windows platform. Client revenue growth is correlated with the growth of purchases of personal computers from OEMs that pre-install versions of Windows operating systems as the OEM channel accounts for over 80% of total Client revenue. We released Windows Vista, the latest generation of the Windows operating system, in fiscal year 2007. This release concluded a major development +phase that we believe resulted in a significantly more manageable and powerful PC operating system compared to prior releases. Windows Vista includes advances in security, digital media, user interfaces, and other areas that enhance the user and +developer experience. Products: Windows Vista, including Home, Home Premium, Ultimate, Business, and Enterprise Starter +Edition; Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems. Competition Client faces strong competition from well-established companies with differing approaches to the PC market. Competing commercial software products, including variants of Unix, are +supplied by competitors such as Apple Computer, Hewlett-Packard, IBM, and Sun Microsystems. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained some acceptance as +competitive pressures lead PC OEMs to reduce costs. The Windows operating system also faces competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer +software that competes with the Internet Explorer Web browsing capabilities of Windows products. Apple Computer, Real Networks, and others compete with Windows Media Player. Our operating system products compete effectively by delivering innovative +software, a familiar, easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any operating system. Server and Tools Server and Tools develops and markets +software server products, services, and solutions. Windows Server products are integrated server infrastructure and middleware software designed to support software applications and tools built on the Windows Server operating system. Windows Server +products include the server platform, database, storage, management and operations, service-oriented architecture platform, and security software. The segment also builds standalone and software development lifecycle tools for software architects, +developers, testers, and project managers. Server products can be run on premise or in a hosting environment. We offer a broad range of consulting +services and provide product support services and customer industry solutions. The segment also provides training and certification to developers and information technology professionals about our Server and Client platform products. Server and +Tools also includes the Enterprise Partner Group, which is responsible for sales, partner management, and partner programs for medium and large organizations, and the Public Sector sales and marketing organization. Approximately 45% of Server revenue comes from multi-year licensing agreements, approximately 30% is purchased through fully packaged product and transactional +volume licensing programs, and approximately 10% comes from licenses sold to OEMs. The remainder of our revenue comes from consulting and product support services. PAGE 4 Table of Contents Part I Item 1 Products and +Services: Windows Server operating system; Microsoft SQL Server; Microsoft Enterprise Services; product support services; Visual Studio; System Center products; Forefront Security products; Biz Talk Server; MSDN; and +TechNet, among others. Competition Our server operating system products +face intense competition from a wide variety of server operating systems and server applications, offered by companies with a variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Sun +Microsystems offer their own variant of Unix preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system. Linux’s competitive position has also benefited from the large number of +compatible applications now produced by many leading commercial software developers and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. Server virtualization platform providers based +on Linux, such as VMWare, represent another means by which Linux competes with the Windows server operating system. We have entered into business and +technical collaboration agreements with Novell and other Linux providers to build, market, and support a series of solutions to make our products work better with their solutions, and to provide each other’s customers with patent coverage for +respective products. We compete in the business of providing enterprise-wide computing solutions with several companies that provide solutions and +middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that provide competing server applications for PC-based distributed +client/server environments include Computer Associates, IBM, and Oracle. Numerous commercial software vendors offer competing commercial software +applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. System Center competes with BMC, Computer Associates, and IBM in the management of information technology (“IT”) infrastructures, while +Forefront Security competes with McAfee, Symantec, and Trend Micro in protecting both client and server applications. Non-commercial software products, including the widely-deployed Apache Web Server, also compete with our solutions. Our products +for software developers compete against offerings from Adobe, BEA Systems, Borland, IBM, Oracle, Sun Microsystems, and other companies. We believe that our server products provide customers with advantages in innovation, performance, total costs of +ownership, and productivity, by delivering superior applications development tools and development environment, compatibility with a broad base of hardware and software applications, security, and manageability. Online Services Business The Online Services Business +(“OSB”) provides personal communications services, such as e-mail and instant messaging, and online information offerings such as Live Search and MSN portals and channels around the world. OSB also provides a variety of online services +such as MSN Internet Access, MSN Premium Web Services, and OneCare. OSB manages many of its own properties, including home page, health, auto and shopping. In addition, OSB creates alliances with third parties, such as CareerBuilder.com, +Expedia.com, Foxsports.com, Match.com, and MSNBC.com. OSB generates revenue primarily from online advertising, subscriptions and transactions of online paid services, as well as MSN narrowband Internet access subscriptions. In fiscal year 2006, OSB +launched adCenter, our proprietary advertising platform, and has since transitioned the advertising business in the U.S. and certain international markets to adCenter. In fiscal year 2007, we launched new online initiatives, including Windows Live +Search™ and Live.com in 54 international markets, Live Local Search in the U.S. and U.K., beta versions of MSN Soapbox (expansion of the MSN Video experience), Virtual Earth™ 3D, Windows Live Hotmail, and others. Products: MSN Search; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN +Hotmail Plus, MSN Bill Pay, and MSN Radio Plus); Windows Live; and MSN Mobile Services. Competition OSB competes with AOL, Google, Yahoo!, and a wide array of Web sites and portals that provide content and online offerings of all types to end users. We compete with these +organizations to provide advertising opportunities for merchants. OSB also competes for narrowband Internet access users with AOL, Earthlink, and other ISPs for dial-up internet access in the United States. Due to the continuing trend of consumers +migrating from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline as we PAGE 5 Table of Contents Part I Item 1 de-emphasize this portion of our business. The Internet advertising industry has grown significantly over the past several years, and we anticipate that this trend +will continue. Competitors are aggressively developing Internet offerings that seek to provide more effective ways of connecting advertisers with audiences through enhanced functionality in communication services, improvements in information +services such as Internet search, and improved advertising infrastructure and support services. We have developed our own algorithmic search engine to provide end users with more relevant search results, a broader selection of content, and expanded +search services. To support the growth of our advertising business, we also are investing in our communication services, technology, operations, and sales efforts. We will continue to introduce new products and services, including the Windows Live +set of services that are aimed at attracting additional users through improvements in the user online experience. We believe that we can compete effectively across the breadth of our Internet services by providing users with software innovation in +the form of information and communication services that help them find, discover, and experience what they want online and by providing merchants with effective advertising results through improved systems and sales support. Microsoft Business Division Microsoft Business +Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of +programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our +product offerings in other information worker areas such as enterprise content management, collaboration, unified communications and business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer +relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts—business revenue which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics +revenue, and consumer revenue which includes revenue from retail packaged product sales, OEM revenue, and sales of pre-installed versions of Office in Japan. Approximately 75% of MBD revenue is generated from sales to businesses. Revenue +from this category generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given year. Approximately 25% of MBD revenue is derived from sales to +consumers. Most of this revenue is generated from new licenses acquired through fully packaged products and licenses sold through OEMs for new PCs and are generally affected by the level of PC shipments and product launches. Products: Microsoft Office; Microsoft Project; Microsoft Visio; Microsoft Office SharePoint Server; Microsoft Exchange Server; +Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communication Server; Microsoft Office Communicator; Microsoft Tellme Service, Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft +Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Accounting. Competition Competitors to the Microsoft Office system include many software application vendors such as Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Sun Microsystems, +and local application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have measurable installed bases with their office productivity products. Apple may distribute certain of its application software products with +various models of its PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red Hat, and Sun. +Corel’s suite and many local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs. Google has launched Google Apps, a hosted messaging and productivity suite, and also provides an enterprise search +offering that competes with Microsoft Office SharePoint Server for Search, our new enterprise search product. Web-based offerings such as AjaxWrite, gOffice, iNetOffice, SimDesk, ThinkFree, wikiCalc, or other small projects competing with +individual applications, can also provide an alternative to Microsoft Office system products. IBM has many different points of competition with Office system products with its Notes and Workplace offerings. PAGE 6 Table of Contents Part I Item 1 Our Microsoft Dynamics products compete with well-known +vendors such as Intuit and Sage in the market focused on providing solutions for small and mid-sized businesses. The market for large organizations and divisions of global enterprises is intensely competitive with a small number of primary +vendors including Oracle and SAP. These vendors are positioning many of their business applications to focus more intensely on small and mid-sized businesses. Additionally Salesforce.com’s on-demand customer relationship management +offerings compete directly with Microsoft Dynamics CRM Live and Microsoft Dynamic CRM’s on-premise offerings. We believe our products compete effectively with these vendors based on our strategy of providing interoperable, adaptable +solutions that work well with technologies our customers already have. As we continue to respond to market demand for additional functionality and +products, we will compete with additional vendors, most notably in enterprise content management, collaboration tools, unified communications, and business intelligence. These competitors include SAP; IBM; Cisco, with their acquisition of WebEx; +Oracle, with the acquisition of Hyperion; and other business intelligence vendors such as Business Objects and Cognos. Entertainment and Devices Division The Entertainment and Devices Division (“EDD”) is responsible for developing, producing, and marketing +the Xbox video game system, including consoles and accessories, third-party games, games published under the Microsoft brand, and Xbox Live operations, as well as research, sales, and support of those products. In addition to Xbox, we offer the Zune +digital music and entertainment device; PC software games; online games; Mediaroom, our Internet protocol television (“IPTV”) software; and other devices. EDD also leads the development efforts of our line of consumer software and hardware +products including application software for Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems. EDD also includes the mobile and +embedded devices platform and is responsible for managing our company-wide sales and customer relations with device manufacturers and other communication-sector customers including network service providers and media and entertainment companies. Products: Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and hardware products +(such as mice and keyboards); Windows Mobile software platform; Windows Embedded device operating system; and Windows Automotive. Competition Entertainment and devices businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the development of +new technologies. The markets for our products are characterized by significant price competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices on certain +products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, quality and +variety, timing of product releases, and effectiveness of distribution and marketing. Our Xbox hardware business competes with console platforms from +Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for video game consoles averages five to seven years. We released Xbox 360, our second generation console, in November 2005. Nintendo and Sony released new +versions of their game consoles in late 2006. We believe the success of video game consoles is determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the +console, and the ability to create new revenue sources such as advertising and downloadable content. We think the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new +developer tools, expanded revenue sources, and continued strong exclusive content from our own game franchises such as Halo. In addition to competing +against software published for non-Xbox platforms, our games business also competes with numerous companies that we have licensed to develop and publish software for the Xbox consoles. Zune competes with the Apple iPod as well as other digital music +and entertainment devices. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Mediaroom faces competition primarily from a variety of competitors +that provide elements of an IPTV delivery platform, but that do not provide end-to-end solutions for the network operator. Windows Mobile software faces substantial competition from Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and +Symbian. The embedded operating system business is highly fragmented with many competitive offerings. Key competitors include IBM, Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. PAGE 7 Table of Contents Part I Item 1 OPERATIONS To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we “localize” many of our products to +reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our operational centers support all operations in their regions, including customer contract and order processing, credit and collections, information processing and vendor management and logistics. The regional center in Ireland supports +the European, Middle Eastern, and African region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, Puerto Rico, Redmond, and Reno support Latin America and North America. We contract most of our manufacturing activities to third parties who produce the Xbox 360, Zune, various retail software packaged products, and Microsoft hardware. +Our products may include some components that are available from only one or limited sources. Our Xbox 360 console includes certain key components that are supplied by a single source. The central processing unit is purchased from IBM and the +graphics chips and embedded dynamic random access memory chips for the graphics processing unit are purchased from Taiwan Semiconductor Manufacturing Company and NEC Corporation, respectively. Although we have chosen to initially source these key +Xbox 360 components from a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the exceptions noted, we generally have the ability to use other custom manufacturers if the current +vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume discount basis. PRODUCT DEVELOPMENT During fiscal years 2007, 2006, and 2005, research +and development expense was $7.12 billion, $6.58 billion, and $6.10 billion, respectively. These amounts represented 14%, 15%, and 15%, respectively, of revenue in each of those years. We plan to continue to make significant investments in a broad +range of research and product development efforts. While most of our software products are developed internally, we also purchase technology, license +intellectual property rights, and oversee third-party development and localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. +Internal development allows us to maintain closer technical control over our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Generally, we also create +product documentation internally. We strive to obtain information at the earliest possible time about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application +vendors with a range of resources and guidelines for development, training, and testing. Business and Product Development +Strategy . Innovation is a key factor affecting Microsoft’s growth. Our model for growth is based on broad adoption of innovation, willingness to enter new markets, and embracing and acting on disruptive trends. +We continue our long-term commitment to research and development, including advanced work aimed at innovations, in a wide spectrum of technologies, tools, and platforms; communication and collaboration; information access and organization; +entertainment; business and e-commerce; and devices. Increasingly, we are taking a global approach to innovation. While our main research and development facilities are located in Redmond, Washington, we also operate research facilities in other +parts of the United States and around the world, including China, Canada, Denmark, England, India, Ireland, and Israel. This global approach will help us remain competitive in local markets and attract top talent wherever it resides. Based on our broad focus on innovation and long-term approach to new markets, we see the following key opportunities for growth: Consumer technology. To build on our strength in the consumer marketplace with Windows Vista, the 2007 Microsoft Office System, Xbox +360, Microsoft Windows Live, Windows Mobile, and Zune, we are focused on delivering products that we believe are compelling and cutting edge in terms of design as well as features and functionality. To succeed in consumer technologies, we also are +working to define the next era of consumer electronics. In the past, consumer electronics was a hardware-centric business; today, the innovation in consumer electronics devices lies in the software that powers them. This is creating new +opportunities for us to deliver end-to-end experiences. PAGE 8 Table of Contents Part I Item 1 Software plus +services. Underlying our opportunities in consumer technologies, and in all of our businesses, is a company-wide commitment to fully embrace software plus services. The ability to combine the power of desktop and server +software with the reach of the Internet represents an opportunity across every one of our businesses. As we continue to build out our services platform, we will bring a broad range of new products and service offerings to market that target the +needs of large enterprises, small and medium-sized businesses, and consumers. Expanding our presence on the desktop and +server. While we enjoyed success in fiscal year 2007 with the launches of Windows Vista and the 2007 Microsoft Office System, we see potential for growth by delivering more value per customer. With the planned releases in +fiscal year 2008 of Windows Server 2008, SQL Server 2008, and Visual Studio 2008, and the possibility to provide additional value in security, messaging, systems management, and collaboration, we believe we are well-positioned to build on our +strength with businesses of all sizes. We will continue to pursue new opportunities in high performance computing, unified communications, healthcare, and business intelligence. Emerging markets are also an important opportunity for us. In fiscal +year 2007, we announced the expansion of our Unlimited Potential program as the foundation for our efforts to reach the five billion people around the globe who do not have access to PCs and digital technology today. DISTRIBUTION, SALES AND MARKETING We distribute our products primarily +through the following channels: OEM; distributors and resellers; and online. OEM. Our operating systems are licensed primarily to OEMs +under agreements that grant the OEMs the right to build computing devices based on our operating systems, principally PCs. Under similar arrangements, we also market and license certain server operating systems, desktop applications, hardware +devices, and consumer software products to OEMs. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, Dell, Fujitsu, Fujitsu Siemens Computers, Gateway, Hewlett-Packard, Lenovo, NEC, +Samsung, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume customized PC vendors operating in local markets. Distributors and Resellers. We license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products +primarily through large account resellers (“LARs”), direct market resellers, and value-added resellers (“VARs”). Many organizations that license products through enterprise agreements (“EAs”) transact directly with us, +with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner +reaches organizations of all sizes, LARs are primarily engaged with large organizations and VARs typically reach the breadth of small- and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our +largest resellers include CDW, Dell, Insight Enterprises, Software House International, and Software Spectrum. Our Dynamics software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and +specialized services. We distribute our finished goods products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain our products primarily through retail +outlets, including Best Buy, Target, and Wal-Mart. We have a network of field sales representatives and field support personnel that solicits orders from distributors and resellers and provides product training and sales support. Our arrangements for organizations to acquire multiple licenses of products are designed to provide them with a means of doing so without having to acquire separate +packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various +parts of the world, generally they include: Open. Designed primarily for small-to-medium organizations (5 to +over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of software products over a specified time period (generally two years). The offering that conveys rights +to future versions of certain software product over the contract period is called Software Assurance. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the Open program, +customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing volume licensing agreements. PAGE 9 Table of Contents Part I Item 1 Select. Designed primarily for medium-to-large organizations (greater than 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, Software +Assurance, which consists of rights to future versions of certain software products, support, tools, and training over a specified time period (generally three years). Similar to the Open program, customers can acquire licenses only, acquire +licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements. Enterprise Agreement. The Enterprise Agreement is targeted at medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their enterprise, +along with rights to future versions of certain software products, support, tools, and training over a specified time period (generally three years). Online. We distribute online content and services through MSN and other online channels. OSB delivers Internet access and various premium services and tools to consumers. OSB also delivers online e-mail and +messaging communication services and information services such as online search, advertising, and premium content. EDD operates the Xbox Live service which allows customers to participate in the gaming experience with other subscribers online. We +operate and deliver the Microsoft Small Business Center portal. This portal provides tools and expertise for small-business owners to build, market, and manage their businesses online. Other services delivered online include Microsoft Developer +Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and solutions. CUSTOMERS Our customers include individual consumers, small and +medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet Service Providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily through +resellers and OEMs. No sales to an individual customer accounted for more than 10% of fiscal year 2007 revenue. Sales to Dell and its subsidiaries accounted for approximately 11% and 10% of fiscal year 2006 and 2005 revenue, respectively. These +sales were made primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Our practice is to ship our products promptly upon receipt of +purchase orders from customers; consequently, backlog is not significant. PAGE 10 Table of Contents Part I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of August 3, 2007 were as follows: Name Age Position with the Company William H. Gates III 51 Chairman of the Board Steven A. Ballmer 51 Chief Executive Officer Robert J. (Robbie) Bach 45 President, Entertainment and Devices Division Lisa E. Brummel 47 Senior Vice President, Human Resources Kevin R. Johnson 46 President, Platforms and Services Division Christopher P. Liddell 49 Senior Vice President and Chief Financial Officer Jeffrey S. Raikes 49 President, Microsoft Business Division Bradford L. Smith 48 Senior Vice President; General Counsel and Secretary Brian Kevin Turner 42 Chief Operating Officer Mr. Gates co-founded Microsoft in 1975 and served as its Chief Executive Officer from the time the +original partnership was incorporated in 1981 until January 2000, when he resigned as Chief Executive Officer and assumed the position of Chief Software Architect. In June 2006, Mr. Gates stepped down as Chief Software Architect and announced a +two-year plan to transition out of a day-to-day role in the Company. Mr. Gates has served as Chairman since our incorporation. Mr. Ballmer +was appointed Chief Executive Officer in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980. Mr. Bach was named President, Entertainment and Devices Division in September 2005. He had been Senior Vice President, Home and Entertainment since March 2000. +Before holding that position, he had been Vice President, Home and Retail since March 1999, Vice President, Learning, Entertainment and Productivity since 1997, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined +Microsoft in 1988. Ms. Brummel was named Senior Vice President, Human Resources in December 2005. She had been Corporate Vice President, Human +Resources since April 2005. From 1995 to April 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of management positions at Microsoft, including +general manager of the Consumer Productivity business and product unit manager of several product lines. Mr. Johnson was named President, +Platforms and Services Division in January 2007. He had been Co-President of the Platforms and Services Division since September 2005. He held the position of Group Vice President, Worldwide Sales, Marketing and Services since March 2003. Before +that position, he had been Senior Vice President, Microsoft Americas since February 2002 and Senior Vice President, U.S. Sales, Marketing, and Services since August 2001, and prior to assuming that role, he had been Vice President, U.S. Sales, +Marketing and Services. He joined Microsoft in 1992. Mr. Liddell was named Senior Vice President and Chief Financial Officer of the Company in +May 2005. Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company from March 2003 through April 2005, and prior to becoming Chief Financial Officer, he held the positions of Vice President-Finance +and Controller. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited, an affiliate of International Paper, from 1999 to 2002 and Chief Financial Officer from 1995 to 1998. Mr. Raikes was named President, Microsoft Business Division in September 2005. He had been Group Vice President, Information Worker Business since June 2004. +Before that position, he had been Group Vice President, Productivity and Business Services since August 2000 and Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981. Mr. Smith was named Senior Vice President, General Counsel, and Secretary in November 2001. Mr. Smith was also named Chief Compliance Officer effective +July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993. Mr. Turner was named Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President and President and Chief Executive +Officer of the Sam’s Club division of Wal-Mart Stores, Inc. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 to September +2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. PAGE 11 Table of Contents Part I Item 1, 1A EMPLOYEES As of June 30, 2007, we employed approximately 79,000 people on a full-time basis, 48,000 in the United States and 31,000 internationally. Of the total, 31,000 were in +product research and development, 24,000 in sales and marketing, 13,000 in product support and consulting services, 3,000 in manufacturing and distribution, and 8,000 in general and administration. Our success is highly dependent on our ability to +attract and retain qualified employees. None of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current +reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the Securities and Exchange Commission (“SEC”). Our SEC reports can be accessed +through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. ITEM 1A.    RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, +including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and trading price of our common stock. Challenges to our business model may reduce our revenues and operating margins. Our business model has been based upon customers paying a fee to license software that we developed and distributed. Under this +license-based software model, software developers bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their +products. In recent years, certain “open source” software business models have evolved into a growing challenge to our license-based software model. Open source commonly refers to software whose source code is subject to a license allowing +it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an open source business model by modifying and then distributing open source +software to end users at nominal cost and earning revenue on complementary services and products. These firms do not have to bear the full costs of research and development for the software. A prominent example of open source software is the Linux +operating system. Although we believe our products provide customers with significant advantages in security, productivity, and total cost of ownership, the popularization of the open source software model continues to pose a significant challenge +to our business model, including continuing efforts by proponents of open source software to convince governments worldwide to mandate the use of open source software in their purchase and deployment of software products. To the extent open source +software gains increasing market acceptance, sales of our products may decline, we may have to reduce the prices we charge for our products, and revenue and operating margins may consequently decline. Another development is the software-as-a-service business model, by which companies provide applications, data, and related services over the Internet. Providers +use primarily advertising or subscription-based revenue models. Recent advances in computing and communications technologies have made this model viable and enabled the rapid growth of some of our competitors. We are devoting significant resources +toward developing our own competing software plus services strategies. It is uncertain whether these strategies will prove successful. We face intense +competition. We continue to experience intense competition across all markets for our products and services. Our competitors range in size from Fortune 100 companies to small, specialized single-product businesses and open +source community-based projects. Although we believe the breadth of our businesses and product portfolio are a competitive advantage, our competitors that are focused on narrower product lines may be more effective in devoting technical, marketing, +and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low and products, once developed, can be distributed broadly and quickly at relatively low cost. Open source software vendors are devoting +considerable efforts to developing software that mimics the features and functionality of our products. In response to competition, we are developing versions of our products with basic functionality that are sold at lower prices than the standard +versions. These competitive PAGE 12 Table of Contents Part I Item 1A pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower +revenue, gross margins and operating income. We may not be able to adequately protect our intellectual property rights. Protecting our +global intellectual property rights and combating unlicensed copying and use of software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, +particularly in countries where laws are less protective of intellectual property rights. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively +educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are +protected. However, continued educational and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual property rights or additional compliance burdens could both adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time we receive notices from others claiming we +infringe their intellectual property rights. The number of these claims may grow. To resolve these claims we may enter into royalty and licensing agreements on less favorable terms, stop selling or redesign affected products, or pay damages to +satisfy indemnification commitments with our customers. Such agreements may cause operating margins to decline. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual +property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of +source code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code +to a number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret +protection for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code could also +increase the security risks described in the next paragraph. Security vulnerabilities in our products could lead to reduced revenues or to liability +claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our products. +Although this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on the most popular operating systems and programs and we expect them to +continue to do so. We devote significant resources to address security vulnerabilities through: • engineering more secure products; • enhancing security and reliability features in our products; • helping our customers make the best us of our products and services to protect against computer viruses and other attacks; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; and • providing customers online automated security tools, published security guidance, and security software such as firewalls, anti-virus, and other security software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security vulnerabilities in +our products could lead some customers to seek to return products, to reduce or delay future purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems from attack, which +could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. In addition, actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain +provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will be held effective under applicable laws and judicial decisions. PAGE 13 Table of Contents Part I Item 1A We are subject to government litigation and regulatory activity that +affects how we design and market our products. As a leading global software maker, we receive close scrutiny from government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights +of action for competitors or consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in November 2001 and a Final Judgment entered in November 2002. +These proceedings imposed various constraints on our Windows operating system businesses. These include limits on certain contracting practices, mandated disclosure of certain software program interfaces and protocols, and rights for computer +manufacturers to limit the visibility of certain Windows features in new PCs. Some of these rules will expire in November 2007; others will stay in force until November 2009 or later. Although we believe we are in full compliance with these rules, +if we fail to comply with them, additional restrictions could be imposed on us that would adversely affect our business. In March 2004, the European +Commission ordered us to create new versions of Windows that do not include certain multimedia technologies to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own +products. The design of these special versions of Windows and the terms on which we make our protocol technology available are closely regulated by the Commission. The product design aspect of the Commission decision may limit our ability to +innovate in Windows in the future, diminish the developer appeal of the Windows platform and increase our product development costs. The availability of protocol licenses may enable competitors to develop software products that better mimic the +functionality of Microsoft’s own products which could result in a reduction in sales of our products. Pending resolution of Microsoft’s appeal, there will remain uncertainty about the legal principles that govern product design and +intellectual properties for future releases of Microsoft products in Europe. In February 2006, the Korean Fair Trade Commission (“KFTC”) +issued a decision requiring us to offer two versions of Windows PC operating systems, one with Windows Media Player and instant messaging software removed and another with those functionalities included but also including promotional links to +competing software products. If upheld on appeal, these remedies could adversely affect the utility and competitive position of Windows PC operating systems in Korea. Government regulatory actions and court decisions may hinder our ability to provide the benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenues that come from +them. New legal actions could be initiated at any time, either by these or other governments or private claimants including with respect to new versions of Windows or other Microsoft products. The outcome of such legal actions could adversely affect +us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to meet mandated +government specifications, which may entail removing functionality that customers want or developers rely on. • Creating mandated alternative versions of our products may cause confusion that harms our reputation, including among consumers and with software and Web site developers who +rely on the functionality removed from these alternative versions. • Government agencies may require that we make available licenses to our proprietary protocol technologies on terms that do not reflect their fair market value or do not +protect our associated intellectual property. • If not reversed or limited on appeal, the rulings described above may be cited as a precedent in other proceedings that seek to limit our ability to continue to improve +Windows by adding new functionality in response to consumer demand or to build our own software development efforts. Our software and services +online offerings are subject to government regulation of the Internet domestically and internationally in many areas including user privacy, telecommunications, data protection, and online content. The application of these laws and regulations to +our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed +on us or orders that we stop doing the alleged noncompliant activity. Our business depends largely on our ability to attract and retain talented +employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our PAGE 14 Table of Contents Part I Item 1A industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our +recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to +ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. Delays in product +development schedules may adversely affect our revenues. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and +testing periods. Significant delays in new product releases or significant problems in creating new products could adversely affect our revenue. We make +significant investments in new products and services that may not be profitable. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and +technologies, including Windows Vista, the 2007 Microsoft Office system, Xbox 360, Live Search, Windows Server, Zune, and Windows Live. Investments in new technology are inherently speculative. Commercial success depends on many factors including +innovativeness, developer support, and effective distribution and marketing. We may not achieve significant revenue from new product and service investments for a number of years, if at all. Moreover, new products and services may not be profitable, +and even if they are profitable, operating margins for new products and businesses may not be as high as the margins we have experienced historically. Adverse +economic conditions may harm our business. Inflation, softness in corporate information technology spending, or other changes in general economic conditions that affect demand for computer hardware or software could +adversely affect our revenue or our investment portfolio. If overall market demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely +affected. In addition, our revenue would be unfavorably impacted if customers reduce their purchases of new software products or upgrades because new offerings such as Windows Vista and the 2007 Microsoft Office system are not perceived as providing +significant new functionality or other value to prospective purchasers. We have claims and lawsuits against us that may result in adverse +outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of the claims pending against us may result in significant monetary damages or injunctive relief against us that could adversely +affect our ability to conduct our business. Although management currently believes that resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position, results of operations, or +cash flows, the litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. There exists the possibility of a material adverse impact on our financial position, results of +operations, and cash flows for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable. We may have additional +tax liabilities. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course +of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax +audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our income tax provision, net income or cash flows in the +period or periods for which that determination is made. Our consumer hardware products may experience quality or supply problems .    Our +hardware products such as the Xbox 360 console are highly complex and can have defects in design, manufacture or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or effectively +address such issues through design, testing or warranty repairs. We obtain some components of our hardware devices from sole suppliers. If a +component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain replacement supplies on a timely basis, resulting in reduced sales. Either component shortages or excess +inventory may require us to record charges to cost of revenue. Xbox 360 consoles are assembled in Asia; disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins. PAGE 15 Table of Contents Part I Item 1A, 1B If our goodwill or amortizable intangible assets become impaired +we may be required to record a significant charge to earnings. Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the +carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in circumstances indicating that the carrying value of our goodwill or amortizable intangible assets may not be +recoverable include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge to earnings in our financial statements during the +period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. We operate a +global business that exposes us to additional risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that +we reduce the sales price of our software in the United States and other countries. Operations outside the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade +and investment; changes in regulatory requirements for software; social, political, labor or economic conditions in a specific country or region; and difficulties in staffing and managing foreign operations. Although we hedge a portion of our +international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our net revenues. Catastrophic events or geo-political conditions may disrupt our business. A disruption or failure of our systems or operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, +or other catastrophic event could cause delays in completing sales, providing services or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other +critical business operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the +destruction or disruption of any of our critical business or information technology systems could severely affect our ability to conduct normal business operations and, as a result, our operating results could be adversely affected. Abrupt political +change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries or operating costs. These conditions may lend additional uncertainty to the timing and budget for technology investment decisions by our +customers. Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions or +entering into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don’t realize a satisfactory +return on the investment we make, or that we experience difficulty in the integration of new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These factors could adversely affect our +operating results or financial condition. Improper disclosure of personal data could result in liability and harm our reputation. We +store and process significant amounts of personally identifiable information. It is possible that our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the +improper disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products also +enable our customers to store and process personal data. Perceptions that our products do not adequately protect the privacy of personal information could inhibit sales of our products. Other risks that may affect our business. Other factors that may affect our performance may include sales channel disruption, such as the bankruptcy of a major distributor, and our ability to +implement operating cost structures that align with revenue growth. ITEM 1B.    UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current +reports from the staff of the SEC that were issued 180 days or more preceding the end of our fiscal year 2007 that remain unresolved. PAGE 16 Table of Contents Part I Item 2, 3, 4 ITEM 2.    PROPERTIES Our corporate offices consist of approximately 11 million square feet of office space +located in King County, Washington: 8 million square feet of owned space that is situated on approximately 500 acres of land we own at our corporate campus and approximately 3 million square feet of space we lease. We own approximately +1 million square feet of office space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately 3 million square feet of office space. We occupy many sites internationally, totaling approximately 8 million square feet that is leased and approximately 1 million square feet that is owned. These +facilities include our European Operations Center in Dublin, Ireland, a disk duplication facility in Humacao, Puerto Rico, and a facility in Singapore for our Asia Pacific Operations Center and Regional headquarters. Leased office space includes the +following locations: Tokyo, Japan; Unterschleissheim, Germany; Les Ulis, France; Reading, England; and Mississauga, Canada. In addition to the above locations, we have various product development facilities, both domestically and internationally, as +described in “Product Development” above. Our facilities are fully used for current operations of all segments, and suitable additional +space is available to accommodate expansion needs. We own 63 acres of land in Issaquah, Washington, which can accommodate 1 million square feet of office space and we have an agreement with the City of Redmond under which we may develop an +additional 1 million square feet of facilities at our campus in Redmond, Washington. ITEM 3.    LEGAL PROCEEDINGS See Note 17 – Contingencies of the Notes to Financial Statements (Part II, +Item 8) for information about legal proceedings in which we are involved. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were +submitted to a vote of security holders during the fourth quarter of fiscal year 2007. PAGE 17 Table of Contents Part II Item 5 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND +ISSUER PURCHASES OF EQUITY SECURITIES Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On August 1, 2007, there were 148,344 +registered holders of record of our common stock. The high and low common stock prices per share were as follows: Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Year Fiscal year 2007 Common stock price per share: High $ 27.52 $ 30.26 $ 31.48 $ 31.16 $ 31.48 Low 22.23 27.15 26.60 27.56 22.23 Fiscal year 2006 Common stock price per share: High $ 27.94 $ 28.25 $ 28.38 $ 27.94 $ 28.38 Low 24.50 24.25 26.10 21.46 21.46 See Note 12 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8) for information +regarding dividends approved by our Board of Directors in fiscal years 2007 and 2006. On July 20, 2006, we announced that our Board of Directors +authorized two new share repurchase programs: a $20.00 billion tender offer which was completed on August 17, 2006; and authorization for up to an additional $20.00 billion ongoing share repurchase program that expires on June 30, 2011. +Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.84 billion at a price per share of $24.75. On August 18, 2006, we announced that the +authorization for the $20.00 billion ongoing share repurchase program had been increased by approximately $16.16 billion. As a result, we are authorized to repurchase additional shares in an amount up to $36.16 billion through June 30, 2011. +The repurchase program may be suspended or discontinued at any time without prior notice. The transactions occurred in open market purchases and pursuant to a trading plan under Rule 10b5-1. We repurchased common stock in each quarter of fiscal year +2007 using available cash resources as follows: Period Total number of shares purchased Average price paid per share July 1, 2006 – September 30, 2006 285,126,354 $ 24.43 October 1, 2006 – December 31, 2006 205,416,571 $ 29.39 January 1, 2007 – March 31, 2007 237,497,727 $ 28.40 April 1, 2007 – June 30, 2007 242,715,913 $ 30.35 Common stock repurchases in the fourth quarter of fiscal year 2007 were as follows: Period (a) Total number of shares purchased (b) Average price paid per share (c) Total number of shares purchased as part of publicly announced plans or programs (d) Approximate dollar value of shares that may yet be purchased under the plans or programs (in +millions) April 1, 2007 – April 30, 2007 10,816,647 $ 28.17 10,816,647 $ 22,200 May 1, 2007 – May 31, 2007 133,980,027 $ 30.71 133,980,027 $ 18,086 June 1, 2007 – June 30, 2007 97,919,239 $ 30.11 97,919,239 $ 15,138 242,715,913 242,715,913 PAGE 18 Table of Contents Part II Item 6 ITEM 6.    SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Fiscal Year Ended June 30 2007 2006 2005 2004 2003 Revenue $ 51,122 $ 44,282 $ 39,788 $ 36,835 $ 32,187 Operating income 18,524 16,472 14,561 9,034 9,545 Net income 14,065 12,599 12,254 8,168 7,531 Diluted earnings per share $ 1.42 $ 1.20 $ 1.12 $ 0.75 $ 0.69 Cash dividends declared per share $ 0.40 $ 0.35 $ 3.40 $ 0.16 $ 0.08 Cash and short-term investments 23,411 34,161 37,751 60,592 49,048 Total assets 63,171 69,597 70,815 94,368 81,732 Long-term obligations 8,320 7,051 5,823 4,574 2,846 Stockholders’ equity 31,097 40,104 48,115 74,825 64,912 PAGE 19 Table of Contents Part II Item 7 ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF +OPERATIONS RESULTS OF OPERATIONS FOR FISCAL YEARS 2007, 2006, AND 2005 OVERVIEW The following Management’s Discussion and Analysis (“MD&A”) is intended to help the +reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial +statements (“Notes”). We develop, manufacture, license, and support a wide range of software products for many computing devices. Our +software products include operating systems for servers, PCs, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software +development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, the Zune digital music and entertainment device, PC games, and PC +peripherals. Online communication and information services are delivered through our MSN portals, channels around the world, and through our search products. Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. +In fiscal year 2007, our revenue was highest in the third quarter due to the recognition of $1.67 billion of revenue previously deferred from the Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments +of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products +became available to consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices +Division has generated over 40% of its yearly segment revenues in our second fiscal quarter. With the exception of fiscal year 2007, we believe the seasonality of revenue is likely to continue in the future. We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality +products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating +systems and to develop operating system versions targeted at emerging markets. We also are increasing our focus on selling our products in emerging markets and reducing the amount of unlicensed software used in those markets. In addition, we +continue to develop innovative software applications and solutions that we believe will enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for +small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver products that provide the best platform for network +computing – software that is easiest to deploy and manage, and that is most secure – with the lowest total cost of ownership. We continue +to invest in research and development in existing and new lines of business, including business solutions, mobile computing, communication, entertainment, and other areas that we believe may contribute to our long-term growth. We also invest in +research and development of advanced technologies for future software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth. We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative products, creating opportunities for partners, +improving customer satisfaction with key audiences, and improving our internal business processes. Our focus in fiscal year 2008 is building on this foundation and executing well in key areas, including continuing to innovate on our integrated +software platform, responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company. Key market opportunities include: Consumer t echnology. We are focused on delivering consumer software products that we believe are compelling in terms of design and features. We are also working to define the next era of consumer electronics through +innovating software that powers today’s consumer devices. PAGE 20 Table of Contents Part II Item 7 Software plus +services. The ability to combine the power of desktop and server software with the reach of the Internet represents an opportunity across every one of our businesses. We believe our software plus services approach will +enable us to deliver new experiences to end users and new value to businesses. Expanding our presence on the desktop and +server. Through our ability to deliver additional value in security, messaging, systems management, and collaboration, and new technology for high performance computing, unified communications, healthcare, and +business intelligence, we believe we are well-positioned to build on our strength with businesses of all sizes. The expansion of our Unlimited Potential program provides the foundation for our efforts to reach the five billion people around the +globe who do not have access to PCs and digital technology today. Summary of Results for Fiscal Years 2007, 2006, and 2005 (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Revenue $ 51,122 $ 44,282 $ 39,788 15% 11% Operating income $ 18,524 $ 16,472 $ 14,561 12% 13% Fiscal year 2007 compared to fiscal year 2006 Revenue growth was driven primarily by licensing of the 2007 Microsoft Office system and Windows Vista, increased revenue associated with SQL Server, Windows Server, and Visual Studio, and increased Xbox 360 console sales. +Foreign currency exchange rates did not have a significant impact on consolidated revenue during the year. Operating income growth was driven +primarily by the increased revenue and decreased costs for legal settlements and legal contingencies, partially offset by increased cost of revenue associated with Xbox 360 and Windows Vista, increased OSB data centers costs, and increased sales and +marketing expenses. In July 2007, we expanded our global Xbox 360 warranty coverage to three years from the date of purchase for a general hardware failure indicated by three flashing red lights. As a result, we recorded a $1.06 billion charge for +anticipated costs under the warranty policy, inventory write-downs, and product returns. The increase in sales and marketing expenses was primarily driven by increased headcount-related costs and marketing costs related to recent product launches. +Headcount-related costs increased 15%, driven by a 10% increase in headcount over the past twelve months and an increase in salaries and benefits for existing headcount. Fiscal year 2006 compared to fiscal year 2005 Revenue growth was driven primarily by growth in SQL Server following the launch of SQL Server 2005 in +the second quarter of fiscal year 2006, Windows Server and other server applications, increased Xbox revenue resulting from the Xbox 360 launch in November 2005, growth in licensing of Windows PC operating systems through OEMs, and increased +licensing of Office and other MBD software. Foreign currency exchange rates did not have a significant impact on consolidated or operating segment revenue during the fiscal year. Operating income increased primarily reflecting the revenue increase and a decrease in costs for legal settlements and legal contingencies. These changes were +partially offset by an increase in cost of revenue primarily related to Xbox 360 and an increase in sales and marketing expenses primarily as a result of increased investments in partner marketing and product launch-related spending. +Headcount-related costs increased 7%, driven by an increase in salaries and benefits for existing headcount and a 16% growth in headcount. Fiscal Year 2008 +Outlook Worldwide macroeconomic factors have a strong correlation to business and consumer demand for our software, services, games, and Internet service +offerings. We expect a broad continuation in the economic conditions and demand in fiscal year 2008. We also expect continued double digit revenue growth. Given our product launches in the second half of fiscal year 2007, we expect revenue growth to +be higher in the first half of fiscal year 2008 than in the second half. We estimate worldwide PC shipments will grow between 9% and 11%. We do not expect a significant PAGE 21 Table of Contents Part II Item 7 impact from changes in year-over-year foreign currency exchange rates in fiscal year 2008. We expect our operating income growth rate to exceed our revenue growth +rate. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) In +July 2006, we announced a change in our operating segments reflecting previously announced reorganizations. We have five operating segments: Client, Server and Tools, the Online Services Business, the Microsoft Business Division, and the +Entertainment and Devices Division. Prior fiscal year information has been recast to conform to the way we internally managed and monitored performance at the business group level in fiscal year 2007. The revenue and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. Generally Accepted Accounting Principles +(“GAAP”) and include certain reconciling items attributable to each of the segments. The segment information appearing in Note 18 – Segment Information of the Notes to Financial Statements (Part II, Item 8) is presented on a +basis consistent with the Company’s internal management reporting, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information . +Certain corporate-level activity has been excluded from our segment operating results and is analyzed separately. Client (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Revenue $ 14,972 $ 13,089 $ 12,042 14% 9% Operating income $ 11,603 $ 10,297 $ 9,442 13% 9% Client offerings consist of premium edition and standard Windows operating systems. Premium offerings are those that include +additional functionality and are sold at a price above our standard versions. Premium offerings include Windows XP Professional, XP Media Center Edition, XP Tablet PC Edition, Vista Business, Vista Home Premium, and Vista Ultimate. Standard Windows +operating systems include Windows XP Home and Windows Vista Home Basic. Client revenue growth correlates with the growth of purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for +approximately 80% of total Client revenue. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the mix of OEM Windows operating systems licensed with premium edition operating systems as a +percentage of total OEM Windows operating systems licensed (“OEM premium mix”), changes in the geographical mix, and changes in the channel mix of products sold by large, multi-national OEMs versus those sold by local and regional system +builders. Fiscal year 2007 compared to fiscal year 2006 Client revenue +increased primarily reflecting licensing of Windows Vista. OEM revenue increased $1.46 billion or 13% driven by 13% growth in OEM license units while revenue from commercial and retail licensing of Windows operating systems increased $422 million or +21%. During the year, the OEM Premium Mix increased 16 percentage points to 68%. Based on our estimates, total worldwide PC shipments from all sources grew 10% to 12% driven by demand in both emerging and mature markets. Client operating income increased reflecting the increased revenue and decreased research and development costs, partially offset by increased Windows Vista product +costs and increased sales and marketing expenses for launch-related programs. The decrease in research and development costs reflects the capitalization of certain Windows Vista software development costs and completion of product development on +Windows Vista. Headcount-related costs decreased 3%, driven by a 1% decrease in headcount and a decrease in stock-based compensation expense. Fiscal year 2006 +compared to fiscal year 2005 Client revenue increased reflecting $1.18 billion or 12% growth in OEM revenue driven by 17% growth in OEM license units from +increased PC unit shipments, partially offset by a $118 million or 6% decrease in revenue from commercial and retail licensing of Windows operating systems. During the year, the OEM premium mix increased two percentage points to 52%. OEM revenue +growth included an increase to revenue of $89 million resulting from the alignment of PAGE 22 Table of Contents Part II Item 7 our billings associated with OEM distributors in our system builder channel with both industry standards and other Microsoft channels. Client operating income increased reflecting the increase in OEM revenue partially offset by a $224 million increase in sales and marketing expenses, excluding +headcount-related costs, mainly driven by increased investments in partner marketing and Windows Vista pre-launch programs. Headcount-related costs increased 6%, driven by a 13% increase in headcount primarily associated with Windows Vista and +further investments in our sales and marketing organization, and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Server and Tools (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Revenue $ 11,175 $ 9,652 $ 8,367 16% 15% Operating income $ 3,900 $ 3,035 $ 2,072 29% 46% Server and Tools offerings consist of server software licenses and client access licenses (“CAL”) for Windows +Server, Microsoft SQL Server, and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server and Tools concentrates +on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. The segment uses multiple channels for licensing including pre-installed OEM versions, +licenses through partners, and licenses directly to end customers. We sell licenses both as one-time licenses and as multi-year volume licenses. Fiscal year 2007 +compared to fiscal year 2006 Server and server application revenue (including CAL revenue) and developer tools, training, and certification revenue increased +$1.12 billion or 14%. This increase was primarily driven by increased revenue associated with SQL Server, Windows Server, and Visual Studio. The results reflect broad adoption of Windows Server products, especially SQL Server which grew over 20%. +Consulting, Premier, and Professional product support services revenue increased $404 million or 24% primarily due to higher demand for Premier services in corporate enterprises. Foreign currency exchange rates accounted for a $165 million or a two +percentage point increase in revenue. Server and Tools operating income increased reflecting the increased revenue, partially offset by growth in +headcount-related costs and cost of revenue for services. Headcount-related costs increased 12%, driven by an 11% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based +compensation expense. Cost of revenue increased $243 million or 13% reflecting growth in services provided. Fiscal year 2006 compared to fiscal year 2005 Server and Tools revenue increased mainly driven by growth in SQL Server, Windows Server, and Visual Studio. SQL Server 2005 and Visual Studio 2005 were launched in +the second quarter of fiscal year 2006 and produced revenue growth in these product lines. Server and Server applications revenue (including CAL revenue) and developer tools, training and certification revenue increased $1.07 billion or 16% during +fiscal year 2006. The results reflect broad adoption of Windows Server products, especially SQL Server, which grew over 30% for the year. Consulting, Premier and Professional product support services revenue increased $217 million or 15% primarily +due to higher demand for services. Server and Tools operating income increased primarily reflecting the increased revenue, partially offset by +increased sales and marketing expenses related to supporting long-term strategies and the launches of SQL Server 2005 and Visual Studio 2005. Headcount-related costs increased 5%, driven by an 11% increase in headcount and an increase in salaries +and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. PAGE 23 Table of Contents Part II Item 7 Online Services Business (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Revenue $ 2,474 $ 2,299 $ 2,344 8% (2)% Operating income (loss) $ (732 ) $ (74 ) $ 402 * * * Not meaningful The Online Services Business (“OSB”) provides personal +communications services, such as e-mail and instant messaging, online information offerings, such as Live Search, and the MSN portals and channels around the world. OSB also provides a variety of online services such as MSN Internet Access, MSN +Premium Web Services and OneCare. We earn revenue primarily from online advertising, from consumers and partners through subscriptions and transactions generated from online paid services, and from MSN narrowband Internet access subscribers. We have +transitioned to adCenter, our own platform, for online delivery of advertising in the U.S. and certain international markets. We continue to launch new online initiatives and expect to do so in the future. In fiscal year 2007, we launched Windows +Live Search and Live.com in 54 international markets, Live Local Search in the U.S. and U.K., beta versions of MSN Soapbox (our expansion of the MSN Video experience), Virtual Earth™ 3D, Windows Live Hotmail, and other offerings. Fiscal year 2007 compared to fiscal year 2006 OSB revenue increased driven primarily by +advertising revenue which grew $314 million or 21% to $1.84 billion. This increase was primarily due to growth in advertising for search, home page, email, and messaging services. The increase in advertising revenue was partially offset by a $156 +million or 31% decrease in access revenue. At June 30, 2007, we estimate that OSB had over 310 million active Hotmail accounts and over 280 million Messenger accounts. OSB operating loss increased driven primarily by increased cost of revenue which grew $352 million or 45% and increased headcount-related costs as a result of +continued search and advertising platform investments. The increase in cost of revenue was primarily driven by increased data center costs, online content expenses, and royalties. Headcount-related costs increased 30%, driven by a 12% increase in +headcount and an increase in salaries and benefits for existing headcount. Fiscal year 2006 compared to fiscal year 2005 OSB revenue decreased primarily reflecting a $195 million or 28% decline in access revenue, partially offset by a $126 million or 9% increase in advertising revenue and a $23 +million or 9% increase in revenue from subscription and transaction services other than access. Advertising revenue for fiscal year 2006 was $1.52 billion. The increase in advertising revenue reflects growth in display advertising for portals, +channels, email, and messaging services, which was partially offset by a decline in search revenue due to the transition to adCenter. As of June 30, 2006, OSB had 2.1 million access subscribers compared with 2.7 million at +June 30, 2005. In addition, OSB had over 261 million active Hotmail accounts and over 243 million active Messenger accounts as of June 30, 2006. OSB operating income decreased due to a $230 million or 39% increase in research and development costs, a $126 million or 22% increase in sales and marketing expenses, and a $67 million or 9% increase in cost of revenue as we +continued to invest in adCenter, Windows Live, and other new platforms. Headcount-related costs increased 25%, reflecting a 44% increase in headcount and increased salaries and benefits for existing employees, partially offset by a decrease in +stock-based compensation. PAGE 24 Table of Contents Part II Item 7 Microsoft Business Division (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Revenue $ 16,396 $ 14,486 $ 13,520 13% 7% Operating income $ 10,838 $ 9,620 $ 9,116 13% 6% MBD offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office system +products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD revenue, +depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as enterprise content management, collaboration, unified communications, and business +intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and +divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts – business revenue which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft +Dynamics revenue, and consumer revenue which includes revenue from retail packaged product sales, OEM revenue, and sales of pre-installed versions of Office in Japan. Fiscal year 2007 compared to fiscal year 2006 MBD revenue increased primarily reflecting licensing of the 2007 Microsoft Office system. Revenue from +consumer sales increased $371 million or 11% while revenue from business sales increased $1.54 billion or 14%. The increase in business revenue includes a 21% increase in Microsoft Dynamics customer billings. Foreign currency exchange rates +accounted for a $248 million or a two percentage point increase in revenue. MBD operating income increased reflecting the increased revenue, partially +offset by increased sales and marketing expenses and cost of revenue primarily associated with the 2007 Microsoft Office system. The increase in sales and marketing expenses reflects increased headcount-related expenses, increased sales support +costs from our Enterprise Software Advisor channel partners, and increased launch-related marketing expenses. Headcount-related costs increased 10%, driven by a 6% increase in headcount and an increase in salaries and benefits for existing +headcount, partially offset by decreased stock-based compensation expense. Fiscal year 2006 compared to fiscal year 2005 MBD revenue increased reflecting an increase in business sales of $1.01 billion or 10%, partially offset by a decrease in consumer sales of $44 million or 1%. The increase in +business sales reflects a 16% increase in Microsoft Dynamics customer billings. MBD operating income increased reflecting the increased revenue +partially offset by increased sales and marketing expenses related to supporting field sales efforts and increased research and development expenses. Headcount-related costs increased 8%, driven by a 14% increase in headcount and an increase in +salaries and benefits for existing headcount, partially offset by decreased stock-based compensation expense. PAGE 25 Table of Contents Part II Item 7 Entertainment and Devices Division (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Revenue $ 6,083 $ 4,756 $ 3,515 28% 35% Operating loss $ (1,892 ) $ (1,284 ) $ (539 ) (47)% (138)% The Entertainment and Devices Division (“EDD”) products include the Xbox video game system; PC games; consumer +software and hardware products; the Zune digital music and entertainment device; Mediaroom, our Internet protocol television software; and Mobile and Embedded devices (Windows Mobile software platform, Windows Embedded device operating system and +Windows Automotive). The success of video game consoles is determined by console innovation and quality, the portfolio of video game content for the console, online offerings, and the market share of the console. We believe that the functionality of +the Xbox 360 console, games portfolio, and online offerings are well-positioned relative to recently launched competitive consoles. Fiscal year 2007 compared to +fiscal year 2006 EDD revenue increased primarily due to increased Xbox 360 console sales, Zune sales, and increased Xbox accessories and video game sales. We +shipped 6.6 million Xbox 360 consoles during fiscal year 2007 as compared to 5.0 million consoles during fiscal year 2006. Xbox and PC game revenue increased $650 million or 19% as a result of increased Xbox 360 platform sales, partially +offset by decreased sales of the first generation Xbox console and related accessories and video games. Zune, which was launched in November 2006, consumer hardware and software, and TV platforms revenue increased $539 million or 65%. Mobile and +Embedded Devices revenue increased $138 million or 28% driven by sales growth in Windows Mobile software and Windows Embedded operating systems. EDD +operating loss increased primarily due to the $1.06 billion Xbox 360 charge recognized in the fourth quarter of fiscal year 2007 and Zune launch-related expenses. The increase in operating loss was partially offset by increased Xbox 360 platform +sales and decreased Xbox 360 console manufacturing costs. Headcount-related costs increased 15%, driven by a 9% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based +compensation expense. Fiscal year 2006 compared to fiscal year 2005 EDD +revenue increased primarily due to the launch of the Xbox 360 console in November 2005, partially offset by a decline in first party Xbox game sales primarily resulting from the significant impact of Halo 2 in fiscal year 2005. The revenue growth +was also attributable to $140 million or 15% growth from our other product lines, primarily as a result of an increase in PC games sales due to significant new game releases, especially “Age of Empires III”, and an increase in TV platform +revenue due to deployments in fiscal year 2006. Mobile and Embedded Devices revenue increased $115 million or 44% driven by unit volume increases in major product lines, especially Windows Mobile software sales and Windows Embedded operating +systems. EDD operating loss increased primarily as a result of a $1.64 billion increase in cost of revenue resulting from the number of Xbox 360 +consoles sold and higher Xbox 360 unit costs, partially offset by the revenue growth. The significant impact of Halo 2 in fiscal year 2005 also contributed to the increase in fiscal year 2006 operating loss. Headcount-related costs increased 8%, +driven by a 21% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. PAGE 26 Table of Contents Part II Item 7 Corporate-Level Activity (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Corporate-level activity $ (5,193 ) $ (5,122 ) $ (5,932 ) (1)% 14% Certain corporate-level results are not allocated to our segments. Those results include expenses related to corporate +operations associated with broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal +settlements and contingencies. Fiscal year 2007 compared to fiscal year 2006 Corporate-level expenses increased primarily driven by increased headcount-related costs offset by decreased costs for legal settlements and legal contingencies. Headcount-related costs increased 25%, driven by a 19% increase in headcount +and an increase in salaries and benefits for existing headcount. We incurred $511 million in legal charges during the twelve months ended June 30, 2007, primarily related to antitrust and unfair competition consumer class actions, intellectual +property claims, and an extension payment to Sun Microsystems, Inc. under our Limited Patent Covenant and Standstill Agreement. We incurred $1.32 billion in legal charges during fiscal year 2006 which included settlement expense of $361 million +related to our settlement with RealNetworks, Inc. as well as other intellectual property and antitrust matters, a € 281 million ($351 million) fine imposed by +the European Commission in July 2006 related to its 2004 decision in its competition law investigation of Microsoft, and an extension payment to Sun Microsystems, Inc. Fiscal year 2006 compared to fiscal year 2005 Corporate-level expenses decreased primarily reflecting decreased costs for legal settlements and +legal contingencies partially offset by increased headcount-related costs. We incurred $1.32 billion in legal charges during fiscal year 2006 as compared to $2.31 billion in legal charges incurred during fiscal year 2005 primarily related to +settlements with Novell, Inc., Gateway, IBM, and other antitrust and competition law matters. Headcount-related costs increased 5%, driven by a 23% increase in headcount and an increase in salaries and benefits for existing headcount, partially +offset by a decrease in stock-based compensation. Outlook Our outlook +for fiscal year 2008 is as follows: Client We expect revenue to grow reflecting improvement in the commercial and +retail portion of the business due to increased acceptance of Windows Vista. We expect PC shipments to grow 9% to 11% for fiscal year 2008. We believe that PC unit growth rates will be higher in the consumer segment than in the business segment and +higher in emerging markets than in mature markets. Server and Tools We expect continued momentum from recent product +launches and to benefit from the upcoming launches of the new versions of SQL Server, Windows Server, and Visual Studio in the second half of fiscal year 2008. Online Services Business We expect increased growth in online advertising revenue as the portals, channels, and communications services continue to expand globally and the overall Internet +advertising industry continues to expand. In May 2007, we agreed to acquire aQuantive, Inc., a digital marketing company, for approximately $6 billion in cash. We expect to complete this transaction in August 2007. This acquisition will enable us to +strengthen relationships with advertisers, agencies and publishers by enhancing our advertising platforms and services. The acquisition also provides us with increased depth in building and supporting next generation advertising solutions and +environments such as cross media planning and video-on-demand. Microsoft Business Division We expect revenue to +continue to increase in fiscal year 2008 due to increased customer acceptance of the 2007 Microsoft Office system. We continue to develop plans to grow revenue in new areas such as unified communications, enterprise content management, collaboration +tools, business intelligence, and through our existing portfolio of Microsoft Dynamics products. PAGE 27 Table of Contents Part II Item 7 Entertainment and Devices +Division We expect revenue to increase due to the increased installed base of the Xbox 360 console and from the release of Halo 3, a new Xbox 360 game. Revenue from existing mobility and embedded devices is expected to +increase due to unit volume increases of Windows Mobile software driven by increased market demand for phone-enabled devices and Windows Embedded operating systems. Operating Expenses Cost of Revenue (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Cost of revenue $ 10,693 $ 7,650 $ 6,031 40% 27% As a percent of revenue 21% 17% 15% 4ppt 2ppt Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs +related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, warranty costs, inventory write-downs, and costs associated with the delivery of consulting +services. Cost of revenue increased in fiscal year 2007 primarily driven by the Xbox 360 charge, increased Windows Vista product costs, increased OSB data center costs, and costs associated with the growth in consulting services. Cost of revenue +increased in fiscal year 2006 mainly due to a $1.64 billion increase in EDD as a result of an increase in the number of total Xbox consoles sold and higher Xbox 360 unit costs. Research and Development (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Research and development $ 7,121 $ 6,584 $ 6,097 8% 8% As a percent of revenue 14% 15% 15% (1)ppt – Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related costs associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the +amortization of purchased software code and services content. Research and development costs increased during fiscal year 2007 primarily due to increased headcount-related costs which grew 8%, reflecting a 9% growth in headcount and an increase in +salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation expense. Research and development costs increased during fiscal year 2006 primarily due to increased development costs associated with upcoming +offerings and corporate research activities. Headcount-related costs increased 3% during fiscal year 2006, driven by a 17% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in +stock-based compensation expense. PAGE 28 Table of Contents Part II Item 7 Sales and Marketing (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 Sales and marketing $ 11,455 $ 9,818 $ 8,563 17% 15% As a percent of revenue 22% 22% 22% – – Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related costs associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased during fiscal year 2007 primarily because of increased +headcount-related costs and increased marketing costs related to recent product launches. Headcount-related costs increased 22% during fiscal year 2007, driven by an 11% increase in headcount and an increase in salaries and benefits for existing +headcount, partially offset by a decrease in stock-based compensation expense. Sales and marketing expenses increased during fiscal year 2006 primarily because of increased headcount-related costs, investments in partner marketing and product +launch-related spending. Headcount-related costs increased 13% during fiscal year 2006, driven by a 20% increase in headcount and an increase in salaries and benefits for existing headcount, partially offset by a decrease in stock-based compensation +expense. General and Administrative (In millions, except percentages) 2007 2006 2005 Percent Change 2007 versus 2006 Percent Change 2006 versus 2005 General and administrative $ 3,329 $ 3,758 $ 4,536 (11)% (17)% As a percent of revenue 7% 8% 11% (1)ppt (3)ppt General and administrative costs include payroll, employee benefits, stock-based compensation expense and other +headcount-related costs associated with finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative costs decreased during fiscal year 2007 primarily +reflecting decreased costs for legal settlements and legal contingencies, partially offset by increased headcount-related costs. During fiscal year 2007, we incurred $511 million of legal charges primarily related to antitrust and unfair competition +consumer class actions, intellectual property claims, and extension payment to Sun Microsystems, Inc. as compared to $1.32 billion of legal charges in fiscal year 2006. Headcount-related costs increased 15% during fiscal year 2007, driven by a 12% +increase in headcount and an increase in salaries and benefits for existing headcount. General and administrative costs decreased in fiscal year 2006 primarily reflecting decreased costs for legal settlements and legal contingencies. During fiscal +year 2006, we incurred $1.32 billion of legal charges primarily related to antitrust and unfair competition consumer class actions, intellectual property claims, and an extension payment to Sun Microsystems, Inc. Legal charges in fiscal year 2006 +also included settlement expense of $361 million related to our settlement with RealNetworks, Inc. and the € 281 million ($351 million) European Commission +fine. Headcount-related costs increased 7% during fiscal year 2006, driven by an 18% increase in headcount and an increase in salaries for existing headcount. We incurred $2.31 billion in legal charges during fiscal year 2005. PAGE 29 Table of Contents Part II Item 7 Investment Income and Other The components of investment income and other were as follows: (In millions) 2007 2006 2005 Dividends and interest $ 1,319 $ 1,510 $ 1,460 Net gains on investments 650 161 856 Net losses on derivatives (358 ) (99 ) (262 ) Other, net (34 ) 218 13 Investment income and other $ 1,577 $ 1,790 $ 2,067 For fiscal year 2007, dividends and interest income declined, reflecting a decline in the average balance of dividend and +interest-bearing investments, partly offset by higher interest rates received on our fixed-income investments. For fiscal year 2006, dividends and interest income increased due to higher interest rates received on our fixed-income investments, +partially offset by a decline in the average balance of dividend and interest-bearing investments as a result of the $32.64 billion special dividend paid on December 2, 2004, and stock repurchases made throughout fiscal year 2006. For fiscal year 2007, net gains on investments increased primarily due to lower other-than-temporary impairments and gains on sales of fixed-income investments +in the current period as compared to losses in fiscal year 2006, partly offset by fewer gains on the sale of equity investments. Other-than-temporary impairments in fiscal year 2007 were not material and were $408 million in fiscal year +2006. Net gains on investments decreased in fiscal year 2006 primarily due to increased net losses on sales of fixed-income investments, higher other-than-temporary impairments, and fewer net gains on equity investments in fiscal year 2006 as +compared to fiscal year 2005. For fiscal year 2006, other-than-temporary impairments were $408 million, as compared to $152 million in fiscal year 2005. The increase in other-than-temporary impairments in fiscal year 2006 was driven by planned sales +of certain investments in an unrealized loss position in order to raise funds for the $20 billion tender offer announced on July 20, 2006. Investments are considered to be impaired when a decline in fair value is judged to be other than temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the +cost of an investment exceeds its fair value, among other factors, we evaluate general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific +adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in +fair value is determined to be other than temporary, an impairment charge is recorded and a new cost basis in the investment is established. We lend +certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the +creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability. We anticipate that the magnitude of securities lent under this program will remain relatively consistent during the fiscal year. We use derivative instruments to manage exposures to interest rates, equity prices, and foreign currency markets and to facilitate portfolio diversification. +Derivative losses during fiscal 2007 were primarily driven by net losses in time value on foreign currency contracts used to hedge anticipated foreign currency revenues. During fiscal year 2006, we experienced lower net losses on derivatives as +compared to fiscal year 2005 primarily due to net gains on non-designated equity derivatives in fiscal 2006 as compared to net losses in fiscal 2005 and higher net gains on commodity positions in fiscal 2006 driven by increases in the related +commodity indices. These gains were partially offset by higher net losses in time value on foreign exchange contracts used to hedge anticipated foreign currency revenues and higher net losses on interest rate derivative contracts in fiscal 2006. Net +derivative losses in fiscal year 2005 were primarily related to losses on equity derivatives, interest rate derivatives, and foreign currency contracts, partly offset by gains related to commodity positions used to provide portfolio diversification. +Gains and losses arising from derivatives not designated as accounting hedges are in large part economically offset by unrealized losses and gains, respectively, in the underlying securities which are recorded as a component of other comprehensive +income. Commodity derivatives are held for the purpose of portfolio diversification. PAGE 30 Table of Contents Part II Item 7 Other, net in fiscal year 2006 includes $195 million of +gains that resulted from the restructuring of joint venture relationships between Microsoft and NBC related to MSNBC Cable L.L.C. and MSNBC Interactive News, L.L.C. Income Taxes Our effective tax rate for fiscal years 2007, 2006, and 2005 was 30%, 31%, and 26%, respectively. The fiscal year 2007 rate +reflects a recurring effective tax rate of 31% offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit +assessments. During fiscal year 2006, we recorded a tax benefit of $108 million from the resolution of state audits and recorded a charge of € 281 million ($351 +million) from the European Commission fine which was not tax deductible. The 2005 tax rate was lower from the reversal of previously accrued taxes and from an IRS settlement. Financial Condition Cash and equivalents and short-term investments totaled $23.41 billion and $34.16 billion as of June 30, 2007 +and 2006, respectively. Equity and other investments were $10.12 billion and $9.23 billion as of June 30, 2007 and 2006, respectively. Our investments consist primarily of fixed-income securities, diversified among industries and individual +issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S.-dollar-denominated securities, but also includes foreign-denominated securities in order to diversify financial risk. As a result of +the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $29.46 billion at June 30, 2007. Our retained deficit is not expected to +impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position. Unearned Revenue Unearned revenue from volume licensing programs represents customer billings, paid either upfront or annually at the beginning of each billing coverage period, that +are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements, revenue attributable to undelivered elements, including free post-delivery telephone support and the right +to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP and previous PC operating systems, is based on the sales price of those elements when sold separately and is recognized +ratably on a straight-line basis over the life cycle of the related product. Other unearned revenue includes services, Microsoft Dynamics business solution products, Xbox Live subscriptions, advertising, and TV platform for which we have been paid +upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table +outlines the expected recognition of unearned revenue as of June 30, 2007: (In millions) Recognition of Unearned Revenue Three months ended: September 30, 2007 $ 4,021 December 31, 2007 3,245 March 31, 2008 2,264 June 30, 2008 1,249 Thereafter 1,867 Unearned revenue $ 12,646 PAGE 31 Table of Contents Part II Item 7 Cash Flows Fiscal year 2007 compared to fiscal year 2006 Cash flow from operations increased $3.39 +billion due to an increase in cash received from customers driven by 15% revenue growth, along with a $1.64 billion decrease in cash outflow for other current assets primarily reflecting changes in inventory. Cash used for financing increased $3.98 +billion. Several events occurred during fiscal year 2007 that affected cash used for financing. We issued $6.78 billion of common stock, including $3.25 billion related to 113 million call options exercised by JPMorgan in December 2006. We also +completed our tender offer on August 17, 2006, which was included in the $27.58 billion of common stock repurchases. Cash from investing decreased $1.91 billion due to a $3.49 billion decline in securities lending activity where cash collateral +is received from the counterparty along with $1.19 billion spent on acquisitions of companies and additions to property and equipment. These impacts were partially offset by a $2.77 billion increase in net cash from combined investment purchases, +sales, and maturities. Fiscal year 2006 compared to fiscal year 2005 Cash flow from operations decreased $2.20 billion primarily due to increased payments to fund a $987 million increase in Xbox 360 inventory and product costs and increased payments to employees resulting from a 16% growth in headcount. +These factors were partially offset by increased cash receipts from customers driven by our 11% revenue growth and a $1.74 billion increase in unearned revenue. Cash used in financing decreased $20.52 billion driven by a $32.57 billion reduction in +cash dividend payments. This impact was partially offset by an $11.15 billion increase in common stock repurchases. Net cash from investing decreased $7.02 billion driven primarily by an $8.93 billion decrease in cash from combined purchase, sales, +and maturities of investments and a $766 million increase in additions to property and equipment. These factors were partially offset by $3.12 billion of net cash proceeds from our securities lending program. We have no material long-term debt. Stockholders’ equity at June 30, 2007, was $31.10 billion. We will continue to invest in sales, marketing, product +support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and +administrative staff. Commitments for constructing new buildings were $821 million on June 30, 2007. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense +totaling $326 million, $276 million, and $299 million in fiscal year 2007, 2006, and 2005, respectively. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely +to materially affect liquidity or the availability of requirements for capital resources. In May 2007, we announced that we had entered into an agreement to purchase aQuantive, Inc. for approximately $6 billion in cash. We expect to complete this +transaction in August 2007. During fiscal years 2007 and 2006, our Board of Directors declared the following dividends: Declaration Date Per Share Dividend Record Date Total Amount Payment Date (in millions) (Fiscal year 2007) September 13, 2006 $ 0.10 November 16, 2006 $ 980 December 14, 2006 December 20, 2006 $ 0.10 February 15, 2007 $ 978 March 8, 2007 March 26, 2007 $ 0.10 May 17, 2007 $ 952 June 14, 2007 June 27, 2007 $ 0.10 August 16, 2007 $ 938 September 13, 2007 (Fiscal year 2006) September 23, 2005 $ 0.08 November 17, 2005 $ 846 December 8, 2005 December 14, 2005 $ 0.09 February 17, 2006 $ 926 March 9, 2006 March 27, 2006 $ 0.09 May 17, 2006 $ 916 June 8, 2006 June 21, 2006 $ 0.09 August 17,2006 $ 897 September 14, 2006 PAGE 32 Table of Contents Part II Item 7 On July 20, 2006, we announced the completion of the repurchase +program initially approved by our Board of Directors on July 20, 2004 to buy back up to $30.00 billion in Microsoft common stock. During fiscal year 2006, we repurchased 754 million shares, or $19.75 billion, of our common stock under this +plan. On July 20, 2006, we announced that our Board of Directors authorized two new share repurchase programs: a $20.00 billion tender offer, which was completed on August 17, 2006; and authorization for up to an additional $20.00 billion +ongoing share repurchase program with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.84 billion at a +price per share of $24.75. On August 18, 2006, we announced that the authorization for the $20.00 billion ongoing share repurchase program had been increased by approximately $16.16 billion. As a result, we are authorized to repurchase +additional shares in an amount up to $36.16 billion through June 30, 2011. As of June 30, 2007, approximately $15.14 billion remained of the $36.16 billion approved repurchase amount. We believe existing cash and equivalents and short-term investments, together with funds generated from operations, should be sufficient to meet operating +requirements, regular quarterly dividends, and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, as well as equity and other investments, reflects our +views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. +We regularly assess our investment management approach in view of our current and potential future needs. Off-Balance Sheet Arrangements and +Contractual Obligations We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made +by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS No. 5, Accounting for Contingencies , as interpreted by Financial Accounting Standards Board (“FASB”) +Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others . We consider factors such as the degree of probability of an unfavorable outcome and +the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any material liabilities related to such indemnifications in our financial +statements. PAGE 33 Table of Contents Part II Item 7 Contractual Obligations The following table summarizes our outstanding contractual obligations as of June 30, 2007: (In millions) (1) Payments due by period Fiscal Years 2008 2009-2011 2012-2014 2015 and thereafter Total Long-term debt $ – $ – $ – $ – $ – Construction commitments (2)(4) 821 – – – 821 Lease obligations: Capital leases – – – – – Operating leases (3) 349 618 258 116 1,341 Purchase commitments (4) 1,824 19 – – 1,843 Other long-term liabilities (5) 1 519 — – 520 Total contractual obligations $ 2,995 $ 1,156 $ 258 $ 116 $ 4,525 (1) We have excluded the $768 million long-term contingent liability related to the antitrust and unfair competition class action lawsuits referred to in Note 17 – Contingencies of the +Notes to Financial Statements (Part II, Item 8) as the timing and amount to be resolved in cash versus vouchers is subject to uncertainty. (2) We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations. (3) Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these commitments with existing +cash and cash flows from operations. (4) The amount presented above as purchase and construction commitments includes all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to fund these +commitments with existing cash and our cash flows from operations. (5) We have excluded other obligations of $5.86 billion from other long-term liabilities presented above as the amount that will be settled in cash is not known. We have also excluded non-cash +items of $71 million and unearned revenue of $1.87 billion. In May 2007, we entered into an Agreement and Plan of Merger with +aQuantive, Inc. to acquire the company for approximately $6 billion in cash. As part of the Agreement and Plan of Merger, we are required to pay $500 million if certain events occur that result in the merger not being completed. Due to the nature of +this obligation, this amount has not been accrued for or included in the above schedule. The acquisition is expected to be completed in August 2007. RECENTLY ISSUED ACCOUNTING STANDARDS In June 2006, the FASB issued Interpretation No. 48 (“FIN No. 48”), Accounting for +Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 , which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement +No. 109, Accounting for Income Taxes . The Interpretation provides a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. +Under FIN No. 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the +position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN No. 48 also provides +guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for us beginning July 1, 2007. Based on our current assessment, the adoption of FIN +No. 48 is expected to decrease beginning retained earnings by $200 million to $400 million upon adoption. In June 2006, the FASB ratified +the Emerging Issues Task Force (“EITF”) consensus on EITF Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies +to accrue the costs of compensated absences under a sabbatical or similar benefit PAGE 34 Table of Contents Part II Item 7 arrangement over the requisite service period. EITF Issue No. 06-2 is effective for us beginning July 1, 2007. The cumulative effect of the application of +this consensus on prior period results should be recognized through a cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. Elective retrospective application is also permitted. We do not expect the +application of this consensus to have a material impact on our financial statements. In fiscal year 2007, we adopted Staff Accounting Bulletin +(“SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Current Year Misstatements . SAB No. 108 requires companies to quantify misstatements using both a balance sheet (iron curtain) and an +income statement (rollover) approach to evaluate whether either approach results in an error that is material in light of relevant quantitative and qualitative factors, and provides for a one-time cumulative effect transition adjustment. The +adoption of SAB No. 108 did not have an impact on our financial statements. In September 2006, the FASB issued SFAS No. 157, Fair Value +Measurements , which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value +measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. This statement is effective for us beginning July 1, 2008. We currently are assessing the +potential impact that adoption of SFAS No. 157 would have on our financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities . SFAS No. 159 gives us the irrevocable option to carry many financial assets and liabilities at fair values, with changes in fair value recognized in earnings. SFAS +No. 159 is effective for us beginning July 1, 2008, although early adoption is permitted. We are currently assessing the potential impact that adoption of SFAS No. 159 will have on our financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and +accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and +assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development +costs, accounting for legal contingencies, accounting for income taxes, and accounting for stock-based compensation. We account for the licensing of +software in accordance with American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, Software Revenue Recognition . The application of SOP 97-2 requires judgment, including whether a software arrangement +includes multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. For some of our products, customers receive certain elements of our products over a period of time. These +elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The fair value of these elements is recognized over the estimated life +cycle for the Windows XP and previous PC operating systems. For Windows Vista, there are no significant undelivered elements and accordingly, no license revenue is deferred for Windows Vista sales. Changes to the elements in a software arrangement, +the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess +whether future releases of certain software represent new products or upgrades and enhancements to existing products. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities , and SAB Topic 5M, Accounting for Noncurrent Marketable Equity Securities , provide guidance on determining when an investment is other-than-temporarily impaired. +Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and +qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less +than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, +operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is PAGE 35 Table of Contents Part II Item 7 recorded and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. SFAS No. 142, Goodwill and Other Intangible Assets , requires that goodwill be tested for impairment at the reporting unit level +(operating segment or one level below an operating segment) on an annual basis (July 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its +carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition or sale or disposition of a significant portion of a reporting unit. Application +of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each +reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This requires significant judgments including estimation of future cash flows, which is dependent on internal forecasts, estimation of the +long-term rate of growth for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair +value and/or goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if necessary, reassign +goodwill using a relative fair value allocation approach. We account for research and development costs in accordance with applicable accounting +pronouncements, including SFAS No. 2, Accounting for Research and Development Costs , and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed . SFAS No. 86 specifies that +costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs +should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software +products is reached after all high-risk development issues have been resolved through coding and testing. This is generally shortly before the products are released to manufacturing. We determined that technological feasibility was reached with +Windows Vista and the 2007 Microsoft Office system during the second quarter of fiscal year 2007 and accordingly, we capitalized approximately $120 million of software development costs. The amortization of these costs will be included in cost of +revenue over the estimated life of the products. Previously, costs incurred prior to technological feasibility were not material and were expensed as incurred. The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies , requires that an estimated loss from a loss contingency such as a +legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if +there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable +estimate of the amount of loss. Changes in these factors could materially impact our results of operations, financial position, or our cash flows. SFAS No. 109, Accounting for Income Taxes , establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or +refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax +consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows. +Accruals for tax contingencies are provided for in accordance with the requirements of SFAS No. 5. We account for stock-based compensation in +accordance with SFAS No. 123(R), Share-Based Payment . Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as +expense over the requisite service period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of share-based +awards that are expected to be forfeited. PAGE 36 Table of Contents Part II Item 7 If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted. We account for product warranties in accordance with SFAS No. 5, Accounting for Contingencies . We provide for the estimated costs of hardware and +software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product +failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include technical support, parts, and labor over a period generally ranging from +90 days to three years. For software, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and +adjust the amounts as necessary. PAGE 37 Table of Contents Part II Item 7 Statement of Management’s Responsibility for Financial +Statements Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The +consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from +unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing +division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged +Deloitte & Touche LLP, independent auditors, to audit and render an opinion on the consolidated financial statements and management’s report on its assessment and the effectiveness of internal control over financial reporting in +accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, +consisting solely of independent directors of the Company, meets periodically with management, internal auditors and our independent auditors to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and +financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief +Executive Officer Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer PAGE 38 Table of Contents Part II Item 7A ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to foreign currency, +interest rate, fixed-income, equity, and commodity price risks. A portion of these risks is hedged, but fluctuations could impact our results of operations, financial position, and cash flows. We hedge a portion of anticipated revenue and accounts +receivable exposure to foreign currency fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies hedged include +the euro, Japanese yen, British pound, and Canadian dollar. Fixed-income securities and interest rate derivatives are subject primarily to interest rate risk. The portfolio is diversified and structured to minimize credit risk. Securities held in +our equity and other investments portfolio and equity derivatives are subject to price risk, and are generally not hedged. However, we use put-call collars to hedge our price risk on certain equity securities that are held primarily for strategic +purposes. Commodity derivatives held for the purpose of portfolio diversification are subject to commodity price risk. We use a value-at-risk +(“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to +represent actual losses in fair value, but is used as a risk estimation and management tool. The model used for currencies, equities, and commodities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk +exposures. For interest rate risk, exposures such as key rate durations and spread durations are used in calculations that reflect the principle that fixed-income security prices revert to maturity value over time. VaR is calculated by computing the exposures of each holding’s market value to a range of over 1,000 equity, fixed-income, foreign exchange, and commodity risk +factors. The exposures are then used to compute the parameters of a distribution of potential changes in the total market value of all holdings, taking into account the weighted historical volatilities of the different rates and prices and the +weighted historical correlations among the different rates and prices. The VaR is then calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out +of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. Certain +securities in our equity portfolio are held for strategic purposes. We hedge the value of a portion of these securities through the use of derivative contracts such as put-call collars. In these arrangements, we hedge a security’s equity price +risk below the purchased put strike and forgo most or all of the benefits of the security’s appreciation above the sold call strike. We also hold equity securities for general investment return purposes. We have incurred material impairment +charges related to these securities in previous periods. The VaR amounts disclosed below are used as a risk management tool and reflect an estimate +of potential reductions in fair value of our portfolio. Losses in fair value over the specified holding period can exceed the reported VaR by significant amounts and can also accumulate over a longer time horizon than the specified holding period +used in the VaR analysis. VaR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. VaR numbers are shown separately for interest rate, currency rate, equity price, and commodity price risks. These VaR numbers include the underlying portfolio +positions and related hedges. We use historical data to estimate VaR. Given the reliance on historical data, VaR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An +inherent limitation in VaR is that the distribution of past changes in market risk factors may not produce accurate predictions of future market risk. The following table sets forth the one-day VaR for substantially all of our positions as of and for the years ended June 30, 2007 and 2006: (In millions) Year ended June 30, 2007 Risk Categories June 30, 2007 June 30, 2006 Average High Low Interest rates $ 34 $ 66 $ 43 $ 67 $ 32 Currency rates 55 91 52 101 15 Equity prices 60 88 59 89 49 Commodity prices 7 12 7 12 4 Total one-day VaR for the combined risk categories was $95 million at June 30, 2007 and $158 million at +June 30, 2006. The total VaR is 39% less at June 30, 2007, and 38% less at June 30, 2006, than the sum of the separate risk categories in the above table due to the diversification benefit of the overall portfolio. PAGE 39 Table of Contents Part II Item 8 ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30 2007 2006 2005 Revenue $ 51,122 $ 44,282 $ 39,788 Operating expenses: Cost of revenue 10,693 7,650 6,031 Research and development 7,121 6,584 6,097 Sales and marketing 11,455 9,818 8,563 General and administrative 3,329 3,758 4,536 Total operating expenses 32,598 27,810 25,227 Operating income 18,524 16,472 14,561 Investment income and other 1,577 1,790 2,067 Income before income taxes 20,101 18,262 16,628 Provision for income taxes 6,036 5,663 4,374 Net income $ 14,065 $ 12,599 $ 12,254 Earnings per share: Basic $ 1.44 $ 1.21 $ 1.13 Diluted $ 1.42 $ 1.20 $ 1.12 Weighted average shares outstanding: Basic 9,742 10,438 10,839 Diluted 9,886 10,531 10,906 Cash dividends declared per common share $ 0.40 $ 0.35 $ 3.40 See accompanying notes. PAGE 40 Table of Contents Part II Item 8 BALANCE SHEETS (In millions) June 30 2007 2006 Assets Current assets: Cash and equivalents $ 6,111 $ 6,714 Short-term investments (including securities pledged as collateral of $2,356 and $3,065) 17,300 27,447 Total cash and short-term investments 23,411 34,161 Accounts receivable, net of allowance for doubtful accounts of $117 and $142 11,338 9,316 Inventories 1,127 1,478 Deferred income taxes 1,899 1,940 Other 2,393 2,115 Total current assets 40,168 49,010 Property and equipment, net 4,350 3,044 Equity and other investments 10,117 9,232 Goodwill 4,760 3,866 Intangible assets, net 878 539 Deferred income taxes 1,389 2,611 Other long-term assets 1,509 1,295 Total assets $ 63,171 $ 69,597 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 3,247 $ 2,909 Accrued compensation 2,325 1,938 Income taxes 1,040 1,557 Short-term unearned revenue 10,779 9,138 Securities lending payable 2,741 3,117 Other 3,622 3,783 Total current liabilities 23,754 22,442 Long-term unearned revenue 1,867 1,764 Other long-term liabilities 6,453 5,287 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 9,380 and 10,062 60,557 59,005 Retained deficit, including accumulated other comprehensive income of $1,654 and $1,229 (29,460 ) (18,901 ) Total stockholders’ equity 31,097 40,104 Total liabilities and stockholders’ equity $ 63,171 $ 69,597 See accompanying notes. PAGE 41 Table of Contents Part II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30 2007 2006 2005 Operations Net income $ 14,065 $ 12,599 $ 12,254 Depreciation, amortization, and other noncash items 1,440 903 855 Stock-based compensation 1,550 1,715 2,448 Net recognized gains on investments (292 ) (270 ) (527 ) Stock option income tax benefits – – 668 Excess tax benefits from stock-based payment arrangements (77 ) (89 ) – Deferred income taxes 421 219 (179 ) Unearned revenue 21,032 16,453 13,831 Recognition of unearned revenue (19,382 ) (14,729 ) (12,919 ) Accounts receivable (1,764 ) (2,071 ) (1,243 ) Other current assets 232 (1,405 ) (245 ) Other long-term assets (435 ) (49 ) 21 Other current liabilities (552 ) (145 ) 396 Other long-term liabilities 1,558 1,273 1,245 Net cash from operations 17,796 14,404 16,605 Financing Common stock issued 6,782 2,101 3,109 Common stock repurchased (27,575 ) (19,207 ) (8,057 ) Common stock cash dividends (3,805 ) (3,545 ) (36,112 ) Excess tax benefits from stock-based payment arrangements 77 89 – Other (23 ) – (18 ) Net cash used in financing (24,544 ) (20,562 ) (41,078 ) Investing Additions to property and equipment (2,264 ) (1,578 ) (812 ) Acquisition of companies, net of cash acquired (1,150 ) (649 ) (207 ) Purchases of investments (36,308 ) (51,117 ) (68,045 ) Maturities of investments 4,736 3,877 29,153 Sales of investments 41,451 54,353 54,938 Securities lending payable (376 ) 3,117 – Net cash from investing 6,089 8,003 15,027 Net change in cash and equivalents (659 ) 1,845 (9,446 ) Effect of exchange rates on cash and equivalents 56 18 (7 ) Cash and equivalents, beginning of period 6,714 4,851 14,304 Cash and equivalents, end of period $ 6,111 $ 6,714 $ 4,851 See accompanying notes. PAGE 42 Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30 2007 2006 2005 Common stock and paid-in capital Balance, beginning of period $ 59,005 $ 60,413 $ 56,396 Common stock issued 6,783 1,939 3,223 Common stock repurchased (6,162 ) (4,447 ) (1,737 ) Stock-based compensation expense 1,550 1,715 2,448 Stock option income tax benefits/(deficiencies) (661 ) (617 ) 89 Other, net 42 2 (6 ) Balance, end of period 60,557 59,005 60,413 Retained earnings (deficit) Balance, beginning of period (18,901 ) (12,298 ) 18,429 Net income 14,065 12,599 12,254 Other comprehensive income: Net unrealized gains/(losses) on derivative instruments 14 76 (58 ) Net unrealized gains/(losses) on investments 326 (282 ) 371 Translation adjustments and other 85 9 (6 ) Comprehensive income 14,490 12,402 12,561 Common stock cash dividends (3,837 ) (3,594 ) (36,968 ) Common stock repurchased (21,212 ) (15,411 ) (6,320 ) Balance, end of period (29,460 ) (18,901 ) (12,298 ) Total stockholders’ equity $ 31,097 $ 40,104 $ 48,115 See accompanying notes. PAGE 43 Table of Contents Part II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES ACCOUNTING PRINCIPLES The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the +United States of America. PRINCIPLES OF CONSOLIDATION The +financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant influence but do not control and are not the +primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. ESTIMATES AND ASSUMPTIONS Preparing financial statements +requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss contingencies, product warranties, product life cycles, product returns, and +stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the +potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments +are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. FOREIGN CURRENCIES Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at +average rates of exchange prevailing during the year. Translation adjustments resulting from this process are charged or credited to Other Comprehensive Income (“OCI”). REVENUE RECOGNITION Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, +the fee is fixed or determinable, and collectibility is probable. We enter into certain arrangements where we are obligated to deliver multiple products and/or services (multiple elements). In these arrangements, we generally allocate the total +revenue among the elements based on the sales price of each element when sold separately (vendor-specific objective evidence). Revenue for retail +packaged products, products licensed to original equipment manufacturers (“OEM”), and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped. A portion of +the revenue related to certain products, which include all Windows XP and previous PC operating systems, is recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive +unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the vendor-specific objective evidence of fair value for those elements using the +residual method. Under the residual method, the total fair value of the undelivered elements, as indicated by vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded +as unearned for the undelivered elements is recognized as revenue related to delivered elements. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle. Revenue related +to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements. Revenue from multi-year licensing +arrangements are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing arrangements include rights to receive future versions of +software product on a when-and-if-available basis under Open and Select volume licensing programs (Software Assurance). In addition, other multi-year licensing PAGE 44 Table of Contents Part II Item 8 arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis +under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions. Revenue related to our Xbox game console and other hardware components is recognized upon shipment of the product to retailers. Revenue related to +games published by us is recognized when those games have been delivered to retailers. Revenue related to games published by third parties for use on the Xbox platform is recognized when manufactured for the game publishers. Online advertising +revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized +as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized based on percentage of +completion. Costs related to insignificant obligations, which include telephone support for developer tools software, PC games, computer hardware, +and Xbox, are accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, warranties, and bad debts. COST OF REVENUE Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to +product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, warranty costs, inventory write-downs, costs associated with the delivery of consulting services, and the +amortization of capitalized research and development costs associated with software products that have reached technological feasibility. RESEARCH +AND DEVELOPMENT Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with +product development. We have determined that technological feasibility for our software products is reached shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated +life of the products. We determined that technological feasibility was reached with Windows Vista and the 2007 Microsoft Office system during the second quarter of fiscal year 2007 and accordingly, we capitalized approximately $120 million of +software development costs. Previously, costs incurred prior to technological feasibility were not material and were expensed as incurred. SALES +AND MARKETING Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with sales +and marketing personnel and advertising, promotions, tradeshows, seminars, and other marketing-related programs. Advertising costs are expensed as incurred. Advertising expense was $1.33 billion, $1.23 billion, and $995 million in fiscal years 2007, +2006, and 2005, respectively. INCOME TAXES Income tax +expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax +returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. FINANCIAL +INSTRUMENTS We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. +The fair value of these investments approximates their carrying value. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments +with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term +investments are classified as available for sale and are recorded at market value using the specific identification method. Changes in market value are reflected in OCI (excluding other-than-temporary impairments). PAGE 45 Table of Contents Part II Item 8 Equity and other investments may include both debt and +equity instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Changes in market value are reflected in OCI (excluding +other-than-temporary impairments). All other investments, excluding those accounted for using the equity method, are recorded at cost. We lend +certain fixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the +creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability. Investments are considered to be impaired +when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the +cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider +specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a +decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. We use derivative instruments to manage exposures to foreign currency, equity price, interest rate and credit risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, +eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair +value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the period of change together with the +offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of OCI and +is subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow hedges, changes in the time value are +excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are recognized in earnings. Foreign Currency Risk. Certain assets, liabilities, and forecasted transactions are exposed to foreign currency risk. We monitor our foreign currency +exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging +instruments under Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities . Principal currencies hedged include the euro, Japanese yen, British pound, and +Canadian dollar. Certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS No. 133. Certain options and forwards not designated as hedging +instruments under SFAS No. 133 are also used to hedge the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures. Equities Price Risk. Equity investments are subject to market price risk. From time to time, we use and designate options to hedge fair values on +certain equity securities. We determine the security, selected for hedging by evaluating market conditions, up-front costs, and other relevant factors. Certain options, futures and swap contracts, not designated as hedging instruments under SFAS +No. 133, are also used to manage equity exposures. Interest Rate Risk. Fixed-income securities are subject to interest rate risk. +The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and futures contracts and over-the-counter swap contracts, not designated as hedging instruments +under SFAS No. 133, to hedge interest rate risk. Other Derivatives. Swap contracts, not designated as hedging instruments under +SFAS No. 133, are used to manage exposures to credit risks, enhance returns, and to facilitate portfolio diversification. In addition, we may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that +can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. “To Be PAGE 46 Table of Contents Part II Item 8 Announced” forward purchase commitments of mortgage-backed assets are also considered derivatives in cases where physical delivery of the assets in not taken at +the earliest available delivery date. All derivative instruments not designated as hedging instruments are recorded at fair value, with changes in value recognized in earnings during the period of change. ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts +reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for +doubtful accounts was as follows: (In millions) Year Ended June 30 Balance at beginning of year Charged to costs and expenses Write-offs and +other Balance at end of year 2005 166 48 (43 ) $ 171 2006 171 40 (69 ) 142 2007 142 64 (89 ) $ 117 INVENTORIES Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities +on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis. PROPERTY AND EQUIPMENT Property and equipment is stated at cost and +depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the straight-line method +over the estimated useful life of the software, generally three years or less. GOODWILL Goodwill is tested for impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No +impairment of goodwill has been identified during any of the periods presented. INTANGIBLE ASSETS Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We evaluate the recoverability of intangible +assets periodically and take into account events or circumstances that warrant revised estimates of useful lives or that indicate that impairment exists. All of our intangible assets are subject to amortization. No material impairments of intangible +assets have been identified during any of the periods presented. PRODUCT WARRANTY We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on +historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which +we do business, but generally include technical support, parts, and labor over a period generally ranging from 90 days to three years. For software, we estimate the costs to provide bug fixes, such as security patches, over the estimated life +of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. PAGE 47 Table of Contents Part II Item 8 RECENTLY ISSUED ACCOUNTING STANDARDS In June 2006, the FASB issued Interpretation No. 48 (“FIN No. 48”), Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement +No. 109 , which clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes . The Interpretation provides a +recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Under FIN No. 48, the Company may recognize the tax benefit from an +uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from +such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN No. 48 also provides guidance on derecognition, classification, interest and penalties, +accounting in interim periods, disclosure, and transition. FIN No. 48 is effective for us beginning July 1, 2007. Based on our current assessment, the adoption of FIN No. 48 is expected to decrease beginning retained earnings by $200 +million to $400 million upon adoption. In June 2006, the FASB ratified the Emerging Issues Task Force (“EITF”) consensus on EITF +Issue No. 06-2, “Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43.” EITF Issue No. 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar +benefit arrangement over the requisite service period. EITF Issue No. 06-2 is effective for us beginning July 1, 2007. The cumulative effect of the application of this consensus on prior period results should be recognized through a +cumulative-effect adjustment to retained earnings as of the beginning of the year of adoption. Elective retrospective application is also permitted. We do not expect the application of this consensus to have a material impact on our financial +statements. In fiscal year 2007, we adopted Staff Accounting Bulletin (“SAB”) No. 108, Considering the Effects of Prior Year +Misstatements when Quantifying Current Year Misstatements . SAB No. 108 requires companies to quantify misstatements using both a balance sheet (iron curtain) and an income statement (rollover) approach to evaluate whether either approach +results in an error that is material in light of relevant quantitative and qualitative factors, and provides for a one-time cumulative effect transition adjustment. The adoption of SAB No. 108 did not have an impact on our financial statements. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements , which defines fair value, establishes a framework for measuring +fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair +value hierarchy used to classify the source of the information. This statement is effective for us beginning July 1, 2008. We currently are assessing the potential impact that adoption of SFAS No. 157 would have on our financial +statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities . SFAS +No. 159 gives us the irrevocable option to carry many financial assets and liabilities at fair values, with changes in fair value recognized in earnings. SFAS No. 159 is effective for us beginning July 1, 2008, although early adoption +is permitted. We are currently assessing the potential impact that adoption of SFAS No. 159 will have on our financial statements. NOTE +2    UNEARNED REVENUE Unearned revenue is comprised of the following items: Volume licensing programs – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing +coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered elements – +Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. This revenue deferral is applicable for Windows XP and previous PC operating +systems shipped as retail packaged products, products licensed to original equipment manufacturers (“OEM”), and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is +based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from +approximately 15% to 25% of the sales price for Windows XP Home and approximately 5% to 15% of the sales price for Windows XP PAGE 48 Table of Contents Part II Item 8 Professional, depending on the terms and conditions of the license and prices of the elements. Product life cycles are currently estimated at three and one-half years +for Windows operating systems. Other – Represents payments for post-delivery support and consulting services to be performed in the future, online +advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions maintenance and enhancement billings, Xbox Live and other billings that are accounted for as subscriptions, and other agreements where Microsoft +is committed to the delivery of future enhancements, products, or services. The components of unearned revenue were as follows: (In millions) June 30 2007 2006 Volume licensing programs $ 9,334 $ 7,661 Undelivered elements 1,839 2,066 Other 1,473 1,175 Unearned revenue $ 12,646 $ 10,902 Unearned revenue by segment was as follows: (In millions) June 30 2007 2006 Client $ 2,875 $ 2,850 Server and Tools 3,652 3,792 Microsoft Business Division 5,771 3,609 Other segments 348 651 Unearned revenue $ 12,646 $ 10,902 PAGE 49 Table of Contents Part II Item 8 NOTE 3    INVESTMENTS The components of investments were as follows: (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2007 Cash $ 3,040 $ – $ – $ 3,040 $ 3,040 $ – $ – Mutual funds 398 4 (1 ) 401 132 205 64 Commercial paper 227 – – 227 179 48 – Certificates of deposit 98 – – 98 – 98 – U. S. Government and Agency securities 3,085 4 (12 ) 3,077 1 3,002 74 Foreign government bonds 3,845 2 (63 ) 3,784 – 3,784 – Mortgage backed securities 3,236 4 (49 ) 3,191 – 3,191 – Corporate notes and bonds 7,184 14 (18 ) 7,180 2,425 4,753 2 Municipal securities 2,639 3 (25 ) 2,617 334 2,283 – Common stock and equivalents 7,290 2,309 (18 ) 9,581 – – 9,581 Preferred stock 62 12 – 74 – – 74 Other investments 258 – – 258 – (64 ) 322 Total $ 31,362 $ 2,352 $ (186 ) $ 33,528 $ 6,111 $ 17,300 $ 10,117 (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and equivalents Short - term investments Equity and other investments June 30, 2006 Cash $ 3,248 $ – $ – $ 3,248 $ 3,248 $ – $ – Mutual funds 723 11 (1 ) 733 288 445 – Commercial paper 3,242 – – 3,242 3,150 92 – Certificates of deposit 364 – – 364 – 364 – U. S. Government and Agency securities 4,904 4 (30 ) 4,878 14 4,790 74 Foreign government bonds 6,034 21 (73 ) 5,982 – 5,982 – Mortgage backed securities 4,285 – (42 ) 4,243 – 4,243 – Corporate notes and bonds 7,605 15 (18 ) 7,602 – 7,475 127 Municipal securities 4,008 5 (45 ) 3,968 14 3,954 – Common stock and equivalents 6,933 1,846 (34 ) 8,745 – – 8,745 Preferred stock 41 5 – 46 – – 46 Other investments 342 – – 342 – 102 240 Total $ 41,729 $ 1,907 $ (243 ) $ 43,393 $ 6,714 $ 27,447 $ 9,232 PAGE 50 Table of Contents Part II Item 8 Investments with continuous unrealized losses for less than and greater +than 12 months and their related fair values were as follows: Less than 12 months 12 months or greater Total (In millions) Fair value unrealized losses Fair value unrealized losses Fair value unrealized losses June 30, 2007 Mutual funds $ 76 $ (1 ) $ 3 $ – $ 79 $ (1 ) U. S. Government and Agency securities 1,219 (8 ) 238 (4 ) 1,457 (12 ) Foreign government bonds 3,554 (63 ) 2 – 3,556 (63 ) Mortgage backed securities 2,520 (43 ) 214 (6 ) 2,734 (49 ) Corporate notes and bonds 526 (14 ) 74 (4 ) 600 (18 ) Municipal securities 575 (9 ) 420 (16 ) 995 (25 ) Common stock and equivalents 237 (17 ) 9 (1 ) 246 (18 ) Total $ 8,707 $ (155 ) $ 960 $ (31 ) $ 9,667 $ (186 ) Less than 12 months 12 months or greater Total (In millions) Fair value unrealized losses Fair value unrealized losses Fair value unrealized losses June 30, 2006 Mutual funds $ 14 $ (1 ) $ 4 $ – $ 18 $ (1 ) U. S. Government and Agency securities 2,303 (24 ) 172 (6 ) 2,475 (30 ) Foreign government bonds 2,523 (56 ) 1,749 (17 ) 4,272 (73 ) Mortgage backed securities 2,692 (40 ) 102 (2 ) 2,794 (42 ) Corporate notes and bonds 4,721 (13 ) 359 (5 ) 5,080 (18 ) Municipal securities 1,323 (13 ) 1,192 (32 ) 2,515 (45 ) Common stock and equivalents 266 (33 ) 29 (1 ) 295 (34 ) Total $ 13,842 $ (180 ) $ 3,607 $ (63 ) $ 17,449 $ (243 ) At June 30, 2007, unrealized losses of $186 million consisted of: $161 million related to investment grade fixed-income +securities, $7 million related to investments in high yield and emerging market fixed-income securities, $7 million related to domestic equity securities, and $11 million related to international equity securities. At June 30, 2006, unrealized +losses of $243 million consisted of: $196 million related to investment grade fixed-income securities, $12 million related to investments in high yield and emerging market fixed-income securities, $2 million related to domestic equity securities, +and $33 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price +movements. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of June 30, 2007. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At June 30, 2007, +the recorded basis and estimated fair value of these investments was $38 million. At June 30, 2006, the recorded basis and estimated fair value of these investments was $41 million. The estimate of fair value is based on publicly available +market information or other estimates determined by management. PAGE 51 Table of Contents Part II Item 8 The maturities of debt securities, including +fixed-maturity securities, at June 30, 2007 were as follows: (In millions) Cost basis Estimated fair value Due in one year or less $ 5,519 $ 5,518 Due after one year through five years 6,886 6,849 Due after five years through ten years 2,935 2,890 Due after ten years 4,910 4,853 Total $ 20,250 $ 20,110 NOTE 4    INVESTMENT INCOME AND OTHER The components of investment income and other were as follows: (In millions) Year Ended June 30 2007 2006 2005 Dividends and interest $ 1,319 $ 1,510 $ 1,460 Net gains on investments 650 161 856 Net losses on derivatives (358 ) (99 ) (262 ) Income/(losses) from equity investees and other (34 ) 218 13 Investment income and other $ 1,577 $ 1,790 $ 2,067 Net gains on investments include other-than-temporary impairments. These were not material in fiscal year 2007, were $408 +million in fiscal year 2006, and were $152 million in fiscal year 2005. The decrease in other-than-temporary impairments in fiscal year 2007 and the increase in fiscal year 2006 were driven by planned sales of certain investments in an unrealized +loss position in order to raise funds for the $20 billion tender offer announced on July 20, 2006. Realized gains and losses from sales of available-for-sale securities (excluding other-than-temporary impairments) were $851 million and $176 +million, respectively, in fiscal year 2007, $1.11 billion and $531 million, respectively, in fiscal year 2006, and $1.38 billion and $376 million, respectively, in fiscal year 2005. NOTE 5    DERIVATIVES For derivative instruments designated as hedges, hedge ineffectiveness, +determined in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, did not have a significant impact on earnings for fiscal years 2007, 2006, or 2005. During fiscal year 2007, $219 million in gains +on fair value hedges from changes in time value and $361 million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in investment income and other. During fiscal year 2006, +$217 million in gains on fair value hedges from changes in time value and $399 million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in investment income and other. +During fiscal year 2005, $79 million in gains on fair value hedges from changes in time value and $116 million in losses on cash flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and included in +investment income and other. Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of +an equity investment is recognized. During fiscal year 2007, $168 million of derivative gains were reclassified to revenue. During fiscal year 2006, $166 million of derivative gains were reclassified to revenue and $23 million in derivative gains +were reclassified to investment income and other. During fiscal year 2005, $57 million of derivative gains were reclassified to revenue and $33 million in derivative gains were reclassified to investment income and other. We estimate that $124 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains +or losses were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur for fiscal years 2007, 2006, and 2005. PAGE 52 Table of Contents Part II Item 8 NOTE 6    INVENTORIES (In millions) June 30 2007 2006 Raw materials $ 435 $ 465 Work in process 148 – Finished goods 544 1,013 Inventories $ 1,127 $ 1,478 NOTE 7    PROPERTY AND EQUIPMENT (In millions) June 30 2007 2006 Land $ 428 $ 362 Buildings and improvements 3,170 2,228 Leasehold improvements 1,077 918 Computer equipment and software 3,458 2,682 Furniture and equipment 1,233 1,033 Property and equipment, at cost 9,366 7,223 Accumulated depreciation (5,016 ) (4,179 ) Property and equipment, net $ 4,350 $ 3,044 Property and equipment are stated at cost. Depreciation is computed principally on the straight-line method over the +estimated useful lives of the assets. The useful lives for buildings range from five to 15 years, leasehold improvements generally range from two to ten years – representing the applicable lease terms plus reasonably assured extensions, +computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated. During fiscal years 2007, 2006, and 2005, depreciation expense was $1.17 billion, $863 million, and $723 million, respectively. The majority of depreciation expense in all years related to computer equipment. NOTE 8    GOODWILL Changes in the carrying amount of +goodwill for fiscal years 2007 and 2006 by segment were as follows: (In millions) Balance as of June 30, 2005 Acquisitions Other Balance as of June 30, 2006 Acquisitions Other Balance as of June 30, 2007 Client $ 43 $ 31 $ – $ 74 $ 6 $ (3 ) $ 77 Server and Tools 241 29 (14 ) 256 325 (1 ) 580 Microsoft Business Division 2,435 246 – 2,681 508 (57 ) 3,132 Online Services Business 171 263 21 455 123 (26 ) 552 Entertainment and Devices Division 419 23 (42 ) 400 21 (2 ) 419 Total $ 3,309 $ 592 $ (35 ) $ 3,866 $ 983 $ (89 ) $ 4,760 We test goodwill for impairment annually on July 1 at the reporting unit level using a fair value approach, in +accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets . Our annual testing resulted in no impairments of goodwill in fiscal years 2007 and 2006. If an event occurs or circumstances change that would PAGE 53 Table of Contents Part II Item 8 more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for impairment between annual tests. During fiscal year 2007, we acquired the following entities for total consideration of $1.34 billion, which was primarily paid in cash: • Softricity, Inc., a provider of application virtualization and dynamic streaming technologies; • TellMe Networks, Inc., a company specializing in speech-recognition technology providing an outsourced, network-based, voice application platform; and • 11 other entities specializing in areas such as application security, desktop, and data management. As a result of these acquisitions, we recorded $983 million of goodwill, none of which is expected to be deductible for tax purposes. All of the entities were +consolidated with Microsoft since their respective acquisition dates. The purchase price allocations for these acquisitions are preliminary and subject to revision as more detailed analyses are completed and additional information about fair value +of assets and liabilities becomes available. Any change in the estimated fair value of the net assets of the acquired companies will change the amount of the purchase price allocable to goodwill. Pro forma results of operations have not been +presented because the effects of these acquisitions, individually and in aggregate, were not material. NOTE 9    INTANGIBLE +ASSETS The components of finite-lived intangible assets were as follows: (In millions) June 30 2007 2006 Gross carrying amount Accumulated amortization Net carrying amount Gross carrying amount Accumulated amortization Net carrying amount Contract-based $ 988 $ (727 ) $ 261 $ 954 $ (661 ) $ 293 Technology-based 916 (407 ) 509 458 (255 ) 203 Marketing-related 57 (39 ) 18 42 (32 ) 10 Customer-related 122 (32 ) 90 54 (21 ) 33 Total $ 2,083 $ (1,205 ) $ 878 $ 1,508 $ (969 ) $ 539 During fiscal year 2007 and 2006, we recorded additions to intangible assets of $473 million and $189 million, respectively. +We estimate that we have no significant residual value related to our intangible assets. The components of finite-lived intangible assets acquired during fiscal years 2007 and 2006 were as follows: (In millions) Year Ended June 30 2007 2006 Amount Weighted average life Amount Weighted average life Contract-based $ 57 5 years $ 36 4 years Technology-based 333 4 years 140 4 years Marketing-related 14 4 years 5 3 years Customer-related 69 5 years 8 4 years Total $ 473 $ 189 Intangible asset additions include $170 million of technology-based intangible assets with a weighted-average life of 4 +years, and $84 million of other intangible assets with a weighted-average life of 4.9 years, related to the acquisitions of Softricity Inc., TellMe Networks, Inc., and the remaining 11 entities acquired. PAGE 54 Table of Contents Part II Item 8 Acquired intangibles are generally amortized on a +straight-line basis over weighted average lives. Intangible assets amortization expense was $236 million for fiscal year 2007, $127 million for fiscal year 2006, and $161 million for fiscal year 2005. The estimated future amortization expense +related to intangible assets as of June 30, 2007 is as follows: (In millions) Year Ended June 30 Amount 2008 $ 263 2009 229 2010 184 2011 111 2012 and thereafter 91 Total $ 878 NOTE 10    INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30 2007 2006 2005 Current taxes: U.S. Federal $ 4,593 $ 4,471 $ 3,401 U.S. State and Local 154 101 152 International 957 882 911 Current taxes 5,704 5,454 4,464 Deferred taxes (benefits) 332 209 (90 ) Provision for income taxes $ 6,036 $ 5,663 $ 4,374 U.S. and international components of income before income taxes were as follows: (In millions) Year Ended June 30 2007 2006 2005 U.S. $ 12,902 $ 11,404 $ 9,806 International 7,199 6,858 6,822 Income before income taxes $ 20,101 $ 18,262 $ 16,628 The items accounting for the difference between income taxes computed at the federal statutory rate and the provision for +income taxes were as follows: Year Ended June 30 2007 2006 2005 Federal statutory rate 35.0 % 35.0 % 35.0 % Effect of: Foreign earnings taxed at lower rates (5.1 )% (4.6 )% (3.1 )% Examination settlements – (0.6 )% (4.7 )% Other reconciling items 0.1 % 1.2 % (0.9 )% Effective rate 30.0 % 31.0 % 26.3 % PAGE 55 Table of Contents Part II Item 8 The 2007 other reconciling items includes the impact of a $195 million +reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments. The 2006 other reconciling item includes the impact of the $351 +million non-deductible European Commission fine. The 2005 other reconciling items include a $179 million repatriation tax benefit under the American Jobs Creation Act of 2004. The components of the deferred tax assets and liabilities were as follows: (In millions) June 30 2007 2006 Deferred income tax assets: Stock-based compensation expense $ 2,859 $ 3,630 Other expense items 1,735 1,451 Unearned revenue 842 1,028 Impaired investments 710 989 Other revenue items 58 102 Deferred income tax assets $ 6,204 $ 7,200 Deferred income tax liabilities: International earnings $ (1,763 ) $ (1,715 ) Unrealized gain on investments (926 ) (801 ) Other (227 ) (133 ) Deferred income tax liabilities (2,916 ) (2,649 ) Net deferred income tax assets $ 3,288 $ 4,551 Reported as: Current deferred tax assets $ 1,899 $ 1,940 Long-term deferred tax assets 1,389 2,611 Net deferred income tax assets $ 3,288 $ 4,551 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and +liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes are actually paid or recovered. We have not +provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $6.10 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount +of unrecognized deferred tax liability associated with these temporary differences is approximately $1.77 million. The American Jobs Creation Act of +2004 (the “Act”) was enacted in October 2004. The Act creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from +controlled foreign corporations. Under these provisions, we repatriated approximately $780 million in dividends subject to the elective 85% dividends received deduction and we recorded a corresponding tax provision benefit of $179 million from the +reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign subsidiary earnings in 2005. The dividend was paid in June 2006. Income taxes paid were $5.24 billion in fiscal year 2007, $4.78 billion in fiscal year 2006, and $4.33 billion in fiscal year 2005. Tax +Contingencies .    We are subject to income taxes in the United States and numerous foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes and recording the related +assets and liabilities. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We are regularly under audit by tax authorities. Accruals for tax contingencies are +provided for in accordance with the requirements of SFAS No. 5, Accounting for Contingencies . PAGE 56 Table of Contents Part II Item 8 Although we believe we have appropriate support for the +positions taken on our tax returns, we have recorded a liability for our best estimate of the probable loss on certain of these positions, the non-current portion of which is included in other long-term liabilities. We believe that our accruals for +tax liabilities are adequate for all open years, based on our assessment of many factors including past experience and interpretations of tax law applied to the facts of each matter, which matters result primarily from inter-company transfer +pricing, restructuring of foreign operations, tax benefits from the Foreign Sales Corporation and Extra Territorial Income tax rules, the amount of research and experimentation tax credits claimed, state income taxes, and certain other matters. +Although we believe our recorded assets and liabilities are reasonable, tax regulations are subject to interpretation and tax litigation is inherently uncertain; therefore our assessments can involve both a series of complex judgments about future +events and rely heavily on estimates and assumptions. Although we believe that the estimates and assumptions supporting our assessments are reasonable, the final determination of tax audit settlements and any related litigation could be materially +different than that which is reflected in historical income tax provisions and recorded assets and liabilities. If we were to settle an audit or a matter under litigation, it could have a material effect on our income tax provision, net income, or +cash flows in the period or periods for which that determination is made. Due to the complexity involved we are not able to estimate the range of reasonably possible losses in excess of amounts recorded. The Internal Revenue Service (“IRS”) has completed and closed its audits of our consolidated federal income tax returns through 1999. The IRS is currently +conducting audits of our consolidated federal income tax return for tax years 2000 through 2006. NOTE 11    OTHER LONG-TERM +LIABILITIES (In millions) June 30 2007 2006 Tax contingencies $ 5,071 $ 4,194 Legal contingencies 778 1,022 Product warranty 487 – Other 117 71 Other long-term liabilities $ 6,453 $ 5,287 NOTE 12    STOCKHOLDERS’ EQUITY Shares of common stock outstanding were as follows: (In millions) Year Ended June 30 2007 2006 2005 Balance, beginning of year 10,062 10,710 10,862 Issued 289 106 160 Repurchased (971 ) (754 ) (312 ) Balance, end of year 9,380 10,062 10,710 On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board of Directors on +July 20, 2004 to buy back up to $30.00 billion in Microsoft common stock. On July 20, 2006, we also announced that our Board of Directors +authorized two new share repurchase programs: a $20.00 billion tender offer, which was completed on August 17, 2006; and authorization for up to an additional $20.00 billion ongoing share repurchase program with an expiration of June 30, +2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.84 billion at a price per share of $24.75. On August 18, 2006, we announced that +the authorization for the $20.00 billion ongoing share repurchase program had been increased by approximately PAGE 57 Table of Contents Part II Item 8 $16.16 billion. As a result, we are authorized to repurchase additional shares in an amount up to $36.16 billion through June 30, 2011. As of June 30, +2007, approximately $15.14 billion remained of the $36.16 billion approved repurchase amount. During fiscal year 2006, we repurchased 754 million shares, or $19.75 billion, of our common stock under a previously approved plan. Under these +repurchase plans, we have made the following share repurchases: (In millions) Fiscal year 2007 (1) 2006 (2) 2005 (2) Shares Amount Shares Amount Shares Amount First quarter 285 $ 6,965 114 $ 3,029 23 $ 625 Second quarter 205 6,037 283 7,666 23 655 Third quarter 238 6,744 181 4,879 95 2,420 Fourth quarter 243 7,367 176 4,175 171 4,302 Total 971 $ 27,113 754 $ 19,749 312 $ 8,002 (1) Approximately 155 million shares of common stock for approximately $3.84 billion were repurchased under our tender offer in the first quarter of fiscal year 2007. All other amounts +repurchased were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. (2) All amounts repurchased in fiscal years 2006 and 2005 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004. In fiscal year 2007, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Date of Record Total Amount (in millions) Payment Date September 13, 2006 $ 0.10 November 16, 2006 $ 980 December 14, 2006 December 20, 2006 $ 0.10 February 15, 2007 $ 978 March 8, 2007 March 26, 2007 $ 0.10 May 17, 2007 $ 952 June 14, 2007 June 27, 2007 $ 0.10 August 16, 2007 $ 938 (1) September 13, 2007 (1) The dividend declared on June 27, 2007 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2007. In fiscal year 2006, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Date of Record Total Amount (in millions) Payment Date September 23, 2005 $ 0.08 November 17, 2005 $ 846 December 8, 2005 December 14, 2005 $ 0.09 February 17, 2006 $ 926 March 9, 2006 March 27, 2006 $ 0.09 May 17, 2006 $ 916 June 8, 2006 June 21, 2006 $ 0.09 August 17, 2006 $ 897 (1) September 14, 2006 (1) The dividend declared on June 21, 2006 was included in other current liabilities as of June 30, 2006. PAGE 58 Table of Contents Part II Item 8 NOTE 13    OTHER COMPREHENSIVE +INCOME The activity in other comprehensive income and related tax effects were as follows: (In millions) Year Ended June 30 2007 2006 2005 Net unrealized gains/(losses) on derivative instruments: Unrealized gains, net of tax effect of $66 in 2007, $107 in 2006, and $0 in 2005 $ 123 $ 199 $ — Reclassification adjustment for gains included in net income, net of tax effect of $(59) in 2007, $(66) in 2006, and $(31) in 2005 (109 ) (123 ) (58 ) Net unrealized gains/(losses) on derivative instruments 14 76 (58 ) Net unrealized gains/(losses) on investments: Unrealized gains/(losses), net of tax effect of $393 in 2007, $(105) in 2006, and $469 in 2005 730 (195 ) 870 Reclassification adjustment for gains included in net income, net of tax effect of $(217) in 2007, $(47) in 2006, and $(269) in 2005 (404 ) (87 ) (499 ) Net unrealized gains/(losses) on investments 326 (282 ) 371 Translation adjustments and other 85 9 (6 ) Other comprehensive income/(loss) $ 425 $ (197 ) $ 307 Certain activity within the unrealized gains/(losses) and reclassification adjustment line items in 2006 and 2005 has been +revised to correct the prior period presentation. These revisions did not affect other comprehensive income/(loss) nor any of the subtotals in the table above. The +components of accumulated other comprehensive income were as follows: (In millions) Year Ended June 30 2007 2006 2005 Net unrealized gains on derivative instruments $ 117 $ 103 $ 27 Net unrealized gains on investments 1,388 1,062 1,344 Translation adjustments and other 149 64 55 Accumulated other comprehensive income $ 1,654 $ 1,229 $ 1,426 NOTE 14    EMPLOYEE STOCK AND SAVINGS PLANS Effective July 1, 2005, we adopted SFAS No. 123(R), Share-Based Payment, using the modified prospective application transition method. Because the fair value +recognition provisions of SFAS No. 123, Stock-Based Compensation, and SFAS No. 123(R) were materially consistent under our equity plans, the adoption of SFAS No. 123(R) did not have a significant impact on our financial +position or our results of operations. Prior to our adoption of SFAS No. 123(R), benefits of tax deductions in excess of recognized compensation costs were reported as operating cash flows. SFAS No. 123(R) requires excess tax benefits be +reported as a financing cash inflow rather than as a reduction of taxes paid. The stock-based compensation and related income tax benefits were as follows: (In millions) 2007 2006 2005 Total stock-based compensation $ 1,550 $ 1,715 $ 2,448 Income tax benefits related to stock-based compensation $ 542 $ 600 $ 857 PAGE 59 Table of Contents Part II Item 8 Employee Stock Purchase Plan. We have an +employee stock purchase plan for all eligible employees. Compensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). Shares of our common stock may be purchased by employees at three-month +intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares: (Shares In millions) 2007 2006 2005 Shares purchased 17 17 16 Average price per share $ 25.36 $ 23.02 $ 23.33 At June 30, 2007, 125 million shares were reserved for future issuance. Savings Plan. We have a savings plan in the United States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of +savings plans in international locations. Participating U.S. employees may contribute up to 50% of their pretax salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a +maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $218 million, $178 million, and $154 million in fiscal years 2007, 2006, and 2005, respectively. Matching contributions are invested proportionate +to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be +invested in Microsoft common stock. Stock Plans. We have stock plans for directors and for officers, employees, consultants, and +advisors. At June 30, 2007, an aggregate of 819 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance stock awards. Awards that expire or are canceled without +delivery of shares generally become available for issuance under the plans. The options transferred to JPMorgan Chase Bank (“JPMorgan”) (see below) in fiscal year 2004 have been removed from our plans; the options transferred to JPMorgan +that expired without being exercised are not available for grant under any of our plans. We issue new shares to satisfy stock option exercises. On +November 9, 2004, our shareholders approved amendments to the stock plans that allowed our Board of Directors to adjust eligible options, unvested stock awards, and shared performance stock awards to maintain their pre-dividend value after the +$3.00 special dividend. Additional awards were granted for options, stock awards, and shared performance stock awards by the ratio of post- and pre-special dividend stock price as of the ex-dividend date. Strike prices for options were decreased by +the same ratio. Stock-based compensation was not affected by this adjustment. As a result of this approval and payment of the $3.00 special dividend on December 2, 2004, an adjustment to the prices and number of shares of existing awards was +made resulting in a total of 96 million options and 7 million stock awards being issued to adjust the outstanding awards. In addition, the target shared performance stock awards were increased by 4 million shares. Stock Awards and Shared Performance Stock Awards. Stock awards are grants that entitle the holder to shares of common stock as the award vests. Our +stock awards generally vest over a five-year period. Shared Performance Stock Awards (“SPSAs”) are a form of stock award in which the +number of shares ultimately received depends on our business performance against specified performance targets. The performance period for SPSAs issued in fiscal years 2004, 2005, and 2006 was July 1, 2003 through June 30, 2006 +(January 1, 2004 through June 30, 2006 for certain executive officers). Following the end of the performance period, the Compensation Committee of the Board of Directors determined that the number of shares of stock awards to be issued was +37.0 million, based on the actual performance against metrics established for the performance period. One-third of the awards vested in fiscal year 2007. An additional one-third of the awards will vest over each of the following two years. +Because the SPSAs covered a three-year period, SPSAs issued in fiscal year 2005 and 2006 were given only to newly hired and promoted employees eligible to receive SPSAs. The Company granted SPSAs for fiscal year 2007 with a performance period of July 1, 2006 through June 30, 2007. At the end of the performance period, the number of shares of stock subject to the award is determined by +multiplying the target award by a percentage ranging from 0% to 150%. The percentage is determined based on performance against metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole +discretion. An additional 15% of the total stock and stock awards will be available as PAGE 60 Table of Contents Part II Item 8 additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award will vest following the end of the +performance period, and an additional one-quarter of the shares will vest over each of the following three years. We measure the fair value of SAs +and SPSAs based upon the market price of the underlying common stock as of the date of grant, reduced by the present value of estimated future dividends. SAs and SPSAs are amortized over their applicable vesting period (generally three to five +years) using the straight-line method. The fair value of each award grant is estimated on the date of grant using the following assumptions: (In millions) 2007 2006 2005 Dividend per share (quarterly amounts) $ 0.09 - $0.10 $ 0.08 - $0.09 $ 0.08 Interest rates range 4.3% - 5.3% 3.2% - 5.3% 1.3% - 4.3% During fiscal year 2007, the following activity occurred under our existing plans: Shares (in millions) Weighted Average Grant-Date Fair Value Stock awards: Nonvested balance at June 30, 2006 98 $ 24.25 Granted 57 25.15 Vested (24 ) 24.15 Forfeited (7 ) 24.44 Nonvested balance at June 30, 2007 124 $ 24.67 Shared performance stock awards: Nonvested balance at June 30, 2006 37 $ 23.57 Granted 11 25.18 Vested (13 ) 23.74 Forfeited (2 ) 23.92 Nonvested balance at June 30, 2007 33 $ 24.11 As of June 30, 2007, there were $2.22 billion and $392 million of total unrecognized compensation costs related to SAs +and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.4 years and 2.1 years, respectively. SPSAs granted in fiscal +year 2007 include adjustments for estimated performance against performance targets. During the 12 months ended June 30, 2006 and June 30, 2005, the +following activity occurred under our plans: (In millions, except fair values) Fiscal Year 2006 Fiscal Year 2005 Stock awards granted 47 41 Weighted average grant-date fair value $ 24.70 $ 24.03 Shared performance stock awards granted 3 4 Weighted average grant-date fair value $ 24.80 $ 24.35 Stock Options. In fiscal year 2004, we began granting employees stock awards rather than stock +options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Nonqualified stock options were granted to our directors under our non-employee +director stock plan. Nonqualified and incentive stock options were granted to our officers and employees under our employee stock plans. Options granted between 1995 and 2001 generally vest over four and PAGE 61 Table of Contents Part II Item 8 one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and +expire ten years from the date of grant. Options granted after 2001 vest over four and one-half years and expire ten years from the date of grant. Approximately 3 million stock options were granted in conjunction with business acquisitions +during fiscal years 2007 and 2006, respectively. No stock options were granted during the year ended June 30, 2005. During fiscal year 2004, we +completed an employee stock option transfer program whereby employees could elect to transfer all of their vested and unvested options with a strike price of $33.00 or higher to JPMorgan. The options transferred to JPMorgan were amended and restated +upon transfer to contain terms and conditions typical of equity option transactions entered into between sophisticated financial counterparties at arm’s length using standard terms and definitions for equity derivatives. As a result of this +program, we recorded additional stock-based compensation expense of $2.21 billion ($1.48 billion after-tax or $0.14 per diluted share) which was recorded in the second quarter of fiscal year 2004. In December 2006, JP Morgan Chase Bank +(“JPMorgan”) exercised approximately 113 million call options for $3.25 billion at an average price per share of $28.80. The call options were among 345 million options acquired by JPMorgan in fiscal year 2004 through our +employee stock option transfer program. The other approximately 232 million options expired unexercised. Employee stock +options outstanding were as follows: Shares (in millions) Weighted Average Exercise Price Weighted Average Remaining Contractual Term (years) Aggregate Intrinsic Value (in millions) Balance, June 30, 2006 750 $ 27.92 Granted 3 27.28 Exercised (134 ) 23.66 Canceled (92 ) 34.46 Forfeited (3 ) 21.51 Balance, June 30, 2007 524 $ 27.86 3.60 $ 1,877 Exercisable, June 30, 2007 511 $ 27.98 3.55 $ 1,773 Included in the options outstanding balance are approximately 5 million options that were granted in conjunction with +business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise prices presented. These options have an exercise price range of $0 to $150.93 and a weighted average +exercise price of $10.35. During fiscal years 2007, 2006, and 2005 the following activity occurred under our plans: (In millions) 2007 2006 2005 Total intrinsic value of stock options exercised $ 818 $ 491 $ 940 Total fair value of stock awards vested 618 377 198 Total fair value of shared performance stock awards vested 316 – – Cash received and income tax benefits from stock option exercises were $6.35 billion and $286 million, respectively, for +fiscal year 2007. NOTE 15    EARNINGS PER SHARE Basic earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of +shares of common stock plus the effect of dilutive potential common shares outstanding during the period using PAGE 62 Table of Contents Part II Item 8 the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of +basic and diluted earnings per share are as follows: (In millions, except earnings per share) Year Ended June 30 2007 2006 2005 Net income available for common shareholders (A) $ 14,065 $ 12,599 $ 12,254 Weighted average outstanding shares of common stock (B) 9,742 10,438 10,839 Dilutive effect of employee stock options and awards 144 93 67 Common stock and common stock equivalents (C) 9,886 10,531 10,906 Earnings per share: Basic (A/B) $ 1.44 $ 1.21 $ 1.13 Diluted (A/C) $ 1.42 $ 1.20 $ 1.12 For the years ended June 30, 2007, 2006, and 2005, 199 million, 649 million, and 854 million shares, +respectively, were attributable to outstanding stock options and were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than or equal to the average price of the common shares, +and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2007, 4 million shared performance stock awards, out of the 14 million targeted amount outstanding, have been excluded from the calculation of +diluted earnings per share because the number of shares ultimately issued is contingent on our performance against metrics established for the performance period, as discussed in Note 14 – Employee Stock and Savings Plans. NOTE 16    COMMITMENTS AND GUARANTEES We have committed $821 million for constructing new buildings. We have operating leases for most U.S. and international sales +and support offices and certain equipment. Rental expense for operating leases was $326 million, $276 million, and $299 million, in fiscal years 2007, 2006, and 2005, respectively. Future minimum rental commitments under noncancellable leases are as +follows: (In millions) Year Ended June 30 Amount 2008 $ 349 2009 242 2010 202 2011 174 2012 and thereafter 374 $ 1,341 In connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase +the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of June 30, 2006, the +maximum amount of the residual value guarantees was approximately $271 million. During 2007, we exercised a provision in the operating lease agreements to purchase the outstanding portion of certain operating leases for approximately $41 million and +are no longer subject to the residual value guarantees. We provide indemnifications of varying scope and size to certain customers against claims of +intellectual property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification PAGE 63 Table of Contents Part II Item 8 against credit risk in several geographical locations to our volume license resellers in case the resellers fail to collect from the end user. Due to the nature of the +indemnification provided to our resellers, we cannot estimate the fair value, nor determine the total nominal amount of the indemnification. We evaluate estimated losses for such indemnifications under SFAS No. 5, Accounting for +Contingencies , as interpreted by FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others . We consider such factors as the degree of probability of an +unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and have not accrued any liabilities related to such indemnifications in our +financial statements. We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, +historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include technical +support, parts, and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate +our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. In July 2007, we expanded our global +Xbox 360 warranty coverage to three years from the date of purchase for a general hardware failure indicated by three flashing red lights. The basic Xbox 360 console warranty remains in place with a warranty period of one year from the date of +purchase in most geographies. The changes in our aggregate product warranty liabilities, which are included in other current liabilities and other +long term-liabilities on our balance sheets, were as follows: (In millions) Amount Balance at July 1, 2005 $ 14 Accruals for warranties issued 45 Adjustments to pre-existing warranties (7 ) Settlements of warranty claims (42 ) Balance at June 30, 2006 10 Accruals for warranties issued (1) 974 Adjustments to pre-existing warranties 92 Settlements of warranty claims (226 ) Balance at June 30, 2007 $ 850 (1) Includes warranty expense incurred as a result of the expansion of our Xbox 360 warranty coverage as discussed above. NOTE 17    CONTINGENCIES Government competition law matters. In +March 2004, the European Commission issued a decision in its competition law investigation of us. The Commission concluded that we infringed European competition law by refusing to license to our competitors certain protocol technology in the +Windows server operating systems and by including streaming media playback features in Windows desktop operating systems. The Commission ordered us to license the protocol technology to our competitors and to develop and make available a version of +the Windows desktop operating system that does not include specified media playback software. The Commission also fined us € 497 million ($605 million). We +appealed the decision to the Court of First Instance. In July 2006, the European Commission determined that we had not complied with the technical documentation requirements of the 2004 Decision, and fined us € 281 million ($351 million). We have appealed this fine to the Court of First Instance. We have expensed and paid both fines, pending resolution of the appeals. In March 2007, the +European Commission announced a new statement of objections. The new statement of objections claims that the pricing terms we proposed for licensing certain server protocol technology as required by the March 2004 decision are “not PAGE 64 Table of Contents Part II Item 8 reasonable.” The statement of objections threatens to impose new fines of up to € 500,000 ($675,000) per day from December 2005 to June 2006, up to € 2 million ($3 million) per day from June to July 2006, and up to € 3 million ($4 million) per day beginning August 2006. The maximum amount of the potential fine as of June 30, 2007 is $1.58 billion. We +have submitted a written response to the statement of objections and are seeking to determine a reasonable royalty rate with the Commission. In +December 2005, the Korean Fair Trade Commission (“KFTC”) ruled that we abused a market dominant position and engaged in unfair trade practices under the Korean Fair Trade Act. The KFTC stated we violated the Act by building instant +messaging and media player features into the Windows PC operating system and streaming media technologies into the Windows server operating system. The KFTC imposed a fine of approximately $34 million which we have expensed and paid. The KFTC’s +order issued in February 2006 held that our integration of these media and messaging features into the Windows PC and server operating systems was an abuse of monopoly power and unlawful tying in violation of the Korean Fair Trade Act. The order +required us to develop and distribute in Korea versions of Windows XP and its successors that do not include Windows Media Player or Windows Messenger functionality. We also may distribute a second modified version of Windows that contains the media +and messenger features, as long as it includes promotional links to certain competing media players and instant messengers. We have appealed the KFTC’s decision to the Seoul High Court. In May 2006, the KFTC denied our motion for +reconsideration of its ruling, but also dropped the element of its ruling that prohibited us from including media player or instant messaging functionality in any product other than the Windows client operating system for which we have a 50% or +greater market share. In other ongoing investigations, various foreign governments and several state attorneys general have requested information from us concerning competition, privacy, and security issues. Antitrust, unfair competition, and overcharge class actions. A large number of antitrust and unfair competition class action lawsuits have been filed +against us in various state and federal courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under +federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements to settle all claims in 20 states. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies +by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class +members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and +schools that are issued and redeem vouchers. The settlements in all states but Iowa have received final court approval. Settlements in Arkansas and +Wisconsin received final court approval in March 2007. The Iowa case settled in February 2007 and the court gave its preliminary approval of the settlement in April 2007. The cases in Mississippi have not been settled. We estimate the total cost to +resolve all of these cases will range between $1.7 billion and $1.9 billion. The actual cost depends on factors such as the quantity and mix of products for which claims will be made, the number of eligible class members who ultimately use the +vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims. At June 30, 2007, we have recorded a liability related to these claims of approximately $1.2 billion, which reflects +our estimated exposure of $1.7 billion less payments made to date of approximately $500 million, mostly for administrative expenses and legal fees. Other +antitrust litigation and claims. In November 2004, Novell, Inc. filed a complaint in U.S. District Court in Utah, now consolidated with other cases in Maryland, asserting antitrust and unfair competition claims against us +related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. An appeal +of that ruling is now pending and the case is effectively stayed during the appeal. Patent and intellectual property claims. We are +vigorously defending more than 45 patent infringement cases. In the case of Eolas Technologies, Inc. and University of California v. Microsoft , filed in U.S. District Court in Illinois in 1999, the plaintiffs alleged infringement by the +browser functionality of Windows. In January 2004, the trial court entered final judgment of $565 million, and entered an injunction against distribution of any new infringing products, but stayed execution of the judgment and the injunction pending +our appeal. We appealed and in March 2005 the PAGE 65 Table of Contents Part II Item 8 U.S. Court of Appeals for the Federal Circuit reversed the decision and vacated the judgment, based on certain evidentiary rulings of the trial court. The appellate +court also reversed the trial court’s decision that the inventors had not engaged in inequitable conduct. Trial has been postponed indefinitely while the parties seek to settle the matter. A settlement is not expected to have a material effect +on our financial position, results of operations, or cash flows. Microsoft and Alcatel-Lucent Matters. Microsoft and Alcatel-Lucent +are parties to a number of legal proceedings relating to certain patents of each of the companies. Some of these actions began before the merger of Alcatel and Lucent in 2006. For simplicity, we refer to the post-merger entity of Alcatel-Lucent +throughout the following discussion. • In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents. Alcatel-Lucent has +asserted claims under these patents against computer manufacturers that sell computers with our operating system and application software pre-installed. In February 2007, the jury returned a verdict in Alcatel-Lucent’s favor in the first of a +series of patent trials, and awarded $1.5 billion in damages. The trial court has dismissed Alcatel-Lucent’s claims with respect to a second group of patents and two patents in a third grouping. Trial on a newly-consolidated group of all +remaining patents is scheduled to begin in February 2008. • In March 2006, Alcatel-Lucent filed a lawsuit against us in U.S. District Court in California, claiming the Xbox 360 violates one of its patents. In response, we asserted +counterclaims that Alcatel-Lucent infringes 10 Microsoft patents by its sales of various products. That case has been set for trial in April 2008. • In November 2006, Alcatel-Lucent filed two patent infringement cases against us in U.S. District Court in Texas, asserting IPTV and various networking functionalities +violate seven of its patents. In April 2007, we asserted infringement counterclaims based on four of our patents relating to functionality similar to that accused by Alcatel-Lucent. The trial on all of the patents is set for January 2009. • In February 2007, we filed a complaint against Alcatel-Lucent with the International Trade Commission claiming Alcatel-Lucent is infringing four Microsoft patents related to +our unified communications technology and seeking to prevent the import of certain Alcatel-Lucent unified communications products into the U.S. This matter has been set for trial in October 2007. • In April 2007, the Multimedia Patent Trust filed a complaint against Microsoft, Dell, and Gateway in San Diego, California accusing the parties of infringing three +video-related patents that originally belonged to Alcatel-Lucent. Alcatel-Lucent created the Multimedia Patent Trust prior to the companies’ merger and transferred the patents at issue to the trust. Motions challenging the validity of the trust +and Alcatel-Lucent’s transfer of these patents to it will be heard in September 2007. The actual costs to resolve these cases +will depend upon many factors such as the outcome of post-trial motions, any appeals, and the results of the remaining trials. In Z4 Technologies, +Inc. v. Microsoft, filed in U.S. District Court in Texas in September 2004, the plaintiff alleged that Microsoft Windows and Office product activation functionality violates its patent rights. In April 2006, the jury rendered a $115 million +verdict against us. In August 2006, the trial court increased damages by $25 million pursuant to the jury’s finding of willful infringement and awarded Z4 $2 million in attorneys’ fees. We have appealed the verdict. In Veritas Operating Corporation v. Microsoft , filed in U.S. District Court in Washington in May 2006, a subsidiary of Symantec filed an action asserting +trade secret misappropriation, breach of contract, and patent infringement relating to certain storage technologies. Adverse outcomes in some or all +of the matters described in this section may result in significant monetary damages or injunctive relief against us that would adversely affect distribution of our operating system or application products. We may enter into material settlements +because of these risks. Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary +course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, our results of operations, or our cash flows, these +matters are subject to inherent uncertainties and management’s view of these matters may change in the future. PAGE 66 Table of Contents Part II Item 8 As of June 30, 2007, we had accrued aggregate +liabilities of approximately $800 million in other current liabilities and approximately $800 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there +exists the possibility of adverse outcomes that we estimate could be up to $4.15 billion in aggregate beyond recorded amounts. Were an unfavorable final outcome to occur, there exists the possibility of a material adverse impact on the +Company’s financial position and on the results of operations for the period in which the effect becomes reasonably estimable NOTE +18    SEGMENT INFORMATION Segment revenue and operating income/(loss) was as follows: (In millions) Year Ended June 30 2007 2006 2005 Revenue: Client $ 14,812 $ 13,040 $ 11,901 Server and Tools 11,182 9,680 8,314 Online Services Business 2,474 2,306 2,353 Microsoft Business Division 16,381 14,516 13,298 Entertainment and Devices Division 6,132 4,808 3,485 Unallocated and other 141 (68 ) 437 Consolidated $ 51,122 $ 44,282 $ 39,788 (In millions) Year Ended June 30 2007 2006 2005 Operating Income/(Loss): Client $ 11,544 $ 10,245 $ 9,435 Server and Tools 3,837 3,171 2,381 Online Services Business (745 ) 115 470 Microsoft Business Division 10,724 9,687 9,146 Entertainment and Devices Division (2,066 ) (1,284 ) (464 ) Reconciling amounts (4,770 ) (5,462 ) (6,407 ) Consolidated $ 18,524 $ 16,472 $ 14,561 SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , establishes standards for +reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting systems present +various data for management to operate the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. In July 2006 we announced a change in our operating segments from seven to five reflecting +previously announced reorganizations. Amounts for fiscal years 2006 and 2005 have been recast to conform to the current management view. The segments are designed to allocate resources internally and provide a framework to determine management +responsibility. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to +allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our five segments are Client; Server and Tools; Online Services Business; Microsoft Business Division; and Entertainment and Devices +Division. PAGE 67 Table of Contents Part II Item 8 The types of products and services +provided by each segment are summarized below: Client – Windows Vista, including Home, Home Premium, Ultimate, Business, and Enterprise Starter Edition; +Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems. Server and Tools – Windows +Server operating system; Microsoft SQL Server; Microsoft Enterprise Services; product support services; Visual Studio; System Center products; Forefront Security products; Biz Talk Server; MSDN; and TechNet, among others. Online Services Business – MSN Search; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, MSN +Bill Pay, and MSN Radio Plus); Windows Live; and MSN Mobile Services. Microsoft Business Division – Microsoft Office; Microsoft Project; Microsoft Visio; +Microsoft Office SharePoint Server; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communication Server; Microsoft Office Communicator; Microsoft Tellme Service; Microsoft Dynamics AX; +Microsoft Dynamics CRM; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Accounting. Entertainment and Devices Division – Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and hardware products; Windows Mobile software +platform; Windows Embedded device operating system; and Windows Automotive. Because of our integrated business structure, operating costs included +in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and +used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment +reporting purposes, which may result in changes to segment allocations in future periods. Assets are not allocated to segments for internal reporting +presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment +that is included in the measure of segment profit or loss. Reconciling amounts include adjustments to conform with U.S. GAAP and corporate-level +activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, period-end cut-off timing, and accelerated amortization for +depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity including certain legal settlements and accruals for legal contingencies. PAGE 68 Table of Contents Part II Item 8 Significant reconciling items were as +follows: (In millions) Year Ended June 30 2007 2006 2005 Summary of reconciling amounts: Corporate-level activity (1) $ (5,193 ) $ (5,122 ) $ (5,932 ) Stock-based compensation expense 124 (174 ) (1,042 ) Revenue reconciling amounts 119 (68 ) 437 Other 180 (98 ) 130 Total $ (4,770 ) $ (5,462 ) $ (6,407 ) (1) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. No sales to an individual customer accounted for more than 10% of fiscal year 2007 revenue. Sales to Dell and its subsidiaries accounted for approximately 11% and +10% of fiscal year 2006 and 2005 revenue, respectively. These sales were made primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Revenue, classified by the major geographic areas in which our customers are located, were as follows: (In millions) Year Ended June 30 2007 2006 2005 United States (1) $ 31,346 $ 27,957 $ 25,427 Other countries 19,776 16,325 14,361 Total $ 51,122 $ 44,282 $ 39,788 (1) Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations. In fiscal year 2007, the Company refined its revenue allocation methodology +and has revised prior year amounts accordingly. Long-lived assets, classified by the geographic location of the controlling statutory company in which +that company operates, were as follows: (In millions) Year Ended June 30 2007 2006 United States $ 9,121 $ 6,661 Other countries 866 788 Total $ 9,987 $ 7,449 PAGE 69 Table of Contents Part II Item 8 QUARTERLY INFORMATION (In millions, except per share amounts) (Unaudited) Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Total Fiscal year 2007 Revenue $ 10,811 $ 12,542 (1) $ 14,398 (2) $ 13,371 $ 51,122 Gross profit 9,115 8,922 12,258 10,134 40,429 Net income 3,478 2,626 4,926 3,035 (3) 14,065 Basic earnings per share 0.35 0.27 0.51 0.32 1.44 Diluted earnings per share 0.35 0.26 0.50 0.31 1.42 Fiscal year 2006 Revenue $ 9,741 $ 11,837 $ 10,900 $ 11,804 $ 44,282 Gross profit 8,488 9,598 8,872 9,674 36,632 Net income 3,141 (4) 3,653 2,977 (5) 2,828 (6) 12,599 Basic earnings per share 0.29 0.35 0.29 0.28 1.21 Diluted earnings per share 0.29 0.34 0.29 0.28 1.20 Fiscal year 2005 Revenue $ 9,189 $ 10,818 $ 9,620 $ 10,161 $ 39,788 Gross profit 7,784 8,943 8,257 8,773 33,757 Net income 2,528 (7) 3,463 2,563 (8 ) 3,700 (9) 12,254 Basic earnings per share 0.23 0.32 0.24 0.34 1.13 Diluted earnings per share 0.23 0.32 0.23 0.34 1.12 (1) Reflects $1.64 billion of revenue deferred to the third quarter of fiscal year 2007 for the Express Upgrade to Windows Vista and Microsoft Office Technology guarantee programs and +pre-shipments of Windows Vista and the 2007 Microsoft Office system. (2) Includes $1.64 billion of revenue discussed above and charges totaling $296 million (pre-tax) related to various legal matters. (3) Includes $1.06 billion charge related to the Xbox 360 warranty policy, inventory write-downs, and product returns. (4) Includes charge of $361 million (pre-tax) related to the settlement with RealNetworks, Inc. (5) Includes charges of $397 million (pre-tax) related to various legal matters. (6) Includes charge of € 281 million ($351 million) as a result of the fine imposed by the European +Commission in July 2006. (7) Includes charges totaling $536 million (pre-tax) related to the settlement of certain litigation with Novell, Inc. (8) Includes charges totaling $768 million (pre-tax) related to the Gateway, Inc. and Burst.com settlements, Sun Microsystems, Inc., and additional charges related to anti-trust and certain other +matters. (9) Includes charges totaling $756 million (pre-tax) related to IBM and other matters. PAGE 70 Table of Contents Part II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2007 and 2006, and the related consolidated statements of income, cash flows, and +stockholders’ equity for each of the three years in the period ended June 30, 2007. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these +financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board +(United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence +supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement +presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements +present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended +June 30, 2007, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance +with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of June 30, 2007, based on the criteria established in Internal +Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 3, 2007, expressed an unqualified opinion on management's assessment of the effectiveness of the +Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company's internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 3, 2007 PAGE 71 Table of Contents Part II Item 9, 9A ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A.    CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including +the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that +evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate +internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with +accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance +that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable +assurance that unauthorized acquisition, use or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over +financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of +the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2007. There were no changes in our internal control over financial reporting +during the quarter ended June 30, 2007 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited this assessment of our internal +control over financial reporting; their report is included in Item 9A. PAGE 72 Table of Contents Part II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of +Microsoft Corporation: We have audited management’s assessment, included in the accompanying Report of Management on Internal Control over Financial Reporting, +that Microsoft Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of June 30, 2007, based on criteria established in Internal Control—Integrated Framework issued +by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control +over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan +and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial +reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our +audit provides a reasonable basis for our opinions. A company’s internal control over financial reporting is a process designed by, or under the +supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding +the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies +and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are +recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management +and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management +override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods +are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of June 30, 2007, is fairly +stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company +maintained, in all material respects, effective internal control over financial reporting as of June 30, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring +Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board +(United States), the consolidated financial statements as of and for the year ended June 30, 2007 of the Company and our report dated August 3, 2007 expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 3, 2007 PAGE 73 Table of Contents Part II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B.    OTHER INFORMATION Not applicable. PART III ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and +biographical information appears in Part I, Item 1 of this report. Information about our directors may be found under the caption “Nominees” of our Proxy Statement for the Annual Meeting of Shareholders to be held November 13, +2007 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by +reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies +to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/msft. If we +make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer or Chief Accounting Officer and Corporate +Controller, we will disclose the nature of such amendment or waiver on that website or in a report on Form 8-K. ITEM 11.    EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions +“Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Interlocks and Insider Participation,” and “Compensation Committee Report” is incorporated herein by reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The +information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and Management” is incorporated herein +by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in +the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” is incorporated herein by reference. ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services +appears in the Proxy Statement under the headings “Fees Billed by Deloitte & Touche LLP” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated +herein by reference. PAGE 74 Table of Contents Part IV Item 15 PART IV ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. Financial statement schedules have been omitted since they are either +not required, not applicable, or the information is otherwise included. (b) Exhibit Listing Filed herewith Incorporated by reference Exhibit number Exhibit description Form Period ending Exhibit Filing date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/02 3.1 1/31/03 3.2 Bylaws of Microsoft Corporation X 4 Call Option Transaction Confirmation dated December 11, 2003 between Microsoft Corporation and JPMorgan Chase Bank 10-K 12/31/03 4 2/6/04 10.1* Microsoft Corporation 2001 Stock Plan 8-K 99.2 7/21/06 10.2* Microsoft Corporation 1991 Stock Option Plan 8-K 99.1 7/21/06 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Stock Option Plan for Non-Employee Directors 8-K 10.4 11/15/04 10.5* Microsoft Corporation Stock Option Plan for Consultants and Advisors 8-K 10.5 11/15/04 10.6* Microsoft Corporation 2003 Employee Stock Purchase Plan 10-K 6/30/04 10.6 9/1/04 10.7* Microsoft Corporation Deferred Compensation Plan S-8 99.1 2/28/06 10.8* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.9* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period 10-K 6/30/04 10.10 9/1/04 PAGE 75 Table of Contents Part IV Item 15 Filed herewith Incorporated by reference Exhibit number Exhibit description Form Period ending Exhibit Filing date 10.11* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period 10-K 6/30/04 10.11 9/1/04 10.12* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.13* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.14 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee) 10-K 6/30/02 10.8 9/6/02 10.15 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee 10-K 6/30/03 10.8 9/5/03 10.16* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.17* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2007 performance period X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X * Indicates a management contract or compensatory plan or arrangement PAGE 76 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused +this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 3, 2007. M ICROSOFT C ORPORATION By: / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on August 3, 2007. Signature Title /s/    W ILLIAM H. G ATES III William H. Gates III Chairman /s/    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer /s/    J AMES I. C ASH , +J R . James I. Cash, Jr. Director /s/    D INA D UBLON Dina Dublon Director /s/    R AYMOND V. G ILMARTIN Raymond V. Gilmartin Director /s/    R EED H ASTINGS Reed Hastings Director /s/    D AVID F. M ARQUARDT David F. Marquardt Director /s/    C HARLES H. +N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/    J ON A. +S HIRLEY Jon A. Shirley Director /s/    C HRISTOPHER P. L IDDELL Christopher P. Liddell Senior Vice President; Chief Financial Officer (Principal Financial Officer) /s/    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) PAGE 77 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-08-162768/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-08-162768/full-submission.txt new file mode 100644 index 0000000..d6ae48a --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-08-162768/full-submission.txt @@ -0,0 +1,1009 @@ +Table of Contents United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2008 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 Securities registered pursuant to +Section 12(b) of the Act: COMMON +STOCK                                         +NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the +registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or +Section 15(d) of the Exchange Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the +registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in +definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a +smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨ (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a +shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ¨ No x As of December 31, 2007, the +aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $287,616,660,928 based on the closing sale price as reported on the NASDAQ National Market System. As of July 28, 2008, there were +9,130,293,074 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 19, 2008 are incorporated by reference into Part +III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2008 INDEX PART I Item 1. Business 3 Executive Officers of the Registrant 11 Item 1A. Risk Factors 12 Item 1B. Unresolved Staff Comments 17 Item 2. Properties 17 Item 3. Legal Proceedings 18 Item 4. Submission of Matters to a Vote of Security Holders 18 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 19 Item 6. Selected Financial Data 20 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 21 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 40 Item 8. Financial Statements and Supplementary Data 41 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 74 Item 9A. Controls and Procedures 74 Report of Management on Internal Control over Financial Reporting 74 Report of Independent Registered Public Accounting Firm 75 Item 9B. Other Information 76 PART III Item 10. Directors, Executive Officers and Corporate Governance 76 Item 11. Executive Compensation 76 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 76 Item 13. Certain Relationships and Related Transactions, and Director Independence 76 Item 14. Principal Accounting Fees and Services 76 PART IV Item 15. Exhibits and Financial Statement Schedules 77 Signatures 79 PAGE 2 Table of Contents Part I Item 1 Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, +objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the +Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” +“estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” +“will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the +forward-looking statements. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk +Factors” (refer to Part I, Item 1A). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise. PART I ITEM 1.    BUSINESS GENERAL Our mission is to enable people and businesses throughout the world to realize their full potential. Since the company was founded in 1975, we have worked to achieve this mission by creating technology +that transforms the way people work, play, and communicate. We develop and market software, services, hardware, and solutions that we believe deliver new opportunities, greater convenience, and enhanced value to people’s lives. We do business +throughout the world and have offices in more than 100 countries. We generate +revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for servers, personal +computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and +video games. We provide consulting and product support services, and we train and certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 video game console, the Zune digital music and +entertainment device, and peripherals. Online offerings and information are delivered through Live Search, Windows Live, Office Live, our MSN portals and channels, and the Microsoft Online Services platform which includes offerings for businesses +such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on Live Search through our proprietary +adCenter® platform. We also research and develop advanced technologies for future software products and services. We believe that +delivering breakthrough innovation and high-value solutions through our integrated software platform is the key to meeting our customers’ needs and to our future growth. We believe that we will continue to lay the foundation for long-term +growth by delivering new products and services, creating new opportunities for partners, improving customer satisfaction, and improving our internal processes. Our focus is to build on this foundation through ongoing innovation in our integrated +software platforms; by delivering compelling value propositions to customers; by responding effectively to customer and partner needs; and by continuing to emphasize the importance of product excellence, business efficacy, and accountability. OPERATING SEGMENTS We have five operating +segments: Client, Server and Tools, Online Services Business, Microsoft Business Division, and Entertainment and Devices Division. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the +alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of development, sales, marketing, and services resources within businesses. +The segments also help focus strategic planning efforts on key objectives and initiatives across our businesses. PAGE 3 Table of Contents Part I Item 1 Due to our integrated business +structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products and services included in each segment. +Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to motivate shared effort. Segments should not be viewed as discrete or easily separable businesses. Client Client has overall +responsibility for technical architecture, engineering, and product delivery of our Windows product family and is responsible for our relationships with personal computer manufacturers, including multinational and regional original equipment +manufacturers (“OEMs”). The segment includes sales and marketing expenses for the Windows operating system and product development efforts for the Windows platform. Client revenue growth is correlated with the growth of purchases of +personal computers from OEMs that pre-install versions of Windows operating systems as the OEM channel accounts for over 80% of total Client revenue. We released Windows Vista, the most recent version of the Windows operating system, in fiscal year 2007. This release concluded a major development phase that we believe resulted in a significantly more manageable and powerful +PC operating system compared with prior releases. Windows Vista includes advances in security, digital media, user interfaces, and other areas that enhance the user and developer experience. Client offerings consist of premium and standard edition Windows operating systems. Premium editions are those that include additional functionality +and are sold at a price above our standard editions. Products: Windows Vista, including Home, Home +Premium, Ultimate, Business, Enterprise and Starter Edition; Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems. Competition Client faces strong competition from well-established companies with differing +approaches to the PC market. Competing commercial software products, including variants of Unix, are supplied by competitors such as Apple, Hewlett-Packard, IBM, and Sun Microsystems. The Linux operating system, which is also derived from Unix and +is available without payment under a General Public License, has gained some acceptance as competitive pressures lead PC OEMs to reduce costs and new, lower price PC form factors gain adoption. Apple takes an integrated approach to the PC experience +and has made inroads in share, particularly in the U.S. and in the consumer segment. The Windows operating system also faces +competition from alternative platforms and new devices that may reduce consumer demand for traditional personal computers. Competitors such as Mozilla offer software that competes with the Internet Explorer Web browsing capabilities of Windows +products. User and usage volumes on mobile devices are increasing around the world relative to the PC. Our operating system products +compete effectively by delivering innovative software, giving customers choice and flexibility, a familiar, easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any +operating system. Server and Tools Server and Tools develops and markets software server products, services, and solutions. Windows Server-based products are integrated server infrastructure and middleware software designed to support software applications and +tools built on the Windows Server operating system. Windows Server-based products include the server platform including targeted segment solutions, database, storage, management and operations, service-oriented architecture platform, and security +and identity software. The segment also builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server products can be run on-site, in a hosting environment, or in a Web-based +environment. We offer a broad range of consulting services and provide product support services and industry solutions. We also +provide training and certification to developers and information technology professionals about our Server and Tools and Client platform products. PAGE 4 Table of Contents Part I Item 1 Approximately 45% of Server and Tools +revenue comes from multi-year licensing agreements, approximately 25% is purchased through fully packaged product and transactional volume licensing programs, and approximately 10% comes from licenses sold to OEMs. The remainder of Server and Tools +revenue comes from consulting and product support services. Major releases from Server and Tools in fiscal year 2008 included Windows +Server 2008 and Visual Studio 2008. Windows Server 2008 provides virtualization technologies, security enhancements, new Internet tools and infrastructure, and management utilities while Visual Studio 2008 provides rapid application development, +team collaboration tools, and advances in building connected applications. In fiscal year 2009, we plan to release Microsoft SQL Server 2008 which will deliver advances in database scalability, performance, security, and policy-based management. Products and Services: Windows Server operating system; Microsoft SQL Server; Microsoft Enterprise +Services; product support services; Visual Studio; System Center products; Forefront security products; Biz Talk Server; MSDN; and other products and services. Competition Our server operating system products face intense competition from a wide variety of server operating +systems and server applications, offered by companies with a variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Sun Microsystems offer their own versions of the Unix operating system +preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large +number of compatible applications now produced by many leading commercial software developers and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. Server virtualization platform +providers, such as VMware, are another form of competition for the Windows server operating system. We have entered into business and +technical collaboration agreements with Novell and other Linux providers to build, market, and support a series of solutions to enhance the interoperability of our products with their virtualization, management, and network security solutions, and +to provide each other’s customers with patent coverage for their respective products. We compete to provide enterprise-wide +computing solutions with several companies that offer solutions and middleware technology platforms. IBM and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). Commercial software developers that +provide competing server applications for PC-based distributed client/server environments include CA, Inc., IBM, and Oracle. Our Web application platform software competes with open source software such as Linux, Apache, MySQL, and PHP, and we +compete against Java middleware such as JBoss, Geronimo, and Spring Framework. Numerous commercial software vendors offer competing +commercial software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. System Center competes with Hewlett-Packard, BMC, CA, Inc., and IBM in the management of information technology +infrastructures, while our Forefront line of business security products compete with McAfee, Symantec, and Trend Micro in protecting both client and server applications. Our products for software developers compete against offerings from Adobe, BEA +Systems, Borland, IBM, Oracle, Sun Microsystems, and other companies. These offerings include open source projects like Eclipse (sponsored by IBM and Oracle). We believe that our server products provide customers with advantages in innovation, +performance, total costs of ownership, and productivity by delivering superior applications, development tools, and compatibility with a broad base of hardware and software applications, security, and manageability. Online Services Business The Online +Services Business (“OSB”) consists of an on-line advertising platform with offerings for both publishers and advertisers, personal communications services such as email and instant messaging, online information offerings such as Live +Search, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, including search, display, and email and messaging services. Revenue is also generated through subscriptions and transactions generated +from online paid services, from advertiser and publisher tools, digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers. We continue to launch new online offerings and expect to do so in the future. +During fiscal year 2008, we launched new releases of PAGE 5 Table of Contents Part I Item 1 Windows Live Search, the Windows Live suite of applications and services, and updated our MSN Video Service. In addition, we launched a new release of adCenter, our +proprietary advertising platform, and also expanded our advertising platform portfolio through acquisitions. We acquired a number of +companies during the fiscal year, the most significant of which was aQuantive, Inc., a digital marketing business that we expect will play a key role in the future development of our Online Services Business. We believe the acquisition will help us +build and support next-generation advertiser and publisher solutions for cross media planning, video-on-demand, and Internet protocol television. Products: Live Search; MSN; MapPoint; MSN Internet Access; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, and MSN Software Services); Windows Live; +MSN Mobile Services; AvenueA Razorfish media agency services; Atlas online tools for advertisers; and the Drive PM ad network for publishers. Competition OSB competes with AOL, Google, Yahoo!, and a wide array of Web sites and portals that provide content and online +offerings of all types to end users. We compete with these organizations to provide advertising opportunities for merchants. OSB also competes for narrowband Internet access users with AOL, Earthlink, and other ISPs for dial-up Internet access in +the United States. The Internet advertising industry has grown significantly over the past several years, and we anticipate that this trend will continue. Competitors are aggressively developing Internet offerings that seek to provide more effective +ways of connecting advertisers with audiences through enhanced functionality in communication services, improvements in information services such as Internet search, and improved advertising infrastructure and support services. We have developed our +own algorithmic search engine to provide end users with more relevant search results, expanded search services, and a broader selection of content. To support the growth of our advertising business, we also are investing in our communication +services, technology, operations, and sales efforts. We will continue to introduce new products and services, including Windows Live services that are aimed at attracting additional users through improvements in the user online experience. As +consumers migrate from narrowband to broadband Internet access, we expect our narrowband Internet access subscriber base to continue to decline and this portion of our business to decrease in importance. We believe that we can compete effectively +across the breadth of our Internet services by providing users with software innovation in the form of information and communication services that help them find and use the information and experiences they want online and by providing merchants +with effective advertising results through improved systems and sales support. Microsoft Business Division Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office +system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD +revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as content management, enterprise search, collaboration, unified communications and +business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and +divisions of global enterprises. We evaluate MBD results based upon the nature of the end user in two primary parts—business +revenue which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue, and consumer revenue which includes revenue from retail packaged product sales and OEM revenue. Approximately +80% of MBD revenue is generated from sales to businesses. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given +year. Approximately 20% of MBD revenue is derived from sales to consumers. Most of this revenue is generated from new licenses acquired through fully packaged products and licenses sold through OEMs for new PCs and is generally affected by +the level of PC shipments and product launches. Products: Microsoft Office; Microsoft Project; +Microsoft Visio; Microsoft Office SharePoint Server; Microsoft PerformancePoint; Microsoft Office Live; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communication Server; +Microsoft Office Communicator; PAGE 6 Table of Contents Part I Item 1 Microsoft Tellme Service, Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics CRM Online; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft +Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office Accounting. Competition Competitors to the Microsoft Office system include many software application vendors such as Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Sun +Microsystems, and local application developers in Europe and Asia. IBM (Smartsuite) and Corel (WordPerfect Suite) have measurable installed bases with their office productivity products. Apple may distribute certain of its application software +products with various models of its PCs. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red +Hat, and Sun. Corel’s suite and many local software suites around the world are aggressively priced for OEMs to preinstall on low-priced PCs. Google has launched Google Apps, a hosted messaging and productivity suite, and also provides an +enterprise search offering that competes with Microsoft Office SharePoint Server for Search, our new enterprise search product. Web-based offerings such as AjaxWrite, gOffice, iNetOffice, SimDesk, ThinkFree, wikiCalc, or other small projects +competing with individual applications, can also provide an alternative to Microsoft Office system products. IBM has many different points of competition with Office system products with its Notes and Workplace offerings. As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in +enterprise content management and search, collaboration tools, unified communications, and business intelligence. These competitors include Autonomy, Cisco, Endeca, Google, IBM, Oracle, and SAP. Our Microsoft Dynamics products compete with well-known vendors such as Intuit and Sage in the market focused on providing solutions for small and +mid-sized businesses. The market for large organizations and divisions of global enterprises is intensely competitive with a small number of primary vendors including Oracle and SAP. These vendors are positioning many of their business +applications to focus more intensely on small and mid-sized businesses. Additionally Salesforce.com’s on-demand customer relationship management offerings compete directly with Microsoft Dynamics CRM Online and Microsoft Dynamic CRM’s +on-premise offerings. We believe our products compete effectively with these vendors based on our strategy of providing interoperable, adaptable solutions that work well with technologies our customers already have. Entertainment and Devices Division The +Entertainment and Devices Division (“EDD”) is responsible for developing, producing, and marketing the Xbox video game system, including consoles and accessories, third-party games, games published under the Microsoft brand, and Xbox Live +operations, as well as research, sales, and support of those products. In addition to Xbox, we offer the Zune digital music and entertainment device; PC software games; online games; Mediaroom, our Internet protocol television software; mobile and +embedded device platforms, Surface computing platform; and other devices. EDD also leads the development efforts of our line of consumer software and hardware products including application software for Macintosh computers and Microsoft PC hardware +products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems. Products: Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and hardware products (such as mice and keyboards); Windows Mobile software and services platform; Windows Embedded +device operating system; Windows Automotive; and Surface computing platform. Competition Entertainment and devices businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the +development of new technologies. The markets for our products are characterized by significant price competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices +on certain products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, +quality and variety, timing of product releases, and effectiveness of distribution and marketing. PAGE 7 Table of Contents Part I Item 1 Our Xbox hardware business competes +with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for video game consoles averages five to seven years. We released Xbox 360, our second generation console, in November 2005. +Nintendo and Sony released new versions of their game consoles in late 2006. We believe the success of video game consoles is determined by the availability of games for the console, providing exclusive game content that gamers seek, the +computational power and reliability of the console, and the ability to create new revenue sources such as advertising and downloadable content. We think the Xbox 360 is positioned well against competitive console products based on significant +innovation in hardware architecture, new developer tools, expanded revenue sources, and continued strong exclusive content from our own game franchises such as Halo. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that we have licensed to develop and publish software for the Xbox +consoles. Zune competes with the Apple iPod and other digital music and entertainment devices. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. +Mediaroom faces competition primarily from a variety of competitors that provide elements of an Internet protocol television delivery platform, but that do not provide end-to-end solutions for the network operator. Windows Mobile software and +services faces substantial competition from Apple, Nokia, Openwave Systems, Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system business is highly fragmented with many competitive offerings. Key competitors include IBM, +Wind River, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. OPERATIONS To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we “localize” many of +our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our operational centers support all operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The +regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, North Dakota, Puerto Rico, Redmond, Washington, and +Reno, Nevada support Latin America and North America. We contract most of our manufacturing activities for Xbox 360 and related +games, Zune, various retail software packaged products, and Microsoft hardware to third parties. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console includes certain key components that +are supplied by a single source. The central processing unit is purchased from IBM and the graphics chips and embedded dynamic random access memory chips for the graphics processing unit are purchased from Taiwan Semiconductor Manufacturing Company +and NEC Corporation, respectively. Although we have chosen to initially source these key Xbox 360 components from a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the exceptions +noted, we generally have the ability to use other custom manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and +materials on a volume discount basis. PRODUCT DEVELOPMENT During fiscal years 2008, 2007, and 2006, research and development expense was $8.2 billion, $7.1 billion, and $6.6 billion, respectively. These amounts represented 14%, 14%, and 15%, respectively, of revenue in each of those +years. We plan to continue to make significant investments in a broad range of research and product development efforts. While most +of our software products are developed internally, we also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We believe we are not materially dependent upon licenses +and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control over our products. It also gives us the freedom to decide which modifications and enhancements +are most important and when they should be implemented. Generally, we also create product documentation internally. We strive to obtain information as early as PAGE 8 Table of Contents Part I Item 1 possible about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors +with a range of resources and guidelines for development, training, and testing. Investing in Business and Product +Development. Innovation is a key factor in Microsoft’s growth. Our model for growth is based on broad adoption of the products and services we develop and market, our willingness to enter new markets, and our ability +to embrace and act on disruptive technology trends. We continue our long-term commitment to research and develop, in a wide spectrum of technologies, tools, and platforms spanning communication and collaboration; information access and organization; +entertainment; business and e-commerce; and devices. Increasingly, we are taking a global approach to innovation. While our main research and development facilities are located in Redmond, Washington, we also operate research facilities in other +parts of the United States and around the world, including Canada, China, Denmark, England, India, Ireland, and Israel. This global approach will help us remain competitive in local markets and enables us to continue to attract top talent from +across the globe. Based on our broad focus on innovation and long-term approach to new markets, we see the following key +opportunities for growth: Consumer technology. To build on our strength in the consumer marketplace +with Windows Vista, the 2007 Microsoft Office System, Xbox 360, Microsoft Windows Live, Windows Mobile, and Zune, we are focused on delivering products that we believe are compelling and cutting edge in terms of design, features, and functionality. +To succeed in consumer technologies, we also are working to define the next era of consumer electronics. In the past, consumer electronics was a hardware-centric business; today, the innovation in consumer electronics devices lies in the software +that powers them. This is creating new opportunities for us to deliver end-to-end experiences that connect users to information, communications, entertainment, and people in new and compelling ways. Software plus services. Underlying our opportunities in all of our businesses is a company-wide commitment to embrace +software plus services. The ability to combine the power of desktop and server software with the reach of the Internet represents an opportunity across every one of our businesses. As we continue to build out our services platform, we will bring a +broad range of new products and service offerings to market that target the needs of large enterprises, small and medium-sized businesses, and consumers. Expanding our presence on the desktop, the server, and with developers. We believe we are well-positioned to build on our strength with businesses of all sizes and with developers. Fiscal year 2008 +saw widespread adoption of Windows Vista and the 2007 Microsoft Office system and the launch of Windows Server 2008, SQL Server 2008, and Visual Studio 2008. We will continue to focus expanding adoption of these products in fiscal year 2009, and in +providing additional value in security, messaging, systems management, and collaboration. We also continue to focus on developers with the release of new tools such as Silverlight. We will continue to pursue new opportunities in high-performance +computing, unified communications, healthcare, and business intelligence. Emerging markets are also an important opportunity for us. DISTRIBUTION, +SALES AND MARKETING We distribute our products primarily through the following channels: OEM; distributors and resellers; and online. OEM. Our operating systems are licensed primarily to OEMs under agreements that grant OEMs the right to build +computing devices based on our operating systems, principally PCs. Under similar arrangements, we also market and license certain server operating systems, desktop applications, hardware devices, and consumer software products to OEMs. We have OEM +agreements covering one or more of our products with virtually all of the major PC OEMs, including Acer, Dell, Fujitsu, Fujitsu Siemens Computers, Gateway, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba. A substantial amount of OEM +business is also conducted with system builders, which are low-volume, customized PC vendors operating in local markets. Distributors and +Resellers. We license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products primarily through large account resellers +(“LARs”), direct market resellers, and value-added resellers (“VARs”). Many organizations that license products through enterprise agreements transact directly with us, with sales support from our Enterprise Software Advisor +channel partners. These Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, PAGE 9 Table of Contents Part I Item 1 LARs are primarily engaged with large organizations and VARs typically reach the small- and medium-sized organizations. Some of our distributors include Ingram Micro +and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, Software House International, and Software Spectrum. Our Microsoft Dynamics software offerings are licensed to enterprises through a global network of channel +partners providing vertical solutions and specialized services. We distribute our finished goods products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain +our products primarily through retail outlets, including Best Buy, Target, and Wal-Mart. We have a network of field sales representatives and field support personnel that solicits orders from distributors and resellers and provides product training +and sales support. Our arrangements for organizations to acquire multiple licenses of products are designed to provide them with a +means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for organizations of various +sizes. While these programs may differ in various parts of the world, generally they include: Open +licensing. Designed primarily for small-to-medium organizations (5 to over 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, rights to future versions of +software products over a specified time period (generally two years). The offering that conveys rights to future versions of certain software product over the contract period is called Software Assurance. Software Assurance also provides support, +tools, and training to help customers deploy and use software efficiently. Under the Open program, customers can acquire licenses only, or licenses with Software Assurance. They can also renew Software Assurance upon the expiration of existing +volume licensing agreements. Select licensing. Designed primarily for medium-to-large +organizations (greater than 250 licenses), this program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance, which consists of rights to future versions of certain software products, support, +tools, and training over a specified time period (generally three years). Similar to the Open program, customers can acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume +licensing agreements. Enterprise Agreement licensing. The Enterprise Agreement is targeted at +medium and large organizations that want to acquire perpetual licenses to software products for all or substantial parts of their enterprise, along with rights to future versions of certain software products, support, tools, and training over a +specified time period (generally three years). Online. We distribute online content and services through Live Search, +Windows Live, Office Live, our MSN portals and channels, the Microsoft Online Services platform, which includes offerings for business, and other online channels. OSB delivers Internet access and various premium services and tools to consumers. OSB +also delivers online email and messaging communication services and information services such as online search, advertising, and premium content. EDD operates the Xbox Live service which allows customers to participate in the gaming experience +online with other subscribers. We operate and deliver the Microsoft Small Business Center portal. This portal provides tools and expertise for small-business owners to build, market, and manage their businesses online. Other services delivered +online include Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and solutions. CUSTOMERS Our customers include individual consumers, +small and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet service providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily +through resellers and OEMs. No sales to an individual customer accounted for more than 10% of fiscal year 2008 or 2007 revenue. Sales to Dell and its subsidiaries accounted for approximately 11% of fiscal year 2006 revenue. These sales were made +primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Our practice is to ship our products promptly upon receipt of purchase orders +from customers; consequently, backlog is not significant. PAGE 10 Table of Contents Part I Item 1 EXECUTIVE OFFICERS OF THE +REGISTRANT Our executive officers as of July 31, 2008 were as follows: Name Age Position with the Company Steven A. Ballmer 52 Chief Executive Officer Robert J. (Robbie) Bach 46 President, Entertainment and Devices Division Lisa E. Brummel 48 Senior Vice President, Human Resources Stephen A. Elop 44 President, Microsoft Business Division Kevin R. Johnson 47 President, Platforms and Services Division Christopher P. Liddell 50 Senior Vice President and Chief Financial Officer Robert L. Muglia 48 Senior Vice President, Server and Tools Craig J. Mundie 59 Chief Research and Strategy Officer Raymond E. Ozzie 52 Chief Software Architect Jeffrey S. Raikes 50 President, Microsoft Business Division Bradford L. Smith 49 Senior Vice President; General Counsel and Secretary Brian Kevin Turner 43 Chief Operating Officer Mr. Ballmer was appointed Chief Executive Officer in January 2000. He served as +President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. He joined Microsoft in 1980. Mr. Bach was named President, Entertainment and Devices Division in September 2005. He had been Senior Vice President, Home and Entertainment since March 2000. Before holding that position, he had +been Vice President, Home and Retail since March 1999, Vice President, Learning, Entertainment and Productivity since 1997, and Vice President, Desktop Applications Marketing since 1996. Mr. Bach joined Microsoft in 1988. Ms. Brummel was named Senior Vice President, Human Resources in December 2005. She had been Corporate Vice President, Human Resources since +April 2005. From 1995 to April 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of management positions, including general manager of the Consumer +Productivity business and product unit manager of several product lines. Mr. Elop was named President, Microsoft Business +Division in January 2008. Prior to joining the Company, Mr. Elop served as Chief Operating Officer of Juniper Networks, Inc. from January 2007 to January 2008. From December 2005 to December 2006, he served as President of Worldwide Field +Operations at Adobe Systems Inc. Mr. Elop joined Adobe following the 2005 acquisition of Macromedia Inc., where he was President and Chief Executive Officer from January 2005 to December 2005. During his almost eight-year tenure at Macromedia, +Mr. Elop held many senior positions, including Chief Operating Officer, Executive Vice President of Worldwide Field Operations and General Manager of Macromedia’s eBusiness division. Mr. Johnson was named President, Platforms and Services Division in January 2007. He had been Co-President of the Platforms and Services +Division since September 2005. He held the position of Group Vice President, Worldwide Sales, Marketing and Services since March 2003. Before that position, he had been Senior Vice President, Microsoft Americas since February 2002 and Senior Vice +President, U.S. Sales, Marketing, and Services since August 2001. Prior to assuming that role, he had been Vice President, U.S. Sales, Marketing and Services. He joined Microsoft in 1992. In July 2008, Mr. Johnson announced his plans to resign +from the Company. Mr. Liddell was named Senior Vice President and Chief Financial Officer of the Company in May 2005. +Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company from March 2003 through April 2005, and prior to becoming Chief Financial Officer, he held the positions of Vice President-Finance and +Controller. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited, an affiliate of International Paper, from 1999 to 2002 and Chief Financial Officer from 1995 to 1998. Mr. Muglia was named Senior Vice President, Server and Tools Business in October 2005. Before holding that position, he had a number of +leadership positions at Microsoft including Senior Vice President, Enterprise Storage Division since November 2001, Group Vice President, Personal Services Group since August 2000, Group Vice President, Business Productivity since December 1999, +Senior Vice President, Business Productivity since March 1999, Senior Vice President, Applications and Tools since February 1998, and Corporate Vice President, Server Applications since 1997. He joined Microsoft in 1988. PAGE 11 Table of Contents Part I Item 1, 1A Mr. Mundie was named Chief +Research and Strategy Officer in June 2006. He had been Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie +joined Microsoft in 1992. Mr. Ozzie was named Chief Software Architect in June 2006. He had been Chief Technical Officer from +April 2005 to June 2006. He assumed that role in April 2005 after Microsoft acquired Groove Networks, a collaboration software company he formed in 1997. Mr. Raikes was named President, Microsoft Business Division in September 2005. He had been Group Vice President, Information Worker Business since June 2004. Before that position, he had been Group Vice President, +Productivity and Business Services since August 2000 and Group Vice President, Sales and Support since July 1998. Mr. Raikes joined Microsoft in 1981. In January 2008, he announced his plans to retire at the end of August 2008. Mr. Smith was named Senior Vice President, General Counsel, and Secretary in November 2001. Mr. Smith was also named Chief Compliance +Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. He joined Microsoft in 1993. Mr. Turner was named Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, +Inc. and President and Chief Executive Officer of the Sam’s Club division. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 +to September 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. EMPLOYEES As of June 30, 2008, we employed approximately 91,000 people on a full-time basis, 55,000 in the United States and 36,000 internationally. +Of the total, 35,000 were in product research and development, 26,000 in sales and marketing, 17,000 in product support and consulting services, 4,000 in manufacturing and distribution, and 9,000 in general and administration. Our success is highly +dependent on our ability to attract and retain qualified employees. None of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. There we make available, free of charge, our annual report on Form +10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file such material with or furnish it to the Securities and Exchange Commission +(“SEC”). Our SEC reports can be accessed through the investor relations section of our Web site. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. ITEM 1A.    RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the +trading price of our common stock. Challenges to our business model may reduce our revenues and operating margins. Our +business model has been based upon customers paying a fee to license software that we develop and distribute. Under this license-based software model, software developers bear the costs of converting original ideas into software products through +investments in research and development, offsetting these costs with the revenue received from the distribution of their products. Certain “open source” software business models challenge our license-based software model. Open source +commonly refers to software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an +open source business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do not bear the full costs of research and development for the +software. Some of these firms may build upon Microsoft ideas that we provide to them free or at low royalties in connection with our interoperability initiatives. To the extent open source software gains increasing market acceptance, our sales, +revenue and operating margins may decline. PAGE 12 Table of Contents Part I Item 1A Another development is the business +model under which companies provide content, and software in the form of applications, data, and related services, over the Internet in exchange for revenues primarily from advertising or subscriptions. An example of an advertising-funded business +model is Internet search, where providing a robust alternative is particularly important and challenging due to the scale effects enjoyed by a single market dominant competitor. Advances in computing and communications technologies have made this +model viable and enabled the rapid growth of some of our competitors. We are devoting significant resources toward developing our own competing software plus services strategies. It is uncertain whether these strategies will be successful. An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse +solutions. A competing vertically-integrated model, in which a single firm controls both the software and hardware elements of a product, has been successful with certain consumer products such as personal computers, mobile phones and digital music +players. We also offer vertically-integrated hardware and software products; however, efforts to compete with the vertically integrated model may increase our cost of sales and reduce operating margins. We face intense competition. We continue to experience intense competition across all markets for our products and services. Our +competitors range in size from Fortune 100 companies to small, specialized single-product businesses and open source community-based projects. Although we believe the breadth of our businesses and product portfolio is a competitive advantage, our +competitors that are focused on narrower product lines may be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low and products, once +developed, can be distributed broadly and quickly at relatively low cost. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products, in some cases on the basis of +technical specifications for Microsoft technologies that we make available. In response to competition, we are developing versions of our products with basic functionality that are sold at lower prices than the standard versions. These competitive +pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins and operating income. We may not be able to adequately protect our intellectual property rights. Protecting our global intellectual property rights and +combating unlicensed copying and use of software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are +less protective of intellectual property rights. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of +licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational +and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these +claims may grow. To resolve these claims we may enter into royalty and licensing agreements on less favorable terms, stop selling or redesign affected products, or pay damages to satisfy indemnification commitments with our customers. Such +agreements may cause operating margins to decline. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source +code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a +number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection +for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the +security risks described in the next paragraph. PAGE 13 Table of Contents Part I Item 1A Security vulnerabilities in our products could lead +to reduced revenues or to liability claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software +programs that attack our products. Although this is an industry- wide problem that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on the most popular operating systems and +programs and we expect them to continue to do so. We devote significant resources to address security vulnerabilities through: • engineering more secure products; • enhancing security and reliability features in our products; • helping our customers make the best use of our products and services to protect against computer viruses and other attacks; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; and • providing customers online automated security tools, published security guidance, and security software such as firewalls, anti-virus, and other security software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security +vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems +from attack, which could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. In addition, actual or perceived vulnerabilities may lead to claims against us. Although our license agreements +typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand all legal challenges. We are subject to government litigation and regulatory activity that affects how we design and market our products. As a leading global software maker, we receive close scrutiny from government +agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved +through a Consent Decree that took effect in 2001 and a Final Judgment entered in 2002. These proceedings imposed various constraints on our Windows operating system businesses. These constraints include limits on certain contracting practices, +mandated disclosure of certain software program interfaces and protocols, and rights for computer manufacturers to limit the visibility of certain Windows features in new PCs. We believe we are in full compliance with these rules. However, if we +fail to comply with them, additional restrictions could be imposed on us that would adversely affect our business. The European +Commission closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In +2004, the Commission ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in +their own products. The Commission’s impact on product design may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The +availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our own products which could result in decreased sales of our products. Government regulatory actions and court decisions may hinder our ability to provide the benefits of our software to consumers and businesses, +thereby reducing the attractiveness of our products and the revenues that come from them. New actions could be initiated at any time, either by these or other governments or private claimants, including with respect to new versions of Windows or +other Microsoft products. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply +with government rulings, which may entail removing functionality that customers want or on which developers rely. PAGE 14 Table of Contents Part I Item 1A • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated +intellectual property. • The rulings described above may be cited as a precedent in other competition law proceedings. Our software and services online offerings are subject to government regulation of the Internet domestically and internationally in many areas, +including user privacy, telecommunications, data protection, and online content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant +costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we stop doing the alleged noncompliant activity. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and +retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in +our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to +ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. Delays +in product development schedules may adversely affect our revenues. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long +development and testing periods. Our increasing focus on software plus services also presents new and complex development issues. Significant delays in new product or service releases or significant problems in creating new products or services +could adversely affect our revenue. We make significant investments in new products and services that may not be +profitable. We have made and will continue to make significant investments in research, development, and marketing for new products, services, and technologies, including Windows Vista, the 2007 Microsoft Office system, +Xbox 360, Live Search, Windows Server, Zune, and Windows Live. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. We may +not achieve significant revenue from new product and service investments for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses +may not be as high as the margins we have experienced historically. Adverse economic conditions may harm our +business. Inflation, softness in corporate information technology spending, or other changes in economic conditions that affect demand for computer hardware or software could adversely affect our revenue or our investment +portfolio. If demand for PCs, servers, and other computing devices declines significantly, or consumer or corporate spending for such products declines, our revenue will be adversely affected. In addition, our revenue may be unfavorably impacted if +customers reduce their purchases of new software products or upgrades because new offerings such as Windows Vista and the 2007 Microsoft Office system are not perceived as providing significant new functionality or other value to prospective +purchasers. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of +claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. Although management currently believes resolving +all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial position, results of operations, or cash flows, the litigation and other claims are subject to inherent uncertainties and +management’s view of these matters may change in the future. A material adverse impact on our financial position, results of operations, and cash flows also could occur for the period in which the effect of an unfavorable final outcome becomes +probable and reasonably estimable. We may have additional tax liabilities. We are subject to income taxes in the +United States and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax +determination is PAGE 15 Table of Contents Part I Item 1A uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related +litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial position, results of operations, or cash flows in the period or +periods for which that determination is made. Our vertically-integrated hardware and software products may experience quality or supply +problems .    Our hardware products such as the Xbox 360 console are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm +if we fail to detect or effectively address such issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. If a component delivery from a sole-source supplier is delayed or becomes +unavailable or industry shortages occur, we may be unable to obtain timely replacement supplies, resulting in reduced sales. Either component shortages or excess or obsolete inventory may require us to record charges to cost of revenue. Xbox 360 +consoles are assembled in Asia; disruptions in the supply chain may result in console shortages that would affect our revenues and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we +may offer. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to +earnings. Under generally accepted accounting principles, we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is +tested for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in stock price and +market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge in our financial statements during the period in which any impairment of our goodwill or +amortizable intangible assets is determined, negatively impacting our results of operations. We operate a global business that exposes us to +additional risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that we reduce the sales price of our +software in the United States and other countries. Operations outside the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment; changes in +regulatory requirements for software; social, political, labor or economic conditions in a specific country or region; and difficulties in staffing and managing foreign operations. Although we hedge a portion of our international currency exposure, +significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our net revenues. Catastrophic +events or geo-political conditions may disrupt our business. A disruption or failure of our systems or operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic +event could cause delays in completing sales, providing services or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business +operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or +disruption of any of our critical business or information technology systems could harm our ability to conduct normal business operations and our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of +general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers. Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions or entering +into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don’t realize a satisfactory return on +our investment, or that we experience difficulty in the integration of new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These events could harm our operating results or financial +condition. PAGE 16 Table of Contents Part I Item 1A, 1B, 2 Improper disclosure of personal data could result in +liability and harm our reputation. We store and process large amounts of personally identifiable information. It is possible that our security controls over personal data, our training of employees and vendors on data +security, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm our reputation and subject us to liability under laws that protect personal data, resulting in +increased costs or loss of revenue. Our software products also enable our customers to store and process personal data. Perceptions that our products do not adequately protect the privacy of personal information could inhibit sales of our products. We may experience outages and disruptions of our online services if we fail to maintain an adequate operations +infrastructure. Our increasing user traffic and complexity of our products and services demand more computing power. We have spent and expect to continue to spend substantial amounts to purchase or lease data centers and +equipment and to upgrade our technology and network infrastructure to handle increased traffic on our Web sites and to introduce new products and services and support existing services such as Xbox Live, Windows Live, and Office Live. This expansion +is expensive, complex, and could result in inefficiencies or operational failures, which could diminish the quality of our products, services, and user experience, resulting in damage to our reputation and loss of current and potential users, +subscribers, and advertisers, harming our operating results and financial condition. Other risks that may affect our +business. Other factors that may affect our performance may include sales channel disruption, such as the bankruptcy of a major distributor, and our ability to implement operating cost structures that align with revenue +growth. ITEM 1B.    UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of our +fiscal year 2008 that remain unresolved. ITEM 2.    PROPERTIES Our corporate offices consist of approximately 13 million square feet of office space located in King County, Washington: nine million square feet of +owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately four million square feet of space we lease. We own approximately two million square feet of office space +domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately four million square feet of office space. We occupy many sites internationally, totaling approximately two million square feet that is owned and approximately eight million square feet that is leased. Facilities that we own include our +European Operations Center in Dublin, Ireland; the India Development Center in Hyderabad, India; and a facility in Reading, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; Bangalore, India; Dublin, +Ireland; Tokyo, Japan; Mississauga, Canada; Taipei, Taiwan; Seoul, Korea; Sydney, Australia; and Milan, Italy. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, a facility in +Singapore for our Asia Pacific Operations Center and Regional headquarters, and various product development facilities, both domestically and internationally, as described in the “Product Development” section above. Our facilities are fully used for current operations of all segments, and suitable additional spaces are available to accommodate expansion needs. +We have a development agreement with the City of Redmond under which we may currently develop approximately 850,000 square feet of additional facilities at our corporate campus in Redmond, Washington. In addition, we own 63 acres of undeveloped land +in Issaquah, Washington, that can accommodate approximately one million square feet of office space. PAGE 17 Table of Contents Part I Item 3, 4 ITEM 3.    LEGAL PROCEEDINGS In March 2004, the European Commission issued a +competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we +proposed for licensing the technology as required by the March 2004 decision were “not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in compliance +with the March 2004 decision and that no further penalty should be imposed from that date. In February 2008, the Commission issued a fine of $1.4 billion ( € 899 +million) related to the period prior to October 22, 2007. In May 2008, we filed an application with the European Court of First Instance to annul the fine. See Note 15 – Contingencies of the Notes to Financial Statements (Part II, Item 8) for information about legal proceedings in which we are involved. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of fiscal year 2008. PAGE 18 Table of Contents Part II Item 5 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER +PURCHASES OF EQUITY SECURITIES Our common stock is traded on The NASDAQ Stock Market under the symbol MSFT. On July 28, 2008, there were +145,903 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Year Fiscal year 2008 Common stock price per share: High $ 31.84 $ 37.50 $ 35.96 $ 32.10 $ 37.50 Low 27.51 29.29 26.87 27.11 26.87 Fiscal year 2007 Common stock price per share: High $ 27.52 $ 30.26 $ 31.48 $ 31.16 $ 31.48 Low 22.23 27.15 26.60 27.56 22.23 See Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8) for +information regarding dividends approved by our Board of Directors in fiscal years 2008 and 2007. On July 20, 2006, we announced +that our Board of Directors authorized two new share repurchase programs: a $20.0 billion tender offer which was completed on August 17, 2006; and authorization for up to an additional $20.0 billion ongoing share repurchase program that expires +on June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On August 18, 2006, we +announced that the authorization for the $20.0 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a result, we were authorized to repurchase additional shares in an amount up to $36.2 billion through +June 30, 2011. The repurchase program may be suspended or discontinued at any time without prior notice. The transactions occurred in open market purchases and pursuant to a trading plan under Rule 10b5-1. We repurchased common stock in each +quarter of fiscal year 2008 using available cash resources as follows: Period Total number of shares purchased Average price paid per share July 1, 2007 – September 30, 2007 80,597,986 $ 29.14 October 1, 2007 – December 31, 2007 119,614,762 $ 34.12 January 1, 2008 – March 31, 2008 30,160,464 $ 33.82 April 1, 2008 – June 30, 2008 171,474,350 $ 29.01 Total share repurchases in fiscal year 2008 401,847,562 Common stock repurchases in the fourth quarter of fiscal year 2008 were as follows: Period (a) Total number of shares purchased (b) Average price paid per share (c) Total number of shares purchased as part of publicly announced plans or programs (d) Approximate dollar value of shares that may yet be purchased under the plans or programs (in millions) April 1, 2008 – April 30, 2008 – $ – – $ 7,688 May 1, 2008 – May 31, 2008 82,151,000 $ 29.77 82,151,000 $ 5,243 June 1, 2008 – June 30, 2008 89,323,350 $ 28.31 89,323,350 $ 2,714 171,474,350 171,474,350 PAGE 19 Table of Contents Part II Item 6 ITEM 6.    SELECTED +FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Fiscal Year Ended June 30, 2008 2007 2006 2005 2004 Revenue $ 60,420 $ 51,122 $ 44,282 $ 39,788 $ 36,835 Operating income $ 22,492 $ 18,524 $ 16,472 $ 14,561 $ 9,034 Net income $ 17,681 $ 14,065 $ 12,599 $ 12,254 $ 8,168 Diluted earnings per share $ 1.87 $ 1.42 $ 1.20 $ 1.12 $ 0.75 Cash dividends declared per share $ 0.44 $ 0.40 $ 0.35 $ 3.40 $ 0.16 Cash, cash equivalents, and short-term investments $ 23,662 $ 23,411 $ 34,161 $ 37,751 $ 60,592 Total assets $ 72,793 $ 63,171 $ 69,597 $ 70,815 $ 94,368 Long-term obligations $ 6,621 $ 8,320 $ 7,051 $ 5,823 $ 4,574 Stockholders’ equity $ 36,286 $ 31,097 $ 40,104 $ 48,115 $ 74,825 PAGE 20 Table of Contents Part II Item 7 ITEM 7.     +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS FOR FISCAL YEARS 2008, 2007, AND 2006 OVERVIEW The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial +condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements (“Notes”). We generate revenue by developing, manufacturing, licensing, and supporting a wide range of +software products and services for many different types of computing devices. Our software products and services include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing +environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product support services, and we train and +certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through +Live Search, Windows Live, Office Live, our MSN portals and channels, and the Microsoft Online Services platform which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint +Online. We enable the delivery of online advertising across our broad range of digital media properties and on Live Search through our proprietary adCenter® platform. Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and +holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and +Devices Division has generated over 40% of its yearly segment revenues in our second fiscal quarter. In fiscal year 2007, our revenue was highest in the third quarter due to the recognition of $1.7 billion of revenue previously deferred from the +Express Upgrade to Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with +free or discounted rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers. We +intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary +challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security, and value of Windows operating systems and to develop operating system versions targeted at emerging markets. We also +are increasing our focus on selling our products in emerging markets and reducing the amount of unlicensed software used in those markets. In addition, we continue to develop innovative software applications and solutions that we believe will +enhance the productivity of information workers, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business +amid competition from other vendors of proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – software that is easiest to deploy and manage, and that is most secure – +with the lowest total cost of ownership. We continue to invest in research and development in existing and new lines of business, +including online solutions, business solutions, mobile computing, communication, entertainment, and other areas that we believe may contribute to our long-term growth. We also invest in research and development of advanced technologies for future +software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth. We believe that over the last few years we have laid a foundation for long-term growth by delivering innovative products, creating opportunities for partners, improving customer satisfaction with key +audiences, and improving our internal business processes. Our focus in fiscal year 2009 is to continue to build on this foundation and to continue to execute well in key areas, including continuing to innovate on our integrated software platform, +responding effectively to customer and partner needs, and continuing to focus internally on product excellence, business efficacy, and accountability across the company. PAGE 21 Table of Contents Part II Item 7 Key market opportunities include: Consumer technology. We are focused on delivering consumer +software products that we believe are compelling in terms of design, features, and functionality. We also are working to define the next era of consumer electronics through the development of innovative software that runs on a wide range of devices +and connects people quickly and easily to the information, experiences, and communities they care about. Software plus +services. The ability to combine the power of desktop and server software with the reach of the Internet represents an opportunity across every one of our businesses. We believe our software plus services approach will +enable us to deliver new experiences to end users and new value to businesses. Expanding our presence on the desktop, the server, +and with developers. Through our ability to deliver additional value in security, messaging, systems management, and collaboration, and new technology for high-performance computing, unified communications, and business +intelligence, we believe we are well-positioned to build on our strength with businesses of all sizes and with developers. Fiscal year 2008 saw widespread adoption of Windows Vista and the 2007 Microsoft Office system and the launch of Windows +Server 2008, SQL Server 2008, and Visual Studio 2008. Summary of Results for Fiscal Years 2008, 2007, and 2006 (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Revenue $ 60,420 $ 51,122 $ 44,282 18% 15% Operating income $ 22,492 $ 18,524 $ 16,472 21% 12% Diluted earnings per share $ 1.87 $ 1.42 $ 1.20 32% 18% Fiscal year 2008 compared with fiscal year 2007 Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated +with Windows Server and SQL Server, and increased licensing of Windows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during the year. Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses, increased costs for +legal settlements and legal contingencies, and increased cost of revenue. Headcount-related expenses increased 12%, reflecting an increase in headcount during the year. We incurred $1.8 billion of legal charges during the year primarily related to +the European Commission fine of $1.4 billion ( € 899 million) as compared with $511 million of legal charges during the prior year. Cost of revenue increased $905 +million or 8%, reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. The decreased Xbox 360 costs +reflect the $1.1 billion charge in fiscal year 2007 related to the expansion of our Xbox 360 warranty coverage as discussed below, partially offset by increased Xbox 360 product costs reflecting growth in unit console sales. The diluted earnings per share growth was impacted by the $1.1 billion Xbox 360 charge in fiscal year 2007 and current year share repurchases. Fiscal year 2007 compared with fiscal year 2006 Revenue growth was driven primarily by licensing of the 2007 Microsoft Office system and Windows Vista, increased revenue associated with SQL Server, Windows Server, and Visual Studio, and increased Xbox 360 platform sales. Foreign currency +exchange rates did not have a significant impact on consolidated revenue during the year. Operating income growth was driven +primarily by increased revenue and decreased costs for legal settlements and legal contingencies, partially offset by increased cost of revenue associated with Xbox 360 and Windows Vista, increased OSB data centers costs, and increased sales and +marketing expenses. In July 2007, we expanded our global Xbox 360 warranty coverage to three years from the date of purchase for a general hardware failure indicated by three flashing red lights. As a result, we recorded a $1.1 billion charge in +fiscal year 2007 for anticipated costs under the warranty policy, inventory write-downs, and product returns. The increase in sales and marketing expenses PAGE 22 Table of Contents Part II Item 7 was primarily driven by increased headcount-related expenses and marketing costs related to product launches. Headcount-related expenses increased 18%, driven by an +increase in headcount during the year. Fiscal Year 2009 Outlook Global macroeconomic factors have a strong correlation to demand for our software, services, hardware, and online offerings. In fiscal year 2009, we expect a broad continuation of the economic conditions +and demand we experienced during the latter part of fiscal year 2008. In fiscal year 2009, we expect double digit revenue growth and we estimate PC shipments will grow between 12% and 14%. Within the overall PC market, we expect current trends to +continue with consumer segment growth exceeding that of the business segment and emerging market growth exceeding that of mature markets. SEGMENT +PRODUCT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) amounts in this section are presented on a basis consistent with +U.S. Generally Accepted Accounting Principles (“GAAP”) and include certain reconciling items attributable to each of the segments. The segment information appearing in Note 19 – Segment Information of the Notes to Financial Statements +(Part II, Item 8) is presented on a basis consistent with the Company’s internal management reporting, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an +Enterprise and Related Information . Certain corporate-level activity has been excluded from our segment operating results and is presented separately. Prior period amounts have been recast to conform to the way we internally manage and monitor +performance at the segment level during the current period. Client (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Revenue $ 16,865 $ 14,976 $ 13,107 13% 14% Operating income $ 13,052 $ 11,467 $ 10,208 14% 12% Client offerings consist of premium and standard edition Windows operating systems. Premium editions are +those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, Windows Vista Enterprise, Windows XP Professional, +Windows XP Media Center Edition, and Windows XP Tablet PC Edition. Standard editions include Windows Vista Home Basic and Windows XP Home. Client revenue growth generally correlates with the growth of PC purchases from OEMs that pre-install versions +of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The differences between unit growth rates and revenue growth rates from year to year are affected by changes in the mix of OEM Windows operating +systems licensed with premium edition operating systems as a percentage of total OEM Windows operating systems licensed (“OEM premium mix”), changes in the geographical mix, and changes in the channel mix of products sold by large, +multi-national OEMs versus those sold by local and regional system builders. Fiscal year 2008 compared with fiscal year 2007 Client revenue increased reflecting growth in licensing of Windows Vista. By the end of fiscal year 2008, more than 180 million Windows Vista licenses had +been sold (approximately 130 million were sold during fiscal year 2008) and millions of enterprise seats had been deployed. OEM revenue increased $1.7 billion or 13%, driven by 16% growth in OEM license units. Revenue from commercial and retail +licensing of Windows operating systems increased $209 million or 8%, primarily from Enterprise Agreements and anti-piracy efforts in emerging markets. During the year, the OEM premium mix increased seven percentage points to 74%, reflecting strong +demand for Windows Vista Home Premium. Based on our estimates, total worldwide PC shipments from all sources grew approximately 12% to 14%, driven by demand in both emerging and mature markets. PAGE 23 Table of Contents Part II Item 7 Client operating income increased reflecting increased revenue, partially offset by increased sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $149 million or 10%, primarily reflecting increased +expenses associated with our corporate sales force. Cost of revenue increased $115 million or 13%, primarily driven by Windows Vista product costs. Fiscal year 2007 compared with fiscal year 2006 Client revenue increased primarily reflecting licensing of Windows Vista. OEM +revenue increased $1.4 billion or 13% driven by 13% growth in OEM license units while revenue from commercial and retail licensing of Windows operating systems increased $447 million or 22%. During the year, the OEM premium mix increased 15 +percentage points to 67%. We estimate total worldwide PC shipments from all sources grew 10% to 12% driven by demand in both emerging and mature markets. Client operating income increased reflecting the increased revenue and decreased research and development costs, partially offset by increased Windows Vista product costs and sales and marketing expenses for launch-related +programs. The decrease in research and development expenses reflected the capitalization of certain Windows Vista software development costs and completion of product development on Windows Vista. Headcount-related expenses decreased 7%, primarily +driven by a decrease in headcount during the year. Fiscal Year 2009 Outlook We expect PC market growth will exceed Client revenue growth. We believe PC unit growth rates will be higher in the consumer segment than in the business segment and higher in emerging markets than in +mature markets. Server and Tools (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Revenue $ 13,170 $ 11,171 $ 9,665 18% 16% Operating income $ 4,593 $ 3,643 $ 2,868 26% 27% Server and Tools concentrates on licensing products, applications, tools, content, and services that make +information technology professionals and developers more productive and efficient. Server and Tools offerings consist of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, and other server +products. We also offer developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. Server products can be run on-site, in a hosted environment, or in a Web-based +environment. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. We sell licenses both as one-time licenses and as multi-year volume licenses. Fiscal year 2008 compared with fiscal year 2007 Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of $464 million or four percentage points. Server and server application revenue +(including CAL revenue) and developer tools revenue increased $1.4 billion or 15%, primarily driven by growth in volume licensing of Windows Server and SQL Server products. This growth reflects broad adoption of the Windows Platform and applications +with the releases of Windows Server 2008 and Visual Studio 2008 during the fiscal year. Consulting and Premier and Professional product support services revenue increased $593 million or 29%, primarily due to higher demand for consulting and support +services by corporate enterprises. Server and Tools operating income increased primarily due to growth in high-margin product +revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $475 million or 14%, due to higher expenses associated with our corporate sales +force. Cost of revenue increased $394 million or 18%, reflecting the growth in Consulting and Premier and PAGE 24 Table of Contents Part II Item 7 Professional product support services. Research and development expenses increased $183 million or 11%, primarily driven by increased headcount-related expenses. +Headcount-related expenses increased 8%, driven by an increase in headcount during the year. Fiscal year 2007 compared with fiscal year 2006 Server and server application revenue (including CAL revenue) and developer tools, training, and certification revenue increased $1.1 billion or +13%, and included a favorable impact from foreign currency exchange rates of $168 million or two percentage points. The increase in server and server application revenue was primarily driven by increased revenue associated with SQL Server, Windows +Server, and Visual Studio. The results reflect broad adoption of Windows Server products, especially SQL Server which grew over 20%. Consulting and Premier and Professional product support services revenue increased $428 million or 26%, primarily +due to higher demand for Premier services by corporate enterprises. Server and Tools operating income increased reflecting the +increased revenue, partially offset by growth in headcount-related expenses and cost of revenue for services. Headcount-related expenses increased 14%, driven by an increase in headcount during the year. Cost of revenue increased $260 million or +14%, reflecting growth in Consulting and Premier and Professional product support services. Fiscal Year 2009 Outlook We expect continued growth in both product and services revenue driven by strong customer demand for the recently released Windows Server 2008 and Visual Studio +2008 and upcoming release of SQL Server 2008. Online Services Business (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Revenue $ 3,214 $ 2,441 $ 2,296 32 % 6 % Operating income (loss) $ (1,233 ) $ (617 ) $ 5 (100 )% * * Not meaningful Online Services Business +(“OSB”) consists of an on-line advertising platform with offerings for both publishers and advertisers, personal communications services such as email and instant messaging, online information offerings such as Live Search, and the MSN +portals and channels around the world. We earn revenue primarily from online advertising, including search, display, and email and messaging services. Revenue is also generated through subscriptions and transactions generated from online paid +services, from advertiser and publisher tools, digital marketing and advertising agency services, and from MSN narrowband Internet access subscribers. We continue to launch new online offerings and expect to do so in the future. During fiscal year +2008, we launched new releases of Windows Live Search, the Windows Live suite of applications and services, and updated our MSN Video Service. In addition, we launched a new release of adCenter and expanded our advertising platform portfolio. During the first quarter of fiscal year 2008, we completed our acquisition of aQuantive, Inc. (“aQuantive”), a digital +marketing business which we expect will play a key role in the development of our advertising business. aQuantive earns revenue from online advertising and from digital marketing and advertising agency services. We believe the acquisition will help +us build and support next-generation advertiser and publisher solutions in environments such as cross-media planning, video-on-demand, and Internet protocol television. aQuantive was consolidated into our results of operations starting +August 10, 2007, the acquisition date. Proposed Acquisition of Yahoo! Inc. To accelerate our advertising strategy, during fiscal year 2008 we submitted a proposal to the Yahoo! Inc. board of directors to acquire all of the outstanding shares of Yahoo!. After careful +consideration, we determined that the price demanded by Yahoo! was not in the best interest of our shareholders and we withdrew our proposal to acquire the PAGE 25 Table of Contents Part II Item 7 company. Subsequently, we submitted several proposals to purchase Yahoo!’s search business and make an investment in Yahoo!, all of which were rejected by +Yahoo!. We continue to invest heavily in new tools, Web experiences, improved search performance, and advertiser satisfaction, and we will continue to seek to build our scale through organic growth, partnerships, and strategic acquisitions. Fiscal year 2008 compared with fiscal year 2007 OSB revenue increased driven by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $553 million or 31%, to $2.3 billion. This +increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $161 million. Agency revenue, which is solely derived from aQuantive, was $345 million during the year. Access revenue +decreased $98 million or 28%, to $256 million, reflecting migration of subscribers to broadband or other competitively-priced service providers. As of June 30, 2008, we estimate we had approximately 460 million Windows Live IDs compared +with 382 million as of the same date last year. OSB operating loss increased driven by increased cost of revenue and other +operating expenses, partially offset by increased revenue. Cost of revenue increased $796 million or 71%, primarily driven by increased data center and equipment costs, online content expenses, and aQuantive-related expenses. Sales and marketing +expenses increased $300 million or 35%, primarily due to increased amortization of customer-related intangible assets of $94 million, increased headcount-related expenses, and increased marketing costs. Research and development expenses increased +$177 million or 18%, and general and administrative expenses increased $117 million or 175%, primarily reflecting increased headcount-related expenses and merger and acquisition-related expenses. Headcount-related expenses increased 24%, driven by +an increase in headcount during the year. Fiscal year 2007 compared with fiscal year 2006 OSB revenue increased driven primarily by advertising revenue which grew $283 million or 19%, to $1.8 billion. This increase was primarily due to growth in +advertising for search, home page, email, and messaging services. The increase in advertising revenue was partially offset by a $156 million or 31% decrease in access revenue. OSB operating loss increased driven primarily by increased cost of revenue which grew $336 million or 42%, and increased headcount-related expenses as a result of continued search and advertising platform +investments. The increase in cost of revenue was primarily driven by increased data center costs, online content expenses, and royalties. Headcount-related expenses increased 31%, driven by an increase in headcount during the year. Fiscal Year 2009 Outlook We expect revenue, including +advertising revenue, to increase in fiscal year 2009 as we begin to see returns from investments we have made, including our acquisition of aQuantive. We also expect operating expenses to increase as we continue to invest in our long-term strategy. Microsoft Business Division (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Revenue $ 18,932 $ 16,402 $ 14,465 15 % 13 % Operating income $ 12,358 $ 10,777 $ 9,534 15 % 13 % Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft +Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office +system offerings, which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as enterprise content management, +collaboration, unified communications, and business intelligence. Microsoft PAGE 26 Table of Contents Part II Item 7 Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small +and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through +volume licensing agreements and Microsoft Dynamics revenue, and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. In April 2008, we completed our acquisition of Fast Search & Transfer ASA +(“FAST”), an enterprise search company. We believe the acquisition will broaden our enterprise search technology product offerings to businesses and will enable innovations in related areas such as our portal and content management. Fiscal year 2008 compared with fiscal year 2007 MBD revenue increased reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of $724 million or four percentage points. Business revenue increased $2.6 billion +or 21%, primarily as a result of growth in volume licensing agreement revenue and strong transactional license sales to businesses. The increase in business revenue also included a 21% increase in Microsoft Dynamics customer billings. Consumer +revenue decreased $80 million or 2%, reflecting the consumer launch of the 2007 Microsoft Office system in the prior fiscal year. MBD +operating income increased reflecting growth in revenue, partially offset by increased sales and marketing expenses, research and development expenses, and cost of revenue. Sales and marketing expenses increased $462 million or 13%, reflecting +increased expenses associated with our corporate sales force. Research and development expenses increased $228 million or 18%, primarily driven by an increase in headcount-related expenses and a $35 million in-process research and development +expense related to the acquisition of FAST. Cost of revenue increased $225 million or 29%, primarily driven by an increase in online services infrastructure costs and product costs related to retail packaged product sales. Headcount-related expenses +increased 10%, driven by an increase in headcount during the year. Fiscal year 2007 compared with fiscal year 2006 MBD revenue increased primarily reflecting licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency exchange rates of +$247 million or two percentage points. Revenue from consumer sales increased $339 million or 10% while revenue from business sales increased $1.6 billion or 15%. The increase in business revenue included a 21% increase in Microsoft Dynamics customer +billings. MBD operating income increased reflecting the increased revenue, partially offset by increased sales and marketing expenses +and cost of revenue primarily associated with the 2007 Microsoft Office system. The increase in sales and marketing expenses reflected increased headcount-related expenses, increased sales support costs from our Enterprise Software Advisor channel +partners, and increased launch-related marketing expenses. Headcount-related expenses increased 8%, driven by an increase in headcount during the year. Fiscal Year 2009 Outlook We expect revenue to continue to increase over the prior year due to the strong performance of the 2007 +Microsoft Office system and business demand for other applications. Fiscal year 2009 represents an important year in delivering on our software plus services strategy with the upcoming releases of Exchange Online, SharePoint Online, and Office +Communication Server Online. Entertainment and Devices Division (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Revenue $ 8,140 $ 6,069 $ 4,732 34% 28 % Operating income (loss) $ 426 $ (1,969 ) $ (1,339 ) * (47 )% * Not meaningful PAGE 27 Table of Contents Part II Item 7 Entertainment and Devices Division (“EDD”) offerings include the Xbox 360 platform (which includes the Microsoft Xbox video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), the Zune digital music +and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), the Surface computing platform, mobile and embedded device platforms, and other devices. EDD leads the development +efforts for our line of consumer software and hardware products including application software for Macintosh computers and Microsoft PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows +operating systems. In April 2008, we acquired Danger, Inc. (“Danger”), a software-as-a-service company that provides mobile operators with an integrated end-to-end solution to deliver mobile data and Internet services to their subscribers. Fiscal year 2008 compared with fiscal year 2007 EDD revenue increased primarily due to increased Xbox 360 platform sales. Xbox 360 platform and PC game revenue increased $1.7 billion or 41% as a result of increased Xbox 360 console sales, video game sales led by Halo 3, Xbox Live +revenue, and Xbox 360 accessory sales. We shipped 8.7 million Xbox 360 consoles during fiscal year 2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007. EDD operating income increased primarily due to increased revenue and decreased cost of revenue, partially offset by increased research and +development expenses and sales and marketing expenses. Cost of revenue decreased $683 million or 13%, reflecting the impact of the $1.1 billion Xbox 360 charge in fiscal year 2007 (which primarily related to the warranty expansion), partially offset +by increased Xbox 360 product costs related to increased unit console sales. Research and development expenses increased $242 million or 18%, primarily reflecting increased headcount-related expenses and costs related to the acquisition of Danger, +including a $24 million in-process research and development expense. Sales and marketing expenses increased $93 million or 8%, primarily reflecting increased headcount-related expenses and increased bad debt expense. Headcount-related expenses +increased 21%, driven by an increase in headcount during the year. Fiscal year 2007 compared with fiscal year 2006 EDD revenue increased primarily due to increased Xbox 360 platform and Zune sales. We shipped 6.6 million Xbox 360 consoles during fiscal year 2007 as +compared to 5.0 million consoles during fiscal year 2006. Xbox and PC game revenue increased $650 million or 19% as a result of increased Xbox 360 platform sales, partially offset by decreased sales of the first generation Xbox console and +related accessories and video games. Zune, consumer hardware and software, and Mediaroom revenue increased $539 million or 65% primarily driven by the Zune launch in November 2006. EDD operating loss increased primarily due to the $1.1 billion Xbox 360 charge recognized in the fourth quarter of fiscal year 2007 and Zune +launch-related expenses. The increase in operating loss was partially offset by increased Xbox 360 platform sales and decreased Xbox 360 console manufacturing costs. Headcount-related expenses increased 14%, driven by an increase in headcount during +the year. Fiscal Year 2009 Outlook We +expect revenue to be flat or to decrease due to year-over-year variations in product launches, volume, mix, and prices across our portfolio of products and services. We expect sustained profitability for fiscal year 2009. Corporate-Level Activity (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Corporate-level activity $ (6,704 ) $ (4,777 ) $ (4,804 ) (40)% 1% Certain corporate-level activity, including expenses related to corporate operations associated with +broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, and legal settlements and contingencies, +is not allocated to our segments. PAGE 28 Table of Contents Part II Item 7 Fiscal year 2008 compared with fiscal year 2007 Corporate-level expenses increased during fiscal year 2008, reflecting increased +costs for legal settlements and legal contingencies and a 12% increase in headcount-related expenses. We incurred $1.8 billion of legal charges during the year primarily related to the European Commission fine of $1.4 billion ( € 899 million) as compared with $511 million of legal charges during the prior year. The increase in headcount-related expenses reflects an increase in headcount during +the year. Fiscal year 2007 compared with fiscal year 2006 Corporate-level expenses increased primarily driven by increased headcount-related expenses offset by decreased costs for legal settlements and legal contingencies. Headcount-related expenses increased 25%, driven by an +increase in headcount and an increase in salaries and benefits for existing headcount. We incurred $511 million in legal charges during fiscal year 2007, primarily related to antitrust and unfair competition consumer class actions, intellectual +property claims, and an extension payment to Sun Microsystems, Inc. under our Limited Patent Covenant and Standstill Agreement. We incurred $1.3 billion in legal charges during fiscal year 2006 which included settlement expense of $361 million +related to our settlement with RealNetworks, Inc. as well as other intellectual property and antitrust matters, a $351 million ( € 281 million) fine imposed +by the European Commission in July 2006 related to its 2004 decision in its competition law investigation of Microsoft, and an extension payment to Sun Microsystems, Inc. Operating Expenses Cost of Revenue (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Cost of revenue $ 11,598 $ 10,693 $ 7,650 8 % 40 % As a percent of revenue 19 % 21 % 17 % (2 )ppt 4 ppt Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, +operating costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the +delivery of consulting services, and the amortization of capitalized research and development costs associated with software products that have reached technological feasibility. Cost of revenue increased in fiscal year 2008, reflecting increased +data center and equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. Xbox 360 costs decreased because of the $1.1 billion charge in fiscal +year 2007 (which primarily related to the expansion of our Xbox 360 warranty coverage), partially offset by increased Xbox 360 product costs, reflecting growth in unit console sales. Cost of revenue increased in fiscal year 2007, primarily driven by +the Xbox 360 warranty charge, increased Windows Vista product costs, increased OSB data center costs, and costs associated with the growth in consulting services. Research and Development (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Research and development $ 8,164 $ 7,121 $ 6,584 15 % 8 % As a percent of revenue 14 % 14 % 15 % – ppt (1 )ppt PAGE 29 Table of Contents Part II Item 7 Research +and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and +programming costs, localization costs incurred to translate software for international markets, the amortization of purchased software code and services content, and in-process research and development. Research and development expenses increased +during fiscal year 2008 reflecting increased headcount-related expenses, increased product development costs, and in-process research and development expenses related to acquisitions during the year. Headcount-related expenses increased 12% during +fiscal year 2008, reflecting an increase in headcount during the year. Research and development costs increased during fiscal year 2007, primarily due to increased headcount-related expenses which grew 8%, reflecting growth in headcount during the +year. Sales and Marketing (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Sales and marketing $ 13,039 $ 11,455 $ 9,818 14 % 17 % As a percent of revenue 22 % 22 % 22 % – ppt – ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased during fiscal year 2008, primarily reflecting increased +headcount-related expenses and increased corporate marketing and advertising campaigns. Headcount-related expenses increased 14% during fiscal year 2008, reflecting an increase in headcount during the year. Sales and marketing expenses increased +during fiscal year 2007 primarily because of increased headcount-related expenses and increased marketing costs related to product launches. Headcount-related expenses increased 22% during fiscal year 2007, driven by an increase in headcount during +the year. General and Administrative (In millions, except percentages) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 General and administrative $ 5,127 $ 3,329 $ 3,758 54 % (11 )% As a percent of revenue 8 % 7 % 8 % 1 ppt (1 )ppt General and administrative costs include payroll, employee benefits, stock-based compensation expense and +other headcount-related expenses associated with finance, legal, facilities, certain human resources, other administrative headcount, and legal and other administrative fees. General and administrative expenses increased during fiscal year 2008, +reflecting increased costs for legal settlements and legal contingencies, increased consulting and professional fees, and increased headcount-related expenses. We incurred $1.8 billion of legal charges during fiscal year 2008, primarily related to +the European Commission fine of $1.4 billion ( € 899 million) as compared with $511 million of legal charges during fiscal year 2007. Headcount-related expenses +increased 7% during fiscal year 2008, reflecting an increase in headcount during the year. During fiscal year 2007, we incurred $511 million of legal charges primarily related to antitrust and unfair competition consumer class actions, intellectual +property claims, and extension payment to Sun Microsystems, Inc. as compared with $1.3 billion of legal charges in fiscal year 2006. Headcount-related expenses increased 15% during fiscal year 2007, driven by an increase in headcount during the +year. PAGE 30 Table of Contents Part II Item 7 Investment Income and Other The components of investment income and other were as follows: (In millions) 2008 2007 2006 Percentage Change 2008 versus 2007 Percentage Change 2007 versus 2006 Dividends and interest $ 888 $ 1,319 $ 1,510 (33)% (13)% Net recognized gains on investments 346 650 161 (47)% 304% Net gains (losses) on derivatives 226 (358 ) (99 ) * 262% Other (138 ) (34 ) 218 306% * Investment income and other $ 1,322 $ 1,577 $ 1,790 (16)% (12)% * Not meaningful Fiscal year 2008 compared +with fiscal year 2007 Dividends and interest income decreased reflecting lower interest rates on our fixed-income investments and a reduction in +the average balance of interest-bearing investments owned. Net recognized gains on investments, which include other-than-temporary impairments of $312 million during fiscal year 2008 and $25 million during fiscal year 2007, decreased primarily due +to declines in equity values as a result of the recent stock market decline. Net gains on derivatives increased primarily due to higher net gains on equity, commodity, and interest rate derivatives. Other of $138 million includes the correction of +several immaterial items from prior periods. Fiscal year 2007 compared with fiscal year 2006 Dividends and interest income declined reflecting a decline in the average balance of dividend and interest-bearing investments owned, partly offset by higher +interest rates received on our fixed-income investments. Net recognized gains on investments, which include other-than-temporary impairments of $25 million during fiscal year 2007 and $408 million in fiscal year 2006, increased primarily due to +lower other-than-temporary impairments and gains on sales of fixed-income investments as compared to losses in fiscal year 2006, partly offset by fewer gains on the sale of equity investments. Derivative losses were primarily driven by net losses in +time value on foreign currency contracts used to hedge anticipated foreign currency revenues. Other in fiscal year 2006 includes $195 million of gains that resulted from the restructuring of joint venture relationships between Microsoft and NBC +related to MSNBC Cable L.L.C. and MSNBC Interactive News, L.L.C. Investments are considered to be impaired when a decline in fair +value is judged to be other-than-temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, among other factors, we +evaluate general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider specific adverse conditions related to the financial health of and business +outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a decline in fair value is determined to be other-than-temporary, an impairment +charge is recorded and a new cost basis in the investment is established. We lend certain fixed-income and equity securities to +increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the creditworthiness of the borrower. Cash +collateral is recorded as an asset with a corresponding liability. We use derivative instruments to manage exposures to interest +rates, equity prices, and foreign currency markets and to facilitate portfolio diversification. Gains and losses arising from derivatives not designated as accounting hedges are in large part economically offset by unrealized losses and gains, +respectively, in the underlying securities which are recorded as a component of other comprehensive income. PAGE 31 Table of Contents Part II Item 7 Income Taxes Our effective tax rates for fiscal years 2008, 2007, and 2006 were 26%, 30%, and 31%, respectively. Our +effective tax rates are less than the statutory tax rate due to foreign earnings taxed at lower rates. The decreased rate in fiscal year 2008 resulted from resolution of tax positions related to our settlement with the Internal Revenue Service +(“IRS”) for its 2000-2003 examination. This decline was partially offset by the tax effect of the European Commission fine of $1.4 billion ( € 899 million), +which was not tax deductible. The fiscal year 2007 rate reflects a recurring effective tax rate of 31%, offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable +developments in an IRS position and multiple foreign audit assessments. During fiscal year 2006, we recorded a tax benefit of $108 million from the resolution of state audits and recorded a charge of $351 million ( € 281 million) from the European Commission fine which was not tax deductible. On July 1, 2007, we adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”) Accounting for Uncertainty in Income Taxes – an +interpretation of FASB Statement No. 109 , which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Adopting FIN 48 had the following impact on our +financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and our retained deficit by $395 million; and decreased our income taxes payable by $394 million. As of +June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if +recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. Interest totaled $121 million in fiscal year 2008. As of June 30, 2008 and July 1, +2007, we had accrued interest related to uncertain tax positions of $324 million and $863 million, respectively, net of federal income tax benefits, on our balance sheets. Financial Condition Cash, cash equivalents, and short-term investments totaled $23.7 billion and +$23.4 billion as of June 30, 2008 and 2007, respectively. Equity and other investments were $6.6 billion and $10.1 billion as of June 30, 2008 and 2007, respectively. Our investments consist primarily of fixed-income securities, +diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S.-dollar-denominated securities, but also includes foreign-denominated securities in order +to diversify financial risk. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $26.6 billion at June 30, 2008. +Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position. In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to price positions. This pricing methodology applies to exchange-traded mutual funds, +domestic and international equities, U.S. treasuries, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to price positions, then we use inputs other than the quoted prices that are +observable either directly or indirectly. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio. While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of June 30, 2008 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. +The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and +Government National Mortgage Association. The remainder of the mortgage position is collateralized by high quality international prime residential mortgage loans. Unearned Revenue Unearned revenue is comprised of the following items: Volume licensing programs – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the beginning of each +billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. PAGE 32 Table of Contents Part II Item 7 Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. This revenue deferral is +applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to original equipment manufacturers (“OEM”), and perpetual licenses for current products under our Open and Select volume licensing +programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as +unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home and approximately 5% to 15% of the sales price for Windows XP Professional, depending on the terms and conditions of the license and +prices of the elements. Product life cycles are currently estimated at three and one-half years for Windows operating systems. Other – +Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live subscriptions, +Mediaroom, and other offerings for which we have been paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected recognition of unearned revenue as of June 30, 2008: (In millions) Recognition of Unearned Revenue Three months ended: September 30, 2008 $ 5,120 December 31, 2008 4,033 March 31, 2009 2,775 June 30, 2009 1,469 Thereafter 1,900 Unearned revenue $ 15,297 Cash Flows Fiscal year 2008 compared with fiscal year 2007 Cash flow from operations increased $3.8 billion due to an increase in +cash received from customers driven by 18% revenue growth, partially offset by the $1.4 billion ( € 899 million) payment of the European Commission fine. Cash used +for financing decreased $11.6 billion primarily due to a $15.0 billion decrease in common stock repurchases, partially offset by a $3.3 billion decrease in cash proceeds from the issuance of common stock. Cash used for investing was $4.6 billion for +fiscal year 2008 as compared with cash provided of $6.1 billion for fiscal year 2007. This decrease was primarily due to a $6.9 billion increase in cash paid for acquisition of companies, reflecting the purchase of aQuantive in the first quarter of +fiscal year 2008, a $918 million increase in purchases of property and equipment, and a $3.1 billion decrease in cash from combined investment purchases, sales, and maturities. As a result of our settlement related to the 2000-2003 examination, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009. Fiscal year 2007 compared with fiscal year 2006 Cash +flow from operations increased $3.4 billion due to an increase in cash received from customers driven by 15% revenue growth, along with a $1.6 billion decrease in cash outflow for other current assets primarily reflecting changes in inventory. Cash +used for financing increased $4.0 billion. Several events occurred during fiscal year 2007 affecting cash used for financing. We issued $6.8 billion of common stock, including $3.3 billion related to 113 million call options exercised by +JPMorgan in December 2006. We also completed our tender offer on August 17, 2006, which was included in the $27.6 billion of common stock repurchases. Cash from investing decreased $1.9 billion due to a $3.5 billion decline in securities +lending activity where cash collateral is received from the counterparty along with $1.2 billion spent on acquisitions of companies and additions to property and equipment. These impacts were partially offset by a $2.8 billion increase in net cash +from combined investment purchases, sales, and maturities. PAGE 33 Table of Contents Part II Item 7 We have no material long-term debt. Stockholders’ equity at June 30, 2008, was $36.3 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions +to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $1.2 billion +on June 30, 2008. We have operating leases for most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $398 million, $325 million, and $271 million in fiscal years 2008, 2007, +and 2006, respectively. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. During fiscal years 2008 and 2007, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (in millions) (Fiscal year 2008) September 12, 2007 $ 0.11 November 15, 2007 $ 1,034 December 13, 2007 December 19, 2007 $ 0.11 February 21, 2008 $ 1,023 March 13, 2008 March 17, 2008 $ 0.11 May 15, 2008 $ 1,020 June 12, 2008 June 11, 2008 $ 0.11 August 21, 2008 $ 1,007 September 11, 2008 (Fiscal year 2007) September 13, 2006 $ 0.10 November 16, 2006 $ 980 December 14, 2006 December 20, 2006 $ 0.10 February 15, 2007 $ 978 March 8, 2007 March 26, 2007 $ 0.10 May 17, 2007 $ 952 June 14, 2007 June 27, 2007 $ 0.10 August 16, 2007 $ 938 September 13, 2007 On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board +of Directors on July 20, 2004 to buy back up to $30.0 billion in Microsoft common stock. During fiscal year 2006, we repurchased 754 million shares, or $19.8 billion, of our common stock under this plan. On July 20, 2006, we announced +that our Board of Directors authorized two new share repurchase programs: a $20.0 billion tender offer, which was completed on August 17, 2006; and authorization for up to an additional $20.0 billion ongoing share repurchase program with an +expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On +August 18, 2006, we announced that the authorization for the $20.0 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a result, we were authorized to repurchase additional shares in an amount up to +$36.2 billion through June 30, 2011. As of June 30, 2008, approximately $2.7 billion remained of the $36.2 billion approved repurchase amount. We believe existing cash, cash equivalents, and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, and planned share +repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, as well as equity and other investments, reflects our views on potential future capital requirements related to +research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in +view of our current and potential future needs. Off-Balance Sheet Arrangements and Contractual Obligations We provide indemnifications of varying scope and amount to certain customers against claims of intellectual property infringement made by third parties arising +from the use of our products. We evaluate estimated losses for these indemnifications under SFAS No. 5, Accounting for Contingencies , as interpreted by FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure +Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others . We consider factors such as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, +we have not encountered material costs as a result of these obligations and have not accrued any material liabilities related to these indemnifications in our financial statements. PAGE 34 Table of Contents Part II Item 7 Contractual Obligations The following table summarizes our outstanding contractual obligations as of June 30, 2008: (In millions) Payments due by period Fiscal Years 2009 2010-2012 2013-2015 2016 and thereafter Total Long-term debt $ – $ – $ – $ – $ – Construction commitments (1)(2) 1,226 – – – 1,226 Lease obligations: Capital leases – 1 – – 1 Operating leases (3) 440 831 522 415 2,208 Purchase commitments (2) 2,520 5 – – 2,525 Other long-term liabilities (4) 196 105 – – 301 Total contractual obligations (5) $ 4,382 $ 942 $ 522 $ 415 $ 6,261 (1) We have certain commitments for the construction of buildings. We expect to fund these commitments with existing cash and cash flows from operations. (2) The amounts presented as purchase and construction commitments include all known open purchase orders and all known contracts that are take-or-pay contracts. We expect to +fund these commitments with existing cash and cash flows from operations. (3) Our future minimum rental commitments under noncancellable leases comprise the majority of the operating lease obligations presented above. We expect to fund these +commitments with existing cash and cash flows from operations. (4) We have excluded long-term tax contingencies and other tax liabilities of $3.8 billion and other long-term contingent liabilities of approximately $500 million (related to +the antitrust and unfair competition class action lawsuits) from the amounts presented as the amounts that will be settled in cash are not known. We have also excluded non-cash items of $77 million and unearned revenue of $1.9 billion. (5) We have excluded $3.1 billion of current taxes payable from the amounts presented. This amount was paid to the IRS during the first quarter of fiscal year 2009 as a result +of our settlement related to the 2000-2003 examination. RECENTLY ISSUED ACCOUNTING STANDARDS Recently Adopted Accounting Pronouncements On +July 1, 2007, we adopted FIN 48 which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Under FIN 48, we may recognize the tax benefit from an +uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from +such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of +current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Upon adoption, we recognized a $395 million charge to our beginning retained deficit as a +cumulative effect of a change in accounting principle. See Note 11 – Income Taxes of the Notes to Financial Statements (Part II, Item 8). On July 1, 2007, we adopted Emerging Issues Task Force Issue No. 06-2 (“EITF 06-2”), Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 . EITF 06-2 +requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. Upon adoption, we recognized a $17 million charge to our beginning retained deficit as a cumulative +effect of a change in accounting principle. PAGE 35 Table of Contents Part II Item 7 Recent Accounting Pronouncements Not Yet Adopted In March 2008, the FASB issued SFAS No. 161, Disclosures about +Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133, which requires additional disclosures about the objectives of the derivative instruments and hedging activities, the method of accounting for such +instruments under SFAS No. 133 and its related interpretations, and a tabular disclosure of the effects of such instruments and related hedged items on our financial position, financial performance, and cash flows. SFAS No. 161 is +effective for us beginning January 1, 2009. We are currently assessing the potential impact that adoption of SFAS No. 161 may have on our financial statements. In December 2007, the FASB issued SFAS No. 141R, Business Combinations , which replaces SFAS No. 141. The statement retains the purchase method of accounting for acquisitions, but requires +a number of changes, including changes in the way assets and liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of +in-process research and development at fair value, and requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning July 1, 2009 and will apply prospectively to business combinations +completed on or after that date. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated +Financial Statements, an amendment of ARB No. 51, which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity +separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be +included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in earnings. SFAS No. 160 +is effective for us beginning July 1, 2009 and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively. We are currently assessing the potential impact that adoption of SFAS +No. 160 may have on our financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for +Financial Assets and Financial Liabilities . SFAS No. 159 gives us the irrevocable option to carry many financial assets and liabilities at fair values, with changes in fair value recognized in earnings. SFAS No. 159 is effective for us +beginning July 1, 2008. We do not believe SFAS No. 159 will have a material impact on our financial statements. In +September 2006, the FASB issued SFAS No. 157, Fair Value Measurements , which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value +measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. In February 2008, the FASB issued +FASB Staff Position (“FSP”) 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or +disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 is effective for us beginning July 1, 2008; FSP 157-2 delays the effective date for certain items to July 1, 2009. We do not +believe SFAS No. 157 will have a material impact on our financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. +Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of +accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for contingencies, accounting for income +taxes, accounting for stock-based compensation, and accounting for product warranties. We account for the licensing of software in +accordance with American Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, Software Revenue Recognition . The application of SOP 97-2 requires judgment, including whether a software arrangement includes +multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. For some of our products, customers receive certain PAGE 36 Table of Contents Part II Item 7 elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements +of Microsoft Internet Explorer on a when-and-if-available basis. The fair value of these elements is recognized over the estimated life cycle for the Windows XP and previous PC operating systems. For Windows Vista, there are no significant +undelivered elements and accordingly, no license revenue is deferred for Windows Vista sales. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes +to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to +existing products. SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities , and Staff Accounting +Bulletin Topic 5M, Accounting for Noncurrent Marketable Equity Securities , provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary +impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. +If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. We also consider +specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency actions. Once a +decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. SFAS No. 142, Goodwill and Other Intangible Assets , requires that goodwill be tested for impairment at the reporting unit +level (operating segment or one level below an operating segment) on an annual basis (July 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below +its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition or sale or disposition of a significant portion of a reporting unit. +Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value +of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, +estimation of the long-term rate of growth for our business, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the +determination of fair value and goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if +necessary, reassign goodwill using a relative fair value allocation approach. We account for research and development costs in +accordance with applicable accounting pronouncements, including SFAS No. 2, Accounting for Research and Development Costs , and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise +Marketed . SFAS No. 86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological +feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined +that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, Accounting for +Contingencies , requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount +of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the +degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our results of operations, financial position, or our cash flows. PAGE 37 Table of Contents Part II Item 7 SFAS No. 109, Accounting for Income Taxes , establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or +refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Accruals for uncertain tax positions are provided +for in accordance with the requirements of FIN 48. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, +based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate +settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and +income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially +impact our financial position, results of operations, or cash flows. We account for stock-based compensation in accordance with SFAS +No. 123(R), Share-Based Payment . Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the +requisite service period. Determining the fair value of share-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of share-based awards that are +expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted. We account for product warranties in accordance with SFAS No. 5, Accounting for Contingencies . We provide for the estimated costs of +hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific +product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three +years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the +amounts as necessary. PAGE 38 Table of Contents Part II Item 7 Statement of Management’s Responsibility for Financial Statements Management is responsible for the preparation of the +consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with +accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal +control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining +accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the +consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, +internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal +auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief Executive Officer Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer PAGE 39 Table of Contents Part II Item 7A ITEM 7A.     +QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We are exposed to foreign currency, interest rate, fixed-income, equity, and commodity +price risks. A portion of these risks is hedged, but fluctuations could impact our results of operations, financial position, and cash flows. We hedge a portion of anticipated revenue and accounts receivable exposure to foreign currency +fluctuations, primarily with option contracts. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our foreign currency hedge positions. Principal currencies hedged include the euro, Japanese yen, British pound, +and Canadian dollar. Fixed-income securities and interest rate derivatives are subject primarily to interest rate risk. The portfolio is diversified and structured to minimize credit risk. Securities held in our equity and other investments +portfolio and equity derivatives are subject to price risk, and generally are not hedged. However, we use put-call collars to hedge our price risk on certain equity securities that are held primarily for strategic purposes. Commodity derivatives +held for the purpose of portfolio diversification are subject to commodity price risk. We use a value-at-risk (“VaR”) model +to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses +in fair value, but is used as a risk estimation and management tool. The model used for currencies, equities, and commodities is geometric Brownian motion, which allows incorporation of optionality with regard to these risk exposures. For interest +rate risk, exposures such as key rate durations and spread durations are used in calculations that reflect the principle that fixed-income security prices revert to maturity value over time. VaR is calculated by computing the exposures of each holding’s market value to a range of over 1,000 equity, fixed-income, foreign exchange, +and commodity risk factors. The exposures are then used to compute the parameters of a distribution of potential changes in the total market value of all holdings, taking into account the weighted historical volatilities of the different rates and +prices and the weighted historical correlations among the different rates and prices. The VaR is then calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed +the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, credit risk, and legal risk. Certain securities in our equity portfolio are held for strategic purposes. We hedge the value of a portion of these securities through the use of derivative contracts such as put-call collars. In these +arrangements, we hedge a security’s equity price risk below the purchased put strike and forgo most or all of the benefits of the security’s appreciation above the sold call strike. We also hold equity securities for general investment +return purposes. The VaR amounts disclosed below are used as a risk management tool and reflect an estimate of potential reductions +in fair value of our portfolio. Losses in fair value over the specified holding period can exceed the reported VaR by significant amounts and can also accumulate over a longer time horizon than the specified holding period used in the VaR analysis. +VaR amounts are not necessarily reflective of potential accounting losses, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP. VaR numbers are shown separately for interest rate, currency rate, equity price, and commodity price risks. These VaR numbers include the underlying portfolio positions and related hedges. We use +historical data to estimate VaR. Given the reliance on historical data, VaR is most effective in estimating risk exposures in markets in which there are no fundamental changes or shifts in market conditions. An inherent limitation in VaR is that the +distribution of past changes in market risk factors may not produce accurate predictions of future market risk. The following table +sets forth the one-day VaR for substantially all of our positions as of and for the years ended June 30, 2008 and 2007: (In millions) Year ended June 30, 2008 Risk Categories June 30, 2008 June 30, 2007 Average High Low Interest rates $ 34 $ 34 $ 32 $ 37 $ 25 Currency rates 100 55 93 145 60 Equity prices 45 60 54 60 44 Commodity prices 7 7 6 7 4 Total one-day VaR for the combined risk categories was $123 million at June 30, 2008 +and $95 million at June 30, 2007. The total VaR is 34% less at June 30, 2008, and 39% less at June 30, 2007, than the sum of the separate risk categories in the above table due to the diversification benefit of the overall portfolio. PAGE 40 Table of Contents Part II Item 8 ITEM 8.    FINANCIAL +STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2008 2007 2006 Revenue $ 60,420 $ 51,122 $ 44,282 Operating expenses: Cost of revenue 11,598 10,693 7,650 Research and development 8,164 7,121 6,584 Sales and marketing 13,039 11,455 9,818 General and administrative 5,127 3,329 3,758 Total operating expenses 37,928 32,598 27,810 Operating income 22,492 18,524 16,472 Investment income and other 1,322 1,577 1,790 Income before income taxes 23,814 20,101 18,262 Provision for income taxes 6,133 6,036 5,663 Net income $ 17,681 $ 14,065 $ 12,599 Earnings per share: Basic $ 1.90 $ 1.44 $ 1.21 Diluted $ 1.87 $ 1.42 $ 1.20 Weighted average shares outstanding: Basic 9,328 9,742 10,438 Diluted 9,470 9,886 10,531 Cash dividends declared per common share $ 0.44 $ 0.40 $ 0.35 See accompanying notes. PAGE 41 Table of Contents Part II Item 8 BALANCE +SHEETS (In millions) June 30, 2008 2007 Assets Current assets: Cash and cash equivalents $ 10,339 $ 6,111 Short-term investments (including securities pledged as collateral of $2,491 and $2,356) 13,323 17,300 Total cash, cash equivalents, and short-term investments 23,662 23,411 Accounts receivable, net of allowance for doubtful accounts of $153 and $117 13,589 11,338 Inventories 985 1,127 Deferred income taxes 2,017 1,899 Other 2,989 2,393 Total current assets 43,242 40,168 Property and equipment, net of accumulated depreciation of $6,302 and $5,016 6,242 4,350 Equity and other investments 6,588 10,117 Goodwill 12,108 4,760 Intangible assets, net 1,973 878 Deferred income taxes 949 1,389 Other long-term assets 1,691 1,509 Total assets $ 72,793 $ 63,171 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 4,034 $ 3,247 Accrued compensation 2,934 2,325 Income taxes 3,248 1,040 Short-term unearned revenue 13,397 10,779 Securities lending payable 2,614 2,741 Other 3,659 3,622 Total current liabilities 29,886 23,754 Long-term unearned revenue 1,900 1,867 Other long-term liabilities 4,721 6,453 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 9,151 and 9,380 62,849 60,557 Retained deficit, including accumulated other comprehensive income of $1,140 and $1,654 (26,563 ) (29,460 ) Total stockholders’ equity 36,286 31,097 Total liabilities and stockholders’ equity $ 72,793 $ 63,171 See accompanying notes. PAGE 42 Table of Contents Part II Item 8 CASH +FLOWS STATEMENTS (In millions) Year Ended June 30, 2008 2007 2006 Operations Net income $ 17,681 $ 14,065 $ 12,599 Depreciation, amortization, and other noncash items 2,056 1,440 903 Stock-based compensation 1,479 1,550 1,715 Net recognized gains on investments (572 ) (292 ) (270 ) Excess tax benefits from stock-based payment arrangements (120 ) (77 ) (89 ) Deferred income taxes 935 421 219 Unearned revenue 24,532 21,032 16,453 Recognition of unearned revenue (21,944 ) (19,382 ) (14,729 ) Accounts receivable (1,569 ) (1,764 ) (2,071 ) Other current assets 153 232 (1,405 ) Other long-term assets (98 ) (435 ) (49 ) Other current liabilities (748 ) (552 ) (145 ) Other long-term liabilities (173 ) 1,558 1,273 Net cash from operations 21,612 17,796 14,404 Financing Common stock issued 3,494 6,782 2,101 Common stock repurchased (12,533 ) (27,575 ) (19,207 ) Common stock cash dividends (4,015 ) (3,805 ) (3,545 ) Excess tax benefits from stock-based payment arrangements 120 77 89 Other – (23 ) – Net cash used in financing (12,934 ) (24,544 ) (20,562 ) Investing Additions to property and equipment (3,182 ) (2,264 ) (1,578 ) Acquisition of companies, net of cash acquired (8,053 ) (1,150 ) (649 ) Purchases of investments (20,954 ) (36,308 ) (51,117 ) Maturities of investments 2,597 4,736 3,877 Sales of investments 25,132 41,451 54,353 Securities lending payable (127 ) (376 ) 3,117 Net cash from (used in) investing (4,587 ) 6,089 8,003 Effect of exchange rates on cash and cash equivalents 137 56 18 Net change in cash and cash equivalents 4,228 (603 ) 1,863 Cash and cash equivalents, beginning of period 6,111 6,714 4,851 Cash and cash equivalents, end of period $ 10,339 $ 6,111 $ 6,714 See accompanying notes. PAGE 43 Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2008 2007 2006 Common stock and paid-in capital Balance, beginning of period $ 60,557 $ 59,005 $ 60,413 Common stock issued 3,504 6,783 1,939 Common stock repurchased (3,022 ) (6,162 ) (4,447 ) Stock-based compensation expense 1,479 1,550 1,715 Stock option income tax benefits (deficiencies) 253 (661 ) (617 ) Other, net 78 42 2 Balance, end of period 62,849 60,557 59,005 Retained earnings (deficit) Balance, beginning of period (29,460 ) (18,901 ) (12,298 ) Cumulative effect of a change in accounting principle – adoption of FIN 48 (1) (395 ) – – Cumulative effect of a change in accounting principle – adoption of EITF 06-2 (1) (17 ) – – Net income 17,681 14,065 12,599 Other comprehensive income: Net unrealized gains on derivative instruments 18 14 76 Net unrealized gains (losses) on investments (653 ) 326 (282 ) Translation adjustments and other 121 85 9 Comprehensive income 17,167 14,490 12,402 Common stock cash dividends (4,084 ) (3,837 ) (3,594 ) Common stock repurchased (9,774 ) (21,212 ) (15,411 ) Balance, end of period (26,563 ) (29,460 ) (18,901 ) Total stockholders’ equity $ 36,286 $ 31,097 $ 40,104 (1) See Note 1 of Notes to Financial Statements. See accompanying notes. PAGE 44 Table of Contents Part II Item 8 NOTES TO +FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES ACCOUNTING PRINCIPLES The financial statements and accompanying notes are prepared in accordance +with accounting principles generally accepted in the United States of America. PRINCIPLES OF CONSOLIDATION The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity +investments in which we exercise significant influence but do not control and are not the primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee and +which do not have readily determinable fair values are accounted for under the cost method. ESTIMATES AND ASSUMPTIONS Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. +Examples include estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction +between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating +the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. FOREIGN CURRENCIES Assets and liabilities recorded in +foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are charged or +credited to Other Comprehensive Income (“OCI”). REVENUE RECOGNITION Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. We enter into certain arrangements where we +are obligated to deliver multiple products and/or services (multiple elements). In these arrangements, we generally allocate the total revenue among the elements based on the sales price of each element when sold separately (vendor-specific +objective evidence). Revenue for retail packaged products, products licensed to original equipment manufacturers (“OEMs”), +and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped. A portion of the revenue related to certain products, which include all Windows XP and previous PC +operating systems, is recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the vendor-specific objective evidence of fair value for those elements using the residual method. Under the residual method, the total fair value of +the undelivered elements, as indicated by vendor-specific objective evidence, is recorded as unearned, and the difference between the total arrangement fee and the amount recorded as unearned for the undelivered elements is recognized as revenue +related to delivered elements. Unearned revenue due to undelivered elements is recognized ratably on a straight-line basis over the related product’s life cycle. Revenue related to Windows Vista is not subject to a similar deferral because +there are no significant undelivered elements. Revenue from multi-year licensing arrangements are accounted for as subscriptions, +with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing arrangements include rights to receive future versions of software product on a when-and-if-available basis +under Open and Select volume licensing programs (Software Assurance). In addition, other multi-year licensing PAGE 45 Table of Contents Part II Item 8 arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis +under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions. Revenue related to our Xbox game console and other hardware components is recognized upon shipment of the product to retailers. +Revenue related to games published by us is recognized when those games have been delivered to retailers. Revenue related to games published by third parties for use on the Xbox platform is recognized when games are manufactured by the game +publishers. Online advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting +services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is +recognized as services are provided. Revenue generally is recognized net of any taxes collected from customers and subsequently +remitted to governmental authorities. Costs related to insignificant obligations, including bug fixes and technical support, are +accrued when the related revenue is recognized. Provisions are recorded for estimated returns, concessions, warranties, and bad debts. COST OF +REVENUE Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operating costs related to product +support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, warranty costs, inventory write-downs, costs associated with the delivery of consulting services, and the +amortization of capitalized research and development costs associated with software products that have reached technological feasibility. RESEARCH +AND DEVELOPMENT Research and development expenses include payroll, employee benefits, stock-based compensation, and other headcount-related +expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, the amortization of purchased +software code and services content, and in-process research and development. We have determined that technological feasibility for our software products is reached shortly before the products are released to manufacturing. The amortization of these +costs is included in cost of revenue over the estimated lives of the products. SALES AND MARKETING Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related expenses associated with sales and marketing +personnel, and the cost of advertising, promotions, tradeshows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.2 billion, $1.3 billion, and $1.2 billion in fiscal years 2008, 2007, and 2006, +respectively. PRODUCT WARRANTY We provide +for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, +and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally ranging +from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded +warranty liabilities and adjust the amounts as necessary. PAGE 46 Table of Contents Part II Item 8 STOCK-BASED COMPENSATION We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment . +Under the fair value recognition provisions of this statement, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the applicable vesting period of the stock award +(generally three to five years) using the straight-line method. INCOME TAXES Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain +items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. FINANCIAL INSTRUMENTS We consider all highly liquid interest-earning investments with a maturity of +three months or less at the date of purchase to be cash equivalents. The fair value of these investments approximates their carrying value. In general, investments with original maturities of greater than three months and remaining maturities of +less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that +is available for current operations. All cash equivalents and short-term investments are classified as available for sale and are recorded at market value using the specific identification method. Changes in market value are reflected in OCI +(excluding other-than-temporary impairments). Equity and other investments classified as long-term include both debt and equity +instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Changes in market value are reflected in OCI (excluding other-than-temporary +impairments). All other investments, excluding those accounted for using the equity method, are recorded at cost. We lend certain +fixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest received is determined based upon the underlying security lent and +the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability. Investments are +considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of +our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment. +We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency +actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established. We use derivative instruments to manage exposures to foreign currency, equity price, interest rate and credit risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for +holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The +accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the +period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially +reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow +hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are +recognized in earnings. PAGE 47 Table of Contents Part II Item 8 Foreign Currency Risk. Certain assets, liabilities, and forecasted transactions are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the overall effectiveness of our +foreign currency hedge positions. Options are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments under Statement of Financial Accounting Standards +(“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities . Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Certain non-U.S. dollar denominated securities are +hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments under SFAS No. 133. Certain options and forwards not designated as hedging instruments under SFAS No. 133 are also used to hedge the +impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies and to manage other foreign currency exposures. Equities Price Risk. Equity investments are subject to market price risk. From time to time, we use and designate options to hedge fair values on certain equity securities. We +determine the security selected for hedging by evaluating market conditions, up-front costs, and other relevant factors. Certain options, futures, and swap contracts, not designated as hedging instruments under SFAS No. 133, are also used to +manage equity exposures. Interest Rate Risk. Fixed-income securities are subject to interest rate risk. The +fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. We use exchange-traded option and futures contracts and over-the-counter swap contracts, not designated as hedging instruments under +SFAS No. 133, to hedge interest rate risk. Other Derivatives. Swap contracts, not designated as hedging +instruments under SFAS No. 133, are used to manage exposures to credit risks, enhance returns, and to facilitate portfolio diversification. In addition, we may invest in warrants to purchase securities of other companies as a strategic +investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. “To Be Announced” forward purchase commitments of mortgage-backed assets are also considered +derivatives in cases where physical delivery of the assets is not taken at the earliest available delivery date. All derivative instruments not designated as hedging instruments are recorded at fair value, with changes in value recognized in +earnings during the period of change. ALLOWANCE FOR DOUBTFUL ACCOUNTS The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical +experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) 2008 2007 2006 Year Ended June 30, Balance, beginning of period $ 117 $ 142 $ 171 Charged to costs and expenses 88 64 40 Write-offs and other (52 ) (89 ) (69 ) Balance, end of period $ 153 $ 117 $ 142 INVENTORIES Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities +on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis. PAGE 48 Table of Contents Part II Item 8 PROPERTY AND EQUIPMENT Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of +the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for internal use is depreciated using the straight-line method over the estimated useful life of the software, generally three +years or less. GOODWILL Goodwill is tested +for impairment on an annual basis as of July 1, and between annual tests if indicators of potential impairment exist, using a fair-value-based approach. No impairment of goodwill has been identified during any of the periods presented. INTANGIBLE ASSETS Intangible assets are +amortized using the straight-line method over their estimated period of benefit, ranging from one to ten years. We evaluate the recoverability of intangible assets periodically and take into account events or circumstances that warrant revised +estimates of useful lives or that indicate that impairment exists. All of our intangible assets are subject to amortization. No material impairments of intangible assets have been identified during any of the periods presented. RECENTLY ISSUED ACCOUNTING STANDARDS Recently Adopted +Accounting Pronouncements On July 1, 2007, we adopted the provisions of Financial Accounting Standards Board (“FASB”) +Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a +tax position taken or expected to be taken in a tax return. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing +authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon +ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, +and income tax disclosures. Upon adoption, we recognized a $395 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. See Note 11 – Income Taxes. On July 1, 2007, we adopted Emerging Issues Task Force Issue No. 06-2 (“EITF 06-2”), Accounting for Sabbatical Leave and +Other Similar Benefits Pursuant to FASB Statement No. 43 . EITF 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar benefit arrangement over the requisite service period. Upon adoption, we +recognized a $17 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. Recent Accounting +Pronouncements Not Yet Adopted In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging +Activities, an amendment of FAS 133 , which requires additional disclosures about the objectives of derivative instruments and hedging activities, the method of accounting for those instruments under SFAS No. 133 and its related +interpretations, and a tabular disclosure of the effects of those instruments and related hedged items on our financial position, financial performance, and cash flows. SFAS No. 161 is effective for us beginning January 1, 2009. We are +currently assessing the potential impact that adoption of SFAS No. 161 may have on our financial statements. In December 2007, +the FASB issued SFAS No. 141R, Business Combinations , which replaces SFAS No 141. The statement retains the purchase method of accounting for acquisitions, but requires a number of changes, including changes in the way assets and +liabilities are recognized in the purchase accounting. It also changes the recognition of assets acquired and liabilities assumed arising from contingencies, requires the capitalization of in-process research and development at fair value, and +requires the expensing of acquisition-related costs as incurred. SFAS No. 141R is effective for us beginning July 1, 2009 and will apply prospectively to business combinations completed on or after that date. PAGE 49 Table of Contents Part II Item 8 In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB 51, which changes the accounting and reporting for minority interests. Minority interests will be +recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity +transactions. In addition, net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement and, upon a loss of control, the interest sold, as well as any interest retained, will +be recorded at fair value with any gain or loss recognized in earnings. SFAS No. 160 is effective for us beginning July 1, 2009 and will apply prospectively, except for the presentation and disclosure requirements, which will apply +retrospectively. We are currently assessing the potential impact that adoption of SFAS No. 160 may have on our financial statements. In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities . SFAS No. 159 gives us the irrevocable option to carry many financial assets and liabilities at fair +value, with changes in fair value recognized in earnings. SFAS No. 159 is effective for us beginning July 1, 2008. We do not believe SFAS No. 159 will have a material impact on our financial statements. In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements , which defines fair value, establishes a framework for +measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing +a fair value hierarchy used to classify the source of the information. In February 2008, the FASB issued FASB Staff Position (“FSP”) 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS +No. 157 for all nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 is effective for us +beginning July 1, 2008; FSP 157-2 delays the effective date for certain items to July 1, 2009. We do not believe SFAS No. 157 will have a material impact on our financial statements. NOTE 2    EARNINGS PER SHARE Basic +earnings per share is computed on the basis of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the +effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic +and diluted earnings per share are as follows: (In millions, except earnings per share) Year Ended June 30, 2008 2007 2006 Net income available for common shareholders (A) $ 17,681 $ 14,065 $ 12,599 Weighted average outstanding shares of common stock (B) 9,328 9,742 10,438 Dilutive effect of employee stock options and awards 142 144 93 Common stock and common stock equivalents (C) 9,470 9,886 10,531 Earnings per share: Basic (A/B) $ 1.90 $ 1.44 $ 1.21 Diluted (A/C) $ 1.87 $ 1.42 $ 1.20 For the years ended June 30, 2008, 2007 and 2006, 91 million, 199 million, and +649 million shares, respectively, were attributable to outstanding stock options and were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than or equal to the average +price of the common shares, and therefore their inclusion would have been anti-dilutive. For the year ended June 30, 2007, four +million shared performance stock awards, out of the 14 million targeted amount outstanding, were excluded from the calculation of the diluted earnings per share because the number of shares ultimately issued was contingent on our performance +against metrics established for the performance period, as discussed in Note 18 – Employee Stock and Savings Plans. PAGE 50 Table of Contents Part II Item 8 NOTE +3    INVESTMENT INCOME AND OTHER The components of investment income and other were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Dividends and interest $ 888 $ 1,319 $ 1,510 Net recognized gains on investments 346 650 161 Net gains (losses) on derivatives 226 (358 ) (99 ) Other (138 ) (34 ) 218 Investment income and other $ 1,322 $ 1,577 $ 1,790 Net gains on investments included other-than-temporary impairments of $312 million, $25 million, and $408 +million in fiscal years 2008, 2007, and 2006, respectively. Realized gains and losses from sales of available-for-sale securities (excluding other-than-temporary impairments) were $751 million and $93 million, respectively, in fiscal year 2008, $851 +million and $176 million, respectively, in fiscal year 2007, and $1.1 billion and $531 million, respectively, in fiscal year 2006. PAGE 51 Table of Contents Part II Item 8 NOTE +4    INVESTMENTS The components of investments, including associated derivatives, were as follows: (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and cash equivalents Short-term investments Equity and other investments June 30, 2008 Cash $ 3,274 $ – $ – $ 3,274 $ 3,274 $ – $ – Mutual funds 1,044 15 (8 ) 1,051 835 136 80 Commercial paper 787 – – 787 787 – – Certificates of deposit 1,580 – – 1,580 1,373 207 – U.S. Government and Agency securities 4,200 37 (4 ) 4,233 1,839 2,318 76 Foreign government bonds 3,466 15 (62 ) 3,419 – 3,419 – Mortgage-backed securities 3,628 31 (25 ) 3,634 – 3,634 – Corporate notes and bonds 5,013 91 (39 ) 5,065 2,122 2,943 – Municipal securities 761 4 (4 ) 761 109 652 – Common stock and equivalents 4,508 1,215 (113 ) 5,610 – – 5,610 Preferred stock 307 9 – 316 – – 316 Other investments 520 – – 520 – 14 506 Total $ 29,088 $ 1,417 $ (255 ) $ 30,250 $ 10,339 $ 13,323 $ 6,588 (In millions) Cost basis Unrealized gains Unrealized losses Recorded basis Cash and cash equivalents Short-term investments Equity and other investments June 30, 2007 Cash $ 3,040 $ – $ – $ 3,040 $ 3,040 $ – $ – Mutual funds 398 4 (1 ) 401 132 205 64 Commercial paper 227 – – 227 179 48 – Certificates of deposit 98 – – 98 – 98 – U.S. Government and Agency securities 3,085 4 (12 ) 3,077 1 3,002 74 Foreign government bonds 3,845 2 (63 ) 3,784 – 3,784 – Mortgage-backed securities 3,236 4 (49 ) 3,191 – 3,191 – Corporate notes and bonds 7,184 14 (18 ) 7,180 2,425 4,753 2 Municipal securities 2,639 3 (25 ) 2,617 334 2,283 – Common stock and equivalents 7,290 2,309 (18 ) 9,581 – – 9,581 Preferred stock 62 12 – 74 – – 74 Other investments 258 – – 258 – (64 ) 322 Total $ 31,362 $ 2,352 $ (186 ) $ 33,528 $ 6,111 $ 17,300 $ 10,117 PAGE 52 Table of Contents Part II Item 8 Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 months 12 months or greater Total (In millions) Fair value unrealized losses Fair value unrealized losses Total fair value unrealized losses June 30, 2008 Mutual funds $ 123 $ (7 ) $ 12 $ (1 ) $ 135 $ (8 ) U.S. Government and Agency securities 342 (4 ) – – 342 (4 ) Foreign government bonds 2,241 (62 ) – – 2,241 (62 ) Mortgage-backed securities 1,078 (25 ) – – 1,078 (25 ) Corporate notes and bonds 807 (26 ) 925 (13 ) 1,732 (39 ) Municipal securities 176 (3 ) 193 (1 ) 369 (4 ) Common stock and equivalents 598 (106 ) 28 (7 ) 626 (113 ) Total $ 5,365 $ (233 ) $ 1,158 $ (22 ) $ 6,523 $ (255 ) Less than 12 months 12 months or greater Total (In millions) Fair value unrealized losses Fair value unrealized losses Total fair value unrealized losses June 30, 2007 Mutual funds $ 76 $ (1 ) $ 3 $ – $ 79 $ (1 ) U.S. Government and Agency securities 1,219 (8 ) 238 (4 ) 1,457 (12 ) Foreign government bonds 3,554 (63 ) 2 – 3,556 (63 ) Mortgage-backed securities 2,520 (43 ) 214 (6 ) 2,734 (49 ) Corporate notes and bonds 526 (14 ) 74 (4 ) 600 (18 ) Municipal securities 575 (9 ) 420 (16 ) 995 (25 ) Common stock and equivalents 237 (17 ) 9 (1 ) 246 (18 ) Total $ 8,707 $ (155 ) $ 960 $ (31 ) $ 9,667 $ (186 ) At June 30, 2008, unrealized losses of $255 million consisted of: $121 million related to investment +grade fixed-income securities, $21 million related to investments in high yield and emerging market fixed-income securities, $99 million related to domestic equity securities, and $14 million related to international equity securities. At +June 30, 2007, unrealized losses of $186 million consisted of: $161 million related to investment grade fixed-income securities, $7 million related to investments in high yield and emerging market fixed-income securities, $7 million related to +domestic equity securities, and $11 million related to international equity securities. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international +equities are due to market price movements. Management does not believe any unrealized losses represent an other-than-temporary impairment based on our evaluation of available evidence as of June 30, 2008. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost. At +June 30, 2008, the recorded basis and estimated fair value of these investments was $289 million. At June 30, 2007, the recorded basis and estimated fair value of these investments was $38 million. The estimate of fair value is based on +publicly available market information or other estimates determined by management. PAGE 53 Table of Contents Part II Item 8 The maturities of debt securities, including fixed-maturity securities, at June 30, 2008, were as follows: (In millions) Cost basis Estimated fair value Due in one year or less $ 3,618 $ 3,618 Due after one year through five years 3,805 3,858 Due after five years through ten years 1,582 1,559 Due after ten years 7,831 7,846 Total $ 16,836 $ 16,881 NOTE 5    DERIVATIVES For derivative instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, did not have a +significant impact on earnings for fiscal years 2008, 2007, or 2006. During fiscal year 2008, $274 million in gains on fair-value hedges from changes in time value and $324 million in losses on cash-flow hedges from changes in time value were +excluded from the assessment of hedge effectiveness and were included in investment income and other. During fiscal year 2007, $219 million in gains on fair-value hedges from changes in time value and $361 million in losses on cash-flow hedges from +changes in time value were excluded from the assessment of hedge effectiveness and were included in investment income and other. During fiscal year 2006, $217 million in gains on fair-value hedges from changes in time value and $399 million in +losses on cash-flow hedges from changes in time value were excluded from the assessment of hedge effectiveness and were included in investment income and other. Derivative gains and losses included in OCI are reclassified into earnings at the time forecasted revenue or the sale of an underlying investment is recognized. During fiscal year 2008, $104 million of +derivative gains were reclassified to revenue. During fiscal year 2007, $168 million of derivative gains were reclassified to revenue. During fiscal year 2006, $166 million of derivative gains were reclassified to revenue and $23 million in +derivative gains were reclassified to investment income and other. We estimate that $111 million of net derivative gains included in +OCI will be reclassified into earnings within the next 12 months. No significant amounts of gains or losses were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur for fiscal years 2008, 2007, and 2006. Derivative fair values are based on quoted market prices or pricing models using current market data. The fair values of all +derivative positions were as follows: (In millions) Short-term investments (1) Other current assets Equity and other investments (1) Other current liabilities Other long-term liabilities Total June 30, 2008 Cash-flow hedges $ – $ 488 $ – $ – $ – $ 488 Fair-value hedges (41 ) – 767 (11 ) – 715 Other derivatives 69 (34 ) 4 (20 ) – 19 Total $ 28 $ 454 $ 771 $ (31 ) $ – $ 1,222 June 30, 2007 Cash-flow hedges $ – $ 258 $ – $ – $ – $ 258 Fair-value hedges (11 ) – (29 ) (340 ) (22 ) (402 ) Other derivatives 9 (20 ) (6 ) (114 ) – (131 ) Total $ (2 ) $ 238 $ (35 ) $ (454 ) $ (22 ) $ (275 ) (1) The amounts presented as short-term investments and equity and other investments were classified as investments in our balance sheets and were included in the amounts +presented in Note 4 – Investments. PAGE 54 Table of Contents Part II Item 8 NOTE +6    INVENTORIES (In millions) June 30, 2008 2007 Raw materials $ 417 $ 435 Work in process 31 148 Finished goods 537 544 Inventories $ 985 $ 1,127 NOTE 7    PROPERTY AND EQUIPMENT (In millions) June 30, 2008 2007 Land $ 518 $ 428 Buildings and improvements 4,302 3,170 Leasehold improvements 1,728 1,077 Computer equipment and software 4,475 3,458 Furniture and equipment 1,521 1,233 Property and equipment, at cost 12,544 9,366 Accumulated depreciation (6,302 ) (5,016 ) Property and equipment, net $ 6,242 $ 4,350 Property and equipment are stated at cost. Depreciation is computed principally on the straight-line method +over the estimated useful lives of the assets. The useful lives for buildings range from five to 15 years, leasehold improvements generally range from two to ten years – representing the applicable lease terms plus reasonably assured +extensions, computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated. During fiscal years 2008, 2007, and 2006, depreciation expense was $1.4 billion, $1.2 billion, and $863 million, respectively. The majority of depreciation expense in all years related to computer +equipment. NOTE 8    ACQUISITIONS On August 10, 2007, we acquired all the outstanding shares of aQuantive, Inc. (“aQuantive”) for $5.9 billion, which was paid primarily in cash. Headquartered in Seattle, Washington, aQuantive is a digital +marketing business that we expect will play a key role in the future development of our Online Services Business. We also believe the acquisition will help us build and support next-generation advertiser and publisher solutions in environments such +as cross media planning, video-on-demand, and Internet protocol television. aQuantive was consolidated into our results of operations starting August 10, 2007, the acquisition date. As a result of the aQuantive acquisition, we recorded $5.2 billion of goodwill in our Online Services Business. Of the $939 million of acquired +intangible assets, $24 million was assigned to in-process research and development assets and was expensed. The remaining acquired intangible assets include $476 million of customer relationships with a weighted average life of six years, $327 +million of technology-based intangible assets with a weighted average life of four years, and $112 million of other intangible assets with a weighted average life of five years. On April 24, 2008, we acquired all the outstanding shares of Fast Search & Transfer ASA (“FAST”) for $1.3 billion, which was paid primarily in cash. Headquartered in Oslo, Norway, +FAST is an enterprise search company that we expect will broaden our enterprise search technology product offerings to businesses and will enable innovation in related areas such as our portal and content management. FAST was consolidated into our +results of operations starting April 24, 2008, the acquisition date. PAGE 55 Table of Contents Part II Item 8 As a result of the FAST acquisition, we recorded $981 million of goodwill in our Microsoft Business Division. Of the $266 million of acquired intangible assets, $35 million was assigned to in-process research and development assets and was +expensed. The remaining acquired intangible assets include $27 million of customer relationships with a weighted average life of seven years, $134 million of technology-based intangible assets with a weighted average life of five years, and $70 +million of other intangible assets with a weighted average life of six years. The following table summarizes the estimated fair +values of the assets acquired and liabilities assumed at the dates of the aQuantive and FAST acquisitions: (In millions) aQuantive as of August 10, 2007 FAST as of April 24, 2008 Cash and cash equivalents $ 342 $ 91 Accounts receivable, net 273 46 Other current assets 6 7 Property, plant and equipment 50 30 Intangible assets 939 266 Goodwill 5,189 981 Deferred income taxes 179 – Other long-term assets 7 5 Total assets acquired $ 6,985 $ 1,426 Accrued compensation 37 39 Other current liabilities 683 38 Deferred income taxes 338 65 Other long-term liabilities 70 10 Total liabilities assumed $ 1,128 $ 152 Net assets acquired $ 5,857 $ 1,274 In addition to aQuantive and FAST, we acquired 19 other entities during fiscal year 2008 for +total consideration of $1.6 billion which was paid primarily in cash and included: • Danger, Inc. (“Danger”), a software-as-a-service company that provides mobile operators with an integrated end-to-end solution to deliver mobile data and +Internet services to their subscribers. We acquired Danger for approximately $500 million in cash; and • 18 other entities specializing in areas such as application security, desktop, and advertising solutions. As a result of our acquisition of Danger and the 18 other entities, we recorded $1.2 billion of goodwill. In addition, $37 million was assigned to +in-process research and development assets and was expensed. All of the entities have been consolidated into our results of operations since their respective acquisition dates. The purchase price allocations for these acquisitions are preliminary +and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities becomes available. Any change in the estimated fair value of the net assets of the acquired companies will change +the amount of the purchase price allocable to goodwill. Pro forma results of operations have not been presented because the effects of Danger and the 18 other acquisitions, individually and in aggregate, were not material. PAGE 56 Table of Contents Part II Item 8 NOTE +9    GOODWILL Changes in the carrying amount of goodwill for fiscal years 2008 and 2007 by segment were as follows: (In millions) Balance as of June 30, 2008 Acquisitions Other Balance as of June 30, 2007 Acquisitions Other Balance as of June 30, 2006 Client $ 153 $ 77 $ (1 ) $ 77 $ 6 $ (3 ) $ 74 Server and Tools 738 90 68 580 325 (1 ) 256 Online Services Business 6,274 5,775 (53 ) 552 123 (26 ) 455 Microsoft Business Division 4,191 1,073 (14 ) 3,132 508 (57 ) 2,681 Entertainment and Devices Division 752 354 (21 ) 419 21 (2 ) 400 Total $ 12,108 $ 7,369 $ (21 ) $ 4,760 $ 983 $ (89 ) $ 3,866 We test goodwill for impairment annually on July 1 at the reporting unit level using a fair value +approach, in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets . Our annual testing resulted in no impairments of goodwill in fiscal years 2008 and 2007. If an event occurs or circumstances change that +would more likely than not reduce the fair value of a reporting unit below its carrying value, goodwill will be evaluated for impairment between annual tests. None of the amount recorded as goodwill during fiscal year 2008 is expected to be deductible for tax purposes. The purchase price allocation for acquisitions is preliminary for up to 12 months after the +acquisition date and subject to revision as more detailed analyses are completed and additional information about fair value of assets and liabilities become available. Any change in the fair value of the net assets of the acquired company will +change the amount of the purchase price allocable to goodwill. Purchase price adjustments are included in “other” in the above table. NOTE 10    INTANGIBLE ASSETS The components of finite-lived intangible assets were as follows: (In millions) June 30, 2008 2007 Gross carrying amount Accumulated amortization Net carrying amount Gross carrying amount Accumulated amortization Net carrying amount Contract-based $ 1,074 $ (796 ) $ 278 $ 988 $ (727 ) $ 261 Technology-based 1,677 (672 ) 1,005 916 (407 ) 509 Marketing-related 171 (65 ) 106 57 (39 ) 18 Customer-related 708 (124 ) 584 122 (32 ) 90 Total $ 3,630 $ (1,657 ) $ 1,973 $ 2,083 $ (1,205 ) $ 878 PAGE 57 Table of Contents Part II Item 8 During +fiscal year 2008 and 2007, we recorded additions to intangible assets of $1.6 billion and $473 million, respectively. We estimate that we have no significant residual value related to our intangible assets. The components of finite-lived intangible +assets acquired during fiscal years 2008 and 2007 were as follows: (In millions) Year Ended June 30, 2008 2007 Amount Weighted average life Amount Weighted average life Contract-based $ 91 6 years $ 57 5 years Technology-based 787 4 years 333 4 years Marketing-related 116 5 years 14 4 years Customer-related 589 6 years 69 5 years Total $ 1,583 $ 473 Intangible asset additions included $694 million of technology-based intangible assets with a +weighted-average life of four years, and $782 million of other intangible assets with a weighted-average life of six years, related to the acquisitions of aQuantive, FAST, Danger, and 18 other entities acquired. See Note 8 – Acquisitions. Acquired intangibles generally are amortized on a straight-line basis over weighted average lives. Intangible assets amortization +expense was $472 million for fiscal year 2008, $236 million for fiscal year 2007, and $127 million for fiscal year 2006. The following table outlines the estimated future amortization expense related to intangible assets as of June 30, 2008: (In millions) Year Ended June 30, Amount 2009 $ 543 2010 495 2011 408 2012 279 2013 and thereafter 248 Total $ 1,973 NOTE 11    INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Current taxes: U.S. Federal $ 4,357 $ 4,593 $ 4,471 U.S. State and Local 256 154 101 International 1,007 957 882 Current taxes 5,620 5,704 5,454 Deferred taxes 513 332 209 Provision for income taxes $ 6,133 $ 6,036 $ 5,663 PAGE 58 Table of Contents Part II Item 8 U.S. and +international components of income before income taxes were as follows: (In millions) Year Ended June 30, 2008 2007 2006 U.S. $ 12,682 $ 12,902 $ 11,404 International 11,132 7,199 6,858 Income before income taxes $ 23,814 $ 20,101 $ 18,262 The items accounting for the difference between income taxes computed at the federal statutory rate and the +provision for income taxes were as follows: Year Ended June 30, 2008 2007 2006 Federal statutory rate 35.0 % 35.0 % 35.0 % Effect of: Foreign earnings taxed at lower rates (7.0 )% (5.1 )% (4.6 )% Examination settlements (5.8 )% – (0.6 )% European Commission fine 2.1 % – 0.7 % Other reconciling items 1.5 % 0.1 % 0.5 % Effective rate 25.8 % 30.0 % 31.0 % In general, other reconciling items consist of interest, U.S. state income taxes, domestic production +deductions, and research credits. In fiscal years 2008 and 2006, there were no individually significant other reconciling items. Other reconciling items in fiscal year 2007 included the impact of a $195 million reduction resulting from various +changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments. The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2008 2007 Deferred income tax assets: Stock-based compensation expense $ 2,225 $ 2,859 Other expense items 1,933 1,735 Unearned revenue 928 842 Impaired investments 331 710 Other revenue items 91 58 Deferred income tax assets $ 5,508 $ 6,204 Deferred income tax liabilities: International earnings $ (1,300 ) $ (1,763 ) Unrealized gain on investments (513 ) (926 ) Other (729 ) (227 ) Deferred income tax liabilities (2,542 ) (2,916 ) Net deferred income tax assets $ 2,966 $ 3,288 Reported as: Current deferred income tax assets $ 2,017 $ 1,899 Long-term deferred income tax assets 949 1,389 Net deferred income tax assets $ 2,966 $ 3,288 PAGE 59 Table of Contents Part II Item 8 Deferred +income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when taxes are actually paid or recovered. We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $7.5 billion +resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the United States. The amount of unrecognized deferred tax liability associated with these temporary differences is approximately $2.2 billion. Income taxes paid were $5.4 billion in fiscal year 2008, $5.2 billion in fiscal year 2007, and $4.8 billion in fiscal year 2006. FIN 48 On July 1, 2007, we +adopted the provisions of FIN 48 which had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and retained deficit by $395 million; and +decreased income taxes payable by $394 million. As of June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate. As of July 1, 2007, we had $7.1 billion of +unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. Interest totaled $121 million in fiscal +year 2008. As of June 30, 2008 and July 1, 2007, we had accrued interest related to uncertain tax positions of $324 million and $863 million, respectively, net of federal income tax benefits, on our balance sheets. The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2008 Balance, beginning of year $ 7,076 Decreases related to settlements (4,787 ) Increases for tax positions related to the current year 934 Increases for tax positions related to prior years 66 Decreases for tax positions related to prior years (80 ) Reductions due to lapsed statute of limitations (14 ) Balance, end of year $ 3,195 During fiscal year 2008, we reached a settlement with the Internal Revenue Service (“IRS”) on its +2000-2003 examination. As a result, we reduced our unrecognized tax benefits by $4.8 billion and recognized a tax provision reduction of $1.2 billion. We are under audit by the IRS for the tax years 2004-2006. We do not believe it is +reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months as we do not believe the examination will be concluded within the next 12 months. As a result of our settlement +related to the 2000-2003 examination, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009. We are +subject to income tax in many jurisdictions outside the United States, none of which are individually material to our financial position, cash flows, or results of operations. NOTE 12    UNEARNED REVENUE Unearned revenue is comprised of the following +items: Volume licensing programs – Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at +the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. PAGE 60 Table of Contents Part II Item 8 Undelivered elements – Represents free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. This revenue deferral is +applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to OEMs, and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is based on +the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. The percentage of revenue recorded as unearned due to undelivered elements ranges from +approximately 15% to 25% of the sales price for Windows XP Home and approximately 5% to 15% of the sales price for Windows XP Professional, depending on the terms and conditions of the license and prices of the elements. Product life cycles are +currently estimated at three and one-half years for Windows operating systems. Other – Represents payments for post-delivery support and +consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and other offerings for which we have been +paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The +components of unearned revenue were as follows: (In millions) June 30, 2008 2007 Volume licensing programs $ 12,232 $ 9,334 Undelivered elements 1,396 1,839 Other 1,669 1,473 Unearned revenue $ 15,297 $ 12,646 Unearned revenue by segment was as follows: (In millions) June 30, 2008 2007 Client $ 2,738 $ 2,875 Server and Tools 5,007 3,652 Microsoft Business Division 7,101 5,771 Other segments 451 348 Unearned revenue $ 15,297 $ 12,646 NOTE 13    OTHER LONG-TERM LIABILITIES (In millions) June 30, 2008 2007 Tax contingencies and other tax liabilities $ 3,812 $ 5,071 Legal contingencies 530 778 Product warranty 278 487 Other 101 117 Other long-term liabilities $ 4,721 $ 6,453 PAGE 61 Table of Contents Part II Item 8 NOTE +14    COMMITMENTS AND GUARANTEES We have committed $1.2 billion for constructing new buildings as of June 30, 2008. We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for +operating leases was $398 million, $325 million, and $271 million, in fiscal years 2008, 2007, and 2006, respectively. Future minimum rental commitments under noncancellable leases are as follows: (In millions) Year Ended June 30, Amount 2009 $ 440 2010 323 2011 272 2012 236 2013 and thereafter 937 $ 2,208 We provide indemnifications of varying scope and size to certain customers against claims of intellectual +property infringement made by third parties arising from the use of our products. In addition, we also provide indemnification against credit risk in several geographical locations to our volume license resellers in case the resellers fail to +collect from the end user. Due to the nature of the indemnification provided to our resellers, we cannot estimate the fair value, nor determine the total nominal amount, of the indemnification. We evaluate estimated losses for these indemnifications +under SFAS No. 5, Accounting for Contingencies , as interpreted by FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others . We consider such +factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of these obligations and have not accrued any liabilities +related to these indemnifications in our financial statements. Product Warranty In July 2007, we announced the expansion of our global Xbox 360 warranty coverage to three years from the date of purchase for a general hardware failure indicated by three flashing red lights. The basic +Xbox 360 console warranty remains in place with a warranty period of one year from the date of purchase in most geographies. The +changes in our aggregate product warranty liabilities, which are included in other current liabilities and other long term-liabilities on our balance sheets, were as follows: (In millions) Year Ended June 30, 2008 2007 Balance, beginning of year $ 850 $ 10 Accruals for warranties issued 365 974 Adjustments to pre-existing warranties 36 92 Settlements of warranty claims (559 ) (226 ) Balance, end of year $ 692 $ 850 Accruals for warranties issued during fiscal year 2007 included charges incurred as a result of the +expansion of our Xbox 360 warranty coverage as discussed above. PAGE 62 Table of Contents Part II Item 8 NOTE +15    CONTINGENCIES Government competition law matters. In March 2004, the European +Commission issued a competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that +the pricing terms we proposed for licensing the technology as required by the March 2004 decision were “not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 +that we were in compliance with the March 2004 decision and that no further penalty should accrue after that date. On February 27, 2008, the Commission issued a fine of $1.4 billion ( € 899 million) relating to the period prior to October 22, 2007. In January 2008, the Commission announced that it was opening two new competition law investigations. These investigations relate primarily to +interoperability with respect to our Microsoft Office family of products and the inclusion of various capabilities in our Windows operating system software, including Web browsing software. These investigations were precipitated by complaints filed +with the Commission by a trade association of Microsoft’s competitors and a firm that offers Web browsing software. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the +$1.4 billion ( € 899 million) fine in June 2008. We are subject to a Consent Decree and Final Judgment that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Consent Decree imposed various constraints on our +Windows operating system businesses. Portions of the Consent Decree were scheduled to expire on January 31, 2008; we voluntarily agreed to extend other elements of the Consent Decree to November 2009. In October 2007, some states filed a +motion with the U.S. District Court for the District of Columbia seeking to have most of the remaining provisions of the Final Judgment in the action to which they are party extended for five years. The U.S. Department of Justice and other states +advised the Court that they would not seek any extension of the Final Judgments to which they are party. In January 2008, the court issued a decision granting the states’ motion to extend these additional provisions of the consent decree until +November 2009. In other ongoing investigations, various foreign governments and several state attorneys general have requested +information from us concerning competition, privacy, and security issues. Antitrust, unfair competition, and overcharge class +actions. A large number of antitrust and unfair competition class action lawsuits have been filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of +our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes in two additional states. We have reached agreements +to settle all claims that have been made to date in 19 states and the District of Columbia. Under the settlements, generally class +members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain +schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued +vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem +vouchers. The settlements in all states have received final court approval. Cases in Arizona, Mississippi and Canada have not been +settled. We estimate the total cost to resolve all of these cases will range between $1.7 billion and $1.9 billion. The actual cost depends on factors such as the quantity and mix of products for which claims will be made, the number of eligible +class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims. At June 30, 2008, we have recorded a liability related to these claims of +approximately $900 million, which reflects our estimated exposure of $1.7 billion less payments made to date of approximately $800 million, mostly for administrative expenses, vouchers, and legal fees. Other antitrust litigation and claims. In November 2004, Novell, Inc. filed a complaint in U.S. District Court in Utah, now +transferred with other cases to Maryland, asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In +June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. Both parties appealed, and in October 2007, the court of appeals affirmed the decision of the trial court, remanding the case to that court for +further proceedings. PAGE 63 Table of Contents Part II Item 8 Patent and intellectual property claims. We are vigorously defending more than 45 patent infringement cases. Microsoft and Alcatel-Lucent are parties to a number of legal proceedings relating to certain patents +of each of the companies. Some of these actions began before the merger of Alcatel and Lucent in 2006. For simplicity, we refer to the post-merger entity as Alcatel-Lucent throughout this discussion. • In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents. Alcatel-Lucent has +asserted claims under these patents against computer manufacturers that sell computers with our operating system and application software pre-installed. In February 2007, the jury returned a verdict in Alcatel-Lucent’s favor in the first of a +series of patent trials, and awarded $1.5 billion in damages. In August 2007, on our motions for judgment as a matter of law, the trial court overturned the jury verdict and entered orders dismissing plaintiff’s claims on multiple grounds. +Alcatel-Lucent appealed. The trial court previously dismissed Alcatel-Lucent’s claims with respect to a second group of patents and two patents in a third grouping. In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a +trial on a consolidated group of video and user interface patents. The jury concluded that Microsoft had infringed two patents and awarded $367 million in damages. On June 19, 2008, the trial judge increased the amount of damages to $512 +million, which includes the $367 million of damages and $145 million of interest. Microsoft will appeal the verdict. • In March 2006, Alcatel-Lucent filed a lawsuit against us in U.S. District Court in California, claiming Windows Vista, Windows Media Player, and the Xbox 360 infringe one +of its patents. In response, we asserted counterclaims that Alcatel-Lucent infringes 10 Microsoft patents by its sale of various products. The case went to trial in April 2008 on Alcatel-Lucent’s video patent and four Microsoft counterclaim +patents. The jury returned a verdict in Microsoft’s favor on June 4, 2008, finding no infringement of Alcatel-Lucent’s patent. The jury also found no infringement of Microsoft’s counterclaim patents. • In November 2006, Alcatel-Lucent filed two patent infringement cases against us in U.S. District Court in Texas, asserting Mediaroom and various networking +functionalities violate seven of its patents. In April 2007, we asserted infringement counterclaims based on four of our patents relating to functionality similar to that accused by Alcatel-Lucent. The trial on all of the patents is set for +January 2009. • In February 2007, we filed a complaint against Alcatel-Lucent with the International Trade Commission claiming Alcatel-Lucent is infringing four Microsoft patents related +to our unified communications technology and seeking to prevent the import into the U.S. of certain Alcatel-Lucent unified communications products. Trial of this matter took place in October 2007. The administrative law judge ruled that +Alcatel-Lucent infringed one of the four asserted patents. The Commission reversed that decision in May 2008. We are appealing that ruling to the U.S. Court of Appeals for the Federal Circuit. • In April 2007, the Multimedia Patent Trust filed a complaint against Microsoft, Dell, and Gateway in San Diego, California accusing the parties of infringing three +video-related patents that originally belonged to Alcatel-Lucent. Alcatel-Lucent created the Multimedia Patent Trust prior to the companies’ merger and transferred the patents at issue to the trust. In June 2008, the plaintiff dismissed one of +the patent claims. The actual costs to resolve these cases will depend upon many factors such as the outcome of +post-trial motions, any appeals, and the results of the remaining trials. Adverse outcomes in some or all of the matters described in this section may result in significant monetary damages or injunctive relief against us that would adversely affect +distribution of our operating system or application products. We may enter into material settlements because of these risks. Other. We are also subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, +individually or in aggregate, will not have a material adverse impact on our financial position, our results of operations, or our cash flows, these matters are subject to inherent uncertainties and management’s view of these matters may change +in the future. As of June 30, 2008, we had accrued aggregate liabilities of approximately $600 million in other current +liabilities and approximately $500 million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we PAGE 64 Table of Contents Part II Item 8 estimate could be up to $2.2 billion in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse +impact on our financial position, results of operations, and cash flows for the period in which the effects become reasonably estimable. NOTE +16    STOCKHOLDERS’ EQUITY Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Balance, beginning of year 9,380 10,062 10,710 Issued 173 289 106 Repurchased (402 ) (971 ) (754 ) Balance, end of year 9,151 9,380 10,062 On July 20, 2006, we announced the completion of the repurchase program initially approved by our Board +of Directors on July 20, 2004 to buy back up to $30.0 billion in Microsoft common stock. On July 20, 2006, we also +announced that our Board of Directors authorized two new share repurchase programs: a $20.0 billion tender offer, which was completed on August 17, 2006; and authorization for up to an additional $20.0 billion ongoing share repurchase program +with an expiration of June 30, 2011. Under the tender offer, we repurchased approximately 155 million shares of common stock, or 1.5% of our common shares outstanding, for approximately $3.8 billion at a price per share of $24.75. On +August 18, 2006, we announced that the authorization for the $20.0 billion ongoing share repurchase program had been increased by approximately $16.2 billion. As a result, we were authorized to repurchase additional shares in an amount up +to $36.2 billion through June 30, 2011. As of June 30, 2008, approximately $2.7 billion remained of the $36.2 billion approved repurchase amount. Under these repurchase plans, we have made the following share repurchases: (In millions) Year Ended June 30, 2008 (1) 2007 (2) 2006 (3) Shares Amount Shares Amount Shares Amount First quarter 81 $ 2,348 285 $ 6,965 114 $ 3,029 Second quarter 120 4,081 205 6,037 283 7,666 Third quarter 30 1,020 238 6,744 181 4,879 Fourth quarter 171 4,975 243 7,367 176 4,175 Total 402 $ 12,424 971 $ 27,113 754 $ 19,749 (1) All amounts repurchased in fiscal year 2008 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. (2) Approximately 155 million shares of common stock for approximately $3.8 billion were repurchased under our tender offer in the first quarter of fiscal year 2007. All +other amounts repurchased were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. (3) All amounts repurchased in fiscal year 2006 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2004. PAGE 65 Table of Contents Part II Item 8 In +fiscal year 2008, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount (in millions) Payment Date September 12, 2007 $ 0.11 November 15, 2007 $ 1,034 December 13, 2007 December 19, 2007 $ 0.11 February 21, 2008 $ 1,023 March 13, 2008 March 17, 2008 $ 0.11 May 15, 2008 $ 1,020 June 12, 2008 June 11, 2008 $ 0.11 August 21, 2008 $ 1,007 (1) September 11, 2008 (1) The dividend declared on June 11, 2008 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of +June 30, 2008. In fiscal year 2007, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount (in millions) Payment Date September 13, 2006 $ 0.10 November 16, 2006 $ 980 December 14, 2006 December 20, 2006 $ 0.10 February 15, 2007 $ 978 March 8, 2007 March 26, 2007 $ 0.10 May 17, 2007 $ 952 June 14, 2007 June 27, 2007 $ 0.10 August 16, 2007 $ 938 (1) September 13, 2007 (1) The dividend declared on June 27, 2007 was included in other current liabilities as of June 30, 2007. NOTE 17    OTHER COMPREHENSIVE INCOME The activity in other comprehensive income and related income tax effects were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Net unrealized gains on derivative instruments: Unrealized gains, net of tax effect of $46 in 2008, $66 in 2007, and $107 in 2006 $ 86 $ 123 $ 199 Reclassification adjustment for gains included in net income, net of tax effect of $(36) in 2008, $(59) in 2007, and $(66) in 2006 (68 ) (109 ) (123 ) Net unrealized gains on derivative instruments 18 14 76 Net unrealized gains (losses) on investments: Unrealized gains (losses), net of tax effect of $(234) in 2008, $393 in 2007, and $(105) in 2006 (435 ) 730 (195 ) Reclassification adjustment for gains included in net income, net of tax effect of $(117) in 2008, $(217) in 2007, and $(47) in 2006 (218 ) (404 ) (87 ) Net unrealized gains (losses) on investments (653 ) 326 (282 ) Translation adjustments and other 121 85 9 Other comprehensive income (loss) $ (514 ) $ 425 $ (197 ) The components of accumulated other comprehensive income were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Net unrealized gains on derivative instruments $ 135 $ 117 $ 103 Net unrealized gains on investments 735 1,388 1,062 Translation adjustments and other 270 149 64 Accumulated other comprehensive income $ 1,140 $ 1,654 $ 1,229 PAGE 66 Table of Contents Part II Item 8 NOTE +18    EMPLOYEE STOCK AND SAVINGS PLANS Stock-based compensation and related income tax benefits were as follows: (In millions) 2008 2007 2006 Total stock-based compensation $ 1,479 $ 1,550 $ 1,715 Income tax benefits related to stock-based compensation $ 518 $ 542 $ 600 Employee Stock Purchase Plan. We have an employee stock purchase plan for all +eligible employees. Compensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on +the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares: (Shares In millions) 2008 2007 2006 Shares purchased 18 17 17 Average price per share $ 26.78 $ 25.36 $ 23.02 At June 30, 2008, 107 million shares were reserved for future issuance. Savings Plan. We have a savings plan in the United States that qualifies under Section 401(k) of the Internal Revenue Code, and +a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a +maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $238 million, $218 million, and $178 million in fiscal years 2008, 2007, and 2006, respectively. Matching contributions are invested proportionate +to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be +invested in Microsoft common stock. Stock Plans. We have stock plans for directors and for officers, employees, +consultants, and advisors. At June 30, 2008, an aggregate of 786 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance stock awards. Awards that expire or are +canceled without delivery of shares generally become available for issuance under the plans. We issue new shares to satisfy stock option exercises. Stock Awards and Shared Performance Stock Awards. Stock awards (“SAs”) are grants that entitle the holder to shares of common stock as the award vests. Our SAs generally vest over a five-year period. Shared performance stock awards (“SPSAs”) are a form of SA in which the number of shares ultimately received depends on our +business performance against specified performance targets. The performance period for SPSAs issued in fiscal years 2004, 2005, and 2006 was July 1, 2003 through June 30, 2006 (January 1, 2004 through June 30, 2006 for certain +executive officers). Following the end of the performance period, the Compensation Committee of the Board of Directors determined that the number of shares of SAs to be issued was 37 million, based on the actual performance against metrics +established for the performance period. One-third of the awards vested in each of the fiscal years 2007 and 2008. An additional one-third of the awards will vest in fiscal year 2009. Because the SPSAs covered a three-year period, SPSAs issued in +fiscal year 2006 were given only to newly hired and promoted employees eligible to receive SPSAs. The Company granted SPSAs for +fiscal years 2007 and 2008 with performance periods of July 1, 2006 through June 30, 2007 and July 1, 2007 through June 30, 2008, respectively. At the end of the fiscal year performance period, the number of shares of stock +subject to the award is determined by multiplying the target award by a percentage ranging from 0% to 150%. The percentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of +Directors in its sole discretion. An additional number of shares, approximately 15% of the total target SPSAs, are available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each +award vest following the end of the PAGE 67 Table of Contents Part II Item 8 performance period, and an additional one-quarter of the shares vest over each of the following three years. Following the end of the fiscal year 2007 performance +period, the Compensation Committee of the Board of Directors determined that the number of shares of SAs to be issued was 11 million, based on the actual performance against metrics established for the performance period. The number of shares +of SAs to be issued for the fiscal year 2008 performance period will be determined in the first quarter of fiscal year 2009. We +measure the fair value of SAs and SPSAs based upon the market price of the underlying common stock as of the date of grant, reduced by the present value of estimated future dividends. SAs and SPSAs are amortized over their applicable vesting period +(generally three to five years) using the straight-line method. The fair value of each award grant is estimated on the date of grant using the following assumptions: (In millions) 2008 2007 2006 Dividend per share (quarterly amounts) $ 0.10 - $0.11 $ 0.09 - $0.10 $ 0.08 - $0.09 Interest rates range 2.5% - 4.9% 4.3% - 5.3% 3.2% - 5.3% During fiscal year 2008, the following activity occurred under our existing plans: Shares (in millions) Weighted Average Grant-Date Fair Value Year Ended June 30, 2008 Stock awards: Nonvested balance, beginning of year 124 $ 24.67 Granted 71 27.83 Vested (33 ) 24.49 Forfeited (9 ) 25.61 Nonvested balance, end of year 153 $ 26.12 Shared performance stock awards: Nonvested balance, beginning of year 33 $ 24.11 Granted 19 27.82 Vested (14 ) 24.07 Forfeited (2 ) 24.44 Nonvested balance, end of year 36 $ 26.14 As of June 30, 2008, there was $3.2 billion and $586 million of total unrecognized compensation costs +related to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.4 years and 2.8 years, respectively. SPSAs granted in fiscal year 2008 include adjustments for estimated performance against performance targets. During fiscal year 2007 and +2006, the following activity occurred under our plans: (In millions, except fair values) 2007 2006 Stock awards granted 57 47 Weighted average grant-date fair value $ 25.15 $ 24.70 Shared performance stock awards granted 11 3 Weighted average grant-date fair value $ 25.18 $ 24.80 Stock Options. In fiscal year 2004, we began granting employees SAs rather +than stock options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Nonqualified stock options were granted to our directors under our +non-employee director PAGE 68 Table of Contents Part II Item 8 stock plan. Nonqualified and incentive stock options were granted to certain officers and employees under our employee stock plans. Options granted between 1995 and +2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire ten years from the date of grant. Options +granted after 2001 vest over four and one-half years and expire ten years from the date of grant. Approximately ten million, two million, and one million stock options were granted in conjunction with business acquisitions during fiscal years +2008, 2007, and 2006, respectively. Employee stock options outstanding were as follows: Shares (in millions) Weighted Average Exercise Price Weighted Average Remaining Contractual Term (years) Aggregate Intrinsic Value (in millions) Balance, June 30, 2007 524 $ 27.86 Granted 10 8.63 Exercised (121 ) 25.06 Canceled (48 ) 32.05 Forfeited (1 ) 15.58 Balance, June 30, 2008 364 $ 28.12 3.01 $ 1,029 Exercisable, June 30, 2008 357 $ 28.12 2.95 $ 899 Options outstanding as of June 30, 2008 include approximately 12 million options that were granted +in conjunction with business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise price of $28.12 presented. These options have an exercise price range of $0 to +$150.93 and a weighted average exercise price of $9.03. During fiscal years 2008, 2007, and 2006 the following activity occurred +under our plans: (In millions) 2008 2007 2006 Total intrinsic value of stock options exercised $ 1,042 $ 818 $ 491 Total fair value of stock awards vested $ 804 $ 566 $ 377 Total fair value of shared performance stock awards vested $ 336 $ 292 $ – Cash received and income tax benefits from stock option exercises were $3.0 billion and $365 million, +respectively, for fiscal year 2008. NOTE 19    SEGMENT INFORMATION Segment revenue and operating income (loss) was as follows: (In millions) Year Ended June 30, 2008 2007 2006 Revenue: Client $ 16,472 $ 14,844 $ 13,077 Server and Tools 13,189 11,184 9,670 Online Services Business 3,214 2,441 2,303 Microsoft Business Division 18,937 16,404 14,461 Entertainment and Devices Division 8,139 6,066 4,761 Unallocated and other 469 183 10 Consolidated $ 60,420 $ 51,122 $ 44,282 PAGE 69 Table of Contents Part II Item 8 (In millions) Year Ended June 30, 2008 2007 2006 Operating Income (Loss): Client $ 12,537 $ 11,338 $ 10,176 Server and Tools 4,261 3,593 2,980 Online Services Business (1,309 ) (630 ) 194 Microsoft Business Division 12,182 10,696 9,567 Entertainment and Devices Division 267 (2,016 ) (1,329 ) Reconciling amounts (5,446 ) (4,457 ) (5,116 ) Consolidated $ 22,492 $ 18,524 $ 16,472 SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information , establishes +standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting of revenue and operating income based upon internal accounting methods. Our financial reporting +systems present various data for management to operate the business, including internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segments are designed to allocate resources internally and provide a framework +to determine management responsibility. Amounts for prior periods have been recast to conform to the current management view. Operating segments are defined as components of an enterprise about which separate financial information is available that +is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our five segments are +Client; Server and Tools; Online Services Business; Microsoft Business Division; and Entertainment and Devices Division. The types of +products and services provided by each segment are summarized below: Client – Windows Vista, including Home, Home Premium, Ultimate, +Business, Enterprise and Starter Edition; Windows XP Professional and Home; Media Center Edition; Tablet PC Edition; and other standard Windows operating systems. Server and Tools – Windows Server operating system; Microsoft SQL Server; Microsoft Enterprise Services; product support services; Visual Studio; System Center products; Forefront security products; Biz Talk Server; +MSDN; and other products and services. Online Services Business – Live Search; MSN; MapPoint; MSN Internet Access; MSN Premium Web +Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, and MSN Software Services); Windows Live; MSN Mobile Services; AvenueA Razorfish media agency services; Atlas online tools for advertisers; and the Drive PM ad network for +publishers. Microsoft Business Division – Microsoft Office; Microsoft Project; Microsoft Visio; Microsoft Office SharePoint Server; +Microsoft PerformancePoint; Microsoft Office Live; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communication Server; Microsoft Office Communicator; Microsoft Tellme +Service, Microsoft Dynamics AX; Microsoft Dynamics CRM; Microsoft Dynamics CRM Online; Microsoft Dynamics GP; Microsoft Dynamics NAV; Microsoft Dynamics SL; Microsoft Dynamics Retail Management System; Microsoft Partner Program; and Microsoft Office +Accounting. Entertainment and Devices Division – Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and +hardware products (such as mice and keyboards); Windows Mobile software and services platform; Windows Embedded device operating system; Windows Automotive; and Surface computing platform. Because of our integrated business structure, operating costs included in one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly +related to the products included in each segment. Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually PAGE 70 Table of Contents Part II Item 8 evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment reporting purposes, which may result in +changes to segment allocations in future periods. Assets are not allocated to segments for internal reporting presentations. A +portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in +the measure of segment profit or loss. Reconciling amounts include adjustments to conform with U.S. GAAP and corporate-level activity +not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and accelerated amortization for depreciation, stock awards, and +performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity including certain legal settlements and accruals for legal contingencies. Significant reconciling items were as follows: (In millions) Year Ended June 30, 2008 2007 2006 Summary of reconciling amounts: Corporate-level activity (1) $ (6,704 ) $ (4,777 ) $ (4,804 ) Stock-based compensation expense 844 123 (173 ) Revenue reconciling amounts 368 120 (7 ) Other 46 77 (132 ) Total $ (5,446 ) $ (4,457 ) $ (5,116 ) (1) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. No sales to an individual customer accounted for more than 10% of fiscal year 2008 or fiscal year 2007 revenue. Sales to Dell and its subsidiaries accounted for +approximately 11% of fiscal year 2006 revenue. These sales were made primarily through our OEM and volume licensing channels and cover a broad array of products including Windows PC operating systems, Microsoft Office, and server products. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2008 2007 2006 United States (1) $ 35,928 $ 31,346 $ 27,957 Other countries 24,492 19,776 16,325 Total $ 60,420 $ 51,122 $ 44,282 (1) Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations. Long-lived assets, classified by the geographic location of the controlling statutory company in which that company operates, were as follows: (In millions) Year Ended June 30, 2008 2007 United States $ 19,129 $ 9,132 Other countries 1,194 856 Total $ 20,323 $ 9,988 PAGE 71 Table of Contents Part II Item 8 QUARTERLY INFORMATION (In millions, except per share amounts) (Unaudited) Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Total Fiscal year 2008 Revenue $ 13,762 $ 16,367 $ 14,454 $ 15,837 $ 60,420 Gross profit 11,087 12,824 11,940 12,971 48,822 Net income 4,289 4,707 (1) 4,388 (2) 4,297 17,681 Basic earnings per share 0.46 0.50 0.47 0.46 1.90 Diluted earnings per share 0.45 0.50 0.47 0.46 1.87 Fiscal year 2007 Revenue $ 10,811 $ 12,542 (3) $ 14,398 (4) $ 13,371 $ 51,122 Gross profit 9,115 8,922 12,258 10,134 (6) 40,429 Net income 3,478 2,626 4,926 (5) 3,035 14,065 Basic earnings per share 0.35 0.27 0.51 0.32 1.44 Diluted earnings per share 0.35 0.26 0.50 0.31 1.42 Fiscal year 2006 Revenue $ 9,741 $ 11,837 $ 10,900 $ 11,804 $ 44,282 Gross profit 8,488 9,598 8,872 9,674 36,632 Net income 3,141 (7) 3,653 2,977 (8) 2,828 (9) 12,599 Basic earnings per share 0.29 0.35 0.29 0.28 1.21 Diluted earnings per share 0.29 0.34 0.29 0.28 1.20 (1) Includes charges of $237 million (pre-tax) related to various legal matters. (2) Includes charge of $1.4 billion ( € 899 million) related to the fine imposed by the +European Commission in February 2008. (3) Reflects $1.6 billion of revenue deferred to the third quarter of fiscal year 2007 for the Express Upgrade to Windows Vista and Microsoft Office Technology guarantee +programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. (4) Includes $1.6 billion of revenue discussed above. (5) Includes charges of $296 million (pre-tax) related to various legal matters. (6) Includes $1.1 billion (pre-tax) charge related to the Xbox 360 warranty policy, inventory write-downs, and product returns. (7) Includes charge of $361 million (pre-tax) related to the settlement with RealNetworks, Inc. (8) Includes charges of $397 million (pre-tax) related to various legal matters. (9) Includes charge of $351 million ( € 281 million) as a result of the fine +imposed by the European Commission in July 2006. PAGE 72 Table of Contents Part II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft +Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of +June 30, 2008 and 2007, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2008. These financial statements are the responsibility of +the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We +conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial +statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and +significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and +subsidiaries as of June 30, 2008 and 2007, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2008, in conformity with accounting principles generally accepted in the United +States of America. As discussed in Note 1 to the financial statements, on July 1, 2007 the Company adopted the provisions of +Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 and Emerging Issues Task Force Issue No. 06-2, Accounting for +Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 . We have also audited, in accordance with the +standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2008, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 31, 2008 expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 31, 2008 PAGE 73 Table of Contents Part II Item 9, 9A ITEM 9.    CHANGES IN +AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A.    CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have +evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer +have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON +INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial +reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted +in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as +necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized +acquisition, use, or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not +intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management +conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway +Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2008. There were no changes in our internal control over financial reporting during the +quarter ended June 30, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as +of June 30, 2008; their report is included in Item 9A. PAGE 74 Table of Contents Part II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and +Stockholders of Microsoft Corporation: We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the +“Company”) as of June 30, 2008, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is +responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over +Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about +whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, +testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable +basis for our opinion. A company’s internal control over financial reporting is a process designed by, or under the supervision +of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding +the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those +policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations +of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of +collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over +financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2008, +based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, +2008 of the Company and our report dated July 31, 2008 expressed an unqualified opinion on those financial statements and included an explanatory paragraph regarding the Company’s adoption of Financial Accounting Standards Board +Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 and Emerging Issues Task Force Issue No. 06-2, Accounting for Sabbatical Leave and Other Similar Benefits +Pursuant to FASB Statement No. 43 . /s/    D ELOITTE & +T OUCHE LLP Seattle, Washington July 31, 2008 PAGE 75 Table of Contents Part II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B.    OTHER +INFORMATION Not applicable. PART III ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this report. Information about our directors may be found under the +caption “Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 19, 2008 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board +Committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy Statement +set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate +Controller, and other finance organization employees. The finance code of ethics is publicly available on our Website at www.microsoft.com/msft/corporate/default.mspx. If we make any substantive amendments to the finance code of ethics or grant any +waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or waiver on that Website +or in a report on Form 8-K. ITEM 11.    EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” +“Compensation Committee Interlocks and Insider Participation,” and “Compensation Committee Report” is incorporated herein by reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Equity Compensation Plan Information” and “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and +Management” is incorporated herein by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED +TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director Independence” and +“Certain Relationships and Related Transactions” is incorporated herein by reference. ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal +accountant fees and services appears in the Proxy Statement under the headings “Fees Billed by Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent +Auditor” and is incorporated herein by reference. PAGE 76 Table of Contents Part IV Item 15 PART IV ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K. Financial statement schedules have been omitted since they are either not required, not applicable, or the information is otherwise included. (b) Exhibit Listing Filed herewith Incorporated by reference Exhibit number Exhibit description Form Period ending Exhibit Filing date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/02 3.1 1/31/03 3.2 Bylaws of Microsoft Corporation 10-K 6/30/07 3.2 8/3/07 10.1* Microsoft Corporation 2001 Stock Plan 8-K 99.2 7/21/06 10.2* Microsoft Corporation 1991 Stock Option Plan 8-K 99.1 7/21/06 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Stock Option Plan for Non-Employee Directors 8-K 10.4 11/15/04 10.5* Microsoft Corporation Stock Option Plan for Consultants and Advisors 8-K 10.5 11/15/04 10.6* Microsoft Corporation 2003 Employee Stock Purchase Plan 10-K 6/30/04 10.6 9/1/04 10.7* Microsoft Corporation Deferred Compensation Plan S-8 99.1 2/28/06 10.8* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.9* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period 10-K 6/30/04 10.10 9/1/04 PAGE 77 Table of Contents Part IV Item 15 Filed herewith Incorporated by reference Exhibit number Exhibit description Form Period ending Exhibit Filing date 10.11* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period 10-K 6/30/04 10.11 9/1/04 10.12* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.13* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.14 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee) 10-K 6/30/02 10.8 9/6/02 10.15 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee 10-K 6/30/03 10.8 9/5/03 10.16* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.17* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2007 performance period 10-K 6/30/07 10.17 8/3/07 10.18* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2008 performance period 10-Q 12/31/07 10.18 1/24/08 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X * Indicates a management contract or compensatory plan or arrangement PAGE 78 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its +behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 31, 2008. M ICROSOFT C ORPORATION By: / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below +by the following persons on behalf of Registrant and in the capacities indicated on July 31, 2008. Signature Title /s/    W ILLIAM H. G ATES III William H. Gates III Chairman /s/    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer /s/    J AMES I. C ASH , +J R . James I. Cash, Jr. Director /s/    D INA D UBLON Dina Dublon Director /s/    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director /s/    R EED H ASTINGS Reed Hastings Director /s/    D AVID F. +M ARQUARDT David F. Marquardt Director /s/    C HARLES H. +N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/    J ON A. +S HIRLEY Jon A. Shirley Director /s/    C HRISTOPHER P. +L IDDELL Christopher P. Liddell Senior Vice President; Chief +Financial Officer (Principal Financial Officer) /s/    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) PAGE 79 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-09-158735/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-09-158735/full-submission.txt new file mode 100644 index 0000000..7137069 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-09-158735/full-submission.txt @@ -0,0 +1,1088 @@ +Table of Contents United States Securities and Exchange Commission Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT +TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 30, 2009 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/msft Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule +405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required +to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for +such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data +File required to be submitted and posted to Rule 405 of Regulation S-T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such +files).    Yes ¨ No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to +Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of +this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” +“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller reporting company ¨ (Do not check if a smaller reporting company) Indicate by check mark whether the registrant is a shell company (as defined in Rule +12b-2 of the Exchange Act).    Yes ¨ No x As of December 31, 2008, the aggregate market value of the +registrant’s common stock held by non-affiliates of the registrant was $149,769,380,603 based on the closing sale price as reported on the NASDAQ National Market System. As of July 27, 2009, there were 8,910,673,817 shares of common stock +outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 19, 2009 are incorporated by reference into Part III. Table of Contents Microsoft Corporation FORM 10-K For The Fiscal Year Ended June 30, 2009 INDEX PART I Item 1. Business 3 Executive Officers of the Registrant 11 Item 1A. Risk Factors 13 Item 1B. Unresolved Staff Comments 18 Item 2. Properties 18 Item 3. Legal Proceedings 18 Item 4. Submission of Matters to a Vote of Security Holders 18 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 19 Item 6. Selected Financial Data 20 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 21 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 42 Item 8. Financial Statements and Supplementary Data 43 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 82 Item 9A. Controls and Procedures 82 Report of Management on Internal Control over Financial Reporting 82 Report of Independent Registered Public Accounting Firm 83 Item 9B. Other Information 84 PART III Item 10. Directors, Executive Officers and Corporate Governance 84 Item 11. Executive Compensation 84 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 84 Item 13. Certain Relationships and Related Transactions, and Director Independence 84 Item 14. Principal Accounting Fees and Services 84 PART IV Item 15. Exhibits and Financial Statement Schedules 85 Signatures 88 PAGE 2 Table of Contents Part I Item 1 Note About Forward-Looking Statements Certain statements in this report, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and +the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the +Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business”, “Management’s Discussion and Analysis”, and “Risk +Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” +“future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. +Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and +uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Risk Factors” (refer to Part I, Item 1A). We undertake no obligation to update or +revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. PART I ITEM 1.    BUSINESS GENERAL Our mission is to enable people and businesses throughout the world to realize their full potential. Since the company was +founded in 1975, we have worked to achieve this mission by creating technology that transforms the way people work, play, and communicate. We develop and market software, services, hardware, and solutions that we believe deliver new opportunities, +greater convenience, and enhanced value to people’s lives. We do business throughout the world and have offices in more than 100 countries. We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services +include operating systems for servers, personal computers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing +applications; software development tools; and video games. We provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 +video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Bing, Windows Live, Office Live, our MSN portals and channels, and the Microsoft Online Services platform +which includes offerings for businesses such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the delivery of online advertising across our broad range of digital media properties and on +Bing through our proprietary adCenter platform. We also conduct research and develop advanced technologies for future software +products and services. We believe that delivering breakthrough innovation and high-value solutions through our integrated software platform is the key to meeting our customers’ needs and to our future growth. We believe that we will continue to +lay the foundation for long-term growth by delivering new products and services, creating new opportunities for partners, improving customer satisfaction, and improving our internal processes. Our focus is to build on this foundation through ongoing +innovation in our integrated software platforms; by delivering compelling value propositions to customers; by responding effectively to customer and partner needs; and by continuing to emphasize the importance of product excellence, business +efficacy, and accountability. OPERATING SEGMENTS We have five operating segments: Client, Server and Tools, Online Services Business, Microsoft Business Division, and Entertainment and Devices Division. Our segments provide management with a comprehensive financial view of our key +businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of development, sales, marketing, and +services resources within businesses. PAGE 3 Table of Contents Part I Item 1 Due to our integrated business +structure, operating costs included in one segment may benefit other segments. Therefore, these segments are not designed to measure operating income or loss that is directly related to the products and services included in each segment. +Inter-segment cost commissions are estimated by management and used to compensate or charge each segment for such shared costs and to motivate shared effort. Segments should not be viewed as discrete or easily separable businesses. Client Client has overall responsibility for technical +architecture, engineering, and delivery of our Windows product family and is responsible for our relationships with personal computer manufacturers, including multinational and regional original equipment manufacturers (“OEMs”). Client +revenue growth is directly impacted by growth of PC purchases from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The differences between unit growth rates and +revenue growth rates from year to year are affected primarily by changes in the mix of OEM Windows premium edition operating systems licensed as a percentage of total OEM Windows operating systems licensed (“OEM premium mix”). Additional +differences in growth rates result from the impact from lower cost netbook PCs, which are sold with a lower cost version of Windows, changes in geographic mix, and changes in the channel mix of products sold by large, multi-national OEMs versus +those sold by local and regional system builders. The majority of revenue in fiscal year 2009 came from sales of Windows Vista, which +was released in fiscal year 2007. Windows XP operating systems reached end-of-life for most editions and sales channels (Windows XP Home Edition will continue to be available on netbooks and other Windows XP editions will continue to be available in +China). Windows 7, the latest version of Windows, was released to manufacturing in July 2009 and is expected to be generally available on October 22, 2009. Client offerings consist of premium and standard edition Windows operating systems. Premium editions are those that include additional functionality and are sold at a price above our standard editions. Products : Windows Vista, including Home Basic, Home Premium, Ultimate, Business, +Enterprise, and Starter Edition; Windows XP, including Professional, Home, Media Center, and Tablet PC Edition; and other standard Windows operating systems. Competition Client faces strong competition from well-established companies with differing approaches to the PC market. Competing +commercial software products, including variants of Unix, are supplied by competitors such as Apple, Canonical, and Red Hat. Apple takes an integrated approach to the PC experience and has made inroads in share, particularly in the U.S. and in the +consumer segment. The Linux operating system, which is also derived from Unix and is available without payment under a General Public License, has gained some acceptance, especially in emerging markets, as competitive pressures lead OEMs to reduce +costs and new, lower-price PC form-factors gain adoption. Partners such as Hewlett-Packard and Intel have been actively working with alternative Linux-based operating systems. The Windows operating system also faces competition from alternative platforms and new devices that may reduce consumer demand for traditional PCs. Competitors such as Apple, Google, Mozilla, and Opera +Software Company offer software that competes with the Internet Explorer Web browsing capabilities of Windows products. User and usage volumes on mobile devices are increasing around the world relative to the PC. OEMs have been working to make the +Google Android mobile operating system more compatible with small form-factor PCs or netbooks. Our operating system products compete +effectively by delivering innovative software, giving customers choice and flexibility, a familiar, easy-to-use interface, compatibility with a broad range of hardware and software applications, and the largest support network for any operating +system. Server and Tools Server and +Tools develops and markets software server products, software developer tools, services, and solutions. Windows Server-based products are integrated server infrastructure and middleware software designed to support software applications built on the +Windows Server operating system. Windows Server-based products include the server platform including targeted segment solutions, database, storage, management and operations, service-oriented PAGE 4 Table of Contents Part I Item 1 architecture platform, and security and identity software. The segment also builds standalone and software development lifecycle tools for software architects, +developers, testers, and project managers. Server products can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. We offer a broad range of consulting services and provide product support services that assist customers in developing, deploying, and managing Microsoft server and desktop solutions. We also provide training and certification +to developers and information technology professionals about our Server and Tools, Microsoft Business Division, and Client platform products. Approximately 50% of Server and Tools revenue comes from multi-year licensing agreements, approximately 20% is purchased through fully packaged product and transactional volume licensing programs, and approximately 10% comes from licenses +sold to OEMs. The remainder of Server and Tools revenue comes from consulting and product and solution support services. Windows +Server 2008 R2, the latest version of the Windows Server operating system was released to manufacturing in July 2009 and is expected to be generally available in September 2009. Products and Services : Windows Server operating system; Microsoft SQL Server; Visual Studio; Silverlight; System Center products; Forefront security products; +Biz Talk Server; Microsoft Consulting Services; Premier product support services; and other products and services. Competition Our server operating system products face intense competition from a wide variety of server operating systems and server applications, offered by companies with a +variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Sun Microsystems offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers +offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many leading +commercial and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. We +have entered into business and technical collaboration agreements with Novell and other Linux providers to build, market, and support a series of solutions to enhance the interoperability of our products with their virtualization, management, and +network security solutions, and to provide each other’s customers with patent coverage for their respective products. We compete +to provide enterprise-wide computing solutions with several companies that offer solutions and middleware technology platforms. IBM, Oracle, and Sun Microsystems lead a group of companies focused on the Java 2 Platform Enterprise Edition (J2EE). +Commercial software developers that provide competing server applications for PC-based distributed client/server environments include CA, Inc., IBM, and Oracle. Our Web application platform software competes with open source software such as Apache, +Linux, MySQL, and PHP, and we compete against Java middleware such as Geronimo, JBoss, and Spring Framework. Numerous commercial +software vendors offer competing software applications for connectivity (both Internet and intranet), security, hosting, and e-business servers. System Center competes with server management and server virtualization platform providers, such as BMC, +CA, Inc., Hewlett-Packard, IBM, and VMWare in the management of information technology infrastructures. Forefront security products compete with McAfee, Symantec, and Trend Micro in protecting both client and server applications. Our products for +software developers compete against offerings from Adobe, Borland, IBM, Oracle, Sun Microsystems, other companies, and open-source projects. Open source projects include Eclipse (sponsored by CA, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among +others. We believe that our server products provide customers with advantages in innovation, performance, total costs of ownership, and productivity by delivering superior applications, development tools, and compatibility with a broad base of +hardware and software applications, security, and manageability. Online Services Business The Online Services Business (“OSB”) consists of an online advertising platform with offerings for both publishers and advertisers, online information +offerings such as Bing, MSN Portals and channels, and personal communications services such as email and instant messaging around the world. We earn revenue primarily from online advertising, including search, display, and email and messaging +services. Revenue is also generated through subscriptions and transactions generated from online paid services, from advertiser and publisher tools, and digital marketing and advertising agency services. We continue to launch updated and new online +offerings and expect to continue to do so in the future. During fiscal year 2009, we launched new releases of our proprietary advertising platforms, adCenter PAGE 5 Table of Contents Part I Item 1 and adExpert, and launched a new release of our search engine named Bing. We also updated behavioral targeting tools, launched new releases of MSN properties globally, +and added applications and services to our existing Windows Live suite. Products and +Services : Bing; Microsoft adCenter/adExpert; Microsoft Media Network (MMN); MSN portals, channels, and mobile services; Windows Live suite of applications and mobile services; Atlas online tools for advertisers +and publishers; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, and MSN Software Services); and Razorfish media agency services. Competition OSB competes with AOL, Google, Yahoo!, and a wide array of Web sites and portals that +provide content and online offerings of all types to end users. We compete with these organizations to provide advertising opportunities for merchants. The Internet advertising industry has grown significantly over the past several years, and we +anticipate that this trend will continue long-term. Competitors are aggressively developing Internet offerings that seek to provide more effective ways of connecting advertisers with audiences through enhanced functionality in information services +such as Internet search, improvements in communication services, and improved advertising infrastructure and support services. We believe our search engine, Bing, helps users make faster, more informed decisions by providing more relevant search +results, expanded search services, and a broader selection of content. We have also enhanced the user interface to bring a richer search experience, which we believe will differentiate us from our competitors. To support the growth of our +advertising business, we also are investing in improving the scale of our advertising platform, seamless integration of content and offerings to the mobile platform, rich and relevant content for wider consumer reach, enhanced communication +services, technology, and operations, along with sustained sales efforts. We will continue to introduce new products and services that are aimed at attracting additional users through improvements in the user online experience. We believe that we +can compete effectively across the breadth of our Internet services by providing users with software innovation in the form of information and communication services that help them find and use the information and experiences they want online and by +providing merchants with effective advertising results through improved systems and sales support. Microsoft Business Division Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business solutions. Microsoft Office +system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD +revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as content management, enterprise search, collaboration, unified communications, and +business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and +divisions of global enterprises. We evaluate MBD results based upon the nature of the end user in two primary parts: business +revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. Approximately +80% of MBD revenue is generated from sales to businesses. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given +year. Approximately 20% of MBD revenue is derived from sales to consumers. Most of this revenue is generated from new licenses acquired through fully packaged products and licenses sold through OEMs for new PCs and is generally affected by +the level of PC shipments and product launches. Products : Microsoft Office; Microsoft +Office Project; Microsoft Office Visio; Microsoft Office SharePoint Server; FAST ESP; Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communications Server; Microsoft Office +Communicator; Microsoft Tellme Service; Microsoft Dynamics ERP products including AX, NAV, GP, SL, Retail Management System, and Point of Sale; Microsoft Dynamics CRM; and Microsoft Dynamics CRM Online. PAGE 6 Table of Contents Part I Item 1 Competition Competitors to the Microsoft Office system include many software application vendors such as Adobe, Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Zoho, and +local application developers in Asia and Europe. Apple may distribute certain versions of its application software products with various models of its PCs and through its mobile devices. Corel (WordPerfect Suite) and IBM (Smartsuite) have measurable +installed bases with their office productivity products. Corel’s suites, and many local software suites around the world, are aggressively priced for OEMs to preinstall them on low-priced PCs. Google provides Google Apps, a hosted messaging and +productivity suite that competes with Microsoft Office, Microsoft Exchange, and Microsoft SharePoint Server, and also provides an enterprise search offering that competes with Microsoft Search Server. IBM competes with Office system products +with its Notes and Workplace offerings. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Red +Hat, and Sun Microsystems. Web-based offerings such as 37Signals, Adobe, AjaxWrite, gOffice, ShareOffice, Socialtext, ThinkFree, Zoho, or other small projects competing with individual applications, can also provide an alternative to Microsoft +Office system products. Our Microsoft Dynamics products compete with well-known vendors such as Intuit and Sage in the market focused on providing solutions for small and mid-sized businesses. The market for large organizations and +divisions of global enterprises is intensely competitive with a small number of primary vendors including Oracle and SAP. Additionally, Salesforce.com’s on-demand customer relationship management offerings compete directly with Microsoft +Dynamics CRM Online and Microsoft Dynamic CRM’s on-premise offerings. As we continue to respond to market demand for additional +functionality and products, we will compete with additional vendors, most notably in content management and enterprise search, collaboration tools, unified communications, and business intelligence. These competitors include Autonomy, Cisco, Endeca, +Google, IBM, Oracle, and SAP. We believe our products compete effectively with all of these vendors based on our strategy of providing flexible, easy to use solutions that work well with technologies our customers already have. Entertainment and Devices Division The Entertainment +and Devices Division (“EDD”) is responsible for developing, producing, and marketing the Xbox video game system, including consoles and accessories, third-party games, games published under the Microsoft brand, and Xbox Live operations, as +well as research, sales, and support of those products. In addition to Xbox, EDD offers the Zune digital music and entertainment device and accessories; PC software games; online games; Mediaroom, our Internet protocol television software; the +Microsoft Surface computing platform; and mobile and embedded device platforms. EDD also leads the development efforts of our line of consumer software and hardware products including application software for Macintosh computers and Microsoft PC +hardware products, and is responsible for all retail sales and marketing for Microsoft Office and the Windows operating systems. Products : Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and hardware products (such as mice and keyboards); Windows Mobile software and services platform; +Windows Embedded device operating system; Windows Automotive; and the Microsoft Surface computing platform. Competition Entertainment and devices businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the +development of new technologies. The markets for our products are characterized by significant price competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices +on certain products. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, +quality and variety, timing of product releases, and effectiveness of distribution and marketing. Our Xbox hardware business competes +with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for video game consoles averages five to 10 years. We released Xbox 360, our second generation console, in November 2005. +Nintendo and Sony released new versions of their game consoles in late 2006. We believe the success of video game consoles is determined by the availability of games for the console, providing exclusive game content that gamers seek, the +computational power and reliability of the console, and the ability to create new experiences via online services, downloadable content, and peripherals. We PAGE 7 Table of Contents Part I Item 1 think the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new developer tools, online gaming +services, and continued strong exclusive content from our own game franchises. In addition to competing against software published +for non-Xbox platforms, our games business also competes with numerous companies that we have licensed to develop and publish software for the Xbox consoles. Zune competes with Apple and other manufacturers of digital music and entertainment +devices. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Mediaroom faces competition primarily from a variety of competitors that provide +elements of an Internet protocol television delivery platform, but that do not provide end-to-end solutions for the network operator. Windows Mobile software and services faces substantial competition from Apple, Google, Nokia, Openwave Systems, +Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system business is highly fragmented with many competitive offerings. Key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors such as +Metrowerks and MontaVista Software. OPERATIONS To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require +modifying the user interface, altering dialog boxes, and translating text. Our operational centers support all operations in their +regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in +Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the +operational centers, we also operate data centers throughout the United States and in Europe. We contract most of our manufacturing +activities for Xbox 360 and related games, Zune, various retail software packaged products, and Microsoft hardware to third parties. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console +includes certain key components that are supplied by a single source. The central processing unit is purchased from IBM and the graphics chips and embedded dynamic random access memory chips for the graphics processing unit are purchased from Taiwan +Semiconductor Manufacturing Company. Although we have chosen to initially source these key Xbox 360 components from a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the +exceptions noted, we generally have the ability to use other custom manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component +parts and materials on a volume discount basis. RESEARCH AND DEVELOPMENT During fiscal years 2009, 2008, and 2007, research and development expense was $9.0 billion, $8.2 billion, and $7.1 billion, respectively. These amounts represented 15%, 14%, and 14%, respectively, of +revenue in each of those years. We plan to continue to make significant investments in a broad range of research and product development efforts. While most of our software products are developed internally, we also purchase technology, license intellectual property rights, and oversee third-party development and localization of certain products. We believe we are not +materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain closer technical control over our products. It also gives us the freedom to decide +which modifications and enhancements are most important and when they should be implemented. Generally, we also create product documentation internally. We strive to obtain information as early as possible about changing usage patterns and hardware +advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. PAGE 8 Table of Contents Part I Item 1 Investing in Business and Product Development Innovation is the foundation for Microsoft’s success. Our model for growth is based on our ability to initiate and embrace disruptive +technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market. We maintain our long-term commitment to research and development across a wide +spectrum of technologies, tools, and platforms spanning communication and collaboration; information access and organization; entertainment; business and e-commerce; advertising; and devices. Increasingly, we are taking a global approach to innovation. While our main research and development facilities are located in the United States, in +Redmond, Washington, we also operate research facilities in other parts of the United States and around the world, including Canada, China, Denmark, England, India, Ireland, and Israel. This global approach will help us remain competitive in local +markets and enables us to continue to attract top talent from across the world. We invest in innovation by focusing on the emerging +technology trends and breakthroughs that we believe offer the greatest opportunity to deliver value to our customers and growth for the company. Microsoft Research is one of the world’s largest computer science research organizations, and works +in close collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends. Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, areas where we see significant opportunities to drive future growth +include: Cloud computing and software plus services The ability to combine the power of desktop and server software with the reach of the Internet is creating important opportunities for growth in almost every one of our businesses. Accordingly, we are +focused on innovation and broadening our platform to develop a cloud computing ecosystem that positions us for success in areas including virtualization, management, and security identity. We are also focused on delivering end-to-end experiences +that connect users to information, communications, entertainment, and people in new ways across their lives at home, at work, and the broadest possible range of mobile scenarios through investments in datacenters; new versions of Windows and Office +that are designed to support a wide range of connected scenarios; solutions for businesses that can be deployed by a customer, by a service provider like Microsoft, or by a Microsoft partner; tools for developers and Web designers; and consumer +products including Xbox 360 and Zune. Natural user interfaces The next few years will also see dramatic changes in the way people interact with technology as touch, gestures, handwriting, and speech +recognition become a normal part of how we control devices. This will make technology more accessible and simpler to use and will create opportunities to reach new markets and deliver new kinds of computing experiences. Our long-term investments in +natural user interfaces can be seen in products like Windows 7, the Microsoft Auto software platform, and Microsoft Surface. New +scenario innovation Continuing improvement in the power of computers and devices and the speed and ubiquity of networks is +creating opportunities to deliver innovation that will transform a number of key industries and address significant global issues including healthcare, environmental sustainability, and education. In healthcare, for example, computing will connect +personal health information to medical research and help make healthcare more preventive, personalized, and cost-effective. Today, Microsoft products such as HealthVault and Amalga help individuals manage their personal health and enable healthcare +professionals to integrate research and health information so they can deliver more effective care. We also believe that we are entering a period where personal computers will play an increasingly important role in virtually every field of +scientific research and discovery. PAGE 9 Table of Contents Part I Item 1 Intelligent computing As computing power increases, our ability to build software that has the intelligence to understand a user’s preferences +based on the tools and information they have accessed in the past and anticipate their future needs is rapidly improving. This development will enable us to deliver a new generation of software solutions that make people more productive by enabling +them to focus more on what they want to accomplish and less on the steps needed to use technology. DISTRIBUTION, SALES, AND MARKETING We distribute our products primarily through the following channels: OEM; distributors and resellers; and online. OEM We license our software to OEMs for distribution +as pre-installed software on new PCs. The most significant part of the OEM business for us is licensing of the Windows operating system. We also license certain server operating systems, desktop applications such as our Office productivity suite, +and consumer software products and we market hardware devices, and software as services including our Windows Live Essentials suite to OEMs. We have OEM agreements covering one or more of our products with virtually all of the major PC OEMs, +including Acer, ASUSTek, Dell, Fujitsu, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba. A substantial amount of OEM business is also conducted with system builders, which are low-volume, customized PC vendors operating in local markets. Distributors and Resellers We license +software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products. Organizations license our products primarily through large account resellers (“LARs”) and value-added resellers +(“VARs”). Many organizations that license products through enterprise agreements transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are also +authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations and VARs typically reach the small- and +medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Software House International, and Insight Enterprises. Our Microsoft Dynamics software offerings are +licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our finished goods products primarily through independent non-exclusive distributors, authorized replicators, +resellers, and retail outlets. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Target, and Wal-Mart. We have a network of field sales representatives and field support personnel that solicits orders +from distributors and resellers and provides product training and sales support. Our arrangements for organizations to acquire +multiple licenses of products are designed to provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different +programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include: Open licensing Designed primarily for small-to-medium organizations (5 to over 250 +licenses), these programs allow customers to acquire perpetual or subscription licenses and, at the customer’s election, rights to future versions of software products over a specified time period (two or three years depending on the Open +program used). The offering that conveys rights to future versions of certain software products over the contract period is called software assurance. Software assurance also provides support, tools, and training to help customers deploy and use +software efficiently. Under the Open program, customers can acquire licenses only, or licenses with software assurance. They can also renew software assurance upon the expiration of existing volume licensing agreements. PAGE 10 Table of Contents Part I Item 1 Select licensing Designed primarily for medium-to-large organizations (greater than 250 licenses), this program allows customers to acquire perpetual licenses and, +at the customer’s election, software assurance over a specified time period (generally three years or less to align to the end of the agreement term). Similar to the Open program, the Select program allows customers to acquire licenses only, +acquire licenses with software assurance, or renew software assurance upon the expiration of existing volume licensing agreements. Enterprise agreement licensing Enterprise agreements are targeted at medium and large organizations (greater than +250 licenses) that want to acquire licenses to software products, along with software assurance, for all or substantial parts of their enterprise. Enterprises can elect to either acquire perpetual licenses or, under the Enterprise Subscription +program, can acquire non-perpetual, subscription agreements for a specified time period (generally three years). Online We have an expanding portfolio of products, services, and solutions that we distribute online. We provide online content and services through Bing, Windows Live, +Office Live, our MSN portals and channels, and the Microsoft Online Services platform, which includes offerings for businesses such as cloud-hosted Exchange, SharePoint, and Office Communications. OSB provides various premium services to consumers +and businesses, such as email and messaging communication services and tools such as online search, advertising, and premium content. EDD offers the Xbox Live service which allows customers to participate in the gaming experience online with other +subscribers. We also offer the Microsoft Small Business Center portal which provides tools for small-business owners to build, market, and manage their businesses online. Other services delivered online include Microsoft Developer Networks +subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and solutions. CUSTOMERS Our customers include individual consumers, small and medium-sized organizations, +enterprises, governmental institutions, educational institutions, Internet service providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily through resellers and OEMs. No sales to +an individual customer accounted for more than 10% of fiscal year 2009, 2008, or 2007 revenue. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 29, 2009 were as follows: Name Age Position with the Company Steven A. Ballmer 53 Chief Executive Officer Robert J. (Robbie) Bach 47 President, Entertainment and Devices Division Lisa E. Brummel 49 Senior Vice President, Human Resources Stephen A. Elop 45 President, Microsoft Business Division Christopher P. Liddell 51 Senior Vice President and Chief Financial Officer Qi Lu, Ph.D. 47 President, Online Services Division Robert L. Muglia 49 President, Server and Tools Business Craig J. Mundie 60 Chief Research and Strategy Officer Raymond E. Ozzie 53 Chief Software Architect Steven Sinofsky 43 President, Windows Division Bradford L. Smith 50 Senior Vice President; General Counsel; Secretary B. Kevin Turner 44 Chief Operating Officer PAGE 11 Table of Contents Part I Item 1 Mr. Ballmer was appointed Chief +Executive Officer in January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. Mr. Ballmer joined Microsoft in 1980. Mr. Bach was named President, Entertainment and Devices Division in September 2005. He had been Senior Vice President, Home and Entertainment +since March 2000. Before holding that position, he had been Vice President, Home and Retail since March 1999, Vice President, Learning, Entertainment and Productivity since 1997, and Vice President, Desktop Applications Marketing since 1996. +Mr. Bach joined Microsoft in 1988. Ms. Brummel was named Senior Vice President, Human Resources in December 2005. She +had been Corporate Vice President, Human Resources since May 2005. From May 2000 to May 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of +management positions at Microsoft, including general manager of Consumer Productivity business, product unit manager of the Kids business, and product unit manager of Desktop and Decision reference products. Mr. Elop was named President, Microsoft Business Division in January 2008. Prior to joining the Company, Mr. Elop served as Chief +Operating Officer of Juniper Networks, Inc. from January 2007 to January 2008. From December 2005 to December 2006, he served as President of Worldwide Field Operations at Adobe Systems Inc. Mr. Elop joined Adobe following the 2005 acquisition +of Macromedia Inc., where he was President and Chief Executive Officer from January 2005 to December 2005. During his almost eight-year tenure at Macromedia, Mr. Elop held many senior positions, including Chief Operating Officer, Executive Vice +President of Worldwide Field Operations and General Manager of Macromedia’s eBusiness division. Mr. Liddell was named +Senior Vice President and Chief Financial Officer of the Company in May 2005. Mr. Liddell served as Senior Vice President and Chief Financial Officer of International Paper Company from March 2003 through April 2005, and prior to becoming Chief +Financial Officer, he held the positions of Vice President-Finance and Controller. Mr. Liddell served as Chief Executive Officer of Carter Holt Harvey Limited, an affiliate of International Paper, from 1999 to 2002 and Chief Financial Officer +from 1995 to 1998. Dr. Lu joined Microsoft in January 2009 as President, Online Services Division. Prior to joining the Company, +Dr. Lu was a senior executive at Yahoo!, Inc. for 10 years. His roles included serving as Executive Vice President of Engineering for Yahoo!’s Search and Advertising Technology Group and Vice President of Engineering. Mr. Muglia was named President, Server and Tools Business in January 2009. He had been Senior Vice President, Server and Tools Business since +October 2005. Before holding that position, he had a number of leadership positions at Microsoft, including Senior Vice President, Enterprise Storage Division since November 2001, Group Vice President, Personal Services Group since August 2000, +Group Vice President, Business Productivity since December 1999, Senior Vice President, Business Productivity since March 1999, Senior Vice President, Applications and Tools since February 1998, and Corporate Vice President, Server Applications +since 1997. Mr. Muglia joined Microsoft in 1988. Mr. Mundie was named Chief Research and Strategy Officer in June 2006. He +had been Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie joined Microsoft in 1992. Mr. Ozzie was named Chief Software Architect in June 2006. He had been Chief Technical Officer from April 2005 to June 2006. He assumed that +role in April 2005 after Microsoft acquired Groove Networks, a collaboration software company he formed in 1997. Mr. Sinofsky +was named President, Windows Division in July 2009. He served as Senior Vice President of the Windows and Windows Live Engineering Group since December 2006 and Senior Vice President, Office from December 1999 to December 2006. He had been Vice +President, Office since December 1998. Mr. Sinofsky joined the Office team in 1994, increasing his responsibility with each subsequent release of the desktop suite. Mr. Sinofsky joined Microsoft in 1989. Mr. Smith was named Senior Vice President, General Counsel, and Secretary in November 2001. Mr. Smith was also named Chief Compliance +Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith joined Microsoft in 1993. Mr. Turner was named Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, +Inc. and President and Chief Executive Officer of the Sam’s Club division. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 +to September 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. PAGE 12 Table of Contents Part I Item 1, 1A EMPLOYEES As of June 30, 2009, we employed approximately 93,000 people on a full-time basis, 56,000 in the United States and 37,000 internationally. Of the total, +36,000 were in product research and development, 26,000 in sales and marketing, 17,000 in product support and consulting services, 5,000 in manufacturing and distribution, and 9,000 in general and administration. Our success is highly dependent on +our ability to attract and retain qualified employees. None of our employees are subject to collective bargaining agreements. AVAILABLE +INFORMATION Our Company Internet address is www.microsoft.com. At our Investor Relations Web site, www.microsoft.com/msft, we make available +free of charge a variety of information for investors. Our goal is to maintain the Investor Relations Web site as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after +we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”). • Our Investor Central site, an interactive and easily navigable source of information including our business strategies, financial results, and key performance indicators. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events +are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles, bylaws, governance guidelines, committee charters, codes of conduct and ethics, and other governance-related +policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. ITEM 1A.    RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the +trading price of our common stock. Challenges to our business model may reduce our revenues and operating margins. Our +business model has been based upon customers paying a fee to license software that we develop and distribute. Under this license-based software model, software developers bear the costs of converting original ideas into software products through +investments in research and development, offsetting these costs with the revenue received from the distribution of their products. Certain “open source” software business models challenge our license-based software model. Open source +commonly refers to software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an +open source business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do not bear the full costs of research and development for the +software. Some of these firms may build upon Microsoft ideas that we provide to them free or at low royalties in connection with our interoperability initiatives. To the extent open source software gains increasing market acceptance, our sales, +revenue, and operating margins may decline. Another development is the business model under which companies provide content, and +software in the form of applications, data, and related services, over the Internet in exchange for revenues primarily from advertising or subscriptions. An example of an advertising-funded business model is Internet search, where providing a robust PAGE 13 Table of Contents Part I Item 1A alternative is particularly important and challenging due to the scale effects enjoyed by a single market dominant competitor. Advances in computing and communications +technologies have made this model viable and enabled the rapid growth of some of our competitors. We are devoting significant resources toward developing our own competing software plus services strategies including the Windows Azure Platform, our +hosted computing platform designed to facilitate the rapid, flexible and scalable development of cloud-based services. It is uncertain whether these strategies will be successful. An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A +competing vertically-integrated model, in which a single firm controls both the software and hardware elements of a product, has been successful with certain consumer products such as personal computers, mobile phones, and digital music players. We +also offer vertically-integrated hardware and software products; however, efforts to compete with the vertically integrated model may increase our cost of sales and reduce our operating margins. We face intense competition. We continue to experience intense competition across all markets for our products and services. Our +competitors range in size from Fortune 100 companies to small, specialized single-product businesses and open source community-based projects. Although we believe the breadth of our businesses and product portfolio is a competitive advantage, our +competitors that are focused on narrower product lines may be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low and products, once +developed, can be distributed broadly and quickly at relatively low cost. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products, in some cases on the basis of +technical specifications for Microsoft technologies that we make available at little or no cost. In response to competition, we are developing versions of our products with basic functionality that are sold at lower prices than the standard +versions. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins, and operating income. We may not be able to adequately protect our intellectual property rights. Protecting our global intellectual property rights and +combating unlicensed copying and use of software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are +less protective of intellectual property rights. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of +licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational +and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these +claims may grow. To resolve these claims we may enter into royalty and licensing agreements on less favorable terms, stop selling or redesign affected products, or pay damages to satisfy indemnification commitments with our customers. Such +agreements may cause operating margins to decline. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source +code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a +number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection +for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the +security risks described in the next paragraph. Security vulnerabilities in our products could lead to reduced revenues or to liability +claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our products. +Although this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend PAGE 14 Table of Contents Part I Item 1A to focus their efforts on the most popular operating systems and programs and we expect them to continue to do so. We devote significant resources to address security +vulnerabilities through: • engineering more secure products; • enhancing security and reliability features in our products; • helping our customers make the best use of our products and services to protect against computer viruses and other attacks; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; and • providing customers online automated security tools, published security guidance, and security software such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security +vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems +from attack, which could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. In addition, actual or perceived vulnerabilities may lead to claims against us. Although our license agreements +typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand all legal challenges. We are subject to government litigation and regulatory activity that affects how we design and market our products. As a leading global software maker, we receive close scrutiny from government +agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved +through a Consent Decree that took effect in 2001 and a Final Judgment entered in 2002. These proceedings imposed various constraints on our Windows operating system businesses. These constraints include limits on certain contracting practices, +mandated disclosure of certain software program interfaces and protocols, and rights for computer manufacturers to limit the visibility of certain Windows features in new PCs. We believe we are in full compliance with these rules. However, if we +fail to comply with them, additional restrictions could be imposed on us that would adversely affect our business. The European +Commission closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In +2004, the Commission ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in +their own products. The Commission’s impact on product design may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The +availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our own products which could result in decreased sales of our products. Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and +businesses, thereby reducing the attractiveness of our products and the revenues that come from them. New actions could be initiated at any time, either by these or other governments or private claimants, including with respect to new versions of +Windows or other Microsoft products. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply +with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated +intellectual property. • The rulings described above may be cited as a precedent in other competition law proceedings. PAGE 15 Table of Contents Part I Item 1A Our software and services online +offerings are subject to government regulation of the Internet domestically and internationally in many areas, including user privacy, telecommunications, data protection, and online content. The application of these laws and regulations to our +business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on +us or orders that we stop doing the alleged noncompliant activity. Our business depends on our ability to attract and retain talented +employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to +recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely +affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. Delays in product development schedules may adversely affect our revenues. The development of software products is a complex and +time-consuming process. New products and enhancements to existing products can require long development and testing periods. Our increasing focus on software plus services also presents new and complex development issues. Significant delays in new +product or service releases or significant problems in creating new products or services could adversely affect our revenue. We make significant +investments in new products and services that may not be profitable. Our growth depends on our ability to innovate by offering new, and adding value to our existing, software and service offerings. We will continue to make +significant investments in research, development, and marketing for new products, services, and technologies, including the Windows PC operating system, the Microsoft Office system, Xbox 360, Live Search, Windows Server, Zune, Windows Live, the +Windows Azure Services platform, and other software plus services offerings. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and +marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. We may not achieve +significant revenue from new product and service investments for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses may not be +as high as the margins we have experienced historically. Adverse economic conditions may harm our +business. Unfavorable changes in economic conditions, including inflation, recession, or other changes in economic conditions, may result in lower information technology spending and adversely affect our revenue. If demand +for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Our product distribution system also relies on an extensive partner network. The +impact of economic conditions on our partners, such as the bankruptcy of a major distributor, could result in sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services +they have purchased. As a result, reserves for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, +liquidity, market, and interest rate risks, which may be exacerbated by unusual events that have affected global financial markets. If global credit and equity markets experience prolonged periods of decline, our investment portfolio may be +adversely impacted and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely impact our financial results. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. +Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. Although management currently believes resolving all of these matters, +individually or in the aggregate, will not have a material adverse impact on our financial position, results of operations, or cash flows, the litigation and other claims are subject to inherent uncertainties and management’s view of these +matters may change in the future. A material adverse impact on our financial position, results of operations, or cash flows also could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably +estimable. PAGE 16 Table of Contents Part I Item 1A We may have additional tax +liabilities. We are subject to income taxes in the United States and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our +business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits +and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial position, results of operations, or cash flows in +the period or periods for which that determination is made. In addition, there have been proposals to reform U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. We earn a substantial +portion of our income in foreign countries. Although we cannot predict whether or in what form this proposed legislation will pass, if enacted it could have a material adverse impact on our tax expense and cash flow. Our vertically-integrated hardware and software products may experience quality or supply problems .    Our hardware products such as the +Xbox 360 console are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or effectively address such issues through design, +testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain timely +replacement supplies, resulting in reduced sales. Either component shortages or excess or obsolete inventory may require us to record charges to cost of revenue. Xbox 360 consoles are assembled in Asia; disruptions in the supply chain may result in +console shortages that would affect our revenues and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings. Under generally accepted accounting principles, +we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in +circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our +industry. We may be required to record a significant charge in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. We operate a global business that exposes us to additional risks. We operate in over 100 countries and a significant +part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the United States and other countries. Operations outside the United States may be +affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment, including the Foreign Corrupt Practices Act and local laws prohibiting corrupt payments; and changes in regulatory +requirements for software. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets presents a number of risks. Deterioration of social, political, labor, or economic conditions in a +specific country or region and difficulties in staffing and managing foreign operations may also adversely affect our operations or financial results. Although we hedge a portion of our international currency exposure, significant fluctuations in +exchange rates between the U.S. dollar and foreign currencies may adversely affect our net revenues. Catastrophic events or geo-political +conditions may disrupt our business. A disruption or failure of our systems or operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in +completing sales, providing services, or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the +Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical +business or information technology systems could harm our ability to conduct normal business operations and our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected +countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers. PAGE 17 Table of Contents Part I Item 1A, 1B, 2, 3, 4 Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions or entering into joint ventures as part of our long-term business strategy. These +transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don’t realize a satisfactory return on our investment, or that we experience difficulty in the integration of +new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These events could harm our operating results or financial condition. Improper disclosure of personal data could result in liability and harm our reputation. We store and process large amounts of personally identifiable information. It is +possible that our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Such disclosure could harm +our reputation and subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data. Perceptions that our +products or services do not adequately protect the privacy of personal information could inhibit sales of our products. We may experience outages +and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic and complexity of our products and services demand more computing power. We have spent and +expect to continue to spend substantial amounts to purchase or lease data centers and equipment and to upgrade our technology and network infrastructure to handle increased traffic on our Web sites and to introduce new products and services and +support existing services such as Xbox Live, Windows Live, and Office Live. This expansion is expensive, complex, and could result in inefficiencies or operational failures, which could diminish the quality of our products, services, and user +experience, resulting in damage to our reputation and loss of current and potential users, subscribers, and advertisers, harming our operating results and financial condition. ITEM 1B.    UNRESOLVED STAFF COMMENTS We have received +no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of our fiscal year 2009 that remain unresolved. ITEM 2.    PROPERTIES Our corporate offices consist of +approximately 15 million square feet of office space located in King County, Washington: ten million square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and +approximately five million square feet of space we lease. We own approximately two million square feet of office and datacenter space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling +approximately four million square feet of office and datacenter space. We occupy many sites internationally, totaling approximately two million square feet that is owned and approximately nine million square feet that is leased. Facilities +that we own include our European Operations Center in Dublin, Ireland; the India Development Center in Hyderabad, India; and a facility in Reading, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; +Bangalore, India; Dublin, Ireland; Tokyo, Japan; Mississauga, Canada; Taipei, Taiwan; Seoul, Korea; Sydney, Australia; and Milan, Italy. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, +Puerto Rico, a facility in Singapore for our Asia Pacific Operations Center and Regional headquarters, and various product development facilities, both domestically and internationally, as described in the “Research and Development” +section above. Our facilities are fully used for current operations of all segments, and suitable additional spaces are available to +accommodate expansion needs. We have a development agreement with the City of Redmond under which we may currently develop approximately 1.6 million square feet of additional facilities at our corporate campus in Redmond, Washington. In +addition, we own 63 acres of undeveloped land in Issaquah, Washington, that can accommodate approximately one million square feet of office space. ITEM 3.    LEGAL PROCEEDINGS See Note 17 – Contingencies of the Notes to Financial +Statements (Part II, Item 8) for information regarding legal proceedings in which we are involved. ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted +to a vote of security holders during the fourth quarter of fiscal year 2009. PAGE 18 Table of Contents Part II Item 5 PART II ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER +PURCHASES OF EQUITY SECURITIES Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 27, 2009, there were +142,468 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Year Fiscal year 2009 Common stock price per share: High $ 28.50 $ 27.47 $ 21.00 $ 24.34 $ 28.50 Low $ 23.50 $ 17.50 $ 14.87 $ 18.18 $ 14.87 Fiscal year 2008 Common stock price per share: High $ 31.84 $ 37.50 $ 35.96 $ 32.10 $ 37.50 Low $ 27.51 $ 29.29 $ 26.87 $ 27.11 $ 26.87 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8) for information regarding dividends and share repurchases. PAGE 19 Table of Contents Part II Item 6 ITEM 6.    SELECTED +FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Fiscal Year Ended June 30, 2009 2008 2007 2006 2005 Revenue $ 58,437 $ 60,420 $ 51,122 $ 44,282 $ 39,788 Operating income $ 20,363 $ 22,271 $ 18,438 $ 16,380 $ 14,576 Net income $ 14,569 $ 17,681 $ 14,065 $ 12,599 $ 12,254 Diluted earnings per share $ 1.62 $ 1.87 $ 1.42 $ 1.20 $ 1.12 Cash dividends declared per share $ 0.52 $ 0.44 $ 0.40 $ 0.35 $ 3.40 Cash and cash equivalents and short-term investments $ 31,447 $ 23,662 $ 23,411 $ 34,161 $ 37,751 Total assets $ 77,888 $ 72,793 $ 63,171 $ 69,597 $ 70,815 Long-term obligations $ 11,296 (a) $ 6,621 $ 8,320 $ 7,051 $ 5,823 Stockholders’ equity $ 39,558 $ 36,286 $ 31,097 $ 40,104 $ 48,115 (a) Includes $3.75 billion of debt securities issued in May 2009. See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8). PAGE 20 Table of Contents Part II Item 7 ITEM 7.     +MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS FOR FISCAL YEARS 2009, 2008, AND 2007 Overview The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations and financial +condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements (“Notes”). We generate revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for +many different types of computing devices. Our software products and services include operating systems for personal computers, servers, and intelligent devices; server applications for distributed computing environments; information worker +productivity applications; business solutions applications; high-performance computing applications; software development tools; and video games. We provide consulting and product support services, and we train and certify computer system +integrators and developers. We also design and sell hardware, including the Xbox 360 video game console, the Zune digital music and entertainment device, and peripherals. Online offerings and information are delivered through Bing, Windows Live, +Office Live, our MSN portals and channels, and the Microsoft Online Services platform, which includes offerings for businesses, such as Microsoft Dynamics CRM Online, Exchange Hosted Services, Exchange Online, and SharePoint Online. We enable the +delivery of online advertising across our broad range of digital media properties and on Bing through our proprietary adCenter platform. Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. +Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated +approximately 40% of its annual segment revenues in our second fiscal quarter. In fiscal year 2007, our revenue was highest in the third quarter due to the recognition of $1.7 billion of revenue previously deferred from the Express Upgrade to +Windows Vista and Microsoft Office Technology Guarantee programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. The technology guarantee programs provided customers who purchased current products with free or discounted +rights to Windows Vista and the 2007 Microsoft Office system when those products became available to consumers. The unfavorable +global economic environment adversely affected our business in fiscal year 2009 as consumers and businesses cut back on spending, which reduced PC shipments and IT investments. But because we offer a wide range of products that enable companies to +improve productivity and reduce costs, and because we have a strong pipeline of products, including new versions of Windows and Office planned for release in fiscal year 2010, we believe that Microsoft is well-positioned to weather the economic +downturn. As the global economy improves, this will create new opportunities to increase revenue. To further help weather the economic downturn, in fiscal year 2009 we made important adjustments to our cost structure and streamlined internal +business processes. Technological innovation is the foundation of our long-term growth and we intend to maintain our commitment to +investment in research and development, engineering excellence, and delivering high-quality products and services to customers and partners. Recognizing that one of our primary business objectives is to help accelerate worldwide PC adoption and +software upgrades, we continue to advance the functionality, security, and value of Windows operating systems. We remain focused on selling our products in emerging markets and reducing the amount of unlicensed software used in those markets. We also continue to develop innovative software applications and solutions that we believe will enhance information worker +productivity, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain growth in the face of competition from other vendors of proprietary and open +source software, our goal is to deliver products that provide the best platform for network computing – software that is easiest to deploy and manage, and that is most secure – with the lowest total cost of ownership. In addition, we continue to invest in research and development in existing and new lines of business, including cloud computing, search, online +solutions, business solutions, mobile computing, communication, entertainment, PAGE 21 Table of Contents Part II Item 7 and other areas that we believe may contribute to our long-term growth. We also invest in research and development of advanced technologies for future software +products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth. This long-term focus on investment in research and development has enabled us to lay a foundation for future growth by delivering innovative products, creating opportunities for partners, and improving +customer satisfaction. Our focus in fiscal year 2010 is to build on this foundation and to continue to execute well in key areas through ongoing innovation on our integrated software platform, by responding effectively to customer and partner needs, +and by focusing internally on product excellence, business efficacy, and accountability across the company. Summary of Results for Fiscal Years +2009, 2008, and 2007 (In millions, except percentages and per share amounts) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Revenue $ 58,437 $ 60,420 $ 51,122 (3)% 18% Operating income $ 20,363 $ 22,271 $ 18,438 (9)% 21% Diluted earnings per share $ 1.62 $ 1.87 $ 1.42 (13)% 32% Fiscal year 2009 compared with fiscal year 2008 Revenue declined across most segments primarily driven by weakness in the global PC market and the unfavorable economic environment. Foreign currency exchange +rates accounted for a $486 million or one percentage point increase in revenue. Primary factors contributing to the decline include the following: • Revenue from Windows operating systems declined reflecting PC market weakness, especially PCs sold to businesses, and a decline in the OEM premium mix. • Revenue from our Entertainment and Devices Division decreased across most lines of business including Xbox 360 platform and PC game revenue which declined primarily as a +result of decreased revenue per console due to price reductions during the past 12 months, partially offset by increased console sales and Xbox Live revenue. The above declines were partially offset by increased server and server application revenue, reflecting recognition of deferred revenue from previously signed agreements and continued adoption of the +Windows Server Platform and applications through SQL Server, Enterprise CAL Suites, and System Center products. Operating income +decreased primarily reflecting decreased revenue. Operating expenses were flat with decreased general and administrative and sales and marketing expenses offset by increased headcount-related expenses, cost of revenue, and employee severance +charges. • General and administrative expenses decreased $1.4 billion or 28%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 million of +legal charges during the twelve months ended June 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were primarily related to the European Commission fine of $1.4 billion ( € 899 million). • Sales and marketing expenses decreased $381 million or 3%, primarily driven by the resource management program. As part of that program, we reduced marketing and +advertising expenses. • Headcount-related expenses, excluding $330 million of employee severance charges, increased 7%, driven by a 2% increase in headcount during the past 12 months and an +increase in salaries and benefits for existing headcount. • Cost of revenue increased $557 million or 5%, primarily reflecting increased online costs, including online traffic acquisition, data center and equipment, and +headcount-related costs, partially offset by decreased Xbox 360 platform costs. In January 2009, we announced and +implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the PAGE 22 Table of Contents Part II Item 7 elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. +During the twelve months ended June 30, 2009, we recorded employee severance charges of $330 million for the expected reduction in employee headcount. Diluted earnings per share declined primarily reflecting decreased net income, partially offset by share repurchases during the past 12 months. We repurchased 318 million shares during the twelve months ended June 30, +2009. Fiscal year 2008 compared with fiscal year 2007 Revenue growth was driven primarily by increased licensing of the 2007 Microsoft Office system, increased Xbox 360 platform sales, increased revenue associated with Windows Server and SQL Server, and increased licensing of +Windows Vista. Foreign currency exchange rates accounted for a $1.6 billion or three percentage point increase in revenue during fiscal year 2008. Operating income increased primarily reflecting increased revenue, partially offset by increased headcount-related expenses, increased costs for legal settlements and legal contingencies, and increased cost of revenue. +Headcount-related expenses increased 12%, reflecting an increase in headcount during fiscal year 2008. We incurred $1.8 billion of legal charges during fiscal year 2008 primarily related to the European Commission fine of $1.4 billion ( € 899 million) as compared with $511 million of legal charges during fiscal year 2007. Cost of revenue increased $905 million or 8%, reflecting increased data center and +equipment costs, online content expenses, and increased costs associated with the growth in our consulting services, partially offset by decreased Xbox 360 costs. The decreased Xbox 360 costs reflect the $1.1 billion charge in fiscal year 2007 +related to the expansion of our Xbox 360 warranty, partially offset by increased Xbox 360 product costs reflecting growth in unit console sales. The diluted earnings per share growth was impacted by the $1.1 billion Xbox 360 charge in fiscal year 2007 and share repurchases during fiscal year 2008. Fiscal Year 2010 Outlook Global macroeconomic factors have a strong correlation to demand for our +software, services, hardware, and online offerings. While we see the potential for improvement in calendar year 2010, we are unable to predict the actual timing. In the meantime, we are positive about our relative market position and our product +delivery plans. In addition, we remain focused on executing in the areas we can control by continuing to provide high value products at the lowest total cost of ownership while managing our expenses. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) The +revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the United States (“U.S. GAAP”) and include certain reconciling items attributable to each of +the segments. Segment information appearing in Note 22 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8) is presented on a basis consistent with our current internal management reporting, in +accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information . Certain corporate-level activity has been excluded from segment operating +results and is analyzed separately. Prior period amounts have been recast to conform to the way we internally managed and monitored performance at the segment level during the current period. Client (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Revenue $ 14,712 $ 16,865 $ 14,911 (13)% 13% Operating income $ 10,856 $ 13,105 $ 11,424 (17)% 15% Client offerings consist of premium and standard edition Windows operating systems. Premium editions are +those that include additional functionality and are sold at a price above our standard editions. Premium editions include Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, Windows Vista Enterprise, PAGE 23 Table of Contents Part II Item 7 Windows XP Professional, Windows XP Media Center, and Windows XP Tablet PC. Standard editions include Windows Vista Home Basic and Windows XP Home. Client revenue +growth is directly impacted by growth of PC purchases from original equipment manufacturers (“OEMs”) that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The +differences between unit growth rates and revenue growth rates from year to year are affected primarily by changes in the mix of OEM Windows premium edition operating systems licensed as a percentage of total OEM Windows operating systems licensed +(“OEM premium mix”). Additional differences in growth rates result from the impact from lower cost netbook PCs, which are sold with a lower cost version of Windows, changes in geographic mix, and changes in the channel mix of products sold +by large, multi-national OEMs versus those sold by local and regional system builders. Fiscal year 2009 compared with fiscal year 2008 Client revenue decreased primarily as a result of PC market weakness, especially PCs sold to businesses. OEM revenue decreased $2.3 billion or +16% while OEM license units declined 2%. The decline in OEM revenue reflects a 10 percentage point decline in the OEM premium mix to 64%. Based on our estimates, total worldwide PC shipments from all sources experienced a decline of approximately 1% +to growth of approximately 2%, driven by changes in demand in emerging and developed markets. Client operating income decreased +primarily reflecting decreased revenue and increased sales and marketing expenses. Sales and marketing expenses increased $122 million or 7%, primarily reflecting increased advertising and marketing. Fiscal year 2008 compared with fiscal year 2007 Client +revenue increased reflecting growth in licensing of Windows Vista. By the end of fiscal year 2008, more than 180 million Windows Vista licenses had been sold (approximately 130 million were sold during fiscal year 2008) and millions of +enterprise seats had been deployed. OEM revenue increased $1.8 billion or 14%, driven by 16% growth in OEM license units. Revenue from commercial and retail licensing of Windows operating systems increased $202 million or 9%, primarily from +Enterprise Agreements and anti-piracy efforts in emerging markets. During fiscal year 2008, the OEM premium mix increased seven percentage points to 74%, reflecting strong demand for Windows Vista Home Premium. We estimate total worldwide PC +shipments from all sources grew approximately 12% to 14%, driven by demand in both emerging and mature markets. Client operating +income increased reflecting increased revenue, partially offset by increased sales and marketing expenses and cost of revenue. Sales and marketing expenses increased $106 million or 7%, primarily reflecting increased expenses associated with our +corporate sales force. Cost of revenue increased $116 million or 14%, primarily driven by Windows Vista product costs. Other The segment information discussed above is presented the way we internally managed and monitored performance at the business group level in fiscal years 2009, +2008, and 2007. Effective July 1, 2009, we reorganized the Windows Live operations from Online Services Business to Client to better align our strategies and focus in those areas. Server and Tools (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Revenue $ 14,126 $ 13,102 $ 11,104 8% 18% Operating income $ 5,327 $ 4,539 $ 3,571 17% 27% Server and Tools licenses products, applications, tools, content, and services that are designed to make +information technology professionals and developers more productive and efficient. Server and Tools offerings consist of server software licenses and client access licenses (“CAL”) for Windows Server, Microsoft SQL Server, and other server +products. We also offer developer tools, training, certification, Microsoft Press, Premier product support services, and Microsoft Consulting Services. Server products can be run on-site, in a partner-hosted environment, or in a Microsoft- PAGE 24 Table of Contents Part II Item 7 hosted environment. We use multiple channels for licensing, including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. We +sell licenses both as one-time licenses and as multi-year volume licenses. Fiscal year 2009 compared with fiscal year 2008 Server and Tools revenue increased reflecting growth in both product and services revenue. Server and server application revenue (including CAL) and developer +tools revenue increased $809 million or 8%, primarily driven by growth in SQL Server, Enterprise CAL Suites, and System Center revenue. This growth reflects recognition of deferred revenue from previously signed agreements and continued adoption of +the Windows Server Platform and applications. Consulting and Premier product support services revenue increased $215 million or 8%, primarily due to revenue from annuity support agreements. Foreign currency exchange rates accounted for a $140 +million or one percentage point increase in revenue. Server and Tools operating income increased primarily due to growth in product +revenue, partially offset by increased research and development expenses and cost of revenue. Research and development expenses increased $168 million or 9%, primarily driven by increased headcount-related expenses. Cost of revenue increased $84 +million or 3%, reflecting the growth in support, online, and consulting services. Fiscal year 2008 compared with fiscal year 2007 Server and Tools revenue increased reflecting growth in product and services revenue and included a favorable impact from foreign currency exchange rates of +$464 million or four percentage points. Server and server application revenue (including CAL revenue) and developer tools revenue increased $1.4 billion or 16%, primarily driven by growth in volume licensing of Windows Server and SQL Server +products. This growth reflects broad adoption of the Windows Platform and applications with the releases of Windows Server 2008 and Visual Studio 2008 during fiscal year 2008. Consulting and Premier product support services revenue increased $593 +million or 29%, primarily due to higher demand for consulting and support services by corporate enterprises. Server and Tools +operating income increased primarily due to growth in product revenue, partially offset by increased sales and marketing expenses, cost of revenue, and research and development expenses. Sales and marketing expenses increased $458 million or 13%, +due to higher expenses associated with our corporate sales force. Cost of revenue increased $404 million or 19%, reflecting the growth in Consulting and Premier product support services. Research and development expenses increased $177 million or +10%, primarily driven by increased headcount-related expenses. Headcount-related expenses increased 6%, driven by an increase in headcount from the prior year-end. Online Services Business (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Revenue $ 3,088 $ 3,214 $ 2,434 (4)% 32% Operating loss $ (2,253 ) $ (1,222 ) $ (604 ) (84)% (102)% Online Services Business (“OSB”) consists of an online advertising platform with offerings for +both publishers and advertisers, personal communications services, such as email and instant messaging, online information offerings, such as Bing, and the MSN portals and channels around the world. We earn revenue primarily from online advertising, +including search, display, email, messaging services, and advertiser and publisher tools. Revenue is also generated through subscriptions and transactions generated from online paid services digital marketing and advertising agency services, and +from MSN narrowband Internet access subscribers (“Access”). During the first quarter of fiscal year 2008, we completed our acquisition of aQuantive, Inc. (“aQuantive”), a digital marketing business. aQuantive was consolidated +into our results of operations starting August 10, 2007, the acquisition date. PAGE 25 Table of Contents Part II Item 7 Fiscal year 2009 compared with fiscal year 2008 OSB revenue decreased primarily as a result of decreased online advertising and +access revenue. Online advertising revenue decreased $73 million or 3%, to $2.3 billion, reflecting a decrease in display advertising, partially offset by an increase in search advertising. Access revenue decreased $72 million or 28%, reflecting +continued migration of subscribers to broadband or other competitively-priced service providers. Foreign currency exchange rates accounted for a $28 million or one percentage point decrease in revenue. OSB operating loss increased due to increased cost of revenue and research and development expenses, and decreased revenue. Cost of revenue +increased $692 million or 36%, primarily driven by increased online traffic acquisition, data center and equipment, and headcount-related costs. Research and development expenses increased $149 million or 13%, primarily due to increased +headcount-related expenses. Fiscal year 2008 compared with fiscal year 2007 OSB revenue increased driven by increased online advertising revenue and the inclusion of aQuantive revenue, partially offset by decreased access revenue. Online advertising revenue increased $550 million +or 31%, to $2.3 billion. This increase reflects growth in our existing online advertising business and includes aQuantive online advertising revenue of $161 million. Agency revenue, which is solely derived from aQuantive, was $345 million during +fiscal year 2008. Access revenue decreased $98 million or 28%, to $256 million, reflecting migration of subscribers to broadband or other competitively-priced service providers. OSB operating loss increased driven by increased cost of revenue and other operating expenses, partially offset by increased revenue. Cost of revenue increased $796 million or 71%, primarily driven by +increased data center and equipment costs, online content expenses, and aQuantive-related expenses. Sales and marketing expenses increased $311 million or 37%, primarily due to increased amortization of customer-related intangible assets of $94 +million, increased headcount-related expenses, and increased marketing costs. Research and development expenses increased $177 million or 17%, and general and administrative expenses increased $114 million or 178%, primarily reflecting increased +headcount-related expenses and merger and acquisition-related expenses. Headcount-related expenses increased 24%, driven by an increase in headcount from the prior year-end. Other The segment information discussed above is presented the way we internally managed and +monitored performance at the business group level in fiscal years 2009, 2008, and 2007. Effective July 1, 2009, we reorganized the Windows Live operations from OSB to Client to better align our strategies and focus in those areas. On July 29, 2009, we announced that we entered into a 10-year agreement with Yahoo! Inc. (“Yahoo”). Under terms of the agreement, +Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo websites. We believe this agreement will allow us over time to improve the effectiveness and increase the value of our search offering through greater scale +in search queries and an expanded and more competitive search and advertising marketplace. The transaction is subject to regulatory review. Both parties anticipate entering into more detailed definitive agreements prior to closing the transaction +which is expected in calendar year 2010. See Note 24 – Subsequent Event of the Notes to Financial Statements (Part II, Item 8). Microsoft +Business Division (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Revenue $ 18,894 $ 18,929 $ 16,476 –% 15% Operating income $ 12,141 $ 12,369 $ 10,838 (2)% 14% Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft +Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office +system PAGE 26 Table of Contents Part II Item 7 offerings, which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings +in other information worker areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship +management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business +revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. Fiscal year 2009 compared with fiscal year 2008 MBD +revenue was flat reflecting decreased consumer revenue offset by increased business revenue, and included a favorable impact from foreign currency exchange rates of $378 million or two percentage points. Consumer revenue decreased $525 million or +14%, primarily as a result of PC market weakness, a shift to lower-priced products, and pricing promotions on the 2007 Microsoft Office system. Business revenue increased $490 million or 3%, primarily reflecting growth in volume licensing +agreement revenue and included a 7% decrease in Microsoft Dynamics customer billings. The growth in volume licensing agreement revenue primarily reflects recognition of deferred revenue from previously signed agreements. MBD operating income decreased reflecting increased cost of revenue and research and development expenses, partially offset by decreased sales and +marketing expenses. Cost of revenue increased $135 million or 14% primarily driven by expenses associated with Fast Search & Transfer ASA (“FAST”) which we acquired in April 2008, as well as online services infrastructure costs. +Research and development expenses increased $119 million or 8%, primarily driven by an increase in headcount-related expenses associated with FAST. Sales and marketing expenses decreased $90 million or 2%, primarily driven by a decrease in corporate +marketing activities and headcount-related costs associated with our corporate sales force. Fiscal year 2008 compared with fiscal year 2007 MBD revenue increased reflecting growth in licensing of the 2007 Microsoft Office system and included a favorable impact from foreign currency +exchange rates of $724 million or four percentage points. Business revenue increased $2.6 billion or 21%, primarily as a result of growth in volume licensing agreement revenue and strong transactional license sales to businesses. The increase in +business revenue also included a 21% increase in Microsoft Dynamics customer billings. Consumer revenue decreased $131 million or 3%, reflecting the consumer launch of the 2007 Microsoft Office system in fiscal year 2007. MBD operating income increased reflecting growth in revenue, partially offset by increased sales and marketing expenses, research and development +expenses, and cost of revenue. Sales and marketing expenses increased $446 million or 13%, reflecting increased expenses associated with our corporate sales force. Research and development expenses increased $229 million or 18%, primarily driven by +an increase in headcount-related expenses and a $35 million in-process research and development expense related to the acquisition of FAST. Cost of revenue increased $214 million or 27%, primarily driven by an increase in online services +infrastructure costs and product costs related to retail packaged product sales. Headcount-related expenses increased 10%, driven by an increase in headcount from the prior year-end. Entertainment and Devices Division (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Revenue $ 7,753 $ 8,206 $ 6,139 (6)% 34% Operating income (loss) $ 169 $ 497 $ (1,898 ) (66)% * * Not meaningful Entertainment and Devices +Division (“EDD”) offerings include the Xbox 360 platform (which includes the Microsoft Xbox 360 video game console system, Xbox 360 video games, Xbox Live, and Xbox 360 accessories), the Zune PAGE 27 Table of Contents Part II Item 7 digital music and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), the Microsoft Surface +computing platform, mobile and embedded device platforms, and other devices. EDD leads the development efforts for our line of consumer software and hardware products including application software for Apple’s Macintosh computers and Microsoft +PC hardware products, and is responsible for all retail sales and marketing for Microsoft Office and Windows operating systems. Fiscal year 2009 +compared with fiscal year 2008 EDD revenue decreased across most lines of business. Revenue from our non-gaming business decreased $292 million +or 12%, primarily reflecting decreased Zune and PC hardware product revenue. Xbox 360 platform and PC game revenue decreased $161 million or 3%, primarily as a result of decreased revenue per Xbox 360 console due to price reductions during the past +12 months, partially offset by increased Xbox 360 console sales and increased Xbox Live revenue. We shipped 11.2 million Xbox 360 consoles during fiscal year 2009, compared with 8.7 million Xbox 360 consoles during fiscal year 2008. +Foreign currency exchange rates accounted for a $74 million or one percentage point decrease in revenue. EDD operating income +decreased primarily due to decreased revenue and increased research and development expenses, partially offset by decreased cost of revenue. Research and development expenses increased $252 million or 16%, primarily reflecting increased +headcount-related expenses associated with the Windows Mobile device platform, driven by recent acquisitions. Cost of revenue decreased $326 million or 7%, primarily due to decreased Xbox 360 platform costs. Fiscal year 2008 compared with fiscal year 2007 EDD +revenue increased primarily due to increased Xbox 360 platform sales. Xbox 360 platform and PC game revenue increased $1.7 billion or 41% as a result of increased Xbox 360 console sales, video game sales led by Halo 3, Xbox Live revenue, and Xbox +360 accessory sales. We shipped 8.7 million Xbox 360 consoles during fiscal year 2008, compared with 6.6 million Xbox 360 consoles during fiscal year 2007. EDD operating income increased primarily due to increased revenue and decreased cost of revenue, partially offset by increased research and development expenses and sales and marketing expenses. Cost of +revenue decreased $684 million or 13%, reflecting the impact of the $1.1 billion Xbox 360 charge in fiscal year 2007 (which primarily related to the warranty expansion), partially offset by increased Xbox 360 product costs related to increased unit +console sales. Research and development expenses increased $242 million or 18%, primarily reflecting increased headcount-related expenses and costs related to the acquisition of Danger, including a $24 million in-process research and development +expense. Sales and marketing expenses increased $89 million or 7%, primarily reflecting increased headcount-related expenses and increased bad debt expense. Headcount-related expenses increased 22%, driven by an increase in headcount from the prior +year-end. Corporate-Level Activity (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Corporate-level activity $ (5,877 ) $ (7,017 ) $ (4,893 ) 16% (43)% Certain corporate-level activity is not allocated to our segments. Those results include expenses such as +broad-based sales and marketing, product support services, human resources, legal, finance, information technology, corporate development and procurement activities, research and development and other costs, legal settlements and contingencies, and +employee severance. Fiscal year 2009 compared with fiscal year 2008 Corporate-level expenses decreased during the twelve months ended June 30, 2009, primarily reflecting decreased general and administrative and sales and marketing expenses, partially offset by +employee severance charges of $330 million. General and administrative expenses decreased $1.4 billion or 28%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 million of legal charges during the twelve +months ended PAGE 28 Table of Contents Part II Item 7 June 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were primarily related to the European +Commission fine of $1.4 billion ( € 899 million). Sales and marketing expenses decreased $412 million or 30%, reflecting the resource management program implemented +in January 2009. Fiscal year 2008 compared with fiscal year 2007 Corporate-level expenses increased, reflecting increased costs for legal settlements and legal contingencies and a 13% increase in headcount-related expenses. We incurred $1.8 billion of legal charges +during fiscal year 2008 primarily related to the European Commission fine of $1.4 billion ( € 899 million) as compared with $511 million of legal charges during +fiscal year 2007. The increase in headcount-related expenses reflects an increase in headcount from the prior year-end. OPERATING EXPENSES Cost of Revenue (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Cost of revenue $ 12,155 $ 11,598 $ 10,693 5% 8% As a percent of revenue 21 % 19 % 21 % 2ppt (2)ppt Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, +operating costs related to product support service centers and product distribution centers, costs incurred to drive traffic to our website and/or acquire online advertising space (“traffic acquisition costs”), costs incurred to support +and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization of capitalized research and development costs associated with +software products that have reached technological feasibility. Fiscal year 2009 compared with fiscal year 2008 Cost of revenue increased during the twelve months ended June 30, 2009, primarily reflecting increased online costs, including traffic acquisition, data +center and equipment, and headcount costs, partially offset by decreased Xbox 360 platform costs. Fiscal year 2008 compared with fiscal year 2007 Cost of revenue increased reflecting increased data center and equipment costs, online content expenses, and increased costs associated with the +growth in our consulting services, partially offset by decreased Xbox 360 costs. Xbox 360 costs decreased because of the $1.1 billion charge in fiscal year 2007 (which primarily related to the expansion of our Xbox 360 warranty coverage), partially +offset by increased Xbox 360 product costs, reflecting growth in unit console sales. Research and Development (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Research and development $ 9,010 $ 8,164 $ 7,121 10% 15% As a percent of revenue 15 % 14 % 14 % 1ppt –ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and +other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, the +amortization of purchased software code and services content, and in-process research and development. PAGE 29 Table of Contents Part II Item 7 Fiscal year 2009 compared with fiscal year 2008 Research and development expenses increased during the twelve months ended +June 30, 2009, primarily reflecting a 13% increase in headcount-related costs. Fiscal year 2008 compared with fiscal year 2007 Research and development expenses increased reflecting increased headcount-related expenses, increased product development costs, and in-process +research and development expenses related to acquisitions during fiscal year 2008. Headcount-related expenses increased 12%, reflecting an increase in headcount from the prior year-end. Sales and Marketing (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Sales and marketing $ 12,879 $ 13,260 $ 11,541 (3)% 15% As a percent of revenue 22 % 22 % 23 % –ppt (1)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with sales and marketing personnel and advertising, promotions, trade shows, seminars, and other programs. Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from +foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of +foreign currency transactions are incidental to our operations. For the twelve months ended June 30, 2009, $509 million of losses were reported as other income (expense). For the twelve months ended June 30, 2008 and 2007, $221 million and +$86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have been recast as other income (expense). Fiscal year 2009 compared with fiscal year 2008 Sales and marketing expenses decreased, primarily driven by the resource management +program implemented in January 2009. Fiscal year 2008 compared with fiscal year 2007 Sales and marketing expenses increased, primarily reflecting increased headcount-related expenses and increased corporate marketing and advertising campaigns. Headcount-related expenses increased 14%, +driven by an increase in headcount from the prior year-end. General and Administrative (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 General and administrative $ 3,700 $ 5,127 $ 3,329 (28)% 54% As a percent of revenue 6 % 8 % 7 % (2)ppt 1ppt General and administrative costs include payroll, employee benefits, stock-based compensation expense and +other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative headcount, and legal and other administrative fees. PAGE 30 Table of Contents Part II Item 7 Fiscal year 2009 compared with fiscal year 2008 General and administrative expenses decreased primarily reflecting decreased costs +for legal settlements and legal contingencies. We incurred legal charges of $283 million in current year, as compared with $1.8 billion during fiscal year 2008. The fiscal year 2008 legal costs were primarily related to the European Commission fine +of $1.4 billion ( € 899 million). Fiscal year 2008 compared +with fiscal year 2007 General and administrative expenses increased reflecting increased costs for legal settlements and legal contingencies, +increased consulting and professional fees, and increased headcount-related expenses. We incurred $1.8 billion of legal charges during fiscal year 2008, primarily related to the European Commission fine, as compared with $511 million of legal +charges during fiscal year 2007. Headcount-related expenses increased 7%, reflecting an increase in headcount from the prior year-end. Employee +Severance In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee +headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. +During the current year, we recorded employee severance charges of $330 million for the expected reduction in employee headcount. Other Income +(Expense) The components of other income (expense) were as follows: (In millions, except percentages) 2009 2008 2007 Percentage Change 2009 Versus 2008 Percentage Change 2008 Versus 2007 Dividends and interest $ 706 $ 888 $ 1,319 Net recognized gains (losses) on investments (125 ) 346 650 Net gains (losses) on derivatives (558 ) 226 (358 ) Net gains (losses) on foreign currency remeasurements (509 ) 226 56 Other (56 ) (143 ) (4 ) Total $ (542 ) $ 1,543 $ 1,663 (135)% (7)% Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency +remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because +this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For the twelve months ended June 30, 2009, $509 +million of losses were reported as other income (expense). For the twelve months ended June 30, 2008 and 2007, $221 million and $86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have +been recast as other income (expense). Investments are considered to be impaired when a decline in fair value is judged to be +other-than-temporary. We employ a systematic methodology that considers available evidence in evaluating potential impairment of our investments, including market declines subsequent to the period end. If the cost of an investment exceeds its fair +value, among other factors, we evaluate general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to +sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions +related to the financial health of and business outlook for the investee, including industry and PAGE 31 Table of Contents Part II Item 7 sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an +impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. We lend certain +fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest is determined based upon the underlying security and the +creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability. We use derivative +instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are +not designated as hedges are recognized in other income (expense). These are generally offset by unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income. Fiscal year 2009 compared with fiscal year 2008 Dividends and interest income decreased primarily reflecting lower interest rates on our fixed-income investments. Net recognized losses on investments increased primarily due to higher other-than-temporary impairments that were partially +offset by gains on sales of certain equity investments held in our strategic investments portfolio. Other-than-temporary impairments were $862 million during the twelve months ended June 30, 2009, as compared with $312 million during the twelve +months ended June 30, 2008 and increased primarily due to declines in equity values as a result of deterioration in equity markets. Net losses on derivatives increased primarily due to losses on equity, commodity, and interest rate derivatives +in the current period as compared with gains in the prior period. Net losses on foreign currency remeasurements increased due to the strengthening of the U.S. dollar, particularly in the first half of the current fiscal year. Fiscal year 2008 compared with fiscal year 2007 Dividends and interest income decreased reflecting lower interest rates on our fixed-income investments and a reduction in the average balance of interest-bearing investments owned. Net recognized gains on investments, which include +other-than-temporary impairments of $312 million during fiscal year 2008 and $25 million during fiscal year 2007, decreased primarily due to declines in equity values as a result of the recent stock market decline. Net gains on derivatives increased +primarily due to higher net gains on equity, commodity, and interest rate derivatives. Income Taxes Fiscal year 2009 compared with fiscal year 2008 Our +effective tax rates in fiscal years 2009 and 2008 were 27% and 26%, respectively. While the fiscal year 2009 rate reflects a higher mix of foreign earnings taxed at lower rates, the rate increased from the prior year because the fiscal year 2008 +rate reflects the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the 2000-2003 examination, partially offset by the European Commission fine which was not tax deductible. As a +result of the settlement and the impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009. Fiscal year 2008 +compared with fiscal year 2007 Our effective tax rates in fiscal year 2008 and 2007 were 26% and 30%, respectively. The fiscal year 2008 rate +was lower due to the items noted above. FINANCIAL CONDITION Cash, cash equivalents, and short-term investments totaled $31.4 billion as of June 30, 2009, compared with $23.7 billion as of June 30, 2008. Equity and other investments were $4.9 billion as of June 30, 2009, +compared with $6.6 billion as of June 30, 2008. Our investments consist primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is +invested predominantly in U.S. dollar-denominated securities, but also includes foreign-denominated securities in order to diversify risk. We invest primarily in short-term securities to facilitate liquidity and for capital preservation. As a result +of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $22.8 billion at June 30, 2009. Our retained deficit is not expected to +affect our future ability to operate, pay dividends, or repay our debt given our continuing profitability and strong cash and financial position. PAGE 32 Table of Contents Part II Item 7 In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, +domestic and international equities, U.S. treasuries, and agency securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and +liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed +securities, and certain agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either +provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our +pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on +similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value +processes include controls that are designed to ensure appropriate fair values are recorded. Such controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of +prices where appropriate. While we own certain mortgage- and asset-backed fixed-income securities, our portfolio as of June 30, +2009 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% +principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association. Debt Short-term Debt In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of +up to $2.0 billion in short-term commercial paper. As of June 30, 2009, $2.0 billion of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance costs, of 0.20% and maturities of 22 to 119 days. In September 2008, we also entered into a $2.0 billion six-month senior unsecured credit facility, principally to support the +commercial paper program. In November 2008, we replaced the six-month credit facility with a $2.0 billion 364-day credit facility. This credit facility expires on November 6, 2009. In March 2009, we entered into an additional credit facility. +This $1.0 billion 364-day credit facility expires on March 12, 2010. As of June 30, 2009, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three +times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against these credit facilities during the year ended June 30, 2009. Long-term Debt In November 2008, we filed a shelf registration statement with the U.S. Securities +and Exchange Commission that allows us to issue debt securities from time to time pursuant to the September 2008 authorization for debt financings of up to $6.0 billion. In May 2009, we issued $3.75 billion of debt securities under that registration +statement as follows: $2.0 billion aggregate principal amount of 2.95% notes due 2014, $1.0 billion aggregate principal amount of 4.20% notes due 2019, and $750 million aggregate principal amount of 5.20% notes due 2039 (collectively “the +Notes”). Interest on the Notes will be payable semi-annually on June 1 and December 1 of each year, commencing on December 1, 2009, to holders of record on the preceding May 15 and November 15. The Notes are senior +unsecured obligations and will rank equally with our other unsecured and unsubordinated debt outstanding. We intend to use the net +proceeds from sales of the debt securities for general corporate purposes, which may include funding for working capital, capital expenditures, repurchases of our capital stock, and acquisitions. PAGE 33 Table of Contents Part II Item 7 Unearned Revenue Unearned revenue is comprised of the following items: Volume Licensing Programs Represents customer billings +for multi-year licensing arrangements, paid either upfront or annually at the beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered Elements Represents the right to receive +unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis and free post-delivery telephone support. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, +products licensed to OEMs, and perpetual licenses for current products under our Open and Select volume licensing programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably +on a straight-line basis over the related product’s life cycle. Product life cycles are currently estimated at three and one-half years for Windows operating systems. Undelivered elements include $276 million of deferred revenue related to the +Windows 7 Upgrade Option program. The program, which started June 26, 2009, allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding +version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the +product becomes generally available. Other Represents payments for post-delivery support and consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live +subscriptions, Mediaroom, and other offerings for which we have been paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected recognition of unearned revenue as of June 30, 2009: (In millions) Recognition of Unearned Revenue Three months ended: September 30, 2009 $  4,740 December 31, 2009 4,120 March 31, 2010 2,743 June 30, 2010 1,400 Thereafter 1,281 Total $14,284 Cash Flows Fiscal year 2009 compared with fiscal year 2008 Cash flow from operations decreased $2.6 billion due to payment of +approximately $4.1 billion to the IRS in connection with our settlement of the 2000-2003 audit examination. This impact was partially offset by the fiscal year 2008 payment of the $1.4 billion ( € 899 million) European Commission fine. Cash used for financing decreased $5.5 billion primarily due to $5.7 billion of net cash proceeds from issuance of short-term and long-term debt in +fiscal PAGE 34 Table of Contents Part II Item 7 year 2009. Financing activities also included a $3.2 billion decrease in common stock repurchased, which was offset by a $2.9 billion decline in common stock issued. +Cash used for investing increased $11.2 billion due to a $15.9 billion rise in purchases of investments along with a $1.7 billion decrease in cash from investment sales and maturities. These impacts were partially offset by a $7.2 billion decrease +in cash paid for acquisition of companies, including the purchase of aQuantive in fiscal year 2008. Fiscal year 2008 compared with fiscal year +2007 Cash flow from operations increased $3.8 billion due to an increase in cash received from customers driven by 18% revenue growth, partially +offset by the $1.4 billion ( € 899 million) payment of the European Commission fine. Cash used for financing decreased $11.6 billion primarily due to a $15.0 billion +decrease in common stock repurchases, partially offset by a $3.3 billion decrease in cash proceeds from the issuance of common stock. Cash used for investing was $4.6 billion for fiscal year 2008 as compared with cash provided of $6.1 billion for +fiscal year 2007. This decrease was primarily due to a $6.9 billion increase in cash paid for acquisition of companies, reflecting the purchase of aQuantive in the first quarter of fiscal year 2008, a $918 million increase in purchases of property +and equipment, and a $3.1 billion decrease in cash from combined investment purchases, sales, and maturities. Stockholders’ +equity at June 30, 2009, was $39.6 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new +facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. Commitments for constructing new buildings were $621 million on June 30, 2009. We have operating leases for +most U.S. and international sales and support offices and certain equipment under which we incurred rental expense totaling $475 million, $398 million, and $325 million, in fiscal years 2009, 2008, and 2007, respectively. We have not engaged in any +related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Share Repurchases On September 22, 2008, we announced the completion of the two repurchase +programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share +repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. We repurchased 318 million shares for $8.2 billion during the fiscal year ended June 30, 2009; 101 million +shares were repurchased for $2.7 billion under the repurchase program approved by our Board of Directors during the first quarter of fiscal year 2007 and 217 million shares were repurchased for $5.5 billion under the repurchase program approved +by our Board of Directors during the first quarter of fiscal year 2009. As of June 30, 2009, approximately $34.5 billion remained of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase +program may be suspended or discontinued at any time without notice. Dividends During fiscal years 2009 and 2008, our Board of Directors declared the following dividends: Declaration Date Per Share Dividend Record Date Total Amount Payment Date (in millions) (Fiscal year 2009) September 19, 2008 $0.13 November 20, 2008 $1,157 December 11, 2008 December 10, 2008 $0.13 February 19, 2009 $1,155 March 12, 2009 March 9, 2009 $0.13 May 21, 2009 $1,158 June 18, 2009 June 10, 2009 $0.13 August 20, 2009 $1,158 September 10, 2009 (Fiscal year 2008) September 12, 2007 $0.11 November 15, 2007 $1,034 December 13, 2007 December 19, 2007 $0.11 February 21, 2008 $1,023 March 13, 2008 March 17, 2008 $0.11 May 15, 2008 $1,020 June 12, 2008 June 11, 2008 $0.11 August 21, 2008 $   998 September 11, 2008 PAGE 35 Table of Contents Part II Item 7 We +believe existing cash, cash equivalents, and short-term investments, together with funds generated from operations, should be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and share repurchases. +Our philosophy regarding the maintenance of a balance sheet with a large component of cash and cash equivalents, short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to +research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in +view of our current and potential future needs. Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other +matters. We evaluate estimated losses for these indemnifications under SFAS No. 5, Accounting for Contingencies , as interpreted by Financial Accounting Standards Board Interpretation (“FIN”) No. 45, Guarantor’s +Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others . We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the +amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements. Contractual Obligations The following table summarizes +our outstanding contractual obligations as of June 30, 2009. We expect to fund these commitments with existing cash and cash equivalents, short-term investments and cash flows from operations. (In millions) Payments Due by Period Fiscal Years 2010 2011-2013 2014-2016 2017 and Thereafter Total Long-term debt: (a) Principal payments $      – $      – $2,000 $1,750 $ 3,750 Interest payments 145 420 302 1,023 1,890 Construction commitments (b) 621 – – – 621 Lease obligations: Capital leases 3 9 1 – 13 Operating leases (c) 457 931 520 477 2,385 Purchase commitments (d) 3,289 382 1 – 3,672 Other long-term liabilities (e) – 110 4 2 116 Total contractual obligations $4,515 $1,852 $2,828 $3,252 $12,447 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8) (b) These amounts represent commitments for the construction of buildings. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as construction +commitments above. (e) We have excluded long-term tax contingencies and other tax liabilities of $5.5 billion and other long-term contingent liabilities of $407 million (related to the antitrust +and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned revenue of $1.3 billion and non-cash +items of $226 million. PAGE 36 Table of Contents Part II Item 7 RECENTLY ISSUED ACCOUNTING STANDARDS Recently Adopted Accounting Pronouncements On April 1, 2009, we adopted the Financial Accounting Standards Board (“FASB”) Staff Positions (“FSP”) FAS 157-4, FSP FAS 115-2 and FAS +124-2, and FSP FAS 107-1 and APB 28-1. These FSPs are intended to provide additional application guidance and enhance disclosures about fair value measurements and impairments of securities. FSP FAS 157-4 clarifies the objective and method of fair +value measurement even when there has been a significant decrease in market activity for the asset being measured. FSP FAS 115-2 and FAS 124-2 establishes a new model for measuring other-than-temporary impairments for debt securities, including +establishing criteria for when to recognize a write-down through earnings versus other comprehensive income. FSP FAS 107-1 and APB 28-1 expands the fair value disclosures required for all financial instruments within the scope of SFAS +No. 107, Disclosures about Fair Value of Financial Instruments, to interim periods. Adoption of these FSPs did not have a significant impact on our accounting for financial instruments but did expand our associated disclosures. On January 1, 2009, we adopted SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an +amendment of FASB Statement No. 133. SFAS No. 161 requires additional disclosures about the Company’s objectives in using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS +No. 133, Accounting for Derivative Instruments and Hedging Activities , and its related interpretations, and tabular disclosures of the effects of such instruments and related hedged items on our financial position, financial performance, +and cash flows. See Note 5 – Derivatives of the Notes to Financial Statements (Part II, Item 8). On July 1, 2008, we +adopted SFAS No. 157, Fair Value Measurements , for all financial assets and liabilities and nonfinancial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least +annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair +value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify the source of the information. See Note 4 – Investments of the Notes to Financial Statements (Part II, Item 8). SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-Including an amendment of FASB Statement +No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for certain financial assets and liabilities on a contract-by-contract +basis with the difference between the carrying value before election of the fair value option and the fair value recorded upon election as an adjustment to beginning retained deficit. As of June 30, 2009, we had not elected the fair value +option for any eligible financial asset or liability. Recent Accounting Pronouncements Not Yet Adopted In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) , which is effective for us beginning July 1, 2010. +This Statement amends FIN 46(R), Consolidation of Variable Interest Entities an interpretation of ARB No. 51 , to require revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over +such entities, and additional disclosures for variable interests. We believe the adoption of this pronouncement will not have a material impact on our financial statements. In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement No. 157, which delays the effective date of SFAS No. 157 for us to July 1, 2009, for all nonfinancial +assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We believe the adoption of the delayed items of SFAS No. 157 will not +have a material impact on our financial statements. In December 2007, the FASB issued SFAS No. 141(R), Business +Combinations , which replaces SFAS No. 141. The statement retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all +business combinations, but requires a number of changes, including changes in the way assets and liabilities are recognized as a result of business combinations. It also requires the capitalization of in-process research and development at fair +value and requires the expensing of acquisition-related costs as incurred. In April 2009, the FASB issued FSP FAS 141(R)-1 which amends SFAS No. 141(R) by establishing a model to account for certain pre-acquisition contingencies. Under the FSP, +an PAGE 37 Table of Contents Part II Item 7 acquirer is required to recognize at fair value an asset acquired or a liability assumed in a business combination that arises from a contingency if the +acquisition-date fair value of that asset or liability can be determined during the measurement period. If the acquisition-date fair value cannot be determined, then the acquirer should follow the recognition criteria in SFAS No. 5, Accounting for Contingencies, and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss – an interpretation of FASB Statement No. 5. SFAS No. 141(R) and FSP FAS 141(R)-1 are effective for us +beginning July 1, 2009, and will apply prospectively to business combinations completed on or after that date. The impact of the adoption of SFAS No. 141(R) and FSP FAS 141(R)-1 will depend on the nature of acquisitions completed after the +date of adoption. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial +Statements – an amendment of ARB No. 51 , which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity +separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be +included in net income and, upon a loss of control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in net income. SFAS No. 160 is effective for us beginning July 1, +2009, and will apply prospectively, except for the presentation and disclosure requirements, which will apply retrospectively. We believe the adoption of SFAS No. 160 will not have a material impact on our financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our +financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and +expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting +for research and development costs, accounting for contingencies, accounting for income taxes, accounting for stock-based compensation, and accounting for product warranties. Revenue Recognition We account for the licensing of software in accordance with American +Institute of Certified Public Accountants Statement of Position (“SOP”) 97-2, Software Revenue Recognition . The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if +so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. A portion of the revenue +related to Windows XP is recorded as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis. The amount of revenue allocated to undelivered elements is based on the VSOE of fair value for those elements using the residual method or relative fair value method. Unearned revenue due to undelivered elements is +recognized ratably on a straight-line basis over the related products’ life cycles. Revenue related to Windows Vista is not subject to a similar deferral because there are no significant undelivered elements. However, Windows Vista revenue is +subject to deferral as a result of the Windows 7 Upgrade Option program which started June 26, 2009. The program allows customers who purchase PCs from participating computer makers or retailers with certain versions of Windows Vista to receive +an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or discounted upgrade to the equivalent Windows 7 product with participating retailers +in participating markets when the product becomes generally available. Accordingly, estimated revenue related to the undelivered Windows 7 product is deferred until the product is delivered. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and +changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements +to existing products. Impairment of Investment Securities SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities , Staff Accounting Bulletin No. 111, and FSP FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary +Impairments , provide guidance PAGE 38 Table of Contents Part II Item 7 on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This +determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of +an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent +and ability to hold, or plans to sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also +consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair +value is determined to be other than temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future +impairments. Goodwill SFAS No. 142, Goodwill and Other Intangible Assets , requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis and between annual tests if an event occurs or +circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance +indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to +reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow methodology. This analysis requires significant +judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our +weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. We allocate goodwill to reporting units based on the reporting unit +expected to benefit from the combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. During the second quarter of fiscal year 2009, we changed the date of our annual impairment test from July 1 to May 1. The change was +made to more closely align the impairment testing date with our long-range planning and forecasting process. We believe the change in accounting principle related to changing our annual impairment testing date did not delay, accelerate, or +avoid an impairment charge. We have determined that this change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied retrospectively. During fiscal year +2009, the annual impairment test was performed as of July 1, 2008 and was performed again as of May 1, 2009. Research and Development +Costs We account for research and development costs in accordance with applicable accounting pronouncements, including SFAS No. 2, Accounting for Research and Development Costs , and SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed . SFAS No. 86 specifies that costs incurred internally in researching and +developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is +available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk +development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the +products. PAGE 39 Table of Contents Part II Item 7 Legal +and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS No. 5, Accounting for Contingencies , requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been +incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among +other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our results of operations, financial position, or our cash +flows. Income Taxes SFAS No. 109, Accounting for Income Taxes , establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current +year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Accruals for uncertain tax positions are provided for in accordance with the +requirements of FIN No. 48, Accounting for Uncertainty in Income Taxes – An interpretation of FASB Statement No. 109 . Under FIN No. 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely +than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the +largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN No. 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and +liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax +returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows. Stock-Based Compensation We account for stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment . Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service +period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be +forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be impacted. Product Warranties We account for product warranties in accordance with SFAS No. 5, Accounting for Contingencies . We +provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we estimate the costs based on historical and projected product failure rates, historical and projected repair +costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and country in which we do business, but generally include parts and labor over a period generally +ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded +warranty liabilities and adjust the amounts as necessary. PAGE 40 Table of Contents Part II Item 7 Statement of Management’s Responsibility for Financial Statements Management is responsible for the preparation of the +consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with +accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal +control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining +accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the +consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, +internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal +auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief Executive Officer Christopher P. Liddell Senior Vice President, Finance and Administration; Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer PAGE 41 Table of Contents Part II Item 7A ITEM 7A.    QUANTATIVE +AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact results of operations cash flows +and financial condition. Foreign Currency. Certain forecasted transactions, assets, and liabilities are exposed to +foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, +Japanese yen, British pound, and Canadian dollar. Interest Rate. Our fixed-income portfolio is diversified across +credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and domestic fixed-income +indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. Equity. Our equity portfolio consists of global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and +domestic indices and expect their economic risk and return to correlate with these indices. Commodity. We use +broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures +relative to global commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in fair value of +our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP, +but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign currency exchange rates, interest +rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not +be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. The following table sets forth the one-day VaR for substantially all of our positions as of June 30, 2009 and 2008 and for the year +ended June 30, 2009: (In millions) Year Ended June 30, 2009 Risk Categories June 30, 2009 June 30, 2008 Average High Low Foreign currency $  68 $100 $53 $  99 $20 Interest rate 42 34 28 43 17 Equity 157 45 98 158 45 Commodity 16 7 10 16 6 Total one-day VaR for the combined risk categories was $211 million at June 30, 2009 +and $123 million at June 30, 2008. The total VaR is 25% less at June 30, 2009, and 34% less at June 30, 2008, than the sum of the separate risk categories in the above table due to the diversification benefit of the overall portfolio. PAGE 42 Table of Contents Part II Item 8 ITEM 8.    FINANCIAL +STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2009 2008 2007 Revenue $ 58,437 $ 60,420 $ 51,122 Operating expenses: Cost of revenue 12,155 11,598 10,693 Research and development 9,010 8,164 7,121 Sales and marketing 12,879 13,260 11,541 General and administrative 3,700 5,127 3,329 Employee severance 330 – – Total operating expenses 38,074 38,149 32,684 Operating income 20,363 22,271 18,438 Other income (expense) (542 ) 1,543 1,663 Income before income taxes 19,821 23,814 20,101 Provision for income taxes 5,252 6,133 6,036 Net income $ 14,569 $ 17,681 $ 14,065 Earnings per share: Basic $ 1.63 $ 1.90 $ 1.44 Diluted $ 1.62 $ 1.87 $ 1.42 Weighted average shares outstanding: Basic 8,945 9,328 9,742 Diluted 8,996 9,470 9,886 Cash dividends declared per common share $ 0.52 $ 0.44 $ 0.40 See accompanying notes. PAGE 43 Table of Contents Part II Item 8 BALANCE SHEETS (In millions) June 30, 2009 2008 Assets Current assets: Cash and cash equivalents $ 6,076 $ 10,339 Short-term investments (including securities pledged as collateral of $1,540 and $2,491) 25,371 13,323 Total cash, cash equivalents, and short-term investments 31,447 23,662 Accounts receivable, net of allowance for doubtful accounts of $451 and $153 11,192 13,589 Inventories 717 985 Deferred income taxes 2,213 2,017 Other 3,711 2,989 Total current assets 49,280 43,242 Property and equipment, net of accumulated depreciation of $7,547 and $6,302 7,535 6,242 Equity and other investments 4,933 6,588 Goodwill 12,503 12,108 Intangible assets, net 1,759 1,973 Deferred income taxes 279 949 Other long-term assets 1,599 1,691 Total assets $ 77,888 $ 72,793 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 3,324 $ 4,034 Short-term debt 2,000 – Accrued compensation 3,156 2,934 Income taxes 725 3,248 Short-term unearned revenue 13,003 13,397 Securities lending payable 1,684 2,614 Other 3,142 3,659 Total current liabilities 27,034 29,886 Long-term debt 3,746 – Long-term unearned revenue 1,281 1,900 Other long-term liabilities 6,269 4,721 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,908 and 9,151 62,382 62,849 Retained deficit, including accumulated other comprehensive income of $969 and $1,140 (22,824 ) (26,563 ) Total stockholders’ equity 39,558 36,286 Total liabilities and stockholders’ equity $ 77,888 $ 72,793 See accompanying notes. PAGE 44 Table of Contents Part II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2009 2008 2007 Operations Net income $ 14,569 $ 17,681 $ 14,065 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other noncash items 2,562 2,056 1,440 Stock-based compensation 1,708 1,479 1,550 Net recognized losses (gains) on investments and derivatives 683 (572 ) (292 ) Excess tax benefits from stock-based compensation (52 ) (120 ) (77 ) Deferred income taxes 762 935 421 Deferral of unearned revenue 24,409 24,532 21,032 Recognition of unearned revenue (25,426 ) (21,944 ) (19,382 ) Changes in operating assets and liabilities: Accounts receivable 2,215 (1,569 ) (1,764 ) Other current assets (422 ) 153 232 Other long-term assets (273 ) (98 ) (435 ) Other current liabilities (3,371 ) (748 ) (552 ) Other long-term liabilities 1,673 (173 ) 1,558 Net cash from operations 19,037 21,612 17,796 Financing Short-term borrowings, maturities of 90 days or less, net 1,178 – – Proceeds from issuance of debt, maturities longer than 90 days 4,796 – – Repayments of debt, maturities longer than 90 days (228 ) – – Common stock issued 579 3,494 6,782 Common stock repurchased (9,353 ) (12,533 ) (27,575 ) Common stock cash dividends (4,468 ) (4,015 ) (3,805 ) Excess tax benefits from stock-based compensation 52 120 77 Other (19 ) – (23 ) Net cash used in financing (7,463 ) (12,934 ) (24,544 ) Investing Additions to property and equipment (3,119 ) (3,182 ) (2,264 ) Acquisition of companies, net of cash acquired (868 ) (8,053 ) (1,150 ) Purchases of investments (36,850 ) (20,954 ) (36,308 ) Maturities of investments 6,191 2,597 4,736 Sales of investments 19,806 25,132 41,451 Securities lending payable (930 ) (127 ) (376 ) Net cash from (used in) investing (15,770 ) (4,587 ) 6,089 Effect of exchange rates on cash and cash equivalents (67 ) 137 56 Net change in cash and cash equivalents (4,263 ) 4,228 (603 ) Cash and cash equivalents, beginning of period 10,339 6,111 6,714 Cash and cash equivalents, end of period $ 6,076 $ 10,339 $ 6,111 See accompanying notes. PAGE 45 Table of Contents Part II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2009 2008 2007 Common stock and paid-in capital Balance, beginning of period $ 62,849 $ 60,557 $ 59,005 Common stock issued 567 3,504 6,783 Common stock repurchased (2,611 ) (3,022 ) (6,162 ) Stock-based compensation expense 1,708 1,479 1,550 Stock-based compensation income tax benefits (deficiencies) (128 ) 253 (661 ) Other, net (3 ) 78 42 Balance, end of period 62,382 62,849 60,557 Retained deficit Balance, beginning of period (26,563 ) (29,460 ) (18,901 ) Cumulative effect of a change in accounting principle – adoption of FIN 48 – (395 ) – Cumulative effect of a change in accounting principle – adoption of EITF 06-2 – (17 ) – Net income 14,569 17,681 14,065 Other comprehensive income: Net unrealized gains on derivatives 302 18 14 Net unrealized gains (losses) on investments (233 ) (653 ) 326 Translation adjustments and other (240 ) 121 85 Comprehensive income 14,398 17,167 14,490 Common stock cash dividends (4,620 ) (4,084 ) (3,837 ) Common stock repurchased (6,039 ) (9,774 ) (21,212 ) Balance, end of period (22,824 ) (26,563 ) (29,460 ) Total stockholders’ equity $ 39,558 $ 36,286 $ 31,097 See accompanying notes. PAGE 46 Table of Contents Part II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1    ACCOUNTING POLICIES Accounting Principles The financial statements and accompanying notes are prepared in accordance with accounting principles +generally accepted in the United States of America. Principles of Consolidation The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments in which we exercise significant +influence but do not control and are not the primary beneficiary are accounted for using the equity method. Investments in which we are not able to exercise significant influence over the investee and which do not have readily determinable fair +values are accounted for under the cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include estimates of loss +contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and +new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill +impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in +foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to Other +Comprehensive Income (“OCI”). Effective July 1, 2008, we began presenting gains and losses resulting from foreign +currency remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation +because this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. Prior period amounts have been recast to conform +to the current period presentation. See Note 3 – Other Income (Expense). Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. +We enter into certain arrangements where we are obligated to deliver multiple products and/or services (multiple elements). In these arrangements, we generally allocate the total revenue among the elements based on the sales price of each element +when sold separately (vendor-specific objective evidence). Revenue for retail packaged products, products licensed to original +equipment manufacturers (“OEMs”), and perpetual licenses for current products under our Open and Select volume licensing programs generally is recognized as products are shipped. A portion of the revenue related to Windows XP is recorded +as unearned due to undelivered elements including, in some cases, free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. The amount of revenue +allocated to undelivered elements is based on the vendor-specific objective evidence of fair value for those elements using the residual method or relative fair value method. Unearned revenue due to undelivered elements is recognized PAGE 47 Table of Contents Part II Item 8 ratably on a straight-line basis over the related products’ life cycles. Revenue related to Windows Vista is not subject to a similar deferral because there are +no significant undelivered elements. However, Windows Vista revenue is subject to deferral as a result of the Windows 7 Upgrade Option program which started June 26, 2009. The program allows customers who purchase PCs from participating +computer makers or retailers with certain versions of Windows Vista to receive an upgrade to the corresponding version of Windows 7 at minimal or no cost. In addition, purchasers of retail packaged Windows Vista may also qualify for a free or +discounted upgrade to the equivalent Windows 7 product with participating retailers in participating markets when the product becomes generally available. Accordingly, estimated revenue related to the undelivered Windows 7 product is deferred until +the product is delivered. Revenue from multi-year licensing arrangements are accounted for as subscriptions, with billings recorded +as unearned revenue and recognized as revenue ratably over the billing coverage period. Certain multi-year licensing arrangements include rights to receive future versions of software product on a when-and-if-available basis under Open and Select +volume licensing programs (software assurance). In addition, other multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available +basis under Open, Select, and Enterprise Agreement volume licensing programs. Premier support services agreements, MSN Internet Access subscriptions, Xbox Live, and Microsoft Developer Network subscriptions are also accounted for as subscriptions. Revenue related to our Xbox 360 game console, games published by us, and other hardware components is generally recognized when +ownership is transferred to the retailers. Revenue related to games published by third parties for use on the Xbox 360 platform is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as +advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, +generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Revenue generally is recognized net of any taxes collected from customers and subsequently remitted to governmental authorities. Cost of Revenue Cost of revenue includes manufacturing +and distribution costs for products sold and programs licensed, operating costs related to product support service centers and product distribution centers, costs incurred to drive traffic to our website and/or acquire online advertising space +(“traffic acquisitions costs”), costs incurred to support and maintain Internet-based products and services, warranty costs, inventory valuation adjustments, costs associated with the delivery of consulting services, and the amortization +of capitalized research and development costs associated with software products that have reached technological feasibility. Capitalized research and development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of +fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair +costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period +generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. Research and Development Research and development expenses include payroll, employee benefits, +stock-based compensation, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for +international markets, the amortization of purchased software code and services content, and in-process research and development. Such costs related to software development are included in research and development expense until PAGE 48 Table of Contents Part II Item 8 the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to manufacturing. Once +technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales +and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related expenses +associated with sales and marketing personnel, and the costs of advertising, promotions, tradeshows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.4 billion, $1.2 billion, and $1.3 billion in +fiscal years 2009, 2008, and 2007, respectively. Employee Severance We record employee severance when a specific plan has been approved by management, the plan has been communicated to employees, and it is unlikely that significant changes will be made to the plan. Stock-Based Compensation We account for +stock-based compensation in accordance with SFAS No. 123(R), Share-Based Payment . Under the fair value recognition provisions of this statement, stock-based compensation cost is measured at the grant date based on the fair value of the +award and is recognized as expense over the applicable vesting period of the stock award (generally four to five years) using the straight-line method. Income Taxes Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed +earnings of international subsidiaries not deemed to be permanently invested. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred +income taxes. Financial Instruments We +consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair value of these investments approximates their carrying value. In general, investments with +original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature +and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using +the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity +and other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification +method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using +the equity method. We lend certain fixed-income and equity securities to enhance investment income. The loaned securities continue to +be carried as investments on our balance sheet. Collateral and/or security interests received (securities pledged as collateral) are determined based upon the underlying security lent and the creditworthiness of the borrower. Cash collateral is +recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged +to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair +value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to PAGE 49 Table of Contents Part II Item 8 sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required +to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and +financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value +of a derivative depends on the intended use of the derivative and the resulting designation. See Note 5 – Derivatives. Our +current financial liabilities, including our short-term debt, have fair values that approximate their carrying values. Our long-term financial liabilities consist of long-term debt which is recorded on the balance sheet at issuance price less +unamortized discount. Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other +currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) 2009 2008 2007 Year Ended June 30, Balance, beginning of period $ 153 $ 117 $ 142 Charged to costs and other 360 88 64 Write-offs (62 ) (52 ) (89 ) Balance, end of period $ 451 $ 153 $ 117 Inventories Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review +inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a +charge to cost of revenue. Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated life of the asset or the lease term, ranging from one to 15 years. Computer software developed or obtained for +internal use is depreciated using the straight-line method over the estimated useful life of the software, generally three years. Goodwill Goodwill is tested for impairment on an annual basis and between annual tests if indicators of potential impairment exist, using a fair-value-based +approach. During the second quarter of fiscal year 2009, we changed the date of our annual impairment test from July 1 to May 1. The change was made to more closely align the impairment testing date with our long-range planning and +forecasting process. We believe the change in our annual impairment testing date did not delay, accelerate, or avoid an impairment charge. We have determined that this change in accounting principle is preferable under the circumstances +and does not result in adjustments to our financial statements when applied retrospectively. See Note 10 – Goodwill. PAGE 50 Table of Contents Part II Item 8 Intangible Assets Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging +from one to 10 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that may indicate the asset may be impaired. All of our +intangible assets are subject to amortization. No material impairments of intangible assets have been identified during any of the periods presented. Subsequent Events We evaluated events occurring between the end of our most recent fiscal year and July 29, 2009, the date the +financial statements were issued. Recently Issued Accounting Standards Recently Adopted Accounting Pronouncements On April 1, 2009, we adopted the Financial +Accounting Standards Board (“FASB”) Staff Positions (“FSP”) FAS 157-4, FSP FAS 115-2 and FAS 124-2, and FSP FAS 107-1 and APB 28-1. These FSPs are intended to provide additional application guidance and enhance disclosures about +fair value measurements and impairments of securities. FSP FAS 157-4 clarifies the objective and method of fair value measurement even when there has been a significant decrease in market activity for the asset being measured. FSP FAS 115-2 and FAS +124-2 establishes a new model for measuring other-than-temporary impairments for debt securities, including establishing criteria for when to recognize a write-down through earnings versus other comprehensive income. FSP FAS 107-1 and APB 28-1 +expands the fair value disclosures required for all financial instruments within the scope of SFAS No. 107, Disclosures about Fair Value of Financial Instruments, to interim periods. Adoption of these FSPs did not have a significant +impact on our accounting for financial instruments but did expand our associated disclosures. On January 1, 2009, we adopted +Statement of Financial Accounting Standards (“SFAS”) No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133. SFAS No. 161 requires additional disclosures about +the Company’s objectives in using derivative instruments and hedging activities, the method of accounting for such instruments under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities , and its related +interpretations, and tabular disclosures of the effects of such instruments and related hedged items on our financial position, financial performance, and cash flows. See Note 5 – Derivatives. On July 1, 2008, we adopted SFAS No. 157, Fair Value Measurements , for all financial assets and liabilities and nonfinancial assets +and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted +accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements, but provides guidance on how to measure fair value by providing a fair value hierarchy used to classify +the source of the information. See Note 4 – Investments. SFAS No. 159, The Fair Value Option for Financial Assets and +Financial Liabilities-Including an amendment of FASB Statement No. 115, became effective for us on July 1, 2008. SFAS No. 159 gives us the irrevocable option to elect fair value for the initial and subsequent measurement for +certain financial assets and liabilities on a contract-by-contract basis with the difference between the carrying value before election of the fair value option and the fair value recorded upon election as an adjustment to beginning retained +deficit. As of June 30, 2009, we had not elected the fair value option for any eligible financial asset or liability. Recent Accounting +Pronouncements Not Yet Adopted In June 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) , which +is effective for us beginning July 1, 2010. This Statement amends Financial Accounting Standards Board Interpretation (“FIN”) No. 46(R), Consolidation of Variable Interest Entities an interpretation of ARB No. 51 , to +require revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. We believe the adoption of this pronouncement will not have a +material impact on our financial statements. In February 2008, the FASB issued FSP FAS 157-2, Effective Date of FASB Statement +No. 157, which delays the effective date of SFAS No. 157 for us to July 1, 2009, for all nonfinancial assets and nonfinancial liabilities, except PAGE 51 Table of Contents Part II Item 8 for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). We believe the adoption of the delayed +items of SFAS No. 157 will not have a material impact on our financial statements. In December 2007, the FASB issued SFAS +No. 141(R), Business Combinations , which replaces SFAS No. 141. The statement retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (previously referred to as the purchase method of +accounting) be used for all business combinations, but requires a number of changes, including changes in the way assets and liabilities are recognized as a result of business combinations. It also requires the capitalization of in-process research +and development at fair value and requires the expensing of acquisition-related costs as incurred. In April 2009, the FASB issued FSP FAS 141(R)-1 which amends SFAS No. 141(R) by establishing a model to account for certain pre-acquisition +contingencies. Under the FSP, an acquirer is required to recognize at fair value an asset acquired or a liability assumed in a business combination that arises from a contingency if the acquisition-date fair value of that asset or liability can be +determined during the measurement period. If the acquisition-date fair value cannot be determined, then the acquirer should follow the recognition criteria in SFAS No. 5, Accounting for Contingencies, and FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss – an interpretation of FASB Statement No. 5. SFAS No. 141(R) and FSP FAS 141(R)-1 are effective for us beginning July 1, 2009, and will apply prospectively to business +combinations completed on or after that date. The impact of the adoption of SFAS No. 141(R) and FSP FAS 141(R)-1 will depend on the nature of acquisitions completed after the date of adoption. In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements – an amendment of +ARB No. 51 , which changes the accounting and reporting for minority interests. Minority interests will be recharacterized as noncontrolling interests and will be reported as a component of equity separate from the parent’s equity, and +purchases or sales of equity interests that do not result in a change in control will be accounted for as equity transactions. In addition, net income attributable to the noncontrolling interest will be included in net income and, upon a loss of +control, the interest sold, as well as any interest retained, will be recorded at fair value with any gain or loss recognized in net income. SFAS No. 160 is effective for us beginning July 1, 2009, and will apply prospectively, except for +the presentation and disclosure requirements, which will apply retrospectively. We believe the adoption of SFAS No. 160 will not have a material impact on our financial statements. NOTE 2    EARNINGS PER SHARE Basic earnings per share is computed on the basis +of the weighted average number of shares of common stock outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of shares of common stock plus the effect of dilutive potential common shares +outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share are as +follows: (In millions, except earnings per share) Year Ended June 30, 2009 2008 2007 Net income available for common shareholders (A) $ 14,569 $ 17,681 $ 14,065 Weighted average outstanding shares of common stock (B) 8,945 9,328 9,742 Dilutive effect of stock-based awards 51 142 144 Common stock and common stock equivalents (C) 8,996 9,470 9,886 Earnings per share: Basic (A/B) $ 1.63 $ 1.90 $ 1.44 Diluted (A/C) $ 1.62 $ 1.87 $ 1.42 For the years ended June 30, 2009, 2008, and 2007, 342 million, 91 million, and +199 million shares, respectively, were attributable to outstanding stock-based awards and were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. PAGE 52 Table of Contents Part II Item 8 NOTE +3    OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2009 2008 2007 Dividends and interest $ 706 $ 888 $ 1,319 Net recognized gains (losses) on investments (125 ) 346 650 Net gains (losses) on derivatives (558 ) 226 (358 ) Net gains (losses) on foreign currency remeasurements (509 ) 226 56 Other (56 ) (143 ) (4 ) Total $ (542 ) $ 1,543 $ 1,663 Effective July 1, 2008, we began presenting gains and losses resulting from foreign currency +remeasurements as a component of other income (expense). Prior to July 1, 2008, we included gains and losses resulting from foreign currency remeasurements as a component of sales and marketing expense. We changed our presentation because +this better reflects how we manage these foreign currency exposures, as such gains and losses arising from the remeasurement of foreign currency transactions are incidental to our operations. For fiscal year 2009, $509 million of losses were +reported as other income (expense). For fiscal years 2008 and 2007, $221 million and $86 million of gains, respectively, were previously recorded as a component of sales and marketing expense and have been recast as other income (expense). Net recognized gains (losses) on investments included other-than-temporary impairments of $862 million, $312 million, and $25 million +in fiscal years 2009, 2008, and 2007, respectively. Realized gains and losses from sales of available-for-sale securities (excluding other-than-temporary impairments) were $1.6 billion and $897 million, respectively, in fiscal year 2009, $751 +million and $93 million, respectively, in fiscal year 2008, and $851 million and $176 million, respectively, in fiscal year 2007. NOTE +4    INVESTMENTS Investment Components, Including Associated Derivatives (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2009 Cash $  2,064 $      – $    – $2,064 $ 2,064 $      – $      – Mutual funds 1,007 – (25 ) 982 900 82 – Commercial paper 2,601 – – 2,601 400 2,201 – Certificates of deposit 555 – – 555 275 280 – U.S. Government and Agency securities 13,450 21 (5 ) 13,466 2,369 11,097 – Foreign government bonds 3,450 71 (4 ) 3,517 – 3,517 – Mortgage-backed securities 3,353 81 (16 ) 3,418 – 3,418 – Corporate notes and bonds 4,361 287 (52 ) 4,596 – 4,596 – Municipal securities 255 2 (1 ) 256 68 188 – Common and preferred stock 4,015 627 (182 ) 4,460 – – 4,460 Other investments 465 – – 465 – (8 ) 473 Total $35,576 $1,089 $(285) $36,380 $6,076 $25,371 $4,933 PAGE 53 Table of Contents Part II Item 8 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2008 Cash $ 3,274 $ – $ – $ 3,274 $ 3,274 $ – $ – Mutual funds 1,044 15 (8 ) 1,051 835 136 80 Commercial paper 787 – – 787 787 – – Certificates of deposit 1,580 – – 1,580 1,373 207 – U.S. Government and Agency securities 4,200 37 (4 ) 4,233 1,839 2,318 76 Foreign government bonds 3,466 15 (62 ) 3,419 – 3,419 – Mortgage-backed securities 3,628 31 (25 ) 3,634 – 3,634 – Corporate notes and bonds 5,013 91 (39 ) 5,065 2,122 2,943 – Municipal securities 761 4 (4 ) 761 109 652 – Common and preferred stock 4,815 1,224 (113 ) 5,926 – – 5,926 Other investments 520 – – 520 – 14 506 Total $ 29,088 $ 1,417 $ (255 ) $ 30,250 $ 10,339 $ 13,323 $ 6,588 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value Unrealized Losses June 30, 2009 Mutual funds $ 3 $ (1 ) $ 77 $ (24 ) $ 80 $ (25 ) U.S. Government and Agency securities 4,033 (5 ) – – 4,033 (5 ) Foreign government bonds 1,444 (3 ) 669 (1 ) 2,113 (4 ) Mortgage-backed securities 503 (16 ) – – 503 (16 ) Corporate notes and bonds 713 (10 ) 504 (42 ) 1,217 (52 ) Municipal securities 16 (1 ) – – 16 (1 ) Common and preferred stock 1,154 (135 ) 120 (47 ) 1,274 (182 ) Total $ 7,866 $ (171 ) $ 1,370 $ (114 ) $ 9,236 $ (285 ) Less than 12 Months 12 Months or Greater Total (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value Unrealized Losses June 30, 2008 Mutual funds $ 123 $ (7 ) $ 12 $ (1 ) $ 135 $ (8 ) U.S. Government and Agency securities 342 (4 ) – – 342 (4 ) Foreign government bonds 2,241 (62 ) – – 2,241 (62 ) Mortgage-backed securities 1,078 (25 ) – – 1,078 (25 ) Corporate notes and bonds 807 (26 ) 925 (13 ) 1,732 (39 ) Municipal securities 176 (3 ) 193 (1 ) 369 (4 ) Common and preferred stock 598 (106 ) 28 (7 ) 626 (113 ) Total $ 5,365 $ (233 ) $ 1,158 $ (22 ) $ 6,523 $ (255 ) PAGE 54 Table of Contents Part II Item 8 At +June 30, 2009, unrealized losses of $285 million consisted of: $79 million related to investment grade fixed-income securities, $24 million related to investments in high yield and emerging market fixed-income securities, $110 million related +to domestic equity securities, and $72 million related to international equity securities. At June 30, 2008, unrealized losses of $255 million consisted of: $121 million related to investment grade fixed-income securities, $21 million related +to investments in high yield and emerging market fixed-income securities, $99 million related to domestic equity securities, and $14 million related to international equity securities. Unrealized losses from fixed-income securities are primarily +attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any unrealized losses represent other-than-temporary impairments based on our +evaluation of available evidence as of June 30, 2009. At June 30, 2009, the recorded basis and estimated fair value of +common and preferred stock and other investments that are restricted for more than one year or are not publicly traded was $204 million. At June 30, 2008, the recorded basis and estimated fair value of these investments was $289 million. The +estimate of fair value is based on publicly available market information or other estimates determined by management. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value Due in one year or less $  8,487 $  6,750 Due after one year through five years 9,796 10,071 Due after five years through ten years 1,212 1,248 Due after ten years 2,759 2,819 Total $22,254 $20,888 NOTE 5    DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our +objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge +accounting treatment under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities . Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily +to maximize the economic effectiveness of our foreign currency hedge positions. Options and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging +instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of June 30, 2009, the total notional amount of such foreign exchange contracts was $7.2 billion. Foreign currency risks related +to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of June 30, 2009, the total notional amount of these foreign exchange contracts sold +was $3.5 billion. Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency +exposures. As of June 30, 2009, the total notional amounts of these foreign exchange contracts purchased and sold were $3.2 billion and $3.6 billion, respectively. Equity Securities held in our equity and other investments portfolio are subject to market price +risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to +hedge our price PAGE 55 Table of Contents Part II Item 8 risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2009, the total notional +amounts of designated and non-designated equity contracts purchased and sold were immaterial. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their various maturities. The average maturity of the +fixed-income portfolio is managed to achieve economic returns which correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated +as hedging instruments. As of June 30, 2009, the total notional amount of fixed-interest rate contracts purchased and sold were $2.7 billion and $456 million, respectively. In addition, we use “To Be Announced” forward purchase +commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. These meet the definition of a derivative instrument under SFAS No. 133 in cases where physical delivery of the assets is not taken at the +earliest available delivery date. As of June 30, 2009, the total notional derivative amount of mortgage contracts purchased was $1.3 billion. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap +contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and facilitate portfolio diversification. We use credit default swaps as they are a low cost way of managing exposure to individual credit +risks or groups of credit risks while continuing to improve liquidity. As of June 30, 2009, the total notional amounts of credit contracts purchased and sold were immaterial. Commodity We use broad-based commodity exposures to enhance portfolio returns and facilitate +portfolio diversification. We use swap and futures contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they are low-cost alternatives to the +purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2009, the total notional amounts of commodity contracts purchased and sold were $543 million and $33 million, +respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a +minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, collateral will be required for posting, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2009, our long-term +unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral is required to be posted. PAGE 56 Table of Contents Part II Item 8 Gross Fair Values of Derivative Instruments (Excluding FIN No. 39 (a) Netting) June 30, 2009 (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives Assets Derivatives not designated as hedging instruments Short-term investments $      9 $78 $ 44 $ 21 $ 2 $ 154 Other current assets 48 – – – – 48 Total $    57 $78 $ 44 $ 21 $ 2 $ 202 Derivatives designated as hedging instruments Short-term investments $    12 $  – $   – $   – $ – $    12 Other current assets 417 – – – – 417 Equity and other investments – 2 – – – 2 Total $  429 $  2 $   – $   – $ – $ 431 Total assets (b) $  486 $80 $ 44 $ 21 $ 2 $ 633 Liabilities Derivatives not designated as hedging instruments Other current liabilities $(183 ) $ (3 ) $(20 ) $(62 ) $(6 ) $(274 ) Derivatives designated as hedging instruments Other current liabilities $  (75 ) $  – $   – $   – $ – $  (75 ) Total liabilities (b) $(258 ) $ (3 ) $(20 ) $(62 ) $(6 ) $(349 ) (a) FIN No. 39, Offsetting of Amounts Related to Certain Contracts – an interpretation of APB No. 10 and FASB Statement No. 105 , permits the netting +of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. (b) See Note 6 – Fair Value Measurements. Fair-Value Hedges For a derivative instrument designated as a fair-value hedge, the gain (loss) is recognized in earnings in the +period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are +recognized in earnings. During fiscal year 2009, we recognized in other income (expense) the following gains (losses) on fair value +hedged derivatives and their related hedged items: (In millions) Foreign Exchange Contracts Equity Contracts Derivatives $121 $191 Hedged items (120 ) (211 ) Total $   1 $ (20 ) PAGE 57 Table of Contents Part II Item 8 Cash-Flow Hedges For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain +(loss) is initially reported as a component of other comprehensive income (“OCI”) and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the +time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are +recognized in earnings. During fiscal year 2009, we recognized the following gains (losses) related to foreign exchange contracts: (In millions) Effective portion: Gain recognized in OCI, net of tax effect of $472 $ 876 Gain reclassified from accumulated OCI into revenue $ 884 Amount excluded from effectiveness assessment and ineffective portion: Loss recognized in other income (expense) $ (314 ) We estimate that $528 million of net derivative gains included in OCI will be reclassified into earnings +within the next 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2009. Non-Designated Derivatives Gains (losses) from changes +in fair values of derivatives that are not designated as hedges are recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally +economically offset by unrealized gains (losses) in the underlying securities and are recorded as a component of OCI. The amounts recognized during fiscal year 2009 were as follows: (In millions) Foreign exchange contracts $ (234 ) Equity contracts (131 ) Interest-rate contracts 5 Credit contracts (18 ) Commodity contracts (126 ) Total $ (504 ) Gains (losses) for foreign exchange, equity, interest rate, credit, and commodity contracts presented in +other income statement line items were immaterial for fiscal year 2009 and have been excluded from the table above. NOTE +6    FAIR VALUE MEASUREMENTS SFAS No. 157 defines fair value as the price that would be received upon sale of an asset +or paid upon transfer of a liability in an orderly transaction between market participants at the measurement date and in the principal or most advantageous market for that asset or liability. The fair value should be calculated based on assumptions +that market participants would use in pricing the asset or liability, not on assumptions specific to the entity. In addition, the fair value of liabilities should include consideration of non-performance risk, including our own credit risk. In addition to defining fair value, SFAS No. 157 expands the disclosure requirements around fair value and establishes a fair +value hierarchy for valuation inputs. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market. Each fair value measurement is PAGE 58 Table of Contents Part II Item 8 reported in one of the three levels, which is determined by the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not +active, and model-based valuation techniques for which all significant assumptions are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset +or liability. The fair values are therefore determined using model-based techniques that include option pricing models, discounted cash flow models, and similar techniques. The following section describes the valuation methodologies we use to measure financial assets and liabilities at fair value. Investments Other Than Derivatives Investments other +than derivatives primarily include U.S. Government and Agency securities, foreign government bonds, mortgage-backed securities, commercial paper, corporate notes and bonds, and common and preferred stock. In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This +pricing methodology applies to our Level 1 investments, such as domestic and international equities, U.S. treasuries, exchange-traded mutual funds, and agency securities. If quoted prices in active markets for identical assets or liabilities +are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. These investments are included in Level 2 and +consist primarily of corporate notes and bonds, foreign government bonds, mortgage-backed securities, commercial paper, and certain agency securities. Our Level 3 assets primarily include investments in certain corporate bonds. We value +the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant to the fair values of the +investments. Derivatives In general, and +where applicable, we use quoted prices in an active market for identical derivative assets and liabilities that are traded on exchanges. These derivative assets and liabilities are included in Level 1. The fair values for the derivative assets and +liabilities included in Level 2 are estimated using industry standard valuation models, such as the Black-Scholes model. Where applicable, these models project future cash flows and discount the future amounts to a present value using +market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot prices for currencies and commodities. Level 2 derivative assets and liabilities primarily include certain over-the-counter options, futures, +and swap contracts. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value. These derivative assets and liabilities are included in Level 3 and primarily +represent derivatives for foreign equities. PAGE 59 Table of Contents Part II Item 8 Assets and Liabilities Measured at Fair Value on a Recurring Basis The following table presents our assets and liabilities at +June 30, 2009, which are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value FIN No. 39 Netting (a) Net Fair Value Assets Mutual funds $     982 $           – $     – $     982 $      – $     982 Commercial paper – 2,601 – 2,601 – 2,601 Certificates of deposit – 555 – 555 – 555 U.S. Government and Agency securities 7,134 6,105 – 13,239 – 13,239 Foreign government bonds 501 3,022 – 3,523 – 3,523 Mortgage-backed securities – 3,593 – 3,593 – 3,593 Corporate notes and bonds – 4,073 253 4,326 – 4,326 Municipal securities – 256 – 256 – 256 Common and preferred stock 4,218 28 5 4,251 – 4,251 Derivatives 5 623 5 633 (235 ) 398 Total $12,840 $20,856 $263 $33,959 $(235 ) $33,724 Liabilities Derivatives $          5 $     344 $     – $     349 $(231 ) $     118 (a) FIN No. 39, Offsetting of Amounts Related to Certain Contracts – an interpretation of APB No. 10 and FASB Statement No. 105 , permits the netting +of derivative assets and derivative liabilities when a legally enforceable master netting agreement exists. These amounts include fair value adjustments related to our own credit risk and counterparty credit risk. Changes in Level 3 Instruments Measured at Fair Value on a Recurring Basis The majority of our Level 3 instruments consist of investment securities classified as available-for-sale with changes in fair value included in other comprehensive income. The following table presents the changes in Level 3 +instruments measured on a recurring basis for the year ended June 30, 2009: (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Balance, beginning of period $138 $      8 $    71 $217 Total realized and unrealized gains (losses): Included in other income (expense) (6 ) (6 ) 51 39 Included in other comprehensive income 111 – – 111 Purchases, issuances, and settlements – 5 (119 ) (114 ) Transfers in (out) 10 (2 ) 2 10 Balance, end of period $253 $      5 $      5 $263 Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2009 $   (7 ) $    (5 ) $      4 $   (8 ) PAGE 60 Table of Contents Part II Item 8 Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis We measure certain assets, including our cost and equity +method investments, at fair value on a nonrecurring basis. These assets are recognized at fair value when they are deemed to be other-than-temporarily impaired. At June 30, 2009, the fair value of the common and preferred stock that we held +that was required to be measured at fair value on a non-recurring basis was $164 million. This fair value was determined using models with significant unobservable inputs. In accordance with the provisions of Accounting Principles Board Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock , we review the carrying values of our +investments when events and circumstances warrant, and we consider all available evidence in evaluating when declines in fair value are other than temporary. The fair values of our investments are determined based on valuation techniques using the +best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to +be other than temporary. During the fiscal year ended June 30, 2009, impairment charges of $86 million were recognized for certain investments measured at fair value on a nonrecurring basis as the decline in their respective fair values below +their cost was determined to be other than temporary in all instances. NOTE 7    INVENTORIES The components of inventories were as follows: (In millions) June 30, 2009 2008 Raw materials $170 $417 Work in process 45 31 Finished goods 502 537 Total $717 $985 NOTE 8    PROPERTY AND EQUIPMENT The components of property and equipment were as +follows: (In millions) June 30, 2009 2008 Land $     526 $     518 Buildings and improvements 5,886 4,302 Leasehold improvements 1,938 1,728 Computer equipment and software 4,989 4,475 Furniture and equipment 1,743 1,521 Total, at cost 15,082 12,544 Accumulated depreciation (7,547 ) (6,302 ) Total, net $ 7,535 $ 6,242 Property and equipment are stated at cost. Depreciation is computed principally on the straight-line method +over the estimated useful lives of the assets. The useful lives for buildings range from five to 15 years, leasehold improvements generally range from two to 10 years (representing the applicable lease terms plus reasonably assured extensions), +computer equipment and software range from two to three years, and furniture and equipment range from one to five years. Land is not depreciated. PAGE 61 Table of Contents Part II Item 8 During fiscal years 2009, 2008, and 2007, depreciation expense was $1.7 billion, $1.4 billion, and $1.2 billion, respectively. The majority of depreciation expense in all years related to computer equipment. NOTE 9    ACQUISITIONS We acquired +nine entities during fiscal year 2009 for total consideration of $925 million, substantially all of which was paid in cash. All of the entities have been consolidated into our results of operations since their respective acquisition dates. The +purchase price allocations for these acquisitions are preliminary for up to 12 months after the acquisition dates and are subject to revision as more detailed analyses are completed and additional information about the fair values of assets and +liabilities becomes available. Any change in the estimated fair value of the net assets of the acquired companies within this timeframe will change the amount of the purchase price allocable to goodwill. Pro forma results of operations have not been +presented because the effects of these acquisitions, individually and in the aggregate, were not material to our consolidated results of operations. NOTE 10    GOODWILL Changes in the carrying amount of goodwill for fiscal years 2009 and 2008 by segment were as +follows: (In millions) Balance as of June 30, 2007 Acquisitions Purchase Accounting Adjustments and Other Balance as of June 30, 2008 Acquisitions Purchase Accounting Adjustments and Other Balance as of June 30, 2009 Client $     77 $     77 $   (1 ) $     153 $    1 $  (77 ) $       77 Server and Tools 580 90 68 738 233 67 1,038 Online Services Business 552 5,775 (53 ) 6,274 447 (64 ) 6,657 Microsoft Business Division 3,132 1,073 (14 ) 4,191 _ (264 ) 3,927 Entertainment and Devices Division 419 354 (21 ) 752 58 (6 ) 804 Total $4,760 $7,369 $(21 ) $12,108 $739 $(344 ) $12,503 None of the amounts recorded as goodwill are expected to be deductible for tax purposes. The purchase price +allocations for all of the acquisitions are preliminary for up to 12 months after the acquisition date and are subject to revision as more detailed analyses are completed and additional information about fair value of the assets and liabilities +become available. Any change in the fair value of the net assets of the acquired company within this timeframe will change the amount of the purchase price allocable to goodwill. Changes in goodwill amounts resulting from foreign currency +translations are included in “purchase accounting adjustments and other” in the above table. We test goodwill for +impairment annually at the reporting unit level using a fair value approach, in accordance with the provisions of SFAS No. 142, Goodwill and Other Intangible Assets . During the second quarter of fiscal year 2009, we changed the date of +our annual impairment test from July 1 to May 1. The change was made to more closely align the impairment testing date with our long-range planning and forecasting process. We believe the change in our annual impairment testing +date did not delay, accelerate, or avoid an impairment charge. We have determined that this change in accounting principle is preferable under the circumstances and does not result in adjustments to our financial statements when applied +retrospectively. During fiscal year 2009, the annual impairment test was performed as of July 1, 2008 and was performed again as of May 1, 2009. PAGE 62 Table of Contents Part II Item 8 NOTE +11    INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) June 30, 2009 2008 Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Contract-based $1,087 $   (855 ) $   232 $1,074 $   (796 ) $   278 Technology-based 2,033 (1,090 ) 943 1,677 (672 ) 1,005 Marketing-related 188 (97 ) 91 171 (65 ) 106 Customer-related 732 (239 ) 493 708 (124 ) 584 Total $4,040 $(2,281 ) $1,759 $3,630 $(1,657 ) $1,973 During fiscal year 2009 and 2008, we recorded additions to intangible assets of $354 million and $1.6 +billion, respectively. We estimate that we have no significant residual value related to our intangible assets. The components of intangible assets +acquired during fiscal years 2009 and 2008 were as follows: (In millions) Year Ended June 30, 2009 2008 Amount Weighted Average Life Amount Weighted Average Life Contract-based $  26 4 years $     91 6 years Technology-based 293 4 years 787 4 years Marketing-related 7 5 years 116 5 years Customer-related 28 2 years 589 6 years Total $354 $1,583 Acquired intangibles generally are amortized on a straight-line basis over their weighted average lives. +Intangible assets amortization expense was $591 million for fiscal year 2009, $472 million for fiscal year 2008, and $236 million for fiscal year 2007. The following table outlines the estimated future amortization expense related to intangible +assets as of June 30, 2009: (In millions) Year Ended June 30, Amount 2010 $   562 2011 511 2012 455 2013 191 2014 and thereafter 40 Total $1,759 PAGE 63 Table of Contents Part II Item 8 NOTE +12    DEBT Short-term Debt In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. Pursuant to the authorization, we established a commercial paper program providing for the issuance and sale of up to $2.0 billion in +short-term commercial paper. As of June 30, 2009, $2.0 billion of the commercial paper was issued and outstanding with a weighted average interest rate, including issuance costs, of 0.20% and maturities of 22 to 119 days. The estimated fair +value of this commercial paper approximates its carrying value. In September 2008, we also entered into a $2.0 billion six-month +senior unsecured credit facility, principally to support the commercial paper program. In November 2008, we replaced the six-month credit facility with a $2.0 billion 364-day credit facility. This credit facility expires on November 6, 2009. In +March 2009, we entered into an additional credit facility. This $1.0 billion 364-day credit facility expires on March 12, 2010. As of June 30, 2009, we were in compliance with the only financial covenant in both credit agreements, which +requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against these credit facilities during the year ended June 30, +2009. Long-term Debt In November 2008, +we filed a shelf registration statement with the U.S. Securities and Exchange Commission that allows us to issue debt securities from time to time pursuant to the September 2008 authorization for debt financings of up to $6.0 billion. In May 2009, +we issued $3.75 billion of debt securities under that registration statement (“Notes”). Interest on the Notes will be payable semi-annually on June 1 and December 1 of each year, commencing on December 1, 2009, to holders of +record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and will rank equally with our other unsecured and unsubordinated debt outstanding. The components of long-term debt as of June 30, 2009 were as follows: (In millions) 2.95% Notes due on June 1, 2014 $ 2,000 4.20% Notes due on June 1, 2019 1,000 5.20% Notes due on June 1, 2039 750 Unamortized debt discount (4 ) Total $ 3,746 Maturities of long-term debt for the next five years are as follows: (In millions) Year Ended June 30, Amount 2010 $ – 2011 – 2012 – 2013 – 2014 2,000 Thereafter 1,750 Total $ 3,750 As of June 30, 2009, the total carrying value and estimated fair value of our long-term debt were $3.75 +billion and $3.74 billion, respectively. The estimate of fair value is based on quoted prices for our publicly-traded debt as of June 30, 2009. The effective interest yields of the Notes due in 2014, 2019, and 2039 were 3.00%, 4.29%, and 5.22%, +respectively, at June 30, 2009. PAGE 64 Table of Contents Part II Item 8 NOTE +13    INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2009 2008 2007 Current taxes: U.S. Federal $3,159 $4,357 $4,593 U.S. State and Local 192 256 154 International 1,139 1,007 957 Current taxes 4,490 5,620 5,704 Deferred taxes 762 513 332 Provision for income taxes $5,252 $6,133 $6,036 U.S. and international components of income before income +taxes were as follows: (In millions) Year Ended June 30, 2009 2008 2007 U.S. $  5,529 $12,682 $12,902 International 14,292 11,132 7,199 Income before income taxes $19,821 $23,814 $20,101 The items +accounting for the difference between income taxes computed at the federal statutory rate and the provision for income taxes were as follows: Year Ended June 30, 2009 2008 2007 Federal statutory rate 35.0 % 35.0 % 35.0 % Effect of: Foreign earnings taxed at lower rates (9.3 )% (7.0 )% (5.1 )% Internal Revenue Service settlement – % (5.8 )% – % European Commission fine – % 2.1 % – % Other reconciling items, net 0.8 % 1.5 % 0.1 % Effective rate 26.5 % 25.8 % 30.0 % In general, other reconciling items consist of interest, U.S. state income taxes, domestic production +deductions, and research credits. In fiscal years 2009 and 2008, there were no individually significant other reconciling items. Other reconciling items in fiscal year 2007 included the impact of a $195 million reduction resulting from various +changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments. PAGE 65 Table of Contents Part II Item 8 The +components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2009 2008 Deferred income tax assets: Stock-based compensation expense $ 2,004 $ 2,225 Other expense items 1,595 1,933 Unearned revenue 743 928 Impaired investments 236 331 Other revenue items 120 91 Deferred income tax assets $ 4,698 $ 5,508 Deferred income tax liabilities: International earnings $ (1,191 ) $ (1,300 ) Unrealized gain on investments (516 ) (513 ) Other (499 ) (729 ) Deferred income tax liabilities (2,206 ) (2,542 ) Net deferred income tax assets $ 2,492 $ 2,966 Reported as: Current deferred income tax assets $ 2,213 $ 2,017 Long-term deferred income tax assets 279 949 Net deferred income tax assets $ 2,492 $ 2,966 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of +assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $18.0 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested +outside the United States. The unrecognized deferred tax liability associated with these temporary differences is approximately $5.4 billion. Income taxes paid were $6.6 billion in fiscal year 2009, $5.4 billion in fiscal year 2008, and $5.2 billion in fiscal year 2007. Uncertain Tax Positions As of June 30, 2009, we had $5.4 billion of unrecognized tax benefits of which $4.4 billion, if +recognized, would affect our effective tax rate. As of June 30, 2008, we had $3.2 billion of unrecognized tax benefits of which $2.3 billion, if recognized, would affect our effective tax rate. Interest and penalties related to unrecognized tax benefits are included in income tax expense. Such interest totaled $230 million in fiscal year +2009 and $121 million in fiscal year 2008. As of June 30, 2009 and 2008, we had accrued interest related to uncertain tax positions of $554 million and $324 million, respectively, net of federal income tax benefits, on our balance sheets. PAGE 66 Table of Contents Part II Item 8 The +aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2009 2008 Balance, beginning of year $ 3,195 $ 7,076 Decreases related to settlements (82 ) (4,787 ) Increases for tax positions related to the current year 2,203 934 Increases for tax positions related to prior years 239 66 Decreases for tax positions related to prior years (132 ) (80 ) Reductions due to lapsed statute of limitations (20 ) (14 ) Balance, end of year $ 5,403 $ 3,195 During fiscal year 2008, we reached a settlement with the Internal Revenue Service (“IRS”) on its +2000-2003 examination. As a result, we reduced our unrecognized tax benefits by $4.8 billion and recognized a tax provision reduction of $1.2 billion. As a result of the 2000-2003 settlement and the related impact on subsequent years, we +paid the IRS approximately $4.1 billion during fiscal year 2009. We are under audit by the IRS for the tax years 2004-2006. We +do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months as we do not believe the examination will be concluded within the next 12 months. We are subject to income tax in many jurisdictions outside the United States, none of which are individually material to our +financial position, cash flows, or results of operations. NOTE 14    UNEARNED REVENUE Unearned revenue is comprised of the following items: Volume licensing programs Represents customer billings for multi-year licensing arrangements, paid either upfront or annually at the +beginning of each billing coverage period, which are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Undelivered elements Represents the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a +when-and-if-available basis and free post-delivery telephone support. This revenue deferral is applicable for Windows XP and prior versions shipped as retail packaged products, products licensed to OEMs, and perpetual licenses for current products +under our Open and Select volume licensing programs. The amount recorded as unearned is based on the sales price of those elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle. +Product life cycles are currently estimated at three and one-half years for Windows operating systems. Undelivered elements include $276 million of deferred revenue related to the Windows 7 Upgrade Option program. Other Represents payments for post-delivery support and +consulting services to be performed in the future, online advertising for which the advertisement has yet to be displayed, Microsoft Dynamics business solutions products, Xbox Live subscriptions, Mediaroom, and other offerings for which we have been +paid upfront and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. PAGE 67 Table of Contents Part II Item 8 The +components of unearned revenue were as follows: (In millions) June 30, 2009 2008 Volume licensing programs $ 11,350 $ 12,232 Undelivered elements 1,083 1,396 Other 1,851 1,669 Total $ 14,284 $ 15,297 Unearned revenue by segment was as follows: (In millions) June 30, 2009 2008 Client $ 2,345 $ 2,738 Server and Tools 4,732 5,007 Microsoft Business Division 6,508 7,101 Other segments 699 451 Total $ 14,284 $ 15,297 NOTE 15    OTHER LONG-TERM LIABILITIES (In millions) June 30, 2009 2008 Tax contingencies and other tax liabilities $ 5,515 $ 3,812 Legal contingencies 407 530 Product warranty 132 278 Other 215 101 Total $ 6,269 $ 4,721 NOTE 16    COMMITMENTS AND GUARANTEES We have committed $621 million for constructing new buildings as of June 30, 2009. We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for operating leases was $475 million, $398 million, and $325 million, in fiscal +years 2009, 2008, and 2007, respectively. Future minimum rental commitments under noncancellable operating leases in place as of June 30, 2009 are as follows: (In millions) Year Ended June 30, Amount 2010 $ 457 2011 370 2012 309 2013 252 2014 and thereafter 997 $ 2,385 PAGE 68 Table of Contents Part II Item 8 We +provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. We evaluate estimated losses for these +indemnifications under SFAS No. 5, Accounting for Contingencies , as interpreted by FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others . +We consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not +accrued any liabilities related to these indemnifications in our financial statements. Product Warranty The changes in our aggregate product warranty liabilities, which are included in other current liabilities and other long term-liabilities on our balance sheets, +were as follows: (In millions) Year Ended June 30, 2009 2008 Balance, beginning of year $ 692 $ 850 Accruals for warranties issued 161 365 Adjustments to pre-existing warranties – 36 Settlements of warranty claims (511 ) (559 ) Balance, end of year $ 342 $ 692 NOTE 17    CONTINGENCIES Government Competition Law Matters In March 2004, the European Commission issued a +competition law decision that, among other things, ordered us to license certain Windows server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we +proposed for licensing the technology as required by the March 2004 decision were “not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in +compliance with the March 2004 decision and that no further penalty should accrue after that date. On February 27, 2008, the Commission issued a fine of $1.4 billion ( € 899 million) relating to the period prior to October 22, 2007. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the $1.4 billion ( € 899 million) fine in June 2008. In January 2008, the +Commission opened a competition law investigation relating to the inclusion of various capabilities in our Windows operating system software, including Web browsing software. The investigation was precipitated by a complaint filed with the +Commission by Opera Software ASA, a firm that offers Web browsing software. On January 15, 2009, the European Commission issued a statement of objections expressing the Commission’s preliminary view that the inclusion of Internet Explorer +in Windows since 1996 has violated European competition law. According to the statement of objections, other browsers are foreclosed from competing because Windows includes Internet Explorer. We filed our written response to the statement of +objections in late April 2009. The European Commission will not make a final determination until after it assesses our response and considers submissions from others, a process that is now underway. The statement of objections seeks to impose a +remedy that is different than the remedy imposed in the earlier proceeding concerning Windows Media Player. While computer users and OEMs are already free to run any Web browsing software on Windows, the Commission is considering ordering other +changes to further promote the prospects of competing browser software. This may include ordering creation of a “ballot screen” from which computer users could choose from among a variety of browsers. The statement of objections also seeks +to impose a significant fine based on worldwide sales of Windows operating systems. In January 2008, the Commission opened an additional competition law investigation that relates primarily to interoperability with respect to our Microsoft +Office family of products. This investigation resulted from complaints filed with the Commission by a trade association of Microsoft’s competitors. On July 24, 2009 we submitted a proposal to the Commission to resolve the investigation +concerning Internet Explorer. Under this proposal, European consumers who use Internet Explorer as their default browser would be shown a “ballot screen” from which they could, if they wished, easily install competing browsers from the +Web. We also submitted a proposal regarding means PAGE 69 Table of Contents Part II Item 8 of promoting greater interoperability between non-Microsoft products and our Windows and Office families of products. We made this proposal following extensive +discussions with the Commission. In a statement issued on July 24, 2009, the Commission stated it welcomes our proposals. We understand the Commission will now consider them, which will likely entail seeking input from a range of industry +participants. We are subject to a Consent Decree and Final Judgment (“Final Judgments”) that resolved lawsuits brought by +the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating system businesses. Originally, the Final Judgments were scheduled to expire in +November 2007. In 2006, we voluntarily agreed to extend certain elements of the Final Judgments to November 2009. The U.S. Department of Justice and other states advised the Court that they would not seek any extension of the Final Judgments to +which they are party. In January 2008, the court issued a decision granting the states’ motion to extend these additional provisions of the Final Judgments until November 2009. On April 16, 2009, we agreed with the Department of Justice +and the states, respectively, to extend the Final Judgments to May 2011, and submitted to the U.S. District Court for the District of Columbia joint motions for this extension. In April 2009, the Court entered an order approving the extension. In other ongoing investigations, various foreign governments and several state attorneys general have requested information from us +concerning competition, privacy, and security issues. Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits have been filed against us in various state, federal, and Canadian courts on behalf of +various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify classes +in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may +issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number +of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members +and schools that are issued and redeem vouchers. The settlements in all states except Arizona have received final court approval. +Cases in Canada have not been settled. We estimate the total cost to resolve all of the overcharge class action cases will range between $1.8 billion and $2.0 billion. The actual cost depends on factors such as the claim rate, the quantity and mix +of products for which claims are made, the number of eligible class members who ultimately use the vouchers, the nature of hardware and software that is acquired using the vouchers, and the cost of administering the claims. At June 30, 2009, we +have recorded a liability related to these claims of approximately $800 million, which reflects our estimated exposure of $1.8 billion less payments made to date of approximately $1.0 billion mostly for vouchers, legal fees, and administrative +expenses. Other Antitrust Litigation and Claims In November 2004, Novell, Inc. filed a complaint in U.S. District Court, asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period +between June 1994 and March 1996. This case was transferred to Maryland. In June 2005, the trial court granted our motion to dismiss four of nine claims of the complaint. Both parties appealed, and in October 2007, the court of appeals affirmed +the decision of the trial court, and remanded the case to that court for further proceedings. Fact discovery has closed and summary judgment motions are expected to be filed in the fall. Patent and Intellectual Property Claims In 2003 we filed an action in U.S. District Court in +California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In +April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million +in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We have appealed that award to the Federal Circuit. In December 2008, we entered into a settlement agreement +resolving all other litigation PAGE 70 Table of Contents Part II Item 8 pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In April 2009, the U.S. Patent and Trademark Office, after a +reexamination of the remaining patent in dispute, determined that the patent was invalid and Alcatel-Lucent has appealed that ruling. In October 2003, Uniloc USA Inc., a subsidiary of a Singapore-based security technology company, filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology in Windows XP and certain +other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for +trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. We are seeking to overturn this verdict via post-trial motions and, if necessary, will appeal, based on evidence that our +product activation technology does not infringe the patent, that the patent is invalid, and that the damages were unsupported. With pre-judgment interest, approximately $500 million is in dispute. In March 2007, i4i Limited Partnership, based in Canada, sued Microsoft in U.S. District Court in the Eastern District of Texas, claiming that +certain custom XML technology in Word 2003 and 2007 infringed i4i’s patent. In May 2009, a jury returned a verdict against us, finding damages of $200 million and that we willfully infringed the patent. Our defense of inequitable conduct has +not yet been ruled upon, and we are also seeking to overturn the verdict via post-trial motions and, if necessary, via appeal. With pre-judgment interest, approximately $240 million is in dispute. There are over 50 other patent infringement cases pending against Microsoft, 10 of which are set for trial in fiscal year 2010. Other We also are subject to a variety of other claims +and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our financial position, +our results of operations, or our cash flows, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2009, we had accrued aggregate liabilities of approximately $800 million in other current liabilities and approximately $400 million in other long-term liabilities for all of the +contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could be up to $2.2 billion in aggregate beyond recorded amounts. The foregoing amount +does not include the January 15, 2009 European Commission statement of objections, the outcome and range of which is not reasonably estimable. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact +on our financial position, results of operations, and cash flows for the period in which the effects become reasonably estimable. NOTE +18    STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2009 2008 2007 Balance, beginning of year 9,151 9,380 10,062 Issued 75 173 289 Repurchased (318 ) (402 ) (971 ) Balance, end of year 8,908 9,151 9,380 Share Repurchases On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. +On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program PAGE 71 Table of Contents Part II Item 8 authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As of June 30, 2009, approximately $34.5 billion remained +of the $40.0 billion approved repurchase amount. All repurchases were made using cash resources. The repurchase program may be suspended or discontinued at any time without prior notice. We repurchased the following shares of common stock under the above-described repurchase plans: (In millions) Year Ended June 30, 2009 (a) 2008 (b) 2007 (c) Shares Amount Shares Amount Shares Amount First quarter 223 $5,966 81 $  2,348 285 $  6,965 Second quarter 95 2,234 120 4,081 205 6,037 Third quarter – – 30 1,020 238 6,744 Fourth quarter – – 171 4,975 243 7,367 Total 318 $8,200 402 $12,424 971 $27,113 (a) Of the 318 million shares of common stock repurchased in fiscal year 2009, 101 million shares were repurchased for $2.7 billion under the repurchase plan +approved by our Board of Directors during the first quarter of fiscal year 2007. The remaining shares were repurchased under the repurchase plan approved by our Board of Directors on September 22, 2008. (b) All shares repurchased in fiscal year 2008 were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. (c) Of the 971 million shares of common stock repurchased in fiscal year 2007, 155 million shares were repurchased for $3.8 billion under our tender offer in the +first quarter of fiscal year 2007. The remaining shares were repurchased under the repurchase plan approved by our Board of Directors on July 20, 2006. Dividends In fiscal year 2009, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount (in millions) Payment Date September 19, 2008 $0.13 November 20, 2008 $1,157 December 11, 2008 December 10, 2008 $0.13 February 19, 2009 $1,155 March 12, 2009 March 9, 2009 $0.13 May 21, 2009 $1,158 June 18, 2009 June 10, 2009 $0.13 August 20, 2009 $1,158 (a) September 10, 2009 (a) The dividend declared on June 10, 2009 will be paid after the filing date of this report on Form 10-K and was included in other current liabilities as of +June 30, 2009. In fiscal year 2008, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount (in millions) Payment Date September 12, 2007 $0.11 November 15, 2007 $1,034 December 13, 2007 December 19, 2007 $0.11 February 21, 2008 $1,023 March 13, 2008 March 17, 2008 $0.11 May 15, 2008 $1,020 June 12, 2008 June 11, 2008 $0.11 August 21, 2008 $   998 (a) September 11, 2008 (a) The dividend declared on June 11, 2008 was included in other current liabilities as of June 30, 2008. Other On July 1, 2007, we adopted the provisions +of FIN No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109 , which provides a financial statement recognition threshold and PAGE 72 Table of Contents Part II Item 8 measurement attribute for a tax position taken or expected to be taken in a tax return. Upon adoption, we recognized a $395 million charge to our beginning retained +deficit as a cumulative effect of a change in accounting principle. On July 1, 2007, we adopted Emerging Issues Task Force Issue +No. 06-2 (“EITF 06-2”), Accounting for Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 . EITF 06-2 requires companies to accrue the costs of compensated absences under a sabbatical or similar +benefit arrangement over the requisite service period. Upon adoption, we recognized a $17 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. NOTE 19    OTHER COMPREHENSIVE INCOME The activity in other comprehensive income and related income tax effects were as follows: (In millions) Year Ended June 30, 2009 2008 2007 Net unrealized gains on derivatives: Unrealized gains, net of tax effects of $472 , $46, and $66 $ 876 $   86 $123 Reclassification adjustment for gains included in net income, net of tax effects of $(309) , $(36), and $(59) (574 ) (68 ) (109 ) Net unrealized gains on derivatives 302 18 14 Net unrealized gains (losses) on investments: Unrealized gains (losses), net of tax effects of $(142) , $(234), and $393 (263 ) (435 ) 730 Reclassification adjustment for losses (gains) included in net income, net of tax effects of $16 , $(117), and $(217) 30 (218 ) (404 ) Net unrealized gains (losses) on investments (233 ) (653 ) 326 Translation adjustments and other (240 ) 121 85 Other comprehensive income (loss) $(171 ) $(514 ) $425 The components of accumulated other comprehensive income were +as follows: (In millions) Year Ended June 30, 2009 2008 2007 Net unrealized gains on derivatives $437 $   135 $   117 Net unrealized gains on investments 502 735 1,388 Translation adjustments and other 30 270 149 Accumulated other comprehensive income $969 $1,140 $1,654 NOTE 20    EMPLOYEE STOCK AND +SAVINGS PLANS Stock-based compensation expense and related +income tax benefits were as follows: (In millions) 2009 2008 2007 Year Ended June 30, Total stock-based compensation expense $1,708 $1,479 $1,550 Income tax benefits related to stock-based compensation $   598 $   518 $   542 PAGE 73 Table of Contents Part II Item 8 Employee Stock Purchase Plan We have an employee stock purchase plan for all eligible employees. Compensation expense for the +employee stock purchase plan is recognized in accordance with SFAS No. 123(R). Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last day of each three-month period. +Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares: (Shares in millions) 2009 2008 2007 Year Ended June 30, Shares purchased 24 18 17 Average price per share $ 20.13 $ 26.78 $ 25.36 At June 30, 2009, 83 million shares were reserved for future issuance. Savings Plan We have a savings plan in the United +States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their salary, but not more than statutory limits. We +contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $262 million, $238 million, and $218 million in fiscal years +2009, 2008, and 2007, respectively, and were expensed as contributed. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the +U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock. Stock Plans We have stock plans for directors and for officers, employees, consultants, and advisors. At June 30, 2009, an +aggregate of 714 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared performance stock awards. Awards that expire or are canceled without delivery of shares generally become +available for issuance under the plans. We issue new shares to satisfy stock option exercises. Stock Awards Stock awards (“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. Our SAs generally vest over a five-year +period. Shared Performance Stock Awards Shared performance stock awards (“SPSAs”) are a form of SA in which the number of shares ultimately received depends on our business performance against specified performance targets. The Company granted SPSAs for fiscal years 2009, 2008, and 2007 with performance periods of July 1, 2008 through June 30, +2009, July 1, 2007 through June 30, 2008, and July 1, 2006 through June 30, 2007, respectively. At the end of each performance period, the number of shares of stock subject to the award is determined by multiplying the +target award by a percentage ranging from 0% to 150%. The percentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional number of +shares, approximately 12.2% of the total target SPSAs, are available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award vest following the end of the performance period, and +an additional one-quarter of the shares vest on each of the following three anniversaries of the grant date. Following the end of the fiscal year 2008 and 2007 performance periods, the Compensation Committee of the Board of Directors determined that +the number of shares of SPSAs to be issued were 18 million and 11 million respectively, based on the actual performance against metrics established for the performance period. The number of shares of SPSAs to be issued for the fiscal year +2009 performance period will be determined in the first quarter of fiscal year 2010. PAGE 74 Table of Contents Part II Item 8 Executive Officer Incentive Plan In fiscal year 2009, the Compensation Committee approved a new Executive Officer Incentive Plan +(“EOIP”) for executive officers of the Company. The EOIP replaced the annual cash bonus opportunity and equity award plans for executive officers. Under the EOIP, the Compensation Committee makes awards of performance-based +compensation for specified performance periods. For fiscal year 2009, executive officers were eligible to receive annual awards comprised of cash and SAs from an incentive pool funded based on the achievement of operating income targets. +Following approval of the awards for fiscal year 2009, 20% of the award will be paid to the executive officers in cash, and the remaining 80% will be converted into an SA for shares of Microsoft common stock. The SA portion of the award will vest +one-quarter immediately after the award is approved following fiscal year 2009, and one-quarter on August 31 of each of the following three years. The Company will grant awards to the executive officers in September 2009 based on the performance period of July 1, 2008 through June 30, 2009, from an incentive pool equal to 0.35% of the +Company’s fiscal year 2009 operating income. Each executive officer will receive a fixed percentage of the pool ranging between 0 and 150% of a target based on an assessment of the executive officer’s performance during fiscal year +2009. The number of shares subject to the SA portion of the award will be determined by dividing the value of the award by the closing price of Microsoft common stock on August 31, 2009. Activity for All Stock Plans We measure the fair value of SAs and SPSAs based upon the market +price of the underlying common stock as of the date of grant, reduced by the present value of estimated future dividends. SAs and SPSAs EOIP are amortized over their applicable vesting period (generally four to five years) using the straight-line +method. The fair value of each award grant is estimated on the date of grant using the following assumptions: 2009 2008 2007 Year Ended June 30, Dividends per share (quarterly amounts) $ 0.11 - $0.13 $ 0.10 - $0.11 $ 0.09 - $0.10 Interest rates range 1.4% - 3.6% 2.5% - 4.9% 4.3% -5.3% During fiscal year 2009, the following activity occurred under our existing plans: Shares (In millions) Weighted Average Grant-Date Fair Value Stock awards: Nonvested balance, beginning of year 153 $ 26.12 Granted 91 $ 24.95 Vested (43 ) $ 25.56 Forfeited (10 ) $ 26.08 Nonvested balance, end of year 191 $ 25.69 Shared performance stock awards: Nonvested balance, beginning of year 36 $ 26.14 Granted 10 $ 25.93 Vested (18 ) $ 25.07 Forfeited – – Nonvested balance, end of year 28 $ 26.79 As of June 30, 2009, there was $3.8 billion and $551 million of total unrecognized compensation costs +related to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.5 years and 2.5 years, respectively. PAGE 75 Table of Contents Part II Item 8 During fiscal year 2008 and 2007, the following activity occurred under our plans: (In millions, except fair values) 2008 2007 Stock awards granted 71 57 Weighted average grant-date fair value $ 27.83 $ 25.15 Shared performance stock awards granted 19 11 Weighted average grant-date fair value $ 27.82 $ 25.18 Stock Options In fiscal year 2004, we began granting employees SAs rather than stock options as part of our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business +acquisitions. Nonqualified stock options were granted to our directors under our non-employee director stock plan until 2004 when we began granting directors SAs. Nonqualified and incentive stock options were granted to certain officers and +employees under our employee stock plans. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven years from the date of grant, while certain options vest either over four and one-half years or over seven +and one-half years and expire 10 years from the date of grant. Options granted after 2001 vest over four and one-half years and expire 10 years from the date of grant. We granted one million, 10 million, and two million stock options, +respectively, in conjunction with business acquisitions during fiscal years 2009, 2008, and 2007. Employee stock options outstanding +were as follows: Shares (In millions) Weighted Average Exercise Price Weighted Average Remaining Contractual Term (Years) Aggregate Intrinsic Value (In millions) Balance, July 1, 2008 364 $28.12 Granted 1 $  2.14 Exercised (6 ) $22.44 Canceled (28 ) $30.31 Forfeited (1 ) $10.50 Balance, June 30, 2009 330 $27.99 1.99 $318 Exercisable, June 30, 2009 327 $27.99 1.98 $271 Options outstanding as of June 30, 2009 include approximately eight million options that were +granted in conjunction with business acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise price. These options have an exercise price range of $0.01 to $150.93 and a +weighted average exercise price of $9.50. During fiscal years 2009, 2008, and 2007, the following activity occurred under our plans: (In millions) 2009 2008 2007 Total intrinsic value of stock options exercised $ 48 $ 1,042 $ 818 Total fair value of stock awards vested $ 1,126 $ 804 $ 566 Total fair value of shared performance stock awards vested $ 450 $ 336 $ 292 Cash received and income tax benefits from stock option exercises were $88 million and $12 million, +respectively, for fiscal year 2009. PAGE 76 Table of Contents Part II Item 8 NOTE +21    EMPLOYEE SEVERANCE In January 2009, we announced and implemented a resource management program to reduce discretionary +operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information +technology by June 30, 2010. During the fiscal year ended June 30, 2009, we recorded charges of $330 million for the +expected reduction in employee headcount which was recorded as corporate-level activity. During the year we had a net reduction of approximately 4,400 positions under the resource management program. The changes in our employee severance liabilities were as follows: (In millions) Year Ended June 30, 2009 Balance, beginning of period $ – Employee severance charges 330 Cash payments (203 ) Balance, end of period $ 127 NOTE 22    SEGMENT INFORMATION AND GEOGRAPHIC DATA Segment revenue and operating income (loss) was as follows: (In millions) Year Ended June 30, 2009 2008 2007 Revenue: Client $ 14,414 $ 16,472 $ 14,779 Server and Tools 14,135 13,121 11,117 Online Services Business 3,088 3,190 2,434 Microsoft Business Division 18,902 18,935 16,478 Entertainment and Devices Division 7,753 8,213 6,136 Unallocated and other 145 489 178 Consolidated $ 58,437 $ 60,420 $ 51,122 (In millions) Year Ended June 30, 2009 2008 2007 Operating Income (Loss): Client $ 10,435 $ 12,566 $ 11,295 Server and Tools 5,047 4,170 3,520 Online Services Business (2,391 ) (1,304 ) (617 ) Microsoft Business Division 11,940 12,169 10,757 Entertainment and Devices Division 5 325 (1,945 ) Reconciling amounts (4,673 ) (5,655 ) (4,572 ) Consolidated $ 20,363 $ 22,271 $ 18,438 PAGE 77 Table of Contents Part II Item 8 SFAS +No. 131, Disclosures about Segments of an Enterprise and Related Information , establishes standards for reporting information about operating segments. This standard requires segmentation based on our internal organization and reporting +of revenue and operating income (loss) based upon internal accounting methods. Our financial reporting systems present various data for management to operate the business, including internal profit and loss statements prepared on a basis not +consistent with U.S. GAAP. The segments are designed to allocate resources internally and provide a framework to determine management responsibility. Amounts for prior periods have been recast to conform to the current management view. Operating +segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in +assessing performance. Our chief operating decision maker is our Chief Executive Officer. Our five segments are Client; Server and Tools; Online Services Business; Microsoft Business Division; and Entertainment and Devices Division. The types of products and services provided by each segment are summarized below: Client – Windows Vista, including Home Basic, Home Premium, Ultimate, Business, Enterprise and Starter Edition; Windows XP, including Professional, Home, Media Center, and Tablet PC Edition; +and other standard Windows operating systems. Server and Tools – Windows Server operating system; Microsoft SQL Server; Visual Studio; +Silverlight; System Center products; Forefront security products; Biz Talk Server; Microsoft Consulting Services; Premier product support services; and other products and services. Online Services Business – Bing; Microsoft adCenter/adExpert; Microsoft Media Network (MMN); MSN portals, channels, and mobile services; Windows Live suite of applications and mobile services; +Atlas online tools for advertisers and publishers; MSN Premium Web Services (consisting of MSN Internet Software Subscription, MSN Hotmail Plus, and MSN Software Services); and Razorfish media agency services. Microsoft Business Division – Microsoft Office; Microsoft Office Project; Microsoft Office Visio; Microsoft Office SharePoint Server; FAST ESP; +Microsoft Exchange Server; Microsoft Exchange Hosted Services; Microsoft Office Live Meeting; Microsoft Office Communications Server; Microsoft Office Communicator; Microsoft Tellme Service; Microsoft Dynamics ERP products including AX, NAV, GP, SL, +Retail Management System, and Point of Sale; Microsoft Dynamics CRM; and Microsoft Dynamics CRM Online. Entertainment and Devices Division – Xbox 360 console and games; Xbox Live; Zune; Mediaroom; numerous consumer software and hardware products (such as mice and keyboards); Windows Mobile software and services platform; Windows Embedded device operating system; Windows +Automotive; and the Microsoft Surface computing platform. Because of our integrated business structure, operating costs included in +one segment may benefit other segments, and therefore these segments are not designed to measure operating income or loss directly related to the products included in each segment. Inter-segment cost commissions are estimated by management and used +to compensate or charge each segment for such shared costs and to incent shared efforts. Management will continually evaluate the alignment of product development organizations, sales organizations, and inter-segment commissions for segment +reporting purposes, which may result in changes to segment allocations in future periods. Assets are not allocated to segments for +internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and +depreciation by segment that is included in the measure of segment profit or loss. Reconciling amounts include adjustments to conform +with U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and accelerated amortization +for depreciation, stock awards, and performance-based stock awards. In addition, certain revenue and expenses are excluded from segments or included in corporate-level activity including certain legal settlements and accruals for legal +contingencies. PAGE 78 Table of Contents Part II Item 8 Significant reconciling items were as follows: (In millions) Year Ended June 30, 2009 2008 2007 Summary of reconciling amounts: Corporate-level activity (a) $(5,877 ) $(7,017 ) $(4,893 ) Stock-based compensation expense 936 950 123 Revenue reconciling amounts 280 385 120 Other (12 ) 27 78 Total $(4,673 ) $(5,655 ) $(4,572 ) (a)    Corporate-level activity excludes stock-based compensation expense and revenue reconciling +amounts presented separately in those line items. No sales to an individual customer accounted for more than 10% of fiscal year 2009, 2008, or 2007 revenue. Revenue, classified by the major geographic areas in which +our customers are located, was as follows: (In millions) Year Ended June 30, 2009 2008 2007 United States (a) $33,052 $35,928 $31,346 Other countries 25,385 24,492 19,776 Total $58,437 $60,420 $51,122 (a)    Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations. Long-lived assets, excluding financial instruments and deferred taxes, classified by the location of the controlling statutory company, were as follows: (In millions) Year Ended June 30, 2009 2008 United States $19,362 $19,129 Other countries 2,435 1,194 Total $21,797 $20,323 PAGE 79 Table of Contents Part II Item 8 NOTE +23    QUARTERLY INFORMATION (Unaudited) (In millions, except per share amounts) Quarter Ended Sep. 30 Dec. 31 Mar. 31 June 30 Total Fiscal year 2009 Revenue $ 15,061 $ 16,629 $ 13,648 $ 13,099 (a) $ 58,437 Gross profit 12,213 12,722 10,834 10,513 46,282 Net income 4,373 4,174 2,977 (b) 3,045 (b) 14,569 Basic earnings per share 0.48 0.47 0.33 0.34 1.63 Diluted earnings per share 0.48 0.47 0.33 0.34 1.62 Fiscal year 2008 Revenue $ 13,762 $ 16,367 $ 14,454 $ 15,837 $ 60,420 Gross profit 11,087 12,824 11,940 12,971 48,822 Net income 4,289 4,707 (c) 4,388 (d) 4,297 17,681 Basic earnings per share 0.46 0.50 0.47 0.46 1.90 Diluted earnings per share 0.45 0.50 0.47 0.46 1.87 Fiscal year 2007 Revenue $ 10,811 $ 12,542 (e) $ 14,398 (f) $ 13,371 $ 51,122 Gross profit 9,115 8,922 12,258 10,134 (h) 40,429 Net income 3,478 2,626 4,926 (g) 3,035 14,065 Basic earnings per share 0.35 0.27 0.51 0.32 1.44 Diluted earnings per share 0.35 0.26 0.50 0.31 1.42 (a) Reflects $276 million of revenue deferred to future periods relating to the Windows 7 Upgrade Option program. (b) Includes employee severance of $290 million and $40 million (pre-tax) in the third and fourth quarters of the year ended June 30, 2009, respectively. (c) Includes charges of $237 million (pre-tax) related to various legal matters. (d) Includes charge of $1.4 billion ( € 899 million) related to the fine imposed by the +European Commission in February 2008. (e) Reflects $1.6 billion of revenue deferred to the third quarter of fiscal year 2007 for the Express Upgrade to Windows Vista and Microsoft Office Technology guarantee +programs and pre-shipments of Windows Vista and the 2007 Microsoft Office system. (f) Includes $1.6 billion of revenue discussed above. (g) Includes charges of $296 million (pre-tax) related to various legal matters. (h) Includes $1.1 billion (pre-tax) charge related to the Xbox 360 warranty policy, inventory write-downs, and product returns. NOTE 24    SUBSEQUENT EVENT On July +29, 2009, Microsoft and Yahoo! announced a 10-year agreement under which Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. As part of the transaction, Microsoft will compensate Yahoo! through a revenue +sharing agreement on traffic generated on the Yahoo! network owned and operated sites, and a guarantee of search revenue in certain countries. Additionally, Yahoo! will become the exclusive worldwide relationship sales force for both companies’ +premium search advertisers. Self-serve advertising for both companies will be fulfilled by Microsoft’s adCenter platform, and prices for all search ads will continue to be set by adCenter’s automated auction process. Microsoft will also +acquire an exclusive 10-year license to Yahoo!’s core search technology and will have the ability to integrate Yahoo! search technology into its existing Web search platform. The agreement does not cover either company’s Web properties and products, email, instant messaging, display advertising, or any other aspect +of the companies’ businesses, and the companies will continue to compete in those areas. The transaction will be subject to regulatory review. The agreement entered into on July 29 anticipates that the parties will enter into more detailed +definitive agreements prior to closing the transaction. The companies are hopeful that closing can occur in early calendar year 2010. PAGE 80 Table of Contents Part II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and +Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the +“Company”) as of June 30, 2009 and 2008, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2009. These financial statements +are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about +whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting +principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and +subsidiaries as of June 30, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2009, in conformity with accounting principles generally accepted in the United +States of America. As discussed in Note 18 to the financial statements, on July 1, 2007 the Company adopted the provisions of +Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, and Emerging Issues Task Force Issue No. 06-2, Accounting for +Sabbatical Leave and Other Similar Benefits Pursuant to FASB Statement No. 43 . We have also audited, in accordance with the +standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2009, based on the criteria established in Internal Control – Integrated +Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 29, 2009, expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 29, 2009 PAGE 81 Table of Contents Part II Item 9, 9A ITEM 9.    CHANGES IN +AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A.    CONTROLS AND PROCEDURES Under the +supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as +of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control over financial +reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over +financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; +providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could +have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of +our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal +control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the +company’s internal control over financial reporting was effective as of June 30, 2009. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2009 that have materially affected, or are +reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2009; their report is included in Item 9A. PAGE 82 Table of Contents Part II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and +Stockholders of Microsoft Corporation: We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the +“Company”) as of June 30, 2009, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is +responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over +Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about +whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, +testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable +basis for our opinion. A company’s internal control over financial reporting is a process designed by, or under the supervision +of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding +the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those +policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that +transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations +of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the +financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of +collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over +financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2009, +based on the criteria established in Internal Control–Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, +2009, of the Company and our report dated July 29, 2009, expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 29, 2009 PAGE 83 Table of Contents Part II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B.    OTHER +INFORMATION Not applicable. PART III ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this report. Information about our directors may be found under the +caption “Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 19, 2009 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board +Committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy Statement +set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate +Controller, and other finance organization employees. The finance code of ethics is publicly available on our Website at www.microsoft.com/about/companyinformation/corporategovernance/financecode.mspx. If we make any substantive amendments to the +finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the +amendment or waiver on that Web site or in a report on Form 8-K. ITEM 11.    EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer +Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference. ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information Regarding Beneficial Ownership of Principal Shareholders, Directors, and +Management” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The +information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” is incorporated herein by reference. ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees Billed by Deloitte & Touche” and “Policy on Audit Committee +Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. PAGE 84 Table of Contents Part IV Item 15 PART IV ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Annual Report on Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is +otherwise included. Index to Financial Statements Page Income Statements 43 Balance Sheets 44 Cash Flows Statements 45 Stockholders’ Equity Statements 46 Notes to Financial Statements 47 Report of Independent Registered Public Accounting Firm 81 (b) Exhibit Listing Filed Herewith Incorporated by Reference Exhibit Number Exhibit Description Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/02 3.1 1/31/03 3.2 Bylaws of Microsoft Corporation 8-K 3.2 9/25/08 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon +Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 10.1* Microsoft Corporation 2001 Stock Plan 8-K 99.2 7/20/06 10.2* Microsoft Corporation 1991 Stock Option Plan 8-K 99.1 7/20/06 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation 2003 Employee Stock Purchase Plan 10-K 6/30/04 10.6 9/1/04 PAGE 85 Table of Contents Part IV Item 15 Filed Herewith Incorporated by Reference Exhibit Number Exhibit Description Form Period Ending Exhibit Filing Date 10.5* Microsoft Corporation Deferred Compensation Plan S-8 99.1 2/28/06 10.6* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.8* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period 10-K 6/30/04 10.10 9/1/04 10.9* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period 10-K 6/30/04 10.11 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 Trust Agreement dated June 1, 1993 between Microsoft Corporation and BNY Western Trust Company as trustee (formerly with First Interstate Bank of Washington as trustee) 10-K 6/30/02 10.8 9/6/02 10.13 Trust Agreement dated June 30, 2003 between Microsoft Corporation and BNY Western Trust Company as trustee 10-K 6/30/03 10.8 9/5/03 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.15* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2007 performance period 10-K 6/30/07 10.17 8/3/07 10.16* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2008 performance period 10-Q 12/31/07 10.18 1/24/08 PAGE 86 Table of Contents Part IV Item 15 Filed Herewith Incorporated by Reference Exhibit Number Exhibit Description Form Period Ending Exhibit Filing Date 10.17* Executive Officer Incentive Plan 10-Q 9/30/08 10.17 10/23/08 10.18* Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/08 10.18 10/23/08 10.19* Annual Performance Bonus Plan for Executive Officers 10-Q 12/31/08 10.19 1/22/09 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X * Indicates a management contract or compensatory plan or arrangement PAGE 87 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its +behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 29, 2009. M ICROSOFT C ORPORATION By: / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below +by the following persons on behalf of Registrant and in the capacities indicated on July 29, 2009. Signature Title /s/    W ILLIAM H. G ATES III William H. Gates III Chairman /s/    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer /s/    J AMES I. C ASH , +J R . James I. Cash, Jr. Director /s/    D INA D UBLON Dina Dublon Director /s/    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director /s/    R EED H ASTINGS Reed Hastings Director /s/    M ARIA K LAWE Maria Klawe Director /s/    D AVID F. +M ARQUARDT David F. Marquardt Director /s/    C HARLES H. +N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/    C HRISTOPHER P. +L IDDELL Christopher P. Liddell Senior Vice President; Chief +Financial Officer (Principal Financial Officer) /s/    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) PAGE 88 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-10-171791/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-10-171791/full-submission.txt new file mode 100644 index 0000000..0833e06 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-10-171791/full-submission.txt @@ -0,0 +1,1040 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2010 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  +to Commission File Number +0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, +WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities +Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 +days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File +required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not +contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form +10-K. ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting +company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2009, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was +$235,244,858,633 based on the closing sale price as reported on the NASDAQ National Market System. As of July 20, 2010, there were 8,653,567,331 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on +November 16, 2010 are incorporated by reference into Part III. Table of Contents MICROSOFT +CORPORATION FORM 10-K For The Fiscal Year Ended June 30, 2010 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 13 Item 1A. Risk Factors 15 Item 1B. Unresolved Staff Comments 20 Item 2. Properties 20 Item 3. Legal Proceedings 21 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 21 Item 6. Selected Financial Data 21 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 43 Item 8. Financial Statements and Supplementary Data 44 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 85 Item 9A. Controls and Procedures 85 Report of Management on Internal Control over Financial Reporting 85 Report of Independent Registered Public Accounting Firm 86 Item 9B. Other Information 87 PART III Item 10. Directors, Executive Officers and Corporate Governance 87 Item 11. Executive Compensation 87 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 87 Item 13. Certain Relationships and Related Transactions, and Director Independence 87 Item 14. Principal Accounting Fees and Services 87 PART IV Item 15. Exhibits and Financial Statement Schedules 88 Signatures 91 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business +plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of +the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business”, “Management’s +Discussion and Analysis”, and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” +“intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely +result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. +A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (refer to Part I, Item 1A of this +Form 10-K). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Our mission is to enable people and businesses throughout the world to realize their full potential. Since the company was founded in 1975, we have +worked to achieve this mission by creating technology that transforms the way people work, play, and communicate. We develop and market software, services, hardware, and solutions that we believe deliver new opportunities, greater convenience, and +enhanced value to people’s lives. We do business throughout the world and have offices in more than 100 countries. We generate +revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, +servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and +video games. We provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware including the Xbox 360 gaming and entertainment console and +accessories, the Zune digital music and entertainment device and accessories, and Microsoft personal computer (“PC”) hardware products. In addition to selling individual products and services, we offer suites of products and services, +including those discussed below and the enterprise client access license (“eCAL”) suite, which licenses access to Microsoft server software products. We earn revenues from customers paying a fee to license software; that will continue to be an important part of our business, even as we develop +and deliver “cloud-based” computing services. Cloud-based computing involves providing software, services and content over the Internet by way of shared computing resources located in centralized data centers. Consumers and business +customers access these resources from a variety of devices. Revenues are earned primarily from usage fees and advertising. Microsoft’s “software plus services” vision reflects our belief that what is most powerful for end users is a computing or +communication device running sophisticated software, interacting with cloud-based resources. Examples of consumer-oriented cloud-based computing services we offer currently include: • Bing, our Internet search service; • Windows Live Essentials suite, which allows users to upload and organize photos, make movies, communicate via email and messaging and enhance online safety; +and • Xbox LIVE service, which enables online gaming, social networking, and content access. 3 Table of Contents PART I Item 1 Our current cloud-based services for business users include: • Microsoft Office Web Apps, which are the online companions to Microsoft Word, Excel, PowerPoint, and OneNote; • our Business Productivity Online Suite, offering communications and collaboration solutions with high availability and simplified enterprise IT management; • Microsoft Dynamics Online family of customer relationship management (“CRM”) and enterprise resources planning services; and • our Azure family of services, including a scalable operating system with compute, storage, hosting and management capabilities, a relational database, and a +platform that helps developers connect applications and services in the cloud or on premise. We also conduct research +and develop advanced technologies for future software products and services. We believe that delivering breakthrough innovation and high-value solutions through our integrated software platform is the key to meeting our customers’ needs and to +our future growth. We believe that we will continue to lay the foundation for long-term growth by delivering new products and services, creating new opportunities for partners, improving customer satisfaction, and improving our internal processes. +Our focus is to build on this foundation through ongoing innovation in our integrated software platforms; by delivering compelling value propositions to customers; by responding effectively to customer and partner needs; and by continuing to +emphasize the importance of product excellence, business efficacy, and accountability. OPERATING SEGMENTS We operate our business in five segments: Windows & Windows Live Division, Server and Tools, Online Services Division, Microsoft Business +Division, and Entertainment and Devices Division. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and +services organizations, and they provide a framework for timely and rational allocation of development, sales, marketing, and services resources within businesses. Windows & Windows Live Division Windows & Windows Live Division (“Windows Division”) has overall responsibility for development and marketing of the Windows +operating system, Windows Live and Internet Explorer. Windows Division revenue growth is largely correlated to the growth of the PC market, as the original equipment manufacturer (“OEM”) distribution channel accounts for approximately 80% +of total Windows Division revenue. In addition to PC market changes, Windows OEM revenue is impacted by: • hardware market changes driven by shifts between emerging markets and developed market, consumer PCs and business PCs, and the impact of lower cost netbook +PCs; • the attachment of Windows to PCs shipped and changes in inventory levels within the OEM channel; and • pricing changes and promotions, the pricing variation associated with OEM channel shifts from local and regional system builders to large, multinational OEMs, +and other pricing factors. Windows Division offerings consist of premium and standard edition Windows operating +systems and online software and services through Windows Live. Premium Windows operating systems are those that include additional functionality and are sold at a price above our standard editions. Products and Services : Windows operating system: Windows 7, including Home +Basic, Home Premium, Professional, Ultimate, Enterprise, and Starter Edition; Windows Vista, including Home Basic, Home Premium, Ultimate, Business, Enterprise and Starter Edition; and Windows XP Home. Windows Live suite of applications and web +services. 4 Table of Contents PART I Item 1 Competition The Windows operating system faces competition from various commercial software products offered by well-established companies, including Apple and +Google, and from the Linux operating system. Linux is derived from Unix and is available without payment under a General Public License. Partners such as Hewlett-Packard and Intel have been actively working with alternative Linux-based operating +systems. The Windows operating system also faces competition from alternative platforms and new devices that may reduce consumer demand +for PCs. User and usage volumes on mobile devices are increasing around the world relative to the PC. Competitors such as Apple, Google, Mozilla, and Opera Software Company offer software that competes with the Web browsing capabilities of Internet +Explorer, a component of the Windows operating system. Our operating system products compete effectively by delivering innovative software, giving customers choice and flexibility, a familiar, easy-to-use interface, compatibility with a broad range +of hardware and software applications, and the largest support network for any operating system. Windows Live software and services +compete with Google, Yahoo!, and a wide array of Web sites and portals that provide communication and sharing tools and services. Server and Tools Server and Tools develops and markets server software, software developer tools, services, and solutions that are designed to make +information technology professionals and developers and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating +system and includes the server platform, database, storage, management and operations, service-oriented architecture platform, security and identity software. Server and Tools also builds standalone and software development lifecycle tools for +software architects, developers, testers, and project managers. Server offerings can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. Our cloud-based services comprise a scalable operating system with compute, +storage, and management capabilities and a relational database, both of which allow customers to run enterprise workloads and web applications in the cloud, as well as a platform that helps developers connect applications and services in the cloud +or on premise. Server and Tools offers a broad range of enterprise consulting and product support services (“Enterprise +Services”) that assist customers in developing, deploying, and managing Microsoft server and desktop solutions. Server and Tools also provides training and certification to developers and information technology professionals for our Server and +Tools, Microsoft Business Division, and Windows & Windows Live Division products and services. Approximately 50% of Server and +Tools revenue comes from annuity volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services. Products and Services : Windows Server operating system; Windows +Azure; Microsoft SQL Server; SQL Azure; Visual Studio; Silverlight; System Center products; Biz Talk Server; Microsoft Consulting Services; Premier product support services; and other products and services. Competition Our server operating system +products face competition from a wide variety of server operating systems and server applications, offered by companies with a variety of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer +their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive +position of Linux has also benefited from the large number of compatible applications now produced by many leading commercial and non-commercial software developers. A number of companies supply versions of Linux, including Novell and Red Hat. 5 Table of Contents PART I Item 1 We have entered into business and technical collaboration agreements with Novell and other Linux +providers to build, market, and support a series of solutions to enhance the interoperability of our products with their virtualization, management, and network security solutions, and to provide each other’s customers with patent coverage for +their respective products. We compete to provide enterprise-wide computing solutions with several companies that offer solutions and +middleware technology platforms. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition. Commercial software developers that provide competing server applications for PC-based distributed client/server environments +include CA Technologies, IBM, and Oracle. Our Web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP, and we compete against Java middleware such as Geronimo, JBoss, and Spring Framework. Numerous commercial software vendors offer competing software applications for connectivity (both Internet and intranet), security, +hosting, database, and e-business servers. System Center competes with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMWare in the management of information technology +infrastructures. Forefront products compete with CA Technologies, IBM, McAfee, Oracle, Symantec, and Trend Micro in protecting both client and server applications. SQL Server competes with products from IBM, Oracle, Sybase, and other companies in +providing database, business intelligence and data warehousing solutions. Our products for software developers compete against offerings from Adobe, Borland, IBM, Oracle, other companies, and open-source projects. Competing open source projects +include Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among others. Our cloud-based services +offerings also have many competitors. Windows Azure faces competition from Google, Salesforce.com, and VMWare. SQL Azure faces competition from IBM and Oracle. We believe that our server products, cloud-based services and Enterprise Services provide customers with advantages in innovation, performance, +total costs of ownership, and productivity by delivering superior applications, development tools, and compatibility with a broad base of hardware and software applications, security, and manageability. Online Services Division The Online +Services Division (“OSD”) consists of online information offerings such as Bing, MSN portals and channels, as well as an online advertising platform with offerings for both publishers and advertisers. We earn revenue primarily from online +advertising, including search, display, and advertiser and publisher tools. We continue to launch updated and new online offerings and expect to continue to do so in the future. During fiscal year 2010, we launched new releases of Bing, MSN and +Advertising Platforms. In addition, on December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. We believe this agreement will +allow us over time to improve the effectiveness and increase the value of our search offering through greater scale in search queries and an expanded and more competitive search and advertising marketplace. Products and Services : Bing; Microsoft adCenter; MSN; and Atlas online tools for +advertisers and publishers. Competition OSD competes with Google, Yahoo!, and a wide array of Web sites and portals that provide content and online offerings to end users. We compete with +these organizations to provide advertising opportunities for merchants. Competitors are continuously developing Internet offerings that seek to provide more effective ways of connecting advertisers with audiences. We believe our search engine, Bing, +helps users make faster, more informed decisions by providing relevant search results, expanded search services, and a broad selection of content. We have also enhanced the user interface to bring a richer search experience. We also invest in +improving the scale of our advertising platform to serve both owned and operated, as well as third-party online properties. We will continue to introduce new products and services to improve the user online experience. We believe that we can compete 6 Table of Contents PART I Item 1 effectively by attracting new users, understanding their intent, and matching their intent with relevant content, advertiser offerings and software services. We will also attract advertisers by +providing them access to targeted end-users on a high traffic network. Microsoft Business Division Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business +solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Growth of revenue from the Microsoft Office system offerings, +which generate over 90% of MBD revenue, depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other information worker areas such as content management, enterprise search, +collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business solutions for financial management, customer relationship management (“CRM”), supply chain management, and analytics +applications for small and mid-size businesses, large organizations, and divisions of global enterprises. Approximately 80% of MBD +revenue is generated from sales to businesses, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue. Revenue from this category generally depends upon the number of information +workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given year. Approximately 20% of MBD revenue is derived from sales to consumers, which includes revenue from retail packaged product sales +and OEM revenue. This revenue is generally affected by the level of PC shipments and product launches. Products and Services : Microsoft Office; Microsoft SharePoint; and Microsoft +Dynamics ERP and CRM, as well as Microsoft Office Web Apps, which are the online companions to Microsoft Word, Excel, PowerPoint and OneNote. Competition Competitors to the Microsoft +Office system include many software application vendors such as Adobe, Apple, Corel, Google, IBM, Novell, Oracle, Red Hat, Zoho, and local application developers in Asia and Europe. Apple may distribute certain versions of its application software +products with various models of its PCs and through its mobile devices. Corel and IBM have measurable installed bases with their office productivity products. Corel’s suites, and many local software suites around the world, are aggressively +priced for OEMs to preinstall them on low-priced PCs. Google provides a hosted messaging and productivity suite that competes with Microsoft Office, Microsoft Exchange, and Microsoft SharePoint, including its FAST enterprise search +technology. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their brands, including IBM, Novell, Oracle, and Red Hat. Web-based +offerings such as 37Signals, Adobe, AjaxWrite, gOffice, ShareOffice, Socialtext, ThinkFree, Zoho, or other small projects competing with individual applications, can also position themselves as alternatives to Microsoft Office system products. Our Microsoft Dynamics products compete with well-known vendors such as Infor and Sage in the market focused on providing business +solutions for small and mid-sized businesses. The market for large organizations and divisions of global enterprises is intensely competitive with a small number of primary vendors including Oracle and SAP. Additionally, +Salesforce.com’s on-demand customer relationship management offerings compete directly with Microsoft Dynamics CRM Online and Microsoft Dynamics CRM’s on-premise offerings. As we continue to respond to market demand for additional functionality and products, we will compete with additional vendors, most notably in +content management and enterprise search, collaboration tools, unified communications, and business intelligence. These competitors include Autonomy, Cisco, Endeca, Google, IBM, Oracle, and SAP. We believe our products compete effectively with all +of these vendors based on our strategy of providing flexible, easy to use solutions that work well with technologies our customers already have. 7 Table of Contents PART I Item 1 Entertainment and Devices Division The Entertainment and Devices Division (“EDD”) is responsible for developing, producing, and marketing: the Xbox 360 platform, including +the Xbox 360 gaming and entertainment console and accessories, third-party games, games published under the Microsoft brand, and Xbox LIVE services, as well as research, sales, and support of those products and services; PC software games; online +games and services; Mediaroom (our Internet protocol television software); Windows Phone and Windows Embedded device platforms; the Zune digital music and entertainment platform; application software for Apple’s Macintosh computers, Microsoft +PC hardware products and other devices. EDD is also responsible for all retail sales and marketing for retail packaged versions of the Microsoft Office system and the Windows operating systems. Products and Services : Xbox 360 console and games; Xbox LIVE; Windows Phone; +Windows Embedded device operating system; Zune; Mediaroom; and numerous consumer software and hardware products (such as Mac Office, mice, and keyboards); and Windows Automotive. Competition Entertainment and devices +businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and titles, and the development of new technologies. The markets for our products are characterized by significant price +competition. We anticipate continued pricing pressure from our competitors. From time to time, we have responded to this pressure by reducing prices on certain products. Our competitors vary in size from very small companies with limited resources +to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, quality and variety, timing of product releases, and effectiveness of distribution and marketing. Our Xbox gaming and entertainment business competes with console platforms from Nintendo and Sony, both of which have a large, +established base of customers. The lifecycle for gaming and entertainment consoles averages five to 10 years. We released Xbox 360, our second generation console, in November 2005. Nintendo and Sony released new versions of their game consoles in +late 2006. We believe the success of gaming and entertainment consoles is determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the console, and the +ability to create new experiences via online services, downloadable content, and peripherals. We think the Xbox 360 is positioned well against competitive console products based on significant innovation in hardware architecture, new developer +tools, online gaming services, and continued strong exclusive content from our own game franchises. In addition to competing against software published for non-Xbox platforms, our games business also competes with numerous companies that we have +licensed to develop and publish software for the Xbox consoles. Windows Phone faces competition from Apple, Google, Nokia, Openwave +Systems, Palm, QUALCOMM, Research In Motion, and Symbian. The embedded operating system business is highly fragmented with many competitive offerings. Key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors +such as Metrowerks and MontaVista Software. Zune competes with Apple and other manufacturers of digital music and entertainment +devices. Our PC hardware products face aggressive competition from computer and other hardware manufacturers, many of which are also current or potential partners. Mediaroom faces competition primarily from a variety of competitors that provide +elements of an Internet protocol television delivery platform, but that do not provide end-to-end solutions for the network operator. Additional information on our operating segments and geographic and product information is contained in Note 22 – Segment Information and +Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). 8 Table of Contents PART I Item 1 OPERATIONS To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of +our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our operational centers support all operations in their regions, including customer contract and order processing, credit and collections, +information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, Greater China and Asia-Pacific region; and the centers +in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operational centers, we also operate data centers throughout the United States and in +Europe. We contract most of our manufacturing activities for Xbox 360 and related games, Zune, various retail software packaged +products, and Microsoft hardware to third parties. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console includes certain key components that are supplied by a single source. The +integrated central processing unit/graphics processing unit is purchased from IBM and the supporting embedded dynamic random access memory chips are purchased from Taiwan Semiconductor Manufacturing Company. Although we have chosen to initially +source these key Xbox 360 components from a single supplier, we are under no obligation to exclusively source components from these vendors in the future. Beyond the exceptions noted, we generally have the ability to use other custom manufacturers +if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume discount basis. RESEARCH AND DEVELOPMENT During fiscal years 2010, 2009, and 2008, research and development expense was $8.7 billion, $9.0 billion, and $8.2 billion, respectively. +These amounts represented 14%, 15%, and 14%, respectively, of revenue in each of those years. We plan to continue to make significant investments in a broad range of research and product development efforts. While most of our software products are developed internally, we also purchase technology, license intellectual property rights, and oversee +third-party development and localization of certain products. We believe we are not materially dependent upon licenses and other agreements with third parties relating to the development of our products. Internal development allows us to maintain +closer technical control over our products. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. Generally, we also create product documentation internally. We strive to +obtain information as early as possible about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for +development, training, and testing. Investing in Business and Product Development Innovation is the foundation for Microsoft’s success. Our model for growth is based on our ability to initiate and embrace disruptive +technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market. We maintain our long-term commitment to research and development across a wide +spectrum of technologies, tools, and platforms spanning communication and collaboration; information access and organization; entertainment; business and e-commerce; advertising; and devices. 9 Table of Contents PART I Item 1 Increasingly, we are taking a global approach to innovation. While our main research and +development facilities are located in the United States, in Redmond, Washington, we also operate research and development facilities in other parts of the United States and around the world, including Canada, China, Denmark, England, India, Ireland, +and Israel. This global approach will help us remain competitive in local markets and enable us to continue to attract top talent from across the world. We invest in innovation by focusing on the emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver +value to our customers and growth for the company. Microsoft Research is one of the world’s largest computer science research organizations, and works in close collaboration with top universities around the world to advance the state-of-the-art +in computer science, providing us a unique perspective on future technology trends. Based on our assessment of key technology trends +and our broad focus on long-term research and development of new products and services, areas where we see significant opportunities to drive future growth include: Cloud computing and software plus services The ability to combine the power of desktop and server software with the reach of the Internet is creating important opportunities +for growth in almost every one of our businesses. Accordingly, we are focused on innovation and broadening our platform to develop a cloud computing ecosystem that positions us for success in areas including virtualization, management, and security +identity. We are also focused on delivering end-to-end experiences that connect users to information, communications, entertainment, and people in new ways across their lives at home, at work, and the broadest possible range of mobile scenarios +through investments in datacenters; new versions of Windows and Office that are designed to support a wide range of connected scenarios; solutions for businesses that can be deployed by a customer, by a service provider like Microsoft, or by a +Microsoft partner; tools for developers and Web designers; and consumer products and services including Xbox 360, Xbox LIVE, Windows Live services and Zune. Natural user interfaces The next few years will also see dramatic changes in the way people interact with technology as touch, gestures, handwriting, and +speech recognition become a normal part of how we control devices. This will make technology more accessible and simpler to use and will create opportunities to reach new markets and deliver new kinds of computing experiences. Our long-term +investments in natural user interfaces can be seen in products like Windows 7, the Microsoft Auto software platform and Kinect for Xbox 360. We believe sensory input is just one aspect of Natural User Interface technology, and we are researching the +impact of several “interaction paradigms” such as contextual awareness and environmental awareness. New scenario +innovation in key industries Continuing improvement in the power of computers and devices and the speed and +ubiquity of networks is creating opportunities to deliver innovation that will transform a number of key industries and address significant global issues including healthcare, environmental sustainability, and education. In healthcare, for example, +computing will connect personal health information to medical research and help make healthcare more preventive, personalized, and cost-effective. Today, Microsoft products such as HealthVault and Amalga help individuals manage their personal health +and enable healthcare professionals to integrate research and health information so they can deliver more effective care. We also believe that we are entering a period where personal computers will play an increasingly important role in virtually +every field of scientific research and discovery. 10 Table of Contents PART I Item 1 Intelligent computing As computing power increases, our ability to build software that has the intelligence to understand a user’s preferences based +on the tools and information they have accessed in the past and anticipate their future needs is rapidly improving. This development will enable us to deliver a new generation of software solutions that make people more productive by enabling them +to focus more on what they want to accomplish and less on the steps needed to use technology. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services primarily through the following channels: OEM; distributors and resellers; and +online. OEM We license our +software to OEMs for distribution as pre-installed software on new PCs. The most significant part of the OEM business for us is licensing of the Windows operating system. We also license to OEMs certain server operating systems and desktop +applications such as our Microsoft Office system and consumer software products. In addition to licensing them software, we market through OEMs hardware devices and software as services, including our Windows Live Essentials suite. We have OEM +agreements covering one or more of our products with virtually all of the multinational OEMs, including Acer, ASUSTek, Dell, Fujitsu, Hewlett-Packard, Lenovo, NEC, Samsung, Sony, and Toshiba, and the regional OEMs, including Medion, MSI, and +Positivo. In addition, a portion of the OEM business is also conducted with system builders, which are low-volume, customized PC vendors operating in local markets. Distributors and Resellers We license +software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products and services. Organizations license our products and services primarily through large account resellers (“LARs”), +distributors, value-added resellers (“VARs”), OEMs, system builder channels and retailers. Additionally, solution integrators, independent software vendors, web agencies and developers advise organizations on the acquisition of licenses of +our products and services. Many organizations that license products through enterprise agreements transact directly with us, with sales support from our Enterprise Software Advisor channel partners. These Enterprise Software Advisors typically are +also authorized as LARs and operate as resellers for our other licensing programs. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations. Distributors resell primarily to VARs +and VARs typically reach the small-sized and medium-sized organizations. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our +Microsoft Dynamics software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our retail packaged products primarily through independent +non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain our products primarily through retail outlets, including Best Buy, Target, and Wal-Mart. We have a network of field sales representatives +and field support personnel that solicits orders from distributors and resellers, and provides product training and sales support. Our +arrangements for organizations to acquire multiple licenses of products are designed to provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing +arrangements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include: Open licensing Designed primarily for small-to-medium organizations (5 to over 250 licenses), these programs allow customers to acquire perpetual +or subscription licenses and, at the customer’s election, rights to future versions of software 11 Table of Contents PART I Item 1 products over a specified time period (two or three years depending on the Open program used). The offering that conveys rights to future versions of certain software products over the contract +period is called software assurance. Software assurance also provides support, tools, and training to help customers deploy and use software efficiently. Under the Open program, customers can acquire licenses only, or licenses with software +assurance. They can also renew software assurance upon the expiration of existing volume licensing agreements. Select licensing Designed primarily for medium-to-large organizations (greater than 250 licenses), this program allows customers to +acquire perpetual licenses and, at the customer’s election, software assurance over a specified time period (generally three years or less). Similar to the Open program, the Select program allows customers to acquire licenses only, acquire +licenses with software assurance, or renew software assurance upon the expiration of existing volume licensing agreements. Enterprise agreement licensing Enterprise agreements are targeted at medium and large organizations (greater than 250 licenses) that want to acquire licenses to +software products, along with software assurance, for all or substantial parts of their enterprise. Enterprises can elect to either acquire perpetual licenses or, under the Enterprise Subscription program, can acquire non-perpetual, subscription +agreements for a specified time period (generally three years). Online services are also available for purchase through the Enterprise agreement and subscriptions are generally structured with three year terms. Online Although client-based software will +continue to be an important part of our business, increasingly we are delivering greater value to customers through cloud-based services. We have an expanding portfolio of products, services, and solutions that we market and distribute online. We +provide online content and services to consumers through Bing, Windows Live Essentials suite, Microsoft Office Web Apps, our MSN portals and channels, and Xbox LIVE. We provide content and services to business users through the Microsoft Online +Services platform, which includes cloud-based services such as Windows Azure, SQL Azure, Microsoft Dynamics CRM Online, SharePoint Online, Exchange Online, and Office Communications. Other services delivered online include our online advertising +platform with offerings for both publishers and advertisers, as well as Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in +developing and selling our products and solutions. CUSTOMERS Our customers include individual consumers, small-sized and medium-sized organizations, enterprises, governmental institutions, educational +institutions, Internet service providers, application developers, and OEMs. Consumers and small-sized and medium-sized organizations obtain our products primarily through distributors, resellers and OEMs. No sales to an individual customer accounted +for more than 10% of fiscal year 2010, 2009, or 2008 revenue. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 12 Table of Contents PART I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 30, 2010 were as follows: Name Age Position with the Company Steven A. Ballmer 54 Chief Executive Officer Lisa E. Brummel 50 Senior Vice President, Human Resources Stephen A. Elop 46 President, Microsoft Business Division Peter S. Klein 47 Chief Financial Officer Robert L. Muglia 50 President, Server and Tools Craig J. Mundie 61 Chief Research and Strategy Officer Steven Sinofsky 44 President, Windows & Windows Live Division Bradford L. Smith 51 Senior Vice President; General Counsel; Secretary B. Kevin Turner 45 Chief Operating Officer Mr. Ballmer was appointed Chief Executive Officer in January 2000. He served as President from July 1998 to February 2001. Previously, he had +served as Executive Vice President, Sales and Support since February 1992. Mr. Ballmer joined Microsoft in 1980. Ms. Brummel +was named Senior Vice President, Human Resources in December 2005. She had been Corporate Vice President, Human Resources since May 2005. From May 2000 to May 2005, she had been Corporate Vice President of the Home & Retail +Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of management positions at Microsoft, including general manager of Consumer Productivity business, product unit manager of the Kids business, and product unit manager +of Desktop and Decision reference products. Mr. Elop was named President, Microsoft Business Division in January 2008. Prior to +joining the Company, Mr. Elop served as Chief Operating Officer of Juniper Networks, Inc. from January 2007 to January 2008. From December 2005 to December 2006, he served as President of Worldwide Field Operations at Adobe Systems Inc. +Mr. Elop joined Adobe following the 2005 acquisition of Macromedia Inc., where he was President and Chief Executive Officer from January 2005 to December 2005. During his almost eight-year tenure at Macromedia, Mr. Elop held many senior +positions, including Chief Operating Officer, Executive Vice President of Worldwide Field Operations and General Manager of Macromedia’s eBusiness division. Mr. Klein was named Chief Financial Officer in November 2009. He served as Corporate Vice President, Chief Financial Officer, Microsoft +Business Division since February 2006 and Chief Financial Officer of the Server and Tools Business Group from July 2003 to February 2006. Mr. Klein joined Microsoft in 2002. Mr. Muglia was named President, Server and Tools in January 2009. He had been Senior Vice President, Server and Tools since October 2005. +Before holding that position, he had a number of leadership positions at Microsoft, including Senior Vice President, Enterprise Storage Division since November 2001, Group Vice President, Personal Services Group since August 2000, Group Vice +President, Business Productivity since December 1999, Senior Vice President, Business Productivity since March 1999, Senior Vice President, Applications and Tools since February 1998, and Corporate Vice President, Server Applications since 1997. +Mr. Muglia joined Microsoft in 1988. Mr. Mundie was named Chief Research and Strategy Officer in June 2006. He had been +Senior Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie joined Microsoft in 1992. Mr. Sinofsky was named President, Windows & Windows Live Division in July 2009. He served as Senior Vice President of the +Windows and Windows Live Engineering Group since December 2006 and Senior Vice President, Office from December 1999 to December 2006. He had been Vice President, Office since December 1998. Mr. Sinofsky joined the Office team in 1994, +increasing his responsibility with each subsequent release of the desktop suite. Mr. Sinofsky joined Microsoft in 1989. 13 Table of Contents PART I Item 1 Mr. Smith was named Senior Vice President, General Counsel, and Secretary in November 2001. +Mr. Smith was also named Chief Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. +Mr. Smith joined Microsoft in 1993. Mr. Turner was named Chief Operating Officer in September 2005. Before joining Microsoft, +he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s Club division. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of +Wal-Mart’s Information Systems Division. From March 2000 to September 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. EMPLOYEES As of +June 30, 2010, we employed approximately 89,000 people on a full-time basis, 54,000 in the United States and 35,000 internationally. Of the total, 35,000 were in product research and development, 25,000 in sales and marketing, 15,000 in product +support and consulting services, 5,000 in manufacturing and distribution, and 9,000 in general and administration. Our success is highly dependent on our ability to attract and retain qualified employees. None of our employees are subject to +collective bargaining agreements. AVAILABLE INFORMATION Our Company Internet address is www.microsoft.com. At our Investor Relations Web site, www.microsoft.com/investor, we make available free of charge +a variety of information for investors. Our goal is to maintain the Investor Relations Web site as a portal through which investors can easily find or navigate to pertinent information about us, including: • our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”); • information on our business strategies, financial results, and key performance indicators; • announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available; • press releases on quarterly earnings, product and service announcements, legal developments, and international news; • corporate governance information including our articles, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate +citizenship initiatives, and other governance-related policies; • other news and announcements that we may post from time to time that investors might find useful or interesting; and • opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our Web site is not part of this or any other report we file with or furnish to the SEC. 14 Table of Contents PART I Item 1A ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect +our business, financial condition, results of operations, cash flows, and the trading price of our common stock. The cloud-based +computing model presents execution and competitive risks. We are transitioning to a computing environment characterized by cloud-based services used with smart client devices. Our competitors are rapidly developing and +deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud. We are devoting significant resources to develop our own +competing cloud-based software plus services strategies. While we believe our expertise, investments in infrastructure, and the breadth of our cloud-based services provides us with a strong foundation to compete, it is uncertain whether our +strategies will attract the users or generate the revenue required to be successful. In addition to software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs may reduce +the operating margins we have previously achieved. Whether we are successful in this new business model depends on our execution in a number of areas, including: • continuing to innovate and bring to market compelling cloud-based experiences that generate increasing traffic and market share; • maintaining the utility, compatibility and performance of our cloud-based services on the growing array of computing devices, including smartphones, handheld +computers, netbooks, tablets and television set top devices; and • continuing to enhance the attractiveness of our cloud platforms to third-party developers. Challenges to our business models may reduce our revenues or operating margins. Whether our software runs in the +cloud or on a device, we continue to face challenges from alternative means of developing and licensing software. Under our license-based software model, software developers bear the costs of converting original ideas into software products through +investments in research and development, offsetting these costs with the revenue received from the distribution of their products. Certain “open source” software business models challenge our license-based software model. Open source +commonly refers to software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set forth in the license. A number of commercial firms compete with us using an +open source business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do not bear the full costs of research and development for the +software. In some cases, their products may infringe patents granted to Microsoft for our inventions. To the extent open source software gains increasing market acceptance, our sales, revenue, and operating margins may decline. An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A +competing vertically-integrated model, in which a single firm controls both the software and hardware elements of a product, has been successful with certain consumer products such as personal computers, mobile phones, and digital music players. We +also offer vertically-integrated hardware and software products; however, efforts to compete with the vertically integrated model may increase our cost of sales and reduce our operating margins. We face intense competition. We continue to experience intense competition across all markets for our products and +services. Our competitors range in size from Fortune 100 companies to small, specialized single-product businesses and open source community-based projects. Although we believe the breadth of our businesses and product portfolio is a competitive +advantage, our competitors that are focused on narrower product lines may be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low and +products, once developed, can be distributed broadly and quickly at relatively low cost. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products, in some cases +in violation of our intellectual property rights or on the basis of technical specifications for Microsoft technologies that we make available at little or no cost in 15 Table of Contents PART I Item 1A connection with our interoperability initiatives. In response to competition, we continue to develop versions of our products with basic functionality that are sold at lower prices than the +standard versions. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross margins, and operating income. We may not be able to adequately protect our intellectual property rights. Protecting our global +intellectual property rights and combating unlicensed copying and use of software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, +particularly in countries where laws are less protective of intellectual property rights. As a result, our revenue in these markets likely will grow slower than the underlying PC market. Similarly, the absence of harmonized patent laws makes it more +difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate +lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may fail to enhance revenue. Reductions in the legal protection for software intellectual +property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property +rights. From time to time we receive notices from others claiming we infringe their intellectual property rights. The number of these claims may grow. To resolve these claims we may enter into royalty and licensing +agreements on less favorable terms, stop selling or redesign affected products, or pay damages to satisfy indemnification commitments with our customers. Such agreements may cause operating margins to decline. We have made and expect to continue +making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source +code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a +number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection +for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the +security risks described in the next paragraph. Security vulnerabilities in our products and services could lead to reduced revenues +or to liability claims. Maintaining the security of computers and computer networks is a critical issue for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software programs that attack +our products and gain access to our networks and data centers. Although this is an industry-wide problem that affects computers across all platforms, it affects our products in particular because hackers tend to focus their efforts on the most +popular operating systems and programs and we expect them to continue to do so. We devote significant resources to address security vulnerabilities through: • engineering more secure products and services; • enhancing security and reliability features in our products and services; • helping our customers make the best use of our products and services to protect against computer viruses and other attacks; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; and • providing customers online automated security tools, published security guidance, and security software such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security +vulnerabilities in our products could lead some customers to seek to return products, to reduce or delay future 16 Table of Contents PART I Item 1A purchases, or to use competing products. Customers may also increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of new technologies. +Any of these actions by customers could adversely affect our revenue. In addition, if third parties gain access to our networks or data centers they could obtain and exploit confidential business information and harm our competitive position. +Finally, actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand +all legal challenges. Improper disclosure of personal data could result in liability and harm our +reputation. We store and process large amounts of personally identifiable information as we sell software, provide support and offer cloud-based services to customers. It is possible that our security controls over +personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of personally identifiable information. Improper disclosure of this information could harm our reputation, +lead to legal exposure to customers, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data. +Perceptions that our products or services do not adequately protect the privacy of personal information could inhibit sales of our products or services. We may experience outages, data loss and disruptions of our online services if we fail to maintain an adequate operations +infrastructure. Our increasing user traffic and complexity of our products and services demand more computing power. We have spent and expect to continue to spend substantial amounts to purchase or lease data centers and +equipment and to upgrade our technology and network infrastructure to handle increased traffic on our Web sites and in our data centers, and to introduce new products and services and support existing services such as Bing, Exchange Online, +SharePoint Online, Xbox LIVE, Windows Live, and Microsoft Office Web Apps. We also are growing our business of providing a platform and back-end hosting for services provided by third-party businesses to their end customers. Maintaining and +expanding this infrastructure is expensive and complex. Inefficiencies or operational failures, including temporary or permanent loss of customer data, could diminish the quality of our products, services, and user experience resulting in +contractual liability, claims by customers and other third parties, damage to our reputation and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition. We are subject to government litigation and regulatory activity that affects how we design and market our +products. As a leading global software maker, we receive close scrutiny from government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or +consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits brought +by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in 2001 and a Final Judgment entered in 2002. These proceedings imposed various constraints on +our Windows operating system businesses. These constraints include limits on certain contracting practices, mandated disclosure of certain software program interfaces and protocols, and rights for computer manufacturers to limit the visibility of +certain Windows features in new PCs. We believe we are in full compliance with these rules. However, if we fail to comply with them, additional restrictions could be imposed on us that would adversely affect our business. The European Commission closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used +in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the Commission ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our +competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns +relating to competition in Web browsing software. The Commission’s impact on product design may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our +product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our own products which could result in decreased sales of +our products. 17 Table of Contents PART I Item 1A Government regulatory actions and court decisions such as these may hinder our ability to provide +the benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenues that come from them. New actions could be initiated at any time, either by these or other governments or private +claimants, including with respect to new versions of Windows or other Microsoft products. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be cited as a precedent in other competition law proceedings. Our software and services online offerings are subject to government regulation of the Internet domestically and internationally in many areas, +including user privacy, telecommunications, data protection, and online content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant +costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we stop the alleged noncompliant activity. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully +attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are +less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term +success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. Delays in product development schedules may adversely affect our revenues. The development of software products is a +complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Our increasing focus on cloud-based software plus services also presents new and complex development issues. +Significant delays in new product or service releases or significant problems in creating new products or services could adversely affect our revenue. We make significant investments in new products and services that may not be profitable. Our growth depends on our +ability to innovate by offering new, and adding value to our existing, software and service offerings. We will continue to make significant investments in research, development, and marketing for new products, services, and technologies, including +the Windows PC operating system, the Microsoft Office system, Xbox 360, Bing, Windows Server, Zune, Windows Live, the Windows Azure Services platform, and other cloud-based services offerings. Investments in new technology are speculative. +Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. Our degree of success with Windows Phone, for example, will impact our ability to grow share of the smartphone +operating system market. It will also be an important factor in supporting our strategy of delivering value to end users seamlessly over PC, phone, and TV device classes. If customers do not perceive our latest offerings as providing significant new +functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. We may not achieve significant revenue from new product and service investments for a number of years, if at all. +Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses may not be as high as the margins we have experienced historically. Adverse economic conditions may harm our business. Unfavorable changes in economic conditions, including inflation, +recession, or other changes in economic conditions, may result in lower information technology spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those +products declines, our revenue will be adversely affected. Our product distribution 18 Table of Contents PART I Item 1A system also relies on an extensive partner network. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, could result in sales channel disruption. +Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, reserves for doubtful accounts and write-offs of accounts receivable may increase. We maintain an +investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that have affected global financial markets. If +global credit and equity markets experience prolonged periods of decline, our investment portfolio may be adversely impacted and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, +requiring impairment charges that could adversely impact our financial results. We have claims and lawsuits against us that may +result in adverse outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect +our ability to conduct our business. Although management currently believes resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial statements, the litigation and other claims are +subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our financial statements also could occur for the period in which the effect of an unfavorable final outcome becomes +probable and reasonably estimable. We may have additional tax liabilities. We are subject to income taxes +in the United States and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate +tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical +income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial statements in the period or periods for which that determination is made. We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions +may result in higher effective tax rates for the company. In addition, there have been proposals to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot +predict whether or in what form this proposed legislation will pass, if enacted it could have a material adverse impact on our tax expense and cash flow. Our vertically-integrated hardware and software products may experience quality or supply problems. Our hardware +products such as the Xbox 360 console are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or effectively address such +issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be +unable to obtain timely replacement supplies, resulting in reduced sales. Either component shortages or excess or obsolete inventory may increase our cost of revenue. Xbox 360 consoles are assembled in Asia; disruptions in the supply chain may +result in console shortages that would affect our revenues and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to +earnings. Under accounting principles generally accepted in the United States (“U.S. GAAP”), we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the +carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be +recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge in our financial statements during the period in +which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. We operate a global business that exposes us to additional risks. We operate in over 100 countries and a significant +part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the United States and other countries. Operations outside 19 Table of Contents PART I Item 1A, 1B, 2 the United States may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment, including the Foreign Corrupt +Practices Act and local laws prohibiting corrupt payments. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets presents a number of risks. Deterioration of social, political, labor, +or economic conditions in a specific country or region and difficulties in staffing and managing foreign operations may also adversely affect our operations or financial results. Although we hedge a portion of our international currency exposure, +significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our net revenues. Catastrophic events or geo-political conditions may disrupt our business. A disruption or failure of our systems or +operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services, or performing other mission-critical functions. Our corporate +headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of +California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or information technology systems could harm our ability to conduct normal business +operations and our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty +to the timing and budget for technology investment decisions by our customers. The long-term effects of climate change on the global economy in general or the information technology industry in particular are unclear. Environmental regulations or +changes in the supply, demand or available sources of energy may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of +powering and cooling computer hardware we use to develop software and provide cloud-based services. New regulations may require us to find alternative compliant and cost-effective methods of distributing our products and services. Acquisitions and joint ventures may have an adverse effect on our business. We expect to continue making acquisitions +or entering into joint ventures as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we don’t realize a satisfactory +return on our investment, or that we experience difficulty in the integration of new employees, business systems, and technology, or diversion of management’s attention from our other businesses. These events could harm our operating results or +financial condition. ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2010 that remain unresolved. ITEM 2. PROPERTIES Our corporate offices consist of approximately 15 million square feet of office space located in King County, Washington: ten million +square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately five million square feet of space we lease. We own approximately two million additional square feet +of office and datacenter space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately four million square feet of office and datacenter space. We occupy many sites internationally, +totaling approximately two million square feet that is owned and approximately nine million square feet that is leased. International facilities that we own include our India Development Center in Hyderabad, India; the European Operations +Center in Dublin, Ireland; a Research and Development Campus in Shaghai, China; and facilities in Reading and Atherstone, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; Tokyo, Japan; +Unterschleissheim, Germany; Paris, France; Dublin, Ireland; Bangalore, India; Reading, UK; Vedbaek, Denmark; and Mississauga, Canada. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto +Rico, a facility in Singapore for our Asia Pacific Operations Center and Regional headquarters, and various product development facilities, both domestically and internationally, as described in the “Research and Development” section of +Item 1 of this Form 10-K. 20 Table of Contents PART I, II Item 2, 3, 5, 6 Our facilities are fully used for current operations of all segments, and suitable additional +spaces are available to accommodate expansion needs. We have a development agreement with the City of Redmond under which we may currently develop approximately 1.6 million square feet of additional facilities at our corporate campus in +Redmond, Washington. In addition, we own 63 acres of undeveloped land in Issaquah, Washington, that can accommodate approximately one million square feet of office space. ITEM 3. LEGAL PROCEEDINGS See Note 17 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal +proceedings in which we are involved. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY +SECURITIES Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 20, 2010, there were 138,568 +registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2010 High $ 26.25 $ 31.50 $ 31.24 $ 31.58 $ 31.58 Low $ 22.00 $ 24.43 $ 27.57 $ 22.95 $ 22.00 Fiscal Year 2009 High $ 28.50 $ 27.47 $ 21.00 $ 24.34 $ 28.50 Low $ 23.50 $ 17.50 $ 14.87 $ 18.18 $ 14.87 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information +regarding dividends and share repurchases. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2010 2009 2008 2007 2006 Revenue $ 62,484 $ 58,437 $ 60,420 $ 51,122 $ 44,282 Operating income $ 24,098 $ 20,363 $ 22,271 (c) $ 18,438 $ 16,380 Net income $ 18,760 $ 14,569 $ 17,681 (c) $ 14,065 $ 12,599 Diluted earnings per share $ 2.10 $ 1.62 $ 1.87 $ 1.42 $ 1.20 Cash dividends declared per share $ 0.52 $ 0.52 $ 0.44 $ 0.40 $ 0.35 Cash and cash equivalents and short-term investments $ 36,788 $ 31,447 $ 23,662 $ 23,411 $ 34,161 Total assets $ 86,113 $ 77,888 $ 72,793 $ 63,171 $ 69,597 Long-term obligations $ 13,791 (a) $ 11,296 (b) $ 6,621 $ 8,320 $ 7,051 Stockholders’ equity $ 46,175 $ 39,558 $ 36,286 $ 31,097 $ 40,104 (a) Includes $1.25 billion of convertible debt securities issued in June 2010 and $3.75 billion of debt securities issued in May 2009. See Note 12 – Debt +in the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Includes $3.75 billion of debt securities issued in May 2009. See Note 12 – Debt in the Notes to Financial Statements (Part II, Item 8 of this +Form 10-K). (c) Includes charge of $1.4 billion ( € 899 +million) related to the fine imposed by the European Commission in February 2008. 21 Table of Contents PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL +CONDITION AND RESULTS OF OPERATIONS OVERVIEW AND OUTLOOK The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations +and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying notes to the financial statements (“Notes”). We generate +revenue by developing, manufacturing, licensing, and supporting a wide range of software products and services for many different types of computing devices. Our software products and services include operating systems for personal computers, +servers, and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; high-performance computing applications; software development tools; and +video games. We provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We also design and sell hardware, including the Xbox 360 gaming and entertainment console and +accessories, the Zune digital music and entertainment device and accessories, and Microsoft PC hardware products. Online offerings and information are delivered to consumers through Bing, Windows Live, Microsoft Office Web Apps, our MSN portals and +channels, and to businesses through Microsoft Online Services offerings, such as Microsoft Dynamics CRM Online, Exchange Online, Windows Azure, SQL Azure and SharePoint Online. We enable the delivery of online advertising across our broad range of +digital media properties and on Bing through our proprietary adCenter platform. Our revenue historically has fluctuated quarterly and +has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division is particularly seasonal +as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its annual segment revenues in our second fiscal +quarter. In addition, quarterly revenues may be impacted by the deferral of revenue. See the discussions below regarding the deferral of revenue related to eligible sales of the 2007 Microsoft Office system with a guarantee to be upgraded to the +2010 Microsoft Office system at minimal or no cost (the “Office 2010 Deferral”) and sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and of Windows 7 to original equipment manufacturers and +retailers before general availability (the “Windows 7 Deferral”). Global macroeconomic factors have a strong correlation to +demand for our software, services, hardware, and online offerings. The unfavorable global economic environment adversely affected our business in fiscal year 2009 as consumers and businesses cut back on spending, which reduced PC shipments and IT +investments. During fiscal year 2010, the environment began to improve. However, the current macroeconomic factors remain dynamic and uncertain and are likely to remain so into 2011. Irrespective of global economic conditions, we are positive +about our relative market position, our current product portfolio and future product pipeline. Because we offer a wide range of products and services that enable companies to improve productivity and reduce costs, including cloud-based +services, we believe that Microsoft is well-positioned to create new opportunities to increase revenue as the global economy improves. We remain focused on executing in the areas we can control by continuing to provide high value products at the +lowest total cost of ownership while managing our expenses. Technological innovation is the foundation of our long-term growth and we +intend to maintain our commitment to investment in research and development, engineering excellence, and delivering high-quality products and services to customers and partners. We continue to develop innovative software applications and solutions +that we believe will enhance information worker productivity, improve communication and collaboration in work groups, aid business intelligence, and streamline processes for small and mid-sized businesses. To sustain growth in the face of +competition from other vendors of proprietary and open source software, our goal is to deliver products that provide the best platform for network computing – software that is easiest to deploy and manage, and that is most secure – with +the lowest total cost of ownership. 22 Table of Contents PART II Item 7 In addition, we continue to invest in research and development in existing and new lines of +business, including cloud computing, search, online solutions, business solutions, mobile computing, communication, entertainment, and other areas that we believe may contribute to our long-term growth. We also invest in research and development of +advanced technologies for future software products. We believe that delivering innovative and high-value solutions through our integrated platform is the key to meeting customer needs and to our future growth. This long-term focus on investment in research and development has enabled us to lay a foundation for future growth by delivering innovative +products, creating opportunities for partners, and improving customer satisfaction. Our focus in fiscal year 2011 is to build on this foundation and to continue to execute well in key areas through ongoing innovation on our integrated software +platform, by responding effectively to customer and partner needs, and by focusing internally on product excellence, business efficacy, and accountability across the company. Summary of Results for Fiscal Years 2010, 2009, and 2008 (In millions, except percentages and per share amounts) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Revenue $ 62,484 $ 58,437 $ 60,420 7% (3)% Operating income $ 24,098 $ 20,363 $ 22,271 18% (9)% Diluted earnings per share $ 2.10 $ 1.62 $ 1.87 30% (13)% Fiscal year 2010 compared with fiscal year 2009 Revenue increased mainly due to strong sales of Windows 7, which was released during fiscal year 2010, and PC market improvement. Operating income +increased reflecting the change in revenue, offset in part by higher operating expenses. • Sales and marketing expenses increased $335 million or 3%, primarily reflecting increased advertising and marketing of Windows 7 and Bing and increased sales +force expenses related to Windows 7. • General and administrative expenses increased $304 million or 8% due mainly to increased legal charges and transition expenses associated with the inception +of the Yahoo! Commercial Agreement, offset in part by a reduction in headcount-related expenses. • Cost of revenue increased $240 million or 2%, primarily reflecting increased online costs and charges resulting from the discontinuation of the KIN phone, +offset in part by decreased Xbox 360 console costs and reductions in other costs due to resource management efforts. • Research and development expenses decreased $296 million or 3%, primarily reflecting a decrease in third-party development and programming costs and increased +capitalization of certain software development costs. Diluted earnings per share increased reflecting increased net +income and the repurchase of 380 million shares during fiscal year 2010. Fiscal year 2009 compared with fiscal year 2008 Revenue declined across most segments primarily driven by weakness in the global PC market and the unfavorable economic environment. Primary +factors contributing to the decline include the following: • Revenue from Windows operating systems declined reflecting PC market weakness, especially PCs sold to businesses. • Revenue from our Entertainment and Devices Division decreased across most lines of business including Xbox 360 platform and PC game revenue which declined +primarily as a result of decreased revenue per console due to price reductions during the prior 12 months, partially offset by increased console sales and Xbox LIVE revenue. 23 Table of Contents PART II Item 7 The above declines were partially offset by increased server and server application revenue, +reflecting recognition of deferred revenue from previously signed agreements and continued adoption of the Windows Server Platform and applications through SQL Server, Enterprise CAL Suites, and System Center products. Foreign currency exchange +rates had a favorable impact of $486 million on revenue. Operating income decreased primarily reflecting decreased revenue. Operating +expenses were flat with decreased general and administrative and sales and marketing expenses offset by increased headcount-related expenses, cost of revenue, and employee severance charges. • General and administrative expenses decreased $1.4 billion or 28%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 +million of legal charges during the twelve months ended June 30, 2009 as compared to $1.8 billion during the twelve months ended June 30, 2008. The prior year costs were primarily related to the European Commission fine of $1.4 billion +( € 899 million). • Sales and marketing expenses decreased $381 million or 3%, primarily driven by the resource management program. As part of that program, we reduced marketing +and advertising expenses. • Headcount-related expenses, excluding $330 million of employee severance charges, increased 7%, driven by a 2% increase in headcount during the past 12 months +and an increase in salaries and benefits for existing headcount. • Cost of revenue increased $557 million or 5%, primarily reflecting increased online costs, including online traffic acquisition, data center and equipment, +and headcount-related costs, partially offset by decreased Xbox 360 platform costs. In January 2009, we announced and +implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. As part of this program, we announced the elimination of up to 5,000 positions in research and development, +marketing, sales, finance, legal, human resources, and information technology by June 30, 2010. During fiscal year 2009, we recorded employee severance charges of $330 million for the expected reduction in employee headcount. Diluted earnings per share declined primarily reflecting decreased net income, partially offset by share repurchases during the prior 12 months. We +repurchased 318 million shares during fiscal year 2009. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted +in the U.S. (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 22 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, +Item 8 of this Form 10-K) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain +prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Windows Live from Online Services Division to Windows & Windows Live +Division, and Razorfish from Online Services Division to Corporate. Razorfish was sold during the second quarter of fiscal year 2010. Windows & Windows Live Division (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Revenue $ 18,491 $ 14,974 $ 17,211 23% (13)% Operating income $ 12,977 $ 9,982 $ 12,422 30% (20)% 24 Table of Contents PART II Item 7 Windows & Windows Live Division (“Windows Division”) offerings consist of +premium and standard edition Windows operating systems and online software and services through Windows Live. Premium Windows operating systems are those that include additional functionality and are sold at a price above our standard editions. +Premium editions include Windows 7 Home Premium, Windows 7 Professional, Windows 7 Ultimate, Windows 7 Enterprise, Windows Vista Business, Windows Vista Home Premium, Windows Vista Ultimate, and Windows Vista Enterprise. Standard editions include +Windows 7 Starter, Windows 7 Home Basic, Windows Vista Starter, Windows Vista Home Basic, and Windows XP Home. Windows Live primarily generates revenue from online advertising. Windows Division revenue growth is largely correlated to the growth of PC purchases from original equipment manufacturers (“OEMs”) that +pre-install versions of Windows operating systems because the OEM channel accounts for approximately 80% of total Windows Division revenue. The remaining approximately 20% of Windows Division revenue (“other revenue”) is generated by +commercial and retail sales of Windows and online advertising from Windows Live. Fiscal year 2010 compared with fiscal year 2009 Windows Division revenue increased primarily as a result of strong sales of Windows 7 and PC market improvement. We estimate total PC shipments +from all sources grew approximately 16% to 18%. OEM revenue increased $2.6 billion or 22%, while OEM license units increased 21%. The OEM revenue increase was driven by PC market growth, higher Windows attach rates across consumer and business +segments, the restoration of normal OEM inventory levels, and the mix of versions of Windows licensed, offset in part by PC market changes, including stronger growth of emerging markets versus developed markets and of consumer PCs versus business +PCs. Fiscal year 2009 OEM revenue reflects a $273 million Windows 7 Deferral, as discussed under Overview and Outlook above. This amount was subsequently recognized in fiscal year 2010. Other revenue increased $912 million or 29% driven primarily by +Windows 7 retail sales. Windows Division operating income increased as a result of increased revenue, offset in part by higher +operating expenses. Cost of revenue increased $296 million or 22%, primarily driven by royalties and other product costs. Sales and marketing expenses increased $256 million or 11% reflecting increased advertising and marketing of Windows 7. Fiscal year 2009 compared with fiscal year 2008 Windows Division revenue decreased primarily as a result of PC market weakness, especially PCs sold to businesses. OEM revenue decreased $2.3 +billion or 16% while OEM license units declined 2%. Based on our estimates, total worldwide PC shipments from all sources experienced a decline of approximately 1% to growth of approximately 2%, driven by changes in demand in emerging and developed +markets. Windows Division operating income decreased primarily reflecting decreased revenue and increased sales and marketing expenses. +Sales and marketing expenses increased $100 million or 5%, primarily reflecting increased advertising and marketing. Server and Tools (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Revenue $ 14,866 $ 14,191 $ 13,195 5% 8% Operating income $ 5,491 $ 4,803 $ 4,149 14% 16% Server and Tools licenses products, applications, tools, content, and delivers Enterprise Services, all of which are designed to make information +technology professionals, developers and their systems more productive and efficient. Server and Tools product and service offerings consist of Windows Server, Microsoft SQL Server, Windows Azure 25 Table of Contents PART II Item 7 and other cloud and server offerings. We also offer developer tools, training and certification. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. +Server product offerings can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. We use multiple sales channels, including pre-installed OEM versions, sales through partners and sales directly to end customers. +Approximately 50% of Server and Tools revenue comes from annuity volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes +from Enterprise Services. Fiscal year 2010 compared with fiscal year 2009 Server and Tools revenue increased mainly reflecting growth in product revenue. Product revenue increased $652 million or 6%, driven primarily by +growth in Windows Server, SQL Server and Enterprise CAL Suites revenue, reflecting increased revenue from annuity volume licensing agreements and continued adoption of Windows platform applications, offset in part by a decline in developer tools +revenue. Enterprise Services revenue was relatively flat, with growth in Premier product support services nearly offset by decreased consulting services. Server and Tools operating income increased due mainly to revenue growth and reduced research and development expenses, offset in part by increased +cost of revenue. Research and development expenses decreased $38 million or 2%, primarily driven by reduced third-party development and programming costs and headcount-related expenses, offset in part by increased hosting, localization and lab +costs. Cost of revenue increased $25 million. Fiscal year 2009 compared with fiscal year 2008 Server and Tools revenue increased reflecting growth in both product and services revenue. Product revenue increased $741 million or 7%, primarily +driven by growth in SQL Server, Enterprise CAL Suites, and System Center revenue. This growth reflects recognition of deferred revenue from previously signed agreements and continued adoption of the Windows Server Platform and applications. +Enterprise Services revenue increased $255 million or 10%, primarily due to revenue from annuity support agreements. Server and Tools +revenue included a favorable foreign currency exchange impact of $140 million. Server and Tools operating income increased primarily +due to growth in product revenue, partially offset by increased research and development expenses and cost of revenue. Research and development expenses increased $242 million or 12%, primarily driven by increased headcount-related expenses. Cost of +revenue increased $82 million or 3%, reflecting the growth in support, online, and consulting services. Online Services Division (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Revenue $ 2,199 $ 2,121 $ 2,198 4% (4)% Operating loss $ (2,355 ) $ (1,652 ) $ (578 ) (43)% (186)% Online Services Division (“OSD”) offerings include Bing, MSN, and advertiser and publisher tools. Yahoo! Commercial Agreement On +December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. We believe this agreement will allow us over time to improve the +effectiveness and increase the value of our search offering through greater scale in search 26 Table of Contents PART II Item 7 queries and an expanded and more competitive search and advertising marketplace. See Note 16 – Commitments and Guarantees in the Notes to Financial Statements (Part II, Item 8 of +this Form 10-K) for additional information about the agreement. Fiscal year 2010 compared with fiscal year 2009 OSD revenue increased reflecting increased online advertising revenue, offset in part by decreased Access revenue. Online advertising revenue +increased $146 million or 8% to $1.9 billion, reflecting higher search and display advertising revenue, offset in part by decreased advertiser and publisher tools revenue. Access revenue decreased $57 million or 31%, reflecting continued migration +of subscribers to broadband or other competitively-priced service providers. OSD operating loss increased due to increased operating +expenses, offset in part by increased revenue. Cost of revenue increased $565 million, primarily driven by higher online traffic acquisition costs and Yahoo! reimbursement and implementation costs. General and administrative expenses increased $136 +million. Sales and marketing expenses increased $56 million or 5% due mainly to increased marketing of Bing, offset in part by decreased headcount-related expenses. Fiscal year 2009 compared with fiscal year 2008 OSD revenue decreased primarily as a result of decreased Access revenue, partially offset by increased online advertising revenue. Access revenue +decreased $72 million or 28%, reflecting continued migration of subscribers to broadband or other competitively-priced service providers. Online advertising revenue increased $6 million to $1.8 billion, reflecting an increase in search revenue, +partially offset by a decrease in display advertising revenue. OSD revenue included an unfavorable foreign currency exchange impact of +$28 million. OSD operating loss increased due to increased cost of revenue and research and development expenses, and decreased +revenue. Cost of revenue increased $700 million or 82%, primarily driven by increased online traffic acquisition, data center and equipment, and headcount-related costs. Research and development expenses increased $153 million or 17%, primarily due +to increased headcount-related expenses. Microsoft Business Division (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Revenue $ 18,642 $ 18,910 $ 18,899 (1)% 0% Operating income $ 11,776 $ 11,664 $ 11,859 1% (2)% Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system and Microsoft Dynamics business +solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions. Microsoft Office system offerings generate over 90% of MBD +revenue. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of +global enterprises. We evaluate our results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; +and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. 27 Table of Contents PART II Item 7 Fiscal year 2010 compared with fiscal year 2009 MBD revenue decreased primarily as a result of the net deferral of $254 million of revenue related to eligible sales of the 2007 Microsoft Office +system with a guarantee to be upgraded to the 2010 Microsoft Office system at minimal or no cost (the “Office 2010 Deferral”). Consumer revenue decreased $166 million or 5%, primarily due to the Office 2010 Deferral, offset in part by +growth in the PC market and sales of the 2010 Microsoft Office system, which was launched during the fourth quarter. Business revenue decreased $102 million or 1%, primarily reflecting a decline in licensing of the 2007 Microsoft Office system to +transactional business customers, offset in part by growth in multi-year volume licensing agreement revenue and licensing of the 2010 Microsoft Office system to transactional business customers. Microsoft Dynamics revenue was flat. MBD operating income increased due mainly to decreased operating expenses, offset in part by decreased revenue. Sales and marketing expenses +decreased $266 million or 6%, primarily driven by a decrease in corporate marketing activities. Research and development expenses decreased $187 million or 11%, primarily as a result of capitalization of certain Microsoft Office system software +development costs and lower headcount-related expenses. General and administrative expenses decreased $53 million or 18% primarily due to expenses in the prior year associated with the acquisition of Fast Search & Transfer ASA +(“FAST”) and lower headcount-related expenses. These decreases were offset in part by a $126 million or 11% increase in cost of revenue, primarily driven by increased traffic acquisition costs and increased costs of providing services. Fiscal year 2009 compared with fiscal year 2008 MBD revenue was flat reflecting increased business revenue offset by decreased consumer revenue. Business revenue increased $458 million or +3%, primarily reflecting growth in volume licensing agreement revenue and included a 7% decrease in Microsoft Dynamics customer billings. The growth in volume licensing agreement revenue primarily reflects recognition of deferred revenue from +previously signed agreements. Consumer revenue decreased $447 million or 12%, primarily as a result of PC market weakness, a shift to lower-priced products, and pricing promotions on the 2007 Microsoft Office system. MBD revenue included a favorable foreign currency exchange impact of $378 million. MBD operating income decreased reflecting increased cost of revenue and research and development expenses, partially offset by decreased sales and +marketing expenses. Cost of revenue increased $134 million or 14% primarily driven by expenses associated with FAST, which we acquired in April 2008, as well as online services infrastructure costs. Research and development expenses increased $118 +million or 8%, primarily driven by an increase in headcount-related expenses associated with FAST. Sales and marketing expenses decreased $79 million or 2%, primarily driven by a decrease in corporate marketing activities and headcount-related costs +associated with our corporate sales force. Entertainment and Devices Division (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Revenue $ 8,058 $ 8,035 $ 8,495 0% (5)% Operating income $ 679 $ 108 $ 445 529% (76)% Entertainment and Devices Division (“EDD”) offerings include the Xbox 360 platform (which includes the Xbox 360 gaming and entertainment +console, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), the Zune digital music and entertainment platform (“Zune”), PC software games, online games and services, Mediaroom (our Internet protocol television software), Windows +Phone and Windows Embedded device platforms, application software for Apple’s Macintosh computers, Microsoft PC hardware products, and other devices. EDD is also responsible for all retail sales and marketing for Microsoft Office and Windows +operating systems. 28 Table of Contents PART II Item 7 Fiscal year 2010 compared with fiscal year 2009 EDD revenue was nearly flat reflecting increased revenue from the non-gaming portion of the business, partially offset by decreased revenue from +Xbox 360 platform and PC games. Non-gaming revenue increased $35 million or 1% primarily reflecting increased sales of Windows Embedded device platforms, offset in part by decreased Zune and Windows Phone revenue. Xbox 360 platform and PC game +revenue decreased $12 million, primarily reflecting a reduction in Xbox 360 consoles sold and revenue per console, offset in part by increased Xbox LIVE revenue. We shipped 10.3 million Xbox 360 consoles during the fiscal year 2010, compared +with 11.2 million Xbox 360 consoles during fiscal year 2009. EDD operating income increased due to reduced operating expenses. +Cost of revenue decreased $528 million or 11%, primarily due to lower Xbox 360 console costs, offset in part by increased royalty costs resulting from increased Xbox LIVE digital marketplace third-party content sales and charges resulting from the +discontinuation of the KIN phone. Research and development expenses decreased $34 million or 2%, primarily reflecting decreased third-party development and programming costs. Fiscal year 2009 compared with fiscal year 2008 EDD revenue decreased across most lines of business. Revenue from our non-gaming business decreased $300 million or 11%, primarily reflecting +decreased Zune and PC hardware product revenue. Xbox 360 platform and PC game revenue decreased $160 million or 3%, primarily as a result of decreased revenue per Xbox 360 console due to price reductions during the past 12 months, partially offset +by increased Xbox 360 console sales and increased Xbox LIVE revenue. We shipped 11.2 million Xbox 360 consoles during fiscal year 2009, compared with 8.7 million Xbox 360 consoles during fiscal year 2008. EDD revenue included an unfavorable foreign currency exchange impact of $74 million. EDD operating income decreased primarily due to decreased revenue and increased research and development expenses, partially offset by decreased +cost of revenue. Research and development expenses increased $275 million or 17%, primarily reflecting increased headcount-related expenses associated with the Windows Phone device platform, driven by recent acquisitions. Cost of revenue decreased +$344 million or 7%, primarily due to decreased Xbox 360 platform costs. Corporate-Level Activity (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Corporate-level activity $ (4,470 ) $ (4,542 ) $ (6,026 ) 2% 25% Certain corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; +human resources; legal; finance; information technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance. Fiscal year 2010 compared with fiscal year 2009 Corporate-level expenses decreased due mainly to employee severance charges of $330 million incurred in the prior year, decreased partner payments, +and reductions in other costs due to resource management efforts. These decreases in expenses were offset in part by an increase in legal charges and costs associated with broad-based sales and marketing activities. Legal charges were approximately +$533 million compared to $283 million in the prior year. 29 Table of Contents PART II Item 7 Fiscal year 2009 compared with fiscal year 2008 Corporate-level expenses decreased during fiscal year 2009, primarily reflecting decreased general and administrative and sales and marketing +expenses, partially offset by employee severance charges of $330 million. General and administrative expenses decreased $1.4 billion or 36%, primarily due to decreased costs for legal settlements and contingencies. We incurred $283 million of legal +charges during fiscal year 2009 as compared to $1.8 billion during fiscal year 2008. The prior year costs were primarily related to the European Commission fine of $1.4 billion +( € 899 million). Sales and marketing expenses decreased $513 million or 82%, reflecting the resource management program implemented in +January 2009. OPERATING EXPENSES Cost of Revenue (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Cost of revenue $ 12,395 $ 12,155 $ 11,598 2% 5% As a percent of revenue 20% 21% 19% (1)ppt 2ppt Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support +service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our Web sites and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support +and maintain Internet-based products and services; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs. Fiscal year 2010 compared with fiscal year 2009 Cost of revenue increased reflecting higher online costs, mainly Yahoo! reimbursement and implementation costs and traffic acquisition costs, as +well as increased royalty costs resulting from increased Xbox LIVE digital marketplace third-party content sales and charges resulting from the discontinuation of the KIN phone. For the current fiscal year, these costs were offset in part by lower +Xbox 360 console costs and reductions in other costs due to resource management efforts. Fiscal year 2009 compared with fiscal year 2008 Cost of revenue increased during fiscal year 2009, primarily reflecting increased online costs, including traffic acquisition, data +center and equipment, and headcount costs, partially offset by decreased Xbox 360 platform costs. Research and Development (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Research and development $ 8,714 $ 9,010 $ 8,164 (3)% 10% As a percent of revenue 14% 15% 14% (1)ppt 1ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses +associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets and the amortization of purchased software +code and services content. 30 Table of Contents PART II Item 7 Fiscal year 2010 compared with fiscal year 2009 Research and development expenses decreased, primarily reflecting decreased third-party development and programming costs and the capitalization of +certain Microsoft Office system software development costs. These decreases were offset in part by the capitalization of certain software and development costs related to Windows 7 product development in the prior year. Fiscal year 2009 compared with fiscal year 2008 Research and development expenses increased during fiscal year 2009, primarily reflecting a 13% increase in headcount-related costs. Sales and Marketing (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Sales and marketing $ 13,214 $ 12,879 $ 13,260 3% (3)% As a percent of revenue 21% 22% 22% (1)ppt 0ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated +with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2010 compared +with fiscal year 2009 Sales and marketing expenses increased, primarily reflecting increased advertising and marketing of Windows 7 +and Bing and increased sales force expenses related to Windows 7. Fiscal year 2009 compared with fiscal year 2008 Sales and marketing expenses decreased, primarily driven by the resource management program implemented in January 2009. General and Administrative (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 General and administrative $ 4,004 $ 3,700 $ 5,127 8% (28)% As a percent of revenue 6% 6% 8% 0ppt (2)ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense and other headcount-related expenses +associated with finance, legal, facilities, certain human resources and other administrative headcount, and legal and other administrative fees. Fiscal year 2010 compared with fiscal year 2009 General and administrative expenses increased due to increased legal charges, as discussed above within Corporate-Level Activity, and transition +expenses associated with the inception of the Yahoo! Commercial Agreement. These increases were offset in part by a 6% reduction in headcount-related expenses. 31 Table of Contents PART II Item 7 Fiscal year 2009 compared with fiscal year 2008 General and administrative expenses decreased primarily reflecting decreased costs for legal settlements and legal contingencies. We incurred legal +charges of $283 million in fiscal year 2009, as compared with $1.8 billion during fiscal year 2008. The fiscal year 2008 legal costs were primarily related to the European Commission fine of $1.4 billion +( € 899 million). Employee Severance In January 2009, we announced and implemented a resource management program to reduce employee headcount. We completed this program +in fiscal year 2010, reducing our overall headcount by approximately 5,300 in various functions, including research and development, marketing, sales, finance, legal, human resources, and information technology. During fiscal years 2010 and 2009, we +recorded employee severance expense of $59 million and $330 million, respectively. OTHER INCOME (EXPENSE) AND INCOME TAXES Other Income (Expense) The +components of other income (expense) were as follows: (In millions, except percentages) 2010 2009 2008 Percentage Change 2010 Versus 2009 Percentage Change 2009 Versus 2008 Dividends and interest income $ 843 $ 744 $ 994 13% (25)% Interest expense (151 ) (38 ) (106 ) (297)% 64% Net recognized gains (losses) on investments 348 (125 ) 346 * * Net gains (losses) on derivatives (140 ) (558 ) 226 75% * Net gains (losses) on foreign currency remeasurements 1 (509 ) 226 * * Other 14 (56 ) (143 ) * 61% Total $ 915 $ (542 ) $ 1,543 * * * Not meaningful We +use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Gains and losses from changes in fair values of +derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other +comprehensive income. Fiscal year 2010 compared with fiscal year 2009 Dividends and interest income increased primarily due to higher average portfolio investment balances, offset in part by lower yields on our +fixed-income investments. Interest expense increased due to our issuance of long term debt in May 2009. Net recognized gains on investments increased primarily due to lower other-than-temporary impairments, offset in part by lower gains on sales of +investments in the current period. Other-than-temporary impairments were $69 million during fiscal year 2010, as compared with $862 million during fiscal year 2009 and decreased primarily due to improvements in market conditions. Net losses on +derivatives decreased due to gains on equity and interest rate derivatives as compared to losses in the prior period and lower losses on commodity and foreign currency contracts in the current period. Net gains from foreign currency remeasurements +were insignificant in fiscal year 2010 compared to net losses of $509 million in the prior year, which had resulted from the strengthening of the U.S. dollar in the prior year. For fiscal year 2010, other includes a gain on the divestiture of +Razorfish. 32 Table of Contents PART II Item 7 Fiscal year 2009 compared with fiscal year 2008 Dividends and interest income decreased primarily reflecting lower interest rates on our fixed-income investments. Interest expense decreased due +to lower average collateral balances on loaned securities and related rates. Net recognized losses on investments increased primarily due to higher other-than-temporary impairments that were partially offset by gains on sales of certain equity +investments held in our strategic investments portfolio. Other-than- temporary impairments were $862 million during fiscal year 2009, as compared with $312 million during fiscal year 2008 and increased primarily due to declines in equity values as a +result of deterioration in equity markets. Net losses on derivatives increased primarily due to losses on equity, commodity, and interest rate derivatives in fiscal year 2009 as compared with gains in the prior period. Net losses on foreign currency +remeasurements increased due to the strengthening of the U.S. dollar, particularly in the first half of the fiscal year 2009. Income Taxes Fiscal year 2010 compared with fiscal year 2009 Our effective tax rates in fiscal years 2010 and 2009 were 25% and 27%, respectively. The fiscal year 2010 rate reflects a higher mix of foreign +earnings taxed at lower rates. Fiscal year 2009 compared with fiscal year 2008 Our effective tax rates in fiscal years 2009 and 2008 were 27% and 26%, respectively. While the fiscal year 2009 rate reflects a higher mix of +foreign earnings taxed at lower rates, the rate increased from the prior year because the fiscal year 2008 rate reflects the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the +2000-2003 examination, partially offset by the European Commission fine which was not tax deductible. As a result of the settlement and the impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009. FINANCIAL CONDITION Cash, +cash equivalents, and short-term investments totaled $36.8 billion as of June 30, 2010, compared with $31.4 billion as of June 30, 2009. Equity and other investments were $7.8 billion as of June 30, 2010, compared with $4.9 billion as +of June 30, 2009. Our short-term investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of investment grade fixed-income securities, diversified among industries and individual issuers. The +investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine fair value. This +pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. treasuries. If quoted prices in active markets for identical assets or liabilities are not available to +determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as +corporate notes and bonds, foreign government bonds, mortgage-backed securities, and agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using +unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are +generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted +price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 +investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all 33 Table of Contents PART II Item 7 of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include +controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where +appropriate. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of June 30, 2010 does +not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of the mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal +and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association. We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on +our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset +with a corresponding liability. Debt In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. As of June 30, 2010, we had $6.0 billion of issued +and outstanding debt comprised of $1.0 billion of commercial paper and $5.0 billion of long-term debt including $1.25 billion of convertible debt. Short-term Debt As of June 30, 2010, +our $1.0 billion of commercial paper issued and outstanding had a weighted average interest rate, including issuance costs, of 0.20% and maturities of 22 to 216 days. In November 2009, we replaced our $2.0 billion and $1.0 billion credit facilities +with a $2.25 billion 364-day credit facility, which expires on November 5, 2010. This facility serves as a back-up for our commercial paper program. In June 2010, we reduced the size of our credit facility from $2.25 billion to $1.0 billion due +to the reduction in commercial paper outstanding. As of June 30, 2010, we were in compliance with the financial covenant in the credit facility agreement, which requires a coverage ratio be maintained of at least three times earnings before +interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against the credit facility during any of the periods presented. Long-term Debt Notes As of June 30, 2010, we had issued and outstanding $3.75 billion of debt securities as follows: $2.0 billion aggregate principal amount of +2.95% notes due 2014, $1.0 billion aggregate principal amount of 4.20% notes due 2019, and $750 million aggregate principal amount of 5.20% notes due 2039 (collectively “the Notes”). Interest on the Notes is payable semi-annually on +June 1 and December 1 of each year to holders of record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. Convertible Debt In June 2010, +we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses which were capitalized. The majority of the proceeds +were used to repay outstanding commercial paper, leaving $1.0 billion of commercial paper outstanding as of June 30, 2010. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of +$33.40 per share. 34 Table of Contents PART II Item 7 Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into +cash and, if applicable, cash, shares of Microsoft’s common stock or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate +principal amount of the notes and pay or deliver cash, shares of our common stock or a combination of cash and shares of our common stock, at our election. Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity +components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ +equity for $58 million, with the portion in stockholders’ equity representing the fair value of the option to convert the debt. In +connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential +dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock +underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price initially equal to $37.16. The purchased capped calls were valued at $40 million and were charged to stockholders’ equity. Unearned Revenue Unearned revenue at +June 30, 2010 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or +annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Unearned revenue at June 30, 2010 also included payments for: post-delivery support +and consulting services to be performed in the future, Xbox LIVE subscriptions; unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP; Microsoft Dynamics business solutions products; +technology guarantee programs, including the 2010 Microsoft Office technology guarantee program; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue +recognition criteria. The following table outlines the expected future recognition of unearned revenue as of June 30, 2010: (In millions) Three Months Ending, September 30, 2010 $ 5,150 December 31, 2010 4,239 March 31, 2011 2,815 June 30, 2011 1,448 Thereafter 1,178 Total $ 14,830 Cash Flows Fiscal year 2010 compared with fiscal year 2009 Cash flow from operations increased $5.0 billion, primarily due to payment of $4.1 billion to the Internal Revenue Service in the prior year as a +result of our settlement of the 2000-2003 audit examination along with increased cash received from customers in the current year. Cash used for financing increased $5.8 billion, primarily due to a $5.6 billion decrease in net cash proceeds from +issuance and repayments of short-term and long-term debt. Financing activities also included a $1.9 billion increase in cash used for common stock repurchases, which was offset in part 35 Table of Contents PART II Item 7 by a $1.7 billion increase in cash received from common stock issued. Cash used for investing decreased $4.5 billion due to a $3.3 billion decrease in cash used for combined investment purchases, +sales, and maturities along with a $1.1 billion decrease in additions to property and equipment. Fiscal year 2009 compared with fiscal year 2008 Cash flow from operations decreased $2.6 billion due to payment of approximately $4.1 billion to the IRS in connection with our +settlement of the 2000-2003 audit examination. This impact was partially offset by the fiscal year 2008 payment of the $1.4 billion ( € 899 +million) European Commission fine. Cash used for financing decreased $5.5 billion primarily due to $5.7 billion of net cash proceeds from issuance of short-term and long-term debt in fiscal year 2009. Financing activities also included a $3.2 +billion decrease in common stock repurchased, which was offset by a $2.9 billion decline in common stock issued. Cash used for investing increased $11.2 billion due to a $15.9 billion rise in purchases of investments along with a $1.7 billion +decrease in cash from investment sales and maturities. These impacts were partially offset by a $7.2 billion decrease in cash paid for acquisition of companies, including the purchase of aQuantive in fiscal year 2008. Share Repurchases On September 22, +2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 (the “2007 Programs”) to buy back up to $40.0 billion of Microsoft common stock. On +September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013 (the “2008 Program”). As +of June 30, 2010, approximately $23.7 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without notice. During the periods reported, we repurchased with cash resources: 380 million shares for $10.8 billion during fiscal year 2010; +318 million shares for $8.2 billion during fiscal year 2009; and 402 million shares for $12.4 billion during fiscal year 2008. All shares repurchased in fiscal year 2010 were repurchased under the 2008 Program, while all shares repurchased +in fiscal year 2008 were repurchased under the 2007 Programs. Of the shares repurchased in fiscal year 2009, 101 million shares were repurchased for $2.7 billion under the 2007 Programs, while the remainder were repurchased under the 2008 +Program. Dividends During +fiscal years 2010 and 2009, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) Fiscal Year 2010 September 18, 2009 $ 0.13 November 19, 2009 $ 1,152 December 10, 2009 December 9, 2009 $ 0.13 February 18, 2010 $ 1,139 March 11, 2010 March 8, 2010 $ 0.13 May 20, 2010 $ 1,130 June 10, 2010 June 16, 2010 $ 0.13 August 19, 2010 $ 1,127 September 9, 2010 Fiscal Year 2009 September 19, 2008 $ 0.13 November 20, 2008 $ 1,157 December 11, 2008 December 10, 2008 $ 0.13 February 19, 2009 $ 1,155 March 12, 2009 March 9, 2009 $ 0.13 May 21, 2009 $ 1,158 June 18, 2009 June 10, 2009 $ 0.13 August 20, 2009 $ 1,157 September 10, 2009 Off-Balance Sheet Arrangements We provide +indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. In evaluating 36 Table of Contents PART II Item 7 estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. To +date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements. Contractual Obligations The following +table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2010. We expect to fund these commitments with existing cash and cash equivalents, short-term investments and cash flows from +operations. (In millions) 2011 2012-2014 2015-2017 2018 and Thereafter Total Long-term +debt: (a) Principal payments $ 0 $ 3,250 $ 0 $ 1,750 $ 5,000 Interest payments 140 420 243 942 1,745 Construction +commitments (b) 347 0 0 0 347 Operating +leases (c) 437 784 407 270 1,898 Purchase +commitments (d) 3,994 184 0 0 4,178 Other long-term +liabilities (e) 0 72 9 1 82 Total contractual obligations $ 4,918 $ 4,710 $ 659 $ 2,963 $ 13,250 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) (b) These amounts represent commitments for the construction of buildings, building improvements and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. (e) We have excluded long-term tax contingencies and other tax liabilities of $7.1 billion and other long-term contingent liabilities of $236 million (related +to the antitrust and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned revenue of +$1.2 billion and non-cash items of $240 million. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to +property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales +and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital +resources. We believe existing cash, cash equivalents and short-term investments, together with funds generated from operations, should +be sufficient to meet operating requirements, regular quarterly dividends, debt repayment schedules, and share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and cash equivalents, short-term +investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution +management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs. 37 Table of Contents PART II Item 7 As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares +repurchased, our retained deficit, including accumulated other comprehensive income, was $16.7 billion at June 30, 2010. Our retained deficit is not expected to affect our future ability to operate, pay dividends, or repay our debt given our +continuing profitability and strong cash and financial position. RECENT LEGISLATION In March 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 were signed into law in +the United States. This legislation expands health care coverage to many uninsured individuals and expands coverage to those already insured. The changes required by this legislation will largely be funded through tax increases to both insurers and +the insured. We do not expect any near term impact on our financial results as a result of the legislation. One provision that will impact certain companies significantly is the elimination of the tax deductibility of the Medicare Part D subsidy. +This provision does not affect us because we do not provide retiree health benefits. RECENTLY ISSUED ACCOUNTING STANDARDS Recently Adopted Accounting Pronouncements In January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to amend the disclosure requirements related to +recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or liabilities) and Level 2 (significant +other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, issuance, and settlements of the +assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance became effective for us with the reporting period beginning January 1, 2010, except for the disclosure on the roll forward +activities for Level 3 fair value measurements, which will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, adoption of this new guidance did not have a material impact +on our financial statements. On July 1, 2009, we adopted guidance issued by the FASB on business combinations. The guidance +retains the fundamental requirements that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all business combinations, but requires a number of changes, including changes in the way assets +and liabilities are recognized and measured as a result of business combinations. It also requires the capitalization of in-process research and development at fair value and requires the expensing of acquisition-related costs as incurred. We have +applied this guidance to business combinations completed since July 1, 2009. On July 1, 2009, we adopted guidance issued by +the FASB that changes the accounting and reporting for non-controlling interests. Non-controlling interests are to be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not +result in a change in control are to be accounted for as equity transactions. In addition, net income attributable to a non-controlling interest is to be included in net income and, upon a loss of control, the interest sold, as well as any interest +retained, is to be recorded at fair value with any gain or loss recognized in net income. Adoption of the new guidance did not have a material impact on our financial statements. On July 1, 2009, we adopted guidance on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized +or disclosed at fair value in the financial statements on a recurring basis (at least annually). Adoption of the new guidance did not have a material impact on our financial statements. Recent Accounting Pronouncements Not Yet Adopted In October 2009, the FASB issued guidance on revenue recognition that will become effective for us beginning July 1, 2010. Under the new +guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope 38 Table of Contents PART II Item 7 of the software revenue recognition guidance, and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue +arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be +determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the +relative selling price method affects the timing and amount of revenue recognition. We believe adoption of this new guidance will not have a material impact on our financial statements. In June 2009, the FASB issued guidance on the consolidation of variable interest entities, which is effective for us beginning July 1, 2010. +The new guidance requires revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. We believe adoption of this new guidance +will not have a material impact on our financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States +(“U.S. GAAP”). Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by +management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, stock-based +compensation, and product warranties. Revenue Recognition Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether +vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. A portion of revenue may be recorded as unearned due to undelivered elements. The amount of revenue allocated to undelivered elements is based on the VSOE +of fair value for those elements using the residual method or relative fair value method, and the deferred revenue is recognized as the elements are delivered. Changes to the elements in a software arrangement, the ability to identify VSOE for those +elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain +software represent new products or upgrades and enhancements to existing products. A portion of the revenue related to Windows XP is +recorded as unearned due to the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis. Revenue related to Windows Vista and Windows 7 is not subject to a similar deferral because there are +no significant undelivered elements. 2007 Microsoft Office system revenue is subject to deferral as a result of the 2010 Microsoft Office system technology guarantee program, which started March 5, 2010. This program allows customers who +purchased certain versions of the 2007 Microsoft Office system to receive an upgrade to the corresponding version of the 2010 Microsoft Office system at minimal or no cost when the product becomes generally available. Accordingly, estimated revenue +related to the undelivered 2010 Microsoft Office system is deferred until the product is delivered. Impairment of Investment Securities Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant +judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair +value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to +sell, the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. 39 Table of Contents PART II Item 7 We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and +operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, +industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 +for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the +business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of +reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted +cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over +which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. We allocate +goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. In addition to the impairment test performed on May 1, 2010, we performed an interim impairment analysis of our Online Services +Division goodwill balance during the first quarter of fiscal year 2010 in connection with the disposal of Razorfish. No impairment of goodwill was identified. Research and Development Costs Costs +incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are +capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products +is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over +the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency +such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required +if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable +estimate of the amount of loss. Changes in these factors could materially impact our financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax +liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax 40 Table of Contents PART II Item 7 position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits +recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on +derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in +assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial statements. Stock-Based Compensation Stock-based +compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of stock-based awards at the grant date requires judgment, including +estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and +our results of operations could be impacted. Product Warranties We provide for the estimated costs of hardware and software warranties at the time the related revenue is recognized. For hardware warranty, we +estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the +product sold and country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranty, we estimate the costs to provide bug fixes, such as security patches, +over the life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. 41 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the +consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, +internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal +auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief Executive Officer Peter S. Klein Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 42 Table of Contents PART II Item 7A ITEM 7A. QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET +RISK RISKS We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion +of these risks is hedged, but they may impact our financial statements. Foreign Currency. Certain +forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign +currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Interest +Rate. Our fixed-income portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to +achieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed +securities. Equity. Our equity portfolio consists of global, developed, and emerging market securities +that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity. We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio +diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity indices and expect their economic risk and return to correlate +with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed +based on the historical volatilities and correlations among foreign currency exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses +could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. The following table sets forth the one-day VaR for substantially all of our positions as of June 30, 2010 and 2009 and for the year ended +June 30, 2010: (In millions) June 30, 2010 June 30, 2009 Year Ended June 30, 2010 Risk Categories Average High Low Foreign currency $ 57 $ 68 $ 53 $ 86 $ 20 Interest rate $ 58 $ 42 $ 54 $ 69 $ 43 Equity $ 183 $ 157 $ 184 $ 206 $ 142 Commodity $ 19 $ 16 $ 17 $ 20 $ 14 Total one-day VaR for the combined risk categories was $235 million at June 30, 2010 and $211 million at June 30, 2009. The total VaR is +26% less at June 30, 2010, and 25% less at June 30, 2009, than the sum of the separate risk categories in the above table due to the diversification benefit of the combination of risks. 43 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2010 2009 2008 Revenue $ 62,484 $ 58,437 $ 60,420 Operating expenses: Cost of revenue 12,395 12,155 11,598 Research and development 8,714 9,010 8,164 Sales and marketing 13,214 12,879 13,260 General and administrative 4,004 3,700 5,127 Employee severance 59 330 0 Total operating expenses 38,386 38,074 38,149 Operating income 24,098 20,363 22,271 Other income (expense) 915 (542 ) 1,543 Income before income taxes 25,013 19,821 23,814 Provision for income taxes 6,253 5,252 6,133 Net income $ 18,760 $ 14,569 $ 17,681 Earnings per share: Basic $ 2.13 $ 1.63 $ 1.90 Diluted $ 2.10 $ 1.62 $ 1.87 Weighted average shares outstanding: Basic 8,813 8,945 9,328 Diluted 8,927 8,996 9,470 Cash dividends declared per common share $ 0.52 $ 0.52 $ 0.44 See accompanying notes. 44 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2010 2009 Assets Current assets: Cash and cash equivalents $ 5,505 $ 6,076 Short-term investments (including securities loaned of $62 and $1,540) 31,283 25,371 Total cash, cash equivalents, and short-term investments 36,788 31,447 Accounts receivable, net of allowance for doubtful accounts of $375 and $451 13,014 11,192 Inventories 740 717 Deferred income taxes 2,184 2,213 Other 2,950 3,711 Total current assets 55,676 49,280 Property and equipment, net of accumulated depreciation of $8,629 and $7,547 7,630 7,535 Equity and other investments 7,754 4,933 Goodwill 12,394 12,503 Intangible assets, net 1,158 1,759 Deferred income taxes 0 279 Other long-term assets 1,501 1,599 Total assets $ 86,113 $ 77,888 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 4,025 $ 3,324 Short-term debt 1,000 2,000 Accrued compensation 3,283 3,156 Income taxes 1,074 725 Short-term unearned revenue 13,652 13,003 Securities lending payable 182 1,684 Other 2,931 3,142 Total current liabilities 26,147 27,034 Long-term debt 4,939 3,746 Long-term unearned revenue 1,178 1,281 Deferred income taxes 229 0 Other long-term liabilities 7,445 6,269 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,668 and 8,908 62,856 62,382 Retained deficit, including accumulated other comprehensive income of $1,055 and $969 (16,681 ) (22,824 ) Total stockholders’ equity 46,175 39,558 Total liabilities and stockholders’ equity $ 86,113 $ 77,888 See accompanying notes. 45 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2010 2009 2008 Operations Net income $ 18,760 $ 14,569 $ 17,681 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other noncash items 2,673 2,562 2,056 Stock-based compensation 1,891 1,708 1,479 Net recognized losses (gains) on investments and derivatives (208 ) 683 (572 ) Excess tax benefits from stock-based compensation (45 ) (52 ) (120 ) Deferred income taxes (220 ) 762 935 Deferral of unearned revenue 29,374 24,409 24,532 Recognition of unearned revenue (28,813 ) (25,426 ) (21,944 ) Changes in operating assets and liabilities: Accounts receivable (2,238 ) 2,215 (1,569 ) Other current assets 420 (422 ) 153 Other long-term assets (223 ) (273 ) (98 ) Other current liabilities 1,295 (3,371 ) (748 ) Other long-term liabilities 1,407 1,673 (173 ) Net cash from operations 24,073 19,037 21,612 Financing Short-term borrowings (repayments), maturities of 90 days or less, net (991 ) 1,178 0 Proceeds from issuance of debt, maturities longer than 90 days 4,167 4,796 0 Repayments of debt, maturities longer than 90 days (2,986 ) (228 ) 0 Common stock issued 2,311 579 3,494 Common stock repurchased (11,269 ) (9,353 ) (12,533 ) Common stock cash dividends paid (4,578 ) (4,468 ) (4,015 ) Excess tax benefits from stock-based compensation 45 52 120 Other 10 (19 ) 0 Net cash used in financing (13,291 ) (7,463 ) (12,934 ) Investing Additions to property and equipment (1,977 ) (3,119 ) (3,182 ) Acquisition of companies, net of cash acquired (245 ) (868 ) (8,053 ) Purchases of investments (30,168 ) (36,850 ) (20,954 ) Maturities of investments 7,453 6,191 2,597 Sales of investments 15,125 19,806 25,132 Securities lending payable (1,502 ) (930 ) (127 ) Net cash used in investing (11,314 ) (15,770 ) (4,587 ) Effect of exchange rates on cash and cash equivalents (39 ) (67 ) 137 Net change in cash and cash equivalents (571 ) (4,263 ) 4,228 Cash and cash equivalents, beginning of period 6,076 10,339 6,111 Cash and cash equivalents, end of period $ 5,505 $ 6,076 $ 10,339 See accompanying notes. 46 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2010 2009 2008 Common stock and paid-in capital Balance, beginning of period $ 62,382 $ 62,849 $ 60,557 Common stock issued 2,311 567 3,504 Common stock repurchased (3,113 ) (2,611 ) (3,022 ) Stock-based compensation expense 1,891 1,708 1,479 Stock-based compensation income tax benefits (deficiencies) (647 ) (128 ) 253 Other, net 32 (3 ) 78 Balance, end of period 62,856 62,382 62,849 Retained deficit Balance, beginning of period (22,824 ) (26,563 ) (29,460 ) Cumulative effect of a change in accounting principle relating to uncertain tax positions 0 0 (395 ) Cumulative effect of a change in accounting principle relating to costs of certain compensated absences 0 0 (17 ) Net income 18,760 14,569 17,681 Other comprehensive income: Net unrealized gains on derivatives 27 302 18 Net unrealized gains (losses) on investments 265 (233 ) (653 ) Translation adjustments and other (206 ) (240 ) 121 Comprehensive income 18,846 14,398 17,167 Common stock cash dividends (4,547 ) (4,620 ) (4,084 ) Common stock repurchased (8,156 ) (6,039 ) (9,774 ) Balance, end of period (16,681 ) (22,824 ) (26,563 ) Total stockholders’ equity $ 46,175 $ 39,558 $ 36,286 See accompanying notes. 47 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The financial +statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Principles of Consolidation The financial +statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant influence over but do not control the investee and +are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable +fair values are accounted for under the cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, +revenue, and expenses. Examples include: estimates of loss contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, +including the distinction between upgrades/enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements +or tax returns; estimating the fair value and/or goodwill impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and +assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are +translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to Other Comprehensive Income (“OCI”). Revenue Recognition Revenue is recognized +when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. Revenue for retail packaged products, products licensed to original equipment manufacturers (“OEMs”), and perpetual licenses under +certain volume licensing programs generally is recognized as products are shipped or made available. A portion of the revenue related to Windows XP is deferred due to the right to receive unspecified upgrades/enhancements of Microsoft Internet +Explorer on a when-and-if-available basis. The amount of revenue allocated to the unspecified upgrade/enhancement rights for Microsoft Internet Explorer is based on the vendor-specific objective evidence of fair value for those elements using the +residual method or relative fair value method and the deferred revenue is recognized ratably on a straight-line basis over the Windows XP life cycle. Revenue related to Windows Vista and Windows 7 is not subject to a similar deferral because there +are no significant undelivered elements. Revenue for products under the technology guarantee programs, which provide free or significantly discounted rights to use upcoming new versions of a software product if an end user licenses existing versions +of the product during the eligibility period, is allocated between existing product and the new product, and revenue allocated to the new product is deferred until that version is delivered. The revenue allocation is based on vendor-specific +objective evidence of fair value of both products. 48 Table of Contents PART II Item 8 Certain multi-year licensing arrangements include a perpetual license for current products +combined with rights to receive future versions of software products on a when-and-if-available basis (“Software Assurance”) and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue +ratably over the billing coverage period. Revenue from certain arrangements that allow for the use of a product or service over a period of time without taking possession of software are also accounted for as subscriptions. Revenue related to our Xbox 360 gaming and entertainment console, games published by us, and other hardware components is generally recognized when +ownership is transferred to the retailers. Revenue related to games published by third parties for use on the Xbox 360 platform is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as +advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, +generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Revenue generally is recognized net of any taxes collected from customers and subsequently remitted to governmental authorities. Cost of Revenue Cost of revenue includes; +manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to +our Web sites and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services; warranty costs; inventory valuation adjustments; costs associated with the +delivery of consulting services; and the amortization of capitalized research and development costs. Capitalized research and development costs are amortized over the estimated lives of the products. Product Warranty We provide for the +estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical +and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor +over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess +the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses +associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased +software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before +the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. 49 Table of Contents PART II Item 8 Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related expenses associated with +sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.6 billion, $1.4 billion, and $1.2 billion in fiscal years +2010, 2009, and 2008, respectively. Employee Severance We record employee severance when a specific plan has been approved by management, the plan has been communicated to employees, and it is unlikely +that significant changes will be made to the plan. Stock-Based Compensation We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense over the applicable +vesting period of the stock award (generally four to five years) using the straight-line method. Employee Stock Purchase Plan Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value of the stock on the last day of +each three-month period. Compensation expense for the employee stock purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes +U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested and interest and penalties on uncertain tax positions. Certain income and expenses are +not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Fair Value Measurements We account for +certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements +in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. treasuries, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where 50 Table of Contents PART II Item 8 applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, +and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency securities, certificates of deposit, and commercial paper. Our +Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain +corporate bonds. We value these corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant +to the fair values of the investments. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop +assumptions to determine fair value for these derivatives. We measure certain assets, including our cost and equity +method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may +include quoted market prices, market comparables, and discounted cash flow projections. Our current financial liabilities, including +our short-term debt, have fair values that approximate their carrying values. Our long-term financial liabilities consist of long-term debt which is recorded on the balance sheet at issuance price less unamortized discount. Financial Instruments We consider all +highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original +maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and +because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the +specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and +other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. +Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the +equity method. We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be +carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loan securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received +is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is +judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and +qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and +extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, 51 Table of Contents PART II Item 8 the investment. For fixed income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before +recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once +a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value +of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as +a fair-value hedge, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time +value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as +cash-flow hedges, the effective portion of the derivative’s gain (loss) is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as +cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or +hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from +changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains +(losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense). Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the +allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2010 2009 2008 Balance, beginning of period $ 451 $ 153 $ 117 Charged to costs and other 45 360 88 Write-offs (121 ) (62 ) (52 ) Balance, end of period $ 375 $ 451 $ 153 Inventories Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead +related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below +carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 52 Table of Contents PART II Item 8 Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset +or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three years; computer equipment, two to three years; buildings and improvements, five to +15 years; leasehold improvements, two to 10 years; and furniture and equipment, one to five years. Land is not depreciated. Goodwill Goodwill is tested for impairment using a fair-value-based approach on an annual basis (May 1 for us) and between annual tests if indicators of +potential impairment exist. Intangible Assets All of our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, +ranging from one to 10 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recently Issued Accounting Standards Recently Adopted +Accounting Pronouncements In January 2010, the Financial Accounting Standards Board (“FASB”) issued guidance to amend the +disclosure requirements related to recurring and nonrecurring fair value measurements. The guidance requires new disclosures on the transfers of assets and liabilities between Level 1 (quoted prices in active market for identical assets or +liabilities) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy, including the reasons and the timing of the transfers. Additionally, the guidance requires a roll forward of activities on purchases, sales, +issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance became effective for us with the reporting period beginning January 1, 2010, except for the +disclosure on the roll forward activities for Level 3 fair value measurements, which will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, adoption of this new guidance did +not have a material impact on our financial statements. See Note 6 – Fair Value Measurements. On July 1, 2009, we adopted +guidance issued by the FASB on business combinations. The guidance retains the fundamental requirements that the acquisition method of accounting (previously referred to as the purchase method of accounting) be used for all business combinations, +but requires a number of changes, including changes in the way assets and liabilities are recognized and measured as a result of business combinations. It also requires the capitalization of in-process research and development at fair value and +requires the expensing of acquisition-related costs as incurred. We have applied this guidance to business combinations completed since July 1, 2009. On July 1, 2009, we adopted guidance issued by the FASB that changes the accounting and reporting for non-controlling interests. +Non-controlling interests are to be reported as a component of equity separate from the parent’s equity, and purchases or sales of equity interests that do not result in a change in control are to be accounted for as equity transactions. In +addition, net income attributable to a non-controlling interest is to be included in net income and, upon a loss of control, the interest sold, as well as any interest retained, is to be recorded at fair value with any gain or loss recognized in net +income. Adoption of the new guidance did not have a material impact on our financial statements. On July 1, 2009, we adopted +guidance on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Adoption of the new guidance did not +have a material impact on our financial statements. 53 Table of Contents PART II Item 8 Recent Accounting Pronouncements Not Yet Adopted In October 2009, the FASB issued guidance on revenue recognition that will become effective for us beginning July 1, 2010. Under the new +guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product will no longer be within the scope of the software revenue recognition guidance, +and software-enabled products will now be subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue +recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and +allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. We +believe adoption of this new guidance will not have a material impact on our financial statements. In June 2009, the FASB issued +guidance on the consolidation of variable interest entities, which is effective for us beginning July 1, 2010. The new guidance requires revised evaluations of whether entities represent variable interest entities, ongoing assessments of +control over such entities, and additional disclosures for variable interests. We believe adoption of this new guidance will not have a material impact on our financial statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted earnings +per share is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include +outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted earnings per share are as follows: (In millions, except earnings per share) Year Ended June 30, 2010 2009 2008 Net income available for common shareholders (A) $ 18,760 $ 14,569 $ 17,681 Weighted average outstanding shares of common stock (B) 8,813 8,945 9,328 Dilutive effect of stock-based awards 114 51 142 Common stock and common stock equivalents (C) 8,927 8,996 9,470 Earnings Per Share Basic (A/B) $ 2.13 $ 1.63 $ 1.90 Diluted (A/C) $ 2.10 $ 1.62 $ 1.87 For fiscal years 2010, 2009, and 2008, 28 million, 342 million, and 91 million shares, respectively, were attributable to +outstanding stock-based awards and were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. In June 2010, we issued $1.25 billion of zero-coupon debt securities that are convertible into shares of our common stock if certain conditions are +met. Shares of common stock into which the debt could convert were excluded from the calculation of diluted earnings per share because their inclusion would have been anti-dilutive. See also Note 12 – Debt. 54 Table of Contents PART II Item 8 NOTE 3 — OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Dividends and interest income $ 843 $ 744 $ 994 Interest expense (151 ) (38 ) (106 ) Net recognized gains (losses) on investments 348 (125 ) 346 Net gains (losses) on derivatives (140 ) (558 ) 226 Net gains (losses) on foreign currency remeasurements 1 (509 ) 226 Other 14 (56 ) (143 ) Total $ 915 $ (542 ) $ 1,543 Other-than-temporary impairments, which +are included in net recognized gains (losses) on investments in the table above, were $69 million, $862 million, and $312 million in fiscal years 2010, 2009, and 2008, respectively. Realized gains and losses from sales of available-for-sale +securities (excluding other-than-temporary impairments) were $605 million and $188 million, respectively, in fiscal year 2010, $1.6 billion and $897 million, respectively, in fiscal year 2009, and $751 million and $93 million, respectively, in +fiscal year 2008. NOTE 4 — INVESTMENTS Investment Components The components of +investments, including associated derivatives, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2010 Cash $ 1,661 $ 0 $ 0 $ 1,661 $ 1,661 $ 0 $ 0 Mutual funds 1,120 0 0 1,120 1,120 0 0 Commercial paper 188 0 0 188 13 175 0 Certificates of deposit 348 0 0 348 68 280 0 U.S. Government and Agency securities 21,036 167 (1 ) 21,202 1,822 19,380 0 Foreign government bonds 518 13 0 531 0 531 0 Mortgage-backed securities 3,137 135 (7 ) 3,265 0 3,265 0 Corporate notes and bonds 7,450 289 (18 ) 7,721 701 7,020 0 Municipal securities 726 22 (1 ) 747 120 627 0 Common and preferred stock 6,640 1,030 (418 ) 7,252 0 0 7,252 Other investments 507 0 0 507 0 5 502 Total $ 43,331 $ 1,656 $ (445 ) $ 44,542 $ 5,505 $ 31,283 $ 7,754 55 Table of Contents PART II Item 8 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2009 Cash $ 2,064 $ 0 $ 0 $ 2,064 $ 2,064 $ 0 $ 0 Mutual funds 1,007 0 (25 ) 982 900 82 0 Commercial paper 2,601 0 0 2,601 400 2,201 0 Certificates of deposit 555 0 0 555 275 280 0 U.S. Government and Agency securities 13,450 21 (5 ) 13,466 2,369 11,097 0 Foreign government bonds 3,450 71 (4 ) 3,517 0 3,517 0 Mortgage-backed securities 3,353 81 (16 ) 3,418 0 3,418 0 Corporate notes and bonds 4,361 287 (52 ) 4,596 0 4,596 0 Municipal securities 255 2 (1 ) 256 68 188 0 Common and preferred stock 4,015 627 (182 ) 4,460 0 0 4,460 Other investments 465 0 0 465 0 (8 ) 473 Total $ 35,576 $ 1,089 $ (285 ) $ 36,380 $ 6,076 $ 25,371 $ 4,933 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2010 U.S. Government and Agency securities $ 216 $ (1 ) $ 0 $ 0 $ 216 $ (1 ) Mortgage-backed securities 105 (6 ) 18 (1 ) 123 (7 ) Corporate notes and bonds 1,124 (13 ) 89 (5 ) 1,213 (18 ) Municipal securities 66 (1 ) 0 0 66 (1 ) Common and preferred stock 2,102 (339 ) 190 (79 ) 2,292 (418 ) Total $ 3,613 $ (360 ) $ 297 $ (85 ) $ 3,910 $ (445 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2009 Mutual funds $ 3 $ (1 ) $ 77 $ (24 ) $ 80 $ (25 ) U.S. Government and Agency securities 4,033 (5 ) 0 0 4,033 (5 ) Foreign government bonds 1,444 (3 ) 669 (1 ) 2,113 (4 ) Mortgage-backed securities 503 (16 ) 0 0 503 (16 ) Corporate notes and bonds 713 (10 ) 504 (42 ) 1,217 (52 ) Municipal securities 16 (1 ) 0 0 16 (1 ) Common and preferred stock 1,154 (135 ) 120 (47 ) 1,274 (182 ) Total $ 7,866 $ (171 ) $ 1,370 $ (114 ) $ 9,236 $ (285 ) 56 Table of Contents PART II Item 8 Unrealized losses from fixed-income securities are primarily attributable to changes in interest +rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence +as of June 30, 2010. At June 30, 2010 and 2009, the recorded bases and estimated fair values of common and preferred stock +and other investments that are restricted for more than one year or are not publicly traded were $216 million and $204 million, respectively. Debt +Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2010 Due in one year or less $ 12,489 $ 12,526 Due after one year through five years 14,987 15,283 Due after five years through 10 years 2,137 2,242 Due after 10 years 3,791 3,952 Total $ 33,404 $ 34,003 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance +investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative +programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents. Foreign Currency Certain forecasted +transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to +hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of +June 30, 2010 and 2009, the total notional amounts of these foreign exchange contracts sold were $9.3 billion and $7.2 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using +foreign exchange forward contracts that are designated as fair-value hedging instruments. As of June 30, 2010 and 2009, the total notional amounts of these foreign exchange contracts sold were $523 million and $3.5 billion, +respectively. Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency +exposures. As of June 30, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $7.8 billion and $5.3 billion, respectively. As of June 30, 2009, the total notional amounts of these foreign +exchange contracts purchased and sold were $3.2 billion and $3.6 billion, respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to +broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity +derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $918 million and $472 million, +respectively. As of June 30, 2009, the total notional amounts of designated and non-designated equity contracts purchased and sold were immaterial. 57 Table of Contents PART II Item 8 Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average +maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are +designated as hedging instruments. As of June 30, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.1 billion and $1.8 billion, respectively. As of June 30, 2009, the total notional amounts of +fixed-interest rate contracts purchased and sold were $2.7 billion and $456 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed +securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2010 and 2009, the total notional derivative amount of +mortgage contracts purchased were immaterial and $1.3 billion, respectively. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not +designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or +groups of credit risks. As of June 30, 2010 and 2009, the total notional amounts of credit contracts purchased and sold were immaterial. Commodity We use broad-based commodity +exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use +derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2010, the total notional amounts of +commodity contracts purchased and sold were $1.1 billion and $376 million, respectively. As of June 30, 2009, the total notional amounts of commodity contracts purchased and sold were $543 million and $33 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured +debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related +to over-the-counter derivatives. As of June 30, 2010, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral is required to be posted. 58 Table of Contents PART II Item 8 Fair Values of Derivative Instruments Following are the gross fair values of derivative instruments held at June 30, 2010 and 2009, excluding the impact of netting derivative +assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk: (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2010 Assets Derivatives not designated as hedging instruments: Short-term investments $ 15 $ 134 $ 12 $ 7 $ 8 $ 176 Other current assets 34 0 0 0 0 34 Total $ 49 $ 134 $ 12 $ 7 $ 8 $ 210 Derivatives designated as hedging instruments: Short-term investments $ 3 $ 0 $ 0 $ 0 $ 0 $ 3 Other current assets 563 0 0 0 0 563 Total $ 566 $ 0 $ 0 $ 0 $ 0 $ 566 Total assets $ 615 $ 134 $ 12 $ 7 $ 8 $ 776 Liabilities Derivatives not designated as hedging instruments: Other current liabilities $ (60 ) $ (17 ) $ (33 ) $ (41 ) $ (5 ) $ (156 ) Derivatives designated as hedging instruments: Other current liabilities $ (9 ) $ 0 $ 0 $ 0 $ 0 $ (9 ) Total liabilities $ (69 ) $ (17 ) $ (33 ) $ (41 ) $ (5 ) $ (165 ) 59 Table of Contents PART II Item 8 (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2009 Assets Derivatives not designated as hedging instruments: Short-term investments $ 9 $ 78 $ 44 $ 21 $ 2 $ 154 Other current assets 48 0 0 0 0 48 Total $ 57 $ 78 $ 44 $ 21 $ 2 $ 202 Derivatives designated as hedging instruments: Short-term investments $ 12 $ 0 $ 0 $ 0 $ 0 $ 12 Other current assets 417 0 0 0 0 417 Equity and other investments 0 2 0 0 0 2 Total $ 429 $ 2 $ 0 $ 0 $ 0 $ 431 Total assets $ 486 $ 80 $ 44 $ 21 $ 2 $ 633 Liabilities Derivatives not designated as hedging instruments: Other current liabilities $ (183 ) $ (3 ) $ (20 ) $ (62 ) $ (6 ) $ (274 ) Derivatives designated as hedging instruments: Other current liabilities $ (75 ) $ 0 $ 0 $ 0 $ 0 $ (75 ) Total liabilities $ (258 ) $ (3 ) $ (20 ) $ (62 ) $ (6 ) $ (349 ) See also Note 4 – Investments and +Note 6 – Fair Value Measurements. Fair-Value Hedges We recognized in other income (expense) the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2010 2009 Foreign Exchange Contracts Derivatives $ (57 ) $ 121 Hedged items 60 (120 ) Total $ 3 $ 1 Equity Contracts Derivatives $ 0 $ 191 Hedged items 0 (211 ) Total $ 0 $ (20 ) 60 Table of Contents PART II Item 8 Cash-Flow Hedges We recognized the following gains (losses) related to foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during +the period): (In millions) Year Ended June 30, 2010 2009 Effective Portion Gain recognized in OCI, net of tax effect of $188 and $472 $ 349 $ 876 Gain reclassified from OCI into revenue $ 495 $ 884 Amount Excluded from Effectiveness Assessment and Ineffective Portion Loss recognized in other income (expense) $ (174 ) $ (314 ) We estimate that $496 million of net derivative gains included in OCI will be reclassified into earnings within the next 12 months. No significant +amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2010. Non-Designated Derivatives Gains (losses) +from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income +statement line items other than other income (expense), which were immaterial for the fiscal years 2010 and 2009. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally +economically offset by unrealized gains (losses) in the underlying available-for-sale securities. (In millions) Year Ended June 30, 2010 2009 Foreign exchange contracts $ 106 $ (234 ) Equity contracts 12 (131 ) Interest-rate contracts (4 ) 5 Credit contracts 22 (18 ) Commodity contracts (1 ) (126 ) Total $ 135 $ (504 ) 61 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2010 Assets Mutual funds $ 1,120 $ 0 $ 0 $ 1,120 $ 0 $ 1,120 Commercial paper 0 172 0 172 0 172 Certificates of deposit 0 348 0 348 0 348 U.S. Government and Agency securities 16,473 4,756 0 21,229 0 21,229 Foreign government bonds 239 294 0 533 0 533 Mortgage-backed securities 0 3,264 0 3,264 0 3,264 Corporate notes and bonds 0 7,460 167 7,627 0 7,627 Municipal securities 0 747 0 747 0 747 Common and preferred stock 6,988 43 5 7,036 0 7,036 Derivatives 22 745 9 776 (207 ) 569 Total $ 24,842 $ 17,829 $ 181 $ 42,852 $ (207 ) $ 42,645 Liabilities Derivatives and other $ 85 $ 137 $ 0 $ 222 $ (205 ) $ 17 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2009 Assets Mutual funds $ 982 $ 0 $ 0 $ 982 $ 0 $ 982 Commercial paper 0 2,601 0 2,601 0 2,601 Certificates of deposit 0 555 0 555 0 555 U.S. Government and Agency securities 7,134 6,105 0 13,239 0 13,239 Foreign government bonds 501 3,022 0 3,523 0 3,523 Mortgage-backed securities 0 3,593 0 3,593 0 3,593 Corporate notes and bonds 0 4,073 253 4,326 0 4,326 Municipal securities 0 256 0 256 0 256 Common and preferred stock 4,218 28 5 4,251 0 4,251 Derivatives 5 623 5 633 (235 ) 398 Total $ 12,840 $ 20,856 $ 263 $ 33,959 $ (235 ) $ 33,724 Liabilities Derivatives and other $ 5 $ 344 $ 0 $ 349 $ (231 ) $ 118 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. 62 Table of Contents PART II Item 8 The table below reconciles the total Net Fair Value of assets above to the balance sheet +presentation of these same assets in Note 4 – Investments for June 30, 2010 and 2009. (In millions) June 30, 2010 2009 Net fair value of assets measured at fair value on a recurring basis $ 42,645 $ 33,724 Cash 1,661 2,064 Common and preferred stock measured at fair value on a nonrecurring basis 216 204 Other investments measured at fair value on a nonrecurring basis 502 465 Derivative assets classified as other current assets (597 ) (465 ) Derivative liabilities under master netting agreements classified as other current assets 53 231 Other 62 157 Recorded basis of investment components $ 44,542 $ 36,380 Changes in Financial Instruments Measured at Level 3 +Fair Value on a Recurring Basis The following tables present the changes during the fiscal years 2010 and 2009 in our Level 3 +financial instruments that are measured at fair value on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI. (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Year Ended June 30, 2010 Balance, beginning of period $ 253 $ 5 $ 5 $ 263 Total realized and unrealized gains (losses): Included in other income (expense) 6 0 4 10 Included in other comprehensive income (92 ) 0 0 (92 ) Balance, end of period $ 167 $ 5 $ 9 $ 181 Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2010 $ 6 $ 0 $ 4 $ 10 (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Year Ended June 30, 2009 Balance, beginning of period $ 138 $ 8 $ 71 $ 217 Total realized and unrealized gains (losses): Included in other income (expense) (6 ) (6 ) 51 39 Included in other comprehensive income 111 0 0 111 Purchases, issuances, and settlements 0 5 (119 ) (114 ) Transfers in (out) 10 (2 ) 2 10 Balance, end of period $ 253 $ 5 $ 5 $ 263 Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2009 $ (7 ) $ (5 ) $ 4 $ (8 ) 63 Table of Contents PART II Item 8 Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal years 2010 and 2009, impairment charges of $5 million and $86 million, respectively, were recognized for certain investments measured +at fair value on a nonrecurring basis, as the decline in their respective fair values below their cost was determined to be other than temporary in all instances. At June 30, 2010 and 2009, the fair values of the common and preferred stocks +that we held that were required to be measured at fair value on a non-recurring basis were $0 and $164 million, respectively. NOTE 7 +— INVENTORIES The components of inventories were as follows: (In millions) June 30, 2010 2009 Raw materials $ 172 $ 170 Work in process 16 45 Finished goods 552 502 Total $ 740 $ 717 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2010 2009 Land $ 526 $ 526 Buildings and improvements 6,087 5,886 Leasehold improvements 2,100 1,938 Computer equipment and software 5,673 4,989 Furniture and equipment 1,873 1,743 Total, at cost 16,259 15,082 Accumulated depreciation (8,629 ) (7,547 ) Total, net $ 7,630 $ 7,535 During fiscal years 2010, 2009, and 2008, +depreciation expense was $1.8 billion, $1.7 billion, and $1.4 billion, respectively. NOTE 9 — BUSINESS COMBINATIONS During fiscal year 2010, we acquired five entities for total consideration of $267 million, substantially all of which was paid in +cash. During this period, we also sold three entities for total consideration of $600 million, including Razorfish in the second quarter of fiscal year 2010. These entities have been included in or removed from our consolidated results of operations +since their acquisition or sale dates, respectively. Pro forma results of operations have not been presented because the effects of these business combinations, individually and in the aggregate, were not material to our consolidated results of +operations. 64 Table of Contents PART II Item 8 NOTE 10 — GOODWILL Changes in the carrying amount of goodwill for fiscal years 2010 and 2009 by segment were as follows: Balance as of June 30, 2008 Acquisitions Purchase Accounting Adjustments and Other Balance as of June 30, 2009 Acquisitions Purchase Accounting Adjustments and Other Balance as of June 30, 2010 (In millions) Windows & Windows Live Division $ 153 $ 1 $ (77 ) $ 77 $ 0 $ 0 $ 77 Server and Tools 738 233 67 1,038 82 (2 ) 1,118 Online Services Division 6,274 447 (64 ) 6,657 0 (284 ) 6,373 Microsoft Business Division 4,191 0 (264 ) 3,927 116 (19 ) 4,024 Entertainment and Devices Division 752 58 (6 ) 804 0 (2 ) 802 Total $ 12,108 $ 739 $ (344 ) $ 12,503 $ 198 $ (307 ) $ 12,394 None of the amounts recorded as goodwill +are expected to be deductible for tax purposes. The measurement period for purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price +allocation may require a recasting of the amounts allocated to goodwill retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” +in the above table. Also included within “other” for fiscal year 2010 is $285 million of goodwill associated with business dispositions. See also Note 9 – Business Combinations. We test goodwill for impairment annually on May 1 at the reporting unit level using a fair value approach. No impairment of goodwill was +identified as of May 1, 2010. In connection with the disposal of Razorfish, we performed an interim impairment analysis of our Online Services Division goodwill balance during the first quarter of fiscal year 2010. No impairment of goodwill was +identified. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Year Ended June 30, 2010 2009 Contract-based $ 1,075 $ (914 ) $ 161 $ 1,087 $ (855 ) $ 232 Technology-based 2,308 (1,521 ) 787 2,033 (1,090 ) 943 Marketing-related 114 (86 ) 28 188 (97 ) 91 Customer-related 390 (208 ) 182 732 (239 ) 493 Total $ 3,887 $ (2,729 ) $ 1,158 $ 4,040 $ (2,281 ) $ 1,759 We estimate that we have no significant +residual value related to our intangible assets. No material impairments of intangible assets were identified during any of the periods presented. 65 Table of Contents PART II Item 8 The components of intangible assets acquired during fiscal years 2010 and 2009 were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2010 2009 Contract-based $ 3 2 years $ 26 4 years Technology-based 322 4 years 293 4 years Marketing-related 0 7 5 years Customer-related 18 5 years 28 2 years Total $ 343 $ 354 Intangible assets amortization expense was $707 million, $591 million, and $472 +million for fiscal years 2010, 2009, and 2008, respectively. The following table outlines the estimated future amortization expense related to intangible assets held at June 30, 2010: (In millions) Year Ending June 30, 2011 $ 486 2012 365 2013 235 2014 36 2015 and thereafter 36 Total $ 1,158 NOTE 12 — DEBT In September 2008, our Board of Directors authorized debt financings of up to $6.0 billion. As of June 30, 2010, we had $6.0 billion of issued +and outstanding debt comprised of $1.0 billion of commercial paper and $5.0 billion of long-term debt, including $1.25 billion of convertible debt. Cash paid for interest on our debt for fiscal year 2010 was $145 million. No cash was paid for +interest on our debt for fiscal years 2009 and 2008. Short-term Debt As of June 30, 2010, our $1.0 billion of commercial paper issued and outstanding had a weighted average interest rate, including issuance +costs, of 0.20% and maturities of 22 to 216 days. The estimated fair value of this commercial paper approximates its carrying value. In +November 2009, we replaced our $2.0 billion and $1.0 billion credit facilities with a $2.25 billion 364-day credit facility, which expires on November 5, 2010. This facility serves as a back-up for our commercial paper program. In June 2010, we +reduced the size of our credit facility from $2.25 billion to $1.0 billion due to the reduction in commercial paper outstanding. As of June 30, 2010, we were in compliance with the financial covenant in the credit facility agreement, which +requires a coverage ratio be maintained of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense. No amounts were drawn against the credit facility during any of the periods presented. Long-term Debt Notes As of June 30, 2010, we had issued and outstanding $3.75 billion of debt securities as illustrated in the table below (collectively “the +Notes”). Interest on the Notes is payable semi-annually on June 1 and December 1 of each year, to holders of record on the preceding May 15 and November 15. The Notes are senior unsecured obligations and rank equally +with our other unsecured and unsubordinated debt outstanding. 66 Table of Contents PART II Item 8 Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds +from the offering were $1.24 billion, net of fees and expenses which were capitalized. The majority of the proceeds were used to repay outstanding commercial paper, leaving $1.0 billion of commercial paper outstanding as of June 30, 2010. Each +$1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of +Microsoft’s common stock or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or +deliver cash, shares of our common stock or a combination of cash and shares of our common stock, at our election. Because the +convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are +recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity representing the fair value of the option +to convert the debt. In connection with the issuance of the notes, we entered into capped call transactions with certain option +counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased +from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price equal to +$37.16. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity. As of June 30, 2010, the +total carrying value and estimated fair value of our long-term debt, including convertible debt, were $4.94 billion and $5.21 billion, respectively. The estimate of fair value is based on quoted prices for our publicly-traded debt as of +June 30, 2010, as applicable. The effective interest yields of the Notes due in 2014, 2019, and 2039 were 3.00%, 4.29%, and 5.22%, respectively, at June 30, 2010. The effective interest yield of the convertible debt due in 2013 is 1.85% at +June 30, 2010 and the coupon interest rate is zero percent. The components of long-term debt as of June 30, 2010 were as +follows: (In millions) Zero coupon convertible notes due on June 15, 2013 $ 1,250 2.95% Notes due on June 1, 2014 2,000 4.20% Notes due on June 1, 2019 1,000 5.20% Notes due on June 1, 2039 750 Unamortized discount for Notes above (61 ) Total $ 4,939 Maturities of long-term debt for the next +five years are as follows: (In millions) Year Ending June 30, 2011 $ 0 2012 0 2013 1,250 2014 2,000 2015 0 Thereafter 1,750 Total $ 5,000 67 Table of Contents PART II Item 8 NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Current Taxes U.S. federal $ 4,415 $ 3,159 $ 4,357 U.S. state and local 357 192 256 International 1,701 1,139 1,007 Current taxes 6,473 4,490 5,620 Deferred Taxes Deferred taxes (220 ) 762 513 Provision for income taxes $ 6,253 $ 5,252 $ 6,133 U.S. and international components of +income before income taxes were as follows: (In millions) Year Ended June 30, 2010 2009 2008 U.S. $ 9,575 $ 5,529 $ 12,682 International 15,438 14,292 11,132 Income before income taxes $ 25,013 $ 19,821 $ 23,814 The items accounting for the difference +between income taxes computed at the federal statutory rate and the provision for income taxes were as follows: Year Ended June 30, 2010 2009 2008 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (12.1)% (9.3)% (7.0)% Internal Revenue Service settlement 0% 0% (5.8)% European Commission fine 0% 0% 2.1% Other reconciling items, net 2.1% 0.8% 1.5% Effective rate 25.0% 26.5% 25.8% In general, other reconciling items consist of interest, U.S. +state income taxes, domestic production deductions, and research credits. In fiscal years 2010, 2009 and 2008, there were no individually significant other reconciling items. 68 Table of Contents PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2010 2009 Deferred Income Tax Assets Stock-based compensation expense $ 1,329 $ 2,004 Other expense items 1,696 1,595 Unearned revenue 556 743 Impaired investments 289 236 Other revenue items 80 120 Deferred income tax assets $ 3,950 $ 4,698 Deferred Income Tax Liabilities International earnings $ (1,056 ) $ (1,191 ) Unrealized gain on investments (674 ) (516 ) Other (265 ) (499 ) Deferred income tax liabilities (1,995 ) (2,206 ) Net deferred income tax assets $ 1,955 $ 2,492 Reported As Current deferred income tax assets $ 2,184 $ 2,213 Long-term deferred income tax assets (liabilities) (229 ) 279 Net deferred income tax assets $ 1,955 $ 2,492 Deferred income tax balances reflect the +effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $29.5 billion resulting from +earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences is approximately $9.2 billion. Income taxes paid were $4.1 billion, $6.6 billion, and $5.4 billion in fiscal years 2010, 2009, and 2008, respectively. Uncertain Tax Positions As of +June 30, 2010, we had $6.5 billion of unrecognized tax benefits of which $5.6 billion, if recognized, would affect our effective tax rate. As of June 30, 2009, we had $5.4 billion of unrecognized tax benefits of which $4.4 billion, if +recognized, would affect our effective tax rate. Interest on unrecognized tax benefits was $193 million, $230 million, and $121 million +in fiscal years 2010, 2009 and 2008, respectively. As of June 30, 2010, 2009 and 2008, we had accrued interest related to uncertain tax positions of $747 million, $554 million, and $324 million, respectively, net of federal income tax benefits. 69 Table of Contents PART II Item 8 The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Balance, beginning of year $ 5,403 $ 3,195 $ 7,076 Decreases related to settlements (57 ) (82 ) (4,787 ) Increases for tax positions related to the current year 1,012 2,203 934 Increases for tax positions related to prior years 364 239 66 Decreases for tax positions related to prior years (166 ) (132 ) (80 ) Reductions due to lapsed statute of limitations (14 ) (20 ) (14 ) Balance, end of year $ 6,542 $ 5,403 $ 3,195 We are under audit by the IRS for the tax +years 2004-2006. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months as we do not believe the examination will be concluded within the +next 12 months. We are subject to income tax in many jurisdictions outside the U.S., and certain jurisdictions are under audit by local +tax authorities. The resolutions of these audits are not expected to be material to our financial statements. NOTE 14 — UNEARNED +REVENUE Unearned revenue comprises mainly unearned revenue from volume licensing programs, as well as payments for undelivered +elements and for other offerings for which we earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria. Volume Licensing Programs Unearned revenue +from volume licensing programs represents customer billings for multi-year licensing arrangements paid either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue +recognized ratably over the billing coverage period. Undelivered Elements Undelivered elements consist mainly of payments for unspecified upgrades or enhancements of Microsoft Internet Explorer on a when-and-if-available +basis for Windows XP, and technology guarantee programs. Other Also included in unearned revenue are payments for post-delivery support and consulting services to be performed in the future; Xbox LIVE +subscriptions; Microsoft Dynamics business solutions products; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The components of unearned revenue were as follows: (In millions) June 30, 2010 2009 Volume licensing programs $ 12,180 $ 11,350 Undelivered elements 624 1,083 Other 2,026 1,851 Total $ 14,830 $ 14,284 70 Table of Contents PART II Item 8 Unearned revenue by segment was as follows: (In millions) June 30, 2010 2009 Windows & Windows Live Division $ 1,701 $ 2,345 Server and Tools 5,282 4,732 Microsoft Business Division 7,004 6,508 Other segments 843 699 Total $ 14,830 $ 14,284 NOTE 15 — OTHER LONG-TERM +LIABILITIES (In millions) June 30, 2010 2009 Tax contingencies and other tax liabilities $ 6,887 $ 5,515 Legal contingencies 236 407 Product warranty 69 132 Other 253 215 Total $ 7,445 $ 6,269 NOTE 16 — COMMITMENTS AND +GUARANTEES Construction and Operating Leases We have committed $347 million for constructing new buildings, building improvements and leasehold improvements as of June 30, 2010. We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for facilities +operating leases was $530 million, $475 million, and $398 million, in fiscal years 2010, 2009, and 2008, respectively. Future minimum rental commitments under noncancellable facilities operating leases in place as of June 30, 2010 are as +follows: (In millions) Year Ending June 30, 2011 $ 437 2012 322 2013 256 2014 206 2015 and thereafter 677 Total $ 1,898 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third +parties arising from the use of our products and certain other matters. We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable +estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements. 71 Table of Contents PART II Item 8 Yahoo! Commercial Agreement On December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid +search platform for Yahoo! Web sites. The transaction received clearance, without restrictions, from both the U.S. Department of Justice and the European Commission during the third fiscal quarter of 2010. The term of the agreement is 10 years +subject to termination provisions after five years based on performance. Microsoft provided Yahoo! country level revenue per search +guarantees for a period of 18 months after implementation of the Bing search platform. These guarantees are calculated, paid, and trued-up in three six-month periods thereafter, and are intended to insure Yahoo! against any persistent drop in +revenue per search from pre-implementation levels. This is a rate guarantee not a guarantee of search volume. We estimate the total cost of the revenue per search guarantees during the guarantee period could range between zero and $150 million; +however, no amount has been recorded for the revenue per search guarantees as we do not believe that such liability exists at this time. Microsoft also agreed to reimburse Yahoo! for certain transition expenses incurred both before and after the effective date of the agreement. Finally, Microsoft also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration +to Microsoft’s platform. Product Warranty The changes in our aggregate product warranty liabilities, which are included in other current liabilities and other long term-liabilities on our +balance sheets, were as follows: (In millions) Year Ended June 30, 2010 2009 Balance, beginning of year $ 342 $ 692 Accruals for warranties issued 144 161 Adjustments to pre-existing warranties (2 ) 0 Settlements of warranty claims (244 ) (511 ) Balance, end of year $ 240 $ 342 NOTE 17 — CONTINGENCIES Government Competition Law Matters In March 2004, the European Commission issued a competition law decision that, among other things, ordered us to license certain Windows +server protocol technology to our competitors. In March 2007, the European Commission issued a statement of objections claiming that the pricing terms we proposed for licensing the technology as required by the March 2004 decision were +“not reasonable.” Following additional steps we took to address these concerns, the Commission announced on October 22, 2007 that we were in compliance with the March 2004 decision and that no further penalty should accrue after that +date. On February 27, 2008, the Commission issued a fine of $1.4 billion ( € 899 million) relating to the period prior to +October 22, 2007. In May 2008, we filed an application with the European Court of First Instance to annul the February 2008 fine. We paid the $1.4 billion +( € 899 million) fine in June 2008, pending the outcome of the appeal. In January 2008, the Commission opened a competition law investigation that relates primarily to interoperability with respect to our Microsoft +Office family of products. This investigation resulted from complaints filed with the Commission by a trade association of Microsoft’s competitors. Microsoft has made a number of proposals to address the Commission’s competition law +concerns in this area. The Commission announced on December 16, 2009 that it welcomed these proposals and that it will take them into account in assessing this matter. During the fourth quarter of fiscal year 2010, the trade association +withdrew its complaint that was the basis of the investigation. 72 Table of Contents PART II Item 8 We are also subject to a Consent Decree and Final Judgment (“Final Judgments”) that +resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating system businesses. The Final Judgments are +scheduled to expire in May 2011. In other ongoing investigations, various foreign governments and several state attorneys general have +requested information from us concerning competition, privacy, and security issues. Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian +courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused +to certify classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia. The settlements in all states have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle +them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that +are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued +is approximately $2.7 billion. The actual costs of these settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the +state overcharge class action cases will range between $1.9 billion and $2.0 billion. At June 30, 2010, we have recorded a liability related to these claims of approximately $651 million, which reflects our estimated exposure of $1.9 billion +less payments made to date of approximately $1.2 billion mostly for vouchers, legal fees, and administrative expenses. The three cases +pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. We have appealed this ruling. The other two actions have been stayed. Other Antitrust Litigation and Claims In +November 2004, Novell, Inc. filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of +WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. On March 30, 2010, the trial court granted +summary judgment in favor of Microsoft as to all remaining claims. Novell has appealed that ruling. Patent and Intellectual Property Claims In 2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain +Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a +trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to +$512 million to include $145 million of interest. We appealed that award to the Federal Circuit. In December 2008, we entered into a settlement agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving +approximately $500 million remaining in dispute. In September 2009, the United States Court of Appeals for the Federal Circuit affirmed the liability award but vacated the verdict and remanded the case to the trial court for a re-trial of the +damages ruling, indicating the damages previously awarded were too high. Trial on the remanded damages claim has been set for the first week of December 2010. 73 Table of Contents PART II Item 8 In October 2003, Uniloc USA Inc., a subsidiary of a Singapore-based security technology company, +filed a patent infringement suit in U.S. District Court in Rhode Island, claiming that product activation technology in Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we +did not infringe any of the claims of this patent, the court of appeals vacated the trial court decision and remanded the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful +infringement. In September 2009, the district court judge overturned the jury verdict, ruling that the evidence did not support the jury’s finding that Microsoft infringed the patent. Uniloc has appealed. In March 2007, i4i Limited Partnership sued Microsoft in U.S. District Court in Texas claiming that certain custom XML technology in Word 2003 and +2007 infringed i4i’s patent. In May 2009, a jury returned a verdict against us, finding damages of $200 million and that we willfully infringed the patent. In August 2009, the court denied our post-trial motions and awarded enhanced damages of +$40 million and prejudgment interest of $37 million. The court also issued a permanent injunction prohibiting additional distribution of the allegedly infringing technology. We appealed and the appellate court stayed the injunction pending our +appeal. On December 22, 2009, the court of appeals rejected our appeal and affirmed the trial court’s judgment and injunction, except that the court of appeals modified the effective date of the injunction to January 11, 2010. On +April 1, 2010, the court of appeals denied our request for a rehearing. We intend to seek review by the U.S. Supreme Court. In +2007, VirnetX Inc. brought suit in U.S. District Court in Texas claiming that various Microsoft products including Windows client and server operating systems software and communications software infringe two patents related to technology for +securely communicating over the Internet. This case was tried by a jury in March 2010. The jury returned a verdict that Microsoft willfully infringed both patents, and found damages of approximately $106 million. In March 2010, +VirnetX filed a new lawsuit in the Eastern District of Texas alleging that additional Microsoft products and services including Windows 7 and Windows Server 2008 R2 infringe the same two patents. The parties have reached an agreement to settle both +lawsuits. There are over 50 other patent infringement cases pending against Microsoft, 10 of which are set for trial in fiscal year +2010. Other We also are +subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material +adverse impact on our financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2010, we had accrued aggregate liabilities of approximately $1.0 billion in other current liabilities and approximately $236 +million in other long-term liabilities for all of the contingent matters described in this note. While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could reach approximately $800 +million in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable. NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock +outstanding were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Balance, beginning of year 8,908 9,151 9,380 Issued 140 75 173 Repurchased (380 ) (318 ) (402 ) Balance, end of year 8,668 8,908 9,151 74 Table of Contents PART II Item 8 Share Repurchases On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter +of fiscal year 2007 to buy back up to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases +with an expiration date of September 30, 2013. As of June 30, 2010, approximately $23.7 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without prior +notice. We repurchased the following shares of common stock under the above-described repurchase plans using cash resources: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2010 (a) 2009 (b) 2008 (c) First quarter 58 $ 1,445 223 $ 5,966 81 $ 2,348 Second quarter 125 3,583 95 2,234 120 4,081 Third quarter 67 2,000 0 0 30 1,020 Fourth quarter 130 3,808 0 0 171 4,975 Total 380 $ 10,836 318 $ 8,200 402 $ 12,424 (a) All shares repurchased in fiscal year 2010 were repurchased under the plan approved by our Board of Directors on September 22, 2008. (b) Of the 318 million shares of common stock repurchased in fiscal year 2009, 101 million shares were repurchased for $2.7 billion under the plan +approved by our Board of Directors during the first quarter of fiscal year 2007. The remaining shares were repurchased under the plan approved by our Board of Directors on September 22, 2008. (c) All shares repurchased in fiscal year 2008 were repurchased under the plan approved by our Board of Directors during the first quarter of fiscal year +2007. Dividends In fiscal year 2010, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 18, 2009 $ 0.13 November 19, 2009 $ 1,152 December 10, 2009 December 9, 2009 $ 0.13 February 18, 2010 $ 1,139 March 11, 2010 March 8, 2010 $ 0.13 May 20, 2010 $ 1,130 June 10, 2010 June 16, 2010 $ 0.13 August 19, 2010 $ 1,127 September 9, 2010 The dividend declared on June 16, 2010 will be paid after the filing date of this report on Form 10-K and was included in other current +liabilities as of June 30, 2010. In fiscal year 2009, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 19, 2008 $ 0.13 November 20, 2008 $ 1,157 December 11, 2008 December 10, 2008 $ 0.13 February 19, 2009 $ 1,155 March 12, 2009 March 9, 2009 $ 0.13 May 21, 2009 $ 1,158 June 18, 2009 June 10, 2009 $ 0.13 August 20, 2009 $ 1,157 September 10, 2009 The dividend declared on June 10, 2009 was included in other current liabilities as of June 30, 2009. 75 Table of Contents PART II Item 8 Cumulative Effects of Changes in Accounting Principle On July 1, 2007, we adopted guidance on accounting for uncertainty in income taxes, which provides a financial statement recognition threshold +and measurement attribute for a tax position taken or expected to be taken in a tax return. Upon adoption, we recognized a $395 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. On July 1, 2007, we adopted accounting guidance which requires companies to accrue the costs of compensated absences under a sabbatical or +similar benefit arrangement over the requisite service period. Upon adoption, we recognized a $17 million charge to our beginning retained deficit as a cumulative effect of a change in accounting principle. NOTE 19 — OTHER COMPREHENSIVE INCOME The activity in other comprehensive income and related income tax effects were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Net Unrealized Gains on Derivatives Unrealized gains, net of tax effects of $188 , $472, and $46 $ 349 $ 876 $ 86 Reclassification adjustment for gains included in net income, net of tax effects of $(173) , $(309), and $(36) (322 ) (574 ) (68 ) Net unrealized gains on derivatives $ 27 $ 302 $ 18 Net Unrealized Gains (Losses) on Investments Unrealized gains (losses), net of tax effects of $263 , $(142), and $(234) $ 488 $ (263 ) $ (435 ) Reclassification adjustment for losses (gains) included in net income, net of tax effects of $(120) , $16, and $(117) (223 ) 30 (218 ) Net unrealized gains (losses) on investments 265 (233 ) (653 ) Translation adjustments and other, net of tax effects of $(103) , $(133), and $69 (206 ) (240 ) 121 Other comprehensive income (loss) $ 86 $ (171 ) $ (514 ) The components of accumulated other +comprehensive income were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Net unrealized gains on derivatives $ 464 $ 437 $ 135 Net unrealized gains on investments 767 502 735 Translation adjustments and other (176 ) 30 270 Accumulated other comprehensive income $ 1,055 $ 969 $ 1,140 NOTE 20 — EMPLOYEE STOCK AND +SAVINGS PLANS Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Total stock-based compensation expense $ 1,891 $ 1,708 $ 1,479 Income tax benefits related to stock-based compensation $ 662 $ 598 $ 518 76 Table of Contents PART II Item 8 Employee Stock Purchase Plan We have an employee stock purchase plan for all eligible employees. Shares of our common stock may be purchased by employees at three-month +intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares +during the periods presented: (Shares in millions) Year Ended June 30, 2010 2009 2008 Shares purchased 20 24 18 Average price per share $ 23.73 $ 20.13 $ 26.78 At June 30, 2010, 64 million shares of our common stock were reserved for future issuance through the employee stock purchase plan. Stock Plans We have stock +plans for directors and for officers, employees, consultants, and advisors. At June 30, 2010, an aggregate of 690 million shares were authorized for future grant under our stock plans, which cover stock options, stock awards, and shared +performance stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares to satisfy exercises and vestings of awards granted under all of our stock plans. Stock Awards Stock awards +(“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. Our SAs generally vest over a five-year period. Shared Performance Stock Awards Shared +performance stock awards (“SPSAs”) are a form of SA in which the number of shares ultimately received depends on our business performance against specified performance targets. We granted SPSAs for fiscal years 2010, 2009, and 2008 with performance periods of July 1, 2009 through June 30, 2010, July 1, +2008 through June 30, 2009, and July 1, 2007 through June 30, 2008, respectively. In September following the end of each performance period, the number of shares of stock subject to the award is determined by multiplying the target +award by a percentage ranging from 0% to 150%. The percentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional number of shares, +approximately 12% of the total target SPSAs, are available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award vest following the end of the performance period, and an +additional one-quarter of the shares vest on each of the following three anniversaries of the grant date. Executive Officer Incentive Plan In fiscal year 2009, the Compensation Committee approved a new Executive Officer Incentive Plan (“EOIP”) for executive +officers of the Company. The EOIP replaced the annual cash bonus opportunity and equity award plans for executive officers. Under the EOIP, the Compensation Committee makes awards of performance-based compensation for specified performance +periods. For fiscal years 2010 and 2009, executive officers were eligible to receive annual awards comprised of cash and SAs from an incentive pool equal to a percentage of the Company’s operating income. For fiscal year 2010 it was 0.45% +of operating income, and for fiscal year 2009 it was 0.35% of operating income. Following approval of the awards, 20% of the award is payable to the executive officers in cash, and the remaining 80% is converted into an SA for shares of Microsoft +common stock. The SA portion of the award vests one-quarter immediately after the award is approved following fiscal year-end, and one-quarter on August 31 of each of the following three years. 77 Table of Contents PART II Item 8 We grant awards from the incentive pool to the executive officers in September following the end +of the fiscal year based on the officer’s performance during the prior fiscal year period. Each executive officer receives a fixed percentage of the pool ranging between 0% and 150% of a target based on an assessment of the executive +officer’s performance during the fiscal year. The number of shares subject to the SA portion of the award is determined by dividing the value of the award by the closing price of Microsoft common stock on August 31 of each year. Activity for All Stock Plans The fair value of each award is estimated on the date of grant using the following assumptions: Year Ended June 30, 2010 2009 2008 Dividends per share (quarterly amounts) $  0.13 $  0.11 - $  0.13 $  0.10 - $  0.11 Interest rates range 2.1% - 2.9% 1.4% - 3.6% 2.5% - 4.9% During fiscal year 2010, the following activity occurred under our existing plans: Shares Weighted Average Grant-Date Fair +Value (In millions) Stock Awards Nonvested balance, beginning of year 191 $ 25.69 Granted 100 $ 23.43 Vested (52 ) $ 25.50 Forfeited (16 ) $ 25.19 Nonvested balance, end of year 223 $ 24.76 Shared Performance Stock Awards Nonvested balance, beginning of year 28 $ 26.79 Granted 12 $ 24.57 Vested (7 ) $ 26.65 Forfeited (3 ) $ 25.74 Nonvested balance, end of year 30 $ 25.32 As of June 30, 2010, there was $4.2 billion and $482 million of total +unrecognized compensation costs related to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.4 years and 2.4 years, respectively. During fiscal year 2009 and 2008, the following activity occurred under our stock plans: (In millions, except fair values) 2009 2008 Stock Awards Awards granted 91 71 Weighted average grant-date fair value $ 24.95 $ 27.83 Shared Performance Stock Awards Awards granted 10 19 Weighted average grant-date fair value $ 25.93 $ 27.82 78 Table of Contents PART II Item 8 Stock Options In fiscal year 2004, we began granting employees and non-employee directors SAs rather than non-qualified and incentive stock options as part of +our equity compensation plans. Since then, stock options issued to employees have been issued primarily in conjunction with business acquisitions. Options granted between 1995 and 2001 generally vest over four and one-half years and expire seven +years from the date of grant, while certain options vest either over four and one-half years or over seven and one-half years and expire 10 years from the date of grant. Options granted after 2001 vest over four and one-half years and expire 10 +years from the date of grant. We granted one million, one million, and 10 million stock options in conjunction with business acquisitions during fiscal years 2010, 2009, and 2008, respectively. Employee stock options activity was as follows: Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value (In millions) (Years) (In millions) Balance, July 1, 2009 330 $ 27.99 Granted 1 $ 3.20 Exercised (74 ) $ 25.86 Canceled (69 ) $ 39.00 Forfeited (1 ) $ 12.94 Balance, June 30, 2010 187 $ 24.68 1.46 $ 143 Exercisable, June 30, 2010 186 $ 24.68 1.43 $ 130 Options outstanding as of June 30, 2010 include approximately three million options that were granted in conjunction with business +acquisitions. While these options are included in the options outstanding balance, they are excluded from the weighted average exercise price. These options have an exercise price range of $0.01 to $150.93 and a weighted average exercise price of +$7.49. During fiscal years 2010, 2009, and 2008, the following activity occurred under our stock plans: (In millions) 2010 2009 2008 Total intrinsic value of stock options exercised $ 365 $ 48 $ 1,042 Total vest-date fair value of stock awards vested $ 1,358 $ 1,137 $ 955 Total vest-date fair value of shared performance stock awards vested $ 227 $ 485 $ 401 Cash received from option exercises for fiscal years 2010, 2009, and 2008, was $1.8 billion, $88 million, and $3.0 billion, respectively. The +actual tax benefit realized for the tax deductions from option exercises totaled $126 million, $12 million, and $365 million for fiscal years 2010, 2009, and 2008, respectively. Savings Plan We have a savings plan in the +United States that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 50% of their salary, but not more than statutory limits. +We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $275 million, $262 million, and $238 million in fiscal +years 2010, 2009, and 2008, respectively, and were expensed as contributed. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in +the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock. 79 Table of Contents PART II Item 8 NOTE 21 — EMPLOYEE SEVERANCE In January 2009, we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and +capital expenditures. As part of this program, we announced the elimination of 5,000 positions in research and development, marketing, sales, finance, legal, human resources, and information technology. As of September 30, 2009, we had reduced +our overall number of positions by approximately 5,000 and headcount by approximately 4,600. In November 2009, we identified an +additional 800 positions for elimination based on our efforts to manage our expenses. Severance expense of approximately $52 million associated with these additional eliminations was reflected in our financial statements. We have now completed this +program and reduced our overall headcount by approximately 5,300. The changes in our employee severance liabilities related to our +resource management efforts were as follows: (In millions) Year Ended June 30, 2010 2009 Balance, beginning of period $ 127 $ 0 Employee severance charges 52 330 Adjustments 7 0 Cash payments (186 ) (203 ) Balance, end of period $ 0 $ 127 NOTE 22 — SEGMENT INFORMATION AND +GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, the Company’s +Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with accounting principles generally accepted in the U.S. (“U.S. GAAP”). Our five +segments are Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division. We have recast certain prior period amounts within this note to conform to the +way we internally managed and monitored segment performance during the current fiscal year, including moving Windows Live from Online Services Division to Windows & Windows Live Division and Razorfish from Online Services Division to +Corporate. Razorfish was sold during the second quarter of fiscal year 2010. Segment revenue and operating income (loss) were as +follows: (In millions) Year Ended June 30, 2010 2009 2008 Revenue Windows & Windows Live Division $ 17,788 $ 14,690 $ 16,815 Server and Tools 14,878 14,276 13,217 Online Services Division 2,198 2,110 2,164 Microsoft Business Division 18,909 18,864 18,904 Entertainment and Devices Division 8,114 8,035 8,502 Unallocated and other 597 462 818 Consolidated $ 62,484 $ 58,437 $ 60,420 80 Table of Contents PART II Item 8 (In millions) Year Ended June 30, 2010 2009 2008 Operating Income (Loss) Windows & Windows Live Division $ 12,089 $ 9,569 $ 11,876 Server and Tools 4,990 4,638 3,845 Online Services Division (2,436 ) (1,760 ) (619 ) Microsoft Business Division 11,664 11,454 11,681 Entertainment and Devices Division 589 (3 ) 314 Reconciling amounts (2,798 ) (3,535 ) (4,826 ) Consolidated $ 24,098 $ 20,363 $ 22,271 The types of products and services provided by each +segment are summarized below: Windows & Windows Live Division – Windows & Windows Live Division offerings +consist of Windows operating systems, including Windows 7, and online software and services through Windows Live. Windows Live primarily generates revenue from online advertising. Server and Tools – Server and Tools product and service offerings consist of Windows Server, Microsoft SQL Server, Windows Azure and +other cloud and server offerings. Server and Tools also offers Enterprise Services, which comprise Premier product support services and Microsoft Consulting Services. Online Services Division – Online Services Division consists of an online advertising platform with offerings for both publishers and +advertisers, online information offerings, such as Bing, and the MSN portals and channels around the world. Microsoft Business +Division – Microsoft Business Division offerings include Microsoft Office, SharePoint, and Microsoft Dynamics business solutions. Entertainment and Devices Division – Entertainment and Devices Division offerings include the Xbox 360 platform, the Zune digital music +and entertainment platform, PC software games, online games and services, Mediaroom (our Internet protocol television software), Windows Phone, Windows Embedded device platforms, application software for Apple’s Macintosh computers, and +Microsoft PC hardware products. Due to the integrated structure of our business, certain costs incurred by one segment may benefit +other segments. The costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually beneficial activity. Each allocation is +measured differently based on the specific facts and circumstances of the costs being allocated. These cost allocations were not material in any period presented. 81 Table of Contents PART II Item 8 In addition, certain costs incurred at a corporate level that are identifiable and that benefit +our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and +circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information +technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various +other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies to U.S. GAAP and corporate-level +activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, depreciation, and amortization of stock-based awards. Significant reconciling items were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Corporate-level +activity (a) $ (4,470 ) $ (4,542 ) $ (6,026 ) Stock-based compensation expense 571 770 790 Revenue reconciling amounts 369 256 396 Other 732 (19 ) 14 Total $ (2,798 ) $ (3,535 ) $ (4,826 ) (a) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. No sales to an individual customer accounted for more than 10% of fiscal year 2010, 2009, or 2008 revenue. Revenue, +classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2010 2009 2008 United +States (a) $ 36,173 $ 33,052 $ 35,928 Other countries 26,311 25,385 24,492 Total $ 62,484 $ 58,437 $ 60,420 (a) Includes shipments to customers in the United States and licensing to certain OEMs and multinational organizations. Revenues from external customers, classified by significant product and service offerings were as follows: (In millions) Year Ended June 30, 2010 2009 2008 Microsoft Office system $ 17,754 $ 17,998 $ 18,083 Windows PC operating systems 18,225 14,653 16,838 Server products and tools 12,007 11,344 10,611 Xbox 360 platform 5,456 5,475 5,598 Consulting and product support services 3,036 3,024 2,743 Advertising 2,528 2,345 2,425 Other 3,478 3,598 4,122 Total $ 62,484 $ 58,437 $ 60,420 82 Table of Contents PART II Item 8 Long-lived assets, excluding financial instruments and deferred taxes, classified by the location +of the controlling statutory company, were as follows: (In millions) June 30, 2010 2009 2008 United States $ 18,716 $ 19,362 $ 19,129 Other countries 2,466 2,435 1,194 Total $ 21,182 $ 21,797 $ 20,323 NOTE 23 — QUARTERLY INFORMATION +(Unaudited) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2010 Revenue $ 12,920 (b) $ 19,022 (a) $ 14,503 $ 16,039 $ 62,484 Gross profit 10,078 15,394 11,748 12,869 50,089 Net income 3,574 6,662 4,006 4,518 18,760 Basic earnings per share 0.40 0.75 0.46 0.52 2.13 Diluted earnings per share 0.40 0.74 0.45 0.51 2.10 Fiscal Year 2009 Revenue $ 15,061 $ 16,629 $ 13,648 $ 13,099 (c) $ 58,437 Gross profit 12,213 12,722 10,834 10,513 46,282 Net income 4,373 4,174 2,977 (d) 3,045 (d) 14,569 Basic earnings per share 0.48 0.47 0.33 0.34 1.63 Diluted earnings per share 0.48 0.47 0.33 0.34 1.62 Fiscal Year 2008 Revenue $ 13,762 $ 16,367 $ 14,454 $ 15,837 $ 60,420 Gross profit 11,087 12,824 11,940 12,971 48,822 Net income 4,289 4,707 4,388 (e) 4,297 17,681 Basic earnings per share 0.46 0.50 0.47 0.46 1.90 Diluted earnings per share 0.45 0.50 0.47 0.46 1.87 (a) Reflects $1.7 billion of revenue recognized for sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and of Windows 7 +to original equipment manufacturers and retailers before general availability (the “Windows 7 Deferral”). (b) Reflects $1.5 billion of revenue deferred to future periods relating to the Windows 7 Deferral. (c) Reflects $276 million of revenue deferred to future periods relating to the Windows 7 Deferral. (d) Includes employee severance of $290 million and $40 million (pre-tax) in the third and fourth quarters of the year ended June 30, 2009, respectively. (e) Includes charge of $1.4 billion ( € 899 +million) related to the fine imposed by the European Commission in February 2008. 83 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of +June 30, 2010 and 2009, and the related consolidated statements of income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2010. These financial statements are the responsibility of +the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We +conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial +statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and +significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation +and subsidiaries as of June 30, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2010, in conformity with accounting principles generally accepted in the +United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board +(United States), the Company’s internal control over financial reporting as of June 30, 2010, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of +the Treadway Commission and our report dated July 30, 2010, expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 30, +2010 84 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have +evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer +have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON +INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control +over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles +generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are +recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that +unauthorized acquisition, use, or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial +reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal +Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as +of June 30, 2010. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over +financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2010; their report is included in Item 9A. 85 Table of Contents PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the “Company”) as of +June 30, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for +maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over Financial +Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered +necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal +control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of +directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting +principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and +dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts +and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or +disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent +limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, +projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance +with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal +control over financial reporting as of June 30, 2010, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial +statements as of and for the year ended June 30, 2010, of the Company and our report dated July 30, 2010, expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 30, 2010 86 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may +be found under the caption “Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 16, 2010 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption +“Board Committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy +Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our +Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our Web site at +www.microsoft.com/investor/CorporateGovernance/BoardofDirectors/Contacts/MSFinanceCode.aspx. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our +Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or waiver on that Web site or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer +Compensation,” “Compensation Committee Report,” and “Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information Regarding Beneficial Ownership of Principal +Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related +Transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND +SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees +Billed by Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. 87 Table of Contents PART IV Item 15 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since +they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 44 Balance Sheets 45 Cash Flows Statements 46 Stockholders’ Equity Statements 47 Notes to Financial Statements 48 Report of Independent Registered Public Accounting Firm 84 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/09 3.1 1/28/10 3.2 Bylaws of Microsoft Corporation 10-Q 12/31/09 3.2 1/28/10 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.3 Indenture, dated as of June 14, 2010, between Microsoft Corporation and the Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 6/18/10 4.4 Form of Global Note representing the Zero Coupon Convertible Senior Notes due 2013 8-K 4.2 6/18/10 10.1* Microsoft Corporation 2001 Stock Plan 8-K 99.2 7/20/06 10.2* Microsoft Corporation 1991 Stock Option Plan 8-K 99.1 7/20/06 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation 2003 Employee Stock Purchase Plan 10-K 6/30/04 10.6 9/1/04 10.5* Microsoft Corporation Deferred Compensation Plan S-8 99.1 2/28/06 88 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.6* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.8* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period 10-K 6/30/04 10.10 9/1/04 10.9* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period 10-K 6/30/04 10.11 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee X 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee X 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.15* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2007 performance period 10-K 6/30/07 10.17 8/3/07 10.16* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2008 performance period 10-Q 12/31/07 10.18 1/24/08 10.17* Executive Officer Incentive Plan 10-Q 9/30/08 10.17 10/23/08 10.18* Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/08 10.18 10/23/08 10.19* Annual Performance Bonus Plan for Executive Officers 10-Q 10.19 1/22/09 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 89 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS** XBRL Instance Document X 101.SCH** XBRL Taxonomy Extension Schema X 101.CAL** XBRL Taxonomy Extension Calculation Linkbase X 101.DEF** XBRL Taxonomy Extension Definition Linkbase X 101.LAB** XBRL Taxonomy Extension Label Linkbase X 101.PRE** XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus +for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability. 90 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 30, 2010. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of +Registrant and in the capacities indicated on July 30, 2010. Signature Title / S /    W ILLIAM H. G ATES III William H. Gates III Chairman / S /    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer / S /    D INA D UBLON Dina Dublon Director / S /    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director / S /    R EED H ASTINGS Reed Hastings Director / S /    M ARIA K LAWE Maria Klawe Director / S /    D AVID F. +M ARQUARDT David F. Marquardt Director / S /    C HARLES H. +N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    P ETER S. +K LEIN Peter S. Klein Chief Financial Officer (Principal Financial +Officer) / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting +Officer) 91 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-11-200680/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-11-200680/full-submission.txt new file mode 100644 index 0000000..12cc593 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-11-200680/full-submission.txt @@ -0,0 +1,1031 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2011 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  +to Commission File Number +0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such +shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its +corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was +required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2010, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $208,370,414,170 based on the closing sale price as reported on the NASDAQ +National Market System. As of July 20, 2011, there were 8,378,265,782 shares of common stock outstanding. DOCUMENTS INCORPORATED +BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of +Shareholders to be held on November 15, 2011 are incorporated by reference into Part III. Table of Contents MICROSOFT CORPORATION FORM 10-K For The Fiscal +Year Ended June 30, 2011 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 12 Item 1A. Risk Factors 14 Item 1B. Unresolved Staff Comments 20 Item 2. Properties 20 Item 3. Legal Proceedings 21 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 21 Item 6. Selected Financial Data 22 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 22 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 44 Item 8. Financial Statements and Supplementary Data 46 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 86 Item 9A. Controls and Procedures 86 Report of Management on Internal Control over Financial Reporting 86 Report of Independent Registered Public Accounting Firm 87 Item 9B. Other Information 88 PART III Item 10. Directors, Executive Officers and Corporate Governance 88 Item 11. Executive Compensation 88 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 88 Item 13. Certain Relationships and Related Transactions, and Director Independence 88 Item 14. Principal Accounting Fees and Services 88 PART IV Item 15. Exhibits and Financial Statement Schedules 89 Signatures 92 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business +plans, objectives and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of +the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business,” “Management’s +Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” +“intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely +result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. +A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part I, Item 1A of this Form +10-K). We undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Microsoft was +founded in 1975. Our mission is to enable people and businesses throughout the world to realize their full potential. We work to achieve this mission by creating technology that transforms the way people work, play, and communicate. We develop and +market software, services, and hardware that deliver new opportunities, greater convenience, and enhanced value to people’s lives. We do business worldwide and have offices in more than 100 countries. We generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware, and +by delivering relevant online advertising to a global customer audience. In addition to selling individual products and services, we offer suites of products and services. Our products include operating systems for personal computers (“PCs”), servers, phones, and other intelligent devices; server applications for distributed computing environments; productivity +applications; business solution applications; desktop and server management tools; software development tools; video games; and online advertising. We also design and sell hardware including the Xbox 360 gaming and entertainment console, Kinect for +Xbox 360, Xbox 360 accessories, and Microsoft PC hardware products. We provide consulting and product and solution support services, +and we train and certify computer system integrators and developers. We also offer cloud-based solutions that provide customers with software, services and content over the Internet by way of shared computing resources located in centralized data +centers. Cloud revenue is earned primarily from usage fees and advertising. Examples of cloud-based computing services we offer +include: • Bing, our Internet search engine that finds and organizes the answers people need so they can make faster, more informed decisions; • Windows Live Essentials suite, which allows users to upload, organize and store photos, make movies, communicate via video, email, and messaging, and enhance +online safety; • Xbox LIVE service, which enables online gaming, social networking, and access to a wide range of video, gaming, and entertainment content; • Microsoft Office 365, an online suite that enables people to work from virtually anywhere, anytime, and on any device with simple, familiar collaboration and +communication solutions, including Microsoft Office, Exchange, SharePoint, and Lync; 3 Table of Contents PART I Item 1 • Microsoft Dynamics CRM Online customer relationship management services for sales, service and marketing professionals provided through a familiar Microsoft +Outlook interface; and • the Azure family of platform and database services that helps developers connect applications and services in the cloud or on premise. These services include +Windows Azure, a scalable operating system with computing, storage, hosting and management capabilities, and Microsoft SQL Azure, a relational database. We also conduct research and develop advanced technologies for future software products and services. We believe that delivering innovative, high-value solutions through our integrated software and services +platforms is the key to meeting our customers’ needs and to our future growth. We believe that we will continue to grow by delivering compelling new products and services, creating new opportunities for partners, improving customer +satisfaction, and improving our service excellence, business efficacy, and internal processes. OPERATING SEGMENTS We operate our business in five segments: Windows & Windows Live Division, Server and Tools, Online Services Division, Microsoft Business +Division, and Entertainment and Devices Division. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and +services organizations, and they provide a framework for timely and rational allocation of development, sales, marketing, and services resources within businesses. Additional information on our operating segments and geographic and product +information is contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Windows & Windows Live Division Windows & Windows Live Division +(“Windows Division”) develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through efficient +Web browsing and seamless operations across the user’s hardware and software. Windows Division revenue growth is largely correlated to the growth of the PC market worldwide, as approximately 75% of total Windows Division revenue comes from +Windows operating system software purchased by original equipment manufacturers (“OEMs”), which they pre-install on equipment they sell. In addition to PC market changes, Windows revenue is impacted by: • hardware market changes driven by shifts between developed markets and emerging markets, consumer PCs and business PCs, and among varying forms of computing +devices; • the attachment of Windows to PCs shipped and changes in inventory levels within the OEM channel; and • pricing changes and promotions, pricing variation associated with OEM channel shifts from local and regional system builders to large, multinational OEMs, and +different pricing of Windows versions licensed. Principal Products and +Services : Windows 7 and prior versions of the Windows operating system; Windows Live suite of applications and web services; and Microsoft PC hardware products. Competition The Windows operating system +faces competition from various commercial software products offered by well-established companies, mainly Apple and Google. The Windows operating system also faces competition from alternative platforms and devices that may reduce demand for PCs. +User and usage volumes on mobile devices are increasing worldwide relative to the PC. We believe Windows competes effectively by giving customers choice, flexibility, security, a familiar and easy-to-use interface, compatibility with a broad range +of hardware and software applications, and the largest support network for any operating system. 4 Table of Contents PART I Item 1 Windows Live software and services compete with Apple, Google, Yahoo!, and a wide array of Web +sites and portals that provide communication and sharing tools and services. Our PC hardware products face competition from computer and other hardware manufacturers, many of which are also current or potential partners. Server and Tools Server and Tools develops +and markets server software, software developer tools, services, and solutions that are designed to make information technology professionals and developers and their systems more productive and efficient. Server software is integrated server +infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, storage, management and operations, service-oriented architecture platform, security +and identity software. Server and Tools also builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server offerings can be run on-site, in a partner-hosted environment, or in a +Microsoft-hosted environment. Our cloud-based services comprise a scalable operating system with computing, storage, and management +capabilities and a relational database, which allow customers to run enterprise workloads and web applications in the cloud. These services also include a platform that helps developers connect applications and services in the cloud or on premise. +Our goal is to enable customers to devote more resources to development and use of applications that benefit their business, rather than to the management of on-premise hardware and software. Server and Tools offers a broad range of enterprise consulting and product support services (“Enterprise Services”) that assist customers +in developing, deploying, and managing Microsoft server and desktop solutions. Server and Tools also provides training and certification to developers and information technology professionals for our Server and Tools, Microsoft Business Division, +and Windows & Windows Live Division products and services. Approximately 50% of Server and Tools revenue comes primarily from +multi-year volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services. Principal Products and Services : Windows Server operating systems; Windows Azure; +Microsoft SQL Server; SQL Azure; Windows Intune; Windows Embedded; Visual Studio; Silverlight; System Center products; Microsoft Consulting Services; and Premier product support services. Competition Our server operating system products face competition from a wide variety of +server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system +preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large +number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions with several companies that offer solutions and middleware technology platforms. IBM and Oracle lead a group of companies focused on the Java Platform +Enterprise Edition. Commercial software developers that provide competing server applications for PC-based distributed client/server environments include CA Technologies, IBM, and Oracle. Our Web application platform software competes with open +source software such as Apache, Linux, MySQL, and PHP, and we compete against Java middleware such as Geronimo, JBoss, and Spring Framework. Numerous commercial software vendors offer competing software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. System Center competes with server +management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMWare in 5 Table of Contents PART I Item 1 the management of information technology infrastructures. SQL Server competes with products from IBM, Oracle, Sybase, and other companies in providing database, business intelligence and data +warehousing solutions. Our products for software developers compete against offerings from Adobe, IBM, Oracle, other companies, and open-source projects. Competing open source projects include Eclipse (sponsored by CA Technologies, IBM, Oracle, and +SAP), PHP, and Ruby on Rails, among others. The embedded operating system business is highly fragmented with many competitive +offerings. Key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. Our cloud-based services offerings also have many competitors. Windows Azure faces competition from Amazon, Google, Salesforce.com, and VMWare. SQL Azure faces competition from IBM, Oracle, and other open source +offerings. For Enterprise Services, we compete with a large group of diverse companies, including multinational consulting firms and small niche businesses focused on specific technologies. We believe our server products, cloud-based services and Enterprise Services provide customers with advantages in innovation, performance, total +costs of ownership, and productivity by delivering superior applications, development tools, and compatibility with a broad base of hardware and software applications, security, and manageability. Online Services Division Online Services +Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and +advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising. Search and display advertising generally accounts for nearly all of OSD’s annual revenue. We provide updated and new online offerings on a frequent basis. In December 2009, we entered into a definitive agreement with Yahoo! whereby +Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites worldwide. We completed the algorithmic transition in the U.S. and Canada in July 2010 and the paid search transition in October 2010 and have begun +transitioning algorithmic search in international markets. We believe this agreement will allow us to improve the effectiveness and increase the value of our search offering through greater scale in search queries and an expanded and more +competitive search and advertising marketplace. Principal Products and +Services : Bing; Microsoft adCenter; MSN; and Atlas online tools for advertisers. Competition OSD competes with Google, Yahoo!, and a wide array of Web sites and portals that provide content and online offerings to end users. We compete with +these organizations to provide advertising opportunities for merchants. Competitors are continuously developing Internet offerings that seek to provide more effective ways of connecting advertisers with audiences. We believe our search engine, Bing, +helps users make faster, more informed decisions by providing relevant search results, expanded search services, social recommendations, and a broad selection of content. We have enhanced the user interface to bring a richer search experience. We +also invest in improving the scale of our advertising platform to serve both owned and operated and third-party online properties. We will continue to introduce new products and services to improve the user online experience. We believe that we can +compete effectively by attracting new users, understanding their intent, and matching their intent with relevant content, advertiser offerings, and software services. Microsoft Business Division Microsoft Business Division (“MBD”) offerings consist +of the Microsoft Office system (comprising mainly Office, SharePoint, Exchange and Lync) and Microsoft Dynamics business solutions. Microsoft Office system products are designed to increase personal, team, and organization productivity through +a range of programs, services, and 6 Table of Contents PART I Item 1 software solutions, which may be delivered either on premise or as a cloud-based service. Growth of revenue from the Microsoft Office system offerings, which generate over 90% of MBD revenue, +depends on our ability to add value to the core Office product set and to continue to expand our product offerings in other areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. +Microsoft Dynamics products provide business solutions for financial management, customer relationship management (“CRM”), supply chain management, and analytics applications for small and mid-size businesses, large organizations, and +divisions of global enterprises. Approximately 80% of MBD revenue is generated from sales to businesses, which includes Microsoft +Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue. Revenue from this category generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent +of the number of PCs sold in a given year. Approximately 20% of MBD revenue is derived from sales to consumers, which includes revenue from retail packaged product sales and OEM revenue. This revenue generally is affected by the level of PC +shipments and by product launches. Principal Products and +Services : Microsoft Office; Microsoft Exchange; Microsoft SharePoint; Microsoft Lync; Microsoft Dynamics ERP and Dynamics CRM; and Microsoft Office Web Apps, which are the online companions to Microsoft Word, +Excel, PowerPoint, and OneNote. In June 2011, MBD launched Office 365, which is an online services offering of Microsoft Office, Exchange, SharePoint, and Lync. Competition Competitors to the Microsoft Office system include software application vendors +such as Adobe, Apple, Corel, Google, IBM, Oracle, and numerous Web-based competitors as well as local application developers in Asia and Europe. Apple may distribute certain versions of its application software products with various models of its +PCs and through its mobile devices. Corel and IBM have measurable installed bases with their office productivity products. Google provides a hosted messaging and productivity suite that competes with Microsoft Office, Microsoft Exchange, and +Microsoft SharePoint, including its FAST enterprise search technology. The OpenOffice.org project provides a freely downloadable cross-platform application that also has been adapted by various commercial software vendors to sell under their +brands. Web-based offerings competing with individual applications can also position themselves as alternatives to Microsoft Office system products. Our Microsoft Dynamics products compete with vendors such as Infor and Sage in the market focused on providing business solutions for small and mid-sized businesses. The market for large organizations and +divisions of global enterprises is intensely competitive with a small number of primary vendors including Oracle and SAP. Additionally, Salesforce.com’s on-demand CRM offerings compete directly with Microsoft Dynamics CRM Online and +Microsoft Dynamics CRM’s on-premise offerings. As we continue to create additional functionality and products, we compete with +additional vendors, most notably in content management and enterprise search, collaboration tools, unified communications, and business intelligence. These competitors include Cisco, Google, IBM, Oracle, and SAP. We believe our products compete +effectively based on our strategy of providing flexible, easy to use solutions that work well with technologies our customers already have. Entertainment and Devices Division Entertainment and Devices Division (“EDD”) develops and markets products and services designed to entertain and connect people. The Xbox +360 entertainment platform, including Kinect, is designed to provide a unique variety of entertainment choices for individuals and families through the use of our devices, peripherals, content, and online services. Mediaroom is designed to provide +live, recorded, and on-demand television programming regardless of your location or device. Windows Phone is designed to bring users closer to the people, applications, and content they need, while providing unique capabilities such as Microsoft +Office and Xbox LIVE functionality. 7 Table of Contents PART I Item 1 Nokia strategic alliance On April 21, 2011, Microsoft and Nokia entered into definitive agreements to form a strategic alliance to jointly create new mobile products and services and to extend established products and services to new +markets. Microsoft will license to Nokia and Nokia will adopt Windows Phone as Nokia’s primary smartphone platform. Microsoft will +receive a running royalty at a competitive rate from Nokia for the Windows Phone platform, with minimum commitments reflecting the large volumes Nokia expects to ship. We will also provide Nokia with developer tools to accelerate developer support +for Windows and Windows-related platforms. Microsoft and Nokia will collaborate on joint developer outreach and application sourcing. Microsoft’s Windows Marketplace infrastructure will support a new Nokia-branded application store. +Participants in the Windows Phone ecosystem will be able to take advantage of Nokia’s billing agreements with operators in markets worldwide. Nokia will deliver mapping, navigation, and location-based services to the Windows Phone ecosystem and will deliver a core set of mapping services for a broader set of Microsoft’s map-based offerings. +Microsoft’s Bing and adCenter will power search and advertising on Nokia’s devices and services. Nokia will innovate and customize on the Windows Phone platform, contributing its expertise on hardware, design, and language support and will +help bring Windows Phone to a broader range of price points, market segments and geographies. Microsoft will make annual payments to Nokia, in recognition of the unique nature of Nokia’s agreement with Microsoft and the contributions that Nokia +is providing. The agreements recognize the value of intellectual property portfolios and put in place mechanisms for exchanging rights +to intellectual property. As part of these arrangements, Nokia will receive payments including consideration to be paid as part of a mutual release. Principal Products and Services: Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox 360 accessories; Xbox LIVE; Mediaroom; and Windows +Phone. Competition Entertainment and devices businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and +game titles, and the development of new technologies. The markets for our products are characterized by significant price competition, and we anticipate continued pricing pressure from our competitors. Our competitors vary in size from very small +companies with limited resources to very large, diversified corporations with substantial financial and marketing resources. We compete primarily on the basis of product innovation, quality and variety, timing of product releases, and effectiveness +of distribution and marketing. Our Xbox gaming and entertainment business competes with console platforms from Nintendo and Sony, both +of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles averages five to 10 years. We released Xbox 360, our second generation console, in November 2005. Nintendo and Sony released new versions of +their game consoles in late 2006. We believe the success of gaming and entertainment consoles is determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of +the console, and the ability to create new experiences via online services, downloadable content, and peripherals. In addition to Nintendo and Sony, our businesses compete with both Apple and Google in offering content products and services to the +consumer. We believe the Xbox 360 entertainment platform is positioned well against competitive products and services based on significant innovation in hardware architecture, new developer tools, online gaming and entertainment services, and +continued strong exclusive content from our own game franchises as well as other digital content offerings. Windows Phone faces +competition primarily from Apple, Google, and Research In Motion. Mediaroom faces competition primarily from a variety of competitors that provide elements of an Internet protocol television delivery platform, but that do not provide end-to-end +solutions for the network operator. 8 Table of Contents PART I Item 1 OPERATIONS We have operations centers that support all operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The +regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, +Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate data centers throughout the U.S. and in Europe. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of +our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. We contract most of our manufacturing activities for Xbox 360 and related games, Kinect for Xbox 360, various retail software packaged products, and Microsoft hardware to third parties. Our products may include +some components that are available from only one or limited sources. Our Xbox 360 console and Kinect for Xbox 360 include key components that are supplied by a single source. The integrated central processing unit/graphics processing unit is +purchased from IBM, and the supporting embedded dynamic random access memory chips are purchased from Taiwan Semiconductor Manufacturing Company. Although we have chosen to initially source these components from a single supplier, we are under no +obligation to exclusively source the components from these vendors in the future. We generally have the ability to use other manufacturers if the current vendor becomes unavailable. We generally have multiple sources for raw materials, supplies, and +components, and are often able to acquire component parts and materials on a volume discount basis. RESEARCH AND DEVELOPMENT During fiscal years 2011, 2010, and 2009, research and development expense was $9.0 billion, $8.7 billion, and $9.0 billion, +respectively. These amounts represented 13%, 14%, and 15%, respectively, of revenue in each of those years. We plan to continue to make significant investments in a broad range of research and product development efforts. Product Development and Intellectual Property Most of our software products and services are developed internally. Internal development allows us to maintain competitive advantages that come from closer technical control over our products and services. It also +gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect +software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our investments in innovation in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of +copyright, trademark, trade secret, and other protections that apply to our software products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 26,000 U.S. +and international patents issued and over 36,000 pending. While we employ many of our innovations exclusively in Microsoft products and services, we also engage in outbound and inbound licensing of specific patented technologies that are +incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. From time to time, we purchase or license technology +that we incorporate in our products or services. While it may be necessary in the future to seek or renew licenses relating to various +aspects of our products and business methods, we believe, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms. We believe our continuing innovation and product development are +not materially dependent on any single license or other agreement with a third party relating to the development of our products. 9 Table of Contents PART I Item 1 Investing in Innovation Innovation is the foundation for Microsoft’s success. Our model for growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and +product areas, and to drive broad adoption of the products and services we develop and market. Our innovation investments focus on the emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to +our customers and growth for the company. We maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning communication and collaboration; information access and organization; +entertainment; business and e-commerce; advertising; and devices. While our main research and development facilities are located in +Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, Denmark, England, India, Ireland, and Israel. This global approach will help us remain competitive in +local markets and enable us to continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We +also fund research and development activities at the business segment level. Many of the innovations created by our business segments are coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s +largest computer science research organizations, and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends. Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, areas +where we see significant opportunities to drive future growth include smart connected devices, cloud computing, entertainment, search, communications, and productivity. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services +primarily through the following channels: OEM; distributors and resellers; and online. OEM We distribute software through OEMs that pre-install our software on new PCs, servers, smartphones, and other intelligent devices that they sell to +end customers. The largest component of the OEM business is the Windows operating system pre-installed on PCs. OEMs also sell hardware pre-installed with other Microsoft products, including server operating systems and application products and +desktop applications such as our Microsoft Office suite. In addition to these products, we also market through OEMs software services such as our Windows Live Essentials suite. There are two broad categories of OEMs. The largest OEMs, many of which operate globally, are referred to as “Direct OEMs,” as our +relationship with them is managed through a direct agreement between Microsoft and the manufacturer. We have distribution agreements covering one or more of our products with virtually all of the multinational OEMs, including Acer, ASUSTek, Dell, +Fujitsu, HTC, Hewlett-Packard, LG, Lenovo, NEC, Nokia, Samsung, Sony, Toshiba, and with many regional and local OEMs, including Medion, MSI, and Positivo. The second broad category of OEMs consists of lower-volume PC manufacturers (also called +“System Builders”), which source their Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Some of the +distributors in the Microsoft distributor channel are global, such as Ingram Micro and Tech Data, but most operate at a local or regional level. 10 Table of Contents PART I Item 1 Distributors and Resellers Many organizations that license our products and services through enterprise agreements transact directly with us, with sales support from solution integrators, independent software vendors, web agencies, and +developers that advise organizations on licensing our products and services (“Enterprise Software Advisors”). Organizations also license our products and services indirectly, primarily through large account resellers (“LARs”), +distributors, value-added resellers (“VARs”), OEMs, system builder channels and retailers. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations, distributors resell +primarily to VARs, and VARs typically reach small-sized and medium-sized organizations. Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs, such as the Select and Open +licensing programs discussed under “Licensing Options” below. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our +Microsoft Dynamics software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our retail packaged products primarily through independent +non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets, such as Wal-Mart and Dixons. We have a network of field sales representatives and field +support personnel that solicits orders from distributors and resellers, and provides product training and sales support. Online Although client-based software will continue to be an important part of our business, increasingly we are delivering additional value to customers +through cloud-based services. We provide online content and services to consumers through Bing, MSN portals and channels, Microsoft Office Web Apps, Microsoft Security Essentials, Windows Live Essentials suite, Windows Phone Marketplace, Xbox LIVE, +and Zune Marketplace. We provide content and services to business users through the Microsoft Online Services platform, which includes cloud-based services such as Business Productivity Online Standard Suite, Exchange Online, Microsoft Dynamics CRM +Online, Microsoft Lync, Microsoft Office 365, Microsoft Office Communications Online, Microsoft Office Live Meeting, SQL Azure, SharePoint Online, Windows Azure, and Windows Intune. Other services delivered online include our online advertising +platform with offerings for advertisers, as well as Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our +products and solutions. LICENSING OPTIONS We license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products and services. Our arrangements for organizations to acquire multiple licenses of +products and services are designed to provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs +designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. Open Licensing Designed primarily for small-to-medium organizations (5 to over 250 licenses), +Open licensing programs allow customers to acquire perpetual or subscription licenses and, at the customer’s election, rights to future versions of software products over a specified time period (two or three years depending on the Open program +used). The offering that conveys rights to future versions of certain software products over the contract period is called software assurance. Software assurance also provides support, tools, and training to help customers deploy and use software +efficiently. Under the Open program, customers can acquire licenses only, or licenses with software assurance. They can also renew software assurance upon the expiration of existing volume licensing agreements. 11 Table of Contents PART I Item 1 Select Licensing Designed primarily for medium-to-large organizations (greater than 250 licenses), the Select program allows customers to acquire perpetual licenses and, at the customer’s election, software assurance over a +specified time period (generally three years or less). Similar to the Open program, the Select program allows customers to acquire licenses only, acquire licenses with software assurance, or renew software assurance upon the expiration of existing +volume licensing agreements. Online services are also available for purchase through the Select program, and subscriptions are generally structured with terms between one and three years. Services Provider Licensing The Microsoft Services Provider License Agreement +(“SPLA”) is a program targeted to service providers and Independent Software Vendors (“ISVs”) allowing these partners to provide software services and hosted applications to their end customers. Agreements are generally +structured with a three-year term, and partners are billed monthly based upon consumption. Enterprise Agreement Licensing Enterprise agreements are targeted at medium and large organizations (greater than 250 licenses) that want to acquire licenses to software +products, along with software assurance, for all or substantial parts of their enterprise. Enterprises can elect to either acquire perpetual licenses or, under the Enterprise Subscription program, can acquire non-perpetual, subscription agreements +for a specified time period (generally three years). Online services are also available for purchase through the Enterprise agreement and subscriptions are generally structured with three year terms. CUSTOMERS Our customers +include individual consumers, small- and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet service providers, application developers, and OEMs. Consumers and small- and medium-sized organizations +obtain our products primarily through distributors, resellers, and OEMs. No sales to an individual customer accounted for more than 10% of fiscal year 2011, 2010, or 2009 revenue. Our practice is to ship our products promptly upon receipt of +purchase orders from customers; consequently, backlog is not significant. EXECUTIVE OFFICERS OF THE +REGISTRANT Our executive officers as of July 28, 2011 were as follows: Name Age Position with the Company Steven A. Ballmer 55 Chief Executive Officer Lisa E. Brummel 51 Senior Vice President, Human Resources Kurt D. DelBene 51 President, Microsoft Office Division Peter S. Klein 48 Chief Financial Officer Craig J. Mundie 62 Chief Research and Strategy Officer Satya Nadella 43 President, Server and Tools Steven Sinofsky 45 President, Windows & Windows Live Division Bradford L. Smith 52 Senior Vice President; General Counsel; Secretary B. Kevin Turner 46 Chief Operating Officer Mr. Ballmer was appointed Chief Executive Officer in +January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. Mr. Ballmer joined Microsoft in 1980. 12 Table of Contents PART I Item 1 Ms. Brummel was named Senior Vice President, Human Resources in December 2005. She had +been Corporate Vice President, Human Resources since May 2005. From May 2000 to May 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of +management positions at Microsoft, including general manager of Consumer Productivity business, product unit manager of the Kids business, and product unit manager of Desktop and Decision reference products. Mr. DelBene was named President, Microsoft Office Division in September 2010. He served as Senior Vice President for the Microsoft Business +Division since 2006. Since joining Microsoft in 1992, Mr. DelBene has served in several roles in Microsoft’s product development teams, including Vice President of Authoring and Collaboration Services, General Manager of Microsoft Outlook, +Group Program Manager for Microsoft Exchange, and Group Manager in Microsoft’s Systems Division. Mr. Klein was named Chief +Financial Officer in November 2009. He served as Corporate Vice President, Chief Financial Officer, Microsoft Business Division from February 2006 to November 2009 and Chief Financial Officer of Server and Tools from July 2003 to February 2006. +Mr. Klein joined Microsoft in 2002. Mr. Mundie was named Chief Research and Strategy Officer in June 2006. He had been Senior +Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie joined Microsoft in 1992. Mr. Nadella was named President, Server and Tools in February 2011. Before holding that position, he had a number of leadership positions at +Microsoft, including Senior Vice President Research and Development for the Online Services Division since 2008 and Corporate Vice President, Research and Development for the Advertising Platform since 2007. From 2000 to 2007, Mr. Nadella led +Microsoft Business Solutions. Prior to that, he spent several years leading engineering efforts in Microsoft’s Server group. Mr. Nadella joined Microsoft in 1992. Mr. Sinofsky was named President, Windows & Windows Live Division in July 2009. He served as Senior Vice President of the Windows and Windows Live Engineering Group since December 2006 and Senior +Vice President, Office from December 1999 to December 2006. He had been Vice President, Office since December 1998. Mr. Sinofsky joined the Office team in 1994, increasing his responsibility with each subsequent release of the desktop suite. +Mr. Sinofsky joined Microsoft in 1989. Mr. Smith was named Senior Vice President, General Counsel, and Secretary in November +2001. Mr. Smith was also named Chief Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. +Mr. Smith joined Microsoft in 1993. Mr. Turner was named Chief Operating Officer in September 2005. Before joining Microsoft, +he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s Club division. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of +Wal-Mart’s Information Systems Division. From March 2000 to September 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. EMPLOYEES As of +June 30, 2011, we employed approximately 90,000 people on a full-time basis, 54,000 in the U.S. and 36,000 internationally. Of the total, 35,000 were in product research and development, 25,000 in sales and marketing, 16,000 in product support +and consulting services, 5,000 in manufacturing and distribution, and 9,000 in general and administration. Our success is highly dependent on our ability to attract and retain qualified employees. None of our employees are subject to collective +bargaining agreements. 13 Table of Contents PART I Item 1, 1A AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations Web site, www.microsoft.com/investor, we make available free of charge a +variety of information for investors. Our goal is to maintain the Investor Relations Web site as a portal through which investors can easily find or navigate to pertinent information about us, including: • our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”); • information on our business strategies, financial results, and key performance indicators; • announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available; • press releases on quarterly earnings, product and service announcements, legal developments, and international news; • corporate governance information including our articles, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate +citizenship initiatives, and other governance-related policies; • other news and announcements that we may post from time to time that investors might find useful or interesting; and • opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our Web site is not part of this or any other report we file with, or furnish to, the SEC. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash +flows, and the trading price of our common stock. The cloud-based computing model presents execution and competitive +risks. We are transitioning our strategy to a computing environment characterized by cloud-based services used with smart client devices. Our competitors are rapidly developing and deploying cloud-based services for +consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud. We are devoting significant resources to develop and deploy our own competing cloud-based software +plus services strategies. While we believe our expertise, investments in infrastructure, and the breadth of our cloud-based services provides us with a strong foundation to compete, it is uncertain whether our strategies will attract the users or +generate the revenue required to be successful. In addition to software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs may reduce the operating margins we have +previously achieved. Whether we are successful in this new business model depends on our execution in a number of areas, including: • continuing to innovate and bring to market compelling cloud-based experiences that generate increasing traffic and market share; • maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including smartphones, handheld +computers, netbooks, tablets, and television set top devices; • continuing to enhance the attractiveness of our cloud platforms to third-party developers; and • ensuring that our cloud services meet the reliability expectations of our customers and maintain the security of their data. 14 Table of Contents PART I Item 1A Challenges to our business models may reduce our revenue or operating +margins. Whether our software runs in the cloud or on a device, we continue to face challenges from alternative means of developing and licensing software. Under our license-based software model, software developers bear +the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from the distribution of their products. Certain “open source” software +business models challenge our license-based software model. Open source commonly refers to software whose source code is subject to a license allowing it to be modified, combined with other software and redistributed, subject to restrictions set +forth in the license. Some companies compete with us using an open source business model by modifying and then distributing open source software to end users at nominal cost and earning revenue on complementary services and products. These firms do +not bear the full costs of research and development for the software. In some cases, their products may infringe our patents. In addition, advertising-based business models seek revenue by delivering third party advertisements to end customers who +receive the software and services at no direct costs. Gains in market acceptance of open source or advertising based software may adversely affect our sales, revenue, and operating margins. An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A +competing vertically-integrated model, in which a single firm controls both the software and hardware elements of a product, has been successful with certain consumer products such as personal computers, mobile phones, and digital music players. We +also offer vertically-integrated hardware and software products; however, efforts to compete with the vertically integrated model may increase our cost of sales and reduce our operating margins. We derive substantial revenue from licenses of Windows operating systems on personal computers. The proliferation of alternative devices and form +factors creates challenges from competing software platforms. It is uncertain to what extent alternative devices will increase the number of computing devices that users own, or will substitute for users’ personal computer purchases. +Alternative devices also run operating systems and applications developed by our competitors. These factors could impact our revenue and margins. We face intense competition. We continue to experience intense competition across all markets for our products and services. Our competitors range in size from Fortune 100 companies to +small, specialized single-product businesses and open source community-based projects. Although we believe the breadth of our businesses and product portfolio is a competitive advantage, our competitors that are focused on narrower product lines may +be more effective in devoting technical, marketing, and financial resources to compete with us. In addition, barriers to entry in our businesses generally are low and products, once developed, can be distributed broadly and quickly at relatively low +cost. Open source software vendors are devoting considerable efforts to developing software that mimics the features and functionality of our products, in some cases in violation of our intellectual property rights or on the basis of technical +specifications for Microsoft technologies that we make available at little or no cost in connection with our interoperability initiatives. In response to competition, we continue to develop versions of our products with basic functionality that are +sold at lower prices than the standard versions. These competitive pressures may result in decreased sales volumes, price reductions, and/or increased operating costs, such as for marketing and sales incentives, resulting in lower revenue, gross +margins, and operating income. We may not be able to adequately protect our intellectual property +rights. Protecting our global intellectual property rights and combating unlicensed copying and use of software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on +revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. As a result, our revenue in these markets likely will grow slower than the underlying PC market. Similarly, +the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits +for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may fail to enhance revenue. Reductions in +the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe +their intellectual property rights. From time to time, we receive notices from others claiming we infringe their intellectual property rights. Because of constant technological change in the 15 Table of Contents PART I Item 1A segments in which we compete, the extensive patent coverage of existing technologies, and the rapid rate of issuance of new patents, it is possible the number of these claims may grow. To resolve +these claims we may enter into royalty and licensing agreements on less favorable terms, stop selling or redesign affected products, or pay damages to satisfy indemnification commitments with our customers. Such agreements may cause operating +margins to decline. We have made and expect to continue making significant expenditures to settle claims related to the use of technology and intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source +code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a +number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection +for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the +security risks described in the next paragraph. Security vulnerabilities could lead to reduced revenue, liability claims, or +competitive harm. Maintaining the security of computers and computer networks is paramount for us and our customers. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our products +and services and gain access to our networks and data centers. Although this is an industry-wide problem that affects computers across all platforms, it affects our products and services in particular because hackers tend to focus their efforts on +the most popular operating systems, programs, and services, and we expect them to continue to do so. Groups of hackers may also act in a coordinated manner to launch distributed denial of service attacks, or other coordinated attacks, that may cause +service outages or other interruptions. We devote significant resources to address security vulnerabilities through: • engineering more secure products and services; • enhancing security and reliability features in our products and services, and continuously evaluating and updating those security and reliability features; • helping our customers make the best use of our products and services to protect against computer viruses and other attacks; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; and • providing customers online automated security tools, published security guidance, and security software such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security +vulnerabilities in our products and services could cause significant reputational harm and lead some customers to seek to return products, to reduce or delay future purchases or adoption of services, or to use competing products. Customers may also +increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of new technologies. Any of these actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities may lead +to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand all legal challenges. In addition, our internal information technology environment continues to evolve. We are often early adopters of new devices and technologies. We +embrace new ways of sharing data and communicating with partners and customers using methods such as social networking. These practices can enhance efficiency and business insight, but they also present risks that our business policies and internal +security controls may not keep pace with the speed of these changes. If third parties gain access to our networks or data centers, they could obtain and exploit confidential business information and harm our competitive position. 16 Table of Contents PART I Item 1A Improper disclosure of personal data could result in liability and harm our +reputation. As we continue to execute our strategy of increasing the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers. +At the same time, the continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. This environment demands that we continuously improve our design and coordination of +security controls across our business groups and geographies. Despite these efforts, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the +improper disclosure of personally identifiable information. Improper disclosure of this information could harm our reputation, lead to legal exposure to customers, or subject us to liability under laws that protect personal data, resulting in +increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on premises or, increasingly, in a cloud-based environment we host. We believe consumers using our email, messaging, +storage, sharing, and social networking services will increasingly want efficient, centralized methods of choosing their privacy preferences and controlling their data. Perceptions that our products or services do not adequately protect the privacy +of personal information could inhibit sales of our products or services, and could constrain consumer and business adoption of cloud-based solutions. We may experience outages, data loss and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic and complexity of +our products and services demand more computing power. We have spent and expect to continue to spend substantial amounts to purchase or lease data centers and equipment and to upgrade our technology and network infrastructure to handle increased +traffic on our Web sites and in our data centers, and to introduce new products and services and support existing services such as Bing, Exchange Online, Office 365, SharePoint Online, Xbox LIVE, Windows Azure, Windows Live, and Microsoft Office Web +Apps. We also are growing our business of providing a platform and back-end hosting for services provided by third-party businesses to their end customers. Maintaining and expanding this infrastructure is expensive and complex. Inefficiencies or +operational failures, including temporary or permanent loss of customer data, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, damage to our +reputation and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition. We are subject to government litigation and regulatory activity that affects how we design and market our products. As a leading global software maker, we receive close scrutiny from +government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following +actions. Lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were +resolved through a Consent Decree that took effect in 2001 and a Final Judgment entered in 2002. These proceedings imposed various constraints on our Windows operating system businesses. These constraints included limits on certain contracting +practices, mandated disclosure of certain software program interfaces and protocols, and rights for computer manufacturers to limit the visibility of certain Windows features in new PCs. Although the Consent Decree and Final Judgment expired in May +2011, we expect that federal and state antitrust authorities will continue to closely scrutinize our business. The European Commission +closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the +Commission ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own +products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns relating to competition in Web browsing software. The Commission’s impact on product design may limit our ability to +innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to +develop software products that better mimic the functionality of our own products which could result in decreased sales of our products. 17 Table of Contents PART I Item 1A Government regulatory actions and court decisions such as these may hinder our ability to provide +the benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenue that come from them. New actions could be initiated at any time, either by these or other governments or private claimants, +including with respect to new versions of Windows or other Microsoft products. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be used as precedent in other competition law proceedings. Our software and services online offerings are subject to government regulation of the Internet domestically and internationally in many areas, +including user privacy, telecommunications, data protection, and online content. The application of these laws and regulations to our business is often unclear and sometimes may conflict. Compliance with these regulations may involve significant +costs or require changes in business practices that result in reduced revenue. Noncompliance could result in penalties being imposed on us or orders that we stop the alleged noncompliant activity. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully +attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are +less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term +success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. Delays in product development schedules may adversely affect our revenue. The development of software products is a complex and time-consuming process. New products and enhancements to +existing products can require long development and testing periods. Our increasing focus on cloud-based software plus services also presents new and complex development issues. Significant delays in new product or service releases or significant +problems in creating new products or services could adversely affect our revenue. We make significant investments in new products +and services that may not be profitable. Our growth depends on our ability to innovate by offering new, and adding value to our existing, software and service offerings. We will continue to make significant investments in +research, development, and marketing for new products, services, and technologies, including the Windows PC operating system, the Microsoft Office system, Bing, Windows Phone, Windows Server, Windows Live, the Windows Azure Services platform and +other cloud-based services offerings, and the Xbox 360 entertainment platform. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and +marketing. Our degree of success with Windows Phone, for example, will impact our ability to grow our share of the smartphone operating system market. It will also be an important factor in supporting our strategy of delivering value to end users +seamlessly over PC, phone, and TV device classes. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably +impacting revenue. We may not achieve significant revenue from new product and service investments for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for +new products and businesses may not be as high as the margins we have experienced historically. Adverse economic conditions may harm +our business. Unfavorable changes in economic conditions, including inflation, recession, or other changes in economic conditions, may result in lower information technology spending and adversely affect our revenue. If +demand for PCs, servers, and other computing devices declines, or consumer or 18 Table of Contents PART I Item 1A business spending for those products declines, our revenue will be adversely affected. Our product distribution system also relies on an extensive partner network. The impact of economic +conditions on our partners, such as the bankruptcy of a major distributor, could result in sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. +As a result, reserves for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and +interest rate risks, which may be exacerbated by unusual events that have affected global financial markets. A significant part of our investment portfolio consists of U.S. government securities. If global credit and equity markets experience +prolonged periods of decline, or if the U.S. federal government budget process results in a default or downgrade of its debt, our investment portfolio may be adversely impacted and we could determine that more of our investments have experienced an +other-than-temporary decline in fair value, requiring impairment charges that could adversely impact our financial results. We have +claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or +injunctive relief that could adversely affect our ability to conduct our business. Although management currently believes resolving all of these matters, individually or in the aggregate, will not have a material adverse impact on our financial +statements, the litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our financial statements also could occur for the period in which +the effect of an unfavorable final outcome becomes probable and reasonably estimable. We may have additional tax +liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, +there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any +related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial statements in the period or periods for which that +determination is made. We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds +currently held in foreign jurisdictions may result in higher effective tax rates for the company. In addition, there have been proposals to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign +earnings. Although we cannot predict whether or in what form this proposed legislation may pass, if enacted it could have a material adverse impact on our tax expense and cash flow. Our vertically-integrated hardware and software products may experience quality or supply problems. Our hardware +products such as the Xbox 360 console are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or effectively address such +issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be +unable to obtain timely replacement supplies, resulting in reduced sales. Either component shortages or excess or obsolete inventory may increase our cost of revenue. Xbox 360 consoles are assembled in Asia; disruptions in the supply chain may +result in console shortages that would affect our revenue and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to +earnings. Under accounting principles generally accepted in the United States (“U.S. GAAP”), we review our amortizable intangible assets for impairment when events or changes in circumstances indicate the +carrying value may not be recoverable. Goodwill is tested for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be +recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge in our financial statements during the period in +which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. 19 Table of Contents PART I Item 1A, 1B, 2 We operate a global business that exposes us to additional risks. We +operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the U.S. and other countries. +Operations outside the U.S. may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment, including the Foreign Corrupt Practices Act and local laws prohibiting corrupt +payments. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets presents a number of risks. Deterioration of social, political, labor, or economic conditions in a specific country or +region and difficulties in staffing and managing foreign operations may also adversely affect our operations or financial results. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between +the U.S. dollar and foreign currencies may adversely affect our net revenue. Catastrophic events or geo-political conditions may +disrupt our business. A disruption or failure of our systems or operations in the event of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing +sales, providing services, or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, +Washington area, and we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or +information technology systems could harm our ability to conduct normal business operations. Our move toward providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our +business continuity management plans, and magnifies the potential impact of prolonged outages on our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, +which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may result in supply chain disruptions for hardware manufacturers, either of which +may adversely affect our revenue. The long-term effects of climate change on the global economy in general or the information technology industry in particular are unclear. Environmental regulations or changes in the supply, demand or available +sources of energy may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to +develop software and provide cloud-based services. New regulations may require us to find alternative compliant and cost-effective methods of distributing our products and services. Acquisitions, joint ventures and strategic alliances may have an adverse effect on our business. We expect to +continue making acquisitions or entering into joint ventures and strategic alliances as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business +strategy, that we don’t realize a satisfactory return on our investment, or that we experience difficulty integrating new employees, business systems, and technology, or diversion of management’s attention from our other businesses. It may +take longer than expected to realize the full benefits, such as increased revenue, enhanced efficiencies, or market share, or those benefits may ultimately be smaller than anticipated, or may not be realized. These events could harm our operating +results or financial condition. ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2011 that remain unresolved. ITEM 2. PROPERTIES Our corporate offices consist of approximately 15 million square feet of office space located in King County, Washington: 10 million +square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately five million square feet of space we lease. We own approximately three million additional square feet +of office and data center space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately four million square feet of office and data center space. 20 Table of Contents PART I, II Item 2, 3, 5 We occupy many sites internationally, totaling approximately three million square feet that is +owned and approximately nine million square feet that is leased. International facilities that we own include our development center in Hyderabad, India; our European operations center in Dublin, Ireland; a research and development campus in +Beijing, China; and facilities in Reading, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; Tokyo, Japan; Unterschleissheim, Germany; Paris, France; Dublin, Ireland; Bangalore, India; Reading, UK; +Vedbaek, Denmark; and Mississauga, Canada. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, a facility in Singapore for our Asia Pacific operations center and regional +headquarters, and various product development facilities, both domestically and internationally, as described in the “Research and Development” section of Item 1 of this Form 10-K. Our facilities are fully used for current operations of all segments, and suitable additional spaces are available to accommodate expansion needs. +We have a development agreement with the City of Redmond under which we may currently develop approximately 1.6 million square feet of additional facilities at our corporate campus in Redmond, Washington. In addition, we own 63 acres of +undeveloped land in Issaquah, Washington, that can accommodate approximately one  +million square feet of office space. ITEM 3. LEGAL PROCEEDINGS See Note 17 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal +proceedings in which we are involved. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our +common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 20, 2011, there were 134,854 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2011 High $ 26.41 $ 28.87 $ 29.46 $ 26.87 $ 29.46 Low $ 22.73 $ 23.78 $ 24.68 $ 23.65 $ 22.73 Fiscal Year 2010 High $ 26.25 $ 31.50 $ 31.24 $ 31.58 $ 31.58 Low $ 22.00 $ 24.43 $ 27.57 $ 22.95 $ 22.00 21 Table of Contents PART II Item 5, 6, 7 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information +regarding dividends and share repurchases by quarter. Following are our monthly stock repurchases for the fourth quarter of fiscal year 2011: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2011 – April 30, 2011 0 $ 0 0 $ 13,851 May 1, 2011 – May 31, 2011 0 $ 0 0 $ 13,851 June 1, 2011 – June 30, 2011 65,839,984 $ 24.77 65,839,984 $ 12,221 65,839,984 65,839,984 The repurchases were made using cash resources and occurred in the open market and pursuant to a trading plan under +Rule 10b5-1 of the Securities Exchange Act of 1934. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2011 2010 2009 2008 2007 Revenue $ 69,943 $ 62,484 $ 58,437 $ 60,420 $ 51,122 Operating income $ 27,161 $ 24,098 $ 20,363 $ 22,271 (a) $ 18,438 Net income $ 23,150 $ 18,760 $ 14,569 $ 17,681 (a) $ 14,065 Diluted earnings per share $ 2.69 $ 2.10 $ 1.62 $ 1.87 $ 1.42 Cash dividends declared per share $ 0.64 $ 0.52 $ 0.52 $ 0.44 $ 0.40 Cash and cash equivalents and short-term investments $ 52,772 $ 36,788 $ 31,447 $ 23,662 $ 23,411 Total assets $ 108,704 $ 86,113 $ 77,888 $ 72,793 $ 63,171 Long-term obligations $ 22,847 $ 13,791 $ 11,296 $ 6,621 $ 8,320 Stockholders’ equity $ 57,083 $ 46,175 $ 39,558 $ 36,286 $ 31,097 (a) Includes a charge of $1.4 billion ( € 899 +million) related to the fine imposed by the European Commission in February 2008. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the +results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes to Financial Statements. OVERVIEW AND OUTLOOK Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology +that transforms the way people work, play and communicate across a wide range of computing devices. We generate revenue by developing, +licensing, and supporting a wide range of software products and services, by designing and selling hardware, and by delivering relevant online advertising to a global customer audience. Our most significant expenses are related to compensating +employees, designing, manufacturing, marketing and selling our products and services, and income taxes. 22 Table of Contents PART II Item 7 Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas which +can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad set of research and technology innovations that seek to anticipate the changing demands of customers, industry trends, and +competitive forces. Key Opportunities and Investments Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to drive future growth. Smart connected devices The price per unit +of processing, storage, and networks continues to decline while at the same time devices increase in capability. This ongoing trend is increasing the capabilities of PCs, mobile, and other devices powered by rich software platforms and applications. +At the same time, the information and services people use increasingly span multiple devices. User experiences will be transformed by the adoption of cloud computing when brought together with the richness of smart, connected devices. Microsoft is +delivering experiences that seamlessly connect PCs and mobile and other devices through the cloud. We are devoting significant resources to consumer cloud offerings like Bing, Windows Live, and Xbox LIVE. Our software and hardware platform +investments can be seen in products like Kinect, Windows, Windows Azure, Windows Phone, Windows Server, and Xbox. Cloud computing transforming the +data center and information technology Cloud-based solutions provide customers with software, services and content over the +Internet by way of shared computing resources located in centralized data centers. Computing is undergoing a long-term shift from client/server to the cloud, a shift similar in importance and impact to the transition from mainframe to client/server. +The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost than smaller ones; larger data centers include diverse customer, geographic, and application +demand patterns which improve the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. As a result of the improved economics, the cloud offers unique levels +of elasticity and agility that will enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus more on innovation while leaving non-differentiating activities to reliable and cost-effective +providers. For most businesses, the first step in achieving cloud economics is the adoption of virtualization in their data center. We are devoting significant resources to developing cloud infrastructure, platforms, and applications including +offerings such as Microsoft Dynamics Online, Microsoft SQL Azure, Office 365, Windows Azure, Windows Intune, and Windows Server. Entertainment The evolution of hardware, software, services, and the cloud are enhancing the delivery and quality of unified entertainment +experiences across many devices. These rich media experiences include games, movies, music, television, and social interactions with family, friends, and colleagues. At Microsoft, our approach is to simplify and increase the accessibility of these +entertainment experiences to broaden market penetration of our software and services. We invest significant resources in partnerships, content, Windows Phone, Xbox, and Xbox LIVE. Search Over the last two decades, web content and social connections have increased +dramatically as people spend more time online, while discoverability and accessibility has been transforming from direct navigation and document links. There is significant opportunity to deliver differentiated products that helps users make better +decisions and 23 Table of Contents PART II Item 7 complete tasks more simply when using PC, mobile, and other devices. Our approach is to use machine learning to try to understand user intent, and differentiate our product by focusing on the +integration of visual, social, and other elements which simplifies people’s interaction with the Internet. We invest significant resources in Bing, SharePoint, Windows, and Windows Phone. Communications and productivity Personal +and business productivity has been transformed by the ubiquity of computing and software tools. Over the last decade, Microsoft redefined software productivity beyond the rich Office client on the PC. Productivity scenarios now encompass unified +communications, business intelligence, collaboration, content management, and relationship management, which are increasingly powered by server-side applications. These server applications can be hosted by the customer, a partner, or by Microsoft in +the cloud. There are significant opportunities to provide productivity and communication scenarios across PCs, mobile devices, and other devices that connect to services. We invest significant resources in Dynamics, Exchange, Lync, Office, Office +365, SharePoint, and Windows Live. Economic Conditions, Challenges and Risks As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for +growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market. At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and +are multi-year in nature. The products and services we bring to market can be built internally, brought to market as part of a partnership or alliance, or through acquisition. Our success is highly dependent on our ability to attract and retain qualified employees. We rely on hiring from a mix of university and industry talent worldwide. Microsoft competes for talented individuals +worldwide by offering broad customer reach, scale in resources, and competitive compensation. Demand for our software, services, and +hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part 1, Item 1a. of this Form 10-K). Seasonality Our revenue historically has +fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Entertainment and Devices Division +is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenue +in our second fiscal quarter. In addition, quarterly revenue may be impacted by the deferral of revenue. See the discussions below regarding sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest +version of the Microsoft Office system at minimal or no cost (the “Office Deferral”) and sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and of Windows 7 to retailers before general availability +(the “Windows 7 Deferral”). 24 Table of Contents PART II Item 7 RESULTS OF OPERATIONS Summary of Results for Fiscal Years 2011, 2010, and 2009 (In millions, except percentages and per share amounts) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Revenue $ 69,943 $ 62,484 $ 58,437 12% 7% Operating income $ 27,161 $ 24,098 $ 20,363 13% 18% Diluted earnings per share $ 2.69 $ 2.10 $ 1.62 28% 30% Fiscal year 2011 compared with fiscal year 2010 Revenue increased primarily due to strong sales of the Xbox 360 entertainment platform, the 2010 Microsoft Office system, and Server and Tools +products, offset in part by lower Windows revenue. Revenue also increased due to the $254 million Office Deferral in fiscal year 2010 and the subsequent recognition of the Office Deferral during fiscal year 2011. Changes in foreign currency exchange +rates had an insignificant impact on revenue. Operating income increased reflecting the change in revenue, offset in part by higher +operating expenses. Key changes in operating expenses were: • Cost of revenue increased $3.2 billion or 26%, due to higher costs associated with our online offerings, including traffic acquisition costs, and increased +volumes of Xbox 360 consoles and Kinect sensors sold. • Sales and marketing expenses increased $726 million or 5%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, +and Windows and Windows Live, higher headcount-related expenses and increased fees paid to third party enterprise software advisors. • Research and development expenses increased $329 million or 4%, due mainly to higher headcount-related expenses. • General and administrative expenses increased $159 million or 4%, due mainly to higher headcount-related expenses and new Puerto Rican excise taxes, partially +offset by prior year transition expenses associated with the inception of the Yahoo! Commercial Agreement. Diluted +earnings per share increased reflecting higher revenue, repurchases of common stock, and lower income tax expense, offset in part by higher operating expenses. Fiscal year 2010 compared with fiscal year 2009 Revenue increased mainly due to strong sales +of Windows 7, which was released during fiscal year 2010, and PC market improvement. Operating income increased reflecting the change in revenue, offset in part by higher operating expenses. • Sales and marketing expenses increased $335 million or 3%, primarily reflecting increased advertising and marketing of Windows 7 and Bing and increased sales +force expenses related to Windows 7. • General and administrative expenses increased $33 million or 1% due mainly to increased legal charges and transition expenses associated with the inception of +the Yahoo! Commercial Agreement, offset in part by a reduction in headcount-related expenses. • Cost of revenue increased $240 million or 2%, primarily reflecting increased online costs and charges resulting from the discontinuation of the KIN phone, +offset in part by decreased Xbox 360 console costs and reductions in other costs due to resource management efforts. • Research and development expenses decreased $296 million or 3%, primarily reflecting a decrease in third-party development and programming costs and increased +capitalization of certain software development costs. 25 Table of Contents PART II Item 7 Diluted earnings per share increased reflecting increased net income and the repurchase of +380 million shares during fiscal year 2010. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted +in the U.S. (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, +Item 8 of this Form 10-K) is presented on a basis consistent with our current internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance +during the current fiscal year, including moving Microsoft’s PC hardware business from Entertainment and Devices Division to Windows & Windows Live Division, Windows Embedded from Entertainment and Devices Division to Server and Tools, +and Office for Mac from Entertainment and Devices Division to Microsoft Business Division, as well as implementing intersegment cost allocations between all segments related to the collaborative investment in mobile platform development. Windows & Windows Live Division (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Revenue $ 19,024 $ 19,494 $ 15,847 (2)% 23% Operating income $ 12,281 $ 13,034 $ 9,790 (6)% 33% Windows & Windows Live Division (“Windows +Division”) develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through efficient browsing +capabilities and seamless operations across the user’s hardware and software. Windows Division offerings consist of multiple editions of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware +products. Windows Division revenue is largely correlated to the PC market worldwide, as approximately 75% of total Windows Division +revenue comes from Windows operating system software purchased by original equipment manufacturers (“OEMs”) which they pre-install on equipment they sell. The remaining approximately 25% of Windows Division revenue (“other +revenue”) is generated by commercial and retail sales of Windows and PC hardware products and online advertising from Windows Live. Fiscal year +2011 compared with fiscal year 2010 Windows Division revenue reflected relative performance in PC market segments. We +estimate that sales of PCs to businesses grew approximately 11% this year and sales of PCs to consumers declined approximately 1%. The decline in consumer PC sales included an approximately 32% decline in the sales of netbooks. Taken together, +the total PC market increased an estimated 2% to 4%. Revenue was negatively impacted by the effect of higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition +of previously deferred Windows XP revenue. Considering the impact of Windows 7 launch in the prior year, including $273 million of revenue recognized related to the Windows 7 Deferral, we estimate that Windows Division revenue was in line with +the PC market. Windows Division operating income decreased as a result of decreased revenue and higher sales and marketing expenses. +Sales and marketing expenses increased $224 million or 8% reflecting increased advertising of Windows and Windows Live. 26 Table of Contents PART II Item 7 Fiscal year 2010 compared with fiscal year 2009 Windows Division revenue increased primarily as a result of strong sales of Windows 7 and PC market improvement. We estimate total PC shipments +from all sources grew approximately 16% to 18%. OEM revenue increased $2.6 billion or 22%, while OEM license units increased 21%. The OEM revenue increase was driven by PC market growth, higher Windows attach rates across consumer and business +segments, the restoration of normal OEM inventory levels, and the mix of versions of Windows licensed, offset in part by PC market changes, including stronger growth of emerging markets versus developed markets and of consumer PCs versus business +PCs. Fiscal year 2009 OEM revenue reflects a $273 million Windows 7 Deferral. This amount was subsequently recognized in fiscal year 2010. Other revenue increased $970 million or 26% driven primarily by Windows 7 retail sales. Windows Division operating income increased as a result of increased revenue, offset in part by higher operating expenses. Sales and marketing +expenses increased $258 million or 11% reflecting increased advertising and marketing of Windows 7. Cost of revenue increased $251 million or 14%, primarily driven by traffic acquisition costs and royalties. Server and Tools (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Revenue $ 17,096 $ 15,378 $ 14,601 11% 5% Operating income $ 6,608 $ 5,539 $ 4,816 19% 15% Server and Tools develops and markets technology and +related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, +System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training and certification. +Approximately 50% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 30% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the +remainder comes from Enterprise Services. Fiscal year 2011 compared with fiscal year 2010 Server and Tools revenue increased reflecting growth in both product sales and Enterprise Services. Product revenue increased $1.4 billion or 11%, +driven primarily by growth in Windows Server, SQL Server, Enterprise CAL Suites, and Windows Embedded, reflecting continued adoption of Windows platform applications. Enterprise Services revenue grew $337 million or 11%, due to growth in both +Premier product support and consulting services. Server and Tools operating income increased due to revenue growth, offset in part by +higher operating expenses. Cost of revenue increased $366 million or 13%, primarily reflecting a $323 million increase in expenses from providing Enterprise Services. Sales and marketing expenses increased $264 million or 6% reflecting increased +fees paid to third party enterprise software advisors and increased corporate marketing activities. Fiscal year 2010 compared with fiscal year 2009 Server and Tools revenue increased mainly reflecting growth in product revenue. Product revenue increased $784 million or 7%, +driven primarily by growth in Windows Server, SQL Server and Enterprise CAL Suites revenue, reflecting increased revenue from annuity volume licensing agreements and continued adoption of Windows platform applications, offset in part by a decline in +developer tools revenue. Enterprise Services revenue was relatively flat, with growth in Premier product support services nearly offset by decreased consulting services. 27 Table of Contents PART II Item 7 Server and Tools operating income increased due mainly to revenue growth, offset in part by +increased cost of revenue. Cost of revenue increased $65 million or 2%, reflecting increased headcount-related expenses and hosting costs. Online +Services Division (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Revenue $ 2,528 $ 2,201 $ 2,121 15% 4% Operating loss $ (2,557 ) $ (2,337 ) $ (1,641 ) (9)% (42)% Online Services Division (“OSD”) develops and +markets information and content designed to help people simplify tasks and make more informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate +revenue through the sale of search and display advertising. Search and display advertising generally accounts for nearly all of OSD’s annual revenue. Fiscal year 2011 compared with fiscal year 2010 OSD revenue increased primarily as a result +of growth in online advertising revenue. Online advertising revenue grew $358 million or 19% to $2.3 billion, reflecting continued growth in search and display advertising revenue, offset in part by decreased third party advertising revenue. Search +revenue grew due to increased volumes reflecting general market growth, relative share gains in the U.S., and our Yahoo! alliance, offset in part by decreased revenue per search primarily related to challenges associated with optimizing the adCenter +platform for the new mix and volume of traffic from the combined Yahoo! and Bing properties. As of June 30, 2011, according to third-party sources, Bing organic U.S. market share grew over 31% to approximately 14%, while Bing-powered U.S. +market share, including Yahoo! properties, was approximately 27%. OSD operating loss increased due to higher operating expenses, offset +in part by increased revenue. Cost of revenue grew $641 million driven by costs associated with the Yahoo! search agreement and increased traffic acquisition costs. General and administrative expenses decreased $157 million or 60% due mainly to +transition expenses in the prior year associated with the inception of the Yahoo! Commercial Agreement. Research and development increased $117 million or 11% due to increased headcount-related costs. Fiscal year 2010 compared with fiscal year 2009 OSD revenue increased reflecting increased online advertising revenue, offset in part by decreased Access (dial-up internet) revenue. Online advertising revenue increased $146 million or 8% to $1.9 billion, +reflecting higher search and display advertising revenue, offset in part by decreased advertiser and publisher tools revenue. Access revenue decreased $57 million or 31%, reflecting continued migration of subscribers to broadband or other +competitively-priced service providers. OSD operating loss increased due to increased operating expenses, offset in part by increased +revenue. Cost of revenue increased $567 million, primarily driven by higher online traffic acquisition costs and Yahoo! reimbursement and implementation costs. General and administrative expenses increased $135 million. Sales and marketing expenses +increased $51 million or 5% due mainly to increased marketing of Bing, offset in part by decreased headcount-related expenses. Microsoft Business +Division (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Revenue $ 22,186 $ 19,076 $ 19,257 16% (1)% Operating income $ 14,124 $ 11,504 $ 11,365 23% 1% 28 Table of Contents PART II Item 7 Microsoft Business Division (“MBD”) develops and markets software and services designed +to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange and Lync), which generates over 90% of MBD revenue, and Microsoft Dynamics business +solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing agreements and Microsoft Dynamics revenue; and +consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. Fiscal year 2011 compared with fiscal year 2010 MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system, the $254 million Office Deferral during +fiscal year 2010, and the subsequent recognition of the Office Deferral during fiscal year 2011. Business revenue increased $2.0 billion or 13%, reflecting licensing of the 2010 Microsoft Office system to transactional business customers, +growth in multi-year volume licensing revenue, and a 10% increase in Microsoft Dynamics revenue. Consumer revenue increased $1.1 billion or 33%, approximately half of which was attributable to the launch of Office 2010 and half of which was +attributable to the Office Deferral during fiscal year 2010 and subsequent recognition of the Office Deferral during fiscal year 2011. Excluding the impact associated with the Office Deferral, consumer revenue increased $620 million or 17% due to +sales of the 2010 Microsoft Office system. MBD operating income increased due mainly to revenue growth, offset in part by higher +operating expenses. Cost of revenue increased $335 million or 26%, primarily driven by higher online costs and services. Sales and marketing expenses increased $97 million or 2%, primarily driven by an increase in corporate and cross-platform +marketing activities. Research and development costs increased $79 million or 4%, primarily as a result of capitalization of certain Microsoft Office system software development costs in the prior year. Fiscal year 2010 compared with fiscal year 2009 MBD revenue decreased primarily as a result of the net deferral of $254 million of revenue related to the Office 2010 Deferral. Consumer revenue decreased $142 million or 4%, primarily due to the Office 2010 +Deferral, offset in part by growth in the PC market and sales of the 2010 Microsoft Office system, which was launched during the fourth quarter of fiscal year 2010. Business revenue decreased $39 million, primarily reflecting a decline in licensing +of the 2007 Microsoft Office system to transactional business customers, offset in part by growth in multi-year volume licensing agreement revenue and licensing of the 2010 Microsoft Office system to transactional business customers. Microsoft +Dynamics revenue was flat. MBD operating income increased due mainly to decreased operating expenses, offset in part by decreased +revenue. Sales and marketing expenses decreased $203 million or 5%, primarily driven by a decrease in corporate marketing activities. Research and development expenses decreased $202 million or 9%, primarily as a result of capitalization of certain +Microsoft Office system software development costs and lower headcount-related expenses. General and administrative expenses decreased $50 million or 17% primarily due to expenses in the prior year associated with the acquisition of Fast +Search & Transfer ASA (“FAST”) and lower headcount-related expenses. These decreases were offset in part by a $135 million or 12% increase in cost of revenue, primarily driven by increased traffic acquisition costs and increased +costs of providing services. Entertainment and Devices Division (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Revenue $ 8,913 $ 6,168 $ 6,416 45% (4)% Operating income $ 1,324 $ 618 $ 351 114% 76% 29 Table of Contents PART II Item 7 Entertainment and Devices Division (“EDD”) develops and markets products and services +designed to entertain and connect people. EDD offerings include the Xbox 360 entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox LIVE, and Xbox 360 accessories), +Mediaroom (our Internet protocol television software), and Windows Phone. In November 2010, we released Kinect for Xbox 360 and the latest version of Windows Phone. Fiscal year 2011 compared with fiscal year 2010 EDD revenue increased primarily reflecting +higher Xbox 360 platform revenue. Xbox 360 platform revenue grew $2.7 billion or 48%, led by increased volumes of Xbox 360 consoles, sales of Kinect sensors, and higher Xbox LIVE revenue. We shipped 13.7 million Xbox 360 consoles during fiscal +year 2011, compared with 10.3 million Xbox 360 consoles during fiscal year 2010. EDD operating income increased primarily +reflecting revenue growth, offset in part by higher cost of revenue. Cost of revenue increased $1.8 billion or 49% primarily reflecting higher volumes of Xbox 360 consoles and Kinect sensors sold, and increased royalty costs resulting from increased +sales of Xbox LIVE digital content. Research and development expenses increased $119 million or 12%, primarily reflecting higher headcount-related costs. Sales and marketing expenses grew $90 million or 12% primarily reflecting increased Xbox 360 +platform marketing activities. Fiscal year 2010 compared with fiscal year 2009 EDD revenue decreased reflecting decreased revenue from Xbox 360 platform and PC games. Xbox 360 platform and PC game revenue decreased $12 +million, primarily reflecting a reduction in Xbox 360 consoles sold and revenue per console, offset in part by increased Xbox LIVE revenue. We shipped 10.3 million Xbox 360 consoles during fiscal year 2010, compared with 11.2 million Xbox +360 consoles during fiscal year 2009. Non-gaming revenue decreased $197 million or 25% primarily reflecting decreased Zune and Windows Phone revenue. EDD operating income increased due to reduced operating expenses. Cost of revenue decreased $496 million or 12%, primarily due to lower Xbox 360 console costs, offset in part by increased royalty costs resulting +from increased Xbox LIVE digital marketplace third-party content sales and charges resulting from the discontinuation of the KIN phone. Sales and marketing costs decreased $75 million or 9%, primarily due to decreased Xbox 360 platform marketing +activities. Research and development expenses increased $54 million or 6%, primarily reflecting increased headcount-related expenses, offset in part by decreased third-party development and programming costs. Corporate-Level Activity (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Corporate-level activity $ (4,619 ) $ (4,260 ) $ (4,318 ) (8)% 1% Certain corporate-level activity is not allocated to our +segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; and legal settlements and +contingencies. Fiscal year 2011 compared with fiscal year 2010 Corporate-level expenses increased due mainly to new Puerto Rican excise taxes, certain revenue related sales and marketing expenses, and increased headcount-related expenses. These increases were offset in part by +lower legal charges, which were $332 million in fiscal year 2011 compared to $533 million in fiscal year 2010. 30 Table of Contents PART II Item 7 Fiscal year 2010 compared with fiscal year 2009 Corporate-level expenses decreased due mainly to employee severance charges of $330 million incurred in the prior year, decreased partner payments, +and reductions in other costs due to resource management efforts. These decreases in expenses were offset in part by an increase in legal charges and costs associated with broad-based sales and marketing activities. Legal charges were approximately +$533 million compared to $283 million in the prior year. OPERATING EXPENSES Cost of Revenue (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Cost of revenue $ 15,577 $ 12,395 $ 12,155 26% 2% As a percent of revenue 22% 20% 21% 2ppt (1)ppt Cost of revenue includes: manufacturing and distribution +costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our Web sites, and to acquire +online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery +of consulting services; and the amortization of capitalized research and development costs. Fiscal year 2011 compared with fiscal year 2010 Cost of revenue increased primarily due to increased volumes of Xbox 360 consoles and Kinect sensors sold, higher costs associated +with our online offerings, including traffic acquisition costs, and higher expenses from providing Enterprise Services, as well as royalty costs relating to Xbox LIVE digital content sold. Fiscal year 2010 compared with fiscal year 2009 Cost of revenue increased reflecting higher +online costs, mainly Yahoo! reimbursement and implementation costs and traffic acquisition costs, as well as increased royalty costs resulting from increased Xbox LIVE digital marketplace third-party content sales and charges resulting from the +discontinuation of the KIN phone. For the current fiscal year, these costs were offset in part by lower Xbox 360 console costs and reductions in other costs due to resource management efforts. Research and Development (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Research and development $ 9,043 $ 8,714 $ 9,010 4% (3)% As a percent of revenue 13% 14% 15% (1)ppt (1)ppt Research and development expenses include payroll, employee +benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to +translate software for international markets, and the amortization of purchased software code and services content. Fiscal year 2011 compared with +fiscal year 2010 Research and development expenses increased primarily due to a 5% increase in headcount-related expenses and the +capitalization of certain software development costs in the prior year. 31 Table of Contents PART II Item 7 Fiscal year 2010 compared with fiscal year 2009 Research and development expenses decreased, primarily reflecting decreased third-party development and programming costs and the capitalization of +certain Microsoft Office system software development costs. These decreases were offset in part by the capitalization of certain software and development costs related to Windows 7 product development in the prior year. Sales and Marketing (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 Sales and marketing $ 13,940 $ 13,214 $ 12,879 5% 3% As a percent of revenue 20% 21% 22% (1)ppt (1)ppt Sales and marketing expenses include payroll, employee +benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2011 compared with fiscal year 2010 Sales and marketing expenses increased primarily as a result of increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, a 5% increase in headcount-related +expenses, and increased fees paid to third party enterprise software advisors. Fiscal year 2010 compared with fiscal year 2009 Sales and marketing expenses increased, primarily reflecting increased advertising and marketing of Windows 7 and Bing and increased sales force +expenses related to Windows 7. General and Administrative (In millions, except percentages) 2011 2010 2009 Percentage Change 2011 Versus 2010 Percentage Change 2010 Versus 2009 General and administrative $ 4,222 $ 4,063 $ 4,030 4% 1% As a percent of revenue 6% 7% 7% (1)ppt 0ppt General and administrative expenses include payroll, +employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other +administrative fees. Fiscal year 2011 compared with fiscal year 2010 General and administrative expenses increased primarily due to a 12% increase in headcount-related expenses and new Puerto Rican excise taxes, partially offset by prior year transition expenses associated with the +inception of the Yahoo! Commercial Agreement. Fiscal year 2010 compared with fiscal year 2009 General and administrative expenses increased due to increased legal charges, as discussed above within Corporate-Level Activity, and transition +expenses associated with the inception of the Yahoo! Commercial Agreement. These increases were offset in part by a 6% reduction in headcount-related expenses and lower severance costs. During fiscal years 2010 and 2009, general and administrative +expenses included employee severance expense of $59 million and $330 million, respectively, associated with a resource management program that was announced in January 2009 and completed in fiscal year 2010. 32 Table of Contents PART II Item 7 OTHER INCOME (EXPENSE) AND INCOME TAXES Other Income (Expense) The components of +other income (expense) were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Dividends and interest income $ 900 $ 843 $ 744 Interest expense (295 ) (151 ) (38 ) Net recognized gains (losses) on investments 439 348 (125 ) Net losses on derivatives (77 ) (140 ) (558 ) Net gains (losses) on foreign currency remeasurements (26 ) 1 (509 ) Other (31 ) 14 (56 ) Total $ 910 $ 915 $ (542 ) We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and +credit; to enhance investment returns; and to facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by +unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income. Fiscal year 2011 compared with fiscal year 2010 Dividends and interest income increased due to higher average portfolio investment balances, offset in part by lower yields on our fixed-income investments. Interest expense increased due to our increased issuance +of debt. Net recognized gains on investments increased due primarily to higher gains on sales of equity securities, offset in part by fewer gains on sales of fixed-income securities. Derivative losses decreased due primarily to higher gains on +commodity derivatives offset in part by higher losses on currency contracts used to hedge foreign currency revenue. Fiscal year 2010 compared with +fiscal year 2009 Dividends and interest income increased primarily due to higher average portfolio investment balances, offset in +part by lower yields on our fixed-income investments. Interest expense increased due to our issuance of long term debt in May 2009. Net recognized gains on investments increased primarily due to lower other-than-temporary impairments, offset in part +by lower gains on sales of investments in the current period. Other-than-temporary impairments were $69 million during fiscal year 2010, as compared with $862 million during fiscal year 2009 and decreased primarily due to improvements in market +conditions. Net losses on derivatives decreased due to gains on equity and interest rate derivatives as compared to losses in the prior period and lower losses on commodity and foreign currency contracts in the current period. Net gains from foreign +currency remeasurements were insignificant in fiscal year 2010 compared to net losses of $509 million in the prior year, which had resulted from the strengthening of the U.S. dollar in the prior year. For fiscal year 2010, other includes a gain on +the divestiture of Razorfish. Income Taxes Fiscal year 2011 compared with fiscal year 2010 Our effective tax rates for fiscal years 2011 and 2010 were approximately 18% and 25%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate and our prior year effective rate primarily +due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which are +subject to 33 Table of Contents PART II Item 7 lower income tax rates. In fiscal years 2011 and 2010, our U.S. income before income taxes was $8.9 billion and $9.6 billion, respectively, and comprised 32% and 38%, respectively, of our +income before income taxes. In fiscal years 2011 and 2010, the foreign income before income taxes was $19.2 billion and $15.4 billion, respectively, and comprised 68% and 62%, respectively, of our income before income taxes. In fiscal years +2011 and 2010, the reduction of the U.S. federal statutory rate as a result of foreign earnings taxed at lower rates was 16% and 12%, respectively. In addition, our effective tax rate was lower than in the prior year due to a partial settlement with the I.R.S. in the third quarter of fiscal year 2011 relating to the audit of tax years 2004 to 2006. This +partial settlement reduced our income tax expense for fiscal year 2011 by $461 million. Tax contingencies and other tax liabilities +were $7.4 billion and $6.9 billion as of June 30, 2011 and 2010, respectively, and are included in other long-term liabilities. We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of +approximately $44.8 billion resulting from earnings for certain non-U.S. subsidiaries because they are permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences was approximately +$14.2 billion as of June 30, 2011. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third +quarter of fiscal year 2011, we remain under audit for these years. During the fourth quarter of fiscal year 2011, the I.R.S. completed its examination and issued a Revenue Agent’s Report (“RAR”) for the remaining unresolved items. We +do not agree with the adjustments in the RAR, and we have filed a protest to initiate the administrative appeals process. The proposed adjustments are primarily related to transfer pricing and could have a significant impact on our financial +statements if not resolved favorably; however, we believe our existing reserves are adequate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 +months, as we do not believe the appeals process will be concluded within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2010. Fiscal year 2010 compared with fiscal year 2009 Our effective tax rates in fiscal years 2010 +and 2009 were approximately 25% and 27%, respectively. In fiscal years 2010 and 2009, the reduction to the U.S. federal statutory rate as a result of foreign earnings taxed at lower rates was 12% and 9%, respectively, reflecting the mix of U.S. and +international income before income taxes and the impact of changes in unrecognized tax benefits related to international income. In fiscal years 2010 and 2009, foreign income before income taxes was $15.4 billion and $14.3 billion, respectively. FINANCIAL CONDITION Cash, +Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $52.8 billion as of June 30, +2011, compared with $36.8 billion as of June 30, 2010. Equity and other investments were $10.9 billion as of June 30, 2011, compared with $7.8 billion as of June 30, 2010. Our short-term investments are primarily to facilitate +liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, +but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to +achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income +securities. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of June 30, 2011 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime +collateral. The majority of our mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage +Corporation, and Government National Mortgage Association. 34 Table of Contents PART II Item 7 Of the cash, cash equivalents, and short-term investments at June 30, 2011, approximately $45 +billion was held by our foreign subsidiaries and were subject to material repatriation tax effects. The amount of cash and investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other +local regulatory) was approximately $379 million. As of June 30, 2011, approximately 68% of the short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 12% were invested in +corporate notes and bonds of U.S. companies, and 5% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars. Securities lending We lend certain +fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount +determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $1.2 billion as of June 30, 2011. Our +average and maximum securities lending payable balances for the fiscal year were $1.6 billion and $3.3 billion, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and +where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual +funds, domestic and international equities, and U.S. treasuries. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or +inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and agency +securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a +quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing +vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments because the broker prices these investments based on similar +assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value +processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of +prices where appropriate. Cash Flows Fiscal +year 2011 compared with fiscal year 2010 Cash flows from operations increased $2.9 billion during the current fiscal year to $27.0 +billion due mainly to increased revenue and cash collections from customers. Cash used in financing decreased $4.9 billion to $8.4 billion due mainly to a $5.8 billion increase in proceeds from issuance of debt, net of repayments, offset in part by +a $602 million increase in cash paid for dividends. Cash used in investing increased $3.3 billion to $14.6 billion due to a $5.8 billion increase in purchases of investments, offset in part by a $2.5 billion increase in cash from securities lending. Fiscal year 2010 compared with fiscal year 2009 Cash flow from operations increased $5.0 billion, primarily due to payment of $4.1 billion to the Internal Revenue Service in the prior year as a result of our settlement of the 2000-2003 audit examination along +with increased cash received from customers in the current year. Cash used for financing increased $5.8 billion, primarily due to a $5.6 35 Table of Contents PART II Item 7 billion decrease in net cash proceeds from issuance and repayments of short-term and long-term debt. Financing activities also included a $1.9 billion increase in cash used for common stock +repurchases, which was offset in part by a $1.7 billion increase in cash received from common stock issued. Cash used for investing decreased $4.5 billion due to a $3.3 billion decrease in cash used for combined investment purchases, sales, and +maturities along with a $1.1 billion decrease in additions to property and equipment. Debt Short-term debt During fiscal year 2011, +we repaid $1.0 billion of commercial paper, leaving zero outstanding. On November 5, 2010, our $1.0 billion 364-day credit +facility expired. This facility served as a back-up for our commercial paper program. No amounts were drawn against the credit facility during any of the periods presented. Long-term debt We issued debt during the periods presented to take advantage of favorable +pricing and liquidity in the debt markets, reflecting our superior credit rating and the low interest rate environment. The proceeds of these issuances were used to partially fund discretionary business acquisitions and share repurchases. As of June 30, 2011, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were +$11.9 billion and $12.1 billion, respectively. This is compared to a carrying value and estimated fair value of $4.9 billion and $5.2 billion, respectively, as of June 30, 2010. The estimated fair value is based on quoted prices for our +publicly-traded debt as of June 30, 2011 and 2010, as applicable. The components of long-term debt, the associated interest rates, +and the semi-annual interest record and payment dates were as follows as of June 30, 2011: Due Date Face Value Stated Interest Rate Effective Interest Rate Interest Record Date Interest Pay Date Interest Record Date Interest Pay Date (In millions) Notes September 27, 2013 $ 1,000 0.875% 1.000% March 15 March 27 September 15 September 27 June 1, 2014 2,000 2.950% 3.049% May 15 June 1 November 15 December 1 September 25, 2015 1,750 1.625% 1.795% March 15 March 25 September 15 September 25 February 8, 2016 750 2.500% 2.642% February 1 February 8 August 1 August 8 June 1, 2019 1,000 4.200% 4.379% May 15 June 1 November 15 December 1 October 1, 2020 1,000 3.000% 3.137% March 15 April 1 September 15 October 1 February 8, 2021 500 4.000% 4.082% February 1 February 8 August 1 August 8 June 1, 2039 750 5.200% 5.240% May 15 June 1 November 15 December 1 October 1, 2040 1,000 4.500% 4.567% March 15 April 1 September 15 October 1 February 8, 2041 1,000 5.300% 5.361% February 1 February 8 August 1 August 8 Total 10,750 Convertible Debt June 15, 2013 1,250 0.000% 1.849% Total unamortized discount (79 ) Total $ 11,921 Notes The +Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. 36 Table of Contents PART II Item 7 Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, +which were capitalized. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. As of June 30, 2011, the net carrying amount of our convertible debt was $1.2 +billion and the unamortized discount was $38 million. Prior to March 15, 2013, the notes will be convertible, only in certain +circumstances, into cash and, if applicable, cash, shares of Microsoft’s common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up +to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock, or a combination of cash and shares of our common stock, at our election. Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt +borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity +representing the fair value of the option to convert the debt. In connection with the issuance of the notes, we entered into capped +call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the +capped call transactions, we purchased from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the +notes and with a cap price equal to $37.16. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity. Unearned Revenue Unearned revenue at +June 30, 2011 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or +annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Unearned revenue at June 30, 2011 also included payments for: post-delivery support +and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; Microsoft Dynamics business solutions products; OEM minimum commitments; unspecified upgrades/enhancements of Windows Phone and Microsoft Internet +Explorer on a when-and-if-available basis for Windows XP; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected future recognition of unearned revenue as of June 30, 2011: (In millions) Three Months Ending, September 30, 2011 $ 5,979 December 31, 2011 4,914 March 31, 2012 3,207 June 30, 2012 1,622 Thereafter 1,398 Total $ 17,120 37 Table of Contents PART II Item 7 Share Repurchases On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 (the “2007 Programs”) to buy back up +to $40.0 billion of Microsoft common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of +September 30, 2013 (the “2008 Program”). As of June 30, 2011, approximately $12.2 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without +notice. During the periods reported, we repurchased with cash resources: 447 million shares for $11.5 billion during fiscal year +2011; 380 million shares for $10.8 billion during fiscal year 2010; and 318 million shares for $8.2 billion during fiscal year 2009. All shares repurchased in fiscal years 2011 and 2010 were repurchased under the 2008 Program. Of the +shares repurchased in fiscal year 2009, 101 million shares were repurchased for $2.7 billion under the 2007 Programs, while the remainder was repurchased under the 2008 Program. Dividends During fiscal years 2011 and 2010, our Board of Directors declared the following +dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) Fiscal Year 2011 September 21, 2010 $ 0.16 November 18, 2010 $ 1,363 December 9, 2010 December 15, 2010 $ 0.16 February 17, 2011 $ 1,349 March 10, 2011 March 14, 2011 $ 0.16 May 19, 2011 $ 1,350 June 9, 2011 June 15, 2011 $ 0.16 August 18, 2011 $ 1,340 September 8, 2011 Fiscal Year 2010 September 18, 2009 $ 0.13 November 19, 2009 $ 1,152 December 10, 2009 December 9, 2009 $ 0.13 February 18, 2010 $ 1,139 March 11, 2010 March 8, 2010 $ 0.13 May 20, 2010 $ 1,130 June 10, 2010 June 16, 2010 $ 0.13 August 19, 2010 $ 1,118 September 9, 2010 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third +parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable +estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued in our financial statements any liabilities related to these indemnifications. 38 Table of Contents PART II Item 7 Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2011. (In millions) 2012 2013-2015 2016-2018 2019 and Thereafter Total Long-term +debt: (a) Principal payments $ 0 $ 4,250 $ 2,500 $ 5,250 $ 12,000 Interest payments 344 959 720 3,228 5,251 Construction commitments (b) 263 0 0 0 263 Operating +leases (c) 481 964 380 127 1,952 Purchase commitments (d) 5,580 355 0 0 5,935 Other long-term liabilities (e) 0 92 22 22 136 Total contractual obligations $ 6,668 $ 6,620 $ 3,622 $ 8,627 $ 25,537 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) (b) These amounts represent commitments for the construction of buildings, building improvements and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. (e) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $8.8 billion and other long-term contingent liabilities +of $276 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned +revenue of $1.4 billion and non-cash items of $279 million. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to +property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales +and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital +resources. Definitive Agreement with Skype On May 10, 2011, we announced that we had entered into a definitive agreement with Skype Global S.à.r.l. (“Skype”) under which we would acquire Skype, a leading internet communications +company, for $8.5 billion in cash. We anticipate the acquisition will extend Skype’s brand and reach of its network platform, while enhancing our existing portfolio of real-time communications products and services. The acquisition is subject +to regulatory approvals and other customary closing conditions. We obtained regulatory approval in the U.S. and expect to obtain all remaining required regulatory approvals during calendar year 2011. Liquidity We earn a significant amount of +our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term +investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, 39 Table of Contents PART II Item 7 short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as +regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term +investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter +for the foreseeable future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to +fund significant discretionary activities, such as acquisitions of businesses and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These +alternatives could result in higher effective tax rates, increased interest expense, or other dilution of our earnings. We have borrowed funds domestically and continue to have the ability to borrow funds domestically at reasonable interest rates. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, +including accumulated other comprehensive income, was $6.3 billion at June 30, 2011. Our retained deficit is not expected to affect our future ability to operate, pay dividends, or repay our debt given our continuing profitability and strong +financial position. RECENTLY ISSUED ACCOUNTING STANDARDS Recently Adopted Accounting Pronouncements On July 1, 2010, we adopted guidance issued +by the Financial Accounting Standards Board (“FASB”) on revenue recognition. Under the new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of +the tangible product are no longer within the scope of the software revenue recognition guidance, and software-enabled products are now subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue +arrangements with multiple deliverables that are outside the scope of the software revenue recognition guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be +determined, a best estimate of the selling price is required to separate deliverables and allocate arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the +relative selling price method affects the timing and amount of revenue recognition. Adoption of the new guidance did not have a material impact on our financial statements. On July 1, 2010, we adopted new guidance issued by the FASB on the consolidation of variable interest entities. The new guidance requires revised evaluations of whether entities represent variable interest +entities, ongoing assessments of control over such entities, and additional disclosures for variable interests. Adoption of the new guidance did not have a material impact on our financial statements. Recent Accounting Pronouncements Not Yet Adopted In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of +changes in equity. Instead, an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. The new guidance will be effective for us beginning +July 1, 2012 and will have presentation changes only. In May 2011, the FASB issued guidance to amend the accounting and disclosure +requirements on fair value measurements. The new guidance limits the highest-and-best-use measure to nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be +measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the new guidance 40 Table of Contents PART II Item 7 expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of +the fair value to changes in unobservable inputs. The new guidance will be effective for us beginning January 1, 2012. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon +adoption. In January 2010, the FASB issued guidance to amend the disclosure requirements related to fair value measurements. The +guidance requires the disclosure of roll forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The guidance will become +effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on our financial statements. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”). Preparing financial statements requires +management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting +policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and stock-based compensation. Revenue Recognition Software revenue recognition requires judgment, including whether a +software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. A portion of revenue may be recorded as unearned due to undelivered elements. Changes +to the elements in a software arrangement, the ability to identify VSOE for those elements, and the fair value of the respective elements could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether +future releases of certain software represent new products or upgrades and enhancements to existing products. Impairment of Investment Securities Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant +judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair +value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to +sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions +related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be +other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting +units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for +impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair +value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant +portion of a reporting unit. 41 Table of Contents PART II Item 7 Application of the goodwill impairment test requires judgment, including the identification of +reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted +cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over +which cash flows will occur, and determination of our weighted average cost of capital. Among our reporting units, the fair value of OSD has been the closest to its carrying value. The carrying value of OSD’s goodwill was $6.4 billion as of +June 30, 2011. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating +results and market conditions. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a +computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general +release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have +been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes +of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been +impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss +should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial statements. Income Taxes The objectives of +accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial +statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the +position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also +provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. +Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial +statements. Stock-Based Compensation Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the requisite service period. Determining the fair value of stock-based awards at +the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these +estimates, stock-based compensation expense and our results of operations could be impacted. 42 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial +reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, +through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities +and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief Executive Officer Peter S. Klein Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 43 Table of Contents PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK RISKS We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our financial +statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and +use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Interest Rate Our fixed-income portfolio +is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and +domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. Equity Our equity portfolio consists of +global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based +commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global +commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed +based on the historical volatilities and correlations among foreign currency exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses +could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. 44 Table of Contents PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of +June 30, 2011 and 2010 and for the year ended June 30, 2011: (In millions) June 30, 2011 June 30, 2010 Year Ended June 30, 2011 Risk Categories Average High Low Foreign currency $ 86 $ 57 $ 67 $ 121 $ 40 Interest rate $ 58 $ 58 $ 56 $ 65 $ 50 Equity $ 212 $ 183 $ 211 $ 230 $ 184 Commodity $ 28 $ 19 $ 22 $ 30 $ 18 Total one-day VaR for the combined risk categories was $290 +million at June 30, 2011 and $235 million at June 30, 2010. The total VaR is 25% less at June 30, 2011, and 26% less at June 30, 2010, than the sum of the separate risk categories in the above table due to the diversification +benefit of the combination of risks. 45 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2011 2010 2009 Revenue $ 69,943 $ 62,484 $ 58,437 Operating expenses: Cost of revenue 15,577 12,395 12,155 Research and development 9,043 8,714 9,010 Sales and marketing 13,940 13,214 12,879 General and administrative 4,222 4,063 4,030 Total operating expenses 42,782 38,386 38,074 Operating income 27,161 24,098 20,363 Other income (expense) 910 915 (542 ) Income before income taxes 28,071 25,013 19,821 Provision for income taxes 4,921 6,253 5,252 Net income $ 23,150 $ 18,760 $ 14,569 Earnings per share: Basic $ 2.73 $ 2.13 $ 1.63 Diluted $ 2.69 $ 2.10 $ 1.62 Weighted average shares outstanding: Basic 8,490 8,813 8,945 Diluted 8,593 8,927 8,996 Cash dividends declared per common share $ 0.64 $ 0.52 $ 0.52 See accompanying notes. 46 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2011 2010 Assets Current assets: Cash and cash equivalents $ 9,610 $ 5,505 Short-term investments (including securities loaned of $1,181 and $62) 43,162 31,283 Total cash, cash equivalents, and short-term investments 52,772 36,788 Accounts receivable, net of allowance for doubtful accounts of $333 and $375 14,987 13,014 Inventories 1,372 740 Deferred income taxes 2,467 2,184 Other 3,320 2,950 Total current assets 74,918 55,676 Property and equipment, net of accumulated depreciation of $9,829 and $8,629 8,162 7,630 Equity and other investments 10,865 7,754 Goodwill 12,581 12,394 Intangible assets, net 744 1,158 Other long-term assets 1,434 1,501 Total assets $ 108,704 $ 86,113 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 4,197 $ 4,025 Short-term debt 0 1,000 Accrued compensation 3,575 3,283 Income taxes 580 1,074 Short-term unearned revenue 15,722 13,652 Securities lending payable 1,208 182 Other 3,492 2,931 Total current liabilities 28,774 26,147 Long-term debt 11,921 4,939 Long-term unearned revenue 1,398 1,178 Deferred income taxes 1,456 229 Other long-term liabilities 8,072 7,445 Total liabilities 51,621 39,938 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,376 and 8,668 63,415 62,856 Retained deficit, including accumulated other comprehensive income of $1,863 and $1,055 (6,332 ) (16,681 ) Total stockholders’ equity 57,083 46,175 Total liabilities and stockholders’ equity $ 108,704 $ 86,113 See accompanying notes. 47 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2011 2010 2009 Operations Net income $ 23,150 $ 18,760 $ 14,569 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other 2,766 2,673 2,562 Stock-based compensation expense 2,166 1,891 1,708 Net recognized losses (gains) on investments and derivatives (362 ) (208 ) 683 Excess tax benefits from stock-based compensation (17 ) (45 ) (52 ) Deferred income taxes 2 (220 ) 762 Deferral of unearned revenue 31,227 29,374 24,409 Recognition of unearned revenue (28,935 ) (28,813 ) (25,426 ) Changes in operating assets and liabilities: Accounts receivable (1,451 ) (2,238 ) 2,215 Inventories (561 ) (44 ) 255 Other current assets (1,259 ) 464 (677 ) Other long-term assets 62 (223 ) (273 ) Accounts payable 58 844 (671 ) Other current liabilities (1,146 ) 451 (2,700 ) Other long-term liabilities 1,294 1,407 1,673 Net cash from operations 26,994 24,073 19,037 Financing Short-term debt borrowings (repayments), maturities of 90 days or less, net (186 ) (991 ) 1,178 Proceeds from issuance of debt, maturities longer than 90 days 6,960 4,167 4,796 Repayments of debt, maturities longer than 90 days (814 ) (2,986 ) (228 ) Common stock issued 2,422 2,311 579 Common stock repurchased (11,555 ) (11,269 ) (9,353 ) Common stock cash dividends paid (5,180 ) (4,578 ) (4,468 ) Excess tax benefits from stock-based compensation 17 45 52 Other (40 ) 10 (19 ) Net cash used in financing (8,376 ) (13,291 ) (7,463 ) Investing Additions to property and equipment (2,355 ) (1,977 ) (3,119 ) Acquisition of companies, net of cash acquired (71 ) (245 ) (868 ) Purchases of investments (35,993 ) (30,168 ) (36,850 ) Maturities of investments 6,897 7,453 6,191 Sales of investments 15,880 15,125 19,806 Securities lending payable 1,026 (1,502 ) (930 ) Net cash used in investing (14,616 ) (11,314 ) (15,770 ) Effect of exchange rates on cash and cash equivalents 103 (39 ) (67 ) Net change in cash and cash equivalents 4,105 (571 ) (4,263 ) Cash and cash equivalents, beginning of period 5,505 6,076 10,339 Cash and cash equivalents, end of period $ 9,610 $ 5,505 $ 6,076 See accompanying notes. 48 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2011 2010 2009 Common stock and paid-in capital Balance, beginning of period $ 62,856 $ 62,382 $ 62,849 Common stock issued 2,422 2,311 567 Common stock repurchased (3,738 ) (3,113 ) (2,611 ) Stock-based compensation expense 2,166 1,891 1,708 Stock-based compensation income tax deficiencies (292 ) (647 ) (128 ) Other, net 1 32 (3 ) Balance, end of period 63,415 62,856 62,382 Retained deficit Balance, beginning of period (16,681 ) (22,824 ) (26,563 ) Net income 23,150 18,760 14,569 Other comprehensive income: Net unrealized gains (losses) on derivatives (627 ) 27 302 Net unrealized gains (losses) on investments 1,054 265 (233 ) Translation adjustments and other 381 (206 ) (240 ) Comprehensive income 23,958 18,846 14,398 Common stock cash dividends (5,394 ) (4,547 ) (4,620 ) Common stock repurchased (8,215 ) (8,156 ) (6,039 ) Balance, end of period (6,332 ) (16,681 ) (22,824 ) Total stockholders’ equity $ 57,083 $ 46,175 $ 39,558 See accompanying notes. 49 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The financial +statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Principles of Consolidation The financial statements include the accounts of Microsoft +Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant influence over but do not control the investee and are not the primary beneficiary of the +investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the +cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples include: estimates of loss +contingencies, product warranties, product life cycles, product returns, and stock-based compensation forfeiture rates; assumptions such as the elements comprising a software arrangement, including the distinction between upgrades/enhancements and +new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; estimating the fair value and/or goodwill +impairment for our reporting units; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities +recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are +recorded to Other Comprehensive Income (“OCI”). Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and +collectibility is probable. Revenue generally is recognized net of any taxes collected from customers and subsequently remitted to governmental authorities. Revenue for retail packaged products, products licensed to original equipment manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are +shipped or made available. Revenue for products under technology guarantee programs, which provide free or significantly discounted rights to use upcoming new versions of a software product if an end user licenses existing versions of the product +during the eligibility period, is allocated between existing product and the new product, and revenue allocated to the new product is deferred until that version is delivered. The revenue allocation is based on vendor-specific objective evidence of +fair value of the products. Certain multi-year licensing arrangements include a perpetual license for current products combined with +rights to receive future versions of software products on a when-and-if-available basis (“Software Assurance”) and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the +billing coverage period. Revenue from certain arrangements that allow for the use of a product or service over a 50 Table of Contents PART II Item 8 period of time without taking possession of software are also accounted for as subscriptions. Revenue for software products where customers have the right to receive unspecified +upgrades/enhancements on a when-and-if-available basis and for which vendor-specific objective evidence of fair value does not exist for the upgrades/enhancements is recognized on a straight-line basis over the estimated life of the software. Revenue related to our Xbox 360 gaming and entertainment console, Kinect for Xbox 360, games published by us, and other hardware +components is generally recognized when ownership is transferred to the resellers. Revenue related to games published by third parties for use on the Xbox 360 platform is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the +search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of +hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Revenue from prepaid points redeemable for the purchase of software or services is recognized upon redemption of the +points and delivery of the software or services. Cost of Revenue Cost of revenue includes; manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to +include software on PCs sold by OEMs, to drive traffic to our Web sites, and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including +royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs. Capitalized research and development costs are amortized over +the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on +historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in +which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of +the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and +development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and +programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development +expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and +amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated +with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.9 billion, $1.6 billion, and $1.4 billion in fiscal years +2011, 2010, and 2009, respectively. 51 Table of Contents PART II Item 8 Employee Severance We record employee severance when a specific plan has been approved by management, the plan has been communicated to employees, and it is unlikely that significant changes will be made to the plan. In January 2009, +we announced and implemented a resource management program to reduce discretionary operating expenses, employee headcount, and capital expenditures. Severance expenses associated with this program were $59 million and $330 million in fiscal years +2010 and 2009, respectively, and are included in general and administrative expenses. Stock-Based Compensation We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense over the vesting or +service period, as applicable, of the stock award (generally four to five years) using the straight-line method. Employee Stock Purchase Plan Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value of the stock on +the last day of each three-month period. Compensation expense for the employee stock purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes +U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested, and interest and penalties on uncertain tax positions. Certain income and expenses are +not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. The deferred income taxes are classified as current or long-term based on the classification of +the related asset or liability. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the +market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. treasuries, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot +prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency securities, certificates of deposit, and commercial paper. Our Level 2 derivative assets +and liabilities primarily include certain over-the-counter option and swap contracts. 52 Table of Contents PART II Item 8 • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain +corporate bonds. We value these corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and volatilities. Unobservable inputs used in these models are significant +to the fair values of the investments. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop +assumptions to determine fair value for these derivatives. We measure certain assets, including our cost and equity +method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may +include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our current financial liabilities have fair values that approximate their carrying values. Our long-term financial liabilities consist of long-term +debt which is recorded on the balance sheet at issuance price less unamortized discount. Financial Instruments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. +The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. +Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents +and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity +securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred +stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the equity method. We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as +collateral for the loan securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on +publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our +investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for +equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security +before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow +factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. 53 Table of Contents PART II Item 8 Derivative instruments are recognized as either assets or liabilities and are measured at fair +value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributed to the risk +being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as cash-flow hedges, the effective portion of the derivative’s gain (loss) is initially reported as a component of OCI and is subsequently recognized in earnings when the +hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing +either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For +derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, +the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which +time the amounts are moved from OCI into other income (expense). Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the +allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2011 2010 2009 Balance, beginning of period $ 375 $ 451 $ 153 Charged to costs and other 14 45 360 Write-offs (56 ) (121 ) (62 ) Balance, end of period $ 333 $ 375 $ 451 Inventories Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead +related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below +carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset +or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three years; computer equipment, two to three years; buildings and improvements, five to +15 years; leasehold improvements, two to 10 years; and furniture and equipment, one to five years. Land is not depreciated. 54 Table of Contents PART II Item 8 Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or +circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated +period of benefit, ranging from one to 10 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be +impaired. Recently Issued Accounting Standards Recently adopted accounting pronouncements On July 1, 2010, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on revenue recognition. Under the +new guidance on arrangements that include software elements, tangible products that have software components that are essential to the functionality of the tangible product are no longer within the scope of the software revenue recognition guidance, +and software-enabled products are now subject to other relevant revenue recognition guidance. Additionally, the FASB issued guidance on revenue arrangements with multiple deliverables that are outside the scope of the software revenue recognition +guidance. Under the new guidance, when vendor specific objective evidence or third party evidence for deliverables in an arrangement cannot be determined, a best estimate of the selling price is required to separate deliverables and allocate +arrangement consideration using the relative selling price method. The new guidance includes new disclosure requirements on how the application of the relative selling price method affects the timing and amount of revenue recognition. Adoption of +the new guidance did not have a material impact on our financial statements. On July 1, 2010, we adopted new guidance issued by +the FASB on the consolidation of variable interest entities. The new guidance requires revised evaluations of whether entities represent variable interest entities, ongoing assessments of control over such entities, and additional disclosures for +variable interests. Adoption of the new guidance did not have a material impact on our financial statements. Recent accounting pronouncements not +yet adopted In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the +current option to report other comprehensive income and its components in the statement of changes in equity. Instead, an entity will be required to present either a continuous statement of net income and other comprehensive income or in two +separate but consecutive statements. The new guidance will be effective for us beginning July 1, 2012 and will have presentation changes only. In May 2011, the FASB issued guidance to amend the accounting and disclosure requirements on fair value measurements. The new guidance limits the highest-and-best-use measure to nonfinancial assets, permits +certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the new guidance +expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. The +new guidance will be effective for us beginning January 1, 2012. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption. 55 Table of Contents PART II Item 8 In January 2010, the FASB issued guidance to amend the disclosure requirements related to fair +value measurements. The guidance requires the disclosure of roll forward activities on purchases, sales, issuance, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value measurements). The +guidance will become effective for us with the reporting period beginning July 1, 2011. Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on our financial statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of +shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options, stock awards, and shared performance stock +awards. The components of basic and diluted EPS are as follows: (In millions, except earnings per share) Year Ended June 30, 2011 2010 2009 Net income available for common shareholders (A) $ 23,150 $ 18,760 $ 14,569 Weighted average outstanding shares of common stock (B) 8,490 8,813 8,945 Dilutive effect of stock-based awards 103 114 51 Common stock and common stock equivalents (C) 8,593 8,927 8,996 Earnings Per Share Basic (A/B) $ 2.73 $ 2.13 $ 1.63 Diluted (A/C) $ 2.69 $ 2.10 $ 1.62 We excluded the following shares underlying stock-based +awards from the calculations of diluted EPS because their inclusion would have been anti-dilutive: (In millions) Year Ended June 30, 2011 2010 2009 Shares excluded from calculations of diluted EPS 21 28 342 The decrease in anti-dilutive shares from fiscal year 2009 +to 2010 was due mainly to the decrease in employee stock options outstanding. In June 2010, we issued $1.25 billion of zero-coupon debt +securities that are convertible into shares of our common stock if certain conditions are met. As of June 30, 2011, none of these securities had met price or other conditions that would make them eligible for issuance and therefore were +excluded from the calculation of either the basic or diluted EPS. See Note 12 – Debt for additional information. NOTE +3 — OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Dividends and interest income $ 900 $ 843 $ 744 Interest expense (295 ) (151 ) (38 ) Net recognized gains (losses) on investments 439 348 (125 ) Net losses on derivatives (77 ) (140 ) (558 ) Net gains (losses) on foreign currency remeasurements (26 ) 1 (509 ) Other (31 ) 14 (56 ) Total $ 910 $ 915 $ (542 ) 56 Table of Contents PART II Item 8 Following are details of net recognized gains (losses) on investments during the periods +reported: (In millions) Year Ended June 30, 2011 2010 2009 Other-than-temporary impairments of investments $ (80 ) $ (69 ) $ (862 ) Realized gains from sales of available-for-sale securities 734 605 1,634 Realized losses from sales of available-for-sale securities (215 ) (188 ) (897 ) Total $ 439 $ 348 $ (125 ) NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, were +as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2011 Cash $ 1,648 $ 0 $ 0 $ 1,648 $ 1,648 $ 0 $ 0 Mutual funds 1,752 0 0 1,752 1,752 0 0 Commercial paper 639 0 0 639 414 225 0 Certificates of deposit 598 0 0 598 372 226 0 U.S. government and agency securities 33,607 162 (7 ) 33,762 2,049 31,713 0 Foreign government bonds 658 11 (2 ) 667 0 667 0 Mortgage-backed securities 2,307 121 (4 ) 2,424 0 2,424 0 Corporate notes and bonds 10,575 260 (11 ) 10,824 3,375 7,449 0 Municipal securities 441 15 (2 ) 454 0 454 0 Common and preferred stock 7,925 2,483 (193 ) 10,215 0 0 10,215 Other investments 654 0 0 654 0 4 650 Total $ 60,804 $ 3,052 $ (219 ) $ 63,637 $ 9,610 $ 43,162 $ 10,865 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2010 Cash $ 1,661 $ 0 $ 0 $ 1,661 $ 1,661 $ 0 $ 0 Mutual funds 1,120 0 0 1,120 1,120 0 0 Commercial paper 188 0 0 188 13 175 0 Certificates of deposit 348 0 0 348 68 280 0 U.S. government and agency securities 21,036 167 (1 ) 21,202 1,822 19,380 0 Foreign government bonds 518 13 0 531 0 531 0 Mortgage-backed securities 3,137 135 (7 ) 3,265 0 3,265 0 Corporate notes and bonds 7,450 289 (18 ) 7,721 701 7,020 0 Municipal securities 726 22 (1 ) 747 120 627 0 Common and preferred stock 6,640 1,030 (418 ) 7,252 0 0 7,252 Other investments 507 0 0 507 0 5 502 Total $ 43,331 $ 1,656 $ (445 ) $ 44,542 $ 5,505 $ 31,283 $ 7,754 57 Table of Contents PART II Item 8 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Fair Value Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses June 30, 2011 U.S. government and agency securities $ 484 $ (7 ) $ 0 $ 0 $ 484 $ (7 ) Foreign government bonds 365 (2 ) 0 0 365 (2 ) Mortgage-backed securities 63 (3 ) 14 (1 ) 77 (4 ) Corporate notes and bonds 750 (10 ) 25 (1 ) 775 (11 ) Municipal securities 79 (2 ) 0 0 79 (2 ) Common and preferred stock 1,377 (146 ) 206 (47 ) 1,583 (193 ) Total $ 3,118 $ (170 ) $ 245 $ (49 ) $ 3,363 $ (219 ) Less than 12 Months 12 Months or Greater Total Fair Value Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses June 30, 2010 U.S. government and agency securities $ 216 $ (1 ) $ 0 $ 0 $ 216 $ (1 ) Mortgage-backed securities 105 (6 ) 18 (1 ) 123 (7 ) Corporate notes and bonds 1,124 (13 ) 89 (5 ) 1,213 (18 ) Municipal securities 66 (1 ) 0 0 66 (1 ) Common and preferred stock 2,102 (339 ) 190 (79 ) 2,292 (418 ) Total $ 3,613 $ (360 ) $ 297 $ (85 ) $ 3,910 $ (445 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized +losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of +June 30, 2011. At June 30, 2011 and 2010, the recorded bases and estimated fair values of common and preferred stock and +other investments that are restricted for more than one year or are not publicly traded were $334 million and $216 million, respectively. Debt +Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2011 Due in one year or less $ 23,982 $ 24,053 Due after one year through five years 19,516 19,733 Due after five years through 10 years 2,516 2,637 Due after 10 years 2,811 2,945 Total $ 48,825 $ 49,368 58 Table of Contents PART II Item 8 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment +returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include +strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to +foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for +up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of June 30, 2011 and 2010, the total notional amounts of +these foreign exchange contracts sold were $10.6 billion and $9.3 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as +fair-value hedging instruments. As of June 30, 2011 and 2010, the total notional amounts of these foreign exchange contracts sold were $572 million and $523 million, respectively. Certain options and forwards not designated as hedging +instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of June 30, 2011, the total notional amounts of these +foreign exchange contracts purchased and sold were $3.9 billion and $7.3 billion, respectively. As of June 30, 2010, the total notional amounts of these foreign exchange contracts purchased and sold were $7.8 billion and $5.3 billion, +respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to +broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity +derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.4 billion and $935 million, +respectively. As of June 30, 2010, the total notional amounts of designated and non-designated equity contracts purchased and sold were $918 million and $472 million, respectively. Interest Rate Securities held in our fixed-income portfolio are subject to different interest +rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and +over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $2.3 billion and $2.2 billion, +respectively. As of June 30, 2010, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.1 billion and $1.8 billion, respectively. In addition, we use “To Be Announced” forward purchase commitments of +mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of +June 30, 2011 and 2010, the total notional derivative amount of mortgage contracts purchased were $868 million and $305 million, respectively. Credit Our fixed-income portfolio is +diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. +We use credit default swaps as they are a low cost method of managing 59 Table of Contents PART II Item 8 exposure to individual credit risks or groups of credit risks. As of June 30, 2011, the total notional amounts of credit contracts purchased and sold were $532 million and $277 million, +respectively. As of June 30, 2010, the total notional amounts of credit contracts purchased and sold were $371 million and $199 million, respectively. Commodity We use broad-based commodity exposures to enhance portfolio returns and to +facilitate portfolio diversification. We use swap, futures and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost +alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2011, the total notional amounts of commodity contracts purchased and sold were $1.9 billion +and $502 million, respectively. As of June 30, 2010, the total notional amounts of commodity contracts purchased and sold were $1.1 billion and $376 million, respectively. Credit Risk-Related Contingent Features Certain of our counterparty agreements for derivative +instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these +requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2011, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 +billion. As a result, no collateral was required to be posted. Fair Values of Derivative Instruments Following are the gross fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not +designated as hedging instruments (“non-designated hedge derivatives”) that were held at June 30, 2011 and 2010. The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting +agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk. (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2011 Assets Non-designated hedge derivatives: Short-term investments $ 14 $ 179 $ 0 $ 17 $ 4 $ 214 Other current assets 73 0 0 0 0 73 Total $ 87 $ 179 $ 0 $ 17 $ 4 $ 287 Designated hedge derivatives: Short-term investments $ 6 $ 0 $ 0 $ 0 $ 0 $ 6 Other current assets 123 0 0 0 0 123 Total $ 129 $ 0 $ 0 $ 0 $ 0 $ 129 Total assets $ 216 $ 179 $ 0 $ 17 $ 4 $ 416 Liabilities Non-designated hedge derivatives: Other current liabilities $ (91 ) $ (12 ) $ (9 ) $ (19 ) $ (4 ) $ (135 ) Designated hedge derivatives: Other current liabilities $ (128 ) $ 0 $ 0 $ 0 $ 0 $ (128 ) Total liabilities $ (219 ) $ (12 ) $ (9 ) $ (19 ) $ (4 ) $ (263 ) 60 Table of Contents PART II Item 8 (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2010 Assets Non-designated hedge derivatives: Short-term investments $ 15 $ 134 $ 12 $ 7 $ 8 $ 176 Other current assets 34 0 0 0 0 34 Total $ 49 $ 134 $ 12 $ 7 $ 8 $ 210 Designated hedge derivatives: Short-term investments $ 3 $ 0 $ 0 $ 0 $ 0 $ 3 Other current assets 563 0 0 0 0 563 Total $ 566 $ 0 $ 0 $ 0 $ 0 $ 566 Total assets $ 615 $ 134 $ 12 $ 7 $ 8 $ 776 Liabilities Non-designated hedge derivatives: Other current liabilities $ (60 ) $ (17 ) $ (33 ) $ (41 ) $ (5 ) $ (156 ) Designated hedge derivatives: Other current liabilities $ (9 ) $ 0 $ 0 $ 0 $ 0 $ (9 ) Total liabilities $ (69 ) $ (17 ) $ (33 ) $ (41 ) $ (5 ) $ (165 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. Fair Value Hedge Gains (Losses) We +recognized in other income (expense) the following gains (losses) related to fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2011 2010 2009 Foreign Exchange Contracts Derivatives $ (92 ) $ (57 ) $ 121 Hedged items 85 60 (120 ) Total $ (7 ) $ 3 $ 1 Equity Contracts Derivatives $ 0 $ 0 $ 191 Hedged items 0 0 (211 ) Total $ 0 $ 0 $ (20 ) 61 Table of Contents PART II Item 8 Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) related to foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods reported): (In millions) Year Ended June 30, 2011 2010 2009 Effective Portion Gain (loss) recognized in OCI, net of tax effect of $(340), $188 and $472 $ (632 ) $ 349 $ 876 Gain (loss) reclassified from OCI into revenue $ (7 ) $ 495 $ 884 Amount Excluded from Effectiveness Assessment and Ineffective Portion Loss recognized in other income (expense) $ (276 ) $ (174 ) $ (314 ) We estimate that $186 million of net derivative losses +included in OCI at June 30, 2011 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur +during fiscal year 2011. Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of +gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for all periods presented. Other than those derivatives entered into for investment purposes, such as commodity +contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities. (In millions) Year Ended June 30, 2011 2010 2009 Foreign exchange contracts $ (27 ) $ 106 $ (234 ) Equity contracts 35 12 (131 ) Interest-rate contracts 19 (4 ) 5 Credit contracts 24 22 (18 ) Commodity contracts 148 (1 ) (126 ) Total $ 199 $ 135 $ (504 ) 62 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2011 Assets Mutual funds $ 1,752 $ 0 $ 0 $ 1,752 $ 0 $ 1,752 Commercial paper 0 639 0 639 0 639 Certificates of deposit 0 598 0 598 0 598 U.S. government and agency securities 23,591 10,175 0 33,766 0 33,766 Foreign government bonds 303 367 0 670 0 670 Mortgage-backed securities 0 2,428 0 2,428 0 2,428 Corporate notes and bonds 0 10,600 58 10,658 0 10,658 Municipal securities 0 454 0 454 0 454 Common and preferred stock 9,821 55 5 9,881 0 9,881 Derivatives 8 388 20 416 (204 ) 212 Total $ 35,475 $ 25,704 $ 83 $ 61,262 $ (204 ) $ 61,058 Liabilities Derivatives and other $ 109 $ 257 $ 0 $ 366 $ (203 ) $ 163 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2010 Assets Mutual funds $ 1,120 $ 0 $ 0 $ 1,120 $ 0 $ 1,120 Commercial paper 0 172 0 172 0 172 Certificates of deposit 0 348 0 348 0 348 U.S. government and agency securities 16,473 4,756 0 21,229 0 21,229 Foreign government bonds 239 294 0 533 0 533 Mortgage-backed securities 0 3,264 0 3,264 0 3,264 Corporate notes and bonds 0 7,460 167 7,627 0 7,627 Municipal securities 0 747 0 747 0 747 Common and preferred stock 6,988 43 5 7,036 0 7,036 Derivatives 22 745 9 776 (207 ) 569 Total $ 24,842 $ 17,829 $ 181 $ 42,852 $ (207 ) $ 42,645 Liabilities Derivatives and other $ 85 $ 137 $ 0 $ 222 $ (205 ) $ 17 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. 63 Table of Contents PART II Item 8 The table below reconciles the total Net Fair Value of assets above to the balance sheet +presentation of these same assets in Note 4 – Investments for June 30, 2011 and 2010. (In millions) June 30, 2011 2010 Net fair value of assets measured at fair value on a recurring basis $ 61,058 $ 42,645 Cash 1,648 1,661 Common and preferred stock measured at fair value on a nonrecurring basis 334 216 Other investments measured at fair value on a nonrecurring basis 650 502 Less derivative assets classified as other current assets (54 ) (544 ) Other 1 62 Recorded basis of investment components $ 63,637 $ 44,542 Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis The following tables present the changes during the fiscal years 2011 and 2010 in our Level 3 financial instruments that are measured at fair value +on a recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI. (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Year Ended June 30, 2011 Balance, beginning of period $ 167 $ 5 $ 9 $ 181 Total realized and unrealized gains (losses): Included in other income (expense) 39 0 11 50 Included in other comprehensive income (63 ) 0 0 (63 ) Purchases, issuances and settlements (85 ) 0 0 (85 ) Balance, end of period $ 58 $ 5 $ 20 $ 83 Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2011 $ 6 $ 0 $ 11 $ 17 (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Year Ended June 30, 2010 Balance, beginning of period $ 253 $ 5 $ 5 $ 263 Total realized and unrealized gains (losses): Included in other income (expense) 6 0 4 10 Included in other comprehensive income (92 ) 0 0 (92 ) Balance, end of period $ 167 $ 5 $ 9 $ 181 Change in unrealized gains (losses) included in other income (expense) related to assets held as of June 30, 2010 $ 6 $ 0 $ 4 $ 10 Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal years 2011 and 2010, impairment charges of $2 million and $5 million, respectively, were recognized for certain +investments measured at fair value on a nonrecurring basis, as the decline in their respective fair values below their cost was determined to be other than temporary in all instances. At June 30, 2011 and 2010, we held no common and preferred +stocks that were required to be measured at fair value on a nonrecurring basis. 64 Table of Contents PART II Item 8 NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2011 2010 Raw materials $ 232 $ 172 Work in process 56 16 Finished goods 1,084 552 Total $ 1,372 $ 740 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2011 2010 Land $ 533 $ 526 Buildings and improvements 6,521 6,087 Leasehold improvements 2,345 2,100 Computer equipment and software 6,601 5,673 Furniture and equipment 1,991 1,873 Total, at cost 17,991 16,259 Accumulated depreciation (9,829 ) (8,629 ) Total, net $ 8,162 $ 7,630 During fiscal years 2011, 2010, and 2009, depreciation expense was $2.0 billion, $1.8 billion, and $1.7 billion, +respectively. NOTE 9 — BUSINESS COMBINATIONS During fiscal year 2011, we acquired three entities for total consideration of $75 million, substantially all of which was paid in cash. During fiscal year 2010, we acquired five entities for total consideration of +$267 million, substantially all of which was paid in cash. During fiscal year 2010, we also sold three entities for total consideration of $600 million, including Razorfish in the second quarter of fiscal year 2010. During fiscal year 2009, we +acquired nine entities for total consideration of $925 million, substantially all of which was paid in cash. These entities have been included in or removed from our consolidated results of operations since their acquisition or sale dates, +respectively. Pro forma results of operations have not been presented because the effects of these business combinations, individually and in the aggregate, were not material to our consolidated results of operations. Definitive Agreement with Skype On +May 10, 2011, we announced that we had entered into a definitive agreement with Skype Global S.à.r.l. (“Skype”) under which we would acquire Skype, a leading internet communications company, for $8.5 billion in cash. The +acquisition will extend Skype’s brand and reach of its network platform, while enhancing our existing portfolio of real-time communications products and services. The acquisition is subject to regulatory approvals and other customary closing +conditions. We obtained regulatory approval in the U.S. and expect to obtain all remaining required regulatory approvals during calendar year 2011. 65 Table of Contents PART II Item 8 NOTE 10 — GOODWILL Changes in the carrying amount of goodwill for fiscal years 2011 and 2010 by segment were as follows: Balance as of June 30, 2009 Acquisitions Purchase Accounting Adjustments and Other Balance as of June 30, 2010 Acquisitions Purchase Accounting Adjustments and Other Balance as of June 30, 2011 (In millions) Windows & Windows Live Division $ 77 $ 0 $ 0 $ 77 $ 0 $ 12 $ 89 Server and Tools 1,038 82 (2 ) 1,118 13 8 1,139 Online Services Division 6,657 0 (284 ) 6,373 0 0 6,373 Microsoft Business Division 3,927 116 (19 ) 4,024 4 139 4,167 Entertainment and Devices Division 804 0 (2 ) 802 30 (19 ) 813 Total $ 12,503 $ 198 $ (307 ) $ 12,394 $ 47 $ 140 $ 12,581 None of the amounts recorded as goodwill are expected to be deductible for tax purposes. The measurement period for +purchase price allocations ends as soon as information on the facts and circumstances becomes available, but will not exceed 12 months. Adjustments in the purchase price allocation may require a recasting of the amounts allocated to goodwill +retroactive to the period in which the acquisition occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the above table. Also included within “other” for fiscal +year 2010 is $285 million of goodwill associated with business dispositions. See also Note 9 – Business Combinations. We test +goodwill for impairment annually on May 1 at the reporting unit level using a fair value approach. No impairment of goodwill was identified as of May 1, 2011. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are +finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Year Ended June 30, 2011 2010 Contract-based $ 1,068 $ (966 ) $ 102 $ 1,075 $ (914 ) $ 161 Technology-based (a) 2,356 (1,831 ) 525 2,308 (1,521 ) 787 Marketing-related 113 (98 ) 15 114 (86 ) 28 Customer-related 326 (224 ) 102 390 (208 ) 182 Total $ 3,863 $ (3,119 ) $ 744 $ 3,887 $ (2,729 ) $ 1,158 (a) Technology-based intangible assets included $179 million and $249 million as of June 30, 2011 and 2010, respectively, of net carrying amount of +software to be sold, leased, or otherwise marketed. We estimate that we have no significant residual value +related to our intangible assets. No material impairments of intangible assets were identified during any of the periods presented. 66 Table of Contents PART II Item 8 The components of intangible assets acquired during fiscal years 2011 and 2010 were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2011 2010 Contract-based $ 0 $ 3 2 years Technology-based 119 3 years 322 4 years Marketing-related 1 7 years 0 Customer-related 2 4 years 18 5 years Total $ 122 3 years $ 343 4 years Intangible assets amortization expense was $537 million, $707 million, and $591 million for fiscal years 2011, +2010, and 2009, respectively. Amortization of capitalized software was $114 million, $97 million, and $65 million for fiscal years 2011, 2010, and 2009, respectively. The following table outlines the estimated future amortization expense related to intangible assets held at June 30, 2011: (In millions) Year Ending June 30, 2012 $ 390 2013 242 2014 68 2015 27 2016 10 2017 and thereafter 7 Total $ 744 NOTE 12 — DEBT Short-term Debt During fiscal year 2011, we repaid $1.0 billion of commercial paper, leaving +zero outstanding. On November 5, 2010, our $1.0 billion 364-day credit facility expired. This facility served as a back-up for our +commercial paper program. No amounts were drawn against the credit facility during any of the periods presented. Long-term Debt As of June 30, 2011, the total carrying value and estimated fair value of our long-term debt, including convertible debt, were $11.9 billion +and $12.1 billion, respectively. This is compared to a carrying value and estimated fair value of $4.9 billion and $5.2 billion, respectively, as of June 30, 2010. The estimated fair value is based on quoted prices for our publicly-traded debt as of +June 30, 2011 and 2010, as applicable. Maturities of long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2012 $ 0 2013 1,250 2014 3,000 2015 0 2016 2,500 Thereafter 5,250 Total $ 12,000 67 Table of Contents PART II Item 8 Cash paid for interest on our debt for fiscal years 2011 and 2010 was $197 million and $145 +million, respectively. No cash was paid for debt interest for fiscal year 2009. The components of long-term debt, the associated +interest rates, and the semi-annual interest record and payment dates were as follows as of June 30, 2011: Due Date Face Value Stated Interest Rate Effective Interest Rate Interest Record Date Interest Pay Date Interest Record Date Interest Pay Date (In millions) Notes September 27, 2013 $ 1,000 0.875% 1.000% March 15 March 27 September 15 September 27 June 1, 2014 2,000 2.950% 3.049% May 15 June 1 November 15 December 1 September 25, 2015 1,750 1.625% 1.795% March 15 March 25 September 15 September 25 February 8, 2016 750 2.500% 2.642% February 1 February 8 August 1 August 8 June 1, 2019 1,000 4.200% 4.379% May 15 June 1 November 15 December 1 October 1, 2020 1,000 3.000% 3.137% March 15 April 1 September 15 October 1 February 8, 2021 500 4.000% 4.082% February 1 February 8 August 1 August 8 June 1, 2039 750 5.200% 5.240% May 15 June 1 November 15 December 1 October 1, 2040 1,000 4.500% 4.567% March 15 April 1 September 15 October 1 February 8, 2041 1,000 5.300% 5.361% February 1 February 8 August 1 August 8 Total 10,750 Convertible Debt June 15, 2013 1,250 0.000% 1.849% Total unamortized discount (79 ) Total $ 11,921 The components of long-term debt, the associated interest rates, and the semi-annual interest record and payment +dates were as follows as of June 30, 2010: Due Date Face Value Stated Interest Rate Effective Interest Rate Interest Record Date Interest Pay Date Interest Record Date Interest Pay Date (In millions) Notes June 1, 2014 $ 2,000 2.950% 3.049% May 15 June 1 November 15 December 1 June 1, 2019 1,000 4.200% 4.379% May 15 June 1 November 15 December 1 June 1, 2039 750 5.200% 5.240% May 15 June 1 November 15 December 1 Total 3,750 Convertible Debt June 15, 2013 1,250 0.000% 1.849% Total unamortized discount (61 ) Total $ 4,939 Notes The +Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. 68 Table of Contents PART II Item 8 Convertible debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, +which were capitalized. Each $1,000 principal amount of notes is convertible into 29.94 shares of Microsoft common stock at a +conversion price of $33.40 per share. As of June 30, 2011, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $38 million. Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of Microsoft’s common stock, or a combination thereof, at our election. On +or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or deliver cash, shares of our common stock, or a combination of cash and shares of +our common stock, at our election. Because the convertible debt may be wholly or partially settled in cash, we are required to +separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated +between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity representing the fair value of the option to convert the debt. In connection with the issuance of the notes, we entered into capped call transactions with certain option counterparties who are initial +purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties +capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with a cap price equal to $37.16. The purchased capped calls +were valued at $40 million and recorded to stockholders’ equity. NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Current Taxes U.S. federal $ 3,108 $ 4,415 $ 3,159 U.S. state and local 209 357 192 International 1,602 1,701 1,139 Current taxes 4,919 6,473 4,490 Deferred Taxes Deferred taxes 2 (220 ) 762 Provision for income taxes $ 4,921 $ 6,253 $ 5,252 U.S. and international components of income before income taxes were as follows: (In millions) Year Ended June 30, 2011 2010 2009 U.S. $ 8,862 $ 9,575 $ 5,529 International 19,209 15,438 14,292 Income before income taxes $ 28,071 $ 25,013 $ 19,821 69 Table of Contents PART II Item 8 The items accounting for the difference between income taxes computed at the U.S. federal +statutory rate and our effective rate were as follows: Year Ended June 30, 2011 2010 2009 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (15.6)% (12.1)% (9.3)% Internal Revenue Service settlement (1.7)% 0% 0% Other reconciling items, net (0.2)% 2.1% 0.8% Effective rate 17.5% 25.0% 26.5% The reduction from the federal statutory rate from foreign earnings taxed at lower rates results from producing and +distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which are subject to lower income tax rates. In general, other reconciling items consist of interest, U.S. state income +taxes, domestic production deductions, and credits. In fiscal years 2011, 2010, and 2009, there were no individually significant other reconciling items. The I.R.S. settlement is discussed below. The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2011 2010 Deferred Income Tax Assets Stock-based compensation expense $ 1,079 $ 1,329 Other expense items 1,411 1,696 Unearned revenue 463 556 Impaired investments 424 289 Other revenue items 69 80 Deferred income tax assets $ 3,446 $ 3,950 Deferred Income Tax Liabilities International earnings $ (1,266 ) $ (1,056 ) Unrealized gain on investments (904 ) (674 ) Other (265 ) (265 ) Deferred income tax liabilities (2,435 ) (1,995 ) Net deferred income tax assets $ 1,011 $ 1,955 Reported As Current deferred income tax assets $ 2,467 $ 2,184 Long-term deferred income tax liabilities (1,456 ) (229 ) Net deferred income tax assets $ 1,011 $ 1,955 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets +and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. We have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $44.8 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently +reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences is approximately $14.2 billion. Income taxes paid were $5.3 billion, $4.1 billion, and $6.6 billion in fiscal years 2011, 2010, and 2009, respectively. 70 Table of Contents PART II Item 8 Uncertain Tax Positions As of June 30, 2011, we had $6.9 billion of unrecognized tax benefits of which $5.9 billion, if recognized, would affect our effective tax rate. As of June 30, 2010, we had $6.5 billion of unrecognized +tax benefits of which $5.6 billion, if recognized, would have affected our effective tax rate. Interest on unrecognized tax benefits +was $38 million, $193 million, and $230 million in fiscal years 2011, 2010, and 2009, respectively. As of June 30, 2011, 2010, and 2009, we had accrued interest related to uncertain tax positions of $785 million, $747 million, and $554 million, +respectively, net of federal income tax benefits. The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Balance, beginning of year $ 6,542 $ 5,403 $ 3,195 Decreases related to settlements (632 ) (57 ) (82 ) Increases for tax positions related to the current year 739 1,012 2,203 Increases for tax positions related to prior years 405 364 239 Decreases for tax positions related to prior years (119 ) (166 ) (132 ) Decreases due to lapsed statute of limitations 0 (14 ) (20 ) Balance, end of year $ 6,935 $ 6,542 $ 5,403 During the third quarter of fiscal year 2011, we reached a partial settlement agreement with the I.R.S. on tax +years 2004 to 2006 and recorded a $461 million income tax provision benefit. During the fourth quarter of fiscal year 2011, the I.R.S. completed its examination and issued a Revenue Agent’s Report (“RAR”) for the remaining unresolved +items. We do not agree with the adjustments in the RAR, and we have filed a protest to initiate the administrative appeals process. The proposed adjustments are primarily related to transfer pricing and could have a significant impact on our +financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the appeals +process will be concluded within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2010. We are subject to income tax in many jurisdictions outside the U.S., and certain jurisdictions remain subject to examination and are currently under audit by local tax authorities. The resolutions of these audits +are not expected to be material to our financial statements. NOTE 14 — UNEARNED REVENUE Unearned revenue comprises mainly unearned revenue from volume licensing programs, as well as payments for offerings for which we have been paid in +advance and we earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria. Volume Licensing +Programs Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid +either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Other Also included in unearned revenue +are payments for post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; Microsoft Dynamics business solutions products; technology guarantee programs; OEM minimum commitments; +unspecified upgrades or enhancements of Microsoft Internet Explorer on a when-and-if-available basis for Windows XP; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software or otherwise +meet the revenue recognition criteria. 71 Table of Contents PART II Item 8 The components of unearned revenue were as follows: (In millions) June 30, 2011 2010 Volume licensing programs $ 14,625 $ 12,180 Other 2,495 2,650 Total $ 17,120 $ 14,830 Unearned revenue by segment was as follows: (In millions) June 30, 2011 2010 Windows & Windows Live Division $ 1,782 $ 1,701 Server and Tools 6,552 5,282 Microsoft Business Division 7,950 7,004 Other segments 836 843 Total $ 17,120 $ 14,830 NOTE 15 — OTHER LONG-TERM LIABILITIES (In millions) June 30, 2011 2010 Tax contingencies and other tax liabilities $ 7,381 $ 6,887 Legal contingencies 276 236 Other 415 322 Total $ 8,072 $ 7,445 NOTE 16 — COMMITMENTS AND GUARANTEES Construction and Operating Leases We have committed $263 million for constructing new +buildings, building improvements and leasehold improvements as of June 30, 2011. We have operating leases for most U.S. and +international sales and support offices and certain equipment. Rental expense for facilities operating leases was $525 million, $530 million, and $475 million, in fiscal years 2011, 2010, and 2009, respectively. Future minimum rental commitments +under noncancellable facilities operating leases in place as of June 30, 2011 are as follows: (In millions) Year Ending June 30, 2012 $ 481 2013 396 2014 319 2015 249 2016 163 2017 and thereafter 344 Total $ 1,952 72 Table of Contents PART II Item 8 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered +significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements. Yahoo! Commercial Agreement On +December 4, 2009, we entered into a definitive agreement with Yahoo! whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! Web sites. The term of the agreement is 10 years subject to termination provisions +after five years based on performance. Microsoft provided Yahoo! with revenue per search guarantees for a period of 18 months after +implementation of the Microsoft search ads platform in each country. These guarantees are calculated, paid and trued-up periodically based on the cumulative reduction in revenue per search, if any, during the 18-month period from pre-implementation +levels, except in the case of the U.S. and Canada where performance during each of the first two calendar quarters after implementation is independent and not cumulative. This is a rate guarantee and not a guarantee of search volume. We estimate the +total cost of the revenue per search guarantees during the guarantee period could range up to $150 million. Microsoft also agreed to +reimburse Yahoo! for certain transition expenses incurred both before and after the effective date of the agreement. Finally, Microsoft +also agreed to reimburse Yahoo! for certain costs of running algorithmic and paid search services prior to migration to Microsoft’s platform. Product Warranty The changes in our +aggregate product warranty liabilities, which are included in other current liabilities and other long term-liabilities on our balance sheets, were as follows: (In millions) Year Ended June 30, 2011 2010 Balance, beginning of year $ 240 $ 342 Accruals for warranties issued 55 144 Adjustments to pre-existing warranties 0 (2 ) Settlements of warranty claims (123 ) (244 ) Balance, end of year $ 172 $ 240 NOTE 17 — CONTINGENCIES Government Competition Law Matters Since 2001, we have been subject to a Consent Decree and +Final Judgment (“Final Judgments”) that resolved lawsuits brought by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions. The Final Judgments imposed various constraints on our Windows operating +system businesses. The Final Judgments expired in May 2011. In other ongoing investigations, various foreign governments and several +state attorneys general have requested information from us concerning competition, privacy, and security issues. 73 Table of Contents PART II Item 8 Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on +behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products. We obtained dismissals of damages claims of indirect purchasers under federal law and in 15 states. Courts refused to certify +classes in two additional states. We have reached agreements to settle all claims that have been made to date in 19 states and the District of Columbia. The settlements in all states have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of +platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending +on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these +settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 +billion and $2.0 billion. At June 30, 2011, we have recorded a liability related to these claims of approximately $568 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.3 billion +mostly for vouchers, legal fees, and administrative expenses. The three cases pending in British Columbia, Ontario, and Quebec, Canada +have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. On April 15, 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that +indirect purchasers do not have a claim. The plaintiffs have sought review by the Canadian Supreme Court. The other two actions have been stayed. Other Antitrust Litigation and Claims In +November 2004, Novell, Inc. (“Novell”) filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to +Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. In March 2010 the +trial court granted summary judgment in favor of Microsoft as to all remaining claims. The court of appeals has reversed that ruling, and the case is scheduled for trial in Utah in October 2011. Patent and Intellectual Property Claims In +2003, we filed an action in U.S. District Court in California seeking a declaratory judgment that we do not infringe certain Alcatel-Lucent patents (although this action began before the merger of Alcatel and Lucent in 2006, for simplicity we refer +to the post-merger entity of Alcatel-Lucent). In April 2008, a jury returned a verdict in Alcatel-Lucent’s favor in a trial on a consolidated group of one video and three user interface patents. The jury concluded that we had infringed two user +interface patents and awarded $367 million in damages. In June 2008, the trial judge increased the amount of damages to $512 million to include $145 million of interest. We appealed that award. In December 2008, we entered into a settlement +agreement resolving all other litigation pending between Microsoft and Alcatel-Lucent, leaving approximately $500 million remaining in dispute. In September 2009, the court of appeals affirmed the liability award but vacated the verdict and +remanded the case to the trial court for a re-trial of the damages ruling, indicating the damages previously awarded were too high. Trial on the remanded damages claim was held in July 2011. In October 2003, Uniloc USA Inc. (“Uniloc”), a subsidiary of a Singapore-based company, filed a patent infringement suit in U.S. District +Court in Rhode Island, claiming that product activation technology supporting Windows XP and certain other Microsoft programs violated a Uniloc patent. After we obtained a favorable summary judgment that we did not infringe any of the claims of this +patent, the court of appeals vacated the trial court decision and remanded 74 Table of Contents PART II Item 8 the case for trial. In April 2009, the jury returned a $388 million verdict against us, including a finding of willful infringement. In September 2009, the district court judge overturned +the jury verdict, ruling that the evidence did not support the jury’s findings either that Microsoft infringed the patent or was willful. Uniloc appealed, and in January 2011 the court of appeals reversed the district court’s finding of +non-infringement (thus reinstating the jury verdict of infringement) but affirmed the district court’s ruling that Microsoft was not willful and affirmed the district court’s grant of a new trial on damages. Uniloc’s petition for +rehearing of the court of appeals’ decision as to damages was denied. A new trial on damages has been set for January 2012. In +March 2007, i4i Limited Partnership (“i4i”) sued Microsoft in U.S. District Court in Texas claiming that certain custom XML technology in Word 2003 and 2007 infringed i4i’s patent. In May 2009, a jury returned a verdict against us, +finding damages of $200 million and that we willfully infringed the patent. In August 2009, the court denied our post-trial motions and awarded enhanced damages of $40 million and prejudgment interest of $37 million. The court also issued a +permanent injunction prohibiting additional distribution of the allegedly infringing technology. We appealed and the appellate court stayed the injunction pending our appeal. In December 2009, the court of appeals rejected our appeal and +affirmed the trial court’s judgment and injunction, except that the court of appeals modified the effective date of the injunction to January 11, 2010. We appealed to the U.S. Supreme Court, and in June 2011 the court affirmed the judgment +of the court of appeals. In October 2010, we filed suit against Motorola with the International Trade Commission (“ITC”) and +in U.S. District Court in Washington for infringement of nine Microsoft patents by Motorola’s Android-based devices. Since then, Microsoft and Motorola have filed additional actions against each other in the ITC and federal courts in +Washington, Wisconsin, Florida, and California. Microsoft asserts Motorola’s Android-based devices violate 23 of its patents, and Motorola asserts various Microsoft products (including Windows, Windows Phone 7, Windows Mobile 6.5, Xbox, Bing +Maps, Hotmail, Messenger, and Exchange Server) violate 21 Motorola patents. Microsoft also claims Motorola has breached its contractual commitments to the Institute of Electrical and Electronics Engineers (“IEEE”) and International +Telecommunications Union (“ITU”) to license identified patents related to wireless and video coding technologies under reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola asserts that Microsoft breached +contractual commitments to the SD Card Association to license two patents under RAND terms and conditions, and asserts federal antitrust and state unfair business practice claims. Trial in our ITC case is set for August 2011, trial in +Motorola’s ITC case is set for October 2011, and trial of both parties’ patent infringement claims in Florida also is set for October 2011. In addition to these cases, there are approximately 55 other patent infringement cases pending against Microsoft. Other We also are subject to a variety of +other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our +financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2011, we had accrued aggregate liabilities of $693 million in other current liabilities and $276 million in other long-term liabilities for all of the contingent matters described in this note. +While we intend to vigorously defend these matters, there exists the possibility of adverse outcomes that we estimate could reach approximately $800 million in aggregate beyond recorded amounts. Were unfavorable final outcomes to occur, there exists +the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable. 75 Table of Contents PART II Item 8 NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock +outstanding were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Balance, beginning of year 8,668 8,908 9,151 Issued 155 140 75 Repurchased (447 ) (380 ) (318 ) Balance, end of year 8,376 8,668 8,908 Share Repurchases On September 22, 2008, we announced the completion of the two repurchase programs approved by our Board of Directors during the first quarter of fiscal year 2007 to buy back up to $40.0 billion of Microsoft +common stock. On September 22, 2008, we also announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As of +June 30, 2011, approximately $12.2 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without prior notice. We repurchased the following shares of common stock under the above-described repurchase plans using cash resources: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2011 (a) 2010 (a) 2009 (b) First quarter 163 $ 4,000 58 $ 1,445 223 $ 5,966 Second quarter 188 5,000 125 3,583 95 2,234 Third quarter 30 827 67 2,000 0 0 Fourth quarter 66 1,631 130 3,808 0 0 Total 447 $ 11,458 380 $ 10,836 318 $ 8,200 (a) All shares repurchased in fiscal years 2011 and 2010 were repurchased under the plan approved by our Board of Directors on September 22, 2008. (b) Of the 318 million shares of common stock repurchased in fiscal year 2009, 101 million shares were repurchased for $2.7 billion under the plan +approved by our Board of Directors during the first quarter of fiscal year 2007. The remaining shares were repurchased under the plan approved by our Board of Directors on September 22, 2008. Dividends In fiscal year 2011, our Board +of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 21, 2010 $ 0.16 November 18, 2010 $ 1,363 December 9, 2010 December 15, 2010 $ 0.16 February 17, 2011 $ 1,349 March 10, 2011 March 14, 2011 $ 0.16 May 19, 2011 $ 1,350 June 9, 2011 June 15, 2011 $ 0.16 August 18, 2011 $ 1,340 September 8, 2011 76 Table of Contents PART II Item 8 The dividend declared on June 15, 2011 will be paid after the filing date of this report on +Form 10-K and was included in other current liabilities as of June 30, 2011. In fiscal year 2010, our Board of Directors declared +the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 18, 2009 $ 0.13 November 19, 2009 $ 1,152 December 10, 2009 December 9, 2009 $ 0.13 February 18, 2010 $ 1,139 March 11, 2010 March 8, 2010 $ 0.13 May 20, 2010 $ 1,130 June 10, 2010 June 16, 2010 $ 0.13 August 19, 2010 $ 1,118 September 9, 2010 The dividend declared on June 16, 2010 was included in +other current liabilities as of June 30, 2010. NOTE 19 — OTHER COMPREHENSIVE INCOME The activity in other comprehensive income and related income tax effects were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Net Unrealized Gains on Derivatives Unrealized gains (losses), net of tax effects of $(340) , $188, and $472 $ (632 ) $ 349 $ 876 Reclassification adjustment for gains included in net income, net of tax effects of $2 , $(173), and $(309) 5 (322 ) (574 ) Net unrealized gains on derivatives $ (627 ) $ 27 $ 302 Net Unrealized Gains (Losses) on Investments Unrealized gains (losses), net of tax effects of $726 , $263, and $(142) $ 1,349 $ 488 $ (263 ) Reclassification adjustment for losses (gains) included in net income, net of tax effects of $(159) , $(120), and $16 (295 ) (223 ) 30 Net unrealized gains (losses) on investments 1,054 265 (233 ) Translation adjustments and other, net of tax effects of $205 , $(103) and $(133) 381 (206 ) (240 ) Other comprehensive income (loss) $ 808 $ 86 $ (171 ) The components of accumulated other comprehensive income were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Net unrealized gains (losses) on derivatives $ (163 ) $ 464 $ 437 Net unrealized gains on investments 1,821 767 502 Translation adjustments and other 205 (176 ) 30 Accumulated other comprehensive income $ 1,863 $ 1,055 $ 969 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to directors and employees. At June 30, 2011, an aggregate of 583 million shares were authorized for +future grant under our stock plans, covering stock options, stock awards, and shared performance stock awards, and excluding shares reserved for issuance under our employee stock purchase plan. Awards that expire or are canceled without delivery of +shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy exercises and vestings of awards granted under all of our stock plans. 77 Table of Contents PART II Item 8 Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Stock-based compensation expense $ 2,166 $ 1,891 $ 1,708 Income tax benefits related to stock-based compensation $ 758 $ 662 $ 598 Stock Plans (Excluding Stock Options) Stock awards Stock awards +(“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. Our SAs generally vest over a five-year period. Shared performance stock awards Shared performance stock awards (“SPSAs”) are a +form of SA in which the number of shares ultimately received depends on our business performance against specified performance targets. We granted SPSAs for fiscal years 2011, 2010, and 2009 with performance periods of July 1, 2010 through June 30, 2011, July 1, +2009 through June 30, 2010, and July 1, 2008 through June 30, 2009, respectively. In August following the end of each performance period, the number of shares of stock subject to the award is determined by multiplying the target award +by a percentage ranging from 0% to 150%. The percentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of Directors in its sole discretion. An additional number of shares, +approximately 12% of the total target SPSAs, are available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each award vest following the end of the performance period, and an +additional one-quarter of the shares vest on each of the following three anniversaries of the grant date. Executive Officer Incentive Plan Under the Executive Officer Incentive Plan (“EOIP”), the Compensation Committee awards performance-based compensation to +executive officers of the Company for specified performance periods. During the periods reported, executive officers were eligible to receive annual awards comprised of cash and SAs from an aggregate incentive pool equal to a percentage of the +Company’s operating income. For fiscal years 2011, 2010, and 2009, the pool was 0.25%, 0.45%, and 0.35% of operating income, respectively. In September following the end of the fiscal year, each executive officer may receive a combined cash and SA award with a total value equal to a fixed percentage of the aggregate pool. The fixed percentage ranges +between 0% and 150% of a target based on an assessment of the executive officer’s performance during the prior fiscal year. Following approval of the awards, 20% of the award is payable to the executive officers in cash, and the remaining 80% +is converted into an SA for shares of Microsoft common stock. The number of shares subject to the SA portion of the award is determined by dividing the value of 80% of the total award by the closing price of Microsoft common stock on the last +business day in August of each year. The SA portion of the award vests one-quarter immediately after the award is approved following fiscal year-end and one-quarter on August 31 of each of the following three years. Activity for all stock plans The fair +value of each award is estimated on the date of grant using the following assumptions: Year Ended June 30, 2011 2010 2009 Dividends per share (quarterly amounts) $ 0.13 – $  0.16 $ 0.13 $ 0.11 - $  0.13 Interest rates range 1.1% - 2.4% 2.1% - 2.9% 1.4% - 3.6% 78 Table of Contents PART II Item 8 During fiscal year 2011, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 223 $ 24.76 Granted 114 $ 22.17 Vested (63 ) $ 25.00 Forfeited (19 ) $ 23.97 Nonvested balance, end of year 255 $ 23.59 Shared Performance Stock Awards Nonvested balance, beginning of year 30 $ 25.32 Granted 18 $ 22.56 Vested (13 ) $ 25.63 Forfeited (3 ) $ 24.05 Nonvested balance, end of year 32 $ 23.76 As of June 30, 2011, there was $4.5 billion and $467 million of total unrecognized compensation costs related +to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 3.3 years and 2.5 years, respectively. During fiscal year 2010 and 2009, the following activity occurred under our stock plans: (In millions, except fair values) 2010 2009 Stock Awards Awards granted 100 91 Weighted average grant-date fair value $ 23.43 $ 24.95 Shared Performance Stock Awards Awards granted 12 10 Weighted average grant-date fair value $ 24.57 $ 25.93 Following are the fair values of stock plan awards vested +during the periods reported: (In millions) 2011 2010 2009 Total vest-date fair value of stock awards vested $ 1,521 $ 1,358 $ 1,137 Total vest-date fair value of shared performance stock awards vested $ 289 $ 227 $ 485 Stock Options We grant stock options primarily in conjunction with business acquisitions. We granted zero, one million, and one million stock options +in conjunction with business acquisitions during fiscal years 2011, 2010, and 2009, respectively. Options generally vest over four and one-half years and expire 10 years from the date of grant. 79 Table of Contents PART II Item 8 Employee stock options activity during 2011 was as follows: Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value (In millions) (Years) (In millions) Balance, July 1, 2010 187 $ 24.68 Exercised (79 ) $ 24.91 Canceled (15 ) $ 28.84 Balance, June 30, 2011 93 $ 23.21 1.04 $ 312 Exercisable, June 30, 2011 92 $ 23.16 1.04 $ 309 Options outstanding as of June 30, 2011 include +approximately two million options that were granted in conjunction with business acquisitions. These options have an exercise price range of $0.01 to $29.24 and a weighted average exercise price of $7.69. During the periods reported, the following stock option exercise activity occurred: (In millions) 2011 2010 2009 Total intrinsic value of stock options exercised $ 222 $ 365 $ 48 Cash received from stock option exercises $ 1,954 $ 1,839 $ 88 Tax benefit realized from stock option exercises $ 77 $ 126 $ 12 Employee Stock Purchase Plan We have an employee stock purchase plan for all eligible employees. Shares of our common stock may be purchased by employees at three-month +intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares +during the periods presented: (Shares in millions) Year Ended June 30, 2011 2010 2009 Shares purchased 20 20 24 Average price per share $ 22.98 $ 23.73 $ 20.13 At June 30, 2011, 43 million shares of our common +stock were reserved for future issuance through the employee stock purchase plan. Savings Plan We have a savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in +international locations. Participating U.S. employees may contribute up to 50% of their salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% +of a participant’s earnings. Matching contributions for all plans were $282 million, $275 million, and $262 million in fiscal years 2011, 2010, and 2009, respectively, and were expensed as contributed. Matching contributions are invested +proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are +required to be invested in Microsoft common stock. 80 Table of Contents PART II Item 8 NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, the Company’s Chief Executive Officer, reviews +certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. Our five segments are Windows & +Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division. Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. Revenue on +certain contracts may be allocated among the segments based on the relative value of the underlying products and services. Costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so +that one segment is not solely burdened by the cost of a mutually beneficial activity. Allocated costs may include those relating to development and marketing of products and services from which multiple segments benefit, or those costs relating to +services performed by one segment on behalf of other segments. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated +costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain other +corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; +research and development; legal settlements and contingencies; and employee severance. We have recast certain prior period amounts +within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year, including moving Microsoft’s PC hardware business from Entertainment and Devices Division to Windows & +Windows Live Division, Windows Embedded from Entertainment and Devices Division to Server and Tools, and Office for Mac from Entertainment and Devices Division to Microsoft Business Division, as well as implementing intersegment cost allocations +between all segments related to the collaborative investment in mobile platform development. The principal products and services +provided by each segment are summarized below: Windows & Windows Live Division – Windows & Windows Live +Division offerings consist of multiple editions of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products. Server and Tools – Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Windows Embedded device platforms, and Enterprise Services. Enterprise +Services comprise Premier product support services and Microsoft Consulting Services. Online Services Division – Online +Services Division offerings include Bing, MSN, and advertiser tools. Microsoft Business Division – Microsoft Business +Division offerings include Microsoft Office, SharePoint, Exchange, Lync, and Microsoft Dynamics business solutions. Entertainment +and Devices Division – Entertainment and Devices Division offerings include the Xbox 360 entertainment platform, including Kinect for Xbox 360, Mediaroom (our Internet protocol television software), and Windows Phone. 81 Table of Contents PART II Item 8 Segment revenue and operating income (loss) were as follows during the periods presented: (In millions) Year Ended June 30, 2011 2010 2009 Revenue Windows & Windows Live Division $ 18,778 $ 18,792 $ 15,563 Server and Tools 17,107 15,390 14,686 Online Services Division 2,528 2,200 2,110 Microsoft Business Division 21,986 19,345 19,211 Entertainment and Devices Division 8,716 6,224 6,416 Unallocated and other 828 533 451 Consolidated $ 69,943 $ 62,484 $ 58,437 (In millions) Year Ended June 30, 2011 2010 2009 Operating Income (Loss) Windows & Windows Live Division $ 11,968 $ 12,253 $ 9,372 Server and Tools 6,453 5,320 4,627 Online Services Division (2,638 ) (2,410 ) (1,749 ) Microsoft Business Division 13,827 11,642 11,153 Entertainment and Devices Division 1,135 573 288 Reconciling amounts (3,584 ) (3,280 ) (3,328 ) Consolidated $ 27,161 $ 24,098 $ 20,363 Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies +to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, depreciation, and amortization of +stock-based awards. Significant reconciling items were as follows: (In millions) Year Ended June 30, 2011 2010 2009 Corporate-level activity (a) $ (4,619 ) $ (4,260 ) $ (4,318 ) Stock-based compensation expense 544 556 753 Revenue reconciling amounts 632 366 256 Other (141 ) 58 (19 ) Total $ (3,584 ) $ (3,280 ) $ (3,328 ) (a) Corporate-level activity excludes stock-based compensation expense and revenue reconciling amounts presented separately in those line items. No sales to an individual customer accounted for more than 10% of fiscal year 2011, 2010, or 2009 revenue. Revenue, +classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2011 2010 2009 United +States (a) $ 38,008 $ 36,173 $ 33,052 Other countries 31,935 26,311 25,385 Total $ 69,943 $ 62,484 $ 58,437 (a) Includes shipments to customers in the U.S. and licensing to certain OEMs and multinational organizations. 82 Table of Contents PART II Item 8 Revenue from external customers, classified by significant product and service offerings were as +follows: (In millions) Year Ended June 30, 2011 2010 2009 Microsoft Office system $ 20,730 $ 17,754 $ 17,998 Windows PC operating systems 17,825 18,225 14,653 Server products and tools 13,251 12,007 11,344 Xbox 360 platform 8,103 5,456 5,475 Consulting and product support services 3,372 3,036 3,024 Advertising 2,913 2,528 2,345 Other 3,749 3,478 3,598 Total $ 69,943 $ 62,484 $ 58,437 Assets are not allocated to segments for internal reporting presentations. A portion of amortization and +depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment +profit or loss. Long-lived assets, excluding financial instruments and deferred taxes, classified by the location of the controlling +statutory company, were as follows: (In millions) June 30, 2011 2010 2009 United States $ 18,498 $ 18,716 $ 19,362 Other countries 2,989 2,466 2,435 Total $ 21,487 $ 21,182 $ 21,797 83 Table of Contents PART II Item 8 NOTE 22 — QUARTERLY INFORMATION (Unaudited) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2011 Revenue $ 16,195 $ 19,953 $ 16,428 $ 17,367 $ 69,943 Gross profit 13,056 15,120 12,531 13,659 54,366 Net income 5,410 6,634 5,232 (a) 5,874 (b) 23,150 Basic earnings per share 0.63 0.78 0.62 0.70 2.73 Diluted earnings per share 0.62 0.77 0.61 0.69 2.69 Fiscal Year 2010 Revenue $ 12,920 (d) $ 19,022 (c) $ 14,503 $ 16,039 $ 62,484 Gross profit 10,078 15,394 11,748 12,869 50,089 Net income 3,574 6,662 4,006 4,518 18,760 Basic earnings per share 0.40 0.75 0.46 0.52 2.13 Diluted earnings per share 0.40 0.74 0.45 0.51 2.10 (a) Includes a partial settlement of an I.R.S. audit of tax years 2004 to 2006, which increased net income by $461 million. (b) Reflects an effective tax rate of 7% due mainly to the adjustment of our previously estimated effective tax rate for the year to reflect the actual full +year mix of foreign and U.S. taxable income. In addition, upon completion of our annual domestic and foreign tax returns, we adjusted the estimated tax provision to reflect the tax returns filed and recorded an income tax benefit which lowered our +effective tax rate. (c) Reflects $1.7 billion of revenue recognized for sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost and of Windows 7 +to original equipment manufacturers and retailers before general availability (the “Windows 7 Deferral”). (d) Reflects $1.5 billion of revenue deferred to future periods relating to the Windows 7 Deferral. 84 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2011 and 2010, and the related consolidated statements of income, +cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2011. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on +these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on +a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated +financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2011 and 2010, and the results of their operations and their cash flows for each of the three years +in the period ended June 30, 2011, in conformity with accounting principles generally accepted in the United States of America. We +have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2011, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 28, 2011, expressed an unqualified opinion on the Company’s internal control over +financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 28, +2011 85 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and +with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of +the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control +over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal +control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial +statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets +that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a +misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our +internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded +that the company’s internal control over financial reporting was effective as of June 30, 2011. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2011 that have materially +affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2011; their report is included in +Item 9A. 86 Table of Contents PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2011, based on criteria established in Internal Control +– Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its +assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s +internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public +Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material +respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on +the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal +executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper +management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to +future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2011, +based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, 2011, of the +Company and our report dated July 28, 2011, expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 28, +2011 87 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may +be found under the caption “Our Director Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 15, 2011 (the “Proxy Statement”). Information about our Audit Committee may be found under +the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference. The information +in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting +Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our Web site at www.microsoft.com/investor/CorporateGovernance/BoardofDirectors/Contacts/MSFinanceCode.aspx. If we make +any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, +we will disclose the nature of the amendment or waiver on that Web site or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Report,” and +“Compensation Committee Interlocks and Insider Participation” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information Regarding Beneficial Ownership of Principal +Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related +Transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND +SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees +Billed by Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. 88 Table of Contents PART IV Item 15 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information +is otherwise included. Index to Financial Statements Page Income Statements 46 Balance Sheets 47 Cash Flows Statements 48 Stockholders’ Equity Statements 49 Notes to Financial Statements 50 Report of Independent Registered Public Accounting Firm 85 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/09 3.1 1/28/10 3.2 Bylaws of Microsoft Corporation 10-Q 12/31/09 3.2 1/28/10 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.3 Indenture, dated as of June 14, 2010, between Microsoft Corporation and the Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 6/18/10 4.4 Form of Global Note representing the Zero Coupon Convertible Senior Notes due 2013 8-K 4.2 6/18/10 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft +Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.5 9/27/10 89 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.6 2/8/11 10.1* Microsoft Corporation 2001 Stock Plan 8-K 99.2 7/20/06 10.2* Microsoft Corporation 1991 Stock Option Plan 8-K 99.1 7/20/06 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation 2003 Employee Stock Purchase Plan 10-K 6/30/04 10.6 9/1/04 10.5* Microsoft Corporation Deferred Compensation Plan X 10.6* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.8* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the January 1, 2004 to June 30, 2006 performance period 10-K 6/30/04 10.10 9/1/04 10.9* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the July 1, 2003 to June 30, 2006 performance period 10-K 6/30/04 10.11 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.12 7/30/10 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.13 7/30/10 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.15* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2007 performance period 10-K 6/30/07 10.17 8/3/07 90 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.16* Form of Shared Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan for the fiscal year 2008 performance period 10-Q 12/31/07 10.18 1/24/08 10.17* Executive Officer Incentive Plan 10-Q 9/30/08 10.17 10/23/08 10.18* Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/10 10.18 10/28/10 10.19* Annual Performance Bonus Plan for Executive Officers 10-Q 10.19 1/22/09 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS** XBRL Instance Document X 101.SCH** XBRL Taxonomy Extension Schema X 101.CAL** XBRL Taxonomy Extension Calculation Linkbase X 101.DEF** XBRL Taxonomy Extension Definition Linkbase X 101.LAB** XBRL Taxonomy Extension Label Linkbase X 101.PRE** XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus +for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability. 91 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 28, 2011. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on July 28, 2011. Signature Title / S /    W ILLIAM H. G ATES III William H. Gates III Chairman / S /    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer / S /    D INA D UBLON Dina Dublon Director / S /    R AYMOND V. +G ILMARTIN Raymond V. Gilmartin Director / S /    R EED H ASTINGS Reed Hastings Director / S /    M ARIA K LAWE Maria Klawe Director / S /    D AVID F. +M ARQUARDT David F. Marquardt Director / S /    C HARLES H. +N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    P ETER S. +K LEIN Peter S. Klein Chief Financial Officer (Principal Financial +Officer) / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 92 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-12-316848/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-12-316848/full-submission.txt new file mode 100644 index 0000000..a7cadaf --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-12-316848/full-submission.txt @@ -0,0 +1,1062 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2012 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period +From                  to Commission File Number 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per +share                                         +  NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such +shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its +corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was +required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2011, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $195,333,665,376 based on the closing sale price as reported on the NASDAQ +National Market System. As of July 18, 2012, there were 8,383,396,575 shares of common stock outstanding. DOCUMENTS INCORPORATED +BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of +Shareholders to be held on November 28, 2012 are incorporated by reference into Part III. Table of Contents MICROSOFT CORPORATION FORM 10-K For The Fiscal +Year Ended June 30, 2012 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 12 Item 1A. Risk Factors 14 Item 1B. Unresolved Staff Comments 22 Item 2. Properties 22 Item 3. Legal Proceedings 22 Item 4. Mine Safety Disclosures 22 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 23 Item 6. Selected Financial Data 23 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 24 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 45 Item 8. Financial Statements and Supplementary Data 47 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 89 Item 9A. Controls and Procedures 89 Report of Management on Internal Control over Financial Reporting 89 Report of Independent Registered Public Accounting Firm 90 Item 9B. Other Information 91 PART III Item 10. Directors, Executive Officers and Corporate Governance 91 Item 11. Executive Compensation 91 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 91 Item 13. Certain Relationships and Related Transactions, and Director Independence 91 Item 14. Principal Accounting Fees and Services 91 PART IV Item 15. Exhibits and Financial Statement Schedules 92 Signatures 95 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business +plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of +the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business,” “Management’s +Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” +“intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely +result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. +A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part I, Item 1A of this Form +10-K). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Microsoft was +founded in 1975. Our mission is to enable people and businesses throughout the world to realize their full potential by creating technology that transforms the way people work, play, and communicate. We develop and market software, services, and +hardware that deliver new opportunities, greater convenience, and enhanced value to people’s lives. We do business worldwide and have offices in more than 100 countries. We generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware, and by delivering relevant online advertising to a global customer +audience. In addition to selling individual products and services, we offer suites of products and services. Our products include +operating systems for personal computers (“PCs”), servers, phones, and other intelligent devices; server applications for distributed computing environments; productivity applications; business solution applications; desktop and server +management tools; software development tools; video games; and online advertising. We also design and sell hardware including the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 accessories, and Microsoft PC hardware +products. We provide consulting and product and solution support services, and we train and certify computer system integrators and +developers. We also offer cloud-based solutions that provide customers with software, services and content over the Internet by way of shared computing resources located in centralized data centers. Cloud revenue is earned primarily from usage fees +and advertising. Examples of cloud-based computing services we offer include: • Microsoft Office 365, an online suite that enables people to work from virtually anywhere at any time with simple, familiar collaboration and communication +solutions, including Microsoft Office, Exchange, SharePoint, and Lync; • Xbox LIVE service, which enables online gaming, social networking, and access to a wide range of video, gaming, and entertainment content; • Microsoft Dynamics CRM Online customer relationship management services for sales, service, and marketing professionals provided through a familiar Microsoft +Outlook interface; 3 Table of Contents PART I Item 1 • Bing, our Internet search engine that finds and organizes the answers people need so they can make faster, more informed decisions; • Skype, which allows users to connect with friends, family, clients, and colleagues through a variety of devices; and • the Azure family of platform and database services that helps developers connect applications and services in the cloud or on premise. These services include +Windows Azure, a scalable operating system with computing, storage, hosting, and management capabilities, and Microsoft SQL Azure, a relational database. We also conduct research and develop advanced technologies for future software and hardware products and services. We believe that we will continue to grow and meet our customers’ needs by delivering +compelling, new, high-value solutions through our integrated software, hardware, and services platforms, creating new opportunities for partners, improving customer satisfaction, and improving our service excellence, business efficacy, and internal +processes. OPERATING SEGMENTS We operate our business in five segments: Windows & Windows Live Division, Server and Tools, Online Services Division, Microsoft Business Division, and Entertainment and Devices Division. Our segments +provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for +timely and rational allocation of development, sales, marketing, and services resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 21 – Segment Information and +Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Windows & Windows Live Division Windows & Windows Live Division (“Windows Division”) develops and markets PC operating systems, related software +and online services, and PC hardware products. This collection of software, hardware, and services is designed to empower individuals, companies, and organizations and simplify everyday tasks through seamless operations across the user’s +hardware and software and efficient Web browsing. User demand for mobility is increasing; as a result, we are working to increase the number of scenarios and devices that Windows enables. Windows Division revenue growth is largely correlated to the growth of the PC market worldwide, as approximately 75% of total Windows Division +revenue comes from Windows operating system software purchased by original equipment manufacturers (“OEMs”), which they pre-install on equipment they sell. In addition to PC market volume changes, Windows revenue is impacted by: • PC market changes driven by shifts between developed markets and emerging markets, consumer PCs and business PCs, and among varying forms of computing +devices; • the attachment of Windows to PCs shipped and changes in inventory levels within the OEM channel; and • pricing changes and promotions, pricing variation that occurs when the mix of PCs manufactured shifts from local and regional system builders to large, +multinational OEMs, and different pricing of Windows versions licensed. Principal Products and +Services : Windows 7 operating system; Windows Live suite of applications and web services; and PC hardware products. The next version of our operating system, Windows 8, will be generally available on October 26, 2012. At that time, we will begin selling the Surface, a series of Microsoft-designed and manufactured hardware +devices. 4 Table of Contents PART I Item 1 Competition The Windows operating system faces competition from various commercial software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving +customers choice, value, flexibility, security, an easy-to-use interface, compatibility with a broad range of hardware and software applications, including those that enable productivity, and the largest support network for any operating system. +Additionally, Windows 8 will run on both x86 and ARM architecture, enabling an even wider range of devices that run Windows. The Windows 8 operating system will include the Windows Store, an online application marketplace. This marketplace will +benefit our developer and partner ecosystems by providing access to a large customer base and will benefit Windows users by providing centralized access to certified applications. Windows Live software and services compete with similar software and service products from Apple, Google, Yahoo!, and a wide array of websites and +portals that provide communication and sharing tools and services. Our PC hardware products face competition from computer and other +hardware manufacturers, many of which are also current or potential partners. Server and Tools Server and Tools develops and markets server software, software developer tools, services, and solutions that are designed to make information +technology professionals and developers and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This +includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security and identity software. Server and Tools also builds standalone and software +development lifecycle tools for software architects, developers, testers, and project managers. Server offerings can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. Our cloud-based services comprise a scalable operating system with computing, storage, management, and database capabilities, from which customers +can run enterprise workloads and web applications. These services also include a platform that helps developers connect applications and services in the cloud or on premise. Our goal is to enable customers to devote more resources to development and +use of applications that benefit their businesses, rather than managing on-premises hardware and software. We are unique in our ability to provide customers hybrid solutions that bring together the benefits of traditional on-site offerings with +cloud-based services. Server and Tools offers a broad range of enterprise consulting and product support services (“Enterprise +Services”) that assist customers in developing, deploying, and managing Microsoft server and desktop solutions. In addition, Windows Embedded extends the power of Windows and the cloud to intelligent systems by delivering specialized operating +systems, tools, and services. Server and Tools also provides training and certification to developers and information technology professionals for our Server and Tools, Microsoft Business Division, and Windows & Windows Live Division +products and services. Approximately 55% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, +approximately 25% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the remainder comes from Enterprise Services. Principal Products and Services : Windows Server operating systems; Windows Azure; +Microsoft SQL Server; SQL Azure; Windows Intune; Windows Embedded; Visual Studio; Silverlight; System Center products; Microsoft Consulting Services; and Premier product support services. 5 Table of Contents PART I Item 1 Competition Our server operating system products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer +manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute +to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red +Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial +software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on +the Java Platform Enterprise Edition that compete with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client/server environments include CA Technologies, IBM, and Oracle. Our Web +application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java middleware such as Geronimo, JBoss, and Spring Framework. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, +Hewlett-Packard, IBM, and VMware. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our products for software developers compete against offerings from +Adobe, IBM, Oracle, other companies, and open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among others. Our embedded systems compete in a highly fragmented environment in which key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista +Software. Our cloud-based services face diverse competition from companies such as Amazon, Google, Salesforce.com, and VMware. SQL +Azure specifically faces competition from IBM, Oracle, and other open source offerings. The Enterprise Services business competes with a number of diverse companies, including multinational consulting firms and small niche businesses focused on +specific technologies. We believe our server products, cloud-based services, and Enterprise Services provide customers with advantages +in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Online Services Division Online Services +Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and +advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD’s annual revenue. Expanding Bing beyond a standalone consumer search engine, we continue to expand our use of +Bing’s technology by integrating the platform into other Microsoft products, including Xbox 360 and Windows Phone, to enhance those offerings. In December 2009, we entered into an agreement with Yahoo! to provide the exclusive algorithmic and paid search platform for Yahoo! websites worldwide. We have completed the worldwide algorithmic transition and the +paid search transition in the U.S., Canada, U.K., France, Germany, and several other markets, and are transitioning paid search in the remaining international markets. We believe this agreement is allowing us to improve the effectiveness and +increase the relevance of our search offering through greater scale in search queries and an expanded and more competitive search and advertising marketplace. Principal Products and Services : Bing; MSN; adCenter; and Atlas online tools for advertisers. 6 Table of Contents PART I Item 1 Competition OSD competes with Google and a wide array of websites and portals that provide content and online offerings to end users. Our success depends on our ability to attract new users, understand intent, and match intent +with relevant content and advertiser offerings. We believe we can attract new users by continuing to offer new and compelling products and services and to further differentiate our offerings by providing a broad selection of content and by helping +users make faster, more informed decisions and take action more quickly by providing relevant search results, expanded search services, and deeply-integrated social recommendations. Microsoft Business Division Microsoft Business Division (“MBD”) offerings consist +of the Microsoft Office system (comprising mainly Office, Office 365, SharePoint, Exchange, and Lync) and Microsoft Dynamics business solutions, which may be delivered either on premise or as a cloud-based service. The Microsoft Office system +is designed to increase personal, team, and organization productivity through a range of programs, services, and software solutions and generates over 90% of MBD revenue. Growth in Office depends on our ability to add value to the core Office +product set and to continue to expand our product offerings in other areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business solutions for +financial management, customer relationship management (“CRM”), supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. Approximately 80% of MBD revenue is generated from sales to businesses, which includes Microsoft Office system revenue generated through volume +licensing agreements and Microsoft Dynamics revenue. Revenue from sales to businesses generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a given +year. Approximately 20% of MBD revenue is derived from sales to consumers, which includes revenue from retail packaged product sales and OEM revenue. This revenue generally is affected by the level of PC shipments and by product launches. Principal Products and Services : Microsoft Office; Microsoft Exchange; +Microsoft SharePoint; Microsoft Lync; Microsoft Office Project and Office Visio; Microsoft Dynamics ERP and Dynamics CRM; Microsoft Office 365, which is an online services offering of Microsoft Office, Exchange, SharePoint, and Lync; and Microsoft +Office Web Apps, which are the online companions to Microsoft Word, Excel, PowerPoint, and OneNote. Competition Competitors to the Microsoft Office system include software application vendors such as Adobe, Apple, Cisco, Google, IBM, Oracle, SAP, and numerous +Web-based competitors as well as local application developers in Asia and Europe. Apple distributes versions of its application software products with various models of its PCs and through its mobile devices. Cisco is using its position in +enterprise communications equipment to grow its unified communications business. IBM has a measurable installed base with its office productivity products. Google provides a hosted messaging and productivity suite that competes with the Microsoft +Office system. Web-based offerings competing with individual applications can also position themselves as alternatives to Microsoft Office system products. We believe our products compete effectively based on our strategy of providing powerful, +flexible, secure, easy to use solutions that work well with technologies our customers already have and are available on a device or via the cloud. Our Microsoft Dynamics products compete with vendors such as Oracle and SAP in the market for large organizations and divisions of global enterprises. In the market focused on providing solutions for small and +mid-sized businesses, our Microsoft Dynamics products compete with vendors such as Infor and Sage. Additionally, Salesforce.com’s on-demand CRM offerings compete directly with Microsoft Dynamics CRM Online and Microsoft Dynamics CRM’s +on-premise offerings. 7 Table of Contents PART I Item 1 Entertainment and Devices Division Entertainment and Devices Division (“EDD”) develops and markets products and services designed to entertain and connect people. The Xbox +360 entertainment platform, including Kinect, is designed to provide a unique variety of entertainment choices through the use of our devices, peripherals, content, and online services. Skype is designed to connect friends, family, clients, and +colleagues through a variety of devices. Windows Phone is designed to bring users closer to the people, applications, and content they need, while providing unique capabilities such as Microsoft Office and Xbox LIVE. Through a strategic alliance, +Windows Phone and Nokia are jointly creating new mobile products and services and extending established product and services to new markets. Principal Products and Services: Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox 360 accessories; Xbox LIVE; Skype; and Windows Phone. Competition Entertainment and +devices businesses are highly competitive, characterized by rapid product life cycles, frequent introductions of new products and game titles, and the development of new technologies. The markets for our products are characterized by significant +price competition, and we anticipate continued pricing pressure from our competitors. Our competitors vary in size from very small companies with limited resources to very large, diversified corporations with substantial financial and marketing +resources. We compete primarily on the basis of product quality and variety, timing of product releases, and effectiveness of distribution and marketing. Our Xbox gaming and entertainment business competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles +averages five to 10 years. We released Xbox 360, our second generation console, in November 2005. Nintendo and Sony released new versions of their game consoles in late 2006. We believe the success of gaming and entertainment consoles is determined +by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the console, and the ability to create new experiences via online services, downloadable content, and +peripherals. In addition to Nintendo and Sony, our businesses compete with both Apple and Google in offering content products and services to the consumer. We believe the Xbox 360 entertainment platform is positioned well against competitive +products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own game franchises as well as other digital +content offerings. Windows Phone faces competition primarily from Apple, Google, and Research In Motion. Skype competes primarily with +Apple and Google, which offer a selection of instant messaging, voice, and video communication products. OPERATIONS We have operations centers that support all operations in their regions, including customer contract and order processing, credit and collections, +information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the +centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate data centers throughout the Americas, +Europe, and Asia regions. To serve the needs of customers around the world and to improve the quality and usability of products in +international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. We contract most of our manufacturing activities for Xbox 360 and related games, Kinect for Xbox 360, various retail software packaged products, +Surface devices, and Microsoft PC hardware to third parties. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console and Kinect for Xbox 8 Table of Contents PART I Item 1 360 include key components that are supplied by a single source. The integrated central processing unit/graphics processing unit is purchased from IBM, and the supporting embedded dynamic random +access memory chips are purchased from Taiwan Semiconductor Manufacturing Company. Sole source suppliers also will produce key components of our Surface devices. We generally have the ability to use other manufacturers if the current vendor becomes +unavailable or unable to meet our requirements. We generally have multiple sources for raw materials, supplies, and components, and are often able to acquire component parts and materials on a volume discount basis. RESEARCH AND DEVELOPMENT During fiscal years 2012, 2011, and 2010, research and development expense was $9.8 billion, $9.0 billion, and $8.7 billion, respectively. +These amounts represented 13%, 13%, and 14%, respectively, of revenue in each of those years. We plan to continue to make significant investments in a broad range of research and development efforts. Product Development and Intellectual Property We develop most of our software products and services internally. Internal development allows us to maintain competitive advantages that come from closer technical control over our products and services. It also +gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect +software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement +of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of +over 31,000 U.S. and international patents issued and over 38,000 pending. While we employ much of our internally developed intellectual property exclusively in Microsoft products and services, we also engage in outbound and inbound licensing of +specific patented technologies that are incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We also +purchase or license technology that we incorporate into our products or services. While it may be necessary in the future to seek or +renew licenses relating to various aspects of our products and business methods, we believe, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms. We believe our continuing +research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Microsoft’s success is based on our ability to create new and +compelling products, services, and experiences for our users, initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging +technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the company. We maintain our long-term commitment to research and development across a wide spectrum of +technologies, tools, and platforms spanning communication and collaboration, information access and organization, entertainment, business and e-commerce, advertising, and devices. While our main research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other +parts of the U.S. and around the world, including Canada, China, Denmark, Estonia, Germany, India, Ireland, Israel, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to continue to attract top +talent from across the world. We generally fund research at 9 Table of Contents PART I Item 1 the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the business +segment level. Much of our business segment level research and development is coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest computer science research organizations, and works in close +collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends. Based on our assessment of key technology trends and our broad focus on long-term research and development, we see significant opportunities to drive future growth in smart connected devices, cloud computing, +entertainment, search, communications, and productivity. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services primarily through the following channels: OEM; distributors and resellers; and online. OEM We distribute software +through OEMs that pre-install our software on new PCs, servers, smartphones, and other intelligent devices that they sell to end customers. The largest component of the OEM business is the Windows operating system pre-installed on PCs. OEMs also +sell hardware pre-installed with other Microsoft products, including server and embedded operating systems and applications such as our Microsoft Office suite. In addition to these products, we also market through OEMs software services such as our +Windows Live Essentials suite. There are two broad categories of OEMs. The largest OEMs, many of which operate globally, are referred +to as “Direct OEMs,” as our relationship with them is managed through a direct agreement between Microsoft and the manufacturer. We have distribution agreements covering one or more of our products with virtually all of the multinational +OEMs, including Acer, ASUS, Dell, Fujitsu, HTC, Hewlett-Packard, LG, Lenovo, Nokia, Samsung, Sony, Toshiba, and with many regional and local OEMs. The second broad category of OEMs consists of lower-volume PC manufacturers (also called “system +builders”), which source their Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Some of the distributors +in the Microsoft distributor channel are global, such as Ingram Micro and Tech Data, but most operate at a local or regional level. Distributors and +Resellers Many organizations that license our products and services through enterprise agreements transact directly with us, with +sales support from solution integrators, independent software vendors, web agencies, and developers that advise organizations on licensing our products and services (“Enterprise Software Advisors”). Organizations also license our products +and services indirectly, primarily through large account resellers (“LARs”), distributors, value-added resellers (“VARs”), OEMs, system builder channels, and retailers. Although each type of reselling partner reaches +organizations of all sizes, LARs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small-sized and medium-sized organizations. Enterprise Software Advisors typically are also authorized +as LARs and operate as resellers for our other licensing programs, such as the Select Plus and Open licensing programs discussed under “Licensing Options” below. Some of our distributors include Ingram Micro and Tech Data, and some of our +largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our Microsoft Dynamics software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and +specialized services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets, including Microsoft Stores. Individual consumers obtain these products +primarily through retail outlets, such as Wal-Mart and Dixons. We have a network of field sales representatives and field support personnel that solicits orders from distributors and resellers, and provides product training and sales support. 10 Table of Contents PART I Item 1 Online Although client-based software will continue to be an important part of our business, increasingly we are delivering additional value to customers through cloud-based services. We provide online content and +services to consumers through Bing, MSN portals and channels, Microsoft Office Web Apps, Windows Phone Marketplace, Xbox LIVE, and Zune Marketplace. We provide content and services to business users through the Microsoft Online Services platform, +which includes cloud-based services such as Exchange Online, Microsoft Dynamics CRM Online, Microsoft Lync, Microsoft Office 365, Microsoft Office Communications Online, Microsoft Office Live Meeting, SQL Azure, SharePoint Online, Windows Azure, and +Windows Intune. Other services delivered online include our online advertising platform with offerings for advertisers, as well as Microsoft Developer Networks subscription content and updates, periodic product updates, and online technical and +practice readiness resources to support our partners in developing and selling our products and solutions. We also sell our products through our online store, microsoftstore.com. LICENSING OPTIONS We +license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products and services. Our arrangements for organizations to acquire multiple licenses of products and services are designed to +provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for +organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. Open +Licensing Designed primarily for small-to-medium organizations, Open Programs allows customers to acquire perpetual or subscription +licenses and, at the customer’s election, rights to future versions of software products over a specified time period (two or three years depending on the Open Programs used). The offering that conveys rights to future versions of certain +software products over the contract period is called software assurance. Software assurance also provides support, tools, and training to help customers deploy and use software efficiently. Open Programs has several variations to fit customers’ +diverse way of purchasing. Under the Open License Program, customers can acquire licenses only, or licenses with software assurance. They can also renew software assurance upon the expiration of existing volume licensing agreements. Select Plus Licensing Designed primarily +for medium-to-large organizations, the Select Plus Program allows customers to acquire perpetual licenses and, at the customer’s election, software assurance over a specified time period (generally three years or less). Similar to Open +Programs, the Select Plus Program allows customers to acquire licenses only, acquire licenses with software assurance, or renew software assurance upon the expiration of existing volume licensing agreements. Online services are also available for +purchase through the Select Plus Program, and subscriptions are generally structured with terms between one and three years. Services Provider +Licensing The Microsoft Services Provider License Agreement (“SPLA”) is a program targeted to service providers and +Independent Software Vendors (“ISVs”) allowing these partners to provide software services and hosted applications to their end customers. Agreements are generally structured with a three-year term, and partners are billed monthly based +upon consumption. 11 Table of Contents PART I Item 1 Enterprise Agreement Licensing Enterprise agreements are targeted at medium and large organizations that want to acquire licenses to Online Services and/or software products, along with software assurance, for all or substantial parts of their +enterprise. Enterprises can elect to either acquire perpetual licenses or, under the Enterprise Subscription Program, can acquire non-perpetual, subscription agreements for a specified time period (generally three years). Online Services are also +available for purchase through the Enterprise agreement and subscriptions are generally structured with three year terms. CUSTOMERS Our customers include individual consumers, small- and medium-sized organizations, enterprises, governmental institutions, +educational institutions, Internet service providers, application developers, and OEMs. Consumers and small- and medium-sized organizations obtain our products primarily through distributors, resellers, and OEMs. No sales to an individual customer +accounted for more than 10% of fiscal year 2012, 2011, or 2010 revenue. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 26, 2012 were as follows: Name Age Position with the Company Steven A. Ballmer 56 Chief Executive Officer Lisa E. Brummel 52 Chief People Officer Kurt D. DelBene 52 President, Microsoft Office Division Peter S. Klein 49 Chief Financial Officer Craig J. Mundie 63 Chief Research and Strategy Officer Satya Nadella 44 President, Server and Tools Business Steven Sinofsky 46 President, Windows & Windows Live Division Bradford L. Smith 53 Executive Vice President; General Counsel; Secretary B. Kevin Turner 47 Chief Operating Officer Mr. Ballmer was appointed Chief Executive Officer in +January 2000. He served as President from July 1998 to February 2001. Previously, he had served as Executive Vice President, Sales and Support since February 1992. Mr. Ballmer joined Microsoft in 1980. Ms. Brummel was named Senior Vice President, Human Resources in December 2005 and in 2011 her title changed to Chief People Officer. She +had been Corporate Vice President, Human Resources since May 2005. From May 2000 to May 2005, she had been Corporate Vice President of the Home & Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of +management positions at Microsoft, including General Manager of Consumer Productivity Business, Product Unit Manager of the Kids Business, and Product Unit Manager of Desktop and Decision Reference Products. Mr. DelBene was named President, Microsoft Office Division in September 2010. He served as Senior Vice President for the Microsoft Business +Division since 2006. Since joining Microsoft in 1992, Mr. DelBene has served in several roles in Microsoft’s product development teams, including Vice President of Authoring and Collaboration Services, General Manager of Microsoft Outlook, +Group Program Manager for Microsoft Exchange, and Group Manager in Microsoft’s Systems Division. Mr. Klein was named Chief +Financial Officer in November 2009. He served as Corporate Vice President, Chief Financial Officer, Microsoft Business Division from February 2006 to November 2009 and Chief Financial Officer of Server and Tools from July 2003 to February 2006. +Mr. Klein joined Microsoft in 2002. 12 Table of Contents PART I Item 1 Mr. Mundie was named Chief Research and Strategy Officer in June 2006. He had been Senior +Vice President and Chief Technical Officer, Advanced Strategies and Policy since August 2001. He was named Senior Vice President, Consumer Platforms in February 1996. Mr. Mundie joined Microsoft in 1992. Mr. Nadella was named President, Server and Tools in February 2011. He previously held other leadership positions at Microsoft including +Senior Vice President Research and Development for the Online Services Division since 2008 and Corporate Vice President, Research and Development for the Advertising Platform since 2007. From 2000 to 2007, Mr. Nadella led Microsoft Business +Solutions. Prior to that, he spent several years leading engineering efforts in Microsoft’s Server group. Mr. Nadella joined Microsoft in 1992. Mr. Sinofsky was named President, Windows & Windows Live Division in July 2009. He served as Senior Vice President of the Windows & Windows Live Engineering Group since December 2006 and +Senior Vice President, Office from December 1999 to December 2006. He had been Vice President, Office since December 1998. Mr. Sinofsky joined the Office team in 1994, increasing his responsibility with each subsequent release of the desktop +suite. Mr. Sinofsky joined Microsoft in 1989. Mr. Smith was named Senior Vice President, General Counsel, and Secretary in +November 2001 and in 2011 his title changed to Executive Vice President, General Counsel, and Secretary. Mr. Smith was also named Chief Compliance Officer effective July 2002. He had been Deputy General Counsel for Worldwide Sales and +previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith joined Microsoft in 1993. Mr. Turner was named Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s +Club division. From September 2001 to August 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From March 2000 to September 2001, he served as its Senior Vice President and +Chief Information Officer of the Information Systems Division. EMPLOYEES As of June 30, 2012, we employed approximately 94,000 people on a full-time basis, 55,000 in the U.S. and 39,000 internationally. Of the +total, 36,000 were in product research and development, 25,000 in sales and marketing, 18,000 in product support and consulting services, 6,000 in manufacturing and distribution, and 9,000 in general and administration. Our success is highly +dependent on our ability to attract and retain qualified employees. None of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our +Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through +which investors can easily find or navigate to pertinent information about us, including: • our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”); • information on our business strategies, financial results, and key performance indicators; • announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available; • press releases on quarterly earnings, product and service announcements, legal developments, and international news; • corporate governance information including our articles, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate +citizenship initiatives, and other governance-related policies; 13 Table of Contents PART I Item 1, 1A • other news and announcements that we may post from time to time that investors might find useful or interesting; and • opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash +flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to +lower revenue or operating margins. Competition in the technology sector. Our competitors range in +size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers +to entry in our businesses generally are low and software products can be distributed broadly and quickly at relatively low cost. Many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, +and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products that appeal to businesses and consumers. Competition among platforms, ecosystems, and devices. An important element of our business model has been to create +platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers and the platform provider that can accelerate growth. Establishing +significant scale in the marketplace is necessary to achieve and maintain competitive margins. The strategic importance of a vibrant ecosystem increases as we launch the Windows 8 operating system, Surface devices, and associated cloud-based +services. We face significant competition from firms that provide competing platforms, applications and services. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has been +successful with some consumer products such as personal computers, mobile phones, gaming consoles, and digital music players. These competitors also earn revenue from services that are integrated with the hardware and software platform. We also +offer vertically-integrated hardware and software products and services; however, our competitors have been in the market longer and in some cases have established significantly large user bases. Efforts to compete with the vertically integrated +model will increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. The proliferation of alternative devices and form factors, in +particular mobile devices such as smartphones and tablet computers, creates challenges from competing software platforms. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users may +increasingly turn to these devices to perform functions that would have been performed by personal computers in the past. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more +difficult to attract applications developers to our platforms. In addition, our Surface devices will compete with products made by our OEM partners, which may affect their commitment to our platform. • Competing platforms have applications marketplaces (sometimes referred to as “stores”) with scale and significant installed bases on mobile devices. +These applications leverage free and user-paid services that over time result in disincentives for users to switch to competing platforms. In order to compete, we must successfully enlist developers to write applications for our marketplace and +ensure that these applications have high quality, customer appeal and value. Efforts to compete with these application marketplaces may increase our cost of revenue and lower our operating margins. 14 Table of Contents PART I Item 1A Business model competition. Companies compete with us based on a +growing variety of business models. • Under the license-based proprietary software model that generates most of our revenue, we bear the costs of converting original ideas into software products +through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model and we expect this +competition to continue. • Other competitors develop and offer free online services and content, and make money by selling third-party advertising. Advertising revenues fund development +of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end users and +earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality +of our products. The competitive pressures described above may result in decreased sales volumes, price reductions, +and/or increased operating costs, such as for marketing and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on devices and services presents execution and competitive risks. A growing part of our strategy involves cloud-based services used with smart client devices. Our +competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and in some cases the +user’s choice of which suite of cloud-based services to use. We are devoting significant resources to develop and deploy our own competing cloud-based software plus services strategies. While we believe our expertise, investments in +infrastructure, and the breadth of our cloud-based services provide us with a strong foundation to compete, it is uncertain whether our strategies will attract the users or generate the revenue required to be successful. In addition to software +development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs may reduce the operating margins we have previously achieved. Whether we are successful in this new business model +depends on our execution in a number of areas, including: • continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share; • maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, +tablets, and television-related devices; • continuing to enhance the attractiveness of our cloud platforms to third-party developers; and • ensuring that our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. We make significant investments in new products and services that may not be profitable. We will continue +to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, the Microsoft Office system, Bing, Windows Phone, Windows Server, the Windows Store, +the Windows Azure Services platform, Office 365, other cloud-based services offerings, and the Xbox 360 entertainment platform. We will also continue to invest in new software and hardware products, services, and technologies, such as the Surface +line of Microsoft-designed and manufactured devices announced in June 2012. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and +marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. We may not achieve +significant revenue from new product and service investments for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses may not be +as high as the margins we have experienced historically. 15 Table of Contents PART I Item 1A In fall 2012, we are launching Windows 8, a major new release of our PC operating system that +seeks to deliver a unique user experience through well-integrated software, hardware, and services. Its success depends on a number of factors including the extent to which customers embrace its new user interface and functionality, successfully +coordinating with our OEM partners in releasing a variety of hardware devices that take advantage of its features, and attracting developers at scale to ensure a competitive array of quality applications. We expect to incur substantial marketing +costs in launching Window 8 and associated services and devices, which may reduce our operating margins. We may not be able to +adequately protect our intellectual property rights. Protecting our global intellectual property rights and combating unlicensed copying and use of software and other intellectual property is difficult. While piracy +adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. As a result, our revenue in these markets may grow slower than +the underlying PC market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products +and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may +fail to enhance revenue. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time, we receive notices from +others claiming we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the segments in which we compete, the extensive patent coverage of existing technologies, and the rapid +rate of issuance of new patents. To resolve these claims we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products, or pay damages to satisfy +indemnification commitments with our customers. These outcomes may cause operating margins to decline. In addition to money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and +selling our products that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have made and expect to continue making +significant expenditures to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source +code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a +number of licensees, we take significant measures to protect the secrecy of large portions of our source code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection +for that source code. This could make it easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the +security risks described in the next paragraph. Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability +claims, or harm to our competitive position. Security of Microsoft’s information +technology. Maintaining the security of computers and computer networks is paramount for us and our customers. Threats to information technology (“IT”) security can take a variety of forms. Hackers develop and +deploy viruses, worms, and other malicious software programs that attack our products and services and gain access to our networks and data centers. Groups of hackers may also act in a coordinated manner to launch distributed denial of service +attacks, or other coordinated attacks. Sophisticated organizations or individuals may launch targeted attacks using novel methods to gain access to computers running our software. These threats may result in breaches of our network or data security, +disruptions of our internal systems and business applications, impairment of our ability to provide services to our customers, product development delays, harm to our competitive position from the compromise of confidential business information, or +other negative impacts on our business. 16 Table of Contents PART I Item 1A In addition, our internal IT environment continues to evolve. Often we are early adopters of new +devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. These practices can enhance efficiency and +business insight, but they also present risks that our business policies and internal security controls may not keep pace with the speed of these changes. Security of our customers’ products and services .    Security threats are a particular challenge to companies like us whose business is technology products and services. The threats +to our own IT infrastructure also affect our customers. Customers using our cloud services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on +the most popular operating systems, programs, and services, including many of ours, and we expect them to continue to do so. The security of our products and services is an important consideration in our customers’ purchasing decisions. We devote significant resources to defend against security threats, both to our internal IT systems and those of our customers. These +include: • engineering more secure products and services; • enhancing security and reliability features in our products and services, and continuously evaluating and updating those security and reliability features; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when such software updates are not deployed; • protecting the digital security infrastructure that ensures the integrity of our products and services; • helping our customers make the best use of our products and services to protect against computer viruses and other attacks; and • providing customers online automated security tools, published security guidance, and security software such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security +vulnerabilities in our products and services could cause significant reputational harm and lead some customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products. Customers may also increase +their expenditures on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Any of these actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities +may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand all legal challenges. Legislative or regulatory +action may increase the costs to develop or implement our products and services. Improper disclosure of personal data could result +in liability and harm our reputation. As we continue to execute our strategy of increasing the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable +information of our customers. At the same time, the continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. This environment demands that we continuously improve +our design and coordination of security controls across our business groups and geographies. Despite these efforts, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices +we follow may not prevent the improper disclosure of personally identifiable information that we or our vendors store and manage. Improper disclosure of this information could harm our reputation, lead to legal exposure to customers, or subject us +to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on premise or, increasingly, in a cloud-based +environment we host. We believe consumers using our email, messaging, storage, sharing, and social networking services will increasingly want efficient, centralized methods of choosing their privacy preferences and controlling their data. +Perceptions that our products or services do not adequately protect the 17 Table of Contents PART I Item 1A privacy of personal information could inhibit sales of our products or services, and could constrain consumer and business adoption of our cloud-based solutions. We may experience outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations +infrastructure. Our increasing user traffic and complexity of our products and services demand more computing power. We have spent and expect to continue to spend substantial amounts to purchase or lease data centers and +equipment and to upgrade our technology and network infrastructure to handle increased traffic on our websites and in our data centers, and to introduce new products and services and support existing services such as Bing, Exchange Online, Office +365, SharePoint Online, Skype, Xbox LIVE, Windows Azure, Windows Live, and Microsoft Office Web Apps. We also are growing our business of providing a platform and back-end hosting for services provided by third-party businesses to their end +customers. Maintaining and expanding this infrastructure is expensive and complex. Inefficiencies or operational failures, including temporary or permanent loss of customer data, could diminish the quality of our products, services, and user +experience resulting in contractual liability, claims by customers and other third parties, damage to our reputation and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial +condition. We are subject to government litigation and regulatory activity that affects how we design and market our +products. As a leading global software maker, we receive close scrutiny from government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or +consumers to assert claims of anti-competitive conduct. For example, we have been involved in the following actions. Lawsuits brought +by the U.S. Department of Justice, 18 states, and the District of Columbia in two separate actions were resolved through a Consent Decree that took effect in 2001 and a Final Judgment entered in 2002. These proceedings imposed various constraints on +our Windows operating system businesses. These constraints included limits on certain contracting practices, mandated disclosure of certain software program interfaces and protocols, and rights for computer manufacturers to limit the visibility of +certain Windows features in new PCs. Although the Consent Decree and Final Judgment expired in May 2011, we expect that federal and state antitrust authorities will continue to closely scrutinize our business. The European Commission closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used +in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the Commission ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our +competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns +relating to competition in Web browsing software. The Commission’s impact on product design may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our +product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our own products which could result in decreased sales of +our products. Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of +our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenue that come from them. New actions could be initiated at any time, either by these or other governments or private claimants, including with +respect to new versions of Windows or other Microsoft products. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be used as precedent in other competition law proceedings. 18 Table of Contents PART I Item 1A • We are subject to a variety of ongoing commitments as a result of court or administrative orders, consent decrees or other voluntary actions we have taken. If +we fail to comply with these commitments we may incur litigation costs and be subject to fines or other remedial actions. For example, in July 2012 we announced that, for some PCs sold in Europe, we were not in compliance with our 2009 agreement to +display a “Browser Choice Screen” on Windows PCs where Internet Explorer is the default browser. Our +products and online services offerings, including new technologies we develop or acquire such as Skype, are subject to government regulation in some jurisdictions, including in areas of user privacy, telecommunications, data protection, and online +content. The application of these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally these laws and governments’ approach to their +enforcement, as well as our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance +could result in penalties being imposed on us or orders that we stop the alleged noncompliant activity. Our business depends on our +ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely +competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver +successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our +strategic planning and execution. Delays in product development schedules may adversely affect our +revenue. The development of software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Our increasing focus on +cloud-based software plus services also presents new and complex development issues. Significant delays in new product or service releases or significant problems in creating new products or services could adversely affect our revenue. We make significant investments in new products and services that may not be profitable. Our growth depends on our +ability to create new and higher value product and service offerings. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows PC operating +system, the Microsoft Office system, Bing, Windows Phone, Windows Server, the Windows Store, the Windows Azure Services platform, Office 365, other cloud-based services offerings, and the Xbox 360 entertainment platform. In June 2012, we announced +the Surface line of Microsoft-designed and manufactured devices. We will also continue to invest in new software and hardware products, services, and technologies. Investments in new technology are speculative. Commercial success depends on many +factors, including innovativeness, developer support, and effective distribution and marketing. Our degree of success with Windows Phone, for example, will impact our ability to grow our share of the smartphone operating system market. It will also +be an important factor in supporting our strategy of delivering value to end users seamlessly over a variety of form factors including PC, phone, and TV device classes. If customers do not perceive our latest offerings as providing significant new +functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. We may not achieve significant revenue from new product and service investments for a number of years, if at all. +Moreover, new products and services may not be profitable, and even if they are profitable, operating margins for new products and businesses may not be as high as the margins we have experienced historically. Adverse economic conditions may harm our business. Unfavorable changes in economic conditions, including inflation, +recession, or other changes in economic conditions, may result in lower information technology spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those +products declines, our revenue will be adversely affected. Our product distribution system also relies on an extensive partner and retail network. Original equipment manufacturers (“OEMs”) building devices that run our software have also +been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could result in sales channel disruption. Challenging economic conditions also may impair +the ability of our customers to pay for products and 19 Table of Contents PART I Item 1A services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and +maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that have affected global financial markets. A significant part of our investment portfolio consists +of U.S. government securities. If global credit and equity markets experience prolonged periods of decline, or if there is a downgrade of U.S. government debt, our investment portfolio may be adversely impacted and we could determine that more of +our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial results. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. Adverse outcomes in some or all of these claims may +result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. Although management currently believes resolving all of these matters, individually or in the aggregate, will not have a +material adverse impact on our financial statements, the litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our financial statements +also could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable. We +may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary +course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of +tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial statements in the period or periods for +which that determination is made. We earn a significant amount of our operating income from outside the U.S., and any repatriation of +funds currently held in foreign jurisdictions to the U.S. may result in higher effective tax rates for the company. In addition, there have been proposals to change U.S. tax laws that would significantly impact how U.S. multinational corporations +are taxed on foreign earnings. Although we cannot predict whether or in what form any proposed legislation may pass, if enacted it could have a material adverse impact on our tax expense and cash flow. Our hardware and software products may experience quality or supply problems. Our vertically-integrated hardware +products such as the Xbox 360 console, Surface devices, and other hardware devices we design and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and +reputational harm if we fail to detect or effectively address such issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. Our competitors use some of the same suppliers and their +demand for hardware components can affect the amount of capacity available to us. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to obtain timely replacement +supplies, resulting in reduced sales. Either component shortages or excess or obsolete inventory may increase our cost of revenue. Xbox 360 consoles are assembled in Asia; disruptions in the supply chain may result in console shortages that would +affect our revenue and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. Our stand-alone software products may also experience quality or reliability problems. The highly sophisticated software products we develop may contain bugs and other defects that interfere with their intended +operation. Any defects we do not detect and fix in pre-release testing could result in reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although +our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to earnings. We acquire other companies and may not realize all the +economic benefit from those acquisitions, which could result in an impairment of goodwill or intangibles. Under accounting principles generally accepted in the United States (“U.S. GAAP”), we review our amortizable intangible assets for +impairment when 20 Table of Contents PART I Item 1A events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be considered a change in circumstances, +indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We +may be required to record a significant charge in our financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. For example, in July +2012, we announced a $6.2 billion charge for the impairment of goodwill in our Online Services Division business segment. We operate +a global business that exposes us to additional risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Pressure to make our pricing structure uniform might require +that we reduce the sales price of our software in the U.S. and other countries. Operations outside the U.S. may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment, +including the Foreign Corrupt Practices Act and local laws prohibiting corrupt payments by our employees, vendors, or agents. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets +presents a number of risks. Deterioration of social, political, labor, or economic conditions in a specific country or region, such as current uncertainties relating to European sovereign and other debt, and difficulties in staffing and managing +foreign operations, may also adversely affect our operations or financial results. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may +adversely affect our net revenue. Catastrophic events or geo-political conditions may disrupt our +business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing +services, or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and +we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or information technology +systems could harm our ability to conduct normal business operations. Our move toward providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity +management plans, and magnifies the potential impact of prolonged service outages on our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may +increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may result in supply chain disruptions for hardware manufacturers, either of which may +adversely affect our revenue. The long-term effects of climate change on the global economy in general or the information technology industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources +of energy may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop +software and provide cloud-based services. New regulations may require us to find alternative compliant and cost-effective methods of distributing our products and services. Acquisitions, joint ventures and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions or entering into joint ventures and strategic +alliances as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business strategy, that we do not realize a satisfactory return on our investment, +or that we experience difficulty integrating new employees, business systems, and technology, or diversion of management’s attention from our other businesses. Our recent acquisition of Skype, for example, provides opportunities to enhance our +existing products. The success of our integration of Skype will depend in part on our ability to provide compelling experiences that distinguish us from our competitors in both consumer and business markets. It may take longer than expected to +realize the full benefits from these transactions, such as increased revenue, enhanced efficiencies, or market share, or those benefits may ultimately be smaller than anticipated or may not be realized. These events could harm our operating results +or financial condition. 21 Table of Contents PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2012 that remain unresolved. ITEM 2. PROPERTIES Our corporate offices consist of approximately 15 million square feet of office space located in King County, Washington: 10 million +square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately five million square feet of space we lease. We own approximately three million additional square feet +of office and data center space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately four million square feet of office and data center space. We occupy many sites internationally, totaling approximately three million square feet that is owned and approximately nine million square +feet that is leased. International facilities that we own include our development center in Hyderabad, India; our European operations center in Dublin, Ireland; a research and development campus in Beijing, China; and facilities in Reading, UK. The +largest leased office spaces include the following locations: Beijing and Shanghai, China; Tokyo, Japan; Unterschleissheim, Germany; Paris, France; Dublin, Ireland; Bangalore, India; Reading, UK; Vedbaek, Denmark; and Mississauga, Canada. In +addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, a facility in Singapore for our Asia Pacific operations center and regional headquarters, and various product development +facilities, both domestically and internationally, as described in the “Research and Development” section of Item 1 of this Form 10-K. Our facilities are fully used for current operations of all segments, and suitable additional spaces are available to accommodate expansion needs. We have a development agreement with the City of Redmond under +which we may currently develop approximately 1.6 million square feet of additional facilities at our corporate campus in Redmond, Washington. In addition, we own 63 acres of undeveloped land in Issaquah, Washington, that can accommodate +approximately one million square feet of office space. ITEM 3. LEGAL PROCEEDINGS See Note 17 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information +regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 22 Table of Contents PART II Item 5, 6 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our +common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 18, 2012, there were 128,992 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2012 High $ 28.15 $ 27.50 $ 32.95 $ 32.89 $ 32.95 Low $ 23.79 $ 24.26 $ 26.39 $ 28.32 $ 23.79 Fiscal Year 2011 High $ 26.41 $ 28.87 $ 29.46 $ 26.87 $ 29.46 Low $ 22.73 $ 23.78 $ 24.68 $ 23.65 $ 22.73 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding dividends and share repurchases by quarter. Following are our +monthly stock repurchases for the fourth quarter of fiscal year 2012, all of which were purchased as part of publicly announced plans or programs: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2012 – April 30, 2012 404,577 $ 31.98 404,577 $ 9,208 May 1, 2012 – May 31, 2012 27,154,632 $ 30.50 27,154,632 $ 8,379 June 1, 2012 – June 30, 2012 5,485,035 $ 28.97 5,485,035 $ 8,221 33,044,244 33,044,244 The repurchases were made using cash resources and occurred in the open market. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2012 2011 2010 2009 2008 Revenue $ 73,723 $ 69,943 $ 62,484 $ 58,437 $ 60,420 Operating income $ 21,763 (a) $ 27,161 $ 24,098 $ 20,363 $ 22,271 (b) Net income $ 16,978 (a) $ 23,150 $ 18,760 $ 14,569 $ 17,681 (b) Diluted earnings per share $ 2.00 (a) $ 2.69 $ 2.10 $ 1.62 $ 1.87 Cash dividends declared per share $ 0.80 $ 0.64 $ 0.52 $ 0.52 $ 0.44 Cash, cash equivalents, and short-term investments $ 63,040 $ 52,772 $ 36,788 $ 31,447 $ 23,662 Total assets $ 121,271 $ 108,704 $ 86,113 $ 77,888 $ 72,793 Long-term obligations $ 22,220 $ 22,847 $ 13,791 $ 11,296 $ 6,621 Stockholders’ equity $ 66,363 $ 57,083 $ 46,175 $ 39,558 $ 36,286 (a) Includes a goodwill impairment charge related to our Online Services Division business segment which decreased operating income and net income by $6.2 +billion and diluted earnings per share by $0.73. (b) Includes a charge of $1.4 billion ( € 899 +million) related to the fine imposed by the European Commission in February 2008. 23 Table of Contents PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF +FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis (“MD&A”) is +intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes +to Financial Statements. OVERVIEW AND OUTLOOK Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology that transforms the way people work, play, and communicate across a +wide range of computing devices. We generate revenue by developing, licensing, and supporting a wide range of software products and +services, including cloud-based services, by designing and selling hardware, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees, designing, manufacturing, +marketing, and selling our products and services, and income taxes. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an +opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that +seek to anticipate the changing demands of customers, industry trends, and competitive forces. Key Opportunities and Investments Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see +significant opportunities to drive future growth. Smart connected devices The price per unit of processing, storage, and networks continues to decline while at the same time devices increase in capability. As a result, +the capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. At the same time, the information and services people use increasingly span multiple +devices enabled by the adoption of cloud computing. For example, the delivery and quality of unified entertainment experiences across +devices is undergoing dramatic evolution. These rich media experiences include books, magazines, newspapers, games, movies, music, television, and social interactions with family, friends, and colleagues. At Microsoft, our approach is to simplify +and increase the accessibility of these entertainment experiences to broaden market penetration of our software, hardware, and services. Additionally, web content and social connections have increased tremendously as people spend more time online, while discoverability and +accessibility has been transforming from direct navigation and document links. There is significant opportunity to deliver products and services that help users make faster, better decisions and complete tasks more simply when using their devices. +Our approach is to use machine learning to understand user intent, and differentiate our products and services by focusing on the integration of speech, visual, social, and other elements to simplify people’s interaction with the Internet. We invest significant resources in enabling and developing smart connected devices that offer a unified, seamless experience across a +common platform. Whether a PC, Windows Phone, Xbox 360, or the newly announced Surface 24 Table of Contents PART II Item 7 devices, our goal is to provide users with a consistent and compelling experience through a common user interface and our services such as SkyDrive, Xbox LIVE, Bing, Skype, and our Windows Azure +cloud platform. Communications and productivity The ubiquity of computing and software tools has transformed personal and business productivity. Over the last decade, Microsoft redefined software productivity beyond the rich Office client on the PC. Productivity +scenarios now encompass unified communications such as instant messaging, voice, and video communications, business intelligence, collaboration, content management, and relationship management, all of which are increasingly available through +server-side applications. These server applications can be hosted in the cloud by the customer, a partner, or by Microsoft. There are significant opportunities to bring to life productivity and communication scenarios across PCs, mobile, and other +devices that connect to services. We invest significant resources in our products and services that make this possible – Dynamics, Exchange, Lync, Skype, Office, Office 365, SharePoint, Windows Live, and Windows Phone. Cloud computing transforming the data center and information technology Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. Computing is undergoing a long-term shift +from client/server to the cloud, a shift similar in importance and impact to the transition from mainframe to client/server. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational +resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the utilization of computing, storage, and network resources; +and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enables new solutions and applications. For businesses of all +sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers. We are devoting significant resources to developing cloud infrastructure, platforms, and +applications including offerings such as Microsoft Dynamics Online, Microsoft SQL Azure, Office 365, Windows Azure, Windows Intune, and Windows Server. Economic Conditions, Challenges, and Risks As discussed above, our industry is dynamic and highly competitive. We must anticipate changes in technology and business models. Our model for +growth is based on our ability to initiate and embrace disruptive technology trends, to enter new markets, both in terms of geographies and product areas, and to drive broad adoption of the products and services we develop and market. At Microsoft, we prioritize our investments among the highest long-term growth opportunities. These investments require significant resources and +are multi-year in nature. The products and services we bring to market may be developed internally, brought to market as part of a partnership or alliance, or through acquisition. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent +worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation. Demand for our software, services, and hardware has a strong correlation to global macroeconomic factors. The current macroeconomic factors remain dynamic. See a discussion of these factors and other risks under +Risk Factors (Part II, Item 1A. of this Form 10-K). Seasonality Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday +season spending 25 Table of Contents PART II Item 7 by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. +Typically, the Entertainment and Devices Division has generated approximately 40% of its yearly segment revenue in our second fiscal quarter. Unearned Revenue Quarterly and annual +revenue may be impacted by the deferral of revenue. See the discussions below regarding sales of earlier versions of the Microsoft Office system with a guarantee to be upgraded to the newest version of the Microsoft Office system at minimal or no +cost (the “Office Deferral”), sales of Windows Vista with a guarantee to be upgraded to Windows 7 at minimal or no cost (the “Windows 7 Deferral”), and sales of Windows 7 with an option to upgrade to Windows 8 Pro at a +discounted price (the “Windows Upgrade Offer”). RESULTS OF OPERATIONS Summary (In millions, except percentages and per share amounts) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Revenue $ 73,723 $ 69,943 $ 62,484 5% 12% Operating income $ 21,763 $ 27,161 $ 24,098 (20)% 13% Diluted earnings per share $ 2.00 $ 2.69 $ 2.10 (26)% 28% Fiscal year 2012 compared with fiscal year 2011 Revenue increased primarily due to strong sales of Server and Tools products and services and the 2010 Microsoft Office system, offset in part by +the decline in Windows operating system revenue primarily due to the deferral of $540 million of revenue relating to the Windows Upgrade Offer. Revenue in fiscal year 2012 also included Skype revenue from the date of acquisition. Operating income decreased reflecting a goodwill impairment charge of $6.2 billion related to our OSD business segment. Other key changes in +operating expenses were: • Cost of revenue increased $2.0 billion or 13%, reflecting higher costs associated with providing Server and Tools products and services, payments made to +Nokia related to joint strategic initiatives, higher Xbox 360 royalty costs, and other changes in the mix of products and services sold. • Research and development expenses increased $768 million or 8%, due mainly to higher headcount-related expenses. • General and administrative expenses increased $347 million or 8%, due mainly to higher headcount-related expenses and the full year impact of new Puerto Rican +excise taxes, offset in part by decreased legal charges. Headcount-related expenses were higher across the company +reflecting a 4% increase in headcount from June 30, 2011 and changes in our employee compensation program. Diluted earnings per +share were negatively impacted by the non-tax deductible goodwill impairment charge, which decreased diluted earnings per share by $0.73. Prior year net income and diluted earnings per share reflected a partial settlement with the U.S. Internal +Revenue Service (“I.R.S.”) and higher other income. The partial settlement with the I.R.S. added $461 million to net income and $0.05 to diluted earnings per share in the prior year. Fiscal year 2011 compared with fiscal year 2010 Revenue increased primarily due to strong sales of the Xbox 360 entertainment platform, the 2010 Microsoft Office system, and Server and Tools products, offset in part by lower Windows revenue. Revenue also +increased due to 26 Table of Contents PART II Item 7 the $254 million Office Deferral in fiscal year 2010 and the subsequent recognition of the Office Deferral during fiscal year 2011. Changes in foreign currency exchange rates had an insignificant +impact on revenue. Operating income increased reflecting the change in revenue, offset in part by higher operating expenses. Key +changes in operating expenses were: • Cost of revenue increased $3.2 billion or 26%, due to higher costs associated with our online offerings, including traffic acquisition costs, and increased +volumes of Xbox 360 consoles and Kinect for Xbox 360 sold. • Sales and marketing expenses increased $726 million or 5%, primarily reflecting increased advertising and marketing of the Xbox 360 platform, Windows Phone, +and Windows and Windows Live, higher headcount-related expenses and increased fees paid to third-party enterprise software advisors. • Research and development expenses increased $329 million or 4%, due mainly to higher headcount-related expenses. • General and administrative expenses increased $159 million or 4%, due mainly to higher headcount-related expenses and new Puerto Rican excise taxes, partially +offset by prior year transition expenses associated with the inception of the Yahoo! Commercial Agreement. Diluted +earnings per share increased, reflecting higher revenue, repurchases of common stock, and lower income tax expense, offset in part by higher operating expenses. SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) +amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. (“U.S. GAAP”) and include certain reconciling items attributable to each of the segments. Segment information appearing +in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) is presented on a basis consistent with our current internal management reporting. Certain corporate-level +activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally managed and monitored segment performance during the current +fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division. Windows & Windows Live Division (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Revenue $ 18,373 $ 19,033 $ 19,491 (3)% (2)% Operating income $ 11,460 $ 12,211 $ 12,895 (6)% (5)% Windows & Windows Live Division (“Windows +Division”) develops and markets PC operating systems, related software and online services, and PC hardware products. This collection of software, hardware, and services is designed to simplify everyday tasks through seamless operations across +the user’s hardware and software and efficient browsing capabilities. Windows Division offerings consist of the Windows operating system, software and services through Windows Live, and Microsoft PC hardware products. Windows Division revenue is largely correlated to the PC market worldwide, as approximately 75% of total Windows Division revenue comes from +Windows operating system software purchased by original equipment manufacturers (“OEMs”) which they pre-install on equipment they sell. The remaining approximately 25% of Windows Division revenue is generated by commercial and retail sales +of Windows and PC hardware products and online advertising from Windows Live. 27 Table of Contents PART II Item 7 Fiscal year 2012 compared with fiscal year 2011 Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 4% +and sales of PCs to consumers decreased 1%. Excluding a decline in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 5%. Taken together, the total PC market increased an estimated 0% to 2%. Relative to PC market +growth, Windows Division revenue was negatively impacted by higher growth in emerging markets, where average selling prices are lower than developed markets, and the deferral of $540 million of revenue relating to the Windows Upgrade Offer. Windows Division operating income decreased, due mainly to lower revenue and a $163 million or 10% increase in research and development +expenses, primarily associated with the Windows 8 operating system. Fiscal year 2011 compared with fiscal year 2010 Windows Division revenue reflected relative performance in PC market segments. We estimate that sales of PCs to businesses grew approximately 11% +this year and sales of PCs to consumers declined approximately 1%. The decline in consumer PC sales included an approximately 32% decline in the sales of netbooks. Taken together, the total PC market increased an estimated 2% to 4%. Revenue was +negatively impacted by the effect of higher growth in emerging markets, where average selling prices are lower, relative to developed markets, and by lower recognition of previously deferred Windows XP revenue. Considering the impact of the Windows +7 launch in the prior year, including $273 million of revenue recognized related to the Windows 7 Deferral, we estimate that Windows Division revenue was in line with the PC market. Windows Division operating income decreased as a result of decreased revenue and higher sales and marketing expenses. Sales and marketing expenses +increased $182 million or 6%, reflecting increased advertising of Windows and Windows Live. Server and Tools (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Revenue $ 18,686 $ 16,680 $ 15,109 12% 10% Operating income $ 7,431 $ 6,290 $ 5,381 18% 17% Server and Tools develops and markets technology and +related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, +System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training, and certification. +Approximately 55% of Server and Tools revenue comes primarily from multi-year volume licensing agreements, approximately 25% is purchased through transactional volume licensing programs, retail packaged product and licenses sold to OEMs, and the +remainder comes from Enterprise Services. Fiscal year 2012 compared with fiscal year 2011 Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $1.4 billion or 11%, driven primarily +by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $595 million or 18%, due to growth in both Premier product support and consulting services. Server and Tools operating income increased primarily due to revenue growth, offset in part by higher costs of providing products and +services and increased sales and marketing expenses. Cost of revenue increased $682 million or 22%, primarily reflecting higher Enterprise Services headcount-related costs. Sales and marketing expenses grew $155 million or 4%, reflecting increased +corporate marketing activities. 28 Table of Contents PART II Item 7 Fiscal year 2011 compared with fiscal year 2010 Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $1.2 billion or 10%, driven primarily +by growth in Windows Server, SQL Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue grew $353 million or 12%, due to growth in both Premier product support and consulting services. Server and Tools operating income increased due to revenue growth, offset in part by higher operating expenses. Cost of revenue +increased $377 million or 13%, primarily reflecting a $323 million increase in expenses from providing Enterprise Services. Sales and marketing expenses increased $270 million or 7%, reflecting increased fees paid to third-party enterprise software +advisors and increased corporate marketing activities. Online Services Division (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Revenue $ 2,867 $ 2,607 $ 2,294 10% 14% Operating loss $ (8,121 ) $ (2,657 ) $ (2,408 ) * (10)% * Not meaningful Online Services Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more +informed decisions online, and that help advertisers connect with audiences. OSD offerings include Bing, MSN, adCenter, and advertiser tools. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all +of OSD’s annual revenue. Fiscal year 2012 compared with fiscal year 2011 Online advertising revenue grew $306 million or 13% to $2.6 billion, reflecting continued growth in search advertising revenue, offset in part by +decreased display advertising revenue. Search revenue grew due to increased revenue per search, increased volumes reflecting general market growth, and share gains in the U.S. According to third-party sources, Bing organic U.S. market share for the +month of June 2012 was approximately 16%, and grew 120 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 26% for the month of June 2012, down 100 basis points year over year. OSD’s fiscal year 2012 operating loss reflects a goodwill impairment charge of $6.2 billion, which we recorded as a result of our annual +goodwill impairment test in the fourth quarter. The non-cash, non-tax-deductible charge related mainly to goodwill acquired through our 2007 acquisition of aQuantive, Inc. While the search business has been improving, our expectations for future +growth and profitability for OSD are lower than our previous estimates. We do not expect this impairment charge to affect OSD’s ongoing business or financial performance. Excluding the $6.2 billion goodwill impairment charge, OSD’s operating loss was reduced by higher revenue and lower sales and marketing expenses and cost of revenue. Sales and marketing expenses decreased $321 +million or 29%, due mainly to lower marketing spend. Cost of revenue decreased $213 million, driven by lower Yahoo! reimbursement costs, amortization, and online operating costs. Fiscal year 2011 compared with fiscal year 2010 OSD revenue increased primarily as a result +of growth in online advertising revenue. Online advertising revenue grew $351 million or 18% to $2.3 billion, reflecting continued growth in search and display advertising revenue, offset in part by decreased third-party advertising revenue. Search +revenue grew due to increased volumes reflecting general market growth, share gains in the U.S., and our Yahoo! alliance, offset in part by decreased revenue per search primarily related to challenges associated with optimizing the adCenter platform +for the new mix and volume 29 Table of Contents PART II Item 7 of traffic from the combined Yahoo! and Bing properties. According to third-party sources, Bing organic U.S. market share for the month of June 2011 was approximately 14%, and grew 170 basis +points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 27% for the month of June 2011. OSD operating loss increased due to higher operating expenses, offset in part by increased revenue. Cost of revenue grew $647 million driven by +costs associated with the Yahoo! search agreement and increased traffic acquisition costs. General and administrative expenses decreased $156 million or 58%, due mainly to transition expenses in the prior year associated with the inception of the +Yahoo! Commercial Agreement. Research and development increased $123 million or 11% due to increased headcount-related costs. Microsoft Business +Division (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Revenue $ 23,991 $ 22,514 $ 19,256 7% 17% Operating income $ 15,719 $ 14,657 $ 11,849 7% 24% Microsoft Business Division (“MBD”) develops and +markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (comprising mainly Office, SharePoint, Exchange, Lync, and Office 365), which generates over +90% of MBD revenue, and Microsoft Dynamics business solutions. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue, which includes Microsoft Office system revenue generated through volume licensing +agreements and Microsoft Dynamics revenue; and consumer revenue, which includes revenue from retail packaged product sales and OEM revenue. Fiscal +year 2012 compared with fiscal year 2011 MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system. +Business revenue increased $1.7 billion or 9%, primarily reflecting growth in multi-year volume licensing revenue, licensing of the 2010 Microsoft Office system to transactional business customers, and an 11% increase in Microsoft Dynamics +revenue. Consumer revenue decreased $195 million or 4% due to the recognition of $254 million of revenue in the prior year associated with the Office Deferral. Excluding the fiscal year 2011 impact associated with the Office Deferral, consumer +revenue increased $59 million, driven by increased sales of the 2010 Microsoft Office system. MBD revenue for the year ended +June 30, 2012 included a favorable foreign currency impact of $506 million. MBD operating income increased, primarily due to +revenue growth, offset in part by higher operating expenses. Cost of revenue increased $258 million or 16%, primarily due to higher online operation and support costs. Research and development expenses increased, due mainly to an increase in +headcount-related costs. Fiscal year 2011 compared with fiscal year 2010 MBD revenue increased primarily reflecting sales of the 2010 Microsoft Office system, the $254 million Office Deferral during fiscal year 2010, and +the subsequent recognition of the Office Deferral during fiscal year 2011. Business revenue increased $2.1 billion or 14%, reflecting licensing of the 2010 Microsoft Office system to transactional business customers, growth in multi-year volume +licensing revenue, and a 10% increase in Microsoft Dynamics revenue. Consumer revenue increased $1.1 billion or 33%, approximately half of which was attributable to the launch of Office 2010 and half of which was attributable to the Office Deferral +during fiscal year 2010 and subsequent recognition of the Office Deferral during fiscal year 2011. Excluding the impact associated with the Office Deferral, consumer revenue increased $617 million or 17% due to sales of the 2010 Microsoft Office +system. MBD operating income increased due mainly to revenue growth, offset in part by higher operating expenses. Cost of revenue +increased $328 million or 25%, primarily driven by higher online operation and support costs. Sales and 30 Table of Contents PART II Item 7 marketing expenses increased, primarily driven by an increase in corporate and cross-platform marketing activities. Research and development costs increased, primarily as a result of +capitalization of certain Microsoft Office system software development costs in the prior year. Entertainment and Devices Division (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Revenue $ 9,593 $ 8,915 $ 6,079 8% 47% Operating income $ 364 $ 1,257 $ 517 (71)% 143% Entertainment and Devices Division (“EDD”) +develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox 360 entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, +Xbox LIVE, and Xbox 360 accessories), Mediaroom (our Internet protocol television software), Skype, and Windows Phone, including related patent licensing revenue. In November 2010, we released Kinect for Xbox 360. We acquired Skype on +October 13, 2011, and its results of operations from that date are reflected in our results discussed below. Fiscal year 2012 compared with +fiscal year 2011 EDD revenue increased primarily reflecting Skype and Windows Phone revenue, offset in part by lower Xbox 360 +platform revenue. Xbox 360 platform revenue decreased $113 million, due mainly to decreased volumes of Kinect for Xbox 360 sold and lower video game revenue, offset in part by higher Xbox LIVE revenue. We shipped 13.0 million Xbox 360 consoles +during fiscal year 2012, compared with 13.7 million Xbox 360 consoles during fiscal year 2011. Video game revenue decreased due to strong sales of Halo Reach in the prior year. EDD operating income decreased reflecting higher operating expenses, offset in part by revenue growth. Cost of revenue grew $900 million or 16%, +primarily due to changes in the mix of products and services sold and payments made to Nokia related to joint strategic initiatives. Research and development expenses increased $356 million or 30%, primarily reflecting higher headcount-related +expenses. Sales and marketing expenses increased $244 million or 28%, primarily reflecting the inclusion of Skype expenses. Fiscal year 2011 +compared with fiscal year 2010 EDD revenue increased primarily reflecting higher Xbox 360 platform revenue. Xbox 360 platform +revenue grew $2.7 billion or 48%, led by increased volumes of Xbox 360 consoles, sales of Kinect for Xbox 360, and higher Xbox LIVE revenue. We shipped 13.7 million Xbox 360 consoles during fiscal year 2011, compared with 10.3 million Xbox +360 consoles during fiscal year 2010. EDD operating income increased primarily reflecting revenue growth, offset in part by higher cost +of revenue. Cost of revenue increased $1.8 billion or 49%, primarily reflecting higher volumes of Xbox 360 consoles and Kinect for Xbox 360 sold, and increased royalty costs resulting from increased sales of Xbox LIVE digital content. Research and +development expenses increased $160 million or 15%, primarily reflecting higher headcount-related costs. Sales and marketing expenses grew $112 million or 15%, primarily reflecting increased Xbox 360 platform marketing activities. Corporate-Level Activity (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Corporate-level activity $ (5,090 ) $ (4,597 ) $ (4,136 ) (11)% (11)% 31 Table of Contents PART II Item 7 Certain corporate-level activity is not allocated to our segments, including costs of: broad-based +sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; and legal settlements and contingencies. Fiscal year 2012 compared with fiscal year 2011 Corporate-level expenses increased due mainly to full year Puerto Rican excise taxes, higher headcount-related expenses, and changes in foreign currency exchange rates. These increases were offset in part by lower +legal charges, which were $56 million in fiscal year 2012 compared with $332 million in fiscal year 2011. Fiscal year 2011 compared with fiscal year +2010 Corporate-level expenses increased due mainly to new Puerto Rican excise taxes, certain revenue related sales and marketing +expenses, and increased headcount-related expenses. These increases were offset in part by lower legal charges, which were $332 million in fiscal year 2011 compared with $533 million in fiscal year 2010. OPERATING EXPENSES Cost of Revenue (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Cost of revenue $ 17,530 $ 15,577 $ 12,395 13% 26% As a percent of revenue 24% 22% 20% 2ppt 2ppt Cost of revenue includes: manufacturing and distribution +costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire +online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services including royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of +consulting services; and the amortization of capitalized research and development costs. Fiscal year 2012 compared with fiscal year 2011 Cost of revenue increased reflecting higher headcount-related costs, payments made to Nokia, and changes in the mix of products and +services sold. Headcount-related expenses increased 20%, primarily related to increased Enterprise Services headcount. Fiscal year 2011 compared +with fiscal year 2010 Cost of revenue increased primarily due to increased volumes of Xbox 360 consoles and Kinect for Xbox 360 +sold, higher costs associated with our online offerings, including traffic acquisition costs, and higher expenses from providing Enterprise Services, as well as royalty costs relating to Xbox LIVE digital content sold. Research and Development (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Research and development $ 9,811 $ 9,043 $ 8,714 8% 4% As a percent of revenue 13% 13% 14% 0ppt (1)ppt 32 Table of Contents PART II Item 7 Research and development expenses include payroll, employee benefits, stock-based compensation +expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international +markets, and the amortization of purchased software code and services content. Fiscal year 2012 compared with fiscal year 2011 Research and development expenses increased, primarily reflecting a 10% increase in headcount-related expenses. Fiscal year 2011 compared with fiscal year 2010 Research and development expenses increased primarily due to a 5% increase in headcount-related expenses and the capitalization of certain software development costs in the prior year. Sales and Marketing (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 Sales and marketing $ 13,857 $ 13,940 $ 13,214 (1)% 5% As a percent of revenue 19% 20% 21% (1)ppt (1)ppt Sales and marketing expenses include payroll, employee +benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2012 compared with fiscal year 2011 Sales and marketing expenses decreased slightly, primarily reflecting decreased advertising and marketing of the Xbox 360 platform, Windows Phone, and Bing, offset in part by a 5% increase in headcount-related +expenses. Fiscal year 2011 compared with fiscal year 2010 Sales and marketing expenses increased, primarily as a result of increased advertising and marketing of the Xbox 360 platform, Windows Phone, and Windows and Windows Live, a 5% increase in headcount-related +expenses, and increased fees paid to third-party enterprise software advisors. General and Administrative (In millions, except percentages) 2012 2011 2010 Percentage Change 2012 Versus 2011 Percentage Change 2011 Versus 2010 General and administrative $ 4,569 $ 4,222 $ 4,063 8% 4% As a percent of revenue 6% 6% 7% 0ppt (1)ppt General and administrative expenses include payroll, +employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other +administrative fees. Fiscal year 2012 compared with fiscal year 2011 General and administrative expenses increased, primarily due to a 10% increase in headcount-related expenses and a full year of Puerto Rican excise taxes, offset in part by a decrease in legal charges. 33 Table of Contents PART II Item 7 Fiscal year 2011 compared with fiscal year 2010 General and administrative expenses increased, primarily due to a 12% increase in headcount-related expenses and new Puerto Rican excise taxes, +partially offset by prior year transition expenses associated with the inception of the Yahoo! Commercial Agreement. Goodwill Impairment We conducted our annual goodwill impairment test as of May 1, 2012 for all reporting units. This test, which was based on our +most recent cash flow forecast, indicated that OSD’s carrying value exceeded its estimated fair value. Accordingly, we recorded a non-cash, non-tax deductible goodwill impairment charge of $6.2 billion during the three months ended +June 30, 2012, reducing OSD’s goodwill from $6.4 billion to $223 million. OTHER INCOME (EXPENSE) AND INCOME TAXES Other Income (Expense) The +components of other income (expense) were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Dividends and interest income $ 800 $ 900 $ 843 Interest expense (380 ) (295 ) (151 ) Net recognized gains on investments 564 439 348 Net losses on derivatives (364 ) (77 ) (140 ) Net gains (losses) on foreign currency remeasurements (117 ) (26 ) 1 Other 1 (31 ) 14 Total $ 504 $ 910 $ 915 We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and +credit; to enhance investment returns; and to facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are recognized in other income (expense). These are generally offset by +unrealized gains and losses in the underlying securities in the investment portfolio and are recorded as a component of other comprehensive income. Fiscal year 2012 compared with fiscal year 2011 Dividends and interest income decreased due to lower yields on our fixed-income investments, offset in part by higher average portfolio investment balances. Interest expense increased due to our increased issuance +of debt in the prior year. Net recognized gains on investments increased, primarily due to higher gains on sales of equity and fixed-income securities and a gain recognized on the partial sale of our Facebook holding upon the initial public offering +on May 18, 2012, offset in part by higher other-than-temporary impairments. Other-than-temporary impairments were $298 million in fiscal year 2012, compared with $80 million in fiscal year 2011. Net losses on derivatives increased due to losses +on commodity and equity derivatives in the current fiscal year as compared with gains in the prior fiscal year, offset in part by fewer losses on foreign exchange contracts in the current fiscal year as compared to the prior fiscal year. Changes in +foreign currency remeasurements were primarily due to currency movements net of our hedging activities. Fiscal year 2011 compared with fiscal year +2010 Dividends and interest income increased due to higher average portfolio investment balances, offset in part by lower yields on +our fixed-income investments. Interest expense increased due to our increased issuance of debt. Net 34 Table of Contents PART II Item 7 recognized gains on investments increased, primarily due to higher gains on sales of equity securities, offset in part by fewer gains on sales of fixed-income securities. Derivative losses +decreased, primarily due to higher gains on commodity derivatives offset in part by higher losses on currency contracts used to hedge foreign currency revenue. Income Taxes Fiscal year 2012 compared with fiscal year 2011 Our effective tax rates for fiscal years 2012 and 2011 were approximately 24% and 18%, respectively. Our effective tax rates were lower than the +U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto +Rico, which have lower income tax rates. Our fiscal year 2012 effective rate increased by 6% from fiscal year 2011 mainly due to a +nonrecurring $6.2 billion non-tax deductible goodwill impairment charge that was recorded in the fourth quarter of 2012. The goodwill impairment charge increased our effective tax rate by 10%. In addition, in fiscal years 2012 and 2011, we +recognized a reduction of 21% and 16%, respectively, to the effective tax rate due to foreign earnings taxed at lower rates. In fiscal year 2011, we settled a portion of an I.R.S. audit of tax years 2004 to 2006, which reduced our income tax expense +for fiscal year 2011 by $461 million and reduced the effective tax rate by 2%. Changes in the mix of income before income taxes between +the U.S. and foreign countries also impacted our effective tax rates and resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. As discussed above, Windows Division operating +income declined $751 million in fiscal year 2012, while MBD and Server and Tools operating income increased $1.1 billion and $1.1 billion, respectively, during this same period. We supply Windows, our primary Windows Division product, to customers +through our U.S. regional operating center, while we supply the Microsoft Office System, our primary MBD product, and our Server and Tools products to customers through our foreign regional operations centers. In fiscal years 2012 and 2011, our U.S. +income before income taxes was $1.6 billion and $8.9 billion, respectively, and comprised 7% and 32%, respectively, of our income before income taxes. In fiscal years 2012 and 2011, the foreign income before income taxes was $20.7 billion and $19.2 +billion, respectively, and comprised 93% and 68%, respectively, of our income before income taxes. The primary driver for the decrease in the U.S. income before income tax in fiscal year 2012 was the goodwill impairment charge. Tax contingencies and other tax liabilities were $7.6 billion and $7.4 billion as of June 30, 2012 and 2011, respectively, and are included in +other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents +Report and reopened the audit phase of the examination. As of June 30, 2012, the primary unresolved issue relates to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We believe our +allowances for tax contingencies are appropriate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the remaining +open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2011. Fiscal year 2011 compared with fiscal year 2010 Our effective tax rates for fiscal years 2011 and 2010 were approximately 18% and 25%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate and our prior year effective rate primarily +due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which have +lower income tax rates. In fiscal years 2011 and 2010, our U.S. income before income taxes was $8.9 billion and $9.6 billion, respectively, and comprised 32% and 38%, respectively, of our income before income taxes. In fiscal years 2011 +and 2010, the foreign income before income taxes was $19.2 billion and $15.4 billion, respectively, and comprised 68% and 62%, respectively, of our income before income taxes. In fiscal years 2011 and 2010, the reduction of the U.S. federal +statutory rate as a result of foreign earnings taxed at lower rates was 16% and 12%, respectively. 35 Table of Contents PART II Item 7 In addition, our effective tax rate was lower than in the prior year due to a partial settlement +with the I.R.S. in the third quarter of fiscal year 2011 relating to the audit of tax years 2004 to 2006. This partial settlement reduced our income tax expense for fiscal year 2011 by $461 million. FINANCIAL CONDITION Cash, Cash +Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $63.0 billion as of June 30, 2012, +compared with $52.8 billion as of June 30, 2011. Equity and other investments were $9.8 billion as of June 30, 2012, compared with $10.9 billion as of June 30, 2011. Our short-term investments are primarily to facilitate liquidity and +for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also +include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve +economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. While +we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of June 30, 2012 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The +majority of our mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and +Government National Mortgage Association. We routinely monitor our financial exposure to both sovereign and non-sovereign borrowers and +counterparties. Our gross exposures to our customers and investments in Portugal, Italy, Ireland, Greece, and Spain are individually and collectively not material. Of the cash, cash equivalents, and short-term investments at June 30, 2012, approximately $54 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount +of cash and investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was approximately $660 million. As of June 30, 2012, approximately 77% of the +short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 10% were invested in corporate notes and bonds of U.S. companies, and 3% were invested in U.S. mortgage-backed securities, +all of which are denominated in U.S. dollars. Securities lending We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as +collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable +balance was $814 million as of June 30, 2012. Our average and maximum securities lending payable balances for the fiscal year were $1.2 billion and $1.4 billion, respectively. Intra-year variances in the amount of securities loaned are mainly +due to fluctuations in the demand for the securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 +investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. treasuries. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices +for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government 36 Table of Contents PART II Item 7 bonds, mortgage-backed securities, and agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using +unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are +generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price +is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally labeled as Level 2 investments +because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are +appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period +fluctuations, and independent recalculation of prices where appropriate. Cash Flows Fiscal year 2012 compared with fiscal year 2011 Cash flows from operations increased $4.6 +billion during the current fiscal year to $31.6 billion due mainly to increased revenue and cash collections from customers. Cash used for financing increased $1.0 billion to $9.4 billion due mainly to a $6.0 billion net decrease in proceeds from +issuances of debt and a $1.2 billion increase in dividends paid, offset in part by a $6.5 billion decrease in cash used for common stock repurchases. Cash used in investing increased $10.2 billion to $24.8 billion due mainly to a $10.0 billion +increase in acquisitions of businesses and purchases of intangible assets and a $1.4 billion decrease in cash from securities lending activities, partially offset by a $1.2 billion decrease in cash used for net purchases, maturities, and sales of +investments. Fiscal year 2011 compared with fiscal year 2010 Cash flows from operations increased $2.9 billion during the current fiscal year to $27.0 billion due mainly to increased revenue and cash collections from customers. Cash used in financing decreased $4.9 billion +to $8.4 billion due mainly to a $5.8 billion increase in proceeds from issuance of debt, net of repayments, offset in part by a $602 million increase in cash paid for dividends. Cash used in investing increased $3.3 billion to $14.6 billion due to a +$5.8 billion increase in purchases of investments, offset in part by a $2.5 billion increase in cash from securities lending. Debt We issued debt in prior periods to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low +interest rate environment. The proceeds of these issuances were used to partially fund discretionary business acquisitions and share repurchases. As of June 30, 2012, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $11.9 billion and $13.2 billion, respectively. This is compared with a carrying +value and estimated fair value of $11.9 billion and $12.1 billion, respectively, as of June 30, 2011. These estimated fair values are based on Level 2 inputs. 37 Table of Contents PART II Item 7 The components of our long-term debt, including the current portion, and the associated interest +rates and semi-annual interest record and payment dates were as follows as of June 30, 2012: Due Date Face Value Stated Interest Rate Effective Interest Rate Interest Record Date Interest Pay Date Interest Record Date Interest Pay Date (In millions) Notes September 27, 2013 $ 1,000 0.875% 1.000% March 15 March 27 September 15 September 27 June 1, 2014 2,000 2.950% 3.049% May 15 June 1 November 15 December 1 September 25, 2015 1,750 1.625% 1.795% March 15 March 25 September 15 September 25 February 8, 2016 750 2.500% 2.642% February 1 February 8 August 1 August 8 June 1, 2019 1,000 4.200% 4.379% May 15 June 1 November 15 December 1 October 1, 2020 1,000 3.000% 3.137% March 15 April 1 September 15 October 1 February 8, 2021 500 4.000% 4.082% February 1 February 8 August 1 August 8 June 1, 2039 750 5.200% 5.240% May 15 June 1 November 15 December 1 October 1, 2040 1,000 4.500% 4.567% March 15 April 1 September 15 October 1 February 8, 2041 1,000 5.300% 5.361% February 1 February 8 August 1 August 8 Total 10,750 Convertible Debt June 15, 2013 1,250 0.000% 1.849% Total face value $ 12,000 As of June 30, 2012, the aggregate unamortized discount for our long-term debt, including the current portion, +was $56 million. Notes The +Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement +offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, which were capitalized. Initially, each $1,000 principal amount of notes was convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 +per share. The conversion ratio is adjusted periodically for dividends in excess of the initial dividend threshold as defined in the debt agreement. As of June 30, 2012, the net carrying amount of our convertible debt was $1.2 billion and the +unamortized discount was $19 million. Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into +cash and, if applicable, cash, shares of Microsoft’s common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate +principal amount of the notes and pay or deliver cash, shares of our common stock, or a combination of cash and shares of our common stock, at our election. Because the convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt +borrowing rate when interest costs are recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity +representing the fair value of the option to convert the debt. In connection with the issuance of the notes, we entered into capped +call transactions with certain option counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to 38 Table of Contents PART II Item 7 reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased from the option counterparties capped call options that in the +aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with an initial cap price equal to $37.16, which is adjusted periodically to mirror any +adjustments to the conversion price. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity. Unearned +Revenue Unearned revenue at June 30, 2012 comprised mainly unearned revenue from volume licensing programs. Unearned revenue +from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with +revenue recognized ratably over the billing coverage period. Unearned revenue at June 30, 2012 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; +the Windows Upgrade Offer; Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; OEM minimum commitments; and other offerings for which we have been paid in advance and earn the revenue when we provide the service +or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected future recognition of +unearned revenue as of June 30, 2012: (In millions) Three Months Ending, September 30, 2012 $ 6,874 December 31, 2012 5,635 March 31, 2013 4,323 June 30, 2013 1,821 Thereafter 1,406 Total $ 20,059 Share Repurchases On September 22, 2008, we announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. +As of June 30, 2012, approximately $8.2 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without notice. During the periods reported, we repurchased with cash resources: 142 million shares for $4.0 billion during fiscal year 2012; 447 million +shares for $11.5 billion during fiscal year 2011; and 380 million shares for $10.8 billion during fiscal year 2010. Dividends During fiscal years 2012 and 2011, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) Fiscal Year 2012 September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011 December 14, 2011 $ 0.20 February 16, 2012 $ 1,683 March 8, 2012 March 13, 2012 $ 0.20 May 17, 2012 $ 1,678 June 14, 2012 June 13, 2012 $ 0.20 August 16, 2012 $ 1,676 September 13, 2012 Fiscal Year 2011 September 21, 2010 $ 0.16 November 18, 2010 $ 1,363 December 9, 2010 December 15, 2010 $ 0.16 February 17, 2011 $ 1,349 March 10, 2011 March 14, 2011 $ 0.16 May 19, 2011 $ 1,350 June 9, 2011 June 15, 2011 $ 0.16 August 18, 2011 $ 1,341 September 8, 2011 39 Table of Contents PART II Item 7 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. To date, we have not encountered +significant costs as a result of these obligations and have not accrued in our financial statements any liabilities related to these indemnifications. Contractual Obligations The following +table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2012: (In millions) 2013 2014-2015 2016-2017 Thereafter Total Long-term +debt: (a) Principal payments $ 1,250 $ 3,000 $ 2,500 $ 5,250 $ 12,000 Interest payments 344 616 491 3,457 4,908 Construction commitments (b) 353 0 0 0 353 Operating +leases (c) 527 748 387 315 1,977 Purchase commitments (d) 6,556 884 236 146 7,822 Other long-term liabilities (e) 0 106 16 30 152 Total contractual obligations $ 9,030 $ 5,354 $ 3,630 $ 9,198 $ 27,212 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) These amounts represent commitments for the construction of buildings, building improvements, and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. (e) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $9.5 billion and other long-term contingent liabilities +of $220 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned +revenue of $1.4 billion and non-cash items of $202 million. Other Planned Uses of Capital On July 18, 2012, we acquired Yammer, Inc. (“Yammer”), a leading provider of enterprise social networks, for $1.2 billion in cash. +Yammer will continue to develop its standalone service and will add an enterprise social networking service to Microsoft’s portfolio of complementary cloud-based services. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to +property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales +and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital +resources. Liquidity We earn a +significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, 40 Table of Contents PART II Item 7 the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect +existing domestic cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular +quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and +cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable +future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant +discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in +higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates. RECENT ACCOUNTING GUIDANCE Recently +Adopted Accounting Guidance On July 1, 2011, we adopted guidance issued by the Financial Accounting Standards Board +(“FASB”) on disclosure requirements related to fair value measurements. The guidance requires the disclosure of roll-forward activities on purchases, sales, issuances, and settlements of the assets and liabilities measured using +significant unobservable inputs (Level 3 fair value measurements). Adoption of this new guidance did not have a material impact on our financial statements. On January 1, 2012, we adopted guidance issued by the FASB on accounting and disclosure requirements related to fair value measurements. The guidance limits the highest-and-best-use measure to +nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and +discounts. Additionally, the guidance expands the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair +value to changes in unobservable inputs. Adoption of this new guidance did not have a material impact on our financial statements. Recent +Accounting Guidance Not Yet Adopted In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature +of an entity’s right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in +accordance with the accounting standards followed, and the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our +financial statements upon adoption. In September 2011, the FASB issued guidance on testing goodwill for impairment. The new guidance +provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is +required to perform the currently prescribed two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines +that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. The new guidance will be effective for us beginning July 1, 2012. In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other +comprehensive income and its components in the statement of changes in stockholders’ equity. Instead, an entity will be required to present either a continuous statement of net income and 41 Table of Contents PART II Item 7 other comprehensive income or in two separate but consecutive statements. This portion of the guidance will be effective for us beginning July 1, 2012 and will require financial +statement presentation changes only. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by component in both the statement in which net income is presented and the statement +in which other comprehensive income is presented. However, in December 2011, the FASB issued guidance that indefinitely defers the guidance related to the presentation of reclassification adjustments. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of +assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, +goodwill, research and development costs, contingencies, income taxes, and stock-based compensation. Revenue Recognition Software revenue recognition requires judgment, including whether a software arrangement includes multiple elements, and if so, whether +vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. A portion of revenue may be recorded as unearned due to undelivered elements. Changes to the elements in a software arrangement, the ability to identify +VSOE for those elements, and the fair value of the respective elements could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or +upgrades and enhancements to existing products. Windows 7 revenue is subject to deferral as a result of the Windows Upgrade Offer, +which started June 2, 2012. The offer provides significantly discounted rights to purchase Windows 8 Pro to qualifying end users that purchase Windows 7 PCs during the eligibility period. Microsoft is responsible for delivering Windows 8 Pro to +the end customer. Accordingly, revenue related to the allocated discount for undelivered Windows 8 is deferred until it is delivered or the redemption period expires. Impairment of Investment Securities We review investments quarterly for indicators of +other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential +impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than +cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to +sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing +cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee +conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a +relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or +circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance +indicators, competition, or sale or disposition of a significant portion of a reporting unit. 42 Table of Contents PART II Item 7 Application of the goodwill impairment test requires judgment, including the identification of +reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted +cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over +which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value +of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each +reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is +established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological +feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs +is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency +such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required +if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable +estimate of the amount of loss. Changes in these factors could materially impact our financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax +liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that +the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that +has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and +liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax +returns. Variations in the actual outcome of these future tax consequences could materially impact our financial statements. Stock-Based +Compensation Stock-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as +expense, net of estimated forfeitures, over the requisite service period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating expected dividends. In addition, judgment is also required in +estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be impacted. 43 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial +reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, +through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities +and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief Executive Officer Peter S. Klein Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 44 Table of Contents PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK RISKS We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our financial +statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and +use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Interest Rate Our fixed-income portfolio +is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and +domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. Equity Our equity portfolio consists of +global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based +commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global +commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed +based on the historical volatilities and correlations among foreign currency exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses +could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. 45 Table of Contents PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of +June 30, 2012 and June 30, 2011 and for the year ended June 30, 2012: (In millions) June 30, 2012 June 30, 2011 Year Ended June 30, 2012 Risk Categories Average High Low Foreign currency $ 98 $ 86 $ 173 $ 229 $ 84 Interest rate $ 71 $ 58 $ 64 $ 73 $ 57 Equity $ 205 $ 212 $ 194 $ 248 $ 165 Commodity $ 18 $ 28 $ 20 $ 29 $ 15 Total one-day VaR for the combined risk categories was +$292 million at June 30, 2012 and $290 million at June 30, 2011. The total VaR is 26% less at June 30, 2012, and 25% less at June 30, 2011, than the sum of the separate risk categories in the above table due to the +diversification benefit of the combination of risks. 46 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2012 2011 2010 Revenue $ 73,723 $ 69,943 $ 62,484 Operating expenses: Cost of revenue 17,530 15,577 12,395 Research and development 9,811 9,043 8,714 Sales and marketing 13,857 13,940 13,214 General and administrative 4,569 4,222 4,063 Goodwill impairment 6,193 0 0 Total operating expenses 51,960 42,782 38,386 Operating income 21,763 27,161 24,098 Other income 504 910 915 Income before income taxes 22,267 28,071 25,013 Provision for income taxes 5,289 4,921 6,253 Net income $ 16,978 $ 23,150 $ 18,760 Earnings per share: Basic $ 2.02 $ 2.73 $ 2.13 Diluted $ 2.00 $ 2.69 $ 2.10 Weighted average shares outstanding: Basic 8,396 8,490 8,813 Diluted 8,506 8,593 8,927 Cash dividends declared per common share $ 0.80 $ 0.64 $ 0.52 See accompanying notes. 47 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2012 2011 Assets Current assets: Cash and cash equivalents $ 6,938 $ 9,610 Short-term investments (including securities loaned of $785 and $1,181) 56,102 43,162 Total cash, cash equivalents, and short-term investments 63,040 52,772 Accounts receivable, net of allowance for doubtful accounts of $389 and $333 15,780 14,987 Inventories 1,137 1,372 Deferred income taxes 2,035 2,467 Other 3,092 3,320 Total current assets 85,084 74,918 Property and equipment, net of accumulated depreciation of $10,962 and $9,829 8,269 8,162 Equity and other investments 9,776 10,865 Goodwill 13,452 12,581 Intangible assets, net 3,170 744 Other long-term assets 1,520 1,434 Total assets $ 121,271 $ 108,704 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 4,175 $ 4,197 Current portion of long-term debt 1,231 0 Accrued compensation 3,875 3,575 Income taxes 789 580 Short-term unearned revenue 18,653 15,722 Securities lending payable 814 1,208 Other 3,151 3,492 Total current liabilities 32,688 28,774 Long-term debt 10,713 11,921 Long-term unearned revenue 1,406 1,398 Deferred income taxes 1,893 1,456 Other long-term liabilities 8,208 8,072 Total liabilities 54,908 51,621 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,381 and 8,376 65,797 63,415 Retained earnings (deficit), including accumulated other comprehensive income of $1,422 and $1,863 566 (6,332 ) Total stockholders’ equity 66,363 57,083 Total liabilities and stockholders’ equity $ 121,271 $ 108,704 See accompanying notes. 48 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2012 2011 2010 Operations Net income $ 16,978 $ 23,150 $ 18,760 Adjustments to reconcile net income to net cash from operations: Goodwill impairment 6,193 0 0 Depreciation, amortization, and other 2,967 2,766 2,673 Stock-based compensation expense 2,244 2,166 1,891 Net recognized gains on investments and derivatives (200 ) (362 ) (208 ) Excess tax benefits from stock-based compensation (93 ) (17 ) (45 ) Deferred income taxes 954 2 (220 ) Deferral of unearned revenue 36,104 31,227 29,374 Recognition of unearned revenue (33,347 ) (28,935 ) (28,813 ) Changes in operating assets and liabilities: Accounts receivable (1,156 ) (1,451 ) (2,238 ) Inventories 184 (561 ) (44 ) Other current assets 493 (1,259 ) 464 Other long-term assets (248 ) 62 (223 ) Accounts payable (31 ) 58 844 Other current liabilities 410 (1,146 ) 451 Other long-term liabilities 174 1,294 1,407 Net cash from operations 31,626 26,994 24,073 Financing Short-term debt repayments, maturities of 90 days or less, net 0 (186 ) (991 ) Proceeds from issuance of debt, maturities longer than 90 days 0 6,960 4,167 Repayments of debt, maturities longer than 90 days 0 (814 ) (2,986 ) Common stock issued 1,913 2,422 2,311 Common stock repurchased (5,029 ) (11,555 ) (11,269 ) Common stock cash dividends paid (6,385 ) (5,180 ) (4,578 ) Excess tax benefits from stock-based compensation 93 17 45 Other 0 (40 ) 10 Net cash used in financing (9,408 ) (8,376 ) (13,291 ) Investing Additions to property and equipment (2,305 ) (2,355 ) (1,977 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (10,112 ) (71 ) (245 ) Purchases of investments (57,250 ) (35,993 ) (30,168 ) Maturities of investments 15,575 6,897 7,453 Sales of investments 29,700 15,880 15,125 Securities lending payable (394 ) 1,026 (1,502 ) Net cash used in investing (24,786 ) (14,616 ) (11,314 ) Effect of exchange rates on cash and cash equivalents (104 ) 103 (39 ) Net change in cash and cash equivalents (2,672 ) 4,105 (571 ) Cash and cash equivalents, beginning of period 9,610 5,505 6,076 Cash and cash equivalents, end of period $ 6,938 $ 9,610 $ 5,505 See accompanying notes. 49 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2012 2011 2010 Common stock and paid-in capital Balance, beginning of period $ 63,415 $ 62,856 $ 62,382 Common stock issued 1,924 2,422 2,311 Common stock repurchased (1,714 ) (3,738 ) (3,113 ) Stock-based compensation expense 2,244 2,166 1,891 Stock-based compensation income tax deficiencies (75 ) (292 ) (647 ) Other, net 3 1 32 Balance, end of period 65,797 63,415 62,856 Retained earnings (deficit) Balance, beginning of period (6,332 ) (16,681 ) (22,824 ) Net income 16,978 23,150 18,760 Other comprehensive income: Net unrealized gains (losses) on derivatives 255 (627 ) 27 Net unrealized gains (losses) on investments (390 ) 1,054 265 Translation adjustments and other (306 ) 381 (206 ) Comprehensive income 16,537 23,958 18,846 Common stock cash dividends (6,721 ) (5,394 ) (4,547 ) Common stock repurchased (2,918 ) (8,215 ) (8,156 ) Balance, end of period 566 (6,332 ) (16,681 ) Total stockholders’ equity $ 66,363 $ 57,083 $ 46,175 See accompanying notes. 50 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of +America (“U.S. GAAP”). Principles of Consolidation The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant +influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the +investee and which do not have readily determinable fair values are accounted for under the cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, +revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, and/or potential goodwill impairment for, our reporting units; product life cycles; useful lives of our tangible and intangible assets; +allowances for doubtful accounts; allowances for product returns; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or +enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax returns; and determining when +investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign +Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. +Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to Other Comprehensive Income (“OCI”). Revenue Recognition Revenue is recognized +when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. Revenue generally is recognized net of allowances for returns and any taxes collected from customers and +subsequently remitted to governmental authorities. Revenue for retail packaged products, products licensed to original equipment +manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are shipped or made available. Revenue for products under technology guarantee programs, which provide free or +significantly discounted rights to use upcoming new versions of a software product if an end user licenses existing versions of the product during the eligibility period, is allocated between existing product and the new product, and revenue +allocated to the new product is deferred until that version is delivered. The revenue allocation is based on vendor-specific objective evidence of fair value of the products. Certain multi-year licensing arrangements include a perpetual license for current products combined with rights to receive future versions of software products on a when-and-if-available basis (“Software +Assurance”) and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the billing coverage period. Revenue from certain arrangements that allow for the use of a product or service +over a period of time without taking possession of software are also accounted for as subscriptions. Revenue for software 51 Table of Contents PART II Item 8 products where customers have the right to receive unspecified upgrades/enhancements on a when-and-if-available basis and for which vendor-specific objective evidence of fair value does not exist +for the upgrades/enhancements is recognized on a straight-line basis over the estimated life of the software. Revenue related to our +Xbox 360 gaming and entertainment console, Kinect for Xbox 360, games published by us, and other hardware components is generally recognized when ownership is transferred to the resellers. Revenue related to games published by third parties for use +on the Xbox 360 platform is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as +advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, +generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Revenue from prepaid +points redeemable for the purchase of software or services is recognized upon redemption of the points and delivery of the software or services. Cost of Revenue Cost of revenue includes; +manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to +our websites, and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including royalties; warranty costs; inventory valuation adjustments; costs +associated with the delivery of consulting services; and the amortization of capitalized research and development costs. Capitalized research and development costs are amortized over the estimated lives of the products. Product Warranty We provide for the +estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical +and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor +over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess +the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses +associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased +software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before +the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, +stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. +Advertising expense was $1.6 billion, $1.9 billion, and $1.6 billion in fiscal years 2012, 2011, and 2010, respectively. 52 Table of Contents PART II Item 8 Stock-Based Compensation We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense, net of estimated forfeitures, over the vesting or service period, as applicable, of the +stock award (generally four to five years) using the straight-line method. Employee Stock Purchase Plan Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value of the stock on the last day of +each three-month period. Compensation expense for the employee stock purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes +U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested, and interest and penalties on uncertain tax positions. Certain income and expenses are +not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not +that a tax benefit will not be realized. The deferred income taxes are classified as current or long-term based on the classification of the related asset or liability. Fair Value Measurements We account for certain assets and liabilities at fair value. The +hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest +level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. treasuries, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, foreign exchange rates, and forward and spot +prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, agency securities, certificates of deposit, and commercial paper. Our Level 2 derivative assets +and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain +corporate bonds and goodwill when it is recorded at fair value due to an impairment charge. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock +prices, and volatilities. Our Level 3 derivative assets and liabilities primarily comprise derivatives for foreign equities. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to +determine fair value for these derivatives. Unobservable inputs used in all of these models are significant to the fair values of the assets and liabilities. 53 Table of Contents PART II Item 8 We measure certain assets, including our cost and equity method investments, at fair value on a +nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market +comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values. Financial Instruments We consider all +highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original +maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and +because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the +specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and +other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. +Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the +equity method. We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be +carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash +received is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value +is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative +and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration +and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more +likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes +in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the +fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments +designated as fair-value hedges, the gain (loss) is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged items attributed to the risk being hedged. For options designated as fair-value hedges, +changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. 54 Table of Contents PART II Item 8 For derivative instruments designated as cash-flow hedges, the effective portion of the +derivative’s gain (loss) is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are +excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in +other income (expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale +securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from OCI into other income (expense). Allowance for Doubtful Accounts The +allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. +Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2012 2011 2010 Balance, beginning of period $ 333 $ 375 $ 451 Charged to costs and other 115 14 45 Write-offs (59 ) (56 ) (121 ) Balance, end of period $ 389 $ 333 $ 375 Inventories Inventories are stated at the lower of cost or market, using the average cost method. Cost includes materials, labor, and manufacturing overhead +related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below +carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset +or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three years; computer equipment, two to three years; buildings and improvements, five to +15 years; leasehold improvements, two to 10 years; and furniture and equipment, one to five years. Land is not depreciated. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 +for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. 55 Table of Contents PART II Item 8 Intangible Assets All of our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of +intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Recently adopted accounting guidance On July 1, 2011, we adopted guidance issued by the Financial Accounting Standards Board (“FASB”) on disclosure requirements related +to fair value measurements. The guidance requires the disclosure of roll-forward activities on purchases, sales, issuances, and settlements of the assets and liabilities measured using significant unobservable inputs (Level 3 fair value +measurements). Adoption of this new guidance did not have a material impact on our financial statements. On January 1, 2012, +we adopted guidance issued by the FASB on accounting and disclosure requirements related to fair value measurements. The guidance limits the highest-and-best-use measure to nonfinancial assets, permits certain financial assets and liabilities +with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally, the guidance expands the disclosures on Level 3 inputs by +requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. Adoption of this new guidance did not have +a material impact on our financial statements. Recent accounting guidance not yet adopted In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related +arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and +the related net exposure. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption. In September 2011, the FASB issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a +qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the currently prescribed +two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is +greater than its carrying amount, the two-step goodwill impairment test is not required. The new guidance will be effective for us beginning July 1, 2012. In June 2011, the FASB issued guidance on presentation of comprehensive income. The new guidance eliminates the current option to report other comprehensive income and its components in the statement of +changes in stockholders’ equity. Instead, an entity will be required to present either a continuous statement of net income and other comprehensive income or in two separate but consecutive statements. This portion of the guidance +will be effective for us beginning July 1, 2012 and will require financial statement presentation changes only. The new guidance also required entities to present reclassification adjustments out of accumulated other comprehensive income by +component in both the statement in which net income is presented and the statement in which other comprehensive income is presented. However, in December 2011, the FASB issued guidance which indefinitely defers the guidance related to the +presentation of reclassification adjustments. 56 Table of Contents PART II Item 8 NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock +outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive +potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic and diluted EPS are as follows: (In millions, except earnings per share) Year Ended June 30, 2012 2011 2010 Net income available for common shareholders (A) $ 16,978 $ 23,150 $ 18,760 Weighted average outstanding shares of common stock (B) 8,396 8,490 8,813 Dilutive effect of stock-based awards 110 103 114 Common stock and common stock equivalents (C) 8,506 8,593 8,927 Earnings Per Share Basic (A/B) $ 2.02 $ 2.73 $ 2.13 Diluted (A/C) $ 2.00 $ 2.69 $ 2.10 We excluded the following shares underlying stock-based +awards from the calculations of diluted EPS because their inclusion would have been anti-dilutive: (In millions) Year Ended June 30, 2012 2011 2010 Shares excluded from calculations of diluted EPS 1 21 28 In June 2010, we issued $1.25 billion of zero-coupon debt +securities that are convertible into shares of our common stock if certain conditions are met. As of June 30, 2012, none of these securities had met price or other conditions that would make them eligible for conversion and therefore were +excluded from the calculation of basic and diluted EPS. See Note 12 – Debt for additional information. NOTE 3 — OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Dividends and interest income $ 800 $ 900 $ 843 Interest expense (380 ) (295 ) (151 ) Net recognized gains on investments 564 439 348 Net losses on derivatives (364 ) (77 ) (140 ) Net gains (losses) on foreign currency remeasurements (117 ) (26 ) 1 Other 1 (31 ) 14 Total $ 504 $ 910 $ 915 57 Table of Contents PART II Item 8 Following are details of net recognized gains on investments during the periods reported: (In millions) Year Ended June 30, 2012 2011 2010 Other-than-temporary impairments of investments $ (298 ) $ (80 ) $ (69 ) Realized gains from sales of available-for-sale securities 1,418 734 605 Realized losses from sales of available-for-sale securities (556 ) (215 ) (188 ) Total $ 564 $ 439 $ 348 NOTE 4 — INVESTMENTS Investment Components The components of +investments, including associated derivatives, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2012 Cash $ 2,019 $ 0 $ 0 $ 2,019 $ 2,019 $ 0 $ 0 Mutual funds 820 0 0 820 820 0 0 Commercial paper 96 0 0 96 96 0 0 Certificates of deposit 744 0 0 744 342 402 0 U.S. government and agency securities 47,178 130 (2 ) 47,306 561 46,745 0 Foreign government bonds 1,741 18 (29 ) 1,730 575 1,155 0 Mortgage-backed securities 1,816 82 (2 ) 1,896 0 1,896 0 Corporate notes and bonds 7,799 224 (15 ) 8,008 2,525 5,483 0 Municipal securities 358 58 0 416 0 416 0 Common and preferred stock 6,965 2,204 (436 ) 8,733 0 0 8,733 Other investments 1,048 0 0 1,048 0 5 1,043 Total $ 70,584 $ 2,716 $ (484 ) $ 72,816 $ 6,938 $ 56,102 $ 9,776 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2011 Cash $ 1,648 $ 0 $ 0 $ 1,648 $ 1,648 $ 0 $ 0 Mutual funds 1,752 0 0 1,752 1,752 0 0 Commercial paper 639 0 0 639 414 225 0 Certificates of deposit 598 0 0 598 372 226 0 U.S. government and agency securities 33,607 162 (7 ) 33,762 2,049 31,713 0 Foreign government bonds 658 11 (2 ) 667 0 667 0 Mortgage-backed securities 2,307 121 (4 ) 2,424 0 2,424 0 Corporate notes and bonds 10,575 260 (11 ) 10,824 3,375 7,449 0 Municipal securities 441 15 (2 ) 454 0 454 0 Common and preferred stock 7,925 2,483 (193 ) 10,215 0 0 10,215 Other investments 654 0 0 654 0 4 650 Total $ 60,804 $ 3,052 $ (219 ) $ 63,637 $ 9,610 $ 43,162 $ 10,865 58 Table of Contents PART II Item 8 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2012 U.S. government and agency securities $ 44 $ (2 ) $ 0 $ 0 $ 44 $ (2 ) Foreign government bonds 657 (27 ) 12 (2 ) 669 (29 ) Mortgage-backed securities 53 0 48 (2 ) 101 (2 ) Corporate notes and bonds 640 (11 ) 70 (4 ) 710 (15 ) Common and preferred stock 2,135 (329 ) 305 (107 ) 2,440 (436 ) Total $ 3,529 $ (369 ) $ 435 $ (115 ) $ 3,964 $ (484 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2011 U.S. government and agency securities $ 484 $ (7 ) $ 0 $ 0 $ 484 $ (7 ) Foreign government bonds 365 (2 ) 0 0 365 (2 ) Mortgage-backed securities 63 (3 ) 14 (1 ) 77 (4 ) Corporate notes and bonds 750 (10 ) 25 (1 ) 775 (11 ) Municipal securities 79 (2 ) 0 0 79 (2 ) Common and preferred stock 1,377 (146 ) 206 (47 ) 1,583 (193 ) Total $ 3,118 $ (170 ) $ 245 $ (49 ) $ 3,363 $ (219 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized +losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of +June 30, 2012. At June 30, 2012 and 2011, the recorded bases of common and preferred stock and other investments that are +restricted for more than one year or are not publicly traded were $313 million and $334 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not possible for +us to reliably estimate the fair value of these investments. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2012 Due in one year or less $ 23,097 $ 23,125 Due after one year through five years 31,029 31,124 Due after five years through 10 years 3,173 3,371 Due after 10 years 2,433 2,576 Total $ 59,732 $ 60,196 59 Table of Contents PART II Item 8 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to +enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative +programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. currency equivalents. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to +foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for +up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of June 30, 2012 and June 30, 2011, the total notional +amounts of these foreign exchange contracts sold were $6.7 billion and $10.6 billion, respectively. Foreign currency risks related to +certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of June 30, 2012 and June 30, 2011, the total notional amounts of these foreign +exchange contracts sold were $1.3 billion and $572 million, respectively. Certain options and forwards not designated as hedging +instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of June 30, 2012, the total notional amounts of these +foreign exchange contracts purchased and sold were $3.6 billion and $7.3 billion, respectively. As of June 30, 2011, the total notional amounts of these foreign exchange contracts purchased and sold were $4.3 billion and $7.1 billion, +respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to +broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity +derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2012, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.4 billion and $982 million, +respectively. As of June 30, 2011, the total notional amounts of designated and non-designated equity contracts purchased and sold were $1.1 billion and $860 million, respectively. Interest Rate Securities held in our fixed-income portfolio are subject to different interest +rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and +over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2012, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.2 billion and $1.9 billion, +respectively. As of June 30, 2011, the total notional amounts of fixed-interest rate contracts purchased and sold were $2.3 billion and $697 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative +instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2012 and 2011, the total notional derivative amount of mortgage contracts purchased were $1.1 billion and $868 +million, respectively. 60 Table of Contents PART II Item 8 Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to +broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or groups of credit risks. As of June 30, 2012, the total notional +amounts of credit contracts purchased and sold were $318 million and $456 million, respectively. As of June 30, 2011, the total notional amounts of credit contracts purchased and sold were $532 million and $281 million, respectively. Commodity We use broad-based +commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swap, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We +use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2012, the total notional amounts of +commodity contracts purchased and sold were $1.5 billion and $445 million, respectively. As of June 30, 2011, the total notional amounts of commodity contracts purchased and sold were $1.9 billion and $502 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured +debt to maintain an investment grade credit rating and require us to maintain a minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related +to over-the-counter derivatives. As of June 30, 2012, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. 61 Table of Contents PART II Item 8 Fair Values of Derivative Instruments The following tables present the gross fair values of derivative instruments designated as hedging instruments (“designated hedge +derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists +and fair value adjustments related to our own credit risk and counterparty credit risk: (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2012 Assets Non-designated hedge derivatives: Short-term investments $ 14 $ 162 $ 10 $ 26 $ 3 $ 215 Other current assets 85 0 0 0 0 85 Total $ 99 $ 162 $ 10 $ 26 $ 3 $ 300 Designated hedge derivatives: Short-term investments $ 6 $ 0 $ 0 $ 0 $ 0 $ 6 Other current assets 177 0 0 0 0 177 Total $ 183 $ 0 $ 0 $ 0 $ 0 $ 183 Total assets $ 282 $ 162 $ 10 $ 26 $ 3 $ 483 Liabilities Non-designated hedge derivatives: Other current liabilities $ (84 ) $ (19 ) $ (17 ) $ (21 ) $ 0 $ (141 ) Designated hedge derivatives: Other current liabilities $ (14 ) $ 0 $ 0 $ 0 $ 0 $ (14 ) Total liabilities $ (98 ) $ (19 ) $ (17 ) $ (21 ) $ 0 $ (155 ) (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2011 Assets Non-designated hedge derivatives: Short-term investments $ 14 $ 179 $ 0 $ 17 $ 4 $ 214 Other current assets 73 0 0 0 0 73 Total $ 87 $ 179 $ 0 $ 17 $ 4 $ 287 Designated hedge derivatives: Short-term investments $ 6 $ 0 $ 0 $ 0 $ 0 $ 6 Other current assets 123 0 0 0 0 123 Total $ 129 $ 0 $ 0 $ 0 $ 0 $ 129 Total assets $ 216 $ 179 $ 0 $ 17 $ 4 $ 416 Liabilities Non-designated hedge derivatives: Other current liabilities $ (91 ) $ (12 ) $ (9 ) $ (19 ) $ (4 ) $ (135 ) Designated hedge derivatives: Other current liabilities $ (128 ) $ 0 $ 0 $ 0 $ 0 $ (128 ) Total liabilities $ (219 ) $ (12 ) $ (9 ) $ (19 ) $ (4 ) $ (263 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. 62 Table of Contents PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense) the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2012 2011 2010 Foreign Exchange Contracts Derivatives $ 52 $ (92 ) $ (57 ) Hedged items (50 ) 85 60 Total $ 2 $ (7 ) $ 3 Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented): (In millions) Year Ended June 30, 2012 2011 2010 Effective Portion Gain (loss) recognized in OCI, net of tax effect of $127, $(340) and $188 $ 236 $ (632 ) $ 349 Gain (loss) reclassified from OCI into revenue $ (27 ) $ (7 ) $ 495 Amount Excluded from Effectiveness Assessment and Ineffective Portion Loss recognized in other income (expense) $ (231 ) $ (276 ) $ (174 ) We estimate that $137 million of net derivative gains +included in OCI at June 30, 2012 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from OCI into earnings as a result of forecasted transactions that failed to occur +during fiscal year 2012. Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of +gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the periods presented. Other than those derivatives entered into for investment purposes, such as commodity +contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities. (In millions) Year Ended June 30, 2012 2011 2010 Foreign exchange contracts $ (119 ) $ (27 ) $ 106 Equity contracts (85 ) 35 12 Interest-rate contracts 93 19 (4 ) Credit contracts (7 ) 24 22 Commodity contracts (121 ) 148 (1 ) Total $ (239 ) $ 199 $ 135 63 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2012 Assets Mutual funds $ 820 $ 0 $ 0 $ 820 $ 0 $ 820 Commercial paper 0 96 0 96 0 96 Certificates of deposit 0 744 0 744 0 744 U.S. government and agency securities 42,291 5,019 0 47,310 0 47,310 Foreign government bonds 31 1,703 0 1,734 0 1,734 Mortgage-backed securities 0 1,892 0 1,892 0 1,892 Corporate notes and bonds 0 7,839 9 7,848 0 7,848 Municipal securities 0 416 0 416 0 416 Common and preferred stock 7,539 877 5 8,421 0 8,421 Derivatives 16 467 0 483 (141 ) 342 Total $ 50,697 $ 19,053 $ 14 $ 69,764 $ (141 ) $ 69,623 Liabilities Derivatives and other $ 10 $ 145 $ 0 $ 155 $ (139 ) $ 16 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2011 Assets Mutual funds $ 1,752 $ 0 $ 0 $ 1,752 $ 0 $ 1,752 Commercial paper 0 639 0 639 0 639 Certificates of deposit 0 598 0 598 0 598 U.S. government and agency securities 23,591 10,175 0 33,766 0 33,766 Foreign government bonds 303 367 0 670 0 670 Mortgage-backed securities 0 2,428 0 2,428 0 2,428 Corporate notes and bonds 0 10,600 58 10,658 0 10,658 Municipal securities 0 454 0 454 0 454 Common and preferred stock 9,821 55 5 9,881 0 9,881 Derivatives 8 388 20 416 (204 ) 212 Total $ 35,475 $ 25,704 $ 83 $ 61,262 $ (204 ) $ 61,058 Liabilities Derivatives and other $ 109 $ 257 $ 0 $ 366 $ (203 ) $ 163 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. 64 Table of Contents PART II Item 8 The following table reconciles the total Net Fair Value of assets above to the balance sheet +presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2012 2011 Net fair value of assets measured at fair value on a recurring basis $ 69,623 $ 61,058 Cash 2,019 1,648 Common and preferred stock measured at fair value on a nonrecurring basis 313 334 Other investments measured at fair value on a nonrecurring basis 1,043 650 Less derivative assets classified as other current assets (185 ) (54 ) Other 3 1 Recorded basis of investment components $ 72,816 $ 63,637 Changes in Financial Instruments Measured at Level 3 Fair Value on a Recurring Basis The following tables present the changes during the periods presented in our Level 3 financial instruments that are measured at fair value on a +recurring basis. The majority of these instruments consist of investment securities classified as available-for-sale with changes in fair value included in OCI. (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Year Ended June 30, 2012 Balance, beginning of period $ 58 $ 5 $ 20 $ 83 Total realized and unrealized losses: Included in other income (expense) 0 0 (5 ) (5 ) Included in other comprehensive income (21 ) 0 0 (21 ) Conversions of Level 3 instruments to Level 1 instruments (28 ) 0 (15 ) (43 ) Balance, end of period $ 9 $ 5 $ 0 $ 14 Change in unrealized gains included in other income (expense) related to assets held as of June 30, 2012 $ 0 $ 0 $ 0 $ 0 (In millions) Corporate Notes and Bonds Common and Preferred Stock Derivative Assets Total Year Ended June 30, 2011 Balance, beginning of period $ 167 $ 5 $ 9 $ 181 Total realized and unrealized gains (losses): Included in other income (expense) 39 0 11 50 Included in other comprehensive income (63 ) 0 0 (63 ) Purchases, issuances and settlements (85 ) 0 0 (85 ) Balance, end of period $ 58 $ 5 $ 20 $ 83 Change in unrealized gains included in other income (expense) related to assets held as of June 30, 2011 $ 6 $ 0 $ 11 $ 17 Financial Assets and Liabilities Measured at Fair Value on a +Nonrecurring Basis During fiscal year 2012 and 2011, we did not record any material other-than-temporary impairments on financial +assets required to be measured at fair value on a nonrecurring basis. 65 Table of Contents PART II Item 8 NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2012 2011 Raw materials $ 210 $ 232 Work in process 96 56 Finished goods 831 1,084 Total $ 1,137 $ 1,372 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2012 2011 Land $ 528 $ 533 Buildings and improvements 6,768 6,521 Leasehold improvements 2,550 2,345 Computer equipment and software 7,298 6,601 Furniture and equipment 2,087 1,991 Total, at cost 19,231 17,991 Accumulated depreciation (10,962 ) (9,829 ) Total, net $ 8,269 $ 8,162 During fiscal years 2012, 2011, and 2010, depreciation expense was $2.2 billion, $2.0 billion, and $1.8 billion, +respectively. NOTE 9 — BUSINESS COMBINATIONS Skype On +October 13, 2011, we acquired all of the issued and outstanding shares of Skype Global S.á r.l. (“Skype”), a leading global provider of software applications and related Internet communications products based in Luxembourg, for +$8.6 billion, primarily in cash. The major classes of assets and liabilities to which we allocated the purchase price were goodwill of $7.1 billion, identifiable intangible assets of $1.6 billion, and unearned revenue of $222 million. The goodwill +recognized in connection with the acquisition is primarily attributable to our expectation of extending Skype’s brand and the reach of its networked platform, while enhancing Microsoft’s existing portfolio of real-time communications +products and services. We assigned the goodwill to the following segments: $4.2 billion to Entertainment and Devices Division, $2.8 billion to Microsoft Business Division, and $54 million to Online Services Division. Skype was consolidated into our +results of operations starting October 13, 2011, the acquisition date. Following are the details of the purchase price allocated +to the intangible assets acquired: (In millions) Weighted Average Life Marketing-related (trade names) $ 1,249 15 years Technology-based 275 5 years Customer-related 114 5 years Contract-based 10 4 years Total $ 1,648 13 years 66 Table of Contents PART II Item 8 Other During fiscal year 2012, we completed an additional four acquisitions for total consideration of $87 million, substantially all of which was paid in cash. During fiscal year 2011, we acquired three entities for +total consideration of $75 million, substantially all of which was paid in cash. During fiscal year 2010, we acquired five entities for total consideration of $267 million, substantially all of which was paid in cash. During fiscal year 2010, we +also sold three entities for total consideration of $600 million, including Razorfish in the second quarter of fiscal year 2010. These entities have been included in or removed from our consolidated results of operations since their acquisition or +sale dates, respectively. Pro forma results of operations have not been presented because the effects of the business combinations +described in this Note, individually and in aggregate, were not material to our consolidated results of operations. NOTE 10 — GOODWILL Changes in the carrying amount of goodwill by segment were as follows: Balance as of June 30, 2010 Acquisitions Other Balance as of June 30, 2011 Acquisitions Other Balance as of June 30, 2012 (In millions) Windows & Windows Live Division $ 77 $ 0 $ 12 $ 89 $ 0 $ 0 $ 89 Server and Tools 1,118 13 8 1,139 7 (2 ) 1,144 Online Services Division 6,373 0 0 6,373 54 (6,204 ) 223 Microsoft Business Division 4,024 4 139 4,167 2,843 (117 ) 6,893 Entertainment and Devices Division 802 30 (19 ) 813 4,294 (4 ) 5,103 Total $ 12,394 $ 47 $ 140 $ 12,581 $ 7,198 $ (6,327) $ 13,452 The measurement periods for purchase price allocations end as soon as information on the facts and circumstances +becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in which the acquisitions occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the above table. Also +included within “other” are business dispositions and transfers between business segments due to reorganizations, as applicable. For fiscal year 2012, a $6.2 billion goodwill impairment charge is included in “other,” as discussed +further below. This goodwill impairment charge also represents our accumulated goodwill impairment as of June 30, 2012. Goodwill Impairment We tested goodwill for impairment as of May 1, 2012 at the reporting unit level using a discounted cash flow methodology with a +peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. Upon completion of the annual test, OSD goodwill was determined to be impaired. The impairment was the result of the OSD unit experiencing slower +than projected growth in search queries and search advertising revenue per query, slower growth in display revenue, and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the +future. Although revenues increased compared to the prior year, the industry is highly competitive and certain operational challenges have affected our expectations such that future growth and profitability are lower than previous estimates. In +addition, in the current year, we added a business-specific risk factor to the weighted average cost of capital used to calculate the discounted cash flows of OSD in estimating the fair value of the business. This business-specific risk factor +reflects the increased uncertainty in forecasting the future performance of OSD. 67 Table of Contents PART II Item 8 Because our annual test indicated that OSD’s carrying value exceeded its estimated fair +value, a second phase of the goodwill impairment test (“Step 2”) was performed specific to OSD. Under Step 2, the fair value of all OSD assets and liabilities were estimated, including tangible assets, existing technology, trade names, and +partner relationships for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in +measuring the value of these assets and liabilities included the discount rates, royalty rates, and obsolescence rates used in valuing the intangible assets, and pricing of comparable transactions in the market in valuing the tangible assets. No other instances of impairment were identified in our May 1, 2012 test. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Year Ended June 30, 2012 2011 Technology-based (a) $ 3,550 $ (1,899 ) $ 1,651 $ 2,356 $ (1,831 ) $ 525 Marketing-related 1,325 (136 ) 1,189 113 (98 ) 15 Contract-based 824 (644 ) 180 1,068 (966 ) 102 Customer-related 408 (258 ) 150 326 (224 ) 102 Total $ 6,107 $ (2,937 ) $ 3,170 $ 3,863 $ (3,119 ) $ 744 (a) Technology-based intangible assets included $177 million and $179 million as of June 30, 2012 and 2011, respectively, of net carrying amount of +software to be sold, leased, or otherwise marketed. We estimate that we have no significant residual value +related to our intangible assets. No material impairments of intangible assets were identified during any of the periods presented. The +components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2012 2011 Technology-based $ 1,548 7 years $ 119 3 years Marketing-related 1,249 15 years 1 7 years Contract-based 115 7 years 0 Customer-related 114 5 years 2 4 years Total $ 3,026 10 years $ 122 3 years Intangible assets amortization expense was $558 million, $537 million, and $707 million for fiscal years 2012, +2011, and 2010, respectively. Amortization of capitalized software was $117 million, $114 million, and $97 million for fiscal years 2012, 2011, and 2010, respectively. 68 Table of Contents PART II Item 8 The following table outlines the estimated future amortization expense related to intangible +assets held at June 30, 2012: (In millions) Year Ending June 30, 2013 $ 597 2014 432 2015 367 2016 304 2017 234 Thereafter 1,236 Total $ 3,170 NOTE 12 — DEBT As of June 30, 2012, the total carrying value and estimated fair value of our long-term debt, including the current +portion, were $11.9 billion and $13.2 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $12.1 billion, respectively, as of June 30, 2011. These estimated fair values are based on Level 2 +inputs. The components of our long-term debt, including the current portion, and the associated interest rates and semi-annual interest +record and payment dates were as follows as of June 30, 2012 and 2011: Due Date Face Value Stated Interest Rate Effective Interest Rate Interest Record Date Interest Pay Date Interest Record Date Interest Pay Date (In millions) Notes September 27, 2013 $ 1,000 0.875% 1.000% March 15 March 27 September 15 September 27 June 1, 2014 2,000 2.950% 3.049% May 15 June 1 November 15 December 1 September 25, 2015 1,750 1.625% 1.795% March 15 March 25 September 15 September 25 February 8, 2016 750 2.500% 2.642% February 1 February 8 August 1 August 8 June 1, 2019 1,000 4.200% 4.379% May 15 June 1 November 15 December 1 October 1, 2020 1,000 3.000% 3.137% March 15 April 1 September 15 October 1 February 8, 2021 500 4.000% 4.082% February 1 February 8 August 1 August 8 June 1, 2039 750 5.200% 5.240% May 15 June 1 November 15 December 1 October 1, 2040 1,000 4.500% 4.567% March 15 April 1 September 15 October 1 February 8, 2041 1,000 5.300% 5.361% February 1 February 8 August 1 August 8 Total 10,750 Convertible Debt June 15, 2013 1,250 0.000% 1.849% Total face value $ 12,000 As of June 30, 2012 and 2011, the aggregate unamortized discount for our long-term debt, including the current +portion, was $56 million and $79 million, respectively. Notes The Notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. 69 Table of Contents PART II Item 8 Convertible Debt In June 2010, we issued $1.25 billion of zero coupon convertible unsecured debt due on June 15, 2013 in a private placement offering. Proceeds from the offering were $1.24 billion, net of fees and expenses, +which were capitalized. Initially, each $1,000 principal amount of notes was convertible into 29.94 shares of Microsoft common stock at a conversion price of $33.40 per share. The conversion ratio is adjusted periodically for dividends in excess of +the initial dividend threshold as defined in the debt agreement. As of June 30, 2012, the net carrying amount of our convertible debt was $1.2 billion and the unamortized discount was $19 million. Prior to March 15, 2013, the notes will be convertible, only in certain circumstances, into cash and, if applicable, cash, shares of +Microsoft’s common stock, or a combination thereof, at our election. On or after March 15, 2013, the notes will be convertible at any time. Upon conversion, we will pay cash up to the aggregate principal amount of the notes and pay or +deliver cash, shares of our common stock, or a combination of cash and shares of our common stock, at our election. Because the +convertible debt may be wholly or partially settled in cash, we are required to separately account for the liability and equity components of the notes in a manner that reflects our nonconvertible debt borrowing rate when interest costs are +recognized in subsequent periods. The net proceeds of $1.24 billion were allocated between debt for $1.18 billion and stockholders’ equity for $58 million with the portion in stockholders’ equity representing the fair value of the option +to convert the debt. In connection with the issuance of the notes, we entered into capped call transactions with certain option +counterparties who are initial purchasers of the notes or their affiliates. The capped call transactions are expected to reduce potential dilution of earnings per share upon conversion of the notes. Under the capped call transactions, we purchased +from the option counterparties capped call options that in the aggregate relate to the total number of shares of our common stock underlying the notes, with a strike price equal to the conversion price of the notes and with an initial cap price +equal to $37.16, which is adjusted periodically to mirror any adjustments to the conversion price. The purchased capped calls were valued at $40 million and recorded to stockholders’ equity. Debt Service Maturities of our long-term +debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2013 $ 1,250 2014 3,000 2015 0 2016 2,500 2017 0 Thereafter 5,250 Total $ 12,000 Cash paid for interest on our debt for fiscal years 2012, 2011, and 2010 was $344 million, $197 million, and $145 +million, respectively. 70 Table of Contents PART II Item 8 NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Current Taxes U.S. federal $ 2,235 $ 3,108 $ 4,415 U.S. state and local 153 209 357 International 1,947 1,602 1,701 Current taxes 4,335 4,919 6,473 Deferred Taxes Deferred taxes 954 2 (220 ) Provision for income taxes $ 5,289 $ 4,921 $ 6,253 U.S. and international components of income before income taxes were as follows: (In millions) Year Ended June 30, 2012 2011 2010 U.S. $ 1,600 $ 8,862 $ 9,575 International 20,667 19,209 15,438 Income before income taxes $ 22,267 $ 28,071 $ 25,013 The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our +effective rate were as follows: Year Ended June 30, 2012 2011 2010 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (21.1)% (15.6)% (12.1)% Goodwill impairment 9.7% 0% 0% I.R.S. settlement 0% (1.7)% 0% Other reconciling items, net 0.2% (0.2)% 2.1% Effective rate 23.8% 17.5% 25.0% The reduction from the federal statutory rate from foreign earnings taxed at lower rates results from producing and +distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which have lower income tax rates. In general, other reconciling items consist of interest, U.S. state income taxes, +domestic production deductions, and credits. In fiscal years 2012, 2011, and 2010, there were no individually significant other reconciling items. The I.R.S. settlement is discussed below. 71 Table of Contents PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2012 2011 Deferred Income Tax Assets Stock-based compensation expense $ 882 $ 1,079 Other expense items 965 1,321 Unearned revenue 571 463 Impaired investments 152 424 Loss carryforwards 532 90 Other revenue items 79 69 Deferred income tax assets $ 3,181 $ 3,446 Less valuation allowance (453 ) 0 Deferred income tax assets, net of valuation allowance $ 2,728 $ 3,446 Deferred Income Tax Liabilities International earnings $ (1,072 ) $ (1,266 ) Unrealized gain on investments (830 ) (904 ) Depreciation and amortization (670 ) (265 ) Other (14 ) 0 Deferred income tax liabilities (2,586 ) (2,435 ) Net deferred income tax assets $ 142 $ 1,011 Reported As Current deferred income tax assets $ 2,035 $ 2,467 Long-term deferred income tax liabilities (1,893 ) (1,456 ) Net deferred income tax assets $ 142 $ 1,011 The valuation allowance disclosed in the table above relates to a portion of a $2.0 billion net operating loss +carryforward generated primarily in foreign countries and acquired primarily through our acquisition of Skype that may not be realized. Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax +bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. As of June 30, +2012, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $60.8 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the U.S. +The unrecognized deferred tax liability associated with these temporary differences was approximately $19.4 billion at June 30, 2012. Income taxes paid were $3.5 billion, $5.3 billion, and $4.1 billion in fiscal years 2012, 2011, and 2010, respectively. Uncertain Tax Positions As of June 30, 2012, we had $7.2 billion of unrecognized tax +benefits of which $6.2 billion, if recognized, would affect our effective tax rate. As of June 30, 2011, we had $6.9 billion of unrecognized tax benefits of which $5.9 billion, if recognized, would have affected our effective tax rate. Interest on unrecognized tax benefits was $154 million, $38 million, and $193 million in fiscal years 2012, 2011, and 2010, +respectively. As of June 30, 2012, 2011, and 2010, we had accrued interest related to uncertain tax positions of $939 million, $785 million, and $747 million, respectively, net of federal income tax benefits. 72 Table of Contents PART II Item 8 The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Balance, beginning of year $ 6,935 $ 6,542 $ 5,403 Decreases related to settlements (16 ) (632 ) (57 ) Increases for tax positions related to the current year 481 739 1,012 Increases for tax positions related to prior years 118 405 364 Decreases for tax positions related to prior years (292 ) (119 ) (166 ) Decreases due to lapsed statutes of limitations (24 ) 0 (14 ) Balance, end of year $ 7,202 $ 6,935 $ 6,542 During the third quarter of fiscal year 2011, we reached a settlement of a portion of an I.R.S. audit of tax years +2004 to 2006, which reduced our income tax expense by $461 million. While we settled a portion of the I.R.S. audit, we remain under audit for these years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit +phase of the examination. As of June 30, 2012, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our financial statements if not resolved favorably. We believe our allowances for tax +contingencies are appropriate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the remaining open issues will be +resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2011. We are +subject to income tax in many jurisdictions outside the U.S. Certain jurisdictions remain subject to examination for tax years 1996 to 2011, some of which are currently under audit by local tax authorities. The resolutions of these audits are not +expected to be material to our financial statements. NOTE 14 — UNEARNED REVENUE Unearned revenue comprises mainly unearned revenue from volume licensing programs, and payments for offerings for which we have +been paid in advance and we earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria. Volume +Licensing Programs Unearned revenue from volume licensing programs represents customer billings for multi-year licensing +arrangements paid either at inception of the agreement or annually at the beginning of each billing coverage period and accounted for as subscriptions with revenue recognized ratably over the billing coverage period. Other Also included in unearned revenue +are payments for post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; sales of Windows 7 with an option to upgrade to Windows 8 at a discounted price (the “Windows Upgrade +Offer”); Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; OEM minimum commitments; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, +or otherwise meet the revenue recognition criteria. 73 Table of Contents PART II Item 8 The components of unearned revenue were as follows: (In millions) June 30, 2012 2011 Volume licensing programs $ 16,717 $ 14,625 Other (a) 3,342 2,495 Total $ 20,059 $ 17,120 (a) Other as of June 30, 2012 includes $540 million of unearned revenue associated with the Windows Upgrade Offer. Unearned revenue by segment was as follows: (In millions) June 30, 2012 2011 Windows & Windows Live Division $ 2,444 $ 1,782 Server and Tools 7,445 6,315 Microsoft Business Division 9,015 8,187 Other segments 1,155 836 Total $ 20,059 $ 17,120 Fiscal year 2011 amounts have been recast for the fiscal year 2012 movement of Forefront Protection for Office, an +anti-malware solution, from Server and Tools to the Microsoft Business Division. NOTE 15 — OTHER LONG-TERM LIABILITIES (In millions) June 30, 2012 2011 Tax contingencies and other tax liabilities $ 7,634 $ 7,381 Legal contingencies 220 276 Other 354 415 Total $ 8,208 $ 8,072 NOTE 16 — COMMITMENTS AND GUARANTEES Construction and Operating Leases We have committed $353 million for constructing new buildings, building improvements, and leasehold improvements as of June 30, 2012. 74 Table of Contents PART II Item 8 We have operating leases for most U.S. and international sales and support offices and certain +equipment. Rental expense for facilities operating leases was $639 million, $525 million, and $530 million, in fiscal years 2012, 2011, and 2010, respectively. Future minimum rental commitments under noncancellable facilities operating leases in +place as of June 30, 2012 are as follows: (In millions) Year Ending June 30, 2013 $ 527 2014 421 2015 327 2016 223 2017 164 Thereafter 315 Total $ 1,977 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered +significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements. Yahoo! Commercial Agreement On +December 4, 2009, we entered into a 10-year agreement with Yahoo! Inc. (“Yahoo!”) whereby Microsoft will provide the exclusive algorithmic and paid search platform for Yahoo! websites. Microsoft provided Yahoo! with revenue per search +guarantees for a period of 18 months after implementation of the Microsoft search ads platform in each country, extended by an additional 12 months for the U.S. and Canada. These guarantees are calculated, paid, and adjusted periodically and are +rate guarantees, not guarantees of search volume. We estimate the remaining cost of the revenue per search guarantees during the guarantee period could range up to $120 million. NOTE 17 — CONTINGENCIES Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC +operating system and certain other software products between 1999 and 2005. We obtained dismissals or reached settlements of all claims made in the United States. All settlements in the United States have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of +platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending +on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these +settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 +billion and $2.0 billion. At June 30, 2012, we have recorded a liability related to these claims of approximately $500 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.4 billion +mostly for vouchers, legal fees, and administrative expenses. 75 Table of Contents PART II Item 8 The three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In +March 2010, the court in the British Columbia case certified it as a class action. In April 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that indirect purchasers do not have +a claim. The plaintiffs have appealed to the Canadian Supreme Court, which will be heard in the fall of 2012. The other two actions have been stayed. Other Antitrust Litigation and Claims In +November 2004, Novell, Inc. (“Novell”) filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to +Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of six claims of the complaint. In March 2010, the +trial court granted summary judgment in favor of Microsoft as to all remaining claims. The court of appeals reversed that ruling as to one claim. Trial of that claim took place from October to December 2011 and resulted in a mistrial because the +jury was unable to reach a verdict. In July 2012, the trial court granted Microsoft’s motion for judgment as a matter of law. Novell may appeal this decision. Government Competition Law Matters In December 2009, the European Commission adopted a +decision that rendered legally binding commitments offered by Microsoft to address the Commission’s concerns about the inclusion of Web browsing software in Windows. Among other things, Microsoft committed to display a “Browser Choice +Screen” on Windows-based PCs in Europe where Internet Explorer is set as the default browser. Due to a technical error, we failed to deliver the requisite software to enable that display to PCs that came preinstalled with a version of Windows 7 +called Windows 7 Service Pack 1. We did deliver the requisite software to PCs running the original version of Windows 7 and earlier editions of Windows. Following notification by the Commission of reports that some PCs were not receiving the update, +we promptly fixed the error and advised the Commission of what we had discovered. PCs that come preinstalled with Windows 7 Service Pack are now receiving the Browser Choice Screen software, as intended. On July 17, 2012, the Commission +announced that it had opened proceedings to investigate whether Microsoft had failed to comply with this commitment. The Commission stated that if a company is found to have breached a legally binding commitment, the company may be fined up to 10% +of its worldwide annual revenue. Patent and Intellectual Property Claims Motorola Litigation In October 2010, Microsoft filed patent infringement complaints against +Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents by Motorola’s Android devices. Since then, Microsoft and +Motorola have filed additional claims against each other in the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, and in courts in Germany and the United Kingdom. In April 2012, following complaints by Microsoft and +Apple, the European Union’s competition office opened two antitrust investigations against Motorola to determine whether it has abused certain of its standard essential patents to distort competition in breach of European Union antitrust rules. +In June 2012, we received a request for information from the U.S. Federal Trade Commission (“FTC”) apparently related to an FTC investigation into whether Motorola’s conduct violates U.S. law. The nature of the claims asserted and +status of individual matters are summarized below. International Trade Commission The hearing in Microsoft’s ITC case against Motorola took place in August 2011 on seven of the nine patents originally asserted in the +complaint. In December 2011, the administrative law judge (“ALJ”) issued an initial determination that Motorola infringed one Microsoft patent, and recommended that the ITC issue a limited exclusion 76 Table of Contents PART II Item 8 order against Motorola prohibiting importation of infringing Motorola Android devices. In May 2012, the ITC issued the limited exclusion order recommended by the ALJ, which became effective on +July 18, 2012. Microsoft has appealed certain aspects of the ITC ruling adverse to Microsoft; Motorola is expected to appeal the ITC exclusion order. In November 2010, Motorola filed an action against Microsoft in the ITC alleging infringement of five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the +allegedly infringing Xbox products into the U.S. In April 2012, the ALJ found that Xbox products infringe four of the five patents asserted by Motorola. The ALJ subsequently recommended that the ITC issue a limited exclusion order and a cease and +desist order. Both Microsoft and Motorola sought ITC review of the ALJ’s findings. In June 2012, Microsoft filed a motion to terminate the investigation as to certain patents based on facts arising as the result of Google’s acquisition of +Motorola. The ITC determined that it would review the ALJ’s initial determination in its entirety and remanded the matter to the ALJ (1) to apply certain ITC case precedent, (2) to rule on Microsoft’s June 2012 motion to +terminate, and (3) set a new target date for completion of the investigation. If the ITC issues an exclusion order or cease and desist order, it will be subject to Presidential review for up to 60 days, during which it is expected that +Microsoft could import Xbox products subject to posting a bond. Should any order issue and survive Presidential review, Microsoft may be able to mitigate its impact by altering Xbox products so they do not infringe the Motorola patents. U.S. District Court The Seattle District +Court case filed in October 2010 by Microsoft as a companion to Microsoft’s ITC case against Motorola has been stayed pending the outcome of Microsoft’s ITC case. In November 2010, Microsoft sued Motorola for breach of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain +patents on reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In suits described below, Motorola +or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District Courts, in the ITC, and in Germany. In February 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that +(1) Motorola entered into binding contractual commitments with standards organizations committing to license its declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. +Subsequently, the court rejected Motorola’s argument that Microsoft had repudiated its right to a RAND license, and ruled a trial is needed to determine whether Motorola is in breach of its obligation to enter into a patent license with +Microsoft and, if so, the amount of the RAND royalty. In April 2012, the court issued a temporary restraining order preventing Motorola from taking steps to enforce an injunction in Germany relating to the H.264 video patents. In May 2012, the court +converted that order into a preliminary injunction. Motorola has appealed the court’s injunction orders to the Court of Appeals for the Ninth Circuit. The Seattle court has set a trial to determine the RAND royalty to begin in +November 2012. Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one currently stayed case in +Wisconsin (a companion case to Motorola’s ITC action), have been transferred at Microsoft’s request to the U.S District Court in Seattle. Motorola and Microsoft both seek damages as well as injunctive relief. No trial dates have been set +in any of the transferred cases, and the parties have agreed to a stay of these cases. • In the transferred cases, Motorola asserts 15 patents are infringed by many Microsoft products including Windows Mobile 6.5 and Windows Phone 7, Windows +Marketplace, Silverlight, Windows Vista and 7, Exchange Server 2003 and later, Exchange ActiveSync, Windows Live Messenger, Lync Server 2010, Outlook 2010, Office 365, SQL Server, Internet Explorer 9, Xbox, and Kinect. • In the Motorola action originally filed in California, Motorola asserts that Microsoft violated antitrust laws in connection with Microsoft’s assertion +of patents against Motorola that Microsoft has agreed to license to certain qualifying entities on RAND terms and conditions. • In counterclaims in the patent actions brought by Motorola, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola +digital video recorders. 77 Table of Contents PART II Item 8 Germany In July 2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries. • Two of the patents are asserted by Motorola to be essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products +including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. Motorola seeks damages and an injunction. In May 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany. However, +due to orders in the separate litigation pending in Seattle, Washington described above, Motorola is enjoined from taking steps to enforce the German injunction. Damages would be determined in later proceedings. Microsoft has appealed the rulings of +the first instance court. • Motorola asserts one of the patents covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail +Mobile, Exchange Online, Exchange Server, and Hotmail Server. Motorola seeks damages and an injunction. In May 2012, the Court invited further argument and evidence from the parties relating to Microsoft’s “prior use” defense. If the +court rules in favor of Motorola, an injunction could be issued immediately relating to these products employing the ActiveSync protocol in Germany, which Motorola could then take steps to enforce. We expect the court to issue a ruling in August +2012. Damages would be determined in later proceedings. • Should injunction orders be issued and enforced by Motorola, Microsoft may be able to mitigate the adverse impact by altering its products so they do not +infringe the Motorola patents. In lawsuits Microsoft filed in Germany in September, October, and December 2011 and in +April 2012, Microsoft asserts Motorola Android devices infringe Microsoft patents. Microsoft seeks damages and an injunction. In May 2012, the court issued an injunction on one patent against Motorola Android devices in Germany and ruled against +Microsoft on a second patent. If the court rules in favor of Microsoft in a given case, an injunction could be issued immediately relating to the sale of the infringing devices in Germany, which Microsoft could then take steps to enforce. Damages +would be determined in later proceedings. Motorola has appealed the first instance court’s ruling in Microsoft’s favor. United Kingdom In December 2011, Microsoft filed an action against Motorola in the High Court of Justice, Chancery Division, Patents Court, in +London, England, seeking to revoke the UK part of the European patent asserted by Motorola in Germany against the ActiveSync protocol. In February 2012, Motorola counterclaimed alleging infringement of the patent and seeking damages and an +injunction. A trial is expected in December 2012. Other Patent and Intellectual Property Claims In addition to these cases, there are approximately 60 other patent infringement cases pending against Microsoft. Other We also are subject to a variety of +other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our +financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2012, we had accrued aggregate liabilities of $384 million in other current liabilities and $220 million in other long-term liabilities for all of our contingent legal matters. While we intend +to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $550 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a +material adverse impact on our financial statements for the period in which the effects become reasonably estimable. 78 Table of Contents PART II Item 8 NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Balance, beginning of year 8,376 8,668 8,908 Issued 147 155 140 Repurchased (142 ) (447 ) (380 ) Balance, end of year 8,381 8,376 8,668 Share Repurchases On September 22, 2008, we announced that our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As +of June 30, 2012, approximately $8.2 billion of the approved repurchase amount remained. The repurchase program may be suspended or discontinued at any time without prior notice. We repurchased the following shares of common stock under the above-described repurchase plan using cash resources: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2012 2011 2010 First quarter 38 $ 1,000 163 $ 4,000 58 $ 1,445 Second quarter 39 1,000 188 5,000 125 3,583 Third quarter 31 1,000 30 827 67 2,000 Fourth quarter 34 1,000 66 1,631 130 3,808 Total 142 $ 4,000 447 $ 11,458 380 $ 10,836 Dividends In fiscal year 2012, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011 December 14, 2011 $ 0.20 February 16, 2012 $ 1,683 March 8, 2012 March 13, 2012 $ 0.20 May 17, 2012 $ 1,678 June 14, 2012 June 13, 2012 $ 0.20 August 16, 2012 $ 1,676 September 13, 2012 The dividend declared on June 13, 2012 will be paid +after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2012. In fiscal +year 2011, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 21, 2010 $ 0.16 November 18, 2010 $ 1,363 December 9, 2010 December 15, 2010 $ 0.16 February 17, 2011 $ 1,349 March 10, 2011 March 14, 2011 $ 0.16 May 19, 2011 $ 1,350 June 9, 2011 June 15, 2011 $ 0.16 August 18, 2011 $ 1,341 September 8, 2011 79 Table of Contents PART II Item 8 The dividend declared on June 15, 2011 was included in other current liabilities as of +June 30, 2011. NOTE 19 — OTHER COMPREHENSIVE INCOME (LOSS) The activity in other comprehensive income (loss) and related income tax effects were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Net Unrealized Gains (Losses) on Derivatives Unrealized gains (losses), net of tax effects of $127 , $(340), and $188 $ 236 $ (632 ) $ 349 Reclassification adjustment for losses (gains) included in net income, net of tax effects of $10 , $2, and $(173) 19 5 (322 ) Net unrealized gains (losses) on derivatives $ 255 $ (627 ) $ 27 Net Unrealized Gains (Losses) on Investments Unrealized gains (losses), net of tax effects of $(93) , $726, and $263 $ (172 ) $ 1,349 $ 488 Reclassification adjustment for gains included in net income, net of tax effects of $(117) , $(159), and $(120) (218 ) (295 ) (223 ) Net unrealized gains (losses) on investments (390 ) 1,054 265 Translation adjustments and other, net of tax effects of $(165) , $205 and $(103) (306 ) 381 (206 ) Other comprehensive income (loss) $ (441 ) $ 808 $ 86 The components of accumulated other comprehensive income were as follows: (In millions) June 30, 2012 2011 2010 Net unrealized gains (losses) on derivatives $ 92 $ (163 ) $ 464 Net unrealized gains on investments 1,431 1,821 767 Translation adjustments and other (101 ) 205 (176 ) Accumulated other comprehensive income $ 1,422 $ 1,863 $ 1,055 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to directors and employees. At June 30, 2012, an aggregate of 507 million shares +were authorized for future grant under our stock plans, covering stock options, stock awards, and shared performance stock awards, and excluding shares reserved for issuance under our employee stock purchase plan. Awards that expire or are canceled +without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy exercises and vestings of awards granted under all of our stock plans. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Stock-based compensation expense $ 2,244 $ 2,166 $ 1,891 Income tax benefits related to stock-based compensation $ 785 $ 758 $ 662 80 Table of Contents PART II Item 8 Stock Plans (Excluding Stock Options) Stock awards Stock awards (“SAs”) are grants that entitle the holder to shares of +Microsoft common stock as the award vests. Our SAs generally vest over a five-year period. Shared performance stock awards Shared performance stock awards (“SPSAs”) are a form of SA in which the number of shares ultimately received depends on our business +performance against specified performance targets. We granted SPSAs for fiscal years 2012, 2011, and 2010 with performance periods of +July 1, 2011 through June 30, 2012, July 1, 2010 through June 30, 2011, and July 1, 2009 through June 30, 2010, respectively. In August following the end of each performance period, the number of shares of stock +subject to the award is determined by multiplying the target award by a percentage ranging from 0% to 150%. The percentage is based on performance metrics for the performance period, as determined by the Compensation Committee of the Board of +Directors in its sole discretion. An additional number of shares, approximately 12% of the total target SPSAs, are available as additional awards to participants based on individual performance. One-quarter of the shares of stock subject to each +award vest following the end of the performance period, and an additional one-quarter of the shares vest on each of the following three anniversaries of the grant date. Executive officer incentive plan Under the Executive Officer Incentive Plan +(“EOIP”), the Compensation Committee awards performance-based compensation to executive officers for specified performance periods. During the periods reported, executive officers were eligible to receive annual awards comprising cash +and SAs from an aggregate incentive pool equal to a percentage of consolidated operating income. For fiscal years 2012, 2011, and 2010, the pool was 0.3%, 0.25%, and 0.45% of operating income, respectively. In September following the end of the fiscal year, each executive officer may receive a combined cash and SA award with a total value equal to a +fixed percentage of the aggregate pool. The fixed percentage ranges between 0% and 150% of a target based on an assessment of the executive officer’s performance during the prior fiscal year. Following approval of the awards, 20% of the award +is payable to the executive officers in cash, and the remaining 80% is converted into an SA for shares of Microsoft common stock. The number of shares subject to the SA portion of the award is determined by dividing the value of 80% of the total +award by the closing price of Microsoft common stock on the last business day in August of each year. The SA portion of the award vests one-quarter immediately after the award is approved following fiscal year-end and one-quarter on +August 31 of each of the following three years. Activity for all stock plans The fair value of each award was estimated on the date of grant using the following assumptions: Year Ended June 30, 2012 2011 2010 Dividends per share (quarterly amounts) $ 0.16 - $  0.20 $ 0.13 - $  0.16 $ 0.13 Interest rates range 0.7% - 1.7% 1.1% - 2.4% 2.1% - 2.9% 81 Table of Contents PART II Item 8 During fiscal year 2012, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 255 $ 23.59 Granted 90 $ 24.96 Vested (73 ) $ 24.20 Forfeited (24 ) $ 23.74 Nonvested balance, end of year 248 $ 23.90 Shared Performance Stock Awards Nonvested balance, beginning of year 32 $ 23.76 Granted 20 $ 22.88 Vested (15 ) $ 24.69 Forfeited (4 ) $ 23.82 Nonvested balance, end of year 33 $ 23.93 As of June 30, 2012, there was $4.4 billion and $495 million of total unrecognized compensation costs related +to SAs and SPSAs, respectively. These costs are expected to be recognized over a weighted average period of 2.9 years and 2.5 years, respectively. During fiscal year 2011 and 2010, the following activity occurred under our stock plans: (In millions, except fair values) 2011 2010 Stock Awards Awards granted 114 100 Weighted average grant-date fair value $ 22.17 $ 23.43 Shared Performance Stock Awards Awards granted 18 12 Weighted average grant-date fair value $ 22.56 $ 24.57 Following are the fair values of stock plan awards vested +during the periods reported: (In millions) 2012 2011 2010 Total vest-date fair value of stock awards vested $ 1,971 $ 1,521 $ 1,358 Total vest-date fair value of shared performance stock awards vested $ 388 $ 289 $ 227 Stock Options Currently, we grant stock options primarily in conjunction with business acquisitions. We granted six million, zero, and one million stock +options in conjunction with business acquisitions during fiscal years 2012, 2011, and 2010, respectively. 82 Table of Contents PART II Item 8 Employee stock options activity during 2012 was as follows: Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value (In millions) (Years) (In millions) Balance, July 1, 2011 93 $ 23.21 Granted 6 $ 9.41 Exercised (64 ) $ 22.20 Canceled (13 ) $ 29.44 Balance, June 30, 2012 22 $ 18.69 2.15 $ 264 Exercisable, June 30, 2012 18 $ 20.77 0.83 $ 178 As of June 30, 2012 approximately six million +options that were granted in conjunction with business acquisitions were outstanding. These options have an exercise price range of $0.01 to $29.24 and a weighted average exercise price of $9.33. During the periods reported, the following stock option exercise activity occurred: (In millions) 2012 2011 2010 Total intrinsic value of stock options exercised $ 456 $ 222 $ 365 Cash received from stock option exercises $ 1,410 $ 1,954 $ 1,839 Tax benefit realized from stock option exercises $ 160 $ 77 $ 126 Employee Stock Purchase Plan We have an employee stock purchase plan (the “Plan”) for all eligible employees. Shares of our common stock may be purchased by employees +at three-month intervals at 90% of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Under the terms of the +Plan that were approved in 2002, the Plan will terminate on December 31, 2012. Microsoft intends to request shareholder approval to renew the Plan and reserve additional shares for issuance under the Plan before December 31, 2012. +Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2012 2011 2010 Shares purchased 20 20 20 Average price per share $ 25.03 $ 22.98 $ 23.73 At June 30, 2012, 23 million shares of our +common stock were reserved for future issuance through the Plan. Savings Plan We have a savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in +international locations. Participating U.S. employees may contribute up to 50% of their salary, but not more than statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% +of a participant’s earnings. Matching contributions for all plans were $373 million, $282 million, and $275 million in fiscal years 2012, 2011, and 2010, respectively, and were expensed as contributed. Matching contributions are invested +proportionate to each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are +required to be invested in Microsoft common stock. 83 Table of Contents PART II Item 8 NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, the company’s Chief Executive +Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. Our five segments are +Windows & Windows Live Division; Server and Tools; Online Services Division; Microsoft Business Division; and Entertainment and Devices Division. Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. Revenue on certain contracts may be allocated among the segments based on the +relative value of the underlying products and services. Costs that are identifiable are allocated to the segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually +beneficial activity. Allocated costs may include those relating to development and marketing of products and services from which multiple segments benefit, or those costs relating to services performed by one segment on behalf of other segments. +Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. In addition, +certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and +support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and +marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance. We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during +the current fiscal year, including moving Forefront Protection for Office, an anti-malware solution, from Server and Tools to the Microsoft Business Division, as well as conforming management reporting and U.S. GAAP reporting for stock-based +compensation. The principal products and services provided by each segment are summarized below: Windows & Windows Live Division – Windows & Windows Live Division offerings consist of the Windows 7 operating +system, software and services through Windows Live, and PC hardware products. Server and Tools – Server and Tools product +and service offerings include Windows Server, Windows Azure, Microsoft SQL Server, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. Online Services Division – Online Services Division offerings include Bing, MSN, and advertiser tools. Microsoft Business Division – Microsoft Business Division offerings include Microsoft Office, SharePoint, Exchange, Lync, and Microsoft +Dynamics business solutions. Entertainment and Devices Division – Entertainment and Devices Division offerings include the +Xbox 360 entertainment platform, including Kinect for Xbox 360, Skype, and Windows Phone. 84 Table of Contents PART II Item 8 Segment revenue and operating income (loss) were as follows during the periods presented: (In millions) Year Ended June 30, 2012 2011 2010 Revenue Windows & Windows Live Division $ 18,818 $ 18,787 $ 18,789 Server and Tools 18,696 16,691 15,121 Online Services Division 2,934 2,680 2,345 Microsoft Business Division 23,963 22,314 19,525 Entertainment and Devices Division 9,585 8,896 6,135 Unallocated and other (273 ) 575 569 Consolidated $ 73,723 $ 69,943 $ 62,484 (In millions) Year Ended June 30, 2012 2011 2010 Operating Income (Loss) Windows & Windows Live Division $ 11,908 $ 11,971 $ 12,193 Server and Tools 7,459 6,332 5,378 Online Services Division (8,122 ) (2,649 ) (2,395 ) Microsoft Business Division 15,688 14,453 12,109 Entertainment and Devices Division 365 1,294 525 Reconciling amounts (5,535 ) (4,240 ) (3,712 ) Consolidated $ 21,763 $ 27,161 $ 24,098 Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies +to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and depreciation. Significant reconciling items were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Corporate-level activity (a) $ (5,090 ) $ (4,597 ) $ (4,136 ) Revenue reconciling amounts (486 ) 381 314 Other 41 (24 ) 110 Total $ (5,535) $ (4,240) $ (3,712) (a) Corporate-level activity excludes revenue reconciling amounts presented separately in that line item. 85 Table of Contents PART II Item 8 No sales to an individual customer or country other than the United States accounted for more than +10% of fiscal year 2012, 2011, or 2010 revenue. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2012 2011 2010 United +States (a) $ 38,846 $ 38,008 $ 36,173 Other countries 34,877 31,935 26,311 Total $ 73,723 $ 69,943 $ 62,484 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the +geographic source of the revenue. Revenue from external customers, classified by significant product and service +offerings were as follows: (In millions) Year Ended June 30, 2012 2011 2010 Microsoft Office system $ 22,299 $ 20,730 $ 17,754 Windows PC operating systems 17,320 17,825 18,225 Server products and tools 14,232 13,251 12,007 Xbox 360 platform 8,045 8,103 5,456 Consulting and product support services 3,976 3,372 3,036 Advertising 3,181 2,913 2,528 Other 4,670 3,749 3,478 Total $ 73,723 $ 69,943 $ 62,484 Assets are not allocated to segments for internal reporting presentations. A portion of amortization and +depreciation is included with various other costs in an overhead allocation to each segment, and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment +profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling +statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2012 2011 2010 United States $ 14,081 $ 18,498 $ 18,716 Luxembourg 6,975 0 0 Other countries 3,835 2,989 2,466 Total $ 24,891 $ 21,487 $ 21,182 NOTE 22 — SUBSEQUENT EVENT Acquisition of Yammer On July 18, 2012, we acquired Yammer, Inc. (“Yammer”), a leading provider of enterprise social networks, for $1.2 billion in cash. +Yammer will continue to develop its standalone service and will add enterprise social networking services to Microsoft’s portfolio of complementary cloud-based services. 86 Table of Contents PART II Item 8 NOTE 23 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2012 Revenue $ 17,372 $ 20,885 $ 17,407 $ 18,059 $ 73,723 Gross profit 13,595 15,247 13,455 13,896 56,193 Net income 5,738 6,624 5,108 (492 ) (a) 16,978 (a) Basic earnings (loss) per share 0.68 0.79 0.61 (0.06 ) 2.02 Diluted earnings (loss) per share 0.68 0.78 0.60 (0.06 ) (a) 2.00 (a) Fiscal Year 2011 Revenue $ 16,195 $ 19,953 $ 16,428 $ 17,367 $ 69,943 Gross profit 13,056 15,120 12,531 13,659 54,366 Net income 5,410 6,634 5,232 (b) 5,874 (c) 23,150 Basic earnings per share 0.63 0.78 0.62 0.70 2.73 Diluted earnings per share 0.62 0.77 0.61 0.69 2.69 (a) Includes a goodwill impairment charge related to our OSD business segment which decreased net income by $6.2 billion and diluted earnings per share by +$0.73. (b) Includes a partial settlement of an I.R.S. audit of tax years 2004 to 2006, which increased net income by $461 million. (c) Reflects an effective tax rate of 7% due mainly to the adjustment of our previously estimated effective tax rate for the year to reflect the actual full +year mix of foreign and U.S. taxable income. In addition, upon completion of our annual domestic and foreign tax returns, we adjusted the estimated tax provision to reflect the tax returns filed and recorded an income tax benefit which lowered our +effective tax rate. 87 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2012 and 2011, and the related consolidated statements of income, +cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2012. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on +these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company +Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on +a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial +statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated +financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2012 and 2011, and the results of their operations and their cash flows for each of the three years +in the period ended June 30, 2012, in conformity with accounting principles generally accepted in the United States of America. We +have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2012, based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 26, 2012, expressed an unqualified opinion on the Company’s internal control over +financial reporting. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 26, +2012 88 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and +with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of +the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control +over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal +control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial +statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets +that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a +misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our +internal control over financial reporting based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded +that the company’s internal control over financial reporting was effective as of June 30, 2012. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2012 that have materially +affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2012; their report is included in +Item 9A. 89 Table of Contents PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation: We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the “Company”) as of +June 30, 2012, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for +maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over Financial +Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable +assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material +weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit +provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed by, or +under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable +assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting +includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable +assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with +authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material +effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the +possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal +control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2012, +based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, 2012, of the +Company and our report dated July 26, 2012, expressed an unqualified opinion on those financial statements. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 26, +2012 90 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may +be found under the caption “Our Director Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 28, 2012 (the “Proxy Statement”). Information about our Audit Committee may be found under +the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference. The information +in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting +Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/investor/MSFinanceCode. If we make any substantive amendments to the finance code of +ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or +waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive +Officer Compensation,” “Compensation Committee Interlocks and Insider Participation,” and “Compensation Committee Report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information Regarding Beneficial Ownership of Principal +Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The +information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related Transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees Billed by +Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. 91 Table of Contents PART IV Item 15 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information +is otherwise included. Index to Financial Statements Page Income Statements 47 Balance Sheets 48 Cash Flows Statements 49 Stockholders’ Equity Statements 50 Notes to Financial Statements 51 Report of Independent Registered Public Accounting Firm 88 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/09 3.1 1/28/10 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/18/12 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.3 Indenture, dated as of June 14, 2010, between Microsoft Corporation and the Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 6/18/10 4.4 Form of Global Note representing the Zero Coupon Convertible Senior Notes due 2013 8-K 4.2 6/18/10 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft +Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.5 9/27/10 92 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.6 2/8/11 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 12/31/11 10.1 1/19/12 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Employee Stock Purchase Plan X 10.5* Microsoft Corporation Deferred Compensation Plan 10-Q 3/31/12 10.5 4/19/12 10.6* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.12 7/30/10 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.13 7/30/10 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.17* Executive Officer Incentive Plan 10-Q 9/30/08 10.17 10/23/08 10.18* Form of Executive Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/11 10.18 10/20/11 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 93 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1 Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2 Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS** XBRL Instance Document X 101.SCH** XBRL Taxonomy Extension Schema X 101.CAL** XBRL Taxonomy Extension Calculation Linkbase X 101.DEF** XBRL Taxonomy Extension Definition Linkbase X 101.LAB** XBRL Taxonomy Extension Label Linkbase X 101.PRE** XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Pursuant to Rule 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus +for purposes of Sections 11 or 12 of the Securities Act of 1933 or Section 18 of the Securities Exchange Act of 1934 and otherwise are not subject to liability. 94 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 26, 2012. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on July 26, 2012. Signature Title / S /    W ILLIAM H. G ATES III William H. Gates III Chairman / S /    S TEVEN A. B ALLMER Steven A. Ballmer Director and Chief Executive Officer / S /    D INA D UBLON Dina Dublon Director / S /    R AYMOND V. G ILMARTIN Raymond V. Gilmartin Director / S /    R EED H ASTINGS Reed Hastings Director / S /    M ARIA K LAWE Maria Klawe Director / S /    S TEPHEN J. L UCZO Stephen J. Luczo Director / S /    D AVID F. M ARQUARDT David F. Marquardt Director / S /    C HARLES H. N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    J OHN W. T HOMPSON John Thompson Director / S /    P ETER S. K LEIN Peter S. Klein Chief Financial Officer (Principal Financial +Officer) / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 95 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-13-310206/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-13-310206/full-submission.txt new file mode 100644 index 0000000..e481c74 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-13-310206/full-submission.txt @@ -0,0 +1,1097 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2013 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES +EXCHANGE ACT OF 1934 For the Transition Period From +                 to Commission File Number 0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such +shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its +corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was +required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2012, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $202,945,146,270 based on the closing sale price as reported on the NASDAQ +National Market System. As of July 18, 2013, there were 8,329,956,402 shares of common stock outstanding. DOCUMENTS INCORPORATED +BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of +Shareholders to be held on November 19, 2013 are incorporated by reference into Part III. Table of Contents MICROSOFT CORPORATION FORM 10-K For The Fiscal +Year Ended June 30, 2013 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 12 Item 1A. Risk Factors 14 Item 1B. Unresolved Staff Comments 21 Item 2. Properties 22 Item 3. Legal Proceedings 22 Item 4. Mine Safety Disclosures 22 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 22 Item 6. Selected Financial Data 23 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 23 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 47 Item 8. Financial Statements and Supplementary Data 49 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 90 Item 9A. Controls and Procedures 90 Report of Management on Internal Control over Financial Reporting 90 Report of Independent Registered Public Accounting Firm 91 Item 9B. Other Information 92 PART III Item 10. Directors, Executive Officers and Corporate Governance 92 Item 11. Executive Compensation 92 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 92 Item 13. Certain Relationships and Related Transactions, and Director Independence 92 Item 14. Principal Accounting Fees and Services 92 PART IV Item 15. Exhibits and Financial Statement Schedules 93 Signatures 96 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business +plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of +the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including without limitation, the following sections: “Business,” “Management’s +Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” +“intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely +result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties which may cause actual results to differ materially from the forward-looking statements. +A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part I, Item 1A of this Form +10-K). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Microsoft was +founded in 1975. Our mission is to enable people and businesses throughout the world to realize their full potential by creating technology that transforms the way people work, play, and communicate. We develop and market software, services, and +hardware devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. We do business worldwide and have offices in more than 100 countries. We generate revenue by developing, licensing, and supporting a wide range of software products and services, by designing and selling hardware +devices, and by delivering relevant online advertising to a global customer audience. In addition to selling individual products and services, we offer suites of products and services. Our products include operating systems for computing devices, servers, phones, and other intelligent devices; server applications for distributed +computing environments; productivity applications; business solution applications; desktop and server management tools; software development tools; video games; and online advertising. We also design and sell hardware devices including Surface RT +and Surface Pro, the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 accessories, and Microsoft PC accessories. We offer cloud-based solutions that provide customers with software, services, and content over the Internet by way of shared computing resources +located in centralized data centers. Examples of cloud-based computing services we offer include Microsoft Office 365, Microsoft Dynamics CRM Online, Windows Azure, Bing, Skype, Xbox LIVE, and Yammer. Cloud revenue is earned primarily from usage +fees, advertising, and subscriptions. We also provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We conduct research and develop advanced technologies for future software, hardware, and services. We believe that we will continue to grow and +meet our customers’ needs by delivering a family of devices and services for individuals and businesses that empower people around the globe at home, at work, and on the go, for the activities they value most. We will continue to create new +opportunities for partners, increase customer satisfaction, and improve our service excellence, business efficacy, and internal processes. OPERATING SEGMENTS During +the periods presented, we operated our business in five segments: Windows Division, Server and Tools, Online Services Division, Microsoft Business Division, and Entertainment and Devices Division. Our segments 3 Table of Contents PART I Item 1 provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services +organizations, and they provide a framework for timely and rational allocation of development, sales, marketing, and services resources within businesses. Additional information on our operating segments and geographic and product information is +contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). In July 2013, we announced a change in organizational structure as part of our transformation to a +devices and services company. As we evolve how we allocate resources and analyze performance in the new structure, it is possible that our segments may change. Windows Division Windows Division develops and markets operating systems for computing +devices, related software and online services, Surface RT and Pro devices, and PC accessories. This collection of software, hardware, and services is designed to empower individuals, companies, and organizations and to simplify everyday tasks +through seamless operations across the user’s hardware and software. Windows 8 is the first version of the Windows operating system that supports both x86 and ARM chip architectures and that focuses on touch. With this version, Windows is able +to scale across more form factors, including mobile devices designed for consuming information and media, and devices that have high performance computing capabilities. Windows Division revenue growth is impacted by growth of the computing device market worldwide. Currently, approximately 65% of total Windows Division revenue comes from Windows operating systems purchased by +original equipment manufacturers (“OEMs”), which they pre-install on the devices they sell. In addition to computing device +market volume, Windows revenue is impacted by: • the proliferation of new computing devices that emphasize touch and mobility functionality; • device market changes driven by shifts between developed markets and emerging markets, and consumer devices and business devices; • attachment of Windows to devices shipped; • changes in inventory levels within the OEM channel; • pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large, +multinational OEMs, and different pricing of Windows versions licensed; • demand of commercial customers for volume licensing and software assurance; • sales of packaged software; and • sales of Surface RT and Pro devices. Principal Products and Services : Windows operating system; Windows Services suite of applications and web services, including Outlook.com and SkyDrive; Surface RT and Pro +devices; and PC accessories. The general availability of Surface RT and Windows 8 started on October 26, 2012. The general +availability of Surface Pro started on February 9, 2013. A preview of Windows 8.1 was released on June 26, 2013. Competition The Windows operating system faces competition from various commercial software products and from alternative platforms and +devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, compatibility with a broad range of hardware and software applications, including +those that enable productivity, and the largest support network for any operating system. The Windows 8 operating system includes the Windows Store, an online application marketplace. This marketplace benefits our developer and partner ecosystems by +providing access to a large customer base and benefits Windows users by providing centralized access to certified applications. 4 Table of Contents PART I Item 1 Windows Services software and applications, including SkyDrive and Outlook.com, compete with +similar software and service products from Apple, Google, Yahoo!, and a wide array of websites and portals that provide communication and sharing tools and services. Surface Pro and RT devices and our PC accessories face competition from computer, tablet, and other hardware manufacturers, many of which are also current or potential partners and customers. Server and Tools Server and Tools develops +and markets server software, software developer tools, cloud-based services, and solutions that are designed to make information technology professionals and developers and their systems more productive and efficient. We offer our customers both +on-premise software and cloud-based offerings, bringing together the benefits of traditional on-site offerings with cloud-based services. Server software is integrated server infrastructure and middleware designed to support software applications +built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security and identity software. Server and +Tools also builds standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server offerings can be run on-site, in a partner-hosted environment, or in a Microsoft-hosted environment. Our cloud-based services comprise a scalable operating system with computing, storage, database, and management, along with +comprehensive cloud solutions, from which customers can build, deploy, and manage enterprise workloads and web applications. These services also include a platform that helps developers build and connect applications and services in the cloud or on +premise. Our goal is to enable customers to devote more resources to development and use of applications that benefit their businesses, rather than managing on-premises hardware and software. Windows Embedded extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and +services. In addition, Server and Tools offers a broad range of enterprise consulting and product support services (“Enterprise Services”) that assist customers in developing, deploying, and managing Microsoft server and desktop solutions. +Server and Tools also provides training and certification to developers and information technology professionals for our Server and Tools, Microsoft Business Division, and Windows Division products and services. Approximately 80% of Server and Tools revenue comes from product revenue, including purchases through volume licensing programs, licenses sold to +OEMs, and retail packaged product, while the remainder comes from Enterprise Services. Principal Products and +Services : Windows Server operating systems; Windows Azure; Microsoft SQL Server; Windows Intune; Windows Embedded; Visual Studio; System Center products; Microsoft Consulting Services; and Premier product +support services. Competition Our server operating system products face competition from a wide variety of server operating systems and applications offered by companies with a +range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server +hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and +non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide +enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both 5 Table of Contents PART I Item 1 Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that compete with our +enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client/server environments include CA Technologies, IBM, and Oracle. Our Web application platform software competes with open source +software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java middleware such as Geronimo, JBoss, and Spring Framework. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our database, business intelligence, and +data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our products for software developers compete against offerings from Adobe, IBM, Oracle, other companies, and open-source projects, including +Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among others. Our embedded systems compete in a +highly fragmented environment in which key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. Our cloud-based services face diverse competition from companies such as Amazon, Google, IBM, Oracle, Salesforce.com, VMware, and other open source +offerings. The Enterprise Services business competes with a wide range of companies, including multinational consulting firms and small niche businesses focused on specific technologies. We believe our server products, cloud-based services, and Enterprise Services provide customers with advantages in performance, total costs of +ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Online Services Division Online Services Division (“OSD”) develops and markets +information and content designed to help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. OSD offerings include Bing, Bing Ads, and MSN. We are also the exclusive algorithmic and paid search +platform for Yahoo! websites worldwide. We have completed the Yahoo! worldwide algorithmic transition and the paid search transition in the U.S. and several international markets, and are transitioning paid search in the remaining international +markets. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD’s revenue. We have expanded Bing beyond a standalone consumer search engine, and have integrated the technology into +other Microsoft products, including Windows 8, the new Office, Xbox 360, and Windows Phone, to enhance those offerings. We plan to continue to incorporate Bing into our product and service portfolio. Principal Products and Services : Bing; Bing Ads; and MSN. Competition OSD competes with Google and a +wide array of websites and portals that provide content and online offerings to end users. Our success depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. We believe we can +attract new users by continuing to offer new and compelling products and services and to further differentiate our offerings by providing a broad selection of content and by helping users make faster, more informed decisions and take action more +quickly by providing relevant search results, expanded search services, and deeply-integrated social recommendations. Microsoft Business Division Microsoft Business Division (“MBD”) offerings consist of the Microsoft Office system (“Office,” comprising +mainly the core Office product set, Office 365, SharePoint, Exchange, and Lync) and Microsoft Dynamics business solutions, which may be delivered either on premise or as a cloud-based service. Office is designed to increase personal, 6 Table of Contents PART I Item 1 team, and organization productivity through a range of programs, services, and software solutions and generates over 90% of MBD revenue. Growth in Office depends on our ability to add value to +the core Office product set and to continue to expand our product offerings in other areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. Microsoft Dynamics products provide business +solutions for financial management, customer relationship management (“CRM”), supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. Approximately 85% of MBD revenue is generated from sales to businesses, which includes Office revenue generated through subscriptions and volume +licensing agreements as well as Microsoft Dynamics revenue. Revenue from sales to businesses generally depends upon the number of information workers in a licensed enterprise and is therefore relatively independent of the number of PCs sold in a +given year. Approximately 15% of MBD revenue is derived from sales to consumers, which includes revenue from retail packaged product, subscription sales, and OEM revenue. This revenue generally is affected by the level of PC shipments, the +shift to subscription-based licensing, and product launches. Principal Products and +Services : Microsoft Office; Microsoft Exchange; Microsoft SharePoint; Microsoft Lync; Yammer; Microsoft Office Project and Office Visio; Microsoft Dynamics ERP and Dynamics CRM; Microsoft Office 365, which is an +online services offering of Microsoft Office, Exchange, SharePoint, Lync, and Microsoft Office Web Apps, which are the online companions to Microsoft Word, Excel, PowerPoint, and OneNote. The general availability of the new Office started on January 29, 2013. Competition Competitors to Office include software application vendors such as Adobe, Apple, +Cisco, Google, IBM, Oracle, SAP, and numerous Web-based competitors as well as local application developers in Asia and Europe. Apple distributes versions of its application software products with various models of its PCs and through its mobile +devices and has a measurable installed base for these pre-installed applications, such as email, note taking, and calendar. Cisco is using its position in enterprise communications equipment to grow its unified communications business. IBM has a +measurable installed base with its office productivity products. Google provides a hosted messaging and productivity suite that competes with Office. Web-based offerings competing with individual applications can also position themselves as +alternatives to Office products. We believe our products compete effectively based on our strategy of providing powerful, flexible, secure, easy to use solutions that work well with technologies our customers already have and are available on a +device or via the cloud. Our Microsoft Dynamics products compete with vendors such as Oracle and SAP in the market for large +organizations and divisions of global enterprises. In the market focused on providing solutions for small and mid-sized businesses, our Microsoft Dynamics products compete with vendors such as Infor, Sage, and NetSuite. Salesforce.com’s +on-demand CRM offerings compete directly with Microsoft Dynamics CRM Online and Microsoft Dynamics CRM’s on-premise offerings. Entertainment +and Devices Division Entertainment and Devices Division (“EDD”) develops and markets products and services designed to +entertain and connect people. The Xbox entertainment platform, including Kinect, is designed to provide a unique variety of entertainment choices through the use of our devices, peripherals, content, and online services. Skype is designed to connect +friends, family, clients, and colleagues through a variety of devices. Windows Phone is designed to bring users closer to the people, applications, and content they need, while providing unique capabilities such as Microsoft Office and Xbox LIVE. +Through a strategic alliance, Windows Phone and Nokia are jointly creating new mobile products and services and extending established product and services to new markets. EDD revenue also includes revenue from licensing mobile-related patents. Principal Products and Services: Xbox 360 gaming and entertainment console, Kinect +for Xbox 360, Xbox 360 video games, Xbox 360 accessories; Xbox LIVE; Skype; and Windows Phone. 7 Table of Contents PART I Item 1 Competition Our Xbox gaming and entertainment business competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles +averages five to 10 years. We released Xbox 360 in November 2005. Nintendo and Sony released competing versions of their game consoles in November 2006. In June 2013, we announced that we expect our next generation console, Xbox One, to be available +for purchase in the second quarter of fiscal year 2014. Sony also announced their next generation console will be available for purchase in late 2013. Nintendo released their latest generation console in November 2012. We believe the success of gaming and entertainment consoles is determined by the availability of games for the console, providing exclusive game +content that gamers seek, the computational power and reliability of the console, and the ability to create new experiences via online services, downloadable content, and peripherals. In addition to Nintendo and Sony, our businesses compete with +both Apple and Google in offering content products and services to the consumer. We believe the Xbox entertainment platform is positioned well against competitive products and services based on significant innovation in hardware architecture, +user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own game franchises as well as other digital content offerings. Windows Phone faces competition primarily from Apple, Google, and Blackberry. Skype competes primarily with Apple and Google, which offer a +selection of instant messaging, voice, and video communication products. We compete primarily on the basis of product quality and +variety, unique capabilities of our products, timing of product releases, and effectiveness of distribution and marketing. OPERATIONS We have operations centers that support all operations in their regions, including customer contract and order processing, credit +and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and +Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate data centers +throughout the Americas, Europe, and Asia regions. To serve the needs of customers around the world and to improve the quality and +usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. We contract most of our manufacturing activities for Xbox 360 and related games, Kinect for Xbox 360, various retail software packaged products, +Surface devices, and Microsoft PC accessories to third parties. Our products may include some components that are available from only one or limited sources. Our Xbox 360 console, Kinect for Xbox 360, Surface devices, and Microsoft PC accessories +include key components that are supplied by a single source. The integrated central processing unit/graphics processing unit for the Xbox 360 console is purchased from IBM, and the supporting embedded dynamic random access memory chips are purchased +from Taiwan Semiconductor Manufacturing Company. We generally have the ability to use other manufacturers if the current vendor becomes unavailable or unable to meet our requirements. We generally have multiple sources for raw materials, supplies, +and components, and are often able to acquire component parts and materials on a volume discount basis. RESEARCH AND DEVELOPMENT During fiscal years 2013, 2012, and 2011, research and development expense was $10.4 billion, $9.8 billion, and $9.0 billion, +respectively. These amounts represented 13% of revenue in each of those years. We plan to continue to make significant investments in a broad range of research and development efforts. 8 Table of Contents PART I Item 1 Product and Service Development and Intellectual Property We develop most of our products and services internally. Internal development allows us to maintain competitive advantages that come from product +differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early +as possible about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. +Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We +work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among +technology companies in pursuing patents and currently have a portfolio of over 35,000 U.S. and international patents issued and over 38,000 pending. While we employ much of our internally developed intellectual property exclusively in Microsoft +products and services, we also engage in outbound and inbound licensing of specific patented technologies that are incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with +other technology companies covering entire groups of patents. We also purchase or license technology that we incorporate into our products or services. At times, we make select intellectual property broadly available at no or low cost to achieve a +strategic objective, such as promoting industry standards, advancing interoperability, or attracting and enabling our external development community. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products and business methods, we believe, based upon past experience and industry practice, such licenses +generally could be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our +products. Investing in the Future Microsoft’s success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and +product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the +company. We maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning communication and collaboration, information access and organization, entertainment, business and +e-commerce, advertising, and devices. While our main research and development facilities are located in Redmond, Washington, we also +operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, Denmark, Estonia, Germany, India, Ireland, Israel, and the United Kingdom. This global approach helps us remain competitive in +local markets and enables us to continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We +also fund research and development activities at the business segment level. Much of our business segment level research and development is coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s +largest computer science research organizations, and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends. Based on our assessment of key technology trends and our broad focus on long-term research and development, we see significant opportunities to +drive future growth in smart connected devices, cloud computing, entertainment, search, communications, and productivity through our devices and services strategy. 9 Table of Contents PART I Item 1 DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services primarily through the following channels: OEMs; distributors and resellers; and online. OEMs We distribute software +through OEMs that pre-install our software on new PCs, tablets, servers, smartphones, and other intelligent devices that they sell to end customers. The largest component of the OEM business is the Windows operating system pre-installed on computing +devices. OEMs also sell hardware pre-installed with other Microsoft products, including server and embedded operating systems and applications such as our Microsoft Office suite. In addition to these products, we also market our services, such as +our Windows SkyDrive service, through OEMs. There are two broad categories of OEMs. The largest OEMs, many of which operate globally, +are referred to as “Direct OEMs,” as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all of the +multinational OEMs, including Acer, ASUS, Dell, Fujitsu, HTC, Hewlett-Packard, LG, Lenovo, Nokia, Samsung, Sony, Toshiba, and with many regional and local OEMs. The second broad category of OEMs consists of lower-volume PC manufacturers (also called +“system builders”), which source their Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Distributors and Resellers Many +organizations that license our products and services through enterprise agreements transact directly with us, with sales support from solution integrators, independent software vendors, web agencies, and developers that advise organizations on +licensing our products and services (“Enterprise Software Advisors”). Organizations also license our products and services indirectly, primarily through large account resellers (“LARs”), distributors, value-added resellers +(“VARs”), OEMs, system builder channels, and retailers. Although each type of reselling partner reaches organizations of all sizes, LARs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs +typically reach small-sized and medium-sized organizations. Enterprise Software Advisors typically are also authorized as LARs and operate as resellers for our other licensing programs, such as the Select Plus and Open licensing programs discussed +under “Licensing Options” below. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our Microsoft Dynamics software offerings are licensed to enterprises through a global network of channel partners providing vertical solutions and +specialized services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail +outlets, such as Wal-Mart, Dixons, and Microsoft Stores. We distribute our hardware products, including Surface, Xbox, and PC accessories, through third-party retailers and Microsoft Stores. We have a network of field sales representatives and field +support personnel that solicits orders from distributors and resellers, and provides product training and sales support. Online Although client-based software will continue to be an important part of our business, increasingly we are delivering additional value to customers +through cloud-based services. We provide online content and services to consumers through Bing, MSN portals and channels, Microsoft Office Web Apps, Office 365, Windows Phone Marketplace, Xbox LIVE, Outlook.com, Skype, and Windows Store. We also +provide to business users commercial cloud-based services such as Exchange Online, Microsoft Dynamics CRM Online, Windows Azure, Windows Intune, and Office 365 consisting of online versions of Office, Exchange, SharePoint, Lync, and Yammer. Other +services delivered 10 Table of Contents PART I Item 1 online include our online advertising platform with offerings for advertisers and publishers, as well as Microsoft Developer Networks subscription content and updates, periodic product updates, +and online technical and practice readiness resources to support our partners in developing and selling our products and solutions. As we increasingly deliver online services, we sell many of these cloud-based services through our enterprise +agreements and have also enabled new sales programs to reach small and medium-sized businesses. These new programs include direct sales, direct sales supported by a large network of partner advisors, and resales of services through operator +channels, such as telephone, cell, and cable providers. We also sell our products through our online store, microsoftstore.com. LICENSING OPTIONS We +license software to organizations under arrangements that allow the end-user customer to acquire multiple licenses of products and services. Our arrangements for organizations to acquire multiple licenses of products and services are designed to +provide them with a means of doing so without having to acquire separate packaged product through retail channels. In delivering organizational licensing arrangements to the market, we use different programs designed to provide flexibility for +organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. Open +Licensing Designed primarily for small-to-medium organizations, Open Programs allows customers to acquire perpetual or subscription +licenses and, at the customer’s election, rights to future versions of software products over a specified time period (two or three years depending on the Open Programs used). The offering that conveys rights to future versions of certain +software products over the contract period is called software assurance. Software assurance also provides support, tools, and training to help customers deploy and use software efficiently. Open Programs has several variations to fit customers’ +diverse way of purchasing. Under the Open License Program, customers can acquire licenses only or licenses with software assurance. They can also renew software assurance upon the expiration of existing volume licensing agreements. Select Plus Licensing Designed primarily +for medium-to-large organizations, the Select Plus Program allows customers to acquire perpetual licenses and, at the customer’s election, software assurance over a specified time period (generally three years or less). Similar to Open +Programs, the Select Plus Program allows customers to acquire licenses only, acquire licenses with software assurance, or renew software assurance upon the expiration of existing volume licensing agreements. Online services are also available for +purchase through the Select Plus Program, and subscriptions are generally structured with terms between one and three years. Partner Licensing The Microsoft Services Provider License Agreement is a program targeted at service providers and Independent Software Vendors +allowing these partners to provide software services and hosted applications to their end customers. Agreements are generally structured with a three-year term, and partners are billed monthly based upon consumption. Microsoft Online Services +Reseller Agreement is a program enabling partners to package Microsoft Online Services with the partners’ services. Microsoft Online Subscription Agreement is designed to enable small and medium-sized businesses to easily purchase Microsoft +Online Services. The program allows customers to acquire monthly or annual subscriptions for cloud-based services. Windows Azure Agreement is designed to enable small and medium-sized businesses to purchase Windows Azure Subscription plans on a +“pay-as-you-go” basis. Enterprise Agreement Licensing Enterprise agreements are targeted at medium- and large-sized organizations that want to acquire licenses to Online Services and/or software products, along with software assurance, for all or substantial parts of +their enterprise. 11 Table of Contents PART I Item 1 Enterprises can elect to either acquire perpetual licenses or, under the Enterprise Subscription Program, can acquire non-perpetual, subscription agreements for a specified time period (generally +three years). Online Services are also available for purchase through the enterprise agreement and subscriptions are generally structured with three year terms. CUSTOMERS Our customers include individual consumers, small- and medium-sized organizations, +enterprises, governmental institutions, educational institutions, Internet service providers, application developers, and OEMs. Consumers and small and medium-sized organizations obtain our products primarily through distributors, resellers, and +OEMs. No sales to an individual customer accounted for more than 10% of fiscal year 2013, 2012, or 2011 revenue. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 30, 2013 were as follows: Name Age Position with the Company Steven A. Ballmer 57 Chief Executive Officer Anthony J. Bates 46 Executive Vice President, Business Development and Evangelism Lisa E. Brummel 53 Executive Vice President, Human Resources Amy E. Hood 41 Executive Vice President, Chief Financial Officer Tami Reller 49 Executive Vice President, Marketing Eric D. Rudder 46 Executive Vice President, Advanced Strategy and Research Bradford L. Smith 54 Executive Vice President, General Counsel; Secretary B. Kevin Turner 48 Chief Operating Officer Mr. Ballmer was appointed Chief Executive Officer in +January 2000. He served as President from 1998 to 2001. Previously, he had served as Executive Vice President, Sales and Support since 1992. Mr. Ballmer joined Microsoft in 1980. Mr. Bates was named Executive Vice President, Business Development and Evangelism in July 2013. He had been President of Microsoft’s +Skype Division since its acquisition by Microsoft in 2011. Mr. Bates had been Chief Executive Officer of Skype since 2010. Before joining Skype, Mr. Bates spent nearly 15 years at Cisco Systems, Inc. where he had been Senior Vice President +and General Manager of several business groups, including Enterprise, Commercial and Small Business, and Cisco’s core high-end router business. Ms. Brummel, Executive Vice President, Human Resources, has served as Microsoft’s senior human resources executive since 2005. From 2000 to 2005, she had been Corporate Vice President of the Home and +Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of management positions at Microsoft, including General Manager of Consumer Productivity Business, Product Unit Manager of the Kids Business, and Product Unit +Manager of Desktop and Decision Reference Products. Ms. Hood, Executive Vice President, Chief Financial Officer, was appointed +Chief Financial Officer in May 2013. Beginning in 2010, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining +Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Reller was named Executive Vice President, Marketing in July 2013. From 2011 to 2013 Ms. Reller was Chief Marketing Officer and Chief Financial Officer for Windows. Ms. Reller served as Corporate +Vice President, Windows Division Marketing and Finance from 2009 to 2011 and as Corporate Vice President, Business Solutions beginning in 2002. Ms. Reller joined Microsoft with its acquisition of Great Plains Software, where she was Chief +Financial Officer, in 2001. 12 Table of Contents PART I Item 1 Mr. Rudder was named Executive Vice President, Advanced Strategy and Research in July 2013. +Mr. Rudder had been Chief Technical Strategy Officer since 2005. Since joining Microsoft in 1988, Mr. Rudder held several positions in networking and operating systems and developer tools, and was Senior Vice President, Server and Tools +from 2003 to 2005 and Senior Vice President, Developer and Platform Evangelism from 2001 to 2003. Mr. Smith, Executive Vice +President, General Counsel, and Secretary, has served in that role since November 2001. Mr. Smith was also named Chief Compliance Officer in 2002. He had been Deputy General Counsel for Worldwide Sales and previously was responsible for +managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith joined Microsoft in 1993. Mr. Turner was +named Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s Club division. From 2001 to 2002, he served as Executive +Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From 2000 to 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. Mr. Turner also serves on +the Board of Directors of Nordstrom, Inc. EMPLOYEES As of June 30, 2013, we employed approximately 99,000 people on a full-time basis, 58,000 in the U.S. and 41,000 internationally. Of the total, 37,000 were in product research and development, 26,000 in sales +and marketing, 21,000 in product support and consulting services, 6,000 in manufacturing and distribution, and 9,000 in general and administration. Our success is highly dependent on our ability to attract and retain qualified employees. None of our +employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a +variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”); • information on our business strategies, financial results, and key performance indicators; • announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available; • press releases on quarterly earnings, product and service announcements, legal developments, and international news; • corporate governance information including our articles, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate +citizenship initiatives, and other governance-related policies; • other news and announcements that we may post from time to time that investors might find useful or interesting; and • opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. 13 Table of Contents PART I Item 1A ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect +our business, financial condition, results of operations, cash flows, and the trading price of our common stock. We face intense competition across +all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, +specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in our businesses generally are low and software products can be distributed broadly and +quickly at relatively low cost. Many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends +on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platforms, +ecosystems, and devices An important element of our business model has been to create platform-based ecosystems on which many +participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is +necessary to achieve and maintain attractive margins. The strategic importance of developing and maintaining a vibrant ecosystem increased with the launch of the Windows 8 operating system, Surface, Windows Phone, and associated cloud-based +services. We face significant competition from firms that provide competing platforms, applications, and services. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has been +successful with some consumer products such as personal computers, tablets, mobile phones, gaming consoles, and digital music players. Competitors pursuing this model also earn revenue from services that are integrated with the hardware and software +platform. We also offer some vertically-integrated hardware and software products and services; however, our competitors in smartphones and tablets have established significantly larger user bases. Efforts to compete with the vertically integrated +model will increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face substantial competitive challenges from competing +platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these +devices to perform functions that would have been performed by personal computers in the past. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract +applications developers to our platforms. In addition, Surface competes with products made by our OEM partners, which may affect their commitment to our platform. • Competing platforms have applications marketplaces (sometimes referred to as “stores”) with scale and significant installed bases on mobile devices. +These applications leverage free and user-paid services that over time result in disincentives for users to switch to competing platforms. In order to compete, we must successfully enlist developers to write applications for our marketplace and +ensure that these applications have high quality, customer appeal, and value. Efforts to compete with these application marketplaces may increase our cost of revenue and lower our operating margins. 14 Table of Contents PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Under the license-based proprietary software model that generates most of our revenue, we bear the costs of converting original ideas into software products +through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model and we expect this +competition to continue. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue +funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users and +earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality +of our products. The competitive pressures described above may result in decreased sales volumes, price reductions, +and/or increased operating costs, such as for marketing and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on services presents execution and competitive risks. A growing part of our strategy involves cloud-based services used with smart devices. Our competitors are +rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and in some cases the user’s choice +of which suite of cloud-based services to use. We are devoting significant resources to develop and deploy our own competing cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. While we believe our +expertise, investments in infrastructure, and the breadth of our cloud-based services provide us with a strong foundation to compete, it is uncertain whether our strategies will attract the users or generate the revenue required to be successful. In +addition to software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs may reduce the operating margins we have previously achieved. Whether we are successful in this new +business model depends on our execution in a number of areas, including: • continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share; • maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, +tablets, and television-related devices; • continuing to enhance the attractiveness of our cloud platforms to third-party developers; and • ensuring that our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. In July 2013, we announced a change in organizational structure as part of our transformation to a devices and +services company. This change in structure is designed to enable us to innovate with greater speed, efficiency, and capability in the fast-changing competitive environment. We expect this change to alter the way we plan, develop, and market our +products and services, as we pursue a single strategy to offer a family of devices and services designed to empower our customers for the activities they value most. It is uncertain whether our “One Microsoft” strategy will yield the +anticipated efficiencies or competitive benefits. As we increasingly license cloud-based versions of our products and services, such as +Office 365, rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the period of the subscription. 15 Table of Contents PART I Item 1A We make significant investments in new products and services that may not be +profitable. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, the Microsoft Office system, +Bing, Windows Phone, Windows Server, the Windows Store, the Windows Azure Services platform, Office 365, other cloud-based services offerings, and the Xbox 360 entertainment platform. We will continue to invest in new software and hardware products, +services, and technologies, such as the Microsoft-designed and manufactured Surface launched in October 2012. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and +effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software products or upgrades, unfavorably impacting revenue. +We may not achieve significant revenue from new product, service, and distribution channel investments for a number of years, if at all. Moreover, new products and services may not be profitable, and even if they are profitable, operating margins +for some new products and businesses will not be as high as the margins we have experienced historically. In October 2012, we launched +Windows 8, a major new release of our operating system, which seeks to deliver a unique user experience through well-integrated software, hardware, and services. Its success depends on a number of factors including the extent to which customers +embrace the new user interface and functionality, successfully coordinating with our OEM partners in releasing a variety of hardware devices that take advantage of new features, pricing Windows 8-based devices competitively, and attracting +developers at scale to ensure a competitive array of quality applications. The marketing costs we are incurring to promote Windows 8 and associated services and devices may reduce our operating margins. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to +continue making acquisitions or entering into joint ventures and strategic alliances as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business +strategy, that we do not realize a satisfactory return on our investment, that we experience difficulty integrating new employees, business systems, and technology, or that the transaction diverts management’s attention from our other +businesses. Our acquisition of Skype, for example, provides opportunities to enhance our existing products. The success of this acquisition will depend in part on our ability to provide compelling experiences that distinguish us from our competitors +in both consumer and business markets. It may take longer than expected to realize the full benefits from these transactions, such as increased revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than +anticipated or may not be realized. These events could harm our operating results or financial condition. We may not be able to +adequately protect our intellectual property rights. Protecting our global intellectual property rights and combating unlicensed copying and use of our software and other intellectual property is difficult. While piracy +adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. As a result, our revenue in these markets may grow slower than +the underlying PC market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we actively educate consumers about the benefits of licensing genuine products +and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. However, continued educational and enforcement efforts may +fail to enhance revenue. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time, we receive notices from +others claiming we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the segments in which we compete, the extensive patent coverage of existing technologies, the rapid rate +of issuance of new patents, and our offering of Microsoft-branded services and hardware devices, such as Surface. To resolve these claims we may enter into royalty and licensing agreements on terms that are less favorable than currently available, +stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. In addition to money damages, in some jurisdictions plaintiffs +can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such 16 Table of Contents PART I Item 1A as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have made and expect to continue making significant expenditures to +settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems +and other software programs, is critical to our business. Although we license portions of our application and operating system source code to a number of licensees, we take significant measures to protect the secrecy of large portions of our source +code. If an unauthorized disclosure of a significant portion of our source code occurs, we could potentially lose future trade secret protection for that source code. It may become easier for third parties to compete with our products by copying +functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our competitive position. Security of Microsoft’s information technology Maintaining the security of computers and +computer networks is paramount for us and our customers. Threats to information technology (“IT”) security can take a variety of forms. Hackers develop and deploy viruses, worms, and other malicious software programs that attack our +products and services and gain access to our networks and data centers. Groups of hackers may also act in a coordinated manner to launch distributed denial of service attacks, or other coordinated attacks. Sophisticated organizations, individuals, +or governments launch targeted attacks to gain access to our network. Breaches of our network or data security could disrupt and compromise the security of our internal systems and business applications, impair our ability to provide services to our +customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our competitive position, result in theft or misuse of our intellectual property, or otherwise +adversely affect our business. In addition, our internal IT environment continues to evolve. Often we are early adopters of new devices +and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. These practices can enhance efficiency and business +insight, but they also present risks that our business policies and internal security controls may not keep pace with the speed of these changes. Security of our customers’ products and services Security threats are a particular challenge to companies like us whose business is technology products and services. The threats to our own IT infrastructure also affect our customers. Customers using our +cloud-based services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on the most popular operating systems, programs, and services, including +many of ours, and we expect them to continue to do so. The security of our products and services is an important consideration in our customers’ purchasing decisions. We devote significant resources to defend against security threats, both to our internal IT systems and those of our customers. These include: • engineering more secure products and services; • enhancing security and reliability features in our products and services, and continuously evaluating and updating those security and reliability features; • improving the deployment of software updates to address security vulnerabilities; • investing in mitigation technologies that help to secure customers from attacks even when software updates are not deployed; 17 Table of Contents PART I Item 1A • protecting the digital security infrastructure that ensures the integrity of our products and services; • helping our customers make the best use of our products and services to protect against computer viruses and other attacks; and • providing customers online automated security tools, published security guidance, and security software such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. Despite these efforts, actual or perceived security +vulnerabilities in our products and services could cause significant reputational harm and lead some customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also +increase their expenditures on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Any of these actions by customers could adversely affect our revenue. Actual or perceived +vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to such liability, there is no assurance these provisions will withstand legal challenges. Legislative +or regulatory action may increase the costs to develop or implement our products and services. Improper disclosure of personal data +could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our +customers. At the same time, the continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. This environment demands that we continuously improve our design and +coordination of security controls across our business groups and geographies. Despite these efforts, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may +not prevent the improper disclosure of personally identifiable information that we or our vendors store and manage. Improper disclosure of this information could harm our reputation, lead to legal exposure to customers, or subject us to liability +under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on premise or, increasingly, in a cloud-based environment we +host. We believe consumers using our email, messaging, storage, sharing, and social networking services will increasingly want efficient, centralized methods of choosing their privacy preferences and controlling their data. Perceptions that our +products or services do not adequately protect the privacy of personal information could inhibit sales of our products or services, and could constrain consumer and business adoption of our cloud-based solutions. We may experience outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations +infrastructure. Our increasing user traffic and the complexity of our products and services demand more computing power. We have spent and expect to continue to spend substantial amounts to purchase or lease data centers +and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our data centers, and to introduce new products and services and support existing services such as Bing, Exchange Online, Office +365, SharePoint Online, SkyDrive, Skype, Xbox LIVE, Windows Azure, Outlook.com, and Microsoft Office Web Apps. We also are growing our business of providing a platform and back-end hosting for services provided by third-party businesses to their end +customers. Maintaining and expanding this infrastructure is expensive and complex. Inefficiencies or operational failures, including temporary or permanent loss of customer data, could diminish the quality of our products, services, and user +experience resulting in contractual liability, claims by customers and other third parties, damage to our reputation and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial +condition. We are subject to government litigation and regulatory activity that may limit how we design and market our +products. As a leading global software maker, we are closely scrutinized by government agencies under U.S. and foreign competition laws. Some jurisdictions also provide private rights of action for competitors or consumers +to assert claims of anti-competitive conduct. For example, we were sued on competition law grounds by the U.S. Department of Justice, 18 states, and the District of Columbia in the late 1990s. The resolution of the government lawsuits imposed +various constraints on our Windows operating system businesses. Although these constraints expired in May 2011, we expect that federal and state antitrust authorities will continue to closely scrutinize our business. 18 Table of Contents PART I Item 1A The European Commission closely scrutinizes the design of high-volume Microsoft products and the +terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the Commission ordered us to create new versions of Windows that do not include +certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by +Microsoft to address the Commission’s concerns relating to competition in Web browsing software, including an undertaking to address Commission concerns relating to interoperability. These obligations may limit our ability to innovate in +Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software +products that better mimic the functionality of our products which could hamper sales of our products. Government regulatory +actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and businesses, thereby reducing the attractiveness of our products and the revenue that come from them. New competition law +actions could be initiated at any time. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be used as precedent in other competition law proceedings. • We are subject to a variety of ongoing commitments as a result of court or administrative orders, consent decrees or other voluntary actions we have taken. If +we fail to comply with these commitments we may incur litigation costs and be subject to substantial fines or other remedial actions. For example, in July 2012, we announced that, for some PCs sold in Europe, we were not in compliance with our 2009 +agreement to display a “Browser Choice Screen” on Windows PCs where Internet Explorer is the default browser. As a result, the European Commission imposed a fine of € 561 million (approximately $733 million). Our products and online +services offerings, including new technologies we develop or acquire such as Skype, are subject to government regulation in some jurisdictions, including in areas of user privacy, telecommunications, data protection, and online content. The +application of these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally these laws and governments’ approach to their enforcement, as +well as our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in +penalties being imposed on us or orders that we stop the alleged noncompliant activity. Our business depends on our ability to +attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are +limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we are unable to retain key employees, our ability to develop and deliver successful products and +services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and +execution. Delays in product development schedules may adversely affect our revenue. The development of +software products is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Our increasing focus on devices and cloud-based services also presents new and complex +development issues. Significant delays in new product or service releases or significant problems in creating new products or services could adversely affect our revenue. 19 Table of Contents PART I Item 1A Adverse economic or market conditions may harm our +business. Unfavorable changes in economic conditions, including inflation, recession, or other changes in economic conditions, may result in lower IT spending and adversely affect our revenue. If demand for PCs, servers, +and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Our product distribution system also relies on an extensive partner and retail network. OEMs building devices +that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could result in sales channel disruption. Challenging +economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment +portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that affect global financial markets. A significant part of +our investment portfolio consists of U.S. government securities. If global credit and equity markets experience prolonged periods of decline, or if there is a downgrade of U.S. government debt, our investment portfolio may be adversely impacted and +we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial results. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and +lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent +uncertainties and management’s view of these matters may change in the future. A material adverse impact on our financial statements also could occur for the period in which the effect of an unfavorable final outcome becomes probable and +reasonably estimable. We may have additional tax liabilities. We are subject to income taxes in the U.S. +and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is +uncertain. We regularly are under audit by tax authorities. Economic and political pressures to increase tax revenues in various jurisdictions may make resolving tax disputes more difficult. Although we believe our tax estimates are +reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial +statements in the period or periods for which that determination is made. We earn a significant amount of our operating income from +outside the U.S., and any repatriation of funds currently held in foreign jurisdictions to the U.S. may result in higher effective tax rates for the company. In addition, there have been proposals from Congress to change U.S. tax laws that would +significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form any proposed legislation may pass, if enacted it could have a material adverse impact on our tax expense and +cash flows. Our hardware and software products may experience quality or supply problems. Our +vertically-integrated hardware products such as the Xbox 360 console, Surface, and other hardware devices we design and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant +expenses, lost revenue, and reputational harm if we fail to detect or effectively address such issues through design, testing, or warranty repairs. We obtain some components of our hardware devices from sole suppliers. Our competitors use some of +the same suppliers and their demand for hardware components can affect the amount of capacity available to us. If a component delivery from a sole-source supplier is delayed or becomes unavailable or industry shortages occur, we may be unable to +obtain timely replacement supplies, resulting in reduced sales. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox 360 consoles and Surface are assembled +in Asia; disruptions in the supply chain may result in shortages that would affect our revenue and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. Our stand-alone software products also may experience quality or reliability problems. The highly sophisticated software products we develop may +contain bugs and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could result in reduced sales and revenue, damage to our 20 Table of Contents PART I Item 1A, 1B reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or +limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. If our goodwill or +amortizable intangible assets become impaired we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those +acquisitions, which could result in an impairment of goodwill or intangibles. Under accounting principles generally accepted in the United States, we review our amortizable intangible assets for impairment when events or changes in circumstances +indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be considered a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may +not be recoverable, include a decline in stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in our industry. We may be required to record a significant charge in our financial statements during the +period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively impacting our results of operations. For example, in the fourth quarter of fiscal year 2012, we recorded a $6.2 billion charge for the +impairment of goodwill in our Online Services Division business segment. We operate a global business that exposes us to additional +risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. Competitive or regulatory pressure to make our pricing structure uniform might require that we reduce the sales +price of our software in the U.S. and other countries. Operations outside the U.S. may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment. The Foreign Corrupt +Practices Act and local laws (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents. While we devote substantial resources to our global compliance programs and have implemented certain policies, training, +and internal controls designed to reduce the risk of corrupt payments, if we fail to comply with Anti-Corruption Laws, we may be exposed to significant fines and penalties. Emerging markets are a significant focus of our international growth +strategy. The developing nature of these markets presents a number of risks. Deterioration of social, political, labor, or economic conditions in a specific country or region, such as current uncertainties relating to European economic weakness, and +difficulties in staffing and managing foreign operations, may also adversely affect our operations or financial results. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. +dollar and foreign currencies may adversely affect our revenue. Catastrophic events or geo-political conditions may disrupt our +business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing +services, or performing other mission-critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other critical business operations are located in the Seattle, Washington area, and +we have other business operations in the Silicon Valley area of California, both of which are near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems could harm +our ability to conduct normal business operations. Our move toward providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and +magnifies the potential impact of prolonged service outages on our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating +costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may result in supply chain disruptions for hardware manufacturers, either of which may adversely affect our revenue. +The long-term effects of climate change on the global economy in general or the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy may affect the availability or cost of +goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2013 that remain unresolved. 21 Table of Contents PART I, II Item 2, 3, 4, 5 ITEM 2. PROPERTIES Our corporate offices consist of approximately 15 million square feet of office space located in King County, Washington: 10 million +square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately five million square feet of space we lease. We own approximately three million additional square feet +of office and data center space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately four million square feet of office and data center space. We occupy many sites internationally, totaling approximately three million square feet that is owned and approximately nine million square +feet that is leased. International facilities that we own include: our development center in Hyderabad, India; our European operations center in Dublin, Ireland; a research and development campus in Beijing, China; and facilities in Reading, UK. The +largest leased office spaces include the following locations: Beijing and Shanghai, China; Tokyo, Japan; Unterschleissheim, Germany; Paris, France; Dublin, Ireland; Bangalore, India; Reading, UK; Vedbaek, Denmark; and Mississauga, Canada. In +addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, a facility in Singapore for our Asia Pacific operations center and regional headquarters, and various product development +facilities, both domestically and internationally, as described in the “Research and Development” section of Item 1 of this Form 10-K. Our facilities are fully used for current operations of all segments, and suitable additional spaces are available to accommodate expansion needs. We have a development agreement with the City of Redmond under +which we may currently develop approximately 1.6 million square feet of additional facilities at our corporate campus in Redmond, Washington. ITEM 3. LEGAL PROCEEDINGS See Note 17 – Contingencies +of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the +symbol MSFT. On July 18, 2013, there were 119,862 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2013 High $ 31.61 $ 30.25 $ 28.66 $ 35.78 $ 35.78 Low $ 28.54 $ 26.26 $ 26.28 $ 28.11 $ 26.26 Fiscal Year 2012 High $ 28.15 $ 27.50 $ 32.95 $ 32.89 $ 32.95 Low $ 23.79 $ 24.26 $ 26.39 $ 28.32 $ 23.79 22 Table of Contents PART II Item 5, 6, 7 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information +regarding dividends and share repurchases by quarter. Following are our monthly stock repurchases for the fourth quarter of fiscal year 2013, all of which were made as part of publicly announced plans or programs: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2013 – April 30, 2013 0 $ 0.00 0 $ 4,614 May 1, 2013 – May 31, 2013 7,002,462 $ 32.61 7,002,462 $ 4,386 June 1, 2013 – June 30, 2013 23,632,259 $ 32.65 23,632,259 $ 3,614 30,634,721 30,634,721 The repurchases were made using cash resources and occurred either in the open market or through the exercise of +call options with a certain counterparty. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2013 2012 2011 2010 2009 Revenue $ 77,849 $ 73,723 $ 69,943 $ 62,484 $ 58,437 Operating income $ 26,764 (a) $ 21,763 (b) $ 27,161 $ 24,098 $ 20,363 Net income $ 21,863 (a) $ 16,978 (b) $ 23,150 $ 18,760 $ 14,569 Diluted earnings per share $ 2.58 (a) $ 2.00 (b) $ 2.69 $ 2.10 $ 1.62 Cash dividends declared per share $ 0.92 $ 0.80 $ 0.64 $ 0.52 $ 0.52 Cash, cash equivalents, and short-term investments $ 77,022 $ 63,040 $ 52,772 $ 36,788 $ 31,447 Total assets $ 142,431 $ 121,271 $ 108,704 $ 86,113 $ 77,888 Long-term obligations $ 26,070 $ 22,220 $ 22,847 $ 13,791 $ 11,296 Stockholders’ equity $ 78,944 $ 66,363 $ 57,083 $ 46,175 $ 39,558 (a) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased operating income and net income by $733 million ( € 561 million) and diluted earnings per share by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth +quarter of fiscal year 2013, which decreased operating income by $900 million, net income by $596 million, and diluted earnings per share by $0.07. (b) Includes a goodwill impairment charge related to our Online Services Division business segment which decreased operating income and net income by $6.2 +billion and diluted earnings per share by $0.73. ITEM 7. MANAGEMENT’S +DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis +(“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements +and the accompanying Notes to Financial Statements. OVERVIEW Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. We create technology +that transforms the way people work, play, and communicate across a wide range of computing devices. 23 Table of Contents PART II Item 7 We generate revenue by developing, licensing, and supporting a wide range of software products, by +offering an array of services, including cloud-based services to consumers and businesses, by designing and selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most +significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, and income taxes. Industry Trends Our industry is dynamic +and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At +Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers, industry trends, and competitive forces. Key Opportunities and Investments Based on +our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to generate future growth. We invest research and development resources in new products and services in these areas. The capabilities and accessibility of PCs, tablets, +phones, televisions, and other devices powered by rich software platforms and applications continue to grow. With this trend, we believe the full potential of software will be seen and felt in how people use these devices and the associated services +at work and in their personal lives. Devices with end-user services We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. In some cases, we build our own devices, as we have chosen to do with Xbox and Surface. In all our work with partners and on our +own devices, we focus on delivering seamless services and experiences across devices. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique +communications, productivity, and entertainment services from Microsoft and our partners and developers around the world. Windows 8 +reflects this shift. Launched in October 2012, Windows 8 was designed to unite the light, thin, and convenient aspects of a tablet with the power of a PC. The Windows 8 operating system includes the Windows Store, which offers a large and growing +number of applications from Microsoft and partners for both business and consumer customers. Going forward, our strategy will focus on +creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work, and on the go, for the activities they value most. This strategy will require investment in datacenters and other +infrastructure to support our services, and will bring continued competition with Apple, Google, and other well-established and emerging competitors. We believe our history of powering devices such as Windows PCs and Xbox, as well as our experience +delivering high-value experiences through Office and other applications, will position us for future success. Services for the enterprise Today, businesses face important opportunities and challenges. Enterprises are asked to deploy technology that drives business +strategy forward. They decide what solutions will make employees more productive, collaborative, and satisfied, or connect with customers in new and compelling ways. They work to unlock business insights from a world of data. At the same time, they +must manage and secure corporate information that employees access across a growing number of personal and corporate devices. 24 Table of Contents PART II Item 7 To address these opportunities, businesses look to our world-class business applications like +Microsoft Dynamics, Office, Exchange, SharePoint, Lync, Yammer, and our business intelligence solutions. They rely on our technology to manage employee corporate identity and to protect their corporate data. And, increasingly, businesses of all +sizes are looking to Microsoft to realize the benefits of the cloud. Helping businesses move to the cloud is one of our largest +opportunities. Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. The shift to the cloud is driven by three important economies of +scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the +utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enable +new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers. Unique to Microsoft, we continue to design and deliver cloud solutions that allow our customers to use both the cloud and their on-premise assets +however best suits their own needs. For example, a company can choose to deploy Office or Microsoft Dynamics on premise, as a cloud service, or a combination of both. With Windows Server 2012, Windows Azure, and System Center infrastructure, +businesses can deploy applications in their own datacenter, a partner’s datacenter, or in Microsoft’s datacenter with common security, management, and administration across all environments, with the flexibility and scale they desire. +These hybrid capabilities allow customers to fully harness the power of the cloud so they can achieve greater levels of efficiency and tap new areas of growth. Our future opportunity There are several distinct areas of technology that we are focused on +driving forward. Our goal is to lead the industry in these areas over the long-term, which we expect will translate to sustained growth well into the future. We are investing significant resources in: • Developing new form factors that have increasingly natural ways to use them, including touch, gesture, and speech. • Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user +experience, and increase agility when bringing new advances to market. • Delivering new high-value experiences with improvements in how people learn, work, play, and interact with one another. We believe the breadth of our devices and services portfolio, our large, global partner and customer base, and the growing Windows ecosystem +position us to be a leader in these areas. Economic Conditions, Challenges, and Risks The market for software, devices, and cloud-based services is dynamic and highly competitive. Some of our traditional businesses such as the +Windows operating system are in a period of transition. Our competitors are developing new devices and deploy competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence +how users access services in the cloud and in some cases the user’s choice of which suite of cloud-based services to use. The Windows ecosystem must continue to evolve and adapt, over an extended time, in pace with this changing environment. To +support our strategy of offering 25 Table of Contents PART II Item 7 a family of devices and services designed to empower our customers for the activities they value most, we announced a functional realignment in July 2013. Through this realignment our goal is to +become more nimble, collaborative, communicative, motivated, and decisive. Even if we achieve these benefits, the investments we are making in devices and infrastructure to support our cloud-based services will increase our operating costs and may +decrease our operation margins. We prioritize our investments among the highest long-term growth opportunities. These investments +require significant resources and are multi-year in nature. The products and services we bring to market may be developed internally, as part of a partnership or alliance, or through acquisition. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent +worldwide. Microsoft competes for talented individuals worldwide by offering broad customer reach, scale in resources, and competitive compensation. Aggregate demand for our software, services, and hardware is correlated to global macroeconomic factors, which remain dynamic. See a discussion of these factors and other risks under Risk Factors (Part I, +Item 1A of this Form 10-K). Seasonality Our revenue historically has fluctuated quarterly and has generally been highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season +spending by consumers. Our Entertainment and Devices Division is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Entertainment and Devices Division +has generated approximately 40% of its yearly revenue in our second fiscal quarter. Unearned Revenue Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding revenue deferred on sales of Windows 7 +with an option to upgrade to Windows 8 Pro at a discounted price (the “Windows Upgrade Offer”) and sales of the previous version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost (the +“Office Upgrade Offer”, for the offer relating to the new Office, and “the 2010 Office Upgrade Offer” for the prior offer relating to Office 2010). If our customers elect to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time +of the transaction to being recognized over the subscription period or upon consumption, as applicable. RESULTS OF OPERATIONS Summary (In millions, except percentages and per share amounts) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Revenue $ 77,849 $ 73,723 $ 69,943 6% 5% Operating income $ 26,764 $ 21,763 $ 27,161 23% (20)% Diluted earnings per share $ 2.58 $ 2.00 $ 2.69 29% (26)% Fiscal year 2013 compared with fiscal year 2012 Revenue increased, primarily due to higher revenue from Server and Tools as well as revenue from new products and services, including Windows 8, Surface, and the new Office, offset in part by the impact on revenue +of a decline in the x86 PC market. 26 Table of Contents PART II Item 7 Operating income grew, primarily due to the $6.2 billion goodwill impairment charge related to our +OSD business recorded during the prior year. Other key changes in cost of revenue and operating expenses were: • Cost of revenue increased $2.7 billion or 16%, reflecting increased product costs associated with Surface and Windows 8, including an approximately $900 +million charge for Surface RT inventory adjustments, higher headcount-related expenses, payments made to Nokia related to joint strategic initiatives, royalties on Xbox LIVE content, and retail stores expenses, offset in part by decreased costs +associated with lower sales of Xbox 360 consoles and decreased traffic acquisition costs. • Sales and marketing expenses increased $1.4 billion or 10%, reflecting advertising of Windows 8 and Surface. • Research and development expenses increased $600 million or 6%, due mainly to higher headcount-related expenses, largely related to the Entertainment and +Devices Division. • General and administrative expenses increased $580 million or 13%, due to higher legal charges, primarily the EU fine of $733 million. Fiscal year 2012 compared with fiscal year 2011 Revenue increased primarily due to strong sales of Server and Tools products and services and the 2010 Microsoft Office system, offset in part by the decline in Windows operating system revenue primarily due to the +deferral of $540 million of revenue relating to the Windows Upgrade Offer. Revenue in fiscal year 2012 also included Skype revenue from the date of acquisition. Operating income decreased reflecting a goodwill impairment charge of $6.2 billion related to our OSD business segment. Other key changes in cost of revenue and operating expenses were: • Cost of revenue increased $2.0 billion or 13%, reflecting higher costs associated with providing Server and Tools products and services, payments made to +Nokia related to joint strategic initiatives, higher Xbox 360 royalty costs, and other changes in the mix of products and services sold. • Research and development expenses increased $768 million or 8%, due mainly to higher headcount-related expenses. • General and administrative expenses increased $347 million or 8%, due mainly to higher headcount-related expenses and the full year impact of new Puerto Rican +excise taxes, offset in part by decreased legal charges. Headcount-related expenses were higher across the company +reflecting a 4% increase in headcount from June 30, 2011 and changes in our employee compensation program. Fiscal year 2012 +diluted earnings per share were negatively impacted by the non-tax deductible goodwill impairment charge, which decreased diluted earnings per share by $0.73. Fiscal year 2011 net income and diluted earnings per share reflected a partial settlement +with the U.S. Internal Revenue Service (“I.R.S.”) and higher other income. The partial settlement with the I.R.S. added $461 million to net income and $0.05 to diluted earnings per share in fiscal year 2011. SEGMENT REVENUE/OPERATING INCOME (LOSS) The revenue and operating income (loss) amounts in this section are presented on a basis consistent with accounting principles generally accepted in the U.S. (“U.S. GAAP”) and include certain reconciling +items attributable to each of the segments. Segment information appearing in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) is presented on a basis consistent with +our internal management reporting. Certain corporate-level activity has been excluded from segment operating results and is analyzed separately. We have recast certain prior period amounts within this MD&A to conform to the way we internally +managed and monitored segment performance during fiscal year 2013, reflecting immaterial movements of 27 Table of Contents PART II Item 7 business activities between segments and changes in cost allocations. In July 2013, we announced a change in organizational structure as part of our transformation to a devices and services +company. As we evolve how we allocate resources and analyze performance in the new structure, it is possible that our segments may change. Windows +Division (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Revenue $ 19,239 $ 18,400 $ 19,061 5% (3)% Operating income $ 9,504 $ 11,555 $ 12,280 (18)% (6)% Windows Division develops and markets operating systems +for computing devices, related software and online services, Surface RT and Pro devices, and PC accessories. This collection of software, hardware, and services is designed to empower individuals, companies, and organizations and to simplify +everyday tasks through seamless operations across the user’s hardware and software. The general availability of Surface RT and Windows 8 started October 26, 2012. The general availability of Surface Pro started February 9, 2013. Currently, approximately 65% of total Windows Division revenue comes from Windows operating systems purchased by original equipment +manufacturers (“OEMs”) and pre-installed on devices they sell. The remaining Windows Division revenue is generated by commercial and retail sales of Windows, Surface, PC accessories, and online advertising. Fiscal year 2013 compared with fiscal year 2012 Windows Division revenue increased $839 million. Surface revenue was $853 million. Revenue from commercial licensing of Windows increased $487 million, while unearned revenue from commercial licensing also +increased, reflecting continued support of our platform. In addition, we recognized $540 million of previously deferred revenue related to the expiration of the Windows Upgrade Offer. Partially offsetting these increases was a decrease in OEM +revenue. OEM revenue decreased 3%. Excluding the impact of the Windows Upgrade Offer, OEM revenue decreased 10%. This decrease primarily +reflects the impact on revenue of the decline in the x86 PC market, which we estimate declined approximately 9%. In May 2013, we +announced that we had surpassed 100 million licenses sold for Windows 8. Windows Division operating income decreased, primarily +due to higher cost of revenue and sales and marketing expenses, offset in part by revenue growth. Cost of revenue increased $1.8 billion, reflecting a $1.6 billion increase in product costs associated with Surface and Windows 8, including a charge +for Surface RT inventory adjustments of approximately $900 million. Sales and marketing expenses increased $1.0 billion or 34%, reflecting an $898 million increase in advertising costs associated primarily with Windows 8 and Surface. Fiscal year 2012 compared with fiscal year 2011 Windows Division revenue reflected relative performance in the PC market segments. We estimate that sales of PCs to businesses grew approximately 4% and sales of PCs to consumers decreased 1%. Excluding a decline +in sales of netbooks, we estimate that sales of PCs to consumers grew approximately 5%. Taken together, the total PC market increased an estimated 0% to 2%. Relative to PC market growth, Windows Division revenue was negatively impacted by higher +growth in emerging markets, where average selling prices are lower than developed markets, and the deferral of $540 million of revenue relating to the Windows Upgrade Offer. Windows Division operating income decreased, due mainly to lower revenue and a $172 million or 11% increase in research and development expenses, primarily associated with the Windows 8 operating system. 28 Table of Contents PART II Item 7 Server and Tools (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Revenue $ 20,281 $ 18,534 $ 16,559 9% 12% Operating income $ 8,164 $ 7,235 $ 6,105 13% 19% Server and Tools develops and markets technology and +related services that enable information technology professionals and their systems to be more productive and efficient. Server and Tools product and service offerings include Windows Server, Microsoft SQL Server, Windows Azure, Visual Studio, +System Center products, Windows Embedded device platforms, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. We also offer developer tools, training, and certification. +Approximately 80% of Server and Tools revenue comes from product revenue, including purchases through volume licensing programs, licenses sold to OEMs, and retail packaged product, while the remainder comes from Enterprise Services. Fiscal year 2013 compared with fiscal year 2012 Server and Tools revenue increased in both product sales and Enterprise Services. Product revenue increased $1.3 billion or 9%, driven primarily by growth in Microsoft SQL Server, System Center, and Windows Server. +Enterprise Services revenue grew $434 million or 11%, due to growth in both Premier product support and consulting services. Server and +Tools operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and sales and marketing expenses. Cost of revenue grew $589 million or 15%, reflecting a $269 million increase in headcount-related expenses +and a $169 million increase in datacenter expenses. Headcount-related expenses increased due mainly to higher Enterprise Services headcount supporting revenue growth, while datacenter expenses grew primarily to support our online services offerings. +Sales and marketing expenses grew $160 million or 3%, reflecting increased fees paid to third-party enterprise software advisors and corporate sales and marketing activities. Fiscal year 2012 compared with fiscal year 2011 Server and Tools revenue increased in both +product sales and Enterprise Services. Product revenue increased $1.4 billion or 11%, driven primarily by growth in SQL Server, Windows Server, and System Center, reflecting continued adoption of the Windows platform. Enterprise Services revenue +grew $585 million or 17%, due to growth in both Premier product support and consulting services. Server and Tools operating income +increased primarily due to revenue growth, offset in part by higher costs of providing products and services and increased sales and marketing expenses. Cost of revenue increased $678 million or 22%, primarily reflecting higher Enterprise Services +headcount-related expenses. Sales and marketing expenses grew $154 million or 3%, reflecting increased corporate marketing activities. Online +Services Division (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Revenue $ 3,201 $ 2,867 $ 2,607 12% 10% Operating loss $ (1,281 ) $ (8,125 ) $ (2,657 ) * * * Not meaningful Online Services Division (“OSD”) develops and markets information and content designed to help people simplify tasks and make more +informed decisions online, and help advertisers connect with audiences. OSD offerings include Bing, Bing Ads, and MSN. Bing and MSN generate revenue through the sale of search and display advertising, accounting for nearly all of OSD’s revenue. 29 Table of Contents PART II Item 7 Fiscal year 2013 compared with fiscal year 2012 Online advertising revenue grew $409 million or 16% to $3.0 billion, reflecting an increase in search advertising revenue, offset in part by a +decrease in display advertising revenue. Search revenue grew primarily due to increased revenue per search, resulting from ongoing improvements in ad products, while display advertising revenue decreased primarily due to industry-wide market +pressure. OSD’s operating loss decreased, primarily due to the prior year goodwill impairment charge of $6.2 billion. Operating +loss was further reduced by higher revenue and lower cost of revenue and operating expenses. Cost of revenue decreased $302 million or 12%, driven by a $271 million decrease in traffic acquisition costs as well as lower Yahoo! reimbursement costs. +Sales and marketing expenses were $120 million or 15% lower, due mainly to decreased corporate sales and marketing activities. Research and development costs increased $94 million or 7%, due primarily to higher headcount-related expenses resulting +mainly from increased headcount. Fiscal year 2012 compared with fiscal year 2011 Online advertising revenue grew $317 million or 14% to $2.6 billion, reflecting continued growth in search advertising revenue, offset in part by +decreased display advertising revenue. Search revenue grew due to increased revenue per search, increased volumes reflecting general market growth, and share gains in the U.S. According to third-party sources, Bing organic U.S. market share for the +month of June 2012 was approximately 16%, and grew 120 basis points year over year. Bing-powered U.S. market share, including Yahoo! properties, was approximately 26% for the month of June 2012, down 100 basis points year over year. OSD’s fiscal year 2012 operating loss reflects a goodwill impairment charge of $6.2 billion, which we recorded as a result of our annual +goodwill impairment test in the fourth quarter. The non-cash, non-tax-deductible charge related mainly to goodwill acquired through our 2007 acquisition of aQuantive, Inc. Excluding the $6.2 billion goodwill impairment charge, OSD’s operating +loss was reduced by higher revenue and lower sales and marketing expenses and cost of revenue. Sales and marketing expenses decreased $321 million or 29%, due mainly to lower marketing spend. Cost of revenue decreased $208 million, driven by lower +Yahoo! reimbursement costs, amortization, and online operating costs. Microsoft Business Division (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Revenue $ 24,724 $ 24,111 $ 22,607 3% 7% Operating income $ 16,194 $ 15,832 $ 14,678 2% 8% Microsoft Business Division (“MBD”) develops and +markets software and online services designed to increase personal, team, and organization productivity. MBD offerings include the Microsoft Office system (“Office,” comprising mainly the core Office product set, Office 365, SharePoint, +Exchange, and Lync), which generates over 90% of MBD revenue, and Microsoft Dynamics business solutions. The general availability of the new Office started on January 29, 2013. We evaluate MBD results based upon the nature of the end user in two primary parts: business revenue and consumer revenue. Business revenue +includes Office revenue generated through subscription and volume licensing agreements with software assurance, license-only agreements for Office, and Microsoft Dynamics revenue. Consumer revenue includes revenue from retail packaged product sales +and OEM revenue. Fiscal year 2013 compared with fiscal year 2012 MBD revenue increased reflecting growth in business revenue, partially offset by a decline in consumer revenue. Business revenue increased $1.2 billion or 6%, which reflects 11% growth in Office revenue from +subscriptions and 30 Table of Contents PART II Item 7 volume licensing agreements with software assurance, and a 12% increase in Microsoft Dynamics revenue, offset in part by a 9% decrease in Office license-only revenue. Consumer revenue decreased +$582 million or 13%, primarily driven by the impact on revenue of a decline in the x86 PC market. MBD revenue for the year ended +June 30, 2013 included an unfavorable foreign currency impact of $475 million. MBD operating income increased, primarily due to +revenue growth, offset in part by higher sales and marketing expenses and cost of revenue. Sales and marketing expenses grew $185 million or 5%, primarily due to higher advertising expenses, fees paid to third-party software advisors, and increased +cross-platform marketing activities. Cost of revenue grew $108 million or 6%, primarily due to an increase in online operation and support costs. Fiscal year 2012 compared with fiscal year 2011 MBD revenue increased primarily reflecting sales of Office. Business revenue increased $1.7 billion or 9%, primarily reflecting growth in multi-year volume licensing revenue, licensing of Office to +transactional business customers, and a 9% increase in Microsoft Dynamics revenue. Consumer revenue decreased $193 million or 4% due to the recognition of $254 million of revenue in the prior year associated with the 2010 Office Upgrade Offer. +Excluding the fiscal year 2011 impact associated with the 2010 Office Upgrade Offer, consumer revenue increased $61 million, driven by increased sales of Office. MBD revenue for the year ended June 30, 2012 included a favorable foreign currency impact of $506 million. MBD operating income increased, primarily due to revenue growth, offset in part by higher cost of revenue and research and development expenses. Cost of revenue increased $278 million or 17%, primarily due to +higher online operation and support costs. Research and development expenses increased, due mainly to an increase in headcount-related expenses. Entertainment and Devices Division (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Revenue $ 10,165 $ 9,599 $ 8,915 6% 8% Operating income $ 848 $ 380 $ 1,261 123% (70)% Entertainment and Devices Division (“EDD”) +develops and markets products and services designed to entertain and connect people. EDD offerings include the Xbox entertainment platform (which includes the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox +LIVE, and Xbox 360 accessories), Skype, and Windows Phone, including related patent licensing revenue. We acquired Skype on October 13, 2011, and its results of operations from that date are reflected in our results discussed below. In June +2013, we announced that we expect our next generation console, Xbox One, to be available for purchase in the second quarter of fiscal year 2014. Fiscal year 2013 compared with fiscal year 2012 EDD revenue increased, due to higher Windows Phone and Skype revenue, offset in part by lower Xbox 360 platform revenue. Windows Phone revenue increased $1.2 billion, including an increase in patent licensing +revenue and sales of Windows Phone licenses. Skype revenue increased, due primarily to including a full year of results in fiscal year 2013. Xbox 360 platform revenue decreased $950 million or 12%, due mainly to lower volumes of consoles sold, +offset in part by higher Xbox LIVE revenue. We shipped 9.8 million Xbox 360 consoles during fiscal year 2013, compared with 13.0 million Xbox 360 consoles during fiscal year 2012. EDD operating income increased, primarily due to revenue growth and lower cost of revenue, offset in part by higher operating expenses. Sales and +marketing expenses decreased $176 million or 16%, reflecting a $248 million 31 Table of Contents PART II Item 7 decrease in Xbox 360 platform marketing. Cost of revenue decreased $143 million or 2%, due mainly to a $1.0 billion decrease in manufacturing and distribution costs associated with lower volumes +of Xbox 360 consoles sold, offset in part by a $375 million increase in expenses for payments made to Nokia related to joint strategic initiatives and a $273 million increase in royalties on Xbox LIVE content. Research and development expenses +increased $432 million or 28%, reflecting $246 million higher headcount-related expenses, resulting mainly from increased headcount in connection with the Xbox platform and Skype. Fiscal year 2012 compared with fiscal year 2011 EDD revenue increased primarily reflecting +Skype and Windows Phone revenue, offset in part by lower Xbox 360 platform revenue. Xbox 360 platform revenue decreased $107 million, due mainly to decreased volumes of Kinect for Xbox 360 sold and lower video game revenue, offset in part by higher +Xbox LIVE revenue. We shipped 13.0 million Xbox 360 consoles during fiscal year 2012, compared with 13.7 million Xbox 360 consoles during fiscal year 2011. Video game revenue decreased due to strong sales of Halo Reach in the prior year. EDD operating income decreased reflecting higher cost of revenue and operating expenses, offset in part by revenue growth. Cost of +revenue grew $896 million or 16%, primarily due to changes in the mix of products and services sold and payments made to Nokia related to joint strategic initiatives. Research and development expenses increased $366 million or 31%, primarily +reflecting higher headcount-related expenses. Sales and marketing expenses increased $242 million or 27%, primarily reflecting the inclusion of Skype expenses. Corporate-Level Activity (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Corporate-level activity $ (6,665) $ (5,114) $ (4,506) (30)% (13)% Certain corporate-level activity is not allocated to our +segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information technology; corporate development and procurement activities; research and development; costs of operating our +retail stores; and legal settlements and contingencies. Fiscal year 2013 compared with fiscal year 2012 Corporate-level expenses increased, primarily due to higher legal charges from the European Commission fine of € 561 million (approximately $733 million) for failure to comply with our 2009 agreement to display a “Browser Choice Screen” on +Windows PCs where Internet Explorer is the default browser (the “EU fine”). Corporate-level expenses also grew due to a $350 million increase in retail stores expenses and $287 million higher intellectual property licensing costs. Fiscal year 2012 compared with fiscal year 2011 Corporate-level expenses increased due mainly to full year Puerto Rican excise taxes, higher headcount-related expenses, and changes in foreign currency exchange rates. These increases were offset in part by lower +legal charges, which were $56 million in fiscal year 2012 compared with $332 million in fiscal year 2011. COST OF REVENUE Cost of Revenue (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Cost of revenue $ 20,249 $ 17,530 $ 15,577 16% 13% As a percent of revenue 26% 24% 22% 2ppt 2ppt 32 Table of Contents PART II Item 7 Cost of revenue includes: manufacturing and distribution costs for products sold, including Xbox +and Surface, and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online +advertising space (“traffic acquisition costs”); costs incurred to support and maintain internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with +the delivery of consulting services; and the amortization of capitalized research and development costs. Fiscal year 2013 compared with fiscal year +2012 Cost of revenue increased, reflecting $1.6 billion in product costs associated with Surface and Windows 8, including a charge +for Surface RT inventory adjustments of approximately $900 million, $578 million higher headcount-related expenses, a $375 million increase in expenses for payments to Nokia related to joint strategic initiatives, $287 million higher intellectual +property licensing costs, a $273 million increase in royalties on Xbox LIVE content, and a $152 million increase in retail store expenses, offset in part by a $1.0 billion decrease in manufacturing and distribution costs associated with lower +volumes of Xbox 360 consoles sold and a $431 million decrease in traffic acquisition costs. Fiscal year 2012 compared with fiscal year 2011 Cost of revenue increased reflecting higher headcount-related expenses, payments made to Nokia, and changes in the mix of products +and services sold. Headcount-related expenses increased 20%, primarily related to increased Enterprise Services headcount. OPERATING +EXPENSES Research and Development (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Research and development $ 10,411 $ 9,811 $ 9,043 6% 8% As a percent of revenue 13% 13% 13% 0ppt 0ppt Research and development expenses include payroll, +employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred +to translate software for international markets, and the amortization of purchased software code. Fiscal year 2013 compared with fiscal year 2012 Research and development expenses increased, reflecting a $460 million or 6% increase in headcount-related expenses, largely +related to the Entertainment and Devices Division. Fiscal year 2012 compared with fiscal year 2011 Research and development expenses increased, primarily reflecting a 10% increase in headcount-related expenses. Sales and Marketing (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 Sales and marketing $ 15,276 $ 13,857 $ 13,940 10% (1)% As a percent of revenue 20% 19% 20% 1ppt (1)ppt 33 Table of Contents PART II Item 7 Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, +and other headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2013 compared with fiscal year 2012 Sales and marketing expenses grew, reflecting +an $898 million increase in advertising costs associated primarily with Windows 8 and Surface, $181 million higher fees paid to third-party software advisors, and a $145 million or 2% increase in headcount-related expenses. Fiscal year 2012 compared with fiscal year 2011 Sales and marketing expenses decreased slightly, primarily reflecting decreased advertising and marketing of the Xbox 360 platform, Windows Phone, and Bing, offset in part by a 5% increase in headcount-related +expenses. General and Administrative (In millions, except percentages) 2013 2012 2011 Percentage Change 2013 Versus 2012 Percentage Change 2012 Versus 2011 General and administrative $ 5,149 $ 4,569 $ 4,222 13% 8% As a percent of revenue 7% 6% 6% 1ppt 0ppt General and administrative expenses include payroll, +employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other +administrative fees. Fiscal year 2013 compared with fiscal year 2012 General and administrative expenses increased due to higher legal charges from the EU fine. Fiscal year 2012 +compared with fiscal year 2011 General and administrative expenses increased, primarily due to a 10% increase in headcount-related +expenses and a full year of Puerto Rican excise taxes, offset in part by a decrease in legal charges. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level using a fair value approach. No impairment of goodwill was +identified as of May 1, 2013. Our goodwill impairment test as of May 1, 2012, indicated that OSD’s carrying value exceeded its estimated fair value. Accordingly, we recorded a non-cash, non-tax deductible goodwill impairment charge of +$6.2 billion during the three months ended June 30, 2012, reducing OSD’s goodwill from $6.4 billion to $223 million. 34 Table of Contents PART II Item 7 OTHER INCOME (EXPENSE) AND INCOME TAXES Other Income (Expense) The components of +other income (expense) were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Dividends and interest income $ 677 $ 800 $ 900 Interest expense (429 ) (380 ) (295 ) Net recognized gains on investments 116 564 439 Net losses on derivatives (196 ) (364 ) (77 ) Net losses on foreign currency remeasurements (74 ) (117 ) (26 ) Other 194 1 (31 ) Total $ 288 $ 504 $ 910 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and +credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). Other than those +derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of +other comprehensive income (“OCI”) until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense). Fiscal year 2013 compared with fiscal year 2012 Dividends and interest income decreased due to lower yields on our fixed-income investments, offset in part by higher average portfolio investment balances. Net recognized gains on investments decreased primarily +due to lower gains on sales of equity and fixed-income securities and a gain recognized on the partial sale of our Facebook holding in the prior year, offset in part by lower other-than-temporary impairments. Other-than-temporary impairments were +$208 million in fiscal year 2013, compared with $298 million in fiscal year 2012. Net losses on derivatives decreased due to gains on equity derivatives in the current fiscal year as compared with losses in the prior fiscal year, and lower losses on +commodity and foreign exchange derivatives as compared to the prior fiscal year, offset in part by losses on interest-rate derivatives in the current fiscal year as compared to gains in the prior fiscal year. For the current year, other reflects +recognized gains on divestitures, including the gain recognized upon the divestiture of our 50% share in the MSNBC joint venture. Fiscal year 2012 +compared with fiscal year 2011 Dividends and interest income decreased due to lower yields on our fixed-income investments, offset +in part by higher average portfolio investment balances. Interest expense increased due to our increased issuance of debt in the prior year. Net recognized gains on investments increased, primarily due to higher gains on sales of equity and +fixed-income securities and a gain recognized on the partial sale of our Facebook holding upon the initial public offering on May 18, 2012, offset in part by higher other-than-temporary impairments. Other-than-temporary impairments were $298 +million in fiscal year 2012, compared with $80 million in fiscal year 2011. Net losses on derivatives increased due to losses on commodity and equity derivatives in the current fiscal year as compared with gains in the prior fiscal year, offset in +part by fewer losses on foreign exchange contracts in the current fiscal year as compared to the prior fiscal year. Changes in foreign currency remeasurements were primarily due to currency movements net of our hedging activities. 35 Table of Contents PART II Item 7 Income Taxes Fiscal year 2013 compared with fiscal year 2012 Our effective tax rate for fiscal years 2013 +and 2012 was approximately 19% and 24%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our +products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Our fiscal year 2013 +effective rate decreased by 5% from fiscal year 2012 mainly due to a nonrecurring $6.2 billion non-tax deductible goodwill impairment charge that was recorded in fiscal year 2012. The goodwill impairment charge increased our effective tax rate by +10% in fiscal year 2012. In addition, in fiscal years 2013 and 2012, we recognized a reduction of 18% and 21%, respectively, to the effective tax rate due to foreign earnings taxed at lower rates. The decrease in our effective tax rate for fiscal +year 2013 was primarily offset by a 1% increase related to the EU fine, which is not tax deductible. Changes in the mix of income +before income taxes between the U.S. and foreign countries also impacted our effective tax rates and resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. As discussed above, +Windows Division operating income declined $2.1 billion in fiscal year 2013, while MBD and Server and Tools operating income increased $362 million and $929 million, respectively, during this same period. We supply Windows, our primary Windows +Division product, to customers through our U.S. regional operating center, while we supply the Microsoft Office System, our primary MBD product, and our Server and Tools products to customers through our foreign regional operations centers. In +fiscal years 2013 and 2012, our U.S. income before income taxes was $6.7 billion and $1.6 billion, respectively, and comprised 25% and 7%, respectively, of our income before income taxes. In fiscal years 2013 and 2012, the foreign income before +income taxes was $20.4 billion and $20.7 billion, respectively, and comprised 75% and 93%, respectively, of our income before income taxes. The primary driver for the increase in the U.S. income before income tax in fiscal year 2013 was the goodwill +impairment charge recorded during the prior year. Tax contingencies and other tax liabilities were $9.4 billion and $7.6 billion as of +June 30, 2013 and 2012, respectively, and are included in other long-term liabilities. This increase relates primarily to transfer pricing, including transfer pricing developments in certain foreign tax jurisdictions, primarily Denmark. While +we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for those years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit +phase of the examination. As of June 30, 2013, the primary unresolved issue relates to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible +that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months because we do not believe the remaining open issues will be resolved within the next 12 months. We also continue to be subject to +examination by the I.R.S. for tax years 2007 to 2012. We are subject to income tax in many jurisdictions outside the U.S. Our +operations in certain jurisdictions remain subject to examination for tax years 1996 to 2012, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our financial +statements. Fiscal year 2012 compared with fiscal year 2011 Our effective tax rates for fiscal years 2012 and 2011 were approximately 24% and 18%, respectively. Our effective tax rates were lower than the U.S. federal statutory rate primarily due to earnings taxed at lower +rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Our fiscal year 2012 effective rate increased by 6% from fiscal year 2011 mainly due to a nonrecurring $6.2 billion non-tax deductible goodwill +impairment charge that was recorded in the fourth quarter of 2012. The goodwill impairment charge increased our effective tax rate by 10%. In addition, in fiscal years 2012 and 2011, we recognized 36 Table of Contents PART II Item 7 a reduction of 21% and 16%, respectively, to the effective tax rate due to foreign earnings taxed at lower rates. In fiscal year 2011, we settled a portion of an I.R.S. audit of tax years 2004 to +2006, which reduced our income tax expense for fiscal year 2011 by $461 million and reduced the effective tax rate by 2%. Changes in +the mix of income before income taxes between the U.S. and foreign countries also impacted our effective tax rates and resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. As +discussed above, Windows Division operating income declined $751 million in fiscal year 2012, while MBD and Server and Tools operating income increased $1.1 billion and $1.1 billion, respectively, during this same period. We supply +Windows, our primary Windows Division product, to customers through our U.S. regional operating center, while we supply the Microsoft Office System, our primary MBD product, and our Server and Tools products to customers through our foreign regional +operations centers. In fiscal years 2012 and 2011, our U.S. income before income taxes was $1.6 billion and $8.9 billion, respectively, and comprised 7% and 32%, respectively, of our income before income taxes. In fiscal years 2012 and 2011, the +foreign income before income taxes was $20.7 billion and $19.2 billion, respectively, and comprised 93% and 68%, respectively, of our income before income taxes. The primary driver for the decrease in the U.S. income before income tax in fiscal year +2012 was the goodwill impairment charge. FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments +totaled $77.0 billion as of June 30, 2013, compared with $63.0 billion as of June 30, 2012. Equity and other investments were $10.8 billion as of June 30, 2013, compared with $9.8 billion as of June 30, 2012. Our short-term +investments are primarily to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are +predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average +maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily +highly liquid investment-grade fixed-income securities. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of June 30, 2013 does not contain material direct exposure to subprime mortgages or +structured vehicles that derive their value from subprime collateral. The majority of our mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National +Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association. We routinely monitor our +financial exposure to both sovereign and non-sovereign borrowers and counterparties. Our gross exposures to our customers and investments in Portugal, Italy, Ireland, Greece, and Spain are individually and collectively not material. Of the cash, cash equivalents, and short-term investments at June 30, 2013, approximately $69.6 billion was held by our foreign subsidiaries +and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local +regulatory) was approximately $880 million. As of June 30, 2013, approximately 87% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 4% were +invested in corporate notes and bonds of U.S. companies, and 2% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars. Securities lending We lend certain fixed-income and equity securities to increase investment +returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the +creditworthiness of 37 Table of Contents PART II Item 7 the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $645 million as of June 30, 2013. Our average and maximum +securities lending payable balances for the fiscal year were $494 million and $1.4 billion, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and where +applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, +domestic and international equities, and U.S. government securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or +inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage-backed securities, and U.S. +agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a +quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or +when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets +without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include +controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Fiscal year 2013 compared with +fiscal year 2012 Cash flows from operations decreased $2.8 billion during the current fiscal year to $28.8 billion, due mainly to +changes in working capital, including increases in inventory and other current assets. Cash used for financing decreased $1.3 billion to $8.1 billion, due mainly to a $3.5 billion increase in proceeds from issuances of debt, net of repayments, +offset in part by a $1.1 billion increase in dividends paid and a $982 million decrease in proceeds from the issuance of common stock. Cash used in investing decreased $975 million to $23.8 billion, due mainly to an $8.5 billion decrease in +cash used for acquisitions of companies and purchases of intangible and other assets, offset in part by a $5.8 billion increase in cash used for net investment purchases, maturities, and sales and a $2.0 billion increase in cash used for additions +to property and equipment. Fiscal year 2012 compared with fiscal year 2011 Cash flows from operations increased $4.6 billion during fiscal year 2012 to $31.6 billion, due mainly to increased revenue and cash collections +from customers. Cash used for financing increased $1.0 billion to $9.4 billion, due mainly to a $6.0 billion net decrease in proceeds from issuances of debt and a $1.2 billion increase in dividends paid, offset in part by a $6.5 billion decrease in +cash used for common stock repurchases. Cash used in investing increased $10.2 billion to $24.8 billion, due mainly to a $10.0 billion increase in acquisitions of businesses and purchases of intangible assets and a $1.4 billion decrease in cash from +securities lending activities, partially offset by a $1.2 billion decrease in cash used for net purchases, maturities, and sales of investments. 38 Table of Contents PART II Item 7 Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for +general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. As of June 30, 2013, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $15.6 +billion and $15.8 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $13.2 billion, respectively, as of June 30, 2012. These estimated fair values are based on Level 2 inputs. The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of +June 30, 2013: Due Date Face Value Stated Interest Rate Effective Interest Rate (In millions) Notes September 27, 2013 $ 1,000 0.875% 1.000% June 1, 2014 2,000 2.950% 3.049% September 25, 2015 1,750 1.625% 1.795% February 8, 2016 750 2.500% 2.642% November 15, +2017 (a) 600 0.875% 1.084% May 1, +2018 (b) 450 1.000% 1.106% June 1, 2019 1,000 4.200% 4.379% October 1, 2020 1,000 3.000% 3.137% February 8, 2021 500 4.000% 4.082% November 15, +2022 (a) 750 2.125% 2.239% May 1, +2023 (b) 1,000 2.375% 2.465% May 2, +2033 (c) 715 2.625% 2.690% June 1, 2039 750 5.200% 5.240% October 1, 2040 1,000 4.500% 4.567% February 8, 2041 1,000 5.300% 5.361% November 15, +2042 (a) 900 3.500% 3.571% May 1, +2043 (b) 500 3.750% 3.829% Total $ 15,665 (a) In November 2012, we issued $2.25 billion of debt securities. (b) In April 2013, we issued $1.95 billion of debt securities. (c) In April 2013, we issued € 550 million +of debt securities. Interest on the notes is paid semi-annually, except for the euro-denominated debt securities +on which interest is paid annually. As of June 30, 2013, the aggregate unamortized discount for our long-term debt, including the current portion, was $65 million. Notes The Notes are senior unsecured obligations and rank equally with our other unsecured +and unsubordinated debt outstanding. 39 Table of Contents PART II Item 7 Convertible Debt In June 2013, we paid cash of $1.25 billion for the principal amount of our zero coupon convertible unsecured debt and elected to deliver cash for the $96 million excess obligation resulting from the conversion of +the notes. Each $1,000 principal amount of notes was convertible into 30.68 shares of Microsoft common stock at a conversion price of $32.59 per share. As of June 30, 2012, the net carrying amount of the convertible debt and the unamortized +discount were $1.2 billion and $19 million, respectively. In connection with the issuance of the notes in 2010, we entered into capped +call transactions with certain option counterparties with a strike price equal to the conversion price of the notes. Upon conversion of the notes in June 2013, we exercised the capped calls. The bulk of the capped calls were physically settled by +acquiring 29 million shares of our own common stock for $938 million. The remaining capped calls were net cash settled for $24 million. Credit +Facility In June 2013, we established a commercial paper program for the issuance and sale of up to $1.3 billion in commercial +paper. As of June 30, 2013, we have not issued any commercial paper under this program. In June 2013, we entered into a $1.3 +billion credit facility, which will serve as a back-up for our commercial paper program. As of June 30, 2013, we were in compliance with the only financial covenant in the credit agreement, which requires us to maintain a coverage ratio of at +least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreement. The credit facility expires on June 24, 2018. No amounts were drawn against the credit facility since its +inception. Unearned Revenue Unearned revenue at June 30, 2013 comprised mainly unearned revenue from volume licensing programs. Unearned revenue from volume licensing +programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over +the coverage period. Unearned revenue at June 30, 2013 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; OEM minimum commitments; Microsoft +Dynamics business solutions products; Skype prepaid credits and subscriptions; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition +criteria. The following table outlines the expected future recognition of unearned revenue as of June 30, 2013: (In millions) Three Months Ending, September 30, 2013 $ 7,790 December 31, 2013 6,571 March 31, 2014 4,252 June 30, 2014 2,026 Thereafter 1,760 Total $ 22,399 Share Repurchases On September 22, 2008, we announced that our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. +As of June 30, 2013, approximately $3.6 billion remained of the $40.0 billion approved repurchase amount. The repurchase program may be suspended or discontinued at any time without notice. 40 Table of Contents PART II Item 7 During the periods reported, we repurchased with cash resources: 158 million shares for $4.6 +billion during fiscal year 2013; 142 million shares for $4.0 billion during fiscal year 2012; and 447 million shares for $11.5 billion during fiscal year 2011. Dividends During fiscal years 2013 and 2012, our Board of Directors declared the following +dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) Fiscal Year 2013 September 18, 2012 $ 0.23 November 15, 2012 $ 1,933 December 13, 2012 November 28, 2012 $ 0.23 February 21, 2013 $ 1,925 March 14, 2013 March 11, 2013 $ 0.23 May 16, 2013 $ 1,921 June 13, 2013 June 12, 2013 $ 0.23 August 15, 2013 $ 1,916 September 12, 2013 Fiscal Year 2012 September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011 December 14, 2011 $ 0.20 February 16, 2012 $ 1,683 March 8, 2012 March 13, 2012 $ 0.20 May 17, 2012 $ 1,678 June 14, 2012 June 13, 2012 $ 0.20 August 16, 2012 $ 1,676 September 13, 2012 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third +parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable +estimate of the amount of loss. These obligations did not have a material impact on our financial statements during the periods presented. Contractual Obligations The following +table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2013: (In millions) 2014 2015-2016 2017-2018 Thereafter Total Long-term +debt: (a) Principal payments $ 3,000 $ 2,500 $ 1,050 $ 9,115 $ 15,665 Interest payments 459 776 693 4,940 6,868 Construction commitments (b) 694 0 0 0 694 Operating +leases (c) 572 800 485 605 2,462 Purchase commitments (d) 13,752 934 258 83 15,027 Other long-term liabilities (e) 0 67 20 23 110 Total contractual obligations $ 18,477 $ 5,077 $ 2,506 $ 14,766 $ 40,826 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) These amounts represent commitments for the construction of buildings, building improvements, and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. 41 Table of Contents PART II Item 7 (e) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $11.3 billion and other long-term contingent liabilities +of $162 million (related to the antitrust and unfair competition class action lawsuits) from the amounts presented, as the amounts that will be settled in cash are not known and the timing of any payments is uncertain. We have also excluded unearned +revenue and non-cash items. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to +property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years in +support of our cloud and devices strategy. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities +or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a +result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these +funds. We expect existing domestic cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, +such as regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term +investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter +for the foreseeable future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to +fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives +could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates. RECENT ACCOUNTING GUIDANCE Recently +Adopted Accounting Guidance In September 2011, the Financial Accounting Standards Board (“FASB”) issued guidance on +testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If an +entity determines that this is the case, it is required to perform the two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be recognized for that reporting unit (if any). +If an entity determines that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. We adopted this new guidance beginning July 1, 2012. Adoption of this new guidance did +not have a material impact on our financial statements. In June 2011, the FASB issued guidance on presentation of comprehensive +income. The new guidance eliminated the option to report other comprehensive income (“OCI”) and its components in the statement of changes in stockholders’ equity. Instead, an entity is required to present either a +continuous statement of net income and OCI or in two separate but consecutive statements. We adopted this new guidance beginning July 1, 2012. Adoption of this new guidance resulted only in changes to presentation of our financial +statements. 42 Table of Contents PART II Item 7 Recent Accounting Guidance Not Yet Adopted In December 2011, the FASB issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related +arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and +the related net exposure. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and +securities lending transactions that are either offset or subject to an enforceable master netting arrangement, or similar agreements. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional +disclosures, we do not anticipate material impacts on our financial statements upon adoption. In February 2013, the FASB issued +guidance on disclosure requirements for items reclassified out of accumulated other comprehensive income (“AOCI”). This new guidance requires entities to present (either on the face of the income statement or in the notes) the effects on +the line items of the income statement for amounts reclassified out of AOCI. The new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial +statements upon adoption. In March 2013, the FASB issued guidance on a parent’s accounting for the cumulative translation +adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative translation adjustment into net income only if the sale or transfer results in the +complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. The new guidance will be effective for us beginning July 1, 2014. We do not anticipate material impacts on our +financial statements upon adoption. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to +make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us +include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Revenue recognition +requires judgment, including whether a software arrangement includes multiple elements, and if so, whether the vendor-specific objective evidence (“VSOE”) of fair value exists for those elements. A portion of revenue may be recorded as +unearned due to undelivered elements. Changes to the elements in a software arrangement, the ability to identify the VSOE for those elements, and the fair value of the respective elements could materially impact the amount of earned and unearned +revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for current products +combined with rights to receive unspecified future versions of software products (“Software Assurance”) and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage +period. Software updates are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade, which may +require revenue to be deferred and recognized when the upgrade is delivered, or if it is determined that implied post-contract customer support (“PCS”) is being provided, revenue from the arrangement is deferred and recognized over the +implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Windows 8.1 will enable new hardware, further the integration with other Microsoft services and address customer issues with Windows 8, and will be provided to Windows 8 customers when available at no additional +charge. We evaluated Windows 8.1 and determined that it did not meet the definition of an upgrade and thus have not deferred revenue related to this planned release. 43 Table of Contents PART II Item 7 Windows 7 revenue was subject to deferral as a result of the Windows Upgrade Offer, which started +June 2, 2012. The offer provided significantly discounted rights to purchase Windows 8 Pro to qualifying end-users that purchased Windows 7 PCs during the eligibility period. Microsoft was responsible for delivering Windows 8 Pro to the end +customer. Accordingly, revenue related to the allocated discount for undelivered Windows 8 was deferred until it was delivered or the redemption period expired. Microsoft Office system revenue was subject to deferral as a result of the Office Upgrade Offer, which started October 19, 2012. The Office Upgrade Offer allowed customers who purchased qualifying 2010 +Microsoft Office system or Office for Mac 2011 products to receive, at no cost, a one-year subscription to Office 365 Home Premium or the equivalent version of 2013 Microsoft Office system upon general availability. Small business customers in +applicable markets were also eligible for a three-month trial of Office 365 Small Business Premium. Accordingly, estimated revenue related to the undelivered 2013 Microsoft Office system and subscription services was deferred until the products and +services were delivered or the redemption period expired. Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this +judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among +other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For +fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial +health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment +charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting +units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for +impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair +value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant +portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting +units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated using a discounted cash flow +methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which +cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a +reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting +unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is +established, all 44 Table of Contents PART II Item 7 software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We +have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to +manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a +loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a +contingency is required if there is at least a reasonable possibility that a loss has been incurred. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the +ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and +deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely +than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest +benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets +and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax +returns. Variations in the actual outcome of these future tax consequences could materially impact our financial statements. Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing +overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand +forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis +through a charge to cost of revenue. The determination of market value and the estimated volume of demand used in the lower of cost or market analysis require significant judgment. 45 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial +reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, +through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities +and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Steven A. Ballmer Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 46 Table of Contents PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK RISKS We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our financial +statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and +use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Interest Rate Our fixed-income portfolio +is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and +domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. Equity Our equity portfolio consists of +global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based commodity +exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity +indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed +based on the historical volatilities and correlations among foreign currency exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses +could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. 47 Table of Contents PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of +June 30, 2013 and 2012 and for the year ended June 30, 2013: (In millions) June 30, 2013 June 30, 2012 Year Ended June 30, 2013 Risk Categories Average High Low Foreign currency $ 199 $ 98 $ 215 $ 256 $ 90 Interest rate $ 85 $ 71 $ 73 $ 86 $ 63 Equity $ 181 $ 205 $ 198 $ 211 $ 178 Commodity $ 19 $ 18 $ 20 $ 24 $ 18 Total one-day VaR for the combined risk categories was +$350 million at June 30, 2013 and $292 million at June 30, 2012. The total VaR is 28% less at June 30, 2013, and 26% less at June 30, 2012, than the sum of the separate risk categories in the above table due to the +diversification benefit of the combination of risks. 48 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2013 2012 2011 Revenue $ 77,849 $ 73,723 $ 69,943 Cost of revenue 20,249 17,530 15,577 Gross profit 57,600 56,193 54,366 Operating expenses: Research and development 10,411 9,811 9,043 Sales and marketing 15,276 13,857 13,940 General and administrative 5,149 4,569 4,222 Goodwill impairment 0 6,193 0 Total operating expenses 30,836 34,430 27,205 Operating income 26,764 21,763 27,161 Other income 288 504 910 Income before income taxes 27,052 22,267 28,071 Provision for income taxes 5,189 5,289 4,921 Net income $ 21,863 $ 16,978 $ 23,150 Earnings per share: Basic $ 2.61 $ 2.02 $ 2.73 Diluted $ 2.58 $ 2.00 $ 2.69 Weighted average shares outstanding: Basic 8,375 8,396 8,490 Diluted 8,470 8,506 8,593 Cash dividends declared per common share $ 0.92 $ 0.80 $ 0.64 See accompanying notes. 49 Table of Contents PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2013 2012 2011 Net income $ 21,863 $ 16,978 $ 23,150 Other comprehensive income (loss): Net unrealized gains (losses) on derivatives (net of tax effects of $(14) , $137, and $(338)) (26 ) 255 (627 ) Net unrealized gains (losses) on investments (net of tax effects of $195 , $(210), and $567) 363 (390 ) 1,054 Translation adjustments and other (net of tax effects of $(8) , $(165), and $205) (16 ) (306 ) 381 Other comprehensive income (loss) 321 (441 ) 808 Comprehensive income $ 22,184 $ 16,537 $ 23,958 See accompanying notes. 50 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2013 2012 Assets Current assets: Cash and cash equivalents $ 3,804 $ 6,938 Short-term investments (including securities loaned of $579 and $785) 73,218 56,102 Total cash, cash equivalents, and short-term investments 77,022 63,040 Accounts receivable, net of allowance for doubtful accounts of $336 and $389 17,486 15,780 Inventories 1,938 1,137 Deferred income taxes 1,632 2,035 Other 3,388 3,092 Total current assets 101,466 85,084 Property and equipment, net of accumulated depreciation of $12,513 and $10,962 9,991 8,269 Equity and other investments 10,844 9,776 Goodwill 14,655 13,452 Intangible assets, net 3,083 3,170 Other long-term assets 2,392 1,520 Total assets $ 142,431 $ 121,271 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 4,828 $ 4,175 Current portion of long-term debt 2,999 1,231 Accrued compensation 4,117 3,875 Income taxes 592 789 Short-term unearned revenue 20,639 18,653 Securities lending payable 645 814 Other 3,597 3,151 Total current liabilities 37,417 32,688 Long-term debt 12,601 10,713 Long-term unearned revenue 1,760 1,406 Deferred income taxes 1,709 1,893 Other long-term liabilities 10,000 8,208 Total liabilities 63,487 54,908 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,328 and 8,381 67,306 65,797 Retained earnings (deficit) 9,895 (856 ) Accumulated other comprehensive income 1,743 1,422 Total stockholders’ equity 78,944 66,363 Total liabilities and stockholders’ equity $ 142,431 $ 121,271 See accompanying notes. 51 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2013 2012 2011 Operations Net income $ 21,863 $ 16,978 $ 23,150 Adjustments to reconcile net income to net cash from operations: Goodwill impairment 0 6,193 0 Depreciation, amortization, and other 3,755 2,967 2,766 Stock-based compensation expense 2,406 2,244 2,166 Net recognized losses (gains) on investments and derivatives 80 (200 ) (362 ) Excess tax benefits from stock-based compensation (209 ) (93 ) (17 ) Deferred income taxes (19 ) 954 2 Deferral of unearned revenue 44,253 36,104 31,227 Recognition of unearned revenue (41,921 ) (33,347 ) (28,935 ) Changes in operating assets and liabilities: Accounts receivable (1,807 ) (1,156 ) (1,451 ) Inventories (802 ) 184 (561 ) Other current assets (129 ) 493 (1,259 ) Other long-term assets (478 ) (248 ) 62 Accounts payable 537 (31 ) 58 Other current liabilities 146 410 (1,146 ) Other long-term liabilities 1,158 174 1,294 Net cash from operations 28,833 31,626 26,994 Financing Short-term debt repayments, maturities of 90 days or less, net 0 0 (186 ) Proceeds from issuance of debt 4,883 0 6,960 Repayments of debt (1,346 ) 0 (814 ) Common stock issued 931 1,913 2,422 Common stock repurchased (5,360 ) (5,029 ) (11,555 ) Common stock cash dividends paid (7,455 ) (6,385 ) (5,180 ) Excess tax benefits from stock-based compensation 209 93 17 Other (10 ) 0 (40 ) Net cash used in financing (8,148 ) (9,408 ) (8,376 ) Investing Additions to property and equipment (4,257 ) (2,305 ) (2,355 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (1,584 ) (10,112 ) (71 ) Purchases of investments (75,396 ) (57,250 ) (35,993 ) Maturities of investments 5,130 15,575 6,897 Sales of investments 52,464 29,700 15,880 Securities lending payable (168 ) (394 ) 1,026 Net cash used in investing (23,811 ) (24,786 ) (14,616 ) Effect of exchange rates on cash and cash equivalents (8 ) (104 ) 103 Net change in cash and cash equivalents (3,134 ) (2,672 ) 4,105 Cash and cash equivalents, beginning of period 6,938 9,610 5,505 Cash and cash equivalents, end of period $ 3,804 $ 6,938 $ 9,610 See accompanying notes. 52 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2013 2012 2011 Common stock and paid-in capital Balance, beginning of period $ 65,797 $ 63,415 $ 62,856 Common stock issued 920 1,924 2,422 Common stock repurchased (2,014 ) (1,714 ) (3,738 ) Stock-based compensation expense 2,406 2,244 2,166 Stock-based compensation income tax benefits (deficiencies) 190 (75 ) (292 ) Other, net 7 3 1 Balance, end of period 67,306 65,797 63,415 Retained earnings (deficit) Balance, beginning of period (856 ) (8,195 ) (17,736 ) Net income 21,863 16,978 23,150 Common stock cash dividends (7,694 ) (6,721 ) (5,394 ) Common stock repurchased (3,418 ) (2,918 ) (8,215 ) Balance, end of period 9,895 (856 ) (8,195 ) Accumulated other comprehensive income Balance, beginning of period 1,422 1,863 1,055 Other comprehensive income (loss) 321 (441 ) 808 Balance, end of period 1,743 1,422 1,863 Total stockholders’ equity $ 78,944 $ 66,363 $ 57,083 See accompanying notes. 53 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of +America (“U.S. GAAP”). Principles of Consolidation The financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we exercise significant +influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the +investee and which do not have readily determinable fair values are accounted for under the cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, +revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, and/or potential goodwill impairment for, our reporting units; product life cycles; useful lives of our tangible and intangible assets; +allowances for doubtful accounts; allowances for product returns; the market value of our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the +distinction between upgrades or enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our financial statements or tax +returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at +the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income +(“OCI”). Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is probable. Revenue generally is recognized net of allowances +for returns and any taxes collected from customers and subsequently remitted to governmental authorities. Revenue for retail packaged +products, products licensed to original equipment manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are shipped or made available. Technology guarantee programs are accounted for as multiple element arrangements as customers receive free or significantly discounted rights to +use upcoming new versions of a software product if they license existing versions of the product during the eligibility period. Revenue is allocated between the existing product and the new product, and revenue allocated to the new product is +deferred until that version is delivered. The revenue allocation is based on the vendor-specific objective evidence (“VSOE”) of fair value of the products. The VSOE of fair value for upcoming new products are based on the price determined +by management having the relevant authority when the element is not yet sold separately, but is expected to be sold in the near future at the price set by management. 54 Table of Contents PART II Item 8 Software updates that will be provided free of charge are evaluated on a case-by-case basis to +determine whether they meet the definition of an upgrade and create a multiple element arrangement, which may require revenue to be deferred and recognized when the upgrade is delivered, or if it is determined that implied post-contract customer +support (“PCS”) is being provided, the arrangement is accounted for as a multiple element arrangement and all revenue from the arrangement is deferred and recognized over the implied PCS term when the VSOE of fair value does not exist. If +updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Windows 8.1 will enable new hardware, further the integration with other Microsoft services and fix some of +the customer issues with Windows 8, and will be provided to Windows 8 customers when available at no additional charge. We evaluated Windows 8.1 and determined that it did not meet the definition of an upgrade and thus have not deferred revenue +related to this planned release. Certain volume licensing arrangements include a perpetual license for current products combined with +rights to receive unspecified future versions of software products (“Software Assurance”), which we have determined are additional software products and are therefore accounted for as subscriptions, with billings recorded as unearned +revenue and recognized as revenue ratably over the coverage period. Arrangements that include term based licenses for current products with the right to use unspecified future versions of the software during the coverage period, are also accounted +for as subscriptions, with revenue recognized ratably over the coverage period. Revenue from cloud-based services arrangements that +allow for the use of a hosted software product or service over a contractually determined period of time without taking possession of software are accounted for as subscriptions with billings recorded as unearned revenue and recognized as revenue +ratably over the coverage period beginning on the date the service is made available to customers. Revenue from cloud-based services arrangements that are provided on a consumption basis (for example, the amount of storage used in a particular +period) is recognized commensurate with the customer utilization of such resources. Some volume licensing arrangements include +time-based subscriptions for cloud-based services and software offerings that are accounted for as subscriptions. These arrangements are considered multiple element arrangements. However, because all elements are accounted for as subscriptions and +have the same coverage period and delivery pattern, they have the same revenue recognition timing. Revenue related to Surface, our Xbox +360 gaming and entertainment console, Kinect for Xbox 360, games published by us, and other hardware components is generally recognized when ownership is transferred to the resellers or end customers when selling directly through Microsoft Stores. +Revenue related to games published by third parties for use on the Xbox 360 platform is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has +been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price +services arrangements is recognized as services are provided. Revenue from prepaid points redeemable for the purchase of software or services is recognized upon redemption of the points and delivery of the software or services. Cost of Revenue Cost of revenue includes: +manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to +our websites, and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation +adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs. Capitalized research and development costs are amortized over the estimated lives of the products. 55 Table of Contents PART II Item 8 Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on +historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in +which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of +the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and +development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and +programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development +expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and +amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated +with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $2.6 billion, $1.6 billion, and $1.9 billion in fiscal years +2013, 2012, and 2011, respectively. Stock-Based Compensation We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense, net of estimated forfeitures, over the vesting or service period, as applicable, of the +stock award (generally four to five years) using the straight-line method. Employee Stock Purchase Plan Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value of the stock on the last day of +each three-month period. Compensation expense for the employee stock purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes +U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested, and interest and penalties on uncertain tax positions. Certain income and expenses are +not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not +that a tax benefit will not be realized. The deferred income taxes are classified as current or long-term based on the classification of the related asset or liability. 56 Table of Contents PART II Item 8 Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the +market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and +forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, mortgage-backed securities, U.S. agency securities, certificates of deposit, and foreign government bonds. +Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets primarily comprise investments in certain corporate bonds and +goodwill when it is recorded at fair value due to an impairment charge. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, and +volatilities. In certain cases, market-based observable inputs are not available and we use management judgment to develop assumptions to determine fair value for these derivatives. Unobservable inputs used in all of these models are significant to +the fair values of the assets and liabilities. We measure certain assets, including our cost and equity method +investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include +quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values. Financial Instruments We consider all +highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original +maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and +because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the +specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and +other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the 57 Table of Contents PART II Item 8 specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for +more than one year or are not publicly traded are recorded at cost or using the equity method. We lend certain fixed-income and equity +securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon +the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by +management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we +evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the +investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to +the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, +an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. Derivative +instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair-value hedges, the gains (losses) are recognized in earnings in the periods of change together with +the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair-value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as cash-flow hedges, the effective portion of the gains (losses) on the derivatives is initially +reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge +effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income +(expense). Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are +recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense). 58 Table of Contents PART II Item 8 Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and +other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2013 2012 2011 Balance, beginning of period $ 389 $ 333 $ 375 Charged to costs and other 4 115 14 Write-offs (57 ) (59 ) (56 ) Balance, end of period $ 336 $ 389 $ 333 Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related +to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below +carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset +or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three years; computer equipment, two to three years; buildings and improvements, five to +15 years; leasehold improvements, two to 10 years; and furniture and equipment, one to five years. Land is not depreciated. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 +for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our intangible assets are subject to amortization and are amortized +using the straight-line method over their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates +of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Recently adopted accounting guidance In September 2011, the Financial Accounting Standards +Board (“FASB”) issued guidance on testing goodwill for impairment. The new guidance provides an entity the option to first perform a qualitative assessment to determine whether it is more likely than not that the fair value of a reporting +unit is less than its carrying amount. If an entity determines that this is the case, it is required to perform the two-step goodwill impairment test to identify potential goodwill impairment and measure the amount of goodwill impairment loss to be +recognized for that reporting unit (if any). If an entity determines that the fair value of a reporting unit is greater than its carrying amount, the two-step goodwill impairment test is not required. We adopted this new guidance beginning +July 1, 2012. Adoption of this new guidance did not have a material impact on our financial statements. 59 Table of Contents PART II Item 8 In June 2011, the FASB issued guidance on presentation of comprehensive income. The new +guidance eliminated the option to report OCI and its components in the statement of changes in stockholders’ equity. Instead, an entity is required to present either a continuous statement of net income and OCI or in two separate but +consecutive statements. We adopted this new guidance beginning July 1, 2012. Adoption of this new guidance resulted only in changes to presentation of our financial statements. Recent accounting guidance not yet adopted In December 2011, the FASB issued guidance +enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments and derivative instruments. The new guidance requires the disclosure of the gross amounts +subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, including bifurcated +embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset or subject to an enforceable master netting arrangement, or similar agreements. The +new guidance will be effective for us beginning July 1, 2013. Other than requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption. In February 2013, the FASB issued guidance on disclosure requirements for items reclassified out of AOCI. This new guidance requires entities to +present (either on the face of the income statement or in the notes) the effects on the line items of the income statement for amounts reclassified out of AOCI. The new guidance will be effective for us beginning July 1, 2013. Other than +requiring additional disclosures, we do not anticipate material impacts on our financial statements upon adoption. In March 2013, the +FASB issued guidance on a parent’s accounting for the cumulative translation adjustment upon derecognition of a subsidiary or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative +translation adjustment into net income only if the sale or transfer results in the complete or substantially complete liquidation of the foreign entity in which the subsidiary or group of assets had resided. The new guidance will be effective for us +beginning July 1, 2014. We do not anticipate material impacts on our financial statements upon adoption. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock +outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive +potential common shares include outstanding stock options, stock awards, and shared performance stock awards. The components of basic +and diluted EPS are as follows: (In millions, except earnings per share) Year Ended June 30, 2013 2012 2011 Net income available for common shareholders (A) $ 21,863 $ 16,978 $ 23,150 Weighted average outstanding shares of common stock (B) 8,375 8,396 8,490 Dilutive effect of stock-based awards 95 110 103 Common stock and common stock equivalents (C) 8,470 8,506 8,593 Earnings Per Share Basic (A/B) $ 2.61 $ 2.02 $ 2.73 Diluted (A/C) $ 2.58 $ 2.00 $ 2.69 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods +presented. 60 Table of Contents PART II Item 8 NOTE 3 — OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Dividends and interest income $ 677 $ 800 $ 900 Interest expense (429 ) (380 ) (295 ) Net recognized gains on investments 116 564 439 Net losses on derivatives (196 ) (364 ) (77 ) Net losses on foreign currency remeasurements (74 ) (117 ) (26 ) Other 194 1 (31 ) Total $ 288 $ 504 $ 910 Following are details of net recognized gains (losses) on investments during the periods reported: (In millions) Year Ended June 30, 2013 2012 2011 Other-than-temporary impairments of investments $ (208 ) $ (298 ) $ (80 ) Realized gains from sales of available-for-sale securities 489 1,418 734 Realized losses from sales of available-for-sale securities (165 ) (556 ) (215 ) Total $ 116 $ 564 $ 439 NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2013 Cash $ 1,967 $ 0 $ 0 $ 1,967 $ 1,967 $ 0 $ 0 Mutual funds 868 0 0 868 868 0 0 Commercial paper 603 0 0 603 214 389 0 Certificates of deposit 994 0 0 994 609 385 0 U.S. government and agency securities 64,934 47 (84 ) 64,897 146 64,751 0 Foreign government bonds 900 16 (41 ) 875 0 875 0 Mortgage-backed securities 1,258 43 (13 ) 1,288 0 1,288 0 Corporate notes and bonds 4,993 169 (40 ) 5,122 0 5,122 0 Municipal securities 350 36 (1 ) 385 0 385 0 Common and preferred stock 6,931 2,938 (281 ) 9,588 0 0 9,588 Other investments 1,279 0 0 1,279 0 23 1,256 Total $ 85,077 $ 3,249 $ (460 ) $ 87,866 $ 3,804 $ 73,218 $ 10,844 61 Table of Contents PART II Item 8 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2012 Cash $ 2,019 $ 0 $ 0 $ 2,019 $ 2,019 $ 0 $ 0 Mutual funds 820 0 0 820 820 0 0 Commercial paper 96 0 0 96 96 0 0 Certificates of deposit 744 0 0 744 342 402 0 U.S. government and agency securities 47,178 130 (2 ) 47,306 561 46,745 0 Foreign government bonds 1,741 18 (29 ) 1,730 575 1,155 0 Mortgage-backed securities 1,816 82 (2 ) 1,896 0 1,896 0 Corporate notes and bonds 7,799 224 (15 ) 8,008 2,525 5,483 0 Municipal securities 358 58 (0 ) 416 0 416 0 Common and preferred stock 6,965 2,204 (436 ) 8,733 0 0 8,733 Other investments 1,048 0 0 1,048 0 5 1,043 Total $ 70,584 $ 2,716 $ (484 ) $ 72,816 $ 6,938 $ 56,102 $ 9,776 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2013 U.S. government and agency securities $ 2,208 $ (84 ) $ 0 $ 0 $ 2,208 $ (84 ) Foreign government bonds 589 (18 ) 69 (23 ) 658 (41 ) Mortgage-backed securities 357 (12 ) 39 (1 ) 396 (13 ) Corporate notes and bonds 1,142 (38 ) 27 (2 ) 1,169 (40 ) Municipal securities 44 (1 ) 0 0 44 (1 ) Common and preferred stock 1,166 (168 ) 409 (113 ) 1,575 (281 ) Total $ 5,506 $ (321 ) $ 544 $ (139 ) $ 6,050 $ (460 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2012 U.S. government and agency securities $ 44 $ (2 ) $ 0 $ 0 $ 44 $ (2 ) Foreign government bonds 657 (27 ) 12 (2 ) 669 (29 ) Mortgage-backed securities 53 0 48 (2 ) 101 (2 ) Corporate notes and bonds 640 (11 ) 70 (4 ) 710 (15 ) Common and preferred stock 2,135 (329 ) 305 (107 ) 2,440 (436 ) Total $ 3,529 $ (369 ) $ 435 $ (115 ) $ 3,964 $ (484 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized +losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of +June 30, 2013. 62 Table of Contents PART II Item 8 At June 30, 2013 and 2012, the recorded bases of common and preferred stock and other +investments that are restricted for more than one year or are not publicly traded were $395 million and $313 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. +It is not practicable for us to reliably estimate the fair value of these investments. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2013 Due in one year or less $ 26,386 $ 26,412 Due after one year through five years 42,343 42,400 Due after five years through 10 years 3,293 3,303 Due after 10 years 2,010 2,049 Total $ 74,032 $ 74,164 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to +enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented +below are measured in U.S. dollar equivalents. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge +positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese +yen, British pound, and Canadian dollar. As of June 30, 2013 and June 30, 2012, the total notional amounts of these foreign exchange contracts sold were $5.1 billion and $6.7 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are +designated as fair value hedging instruments. As of June 30, 2013 and June 30, 2012, the total notional amounts of these foreign exchange contracts sold were $407 million and $1.3 billion, respectively. Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts +receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of June 30, 2013, the total notional amounts of these foreign exchange contracts purchased and sold were $5.0 billion and $7.9 billion, +respectively. As of June 30, 2012, the total notional amounts of these foreign exchange contracts purchased and sold were $3.6 billion and $7.3 billion, respectively. Equity Securities held in our equity and other investments portfolio are subject to market +price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, +to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2013, the total notional amounts of designated and non-designated equity contracts 63 Table of Contents PART II Item 8 purchased and sold were $898 million and $1.0 billion, respectively. As of June 30, 2012, the total notional amounts of designated and non-designated equity contracts purchased and sold were +$1.4 billion and $982 million, respectively. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that +correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2013, the total +notional amounts of fixed-interest rate contracts purchased and sold were $1.1 billion and $809 million, respectively. As of June 30, 2012, the total notional amounts of fixed-interest rate contracts purchased and sold were $3.2 billion and +$1.9 billion, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to +gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2013 and 2012, the +total notional derivative amounts of mortgage contracts purchased were $1.2 billion and $1.1 billion, respectively. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not +designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or +groups of credit risks. As of June 30, 2013, the total notional amounts of credit contracts purchased and sold were $377 million and $501 million, respectively. As of June 30, 2012, the total notional amounts of credit contracts purchased +and sold were $318 million and $456 million, respectively. Commodity We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and +manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As +of June 30, 2013, the total notional amounts of commodity contracts purchased and sold were $1.2 billion and $249 million, respectively. As of June 30, 2012, the total notional amounts of commodity contracts purchased and sold were $1.5 +billion and $445 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured +debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to +over-the-counter derivatives. As of June 30, 2013, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. 64 Table of Contents PART II Item 8 Fair Values of Derivative Instruments The following tables present the gross fair values of derivative instruments designated as hedging instruments (“designated hedge +derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists +and fair value adjustments related to our own credit risk and counterparty credit risk: (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2013 Assets Non-designated hedge derivatives: Short-term investments $ 41 $ 157 $ 18 $ 19 $ 3 $ 238 Other current assets 87 0 0 0 0 87 Total $ 128 $ 157 $ 18 $ 19 $ 3 $ 325 Designated hedge derivatives: Short-term investments $ 9 $ 0 $ 0 $ 0 $ 0 $ 9 Other current assets 167 0 0 0 0 167 Total $ 176 $ 0 $ 0 $ 0 $ 0 $ 176 Total assets $ 304 $ 157 $ 18 $ 19 $ 3 $ 501 Liabilities Non-designated hedge derivatives: Other current liabilities $ (63 ) $ (9 ) $ (45 ) $ (17 ) $ (1 ) $ (135 ) Designated hedge derivatives: Other current liabilities $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 Total liabilities $ (63 ) $ (9 ) $ (45 ) $ (17 ) $ (1 ) $ (135 ) (In millions) Foreign Exchange Contracts Equity Contracts Interest Rate Contracts Credit Contracts Commodity Contracts Total Derivatives June 30, 2012 Assets Non-designated hedge derivatives: Short-term investments $ 14 $ 162 $ 10 $ 26 $ 3 $ 215 Other current assets 85 0 0 0 0 85 Total $ 99 $ 162 $ 10 $ 26 $ 3 $ 300 Designated hedge derivatives: Short-term investments $ 6 $ 0 $ 0 $ 0 $ 0 $ 6 Other current assets 177 0 0 0 0 177 Total $ 183 $ 0 $ 0 $ 0 $ 0 $ 183 Total assets $ 282 $ 162 $ 10 $ 26 $ 3 $ 483 Liabilities Non-designated hedge derivatives: Other current liabilities $ (84 ) $ (19 ) $ (17 ) $ (21 ) $ 0 $ (141 ) Designated hedge derivatives: Other current liabilities $ (14 ) $ 0 $ 0 $ 0 $ 0 $ (14 ) Total liabilities $ (98 ) $ (19 ) $ (17 ) $ (21 ) $ 0 $ (155 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. 65 Table of Contents PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense) the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2013 2012 2011 Foreign Exchange Contracts Derivatives $ 70 $ 52 $ (92 ) Hedged items (69 ) (50 ) 85 Total $ 1 $ 2 $ (7 ) Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented): (In millions) Year Ended June 30, 2013 2012 2011 Effective Portion Gains (losses) recognized in OCI, net of tax effects of $54 , $127 and $(340) $ 101 $ 236 $ (632 ) Gains (losses) reclassified from AOCI into revenue $ 195 $ (27 ) $ (7 ) Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense) $ (168 ) $ (231 ) $ (276 ) We estimate that $95 million of net derivative gains +included in AOCI at June 30, 2013 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur +during fiscal year 2013. Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). These amounts are shown in the table below, with the exception of +gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the periods presented. Other than those derivatives entered into for investment purposes, such as commodity +contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities. (In millions) Year Ended June 30, 2013 2012 2011 Foreign exchange contracts $ 18 $ (119 ) $ (27 ) Equity contracts 16 (85 ) 35 Interest-rate contracts (11 ) 93 19 Credit contracts (3 ) (7 ) 24 Commodity contracts (42 ) (121 ) 148 Total $ (22 ) $ (239 ) $ 199 66 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2013 Assets Mutual funds $ 868 $ 0 $ 0 $ 868 $ 0 $ 868 Commercial paper 0 603 0 603 0 603 Certificates of deposit 0 994 0 994 0 994 U.S. government and agency securities 62,237 2,664 0 64,901 0 64,901 Foreign government bonds 9 851 0 860 0 860 Mortgage-backed securities 0 1,311 0 1,311 0 1,311 Corporate notes and bonds 0 4,915 19 4,934 0 4,934 Municipal securities 0 385 0 385 0 385 Common and preferred stock 8,470 717 5 9,192 0 9,192 Derivatives 12 489 0 501 (81 ) 420 Total $ 71,596 $ 12,929 $ 24 $ 84,549 $ (81 ) $ 84,468 Liabilities Derivatives and other $ 14 $ 121 $ 0 $ 135 $ (80 ) $ 55 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2012 Assets Mutual funds $ 820 $ 0 $ 0 $ 820 $ 0 $ 820 Commercial paper 0 96 0 96 0 96 Certificates of deposit 0 744 0 744 0 744 U.S. government and agency securities 42,291 5,019 0 47,310 0 47,310 Foreign government bonds 31 1,703 0 1,734 0 1,734 Mortgage-backed securities 0 1,892 0 1,892 0 1,892 Corporate notes and bonds 0 7,839 9 7,848 0 7,848 Municipal securities 0 416 0 416 0 416 Common and preferred stock 7,539 877 5 8,421 0 8,421 Derivatives 16 467 0 483 (141 ) 342 Total $ 50,697 $ 19,053 $ 14 $ 69,764 $ (141 ) $ 69,623 Liabilities Derivatives and other $ 10 $ 145 $ 0 $ 155 $ (139 ) $ 16 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. The changes in our Level 3 +financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented. 67 Table of Contents PART II Item 8 The following table reconciles the total Net Fair Value of assets above to the balance sheet +presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2013 2012 Net fair value of assets measured at fair value on a recurring basis $ 84,468 $ 69,623 Cash 1,967 2,019 Common and preferred stock measured at fair value on a nonrecurring basis 395 313 Other investments measured at fair value on a nonrecurring basis 1,256 1,043 Less derivative net assets classified as other current assets (213 ) (185 ) Other (7 ) 3 Recorded basis of investment components $ 87,866 $ 72,816 Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal year 2013 and 2012, we did not record any material other-than-temporary impairments on financial assets required to be measured at +fair value on a nonrecurring basis. NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2013 2012 Raw materials $ 328 $ 210 Work in process 201 96 Finished goods 1,409 831 Total $ 1,938 $ 1,137 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2013 2012 Land $ 525 $ 528 Buildings and improvements 7,326 6,768 Leasehold improvements 2,946 2,550 Computer equipment and software 9,242 7,298 Furniture and equipment 2,465 2,087 Total, at cost 22,504 19,231 Accumulated depreciation (12,513 ) (10,962 ) Total, net $ 9,991 $ 8,269 During fiscal years 2013, 2012, and 2011, depreciation expense was $2.6 billion, $2.2 billion, and $2.0 billion, +respectively. 68 Table of Contents PART II Item 8 NOTE 9 — BUSINESS COMBINATIONS Yammer On July 18, +2012, we acquired Yammer, Inc. (“Yammer”), a leading provider of enterprise social networks, for $1.1 billion in cash. Yammer will continue to develop its standalone service and will add an enterprise social networking service to +Microsoft’s portfolio of complementary cloud-based services. The major classes of assets to which we allocated the purchase price were goodwill of $937 million and identifiable intangible assets of $178 million. We assigned the goodwill to the +Microsoft Business Division. Yammer was consolidated into our results of operations starting on the acquisition date. Skype On October 13, 2011, we acquired all of the issued and outstanding shares of Skype Global S.á r.l. (“Skype”), a leading +global provider of software applications and related Internet communications products based in Luxembourg, for $8.6 billion, primarily in cash. The major classes of assets and liabilities to which we allocated the purchase price were goodwill of +$7.1 billion, identifiable intangible assets of $1.6 billion, and unearned revenue of $222 million. The goodwill recognized in connection with the acquisition is primarily attributable to our expectation of extending Skype’s brand and the reach +of its networked platform, while enhancing Microsoft’s existing portfolio of real-time communications products and services. We assigned the goodwill to the following segments: $4.2 billion to Entertainment and Devices Division, $2.8 billion to +Microsoft Business Division, and $54 million to Online Services Division. Skype was consolidated into our results of operations starting on the acquisition date. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Weighted Average Life Marketing-related (trade names) $ 1,249 15 years Technology-based 275 5 years Customer-related 114 5 years Contract-based 10 4 years Total $ 1,648 13 years Other During fiscal year 2013, we completed 11 additional acquisitions for total consideration of $437 million, all of which was paid in cash. These +entities have been included in our consolidated results of operations since their respective acquisition dates. Pro forma results of +operations have not been presented because the effects of the business combinations described in this Note, individually and in aggregate, were not material to our consolidated results of operations. NOTE 10 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) Balance as of June 30, 2011 Acquisitions Other Balance as of June 30, 2012 Acquisitions Other Balance as of June 30, 2013 Windows Division $ 89 $ 0 $ 0 $ 89 $ 12 $ 0 $ 101 Server and Tools 1,139 7 (2 ) 1,144 217 (3 ) 1,358 Online Services Division 6,373 54 (6,204 ) 223 0 (5 ) 218 Microsoft Business Division 4,167 2,843 (117 ) 6,893 987 (11 ) 7,869 Entertainment and Devices Division 813 4,294 (4 ) 5,103 27 (21 ) 5,109 Total $ 12,581 $ 7,198 $ (6,327 ) $ 13,452 $ 1,243 $ (40 ) $ 14,655 69 Table of Contents PART II Item 8 The measurement periods for purchase price allocations end as soon as information on the facts and +circumstances becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in which the acquisitions occurred. Any change in the goodwill amounts resulting from foreign currency translations are presented as “other” in the above table. Also +included within “other” are business dispositions and transfers between business segments due to reorganizations, as applicable. For fiscal year 2012, a $6.2 billion goodwill impairment charge was included in “other,” as +discussed further below. This goodwill impairment charge also represented our accumulated goodwill impairment as of June 30, 2013 and 2012. Goodwill Impairment We test goodwill for +impairment annually on May 1 at the reporting unit level using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable +indicator of the fair values of the businesses. No impairment of goodwill was identified as of May 1, 2013. Upon completion of the +fiscal year 2012 test, OSD goodwill was determined to be impaired. The impairment was the result of the OSD unit experiencing slower than projected growth in search queries and search advertising revenue per query, slower growth in display revenue, +and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the future. Because our fiscal year 2012 annual test indicated that OSD’s carrying value exceeded its estimated fair value, a second phase of the goodwill +impairment test (“Step 2”) was performed specific to OSD. Under Step 2, the fair value of all OSD assets and liabilities were estimated, including tangible assets, existing technology, trade names, and partner relationships for the purpose +of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and +liabilities included the discount rates, royalty rates, and obsolescence rates used in valuing the intangible assets, and pricing of comparable transactions in the market in valuing the tangible assets. No other instances of impairment were identified in our May 1, 2012 test. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Year Ended June 30, 2013 2012 Technology-based (a) $ 3,760 $ (2,110 ) $ 1,650 $ 3,550 $ (1,899 ) $ 1,651 Marketing-related 1,348 (211 ) 1,137 1,325 (136 ) 1,189 Contract-based 823 (688 ) 135 824 (644 ) 180 Customer-related 380 (219 ) 161 408 (258 ) 150 Total $ 6,311 $ (3,228 ) $ 3,083 $ 6,107 $ (2,937 ) $ 3,170 (a) Technology-based intangible assets included $218 million and $177 million as of June 30, 2013 and 2012, respectively, of net carrying amount of +software to be sold, leased, or otherwise marketed. We estimate that we have no significant residual value +related to our intangible assets. No material impairments of intangible assets were identified during any of the periods presented. 70 Table of Contents PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2013 2012 Technology-based $ 539 4 years $ 1,548 7 years Marketing-related 39 7 years 1,249 15 years Contract-based 0 115 7 years Customer-related 89 6 years 114 5 years Total $ 667 5 years $ 3,026 10 years Intangible assets amortization expense was $739 million, $558 million, and $537 million for fiscal years 2013, +2012, and 2011, respectively. Amortization of capitalized software was $210 million, $117 million, and $114 million for fiscal years 2013, 2012, and 2011, respectively. The following table outlines the estimated future amortization expense related to intangible assets held at June 30, 2013: (In millions) Year Ending June 30, 2014 $ 645 2015 454 2016 382 2017 281 2018 242 Thereafter 1,079 Total $ 3,083 NOTE 12 — DEBT As of June 30, 2013, the total carrying value and estimated fair value of our long-term debt, including the current +portion, were $15.6 billion and $15.8 billion, respectively. This is compared to a carrying value and estimated fair value of $11.9 billion and $13.2 billion, respectively, as of June 30, 2012. These estimated fair values are based on Level 2 +inputs. 71 Table of Contents PART II Item 8 The components of our long-term debt, including the current portion, and the associated interest +rates were as follows as of June 30, 2013 and 2012: Due Date Face Value June 30, 2013 Face Value June 30, 2012 Stated Interest Rate Effective Interest Rate (In millions) Notes September 27, 2013 $ 1,000 $ 1,000 0.875% 1.000% June 1, 2014 2,000 2,000 2.950% 3.049% September 25, 2015 1,750 1,750 1.625% 1.795% February 8, 2016 750 750 2.500% 2.642% November 15, +2017 (a) 600 * 0.875% 1.084% May 1, +2018 (b) 450 * 1.000% 1.106% June 1, 2019 1,000 1,000 4.200% 4.379% October 1, 2020 1,000 1,000 3.000% 3.137% February 8, 2021 500 500 4.000% 4.082% November 15, +2022 (a) 750 * 2.125% 2.239% May 1, +2023 (b) 1,000 * 2.375% 2.465% May 2, +2033 (c) 715 * 2.625% 2.690% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, +2042 (a) 900 * 3.500% 3.571% May 1, +2043 (b) 500 * 3.750% 3.829% Total 15,665 10,750 Convertible Debt June 15, 2013 0 1,250 0.000% 1.849% Total $ 15,665 $ 12,000 (a) In November 2012, we issued $2.25 billion of debt securities. (b) In April 2013, we issued $1.95 billion of debt securities. (c) In April 2013, we issued € 550 million +of debt securities. * Not applicable. As +of June 30, 2013 and 2012, the aggregate unamortized discount for our long-term debt, including the current portion, was $65 million and $56 million, respectively. Notes The Notes are senior unsecured obligations and rank equally with our other unsecured +and unsubordinated debt outstanding. Convertible Debt In June 2013, we paid cash of $1.25 billion for the principal amount of our zero coupon convertible unsecured debt and elected to deliver cash for the $96 million excess obligation resulting from the conversion of +the notes. Each $1,000 principal amount of notes was convertible into 30.68 shares of Microsoft common stock at a conversion price of $32.59 per share. As of June 30, 2012, the net carrying amount of the convertible debt and the unamortized +discount were $1.2 billion and $19 million, respectively. In connection with the issuance of the notes in 2010, we entered into capped +call transactions with certain option counterparties with a strike price equal to the conversion price of the notes. Upon conversion of the notes in June 72 Table of Contents PART II Item 8 2013, we exercised the capped calls. The bulk of the capped calls were physically settled by acquiring 29 million shares of our own common stock for $938 million. The remaining capped calls +were net cash settled for $24 million. Debt Service Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2014 $ 3,000 2015 0 2016 2,500 2017 0 2018 1,050 Thereafter 9,115 Total $ 15,665 Interest on the notes is paid semi-annually, except for the euro-denominated debt securities on which interest is +paid annually. Cash paid for interest on our debt for fiscal years 2013, 2012, and 2011 was $371 million, $344 million, and $197 million, respectively. Credit Facility In June 2013, we +established a commercial paper program for the issuance and sale of up to $1.3 billion in commercial paper. As of June 30, 2013, we have not issued any commercial paper under this program. In June 2013, we entered into a $1.3 billion credit facility, which will serve as a back-up for our commercial paper program. As of June 30, +2013, we were in compliance with the only financial covenant in the credit agreement, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as +defined in the credit agreement. The credit facility expires on June 24, 2018. No amounts were drawn against the credit facility since its inception. NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Current Taxes U.S. federal $ 3,131 $ 2,235 $ 3,108 U.S. state and local 332 153 209 International 1,745 1,947 1,602 Current taxes 5,208 4,335 4,919 Deferred Taxes Deferred taxes (19 ) 954 2 Provision for income taxes $ 5,189 $ 5,289 $ 4,921 73 Table of Contents PART II Item 8 U.S. and international components of income before income taxes were as follows: (In millions) Year Ended June 30, 2013 2012 2011 U.S. $ 6,674 $ 1,600 $ 8,862 International 20,378 20,667 19,209 Income before income taxes $ 27,052 $ 22,267 $ 28,071 The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our +effective rate were as follows: Year Ended June 30, 2013 2012 2011 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (17.5)% (21.1)% (15.6)% Goodwill impairment 0% 9.7% 0% I.R.S. settlement 0% 0% (1.7)% Other reconciling items, net 1.7% 0.2% (0.2)% Effective rate 19.2% 23.8% 17.5% The reduction from the federal statutory rate from foreign earnings taxed at lower rates results from producing and +distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Our foreign earnings, which are taxed at rates lower than the U.S. rate and are generated from our regional operating +centers, were 79%, 79%, and 78% of our international income before tax in fiscal years 2013, 2012, and 2011, respectively. In general, other reconciling items consist of interest, U.S. state income taxes, domestic production deductions, and credits. +In fiscal years 2013, 2012, and 2011, there were no individually significant other reconciling items. The I.R.S. settlement is discussed below. 74 Table of Contents PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2013 2012 Deferred Income Tax Assets Stock-based compensation expense $ 888 $ 882 Other expense items 917 965 Unearned revenue 445 571 Impaired investments 246 152 Loss carryforwards 715 532 Other revenue items 55 79 Deferred income tax assets $ 3,266 $ 3,181 Less valuation allowance (579 ) (453 ) Deferred income tax assets, net of valuation allowance $ 2,687 $ 2,728 Deferred Income Tax Liabilities International earnings $ (1,146 ) $ (1,072 ) Unrealized gain on investments (1,012 ) (830 ) Depreciation and amortization (604 ) (670 ) Other (2 ) (14 ) Deferred income tax liabilities $ (2,764 ) $ (2,586 ) Net deferred income tax assets (liabilities) $ (77 ) $ 142 Reported As Current deferred income tax assets $ 1,632 $ 2,035 Long-term deferred income tax liabilities (1,709 ) (1,893 ) Net deferred income tax assets (liabilities) $ (77 ) $ 142 As of June 30, 2013, we had net operating loss carryforwards of $2.7 billion, including $2.2 billion of +foreign net operating loss carryforwards acquired through our acquisition of Skype. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards that may not be realized. Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax +bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. As of June 30, +2013, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $76.4 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the U.S. +The unrecognized deferred tax liability associated with these temporary differences was approximately $24.4 billion at June 30, 2013. Income taxes paid were $3.9 billion, $3.5 billion, and $5.3 billion in fiscal years 2013, 2012, and 2011, respectively. Uncertain Tax Positions As of June 30, 2013, we had $8.6 billion of unrecognized tax +benefits of which $6.5 billion, if recognized, would affect our effective tax rate. As of June 30, 2012, we had $7.2 billion of unrecognized tax benefits of which $6.2 billion, if recognized, would have affected our effective tax rate. Interest on unrecognized tax benefits was $400 million, $154 million, and $38 million in fiscal years 2013, 2012, and 2011, +respectively. As of June 30, 2013, 2012, and 2011, we had accrued interest related to uncertain tax positions of $1.3 billion, $939 million, and $785 million, respectively, net of federal income tax benefits. 75 Table of Contents PART II Item 8 The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Balance, beginning of year $ 7,202 $ 6,935 $ 6,542 Decreases related to settlements (30 ) (16 ) (632 ) Increases for tax positions related to the current year 612 481 739 Increases for tax positions related to prior years 931 118 405 Decreases for tax positions related to prior years (65 ) (292 ) (119 ) Decreases due to lapsed statutes of limitations (2 ) (24 ) 0 Balance, end of year $ 8,648 $ 7,202 $ 6,935 During the third quarter of fiscal year 2011, we reached a settlement of a portion of an I.R.S. audit of tax years +2004 to 2006, which reduced our income tax expense by $461 million. While we settled a portion of the I.R.S. audit, we remain under audit for these years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit +phase of the examination. As of June 30, 2013, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our financial statements if not resolved favorably. We believe our allowances for tax +contingencies are appropriate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, because we do not believe the remaining open issues will +be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2012. We are +subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2012, some of which are currently under audit by local tax authorities. The resolutions of these +audits are not expected to be material to our financial statements. NOTE 14 — UNEARNED REVENUE Unearned revenue comprises mainly unearned revenue from volume licensing programs, and payments for offerings for which we have +been paid in advance and we earn the revenue when we provide the service or software or otherwise meet the revenue recognition criteria. Volume +Licensing Programs Unearned revenue from volume licensing programs represents customer billings for multi-year licensing +arrangements paid either at inception of the agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Other Also included in unearned revenue +are payments for post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; OEM minimum commitments; Microsoft Dynamics business solutions products; Skype prepaid credits and +subscriptions; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. 76 Table of Contents PART II Item 8 The components of unearned revenue were as follows: (In millions) June 30, 2013 2012 Volume licensing programs $ 18,871 $ 16,717 Other (a) 3,528 3,342 Total $ 22,399 $ 20,059 (a) Other as of June 30, 2012 included $540 million of unearned revenue associated with sales of Windows 7 with an option to upgrade to Windows 8 Pro at a +discounted price (the “Windows Upgrade Offer”). Unearned revenue by segment was as follows: (In millions) June 30, 2013 2012 Windows Division $ 2,086 $ 2,444 Server and Tools 8,639 7,445 Microsoft Business Division 10,142 9,015 Other segments 1,532 1,155 Total $ 22,399 $ 20,059 NOTE 15 — OTHER LONG-TERM LIABILITIES (In millions) June 30, 2013 2012 Tax contingencies and other tax liabilities $ 9,548 $ 7,634 Legal contingencies 162 220 Other 290 354 Total $ 10,000 $ 8,208 NOTE 16 — COMMITMENTS AND GUARANTEES Construction and Operating Leases We have committed $694 million for constructing new buildings, building improvements, and leasehold improvements as of June 30, 2013. We have operating leases for most U.S. and international sales and support offices and certain equipment. Rental expense for facilities operating leases was $711 million, $639 million, and $525 million, in fiscal +years 2013, 2012, and 2011, respectively. Future minimum rental commitments under non-cancellable facilities operating leases in place as of June 30, 2013 are as follows: (In millions) Year Ending June 30, 2014 $ 572 2015 451 2016 349 2017 281 2018 204 Thereafter 605 Total $ 2,462 77 Table of Contents PART II Item 8 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered +significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our financial statements. NOTE 17 — CONTINGENCIES Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC +operating system and certain other software products between 1999 and 2005. We obtained dismissals or reached settlements of all claims made in the United States. All settlements in the United States have received final court approval. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of +platform-neutral computer hardware and software. The total value of vouchers we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on +the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. The maximum value of vouchers to be issued is approximately $2.7 billion. The actual costs of these +settlements will be less than that maximum amount, depending on the number of class members and schools that are issued and redeem vouchers. We estimate the total cost to resolve all of the state overcharge class action cases will range between $1.9 +billion and $2.0 billion. At June 30, 2013, we have recorded a liability related to these claims of approximately $500 million, which reflects our estimated exposure of $1.9 billion less payments made to date of approximately $1.4 billion +mostly for vouchers, legal fees, and administrative expenses. The three cases pending in British Columbia, Ontario, and Quebec, Canada +have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. In April 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that +indirect purchasers do not have a claim. The plaintiffs have filed an appeal to the Canadian Supreme Court, which was heard in the fall of 2012. The other two actions have been stayed. Other Antitrust Litigation and Claims In November 2004, Novell, Inc. (“Novell”) +filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity +applications during the period between June 1994 and March 1996. In June 2005, the trial court granted our motion to dismiss four of Novell’s six claims. In March 2010, the trial court granted summary judgment in favor of Microsoft as to +all remaining claims. The court of appeals reversed that ruling as to one claim. Trial of that claim took place from October to December 2011 and resulted in a mistrial because the jury was unable to reach a verdict. In July 2012, the trial court +granted Microsoft’s motion for judgment as a matter of law. Novell has appealed this decision to the U.S. Court of Appeals for the Tenth Circuit, which heard oral arguments in May 2013. Patent and Intellectual Property Claims Motorola Litigation In October 2010, Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade +Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents 78 Table of Contents PART II Item 8 by Motorola’s Android devices. Since then, Microsoft and Motorola have filed additional claims against each other in the ITC, in federal district courts in Seattle, Wisconsin, Florida, and +California, and in courts in Germany and the United Kingdom. In April 2012, following complaints by Microsoft and Apple, the European Union’s competition office opened two antitrust investigations against Motorola to determine whether it has +abused certain of its standard essential patents to distort competition in breach of European Union antitrust rules. In June 2012, we received a request for information from the U.S. Federal Trade Commission (“FTC”) apparently related to +an FTC investigation into whether Motorola’s conduct violates U.S. law. The nature of the claims asserted and status of individual matters are summarized below. International Trade Commission The hearing in Microsoft’s ITC case against Motorola took +place in August 2011 on seven of the nine patents originally asserted in the complaint. In December 2011, the administrative law judge (“ALJ”) issued an initial determination that Motorola infringed one Microsoft patent, and recommended +that the ITC issue a limited exclusion order against Motorola prohibiting importation of infringing Motorola Android devices. In May 2012, the ITC issued the limited exclusion order recommended by the ALJ, which became effective on July 18, +2012. Microsoft has appealed certain aspects of the ITC ruling adverse to Microsoft and Motorola has appealed the ITC exclusion order to the Court of Appeals for the Federal Circuit. In addition, in July 2013, Microsoft filed an action in U.S. +district court in Washington, D.C. seeking an order to compel enforcement of the ITC’s May 2012 import ban against infringing Motorola products by the Bureau of Customs and Border Protection (“CBP”), after learning that CBP had failed +to fully enforce the order. In November 2010, Motorola filed an action against Microsoft in the ITC alleging infringement of five +Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing Xbox products into the U.S. In April 2012, the ALJ found that Xbox products infringe four of the five patents +asserted by Motorola. The ALJ recommended that the ITC issue a limited exclusion order and a cease and desist order. Both Microsoft and Motorola sought ITC review of the ALJ’s findings. In June 2012, Microsoft filed a motion to terminate the +investigation as to certain patents based on facts arising as the result of Google’s acquisition of Motorola. The ITC determined that it would review the ALJ’s initial determination in its entirety and remanded the matter to the ALJ +(1) to apply certain ITC case precedent, (2) to rule on Microsoft’s June 2012 motion to terminate, and (3) set a new target date for completion of the investigation. The ALJ held a hearing in December 2012 and set a target +date for a final ITC ruling in July 2013. At Motorola’s request, the ITC terminated its investigation as to four Motorola patents, leaving only one Motorola patent at issue before the ITC. In March 2013, the ALJ ruled that there has been no +violation as to the remaining Motorola patent. Motorola sought ITC review of the ALJ’s determination, which the ITC denied in May 2013. U.S. +District Court The Seattle District Court case filed in October 2010 by Microsoft as a companion to Microsoft’s ITC case +against Motorola has been stayed pending the outcome of Microsoft’s ITC case. In November 2010, Microsoft sued Motorola for breach +of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory (“RAND”) terms and conditions. +Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In suits described below, Motorola or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District +Courts, in the ITC, and in Germany. In February 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that (1) Motorola entered into binding contractual commitments with standards organizations +committing to license its declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. The court rejected Motorola’s argument that Microsoft had repudiated its right to a +RAND license, and ruled a trial is needed to determine whether Motorola is in breach of its obligation to enter into a patent license with Microsoft and, if so, the amount of the RAND royalty. In April 2012, the court issued a temporary restraining +order preventing Motorola from taking steps to enforce an injunction in Germany relating to the H.264 video patents. In May 2012, the court converted that order into a preliminary injunction. Motorola appealed the court’s injunction 79 Table of Contents PART II Item 8 orders to the Court of Appeals for the Ninth Circuit, which affirmed the orders in September 2012. The Seattle District Court held a trial in November 2012 to determine the RAND royalty for +Motorola’s H.264 and 802.11 patents. In December 2012, the Seattle District Court ruled that Motorola could not obtain injunctive relief in connection with any of its claims for infringement of its H.264 and 802.11 patents. In April 2013, the +court set per unit royalties for Motorola’s H.264 and 802.11 patents, which resulted in an immaterial Microsoft liability. Trial of Microsoft’s breach of contract claim is set for August 26, 2013. Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one currently stayed case in Wisconsin (a companion case to +Motorola’s ITC action), have been transferred to the U.S District Court in Seattle. Motorola and Microsoft both seek damages as well as injunctive relief. No trial dates have been set in any of the transferred cases, and the court has stayed +these cases on agreement of the parties. • In the transferred cases, Motorola asserts 15 patents are infringed by many Microsoft products including Windows Mobile 6.5 and Windows Phone 7, Windows +Marketplace, Silverlight, Windows Vista and Windows 7, Exchange Server 2003 and later, Exchange ActiveSync, Windows Live Messenger, Lync Server 2010, Outlook 2010, Office 365, SQL Server, Internet Explorer 9, Xbox, and Kinect. • In the Motorola action originally filed in California, Motorola asserts that Microsoft violated antitrust laws in connection with Microsoft’s assertion +of patents against Motorola that Microsoft has agreed to license to certain qualifying entities on RAND terms and conditions. • In counterclaims in the patent actions brought by Motorola, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola +digital video recorders. Germany In July 2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries. • Two of the patents are asserted by Motorola to be essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products +including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. Motorola seeks damages and an injunction. In May 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany. However, +due to orders in the separate litigation pending in Seattle, Washington described above, Motorola is enjoined from taking steps to enforce the German injunction. Damages would be determined in later proceedings. Microsoft has appealed the rulings of +the first instance court. • Motorola asserts one of the patents covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail +Mobile, Exchange Online, Exchange Server, and Hotmail Server. Motorola seeks damages and an injunction. In April 2013, the court stayed the case pending the outcome of parallel proceedings in which Microsoft is seeking to invalidate the patent. • Should an injunction order be issued and enforced by Motorola, Microsoft may be able to mitigate the adverse impact by altering its products to avoid +Motorola’s infringement claims. In lawsuits Microsoft filed in Germany in September, October, and December 2011 +and in April 2012, Microsoft asserts Motorola Android devices infringe Microsoft patents. Microsoft seeks damages and an injunction. In May, July, and September 2012, courts in Germany issued injunctions on three patents against Motorola Android +devices and in May and July ruled against Microsoft on two patents. Microsoft is taking steps to enforce the injunctions. Damages will be determined in later proceedings. Each party has appealed or is expected to appeal the rulings against it. +Motorola is also seeking to invalidate Microsoft’s patents in parallel court proceedings. United Kingdom In December 2011, Microsoft filed an action against Motorola in the High Court of Justice, Chancery Division, Patents Court, in London, England, +seeking to revoke the UK part of the European patent asserted by Motorola in Germany against the ActiveSync protocol. In February 2012, Motorola counterclaimed alleging infringement of the 80 Table of Contents PART II Item 8 patent and seeking damages and an injunction. A trial took place in December 2012, and the court ruled that Motorola’s patent is invalid and revoked. The court also ruled that the patent, +even if valid, would be licensed under the grant-back clause in Google’s ActiveSync license. Motorola has appealed. Other Patent and +Intellectual Property Claims In addition to these cases, there are approximately 65 other patent infringement cases pending against +Microsoft. Other We also are +subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material +adverse impact on our financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2013, we had accrued aggregate liabilities of $412 million in other current liabilities and $162 million in other long-term liabilities for all of our legal matters that were contingencies as of +that date. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $400 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there +exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable. NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Balance, beginning of year 8,381 8,376 8,668 Issued 105 147 155 Repurchased (158 ) (142 ) (447 ) Balance, end of year 8,328 8,381 8,376 Share Repurchases On September 22, 2008, we announced that our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases with an expiration date of September 30, 2013. As +of June 30, 2013, approximately $3.6 billion of the approved repurchase amount remained. The repurchase program may be suspended or discontinued at any time without prior notice. We repurchased the following shares of common stock under the above-described repurchase plan using cash resources: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2013 2012 2011 First quarter 33 $ 1,000 38 $ 1,000 163 $ 4,000 Second quarter 58 1,607 39 1,000 188 5,000 Third quarter 36 1,000 31 1,000 30 827 Fourth quarter 31 1,000 34 1,000 66 1,631 Total 158 $ 4,607 142 $ 4,000 447 $ 11,458 81 Table of Contents PART II Item 8 Dividends In fiscal year 2013, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 18, 2012 $ 0.23 November 15, 2012 $ 1,933 December 13, 2012 November 28, 2012 $ 0.23 February 21, 2013 $ 1,925 March 14, 2013 March 11, 2013 $ 0.23 May 16, 2013 $ 1,921 June 13, 2013 June 12, 2013 $ 0.23 August 15, 2013 $ 1,916 September 12, 2013 The dividend declared on June 12, 2013 will be paid +after the filing date of this report on Form 10-K and was included in other current liabilities as of June 30, 2013. In fiscal +year 2012, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 20, 2011 $ 0.20 November 17, 2011 $ 1,683 December 8, 2011 December 14, 2011 $ 0.20 February 16, 2012 $ 1,683 March 8, 2012 March 13, 2012 $ 0.20 May 17, 2012 $ 1,678 June 14, 2012 June 13, 2012 $ 0.20 August 16, 2012 $ 1,676 September 13, 2012 The dividend declared on June 13, 2012 was included +in other current liabilities as of June 30, 2012. NOTE 19 — OTHER COMPREHENSIVE INCOME (LOSS) The activity in other comprehensive income (loss) and related income tax effects were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Net Unrealized Gains (Losses) on Derivatives Unrealized gains (losses), net of tax effects of $54 , $127, and $(340) $ 101 $ 236 $ (632 ) Reclassification adjustment for losses (gains) included in net income, net of tax effects of $(68) , $10, and $2 (127 ) 19 5 Net unrealized gains (losses) on derivatives $ (26 ) $ 255 $ (627 ) Net Unrealized Gains (Losses) on Investments Unrealized gains (losses), net of tax effects of $244 , $(93), and $726 $ 453 $ (172 ) $ 1,349 Reclassification adjustment for gains included in net income, net of tax effects of $(49) , $(117), and $(159) (90 ) (218 ) (295 ) Net unrealized gains (losses) on investments 363 (390 ) 1,054 Translation adjustments and other, net of tax effects of $(8) , $(165) and $205 (16 ) (306 ) 381 Other comprehensive income (loss) $ 321 $ (441) $ 808 82 Table of Contents PART II Item 8 The components of accumulated other comprehensive income were as follows: (In millions) June 30, 2013 2012 2011 Net unrealized gains (losses) on derivatives $ 66 $ 92 $ (163 ) Net unrealized gains on investments 1,794 1,431 1,821 Translation adjustments and other (117 ) (101 ) 205 Accumulated other comprehensive income $ 1,743 $ 1,422 $ 1,863 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to directors and employees. At June 30, 2013, an aggregate of 425 million shares +were authorized for future grant under our stock plans, covering stock options, stock awards, and leadership stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We +issue new shares of Microsoft common stock to satisfy exercises and vesting of awards granted under all of our stock plans. Stock-based +compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Stock-based compensation expense $ 2,406 $ 2,244 $ 2,166 Income tax benefits related to stock-based compensation $ 842 $ 785 $ 758 Stock Plans (Excluding Stock Options) Stock awards Stock awards +(“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. SAs generally vest over a five-year period. Leadership stock awards Leadership stock +awards (“LSAs”) are a form of SAs in which the number of shares ultimately received depends on our business performance against specified performance metrics. LSAs replaced shared performance stock awards (“SPSA”) in fiscal year +2013. Shares previously issued under the SPSA program will continue to vest ratably under their original term, generally with a three-year remaining service period. A base number of LSAs are granted in each fiscal year, which represents the performance period for the awards. Following the end of the performance period, the number of shares can be increased by 25% if certain +performance metrics are met. One quarter of the awarded shares will vest one year after the grant date. The remaining shares will vest semi-annually during the following three years. Executive incentive plan Under the Executive Incentive Plan (“EIP”), the +Compensation Committee awards performance-based compensation comprising both cash and SAs to executive officers and certain senior executives. For executive officers, their awards are based on an aggregate incentive pool equal to a percentage of +consolidated operating income. For fiscal years 2013, 2012, and 2011, the pool was 0.35%, 0.3%, and 0.25% of operating income, respectively. The SAs vest ratably in August of each of the four years following the grant date. The final cash awards +will be determined after each performance period based on individual and business performance. 83 Table of Contents PART II Item 8 Activity for all stock plans The fair value of each award was estimated on the date of grant using the following assumptions: Year Ended June 30, 2013 2012 2011 Dividends per share (quarterly amounts) $ 0.20 - $  0.23 $ 0.16 - $  0.20 $ 0.13 - $  0.16 Interest rates range 0.6% - 1.1% 0.7% - 1.7% 1.1% - 2.4% During fiscal year 2013, the following activity occurred +under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 281 $ 23.91 Granted 104 $ 28.37 Vested (90 ) $ 24.49 Forfeited (22 ) $ 25.10 Nonvested balance, end of year 273 $ 25.50 As of June 30, 2013, there was approximately $5.0 billion of total unrecognized compensation costs related to +stock awards. These costs are expected to be recognized over a weighted average period of 3 years. During fiscal year 2012 and 2011, +the following activity occurred under our stock plans: (In millions, except fair values) 2012 2011 Stock Awards Awards granted 110 132 Weighted average grant-date fair value $ 24.60 $ 22.22 Total vest-date fair value of stock awards vested was $2.8 +billion, $2.4 billion, and $1.8 billion, for fiscal years 2013, 2012, and 2011, respectively. Stock Options Currently, we grant stock options primarily in conjunction with business acquisitions. We granted two million, six million, and zero stock options +in conjunction with business acquisitions during fiscal years 2013, 2012, and 2011, respectively. Employee stock options activity +during 2013 was as follows: Shares Weighted Average Exercise Price Weighted Average Remaining Contractual Term Aggregate Intrinsic Value (In millions) (Years) (In millions) Balance, July 1, 2012 22 $ 18.69 Granted 2 $ 2.08 Exercised (19 ) $ 19.26 Canceled (1 ) $ 14.71 Balance, June 30, 2013 4 $ 6.88 6.74 $ 98 Exercisable, June 30, 2013 2 $ 8.47 5.79 $ 50 84 Table of Contents PART II Item 8 As of June 30, 2013, approximately four million options that were granted in conjunction +with business acquisitions were outstanding. These options have an exercise price range of $0.01 to $29.24 and a weighted average exercise price of $7.33. During the periods reported, the following stock option exercise activity occurred: (In millions) 2013 2012 2011 Total intrinsic value of stock options exercised $ 197 $ 456 $ 222 Cash received from stock option exercises $ 382 $ 1,410 $ 1,954 Tax benefit realized from stock option exercises $ 69 $ 160 $ 77 Employee Stock Purchase Plan We have an employee stock purchase plan (the “Plan”) for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the +last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2013 2012 2011 Shares purchased 20 20 20 Average price per share $ 26.81 $ 25.03 $ 22.98 At June 30, 2013, 191 million shares of our common stock were reserved for future issuance through the +Plan. Savings Plan We have a +savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 75% of their salary, but not more than +statutory limits. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum contribution of 3% of a participant’s earnings. Matching contributions for all plans were $393 million, $373 million, and $282 +million in fiscal years 2013, 2012, and 2011, respectively, and were expensed as contributed. Matching contributions are invested proportionate to each participant’s voluntary contributions in the investment options provided under the plan. +Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in Microsoft common stock. NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, the company’s Chief Executive +Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information within this note is reported on that basis. During the periods +presented, our five segments were Windows Division, Server and Tools, Online Services Division, Microsoft Business Division, and Entertainment and Devices Division. During the three months ended December 31, 2012, we changed the name of our +Windows & Windows Live Division to Windows Division. Due to the integrated structure of our business, certain revenue earned +and costs incurred by one segment may benefit other segments. Revenue on certain contracts may be allocated among the segments based on the relative value of the underlying products and services. Costs that are identifiable are allocated to the +segments that benefit to incent cross-collaboration among our segments so that one segment is not solely burdened by the cost of a mutually beneficial activity. Allocated costs may include those relating to development and marketing of products and +services from which multiple segments benefit, or those costs relating to services performed by one segment on behalf of other segments. Each allocation is measured differently based on the specific facts and circumstances of the costs being +allocated. 85 Table of Contents PART II Item 8 In addition, certain costs incurred at a corporate level that are identifiable and that benefit +our segments are allocated to them. These allocated costs include costs of: field selling; employee benefits; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and +circumstances of the costs being allocated. Certain other corporate-level activity is not allocated to our segments, including costs of: broad-based sales and marketing; product support services; human resources; legal; finance; information +technology; corporate development and procurement activities; research and development; legal settlements and contingencies; and employee severance. We have recast certain prior period amounts within this note to conform to the way we internally managed and monitored segment performance during the current fiscal year, reflecting immaterial movements of business +activities between segments and changes in cost allocations. In July 2013, we announced a change in organizational structure as part of our transformation to a devices and services company. As we evolve how we allocate resources and analyze +performance in the new structure, it is possible that our segments may change. The principal products and services provided by each +segment are summarized below: Windows Division – Windows Division offerings consist of the Windows operating system, Surface, and PC +accessories. Server and Tools – Server and Tools product and service offerings include Windows Server, Windows Azure, +Microsoft SQL Server, Windows Intune, Windows Embedded, Visual Studio, System Center products, and Enterprise Services. Enterprise Services comprise Premier product support services and Microsoft Consulting Services. Online Services Division – Online Services Division offerings include Bing, Bing Ads, and MSN. Microsoft Business Division – Microsoft Business Division offerings include Microsoft Office, Exchange, SharePoint, Lync, Yammer, +Microsoft Dynamics business solutions, and Office 365. Entertainment and Devices Division – Entertainment and Devices +Division offerings include the Xbox 360 gaming and entertainment console, Kinect for Xbox 360, Xbox 360 video games, Xbox 360 accessories, Xbox LIVE, Skype, and Windows Phone. Segment revenue and operating income (loss) were as follows during the periods presented: (In millions) Year Ended June 30, 2013 2012 2011 Revenue Windows Division $ 18,680 $ 18,844 $ 18,815 Server and Tools 20,295 18,544 16,571 Online Services Division 3,284 2,935 2,680 Microsoft Business Division 24,738 24,082 22,407 Entertainment and Devices Division 10,213 9,590 8,896 Corporate and other 639 (272 ) 574 Consolidated $ 77,849 $ 73,723 $ 69,943 86 Table of Contents PART II Item 8 (In millions) Year Ended June 30, 2013 2012 2011 Operating Income (Loss) Windows Division $ 8,943 $ 12,005 $ 12,040 Server and Tools 8,152 7,256 6,132 Online Services Division (1,298 ) (8,117 ) (2,649 ) Microsoft Business Division 16,189 15,803 14,467 Entertainment and Devices Division 888 381 1,299 Corporate and other (6,110 ) (5,565 ) (4,128 ) Consolidated $ 26,764 $ 21,763 $ 27,161 Reconciling amounts in the tables above and below include adjustments to conform our internal accounting policies +to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and depreciation. Significant reconciling items were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Corporate-level activity (a) $ (6,665 ) $ (5,114 ) $ (4,506 ) Revenue reconciling amounts (b) 400 (484 ) 380 Other 155 33 (2 ) Total $ (6,110) $ (5,565) $ (4,128) (a) Corporate-level activity excludes revenue reconciling amounts presented separately in that line item. (b) Revenue reconciling amounts for fiscal year 2012 and 2013 include the deferral and subsequent recognition, respectively, of $540 million of revenue related +to the Windows Upgrade Offer. No sales to an individual customer or country other than the United States +accounted for more than 10% of fiscal year 2013, 2012, or 2011 revenue. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2013 2012 2011 United +States (a) $ 41,344 $ 38,846 $ 38,008 Other countries 36,505 34,877 31,935 Total $ 77,849 $ 73,723 $ 69,943 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the +geographic source of the revenue. Revenue from external customers, classified by significant product and service +offerings were as follows: (In millions) Year Ended June 30, 2013 2012 2011 Microsoft Office system $ 22,995 $ 22,299 $ 20,730 Windows operating systems for computing devices 17,529 17,320 17,825 Server products and tools 15,408 14,232 13,251 Xbox 360 platform 7,100 8,045 8,103 Consulting and product support services 4,372 3,976 3,372 Advertising 3,387 3,181 2,913 Other 7,058 4,670 3,749 Total $ 77,849 $ 73,723 $ 69,943 87 Table of Contents PART II Item 8 Assets are not allocated to segments for internal reporting presentations. A portion of +amortization and depreciation is included with various other costs in an overhead allocation to each segment, and it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the +measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the +controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2013 2012 2011 United States $ 16,615 $ 14,081 $ 18,498 Luxembourg 6,943 6,975 0 Other countries 4,171 3,835 2,989 Total $ 27,729 $ 24,891 $ 21,487 NOTE 22 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2013 Revenue $ 16,008 $ 21,456 $ 20,489 $ 19,896 $ 77,849 Gross profit 11,840 15,764 15,702 14,294 57,600 Net income 4,466 6,377 6,055 (a) 4,965 (b) 21,863 (c) Basic earnings per share 0.53 0.76 0.72 0.59 2.61 Diluted earnings per share 0.53 0.76 0.72 (a) 0.59 (b) 2.58 (c) Fiscal Year 2012 Revenue $ 17,372 $ 20,885 $ 17,407 $ 18,059 $ 73,723 Gross profit 13,595 15,247 13,455 13,896 56,193 Net income 5,738 6,624 5,108 (492 ) (d) 16,978 (d) Basic earnings (loss) per share 0.68 0.79 0.61 (0.06 ) 2.02 Diluted earnings (loss) per share 0.68 0.78 0.60 (0.06 ) (d) 2.00 (d) (a) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased net income by $733 million ( € 561 million) and diluted earnings per share by $0.09. (b) Includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased net income by $596 million and +diluted earnings per share by $0.07. (c) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased net income by $733 million ( € 561 million) and diluted earnings per share by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth +quarter of fiscal year 2013, which decreased net income by $596 million and diluted earnings per share by $0.07. (d) Includes a goodwill impairment charge related to our OSD business segment which decreased net income by $6.2 billion and diluted earnings per share by +$0.73. 88 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the accompanying consolidated balance sheets of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2013 and 2012, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for each of the three years in the period +ended June 30, 2013. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in +the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the +financial position of Microsoft Corporation and subsidiaries as of June 30, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2013, in conformity with +accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2013, based on the criteria established in Internal Control – Integrated Framework +(1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 30, 2013, expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 30, +2013 89 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and +with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of +the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control +over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal +control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial +statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets +that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a +misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our +internal control over financial reporting based on the framework in Internal Control – Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management +concluded that the company’s internal control over financial reporting was effective as of June 30, 2013. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2013 that have +materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2013; their report is +included in Item 9A. 90 Table of Contents PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the internal control over financial reporting of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2013, based on criteria established in Internal Control – Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway +Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying +Report of Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered +necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal +control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of +directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting +principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and +dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts +and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or +disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent +limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, +projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance +with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal +control over financial reporting as of June 30, 2013, based on the criteria established in Internal Control – Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +consolidated financial statements as of and for the year ended June 30, 2013, of the Company and our report dated July 30, 2013, expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington July 30, +2013 91 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may +be found under the caption “Our Director Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 19, 2013 (the “Proxy Statement”). Information about our Audit Committee may be found under +the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference. The information +in the Proxy Statement set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting +Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/investor/MSFinanceCode. If we make any substantive amendments to the finance code of +ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or +waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive +Officer Compensation,” “Compensation Committee Interlocks and Insider Participation,” and “Compensation Committee Report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information Regarding Beneficial Ownership of Principal +Shareholders, Directors, and Management” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director Independence” and “Certain Relationships and Related +Transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND +SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees +Billed by Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. 92 Table of Contents PART IV Item 15 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information +is otherwise included. Index to Financial Statements Page Income Statements 49 Comprehensive Income Statements 50 Balance Sheets 51 Cash Flows Statements 52 Stockholders’ Equity Statements 53 Notes to Financial Statements 54 Report of Independent Registered Public Accounting Firm 89 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/09 3.1 1/28/10 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/18/12 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft +Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.5 9/27/10 93 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.6 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.7 11/7/12 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 12/31/11 10.1 1/19/12 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-Q 3/31/12 10.5 4/19/12 10.6* Form of Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 10.8 8/25/06 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.12 7/30/10 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.13 7/30/10 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 94 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.17* Executive Officer Incentive Plan 10-Q 9/30/08 10.17 10/23/08 10.18* Form of Executive Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/12 10.18 10/18/12 10.19* Resignation Agreement and Full and Final Release of Claims between Microsoft Corporation and Steven Sinofsky X 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Furnished, not filed 95 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 30, 2013. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on July 30, 2013. Signature Title / S /    W ILLIAM H. G ATES III William H. Gates III Chairman / S /    S TEVEN A. +B ALLMER Steven A. Ballmer Director and Chief Executive Officer / S /    D INA D UBLON Dina Dublon Director / S /    M ARIA K LAWE Maria Klawe Director / S /    S TEPHEN J. +L UCZO Stephen J. Luczo Director / S /    D AVID F. +M ARQUARDT David F. Marquardt Director / S /    C HARLES H. +N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    J OHN W. +T HOMPSON John Thompson Director / S /    A MY E. +H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 96 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-14-289961/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-14-289961/full-submission.txt new file mode 100644 index 0000000..0744f59 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-14-289961/full-submission.txt @@ -0,0 +1,1165 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2014 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  +to Commission File Number +0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such +shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its +corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was +required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2013, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $284,539,953,282 based on the closing sale price as reported on the NASDAQ +National Market System. As of July 22, 2014, there were 8,239,848,789 shares of common stock outstanding. DOCUMENTS INCORPORATED +BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of +Shareholders to be held on December 3, 2014 are incorporated by reference into Part III. Table of Contents MICROSOFT CORPORATION FORM 10-K For The Fiscal +Year Ended June 30, 2014 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 14 Item 1A. Risk Factors 15 Item 1B. Unresolved Staff Comments 24 Item 2. Properties 24 Item 3. Legal Proceedings 24 Item 4. Mine Safety Disclosures 24 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 25 Item 6. Selected Financial Data 25 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 26 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 51 Item 8. Financial Statements and Supplementary Data 53 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 98 Item 9A. Controls and Procedures 98 Report of Management on Internal Control over Financial Reporting 98 Report of Independent Registered Public Accounting Firm 99 Item 9B. Other Information 100 PART III Item 10. Directors, Executive Officers and Corporate Governance 100 Item 11. Executive Compensation 100 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 100 Item 13. Certain Relationships and Related Transactions, and Director Independence 100 Item 14. Principal Accounting Fees and Services 100 PART IV Item 15. Exhibits, Financial Statement Schedules 101 Signatures 105 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are +“forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements +may appear throughout this report, including the following sections: “Business,” “Management’s Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words +“believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” +“will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and +uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors” (Part I, Item 1A of this Form 10-K), +“Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A), and “Management’s Discussion and Analysis” (Part II, Item 7). We undertake no obligation to update or revise publicly any +forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Microsoft was founded in 1975. Our mission is to enable people and organizations +throughout the world to do more and achieve more by creating technology that transforms the way people learn, work, play, and communicate. We develop and market software, services, and devices that deliver new opportunities, greater convenience, and +enhanced value to people’s lives. We do business worldwide and have offices in more than 100 countries. We generate revenue by +developing, licensing, and supporting a wide range of software products and services, by designing, manufacturing, and selling devices, and by delivering relevant online advertising to a global customer audience. In addition to selling individual +products and services, we offer suites of products and services. Our products include operating systems for computing devices, servers, +phones, and other intelligent devices; server applications for distributed computing environments; productivity applications; business solution applications; desktop and server management tools; software development tools; video games; and online +advertising. We also design and sell hardware including PCs, tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories. We offer cloud-based solutions that provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. Examples of cloud-based +computing services we offer include Bing, Microsoft Azure, Microsoft Dynamics CRM Online, Microsoft Office 365, OneDrive, Skype, Xbox Live, and Yammer. Cloud revenue is earned primarily from usage fees, advertising, and subscriptions. We also +provide consulting and product and solution support services, and we train and certify computer system integrators and developers. We +conduct research and develop advanced technologies for future software, devices, and services. We believe that we will continue to grow and meet our customers’ needs as the productivity and platform company for the mobile-first and cloud-first +world. We will continue to create new opportunities for partners, increase customer satisfaction, and improve our service excellence, business efficacy, and internal processes. OPERATING SEGMENTS During the first quarter of fiscal year 2014, we changed our +organizational structure as part of our transformation to a devices and services company. As a result, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. +Therefore, beginning in fiscal year 2014, we reported our financial performance based on our new segments: Devices and Consumer (“D&C”) Licensing, D&C Hardware, D&C Other, Commercial Licensing, and Commercial Other. 3 Table of Contents PART I Item 1 On April 25, 2014, we completed the transaction to acquire substantially all of Nokia +Corporation’s (“Nokia”) Devices and Services Business (“NDS”). We report the financial performance of NDS in our new Phone Hardware segment. Prior to the acquisition of NDS, financial results associated with our joint +strategic initiatives with Nokia were reflected in our D&C Licensing segment. The contractual relationship with Nokia related to those initiatives terminated in conjunction with the acquisition. With the creation of the new Phone Hardware +segment, the D&C Hardware segment was renamed Computing and Gaming Hardware in the fourth quarter of fiscal year 2014. Our segments +provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for +timely and rational allocation of development, sales, marketing, and services resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 21 – Segment Information and +Geographic Data of the Notes to Financial Statements. Devices and Consumer Our D&C segments develop, manufacture, market, and support products and services designed to increase personal productivity, help people +simplify tasks and make more informed decisions online, entertain and connect people, and help advertisers connect with audiences. Our D&C segments are made up of D&C Licensing, Computing and Gaming Hardware, Phone Hardware, and D&C +Other. D&C Licensing The +principal products and services provided by the D&C Licensing segment are: Windows, including original equipment manufacturer (“OEM”) licensing (“Windows OEM”) and other non-volume licensing and academic volume licensing of +the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Office Consumer”); Windows Phone operating system, including related patent licensing; and +certain other patent licensing revenue. The Windows operating system is designed to empower individuals, companies, and organizations +to simplify everyday tasks through seamless operations across the user’s hardware and software. Windows revenue growth is impacted +significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows revenue is impacted by: • the mix of computing devices based on form factor and screen size; • differences in device market demand between developed markets and emerging markets; • attachment of Windows to devices shipped; • customer mix between consumer, small and medium sized businesses, and large enterprises; • changes in inventory levels in the OEM channel; • pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large, +multinational OEMs, and different pricing of Windows versions licensed; • piracy; and • sales of packaged software. The versions of Office included in our D&C Licensing segment are designed to increase personal productivity through a range of programs, +services, and software solutions. Growth depends on our ability to add value to the core product set and to continue to expand our product offerings in other areas such as content management and collaboration. Office Consumer revenue is impacted by +sales to customers that buy Office with their new devices and by product launches, as well as the transition to Office 365 Consumer, our subscription-based cloud service that provides access to Office plus other productivity services. Office 365 +Consumer revenue is included in our D&C Other segment. 4 Table of Contents PART I Item 1 The Windows Phone operating system is designed to bring users closer to the people, applications, +and content they need. As noted above, prior to our acquisition of NDS, Microsoft and Nokia jointly created new mobile products and services and extended established products and services to new markets through a strategic alliance. Windows Phone +revenue associated with this contractual relationship was reflected in D&C Licensing. Windows Phone revenue also includes revenue from licensing mobile-related patents. Competition The Windows operating system faces competition from various software products and +from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, compatibility with a broad range of hardware and +software applications, including those that enable productivity, and the largest support network for any operating system. Competitors +to the versions of Office included in D&C Licensing include global application vendors such as Apple and Google, numerous web-based competitors, and local application developers in Asia and Europe. Apple distributes versions of its pre-installed +application software, such as email, note taking, and calendar products, through its PCs, tablets, and phones. Google provides a hosted messaging and productivity suite and distributes its productivity services through the Android and Chrome +operating systems. Web-based offerings competing with individual applications can also position themselves as alternatives to our products. We believe our products compete effectively based on our strategy of providing powerful, flexible, secure, +and easy to use solutions that work across a variety of devices. Windows Phone operating system faces competition from iOS, Android, +and Blackberry operating systems. Windows Phone competes based on differentiated user interface, personalized applications, compatibility with Windows PCs and tablets, and other unique capabilities. Computing and Gaming Hardware The +principal products and services provided by the Computing and Gaming Hardware segment are: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, and Xbox Live subscriptions (“Xbox +Platform”); Surface devices and accessories; and Microsoft PC accessories. The Xbox Platform is designed to provide a unique +variety of entertainment choices through the use of our devices, peripherals, content, and online services. We released Xbox 360 and Xbox One in November 2005 and November 2013, respectively. Surface devices are designed to help organizations, students, and consumers to be more productive, offering accessories and compatibility with +peripherals. Surface devices were first released in October 2012. Our latest Surface device, the Surface Pro 3, was released in June 2014. Competition Our Xbox Platform competes +with console platforms from Sony and Nintendo, both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles averages five to ten years. Nintendo released their latest generation console in November +2012. Sony released their latest generation console in November 2013. We believe the success of gaming and entertainment consoles is +determined by the availability of games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the console, and the ability to create new experiences via online services, downloadable content, +and peripherals. In addition to Sony and Nintendo, we compete with other providers of entertainment services through online marketplaces. We believe the Xbox Platform is effectively positioned against competitive products and services based on +significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own game franchises as well as other digital content offerings. 5 Table of Contents PART I Item 1 Surface devices face competition from computer, tablet, and other hardware manufacturers, many of +which are also current or potential partners and customers. Phone Hardware The principal products and services provided by the new Phone Hardware segment are Lumia Smartphones and other non-Lumia phones, which we began +manufacturing and selling with the acquisition of NDS on April 25, 2014. Competition Our phones face competition primarily from Samsung and Apple, as well as many other mobile device manufacturers. We believe our phones will compete +by being tailored for virtually every demographic and geography worldwide, offering unique industrial design and imaging technologies at high and low ranges of price points, and by incorporating Microsoft’s digital work and digital life +experiences. D&C Other The +principal products and services provided by the D&C Other segment are: Resale, including the Windows Store, Xbox Live transactions, and the Windows Phone Store; search advertising; display advertising; Office 365 Consumer, comprising Office 365 +Home and Office 365 Personal; Studios, comprising first-party video games; and our retail stores. Windows Store and Windows Phone Store +are online application marketplaces that are designed to benefit our developers and partner ecosystems by providing access to a large customer base and benefit users by providing centralized access to certified applications. Xbox Live transactions +consist of online entertainment content, such as games, music, movies, and TV shows, accessible on Xbox consoles and other devices. Search and display advertising includes Bing, Bing Ads, MSN, Windows Services, and Xbox ads. We are the exclusive algorithmic and paid search +platform for Yahoo! websites worldwide. We have completed the Yahoo! worldwide algorithmic transition and the paid search transition in the U.S. and planned international markets. Office 365 Consumer is designed to increase personal productivity through a range of Microsoft Office programs and services delivered across +multiple platforms via the cloud. Studios designs and markets games for Xbox consoles, Windows-enabled devices, and online. Growth +depends on our ability to attract new users and increase engagement by developing a deep library of content which consumers seek. Competition We face competition for our Resale products and services from various online marketplaces, including those operated by Amazon, +Apple, and Google. Our search and display advertising business competes with Google and a wide array of websites, social platforms like +Facebook, and portals like Yahoo! that provide content and online offerings to end users. Our success depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. We believe we can +attract new users by continuing to offer new and compelling products and services. We differentiate our offerings by providing a broad selection of content that helps users make faster, informed decisions, and take action more quickly by providing +relevant search results, expanded search services, and deeply-integrated social recommendations. Competitors to Office 365 Consumer are +the same as those discussed above for Office Consumer. 6 Table of Contents PART I Item 1 Competitors to Studios are the same as those discussed above for our Xbox gaming and entertainment +business, as well as game studios like Electronic Arts and Activision Blizzard. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organization productivity and +efficiency, and to simplify everyday tasks through seamless operations across the user’s hardware and software. Commercial is made up of the Commercial Licensing and Commercial Other segments. Commercial Licensing The principal +products and services provided by the Commercial Licensing segment are: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client Access Licenses (“CAL”); Windows Embedded; volume +licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Office for business, including Office, Exchange, SharePoint, Lync, and related CAL (“Office Commercial”); Skype; and Microsoft +Dynamics business solutions, excluding Dynamics CRM Online. Our server products are designed to make information technology +professionals and developers and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes +the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools +for software architects, developers, testers, and project managers. Revenue comes from product revenue, including purchases through volume licensing programs, licenses sold to OEMs, and retail packaged product. CAL provide access rights to certain +server and Office products, including Windows Server, Microsoft SQL Server, Exchange, SharePoint, and Lync. CAL revenue is reported along with the associated server or Office product. Windows Embedded extends the power of Windows and the cloud to intelligent systems, including the Internet of Things, by delivering specialized +operating systems, tools, and services. Windows Commercial revenue is mainly affected by the demand from commercial customers for +volume licensing and software assurance, often reflecting the number of information workers in a licensed enterprise, and is therefore relatively independent of the number of PCs sold in a given year. The versions of Office in Commercial Licensing are designed to increase personal, team and organizational productivity through a range of programs, +services, and software solutions. Office Commercial revenue is mainly affected by a combination of the demand from commercial customers for volume licensing and software assurance and the number of information workers in a licensed enterprise, and +is therefore relatively independent of the number of PCs sold in a given year. Skype is designed to connect friends, family, clients, +and colleagues through a variety of devices. Revenue is largely driven by the sale of minutes, subscriptions, and advertising. Microsoft Dynamics products provide business solutions for financial management, customer relationship management, supply chain management, and +analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. Revenue is largely driven by the number of information workers licensed. Competition Our server operating system products face competition from a wide variety of +server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system +preinstalled on 7 Table of Contents PART I Item 1 server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of +Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and +middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that +compete with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client/server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes +with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java middleware such as Geronimo, Wildfly, and Spring Framework. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our database, business intelligence, and +data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our products for software developers compete against offerings from Adobe, IBM, Oracle, other companies, and open-source projects, including +Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among others. Our embedded systems compete in a +highly fragmented environment in which key competitors include IBM, Intel, and versions of embeddable Linux from commercial Linux vendors such as Metrowerks and MontaVista Software. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior +applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Competitors to Windows Commercial are the same as those discussed above for Windows in the D&C Licensing segment. Office Commercial revenue growth depends on our ability to add value to the core product set and to continue to expand our product offerings in +other areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. Competitors to Office Commercial includes software application vendors such as Adobe Systems, Apple, Cisco Systems, Google, +IBM, Oracle, SAP, and numerous web-based competitors as well as local application developers in Asia and Europe. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides +a hosted messaging and productivity suite. Web-based offerings competing with individual applications can also position themselves as alternatives to our products. We believe our products compete effectively based on our strategy of providing +powerful, flexible, secure, easy to use solutions that work well with technologies our customers already have and are available on a device or via the cloud. Skype competes with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Our Microsoft Dynamics products compete with vendors such as Oracle and SAP in the market for large organizations and divisions of global +enterprises. In the market focused on providing solutions for small and mid-sized businesses, our Microsoft Dynamics products compete with vendors such as Infor, The Sage Group, and NetSuite. Salesforce.com’s cloud CRM offerings compete +directly with Microsoft Dynamics CRM on-premises offerings. Commercial Other The principal products and services provided by the Commercial Other segment are: Enterprise Services, including Premier product support services +and Microsoft Consulting Services; Commercial Cloud, comprising Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure. 8 Table of Contents PART I Item 1 Enterprise Services, including Premier product support services and Microsoft Consulting Services +assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and information technology professionals on various Microsoft products. Office 365 Commercial is an online services offering that includes Microsoft Office, Exchange, SharePoint, and Lync, and is available across a +variety of devices and platforms. Dynamics CRM Online is designed to provide customer relationship management and supply chain +management for small and mid-size businesses, large organizations, and divisions of global enterprises. Revenue is largely driven by the number of information workers licensed. Microsoft Azure is a scalable operating system with computing, storage, database, and management, along with comprehensive cloud solutions, from +which customers can build, deploy, and manage enterprise workloads and web applications. These services also include a platform that helps developers build and connect applications and services in the cloud. Our goal is to enable customers to devote +more resources to development and use of applications that benefit their businesses, rather than managing on-premises hardware and software. Competition The Enterprise Services +business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. Competitors to Office 365 Commercial are the same as those discussed above for Office Commercial. Microsoft Dynamics CRM’s online offerings primarily compete with Salesforce.com’s on-demand CRM offerings. Microsoft Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, Salesforce.com, VMware, and other open source +offerings. OPERATIONS We have operations centers that support all operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The +regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto +Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate data centers throughout the Americas, Europe, and Asia regions. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of +our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our Xbox consoles and games, Surface devices, and Microsoft PC accessories are manufactured by third party contract manufacturers. We generally have the ability to use other manufacturers if the current vendor +becomes unavailable or unable to meet our requirements. With the acquisition of NDS, we now operate manufacturing facilities for the +production and customization of phones in Brazil, China, Hungary, Mexico, and Vietnam. All our devices may include key components that +are available from only one or limited sources. Disruption of component supply from these suppliers could potentially lead to a disruption of production of certain devices. 9 Table of Contents PART I Item 1 RESEARCH AND DEVELOPMENT During fiscal years 2014, 2013, and 2012, research and development expense was $11.4 billion, $10.4 billion, and $9.8 billion, respectively. +These amounts represented 13% of revenue in each of those years. We plan to continue to make significant investments in a broad range of research and development efforts. Product and Service Development and Intellectual Property We develop most of our products and +services internally through four primary engineering groups. • Applications and Services Engineering Group , focuses on broad applications and services core technologies in productivity, communication, search, and +other information categories. • Cloud and Enterprise Engineering Group , focuses on development of Microsoft’s back-end technologies like datacenter, database, and our specific +technologies for enterprise IT scenarios and development tools. This group also engineers datacenter development, construction, and operation. • Devices Engineering Group , focuses on all hardware development and supply chain, including Xbox consoles, Surface devices, Lumia Smartphones, other +non-Lumia phones, Perceptive Pixel products, and accessories. • Operating Systems Engineering Group , focuses on Microsoft’s operating systems for consoles, mobile devices, PCs, and back-end systems. Studios and +Universal Store, the core cloud services for marketplaces, membership, and commerce platform, are also in this group. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our +products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and +hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product +documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and +internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing +patents and currently have a portfolio of over 55,000 U.S. and international patents issued and over 40,000 pending. While we employ much of our internally developed intellectual property exclusively in Microsoft products and services, we also +engage in outbound and inbound licensing of specific patented technologies that are incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with other technology companies +covering entire groups of patents. We also purchase or license technology that we incorporate into our products or services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as +promoting industry standards, advancing interoperability, or attracting and enabling our external development community. In conjunction with the NDS acquisition, we received an initial 10-year non-exclusive license to certain Nokia patents. We also +agreed to license Nokia’s mapping services and granted Nokia reciprocal rights to use our patents for their mapping and location services. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products and business methods, we believe, based upon past experience and industry practice, such licenses +generally could be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our +products. Investing in the Future Microsoft’s success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and +product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and 10 Table of Contents PART I Item 1 breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the company. We maintain our long-term commitment to research and development across +a wide spectrum of technologies, tools, and platforms spanning communication and collaboration, information access and organization, entertainment, business and e-commerce, advertising, and devices. While our main research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other +parts of the U.S. and around the world, including Canada, China, Denmark, Estonia, Finland, India, Ireland, Israel, Norway, Sweden, Taiwan, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to +continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and +development activities at the business segment level. Much of our business segment level research and development is coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s +largest computer science research organizations, and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends and +contributing to our product and service innovation. Based on our assessment of key technology trends and our broad focus on long-term +research and development, we see significant opportunities to drive future growth in productivity, platforms, cloud computing, search, communications, and smart connected devices. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services primarily through the following channels: OEMs; distributors and resellers; online; and Microsoft retail stores. OEMs We distribute software through OEMs +that pre-install our software on new PCs, tablets, servers, smartphones, and other intelligent devices that they sell to end customers. The largest component of the OEM business is the Windows operating system pre-installed on computing devices. +OEMs also sell hardware pre-installed with other Microsoft products, including server and embedded operating systems and applications such as our Microsoft Office suite. In addition to these products, we also market our services through OEMs and +service bundles such as Windows with Bing or Windows with Office 365 subscription. There are two broad categories of OEMs. The largest +OEMs, many of which operate globally, are referred to as “Direct OEMs,” as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products +with virtually all of the multinational OEMs, including Acer, ASUS, Dell, Fujitsu, HTC, Hewlett-Packard, LG, Lenovo, Samsung, Sony, Toshiba, and with many regional and local OEMs. The second broad category of OEMs consists of lower-volume PC +manufacturers (also called “system builders”), which source their Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship +with Microsoft. Distributors and Resellers Many organizations that license our products and services through enterprise agreements transact directly with us, with sales support from solution integrators, independent software vendors, web agencies, and +developers that advise organizations on licensing our products and services (“Enterprise Agreement Direct Advisors”, or “EDAs”). Organizations also license our products and services indirectly, primarily through license solutions +partners (“LSPs”), distributors, value-added resellers (“VARs”), OEMs, system builder channels, and retailers. Although each type of 11 Table of Contents PART I Item 1 reselling partner reaches organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small-sized and +medium-sized organizations. EDAs typically are also authorized as LSPs and operate as resellers for our other licensing programs, such as the Select Plus and Open licensing programs discussed under “Licensing Options” below. Some of our +distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our Microsoft Dynamics software offerings are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our retail packaged +products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets, such as Wal-Mart, Dixons, and Microsoft retail +stores. We distribute our hardware products, including Surface, Xbox, phones, and PC accessories, through third-party retailers and Microsoft retail stores. Our phones are also distributed through global wireless communications carriers. We have a +network of field sales representatives and field support personnel that solicits orders from distributors and resellers, and provides product training and sales support. Online Although on-premises software will continue to be an important part of our business, +increasingly we are delivering additional value to customers through cloud-based services. We provide online content and services to consumers through Bing, MSN portals and channels, Office 365, Windows Phone Store, Xbox Live, Outlook.com, Skype, +and Windows Store. We also provide commercial cloud-based services such as Microsoft Dynamics CRM Online, Microsoft Azure, and Office 365 consisting of online versions of Microsoft Office, Exchange, SharePoint, Lync, and Yammer. Other services +delivered online include our online advertising platform with offerings for advertisers and publishers, as well as Microsoft Developer Network subscription content and updates, periodic product updates, and online technical and practice readiness +resources to support our partners in developing and selling our products and solutions. As we increasingly deliver online services, we sell many of these cloud-based services through our enterprise agreements and have also enabled new sales programs +to reach small and medium-sized businesses. These new programs include direct sales, direct sales supported by a large network of partner advisors, and resell of services through operator channels, such as telephone, cell, and cable providers. We also sell our products through our Microsoft retail stores and online marketplaces. LICENSING OPTIONS We +license software to organizations under agreements that allow the customer to acquire multiple licenses of products and services. Our agreements for organizations to acquire multiple licenses of products and services are designed to provide them +with a means of doing so without having to acquire separate licenses through retail channels. In delivering organizational licensing agreements to the market, we use different programs designed to provide flexibility for organizations of various +sizes. While these programs may differ in various parts of the world, generally they include those discussed below. Customer Licensing Programs Open Licensing Designed +primarily for small-to-medium organizations, Open Programs allows customers to acquire perpetual or subscription licenses and, at the customer’s election, rights to future versions of software products over a specified time period (two or three +years depending on the Open Programs used). The offering that conveys rights to future versions of certain software products over the contract period is called software assurance. Software assurance also provides support, tools, and training to help +customers deploy and use software efficiently. Open Programs has several variations to fit customers’ diverse way of purchasing. Under the Open Program, customers can acquire licenses only or licenses with software assurance. They can also +renew software assurance upon the expiration of existing volume licensing agreements. Office 365 is also available for purchase through the Open Program. 12 Table of Contents PART I Item 1 Select Plus Licensing Designed primarily for medium-to-large organizations, the Select Plus Program allows customers to acquire perpetual licenses and, at the customer’s election, software assurance over a specified time period +(generally three years or less). Similar to Open Programs, the Select Plus Program allows customers to acquire licenses only, acquire licenses with software assurance, or renew software assurance upon the expiration of existing volume licensing +agreements. A subset of online services are also available for purchase through the Select Plus Program, and subscriptions are generally structured with terms between one and three years. Enterprise Agreement Licensing Designed primarily for medium- and large-sized organizations +that want to acquire licenses to Online Services and/or software products, along with software assurance, for all or substantial parts of their enterprise. Enterprises can elect to acquire perpetual licenses or, under the Enterprise Subscription +Program, can acquire non-perpetual, subscription agreements for a specified time period (generally three years). Online Services are also available for purchase through the enterprise agreement and subscriptions are generally structured with three +year terms. Customer Licensing Programs — Online Services Only Microsoft Online Subscription Agreement is designed to enable small and medium-sized businesses to easily purchase Microsoft Online Services (excluding Azure). The program allows customers to acquire monthly or +annual subscriptions for cloud-based services. Microsoft Azure Agreement is designed to enable small and medium-sized businesses to +purchase Microsoft Azure Subscription plans on a “pay-as-you-go” basis. Partner Programs The Microsoft Services Provider License Agreement is a program targeted at service providers and Independent Software Vendors allowing these +partners to provide software services and hosted applications to their end customers. Agreements are generally structured with a three-year term, and partners are billed monthly based upon consumption. Microsoft Online Services Reseller Agreement is a program enabling partners to package Microsoft Online Services with the partners’ services. Independent Software Vendor Royalty Program is a program that enables partners to use Microsoft software in their own software +programs. CUSTOMERS Our customers include individual consumers, small- and medium-sized organizations, enterprises, governmental institutions, educational institutions, Internet service providers, application developers, and OEMs. +Consumers and small and medium-sized organizations obtain our products primarily through distributors, resellers, and OEMs. No sales to an individual customer accounted for more than 10% of fiscal year 2014, 2013, or 2012 revenue. Our practice is to +ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 13 Table of Contents PART I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 25, 2014 were as follows: Name Age Position with the Company Satya Nadella 46 Chief Executive Officer Lisa E. Brummel 54 Executive Vice President, Human Resources Christopher C. Capossela 44 Executive Vice President, Chief Marketing Officer Amy E. Hood 42 Executive Vice President, Chief Financial Officer Bradford L. Smith 55 Executive Vice President, General Counsel; Secretary B. Kevin Turner 49 Chief Operating Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, +Cloud and Enterprise since July 2013. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, +Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles have also included Vice President of Microsoft Business Division. Ms. Brummel was appointed Executive Vice President, Human Resources in July 2013, after serving as Chief People Officer since 2011 and Senior Vice President, Human Resources beginning in 2005. Prior to +that she had been Corporate Vice President, Human Resources since May 2005. From 2000 to 2005, she had been Corporate Vice President of the Home and Retail Division. Since joining Microsoft in 1989, Ms. Brummel has held a number of +management positions at Microsoft, including General Manager of Consumer Productivity Business, Product Unit Manager of the Kids Business, and Product Unit Manager of Desktop and Decision Reference Products. Mr. Capossela was appointed Executive Vice President, Chief Marketing Officer in March 2014. Prior to that he served as the worldwide +leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 20 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the +Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Lync, Project, and Visio. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. Beginning in 2010, Ms. Hood was Chief +Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the +Server and Tools Business and the corporate finance organization. Mr. Smith was appointed Executive Vice President, General +Counsel, and Secretary in 2011. Prior to that he served as Senior Vice President, General Counsel, and Secretary since November 2001. Mr. Smith was also named Chief Compliance Officer in 2002. He had been Deputy General Counsel for Worldwide +Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith joined Microsoft in 1993. Mr. Turner was appointed Chief Operating Officer in September 2005. Before joining Microsoft, he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the +Sam’s Club division. From 2001 to 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information Systems Division. From 2000 to 2001, he served as its Senior Vice President and Chief Information Officer +of the Information Systems Division. Mr. Turner also serves on the Board of Directors of Nordstrom, Inc. 14 Table of Contents PART I Item 1, 1A EMPLOYEES As of June 30, 2014, we employed approximately 128,000 people on a full-time basis, 62,000 in the U.S. and 66,000 internationally, including approximately 25,000 employees transferred as part of the NDS +acquisition in April 2014. Of the total employed people, 44,000 were in product research and development, 30,000 in sales and marketing, 23,000 in product support and consulting services, 20,000 in manufacturing and distribution, and 11,000 in +general and administration. In July 2014, we announced a restructuring plan which will eliminate up to 18,000 positions in fiscal year 2015, including 12,500 professional and factory positions related to the acquisition of NDS. As a result of the +NDS acquisition, we have certain employees that are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of +charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”); • information on our business strategies, financial results, and key performance indicators; • announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available; • press releases on quarterly earnings, product and service announcements, legal developments, and international news; • corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, +global corporate citizenship initiatives, and other governance-related policies; • other news and announcements that we may post from time to time that investors might find useful or interesting; and • opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, +we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the +information we post on the social media channels listed on our Investor Relations website. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash +flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to +lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms +whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in our businesses are low and software products can 15 Table of Contents PART I Item 1A be distributed broadly and quickly at relatively low cost. Many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent +introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platforms, ecosystems, and devices An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among +users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. The strategic importance of developing and maintaining a +vibrant ecosystem increased with the launch of the Windows 8 operating system, Surface, Windows Phone, Xbox One, and associated cloud-based services. We face significant competition from firms that provide competing platforms, applications, and +services. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded +with some consumer products such as personal computers, tablets, phones, gaming consoles, and digital music players. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform. We also offer +some vertically-integrated hardware and software products and services; however, our competitors in smartphones and tablets have established significantly larger user bases. Competing with the vertically integrated model will increase our cost of +revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms +developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to +perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to +our platforms. Competing operating systems licensed at low or no cost may decrease PC operating system margins. In addition, Surface competes with products made by our OEM partners, which may affect their commitment to our platform. • The success of the Windows phone platform is an important element of our goal to enhance personal productivity in a mobile-first and cloud-first world. The +marketplace among mobile phone platforms is highly competitive. We may face issues in selecting, engaging or securing support from operators and retailers for Windows phones due to, for instance, inadequate sales training or incentives, or +insufficient marketing support for the Windows Phone platform. • Competing platforms have application marketplaces (sometimes referred to as “stores”) with scale and significant installed bases on mobile devices. +The variety and utility of applications available on a platform is important to device purchasing decisions. Users incur costs to move data and buy new applications when switching platforms. To compete, we must successfully enlist developers to +write applications for our marketplace and ensure that these applications have high quality, customer appeal, and value. Efforts to compete with these application marketplaces may increase our cost of revenue and lower our operating margins. Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition to a mobile-first and cloud-first strategy, the license-based proprietary software model generates most of our software revenue. We bear +the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to +businesses and consumers under this model. 16 Table of Contents PART I Item 1A • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue +funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users and +earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality +of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, +and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing +devices. In July 2014, our leadership announced its strategic vision to compete and grow as a productivity and platform company for the mobile-first and cloud-first world. At the same time, our competitors are rapidly developing and deploying +cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based +services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are embracing cultural and organizational changes to drive +accountability and eliminate obstacles to innovation. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have +previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share; • maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, +tablets, and television-related devices, including gaming consoles; • continuing to enhance the attractiveness of our cloud platforms to third-party developers; • ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data; and • making our suite of cloud-based services platform agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are +not effective in executing organizational changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenues in line with the infrastructure and development +investments described above. This may negatively impact gross margins and operating income. We make significant investments in new +products and services that may not be profitable. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating +system, the Microsoft Office system, Bing, Windows Phone, Windows Server, the Windows Store, the Microsoft Azure Services platform, Office 365, other cloud-based services offerings, and the Xbox entertainment platform. We also invest in the +development and acquisition of a variety of hardware for productivity, communication and entertainment including PCs, tablets, phones, and gaming devices. Investments in new technology are speculative. Commercial success depends on many factors, +including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and +hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and 17 Table of Contents PART I Item 1A distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and +businesses will not be as high as the margins we have experienced historically. Developing new technologies is complex and +time-consuming. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to +continue making acquisitions or entering into joint ventures and strategic alliances as part of our long-term business strategy. These transactions involve significant challenges and risks including that the transaction does not advance our business +strategy, that we get no satisfactory return on our investment, that we have difficulty integrating new employees, business systems, and technology, or that the transaction distracts management from our other businesses. The success of these +transactions will depend in part on our ability to leverage them enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions, such as increased +revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than we expected. These events could adversely affect our operating results or financial condition. In April 2014, we acquired from Nokia substantially all of its NDS business to accelerate our growth in phones and support the entire Windows +ecosystem. We may not realize all of the anticipated financial and other benefits from this transaction including operating efficiencies and cost savings. We may not be successful in developing a vibrant and competitive ecosystem for Windows-based +phones that combines differentiated hardware, software, services, and third-party applications. We may not achieve mobile phone market share targets. We may see lower than expected growth rates for the phone markets. The mix of premium and +lower-cost devices we sell may put downward pressure on prices or margins. We may not be effective in executing the restructuring we announced in July 2014 or otherwise integrating the NDS business with Microsoft’s ongoing operations, including +matching manufacturing capacity to demand. Existing Microsoft smart device original equipment manufacturers may respond negatively to the changes in our business or the new competitive environment. If our goodwill or amortizable intangible assets become impaired we may be required to record a significant charge to +earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable +intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the +carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we +participate. We may be required to record a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of +operations. For example, in the fourth quarter of fiscal year 2012, we recorded a $6.2 billion charge for the impairment of goodwill in our previous Online Services Division business (Devices and Consumer Other under our current segment structure). The valuation of acquired assets and liabilities, including goodwill, resulting from the acquisition of NDS, is reflective of the +enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, we may not realize our forecasts. As a result, we may be required to record a significant charge to earnings in our +consolidated financial statements due to an impairment of our goodwill or amortizable intangible assets. We may not be able to +adequately protect our intellectual property rights. Protecting our global intellectual property rights and combating unlicensed copying and use of our software and other intellectual property is difficult. While piracy +adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Our revenue in these markets may grow slower than the +underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate consumers about the 18 Table of Contents PART I Item 1A benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where +intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may +grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface and Lumia +phones. To resolve these claims we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification +commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or +services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to +the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems +and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source +code. If a significant portion of our source code leaks, we might lose future trade secret protection for that source code. It may become easier for third parties to compete with our products by copying functionality, which could adversely affect +our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our competitive position. Security of Microsoft’s information technology Threats to information technology (“IT”) security can take a variety of forms. Individual and groups of hackers, and sophisticated organizations including state-sponsored organizations, may take steps +that pose threats to our customers and our IT. They may develop and deploy malicious software to attack our products and services and gain access to our networks and datacenters, or act in a coordinated manner to launch distributed denial of +service or other coordinated attacks. Cyber threats are constantly evolving, thereby increasing the difficulty of detecting and successfully defending against them. Cyber threats can have cascading impacts that unfold with increasing speed across +our internal networks and systems and those of our partners and customers. Breaches of our network or data security could disrupt the security of our internal systems and business applications, impair our ability to provide services to our customers +and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our competitive position, result in theft or misuse of our intellectual property or other assets, require +us to allocate more resources to improved technologies, or otherwise adversely affect our business. In addition, our internal IT +environment continues to evolve. Often we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other +consumer-oriented technologies. Our business policies and internal security controls may not keep pace with the speed of these changes as new threats emerge. Security of our product, services, devices and customers’ data Security threats are a +particular challenge to companies like us whose business is technology products and services. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure to +ensure the reliability of our services and the protection of their data. Hackers 19 Table of Contents PART I Item 1A tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. The security of our products and services is +important in our customers’ purchasing decisions. To defend against security threats, both to our internal IT systems and those of +our customers, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities, develop mitigation technologies that help to +secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products and services, and provide customers security tools such as firewalls and +anti-virus software. The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or +perceived security vulnerabilities in our products and services could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also +spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or +may fail timely to install security patches. Any of these actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that +eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenges. Legislative or regulatory action in these areas may increase the costs to develop, implement or secure our products and services. Disclosure of personal data could cause liability and harm our reputation. As we continue to grow the +number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers. The continued occurrence of high-profile data breaches provides evidence of an external +environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and vendors +on data security, and other practices we follow may not prevent the improper disclosure of customer data we or our vendors store and manage. Improper disclosure could harm our reputation, lead to legal exposure to customers, or subject us to +liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on-premises or, increasingly, in a cloud-based +environment we host. Like all providers of communications services, government authorities can sometimes require us to produce customer data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these +requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer data, perceptions that the privacy of personal information is not satisfactorily protected could inhibit sales of our products +or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer concerns, or constraints on our flexibility to determine where and how +to operate datacenters in response to customer expectations or governmental rules or actions, may cause higher operating expenses. We may have outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations +infrastructure. Our increasing user traffic, growth in services and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase or lease datacenters and +equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing +services such as Bing, Exchange Online, Office 365, SharePoint Online, OneDrive, Skype, Xbox Live, Microsoft Azure, Outlook.com, Microsoft Office Web Apps, Windows Stores and Microsoft Account services. We are rapidly growing our business of +providing a platform and back-end hosting for services provided by third-parties to their end users. Maintaining, securing and expanding this infrastructure is expensive and complex. Inefficiencies or operational failures, including temporary or +permanent loss of customer data, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, damage to our reputation and loss of current and potential +users, subscribers, and advertisers, each of which may harm our operating results and financial condition. 20 Table of Contents PART I Item 1A Government litigation and regulatory activity relating to competition rules may limit how we +design and market our products. As a leading global software and device maker, we are closely scrutinized by government agencies under U.S. and foreign competition laws. An increasing number of governments are regulating +competition law activities and this includes increased scrutiny in potentially large markets such as China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust +authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission closely +scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. In 2004, the Commission +ordered us to create new versions of Windows that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In +2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. +These obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and +file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM +partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their +competition laws that exert downward pressure on royalties for our intellectual property. Because these jurisdictions only recently implemented competition laws, their enforcement activities are unpredictable. Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and +businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, +including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be precedent in other competition law proceedings. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees or other voluntary actions we have taken. If we +fail to comply with these commitments we may incur litigation costs and be subject to substantial fines or other remedial actions. Our international operations subject us to potential liability under anti-corruption, trade protection, and other laws and regulations. The Foreign Corrupt Practices Act and other +anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents. From time to time, we receive inquiries from authorities in the U.S. and elsewhere about our business activities +outside the U.S. and our compliance with Anti-Corruption Laws. While we devote substantial resources to our global compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments, +our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws could result in significant fines and penalties, criminal sanctions against us, our officers or our employees, prohibitions on the conduct of +our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies and measures, and other regulatory requirements affecting trade and investment. We may be subject to legal +liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on countries such as Iran, North Korea, Cuba, Sudan, and Syria. 21 Table of Contents PART I Item 1A Other regulatory areas that may apply to our products and online services offerings include user +privacy, telecommunications, data protection, and online content. For example, regulators may take the position that our offerings such as Skype are covered by laws regulating telecommunications services. Applying these laws and regulations to our +business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to +evolve. Some governments are expressing increasing concern about government surveillance practices around the world and this may lead to increased regulation requiring local hosting obligations or the use of domestic hosting providers. Compliance +with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant +activity. Our business depends on our ability to attract and retain talented employees. Our business is +based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic +immigration laws. If we are less successful in our recruiting efforts, or if we cannot retain key employees, including key employees of the NDS business acquired in April 2014, our ability to develop and deliver successful products and services +may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety +of claims and lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to +inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our consolidated financial statements could occur for the period in which the effect of an unfavorable final outcome becomes +probable and reasonably estimable. We may have additional tax liabilities. We are subject to income taxes +in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax +determination is uncertain. We regularly are under audit by tax authorities. Economic and political pressures to increase tax revenues in various jurisdictions may make resolving tax disputes more difficult. Although we believe our tax +estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on +our consolidated financial statements in the period or periods for which that determination is made. We earn a significant amount of +our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions to the U.S. may result in higher effective tax rates for the company. In addition, there have been proposals from Congress to change +U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form any proposed legislation may pass, if enacted it could have a material adverse impact +on our tax expense and cash flows. Our hardware and software products may experience quality or supply +problems. Our vertically-integrated hardware products such as Xbox consoles, Surface devices, Lumia Smartphones, and other devices we design and market are highly complex and can have defects in design, manufacture, or +associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or address such issues through design, testing, or warranty repairs. We get some device components from sole suppliers. Our +competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity +constraint or industry shortages, we may not obtain timely replacement supplies, resulting in reduced sales. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. +Xbox consoles and Surface devices and Lumia phones are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would +apply to any other vertically-integrated hardware and software products we may offer. 22 Table of Contents PART I Item 1A Our software products also may experience quality or reliability problems. The highly +sophisticated software products we develop may contain bugs and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, +repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these +provisions will withstand legal challenge. Our global business exposes us to operational and economic +risks. We operate in over 100 countries and a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Emerging markets are a significant +focus of our international growth strategy. The developing nature of these markets presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing +foreign operations. Although we hedge a portion of our international currency exposure, significant fluctuations in exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenue. Competitive or regulatory pressure to +make our pricing structure uniform might require that we reduce the sales price of our software in the U.S. and other countries. Catastrophic events or geo-political conditions may disrupt our business. A disruption or failure of our systems or +operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a +significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are +near major earthquake faults. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems could harm our ability to conduct normal business operations. Providing our customers with more services +and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages on our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may +increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain disruptions for hardware manufacturers, either of which may adversely +affect our revenue. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy may affect the availability or +cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Adverse economic or market conditions may harm our business. Worsening economic conditions, including +inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products +declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal government shutdown resulting from failing to pass budget appropriations, adopt continuing funding resolutions or +raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT spending on our products and services and adversely affect our revenues. Our product distribution system also relies +on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or +retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of +accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events +that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global credit and equity markets decline for long periods, or if there is a downgrade of the U.S. government credit rating +due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment +charges that could adversely affect our financial results. 23 Table of Contents PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2014 that remain unresolved. ITEM 2. PROPERTIES Our corporate offices consist of approximately 15 million square feet of office space located in King County, Washington: 10 million +square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately five million square feet of space we lease. We own approximately three million additional square feet +of office and data center space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately five million square feet of office and data center space. We occupy many sites internationally, totaling approximately five million square feet that is owned and approximately twelve million square +feet that is leased. International facilities that we own include: our development center in Hyderabad, India; our European operations center in Dublin, Ireland; a research and development campus in Beijing, China; and our facilities in Salo, +Finland and Reading, UK. The largest leased office spaces include the following locations: Beijing and Shanghai, China; Tokyo, Japan; Unterschleissheim, Germany; Paris, France; Dublin, Ireland; Espoo, Tampere, and Oulu, Finland, Bangalore, India; +Reading, UK; Vedbaek, Denmark; and Mississauga, Canada. In addition to the above locations, we have a disk duplication and digital distribution facility in Humacao, Puerto Rico, a facility in Singapore for our Asia Pacific operations center and +regional headquarters, and various product development facilities, both domestically and internationally, as described in the “Research and Development” section of Item 1 of this Form 10-K. Our facilities are fully used for current operations of all segments, and suitable additional spaces are available to accommodate expansion needs. +We have a development agreement with the City of Redmond under which we may currently develop approximately 1.6 million square feet of additional facilities at our corporate campus in Redmond, Washington. We operate manufacturing facilities in Brazil, China, Hungary, Mexico, and Vietnam for the production of phones. ITEM 3. LEGAL PROCEEDINGS See Note 17 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 24 Table of Contents PART II Item 5, 6 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our +common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 22, 2014, there were 113,923 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2014 High $  36.43 $  38.98 $  41.50 $  42.29 $  42.29 Low $  30.84 $  32.80 $  34.63 $  38.51 $  30.84 Fiscal Year 2013 High $  31.61 $  30.25 $  28.66 $  35.78 $  35.78 Low $  28.54 $  26.26 $  26.28 $  28.11 $  26.26 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding dividends and share repurchases by quarter. Following are our +monthly stock repurchases for the fourth quarter of fiscal year 2014, all of which were made as part of publicly announced plans or programs: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2014 – April 30, 2014 756,720 $ 41.37 756,720 $  36,177 May 1, 2014 – May 31, 2014 27,395,976 $ 39.63 27,395,976 $  35,092 June 1, 2014 – June 30, 2014 0 $ 0.00 0 $  35,092 28,152,696 28,152,696 The repurchases were made using cash resources and occurred in the open market. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2014 (a) 2013 2012 2011 2010 Revenue $ 86,833 $ 77,849 $ 73,723 $ 69,943 $ 62,484 Operating income $ 27,759 $ 26,764 (c) $ 21,763 (d) $ 27,161 $ 24,098 Net income $ 22,074 (b) $ 21,863 (c) $ 16,978 (d) $ 23,150 $ 18,760 Diluted earnings per share $ 2.63 (b) $ 2.58 (c) $ 2.00 (d) $ 2.69 $ 2.10 Cash dividends declared per share $ 1.12 $ 0.92 $ 0.80 $ 0.64 $ 0.52 Cash, cash equivalents, and short-term investments $ 85,709 $ 77,022 $ 63,040 $ 52,772 $ 36,788 Total assets $ 172,384 $ 142,431 $ 121,271 $ 108,704 $ 86,113 Long-term obligations $ 36,975 $ 26,070 $ 22,220 $ 22,847 $ 13,791 Stockholders’ equity $ 89,784 $ 78,944 $ 66,363 $ 57,083 $ 46,175 25 Table of Contents PART II Item 6, 7 (a) On April 25, 2014, we acquired substantially all of Nokia’s Devices and Services business (“NDS”). NDS has been included in our +consolidated results of operations starting on the acquisition date. (b) Includes a tax provision adjustment recorded in the fourth quarter of fiscal year 2014 related to adjustments to prior years’ liabilities for +intercompany transfer pricing which decreased net income by $458 million and diluted earnings per share by $0.05. (c) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased operating income and net income by $733 million +(€561 million) and diluted earnings per share by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased operating income by $900 million, net income by $596 +million, and diluted earnings per share by $0.07. (d) Includes a goodwill impairment charge related to our previous Online Services Division business segment (related to Devices and Consumer Other under our +current segment structure) which decreased operating income and net income by $6.2 billion and diluted earnings per share by $0.73. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations +and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements. OVERVIEW Microsoft is a +technology leader focused on being the productivity and platform company for the mobile-first and cloud-first world. We strive to reinvent productivity to empower people and organizations to do more and achieve more. We create technology that +transforms the way people work, play, and communicate across a wide range of computing devices. We generate revenue by developing, +licensing, and supporting a wide range of software products, by offering an array of services, including cloud-based services to consumers and businesses, by designing, manufacturing, and selling devices that integrate with our cloud-based services, +and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees, designing, manufacturing, marketing, and selling our products and services, datacenter costs in support of our +cloud-based services, and income taxes. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that +can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers, industry +trends, and competitive forces. Key Opportunities and Investments We see significant opportunities for growth by investing research and development resources in the following areas: • Digital work and life experiences • Our cloud operating system • Our devices operating system and hardware 26 Table of Contents PART II Item 7 With investments in these areas, we work to fulfill the evolving needs of our customers in a +mobile-first and cloud-first world. We view mobility broadly – not just by devices, but by experiences. Today, people move just as quickly into new contexts as to new locations. Mobility goes beyond devices users carry with them as they move +from place to place, to encompass the rich collection of data, applications, and services that accompany them as they move from setting to setting in their lives. Many of our customers are “dual users,” employing technology for work or +school and also deeply in their personal lives. Digital work and life experiences We believe we can significantly enhance the digital lives of our customers using our broad portfolio of communication, productivity, and +information services. We work to deliver digital work and life experiences that are reinvented for the mobile-first and cloud-first world. Productivity will be the first and foremost objective, to enable people to meet and collaborate more easily, +and to effectively express ideas in new ways. We will design applications as dual use with the intelligence to partition data between work and life while respecting each person’s privacy choices. The foundation for these efforts will rest on +advancing our leading productivity, collaboration, and business process tools including Skype, OneDrive, OneNote, Outlook, Word, Excel, PowerPoint, Bing, and Dynamics. We see opportunity in combining these services in new ways that are more contextual and personal, while ensuring people, rather than their devices, remain at the center of the digital experience. We will offer our +services across ecosystems and devices outside our own. As people move from device to device, so will their content and the richness of their services. We will engineer applications so users can find, try, and buy them in friction-free ways. Cloud operating system Today, +businesses face important opportunities and challenges. Enterprises are asked to deploy technology that advances business strategy. They decide what solutions will make employees more productive, collaborative, and satisfied, or connect with +customers in new and compelling ways. They work to unlock business insights from a world of data. They rely on our technology to manage employee corporate identity, and to manage and secure corporate information accessed and stored across a growing +number of devices. To achieve these objectives increasingly businesses look to leverage the benefits of the cloud. Helping businesses move to the cloud is one of our largest opportunities, and we believe we work from a position of strength. The shift to the cloud is driven by three important economies of scale: larger datacenters can deploy computational resources at +significantly lower cost per unit than smaller ones; larger datacenters can coordinate and aggregate diverse customer, geographic, and application demand patterns improving the utilization of computing, storage, and network resources; and +multi-tenancy lowers application maintenance labor costs for large public clouds. The cloud creates the opportunity for businesses to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers. With Azure, we are one of very few cloud vendors that run at a scale that meets the needs of businesses of all sizes and complexities. +We believe the combination of Azure and Windows Server makes us the only company with a public, private, and hybrid cloud platform that can power modern business. We are working to enhance the return on IT investment by enabling enterprises to +combine their existing datacenters and our public cloud into a single cohesive infrastructure. Businesses can deploy applications in their own datacenter, a partner’s datacenter, or in our datacenters with common security, management, and +administration across all environments, with the flexibility and scale they desire. Our cloud will also enable richer employee +experiences. We enable organizations to securely adopt software-as-a-service applications (both our own and third-party) and integrate them with their existing security and management infrastructure. We will continue to innovate with higher level +services including identity and directory services, rich data storage and analytics services, machine learning services, media services, web, and mobile backend services, and developer productivity services. To foster a rich developer ecosystem, our +digital work 27 Table of Contents PART II Item 7 and life experiences will also be extensible, enabling customers and partners to further customize and enhance our solutions, achieving even more value. Our strategy requires continuing +investment in datacenters and other infrastructure to support our devices and services, and will bring continued competition with Google, Amazon, and other well-established and emerging competitors. Device operating system and hardware With +our Windows device operating system and first-party hardware, we strive to set the standard for productivity experiences. We aim to deliver the richest and most consistent user experience for digital work and life scenarios on screens of all sizes +– from phones, tablets, and laptops to TVs and large, multi-touch displays. We are investing to make Windows the most secure, manageable, and capable operating system for the needs of a modern workforce. We are working to create a broad +developer opportunity by enabling universal Windows applications to run across all device targets. We are developing new input/output methods like speech, pen, and gesture to power more personal computing experiences. We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. We also build first-party hardware to set the standard for +productivity experiences and stimulate more demand for the entire Windows ecosystem, as we do with Surface, and with the acquisition of substantially all Nokia Corporation’s (“Nokia”) Devices and Services business (“NDS”) on +April 25, 2014, phones. As consumer services and hardware advance, we expect they will continue to better complement one another, connecting the devices people use daily to unique communications, productivity, and entertainment services from +Microsoft and our partners and developers. We anticipate many new mobile device categories and we anticipate experiences to emerge that span a variety of devices of all screen sizes. We will invest to be on the forefront of this innovation focusing +on dual users and their needs across work and life. With the acquisition of NDS, we expect our effective tax rate to increase as our business mix changes. Our future opportunity There are several distinct areas of technology that we aim to drive +forward. Our goal is to lead the industry in these areas over the long term, which we expect will translate to sustained growth. We are investing significant resources in: • Delivering new high-value digital work and digital life experiences to improve how people learn, work, play, and interact with one another. • Establishing our Windows platform across the PC, tablet, phone, server, other devices, and the cloud to drive a thriving ecosystem of developers, unify the +cross-device user experience, and increase agility when bringing new advances to market. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Developing new devices that have increasingly natural ways to use them, including touch, gesture, and speech. • Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command. We believe the breadth of our products and services portfolio, our large, global partner and customer base, our growing ecosystem, and our ongoing +investment in innovation position us to be a leader in these areas. Economic Conditions, Challenges, and Risks The market for software, devices, and cloud-based services is dynamic and highly competitive. Our competitors are developing new software and +devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud and in some cases the user’s choice of +which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. To support our strategy of 28 Table of Contents PART II Item 7 reinventing productivity to empower every person and every organization to do more and achieve more, we announced a restructuring plan in July 2014. Through this restructuring, we strive to +increase agility, streamline engineering processes, move faster and more efficiently, and simplify our organization. Even if we achieve these goals, the investments we are making in devices and infrastructure will increase our operating costs and +may decrease our operating margins. We prioritize our investments among the highest long-term growth opportunities. These investments +require significant resources and are multi-year in nature. The products and services we bring to market may be developed internally, as part of a partnership or alliance, or through acquisition. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent +worldwide. Microsoft competes for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and +competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. See a discussion of these factors and other risks under Risk +Factors (Part I, Item 1A of this Form 10-K). Unearned Revenue Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions below regarding: • revenue deferred on certain devices bundled with other products and services (“Bundled Offerings”); and • revenue deferred on sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the “Windows Upgrade Offer”). If our customers choose to license cloud-based versions of our products and services rather than licensing +transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Reportable Segments The segment amounts +included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of +this Form 10-K) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the U.S. (“U.S. GAAP”), along with certain corporate-level and other activity, +are included in Corporate and other. Operating expenses are not allocated to our segments. During the first quarter of fiscal year +2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing +performance changed. Therefore, we have recast certain prior period amounts to conform to the way we internally managed and monitored segment performance during fiscal year 2014. Our reportable segments are described below. On April 25, 2014, we acquired substantially all of NDS for total consideration of $9.5 billion. This amount was greater than the $7.2 billion +disclosed previously, primarily due to $1.5 billion of cash acquired, foreign currency movements of $330 million, working capital adjustments of $210 million, and other adjustments of $260 million. See Note 9 – Business Combinations of the +Notes to Financial Statements for additional details. NDS has been included in our consolidated results of operations starting on the acquisition date. We report the financial performance of the acquired business in our new Phone Hardware segment. +Prior to the acquisition of NDS, financial results associated with our joint strategic initiatives with Nokia were reflected in our D&C Licensing segment. The contractual relationship with Nokia related to those initiatives terminated in +conjunction with the acquisition. With the creation of the new Phone Hardware segment, the D&C Hardware segment was renamed Computing and Gaming Hardware in the fourth quarter of fiscal year 2014. 29 Table of Contents PART II Item 7 Devices and Consumer (“D&C”) Our D&C segments develop, manufacture, market, and support products and services designed to entertain and connect people, increase personal +productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. Our D&C segments are: • D&C Licensing , comprising: Windows, including all OEM licensing (“Windows OEM”) and other non-volume licensing and academic volume +licensing of the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Office Consumer”); Windows Phone operating system, including related patent +licensing; and certain other patent licensing revenue; • Computing and Gaming Hardware , comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, +and Xbox Live subscriptions (“Xbox Platform”); Surface devices and accessories; and Microsoft PC accessories; • Phone Hardware, comprising: Lumia Smartphones and other non-Lumia phones, beginning with our acquisition of NDS; and • D&C Other , comprising: Resale, including Windows Store, Xbox Live transactions, and Windows Phone Store; search advertising; display advertising; +Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity +and efficiency, including simplifying everyday tasks through seamless operations across the user’s hardware and software. Our Commercial segments are: • Commercial Licensing , comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client +Access Licenses (“CALs”); Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Office for business, including Office, Exchange, SharePoint, Lync, and related +CALs (“Office Commercial”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and • Commercial Other , comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Commercial Cloud, comprising +Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure; and certain other commercial products and online services not included in the categories above. SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 Revenue $ 86,833 $ 77,849 $ 73,723 12% 6% Gross margin $ 59,899 $ 57,600 $ 56,193 4% 3% Operating income $ 27,759 $ 26,764 $ 21,763 4% 23% Diluted earnings per share $ 2.63 $ 2.58 $ 2.00 2% 29% Fiscal year 2014 compared with fiscal year 2013 Revenue increased $9.0 billion or 12%, demonstrating growth across our consumer and commercial businesses, primarily due to higher revenue from server products, Xbox Platform, Commercial Cloud, and Surface. Revenue +also increased due to the acquisition of NDS. Commercial Cloud revenue doubled, reflecting continued subscriber growth from our cloud-based offerings. 30 Table of Contents PART II Item 7 Gross margin increased $2.3 billion or 4%, primarily due to higher revenue, offset in part by a +$6.7 billion or 33% increase in cost of revenue. Cost of revenue increased mainly due to higher volumes of Xbox consoles and Surface devices sold, and $575 million higher datacenter expenses, primarily in support of Commercial Cloud revenue growth. +Cost of revenue also increased due to the acquisition of NDS. Operating income increased $995 million or 4%, reflecting higher gross +margin, offset in part by increased research and development expenses and sales and marketing expenses. Key changes in operating expenses were: • Research and development expenses increased $970 million or 9%, due mainly to increased investment in new products and services in our Devices engineering +group, including NDS expenses, and increased investment in our Applications and Services engineering group. • Sales and marketing expenses increased $535 million or 4%, primarily due to NDS expenses and increased investment in sales resources, offset in part by lower +advertising costs. Fiscal year 2013 compared with fiscal year 2012 Revenue increased $4.1 billion or 6%, mainly due to growth in revenue from our Commercial segments. Revenue was also impacted by the timing of +revenue deferrals. Operating income grew $5.0 billion or 23%, primarily due to the $6.2 billion goodwill impairment charge recorded +during the prior year. Other key changes in cost of revenue and operating expenses were: • Cost of revenue increased $2.7 billion or 16%, reflecting increased product costs associated with Surface and Windows 8, including an approximately $900 +million charge for Surface RT inventory adjustments, higher headcount-related expenses, payments made to Nokia related to joint strategic initiatives, royalties on Xbox Live content, and retail stores expenses, offset in part by decreased costs +associated with lower sales of Xbox 360 consoles and decreased traffic acquisition costs. • Sales and marketing expenses increased $1.4 billion or 10%, reflecting advertising of Windows 8 and Surface. • Research and development expenses increased $600 million or 6%, due mainly to higher headcount-related expenses, largely related to the Xbox Platform. • General and administrative expenses increased $580 million or 13%, due to higher legal charges, primarily due to the European Commission fine of € 561 million (approximately $733 million) for failure to comply with our 2009 agreement to display a “Browser Choice Screen” on +Windows PCs where Internet Explorer is the default browser (the “EU fine”). 31 Table of Contents PART II Item 7 SEGMENT RESULTS OF OPERATIONS Devices and Consumer (In millions, except percentages) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 Revenue Licensing $ 18,803 $ 19,021 $ 19,495 (1)% (2)% Hardware: Computing and Gaming Hardware 9,628 6,461 6,740 49% (4)% Phone Hardware 1,985 0 0 * * Total D&C Hardware 11,613 6,461 6,740 80% (4)% Other 7,258 6,618 6,203 10% 7% Total D&C revenue $ 37,674 $ 32,100 $ 32,438 17% (1)% Gross Margin Licensing $ 17,216 $ 17,044 $ 17,240 1% (1)% Hardware: Computing and Gaming Hardware 893 956 2,495 (7)% (62)% Phone Hardware 54 0 0 * * Total D&C Hardware 947 956 2,495 (1)% (62)% Other 1,770 2,046 1,998 (13)% 2% Total D&C gross margin $ 19,933 $ 20,046 $ 21,733 (1)% (8)% * Not meaningful Fiscal year 2014 +compared with fiscal year 2013 D&C revenue increased $5.6 billion or 17%, primarily due to higher revenue from Xbox Platform, +Surface, and Windows Phone. Revenue also increased $2.0 billion due to the acquisition of NDS. D&C gross margin decreased slightly, reflecting higher cost of revenue, offset in part by higher revenue. Cost of revenue increased $5.7 billion or +47%, due mainly to Xbox Platform and Surface. Cost of revenue also increased $1.9 billion due to NDS. D&C Licensing D&C Licensing revenue decreased $218 million or 1%, due mainly to lower revenue from licenses of Windows and Office Consumer, as well as a +decrease in royalty revenue, offset in part by increased Windows Phone revenue. Retail and non-OEM sales of Windows declined $304 million or 41%, due mainly to the launch of Windows 8 in the prior year. Windows OEM revenue declined $136 million or +1%, due to continued softness in the consumer PC market, offset in part by a 12% increase in OEM Pro revenue. Office Consumer revenue declined $243 million or 8%, reflecting the transition of customers to Office 365 Consumer as well as continued +softness in the consumer PC market. The declines in Windows OEM and Office Consumer revenue were partially offset by benefits realized from ending our support for Windows XP in April 2014. Windows Phone revenue increased $822 million or 48%, due +mainly to the recognition of $382 million revenue under our joint strategic initiatives with Nokia, which concluded in conjunction with the acquisition of NDS, as well as an increase in phone patent licensing revenue. D&C Licensing gross margin increased $172 million or 1%, primarily due to a $390 million or 20% decrease in cost of revenue. D&C Licensing +cost of revenue decreased, due mainly to a $411 million or 23% decline in traffic acquisition costs. 32 Table of Contents PART II Item 7 Computing and Gaming Hardware Computing and Gaming Hardware revenue increased $3.2 billion or 49%, primarily due to higher revenue from the Xbox Platform and Surface. Xbox Platform revenue increased $1.7 billion or 34%, due mainly to sales of +Xbox One, which was released in November 2013, offset in part by a decrease in sales of Xbox 360. We sold 11.7 million Xbox consoles during fiscal year 2014 compared with 9.8 million Xbox consoles during fiscal year 2013. Surface revenue +increased $1.3 billion or 157%, due mainly to a higher number of devices and accessories sold. Computing and Gaming Hardware gross +margin decreased slightly, due to a $3.2 billion or 59% increase in cost of revenue, offset in part by higher revenue. Xbox Platform cost of revenue increased $2.1 billion or 72%, due mainly to higher volumes of consoles sold and higher costs +associated with Xbox One. Surface cost of revenue increased $970 million or 51%, due mainly to a higher number of devices and accessories sold, offset in part by a charge for Surface RT inventory adjustments of approximately $900 million in fiscal +year 2013. Phone Hardware Phone Hardware revenue was $2.0 billion, reflecting sales of Lumia Smartphones and other non-Lumia phones following the acquisition of NDS on +April 25, 2014. Since the acquisition, we sold 5.8 million Lumia Smartphones and 30.3 million non-Lumia phones. Phone +Hardware gross margin was $54 million, reflecting revenue of $2.0 billion, offset in part by $1.9 billion cost of revenue, including amortization of acquired intangible assets and the impact of decisions to rationalize our device portfolio. D&C Other D&C Other +revenue increased $640 million or 10%, due mainly to higher online advertising revenue and Office 365 Consumer revenue, offset in part by a $213 million decrease in first-party video games revenue, primarily due to the release of Halo 4 in the +second quarter of fiscal year 2013. Online advertising revenue increased $497 million or 14%. Search advertising revenue increased 39%, due primarily to increased revenue per search resulting from ongoing improvements in advertising +products, higher search volume, and the expiration of North American revenue per search guarantee payments to Yahoo! in the prior year , offset in part by a 25% reduction in display advertising revenue. Office 365 Consumer revenue grew $316 +million, primarily reflecting subscriber growth. We ended fiscal year 2014 with over five million subscribers. D&C Other gross +margin decreased $276 million or 13%, due to a $916 million or 20% increase in cost of revenue, offset in part by higher revenue. D&C Other cost of revenue grew, due mainly to a $541 million or 24% increase in online advertising cost of revenue, +reflecting support of online infrastructure. Cost of revenue also increased $219 million or 15%, due to higher resale transactions costs. Fiscal +year 2013 compared with fiscal year 2012 D&C revenue decreased $338 million or 1%, reflecting lower revenue from D&C +Licensing and Computing and Gaming Hardware, offset in part by increased revenue from D&C Other. D&C gross margin decreased $1.7 billion or 8%, primarily due to higher cost of revenue and lower revenue. Cost of revenue increased $1.3 billion +or 13%, primarily due to Computing and Gaming Hardware. D&C Licensing D&C Licensing revenue decreased $474 million or 2%, due mainly to lower revenue from licenses of Consumer and Windows OEM, offset in part by +increased Windows Phone revenue. Office Consumer revenue declined $618 million or 15%, while Windows OEM revenue declined 10%. These decreases resulted primarily from the impact on revenue of a decline in the x86 PC market, which we estimate +declined approximately 9%. Windows Phone revenue increased $1.2 billion, including an increase in patent licensing revenue and sales of Windows Phone licenses. 33 Table of Contents PART II Item 7 In May 2013, we announced that we had surpassed 100 million licenses sold for Windows 8. D&C Licensing gross margin decreased $196 million or 1%, due to decreased revenue, offset in part by a $278 million or 12% decrease +in cost of revenue. D&C Licensing cost of revenue decreased, due mainly to lower traffic acquisition costs, offset in part by a $375 million increase in expenses for payments made to Nokia related to joint strategic initiatives. Computing and Gaming Hardware Computing +and Gaming Hardware revenue decreased $279 million or 4%, due primarily to lower revenue from the Xbox Platform, offset in part by Surface revenue. Xbox Platform revenue decreased $1.3 billion or 22%, due mainly to lower volumes of consoles sold, +offset in part by higher Xbox Live subscription revenue. We shipped 9.8 million Xbox 360 consoles during fiscal year 2013, compared with 13.0 million Xbox 360 consoles during fiscal year 2012. Surface revenue was $853 million. The general +availability of Surface RT and Surface Pro started October 26, 2012 and February 9, 2013, respectively. Computing and Gaming +Hardware gross margin decreased $1.5 billion or 62%, due to a $1.3 billion or 30% increase in cost of revenue and decreased revenue. Computing and Gaming Hardware cost of revenue increased, primarily due to $1.9 billion in product costs associated +with Surface, including a charge for Surface RT inventory adjustments of approximately $900 million. These costs were offset in part by a $920 million or 24% decrease in Xbox Platform cost of revenue, due mainly to a decrease in manufacturing and +distribution costs associated with lower volumes of Xbox 360 consoles sold. D&C Other D&C Other revenue increased $415 million or 7%, due mainly to higher advertising revenue, which increased $213 million or 7% to $3.5 billion. +Search advertising revenue growth was offset in part by a decline in display advertising revenue. Search advertising revenue grew primarily due to increased revenue per search, resulting from ongoing improvements in ad products, while display +advertising revenue decreased primarily due to industry-wide market pressure. D&C Other revenue also increased $202 million or 7%, due mainly to higher volumes of content resold through our online platforms. D&C Other gross margin increased $48 million or 2%, due to increased revenue offset in part by a $367 million or 9% increase in cost of +revenue. D&C Other cost of revenue increased, due mainly to a $327 million or 28% increase in costs associated with higher volumes of resale transactions, primarily a $257 million increase in royalties on Xbox Live content. Increased traffic +acquisition costs were offset in part by lower Yahoo! reimbursement costs. Commercial (In millions, except percentages) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 Revenue Licensing $ 42,027 $ 39,686 $ 37,126 6% 7% Other 7,547 5,660 4,644 33% 22% Total Commercial revenue $ 49,574 $ 45,346 $ 41,770 9% 9% Gross Margin Licensing $ 38,604 $ 36,261 $ 34,463 6% 5% Other 1,856 921 579 102% 59% Total Commercial gross margin $ 40,460 $ 37,182 $ 35,042 9% 6% 34 Table of Contents PART II Item 7 Fiscal year 2014 compared with fiscal year 2013 Commercial revenue increased $4.2 billion or 9%, due mainly to growth in revenue from our on-premises licensing businesses and Commercial Cloud. +Collectively, Office Commercial and Office 365 Commercial revenue grew 8%. Collectively, our server products revenue, including Microsoft Azure, grew 13%. Commercial gross margin increased $3.3 billion or 9%, in line with revenue. Commercial Licensing Commercial Licensing +revenue increased $2.3 billion or 6%, due primarily to increased revenue from our server products, as well as higher revenue from Windows Commercial and Office Commercial. Our server products revenue grew $1.7 billion or 11%, driven primarily +by increased sales of Microsoft SQL Server. Windows Commercial revenue grew $334 million or 10%, due mainly to increased renewal rates and transactional purchases driven by Windows XP end of support. Office Commercial revenue grew $253 million or +1%, and was impacted by customers transitioning to Office 365 Commercial. Commercial Licensing gross margin increased $2.3 billion or +6%, in line with revenue growth. Commercial Other Commercial Other revenue increased $1.9 billion or 33%, due to higher Commercial Cloud revenue and Enterprise Services revenue. Commercial Cloud revenue grew $1.5 billion or 116%, due mainly to higher revenue from +Office 365 Commercial. Enterprise Services revenue grew $380 million or 9%, due mainly to growth in Premier Support Services. Commercial Other gross margin increased $935 million or 102%, due to higher revenue, offset in part by a $952 million or 20% increase in cost of +revenue. The increase in cost of revenue was due mainly to higher datacenter expenses, reflecting support of our growing Commercial Cloud. Fiscal +year 2013 compared with fiscal year 2012 Commercial revenue increased $3.6 billion or 9%, due mainly to growth in revenue from our +on-premises licensing businesses and Commercial Cloud. Commercial gross margin increased $2.1 billion or 6%. Commercial Licensing Commercial Licensing +revenue increased $2.6 billion or 7%, due to increased revenue from all major commercial offerings. Server products revenue increased $1.2 billion or 9%, driven primarily by growth in Microsoft SQL Server, System Center, and Windows Server. Office +Commercial revenue increased $622 million or 4%, reflecting growth in Office revenue from volume licensing agreements with software assurance. Windows Commercial revenue increased $379 million or 13%, reflecting continued support of our platform. +Skype revenue increased, due primarily to including a full year of results in fiscal year 2013. Commercial Licensing gross margin +increased $1.8 billion or 5%, due to higher revenue, offset in part by a $762 million or 29% increase in cost of revenue. Commercial Licensing cost of revenue increased, due to increased costs from all major commercial offerings, including $287 +million higher intellectual property licensing costs. Commercial Other Commercial Other revenue increased $1.0 billion or 22%, due to higher Commercial Cloud and Enterprise Services revenue. Commercial Cloud revenue grew $582 million or 82%, due mainly to higher revenue from Office +365 Commercial. Enterprise Services revenue grew $434 million or 11%, due to growth in both Premier product support and consulting services. 35 Table of Contents PART II Item 7 Commercial Other gross margin increased $342 million or 59%, due to higher revenue, offset in part +by a $674 million or 17% increase in cost of revenue. The increase in cost of revenue was due mainly to higher datacenter expenses, reflecting investment in online operations infrastructure, and increased headcount-related expenses, mainly due to +higher Enterprise Services headcount supporting revenue growth. Corporate and Other (In millions, except percentages) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 Revenue $ (415 ) $ 403 $ (485 ) (203)% 183% Gross margin $ (494 ) $ 372 $ (582 ) (233)% 164% Corporate and Other revenue comprises certain revenue deferrals, including those related to product and service +upgrade offers and pre-sales of new products to OEMs prior to general availability. Fiscal year 2014 compared with fiscal year 2013 Corporate and Other revenue decreased $818 million, primarily due to the timing of revenue deferrals. During fiscal year 2014, we deferred a net +$349 million of revenue related to Bundled Offerings. During fiscal year 2013, we recognized $540 million of previously deferred revenue related to the Windows Upgrade Offer. The revenue was recognized upon expiration of the offer. Corporate and Other gross margin decreased $866 million, due mainly to decreased revenue. Fiscal year 2013 compared with fiscal year 2012 Corporate and Other revenue increased $888 +million or 183%, primarily due to the timing of revenue deferrals. During fiscal year 2013, we recognized $540 million of revenue that had been deferred in fiscal year 2012 related to the Windows Upgrade Offer. The revenue was recognized upon +expiration of the offer. Corporate and Other gross margin increased $954 million or 164%, due mainly to increased revenue. OPERATING EXPENSES Research and +Development (In millions, except percentages) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 Research and development $ 11,381 $ 10,411 $ 9,811 9% 6% As a percent of revenue 13% 13% 13% 0ppt 0ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the +amortization of purchased software code. Fiscal year 2014 compared with fiscal year 2013 Research and development expenses increased $970 million or 9%, due mainly to increased investment in new products and services in our Devices +engineering group, including $275 million of NDS expenses, and increased investment in our Applications and Services engineering group. 36 Table of Contents PART II Item 7 Fiscal year 2013 compared with fiscal year 2012 Research and development expenses increased, reflecting a $460 million or 6% increase in headcount-related expenses, largely related to the Xbox +Platform. Sales and Marketing (In millions, except percentages) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 Sales and marketing $ 15,811 $ 15,276 $ 13,857 4% 10% As a percent of revenue 18% 20% 19% (2)ppt 1ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2014 compared with fiscal year 2013 Sales and marketing expenses increased $535 +million or 4%, primarily due to NDS expenses and increased investment in sales resources, offset in part by lower advertising costs. NDS sales and marketing expenses were $394 million during fiscal year 2014. Average headcount, excluding NDS, grew +4%. Advertising costs, excluding NDS, declined $403 million or 15%, primarily due to Windows 8 and Surface costs in the prior year. Fiscal year 2013 +compared with fiscal year 2012 Sales and marketing expenses grew, reflecting an $898 million increase in advertising costs +associated primarily with Windows 8 and Surface, $181 million higher fees paid to third-party software advisors, and a $145 million or 2% increase in headcount-related expenses. General and Administrative (In millions, except percentages) 2014 2013 2012 Percentage Change 2014 Versus 2013 Percentage Change 2013 Versus 2012 General and administrative $ 4,821 $ 5,149 $ 4,569 (6)% 13% As a percent of revenue 6% 7% 6% (1)ppt 1ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance +expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal year 2014 compared with fiscal year 2013 General and administrative expenses decreased $328 million or 6%, due mainly to the EU fine in the prior year, offset in part by higher business taxes, higher costs for internal use software capitalized in the +prior year, and NDS expenses. NDS general and administrative expenses were $77 million during fiscal year 2014. Fiscal year 2013 compared with +fiscal year 2012 General and administrative expenses increased, primarily due to legal charges for the EU fine. 37 Table of Contents PART II Item 7 Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. No impairment of +goodwill was identified as of May 1, 2014 or May 2013. Our goodwill impairment test as of May 1, 2012, indicated that the carrying value of our previous Online Services Division reporting unit (in Devices and Consumer Other under our +current segment structure) exceeded its estimated fair value. Accordingly, we recorded a non-cash, non-tax deductible goodwill impairment charge of $6.2 billion during the three months ended June 30, 2012, reducing the unit’s goodwill from +$6.4 billion to $223 million. Integration and Restructuring Integration and restructuring expenses consist of transaction fees and direct acquisition costs, including legal, finance, consulting, and other professional fees. Integration and restructuring expenses also +include employee compensation and termination costs associated with certain reorganization activities. Integration and restructuring +expenses were $127 million for fiscal year 2014, reflecting expenses associated with the acquisition and integration of NDS. OTHER +INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2014 2013 2012 Dividends and interest income $ 883 $ 677 $ 800 Interest expense (597 ) (429 ) (380 ) Net recognized gains on investments 437 116 564 Net losses on derivatives (328 ) (196 ) (364 ) Net losses on foreign currency remeasurements (165 ) (74 ) (117 ) Other (169 ) 194 1 Total $ 61 $ 288 $ 504 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and +credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). Other than those +derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of +other comprehensive income (“OCI”) until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense). Fiscal year 2014 compared with fiscal year 2013 Dividends and interest income increased due to higher portfolio balances. Interest expense increased due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher +gains on sales of equity securities and lower other-than-temporary impairments. Other-than-temporary impairments were $106 million in fiscal year 2014, compared with $208 million in fiscal year 2013. Net losses on derivatives increased due to higher +losses on foreign exchange contracts, losses on equity derivatives as compared to gains in the prior period, offset in part by gains on commodity and interest rate derivatives as compared to losses in the prior period. For fiscal year 2014, other +reflects recognized losses from certain joint ventures, offset in part by a recognized gain on a divestiture. For fiscal year 2013, other reflects recognized gains on divestitures, including the gain recognized upon the divestiture of our 50% share +in the MSNBC joint venture. 38 Table of Contents PART II Item 7 Fiscal year 2013 compared with fiscal year 2012 Dividends and interest income decreased due to lower yields on our fixed-income investments, offset in part by higher average portfolio investment +balances. Net recognized gains on investments decreased primarily due to lower gains on sales of equity and fixed-income securities and a gain recognized on the partial sale of our Facebook holding in the prior year, offset in part by lower +other-than-temporary impairments. Other-than-temporary impairments were $208 million in fiscal year 2013, compared with $298 million in fiscal year 2012. Net losses on derivatives decreased due to gains on equity derivatives in the current fiscal +year as compared with losses in the prior fiscal year, and lower losses on commodity and foreign exchange derivatives as compared to the prior fiscal year, offset in part by losses on interest-rate derivatives in the current fiscal year as compared +to gains in the prior fiscal year. For the current year, other reflects recognized gains on divestitures, including the gain recognized upon the divestiture of our 50% share in the MSNBC joint venture. INCOME TAXES Fiscal year 2014 compared +with fiscal year 2013 Our effective tax rate for fiscal years 2014 and 2013 was approximately 21% and 19%, respectively. Our +effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations +centers in Ireland, Singapore, and Puerto Rico. Our fiscal year 2014 effective rate increased by 2% from fiscal year 2013 mainly due to +adjustments of $458 million to prior years’ liabilities for intercompany transfer pricing that increased taxable income in more highly taxed jurisdictions, as well as losses incurred by NDS and changes in the geographic mix of our business. +This was offset in part by favorable transfer pricing developments in certain foreign tax jurisdictions, primarily Denmark. Changes in +the mix of income before income taxes between the U.S. and foreign countries also impacted our effective tax rates and resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. We +supply our Windows PC operating system to customers through our U.S. regional operating center, while we supply the Microsoft Office system and our server products and tools to customers through our foreign regional operations centers. Windows PC +operating system revenue decreased $655 million in fiscal year 2014, while Microsoft Office system and server products and tools revenue increased $1.3 billion and $1.6 billion, respectively, during this same period. In fiscal years 2014 and 2013, +our U.S. income before income taxes was $7.1 billion and $6.7 billion, respectively, and comprised 26% and 25%, respectively, of our income before income taxes. In fiscal years 2014 and 2013, the foreign income before income taxes was $20.7 billion +and $20.4 billion, respectively, and comprised 74% and 75%, respectively, of our income before income taxes. Tax contingencies and +other tax liabilities were $10.4 billion and $9.4 billion as of June 30, 2014 and 2013, respectively, and are included in other long-term liabilities. This increase relates primarily to adjustments to prior years’ liabilities for +intercompany transfer pricing and adjustments related to our IRS audits. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for those years. In February 2012, +the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of June 30, 2014, the primary unresolved issue relates to transfer pricing which could have a significant impact on our consolidated +financial statements if not resolved favorably. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do +not anticipate a significant increase or decrease to our tax contingencies for these issues. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2013. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax +years 1996 to 2013, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. 39 Table of Contents PART II Item 7 Fiscal year 2013 compared with fiscal year 2012 Our effective tax rate for fiscal years 2013 and 2012 was approximately 19% and 24%, respectively. Our effective tax rate was lower than the U.S. +federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto +Rico. Our fiscal year 2013 effective rate decreased by 5% from fiscal year 2012 mainly due to a nonrecurring $6.2 billion non-tax +deductible goodwill impairment charge that was recorded in fiscal year 2012. The goodwill impairment charge increased our effective tax rate by 10% in fiscal year 2012. In addition, in fiscal years 2013 and 2012, we recognized a reduction of 18% and +21%, respectively, to the effective tax rate due to foreign earnings taxed at lower rates. The decrease in our effective tax rate for fiscal year 2013 was primarily offset by a 1% increase related to the EU fine, which is not tax deductible. Changes in the mix of income before income taxes between the U.S. and foreign countries also impacted our effective tax rates and +resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. We supply our Windows PC operating system to customers through our U.S. regional operating center, while we supply the +Microsoft Office system and our server products and tools to customers through our foreign regional operations centers. Windows PC operating system revenue increased $209 million in fiscal year 2013, while Microsoft Office system and server products +and tools revenue increased $696 million and $1.2 billion, respectively, during this same period. In fiscal years 2013 and 2012, our U.S. income before income taxes was $6.7 billion and $1.6 billion, respectively, and comprised 25% and 7%, +respectively, of our income before income taxes. In fiscal years 2013 and 2012, the foreign income before income taxes was $20.4 billion and $20.7 billion, respectively, and comprised 75% and 93%, respectively, of our income before income taxes. The +primary driver for the increase in the U.S. income before income tax in fiscal year 2013 was the goodwill impairment charge recorded during the prior year. Tax contingencies and other tax liabilities were $9.4 billion and $7.6 billion as of June 30, 2013 and 2012, respectively, and are included in other long-term liabilities. This increase relates primarily to +transfer pricing, including transfer pricing developments in certain foreign tax jurisdictions, primarily Denmark. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain +under audit for those years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit phase of the examination. As of June 30, 2013, the primary unresolved issue relates to transfer pricing which could have a +significant impact on our consolidated financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months +because we do not believe the remaining open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2012. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax +years 1996 to 2012, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. FINANCIAL CONDITION Cash, Cash +Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $85.7 billion as of June 30, 2014, +compared with $77.0 billion as of June 30, 2013. Equity and other investments were $14.6 billion as of June 30, 2014, compared with $10.8 billion as of June 30, 2013. Our short-term investments are primarily to facilitate liquidity +and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also +include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are 40 Table of Contents PART II Item 7 managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held +are primarily highly liquid investment-grade fixed-income securities. Of the cash, cash equivalents, and short-term investments at +June 30, 2014, $77.1 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other +restrictions on the free flow of funds (primarily currency and other local regulatory) was $2.6 billion. As of June 30, 2014, approximately 84% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in +U.S. government and agency securities, approximately 5% were invested in corporate notes and bonds of U.S. companies, and approximately 1% were invested in U.S. mortgage-backed securities, all of which are denominated in U.S. dollars. Securities lending We lend certain +fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount +determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $558 million as of June 30, 2014. Our +average and maximum securities lending payable balances for the fiscal year were $619 million and $1.3 billion, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and +where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, +domestic and international equities, and U.S. government securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or +inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, common and preferred stock, foreign government bonds, +mortgage-backed securities, and certificates of deposit. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an +immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 +investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the +investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker +prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these +investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and +independent recalculation of prices where appropriate. Cash Flows Fiscal year 2014 compared with fiscal year 2013 Cash flows from operations increased $3.4 +billion during the current fiscal year to $32.2 billion, due mainly to increases in cash received from customers. Cash used in financing increased $246 million to $8.4 billion, due mainly to a $2.0 billion increase in cash used for common stock +repurchases, a $1.4 billion increase in dividends paid, and a $324 million decrease in proceeds from the issuance of common stock, offset in part by a $3.4 billion increase in 41 Table of Contents PART II Item 7 proceeds from issuances of debt, net of repayments. Cash used in investing decreased $5.0 billion to $18.8 billion, due mainly to a $10.5 billion decrease in cash used for net investment +purchases, sales, and maturities, offset in part by a $4.4 billion increase in cash used for acquisition of companies and purchases of intangible and other assets, and a $1.2 billion increase in capital expenditures for property and equipment. Fiscal year 2013 compared with fiscal year 2012 Cash flows from operations decreased $2.8 billion during the current fiscal year to $28.8 billion, due mainly to changes in working capital, including increases in inventory and other current assets. Cash used for +financing decreased $1.3 billion to $8.1 billion, due mainly to a $3.5 billion increase in proceeds from issuances of debt, net of repayments, offset in part by a $1.1 billion increase in dividends paid and a $982 million decrease in proceeds from +the issuance of common stock. Cash used in investing decreased $975 million to $23.8 billion, due mainly to an $8.5 billion decrease in cash used for acquisitions of companies and purchases of intangible and other assets, offset in part by a $5.8 +billion increase in cash used for net investment purchases, maturities, and sales, and a $2.0 billion increase in cash used for additions to property and equipment. Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, +reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, +repurchases of capital stock, acquisitions, and repayment of existing debt. As of June 30, 2014, we had $22.6 billion of issued +and outstanding debt, comprising $2.0 billion of short-term debt and $20.6 billion of long-term debt. Short-term debt As of June 30, 2014, we had $2.0 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.12% and +maturities ranging from 86 days to 91 days. The estimated fair value of this commercial paper approximates its carrying value. We have +a $5.0 billion credit facility that expires on November 14, 2018, which serves as a back-up for our commercial paper program. As of June 30, 2014, we were in compliance with the only financial covenant in the credit agreement, which +requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreement. No amounts were drawn against the credit facility during any of +the periods presented. Long-term debt As of June 30, 2014, the total carrying value and estimated fair value of our long-term debt were $20.6 billion and $21.5 billion, respectively. These estimated fair values are based on Level 2 inputs. 42 Table of Contents PART II Item 7 The components of our long-term debt and the associated interest rates were as follows as of +June 30, 2014: Due Date Face Value Stated Interest Rate Effective Interest Rate (In millions) Notes September 25, 2015 $ 1,750 1.625% 1.795% February 8, 2016 750 2.500% 2.642% November 15, 2017 600 0.875% 1.084% May 1, 2018 450 1.000% 1.106% December 6, 2018 (a) 1,250 1.625% 1.824% June 1, 2019 1,000 4.200% 4.379% October 1, 2020 1,000 3.000% 3.137% February 8, 2021 500 4.000% 4.082% December 6, 2021 (b) 2,396 2.125% 2.233% November 15, 2022 750 2.125% 2.239% May 1, 2023 1,000 2.375% 2.465% December 15, 2023 (a) 1,500 3.625% 3.726% December 6, 2028 (b) 2,396 3.125% 3.218% May 2, +2033 (c) 753 2.625% 2.690% June 1, 2039 750 5.200% 5.240% October 1, 2040 1,000 4.500% 4.567% February 8, 2041 1,000 5.300% 5.361% November 15, 2042 900 3.500% 3.571% May 1, 2043 500 3.750% 3.829% December 15, 2043 (a) 500 4.875% 4.918% Total $ 20,745 (a) In December 2013, we issued $3.3 billion of debt securities. (b) In December 2013, we issued €3.5 billion of debt securities. (c) In April 2013, we issued €550 million of debt securities. The notes in this table are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes +is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of June 30, 2014, the aggregate unamortized discount for our long-term debt was $100 million. Unearned Revenue Unearned revenue at +June 30, 2014 was comprised mainly of unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the +agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Unearned revenue at June 30, 2014 also included payments for: post-delivery support and +consulting services to be performed in the future; Xbox Live subscriptions and prepaid points; Microsoft Dynamics business solutions products; Office 365 subscriptions; Bundled Offerings; Skype prepaid credits and subscriptions; and other offerings +for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. 43 Table of Contents PART II Item 7 The following table outlines the expected future recognition of unearned revenue as of +June 30, 2014: (In millions) Three Months Ending, September 30, 2014 $ 8,667 December 31, 2014 7,380 March 31, 2015 4,812 June 30, 2015 2,291 Thereafter 2,008 Total $ 25,158 Share Repurchases On September 16, 2013, our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, +2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of June 30, 2014, $35.1 billion remained of the $40.0 billion share repurchase program. During fiscal year 2014, we repurchased 175 million shares of Microsoft common stock for $6.4 billion; 128 million shares were +repurchased for $4.9 billion under the share repurchase program approved by our Board of Directors on September 16, 2013 and 47 million shares were repurchased for $1.5 billion under the share repurchase program that was announced on +September 22, 2008 and expired September 30, 2013. During fiscal years 2013 and 2012, we repurchased 158 million shares for $4.6 billion and 142 million shares for $4.0 billion, respectively, under the share repurchase program +announced on September 22, 2008. All repurchases were made using cash resources. Dividends During fiscal years 2014 and 2013, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) Fiscal Year 2014 September 16, 2013 $  0.28 November 21, 2013 $  2,332 December 12, 2013 November 19, 2013 $  0.28 February 20, 2014 $  2,322 March 13, 2014 March 11, 2014 $  0.28 May 15, 2014 $  2,309 June 12, 2014 June 10, 2014 $  0.28 August 21, 2014 $  2,307 September 11, 2014 Fiscal Year 2013 September 18, 2012 $  0.23 November 15, 2012 $  1,933 December 13, 2012 November 28, 2012 $  0.23 February 21, 2013 $  1,925 March 14, 2013 March 11, 2013 $  0.23 May 16, 2013 $  1,921 June 13, 2013 June 12, 2013 $  0.23 August 15, 2013 $  1,916 September 12, 2013 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material +impact on our consolidated financial statements during the periods presented. 44 Table of Contents PART II Item 7 Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2014: (In millions) 2015 2016-2017 2018-2019 Thereafter Total Long-term +debt: (a) Principal payments $ 0 $ 2,500 $ 3,300 $ 14,945 $ 20,745 Interest payments 566 1,069 1,015 6,110 8,760 Construction commitments (b) 880 0 0 0 880 Operating +leases (c) 878 1,419 1,054 1,063 4,414 Purchase commitments (d) 12,995 969 657 153 14,774 Other long-term liabilities (e) 0 354 80 393 827 Total contractual obligations $ 15,319 $ 6,311 $ 6,106 $ 22,664 $ 50,400 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) These amounts represent commitments for the construction of buildings, building improvements, and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. (e) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $13.3 billion from the amounts presented. We have also +excluded unearned revenue and non-cash items. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to +property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years in +support of our cloud and devices strategy. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities +or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a +result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these +funds. We expect existing domestic cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, +such as regular quarterly dividends, debt repayment schedules, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term +investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter +for the foreseeable future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to +fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives +could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates. 45 Table of Contents PART II Item 7 RECENT ACCOUNTING GUIDANCE Recently Adopted Accounting Guidance In December 2011, the Financial Accounting Standards +Board (“FASB”) issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments. The new guidance requires the disclosure of the gross +amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, repurchase +agreements, and securities lending arrangements that are either offset or subject to an enforceable master netting arrangement, or similar agreements. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted +only in changes to the presentation of Note 5 – Derivatives of the Notes to Financial Statements. In February 2013, the FASB +issued guidance on disclosure requirements for items reclassified out of AOCI. This new guidance requires entities to present (either on the face of the income statement or in the notes to financial statements) the effects on the line items of the +income statement for amounts reclassified out of AOCI. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 19 – Accumulated Other Comprehensive Income of +the Notes to Financial Statements. Recent Accounting Guidance Not Yet Adopted In March 2013, the FASB issued guidance on a parent’s accounting for the cumulative translation adjustment upon derecognition of a subsidiary +or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative translation adjustment into net income only if the sale or transfer results in the complete or substantially complete liquidation +of the foreign entity in which the subsidiary or group of assets had resided. The new guidance will be effective for us beginning July 1, 2014. We do not anticipate material impacts on our consolidated financial statements upon adoption. In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards, +the FASB issued a new standard related to revenue recognition. Under the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity +expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new standard will be +effective for us beginning July 1, 2017 and early adoption is not permitted. We anticipate this standard will have a material impact on our consolidated financial statements, and we are currently evaluating its impact. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect +the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of +investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted +for as separate units of accounting, and if so, the fair value for each of the elements. Judgment is also required to assess whether +future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for 46 Table of Contents PART II Item 7 current products combined with rights to receive unspecified future versions of software products (“Software Assurance”) and are accounted for as subscriptions, with billings recorded +as unearned revenue and recognized as revenue ratably over the coverage period. Software updates are evaluated on a case-by-case basis +to determine whether they meet the definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered. If it is determined that implied post-contract customer support (“PCS”) is being provided, +revenue from the arrangement is deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over +different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a +hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price +(“ESP”). For software elements, we follow the industry specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price +established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables +were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Windows 7 revenue was subject to deferral as a result of the Windows Upgrade Offer, which started June 2, 2012. The offer provided +significantly discounted rights to purchase Windows 8 Pro to qualifying end-users that purchased Windows 7 PCs during the eligibility period. Microsoft was responsible for delivering Windows 8 Pro to the end customer. Accordingly, revenue related to +the allocated discount for undelivered Windows 8 was deferred until it was delivered or the redemption period expired. Impairment of Investment +Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires +significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds +its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or +plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse +conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be +other-than-temporary, an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting +units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for +impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair +value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant +portion of a reporting unit. 47 Table of Contents PART II Item 7 Application of the goodwill impairment test requires judgment, including the identification of +reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the +use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of +the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to +calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill +impairment for each reporting unit. The valuation of acquired assets and liabilities, including goodwill, resulting from the +acquisition of NDS, is reflective of the enterprise value based on the long-term financial forecast for the business. In this highly competitive and volatile market, it is possible that we may not realize our forecasts. Given the value assigned +to goodwill in the purchase price allocation, we will closely monitor the performance of the business versus the long-term forecast to determine if any impairments arise. Research and Development Costs Costs incurred internally in researching and developing a +computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general +release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have +been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes +of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been +impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability +to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Income +Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year +and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more +likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the +largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax +assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial +statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. Inventories Inventories are stated at average cost, subject to the lower of cost or market. +Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory 48 Table of Contents PART II Item 7 quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, +product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The +determination of market value and the estimated volume of demand used in the lower of cost or market analysis require significant judgment. 49 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial +reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, +through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities +and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 50 Table of Contents PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK RISKS We are exposed to economic risk from foreign currency exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our consolidated +financial statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the +economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. Interest Rate Our fixed-income portfolio +is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and +domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency and mortgage-backed securities. Equity Our equity portfolio consists of +global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based +commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global +commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with accounting principles generally accepted in the United States (“U.S. GAAP”), but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed +based on the historical volatilities and correlations among foreign currency exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses +could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. 51 Table of Contents PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of +June 30, 2014 and 2013 and for the year ended June 30, 2014: (In millions) June 30, 2014 June 30, 2013 Year Ended June 30, 2014 Risk Categories Average High Low Foreign currency $ 179 $ 199 $ 215 $ 287 $ 117 Interest rate $ 73 $ 85 $ 82 $ 91 $ 73 Equity $ 176 $ 181 $ 208 $ 246 $ 173 Commodity $ 17 $ 19 $ 18 $ 21 $ 16 Total one-day VaR for the combined risk categories was $333 million at June 30, 2014 and $350 million at +June 30, 2013. The total VaR is 25% less at June 30, 2014, and 28% less at June 30, 2013, than the sum of the separate risk categories in the table above due to the diversification benefit of the combination of risks. 52 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2014 2013 2012 Revenue $ 86,833 $ 77,849 $ 73,723 Cost of revenue 26,934 20,249 17,530 Gross margin 59,899 57,600 56,193 Research and development 11,381 10,411 9,811 Sales and marketing 15,811 15,276 13,857 General and administrative 4,821 5,149 4,569 Goodwill impairment 0 0 6,193 Integration and restructuring 127 0 0 Operating income 27,759 26,764 21,763 Other income, net 61 288 504 Income before income taxes 27,820 27,052 22,267 Provision for income taxes 5,746 5,189 5,289 Net income $ 22,074 $ 21,863 $ 16,978 Earnings per share: Basic $ 2.66 $ 2.61 $ 2.02 Diluted $ 2.63 $ 2.58 $ 2.00 Weighted average shares outstanding: Basic 8,299 8,375 8,396 Diluted 8,399 8,470 8,506 Cash dividends declared per common share $ 1.12 $ 0.92 $ 0.80 See accompanying notes. 53 Table of Contents PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2014 2013 2012 Net income $ 22,074 $ 21,863 $ 16,978 Other comprehensive income (loss): Net unrealized gains (losses) on derivatives (net of tax effects of $(4) , $(14), and $137) (35 ) (26 ) 255 Net unrealized gains (losses) on investments (net of tax effects of $936 , $195, and $(210)) 1,737 363 (390 ) Translation adjustments and other (net of tax effects of $12 , $(8), and $(165)) 263 (16 ) (306 ) Other comprehensive income (loss) 1,965 321 (441 ) Comprehensive income $ 24,039 $ 22,184 $ 16,537 See accompanying notes. 54 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2014 2013 Assets Current assets: Cash and cash equivalents $ 8,669 $ 3,804 Short-term investments (including securities loaned of $541 and $579) 77,040 73,218 Total cash, cash equivalents, and short-term investments 85,709 77,022 Accounts receivable, net of allowance for doubtful accounts of $301 and $336 19,544 17,486 Inventories 2,660 1,938 Deferred income taxes 1,941 1,632 Other 4,392 3,388 Total current assets 114,246 101,466 Property and equipment, net of accumulated depreciation of $14,793 and $12,513 13,011 9,991 Equity and other investments 14,597 10,844 Goodwill 20,127 14,655 Intangible assets, net 6,981 3,083 Other long-term assets 3,422 2,392 Total assets $ 172,384 $ 142,431 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 7,432 $ 4,828 Short-term debt 2,000 0 Current portion of long-term debt 0 2,999 Accrued compensation 4,797 4,117 Income taxes 782 592 Short-term unearned revenue 23,150 20,639 Securities lending payable 558 645 Other 6,906 3,597 Total current liabilities 45,625 37,417 Long-term debt 20,645 12,601 Long-term unearned revenue 2,008 1,760 Deferred income taxes 2,728 1,709 Other long-term liabilities 11,594 10,000 Total liabilities 82,600 63,487 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,239 and 8,328 68,366 67,306 Retained earnings 17,710 9,895 Accumulated other comprehensive income 3,708 1,743 Total stockholders’ equity 89,784 78,944 Total liabilities and stockholders’ equity $ 172,384 $ 142,431 See accompanying notes. 55 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2014 2013 2012 Operations Net income $ 22,074 $ 21,863 $ 16,978 Adjustments to reconcile net income to net cash from operations: Goodwill impairment 0 0 6,193 Depreciation, amortization, and other 5,212 3,755 2,967 Stock-based compensation expense 2,446 2,406 2,244 Net recognized losses (gains) on investments and derivatives (109 ) 80 (200 ) Excess tax benefits from stock-based compensation (271 ) (209 ) (93 ) Deferred income taxes (331 ) (19 ) 954 Deferral of unearned revenue 44,325 44,253 36,104 Recognition of unearned revenue (41,739 ) (41,921 ) (33,347 ) Changes in operating assets and liabilities: Accounts receivable (1,120 ) (1,807 ) (1,156 ) Inventories (161 ) (802 ) 184 Other current assets (29 ) (129 ) 493 Other long-term assets (628 ) (478 ) (248 ) Accounts payable 473 537 (31 ) Other current liabilities 1,075 146 410 Other long-term liabilities 1,014 1,158 174 Net cash from operations 32,231 28,833 31,626 Financing Proceeds from issuance of short-term debt, maturities of 90 days or less, net 500 0 0 Proceeds from issuance of debt 10,350 4,883 0 Repayments of debt (3,888 ) (1,346 ) 0 Common stock issued 607 931 1,913 Common stock repurchased (7,316 ) (5,360 ) (5,029 ) Common stock cash dividends paid (8,879 ) (7,455 ) (6,385 ) Excess tax benefits from stock-based compensation 271 209 93 Other (39 ) (10 ) 0 Net cash used in financing (8,394 ) (8,148 ) (9,408 ) Investing Additions to property and equipment (5,485 ) (4,257 ) (2,305 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (5,937 ) (1,584 ) (10,112 ) Purchases of investments (72,690 ) (75,396 ) (57,250 ) Maturities of investments 5,272 5,130 15,575 Sales of investments 60,094 52,464 29,700 Securities lending payable (87 ) (168 ) (394 ) Net cash used in investing (18,833 ) (23,811 ) (24,786 ) Effect of exchange rates on cash and cash equivalents (139 ) (8 ) (104 ) Net change in cash and cash equivalents 4,865 (3,134 ) (2,672 ) Cash and cash equivalents, beginning of period 3,804 6,938 9,610 Cash and cash equivalents, end of period $ 8,669 $ 3,804 $ 6,938 See accompanying notes. 56 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2014 2013 2012 Common stock and paid-in capital Balance, beginning of period $ 67,306 $ 65,797 $ 63,415 Common stock issued 607 920 1,924 Common stock repurchased (2,328 ) (2,014 ) (1,714 ) Stock-based compensation expense 2,446 2,406 2,244 Stock-based compensation income tax benefits (deficiencies) 272 190 (75 ) Other, net 63 7 3 Balance, end of period 68,366 67,306 65,797 Retained earnings (deficit) Balance, beginning of period 9,895 (856 ) (8,195 ) Net income 22,074 21,863 16,978 Common stock cash dividends (9,271 ) (7,694 ) (6,721 ) Common stock repurchased (4,988 ) (3,418 ) (2,918 ) Balance, end of period 17,710 9,895 (856 ) Accumulated other comprehensive income Balance, beginning of period 1,743 1,422 1,863 Other comprehensive income (loss) 1,965 321 (441 ) Balance, end of period 3,708 1,743 1,422 Total stockholders’ equity $ 89,784 $ 78,944 $ 66,363 See accompanying notes. 57 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United +States of America (“U.S. GAAP”). Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we are able to +exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant +influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. Estimates and +Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts +of assets, liabilities, revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, and/or potential goodwill impairment for, our reporting units; product life cycles; useful lives of our tangible +and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software +arrangement, including the distinction between upgrades or enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our +consolidated financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Recasting of Certain Prior Period Information During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result, information that our chief operating decision +maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we reported our financial performance based on our new segments described in Note 21 – Segment Information +and Geographic Data. We have recast certain prior period amounts to conform to the way we internally managed and monitored segment performance during fiscal year 2014. This change impacted Note 10 – Goodwill, Note 14 – Unearned Revenue, +and Note 21 – Segment Information and Geographic Data, with no impact on our consolidated financial statements. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and +expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income (“OCI”). Revenue Recognition Revenue is recognized +when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable. Revenue generally is recognized net of allowances for returns and any taxes collected from customers and +subsequently remitted to governmental authorities. 58 Table of Contents PART II Item 8 Revenue recognition for multiple-element arrangements requires judgment to determine if multiple +elements exist, whether elements can be accounted for as separate units of accounting, and if so, the fair value for each of the elements. Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue +is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating +revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry +specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it +is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for +determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Revenue for retail packaged products, products licensed to original equipment manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are +shipped or made available. Technology guarantee programs are accounted for as multiple-element arrangements as customers receive free +or significantly discounted rights to use upcoming new versions of a software product if they license existing versions of the product during the eligibility period. Revenue is allocated between the existing product and the new product, and revenue +allocated to the new product is deferred until that version is delivered. The revenue allocation is based on the VSOE of fair value of the products. The VSOE of fair value for upcoming new products are based on the price determined by management +having the relevant authority when the element is not yet sold separately, but is expected to be sold in the near future at the price set by management. Software updates that will be provided free of charge are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade and create a multiple-element arrangement, which may require +revenue to be deferred and recognized when the upgrade is delivered, or if it is determined that implied post-contract customer support (“PCS”) is being provided, the arrangement is accounted for as a multiple-element arrangement and all +revenue from the arrangement is deferred and recognized over the implied PCS term when the VSOE of fair value does not exist. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped +or made available. Certain volume licensing arrangements include a perpetual license for current products combined with rights to +receive unspecified future versions of software products (“Software Assurance”), which we have determined are additional software products and are therefore accounted for as subscriptions, with billings recorded as unearned revenue and +recognized as revenue ratably over the coverage period. Arrangements that include term-based licenses for current products with the right to use unspecified future versions of the software during the coverage period, are also accounted for as +subscriptions, with revenue recognized ratably over the coverage period. Revenue from cloud-based services arrangements that allow for +the use of a hosted software product or service over a contractually determined period of time without taking possession of software are accounted for as subscriptions with billings recorded as unearned revenue and recognized as revenue ratably over +the coverage period beginning on the date the service is made available to customers. Revenue from cloud-based services arrangements that are provided on a consumption basis (for example, the amount of storage used in a particular period) is +recognized commensurate with the customer utilization of such resources. Some volume licensing arrangements include time-based +subscriptions for cloud-based services and software offerings that are accounted for as subscriptions. These arrangements are considered multiple-element arrangements. However, because all elements are accounted for as subscriptions and have the +same coverage period and delivery pattern, they have the same revenue recognition timing. 59 Table of Contents PART II Item 8 Revenue related to phones, Surface, Xbox consoles, games published by us, and other hardware +components is generally recognized when ownership is transferred to the resellers or to end customers when selling directly through Microsoft retail stores and online marketplaces. A portion of revenue may be deferred when these products are +combined with software elements, and/or services. Revenue related to licensing for games published by third parties for use on the Xbox consoles is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the +search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of +hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Revenue from prepaid points redeemable for the purchase of software or services is recognized upon redemption of the +points and delivery of the software or services. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to +include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including +datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs. Capitalized research and development +costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is +recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and +conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to +provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and +development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and +programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development +expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and +amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated +with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $2.3 billion, $2.6 billion, and $1.6 billion in fiscal years +2014, 2013, and 2012, respectively. 60 Table of Contents PART II Item 8 Stock-Based Compensation We measure stock-based compensation cost at the grant date based on the fair value of the award and recognize it as expense, net of estimated forfeitures, over the vesting or service period, as applicable, of the +stock award (generally four to five years) using the straight-line method. Employee Stock Purchase Plan Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value of the stock on the last day of +each three-month period. Compensation expense for the employee stock purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes +U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested, and interest and penalties on uncertain tax positions. Certain income and expenses are +not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not +that a tax benefit will not be realized. The deferred income taxes are classified as current or long-term based on the classification of the related asset or liability. Fair Value Measurements We account for certain assets and liabilities at fair value. The +hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest +level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and +forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, common and preferred stock, mortgage-backed securities, certificates of deposit, and foreign government +bonds. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in common and +preferred stock and goodwill when it is recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be +other-than-temporarily impaired. The fair values of these investments are determined 61 Table of Contents PART II Item 8 based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is +recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other +current financial assets and our current financial liabilities have fair values that approximate their carrying values. Financial Instruments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be +cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term +investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash +equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in +OCI. Equity and other investments classified as long-term include both debt and equity instruments. With the exception of certain +corporate notes that are classified as held-to-maturity, debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in the market value +of available-for-sale securities, excluding other-than-temporary impairments, are reflected in OCI. Held-to-maturity investments are recorded and held at amortized cost. Common and preferred stock and other investments that are restricted for more +than one year or are not publicly traded are recorded at cost or using the equity method. We lend certain fixed-income and equity +securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon +the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by +management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we +evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the +investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to +the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, +an impairment charge is recorded to other income (expense) and a new cost basis in the investment is established. Derivative +instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, the gains (losses) are recognized in earnings in the periods of change together with +the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as cash-flow hedges, the effective portion of the gains (losses) on the derivatives is initially +reported as a component of OCI and is subsequently recognized in earnings when the hedged 62 Table of Contents PART II Item 8 exposure is recognized in earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. +Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense). Other than those derivatives entered into for investment +purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or +other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense). Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best +estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was +as follows: (In millions) Year Ended June 30, 2014 2013 2012 Balance, beginning of period $ 336 $ 389 $ 333 Charged to costs and other 16 4 115 Write-offs (51 ) (57 ) (59 ) Balance, end of period $ 301 $ 336 $ 389 Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related +to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below +carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The determination of market value and the estimated volume of demand used in the lower of cost or market analysis require significant judgment. Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset +or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years; computer equipment, two to three years; buildings and improvements, +five to 15 years; leasehold improvements, two to 20 years; and furniture and equipment, one to 10 years. Land is not depreciated. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an +annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our intangible +assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of intangible assets periodically by taking into account events +or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. 63 Table of Contents PART II Item 8 Recent Accounting Guidance Recently adopted accounting guidance In December 2011, the Financial Accounting Standards +Board (“FASB”) issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments. The new guidance requires the disclosure of the gross +amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, repurchase +agreements, and securities lending arrangements that are either offset or subject to an enforceable master netting arrangement, or similar agreements. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted +only in changes to the presentation of Note 5 – Derivatives. In February 2013, the FASB issued guidance on disclosure requirements +for items reclassified out of AOCI. This new guidance requires entities to present (either on the face of the income statement or in the notes to financial statements) the effects on the line items of the income statement for amounts reclassified +out of AOCI. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 19 – Accumulated Other Comprehensive Income. Recent accounting guidance not yet adopted In March 2013, the FASB issued guidance on a parent’s accounting for the cumulative translation adjustment upon derecognition of a subsidiary +or group of assets within a foreign entity. This new guidance requires that the parent release any related cumulative translation adjustment into net income only if the sale or transfer results in the complete or substantially complete liquidation +of the foreign entity in which the subsidiary or group of assets had resided. The new guidance will be effective for us beginning July 1, 2014. We do not anticipate material impacts on our consolidated financial statements upon adoption. In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards, +the FASB issued a new standard related to revenue recognition. Under the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that reflects the consideration to which the entity +expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The new standard will be +effective for us beginning July 1, 2017 and early adoption is not permitted. We anticipate this standard will have a material impact, and we are currently evaluating the impact this standard will have on our consolidated financial statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock +outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive +potential common shares include outstanding stock options and stock awards. 64 Table of Contents PART II Item 8 The components of basic and diluted EPS are as follows: (In millions, except earnings per share) Year Ended June 30, 2014 2013 2012 Net income available for common shareholders (A) $ 22,074 $ 21,863 $ 16,978 Weighted average outstanding shares of common stock (B) 8,299 8,375 8,396 Dilutive effect of stock-based awards 100 95 110 Common stock and common stock equivalents (C) 8,399 8,470 8,506 Earnings Per Share Basic (A/B) $ 2.66 $ 2.61 $ 2.02 Diluted (A/C) $ 2.63 $ 2.58 $ 2.00 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods +presented. NOTE 3 — OTHER INCOME (EXPENSE) The components of other income (expense) were as follows: (In millions) Year Ended June 30, 2014 2013 2012 Dividends and interest income $ 883 $ 677 $ 800 Interest expense (597 ) (429 ) (380 ) Net recognized gains on investments 437 116 564 Net losses on derivatives (328 ) (196 ) (364 ) Net losses on foreign currency remeasurements (165 ) (74 ) (117 ) Other (169 ) 194 1 Total $ 61 $ 288 $ 504 Following are details of net recognized gains (losses) on investments during the periods reported: (In millions) Year Ended June 30, 2014 2013 2012 Other-than-temporary impairments of investments $ (106 ) $ (208 ) $ (298 ) Realized gains from sales of available-for-sale securities 776 489 1,418 Realized losses from sales of available-for-sale securities (233 ) (165 ) (556 ) Total $ 437 $ 116 $ 564 65 Table of Contents PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, but excluding held-to-maturity investments, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2014 Cash $ 4,980 $ 0 $ 0 $ 4,980 $ 4,980 $ 0 $ 0 Mutual funds 590 0 0 590 590 0 0 Commercial paper 189 0 0 189 89 100 0 Certificates of deposit 1,197 0 0 1,197 865 332 0 U.S. government and agency securities 66,952 103 (29 ) 67,026 109 66,917 0 Foreign government bonds 3,328 17 (10 ) 3,335 2,027 1,308 0 Mortgage-backed securities 991 30 (2 ) 1,019 0 1,019 0 Corporate notes and bonds 6,845 191 (9 ) 7,027 9 7,018 0 Municipal securities 287 45 0 332 0 332 0 Common and preferred stock 6,785 5,207 (81 ) 11,911 0 0 11,911 Other investments 1,164 0 0 1,164 0 14 1,150 Total $ 93,308 $ 5,593 $ (131 ) $ 98,770 $ 8,669 $ 77,040 $ 13,061 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2013 Cash $ 1,967 $ 0 $ 0 $ 1,967 $ 1,967 $ 0 $ 0 Mutual funds 868 0 0 868 868 0 0 Commercial paper 603 0 0 603 214 389 0 Certificates of deposit 994 0 0 994 609 385 0 U.S. government and agency securities 64,934 47 (84 ) 64,897 146 64,751 0 Foreign government bonds 900 16 (41 ) 875 0 875 0 Mortgage-backed securities 1,258 43 (13 ) 1,288 0 1,288 0 Corporate notes and bonds 4,993 169 (40 ) 5,122 0 5,122 0 Municipal securities 350 36 (1 ) 385 0 385 0 Common and preferred stock 6,931 2,938 (281 ) 9,588 0 0 9,588 Other investments 1,279 0 0 1,279 0 23 1,256 Total $ 85,077 $ 3,249 $ (460 ) $ 87,866 $ 3,804 $ 73,218 $ 10,844 In addition to the investments in the table above, we also own corporate notes that were purchased in connection +with our agreement to lend $2.0 billion to the group that completed their acquisition of Dell on October 29, 2013. These corporate notes are classified as held-to-maturity investments and are included in equity and other investments on the +balance sheet. As of June 30, 2014, the amortized cost, recorded basis, and estimated fair value of these corporate notes was $1.5 billion, $1.5 billion, and $1.7 billion, respectively, while their associated gross unrecognized holding +gains were $164 million. As of June 30, 2014 and 2013, the recorded bases of common and preferred stock that are restricted for +more than one year or are not publicly traded were $520 million and $395 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to +reliably estimate the fair value of these investments. 66 Table of Contents PART II Item 8 Unrealized Losses on Investments Investments, excluding those held-to-maturity, with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2014 U.S. government and agency securities $ 4,161 $ (29 ) $ 850 $ 0 $ 5,011 $ (29 ) Foreign government bonds 566 (4 ) 21 (6 ) 587 (10 ) Mortgage-backed securities 120 0 61 (2 ) 181 (2 ) Corporate notes and bonds 1,154 (8 ) 34 (1 ) 1,188 (9 ) Common and preferred stock 463 (48 ) 257 (33 ) 720 (81 ) Total $ 6,464 $ (89 ) $ 1,223 $ (42 ) $ 7,687 $ (131 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2013 U.S. government and agency securities $ 2,208 $ (84 ) $ 0 $ 0 $ 2,208 $ (84 ) Foreign government bonds 589 (18 ) 69 (23 ) 658 (41 ) Mortgage-backed securities 357 (12 ) 39 (1 ) 396 (13 ) Corporate notes and bonds 1,142 (38 ) 27 (2 ) 1,169 (40 ) Municipal securities 44 (1 ) 0 0 44 (1 ) Common and preferred stock 1,166 (168 ) 409 (113 ) 1,575 (281 ) Total $ 5,506 $ (321 ) $ 544 $ (139 ) $ 6,050 $ (460 ) As of June 30, 2014, we did not hold any held-to-maturity investments that are in an unrealized loss position. Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic +and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of June 30, 2014. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2014 Due in one year or less $ 28,681 $ 28,719 Due after one year through five years 46,734 46,881 Due after five years through 10 years 2,910 2,987 Due after 10 years 1,464 1,538 Total (a) $ 79,789 $ 80,125 (a) Excludes held-to-maturity investments due October 31, 2023 with a cost basis and estimated fair value at June 30, 2014 of $1.5 billion and $1.7 +billion, respectively. 67 Table of Contents PART II Item 8 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to +enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative +programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. dollar equivalents. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to +foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for +up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of June 30, 2014 and June 30, 2013, the total notional +amounts of these foreign exchange contracts sold were $4.9 billion and $5.1 billion, respectively. Foreign currency risks related to +certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of June 30, 2014 and June 30, 2013, the total notional amounts of these foreign +exchange contracts sold were $3.1 billion and $407 million, respectively. Certain options and forwards not designated as hedging +instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of June 30, 2014, the total notional amounts of these +foreign exchange contracts purchased and sold were $6.2 billion and $8.5 billion, respectively. As of June 30, 2013, the total notional amounts of these foreign exchange contracts purchased and sold were $5.0 billion and $7.9 billion, +respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to +broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity +derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2014, the total notional amounts of equity contracts purchased and sold for managing market price risk were $3.1 billion and $2.1 billion, +respectively, of which $362 million and $420 million, respectively, were designated as hedging instruments. As of June 30, 2013, the total notional amounts of equity contracts purchased and sold for managing market price risk were $898 million +and $1.0 billion, respectively, none of which were designated as hedging instruments. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average +maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are +designated as hedging instruments. As of June 30, 2014, the total notional amounts of fixed-interest rate contracts purchased and sold were $503 million and $741 million, respectively. As of June 30, 2013, the total notional amounts of +fixed-interest rate contracts purchased and sold were $1.1 billion and $809 million, respectively. In addition, we use “To Be +Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at +the earliest available delivery date. As of June 30, 2014 and 2013, the total notional derivative amounts of mortgage contracts purchased were $1.1 billion and $1.2 billion, respectively. 68 Table of Contents PART II Item 8 Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to +broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low cost method of managing exposure to individual credit risks or groups of credit risks. As of June 30, 2014, the total notional +amounts of credit contracts purchased and sold were $412 million and $440 million, respectively. As of June 30, 2013, the total notional amounts of credit contracts purchased and sold were $377 million and $501 million, respectively. Commodity We use broad-based +commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We +use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2014, the total notional amounts of +commodity contracts purchased and sold were $1.4 billion and $408 million, respectively. As of June 30, 2013, the total notional amounts of commodity contracts purchased and sold were $1.2 billion and $249 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured +debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to +over-the-counter derivatives. As of June 30, 2014, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. 69 Table of Contents PART II Item 8 Fair Values of Derivative Instruments The following tables present the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) +and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value +adjustments related to our own credit risk and counterparty credit risk: June 30, 2014 June 30, 2013 Assets Liabilities Assets Liabilities (In millions) Short-term Investments Other Current Assets Equity and Other Investments Other Current Liabilities Short-term Investments Other Current Assets Other Current Liabilities Non-designated Hedge Derivatives Foreign exchange contracts $ 10 $ 39 $ 0 $ (97 ) $ 41 $ 87 $ (63 ) Equity contracts 177 0 0 (21 ) 157 0 (9 ) Interest rate contracts 17 0 0 (12 ) 18 0 (45 ) Credit contracts 24 0 0 (13 ) 19 0 (17 ) Commodity contracts 15 0 0 (1 ) 3 0 (1 ) Total $ 243 $ 39 $ 0 $ (144 ) $ 238 $ 87 $ (135 ) Designated Hedge Derivatives Foreign exchange contracts $ 1 $ 70 $ 0 $ (15 ) $ 9 $ 167 $ 0 Equity contracts 0 0 7 (125 ) 0 0 0 Total $ 1 $ 70 $ 7 $ (140 ) $ 9 $ 167 $ 0 Total gross amounts of derivatives $ 244 $ 109 $ 7 $ (284 ) $ 247 $ 254 $ (135 ) Gross derivatives either offset or subject to an enforceable master netting agreement $ 99 $ 109 $ 7 $ (284 ) $ 105 $ 254 $ (97 ) Gross amounts offset in the balance sheet (77 ) (71 ) (7 ) 155 (72 ) (9 ) 80 Net amounts presented in the balance sheet $ 22 $ 38 $ 0 $ (129 ) $ 33 $ 245 $ (17 ) Gross amounts not offset in the balance sheet 0 0 0 0 0 0 0 Net amount $ 22 $ 38 $ 0 $ (129 ) $ 33 $ 245 $ (17 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. 70 Table of Contents PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense) the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2014 2013 2012 Foreign Exchange Contracts Derivatives $ (14 ) $ 70 $ 52 Hedged items 6 (69 ) (50 ) Total amount of ineffectiveness $ (8 ) $ 1 $ 2 Equity Contracts Derivatives $ (110 ) $ 0 $ 0 Hedged items 110 0 0 Total amount of ineffectiveness $ 0 $ 0 $ 0 Amount of equity contracts excluded from effectiveness assessment $ (9 ) $ 0 $ 0 Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented): (In millions) Year Ended June 30, 2014 2013 2012 Effective Portion Gains recognized in OCI, net of tax effects of $2 , $54 and $127 $ 63 $ 101 $ 236 Gains (losses) reclassified from AOCI into revenue $ 104 $ 195 $ (27 ) Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense) $ (239 ) $ (168 ) $ (231 ) We estimate that $32 million of net derivative gains included in AOCI at June 30, 2014 will be reclassified +into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2014. Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense). +These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), which were immaterial for the periods presented. Other than those derivatives +entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities. (In millions) Year Ended June 30, 2014 2013 2012 Foreign exchange contracts $ (78 ) $ 18 $ (119 ) Equity contracts (64 ) 16 (85 ) Interest-rate contracts 24 (11 ) 93 Credit contracts 13 (3 ) (7 ) Commodity contracts 71 (42 ) (121 ) Total $ (34 ) $ (22 ) $ (239 ) 71 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2014 Assets Mutual funds $ 590 $ 0 $ 0 $ 590 $ 0 $ 590 Commercial paper 0 189 0 189 0 189 Certificates of deposit 0 1,197 0 1,197 0 1,197 U.S. government and agency securities 66,288 745 0 67,033 0 67,033 Foreign government bonds 139 3,210 0 3,349 0 3,349 Mortgage-backed securities 0 1,015 0 1,015 0 1,015 Corporate notes and bonds 0 6,863 0 6,863 0 6,863 Municipal securities 0 332 0 332 0 332 Common and preferred stock 9,552 1,825 14 11,391 0 11,391 Derivatives 5 348 7 360 (155 ) 205 Total $ 76,574 $ 15,724 $ 21 $ 92,319 $ (155 ) $ 92,164 Liabilities Derivatives and other $ 5 $ 153 $ 126 $ 284 $ (155 ) $ 129 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2013 Assets Mutual funds $ 868 $ 0 $ 0 $ 868 $ 0 $ 868 Commercial paper 0 603 0 603 0 603 Certificates of deposit 0 994 0 994 0 994 U.S. government and agency securities 62,237 2,664 0 64,901 0 64,901 Foreign government bonds 9 851 0 860 0 860 Mortgage-backed securities 0 1,311 0 1,311 0 1,311 Corporate notes and bonds 0 4,915 19 4,934 0 4,934 Municipal securities 0 385 0 385 0 385 Common and preferred stock 8,470 717 5 9,192 0 9,192 Derivatives 12 489 0 501 (81 ) 420 Total $ 71,596 $ 12,929 $ 24 $ 84,549 $ (81 ) $ 84,468 Liabilities Derivatives and other $ 14 $ 121 $ 0 $ 135 $ (80 ) $ 55 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. In connection with the +transaction to acquire substantially all of Nokia Corporation’s (“Nokia”) Devices and Services Business (“NDS”), on September 23, 2013 we provided Nokia € 1.5 billion ($2.1 billion) principal of convertible notes classified as Level 3 financial instruments. Upon closing of the acquisition, Nokia repurchased these notes at their principal amount plus accrued +interest. All other changes in our Level 3 financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented. 72 Table of Contents PART II Item 8 The following table reconciles the total Net Fair Value of assets above to the balance sheet +presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2014 2013 Net fair value of assets measured at fair value on a recurring basis $ 92,164 $ 84,468 Cash 4,980 1,967 Common and preferred stock measured at fair value on a nonrecurring basis 520 395 Other investments measured at fair value on a nonrecurring basis 1,150 1,256 Less derivative net assets classified as other current assets (38 ) (213 ) Other (6 ) (7 ) Recorded basis of investment components (a) $ 98,770 $ 87,866 (a) Excludes held-to-maturity investments recorded at amortized cost and measured at fair value on a nonrecurring basis. Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal year 2014 and 2013, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis. NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2014 2013 Raw materials $ 944 $ 328 Work in process 266 201 Finished goods 1,450 1,409 Total $ 2,660 $ 1,938 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2014 2013 Land $ 541 $ 525 Buildings and improvements 8,867 7,326 Leasehold improvements 3,560 2,946 Computer equipment and software 11,430 9,242 Furniture and equipment 3,406 2,465 Total, at cost 27,804 22,504 Accumulated depreciation (14,793 ) (12,513 ) Total, net $ 13,011 $ 9,991 During fiscal years 2014, 2013, and 2012, depreciation expense was $3.4 billion, $2.6 billion, and $2.2 billion, +respectively. 73 Table of Contents PART II Item 8 NOTE 9 — BUSINESS COMBINATIONS Nokia’s Devices and Services Business On April 25, 2014, we completed the transaction to acquire substantially all of NDS for a total purchase price of $9.5 billion, including cash acquired of $1.5 billion (“the Acquisition”). The +purchase price consisted primarily of cash of $7.1 billion and Nokia’s repurchase of convertible notes of $2.1 billion which was a non-cash transaction. The Acquisition is expected to accelerate the growth of our Devices and Consumer +(“D&C”) business through faster innovation, synergies, and unified branding and marketing. The purchase price allocation +as of the date of the Acquisition was based on a preliminary valuation and is subject to revision as more detailed analyses are completed and additional information about the fair value of assets acquired and liabilities assumed become available. The major classes of assets and liabilities to which we have preliminarily allocated the purchase price were as follows: (In millions) Cash $ 1,503 Accounts +receivable (a) 754 Inventories 544 Other current assets 960 Property and equipment 981 Intangible assets 4,509 Goodwill (b) 5,458 Other 249 Current liabilities (4,576 ) Long-term liabilities (917 ) Total purchase price $ 9,465 (a) Gross accounts receivable is $901 million, of which $147 million is expected to be uncollectible. (b) Goodwill was assigned to our new Phone Hardware segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from +the integration of NDS. Goodwill of $4.5 billion is expected to be deductible in Finland for tax purposes. Following +are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Technology-based $ 2,493 9 years Contract-based 1,500 9 years Customer-related 359 3 years Marketing-related (trade names) 157 2 years Fair value of intangible assets acquired $ 4,509 8 years Our consolidated income statement for fiscal year 2014 includes revenue and operating loss of $2.0 billion and $692 +million, respectively, attributable to NDS since the Acquisition. 74 Table of Contents PART II Item 8 Following are the supplemental consolidated results of Microsoft Corporation on an unaudited pro +forma basis, as if the Acquisition had been consummated on July 1, 2012: (In millions, except per share amounts) Year Ended June 30, 2014 2013 Revenue $ 96,248 $ 93,243 Net income $ 20,234 $ 20,153 Diluted earnings per share $ 2.41 $ 2.38 These pro forma results were based on estimates and assumptions, which we believe are reasonable. They are not the +results that would have been realized had we been a combined company during the periods presented and are not necessarily indicative of our consolidated results of operations in future periods. The pro forma results include adjustments primarily +related to purchase accounting adjustments and the elimination of related party transactions between Microsoft and NDS. Acquisition costs and other non-recurring charges incurred are included in the earliest period presented. During the fourth quarter of fiscal year 2014, we incurred $21 million of acquisition costs associated with the purchase of NDS. Acquisition costs +are primarily comprised of transaction fees and direct acquisition costs, including legal, finance, consulting, and other professional fees. These costs are included in Integration and restructuring costs on our consolidated income statement for +fiscal year 2014. Certain concurrent transactions were recognized separately from the Acquisition. Prior to the Acquisition, we had +joint strategic initiatives with Nokia; this contractual relationship was terminated in conjunction with the Acquisition. No gain or loss was recorded upon termination of this agreement, as it was determined to be at market value. In addition, we +agreed to license Nokia’s mapping services and will pay Nokia separately for the services provided under a four-year license as they are rendered. Yammer On July 18, 2012, we acquired +Yammer, Inc. (“Yammer”), a leading provider of enterprise social networks, for $1.1 billion in cash. Yammer will continue to develop its standalone service and will add an enterprise social networking service to Microsoft’s portfolio +of complementary cloud-based services. The major classes of assets to which we allocated the purchase price were goodwill of $937 million and identifiable intangible assets of $178 million. We assigned the goodwill to Commercial Other under our +current segment structure. Yammer was consolidated into our results of operations starting on the acquisition date. Skype On October 13, 2011, we acquired Skype Global S.á r.l. (“Skype”), a leading global provider of software applications and +related Internet communications products based in Luxembourg, for $8.6 billion, primarily in cash. The major classes of assets and liabilities to which we allocated the purchase price were goodwill of $7.1 billion, identifiable intangible assets of +$1.6 billion, and unearned revenue of $222 million. The goodwill recognized in connection with the acquisition is primarily attributable to our expectation of extending Skype’s brand and the reach of its networked platform, while enhancing +Microsoft’s existing portfolio of real-time communications products and services. We assigned the goodwill to the following segments under our current segment structure: $5.6 billion to Commercial Licensing, $1.4 billion to Computing and Gaming +Hardware, and $54 million to D&C Other. Skype was consolidated into our results of operations starting on the acquisition date. 75 Table of Contents PART II Item 8 Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Weighted Average Life Marketing-related (trade names) $ 1,249 15 years Technology-based 275 5 years Customer-related 114 5 years Contract-based 10 4 years Total $ 1,648 13 years Other During fiscal year 2014, we completed five additional acquisitions for total consideration of $140 million, all of which was paid in cash. These +entities have been included in our consolidated results of operations since their respective acquisition dates. With the exception of +NDS, pro forma results of operations have not been presented because the effects of the business combinations described in this note, individually and in aggregate, were not material to our consolidated results of operations. NOTE 10 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2012 Acquisitions Other June 30, 2013 Acquisitions Other June 30, 2014 Devices and Consumer Licensing $ 866 $ 0 $ 0 $ 866 $ 0 $ 2 $ 868 Hardware: Computing and Gaming Hardware 1,641 75 (27 ) 1,689 0 9 1,698 Phone Hardware 0 0 0 0 5,458 (a) (104 ) 5,354 Total D&C Hardware 1,641 75 (27 ) 1,689 5,458 (95 ) 7,052 Other 742 0 (4 ) 738 0 0 738 Total Devices and Consumer 3,249 75 (31 ) 3,293 5,458 (93 ) 8,658 Commercial Licensing 10,054 4 (7 ) 10,051 2 5 10,058 Other 149 1,164 (2 ) 1,311 105 (5 ) 1,411 Total Commercial 10,203 1,168 (9 ) 11,362 107 0 11,469 Total goodwill $ 13,452 $ 1,243 $ (40 ) $ 14,655 $ 5,565 $ (93 ) $ 20,127 (a) Goodwill acquired during fiscal year 2014 related to the acquisition of NDS. See Note 9 – Business Combinations for additional details. The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on +the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in +which the acquisitions occurred. 76 Table of Contents PART II Item 8 Any change in the goodwill amounts resulting from foreign currency translations are presented as +“Other” in the above table. Also included in “Other” are business dispositions and transfers between business segments due to reorganizations, as applicable. As discussed in Note 21 – Segment Information and Geographic Data, during the first quarter of fiscal year 2014, we changed our organizational +structure as part of our transformation to a devices and services company. This resulted in a change in our operating segments and reporting units. We allocated goodwill to our new reporting units using a relative fair value approach. In addition, +we completed an assessment of any potential goodwill impairment for all reporting units immediately prior to the reallocation and determined that no impairment existed. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting +unit level using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No impairment of goodwill was identified as of May 1, 2014 or May 1, 2013. Upon completion of the fiscal year 2012 test, the goodwill of +our OSD unit (in Devices and Consumer Other under our current segment structure) was determined to be impaired. The impairment was the result of the OSD unit experiencing slower than projected growth in search queries and search advertising revenue +per query, slower growth in display revenue, and changes in the timing and implementation of certain initiatives designed to drive search and display revenue growth in the future. This goodwill impairment charge of $6.2 billion also represented our +accumulated goodwill impairment as of June 30, 2014 and 2013. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Year Ended June 30, 2014 2013 Technology-based (a) $ 6,440 $ (2,615 ) $ 3,825 $ 3,760 $ (2,110 ) $ 1,650 Marketing-related 1,518 (324 ) 1,194 1,348 (211 ) 1,137 Contract-based 2,266 (716 ) 1,550 823 (688 ) 135 Customer-related 732 (320 ) 412 380 (219 ) 161 Total $ 10,956 $ (3,975 ) $ 6,981 $ 6,311 $ (3,228 ) $ 3,083 (a) Technology-based intangible assets included $98 million and $218 million as of June 30, 2014 and 2013, respectively, of net carrying amount of +software to be sold, leased, or otherwise marketed. We estimate that we have no significant residual value +related to our intangible assets. No material impairments of intangible assets were identified during any of the periods presented. The +components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2014 2013 Technology-based $ 2,841 9 years $ 539 4 years Marketing-related 174 2 years 39 7 years Contract-based 1,500 9 years 0 * Customer-related 363 3 years 89 6 years Total $ 4,878 8 years $ 667 5 years * Not applicable 77 Table of Contents PART II Item 8 The table above includes $4.5 billion related to the acquisition of NDS during fiscal year 2014. +See Note 9 – Business Combination for additional details. Intangible assets amortization expense was $845 million, $739 million, +and $558 million for fiscal years 2014, 2013, and 2012, respectively. Amortization of capitalized software was $200 million, $210 million, and $117 million for fiscal years 2014, 2013, and 2012, respectively. The following table outlines the estimated future amortization expense related to intangible assets held at June 30, 2014: (In millions) Year Ending June 30, 2015 $ 1,237 2016 1,075 2017 804 2018 661 2019 637 Thereafter 2,567 Total $ 6,981 NOTE 12 — DEBT As of June 30, 2014, we had $22.6 billion of issued and outstanding debt, comprising $2.0 billion of short-term debt and +$20.6 billion of long-term debt. As of June 30, 2013, we had $15.6 billion of issued and outstanding long-term debt. Short-term Debt As of June 30, 2014, we had $2.0 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.12% and +maturities ranging from 86 days to 91 days. The estimated fair value of this commercial paper approximates its carrying value. We have +a $5.0 billion credit facility that expires on November 14, 2018, which serves as a back-up for our commercial paper program. As of June 30, 2014, we were in compliance with the only financial covenant in the credit agreement, which +requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreement. No amounts were drawn against the credit facility during any of +the periods presented. Long-term Debt As of June 30, 2014, the total carrying value and estimated fair value of our long-term debt were $20.6 billion and $21.5 billion, respectively. This is compared to a carrying value and estimated fair value of +our long-term debt, including the current portion, of $15.6 billion and $15.8 billion, respectively, as of June 30, 2013. These estimated fair values are based on Level 2 inputs. 78 Table of Contents PART II Item 8 The components of our long-term debt and the associated interest rates were as follows as of +June 30, 2014 and 2013: Due Date Face Value June 30, 2014 Face Value June 30, 2013 Stated Interest Rate Effective Interest Rate (In millions) Notes September 27, 2013 $ * $ 1,000 0.875% 1.000% June 1, 2014 * 2,000 2.950% 3.049% September 25, 2015 1,750 1,750 1.625% 1.795% February 8, 2016 750 750 2.500% 2.642% November 15, 2017 600 600 0.875% 1.084% May 1, 2018 450 450 1.000% 1.106% December 6, 2018 (a) 1,250 * 1.625% 1.824% June 1, 2019 1,000 1,000 4.200% 4.379% October 1, 2020 1,000 1,000 3.000% 3.137% February 8, 2021 500 500 4.000% 4.082% December 6, 2021 (b) 2,396 * 2.125% 2.233% November 15, 2022 750 750 2.125% 2.239% May 1, 2023 1,000 1,000 2.375% 2.465% December 15, 2023 (a) 1,500 * 3.625% 3.726% December 6, 2028 (b) 2,396 * 3.125% 3.218% May 2, +2033 (c) 753 715 2.625% 2.690% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, 2042 900 900 3.500% 3.571% May 1, 2043 500 500 3.750% 3.829% December 15, 2043 (a) 500 * 4.875% 4.918% Total $ 20,745 $ 15,665 (a) In December 2013, we issued $3.3 billion of debt securities. (b) In December 2013, we issued €3.5 billion of debt securities. (c) In April 2013, we issued €550 million of debt securities. * Not applicable. The +notes in this table are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid +annually. Cash paid for interest on our debt for fiscal years 2014, 2013, and 2012 was $509 million, $371 million, and $344 million, respectively. As of June 30, 2014 and 2013, the aggregate unamortized discount for our long-term debt, +including the current portion, was $100 million and $65 million, respectively. 79 Table of Contents PART II Item 8 Debt Service Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2015 $ 0 2016 2,500 2017 0 2018 1,050 2019 2,250 Thereafter 14,945 Total $ 20,745 NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2014 2013 2012 Current Taxes U.S. federal $ 3,738 $ 3,131 $ 2,235 U.S. state and local 266 332 153 Foreign 2,073 1,745 1,947 Current taxes 6,077 5,208 4,335 Deferred Taxes Deferred taxes (331 ) (19 ) 954 Provision for income taxes $ 5,746 $ 5,189 $ 5,289 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2014 2013 2012 U.S. $ 7,127 $ 6,674 $ 1,600 Foreign 20,693 20,378 20,667 Income before income taxes $ 27,820 $ 27,052 $ 22,267 The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our +effective rate were as follows: Year Ended June 30, 2014 2013 2012 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (17.1)% (17.5)% (21.1)% Goodwill impairment 0% 0% 9.7% Other reconciling items, net 2.8% 1.7% 0.2% Effective rate 20.7% 19.2% 23.8% The reduction from the federal statutory rate from foreign earnings taxed at lower rates results from producing and +distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and 80 Table of Contents PART II Item 8 Puerto Rico. Our foreign earnings, which are taxed at rates lower than the U.S. rate and are generated from our regional operating centers, were 81%, 79%, and 79% of our foreign income before tax +in fiscal years 2014, 2013, and 2012, respectively. In general, other reconciling items consist of interest, adjustments for intercompany transfer pricing, U.S. state income taxes, domestic production deductions, and credits. In fiscal years 2014, +2013, and 2012, there were no individually significant other reconciling items. The components of the deferred income tax assets and +liabilities were as follows: (In millions) June 30, 2014 2013 Deferred Income Tax Assets Stock-based compensation expense $ 903 $ 888 Other expense items 1,112 917 Unearned revenue 520 445 Impaired investments 209 246 Loss carryforwards 922 715 Other revenue items 64 55 Deferred income tax assets $ 3,730 $ 3,266 Less valuation allowance (903 ) (579 ) Deferred income tax assets, net of valuation allowance $ 2,827 $ 2,687 Deferred Income Tax Liabilities Foreign earnings $ (1,140 ) $ (1,146 ) Unrealized gain on investments (1,911 ) (1,012 ) Depreciation and amortization (470 ) (604 ) Other (87 ) (2 ) Deferred income tax liabilities $ (3,608 ) $ (2,764 ) Net deferred income tax assets (liabilities) $ (781 ) $ (77 ) Reported As Current deferred income tax assets $ 1,941 $ 1,632 Other current liabilities (125 ) 0 Other long-term assets 131 0 Long-term deferred income tax liabilities (2,728 ) (1,709 ) Net deferred income tax assets (liabilities) $ (781 ) $ (77 ) As of June 30, 2014, we had net operating loss carryforwards of $3.6 billion, including $2.2 billion of +foreign net operating loss carryforwards acquired through our acquisition of Skype, and $545 million through our acquisition of NDS. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and +other net deferred tax assets that may not be realized. Deferred income tax balances reflect the effects of temporary differences +between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. As of June 30, 2014, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately +$92.9 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences was approximately $29.6 billion at +June 30, 2014. Income taxes paid were $5.5 billion, $3.9 billion, and $3.5 billion in fiscal years 2014, 2013, and 2012, +respectively. 81 Table of Contents PART II Item 8 Uncertain Tax Positions Unrecognized tax benefits as of June 30, 2014, 2013, and 2012, were $8.7 billion, $8.6 billion, and $7.2 billion, respectively. If recognized, these tax benefits would affect our effective tax rates for fiscal +years 2014, 2013, and 2012, by $7.0 billion, $6.5 billion, and $6.2 billion, respectively. As of June 30, 2014, 2013, and 2012, we +had accrued interest expense related to uncertain tax positions of $1.5 billion, $1.3 billion, and $939 million, respectively, net of federal income tax benefits. Interest expense on unrecognized tax benefits was $235 million, $400 million, and $154 +million in fiscal years 2014, 2013, and 2012, respectively. The aggregate changes in the balance of unrecognized tax benefits were as +follows: (In millions) Year Ended June 30, 2014 2013 2012 Balance, beginning of year $ 8,648 $ 7,202 $ 6,935 Decreases related to settlements (583 ) (30 ) (16 ) Increases for tax positions related to the current year 566 612 481 Increases for tax positions related to prior years 217 931 118 Decreases for tax positions related to prior years (95 ) (65 ) (292 ) Decreases due to lapsed statutes of limitations (39 ) (2 ) (24 ) Balance, end of year $ 8,714 $ 8,648 $ 7,202 During the third quarter of fiscal year 2011, we reached a settlement of a portion of an I.R.S. audit of tax years +2004 to 2006, which reduced our income tax expense by $461 million. While we settled a portion of the I.R.S. audit, we remain under audit for these years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit +phase of the examination. As of June 30, 2014, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for +income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not +anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2013. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax +years 1996 to 2013, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. NOTE 14 — UNEARNED REVENUE Unearned revenue by segment was as follows, with segments with significant balances shown separately: (In millions) June 30, 2014 2013 Commercial Licensing $ 19,099 $ 18,460 Commercial Other 3,934 2,272 Rest of the segments 2,125 1,667 Total $ 25,158 $ 22,399 82 Table of Contents PART II Item 8 NOTE 15 — OTHER LONG-TERM LIABILITIES (In millions) June 30, 2014 2013 Tax contingencies and other tax liabilities $ 10,510 $ 9,548 Other 1,084 452 Total $ 11,594 $ 10,000 NOTE 16 — COMMITMENTS AND GUARANTEES Construction and Operating Leases We have committed $880 million for constructing new buildings, building improvements, and leasehold improvements as of June 30, 2014. We have operating leases for most U.S. and international sales and support offices, research and development facilities, manufacturing facilities, and certain equipment. Rental expense for facilities operating +leases was $874 million, $711 million, and $639 million, in fiscal years 2014, 2013, and 2012, respectively. Future minimum rental commitments under non-cancellable facilities operating leases in place as of June 30, 2014 are as follows: (In millions) Year Ending June 30, 2015 $ 878 2016 748 2017 671 2018 598 2019 456 Thereafter 1,063 Total $ 4,414 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered +significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our consolidated financial statements. NOTE 17 — CONTINGENCIES Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC +operating system and certain other software products between 1999 and 2005. We obtained dismissals or reached settlements of all claims +made in the United States. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we +may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two- 83 Table of Contents PART II Item 8 thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. We estimate the total remaining +cost of the settlements is approximately $400 million, all of which had been accrued as of June 30, 2014. Three similar cases +pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. The plaintiffs successfully appealed a British Columbia Court of Appeal decision +reversing class certification and dismissing the case. In October 2013, the Canadian Supreme Court reversed the appellate court and reinstated part of the British Columbia case, which is now scheduled for trial in September 2015. The other two cases +were inactive pending action by the Supreme Court on the British Columbia case. Other Antitrust Litigation and Claims Novell litigation In November 2004, +Novell, Inc. (“Novell”) filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of +WordPerfect and other productivity applications during the period between June 1994 and March 1996. After the trial court dismissed or granted summary judgment on a number of Novell’s claims, trial of the one remaining claim took place in late +2011 and resulted in a mistrial. In July 2012, the trial court granted Microsoft’s motion for judgment as a matter of law. Novell appealed this decision to the U.S. Court of Appeals for the Tenth Circuit, which affirmed the trial court’s +decision in September 2013. The Supreme Court denied Novell’s petition for review in April 2014. Go Computer litigation In June 2005, GO Computer Inc. and co-founder Jerry Kaplan filed a complaint in California state court asserting antitrust claims under the +Cartwright Act related to the business of the former GO Corporation in the early 1990s and its successor in interest, Lucent Corporation in the early 2000s. All claims prior to June 2001 have been dismissed with prejudice as barred by the statute of +limitations. After a mini-trial on standing issues, the case is now moving forward with discovery, and a trial is set for September 2015. China +State Administration for Industry and Commerce investigation On July 28, 2014, Microsoft was informed that China’s State +Administration for Industry and Commerce (SAIC) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAIC conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. SAIC has stated +the investigation relates to compatibility, bundle sales, and file verification issues related to Windows and Office software. Patent and +Intellectual Property Claims Motorola litigation In October 2010, Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for +infringement of nine Microsoft patents by Motorola’s Android devices. Since then, Microsoft and Motorola have filed additional claims against each other with the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, +and in courts in Germany and the United Kingdom. The nature of the claims asserted and status of individual matters are summarized below. International Trade Commission In May +2012, the ITC issued a limited exclusion order against Motorola on one Microsoft patent, which became effective in July 2012 and was affirmed on appeal in December 2013. In July 2013, Microsoft filed an action in U.S. District Court in +Washington, D.C. seeking an order to compel enforcement of the ITC’s May 2012 import ban against infringing Motorola products by the Bureau of Customs and Border Protection (“CBP”), after learning that CBP had failed to fully enforce +the order. 84 Table of Contents PART II Item 8 In November 2010, Motorola filed an action against Microsoft with the ITC alleging infringement of +five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing Xbox products. At Motorola’s request, the ITC terminated its investigation of four Motorola patents. In +March 2013, the ITC affirmed there was no violation of the remaining Motorola patent. Motorola appealed the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit. U.S. District Court The Seattle District Court case filed in October 2010 by Microsoft as a +companion to Microsoft’s ITC case against Motorola was stayed pending the outcome of the ITC case. In November 2010, Microsoft +sued Motorola for breach of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory +(“RAND”) terms and conditions. Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In the Motorola ITC case described above and in suits described below, Motorola +or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District Courts, in the ITC, and in Germany. In February 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that +(1) Motorola had committed to standards organizations to license its declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. After trial, the Seattle District Court set +per unit royalties for Motorola’s H.264 and 802.11 patents, which resulted in an immaterial Microsoft liability. In September 2013, following trial of Microsoft’s breach of contract claim, a jury awarded $14.5 million in damages to +Microsoft. Motorola appealed. Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one currently stayed +case in Wisconsin (a companion case to Motorola’s ITC action), have been transferred to the U.S District Court in Seattle. Motorola and Microsoft both seek damages as well as injunctive relief. The court has stayed these cases on agreement of +the parties. • In the transferred cases, Motorola asserts 15 patents are infringed by a range of Microsoft products including mobile and PC operating system, productivity, +server, communication, browser and gaming products. • In the Motorola action originally filed in California, Motorola asserts Microsoft violated antitrust laws in connection with Microsoft’s assertion of +patents against Motorola that Microsoft agreed to license to certain qualifying entities on RAND terms and conditions. • In counterclaims, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola digital video recorders. Germany In +July 2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries. • Motorola asserts two patents (one now expired) are essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products +including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. In May 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany, which Microsoft appealed. Orders in the litigation +pending in Seattle, Washington described above enjoin Motorola from enforcing the German injunction. • Motorola asserts that one patent covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail Mobile, +Exchange Online, Exchange Server, and Hotmail Server. In April 2013, the court stayed the case pending the outcome of parallel proceedings in which Microsoft is seeking to invalidate the patent. In November 2013, the Federal Patent Court invalidated +the originally issued patent claims, but ruled that certain new amended claims were patentable. Both Motorola and Microsoft appealed. In June 2014, the court reopened infringement proceedings and scheduled a hearing in November 2014. • Microsoft may be able to mitigate the adverse impact of any injunction by altering its products to avoid Motorola’s infringement claims. • Any damages would be determined in separate proceedings. 85 Table of Contents PART II Item 8 In lawsuits Microsoft filed in Germany in 2011 and 2012, Microsoft asserts that Motorola Android +devices infringe Microsoft patents and is seeking damages and injunctions. In 2012, regional courts in Germany issued injunctions on three of the Microsoft patents, which Motorola appealed. One judgment has been affirmed on appeal (and Motorola has +further appealed), and the other two appeals are pending. In actions filed separately by Motorola to invalidate these patents, the Federal Patent Court in 2013 and 2014 held the Microsoft patents invalid, and Microsoft appealed. For the cases in +which Microsoft obtained injunctions, if Motorola were to prevail following all appeals, Motorola could have a claim against Microsoft for damages caused by an erroneously granted injunction. United Kingdom In December 2011, Microsoft filed an action against Motorola in the High Court +of Justice, Chancery Division, Patents Court, in London, England, seeking to revoke the UK part of the European patent asserted by Motorola in Germany against the ActiveSync protocol. In February 2012, Motorola counterclaimed alleging infringement +of the patent and seeking damages and an injunction. In December 2012, the court ruled that Motorola’s patent is invalid. The court also ruled that the patent, even if valid, would be licensed under the grant-back clause in Google’s +ActiveSync license. Motorola appealed and the appeals court affirmed the lower court’s ruling in Microsoft’s favor in November 2013. Motorola has exhausted all appeals and the rulings in Microsoft’s favor are final. IPCom patent litigation IPCom +GmbH & Co. is a German company that holds a large portfolio of mobile technology related patents spanning about 170 patent families and addressing a broad range of cellular technologies. IPCom has asserted 19 of these patents in litigation +against Nokia and many of the leading cell phone companies and operators. Three of the infringement suits against Nokia (now assumed by Microsoft through the NDS acquisition) are still pending in courts in Germany, England, and Italy. These courts +have held a number of IPCom’s patents were invalid or not infringed. We continue to contest the validity or infringement of the patents remaining in dispute. Interdigital patent litigation InterDigital Technology Corporation and InterDigital +Communications Corporation (collectively, “IDT”) filed four patent infringement cases against Nokia in the ITC and in U.S. District Court for the District of Delaware between 2007 and 2013. We are being substituted for Nokia in these +cases. Each case includes other co-defendants because most of the patents at issue allegedly relate to 3G and 4G wireless communications standards essential functionality. The suite of cases include three ITC investigations where IDT is seeking an +order excluding importation of 3G and 4G phones into the U.S. and one active case in U.S. District Court in Delaware seeking an injunction and damages. European copyright levies We have assumed +from Nokia all potential liability due to Nokia’s alleged failure to pay “private copying levies” in various European countries based upon sale of memory cards and mobile phones that incorporate blank memory. The levies are based +upon a 2001 EU Directive establishing a right for end users to make copies of copyrighted works for personal or private use, but also allowing the collection of levies based upon sales of blank media or recording devices to compensate copyright +holders for private copying. Various collecting societies in EU countries initiated litigation against Nokia, stating that Nokia must pay levies not only based upon sales of blank memory cards, but also phones that include blank memory for data +storage on the phones, regardless of actual usage of that memory. The most significant cases against Nokia are pending in Germany and Austria, due to both high volume of sales and high levy amounts sought in these countries. We are +litigating against certain collecting societies on the basis that the levy schemes exceed what the EU Directive and European Court of Justice decisions permit. Other patent and intellectual property claims In addition to these cases, there are +approximately 90 other patent infringement cases pending against Microsoft. 86 Table of Contents PART II Item 8 Product-Related Litigation U.S. cell phone litigation Nokia, along with other handset manufacturers and network +operators, is a defendant in 19 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We have +assumed responsibility for these claims as part of the NDS acquisition. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining ten cases are stayed. In a separate 2009 decision, the Court of +Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are +pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the +science and testing around emission guidelines. In September 2013, defendants in the consolidated cases moved to exclude plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. The motion was heard in +December 2013 and January 2014. In March 2014, defendants filed a separate motion to preclude plaintiffs’ general causation testimony on the ground that it is pre-empted by federal law because the experts challenge the safety of all cellular +handsets, including those that comply with the FCC Guidelines. Both motions are pending. Canadian cell phone class action Nokia, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of +British Columbia by a purported class of Canadians who have used cellular phones for at least 1600 hours, including a subclass of users with brain tumors. Microsoft was served with the complaint in June 2014. The litigation is not yet active as +several defendants remain to be served. Other We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually +or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2014, we had accrued aggregate liabilities of $780 million in other current liabilities and $81 million in other long-term +liabilities for all of our legal matters that were contingencies as of that date. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $2.0 billion in aggregate beyond recorded amounts are +reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable. Substantially all +changes from the prior quarter in these accruals and estimates are attributable to matters involving Nokia that we assumed as a result of the NDS acquisition. NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2014 2013 2012 Balance, beginning of year 8,328 8,381 8,376 Issued 86 105 147 Repurchased (175 ) (158 ) (142 ) Balance, end of year 8,239 8,328 8,381 87 Table of Contents PART II Item 8 Share Repurchases On September 16, 2013, our Board of Directors approved a new share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, +2013, has no expiration date, and may be suspended or discontinued at any time without notice. This new share repurchase program replaced the share repurchase program that was announced on September 22, 2008 and expired on September 30, +2013. As of June 30, 2014, $35.1 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources. We repurchased the following shares of common stock under the above-described repurchase plans: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2014 (a) 2013 (b) 2012 (b) First quarter 47 $ 1,500 33 $ 1,000 38 $ 1,000 Second quarter 53 2,000 58 1,607 39 1,000 Third quarter 47 1,791 36 1,000 31 1,000 Fourth quarter 28 1,118 31 1,000 34 1,000 Total 175 $ 6,409 158 $ 4,607 142 $ 4,000 (a) Of the 175 million shares repurchased in fiscal year 2014, 128 million shares were repurchased for $4.9 billion under the share repurchase +program approved by our Board of Directors on September 16, 2013 and 47 million shares were repurchased for $1.5 billion under the share repurchase program that was announced on September 22, 2008 and expired on September 30, +2013. (b) All shares repurchased in fiscal years 2013 and 2012 were repurchased under the repurchase plan that was announced on September 22, 2008 and expired +on September 30, 2013. The above table excludes shares repurchased to settle statutory employee tax +withholding related to the vesting of stock awards. Dividends In fiscal year 2014, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 16, 2013 $  0.28 November 21, 2013 $  2,332 December 12, 2013 November 19, 2013 $  0.28 February 20, 2014 $  2,322 March 13, 2014 March 11, 2014 $  0.28 May 15, 2014 $  2,309 June 12, 2014 June 10, 2014 $  0.28 August 21, 2014 $  2,307 September 11, 2014 The dividend declared on June 10, 2014 will be paid after the filing date of this Form 10-K and was included +in other current liabilities as of June 30, 2014. In fiscal year 2013, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 18, 2012 $ 0.23 November 15, 2012 $ 1,933 December 13, 2012 November 28, 2012 $ 0.23 February 21, 2013 $ 1,925 March 14, 2013 March 11, 2013 $ 0.23 May 16, 2013 $ 1,921 June 13, 2013 June 12, 2013 $ 0.23 August 15, 2013 $ 1,916 September 12, 2013 The dividend declared on June 12, 2013 was included in other current liabilities as of June 30, 2013. 88 Table of Contents PART II Item 8 NOTE 19 — ACCUMULATED OTHER COMPREHENSIVE INCOME The following table summarizes the changes in accumulated other comprehensive income by component: (In millions) Year Ended June 30, 2014 2013 2012 Derivatives Accumulated other comprehensive income (loss) balance, beginning of period $ 66 $ 92 $ (163 ) Unrealized gains (losses), net of tax effects of $2 , $54 and $127 63 101 236 Reclassification adjustments for losses (gains) included in revenue (104 ) (195 ) 29 Tax expense (benefit) included in provision for income taxes 6 68 (10 ) Amounts reclassified from accumulated other comprehensive income (98 ) (127 ) 19 Net current period other comprehensive income (loss) (35 ) (26 ) 255 Accumulated other comprehensive income balance, end of period $ 31 $ 66 $ 92 Investments Accumulated other comprehensive income balance, beginning of period $ 1,794 $ 1,431 $ 1,821 Unrealized gains (losses), net of tax effects of $1,067 , $244 and $(93) 2,053 453 (172 ) Reclassification adjustments for gains included in other income (expense) (447 ) (139 ) (335 ) Tax expense included in provision for income taxes 131 49 117 Amounts reclassified from accumulated other comprehensive income (316 ) (90 ) (218 ) Net current period other comprehensive income (loss) 1,737 363 (390 ) Accumulated other comprehensive income balance, end of period $ 3,531 $ 1,794 $ 1,431 Translation Adjustments and Other Accumulated other comprehensive income (loss) balance, beginning of period $ (117 ) $ (101 ) $ 205 Translation adjustments and other, net of tax effects of $12 , $(8) and $(165) 263 (16 ) (306 ) Accumulated other comprehensive loss balance, end of period $ 146 $ (117 ) $ (101 ) Accumulated other comprehensive income, end of period $ 3,708 $ 1,743 $ 1,422 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to directors and employees. At June 30, 2014, an aggregate of 346 million shares +were authorized for future grant under our stock plans, covering stock options, stock awards, and leadership stock awards. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We +issue new shares of Microsoft common stock to satisfy exercises and vesting of awards granted under all of our stock plans. Stock-based +compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2014 2013 2012 Stock-based compensation expense $ 2,446 $ 2,406 $ 2,244 Income tax benefits related to stock-based compensation $ 830 $ 842 $ 785 Stock Plans Stock +awards Stock awards (“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. +SAs generally vest over a four or five-year period. 89 Table of Contents PART II Item 8 Executive incentive plan Under the Executive Incentive Plan (“EIP”), the Compensation Committee awards performance-based compensation comprising both cash and SAs to executive officers and certain senior executives. For executive +officers, their awards are based on an aggregate incentive pool equal to a percentage of consolidated operating income. For fiscal years 2014, 2013, and 2012, the pool was 0.44%, 0.35%, and 0.30% of operating income, respectively. The SAs vest +ratably in August of each of the four years following the grant date. The final cash awards will be determined after each performance period based on individual and business performance. Activity for all stock plans The fair value of each award was estimated on the date of grant +using the following assumptions: Year Ended June 30, 2014 2013 2012 Dividends per share (quarterly amounts) $ 0.23 - $  0.28 $ 0.20 - $  0.23 $ 0.16 - $  0.20 Interest rates range 1.3% - 1.8% 0.6% - 1.1% 0.7% - 1.7% During fiscal year 2014, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 273 $ 25.50 Granted (a) 103 $ 31.50 Vested (93 ) $ 25.12 Forfeited (24 ) $ 27.01 Nonvested balance, end of year 259 $ 27.88 (a) Includes four million shares in stock replacement awards related to the acquisition of NDS. The weighted average grant-date fair value was $37.64. As of June 30, 2014, there was approximately $5.2 billion of total unrecognized compensation costs related +to stock awards. These costs are expected to be recognized over a weighted average period of 3 years. During fiscal years 2013 and +2012, the following activity occurred under our stock plans: (In millions, except fair values) 2013 2012 Stock Awards Awards granted 104 110 Weighted average grant-date fair value $ 28.37 $ 24.60 Total vest-date fair value of stock awards vested was $3.2 billion, $2.8 billion, and $2.4 billion, for fiscal +years 2014, 2013, and 2012, respectively. 90 Table of Contents PART II Item 8 Employee Stock Purchase Plan We have an employee stock purchase plan (the “Plan”) for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the +last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2014 2013 2012 Shares purchased 18 20 20 Average price per share $ 33.60 $ 26.81 $ 25.03 At June 30, 2014, 173 million shares of our common stock were reserved for future issuance through the +Plan. Savings Plan We have a +savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 75% of their salary, but not more than +statutory limits. We contribute fifty cents for each dollar of the first 6% a participant contributes in this plan, with a maximum contribution of the lesser of 3% of a participant’s earnings or 3% of the IRS compensation limit for the given +year. Matching contributions for all plans were $420 million, $393 million, and $373 million in fiscal years 2014, 2013, and 2012, respectively, and were expensed as contributed. Matching contributions are invested proportionate to each +participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested in +Microsoft common stock. NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, the company’s Chief Executive +Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information in this note is reported on that basis. During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services +company. As a result, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we reported our financial performance based +on our new segments; D&C Licensing, D&C Hardware, D&C Other, Commercial Licensing, and Commercial Other. We have recast certain prior period amounts to conform to the way we internally managed and monitored segment performance during +fiscal year 2014. On April 25, 2014, we acquired substantially all of NDS. See Note 9 – Business Combinations for additional +details. NDS has been included in our consolidated results of operations starting on the acquisition date. We report the financial performance of the acquired business in our new Phone Hardware segment. Prior to the acquisition of NDS, financial +results associated with our joint strategic initiatives with Nokia were reflected in our D&C Licensing segment. The contractual relationship with Nokia related to those initiatives terminated in conjunction with the acquisition. With the +creation of the new Phone Hardware segment, the D&C Hardware segment was renamed Computing and Gaming Hardware in the fourth quarter of fiscal year 2014. Our reportable segments are described below. 91 Table of Contents PART II Item 8 Devices and Consumer Our D&C segments develop, manufacture, market, and support products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed +decisions online, and help advertisers connect with audiences. Our D&C segments are: • D&C Licensing , comprising: Windows, including all OEM licensing (“Windows OEM”) and other non-volume licensing and academic volume +licensing of the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Office Consumer”); Windows Phone operating system, including related patent +licensing; and certain other patent licensing revenue; • Computing and Gaming Hardware , comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, +and Xbox Live subscriptions (“Xbox Platform”); Surface devices and accessories; and Microsoft PC accessories; • Phone Hardware , comprising: Lumia Smartphones and other non-Lumia phones, beginning with the acquisition of NDS; and • D&C Other , comprising: Resale, including Windows Store, Xbox Live transactions, and Windows Phone Store; search advertising; display advertising; +Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity +and efficiency, including simplifying everyday tasks through seamless operations across the user’s hardware and software. Our Commercial segments are: • Commercial Licensing , comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client +Access Licenses (“CALs”); Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Office for business, including Office, Exchange, SharePoint, Lync, and related +CALs (“Office Commercial”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and • Commercial Other , comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Commercial Cloud, comprising +Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure; and certain other commercial products and online services not included in the categories above. Revenue and cost of revenue are generally directly attributed to our segments. Certain revenue contracts are allocated among the segments based on +the relative value of the underlying products and services. Cost of revenue is directly charged to our hardware segments. For the remaining segments, cost of revenue is directly charged in most cases and allocated in certain cases, generally using a +relative revenue methodology. We do not allocate operating expenses to our segments. Rather, we allocate them to our two segment +groups, Devices and Consumer and Commercial. Due to the integrated structure of our business, allocations of expenses are made in certain cases to incent cross-collaboration among our segment groups so that a segment group is not solely burdened by +the cost of a mutually beneficial activity as we seek to deliver seamless experiences across devices, whether on-premises or in the cloud. Operating expenses are attributed to our segment groups as follows: • Sales and marketing expenses are primarily recorded directly to each segment group based on identified customer segment. • Research and development expenses are primarily shared across the segment groups based on relative gross margin but are mapped directly in certain cases where +the value of the expense only accrues to that segment group. 92 Table of Contents PART II Item 8 • General and administrative expenses are primarily allocated based on relative gross margin. Certain corporate-level activity is not allocated to our segment groups, including costs of: legal, including expenses, settlements, and fines; +information technology; human resources; finance; excise taxes; and integration and restructuring costs. Segment revenue and gross +margin were as follows during the periods presented: (In millions) Year Ended June 30, 2014 2013 2012 Revenue Devices and Consumer Licensing $ 18,803 $ 19,021 $ 19,495 Hardware: Computing and Gaming Hardware 9,628 6,461 6,740 Phone Hardware 1,985 0 0 Total D&C Hardware 11,613 6,461 6,740 Other 7,258 6,618 6,203 Total Devices and Consumer 37,674 32,100 32,438 Commercial Licensing 42,027 39,686 37,126 Other 7,547 5,660 4,644 Total Commercial 49,574 45,346 41,770 Corporate and Other (415 ) 403 (485 ) Total revenue $ 86,833 $ 77,849 $ 73,723 (In millions) Year Ended June 30, 2014 2013 2012 Gross margin Devices and Consumer Licensing $ 17,216 $ 17,044 $ 17,240 Hardware: Computing and Gaming Hardware 893 956 2,495 Phone Hardware 54 0 0 Total D&C Hardware 947 956 2,495 Other 1,770 2,046 1,998 Total Devices and Consumer 19,933 20,046 21,733 Commercial Licensing 38,604 36,261 34,463 Other 1,856 921 579 Total Commercial 40,460 37,182 35,042 Corporate and Other (494 ) 372 (582 ) Total gross margin $ 59,899 $ 57,600 $ 56,193 Following is operating expenses by segment group. As discussed above, we do not allocate operating expenses below +cost of revenue to our segments. (In millions) Year Ended June 30, 2014 2013 2012 Devices and Consumer $ 11,219 $ 10,625 $ 15,682 Commercial 16,993 16,050 15,064 Corporate and Other 3,928 4,161 3,684 Total operating expenses $ 32,140 $ 30,836 $ 34,430 93 Table of Contents PART II Item 8 Following is operating income (loss) by segment group. (In millions) Year Ended June 30, 2014 2013 2012 Devices and Consumer $ 8,714 $ 9,421 $ 6,051 Commercial 23,467 21,132 19,978 Corporate and Other (4,422 ) (3,789 ) (4,266 ) Total operating income $ 27,759 $ 26,764 $ 21,763 Corporate and Other operating income includes adjustments to conform our internal accounting policies to U.S. GAAP +and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and depreciation. Corporate and Other activity was as follows: (In millions) Year Ended June 30, 2014 2013 2012 Corporate (a) $ (3,888 ) $ (4,236 ) $ (3,671 ) Other (adjustments to U.S. GAAP): Revenue reconciling amounts (b) (415 ) 403 (485 ) Cost of revenue reconciling amounts (79 ) (31 ) (97 ) Operating expenses reconciling amounts (40 ) 75 (13 ) Total Corporate and Other $ (4,422 ) $ (3,789 ) $ (4,266 ) (a) Corporate is presented on the basis of our internal accounting policies and excludes the adjustments to U.S. GAAP that are presented separately in those +line items. (b) Revenue reconciling amounts for fiscal year 2014 included a net $349 million of revenue deferrals related to sales of certain devices bundled with other +products and services (“Bundled Offerings”). Revenue reconciling amounts for fiscal years 2012 and 2013 included the deferral and subsequent recognition, respectively, of $540 million of revenue related to the Windows Upgrade Offer. No sales to an individual customer or country other than the United States accounted for more than 10% of fiscal +year 2014, 2013, or 2012 revenue. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2014 2013 2012 United +States (a) $ 43,474 $ 41,344 $ 38,846 Other countries 43,359 36,505 34,877 Total $ 86,833 $ 77,849 $ 73,723 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the +geographic source of the revenue. 94 Table of Contents PART II Item 8 Revenue from external customers, classified by significant product and service offerings were as +follows: (In millions) Year Ended June 30, 2014 2013 2012 Microsoft Office system $ 24,323 $ 22,995 $ 22,299 Windows PC operating system 16,856 17,529 17,320 Server products and tools 17,055 15,408 14,232 Xbox Platform 8,643 7,100 8,045 Consulting and product support services 4,767 4,372 3,976 Advertising 4,016 3,387 3,181 Phone 3,073 615 162 Surface 1,883 853 0 Other 6,217 5,590 4,508 Total $ 86,833 $ 77,849 $ 73,723 Our total Commercial Cloud revenue was $2.8 billion, $1.3 billion, and $0.7 billion in fiscal years 2014, 2013, and +2012, respectively. These amounts are included in their respective product categories in the table above. Assets are not allocated to +segments for internal reporting presentations. A portion of amortization and depreciation is charged to the respective segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included +in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location +of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2014 2013 2012 United States $ 17,653 $ 16,615 $ 14,081 Finland 9,840 12 8 Luxembourg 6,913 6,943 6,975 Other countries 5,713 4,159 3,827 Total $ 40,119 $ 27,729 $ 24,891 NOTE 22 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 (a) Total (a) Fiscal Year 2014 Revenue $  18,529 $  24,519 $  20,403 $  23,382 $  86,833 Gross margin 13,415 16,235 14,462 15,787 59,899 Net income 5,244 6,558 5,660 4,612 (b) 22,074 (b) Basic earnings per share 0.63 0.79 0.68 0.56 2.66 Diluted earnings per share 0.62 0.78 0.68 0.55 (b) 2.63 (b) Fiscal Year 2013 Revenue $  16,008 $  21,456 $  20,489 $  19,896 $  77,849 Gross margin 11,840 15,764 15,702 14,294 57,600 Net income 4,466 6,377 6,055 (c) 4,965 (d) 21,863 (e) Basic earnings per share 0.53 0.76 0.72 0.59 2.61 Diluted earnings per share 0.53 0.76 0.72 (c) 0.59 (d) 2.58 (e) (a) NDS has been included in our consolidated results of operations starting on April 25, 2014, the date of acquisition. (b) Includes a tax provision adjustment recorded in the fourth quarter of fiscal year 2014 related to adjustments to prior years’ liabilities for +intercompany transfer pricing which decreased net income by $458 million and diluted earnings per share by $0.05. 95 Table of Contents PART II Item 8 (c) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased net income by $733 million (€561 million) and +diluted earnings per share by $0.09. (d) Includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased net income by $596 million and +diluted earnings per share by $0.07. (e) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased net income by $733 million (€561 million) and +diluted earnings per share by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased net income by $596 million and diluted earnings per share by $0.07. NOTE 23 — SUBSEQUENT EVENT On July 17, 2014, we announced a restructuring plan to simplify our organization and align the recently acquired NDS +business with our company’s overall strategy. We will eliminate up to 18,000 positions over the next year, including 12,500 professional and factory positions related to the acquisition of NDS. We expect to incur pre-tax charges of +approximately $1.1 billion to $1.6 billion in fiscal year 2015. 96 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the accompanying consolidated balance sheets of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2014 and 2013, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for each of the three years in the period +ended June 30, 2014. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in +the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the +financial position of Microsoft Corporation and subsidiaries as of June 30, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2014, in conformity with +accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2014, based on the criteria established in Internal Control – Integrated Framework +(2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 31, 2014, expressed an unqualified opinion on the Company’s internal control over financial reporting. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 31, +2014 97 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and +with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of +the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control +over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal +control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial +statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets +that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a +misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our +internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Our assessment of, and conclusion on, +the effectiveness of internal control over financial reporting did not include the internal controls of Nokia Corporation’s Devices and Services business, acquired on April 25, 2014, which is included in our 2014 consolidated financial +statements and represented approximately 9% of our total assets as of June 30, 2014, and 2% of our total revenues for the year ended June 30, 2014. Based on this evaluation, management concluded that the company’s internal control +over financial reporting was effective as of June 30, 2014. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2014 that have materially affected, or are reasonably likely to materially +affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2014; their report is included in Item 9A. 98 Table of Contents PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the internal +control over financial reporting of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2014, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee +of Sponsoring Organizations of the Treadway Commission. As described in the Report of Management on Internal Control over Financial Reporting, management excluded from its assessment the internal control over financial reporting at Nokia +Corporation’s Devices and Services business, acquired on April 25, 2014 and whose financial statements constitute 9% of total assets as of June 30, 2014 and 2% of total revenues for the year ended June 30, 2014. Accordingly, our +audit did not include the internal control over financial reporting at Nokia Corporation’s Devices and Services business. The Company’s management is responsible for maintaining effective internal control over financial reporting and for +its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s +internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public +Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material +respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on +the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal +executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial +reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that +(1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as +necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors +of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper +management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to +future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2014, +based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial +statements as of and for the year ended June 30, 2014, of the Company and our report dated July 31, 2014, expressed an unqualified opinion on those financial statements. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 31, +2014 99 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Effective July 1, 2014, we amended our Bylaws to establish the size of the Board of Directors as a range of 5 to 14 members, and to designate +the chief executive officer as the sole officer with authority to appoint corporate officers. The amended Bylaws are filed as Exhibit 3.2 to this Report. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND +CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form +10-K. Information about our directors may be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held December 3, 2014 (the “Proxy Statement”). Information +about our Audit Committee may be found under the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy Statement set forth under the caption “Section 16(a) Beneficial ownership reporting compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our +Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at +www.microsoft.com/investor/MSFinanceCode. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, +or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy +Statement set forth under the captions “Director compensation,” “Named executive officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is +incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND +MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information +regarding beneficial ownership of principal shareholders, directors, and management” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related +transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND +SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees +billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 100 Table of Contents PART IV Item 15 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information +is otherwise included. Index to Financial Statements Page Income Statements 53 Comprehensive Income Statements 54 Balance Sheets 55 Cash Flows Statements 56 Stockholders’ Equity Statements 57 Notes to Financial Statements 58 Report of Independent Registered Public Accounting Firm 97 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/09 3.1 1/28/10 3.2 Bylaws of Microsoft Corporation X 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft +Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.5 9/27/10 101 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New +York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.6 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.7 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013 between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the +Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, +N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 102 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New +York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 12/31/11 10.1 1/19/12 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-Q 3/31/12 10.5 4/19/12 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.12 7/30/10 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.13 7/30/10 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors S-8 99.2 2/28/06 10.17* Executive Officer Incentive Plan 8-K 10.17 9/23/13 10.18* Form of Executive Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 8-K 10.20 9/23/13 10.19* Resignation Agreement and Full and Final Release of Claims between Microsoft Corporation and Steven Sinofsky 10-K 6/30/13 10.19 7/30/13 10.21 Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan (Service-Based) 8-K 10.21 9/23/13 10.22 Senior Executive Severance Benefit Plan 8-K 10.22 9/26/13 103 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Furnished, not filed 104 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 31, 2014. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on July 31, 2014. Signature Title / S /    J OHN W. +T HOMPSON John W. Thompson Chairman / S /    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer / S /    S TEVEN A. +B ALLMER Steven A. Ballmer Director / S /    D INA D UBLON Dina Dublon Director / S /    W ILLIAM H. G ATES III William H. Gates III Director / S /    M ARIA M. +K LAWE Maria M. Klawe Director / S /    D AVID F. +M ARQUARDT David F. Marquardt Director / S /    G. M ASON M ORFIT G. Mason Morfit Director / S /    C HARLES H. +N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    A MY E. +H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 105 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-15-272806/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-15-272806/full-submission.txt new file mode 100644 index 0000000..681debd --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-15-272806/full-submission.txt @@ -0,0 +1,1171 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2015 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  +to Commission File Number +0-14278 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such +shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its +corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was +required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2014, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $365,312,377,595 based on the closing sale price as reported on the NASDAQ +National Market System. As of July 27, 2015, there were 7,997,980,969 shares of common stock outstanding. DOCUMENTS INCORPORATED +BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of +Shareholders to be held on December 2, 2015 are incorporated by reference into Part III. Table of Contents MICROSOFT CORPORATION FORM 10-K For The Fiscal +Year Ended June 30, 2015 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 16 Item 1A. Risk Factors 18 Item 1B. Unresolved Staff Comments 26 Item 2. Properties 26 Item 3. Legal Proceedings 27 Item 4. Mine Safety Disclosures 27 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 28 Item 6. Selected Financial Data 28 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 29 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 51 Item 8. Financial Statements and Supplementary Data 53 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 99 Item 9A. Controls and Procedures 99 Report of Management on Internal Control over Financial Reporting 99 Report of Independent Registered Public Accounting Firm 100 Item 9B. Other Information 101 PART III Item 10. Directors, Executive Officers and Corporate Governance 101 Item 11. Executive Compensation 101 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 101 Item 13. Certain Relationships and Related Transactions, and Director Independence 101 Item 14. Principal Accounting Fees and Services 101 PART IV Item 15. Exhibits, Financial Statement Schedules 102 Signatures 106 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are +“forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements +may appear throughout this report, including the following sections: “Business,” “Management’s Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by the words +“believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” +“will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and +uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors” (Part I, Item 1A of this Form 10-K), +“Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A), and “Management’s Discussion and Analysis” (Part II, Item 7). We undertake no obligation to update or revise publicly any +forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Our vision Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. Our strategy is to build best-in-class platforms and productivity services for a +mobile-first, cloud-first world. The mobile-first, cloud-first world is transforming the way individuals and organizations use and +interact with technology. Our worldview for mobile-first is not about the mobility of devices; it is centered on the mobility of experiences that, in turn, are orchestrated by the cloud. Cloud computing and storage solutions provide users and +enterprises with various capabilities to store and process their data in third-party data centers. Mobility encompasses the rich collection of data, applications, and services that accompany our customers as they move from setting to setting in +their lives. We are transforming our businesses to enable Microsoft to lead the direction of this transformation, and enable our customers and partners to thrive in this evolving world. What we offer Founded in 1975, we operate worldwide and have offices in more than 100 +countries. We develop, license, and support a wide range of software products, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. We offer an array of services, including cloud-based +services, to consumers and businesses. We design, manufacture, and sell devices that integrate with our cloud-based services, and we deliver relevant online advertising to a global audience. Our products include operating systems for computing devices, servers, phones, and other intelligent devices; server applications for distributed +computing environments; cross-device productivity applications; business solution applications; desktop and server management tools; software development tools; video games; and online advertising. We also design and sell hardware including PCs, +tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories. We offer cloud-based solutions that provide customers with software, services, platforms, and content. We also provide consulting and product and +solution support services, and we train and certify computer system integrators and developers. 3 Table of Contents PART I Item 1 The ambitions that drive us To carry out our strategy, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud platform. • Create more personal computing. Reinvent productivity and business processes We believe we can significantly enhance the lives of our customers using our broad portfolio of communication, productivity, and information +services that spans devices and platforms. Productivity will be the first and foremost objective, to enable people to meet and collaborate more easily, and to effectively express ideas in new ways. We will design applications as dual-use with the +intelligence to partition data between work and life while respecting each person’s privacy choices. The foundation for these efforts will rest on advancing our leading productivity, collaboration, and business process tools including Skype, +OneDrive, OneNote, Outlook, Word, Excel, PowerPoint, Bing, and Dynamics. With Office 365, we provide these familiar industry-leading productivity and business process tools as cloud services, enabling access from anywhere and any device. This +creates an opportunity to reach new customers, and expand the usage of our services by our existing customers. We see opportunity in +combining our offerings in new ways that are more contextual and personal, while ensuring people, rather than their devices, remain at the center of the digital experience. We will offer our services across ecosystems and devices outside our own. As +people move from device to device, so will their content and the richness of their services. We are engineering our applications so users can find, try, and buy them in friction-free ways. Build the intelligent cloud platform In deploying technology that advances business strategy, +enterprises decide what solutions will make employees more productive, collaborative, and satisfied, and connect with customers in new and compelling ways. They work to unlock business insights from a world of data. To achieve these objectives, +increasingly businesses look to leverage the benefits of the cloud. Helping businesses move to the cloud is one of our largest opportunities, and we believe we work from a position of strength. The shift to the cloud is driven by three important economies of scale: larger datacenters can deploy computational resources at significantly +lower cost per unit than smaller ones; larger datacenters can coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy lowers +application maintenance labor costs for large public clouds. As one of the largest providers of cloud computing at scale, we are well-positioned to help businesses move to the cloud so that businesses can focus on innovation while leaving +non-differentiating activities to reliable and cost-effective providers like Microsoft. With Azure, we are one of very few cloud +vendors that run at a scale that meets the needs of businesses of all sizes and complexities. We believe the combination of Azure and Windows Server makes us the only company with a public, private, and hybrid cloud platform that can power modern +business. We are working to enhance the return on information technology (“IT”) investment by enabling enterprises to combine their existing datacenters and our public cloud into a single cohesive infrastructure. Businesses can deploy +applications in their own datacenter, a partner’s datacenter, or in our datacenters with common security, management, and administration across all environments, with the flexibility and scale they want. We enable organizations to securely adopt software-as-a-service applications (both our own and third-party) and integrate them with their existing +security and management infrastructure. We will continue to innovate with higher-level services including identity and directory services that manage employee corporate identity and manage and secure corporate information accessed and stored across +a growing number of devices, rich data storage and analytics services, machine learning services, media services, web and mobile backend services, and developer 4 Table of Contents PART I Item 1 productivity services. To foster a rich developer ecosystem, our digital work and life experiences will also be extensible, enabling customers and partners to further customize and enhance our +solutions, achieving even more value. This strategy requires continuing investment in datacenters and other infrastructure to support our devices and services. Create more personal computing Windows 10 is the cornerstone of our ambition to usher in +an era of more personal computing. We see the launch of Windows 10 in July 2015 as a critical, transformative moment for the Company because we will move from an operating system that runs on a PC to a service that can power the full spectrum of +devices in our customers’ lives. We developed Windows 10 not only to be familiar to our users, but more safe and secure, and always up-to-date. We believe Windows 10 is more personal and productive, working seamlessly with functionality such as +Cortana, Office, Continuum, and universal applications. We designed Windows 10 to foster innovation – from us, our partners and developers – through experiences such as our new browser Microsoft Edge, across the range of existing devices, +and into entirely new device categories. Our ambition for Windows 10 is to broaden our economic opportunity through three key levers: +an original equipment manufacturer (“OEM”) ecosystem that creates exciting new hardware designs for Windows 10; our own commitment to the health and profitability of our first-party premium device portfolio; and monetization opportunities +such as services, subscriptions, gaming, and search. Our OEM partners are investing in an extensive portfolio of hardware designs and configurations as they ready for Windows 10. By December 2015, we anticipate the widest range of Windows hardware +ever to be available. With the launch of Windows 10, we are realizing our vision of a single, unified Windows operating system on which +developers and OEMs can contribute to a thriving Windows ecosystem. We invest heavily to make Windows the most secure, manageable, and capable operating system for the needs of a modern workforce. We are working to create a broad developer +opportunity by unifying the installed base to Windows 10 through upgrades and ongoing updates, and by enabling universal Windows applications to run across all device targets. As part of our strategic objectives, we are committed to designing and +marketing first-party devices to help drive innovation, create new categories, and stimulate demand in the Windows ecosystem, including across PCs, phones, tablets, consoles, wearables, large multi-touch displays, and new categories such as the +HoloLens holographic computing platform. We are developing new input/output methods like speech, pen, gesture, and augmented reality holograms to power more personal computing experiences with Windows 10. Our future opportunity There are several +distinct areas of technology that we aim to drive forward. Our goal is to lead the industry in these areas over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Delivering new productivity, entertainment, and business processes to improve how people communicate, collaborate, learn, work, play, and interact with one +another. • Establishing the Windows platform across the PC, tablet, phone, server, other devices, and the cloud to drive a thriving ecosystem of developers, unify the +cross-device user experience, and increase agility when bringing new advances to market. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Developing new devices that have increasingly natural ways to interact with them, including speech, pen, gesture, and augmented reality holograms. • Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command. We believe the breadth of our products and services portfolio, our large global partner and customer base, our growing ecosystem, and our ongoing +investment in innovation position us to be a leader in these areas and differentiate ourselves from competitors. 5 Table of Contents PART I Item 1 OPERATING SEGMENTS We operate our business in six segments. Our Devices and Consumer (“D&C”) segments include D&C Licensing, Computing and Gaming Hardware, Phone Hardware, and D&C Other. Our Commercial segments +include Commercial Licensing and Commercial Other. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, +and services organizations, and they provide a framework for timely and rational allocation of development, sales, marketing, and services resources within businesses. In June 2015, we announced a change in organizational structure as part of our +transformation in the mobile-first, cloud-first world. As we evolve how we allocate resources and analyze performance in the new structure, it is possible that our segments may change. On April 25, 2014, we acquired substantially all of Nokia Corporation’s (“Nokia”) Devices and Services Business +(“NDS”). We report the financial performance of the acquired business in our Phone Hardware segment. Prior to the acquisition of NDS, financial results associated with our joint strategic initiatives with Nokia were reflected in our +D&C Licensing segment. The contractual relationship with Nokia related to those initiatives ended in conjunction with the acquisition. Additional information on our operating segments and geographic and product information is contained in Note 22 – Segment Information and Geographic Data of the Notes to Financial Statements (Part +II, Item 8 of this Form 10-K). Devices and Consumer Our D&C segments develop, manufacture, market, and support products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed +decisions online, and help advertisers connect with audiences. Our D&C segments are made up of D&C Licensing, Computing and Gaming Hardware, Phone Hardware, and D&C Other. D&C Licensing The principal products and services provided by the D&C Licensing +segment are: Windows, including all OEM licensing (“Windows OEM”) and other non-volume licensing and academic volume licensing of the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the +core Office product set, for consumers (“Office Consumer”); Windows Phone operating system, including related patent licensing; and certain other patent licensing revenue. The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, +applications, and information across their devices. Windows revenue is impacted significantly by the number of Windows operating system +licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and emerging markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small- and medium-sized businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large, +multinational OEMs, and different pricing of Windows versions licensed. • Piracy. 6 Table of Contents PART I Item 1 The versions of Office included in our D&C Licensing segment are designed to increase personal +productivity through a range of programs, services, and software solutions. Growth depends on our ability to add value to the core product set and to continue to expand our product offerings in other areas such as content management and +collaboration. Office Consumer revenue is impacted by sales to customers that buy Office with their new devices and by product launches, as well as the transition to Office 365 Consumer, our subscription-based cloud service that provides access to +Office plus other productivity services. Office 365 Consumer revenue is included in our D&C Other segment. The Windows Phone +operating system is designed to bring users closer to the people, applications, and content they need. As noted above, prior to our acquisition of NDS, Microsoft and Nokia jointly created new mobile products and services and extended established +products and services to new markets through a strategic alliance. Windows Phone revenue associated with this contractual relationship was reflected in D&C Licensing. Windows Phone revenue also includes revenue from licensing mobile-related +patents. Competition The +Windows operating system faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an +easy-to-use interface, compatibility with a broad range of hardware and software applications, including those that enable productivity, and the largest support network for any operating system. Competitors to the versions of Office included in D&C Licensing include global application vendors such as Apple and Google, numerous web-based +and mobile application competitors, and local application developers in Asia and Europe. Apple distributes versions of its pre-installed application software, such as email, note-taking, and calendar products, through its PCs, tablets, and phones. +Google provides a hosted messaging and productivity suite. Web-based offerings competing with individual applications can also position themselves as alternatives to our products. We believe our products compete effectively based on our strategy of +providing powerful, flexible, secure, and easy to use solutions that work across a variety of devices. Windows Phone operating system +faces competition from iOS, Android, and Blackberry operating systems. Windows Phone competes based on differentiated user interface, personalized applications, compatibility with Windows PCs and tablets, and other unique capabilities. Computing and Gaming Hardware The +principal products and services provided by the Computing and Gaming Hardware segment are: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, and Xbox Live subscriptions (“Xbox +Platform”); Surface devices and accessories (“Surface”); and Microsoft PC accessories. The Xbox Platform is designed to +provide a unique variety of entertainment choices through the use of our devices, peripherals, content, and online services. We released Xbox 360 and Xbox One in November 2005 and November 2013, respectively. Surface is designed to help organizations, students, and consumers to be more productive. Our latest Surface devices, the Surface Pro 3 and Surface +3, were released in June 2014 and May 2015, respectively. Competition Our Xbox Platform competes with console platforms from Sony and Nintendo, both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles averages five to ten years. +Nintendo released their latest generation console in November 2012. Sony released their latest generation console in November 2013. 7 Table of Contents PART I Item 1 We believe the success of gaming and entertainment consoles is determined by the availability of +games for the console, providing exclusive game content that gamers seek, the computational power and reliability of the console, and the ability to create new experiences via online services, downloadable content, and peripherals. In addition to +Sony and Nintendo, we compete with other providers of entertainment services through online marketplaces. We believe the Xbox Platform is effectively positioned against competitive products and services based on significant innovation in +hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own game franchises as well as other digital content offerings. Surface devices face competition from Apple, as well as other computer, tablet, and hardware manufacturers, many of which are also current or +potential partners and customers. Phone Hardware The principal products provided by the Phone Hardware segment are Lumia phones and other non-Lumia phones, which we began manufacturing and selling with the acquisition of NDS on April 25, 2014. Our Lumia +phones run Windows and are designed to enable people and organizations to connect to the people and content that matter most, using integrated Microsoft services such as Outlook, OneDrive, Skype, and Office. Competition Our phones face competition +primarily from Apple, Samsung, and many other mobile device manufacturers running the Android operating system, and offer a unique combination of high-quality industrial design and innovative imaging technologies across various price points. D&C Other The principal +products and services provided by the D&C Other segment are: Resale, consisting of transactions in our Windows Store and Xbox marketplace; search advertising; display advertising; Office 365 Consumer, comprising Office 365 Home and Office 365 +Personal; Studios, comprising first-party video games; Mojang; and non-Microsoft products sold in our retail stores. Our online +application marketplaces are designed to benefit our developer and partner ecosystems by providing access to a large customer base and benefit users by providing centralized access to certified applications. Xbox Live transactions consist of online +entertainment content, such as games, music, movies, and TV shows, accessible on Xbox consoles and other devices. Search and display +advertising includes Bing, Bing Ads, MSN, and Xbox ads. We have a partnership with Yahoo! in which we provide algorithmic and paid search platform for Yahoo! websites worldwide. In June 2015, we entered into agreements with AOL and AppNexus to +outsource our display sales efforts. Office 365 Consumer is designed to increase personal productivity through a range of Microsoft +Office programs and services delivered across multiple platforms via the cloud. Studios designs and markets games for Xbox consoles, +Windows-enabled devices, and online. Growth depends on our ability to attract new users and increase engagement by developing a deep library of content that consumers seek. We acquired Mojang Synergies AB (“Mojang”), the Swedish video game developer of the Minecraft gaming franchise, in November 2014. The addition of Minecraft and its community enhances our gaming portfolio +across Windows, Xbox, and other ecosystems besides our own. Competition We face competition for our Resale products and services from various online marketplaces, including those operated by Amazon, Apple, and Google. 8 Table of Contents PART I Item 1 Our search and display advertising business competes with Google and a wide array of websites, +social platforms like Facebook, and portals like Yahoo! that provide content and online offerings to end users. Our success depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser +offerings. We believe we can attract new users by continuing to offer new and compelling products and services. Competitors to Office +365 Consumer are the same as those discussed above for Office Consumer. Competitors to Studios and Mojang are the same as those +discussed above for our Xbox gaming and entertainment business, as well as game studios like Electronic Arts and Activision Blizzard. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and +organizational productivity and efficiency, including simplifying everyday tasks through seamless operations across the user’s hardware and software. Commercial is made up of the Commercial Licensing and Commercial Other segments. Commercial Licensing The principal +products and services provided by the Commercial Licensing segment are: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); Microsoft Office for +business, including Office, Exchange, SharePoint, Skype for Business, and related CALs (“Office Commercial”); volume licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Dynamics +business solutions, excluding Dynamics CRM Online; Windows Embedded; and Skype. Our server products are designed to make information +technology professionals and developers and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This +includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle +tools for software architects, developers, testers, and project managers. Revenue comes from purchases through volume licensing programs, licenses sold to OEMs, and retail packaged product. CALs provide access rights to certain server products, +including Windows Server and SQL Server. CAL revenue is reported along with the associated server product. The versions of Office in +Commercial Licensing are designed to increase personal, team, and organizational productivity through a range of programs, services, and software solutions. Office Commercial revenue is mainly affected by a combination of the demand from commercial +customers for volume licensing and software assurance and the number of information workers in a licensed enterprise. Office Commercial revenue growth depends on our ability to add value to the core product set and to continue to expand our product +offerings in other areas such as content management, enterprise search, collaboration, unified communications, and business intelligence. CALs provide access rights to certain Office Commercial products, including Exchange, SharePoint, and Skype for +Business, formerly Lync. CAL revenue is reported along with the associated Office product. Windows Commercial includes volume licensing +of the Windows operating system, excluding academic. Windows Commercial revenue is affected mainly by the demand from commercial customers for volume licensing and software assurance, often reflecting the number of information workers in a licensed +enterprise, and is therefore relatively independent of the number of PCs sold in a given year. Microsoft Dynamics products provide +business solutions for financial management, customer relationship management, supply chain management, and analytics applications for small and mid-size businesses, large organizations, and divisions of global enterprises. Revenue is largely driven +by the number of information workers licensed. 9 Table of Contents PART I Item 1 Windows Embedded extends the power of Windows and the cloud to intelligent systems, including the +Internet of Things (“IoT”), by delivering specialized operating systems, tools, and services. Skype is designed to connect +friends, family, clients, and colleagues through a variety of devices. Revenue is largely driven by the sale of minutes, subscriptions, and advertising. Competition Our server products face +competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of +the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also +benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and +middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that +competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client/server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes +with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java middleware vendors. Our system +management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our database, business intelligence, and data warehousing solutions offerings compete +with products from IBM, Oracle, SAP, and other companies. Our products for software developers compete against offerings from Adobe, IBM, Oracle, other companies, and open-source projects, including Eclipse (sponsored by CA Technologies, IBM, +Oracle, and SAP), PHP, and Ruby on Rails, among others. We believe our server products provide customers with advantages in +performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Competitors to Office Commercial includes software application vendors such as Adobe Systems, Apple, Cisco Systems, Google, IBM, Oracle, SAP, and +numerous web-based and mobile application competitors as well as local application developers in Asia and Europe. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides +a hosted messaging and productivity suite. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products. We believe our products compete effectively based on our strategy of providing +powerful, flexible, secure, easy to use solutions that work well with technologies our customers already have and are available on a device or via the cloud. Competitors to Windows Commercial are the same as those discussed above for Windows in the D&C Licensing segment. Our Microsoft Dynamics products compete with vendors such as Oracle and SAP in the market for large organizations and divisions of global enterprises. In the market focused on providing solutions for small and +mid-sized businesses, our Microsoft Dynamics products compete with vendors such as Infor, The Sage Group, and NetSuite. Salesforce.com’s cloud customer relationship management (“CRM”) offerings compete directly with Microsoft +Dynamics CRM on-premises offerings. 10 Table of Contents PART I Item 1 Skype competes with a variety of instant messaging, voice, and video communication providers, +ranging from start-ups to established enterprises. Commercial Other The principal products and services provided by the Commercial Other segment are: Commercial Cloud, comprising Office 365 Commercial, Microsoft Azure, Dynamics CRM Online, and other Microsoft Office online +offerings; and Enterprise Services, including Premier Support Services and Microsoft Consulting Services. Office 365 Commercial is an +online services offering that includes Microsoft Office, Exchange, SharePoint, and Skype for Business, and is available across a variety of devices and platforms. Microsoft Azure is a scalable cloud platform with computing, networking, storage, database, and management, along with advanced services such as analytics, and comprehensive solutions such as Enterprise Mobility +Suite. Microsoft Azure also includes a flexible platform that helps developers build, deploy, and manage enterprise, mobile, web, and IoT applications, for any platform or device without having to worry about the underlying infrastructure. Microsoft +Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Dynamics CRM Online is designed to provide customer relationship management and analytics applications for small and mid-size businesses, large +organizations, and divisions of global enterprises. Revenue is largely driven by the number of information workers licensed. Enterprise +Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and information +technology professionals on various Microsoft products. Competition Competitors to Office 365 Commercial are the same as those discussed above for Office Commercial. Microsoft Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, Salesforce.com, VMware, and open source offerings. +Azure competes by enabling deployment of existing data centers with our public cloud into a single, cohesive infrastructure, and runs at a scale that meets the needs of businesses of all sizes and complexities. Dynamics CRM Online primarily competes with Salesforce.com’s on-demand CRM offerings. The Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and +infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. OPERATIONS We have +operations centers that support all operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the +European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, +Nevada support Latin America and North America. In addition to the operations centers, we also operate data centers throughout the Americas, Australia, Europe, and Asia. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. +Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. 11 Table of Contents PART I Item 1 We operate manufacturing facilities for the production and customization of phones, predominantly +in Vietnam. Our Xbox consoles, Surface, first-party video games, Microsoft PC accessories, and other hardware are primarily +manufactured by third-party contract manufacturers. We generally have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. RESEARCH AND DEVELOPMENT During fiscal years 2015, 2014, and 2013, research and development expense was $12.0 billion, $11.4 billion, and $10.4 billion, respectively. +These amounts represented 13% of revenue in each of those years. We plan to continue to make significant investments in a broad range of research and development efforts. Product and Service Development and Intellectual Property We develop most of our products and +services internally through three engineering groups. • Applications and Services Engineering Group , focuses on broad applications and services core technologies in productivity, communication, education, +search, and other information categories. • Cloud and Enterprise Engineering Group , focuses on development of our cloud infrastructure, server, database, CRM, enterprise resource planning, +management, development tools, and other business process applications and services for enterprises. • Windows and Devices Engineering Group , focuses on our Windows platform across devices of all types, hardware development of our devices, including Xbox +consoles, Surface devices, Lumia phones, non-Lumia phones, Surface Hub, Microsoft Band, and other hardware products and accessories, and associated online marketplaces. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our +products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and +hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product +documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and +internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing +patents and currently have a portfolio of over 57,000 U.S. and international patents issued and over 35,000 pending. While we employ much of our internally developed intellectual property exclusively in Microsoft products and services, we also +engage in outbound and inbound licensing of specific patented technologies that are incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with other technology companies +covering entire groups of patents. We also purchase or license technology that we incorporate into our products or services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as +promoting industry standards, advancing interoperability, or attracting and enabling our external development community. While it may +be necessary in the future to seek or renew licenses relating to various aspects of our products and business methods, we believe, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable +terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. 12 Table of Contents PART I Item 1 Investing in the Future Microsoft’s success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and +product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the +company. Based on our assessment of key technology trends and our broad focus on long-term research and development, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms +spanning digital work and life experiences, cloud computing, and devices operating systems and hardware. While our main research and +development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, Denmark, Finland, France, Germany, India, Ireland, Israel, +Japan, and the United Kingdom, among others. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that +we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the business segment level. Much of our business segment level research and development is coordinated +with other segments and leveraged across the company. In addition to our main research and development operations, we also operate +Microsoft Research. Microsoft Research is one of the world’s largest computer science research organizations, and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science, providing +us a unique perspective on future technology trends and contributing to our innovation. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs; distributors and resellers; online; and +Microsoft retail stores. Our sales force performs a variety of functions, including working directly with enterprises and public sector organizations worldwide to identify and meet their software requirements; managing OEM relationships; and +supporting solution integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products. OEMs We distribute software through OEMs +that pre-install our software on new PCs, tablets, servers, phones, and other intelligent devices that they sell. The largest component of the OEM business is the Windows operating system pre-installed on computing devices. OEMs also sell hardware +pre-installed with other Microsoft products, including server and embedded operating systems and applications such as our Microsoft Office suite. In addition to these products, we also market our services through OEMs and service bundles such as +Windows with Bing or Windows with Office 365 subscription. There are two broad categories of OEMs. The largest OEMs, many of which +operate globally, are referred to as “Direct OEMs,” as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all +of the multinational OEMs, including Acer, ASUSTeK, Dell, Fujitsu, Hewlett-Packard, Lenovo, Samsung, Toshiba, and with many regional and local OEMs. The second broad category of OEMs consists of lower-volume PC manufacturers (also called +“system builders”), which source their Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Distributors and Resellers Many +organizations that license our products and services through enterprise agreements transact directly with us, with sales support from solution integrators, independent software vendors, web agencies, and developers that advise organizations on +licensing our products and services (“Enterprise Agreement Direct Advisors”, or “EDAs”). 13 Table of Contents PART I Item 1 Organizations also license our products and services indirectly, primarily through license solutions partners (“LSPs”), distributors, value-added resellers (“VARs”), OEMs, +system builder channels, and retailers. Although each type of reselling partner reaches organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small-sized and +medium-sized organizations. EDAs typically are also authorized as LSPs and operate as resellers for our other licensing programs, such as the Select Plus and Open licensing programs discussed under “Licensing Options” below. Some of our +distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our Microsoft Dynamics software offerings are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our retail packaged +products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets, including Microsoft retail stores. We distribute +our hardware products, including Surface, Xbox, phones, and PC accessories, through third-party retailers and Microsoft retail stores. Our phones are also distributed through global wireless communications carriers. We have a network of field sales +representatives and field support personnel that solicits orders from distributors and resellers, and provides product training and sales support. Online Although on-premises software +continues to be an important part of our business, increasingly we are delivering additional value to customers through cloud-based services. We provide online content services to consumers through Bing, MSN portals and channels, Office 365, Windows +Phone Store, Xbox Live, Outlook.com, OneDrive, Skype, and Windows Store. We also provide commercial cloud-based services such as Dynamics CRM Online, Microsoft Azure, and Office 365. Other services delivered online include our online advertising +platform with offerings for advertisers and publishers, as well as Microsoft Developer Network subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing +and selling our products and solutions. As we increasingly deliver online services, we sell many of these cloud-based services through our enterprise agreements and have also enabled new sales programs to reach small and medium-sized +businesses. These programs include direct sales, direct sales supported by a large network of partner advisors, and resale of services through operator channels, such as telephone, cell, and cable providers. We also sell our products through our Microsoft retail stores and online marketplaces. LICENSING OPTIONS We +license software to organizations under agreements that allow the customer to acquire multiple licenses of products and services. Our agreements for organizations to acquire multiple licenses of products and services are designed to provide them +with a means of doing so without having to acquire separate licenses through retail channels. In delivering organizational licensing agreements to the market, we use different programs designed to provide flexibility for organizations of various +sizes. While these programs may differ in various parts of the world, generally they include those discussed below. Customer Licensing Programs Open Licensing Designed +primarily for small-to-medium organizations, the Open Programs allow customers to acquire perpetual or subscription licenses and, at the customer’s election, rights to future versions of software products over a specified time period (two or +three years depending on the Open Programs used). The offering that conveys rights to future versions of certain software products over the contract period is called software assurance. Software assurance also provides support, tools, and training +to help customers deploy and use software efficiently. The Open Programs have several variations to fit customers’ diverse ways of purchasing. Under the Open License Program, customers can acquire licenses only or licenses with software +assurance, and/or renew software assurance upon the expiration 14 Table of Contents PART I Item 1 of other existing volume licensing agreements. Under the Open Value and Open Value Subscription programs, customers can acquire perpetual or subscription licenses, respectively, over a three-year +period. Online services are available in each of the Open Programs. Microsoft Product and Services Agreement Suited for medium-to-large organizations, the Microsoft Products and Services Agreement (“MPSA”) provides customers the ability to +purchase online services subscriptions, software licenses, software licenses with software assurance, and renewals of software assurance through a single agreement. Software assurance and online services subscriptions are generally available up +to three years. Select Plus Licensing Designed primarily for medium-to-large organizations, the Select Plus Program allows customers to acquire perpetual licenses and, at the customer’s election, software assurance over a specified time period +(generally three years or less). Similar to Open Programs, the Select Plus Program allows customers to acquire licenses only, acquire licenses with software assurance, or renew software assurance upon the expiration of existing volume licensing +agreements. A subset of online services are also available for purchase through the Select Plus Program, and subscriptions are generally structured with terms between one and three years. In July 2014, we announced that we would no longer sign new +Select Plus agreements with commercial organizations starting July 2015, and encouraged customers who want to purchase licenses to transition to the MPSA. We expect Select Plus business to transition to the MPSA within a few years. Enterprise Agreement Licensing Designed +primarily for medium- and large-sized organizations that want to acquire licenses to online services and/or software products, along with software assurance and obtain the best value by standardizing on a common IT platform across the organization. +Enterprises can elect to acquire perpetual licenses or, under the Enterprise Subscription option, can acquire non-perpetual, subscription licenses for a specified period (generally three years). Online services are also available for purchase +through the enterprise agreement and subscriptions are generally structured with three-year terms. Customer Licensing Programs — Online +Services Only Microsoft Online Subscription Agreement is designed to enable small and medium-sized businesses to easily purchase +Microsoft Online Services. The program allows customers to acquire monthly or annual subscriptions for cloud-based services. Partner Programs The Microsoft Cloud Solution Provider program enables partners to directly manage their entire Microsoft cloud customer lifecycle. +Partners in this program use dedicated in-product tools to directly provision, manage, and support their customer subscriptions. Partners can easily package their own tools, products, and services, and combine them into one monthly or annual +customer bill. The Microsoft Services Provider License Agreement is a program targeted at service providers and independent software +vendors allowing these partners to provide software services and hosted applications to their end customers. Agreements are generally structured with a three-year term, and partners are billed monthly based upon consumption. Microsoft Online Services Reseller Agreement is a program enabling partners to package Microsoft online services with the partners’ services. Independent Software Vendor Royalty Program is a program that enables partners to use Microsoft software in their own software +programs. 15 Table of Contents PART I Item 1 CUSTOMERS Our customers include individual consumers, small- and medium-sized organizations, large global enterprises, public sector institutions, Internet service providers, application developers, and OEMs. No sales to an +individual customer accounted for more than 10% of fiscal year 2015, 2014, or 2013 revenue. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 30, 2015 were as follows: Name Age Position with the Company Satya Nadella 47 Chief Executive Officer Christopher C. Capossela 45 Executive Vice President, Chief Marketing Officer Kathleen T. Hogan 49 Executive Vice President, Human Resources Amy E. Hood 43 Executive Vice President, Chief Financial Officer Margaret Johnson 53 Executive Vice President, Business Development Bradford L. Smith 56 Executive Vice President, General Counsel; Secretary B. Kevin Turner 50 Chief Operating Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, +Cloud and Enterprise beginning July 2013. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, +Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles included Vice President of Microsoft Business Division. Mr. Capossela was appointed Executive Vice President, Chief Marketing Officer in March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and +marketing activities with OEMs, operators, and retail partners. In his more than 20 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing +productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President +of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. Beginning in 2010, Ms. Hood was Chief +Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the +Server and Tools Business and the corporate finance organization. Ms. Johnson was appointed Executive Vice President, Business +Development in September 2014. Prior to that Ms. Johnson spent 24 years at Qualcomm in various leadership positions across engineering, sales, marketing and business development. She most recently served as Executive Vice President of Qualcomm +Technologies, Inc. Ms. Johnson also serves on the Board of Directors of Live Nation Entertainment, Inc. Mr. Smith was +appointed Executive Vice President, General Counsel, and Secretary in 2011. Prior to that he served as Senior Vice President, General Counsel, and Secretary since November 2001. Mr. Smith was also named Chief Compliance Officer in 2002. He had +been Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith joined Microsoft in 1993. Mr. Smith also serves on the Board of Directors +of Netflix, Inc. 16 Table of Contents PART I Item 1 Mr. Turner was appointed Chief Operating Officer in September 2005. Before joining Microsoft, +he was Executive Vice President of Wal-Mart Stores, Inc. and President and Chief Executive Officer of the Sam’s Club division. From 2001 to 2002, he served as Executive Vice President and Chief Information Officer of Wal-Mart’s Information +Systems Division. From 2000 to 2001, he served as its Senior Vice President and Chief Information Officer of the Information Systems Division. Mr. Turner also serves on the Board of Directors of Nordstrom, Inc. EMPLOYEES As of +June 30, 2015, we employed approximately 118,000 people on a full-time basis, 60,000 in the U.S. and 58,000 internationally. Of the total employed people, 39,000 were in product research and development, 29,000 in sales and marketing, 32,000 in +product support and consulting services, 8,000 in manufacturing and distribution, and 10,000 in general and administration. In June 2015, management approved a restructuring plan that will eliminate up to 7,800 positions in fiscal year 2016, +primarily in our Phone Hardware business. As a result of the NDS acquisition, we have certain employees that are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations +website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent +information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”). • Information on our business strategies, financial results, and key performance indicators. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, +global corporate citizenship initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, +we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the +information we post on the social media channels listed on our Investor Relations website. 17 Table of Contents PART I Item 1A ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect +our business, financial condition, results of operations, cash flows, and the trading price of our common stock. We face intense competition across +all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, +specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly +with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to +businesses and consumers. Competition among platforms, ecosystems, and devices An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A +well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain +attractive margins. We face significant competition from firms that provide competing platforms, applications, and services. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded +with some consumer products such as personal computers, tablets, phones, gaming consoles, and wearables. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform. We also offer some +vertically-integrated hardware and software products and services; however, our competitors in smartphones and tablets have established significantly larger user bases. Shifting a portion of our business to a vertically integrated model will +increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms +developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to +perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to +our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. In addition, some of our devices compete with products made by our OEM partners, which may affect their +commitment to our platform. • The success of the Windows Phone platform is an important element of our goal to enhance personal productivity in a mobile-first and cloud-first world. The +marketplace among mobile phone platforms is highly competitive. We may face issues in selecting, engaging, or securing support from operators and retailers for Windows phones due to, for instance, inadequate sales training or incentives, or +insufficient marketing support for the Windows Phone platform. • Competing platforms have application marketplaces (sometimes referred to as “stores”) with scale and significant installed bases. The variety and +utility of applications available on a platform are important to device purchasing decisions. Users incur costs to move data and buy new applications when switching platforms. To compete, we must successfully enlist developers to write +applications for our marketplace and ensure that these applications have high quality, customer appeal, and value. Efforts to compete with competitors’ application marketplaces may increase our cost of revenue and lower our operating margins. 18 Table of Contents PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition to a mobile-first and cloud-first strategy, the license-based proprietary software model generates most of our software revenue. We bear +the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to +businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue +funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users, and +earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality +of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, +and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing +devices. Our strategic vision is to compete and grow as a productivity and platform company for the mobile-first and cloud-first world. At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and +business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based services to use. We are devoting significant +resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to +innovation. The Company’s increasing reliance on data-driven insights is becoming more important to the success of key opportunities in monetization, customer perceptions of quality, and operational efficiency. Besides software development +costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in +several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, +tablets, gaming consoles, and other television-related devices. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. • Making our suite of cloud-based services platform agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are +not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure +and development investments described above. This may negatively impact gross margins and operating income. 19 Table of Contents PART I Item 1A We make significant investments in new products and services that may not achieve expected +returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, the Microsoft Office system, +Bing, Windows Phone, Windows Server, the Windows Store, the Microsoft Azure Services platform, Office 365, other cloud-based services offerings, and the Xbox entertainment platform. We also invest in the development and acquisition of a variety of +hardware for productivity, communication, and entertainment including PCs, tablets, phones, and gaming devices. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, +and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably +affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating +margins for some new products and businesses will not be as high as the margins we have experienced historically. The launch of Windows +10, with free upgrades available to existing users of Windows 7 and 8.1, constitutes the most ambitious update effort we have ever undertaken. We have done extensive preparation and compatibility testing for applications and devices to help ensure a +positive experience for our users installing Windows 10. However, if users have a negative upgrade experience, or the community reacts negatively to the process we are following to promote and undertake the upgrades, the reception of Windows 10 +in the marketplace may be harmed. In addition, we anticipate that Windows 10 will enable new post-license monetization opportunities beyond initial license revenues. Our failure to realize these opportunities to the extent we expect +could have an adverse impact on our revenues. Developing new technologies is complex. It can require long development and testing +periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and +strategic alliances as part of our long-term business strategy. These transactions and arrangements involve significant challenges and risks including that they do not advance our business strategy, that we get an unsatisfactory return on our +investment, that we have difficulty integrating new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a +party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling +new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements, such as increased revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than we +expected. These events could adversely affect our operating results or financial condition. If our goodwill or amortizable +intangible assets become impaired we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which +could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least +annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash +flow estimates, and slower growth rates in industry segments in which we participate. We may be required to record a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable +intangible assets is determined, negatively affecting our results of operations. For example, in the fourth quarter of fiscal year 2012, we recorded a $6.2 billion charge for the impairment of goodwill in our previous Online Services Division +business (Devices and Consumer Other under our current segment structure), and in the fourth quarter of fiscal year 2015, we recorded a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible +assets in our Phone Hardware segment. 20 Table of Contents PART I Item 1A We may not earn the revenues we expect from our intellectual property rights. We may not be able to adequately protect our intellectual property rights Protecting our global intellectual property rights and combating unlicensed copying and use of our software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on +revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Our revenue in these markets may grow slower than the underlying device market. Similarly, the absence of +harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual +property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. We may not receive expected royalties from our patent licenses We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some +instances, by licensing our patents to others in return for a royalty. Changes in the law may weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and +regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest +the scope and extent of their obligations. Finally, the royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of +discovering infringements. Third parties may claim we infringe their intellectual property rights. From +time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the +rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface and Lumia phones. To resolve these claims we may enter into royalty and licensing agreements on terms that are less favorable than currently available, +stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek +injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the +validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may +continue to do so. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source +code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to +several licensees, we take significant measures to protect the secrecy of large portions of our source code. If a significant portion of our source code leaks, we might lose future trade secret protection for that source code. It may become easier +for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. 21 Table of Contents PART I Item 1A Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or +harm to our competitive position. Security of Microsoft’s information technology Threats to IT security can take a variety of forms. Individual and groups of hackers, and sophisticated organizations including state-sponsored +organizations or nation-states themselves, may take steps that pose threats to our customers and our IT. They may develop and deploy malicious software to attack our products and services and gain access to our networks and datacenters, or act +in a coordinated manner to launch distributed denial of service or other coordinated attacks. Cyber threats are constantly evolving, thereby increasing the difficulty of detecting and successfully defending against them. Cyber threats can have +cascading impacts that unfold with increasing speed across our internal networks and systems, and those of our partners and customers. Breaches of our network or data security could disrupt the security of our internal systems and business +applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our competitive position, result in +theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise adversely affect our business. In addition, our internal IT environment continues to evolve. Often we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and +customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge. Security of our products, services, devices, and customers’ data Security threats are a particular challenge to companies like us whose business is technology products and services. Threats to our own IT infrastructure can also affect our customers. Customers using our +cloud-based services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on the most popular operating systems, programs, and services, including +many of ours, and we expect that to continue. The security of our products and services is important in our customers’ purchasing decisions. To defend against security threats, both to our internal IT systems and those of our customers, we must continuously engineer more secure products and services, enhance security and reliability features, improve +the deployment of software updates to address security vulnerabilities, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that +protects the integrity of our network, products, and services, and provide customers security tools such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services could harm our reputation and lead customers +to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional +products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install security patches. Any of these actions by customers could adversely affect our +revenue. Actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal +challenges. Legislative or regulatory action in these areas may increase the costs to develop, implement, or secure our products and services. Disclosure of personal data could cause liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly +large amounts of personally identifiable information of our customers. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve +the security controls across our business groups and geographies, it is possible our security controls over personal data, our 22 Table of Contents PART I Item 1A training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of customer data we or our vendors store and manage. Improper disclosure +could harm our reputation, lead to legal exposure to customers, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store +and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer data in response to valid legal orders. In the U.S. and elsewhere, we advocate for +transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer data, perceptions that the privacy of personal information is not satisfactorily protected could +inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer concerns, or constraints on our +flexibility to determine where and how to operate datacenters in response to customer expectations or governmental rules or actions, may cause higher operating expenses. We may have outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, +and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our +websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Exchange Online, Office 365, SharePoint Online, OneDrive, Skype, Xbox Live, +Microsoft Azure, Outlook.com, Windows Stores, and Microsoft Account services. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and +expanding this infrastructure is expensive and complex. It requires that we maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or +operational failures, including temporary or permanent loss of customer data or insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and +other third parties, damage to our reputation and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition. Government litigation and regulatory activity relating to competition rules may limit how we design and market our +products. As a leading global software and device maker, we are closely scrutinized by government agencies under U.S. and foreign competition laws. An increasing number of governments are regulating competition law +activities and this includes increased scrutiny in potentially large markets such as the European Union, the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state +antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission +(“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other +companies. In 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary +Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns relating to competition in web browsing software, including an undertaking +to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the +Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could +hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a +large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. +Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Because these jurisdictions only recently +implemented competition laws, their enforcement activities are unpredictable. 23 Table of Contents PART I Item 1A Government regulatory actions and court decisions such as these may hinder our ability to provide +the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated. The outcome of such actions, or steps taken to avoid them, +could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be precedent in other competition law proceedings. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we +fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited. Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and +regulations. The Foreign Corrupt Practices Act and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents. From time to time, we receive +inquiries from authorities in the U.S. and elsewhere about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. While we devote substantial resources to our global compliance programs and have implemented policies, +training, and internal controls designed to reduce the risk of corrupt payments, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws could result in significant fines and penalties, criminal +sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, and measures, and other +regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on countries such as Iran, North Korea, Cuba, Sudan, and Syria. Other regulatory areas that may apply to our products and online services offerings include user privacy, telecommunications, data +storage and protection, and online content. For example, regulators may take the position that our offerings such as Skype are covered by laws regulating telecommunications services. Applying these laws and regulations to our business is often +unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Increasing +concern about government surveillance practices around the world may lead to increased regulation requiring local data hosting obligations or the use of domestic hosting providers. Compliance with these types of regulation may involve significant +costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. Geopolitical instability may lead to sanctions +and impact our ability to do business in some geographies. Our business depends on our ability to attract and retain talented +employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to +recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we cannot retain key employees, our ability to develop and deliver successful products and services may be adversely +affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and +lawsuits. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are 24 Table of Contents PART I Item 1A subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our consolidated financial statements could occur for the +period in which the effect of an unfavorable final outcome becomes probable and reasonably estimable. We may have additional tax +liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, +there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Economic and political pressures to increase tax revenue in various jurisdictions may make +resolving tax disputes favorably more difficult. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and +accruals. The results of an audit or litigation could have a material effect on our consolidated financial statements in the period or periods in which that determination is made. We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions +to the U.S. may result in higher effective tax rates for the company. In addition, there have been proposals from Congress to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. +Although we cannot predict whether or in what form any proposed legislation may pass, if enacted, it could have a material adverse impact on our tax expense and cash flows. Our hardware and software products may experience quality or supply problems. Our vertically-integrated hardware products such as Xbox consoles, Surface devices, phones, and other +devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or address such issues +through design, testing, or warranty repairs. We acquire some device components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from +a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint or industry shortages, we may not obtain timely replacement supplies, resulting in reduced sales. Component shortages, excess or obsolete +inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, phones, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the +supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. Our software products also may experience quality or reliability problems. The highly sophisticated software products we develop may contain bugs +and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new +products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. Our global business exposes us to operational and economic risks. Our customers are located in over 200 countries and +a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Emerging markets are a significant focus of our international growth strategy. The developing nature of these +markets presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Although we hedge a portion of our international +currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenue. Competitive or regulatory pressure to make our pricing structure uniform might require that we +reduce the sales price of our software in the U.S. and other countries. Catastrophic events or geopolitical conditions may disrupt +our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing +services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other +business operations in the 25 Table of Contents PART I Item 1A, 1B, 2 Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems +could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and +magnifies the potential impact of prolonged service outages on our operating results. Abrupt political change, terrorist activity, and +armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may +cause supply chain disruptions for hardware manufacturers, either of which may adversely affect our revenue. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or +changes in the supply, demand or available sources of energy or other natural resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may +increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Adverse +economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If +demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal +government shutdown resulting from failing to pass budget appropriations, adopt continuing funding resolutions or raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT +spending on our products and services and adversely affect our revenue. Our product distribution system relies on an extensive partner +and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales +channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they +have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an +investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that affect global financial markets. A +significant part of our investment portfolio comprises U.S. government securities. If global credit and equity markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default +on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our +financial results. ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2015 that remain unresolved. ITEM 2. PROPERTIES Our corporate offices consist of approximately 15 million square feet of office space located in King County, Washington: 10 million +square feet of owned space situated on approximately 500 acres of land we own at our corporate campus in Redmond, Washington and approximately five million square feet of space we lease. We own approximately five million additional square feet +of office and data center space domestically (outside of the Puget Sound corporate campus) and lease many sites domestically totaling approximately five million square feet of office and data center space. 26 Table of Contents PART I Item 2, 3, 4 We occupy many sites internationally, totaling approximately twelve million square feet that is +owned and approximately eleven million square feet that is leased. International facilities that we own include: our research and development centers in China and India; our phone manufacturing facilities, predominantly in Vietnam; our regional +operations centers in Ireland and Singapore; and our facilities in UK. The largest leased office spaces include the following locations: China; Finland; Germany; India; Japan; and UK. In addition to the above locations, we have various product +development facilities, both domestically and internationally, as described in the “Research and Development” section of Item 1 of this Form 10-K. Our facilities are used for current operations of all segments, and suitable additional spaces are available to accommodate expansion needs. We have a development agreement with the City of Redmond under which we +may currently develop approximately 1.4 million square feet of additional facilities at our corporate campus in Redmond, Washington. ITEM 3. LEGAL PROCEEDINGS See Note 18 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 27 Table of Contents PART II Item 5, 6 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our +common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 27, 2015, there were 109,479 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2015 High $  47.57 $  50.05 $  47.91 $  49.54 $  50.05 Low $  41.05 $  42.10 $  40.23 $  40.12 $  40.12 Fiscal Year 2014 High $  36.43 $  38.98 $  41.50 $  42.29 $  42.29 Low $  30.84 $  32.80 $  34.63 $  38.51 $  30.84 DIVIDENDS AND SHARE REPURCHASES See Note 19 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding dividends and share repurchases by quarter. Following are our +monthly stock repurchases for the fourth quarter of fiscal year 2015, all of which were made as part of publicly announced plans or programs: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2015 – April 30, 2015 45,393,872 $ 42.92 45,393,872 $  24,143 May 1, 2015 – May 31, 2015 23,541,167 $ 47.58 23,541,167 $  23,023 June 1, 2015 – June 30, 2015 24,705,187 $ 46.15 24,705,187 $  21,883 93,640,226 93,640,226 The repurchases were made using cash resources and occurred in the open market. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2015 2014 (b) 2013 2012 2011 Revenue $ 93,580 $ 86,833 $ 77,849 $ 73,723 $ 69,943 Gross margin $ 60,542 $ 59,755 $ 57,464 $ 56,193 $ 54,366 Operating income $ 18,161 (a) $ 27,759 $ 26,764 (c) $ 21,763 (d) $ 27,161 Net income $ 12,193 (a) $ 22,074 $ 21,863 (c) $ 16,978 (d) $ 23,150 Diluted earnings per share $ 1.48 (a) $ 2.63 $ 2.58 (c) $ 2.00 (d) $ 2.69 Cash dividends declared per share $ 1.24 $ 1.12 $ 0.92 $ 0.80 $ 0.64 Cash, cash equivalents, and short-term investments $ 96,526 $ 85,709 $ 77,022 $ 63,040 $ 52,772 Total assets $ 176,223 $ 172,384 $ 142,431 $ 121,271 $ 108,704 Long-term obligations $ 46,282 $ 36,975 $ 26,070 $ 22,220 $ 22,847 Stockholders’ equity $ 80,083 $ 89,784 $ 78,944 $ 66,363 $ 57,083 28 Table of Contents PART II Item 6, 7 (a) Includes $7.5 billion of goodwill and asset impairment charges related to Phone Hardware, and $2.5 billion of integration and restructuring expenses, +primarily costs associated with our restructuring plans, which decreased fiscal year 2015 operating income and net income by $10.0 billion and diluted earnings per share (“EPS”) by $1.15. (b) On April 25, 2014, we acquired substantially all of NDS. NDS has been included in our consolidated results of operations starting on the acquisition +date. (c) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased operating income and net income by $733 million +(€561 million) and diluted EPS by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased operating income by $900 million, net income by $596 million, and diluted +EPS by $0.07. (d) Includes a goodwill impairment charge related to our previous Online Services Division business segment (related to Devices and Consumer Other under our +current segment structure) which decreased operating income and net income by $6.2 billion and diluted EPS by $0.73. ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the +results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements. OVERVIEW Microsoft is a technology leader focused on building best-in-class platforms and productivity services for a mobile-first, cloud-first world. We +strive to empower every person and every organization on the planet to achieve more. We develop and market software, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. We generate revenue by developing, licensing, and supporting a wide range of software products, by offering an array of services, including +cloud-based services to consumers and businesses, by designing, manufacturing, and selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are +related to compensating employees, designing, manufacturing, marketing, and selling our products and services, datacenter costs in support of our cloud-based services, and income taxes. Much of our focus in fiscal year 2015 was toward transforming our organization to support our strategy of building best-in-class platforms and +productivity services for a mobile-first, cloud-first world. We achieved product development milestones, implemented organizational changes, and made strategic and tactical moves to support the three central ambitions that support our strategy: +reinventing productivity and business processes; building the intelligent cloud platform; and creating more personal computing. Highlights from fiscal year 2015 included: • Momentum continued to grow in our Commercial Cloud and productivity offerings as we surpassed an $8 billion annualized run rate* at the end of the year. • Office 365 Commercial seats grew 74%, and Office 365 is now deployed in four out of five Fortune 500 enterprises, with more than half of that install base +using premium workloads. We also added over 50,000 small- and medium-sized business customers each month. • Server products and services revenue increased 9%, driven by growth across our cloud and on-premises server products. Azure revenue and compute usage +increased by triple digits in the fourth quarter year over year, and we ended fiscal year 2015 with more than 17,000 Enterprise Mobility Services customers. * Annualized run rate was calculated by multiplying June 2015 revenue by twelve months. 29 Table of Contents PART II Item 7 • We reached over 8 million paid Dynamics seats and refreshed and enhanced Microsoft Dynamics ERP products. We also introduced new social, productivity, +mobility, customer service, and marketing capabilities in Dynamics CRM. • We currently have more than 15 million Office 365 consumer subscribers, with new customers signing up at a current pace of nearly one million per month. +We also surpassed 150 million downloads of Office mobile to iOS and Android devices. • Bing exceeded 20% U.S. market share as we focused our advertising business on search. In June 2015, we entered into agreements with AOL and AppNexus to +outsource our display sales efforts. • In hardware, we released Surface 3 and expanded distribution of Surface Pro and the related gross margin percentage grew with increased revenue, and +introduced new categories like HoloLens – all with an eye toward generating new growth in Windows more broadly. • Xbox console volumes grew to over 12 million, and Xbox Live users increased 22%. • We shipped over 36 million Lumia units, and announced the restructuring of our Phone Hardware business to run it more effectively near-term while driving +reinvention longer term. • We completed 16 acquisitions, including Mojang Synergies AB (“Mojang”), the Swedish video game developer of the Minecraft gaming franchise, and +others, to strengthen our cloud platform and invest in mobile applications. • We advanced Windows 10 to the threshold of its launch in July 2015 with the help of the Windows Insider Program, a new paradigm to incorporate unprecedented +levels of user and developer feedback in our development process. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an +opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that +seek to identify and address the changing demands of customers, industry trends, and competitive forces. Economic Conditions, Challenges, and Risks The market for software, devices, and cloud-based services is dynamic and highly competitive. Our competitors are developing new +software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the +user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in devices and infrastructure will increase our +operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified +employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s +career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are +denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Recently, the significant strengthening of the U.S. dollar relative to certain foreign currencies has +negatively impacted reported revenue and reduced reported expenses from our international operations. 30 Table of Contents PART II Item 7 See a discussion of these factors and other risks under Risk Factors (Part I, Item 1A of this +Form 10-K). Seasonality Our +revenue historically has fluctuated quarterly and has generally been highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Computing and +Gaming Hardware segment is particularly seasonal as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Typically, the Computing and Gaming Hardware segment has generated approximately 40-50% +of its yearly revenue in our second fiscal quarter. Unearned Revenue Quarterly and annual revenue may be impacted by the deferral of revenue, including: • Revenue deferred on pre-sales of Windows to original equipment manufacturers (“OEMs”) and retailers before general availability. • Revenue deferred on bundled products and services (“Bundled Offerings”). • Revenue deferred on sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the “Windows Upgrade Offer”). If our customers choose to license cloud-based versions of our products and services rather than licensing +transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Reportable Segments The segment amounts +included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 22 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of +this Form 10-K) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the United States (“U.S. GAAP”), along with certain corporate-level and other +activity, are included in Corporate and Other. Operating expenses are not allocated to our segments. We have recast certain prior period amounts to conform to the current period presentation, with no impact on consolidated net income or cash flows. On April 25, 2014, we acquired substantially all of Nokia Corporation’s (“Nokia”) Devices and Services business +(“NDS”). NDS has been included in our consolidated results of operations since the acquisition date. We report the financial performance of the acquired business in our Phone Hardware segment. Prior to the acquisition of NDS, financial +results associated with our joint strategic initiatives with Nokia were reflected in our Devices and Consumer (“D&C”) Licensing segment. The contractual relationship with Nokia related to those initiatives ended in conjunction with the +acquisition. Our reportable segments are described below. Devices and Consumer Our D&C segments develop, manufacture, market, and support products +and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with audiences. Our D&C segments are: • D&C Licensing , comprising: Windows, including all OEM licensing (“Windows OEM”) and other non-volume licensing and academic volume +licensing of the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Office Consumer”); Windows Phone operating system, including related patent +licensing; and certain other patent licensing revenue. 31 Table of Contents PART II Item 7 • Computing and Gaming Hardware , comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, +and Xbox Live subscriptions (“Xbox Platform”); Surface devices and accessories (“Surface”); and Microsoft PC accessories. • Phone Hardware, comprising: Lumia phones and other non-Lumia phones, beginning with our acquisition of NDS. • D&C Other , comprising: Resale, consisting of transactions in our Windows Store and Xbox marketplace; search advertising; display advertising; +Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games; Mojang; non-Microsoft products sold in our retail stores; and certain other consumer products and services not included in the +categories above. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity and efficiency, including simplifying everyday tasks through +seamless operations across the user’s hardware and software. Our Commercial segments are: • Commercial Licensing , comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client +Access Licenses (“CALs”); Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Office for business, including Office, Exchange, SharePoint, Skype for Business, +and related CALs (“Office Commercial”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype. • Commercial Other , comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Commercial Cloud, comprising +Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure; and certain other commercial products and online services not included in the categories above. SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 Revenue $ 93,580 $ 86,833 $ 77,849 8% 12% Gross margin $ 60,542 $ 59,755 $ 57,464 1% 4% Operating income $ 18,161 $ 27,759 $ 26,764 (35)% 4% Diluted earnings per share $ 1.48 $ 2.63 $ 2.58 (44)% 2% Fiscal year 2015 compared with fiscal year 2014 Revenue increased $6.7 billion or 8%, reflecting a full year of Phone Hardware sales and growth in revenue from our Commercial Cloud, Surface, server products, search advertising, and Xbox Live transactions. These +increases were offset in part by a decline in revenue from Office Commercial, Windows OEM, licensing of Windows Phone operating system, and Office Consumer. Revenue included an unfavorable foreign currency impact of approximately 2%. Gross margin increased $787 million or 1%, primarily due to higher revenue, offset in part by a $6.0 billion or 22% increase in cost of revenue. +Cost of revenue increased, mainly due to Phone Hardware, as well as increasing costs in support of our Commercial Cloud, including $396 million of higher datacenter expenses. Gross margin, as a percentage of revenue, improved year over year in each +of our reportable segments. 32 Table of Contents PART II Item 7 Operating income decreased $9.6 billion or 35%, primarily due to impairment, integration, and +restructuring expenses in the current year, as well as increased research and development expenses, offset in part by higher gross margin. Key changes in operating expenses were: • Impairment, integration, and restructuring expenses were $10.0 billion in the current year, reflecting goodwill and asset impairment charges of $7.5 billion +related to our Phone Hardware business, and $2.5 billion of integration and restructuring expenses, driven by costs associated with our restructuring plans. • Research and development expenses increased $665 million or 6%, mainly due to increased investment in new products and services, including NDS expenses, +offset in part by reduced headcount-related expenses. Diluted earnings per share (“EPS”) were negatively +impacted by impairment, integration, and restructuring expenses, which decreased diluted EPS by $1.15. Fiscal year 2014 compared with fiscal year +2013 Revenue increased $9.0 billion or 12%, demonstrating growth across our consumer and commercial businesses, primarily due to +higher revenue from server products, Xbox Platform, Commercial Cloud, and Surface. Revenue also increased due to the acquisition of NDS. Commercial Cloud revenue doubled, reflecting continued subscriber growth from our cloud-based offerings. Gross margin increased $2.3 billion or 4%, primarily due to higher revenue, offset in part by a $6.7 billion or 33% increase in cost of +revenue. Cost of revenue increased mainly due to higher volumes of Xbox consoles and Surface devices sold, and $575 million of higher datacenter expenses, primarily in support of Commercial Cloud revenue growth. Cost of revenue also increased due to +the acquisition of NDS. Operating income increased $995 million or 4%, reflecting higher gross margin, offset in part by increased +research and development expenses and sales and marketing expenses. Key changes in operating expenses were: • Research and development expenses increased $970 million or 9%, mainly due to increased investment in new products and services in our Devices engineering +group, including NDS expenses, and increased investment in our Applications and Services engineering group. • Sales and marketing expenses increased $535 million or 4%, primarily due to NDS expenses and increased investment in sales resources, offset in part by lower +advertising costs. 33 Table of Contents PART II Item 7 SEGMENT RESULTS OF OPERATIONS Devices and Consumer (In millions, except percentages) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 Revenue Licensing $ 14,969 $ 19,528 $ 19,427 (23)% 1% Hardware: Computing and Gaming Hardware 10,183 9,093 6,149 12% 48% Phone Hardware 7,524 1,982 0 * * Total Devices and Consumer Hardware 17,707 11,075 6,149 60% 80% Other 8,825 7,014 6,431 26% 9% Total Devices and Consumer revenue $ 41,501 $ 37,617 $ 32,007 10% 18% Gross Margin Licensing $ 13,870 $ 17,439 $ 16,985 (20)% 3% Hardware: Computing and Gaming Hardware 1,788 892 956 100% (7)% Phone Hardware 701 54 0 * * Total Devices and Consumer Hardware 2,489 946 956 163% (1)% Other 2,022 1,393 1,951 45% (29)% Total Devices and Consumer gross margin $ 18,381 $ 19,778 $ 19,892 (7)% (1)% * Not meaningful Fiscal year 2015 +compared with fiscal year 2014 D&C revenue increased $3.9 billion or 10%, primarily due to a full year of Phone Hardware sales, +as well as higher revenue from Surface, search advertising, and Xbox Live transactions, offset in part by a decrease in revenue from Windows OEM, licensing of Windows Phone operating system, and Office Consumer. Collectively, Office Consumer and +Office 365 Consumer revenue declined 17%. D&C gross margin decreased $1.4 billion or 7%, reflecting higher cost of revenue, offset in part by higher revenue. D&C cost of revenue increased $5.3 billion or 30%, mainly due to a full year of +Phone Hardware costs. D&C Licensing D&C Licensing revenue decreased $4.6 billion or 23%, mainly due to lower revenue from Windows OEM, Windows Phone licensing, and Office Consumer. Windows OEM revenue declined $1.9 billion or 15%, primarily due +to declines of 15% in OEM Pro revenue and 16% in OEM non-Pro revenue. Windows OEM Pro revenue decreased, primarily due to benefits realized from the expiration of support for Windows XP in the prior year, and declines in the business PC market. +Windows OEM non-Pro revenue declined, mainly due to an increased mix of opening price point devices sold, and declines in the consumer PC market. Revenue from licensing of Windows Phone operating system decreased $1.4 billion or 55%, primarily due +to prior year revenue associated with our joint strategic initiatives with Nokia that terminated when we acquired NDS. Office Consumer revenue declined $946 million or 29%, reflecting the transition of customers to Office 365 Consumer, where revenue +is recognized ratably, and declines in the Japan PC market, where Office is predominantly pre-installed on new PCs. D&C Licensing +gross margin decreased $3.6 billion or 20%, primarily due to the decline in revenue, offset in part by a $990 million or 47% decrease in cost of revenue. D&C Licensing cost of revenue decreased, mainly due to a $788 million decline in traffic +acquisition costs, driven by prior year costs associated with our joint strategic initiatives with Nokia that terminated when we acquired NDS. 34 Table of Contents PART II Item 7 Computing and Gaming Hardware Computing and Gaming Hardware revenue increased $1.1 billion or 12%, primarily due to higher revenue from Surface, offset in part by lower revenue from Xbox Platform. Surface revenue increased 65% to $3.6 billion, +primarily due to Surface Pro 3 units sold. Surface Pro 3 was released in June 2014. Xbox Platform revenue decreased $385 million or 6%, driven by lower prices of Xbox One consoles compared to the prior year, as well as a decrease in second- and +third-party video games revenue. We sold 12.1 million Xbox consoles in fiscal year 2015 compared with 11.7 million consoles in fiscal year 2014. Computing and Gaming Hardware gross margin increased $896 million or 100%, mainly due to higher revenue, offset in part by a $194 million or 2% increase in cost of revenue. Gross margin expansion was driven by +Surface, which benefited from the mix shift to Surface Pro 3. Xbox Platform cost of revenue was comparable to the prior year. Phone Hardware Phone Hardware revenue increased $5.5 billion, as we sold 36.8 million Lumia phones and 126.8 million other non-Lumia +phones in fiscal year 2015, compared with 5.8 million and 30.3 million sold, respectively, in fiscal year 2014 following the acquisition of NDS. We acquired NDS in the fourth quarter of fiscal year 2014. Phone Hardware gross margin increased $647 million, primarily due to higher revenue, offset in part by higher cost of revenue. Phone Hardware cost +of revenue increased $4.9 billion, and included $476 million of amortization of acquired intangible assets in fiscal year 2015. We +recorded goodwill and asset impairment charges of $7.5 billion related to our Phone Hardware business in the fourth quarter of fiscal year 2015. See further discussion under Impairment, Integration, and Restructuring Expenses below. D&C Other D&C Other revenue +increased $1.8 billion or 26%, mainly due to higher revenue from search advertising, Xbox Live, first-party video games, including Minecraft, and Office 365 Consumer. D&C Other revenue included an unfavorable foreign currency impact of +approximately 2%. Search advertising revenue increased $651 million or 22%, primarily driven by growth in Bing, due to higher revenue per search and search volume. Xbox Live and other store transaction revenue increased $531 million, driven by +increased Xbox Live users and revenue per user. First-party video games revenue increased $367 million, mainly due to sales of Minecraft following the acquisition of Mojang in November 2014, and new Xbox titles released in the current year. Office +365 Consumer revenue increased $323 million, reflecting subscriber growth. D&C Other gross margin increased $629 million or 45%, +due to higher revenue, offset in part by a $1.2 billion or 21% increase in cost of revenue. D&C Other cost of revenue grew, mainly due to $372 million higher Xbox Live and other store transaction costs, a $279 million increase in search +infrastructure costs, $267 million higher retail stores expenses, and $194 million higher first-party video games and Minecraft costs. Fiscal year +2014 compared with fiscal year 2013 D&C revenue increased $5.6 billion or 18%, primarily due to higher revenue from Xbox +Platform, Surface, and Windows Phone. Revenue also increased $2.0 billion due to the acquisition of NDS. D&C gross margin decreased slightly, reflecting higher cost of revenue, offset in part by higher revenue. Cost of revenue increased $5.7 +billion or 47%, mainly due to Xbox Platform and Surface. Cost of revenue also increased $1.9 billion due to NDS. D&C Licensing D&C Licensing revenue increased $101 million or 1%, mainly due to increased Windows Phone revenue, offset in part by lower revenue from +licenses of Windows and Office Consumer. Windows Phone revenue increased $822 million or 48%, mainly due to the recognition of $382 million revenue under our joint strategic initiatives with Nokia, 35 Table of Contents PART II Item 7 which concluded in conjunction with the acquisition of NDS, as well as an increase in phone patent licensing revenue. Retail and non-OEM sales of Windows declined $274 million or 35%, mainly due +to the launch of Windows 8 in the prior year. Windows OEM revenue declined $136 million or 1%, due to continued softness in the consumer PC market, offset in part by a 12% increase in OEM Pro revenue. Office Consumer revenue declined $249 +million or 7%, reflecting the transition of customers to Office 365 Consumer as well as continued softness in the consumer PC market. The declines in Windows OEM and Office Consumer revenue were partially offset by benefits realized from ending our +support for Windows XP in April 2014. D&C Licensing gross margin increased $454 million or 3%, primarily due to a $353 million or +14% decrease in cost of revenue. D&C Licensing cost of revenue decreased, mainly due to a $411 million or 23% decline in traffic acquisition costs. Computing and Gaming Hardware Computing +and Gaming Hardware revenue increased $2.9 billion or 48%, primarily due to higher revenue from the Xbox Platform and Surface. Xbox Platform revenue increased $1.7 billion or 34%, mainly due to sales of Xbox One, which was released in November 2013, +offset in part by a decrease in sales of Xbox 360. We sold 11.7 million Xbox consoles during fiscal year 2014 compared with 9.8 million Xbox consoles during fiscal year 2013. Surface revenue increased $1.3 billion or 157%, mainly due to a +higher number of devices and accessories sold. Computing and Gaming Hardware gross margin decreased slightly, due to a $3.0 billion or +58% increase in cost of revenue, offset in part by higher revenue. Xbox Platform cost of revenue increased $2.1 billion or 72%, mainly due to higher volumes of consoles sold and higher costs associated with Xbox One. Surface cost of revenue +increased $970 million or 51%, mainly due to a higher number of devices and accessories sold, offset in part by a charge for Surface RT inventory adjustments of approximately $900 million in fiscal year 2013. Phone Hardware Phone Hardware revenue was +$2.0 billion in fiscal year 2014, reflecting sales of Lumia phones and other non-Lumia phones following the acquisition of NDS on April 25, 2014. Since the acquisition, we sold 5.8 million Lumia phones and 30.3 million other non-Lumia +phones in fiscal year 2014. Phone Hardware gross margin was $54 million in fiscal year 2014, reflecting revenue of $2.0 billion, offset +in part by $1.9 billion cost of revenue, including amortization of acquired intangible assets and the impact of decisions to rationalize our device portfolio. D&C Other D&C Other revenue increased $583 million or 9%, mainly due to higher online +advertising revenue and Office 365 Consumer revenue, offset in part by a $213 million decrease in first-party video games revenue, primarily due to the release of Halo 4 in the second quarter of fiscal year 2013. Online advertising revenue +increased $497 million or 14%. Search advertising revenue increased 39%, primarily due to increased revenue per search resulting from ongoing improvements in advertising products, higher search volume, and the expiration of North American +revenue per search guarantee payments to Yahoo! in the prior year , offset in part by a 25% reduction in display advertising revenue. Office 365 Consumer revenue grew $316 million, primarily reflecting subscriber growth. We ended fiscal year +2014 with over five million subscribers. D&C Other gross margin decreased $558 million or 29%, due to a $1.1 billion or 25% +increase in cost of revenue, offset in part by higher revenue. D&C Other cost of revenue grew, mainly due to a $541 million or 24% increase in online advertising cost of revenue, reflecting support of online infrastructure. Cost of revenue also +increased $219 million or 15%, due to higher resale transactions costs. 36 Table of Contents PART II Item 7 Commercial (In millions, except percentages) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 Revenue Licensing $ 41,039 $ 42,085 $ 39,778 (2)% 6% Other 10,836 7,546 5,661 44% 33% Total Commercial revenue $ 51,875 $ 49,631 $ 45,439 5% 9% Gross Margin Licensing $ 37,830 $ 38,615 $ 36,280 (2)% 6% Other 4,199 1,855 922 126% 101% Total Commercial gross margin $ 42,029 $ 40,470 $ 37,202 4% 9% Fiscal year 2015 compared with fiscal year 2014 Commercial revenue increased $2.2 billion or 5%, mainly due to growth in revenue from our Commercial Cloud and server products, offset in part by a decline in Office Commercial. Commercial revenue included an +unfavorable foreign currency impact of approximately 2%. Our server products and services grew 9%. Our Office Commercial products and services declined 1%. Commercial gross margin increased $1.6 billion or 4%. Commercial Licensing Commercial Licensing +revenue decreased $1.0 billion or 2%, primarily due to a decline in revenue from Office Commercial, offset in part by increased revenue from our server products. Commercial Licensing revenue included an unfavorable foreign currency impact of +approximately 2%. Office Commercial revenue declined $2.5 billion or 13%, due to lower transactional license volume, reflecting a decline in the business PC market following Windows XP end of support in the prior year, customers transitioning to +Office 365 Commercial, and declines in Japan. Our server products revenue grew $1.1 billion or 7%, primarily driven by higher premium mix of Microsoft SQL Server, Windows Server, and System Center. Commercial Licensing gross margin decreased $785 million or 2%, in line with revenue. Commercial Other Commercial Other revenue increased $3.3 billion or 44%, primarily due to +higher Commercial Cloud revenue. Commercial Other revenue included an unfavorable foreign currency impact of approximately 3%. Commercial Cloud revenue grew $3.0 billion or 106%, mainly due to subscriber growth and higher premium mix of Office 365 +Commercial, as well as continued revenue growth from Microsoft Azure. Commercial Other gross margin increased $2.3 billion or 126%, due +to higher revenue, offset in part by a $946 million or 17% increase in cost of revenue. The increase in Commercial Other cost of revenue was mainly due to higher datacenter and other online infrastructure expenses, reflecting increased datacenter +capacity to serve our growing Commercial Cloud. Fiscal year 2014 compared with fiscal year 2013 Commercial revenue increased $4.2 billion or 9%, mainly due to growth in revenue from our on-premises licensing businesses and Commercial Cloud. +Collectively, Office Commercial and Office 365 Commercial revenue grew 7%. Collectively, our server products revenue, including Microsoft Azure, grew 13%. Commercial gross margin increased $3.3 billion or 9%, in line with revenue. 37 Table of Contents PART II Item 7 Commercial Licensing Commercial Licensing revenue increased $2.3 billion or 6%, primarily due to increased revenue from our server products, as well as higher revenue from Windows Commercial and Office Commercial. Our server +products revenue grew $1.7 billion or 11%, driven primarily by increased sales of Microsoft SQL Server. Windows Commercial revenue grew $334 million or 10%, mainly due to increased renewal rates and transactional purchases driven by Windows XP end +of support. Office Commercial revenue grew $219 million or 1%, and was impacted by customers transitioning to Office 365 Commercial. Commercial Licensing gross margin increased $2.3 billion or 6%, in line with revenue growth. Commercial Other Commercial Other revenue +increased $1.9 billion or 33%, due to higher Commercial Cloud revenue and Enterprise Services revenue. Commercial Cloud revenue grew $1.5 billion or 116%, mainly due to higher revenue from Office 365 Commercial. Enterprise Services revenue grew $380 +million or 9%, mainly due to growth in Premier Support Services. Commercial Other gross margin increased $933 million or 101%, due to +higher revenue, offset in part by a $952 million or 20% increase in cost of revenue. The increase in cost of revenue was mainly due to higher datacenter expenses, reflecting support of our growing Commercial Cloud. Corporate and Other (In millions, except percentages) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 Revenue $ 204 $ (415 ) $ 403 149% (203)% Gross margin $ 132 $ (493 ) $ 370 127% (233)% Corporate and Other revenue comprises certain revenue deferrals, including those related to product and service +upgrade offers and pre-sales of new products to OEMs prior to general availability. Fiscal year 2015 compared with fiscal year 2014 Corporate and Other revenue increased $619 million, primarily due to the timing of revenue deferrals compared to the prior year. During fiscal year +2015, we recognized a net $303 million of previously deferred revenue related to Bundled Offerings. During fiscal year 2014, we deferred a net $349 million of revenue related to Bundled Offerings. Corporate and Other gross margin increased $625 million, primarily due to increased revenue. Fiscal year 2014 compared with fiscal year 2013 Corporate and Other revenue decreased $818 million, primarily due to the timing of revenue deferrals. During fiscal year 2014, we deferred a net $349 million of revenue related to Bundled Offerings. During fiscal +year 2013, we recognized $540 million of previously deferred revenue related to the Windows Upgrade Offer. The revenue was recognized upon expiration of the offer. Corporate and Other gross margin decreased $863 million, mainly due to decreased revenue. 38 Table of Contents PART II Item 7 OPERATING EXPENSES Research and Development (In millions, except percentages) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 Research and development $ 12,046 $ 11,381 $ 10,411 6% 9% As a percent of revenue 13% 13% 13% 0ppt 0ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the +amortization of purchased software code. Fiscal year 2015 compared with fiscal year 2014 Research and development expenses increased $665 million or 6%, mainly due to increased investment in new products and services, including $739 +million higher NDS expenses, offset in part by reduced headcount-related expenses. Fiscal year 2014 compared with fiscal year 2013 Research and development expenses increased $970 million or 9%, mainly due to increased investment in new products and services in our Devices +engineering group, including $275 million of NDS expenses, and increased investment in our Applications and Services engineering group. Sales and +Marketing (In millions, except percentages) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 Sales and marketing $ 15,713 $ 15,811 $ 15,276 (1)% 4% As a percent of revenue 17% 18% 20% (1)ppt (2)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2015 compared with fiscal year 2014 Sales and marketing expenses decreased $98 +million or 1%, primarily due to a decline in advertising and marketing programs costs and a reduction in headcount-related expenses, offset in part by an increase in NDS expenses. Sales and marketing expenses included a favorable foreign currency +impact of approximately 4%. Fiscal year 2014 compared with fiscal year 2013 Sales and marketing expenses increased $535 million or 4%, primarily due to NDS expenses and increased investment in sales resources, offset in +part by lower advertising costs. NDS sales and marketing expenses were $394 million during fiscal year 2014. Average headcount, excluding NDS, grew 4%. Advertising costs, excluding NDS, declined $403 million or 15%, primarily due to Windows 8 and +Surface costs in the prior year. 39 Table of Contents PART II Item 7 General and Administrative (In millions, except percentages) 2015 2014 2013 Percentage Change 2015 Versus 2014 Percentage Change 2014 Versus 2013 General and administrative $ 4,611 $ 4,677 $ 5,013 (1)% (7)% As a percent of revenue 5% 5% 6% 0ppt (1)ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance +expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal year 2015 compared with fiscal year 2014 General and administrative expenses were comparable to the prior year. Fiscal year 2014 compared with fiscal year +2013 General and administrative expenses decreased $336 million or 7%, mainly due to the European Commission fine in the prior +year, offset in part by higher business taxes, higher costs for internal use software capitalized in the prior year, and NDS expenses. NDS general and administrative expenses were $77 million during fiscal year 2014. IMPAIRMENT, INTEGRATION, AND RESTRUCTURING EXPENSES Impairment, integration, and restructuring expenses include costs associated with the impairment of goodwill and intangible assets related to our Phone Hardware business, employee severance expenses and costs +associated with the consolidation of facilities and manufacturing operations related to restructuring activities, and systems consolidation and other business integration expenses associated with our acquisition of NDS. Fiscal year 2015 compared with fiscal year 2014 Impairment, integration, and restructuring expenses were $10.0 billion for fiscal year 2015, compared to $127 million for fiscal year 2014. The increase was mainly due to impairment charges of $7.5 billion related +to our Phone Hardware business in the fourth quarter of fiscal year 2015. Our annual goodwill impairment test as of May 1, 2015 indicated that the carrying value of Phone Hardware goodwill exceeded its estimated fair value. Accordingly, we +recorded a goodwill impairment charge of $5.1 billion, reducing Phone Hardware’s goodwill from $5.4 billion to $116 million, net of foreign currency remeasurements, as well as an impairment charge of $2.2 billion related to the write-down of +Phone Hardware intangible assets. Restructuring charges were $2.1 billion, including employee severance expenses and the write-down of certain assets in connection with our restructuring activities. Integration expenses increased $308 million, due +to a full-year of integration activities in fiscal year 2015 associated with the acquisition of NDS. Fiscal year 2014 compared with fiscal year 2013 Impairment, integration, and restructuring expenses were $127 million for fiscal year 2014, reflecting integration expenses +associated with the acquisition of NDS. No impairment, integration, and restructuring expenses were recorded in fiscal year 2013. 40 Table of Contents PART II Item 7 OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2015 2014 2013 Dividends and interest income $ 766 $ 883 $ 677 Interest expense (781 ) (597 ) (429 ) Net recognized gains on investments 716 437 116 Net losses on derivatives (423 ) (328 ) (196 ) Net gains (losses) on foreign currency remeasurements 335 (165 ) (74 ) Other (267 ) (169 ) 194 Total $ 346 $ 61 $ 288 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and +credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. Other than those +derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) on certain balance +sheet amounts from foreign exchange rate changes. Fiscal year 2015 compared with fiscal year 2014 Dividends and interest income decreased due to lower yields on fixed income securities, offset in part by higher portfolio balances. Interest +expense increased due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher gains on sales of equity securities, offset in part by higher other-than-temporary impairments. Other-than-temporary +impairments were $183 million in fiscal year 2015, compared with $106 million in fiscal year 2014. Net losses on derivatives increased due to losses on commodity contracts in the current period as compared to gains in the prior period, offset in +part by lower losses on currency and equity contracts. For fiscal year 2015, other reflects recognized losses from certain joint ventures and divestitures. Fiscal year 2014 compared with fiscal year 2013 Dividends and interest income increased due +to higher portfolio balances. Interest expense increased due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher gains on sales of equity securities and lower other-than-temporary impairments. +Other-than-temporary impairments were $106 million in fiscal year 2014, compared with $208 million in fiscal year 2013. Net losses on derivatives increased due to higher losses on foreign exchange contracts, losses on equity derivatives as compared +to gains in the prior period, offset in part by gains on commodity and interest rate derivatives as compared to losses in the prior period. For fiscal year 2014, other reflects recognized losses from certain joint ventures, offset in part by a +recognized gain on a divestiture. For fiscal year 2013, other reflects recognized gains on divestitures, including the gain recognized upon the divestiture of our 50% share in the MSNBC joint venture. INCOME TAXES Fiscal year 2015 compared +with fiscal year 2014 Our effective tax rate for fiscal years 2015 and 2014 was approximately 34% and 21%, respectively. The fiscal +year 2015 effective rate increased by 13%, primarily due to goodwill and asset impairments and restructuring charges recorded in fiscal year 2015, most of which did not generate a tax benefit. Our effective tax rate was lower than the U.S. federal +statutory rate primarily due to foreign earnings taxed at lower rates resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. In fiscal year 2015, +this reduction was mostly offset by losses in foreign jurisdictions for which we may not realize a tax benefit, primarily as a result of impairment and restructuring charges. 41 Table of Contents PART II Item 7 Changes in the mix of income before income taxes between the U.S. and foreign countries also +impacted our effective tax rates and resulted primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. We supply our Windows PC operating system to customers through our U.S. regional +operating center, while we supply the Microsoft Office system and our server products and tools to customers through our foreign regional operations centers. In fiscal years 2015 and 2014, our U.S. income before income taxes was $7.4 billion and +$7.1 billion, respectively, and comprised 40% and 26%, respectively, of our income before income taxes. In fiscal years 2015 and 2014, our foreign income before income taxes was $11.1 billion and $20.7 billion, respectively, and comprised 60% and +74%, respectively, of our income before income taxes. Tax contingencies and other income tax liabilities were $12.1 billion and $10.4 +billion as of June 30, 2015 and 2014, respectively, and are included in other long-term liabilities. This increase relates primarily to adjustments to prior years’ liabilities for intercompany transfer pricing and adjustments related to +our IRS audits. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for those years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and +reopened the audit phase of the examination. As of June 30, 2015, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our +allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, +we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2015. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax +years 1996 to 2015, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. Fiscal year 2014 compared with fiscal year 2013 Our effective tax rate for fiscal years 2014 +and 2013 was approximately 21% and 19%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our +products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Our fiscal year 2014 +effective rate increased by 2% from fiscal year 2013 mainly due to adjustments of $458 million to prior years’ liabilities for intercompany transfer pricing that increased taxable income in more highly taxed jurisdictions, as well as losses +incurred by NDS and changes in the geographic mix of our business. This was offset in part by favorable transfer pricing developments in certain foreign tax jurisdictions, primarily Denmark. Changes in the mix of income before income taxes between the U.S. and foreign countries also impacted our effective tax rates and resulted +primarily from changes in the geographic distribution of and changes in consumer demand for our products and services. We supply our Windows PC operating system to customers through our U.S. regional operating center, while we supply the Microsoft +Office system and our server products and tools to customers through our foreign regional operations centers. Windows PC operating system revenue decreased $655 million in fiscal year 2014, while Microsoft Office system and server products and tools +revenue increased $1.3 billion and $1.6 billion, respectively, during this same period. In fiscal years 2014 and 2013, our U.S. income before income taxes was $7.1 billion and $6.7 billion, respectively, and comprised 26% and 25%, respectively, of +our income before income taxes. In fiscal years 2014 and 2013, the foreign income before income taxes was $20.7 billion and $20.4 billion, respectively, and comprised 74% and 75%, respectively, of our income before income taxes. FINANCIAL CONDITION Cash, Cash +Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $96.5 billion as of June 30, 2015, +compared with $85.7 billion as of June 30, 2014. Equity and other investments were $12.1 billion as of June 30, 2015, compared with $14.6 billion as of June 30, 2014. Our short-term investments are primarily to facilitate liquidity +and for capital 42 Table of Contents PART II Item 7 preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. +dollar-denominated securities, but also include foreign currency-denominated securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our +fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid +investment-grade fixed-income securities. Of the cash, cash equivalents, and short-term investments at June 30, 2015, $94.4 +billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of +funds (primarily currency and other local regulatory) was $2.1 billion. As of June 30, 2015, approximately 79% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency +securities, approximately 5% were invested in corporate notes and bonds of U.S. companies, and approximately 5% were invested in U.S. mortgage- and asset-backed securities, all of which are denominated in U.S. dollars. Securities lending We lend certain +fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount +determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $92 million as of June 30, 2015. Our +average and maximum securities lending payable balances for the fiscal year were $287 million and $750 million, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and +where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, +domestic and international equities, and U.S. government securities. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or +inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, common and preferred stock, foreign government bonds, mortgage- and +asset-backed securities, U.S. government and agency securities, and certificates of deposit. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring +basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors +and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a +quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as +Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the +fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of +period-over-period fluctuations, and independent recalculation of prices where appropriate. 43 Table of Contents PART II Item 7 Cash Flows Fiscal year 2015 compared with fiscal year 2014 Cash flows from operations decreased $3.2 billion during the fiscal year to $29.1 billion, mainly due to an increase in materials and production costs in support of sales growth as well as payments related to +restructuring charges and other changes in working capital, offset in part by increases in cash received from customers. Cash used in financing increased $686 million to $9.1 billion, mainly due to a $7.1 billion increase in cash used for common +stock repurchases, offset in part by a $6.7 billion increase in proceeds from issuances of debt, net of repayments. Cash used in investing increased $4.2 billion to $23.0 billion, mainly due to a $5.5 billion increase in cash used for net investment +purchases, sales, and maturities, partially offset by a $2.2 billion decrease in cash used for acquisitions of companies and purchases of intangible and other assets. Fiscal year 2014 compared with fiscal year 2013 Cash flows from operations increased $3.4 +billion during fiscal year 2014 to $32.2 billion, mainly due to increases in cash received from customers. Cash used in financing increased $246 million to $8.4 billion, mainly due to a $2.0 billion increase in cash used for common stock +repurchases, a $1.4 billion increase in dividends paid, and a $324 million decrease in proceeds from the issuance of common stock, offset in part by a $3.4 billion increase in proceeds from issuances of debt, net of repayments. Cash used in +investing decreased $5.0 billion to $18.8 billion, mainly due to a $10.5 billion decrease in cash used for net investment purchases, sales, and maturities, offset in part by a $4.4 billion increase in cash used for acquisition of companies and +purchases of intangible and other assets, and a $1.2 billion increase in capital expenditures for property and equipment. Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate +environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of +existing debt. See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K for further discussion. Unearned +Revenue Unearned revenue at June 30, 2015 was comprised mainly of unearned revenue from volume licensing programs. Unearned +revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each coverage period and accounted for as subscriptions with +revenue recognized ratably over the coverage period. Unearned revenue at June 30, 2015 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox Live subscriptions and prepaid points; +Microsoft Dynamics business solutions products; Office 365 subscriptions; Skype prepaid credits and subscriptions; Bundled Offerings; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or +software, or otherwise meet the revenue recognition criteria. The following table outlines the expected future recognition of unearned +revenue as of June 30, 2015: (In millions) Three Months Ending, September 30, 2015 $ 8,889 December 31, 2015 7,172 March 31, 2016 4,848 June 30, 2016 2,314 Thereafter 2,095 Total $ 25,318 44 Table of Contents PART II Item 7 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, +has no expiration date, and may be suspended or discontinued at any time without notice. While the program has no expiration date, we intend to complete it by December 31, 2016. As of June 30, 2015, $21.9 billion remained of our $40.0 +billion share repurchase program. During fiscal year 2015, we repurchased 295 million shares of Microsoft common stock for $13.2 +billion under the share repurchase program approved by our Board of Directors on September 16, 2013. During fiscal year 2014, we repurchased 175 million shares for $6.4 billion; 128 million shares were repurchased for $4.9 billion +under the share repurchase program approved by our Board of Directors on September 16, 2013, and 47 million shares were repurchased for $1.5 billion under the share repurchase program that was announced on September 22, 2008 and +expired September 30, 2013. During fiscal year 2013, we repurchased 158 million shares for $4.6 billion, under the share repurchase program announced on September 22, 2008. All repurchases were made using cash resources. Dividends See Note 19 – +Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Off-Balance Sheet +Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property +infringement made by third parties arising from the use of our products and certain other matters. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our +ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our consolidated financial statements during the periods presented. Contractual Obligations The following table summarizes the payments due by fiscal year for +our outstanding contractual obligations as of June 30, 2015: (In millions) 2016 2017-2018 2019-2020 Thereafter Total Long-term +debt: (a) Principal payments $ 2,500 $ 1,050 $ 3,750 $ 23,163 $ 30,463 Interest payments 855 1,641 1,552 11,412 15,460 Construction commitments (b) 681 0 0 0 681 Operating +leases (c) 863 1,538 1,135 1,617 5,153 Purchase commitments (d) 13,018 989 164 261 14,432 Other long-term liabilities (e) 0 237 75 639 951 Total contractual obligations $ 17,917 $ 5,455 $ 6,676 $ 37,092 $ 67,140 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) These amounts represent commitments for the construction of buildings, building improvements, and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. (e) We have excluded long-term tax contingencies, other tax liabilities, deferred income taxes, and long-term pension liabilities of $15.2 billion from the +amounts presented. We have also excluded unearned revenue and non-cash items. 45 Table of Contents PART II Item 7 Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. +Additions to property and equipment will continue, including new facilities, data centers, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in +coming years in support of our productivity and platform strategy. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with +unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity We earn a significant amount of +our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term +investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, cash flows from operations, and access to capital +markets to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt maturities, and material capital expenditures, for at least the +next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities +and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could +elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We +have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates. RECENT ACCOUNTING +GUIDANCE See Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further +discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect +the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of +investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted +for as separate units of accounting, and if so, the fair value for each of the elements. Judgment is also required to assess whether +future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future +versions of software products and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. 46 Table of Contents PART II Item 7 Software updates are evaluated on a case-by-case basis to determine whether they meet the +definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered. If it is determined that implied post-contract customer support (“PCS”) is being provided, revenue from the arrangement is +deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over +different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a +hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price +(“ESP”). For software elements, we follow the industry specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price +established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables +were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. In January 2015, we announced Windows 10 will be free to all qualified existing users of Windows 7 and Windows 8.1. This offer differs from +historical offers preceding the launch of new versions of Windows as it is being made available for free to existing users in addition to new customers after the offer announcement. We evaluated the nature and accounting treatment of the Windows 10 +offer and determined that it represents a marketing and promotional activity, in part because the offer is being made available for free to existing users. As this is a marketing and promotional activity, revenue recognition of new sales of Windows +8 will continue to be recognized as delivered. Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this +judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among +other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For +fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial +health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment +charge is recorded to other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting +units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for +impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair +value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant +portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting +units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a 47 Table of Contents PART II Item 7 discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term +rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could +materially affect the determination of fair value and goodwill impairment for each reporting unit. Based on the results of our annual +goodwill impairment testing as of May 1, 2015, we determined that goodwill associated with our Phone Hardware reporting unit was impaired, resulting in a material charge to earnings in the fourth quarter of fiscal year 2015. As of June 30, +2015, none of our reporting units were considered to be at risk of impairment. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been +established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a +product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products +are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and +Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An +estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In +determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact +our consolidated financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that +have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing +authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate +settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax +positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax +consequences could materially impact our consolidated financial statements. 48 Table of Contents PART II Item 7 Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review +inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, +pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The determination of market value and the estimated +volume of demand used in the lower of cost or market analysis require significant judgment. 49 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial +reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, +through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities +and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 50 Table of Contents PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our consolidated financial +statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and +use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Our fixed-income +portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain +global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. Equity Our equity portfolio consists of +global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based +commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global +commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with U.S. GAAP, but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign exchange +rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss +that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and +legal risk. 51 Table of Contents PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of +June 30, 2015 and 2014 and for the year ended June 30, 2015: (In millions) June 30, 2015 June 30, 2014 Year Ended June 30, 2015 Risk Categories Average High Low Foreign currency $ 120 $ 179 $ 162 $ 200 $ 107 Interest rate $ 51 $ 73 $ 57 $ 74 $ 48 Equity $ 149 $ 176 $ 161 $ 178 $ 146 Commodity $ 13 $ 17 $ 16 $ 20 $ 11 Total one-day VaR for the combined risk categories was $237 million at June 30, 2015 and $333 million at +June 30, 2014. The total VaR is 29% less at June 30, 2015, and 25% less at June 30, 2014, than the sum of the separate risk categories in the table above due to the diversification benefit of the combination of risks. 52 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND +SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2015 2014 2013 Revenue $ 93,580 $ 86,833 $ 77,849 Cost of revenue 33,038 27,078 20,385 Gross margin 60,542 59,755 57,464 Research and development 12,046 11,381 10,411 Sales and marketing 15,713 15,811 15,276 General and administrative 4,611 4,677 5,013 Impairment, integration, and restructuring 10,011 127 0 Operating income 18,161 27,759 26,764 Other income, net 346 61 288 Income before income taxes 18,507 27,820 27,052 Provision for income taxes 6,314 5,746 5,189 Net income $ 12,193 $ 22,074 $ 21,863 Earnings per share: Basic $ 1.49 $ 2.66 $ 2.61 Diluted $ 1.48 $ 2.63 $ 2.58 Weighted average shares outstanding: Basic 8,177 8,299 8,375 Diluted 8,254 8,399 8,470 Cash dividends declared per common share $ 1.24 $ 1.12 $ 0.92 See accompanying notes. 53 Table of Contents PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2015 2014 2013 Net income $ 12,193 $ 22,074 $ 21,863 Other comprehensive income (loss): Net unrealized gains (losses) on derivatives (net of tax effects of $20 , $(4), and $(14)) 559 (35 ) (26 ) Net unrealized gains (losses) on investments (net of tax effects of $(197) , $936, and $195) (362 ) 1,737 363 Translation adjustments and other (net of tax effects of $16 , $12, and $(8)) (1,383 ) 263 (16 ) Other comprehensive income (loss) (1,186 ) 1,965 321 Comprehensive income $ 11,007 $ 24,039 $ 22,184 See accompanying notes. 54 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2015 2014 Assets Current assets: Cash and cash equivalents $ 5,595 $ 8,669 Short-term investments (including securities loaned of $75 and $541) 90,931 77,040 Total cash, cash equivalents, and short-term investments 96,526 85,709 Accounts receivable, net of allowance for doubtful accounts of $335 and $301 17,908 19,544 Inventories 2,902 2,660 Deferred income taxes 1,915 1,941 Other 5,461 4,392 Total current assets 124,712 114,246 Property and equipment, net of accumulated depreciation of $17,606 and $14,793 14,731 13,011 Equity and other investments 12,053 14,597 Goodwill 16,939 20,127 Intangible assets, net 4,835 6,981 Other long-term assets 2,953 3,422 Total assets $ 176,223 $ 172,384 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 6,591 $ 7,432 Short-term debt 4,985 2,000 Current portion of long-term debt 2,499 0 Accrued compensation 5,096 4,797 Income taxes 606 782 Short-term unearned revenue 23,223 23,150 Securities lending payable 92 558 Other 6,766 6,906 Total current liabilities 49,858 45,625 Long-term debt 27,808 20,645 Long-term unearned revenue 2,095 2,008 Deferred income taxes 2,835 2,728 Other long-term liabilities 13,544 11,594 Total liabilities 96,140 82,600 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 8,027 and 8,239 68,465 68,366 Retained earnings 9,096 17,710 Accumulated other comprehensive income 2,522 3,708 Total stockholders’ equity 80,083 89,784 Total liabilities and stockholders’ equity $ 176,223 $ 172,384 See accompanying notes. 55 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2015 2014 2013 Operations Net income $ 12,193 $ 22,074 $ 21,863 Adjustments to reconcile net income to net cash from operations: Goodwill and asset impairments 7,498 0 0 Depreciation, amortization, and other 5,957 5,212 3,755 Stock-based compensation expense 2,574 2,446 2,406 Net recognized losses (gains) on investments and derivatives (443 ) (109 ) 80 Excess tax benefits from stock-based compensation (588 ) (271 ) (209 ) Deferred income taxes 224 (331 ) (19 ) Deferral of unearned revenue 45,072 44,325 44,253 Recognition of unearned revenue (44,920 ) (41,739 ) (41,921 ) Changes in operating assets and liabilities: Accounts receivable 1,456 (1,120 ) (1,807 ) Inventories (272 ) (161 ) (802 ) Other current assets 62 (29 ) (129 ) Other long-term assets 346 (628 ) (478 ) Accounts payable (1,054 ) 473 537 Other current liabilities (624 ) 1,075 146 Other long-term liabilities 1,599 1,014 1,158 Net cash from operations 29,080 32,231 28,833 Financing Proceeds from issuance of short-term debt, maturities of 90 days or less, net 4,481 500 0 Proceeds from issuance of debt 10,680 10,350 4,883 Repayments of debt (1,500 ) (3,888 ) (1,346 ) Common stock issued 634 607 931 Common stock repurchased (14,443 ) (7,316 ) (5,360 ) Common stock cash dividends paid (9,882 ) (8,879 ) (7,455 ) Excess tax benefits from stock-based compensation 588 271 209 Other 362 (39 ) (10 ) Net cash used in financing (9,080 ) (8,394 ) (8,148 ) Investing Additions to property and equipment (5,944 ) (5,485 ) (4,257 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (3,723 ) (5,937 ) (1,584 ) Purchases of investments (98,729 ) (72,690 ) (75,396 ) Maturities of investments 15,013 5,272 5,130 Sales of investments 70,848 60,094 52,464 Securities lending payable (466 ) (87 ) (168 ) Net cash used in investing (23,001 ) (18,833 ) (23,811 ) Effect of exchange rates on cash and cash equivalents (73 ) (139 ) (8 ) Net change in cash and cash equivalents (3,074 ) 4,865 (3,134 ) Cash and cash equivalents, beginning of period 8,669 3,804 6,938 Cash and cash equivalents, end of period $ 5,595 $ 8,669 $ 3,804 See accompanying notes. 56 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2015 2014 2013 Common stock and paid-in capital Balance, beginning of period $ 68,366 $ 67,306 $ 65,797 Common stock issued 634 607 920 Common stock repurchased (3,700 ) (2,328 ) (2,014 ) Stock-based compensation expense 2,574 2,446 2,406 Stock-based compensation income tax benefits 588 272 190 Other, net 3 63 7 Balance, end of period 68,465 68,366 67,306 Retained earnings Balance, beginning of period 17,710 9,895 (856 ) Net income 12,193 22,074 21,863 Common stock cash dividends (10,063 ) (9,271 ) (7,694 ) Common stock repurchased (10,744 ) (4,988 ) (3,418 ) Balance, end of period 9,096 17,710 9,895 Accumulated other comprehensive income Balance, beginning of period 3,708 1,743 1,422 Other comprehensive income (loss) (1,186 ) 1,965 321 Balance, end of period 2,522 3,708 1,743 Total stockholders’ equity $ 80,083 $ 89,784 $ 78,944 See accompanying notes. 57 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United +States of America (“U.S. GAAP”). We have recast certain prior period amounts to conform to the current period presentation, +with no impact on consolidated net income or cash flows. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances +have been eliminated. Equity investments through which we are able to exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity +method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. Estimates and Assumptions Preparing +financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, +and/or potential impairment of goodwill and intangibles assets, for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of +our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or enhancements and new products; when technological +feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our consolidated financial statements or tax returns; and determining when investment impairments are +other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are +translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income (“OCI”). Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, +delivery has occurred, the fee is fixed or determinable, and collectability is probable. Revenue generally is recognized net of allowances for returns and any taxes collected from customers and subsequently remitted to governmental authorities. Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can +be accounted for as separate units of accounting, and if so, the fair value for each of the elements. Microsoft enters into +arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their +relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective +evidence of fair value (“VSOE”), (ii) third-party evidence, 58 Table of Contents PART II Item 8 and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry specific software guidance which only allows for the use of VSOE in establishing +fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the +marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary +over time depending upon the unique facts and circumstances related to each deliverable. Revenue for retail packaged products, products +licensed to original equipment manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are shipped or made available. Technology guarantee programs are accounted for as multiple-element arrangements as customers receive free or significantly discounted rights to +use upcoming new versions of a software product if they license existing versions of the product during the eligibility period. Revenue is allocated between the existing product and the new product, and revenue allocated to the new product is +deferred until that version is delivered. The revenue allocation is based on the VSOE of fair value of the products. The VSOE of fair value for upcoming new products are based on the price determined by management having the relevant authority when +the element is not yet sold separately, but is expected to be sold in the near future at the price set by management. Software updates +that will be provided free of charge are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade and create a multiple-element arrangement, which may require revenue to be deferred and recognized when the +upgrade is delivered, or if it is determined that implied post-contract customer support (“PCS”) is being provided, the arrangement is accounted for as a multiple-element arrangement and all revenue from the arrangement is deferred and +recognized over the implied PCS term when the VSOE of fair value does not exist. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future versions +of software products, which we have determined are additional software products and are therefore accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. Arrangements +that include term-based licenses for current products with the right to use unspecified future versions of the software during the coverage period, are also accounted for as subscriptions, with revenue recognized ratably over the coverage period. Revenue from cloud-based services arrangements that allow for the use of a hosted software product or service over a contractually +determined period of time without taking possession of software are accounted for as subscriptions with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period beginning on the date the service is made +available to customers. Revenue from cloud-based services arrangements that are provided on a consumption basis (for example, the amount of storage used in a particular period) is recognized commensurate with the customer utilization of such +resources. Some volume licensing arrangements include time-based subscriptions for cloud-based services and software offerings that are +accounted for as subscriptions. These arrangements are considered multiple-element arrangements. However, because all elements are accounted for as subscriptions and have the same coverage period and delivery pattern, they have the same revenue +recognition timing. Revenue related to phones, Surface devices, Xbox consoles, games published by us, and other hardware components is +generally recognized when ownership is transferred to the resellers or to end customers when selling directly through Microsoft retail stores and online marketplaces. A portion of revenue may be deferred when these products are combined with +software elements, and/or services. Revenue related to licensing for games published by third parties for use on the Xbox consoles is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the +search results or when the action necessary to earn the revenue has been 59 Table of Contents PART II Item 8 completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during +the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Revenue from prepaid points redeemable for the purchase of software or services is recognized upon redemption of the points and delivery of +the software or services. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to +include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain Internet-based products and services, including datacenter costs and royalties; warranty costs; +inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the +products. Product Warranty We +provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure +rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally +include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate +our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related +expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of +purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally +shortly before the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing +expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. +Advertising costs are expensed as incurred. Advertising expense was $1.9 billion, $2.3 billion, and $2.6 billion in fiscal years 2015, 2014, and 2013, respectively. Stock-Based Compensation We measure stock-based compensation cost at the grant date based on +the fair value of the award and recognize it as expense, net of estimated forfeitures, over the vesting or service period, as applicable, of the stock award (generally four to five years) using the straight-line method. 60 Table of Contents PART II Item 8 Employee Stock Purchase Plan Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value of the stock on the last day of each three-month period. Compensation expense for the employee stock +purchase plan is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of +international subsidiaries not deemed to be permanently invested, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such +temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. The deferred income taxes are classified as current or +long-term based on the classification of the related asset or liability. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which +inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. +These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and +forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, common and preferred stock, mortgage- and asset-backed securities, U.S. government and agency securities, +and foreign government bonds. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in common and +preferred stock and goodwill when it is recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. Our Level 3 derivative assets and liabilities +primarily include equity derivatives. We measure certain assets, including our cost and equity method investments, at +fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market +prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values. 61 Table of Contents PART II Item 8 Financial Instruments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying +values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as +short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and +realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and other investments classified as long-term include both debt and equity instruments. With the exception of certain corporate notes that are classified as held-to-maturity, debt and publicly-traded equity +securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in the market value of available-for-sale securities, excluding other-than-temporary impairments, are +reflected in OCI. Held-to-maturity investments are recorded and held at amortized cost. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the equity +method. We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried +as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is +recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged +to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and +qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and +extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more +likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes +in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is +established. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for +changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative +instruments designated as fair value hedges, the gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair +value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For +derivative instruments designated as cash-flow hedges, the effective portion of the gains (losses) on the derivatives is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in +earnings. For options designated as cash-flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from +the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated +as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense), net. Other than those derivatives entered into for investment 62 Table of Contents PART II Item 8 purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a +component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense), net. Allowance for Doubtful Accounts The +allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. +Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2015 2014 2013 Balance, beginning of period $ 301 $ 336 $ 389 Charged to costs and other 77 16 4 Write-offs (43 ) (51 ) (57 ) Balance, end of period $ 335 $ 301 $ 336 Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related +to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below +carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. The determination of market value and the estimated volume of demand used in the lower of cost or market analysis require significant judgment. Property and Equipment Property and equipment is stated at cost and depreciated using the straight-line method over the shorter of the estimated useful life of the asset +or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years; computer equipment, two to three years; buildings and improvements, +five to 15 years; leasehold improvements, three to 20 years; and furniture and equipment, one to 10 years. Land is not depreciated. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an +annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our intangible +assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of intangible assets periodically by taking into account events +or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. 63 Table of Contents PART II Item 8 Recent Accounting Guidance Not Yet Adopted In May 2014, as part of its ongoing efforts to assist in the convergence of U.S. GAAP and International Financial Reporting Standards, the +Financial Accounting Standards Board (“FASB”) issued a new standard related to revenue recognition. Under the new standard, recognition of revenue occurs when a customer obtains control of promised goods or services in an amount that +reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts +with customers. The new standard will be effective for us beginning July 1, 2018, and adoption as of the original effective date of July 1, 2017 is permitted. We anticipate this standard will have a material impact on our consolidated +financial statements, and we are currently evaluating its impact. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock +outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive +potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2015 2014 2013 Net income available for common shareholders (A) $ 12,193 $ 22,074 $ 21,863 Weighted average outstanding shares of common stock (B) 8,177 8,299 8,375 Dilutive effect of stock-based awards 77 100 95 Common stock and common stock equivalents (C) 8,254 8,399 8,470 Earnings Per Share Basic (A/B) $ 1.49 $ 2.66 $ 2.61 Diluted (A/C) $ 1.48 $ 2.63 $ 2.58 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods +presented. NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2015 2014 2013 Dividends and interest income $ 766 $ 883 $ 677 Interest expense (781 ) (597 ) (429 ) Net recognized gains on investments 716 437 116 Net losses on derivatives (423 ) (328 ) (196 ) Net gains (losses) on foreign currency remeasurements 335 (165 ) (74 ) Other (267 ) (169 ) 194 Total $ 346 $ 61 $ 288 64 Table of Contents PART II Item 8 Following are details of net recognized gains on investments during the periods reported: (In millions) Year Ended June 30, 2015 2014 2013 Other-than-temporary impairments of investments $ (183 ) $ (106 ) $ (208 ) Realized gains from sales of available-for-sale securities 1,176 776 489 Realized losses from sales of available-for-sale securities (277 ) (233 ) (165 ) Total $ 716 $ 437 $ 116 NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, but excluding held-to-maturity investments, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2015 Cash $ 3,679 $ 0 $ 0 $ 3,679 $ 3,679 $ 0 $ 0 Mutual funds 1,100 0 0 1,100 1,100 0 0 Commercial paper 1 0 0 1 1 0 0 Certificates of deposit 906 0 0 906 776 130 0 U.S. government and agency securities 72,843 76 (30 ) 72,889 39 72,850 0 Foreign government bonds 5,477 3 (24 ) 5,456 0 5,456 0 Mortgage- and asset-backed securities 4,899 23 (6 ) 4,916 0 4,916 0 Corporate notes and bonds 7,192 97 (37 ) 7,252 0 7,252 0 Municipal securities 285 35 (1 ) 319 0 319 0 Common and preferred stock 6,668 4,986 (215 ) 11,439 0 0 11,439 Other investments 597 0 0 597 0 8 589 Total $ 103,647 $ 5,220 $ (313 ) $ 108,554 $ 5,595 $ 90,931 $ 12,028 65 Table of Contents PART II Item 8 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2014 Cash $ 4,980 $ 0 $ 0 $ 4,980 $ 4,980 $ 0 $ 0 Mutual funds 590 0 0 590 590 0 0 Commercial paper 189 0 0 189 89 100 0 Certificates of deposit 1,197 0 0 1,197 865 332 0 U.S. government and agency securities 66,952 103 (29 ) 67,026 109 66,917 0 Foreign government bonds 3,328 17 (10 ) 3,335 2,027 1,308 0 Mortgage- and asset-backed securities 991 30 (2 ) 1,019 0 1,019 0 Corporate notes and bonds 6,845 191 (9 ) 7,027 9 7,018 0 Municipal securities 287 45 0 332 0 332 0 Common and preferred stock 6,785 5,207 (81 ) 11,911 0 0 11,911 Other investments 1,164 0 0 1,164 0 14 1,150 Total $ 93,308 $ 5,593 $ (131 ) $ 98,770 $ 8,669 $ 77,040 $ 13,061 In addition to the investments in the table above, we also own corporate notes that are classified as +held-to-maturity investments, which are included in equity and other investments on the balance sheet. These corporate notes are due October 31, 2023 and are measured at fair value on a nonrecurring basis. As of June 30, 2015, the +amortized cost and recorded basis of these corporate notes were both $25 million with an estimated fair value that approximates the carrying value. As of June 30, 2014, the amortized cost, recorded basis, and estimated fair value of these +corporate notes was $1.5 billion, $1.5 billion, and $1.7 billion, respectively, while their associated gross unrealized holding gains were $164 million. As of June 30, 2015 and 2014, the recorded bases of common and preferred stock that are restricted for more than one year or are not publicly traded were $561 million and $520 million, respectively. These +investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments. We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and +the loaned securities continue to be carried as investments on our balance sheet. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the +creditworthiness of the borrower. As of June 30, 2015, collateral received under these agreements totaled $92 million which is comprised of $79 million of certificates of deposit and $13 million of U.S. government and agency securities. The +contractual maturities of these agreements are primarily on a continuous and overnight basis. 66 Table of Contents PART II Item 8 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2015 U.S. government and agency securities $ 6,636 $ (9 ) $ 421 $ (21 ) $ 7,057 $ (30 ) Foreign government bonds 4,611 (12 ) 18 (12 ) 4,629 (24 ) Mortgage- and asset-backed securities 3,171 $ (5 ) 28 (1 ) 3,199 (6 ) Corporate notes and bonds 2,946 (29 ) 104 (8 ) 3,050 (37 ) Municipal securities 36 (1 ) 0 0 36 (1 ) Common and preferred stock 1,389 (180 ) 148 (35 ) 1,537 (215 ) Total $ 18,789 $ (236 ) $ 719 $ (77 ) $ 19,508 $ (313 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2014 U.S. government and agency securities $ 4,161 $ (29 ) $ 850 $ 0 $ 5,011 $ (29 ) Foreign government bonds 566 (4 ) 21 (6 ) 587 (10 ) Mortgage- and asset-backed securities 120 0 61 (2 ) 181 (2 ) Corporate notes and bonds 1,154 (8 ) 34 (1 ) 1,188 (9 ) Common and preferred stock 463 (48 ) 257 (33 ) 720 (81 ) Total $ 6,464 $ (89 ) $ 1,223 $ (42 ) $ 7,687 $ (131 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized +losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of +June 30, 2015. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2015 Due in one year or less $ 53,616 $ 53,645 Due after one year through five years 33,260 33,336 Due after five years through 10 years 3,180 3,161 Due after 10 years 1,547 1,597 Total $ 91,603 $ 91,739 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to +enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented +below are measured in U.S. dollar equivalents. 67 Table of Contents PART II Item 8 Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge +positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese +yen, British pound, Canadian dollar, and Australian dollar. As of June 30, 2015 and June 30, 2014, the total notional amounts of these foreign exchange contracts sold were $9.8 billion and $4.9 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are +designated as fair value hedging instruments. As of June 30, 2015 and June 30, 2014, the total notional amounts of these foreign exchange contracts sold were $5.3 billion and $3.1 billion, respectively. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain +balance sheet amounts and to manage other foreign currency exposures. As of June 30, 2015, the total notional amounts of these foreign exchange contracts purchased and sold were $9.7 billion and $11.0 billion, respectively. As of +June 30, 2014, the total notional amounts of these foreign exchange contracts purchased and sold were $6.2 billion and $8.5 billion, respectively. Equity Securities held in our equity and +other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not +designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2015, the total notional amounts +of equity contracts purchased and sold for managing market price risk were $2.2 billion and $2.6 billion, respectively, of which $1.1 billion and $1.4 billion, respectively, were designated as hedging instruments. As of June 30, 2014, the total +notional amounts of equity contracts purchased and sold for managing market price risk were $1.9 billion and $1.9 billion, respectively, of which $362 million and $420 million, respectively, were designated as hedging instruments. Interest Rate Securities held in our +fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using +exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2015, the total notional amounts of fixed-interest rate contracts purchased and +sold were $1.0 billion and $3.2 billion, respectively. As of June 30, 2014, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.7 billion and $936 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed +securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2015 and 2014, the total notional derivative amounts of +mortgage contracts purchased were $812 million and $1.1 billion, respectively. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not +designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or +groups of credit risks. As of June 30, 2015, the total notional amounts of credit contracts purchased and sold were $618 million and $430 million, respectively. As of June 30, 2014, the total notional amounts of credit contracts purchased +and sold were $550 million and $440 million, respectively. 68 Table of Contents PART II Item 8 Commodity We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and +manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As +of June 30, 2015, the total notional amounts of commodity contracts purchased and sold were $882 million and $316 million, respectively. As of June 30, 2014, the total notional amounts of commodity contracts purchased and sold were $1.4 +billion and $408 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured +debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to +over-the-counter derivatives. As of June 30, 2015, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. 69 Table of Contents PART II Item 8 Fair Values of Derivative Instruments The following table presents the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) +and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value +adjustments related to our own credit risk and counterparty credit risk: June 30, 2015 June 30, 2014 Assets Liabilities Assets Liabilities (In millions) Short-term Investments Other Current Assets Equity and Other Investments Other Current Liabilities Short-term Investments Other Current Assets Equity and Other Investments Other Current Liabilities Non-designated Hedge Derivatives Foreign exchange contracts $ 17 $ 167 $ 0 $ (79 ) $ 10 $ 39 $ 0 $ (97 ) Equity contracts 148 0 0 (18 ) 177 0 0 (21 ) Interest rate contracts 7 0 0 (12 ) 17 0 0 (12 ) Credit contracts 16 0 0 (9 ) 24 0 0 (13 ) Commodity contracts 0 0 0 0 15 0 0 (1 ) Total $ 188 $ 167 $ 0 $ (118 ) $ 243 $ 39 $ 0 $ (144 ) Designated Hedge Derivatives Foreign exchange contracts $ 56 $ 552 $ 0 $ (31 ) $ 1 $ 70 $ 0 $ (15 ) Equity contracts 0 0 25 (69 ) 0 0 7 (125 ) Total $ 56 $ 552 $ 25 $ (100 ) $ 1 $ 70 $ 7 $ (140 ) Total gross amounts of derivatives $ 244 $ 719 $ 25 $ (218 ) $ 244 $ 109 $ 7 $ (284 ) Gross derivatives either offset or subject to an enforceable master netting agreement $ 126 $ 719 $ 25 $ (218 ) $ 99 $ 109 $ 7 $ (284 ) Gross amounts of derivatives offset in the balance sheet (66 ) (71 ) (25 ) 161 (77 ) (71 ) (7 ) 155 Net amounts presented in the balance sheet 60 648 0 (57 ) 22 38 0 (129 ) Gross amounts of derivatives not offset in the balance sheet 0 0 0 0 0 0 0 0 Cash collateral received 0 0 0 (456 ) 0 0 0 0 Net amount $ 60 $ 648 $ 0 $ (513 ) $ 22 $ 38 $ 0 $ (129 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. 70 Table of Contents PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense), net the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2015 2014 2013 Foreign Exchange Contracts Derivatives $ 741 $ (14 ) $ 70 Hedged items $ (725 ) 6 (69 ) Total amount of ineffectiveness $ 16 $ (8 ) $ 1 Equity Contracts Derivatives $ (107 ) $ (110 ) $ 0 Hedged items 107 110 0 Total amount of ineffectiveness $ 0 $ 0 $ 0 Amount of equity contracts excluded from effectiveness assessment $ 0 $ (9 ) $ 0 Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges (our only cash flow hedges during the periods presented): (In millions) Year Ended June 30, 2015 2014 2013 Effective Portion Gains recognized in OCI (net of tax effects of $35 , $2 and $54) $ 1,152 $ 63 $ 101 Gains reclassified from AOCI into revenue $ 608 $ 104 $ 195 Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense), net $ (346 ) $ (239 ) $ (168 ) We estimate that $492 million of net derivative gains included in AOCI at June 30, 2015 will be reclassified +into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2015. Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), +net. These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), net, which were immaterial for the periods presented. Other than those +derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) from foreign +exchange rate changes on certain balance sheet amounts. (In millions) Year Ended June 30, 2015 2014 2013 Foreign exchange contracts $ (483 ) $ (78 ) $ 18 Equity contracts (19 ) (64 ) 16 Interest-rate contracts 23 24 (11 ) Credit contracts (1 ) 13 (3 ) Commodity contracts (223 ) 71 (42 ) Total $ (703 ) $ (34 ) $ (22 ) 71 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2015 Assets Mutual funds $ 1,100 $ 0 $ 0 $ 1,100 $ 0 $ 1,100 Commercial paper 0 1 0 1 0 1 Certificates of deposit 0 906 0 906 0 906 U.S. government and agency securities 71,930 955 0 72,885 0 72,885 Foreign government bonds 131 5,299 0 5,430 0 5,430 Mortgage- and asset-backed securities 0 4,917 0 4,917 0 4,917 Corporate notes and bonds 0 7,108 1 7,109 0 7,109 Municipal securities 0 319 0 319 0 319 Common and preferred stock 8,585 2,277 14 10,876 0 10,876 Derivatives 4 979 5 988 (162 ) 826 Total $ 81,750 $ 22,761 $ 20 $ 104,531 $ (162 ) $ 104,369 Liabilities Derivatives and other $ 5 $ 159 $ 54 $ 218 $ (161 ) $ 57 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2014 Assets Mutual funds $ 590 $ 0 $ 0 $ 590 $ 0 $ 590 Commercial paper 0 189 0 189 0 189 Certificates of deposit 0 1,197 0 1,197 0 1,197 U.S. government and agency securities 66,288 745 0 67,033 0 67,033 Foreign government bonds 139 3,210 0 3,349 0 3,349 Mortgage- and asset-backed securities 0 1,015 0 1,015 0 1,015 Corporate notes and bonds 0 6,863 0 6,863 0 6,863 Municipal securities 0 332 0 332 0 332 Common and preferred stock 9,552 1,825 14 11,391 0 11,391 Derivatives 5 348 7 360 (155 ) 205 Total $ 76,574 $ 15,724 $ 21 $ 92,319 $ (155 ) $ 92,164 Liabilities Derivatives and other $ 5 $ 153 $ 126 $ 284 $ (155 ) $ 129 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. The changes in our Level 3 +financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented. 72 Table of Contents PART II Item 8 The following table reconciles the total “Net Fair Value” of assets above to the balance +sheet presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2015 2014 Net fair value of assets measured at fair value on a recurring basis $ 104,369 $ 92,164 Cash 3,679 4,980 Common and preferred stock measured at fair value on a nonrecurring basis 561 520 Other investments measured at fair value on a nonrecurring basis 589 1,150 Less derivative net assets classified as other current assets (648 ) (38 ) Other 4 (6 ) Recorded basis of investment components $ 108,554 $ 98,770 Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal year 2015 and 2014, we did not record any material other-than-temporary impairments on financial assets required to be measured at +fair value on a nonrecurring basis. NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2015 2014 Raw materials $ 1,100 $ 944 Work in process 202 266 Finished goods 1,600 1,450 Total $ 2,902 $ 2,660 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2015 2014 Land $ 769 $ 541 Buildings and improvements 10,800 8,867 Leasehold improvements 3,577 3,560 Computer equipment and software 13,612 11,430 Furniture and equipment 3,579 3,406 Total, at cost 32,337 27,804 Accumulated depreciation (17,606 ) (14,793 ) Total, net $ 14,731 $ 13,011 During fiscal years 2015, 2014, and 2013, depreciation expense was $4.1 billion, $3.4 billion, and $2.6 billion, +respectively. 73 Table of Contents PART II Item 8 NOTE 9 — BUSINESS COMBINATIONS Mojang Synergies AB On +November 6, 2014, we acquired Mojang Synergies AB (“Mojang”), the Swedish video game developer of the Minecraft gaming franchise, for $2.5 billion in cash, net of cash acquired. The addition of Minecraft and its community enhances our +gaming portfolio across Windows, Xbox, and other ecosystems besides our own. Our purchase price allocation is preliminary and subject to revision as more detailed analyses are completed and additional information about fair value of assets and +liabilities becomes available, including additional information relating to tax matters and finalization of our valuation of identified intangible assets. The significant classes of assets and liabilities to which we preliminarily allocated the purchase price were goodwill of $1.8 billion and identifiable intangible assets of $928 million, primarily marketing-related +(trade names). The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth, and is not expected to be deductible for tax purposes. We assigned the goodwill to our Devices and +Consumer (“D&C”) Other segment. Identifiable intangible assets were assigned a total weighted-average amortization period of 6.3 years. Mojang has been included in our consolidated results of operations since the acquisition date. Nokia’s Devices and Services Business On April 25, 2014, we acquired substantially all of Nokia Corporation’s (“Nokia”) Devices and Services business (“NDS”) for a total purchase price of $9.4 billion, including cash +acquired of $1.5 billion (the “Acquisition”). The purchase price consisted primarily of cash of $7.1 billion and Nokia’s repurchase of convertible notes of $2.1 billion, which was a non-cash transaction, and liabilities assumed of +$0.2 billion. The Acquisition was expected to accelerate the growth of our D&C business through faster innovation, synergies, and unified branding and marketing. The allocation of the purchase price to goodwill was completed as of March 31, 2015. The major classes of assets and liabilities to which we have allocated the purchase price were as follows: (In millions) Cash $ 1,506 Accounts +receivable (a) 754 Inventories 544 Other current assets 936 Property and equipment 981 Intangible assets 4,509 Goodwill (b) 5,456 Other 221 Current liabilities (4,575 ) Long-term liabilities (890 ) Total purchase price $ 9,442 (a) Gross accounts receivable was $901 million, of which $147 million was expected to be uncollectible. (b) Goodwill was assigned to our Phone Hardware segment. The goodwill was primarily attributed to increased synergies that were expected to be achieved from +the integration of NDS. 74 Table of Contents PART II Item 8 Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Technology-based $ 2,493 9 years Contract-based 1,500 9 years Customer-related 359 3 years Marketing-related (trade names) 157 2 years Fair value of intangible assets acquired $ 4,509 8 years During the fourth quarter of fiscal year 2015, we recorded $7.5 billion of goodwill and asset impairment charges +related to our Phone Hardware business. These costs are included in impairment, integration, and restructuring expenses in our consolidated income statement. See Note 10 – Goodwill and Note 11 – Intangible Assets for additional details. Our consolidated income statement for fiscal year 2014 included revenue and operating loss of $2.0 billion and $692 million, +respectively, attributable to NDS since the Acquisition. Following are the supplemental consolidated results of Microsoft Corporation +on an unaudited pro forma basis, as if the Acquisition had been consummated on July 1, 2012: (In millions, except per share amounts) Year Ended June 30, 2014 2013 Revenue $ 96,248 $ 93,243 Net income $ 20,234 $ 20,153 Diluted earnings per share $ 2.41 $ 2.38 These pro forma results were based on estimates and assumptions, which we believe are reasonable. They are not the +results that would have been realized had we been a combined company during the periods presented and are not necessarily indicative of our consolidated results of operations in future periods. The pro forma results include adjustments primarily +related to purchase accounting adjustments and the elimination of related party transactions between Microsoft and NDS. Acquisition costs and other nonrecurring charges incurred are included in the earliest period presented. During the fourth quarter of fiscal year 2014, we incurred $21 million of acquisition costs associated with the purchase of NDS. Acquisition costs +are primarily comprised of transaction fees and direct acquisition costs, including legal, finance, consulting, and other professional fees. These costs are included in impairment, integration, and restructuring expenses on our consolidated income +statement for fiscal year 2014. Certain concurrent transactions were recognized separately from the Acquisition. Prior to the +Acquisition, we had joint strategic initiatives with Nokia; this contractual relationship was terminated in conjunction with the Acquisition. No gain or loss was recorded upon termination of this agreement, as it was determined to be at market +value. In addition, we agreed to license Nokia’s mapping services and will pay Nokia separately for the services provided under a four-year license as they are rendered. Yammer On July 18, 2012, we acquired Yammer, Inc. (“Yammer”), a leading +provider of enterprise social networks, for $1.1 billion in cash. Yammer added an enterprise social networking service to Microsoft’s portfolio of complementary cloud-based services. The major classes of assets to which we allocated the +purchase price were goodwill of $937 million and identifiable intangible assets of $178 million. We assigned the goodwill to Commercial Other under our current segment structure. Yammer was consolidated into our results of operations starting on the +acquisition date. 75 Table of Contents PART II Item 8 Other During fiscal year 2015, we completed 15 additional acquisitions for total cash consideration of $892 million. These entities have been included in our consolidated results of operations since their respective +acquisition dates. Pro forma results of operations for Mojang and our other acquisitions during the current period have not been +presented because the effects of these business combinations, individually and in aggregate, were not material to our consolidated results of operations. NOTE 10 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2013 Acquisitions Other June 30, 2014 Acquisitions Other June 30, 2015 Devices and Consumer Licensing $ 866 $ 0 $ 2 $ 868 $ 4 $ 0 $ 872 Hardware: Computing and Gaming Hardware 1,689 0 9 1,698 13 (36 ) 1,675 Phone Hardware 0 5,458 (a) (104 ) 5,354 0 (5,238 ) 116 Total Devices and Consumer Hardware 1,689 5,458 (95 ) 7,052 13 (5,274 ) 1,791 Other 738 0 0 738 1,772 (195 ) 2,315 Total Devices and Consumer 3,293 5,458 (93 ) 8,658 1,789 (5,469 ) 4,978 Commercial Licensing 10,051 2 5 10,058 77 (170 ) 9,965 Other 1,311 105 (5 ) 1,411 589 (4 ) 1,996 Total Commercial 11,362 107 0 11,469 666 (174 ) 11,961 Total goodwill $ 14,655 $ 5,565 $ (93 ) $ 20,127 $ 2,455 $ (5,643 ) $ 16,939 (a) Goodwill acquired during fiscal year 2014 related to the acquisition of NDS. See Note 9 – Business Combinations for additional details. The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on +the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in +which the acquisitions occurred. Any change in the goodwill amounts resulting from foreign currency translations and purchase +accounting adjustments are presented as “Other” in the above table. Also included in “Other” are business dispositions and transfers between business segments due to reorganizations, as applicable. For fiscal year 2015, a $5.1 +billion goodwill impairment charge was included in “Other,” as discussed further below. This goodwill impairment charge was included in impairment, integration, and restructuring expenses in our consolidated income statement, and reflected +in Corporate and Other in our table of operating income (loss) by segment group in Note 22 – Segment Information and Geographic Data. Our accumulated goodwill impairment as of June 30, 2015 and 2014 was $11.3 billion and $6.2 billion, respectively. 76 Table of Contents PART II Item 8 Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe +use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. Upon completion of the +annual testing as of May 1, 2015, Phone Hardware goodwill was determined to be impaired. In the second half of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than +planned. These results, along with changes in the competitive marketplace and an evaluation of business priorities, led to a shift in strategic direction and reduced future revenue and profitability expectations for the business. As a result of +these changes in strategy and expectations, we have forecasted reductions in unit volume growth rates and lower future cash flows used to estimate the fair value of the Phone Hardware reporting unit, which resulted in the determination that an +impairment adjustment was required. Because our annual test indicated that Phone Hardware’s carrying value exceeded its estimated +fair value, a second phase of the goodwill impairment test (“Step 2”) was performed specific to Phone Hardware. Under Step 2, the fair value of all Phone Hardware assets and liabilities were estimated, including tangible assets, existing +technology, patent agreements, and contractual arrangements, for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of +the impairment. Assumptions used in measuring the value of these assets and liabilities included the discount rates and royalty rates used in valuing the intangible assets, and consideration of the market environment in valuing the tangible assets. No other instances of impairment were identified in our May 1, 2015 test. No impairment of goodwill was identified as of +May 1, 2014. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount Year Ended June 30, 2015 2014 Technology-based (a) $ 6,187 $ (3,410 ) $ 2,777 $ 6,440 $ (2,615 ) $ 3,825 Marketing-related 1,974 (540 ) 1,434 1,518 (324 ) 1,194 Contract-based 1,344 (862 ) 482 2,266 (716 ) 1,550 Customer-related 632 (490 ) 142 732 (320 ) 412 Total $ 10,137 $ (5,302 ) $ 4,835 $ 10,956 $ (3,975 ) $ 6,981 (a) Technology-based intangible assets included $116 million and $98 million as of June 30, 2015 and 2014, respectively, of net carrying amount of +software to be sold, leased, or otherwise marketed. We estimate that we have no significant residual value +related to our intangible assets. During fiscal year 2015, we recorded impairment charges of $2.2 billion related to our Phone Hardware intangible assets. In the fourth quarter of fiscal year 2015, we tested the intangible assets for recoverability +due to changes in facts and circumstances associated with the shift in strategic direction and reduced profitability expectations for Phone Hardware. Based on the results of our testing, we determined that the carrying value of the intangible assets +was not recoverable, and an impairment charge was recorded to the extent that estimated fair value exceeded carrying value. We primarily used a relief from royalty income approach to determine the fair value of the intangible assets and determine +the amount of impairment. These intangible assets impairment charges were included in impairment, integration, and restructuring expenses in our consolidated income statement, and reflected in Corporate and Other in our table of operating income +(loss) by segment group in Note 22 – Segment Information and Geographic Data. No material impairments of intangible assets were identified during fiscal year 2014. 77 Table of Contents PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2015 2014 Technology-based $ 874 5 years $ 2,841 9 years Marketing-related 543 8 years 174 2 years Contract-based 0 1,500 9 years Customer-related 37 4 years 363 3 years Total $ 1,454 6 years $ 4,878 8 years The table above includes $4.5 billion related to the acquisition of NDS during fiscal year 2014, of which $2.2 +billion was impaired in fiscal year 2015. See Note 9 – Business Combination for additional details. Intangible assets amortization +expense was $1.3 billion, $845 million, and $739 million for fiscal years 2015, 2014, and 2013, respectively. Amortization of capitalized software was $79 million, $200 million, and $210 million for fiscal years 2015, 2014, and 2013, respectively. The following table outlines the estimated future amortization expense related to intangible assets held at June 30, 2015: (In millions) Year Ending June 30, 2016 $ 910 2017 755 2018 670 2019 554 2020 495 Thereafter 1,451 Total $ 4,835 NOTE 12 — DEBT Short-term Debt As of +June 30, 2015, we had $5.0 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.11% and maturities ranging from 8 days to 63 days. As of June 30, 2014, we had $2.0 billion of commercial paper +issued and outstanding, with a weighted-average interest rate of 0.12% and maturities ranging from 86 to 91 days. The estimated fair value of this commercial paper approximates its carrying value. We have two $5.0 billion credit facilities that expire on November 4, 2015 and November 14, 2018, respectively. These credit facilities +serve as a back-up for our commercial paper program. As of June 30, 2015, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before +interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreements. No amounts were drawn against these credit facilities during any of the periods presented. Long-term Debt As of June 30, 2015, +the total carrying value and estimated fair value of our long-term debt, including the current portion, were $30.3 billion and $30.5 billion, respectively. This is compared to a carrying value and estimated fair value of our long-term debt of $20.6 +billion and $21.5 billion, respectively, as of June 30, 2014. These estimated fair values are based on Level 2 inputs. 78 Table of Contents PART II Item 8 The components of our long-term debt, including the current portion, and the associated interest +rates were as follows as of June 30, 2015 and 2014: Due Date Face Value June 30, 2015 Face Value June 30, 2014 Stated Interest Rate Effective Interest Rate (In millions) Notes September 25, 2015 $ 1,750 $ 1,750 1.625% 1.795% February 8, 2016 750 750 2.500% 2.642% November 15, 2017 600 600 0.875% 1.084% May 1, 2018 450 450 1.000% 1.106% December 6, 2018 1,250 1,250 1.625% 1.824% June 1, 2019 1,000 1,000 4.200% 4.379% February 12, 2020 (a) 1,500 0 1.850% 1.935% October 1, 2020 1,000 1,000 3.000% 3.137% February 8, 2021 500 500 4.000% 4.082% December 6, 2021 (b) 1,950 2,396 2.125% 2.233% February 12, 2022 (a) 1,500 0 2.375% 2.466% November 15, 2022 750 750 2.125% 2.239% May 1, 2023 1,000 1,000 2.375% 2.465% December 15, 2023 1,500 1,500 3.625% 3.726% February 12, 2025 (a) 2,250 0 2.700% 2.772% December 6, 2028 (b) 1,950 2,396 3.125% 3.218% May 2, +2033 (b) 613 753 2.625% 2.690% February 12, 2035 (a) 1,500 0 3.500% 3.604% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, 2042 900 900 3.500% 3.571% May 1, 2043 500 500 3.750% 3.829% December 15, 2043 500 500 4.875% 4.918% February 12, 2045 (a) 1,750 0 3.750% 3.800% February 12, 2055 (a) 2,250 0 4.000% 4.063% Total $ 30,463 $ 20,745 (a) In February 2015, we issued $10.8 billion of debt securities. (b) Euro-denominated debt securities. The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt +securities on which interest is paid annually. Cash paid for interest on our debt for fiscal years 2015, 2014, and 2013 was $620 million, $509 million, and $371 million, respectively. As of June 30, 2015 and 2014, the aggregate unamortized +discount for our long-term debt, including the current portion, was $156 million and $100 million, respectively. 79 Table of Contents PART II Item 8 Debt Service Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2016 $ 2,500 2017 0 2018 1,050 2019 2.250 2020 1,500 Thereafter 23,163 Total $ 30,463 NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2015 2014 2013 Current Taxes U.S. federal $ 3,661 $ 3,738 $ 3,131 U.S. state and local 364 266 332 Foreign 2,065 2,073 1,745 Current taxes 6,090 6,077 5,208 Deferred Taxes Deferred taxes 224 (331 ) (19 ) Provision for income taxes $ 6,314 $ 5,746 $ 5,189 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2015 2014 2013 U.S. $ 7,363 $ 7,127 $ 6,674 Foreign 11,144 20,693 20,378 Income before income taxes $ 18,507 $ 27,820 $ 27,052 The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our +effective rate were as follows: Year Ended June 30, 2015 2014 2013 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (20.9)% (17.1)% (17.5)% Phone Hardware nondeductible charges and valuation allowance 19.1% 0.9% 0% Domestic production activities deduction (2.4)% (1.0)% (1.2)% Other reconciling items, net 3.3% 2.9% 2.9% Effective rate 34.1% 20.7% 19.2% 80 Table of Contents PART II Item 8 The reduction from the federal statutory rate is primarily due to foreign earnings taxed at lower +rates resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. In fiscal year 2015, this reduction was mostly offset by losses in foreign +jurisdictions for which we may not realize a tax benefit, primarily as a result of impairment and restructuring charges. Excluding these losses, our foreign earnings, which are taxed at rates lower than the U.S. rate and are generated from our +regional operating centers, were 73%, 81%, and 79% of our foreign income before tax in fiscal years 2015, 2014, and 2013, respectively. In general, other reconciling items consist of interest, U.S. state income taxes, and credits. In fiscal years +2015, 2014, and 2013, there were no individually significant other reconciling items. The components of the deferred income tax assets +and liabilities were as follows: (In millions) June 30, 2015 2014 Deferred Income Tax Assets Stock-based compensation expense $ 884 $ 903 Other expense items 1,531 1,112 Restructuring charges 211 0 Unearned revenue 520 520 Impaired investments 257 272 Loss carryforwards 1,158 922 Depreciation and amortization 798 0 Other revenue items 56 64 Deferred income tax assets 5,415 3,793 Less valuation allowance (2,265 ) (903 ) Deferred income tax assets, net of valuation allowance $ 3,150 $ 2,890 Deferred Income Tax Liabilities Foreign earnings $ (1,280 ) $ (1,140 ) Unrealized gain on investments and debt (2,223 ) (1,974 ) Depreciation and amortization (685 ) (470 ) Other (29 ) (87 ) Deferred income tax liabilities (4,217 ) (3,671 ) Net deferred income tax assets (liabilities) $ (1,067 ) $ (781 ) Reported As Current deferred income tax assets $ 1,915 $ 1,941 Other current liabilities (211 ) (125 ) Other long-term assets 64 131 Long-term deferred income tax liabilities (2,835 ) (2,728 ) Net deferred income tax assets (liabilities) $ (1,067 ) $ (781 ) As of June 30, 2015, we had net operating loss carryforwards of $4.6 billion, including $1.8 billion of +foreign net operating loss carryforwards acquired through our acquisition of Skype, and $545 million through our acquisition of NDS. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and +other future deductible net deferred tax assets that may not be realized. Deferred income tax balances reflect the effects of temporary +differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. As of June 30, 2015, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately +$108.3 billion resulting from earnings for certain non-U.S. subsidiaries which are 81 Table of Contents PART II Item 8 permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences was approximately $34.5 billion at June 30, 2015. Income taxes paid were $4.4 billion, $5.5 billion, and $3.9 billion in fiscal years 2015, 2014, and 2013, respectively. Uncertain Tax Positions Unrecognized tax +benefits as of June 30, 2015, 2014, and 2013, were $9.6 billion, $8.7 billion, and $8.6 billion, respectively. If recognized, these tax benefits would affect our effective tax rates for fiscal years 2015, 2014, and 2013, by $7.9 billion, $7.0 +billion, and $6.5 billion, respectively. As of June 30, 2015, 2014, and 2013, we had accrued interest expense related to uncertain +tax positions of $1.7 billion, $1.5 billion, and $1.3 billion, respectively, net of federal income tax benefits. Interest expense on unrecognized tax benefits was $237 million, $235 million, and $400 million in fiscal years 2015, 2014, and 2013, +respectively, and was included in income tax expense. The aggregate changes in the balance of unrecognized tax benefits were as +follows: (In millions) Year Ended June 30, 2015 2014 2013 Balance, beginning of year $ 8,714 $ 8,648 $ 7,202 Decreases related to settlements (50 ) (583 ) (30 ) Increases for tax positions related to the current year 1,091 566 612 Increases for tax positions related to prior years 94 217 931 Decreases for tax positions related to prior years (144 ) (95 ) (65 ) Decreases due to lapsed statutes of limitations (106 ) (39 ) (2 ) Balance, end of year $ 9,599 $ 8,714 $ 8,648 During the third quarter of fiscal year 2011, we reached a settlement of a portion of an I.R.S. audit of tax years +2004 to 2006, which reduced our income tax expense by $461 million. While we settled a portion of the I.R.S. audit, we remain under audit for these years. In February 2012, the I.R.S. withdrew its 2011 Revenue Agents Report and reopened the audit +phase of the examination. As of June 30, 2015, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for +income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not +anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2015. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax +years 1996 to 2015, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. NOTE 14 — RESTRUCTURING CHARGES Phone Hardware Integration In July 2014, we announced a restructuring plan to simplify our organization and align NDS with our company’s overall strategy (the “Phone Hardware Integration Plan”). Pursuant to the Phone Hardware +Integration Plan, we eliminated approximately 19,000 positions in fiscal year 2015, including approximately 13,000 professional and factory positions related to the NDS business. The actions associated with the Phone Hardware Integration Plan were +completed as of June 30, 2015. 82 Table of Contents PART II Item 8 In connection with the Phone Hardware Integration Plan, we incurred restructuring charges of $1.3 +billion during fiscal year 2015, including severance expenses and other reorganization costs, primarily associated with our facilities consolidation and write-downs of certain assets. Phone Hardware Restructuring In June 2015, management approved a plan to restructure our +Phone Hardware business to better focus and align resources (the “Phone Hardware Restructuring Plan”), under which we will eliminate up to 7,800 positions in fiscal year 2016. In connection with the Phone Hardware Restructuring Plan, we +recorded restructuring charges of $780 million during fiscal year 2015, including severance expenses and other reorganization costs, primarily related to contractual obligations. The actions associated with the Phone Hardware Restructuring Plan are +expected to be completed as of June 30, 2016. Restructuring charges associated with each plan were included in impairment, +integration, and restructuring expenses in our consolidated income statement, and reflected in Corporate and Other in our table of operating income (loss) by segment group in Note 22 — Segment Information and Geographic Data. Changes in the restructuring liability were as follows: (In millions) Severance Asset Impairments and Other (a) Total Restructuring liability as of June 30, 2014 $ 0 $ 0 $ 0 Restructuring charges 1,308 770 2,078 Cash paid (701 ) (134 ) (835 ) Other (19 ) (387 ) (406 ) Restructuring liability as of June 30, 2015 $ 588 $ 249 $ 837 (a) “Asset Impairments and Other” primarily reflects activities associated with the consolidation of our facilities and manufacturing operations, +including asset write-downs of $372 million during fiscal year 2015, as well as contract termination costs. NOTE 15 — UNEARNED REVENUE Unearned revenue by segment was as follows, with segments with significant balances shown separately: (In millions) June 30, 2015 2014 Commercial Licensing $ 17,672 $ 19,099 Commercial Other 5,641 3,934 Rest of the segments 2,005 2,125 Total $ 25,318 $ 25,158 NOTE 16 — OTHER LONG-TERM LIABILITIES (In millions) June 30, 2015 2014 Tax contingencies and other tax liabilities $ 12,290 $ 10,510 Other 1,254 1,084 Total $ 13,544 $ 11,594 83 Table of Contents PART II Item 8 NOTE 17 — COMMITMENTS AND GUARANTEES Construction and Operating Leases We have committed $681 million for constructing new buildings, building improvements, and leasehold improvements as of June 30, 2015. We have operating leases for most U.S. and international sales and support offices, research and development facilities, manufacturing facilities, retail stores, and certain equipment. Rental expense for facilities +operating leases was $989 million, $874 million, and $711 million, in fiscal years 2015, 2014, and 2013, respectively. Future minimum rental commitments under non-cancellable facilities operating leases in place as of June 30, 2015 are as +follows: (In millions) Year Ending June 30, 2016 $ 863 2017 803 2018 735 2019 611 2020 524 Thereafter 1,617 Total $ 5,153 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered +significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications in our consolidated financial statements. NOTE 18 — CONTINGENCIES Patent and Intellectual Property Claims Motorola litigation In October 2010, +Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents by +Motorola’s Android devices. Microsoft and Motorola have filed additional claims against each other with the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, and in courts in Germany. The nature of the claims +asserted and status of individual matters are summarized below. International Trade Commission In 2012, the ITC issued a limited exclusion order against Motorola on one Microsoft patent, which was affirmed on appeal. In 2013, Microsoft filed +an action in U.S. District Court in Washington, D.C. seeking an order to compel enforcement of the ITC’s 2012 import ban against infringing Motorola products by the Bureau of Customs and Border Protection (“CBP”), after learning that +CBP had failed to fully enforce the order. In 2010, Motorola filed an action against Microsoft with the ITC alleging infringement of +five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing 84 Table of Contents PART II Item 8 Xbox products. At Motorola’s request, the ITC terminated its investigation of four Motorola patents. In 2013, the ITC affirmed there was no violation of the remaining Motorola patent. +Motorola appealed the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit. U.S. District Court The Seattle District Court case filed in October 2010 by Microsoft as a companion to Microsoft’s ITC case against Motorola was stayed pending +the outcome of the ITC case. In November 2010, Microsoft sued Motorola for breach of contract in U.S. District Court in Seattle, +alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola has declared these patents essential to +the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In the Motorola ITC case described above and in suits described below, Motorola or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District +Courts, in the ITC, and in Germany. In 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that (1) Motorola had committed to standards organizations to license its declared-essential patents on RAND +terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. After trial, the Seattle District Court set per unit royalties for Motorola’s H.264 and 802.11 patents, which resulted in an immaterial Microsoft +liability. In 2013, following trial of Microsoft’s breach of contract claim, a jury awarded $14.5 million in damages to Microsoft. Motorola appealed with respect to both the Court’s determination of royalties due Motorola and the +jury’s award of damages against Motorola; in July 2015 the U.S. Court of Appeals for the Ninth Circuit affirmed the trial court’s judgment in all respects. Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one case in Wisconsin initially stayed and later dismissed without prejudice (a companion case to Motorola’s ITC action), +have been transferred to the U.S District Court in Seattle. Motorola and Microsoft both seek damages as well as injunctive relief. The court has stayed these cases in Seattle on agreement of the parties. • In the transferred cases, Motorola asserts 15 patents are infringed by a range of Microsoft products including mobile and PC operating system, productivity, +server, communication, browser and gaming products. • In the Motorola action originally filed in California, Motorola asserts Microsoft violated antitrust laws in connection with Microsoft’s assertion of +patents against Motorola that Microsoft agreed to license to certain qualifying entities on RAND terms and conditions. • In counterclaims, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola digital video recorders. Germany In +2011, Motorola filed patent infringement actions in Germany against Microsoft and several Microsoft subsidiaries. • Motorola asserts two patents (both now expired) are essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products +including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. In 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany, which Microsoft appealed. Orders in the litigation +pending in Seattle, Washington described above enjoin Motorola from enforcing the German injunction. • Motorola asserts that one patent covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail Mobile, +Exchange Online, Exchange Server, and Hotmail Server. In 2013, the court stayed the case pending the outcome of parallel proceedings in which Microsoft is seeking to invalidate the patent. In 2013, the Federal Patent Court invalidated the originally +issued patent claims, but ruled that certain new amended claims were patentable. Both Motorola and Microsoft appealed. In June 2014, the court reopened infringement proceedings, which are currently stayed. • Microsoft may be able to mitigate the adverse impact of any injunction by altering its products to avoid Motorola’s infringement claims. • Any damages would be determined in separate proceedings. 85 Table of Contents PART II Item 8 In lawsuits Microsoft filed in Germany in 2011 and 2012, Microsoft asserts that Motorola Android +devices infringe Microsoft patents and is seeking damages and injunctions. In 2012, regional courts in Germany issued injunctions on three of the Microsoft patents, which Motorola appealed. One judgment has been affirmed on appeal (and Motorola has +further appealed), and the other two appeals are pending (in one of these two cases the asserted patent has expired). An additional infringement proceeding is still pending in the court of first instance. In actions filed separately by Motorola to +invalidate these patents, the Federal Patent Court in 2013 and 2014 held the Microsoft patents invalid, and Microsoft appealed. For the cases in which Microsoft obtained injunctions, if Motorola were to prevail following all appeals, Motorola could +have a claim against Microsoft for damages caused by an erroneously granted injunction. IPCom patent litigation IPCom GmbH & Co. (“IPCom”) is a German company that holds a large portfolio of mobile technology-related patents spanning about +170 patent families and addressing a broad range of cellular technologies. IPCom has asserted 19 of these patents in litigation against Nokia and many of the leading cell phone companies and operators. In November 2014, Microsoft and IPCom entered +into a standstill agreement staying all of the pending litigation against Microsoft to permit the parties to pursue settlement discussions. InterDigital patent litigation InterDigital Technology Corporation and InterDigital Communications Corporation (collectively, “IDT”) filed four patent infringement +cases against Nokia in the ITC and in U.S. District Court for the District of Delaware between 2007 and 2013. We have been added to these cases as a defendant. IDT has cases pending against other defendants based on the same patents because most of +the patents at issue allegedly relate to 3G and 4G wireless communications standards essential functionality. The cases involving us include three ITC investigations where IDT is seeking an order excluding importation of 3G and 4G phones into the +U.S. and one active case in U.S. District Court in Delaware seeking an injunction and damages. The ITC issued a finding of no violation relating to two of the investigations, which IDT appealed. In February 2015, the U.S. Court of Appeals for the +Federal Circuit affirmed one of the ITC’s findings; the other has been stayed. In the third ITC action the administrative law judge (“ALJ”) issued a determination finding: (1) infringement; (2) evidence of “reverse +hold-up;” and (3) the public interest does not preclude issuance of an exclusion order. The ITC is reviewing the ALJ’s initial determination. The trial in the Delaware case is scheduled for November 2015. European copyright levies We assumed from +Nokia all potential liability due to Nokia’s alleged failure to pay “private copying levies” in various European countries based upon sale of memory cards and mobile phones that incorporate blank memory. The levies are based upon +a 2001 European Union (“EU”) Directive establishing a right for end users to make copies of copyrighted works for personal or private use, but also allowing the collection of levies based upon sales of blank media or recording devices to +compensate copyright holders for private copying. Various collecting societies in EU countries initiated litigation against Nokia, stating that Nokia must pay levies not only based upon sales of blank memory cards, but also phones that include +blank memory for data storage on the phones, regardless of actual usage of that memory. The most significant cases against Nokia are pending in Germany and Austria, due to both the high volume of sales and high levy amounts sought in these +countries. Since April 2015, we and other major manufacturers have been engaged in settlement negotiations with the German collecting society, with the aim of concluding negotiations by October 2015. Other patent and intellectual property claims In addition to these cases, there are approximately 70 other patent infringement cases pending against Microsoft. 86 Table of Contents PART II Item 8 Antitrust, Unfair Competition, and Overcharge Class Actions A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on +behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products between 1999 and 2005. We obtained dismissals or reached settlements of all claims made in the U.S. Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of +platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending +on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. We estimate the total remaining cost of the settlements is approximately $200 million, all of which +had been accrued as of June 30, 2015. Three similar cases pending in British Columbia, Ontario, and Quebec, Canada have not been +settled. In 2010, the court in the British Columbia case certified it as a class action. After the British Columbia Court of Appeal dismissed the case, in 2013 the Canadian Supreme Court reversed the appellate court and reinstated part of the +British Columbia case, which is now scheduled for trial in 2016. The other two cases are inactive. Other Antitrust Litigation and Claims GO Computer litigation In +June 2005, GO Computer Inc. and co-founder Jerry Kaplan filed a complaint in California state court asserting antitrust claims under the Cartwright Act related to the business of the former GO Corporation in the early 1990s and its successor in +interest, Lucent Corporation in the early 2000s. All claims prior to June 2001 have been dismissed with prejudice as barred by the statute of limitations. The case is moving forward with discovery, and a trial is set for September 2015. China State Administration for Industry and Commerce investigatio n In July 2014, Microsoft was informed that China’s State Administration for Industry and Commerce (“SAIC”) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAIC +conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. SAIC has stated the investigation relates to compatibility, bundle sales, and file verification issues related to Windows and Office software. Product-Related Litigation U.S. cell phone +litigation Nokia, along with other handset manufacturers and network operators, is a defendant in 19 lawsuits filed in the Superior +Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We have assumed responsibility for these claims as part of the NDS +acquisition and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining 10 cases are stayed. In a separate 2009 decision, the Court of Appeals for +the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted +by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and +testing around emission guidelines. In September 2013, defendants in the consolidated cases moved to exclude plaintiffs’ expert +evidence of general causation on the basis of flawed scientific methodologies. In March 2014, defendants filed a separate motion to 87 Table of Contents PART II Item 8 preclude plaintiffs’ general causation testimony. In August 2014, the court granted in part defendants’ motion to exclude plaintiffs’ general causation experts. The plaintiffs +filed an interlocutory appeal. In December 2014, the District of Columbia Court of Appeals agreed to hear en banc defendants’ interlocutory appeal challenging the standard for evaluating expert scientific evidence. Trial court +proceedings are stayed pending resolution of the appeal. Canadian cell phone class action Nokia, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of +British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors. Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia +defendants. The litigation is not yet active as several defendants remain to be served. Other We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management +currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of +these matters may change in the future. As of June 30, 2015, we accrued aggregate legal liabilities of $614 million in other +current liabilities and $20 million in other long-term liabilities. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.6 billion in aggregate beyond recorded amounts are reasonably +possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable. NOTE 19 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2015 2014 2013 Balance, beginning of year 8,239 8,328 8,381 Issued 83 86 105 Repurchased (295 ) (175 ) (158 ) Balance, end of year 8,027 8,239 8,328 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, +has no expiration date, and may be suspended or discontinued at any time without notice. This share repurchase program replaced the share repurchase program that was announced on September 22, 2008 and expired on September 30, 2013. As of +June 30, 2015, $21.9 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources. 88 Table of Contents PART II Item 8 We repurchased the following shares of common stock under the above-described repurchase plans: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2015 2014 (a) 2013 First quarter 43 $ 2,000 47 $ 1,500 33 $ 1,000 Second quarter 43 2,000 53 2,000 58 1,607 Third quarter 116 5,000 47 1,791 36 1,000 Fourth quarter 93 4,209 28 1,118 31 1,000 Total 295 $ 13,209 175 $ 6,409 158 $ 4,607 (a) Of the 175 million shares repurchased in fiscal year 2014, 128 million shares were repurchased for $4.9 billion under the share repurchase +program approved by our Board of Directors on September 16, 2013 and 47 million shares were repurchased for $1.5 billion under the share repurchase program that was announced on September 22, 2008 and expired on September 30, +2013. The above table excludes shares repurchased to settle statutory employee tax withholding related to the +vesting of stock awards. Dividends In fiscal year 2015, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 16, 2014 $  0.31 November 20, 2014 $  2,547 December 11, 2014 December 3, 2014 $  0.31 February 19, 2015 $  2,532 March 12, 2015 March 10, 2015 $  0.31 May 21, 2015 $  2,496 June 11, 2015 June 9, 2015 $  0.31 August 20, 2015 $  2,488 September 10, 2015 The dividend declared on June 9, 2015 will be paid after the filing date of this Form 10-K and was included in +other current liabilities as of June 30, 2015. In fiscal year 2014, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 16, 2013 $ 0.28 November 21, 2013 $ 2,332 December 12, 2013 November 19, 2013 $ 0.28 February 20, 2014 $ 2,322 March 13, 2014 March 11, 2014 $ 0.28 May 15, 2014 $ 2,309 June 12, 2014 June 10, 2014 $ 0.28 August 21, 2014 $ 2,307 September 11, 2014 The dividend declared on June 10, 2014 was included in other current liabilities as of June 30, 2014. 89 Table of Contents PART II Item 8 NOTE 20 — ACCUMULATED OTHER COMPREHENSIVE INCOME The following table summarizes the changes in accumulated other comprehensive income by component: (In millions) Year Ended June 30, 2015 2014 2013 Derivatives Accumulated other comprehensive income balance, beginning of period $ 31 $ 66 $ 92 Unrealized gains, net of tax effects of $35 , $2 and $54 1,152 63 101 Reclassification adjustments for gains included in revenue (608 ) (104 ) (195 ) Tax expense included in provision for income taxes 15 6 68 Amounts reclassified from accumulated other comprehensive income (593 ) (98 ) (127 ) Net current period other comprehensive income (loss) 559 (35 ) (26 ) Accumulated other comprehensive income balance, end of period $ 590 $ 31 $ 66 Investments Accumulated other comprehensive income balance, beginning of period $ 3,531 $ 1,794 $ 1,431 Unrealized gains, net of tax effects of $59 , $1,067 and $244 110 2,053 453 Reclassification adjustments for gains included in other income (expense), net (728 ) (447 ) (139 ) Tax expense included in provision for income taxes 256 131 49 Amounts reclassified from accumulated other comprehensive income (472 ) (316 ) (90 ) Net current period other comprehensive income (loss) (362 ) 1,737 363 Accumulated other comprehensive income balance, end of period $ 3,169 $ 3,531 $ 1,794 Translation Adjustments and Other Accumulated other comprehensive income (loss) balance, beginning of period $ 146 $ (117 ) $ (101 ) Translation adjustments and other, net of tax effects of $16 , $12 and $(8) (1,383 ) 263 (16 ) Accumulated other comprehensive income (loss) balance, end of period $ (1,237 ) $ 146 $ (117 ) Accumulated other comprehensive income, end of period $ 2,522 $ 3,708 $ 1,743 NOTE 21 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to directors and employees. At June 30, 2015, an aggregate of 294 million shares +were authorized for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy exercises and +vesting of awards granted under all of our stock plans. Stock-based compensation expense and related income tax benefits were as +follows: (In millions) Year Ended June 30, 2015 2014 2013 Stock-based compensation expense $ 2,574 $ 2,446 $ 2,406 Income tax benefits related to stock-based compensation $ 868 $ 830 $ 842 Stock Plans Stock +awards Stock awards (“SAs”) are grants that entitle the holder to shares of Microsoft common stock as the award vests. +SAs generally vest over a four or five-year period. 90 Table of Contents PART II Item 8 Executive incentive plan Under the Executive Incentive Plan, the Compensation Committee awards SAs to executive officers and certain senior executives. The SAs vest ratably in August of each of the four years following the grant date. Activity for all stock plans The fair value of each award was estimated on the date of grant using the following assumptions: Year Ended June 30, 2015 2014 2013 Dividends per share (quarterly amounts) $ 0.28 - $  0.31 $ 0.23 - $  0.28 $ 0.20 - $  0.23 Interest rates range 1.2% - 1.9% 1.3% - 1.8% 0.6% - 1.1% During fiscal year 2015, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 259 $ 27.88 Granted 75 $ 42.36 Vested (94 ) $ 27.47 Forfeited (24 ) $ 31.81 Nonvested balance, end of year 216 $ 32.72 As of June 30, 2015, there was approximately $4.7 billion of total unrecognized compensation costs related to +stock awards. These costs are expected to be recognized over a weighted average period of 3 years. During fiscal years 2014 and 2013, +the following activity occurred under our stock plans: (In millions, except fair values) 2014 2013 Stock Awards Awards +granted (a) 103 104 Weighted average grant-date fair value $ 31.50 $ 28.37 (a) Awards granted during fiscal year 2014 included four million shares in stock replacement awards related to the acquisition of NDS. The weighted average +grant-date fair value was $37.64. Total vest-date fair value of stock awards vested was $4.2 billion, $3.2 +billion, and $2.8 billion, for fiscal years 2015, 2014, and 2013, respectively. 91 Table of Contents PART II Item 8 Employee Stock Purchase Plan We have an employee stock purchase plan (the “Plan”) for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the +last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2015 2014 2013 Shares purchased 16 18 20 Average price per share $ 39.87 $ 33.60 $ 26.81 At June 30, 2015, 157 million shares of our common stock were reserved for future issuance through the +Plan. Savings Plan We have a +savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute up to 75% of their salary, but not more than +statutory limits. We contribute fifty cents for each dollar of the first 6% a participant contributes in this plan, with a maximum contribution of the lesser of 3% of a participant’s earnings or 3% of the IRS compensation limit for the given +year. Matching contributions for all plans were $454 million, $420 million, and $393 million in fiscal years 2015, 2014, and 2013, respectively, and were expensed as contributed. Matching contributions in the U.S. plan are invested proportionate to +each participant’s voluntary contributions in the investment options provided under the plan. Investment options in the U.S. plan include Microsoft common stock, but neither participant nor our matching contributions are required to be invested +in Microsoft common stock. NOTE 22 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, the company’s Chief Executive +Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. The segment information in this note is reported on that basis. During the periods presented, +we reported our financial performance based on the following segments; D&C Licensing, Computing and Gaming Hardware, Phone Hardware, D&C Other, Commercial Licensing, and Commercial Other. On April 25, 2014, we acquired substantially all of NDS. See Note 9 – Business Combinations for additional details. NDS has been included +in our consolidated results of operations since the acquisition date. We report the financial performance of the acquired business in our Phone Hardware segment. Prior to the acquisition of NDS, financial results associated with our joint strategic +initiatives with Nokia were reflected in our D&C Licensing segment. The contractual relationship with Nokia related to those initiatives ended in conjunction with the acquisition. Our reportable segments are described below. Devices and Consumer Our D&C segments +develop, manufacture, market, and support products and services designed to entertain and connect people, increase personal productivity, help people simplify tasks and make more informed decisions online, and help advertisers connect with +audiences. Our D&C segments are: • D&C Licensing , comprising: Windows, including all OEM licensing (“Windows OEM”) and other non-volume licensing and academic volume +licensing of the Windows operating system and related software; non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Office Consumer”); Windows Phone operating system, including related patent +licensing; and certain other patent licensing revenue. 92 Table of Contents PART II Item 8 • Computing and Gaming Hardware , comprising: Xbox gaming and entertainment consoles and accessories, second-party and third-party video game royalties, +and Xbox Live subscriptions (“Xbox Platform”); Surface devices and accessories (“Surface”); and Microsoft PC accessories. • Phone Hardware , comprising: Lumia phones and other non-Lumia phones, beginning with our acquisition of NDS. • D&C Other , comprising: Resale, consisting of transactions in our Windows Store and Xbox marketplace; search advertising; display advertising; +Office 365 Consumer, comprising Office 365 Home and Office 365 Personal; Studios, comprising first-party video games; Mojang; non-Microsoft products sold in our retail stores; and certain other consumer products and services not included in the +categories above. Commercial Our Commercial segments develop, market, and support software and services designed to increase individual, team, and organizational productivity and efficiency, including simplifying everyday tasks through +seamless operations across the user’s hardware and software. Our Commercial segments are: • Commercial Licensing , comprising: server products, including Windows Server, Microsoft SQL Server, Visual Studio, System Center, and related Client +Access Licenses (“CALs”); Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Windows Commercial”); Microsoft Office for business, including Office, Exchange, SharePoint, Skype for Business, +and related CALs (“Office Commercial”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype. • Commercial Other , comprising: Enterprise Services, including Premier Support Services and Microsoft Consulting Services; Commercial Cloud, comprising +Office 365 Commercial, other Microsoft Office online offerings, Dynamics CRM Online, and Microsoft Azure; and certain other commercial products and online services not included in the categories above. Revenue and cost of revenue are generally directly attributed to our segments. Certain revenue contracts are allocated among the segments based on +the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is directly charged to our hardware +segments. For the remaining segments, cost of revenue is directly charged in most cases and allocated in certain cases, generally using a relative revenue methodology. We do not allocate operating expenses to our segments. Rather, we allocate them to our two segment groups, Devices and Consumer and Commercial. Due to the integrated structure of our business, allocations of +expenses are made in certain cases to incent cross-collaboration among our segment groups so that a segment group is not solely burdened by the cost of a mutually beneficial activity as we seek to deliver seamless experiences across devices, whether +on-premises or in the cloud. Operating expenses are attributed to our segment groups as follows: • Sales and marketing expenses are primarily recorded directly to each segment group based on identified customer segment. • Research and development expenses are primarily shared across the segment groups based on relative gross margin but are mapped directly in certain cases where +the value of the expense only accrues to that segment group. • General and administrative expenses are primarily allocated based on relative gross margin. Certain corporate-level activity is not allocated to our segment groups, including costs of: legal, including expenses, settlements, and fines; +information technology; human resources; finance; excise taxes; and impairment, integration, and restructuring expenses. 93 Table of Contents PART II Item 8 Segment revenue and gross margin were as follows during the periods presented: (In millions) Year Ended June 30, 2015 2014 2013 Revenue Devices and Consumer Licensing $ 14,969 $ 19,528 $ 19,427 Hardware: Computing and Gaming Hardware 10,183 9,093 6,149 Phone Hardware 7,524 1,982 0 Total Devices and Consumer Hardware 17,707 11,075 6,149 Other 8,825 7,014 6,431 Total Devices and Consumer 41,501 37,617 32,007 Commercial Licensing 41,039 42,085 39,778 Other 10,836 7,546 5,661 Total Commercial 51,875 49,631 45,439 Corporate and Other 204 (415 ) 403 Total revenue $ 93,580 $ 86,833 $ 77,849 (In millions) Year Ended June 30, 2015 2014 2013 Gross margin Devices and Consumer Licensing $ 13,870 $ 17,439 $ 16,985 Hardware: Computing and Gaming Hardware 1,788 892 956 Phone Hardware 701 54 0 Total Devices and Consumer Hardware 2,489 946 956 Other 2,022 1,393 1,951 Total Devices and Consumer 18,381 19,778 19,892 Commercial Licensing 37,830 38,615 36,280 Other 4,199 1,855 922 Total Commercial 42,029 40,470 37,202 Corporate and Other 132 (493 ) 370 Total gross margin $ 60,542 $ 59,755 $ 57,464 Below are operating expenses by segment group. As discussed above, we do not allocate operating expenses to our +segments. (In millions) Year Ended June 30, 2015 2014 2013 Devices and Consumer $ 11,505 $ 11,219 $ 10,625 Commercial 17,177 16,993 16,050 Corporate and Other 3,688 3,657 4,025 Total segment operating expenses 32,370 31,869 30,700 Impairment, integration, and restructuring 10,011 127 0 Total operating expenses $ 42,381 $ 31,996 $ 30,700 94 Table of Contents PART II Item 8 Below is operating income (loss) by segment group. (In millions) Year Ended June 30, 2015 2014 2013 Devices and Consumer $ 6,876 $ 8,559 $ 9,267 Commercial 24,852 23,477 21,152 Corporate and Other (13,567 ) (4,277 ) (3,655 ) Total operating income $ 18,161 $ 27,759 $ 26,764 Corporate and Other operating income includes adjustments to conform our internal accounting policies to U.S. GAAP, +corporate-level activity not specifically attributed to a segment, and impairment, integration, and restructuring expenses. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement +classification, and depreciation. Corporate and Other activity was as follows: (In millions) Year Ended June 30, 2015 2014 2013 Corporate (a) +(b) $ (13,575 ) $ (3,744 ) $ (4,102 ) Other (adjustments to U.S. GAAP): Revenue reconciling amounts (c) 204 (415 ) 403 Cost of revenue reconciling amounts (72 ) (78 ) (31 ) Operating expenses reconciling amounts (124 ) (40 ) 75 Total Corporate and Other $ (13,567 ) $ (4,277 ) $ (3,655 ) (a) Corporate is presented on the basis of our internal accounting policies and excludes the adjustments to U.S. GAAP that are presented separately in those +line items. (b) Corporate for fiscal year 2015 included impairment, integration, and restructuring expenses of $10.0 billion. (c) Revenue reconciling amounts for fiscal year 2015 included a net $303 million of previously deferred net revenue related to sales of bundled products and +services (“Bundled Offerings”). Revenue reconciling amounts for fiscal year 2014 included a net $349 million of revenue deferrals related to Bundled Offerings. Revenue reconciling amounts for fiscal year 2013 included the recognition of +$540 million of revenue previously deferred on sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price. No sales to an individual customer or country other than the United States accounted for more than 10% of fiscal year 2015, 2014, or 2013 revenue. Revenue, classified by the major geographic areas in which our +customers are located, was as follows: (In millions) Year Ended June 30, 2015 2014 2013 United +States (a) $ 42,941 $ 43,474 $ 41,344 Other countries 50,639 43,359 36,505 Total $ 93,580 $ 86,833 $ 77,849 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the +geographic source of the revenue. 95 Table of Contents PART II Item 8 Revenue from external customers, classified by significant product and service offerings were as +follows: (In millions) Year Ended June 30, 2015 2014 2013 Microsoft Office system $ 23,538 $ 24,323 $ 22,995 Server products and tools 18,612 17,055 15,408 Windows PC operating system 14,826 16,856 17,529 Xbox 9,121 8,643 7,100 Phone 7,702 3,073 615 Consulting and product support services 5,090 4,767 4,372 Advertising 4,557 4,016 3,387 Surface 3,900 1,883 853 Other 6,234 6,217 5,590 Total $ 93,580 $ 86,833 $ 77,849 Our total Commercial Cloud revenue was $5.8 billion, $2.8 billion, and $1.3 billion in fiscal years 2015, 2014, and +2013, respectively. These amounts are included in their respective product categories in the table above. Assets are not allocated to +segments for internal reporting presentations. A portion of amortization and depreciation is charged to the respective segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included +in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location +of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2015 2014 2013 United States $ 19,562 $ 17,653 $ 16,615 Luxembourg 6,879 6,913 6,943 Finland 1,757 9,840 12 Other countries 8,307 5,713 4,159 Total $ 36,505 $ 40,119 $ 27,729 96 Table of Contents PART II Item 8 NOTE 23 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2015 Revenue $  23,201 $  26,470 $  21,729 $  22,180 $  93,580 Gross margin 14,928 16,334 14,568 14,712 60,542 Net income (loss) 4,540 5,863 4,985 (3,195 ) (a) 12,193 (b) Basic earnings (loss) per share 0.55 0.71 0.61 (0.40 ) 1.49 Diluted earnings (loss) per share 0.54 0.71 0.61 (0.40 ) (a) 1.48 (b) Fiscal Year 2014 Revenue $  18,529 $  24,519 $  20,403 $  23,382 $  86,833 Gross margin 13,384 16,197 14,425 15,749 59,755 Net income 5,244 6,558 5,660 4,612 (c) 22,074 (c) Basic earnings per share 0.63 0.79 0.68 0.56 2.66 Diluted earnings per share 0.62 0.78 0.68 0.55 (c) 2.63 (c) (a) Includes $7.5 billion of goodwill and asset impairment charges related to Phone Hardware, as well as $940 million of integration and restructuring +expenses, primarily costs associated with our Phone Hardware Restructuring Plan, which decreased fourth quarter fiscal year 2015 net income by $8.4 billion and diluted EPS by $1.02. (b) Includes $7.5 billion of goodwill and asset impairment charges related to Phone Hardware, as well as $2.5 billion of integration and restructuring +expenses, primarily costs associated with our restructuring plans, which decreased fiscal year 2015 net income by $10.0 billion and diluted EPS by $1.15. (c) Includes a tax provision adjustment recorded in the fourth quarter of fiscal year 2014 related to adjustments to prior years’ liabilities for +intercompany transfer pricing which decreased net income by $458 million and diluted EPS by $0.05. 97 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the accompanying consolidated balance sheets of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2015 and 2014, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for each of the three years in the period +ended June 30, 2015. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in +the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the +financial position of Microsoft Corporation and subsidiaries as of June 30, 2015 and 2014, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2015, in conformity with +accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2015, based on the criteria established in Internal Control – Integrated Framework +(2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 31, 2015, expressed an unqualified opinion on the Company’s internal control over financial reporting. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 31, +2015 98 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and +with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of +the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control +over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal +control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial +statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of company assets +that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a +misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our +internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management +concluded that the company’s internal control over financial reporting was effective as of June 30, 2015. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2015 that have +materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2015; their report is +included in Item 9A. 99 Table of Contents PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the internal control over financial reporting of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2015, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway +Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying +Report of Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered +necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal +control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of +directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting +principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and +dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts +and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or +disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent +limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, +projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance +with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal +control over financial reporting as of June 30, 2015, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the +consolidated financial statements as of and for the year ended June 30, 2015, of the Company and our report dated July 31, 2015, expressed an unqualified opinion on those financial statements. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 31, +2015 100 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may +be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held December 2, 2015 (the “Proxy Statement”). Information about our Audit Committee may be found under +the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. The information +in the Proxy Statement set forth under the caption “Section 16(a) Beneficial ownership reporting compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting +Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/investor/MSFinanceCode. If we make any substantive amendments to the finance code of +ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or +waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive +officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Information regarding beneficial ownership of principal +shareholders, directors, and management” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related +transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND +SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees +billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 101 Table of Contents PART IV Item 15 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information +is otherwise included. Index to Financial Statements Page Income Statements 53 Comprehensive Income Statements 54 Balance Sheets 55 Cash Flows Statements 56 Stockholders’ Equity Statements 57 Notes to Financial Statements 58 Report of Independent Registered Public Accounting Firm 98 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 10-Q 12/31/09 3.1 1/28/10 3.2 Bylaws of Microsoft Corporation 10-K 6/30/14 3.2 7/31/14 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft +Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.5 9/27/10 102 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New +York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.6 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.7 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013 between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the +Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, +N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 103 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New +York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of +February 12, 2015, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as +Trustee 8-K 4.1 2/12/15 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 12/31/11 10.1 1/19/12 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-Q 3/31/12 10.5 4/19/12 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.12 7/30/10 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.13 7/30/10 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors X 10.17* Executive Officer Incentive Plan 8-K 10.17 9/23/13 104 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.18* Form of Executive Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan X 10.19* Resignation Agreement and Full and Final Release of Claims between Microsoft Corporation and Steven Sinofsky 10-K 6/30/13 10.19 7/30/13 10.21* Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan (Service-Based) 8-K 10.21 9/23/13 10.22* Senior Executive Severance Benefit Plan 8-K 10.22 9/26/13 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 10.25* Form of Executive Officer Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan X 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Furnished, not filed 105 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 31, 2015. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on July 31, 2015. Signature Title / S /    J OHN W. +T HOMPSON John W. Thompson Chairman / S /    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer / S /    W ILLIAM H. G ATES III William H. Gates III Director / S /    M ARIA M. +K LAWE Maria M. Klawe Director / S /    T ERI L. +L IST -S TOLL Teri L. +List-Stoll Director / S /    G. M ASON M ORFIT G. Mason Morfit Director / S /    C HARLES H. +N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    C HARLES W. +S CHARF Charles W. Scharf Director / S /    J OHN W. +S TANTON John W. Stanton Director / S /    A MY E. +H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 106 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-16-662209/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-16-662209/full-submission.txt new file mode 100644 index 0000000..74341e7 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001193125-16-662209/full-submission.txt @@ -0,0 +1,1192 @@ +Table of Contents UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2016 OR ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  +to Commission File Number +001-37845 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share +                                         NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark +if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes x No ¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange +Act.    Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter +period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its +corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was +required to submit and post such +files).    Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of +registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨ Indicate by check mark whether the +registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting +company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a +smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange +Act).    Yes ¨ No x As of December 31, 2015, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $424.5 billion based on the closing sale price as reported on the NASDAQ +National Market System. As of July 25, 2016, there were 7,792,515,573 shares of common stock outstanding. DOCUMENTS INCORPORATED +BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of +Shareholders to be held on November 30, 2016 are incorporated by reference into Part III. Table of Contents MICROSOFT CORPORATION FORM 10-K For The Fiscal +Year Ended June 30, 2016 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 15 Item 1A. Risk Factors 17 Item 1B. Unresolved Staff Comments 26 Item 2. Properties 26 Item 3. Legal Proceedings 27 Item 4. Mine Safety Disclosures 27 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 28 Item 6. Selected Financial Data 28 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 29 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 50 Item 8. Financial Statements and Supplementary Data 52 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 96 Item 9A. Controls and Procedures 96 Report of Management on Internal Control over Financial Reporting 96 Report of Independent Registered Public Accounting Firm 97 Item 9B. Other Information 98 PART III Item 10. Directors, Executive Officers and Corporate Governance 98 Item 11. Executive Compensation 98 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 98 Item 13. Certain Relationships and Related Transactions, and Director Independence 98 Item 14. Principal Accounting Fees and Services 98 PART IV Item 15. Exhibits, Financial Statement Schedules 99 Signatures 103 2 Table of Contents PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are +“forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking +statements may appear throughout this report, including the following sections: “Business,” “Management’s Discussion and Analysis,” and “Risk Factors.” These forward-looking statements generally are identified by +the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” +“should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are +subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors” (Part I, Item 1A of this Form +10-K), “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K), and “Management’s Discussion and Analysis” (Part II, Item 7 of this Form 10-K). We undertake no obligation +to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Our vision Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. Our strategy is to build best-in-class platforms and productivity services for a +mobile-first, cloud-first world. The mobile-first, cloud-first world is transforming the way individuals and organizations use and +interact with technology. Mobility is not focused on any one device; it is centered on the mobility of experiences that, in turn, are orchestrated by the cloud. Cloud computing and storage solutions provide people and enterprises with various +capabilities to store and process their data in third-party datacenters. Mobility encompasses the rich collection of data, applications, and services that accompany our customers as they move from setting to setting in their lives. We are +transforming our businesses to enable Microsoft to lead the direction of this digital transformation, and enable our customers and partners to thrive in this evolving world. What we offer Founded in 1975, we operate worldwide in over 190 countries. We develop, +license, and support a wide range of software products, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. Our products include operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; and +training and certification of computer system integrators and developers. We also design, manufacture, and sell devices, including PCs, tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories, that +integrate with our cloud-based offerings. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver +relevant online advertising to a global audience. The ambitions that drive us To carry out our strategy, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. 3 Table of Contents PART I Item 1 • Build the intelligent cloud platform. • Create more personal computing. Reinvent productivity and business processes We believe we can significantly enhance the lives of our customers using our broad portfolio of productivity, communication, and information +services that span devices and platforms. Productivity will be the first and foremost objective, to enable people to meet and collaborate more easily, and to effectively express ideas in new ways. We invent new scenarios that in turn create +opportunity for our partners and help businesses accelerate their transformation while respecting each person’s privacy choices. The foundation for these efforts will rest on advancing our leading productivity, collaboration, communication, and +business process tools including Word, Excel, PowerPoint, Outlook, OneNote, OneDrive, Skype, and Microsoft Dynamics (“Dynamics”). With Office 365, we provide these familiar industry-leading productivity and business process tools as cloud +services, enabling access from anywhere and any device. This creates an opportunity to reach new customers and expand the usage of our services by our existing customers. We see opportunity in combining our offerings in new ways that are +mobile, collaborative, intelligent and trustworthy. We offer our services across platforms and devices outside our own. As people move from device to device, so will their content and the richness of their services. We engineer our applications so +users can find, try, and buy them in friction-free ways. Build the intelligent cloud platform In deploying technology that advances business strategy, enterprises decide what solutions will make employees more productive, collaborative, and +satisfied, and connect with customers in new and compelling ways. They work to unlock business insights from a world of data. To achieve these objectives, increasingly businesses look to leverage the benefits of the cloud. Helping businesses move to +the cloud is one of our largest opportunities, and we believe we work from a position of strength. Microsoft is one of two leaders in the market. The shift to the cloud is driven by three important economies of scale: larger datacenters can deploy computational resources at significantly lower cost per unit than smaller ones; larger datacenters can +coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy lowers application maintenance labor costs for large public clouds. As +one of the largest providers of cloud computing at scale, we are well-positioned to help businesses move to the cloud and focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers like Microsoft. We believe our server products and cloud services, which include Microsoft SQL Server (“SQL Server”), Windows Server, Visual +Studio, System Center, and Microsoft Azure (“Azure”), make us the only company with a public, private, and hybrid cloud platform that can power modern business. With Azure, we are one of very few cloud vendors that run at a scale that +meets the needs of businesses of all sizes and complexities. We are working to enhance the return on IT investment by enabling enterprises to combine their existing datacenters and our public cloud into a single cohesive infrastructure. Businesses +can deploy applications in their own datacenter, a partner’s datacenter, or in our datacenters with common security, management, and administration across all environments, with the flexibility and scale they want. We enable organizations to securely adopt software-as-a-service applications, both our own and third-party, and integrate them with their existing +security and management infrastructure. We continue to innovate with higher-level services including identity and directory services that manage employee corporate identity and manage and secure corporate information accessed and stored across a +growing number of devices, rich data storage and analytics services, machine learning services, media services, web and mobile backend services, and developer productivity services. To foster a rich developer ecosystem, our platform is extensible, +enabling customers and partners to further customize and enhance our solutions, achieving even more value. This strategy requires continuing investment in datacenters and other infrastructure to support our services. 4 Table of Contents PART I Item 1 Create more personal computing We strive to make computing more personal by putting users at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. A computing device should be not +just a tool, but a partner. Windows 10 is the cornerstone of our ambition to usher in this era of more personal computing. We consider the launch of Windows 10 in July 2015 to be a transformative moment as we moved from an operating system that +runs on a PC to a service that can power the full spectrum of devices. We developed Windows 10 not only to be familiar to our users, but more safe, secure, and always up-to-date. Windows 10 is more personal and productive with functionality such as +Cortana, Windows Hello, Windows Ink, Microsoft Edge, and universal applications. Windows 10 is designed to foster innovation – from us, our partners, and developers – through rich and consistent experiences across the range of existing +devices and entirely new device categories. Our ambition for Windows 10 is to broaden our economic opportunity through three key +levers: an original equipment manufacturer (“OEM”) ecosystem that creates exciting new hardware designs for Windows 10; our own commitment to the health and profitability of our first-party premium device portfolio; and monetization +opportunities such as services, subscriptions, gaming, and search advertising. Our OEM partners are investing in an extensive portfolio of hardware designs and configurations for Windows 10. We now have the widest range of Windows hardware ever +available. With the unified Windows operating system, developers and OEMs can contribute to a thriving Windows ecosystem. We invest +heavily to make Windows the most secure, manageable, and capable operating system for the needs of a modern workforce. We are working to create a broad developer opportunity by unifying the installed base to Windows 10 through upgrades and ongoing +updates, and by enabling universal Windows applications to run across all device targets. As part of our strategic objectives, we are committed to designing and marketing first-party devices to help drive innovation, create new categories, and +stimulate demand in the Windows ecosystem. We are developing new input/output methods within Windows 10, including speech, pen, gesture, and augmented reality holograms to power more personal computing experiences. Our future opportunity There are several +distinct areas of technology that we aim to drive forward. Our goal is to lead the industry in these areas over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Delivering new productivity and business processes to improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Establishing the Windows platform across servers and devices, both our own and third-party, and the cloud to drive a thriving ecosystem of developers, unify +the cross-device user experience, and increase agility when bringing new advances to market. • Developing new devices that have increasingly natural ways to interact with them, including speech, pen, gesture, and augmented reality holograms. • Applying machine learning to make technology more intuitive and able to act on our behalf to understand and interpret our needs using natural methods of +communication. We believe the breadth of our products and services portfolio, our large global partner and customer +base, our growing ecosystem, and our ongoing investment in innovation position us to be a leader in these areas and differentiate ourselves from competitors. 5 Table of Contents PART I Item 1 OPERATING SEGMENTS Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services +organizations, and they provide a framework for timely and rational allocation of resources within businesses. In June 2015, we +announced a change in organizational structure to align to our strategic direction as a productivity and platform company. During the first quarter of fiscal year 2016, our chief operating decision maker, who is also our Chief Executive Officer, +requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we report our financial performance based on our new segments, Productivity +and Business Processes, Intelligent Cloud, and More Personal Computing. Additional information on our operating segments and geographic +and product information is contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our +Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including volume licensing and subscriptions to Office 365 commercial for products and services such as Office, Exchange, SharePoint, and +Skype for Business, and related Client Access Licenses (“CALs”). • Office Consumer, including Office sold through retail or through an Office 365 consumer subscription, and Office Consumer Services, including Skype, +Outlook.com, and OneDrive. • Dynamics business solutions, including Dynamics ERP products, Dynamics CRM on-premises, and Dynamics CRM Online. Office Commercial Office Commercial is +designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service +offerings into new markets such as security, analytics, collaboration, unified communications, and business intelligence. Office Commercial revenue is mainly affected by a combination of the demand from commercial customers for volume licensing and +Software Assurance and the number of information workers in an enterprise, as well as the continued shift to Office 365. Office 365 is our cloud-based service that provides access to Office plus other productivity services. CALs provide access +rights to certain Office Commercial products and services, including Exchange, SharePoint, and Skype for Business, and revenue is reported along with the associated Office products and services. Office Consumer Office Consumer is +designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. +Office Consumer revenue is mainly affected by the combination of customers that buy Office with their new devices and the continued shift to Office 365. Office Consumer Services revenue is mainly affected by the demand for communication and storage +through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. Skype is designed to connect friends, family, clients, and colleagues through a variety of devices. 6 Table of Contents PART I Item 1 Dynamics Dynamics provides business solutions for financial management, customer relationship management (“CRM”), supply chain management, and analytics applications for small and mid-size businesses, large +organizations, and divisions of global enterprises. Dynamics revenue is largely driven by the number of information workers licensed. Competition Competitors to Office include software and global application vendors such as Adobe Systems, Apple, Cisco Systems, Facebook, +Google, IBM, Oracle, SAP, and numerous web-based and mobile application competitors as well as local application developers in Asia and Europe. Cisco Systems is using its position in enterprise communications equipment to grow its unified +communications business. Google provides a hosted messaging and productivity suite. Apple distributes versions of its pre-installed application software, such as email, note-taking, and calendar products, through its PCs, tablets, and phones. Skype +for Business and Skype also compete with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Web-based offerings competing with individual applications have also positioned +themselves as alternatives to our products. We believe our products compete effectively based on our strategy of providing powerful, flexible, secure, and easy-to-use solutions that work well with technologies our customers already have and are +available on a device or via the cloud. Our Dynamics products compete with vendors such as Oracle and SAP in the market for large +organizations and divisions of global enterprises. In the market focused on providing solutions for small and mid-sized businesses, our Dynamics products compete with vendors such as Infor, The Sage Group, and NetSuite. Salesforce.com’s +cloud CRM offerings compete directly with our Dynamics CRM on-premises and CRM Online offerings. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This +segment primarily comprises: • Server products and cloud services, including SQL Server, Windows Server, Visual Studio, System Center, and related CALs, as well as Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. Server Products and Cloud Services Our +server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows +Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and +software development lifecycle tools for software architects, developers, testers, and project managers. Server products and cloud services revenue is mainly affected by purchases through volume licensing programs, licenses sold to OEMs, and retail +packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Azure is a scalable cloud platform with computing, networking, storage, database, and management, along with advanced services such as analytics, +and comprehensive solutions such as Enterprise Mobility Suite. Azure includes a flexible platform that helps developers build, deploy, and manage enterprise, mobile, web, and Internet of Things applications, for any platform or device without having +to worry about the underlying infrastructure. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. 7 Table of Contents PART I Item 1 Enterprise Services Enterprise Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and +certification to developers and IT professionals on various Microsoft products. Competition Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market +approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the +Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software +developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions +and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and +Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client/server environments +include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our +system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, +Oracle, other companies, and open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails, among others. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of +hardware and software applications, security, and manageability. Azure faces diverse competition from companies such as Amazon, Google, +IBM, Oracle, Salesforce.com, VMware, and open source offerings. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the +ability to run at a scale that meets the needs of businesses of all sizes and complexities. Our Enterprise Services business competes +with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal +Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across screens of all sizes. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system, volume licensing of the +Windows operating system, patent licensing, Windows Embedded, MSN display advertising, and Windows Phone licensing. • Devices, including Microsoft Surface (“Surface”), phones, and PC accessories. 8 Table of Contents PART I Item 1 • Gaming, including Xbox hardware; Xbox Live, comprising transactions, subscriptions, and advertising; video games; and third-party video game royalties. • Search advertising. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of +experience, applications, and information across their devices. We consider the launch of Windows 10 in July 2015 to be a transformative moment as we moved from an operating system that runs on a PC to a service that can power the full spectrum of +devices. Windows revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they +pre-install on the devices they sell. In addition to computing device market volume, Windows revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and emerging markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small- and medium-sized businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large +multinational OEMs, and different pricing of Windows versions licensed. • Piracy. Volume licensing +of the Windows operating system is affected mainly by the demand from commercial customers for volume licensing and Software Assurance, often reflecting the number of information workers in a licensed enterprise, and is therefore relatively +independent of the number of PCs sold in a given year. Patent licensing includes our programs to license patents across a broad array +of technology areas, including mobile devices and cloud offerings. Windows Embedded extends the power of Windows and the cloud to +intelligent systems by delivering specialized operating systems, tools, and services. Display advertising primarily includes MSN ads. +In June 2015, we entered into agreements with AOL and AppNexus to outsource our display sales responsibility. The Windows Phone +operating system is designed to bring users closer to the people, applications, and content they need. Prior to our acquisition of Nokia Corporation’s (“Nokia”) Devices and Services business (“NDS”) in April 2014, Microsoft +and Nokia jointly created new mobile products and services and extended established products and services to new markets through a strategic alliance. Devices We design, manufacture, and sell +devices such as Surface, phones, and other intelligent devices, as well as PC accessories. Our devices are designed to enable people and organizations to connect to the people and content that matter most using integrated Microsoft services and +Windows. Surface is designed to help organizations, students, and consumers to be more productive. Our latest Surface devices, the Surface Pro 4 and Surface Book, were released in October 2015. We began manufacturing and selling Microsoft Lumia +(“Lumia”) phones and other phones with the acquisition of NDS in April 2014. In July 2015, we announced a plan to restructure our phone business to better focus and align resources. In May 2016, we announced plans to further streamline our +smartphone hardware business. We also recently announced the sale of our entry-level feature phone business in May 2016. The transaction is expected to close in the second half of 2016, subject to regulatory approvals and other closing conditions. 9 Table of Contents PART I Item 1 Gaming Our gaming platform is designed to provide a unique variety of entertainment through the use of our devices, peripherals, applications, online services, and content. We released Xbox 360 and Xbox One in November +2005 and November 2013, respectively, and recently announced Xbox One S will be released in August 2016. We also launched our Windows 10 Xbox app in July 2015. Xbox Live enables people to connect and share online gaming experiences and is +accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox Live services consist of subscriptions and sales of Xbox Live enabled content, as well as advertising, and are designed to benefit users by providing access to a +network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. We also design and sell gaming content to showcase our unique platform capabilities for Xbox consoles, +Windows-enabled devices, and other devices. We acquired Mojang Synergies AB, the Swedish video game developer of the Minecraft gaming franchise, in November 2014. The addition of Minecraft and its community enhances our gaming portfolio across +Windows, Xbox, and other ecosystems besides our own. We believe the success of our gaming business is determined by the overall active user base through Xbox Live enabled content, availability of games, providing exclusive game content that gamers +seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences via online services, downloadable content, and peripherals. Search Advertising Search advertising, +including Bing and Bing Ads, is designed to deliver relevant online advertising to a global audience. We have several partnerships with other companies, including Yahoo!, in which we provide and monetize search results. Growth depends on our ability +to attract new users, understand intent, and match intent with relevant content and advertiser offerings. Competition The Windows operating system faces competition from various software products and from alternative platforms and devices, mainly from Apple and +Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. Our devices face competition from various computer, tablet, hardware, and phone manufacturers, and offer a unique combination of +high-quality industrial design and innovative technologies across various price points, many of which are also current or potential partners and customers. These manufacturers include Apple, as well as our Windows OEM partners. Our gaming platform competes with console platforms from Sony and Nintendo, both of which have a large, established base of customers. The +lifecycle for gaming and entertainment consoles averages five to ten years. Nintendo released their latest generation console in November 2012. Sony released their latest generation console in November 2013. In addition to Sony and Nintendo, we compete with other providers of entertainment services through online marketplaces. We believe our gaming +platform is effectively positioned against competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content +from our own game franchises as well as other digital content offerings. Our video games competitors include Electronic Arts and Activision Blizzard. Xbox Live faces competition from various online marketplaces, including those operated by Amazon, +Apple, and Google. Our search advertising business competes with Google and a wide array of websites, social platforms like Facebook, +and portals that provide content and online offerings to end users. 10 Table of Contents PART I Item 1 OPERATIONS We have operations centers that support all operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The +regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto +Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Australia, Europe, and Asia. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of +our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. We operate manufacturing facilities for the production and customization of phones, predominantly in Vietnam. We announced the sale of our entry-level feature phone business in May 2016, which includes the sale of +our phone manufacturing facility in Vietnam. Our devices, other than phones, are primarily manufactured by third-party contract +manufacturers. We generally have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. RESEARCH AND DEVELOPMENT During fiscal years 2016, 2015, and 2014, research and development +expense was $12.0 billion, $12.0 billion, and $11.4 billion, respectively. These amounts represented 14%, 13%, and 13% of revenue in fiscal years 2016, 2015, and 2014, respectively. We plan to continue to make significant investments in a broad +range of research and development efforts. Product and Service Development, and Intellectual Property We develop most of our products and services internally through three engineering groups. • Applications and Services Engineering Group , focuses on broad applications and services core technologies in productivity, communication, education, +search, and other information categories. • Cloud and Enterprise Engineering Group , focuses on our cloud infrastructure, server, database, CRM, enterprise resource planning, management, +development tools, and other business process applications and services for enterprises. • Windows and Devices Engineering Group , focuses on our Windows platform across devices of all types, hardware development of our devices, and associated +online marketplaces. Internal development allows us to maintain competitive advantages that come from product +differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early +as possible about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. +Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We +work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among +technology companies in pursuing patents and currently have a portfolio of over 61,000 U.S. and international patents issued and over 35,000 11 Table of Contents PART I Item 1 pending. While we employ much of our internally developed intellectual property exclusively in Microsoft products and services, we also engage in outbound and inbound licensing of specific +patented technologies that are incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We also purchase or +license technology that we incorporate into our products or services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing +interoperability, or attracting and enabling our external development community. While it may be necessary in the future to seek or +renew licenses relating to various aspects of our products and business methods, we believe, based upon past experience and industry practice, such licenses generally could be obtained on commercially reasonable terms. We believe our continuing +research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Microsoft’s success is based on our ability to create new and +compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of +emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the company. Based on our assessment of key technology trends, we maintain our long-term commitment to +research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, and devices operating systems and hardware. While our main research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other +parts of the U.S. and around the world, including Canada, China, Denmark, Finland, France, India, Ireland, Israel, Japan, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to continue to attract +top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the +business segment level. Much of our business segment level research and development is coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest computer science research organizations, and works in close +collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends and contributing to our innovation. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, distributors and resellers, online, and Microsoft retail stores. Our sales force performs a variety of functions, including +working directly with enterprises and public sector organizations worldwide to identify and meet their software requirements; managing OEM relationships; and supporting solution integrators, independent software vendors, and other partners who +engage directly with our customers to perform sales, consulting, and fulfillment functions for our products. OEMs We distribute software through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business +is the Windows operating system pre-installed on computing devices. OEMs also sell hardware pre-installed with other Microsoft products, including server and embedded operating systems and applications such as our Microsoft Office suite. In addition +to these products, we also market our services through OEMs and service bundles such as Windows with Bing or Windows with Office 365 subscription. 12 Table of Contents PART I Item 1 There are two broad categories of OEMs. The largest OEMs, many of which operate globally, are +referred to as “Direct OEMs,” as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all of the multinational +OEMs, including Acer, ASUST, Dell, Fujitsu, Hewlett-Packard, Lenovo, Samsung, Toshiba, and with many regional and local OEMs. The second broad category of OEMs consists of lower-volume PC manufacturers (also called “system builders”), +which source their Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Distributors and Resellers Many +organizations that license our products and services through Enterprise Agreements transact directly with us, with sales support from solution integrators, independent software vendors, web agencies, and developers that advise organizations on +licensing our products and services (“Enterprise Agreement Software Advisors”, or “ESAs”). Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSPs”), +distributors, value-added resellers (“VARs”), OEMs, system builder channels, and retailers. Although each type of reselling partner reaches organizations of all sizes, LSPs are primarily engaged with large organizations, distributors +resell primarily to VARs, and VARs typically reach small- and medium-sized organizations. ESAs typically are also authorized as LSPs and operate as resellers for our other licensing programs, such as the Select Plus and Open licensing programs +discussed under “Licensing Options” below. Some of our distributors include Ingram Micro and Tech Data, and some of our largest resellers include CDW, Dell, Insight Enterprises, and Software House International. Our Dynamics software offerings are also licensed to enterprises through a global network of channel partners providing vertical solutions and +specialized services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail +outlets, including Microsoft retail stores. We distribute our devices through third-party retailers and Microsoft retail stores. Our phones are also distributed through global wireless communications carriers. We have a network of field sales +representatives and field support personnel that solicit orders from distributors and resellers, and provide product training and sales support. Online Although on-premises software +continues to be an important part of our business, increasingly we are delivering additional value to customers through cloud-based services. We provide commercial cloud-based solutions such as Office 365, Azure, and Dynamics CRM Online. We also +provide online content services to consumers through Bing, MSN portals and channels, Office 365, Xbox Live, Outlook.com, OneDrive, Skype, and Windows Store. Other services delivered online include our online advertising platform with offerings for +advertisers and publishers, as well as Microsoft Developer Network subscription content and updates, periodic product updates, and online technical and practice readiness resources to support our partners in developing and selling our products and +solutions. As we increasingly deliver online services, we sell many of these cloud-based services through our enterprise agreements and have also enabled new sales programs to reach small and medium-sized businesses. These programs include +direct sales, direct sales supported by a large network of partner advisors, and resale of services through operator channels, such as telephone, cell, and cable providers. We also sell our products through our Microsoft retail stores and online marketplaces. LICENSING +OPTIONS We license software to organizations under agreements that allow the customer to acquire multiple licenses of products and +services. Our agreements for organizations to acquire multiple licenses of products and services are designed to provide them with a means of doing so without having to acquire separate licenses through retail channels. In delivering organizational +licensing agreements to the market, we use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. 13 Table of Contents PART I Item 1 Customer Licensing Programs Enterprise Agreement Licensing Designed primarily for medium- and large-sized organizations +that want to obtain the best value by standardizing on a common IT platform across their organization. Under the Enterprise Agreement, customers can acquire licenses for online services and/or software products with Software Assurance, which convey +rights to future versions of certain software products over the contract period. Software Assurance also provides support, tools, and training to help customers deploy and use software efficiently. Enterprises can elect to acquire perpetual licenses +or, under the Enterprise Subscription option, can acquire non-perpetual, subscription licenses for a specified period (generally three years). Online services are also available, and subscriptions are generally structured with three-year terms. Microsoft Product and Services Agreement Licensing Suited for medium- and large-sized organizations, the Microsoft Products and Services Agreement (“MPSA”) provides customers the ability to purchase online services subscriptions, software licenses, +software licenses with Software Assurance, and renewals of Software Assurance through a single agreement. Software Assurance and online services subscriptions are generally available for a term of up to three years. We plan on expanding the +offers under the MPSA in fiscal year 2017 to better enable organizations to obtain the best value by standardizing on a common IT platform across their organization. Select Plus Licensing Designed primarily for medium- and large-sized organizations, the +Select Plus program allows customers to acquire perpetual licenses and, at the customer’s election, Software Assurance over a specified time period (generally three years or less). Similar to Open programs, the Select Plus program allows +customers to acquire licenses only, acquire licenses with Software Assurance, or renew Software Assurance upon the expiration of existing volume licensing agreements. A subset of online services is also available for purchase through the Select Plus +program, and subscriptions are generally structured with terms between one and three years. In July 2014, we announced the retirement +over a two-year period of Select Plus agreements for commercial customers, in favor of modern licensing options. Beginning July 2015, no new Select Plus agreements were signed with commercial organizations, and customers who want to purchase +licenses were encouraged to transition to the MPSA. Starting in July 2016, we will no longer be accepting orders from commercial organizations for Select Plus after their next agreement anniversary. We expect the entire Select Plus business to +transition to the MPSA within a few years. Open Licensing Designed primarily for small- and medium-sized organizations, the Open programs allow customers to acquire perpetual or subscription licenses and, at the customer’s election, rights to future versions of +software products over a specified time period (generally two or three years depending on the specific programs used). The Open programs have several variations to fit customers’ diverse ways of purchasing. Under the Open License program, +customers can acquire licenses only or licenses with Software Assurance, and/or renew Software Assurance upon the expiration of other existing volume licensing agreements. Under the Open Value and Open Value Subscription programs, customers can +acquire perpetual or subscription licenses, respectively, over a three-year period. Online services are available in each of the Open programs. Customer Licensing Programs — Online Services Only Microsoft Online Subscription Agreement is designed to enable small and medium-sized businesses to easily purchase Microsoft Online Services. The program allows customers to acquire monthly or annual subscriptions +for cloud-based services. 14 Table of Contents PART I Item 1 Partner Programs The Microsoft Cloud Solution Provider program enables partners to directly manage their entire Microsoft cloud customer lifecycle. Partners in this program use dedicated tools to directly provision, manage, and +support their customer subscriptions. Partners can easily package their own tools, products, and services, and combine them into one monthly or annual customer bill. The Microsoft Services Provider License Agreement is a program targeted at service providers and independent software vendors allowing these partners to provide software services and hosted applications to their +end customers. Agreements are generally structured with a three-year term, and partners are billed monthly based upon consumption. The +Microsoft Online Services Reseller Agreement is a program that enables partners to package Microsoft online services with the partners’ services. The Independent Software Vendor Royalty program enables partners to use Microsoft software in their own software programs. CUSTOMERS Our customers include individual consumers, small- and medium-sized organizations, +large global enterprises, public sector institutions, Internet service providers, application developers, and OEMs. No sales to an individual customer accounted for more than 10% of revenue in fiscal years 2016, 2015, or 2014. Our practice is to +ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 28, 2016 were as follows: Name Age Position with the Company Satya Nadella 48 Chief Executive Officer Christopher C. Capossela 46 Executive Vice President, Chief Marketing Officer Jean-Philippe Courtois 55 Executive Vice President and President, Microsoft Global Sales, Marketing and Operations Kathleen T. Hogan 50 Executive Vice President, Human Resources Amy E. Hood 44 Executive Vice President, Chief Financial Officer Margaret L. Johnson 54 Executive Vice President, Business Development Bradford L. Smith 57 President and Chief Legal Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, +Cloud and Enterprise since July 2013. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, +Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Capossela was appointed Executive Vice President, Chief Marketing Officer in March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and +marketing activities with OEMs, operators, and retail partners. In his more than 20 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing +productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Mr. Courtois was named Executive Vice President and President, Microsoft Global Sales, Marketing and Operations in July 2016. Before that he +was President of Microsoft International since June 2005. He had been Chief Executive Officer, Microsoft Europe, Middle East, and Africa since March 2003. Previous to that, he had been Senior Vice 15 Table of Contents PART I Item 1 President and President, Microsoft Europe, Middle East, and Africa since July 2000. Before holding that position, he had been Corporate Vice President, Worldwide Customer Marketing since July +1998. Mr. Courtois joined Microsoft in 1984. He also serves on the Board of Directors of AstraZeneca PLC. Ms. Hogan was +appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined +Microsoft in 2003. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her +appointment as Chief Financial Officer in May 2013. Beginning in 2010, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division +Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Johnson was appointed Executive Vice President, Business Development in September 2014. Prior to that Ms. Johnson spent 24 years at Qualcomm in various leadership positions across engineering, sales, +marketing and business development. She most recently served as Executive Vice President of Qualcomm Technologies, Inc. Ms. Johnson also serves on the Board of Directors of Live Nation Entertainment, Inc. Mr. Smith was appointed President and Chief Legal Officer in September 2015. Prior to that he served as Executive Vice President, General +Counsel, and Secretary since 2011, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. He had been Deputy General Counsel for Worldwide Sales and +previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith joined Microsoft in 1993. Mr. Smith also serves on the Board of Directors of Netflix, Inc. EMPLOYEES As of +June 30, 2016, we employed approximately 114,000 people on a full-time basis, 63,000 in the U.S. and 51,000 internationally. Of the total employed people, 38,000 were in operations, including manufacturing, distribution, product support, and +consulting services; 37,000 in product research and development; 29,000 in sales and marketing; and 10,000 in general and administration. Certain employees are subject to collective bargaining agreements. In June 2015, management approved a restructuring plan that eliminated approximately 7,400 positions in fiscal year 2016, primarily in our phone +hardware business. We periodically evaluate how to best deploy the company’s resources. In the fourth quarter of 2016, management +approved restructuring plans that would result in job eliminations, primarily across our smartphone hardware business and global sales. In addition to the elimination of 1,850 positions that were announced in May 2016, approximately 2,850 roles +globally will be reduced during the year as an extension of the earlier plan, and these actions are expected to be completed by the end of fiscal year 2017. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations +website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent +information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably +practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”). • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of +these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. 16 Table of Contents PART I Item 1, 1A • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, +global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, +we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the +information we post on the social media channels listed on our Investor Relations website. ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash +flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to +lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms +whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and +disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and +consumers. Competition among platforms, ecosystems, and devices An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among +users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide +competing platforms, applications, and services. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded +with some consumer products such as personal computers, tablets, phones, gaming consoles, and wearables. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform. We also offer some +vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms +developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to +perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to 17 Table of Contents PART I Item 1A attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. In addition, some of +our devices compete with products made by our OEM partners, which may affect their commitment to our platform. • Competing platforms have application marketplaces (sometimes referred to as “stores”) with scale and significant installed bases. The variety and +utility of applications available on a platform are important to device purchasing decisions. Users incur costs to move data and buy new applications when switching platforms. To compete, we must successfully enlist developers to write +applications for our marketplace and ensure that these applications have high quality, customer appeal, and value. Efforts to compete with competitors’ application marketplaces may increase our cost of revenue and lower our operating margins. Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition to a mobile-first and cloud-first strategy, the license-based proprietary software model generates most of our software revenue. We bear +the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to +businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue +funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users, and +earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality +of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, +and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing +devices. Our strategic vision is to compete and grow as a productivity and platform company for the mobile-first and cloud-first world. At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and +business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based services to use. We are devoting significant +resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to +innovation. The Company’s increasing reliance on data-driven insights is becoming more important to the success of key opportunities in monetization, customer perceptions of quality, and operational efficiency. Besides software development +costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in +several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, +tablets, gaming consoles, and other television-related devices. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. 18 Table of Contents PART I Item 1A • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are +not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure +and development investments described above. This may negatively impact gross margins and operating income. We make significant +investments in new products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, +including the Windows operating system, the Microsoft Office system, Bing, Windows Phone, Windows Server, the Windows Store, the Microsoft Azure Services platform, Office 365, other cloud-based offerings, and the Xbox entertainment platform. We also +invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, phones, and gaming devices. Investments in new technology are speculative. Commercial success depends on +many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new +software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be +profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. The launch of Windows 10, with free upgrades available to existing users of Windows 7 and 8.1, constitutes the most ambitious update effort we have ever undertaken. We have done extensive preparation and +compatibility testing for applications and devices to help ensure a positive experience for our users installing Windows 10. However, if users have a negative upgrade experience, or the community reacts negatively to the process we are following to +promote and undertake the upgrades, the reception of Windows 10 in the marketplace may be harmed, and customers or government agencies may bring litigation or regulatory actions. In addition, we anticipate that Windows 10 will enable +new post-license monetization opportunities beyond initial license revenues. Our failure to realize these opportunities to the extent we expect could have an adverse impact on our revenues. Finally, our practices around data collection, use, +and management in Windows 10 could result in regulatory review and decisions directing us to change these practices and imposing fines. If so, we could face negative public reaction, degraded user experiences, and reduced flexibility in product +design. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases +or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and +strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. In June 2016, +we announced our acquisition of LinkedIn for approximately $26.2 billion. The LinkedIn acquisition and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we +get an unsatisfactory return on our investment, that we have difficulty integrating new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate +changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing +products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements, such as increased revenue, enhanced efficiencies, or increased market share, or the +benefits may ultimately be smaller than we expected. These events could adversely affect our operating results or financial condition. 19 Table of Contents PART I Item 1A If our goodwill or amortizable intangible assets become impaired, we may be required to record +a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review +our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating +that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in +which we participate. We may be required to record a significant charge on our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our +results of operations. For example, in the fourth quarter of fiscal year 2015, we recorded a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible assets, and in the fourth quarter of fiscal +year 2016 we recorded a $480 million charge for the impairment of intangible assets. The impairment charges for both periods related to our phone business. Our acquisition of LinkedIn will result in a significant increase in our goodwill and +intangible asset balances. We may not earn the revenues we expect from our intellectual property rights. We may not be able to adequately protect our intellectual property rights Protecting our global intellectual property rights and combating unlicensed copying and use of our software and other intellectual property is difficult. While piracy adversely affects U.S. revenue, the impact on +revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Our revenue in these markets may grow slower than the underlying device market. Similarly, the absence of +harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate consumers about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual +property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. We may not receive expected royalties from our patent licenses We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some +instances, by licensing our patents to others in return for a royalty. Changes in the law may weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and +regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest +the scope and extent of their obligations. Finally, the royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of +discovering infringements. Third parties may claim we infringe their intellectual property rights. From +time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the +rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface and Lumia phones. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, +stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek +injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the +validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may +continue to do so. 20 Table of Contents PART I Item 1A We may not be able to protect our source code from copying if there is an unauthorized +disclosure of source code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system +source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If a significant portion of our source code leaks, we might lose future trade secret protection for that source code. It may +become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the +next paragraph. Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our +competitive position. Security of Microsoft’s information technology Threats to IT security can take a variety of forms. Individual and groups of hackers, and sophisticated organizations including state-sponsored +organizations or nation-states themselves, may take steps that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software to attack our products and +services and gain access to our networks and datacenters, using social engineering techniques, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Cyber threats are constantly evolving, thereby +increasing the difficulty of detecting and successfully defending against them. Cyber threats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of +our network or data security could disrupt the security of our internal systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, +compromise confidential or technical business information harming our competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise +adversely affect our business. In addition, our internal IT environment continues to evolve. Often we are early adopters of new devices +and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls +may not keep pace with these changes as new threats emerge. Security of our products, services, devices, and customers’ data Security threats are a particular challenge to companies like us whose business is technology products and services. Threats to our own IT +infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on the +most popular operating systems, programs, and services, including many of ours, and we expect that to continue. The security of our products and services is important in our customers’ purchasing decisions. To defend against security threats, both to our internal IT systems and those of our customers, we must continuously engineer more secure products +and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities, develop mitigation technologies that help to secure customers from attacks even when software updates are not +deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide customers security tools such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our +products and services could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing +computer systems from attack, which could delay adoption of additional 21 Table of Contents PART I Item 1A products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install security patches. Any of these +actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no +assurance these provisions will withstand legal challenges. Legislative or regulatory action in these areas may increase the costs to develop, implement, or secure our products and services. Disclosure of personal data could cause liability and harm our reputation. As we continue to grow the number and +scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers. The continued occurrence of high-profile data breaches provides evidence of an external environment +increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and vendors on data +security, and other practices we follow may not prevent the improper disclosure of customer data we or our vendors store and manage. Improper disclosure could harm our reputation, lead to legal exposure to customers, or subject us to liability under +laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. +Government authorities can sometimes require us to produce customer data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to +compel disclosure. Despite our efforts to protect customer data, perceptions that the collection, use and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of +our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to +customer expectations or governmental rules or actions, may cause higher operating expenses. We may have outages, data losses, and +disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. +We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we +introduce new products and services and support the growth of existing services such as Bing, Exchange Online, Office 365, SharePoint Online, OneDrive, Skype, Xbox Live, Microsoft Azure, Outlook.com, Windows Stores, and Microsoft Account services. +We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex. It requires that we +maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data or +insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, damage to our reputation and loss of current and potential +users, subscribers, and advertisers, each of which may harm our operating results and financial condition. Government litigation and +regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, we are closely scrutinized by government agencies under U.S. and foreign +competition laws. An increasing number of governments are regulating competition law activities and this includes increased scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions +also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we +make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For +example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our 22 Table of Contents PART I Item 1A competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by +Microsoft to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining +obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file +formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM +partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their +competition laws that exert downward pressure on royalties for our intellectual property. Because these jurisdictions only recently implemented competition laws, their enforcement activities are unpredictable. Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and +businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, +including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products +to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our +associated intellectual property. • The rulings described above may be precedent in other competition law proceedings. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we +fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited. Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and +regulations. The Foreign Corrupt Practices Act and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents. From time to time, we receive +inquiries from authorities in the U.S. and elsewhere and reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Specifically, we have been cooperating with authorities in the US +in connection with reports concerning our compliance with the Foreign Corrupt Practices Act in various countries. While we devote substantial resources to our global compliance programs and have implemented policies, training, and internal controls +designed to reduce the risk of corrupt payments, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws could result in significant fines and penalties, criminal sanctions against us, our +officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Geopolitical instability may lead to sanctions and impact our ability to do business in some geographies. Operations outside the U.S. may be +affected by changes in trade protection laws, policies, and measures, sanctions, and other regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation +of U.S. trade sanctions on countries such as Iran, North Korea, Cuba, Sudan, and Syria. Other regulatory areas that may apply to our +products and online services offerings include user privacy, telecommunications, data storage and protection, and online content. For example, regulators may take the position that our offerings such as Skype are covered by laws regulating +telecommunications services. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from 23 Table of Contents PART I Item 1A jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of +regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal +claims, or fines against us. The growth of our internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, +storage, handling, and transfer of personal data continue to evolve. For example, in October 2015 the European Court of Justice (“ECJ”) invalidated the EU/U.S. safe harbor framework, in place since 2000, that enabled companies to transfer +data from EU member states to the U.S. Although other legally-recognized methods to enable data transfers currently remain valid, the reasoning of the ECJ striking down the safe harbor framework could be used to challenge those methods in future +complaints. There is a recognized need for a new regulatory safe harbor framework that will also support other methods of data transfer between the EU and U.S. Outcomes may include a new trans-Atlantic data transfer agreement, a new EU data +protection directive, or a range of legal requirements adopted by individual EU member states, or no action at all. One or more of these outcomes may result in burdensome or inconsistent requirements affecting the location and movement of our +customer and internal employee data as well as the management of that data. Compliance may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty +in competing with foreign-based firms. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly +skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. If we are less successful in our recruiting efforts, or if we cannot retain key +employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth +transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our +workforce needs. We have claims and lawsuits against us that may result in adverse outcomes. We are +subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows 10, significant business transactions, and employment practices. +Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties +and management’s view of these matters may change in the future. A material adverse impact on our consolidated financial statements could occur for the period in which the effect of an unfavorable final outcome becomes probable and reasonably +estimable. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many +foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. +We regularly are under audit by tax authorities in different jurisdictions. Economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. Although we believe our +tax estimates are reasonable, the final determination of tax audits and any related litigation in the jurisdictions where we are subject to taxation could be materially different from our historical income tax provisions and accruals. The results of +an audit or litigation could have a material effect on our consolidated financial statements in the period or periods in which that determination is made. We earn a significant amount of our operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions to the U.S. may result in higher effective tax rates for the +company. In addition, there have been proposals from Congress to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form any proposed +legislation may pass, if enacted, it could have a material adverse impact on our tax expense and cash flows. 24 Table of Contents PART I Item 1A Our hardware and software products may experience quality or supply +problems. Our vertically-integrated hardware products such as Xbox consoles, Surface devices, phones, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or +associated software. We could incur significant expenses, lost revenue, and reputational harm if we fail to detect or address such issues through design, testing, or warranty repairs. We acquire some device components from sole suppliers. Our +competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity +constraint or industry shortages, we may not obtain timely replacement supplies, resulting in reduced sales. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. +Xbox consoles, Surface devices, phones, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same +risks would apply to any other vertically-integrated hardware and software products we may offer. Our software products also may +experience quality or reliability problems. The highly sophisticated software products we develop may contain bugs and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could +cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our +exposure to liability, there is no assurance these provisions will withstand legal challenge. We strive to empower all people and +organizations to achieve more and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, and customers to make technology more accessible. If our products do not +meet customer expectations or emerging global accessibility requirements, we could lose sales opportunities or face regulatory actions. Our global business exposes us to operational and economic risks. Our customers are located in over 200 countries and +a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Emerging markets are a significant focus of our international growth strategy. The developing nature of these +markets presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Although we hedge a portion of our international +currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenue. Competitive or regulatory pressure to make our pricing structure uniform might require that we +reduce the sales price of our software in the U.S. and other countries. Catastrophic events or geopolitical conditions may disrupt +our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing +services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other +business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems could harm our ability to +conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of +prolonged service outages on our operating results. Abrupt political change, terrorist activity, and armed conflict pose a risk of +general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain +disruptions for hardware manufacturers, either of which may adversely affect our revenue. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or changes in the supply, +demand or available sources of energy or other natural resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of +powering and cooling computer hardware we use to develop software and provide cloud-based services. 25 Table of Contents PART I Item 1A, 1B, 2 Adverse economic or market conditions may harm our +business. Worsening economic conditions, including inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other +computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal government shutdown resulting from +failing to pass budget appropriations, adopt continuing funding resolutions or raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT spending on our products and services +and adversely affect our revenue. Our product distribution system relies on an extensive partner and retail network. OEMs building +devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, +allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various +holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that affect global financial markets. A significant part of our investment +portfolio comprises U.S. government securities. If global credit and equity markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment +portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial results. ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more +preceding the end of our fiscal year 2016 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, +Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 500 acres of land +we own at our corporate headquarters, and approximately five million square feet of space we lease. In addition, we own and lease space domestically that includes office, retail, and datacenter space. We also own and lease facilities internationally. Properties that we own include: our research and development centers in China and India; our +operations in Ireland and Singapore; our phone manufacturing facilities, predominantly in Vietnam; and our facilities in the United Kingdom. The largest leased office spaces include the following locations: Finland, China, India, Germany, the United +Kingdom, Canada, and Japan. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described in the “Research and Development” section of Item 1 of this Form 10-K. The table below shows a summary of facilities owned and leased domestically and internationally as of June 30, 2016: (Square feet in millions) Location Owned Leased Total U.S. 16.4 9.7 26.1 International 9.0 10.8 19.8 Total 25.4 20.5 45.9 26 Table of Contents PART I Item 3, 4 I TEM 3. LEGAL PROCEEDINGS While not material to the Company, the Company makes the following annual report of the general activities of the Company’s Antitrust +Compliance Office as required by the Final Order and Judgment in Barovic v. Ballmer et al, United States District Court for the Western District of Washington (“Final Order”). For more information see +http://aka.ms/MSLegalNotice2015. These annual reports will continue through 2020. During fiscal year 2016, the Antitrust Compliance Office (a) monitored the Company’s compliance with the European Commission Decision of March 24, 2004, +(“2004 Decision”) and with the Company’s Public Undertaking to the European Commission dated December 16, 2009 (“2009 Undertaking”); (b) monitored, in the manner required by the Final Order, employee, customer, +competitor, regulator, or other third-party complaints regarding compliance with the 2004 Decision, the 2009 Undertaking, or other EU or U.S. laws or regulations governing tying, bundling, and exclusive dealing contracts; and, (c) monitored, in +the manner required by the Final Order, the training of the Company’s employees regarding the Company’s antitrust compliance polices. In addition, the Antitrust Compliance Officer reports to the Regulatory and Public Policy Committee +of the Board at each of its regularly scheduled meetings and to the full Board annually. See Note 17 – Contingencies of the Notes +to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4 . MINE SAFETY DISCLOSURES Not applicable. 27 Table of Contents PART II Item 5, 6 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our +common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 25, 2016, there were 106,534 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2016 High $  48.41 $  56.85 $  55.64 $  56.77 $  56.85 Low $  39.72 $  43.75 $  48.19 $  48.04 $  39.72 Fiscal Year 2015 High $  47.57 $  50.05 $  47.91 $  49.54 $  50.05 Low $  41.05 $  42.10 $  40.23 $  40.12 $  40.12 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding dividends and share repurchases by quarter. Following are our +monthly stock repurchases for the fourth quarter of fiscal year 2016, all of which were made as part of publicly announced plans or programs: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2016 – April 30, 2016 23,687,526 $ 53.72 23,687,526 $  9,410 May 1, 2016 – May 31, 2016 11,691,472 $ 50.51 11,691,472 $  8,820 June 1, 2016 – June 30, 2016 34,576,695 $ 50.23 34,576,695 $  7,083 69,955,693 69,955,693 All repurchases were made using cash resources. Our stock repurchases may occur through open market purchases or +pursuant to a Rule 10b5-1 trading plan. ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2016 2015 2014 (d) 2013 2012 Revenue $ 85,320 (a) $ 93,580 $ 86,833 $ 77,849 $ 73,723 Gross margin $ 52,540 (a) $ 60,542 $ 59,755 $ 57,464 $ 56,193 Operating income $ 20,182 (a)(b) $ 18,161 (c) $ 27,759 $ 26,764 (e) $ 21,763 (f) Net income $ 16,798 (a)(b) $ 12,193 (c) $ 22,074 $ 21,863 (e) $ 16,978 (f) Diluted earnings per share $ 2.10 (a)(b) $ 1.48 (c) $ 2.63 $ 2.58 (e) $ 2.00 (f) Cash dividends declared per share $ 1.44 $ 1.24 $ 1.12 $ 0.92 $ 0.80 Cash, cash equivalents, and short-term investments $ 113,240 $ 96,526 $ 85,709 $ 77,022 $ 63,040 Total assets $ 193,694 $ 174,472 (g) $ 170,675 (g) $ 140,962 (g) $ 119,388 (g) Long-term obligations $ 62,340 $ 44,742 (g) $ 35,391 (g) $ 24,601 (g) $ 20,337 (g) Stockholders’ equity $ 71,977 $ 80,083 $ 89,784 $ 78,944 $ 66,363 28 Table of Contents PART II Item 6, 7 (a) Reflects the impact of the net revenue deferral from Windows 10 of $6.6 billion, which decreased operating income, net income, and diluted earnings per +share (“EPS”) by $6.6 billion, $4.6 billion, and $0.58, respectively . (b) Includes $630 million of asset impairment charges related to our phone business, and $480 million of restructuring charges associated with our phone +business restructuring plans, which together decreased operating income, net income, and diluted EPS by $1.1 billion, $895 million, and $0.11, respectively. (c) Includes $7.5 billion of goodwill and asset impairment charges related to our phone business, and $2.5 billion of integration and restructuring expenses, +primarily associated with our phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $10.0 billion, $9.5 billion, and $1.15, respectively. (d) On April 25, 2014, we acquired substantially all of NDS. NDS has been included in our consolidated results of operations starting on the acquisition +date . (e) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased operating income and net income by $733 million +(€561 million) and diluted EPS by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased operating income, net income, and diluted EPS by $900 million, $596 +million, and $0.07, respectively. (f) Includes a goodwill impairment charge related to our previous Online Services Division business segment (related to More Personal Computing under our +current segment structure) which decreased operating income and net income by $6.2 billion and diluted EPS by $0.73. (g) Reflects the impact of the adoption of the new accounting standard in fiscal year 2016 related to balance sheet classification of deferred taxes. See Note +1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. I TEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis (“MD&A”) is intended to help the reader understand the results of operations +and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes to Financial Statements. OVERVIEW Microsoft is a +technology company whose mission is to empower every person and every organization on the planet to achieve more. Our strategy is to build best-in-class platforms and productivity services for a mobile-first, cloud-first world. We develop, license, +and support a wide range of software products, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. We generate revenue by licensing and supporting an array of software products, by offering a wide range of services, including cloud-based services to consumers and businesses, by designing, manufacturing, and +selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling +our products and services; datacenter costs in support of our cloud-based services; and income taxes. Much of our focus in fiscal year +2016 was toward transforming our organization to support our strategy of building best-in-class platforms and productivity services for a mobile-first, cloud-first world. We achieved product development milestones, implemented organizational +changes, and made strategic and tactical moves to support the three central ambitions that support our strategy: reinventing productivity and business processes; building the intelligent cloud platform; and creating more personal computing. Highlights from fiscal year 2016 included: • Commercial cloud annualized revenue run rate* exceeded $12.1 billion. • Office 365 Consumer subscribers increased to 23.1 million. 29 Table of Contents PART II Item 7 • Microsoft Dynamics (“Dynamics”) CRM Online seat additions more than doubled year-over-year. • Microsoft Azure (“Azure”) revenue grew 113%, with usage of Azure compute and Azure SQL database more than doubling year-over-year. Enterprise +Mobility customers nearly doubled year-over-year to over 33,000. • Windows 10 is now active on more than 350 million devices around the world. • Xbox Live monthly active users grew 33% year-over-year to 49 million. * Commercial cloud annualized revenue run rate is calculated by multiplying revenue for the last month of the quarter by twelve for Office 365 commercial, +Azure, Dynamics Online, and other cloud properties. In June 2016, we entered into a definitive agreement to +acquire LinkedIn for $196 per share in an all-cash transaction valued at $26.2 billion, inclusive of LinkedIn’s net cash (the “Merger Agreement”). We will finance the transaction primarily through the issuance of new indebtedness. The +Merger Agreement has been unanimously approved by the Boards of Directors of both Microsoft and LinkedIn, and we expect the acquisition will close in calendar year 2016, subject to approval by LinkedIn’s shareholders, satisfaction of certain +regulatory approvals, and other customary closing conditions. The acquisition is anticipated to accelerate the growth of LinkedIn, as well as Office 365 and Dynamics. In May 2016, we announced the sale of our entry-level feature phone business for $350 million. The transaction is expected to close in the second half of 2016, subject to regulatory approvals and other closing +conditions. In July 2015, we announced a plan to restructure our phone business to better focus and align resources. In May 2016, we +announced plans to further streamline our smartphone hardware business. These changes in the phone business reinforce our strategy to create a vibrant Windows ecosystem with a single set of experiences across our first-party device family and +original equipment manufacturer (“OEM”) offerings. Part of this strategy involves focusing our phone devices on a narrower range of customer categories and differentiating through the combination of hardware and software we are uniquely +positioned to offer. As anticipated, our change in phone strategy resulted in a reduction in units sold and associated expenses in fiscal year 2016, and this trend is expected to continue in fiscal year 2017. Industry Trends Our industry is dynamic +and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At +Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. Economic Conditions, Challenges, and Risks The market for software, devices, and cloud-based services is dynamic and highly competitive. Our competitors are developing new software and +devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice +of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in devices and infrastructure will continue to increase our operating +costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. +We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across +many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. 30 Table of Contents PART II Item 7 Our international operations provide a significant portion of our total revenue and expenses. Many +of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. The strengthening of the U.S. dollar relative to certain foreign +currencies throughout fiscal year 2015, and continuing into fiscal year 2016, negatively impacted reported revenue and reduced reported expenses from our international operations. See a discussion of these factors and other risks under Risk Factors (Part I, Item 1A of this Form 10-K). Seasonality Our revenue historically has +fluctuated quarterly and has generally been highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Unearned Revenue Quarterly and annual revenue is impacted +by the deferral of revenue, primarily including: • Revenue deferred on Windows 10 licenses to reflect ratable recognition over the life of the device. • Revenue deferred on bundled products and services (“Bundled Offerings”). If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, +the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Product Revenue and Service and Other Revenue Due to the growth in our cloud-based solutions, +service revenue exceeded 10% of total revenue for the first time in fiscal year 2016. As a result, we have separately disclosed product revenue and service and other revenue on our consolidated income statements. Product revenue includes sales from operating systems; cross-device productivity applications; server applications; business solution applications; +desktop and server management tools; software development tools; video games; hardware such as PCs, tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories; and training and certification of computer +system integrators and developers. Service and other revenue includes sales from cloud-based solutions that provide customers with +software, services, platforms, and content such as Office 365, Azure, Dynamics CRM Online, and Xbox Live; solution support; and consulting services. Service and other revenue also includes sales from online advertising. Reportable Segments The segment amounts +included in MD&A are presented on a basis consistent with our internal management reporting. Segment information appearing in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of +this Form 10-K) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the United States (“U.S. GAAP”), along with certain corporate-level and other +activity, are included in Corporate and Other. In June 2015, we announced a change in organizational structure to align to our +strategic direction as a productivity and platform company. During the first quarter of fiscal year 2016, our chief operating decision maker, who is also our Chief Executive Officer, requested changes in the information that he regularly reviews for +purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we report our financial performance based on our new segments, Productivity and Business Processes, Intelligent Cloud, and More Personal +Computing, and analyze operating income as the measure of segment profitability. We have recast certain previously reported amounts to conform to the way we internally manage and monitor segment performance. 31 Table of Contents PART II Item 7 We expect to report the financial performance of LinkedIn as part of our Productivity and Business +Processes segment. Additional information on our reportable segments is contained in Note 21 – Segment Information and Geographic +Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2016 2015 2014 Percentage Change 2016 Versus 2015 Percentage Change 2015 Versus 2014 Revenue $ 85,320 $ 93,580 $ 86,833 (9)% 8% Gross margin $ 52,540 $ 60,542 $ 59,755 (13)% 1% Operating income $ 20,182 $ 18,161 $ 27,759 11% (35)% Diluted earnings per share $ 2.10 $ 1.48 $ 2.63 42% (44)% Fiscal year 2016 compared with fiscal year 2015 Revenue decreased $8.3 billion or 9%, primarily due to the impact of the net revenue deferral from Windows 10 of $6.6 billion and an unfavorable foreign currency impact of approximately $3.8 billion or 4%. Windows +10 revenue is primarily recognized at the time of billing in the More Personal Computing segment, and the deferral and subsequent recognition of revenue is reflected in Corporate and Other. More Personal Computing revenue decreased, mainly due to +lower revenue from Devices and Windows, offset in part by higher revenue from search advertising and Gaming. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services and Enterprise Services. +Productivity and Business Processes revenue increased slightly, driven by an increase in Office and Dynamics revenue. Operating income +increased $2.0 billion or 11%, primarily due to a decrease in impairment, integration, and restructuring expenses and sales and marketing expenses, offset in part by lower gross margin. Gross margin decreased $8.0 billion or 13%, driven by the +decline in revenue as discussed above, and included an unfavorable foreign currency impact of approximately $3.3 billion or 5%. Productivity and Business Processes and More Personal Computing gross margin decreased, offset in part by higher gross +margin from Intelligent Cloud. Key changes in expenses were: • Cost of revenue decreased $258 million or 1%, mainly due to a reduction in phone sales, driven by the change in strategy for the phone business, offset in +part by growth in commercial cloud and search advertising. • Impairment, integration, and restructuring expenses decreased $8.9 billion, primarily driven by prior year goodwill and asset impairment charges related to +our phone business and restructuring charges associated with our phone business restructuring plans. • Sales and marketing expenses decreased $1.0 billion or 6%, driven by a reduction in phone expenses and a favorable foreign currency impact of approximately +2%. Diluted earnings per share (“EPS”) was $2.10 for fiscal year 2016. Current year diluted EPS was +negatively impacted by the net revenue deferral from Windows 10 and impairment, integration, and restructuring expenses, which resulted in a decrease to diluted EPS of $0.69, and favorably impacted by the adoption of new accounting guidance related +to stock-based compensation, which resulted in an increase to diluted EPS of $0.05. Diluted EPS was $1.48 for fiscal year 2015. Prior year diluted EPS was negatively impacted by impairment, integration, and restructuring expenses, which resulted in +a decrease to diluted EPS of $1.15. 32 Table of Contents PART II Item 7 Fiscal year 2015 compared with fiscal year 2014 Revenue increased $6.7 billion or 8%, primarily due to higher revenue from More Personal Computing and Intelligent Cloud. More Personal Computing +revenue increased, primarily due to higher revenue from Devices, search advertising and Gaming, offset in part by a decline in Windows revenue. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud +services. Revenue included an unfavorable foreign currency impact of approximately 2%. Operating income decreased $9.6 billion or 35%, +primarily due to impairment, integration, and restructuring expenses in fiscal year 2015, as well as increased research and development expenses, offset in part by higher gross margin. Gross margin increased $787 million or 1%, driven by our +Intelligent Cloud, offset in part by a reduction in gross margin from Productivity and Business Processes. Key changes in expenses were: • Cost of revenue increased $6.0 billion or 22%, mainly due to phone sales, as well as increasing costs in support of our commercial cloud, including $396 +million of higher datacenter expenses. • Impairment, integration, and restructuring expenses were $10.0 billion in fiscal year 2015, reflecting goodwill and asset impairment charges of $7.5 billion +related to our phone business, and $2.5 billion of integration and restructuring expenses, primarily driven by costs associated with our phone business restructuring plans. • Research and development expenses increased $665 million or 6%, mainly due to increased investment in new products and services, including phone expenses, +offset in part by reduced headcount-related expenses. Diluted EPS was $1.48 for fiscal year 2015. Diluted EPS was +negatively impacted by impairment, integration, and restructuring expenses, which decreased diluted EPS by $1.15. SEGMENT RESULTS OF +OPERATIONS (In millions, except percentages) 2016 2015 2014 Percentage Change 2016 Versus 2015 Percentage Change 2015 Versus 2014 Revenue Productivity and Business Processes $ 26,487 $ 26,430 $ 26,976 0% (2)% Intelligent Cloud 25,042 23,715 21,735 6% 9% More Personal Computing 40,460 43,160 38,460 (6)% 12% Corporate and Other (6,669 ) 275 (338 ) * * Total revenue $ 85,320 $ 93,580 $ 86,833 (9)% 8% Operating income (loss) Productivity and Business Processes $ 12,461 $ 13,359 $ 14,173 (7)% (6)% Intelligent Cloud 9,358 9,871 8,446 (5)% 17% More Personal Computing 6,142 4,667 5,605 32% (17)% Corporate and Other (7,779 ) (9,736 ) (465 ) * * Total operating income $ 20,182 $ 18,161 $ 27,759 11% (35)% * Not meaningful 33 Table of Contents PART II Item 7 Reportable Segments Fiscal year 2016 compared with fiscal year 2015 Productivity and Business Processes Productivity and Business Processes revenue increased slightly, primarily due to an increase in Office and Dynamics revenue. Revenue included an +unfavorable foreign currency impact of approximately 6%. • Office Commercial revenue increased $135 million or 1%, driven by higher revenue from Office 365 commercial, mainly due to growth in subscribers, offset by +lower transactional license volume, reflecting a continued shift to Office 365 commercial and a decline in the business PC market. Revenue included an unfavorable foreign currency impact of approximately 6%. • Office Consumer revenue decreased $69 million or 2%, driven by a decline in the consumer PC market, offset in part by higher revenue from Office 365 consumer, +mainly due to growth in subscribers. Revenue included an unfavorable foreign currency impact of approximately 4%. • Dynamics revenue increased 4%, mainly due to higher revenue from Dynamics CRM Online, driven by seat growth. Revenue included an unfavorable foreign currency +impact of approximately 6%. Productivity and Business Processes operating income decreased $898 million or 7%, driven +by lower gross margin. Gross margin decreased $970 million or 4%, primarily due to higher cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 6%. Cost of revenue increased $1.0 billion or 26%, primarily due +to an increased mix of cloud offerings. Operating expenses decreased $72 million or 1%, driven by lower sales and marketing expenses. Sales and marketing expenses decreased $82 million or 2%, mainly due to a reduction in headcount-related expenses +and lower fees paid to third-party enterprise software advisors. Intelligent Cloud Intelligent Cloud revenue increased $1.3 billion or 6%, primarily due to higher server products and cloud services revenue and Enterprise Services +revenue. Revenue included an unfavorable foreign currency impact of approximately 5%. • Server products and cloud services revenue grew $686 million or 4%, driven by revenue growth from Azure of 113%, offset in part by a decline in transactional +revenue from our on-premises server products. Revenue included an unfavorable foreign currency impact of approximately 5%. • Enterprise Services revenue grew $536 million or 11%, mainly due to growth in Premier Support Services. Revenue included an unfavorable foreign currency +impact of approximately 5%. Intelligent Cloud operating income decreased $513 million or 5%, primarily due to higher +operating expenses, offset in part by higher gross margin. Operating expenses increased $989 million or 12%, mainly due to higher research and development expenses and sales and marketing expenses. Research and development expenses increased $567 +million or 21% and sales and marketing expenses increased $347 million or 9%, driven by increased strategic investments and acquisitions to drive cloud sales capacity and innovation. Gross margin increased $476 million or 3%, driven by revenue +growth, offset in part by higher cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 5%. Cost of revenue increased $851 million or 15%, primarily driven by an increased mix of cloud services. More Personal Computing More Personal +Computing revenue decreased $2.7 billion or 6%, mainly due to lower revenue from Devices and Windows, offset in part by higher revenue from search advertising and Gaming. Revenue included an unfavorable foreign currency impact of approximately 2%. • Devices revenue decreased $3.7 billion or 32%, mainly due to lower revenue from phones, driven by the change in strategy for the phone business, offset in +part by higher Microsoft Surface (“Surface”) revenue. 34 Table of Contents PART II Item 7 Phone revenue decreased $4.2 billion or 56%, as we sold 13.8 million Microsoft Lumia (“Lumia”) phones and 75.5 million other phones in fiscal year 2016, compared with +36.8 million and 126.8 million sold, respectively, in fiscal year 2015. Surface revenue increased $486 million or 13%, primarily driven by the release of Surface Pro 4 and Surface Book in the second quarter of fiscal year 2016, as well as +the release of Surface 3 in the fourth quarter of fiscal year 2015, offset in part by a decline in revenue from Surface Pro 3. Devices revenue included an unfavorable foreign currency impact of approximately 3%. • Windows revenue decreased $871 million or 5%, mainly due to lower revenue from patent licensing, Windows OEM licensing (“Windows OEM”), and Windows +Phone licensing. Patent licensing revenue decreased 27%, due to a decline in license revenue per unit and licensed units. Windows OEM revenue decreased 1%. Windows OEM Pro revenue declined 6%, driven by a decline in the business PC market. Windows +OEM non-Pro revenue increased 7%, outperforming the consumer PC market, driven by a higher mix of premium licenses sold. Windows Phone licensing revenue decreased 64%, driven by the recognition of deferred revenue in fiscal year 2015 from Windows +Phone 8. Windows revenue included an unfavorable foreign currency impact of approximately 2%. • Search advertising revenue increased $1.7 billion or 46%. Search advertising revenue, excluding traffic acquisition costs, increased 17%, primarily driven by +growth in Bing, due to higher revenue per search and search volume. Search advertising revenue included an unfavorable foreign currency impact of approximately 2%. • Gaming revenue increased $132 million or 1%, primarily due to higher revenue from Xbox Live and video games, offset in part by lower Xbox hardware revenue. +Xbox Live revenue increased 17%, driven by higher revenue per transaction and volume of transactions. Video games revenue grew 34%, driven by the launch of Halo 5 and sales of Minecraft. We acquired Mojang AB (“Mojang”), the Swedish video +game developer of the Minecraft gaming franchise, in November 2014. Xbox hardware revenue decreased 16%, mainly due to lower prices of Xbox One consoles sold and a decline in Xbox 360 console volume, offset in part by higher Xbox One console volume. +Gaming revenue included an unfavorable foreign currency impact of approximately 4%. More Personal Computing operating +income increased $1.5 billion or 32%, primarily due to lower operating expenses, offset in part by lower gross margin. Operating expenses decreased $2.0 billion or 13%, mainly due to lower sales and marketing expenses and research and development +expenses. Sales and marketing expenses decreased $1.3 billion or 19% and research and development expenses decreased $676 million or 10%, driven by a reduction in phone expenses. Gross margin decreased $564 million or 3%, reflecting lower revenue, +offset in part by a reduction in cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 5%. Cost of revenue decreased $2.1 billion or 9%, primarily driven by a reduction in phone sales, offset in part by +higher search advertising cost of revenue. Fiscal year 2015 compared with fiscal year 2014 Productivity and Business Processes Productivity and Business Processes revenue decreased $546 million or 2%, mainly due to a decline in revenue from Office, offset in part by growth +in revenue from Dynamics. Revenue included an unfavorable foreign currency impact of approximately 2%. • Office Consumer revenue decreased $624 million or 17%, driven by declines in the Japan PC market, where Office is predominantly pre-installed on new PCs, +offset in part by subscriber growth of Office 365 consumer. • Office Commercial revenue decreased $152 million or 1%, driven by lower transactional license volume, reflecting a decline in the business PC market following +Windows XP end of support in the prior year, and declines in Japan, offset in part by subscriber growth and higher premium mix of Office 365 commercial. • Dynamics revenue grew 12%, mainly due to higher revenue from Dynamics CRM Online and Dynamics ERP products. Dynamics users increased, with 30% growth in +number of Dynamics paid seats, and we ended fiscal year 2015 with over eight million paid seats. 35 Table of Contents PART II Item 7 Productivity and Business Processes operating income decreased $814 million or 6%, driven by lower +gross margin, offset in part by a reduction in operating expenses. Gross margin decreased $1.0 billion or 4%, primarily due to the decline in Office Consumer revenue. Gross margin included an unfavorable foreign currency impact of approximately 2%. +Cost of revenue increased $492 million or 15%, primarily due to higher cloud infrastructure expenses, reflecting increased datacenter capacity to serve our Office 365 offerings. Operating expenses decreased $224 million or 2%. Sales and marketing +and general and administrative expenses decreased $258 million and $125 million, respectively, mainly due to lower headcount-related expenses. Research and development expenses increased $159 million or 6%, mainly due to increased investment in new +products and services. Intelligent Cloud Intelligent Cloud revenue increased $2.0 billion or 9%, mainly due to higher server products and services revenue, as well as higher Enterprise Services revenue. Revenue included an unfavorable foreign currency +impact of approximately 2%. • Server products and cloud services revenue grew $1.6 billion or 9%, primarily driven by higher premium mix of Microsoft SQL Server, Windows Server, and System +Center, as well as continued revenue growth from Azure. • Enterprise Services revenue grew $325 million or 7%, mainly due to growth in Premier Support Services. Intelligent Cloud operating income increased $1.4 billion or 17%, primarily due to higher gross margin, offset in part by higher operating +expenses. Gross margin increased $1.6 billion or 10%, driven by revenue growth from our server products and services. Gross margin included an unfavorable foreign currency impact of approximately 2%. Cost of revenue increased $404 million or 7%, +mainly due to higher cloud infrastructure expenses, reflecting increased datacenter capacity for our Azure services. Operating expenses increased $151 million or 2%, driven by higher research and development expenses. Research and development +expenses increased $160 million or 6%, mainly due to increased investment in new products and services. More Personal Computing More Personal Computing revenue increased $4.7 billion or 12%, mainly due to growth in Devices, search advertising, and Gaming revenue, offset in +part by a decline in revenue from Windows. • Devices revenue increased $7.0 billion or 152%, mainly due to a full year of phone sales and higher Surface revenue. Devices revenue included an unfavorable +foreign currency impact of approximately 5%. Phones revenue increased $5.5 billion, as we sold 36.8 million Lumia phones and 126.8 million other phones in fiscal year 2015, compared with 5.8 million and 30.3 million sold, +respectively, in fiscal year 2014 following the acquisition of Nokia Corporation’s (“Nokia”) Devices and Services business (“NDS”). We acquired NDS in the fourth quarter of fiscal year 2014. Surface revenue increased 65% to +$3.6 billion, primarily due to Surface Pro 3 units sold. Surface Pro 3 was released in June 2014. • Search advertising revenue increased $651 million or 22%, primarily driven by growth in Bing, due to higher revenue per search and search volume. • Gaming revenue increased $463 million or 5%, mainly due to growth in Xbox Live and video games revenue, offset in part by a decrease in Xbox hardware revenue +and third-party video game royalties. We sold 12.1 million Xbox consoles in fiscal year 2015 compared with 11.7 million consoles in fiscal year 2014. Xbox Live revenue increased $500 million, driven by increased Xbox Live users and revenue +per user. Video games revenue increased $265 million, mainly due to sales of Minecraft following the acquisition of Mojang in November 2014, and new Xbox titles released in the current year. • Windows revenue decreased $3.6 billion or 16%, mainly due to lower revenue from Windows OEM and Windows Phone. Windows OEM revenue decreased $1.9 billion or +15%, primarily due to declines of 15% in OEM Pro revenue and 16% in OEM non-Pro revenue. Windows OEM Pro revenue decreased, primarily due to benefits realized from the expiration of support for Windows XP in the prior year, and declines in the 36 Table of Contents PART II Item 7 business PC market. Windows OEM non-Pro revenue declined, mainly due to an increased mix of opening price point devices sold, and declines in the consumer PC market. Windows Phone revenue, +including related patent licensing, decreased $1.4 billion or 55%, primarily due to prior year revenue associated with our joint strategic initiatives with Nokia that terminated when we acquired NDS. More Personal Computing operating income decreased $938 million or 17%, primarily due to higher operating expenses, as well as a reduction in gross +margin. Gross margin decreased $364 million or 2%, reflecting a reduction in Windows gross margin, offset in part by an increase in devices gross margin. Cost of revenue increased $5.1 billion or 28%, driven by higher phones cost of revenue, as well +as higher Xbox Live and search infrastructure costs, offset in part by a reduction in Windows Phone cost of revenue. Phones cost of revenue increased $4.8 billion, reflecting a full year of phone sales in fiscal year 2015. Windows Phone cost of +revenue decreased $897 million, driven by prior year costs associated with our joint strategic initiatives with Nokia that terminated when we acquired NDS. Operating expenses increased $574 million or 4%, driven by a full year of NDS expenses. +Research and development expenses increased $346 million or 5%, mainly due to increased investment in new product and services, including higher phone expenses, offset in part by reduced headcount-related expenses. Sales and marketing expenses +increased $211 million or 3%, primarily due to higher phone expenses, offset in part by a decline in advertising and other marketing program costs. Corporate and Other Corporate and Other +revenue primarily comprises certain revenue deferrals, including those related to Windows 10, Bundled Offerings, and video games. Corporate and Other operating income (loss) primarily comprises revenue deferrals and corporate-level activity not +specifically allocated to a segment, including impairment, integration, and restructuring expenses. Fiscal year 2016 compared with fiscal year 2015 Corporate and Other revenue decreased $6.9 billion, primarily due to the impact of the net revenue deferral from Windows 10. During +fiscal year 2016, we deferred net revenue from Windows 10 of $6.6 billion. During fiscal year 2015, we recognized a net $303 million of previously deferred revenue related to Bundled Offerings. Corporate and Other operating loss decreased $2.0 billion, primarily due to an $8.9 billion reduction in impairment, integration, and restructuring +expenses, driven by prior year goodwill and asset impairment charges related to our phone business, offset in part by lower revenue. Fiscal year +2015 compared with fiscal year 2014 Corporate and Other revenue increased $613 million, primarily due to the timing of net revenue +deferrals compared to the prior year. During fiscal year 2015, we recognized a net $303 million of previously deferred revenue related to Bundled Offerings. During fiscal year 2014, we deferred a net $349 million of revenue related to Bundled +Offerings. Corporate and Other operating loss increased $9.3 billion, primarily due to higher impairment, integration, and +restructuring expenses, offset in part by increased revenue. OPERATING EXPENSES Research and Development (In millions, except percentages) 2016 2015 2014 Percentage Change 2016 Versus 2015 Percentage Change 2015 Versus 2014 Research and development $ 11,988 $ 12,046 $ 11,381 0% 6% As a percent of revenue 14% 13% 13% 1ppt 0ppt 37 Table of Contents PART II Item 7 Research and development expenses include payroll, employee benefits, stock-based compensation +expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international +markets, and the amortization of purchased software code. Fiscal year 2016 compared with fiscal year 2015 Research and development expenses decreased $58 million, primarily due to a reduction in phone expenses, driven by the change in strategy for the +phone business, offset in part by increased strategic investments and acquisitions to drive cloud innovation. Fiscal year 2015 compared with fiscal +year 2014 Research and development expenses increased $665 million or 6%, mainly due to increased investment in new products and +services, including $739 million higher phone expenses, offset in part by reduced headcount-related expenses. Sales and Marketing (In millions, except percentages) 2016 2015 2014 Percentage Change 2016 Versus 2015 Percentage Change 2015 Versus 2014 Sales and marketing $ 14,697 $ 15,713 $ 15,811 (6)% (1)% As a percent of revenue 17% 17% 18% 0ppt (1)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other +headcount-related expenses associated with sales and marketing personnel and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2016 compared with fiscal year 2015 Sales and marketing expenses decreased $1.0 +billion or 6%, primarily due to a reduction in phone expenses, driven by the change in strategy for the phone business. Expenses included a favorable foreign currency impact of approximately 2%. Fiscal year 2015 compared with fiscal year 2014 Sales and marketing expenses decreased $98 million or 1%, primarily due to a decline in advertising and marketing programs costs and a reduction in headcount-related expenses, offset in part by an increase in phone +expenses. Expenses included a favorable foreign currency impact of approximately 4%. General and Administrative (In millions, except percentages) 2016 2015 2014 Percentage Change 2016 Versus 2015 Percentage Change 2015 Versus 2014 General and administrative $ 4,563 $ 4,611 $ 4,677 (1)% (1)% As a percent of revenue 5% 5% 5% 0ppt 0ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance +expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. 38 Table of Contents PART II Item 7 Fiscal year 2016 compared with fiscal year 2015 General and administrative expenses decreased $48 million or 1%, primarily due to a reduction in employee-related expenses, offset in part by +increased investments in infrastructure supporting our business transformation. Expenses included a favorable foreign currency impact of approximately 2%. Fiscal year 2015 compared with fiscal year 2014 General and administrative expenses were comparable to the +prior year. IMPAIRMENT, INTEGRATION, AND RESTRUCTURING EXPENSES Impairment, integration, and restructuring expenses include costs associated with the impairment of goodwill and intangible assets related to our +phone business, employee severance expenses and costs associated with the consolidation of facilities and manufacturing operations related to restructuring activities, and systems consolidation and other business integration expenses associated with +our acquisition of NDS. Fiscal year 2016 compared with fiscal year 2015 Impairment, integration, and restructuring expenses were $1.1 billion for fiscal year 2016, compared to $10.0 billion for fiscal year 2015. During fiscal year 2016, we recorded $630 million of asset impairment charges related to our phone business. We also recorded $480 +million of restructuring charges, including employee severance expenses and contract termination costs, primarily related to our previously announced phone business restructuring plans. During fiscal year 2015, we recognized impairment charges of $7.5 billion related to our phone business. Our annual goodwill impairment test as of +May 1, 2015 indicated that the carrying value of our previous Phone Hardware reporting unit goodwill exceeded its estimated fair value. Accordingly, we recorded a goodwill impairment charge of $5.1 billion, reducing our Phone Hardware reporting +unit goodwill from $5.4 billion to $116 million, net of foreign currency remeasurements, as well as an impairment charge of $2.2 billion related to the write-down of our Phone Hardware reporting unit intangible assets. All remaining goodwill and +intangible assets are included in our Devices reporting unit, within More Personal Computing under our current segment structure. Restructuring charges were $2.1 billion, including employee severance expenses and the write-down of certain assets in +connection with our restructuring activities. Integration expenses associated with the acquisition of NDS were $435 million in fiscal year 2015. Fiscal year 2015 compared with fiscal year 2014 Impairment, integration, and restructuring expenses were $10.0 billion for fiscal year 2015, compared to $127 million for fiscal year 2014. Impairment, integration, and restructuring expenses for fiscal year 2015 +are comprised mainly of impairment and restructuring charges of $7.5 billion and $2.1 billion, respectively, related to our phone business. Integration expenses increased $308 million, due to a full-year of integration activities in fiscal year 2015 +associated with the acquisition of NDS. 39 Table of Contents PART II Item 7 OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Dividends and interest income $ 903 $ 766 $ 883 Interest expense (1,243 ) (781 ) (597 ) Net recognized gains on investments 668 716 437 Net losses on derivatives (443 ) (423 ) (328 ) Net gains (losses) on foreign currency remeasurements (121 ) 335 (165 ) Other (195 ) (267 ) (169 ) Total $ (431 ) $ 346 $ 61 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and +credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. Other than those +derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) on certain balance +sheet amounts from foreign exchange rate changes. Fiscal year 2016 compared with fiscal year 2015 Dividends and interest income increased due to higher portfolio balances and slightly higher yields on fixed-income securities. Interest expense +increased due to higher outstanding long-term debt. Net recognized gains on investments decreased primarily due to higher other-than-temporary impairments and lower gains on sales of fixed-income securities, offset in part by higher gains on sales +of equity securities. Other-than-temporary impairments were $322 million in fiscal year 2016, compared with $183 million in fiscal year 2015. Net losses on derivatives increased due to higher losses on currency and equity contracts and lower gains +on interest rate contracts in the current period as compared to the prior period, offset in part by lower losses on commodity contracts. For fiscal year 2016, other reflects recognized losses from divestitures and certain joint ventures. Fiscal year 2015 compared with fiscal year 2014 Dividends and interest income decreased due to lower yields on fixed-income securities, offset in part by higher portfolio balances. Interest expense increased due to higher outstanding long-term debt. Net +recognized gains on investments increased primarily due to higher gains on sales of equity securities, offset in part by higher other-than-temporary impairments. Other-than-temporary impairments were $183 million in fiscal year 2015, compared with +$106 million in fiscal year 2014. Net losses on derivatives increased due to losses on commodity contracts in fiscal year 2015 as compared to gains in fiscal year 2014, offset in part by lower losses on currency and equity contracts. For fiscal year +2015, other reflects recognized losses from certain joint ventures and divestitures. INCOME TAXES Fiscal year 2016 compared with fiscal year 2015 Our effective tax rate for fiscal years 2016 and 2015 was 15% and 34%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in +foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The decrease in our effective tax rate for fiscal year 2016 compared to fiscal year 2015 was primarily due to changes in the mix of our income +before income taxes between the U.S. and foreign countries including the impact of net 40 Table of Contents PART II Item 7 revenue deferrals related to sales of Windows 10, tax benefits from the adoption of the new accounting guidance relating to stock-based compensation, and distributions from foreign affiliates. +The fiscal year 2015 effective tax rate included the tax impact of losses in foreign jurisdictions for which we may not realize a tax benefit, primarily as a result of impairment and restructuring charges. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic +distribution of, and customer demand for, our products and services. We supply our Windows PC operating system to customers through our U.S. regional operating center, while we supply the Microsoft Office system and our server products and tools to +customers through our foreign regional operations centers. In fiscal year 2016, our U.S. loss before income taxes was $325 million and our foreign income before income taxes was $20.1 billion. Net revenue deferrals related to sales of Windows 10 +negatively impacted our fiscal year 2016 U.S. loss before income taxes by $6.0 billion and foreign income before income taxes by $588 million. In fiscal year 2015, our U.S. income before income taxes was $7.4 billion and our foreign income before +income taxes was $11.1 billion. Impairment, integration, and restructuring expense relating to our phone business decreased our fiscal year 2015 U.S income before income taxes by $1.1 billion and foreign income before income taxes by +$8.9 billion. On July 27, 2015, the U.S. Tax Court issued an opinion in Altera Corp. v. Commissioner related to the treatment +of stock-based compensation expense in an intercompany cost-sharing arrangement. The IRS’s decision to appeal on February 19, 2016 prolongs the uncertainty regarding the ultimate outcome of the Altera case, and we do not expect to adjust +our consolidated financial statements until there is a final resolution of this case. Tax contingencies and other income tax +liabilities were $11.8 billion and $12.1 billion as of June 30, 2016 and 2015, respectively, and are included in other long-term liabilities. This decrease relates primarily to tax credits available for carryover and a partial settlement of the +IRS audit for tax years 2007 to 2009, offset by increases relating to intercompany transfer pricing. While we settled a portion of the +IRS audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. In February +2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of June 30, 2016, the primary unresolved issue relates to transfer pricing, which could have a significant +impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution +of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to +examination by the IRS for tax years 2010 to 2016. We are subject to income tax in many jurisdictions outside the U.S. Our operations +in certain jurisdictions remain subject to examination for tax years 1996 to 2016, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial +statements. Fiscal year 2015 compared with fiscal year 2014 Our effective tax rate for fiscal years 2015 and 2014 was 34% and 21%, respectively. The fiscal year 2015 effective rate increased by 13%, primarily due to goodwill and asset impairments and restructuring charges +recorded in fiscal year 2015, most of which did not generate a tax benefit. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to foreign earnings taxed at lower rates resulting from producing and distributing our +products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. In fiscal year 2015, this reduction was mostly offset by losses in foreign jurisdictions for which we may not realize a tax benefit, +primarily as a result of impairment and restructuring charges. Changes in the mix of income before income taxes between the U.S. and +foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. We supply our Windows PC operating system to customers through our U.S. regional operating center, +while we supply 41 Table of Contents PART II Item 7 the Microsoft Office system and our server products and tools to customers through our foreign regional operations centers. In fiscal years 2015 and 2014, our U.S. income before income taxes was +$7.4 billion and $7.1 billion, respectively, and comprised 40% and 26%, respectively, of our income before income taxes. In fiscal years 2015 and 2014, our foreign income before income taxes was $11.1 billion and $20.7 billion, respectively, and +comprised 60% and 74%, respectively, of our income before income taxes. FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $113.2 billion as of June 30, 2016, compared with $96.5 billion as of June 30, +2015. Equity and other investments were $10.4 billion as of June 30, 2016, compared with $12.1 billion as of June 30, 2015. Our short-term investments are primarily intended to facilitate liquidity and for capital preservation. They +consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated +securities in order to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to +certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Of the cash, cash equivalents, and short-term investments as of June 30, 2016, $108.9 billion was held by our foreign subsidiaries and would +be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) +was $2.4 billion. As of June 30, 2016, approximately 83% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 4% were invested in corporate +notes and bonds of U.S. companies, and approximately 5% were invested in U.S. mortgage- and asset-backed securities, all of which are denominated in U.S. dollars. The remaining cash equivalents and short-term investments held by our foreign +subsidiaries were invested in foreign securities. Securities lending We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our consolidated balance sheets. Cash and/or security interests are +received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Collateral received is recorded as an asset with a corresponding liability. Our securities +lending payable balance was $294 million as of June 30, 2016. Our average and maximum securities lending payable balances for fiscal year 2016 were $361 million and $1.2 billion, respectively. Intra-year variances in the amount of securities +loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our +financial instruments. This pricing methodology applies to our Level 1 investments, such as exchange-traded mutual funds, domestic and international equities, and U.S. government securities. If quoted prices in active markets for identical assets or +liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our +Level 2 investments such as corporate notes and bonds, common and preferred stock, foreign government bonds, mortgage- and asset-backed securities, U.S. government and agency securities, and certificates of deposit. Level 3 investments are valued +using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. 42 Table of Contents PART II Item 7 A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 +investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the +investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker +prices these investments based on similar assets without applying significant adjustments. In addition, all of our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these +investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and +independent recalculation of prices where appropriate. Cash Flows Fiscal year 2016 compared with fiscal year 2015 Cash flows from operations increased $3.7 +billion to $33.3 billion during the fiscal year, mainly due to lower operating expenditures and a reduction in materials and production costs, offset in part by a decrease in cash received from customers. Cash used in financing decreased $1.3 +billion to $8.4 billion, mainly due to a $4.6 billion increase in proceeds from issuances of debt, net of repayments, offset in part by a $1.5 billion increase in cash used for common stock repurchases and a $1.1 billion increase in dividends paid. +Cash used in investing increased $949 million to $24.0 billion, mainly due to a $2.4 billion increase in cash used for additions to property and equipment and a $1.5 billion increase in cash used for net investment purchases, sales, and maturities, +offset in part by a $2.3 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangibles and other assets. Fiscal year 2015 compared with fiscal year 2014 Cash flows from operations decreased $2.8 +billion to $29.7 billion, mainly due to an increase in materials and production costs in support of sales growth as well as payments related to restructuring charges and other changes in working capital, offset in part by increases in cash received +from customers. Cash used in financing increased $1.0 billion to $9.7 billion, mainly due to a $7.1 billion increase in cash used for common stock repurchases, offset in part by a $6.7 billion increase in proceeds from issuances of debt, net of +repayments. Cash used in investing increased $4.2 billion to $23.0 billion, mainly due to a $5.5 billion increase in cash used for net investment purchases, sales, and maturities, partially offset by a $2.2 billion decrease in cash used for +acquisitions of companies, net of cash acquired, and purchases of intangible and other assets. Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate +environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of +existing debt. See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue as of +June 30, 2016 was comprised mainly of unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the +agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Unearned revenue as of June 30, 2016 also included payments for: Windows 10 licenses; +post-delivery support and consulting services to be performed in the future; Office 365 subscriptions; Xbox Live subscriptions; Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; Bundled Offerings; and other +offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. 43 Table of Contents PART II Item 7 The following table outlines the expected future recognition of unearned revenue as of +June 30, 2016: (In millions) Three Months Ending, September 30, 2016 $ 10,194 December 31, 2016 8,348 March 31, 2017 5,868 June 30, 2017 3,058 Thereafter 6,441 Total $ 33,909 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, +has no expiration date, and may be suspended or discontinued at any time without notice. This share repurchase program replaced the share repurchase program that was announced on September 22, 2008 and expired on September 30, 2013. As of +June 30, 2016, $7.1 billion remained of our $40.0 billion share repurchase program. While the program has no expiration date, we intend to complete it by December 31, 2016. All repurchases were made using cash resources. During fiscal year 2016, we repurchased 294 million shares of Microsoft common stock for $14.8 billion under the share repurchase program +approved by our Board of Directors on September 16, 2013. During fiscal year 2015, we repurchased 295 million shares of Microsoft common stock for $13.2 billion under the share repurchase program approved by our Board of Directors on +September 16, 2013. During fiscal year 2014, we repurchased 175 million shares for $6.4 billion; 128 million shares were repurchased for $4.9 billion under the share repurchase program approved by our Board of Directors on +September 16, 2013, and 47 million shares were repurchased for $1.5 billion under the share repurchase program that was announced on September 22, 2008 and expired September 30, 2013. Dividends See Note 18 – +Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Off-Balance Sheet +Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property +infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating +estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our +consolidated financial statements during the periods presented. 44 Table of Contents PART II Item 7 Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2016: (In millions) 2017 2018-2019 2020-2021 Thereafter Total Long-term +debt: (a) Principal payments $ 0 $ 5,050 $ 5,250 $ 30,649 $ 40,949 Interest payments 1,289 2,547 2,324 16,836 22,996 Construction commitments (b) 1,809 162 0 0 1,971 Operating +leases (c) 961 1,918 1,467 2,118 6,464 Purchase commitments (d) 13,214 1,102 758 4,004 19,078 Other long-term liabilities (e) 0 87 23 275 385 Total contractual obligations $ 17,273 $ 10,866 $ 9,822 $ 53,882 $ 91,843 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) These amounts represent commitments for the construction of buildings, building improvements, and leasehold improvements. (c) These amounts represent undiscounted future minimum rental commitments under noncancellable facilities leases. (d) These amounts represent purchase commitments, including all open purchase orders and all contracts that are take-or-pay contracts that are not presented as +construction commitments above. (e) We have excluded long-term tax contingencies, other tax liabilities, deferred income taxes, and long-term pension liabilities of $13.0 billion from the +amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items. Other Planned Uses of Capital In June +2016, we entered into a definitive agreement to acquire LinkedIn in an all-cash transaction valued at $26.2 billion, inclusive of LinkedIn’s net cash. We expect the acquisition will close in calendar year 2016, and we will finance the +transaction primarily through the issuance of new debt. We will continue to invest in sales, marketing, product support infrastructure, +and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research +and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years in support of our productivity and platform strategy. We have operating leases for most U.S. and international sales +and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital +resources. Liquidity We earn a +significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash +equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, cash flows from +operations, and access to capital markets to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt maturities, and material capital +expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our +foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. 45 Table of Contents PART II Item 7 Should we require more capital in the U.S. than is generated by our operations domestically, for +example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These +alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates. RECENT ACCOUNTING GUIDANCE See Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect +the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of +investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted +for as separate units of accounting, and if so, the fair value for each of the elements. Judgment is also required to assess whether +future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future +versions of software products and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. Software updates are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered. If it is +determined that implied post-contract customer support (“PCS”) is being provided, revenue from the arrangement is deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, +revenue is generally recognized as products are shipped or made available. Microsoft enters into arrangements that can include various +combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception +of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) +third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry-specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price +charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best +estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts +and circumstances related to each deliverable. In January 2015, we announced Windows 10 would be free to all qualified existing users +of Windows 7 and Windows 8.1. This offer differs from historical offers preceding the launch of new versions of Windows as it is being made 46 Table of Contents PART II Item 7 available for free to existing users in addition to new customers after the offer announcement. We evaluated the nature and accounting treatment of the Windows 10 offer and determined that it +represents a marketing and promotional activity, in part because the offer is being made available for free to existing users. As this is a marketing and promotional activity, revenue recognition of new sales of Windows 8 will continue to be +recognized as delivered. Customers purchasing a Windows 10 license will receive unspecified updates and upgrades over the life of their +Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish VSOE. Accordingly, revenue from licenses of Windows 10 is recognized ratably over the estimated life of the +related device, which ranges between two to four years. We currently are evaluating the impact of the new standard related to revenue +recognition, which we anticipate will have a material impact on our consolidated financial statements. See Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that +considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt +instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans +to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including +industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new +cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate +our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on +an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a +significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, +and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of +future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market +conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. 47 Table of Contents PART II Item 7 Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is +established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological +feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs +is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency +such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be +accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial +statements. Income Taxes The +objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s +financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of +the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also +provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is +required in assessing the future tax consequences of events that have been recognized on our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated +financial statements. Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review +inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, +pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 48 Table of Contents PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. +The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are +safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an +organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial +reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, +through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities +and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 49 Table of Contents PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT +MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our consolidated financial +statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and +use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Our fixed-income +portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain +global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. Equity Our equity portfolio consists of +global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based +commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global +commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, +in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in +accordance with U.S. GAAP, but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign exchange +rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss +that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and +legal risk. 50 Table of Contents PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of +June 30, 2016 and 2015 and for the year ended June 30, 2016: (In millions) June 30, 2016 June 30, 2015 Year Ended June 30, 2016 Risk Categories Average High Low Foreign currency $ 92 $ 120 $ 171 $ 258 $ 83 Interest rate $ 58 $ 51 $ 56 $ 63 $ 50 Equity $ 157 $ 149 $ 163 $ 178 $ 137 Commodity $ 12 $ 13 $ 10 $ 14 $ 6 Total one-day VaR for the combined risk categories was $225 million as of June 30, 2016 and $237 million as of +June 30, 2015. The total VaR is 29% less as of June 30, 2016 and June 30, 2015, respectively, than the sum of the separate risk categories in the table above due to the diversification benefit of the combination of risks. 51 Table of Contents PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2016 2015 2014 Revenue: Product $ 61,502 $ 75,956 $ 72,948 Service and other 23,818 17,624 13,885 Total revenue 85,320 93,580 86,833 Cost of revenue: Product 17,880 21,410 16,681 Service and other 14,900 11,628 10,397 Total cost of revenue 32,780 33,038 27,078 Gross margin 52,540 60,542 59,755 Research and development 11,988 12,046 11,381 Sales and marketing 14,697 15,713 15,811 General and administrative 4,563 4,611 4,677 Impairment, integration, and restructuring 1,110 10,011 127 Operating income 20,182 18,161 27,759 Other income (expense), net (431 ) 346 61 Income before income taxes 19,751 18,507 27,820 Provision for income taxes 2,953 6,314 5,746 Net income $ 16,798 $ 12,193 $ 22,074 Earnings per share: Basic $ 2.12 $ 1.49 $ 2.66 Diluted $ 2.10 $ 1.48 $ 2.63 Weighted average shares outstanding: Basic 7,925 8,177 8,299 Diluted 8,013 8,254 8,399 Cash dividends declared per common share $ 1.44 $ 1.24 $ 1.12 See accompanying notes. 52 Table of Contents PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2016 2015 2014 Net income $ 16,798 $ 12,193 $ 22,074 Other comprehensive income (loss): Net unrealized gains (losses) on derivatives (net of tax effects of $(12) , $20, and $(4)) (238 ) 559 (35 ) Net unrealized gains (losses) on investments (net of tax effects of $(121) , $(197), and $936) (228 ) (362 ) 1,737 Translation adjustments and other (net of tax effects of $(33) , $16, and $12) (519 ) (1,383 ) 263 Other comprehensive income (loss) (985 ) (1,186 ) 1,965 Comprehensive income $ 15,813 $ 11,007 $ 24,039 See accompanying notes. 53 Table of Contents PART II Item 8 BALANCE SHEETS (In millions) June 30, 2016 2015 Assets Current assets: Cash and cash equivalents $ 6,510 $ 5,595 Short-term investments (including securities loaned of $204 and $75) 106,730 90,931 Total cash, cash equivalents, and short-term investments 113,240 96,526 Accounts receivable, net of allowance for doubtful accounts of $426 and $335 18,277 17,908 Inventories 2,251 2,902 Other 5,892 5,461 Total current assets 139,660 122,797 Property and equipment, net of accumulated depreciation of $19,800 and $17,606 18,356 14,731 Equity and other investments 10,431 12,053 Goodwill 17,872 16,939 Intangible assets, net 3,733 4,835 Other long-term assets 3,642 3,117 Total assets $ 193,694 $ 174,472 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 6,898 $ 6,591 Short-term debt 12,904 4,985 Current portion of long-term debt 0 2,499 Accrued compensation 5,264 5,096 Income taxes 580 606 Short-term unearned revenue 27,468 23,223 Securities lending payable 294 92 Other 5,949 6,555 Total current liabilities 59,357 49,647 Long-term debt 40,783 27,808 Long-term unearned revenue 6,441 2,095 Deferred income taxes 1,476 1,295 Other long-term liabilities 13,640 13,544 Total liabilities 121,697 94,389 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 7,808 and 8,027 68,178 68,465 Retained earnings 2,282 9,096 Accumulated other comprehensive income 1,537 2,522 Total stockholders’ equity 71,997 80,083 Total liabilities and stockholders’ equity $ 193,694 $ 174,472 See accompanying notes. 54 Table of Contents PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2016 2015 2014 Operations Net income $ 16,798 $ 12,193 $ 22,074 Adjustments to reconcile net income to net cash from operations: Goodwill and asset impairments 630 7,498 0 Depreciation, amortization, and other 6,622 5,957 5,212 Stock-based compensation expense 2,668 2,574 2,446 Net recognized gains on investments and derivatives (223 ) (443 ) (109 ) Deferred income taxes 332 224 (331 ) Deferral of unearned revenue 57,072 45,072 44,325 Recognition of unearned revenue (48,498 ) (44,920 ) (41,739 ) Changes in operating assets and liabilities: Accounts receivable (530 ) 1,456 (1,120 ) Inventories 600 (272 ) (161 ) Other current assets (1,167 ) 62 (29 ) Other long-term assets (41 ) 346 (628 ) Accounts payable 88 (1,054 ) 473 Other current liabilities (260 ) (624 ) 1,075 Other long-term liabilities (766 ) 1,599 1,014 Net cash from operations 33,325 29,668 32,502 Financing Proceeds from issuance of short-term debt, maturities of 90 days or less, net 7,195 4,481 500 Proceeds from issuance of debt 13,884 10,680 10,350 Repayments of debt (2,796 ) (1,500 ) (3,888 ) Common stock issued 668 634 607 Common stock repurchased (15,969 ) (14,443 ) (7,316 ) Common stock cash dividends paid (11,006 ) (9,882 ) (8,879 ) Other (369 ) 362 (39 ) Net cash used in financing (8,393 ) (9,668 ) (8,665 ) Investing Additions to property and equipment (8,343 ) (5,944 ) (5,485 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (1,393 ) (3,723 ) (5,937 ) Purchases of investments (129,758 ) (98,729 ) (72,690 ) Maturities of investments 22,054 15,013 5,272 Sales of investments 93,287 70,848 60,094 Securities lending payable 203 (466 ) (87 ) Net cash used in investing (23,950 ) (23,001 ) (18,833 ) Effect of foreign exchange rates on cash and cash equivalents (67 ) (73 ) (139 ) Net change in cash and cash equivalents 915 (3,074 ) 4,865 Cash and cash equivalents, beginning of period 5,595 8,669 3,804 Cash and cash equivalents, end of period $ 6,510 $ 5,595 $ 8,669 See accompanying notes. 55 Table of Contents PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2016 2015 2014 Common stock and paid-in capital Balance, beginning of period $ 68,465 $ 68,366 $ 67,306 Common stock issued 668 634 607 Common stock repurchased (3,689 ) (3,700 ) (2,328 ) Stock-based compensation expense 2,668 2,574 2,446 Stock-based compensation income tax benefits 0 588 272 Other, net 66 3 63 Balance, end of period 68,178 68,465 68,366 Retained earnings Balance, beginning of period 9,096 17,710 9,895 Net income 16,798 12,193 22,074 Common stock cash dividends (11,329 ) (10,063 ) (9,271 ) Common stock repurchased (12,283 ) (10,744 ) (4,988 ) Balance, end of period 2,282 9,096 17,710 Accumulated other comprehensive income Balance, beginning of period 2,522 3,708 1,743 Other comprehensive income (loss) (985 ) (1,186 ) 1,965 Balance, end of period 1,537 2,522 3,708 Total stockholders’ equity $ 71,997 $ 80,083 $ 89,784 See accompanying notes. 56 Table of Contents PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The consolidated +financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). We have recast certain prior period amounts to conform to the current period presentation, with no impact on consolidated net income or cash flows. Principles of Consolidation The consolidated financial statements include the accounts of +Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we are able to exercise significant influence over but do not control the investee and are not the primary +beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are +accounted for under the cost method. Segment Information In June 2015, we announced a change in organizational structure to align to our strategic direction as a productivity and platform company. During the first quarter of fiscal year 2016, our chief operating decision +maker, who is also our Chief Executive Officer, requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we report our financial +performance based on our new segments described in Note 21 – Segment Information and Geographic Data. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during fiscal year +2016. This change primarily impacted Note 10 – Goodwill, Note 15 – Unearned Revenue, and Note 21 – Segment Information and Geographic Data, with no impact on consolidated net income or cash flows. Estimates and Assumptions Preparing +financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of, +and/or potential impairment of goodwill and intangible assets, for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of +and volume of demand for our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or enhancements and new products; when +technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized on our consolidated financial statements or tax returns; and determining when investment impairments are +other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are +translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income (“OCI”). 57 Table of Contents PART II Item 8 Product Revenue and Service and Other Revenue Service revenue exceeded 10% of total revenue for the first time in fiscal year 2016. As a result, we have separately disclosed product revenue and +service and other revenue on our consolidated income statements. Product revenue includes sales from operating systems; cross-device +productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; hardware such as PCs, tablets, gaming and entertainment consoles, phones, other intelligent +devices, and related accessories; and training and certification of computer system integrators and developers. Service and other +revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Office 365, Microsoft Azure (“Azure”), Microsoft Dynamics (“Dynamics”) CRM Online, and Xbox Live; +solution support; and consulting services. Service and other revenue also includes sales from online advertising. Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, +and collectability is probable. Revenue generally is recognized net of allowances for returns and any taxes collected from customers and subsequently remitted to governmental authorities. Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted +for as separate units of accounting, and if so, the fair value for each of the elements. Microsoft enters into arrangements that can +include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices +at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value +(“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry specific software guidance which only allows for the use of VSOE in establishing fair +value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. +ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time +depending upon the unique facts and circumstances related to each deliverable. Revenue for retail packaged products, products licensed +to original equipment manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are shipped or made available. Technology guarantee programs are accounted for as multiple-element arrangements as customers receive free or significantly discounted rights to +use upcoming new versions of a software product if they license existing versions of the product during the eligibility period. Revenue is allocated between the existing product and the new product, and revenue allocated to the new product is +deferred until that version is delivered. The revenue allocation is based on the VSOE of fair value of the products. The VSOE of fair value for upcoming new products are based on the price determined by management having the relevant authority when +the element is not yet sold separately, but is expected to be sold in the near future at the price set by management. Software updates +that will be provided free of charge are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade and create a multiple-element arrangement, which may require revenue to be deferred and recognized when the +upgrade is delivered, or if it is determined that implied post-contract customer support (“PCS”) is being provided, the arrangement is accounted for as a multiple-element arrangement and all 58 Table of Contents PART II Item 8 revenue from the arrangement is deferred and recognized over the implied PCS term when the VSOE of fair value does not exist. If updates are determined to not meet the definition of an upgrade, +revenue is generally recognized as products are shipped or made available. Customers purchasing a Windows 10 license will receive +unspecified updates and upgrades over the life of their Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish VSOE of fair value. Accordingly, revenue from licenses +of Windows 10 is recognized ratably over the estimated life of the related device, which ranges between two to four years. Certain +volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future versions of software products, which we have determined are additional software products and are therefore accounted +for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. Arrangements that include term-based licenses for current products with the right to use unspecified future versions of the +software during the coverage period, are also accounted for as subscriptions, with revenue recognized ratably over the coverage period. Revenue from cloud-based services arrangements that allow for the use of a hosted software product or service +over a contractually determined period of time without taking possession of software are accounted for as subscriptions with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period beginning on the date the +service is made available to customers. Revenue from cloud-based services arrangements that are provided on a consumption basis (for example, the amount of storage used in a particular period) is recognized commensurate with the customer utilization +of such resources. Some volume licensing arrangements include time-based subscriptions for cloud-based services and software offerings +that are accounted for as subscriptions. These arrangements are considered multiple-element arrangements. However, because all elements are accounted for as subscriptions and have the same coverage period and delivery pattern, they have the same +revenue recognition timing. Revenue related to Microsoft Surface (“Surface”) devices, Xbox consoles, games published by us, +phones, and other hardware components is generally recognized when ownership is transferred to the resellers or to end customers when selling directly through Microsoft retail stores and online marketplaces. A portion of revenue may be deferred when +these products are combined with software elements, and/or services. Revenue related to licensing for games published by third parties for use on the Xbox consoles is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the +search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of +hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to +product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain +Internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development +costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is +recognized. For hardware warranties, we estimate the costs based on historical and projected 59 Table of Contents PART II Item 8 product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the +product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security +patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and development expenses include payroll, employee +benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to +translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological +feasibility is reached, which for our software products, is generally shortly before the products are released to manufacturing. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the +estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, +promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.6 billion, $1.9 billion, and $2.3 billion in fiscal years 2016, 2015, and 2014, respectively. Stock-Based Compensation Compensation cost +for stock awards is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service period using the straight-line method. The fair value of stock awards is based on the quoted price of +our common stock on the grant date less the present value of expected dividends not received during the vesting period. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled +to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international +subsidiaries not deemed to be permanently reinvested, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary +differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term on our +consolidated balance sheets. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the +market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments traded in active markets. Our Level 1 non-derivative +investments primarily include U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. 60 Table of Contents PART II Item 8 • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in +markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the +assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and +forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, common and preferred stock, mortgage- and asset-backed securities, U.S. government and agency securities, +and foreign government bonds. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in +pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in common and +preferred stock, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis +when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and +discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. +The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. +Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents +and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity +securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in the market value of available-for-sale securities, excluding other-than-temporary impairments, are +reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the equity method. We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and +the loaned securities continue to be carried as investments on our consolidated balance sheets. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent +and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Investments are +considered to be impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a +quarterly basis that considers available quantitative and qualitative 61 Table of Contents PART II Item 8 evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of +debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have +plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including +industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new +cost basis in the investment is established. Derivatives Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and +the resulting designation. For derivative instruments designated as fair value hedges, the gains (losses) are recognized in earnings in +the periods of change together with the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness +and are recognized in earnings. For derivative instruments designated as cash flow hedges, the effective portion of the gains (losses) +on the derivatives is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash flow hedges, changes in the time value are excluded from the +assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income +(expense), net. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which +are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense), net. Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the +allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2016 2015 2014 Balance, beginning of period $ 335 $ 301 $ 336 Charged to costs and other 146 77 16 Write-offs (55 ) (43 ) (51 ) Balance, end of period $ 426 $ 335 $ 301 Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related +to the purchase and production of inventories. We regularly review inventory 62 Table of Contents PART II Item 8 quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our +inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the +estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years; computer equipment, two to three +years; buildings and improvements, five to 15 years; leasehold improvements, three to 20 years; and furniture and equipment, one to 10 years. Land is not depreciated. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or +one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our +intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of intangible assets periodically by taking into +account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting +Guidance Recently adopted accounting guidance Improvements to Employee Share-Based Payment Accounting In March 2016, the Financial +Accounting Standards Board (“FASB”) issued a new standard that changes the accounting for certain aspects of share-based payments to employees. The new guidance requires excess tax benefits and tax deficiencies to be recorded in the income +statement when stock awards vest or are settled. In addition, cash flows related to excess tax benefits will no longer be separately classified as a financing activity apart from other income tax cash flows. The standard also allows us to repurchase +more of an employee’s vesting shares for tax withholding purposes without triggering liability accounting, clarifies that all cash payments made to tax authorities on an employee’s behalf for withheld shares should be presented as a +financing activity on our cash flows statement, and provides an accounting policy election to account for forfeitures as they occur. The new standard is effective for us beginning July 1, 2017, with early adoption permitted. We elected to early adopt the new guidance in the third quarter of fiscal year 2016 which requires us to reflect any adjustments as of July 1, +2015, the beginning of the annual period that includes the interim period of adoption. The primary impact of adoption was the recognition of excess tax benefits in our provision for income taxes rather than paid-in capital for all periods in fiscal +year 2016. Additional amendments to the accounting for income taxes and minimum statutory withholding tax requirements had no impact to retained earnings as of July 1, 2015, where the cumulative effect of these changes are required to be +recorded. We have elected to continue to estimate forfeitures expected to occur to determine the amount of compensation cost to be recognized in each period. We elected to apply the presentation requirements for cash flows related to excess tax benefits retrospectively to all periods presented which resulted in an increase to both net cash from operations and net cash +used in financing of $588 million and $271 million for the years ended June 30, 2015 and 2014, respectively. The presentation requirements for cash flows related to employee taxes paid for withheld shares had no impact to any of the periods +presented on our consolidated cash flows statements since such cash flows have historically been presented as a financing activity. 63 Table of Contents PART II Item 8 Adoption of the new standard resulted in the recognition of excess tax benefits in our provision +for income taxes rather than paid-in capital of $402 million for the year ended June 30, 2016. Balance Sheet Classification of Deferred Taxes In November 2015, the FASB issued guidance that requires companies to classify all deferred tax assets and liabilities as +noncurrent on the balance sheet rather than separately disclosing deferred taxes as current and noncurrent. This standard is effective for us beginning July 1, 2017, and can be early adopted and applied either prospectively or retrospectively +to all periods presented upon adoption. We elected to early adopt the new guidance in the fourth quarter of fiscal year 2016 on a +retrospective basis. While the guidance changes the manner in which deferred taxes are classified on the balance sheet, we are still required to offset deferred tax assets and liabilities for each taxpaying component within a tax jurisdiction. +Adoption of the new standard impacted our previously reported results as follows: (In millions) June 30, 2015 As adjusted As reported Balance sheets: Current deferred income tax assets $ 0 $ 1,915 Other long-term assets $ 3,117 $ 2,953 Other current liabilities $ 6,555 $ 6,766 Long-term deferred income tax liabilities $ 1,295 $ 2,835 Recent accounting guidance not yet adopted Financial Instruments – Credit Losses In June 2016, the FASB issued a new standard to +replace the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. For +trade and other receivables, loans, and other financial instruments, we will be required to use a forward-looking expected loss model rather than the incurred loss model for recognizing credit losses which reflects losses that are probable. Credit +losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The new standard will be effective for us beginning +July 1, 2020, with early adoption permitted beginning July 1, 2019. Application of the amendments is through a cumulative-effect adjustment to retained earnings as of the effective date. We are currently evaluating the impact of this +standard on our consolidated financial statements. Leases In February 2016, the FASB issued a new standard related to leases to increase transparency and comparability among organizations by requiring the recognition of lease assets and lease liabilities on the balance +sheet. Most prominent among the amendments is the recognition of assets and liabilities by lessees for those leases classified as operating leases under previous U.S. GAAP. Under the new standard, disclosures are required to meet the objective of +enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. We will be required to recognize and measure leases at the beginning of the earliest period presented using a modified +retrospective approach. The new standard will be effective for us beginning July 1, 2019, with early adoption permitted. We +currently anticipate early adoption of the new standard effective July 1, 2017 in conjunction with our adoption of the new revenue standard. Our ability to early adopt is dependent on system readiness, including software procured from +third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements. 64 Table of Contents PART II Item 8 We anticipate this standard will have a material impact on our consolidated financial statements. +While we are continuing to assess all potential impacts of the standard, we currently believe the most significant impact relates to our accounting for office, retail, and datacenter operating leases. Financial Instruments – Recognition, Measurement, Presentation, and Disclosure In January 2016, the FASB issued a new standard to amend certain aspects of recognition, measurement, presentation, and disclosure of financial +instruments. Most prominent among the amendments is the requirement for changes in the fair value of our equity investments, with certain exceptions, to be recognized through net income rather than OCI. The new standard will be effective for us +beginning July 1, 2018. The application of the amendments will result in a cumulative-effect adjustment to our consolidated balance sheets as of the effective date. We are currently evaluating the impact of this standard on our consolidated +financial statements. Revenue from Contracts with Customers In May 2014, the FASB issued a new standard related to revenue recognition. Under the new standard, revenue is recognized when a customer obtains control of promised goods or services and is recognized in an amount +that reflects the consideration which the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from +contracts with customers. The FASB has recently issued several amendments to the standard, including clarification on accounting for licenses of intellectual property and identifying performance obligations. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or +retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (the cumulative catch-up transition method). We currently anticipate adopting the standard using the full retrospective +method to restate each prior reporting period presented. The new standard will be effective for us beginning July 1, 2018, and +adoption as of the original effective date of July 1, 2017 is permitted. We currently anticipate early adoption of the new standard effective July 1, 2017. Our ability to early adopt using the full retrospective method is dependent on +system readiness, including software procured from third-party providers, and the completion of our analysis of information necessary to restate prior period financial statements. We anticipate this standard will have a material impact on our consolidated financial statements. While we are continuing to assess all potential +impacts of the standard, we currently believe the most significant impact relates to our accounting for software license revenue. We expect revenue related to hardware, cloud offerings, and professional services to remain substantially unchanged. +Specifically, under the new standard we expect to recognize Windows 10 revenue predominantly at the time of billing rather than ratably over the life of the related device. We also expect to recognize license revenue at the time of billing rather +than over the subscription period from certain multi-year commercial software subscriptions that include both software licenses and Software Assurance. Due to the complexity of certain of our commercial license subscription contracts, the actual +revenue recognition treatment required under the standard will be dependent on contract-specific terms, and may vary in some instances from recognition at the time of billing. We currently believe that the net change in Windows 10 revenue from period to period is indicative of the net change in revenue we expect from the adoption of the new standard. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of +shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. 65 Table of Contents PART II Item 8 The components of basic and diluted EPS are as follows: (In millions, except earnings per share) Year Ended June 30, 2016 2015 2014 Net income available for common shareholders (A) $ 16,798 $ 12,193 $ 22,074 Weighted average outstanding shares of common stock (B) 7,925 8,177 8,299 Dilutive effect of stock-based awards 88 77 100 Common stock and common stock equivalents (C) 8,013 8,254 8,399 Earnings Per Share Basic (A/B) $ 2.12 $ 1.49 $ 2.66 Diluted (A/C) $ 2.10 $ 1.48 $ 2.63 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods +presented. NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Dividends and interest income $ 903 $ 766 $ 883 Interest expense (1,243 ) (781 ) (597 ) Net recognized gains on investments 668 716 437 Net losses on derivatives (443 ) (423 ) (328 ) Net gains (losses) on foreign currency remeasurements (121 ) 335 (165 ) Other (195 ) (267 ) (169 ) Total $ (431 ) $ 346 $ 61 Following are details of net recognized gains (losses) on investments during the periods reported: (In millions) Year Ended June 30, 2016 2015 2014 Other-than-temporary impairments of investments $ (322 ) $ (183 ) $ (106 ) Realized gains from sales of available-for-sale securities 1,376 1,176 776 Realized losses from sales of available-for-sale securities (386 ) (277 ) (233 ) Total $ 668 $ 716 $ 437 66 Table of Contents PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, but +excluding held-to-maturity investments, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2016 Cash $ 3,501 $ 0 $ 0 $ 3,501 $ 3,501 $ 0 $ 0 Mutual funds 1,012 0 0 1,012 1,012 0 0 Commercial paper 298 0 0 298 298 0 0 Certificates of deposit 1,000 0 0 1,000 868 132 0 U.S. government and agency securities 89,970 245 (11 ) 90,204 100 90,104 0 Foreign government bonds 5,502 10 (18 ) 5,494 731 4,763 0 Mortgage- and asset-backed securities 4,789 21 (2 ) 4,808 0 4,808 0 Corporate notes and bonds 6,509 110 (35 ) 6,584 0 6,584 0 Municipal securities 285 57 0 342 0 342 0 Common and preferred stock 5,597 4,452 (236 ) 9,813 0 0 9,813 Other investments 590 0 0 590 0 (3 ) 593 Total $ 119,053 $ 4,895 $ (302 ) $ 123,646 $ 6,510 $ 106,730 $ 10,406 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2015 Cash $ 3,679 $ 0 $ 0 $ 3,679 $ 3,679 $ 0 $ 0 Mutual funds 1,100 0 0 1,100 1,100 0 0 Commercial paper 1 0 0 1 1 0 0 Certificates of deposit 906 0 0 906 776 130 0 U.S. government and agency securities 72,843 76 (30 ) 72,889 39 72,850 0 Foreign government bonds 5,477 3 (24 ) 5,456 0 5,456 0 Mortgage- and asset-backed securities 4,899 23 (6 ) 4,916 0 4,916 0 Corporate notes and bonds 7,192 97 (37 ) 7,252 0 7,252 0 Municipal securities 285 35 (1 ) 319 0 319 0 Common and preferred stock 6,668 4,986 (215 ) 11,439 0 0 11,439 Other investments 597 0 0 597 0 8 589 Total $ 103,647 $ 5,220 $ (313 ) $ 108,554 $ 5,595 $ 90,931 $ 12,028 As of June 30, 2016 and 2015, the recorded bases of common and preferred stock that are restricted for more +than one year or are not publicly traded were $767 million and $561 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably +estimate the fair value of these investments. As of June 30, 2016 and 2015, the collateral received under agreements for loaned +securities totaled $294 million and $92 million, which is primarily comprised of U.S. government and agency securities. 67 Table of Contents PART II Item 8 Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2016 U.S. government and agency securities $ 5,816 $ (3 ) $ 432 $ (8 ) $ 6,248 $ (11 ) Foreign government bonds 3,452 (3 ) 35 (15 ) 3,487 (18 ) Mortgage- and asset-backed securities 844 (1 ) 322 (1 ) 1,166 (2 ) Corporate notes and bonds 1,180 (11 ) 788 (24 ) 1,968 (35 ) Common and preferred stock 896 (147 ) 390 (89 ) 1,286 (236 ) Total $ 12,188 $ (165 ) $ 1,967 $ (137 ) $ 14,155 $ (302 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2015 U.S. government and agency securities $ 6,636 $ (9 ) $ 421 $ (21 ) $ 7,057 $ (30 ) Foreign government bonds 4,611 (12 ) 18 (12 ) 4,629 (24 ) Mortgage- and asset-backed securities 3,171 (5 ) 28 (1 ) 3,199 (6 ) Corporate notes and bonds 2,946 (29 ) 104 (8 ) 3,050 (37 ) Municipal securities 36 (1 ) 0 0 36 (1 ) Common and preferred stock 1,389 (180 ) 148 (35 ) 1,537 (215 ) Total $ 18,789 $ (236 ) $ 719 $ (77 ) $ 19,508 $ (313 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized +losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2016 Due in one year or less $ 54,503 $ 54,544 Due after one year through five years 50,683 50,896 Due after five years through 10 years 1,914 1,954 Due after 10 years 1,253 1,336 Total $ 108,353 $ 108,730 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for +holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. dollar equivalents. 68 Table of Contents PART II Item 8 Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge +positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese +yen, British pound, Canadian dollar, and Australian dollar. As of June 30, 2016 and June 30, 2015, the total notional amounts of these foreign exchange contracts sold were $8.4 billion and $9.8 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are +designated as fair value hedging instruments. As of June 30, 2016 and June 30, 2015, the total notional amounts of these foreign exchange contracts sold were $5.3 billion for both periods. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain +balance sheet amounts and to manage other foreign currency exposures. As of June 30, 2016, the total notional amounts of these foreign exchange contracts purchased and sold were $12.0 billion and $11.7 billion, respectively. As of +June 30, 2015, the total notional amounts of these foreign exchange contracts purchased and sold were $9.7 billion and $11.0 billion, respectively. Equity Securities held in our equity and +other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not +designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2016, the total notional amounts +of equity contracts purchased and sold for managing market price risk were $1.3 billion and $2.2 billion, respectively, of which $737 million and $986 million, respectively, were designated as hedging instruments. As of June 30, 2015, the total +notional amounts of equity contracts purchased and sold for managing market price risk were $2.2 billion and $2.6 billion, respectively, of which $1.1 billion and $1.4 billion, respectively, were designated as hedging instruments. Interest Rate Securities held in our +fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using +exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2016, the total notional amounts of fixed-interest rate contracts purchased and +sold were $328 million and $2.4 billion, respectively. As of June 30, 2015, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.0 billion and $3.2 billion, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed +securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2016 and 2015, the total notional derivative amounts of +mortgage contracts purchased were $548 million and $812 million, respectively. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not +designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or +groups of credit risks. As of June 30, 2016, the total notional amounts of credit contracts purchased and sold were $440 million and $273 million, respectively. As of June 30, 2015, the total notional amounts of credit contracts purchased +and sold were $618 million and $430 million, respectively. 69 Table of Contents PART II Item 8 Commodity We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and +manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As +of June 30, 2016, the total notional amounts of commodity contracts purchased and sold were $631 million and $162 million, respectively. As of June 30, 2015, the total notional amounts of commodity contracts purchased and sold were $882 +million and $316 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured +debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to +over-the-counter derivatives. As of June 30, 2016, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. 70 Table of Contents PART II Item 8 Fair Values of Derivative Instruments The following table presents the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) +and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value +adjustments related to our own credit risk and counterparty credit risk: June 30, 2016 June 30, 2015 Assets Liabilities Assets Liabilities (In millions) Short-term Investments Other Current Assets Equity and Other Investments Other Current Liabilities Short-term Investments Other Current Assets Equity and Other Investments Other Current Liabilities Non-designated Hedge Derivatives Foreign exchange contracts $ 33 $ 156 $ 0 $ (296 ) $ 17 $ 167 $ 0 $ (79 ) Equity contracts 23 0 0 (16 ) 148 0 0 (18 ) Interest rate contracts 10 0 0 (25 ) 7 0 0 (12 ) Credit contracts 6 0 0 (5 ) 16 0 0 (9 ) Commodity contracts 0 0 0 0 0 0 0 0 Total $ 72 $ 156 $ 0 $ (342 ) $ 188 $ 167 $ 0 $ (118 ) Designated Hedge Derivatives Foreign exchange contracts $ 1 $ 392 $ 0 $ (263 ) $ 56 $ 552 $ 0 $ (31 ) Equity contracts 0 0 18 (25 ) 0 0 25 (69 ) Total $ 1 $ 392 $ 18 $ (288 ) $ 56 $ 552 $ 25 $ (100 ) Total gross amounts of derivatives $ 73 $ 548 $ 18 $ (630 ) $ 244 $ 719 $ 25 $ (218 ) Gross derivatives either offset or subject to an enforceable master netting agreement $ 69 $ 548 $ 18 $ (630 ) $ 126 $ 719 $ 25 $ (218 ) Gross amounts of derivatives offset in the balance sheet (74 ) (302 ) (25 ) 398 (66 ) (71 ) (25 ) 161 Net amounts presented in the balance sheet (5 ) 246 (7 ) (232 ) 60 648 0 (57 ) Gross amounts of derivatives not offset in the balance sheet 0 0 0 0 0 0 0 0 Cash collateral received 0 0 0 (250 ) 0 0 0 (456 ) Net amount $ (5 ) $ 246 $ (7 ) $ (482 ) $ 60 $ 648 $ 0 $ (513 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. 71 Table of Contents PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense), net the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2016 2015 2014 Foreign Exchange Contracts Derivatives $ (797 ) $ 741 $ (14 ) Hedged items 838 (725 ) 6 Total amount of ineffectiveness $ 41 $ 16 $ (8 ) Equity Contracts Derivatives $ (76 ) $ (107 ) $ (110 ) Hedged items 76 107 110 Total amount of ineffectiveness $ 0 $ 0 $ 0 Amount of equity contracts excluded from effectiveness assessment $ (10 ) $ 0 $ (9 ) Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges: (In millions) Year Ended June 30, 2016 2015 2014 Effective Portion Gains recognized in OCI (net of tax effects of $24 , $35 and $2) $ 351 $ 1,152 $ 63 Gains reclassified from AOCI into revenue $ 625 $ 608 $ 104 Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense), net $ (354 ) $ (346 ) $ (239 ) We estimate that $319 million of net derivative gains included in AOCI as of June 30, 2016 will be +reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2016. Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), +net. These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), net, which were immaterial for the periods presented. Other than those +derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) from foreign +exchange rate changes on certain balance sheet amounts. (In millions) Year Ended June 30, 2016 2015 2014 Foreign exchange contracts $ (55 ) $ (483 ) $ (78 ) Equity contracts (21 ) (19 ) (64 ) Interest-rate contracts 10 23 24 Credit contracts (1 ) (1 ) 13 Commodity contracts (87 ) (223 ) 71 Total $ (154 ) $ (703 ) $ (34 ) 72 Table of Contents PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2016 Assets Mutual funds $ 1,012 $ 0 $ 0 $ 1,012 $ 0 $ 1,012 Commercial paper 0 298 0 298 0 298 Certificates of deposit 0 1,000 0 1,000 0 1,000 U.S. government and agency securities 86,492 3,707 0 90,199 0 90,199 Foreign government bonds 10 5,705 0 5,715 0 5,715 Mortgage- and asset-backed securities 0 4,803 0 4,803 0 4,803 Corporate notes and bonds 0 6,361 1 6,362 0 6,362 Municipal securities 0 342 0 342 0 342 Common and preferred stock 6,918 2,114 18 9,050 0 9,050 Derivatives 6 633 0 639 (401 ) 238 Total $ 94,438 $ 24,963 $ 19 $ 119,420 $ (401 ) $ 119,019 Liabilities Derivatives and other $ 17 $ 613 $ 0 $ 630 $ (398 ) $ 232 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2015 Assets Mutual funds $ 1,100 $ 0 $ 0 $ 1,100 $ 0 $ 1,100 Commercial paper 0 1 0 1 0 1 Certificates of deposit 0 906 0 906 0 906 U.S. government and agency securities 71,930 955 0 72,885 0 72,885 Foreign government bonds 131 5,299 0 5,430 0 5,430 Mortgage- and asset-backed securities 0 4,917 0 4,917 0 4,917 Corporate notes and bonds 0 7,108 1 7,109 0 7,109 Municipal securities 0 319 0 319 0 319 Common and preferred stock 8,585 2,277 14 10,876 0 10,876 Derivatives 4 979 5 988 (162 ) 826 Total $ 81,750 $ 22,761 $ 20 $ 104,531 $ (162 ) $ 104,369 Liabilities Derivatives and other $ 5 $ 159 $ 54 $ 218 $ (161 ) $ 57 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and +fair value adjustments related to our own credit risk and counterparty credit risk. The changes in our Level 3 +financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented. 73 Table of Contents PART II Item 8 The following table reconciles the total “Net Fair Value” of assets above to our balance +sheet presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2016 2015 Net fair value of assets measured at fair value on a recurring basis $ 119,019 $ 104,369 Cash 3,501 3,679 Common and preferred stock measured at fair value on a nonrecurring basis 767 561 Other investments measured at fair value on a nonrecurring basis 593 589 Less derivative net assets classified as other current assets (246 ) (648 ) Other 12 4 Recorded basis of investment components $ 123,646 $ 108,554 Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal year 2016 and 2015, we did not record any material other-than-temporary impairments on financial assets required to be measured at +fair value on a nonrecurring basis. NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2016 2015 Raw materials $ 612 $ 1,100 Work in process 158 202 Finished goods 1,481 1,600 Total $ 2,251 $ 2,902 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2016 2015 Land $ 824 $ 769 Buildings and improvements 12,393 10,800 Leasehold improvements 3,659 3,577 Computer equipment and software 17,391 13,612 Furniture and equipment 3,889 3,579 Total, at cost 38,156 32,337 Accumulated depreciation (19,800 ) (17,606 ) Total, net $ 18,356 $ 14,731 During fiscal years 2016, 2015, and 2014, depreciation expense was $4.9 billion, $4.1 billion, and $3.4 billion, +respectively. 74 Table of Contents PART II Item 8 NOTE 9 — BUSINESS COMBINATIONS Mojang Synergies AB On +November 6, 2014, we acquired Mojang Synergies AB (“Mojang”), the Swedish video game developer of the Minecraft gaming franchise, for $2.5 billion in cash, net of cash acquired. The addition of Minecraft and its community enhances our +gaming portfolio across Windows, Xbox, and other ecosystems besides our own. The significant classes of assets and liabilities to which we allocated the purchase price were goodwill of $1.8 billion and identifiable intangible assets of $928 million, +primarily marketing-related (trade names). The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth, and is not expected to be deductible for tax purposes. We assigned the +goodwill to More Personal Computing under our current segment structure. Identifiable intangible assets were assigned a total weighted-average amortization period of 6.3 years. Mojang has been included in our consolidated results of operations since +the acquisition date. Nokia’s Devices and Services Business On April 25, 2014, we acquired substantially all of Nokia Corporation’s (“Nokia”) Devices and Services business (“NDS”) for a total purchase price of $9.4 billion, including cash +acquired of $1.5 billion (the “Acquisition”). The purchase price consisted primarily of cash of $7.1 billion and Nokia’s repurchase of convertible notes of $2.1 billion, which was a non-cash transaction, and liabilities assumed of +$0.2 billion. The Acquisition was expected to accelerate the growth of our Devices business through faster innovation, synergies, and unified branding and marketing. The allocation of the purchase price to goodwill was completed as of March 31, 2015. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash $ 1,506 Accounts +receivable (a) 754 Inventories 544 Other current assets 936 Property and equipment 981 Intangible assets 4,509 Goodwill (b) 5,456 Other 221 Current liabilities (4,575 ) Long-term liabilities (890 ) Total purchase price $ 9,442 (a) Gross accounts receivable was $901 million, of which $147 million was expected to be uncollectible. (b) Goodwill was assigned to More Personal Computing under our current segment structure. The goodwill was primarily attributed to increased synergies that +were expected to be achieved from the integration of NDS. Following are the details of the purchase price allocated to the +intangible assets acquired: (In millions) Amount Weighted Average Life Technology-based $ 2,493 9 years Contract-based 1,500 9 years Customer-related 359 3 years Marketing-related (trade names) 157 2 years Fair value of intangible assets acquired $ 4,509 8 years 75 Table of Contents PART II Item 8 During the fourth quarter of fiscal year 2016, we recorded $630 million of intangible and fixed +asset impairment charges, and during the fourth quarter of fiscal year 2015, we recorded $7.5 billion of goodwill and asset impairment charges. The impairment charges for both periods related to our phone business. These costs are included in +impairment, integration, and restructuring expenses on our consolidated income statement. See Note 10 – Goodwill and Note 11 – Intangible Assets for additional details. In May 2016, we announced an agreement to sell our entry-level feature phone assets for $350 million. The transaction is expected to close in the +second half of calendar year 2016, subject to regulatory approvals and other closing conditions. Our consolidated income statement for +fiscal year 2014 included revenue and operating loss of $2.0 billion and $692 million, respectively, attributable to NDS since the Acquisition. Following are the supplemental consolidated results of Microsoft Corporation on an unaudited pro forma basis, as if the Acquisition had been consummated on July 1, 2012: (In millions, except per share amounts) Year Ended June 30, 2014 Revenue $ 96,248 Net income $ 20,234 Diluted earnings per share $ 2.41 These pro forma results were based on estimates and assumptions, which we believe are reasonable. They are not the +results that would have been realized had we been a combined company during the periods presented and are not necessarily indicative of our consolidated results of operations in future periods. The pro forma results include adjustments primarily +related to purchase accounting adjustments and the elimination of related party transactions between Microsoft and NDS. Acquisition costs and other nonrecurring charges incurred are included in the earliest period presented. During the fourth quarter of fiscal year 2014, we incurred $21 million of acquisition costs associated with the purchase of NDS. Acquisition costs +are primarily comprised of transaction fees and direct acquisition costs, including legal, finance, consulting, and other professional fees. These costs are included in impairment, integration, and restructuring expenses on our consolidated income +statement for fiscal year 2014. Certain concurrent transactions were recognized separately from the Acquisition. Prior to the +Acquisition, we had joint strategic initiatives with Nokia; this contractual relationship was terminated in conjunction with the Acquisition. No gain or loss was recorded upon termination of this agreement, as it was determined to be at market +value. In addition, we agreed to license Nokia’s mapping services and will pay Nokia separately for the services provided under a four-year license as they are rendered. Other During fiscal year 2016, we completed 17 acquisitions for total cash consideration of +$1.4 billion. These entities have been included in our consolidated results of operations since their respective acquisition dates. Pro +forma results of operations for Mojang and our other acquisitions during the current period have not been presented because the effects of these business combinations, individually and in aggregate, were not material to our consolidated results of +operations. 76 Table of Contents PART II Item 8 NOTE 10 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2014 Acquisitions Other June 30, 2015 Acquisitions Other June 30, 2016 Productivity and Business Processes $ 6,116 $ 376 $ (183 ) $ 6,309 $ 443 $ (74 ) $ 6,678 Intelligent Cloud 4,631 291 (5 ) 4,917 549 1 5,467 More Personal Computing 9,380 1,788 (5,455 ) 5,713 100 (86 ) 5,727 Total goodwill $ 20,127 $ 2,455 $ (5,643 ) $ 16,939 $ 1,092 $ (159 ) $ 17,872 The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on +the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a recasting of the amounts allocated to goodwill retroactive to the periods in +which the acquisitions occurred. Any change in the goodwill amounts resulting from foreign currency translations and purchase +accounting adjustments are presented as “Other” in the above table. Also included in “Other” are business dispositions and transfers between business segments due to reorganizations, as applicable. For fiscal year 2015, a $5.1 +billion goodwill impairment charge was included in “Other,” as discussed below. This goodwill impairment charge was included in impairment, integration, and restructuring expenses on our consolidated income statement, and reflected in +Corporate and Other in our table of operating income (loss) by segment in Note 21 – Segment Information and Geographic Data. Our +accumulated goodwill impairment as of both June 30, 2016 and 2015 was $11.3 billion. As discussed in Note 21 – Segment +Information and Geographic Data, during the first quarter of fiscal year 2016 our chief operating decision maker requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. This +resulted in a change in our operating segments and reporting units. We allocated goodwill to our new reporting units using a relative fair value approach. In addition, we completed an assessment of any potential goodwill impairment for all reporting +units immediately prior to the reallocation and determined that no impairment existed. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a +peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2016 test. Upon completion of the annual testing as of May 1, 2015, our previous Phone Hardware reporting unit goodwill was determined to be impaired. Phone Hardware goodwill is included in the Devices reporting unit +within More Personal Computing under our current segment structure. In the second half of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. These results, +along with changes in the competitive marketplace and an evaluation of business priorities, led to a shift in strategic direction and reduced future revenue and profitability expectations for the business. As a result of these changes in strategy +and expectations, we forecasted reductions in unit volume growth rates and lower future cash flows used to estimate the fair value of the Phone Hardware reporting unit, which resulted in the determination that an impairment adjustment was required. Because our annual test indicated that Phone Hardware’s carrying value exceeded its estimated fair value, a second phase of the +goodwill impairment test (“Step 2”) was performed specific to Phone Hardware. Under Step 2, the fair value of all Phone Hardware assets and liabilities were estimated, including tangible assets, existing technology, 77 Table of Contents PART II Item 8 patent agreements, and contractual arrangements, for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the +recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and liabilities included the discount rates and royalty rates used in valuing the intangible assets, and consideration of the market +environment in valuing the tangible assets. No other instances of impairment were identified in our May 1, 2015 test. NOTE 11 — INTANGIBLE ASSETS The +components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2016 2015 Technology-based (a) $ 5,970 $ (3,648 ) $ 2,322 $ 5,926 $ (3,149 ) $ 2,777 Marketing-related 1,869 (616 ) 1,253 1,942 (508 ) 1,434 Contract-based 796 (718 ) 78 1,192 (710 ) 482 Customer-related 465 (385 ) 80 492 (350 ) 142 Total $ 9,100 $ (5,367 ) $ 3,733 $ 9,552 $ (4,717 ) $ 4,835 (a) Technology-based intangible assets included $115 million and $116 million as of June 30, 2016 and 2015, respectively, of net carrying amount of +software to be sold, leased, or otherwise marketed. In the third quarter of fiscal year 2016, we corrected our +intangible assets in the table above for a $585 million misstatement between gross carrying amount and accumulated amortization as of June 30, 2015. We do not consider this correction to be material, and there was no impact to our consolidated +financial statements. During fiscal year 2016, we recorded impairment charges of $480 million related to intangible assets in the +Devices reporting unit within our More Personal Computing segment. In the fourth quarter of fiscal year 2016, we tested these intangible assets for recoverability due to changes in facts and circumstances associated with the shift in strategic +direction and reduced profitability expectations for our phone business. Based on the results of our testing, we determined that the carrying value of the intangible assets was not recoverable, and an impairment charge was recorded to the extent +that estimated fair value exceeded carrying value. We primarily used the income approach to determine the fair value of the intangible assets and determine the amount of impairment. During fiscal year 2015, we recorded impairment charges of $2.2 billion related to intangible assets in our previous Phone Hardware reporting unit. +Phone Hardware intangible assets are included in the Devices reporting unit under our current segment structure. In the fourth quarter of fiscal year 2015, we tested these intangible assets for recoverability due to changes in facts and +circumstances associated with the shift in strategic direction and reduced profitability expectations for Phone Hardware. Based on the results of our testing, we determined that the carrying value of the intangible assets was not recoverable, and an +impairment charge was recorded to the extent that estimated fair value exceeded carrying value. We primarily used a relief from royalty income approach to determine the fair value of the intangible assets and determine the amount of impairment. These intangible assets impairment charges were included in impairment, integration, and restructuring expenses on our consolidated +income statement, and reflected in Corporate and Other in our table of operating income (loss) by segment in Note 21 – Segment Information and Geographic Data. We estimate that we have no significant residual value related to our intangible assets. 78 Table of Contents PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2016 2015 Technology-based $ 361 4 years $ 874 5 years Marketing-related 2 1 year 543 8 years Customer-related 30 3 years 37 4 years Total $ 393 4 years $ 1,454 6 years Intangible assets amortization expense was $978 million, $1.3 billion, and $845 million for fiscal years 2016, +2015, and 2014, respectively. Amortization of capitalized software was $69 million, $79 million, and $200 million for fiscal years 2016, 2015, and 2014, respectively. The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2016: (In millions) Year Ending June 30, 2017 $ 787 2018 677 2019 526 2020 448 2021 379 Thereafter 916 Total $ 3,733 NOTE 12 — DEBT Short-term Debt As of +June 30, 2016, we had $12.9 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.43% and maturities ranging from 1 day to 99 days. As of June 30, 2015, we had $5.0 billion of commercial paper +issued and outstanding, with a weighted-average interest rate of 0.11% and maturities ranging from 8 days to 63 days. The estimated fair value of this commercial paper approximates its carrying value. We have two $5.0 billion credit facilities that expire on November 1, 2016 and November 14, 2018, respectively. These credit facilities +serve as a back-up for our commercial paper program. As of June 30, 2016, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before +interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreements. No amounts were drawn against these credit facilities during any of the periods presented. Long-term Debt As of June 30, 2016, +the total carrying value and estimated fair value of our long-term debt were $40.8 billion and $44.0 billion, respectively. This is compared to a carrying value and estimated fair value of our long-term debt, including the current portion, of $30.3 +billion and $30.5 billion, respectively, as of June 30, 2015. These estimated fair values are based on Level 2 inputs. 79 Table of Contents PART II Item 8 The components of our long-term debt, including the current portion, and the associated interest +rates were as follows as of June 30, 2016 and 2015: Due Date Face Value June 30, 2016 Face Value June 30, 2015 Stated Interest Rate Effective Interest Rate (In millions) Notes September 25, 2015 $ * $ 1,750 1.625% 1.795% February 8, 2016 * 750 2.500% 2.642% November 15, 2017 600 600 0.875% 1.084% May 1, 2018 450 450 1.000% 1.106% November 3, 2018 (a) 1,750 * 1.300% 1.396% December 6, 2018 1,250 1,250 1.625% 1.824% June 1, 2019 1,000 1,000 4.200% 4.379% February 12, 2020 1,500 1,500 1.850% 1.935% October 1, 2020 1,000 1,000 3.000% 3.137% November 3, 2020 (a) 2,250 * 2.000% 2.093% February 8, 2021 500 500 4.000% 4.082% December 6, 2021 (b) 1,944 1,950 2.125% 2.233% February 12, 2022 1,500 1,500 2.375% 2.466% November 3, 2022 (a) 1,000 * 2.650% 2.717% November 15, 2022 750 750 2.125% 2.239% May 1, 2023 1,000 1,000 2.375% 2.465% December 15, 2023 1,500 1,500 3.625% 3.726% February 12, 2025 2,250 2,250 2.700% 2.772% November 3, 2025 (a) 3,000 * 3.125% 3.176% December 6, 2028 (b) 1,944 1,950 3.125% 3.218% May 2, +2033 (b) 611 613 2.625% 2.690% February 12, 2035 1,500 1,500 3.500% 3.604% November 3, 2035 (a) 1,000 * 4.200% 4.260% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, 2042 900 900 3.500% 3.571% May 1, 2043 500 500 3.750% 3.829% December 15, 2043 500 500 4.875% 4.918% February 12, 2045 1,750 1,750 3.750% 3.800% November 3, 2045 (a) 3,000 * 4.450% 4.492% February 12, 2055 2,250 2,250 4.000% 4.063% November 3, 2055 (a) 1,000 * 4.750% 4.782% Total $ 40,949 $ 30,463 (a) In November 2015, we issued $13.0 billion of debt securities. (b) Euro-denominated debt securities. * Not applicable The +notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid +annually. Cash paid for interest on our debt for fiscal years 2016, 2015, and 2014 was $1.1 billion, $620 million, and $509 million, respectively. As of June 30, 2016 and 2015, the aggregate unamortized discount for our long-term debt, +including the current portion, was $166 million and $156 million, respectively. 80 Table of Contents PART II Item 8 Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2017 $ 0 2018 1,050 2019 4,000 2020 1,500 2021 3,750 Thereafter 30,649 Total $ 40,949 NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Current Taxes U.S. federal $ 545 $ 3,661 $ 3,738 U.S. state and local 136 364 266 Foreign 1,940 2,065 2,073 Current taxes 2,621 6,090 6,077 Deferred Taxes Deferred taxes 332 224 (331 ) Provision for income taxes $ 2,953 $ 6,314 $ 5,746 U.S. and foreign components of income (loss) before income taxes were as follows: (In millions) Year Ended June 30, 2016 2015 2014 U.S. $ (325 ) $ 7,363 $ 7,127 Foreign 20,076 11,144 20,693 Income before income taxes $ 19,751 $ 18,507 $ 27,820 In fiscal year 2016, income before income taxes included the net impact of U.S. and foreign revenue deferrals +related to the sales of Windows 10 of $6.0 billion and $588 million, respectively. In fiscal year 2015, income before income taxes included the net impact of U.S. and foreign impairment, integration, and restructuring expenses relating to our phone +business of $1.1 billion and $8.9 billion, respectively. The items accounting for the difference between income taxes computed at the +U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2016 2015 2014 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (19.4)% (20.9)% (17.1)% Phone nondeductible charges and valuation allowance 1.3% 19.1% 0.9% Domestic production activities deduction (0.6)% (2.4)% (1.0)% Excess tax benefits relating to stock-based compensation (2.0)% 0% 0% Other reconciling items, net 0.7% 3.3% 2.9% Effective rate 15.0% 34.1% 20.7% 81 Table of Contents PART II Item 8 The reduction from the federal statutory rate is primarily due to earnings taxed at lower rates in +foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Our foreign regional operating centers, which are taxed at rates lower +than the U.S. rate, generated 69%, 73%, and 81% of our foreign income before tax in fiscal years 2016, 2015, and 2014, respectively. In general, other reconciling items consist of interest, U.S. state income taxes, and credits. In fiscal years 2016, +2015, and 2014, there were no individually significant other reconciling items. The decrease in our effective tax rate for fiscal year +2016 compared to fiscal year 2015 was primarily due to changes in the mix of our income before income taxes between the U.S. and foreign countries, including the net impact of revenue deferrals related to sales of Windows 10, tax benefits from the +adoption of the new accounting guidance relating to stock-based compensation, and distributions from foreign affiliates. The fiscal year 2015 effective tax rate included the tax impact of losses in foreign jurisdictions for which we may not realize +a tax benefit, primarily as a result of impairment and restructuring charges. The components of the deferred income tax assets and +liabilities were as follows: (In millions) June 30, 2016 2015 Deferred Income Tax Assets Stock-based compensation expense $ 809 $ 884 Other expense items 1,609 1,531 Restructuring charges 284 211 Unearned revenue 494 520 Impaired investments 226 257 Loss carryforwards 1,703 1,158 Depreciation and amortization 115 798 Other revenue items 89 56 Deferred income tax assets 5,329 5,415 Less valuation allowance (2,180 ) (2,265 ) Deferred income tax assets, net of valuation allowance $ 3,149 $ 3,150 Deferred Income Tax Liabilities Foreign earnings $ (1,242 ) $ (1,280 ) Unrealized gain on investments and debt (2,102 ) (2,223 ) Depreciation and amortization (1,008 ) (685 ) Other (54 ) (29 ) Deferred income tax liabilities (4,406 ) (4,217 ) Net deferred income tax assets (liabilities) $ (1,257 ) $ (1,067 ) Reported As Other long-term assets (a) $ 219 $ 228 Long-term deferred income tax liabilities (a) (1,476 ) (1,295 ) Net deferred income tax assets (liabilities) (a) $ (1,257 ) $ (1,067 ) (a) Balances as of June 30, 2015 reflect the impact of the adoption of the new accounting standard in fiscal year 2016 related to balance sheet +classification of deferred taxes. See Note 1 – Accounting Policies for additional details. As of +June 30, 2016, we had net operating loss carryforwards of $8.0 billion, including $6.3 billion of foreign net operating loss carryforwards. The valuation allowance disclosed in the table above relates to the foreign net operating loss +carryforwards and other net deferred tax assets that may not be realized. 82 Table of Contents PART II Item 8 Deferred income tax balances reflect the effects of temporary differences between the carrying +amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are actually paid or recovered. As of June 30, 2016, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $124.0 billion resulting from earnings for certain non-U.S. +subsidiaries which are permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences was approximately $39.3 billion as of June 30, 2016. Income taxes paid were $3.9 billion, $4.4 billion, and $5.5 billion in fiscal years 2016, 2015, and 2014, respectively. Tax contingencies and other income tax liabilities were $11.8 billion and $12.1 billion as of June 30, 2016 and 2015, respectively, and are +included in other long-term liabilities. This decrease relates primarily to tax credits available for carryover and a partial settlement of the IRS audit for tax years 2007 to 2009, offset by increases relating to intercompany transfer pricing. Uncertain Tax Positions Unrecognized tax benefits as of June 30, 2016, 2015, and 2014, were $10.2 billion, $9.6 billion, and $8.7 billion, respectively. If +recognized, these tax benefits would affect our effective tax rates for fiscal years 2016, 2015, and 2014, by $8.8 billion, $7.9 billion, and $7.0 billion, respectively. As of June 30, 2016, 2015, and 2014, we had accrued interest expense related to uncertain tax positions of $1.9 billion, $1.7 billion, and $1.5 billion, respectively, net of federal income tax benefits. +Interest expense on unrecognized tax benefits was $163 million, $237 million, and $235 million in fiscal years 2016, 2015, and 2014, respectively, and was included in provision for income taxes. The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Balance, beginning of year $ 9,599 $ 8,714 $ 8,648 Decreases related to settlements (201 ) (50 ) (583 ) Increases for tax positions related to the current year 1,086 1,091 566 Increases for tax positions related to prior years 115 94 217 Decreases for tax positions related to prior years (317 ) (144 ) (95 ) Decreases due to lapsed statutes of limitations (118 ) (106 ) (39 ) Balance, end of year $ 10,164 $ 9,599 $ 8,714 While we settled a portion of our IRS audit for tax years 2004 to 2006 during the third quarter of fiscal year +2011, and settled a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 +and reopened the audit phase of the examination. As of June 30, 2016, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe +our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently +available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We also continue to be subject to examination by the IRS for tax years 2010 to 2016. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax +years 1996 to 2016, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. 83 Table of Contents PART II Item 8 NOTE 14 — RESTRUCTURING CHARGES Phone Hardware Integration In July 2014, +we announced a restructuring plan to simplify our organization and align NDS with our company’s overall strategy (the “Phone Hardware Integration Plan”). Pursuant to the Phone Hardware Integration Plan, we eliminated approximately +19,000 positions in fiscal year 2015, including approximately 13,000 professional and factory positions related to the NDS business. The actions associated with the Phone Hardware Integration Plan were completed as of June 30, 2015. In connection with the Phone Hardware Integration Plan, we incurred total restructuring charges of $1.3 billion, including severance expenses and +other reorganization costs, primarily associated with our facilities consolidation and write-downs of certain assets. All restructuring charges incurred under the Phone Hardware Integration Plan were recognized in fiscal year 2015. Phone Hardware Restructuring In June 2015, +management approved a plan to restructure our phone business to better focus and align resources (the “Phone Hardware Restructuring Plan”), under which we eliminated approximately 7,400 positions in fiscal year 2016. In fiscal year 2015, we incurred restructuring charges of $780 million under the Phone Hardware Restructuring Plan, including severance expenses +and other reorganization costs. In fiscal year 2016, we reversed $21 million of previously estimated restructuring charges related to contract termination costs. The actions associated with the Phone Hardware Restructuring Plan were substantially +complete as of June 30, 2016, and are expected to be completed by the end of calendar year 2016. 2016 Restructuring We periodically evaluate how to best deploy the company’s resources. In the fourth quarter of 2016, management approved restructuring plans +that would result in job eliminations, primarily across our smartphone hardware business and global sales. In addition to the elimination of 1,850 positions that were announced in May 2016, approximately 2,850 roles globally will be reduced during +the year as an extension of the earlier plan, and these actions are expected to be completed by the end of fiscal year 2017. In +connection with the restructuring plans, we incurred restructuring charges of $501 million in fiscal year 2016, including severance expenses and other reorganization costs. We do not expect to incur additional charges for these restructuring plans +in subsequent years. Restructuring charges associated with each of these plans were included in impairment, integration, and +restructuring expenses on our consolidated income statement, and reflected in Corporate and Other in our table of operating income (loss) by segment in Note 21– Segment Information and Geographic Data. Changes in the restructuring liability were as follows: (In millions) Severance Other (a) Total Restructuring liability as of June 30, 2015 $ 588 $ 249 $ 837 Restructuring charges 372 129 501 Reversal of prior year restructuring charges 0 (21 ) (21 ) Cash paid (466 ) (112 ) (578 ) Other (24 ) (6 ) (30 ) Restructuring liability as of June 30, 2016 $ 470 $ 239 $ 709 (a) “ Other” primarily reflects activities associated with the consolidation of our facilities and manufacturing operations, including contract +termination costs and asset write-downs. 84 Table of Contents PART II Item 8 NOTE 15 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2016 2015 Productivity and Business Processes $ 12,482 $ 11,643 Intelligent Cloud 11,472 10,346 More Personal Computing 3,246 3,246 Corporate and Other 6,709 83 Total $ 33,909 $ 25,318 Revenue from Windows 10 is primarily recognized at the time of billing in the More Personal Computing segment, and +the deferral and subsequent recognition of revenue is reflected in Corporate and Other in the table above. As of June 30, 2016, we deferred a net $6.6 billion in revenue related to Windows 10. NOTE 16 — COMMITMENTS Construction +and Operating Lease Commitments We have committed $2.0 billion for constructing new buildings, building improvements, and leasehold +improvements as of June 30, 2016. We have operating leases for most U.S. and international sales and support offices, research and +development facilities, manufacturing facilities, retail stores, and certain equipment. Rental expense for facilities operating leases was $1.0 billion, $989 million, and $874 million, in fiscal years 2016, 2015, and 2014, respectively. Future +minimum rental commitments under non-cancellable facilities operating leases in place as of June 30, 2016 are as follows: (In millions) Year Ending June 30, 2017 $ 961 2018 996 2019 922 2020 833 2021 634 Thereafter 2,118 Total $ 6,464 Other Commitments On June 11, 2016, we entered into a definitive agreement to acquire LinkedIn Corporation (“LinkedIn”) for $196 per share in an all-cash transaction valued at $26.2 billion, inclusive of +LinkedIn’s net cash (the “Merger Agreement”). We will finance the transaction primarily through the issuance of new indebtedness. The Merger Agreement has been unanimously approved by the Boards of Directors of both Microsoft and +LinkedIn, and we expect the acquisition will close in the 2016 calendar year, subject to approval by LinkedIn’s shareholders, satisfaction of certain regulatory approvals, and other customary closing conditions. The transaction is expected to +accelerate the growth of LinkedIn, as well as Office 365 and Dynamics. 85 Table of Contents PART II Item 8 NOTE 17 — CONTINGENCIES Patent and Intellectual Property Claims IPCom patent litigation IPCom +GmbH & Co. (“IPCom”) is a German company that holds a large portfolio of mobile technology-related patents spanning about 170 patent families and addressing a broad range of cellular technologies. IPCom has asserted 19 of these +patents in litigation against Nokia and many of the leading cell phone companies and operators. In November 2014, Microsoft and IPCom entered into a standstill agreement staying all of the pending litigation against Microsoft to permit the parties +to pursue settlement discussions. InterDigital patent litigation InterDigital Technology Corporation and InterDigital Communications Corporation (collectively, “IDT”) filed four patent infringement cases against Nokia in the International Trade Commission +(“ITC”) and in U.S. District Court for the District of Delaware between 2007 and 2013. We have been added to these cases as a defendant. IDT has cases pending against other defendants based on the same patents because most of the patents +at issue allegedly relate to 3G and 4G wireless communications standards essential functionality. The cases involving us include three ITC investigations where IDT sought an order excluding importation of 3G and 4G phones into the U.S. and one +active case in U.S. District Court in Delaware seeking an injunction and damages. Each of the ITC matters has been resolved in our favor. In September 2015, in an inter partes review the United States Patent Trial and Appeal Board issued a +final written decision that deemed unpatentable all asserted claims of the patent remaining at issue in the Delaware case. IDT has appealed this decision to the U.S. Court of Appeals for the Federal Circuit. The Delaware case has been stayed pending +final completion of the inter partes review (including appeals and any subsequent proceedings in the Patent Office). We filed an antitrust complaint against IDT in the District of Delaware in August 2015 asserting violations of Section 2 +of the Sherman Act, alleging the unlawful exploitation of standard essential patents. IDT filed a motion to dismiss, which the District Court denied. European copyright levies We assumed from +Nokia all potential liability due to Nokia’s alleged failure to pay “private copying levies” in various European countries based upon sale of memory cards and mobile phones that incorporate blank memory. The levies are based upon +a 2001 European Union (“EU”) Directive establishing a right for end users to make copies of copyrighted works for personal or private use, but also allowing the collection of levies based upon sales of blank media or recording devices to +compensate copyright holders for private copying. Various collecting societies in EU countries initiated litigation against Nokia, stating that Nokia must pay levies not only based upon sales of blank memory cards, but also phones that include +blank memory for data storage on the phones, regardless of actual usage of that memory. The most significant cases against Nokia are pending in Germany and Austria, due to both the high volume of sales and high levy amounts sought in these +countries. In December 2015, the industry group BITKOM, of which we are a member, reached a settlement with the German collecting society for all claims from 2008 forward, leaving litigation only for the period 2004-2007 pending in Germany. In +addition, the industry is engaged in settlement negotiations with the Austrian collecting society. We have also settled copyright levies litigation in Spain and France. Other patent and intellectual property claims In addition to these cases, there were 54 other +patent infringement cases pending against Microsoft as of June 30, 2016. Antitrust, Unfair Competition, and Overcharge Class Actions Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All +three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010. 86 Table of Contents PART II Item 8 The trial of the British Columbia action commenced in May 2016. The plaintiffs are expected to +file their case in chief in August 2016, setting out claims made, authorities, and evidence in support. A six-month oral hearing is scheduled to commence in September 2017, consisting of cross examination on witness affidavits. The Ontario and +Quebec cases are inactive. Other Antitrust Litigation and Claims China State Administration for Industry and Commerce investigatio n In 2014, Microsoft +was informed that China’s State Administration for Industry and Commerce (“SAIC”) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAIC conducted onsite inspections of Microsoft offices in Beijing, +Shanghai, Guangzhou, and Chengdu. SAIC has stated the investigation relates to compatibility, bundle sales, file verification issues related to Windows and Office software, and potentially other issues. Product-Related Litigation U.S. cell phone litigation Nokia, along with other handset manufacturers and network operators, is a defendant in 19 lawsuits filed in the Superior Court for +the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims as part of the NDS acquisition and have +been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining 10 cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of +Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. +The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around +emission guidelines. In 2013, defendants in the consolidated cases moved to exclude plaintiffs’ expert evidence of general +causation on the basis of flawed scientific methodologies. In 2014, the court granted in part defendants’ motion to exclude plaintiffs’ general causation experts. The plaintiffs filed an interlocutory appeal challenging the standard for +evaluating expert scientific evidence, which the District of Columbia Court of Appeals agreed to hear en banc . Trial court proceedings are stayed pending resolution of the appeal. Canadian cell phone class action Nokia, along with other handset manufacturers and network +operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors. +Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia defendants. The litigation is not yet active as several defendants remain to be served. Other We also are subject to a variety of other claims and suits that arise from time to time +in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are +subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2016, we +accrued aggregate legal liabilities of $521 million in other current liabilities. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.6 billion in aggregate beyond recorded amounts are +reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable. 87 Table of Contents PART II Item 8 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. +Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of +probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these +indemnifications on our consolidated financial statements. NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Balance, beginning of year 8,027 8,239 8,328 Issued 75 83 86 Repurchased (294 ) (295 ) (175 ) Balance, end of year 7,808 8,027 8,239 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. The share repurchase program became effective on October 1, 2013, +has no expiration date, and may be suspended or discontinued at any time without notice. This share repurchase program replaced the share repurchase program that was announced on September 22, 2008 and expired on September 30, 2013. As of +June 30, 2016, $7.1 billion remained of our $40.0 billion share repurchase program. All repurchases were made using cash resources. We repurchased the following shares of common stock under the above-described repurchase plans: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2016 2015 2014 (a) First quarter 89 $ 4,000 43 $ 2,000 47 $ 1,500 Second quarter 66 3,600 43 2,000 53 2,000 Third quarter 69 3,600 116 5,000 47 1,791 Fourth quarter 70 3,600 93 4,209 28 1,118 Total 294 $ 14,800 295 $ 13,209 175 $ 6,409 (a) Of the 175 million shares repurchased in fiscal year 2014, 128 million shares were repurchased for $4.9 billion under the share repurchase +program approved by our Board of Directors on September 16, 2013 and 47 million shares were repurchased for $1.5 billion under the share repurchase program that was announced on September 22, 2008 and expired on September 30, +2013. The above table excludes shares repurchased to settle statutory employee tax withholding related to the +vesting of stock awards. 88 Table of Contents PART II Item 8 Dividends In fiscal year 2016, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 15, 2015 $ 0.36 November 19, 2015 $ 2,868 December 10, 2015 December 2, 2015 $ 0.36 February 18, 2016 $ 2,842 March 10, 2016 March 15, 2016 $ 0.36 May 19, 2016 $ 2,821 June 9, 2016 June 14, 2016 $ 0.36 August 18, 2016 $ 2,811 September 8, 2016 The dividend declared on June 14, 2016 will be paid after the filing date of the 2016 Form 10-K and was +included in other current liabilities as of June 30, 2016. In fiscal year 2015, our Board of Directors declared the following +dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 16, 2014 $ 0.31 November 20, 2014 $ 2,547 December 11, 2014 December 3, 2014 $ 0.31 February 19, 2015 $ 2,532 March 12, 2015 March 10, 2015 $ 0.31 May 21, 2015 $ 2,496 June 11, 2015 June 9, 2015 $ 0.31 August 20, 2015 $ 2,475 September 10, 2015 The dividend declared on June 9, 2015 was included in other current liabilities as of June 30, 2015. NOTE 19 — ACCUMULATED OTHER COMPREHENSIVE INCOME The following table summarizes the changes in accumulated other comprehensive income by component: (In millions) Year Ended June 30, 2016 2015 2014 Derivatives Accumulated other comprehensive income balance, beginning of period $ 590 $ 31 $ 66 Unrealized gains, net of tax effects of $24 , $35 and $2 351 1,152 63 Reclassification adjustments for gains included in revenue (625 ) (608 ) (104 ) Tax expense included in provision for income taxes 36 15 6 Amounts reclassified from accumulated other comprehensive income (589 ) (593 ) (98 ) Net current period other comprehensive income (loss) (238 ) 559 (35 ) Accumulated other comprehensive income balance, end of period $ 352 $ 590 $ 31 Investments Accumulated other comprehensive income balance, beginning of period $ 3,169 $ 3,531 $ 1,794 Unrealized gains, net of tax effects of $120 , $59 and $1,067 219 110 2,053 Reclassification adjustments for gains included in other income (expense), net (688 ) (728 ) (447 ) Tax expense included in provision for income taxes 241 256 131 Amounts reclassified from accumulated other comprehensive income (447 ) (472 ) (316 ) Net current period other comprehensive income (loss) (228 ) (362 ) 1,737 Accumulated other comprehensive income balance, end of period $ 2,941 $ 3,169 $ 3,531 Translation Adjustments and Other Accumulated other comprehensive income (loss) balance, beginning of period $ (1,237 ) $ 146 $ (117 ) Translation adjustments and other, net of tax effects of $(33) , $16 and $12 (519 ) (1,383 ) 263 Accumulated other comprehensive income (loss) balance, end of period $ (1,756 ) $ (1,237 ) $ 146 Accumulated other comprehensive income, end of period $ 1,537 $ 2,522 $ 3,708 89 Table of Contents PART II Item 8 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. As of June 30, 2016 an aggregate of 214 million shares +were authorized for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy exercises and +vesting of awards granted under all of our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation +expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Stock-based compensation expense $ 2,668 $ 2,574 $ 2,446 Income tax benefits related to stock-based compensation 882 868 830 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a four or +five-year service period. Executive incentive plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. The stock awards vest ratably in August of each of the four years following +the grant date. Activity for all stock plans The fair value of stock awards were estimated on the date of grant using the following assumptions: Year Ended June 30, 2016 2015 2014 Dividends per share (quarterly amounts) $ 0.31 - $  0.36 $ 0.28 - $  0.31 $ 0.23 - $  0.28 Interest rates 1.1% -1.8% 1.2% - 1.9% 1.3% - 1.8% During fiscal year 2016, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 216 $ 32.72 Granted 83 $ 41.51 Vested (85 ) $ 30.98 Forfeited (20 ) $ 35.93 Nonvested balance, end of year 194 $ 36.92 As of June 30, 2016, there was approximately $4.8 billion of total unrecognized compensation costs related to +stock awards. These costs are expected to be recognized over a weighted average period of 3 years. The weighted average grant-date fair value of stock award granted was $41.51, $42.36, and $31.50 for fiscal years 2016, 2015, and 2014, respectively. +The fair value of stock awards vested was $3.9 billion, $4.2 billion, and $3.2 billion, for fiscal years 2016, 2015, and 2014, respectively. 90 Table of Contents PART II Item 8 Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last trading day of each three-month period. +Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2016 2015 2014 Shares purchased 15 16 18 Average price per share $ 44.83 $ 39.87 $ 33.60 As of June 30, 2016, 142 million shares of our common stock were reserved for future issuance through the +ESPP. Savings Plan We have a +savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute a portion of their salary, subject to certain +limitations. Beginning January 2016, we contribute fifty cents for each dollar a participant contributes in this plan, with a maximum employer contribution of 50% of the IRS contribution limit for the calendar year. Prior to January 2016, we +contributed fifty cents for each dollar of the first 6% a participant contributed in this plan, with a maximum contribution of the lesser of 3% of a participant’s earnings or 3% of the IRS compensation limit for the calendar year. Matching +contributions for all plans were $549 million, $454 million, and $420 million in fiscal years 2016, 2015, and 2014, respectively, and were expensed as contributed. NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, +management, including our chief operating decision maker, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. In June 2015, we announced a change in organizational structure to align to our strategic direction as a productivity and platform company. During +the first quarter of fiscal year 2016, our chief operating decision maker requested changes in the information that he regularly reviews for purposes of allocating resources and assessing performance. As a result, beginning in fiscal year 2016, we +report our financial performance based on our new segments, Productivity and Business Processes, Intelligent Cloud, and More Personal Computing, and analyze operating income as the measure of segment profitability. We have recast certain prior +period amounts to conform to the way we internally manage and monitor segment performance. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment +primarily comprises: • Office Commercial, including volume licensing and subscriptions to Office 365 commercial for products and services such as Office, Exchange, SharePoint, and +Skype for Business, and related Client Access Licenses (“CALs”). • Office Consumer, including Office sold through retail or through an Office 365 consumer subscription, and Office Consumer Services, including Skype, +Outlook.com, and OneDrive. • Dynamics business solutions, including Dynamics ERP products, Dynamics CRM on-premises, and Dynamics CRM Online. 91 Table of Contents PART II Item 8 Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, as well as Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. More Personal Computing Our More Personal +Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across screens of all sizes. This segment primarily comprises: • Windows, including Windows original equipment manufacturer licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system, +volume licensing of the Windows operating system, patent licensing, Windows Embedded, MSN display advertising, and Windows Phone licensing. • Devices, including Surface, phones, and PC accessories. • Gaming, including Xbox hardware; Xbox Live, comprising transactions, subscriptions, and advertising; video games; and third-party video game royalties. • Search advertising. Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue +recognized and costs incurred by one segment may benefit other segments. Revenue on certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual +prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to +marketing of products and services from which multiple segments benefit, and are generally allocated based on relative gross margin. In +addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements, and fines; information technology; human +resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain +corporate-level activity is not allocated to our segments, including impairment, integration, and restructuring expenses. Segment +revenue and operating income (loss) were as follows during the periods presented: (In millions) Year Ended June 30, 2016 2015 2014 Revenue Productivity and Business Processes $ 26,487 $ 26,430 $ 26,976 Intelligent Cloud 25,042 23,715 21,735 More Personal Computing 40,460 43,160 38,460 Corporate and Other (6,669 ) 275 (338 ) Total revenue $ 85,320 $ 93,580 $ 86,833 92 Table of Contents PART II Item 8 (In millions) Year Ended June 30, 2016 2015 2014 Operating income (loss) Productivity and Business Processes $ 12,461 $ 13,359 $ 14,173 Intelligent Cloud 9,358 9,871 8,446 More Personal Computing 6,142 4,667 5,605 Corporate and Other (7,779 ) (9,736 ) (465 ) Total operating income $ 20,182 $ 18,161 $ 27,759 Corporate and Other operating income (loss) includes adjustments to conform our internal accounting policies to +U.S. GAAP, and impairment, integration, and restructuring expenses. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition. Corporate and Other operating income (loss) activity was as follows during the periods presented: (In millions) Year Ended June 30, 2016 2015 2014 Impairment, integration and restructuring expenses $ (1,110 ) $ (10,011 ) $ (127 ) Revenue reconciling amounts and other (a) (6,669 ) 275 (338 ) Total Corporate and Other $ (7,779 ) $ (9,736 ) $ (465 ) (a) Revenue reconciling amounts and other for fiscal year 2016 primarily consisted of a net $6.6 billion of revenue deferrals related to sales of Windows 10. +Revenue reconciling amounts for fiscal year 2015 included a net $303 million of previously deferred net revenue related to sales of bundled products and services (“Bundled Offerings”). Revenue reconciling amounts for fiscal year 2014 +included a net $349 million of revenue deferrals related to Bundled Offerings. No sales to an individual customer +or country other than the United States accounted for more than 10% of fiscal year 2016, 2015, or 2014 revenue. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2016 2015 2014 United +States (a) $ 40,578 $ 42,941 $ 43,474 Other countries 44,742 50,639 43,359 Total $ 85,320 $ 93,580 $ 86,833 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the +geographic source of the revenue. Revenue from external customers, classified by significant product and service +offerings were as follows: (In millions) Year Ended June 30, 2016 2015 2014 Microsoft Office system $ 23,588 $ 23,538 $ 24,323 Server products and tools 19,177 18,612 17,055 Xbox 9,395 9,121 8,643 Windows PC operating system 8,104 (a) 14,826 16,856 Advertising 6,098 4,557 4,016 Consulting and product support services 5,641 5,090 4,767 Surface 4,108 3,900 1,883 Phone 3,358 7,702 3,073 Other 5,851 6,234 6,217 Total $ 85,320 $ 93,580 $ 86,833 (a) Includes a net $6.6 billion of revenue deferrals related to sales of Windows 10. 93 Table of Contents PART II Item 8 Our total commercial cloud revenue, which primarily comprises Office 365 commercial, Azure, +Dynamics Online, and other cloud properties, was $9.5 billion, $5.8 billion, and $2.8 billion in fiscal years 2016, 2015, and 2014, respectively. These amounts are included in their respective product categories in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various +other costs in an overhead allocation to each segment; it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with +countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2016 2015 2014 United States $ 22,819 $ 19,562 $ 17,653 Luxembourg 6,854 6,879 6,913 Finland 389 1,757 9,840 Other countries 9,899 8,307 5,713 Total $ 39,961 $ 36,505 $ 40,119 NOTE 22 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2016 Revenue (a) $ 20,379 $ 23,796 $ 20,531 $ 20,614 $ 85,320 Gross margin 13,172 13,924 12,809 12,635 52,540 Operating income 5,793 6,026 5,283 3,080 20,182 Net income 4,902 5,018 3,756 3,122 (b) 16,798 (b) Basic earnings per share 0.61 0.63 0.48 0.40 2.12 Diluted earnings per share 0.61 0.62 0.47 0.39 (b) 2.10 (b) Fiscal Year 2015 Revenue $ 23,201 $ 26,470 $ 21,729 $ 22,180 $ 93,580 Gross margin 14,928 16,334 14,568 14,712 60,542 Operating income (loss) 5,844 7,776 6,594 (2,053 ) 18,161 Net income (loss) 4,540 5,863 4,985 (3,195 ) (c) 12,193 (d) Basic earnings (loss) per share 0.55 0.71 0.61 (0.40 ) 1.49 Diluted earnings (loss) per share 0.54 0.71 0.61 (0.40 ) (c) 1.48 (d) (a) Reflects the impact of the net revenue deferral from Windows 10 of $1.3 billion, $1.7 billion, $1.6 billion, and $2.0 billion, for the first, second, +third, and fourth quarter of fiscal year 2016, respectively, and $6.6 billion for fiscal year 2016. (b) Includes $630 million of asset impairment charges related to our phone business, and $480 million of restructuring charges associated with our 2016 +restructuring plans, which together decreased net income and diluted EPS by $895 million and $0.11, respectively. (c) Includes $7.5 billion of goodwill and asset impairment charges related to our phone business, and $940 million of integration and restructuring expenses, +primarily associated with our Phone Hardware Restructuring Plan, which together decreased net income and diluted EPS by $8.3 billion and $1.02, respectively. (d) Includes $7.5 billion of goodwill and asset impairment charges related to our phone business, and $2.5 billion of integration and restructuring expenses, +primarily associated with our Phone Hardware Integration Plan and Phone Hardware Restructuring Plan, which together decreased net income and diluted EPS by $9.5 billion and $1.15, respectively. 94 Table of Contents PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the accompanying consolidated balance sheets of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2016 and 2015, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for each of the three years in the period +ended June 30, 2016. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in +the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a +reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the +financial position of Microsoft Corporation and subsidiaries as of June 30, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2016, in conformity with +accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the +Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2016, based on the criteria established in Internal Control – Integrated Framework (2013) issued +by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 28, 2016 expressed an unqualified opinion on the Company’s internal control over financial reporting. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 28, +2016 95 Table of Contents PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON +ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and +with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of +the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control +over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal +control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial +statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets +that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a +misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our +internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management +concluded that the company’s internal control over financial reporting was effective as of June 30, 2016. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2016 that have +materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2016; their report is +included in Item 9A. 96 Table of Contents PART II Item 9A R EPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the internal control over financial reporting of Microsoft +Corporation and subsidiaries (the “Company”) as of June 30, 2016, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway +Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying +Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards +require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal +control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered +necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal +control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of +directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting +principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and +dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and +expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or +disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent +limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, +projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance +with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal +control over financial reporting as of June 30, 2016, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial +statements as of and for the year ended June 30, 2016 of the Company and our report dated July 28, 2016 expressed an unqualified opinion on those financial statements. / S /    D ELOITTE & T OUCHE LLP Seattle, Washington July 28, +2016 97 Table of Contents PART II, III Item 9B, 10, 11, 12, 13, 14 I TEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may +be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 30, 2016 (the “Proxy Statement”). Information about our Audit Committee may be found under +the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. The information +in the Proxy Statement set forth under the caption “Section 16(a) Beneficial ownership reporting compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting +Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/investor/MSFinanceCode. If we make any substantive amendments to the finance code of +ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or +waiver on that website or in a report on Form 8-K. I TEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive +officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is incorporated herein by reference. I TEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock ownership information” and “Equity +compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND +RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions +“Director independence” and “Certain relationships and related transactions” is incorporated herein by reference. ITE M 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees billed by +Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 98 Table of Contents PART IV Item 15 PART IV I TEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information +is otherwise included. Index to Financial Statements Page Income Statements 52 Comprehensive Income Statements 53 Balance Sheets 54 Cash Flows Statements 55 Stockholders’ Equity Statements 56 Notes to Financial Statements 57 Report of Independent Registered Public Accounting Firm 95 (b) Exhibit Listing Incorporated by Reference Exhibit Number Ehibit Description Filed Herewith Form Period Ending Exhibit Filing Date 2.1 Agreement and Plan of Merger, dated as of June 11, 2016, by and among Microsoft Corporation, Liberty Merger Sub Inc., and LinkedIn Corporation 8-K *** 2.1 6/13/16 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 3/17/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 7/5/16 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) 3-ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft +Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.5 9/27/10 99 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New +York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.6 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.7 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013 between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the +Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York +Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, +N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New +York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 100 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of +February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due +2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as +Trustee 8-K 4.1 11/3/15 10.1* Microsoft Corporation 2001 Stock Plan X 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 8-K 10.3 11/15/04 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-Q 3/31/12 10.5 4/19/12 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 2009 Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.12 7/30/10 10.13 Amended and Restated 2003 Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, as trustee 10-K 6/30/10 10.13 7/30/10 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-K 6/30/15 10.14 7/31/15 10.17* Executive Officer Incentive Plan 10-Q 9/30/15 10.17 10/22/15 101 Table of Contents PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.18* Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/15 10.18 10/22/15 10.19* Resignation Agreement and Full and Final Release of Claims between Microsoft Corporation and Steven Sinofsky 10-K 6/30/13 10.19 7/30/13 10.21* Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan (Service-Based) 10-Q 9/30/15 10.21 10/22/15 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/15 10.22 10/22/15 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 10.25* Form of Executive Officer Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/15 10.25 10/22/15 12 Computation of Ratio of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Furnished, not filed *** Form 8-K of LinkedIn Corporation 102 Table of Contents SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be +signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 28, 2016. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the +following persons on behalf of Registrant and in the capacities indicated on July 28, 2016. Signature Title / S /    J OHN W. +T HOMPSON John W. Thompson Chairman / S /    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer / S /    W ILLIAM H. G ATES III William H. Gates +III Director / S /    T ERI L. +L IST -S TOLL Teri L. List-Stoll Director / S /    G. M ASON M ORFIT G. Mason Morfit Director / S /    C HARLES H. +N OSKI Charles H. Noski Director / S /    H ELMUT P ANKE Helmut Panke Director / S /    S ANDRA E. +P ETERSON Sandra E. Peterson Director / S /    C HARLES W. +S CHARF Charles W. Scharf Director / S /    J OHN W. +S TANTON John W. Stanton Director / S /    P ADMASREE W ARRIOR Padmasree Warrior Director / S /    A MY E. +H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) / S /    F RANK H. +B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 103 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-17-014900/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-17-014900/full-submission.txt new file mode 100644 index 0000000..56bdc16 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-17-014900/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2017 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  to Commission File Number 001-37845 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share                                          NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ☒ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ (Do not check if a smaller reporting company) Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of December 31, 2016, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $466.5 billion based on the closing sale price as reported on the NASDAQ National Market System. As of July 31, 2017, there were 7,702,243,979 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 29, 2017 are incorporated by reference into Part III. MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2017 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 15 Item 1A. Risk Factors 17 Item 1B. Unresolved Staff Comments 26 Item 2. Properties 26 Item 3. Legal Proceedings 26 Item 4. Mine Safety Disclosures 26 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 27 Item 6. Selected Financial Data 28 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 29 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 47 Item 8. Financial Statements and Supplementary Data 49 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 95 Item 9A. Controls and Procedures 95 Report of Management on Internal Control over Financial Reporting 95 Report of Independent Registered Public Accounting Firm 96 Item 9B. Other Information 97 PART III Item 10. Directors, Executive Officers and Corporate Governance 97 Item 11. Executive Compensation 97 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 97 Item 13. Certain Relationships and Related Transactions, and Director Independence 97 Item 14. Principal Accounting Fees and Services 97 PART IV Item 15. Exhibits, Financial Statement Schedules 98 Item 16. Form 10-K Summary 103 Signatures 104 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Our vision Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our strategy is to build best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). The way individuals and organizations use and interact with technology continues to evolve. A person’s experience with technology increasingly spans a multitude of devices and becomes more natural and multi-sensory with voice, ink, and gaze interactions. We believe a new technology paradigm is emerging that manifests itself through an intelligent cloud and an intelligent edge where computing is more distributed, AI drives insights and acts on the user’s behalf, and user experiences span devices with a user’s available data and information. We continue to transform our business to lead this new era of digital transformation and enable our customers and partners to thrive in this evolving world. What we offer Founded in 1975, we operate worldwide in over 190 countries. We develop, license, and support a wide range of software products, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. Our products include operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; and training and certification of computer system integrators and developers. We also design, manufacture, and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories, that integrate with our cloud-based offerings. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. 3 PART I Item 1 The ambitions that drive us To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud platform. • Create more personal computing. Reinvent productivity and business processes We believe we can significantly enhance the lives of our customers using our broad portfolio of productivity, communication, and information products and services that span platforms and devices. Productivity is our first and foremost objective, to enable people to meet and collaborate more easily, and to effectively express ideas in new ways. We invent new scenarios that in turn create opportunity for our partners and help businesses accelerate their digital transformation while respecting each person’s privacy choices. The foundation for these efforts rests on advancing our leading productivity, collaboration, communication, and business process tools including Microsoft Office, Microsoft Dynamics, and LinkedIn. With Office 365, we provide familiar industry-leading productivity and business process tools as cloud services, enabling access from anywhere and any device. New scenarios – like those enabled by Microsoft Teams – will redefine how work gets done and help foster employee engagement and culture. This work creates an opportunity to reach new customers and expand the usage of our services by our existing customers. We see opportunity in combining our offerings in new ways that are mobile, secure, collaborative, intelligent, and trustworthy. We offer our services across platforms and devices outside our own. As people move from device to device, so does their content and the richness of their services. We engineer our applications so users can find, try, and buy them in friction-free ways. On December 8, 2016, we completed our acquisition of LinkedIn Corporation, the world’s largest professional network on the Internet. The acquisition is expected to accelerate the growth of Office 365, Dynamics 365, and LinkedIn. Build the intelligent cloud platform Cloud computing is foundational to enabling any organization’s digital transformation. In deploying technology that advances business strategy, enterprises decide what solutions will make employees more productive, collaborative, and satisfied, and connect with customers in new and compelling ways. Enterprises work to unlock business insights from a world of data. To achieve these objectives, they increasingly look to leverage the benefits of the cloud. Helping businesses digitally transform and move to the cloud is one of our largest opportunities. As one of the two largest providers of cloud computing at scale, we believe we work from a position of strength. The Microsoft Cloud is a secure solution that can listen, learn, and predict; turning data into actionable insight that enhances business opportunities. It provides a scalable and complete collaboration suite that transforms the way teams work. With the cloud, high-performance computing and agility can help businesses expand their growth. Our cloud business benefits from three economies of scale: larger datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; larger datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. We believe our server products and cloud services, which include Microsoft SQL Server, Windows Server, Visual Studio, System Center, and Microsoft Azure, make us the only company with a public, private, and hybrid cloud platform that can power modern business. What differentiates Azure is our hybrid consistency, developer productivity, and software-as-a-service (“SaaS”) application integration. In addition, our hybrid infrastructure spans identity, data, compute, management, and security, helping to support the real-world needs and evolving regulatory requirements of commercial customers and enterprise-focused SaaS partners. We are working to enhance the customer’s return on investment by enabling enterprises to combine their existing datacenters and our public cloud into a single cohesive infrastructure. Businesses can deploy applications in their own d atacenter, a partner’s datacenter, or in our datacenters with common security, management, and administration across all environments, providing the flexibility and scale they want. AI will be pervasive across devices, applications, and infrastructure to drive insights and act on the user’s behalf. Azure is also unique in its support for emerging applications so that Internet of Things (“IoT”) devices can act locally at the edge while taking advantage of the cloud for global coordination and machine learning at scale. 4 PART I Item 1 We enable organizations to securely adopt SaaS applications, both our own and third-party, and integrate them with their existing security and management infrastructure. We continue to innovate with higher-level services including identity and directory services that manage employee corporate identity and manage and secure corporate information accessed and stored across a growing number of devices, rich data storage and analytics services, machine learning services, media services, web and mobi le backend services, and developer productivity services. To foster a rich developer ecosystem, our platform is extensible, enabling customers and partners to further customize and enhance our solutions, achieving even more value. This strategy requires co ntinuing investment in datacenters and other infrastructure to support our services. Create more personal computing We strive to make computing more personal by putting users at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. Windows 10 is the cornerstone of our ambition to create more personal computing, allowing us to move from an operating system that runs on a PC to a service that can power the full spectrum of devices. Windows 10 is more personal and productive with functionality such as Cortana, Windows Hello, Windows Ink, Microsoft Edge, and universal applications. Windows 10 offers a foundation for the secure, modern workplace. Windows 10 is designed to foster innovation – from us, our partners, and developers – through rich and consistent experiences across the range of existing devices and entirely new device categories. Our ambition for Windows 10 is to broaden our economic opportunity through three key levers: an original equipment manufacturer (“OEM”) ecosystem that creates exciting new hardware designs for Windows 10; our own commitment to the health and profitability of our first-party premium device portfolio; and monetization opportunities such as services, subscriptions, gaming, and search advertising. Our OEM partners are investing in an extensive portfolio of hardware designs and configurations for Windows 10. We now have the widest range of Windows hardware ever available. With the unified Windows operating system, developers and OEMs can contribute to a thriving Windows ecosystem. We invest heavily to make Windows the most secure, manageable, and capable operating system for the needs of a modern workforce. We are working to create a broad developer opportunity by unifying the Windows installed base on Windows 10, and by enabling universal Windows applications to run across all device targets. As part of our strategic objectives, we are committed to designing and marketing first-party devices to help drive innovation, create new categories, and stimulate demand in the Windows ecosystem. We are developing new input and output methods within Windows 10, including speech, pen, gesture, and mixed reality capabilities to power more personal computing experiences. The experiences and tools we build will unlock the creator in everyone and enable seamless teamwork not just in the workplace, but also at school and at home across all the devices people use. Our future opportunity Customers are looking to Microsoft and our thriving partner ecosystem to accelerate their own digital transformations and to unlock new opportunity in this era of intelligent cloud and intelligent edge. We continue to develop complete, intelligent solutions for our customers, including offerings like the recently introduced Microsoft 365 which brings together Office 365, Windows 10, and Enterprise Mobility and Security, that empower users to be creative and work together while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modular business applications to improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals, including converting data into AI. • Using Windows to develop new categories of devices – both our own and third-party – as a person’s experience with technology becomes more natural, personal, and predictive with multi-sensory breakthroughs in voice, ink, gaze interactions, and augmented reality holograms. 5 PART I Item 1 • Inventing new gaming experiences that bring people together around their shared love for games, using an approach th at enables people to play the games they want, with the people they want, on the devices they want. • Applying AI to drive insights and act on our customer’s behalf by understanding and interpreting their needs using natural methods of communication. Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. We have the opportunity to redefine what customers and partners can expect and are working to deliver new solutions that reflect the best of Microsoft. OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Skype for Business, and Microsoft Teams, and related Client Access Licenses (“CALs”). • Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics ERP on-premises, Dynamics CRM on-premises, and Dynamics 365, a set of cloud-based applications across ERP and CRM. Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets such as security, analytics, collaboration, unified communications, and business intelligence. Office Commercial revenue is mainly affected by a combination of the demand from commercial customers for volume licensing, including Software Assurance, and the number of information workers in an enterprise, as well as the continued shift to Office 365. CALs provide certain Office Commercial products and services with access rights to our server products and CAL revenue is reported with the associated Office products and services. Office Consumer Office Consumer is designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift to Office 365. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. 6 PART I Item 1 LinkedIn LinkedIn connects the world's professionals to make them more productive and successful, and is the world's largest professional network on the Internet. LinkedIn offers services that can be used by customers to transform the way they hire, market, sell, and learn. In addition to LinkedIn’s free services, LinkedIn offers three categories of monetized solutions: Talent Solutions, Marketing Solutions, and Premium Subscriptions, which includes Sales Solutions. Talent Solutions is comprised of two elements: Hiring, and Learning and Development. Hiring provides services to recruiters that enable them to attract, recruit, and hire talent. Learning and Development provides subscriptions to enterprises and individuals to access online learning content. Marketing Solutions enables companies to advertise to LinkedIn’s member base. Premium Subscriptions enables professionals to manage their professional identity, grow their network, and connect with talent through additional services like premium search. Premium Subscriptions also includes Sales Solutions, which helps sales professionals find, qualify, and create sales opportunities and accelerate social selling capabilities. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. Dynamics Dynamics provides on-premises and cloud-based business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and analytics applications for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is largely driven by the number of information workers licensed and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications for enterprises. Competition Competitors to Office include software and global application vendors such as Adobe Systems, Apple, Cisco Systems, Facebook, Google, IBM, Oracle, SAP, and numerous web-based and mobile application competitors as well as local application developers in Asia and Europe. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides a hosted messaging and productivity suite. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Skype for Business and Skype also compete with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products. We believe our products compete effectively based on our strategy of providing powerful, flexible, secure, and easy-to-use solutions that work well with technologies our customers already have and are available on a device or via the cloud. LinkedIn faces competition from online recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers. Dynamics competes with vendors such as Oracle and SAP in the market that provides solutions for large organizations and divisions of global enterprises. In the market that provides solutions for small and mid-sized businesses, our Dynamics products compete with vendors such as Infor, The Sage Group, and NetSuite. Salesforce.com’s cloud CRM offerings compete with our Dynamics CRM on-premises and Dynamics 365 offerings. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, and Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. 7 PART I Item 1 Server Products and Cloud Services Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server products and cloud services revenue is mainly affected by purchases through volume licensing programs, licenses sold to OEMs, and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Azure is a scalable cloud platform with computing, networking, storage, database, and management, along with advanced services such as analytics, and comprehensive solutions such as Enterprise Mobility Suite. Azure includes a flexible platform that helps developers build, deploy, and manage enterprise, mobile, web, and IoT applications, for any platform or device without having to worry about the underlying infrastructure. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Enterprise Services Enterprise Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and IT professionals on various Microsoft products. Competition Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, Salesforce.com, VMware, and open source offerings. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. 8 PART I Item 1 Our Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on speci fic technologies. More Personal Computing Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows IoT; and MSN display advertising. • Devices, including Microsoft Surface, PC accessories, and other intelligent devices. • Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, and advertising (“Xbox Live”), video games, and third-party video game royalties. • Search advertising. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and emerging markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Piracy. Windows Commercial revenue, which includes volume licensing of the Windows operating system, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance, often reflecting the number of information workers in a licensed enterprise, and is therefore relatively independent of the number of PCs sold in a given year. Revenue from Windows cloud services, such as Windows Defender Advanced Threat Protection, and other Windows commercial offerings, is mainly impacted by attachment of Windows to devices shipped, pricing changes and promotions, mix of computing devices, and the customer mix among large enterprises, small and medium businesses, and educational institutions. Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. Display advertising primarily includes MSN ads. In June 2015, we entered into agreements with AOL and AppNexus to outsource our display sales responsibility. 9 PART I Item 1 Devices We design, manufacture, and sell devices, including Surface, PC accessories, and other intelligent devices, such as Surface Hub and HoloLens. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. We released the Surface Studio in December 2016 and our latest Surface devices, the Surface Laptop and Surface Pro, in June 2017. In July 2015, we announced a plan to restructure our phone business to better focus and align resources. In May 2016, we announced plans to further streamline our smartphone hardware business. In November 2016, we completed the sale of our feature phone business. Gaming Our gaming platform is designed to provide a unique variety of entertainment using our devices, peripherals, applications, online services, and content. We released Xbox One and Xbox One S in November 2013 and August 2016, respectively, and announced Xbox One X in June 2017. With the launch of the Windows 10 Xbox app in July 2015, and the launch of the Mixer service in May 2017, we continue to open new opportunities for customers to engage both on- and off-console. Xbox Live enables people to connect and share online gaming experiences and is accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox Live is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox Live revenue is mainly affected by subscriptions and sales of Xbox Live enabled content, as well as advertising. We also design and sell gaming content to showcase our unique platform capabilities for Xbox consoles, Windows-enabled devices, and other devices. Growth of our gaming business is determined by the overall active user base through Xbox Live enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences via online services, downloadable content, and peripherals. Search Advertising Search advertising, including Bing and Bing Ads, is designed to deliver relevant online advertising to a global audience. We have several partnerships with other companies, including Oath (formerly Yahoo! and AOL) which is owned by Verizon, through which we provide and monetize search queries. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. Devices face competition from various computer, tablet, hardware, and phone manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. Our gaming platform competes with console platforms from Sony and Nintendo, both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles averages five to ten years. Nintendo released its latest generation console in March 2017 and Sony released its latest generation console in November 2013. We also compete with other providers of entertainment services through online marketplaces. We believe our gaming platform is effectively positioned against competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own game franchises as well as other digital content offerings. Our video games competitors include Electronic Arts and Activision Blizzard. Xbox Live faces competition from various online marketplaces, including those operated by Amazon, Apple, and Google. Our search advertising business competes with Google and a wide array of websites, social platforms like Facebook, and portals that provide content and online offerings to end users. 10 PART I Item 1 OPERATIONS We have operations centers that support operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Australia, Europe, and Asia. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our devices are primarily manufactured by third-party contract manufacturers. We generally have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. We sold our feature phone business in November 2016, which included the sale of our phone manufacturing facility in Vietnam. RESEARCH AND DEVELOPMENT During fiscal years 2017, 2016, and 2015, research and development expense was $13.0 billion, $12.0 billion, and $12.0 billion, respectively. These amounts represented 14%, 14%, and 13% of revenue in fiscal years 2017, 2016, and 2015, respectively. We plan to continue to make significant investments in a broad range of research and development efforts. Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Office Product Group , focuses on our business across productivity, communications, education, and other information applications and services. • Artificial Intelligence and Research , focuses on our AI development and other forward-looking research and development efforts spanning infrastructure, services, applications, and search. • Cloud and Enterprise , focuses on our cloud infrastructure, server, database, CRM, ERP, management and development tools, and other business process applications and services for enterprises. • Windows and Devices Group , focuses on our Windows platform, applications, games, store, and devices that power the Windows ecosystem. • LinkedIn , focuses on our services that transform the way customers hire, market, sell, and learn. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software design. Before releasing new software platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 66,000 U.S. and international patents issued and over 35,000 pending. While we employ much of our internally developed intellectual property exclusively in our products and services, we also engage in outbound and inbound licensing of specific patented technologies that are incorporated into licensees’ or Microsoft’s products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We also purchase or license technology that we incorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, or attracting and enabling our external development community. 11 PART I Item 1 W hile it may be necessary in the future to seek or renew licenses relating to various aspects of our products, services, and business methods, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercia lly reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, and hardware operating systems. While our main research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, India, Ireland, Israel, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the operating segment level. Much of our segment level research and development is coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest computer science research organizations, and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science, providing us a unique perspective on future technology trends and contributing to our innovation. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales force performs a variety of functions, including working directly with enterprises and public-sector organizations worldwide to identify and meet their technology requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. OEMs We distribute our software through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Acer, ASUS, Dell, Fujitsu, Hewlett-Packard, Lenovo, Samsung, Toshiba, and with many regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors”, or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. 12 PART I Item 1 We also provide commercial and consumer products and services directly to customers, such as cloud services , search, and gaming, through our online portals, marketplaces, and retail stores. Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), OEMs, and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. Our Dynamics software offerings are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers, and provide product training and sales support. LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and Software Assurance. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. Software Assurance conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, and training to help customers deploy and use software efficiently. Software Assurance is included with certain volume licensing agreements and is an optional purchase with others. Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. Software Assurance is included. Microsoft Product and Services Agreement MPSAs are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. Software Assurance is optional for customers that purchase perpetual licenses. Open Open Licensing agreements are a simple, cost-effective way to acquire the latest Microsoft technology. Open Licensing agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a one- to three-year period. Under the Open License program, organizations purchase perpetual licenses and Software Assurance is optional. Under Open Value programs, organizations can elect to purchase perpetual licenses or subscribe to licenses and Software Assurance is included. 13 PART I Item 1 Select Plus Select Plus agreements are designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and Software Assurance is optional. In July 2014, we announced the retirement over a two-year period of Select Plus agreements for commercial organizations. Beginning July 2015, no new Select Plus agreements were signed with commercial organizations. Starting in July 2016, we no longer accept orders from commercial organizations for Select Plus after their next agreement anniversary. Microsoft Online Subscription Agreement Microsoft Online Subscription Agreement is designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web, through the Microsoft Online Subscription Program. The program allows customers to acquire monthly or annual subscriptions for cloud-based services. Partner Programs The Microsoft Cloud Solution Provider program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, hosting partner, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. The Independent Software Vendor Royalty program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, Internet service providers, application developers, and OEMs. No sales to an individual customer accounted for more than 10% of revenue in fiscal years 2017, 2016, or 2015. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 14 PART I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of August 2, 2017 were as follows: Name Age Position with the Company Satya Nadella 49 Chief Executive Officer Christopher C. Capossela 47 Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer Jean-Philippe Courtois 56 Executive Vice President and President, Microsoft Global Sales, Marketing and Operations Kathleen T. Hogan 51 Executive Vice President, Human Resources Amy E. Hood 45 Executive Vice President, Chief Financial Officer Margaret L. Johnson 55 Executive Vice President, Business Development Bradford L. Smith 58 President and Chief Legal Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 25 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Mr. Courtois was named Executive Vice President and President, Microsoft Global Sales, Marketing and Operations in July 2016. Before that he was President of Microsoft International since 2005. He was Chief Executive Officer, Microsoft Europe, Middle East, and Africa from 2003 to 2005.He was Senior Vice President and President, Microsoft Europe, Middle East, and Africa from 2000 to 2003. He was Corporate Vice President, Worldwide Customer Marketing from 1998 to 2000. Mr. Courtois joined Microsoft in 1984. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Johnson was appointed Executive Vice President, Business Development in September 2014. Prior to that Ms. Johnson spent 24 years at Qualcomm in various leadership positions across engineering, sales, marketing and business development. She most recently served as Executive Vice President of Qualcomm Technologies, Inc. Ms. Johnson also serves on the Board of Directors of Live Nation Entertainment, Inc. Mr. Smith was appointed President and Chief Legal Officer in September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. 15 PART I Item 1 EMPLOYEES As of June 30, 2017, we employed approximately 124,000 people on a full-time basis, 73,000 in the U.S. and 51,000 internationally. Of the total employed people, 39,000 were in operations, including manufacturing, distribution, product support, and consulting services; 40,000 were in product research and development; 34,000 were in sales and marketing; and 11,000 were in general and administration. The acquisition of LinkedIn Corporation resulted in the addition of approximately 11,000 people in fiscal year 2017. Certain of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”). • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts and RSS feeds to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 16 PART I Item 1A ITEM 1A. RIS K FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platforms, ecosystems, and devices An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms, applications, and services. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, and wearables. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. In addition, some of our devices compete with products made by our OEM partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users sometimes incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our marketplace and ensure that these applications have high quality, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to a services and subscription business model, the license-based proprietary software model generates most of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. 17 PART I Item 1A • Other competitors develop and offer free applications, online services and content, and make money by selling third-party adve rtising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users, and earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with AI. At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to innovation. The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other television-related devices. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. We make significant investments in new products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, the Microsoft Office system, Bing, Windows Server, the Windows Store, the Microsoft Azure Services platform, Office 365, other cloud-based offerings, and the Xbox entertainment platform. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and 18 PART I Item 1A distr ibution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced histor ically. We did extensive preparation and ongoing compatibility testing for applications and devices to help ensure a positive experience for our users installing Windows 10. However, negative upgrade experiences could adversely affect the reception of Windows 10 in the marketplace and could lead to litigation or regulatory actions by customers and government agencies. In addition, we anticipate that Windows 10 will enable new post-license monetization opportunities beyond initial license revenues. Our inability to realize these opportunities to the extent we expect could have an adverse impact on our revenues. Finally, our practices for data collection, use, and management in Windows 10 are subject to regulatory review, and may result in decisions directing us to change these practices and imposing fines. If so, we could face negative public reaction, degraded user experiences, and reduced flexibility in product design. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. In December 2016, we completed our acquisition of LinkedIn for $27.0 billion. The LinkedIn acquisition and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating and retaining new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements, such as increased revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than we expected. These events could adversely affect our operating results or financial condition. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We may be required to record a significant charge on our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. For example, in the fourth quarter of fiscal year 2015, we recorded a $5.1 billion charge for the impairment of goodwill and a $2.2 billion charge for the impairment of intangible assets, and in the fourth quarter of fiscal year 2016 we recorded a $480 million charge for the impairment of intangible assets. The impairment charges for both periods related to our phone business. Our acquisition of LinkedIn resulted in a significant increase in our goodwill and intangible asset balances. We may not earn the revenues we expect from our intellectual property rights. We may not be able to adequately protect our intellectual property rights Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly in countries where laws are less protective of intellectual property rights. Our revenue in these markets may grow slower than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. 19 PART I Item 1A We may not receive expected royalties from our patent licenses We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. Finally, the royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of discovering infringements. Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface and Lumia phones. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. We may not be able to protect our source code from copying if there is an unauthorized disclosure of source code. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If a significant portion of our source code leaks, we might lose future trade secret protection for that source code. It may become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. Cyber-attacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our competitive position. Security of Microsoft’s information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software to attack our products and services and gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Cyber threats are constantly evolving, increasing the difficulty of detecting and successfully defending against them. Cyber threats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our network or data security could disrupt the security of our internal systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise adversely affect our business. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge. 20 PART I Item 1A Security of our products, services, devices, and customers’ data The Security of our products and services is important in our customers’ decisions to purchase or use our products or services. Security threats are a challenge to companies like us whose business is technology products and services. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure to ensure the reliability of our services and the protection of their data. Hackers tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. Hackers that acquire user account information at other companies can use that information to compromise our users’ accounts where accounts share the same attributes like passwords. To defend against security threats, both to our internal IT systems and those of our customers, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide customers security tools such as firewalls and anti-virus software. The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install security patches. Any of these actions by customers could adversely affect our revenue. Actual or perceived vulnerabilities may lead to claims against us. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenges. Legislative or regulatory action in these areas may increase the costs to develop, implement, or secure our products and services. Disclosure of personal data could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of customer data we or our vendors store and manage. Improper disclosure could harm our reputation, lead to legal exposure to customers, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer expectations or governmental rules or actions, may cause higher operating expenses. We may have outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Exchange Online, Microsoft Azure, Microsoft Account services, Office 365, OneDrive, SharePoint Online, Skype, Xbox Live, Outlook.com, and Windows Stores. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex. It requires that we maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data or insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition. 21 PART I Item 1A Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scruti nize us under U.S. and foreign competition laws. An increasing number of governments are regulating competition law activities and this includes increased scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some ju risdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments offered by Microsoft to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Because these jurisdictions only recently implemented competition laws, their enforcement activities are unpredictable. Government regulatory actions and court decisions such as these may hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. • The rulings described above may be precedent in other competition law proceedings. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited. Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and regulations. The Foreign Corrupt Practices Act and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents. From time to time, we receive inquiries from authorities in the U.S. and elsewhere and reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Specifically, we have been cooperating with authorities in the U.S. in connection with reports concerning our compliance with the Foreign Corrupt Practices Act in various countries. While we devote substantial resources to our global compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, and measures, sanctions, and other regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on countries such as Iran, North Korea, Cuba, Sudan, and Syria. 22 PART I Item 1A Other regulatory areas that may apply to our products and online services offerings include user privacy, te lecommunications, data storage and protection, and online content. For example, regulators may take the position that our offerings such as Skype are covered by laws regulating telecommunications services. Data protection authorities may assert that our co llection, use, and management of customer data is inconsistent with their laws and regulations. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, or fines against us. The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, the EU and the U.S. formally entered into a new framework in July 2016 that provides a mechanism for companies to transfer data from EU member states to the U.S. This new framework, called the Privacy Shield, is intended to address shortcomings identified by the European Court of Justice in a predecessor mechanism. The Privacy Shield and other mechanisms are subject to review by the European courts, which may lead to uncertainty about the legal basis for data transfers across the Atlantic. In 2016, the EU adopted a new law governing data practices and privacy called the General Data Protection Regulation (“GDPR”), which becomes effective in May 2018. The law requires firms to meet new requirements regarding the handling of personal data. Engineering efforts to build new capabilities to facilitate compliance with the law may entail substantial expense and the diversion of engineering resources from other projects. If we are unable to engineer products that meet Microsoft’s legal duties or help our customers meet their obligations under the GDPR or other data regulations, we might experience reduced demand for our offerings. Non-compliance with the GDPR may result in monetary penalties of up to 4% of worldwide revenue. Ongoing legal reviews by regulators may result in burdensome or inconsistent requirements affecting the location and movement of our customer and internal employee data as well as the management of that data. Compliance may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. We are limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain key employees, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows 10, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities in different jurisdictions. Economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation in the jurisdictions where we are subject to taxation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our consolidated financial statements in the period or periods in which that determination is made. 23 PART I Item 1A We earn a significant amount of our operat ing income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions to the U.S. may result in higher effective tax rates for the company. In addition, there have been proposals from Congress to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings. Although we cannot predict whether or in what form any proposed legislation may pass, if enacted, it could have a material adverse impact on our tax expense and c ash flows. Our hardware and software products may experience quality or supply problems. Our vertically-integrated hardware products such as Xbox consoles, Surface devices, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. We acquire some device components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint or industry shortages, we may not obtain timely replacement supplies, resulting in reduced sales. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other vertically-integrated hardware and software products we may offer. Our software products also may experience quality or reliability problems. The highly-sophisticated software products we develop may contain bugs and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, and customers to make technology more accessible. If our products do not meet customer expectations or emerging global accessibility requirements, we could lose sales opportunities or face regulatory actions. Our global business exposes us to operational and economic risks. Our customers are located in over 200 countries and a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Emerging markets are a significant focus of our international growth strategy. The developing nature of these markets presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenue. Competitive or regulatory pressure to make our pricing structure uniform might require that we reduce the sales price of our software in the U.S. and other countries. Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyber-attack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages on our operating results. 24 PART I Item 1A Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affect ed countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain disruptions for hardware manufacturers. Geopolitical c hange may result in changing regulatory requirements that could impact our operating strategies, access to global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or wi th some public-sector customers. Emerging nationalist trends in specific countries may significantly alter the trade environment. Changes to trade policy or agreements may result in higher tariffs, local sourcing initiatives, or other developments that mak e it more difficult to sell our products in foreign countries. Any of these changes may negatively impact our revenues. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other natural resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal government shutdown resulting from failing to pass budget appropriations, adopt continuing funding resolutions or raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT spending on our products and services and adversely affect our revenue. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by unusual events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global credit and equity markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial results. Changes in our sales organization may impact revenues. In July 2017, we announced plans to reorganize our global sales organization to help enable customers’ digital transformation, add greater technical ability to our sales force, and create pooled resources that can be used across countries and industries. The reorganization is the most significant change in our global sales organization in Microsoft’s history, involving employees changing roles, adding additional talent, realigning teams, and onboarding new partners. Successfully executing these changes will be a significant factor in enabling future revenue growth. As we navigate through this transition, sales, profitability, and cash flow could be adversely impacted. 25 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVE D STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the SEC that were issued 180 days or more preceding the end of our fiscal year 2017 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 500 acres of land we own at our corporate headquarters, and approximately five million square feet of space we lease. In addition, we own and lease space domestically that includes office, retail, and datacenter space. We also own and lease facilities internationally. Properties that we own include: our research and development centers in China and India; our operations in Ireland; and our facilities in Singapore, the Netherlands, and the United Kingdom. The largest leased properties include space in the following locations: India, China, the United Kingdom, Canada, France, Australia, Germany, and Japan. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described under Research and Development (Part I, Item 1 of this Form 10-K). In fiscal year 2017, the acquisition of LinkedIn Corporation increased our owned and leased space both domestically and internationally. We also sold various facilities related to the divestiture of our feature phone business. The table below shows a summary of the square footage of our facilities owned and leased domestically and internationally as of June 30, 2017: (Square feet in millions) Location Owned Leased Total U.S. 17 13 30 International 6 12 18 Total 23 25 48 ITEM 3. LEGAL PROCEEDINGS While not material to the Company, the Company makes the following annual report of the general activities of the Company’s Antitrust Compliance Office as required by the Final Order and Judgment in Barovic v. Ballmer et al, United States District Court for the Western District of Washington (“Final Order”). For more information see http://aka.ms/MSLegalNotice2015. These annual reports will continue through 2020. During fiscal year 2017, the Antitrust Compliance Office (a) monitored the Company’s compliance with the European Commission Decision of March 24, 2004, (“2004 Decision”) and with the Company’s Public Undertaking to the European Commission dated December 16, 2009 (“2009 Undertaking”); (b) monitored, in the manner required by the Final Order, employee, customer, competitor, regulator, or other third-party complaints regarding compliance with the 2004 Decision, the 2009 Undertaking, or other EU or U.S. laws or regulations governing tying, bundling, and exclusive dealing contracts; and, (c) monitored, in the manner required by the Final Order, the training of the Company’s employees regarding the Company’s antitrust compliance polices. In addition, the Antitrust Compliance Officer reports to the Regulatory and Public Policy Committee of the Board at each of its regularly scheduled meetings and to the full Board annually. See Note 17 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SA FETY DISCLOSURES Not applicable. 26 PART II Item 5 PAR T II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 31, 2017, there were 101,825 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2017 High $ 58.70 $ 64.10 $ 66.19 $ 72.89 $ 72.89 Low 50.39 56.32 61.95 64.85 50.39 Fiscal Year 2016 High $ 48.41 $ 56.85 $ 55.64 $ 56.77 $ 56.85 Low 39.72 43.75 48.19 48.04 39.72 DIVIDENDS AND SHARE REPURCHASES See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding dividends and share repurchases. Following are our monthly stock repurchases for the fourth quarter of fiscal year 2017: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2017 – April 30, 2017 5,241,413 $ 66.17 5,241,413 $ 38,053 May 1, 2017 – May 31, 2017 9,635,700 $ 68.77 9,635,700 $ 37,391 June 1, 2017 – June 30, 2017 8,369,066 $ 70.56 8,369,066 $ 36,800 23,246,179 23,246,179 All repurchases were made using cash resources. Our stock repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards. 27 PART II Item 6 ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2017 (a) 2016 2015 2014 (h) 2013 Revenue $ 89,950 (b) $ 85,320 (d) $ 93,580 $ 86,833 $ 77,849 Gross margin 55,689 (b) 52,540 (d) 60,542 59,755 57,464 Operating income 22,326 (b)(c) 20,182 (d)(e) 18,161 (g) 27,759 26,764 (i) Net income 21,204 (b)(c) 16,798 (d)(e) 12,193 (g) 22,074 21,863 (i) Diluted earnings per share 2.71 (b)(c) 2.10 (d)(e) 1.48 (g) 2.63 2.58 (i) Cash dividends declared per share 1.56 1.44 1.24 1.12 0.92 Cash, cash equivalents, and short-term investments 132,981 113,240 96,526 85,709 77,022 Total assets 241,086 193,468 (f) 174,303 (f) 170,569 (f) 140,890 (f) Long-term obligations 104,165 62,114 (f) 44,574 (f) 35,285 (f) 24,531 (f) Stockholders’ equity 72,394 71,997 80,083 89,784 78,944 (a) On December 8, 2016, we acquired LinkedIn Corporation. LinkedIn has been included in our consolidated results of operations starting on the acquisition date . (b ) Reflects the impact of the net revenue deferral from Windows 10 of $6.7 billion, which decreased operating income, net income, and diluted earnings per share (“EPS”) by $6.7 billion, $4.4 billion, and $0.57, respectively . ( c ) Includes $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan, which decreased operating income, net income, and diluted EPS by $306 million, $243 million, and $0.03, respectively. ( d ) Reflects the impact of the net revenue deferral from Windows 10 of $6.6 billion, which decreased operating income, net income, and diluted EPS by $6.6 billion, $4.6 billion, and $0.58, respectively . (e) Includes $630 million of asset impairment charges related to our phone business, and $480 million of restructuring charges associated with our phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $1.1 billion, $895 million, and $0.11, respectively. (f) Reflects the impact of the adoption of the new accounting standard in fiscal year 2017 related to balance sheet classification of debt issuance costs. See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. (g) Includes $7.5 billion of goodwill and asset impairment charges related to our phone business, and $2.5 billion of integration and restructuring expenses, primarily associated with our phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $10.0 billion, $9.5 billion, and $1.15, respectively. (h) On April 25, 2014, we acquired substantially all of Nokia Corporation’s Devices and Services business (“NDS”). NDS has been included in our consolidated results of operations starting on the acquisition date. (i) Includes a charge related to a fine imposed by the European Commission in March 2013 which decreased operating income and net income by $733 million (€561 million) and diluted EPS by $0.09. Also includes a charge for Surface RT inventory adjustments recorded in the fourth quarter of fiscal year 2013, which decreased operating income, net income, and diluted EPS by $900 million, $596 million, and $0.07, respectively. 28 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our strategy is to build best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). We develop, license, and support a wide range of software products, services, and devices that deliver new opportunities, greater convenience, and enhanced value to people’s lives. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by licensing and supporting an array of software products, by offering a wide range of cloud-based and other services to consumers and businesses, by designing, manufacturing, and selling devices that integrate with our cloud-based services, and by delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes. Highlights* from fiscal year 2017 included: • Commercial cloud annualized revenue run rate** exceeded $18.9 billion. • Office Commercial revenue grew 6%, driven by Office 365 commercial revenue growth of 46%. • Office Consumer revenue grew 14%, and Office 365 consumer subscribers increased to 27.0 million. • Microsoft Dynamics revenue grew 9%, driven by Dynamics 365 revenue growth of 78%. • LinkedIn contributed revenue of $2.3 billion. • Server products and cloud services revenue grew 13%, driven by Microsoft Azure revenue growth of 99%. • Enterprise Services revenue decreased 2%, driven by a decline in revenue from custom support agreements, offset in part by higher revenue from Premier Support Services and Microsoft Consulting Services. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue increased 3%. • Windows Commercial revenue grew 5%, driven by multi-year agreement revenue. • Microsoft Surface revenue decreased 2%, driven by a reduction in volumes sold, offset in part by a higher mix of premium devices. • Search advertising revenue, excluding traffic acquisition costs, grew 9%. • Gaming revenue decreased slightly, driven by lower Xbox hardware revenue, offset in part by growth in Xbox software and services. * Highlights are presented based on segment results. ** Commercial cloud annualized revenue run rate is calculated by multiplying revenue for the last month of the quarter by twelve for Office 365 commercial, Azure, Dynamics 365, and other cloud properties. On December 8, 2016, we completed our acquisition of LinkedIn Corporation for a total purchase price of $27.0 billion. LinkedIn has been included in our consolidated results of operations since the date of acquisition. See Note 9 – Business Combinations in the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. In November 2016, we completed the sale of our feature phone business for $350 million. 29 PART II Item 7 In July 2015, we announced a plan to restructure our phone business to better focus and align resources. In May 2016, we announced pl ans to further streamline our smartphone hardware business.  Our change in phone strategy resulted in a reduction in units sold and associated expenses in fiscal year 2016 and 2017. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. Microsoft competes for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. The strengthening of the U.S. dollar relative to certain foreign currencies throughout fiscal year 2015, 2016, and 2017, negatively impacted reported revenue and reduced reported expenses from our international operations. See a discussion of these factors and other risks under Risk Factors (Part I, Item 1A of this Form 10-K). Seasonality Our revenue historically has fluctuated quarterly and has generally been highest in the second quarter of our fiscal year due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted in the United States (“U.S. GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other. We have recast certain previously reported amounts to conform to the way we internally manage and monitor segment performance. Additional information on our reportable segments is contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). 30 PART II Item 7 SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2017 2016 2015 Percentage Change 2017 Versus 2016 Percentage Change 2016 Versus 2015 Revenue $ 89,950 $ 85,320 $ 93,580 5% (9)% Gross margin 55,689 52,540 60,542 6% (13)% Operating income 22,326 20,182 18,161 11% 11% Diluted earnings per share 2.71 2.10 1.48 29% 42% Fiscal year 2017 compared with fiscal year 2016 Revenue increased $4.6 billion or 5%, driven by growth in Productivity and Business Processes and Intelligent Cloud, offset in part by lower revenue from More Personal Computing. Productivity and Business Processes revenue increased, driven by the acquisition of LinkedIn and higher revenue from Microsoft Office. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services. More Personal Computing revenue decreased, mainly due to lower revenue from Devices, offset in part by higher revenue from Windows and Search advertising. Revenue included an unfavorable foreign currency impact of 2%. Gross margin increased $3.1 billion or 6%, due to growth across each of our segments, including the acquisition of LinkedIn, driven by higher revenue. Gross margin included an unfavorable foreign currency impact of 2%. Gross margin percentage increased slightly due to a margin percent increase in More Personal Computing and segment sales mix, offset in part by margin percent declines in Productivity and Business Processes and Intelligent Cloud. Gross margin percentage includes a 5-point improvement in commercial cloud gross margin primarily across Azure and Office 365. Operating income increased $2.1 billion or 11%, primarily due to higher gross margin and lower impairment, integration, and restructuring expenses, offset in part by an increase in research and development and sales and marketing expenses. Operating income included an operating loss of $948 million related to the acquisition of LinkedIn, including $866 million of amortization of intangible assets. Operating income also included an unfavorable foreign currency impact of 4%. Key changes in expenses were: • Cost of revenue increased $1.5 billion or 5%, mainly due to growth in our commercial cloud, the acquisition of LinkedIn, and higher Search advertising traffic acquisition costs, offset in part by a reduction in phone sales and Gaming cost of revenue. • Research and development expenses increased $1.0 billion or 9%, primarily due to LinkedIn expenses and increased investments in cloud engineering, offset in part by a reduction in phone expenses. • Sales and marketing expenses increased $842 million or 6%, primarily due to LinkedIn expenses and increased investments in sales capacity for our commercial cloud, offset in part by a reduction in phone and marketing expenses. • Impairment, integration, and restructuring expenses decreased $804 million, driven by prior year asset impairment charges and restructuring charges related to our phone business, offset in part by current year employee severance expenses primarily related to our sales and marketing restructuring plan. Diluted earnings per share (“EPS”) was $2.71 for fiscal year 2017. Current year diluted EPS was negatively impacted by the net revenue deferral from Windows 10 and restructuring expenses, which resulted in a decrease in diluted EPS of $0.60. Diluted EPS was $2.10 for fiscal year 2016. Prior year diluted EPS was negatively impacted by the net revenue deferral from Windows 10 and impairment and restructuring expenses, which resulted in a decrease in diluted EPS of $0.69. Fiscal year 2016 compared with fiscal year 2015 Revenue decreased $8.3 billion or 9%, primarily due to the impact of the net revenue deferral from Windows 10 of $6.6 billion and an unfavorable foreign currency impact of approximately $3.8 billion or 4%. Windows 10 revenue is primarily recognized at the time of billing in the More Personal Computing segment, and the deferral and subsequent recognition of revenue is reflected in Corporate and Other. More Personal Computing revenue decreased, mainly due to lower revenue from Devices and Windows, offset in part by higher revenue from Search advertising and Gaming. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services and Enterprise Services. Productivity and Business Processes revenue increased slightly, driven by an increase in Office and Dynamics revenue. 31 PART II Item 7 Operating income increased $2.0 billion or 11%, primarily due to a decrease in impairment, integration, and restructuring expenses and sales and marketing expenses, offset in part by lower gross margin. Gross margin decreased $8.0 billion or 13%, driven by the decline in revenue as discussed above, and included an unfavorable foreign currency impact of approximately $3.3 billion or 5%. Productivity and Business Processes and More Personal Computing gross margin decreased, offset in part by higher gross margin from Intelligent Cloud. Key changes in expenses were: • Cost of revenue decreased $258 million or 1%, mainly due to a reduction in phone sales, driven by the change in strategy for the phone business, offset in part by growth in commercial cloud and Search advertising. • Impairment, integration, and restructuring expenses decreased $8.9 billion, primarily driven by prior year goodwill and asset impairment charges related to our phone business and restructuring charges associated with our phone business restructuring plans. • Sales and marketing expenses decreased $1.0 billion or 6%, driven by a reduction in phone expenses and a favorable foreign currency impact of approximately 2%. Diluted EPS was $2.10 for fiscal year 2016. Diluted EPS was negatively impacted by the net revenue deferral from Windows 10 and impairment, integration, and restructuring expenses, which resulted in a decrease to diluted EPS of $0.69. Diluted EPS was $1.48 for fiscal year 2015. Diluted EPS was negatively impacted by impairment, integration, and restructuring expenses, which resulted in a decrease to diluted EPS of $1.15. SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2017 2016 2015 Percentage Change 2017 Versus 2016 Percentage Change 2016 Versus 2015 Revenue Productivity and Business Processes $ 30,444 $ 26,487 $ 26,430 15% 0% Intelligent Cloud 27,440 25,042 23,715 10% 6% More Personal Computing 38,773 40,434 43,435 (4)% (7)% Corporate and Other (6,707 ) (6,643 ) 0 (1)% * Total $ 89,950 $ 85,320 $ 93,580 5% (9)% Operating income (loss) Productivity and Business Processes $ 11,913 $ 12,418 $ 13,274 (4)% (6)% Intelligent Cloud 9,138 9,315 9,803 (2)% (5)% More Personal Computing 8,288 6,202 5,095 34% 22% Corporate and Other (7,013 ) (7,753 ) (10,011 ) * * Total $ 22,326 $ 20,182 $ 18,161 11% 11% * Not meaningful Reportable Segments Fiscal year 2017 compared with fiscal year 2016 Productivity and Business Processes Revenue increased $4.0 billion or 15%, driven by the acquisition of LinkedIn and higher revenue from Office. • LinkedIn revenue was $2.3 billion, primarily comprised of revenue from Talent Solutions. • Office Commercial revenue increased $1.2 billion or 6%, driven by higher revenue from Office 365 commercial, mainly due to growth in subscribers, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 commercial. 32 PART II Item 7 • Office Consumer revenue increased $425 million or 14%, driven by higher revenue from Office 365 consumer, mainly due to growth in subscribers. • Dynamics revenue increased 9%, primarily due to higher revenue from Dynamics 365. Operating income decreased $505 million or 4%, primarily due to higher operating expenses, offset in part by higher gross margin. Operating income included an unfavorable foreign currency impact of 3%. • Operating expenses increased $2.4 billion or 26%, mainly due to LinkedIn and cloud engineering expenses. Operating expenses included $2.3 billion related to our acquisition of LinkedIn, including $359 million of amortization of acquired intangible assets. Sales and marketing expenses increased $1.2 billion or 24%, research and development expenses increased $955 million or 35%, and general and administrative expenses increased $212 million or 14%. • Gross margin increased $1.8 billion or 9%, primarily due to our acquisition of LinkedIn. Gross margin percentage decreased due to an increased mix of cloud offerings and amortization of acquired intangible assets related to LinkedIn. Cost of revenue included $918 million related to our acquisition of LinkedIn, including $507 million of amortization of acquired intangible assets. Intelligent Cloud Revenue increased $2.4 billion or 10%, primarily due to higher revenue from server products and cloud services. • Server products and cloud services revenue grew $2.5 billion or 13%, driven by Azure revenue growth of 99% and server products licensed on-premises revenue growth of 4%. • Enterprise Services revenue decreased 2%, driven by a decline in revenue from custom support agreements, offset in part by higher revenue from Premier Support Services and Microsoft Consulting Services. Operating income decreased $177 million or 2%, primarily due to higher operating expenses, offset in part by higher gross margin. Operating income included an unfavorable foreign currency impact of 3%. • Operating expenses increased $973 million or 11%, driven by investments in sales capacity, cloud engineering, and developer engagement. Sales and marketing expenses increased $547 million or 13%, research and development expenses increased $468 million or 14%, and general and administrative expenses decreased $42 million or 3%. • Gross margin increased $796 million or 4%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies, offset in part by a decline in Enterprise Services gross margin. Gross margin included an unfavorable foreign currency impact of 2%. Gross margin percentage decreased due to an increased mix of cloud offerings and lower Enterprise Services gross margin percent, offset by improvement in Azure gross margin percent. More Personal Computing Revenue decreased $1.7 billion or 4%, mainly due to lower revenue from Devices, offset in part by higher revenue from Windows and Search advertising. • Windows revenue increased $442 million or 3%, mainly due to higher revenue from Windows OEM and Windows Commercial. Windows OEM revenue increased 3%. Windows OEM Pro revenue grew 5%, outperforming the commercial PC market, primarily due to a higher mix of premium licenses sold. Windows OEM non-Pro revenue grew 1%, outperforming the consumer PC market, primarily due to a higher mix of premium devices sold. Windows Commercial revenue grew 5%, driven by multi-year agreement revenue. • Search advertising revenue increased $791 million or 15%. Search advertising revenue, excluding traffic acquisition costs, increased 9%, primarily driven by growth in Bing, due to higher revenue per search and search volume. • Gaming revenue decreased slightly, primarily due to lower Xbox hardware revenue, offset in part by higher revenue from Xbox software and services. Xbox hardware revenue decreased 21%, mainly due to lower prices of consoles sold and a decline in volume of consoles sold. Xbox software and services revenue increased 11%, driven by a higher volume of Xbox Live transactions and revenue per transaction. 33 PART II Item 7 • Surface revenue decreased $82 million or 2%, primarily due to a reduction in volumes sold, offset in part by a higher mix of premium devices. • Phone revenue decreased $2.8 billion. Operating income increased $2.1 billion or 34%, due to lower operating expenses and higher gross margin. Operating income included an unfavorable foreign currency impact of 4%. • Operating expenses decreased $1.5 billion or 12%, driven by a reduction in phone expenses and Surface launch-related expenses in the prior year. Sales and marketing expenses decreased $892 million or 16%, research and development expenses decreased $374 milli on or 6%, and general and administrative expenses decreased $252 million or 16%. • Gross margin increased $568 million or 3%, driven by growth in Windows, Search advertising, and Gaming, offset in part by a decline in Phone and Surface. Gross margin percentage increased due to favorable sales mix and gross margin percent improvements across Gaming, Windows, and Search advertising, offset by a gross margin percent decline in Devices. Gross margin included an unfavorable foreign currency impact of 2%. Fiscal year 2016 compared with fiscal year 2015 Productivity and Business Processes Productivity and Business Processes revenue increased slightly, primarily due to an increase in Office and Dynamics revenue. Revenue included an unfavorable foreign currency impact of approximately 6%. • Office Commercial revenue increased $135 million or 1%, driven by higher revenue from Office 365 commercial, mainly due to growth in subscribers, offset by lower transactional license volume, reflecting a continued shift to Office 365 commercial and a decline in the business PC market. Revenue included an unfavorable foreign currency impact of approximately 6%. • Office Consumer revenue decreased $69 million or 2%, driven by a decline in the consumer PC market, offset in part by higher revenue from Office 365 consumer, mainly due to growth in subscribers. Revenue included an unfavorable foreign currency impact of approximately 4%. • Dynamics revenue increased 4%, mainly due to higher revenue from Dynamics CRM Online, driven by seat growth. Revenue included an unfavorable foreign currency impact of approximately 6%. Productivity and Business Processes operating income decreased $856 million or 6%, driven by lower gross margin. Gross margin decreased $928 million or 4%, primarily due to higher cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 6%. Cost of revenue increased $985 million or 25%, primarily due to an increased mix of cloud offerings. Operating expenses decreased $72 million or 1%, driven by lower sales and marketing expenses. Sales and marketing expenses decreased $82 million or 2%, mainly due to a reduction in headcount-related expenses and lower fees paid to third-party enterprise software advisors. Intelligent Cloud Intelligent Cloud revenue increased $1.3 billion or 6%, primarily due to higher server products and cloud services revenue and Enterprise Services revenue. Revenue included an unfavorable foreign currency impact of approximately 5%. • Server products and cloud services revenue grew $686 million or 4%, driven by revenue growth from Azure of 113%, offset in part by a decline in transactional revenue from our on-premises server products. Revenue included an unfavorable foreign currency impact of approximately 5%. • Enterprise Services revenue grew $536 million or 11%, mainly due to growth in Premier Support Services. Revenue included an unfavorable foreign currency impact of approximately 5%. Intelligent Cloud operating income decreased $488 million or 5%, primarily due to higher operating expenses, offset in part by higher gross margin. Operating expenses increased $989 million or 12%, mainly due to higher research and development expenses and sales and marketing expenses. Research and development expenses increased $567 million or 21% and sales and marketing expenses increased $347 million or 9%, driven by increased strategic investments and acquisitions to drive cloud sales capacity and innovation. Gross margin increased $501 million or 3%, driven by revenue growth, offset in part by higher cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 5%. Cost of revenue increased $826 million or 14%, primarily driven by an increased mix of cloud services. 34 PART II Item 7 More Personal Computing More Personal Computing revenue decreased $3.0 billion or 7%, mainly due to lower revenue from Devices and Windows, offset in part by higher revenue from Search advertising and Gaming. Revenue included an unfavorable foreign currency impact of approximately 2%. • Devices revenue decreased $4.0 billion or 33%, mainly due to lower revenue from phones, driven by the change in strategy for the phone business, offset in part by higher Surface revenue. Phone revenue decreased $4.2 billion or 56%, as we sold 13.8 million Microsoft Lumia phones and 75.5 million other phones in fiscal year 2016, compared with 36.8 million and 126.8 million sold, respectively, in fiscal year 2015. Surface revenue increased $207 million or 5%, primarily driven by the release of Surface Pro 4 and Surface Book in the second quarter of fiscal year 2016, as well as the release of Surface 3 in the fourth quarter of fiscal year 2015, offset in part by a decline in revenue from Surface Pro 3. Devices revenue included an unfavorable foreign currency impact of approximately 3%. • Windows revenue decreased $958 million or 5%, mainly due to lower revenue from patent licensing, Windows OEM, and Windows Phone licensing. Patent licensing revenue decreased 27%, due to a decline in license revenue per unit and licensed units. Windows OEM revenue decreased 1%. Windows OEM Pro revenue declined 6%, driven by a decline in the business PC market. Windows OEM non-Pro revenue increased 7%, outperforming the consumer PC market, driven by a higher mix of premium licenses sold. Windows Phone licensing revenue decreased 64%, driven by the recognition of deferred revenue in fiscal year 2015 from Windows Phone 8. Windows revenue included an unfavorable foreign currency impact of approximately 2%. • Search advertising revenue increased $1.7 billion or 46%. Search advertising revenue, excluding traffic acquisition costs, increased 17%, primarily driven by growth in Bing, due to higher revenue per search and search volume. Search advertising revenue included an unfavorable foreign currency impact of approximately 2%. • Gaming revenue increased $75 million or 1%, primarily due to higher revenue from Xbox Live and video games, offset in part by lower Xbox hardware revenue. Xbox Live revenue increased 17%, driven by higher revenue per transaction and volume of transactions. Video games revenue grew 28%, driven by the launch of Halo 5 and sales of Minecraft. We acquired Mojang AB, the Swedish video game developer of the Minecraft gaming franchise, in November 2014. Xbox hardware revenue decreased 16%, mainly due to lower prices of Xbox One consoles sold and a decline in Xbox 360 console volume, offset in part by higher Xbox One console volume. Gaming revenue included an unfavorable foreign currency impact of approximately 4%. More Personal Computing operating income increased $1.1 billion or 22%, primarily due to lower operating expenses, offset in part by lower gross margin. Operating expenses decreased $2.0 billion or 13%, mainly due to lower sales and marketing expenses and research and development expenses. Sales and marketing expenses decreased $1.3 billion or 19% and research and development expenses decreased $676 million or 10%, driven by a reduction in phone expenses. Gross margin decreased $932 million or 5%, reflecting lower revenue, offset in part by a reduction in cost of revenue. Gross margin included an unfavorable foreign currency impact of approximately 5%. Cost of revenue decreased $2.1 billion or 9%, primarily driven by a reduction in phone sales, offset in part by higher search advertising cost of revenue. Corporate and Other Corporate and Other revenue is comprised of revenue deferrals related to Windows 10. Corporate and Other operating income (loss) is comprised of revenue deferrals related to Windows 10 and corporate-level activity not specifically allocated to a segment, including impairment, integration, and restructuring expenses. Fiscal year 2017 compared with fiscal year 2016 Revenue decreased $64 million, due to an increase in the net revenue deferral from Windows 10. During fiscal year 2017 and 2016, we deferred net revenue from Windows 10 of $6.7 billion and $6.6 billion, respectively. Corporate and Other operating loss decreased $740 million, primarily due to an $804 million reduction in impairment, integration, and restructuring expenses, driven by prior year goodwill and asset impairment charges and restructuring charges related to our phone business, offset in part by current year employee severance expenses primarily related to our sales and marketing restructuring plan. 35 PART II Item 7 Fiscal year 2016 compared with fiscal year 2015 Corporate and Other revenue decreased $6.6 billion, due to the net revenue deferral from Windows 10. Corporate and Other operating loss decreased $2.3 billion, primarily due to an $8.9 billion reduction in impairment, integration, and restructuring expenses, driven by prior year goodwill and asset impairment charges related to our phone business, offset in part by lower revenue. OPERATING EXPENSES Research and Development (In millions, except percentages) 2017 2016 2015 Percentage Change 2017 Versus 2016 Percentage Change 2016 Versus 2015 Research and development $ 13,037 $ 11,988 $ 12,046 9% 0% As a percent of revenue 14% 14% 13% 0ppt 1ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Fiscal year 2017 compared with fiscal year 2016 Research and development expenses increased $1.0 billion or 9%, primarily due to LinkedIn expenses and increased investments in cloud engineering, offset in part by a reduction in phone expenses. Expenses included $745 million related to our acquisition of LinkedIn. Fiscal year 2016 compared with fiscal year 2015 Research and development expenses decreased $58 million, primarily due to a reduction in phone expenses, driven by the change in strategy for the phone business, offset in part by increased strategic investments and acquisitions to drive cloud innovation. Sales and Marketing (In millions, except percentages) 2017 2016 2015 Percentage Change 2017 Versus 2016 Percentage Change 2016 Versus 2015 Sales and marketing $ 15,539 $ 14,697 $ 15,713 6% (6)% As a percent of revenue 17% 17% 17% 0ppt 0ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal year 2017 compared with fiscal year 2016 Sales and marketing expenses increased $842 million or 6%, primarily due to LinkedIn expenses and increased investments in sales capacity for our commercial cloud, offset in part by a reduction in phone expenses and prior year marketing expenses primarily related to Surface, commercial, and Windows 10. Expenses included $1.3 billion related to our acquisition of LinkedIn, including $359 million of amortization of acquired intangible assets. 36 PART II Item 7 Fiscal year 2016 compared with fiscal year 2015 Sales and marketing expenses decreased $1.0 billion or 6%, primarily due to a reduction in phone expenses, driven by the change in strategy for the phone business. Expenses included a favorable foreign currency impact of approximately 2%. General and Administrative (In millions, except percentages) 2017 2016 2015 Percentage Change 2017 Versus 2016 Percentage Change 2016 Versus 2015 General and administrative $ 4,481 $ 4,563 $ 4,611 (2)% (1)% As a percent of revenue 5% 5% 5% 0ppt 0ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal year 2017 compared with fiscal year 2016 General and administrative expenses decreased $82 million or 2%, primarily due to prior year investments in infrastructure supporting our business transformation, a reduction in phone expenses, and lower employee-related expenses, offset in part by LinkedIn expenses. Expenses included $294 million related to our acquisition of LinkedIn. Fiscal year 2016 compared with fiscal year 2015 General and administrative expenses decreased $48 million or 1%, primarily due to a reduction in employee-related expenses, offset in part by increased investments in infrastructure supporting our business transformation. Expenses included a favorable foreign currency impact of approximately 2%. IMPAIRMENT, INTEGRATION, AND RESTRUCTURING EXPENSES Impairment, integration, and restructuring expenses include costs associated with the impairment of goodwill and intangible assets related to our phone business, employee severance expenses and costs associated with the consolidation of facilities and manufacturing operations related to restructuring activities, and systems consolidation and other business integration expenses associated with our acquisition of Nokia Corporation’s Devices and Services business (“NDS”). Fiscal year 2017 compared with fiscal year 2016 Impairment, integration, and restructuring expenses were $306 million for fiscal year 2017, compared to $1.1 billion for fiscal year 2016. During fiscal year 2017, we recorded $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan.  During fiscal year 2016, we recorded $630 million of asset impairment charges related to our phone business. We also recorded $480 million of restructuring charges, including employee severance expenses and contract termination costs, primarily related to our previously announced phone business restructuring plans. Fiscal year 2016 compared with fiscal year 2015 Impairment, integration, and restructuring expenses were $1.1 billion for fiscal year 2016, compared to $10.0 billion for fiscal year 2015. 37 PART II Item 7 During fiscal year 2015, we recognized impairment charges of $7.5 billion related to our phone business. O ur annual goodwill impairment test as of May 1, 2015 indicated that the carrying value of our previous Phone Hardware reporting unit goodwill exceeded its estimated fair value. Accordingly, we recorde d a goodwill impairment charge of $5.1 billion, reducing our Phone Hardware reporting unit goodwill from $5.4 billion to $116 million, net of foreign currency remeasurements, as well as an impairment charge of $2.2 billion related to the write-down of our Phone Hardware reporting unit intangible assets. All remaining goodwill and intangible assets are included in our Devices reporting unit, within More Personal Computing under our current segment structure. Restructuring charges were $2.1 billion, including employee severance expenses and the write-down of certain assets in connection with our restructuring activities. Integration expenses associated with the acquisition of NDS were $435 million in fiscal year 2015. OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Dividends and interest income $ 1,387 $ 903 $ 766 Interest expense (2,222 ) (1,243 ) (781 ) Net recognized gains on investments 2,583 668 716 Net losses on derivatives (510 ) (443 ) (423 ) Net gains (losses) on foreign currency remeasurements (164 ) (121 ) 335 Other (251 ) (195 ) (267 ) Total $ 823 $ (431 ) $ 346 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) on certain balance sheet amounts from foreign exchange rate changes. Fiscal year 2017 compared with fiscal year 2016 Dividends and interest income increased primarily due to higher portfolio balances and yields on fixed-income securities. Interest expense increased primarily due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher gains on sales of equity securities. Net losses on derivatives increased due to higher losses on equity derivatives, offset in part by lower losses on commodity and foreign currency derivatives. Other, net reflects recognized losses from certain joint ventures and divestitures. Fiscal year 2016 compared with fiscal year 2015 Dividends and interest income increased due to higher portfolio balances and slightly higher yields on fixed-income securities. Interest expense increased due to higher outstanding long-term debt. Net recognized gains on investments decreased primarily due to higher other-than-temporary impairments and lower gains on sales of fixed-income securities, offset in part by higher gains on sales of equity securities. Net losses on derivatives increased due to higher losses on currency and equity contracts and lower gains on interest rate contracts in the current period as compared to the prior period, offset in part by lower losses on commodity contracts. For fiscal year 2016, other reflects recognized losses from divestitures and certain joint ventures. INCOME TAXES Fiscal year 2017 compared with fiscal year 2016 Our effective tax rate for fiscal years 2017 and 2016 was 8% and 15%, respectively. The decrease in our effective tax rate for fiscal year 2017 compared to fiscal year 2016 was primarily due to the realization of tax benefits attributable to previous phone business losses, offset in part by changes in the mix of our income before income 38 PART II Item 7 taxes between the U. S. and foreign countries. The fiscal year 2016 effective tax rate included the impact of nondeductible phone charges and valuation allowances. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower ra tes in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Additionally, our effective tax rate in fiscal year 2017 reflects the r ealization of tax benefits attributable to previous phone business losses. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. We supply our Windows PC operating system to customers through our U.S. regional operating center, while we supply the Microsoft Office system and our server products and tools to customers through our foreign regional operations centers. In fiscal year 2017, our U.S. income before income taxes was $453 million and our foreign income before income taxes was $22.7 billion. Net revenue deferrals related to sales of Windows 10 negatively impacted our fiscal year 2017 U.S. income before income taxes by $6.4 billion and foreign income before income taxes by $317 million. In fiscal year 2016, our U.S. loss before income taxes was $325 million and our foreign income before income taxes was $20.1 billion. Net revenue deferrals related to sales of Windows 10 negatively impacted our fiscal year 2016 U.S. loss by $6.0 billion and foreign income before income taxes by $588 million. Tax contingencies and other income tax liabilities were $13.5 billion and $11.8 billion as of June 30, 2017 and 2016, respectively, and are included in other long-term liabilities. This increase relates primarily to current period intercompany transfer pricing and tax credits. While we settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. We also continue to be subject to examination by the IRS for tax years 2010 to 2016. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of June 30, 2017, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2017, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. Fiscal year 2016 compared with fiscal year 2015 Our effective tax rate for fiscal years 2016 and 2015 was 15% and 34%, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The decrease in our effective tax rate for fiscal year 2016 compared to fiscal year 2015 was primarily due to changes in the mix of our income before income taxes between the U.S. and foreign countries including the impact of net revenue deferrals related to sales of Windows 10, tax benefits from the adoption of the new accounting guidance relating to stock-based compensation, and distributions from foreign affiliates. The fiscal year 2015 effective tax rate included the tax impact of losses in foreign jurisdictions for which we may not realize a tax benefit, primarily as a result of impairment and restructuring charges. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. We supply our Windows PC operating system to customers through our U.S. regional operating center, while we supply the Microsoft Office system and our server products and tools to customers through our foreign regional operations centers. In fiscal year 2016, our U.S. loss before income taxes was $325 million and our foreign income before income taxes was $20.1 billion. Net revenue deferrals related to sales of Windows 10 negatively impacted our fiscal year 2016 U.S. loss before income taxes by $6.0 billion and foreign income before income taxes by $588 million. In fiscal year 2015, our U.S. income before income taxes was $7.4 billion and our foreign income before income taxes was $11.1 billion. Impairment, integration, and restructuring expense relating to our phone business decreased our fiscal year 2015 U.S income before income taxes by $1.1 billion and foreign income before income taxes by $8.9 billion. 39 PART II Item 7 FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $133.0 billion as of June 30, 2017, compared with $113.2 billion as of June 30, 2016. Equity and other investments were $6.0 billion as of June 30, 2017, compared with $10.4 billion as of June 30, 2016. Our short-term investments are primarily intended to facilitate liquidity and for capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Of the cash, cash equivalents, and short-term investments as of June 30, 2017, $127.9 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was $2.4 billion. As of June 30, 2017, approximately 87% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 3% were invested in U.S. mortgage- and asset-backed securities, and approximately 2% were invested in corporate notes and bonds of U.S. companies, all of which are denominated in U.S. dollars. The remaining cash equivalents and short-term investments held by our foreign subsidiaries were primarily invested in foreign securities. Securities lending We lend certain fixed-income and equity securities to increase investment returns. The loaned securities continue to be carried as investments on our consolidated balance sheets. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash collateral received is recorded as an asset with a corresponding liability. Our securities lending payable balance was $97 million as of June 30, 2017. Our average and maximum securities lending payable balances for fiscal year 2017 were $484 million and $1.5 billion, respectively. Intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, domestic and international equities, and exchange-traded mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as foreign government bonds, corporate notes and bonds, mortgage- and asset-backed securities, U.S. government and agency securities, common and preferred stock, and certificates of deposit. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. 40 PART II Item 7 Cash Flows Fiscal year 2017 compared with fiscal year 2016 Cash from operations increased $6.2 billion to $39.5 billion during the fiscal year, mainly due to an increase in cash received from customers and an income tax refund for overpayment of estimated taxes, offset in part by an increase in cash paid to employees. Cash from financing increased $16.8 billion to $8.4 billion, mainly due to a $13.2 billion increase in proceeds from issuances of debt, net of repayments, and a $4.2 billion decrease in cash used for common stock repurchases, offset in part by an $839 million increase in dividends paid. Cash used in investing increased $22.8 billion to $46.8 billion, mainly due to a $24.6 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangibles and other assets, offset in part by a $1.9 billion decrease in cash used for net investment purchases, sales, and maturities. Fiscal year 2016 compared with fiscal year 2015 Cash from operations increased $3.7 billion to $33.3 billion during the fiscal year, mainly due to lower operating expenditures and a reduction in materials and production costs, offset in part by a decrease in cash received from customers. Cash used in financing decreased $1.3 billion to $8.4 billion, mainly due to a $4.6 billion increase in proceeds from issuances of debt, net of repayments, offset in part by a $1.5 billion increase in cash used for common stock repurchases and a $1.1 billion increase in dividends paid. Cash used in investing increased $949 million to $24.0 billion, mainly due to a $2.4 billion increase in cash used for additions to property and equipment and a $1.5 billion increase in cash used for net investment purchases, sales, and maturities, offset in part by a $2.3 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangibles and other assets. Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue as of June 30, 2017 was comprised mainly of unearned revenue from volume licensing programs. Unearned revenue from volume licensing programs represents customer billings for multi-year licensing arrangements paid for either at inception of the agreement or annually at the beginning of each coverage period and accounted for as subscriptions with revenue recognized ratably over the coverage period. Unearned revenue as of June 30, 2017 also included payments for: Windows 10 licenses; post-delivery support and consulting services to be performed in the future; Office 365 subscriptions; LinkedIn; Xbox Live subscriptions; Dynamics business solutions products; Skype prepaid credits and subscriptions; and other offerings for which we have been paid in advance and earn the revenue when we provide the service or software, or otherwise meet the revenue recognition criteria. The following table outlines the expected future recognition of unearned revenue as of June 30, 2017: (In millions) Three Months Ending, September 30, 2017 $ 12,544 December 31, 2017 9,993 March 31, 2018 7,307 June 30, 2018 4,258 Thereafter 10,377 Total $ 44,479 41 PART II Item 7 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Share Repurchases During fiscal year 2017, 2016, and 2015, we repurchased 170 million shares, 294 million shares, and 295 million shares of our common stock for $10.3 billion, $14.8 billion, and $13.2 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends See Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these indemnifications, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our consolidated financial statements during the periods presented. Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2017: (In millions) 2018 2019-2020 2021-2022 Thereafter Total Long-term debt: (a) Principal payments $ 1,050 $ 9,518 $ 11,746 $ 55,523 $ 77,837 Interest payments 2,402 4,672 4,301 33,179 44,554 Construction commitments (b) 1,067 0 0 0 1,067 Operating leases (b) 1,292 2,335 1,657 2,588 7,872 Capital leases, including imputed interest (b) 334 835 866 4,612 6,647 Purchase commitments (c) 16,002 628 176 397 17,203 Other long-term liabilities (d) 0 120 26 319 465 Total contractual obligations $ 22,147 $ 18,108 $ 18,772 $ 96,618 $ 155,645 (a) See Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) See Note 16 – Commitments of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (c) Amounts represent purchase commitments, including open purchase orders and take-or-pay contracts that are not presented as construction commitments above. (d) We have excluded long-term tax contingencies, other tax liabilities, deferred income taxes, and long-term pension liabilities of $14.4 billion from the amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items. 42 PART II Item 7 Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating leases for most U.S. and international sales and support offices and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity We earn a significant amount of our operating income outside the U.S., which is deemed to be permanently reinvested in foreign jurisdictions. As a result, as discussed above under Cash, Cash Equivalents, and Investments, the majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries. We currently do not intend nor foresee a need to repatriate these funds. We expect existing domestic cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our domestic operating activities and cash commitments for investing and financing activities, such as regular quarterly dividends, debt maturities, and material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. In addition, we expect existing foreign cash, cash equivalents, short-term investments, and cash flows from operations to continue to be sufficient to fund our foreign operating activities and cash commitments for investing activities, such as material capital expenditures, for at least the next 12 months and thereafter for the foreseeable future. Should we require more capital in the U.S. than is generated by our operations domestically, for example to fund significant discretionary activities, such as business acquisitions and share repurchases, we could elect to repatriate future earnings from foreign jurisdictions or raise capital in the U.S. through debt or equity issuances. These alternatives could result in higher effective tax rates, increased interest expense, or dilution of our earnings. We have borrowed funds domestically and continue to believe we have the ability to do so at reasonable interest rates. RECENT ACCOUNTING GUIDANCE See Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted for as separate units of accounting, and if so, the fair value for each of the elements. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future versions of software products and are accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. 43 PART II Item 7 Software updates are evaluated on a cas e-by-case basis to determine whether they meet the definition of an upgrade, which may require revenue to be deferred and recognized when the upgrade is delivered. If it is determined that implied post-contract customer support (“PCS”) is being provided, r evenue from the arrangement is deferred and recognized over the implied PCS term. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry-specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Customers purchasing a Windows 10 license will receive unspecified updates and upgrades over the life of their Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish VSOE. Accordingly, revenue from licenses of Windows 10 is recognized ratably over the estimated life of the related device, which ranges between two to four years. The new standard related to revenue recognition will have a material impact on our consolidated financial statements. See Note 1 – Accounting Policies in the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. 44 PART II Item 7 The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized on our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 45 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 46 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, equity prices, and commodity prices. A portion of these risks is hedged, but they may impact our consolidated financial statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily and use hedges where practicable to offset the risks and maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Our fixed-income portfolio is diversified across credit sectors and maturities, consisting primarily of investment-grade securities. The credit risk and average maturity of the fixed-income portfolio is managed to achieve economic returns that correlate to certain global and domestic fixed-income indices. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. Equity Our equity portfolio consists of global, developed, and emerging market securities that are subject to market price risk. We manage the securities relative to certain global and domestic indices and expect their economic risk and return to correlate with these indices. Commodity We use broad-based commodity exposures to enhance portfolio returns and facilitate portfolio diversification. Our investment portfolio has exposure to a variety of commodities, including precious metals, energy, and grain. We manage these exposures relative to global commodity indices and expect their economic risk and return to correlate with these indices. VALUE-AT-RISK We use a value-at-risk (“VaR”) model to estimate and quantify our market risks. VaR is the expected loss, for a given confidence level, in the fair value of our portfolio due to adverse market movements over a defined time horizon. The VaR model is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with U.S. GAAP, but is used as a risk estimation and management tool. The distribution of the potential changes in total market value of all holdings is computed based on the historical volatilities and correlations among foreign exchange rates, interest rates, equity prices, and commodity prices, assuming normal market conditions. The VaR is calculated as the total loss that will not be exceeded at the 97.5 percentile confidence level or, alternatively stated, the losses could exceed the VaR in 25 out of 1,000 cases. Several risk factors are not captured in the model, including liquidity risk, operational risk, and legal risk. 47 PART II Item 7A The following table sets forth the one-day VaR for substantially all of our positions as of June 30, 2017 and 2016 and for the year ended June 30, 2017: (In millions) June 30, 2017 June 30, 2016 Year Ended June 30, 2017 Risk Categories Average High Low Foreign currency $ 114 $ 92 $ 169 $ 303 $ 88 Interest rate 152 58 113 155 57 Equity 54 157 121 165 54 Commodity 0 12 8 12 0 Total one-day VaR for the combined risk categories was $207 million and $225 million as of June 30, 2017 and 2016. The total VaR is 35% and 29% less as of June 30, 2017 and 2016, respectively, than the sum of the separate risk categories in the table above due to the diversification benefit of the combination of risks. 48 PART II Item 8 ITEM 8. FINANCIAL STATE MENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2017 2016 2015 Revenue: Product $ 57,190 $ 61,502 $ 75,956 Service and other 32,760 23,818 17,624 Total revenue 89,950 85,320 93,580 Cost of revenue: Product 15,175 17,880 21,410 Service and other 19,086 14,900 11,628 Total cost of revenue 34,261 32,780 33,038 Gross margin 55,689 52,540 60,542 Research and development 13,037 11,988 12,046 Sales and marketing 15,539 14,697 15,713 General and administrative 4,481 4,563 4,611 Impairment, integration, and restructuring 306 1,110 10,011 Operating income 22,326 20,182 18,161 Other income (expense), net 823 (431 ) 346 Income before income taxes 23,149 19,751 18,507 Provision for income taxes 1,945 2,953 6,314 Net income $ 21,204 $ 16,798 $ 12,193 Earnings per share: Basic $ 2.74 $ 2.12 $ 1.49 Diluted $ 2.71 $ 2.10 $ 1.48 Weighted average shares outstanding: Basic 7,746 7,925 8,177 Diluted 7,832 8,013 8,254 Cash dividends declared per common share $ 1.56 $ 1.44 $ 1.24 See accompanying notes. 49 PART II Item 8 COMPREHENSIVE IN COME STATEMENTS (In millions) Year Ended June 30, 2017 2016 2015 Net income $ 21,204 $ 16,798 $ 12,193 Other comprehensive income (loss): Net unrealized gains (losses) on derivatives (net of tax effects of $(5) , $(12), and $20) (218 ) (238 ) 559 Net unrealized losses on investments (net of tax effects of $(613) , $(121), and $(197)) (1,116 ) (228 ) (362 ) Translation adjustments and other (net of tax effects of $9 , $(33), and $16) 228 (519 ) (1,383 ) Other comprehensive loss (1,106 ) (985 ) (1,186 ) Comprehensive income $ 20,098 $ 15,813 $ 11,007 See accompanying notes. Refer to Note 19 — Accumulated Other Comprehensive Income for further information. 50 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2017 2016 Assets Current assets: Cash and cash equivalents $ 7,663 $ 6,510 Short-term investments (including securities loaned of $3,694 and $204) 125,318 106,730 Total cash, cash equivalents, and short-term investments 132,981 113,240 Accounts receivable, net of allowance for doubtful accounts of $405 and $426 19,792 18,277 Inventories 2,181 2,251 Other 4,897 5,892 Total current assets 159,851 139,660 Property and equipment, net of accumulated depreciation of $24,179 and $19,800 23,734 18,356 Equity and other investments 6,023 10,431 Goodwill 35,122 17,872 Intangible assets, net 10,106 3,733 Other long-term assets 6,250 3,416 Total assets $ 241,086 $ 193,468 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 7,390 $ 6,898 Short-term debt 9,072 12,904 Current portion of long-term debt 1,049 0 Accrued compensation 5,819 5,264 Income taxes 718 580 Short-term unearned revenue 34,102 27,468 Securities lending payable 97 294 Other 6,280 5,949 Total current liabilities 64,527 59,357 Long-term debt 76,073 40,557 Long-term unearned revenue 10,377 6,441 Deferred income taxes 531 1,476 Other long-term liabilities 17,184 13,640 Total liabilities 168,692 121,471 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 7,708 and 7,808 69,315 68,178 Retained earnings 2,648 2,282 Accumulated other comprehensive income 431 1,537 Total stockholders’ equity 72,394 71,997 Total liabilities and stockholders’ equity $ 241,086 $ 193,468 See accompanying notes. 51 PART II Item 8 CASH FLOWS S TATEMENTS (In millions) Year Ended June 30, 2017 2016 2015 Operations Net income $ 21,204 $ 16,798 $ 12,193 Adjustments to reconcile net income to net cash from operations: Goodwill and asset impairments 0 630 7,498 Depreciation, amortization, and other 8,778 6,622 5,957 Stock-based compensation expense 3,266 2,668 2,574 Net recognized gains on investments and derivatives (2,073 ) (223 ) (443 ) Deferred income taxes (3,296 ) 332 224 Deferral of unearned revenue 67,711 57,072 45,072 Recognition of unearned revenue (57,735 ) (48,498 ) (44,920 ) Changes in operating assets and liabilities: Accounts receivable (925 ) (530 ) 1,456 Inventories 50 600 (272 ) Other current assets 1,066 (1,167 ) 62 Other long-term assets (539 ) (41 ) 346 Accounts payable 81 88 (1,054 ) Other current liabilities 386 (260 ) (624 ) Other long-term liabilities 1,533 (766 ) 1,599 Net cash from operations 39,507 33,325 29,668 Financing Proceeds from issuance (repayments) of short-term debt, maturities of 90 days or less, net (4,963 ) 7,195 4,481 Proceeds from issuance of debt 44,344 13,884 10,680 Repayments of debt (7,922 ) (2,796 ) (1,500 ) Common stock issued 772 668 634 Common stock repurchased (11,788 ) (15,969 ) (14,443 ) Common stock cash dividends paid (11,845 ) (11,006 ) (9,882 ) Other, net (190 ) (369 ) 362 Net cash from (used in) financing 8,408 (8,393 ) (9,668 ) Investing Additions to property and equipment (8,129 ) (8,343 ) (5,944 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (25,944 ) (1,393 ) (3,723 ) Purchases of investments (176,905 ) (129,758 ) (98,729 ) Maturities of investments 28,044 22,054 15,013 Sales of investments 136,350 93,287 70,848 Securities lending payable (197 ) 203 (466 ) Net cash used in investing (46,781 ) (23,950 ) (23,001 ) Effect of foreign exchange rates on cash and cash equivalents 19 (67 ) (73 ) Net change in cash and cash equivalents 1,153 915 (3,074 ) Cash and cash equivalents, beginning of period 6,510 5,595 8,669 Cash and cash equivalents, end of period $ 7,663 $ 6,510 $ 5,595 See accompanying notes. 52 PART II Item 8 STOCKHOLDERS’ EQ UITY STATEMENTS (In millions) Year Ended June 30, 2017 2016 2015 Common stock and paid-in capital Balance, beginning of period $ 68,178 $ 68,465 $ 68,366 Common stock issued 772 668 634 Common stock repurchased (2,987 ) (3,689 ) (3,700 ) Stock-based compensation expense 3,266 2,668 2,574 Stock-based compensation income tax benefits 0 0 588 Other, net 86 66 3 Balance, end of period 69,315 68,178 68,465 Retained earnings Balance, beginning of period 2,282 9,096 17,710 Net income 21,204 16,798 12,193 Common stock cash dividends (12,040 ) (11,329 ) (10,063 ) Common stock repurchased (8,798 ) (12,283 ) (10,744 ) Balance, end of period 2,648 2,282 9,096 Accumulated other comprehensive income Balance, beginning of period 1,537 2,522 3,708 Other comprehensive loss (1,106 ) (985 ) (1,186 ) Balance, end of period 431 1,537 2,522 Total stockholders’ equity $ 72,394 $ 71,997 $ 80,083 See accompanying notes. 53 PART II Item 8 NOTES TO FINANCI AL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles The consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”). We have recast certain prior period amounts to conform to the current period presentation, with no impact on consolidated net income or cash flows. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments through which we are able to exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments through which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates include: loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; allowances for product returns; the market value of, and demand for, our inventory; and stock-based compensation forfeiture rates. Examples of assumptions include: the elements comprising a software arrangement, including the distinction between upgrades or enhancements and new products; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized on our consolidated financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income (“OCI”). Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; hardware such as PCs, tablets, gaming and entertainment consoles, phones, other intelligent devices, and related accessories; and training and certification of computer system integrators and developers. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Microsoft Office 365, Microsoft Azure, Microsoft Dynamics 365, and Xbox Live; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. Revenue Recognition Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectability is probable. Revenue generally is recognized net of allowances for returns and any taxes collected from customers and subsequently remitted to governmental authorities. 54 PART II Item 8 Revenue recognition for multiple-element arrangements requires judgment to determine if multiple elements exist, whether elements can be accounted for as separate units of accounting, and if so, th e fair value for each of the elements. Microsoft enters into arrangements that can include various combinations of software, services, and hardware. Where elements are delivered over different periods of time, and when allowed under U.S. GAAP, revenue is allocated to the respective elements based on their relative selling prices at the inception of the arrangement, and revenue is recognized as each element is delivered. We use a hierarchy to determine the fair value to be used for allocating revenue to elements: (i) vendor-specific objective evidence of fair value (“VSOE”), (ii) third-party evidence, and (iii) best estimate of selling price (“ESP”). For software elements, we follow the industry specific software guidance which only allows for the use of VSOE in establishing fair value. Generally, VSOE is the price charged when the deliverable is sold separately or the price established by management for a product that is not yet sold if it is probable that the price will not change before introduction into the marketplace. ESPs are established as best estimates of what the selling prices would be if the deliverables were sold regularly on a stand-alone basis. Our process for determining ESPs requires judgment and considers multiple factors that may vary over time depending upon the unique facts and circumstances related to each deliverable. Revenue for retail packaged products, products licensed to original equipment manufacturers (“OEMs”), and perpetual licenses under certain volume licensing programs generally is recognized as products are shipped or made available. Technology guarantee programs are accounted for as multiple-element arrangements as customers receive free or significantly discounted rights to use upcoming new versions of a software product if they license existing versions of the product during the eligibility period. Revenue is allocated between the existing product and the new product, and revenue allocated to the new product is deferred until that version is delivered. The revenue allocation is based on the VSOE of fair value of the products. The VSOE of fair value for upcoming new products are based on the price determined by management having the relevant authority when the element is not yet sold separately, but is expected to be sold in the near future at the price set by management. Software updates that will be provided free of charge are evaluated on a case-by-case basis to determine whether they meet the definition of an upgrade and create a multiple-element arrangement, which may require revenue to be deferred and recognized when the upgrade is delivered, or if it is determined that implied post-contract customer support (“PCS”) is being provided, the arrangement is accounted for as a multiple-element arrangement and all revenue from the arrangement is deferred and recognized over the implied PCS term when the VSOE of fair value does not exist. If updates are determined to not meet the definition of an upgrade, revenue is generally recognized as products are shipped or made available. Customers purchasing a Windows 10 license will receive unspecified updates and upgrades over the life of their Windows 10 device at no additional cost. As these updates and upgrades will not be sold on a stand-alone basis, we are unable to establish VSOE of fair value. Accordingly, revenue from licenses of Windows 10 is recognized ratably over the estimated life of the related device, which ranges between two to four years. Certain volume licensing arrangements include a perpetual license for current products combined with rights to receive unspecified future versions of software products, which we have determined are additional software products and are therefore accounted for as subscriptions, with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period. Arrangements that include term-based licenses for current products with the right to use unspecified future versions of the software during the coverage period, are also accounted for as subscriptions, with revenue recognized ratably over the coverage period. Revenue from cloud-based services arrangements that allow for the use of a hosted software product or service over a contractually determined period of time without taking possession of software are accounted for as subscriptions with billings recorded as unearned revenue and recognized as revenue ratably over the coverage period beginning on the date the service is made available to customers. Revenue from cloud-based services arrangements that are provided on a consumption basis (for example, the amount of storage used in a particular period) is recognized commensurate with the customer utilization of such resources. Some volume licensing arrangements include time-based subscriptions for cloud-based services and software offerings that are accounted for as subscriptions. These arrangements are considered multiple-element arrangements. However, because all elements are accounted for as subscriptions and have the same coverage period and delivery pattern, they have the same revenue recognition timing. 55 PART II Item 8 Revenue related to Surface devices, Xbox consoles, games published by us, phones, and other hardware components is generally recognized when ownership is transferred to the resellers or to end customers when selling directly through Microsoft retail stores and online marketplaces. A portion of revenue may be deferred when these products are combined with software elements, and/or services. Revenue related to licensing for games published by third parties for use on th e Xbox consoles is recognized when games are manufactured by the game publishers. Display advertising revenue is recognized as advertisements are displayed. Search advertising revenue is recognized when the ad appears in the search results or when the action necessary to earn the revenue has been completed. Consulting services revenue is recognized as services are rendered, generally based on the negotiated hourly rate in the consulting arrangement and the number of hours worked during the period. Consulting revenue for fixed-price services arrangements is recognized as services are provided. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain Internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.5 billion, $1.6 billion, and $1.9 billion in fiscal years 2017, 2016, and 2015, respectively. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. 56 PART II Item 8 Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the per iod of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently reinvested, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term on our consolidated balance sheets. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 non-derivative investments primarily include U.S. government securities, domestic and international equities, and actively traded mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies and commodities. Our Level 2 non-derivative investments consist primarily of foreign government bonds, corporate notes and bonds, mortgage- and asset-backed securities, U.S. government and agency securities, common and preferred stock, and certificates of deposit. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets and liabilities primarily comprise investments in common and preferred stock, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other current financial assets and our current financial liabilities have fair values that approximate their carrying values. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term 57 PART II Item 8 based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are re corded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in the market value of available-for-sale securities, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the equity method. We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and the loaned securities continue to be carried as investments on our consolidated balance sheets. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established. Derivatives Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, the gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as cash flow hedges, the effective portion of the gains (losses) on the derivatives is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense), net. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities, which are recorded as a component of OCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense), net. 58 PART II Item 8 Allowance for Doubtful Accounts The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2017 2016 2015 Balance, beginning of period $ 426 $ 335 $ 301 Charged to costs and other 85 146 77 Write-offs (106 ) (55 ) (43 ) Balance, end of period $ 405 $ 426 $ 335 Inventories Inventories are stated at average cost, subject to the lower of cost or market. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years; computer equipment, two to three years; buildings and improvements, five to 15 years; leasehold improvements, three to 20 years; and furniture and equipment, one to 10 years. Land is not depreciated. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 15 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Accounting for Income Taxes – Intra-Entity Asset Transfers In October 2016, the Financial Accounting Standards Board (“FASB”) issued new guidance requiring an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs, rather than when the asset has been sold to an outside party. This guidance is effective for us beginning July 1, 2018, with early adoption permitted beginning July 1, 2017. We plan to adopt the guidance effective July 1, 2018. Adoption of the guidance will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. A cumulative-effect adjustment will capture the write-off of income tax consequences deferred from past intra-entity transfers involving assets other than inventory and new deferred tax assets for amounts not recognized under current U.S. GAAP. We anticipate this guidance will have a material impact on our consolidated balance sheets upon adoption, and continue to evaluate any impacts to our accounting policies, processes, and systems. 59 PART II Item 8 Financial Instruments – Credit Losses In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current U.S. GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We will be required to use a forward-looking expected credit loss model for accounts receivables, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The standard will be effective for us beginning July 1, 2020, with early adoption permitted beginning July 1, 2019. Adoption of the standard will be applied using a modified retrospective a pproach through a cumulative-effect adjustment to retained earnings as of the effective date. We are currently evaluating the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems. Leases In February 2016, the FASB issued a new standard related to leases to increase transparency and comparability among organizations by requiring the recognition of right-of-use (“ROU”) assets and lease liabilities on the balance sheet. Most prominent among the changes in the standard is the recognition of ROU assets and lease liabilities by lessees for those leases classified as operating leases under current U.S. GAAP. Under the standard, disclosures are required to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. We will be required to recognize and measure leases existing at, or entered into after, the beginning of the earliest comparative period presented using a modified retrospective approach, with certain practical expedients available. The standard will be effective for us beginning July 1, 2019, with early adoption permitted. We elected to early adopt the standard effective July 1, 2017 concurrent with our adoption of the new standard related to revenue recognition. We elected the available practical expedients on adoption. In preparation for adoption of the standard, we have implemented internal controls and key system functionality to enable the preparation of financial information. The standard will have a material impact on our consolidated balance sheets, but will not have a material impact on our consolidated income statements. The most significant impact will be the recognition of ROU assets and lease l iabilities for operating leases, while our accounting for capital leases remains substantially unchanged. Adoption of the standard will result in the recognition of additional ROU assets and lease liabilities for operating leases of $6.6 billion and $5.2 billion as of June 30, 2017 and 2016, respectively. See Expected Impacts to Reported Results below for the impact of adoption of the standard on our consolidated financial statements. Financial Instruments – Recognition, Measurement, Presentation, and Disclosure In January 2016, the FASB issued a new standard related to certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most prominent among the changes in the standard is the requirement for changes in the fair value of our equity investments, with certain exceptions, to be recognized through net income rather than OCI. The standard will be effective for us beginning July 1, 2018. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We are currently evaluating the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems. Revenue from Contracts with Customers In May 2014, the FASB issued a new standard related to revenue recognition. Under the standard, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. The guidance permits two methods of adoption: retrospectively to each prior reporting period presented (full retrospective method), or retrospectively with the cumulative effect of initially applying the guidance recognized at the date of initial application (modified retrospective method). We will adopt the standard using the full retrospective method to restate each prior reporting period presented. 60 PART II Item 8 The standard will be effective for us beginning July 1, 2018, with early adoption permitted. We elected to early adopt the s tandard effective July 1, 2017. In preparation for adoption of the standard, we have implemented internal controls and key system functionality to enable the preparation of financial information and have reached conclusions on key accounting assessments re lated to the standard, including our assessment that the impact of accounting for costs incurred to obtain a contract is immaterial. The most significant impact of the standard relates to our accounting for software license revenue. Specifically, for Windows 10, we will recognize revenue predominantly at the time of billing and delivery rather than ratably over the life of the related device. For certain multi-year commercial software subscriptions that include both distinct software licenses and Software Assurance, we will recognize license revenue at the time of contract execution rather than over the subscription period. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard will depend on contract-specific terms and in some instances may vary from recognition at the time of billing. Revenue recognition related to our hardware, cloud offerings such as Office 365, LinkedIn, and professional services will remain substantially unchanged. Adoption of the standard will result in the recognition of additional revenue of $6.6 billion and $5.8 billion for fiscal year 2017 and 2016, respectively, and an increase in the provision for income taxes of $2.5 billion and $2.1 billion, respectively, primarily due to the net change in Windows 10 revenue recognition. In addition, adoption of the standard will result in an increase in accounts receivable and other current and long-term assets of $2.7 billion and $4.2 billion, as of June 30, 2017 and 2016, respectively, driven by unbilled receivables from upfront recognition of revenue for certain multi-year commercial software subscriptions that include both distinct software licenses and Software Assurance; a reduction of unearned revenue of $17.8 billion and $11.7 billion as of June 30, 2017 and 2016, respectively, driven by the upfront recognition of license revenue from Windows 10 and certain multi-year commercial software subscriptions; and an increase in deferred income taxes of $5.2 billion and $4.8 billion as of June 30, 2017 and 2016, respectively, driven by the upfront recognition of revenue. See Expected Impacts to Reported Results below for the impact of adoption of the standard on our consolidated financial statements. Expected Impacts to Reported Results Adoption of the standards related to revenue recognition and leases is expected to impact our reported results as follows: (In millions, except earnings per share) Year Ended June 30, 2017 As Reported New Revenue Standard Adjustment New Lease Standard Adjustment As Adjusted Income statements: Revenue $ 89,950 $ 6,621 $ 0 $ 96,571 Provision for income taxes 1,945 2,467 0 4,412 Net income 21,204 4,285 0 25,489 Diluted earnings per share 2.71 0.54 0 3.25 (In millions, except earnings per share) Year Ended June 30, 2016 As Reported New Revenue Standard Adjustment New Lease Standard Adjustment As Adjusted Income statements: Revenue $ 85,320 $ 5,834 $ 0 $ 91,154 Provision for income taxes 2,953 2,147 0 5,100 Net income 16,798 3,741 0 20,539 Diluted earnings per share 2.10 0.46 0 2.56 61 PART II Item 8 (In millions) June 30, 2017 As Reported New Revenue Standard Adjustment New Lease Standard Adjustment As Adjusted Balance sheets: Accounts receivable, net $ 19,792 $ 2,639 $ 0 $ 22,431 Operating lease right-of-use assets 0 0 6,555 6,555 Other current and long-term assets 11,147 32 0 11,179 Unearned revenue 44,479 (17,823) 0 26,656 Deferred income taxes 531 5,203 0 5,734 Operating lease liabilities 0 0 5,372 5,372 Other current and long-term liabilities 23,464 (26) 1,183 24,621 Stockholders' equity 72,394 15,317 0 87,711 (In millions) June 30, 2016 As Reported New Revenue Standard Adjustment New Lease Standard Adjustment As Adjusted Balance sheets: Accounts receivable, net $ 18,277 $ 2,359 $ 0 $ 20,636 Operating lease right-of-use assets 0 0 5,198 5,198 Other current and long-term assets 9,308 1,872 0 11,180 Unearned revenue 33,909 (11,716) 0 22,193 Deferred income taxes 1,476 4,837 0 6,313 Operating lease liabilities 0 0 4,257 4,257 Other current and long-term liabilities 19,589 17 941 20,547 Stockholders' equity 71,997 11,093 0 83,090 Adoption of the standards related to revenue recognition and leases had no impact to cash from or used in operating, financing, or investing on our consolidated cash flows statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2017 2016 2015 Net income available for common shareholders (A) $ 21,204 $ 16,798 $ 12,193 Weighted average outstanding shares of common stock (B) 7,746 7,925 8,177 Dilutive effect of stock-based awards 86 88 77 Common stock and common stock equivalents (C) 7,832 8,013 8,254 Earnings Per Share Basic (A/B) $ 2.74 $ 2.12 $ 1.49 Diluted (A/C) $ 2.71 $ 2.10 $ 1.48 62 PART II Item 8 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Dividends and interest income $ 1,387 $ 903 $ 766 Interest expense (2,222 ) (1,243 ) (781 ) Net recognized gains on investments 2,583 668 716 Net losses on derivatives (510 ) (443 ) (423 ) Net gains (losses) on foreign currency remeasurements (164 ) (121 ) 335 Other, net (251 ) (195 ) (267 ) Total $ 823 $ (431 ) $ 346 Following are details of net recognized gains (losses) on investments during the periods reported: (In millions) Year Ended June 30, 2017 2016 2015 Other-than-temporary impairments of investments $ (55 ) $ (322 ) $ (183 ) Realized gains from sales of available-for-sale securities 3,064 1,376 1,176 Realized losses from sales of available-for-sale securities (426 ) (386 ) (277 ) Total $ 2,583 $ 668 $ 716 63 PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2017 Cash $ 3,624 $ 0 $ 0 $ 3,624 $ 3,624 $ 0 $ 0 Mutual funds 1,478 0 0 1,478 1,478 0 0 Commercial paper 319 0 0 319 69 250 0 Certificates of deposit 1,358 0 0 1,358 972 386 0 U.S. government and agency securities 112,119 85 (360 ) 111,844 16 111,828 0 Foreign government bonds 5,276 2 (13 ) 5,265 1,504 3,761 0 Mortgage- and asset-backed securities 3,921 14 (4 ) 3,931 0 3,931 0 Corporate notes and bonds 4,786 61 (12 ) 4,835 0 4,835 0 Municipal securities 284 43 0 327 0 327 0 Common and preferred stock 2,472 3,062 (34 ) 5,500 0 0 5,500 Other investments 523 0 0 523 0 0 523 Total $ 136,160 $ 3,267 $ (423 ) $ 139,004 $ 7,663 $ 125,318 $ 6,023 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2016 Cash $ 3,501 $ 0 $ 0 $ 3,501 $ 3,501 $ 0 $ 0 Mutual funds 1,012 0 0 1,012 1,012 0 0 Commercial paper 298 0 0 298 298 0 0 Certificates of deposit 1,000 0 0 1,000 868 132 0 U.S. government and agency securities 89,970 245 (11 ) 90,204 100 90,104 0 Foreign government bonds 5,502 10 (18 ) 5,494 731 4,763 0 Mortgage- and asset-backed securities 4,789 21 (2 ) 4,808 0 4,808 0 Corporate notes and bonds 6,509 110 (35 ) 6,584 0 6,584 0 Municipal securities 285 57 0 342 0 342 0 Common and preferred stock 5,597 4,452 (236 ) 9,813 0 0 9,813 Other investments 615 0 0 615 0 (3 ) 618 Total $ 119,078 $ 4,895 $ (302 ) $ 123,671 $ 6,510 $ 106,730 $ 10,431 As of June 30, 2017 and 2016, the recorded bases of common and preferred stock that are restricted for more than one year or are not publicly traded were $1.1 billion and $767 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments. As of June 30, 2017, collateral received under agreements for loaned securities was $3.7 billion, which was primarily comprised of U.S. government and agency securities. As of June 30, 2016, collateral received under agreements for loaned securities was $294 million, which was primarily comprised of cash. 64 PART II Item 8 Unrealized Losses on Inve stments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2017 U.S. government and agency securities $ 87,558 $ (348 ) $ 371 $ (12 ) $ 87,929 $ (360 ) Foreign government bonds 4,006 (2 ) 23 (11 ) 4,029 (13 ) Mortgage- and asset-backed securities 1,068 (3 ) 198 (1 ) 1,266 (4 ) Corporate notes and bonds 669 (8 ) 177 (4 ) 846 (12 ) Common and preferred stock 69 (6 ) 148 (28 ) 217 (34 ) Total $ 93,370 $ (367 ) $ 917 $ (56 ) $ 94,287 $ (423 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2016 U.S. government and agency securities $ 5,816 $ (3 ) $ 432 $ (8 ) $ 6,248 $ (11 ) Foreign government bonds 3,452 (3 ) 35 (15 ) 3,487 (18 ) Mortgage- and asset-backed securities 844 (1 ) 322 (1 ) 1,166 (2 ) Corporate notes and bonds 1,180 (11 ) 788 (24 ) 1,968 (35 ) Common and preferred stock 896 (147 ) 390 (89 ) 1,286 (236 ) Total $ 12,188 $ (165 ) $ 1,967 $ (137 ) $ 14,155 $ (302 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2017 Due in one year or less $ 18,212 $ 18,188 Due after one year through five years 102,374 102,168 Due after five years through 10 years 6,478 6,504 Due after 10 years 999 1,019 Total $ 128,063 $ 127,879 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. dollar equivalents. 65 PART II Item 8 Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. As of June 30, 2017 and 2016, the total notional amounts of these foreign exchange contracts sold were $8.9 billion and $8.4 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of June 30, 2017 and 2016, the total notional amounts of these foreign exchange contracts sold were $5.1 billion and $5.3 billion, respectively. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. As of June 30, 2017, the total notional amounts of these foreign exchange contracts purchased and sold were $8.8 billion and $10.6 billion, respectively. As of June 30, 2016, the total notional amounts of these foreign exchange contracts purchased and sold were $12.0 billion and $11.7 billion, respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2017, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.9 billion and $2.4 billion, respectively, of which $1.6 billion and $1.8 billion, respectively, were designated as hedging instruments. As of June 30, 2016, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.3 billion and $2.2 billion, respectively, of which $737 million and $986 million, respectively, were designated as hedging instruments. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2017, the total notional amounts of fixed-interest rate contracts purchased and sold were $233 million and $352 million, respectively. As of June 30, 2016, the total notional amounts of fixed-interest rate contracts purchased and sold were $328 million and $2.4 billion, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2017 and 2016, the total notional derivative amounts of mortgage contracts purchased were $567 million and $548 million, respectively. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of June 30, 2017, the total notional amounts of credit contracts purchased and sold were $267 million and $63 million, respectively. As of June 30, 2016, the total notional amounts of credit contracts purchased and sold were $440 million and $273 million, respectively. 66 PART II Item 8 Commodity We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of June 30, 2017, the total notional amounts of commodity contracts purchased were $19 million. As of June 30, 2016, the total notional amounts of commodity contracts purchased and sold were $631 million and $162 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2017, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. 67 PART II Item 8 Fair Values of Derivative Instruments The following table presents the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk: June 30, 2017 June 30, 2016 Assets Liabilities Assets Liabilities (In millions) Short-term Investments Other Current Assets Equity and Other Investments Other Long-term Assets Other Current Liabilities Other Long-term Liabilities Short-term Investments Other Current Assets Equity and Other Investments Other Current Liabilities Non-designated Hedge Derivatives Foreign exchange contracts $ 9 $ 203 $ 0 $ 6 $ (134 ) $ (8 ) $ 33 $ 156 $ 0 $ (296 ) Equity contracts 3 0 0 0 (6 ) 0 23 0 0 (16 ) Interest rate contracts 3 0 0 0 (7 ) 0 10 0 0 (25 ) Credit contracts 5 0 0 0 (1 ) 0 6 0 0 (5 ) Total $ 20 $ 203 $ 0 $ 6 $ (148 ) $ (8 ) $ 72 $ 156 $ 0 $ (342 ) Designated Hedge Derivatives Foreign exchange contracts $ 80 $ 133 $ 0 $ 0 $ (3 ) $ 0 $ 1 $ 392 $ 0 $ (263 ) Equity contracts 0 0 67 0 (186 ) 0 0 0 18 (25 ) Total $ 80 $ 133 $ 67 $ 0 $ (189 ) $ 0 $ 1 $ 392 $ 18 $ (288 ) Total gross amounts of derivatives $ 100 $ 336 $ 67 $ 6 $ (337 ) $ (8 ) $ 73 $ 548 $ 18 $ (630 ) Gross derivatives either offset or subject to an enforceable master netting agreement $ 100 $ 336 $ 67 $ 6 $ (334 ) $ (8 ) $ 69 $ 548 $ 18 $ (630 ) Gross amounts of derivatives offset on the balance sheet (20 ) (132 ) (67 ) (8 ) 221 7 (74 ) (302 ) (25 ) 398 Net amounts presented on the balance sheet 80 204 0 (2 ) (113 ) (1 ) (5 ) 246 (7 ) (232 ) Gross amounts of derivatives not offset on the balance sheet 0 0 0 0 0 0 0 0 0 0 Cash collateral received 0 0 0 0 (228 ) 0 0 0 0 (250 ) Net amount $ 80 $ 204 $ 0 $ (2 ) $ (341 ) $ (1 ) $ (5 ) $ 246 $ (7 ) $ (482 ) See also Note 4 – Investments and Note 6 – Fair Value Measurements. 68 PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense), net the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2017 2016 2015 Foreign Exchange Contracts Derivatives $ 441 $ (797 ) $ 741 Hedged items (386 ) 838 (725 ) Total amount of ineffectiveness $ 55 $ 41 $ 16 Equity Contracts Derivatives $ (74 ) $ (76 ) $ (107 ) Hedged items 74 76 107 Total amount of ineffectiveness $ 0 $ 0 $ 0 Amount of equity contracts excluded from effectiveness assessment $ (80 ) $ (10 ) $ 0 Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges: (In millions) Year Ended June 30, 2017 2016 2015 Effective Portion Gains recognized in other comprehensive income (net of tax effects of $4 , $24 and $35) $ 328 $ 351 $ 1,152 Gains reclassified from accumulated other comprehensive income into revenue 555 625 608 Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense), net (389 ) (354 ) (346 ) We estimate that $130 million of net derivative gains included in AOCI as of June 30, 2017 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2017. 69 PART II Item 8 Non-Designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), net, which were immaterial for the periods presented. Other than those derivatives entered into for investment purposes, such as commodity contracts, the gains (losses) below are generally economically offset by unrealized gains (losses) in the underlying available-for-sale securities and gains (losses) from foreign exchange rate changes on certain balance sheet amounts. (In millions) Year Ended June 30, 2017 2016 2015 Foreign exchange contracts $ (117 ) $ (55 ) $ (483 ) Equity contracts (114 ) (21 ) (19 ) Interest-rate contracts 14 10 23 Credit contracts 5 (1 ) (1 ) Commodity contracts (22 ) (87 ) (223 ) Total $ (234 ) $ (154 ) $ (703 ) NOTE 6 — FAIR VALUE MEASUREMENTS Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2017 Assets Mutual funds $ 1,478 $ 0 $ 0 $ 1,478 $ 0 $ 1,478 Commercial paper 0 319 0 319 0 319 Certificates of deposit 0 1,358 0 1,358 0 1,358 U.S. government and agency securities 109,228 2,616 0 111,844 0 111,844 Foreign government bonds 0 5,187 0 5,187 0 5,187 Mortgage- and asset-backed securities 0 3,934 0 3,934 0 3,934 Corporate notes and bonds 0 4,829 1 4,830 0 4,830 Municipal securities 0 327 0 327 0 327 Common and preferred stock 2,414 1,994 18 4,426 0 4,426 Derivatives 1 508 0 509 (227 ) 282 Total $ 113,121 $ 21,072 $ 19 $ 134,212 $ (227 ) $ 133,985 Liabilities Derivatives and other $ 0 $ 345 $ 39 $ 384 $ (228 ) $ 156 70 PART II Item 8 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2016 Assets Mutual funds $ 1,012 $ 0 $ 0 $ 1,012 $ 0 $ 1,012 Commercial paper 0 298 0 298 0 298 Certificates of deposit 0 1,000 0 1,000 0 1,000 U.S. government and agency securities 86,492 3,707 0 90,199 0 90,199 Foreign government bonds 10 5,705 0 5,715 0 5,715 Mortgage- and asset-backed securities 0 4,803 0 4,803 0 4,803 Corporate notes and bonds 0 6,361 1 6,362 0 6,362 Municipal securities 0 342 0 342 0 342 Common and preferred stock 6,918 2,114 18 9,050 0 9,050 Derivatives 6 633 0 639 (401 ) 238 Total $ 94,438 $ 24,963 $ 19 $ 119,420 $ (401 ) $ 119,019 Liabilities Derivatives and other $ 17 $ 613 $ 0 $ 630 $ (398 ) $ 232 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk. The changes in our Level 3 financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented. The following table reconciles the total “Net Fair Value” of assets above to the balance sheet presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2017 2016 Net fair value of assets measured at fair value on a recurring basis $ 133,985 $ 119,019 Cash 3,624 3,501 Common and preferred stock measured at fair value on a nonrecurring basis 1,073 767 Other investments measured at fair value on a nonrecurring basis 523 618 Less derivative net assets classified as other current and long-term assets (202 ) (246 ) Other 1 12 Recorded basis of investment components $ 139,004 $ 123,671 Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal year 2017 and 2016, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis. 71 PART II Item 8 NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2017 2016 Raw materials $ 797 $ 612 Work in process 145 158 Finished goods 1,239 1,481 Total $ 2,181 $ 2,251 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2017 2016 Land $ 1,107 $ 824 Buildings and improvements 16,284 12,393 Leasehold improvements 5,064 3,659 Computer equipment and software 21,414 17,391 Furniture and equipment 4,044 3,889 Total, at cost 47,913 38,156 Accumulated depreciation (24,179 ) (19,800 ) Total, net $ 23,734 $ 18,356 As of June 30, 2017 and 2016, assets recorded under capital leases were $2.7 billion and $865 million, respectively, and accumulated depreciation associated with capital leases was $161 million and $57 million, respectively. During fiscal years 2017 and 2016, property and equipment acquired under capital leases was $1.8 billion and $413 million, respectively. During fiscal years 2017, 2016, and 2015, depreciation expense was $6.1 billion, $4.9 billion, and $4.1 billion, respectively. NOTE 9 — BUSINESS COMBINATIONS On December 8, 2016, we completed our acquisition of all issued and outstanding shares of LinkedIn Corporation, the world’s largest professional network on the Internet, for a total purchase price of $27.0 billion. The purchase price consisted primarily of cash of $26.9 billion. The acquisition is expected to accelerate the growth of LinkedIn, Office 365, and Dynamics 365. The financial results of LinkedIn have been included in our consolidated financial statements since the date of the acquisition. 72 PART II Item 8 The allocation of the purc hase price to goodwill was completed as of June 30, 2017. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash and cash equivalents $ 1,328 Short-term investments 2,110 Other current assets 697 Property and equipment 1,529 Intangible assets 7,887 Goodwill ( a ) 16,803 Short-term debt (b) (1,323 ) Other current liabilities (1,117 ) Deferred income taxes (774 ) Other (131 ) Total purchase price $ 27,009 (a) Goodwill was assigned to our Productivity and Business Processes segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of LinkedIn. None of the goodwill is expected to be deductible for income tax purposes. (b) Convertible senior notes issued by LinkedIn on November 12, 2014, substantially all of which were redeemed after our acquisition of LinkedIn. The remaining $18 million of notes are not redeemable and are included in long-term debt on our consolidated balance sheets. See Note 12 – Debt for further information. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Customer-related $ 3,607 7 years Marketing-related (trade names) 2,148 20 years Technology-based 2,109 3 years Contract-based 23 5 years Fair value of intangible assets acquired $ 7,887 9 years Our consolidated income statement includes the following revenue and operating loss attributable to LinkedIn since the date of acquisition: (In millions) Year Ended June 30, 2017 Revenue $ 2,268 Operating loss $ (948 ) Following are the supplemental consolidated financial results of Microsoft Corporation on an unaudited pro forma basis, as if the acquisition had been consummated on July 1, 2015: (In millions, except earnings per share) Year Ended June 30, 2017 2016 Revenue $ 91,668 $ 88,652 Net income 20,894 15,383 Diluted earnings per share 2.67 1.92 73 PART II Item 8 These pro forma results were based on estimates and assumptions, which we believe are reasonable. They are not the results that would have been realized had we been a combined company during the periods presented and are not necessarily indicative of our c onsolidated results of operations in future periods. The pro forma results include adjustments related to purchase accounting, primarily amortization of intangible assets. Acquisition costs and other nonrecurring charges were immaterial and are included in the earliest period presented. NOTE 10 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2015 Acquisitions Other June 30, 2016 Acquisitions Other June 30, 2017 Productivity and Business Processes $ 6,309 $ 443 $ (74 ) $ 6,678 $ 17,072 (a) $ (11 ) $ 23,739 Intelligent Cloud 4,917 549 1 5,467 49 39 5,555 More Personal Computing 5,713 100 (86 ) 5,727 115 (14 ) 5,828 Total $ 16,939 $ 1,092 $ (159 ) $ 17,872 $ 17,236 $ 14 $ 35,122 (a) Includes goodwill related to LinkedIn and other acquisitions. See Note 9 – Business Combinations for further information. The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the above table. Also included in “Other” are business dispositions and transfers between business segments due to reorganizations, as applicable. Our accumulated goodwill impairment as of both June 30, 2017 and 2016 was $11.3 billion. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. Effective May 1, 2017, we prospectively adopted accounting guidance that simplifies our goodwill impairment testing by eliminating the requirement to calculate the implied fair value of goodwill (formerly “Step 2”) in the event that an impairment is identified. Instead, an impairment charge is recorded based on the excess of the reporting unit’s carrying amount over its fair value. No instances of impairment were identified in our May 1, 2017 or May 1, 2016 test. During fiscal year 2015, we recorded impairment charges of $5.1 billion related to goodwill in our previous Phone Hardware reporting unit. Phone Hardware goodwill is included in the Devices reporting unit within More Personal Computing under our current segment structure. Upon completion of the annual testing as of May 1, 2015, our previous Phone Hardware reporting unit goodwill was determined to be impaired. In the second half of fiscal year 2015, Phone Hardware did not meet its sales volume and revenue goals, and the mix of units sold had lower margins than planned. These results, along with changes in the competitive marketplace and an evaluation of business priorities, led to a shift in strategic direction and reduced future revenue and profitability expectations for the business. As a result of these changes in strategy and expectations, we forecasted reductions in unit volume growth rates and lower future cash flows used to estimate the fair value of the Phone Hardware reporting unit, which resulted in the determination that an impairment adjustment was required. 74 PART II Item 8 Because our annual test indicated that Phone Hardware’s carrying value exceeded its estimated fair value, Step 2 of the goodwill impairment test was performed specific to Phone Hardware. Under Step 2, the fair value of all Phone Hardware assets and liabilities were estimated, including tangible assets, existing technology, patent agreements, and contractual arrangements, for the purpose of deriving an estimate of the implied fair value of goodwill. The implied fair value of the goodwill was then compared to the recorded goodwill to determine the amount of the impairment. Assumptions used in measuring the value of these assets and liabilities included th e discount rates and royalty rates used in valuing the intangible assets, and consideration of the market environment in valuing the tangible assets. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2017 2016 Technology-based (a) $ 7,765 $ (4,318 ) $ 3,447 $ 5,970 $ (3,648 ) $ 2,322 Marketing-related 4,016 (829 ) 3,187 1,869 (616 ) 1,253 Contract-based 841 (722 ) 119 796 (718 ) 78 Customer-related 4,045 (692 ) 3,353 465 (385 ) 80 Total $ 16,667 (b) $ (6,561 ) $ 10,106 $ 9,100 $ (5,367 ) $ 3,733 (a) Technology-based intangible assets included $59 million and $115 million of net carrying amount of software to be sold, leased, or otherwise marketed as of June 30, 2017 and 2016, respectively. (b) Includes intangible assets related to LinkedIn and other additions. See Note 9 – Business Combinations for further information. No material impairments of intangible assets were identified during fiscal year 2017. During fiscal year 2016, we recorded impairment charges of $480 million related to intangible assets in the Devices reporting unit within our More Personal Computing segment. In the fourth quarter of fiscal year 2016, we tested these intangible assets for recoverability due to changes in facts and circumstances associated with the shift in strategic direction and reduced profitability expectations for our phone business. Based on the results of our testing, we determined that the carrying value of the intangible assets was not recoverable, and an impairment charge was recorded to the extent that estimated fair value exceeded carrying value. We primarily used the income approach to determine the fair value of the intangible assets and determine the amount of impairment. During fiscal year 2015, we recorded impairment charges of $2.2 billion related to intangible assets in our previous Phone Hardware reporting unit. Phone Hardware intangible assets are included in the Devices reporting unit under our current segment structure. In the fourth quarter of fiscal year 2015, we tested these intangible assets for recoverability due to changes in facts and circumstances associated with the shift in strategic direction and reduced profitability expectations for Phone Hardware. Based on the results of our testing, we determined that the carrying value of the intangible assets was not recoverable, and an impairment charge was recorded to the extent that estimated fair value exceeded carrying value. We primarily used a relief from royalty income approach to determine the fair value of the intangible assets and determine the amount of impairment. These intangible assets impairment charges were included in impairment, integration, and restructuring expenses on our consolidated income statement, and reflected in Corporate and Other in our table of operating income (loss) by segment in Note 21 – Segment Information and Geographic Data. We estimate that we have no significant residual value related to our intangible assets. 75 PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2017 2016 Customer-related $ 3,607 7 years $ 30 3 years Technology-based 2,265 2 years 361 4 years Marketing-related 2,148 19 years 2 1 year Contract-based 63 6 years 0 n/a Total $ 8,083 9 years $ 393 4 years Intangible assets amortization expense was $1.7 billion, $978 million, and $1.3 billion for fiscal years 2017, 2016, and 2015, respectively. Amortization of capitalized software was $55 million, $69 million, and $79 million for fiscal years 2017, 2016, and 2015, respectively. The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2017: (In millions) Year Ending June 30, 2018 $ 2,190 2019 1,698 2020 1,180 2021 1,006 2022 932 Thereafter 3,100 Total $ 10,106 NOTE 12 — DEBT Short-term Debt As of June 30, 2017, we had $9.1 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 1.01% and maturities ranging from 25 days to 264 days. As of June 30, 2016, we had $12.9 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.43% and maturities ranging from 1 day to 99 days. The estimated fair value of this commercial paper approximates its carrying value. We have two $5.0 billion credit facilities that expire on October 31, 2017 and November 14, 2018, respectively. These credit facilities serve as a back-up for our commercial paper program. As of June 30, 2017, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreements. No amounts were drawn against these credit facilities during any of the periods presented. Long-term Debt As of June 30, 2017, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $77.1 billion and $80.3 billion, respectively. As of June 30, 2016, the total carrying value and estimated fair value of our long-term debt were $40.6 billion and $44.0 billion, respectively. These estimated fair values are based on Level 2 inputs. 76 PART II Item 8 The components of our long-term debt, including the current p ortion, and the associated interest rates were as follows: (In millions, except interest rates) Face Value Face Value Stated Interest Rate Effective Interest Rate June 30, 2017 2016 Notes November 15, 2017 $ 600 $ 600 0.875% 1.084% May 1, 2018 450 450 1.000% 1.106% November 3, 2018 1,750 1,750 1.300% 1.396% December 6, 2018 1,250 1,250 1.625% 1.824% June 1, 2019 1,000 1,000 4.200% 4.379% August 8, 2019 (a) 2,500 * 1.100% 1.203% November 1, 2019 (b) 18 * 0.500% 0.500% February 6, 2020 (c) 1,500 * 1.850% 1.952% February 12, 2020 1,500 1,500 1.850% 1.935% October 1, 2020 1,000 1,000 3.000% 3.137% November 3, 2020 2,250 2,250 2.000% 2.093% February 8, 2021 500 500 4.000% 4.082% August 8, 2021 (a) 2,750 * 1.550% 1.642% December 6, 2021 (d) 1,996 1,944 2.125% 2.233% February 6, 2022 (c) 1,750 * 2.400% 2.520% February 12, 2022 1,500 1,500 2.375% 2.466% November 3, 2022 1,000 1,000 2.650% 2.717% November 15, 2022 750 750 2.125% 2.239% May 1, 2023 1,000 1,000 2.375% 2.465% August 8, 2023 (a) 1,500 * 2.000% 2.101% December 15, 2023 1,500 1,500 3.625% 3.726% February 6, 2024 (c) 2,250 * 2.875% 3.041% February 12, 2025 2,250 2,250 2.700% 2.772% November 3, 2025 3,000 3,000 3.125% 3.176% August 8, 2026 (a) 4,000 * 2.400% 2.464% February 6, 2027 (c) 4,000 * 3.300% 3.383% December 6, 2028 (d) 1,996 1,944 3.125% 3.218% May 2, 2033 (d) 627 611 2.625% 2.690% February 12, 2035 1,500 1,500 3.500% 3.604% November 3, 2035 1,000 1,000 4.200% 4.260% August 8, 2036 (a) 2,250 * 3.450% 3.510% February 6, 2037 (c) 2,500 * 4.100% 4.152% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, 2042 900 900 3.500% 3.571% May 1, 2043 500 500 3.750% 3.829% December 15, 2043 500 500 4.875% 4.918% February 12, 2045 1,750 1,750 3.750% 3.800% November 3, 2045 3,000 3,000 4.450% 4.492% August 8, 2046 (a) 4,500 * 3.700% 3.743% February 6, 2047 (c) 3,000 * 4.250% 4.287% February 12, 2055 2,250 2,250 4.000% 4.063% November 3, 2055 1,000 1,000 4.750% 4.782% August 8, 2056 (a) 2,250 * 3.950% 4.033% February 6, 2057 (c) 2,000 * 4.500% 4.528% Total $ 77,837 $ 40,949 (a) In August 2016, we issued $19.8 billion of debt securities. 77 PART II Item 8 (b) Remaining notes that were acquired as part of the LinkedIn acquisition. See Note 9 – Business Combinations for further information. (c) In February 2017, we issued $17.0 billion of debt securities. (d) Euro-denominated debt securities. * Not applicable. The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. Cash paid for interest on our debt for fiscal years 2017, 2016, and 2015 was $1.6 billion, $1.1 billion, and $620 million, respectively. Effective July 1, 2016, we retrospectively adopted accounting guidance that requires debt issuance costs to be recorded as a deduction from the carrying amount of the debt liability, consistent with debt discounts. As of June 30, 2017 and 2016, the aggregate unamortized discount and debt issuance costs associated with our long-term debt, including the current portion, were $715 million and $392 million, respectively. Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2018 $ 1,050 2019 4,000 2020 5,518 2021 3,750 2022 7,996 Thereafter 55,523 Total $ 77,837 NOTE 13 — INCOME TAXES The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Current Taxes U.S. federal $ 2,739 $ 545 $ 3,661 U.S. state and local 30 136 364 Foreign 2,472 1,940 2,065 Current taxes 5,241 2,621 6,090 Deferred Taxes Deferred taxes (3,296 ) 332 224 Provision for income taxes $ 1,945 $ 2,953 $ 6,314 78 PART II Item 8 In fiscal year 2017, deferred taxes included U.S. and foreign deferred tax benefit of $2.7 billion and $617 million, respectively. U.S. and foreign components of income (loss) before income taxes were as follows: (In millions) Year Ended June 30, 2017 2016 2015 U.S. $ 453 $ (325 ) $ 7,363 Foreign 22,696 20,076 11,144 Income before income taxes $ 23,149 $ 19,751 $ 18,507 In fiscal year 2017, income before income taxes included the net impact of U.S. and foreign revenue deferrals related to the sales of Windows 10 of $6.4 billion and $317 million, respectively. In fiscal year 2016, income before income taxes included the net impact of U.S. and foreign revenue deferrals related to the sales of Windows 10 of $6.0 billion and $588 million, respectively. In fiscal year 2015, income before income taxes included the net impact of U.S. and foreign impairment, integration, and restructuring expenses relating to our phone business of $1.1 billion and $8.9 billion, respectively. The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2017 2016 2015 Federal statutory rate 35.0% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (15.7)% (19.4)% (20.9)% Phone business losses (7.3)% 1.3% 19.1% Excess tax benefits relating to stock-based compensation (2.7)% (2.0)% 0% Domestic production activities deduction (1.4)% (0.6)% (2.4)% Interest, net 1.8% 1.2% 1.5% Other reconciling items, net (1.3)% (0.5)% 1.8% Effective rate 8.4% 15.0% 34.1% The reduction from the federal statutory rate is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. Our foreign regional operating centers, which are taxed at rates lower than the U.S. rate, generated 64%, 69%, and 73% of our foreign income before tax in fiscal years 2017, 2016, and 2015, respectively. Additionally, our effective tax rate in fiscal year 2017 reflects the realization of tax benefits attributable to previous phone business losses. In general, other reconciling items consist primarily of U.S. state income taxes, permanent items, and credits. In fiscal years 2017, 2016, and 2015, there were no individually significant other reconciling items. The decrease in our effective tax rate for fiscal year 2017 compared to fiscal year 2016 was primarily due to the realization of tax benefits attributable to previous phone business losses, offset in part by changes in the mix of our income before income taxes between the U.S. and foreign countries. The fiscal year 2016 effective tax rate included the impact of nondeductible phone charges and valuation allowances. 79 PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2017 2016 Deferred Income Tax Assets Stock-based compensation expense $ 777 $ 809 Other expense items 1,550 1,609 Restructuring charges 66 284 Unearned revenue 1,889 494 Impaired investments 59 226 Loss carryforwards 4,809 4,252 Depreciation and amortization 53 115 Other revenue items 130 89 Deferred income tax assets 9,333 7,878 Less valuation allowance (3,310 ) (4,729 ) Deferred income tax assets, net of valuation allowance $ 6,023 $ 3,149 Deferred Income Tax Liabilities Foreign earnings $ (1,107 ) $ (1,242 ) Unrealized gain on investments and debt (1,384 ) (2,102 ) Depreciation and amortization (1,630 ) (1,008 ) Other (21 ) (54 ) Deferred income tax liabilities (4,142 ) (4,406 ) Net deferred income tax assets (liabilities) $ 1,881 $ (1,257 ) Reported As Other long-term assets $ 2,412 $ 219 Long-term deferred income tax liabilities (531 ) (1,476 ) Net deferred income tax assets (liabilities) $ 1,881 $ (1,257 ) In fiscal year 2017, we corrected the table above to include a $2.5 billion loss carryforward and valuation allowance as of June 30, 2016. We do not consider this correction to be material, and there was no impact to our consolidated financial statements. As of June 30, 2017, we had net operating loss carryforwards of $13.7 billion, including $11.1 billion of foreign net operating loss carryforwards. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and other net deferred tax assets that may not be realized. Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. As of June 30, 2017, we have not provided deferred U.S. income taxes or foreign withholding taxes on temporary differences of approximately $142 billion resulting from earnings for certain non-U.S. subsidiaries which are permanently reinvested outside the U.S. The unrecognized deferred tax liability associated with these temporary differences was approximately $45 billion as of June 30, 2017. Income taxes paid, net of refunds, were $2.4 billion, $3.9 billion, and $4.4 billion in fiscal years 2017, 2016, and 2015, respectively. 80 PART II Item 8 T ax contingencies and other income tax liabilities were $13.5 billion and $11.8 billion as of June 30, 2017 and 2016, respectively, and are included in other long-term liabilitie s. This increase relates primarily to current period intercompany transfer pricing and tax credits. Uncertain Tax Positions Unrecognized tax benefits as of June 30, 2017, 2016, and 2015, were $11.7 billion, $10.2 billion, and $9.6 billion, respectively. If recognized, these tax benefits would affect our effective tax rates for fiscal years 2017, 2016, and 2015, by $10.2 billion, $8.8 billion, and $7.9 billion, respectively. As of June 30, 2017, 2016, and 2015, we had accrued interest expense related to uncertain tax positions of $2.3 billion, $1.9 billion, and $1.7 billion, respectively, net of federal income tax benefits. Interest expense on unrecognized tax benefits was $399 million, $163 million, and $237 million in fiscal years 2017, 2016, and 2015, respectively, and was included in provision for income taxes. The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Balance, beginning of year $ 10,164 $ 9,599 $ 8,714 Decreases related to settlements (4 ) (201 ) (50 ) Increases for tax positions related to the current year 1,277 1,086 1,091 Increases for tax positions related to prior years 397 115 94 Decreases for tax positions related to prior years (49 ) (317 ) (144 ) Decreases due to lapsed statutes of limitations (48 ) (118 ) (106 ) Balance, end of year $ 11,737 $ 10,164 $ 9,599 While we settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and settled a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. We also continue to be subject to examination by the IRS for tax years 2010 to 2016. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of June 30, 2017, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2017, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our consolidated financial statements. NOTE 14 — RESTRUCTURING CHARGES Phone Hardware Restructuring In June 2015, management approved a plan to restructure our phone business to better focus and align resources (the “Phone Hardware Restructuring Plan”), under which we eliminated approximately 7,400 positions in fiscal year 2016. In fiscal year 2015, we incurred restructuring charges of $780 million under the Phone Hardware Restructuring Plan, including severance expenses and other reorganization costs. In fiscal year 2016, we reversed $21 million of previously estimated restructuring charges related to contract termination costs. The actions associated with the Phone Hardware Restructuring Plan were completed as of June 30, 2017. 81 PART II Item 8 2016 Restructuring In the fourth quarter of fiscal year 2016, management approved restructuring plans that resulted in approximately 4,700 job eliminations in fiscal year 2017, primarily across our smartphone hardware business and global sales. In fiscal year 2016, we incurred restructuring charges of $501 million in connection with the 2016 restructuring plans, including severance expenses and other reorganization costs. The actions associated with these restructuring plans were completed as of June 30, 2017. 2017 Restructuring In June 2017, management approved a sales and marketing restructuring plan. In fiscal year 2017, we recorded employee severance expenses of $306 million primarily related to this sales and marketing restructuring plan. We do not expect to incur additional charges for this restructuring plan in subsequent years. The actions associated with this restructuring plan are expected to be completed by the end of fiscal year 2018. Restructuring Summary Restructuring charges associated with each of these plans were included in impairment, integration, and restructuring expenses on our consolidated income statements, and were reflected in Corporate and Other in our table of operating income (loss) by segment. Changes in the restructuring liability were as follows: (In millions) Severance Other (a) Total Balance, as of June 30, 2016 $ 470 $ 239 $ 709 Restructuring charges 306 0 306 Cash paid (367 ) (101 ) (468 ) Other (36) (79 ) (115 ) Balance, as of June 30, 2017 $ 373 $ 59 $ 432 (a) Primarily reflects activities associated with the consolidation of our facilities and manufacturing operations, including contract termination costs and asset write-downs. NOTE 15 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2017 2016 Productivity and Business Processes $ 14,291 $ 12,497 Intelligent Cloud 13,464 11,472 More Personal Computing 3, 420 3,334 Corporate and Other 13,304 6,606 Total $ 44,479 $ 33,909 Corporate and Other consists of the net revenue deferral from Windows 10. Revenue from Windows 10 is primarily recognized at the time of billing in the More Personal Computing segment, and the deferral and subsequent recognition of revenue is reflected in Corporate and Other. 82 PART II Item 8 NOTE 16 — COMMITMENTS Construction and Operating Leases We have committed $1.1 billion for constructing new buildings, building improvements, and leasehold improvements as of June 30, 2017. We have operating leases for most U.S. and international sales and support offices, datacenters, research and development facilities, manufacturing facilities, retail stores, and certain equipment. Rental expense for facilities operating leases was $1.3 billion, $1.0 billion, and $989 million, in fiscal years 2017, 2016, and 2015, respectively. Future minimum rental commitments under non-cancellable facilities operating leases in place as of June 30, 2017 are as follows: (In millions) Year Ending June 30, 2018 $ 1,292 2019 1,220 2020 1,115 2021 908 2022 749 Thereafter 2,588 Total $ 7,872 Capital Leases We have capital leases for datacenters and corporate offices. As of June 30, 2017 and 2016, capital lease obligations included in other current liabilities were $113 million and $25 million, respectively, and capital lease obligations included in other long-term liabilities were $2.4 billion and $761 million, respectively. Future minimum lease payments under non-cancellable capital leases as of June 30, 2017 were as follows: (In millions) Year Ending June 30, 2018 $ 209 2019 217 2020 222 2021 227 2022 232 Thereafter 2,353 Total (a) $ 3,460 (a) Includes imputed interest of $922 million. As of June 30, 2017, we had additional purchase obligations for capital leases executed but not yet recorded of $3.2 billion. 83 PART II Item 8 NOTE 17 — CONTINGENCIES Patent and Intellectual Property Claims IPCom patent litigation IPCom GmbH & Co. (“IPCom”) is a German company that holds a large portfolio of mobile technology-related patents spanning about 170 patent families and addressing a broad range of cellular technologies. IPCom has asserted 19 of these patents in litigation against Nokia Corporation (“Nokia”) and many of the leading cell phone companies and operators. In November 2014, Microsoft and IPCom entered into a standstill agreement staying all of the pending litigation against Microsoft to permit the parties to pursue settlement discussions, which continue. InterDigital patent litigation InterDigital Technology Corporation and InterDigital Communications Corporation (collectively, “IDT”) filed four patent infringement cases against Nokia in the International Trade Commission (“ITC”) and in U.S. District Court for the District of Delaware between 2007 and 2013. We were added to these cases as a defendant after we acquired the Nokia phone business. Each of the ITC matters was resolved in our favor. In September 2015, in an inter partes review the United States Patent Trial and Appeal Board issued a final written decision that deemed unpatentable all asserted claims of the patent remaining at issue in the Delaware case. IDT’s appeal of this decision was heard by the U.S. Court of Appeals for the Federal Circuit on April 7, 2017 and the Delaware case was stayed pending final completion of the inter partes review (including appeals and any subsequent proceedings in the Patent Office). We filed an antitrust complaint against IDT in the District of Delaware in August 2015 asserting violations of Section 2 of the Sherman Act, alleging unlawful exploitation of standard essential patents. Microsoft and IDT settled these cases in May 2017 and they have been dismissed. European copyright levies We assumed from Nokia all potential liability due to Nokia’s alleged failure to pay “private copyright levies” in various European countries based upon sale of memory cards and mobile phones that incorporate blank memory. The levies are based upon a 2001 European Union (“EU”) Directive establishing a right for end users to make copies of copyrighted works for personal or private use, but also allowing the collection of levies based upon sales of blank media or recording devices to compensate copyright holders for private copying. Various collecting societies in EU countries initiated litigation against Nokia, stating it must pay levies not only based upon sales of blank memory cards, but also phones that include blank memory for data storage on the phones, regardless of actual usage of that memory. The most significant cases against Nokia were pending in Germany and Austria, due to both the high volume of sales and high levy amounts sought in these countries. We reached a settlement of the Austrian case in August 2016. In Germany, the only period for which settlement has not been reached is 2004 through 2007. In July 2016, the German Supreme Court heard our appeal contesting the legality of the levy assessed on phones with music players and over five megabytes of memory. The Supreme Court issued a ruling in December 2016, finding that the levy may not be appropriate for phones that have the ability to receive music files only via Bluetooth or infrared inputs, and remanded for further proceedings. A new case schedule has not been set, and we have reached a tentative settlement. Other patent and intellectual property claims In addition to the IPCom cases, there were 41 other patent infringement cases pending against Microsoft as of June 30, 2017. Antitrust, Unfair Competition, and Overcharge Class Actions Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010. The trial of the British Columbia action commenced in May 2016. The plaintiffs filed their case in chief in August 2016, setting out claims made, authorities, and evidence in support of their claims. A six-month oral hearing is scheduled to commence in September 2017, consisting of cross examination on witness affidavits. The Ontario and Quebec cases are inactive. 84 PART II Item 8 Other Antitrust Litigation and Claims China State Administration for Industry and Commerce investigatio n In 2014, Microsoft was informed that China’s State Administration for Industry and Commerce (“SAIC”) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAIC conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. SAIC has stated the investigation relates to compatibility, bundle sales, file verification issues related to Windows and Office software, and potentially other issues. Product-Related Litigation U.S. cell phone litigation Nokia, along with other handset manufacturers and network operators, is a defendant in 19 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims as part of our acquisition of Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining 10 cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, defendants in the consolidated cases moved to exclude plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part defendants’ motion to exclude plaintiffs’ general causation experts. The defendants filed an interlocutory appeal challenging the standard for evaluating expert scientific evidence, which the District of Columbia Court of Appeals heard en banc . In October 2016, the Court of Appeals issued its decision adopting the standard advocated by defendants and remanding the cases to the trial court for further proceedings under that standard. Plaintiffs have filed a motion to reopen discovery and file additional expert evidence. Canadian cell phone class action Nokia, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors. Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia defendants. The litigation has been dormant for more than two years. Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2017, we accrued aggregate legal liabilities of $352 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.0 billion in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable. 85 PART II Item 8 Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. We evaluate estimated losses for these indemnifications, and we consider such factors as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered significant costs as a result of these obligations and have not accrued any liabilities related to these indemnifications on our consolidated financial statements. NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Balance, beginning of year 7,808 8,027 8,239 Issued 70 75 83 Repurchased (170 ) (294 ) (295 ) Balance, end of year 7,708 7,808 8,027 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. This share repurchase program became effective on October 1, 2013, and was completed on December 22, 2016. On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to an additional $40.0 billion in share repurchases. This share repurchase program commenced on December 22, 2016 following completion of the prior program approved on September 16, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of June 30, 2017, $36.8 billion remained of this $40.0 billion share repurchase program. We repurchased the following shares of common stock under the share repurchase programs: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2017 2016 2015 First Quarter 63 $ 3,550 89 $ 4,000 43 $ 2,000 Second Quarter 59 3,533 66 3,600 43 2,000 Third Quarter 25 1,600 69 3,600 116 5,000 Fourth Quarter 23 1,600 70 3,600 93 4,209 Total 170 $ 10,283 294 $ 14,800 295 $ 13,209 Shares repurchased during the third and fourth quarter of fiscal year 2017 were under the share repurchase program approved September 20, 2016. All other shares repurchased were under the share repurchase program approved September 16, 2013. The above table excludes shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards. All repurchases were made using cash resources. 86 PART II Item 8 Dividends In fiscal year 2017, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 20, 2016 $ 0.39 November 17, 2016 $ 3,024 December 8, 2016 November 30, 2016 0.39 February 16, 2017 3,012 March 9, 2017 March 14, 2017 0.39 May 18, 2017 3,009 June 8, 2017 June 13, 2017 0.39 August 17, 2017 3,006 September 14, 2017 The dividend declared on June 13, 2017 will be paid after the filing date of the 2017 Form 10-K and was included in other current liabilities as of June 30, 2017. In fiscal year 2016, our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Total Amount Payment Date (In millions) September 15, 2015 $ 0.36 November 19, 2015 $ 2,868 December 10, 2015 December 2, 2015 0.36 February 18, 2016 2,842 March 10, 2016 March 15, 2016 0.36 May 19, 2016 2,821 June 9, 2016 June 14, 2016 0.36 August 18, 2016 2,800 September 8, 2016 The dividend declared on June 14, 2016 was included in other current liabilities as of June 30, 2016. 87 PART II Item 8 NOTE 19 — ACCUMULATED OTHER COMPREHENSIVE INCOME The following table summarizes the changes in accumulated other comprehensive income by component: (In millions) Year Ended June 30, 2017 2016 2015 Derivatives Balance, beginning of period $ 352 $ 590 $ 31 Unrealized gains, net of tax effects of $4 , $24 and $35 328 351 1,152 Reclassification adjustments for gains included in revenue (555 ) (625 ) (608 ) Tax expense included in provision for income taxes 9 36 15 Amounts reclassified from accumulated other comprehensive income (546 ) (589 ) (593 ) Net current period other comprehensive income (loss) (218 ) (238 ) 559 Balance, end of period $ 134 $ 352 $ 590 Investments Balance, beginning of period $ 2,941 $ 3,169 $ 3,531 Unrealized gains, net of tax effects of $267 , $120 and $59 517 219 110 Reclassification adjustments for gains included in other income (expense), net (2,513 ) (688 ) (728 ) Tax expense included in provision for income taxes 880 241 256 Amounts reclassified from accumulated other comprehensive income (1,633 ) (447 ) (472 ) Net current period other comprehensive loss (1,116 ) (228 ) (362 ) Balance, end of period $ 1,825 $ 2,941 $ 3,169 Translation Adjustments and Other Balance, beginning of period $ (1,756 ) $ (1,237 ) $ 146 Translation adjustments and other, net of tax effects of $9 , $(33) and $16 228 (519 ) (1,383 ) Balance, end of period $ (1,528 ) $ (1,756 ) $ (1,237 ) Accumulated other comprehensive income, end of period $ 431 $ 1,537 $ 2,522 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. As of June 30, 2017, an aggregate of 127 million shares were authorized for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Stock-based compensation expense $ 3,266 $ 2,668 $ 2,574 Income tax benefits related to stock-based compensation 1,066 882 868 88 PART II Item 8 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a four or five-year service period. Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a four-year service period. PSUs generally vest over a three-year performance period. The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for all stock plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year Ended June 30, 2017 2016 2015 Dividends per share (quarterly amounts) $ 0.36 - $  0.39 $ 0.31 - $  0.36 $ 0.28 - $  0.31 Interest rates 1.2% - 2.2% 1.1% - 1.8% 1.2% - 1.9% During fiscal year 2017, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 194 $ 36.92 Granted (a) 84 55.64 Assumed in acquisitions (b) 23 59.09 Vested (80 ) 37.36 Forfeited (20 ) 43.71 Nonvested balance, end of year 201 46.32 (a) Includes 2 million PSUs granted during fiscal year 2017. During both fiscal year 2016 and 2015 we granted 1 million PSUs. (b) Substantially all awards assumed were related to LinkedIn. See Note 9 – Business Combinations for further information. As of June 30, 2017, there was approximately $6.5 billion of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of 3 years. The weighted average grant-date fair value of stock awards granted was $55.64, $41.51, and $42.36 for fiscal years 2017, 2016, and 2015, respectively. The fair value of stock awards vested was $4.8 billion, $3.9 billion, and $4.2 billion, for fiscal years 2017, 2016, and 2015, respectively. 89 PART II Item 8 Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2017 2016 2015 Shares purchased 13 15 16 Average price per share $ 56.36 $ 44.83 $ 39.87 As of June 30, 2017, 129 million shares of our common stock were reserved for future issuance through the ESPP. Savings Plan We have a savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute a portion of their salary, subject to certain limitations. Beginning January 2016, we contribute fifty cents for each dollar a participant contributes in this plan, with a maximum employer contribution of 50% of the IRS contribution limit for the calendar year. Prior to January 2016, we contributed fifty cents for each dollar of the first 6% a participant contributed in this plan, with a maximum contribution of the lesser of 3% of a participant’s earnings or 3% of the IRS compensation limit for the calendar year. Matching contributions for all plans were $734 million, $549 million, and $454 million in fiscal years 2017, 2016, and 2015, respectively, and were expensed as contributed. NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with U.S. GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. In December 2016, we completed our acquisition of LinkedIn Corporation. LinkedIn is reported as part of our Productivity and Business Processes segment. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Skype for Business, and Microsoft Teams, and related Client Access Licenses (“CALs”). • Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics ERP on-premises, Dynamics CRM on-premises, and Dynamics 365, a set of cloud-based applications across ERP and CRM. 90 PART II Item 8 Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, and Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. More Personal Computing Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises: • Windows, including Windows original equipment manufacturer licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things (“IoT”); and MSN display advertising. • Devices, including Microsoft Surface, PC accessories, and other intelligent devices. • Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, and advertising (“Xbox Live”), video games, and third-party video game royalties. • Search advertising. Corporate and Other includes adjustments to conform our internal accounting policies to U.S. GAAP, and impairment, integration, and restructuring expenses. Significant internal accounting policies that differ from U.S. GAAP relate to Windows 10 revenue recognition. Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue on certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit, and are generally allocated based on relative gross margin. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements, and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments, including impairment, integration, and restructuring expenses. Segment revenue and operating income (loss) were as follows during the periods presented: (In millions) Year Ended June 30, 2017 2016 2015 Revenue Productivity and Business Processes $ 30,444 $ 26,487 $ 26,430 Intelligent Cloud 27,440 25,042 23,715 More Personal Computing 38,773 40,434 43,435 Corporate and Other (6,707 ) (6,643 ) 0 Total $ 89,950 $ 85,320 $ 93,580 91 PART II Item 8 (In millions) Year Ended June 30, 2017 2016 2015 Operating income (loss) Productivity and Business Processes $ 11,913 $ 12,418 $ 13,274 Intelligent Cloud 9,138 9,315 9,803 More Personal Computing 8,288 6,202 5,095 Corporate and Other (7,013 ) (7,753 ) (10,011 ) Total $ 22,326 $ 20,182 $ 18,161 Corporate and Other operating loss activity was as follows during the periods presented: (In millions) Year Ended June 30, 2017 2016 2015 Net revenue deferral from Windows 10 $ (6,707 ) $ (6,643 ) $ 0 Impairment, integration, and restructuring expenses (306 ) (1,110 ) (10,011 ) Total Corporate and Other $ (7,013 ) $ (7,753 ) $ (10,011 ) No sales to an individual customer or country other than the United States accounted for more than 10% of fiscal year 2017, 2016, or 2015 revenue. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2017 2016 2015 United States (a) $ 45,248 $ 40,578 $ 42,941 Other countries 44,702 44,742 50,639 Total $ 89,950 $ 85,320 $ 93,580 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. Revenue from external customers, classified by significant product and service offerings, were as follows: (In millions) Year Ended June 30, 2017 2016 2015 Microsoft Office system $ 25,389 $ 23,588 $ 23,538 Server products and tools 21,758 19,177 18,612 Xbox 9,256 9,395 9,121 Windows PC operating system 8,625 (a) 8,104 (a) 14,826 Advertising 6,971 6,098 4,557 Consulting and product support services 5,588 5,641 5,090 Devices 4,557 7,466 11,602 LinkedIn 2,268 (b) 0 0 Other 5,538 5,851 6,234 Total $ 89,950 $ 85,320 $ 93,580 (a) Includes the net revenue deferral from Windows 10. (b) Includes advertising revenue . Our total commercial cloud revenue, which primarily comprises Office 365 commercial, Azure, Dynamics 365, and other cloud properties, was $14.9 billion, $9.5 billion, and $5.8 billion in fiscal years 2017, 2016, and 2015, respectively. These amounts are included in their respective product categories in the table above. 92 PART II Item 8 Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment; it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measur e of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2017 2016 2015 United States $ 39,118 $ 22,819 $ 19,562 Ireland 12,876 2,078 1,595 Luxembourg 6,845 6,854 6,879 Other countries 10,123 8,210 8,469 Total $ 68,962 $ 39,961 $ 36,505 NOTE 22 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2017 (a) Revenue (b) $ 20,453 $ 24,090 $ 22,090 $ 23,317 $ 89,950 Gross margin 12,609 14,189 14,030 14,861 55,689 Operating income 5,225 6,177 5,594 5,330 22,326 Net income 4,690 5,200 4,801 6,513 (c) 21,204 (c) Basic earnings per share 0.60 0.67 0.62 0.84 2.74 Diluted earnings per share 0.60 0.66 0.61 0.83 (c) 2.71 (c) Fiscal Year 2016 Revenue (d) $ 20,379 $ 23,796 $ 20,531 $ 20,614 $ 85,320 Gross margin 13,172 13,924 12,809 12,635 52,540 Operating income 5,793 6,026 5,283 3,080 20,182 Net income 4,902 5,018 3,756 3,122 (e) 16,798 (e) Basic earnings per share 0.61 0.63 0.48 0.40 2.12 Diluted earnings per share 0.61 0.62 0.47 0.39 (e) 2.10 (e) (a) On December 8, 2016, we acquired LinkedIn Corporation. LinkedIn has been included in our consolidated results of operations starting on the acquisition date. (b) Reflects the impact of the net revenue deferral from Windows 10 of $1.9 billion, $2.0 billion, $1.5 billion, and $1.4 billion, for the first, second, third, and fourth quarter of fiscal year 2017, respectively, and $6.7 billion for fiscal year 2017. (c) Includes $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan, which decreased operating income, net income, and diluted EPS by $306 million, $243 million, and $0.03, respectively. (d) Reflects the impact of the net revenue deferral from Windows 10 of $1.3 billion, $1.7 billion, $1.6 billion, and $2.0 billion, for the first, second, third, and fourth quarter of fiscal year 2016, respectively, and $6.6 billion for fiscal year 2016. (e) Includes $630 million of asset impairment charges related to our phone business, and $480 million of restructuring charges associated with our 2016 restructuring plans, which together decreased operating income, net income, and diluted EPS by $1.1 billion, $895 million, and $0.11, respectively. 93 PART II Item 8 REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2017 and 2016, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for each of the three years in the period ended June 30, 2017. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Microsoft Corporation and subsidiaries as of June 30, 2017 and 2016, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 2017, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of June 30, 2017, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 2, 2017 expressed an unqualified opinion on the Company’s internal control over financial reporting. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 2, 2017 94 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOU NTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2017. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2017; their report is included in Item 9A. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. During fiscal year 2017, we implemented internal controls to ensure we have adequately evaluated our contracts and properly assessed the impact of the new accounting standards related to revenue recognition and leases on our financial statements to facilitate the adoption on July 1, 2017. We do not expect significant changes to our internal control over financial reporting due to the adoption of the new standards. 95 PART II Item 9A REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Stockholders of Microsoft Corporation Redmond, Washington We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2017, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2017, based on the criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended June 30, 2017 of the Company and our report dated August 2, 2017 expressed an unqualified opinion on those financial statements. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 2, 2017 96 PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 29, 2017 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy Statement set forth under the caption “Section 16(a) beneficial ownership reporting compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer and Corporate Controller, and other finance organization employees. The finance code of ethics is publicly available on our website at www.microsoft.com/investor/MSFinanceCode. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer and Corporate Controller, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock ownership information” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 97 PART IV Item 15 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 49 Comprehensive Income Statements 50 Balance Sheets 51 Cash Flows Statements 52 Stockholders’ Equity Statements 53 Notes to Financial Statements 54 Report of Independent Registered Public Accounting Firm 94 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 2.1 Agreement and Plan of Merger, dated as of June 11, 2016, by and among Microsoft Corporation, Liberty Merger Sub Inc., and LinkedIn Corporation 8-K*** 2.1 6/13/16 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/14/17 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/10 98 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 99 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/3/15 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 8/5/16 100 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/17 10.1* Microsoft Corporation 2001 Stock Plan 10-K 6/30/16 10.1 7/28/16 10.3* Microsoft Corporation 1999 Stock Plan for Non-Employee Directors X 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-Q 3/31/12 10.5 4/19/12 10.7* Form of Stock Award Agreement for Non-Employee Directors under the Microsoft Corporation 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.9 9/1/04 10.10* Form of Stock Option Agreement under the Microsoft Corporation 2001 Stock Plan 10-K 6/30/04 10.12 9/1/04 10.11* Form of Stock Option Agreement for Non-Employee Directors under the 1999 Stock Plan for Non-Employee Directors 10-K 6/30/04 10.13 9/1/04 10.12 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.12 10/20/16 10.13 Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.13 10/20/16 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-K 6/30/15 10.14 7/31/15 10.17* Executive Officer Incentive Plan 10-Q 9/30/15 10.17 10/22/15 10.18* Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/15 10.18 10/22/15 101 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.21* Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan (Service-Based) 10-Q 9/30/15 10.21 10/22/15 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/15 10.22 10/22/15 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 10.25* Form of Executive Officer Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/15 10.25 10/22/15 12 Computation of Ratios of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 102 PART IV Item 15, 16 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Furnished, not filed *** Form 8-K of LinkedIn Corporation ITEM 16. FORM 10-K SUMMARY None. 103 SIGNAT URES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 2, 2017. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on August 2, 2017. Signature Title /s/    J OHN W. T HOMPSON John W. Thompson Chairman /s/    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer /s/    W ILLIAM H. G ATES III William H. Gates III Director /s/    R EID H OFFMAN Reid Hoffman Director /s/ Teri L. List-Stoll Teri L. List-Stoll Director /s/    G. M ASON M ORFIT G. Mason Morfit Director /s/    C HARLES H. N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/ Sandra E. Peterson Sandra E. Peterson Director /s/ Charles W. Scharf Charles W. Scharf Director /s/ John W. Stanton John W. Stanton Director /s/ Padmasree Warrior Padmasree Warrior Director /s/    A MY E. H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 104 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-18-019062/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-18-019062/full-submission.txt new file mode 100644 index 0000000..528844a --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-18-019062/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2018 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  to Commission File Number 001-37845 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: COMMON STOCK, $0.00000625 par value per share                                          NASDAQ Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes ☒ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ (Do not check if a smaller reporting company) Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of December 31, 2017, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $650.1 billion based on the closing sale price as reported on the NASDAQ National Market System. As of July 31, 2018, there were 7,668,217,316 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 28, 2018 are incorporated by reference into Part III. MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2018 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 15 Item 1A. Risk Factors 17 Item 1B. Unresolved Staff Comments 29 Item 2. Properties 29 Item 3. Legal Proceedings 29 Item 4. Mine Safety Disclosures 29 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 30 Item 6. Selected Financial Data 31 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 32 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 50 Item 8. Financial Statements and Supplementary Data 51 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 98 Item 9A. Controls and Procedures 98 Report of Management on Internal Control over Financial Reporting 98 Report of Independent Registered Public Accounting Firm 99 Item 9B. Other Information 100 PART III Item 10. Directors, Executive Officers and Corporate Governance 100 Item 11. Executive Compensation 100 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 100 Item 13. Certain Relationships and Related Transactions, and Director Independence 100 Item 14. Principal Accounting Fees and Services 100 PART IV Item 15. Exhibits, Financial Statement Schedules 101 Item 16. Form 10-K Summary 105 Signatures 106 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Embracing Our Future Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We continue to transform our business to lead in the new era of the intelligent cloud and intelligent edge. We bring technology and products together into experiences and solutions that unlock value for our customers. In this next phase of innovation, computing is more powerful and ubiquitous from the cloud to the edge. Artificial intelligence (“AI”) capabilities are rapidly advancing, fueled by data and knowledge of the world. Physical and virtual worlds are coming together to create richer experiences that understand the context surrounding people, the things they use, the places they go, and their activities and relationships. A person’s experience with technology spans a multitude of devices and has become increasingly more natural and multi-sensory with voice, ink, and gaze interactions. What We Offer Founded in 1975, we develop and support software, services, devices, and solutions that deliver new value for customers and help people and businesses realize their full potential. Our products include operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; and video games. We also design, manufacture, and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. 3 PART I Item 1 The A mbitions T hat D rive U s To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud platform. • Create more personal computing. Reinvent Productivity and Business Processes We are in a unique position to empower people and organizations to succeed in a rapidly evolving workplace. Computing experiences are evolving, no longer bound to one device at a time. Instead, experiences are expanding to many devices as people move from home to work to on the go. These modern needs, habits, and expectations of our customers are motivating us to bring Microsoft Office 365, Windows platform, devices, including Microsoft Surface, and third-party applications into a more cohesive Microsoft 365 experience. Our growth depends on securely delivering continuous innovation and advancing our leading productivity and collaboration tools and services, including Office, Microsoft Dynamics, and LinkedIn. Microsoft 365 brings together Office 365, Windows 10, and Enterprise Mobility + Security to help organizations empower their employees with AI-backed tools that unlock creativity, increase teamwork, and fuel innovation, all the while enabling compliance coverage and data protection. Microsoft Teams is core to our vision for the modern workplace as the digital hub that creates a single canvas for teamwork, conversations, meetings, and content. Microsoft Relationship Sales solution brings together LinkedIn Sales Navigator and Dynamics to transform business to business sales through social selling. Dynamics 365 for Talent with LinkedIn Recruiter and Learning gives human resource professionals a complete solution to compete for talent. These scenarios represent a move to unlock creativity and inspire teamwork, while simplifying security and management. Organizations of all sizes can now digitize business-critical functions, redefining what customers can expect from their business applications. This creates an opportunity for us to reach new customers and increase usage and engagement with existing customers. Build the Intelligent Cloud Platform Companies are looking to use digital technology to fundamentally reimagine how they empower their employees, engage customers, optimize their operations, and change the very core of their products and services. Partnering with organizations on their digital transformation is one of our largest opportunities and we are uniquely positioned to become the strategic digital transformation platform and partner of choice. Our strategy requires continued investment in datacenters and other infrastructure to support our services. Microsoft Azure is a trusted cloud with comprehensive compliance coverage and AI-based security built in. Our cloud business benefits from three economies of scale: datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. As one of the two largest providers of cloud computing at scale, we believe we work from a position of strength. Being a global, hyper-scale cloud, Azure uniquely offers hybrid consistency, developer productivity, AI capabilities, and trusted security and compliance. Moreover, with Azure Stack, organizations can extend Azure into their own datacenters to create a consistent stack across the public cloud and the intelligent edge. Our hybrid infrastructure consistency spans identity, data, compute, management, and security, helping to support the real-world needs and evolving regulatory requirements of commercial customers and enterprises. The ability to convert data into AI drives our competitive advantage. Azure SQL Database makes it possible for customers to take Microsoft SQL Server from their on-premises datacenter to a fully managed instance in the cloud to utilize built-in AI. We are accelerating adoption of AI innovations from research to products. Our innovation helps every developer be an AI developer, with approachable new tools from Azure Machine Learning Studio for creating simple machine learning models, to the powerful Azure Machine Learning Workbench for the most advanced AI modeling and data science. 4 PART I Item 1 On June 4, 2018, Microsoft announced plans to acquire GitHub, Inc., a service that millions of developers around the world rely on to write code together. The acquisition is expected to close by the end of the calendar year. Create More Personal Computing We strive to make computing more personal by putting users at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. Windows 10 is the cornerstone of our ambition, providing a foundation for the secure, modern workplace, and designed to foster innovation through rich and consistent experiences across the range of existing devices and entirely new device categories. Windows 10 empowers people with AI-first interfaces ranging from voice-activated commands through Cortana, inking, immersive 3D content storytelling, and mixed reality experiences. Cloud sharing and co-authoring experiences are now natively enabled with OneDrive files on demand. Windows 10 is more accessible for everyone with new features like Eye Control, which gives people the ability to operate a PC using just their eyes. Our ambition for Windows 10 is to broaden our economic opportunity through three key levers: an original equipment manufacturer (“OEM”) ecosystem that creates exciting new hardware designs for Windows 10; our commitment to our first-party premium device portfolio; and monetization opportunities such as gaming, services, subscriptions, and search advertising. We are working to create a broad developer opportunity by unifying the Windows installed base on Windows 10 and enabling universal Windows applications to run across devices so developers and OEMs can contribute to a thriving Windows ecosystem. Additionally, we are committed to designing and marketing first-party devices, such as the Surface Laptop, Surface Book 2, and Surface Pro to help drive innovation, create new device categories, and stimulate demand in the Windows ecosystem. We are mobilizing to pursue our expansive opportunity in the gaming industry, broadening our approach to how we think about gaming end-to-end, from the way games are created and distributed to how they are played and viewed. We have a strong position with our Xbox One console, our large and growing highly engaged community of gamers on Xbox Live, and with Windows 10, the most popular operating system for PC gamers. And we will continue to connect our gaming assets across PC, console, and mobile, and work to grow and engage the Xbox Live member network more deeply and frequently with new services like Mixer and Xbox Game Pass. Our approach is to enable gamers to play the games they want, with the people they want, on the devices they want. Our Future Opportunity Customers are looking to us to accelerate their own digital transformations and to unlock new opportunity in this era of intelligent cloud and intelligent edge. We continue to develop complete, intelligent solutions for our customers that empower users to be creative and work together while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modern, modular business applications to improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Applying AI to drive insights and act on our customer’s behalf by understanding and interpreting their needs using natural methods of communication. • Using Windows to develop new categories of devices – both our own and third-party – as a person’s experience with technology becomes more natural, personal, and predictive with multi-sensory breakthroughs in voice, ink, gaze interactions, and augmented reality holograms. • Inventing new gaming experiences that bring people together around their shared love for games on any devices and pushing the boundaries of innovation with console and PC gaming by creating the next wave of entertainment. Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. We have the opportunity to redefine what customers and partners can expect and are working to deliver new solutions that reflect the best of Microsoft. 5 PART I Item 1 OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Skype for Business, and Microsoft Teams, and related Client Access Licenses (“CALs”). • Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics ERP on-premises, Dynamics CRM on-premises, and Dynamics 365, a set of cloud-based applications across ERP and CRM. Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users in new markets such as first-line workers, small and medium businesses, and growth markets, as well as add value to our core product and service offerings to span productivity categories such as communication, collaboration, analytics, and security. Office Commercial revenue is mainly affected by a combination of continued installed base growth and average revenue per user expansion, as well as the continued shift from Office licensed on-premises to Office 365. CALs provide certain Office Commercial products and services with access rights to our server products and CAL revenue is reported with the associated Office products and services. Office Consumer Office Consumer is designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift from Office licensed on-premises to Office 365. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. 6 PART I Item 1 LinkedIn LinkedIn connects the world's professionals to make them more productive and successful, and is the world's largest professional network on the Internet. LinkedIn offers services that can be used by customers to transform the way they hire, market, sell, and learn. In addition to LinkedIn’s free services, LinkedIn offers three categories of monetized solutions: Talent Solutions, Marketing Solutions, and Premium Subscriptions, which includes Sales Solutions. Talent Solutions is comprised of two elements: Hiring, and Learning and Development. Hiring provides services to recruiters that enable them to attract, recruit, and hire talent. Learning and Development provides subscriptions to enterprises and individuals to access online learning content. Marketing Solutions enables companies to advertise to LinkedIn’s member base. Premium Subscriptions enables professionals to manage their professional identity, grow their network, and connect with talent through additional services like premium search. Premium Subscriptions also includes Sales Solutions, which helps sales professionals find, qualify, and create sales opportunities and accelerate social selling capabilities. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. Dynamics Dynamics provides on-premises and cloud-based business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and analytics applications for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is largely driven by the number of users licensed and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications. Competition Competitors to Office include software and global application vendors, such as Apple, Cisco Systems, Facebook, Google, IBM, and Slack, and numerous web-based and mobile application competitors as well as local application developers. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides a hosted messaging and productivity suite. Skype for Business and Skype also compete with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products and services. We compete by providing powerful, flexible, secure, and easy-to-use productivity and collaboration tools and services that create comprehensive solutions and work well with technologies our customers already have both on-premises or in the cloud. LinkedIn faces competition from online recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers. Dynamics competes with vendors such as Infor, Oracle, NetSuite. Salesforce.com, SAP, and The Sage Group to provide on-premise and cloud-based business solutions for small, medium, and large organizations. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including SQL Server, Windows Server, Visual Studio, System Center, and related CALs, and Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. 7 PART I Item 1 Server Products and Cloud Services Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. Server products revenue is mainly affected by purchases through volume licensing programs, licenses sold to OEMs, and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Azure is a comprehensive set of cloud services that offer developers, IT professionals, and enterprises freedom to build, deploy, and manage applications on any platform or device. Customers can use Azure through our global network of datacenters for basic computing, networking, storage, mobile and web app services, AI, Internet of Things (“IoT”), cognitive services, and machine learning. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Azure revenue is mainly affected by infrastructure-as-a-service and platform-as-a-service consumption-based services, and per user-based services such as Enterprise Mobility + Security. Enterprise Services Enterprise Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and IT professionals on various Microsoft products. Competition Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, Salesforce.com, VMware, and open source offerings. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. 8 PART I Item 1 Our Enterprise Services business comp etes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows IoT; and MSN advertising. • Devices, including Surface, PC accessories, and other intelligent devices. • Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, and advertising (“Xbox Live”), video games, and third-party video game royalties. • Search. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and growth markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Piracy. Windows Commercial revenue, which includes volume licensing of the Windows operating system and Windows cloud services such as Windows Defender Advanced Threat Protection, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance (“SA”), as well as advanced security offerings. Windows Commercial revenue often reflects the number of information workers in a licensed enterprise and is relatively independent of the number of PCs sold in a given year. Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. MSN advertising includes both native and display ads. Devices We design, manufacture, and sell devices, including Surface, PC accessories, and other intelligent devices, such as Surface Hub and HoloLens. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. In May 2016, we announced plans to streamline our smartphone hardware business. In November 2016, we completed the sale of our feature Phone business. 9 PART I Item 1 Gaming Our gaming platform is designed to provide a unique variety of entertainment using our devices, peripherals, applications, online services, and content. We released Xbox One S and Xbox One X in August 2016 and November 2017, respectively. With the launch of the Mixer service in May 2017, offering interactive live game streaming, and Xbox Game Pass in June 2017, providing unlimited access to over 100 Xbox titles, we continue to open new opportunities for customers to engage both on- and off-console. Xbox Live enables people to connect and share online gaming experiences and is accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox Live is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox Live revenue is mainly affected by subscriptions and sales of Xbox Live enabled content, as well as advertising. We also continue to design and sell gaming content to showcase our unique platform capabilities for Xbox consoles, Windows-enabled devices, and other devices. Growth of our Gaming business is determined by the overall active user base through Xbox Live enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences via online services, downloadable content, and peripherals. Search Our Search business, including Bing and Bing Ads, is designed to deliver relevant online advertising to a global audience. We have several partnerships with other companies, including Oath (formerly Yahoo! and AOL) which is owned by Verizon, through which we provide and monetize search queries. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. Devices face competition from various computer, tablet, and hardware manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. Our gaming platform competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles averages five to ten years. Nintendo released its latest generation console in March 2017 and Sony released its latest generation console in November 2013. We also compete with other providers of entertainment services through online marketplaces. We believe our gaming platform is effectively positioned against competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own game franchises as well as other digital content offerings. Our video games competitors include Electronic Arts and Activision Blizzard. Xbox Live faces competition from various online marketplaces, including those operated by Amazon, Apple, and Google. Our search business competes with Google and a wide array of websites, social platforms like Facebook, and portals that provide content and online offerings to end users. OPERATIONS We have operations centers that support operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Australia, Europe, and Asia. 10 PART I Item 1 To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require mod ifying the user interface, altering dialog boxes, and translating text. Our devices are primarily manufactured by third-party contract manufacturers. We generally have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. RESEARCH AND DEVELOPMENT During fiscal years 2018, 2017, and 2016, research and development expense was $14.7 billion, $13.0 billion, and $12.0 billion, respectively. These amounts represented 13% of revenue in fiscal years 2018, 2017, and 2016. We plan to continue to make significant investments in a broad range of research and development efforts. Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Cloud and AI Platform , focuses on making IT professionals, developers, and their systems more productive and efficient through development of cloud infrastructure, server, database, CRM, ERP, management and development tools, AI cognitive services, and other business process applications and services for enterprises. • Experiences and Devices , focuses on instilling a unifying product ethos across our end-user experiences and devices, including Office, Windows, Enterprise Mobility and Management, and devices. • AI and Research , focuses on our AI innovations and other forward-looking research and development efforts spanning infrastructure, services, applications, and search. • LinkedIn , focuses on our services that transform the way customers hire, market, sell, and learn. • Gaming , focuses on connecting gaming assets across the range of devices to grow and engage the Xbox Live member network through game experiences, streaming content, and social interaction. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software and hardware design. Before releasing new software platforms, and as we make significant modifications to existing platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 53,000 U.S. and international patents issued and over 29,000 pending. While we employ much of our internally developed intellectual property exclusively in our products and services, we also engage in outbound licensing of specific patented technologies that are incorporated into licensees’ products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We also purchase or license technology that we incorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, or attracting and enabling our external development community. Our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, services, and business methods, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. 11 PART I Item 1 Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, devices, and operating systems. While our main research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, India, Ireland, Israel, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the operating segment level. Much of our segment level research and development is coordinated with other segments and leveraged across the company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest corporate research organizations and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science and a broad range of other disciplines, providing us a unique perspective on future trends and contributing to our innovation. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales force performs a variety of functions, including working directly with enterprises and public-sector organizations worldwide to identify and meet their technology requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. OEMs We distribute our products and services through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Acer, ASUS, Dell, Fujitsu, Hewlett-Packard, Lenovo, Samsung, Toshiba, and with many regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors”, or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. We also sell commercial and consumer products and services directly to customers, such as cloud services, search, and gaming, through our digital marketplaces, online stores, and retail stores. 12 PART I Item 1 Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers, and provide product training and sales support. Our Dynamics business solutions are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and Software Assurance. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. SA conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, and training to help customers deploy and use software efficiently. SA is included with certain volume licensing agreements and is an optional purchase with others. Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. SA is included. Microsoft Product and Services Agreement Microsoft Product and Services Agreements are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. SA is optional for customers that purchase perpetual licenses. Open Open agreements are a simple, cost-effective way to acquire the latest Microsoft technology. Open agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a one- to three-year period. Under the Open agreements, organizations purchase perpetual licenses and SA is optional. Under Open Value agreements, organizations can elect to purchase perpetual licenses or subscribe to licenses and SA is included. Select Plus Select Plus agreements are designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and SA is optional. In July 2014, we announced the retirement over a two-year period of Select Plus agreements for commercial organizations. Beginning July 2015, no new Select Plus agreements were signed with commercial organizations. 13 PART I Item 1 Microsoft Online Subscription Agreement Microsoft Online Subscription Agreements are designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web. The agreement allows customers to acquire monthly or annual subscriptions for cloud-based services. Partner Programs The Microsoft Cloud Solution Provider program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, hosting partner, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. The Independent Software Vendor Royalty program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, internet service providers, application developers, and OEMs. No sales to an individual customer accounted for more than 10% of revenue in fiscal years 2018, 2017, or 2016. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 14 PART I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of August 3, 2018 were as follows: Name Age Position with the Company Satya Nadella 50 Chief Executive Officer Christopher C. Capossela 48 Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer Jean-Philippe Courtois 57 Executive Vice President and President, Microsoft Global Sales, Marketing and Operations Kathleen T. Hogan 52 Executive Vice President, Human Resources Amy E. Hood 46 Executive Vice President, Chief Financial Officer Margaret L. Johnson 56 Executive Vice President, Business Development Bradford L. Smith 59 President and Chief Legal Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 25 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Mr. Courtois was named Executive Vice President and President, Microsoft Global Sales, Marketing and Operations in July 2016. Before that he was President of Microsoft International since 2005. He was Chief Executive Officer, Microsoft Europe, Middle East, and Africa from 2003 to 2005.He was Senior Vice President and President, Microsoft Europe, Middle East, and Africa from 2000 to 2003. He was Corporate Vice President, Worldwide Customer Marketing from 1998 to 2000. Mr. Courtois joined Microsoft in 1984. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Hood also serves on the Board of Directors of 3M Corporation. Ms. Johnson was appointed Executive Vice President, Business Development in September 2014. Prior to that Ms. Johnson spent 24 years at Qualcomm in various leadership positions across engineering, sales, marketing and business development. She most recently served as Executive Vice President of Qualcomm Technologies, Inc. Ms. Johnson also serves on the Board of Directors of BlackRock, Inc. Mr. Smith was appointed President and Chief Legal Officer in September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. 15 PART I Item 1 EMPLOYEES As of June 30, 2018, we employed approximately 131,000 people on a full-time basis, 78,000 in the U.S. and 53,000 internationally. Of the total employed people, 42,000 were in operations, including manufacturing, distribution, product support, and consulting services; 42,000 were in product research and development; 36,000 were in sales and marketing; and 11,000 were in general and administration. Certain of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”). • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 16 PART I Item 1A ITEM 1A. RIS K FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platform-based ecosystems An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, and wearables. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users sometimes incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. 17 PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us using an open source business model by modifying and then distributing open source software at nominal cost to end-users, and earning revenue on advertising or complementary services and products. These firms do not bear the full costs of research and development for the software. Some open source software vendors develop software that mimics the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which suite of cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge worldview is connected with the growth of the internet of things (“IoT”). Our success in the IoT will depend on the level of adoption of our offerings such as Microsoft Azure, Azure Stack, Azure IoT Edge, and Azure Sphere. We may not establish market share sufficient to achieve scale necessary to achieve our business objectives. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other endpoints. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. 18 PART I Item 1A We make significant investment s in new products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Micros oft 365, Office, Bing, Microsoft SQL Server, Windows Server, the Windows Store, Azure, Office 365, Xbox Live, Mixer, LinkedIn, and other cloud-based offerings. We also invest in the development and acquisition of a variety of hardware for productivity, com munication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marke ting. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve signific ant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be a s high as the margins we have experienced historically. We may not get engagement in certain features, like Windows Store, Microsoft Edge , and Bing, that drive post-license monetization opportunities. Our data handling practices across our products and ser vices will continue to be under scrutiny and perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or product experiences, which could negatively impact product and feature adoption, product design , and pr oduct quality. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. In December 2016, we completed our acquisition of LinkedIn Corporation for $27.0 billion. In June 2018, we announced an agreement to acquire GitHub, Inc. for $7.5 billion. These acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating and retaining new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements, such as increased revenue, enhanced efficiencies, or increased market share, or the benefits may ultimately be smaller than we expected. These events could adversely affect our operating results or financial condition. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. Our acquisition of LinkedIn resulted in a significant increase in our goodwill and intangible asset balances. We may not earn the revenues we expect from our intellectual property rights. We may not be able to adequately protect our intellectual property rights Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly countries in which the legal system provides less protection for intellectual property rights. Our revenue in these markets may grow more slowly than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. 19 PART I Item 1A We may not receive expected royalties from our patent licenses We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. Finally, the royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of discovering infringements. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations and may negatively impact revenue. Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Microsoft Surface. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. We may not be able to protect our source code from copying if there is an unauthorized disclosure. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position. Security of our information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Inadequate account security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems, or reveal confidential information. 20 PART I Item 1A Cyberthreats are constantly evolving, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network , or data secur ity could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their dat a, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise adversely affect our business. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge. Security of our products, services, devices, and customers’ data The security of our products and services is important in our customers’ decisions to purchase or use our products or services. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. Adversaries that acquire user account information at other companies can use that information to compromise our users’ accounts where accounts share the same attributes like passwords. Inadequate account security practices may also result in unauthorized access. We are also increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks. To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide customers security tools such as firewalls and anti-virus software and information about the need to deploy security measures and the impact of doing so. The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches. Any of these actions by customers could adversely affect our reputation and revenue. Actual or perceived vulnerabilities may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers. As illustrated by the recent Spectre and Meltdown threats, our products operate in conjunction with and are dependent on products and components across a broad ecosystem. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position. 21 PART I Item 1A Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers and users. The continued occurrence of h igh-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and vendors on data security, and other practices we follow may not prevent the improper disclosure of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increase d costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to pro duce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect custome r and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, an d government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services. We may not be able to protect information in our products and services from use by others . LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services. Abuse of our advertising or social platforms may harm our reputation or user engagement. For LinkedIn, Bing Ads, and other products and services that provide content or host ads that come from or can be influenced by third parties, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate to other people, by users impersonating other people or organizations, by use of our products or services to disseminate information that may be viewed as misleading or intended to manipulate the opinions of our users, or by the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and financial results. We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Exchange Online, Azure, Microsoft account services, Office 365, OneDrive, SharePoint Online, Skype, Xbox Live, Outlook.com, and Windows Stores. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex. It requires that we maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data or insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may harm our operating results and financial condition. 22 PART I Item 1A Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scrutinize us under U.S. and foreign competition laws. An increasing number of governments are actively enforc ing competition laws and regulations and this includes increased scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive condu ct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments we offered to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices on our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Government regulatory actions and court decisions such as these may result in fines, or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited. 23 PART I Item 1A Our global operations subje ct us to potential liability under anti-corruption, trade protection, and other laws and regulations. The Foreign Corrupt Practices Act and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vend ors, or agents. From time to time, we receive inquiries from authorities in the U.S. and elsewhere and reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Specifically, we have been cooperating with authorities in the U.S. in connection with reports concerning our compliance with the Foreign Corrupt Practices Act in various countries. Most countries in which we operate also have competition laws that prohibit competitors from colludi ng or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our global compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity , our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employe es, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, and measures, sanctions, and other regulatory requirements affecting trade and investm ent. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on countries such as Iran, North Korea, Cuba, Sudan, and Syria. Other regulatory areas that may apply to our products and online services offerings include user privacy, telecommunications, data storage and protection, and online content. For example, regulators may take the position that our offerings such as Skype are covered by existing laws regulating telecommunications services and new laws may define more of our services as regulated telecommunications services. Data protection authorities may assert that our collection, use, and management of customer data is inconsistent with their laws and regulations. Legislative or regulatory action relating cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Legislative or regulatory action could also emerge in the area of AI, increasing costs or restricting opportunity. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, and customers to make technology more accessible. If our products do not meet customer expectations or emerging global accessibility requirements, we could lose sales opportunities or face regulatory actions Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us, or reputational damage. The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, the EU and the U.S. formally entered into a new framework in July 2016 that provides a mechanism for companies to transfer data from EU member states to the U.S. This framework, called the Privacy Shield, is intended to address shortcomings identified by the European Court of Justice in a predecessor mechanism. The Privacy Shield and other mechanisms are currently subject to challenges in European courts, which may lead to uncertainty about the legal basis for data transfers across the Atlantic. The Privacy Shield and other potential rules on the flow of data across borders could increase the cost and complexity of delivering our products and services in some markets. In May 2018, a new EU law governing data practices and privacy, the General Data Protection Regulation (“GDPR”), became effective. The law, which applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of new compliance obligations regarding the handling of personal data. Engineering efforts to build new capabilities to facilitate compliance with the law have entailed substantial expense and the diversion of engineering resources from other projects and may continue to do so. We might experience reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under the GDPR or other data regulations, or if the changes we implement to comply with the GDPR make our offerings less attractive. The GDPR imposes significant new obligations and compliance with these obligations depends in part on how particular regulators apply and interpret them. If we fail to comply with the GDPR, or if regulators assert we have failed to comply with the GDPR, it may lead to regulatory enforcement actions, which can result in monetary penalties of up to 4% of worldwide revenue, private lawsuits, or reputational damage. 24 PART I Item 1A The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our opera tional efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this inve stment. Ongoing legal reviews by regulators may result in burdensome or inconsistent requirements , including data sovereignty and localization requirements, affecting the location and movement of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in som e jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity , as well as negative publicity and diversion of management time and effort. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows 10, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact in our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cut and Jobs Act (“TCJA”) may require the collection of information not regularly produced within the Company, the use of estimates in our financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to TCJA, and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our financial position. We regularly are under audit by tax authorities in different jurisdictions. Economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation in the jurisdictions where we are subject to taxation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect in our consolidated financial statements in the period or periods in which that determination is made. We earn a significant amount of our operating income outside the U.S. A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the Company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our tax expense and cash flows. 25 PART I Item 1A We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and r eputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. Our software products also may experience quality or reliability problems. The highly-sophisticated software products we develop may contain bugs and other defects that interfere with their intended operation. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. We acquire some device and datacenter components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other hardware and software products we may offer. Our global business exposes us to operational and economic risks. Our customers are located in over 200 countries and a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist trends in specific countries may significantly alter the trade environment. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our revenue. Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages on our operating results. 26 PART I Item 1A Abrupt political c hange, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions b y our customers, and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory requirements that could impact our operating strategies, access to global markets, hiring, and profitability. Geopolit ical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other natural resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal government shutdown resulting from failing to pass budget appropriations, adopt continuing funding resolutions or raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT spending on our products and services and adversely affect our revenue. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our financial results. Changes in our sales organization may impact revenues. In July 2017, we announced plans to reorganize our global sales organization to help enable customers’ digital transformation, add greater technical ability to our sales force, and create pooled resources that can be used across countries and industries. The reorganization is the most significant change in our global sales organization in our history, involving employees changing roles, adding additional talent, realigning teams, and onboarding new partners. Successfully executing these changes will be a significant factor in enabling future revenue growth. As we continue to navigate through this transition, sales, profitability, and cash flow could be adversely impacted. The development of the internet of things presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT, a network of distributed and interconnected devices employing sensors, data, and computing capabilities including AI. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation, that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins. 27 PART I Item 1A Issues in the use of artificial intelligence in our offerings may result in reputational harm or liability . We are building AI into many of o ur offerings and we expect this element of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many disruptive innovat ions, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms may be flawed. Datasets may be insufficient or contain biased information. Inappropriate or controversial data practices by Microsoft or others could impair the acceptance of AI solutions. These deficiencies could undermine the decisions, predictions, or analysis AI applications produce, subjecting us to competitive harm, legal liability, and brand or reputational harm. Some AI scenarios present ethical issues. If we enable or offer AI solutions that are controversial because of their impact on human rights, privacy, employment, or other social issues, we may experience brand or reputational harm. If our reputation or our brands are damaged, our business and operating results may be harmed . Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, or our environmental impact, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things: • The introduction of new features, products, services, or terms of service that customers, users, or partners do not like. • Public scrutiny of our decisions regarding user privacy, data practices, or content. • Data security breaches, compliance failures, or actions of partners or individual employees. The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees. 28 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVE D STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our fiscal year 2018 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 540 acres of land we own at our corporate headquarters, and approximately five million square feet of space we lease. In addition, we own and lease space domestically that includes office, datacenter, and retail space. We also own and lease facilities internationally. The largest owned properties include: our research and development centers in China and India; our datacenters in Ireland, Singapore, and the Netherlands; and our operations and facilities in Ireland and the United Kingdom. The largest leased properties include space in the following locations: India, China, France, the United Kingdom, Canada, Australia, Germany, and Japan. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described under Research and Development (Part I, Item 1 of this Form 10-K). The table below shows a summary of the square footage of our office, datacenter, retail, and other facilities owned and leased domestically and internationally as of June 30, 2018: (Square feet in millions) Location Owned Leased Total U.S. 18 13 31 International 6 13 19 Total 24 26 50 ITEM 3. LEGAL PROCEEDINGS While not material to the Company, the Company makes the following annual report of the general activities of the Company’s Antitrust Compliance Office as required by the Final Order and Judgment in Barovic v. Ballmer et al, United States District Court for the Western District of Washington (“Final Order”). For more information see http://aka.ms/MSLegalNotice2015. These annual reports will continue through 2020. During fiscal year 2018, the Antitrust Compliance Office (a) monitored the Company’s compliance with the European Commission Decision of March 24, 2004, (“2004 Decision”) and with the Company’s Public Undertaking to the European Commission dated December 16, 2009 (“2009 Undertaking”); (b) monitored, in the manner required by the Final Order, employee, customer, competitor, regulator, or other third-party complaints regarding compliance with the 2004 Decision, the 2009 Undertaking, or other EU or U.S. laws or regulations governing tying, bundling, and exclusive dealing contracts; and, (c) monitored, in the manner required by the Final Order, the training of the Company’s employees regarding the Company’s antitrust compliance polices. In addition, the Antitrust Compliance Officer reports to the Regulatory and Public Policy Committee of the Board at each of its regularly scheduled meetings and to the full Board annually. Refer to Note 17 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 29 PART II Item 5 PAR T II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 31, 2018, there were 97,535 registered holders of record of our common stock. The high and low common stock sales prices per share were as follows: Quarter Ended September 30 December 31 March 31 June 30 Fiscal Year Fiscal Year 2018 High $ 75.97 $ 87.50 $ 97.24 $ 102.69 $ 102.69 Low 68.02 73.71 83.83 87.51 68.02 Fiscal Year 2017 High $ 58.70 $ 64.10 $ 66.19 $ 72.89 $ 72.89 Low 50.39 56.32 61.95 64.85 50.39 DIVIDENDS AND SHARE REPURCHASES Refer to Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding dividends and share repurchases. Following are our monthly stock repurchases for the fourth quarter of fiscal year 2018: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (in millions) April 1, 2018 – April 30, 2018 10,320,190 $ 93.11 10,320,190 $ 29,339 May 1, 2018 – May 31, 2018 0 0 0 29,339 June 1, 2018 – June 30, 2018 11,335,224 100.49 11,335,224 28,200 21,655,414 21,655,414 All repurchases were made using cash resources. Our stock repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. 30 PART II Item 6 ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share data) Year Ended June 30, 2018 2017 (b) (c) 2016 ( b ) 2015 2014 ( h ) Revenue $ 110,360 $ 96,571 $ 91,154 $ 93,580 $ 86,833 Gross margin 72,007 62,310 58,374 60,542 59,755 Operating income 35,058 29,025 ( d ) 26,078 ( e ) 18,161 ( g ) 27,759 Net income 16,571 (a) 25,489 ( d ) 20,539 ( e ) 12,193 ( g ) 22,074 Diluted earnings per share 2.13 (a) 3.25 ( d ) 2.56 ( e ) 1.48 ( g ) 2.63 Cash dividends declared per share 1.68 1.56 1.44 1.24 1.12 Cash, cash equivalents, and short-term investments 133,768 132,981 113,240 96,526 85,709 Total assets 258,848 250,312 202,897 ( f ) 174,303 ( f ) 170,569 ( f ) Long-term obligations 117,642 106,856 66,705 ( f ) 44,574 ( f ) 35,285 ( f ) Stockholders’ equity 82,718 87,711 83,090 80,083 89,784 (a) Includes a $13.7 billion net charge related to the Tax Cuts and Jobs Act, which decreased net income and diluted earnings per share (“EPS”) by $13.7 billion and $1.75, respectively. Refer to Note 13 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. (b ) Reflects the impact of the adoption of new accounting standards in fiscal year 2018 related to revenue recognition and leases. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. ( c ) On December 8, 2016, we acquired LinkedIn Corporation. LinkedIn has been included in our consolidated results of operations starting on the acquisition date . ( d ) Includes $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan, which decreased operating income, net income, and diluted EPS by $306 million, $243 million, and $0.04, respectively. ( e ) Includes $630 million of asset impairment charges related to our Phone business, and $480 million of restructuring charges associated with our Phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $1.1 billion, $895 million, and $0.11, respectively. ( f ) Reflects the impact of the adoption of the new accounting standard in fiscal year 2017 related to balance sheet classification of debt issuance costs. ( g ) Includes $7.5 billion of goodwill and asset impairment charges related to our Phone business, and $2.5 billion of integration and restructuring expenses, primarily associated with our Phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $10.0 billion, $9.5 billion, and $1.15, respectively. ( h ) On April 25, 2014, we acquired substantially all of Nokia Corporation’s Devices and Services business (“NDS”). NDS has been included in our consolidated results of operations starting on the acquisition date. 31 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by licensing and supporting an array of software products; offering a wide range of cloud-based and other services to people and businesses; designing, manufacturing, and selling devices; and delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes. Highlights from fiscal year 2018 compared with fiscal year 2017 included: • Commercial cloud revenue, which primarily comprises Microsoft Office 365 commercial, Microsoft Azure, Microsoft Dynamics 365, and other cloud properties, increased 56% to $23.2 billion. • Office Commercial revenue increased 11%, driven by Office 365 commercial revenue growth of 41%. • Office Consumer revenue increased 11% and Office 365 consumer subscribers increased to 31.4 million. • LinkedIn contributed revenue of $5.3 billion, driven by strong momentum across all business lines. • Dynamics revenue increased 13%, driven by Dynamics 365 revenue growth of 65%. • Server products and cloud services revenue increased 21%, driven by Azure revenue growth of 91%. • Enterprise Services revenue increased 5%. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue increased 5%, driven by OEM Pro revenue growth of 11%. • Windows Commercial revenue increased 12%, driven by an increased volume of multi-year agreements. • Gaming revenue increased 14%, driven by Xbox software and services revenue growth of 20%, mainly from third-party title strength. • Microsoft Surface revenue increased 16%, driven by a higher mix of premium devices and an increase in volumes sold, due to the latest editions of Surface. • Search advertising revenue, excluding traffic acquisition costs, increased 16%, driven by higher revenue per search and search volume. On June 4, 2018, we entered into a definitive agreement to acquire GitHub, Inc. for $7.5 billion in an all-stock transaction, which is expected to close by the end of the calendar year. On December 8, 2016, we completed our acquisition of LinkedIn Corporation for a total purchase price of $27.0 billion. LinkedIn has been included in our consolidated results of operations since the date of acquisition. Refer to Note 9 – Business Combinations of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changes existing U.S. tax law and includes numerous provisions that affect our business. During fiscal year 2018, we recorded a net charge of $13.7 billion related to the TCJA. Refer to Note 13 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. We adopted the new accounting standards for revenue recognition and leases effective July 1, 2017. These new standards had a material impact in our consolidated financial statements. Beginning in fiscal year 2018, our financial results reflect adoption of the standards with prior periods restated accordingly. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 32 PART II Item 7 Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Strengthening of the U.S. dollar relative to certain foreign currencies throughout fiscal year 2017 negatively impacted reported revenue and reduced reported expenses from our international operations. This trend reversed in fiscal year 2018. Strengthening of foreign currencies relative to the U.S. dollar positively impacted reported revenue and increased reported expenses from our international operations. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Seasonality We expect our revenue to fluctuate quarterly and to be higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period. Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted in the United States of America (“GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other. Additional information on our reportable segments is contained in Note 21 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). 33 PART II Item 7 SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2018 2017 2016 Percentage Change 2018 Versus 2017 Percentage Change 2017 Versus 2016 Revenue $ 110,360 $ 96,571 $ 91,154 14% 6% Gross margin 72,007 62,310 58,374 16% 7% Operating income 35,058 29,025 26,078 21% 11% Net Income 16,571 25,489 20,539 (35)% 24% Diluted earnings per share 2.13 3.25 2.56 (34)% 27% Adjusted operating income 35,058 29,331 27,188 20% 8% Adjusted net income 30,267 25,732 21,434 18% 20% Adjusted diluted earnings per share 3.88 3.29 2.67 18% 23% Consolidated results of operations include LinkedIn results since the date of acquisition on December 8, 2016. Fiscal year 2018 includes a full period of LinkedIn results, whereas fiscal year 2017 only includes results from the date of acquisition. Adjusted operating income, net income, and adjusted diluted earnings per share (“EPS”) exclude the net charge related to the TCJA, and impairment and restructuring expenses. Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results. Fiscal Year 2018 Compared with Fiscal Year 2017 Revenue increased $13.8 billion or 14%, driven by growth across each of our segments. Productivity and Business Processes revenue increased, driven by LinkedIn and higher revenue from Office. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services. More Personal Computing revenue increased, driven by higher revenue from Gaming, Windows, Search advertising, and Surface, offset in part by lower revenue from Phone. Gross margin increased $9.7 billion or 16%, due to growth across each of our segments. Gross margin percentage increased slightly, driven by favorable segment sales mix and gross margin percentage improvement in More Personal Computing. Gross margin included a 7 percentage point improvement in commercial cloud, primarily from Azure. Operating income increased $6.0 billion or 21%, driven by growth across each of our segments. LinkedIn operating loss increased $63 million to $987 million, including $1.5 billion of amortization of intangible assets. Operating income included a favorable foreign currency impact of 2%. Key changes in expenses were: • Cost of revenue increased $4.1 billion or 12%, mainly due to growth in our commercial cloud, Gaming, LinkedIn, and Search advertising, offset in part by a reduction in Phone cost of revenue. • Sales and marketing expenses increased $2.0 billion or 13%, primarily due to LinkedIn expenses and investments in commercial sales capacity, offset in part by a decrease in Windows marketing expenses. • Research and development expenses increased $1.7 billion or 13%, primarily due to investments in cloud engineering and LinkedIn expenses. • General and administrative expenses increased $273 million or 6%, primarily due to LinkedIn expenses. Current year net income and diluted EPS were negatively impacted by the net charge related to TCJA, which resulted in a decrease to net income and diluted earnings per share of $13.7 billion and $1.75, respectively. Prior year diluted EPS was negatively impacted by restructuring expenses, which resulted in a decrease in operating income, net income, and diluted EPS of $306 million, $243 million, and $0.04, respectively. 34 PART II Item 7 Fiscal Year 2017 Compared with Fiscal Year 2016 Revenue increased $5.4 billion or 6%, driven by growth in Productivity and Business Processes and Intelligent Cloud, offset in part by lower revenue from More Personal Computing. Productivity and Business Processes revenue increased, driven by the acquisition of LinkedIn and higher revenue from Microsoft Office. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services. More Personal Computing revenue decreased, mainly due to lower revenue from Devices, offset in part by higher revenue from Windows and Search advertising. Gross margin increased $3.9 billion or 7%, due to growth across each of our segments, including the acquisition of LinkedIn, driven by higher revenue. Gross margin percentage increased slightly due to a margin percent increase in More Personal Computing and segment sales mix, offset in part by margin percent declines in Productivity and Business Processes and Intelligent Cloud. Gross margin percentage includes a 5 percentage point improvement in commercial cloud gross margin primarily across Azure and Office 365. Operating income increased $2.9 billion or 11%, primarily due to higher gross margin and lower impairment and restructuring expenses, offset in part by an increase in research and development and sales and marketing expenses. Operating income included an operating loss of $924 million related to the acquisition of LinkedIn, including $866 million of amortization of intangible assets. Operating income also included an unfavorable foreign currency impact of 3%. Key changes in expenses were: • Cost of revenue increased $1.5 billion or 5%, mainly due to growth in our commercial cloud, the acquisition of LinkedIn, and higher Search advertising traffic acquisition costs, offset in part by a reduction in Phone sales and Gaming cost of revenue. • Research and development expenses increased $1.0 billion or 9%, primarily due to LinkedIn expenses and increased investments in cloud engineering, offset in part by a reduction in Phone expenses. • Sales and marketing expenses increased $826 million or 6%, primarily due to LinkedIn expenses and increased investments in sales capacity for our commercial cloud, offset in part by a reduction in Phone and marketing expenses. • Impairment and restructuring expenses decreased $804 million, driven by asset impairment charges and restructuring charges related to our Phone business in fiscal year 2016, offset in part by employee severance expenses primarily related to our sales and marketing restructuring plan in fiscal year 2017. Diluted EPS was $3.25 for fiscal year 2017, and was negatively impacted by restructuring expenses, which resulted in a decrease of $0.04. Diluted EPS was $2.56 for fiscal year 2016, and was negatively impacted by impairment and restructuring expenses, which resulted in a decrease of $0.11. SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2018 2017 2016 Percentage Change 2018 Versus 2017 Percentage Change 2017 Versus 2016 Revenue Productivity and Business Processes $ 35,865 $ 29,870 $ 25,792 20% 16% Intelligent Cloud 32,219 27,407 24,952 18% 10% More Personal Computing 42,276 39,294 40,410 8% (3)% Total $ 110,360 $ 96,571 $ 91,154 14% 6% Operating Income (Loss) Productivity and Business Processes $ 12,924 $ 11,389 $ 11,756 13% (3)% Intelligent Cloud 11,524 9,127 9,249 26% (1)% More Personal Computing 10,610 8,815 6,183 20% 43% Corporate and Other 0 (306 ) (1,110 ) * * Total $ 35,058 $ 29,025 $ 26,078 21% 11% * Not meaningful 35 PART II Item 7 Reportable Segments Fiscal Year 2018 Compared with Fiscal Year 2017 Productivity and Business Processes Revenue increased $6.0 billion or 20%. • LinkedIn revenue increased $3.0 billion to $5.3 billion. Fiscal year 2018 includes a full period of results, whereas fiscal year 2017 only includes results from the date of acquisition on December 8, 2016. LinkedIn revenue primarily consisted of revenue from Talent Solutions. • Office Commercial revenue increased $2.4 billion or 11%, driven by Office 365 commercial revenue growth, mainly due to growth in subscribers and average revenue per user, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 commercial. • Office Consumer revenue increased $382 million or 11%, driven by Office 365 consumer revenue growth, mainly due to growth in subscribers. • Dynamics revenue increased 13%, driven by Dynamics 365 revenue growth. Operating income increased $1.5 billion or 13%, including a favorable foreign currency impact of 2%. • Gross margin increased $4.4 billion or 19%, driven by LinkedIn and growth in Office commercial. Gross margin percentage decreased slightly, due to an increased mix of cloud offerings, offset in part by gross margin percentage improvement in Office 365 commercial and LinkedIn. LinkedIn cost of revenue increased $818 million to $1.7 billion, including $888 million of amortization for acquired intangible assets. • Operating expenses increased $2.9 billion or 25%, driven by LinkedIn expenses and investments in commercial sales capacity and cloud engineering. LinkedIn operating expenses increased $2.2 billion to $4.5 billion, including $617 million of amortization of acquired intangible assets. Intelligent Cloud Revenue increased $4.8 billion or 18%. • Server products and cloud services revenue increased $4.5 billion or 21%, driven by Azure and server products licensed on-premises revenue growth. Azure revenue growth of 91%, due to higher infrastructure-as-a-service and platform-as-a-service consumption-based and per user-based services. Server products licensed on-premises revenue increased 5% , mainly due to a higher mix of premium licenses for Windows Server and Microsoft SQL Server. • Enterprise Services revenue increased $304 million or 5% , driven by higher revenue from Premier Support Services and Microsoft Consulting Services, offset in part by a decline in revenue from custom support agreements. Operating income increased $2.4 billion or 26%. • Gross margin increased $3.1 billion or 16%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies. Gross margin percentage decreased, due to an increased mix of cloud offerings, offset in part by gross margin percentage improvement in Azure. • Operating expenses increased $683 million or 7%, driven by investments in commercial sales capacity and cloud engineering. More Personal Computing Revenue increased $3.0 billion or 8%. • Windows revenue increased $925 million or 5%, driven by growth in Windows Commercial and Windows OEM, offset by a decline in patent licensing revenue. Windows Commercial revenue increased 12%, driven by multi-year agreement revenue growth. Windows OEM revenue increased 5%. Windows OEM Pro revenue grew 11%, ahead of a strengthening commercial PC market. Windows OEM non-Pro revenue declined 4%, below the consumer PC market, driven by continued pressure in the entry-level price category. 36 PART II Item 7 • Gaming revenue increased $ 1.3 b illion or 14 %, driven by Xbox so ftware and services revenue growth of 20 %, mainly from third-party title strength. • Search advertising revenue increased $793 million or 13%. Search advertising revenue, excluding traffic acquisition costs, increased 16%, driven by growth in Bing, due to higher revenue per search and search volume. • Surface revenue increased $625 million or 16%, driven by a higher mix of premium devices and an increase in volumes sold, due to the latest editions of Surface. • Phone revenue decreased $525 million. Operating income increased $1.8 billion or 20%, including a favorable foreign currency impact of 2%. • Gross margin increased $2.2 billion or 11%, driven by growth in Windows, Surface, Search, and Gaming. Gross margin percentage increased, primarily due to gross margin percentage improvement in Surface. • Operating expenses increased $391 million or 3%, driven by investments in Search, artificial intelligence, and Gaming engineering and commercial sales capacity, offset in part by a decrease in Windows marketing expenses. Fiscal Year 2017 Compared with Fiscal Year 2016 Productivity and Business Processes Revenue increased $4.1 billion or 16%. • LinkedIn revenue was $2.3 billion, primarily comprised of revenue from Talent Solutions. • Office Commercial revenue increased $1.4 billion or 7%, driven by higher revenue from Office 365 commercial, mainly due to growth in subscribers, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 commercial. • Office Consumer revenue increased $351 million or 11%, driven by higher revenue from Office 365 consumer, mainly due to growth in subscribers. • Dynamics revenue increased 5%, primarily due to higher revenue from Dynamics 365. Operating income decreased $367 million or 3%, including an unfavorable foreign currency impact of 2%. • Operating expenses increased $2.3 billion or 26%, mainly due to LinkedIn and cloud engineering expenses. Operating expenses included $2.3 billion related to our acquisition of LinkedIn, including $359 million of amortization of acquired intangible assets. Sales and marketing expenses increased $1.2 billion or 24%, research and development expenses increased $955 million or 35%, and general and administrative expenses increased $212 million or 14%. • Gross margin increased $2.0 billion or 9%, primarily due to our acquisition of LinkedIn. Gross margin percentage decreased, due to an increased mix of cloud offerings and amortization of acquired intangible assets related to LinkedIn. Cost of revenue included $918 million related to our acquisition of LinkedIn, including $507 million of amortization of acquired intangible assets. Intelligent Cloud Revenue increased $2.5 billion or 10%. • Server products and cloud services revenue grew $2.6 billion or 14%, driven by Azure revenue growth of 98% and server products licensed on-premises revenue growth of 5%. • Enterprise Services revenue decreased 2%, driven by a decline in revenue from custom support agreements, offset in part by higher revenue from Premier Support Services and Microsoft Consulting Services. 37 PART II Item 7 Operating income decreased $122 million or 1%, including an unfavorable foreign currency impact of 2 %. • Operating expenses increased $975 million or 11%, driven by investments in sales capacity, cloud engineering, and developer engagement. Sales and marketing expenses increased $549 million or 13%, research and development expenses increased $468 million or 14%, and general and administrative expenses decreased $42 million or 3%. • Gross margin increased $853 million or 5%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies, offset in part by a decline in Enterprise Services gross margin. Gross margin percentage decreased, due to an increased mix of cloud offerings and lower Enterprise Services gross margin percent, offset by improvement in Azure gross margin percent. More Personal Computing Revenue decreased $1.1 billion or 3%. • Windows revenue increased $1.0 billion or 6%, mainly due to higher revenue from Windows Commercial and Windows OEM. Windows Commercial revenue grew 14%, driven by multi-year agreement revenue. Windows OEM revenue increased 3%. Windows OEM Pro revenue grew 4%, outperforming the commercial PC market, primarily due to a higher mix of premium licenses sold. Windows OEM non-Pro revenue grew 3%, outperforming the consumer PC market, primarily due to a higher mix of premium devices sold. • Search advertising revenue increased $791 million or 15%. Search advertising revenue, excluding traffic acquisition costs, increased 9%, primarily driven by growth in Bing, due to higher revenue per search and search volume. • Gaming revenue decreased slightly, primarily due to lower Xbox hardware revenue, offset in part by higher revenue from Xbox software and services. Xbox hardware revenue decreased 21%, mainly due to lower prices of consoles sold and a decline in volume of consoles sold. Xbox software and services revenue increased 11%, driven by a higher volume of Xbox Live transactions and revenue per transaction. • Surface revenue decreased $82 million or 2%, primarily due to a reduction in volumes sold, offset in part by a higher mix of premium devices. • Phone revenue decreased $2.8 billion. Operating income increased $2.6 billion or 43%, including an unfavorable foreign currency impact of 3%. • Operating expenses decreased $1.5 billion or 12%, driven by a reduction in Phone expenses and Surface launch-related expenses in the prior year. Sales and marketing expenses decreased $893 million or 16%, research and development expenses decreased $374 million or 6%, and general and administrative expenses decreased $252 million or 16%. • Gross margin increased $1.1 billion or 6%, driven by growth in Windows, Search advertising, and Gaming, offset in part by a decline in Phone and Surface. Gross margin percentage increased, due to favorable sales mix and gross margin percent improvements across Windows, Gaming, and Search advertising, offset by a gross margin percent decline in Devices. Corporate and Other Corporate and Other operating loss is comprised of corporate-level activity not specifically allocated to a segment, including impairment and restructuring expenses. Fiscal Year 2018 Compared with Fiscal Year 2017 Corporate and Other operating loss decreased $306 million, due to a reduction in impairment and restructuring expenses, driven by employee severance expenses primarily related to our sales and marketing restructuring plan in fiscal year 2017. 38 PART II Item 7 Fiscal Y ear 2017 Compared with F iscal Y ear 2016 Corporate and Other operating loss decreased $804 million, primarily due to a reduction in impairment and restructuring expenses, driven by asset impairment charges and restructuring charges related to our Phone business in fiscal year 2016, offset in part by employee severance expenses primarily related to our sales and marketing restructuring plan in fiscal year 2017. OPERATING EXPENSES Research and Development (In millions, except percentages) 2018 2017 2016 Percentage Change 2018 Versus 2017 Percentage Change 2017 Versus 2016 Research and development $ 14,726 $ 13,037 $ 11,988 13% 9% As a percent of revenue 13% 13% 13% 0ppt 0ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Fiscal Year 2018 Compared with Fiscal Year 2017 Research and development expenses increased $1.7 billion or 13%, primarily due to investments in cloud engineering and LinkedIn expenses. LinkedIn expenses increased $762 million to $1.5 billion. Fiscal Year 2017 Compared with Fiscal Year 2016 Research and development expenses increased $1.0 billion or 9%, primarily due to LinkedIn expenses and increased investments in cloud engineering, offset in part by a reduction in Phone expenses. Expenses included $745 million related to our acquisition of LinkedIn. Sales and Marketing (In millions, except percentages) 2018 2017 2016 Percentage Change 2018 Versus 2017 Percentage Change 2017 Versus 2016 Sales and marketing $ 17,469 $ 15,461 $ 14,635 13% 6% As a percent of revenue 16% 16% 16% 0ppt 0ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal Year 2018 Compared with Fiscal Year 2017 Sales and marketing expenses increased $2.0 billion or 13%, primarily due to LinkedIn expenses and investments in commercial sales capacity, offset in part by a decrease in Windows marketing expenses. LinkedIn expenses increased $1.2 billion to $2.5 billion, including $617 million of amortization of acquired intangible assets. Fiscal Year 2017 Compared with Fiscal Year 2016 Sales and marketing expenses increased $826 million or 6%, primarily due to LinkedIn expenses and increased investments in sales capacity for our commercial cloud, offset in part by a reduction in Phone expenses and prior year marketing expenses primarily related to Surface, commercial, and Windows 10. Expenses included $1.2 billion related to our acquisition of LinkedIn, including $359 million of amortization of acquired intangible assets. 39 PART II Item 7 General and Administrative (In millions, except percentages) 2018 2017 2016 Percentage Change 2018 Versus 2017 Percentage Change 2017 Versus 2016 General and administrative $ 4,754 $ 4,481 $ 4,563 6% (2)% As a percent of revenue 4% 5% 5% (1)ppt 0ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal Year 2018 Compared with Fiscal Year 2017 General and administrative expenses increased $273 million or 6%, primarily due to LinkedIn expenses. LinkedIn expenses increased $234 million to $528 million. Fiscal Year 2017 Compared with Fiscal Year 2016 General and administrative expenses decreased $82 million or 2%, primarily due to prior year investments in infrastructure supporting our business transformation, a reduction in Phone expenses, and lower employee-related expenses, offset in part by LinkedIn expenses. Expenses included $294 million related to our acquisition of LinkedIn. IMPAIRMENT AND RESTRUCTURING EXPENSES Impairment and restructuring expenses include costs associated with the impairment of intangible assets related to our Phone business, and employee severance expenses and other costs associated with the consolidation of facilities and manufacturing operations related to restructuring activities. Fiscal Year 2018 Compared with Fiscal Year 2017 During fiscal year 2017, we recorded $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan. Fiscal Year 2017 Compared with Fiscal Year 2016 Impairment and restructuring expenses were $306 million for fiscal year 2017, compared to $1.1 billion for fiscal year 2016. During fiscal year 2016, we recorded $630 million of asset impairment charges related to our Phone business. We also recorded $480 million of restructuring charges, including employee severance expenses and contract termination costs, primarily related to our previously announced Phone business restructuring plans. OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Dividends and interest income $ 2,214 $ 1,387 $ 903 Interest expense (2,733 ) (2,222 ) (1,243 ) Net recognized gains on investments 2,399 2,583 668 Net losses on derivatives (187 ) (510 ) (443 ) Net losses on foreign currency remeasurements (218 ) (111 ) (129 ) Other, net (59 ) (251 ) (195 ) Total $ 1,416 $ 876 $ (439 ) 40 PART II Item 7 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. Fiscal Year 2018 Compared with Fiscal Year 2017 Dividends and interest income increased primarily due to higher average portfolio balances and yields on fixed-income securities. Interest expense increased primarily due to higher average outstanding long-term debt and higher finance lease expense. Net recognized gains on investments decreased primarily due to higher losses on sales of fixed-income securities, offset in part by higher gains on sales of equity securities. Net losses on derivatives decreased primarily due to lower losses on equity, foreign exchange, and commodity derivatives, offset in part by losses on interest rate derivatives in the current period as compared to gains in the prior period. Fiscal Year 2017 Compared with Fiscal Year 2016 Dividends and interest income increased primarily due to higher portfolio balances and yields on fixed-income securities. Interest expense increased primarily due to higher outstanding long-term debt. Net recognized gains on investments increased primarily due to higher gains on sales of equity securities. Net losses on derivatives increased due to higher losses on equity derivatives, offset in part by lower losses on commodity and foreign currency derivatives. Other, net reflects recognized losses from certain joint ventures and divestitures. INCOME TAXES Effective Tax Rate Fiscal Year 2018 Compared with Fiscal Year 2017 Our effective tax rate for fiscal years 2018 and 2017 was 55% and 15%, respectively. The increase in our effective tax rate for fiscal year 2018 compared to fiscal year 2017 was primarily due to the net charge related to the enactment of the TCJA in fiscal year 2018 and the realization of tax benefits attributable to previous Phone business losses in fiscal year 2017. Our effective tax rate was higher than the U.S. federal statutory rate primarily due to the net charge related to the enactment of the TCJA, offset in part by earnings taxed at lower rates in foreign jurisdictions resulting from our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2018, our U.S. income before income taxes was $11.5 billion and our foreign income before income taxes was $24.9 billion. In fiscal year 2017, our U.S. income before income taxes was $6.8 billion and our foreign income before income taxes was $23.1 billion. Fiscal Year 2017 Compared with Fiscal Year 2016 Our effective tax rate for fiscal years 2017 and 2016 was 15% and 20%, respectively. The decrease in our effective tax rate for fiscal year 2017 compared to fiscal year 2016 was primarily due to the realization of tax benefits attributable to previous Phone business losses, offset in part by changes in the mix of our income before income taxes between the U.S. and foreign countries. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2017, our U.S. income before income taxes was $6.8 billion and our foreign income before income taxes was $23.1 billion. In fiscal year 2016, our U.S. income before income taxes was $5.1 billion and our foreign income before income taxes was $20.5 billion. 41 PART II Item 7 Recent Tax Legislation On December 22, 2017, the TCJA was enacted into law, which significantly changes existing U.S. tax law and includes numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. The TCJA required us to incur a one-time transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA also reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. For fiscal year 2018, our blended U.S. federal statutory tax rate is 28.1%. This is the result of using the tax rate of 35% for the first and second quarter of fiscal year 2018 and the reduced tax rate of 21% for the third and fourth quarter of fiscal year 2018. The TCJA includes a provision to tax global intangible low-taxed income (“GILTI”) of foreign subsidiaries and a base erosion anti-abuse tax (“BEAT”) measure that taxes certain payments between a U.S. corporation and its foreign subsidiaries. The GILTI and BEAT provisions of the TCJA will be effective for us beginning July 1, 2018. The TCJA was effective in the second quarter of fiscal year 2018. As of June 30, 2018, we have not completed our accounting for the estimated tax effects of the TCJA. During fiscal year 2018, we recorded a provisional net charge of $13.7 billion related to the TCJA based on reasonable estimates for those tax effects. Due to the timing of the enactment and the complexity in applying the provisions of the TCJA, the provisional net charge is subject to revisions as we continue to complete our analysis of the TCJA, collect and prepare necessary data, and interpret any additional guidance issued by the U.S. Treasury Department, Internal Revenue Service (“IRS”), Financial Accounting Standards Board, and other standard-setting and regulatory bodies. Adjustments may materially impact our provision for income taxes and effective tax rate in the period in which the adjustments are made. Our accounting for the estimated tax effects of the TCJA will be completed during the measurement period, which is not expected to extend beyond one year from the enactment date. During fiscal year 2018, we recorded an estimated net charge of $13.7 billion related to the TCJA, due to the impact of the one-time transition tax on the deemed repatriation of deferred foreign income of $17.9 billion, offset in part by the impact of changes in the tax rate of $4.2 billion, primarily on deferred tax assets and liabilities. Uncertain Tax Positions While we settled a portion of the IRS audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. In the second quarter of fiscal year 2018, we settled a portion of the IRS audit for tax years 2010 to 2013. We continue to be subject to examination by the IRS for tax years 2010 to 2017. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of June 30, 2018, the primary unresolved issue relates to transfer pricing, which could have a significant impact in our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2017, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Adjusted operating income, net income and diluted earnings per share are non-GAAP financial measures which exclude the net charge related to the TCJA, and impairment and restructuring expenses. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. 42 PART II Item 7 The following table reconciles our financial res ults reported in accordance with GAAP to non-GAAP financial results: (In millions, except percentages and per share amounts) 2018 2017 2016 Percentage Change 2018 Versus 2017 Percentage Change 2017 Versus 2016 Operating income $ 35,058 $ 29,025 $ 26,078 21% 11% Net charge related to the TCJA 0 0 0 Impairment and restructuring expenses 0 306 1,110 Adjusted operating income $ 35,058 $ 29,331 $ 27,188 20% 8% Net income $ 16,571 $ 25,489 $ 20,539 (35)% 24% Net charge related to the TCJA 13,696 0 0 Impairment and restructuring expenses 0 243 895 Adjusted net income $ 30,267 $ 25,732 $ 21,434 18% 20% Diluted earnings per share $ 2.13 $ 3.25 $ 2.56 (34)% 27% Net charge related to the TCJA 1.75 0 0 Impairment and restructuring expenses 0 0.04 0.11 Adjusted diluted earnings per share $ 3.88 $ 3.29 $ 2.67 18% 23% FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $133.8 billion and $133.0 billion as of June 30, 2018 and 2017, respectively. Equity and other investments were $1.9 billion and $6.0 billion as of June 30, 2018 and 2017, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. As a result of the TCJA, our cash, cash equivalents, and short-term investments held by foreign subsidiaries are no longer subject to U.S. tax on repatriation into the U.S. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments such as corporate notes and bonds, foreign government bonds, mortgage- and asset-backed securities, commercial paper, certificates of deposit, and U.S. agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. 43 PART II Item 7 A majority of our investment s are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing i s used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally clas sified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fai r values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-pe riod fluctuations, and independent recalculation of prices where appropriate. Cash Flows Fiscal Year 2018 Compared with Fiscal Year 2017 Cash from operations increased $4.4 billion to $43.9 billion for the fiscal year ended June 30, 2018, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to employees, net cash paid for income taxes, cash paid for interest on debt, and cash paid to suppliers. Cash used in financing was $33.6 billion for the fiscal year ended June 30, 2018, compared to cash from financing of $8.4 billion for the fiscal year ended June 30, 2017. The change was mainly due to a $41.7 billion decrease in proceeds from issuance of debt, net of repayments, offset in part by a $1.1 billion decrease in cash used for common stock repurchases. Cash used in investing decreased $40.7 billion to $6.1 billion for the fiscal year ended June 30, 2018, mainly due to a $ 25. 1 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, and a $19.1 billion increase in cash from net investment purchases, sales, and maturities. Fiscal Year 2017 Compared with Fiscal Year 2016 Cash from operations increased $6.2 billion to $39.5 billion during the fiscal year, mainly due to an increase in cash received from customers and an income tax refund for overpayment of estimated taxes, offset in part by an increase in cash paid to employees. Cash from financing increased $16.8 billion to $8.4 billion, mainly due to a $13.2 billion increase in proceeds from issuances of debt, net of repayments, and a $4.2 billion decrease in cash used for common stock repurchases, offset in part by an $839 million increase in dividends paid. Cash used in investing increased $22.8 billion to $46.8 billion, mainly due to a $24.6 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangibles and other assets, offset in part by a $1.9 billion decrease in cash used for net investment purchases, sales, and maturities. Debt We issued debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. Refer to Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue comprises mainly unearned revenue related to volume licensing programs and includes Software Assurance (“SA”) and cloud services. Unearned revenue is generally billed upfront at the beginning of each annual coverage period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 44 PART II Item 7 The following table outlines the expected future recognition of unearned revenue as of June 30, 2018: (In millions) Three Months Ending, September 30, 2018 $ 11,081 December 31, 2018 8,688 March 31, 2019 5,995 June 30, 2019 3,141 Thereafter 3,815 Total $ 32,720 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Share Repurchases For the fiscal years ended June 30, 2018, 2017, and 2016, we repurchased 99 million shares, 170 million shares, and 294 million shares of our common stock for $8.6 billion, $10.3 billion, and $14.8 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends Refer to Note 18 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented. Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2018: (In millions) 2019 2020-2021 2022-2023 Thereafter Total Long-term debt: (a) Principal payments $ 4,000 $ 9,268 $ 10,794 $ 52,836 $ 76,898 Interest payments 2,377 4,495 4,066 31,247 42,185 Construction commitments (b) 1,793 107 0 0 1,900 Operating leases, including imputed interest ( c ) 1,538 2,567 1,778 2,416 8,299 Finance leases, including imputed interest ( c ) 470 1,101 1,142 5,751 8,464 Transition tax (d) 1,495 2,808 2,808 10,530 17,641 Purchase commitments ( e ) 19,321 874 255 408 20,858 Other long-term liabilities ( f ) 0 76 19 313 408 Total contractual obligations $ 30,994 $ 21,296 $ 20,862 $ 103,501 $ 176,653 (a) Refer to Note 12 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Refer to Note 8 – Property and Equipment of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). 45 PART II Item 7 ( c ) Refer to Note 16 – Leases of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (d) Refer to Note 13 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). ( e ) Amounts represent purchase commitments, including open purchase orders and take-or-pay contracts that are not presented as construction commitments above. ( f ) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $13.6 billion from the amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity As a result of the TCJA, we are required to pay a one-time transition tax of $17.9 billion on deferred foreign income not previously subject to U.S. income tax. In fiscal year 2018, we paid transition tax of $228 million. Under the TCJA, the remaining transition tax of $17.6 billion is payable interest-free over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future. RECENT ACCOUNTING GUIDANCE Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 46 PART II Item 7 Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance oblig ation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the produ cts and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. The new standard related to revenue recognition had a material impact in our consolidated financial statements. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Impairment of Investment Securities We review investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. 47 PART II Item 7 The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. The TCJA significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 13 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 48 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 49 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. Equity Securities held in our equity and other investments portfolio are subject to market price risk. SENSITIVITY ANALYSIS Historically, we used a value-at-risk (“VaR”) model to estimate and quantify our market risks. This included presenting one-day VaR as well as average, high, and low VaR by risk category throughout the reporting period. Given the changes in size and allocation of our portfolio of financial assets, we believe sensitivity analysis is more informative in representing the potential impact to the portfolio as a result of market movements. Therefore, we have presented a sensitivity analysis for each risk category below. Sensitivity analysis is not intended to represent actual losses in fair value, including determinations of other-than-temporary losses in fair value in accordance with accounting principles generally accepted in the United States of America, but is used as a risk estimation and management tool. The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices: (In millions) Risk Categories Hypothetical Change June 30, 2018 June 30, 2017 Impact Foreign currency - Revenue 10% decrease in foreign exchange rates $ (2,187 ) $ (1,785 ) Earnings Foreign currency - Investments 10% decrease in foreign exchange rates (70 ) (92 ) Fair Value Interest rate 100 basis point increase in U.S. treasury interest rates (2,705 ) (2,394 ) Fair Value Credit 100 basis point increase in credit spreads (232 ) (167 ) Fair Value Equity 10% decrease in equity market prices (140 ) (323 ) Fair Value 50 PART II Item 8 ITEM 8. FINANCIAL STATE MENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2018 2017 2016 Revenue: Product $ 64,497 $ 63,811 $ 67,336 Service and other 45,863 32,760 23,818 Total revenue 110,360 96,571 91,154 Cost of revenue: Product 15,420 15,175 17,880 Service and other 22,933 19,086 14,900 Total cost of revenue 38,353 34,261 32,780 Gross margin 72,007 62,310 58,374 Research and development 14,726 13,037 11,988 Sales and marketing 17,469 15,461 14,635 General and administrative 4,754 4,481 4,563 Impairment and restructuring 0 306 1,110 Operating income 35,058 29,025 26,078 Other income (expense), net 1,416 876 (439 ) Income before income taxes 36,474 29,901 25,639 Provision for income taxes 19,903 4,412 5,100 Net income $ 16,571 $ 25,489 $ 20,539 Earnings per share: Basic $ 2.15 $ 3.29 $ 2.59 Diluted $ 2.13 $ 3.25 $ 2.56 Weighted average shares outstanding: Basic 7,700 7,746 7,925 Diluted 7,794 7,832 8,013 Cash dividends declared per common share $ 1.68 $ 1.56 $ 1.44 Refer to accompanying notes. 51 PART II Item 8 COMPREHENSIVE IN COME STATEMENTS (In millions) Year Ended June 30, 2018 2017 2016 Net income $ 16,571 $ 25,489 $ 20,539 Other comprehensive income (loss), net of tax: Net change related to derivatives 39 (218 ) (238 ) Net change related to investments (2,717 ) (1,116 ) (228 ) Translation adjustments and other (178 ) 167 (262 ) Other comprehensive loss (2,856 ) (1,167 ) (728 ) Comprehensive income $ 13,715 $ 24,322 $ 19,811 Refer to accompanying notes. Refer to Note 19 – Accumulated Other Comprehensive Income (Loss) for further information. 52 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2018 2017 Assets Current assets: Cash and cash equivalents $ 11,946 $ 7,663 Short-term investments 121,822 125,318 Total cash, cash equivalents, and short-term investments 133,768 132,981 Accounts receivable, net of allowance for doubtful accounts of $377 and $345 26,481 22,431 Inventories 2,662 2,181 Other 6,751 5,103 Total current assets 169,662 162,696 Property and equipment, net of accumulated depreciation of $29,223 and $24,179 29,460 23,734 Operating lease right-of-use assets 6,686 6,555 Equity and other investments 1,862 6,023 Goodwill 35,683 35,122 Intangible assets, net 8,053 10,106 Other long-term assets 7,442 6,076 Total assets $ 258,848 $ 250,312 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 8,617 $ 7,390 Short-term debt 0 9,072 Current portion of long-term debt 3,998 1,049 Accrued compensation 6,103 5,819 Short-term income taxes 2,121 718 Short-term unearned revenue 28,905 24,013 Other 8,744 7,684 Total current liabilities 58,488 55,745 Long-term debt 72,242 76,073 Long-term income taxes 30,265 13,485 Long-term unearned revenue 3,815 2,643 Deferred income taxes 541 5,734 Operating lease liabilities 5,568 5,372 Other long-term liabilities 5,211 3,549 Total liabilities 176,130 162,601 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 7,677 and 7,708 71,223 69,315 Retained earnings 13,682 17,769 Accumulated other comprehensive income (loss) (2,187 ) 627 Total stockholders’ equity 82,718 87,711 Total liabilities and stockholders’ equity $ 258,848 $ 250,312 Refer to accompanying notes. 53 PART II Item 8 CASH FLOWS S TATEMENTS (In millions) Year Ended June 30, 2018 2017 2016 Operations Net income $ 16,571 $ 25,489 $ 20,539 Adjustments to reconcile net income to net cash from operations: Asset impairments 0 0 630 Depreciation, amortization, and other 10,261 8,778 6,622 Stock-based compensation expense 3,940 3,266 2,668 Net recognized gains on investments and derivatives (2,212 ) (2,073 ) (223 ) Deferred income taxes (5,143 ) (829 ) 2,479 Changes in operating assets and liabilities: Accounts receivable (3,862 ) (1,216 ) 562 Inventories (465 ) 50 600 Other current assets (952 ) 1,028 (1,212 ) Other long-term assets (285 ) (917 ) (1,110 ) Accounts payable 1,148 81 88 Unearned revenue 5,922 3,820 2,565 Income taxes 18,183 1,792 (298 ) Other current liabilities 798 356 (179 ) Other long-term liabilities (20 ) (118 ) (406 ) Net cash from operations 43,884 39,507 33,325 Financing Proceeds from issuance (repayments) of short-term debt, maturities of 90 days or less, net (7,324 ) (4,963 ) 7,195 Proceeds from issuance of debt 7,183 44,344 13,884 Repayments of debt (10,060 ) (7,922 ) (2,796 ) Common stock issued 1,002 772 668 Common stock repurchased (10,721 ) (11,788 ) (15,969 ) Common stock cash dividends paid (12,699 ) (11,845 ) (11,006 ) Other, net (971 ) (190 ) (369 ) Net cash from (used in) financing (33,590 ) 8,408 (8,393 ) Investing Additions to property and equipment (11,632 ) (8,129 ) (8,343 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (888 ) (25,944 ) (1,393 ) Purchases of investments (137,380 ) (176,905 ) (129,758 ) Maturities of investments 26,360 28,044 22,054 Sales of investments 117,577 136,350 93,287 Securities lending payable (98 ) (197 ) 203 Net cash used in investing (6,061 ) (46,781 ) (23,950 ) Effect of foreign exchange rates on cash and cash equivalents 50 19 (67 ) Net change in cash and cash equivalents 4,283 1,153 915 Cash and cash equivalents, beginning of period 7,663 6,510 5,595 Cash and cash equivalents, end of period $ 11,946 $ 7,663 $ 6,510 Refer to accompanying notes. 54 PART II Item 8 STOCKHOLDERS’ EQ UITY STATEMENTS (In millions) Year Ended June 30, 2018 2017 2016 Common stock and paid-in capital Balance, beginning of period $ 69,315 $ 68,178 $ 68,465 Common stock issued 1,002 772 668 Common stock repurchased (3,033 ) (2,987 ) (3,689 ) Stock-based compensation expense 3,940 3,266 2,668 Other, net (1 ) 86 66 Balance, end of period 71,223 69,315 68,178 Retained earnings Balance, beginning of period 17,769 13,118 16,191 Net income 16,571 25,489 20,539 Common stock cash dividends (12,917 ) (12,040 ) (11,329 ) Common stock repurchased (7,699 ) (8,798 ) (12,283 ) Cumulative effect of accounting change (42 ) 0 0 Balance, end of period 13,682 17,769 13,118 Accumulated other comprehensive income (loss) Balance, beginning of period 627 1,794 2,522 Other comprehensive loss (2,856 ) (1,167 ) (728 ) Cumulative effect of accounting change 42 0 0 Balance, end of period (2,187 ) 627 1,794 Total stockholders’ equity $ 82,718 $ 87,711 $ 83,090 Refer to accompanying notes. 55 PART II Item 8 NOTES TO FINANCI AL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have recast certain prior period income tax liabilities as discussed in the Recent Tax Legislation section below. We have also recast prior period securities lending payables to other current liabilities in our consolidated balance sheets to conform to the current period presentation. These items had no impact in our consolidated income statements or net cash from or used in operating, financing, or investing in our consolidated cash flows statements. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Equity investments for which we are able to exercise significant influence over but do not control the investee and are not the primary beneficiary of the investee’s activities are accounted for using the equity method. Investments for which we are not able to exercise significant influence over the investee and which do not have readily determinable fair values are accounted for under the cost method. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized in our consolidated financial statements or tax returns; and determining when investment impairments are other-than-temporary. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income (“OCI”). Revenue Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; and hardware such as PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Microsoft Office 365, Microsoft Azure, Microsoft Dynamics 365, and Xbox Live; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. 56 PART II Item 8 Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental authorities. Nature of Products and Services Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. In cases where we allocate revenue to software updates, primarily because the updates are provided at no additional charge, revenue is recognized as the updates are provided, which is generally ratably over the estimated life of the related device or license. Certain volume licensing programs, including Enterprise Agreements, include on-premises licenses combined with Software Assurance (“SA”). SA conveys rights to new software and upgrades released over the contract period and provides support, tools, and training to help customers deploy and use products more efficiently. On-premises licenses are considered distinct performance obligations when sold with SA. Revenue allocated to SA is generally recognized ratably over the contract period as customers simultaneously consume and receive benefits, given that SA comprises distinct performance obligations that are satisfied over time. Cloud services, which allow customers to use hosted software over the contract period without taking possession of the software, are provided on either a subscription or consumption basis. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract period. Revenue related to cloud services provided on a consumption basis, such as the amount of storage used in a period, is recognized based on the customer utilization of such resources. When cloud services require a significant level of integration and interdependency with software and the individual components are not considered distinct, all revenue is recognized over the period in which the cloud services are provided. Revenue from search advertising is recognized when the advertisement appears in the search results or when the action necessary to earn the revenue has been completed. Revenue from consulting services is recognized as services are provided. Our hardware is generally highly dependent on, and interrelated with, the underlying operating system and cannot function without the operating system. In these cases, the hardware and software license are accounted for as a single performance obligation and revenue is recognized at the point in time when ownership is transferred to resellers or directly to end customers through retail stores and online marketplaces. Refer to Note 21 – Segment Information and Geographic Data for further information, including revenue by significant product and service offering. Significant Judgments Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 57 PART II Item 8 Judgment is required to determine the SSP for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various product s and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Contract Balances Timing of revenue recognition may differ from the timing of invoicing to customers. We record a receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For multi-year agreements, we generally invoice customers annually at the beginning of each annual coverage period. We record a receivable related to revenue recognized for multi-year on-premises licenses as we have an unconditional right to invoice and receive payment in the future related to those licenses. The opening balance of current and long-term accounts receivable, net of allowance for doubtful accounts, was $22.3 billion as of July 1, 2016. As of June 30, 2018 and 2017, long-term accounts receivable, net of allowance for doubtful accounts, were $1.8 billion and $1.7 billion, respectively, and are included in other long-term assets in our consolidated balance sheets. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2018 2017 2016 Balance, beginning of period $ 361 $ 409 $ 289 Charged to costs and other 134 58 175 Write-offs (98 ) (106 ) (55 ) Balance, end of period $ 397 $ 361 $ 409 Allowance for doubtful accounts included in our consolidated balance sheets: June 30, 2018 2017 2016 Accounts receivable, net of allowance for doubtful accounts $ 377 $ 345 $ 392 Other long-term assets 20 16 17 Total $ 397 $ 361 $ 409 58 PART II Item 8 Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include SA and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for consulting services to be performed in the future; LinkedIn subscriptions; Office 365 subscriptions; Xbox Live subscriptions; Windows 10 post-delivery support; Dynamics business solutions; Skype prepaid credits and subscriptions; and other offerings for which we have been paid in advance and e arn the revenue when we transfer control of the product or service. Refer to Note 15 – Unearned Revenue for further information, including unearned revenue by segment and changes in unearned revenue during the period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with revenue recognized upfront. Assets Recognized from Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets in our consolidated balance sheets. We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less. These costs include our internal sales force compensation program and certain partner sales incentive programs as we have determined annual compensation is commensurate with annual sales activities. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by original equipment manufacturers (“OEM”), to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain Internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. 59 PART II Item 8 Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.6 billion, $1.5 billion, and $1.6 billion in fiscal years 2018, 2017, and 2016, respectively. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term in our consolidated balance sheets. 60 PART II Item 8 Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 non-derivative investments primarily include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 non-derivative investments consist primarily of corporate notes and bonds, foreign government bonds, mortgage- and asset-backed securities, commercial paper, certificates of deposit, and U.S. agency securities. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets and liabilities primarily comprise investments in common and preferred stock, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure certain assets, including our cost and equity method investments, at fair value on a nonrecurring basis when they are deemed to be other-than-temporarily impaired. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. An impairment charge is recorded when the cost of the investment exceeds its fair value and this condition is determined to be other-than-temporary. Our other current financial assets and current financial liabilities have fair values that approximate their carrying values. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. All cash equivalents and short-term investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in market value, excluding other-than-temporary impairments, are reflected in OCI. Equity and other investments classified as long-term include both debt and equity instruments. Debt and publicly-traded equity securities are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in the market value of available-for-sale securities, excluding other-than-temporary impairments, are reflected in OCI. Common and preferred stock and other investments that are restricted for more than one year or are not publicly traded are recorded at cost or using the equity method. 61 PART II Item 8 We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and the loaned securities continue to be carried as investments in ou r consolidated balance sheets. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, the duration and extent to which the fair value is less than cost, and for equity securities, our intent and ability to hold, or plans to sell, the investment. For fixed-income securities, we also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded to other income (expense), net and a new cost basis in the investment is established. Derivatives Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, the gains (losses) are recognized in earnings in the periods of change together with the offsetting losses (gains) on the hedged items attributed to the risk being hedged. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. For derivative instruments designated as cash flow hedges, the effective portion of the gains (losses) on the derivatives is initially reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure is recognized in earnings. For options designated as cash flow hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains (losses) on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains (losses) from changes in fair values are primarily recognized in other income (expense), net. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years; computer equipment, two to three years; buildings and improvements, five to 15 years; leasehold improvements, three to 20 years; and furniture and equipment, one to 10 years. Land is not depreciated. 62 PART II Item 8 Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets, other current liabilities, and operating lease liabilities in our consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in our consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. We use the implicit rate when readily determinable. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. We have lease agreements with lease and non-lease components, which are generally accounted for separately. For certain equipment leases, such as vehicles, we account for the lease and non-lease components as a single lease component. Additionally, for certain equipment leases, we apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets All of our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 20 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Tax Legislation On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 13 – Income Taxes for further discussion. 63 PART II Item 8 As a result of the TCJA, we have recast certain prior period income tax liabilities in our consolidated balance she ets to conform to the current period presentation. Previously reported balances were impacted as follows: (In millions) As Previously Reported As Adjusted Balance Sheets June 30, 2017 Long-term income taxes $ 0 $ 13,485 Other long-term liabilities 17,034 3,549 These adjustments had no impact in our consolidated income statements or net cash from or used in operating, financing, or investing in our consolidated cash flows statements. Recent Accounting Guidance Recently Adopted Accounting Guidance Comprehensive Income – Reclassification of Certain Tax Effects In February 2018, the Financial Accounting Standards Board (“FASB”) issued new guidance to allow a reclassification from accumulated other comprehensive income (“AOCI”) to retained earnings for stranded tax effects resulting from the TCJA. In the second quarter of fiscal year 2018, we remeasured our deferred taxes related to unrealized gains on our investment balances using the reduced tax rate. As required by GAAP, we recognized the net tax benefit in the provision for income taxes in our consolidated income statements, even though the deferred taxes were initially recognized in AOCI, which resulted in stranded tax effects. We elected to early adopt the standard effective April 1, 2018 and reclassified a $42 million net tax benefit from AOCI to retained earnings in our consolidated balance sheets. Adoption of the standard had no impact to our consolidated income statements or cash flows statements. Leases In February 2016, the FASB issued a new standard related to leases to increase transparency and comparability among organizations by requiring the recognition of ROU assets and lease liabilities on the balance sheet. Most prominent among the changes in the standard is the recognition of ROU assets and lease liabilities by lessees for those leases classified as operating leases. Under the standard, disclosures are required to meet the objective of enabling users of financial statements to assess the amount, timing, and uncertainty of cash flows arising from leases. We are also required to recognize and measure leases existing at, or entered into after, the beginning of the earliest comparative period presented using a modified retrospective approach, with certain practical expedients available. We elected to early adopt the standard effective July 1, 2017 concurrent with our adoption of the new standard related to revenue recognition. We elected the available practical expedients and implemented internal controls and key system functionality to enable the preparation of financial information on adoption. The standard had a material impact in our consolidated balance sheets, but did not have an impact in our consolidated income statements. The most significant impact was the recognition of ROU assets and lease liabilities for operating leases, while our accounting for finance leases remained substantially unchanged. Adoption of the standard required us to restate certain previously reported results, including the recognition of additional ROU assets and lease liabilities for operating leases. Refer to Impacts to Previously Reported Results below for the impact of adoption of the standard in our consolidated financial statements. Revenue from Contracts with Customers In May 2014, the FASB issued a new standard related to revenue recognition. Under the standard, revenue is recognized when a customer obtains control of promised goods or services in an amount that reflects the consideration the entity expects to receive in exchange for those goods or services. In addition, the standard requires disclosure of the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. 64 PART II Item 8 We elected to early adopt the standard effective July 1, 2017, using the full retrospective method, which required us to restate each prior reporting period presented. We implemented internal controls and key system functionality to enable the preparation of financial information on adoption. The most significant impact of the standard relates to our accounting for software license revenue. Specifically, for Windows 10, we recognize revenue predominantly at the time of billing and delivery rather than ratably over the life of the related device. For certain multi-year commercial software subscriptions that include both distinct software licenses and SA, we recognize license revenue at the time of contract execution rather than over the subscription period. Due to the complexity of certain of our commercial license subscription contracts, the actual revenue recognition treatment required under the standard depends on contract-specific terms and in some instances may vary from recognition at the time of billing. Revenue recognition related to our hardware, cloud offerings (such as Office 365), LinkedIn, and professional services remains substantially unchanged. Adoption of the standard using the full retrospective method required us to restate certain previously reported results, including the recognition of additional revenue and an increase in the provision for income taxes, primarily due to the net change in Windows 10 revenue recognition. In addition, adoption of the standard resulted in an increase in accounts receivable and other current and long-term assets, driven by unbilled receivables from upfront recognition of revenue for certain multi-year commercial software subscriptions that include both distinct software licenses and SA; a reduction of unearned revenue, driven by the upfront recognition of license revenue from Windows 10 and certain multi-year commercial software subscriptions; and an increase in deferred income taxes, driven by the upfront recognition of revenue. Refer to Impacts to Previously Reported Results below for the impact of adoption of the standard in our consolidated financial statements. Impacts to Previously Reported Results Adoption of the standards related to revenue recognition and leases impacted our previously reported results as follows: (In millions, except per share amounts) As Previously Reported New Revenue Standard Adjustment As Restated Income Statements Year Ended June 30, 2017 Revenue $ 89,950 $ 6,621 $ 96,571 Provision for income taxes 1,945 2,467 4,412 Net income 21,204 4,285 25,489 Diluted earnings per share 2.71 0.54 3.25 Year Ended June 30, 2016 Revenue $ 85,320 $ 5,834 $ 91,154 Provision for income taxes 2,953 2,147 5,100 Net income 16,798 3,741 20,539 Diluted earnings per share 2.10 0.46 2.56 65 PART II Item 8 (In millions) As Previously Reported New Revenue Standard Adjustment New Lease Standard Adjustment As Restated Balance Sheets June 30, 2017 Accounts receivable, net of allowance for doubtful accounts $ 19,792 $ 2,639 $ 0 $ 22,431 Operating lease right-of-use assets 0 0 6,555 6,555 Other current and long-term assets 11,147 32 0 11,179 Unearned revenue 44,479 (17,823 ) 0 26,656 Deferred income taxes 531 5,203 0 5,734 Operating lease liabilities 0 0 5,372 5,372 Other current and long-term liabilities 23,464 (26 ) 1,183 24,621 Stockholders' equity 72,394 15,317 0 87,711 Adoption of the standards related to revenue recognition and leases had no impact to cash from or used in operating, financing, or investing in our consolidated cash flows statements. Recent Accounting Guidance Not Yet Adopted Financial Instruments – Targeted Improvements to Accounting for Hedging Activities In August 2017, the FASB issued new guidance related to accounting for hedging activities. This guidance expands strategies that qualify for hedge accounting, changes how many hedging relationships are presented in the financial statements, and simplifies the application of hedge accounting in certain situations. The standard will be effective for us beginning July 1, 2019, with early adoption permitted for any interim or annual period before the effective date. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We are currently evaluating the impact of this standard in our consolidated financial statements, including accounting policies, processes, and systems. Income Taxes – Intra-Entity Asset Transfers In October 2016, the FASB issued new guidance requiring an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs, rather than when the asset has been sold to an outside party. This guidance is effective for us beginning July 1, 2018, with early adoption permitted beginning July 1, 2017. We plan to adopt the guidance effective July 1, 2018. Adoption of the guidance will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We currently expect a net cumulative-effect adjustment of approximately $550 million, which will reverse the deferral of income tax consequences from past intra-entity transfers involving assets other than inventory and new deferred tax assets for amounts not recognized under current GAAP, partially offset by a U.S. deferred tax liability related to global intangible low-taxed income (“GILTI”). Adoption of the standard is expected to result in an increase in long-term deferred tax assets of $2.8 billion, an increase in long-term deferred tax liabilities of $2.1 billion, and a reduction to other current assets of $150 million. As a result of the TCJA, we are continuing to evaluate the impact of this standard in our consolidated financial statements, including accounting policies, processes, and systems. Financial Instruments – Credit Losses In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We will be required to use a forward-looking expected credit loss model for accounts receivables, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The standard will be effective for us beginning July 1, 2020, with early adoption permitted beginning July 1, 2019. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date to align our credit loss methodology with the new standard. We are currently evaluating the impact of this standard in our consolidated financial statements, including accounting policies, processes, and systems. 66 PART II Item 8 Financial Instruments – Recognition, Measurement, Presentation, and Disclosure In January 2016, the FASB issued a new standard related to certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most prominent among the changes in the standard is the requirement for changes in the fair value of our equity investments, with certain exceptions, to be recognized through net income rather than OCI. Under the standard, equity investments that do not have a readily determinable fair value are eligible for the measurement alternative. Using the measurement alternative, investments without readily determinable fair values will be valued at cost, with adjustments for changes in price or impairments reflected through net income. The standard will be effective for us beginning July 1, 2018. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment from AOCI to retained earnings as of the effective date. A cumulative-effect adjustment will capture any previously held unrealized gains and losses held in AOCI related to our equity investments carried at fair value as well as the impact of recording the fair value of certain equity investments carried at cost. In preparation for adoption of this standard, we have implemented internal controls to align with the new standard and have concluded that we will elect the measurement alternative for equity investments that do not have readily determinable fair values. The impact in our consolidated balance sheets upon adoption will not be material. Adoption of the standard will have no impact to cash from or used in operating, financing or investing in our consolidated cash flows statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2018 2017 2016 Net income available for common shareholders (A) $ 16,571 $ 25,489 $ 20,539 Weighted average outstanding shares of common stock (B) 7,700 7,746 7,925 Dilutive effect of stock-based awards 94 86 88 Common stock and common stock equivalents (C) 7,794 7,832 8,013 Earnings Per Share Basic (A/B) $ 2.15 $ 3.29 $ 2.59 Diluted (A/C) $ 2.13 $ 3.25 $ 2.56 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Dividends and interest income $ 2,214 $ 1,387 $ 903 Interest expense (2,733 ) (2,222 ) (1,243 ) Net recognized gains on investments 2,399 2,583 668 Net losses on derivatives (187 ) (510 ) (443 ) Net losses on foreign currency remeasurements (218 ) (111 ) (129 ) Other, net (59 ) (251 ) (195 ) Total $ 1,416 $ 876 $ (439 ) 67 PART II Item 8 Following are details of net recognized gains (losses) on investments during the periods reported: (In millions) Year Ended June 30, 2018 2017 2016 Other-than-temporary impairments of investments $ (47 ) $ (55 ) $ (322 ) Realized gains from sales of available-for-sale securities 3,478 3,064 1,376 Realized losses from sales of available-for-sale securities (1,032 ) (426 ) (386 ) Total $ 2,399 $ 2,583 $ 668 NOTE 4 — INVESTMENTS Investment Components The components of investments, including associated derivatives, were as follows: (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2018 Cash $ 3,942 $ 0 $ 0 $ 3,942 $ 3,942 $ 0 $ 0 Mutual funds 246 0 0 246 246 0 0 Commercial paper 2,513 0 0 2,513 2,215 298 0 Certificates of deposit 2,058 0 0 2,058 1,865 193 0 U.S. government and agency securities 109,862 62 (1,167 ) 108,757 3,678 105,079 0 Foreign government bonds 5,182 1 (10 ) 5,173 0 5,173 0 Mortgage- and asset-backed securities 3,868 4 (13 ) 3,859 0 3,859 0 Corporate notes and bonds 6,947 21 (56 ) 6,912 0 6,912 0 Municipal securities 271 37 (1 ) 307 0 307 0 Common and preferred stock 1,220 95 (10 ) 1,305 0 0 1,305 Other investments 558 0 0 558 0 1 557 Total $ 136,667 $ 220 $ (1,257 ) $ 135,630 $ 11,946 $ 121,822 $ 1,862 (In millions) Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity and Other Investments June 30, 2017 Cash $ 3,624 $ 0 $ 0 $ 3,624 $ 3,624 $ 0 $ 0 Mutual funds 1,478 0 0 1,478 1,478 0 0 Commercial paper 319 0 0 319 69 250 0 Certificates of deposit 1,358 0 0 1,358 972 386 0 U.S. government and agency securities 112,119 85 (360 ) 111,844 16 111,828 0 Foreign government bonds 5,276 2 (13 ) 5,265 1,504 3,761 0 Mortgage- and asset-backed securities 3,921 14 (4 ) 3,931 0 3,931 0 Corporate notes and bonds 4,786 61 (12 ) 4,835 0 4,835 0 Municipal securities 284 43 0 327 0 327 0 Common and preferred stock 2,472 3,062 (34 ) 5,500 0 0 5,500 Other investments 523 0 0 523 0 0 523 Total $ 136,160 $ 3,267 $ (423 ) $ 139,004 $ 7,663 $ 125,318 $ 6,023 68 PART II Item 8 As of June 30, 2018 and 2017, the recorded bases of common and preferred stock that are restricted for more than one year or are not publicly traded were $ 999 m illion and $1.1 billion, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments. As of June 30, 2018 and 2017, collateral received under agreements for loaned securities was $1.8 billion and $3.7 billion, respectively, and primarily comprised U.S. government and agency securities. Unrealized Losses on Investments Investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2018 U.S. government and agency securities $ 82,352 $ (1,064 ) $ 4,459 $ (103 ) $ 86,811 $ (1,167 ) Foreign government bonds 3,457 (7 ) 13 (3 ) 3,470 (10 ) Mortgage- and asset-backed securities 2,072 (9 ) 96 (4 ) 2,168 (13 ) Corporate notes and bonds 3,111 (43 ) 301 (13 ) 3,412 (56 ) Municipal securities 45 (1 ) 0 0 45 (1 ) Common and preferred stock 75 (6 ) 8 (4 ) 83 (10 ) Total $ 91,112 $ (1,130 ) $ 4,877 $ (127 ) $ 95,989 $ (1,257 ) Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2017 U.S. government and agency securities $ 87,558 $ (348 ) $ 371 $ (12 ) $ 87,929 $ (360 ) Foreign government bonds 4,006 (2 ) 23 (11 ) 4,029 (13 ) Mortgage- and asset-backed securities 1,068 (3 ) 198 (1 ) 1,266 (4 ) Corporate notes and bonds 669 (8 ) 177 (4 ) 846 (12 ) Common and preferred stock 69 (6 ) 148 (28 ) 217 (34 ) Total $ 93,370 $ (367 ) $ 917 $ (56 ) $ 94,287 $ (423 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2018 Due in one year or less $ 31,590 $ 31,451 Due after one year through five years 76,422 75,810 Due after five years through 10 years 21,765 21,396 Due after 10 years 924 922 Total $ 130,701 $ 129,579 69 PART II Item 8 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. dollar equivalents. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. As of June 30, 2018 and 2017, the total notional amounts of these foreign exchange contracts sold were $6.1 billion and $8.9 billion, respectively. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. As of June 30, 2018 and 2017, the total notional amounts of these foreign exchange contracts sold were $5.0 billion and $5.1 billion, respectively. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. As of June 30, 2018, the total notional amounts of these foreign exchange contracts purchased and sold were $9.4 billion and $13.4 billion, respectively. As of June 30, 2017, the total notional amounts of these foreign exchange contracts purchased and sold were $8.8 billion and $10.6 billion, respectively. Equity Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of June 30, 2018, the total notional amounts of equity contracts purchased and sold for managing market price risk were $49 million and $5 million, respectively. As of June 30, 2017, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.9 billion and $2.4 billion, respectively, of which $1.6 billion and $1.8 billion, respectively, were designated as hedging instruments. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of June 30, 2018, the total notional amounts of fixed-interest rate contracts purchased and sold were $306 million and $390 million, respectively. As of June 30, 2017, the total notional amounts of fixed-interest rate contracts purchased and sold were $233 million and $352 million, respectively. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of June 30, 2018 and 2017, the total notional derivative amounts of mortgage contracts purchased were $568 million and $567 million, respectively. 70 PART II Item 8 Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of June 30, 2018, the total notional amounts of credit contracts purchased and sold were $4 million and $82 million, respectively. As of June 30, 2017, the total notional amounts of credit contracts purchased and sold were $267 million and $63 million, respectively. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2018, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. Fair Values of Derivative Instruments The following table presents the fair values of derivative instruments designated as hedging instruments (“designated hedge derivatives”) and not designated as hedging instruments (“non-designated hedge derivatives”). The fair values exclude the impact of netting derivative assets and liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk: Assets Liabilities (In millions) Short-term Investments Other Current Assets Equity and Other Investments Other Long-term Assets Other Current Liabilities Other Long-term Liabilities June 30, 2018 Non-designated Hedge Derivatives Foreign exchange contracts $ 10 $ 221 $ 0 $ 25 $ (193 ) $ (4 ) Equity contracts 2 0 0 0 (7 ) 0 Interest rate contracts 11 0 0 0 (2 ) 0 Credit contracts 0 0 0 0 (1 ) 0 Total $ 23 $ 221 $ 0 $ 25 $ (203 ) $ (4 ) Designated Hedge Derivatives Foreign exchange contracts $ 95 $ 174 $ 0 $ 0 $ 0 $ 0 Equity contracts 0 0 0 0 0 0 Total $ 95 $ 174 $ 0 $ 0 $ 0 $ 0 Total gross amounts of derivatives $ 118 $ 395 $ 0 $ 25 $ (203 ) $ (4 ) Gross derivatives either offset or subject to an enforceable master netting agreement $ 113 $ 395 $ 0 $ 25 $ (203 ) $ (4 ) Gross amounts of derivatives offset on the balance sheet (14 ) (135 ) 0 (3 ) 150 3 Net amounts presented on the balance sheet 99 260 0 22 (53 ) (1 ) Gross amounts of derivatives not offset on the balance sheet 0 0 0 0 0 0 Cash collateral received 0 0 0 0 (235 ) 0 Net amount $ 99 $ 260 $ 0 $ 22 $ (288 ) $ (1 ) 71 PART II Item 8 Assets Liabilities (In millions) Short-term Investments Other Current Assets Equity and Other Investments Other Long-term Assets Other Current Liabilities Other Long-term Liabilities June 30, 2017 Non-designated Hedge Derivatives Foreign exchange contracts $ 9 $ 203 $ 0 $ 6 $ (134 ) $ (8 ) Equity contracts 3 0 0 0 (6 ) 0 Interest rate contracts 3 0 0 0 (7 ) 0 Credit contracts 5 0 0 0 (1 ) 0 Total $ 20 $ 203 $ 0 $ 6 $ (148 ) $ (8 ) Designated Hedge Derivatives Foreign exchange contracts $ 80 $ 133 $ 0 $ 0 $ (3 ) $ 0 Equity contracts 0 0 67 0 (186 ) 0 Total $ 80 $ 133 $ 67 $ 0 $ (189 ) $ 0 Total gross amounts of derivatives $ 100 $ 336 $ 67 $ 6 $ (337 ) $ (8 ) Gross derivatives either offset or subject to an enforceable master netting agreement $ 100 $ 336 $ 67 $ 6 $ (334 ) $ (8 ) Gross amounts of derivatives offset on the balance sheet (20 ) (132 ) (67 ) (8 ) 221 7 Net amounts presented on the balance sheet 80 204 0 (2 ) (113 ) (1 ) Gross amounts of derivatives not offset on the balance sheet 0 0 0 0 0 0 Cash collateral received 0 0 0 0 (228 ) 0 Net amount $ 80 $ 204 $ 0 $ (2 ) $ (341 ) $ (1 ) Refer to Note 4 – Investments and Note 6 – Fair Value Measurements for further information. Fair Value Hedge Gains (Losses) We recognized in other income (expense), net the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2018 2017 2016 Foreign Exchange Contracts Derivatives $ 25 $ 441 $ (797 ) Hedged items 78 (386 ) 838 Total amount of ineffectiveness $ 103 $ 55 $ 41 Equity Contracts Derivatives $ (324 ) $ (74 ) $ (76 ) Hedged items 324 74 76 Total amount of ineffectiveness $ 0 $ 0 $ 0 Amount of equity contracts excluded from effectiveness assessment $ 80 $ (80 ) $ (10 ) 72 PART II Item 8 Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges: (In millions) Year Ended June 30, 2018 2017 2016 Effective Portion Gains recognized in other comprehensive income (net of tax of $11 , $4, and $24) $ 219 $ 328 $ 351 Gains reclassified from accumulated other comprehensive income (loss) into revenue 185 555 625 Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense), net (255 ) (389 ) (354 ) We estimate that $179 million of net derivative gains included in AOCI as of June 30, 2018 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2018. Non-designated Derivative Gains (Losses) Gains (losses) from changes in fair values of derivatives that are not designated as hedges are primarily recognized in other income (expense), net. These amounts are shown in the table below, with the exception of gains (losses) on derivatives presented in income statement line items other than other income (expense), net, which were immaterial for the periods presented. (In millions) Year Ended June 30, 2018 2017 2016 Foreign exchange contracts $ (33 ) $ (117 ) $ (55 ) Equity contracts (87 ) (114 ) (21 ) Interest rate contracts (15 ) 14 10 Credit contracts (2 ) 5 (1 ) Other contracts 0 (22 ) (87 ) Total $ (137 ) $ (234 ) $ (154 ) 73 PART II Item 8 NOTE 6 — FAIR VALUE MEASUREMENTS Financial Assets and Liabilities Measured at Fair Value on a Recurring Basis The following tables present the fair value of our financial instruments that are measured at fair value on a recurring basis: (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2018 Assets Mutual funds $ 246 $ 0 $ 0 $ 246 $ 0 $ 246 Commercial paper 0 2,513 0 2,513 0 2,513 Certificates of deposit 0 2,058 0 2,058 0 2,058 U.S. government and agency securities 107,015 1,742 0 108,757 0 108,757 Foreign government bonds 22 5,054 0 5,076 0 5,076 Mortgage- and asset-backed securities 0 3,855 0 3,855 0 3,855 Corporate notes and bonds 0 6,894 15 6,909 0 6,909 Municipal securities 0 307 0 307 0 307 Common and preferred stock 287 0 18 305 0 305 Derivatives 1 535 2 538 (152 ) 386 Total $ 107,571 $ 22,958 $ 35 $ 130,564 $ (152 ) $ 130,412 Liabilities Derivatives and other $ 1 $ 206 $ 0 $ 207 $ (153 ) $ 54 (In millions) Level 1 Level 2 Level 3 Gross Fair Value Netting (a) Net Fair Value June 30, 2017 Assets Mutual funds $ 1,478 $ 0 $ 0 $ 1,478 $ 0 $ 1,478 Commercial paper 0 319 0 319 0 319 Certificates of deposit 0 1,358 0 1,358 0 1,358 U.S. government and agency securities 109,228 2,616 0 111,844 0 111,844 Foreign government bonds 0 5,187 0 5,187 0 5,187 Mortgage- and asset-backed securities 0 3,934 0 3,934 0 3,934 Corporate notes and bonds 0 4,829 1 4,830 0 4,830 Municipal securities 0 327 0 327 0 327 Common and preferred stock 2,414 1,994 18 4,426 0 4,426 Derivatives 1 508 0 509 (227 ) 282 Total $ 113,121 $ 21,072 $ 19 $ 134,212 $ (227 ) $ 133,985 Liabilities Derivatives and other $ 0 $ 345 $ 39 $ 384 $ (228 ) $ 156 (a) These amounts represent the impact of netting derivative assets and derivative liabilities when a legally enforceable master netting agreement exists and fair value adjustments related to our own credit risk and counterparty credit risk. The changes in our Level 3 financial instruments that are measured at fair value on a recurring basis were immaterial during the periods presented. 74 PART II Item 8 The following table reconciles the total “Net Fair Value” of assets above to the balance sheet presentation of these same assets in Note 4 – Investments. (In millions) June 30, 2018 2017 Net fair value of assets measured at fair value on a recurring basis $ 130,412 $ 133,985 Cash 3,942 3,624 Common and preferred stock measured at fair value on a nonrecurring basis 999 1,073 Other investments measured at fair value on a nonrecurring basis 557 523 Less derivative net assets classified as other current and long-term assets (282 ) (202 ) Other 2 1 Recorded basis of investment components $ 135,630 $ 139,004 Financial Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis During fiscal year 2018 and 2017, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis. NOTE 7 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2018 2017 Raw materials $ 655 $ 797 Work in process 54 145 Finished goods 1,953 1,239 Total $ 2,662 $ 2,181 NOTE 8 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2018 2017 Land $ 1,254 $ 1,107 Buildings and improvements 20,604 16,284 Leasehold improvements 4,735 5,064 Computer equipment and software 27,633 21,414 Furniture and equipment 4,457 4,044 Total, at cost 58,683 47,913 Accumulated depreciation (29,223 ) (24,179 ) Total, net $ 29,460 $ 23,734 During fiscal years 2018, 2017, and 2016, depreciation expense was $7.7 billion, $6.1 billion, and $4.9 billion, respectively. We have committed $1.9 billion for the construction of new buildings, building improvements, and leasehold improvements as of June 30, 2018. 75 PART II Item 8 NOTE 9 — BUSINESS COMBINATIONS LinkedIn Corporation On December 8, 2016, we completed our acquisition of all issued and outstanding shares of LinkedIn Corporation, the world’s largest professional network on the Internet, for a total purchase price of $27.0 billion. The purchase price consisted primarily of cash of $26.9 billion. The acquisition is expected to accelerate the growth of LinkedIn, Office 365, and Dynamics 365. The financial results of LinkedIn have been included in our consolidated financial statements since the date of the acquisition. The allocation of the purchase price to goodwill was completed as of June 30, 2017. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash and cash equivalents $ 1,328 Short-term investments 2,110 Other current assets 697 Property and equipment 1,529 Intangible assets 7,887 Goodwill ( a ) 16,803 Short-term debt (b) (1,323 ) Other current liabilities (1,117 ) Deferred income taxes (774 ) Other (131 ) Total purchase price $ 27,009 (a) Goodwill was assigned to our Productivity and Business Processes segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of LinkedIn. None of the goodwill is expected to be deductible for income tax purposes. (b) Convertible senior notes issued by LinkedIn on November 12, 2014, substantially all of which were redeemed after our acquisition of LinkedIn. The remaining $18 million of notes are not redeemable and are included in long-term debt in our consolidated balance sheets. Refer to Note 12 – Debt for further information. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Customer-related $ 3,607 7 years Marketing-related (trade names) 2,148 20 years Technology-based 2,109 3 years Contract-based 23 5 years Fair value of intangible assets acquired $ 7,887 9 years Our consolidated income statements include the following revenue and operating loss attributable to LinkedIn since the date of acquisition: (In millions) Year Ended June 30, 2017 Revenue $ 2,271 Operating loss (924 ) 76 PART II Item 8 Following are the supplemental consolidated financial results of Microsoft Corporation on an unaudited pro forma basis, as if the acquisition had been consummated on July 1, 2015: (In millions, except earnings per share) Year Ended June 30, 2017 2016 Revenue $ 98,291 $ 94,490 Net income 25,179 19,128 Diluted earnings per share 3.21 2.38 These pro forma results were based on estimates and assumptions, which we believe are reasonable. They are not the results that would have been realized had we been a combined company during the periods presented and are not necessarily indicative of our consolidated results of operations in future periods. The pro forma results include adjustments related to purchase accounting, primarily amortization of intangible assets. Acquisition costs and other nonrecurring charges were immaterial and are included in the earliest period presented. GitHub Inc. On June 4, 2018, we entered into a definitive agreement to acquire GitHub Inc. (“GitHub”) for $7.5 billion in an all-stock transaction. We expect the acquisition will close by the end of the calendar year, subject to approval by GitHub’s shareholders, satisfaction of certain regulatory approvals, and other customary closing conditions. GitHub will be included in our consolidated results of operations as of the date of acquisition. Other During fiscal year 2018, we completed nine acquisitions for total consideration of $948 million, substantially all of which was paid in cash. These entities have been included in our consolidated results of operations since their respective acquisition dates. Pro forma results of operations for these acquisitions have not been presented because the effects of these business combinations, individually and in aggregate, were not material to our consolidated results of operations. NOTE 10 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2016 Acquisitions Other June 30, 2017 Acquisitions Other June 30, 2018 Productivity and Business Processes $ 6,678 $ 17,072 (a) $ (11 ) $ 23,739 $ 72 $ 12 $ 23,823 Intelligent Cloud 5,467 49 39 5,555 164 (16 ) 5,703 More Personal Computing 5,727 115 (14 ) 5,828 394 (65 ) 6,157 Total $ 17,872 $ 17,236 $ 14 $ 35,122 $ 630 $ (69 ) $ 35,683 (a) Includes goodwill related to LinkedIn and other acquisitions. Refer to Note 9 – Business Combinations for further information. The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the above table. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable. As of June 30, 2018 and 2017, accumulated goodwill impairment was $11.3 billion. 77 PART II Item 8 Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2018, May 1, 2017, or May 1, 2016 tests. NOTE 11 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2018 2017 Technology-based $ 7,220 $ (5,018 ) $ 2,202 $ 7,765 $ (4,318 ) $ 3,447 Customer-related 4,031 (1,205 ) 2,826 4,045 (692 ) 3,353 Marketing-related 4,006 (1,071 ) 2,935 4,016 (829 ) 3,187 Contract-based 679 (589 ) 90 841 (722 ) 119 Total $ 15,936 $ (7,883 ) $ 8,053 $ 16,667 $ (6,561 ) $ 10,106 No material impairments of intangible assets were identified during fiscal year 2018 or 2017. During fiscal year 2016, we recorded impairment charges of $480 million related to intangible assets in the Devices reporting unit within our More Personal Computing segment. In the fourth quarter of fiscal year 2016, we tested these intangible assets for recoverability due to changes in facts and circumstances associated with the shift in strategic direction and reduced profitability expectations for our Phone business. Based on the results of our testing, we determined that the carrying value of the intangible assets was not recoverable, and an impairment charge was recorded to the extent that estimated fair value exceeded carrying value. We primarily used the income approach to determine the fair value of the intangible assets and determine the amount of impairment. These intangible assets impairment charges were included in impairment and restructuring expenses in our consolidated income statement and reflected in Corporate and Other in our table of operating income (loss) by segment in Note 21 – Segment Information and Geographic Data. We estimate that we have no significant residual value related to our intangible assets. The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2018 2017 Technology-based $ 178 4 years $ 2,265 2 years Marketing-related 14 5 years 2,148 19 years Contract-based 14 4 years 63 6 years Customer-related 13 5 years 3,607 7 years Total $ 219 5 years $ 8,083 9 years Intangible assets amortization expense was $2.2 billion, $1.7 billion, and $978 million for fiscal years 2018, 2017, and 2016, respectively. Amortization of capitalized software was $54 million, $55 million, and $69 million for fiscal years 2018, 2017, and 2016, respectively. 78 PART II Item 8 The following table outlines the est imated future amortization expense related to intangible assets held as of June 30, 2018: (In millions) Year Ending June 30, 2019 $ 1,785 2020 1,260 2021 1,043 2022 949 2023 806 Thereafter 2,210 Total $ 8,053 NOTE 12 — DEBT Short-term Debt As of June 30, 2018, we had no commercial paper issued and outstanding. As of June 30, 2017, we had $9.1 billion of commercial paper issued and outstanding, with a weighted average interest rate of 1.01% and maturities ranging from 25 days to 264 days. The estimated fair value of this commercial paper approximates its carrying value. We have two $5.0 billion credit facilities that expire on October 30, 2018 and October 31, 2022, respectively. These credit facilities serve as a back-up for our commercial paper program. As of June 30, 2018, we were in compliance with the only financial covenant in both credit agreements, which requires us to maintain a coverage ratio of at least three times earnings before interest, taxes, depreciation, and amortization to interest expense, as defined in the credit agreements. No amounts were drawn against these credit facilities during any of the periods presented. Long-term Debt As of June 30, 2018, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $76.2 billion and $77.5 billion, respectively. As of June 30, 2017, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $77.1 billion and $80.3 billion, respectively. These estimated fair values are based on Level 2 inputs. 79 PART II Item 8 The components of our long-term debt, including the current portion, and the associated interest rates were as fol lows: (In millions, except interest rates) Face Value June 30, 2018 Face Value June 30, 2017 Stated Interest Rate Effective Interest Rate Notes November 15, 2017 $ 0 $ 600 0.875% 1.084% May 1, 2018 0 450 1.000% 1.106% November 3, 2018 1,750 1,750 1.300% 1.396% December 6, 2018 1,250 1,250 1.625% 1.824% June 1, 2019 1,000 1,000 4.200% 4.379% August 8, 2019 2,500 2,500 1.100% 1.203% November 1, 2019 18 18 0.500% 0.500% February 6, 2020 1,500 1,500 1.850% 1.952% February 12, 2020 1,500 1,500 1.850% 1.935% October 1, 2020 1,000 1,000 3.000% 3.137% November 3, 2020 2,250 2,250 2.000% 2.093% February 8, 2021 500 500 4.000% 4.082% August 8, 2021 2,750 2,750 1.550% 1.642% December 6, 2021 (a) 2,044 1,996 2.125% 2.233% February 6, 2022 1,750 1,750 2.400% 2.520% February 12, 2022 1,500 1,500 2.375% 2.466% November 3, 2022 1,000 1,000 2.650% 2.717% November 15, 2022 750 750 2.125% 2.239% May 1, 2023 1,000 1,000 2.375% 2.465% August 8, 2023 1,500 1,500 2.000% 2.101% December 15, 2023 1,500 1,500 3.625% 3.726% February 6, 2024 2,250 2,250 2.875% 3.041% February 12, 2025 2,250 2,250 2.700% 2.772% November 3, 2025 3,000 3,000 3.125% 3.176% August 8, 2026 4,000 4,000 2.400% 2.464% February 6, 2027 4,000 4,000 3.300% 3.383% December 6, 2028 (a) 2,044 1,996 3.125% 3.218% May 2, 2033 (a) 642 627 2.625% 2.690% February 12, 2035 1,500 1,500 3.500% 3.604% November 3, 2035 1,000 1,000 4.200% 4.260% August 8, 2036 2,250 2,250 3.450% 3.510% February 6, 2037 2,500 2,500 4.100% 4.152% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, 2042 900 900 3.500% 3.571% May 1, 2043 500 500 3.750% 3.829% December 15, 2043 500 500 4.875% 4.918% February 12, 2045 1,750 1,750 3.750% 3.800% November 3, 2045 3,000 3,000 4.450% 4.492% August 8, 2046 4,500 4,500 3.700% 3.743% February 6, 2047 3,000 3,000 4.250% 4.287% February 12, 2055 2,250 2,250 4.000% 4.063% November 3, 2055 1,000 1,000 4.750% 4.782% August 8, 2056 2,250 2,250 3.950% 4.033% February 6, 2057 2,000 2,000 4.500% 4.528% Total $ 76,898 $ 77,837 (a) Euro-denominated debt securities. 80 PART II Item 8 The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annual ly. Cash paid for interest on our debt for fiscal years 2018, 2017, and 2016 was $ 2 . 4 billion, $1. 6 billion, and $ 1.1 b illion, respectively. As of June 30, 2018 and 2017, the aggregate debt issuance costs and unamortized discount associated with our long-t erm debt, including the current portion, were $6 58 million and $ 715 million, respectively . Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2019 $ 4,000 2020 5,518 2021 3,750 2022 8,044 2023 2,750 Thereafter 52,836 Total $ 76,898 NOTE 13 — INCOME TAXES Recent Tax Legislation On December 22, 2017, the TCJA was enacted into law, which significantly changes existing U.S. tax law and includes numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. The TCJA required us to incur a one-time transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA also reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. For fiscal year 2018, our blended U.S. federal statutory tax rate is 28.1%. This is the result of using the tax rate of 35% for the first and second quarter of fiscal year 2018 and the reduced tax rate of 21% for the third and fourth quarter of fiscal year 2018. The TCJA includes a provision to tax global intangible low-taxed income (“GILTI”) of foreign subsidiaries and a base erosion anti-abuse tax (“BEAT”) measure that taxes certain payments between a U.S. corporation and its foreign subsidiaries. The GILTI and BEAT provisions of the TCJA will be effective for us beginning July 1, 2018. The TCJA was effective in the second quarter of fiscal year 2018. As of June 30, 2018, we have not completed our accounting for the estimated tax effects of the TCJA. During fiscal year 2018, we recorded a provisional net charge of $13.7 billion related to the TCJA based on reasonable estimates for those tax effects. Due to the timing of the enactment and the complexity in applying the provisions of the TCJA, the provisional net charge is subject to revisions as we continue to complete our analysis of the TCJA, collect and prepare necessary data, and interpret any additional guidance issued by the U.S. Treasury Department, Internal Revenue Service (“IRS”), FASB, and other standard-setting and regulatory bodies. Adjustments may materially impact our provision for income taxes and effective tax rate in the period in which the adjustments are made. Our accounting for the estimated tax effects of the TCJA will be completed during the measurement period, which is not expected to extend beyond one year from the enactment date. The impacts of our estimates are described further below. During fiscal year 2018, we recorded an estimated net charge of $13.7 billion related to the TCJA, due to the impact of the one-time transition tax on the deemed repatriation of deferred foreign income of $17.9 billion, offset in part by the impact of changes in the tax rate of $4.2 billion, primarily on deferred tax assets and liabilities. We recorded an estimated $17.9 billion charge in fiscal year 2018 related to the transition tax, which was included in the provision for income taxes in our consolidated income statements and income taxes in our consolidated balance sheets. We have not yet completed our accounting for the transition tax as our analysis of deferred foreign income is not complete. To calculate the transition tax, we estimated our deferred foreign income for fiscal year 2018 because these tax returns are not complete or due. Fiscal year 2018 taxable income will be known once the respective tax returns are completed and filed. In addition, U.S. and foreign audit settlements may significantly impact the estimated transition tax. The impact of the U.S. and foreign audits on the transition tax will be known as the audits are concluded. 81 PART II Item 8 In addition, we recorded an estimated $4. 2 billio n benefit in fiscal year 2018 from the impact of changes in the tax rate, primarily on deferred tax assets and liabilities, which was included in provision for income taxes in our consolidated income statements and deferred income taxes and long-term incom e taxes in our consolidated balance sheets. We remeasured our deferred taxes to reflect the reduced rate that will apply when these deferred taxes are settled or realized in future periods. The TCJA subjects a U.S. corporation to tax on its GILTI. Due to the complexity of the new GILTI tax rules, we are continuing to evaluate this provision of the TCJA and the application of GAAP. Under GAAP, we can make an accounting policy election to either treat taxes due on the GILTI inclusion as a current period expense or factor such amounts into our measurement of deferred taxes. We elected the deferred method, and the corresponding deferred tax assets and liabilities are included in the table of deferred income tax assets and liabilities below. On August 1, 2018, the Internal Revenue Service published on its website proposed regulations relating to the transition tax imposed by the TCJA. Once published in the Federal Register, the proposed regulations are subject to a 60-day comment period. Final regulations are expected to be issued after consideration of comments. We are currently evaluating the impact of the proposed regulations. Provision for Income Taxes The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Current Taxes U.S. federal $ 19,764 $ 2,739 $ 545 U.S. state and local 934 30 136 Foreign 4,348 2,472 1,940 Current taxes $ 25,046 $ 5,241 $ 2,621 Deferred Taxes U.S. federal $ (4,292 ) $ (554 ) $ 1,919 U.S. state and local (458 ) 269 111 Foreign (393 ) (544 ) 449 Deferred taxes $ (5,143 ) $ (829 ) $ 2,479 Provision for income taxes $ 19,903 $ 4,412 $ 5,100 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2018 2017 2016 U.S. $ 11,527 $ 6,843 $ 5,125 Foreign 24,947 23,058 20,514 Income before income taxes $ 36,474 $ 29,901 $ 25,639 82 PART II Item 8 Effective Tax Rate The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2018 2017 2016 Federal statutory rate 28.1% 35.0% 35.0% Effect of: Foreign earnings taxed at lower rates (7.8)% (11.6)% (14.5)% Impacts of TCJA 37.7% 0% 0% Phone business losses 0% (5.7)% 1.0% Excess tax benefits relating to stock-based compensation (2.5)% (2.1)% (1.6)% Interest, net 1.2% 1.4% 0.9% Other reconciling items, net (2.1)% (2.2)% (0.9)% Effective rate 54.6% 14.8% 19.9% The increase from the federal statutory rate in fiscal year 2018 is primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018, offset in part by earnings taxed at lower rates in foreign jurisdictions. The decrease from the federal statutory rate in fiscal year 2017 and 2016 is primarily due to earnings taxed at lower rates in foreign jurisdictions. Our foreign regional operating centers in Ireland, Singapore and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 87%, 76%, and 91% of our foreign income before tax in fiscal years 2018, 2017, and 2016, respectively. Other reconciling items, net consists primarily of tax credits, U.S. state income taxes, and domestic production activities deduction. In fiscal years 2018, 2017, and 2016, there were no individually significant other reconciling items. The increase in our effective tax rate for fiscal year 2018 compared to fiscal year 2017 was primarily due to the net charge related to the enactment of the TCJA and the realization of tax benefits attributable to previous Phone business losses in fiscal year 2017. The decrease in our effective tax rate for fiscal year 2017 compared to fiscal year 2016 was primarily due to the realization of tax benefits attributable to previous Phone business losses, offset in part by changes in the mix of our income before income taxes between the U.S. and foreign countries. 83 PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2018 2017 Deferred Income Tax Assets Stock-based compensation expense $ 460 $ 777 Accruals, reserves, and other expenses 1,832 1,859 Loss and credit carryforwards 3,369 4,809 Depreciation and amortization 351 53 Other 56 255 Deferred income tax assets 6,068 7,753 Less valuation allowance (3,186 ) (3,310 ) Deferred income tax assets, net of valuation allowance $ 2,882 $ 4,443 Deferred Income Tax Liabilities Foreign earnings $ 0 $ (1,134 ) Unrealized gain on investments and debt 0 (1,384 ) Unearned revenue (639 ) (5,760 ) Depreciation and amortization (1,103 ) (1,630 ) Other (312 ) (21 ) Deferred income tax liabilities $ (2,054 ) $ (9,929 ) Net deferred income tax assets (liabilities) $ 828 $ (5,486 ) Reported As Other long-term assets $ 1,369 $ 248 Long-term deferred income tax liabilities (541 ) (5,734 ) Net deferred income tax assets (liabilities) $ 828 $ (5,486 ) We recorded a deferred tax liability of $7.4 billion related to the recognition of revenue as part of the adoption of the new revenue standard. As of June 30, 2018, we had federal, state and foreign net operating loss carryforwards of $257 million, $1.4 billion and $11.4 billion, respectively. The federal and state net operating loss carryforwards will expire in various years from fiscal 2019 through 2038, if not utilized. The majority of our foreign net operating loss carryforwards do not expire. Certain acquired net operating loss carryforwards are subject to an annual limitation, but are expected to be realized with the exception of those which have a valuation allowance. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and other net deferred tax assets that may not be realized. Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. Income taxes paid, net of refunds, were $5.5 billion, $2.4 billion, and $3.9 billion in fiscal years 2018, 2017, and 2016, respectively. Uncertain Tax Positions Unrecognized tax benefits as of June 30, 2018, 2017, and 2016, were $12.0 billion, $11.7 billion, and $10.2 billion, respectively, and were included in long-term income taxes in our consolidated balance sheets. If recognized, these tax benefits would affect our effective tax rates for fiscal years 2018, 2017, and 2016, by $11.3 billion, $10.2 billion, and $8.8 billion, respectively. 84 PART II Item 8 As of June 30, 2018, 2017, and 2016, we had accrued interest expense related to uncertain tax positions of $3 .0 billion, $2.3 billion, and $1.9 billion, respectively, net of income tax benefits. Interest expense on unrecognized tax benefits , net of tax effects, was $688 million, $399 million, and $163 million in fiscal years 2018, 2017, and 2016, respectively, and was included in provision for income taxes. The aggregate changes in the balance of unrecognized tax benefits were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Balance, beginning of year $ 11,737 $ 10,164 $ 9,599 Decreases related to settlements (193 ) (4 ) (201 ) Increases for tax positions related to the current year 1,445 1,277 1,086 Increases for tax positions related to prior years 151 397 115 Decreases for tax positions related to prior years (1,176 ) (49 ) (317 ) Decreases due to lapsed statutes of limitations (3 ) (48 ) (118 ) Balance, end of year $ 11,961 $ 11,737 $ 10,164 While we settled a portion of the IRS audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, and a portion of the IRS audit for tax years 2007 to 2009 during the first quarter of fiscal year 2016, we remain under audit for those years. In the second quarter of fiscal year 2018, we settled a portion of the IRS audit for tax years 2010 to 2013. We continue to be subject to examination by the IRS for tax years 2010 to 2017. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of June 30, 2018, the primary unresolved issue relates to transfer pricing, which could have a significant impact in our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2017, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NOTE 14 — RESTRUCTURING CHARGES 2016 Restructuring In the fourth quarter of fiscal year 2016, management approved restructuring plans that resulted in approximately 4,700 job eliminations in fiscal year 2017, primarily across our smartphone hardware business and global sales. In fiscal year 2016, we incurred restructuring charges of $501 million in connection with the 2016 restructuring plans, including severance expenses and other reorganization costs. The actions associated with these restructuring plans were completed as of June 30, 2017. 2017 Restructuring In June 2017, management approved a sales and marketing restructuring plan. In fiscal year 2017, we recorded employee severance expenses of $306 million primarily related to this sales and marketing restructuring plan. The actions associated with this restructuring plan were completed as of June 30, 2018. 85 PART II Item 8 NOTE 15 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2018 2017 Productivity and Business Processes $ 14,864 $ 12,692 Intelligent Cloud 14,706 11,152 More Personal Computing 3,150 2,812 Total $ 32,720 $ 26,656 The opening balance of unearned revenue was $22.2 billion as of July 1, 2016. Changes in unearned revenue were as follows: (In millions) Year Ended June 30, 2018 Balance, beginning of period $ 26,656 Deferral of revenue 61,142 Recognition of unearned revenue (55,078 ) Balance, end of period $ 32,720 Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized (“contracted not recognized revenue”), which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods. Contracted not recognized revenue was $73 billion as of June 30, 2018, of which we expect to recognize approximately 60% of the revenue over the next 12 months and the remainder thereafter. NOTE 16 — LEASES We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. Our leases have remaining lease terms of 1 year to 20 years, some of which include options to extend the leases for up to 5 years, and some of which include options to terminate the leases within 1 year. The components of lease expense were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Operating lease cost $ 1,585 $ 1,412 $ 936 Finance lease cost: Amortization of right-of-use assets $ 243 $ 104 $ 28 Interest on lease liabilities 175 68 28 Total finance lease cost $ 418 $ 172 $ 56 86 PART II Item 8 Supplemental cash flow information related to leases was as follows: (In millions) Year Ended June 30, 2018 2017 2016 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 1,522 $ 1,157 $ 936 Operating cash flows from finance leases 175 68 28 Financing cash flows from finance leases 144 46 6 Right-of-use assets obtained in exchange for lease obligations: Operating leases 1,571 1,270 1,062 Finance leases 1,933 1,773 413 Supplemental balance sheet information related to leases was as follows: (In millions, except lease term and discount rate) June 30, 2018 2017 Operating Leases Operating lease right-of-use assets $ 6,686 $ 6,555 Other current liabilities $ 1,399 $ 1,423 Operating lease liabilities 5,568 5,372 Total operating lease liabilities $ 6,967 $ 6,795 Finance Leases Property and equipment, gross $ 4,543 $ 2,658 Accumulated depreciation (404 ) (161 ) Property and equipment, net $ 4,139 $ 2,497 Other current liabilities $ 176 $ 113 Other long-term liabilities 4,125 2,425 Total finance lease liabilities $ 4,301 $ 2,538 Weighted Average Remaining Lease Term Operating leases 7 years 7 years Finance leases 13 years 13 years Weighted Average Discount Rate Operating leases 2.7% 2.5% Finance leases 5.2% 4.7% Maturities of lease liabilities were as follows: (In millions) Year Ending June 30, Operating Leases Finance Leases 2019 $ 1,492 $ 386 2020 1,347 393 2021 1,086 401 2022 902 408 2023 721 410 Thereafter 2,157 4,036 Total lease payments 7,705 6,034 Less imputed interest (738 ) (1,733 ) Total $ 6,967 $ 4,301 87 PART II Item 8 As of June 30 , 2018, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $ 594 million and $ 2.4 billion, respectively. These operating and finance leases will commence between fiscal year 201 9 and fiscal year 2020 with lease terms of 1 year to 20 years. NOTE 17 — CONTINGENCIES Patent and Intellectual Property Claims There were 34 patent infringement cases pending against Microsoft as of June 30, 2018, none of which are material individually or in aggregate. Antitrust, Unfair Competition, and Overcharge Class Actions Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010. The trial of the British Columbia action commenced in May 2016. Following a mediation, the parties agreed to a global settlement of all three Canadian actions, and have submitted the proposed settlement agreement to the courts in all three jurisdictions for approval. The courts will likely reach a decision on approval in September 2018. Other Antitrust Litigation and Claims China State Administration for Industry and Commerce Investigatio n In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. SAMR has stated the investigation relates to compatibility, bundle sales, file verification issues related to Windows and Office software, and potentially other issues. Product-Related Litigation U.S. Cell Phone Litigation Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 35 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal challenging the standard for evaluating expert scientific evidence, which the District of Columbia Court of Appeals heard en banc . In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. 88 PART II Item 8 Canadian Cell P hone Class Action Microsoft Mobile Oy, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors, alleging adverse health effects from cellular phone use. Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia defendants. The litigation has been dormant for more than three years. Employment-Related Litigation Moussouris v. Microsoft Current and former female Microsoft employees in certain engineering and information technology roles brought this class action in federal court in Seattle in 2015, alleging systemic gender discrimination in pay and promotions. The plaintiffs moved to certify the class in October 2017. Microsoft filed an opposition in January 2018, attaching an expert report showing no statistically significant disparity in pay and promotions between similarly situated men and women. In June 2018, the court denied the plaintiffs’ motion for class certification. The plaintiffs have appealed to the U.S. Court of Appeals for the Ninth Circuit. In July, the court denied Microsoft’s motion for summary judgment with respect to the named plaintiffs. Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact in our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2018, we accrued aggregate legal liabilities of $323 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.1 billion in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact in our consolidated financial statements for the period in which the effects become reasonably estimable. Indemnifications We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented. NOTE 18 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Balance, beginning of year 7,708 7,808 8,027 Issued 68 70 75 Repurchased (99 ) (170 ) (294 ) Balance, end of year 7,677 7,708 7,808 89 PART II Item 8 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. This share repurchase program became effective on October 1, 2013, and was completed on December 22, 2016. On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to an additional $40.0 billion in share repurchases. This share repurchase program commenced on December 22, 2016 following completion of the prior program approved on September 16, 2013, has no expiration date, and may be suspended or discontinued at any time without notice. As of June 30, 2018, $28.2 billion remained of this $40.0 billion share repurchase program. We repurchased the following shares of common stock under the share repurchase programs: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2018 2017 2016 First Quarter 22 $ 1,600 63 $ 3,550 89 $ 4,000 Second Quarter 22 1,800 59 3,533 66 3,600 Third Quarter 34 3,100 25 1,600 69 3,600 Fourth Quarter 21 2,100 23 1,600 70 3,600 Total 99 $ 8,600 170 $ 10,283 294 $ 14,800 Shares repurchased beginning in the third quarter of fiscal year 2017 were under the share repurchase program approved September 20, 2016. All other shares repurchased were under the share repurchase program approved September 16, 2013. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. All repurchases were made using cash resources. Dividends Our Board of Directors declared the following dividends: Declaration Date Dividend Per Share Record Date Amount Payment Date Fiscal Year 2018 (in millions) September 19, 2017 $ 0.42 November 16, 2017 $ 3,238 December 14, 2017 November 29, 2017 0.42 February 15, 2018 3,232 March 8, 2018 March 12, 2018 0.42 May 17, 2018 3,226 June 14, 2018 June 13, 2018 0.42 August 16, 2018 3,224 September 13, 2018 Fiscal Year 2017 September 20, 2016 $ 0.39 November 17, 2016 $ 3,024 December 8, 2016 November 30, 2016 0.39 February 16, 2017 3,012 March 9, 2017 March 14, 2017 0.39 May 18, 2017 3,009 June 8, 2017 June 13, 2017 0.39 August 17, 2017 3,003 September 14, 2017 The dividend declared on June 13, 2018 was included in other current liabilities as of June 30, 2018. 90 PART II Item 8 NOTE 19 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table summarizes the changes in accumulated other comprehensive income (loss) by component: (In millions) Year Ended June 30, 2018 2017 2016 Derivatives Balance, beginning of period $ 134 $ 352 $ 590 Unrealized gains, net of tax of $11 , $4, and $24 218 328 351 Reclassification adjustments for gains included in revenue (185 ) (555 ) (625 ) Tax expense included in provision for income taxes 6 9 36 Amounts reclassified from accumulated other comprehensive income (179 ) (546 ) (589 ) Net change related to derivatives, net of tax of $5, $(5), and $(12) 39 (218 ) (238 ) Balance, end of period $ 173 $ 134 $ 352 Investments Balance, beginning of period $ 1,825 $ 2,941 $ 3,169 Unrealized gains (losses), net of tax of $(427) , $267, and $120 (1,146 ) 517 219 Reclassification adjustments for gains included in other income (expense), net (2,309 ) (2,513 ) (688 ) Tax expense included in provision for income taxes 738 880 241 Amounts reclassified from accumulated other comprehensive income (1,571 ) (1,633 ) (447 ) Net change related to investments, net of tax of $(1,165) , $(613), and $(121) (2,717 ) (1,116 ) (228 ) Balance, end of period $ (892 ) $ 1,825 $ 2,941 Translation Adjustments and Other Balance, beginning of period $ (1,332 ) $ (1,499 ) $ (1,237 ) Translation adjustments and other, net of tax effects of $0 , $9, and $(33) (178 ) 167 (262 ) Balance, end of period $ (1,510 ) $ (1,332 ) $ (1,499 ) Cumulative effect of accounting change 42 0 0 Accumulated other comprehensive income (loss), end of period $ (2,187 ) $ 627 $ 1,794 NOTE 20 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. As of June 30, 2018, an aggregate of 381 million shares were authorized for future grant under our stock plans. In fiscal year 2018, our Board of Directors approved the 2017 Stock Plan, which authorized an additional 308 million shares for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2018 2017 2016 Stock-based compensation expense $ 3,940 $ 3,266 $ 2,668 Income tax benefits related to stock-based compensation 823 1,066 882 91 PART II Item 8 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a four or five-year service period. Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a four-year service period. PSUs generally vest over a three-year performance period. The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for All Stock Plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year Ended June 30, 2018 2017 2016 Dividends per share (quarterly amounts) $0.39 - $0.42 $0.36 - $0.39 $0.31 - $0.36 Interest rates 1.7% - 2.9% 1.2% - 2.2% 1.1% - 1.8% During fiscal year 2018, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 201 $ 46.32 Granted (a) 70 75.88 Vested (80 ) 45.74 Forfeited (17 ) 53.41 Nonvested balance, end of year 174 57.85 (a) Includes 3 million, 2 million, and 1 million of PSUs granted at target and performance adjustments above target levels for fiscal years 2018, 2017, and 2016, respectively. As of June 30, 2018, there was approximately $7.0 billion of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of 3 years. The weighted average grant-date fair value of stock awards granted was $75.88, $55.64, and $41.51 for fiscal years 2018, 2017, and 2016, respectively. The fair value of stock awards vested was $6.6 billion, $4.8 billion, and $3.9 billion, for fiscal years 2018, 2017, and 2016, respectively. Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2018 2017 2016 Shares purchased 13 13 15 Average price per share $ 76.40 $ 56.36 $ 44.83 As of June 30, 2018, 116 million shares of our common stock were reserved for future issuance through the ESPP. 92 PART II Item 8 Savings Plan We have a savings plan in the U.S. that qualifies under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Participating U.S. employees may contribute a portion of their salary, subject to certain limitations. We contribute fifty cents for each dollar a participant contributes in this plan, with a maximum employer contribution of 50% of the IRS contribution limit for the calendar year. Matching contributions for all plans were $807 million, $734 million, and $549 million in fiscal years 2018, 2017, and 2016, respectively, and were expensed as contributed. NOTE 21 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Skype for Business, and Microsoft Teams, and related Client Access Licenses (“CALs”). • Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics ERP on-premises, Dynamics CRM on-premises, and Dynamics 365, a set of cloud-based applications across ERP and CRM. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, and Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. More Personal Computing Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises: • Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things (“IoT”); and MSN advertising. • Devices, including Microsoft Surface, PC accessories, and other intelligent devices. • Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, and advertising (“Xbox Live”), video games, and third-party video game royalties. • Search. 93 PART II Item 8 Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expe nses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments, including impairment and restructuring expenses. Segment revenue and operating income were as follows during the periods presented: (In millions) Year Ended June 30, 2018 2017 2016 Revenue Productivity and Business Processes $ 35,865 $ 29,870 $ 25,792 Intelligent Cloud 32,219 27,407 24,952 More Personal Computing 42,276 39,294 40,410 Total $ 110,360 $ 96,571 $ 91,154 Operating Income (Loss) Productivity and Business Processes $ 12,924 $ 11,389 $ 11,756 Intelligent Cloud 11,524 9,127 9,249 More Personal Computing 10,610 8,815 6,183 Corporate and Other 0 (306 ) (1,110 ) Total $ 35,058 $ 29,025 $ 26,078 Corporate and Other operating loss comprised impairment and restructuring expenses. No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for the fiscal years 2018, 2017, or 2016. Revenue, classified by the major geographic areas in which our customers are located, was as follows: (In millions) Year Ended June 30, 2018 2017 2016 United States (a) $ 55,926 $ 51,078 $ 46,416 Other countries 54,434 45,493 44,738 Total $ 110,360 $ 96,571 $ 91,154 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. 94 PART II Item 8 Revenue from external customers, classified by significant product and service offerings, was as follows: (In millions) Year Ended June 30, 2018 2017 2016 Office products and cloud services $ 28,316 $ 25,573 $ 23,868 Server products and cloud services 26,129 21,649 19,062 Windows 19,518 18,593 17,548 Gaming 10,353 9,051 9,202 Search advertising 7,012 6,219 5,428 Enterprise Services 5,846 5,542 5,659 Devices 5,134 5,062 7,888 LinkedIn 5,259 2,271 0 Other 2,793 2,611 2,499 Total $ 110,360 $ 96,571 $ 91,154 Our commercial cloud revenue, which primarily comprises Office 365 commercial, Azure, Dynamics 365, and other cloud properties, was $23.2 billion, $14.9 billion, and $9.5 billion in fiscal years 2018, 2017, and 2016, respectively. These amounts are primarily included in Office products and services and server products and cloud services in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment; it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2018 2017 2016 United States $ 44,501 $ 42,730 $ 25,145 Ireland 12,843 12,889 2,099 Luxembourg 6,856 6,854 6,868 Other countries 15,682 13,044 11,047 Total $ 79,882 $ 75,517 $ 45,159 95 PART II Item 8 NOTE 22 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2018 Revenue $ 24,538 $ 28,918 $ 26,819 $ 30,085 $ 110,360 Gross margin 16,260 17,854 17,550 20,343 72,007 Operating income 7,708 8,679 8,292 10,379 35,058 Net income (loss) (a) 6,576 (6,302 ) 7,424 8,873 16,571 Basic earnings (loss) per share 0.85 (0.82 ) 0.96 1.15 2.15 Diluted earnings (loss) per share (b) 0.84 (0.82 ) 0.95 1.14 2.13 Fiscal Year 2017 (c) Revenue $ 21,928 $ 25,826 $ 23,212 $ 25,605 $ 96,571 Gross margin 14,084 15,925 15,152 17,149 62,310 Operating income 6,715 7,905 6,723 7,682 (d) 29,025 (d) Net income 5,667 6,267 5,486 8,069 (d) 25,489 (d) Basic earnings per share 0.73 0.81 0.71 1.05 3.29 Diluted earnings per share 0.72 0.80 0.70 1.03 (d) 3.25 (d) (a) Reflects the net charge (benefit) related to the TCJA of $13.8 billion for the second quarter, $(104) million for the fourth quarter, and $13.7 billion for fiscal year 2018. (b) Reflects the net charge (benefit) related to the TCJA, which decreased (increased) diluted EPS $1.78 for the second quarter, $(0.01) for the fourth quarter, and $1.75 for fiscal year 2018. (c) On December 8, 2016, we acquired LinkedIn Corporation. LinkedIn has been included in our consolidated results of operations starting on the acquisition date. (d) Includes $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan, which decreased operating income, net income, and diluted EPS by $306 million, $243 million, and $0.04, respectively. 96 PART II Item 8 REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2018 and 2017, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows, for each of the three years in the period ended June 30, 2018, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2018, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of June 30, 2018, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 3, 2018, expressed an unqualified opinion on the Company's internal control over financial reporting. Change in Accounting Principles As discussed in Note 1 to the financial statements, the Company has changed its method of accounting for revenue from contracts with customers and for accounting for leases in fiscal year 2018 due to the adoption of the new revenue standard and new lease standard, respectively. The Company adopted the new revenue standard using the full retrospective approach and adopted the new lease standard using a modified retrospective approach. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 3, 2018 We have served as the Company’s auditor since 1983. 97 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOU NTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the company’s internal control over financial reporting was effective as of June 30, 2018. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2018; their report is included in Item 9A. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2018 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. We implemented internal controls to ensure we adequately evaluated our contracts and properly assessed the impact of the new accounting standards related to revenue recognition and leases on our financial statements to facilitate their adoption on July 1, 2017. There were no significant changes to our internal control over financial reporting due to the adoption of the new standards. 98 PART II Item 9A REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2018, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2018, based on the criteria established in Internal Control — Integrated Framework (2013) issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements and the related notes (collectively referred to as the “financial statements”) as of and for the year ended June 30, 2018, of the Company and our report dated August 3, 2018, expressed an unqualified opinion on those financial statements and included an explanatory paragraph related to the Company’s change in method of accounting for revenue from contracts with customers and for accounting for leases in fiscal year 2018 due to the adoption of the new revenue standard and new lease standard, respectively. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 3, 2018 99 PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION During the quarter ended December 31, 2017, Microsoft provided software services to a person or entity identified under section 560.304 of title 31, Code of Federal Regulations. The services constituted a cloud-based spam and malware filtering service and the cloud-based provision of Office 365 software services provided to two entities associated with the Iranian bank, Bank Sepah – Bank Sepah International PLC and Banque Sepah, respectively. For the former, an annual service fee equivalent to $600 was charged for a one-year period beginning in February 2017, and for the latter, use rights were charged at a price equivalent to approximately $55 per month from September 2016 through November 2017, totaling $770. It is not possible to determine the precise profits, if any, attributable to these activities, though they are less than the associated revenues. Microsoft has ceased providing these software services to these entities and has no intention of doing so in the future. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 28, 2018 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. The information in the Proxy Statement set forth under the caption “Section 16(a) beneficial ownership reporting compliance” is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and other finance organization employees. The finance code of ethics is publicly available on our website at https://aka.ms/FinanceCodeProfessionalConduct. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock ownership information,” “Principal shareholders” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 100 PART IV Item 15 PART IV ITEM 15 . EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 51 Comprehensive Income Statements 52 Balance Sheets 53 Cash Flows Statements 54 Stockholders’ Equity Statements 55 Notes to Financial Statements 56 Report of Independent Registered Public Accounting Firm 97 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/14/17 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/10 101 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 102 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/3/15 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 8/5/16 103 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/17 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.1 10/20/16 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan X 10.6* Microsoft Corporation 2017 Stock Plan DEF14A Annex C 10/16/17 10.7* Form of Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.26 4/26/18 10.8* Form of Performance Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.27 4/26/18 10.12 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.12 10/20/16 10.13 Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.13 10/20/16 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-Q 12/31/17 10.14 1/31/18 10.17* Executive Officer Incentive Plan 10-Q 9/30/15 10.17 10/22/15 10.18* Form of Executive Officer Incentive Plan Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/15 10.18 10/22/15 10.19* Microsoft Corporation Executive Incentive Plan 10-Q 9/30/16 10.17 10/20/16 10.20* Form of Executive Incentive Plan (Executive Officer SAs) Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.18 10/20/16 104 PART IV Item 15, 16 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.21* Form of Executive Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.25 10/20/16 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/16 10.22 10/20/16 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 10.25* Form of Executive Officer Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/15 10.25 10/22/15 12 Computation of Ratios of Earnings to Fixed Charges X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement ** Furnished, not filed ITEM 16 . FORM 10-K SUMMARY None. 105 SIGNAT URES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 3, 2018. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 106 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on August 3, 20 18. Signature Title /s/    J OHN W. T HOMPSON John W. Thompson Chairman /s/    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer /s/    W ILLIAM H. G ATES III William H. Gates III Director /s/    R EID H OFFMAN Reid Hoffman Director /s/    H UGH F. J OHNSTON Hugh F. Johnston Director /s/ T ERI L. L IST -S TOLL Teri L. List-Stoll Director /s/    C HARLES H. N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/ S ANDRA E. P ETERSON Sandra E. Peterson Director /s/    P ENNY S. P RITZKER Penny S. Pritzker Director /s/ C HARLES W. S CHARF Charles W. Scharf Director /s/    A RNE M. S ORENSON Arne M. Sorenson Director /s/ J OHN W. S TANTON John W. Stanton Director /s/ P ADMASREE W ARRIOR Padmasree Warrior Director /s/    A MY E. H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 107 \ No newline at end of file diff --git a/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-19-027952/full-submission.txt b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-19-027952/full-submission.txt new file mode 100644 index 0000000..6038fd1 --- /dev/null +++ b/src/data/cleaned-sec-edgar-filings/MSFT/10-K/0001564590-19-027952/full-submission.txt @@ -0,0 +1 @@ +UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2019 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  to Commission File Number 001-37845 MICROSOFT CORPORATION WASHINGTON 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY, REDMOND, WASHINGTON 98052-6399 (425) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol Name of exchange on which registered COMMON STOCK, $0.00000625 par value per share MSFT NASDAQ 2.125% Notes due 2021 MSFT New York Stock Exchange 3.125% Notes due 2028 MSFT New York Stock Exchange 2.625% Notes due 2033 MSFT New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of December 31, 2018, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $ 769.6 billion based on the closing sale price as reported on the NASDAQ National Market System. As of July 29, 2019, there were 7,635,409,400 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on December 4, 2019 are incorporated by reference into Part III. MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2019 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 15 Item 1A. Risk Factors 17 Item 1B. Unresolved Staff Comments 29 Item 2. Properties 29 Item 3. Legal Proceedings 29 Item 4. Mine Safety Disclosures 29 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 30 Item 6. Selected Financial Data 31 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 32 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 50 Item 8. Financial Statements and Supplementary Data 51 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 96 Item 9A. Controls and Procedures 96 Report of Management on Internal Control over Financial Reporting 96 Report of Independent Registered Public Accounting Firm 97 Item 9B. Other Information 98 PART III Item 10. Directors, Executive Officers and Corporate Governance 98 Item 11. Executive Compensation 98 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 98 Item 13. Certain Relationships and Related Transactions, and Director Independence 98 Item 14. Principal Accounting Fees and Services 98 PART IV Item 15. Exhibits, Financial Statement Schedules 99 Item 16. Form 10-K Summary 104 Signatures 105 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Embracing Our Future Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We continue to transform our business to lead in the new era of the intelligent cloud and intelligent edge. We bring technology and products together into experiences and solutions that unlock value for our customers. In this next phase of innovation, computing is more powerful and ubiquitous from the cloud to the edge. Artificial intelligence (“AI”) capabilities are rapidly advancing, fueled by data and knowledge of the world. Physical and virtual worlds are coming together with the Internet of Things (“IoT”) and mixed reality to create richer experiences that understand the context surrounding people, the things they use, the places they go, and their activities and relationships. A person’s experience with technology spans a multitude of devices and has become increasingly more natural and multi-sensory with voice, ink, and gaze interactions. What We Offer Founded in 1975, we develop and support software, services, devices, and solutions that deliver new value for customers and help people and businesses realize their full potential. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. Our products include operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; and video games. We also design, manufacture, and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. 3 PART I Item 1 The A mbitions T hat D rive U s To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud and intelligent edge platform. • Create more personal computing. Reinvent Productivity and Business Processes We are in a unique position to empower people and organizations to succeed in a rapidly evolving workplace. Computing experiences are evolving, no longer bound to one device at a time. Instead, experiences are expanding to many devices as people move from home to work to on the go. These modern needs, habits, and expectations of our customers are motivating us to bring Microsoft Office 365, Windows platform, devices, including Microsoft Surface, and third-party applications into a more cohesive Microsoft 365 experience. Our growth depends on securely delivering continuous innovation and advancing our leading productivity and collaboration tools and services, including Office, Microsoft Dynamics, and LinkedIn. Microsoft 365 brings together Office 365, Windows 10, and Enterprise Mobility + Security to help organizations empower their employees with AI-backed tools that unlock creativity, increase teamwork, and fuel innovation, all the while enabling compliance coverage and data protection. Microsoft Teams is core to our vision for the modern workplace as the digital hub that creates a single canvas for teamwork, conversations, meetings, and content. Microsoft Relationship Sales solution brings together LinkedIn Sales Navigator and Dynamics to transform business to business sales through social selling. Dynamics 365 for Talent with LinkedIn Recruiter and Learning gives human resource professionals a complete solution to compete for talent. Microsoft Power Platform empowers employees to build custom applications, automate workflow, and analyze data no matter their technical expertise. These scenarios represent a move to unlock creativity and inspire teamwork, while simplifying security and management. Organizations of all sizes can now digitize business-critical functions, redefining what customers can expect from their business applications. This creates an opportunity for us to reach new customers and increase usage and engagement with existing customers. Build the Intelligent Cloud and Intelligent Edge Platform Companies are looking to use digital technology to fundamentally reimagine how they empower their employees, engage customers, optimize their operations, and change the very core of their products and services. Partnering with organizations on their digital transformation is one of our largest opportunities and we are uniquely positioned to become the strategic digital transformation platform and partner of choice. Our strategy requires continued investment in datacenters and other hybrid and edge infrastructure to support our services. Microsoft Azure is a trusted cloud with comprehensive compliance coverage and AI-based security built in. Our cloud business benefits from three economies of scale: datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. As one of the two largest providers of cloud computing at scale, we believe we work from a position of strength. Being a global-scale cloud, Azure uniquely offers hybrid consistency, developer productivity, AI capabilities, and trusted security and compliance. We see more emerging use cases and needs for compute and security at the edge and are accelerating our innovation across the spectrum of intelligent edge devices, from IoT sensors to gateway devices and edge hardware to build, manage, and secure edge workloads. With Azure Stack, organizations can extend Azure into their own datacenters to create a consistent stack across the public cloud and the intelligent edge. Our hybrid infrastructure consistency spans identity, data, compute, management, and security, helping to support the real-world needs and evolving regulatory requirements of commercial customers and enterprises. We are accelerating our development of mixed reality solutions, with new Azure services and devices such as HoloLens 2. The opportunity to merge the physical and digital worlds, when combined with the power of Azure cloud services, unlocks the potential for entirely new workloads which we believe will shape the next era of computing. 4 PART I Item 1 The ability to convert data into AI drives our competitive advantage. Azure SQL Database makes it possible for cus tomers to take Microsoft SQL Server from their on-premises datacenter to a fully managed instance in the cloud to utilize built-in AI. We are accelerating adoption of AI innovations from research to products. Our innovation help s every developer be an AI d eveloper, with approachable new tools from Azure Machine Learning Studio for creating simple machine learning models, to the powerful Azure Machine Learning Workbench for the most advanced AI modeling and data science. On October 25, 2018, we completed our acquisition of GitHub, Inc. (“GitHub”), a service that millions of developers around the world rely on to write code together. The acquisition is expected to empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences. Create More Personal Computing We strive to make computing more personal by putting users at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. In support of this, we are bringing Office, Windows, and devices together for an enhanced and more cohesive customer experience. Windows 10 continues to gain traction in the enterprise as the most secure and productive operating system. It empowers people with AI-first interfaces ranging from voice-activated commands through Cortana, inking, immersive 3D content storytelling, and mixed reality experiences. Windows also plays a critical role in fueling our cloud business and Microsoft 365 strategy, and it powers the growing range of devices on the “intelligent edge.” Our ambition for Windows 10 monetization opportunities includes gaming, services, subscriptions, and search advertising. We are committed to designing and marketing first-party devices to help drive innovation, create new device categories, and stimulate demand in the Windows ecosystem. We recently expanded our Surface family of devices with the Surface Hub 2S, which brings together Microsoft Teams, Windows, and Surface hardware to power teamwork for organizations. We are mobilizing to pursue our expansive opportunity in the gaming industry, broadening our approach to how we think about gaming end-to-end, from the way games are created and distributed to how they are played and viewed. We have a strong position with our Xbox One console, our large and growing highly engaged community of gamers on Xbox Live, and with Windows 10, the most popular operating system for PC gamers. We will continue to connect our gaming assets across PC, console, and mobile, and work to grow and engage the Xbox Live member network more deeply and frequently with services like Mixer and Xbox Game Pass. Our approach is to enable gamers to play the games they want, with the people they want, on the devices they want. Our Future Opportunity Customers are looking to us to accelerate their own digital transformations and to unlock new opportunity in this era of intelligent cloud and intelligent edge. We continue to develop complete, intelligent solutions for our customers that empower users to be creative and work together while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modern, modular business applications to improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Applying AI to drive insights and act on our customer’s behalf by understanding and interpreting their needs using natural methods of communication. • Using Windows to fuel our cloud business and Microsoft 365 strategy, and to develop new categories of devices – both our own and third-party – on the intelligent edge. • Inventing new gaming experiences that bring people together around their shared love for games on any devices and pushing the boundaries of innovation with console and PC gaming by creating the next wave of entertainment. 5 PART I Item 1 Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. We have the opportunity to redefine what customers and partners can expect and are working to deliver new solutions that reflect the best of Microsoft. OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 20 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”). • Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises. Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users in new markets such as first-line workers, small and medium businesses, and growth markets, as well as add value to our core product and service offerings to span productivity categories such as communication, collaboration, analytics, security, and compliance. Office Commercial revenue is mainly affected by a combination of continued installed base growth and average revenue per user expansion, as well as the continued shift from Office licensed on-premises to Office 365. CALs provide certain Office Commercial products and services with access rights to our server products and CAL revenue is reported with the associated Office products and services. Office Consumer Office Consumer is designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift from Office licensed on-premises to Office 365. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. 6 PART I Item 1 LinkedIn LinkedIn connects the world's professionals to make them more productive and successful, and is the world's largest professional network on the Internet. LinkedIn offers services that can be used by customers to transform the way they hire, market, sell, and learn. In addition to LinkedIn’s free services, LinkedIn offers three categories of monetized solutions: Talent Solutions, Marketing Solutions, and Premium Subscriptions, which includes Sales Solutions. Talent Solutions is comprised of two elements: Hiring, and Learning and Development. Hiring provides services to recruiters that enable them to attract, recruit, and hire talent. Learning and Development provides subscriptions to enterprises and individuals to access online learning content. Marketing Solutions enables companies to advertise to LinkedIn’s member base. Premium Subscriptions enables professionals to manage their professional identity, grow their network, and connect with talent through additional services like premium search. Premium Subscriptions also includes Sales Solutions, which helps sales professionals find, qualify, and create sales opportunities and accelerate social selling capabilities. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. On November 16, 2018, LinkedIn acquired Glint, an employee engagement platform, to expand its Talent Solutions offerings. Dynamics Dynamics provides cloud-based and on-premises business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and analytics applications for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is driven by the number of users licensed, expansion of average revenue per user, and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications. Competition Competitors to Office include software and global application vendors, such as Apple, Cisco Systems, Facebook, Google, IBM, Okta, Proofpoint, Slack, Symantec, Zoom, and numerous web-based and mobile application competitors as well as local application developers. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides a hosted messaging and productivity suite. Slack provides teamwork and collaboration software. Zoom offers videoconferencing and cloud phone solutions. Skype for Business and Skype also compete with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Okta, Proofpoint, and Symantec provide security solutions across email security, information protection, identity, and governance. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products and services. We compete by providing powerful, flexible, secure, integrated industry-specific, and easy-to-use productivity and collaboration tools and services that create comprehensive solutions and work well with technologies our customers already have both on-premises or in the cloud. LinkedIn faces competition from online recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers. Dynamics competes with vendors such as Infor, NetSuite, Oracle, Salesforce.com, SAP, and The Sage Group to provide cloud-based and on-premise business solutions for small, medium, and large organizations. 7 PART I Item 1 Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including SQL Server, Windows Server, Visual Studio, System Center, and related CALs, GitHub, and Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. Server Products and Cloud Services Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. GitHub provides a collaboration platform and code hosting service for developers. Server products revenue is mainly affected by purchases through volume licensing programs, licenses sold to original equipment manufacturers (“OEM”), and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Azure is a comprehensive set of cloud services that offer developers, IT professionals, and enterprises freedom to build, deploy, and manage applications on any platform or device. Customers can use Azure through our global network of datacenters for computing, networking, storage, mobile and web application services, AI, IoT, cognitive services, and machine learning. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Azure revenue is mainly affected by infrastructure-as-a-service and platform-as-a-service consumption-based services, and per user-based services such as Enterprise Mobility + Security. Enterprise Services Enterprise Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and IT professionals on various Microsoft products. Competition Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. 8 PART I Item 1 We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware a nd software applications, security, and manageability. Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, Salesforce.com, VMware, and open source offerings. Our Enterprise Mobility + Security offerings also compete with products from a range of competitors including identity vendors, security solution vendors, and numerous other security point solution vendors. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. We believe our cloud’s global scale, coupled with our broad portfolio of identity and security solutions, allows us to effectively solve complex cybersecurity challenges for our customers and differentiates us from the competition. Our Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows IoT; and MSN advertising. • Devices, including Surface, PC accessories, and other intelligent devices. • Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, cloud services, and advertising (“Xbox Live”), video games, and third-party video game royalties. • Search. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and growth markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Constraints in the supply chain of device components. • Piracy. Windows Commercial revenue, which includes volume licensing of the Windows operating system and Windows cloud services such as Microsoft Defender Advanced Threat Protection, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance (“SA”), as well as advanced security offerings. Windows Commercial revenue often reflects the number of information workers in a licensed enterprise and is relatively independent of the number of PCs sold in a given year. 9 PART I Item 1 Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. MSN advertising includes both native and display ads. Devices We design, manufacture, and sell devices, including Surface, PC accessories, and other intelligent devices. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. Gaming Our gaming platform is designed to provide a unique variety of entertainment using our devices, peripherals, applications, online services, and content. We released Xbox One S and Xbox One X in August 2016 and November 2017, respectively. With the launch of the Mixer service in May 2017, offering interactive live streaming, and Xbox Game Pass in June 2017, providing unlimited access to over 100 Xbox titles, we continue to open new opportunities for customers to engage both on- and off-console. With our acquisition of PlayFab in January 2018, we enable worldwide game developers to utilize game services, LiveOps, and analytics for player acquisition, engagement, and retention. We have also made these services available for developers outside of the gaming industry. Xbox Live enables people to connect and share online gaming experiences and is accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox Live is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox Live revenue is mainly affected by subscriptions and sales of Xbox Live enabled content, as well as advertising. We also continue to design and sell gaming content to showcase our unique platform capabilities for Xbox consoles, Windows-enabled devices, and other devices. Growth of our Gaming business is determined by the overall active user base through Xbox Live enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences via online services including game streaming, downloadable content, and peripherals. Search Our Search business, including Bing and Microsoft Advertising, is designed to deliver relevant online advertising to a global audience. We have several partnerships with other companies, including Verizon Media Group, through which we provide and monetize search queries. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. Devices face competition from various computer, tablet, and hardware manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. 10 PART I Item 1 Our gaming platform competes with console platforms from Nintendo and Sony , both of which have a large, established base of customers. The lifecycle for gaming and entertainment consoles averages five to ten years. Nintendo released its latest generation console in March 2017 and Sony released its latest generation console in November 2013. We also compete with other providers of entertainment services through online marketplaces. We believe our gaming pla tform is effectively positioned against competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our o wn game franchises as well as other digital content offerings. Our video games competitors include Electronic Arts and Activision Blizzard. Xbox Live and our cloud gaming services face competition from various online marketplaces, including those operated by Amazon, Apple, and Google. Our search business competes with Google and a wide array of websites, social platforms like Facebook, and portals that provide content and online offerings to end users. OPERATIONS We have operations centers that support operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Europe, Australia, and Asia, as well as in the Middle East and Africa. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our devices are primarily manufactured by third-party contract manufacturers. We generally have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. RESEARCH AND DEVELOPMENT Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Cloud and AI , focuses on making IT professionals, developers, and their systems more productive and efficient through development of cloud infrastructure, server, database, CRM, ERP, management and development tools, AI cognitive services, and other business process applications and services for enterprises. • Experiences and Devices , focuses on instilling a unifying product ethos across our end-user experiences and devices, including Office, Windows, Enterprise Mobility and Management, and Surface. • AI and Research , focuses on our AI innovations and other forward-looking research and development efforts spanning infrastructure, services, applications, and search. • LinkedIn , focuses on our services that transform the way customers hire, market, sell, and learn. • Gaming , focuses on connecting gaming assets across the range of devices to grow and engage the Xbox Live member network through game experiences, streaming content, and social interaction. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software and hardware design. Before releasing new software platforms, and as we make significant modifications to existing platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. 11 PART I Item 1 We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internatio nally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and curren tly have a portfolio of over 61,000 U.S. and international patents issued and over 26,000 pending. While we employ much of our internally- developed intellectual property exclusively in our products and services, we also engage in outbound licensing of spec ific patented technologies that are incorporated into licensees’ products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We also purchase or license technology that we i ncorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, or attracting and enabling our external development community. Our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, services, and business methods, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the Company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, devices, and operating systems. While our main research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, Czech Republic, India, Ireland, Israel, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the operating segment level. Much of our segment level research and development is coordinated with other segments and leveraged across the Company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest corporate research organizations and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science and a broad range of other disciplines, providing us a unique perspective on future trends and contributing to our innovation. We plan to continue to make significant investments in a broad range of research and development efforts. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales force performs a variety of functions, including working directly with enterprises and public-sector organizations worldwide to identify and meet their technology requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. OEMs We distribute our products and services through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. 12 PART I Item 1 There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a di rect agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Acer, ASUS, Dell, Fujitsu, Hewlett-Packard, Lenovo, Samsung, Sharp, Toshiba, and with ma ny regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors” or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. We also sell commercial and consumer products and services directly to customers, such as cloud services, search, and gaming, through our digital marketplaces, online stores, and retail stores. Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers, and provide product training and sales support. Our Dynamics business solutions are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and Software Assurance. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. SA conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, and training to help customers deploy and use software efficiently. SA is included with certain volume licensing agreements and is an optional purchase with others. Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. SA is included. 13 PART I Item 1 Microsoft Product and Services Agreement Microsoft Product and Services Agreements are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. SA is optional for customers that purchase perpetual licenses. Open Open agreements are a simple, cost-effective way to acquire the latest Microsoft technology. Open agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a one- to three-year period. Under the Open agreements, organizations purchase perpetual licenses and SA is optional. Under Open Value agreements, organizations can elect to purchase perpetual licenses or subscribe to licenses and SA is included. Select Plus Select Plus agreements are designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and SA is optional. Microsoft Online Subscription Agreement Microsoft Online Subscription Agreements are designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web. The agreement allows customers to acquire monthly or annual subscriptions for cloud-based services. Partner Programs The Microsoft Cloud Solution Provider program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, hosting partner, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. The Independent Software Vendor Royalty program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, Internet service providers, application developers, and OEMs. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 14 PART I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 31, 2019 were as follows: Name Age Position with the Company Satya Nadella 51 Chief Executive Officer Christopher C. Capossela 49 Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer Jean-Philippe Courtois 58 Executive Vice President and President, Microsoft Global Sales, Marketing and Operations Kathleen T. Hogan 53 Executive Vice President, Human Resources Amy E. Hood 47 Executive Vice President, Chief Financial Officer Margaret L. Johnson 57 Executive Vice President, Business Development Bradford L. Smith 60 President and Chief Legal Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 25 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Mr. Courtois was appointed Executive Vice President and President, Microsoft Global Sales, Marketing and Operations in July 2016. Before that he was President of Microsoft International since 2005. He was Chief Executive Officer, Microsoft Europe, Middle East, and Africa from 2003 to 2005. He was Senior Vice President and President, Microsoft Europe, Middle East, and Africa from 2000 to 2003. He was Corporate Vice President, Worldwide Customer Marketing from 1998 to 2000. Mr. Courtois joined Microsoft in 1984. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Hood also serves on the Board of Directors of 3M Corporation. Ms. Johnson was appointed Executive Vice President, Business Development in September 2014. Prior to that Ms. Johnson spent 24 years at Qualcomm in various leadership positions across engineering, sales, marketing and business development. She most recently served as Executive Vice President of Qualcomm Technologies, Inc. Ms. Johnson also serves on the Board of Directors of BlackRock, Inc. Mr. Smith was appointed President and Chief Legal Officer in September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. 15 PART I Item 1 EMPLOYEES As of June 30, 2019, we employed approximately 144,000 people on a full-time basis, 85,000 in the U.S. and 59,000 internationally. Of the total employed people, 47,000 were in operations, including manufacturing, distribution, product support, and consulting services; 47,000 were in product research and development; 38,000 were in sales and marketing; and 12,000 were in general and administration. Certain of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”) at www.sec.gov. • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 16 PART I Item 1A ITEM 1A. RIS K FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platform-based ecosystems An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, wearables, and other endpoint devices. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on personal computers. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users may incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. 17 PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us by modifying and then distributing open source software at little or no cost to end-users, and earning revenue on advertising or integrated products and services. These firms do not bear the full costs of research and development for the open source software. Some open source software mimics the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge worldview is connected with the growth of the Internet of Things (“IoT”). Our success in the IoT will depend on the level of adoption of our offerings such as Microsoft Azure, Azure Stack, Azure IoT Edge, and Azure Sphere. We may not establish market share sufficient to achieve scale necessary to achieve our business objectives. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other endpoints. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. 18 PART I Item 1A We make significant investments in products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Microsoft 365, Office, Bing, Microsoft SQL Server, Windows Server, Azure, Office 365, Xbox Live, Mixer, LinkedIn, and other p roducts and services. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commerc ial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their p urchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may no t be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. We may not get engagement in certain features, like Microsoft Edge and Bing, that drive post- sale monetization opportunities. Our data handling practices across our products and services will continue to be under scrutiny and perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or prod uct experiences, which could negatively impact product and feature adoption, product design , and product quality. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. In December 2016, we completed our acquisition of LinkedIn Corporation (“LinkedIn”) for $27.0 billion, and in October 2018, we completed our acquisition of GitHub, Inc. for $7.5 billion. These acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating and retaining new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements such as increased revenue or enhanced efficiencies, or the benefits may ultimately be smaller than we expected. These events could adversely affect our consolidated financial statements. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record a significant charge on our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. Our acquisition of LinkedIn resulted in a significant increase in our goodwill and intangible asset balances. 19 PART I Item 1A Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position. Security of our information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Inadequate account security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems, or reveal confidential information. Cyberthreats are constantly evolving, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network, or data security could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improved technologies, or otherwise adversely affect our business. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge. Security of our products, services, devices, and customers’ data The security of our products and services is important in our customers’ decisions to purchase or use our products or services. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. Adversaries that acquire user account information at other companies can use that information to compromise our users’ accounts where accounts share the same attributes like passwords. Inadequate account security practices may also result in unauthorized access. We are also increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks. To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide security tools such as firewalls and anti-virus software and information about the need to deploy security measures and the impact of doing so. 20 PART I Item 1A The cost of these steps could reduc e our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future pu rchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers ma y fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches. Any of these could adversely affect our reputation and revenue. Actual or perceived vulnerabilitie s may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers. As illustrated by the Spectre and Meltdown threats, our products operate in conjunction with and are dependent on products and components across a broad ecosystem of third parties. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position. Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers and users. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and third parties on data security, and other practices we follow may not prevent the improper disclosure or misuse of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services. We may not be able to protect information in our products and services from use by others . LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services. Abuse of our platforms may harm our reputation or user engagement. Advertising, professional, and social platform abuses For LinkedIn, Microsoft Advertising, MSN, Xbox Live, and other products and services that provide content or host ads that come from or can be influenced by third parties, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate. This activity may come from users impersonating other people or organizations, use of our products or services to spread terrorist or violent extremist content or to disseminate information that may be viewed as misleading or intended to manipulate the opinions of our users, or the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing or responding to these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and consolidated financial statements. 21 PART I Item 1A Harmful content online Our hosted consumer services as well as our enterprise services may be used by third parties to disseminate harmful or illegal content in violation of our terms or applicable law. We may not proactively discover such content due to scale and the limitations of existing technologies, and when discovered by users, such content may negatively affect our reputation, our brands, and user engagement. Regulations and other initiatives to make platforms responsible for preventing or eliminating harmful content online are gaining momentum and we expect this to continue. We may be subject to enhanced regulatory oversight, substantial liability, or reputational damage if we fail to comply with content moderation regulations, adversely affecting our business and consolidated financial statements. The development of the IoT presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT, a network of distributed and interconnected devices employing sensors, data, and computing capabilities including AI. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation, that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins. Issues in the use of AI in our offerings may result in reputational harm or liability . We are building AI into many of our offerings and we expect this element of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many disruptive innovations, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms may be flawed. Datasets may be insufficient or contain biased information. Inappropriate or controversial data practices by Microsoft or others could impair the acceptance of AI solutions. These deficiencies could undermine the decisions, predictions, or analysis AI applications produce, subjecting us to competitive harm, legal liability, and brand or reputational harm. Some AI scenarios present ethical issues. If we enable or offer AI solutions that are controversial because of their impact on human rights, privacy, employment, or other social issues, we may experience brand or reputational harm. We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Azure, Microsoft Account services, Office 365, Microsoft Teams, Dynamics 365, OneDrive, SharePoint Online, Skype, Xbox Live, and Outlook.com. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex. It requires that we maintain an Internet connectivity infrastructure that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data or insufficient Internet connectivity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may adversely impact our consolidated financial statements. We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. 22 PART I Item 1A Our software products and services also may experience quality or reliability problems. The highly sophis ticated software we develop may contain bugs and other defects that interfere with their intended operation. Our customers increasingly rely on us for critical functions, potentially magnifying the impact of quality or reliability issues. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contai n provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. We acquire some device and datacenter components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other hardware and software products we may offer. We may not be able to protect our source code from copying if there is an unauthorized disclosure. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described in the next paragraph. Legal changes, our evolving business model, piracy, and other factors may decrease the value of our intellectual property. Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly countries in which the legal system provides less protection for intellectual property rights. Our revenue in these markets may grow more slowly than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. The royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of discovering infringements. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations and may negatively impact revenue. 23 PART I Item 1A Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow bec ause of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Microsoft Surface. To resolve thes e claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In s ome countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows 10, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact on our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scrutinize us under U.S. and foreign competition laws. Governments are actively enforcing competition laws and regulations, and this includes scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments we offered to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices for our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Government regulatory actions and court decisions such as these may result in fines, or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. 24 PART I Item 1A • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited. Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and regulations. The Foreign Corrupt Practices Act (“FCPA”) and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents, and the accounting provisions of the FCPA require us to maintain accurate books and records and adequate internal controls. From time to time, we receive inquiries from authorities in the U.S. and elsewhere which may be based on reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Periodically, we receive such reports directly and investigate them. On July 22, 2019, our Hungarian subsidiary entered into a non-prosecution agreement (“NPA”) with the U.S. Department of Justice (“DOJ”) and we agreed to the terms of a cease and desist order with the Securities and Exchange Commission. These agreements required us to pay $25.3 million in monetary penalties, disgorgement, and interest pertaining to activities at Microsoft’s subsidiary in Hungary. The NPA, which has a three-year term, also contains certain ongoing compliance requirements, including the obligations to disclose to the DOJ issues that may implicate the FCPA and to cooperate in any inquiries. Most countries in which we operate also have competition laws that prohibit competitors from colluding or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our U.S. and international compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, sanctions, and other regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on restricted entities or countries such as Iran, North Korea, Cuba, Sudan, and Syria. Other regulatory areas that may apply to our products and online services offerings include user privacy, telecommunications, data storage and protection, and online content. For example, some regulators are taking the position that our offerings such as Skype are covered by existing laws regulating telecommunications services, and some new laws are defining more of our services as regulated telecommunications services. This trend may continue and will result in these offerings being subjected to additional data protection, security, and law enforcement surveillance obligations. Data protection authorities may assert that our collection, use, and management of customer data is inconsistent with their laws and regulations. Legislative or regulatory action relating to cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Legislative or regulatory action could also emerge in the area of AI and content moderation, increasing costs or restricting opportunity. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, customers, and other stakeholders to make technology more accessible. If our products do not meet customer expectations or emerging global accessibility requirements, we could lose sales opportunities or face regulatory actions 25 PART I Item 1A Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us , or reputational damage . The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve . For example, the EU and the U.S. formally entered into a new framework in July 2016 that provides a mechanism for companies to transfer data from EU member states to the U.S. This framework, called the Privacy Shield, is intended to address shortcomings identified by the European Court of Justice in a predecessor mechanism. The Privacy Shield and other mechanisms are currently subject to challenges in European courts, which may lead to uncertainty about the legal basis for data transfers across the Atlant ic. The Privacy Shield and other potential rules on the flow of data across borders could increase the cost and complexity of delivering our products and services in some markets. In May 2018, a new EU law governing data practices and privacy , the General Data Protection Regulation (“GDPR”), bec a me effective. The law , which applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of new compliance obligations regarding the handling of personal data. Engineering efforts to build new capabilities to facilitate compliance with the law have entailed substantial expense and the diversion of engineering resources from other projects and may continue to do so. We might experien ce reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under the GDPR or other data regulations, or if the changes we implement to comply with the GDPR make our offe rings less attractive. The GDPR imposes significant new obligations and compliance with these obligations depends in part on how particular regulators interpret and apply them. If we fail to comply with the GDPR, or if regulators assert we have failed to c omply with the GDPR, it may lead to regulatory enforcement actions, which can result in monetary penalties of up to 4% of worldwide revenue, private lawsuits , or reputational damage . In the U.S., California has adopted and several states are considering ad opting laws and regulations imposing obligations regarding the handling of personal data. The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Ongoing legal reviews by regulators may result in burdensome or inconsistent requirements, including data sovereignty and localization requirements, affecting the location and movement of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in some jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity, as well as negative publicity and diversion of management time and effort. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cuts and Jobs Act (“TCJA”) may require the collection of information not regularly produced within the Company, the use of estimates in our consolidated financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to the TCJA, and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our consolidated financial statements. We regularly are under audit by tax authorities in different jurisdictions. Although we believe that our provision for income taxes and our tax estimates are reasonable, tax authorities may disagree with certain positions we have taken.  In addition, economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. We are currently under Internal Revenue Service audit for prior tax years, with the primary unresolved issues relating to transfer pricing. The final resolution of those audits, and other audits or litigation, may differ from the amounts recorded in our consolidated financial statements and may materially affect our consolidated financial statements in the period or periods in which that determination is made. 26 PART I Item 1A We earn a significant amount of our operating income outside the U.S . A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the Company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing juris dictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our consolidated financial statements . If our reputation or our brands are damaged, our business and operating results may be harmed . Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, or our environmental impact and sustainability, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things: • The introduction of new features, products, services, or terms of service that customers, users, or partners do not like. • Public scrutiny of our decisions regarding user privacy, data practices, or content. • Data security breaches, compliance failures, or actions of partners or individual employees. The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees. Our global business exposes us to operational and economic risks. Our customers are located throughout the world and a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist trends in specific countries may significantly alter the trade environment. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our results of operations . Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Substantial revenue comes from our U.S. government contracts. An extended federal government shutdown resulting from failing to pass budget appropriations, adopt continuing funding resolutions or raise the debt ceiling, and other budgetary decisions limiting or delaying federal government spending, could reduce government IT spending on our products and services and adversely affect our revenue. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. 27 PART I Item 1A We maintain an investment portfolio of various holdings, t ypes, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio c omprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our consolidated financial statements . Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems, or the infrastructure or systems they rely on, such as power grids, could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages on our consolidated financial statements. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory requirements that could impact our operating strategies, access to global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues. The long-term effects of climate change on the global economy or the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other natural resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in weather where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees representing diverse backgrounds, experiences, and skill sets. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation, as well as a diverse and inclusive work environment that enables all our employees to thrive, are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. 28 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVE D STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our fiscal year 2019 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 520 acres of land we own at our corporate headquarters, and approximately five million square feet of space we lease. In addition, we own and lease space domestically that includes office, datacenter, and retail space. We also own and lease facilities internationally. The largest owned properties include: our research and development centers in China and India; our datacenters in Ireland, the Netherlands, and Singapore; and our operations and facilities in Ireland and the United Kingdom. The largest leased properties include space in the following locations: Australia, Canada, China, Germany, India, Japan, and the United Kingdom. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described under Research and Development (Part I, Item 1 of this Form 10-K). The table below shows a summary of the square footage of our office, datacenter, retail, and other facilities owned and leased domestically and internationally as of June 30, 2019: (Square feet in millions) Location Owned Leased Total U.S. 18 14 32 International 6 14 20 Total 24 28 52 ITEM 3. LEGAL PROCEEDINGS While not material to the Company, the Company makes the following annual report of the general activities of the Company’s Antitrust Compliance Office as required by the Final Order and Judgment in Barovic v. Ballmer et al, United States District Court for the Western District of Washington (“Final Order”). For more information see http://aka.ms/MSLegalNotice2015. These annual reports will continue through 2020. During fiscal year 2019, the Antitrust Compliance Office (a) monitored the Company’s compliance with the European Commission Decision of March 24, 2004, (“2004 Decision”) and with the Company’s Public Undertaking to the European Commission dated December 16, 2009 (“2009 Undertaking”); (b) monitored, in the manner required by the Final Order, employee, customer, competitor, regulator, or other third-party complaints regarding compliance with the 2004 Decision, the 2009 Undertaking, or other EU or U.S. laws or regulations governing tying, bundling, and exclusive dealing contracts; and, (c) monitored, in the manner required by the Final Order, the training of the Company’s employees regarding the Company’s antitrust compliance polices. In addition, the Antitrust Compliance Officer reports to the Regulatory and Public Policy Committee of the Board at each of its regularly scheduled meetings and to the full Board annually. Refer to Note 16 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 29 PART II Item 5 PAR T II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 29, 2019, there were 94,069 registered holders of record of our common stock. SHARE REPURCHASES AND DIVIDENDS Following are our monthly share repurchases for the fourth quarter of fiscal year 2019: Period Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet be Purchased under the Plans or Programs (In millions) April 1, 2019 – April 30, 2019 8,547,612 $ 122.85 8,547,612 $ 14,551 May 1, 2019 – May 31, 2019 14,029,339 126.32 14,029,339 12,778 June 1, 2019 – June 30, 2019 10,469,682 131.59 10,469,682 11,401 33,046,633 33,046,633 All share repurchases were made using cash resources. Our share repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. Our Board of Directors declared the following dividends during the fourth quarter of fiscal year 2019: Declaration Date Record Date Payment Date Dividend Per Share Amount (In millions) June 12, 2019 August 15, 2019 September 12, 2019 $ 0.46 $ 3,516 We returned $7.7 billion to shareholders in the form of share repurchases and dividends in the fourth quarter of fiscal year 2019.  Refer to Note 17 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding share repurchases and dividends. 30 PART II Item 6 ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share amounts) Year Ended June 30, 2019 ( a ) 2018 2017 (d)(e) 2016 (d) 2015 Revenue $ 125,843 $ 110,360 $ 96,571 $ 91,154 $ 93,580 Gross margin 82,933 72,007 62,310 58,374 60,542 Operating income 42,959 35,058 29,025 ( f ) 26,078 ( g ) 18,161 ( h ) Net income 39,240 ( b ) 16,571 ( c ) 25,489 ( f ) 20,539 ( g ) 12,193 ( h ) Diluted earnings per share 5.06 ( b ) 2.13 ( c ) 3.25 ( f ) 2.56 ( g ) 1.48 ( h ) Cash dividends declared per share 1.84 1.68 1.56 1.44 1.24 Cash, cash equivalents, and short-term investments 133,819 133,768 132,981 113,240 96,526 Total assets 286,556 258,848 250,312 202,897 174,303 Long-term obligations 114,806 117,642 106,856 66,705 44,574 Stockholders’ equity 102,330 82,718 87,711 83,090 80,083 (a) GitHub has been included in our consolidated results of operations starting on the October 25, 2018 acquisition date . (b) Includes a $2.6 billion net income tax benefit related to intangible property transfers and a $157 million net charge related to the enactment of the Tax Cuts and Jobs Act (“TCJA”), which together increased net income and diluted earnings per share (“EPS”) by $2.4 billion and $0.31, respectively. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. ( c ) Includes a $13.7 billion net charge related to the enactment of the TCJA, which decreased net income and diluted EPS by $13.7 billion and $1.75, respectively. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. ( d ) Reflects the impact of the adoption of new accounting standards in fiscal year 2018 related to revenue recognition and leases. ( e ) LinkedIn has been included in our consolidated results of operations starting on the December 8, 2016 acquisition date. ( f ) Includes $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan, which decreased operating income, net income, and diluted EPS by $306 million, $243 million, and $0.04, respectively. ( g ) Includes $630 million of asset impairment charges related to our Phone business and $480 million of restructuring charges associated with our Phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $1.1 billion, $895 million, and $0.11, respectively. (h ) Includes $7.5 billion of goodwill and asset impairment charges related to our Phone business and $2.5 billion of integration and restructuring expenses, primarily associated with our Phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $10.0 billion, $9.5 billion, and $1.15, respectively. 31 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by offering a wide range of cloud-based and other services to people and businesses; licensing and supporting an array of software products; designing, manufacturing, and selling devices; and delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes. Highlights from fiscal year 2019 compared with fiscal year 2018 included: • Commercial cloud revenue, which includes Microsoft Office 365 Commercial, Microsoft Azure, the commercial portion of LinkedIn, Microsoft Dynamics 365, and other commercial cloud properties, increased 43% to $38.1 billion. • Office Commercial revenue increased 13%, driven by Office 365 Commercial growth of 33%. • Office Consumer revenue increased 7%, and Office 365 Consumer subscribers increased to 34.8 million. • LinkedIn revenue increased 28%, with record levels of engagement highlighted by LinkedIn sessions growth of 27%. • Dynamics revenue increased 15%, driven by Dynamics 365 growth of 47%. • Server products and cloud services revenue, including GitHub, increased 25%, driven by Azure growth of 72%. • Enterprise Services revenue increased 5%. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue increased 4%. • Windows Commercial revenue increased 14%. • Microsoft Surface revenue increased 23%. • Gaming revenue increased 10%, driven by Xbox software and services growth of 19%. • Search advertising revenue, excluding traffic acquisition costs, increased 13%. We have recast certain prior period commercial cloud metrics to include the commercial portion of LinkedIn to provide a comparable view of our commercial cloud business performance. The commercial portion of LinkedIn includes LinkedIn Recruiter, Sales Navigator, premium business subscriptions, and other services for organizations. On October 25, 2018, we acquired GitHub, Inc. (“GitHub”) in a $7.5 billion stock transaction (inclusive of total cash payments of $1.3 billion in respect of vested GitHub equity awards and an indemnity escrow). The financial results of GitHub have been included in our consolidated financial statements since the date of the acquisition. GitHub is reported as part of our Intelligent Cloud segment. Refer to Note 8 – Business Combinations of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 32 PART II Item 7 On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business. We recorded a provisional ne t charge related to the enactment of the TCJA of $13. 7 billion in fiscal year 2018 , and adjusted our provisional net charge by recording additional tax expense of $ 157 million in the second quarter of fiscal year 2019. In the fourth quarter of fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland, which resulted in a $2.6 billion net income tax benef it . Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Strengthening of foreign currencies relative to the U.S. dollar throughout fiscal year 2018 positively impacted reported revenue and increased reported expenses from our international operations. Strengthening of the U.S. dollar relative to certain foreign currencies did not significantly impact reported revenue or expenses from our international operations in the first and second quarters of fiscal year 2019, and reduced reported revenue and expenses from our international operations in the third and fourth quarters of fiscal year 2019. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Seasonality Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period. Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted in the United States of America (“GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other. Additional information on our reportable segments is contained in Note 20 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). 33 PART II Item 7 SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2019 2018 2017 Percentage Change 2019 Versus 2018 Percentage Change 2018 Versus 2017 Revenue $ 125,843 $ 110,360 $ 96,571 14% 14% Gross margin 82,933 72,007 62,310 15% 16% Operating income 42,959 35,058 29,025 23% 21% Net income 39,240 16,571 25,489 137% (35)% Diluted earnings per share 5.06 2.13 3.25 138% (34)% Non-GAAP operating income 42,959 35,058 29,331 23% 20% Non-GAAP net income 36,830 30,267 25,732 22% 18% Non-GAAP diluted earnings per share 4.75 3.88 3.29 22% 18% Non-GAAP operating income, net income, and diluted earnings per share (“EPS”) exclude the net tax impact of transfer of intangible properties, the net tax impact of the TCJA, and restructuring expenses. Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results. Fiscal Year 2019 Compared with Fiscal Year 2018 Revenue increased $15.5 billion or 14%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. Productivity and Business Processes revenue increased, driven by Office and LinkedIn. More Personal Computing revenue increased, driven by Surface, Gaming, and Windows. Gross margin increased $10.9 billion or 15%, driven by growth across each of our segments. Gross margin percentage increased slightly, due to gross margin percentage improvement across each of our segments and favorable segment sales mix. Gross margin included a 5 percentage point improvement in commercial cloud, primarily from Azure. Operating income increased $7.9 billion or 23%, driven by growth across each of our segments. Key changes in expenses were: • Cost of revenue increased $4.6 billion or 12%, driven by growth in commercial cloud, Surface, and Gaming. • Research and development expenses increased $2.2 billion or 15%, driven by investments in cloud and artificial intelligence (“AI”) engineering, Gaming, LinkedIn, and GitHub. • Sales and marketing expenses increased $744 million or 4%, driven by investments in commercial sales capacity, LinkedIn, and GitHub, offset in part by a decrease in marketing. Sales and marketing expenses included a favorable foreign currency impact of 2%. Current year net income included a $2.6 billion net income tax benefit related to intangible property transfers and a $157 million net charge related to the enactment of the TCJA, which together resulted in an increase to net income and diluted EPS of $2.4 billion and $0.31, respectively. Prior year net income and diluted EPS were negatively impacted by the net charge related to the enactment of the TCJA, which resulted in a decrease to net income and diluted EPS of $13.7 billion and $1.75, respectively. Fiscal Year 2018 Compared with Fiscal Year 2017 Revenue increased $13.8 billion or 14%, driven by growth across each of our segments. Productivity and Business Processes revenue increased, driven by LinkedIn and higher revenue from Office. Intelligent Cloud revenue increased, primarily due to higher revenue from server products and cloud services. More Personal Computing revenue increased, driven by higher revenue from Gaming, Windows, Search advertising, and Surface, offset in part by lower revenue from Phone. 34 PART II Item 7 Gross margin increased $9.7 billion or 16%, due to growth across each of our segments. Gross margin percentage increased slightly, driven by favo rable segment sales mix and gross margin percentage improvement in More Personal Computing. Gross margin included a 7 percentage point improvement in commercial cloud, primarily from Azure. Operating income increased $6.0 billion or 21%, driven by growth across each of our segments. LinkedIn operating loss increased $63 million to $987 million, including $1.5 billion of amortization of intangible assets. Operating income included a favorable foreign currency impact of 2%. Key changes in expenses were: • Cost of revenue increased $4.1 billion or 12%, mainly due to growth in our commercial cloud, Gaming, LinkedIn, and Search advertising, offset in part by a reduction in Phone cost of revenue. • Sales and marketing expenses increased $2.0 billion or 13%, primarily due to LinkedIn expenses and investments in commercial sales capacity, offset in part by a decrease in Windows marketing expenses. • Research and development expenses increased $1.7 billion or 13%, primarily due to investments in cloud engineering and LinkedIn expenses. • General and administrative expenses increased $273 million or 6%, primarily due to LinkedIn expenses. Fiscal year 2018 net income and diluted EPS were negatively impacted by the net charge related to the enactment of the TCJA, which resulted in a decrease to net income and diluted earnings per share of $13.7 billion and $1.75, respectively. Fiscal year 2017 operating income, net income, and diluted EPS were negatively impacted by restructuring expenses, which resulted in a decrease to operating income, net income, and diluted EPS of $306 million, $243 million, and $0.04, respectively. SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2019 2018 2017 Percentage Change 2019 Versus 2018 Percentage Change 2018 Versus 2017 Revenue Productivity and Business Processes $ 41,160 $ 35,865 $ 29,870 15% 20% Intelligent Cloud 38,985 32,219 27,407 21% 18% More Personal Computing 45,698 42,276 39,294 8% 8% Total $ 125,843 $ 110,360 $ 96,571 14% 14% Operating Income (Loss) Productivity and Business Processes $ 16,219 $ 12,924 $ 11,389 25% 13% Intelligent Cloud 13,920 11,524 9,127 21% 26% More Personal Computing 12,820 10,610 8,815 21% 20% Corporate and Other 0 0 (306 ) * * Total $ 42,959 $ 35,058 $ 29,025 23% 21% * Not meaningful. Reportable Segments Fiscal Year 2019 Compared with Fiscal Year 2018 Productivity and Business Processes Revenue increased $5.3 billion or 15%. • Office Commercial revenue increased $3.2 billion or 13%, driven by Office 365 Commercial, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to cloud offerings. Office 365 Commercial grew 33%, due to growth in seats and higher average revenue per user. 35 PART II Item 7 • Office Consumer revenue increased $286 million or 7 %, driven by Office 365 Consumer, due to recurring subscription revenue and transactional strength in Japan . • LinkedIn revenue increased $1.5 billion or 28%, driven by growth across each line of business. • Dynamics revenue increased 15%, driven by Dynamics 365 growth. Operating income increased $3.3 billion or 25%, including an unfavorable foreign currency impact of 2%. • Gross margin increased $4.1 billion or 15%, driven by growth in Office Commercial and LinkedIn. Gross margin percentage increased slightly, due to gross margin percentage improvement in LinkedIn and Office 365 Commercial, offset in part by an increased mix of cloud offerings. • Operating expenses increased $806 million or 6%, driven by investments in LinkedIn and cloud engineering, offset in part by a decrease in marketing. Intelligent Cloud Revenue increased $6.8 billion or 21%. • Server products and cloud services revenue, including GitHub, increased $6.5 billion or 25%, driven by Azure. Azure revenue growth was 72%, due to higher infrastructure-as-a-service and platform-as-a-service consumption-based and per user-based services. Server products revenue increased 6% , due to continued demand for premium versions and hybrid solutions, GitHub, and demand ahead of end-of-support for SQL Server 2008 and Windows Server 2008. • Enterprise Services revenue increased $278 million or 5% , driven by growth in Premier Support Services and Microsoft Consulting Services. Operating income increased $2.4 billion or 21%. • Gross margin increased $4.8 billion or 22%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies. Gross margin percentage increased slightly, due to gross margin percentage improvement in Azure, offset in part by an increased mix of cloud offerings. • Operating expenses increased $2.4 billion or 22%, driven by investments in cloud and AI engineering, GitHub, and commercial sales capacity. More Personal Computing Revenue increased $3.4 billion or 8%. • Windows revenue increased $877 million or 4%, driven by growth in Windows Commercial and Windows OEM, offset in part by a decline in patent licensing. Windows Commercial revenue increased 14%, driven by an increased mix of multi-year agreements that carry higher in-quarter revenue recognition. Windows OEM revenue increased 4%. Windows OEM Pro revenue grew 10%, ahead of the commercial PC market, driven by healthy Windows 10 demand. Windows OEM non-Pro revenue declined 7%, below the consumer PC market, driven by continued pressure in the entry level category. • Surface revenue increased $1.1 billion or 23%, with strong growth across commercial and consumer. • Gaming revenue increased $1.0 billion or 10%, driven by Xbox software and services growth of 19%, primarily due to third-party title strength and subscriptions growth, offset in part by a decline in Xbox hardware of 13% primarily due to a decrease in volume of consoles sold. • Search advertising revenue increased $616 million or 9%. Search advertising revenue, excluding traffic acquisition costs, increased 13%, driven by higher revenue per search. Operating income increased $2.2 billion or 21%, including an unfavorable foreign currency impact of 2%. • Gross margin increased $2.0 billion or 9%, driven by growth in Windows, Gaming, and Search. Gross margin percentage increased slightly, due to a sales mix shift to higher gross margin businesses in Windows and Gaming. • Operating expenses decreased $172 million or 1%. 36 PART II Item 7 Fiscal Year 2018 Compared with Fiscal Year 2017 Productivity and Business Processes Revenue increased $6.0 billion or 20%. • LinkedIn revenue increased $3.0 billion to $5.3 billion. Fiscal year 2018 included a full period of results, whereas fiscal year 2017 only included results from the date of acquisition on December 8, 2016. LinkedIn revenue primarily consisted of revenue from Talent Solutions. • Office Commercial revenue increased $2.4 billion or 11%, driven by Office 365 Commercial revenue growth, mainly due to growth in subscribers and average revenue per user, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 Commercial. • Office Consumer revenue increased $382 million or 11%, driven by Office 365 Consumer revenue growth, mainly due to growth in subscribers. • Dynamics revenue increased 13%, driven by Dynamics 365 revenue growth. Operating income increased $1.5 billion or 13%, including a favorable foreign currency impact of 2%. • Gross margin increased $4.4 billion or 19%, driven by LinkedIn and growth in Office Commercial. Gross margin percentage decreased slightly, due to an increased mix of cloud offerings, offset in part by gross margin percentage improvement in Office 365 Commercial and LinkedIn. LinkedIn cost of revenue increased $818 million to $1.7 billion, including $888 million of amortization for acquired intangible assets. • Operating expenses increased $2.9 billion or 25%, driven by LinkedIn expenses and investments in commercial sales capacity and cloud engineering. LinkedIn operating expenses increased $2.2 billion to $4.5 billion, including $617 million of amortization of acquired intangible assets. Intelligent Cloud Revenue increased $4.8 billion or 18%. • Server products and cloud services revenue increased $4.5 billion or 21%, driven by Azure and server products licensed on-premises revenue growth. Azure revenue grew 91%, due to higher infrastructure-as-a-service and platform-as-a-service consumption-based and per user-based services. Server products licensed on-premises revenue increased 5% , mainly due to a higher mix of premium licenses for Windows Server and Microsoft SQL Server. • Enterprise Services revenue increased $304 million or 5% , driven by higher revenue from Premier Support Services and Microsoft Consulting Services, offset in part by a decline in revenue from custom support agreements. Operating income increased $2.4 billion or 26%. • Gross margin increased $3.1 billion or 16%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies. Gross margin percentage decreased, due to an increased mix of cloud offerings, offset in part by gross margin percentage improvement in Azure. • Operating expenses increased $683 million or 7%, driven by investments in commercial sales capacity and cloud engineering. More Personal Computing Revenue increased $3.0 billion or 8%. • Windows revenue increased $925 million or 5%, driven by growth in Windows Commercial and Windows OEM, offset by a decline in patent licensing revenue. Windows Commercial revenue increased 12%, driven by multi-year agreement revenue growth. Windows OEM revenue increased 5%. Windows OEM Pro revenue grew 11%, ahead of a strengthening commercial PC market. Windows OEM non-Pro revenue declined 4%, below the consumer PC market, driven by continued pressure in the entry-level price category. • Gaming revenue increased $1.3 billion or 14%, driven by Xbox software and services revenue growth of 20%, mainly from third-party title strength. 37 PART II Item 7 • Search advertising revenue increased $793 million or 13%. Search advertising revenue, excluding traffic acquisition costs, increased 16%, driven by growth in Bing, due to higher revenue per search and search volume. • Surface revenue increased $625 million or 16%, driven by a higher mix of premium devices and an increase in volumes sold, due to the latest editions of Surface. • Phone revenue decreased $525 million. Operating income increased $1.8 billion or 20%, including a favorable foreign currency impact of 2%. • Gross margin increased $2.2 billion or 11%, driven by growth in Windows, Surface, Search, and Gaming. Gross margin percentage increased, primarily due to gross margin percentage improvement in Surface. • Operating expenses increased $391 million or 3%, driven by investments in Search, AI, and Gaming engineering and commercial sales capacity, offset in part by a decrease in Windows marketing expenses. Corporate and Other Corporate and Other includes corporate-level activity not specifically allocated to a segment, including restructuring expenses. Fiscal Year 2019 Compared with Fiscal Year 2018 We did not incur Corporate and Other activity in fiscal years 2019 or 2018. Fiscal Year 2018 Compared with Fiscal Year 2017 Corporate and Other operating loss decreased $306 million, due to a reduction in restructuring expenses, driven by employee severance expenses primarily related to our sales and marketing restructuring plan in fiscal year 2017. OPERATING EXPENSES Research and Development (In millions, except percentages) 2019 2018 2017 Percentage Change 2019 Versus 2018 Percentage Change 2018 Versus 2017 Research and development $ 16,876 $ 14,726 $ 13,037 15% 13% As a percent of revenue 13% 13% 13% 0ppt 0ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Fiscal Year 2019 Compared with Fiscal Year 2018 Research and development expenses increased $2.2 billion or 15%, driven by investments in cloud and AI engineering, Gaming, LinkedIn, and GitHub. Fiscal Year 2018 Compared with Fiscal Year 2017 Research and development expenses increased $1.7 billion or 13%, primarily due to investments in cloud engineering and LinkedIn expenses. LinkedIn expenses increased $762 million to $1.5 billion. 38 PART II Item 7 Sales and Marketing (In millions, except percentages) 2019 2018 2017 Percentage Change 2019 Versus 2018 Percentage Change 2018 Versus 2017 Sales and marketing $ 18,213 $ 17,469 $ 15,461 4% 13% As a percent of revenue 14% 16% 16% (2)ppt 0ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal Year 2019 Compared with Fiscal Year 2018 Sales and marketing expenses increased $744 million or 4%, driven by investments in commercial sales capacity, LinkedIn, and GitHub, offset in part by a decrease in marketing. Expenses included a favorable foreign currency impact of 2%. Fiscal Year 2018 Compared with Fiscal Year 2017 Sales and marketing expenses increased $2.0 billion or 13%, primarily due to LinkedIn expenses and investments in commercial sales capacity, offset in part by a decrease in Windows marketing expenses. LinkedIn expenses increased $1.2 billion to $2.5 billion, including $617 million of amortization of acquired intangible assets. General and Administrative (In millions, except percentages) 2019 2018 2017 Percentage Change 2019 Versus 2018 Percentage Change 2018 Versus 2017 General and administrative $ 4,885 $ 4,754 $ 4,481 3% 6% As a percent of revenue 4% 4% 5% 0ppt (1)ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal Year 2019 Compared with Fiscal Year 2018 General and administrative expenses increased $131 million or 3%. Fiscal Year 2018 Compared with Fiscal Year 2017 General and administrative expenses increased $273 million or 6%, primarily due to LinkedIn expenses. LinkedIn expenses increased $234 million to $528 million. RESTRUCTURING EXPENSES Restructuring expenses include employee severance expenses and other costs associated with the consolidation of facilities and manufacturing operations related to restructuring activities. Fiscal Year 2019 Compared with Fiscal Year 2018 We did not incur restructuring expenses in fiscal years 2019 or 2018. Fiscal Year 2018 Compared with Fiscal Year 2017 During fiscal year 2017, we recorded $306 million of employee severance expenses, primarily related to our sales and marketing restructuring plan. 39 PART II Item 7 OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Interest and dividends income $ 2,762 $ 2,214 $ 1,387 Interest expense (2,686 ) (2,733 ) (2,222 ) Net recognized gains on investments 648 2,399 2,583 Net gains (losses) on derivatives 144 (187 ) (510 ) Net losses on foreign currency remeasurements (82 ) (218 ) (111 ) Other, net (57 ) (59 ) (251 ) Total $ 729 $ 1,416 $ 876 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net. Fiscal Year 2019 Compared with Fiscal Year 2018 Interest and dividends income increased primarily due to higher yields on fixed-income securities. Interest expense decreased primarily driven by a decrease in outstanding long-term debt due to debt maturities, offset in part by higher finance lease expense . Net recognized gains on investments decreased primarily due to lower gains on sales of equity investments. Net gains on derivatives includes gains on foreign exchange and interest rate derivatives in the current period as compared to losses in the prior period . Fiscal Year 2018 Compared with Fiscal Year 2017 Dividends and interest income increased primarily due to higher average portfolio balances and yields on fixed-income securities. Interest expense increased primarily due to higher average outstanding long-term debt and higher finance lease expense. Net recognized gains on investments decreased primarily due to higher losses on sales of fixed-income securities, offset in part by higher gains on sales of equity securities. Net losses on derivatives decreased primarily due to lower losses on equity, foreign exchange, and commodity derivatives, offset in part by losses on interest rate derivatives in the current period as compared to gains in the prior period. INCOME TAXES Effective Tax Rate Fiscal Year 2019 Compared with Fiscal Year 2018 Our effective tax rate for fiscal years 2019 and 2018 was 10% and 55%, respectively. The decrease in our effective tax rate for fiscal year 2019 compared to fiscal year 2018 was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018 and a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to the tax benefit related to intangible property transfers, and earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2019, our U.S. income before income taxes was $15.8 billion and our foreign income before income taxes was $27.9 billion. In fiscal year 2018, our U.S. income before income taxes was $11.5 billion and our foreign income before income taxes was $24.9 billion. 40 PART II Item 7 Fiscal Year 2018 Compared with Fiscal Year 2017 Our effective tax rate for fiscal years 2018 and 2017 was 55% and 15%, respectively. The increase in our effective tax rate for fiscal year 2018 compared to fiscal year 2017 was primarily due to the net charge related to the enactment of the TCJA in fiscal year 2018 and the realization of tax benefits attributable to previous Phone business losses in fiscal year 2017. Our effective tax rate was higher than the U.S. federal statutory rate primarily due to the net charge related to the enactment of the TCJA, offset in part by earnings taxed at lower rates in foreign jurisdictions resulting from our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2018, our U.S. income before income taxes was $11.5 billion and our foreign income before income taxes was $24.9 billion. In fiscal year 2017, our U.S. income before income taxes was $6.8 billion and our foreign income before income taxes was $23.1 billion. Tax Cuts and Jobs Act On December 22, 2017, the TCJA was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. In fiscal year 2018, the TCJA required us to incur a transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. In addition, the TCJA subjected us to a tax on our global intangible low-taxed income (“GILTI”) effective July 1, 2018. Under GAAP, we can make an accounting policy election to either treat taxes due on the GILTI inclusion as a current period expense or factor such amounts into our measurement of deferred taxes. We elected the deferred method, under which we recorded the corresponding deferred tax assets and liabilities on our consolidated balance sheets. During fiscal year 2018, we recorded a net charge of $13.7 billion related to the enactment of the TCJA, due to the impact of the one-time transition tax on the deemed repatriation of deferred foreign income of $17.9 billion, offset in part by the impact of changes in the tax rate of $4.2 billion, primarily on deferred tax assets and liabilities. During the second quarter of fiscal year 2019, we recorded additional tax expense of $157 million, which related to completing our provisional accounting for GILTI deferred taxes pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 118. In the fourth quarter of fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland. The transfers of intangible properties resulted in a $2.6 billion net income tax benefit recorded in the fourth quarter of fiscal year 2019, as the value of future tax deductions exceeded the current tax liability from foreign jurisdictions and U.S. GILTI tax. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 41 PART II Item 7 Uncertain Tax Positions We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under audit for tax years 2004 to 2013. We expect the IRS to begin an examination of tax years 2014 to 2017 within the next 12 months. As of June 30, 2019, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact on our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2018, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Non-GAAP operating income, net income, and diluted EPS are non-GAAP financial measures which exclude the net tax impact of transfer of intangible properties, the net tax impact of the TCJA, and restructuring expenses. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results: (In millions, except percentages and per share amounts) 2019 2018 2017 Percentage Change 2019 Versus 2018 Percentage Change 2018 Versus 2017 Operating income $ 42,959 $ 35,058 $ 29,025 23% 21% Net tax impact of transfer of intangible properties 0 0 0 * * Net tax impact of the TCJA 0 0 0 * * Restructuring expenses 0 0 306 * * Non-GAAP operating income $ 42,959 $ 35,058 $ 29,331 23% 20% Net income $ 39,240 $ 16,571 $ 25,489 137% (35)% Net tax impact of transfer of intangible properties (2,567 ) 0 0 * * Net tax impact of the TCJA 157 13,696 0 * * Restructuring expenses 0 0 243 * * Non-GAAP net income $ 36,830 $ 30,267 $ 25,732 22% 18% Diluted earnings per share $ 5.06 $ 2.13 $ 3.25 138% (34)% Net tax impact of transfer of intangible properties (0.33 ) 0 0 * * Net tax impact of the TCJA 0.02 1.75 0 * * Restructuring expenses 0 0 0.04 * * Non-GAAP diluted earnings per share $ 4.75 $ 3.88 $ 3.29 22% 18% * Not meaningful. 42 PART II Item 7 FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $133.8 billion as of both June 30, 2019 and 2018. Equity investments were $2.6 billion and $1.9 billion as of June 30, 2019 and 2018, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Fiscal Year 2019 Compared with Fiscal Year 2018 Cash from operations increased $8.3 billion to $52.2 billion for fiscal year 2019, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees and an increase in cash paid for income taxes. Cash used in financing increased $3.3 billion to $36.9 billion for fiscal year 2019, mainly due to an $8.8 billion increase in common stock repurchases and a $1.1 billion increase in dividends paid, offset in part by a $6.2 billion decrease in repayments of debt, net of proceeds from issuance of debt. Cash used in investing increased $9.7 billion to $15.8 billion for fiscal year 2019, mainly due to a $6.0 billion decrease in cash from net investment purchases, sales, and maturities, a $2.3 billion increase in additions to property and equipment, and a $1.5 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets. 43 PART II Item 7 Fiscal Year 2018 Compared with Fiscal Year 2017 Cash from operations increased $4.4 billion to $43.9 billion for fiscal year 2018, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to employees, net cash paid for income taxes, cash paid for interest on debt, and cash paid to suppliers. Cash used in financing was $33.6 billion for fiscal year 2018, compared to cash from financing of $8.4 billion for fiscal year 2017. The change was mainly due to a $41.7 billion decrease in proceeds from issuance of debt, net of repayments of debt, offset in part by a $1.1 billion decrease in cash used for common stock repurchases. Cash used in investing decreased $40.7 billion to $6.1 billion for fiscal year 2018, mainly due to a $25.1 billion decrease in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, and a $19.1 billion increase in cash from net investment purchases, sales, and maturities. Debt We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. The following table outlines the expected future recognition of unearned revenue as of June 30, 2019: (In millions) Three Months Ending, September 30, 2019 $ 12,353 December 31, 2019 9,807 March 31, 2020 6,887 June 30, 2020 3,629 Thereafter 4,530 Total $ 37,206 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Share Repurchases For fiscal years 2019, 2018, and 2017, we repurchased 150 million shares, 99 million shares, and 170 million shares of our common stock for $16.8 billion, $8.6 billion, and $10.3 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 17 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends Refer to Note 17 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 44 PART II Item 7 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact on our consolidated financial statements during the periods presented. Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2019: (In millions) 2020 2021-2022 2023-2024 Thereafter Total Long-term debt: (a) Principal payments $ 5,518 $ 11,744 $ 8,000 $ 47,519 $ 72,781 Interest payments 2,299 4,309 3,818 29,383 39,809 Construction commitments (b) 3,443 515 0 0 3,958 Operating leases, including imputed interest (c) 1,790 3,144 2,413 3,645 10,992 Finance leases, including imputed interest (c) 797 2,008 2,165 9,872 14,842 Transition tax (d) 1,180 2,900 4,168 8,155 16,403 Purchase commitments (e) 17,478 1,185 159 339 19,161 Other long-term liabilities (f) 0 72 29 324 425 Total $ 32,505 $ 25,877 $ 20,752 $ 99,237 $ 178,371 (a) Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Refer to Note 7 – Property and Equipment of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). ( c ) Refer to Note 15 – Leases of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (d) Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). ( e ) Amounts represent purchase commitments, including open purchase orders and take-or-pay contracts that are not presented as construction commitments above. ( f ) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $14.2 billion from the amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable interest free over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of approximately $2.0 billion, which included $1.5 billion for fiscal year 2019. The first installment of the transition tax was paid in fiscal year 2019, and the remaining transition tax of $16.4 billion is payable over the next seven years with a final payment in fiscal year 2026. During the first quarter of fiscal year 2020, we expect to pay $1.2 billion related to the second installment of the transition tax, and $3.5 billion related to the transfer of intangible properties in the fourth quarter of fiscal year 2019. 45 PART II Item 7 We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be s ufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future. RECENT ACCOUNTING GUIDANCE Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. 46 PART II Item 7 Impairment of Investment Securities We review debt investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the duration and extent to which the fair value is less than cost. We also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. In addition, we consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a quarterly basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. 47 PART II Item 7 Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized on our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. The TCJA significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 48 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 49 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. Equity Securities held in our equity investments portfolio are subject to price risk. SENSITIVITY ANALYSIS The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices: (In millions) Risk Categories Hypothetical Change June 30, 2019 Impact Foreign currency - Revenue 10% decrease in foreign exchange rates $ (3,402 ) Earnings Foreign currency - Investments 10% decrease in foreign exchange rates (120 ) Fair Value Interest rate 100 basis point increase in U.S. treasury interest rates (2,909 ) Fair Value Credit 100 basis point increase in credit spreads (224 ) Fair Value Equity 10% decrease in equity market prices (244 ) Earnings 50 PART II Item 8 ITEM 8. FINANCIAL STATE MENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2019 2018 2017 Revenue: Product $ 66,069 $ 64,497 $ 63,811 Service and other 59,774 45,863 32,760 Total revenue 125,843 110,360 96,571 Cost of revenue: Product 16,273 15,420 15,175 Service and other 26,637 22,933 19,086 Total cost of revenue 42,910 38,353 34,261 Gross margin 82,933 72,007 62,310 Research and development 16,876 14,726 13,037 Sales and marketing 18,213 17,469 15,461 General and administrative 4,885 4,754 4,481 Restructuring 0 0 306 Operating income 42,959 35,058 29,025 Other income, net 729 1,416 876 Income before income taxes 43,688 36,474 29,901 Provision for income taxes 4,448 19,903 4,412 Net income $ 39,240 $ 16,571 $ 25,489 Earnings per share: Basic $ 5.11 $ 2.15 $ 3.29 Diluted $ 5.06 $ 2.13 $ 3.25 Weighted average shares outstanding: Basic 7,673 7,700 7,746 Diluted 7,753 7,794 7,832 Refer to accompanying notes. 51 PART II Item 8 COMPREHENSIVE IN COME STATEMENTS (In millions) Year Ended June 30, 2019 2018 2017 Net income $ 39,240 $ 16,571 $ 25,489 Other comprehensive income (loss), net of tax: Net change related to derivatives (173 ) 39 (218 ) Net change related to investments 2,405 (2,717 ) (1,116 ) Translation adjustments and other (318 ) (178 ) 167 Other comprehensive income (loss) 1,914 (2,856 ) (1,167 ) Comprehensive income $ 41,154 $ 13,715 $ 24,322 Refer to accompanying notes. Refer to Note 18 – Accumulated Other Comprehensive Income (Loss) for further information. 52 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2019 2018 Assets Current assets: Cash and cash equivalents $ 11,356 $ 11,946 Short-term investments 122,463 121,822 Total cash, cash equivalents, and short-term investments 133,819 133,768 Accounts receivable, net of allowance for doubtful accounts of $411 and $377 29,524 26,481 Inventories 2,063 2,662 Other 10,146 6,751 Total current assets 175,552 169,662 Property and equipment, net of accumulated depreciation of $35,330 and $29,223 36,477 29,460 Operating lease right-of-use assets 7,379 6,686 Equity investments 2,649 1,862 Goodwill 42,026 35,683 Intangible assets, net 7,750 8,053 Other long-term assets 14,723 7,442 Total assets $ 286,556 $ 258,848 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 9,382 $ 8,617 Current portion of long-term debt 5,516 3,998 Accrued compensation 6,830 6,103 Short-term income taxes 5,665 2,121 Short-term unearned revenue 32,676 28,905 Other 9,351 8,744 Total current liabilities 69,420 58,488 Long-term debt 66,662 72,242 Long-term income taxes 29,612 30,265 Long-term unearned revenue 4,530 3,815 Deferred income taxes 233 541 Operating lease liabilities 6,188 5,568 Other long-term liabilities 7,581 5,211 Total liabilities 184,226 176,130 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000; outstanding 7,643 and 7,677 78,520 71,223 Retained earnings 24,150 13,682 Accumulated other comprehensive loss (340 ) (2,187 ) Total stockholders’ equity 102,330 82,718 Total liabilities and stockholders’ equity $ 286,556 $ 258,848 Refer to accompanying notes. 53 PART II Item 8 CASH FLOWS S TATEMENTS (In millions) Year Ended June 30, 2019 2018 2017 Operations Net income $ 39,240 $ 16,571 $ 25,489 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other 11,682 10,261 8,778 Stock-based compensation expense 4,652 3,940 3,266 Net recognized gains on investments and derivatives (792 ) (2,212 ) (2,073 ) Deferred income taxes (6,463 ) (5,143 ) (829 ) Changes in operating assets and liabilities: Accounts receivable (2,812 ) (3,862 ) (1,216 ) Inventories 597 (465 ) 50 Other current assets (1,718 ) (952 ) 1,028 Other long-term assets (1,834 ) (285 ) (917 ) Accounts payable 232 1,148 81 Unearned revenue 4,462 5,922 3,820 Income taxes 2,929 18,183 1,792 Other current liabilities 1,419 798 356 Other long-term liabilities 591 (20 ) (118 ) Net cash from operations 52,185 43,884 39,507 Financing Repayments of short-term debt, maturities of 90 days or less, net 0 (7,324 ) (4,963 ) Proceeds from issuance of debt 0 7,183 44,344 Repayments of debt (4,000 ) (10,060 ) (7,922 ) Common stock issued 1,142 1,002 772 Common stock repurchased (19,543 ) (10,721 ) (11,788 ) Common stock cash dividends paid (13,811 ) (12,699 ) (11,845 ) Other, net (675 ) (971 ) (190 ) Net cash from (used in) financing (36,887 ) (33,590 ) 8,408 Investing Additions to property and equipment (13,925 ) (11,632 ) (8,129 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (2,388 ) (888 ) (25,944 ) Purchases of investments (57,697 ) (137,380 ) (176,905 ) Maturities of investments 20,043 26,360 28,044 Sales of investments 38,194 117,577 136,350 Securities lending payable 0 (98 ) (197 ) Net cash used in investing (15,773 ) (6,061 ) (46,781 ) Effect of foreign exchange rates on cash and cash equivalents (115 ) 50 19 Net change in cash and cash equivalents (590 ) 4,283 1,153 Cash and cash equivalents, beginning of period 11,946 7,663 6,510 Cash and cash equivalents, end of period $ 11,356 $ 11,946 $ 7,663 Refer to accompanying notes. 54 PART II Item 8 STOCKHOLDERS’ EQ UITY STATEMENTS (In millions) Year Ended June 30, 2019 2018 2017 Common stock and paid-in capital Balance, beginning of period $ 71,223 $ 69,315 $ 68,178 Common stock issued 6,829 1,002 772 Common stock repurchased (4,195 ) (3,033 ) (2,987 ) Stock-based compensation expense 4,652 3,940 3,266 Other, net 11 (1 ) 86 Balance, end of period 78,520 71,223 69,315 Retained earnings Balance, beginning of period 13,682 17,769 13,118 Net income 39,240 16,571 25,489 Common stock cash dividends (14,103 ) (12,917 ) (12,040 ) Common stock repurchased (15,346 ) (7,699 ) (8,798 ) Cumulative effect of accounting changes 677 (42 ) 0 Balance, end of period 24,150 13,682 17,769 Accumulated other comprehensive income (loss) Balance, beginning of period (2,187 ) 627 1,794 Other comprehensive income (loss) 1,914 (2,856 ) (1,167 ) Cumulative effect of accounting changes (67 ) 42 0 Balance, end of period (340 ) (2,187 ) 627 Total stockholders’ equity $ 102,330 $ 82,718 $ 87,711 Cash dividends declared per common share $ 1.84 $ 1.68 $ 1.56 Refer to accompanying notes. 55 PART II Item 8 NOTES TO FINANCI AL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have recast certain prior period amounts related to investments, derivatives, and fair value measurements to conform to the current period presentation based on our adoption of the new accounting standard for financial instruments. We have recast prior period commercial cloud revenue to include the commercial portion of LinkedIn to provide a comparable view of our commercial cloud business performance. The commercial portion of LinkedIn includes LinkedIn Recruiter, Sales Navigator, premium business subscriptions, and other services for organizations. We have also recast components of the prior period deferred income tax assets and liabilities to conform to the current period presentation. The recast of these prior period amounts had no impact on our consolidated balance sheets, consolidated income statements, or net cash from or used in operating, financing, or investing on our consolidated cash flows statements. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of uncertain tax positions that have been recognized on our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income (“OCI”). Revenue Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; and hardware such as PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Microsoft Office 365, Microsoft Azure, Microsoft Dynamics 365, and Xbox Live; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. 56 PART II Item 8 Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental authorities. Nature of Products and Services Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. In cases where we allocate revenue to software updates, primarily because the updates are provided at no additional charge, revenue is recognized as the updates are provided, which is generally ratably over the estimated life of the related device or license. Certain volume licensing programs, including Enterprise Agreements, include on-premises licenses combined with Software Assurance (“SA”). SA conveys rights to new software and upgrades released over the contract period and provides support, tools, and training to help customers deploy and use products more efficiently. On-premises licenses are considered distinct performance obligations when sold with SA. Revenue allocated to SA is generally recognized ratably over the contract period as customers simultaneously consume and receive benefits, given that SA comprises distinct performance obligations that are satisfied over time. Cloud services, which allow customers to use hosted software over the contract period without taking possession of the software, are provided on either a subscription or consumption basis. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract period. Revenue related to cloud services provided on a consumption basis, such as the amount of storage used in a period, is recognized based on the customer utilization of such resources. When cloud services require a significant level of integration and interdependency with software and the individual components are not considered distinct, all revenue is recognized over the period in which the cloud services are provided. Revenue from search advertising is recognized when the advertisement appears in the search results or when the action necessary to earn the revenue has been completed. Revenue from consulting services is recognized as services are provided. Our hardware is generally highly dependent on, and interrelated with, the underlying operating system and cannot function without the operating system. In these cases, the hardware and software license are accounted for as a single performance obligation and revenue is recognized at the point in time when ownership is transferred to resellers or directly to end customers through retail stores and online marketplaces. Refer to Note 20 – Segment Information and Geographic Data for further information, including revenue by significant product and service offering. Significant Judgments Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 57 PART II Item 8 Judgment is required to determine the SSP for each distinct pe rformance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell ea ch of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Contract Balances Timing of revenue recognition may differ from the timing of invoicing to customers. We record a receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For multi-year agreements, we generally invoice customers annually at the beginning of each annual coverage period. We record a receivable related to revenue recognized for multi-year on-premises licenses as we have an unconditional right to invoice and receive payment in the future related to those licenses. As of June 30, 2019 and 2018, long-term accounts receivable, net of allowance for doubtful accounts, was $2.2 billion and $1.8 billion, respectively, and is included in other long-term assets in our consolidated balance sheets. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2019 2018 2017 Balance, beginning of period $ 397 $ 361 $ 409 Charged to costs and other 153 134 58 Write-offs (116 ) (98 ) (106 ) Balance, end of period $ 434 $ 397 $ 361 Allowance for doubtful accounts included in our consolidated balance sheets: (In millions) June 30, 2019 2018 2017 Accounts receivable, net of allowance for doubtful accounts $ 411 $ 377 $ 345 Other long-term assets 23 20 16 Total $ 434 $ 397 $ 361 58 PART II Item 8 Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include SA and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recogni zed ratably over the coverage period. Unearned revenue also includes payments for consulting services to be performed in the future; LinkedIn subscriptions; Office 365 subscriptions; Xbox Live subscriptions; Windows 10 post-delivery support; Dynamics busin ess solutions; Skype prepaid credits and subscriptions; and other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 14 – Unearned Revenue for further information, including unearned revenue by segment and changes in unearned revenue during the period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with revenue recognized upfront. Assets Recognized from Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets in our consolidated balance sheets. We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less. These costs include our internal sales force compensation program and certain partner sales incentive programs as we have determined annual compensation is commensurate with annual sales activities. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by original equipment manufacturers (“OEM”), to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain online products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. 59 PART II Item 8 Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $1.6 billion, $1.6 billion, and $1.5 billion in fiscal years 2019, 2018, and 2017, respectively. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term in our consolidated balance sheets. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. 60 PART II Item 8 Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding other-than-temporary impairments, are recorded in OCI. Debt investments are impaired whe n a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers avai lable quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the duration and extent to which the fair value is less than cost. We also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. In addition, we consider specifi c adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded in other income (expense), net and a new cost basis in the investment is established. Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method, or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a quarterly basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net. We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and the loaned securities continue to be carried as investments on our consolidated balance sheets. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability. Derivatives Derivative instruments are recognized as either assets or liabilities and measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. For derivative instruments designated as cash flow hedges, the effective portion of the gains and losses are initially reported as a component of OCI and subsequently recognized in revenue when the hedged exposure is recognized in revenue. Gains and losses on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in other income (expense), net. For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. 61 PART II Item 8 • Level 2 – inputs are based upon quoted prices for similar instr uments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corrobo rated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interes t rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 investments include commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed secur ities, corporate notes and bonds, and municipal securities . Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets and liabilities include investments in corporate notes and bonds, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure equity investments without readily determinable fair values on a nonrecurring basis. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. Our other current financial assets and current financial liabilities have fair values that approximate their carrying values. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years; computer equipment, two to three years; buildings and improvements, five to 15 years; leasehold improvements, three to 20 years; and furniture and equipment, one to 10 years. Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets, other current liabilities, and operating lease liabilities in our consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in our consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we generally use our incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. 62 PART II Item 8 We have lease agreem ents with lease and non-lease components, which are generally accounted for separately. For certain equipment leases, such as vehicles, we account for the lease and non-lease components as a single lease component. Additionally, for certain equipment lease s, we apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Intangible Assets Our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 20 years. We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Recently Adopted Accounting Guidance Income Taxes – Intra-Entity Asset Transfers In October 2016, the Financial Accounting Standards Board (“FASB”) issued new guidance requiring an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs, rather than when the asset has been sold to an outside party. We adopted the guidance effective July 1, 2018. Adoption of the guidance was applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We recorded a net cumulative-effect adjustment that resulted in an increase in retained earnings of $557 million, which reversed the previous deferral of income tax consequences and recorded new deferred tax assets from intra-entity transfers involving assets other than inventory, partially offset by a U.S. deferred tax liability related to global intangible low-taxed income (“GILTI”). Adoption of the standard resulted in an increase in long-term deferred tax assets of $2.8 billion, an increase in long-term deferred tax liabilities of $2.1 billion, and a reduction in other current assets of $152 million. Adoption of the standard had no impact on cash from or used in operating, financing, or investing on our consolidated cash flows statements. Financial Instruments – Recognition, Measurement, Presentation, and Disclosure In January 2016, the FASB issued a new standard related to certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most prominent among the changes in the standard is the requirement for changes in the fair value of our equity investments, with certain exceptions, to be recognized through net income rather than OCI. We adopted the standard effective July 1, 2018. Adoption of the standard was applied using a modified retrospective approach through a cumulative-effect adjustment from accumulated other comprehensive income (“AOCI”) to retained earnings as of the effective date, and we elected to measure equity investments without readily determinable fair values at cost with adjustments for observable changes in price or impairments. The cumulative-effect adjustment included any previously held unrealized gains and losses held in AOCI related to our equity investments carried at fair value as well as the impact of recording the fair value of certain equity investments carried at cost. The impact on our consolidated balance sheets upon adoption was not material. Adoption of the standard had no impact on cash from or used in operating, financing, or investing on our consolidated cash flows statements. 63 PART II Item 8 Recent Accounting Guid ance Not Yet Adopted Financial Instruments – Targeted Improvements to Accounting for Hedging Activities In August 2017, the FASB issued new guidance related to accounting for hedging activities. This guidance expands strategies that qualify for hedge accounting, changes how many hedging relationships are presented in the financial statements, and simplifies the application of hedge accounting in certain situations. The standard will be effective for us beginning July 1, 2019, with early adoption permitted for any interim or annual period before the effective date. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We evaluated the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems, and do not expect the impact to be material upon adoption. Financial Instruments – Credit Losses In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We will be required to use a forward-looking expected credit loss model for accounts receivables, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The standard will be adopted upon the effective date for us beginning July 1, 2020. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date to align our credit loss methodology with the new standard. We are currently evaluating the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2019 2018 2017 Net income available for common shareholders (A) $ 39,240 $ 16,571 $ 25,489 Weighted average outstanding shares of common stock (B) 7,673 7,700 7,746 Dilutive effect of stock-based awards 80 94 86 Common stock and common stock equivalents (C) 7,753 7,794 7,832 Earnings Per Share Basic (A/B) $ 5.11 $ 2.15 $ 3.29 Diluted (A/C) $ 5.06 $ 2.13 $ 3.25 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. 64 PART II Item 8 NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Interest and dividends income $ 2,762 $ 2,214 $ 1,387 Interest expense (2,686 ) (2,733 ) (2,222 ) Net recognized gains on investments 648 2,399 2,583 Net gains (losses) on derivatives 144 (187 ) (510 ) Net losses on foreign currency remeasurements (82 ) (218 ) (111 ) Other, net (57 ) (59 ) (251 ) Total $ 729 $ 1,416 $ 876 Net Recognized Gains (Losses) on Investments Net recognized gains (losses) on debt investments were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Realized gains from sales of available-for-sale securities $ 12 $ 27 $ 108 Realized losses from sales of available-for-sale securities (93 ) (987 ) (162 ) Other-than-temporary impairments of investments (16 ) (6 ) (14 ) Total $ (97 ) $ (966 ) $ (68 ) Net recognized gains (losses) on equity investments were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Net realized gains on investments sold $ 276 $ 3,406 $ 2,692 Net unrealized gains on investments still held 479 0 0 Impairments of investments (10 ) (41 ) (41 ) Total $ 745 $ 3,365 $ 2,651 65 PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments were as follows: (In millions) Fair Value Level Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2019 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 2,211 $ 0 $ 0 $ 2,211 $ 1,773 $ 438 $ 0 Certificates of deposit Level 2 2,018 0 0 2,018 1,430 588 0 U.S. government securities Level 1 104,925 1,854 (104 ) 106,675 769 105,906 0 U.S. agency securities Level 2 988 0 0 988 698 290 0 Foreign government bonds Level 2 6,350 4 (8 ) 6,346 2,506 3,840 0 Mortgage- and asset-backed securities Level 2 3,554 10 (3 ) 3,561 0 3,561 0 Corporate notes and bonds Level 2 7,437 111 (7 ) 7,541 0 7,541 0 Corporate notes and bonds Level 3 15 0 0 15 0 15 0 Municipal securities Level 2 242 48 0 290 0 290 0 Municipal securities Level 3 7 0 0 7 0 7 0 Total debt investments $ 127,747 $ 2,027 $ (122 ) $ 129,652 $ 7,176 $ 122,476 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 973 $ 409 $ 0 $ 564 Equity investments Other 2,085 0 0 2,085 Total equity investments $ 3,058 $ 409 $ 0 $ 2,649 Cash $ 3,771 $ 3,771 $ 0 $ 0 Derivatives, net (a) (13 ) 0 (13 ) 0 Total $ 136,468 $ 11,356 $ 122,463 $ 2,649 66 PART II Item 8 (In millions) Fair Value Level Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2018 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 2,513 $ 0 $ 0 $ 2,513 $ 2,215 $ 298 $ 0 Certificates of deposit Level 2 2,058 0 0 2,058 1,865 193 0 U.S. government securities Level 1 108,120 62 (1,167 ) 107,015 2,280 104,735 0 U.S. agency securities Level 2 1,742 0 0 1,742 1,398 344 0 Foreign government bonds Level 1 22 0 0 22 0 22 0 Foreign government bonds Level 2 5,063 1 (10 ) 5,054 0 5,054 0 Mortgage- and asset-backed securities Level 2 3,864 4 (13 ) 3,855 0 3,855 0 Corporate notes and bonds Level 2 6,929 21 (56 ) 6,894 0 6,894 0 Corporate notes and bonds Level 3 15 0 0 15 0 15 0 Municipal securities Level 2 271 37 (1 ) 307 0 307 0 Total debt investments $ 130,597 $ 125 $ (1,247 ) $ 129,475 $ 7,758 $ 121,717 $ 0 Equity investments Level 1 $ 533 $ 246 $ 0 $ 287 Equity investments Level 3 18 0 0 18 Equity investments Other 1,558 0 1 1,557 Total equity investments $ 2,109 $ 246 $ 1 $ 1,862 Cash $ 3,942 $ 3,942 $ 0 $ 0 Derivatives, net (a) 104 0 104 0 Total $ 135,630 $ 11,946 $ 121,822 $ 1,862 (a) Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments. Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of June 30, 2019 and 2018, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $1.2 billion and $697 million, respectively. As of June 30, 2019, we had no collateral received under agreements for loaned securities. As of June 30, 2018, collateral received under agreements for loaned securities was $1.8 billion and primarily comprised U.S. government and agency securities. Unrealized Losses on Debt Investments Debt investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2019 U.S. government and agency securities $ 1,491 $ (1 ) $ 39,158 $ (103 ) $ 40,649 $ (104 ) Foreign government bonds 25 0 77 (8 ) 102 (8 ) Mortgage- and asset-backed securities 664 (1 ) 378 (2 ) 1,042 (3 ) Corporate notes and bonds 498 (3 ) 376 (4 ) 874 (7 ) Total $ 2,678 $ (5 ) $ 39,989 $ (117 ) $ 42,667 $ (122 ) 67 PART II Item 8 Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2018 U.S. government and agency securities $ 82,352 $ (1,064 ) $ 4,459 $ (103 ) $ 86,811 $ (1,167 ) Foreign government bonds 3,457 (7 ) 13 (3 ) 3,470 (10 ) Mortgage- and asset-backed securities 2,072 (9 ) 96 (4 ) 2,168 (13 ) Corporate notes and bonds 3,111 (43 ) 301 (13 ) 3,412 (56 ) Municipal securities 45 (1 ) 0 0 45 (1 ) Total $ 91,037 $ (1,124 ) $ 4,869 $ (123 ) $ 95,906 $ (1,247 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2019 Due in one year or less $ 53,200 $ 53,124 Due after one year through five years 47,016 47,783 Due after five years through 10 years 26,658 27,824 Due after 10 years 873 921 Total $ 127,747 $ 129,652 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. Foreign Currency Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. Equity Securities held in our equity investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. In the past, to hedge our price risk, we also used and designated equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. 68 PART II Item 8 Other Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments. In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2019, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted. The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents: (In millions) June 30, 2019 June 30, 2018 Designated as Hedging Instruments Foreign exchange contracts sold $ 6,034 $ 11,101 Not Designated as Hedging Instruments Foreign exchange contracts purchased 14,889 9,425 Foreign exchange contracts sold 15,614 13,374 Equity contracts purchased 680 49 Equity contracts sold 5 5 Other contracts purchased 1,327 878 Other contracts sold 451 472 69 PART II Item 8 Fair Values of Derivative Instruments The following table presents our derivative instruments: Derivative Derivative Derivative Derivative (In millions) Assets Liabilities Assets Liabilities June 30, 2019 June 30, 2018 Changes in Fair Value Recorded in Other Comprehensive Income Designated as Hedging Instruments Foreign exchange contracts $ 0 $ 0 $ 174 $ 0 Changes in Fair Value Recorded in Net Income Designated as Hedging Instruments Foreign exchange contracts 0 (93 ) 95 0 Not Designated as Hedging Instruments Foreign exchange contracts 204 (172 ) 256 (197 ) Equity contracts 38 0 2 (7 ) Other contracts 8 (7 ) 11 (3 ) Gross amounts of derivatives 250 (272 ) 538 (207 ) Gross amounts of derivatives offset in the balance sheet (113 ) 114 (152 ) 153 Cash collateral received 0 (78 ) 0 (235 ) Net amounts of derivatives $ 137 $ (236 ) $ 386 $ (289 ) Reported as Short-term investments $ (13 ) $ 0 $ 104 $ 0 Other current assets 146 0 260 0 Other long-term assets 4 0 22 0 Other current liabilities 0 (221 ) 0 (288 ) Other long-term liabilities 0 (15 ) 0 (1 ) Total $ 137 $ (236 ) $ 386 $ (289 ) Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $247 million and $272 million, respectively, as of June 30, 2019, and $533 million and $207 million, respectively, as of June 30, 2018. The following table presents the fair value of our derivatives instruments on a gross basis: (In millions) Level 1 Level 2 Level 3 Total June 30, 2019 Derivative assets $ 0 $ 247 $ 3 $ 250 Derivative liabilities 0 (272 ) 0 (272 ) June 30, 2018 Derivative assets 1 535 2 538 Derivative liabilities (1 ) (206 ) 0 (207 ) 70 PART II Item 8 Fair Value Hedge Gains (Losses) We recognized in other income (expense), net the following gains (losses) on contracts designated as fair value hedges and their related hedged items: (In millions) Year Ended June 30, 2019 2018 2017 Foreign Exchange Contracts Derivatives $ 38 $ 25 $ 441 Hedged items 130 78 (386 ) Total amount of ineffectiveness $ 168 $ 103 $ 55 Equity Contracts Derivatives $ 0 $ (324 ) $ (74 ) Hedged items 0 324 74 Total amount of ineffectiveness $ 0 $ 0 $ 0 Amount of equity contracts excluded from effectiveness assessment $ 0 $ 80 $ (80 ) Cash Flow Hedge Gains (Losses) We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges: (In millions) Year Ended June 30, 2019 2018 2017 Effective Portion Gains recognized in other comprehensive income (loss), net of tax of $1 , $11, and $4 $ 159 $ 219 $ 328 Gains reclassified from accumulated other comprehensive income (loss) into revenue 341 185 555 Amount Excluded from Effectiveness Assessment and Ineffective Portion Losses recognized in other income (expense), net (64 ) (255 ) (389 ) We do not have any net derivative gains included in AOCI as of June 30, 2019 that will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during fiscal year 2019. Non-designated Derivative Gains (Losses) We recognized in other income (expense), net the following gains (losses) on derivatives not designated as hedging instruments: (In millions) Year Ended June 30, 2019 2018 2017 Foreign exchange contracts $ (97 ) $ (33 ) $ (117 ) Equity contracts 3 (87 ) (114 ) Other contracts 35 (17 ) (3 ) Total $ (59 ) $ (137 ) $ (234 ) 71 PART II Item 8 NOTE 6 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2019 2018 Raw materials $ 399 $ 655 Work in process 53 54 Finished goods 1,611 1,953 Total $ 2,063 $ 2,662 NOTE 7 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2019 2018 Land $ 1,540 $ 1,254 Buildings and improvements 26,288 20,604 Leasehold improvements 5,316 4,735 Computer equipment and software 33,823 27,633 Furniture and equipment 4,840 4,457 Total, at cost 71,807 58,683 Accumulated depreciation (35,330 ) (29,223 ) Total, net $ 36,477 $ 29,460 During fiscal years 2019, 2018, and 2017, depreciation expense was $9.7 billion, $7.7 billion, and $6.1 billion, respectively. We have committed $4.0 billion for the construction of new buildings, building improvements, and leasehold improvements as of June 30, 2019. NOTE 8 — BUSINESS COMBINATIONS GitHub, Inc. On October 25, 2018, we acquired GitHub, Inc. (“GitHub”), a software development platform, in a $7.5 billion stock transaction (inclusive of total cash payments of $1.3 billion in respect of vested GitHub equity awards and an indemnity escrow). The acquisition is expected to empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences. The financial results of GitHub have been included in our consolidated financial statements since the date of the acquisition. GitHub is reported as part of our Intelligent Cloud segment. 72 PART II Item 8 The allocation of the purchase price to goodwill was completed as of June 30, 2019. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash, cash equivalents, and short-term investments $ 234 Goodwill 5,497 Intangible assets 1,267 Other assets 143 Other liabilities (217 ) Total $ 6,924 The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth and is not expected to be deductible for tax purposes. We assigned the goodwill to our Intelligent Cloud segment. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Customer-related $ 648 8 years Technology-based 447 5 years Marketing-related 170 10 years Contract-based 2 2 years Total $ 1,267 7 years Transactions recognized separately from the purchase price allocation were approximately $600 million, primarily related to equity awards recognized as expense over the related service period. LinkedIn Corporation On December 8, 2016, we completed our acquisition of all issued and outstanding shares of LinkedIn Corporation (“LinkedIn”), the world’s largest professional network on the Internet, for a total purchase price of $27.0 billion. The purchase price consisted primarily of cash of $26.9 billion. The acquisition is expected to accelerate the growth of LinkedIn, Office 365, and Dynamics 365. The financial results of LinkedIn have been included in our consolidated financial statements since the date of the acquisition. 73 PART II Item 8 The allocation of the purchase price to goodwill was completed as of June 30, 2017. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash and cash equivalents $ 1,328 Short-term investments 2,110 Other current assets 697 Property and equipment 1,529 Intangible assets 7,887 Goodwill ( a ) 16,803 Short-term debt (b) (1,323 ) Other current liabilities (1,117 ) Deferred income taxes (774 ) Other (131 ) Total purchase price $ 27,009 (a) Goodwill was assigned to our Productivity and Business Processes segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of LinkedIn. None of the goodwill is expected to be deductible for income tax purposes. (b) Convertible senior notes issued by LinkedIn on November 12, 2014, substantially all of which were redeemed after our acquisition of LinkedIn. The remaining $18 million of notes are not redeemable and are included in long-term debt in our consolidated balance sheets. Refer to Note 11 – Debt for further information. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Customer-related $ 3,607 7 years Marketing-related (trade names) 2,148 20 years Technology-based 2,109 3 years Contract-based 23 5 years Fair value of intangible assets acquired $ 7,887 9 years Our consolidated income statements include the following revenue and operating loss attributable to LinkedIn since the date of acquisition: (In millions) Year Ended June 30, 2017 Revenue $ 2,271 Operating loss (924 ) Following are the supplemental consolidated financial results of Microsoft Corporation on an unaudited pro forma basis, as if the acquisition had been consummated on July 1, 2015: (In millions, except per share amounts) Year Ended June 30, 2017 2016 Revenue $ 98,291 $ 94,490 Net income 25,179 19,128 Diluted earnings per share 3.21 2.38 These pro forma results were based on estimates and assumptions, which we believe are reasonable. They are not the results that would have been realized had we been a combined company during the periods presented and are not necessarily indicative of our consolidated results of operations in future periods. The pro forma results include adjustments related to purchase accounting, primarily amortization of intangible assets. Acquisition costs and other nonrecurring charges were immaterial and are included in the earliest period presented. 74 PART II Item 8 Other During fiscal year 2019, we completed 19 additional acquisitions for $1.6 billion, substantially all of which were paid in cash. These entities have been included in our consolidated results of operations since their respective acquisition dates. NOTE 9 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2017 Acquisitions Other June 30, 2018 Acquisitions Other June 30, 2019 Productivity and Business Processes $ 23,739 $ 72 $ 12 $ 23,823 $ 514 $ (60 ) $ 24,277 Intelligent Cloud 5,555 164 (16 ) 5,703 5,605 (a) 43 (a) 11,351 More Personal Computing 5,828 394 (65 ) 6,157 289 (48 ) 6,398 Total $ 35,122 $ 630 $ (69 ) $ 35,683 $ 6,408 $ (65 ) $ 42,026 (a) Includes goodwill of $5.5 billion related to GitHub. See Note 8 – Business Combinations for further information. The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2019, May 1, 2018, or May 1, 2017 tests. As of June 30, 2019 and 2018, accumulated goodwill impairment was $11.3 billion. NOTE 10 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2019 2018 Technology-based $ 7,691 $ (5,771 ) $ 1,920 $ 7,220 $ (5,018 ) $ 2,202 Customer-related 4,709 (1,785 ) 2,924 4,031 (1,205 ) 2,826 Marketing-related 4,165 (1,327 ) 2,838 4,006 (1,071 ) 2,935 Contract-based 574 (506 ) 68 679 (589 ) 90 Total $ 17,139 (a) $ (9,389 ) $ 7,750 $ 15,936 $ (7,883 ) $ 8,053 (a) Includes intangible assets of $1.3 billion related to GitHub. See Note 8 – Business Combinations for further information. No material impairments of intangible assets were identified during fiscal years 2019, 2018, or 2017. We estimate that we have no significant residual value related to our intangible assets. 75 PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2019 2018 Technology-based $ 814 5 years $ 178 4 years Marketing-related 177 10 years 14 5 years Contract-based 7 3 years 14 4 years Customer-related 710 8 years 13 5 years Total $ 1,708 7 years $ 219 5 years Intangible assets amortization expense was $1.9 billion, $2.2 billion, and $1.7 billion for fiscal years 2019, 2018, and 2017, respectively. The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2019: (In millions) Year Ending June 30, 2020 $ 1,488 2021 1,282 2022 1,187 2023 1,053 2024 737 Thereafter 2,003 Total $ 7,750 NOTE 11 — DEBT Short-term Debt As of June 30, 2019 and 2018, we had no commercial paper issued or outstanding. Effective August 31, 2018, we terminated our credit facilities, which served as back-up for our commercial paper program. Long-term Debt As of June 30, 2019, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $72.2 billion and $78.9 billion, respectively. As of June 30, 2018, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $76.2 billion and $77.5 billion, respectively. These estimated fair values are based on Level 2 inputs. 76 PART II Item 8 The components of our long-term debt, including the current portion, and the associated interest rates were as follows: (In millions, except interest rates) Face Value June 30, 2019 Face Value June 30, 2018 Stated Interest Rate Effective Interest Rate Notes November 3, 2018 $ 0 $ 1,750 1.300% 1.396% December 6, 2018 0 1,250 1.625% 1.824% June 1, 2019 0 1,000 4.200% 4.379% August 8, 2019 2,500 2,500 1.100% 1.203% November 1, 2019 18 18 0.500% 0.500% February 6, 2020 1,500 1,500 1.850% 1.952% February 12, 2020 1,500 1,500 1.850% 1.935% October 1, 2020 1,000 1,000 3.000% 3.137% November 3, 2020 2,250 2,250 2.000% 2.093% February 8, 2021 500 500 4.000% 4.082% August 8, 2021 2,750 2,750 1.550% 1.642% December 6, 2021 (a) 1,994 2,044 2.125% 2.233% February 6, 2022 1,750 1,750 2.400% 2.520% February 12, 2022 1,500 1,500 2.375% 2.466% November 3, 2022 1,000 1,000 2.650% 2.717% November 15, 2022 750 750 2.125% 2.239% May 1, 2023 1,000 1,000 2.375% 2.465% August 8, 2023 1,500 1,500 2.000% 2.101% December 15, 2023 1,500 1,500 3.625% 3.726% February 6, 2024 2,250 2,250 2.875% 3.041% February 12, 2025 2,250 2,250 2.700% 2.772% November 3, 2025 3,000 3,000 3.125% 3.176% August 8, 2026 4,000 4,000 2.400% 2.464% February 6, 2027 4,000 4,000 3.300% 3.383% December 6, 2028 (a) 1,993 2,044 3.125% 3.218% May 2, 2033 (a) 626 642 2.625% 2.690% February 12, 2035 1,500 1,500 3.500% 3.604% November 3, 2035 1,000 1,000 4.200% 4.260% August 8, 2036 2,250 2,250 3.450% 3.510% February 6, 2037 2,500 2,500 4.100% 4.152% June 1, 2039 750 750 5.200% 5.240% October 1, 2040 1,000 1,000 4.500% 4.567% February 8, 2041 1,000 1,000 5.300% 5.361% November 15, 2042 900 900 3.500% 3.571% May 1, 2043 500 500 3.750% 3.829% December 15, 2043 500 500 4.875% 4.918% February 12, 2045 1,750 1,750 3.750% 3.800% November 3, 2045 3,000 3,000 4.450% 4.492% August 8, 2046 4,500 4,500 3.700% 3.743% February 6, 2047 3,000 3,000 4.250% 4.287% February 12, 2055 2,250 2,250 4.000% 4.063% November 3, 2055 1,000 1,000 4.750% 4.782% August 8, 2056 2,250 2,250 3.950% 4.033% February 6, 2057 2,000 2,000 4.500% 4.528% Total $ 72,781 $ 76,898 (a) Euro-denominated debt securities. The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. Cash paid for interest on our debt for fiscal years 2019, 2018, and 2017 was $2.4 billion, $2.4 billion, and $1.6 billion, respectively. As of June 30, 2019 and 2018, the aggregate debt issuance costs and unamortized discount associated with our long-term debt, including the current portion, were $603 million and $658 million, respectively. 77 PART II Item 8 Maturities of our long-term debt for each of the next five years and thereafter are as follows: (In millions) Year Ending June 30, 2020 $ 5,518 2021 3,750 2022 7,994 2023 2,750 2024 5,250 Thereafter 47,519 Total $ 72,781 NOTE 12 — INCOME TAXES Tax Cuts and Jobs Act On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. In fiscal year 2018, the TCJA required us to incur a transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. In addition, the TCJA subjected us to a tax on our GILTI effective July 1, 2018. Under GAAP, we can make an accounting policy election to either treat taxes due on the GILTI inclusion as a current period expense or factor such amounts into our measurement of deferred taxes. We elected the deferred method, under which we recorded the corresponding deferred tax assets and liabilities on our consolidated balance sheets. During fiscal year 2018, we recorded a net charge of $13.7 billion related to the enactment of the TCJA, due to the impact of the one-time transition tax on the deemed repatriation of deferred foreign income of $17.9 billion, offset in part by the impact of changes in the tax rate of $4.2 billion, primarily on deferred tax assets and liabilities. During the second quarter of fiscal year 2019, we recorded additional tax expense of $157 million, which related to completing our provisional accounting for GILTI deferred taxes pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 118. In the fourth quarter of fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland. The transfers of intangible properties resulted in a $2.6 billion net income tax benefit recorded in the fourth quarter of fiscal year 2019, as the value of future tax deductions exceeded the current tax liability from foreign jurisdictions and U.S. GILTI tax. 78 PART II Item 8 Provision for Income Taxes The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Current Taxes U.S. federal $ 4,718 $ 19,764 $ 2,739 U.S. state and local 662 934 30 Foreign 5,531 4,348 2,472 Current taxes $ 10,911 $ 25,046 $ 5,241 Deferred Taxes U.S. federal $ (5,647 ) $ (4,292 ) $ (554 ) U.S. state and local (1,010 ) (458 ) 269 Foreign 194 (393 ) (544 ) Deferred taxes $ (6,463 ) $ (5,143 ) $ (829 ) Provision for income taxes $ 4,448 $ 19,903 $ 4,412 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2019 2018 2017 U.S. $ 15,799 $ 11,527 $ 6,843 Foreign 27,889 24,947 23,058 Income before income taxes $ 43,688 $ 36,474 $ 29,901 Effective Tax Rate The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2019 2018 2017 Federal statutory rate 21.0% 28.1% 35.0% Effect of: Foreign earnings taxed at lower rates (4.1)% (7.8)% (11.6)% Impact of the enactment of the TCJA 0.4% 37.7% 0% Phone business losses 0% 0% (5.7)% Impact of intangible property transfers (5.9)% 0% 0% Foreign-derived intangible income deduction (1.4)% 0% 0% Research and development credit (1.1)% (1.3)% (0.9)% Excess tax benefits relating to stock-based compensation (2.2)% (2.5)% (2.1)% Interest, net 1.0% 1.2% 1.4% Other reconciling items, net 2.5% (0.8)% (1.3)% Effective rate 10.2% 54.6% 14.8% 79 PART II Item 8 The decrease from the federal statutory rate in fiscal year 2019 is primarily due to a $2.6 billion net income tax benefit related to intangible property transfers , and earnings taxed at lower rates in foreign jurisdictions resulting from producing and dis tributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico . The increase from the federal statutory rate in fiscal year 2018 is primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018 , offset in part by earnings taxed at lower rates in foreign jurisdictions. The decrease from the federal statutory rate in fiscal year 2017 is primarily due to earnings taxed at lower rates in foreign jurisdictions. Our foreign regional operating centers in Ireland, Singapore and Puerto Rico , which are taxed at rates lower than the U.S. rate, generated 82 %, 8 7 %, and 76 % of our foreign income b efore tax in fiscal years 2019, 2018, and 2017, respectively. Other reconciling items, net consists primarily of tax credits, GILTI, and U.S. state income taxes. In fiscal years 2019, 2018, and 2017, there were no individually significant other reconciling items. The decrease in our effective tax rate for fiscal year 2019 compared to fiscal year 2018 was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018, and a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. The increase in our effective tax rate for fiscal year 2018 compared to fiscal year 2017 was primarily due to the net charge related to the enactment of the TCJA and the realization of tax benefits attributable to previous Phone business losses in fiscal year 2017. The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2019 2018 Deferred Income Tax Assets Stock-based compensation expense $ 406 $ 460 Accruals, reserves, and other expenses 2,287 1,832 Loss and credit carryforwards 3,518 3,369 Depreciation and amortization 7,046 351 Leasing liabilities 1,594 1,427 Unearned revenue 475 0 Other 367 56 Deferred income tax assets 15,693 7,495 Less valuation allowance (3,214 ) (3,186 ) Deferred income tax assets, net of valuation allowance $ 12,479 $ 4,309 Deferred Income Tax Liabilities Unrealized gain on investments and debt $ (738 ) $ 0 Unearned revenue (30 ) (639 ) Depreciation and amortization 0 (1,164 ) Leasing assets (1,510 ) (1,366 ) Deferred GILTI tax liabilities (2,607 ) (61 ) Other (291 ) (251 ) Deferred income tax liabilities $ (5,176 ) $ (3,481 ) Net deferred income tax assets (liabilities) $ 7,303 $ 828 Reported As Other long-term assets $ 7,536 $ 1,369 Long-term deferred income tax liabilities (233 ) (541 ) Net deferred income tax assets (liabilities) $ 7,303 $ 828 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. 80 PART II Item 8 As of J une 30, 2019, we had federal, state and foreign net operating loss carryforwards of $ 978 million, $ 770 million, and $11. 6 billion, respectively. The federal and state net operating loss carryforwards will expire in various years from fiscal 20 20 through 203 9 , if not utilized. The majority of our foreign net operating loss carryforwards do not expire. Certain acquired net operating loss carryforwards are subject to an annual limitation, but are expected to be realized with the exception of those which have a valuation allowance. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and other net deferred tax assets that may not be realized. Income taxes paid, net of refunds, were $8.4 billion, $5.5 billion, and $2.4 billion in fiscal years 2019, 2018, and 2017, respectively. Uncertain Tax Positions Gross unrecognized tax benefits related to uncertain tax positions as of June 30, 2019, 2018, and 2017, were $13.1 billion, $12.0 billion, and $11.7 billion, respectively, which were primarily included in long-term income taxes in our consolidated balance sheets. If recognized, the resulting tax benefit would affect our effective tax rates for fiscal years 2019, 2018, and 2017 by $12.0 billion, $11.3 billion, and $10.2 billion, respectively. As of June 30, 2019, 2018, and 2017, we had accrued interest expense related to uncertain tax positions of $3.4 billion, $3.0 billion, and $2.3 billion, respectively, net of income tax benefits. The provision for (benefit from) income taxes for fiscal years 2019, 2018, and 2017 included interest expense related to uncertain tax positions of $515 million, $688 million, and $399 million, respectively, net of income tax benefits. The aggregate changes in the gross unrecognized tax benefits related to uncertain tax positions were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Beginning unrecognized tax benefits $ 11,961 $ 11,737 $ 10,164 Decreases related to settlements (316 ) (193 ) (4 ) Increases for tax positions related to the current year 2,106 1,445 1,277 Increases for tax positions related to prior years 508 151 397 Decreases for tax positions related to prior years (1,113 ) (1,176 ) (49 ) Decreases due to lapsed statutes of limitations 0 (3 ) (48 ) Ending unrecognized tax benefits $ 13,146 $ 11,961 $ 11,737 We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under audit for tax years 2004 to 2013. We expect the IRS to begin an examination of tax years 2014 to 2017 within the next 12 months. As of June 30, 2019, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact on our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2018, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NOTE 13 — RESTRUCTURING CHARGES In June 2017, management approved a sales and marketing restructuring plan. In fiscal year 2017, we recorded employee severance expenses of $306 million primarily related to this sales and marketing restructuring plan. The actions associated with this restructuring plan were completed as of June 30, 2018. 81 PART II Item 8 NOTE 14 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2019 2018 Productivity and Business Processes $ 16,831 $ 14,864 Intelligent Cloud 16,988 14,706 More Personal Computing 3,387 3,150 Total $ 37,206 $ 32,720 Changes in unearned revenue were as follows: (In millions) Year Ended June 30, 2019 Balance, beginning of period $ 32,720 Deferral of revenue 69,493 Recognition of unearned revenue (65,007 ) Balance, end of period $ 37,206 Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized (“contracted not recognized revenue”), which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods. Contracted not recognized revenue was $91 billion as of June 30, 2019, of which we expect to recognize approximately 50% of the revenue over the next 12 months and the remainder thereafter. Many customers are committing to our products and services for longer contract terms, which is increasing the percentage of contracted revenue that will be recognized beyond the next 12 months. NOTE 15 — LEASES We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. Our leases have remaining lease terms of 1 year to 20 years, some of which include options to extend the leases for up to 5 years, and some of which include options to terminate the leases within 1 year. The components of lease expense were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Operating lease cost $ 1,707 $ 1,585 $ 1,412 Finance lease cost: Amortization of right-of-use assets $ 370 $ 243 $ 104 Interest on lease liabilities 247 175 68 Total finance lease cost $ 617 $ 418 $ 172 82 PART II Item 8 Supplemental cash flow information related to leases was as follows: (In millions) Year Ended June 30, 2019 2018 2017 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 1,670 $ 1,522 $ 1,157 Operating cash flows from finance leases 247 175 68 Financing cash flows from finance leases 221 144 46 Right-of-use assets obtained in exchange for lease obligations: Operating leases 2,303 1,571 1,270 Finance leases 2,532 1,933 1,773 Supplemental balance sheet information related to leases was as follows: (In millions, except lease term and discount rate) June 30, 2019 2018 Operating Leases Operating lease right-of-use assets $ 7,379 $ 6,686 Other current liabilities $ 1,515 $ 1,399 Operating lease liabilities 6,188 5,568 Total operating lease liabilities $ 7,703 $ 6,967 Finance Leases Property and equipment, at cost $ 7,041 $ 4,543 Accumulated depreciation (774 ) (404 ) Property and equipment, net $ 6,267 $ 4,139 Other current liabilities $ 317 $ 176 Other long-term liabilities 6,257 4,125 Total finance lease liabilities $ 6,574 $ 4,301 Weighted Average Remaining Lease Term Operating leases 7 years 7 years Finance leases 13 years 13 years Weighted Average Discount Rate Operating leases 3.0% 2.7% Finance leases 4.6% 5.2% Maturities of lease liabilities were as follows: (In millions) Year Ending June 30, Operating Leases Finance Leases 2020 $ 1,678 $ 591 2021 1,438 616 2022 1,235 626 2023 1,036 631 2024 839 641 Thereafter 2,438 5,671 Total lease payments 8,664 8,776 Less imputed interest (961 ) (2,202 ) Total $ 7,703 $ 6,574 83 PART II Item 8 As of June 30 , 201 9 , we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $ 2.3 billion and $ 6.1 billion, respectively. These operating and finance leases will commence between fiscal year 20 20 and fiscal year 202 2 with lease terms of 1 year to 15 years. NOTE 16 — CONTINGENCIES Patent and Intellectual Property Claims There were 44 patent infringement cases pending against Microsoft as of June 30, 2019, none of which are material individually or in aggregate. Antitrust, Unfair Competition, and Overcharge Class Actions Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010. The trial of the British Columbia action commenced in May 2016. Following a mediation, the parties agreed to a global settlement of all three Canadian actions, and submitted the proposed settlement agreement to the courts in all three jurisdictions for approval. The final settlement has been approved by the courts in British Columbia, Ontario, and Quebec, and the claims administration process will commence. Other Antitrust Litigation and Claims China State Administration for Industry and Commerce Investigatio n In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. The SAMR has presented its preliminary views as to certain possible violations of China's Anti-Monopoly Law, and discussions are expected to continue. Product-Related Litigation U.S. Cell Phone Litigation Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 40 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. In August 2018, the trial court issued an order striking portions of the plaintiffs’ expert reports. A hearing is expected to be scheduled in the second half of calendar year 2019. 84 PART II Item 8 Employment-Related Lit igation Moussouris v. Microsoft Current and former female Microsoft employees in certain engineering and information technology roles brought this class action in federal court in Seattle in 2015, alleging systemic gender discrimination in pay and promotions. The plaintiffs moved to certify the class in October 2017. Microsoft filed an opposition in January 2018, attaching an expert report showing no statistically significant disparity in pay and promotions between similarly situated men and women. In June 2018, the court denied the plaintiffs’ motion for class certification. Plaintiffs sought an interlocutory appeal to the U.S. Court of Appeals for the Ninth Circuit, which was granted in September 2018. Oral argument is scheduled for October 2019. Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2019, we accrued aggregate legal liabilities of $386 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.0 billion in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable. NOTE 17 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Balance, beginning of year 7,677 7,708 7,808 Issued 116 68 70 Repurchased (150 ) (99 ) (170 ) Balance, end of year 7,643 7,677 7,708 Share Repurchases On September 16, 2013, our Board of Directors approved a share repurchase program (“2013 Share Repurchase Program”) authorizing up to $40.0 billion in share repurchases. The 2013 Share Repurchase Program became effective on October 1, 2013, and was completed on December 22, 2016. On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to an additional $40.0 billion in share repurchases (“2016 Share Repurchase Program”). This share repurchase program commenced on December 22, 2016 following completion of the 2013 Share Repurchase Program, has no expiration date, and may be suspended or discontinued at any time without notice. As of June 30, 2019, $11.4 billion remained of the 2016 Share Repurchase Program. 85 PART II Item 8 We repurchased the following shares of common stock under the share repurchase prog rams: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2019 2018 2017 First Quarter 24 $ 2,600 22 $ 1,600 63 $ 3,550 Second Quarter 57 6,100 22 1,800 59 3,533 Third Quarter 36 3,899 34 3,100 25 1,600 Fourth Quarter 33 4,200 21 2,100 23 1,600 Total 150 $ 16,799 99 $ 8,600 170 $ 10,283 Shares repurchased in the first and second quarter of fiscal year 2017 were under the 2013 Share Repurchase Program. All other shares repurchased were under the 2016 Share Repurchase Program. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards of $2.7 billion, $2.1 billion, and $1.5 billion for fiscal years 2019, 2018, and 2017, respectively. All share repurchases were made using cash resources. Dividends Our Board of Directors declared the following dividends: Declaration Date Record Date Payment Date Dividend Per Share Amount Fiscal Year 2019 (In millions) September 18, 2018 November 15, 2018 December 13, 2018 $ 0.46 $ 3,544 November 28, 2018 February 21, 2019 March 14, 2019 0.46 3,526 March 11, 2019 May 16, 2019 June 13, 2019 0.46 3,521 June 12, 2019 August 15, 2019 September 12, 2019 0.46 3,516 Total $ 1.84 $ 14,107 Fiscal Year 2018 September 19, 2017 November 16, 2017 December 14, 2017 $ 0.42 $ 3,238 November 29, 2017 February 15, 2018 March 8, 2018 0.42 3,232 March 12, 2018 May 17, 2018 June 14, 2018 0.42 3,226 June 13, 2018 August 16, 2018 September 13, 2018 0.42 3,220 Total $ 1.68 $ 12,916 The dividend declared on June 12, 2019 was included in other current liabilities as of June 30, 2019. 86 PART II Item 8 NOTE 1 8 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table summarizes the changes in accumulated other comprehensive income (loss) by component: (In millions) Year Ended June 30, 2019 2018 2017 Derivatives Balance, beginning of period $ 173 $ 134 $ 352 Unrealized gains, net of tax of $2 , $11, and $4 160 218 328 Reclassification adjustments for gains included in revenue (341 ) (185 ) (555 ) Tax expense included in provision for income taxes 8 6 9 Amounts reclassified from accumulated other comprehensive income (loss) (333 ) (179 ) (546 ) Net change related to derivatives, net of tax of $(6), $5, and $(5) (173 ) 39 (218 ) Balance, end of period $ 0 $ 173 $ 134 Investments Balance, beginning of period $ (850 ) $ 1,825 $ 2,941 Unrealized gains (losses), net of tax of $616 , $(427), and $267 2,331 (1,146 ) 517 Reclassification adjustments for (gains) losses included in other income (expense), net 93 (2,309 ) (2,513 ) Tax expense (benefit) included in provision for income taxes (19 ) 738 880 Amounts reclassified from accumulated other comprehensive income (loss) 74 (1,571 ) (1,633 ) Net change related to investments, net of tax of $635 , $(1,165), and $(613) 2,405 (2,717 ) (1,116 ) Cumulative effect of accounting changes (67 ) 42 0 Balance, end of period $ 1,488 $ (850 ) $ 1,825 Translation Adjustments and Other Balance, beginning of period $ (1,510 ) $ (1,332 ) $ (1,499 ) Translation adjustments and other, net of tax effects of $(1) , $0, and $9 (318 ) (178 ) 167 Balance, end of period $ (1,828 ) $ (1,510 ) $ (1,332 ) Accumulated other comprehensive income (loss), end of period $ (340 ) $ (2,187 ) $ 627 NOTE 19 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. As of June 30, 2019, an aggregate of 327 million shares were authorized for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2019 2018 2017 Stock-based compensation expense $ 4,652 $ 3,940 $ 3,266 Income tax benefits related to stock-based compensation 816 823 1,066 87 PART II Item 8 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a four or five-year service period. Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a four-year service period. PSUs generally vest over a three-year performance period. The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for All Stock Plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year Ended June 30, 2019 2018 2017 Dividends per share (quarterly amounts) $0.42 - $0.46 $0.39 - $0.42 $0.36 - $0.39 Interest rates 1.8% - 3.1% 1.7% - 2.9% 1.2% - 2.2% During fiscal year 2019, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 174 $ 57.85 Granted (a) 63 107.02 Vested (77 ) 57.08 Forfeited (13 ) 69.35 Nonvested balance, end of year 147 $ 78.49 (a) Includes 2 million, 3 million, and 2 million of PSUs granted at target and performance adjustments above target levels for fiscal years 2019, 2018, and 2017, respectively. As of June 30, 2019, there was approximately $8.6 billion of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of 3 years. The weighted average grant-date fair value of stock awards granted was $107.02, $75.88, and $55.64 for fiscal years 2019, 2018, and 2017, respectively. The fair value of stock awards vested was $8.7 billion, $6.6 billion, and $4.8 billion, for fiscal years 2019, 2018, and 2017, respectively. Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2019 2018 2017 Shares purchased 11 13 13 Average price per share $ 104.85 $ 76.40 $ 56.36 As of June 30, 2019, 105 million shares of our common stock were reserved for future issuance through the ESPP. 88 PART II Item 8 Savings Plan We have savings plans in the U.S. that qualify under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Eligible U.S. employees may contribute a portion of their salary into the savings plans, subject to certain limitations. We contribute fifty cents for each dollar a participant contributes into the plans, with a maximum employer contribution of 50% of the IRS contribution limit for the calendar year. Employer-funded retirement benefits for all plans were $877 million, $807 million, and $734 million in fiscal years 2019, 2018, and 2017, respectively, and were expensed as contributed. NOTE 20 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”). • Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises: • Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, GitHub, and Azure. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. More Personal Computing Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises: • Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things (“IoT”); and MSN advertising. • Devices, including Microsoft Surface, PC accessories, and other intelligent devices. • Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, cloud services, and advertising (“Xbox Live”), video games, and third-party video game royalties. • Search. 89 PART II Item 8 Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments, including restructuring expenses. Segment revenue and operating income were as follows during the periods presented: (In millions) Year Ended June 30, 2019 2018 2017 Revenue Productivity and Business Processes $ 41,160 $ 35,865 $ 29,870 Intelligent Cloud 38,985 32,219 27,407 More Personal Computing 45,698 42,276 39,294 Total $ 125,843 $ 110,360 $ 96,571 Operating Income (Loss) Productivity and Business Processes $ 16,219 $ 12,924 $ 11,389 Intelligent Cloud 13,920 11,524 9,127 More Personal Computing 12,820 10,610 8,815 Corporate and Other 0 0 (306 ) Total $ 42,959 $ 35,058 $ 29,025 Corporate and Other operating loss comprised restructuring expenses. No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for fiscal years 2019, 2018, or 2017. Revenue, classified by the major geographic areas in which our customers were located, was as follows: (In millions) Year Ended June 30, 2019 2018 2017 United States (a) $ 64,199 $ 55,926 $ 51,078 Other countries 61,644 54,434 45,493 Total $ 125,843 $ 110,360 $ 96,571 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. 90 PART II Item 8 Revenue from external customers, classified by significant product and service offerings, was as follows: (In millions) Year Ended June 30, 2019 2018 2017 Server products and cloud services $ 32,622 $ 26,129 $ 21,649 Office products and cloud services 31,769 28,316 25,573 Windows 20,395 19,518 18,593 Gaming 11,386 10,353 9,051 Search advertising 7,628 7,012 6,219 LinkedIn 6,754 5,259 2,271 Enterprise Services 6,124 5,846 5,542 Devices 6,095 5,134 5,062 Other 3,070 2,793 2,611 Total $ 125,843 $ 110,360 $ 96,571 Our commercial cloud revenue, which includes Office 365 Commercial, Azure, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $38.1 billion, $26.6 billion and $16.2 billion in fiscal years 2019, 2018, and 2017, respectively. These amounts are primarily included in Office products and cloud services, Server products and cloud services, and LinkedIn in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment; it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2019 2018 2017 United States $ 55,252 $ 44,501 $ 42,730 Ireland 12,958 12,843 12,889 Other countries 25,422 22,538 19,898 Total $ 93,632 $ 79,882 $ 75,517 91 PART II Item 8 NOTE 2 1 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2019 Revenue $ 29,084 $ 32,471 $ 30,571 $ 33,717 $ 125,843 Gross margin 19,179 20,048 20,401 23,305 82,933 Operating income 9,955 10,258 10,341 12,405 42,959 Net income (a) 8,824 8,420 8,809 13,187 39,240 Basic earnings per share 1.15 1.09 1.15 1.72 5.11 Diluted earnings per share (b) 1.14 1.08 1.14 1.71 5.06 Fiscal Year 2018 Revenue $ 24,538 $ 28,918 $ 26,819 $ 30,085 $ 110,360 Gross margin 16,260 17,854 17,550 20,343 72,007 Operating income 7,708 8,679 8,292 10,379 35,058 Net income (loss) ( c ) 6,576 (6,302 ) 7,424 8,873 16,571 Basic earnings (loss) per share 0.85 (0.82 ) 0.96 1.15 2.15 Diluted earnings (loss) per share ( d ) 0.84 (0.82 ) 0.95 1.14 2.13 (a) Reflects the $157 million net charge related to the enactment of the TCJA for the second quarter and the $2.6 billion net income tax benefit related to the intangible property transfers for the fourth quarter, which together increased net income by $2.4 billion for fiscal year 2019. See Note 12 – Income Taxes for further information. (b) Reflects the net charge related to the enactment of the TCJA and the net income tax benefit related to the intangible property transfers, which decreased (increased) diluted EPS $0.02 for the second quarter, $(0.34) for the fourth quarter, and $(0.31) for fiscal year 2019. ( c ) Reflects the net charge (benefit) related to the enactment of the TCJA of $13.8 billion for the second quarter, $(104) million for the fourth quarter, and $13.7 billion for fiscal year 2018. ( d ) Reflects the net charge (benefit) related to the enactment of the TCJA, wh ich decreased (increased) diluted EPS $1.78 for the second quarter, $(0.01) for the fourth quarter, and $1.75 for fiscal year 2018. 92 PART II Item 8 REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the “Company”) as of June 30, 2019 and 2018, the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows, for each of the three years in the period ended June 30, 2019, and the related notes (collectively referred to as the “financial statements”). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2019 and 2018, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2019, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the Company's internal control over financial reporting as of June 30, 2019, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated August 1, 2019, expressed an unqualified opinion on the Company's internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the Company’s Audit Committee and that: (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 93 PART II Item 8 Revenue Recognition — Refer to Note 1 to the F inancial S tatements Critical Audit Matter Description The Company recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company offers customers the ability to acquire multiple licenses of software products and services, including cloud-based services, in its customer agreements through its volume licensing programs. Significant judgment is exercised by the Company in determining revenue recognition for these customer agreements, and includes the following: • Determination of whether products and services are considered distinct performance obligations that should be accounted for separately versus together, such as software licenses and related services that are sold with cloud-based services. • Determination of stand-alone selling prices for each distinct performance obligation and for products and services that are not sold separately. • The pattern of delivery (i.e., timing of when revenue is recognized) for each distinct performance obligation. • Estimation of variable consideration when determining the amount of revenue to recognize (e.g., customer credits, incentives, and in certain instances, estimation of customer usage of products and services). Given these factors, the related audit effort in evaluating management’s judgments in determining revenue recognition for these customer agreements was extensive and required a high degree of auditor judgment. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures related to the Company’s revenue recognition for these customer agreements included the following: • We tested the effectiveness of internal controls related to the identification of distinct performance obligations, the determination of the timing of revenue recognition, and the estimation of variable consideration. • We evaluated management’s significant accounting policies related to these customer agreements for reasonableness. • We selected a sample of customer agreements and performed the following procedures: • Obtained and read contract source documents for each selection, including master agreements, and other documents that were part of the agreement. • Tested management’s identification of significant terms for completeness, including the identification of distinct performance obligations and variable consideration. • Assessed the terms in the customer agreement and evaluated the appropriateness of management’s application of their accounting policies, along with their use of estimates, in the determination of revenue recognition conclusions. • We evaluated the reasonableness of management’s estimate of stand-alone selling prices for products and services that are not sold separately. • We tested the mathematical accuracy of management’s calculations of revenue and the associated timing of revenue recognized in the financial statements. 94 PART II Item 8 Income Taxes — Uncertain Tax Positions — Refer to Note 1 2 to the F inancial S tatements Critical Audit Matter Description The Company’s long-term income taxes liability includes uncertain tax positions related to transfer pricing issues that remain unresolved with the Internal Revenue Service (“IRS”). The Company remains under IRS audit, or subject to IRS audit, for tax years subsequent to 2003. While the Company has settled a portion of the IRS audits, resolution of the remaining matters could have a material impact on the Company’s financial statements. Conclusions on recognizing and measuring uncertain tax positions involve significant estimates and management judgment and include complex considerations of the Internal Revenue Code, related regulations, tax case laws, and prior-year audit settlements. Given the complexity and the subjective nature of the transfer pricing issues that remain unresolved with the IRS, evaluating management’s estimates relating to their determination of uncertain tax positions required extensive audit effort and a high degree of auditor judgment, including involvement of our tax specialists. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures to evaluate management’s estimates of uncertain tax positions related to unresolved transfer pricing issues included the following: • We evaluated the appropriateness and consistency of management’s methods and assumptions used in the identification, recognition, measurement, and disclosure of uncertain tax positions, which included testing the effectiveness of the related internal controls. • We read and evaluated management’s documentation, including relevant accounting policies and information obtained by management from outside tax specialists, that detailed the basis of the uncertain tax positions. • We tested the reasonableness of management’s judgments regarding the future resolution of the uncertain tax positions, including an evaluation of the technical merits of the uncertain tax positions. • For those uncertain tax positions that had not been effectively settled, we evaluated whether management had appropriately considered new information that could significantly change the recognition, measurement or disclosure of the uncertain tax positions. • We evaluated the reasonableness of management’s estimates by considering how tax law, including statutes, regulations and case law, impacted management’s judgments. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 1, 2019 We have served as the Company’s auditor since 1983. 95 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOU NTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our consolidated financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our consolidated financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our consolidated financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of June 30, 2019. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2019 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2019; their report is included in Item 9A. 96 PART II Item 9A REPORT OF INDEPENDENT REGIST ERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2019, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2019, based on the criteria established in Internal Control — Integrated Framework (2013) issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated financial statements and the related notes (collectively referred to as the “financial statements”) as of and for the year ended June 30, 2019, of the Company and our report dated August 1, 2019, expressed an unqualified opinion on those financial statements. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/    D ELOITTE & T OUCHE LLP Seattle, Washington August 1, 2019 97 PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held December 4, 2019 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and other finance organization employees. The finance code of ethics is publicly available on our website at https://aka.ms/FinanceCodeProfessionalConduct. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITE M 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock ownership information,” “Principal shareholders” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 98 PART IV Item 15 ITEM 1 5 . EXHIBITS, FINANC IAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 51 Comprehensive Income Statements 52 Balance Sheets 53 Cash Flows Statements 54 Stockholders’ Equity Statements 55 Notes to Financial Statements 56 Report of Independent Registered Public Accounting Firm 93 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/14/17 4.1 Form of Indenture between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 11/20/08 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/10 99 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 100 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/3/15 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 8/5/16 101 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/17 4.16 Description of Securities X 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.1 10/20/16 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-K 6/30/18 10.5 8/3/18 10.6* Microsoft Corporation 2017 Stock Plan DEF14A Annex C 10/16/17 10.7* Form of Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.26 4/26/18 10.8* Form of Performance Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.27 4/26/18 10.12 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.12 10/20/16 10.13 Form of Indemnification Agreement and Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee X 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-Q 12/31/17 10.14 1/31/18 10.15* Microsoft Corporation Executive Incentive Plan 8-K 10.1 9/19/18 10.19* Microsoft Corporation Executive Incentive Plan 10-Q 9/30/16 10.17 10/20/16 10.20* Form of Executive Incentive Plan (Executive Officer SAs) Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.18 10/20/16 102 PART IV Item 15 10.21* Form of Executive Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.25 10/20/16 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/16 10.22 10/20/16 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS XBRL Instance Document X 101.SCH XBRL Taxonomy Extension Schema X 101.CAL XBRL Taxonomy Extension Calculation Linkbase X 101.DEF XBRL Taxonomy Extension Definition Linkbase X 101.LAB XBRL Taxonomy Extension Label Linkbase X 101.PRE XBRL Taxonomy Extension Presentation Linkbase X * Indicates a management contract or compensatory plan or arrangement. ** Furnished, not filed. 103 PART IV Item 15 ITEM 1 6 . FORM 10-K SUMMARY None. 104 SIGNAT URES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on August 1, 2019. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 105 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on August 1 , 201 9 . Signature Title /s/    J OHN W. T HOMPSON John W. Thompson Chairman /s/    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer /s/    W ILLIAM H. G ATES III William H. Gates III Director /s/    R EID H OFFMAN Reid Hoffman Director /s/    H UGH F. J OHNSTON Hugh F. Johnston Director /s/ T ERI L. L IST -S TOLL Teri L. List-Stoll Director /s/    C HARLES H. N OSKI Charles H. Noski Director /s/    H ELMUT P ANKE Helmut Panke Director /s/ S ANDRA E. P ETERSON Sandra E. Peterson Director /s/    P ENNY S. P RITZKER Penny S. Pritzker Director /s/ C HARLES W. S CHARF Charles W. Scharf Director /s/    A RNE M. S ORENSON Arne M. Sorenson Director /s/ J OHN W. S TANTON John W. Stanton Director /s/ P ADMASREE W ARRIOR Padmasree Warrior Director /s/    A MY E. H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/    F RANK H. B ROD Frank H. 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SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  to Commission File Number 001-37845 MICROSOFT CORPORATION Washington 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY , REDMOND , Washington 98052-6399 ( 425 ) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol Name of exchange on which registered Common stock, $ 0.00000625 par value per share MSFT Nasdaq 2.125% Notes due 2021 MSFT Nasdaq 3.125% Notes due 2028 MSFT Nasdaq 2.625% Notes due 2033 MSFT Nasdaq Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large Accelerated Filer ☒ Accelerated Filer ☐ Non-accelerated Filer ☐ Smaller Reporting Company ☐ Emerging Growth Company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes ☐ No ☒ As of December 31, 2019, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $ 1.2 trillion based on the closing sale price as reported on the NASDAQ National Market System. As of July 27, 2020, there were 7,567,652,935 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on December 2, 2020 are incorporated by reference into Part III . MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2020 INDEX Page PART I Item 1. Business 3 Executive Officers of the Registrant 17 Item 1A. Risk Factors 19 Item 1B. Unresolved Staff Comments 32 Item 2. Properties 32 Item 3. Legal Proceedings 32 Item 4. Mine Safety Disclosures 32 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 33 Item 6. Selected Financial Data 34 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 35 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 54 Item 8. Financial Statements and Supplementary Data 55 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 97 Item 9A. Controls and Procedures 97 Report of Management on Internal Control over Financial Reporting 97 Report of Independent Registered Public Accounting Firm 98 Item 9B. Other Information 99 PART III Item 10. Directors, Executive Officers and Corporate Governance 99 Item 11. Executive Compensation 99 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 99 Item 13. Certain Relationships and Related Transactions, and Director Independence 99 Item 14. Principal Accounting Fees and Services 99 PART IV Item 15. Exhibits, Financial Statement Schedules 100 Item 16. Form 10-K Summary 106 Signatures 107 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Embracing Our Future Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. As the world responds to the outbreak of a novel strain of the coronavirus (“COVID-19”), we are working to do our part by ensuring the safety of our employees, striving to protect the health and well-being of the communities in which we operate, and providing technology and resources to our customers to help them do their best work while remote. We continue to transform our business to lead in the new era of the intelligent cloud and intelligent edge. We bring technology and products together into experiences and solutions that unlock value for our customers. Our unique role as a platform and tools provider allows us to connect the dots, bring together an ecosystem of partners, and enable organizations of all sizes to build the digital capability required to address these challenges. In this next phase of innovation, computing is more powerful and ubiquitous from the cloud to the edge. Artificial intelligence (“AI”) capabilities are rapidly advancing, fueled by data and knowledge of the world. Physical and virtual worlds are coming together with the Internet of Things (“IoT”) and mixed reality to create richer experiences that understand the context surrounding people, the things they use, the places they go, and their activities and relationships. A person’s experience with technology spans a multitude of devices and has become increasingly more natural and multi-sensory with voice, ink, and gaze interactions. What We Offer Founded in 1975, we develop and support software, services, devices, and solutions that deliver new value for customers and help people and businesses realize their full potential. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. Our products include operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; and video games. We also design, manufacture, and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. 3 PART I Item 1 The Ambitions That Drive Us To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud and intelligent edge platform. • Create more personal computing. Reinvent Productivity and Business Processes At Microsoft, we’re providing technology and resources to help our customers navigate a remote environment. We’re seeing our family of products play key roles in the ways the world is continuing to work, learn, and connect. Our growth depends on securely delivering continuous innovation and advancing our leading productivity and collaboration tools and services, including Office, Dynamics, and LinkedIn. Microsoft 365 brings together Office 365, Windows 10, and Enterprise Mobility + Security to help organizations empower their employees with AI-backed tools that unlock creativity, increase teamwork, and fuel innovation, all the while enabling compliance coverage and data protection. Microsoft Teams is enabling rapid digital transformation by giving people a single tool to chat, call, meet, and collaborate. Microsoft Relationship Sales solution brings together LinkedIn Sales Navigator and Dynamics to transform business to business sales through social selling. Dynamics 365 for Talent with LinkedIn Recruiter and Learning gives human resource professionals a complete solution to compete for talent. Microsoft Power Platform empowers employees to build custom applications, automate workflow, and analyze data no matter their technical expertise. These scenarios represent a move to unlock creativity and discover new habits, while simplifying security and management. Organizations of all sizes have digitized business-critical functions, redefining what they can expect from their business applications. This creates an opportunity to reach new customers and increase usage and engagement with existing customers. Build the Intelligent Cloud and Intelligent Edge Platform In the new remote world, companies have accelerated their own digital transformation to empower their employees, optimize their operations, engage customers, and in some cases, change the very core of their products and services. Partnering with organizations on their digital transformation during this period is one of our largest opportunities and we are uniquely positioned to become the strategic digital transformation platform and partner of choice; their success is our success. Our strategy requires continued investment in datacenters and other hybrid and edge infrastructure to support our services. Azure is a trusted cloud with comprehensive compliance coverage and AI-based security built in. Our cloud business benefits from three economies of scale: datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. As one of the two largest providers of cloud computing at scale, we believe we work from a position of strength. Being a global-scale cloud, Azure uniquely offers hybrid consistency, developer productivity, AI capabilities, and trusted security and compliance. We see more emerging use cases and needs for compute and security at the edge and are accelerating our innovation across the spectrum of intelligent edge devices, from IoT sensors to gateway devices and edge hardware to build, manage, and secure edge workloads. With Azure Stack, organizations can extend Azure into their own datacenters to create a consistent stack across the public cloud and the intelligent edge. Our hybrid infrastructure consistency spans identity, data, compute, management, and security, helping to support the real-world needs and evolving regulatory requirements of commercial customers and enterprises. We are accelerating our development of mixed reality solutions with new Azure services and devices. The opportunity to merge the physical and digital worlds, when combined with the power of Azure cloud services, unlocks the potential for entirely new workloads which we believe will shape the next era of computing. 4 PART I Item 1 The ability to convert data into AI drives our competitive advantage. Azure SQL Database makes it possible for customers to take SQL Server from their on-premises datacenter to a fully managed instance in the cloud to utilize built-in AI. We are accelerating adoption of AI innovations from research to products. Our innovation helps every developer be an AI developer, with approachable new tools from Azure Machine Learning Studio for creating simple machine learning models, to the powerful Azure Machine Learning Workbench for the most advanced AI modeling and data science. Create More Personal Computing We strive to make computing more personal by putting users at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. In support of this, we are bringing Office, Windows, and devices together for an enhanced and more cohesive customer experience. Windows 10 serves the enterprise as the most secure and productive operating system. It empowers people with AI-first interfaces ranging from voice-activated commands through Cortana, inking, immersive 3D content storytelling, and mixed reality experiences. Our ambition for Windows 10 monetization opportunities includes gaming, services, subscriptions, and search advertising. Windows also plays a critical role in fueling our cloud business and Microsoft 365 strategy, and it powers the growing range of devices on the “intelligent edge.” We are committed to designing and marketing first-party devices to help drive innovation, create new device categories, and stimulate demand in the Windows ecosystem. We recently added several new products and accessories into the Surface family, including Surface Book 3 and Surface Go 2. These new Surface products join Surface Pro 7, Surface Laptop 3, and Surface Pro X. To expand usage and deepen engagement, we continue to invest in content, community, and cloud services as we pursue the expansive opportunity in the gaming industry. We are broadening our approach to how we think about gaming end-to-end, from the way games are created and distributed to how they are played and viewed across PC, console, and mobile. We have a strong position with our large and growing highly engaged community of gamers. Xbox Game Pass, with over 10 million members from 41 countries, is a community with access to a curated library of over 100 first- and third-party console and PC titles. Project xCloud is Microsoft’s game streaming technology that is complementary to our console hardware and will give fans the ultimate choice to play the games they want, with the people they want, on the devices they want. Our Future Opportunity In a time of great disruption and uncertainty, customers are looking to us to accelerate their own digital transformations as software and cloud computing play a huge role across every industry and around the world. We continue to develop complete, intelligent solutions for our customers that empower people to stay productive and collaborate, while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modern, modular business applications to improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Applying AI to drive insights and act on our customer’s behalf by understanding and interpreting their needs using natural methods of communication. • Using Windows to fuel our cloud business and Microsoft 365 strategy, and to develop new categories of devices – both our own and third-party – on the intelligent edge. • Inventing new gaming experiences that bring people together around their shared love for games on any devices and pushing the boundaries of innovation with console and PC gaming by creating the next wave of entertainment. Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. We have the opportunity to redefine what customers and partners can expect and are working to deliver new solutions that reflect the best of Microsoft. 5 PART I Item 1 COVID-19 In March 2020, the World Health Organization declared the outbreak of COVID-19 to be a pandemic. The COVID-19 pandemic is having widespread, rapidly evolving, and unpredictable impacts on global society, economies, financial markets, and business practices. Federal and state governments have implemented measures in an effort to contain the virus, including social distancing, travel restrictions, border closures, limitations on public gatherings, work from home, supply chain logistical changes, and closure of non-essential businesses. To protect the health and well-being of our employees, suppliers, and customers, we have made substantial modifications to employee travel policies, implemented office closures as employees are advised to work from home, and cancelled or shifted our conferences and other marketing events to virtual-only through fiscal year 2021. The COVID-19 pandemic has impacted and may continue to impact our business operations, including our employees, customers, partners, and communities, and there is substantial uncertainty in the nature and degree of its continued effects over time. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations (Part II, Item 7 of this Form 10-K) for further discussion regarding the impact of COVID-19 on our fiscal year 2020 financial results. The extent to which the COVID-19 pandemic impacts our business going forward will depend on numerous evolving factors we cannot reliably predict, including the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity including the possibility of recession or financial market instability. These factors may adversely impact consumer, business, and government spending on technology as well as customers' ability to pay for our products and services on an ongoing basis. This uncertainty also affects management’s accounting estimates and assumptions, which could result in greater variability in a variety of areas that depend on these estimates and assumptions, including investments, receivables, and forward-looking guidance. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Commitment to Sustainability We work to ensure that technology is inclusive, trusted, and increases sustainability. We’re empowering our customers and partners with new technology to help them drive efficiencies, transform their businesses, and create their own solutions for sustainability. In January 2020, we announced a bold new environmental sustainability strategy focused on carbon, water, waste, and ecosystems. As part of our commitment, we are investing $1 billion over the next four years in new technologies and innovative climate solutions. We set an ambitious goal to reduce and ultimately remove Microsoft’s carbon footprint. By 2030 Microsoft will be carbon negative, and by 2050 Microsoft will remove from the environment all the carbon the company has emitted directly or by electrical consumption since it was founded in 1975. We also launched a new initiative to use Microsoft technology to help our suppliers and customers around the world reduce their own carbon footprint. The investments we make in sustainability carry through to our products, services, and devices. We design our devices, from Surface to Xbox, to minimize their impact on the environment. Our cloud and AI services help businesses cut energy consumption, reduce physical footprints, and design sustainable products. We also pledged a $50 million investment in AI for Earth to accelerate innovation by putting AI in the hands of those working to directly address sustainability challenges. Lastly, this work is supported by using our voice to support policies we think can advance sustainability efforts. Addressing Racial Injustice Our future opportunity depends on reaching and empowering all communities, and we are committed to taking action to help address racial injustice and inequity. With significant input from employees and leaders who are members of the Black and African American community, our senior leadership team and board of directors has developed a set of actions to help improve the lived experience at Microsoft and drive change in the communities in which we live and work. These efforts include increasing our representation and culture of inclusion by doubling the number of Black and African American people managers, senior individual contributors, and senior leaders in the United States by 2025; engaging our ecosystem by using our balance sheet and engagement with suppliers and partners to extend the vision for societal change; and strengthening our communities by using the power of data, technology, and partnership to help improve the lives of Black and African American citizens across the United States. 6 PART I Item 1 Investing in Digital Skills With a continued focus on digital transformation, Microsoft is making efforts to help ensure that no one is left behind, particularly as economies start to recover from the COVID-19 pandemic. We are expanding access to the digital skills that have become increasingly vital to many of the world’s jobs, and especially to individuals hardest hit by recent job losses, including those with lower incomes, women, and underrepresented minorities. Our skills initiative brings together learning resources, certification opportunities, and job-seeker tools from LinkedIn, GitHub, and Microsoft Learn, and is built on data insights drawn from LinkedIn’s Economic Graph. This is combined with $20 million we are investing in key non-profit partnerships through Microsoft Philanthropies. OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions, the Office portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”). • Office Consumer, including Microsoft 365 Consumer (formerly Office 365 Consumer) subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Learning Solutions, Marketing Solutions, Sales Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises. Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users in new markets such as first-line workers, small and medium businesses, and growth markets, as well as add value to our core product and service offerings to span productivity categories such as communication, collaboration, analytics, security, and compliance. Office Commercial revenue is mainly affected by a combination of continued installed base growth and average revenue per user expansion, as well as the continued shift from Office licensed on-premises to Office 365. CALs provide certain Office Commercial products and services with access rights to our server products and CAL revenue is reported with the associated Office products and services. 7 PART I Item 1 Office Consumer Office Consumer is designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift from Office licensed on-premises to Microsoft 365 Consumer subscriptions. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. LinkedIn LinkedIn connects the world’s professionals to make them more productive and successful and transforms the way companies hire, market, sell, and learn. Our vision is to create economic opportunity for every member of the global workforce through the ongoing development of the world’s first Economic Graph, a digital representation of the global economy. In addition to LinkedIn’s free services, LinkedIn offers monetized solutions: Talent Solutions, Learning Solutions, Marketing Solutions, Sales Solutions, and Premium Subscriptions. Talent Solutions provide insights for workforce planning and tools to hire, nurture, and develop talent. Learning Solutions, including Glint, help businesses close critical skills gaps in times where companies are having to do more with existing talent. Marketing Solutions help companies grow relationships between businesses. Sales Solutions help companies strengthen customer relationships, empower teams with digital selling tools, and acquire new opportunities. Finally, Premium Subscriptions enables professionals to manage their professional identity, grow their network, and connect with talent through additional services like premium search. LinkedIn has over 700 million members and has offices around the globe. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions , Learning Solutions, Sales Solutions, and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. Dynamics Dynamics provides cloud-based and on-premises business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and other application development platforms for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is driven by the number of users licensed, expansion of average revenue per user, and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications. Competition Competitors to Office include software and global application vendors, such as Apple, Cisco Systems, Facebook, Google, IBM, Okta, Proofpoint, Slack, Symantec, Zoom, and numerous web-based and mobile application competitors as well as local application developers. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides a hosted messaging and productivity suite. Slack provides teamwork and collaboration software. Zoom offers videoconferencing and cloud phone solutions. Skype for Business and Skype also compete with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Okta, Proofpoint, and Symantec provide security solutions across email security, information protection, identity, and governance. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products and services. We compete by providing powerful, flexible, secure, integrated industry-specific, and easy-to-use productivity and collaboration tools and services that create comprehensive solutions and work well with technologies our customers already have both on-premises or in the cloud. LinkedIn faces competition from online professional networks, recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers, and Sales Solutions competes with online and offline outlets for companies with lead generation and customer intelligence and insights. 8 PART I Item 1 Dynamics competes with vendors such as Oracle, Salesforce.com, and SAP to provide cloud-based and on-premise s business solutions for small, medium, and large organizations. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related CALs; and GitHub. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. Server Products and Cloud Services Azure is a comprehensive set of cloud services that offer developers, IT professionals, and enterprises freedom to build, deploy, and manage applications on any platform or device. Customers can use Azure through our global network of datacenters for computing, networking, storage, mobile and web application services, AI, IoT, cognitive services, and machine learning. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Azure revenue is mainly affected by infrastructure-as-a-service and platform-as-a-service consumption-based services, and per user-based services such as Enterprise Mobility + Security. Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. GitHub provides a collaboration platform and code hosting service for developers. Server products revenue is mainly affected by purchases through volume licensing programs, licenses sold to original equipment manufacturers (“OEM”), and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Enterprise Services Enterprise Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and IT professionals on various Microsoft products. Competition Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, VMware, and open source offerings. Our Enterprise Mobility + Security offerings also compete with products from a range of competitors including identity vendors, security solution vendors, and numerous other security point solution vendors. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. We believe our cloud’s global scale, coupled with our broad portfolio of identity and security solutions, allows us to effectively solve complex cybersecurity challenges for our customers and differentiates us from the competition. Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. 9 PART I Item 1 We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Our Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows IoT; and MSN advertising. • Devices, including Surface and PC accessories. • Gaming, including Xbox hardware and Xbox content and services, comprising Xbox Live (transactions, subscriptions, cloud services, and advertising), video games, and third-party video game royalties. • Search. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and growth markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Constraints in the supply chain of device components. • Piracy. 10 PART I Item 1 Windows Commercial revenue, which includes volume licensing of the Windows operating system and Windows cloud services such as Microsoft Defender Advanced Threat Protection, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance (“SA”), as well as advanced security offerings. Windows Commercial revenue often reflects the number of information workers in a licensed enterprise and is relatively independent of the number of PCs sold in a given year. Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. MSN advertising includes both native and display ads. Devices We design, manufacture, and sell devices, including Surface and PC accessories. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. Growth in Devices is dependent on total PC shipments, the ability to attract new customers, our product roadmap, and expanding into new categories. Gaming Our gaming platform is designed to provide a variety of entertainment through a unique combination of content, community, and cloud. Our exclusive game content is created through Xbox Game Studios, a collection of first-party studios creating iconic and differentiated gaming experiences. We continue to invest in new gaming studios and content to expand our IP roadmap and leverage new content creators. These unique gaming experiences are the cornerstone of Xbox Game Pass, a subscription service and gaming community with access to a curated library of over 100 first- and third-party console and PC titles. The gamer remains at the heart of the Xbox ecosystem. We continue to open new opportunities for gamers to engage both on- and off-console with both the launch of Project xCloud, our game streaming service, and continued investment in gaming hardware. Project xCloud utilizes Microsoft’s Azure cloud technology to allow direct and on-demand streaming of games to PCs, consoles, and mobile devices, enabling gamers to take their favorites games with them and play on the device most convenient to them. Project xCloud will provide players with more choice over how and where they play. Xbox Live enables people to connect and share online gaming experiences and is accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox Live is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox revenue is mainly affected by subscriptions and sales of first- and third-party content, as well as advertising. Growth of our Gaming business is determined by the overall active user base through Xbox enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences through first-party content creators. Search Our Search business, including Bing and Microsoft Advertising, is designed to deliver relevant online advertising to a global audience. We have several partnerships with other companies, including Verizon Media Group, through which we provide and monetize search queries. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. 11 PART I Item 1 Devices face competition from various computer, tablet, and hardware manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. Xbox Live and our cloud gaming services face competition from various online gaming ecosystems and game streaming services, including those operated by Amazon, Apple, Facebook, Google, and Tencent. We also compete with other providers of entertainment services such as Netflix and Hulu. Our gaming platform competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. We believe our gaming platform is effectively positioned against, and uniquely differentiated from, competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own first-party game franchises as well as other digital content offerings. Our search business competes with Google and a wide array of websites, social platforms like Facebook, and portals that provide content and online offerings to end users. OPERATIONS We have operations centers that support operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Europe, Australia, and Asia, as well as in the Middle East and Africa. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our devices are primarily manufactured by third-party contract manufacturers. We generally have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. The majority of our hardware products contain components for which there is only one qualified supplier. Extended disruptions at these suppliers could lead to a similar disruption in our ability to manufacture devices. RESEARCH AND DEVELOPMENT Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Cloud and AI , focuses on making IT professionals, developers, and their systems more productive and efficient through development of cloud infrastructure, server, database, CRM, ERP, management and development tools, AI cognitive services, and other business process applications and services for enterprises. • Experiences and Devices , focuses on instilling a unifying product ethos across our end-user experiences and devices, including Office, Windows, Enterprise Mobility + Security, and Surface. • AI and Research , focuses on our AI innovations and other forward-looking research and development efforts spanning infrastructure, services, applications, and search. • LinkedIn , focuses on our services that transform the way customers hire, market, sell, and learn. • Gaming , focuses on developing hardware, content, and services across a large range of platforms to help grow our user base through game experiences and social interaction. 12 PART I Item 1 Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software and hardware design. Before releasing new software platforms, and as we make significant modifications to existing platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 63,000 U.S. and international patents issued and over 24,500 pending worldwide. While we employ much of our internally-developed intellectual property exclusively in our products and services, we also engage in outbound licensing of specific patented technologies that are incorporated into licensees’ products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We also purchase or license technology that we incorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, or attracting and enabling our external development community. Our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, services, and business methods, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the Company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, devices, and operating systems. While our main product research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world, including Canada, China, Czech Republic, India, Ireland, Israel, and the United Kingdom. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest corporate research organizations and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science and a broad range of other disciplines, providing us a unique perspective on future trends and contributing to our innovation. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the operating segment level. Much of our segment level research and development is coordinated with other segments and leveraged across the Company. We plan to continue to make significant investments in a broad range of research and development efforts. 13 PART I Item 1 DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales force performs a variety of functions, including working directly with commercial enterprises and public-sector organizations worldwide to identify and meet their technology and digital transformation requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. OEMs We distribute our products and services through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Acer, ASUS, Dell, Fujitsu, Hewlett-Packard, Lenovo, Samsung, Sharp, Toshiba, and with many regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors” or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. We also sell commercial and consumer products and services directly to customers, such as cloud services, search, and gaming, through our digital marketplaces and online stores. In June 2020, we announced a strategic change in our retail operations, including closing our Microsoft Store physical locations. Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers, and provide product training and sales support. Our Dynamics business solutions are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. 14 PART I Item 1 LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and Software Assurance. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. SA conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, training, and other licensing benefits to help customers deploy and use software efficiently. SA is included with certain volume licensing agreements and is an optional purchase with others. Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. SA is included. Microsoft Product and Services Agreement Microsoft Product and Services Agreements are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. SA is optional for customers that purchase perpetual licenses. Open Open agreements are a simple, cost-effective way to acquire the latest Microsoft technology. Open agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a one- to three-year period. Under the Open agreements, organizations purchase perpetual licenses and SA is optional. Under Open Value agreements, organizations can elect to purchase perpetual licenses or subscribe to licenses and SA is included. Select Plus Select Plus agreements are designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and SA is optional. Microsoft Online Subscription Agreement Microsoft Online Subscription Agreements are designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web. The agreement allows customers to acquire monthly or annual subscriptions for cloud-based services. Partner Programs The Microsoft Cloud Solution Provider program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, managed services provider, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows hosting service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. 15 PART I Item 1 The Independent Software Vendor Royalty program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, Internet service providers, application developers, and OEMs. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 16 PART I Item 1 EXECUTIVE OFFICERS OF THE REGISTRANT Our executive officers as of July 30, 2020 were as follows: Name Age Position with the Company Satya Nadella 52 Chief Executive Officer Christopher C. Capossela 50 Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer Jean-Philippe Courtois 59 Executive Vice President and President, Microsoft Global Sales, Marketing and Operations Kathleen T. Hogan 54 Executive Vice President, Human Resources Amy E. Hood 48 Executive Vice President, Chief Financial Officer Bradford L. Smith 61 President and Chief Legal Officer Mr. Nadella was appointed Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 26 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Mr. Courtois was appointed Executive Vice President and President, Microsoft Global Sales, Marketing and Operations in July 2016. Before that he was President of Microsoft International since 2005. He was Chief Executive Officer, Microsoft Europe, Middle East, and Africa from 2003 to 2005. He was Senior Vice President and President, Microsoft Europe, Middle East, and Africa from 2000 to 2003. He was Corporate Vice President, Worldwide Customer Marketing from 1998 to 2000. Mr. Courtois joined Microsoft in 1984. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hogan also serves on the Board of Directors of Alaska Air Group, Inc. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Hood also serves on the Board of Directors of 3M Corporation. Mr. Smith was appointed President and Chief Legal Officer in September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. 17 PART I Item 1 EMPLOYEES As of June 30, 2020, we employed approximately 163,000 people on a full-time basis, 96,000 in the U.S. and 67,000 internationally. Of the total employed people, 56,000 were in operations, including manufacturing, distribution, product support, and consulting services; 55,000 were in product research and development; 40,000 were in sales and marketing; and 12,000 were in general and administration. Certain of our employees are subject to collective bargaining agreements. AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”) at www.sec.gov. • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts to have information pushed in real time. The information found on our website is not part of this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 18 PART I Item 1A ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platform-based ecosystems An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, wearables, and other endpoint devices. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on PCs. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users may incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. Competitors’ rules governing their content and applications marketplaces may restrict our ability to distribute products and services through them in accordance with our technical and business model objectives. 19 PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us by modifying and then distributing open source software at little or no cost to end users, and earning revenue on advertising or integrated products and services. These firms do not bear the full costs of research and development for the open source software. Some open source software mimics the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We are undertaking cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge worldview is connected with the growth of the Internet of Things (“IoT”). Our success in the IoT will depend on the level of adoption of our offerings such as Azure, Azure Stack, Azure IoT Edge, and Azure Sphere. We may not establish market share sufficient to achieve scale necessary to achieve our business objectives. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other endpoints. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data as well as help them meet their own compliance needs. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. 20 PART I Item 1A We make significant investments in products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Microsoft 365, Office, Bing, SQL Server, Windows Server, Azure, Office 365, Xbox Live, LinkedIn, and other products and services. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. We may not get engagement in certain features, like Edge and Bing, that drive post-sale monetization opportunities. Our data handling practices across our products and services will continue to be under scrutiny and perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or product experiences, which could negatively impact product and feature adoption, product design, and product quality. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. For example, in October 2018, we completed our acquisition of GitHub, Inc. (“GitHub”) for $7.5 billion. These acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating and retaining new employees, business systems, and technology, or that they distract management from our other businesses. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements such as increased revenue or enhanced efficiencies, or the benefits may ultimately be smaller than we expected. These events could adversely affect our consolidated financial statements. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. 21 PART I Item 1A Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position. Security of our information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Inadequate account security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems, or reveal confidential information. Cyberthreats are constantly evolving, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network, or data security could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improve technologies, or otherwise adversely affect our business. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge. Security of our products, services, devices, and customers’ data The security of our products and services is important in our customers’ decisions to purchase or use our products or services. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. Adversaries that acquire user account information at other companies can use that information to compromise our users’ accounts where accounts share the same attributes as passwords. Inadequate account security practices may also result in unauthorized access. User activity may also result in ransomware or other malicious software impacting a customer’s use of our products or services. We are also increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks. To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide security tools such as firewalls and anti-virus software and information about the need to deploy security measures and the impact of doing so. Customers in certain industries such as financial services, health care, and government may have enhanced or specialized requirements to which we must engineer our product and services. 22 PART I Item 1A The cost of these steps could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers, and third parties granted access to their systems, may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches, or may otherwise fail to adopt adequate security practices. Any of these could adversely affect our reputation and revenue. Actual or perceived vulnerabilities may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers. Our products operate in conjunction with and are dependent on products and components across a broad ecosystem of third parties. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position. Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers and users. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and third parties on data security, and other practices we follow may not prevent the improper disclosure or misuse of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services, and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services. We may not be able to protect information in our products and services from use by others . LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services. Abuse of our platforms may harm our reputation or user engagement. Advertising, professional, and social platform abuses For platform products and services that provide content or host ads that come from or can be influenced by third parties, including GitHub, LinkedIn, Microsoft Advertising, MSN, and Xbox Live, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate. This activity may come from users impersonating other people or organizations, use of our products or services to spread terrorist or violent extremist content or to disseminate information that may be viewed as misleading or intended to manipulate the opinions of our users, or the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing or responding to these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and consolidated financial statements. 23 PART I Item 1A Digital safety and service misuse Our hosted consumer services as well as our enterprise services may be used by third parties to disseminate harmful or illegal content in violation of our terms or applicable law. We may not proactively discover such content due to scale and the limitations of existing technologies, and when discovered by users, such content may negatively affect our reputation, our brands, and user engagement. Regulations and other initiatives to make platforms responsible for preventing or eliminating harmful content online are gaining momentum and we expect this to continue. We may be subject to enhanced regulatory oversight, civil or criminal liability, or reputational damage if we fail to comply with content moderation regulations, adversely affecting our business and consolidated financial statements. The development of the IoT presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT, a network of distributed and interconnected devices employing sensors, data, and computing capabilities including AI. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation, that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins. Issues in the use of AI in our offerings may result in reputational harm or liability . We are building AI into many of our offerings and we expect this element of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many disruptive innovations, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms may be flawed. Datasets may be insufficient or contain biased information. Inappropriate or controversial data practices by Microsoft or others could impair the acceptance of AI solutions. These deficiencies could undermine the decisions, predictions, or analysis AI applications produce, subjecting us to competitive harm, legal liability, and brand or reputational harm. Some AI scenarios present ethical issues. If we enable or offer AI solutions that are controversial because of their impact on human rights, privacy, employment, or other social issues, we may experience brand or reputational harm. We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Azure, Microsoft Account services, Office 365, Microsoft Teams, Dynamics 365, OneDrive, SharePoint Online, Skype, Xbox Live, and Outlook.com. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex, and requires development of principles for datacenter builds in geographies with higher safety risks. It requires that we maintain an Internet connectivity infrastructure and storage and compute capacity that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data, insufficient Internet connectivity, or inadequate storage and compute capacity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may adversely impact our consolidated financial statements. We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design, manufacture, and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. 24 PART I Item 1A Our software products and services also may experience quality or reliability problems. The highly sophisticated software we develop may contain bugs and other defects that interfere with their intended operation. Our customers increasingly rely on us for critical functions, potentially magnifying the impact of quality or reliability issues. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. We acquire some device and datacenter components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other hardware and software products we may offer. We may not be able to protect our source code from copying if there is an unauthorized disclosure. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described elsewhere in these risk factors. Legal changes, our evolving business model, piracy, and other factors may decrease the value of our intellectual property. Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly countries in which the legal system provides less protection for intellectual property rights. Our revenue in these markets may grow more slowly than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing our patents to others in return for a royalty. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties, or may contest the scope and extent of their obligations. The royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, selling price changes in products using licensed patents, or the difficulty of discovering infringements. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations and may negatively impact revenue. 25 PART I Item 1A Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows 10, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact in our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scrutinize us under U.S. and foreign competition laws. Governments are actively enforcing competition laws and regulations, and this includes scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows 10 can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments we offered to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices for our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Government regulatory actions and court decisions such as these may result in fines, or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. 26 PART I Item 1A • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows 10 post-sale monetization opportunities may be limited. Our global operations subject us to potential liability under anti-corruption, trade protection, and other laws and regulations. The Foreign Corrupt Practices Act (“FCPA”) and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents, and the accounting provisions of the FCPA require us to maintain accurate books and records and adequate internal controls. From time to time, we receive inquiries from authorities in the U.S. and elsewhere which may be based on reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Periodically, we receive such reports directly and investigate them. On July 22, 2019, our Hungarian subsidiary entered into a non-prosecution agreement (“NPA”) with the U.S. Department of Justice (“DOJ”) and we agreed to the terms of a cease and desist order with the Securities and Exchange Commission. These agreements required us to pay $25.3 million in monetary penalties, disgorgement, and interest pertaining to activities at Microsoft’s subsidiary in Hungary. The NPA, which has a three-year term, also contains certain ongoing compliance requirements, including the obligations to disclose to the DOJ issues that may implicate the FCPA and to cooperate in any inquiries. Most countries in which we operate also have competition laws that prohibit competitors from colluding or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our U.S. and international compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Operations outside the U.S. may be affected by changes in trade protection laws, policies, sanctions, and other regulatory requirements affecting trade and investment. We may be subject to legal liability and reputational damage if we sell goods or services in violation of U.S. trade sanctions on restricted entities or countries such as Crimea, Cuba, Iran, North Korea, Sudan, and Syria. Other regulatory areas that may apply to our products and online services offerings include user privacy, telecommunications, data storage and protection, and online content. For example, some regulators are taking the position that our offerings such as Microsoft Teams and Skype are covered by existing laws regulating telecommunications services, and some new laws, including EU Member State laws under the European Electronic Communications Code, are defining more of our services as regulated telecommunications services. This trend may continue and will result in these offerings being subjected to additional data protection, security, and law enforcement surveillance obligations. Data protection authorities may assert that our collection, use, and management of customer data is inconsistent with their laws and regulations. Legislative or regulatory action relating to cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Legislative or regulatory action could also emerge in the area of AI and content moderation, increasing costs or restricting opportunity. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, customers, and other stakeholders to make technology more accessible. If our products do not meet customer expectations or emerging global accessibility requirements, we could lose sales opportunities or face regulatory actions 27 PART I Item 1A Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us, or reputational damage . The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, in July 2020 the Court of Justice of the EU invalidated a framework called Privacy Shield for companies to transfer data from EU member states to the United States. This ruling has led to uncertainty about the legal requirements for data transfers from the EU under other l egal mechanisms. Potential new rules and restrictions on the flow of data across borders could increase the cost and complexity of delivering our products and services in some markets. In May 2018, the EU General Data Protection Regulation (“GDPR”), became effective. The law, which applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of compliance obligations regarding the handling of personal data. Engineering efforts to build and maintain capabilities to facilitate compliance with the law have entailed substantial expense and the diversion of engineering resources from other projects and may continue to do so. We might experience reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under the GDPR or other data regulations, or if our implementation to comply with the GDPR make s our offerings less attractive. The GDPR imposes significant new obligations and compliance with these obligations depends in part on how particular regulators interpret and apply them. If we fail to comply with the GDPR, or if regulators assert we have failed to comply with the GDPR, it may lead to regulatory enforcement actions, which can result in monetary penalties of up to 4% of worldwide revenue, private lawsuits, reputational damage , and loss of customers . Countries around the world, and states in the U.S . such as California , ha ve adopted, or are considering adopting or expanding , laws and regulations imposing obligations regarding the handling of personal data. The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Ongoing legal analyses, reviews, and inquiries by regulators of Microsoft practices, or relevant practices of other organizations, may result in burdensome or inconsistent requirements, including data sovereignty and localization requirements, affecting the location, movement, collection, and use of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in some jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity, as well as negative publicity and diversion of management time and effort. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cuts and Jobs Act (“TCJA”) may require the collection of information not regularly produced within the Company, the use of estimates in our consolidated financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to the TCJA, and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our consolidated financial statements. We regularly are under audit by tax authorities in different jurisdictions. Although we believe that our provision for income taxes and our tax estimates are reasonable, tax authorities may disagree with certain positions we have taken. In addition, economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. We are currently under Internal Revenue Service audit for prior tax years, with the primary unresolved issues relating to transfer pricing. The final resolution of those audits, and other audits or litigation, may differ from the amounts recorded in our consolidated financial statements and may materially affect our consolidated financial statements in the period or periods in which that determination is made. 28 PART I Item 1A We earn a significant amount of our operating income outside the U.S. A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the Company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our consolidated financial statements. If our reputation or our brands are damaged, our business and operating results may be harmed . Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, or our environmental impact and sustainability, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things: • The introduction of new features, products, services, or terms of service that customers, users, or partners do not like. • Public scrutiny of our decisions regarding user privacy, data practices, or content. • Data security breaches, compliance failures, or actions of partners or individual employees. The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees. Our global business exposes us to operational and economic risks. Our customers are located throughout the world and a significant part of our revenue comes from international sales. The global nature of our business creates operational and economic risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist trends in specific countries may significantly alter the trade environment. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our results of operations . Our business with government customers may present additional uncertainties. We derive substantial revenue from government contracts. Government contracts generally can present risks and challenges not present in private commercial agreements. For instance, we may be subject to government audits and investigations relating to these contracts, we could be suspended or debarred as a governmental contractor, we could incur civil and criminal fines and penalties, and under certain circumstances contracts may be rescinded. Some agreements may allow a government to terminate without cause and provide for higher liability limits for certain losses. Some contracts may be subject to periodic funding approval, reductions, or delays which could adversely impact public-sector demand for our products and services. These events could negatively impact our results of operations, financial condition, and reputation . Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, pandemic, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. 29 PART I Item 1A Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced an other-than-temporary decline in fair value, requiring impairment charges that could adversely affect our consolidated financial statements. Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, pandemic, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems, or the infrastructure or systems they rely on, such as power grids, could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans, and magnifies the potential impact of prolonged service outages in our consolidated financial statements. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers, and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory requirements that could impact our operating strategies, access to global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues. The occurrence of regional epidemics or a global pandemic may adversely affect our operations, financial condition, and results of operations. The COVID-19 pandemic is having widespread, rapidly evolving, and unpredictable impacts on global society, economies, financial markets, and business practices. Federal and state governments have implemented measures in an effort to contain the virus, including social distancing, travel restrictions, border closures, limitations on public gatherings, work from home, supply chain logistical changes, and closure of non-essential businesses. To protect the health and well-being of our employees, suppliers, and customers, we have made substantial modifications to employee travel policies, implemented office closures as employees are advised to work from home, and cancelled or shifted our conferences and other marketing events to virtual-only through fiscal year 2021. The COVID-19 pandemic has impacted and may continue to impact our business operations, including our employees, customers, partners, and communities, and there is substantial uncertainty in the nature and degree of its continued effects over time. In the third and fourth quarters of fiscal year 2020, we have experienced adverse impacts to our supply chain, a slowdown in transactional licensing, and lower demand for our advertising services. The extent to which the COVID-19 pandemic impacts our business going forward will depend on numerous evolving factors we cannot reliably predict, including the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity including the possibility of recession or financial market instability. These factors may adversely impact consumer, business, and government spending on technology as well as customers' ability to pay for our products and services on an ongoing basis. This uncertainty also affects management’s accounting estimates and assumptions, which could result in greater variability in a variety of areas that depend on these estimates and assumptions, including investments, receivables, and forward-looking guidance. 30 PART I Item 1A Measures to contain the virus that impact us, our partners, distributors, and suppliers may further intensify these impacts and other risks described in these Risk Factors. Any of these may adversely impact our ability to: • Maintain our operations infrastructure, including the reliability and adequate capacity of cloud services. • Satisfy our contractual and regulatory compliance obligations as we adapt to changing usage patterns, such as through datacenter load balancing. • Ensure a high-quality and consistent supply chain and manufacturing operations for our hardware devices and datacenter operations. • Effectively manage our international operations through changes in trade practices and policies. • Hire and deploy people where we most need them. • Sustain the effectiveness and productivity of our operations including our sales, marketing, engineering, and distribution functions. We may incur increased costs to effectively manage these aspects of our business. If we are unsuccessful it may adversely impact our revenues, cash flows, market share growth, and reputation. The long-term effects of climate change on the global economy and the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in climate where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees representing diverse backgrounds, experiences, and skill sets. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation, as well as a diverse and inclusive work environment that enables all our employees to thrive, are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. 31 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our fiscal year 2020 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 520 acres of land we own at our corporate headquarters, and approximately five million square feet of space we lease. In addition, we own and lease space domestically that includes office, datacenter, and retail space. We also own and lease facilities internationally. The largest owned properties include: our research and development centers in China and India; our datacenters in Ireland, the Netherlands, and Singapore; and our operations and facilities in Ireland and the United Kingdom. The largest leased properties include space in the following locations: Australia, Canada, China, France, Germany, India, Israel, Japan, Netherlands, and the United Kingdom. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described under Research and Development (Part I, Item 1 of this Form 10-K). The table below shows a summary of the square footage of our office, datacenter, retail, and other facilities owned and leased domestically and internationally as of June 30, 2020: (Square feet in millions) Location Owned Leased Total U.S. 20 14 34 International 7 16 23 Total 27 30 57 ITEM 3. LEGAL PROCEEDINGS While not material to the Company, the Company makes the following annual report of the general activities of the Company’s Antitrust Compliance Office as required by the Final Order and Judgment in Barovic v. Ballmer et al, United States District Court for the Western District of Washington (“Final Order”). For more information see http://aka.ms/MSLegalNotice2015. This will be the last annual report under the Final Order. During fiscal year 2020, the Antitrust Compliance Office (a) monitored the Company’s compliance with the European Commission Decision of March 24, 2004, (“2004 Decision”) and with the Company’s Public Undertaking to the European Commission dated December 16, 2009 (“2009 Undertaking”); (b) monitored, in the manner required by the Final Order, employee, customer, competitor, regulator, or other third-party complaints regarding compliance with the 2004 Decision, the 2009 Undertaking, or other EU or U.S. laws or regulations governing tying, bundling, and exclusive dealing contracts; and, (c) monitored, in the manner required by the Final Order, the training of the Company’s employees regarding the Company’s antitrust compliance polices. In addition, the Antitrust Compliance Officer reports to the Regulatory and Public Policy Committee of the Board at each of its regularly scheduled meetings and to the full Board annually. Refer to Note 15 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 32 PART II Item 5 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 27, 2020, there were 91,674 registered holders of record of our common stock. SHARE REPURCHASES AND DIVIDENDS Following are our monthly share repurchases for the fourth quarter of fiscal year 2020: Period Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet be Purchased Under the Plans or Programs (In millions) April 1, 2020 – April 30, 2020 8,906,563 $ 165.90 8,906,563 $ 35,323 May 1, 2020 – May 31, 2020 9,655,700 182.31 9,655,700 33,563 June 1, 2020 – June 30, 2020 9,648,400 191.80 9,648,400 31,712 28,210,663 28,210,663 All share repurchases were made using cash resources. Our share repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. Our Board of Directors declared the following dividends during the fourth quarter of fiscal year 2020: Declaration Date Record Date Payment Date Dividend Per Share Amount (In millions) June 17, 2020 August 20, 2020 September 10, 2020 $ 0.51 $ 3,861 We returned $8.9 billion to shareholders in the form of share repurchases and dividends in the fourth quarter of fiscal year 2020. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding share repurchases and dividends. 33 PART II Item 6 ITEM 6. SELECTED FINANCIAL DATA FINANCIAL HIGHLIGHTS (In millions, except per share amounts) Year Ended June 30, 2020 2019 (a) 2018 2017 (d)(e) 2016 (d) Revenue $ 143,015 $ 125,843 $ 110,360 $ 96,571 $ 91,154 Gross margin 96,937 82,933 72,007 62,310 58,374 Operating income 52,959 42,959 35,058 29,025 (f) 26,078 (g) Net income 44,281 39,240 (b) 16,571 (c) 25,489 (f) 20,539 (g) Diluted earnings per share 5.76 5.06 (b) 2.13 (c) 3.25 (f) 2.56 (g) Cash dividends declared per common share 2.04 1.84 1.68 1.56 1.44 Cash, cash equivalents, and short-term investments 136,527 133,819 133,768 132,981 113,240 Total assets 301,311 286,556 258,848 250,312 202,897 Long-term obligations 110,697 114,806 117,642 106,856 66,705 Stockholders’ equity 118,304 102,330 82,718 87,711 83,090 (a) GitHub has been included in our consolidated results of operations starting on the October 25, 2018 acquisition date . (b) Includes a $2.6 billion net income tax benefit related to intangible property transfers and a $157 million net charge related to the enactment of the Tax Cuts and Jobs Act (“TCJA”), which together increased net income and diluted earnings per share (“EPS”) by $2.4 billion and $0.31, respectively. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. ( c ) Includes a $13.7 billion net charge related to the enactment of the TCJA, which decreased net income and diluted EPS by $13.7 billion and $1.75, respectively. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. ( d ) Reflects the impact of the adoption of new accounting standards in fiscal year 2018 related to revenue recognition and leases. ( e ) LinkedIn has been included in our consolidated results of operations starting on the December 8, 2016 acquisition date. ( f ) Includes $306 million of employee severance expenses primarily related to our sales and marketing restructuring plan, which decreased operating income, net income, and diluted EPS by $306 million, $243 million, and $0.04, respectively. ( g ) Includes $630 million of asset impairment charges related to our Phone business and $480 million of restructuring charges associated with our Phone business restructuring plans, which together decreased operating income, net income, and diluted EPS by $1.1 billion, $895 million, and $0.11, respectively. 34 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by offering a wide range of cloud-based and other services to people and businesses; licensing and supporting an array of software products; designing, manufacturing, and selling devices; and delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes. As the world responds to the outbreak of a novel strain of the coronavirus (“COVID-19”), we are working to do our part by ensuring the safety of our employees, striving to protect the health and well-being of the communities in which we operate, and providing technology and resources to our customers to help them do their best work while remote. Highlights from fiscal year 2020 compared with fiscal year 2019 included: • Commercial cloud revenue increased 36% to $51.7 billion. • Office Commercial products and cloud services revenue increased 12%, driven by Office 365 Commercial growth of 24%. • Office Consumer products and cloud services revenue increased 11%, with continued growth in Office 365 Consumer subscribers to 42.7 million. • LinkedIn revenue increased 20%. • Dynamics products and cloud services revenue increased 14%, driven by Dynamics 365 growth of 42%. • Server products and cloud services revenue increased 27%, driven by Azure growth of 56%. • Enterprise Services revenue increased 5%. • Windows Commercial products and cloud services revenue increased 18%. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue increased 9%. • Surface revenue increased 8%. • Xbox content and services revenue increased 11%. • Search advertising revenue, excluding traffic acquisition costs, was relatively unchanged. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. 35 PART II Item 7 Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Strengthening of the U.S. dollar relative to certain foreign currencies did not significantly impact reported revenue or expenses from our international operations in the first and second quarters of fiscal year 2019, and reduced reported revenue and expenses from our international operations in the third and fourth quarters of fiscal year 2019. Strengthening of the U.S. dollar relative to certain foreign currencies reduced reported revenue and expenses from our international operations in fiscal year 2020. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. COVID-19 In fiscal year 2020, the COVID-19 pandemic impacted our business operations, including our employees, customers, partners, and communities, and we saw the following trends in our financial operating results. In the Productivity and Business Processes and Intelligent Cloud segments, cloud usage and demand increased as customers shifted to work and learn from home. We also experienced a slowdown in transactional licensing, particularly in small and medium businesses, and LinkedIn was negatively impacted by the weak job market and reductions in advertising spend. In the More Personal Computing segment, Windows OEM, Surface, and Gaming benefited from increased demand to support remote work-, play-, and learn-from-home scenarios, while Search was negatively impacted by reductions in advertising spend. The COVID-19 pandemic may continue to impact our business operations and financial operating results, and there is substantial uncertainty in the nature and degree of its continued effects over time. The extent to which the COVID-19 pandemic impacts our business going forward will depend on numerous evolving factors we cannot reliably predict, including the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity including the possibility of recession or financial market instability. These factors may adversely impact consumer, business, and government spending on technology as well as customers' ability to pay for our products and services on an ongoing basis. This uncertainty also affects management’s accounting estimates and assumptions, which could result in greater variability in a variety of areas that depend on these estimates and assumptions, including investments, receivables, and forward-looking guidance. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Seasonality Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period. 36 PART II Item 7 Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted in the United States of America (“GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other. Additional information on our reportable segments is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Metrics We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Financial metrics are calculated based on GAAP results and growth comparisons relate to the corresponding period of last fiscal year. Commercial Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance. Commercial remaining performance obligation Commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods Commercial cloud revenue Revenue from our commercial cloud business, which includes Office 365 Commercial, Azure, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties Commercial cloud gross margin percentage Gross margin percentage for our commercial cloud business 37 PART II Item 7 Productivity and Business Processes and Intelligent Cloud Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends. Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and cloud services, including Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”) Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud services, including Microsoft 365 Consumer (formerly Office 365 Consumer) subscriptions and Office licensed on-premises Office 365 Commercial seat growth The number of Office 365 Commercial seats at end of period where seats are paid users covered by an Office 365 Commercial subscription Office 365 Consumer subscribers The number of Office 365 Consumer subscribers at end of period Dynamics products and cloud services revenue growth Revenue from Dynamics products and cloud services, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises LinkedIn revenue growth Revenue from LinkedIn, including Talent Solutions, Learning Solutions, Marketing Solutions, Sales Solutions, and Premium Subscriptions Server products and cloud services revenue growth Revenue from Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related CALs; and GitHub Enterprise Services revenue growth Revenue from Enterprise Services, including Premier Support Services and Microsoft Consulting Services More Personal Computing Metrics related to our More Personal Computing segment assess the performance of key lines of business within this segment. These metrics provide strategic product insights which allow us to assess the performance across our commercial and consumer businesses. As we have diversity of target audiences and sales motions within the Windows business, we monitor metrics that are reflective of those varying motions. Windows OEM Pro revenue growth Revenue from sales of Windows Pro licenses sold through the OEM channel, which primarily addresses demand in the commercial market Windows OEM non-Pro revenue growth Revenue from sales of Windows non-Pro licenses sold through the OEM channel, which primarily addresses demand in the consumer market Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and cloud services, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings Surface revenue Revenue from Surface devices and accessories Xbox content and services revenue growth Revenue from Xbox content and services, comprising Xbox Live (transactions, subscriptions, cloud services, and advertising), video games, and third-party video game royalties Search advertising revenue, excluding TAC, growth Revenue from search advertising excluding traffic acquisition costs (“TAC”) paid to Bing Ads network publishers 38 PART II Item 7 SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2020 2019 2018 Percentage Change 2020 Versus 2019 Percentage Change 2019 Versus 2018 Revenue $ 143,015 $ 125,843 $ 110,360 14% 14% Gross margin 96,937 82,933 72,007 17% 15% Operating income 52,959 42,959 35,058 23% 23% Net income 44,281 39,240 16,571 13% 137% Diluted earnings per share 5.76 5.06 2.13 14% 138% Non-GAAP net income 44,281 36,830 30,267 20% 22% Non-GAAP diluted earnings per share 5.76 4.75 3.88 21% 22% Non-GAAP net income and diluted earnings per share (“EPS”) exclude the net tax impact of transfer of intangible properties in fiscal year 2019 and the net tax impact of the Tax Cuts and Jobs Act (“TCJA”) in fiscal years 2019 and 2018 . Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results. Fiscal Year 2020 Compared with Fiscal Year 2019 Revenue increased $17.2 billion or 14%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. Productivity and Business Processes revenue increased, driven by Office Commercial and LinkedIn. More Personal Computing revenue increased, driven by Windows and Surface. Gross margin increased $14.0 billion or 17%, driven by growth across each of our segments. Gross margin percentage increased, driven by sales mix shift to higher margin businesses. Commercial cloud gross margin percentage increased 4 points to 67%, primarily driven by improvement in Azure. Operating income increased $10.0 billion or 23%, driven by growth across each of our segments. Key changes in expenses were: • Cost of revenue increased $3.2 billion or 7%, driven by growth in commercial cloud. • Research and development expenses increased $2.4 billion or 14%, driven by investments in cloud engineering, LinkedIn, Devices, and Gaming. • Sales and marketing expenses increased $1.4 billion or 8%, driven by investments in LinkedIn and commercial sales, and an increase in bad debt expense. • General and administrative expenses increased $226 million or 5%, driven by charges associated with the closing of our Microsoft Store physical locations, offset in part by a reduction in business taxes and legal expenses. Gross margin and operating income included an unfavorable foreign currency impact of 2% and 4%, respectively. Prior year net income included a $2.6 billion net income tax benefit related to intangible property transfers and a $157 million net charge related to the enactment of the TCJA, which together resulted in an increase to net income and diluted EPS of $2.4 billion and $0.31, respectively. Fiscal Year 2019 Compared with Fiscal Year 2018 Revenue increased $15.5 billion or 14%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. Productivity and Business Processes revenue increased, driven by Office and LinkedIn. More Personal Computing revenue increased, driven by Surface, Gaming, and Windows. Gross margin increased $10.9 billion or 15%, driven by growth across each of our segments. Gross margin percentage increased slightly, due to gross margin percentage improvement across each of our segments and favorable segment sales mix. Gross margin included a 5 percentage point improvement in commercial cloud, primarily from Azure. 39 PART II Item 7 Operating income increased $7.9 billion or 23%, driven by growth across each of our segments. Key changes in expenses were: • Cost of revenue increased $4.6 billion or 12%, driven by growth in commercial cloud, Surface, and Gaming. • Research and development expenses increased $2.2 billion or 15%, driven by investments in cloud and artificial intelligence (“AI”) engineering, Gaming, LinkedIn, and GitHub. • Sales and marketing expenses increased $744 million or 4%, driven by investments in commercial sales capacity, LinkedIn, and GitHub, offset in part by a decrease in marketing. Sales and marketing expenses included a favorable foreign currency impact of 2%. Fiscal year 2019 net income included a $2.6 billion net income tax benefit related to intangible property transfers and a $157 million net charge related to the enactment of the TCJA, which together resulted in an increase to net income and diluted EPS of $2.4 billion and $0.31, respectively. Fiscal year 2018 net income and diluted EPS were negatively impacted by the net charge related to the enactment of the TCJA, which resulted in a decrease to net income and diluted EPS of $13.7 billion and $1.75, respectively. SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2020 2019 2018 Percentage Change 2020 Versus 2019 Percentage Change 2019 Versus 2018 Revenue Productivity and Business Processes $ 46,398 $ 41,160 $ 35,865 13% 15% Intelligent Cloud 48,366 38,985 32,219 24% 21% More Personal Computing 48,251 45,698 42,276 6% 8% Total $ 143,015 $ 125,843 $ 110,360 14% 14% Operating Income Productivity and Business Processes $ 18,724 $ 16,219 $ 12,924 15% 25% Intelligent Cloud 18,324 13,920 11,524 32% 21% More Personal Computing 15,911 12,820 10,610 24% 21% Total $ 52,959 $ 42,959 $ 35,058 23% 23% Reportable Segments Fiscal Year 2020 Compared with Fiscal Year 2019 Productivity and Business Processes Revenue increased $5.2 billion or 13%. • Office Commercial products and cloud services revenue increased $3.1 billion or 12%, driven by Office 365 Commercial, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to cloud offerings. Office 365 Commercial revenue grew 24%, due to seat growth and higher revenue per user. • Office Consumer products and cloud services revenue increased $458 million or 11%, driven by Microsoft 365 Consumer subscription revenue and transactional strength in Japan. Office 365 Consumer subscribers increased 23% to 42.7 million with increased demand from remote work and learn scenarios. • LinkedIn revenue increased $1.3 billion or 20%, driven by growth across all businesses. • Dynamics products and cloud services revenue increased 14%, driven by Dynamics 365 growth of 42%. 40 PART II Item 7 Operating income increased $2 .5 billion or 15 %. • Gross margin increased $4.1 billion or 13%, driven by growth in Office Commercial and LinkedIn. Gross margin percentage was relatively unchanged, due to gross margin percentage improvement in LinkedIn, offset in part by an increased mix of cloud offerings. • Operating expenses increased $1.6 billion or 11%, driven by investments in LinkedIn and cloud engineering. Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively. Intelligent Cloud Revenue increased $9.4 billion or 24%. • Server products and cloud services revenue increased $8.8 billion or 27%, driven by Azure. Azure revenue grew 56%, due to growth in our consumption-based services. Server products revenue increased 8% , due to hybrid and premium solutions, as well as demand related to SQL Server 2008 and Windows Server 2008 end of support. • Enterprise Services revenue increased $285 million or 5% , driven by growth in Premier Support Services. Operating income increased $4.4 billion or 32%. • Gross margin increased $6.9 billion or 26%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies. Gross margin percentage increased slightly, due to gross margin percentage improvement in Azure, offset in part by an increased mix of cloud offerings. • Operating expenses increased $2.5 billion or 19%, driven by investments in Azure. Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively. More Personal Computing Revenue increased $2.6 billion or 6%. • Windows revenue increased $1.9 billion or 9%, driven by growth in Windows Commercial and Windows OEM. Windows Commercial products and cloud services revenue increased 18%, driven by increased demand for Microsoft 365. Windows OEM revenue increased 9%, ahead of PC market growth. Windows OEM Pro revenue grew 11%, driven by Windows 7 end of support and healthy Windows 10 demand, offset in part by weakness in small and medium businesses. Windows OEM non-Pro revenue grew 5%, driven by consumer demand from remote work and learn scenarios. • Surface revenue increased $457 million or 8%, driven by increased demand from remote work and learn scenarios. • Gaming revenue increased $189 million or 2%, driven by an increase in Xbox content and services, offset in part by a decrease in Xbox hardware. Xbox content and services revenue increased $943 million or 11% on a strong prior year comparable, driven by growth in Minecraft, third-party titles, and subscriptions, accelerated by higher engagement during stay-at-home guidelines. Xbox hardware revenue declined 31%, primarily due to a decrease in volume and price of consoles sold. • Search advertising revenue increased $112 million or 1%. Search advertising revenue, excluding traffic acquisition costs, was relatively unchanged. Operating income increased $3.1 billion or 24%. • Gross margin increased $3.0 billion or 12%, driven by growth in Windows, Gaming, and Surface. Gross margin percentage increased, due to sales mix shift to higher margin businesses and gross margin percentage improvement in Gaming. • Operating expenses decreased $119 million or 1%, driven by the redeployment of engineering resources, offset in part by charges associated with the closing of our Microsoft Store physical locations and investments in Gaming. 41 PART II Item 7 Gross margin and operating income included an unfavorable foreign currency impact of 2% and 3%, respectively. Fiscal Year 2019 Compared with Fiscal Year 2018 Productivity and Business Processes Revenue increased $5.3 billion or 15%. • Office Commercial products and cloud services revenue increased $3.2 billion or 13%, driven by Office 365 Commercial, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to cloud offerings. Office 365 Commercial grew 33%, due to growth in seats and higher average revenue per user. • Office Consumer products and cloud services revenue increased $286 million or 7%, driven by Microsoft 365 Consumer, due to recurring subscription revenue and transactional strength in Japan. • LinkedIn revenue increased $1.5 billion or 28%, driven by growth across each line of business. • Dynamics products and cloud services revenue increased 15%, driven by Dynamics 365 growth. Operating income increased $3.3 billion or 25%, including an unfavorable foreign currency impact of 2%. • Gross margin increased $4.1 billion or 15%, driven by growth in Office Commercial and LinkedIn. Gross margin percentage increased slightly, due to gross margin percentage improvement in LinkedIn and Office 365 Commercial, offset in part by an increased mix of cloud offerings. • Operating expenses increased $806 million or 6%, driven by investments in LinkedIn and cloud engineering, offset in part by a decrease in marketing. Intelligent Cloud Revenue increased $6.8 billion or 21%. • Server products and cloud services revenue, including GitHub, increased $6.5 billion or 25%, driven by Azure. Azure revenue growth was 72%, due to higher infrastructure-as-a-service and platform-as-a-service consumption-based and per user-based services. Server products revenue increased 6% , due to continued demand for premium versions and hybrid solutions, GitHub, and demand ahead of end-of-support for SQL Server 2008 and Windows Server 2008. • Enterprise Services revenue increased $278 million or 5% , driven by growth in Premier Support Services and Microsoft Consulting Services. Operating income increased $2.4 billion or 21%. • Gross margin increased $4.8 billion or 22%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies. Gross margin percentage increased slightly, due to gross margin percentage improvement in Azure, offset in part by an increased mix of cloud offerings. • Operating expenses increased $2.4 billion or 22%, driven by investments in cloud and AI engineering, GitHub, and commercial sales capacity. More Personal Computing Revenue increased $3.4 billion or 8%. • Windows revenue increased $877 million or 4%, driven by growth in Windows Commercial and Windows OEM, offset in part by a decline in patent licensing. Windows Commercial products and cloud services revenue increased 14%, driven by an increased mix of multi-year agreements that carry higher in-quarter revenue recognition. Windows OEM revenue increased 4%. Windows OEM Pro revenue grew 10%, ahead of the commercial PC market, driven by healthy Windows 10 demand. Windows OEM non-Pro revenue declined 7%, below the consumer PC market, driven by continued pressure in the entry level category. • Surface revenue increased $1.1 billion or 23%, with strong growth across commercial and consumer. 42 PART II Item 7 • Gaming revenue increased $1.0 billion or 10%, driven by Xbox software and services growth of 19%, primarily due to third-party title strength and subscriptions growth, offset in part by a decline in Xbox hardware of 13% primarily due to a decrease in volume of consoles sold. • Search advertising revenue increased $616 million or 9%. Search advertising revenue, excluding traffic acquisition costs, increased 13%, driven by higher revenue per search. Operating income increased $2.2 billion or 21%, including an unfavorable foreign currency impact of 2%. • Gross margin increased $2.0 billion or 9%, driven by growth in Windows, Gaming, and Search. Gross margin percentage increased slightly, due to sales mix shift to higher gross margin businesses in Windows and Gaming. • Operating expenses decreased $172 million or 1%. OPERATING EXPENSES Research and Development (In millions, except percentages) 2020 2019 2018 Percentage Change 2020 Versus 2019 Percentage Change 2019 Versus 2018 Research and development $ 19,269 $ 16,876 $ 14,726 14% 15% As a percent of revenue 13% 13% 13% 0ppt 0ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Fiscal Year 2020 Compared with Fiscal Year 2019 Research and development expenses increased $2.4 billion or 14%, driven by investments in cloud engineering, LinkedIn, Devices, and Gaming. Fiscal Year 2019 Compared with Fiscal Year 2018 Research and development expenses increased $2.2 billion or 15%, driven by investments in cloud and AI engineering, Gaming, LinkedIn, and GitHub. Sales and Marketing (In millions, except percentages) 2020 2019 2018 Percentage Change 2020 Versus 2019 Percentage Change 2019 Versus 2018 Sales and marketing $ 19,598 $ 18,213 $ 17,469 8% 4% As a percent of revenue 14% 14% 16% 0ppt (2)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Fiscal Year 2020 Compared with Fiscal Year 2019 Sales and marketing expenses increased $1.4 billion or 8%, driven by investments in LinkedIn and commercial sales, and an increase in bad debt expense. 43 PART II Item 7 Fiscal Year 2019 Compared with Fiscal Year 2018 Sales and marketing expenses increased $744 million or 4%, driven by investments in commercial sales capacity, LinkedIn, and GitHub, offset in part by a decrease in marketing. Expenses included a favorable foreign currency impact of 2%. General and Administrative (In millions, except percentages) 2020 2019 2018 Percentage Change 2020 Versus 2019 Percentage Change 2019 Versus 2018 General and administrative $ 5,111 $ 4,885 $ 4,754 5% 3% As a percent of revenue 4% 4% 4% 0ppt 0ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. Fiscal Year 2020 Compared with Fiscal Year 2019 General and administrative expenses increased $226 million or 5%, driven by charges associated with the closing of our Microsoft Store physical locations, offset in part by a reduction in business taxes and legal expenses. Fiscal Year 2019 Compared with Fiscal Year 2018 General and administrative expenses increased $131 million or 3%. OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Interest and dividends income $ 2,680 $ 2,762 $ 2,214 Interest expense (2,591 ) (2,686 ) (2,733 ) Net recognized gains on investments 32 648 2,399 Net gains (losses) on derivatives 187 144 (187 ) Net losses on foreign currency remeasurements (191 ) (82 ) (218 ) Other, net (40 ) (57 ) (59 ) Total $ 77 $ 729 $ 1,416 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net. Fiscal Year 2020 Compared with Fiscal Year 2019 Interest and dividends income decreased due to lower yields, offset in part by higher average portfolio balances on fixed-income securities. Interest expense decreased due to capitalization of interest expense and a decrease in outstanding long-term debt due to debt maturities, offset in part by debt exchange transaction fees and higher finance lease expense. Net recognized gains on investments decreased due to lower gains and higher other-than-temporary impairments on equity investments, offset in part by gains on fixed income securities in the current period compared to losses in the prior period. Net gains on derivatives increased due to higher gains on foreign exchange and equity derivatives. 44 PART II Item 7 Fiscal Year 2019 Compared with Fiscal Year 2018 Interest and dividends income increased primarily due to higher yields on fixed-income securities. Interest expense decreased primarily driven by a decrease in outstanding long-term debt due to debt maturities, offset in part by higher finance lease expense . Net recognized gains on investments decreased primarily due to lower gains on sales of equity investments. Net gains on derivatives includes gains on foreign exchange and interest rate derivatives in the current period as compared to losses in the prior period . INCOME TAXES Effective Tax Rate Fiscal Year 2020 Compared with Fiscal Year 2019 Our effective tax rate for fiscal years 2020 and 2019 was 17% and 10%, respectively. The increase in our effective tax rate for fiscal year 2020 compared to fiscal year 2019 was primarily due to a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, and tax benefits relating to stock-based compensation. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2020, our U.S. income before income taxes was $24.1 billion and our foreign income before income taxes was $28.9 billion. In fiscal year 2019, our U.S. income before income taxes was $15.8 billion and our foreign income before income taxes was $27.9 billion. Fiscal Year 2019 Compared with Fiscal Year 2018 Our effective tax rate for fiscal years 2019 and 2018 was 10% and 55%, respectively. The decrease in our effective tax rate for fiscal year 2019 compared to fiscal year 2018 was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018 and a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to the tax benefit related to intangible property transfers, and earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2019, our U.S. income before income taxes was $15.8 billion and our foreign income before income taxes was $27.9 billion. In fiscal year 2018, our U.S. income before income taxes was $11.5 billion and our foreign income before income taxes was $24.9 billion. Tax Cuts and Jobs Act On December 22, 2017, the TCJA was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business. We recorded a provisional net charge of $13.7 billion related to the enactment of the TCJA in fiscal year 2018, and adjusted the provisional net charge by recording additional tax expense of $157 million in fiscal year 2019 pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 118. In fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland. The transfers of intangible properties resulted in a $2.6 billion net income tax benefit recorded in the fourth quarter of fiscal year 2019, as the value of future tax deductions exceeded the current tax liability from foreign jurisdictions and U.S. global intangible low-taxed income tax. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 45 PART II Item 7 Uncertain Tax Positions We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under audit for tax years 2004 to 2013. In April 2020, the IRS commenced the audit for tax years 2014 to 2017. As of June 30, 2020, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2019, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Non-GAAP net income and diluted EPS are non-GAAP financial measures which exclude the net tax impact of transfer of intangible properties in fiscal year 2019 and the net tax impact of the TCJA in fiscal years 2019 and 2018. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results: (In millions, except percentages and per share amounts) 2020 2019 2018 Percentage Change 2020 Versus 2019 Percentage Change 2019 Versus 2018 Net income $ 44,281 $ 39,240 $ 16,571 13% 137% Net tax impact of transfer of intangible properties 0 (2,567 ) 0 * * Net tax impact of the TCJA 0 157 13,696 * * Non-GAAP net income $ 44,281 $ 36,830 $ 30,267 20% 22% Diluted earnings per share $ 5.76 $ 5.06 $ 2.13 14% 138% Net tax impact of transfer of intangible properties 0 (0.33 ) 0 * * Net tax impact of the TCJA 0 0.02 1.75 * * Non-GAAP diluted earnings per share $ 5.76 $ 4.75 $ 3.88 21% 22% * Not meaningful. 46 PART II Item 7 FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $136.5 billion and $133.8 billion as of June 30, 2020 and 2019. Equity investments were $3.0 billion and $2.6 billion as of June 30, 2020 and 2019, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Fiscal Year 2020 Compared with Fiscal Year 2019 Cash from operations increased $8.5 billion to $60.7 billion for fiscal year 2020, mainly due to an increase in cash from customers, offset in part by an increase in cash used to pay income taxes, suppliers, and employees. Cash used in financing increased $9.1 billion to $46.0 billion for fiscal year 2020, mainly due to a $3.4 billion cash premium on our debt exchange, a $3.4 billion increase in common stock repurchases, a $1.5 billion increase in repayments of debt, and a $1.3 billion increase in dividends paid. Cash used in investing decreased $3.6 billion to $12.2 billion for fiscal year 2020, mainly due to a $6.4 billion increase in cash from net investment purchases, sales, and maturities, offset in part by a $1.5 billion increase in additions to property and equipment and $1.2 billion in other investing to facilitate the purchase of components. 47 PART II Item 7 Fiscal Year 2019 Compared with Fiscal Year 2018 Cash from operations increased $8.3 billion to $52.2 billion for fiscal year 2019, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees and an increase in cash paid for income taxes. Cash used in financing increased $3.3 billion to $36.9 billion for fiscal year 2019, mainly due to an $8.8 billion increase in common stock repurchases and a $1.1 billion increase in dividends paid, offset in part by a $6.2 billion decrease in repayments of debt, net of proceeds from issuance of debt. Cash used in investing increased $9.7 billion to $15.8 billion for fiscal year 2019, mainly due to a $6.0 billion decrease in cash from net investment purchases, sales, and maturities, a $2.3 billion increase in additions to property and equipment, and a $1.5 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets. Debt We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. In June 2020, we exchanged a portion of our existing debt at premium for cash and new debt with longer maturities to take advantage of favorable financing rates in the debt markets, reflecting our credit rating and the low interest rate environment. Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. The following table outlines the expected future recognition of unearned revenue as of June 30, 2020: (In millions) Three Months Ending September 30, 2020 $ 13,884 December 31, 2020 10,950 March 31, 2021 7,476 June 30, 2021 3,690 Thereafter 3,180 Total $ 39,180 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Share Repurchases For fiscal years 2020, 2019, and 2018, we repurchased 126 million shares, 150 million shares, and 99 million shares of our common stock for $19.7 billion, $16.8 billion, and $8.6 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 48 PART II Item 7 Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented. Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2020: (In millions) 2021 2022-2023 2024-2025 Thereafter Total Long-term debt: (a) Principal payments $ 3,750 $ 10,716 $ 7,500 $ 45,441 $ 67,407 Interest payments 2,028 3,736 3,293 25,265 34,322 Construction commitments (b) 4,761 280 0 0 5,041 Operating leases, including imputed interest (c) 2,420 3,986 2,929 4,409 13,744 Finance leases, including imputed interest (c) 992 2,243 2,676 9,611 15,522 Transition tax (d) 1,450 2,899 6,343 4,531 15,223 Purchase commitments (e) 25,059 1,324 369 272 27,024 Other long-term liabilities (f) 0 294 32 356 682 Total $ 40,460 $ 25,478 $ 23,142 $ 89,885 $ 178,965 (a) Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Refer to Note 7 – Property and Equipment of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (c) Refer to Note 14 – Leases of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (d) Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (e) Amounts represent purchase commitments, including open purchase orders and take-or-pay contracts that are not presented as construction commitments above. (f) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $15.2 billion from the amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items. Other Planned Uses of Capital We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of $3.2 billion, which included $1.2 billion for fiscal year 2020. The remaining transition tax of $15.2 billion is payable over the next six years with a final payment in fiscal year 2026. During fiscal year 2020, we also paid $3.7 billion related to the transfer of intangible properties that occurred in the fourth quarter of fiscal year 2019. 49 PART II Item 7 We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future. RECENT ACCOUNTING GUIDANCE Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies, as well as uncertainty in the current economic environment due to the recent outbreak of COVID-19. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. 50 PART II Item 7 Impairment of Investment Securities We review debt investments quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we employ a systematic methodology quarterly that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the duration and extent to which the fair value is less than cost. We also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. In addition, we consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a quarterly basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. 51 PART II Item 7 Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. The TCJA significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. CHANGE IN ACCOUNTING ESTIMATE In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years. This change in accounting estimate will be effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in “Property and equipment, net” as of June 30, 2020, it is estimated this change will increase our fiscal year 2021 operating income by $2.7 billion. 52 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer 53 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions, including hedges. Principal currency exposures include the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. Equity Securities held in our equity investments portfolio are subject to price risk. SENSITIVITY ANALYSIS The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices: (In millions) Risk Categories Hypothetical Change June 30, 2020 Impact Foreign currency–Revenue 10% decrease in foreign exchange rates $ (4,142 ) Earnings Foreign currency–Investments 10% decrease in foreign exchange rates (119 ) Fair Value Interest rate 100 basis point increase in U.S. treasury interest rates (3,951 ) Fair Value Credit 100 basis point increase in credit spreads (301 ) Fair Value Equity 10% decrease in equity market prices (239 ) Earnings 54 PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2020 2019 2018 Revenue: Product $ 68,041 $ 66,069 $ 64,497 Service and other 74,974 59,774 45,863 Total revenue 143,015 125,843 110,360 Cost of revenue: Product 16,017 16,273 15,420 Service and other 30,061 26,637 22,933 Total cost of revenue 46,078 42,910 38,353 Gross margin 96,937 82,933 72,007 Research and development 19,269 16,876 14,726 Sales and marketing 19,598 18,213 17,469 General and administrative 5,111 4,885 4,754 Operating income 52,959 42,959 35,058 Other income, net 77 729 1,416 Income before income taxes 53,036 43,688 36,474 Provision for income taxes 8,755 4,448 19,903 Net income $ 44,281 $ 39,240 $ 16,571 Earnings per share: Basic $ 5.82 $ 5.11 $ 2.15 Diluted $ 5.76 $ 5.06 $ 2.13 Weighted average shares outstanding: Basic 7,610 7,673 7,700 Diluted 7,683 7,753 7,794 Refer to accompanying notes. 55 PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2020 2019 2018 Net income $ 44,281 $ 39,240 $ 16,571 Other comprehensive income (loss), net of tax: Net change related to derivatives ( 38 ) ( 173 ) 39 Net change related to investments 3,990 2,405 ( 2,717 ) Translation adjustments and other ( 426 ) ( 318 ) ( 178 ) Other comprehensive income (loss) 3,526 1,914 ( 2,856 ) Comprehensive income $ 47,807 $ 41,154 $ 13,715 Refer to accompanying notes. 56 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2020 2019 Assets Current assets: Cash and cash equivalents $ 13,576 $ 11,356 Short-term investments 122,951 122,463 Total cash, cash equivalents, and short-term investments 136,527 133,819 Accounts receivable, net of allowance for doubtful accounts of $ 788 and $ 411 32,011 29,524 Inventories 1,895 2,063 Other current assets 11,482 10,146 Total current assets 181,915 175,552 Property and equipment, net of accumulated depreciation of $ 43,197 and $ 35,330 44,151 36,477 Operating lease right-of-use assets 8,753 7,379 Equity investments 2,965 2,649 Goodwill 43,351 42,026 Intangible assets, net 7,038 7,750 Other long-term assets 13,138 14,723 Total assets $ 301,311 $ 286,556 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 12,530 $ 9,382 Current portion of long-term debt 3,749 5,516 Accrued compensation 7,874 6,830 Short-term income taxes 2,130 5,665 Short-term unearned revenue 36,000 32,676 Other current liabilities 10,027 9,351 Total current liabilities 72,310 69,420 Long-term debt 59,578 66,662 Long-term income taxes 29,432 29,612 Long-term unearned revenue 3,180 4,530 Deferred income taxes 204 233 Operating lease liabilities 7,671 6,188 Other long-term liabilities 10,632 7,581 Total liabilities 183,007 184,226 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000 ; outstanding 7,571 and 7,643 80,552 78,520 Retained earnings 34,566 24,150 Accumulated other comprehensive income (loss) 3,186 ( 340 ) Total stockholders’ equity 118,304 102,330 Total liabilities and stockholders’ equity $ 301,311 $ 286,556 Refer to accompanying notes. 57 PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2020 2019 2018 Operations Net income $ 44,281 $ 39,240 $ 16,571 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other 12,796 11,682 10,261 Stock-based compensation expense 5,289 4,652 3,940 Net recognized gains on investments and derivatives ( 219 ) ( 792 ) ( 2,212 ) Deferred income taxes 11 ( 6,463 ) ( 5,143 ) Changes in operating assets and liabilities: Accounts receivable ( 2,577 ) ( 2,812 ) ( 3,862 ) Inventories 168 597 ( 465 ) Other current assets ( 2,330 ) ( 1,718 ) ( 952 ) Other long-term assets ( 1,037 ) ( 1,834 ) ( 285 ) Accounts payable 3,018 232 1,148 Unearned revenue 2,212 4,462 5,922 Income taxes ( 3,631 ) 2,929 18,183 Other current liabilities 1,346 1,419 798 Other long-term liabilities 1,348 591 ( 20 ) Net cash from operations 60,675 52,185 43,884 Financing Repayments of short-term debt, maturities of 90 days or less, net 0 0 ( 7,324 ) Proceeds from issuance of debt 0 0 7,183 Cash premium on debt exchange ( 3,417 ) 0 0 Repayments of debt ( 5,518 ) ( 4,000 ) ( 10,060 ) Common stock issued 1,343 1,142 1,002 Common stock repurchased ( 22,968 ) ( 19,543 ) ( 10,721 ) Common stock cash dividends paid ( 15,137 ) ( 13,811 ) ( 12,699 ) Other, net ( 334 ) ( 675 ) ( 971 ) Net cash used in financing ( 46,031 ) ( 36,887 ) ( 33,590 ) Investing Additions to property and equipment ( 15,441 ) ( 13,925 ) ( 11,632 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets ( 2,521 ) ( 2,388 ) ( 888 ) Purchases of investments ( 77,190 ) ( 57,697 ) ( 137,380 ) Maturities of investments 66,449 20,043 26,360 Sales of investments 17,721 38,194 117,577 Other, net ( 1,241 ) 0 ( 98 ) Net cash used in investing ( 12,223 ) ( 15,773 ) ( 6,061 ) Effect of foreign exchange rates on cash and cash equivalents ( 201 ) ( 115 ) 50 Net change in cash and cash equivalents 2,220 ( 590 ) 4,283 Cash and cash equivalents, beginning of period 11,356 11,946 7,663 Cash and cash equivalents, end of period $ 13,576 $ 11,356 $ 11,946 Refer to accompanying notes. 58 PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions) Year Ended June 30, 2020 2019 2018 Common stock and paid-in capital Balance, beginning of period $ 78,520 $ 71,223 $ 69,315 Common stock issued 1,343 6,829 1,002 Common stock repurchased ( 4,599 ) ( 4,195 ) ( 3,033 ) Stock-based compensation expense 5,289 4,652 3,940 Other, net ( 1 ) 11 ( 1 ) Balance, end of period 80,552 78,520 71,223 Retained earnings Balance, beginning of period 24,150 13,682 17,769 Net income 44,281 39,240 16,571 Common stock cash dividends ( 15,483 ) ( 14,103 ) ( 12,917 ) Common stock repurchased ( 18,382 ) ( 15,346 ) ( 7,699 ) Cumulative effect of accounting changes 0 677 ( 42 ) Balance, end of period 34,566 24,150 13,682 Accumulated other comprehensive income (loss) Balance, beginning of period ( 340 ) ( 2,187 ) 627 Other comprehensive income (loss) 3,526 1,914 ( 2,856 ) Cumulative effect of accounting changes 0 ( 67 ) 42 Balance, end of period 3,186 ( 340 ) ( 2,187 ) Total stockholders’ equity $ 118,304 $ 102,330 $ 82,718 Cash dividends declared per common share $ 2.04 $ 1.84 $ 1.68 Refer to accompanying notes. 59 PART II Item 8 NOTES TO FINANCI AL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have recast certain prior period amounts to conform to the current period presentation. The recast of these prior period amounts had no impact on our consolidated balance sheets, consolidated income statements, or net cash from or used in operating, financing, or investing on our consolidated cash flows statements. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of uncertain tax positions that have been recognized in our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions due to risks and uncertainties, including uncertainty in the current economic environment due to the recent outbreak of a novel strain of the coronavirus (“COVID-19”). In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years . This change in accounting estimate will be effective beginning fiscal year 2021. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income. Revenue Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems; cross-device productivity applications; server applications; business solution applications; desktop and server management tools; software development tools; video games; and hardware such as PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Office 365, Azure, Dynamics 365, and Xbox Live; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. 60 PART II Item 8 Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental authorities. Nature of Products and Services Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. In cases where we allocate revenue to software updates, primarily because the updates are provided at no additional charge, revenue is recognized as the updates are provided, which is generally ratably over the estimated life of the related device or license. Certain volume licensing programs, including Enterprise Agreements, include on-premises licenses combined with Software Assurance (“SA”). SA conveys rights to new software and upgrades released over the contract period and provides support, tools, and training to help customers deploy and use products more efficiently. On-premises licenses are considered distinct performance obligations when sold with SA. Revenue allocated to SA is generally recognized ratably over the contract period as customers simultaneously consume and receive benefits, given that SA comprises distinct performance obligations that are satisfied over time. Cloud services, which allow customers to use hosted software over the contract period without taking possession of the software, are provided on either a subscription or consumption basis. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract period. Revenue related to cloud services provided on a consumption basis, such as the amount of storage used in a period, is recognized based on the customer utilization of such resources. When cloud services require a significant level of integration and interdependency with software and the individual components are not considered distinct, all revenue is recognized over the period in which the cloud services are provided. Revenue from search advertising is recognized when the advertisement appears in the search results or when the action necessary to earn the revenue has been completed. Revenue from consulting services is recognized as services are provided. Our hardware is generally highly dependent on, and interrelated with, the underlying operating system and cannot function without the operating system. In these cases, the hardware and software license are accounted for as a single performance obligation and revenue is recognized at the point in time when ownership is transferred to resellers or directly to end customers through retail stores and online marketplaces. Refer to Note 19 – Segment Information and Geographic Data for further information, including revenue by significant product and service offering. Significant Judgments Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 61 PART II Item 8 Judgment is required to determine the SSP for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Contract Balances Timing of revenue recognition may differ from the timing of invoicing to customers. We record a receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For multi-year agreements, we generally invoice customers annually at the beginning of each annual coverage period. We record a receivable related to revenue recognized for multi-year on-premises licenses as we have an unconditional right to invoice and receive payment in the future related to those licenses. As of June 30, 2020 and 2019, long-term accounts receivable, net of allowance for doubtful accounts, was $ 2.7 billion and $ 2.2 billion, respectively, and is included in other long-term assets in our consolidated balance sheets. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2020 2019 2018 Balance, beginning of period $ 434 $ 397 $ 361 Charged to costs and other 560 153 134 Write-offs ( 178 ) ( 116 ) ( 98 ) Balance, end of period $ 816 $ 434 $ 397 Allowance for doubtful accounts included in our consolidated balance sheets: (In millions) June 30, 2020 2019 2018 Accounts receivable, net of allowance for doubtful accounts $ 788 $ 411 $ 377 Other long-term assets 28 23 20 Total $ 816 $ 434 $ 397 62 PART II Item 8 Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include SA and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for consulting services to be performed in the future; LinkedIn subscriptions; Office 365 subscriptions; Xbox Live subscriptions; Windows 10 post-delivery support; Dynamics business solutions; Skype prepaid credits and subscriptions; and other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 13 – Unearned Revenue for further information, including unearned revenue by segment and changes in unearned revenue during the period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with revenue recognized upfront. We record financing receivables when we offer certain of our customers the option to acquire our software products and services offerings through a financing program in a limited number of countries. As of June 30, 2020 and 2019, our financing receivables, net were $ 5.2 billion and $ 4.3 billion, respectively, for short-term and long-term financing receivables, which are included in other current assets and other long-term assets in our consolidated balance sheets. We record an allowance to cover expected losses based on troubled accounts, historical experience, and other currently available evidence. Assets Recognized from Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets in our consolidated balance sheets. We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less. These costs include our internal sales force compensation program and certain partner sales incentive programs as we have determined annual compensation is commensurate with annual sales activities. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by original equipment manufacturers (“OEM”), to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain online products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. 63 PART II Item 8 Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 1.6 billion in fiscal years 2020, 2019, and 2018. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term in our consolidated balance sheets. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. 64 PART II Item 8 Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding other-than-temporary impairments, are recorded in other comprehensive income . Debt investments are impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the duration and extent to which the fair value is less than cost. We also evaluate whether we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery. In addition, we consider specific adverse conditions related to the financial health of , and business outlook , for the investee, including industry and sector performance, changes in technology, and operational and financing cash flow factors. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded in other income (expense), net and a new cost basis in the investment is established. Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a quarterly basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net. Derivatives Derivative instruments are recognized as either assets or liabilities and measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments designated as cash flow hedges, gains and losses are initially reported as a component of other comprehensive income and subsequently recognized in earnings with the corresponding hedged item. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 investments include commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. 65 PART II Item 8 • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets and liabilities include investments in corporate notes and bonds , municipal securities , and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure equity investments without readily determinable fair values on a nonrecurring basis. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. Our other current financial assets and current financial liabilities have fair values that approximate their carrying values. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years ; computer equipment, two to three years ; buildings and improvements, five to 15 years ; leasehold improvements, three to 20 years ; and furniture and equipment, one to 10 years . Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets, other current liabilities, and operating lease liabilities in our consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in our consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we generally use our incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. We have lease agreements with lease and non-lease components, which are generally accounted for separately. For certain equipment leases, such as vehicles, we account for the lease and non-lease components as a single lease component. Additionally, for certain equipment leases, we apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. 66 PART II Item 8 Intangible Assets Our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 20 years . We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Recently Adopted Accounting Guidance Financial Instruments – Targeted Improvements to Accounting for Hedging Activities In August 2017, the Financial Accounting Standards Board (“FASB”) issued new guidance related to accounting for hedging activities. This guidance expands strategies that qualify for hedge accounting, changes how many hedging relationships are presented in the financial statements, and simplifies the application of hedge accounting in certain situations. We adopted the standard effective July 1, 2019. As we did not hold derivative instruments requiring an adjustment upon adoption, there was no impact in our consolidated financial statements. Adoption of the standard enhanced the presentation of the effects of our hedging instruments and the hedged items in our consolidated financial statements to increase the understandability of the results of our hedging strategies. Recent Accounting Guidance Not Yet Adopted Financial Instruments – Credit Losses In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We will be required to use a forward-looking expected credit loss model for accounts receivable, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The standard will be adopted upon the effective date for us beginning July 1, 2020. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date to align our credit loss methodology with the new standard. We have evaluated the impact of this standard in our consolidated financial statements, including accounting policies, processes, and systems. We continue to monitor economic implications of the COVID-19 pandemic. Based on current market conditions, adoption of the standard will not have a material impact on our consolidated financial statements. Accounting for Income Taxes In December 2019, the FASB issued a new standard to simplify the accounting for income taxes. The guidance eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period, and the recognition of deferred tax liabilities for outside basis differences related to changes in ownership of equity method investments and foreign subsidiaries. The guidance also simplifies aspects of accounting for franchise taxes and enacted changes in tax laws or rates, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard will be effective for us beginning July 1, 2021, with early adoption permitted. We are currently evaluating the impact of this standard in our consolidated financial statements, including accounting policies, processes, and systems. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. 67 PART II Item 8 The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2020 2019 2018 Net income available for common shareholders (A) $ 44,281 $ 39,240 $ 16,571 Weighted average outstanding shares of common stock (B) 7,610 7,673 7,700 Dilutive effect of stock-based awards 73 80 94 Common stock and common stock equivalents (C) 7,683 7,753 7,794 Earnings Per Share Basic (A/B) $ 5.82 $ 5.11 $ 2.15 Diluted (A/C) $ 5.76 $ 5.06 $ 2.13 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Interest and dividends income $ 2,680 $ 2,762 $ 2,214 Interest expense ( 2,591 ) ( 2,686 ) ( 2,733 ) Net recognized gains on investments 32 648 2,399 Net gains (losses) on derivatives 187 144 ( 187 ) Net losses on foreign currency remeasurements ( 191 ) ( 82 ) ( 218 ) Other, net ( 40 ) ( 57 ) ( 59 ) Total $ 77 $ 729 $ 1,416 Net Recognized Gains (Losses) on Investments Net recognized gains (losses) on debt investments were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Realized gains from sales of available-for-sale securities $ 50 $ 12 $ 27 Realized losses from sales of available-for-sale securities ( 37 ) ( 93 ) ( 987 ) Other-than-temporary impairments of investments ( 17 ) ( 16 ) ( 6 ) Total $ ( 4 ) $ ( 97 ) $ ( 966 ) Net recognized gains (losses) on equity investments were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Net realized gains on investments sold $ 83 $ 276 $ 3,406 Net unrealized gains on investments still held 69 479 0 Impairments of investments ( 116 ) ( 10 ) ( 41 ) Total $ 36 $ 745 $ 3,365 68 PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments were as follows: (In millions) Fair Value Level Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2020 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 4,687 $ 1 $ 0 $ 4,688 $ 1,618 $ 3,070 $ 0 Certificates of deposit Level 2 2,898 0 0 2,898 1,646 1,252 0 U.S. government securities Level 1 92,067 6,495 ( 1 ) 98,561 3,168 95,393 0 U.S. agency securities Level 2 2,439 2 0 2,441 449 1,992 0 Foreign government bonds Level 2 6,982 6 ( 3 ) 6,985 1 6,984 0 Mortgage- and asset-backed securities Level 2 4,865 41 ( 6 ) 4,900 0 4,900 0 Corporate notes and bonds Level 2 8,500 327 ( 17 ) 8,810 0 8,810 0 Corporate notes and bonds Level 3 58 0 0 58 0 58 0 Municipal securities Level 2 313 57 ( 4 ) 366 0 366 0 Municipal securities Level 3 91 0 0 91 0 91 0 Total debt investments $ 122,900 $ 6,929 $ ( 31 ) $ 129,798 $ 6,882 $ 122,916 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 1,198 $ 784 $ 0 $ 414 Equity investments Other 2,551 0 0 2,551 Total equity investments $ 3,749 $ 784 $ 0 $ 2,965 Cash $ 5,910 $ 5,910 $ 0 $ 0 Derivatives, net (a) 35 0 35 0 Total $ 139,492 $ 13,576 $ 122,951 $ 2,965 69 PART II Item 8 (In millions) Fair Value Level Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2019 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 2,211 $ 0 $ 0 $ 2,211 $ 1,773 $ 438 $ 0 Certificates of deposit Level 2 2,018 0 0 2,018 1,430 588 0 U.S. government securities Level 1 104,925 1,854 ( 104 ) 106,675 769 105,906 0 U.S. agency securities Level 2 988 0 0 988 698 290 0 Foreign government bonds Level 2 6,350 4 ( 8 ) 6,346 2,506 3,840 0 Mortgage- and asset-backed securities Level 2 3,554 10 ( 3 ) 3,561 0 3,561 0 Corporate notes and bonds Level 2 7,437 111 ( 7 ) 7,541 0 7,541 0 Corporate notes and bonds Level 3 15 0 0 15 0 15 0 Municipal securities Level 2 242 48 0 290 0 290 0 Municipal securities Level 3 7 0 0 7 0 7 0 Total debt investments $ 127,747 $ 2,027 $ ( 122 ) $ 129,652 $ 7,176 $ 122,476 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 973 $ 409 $ 0 $ 564 Equity investments Other 2,085 0 0 2,085 Total equity investments $ 3,058 $ 409 $ 0 $ 2,649 Cash $ 3,771 $ 3,771 $ 0 $ 0 Derivatives, net (a) ( 13 ) 0 ( 13 ) 0 Total $ 136,468 $ 11,356 $ 122,463 $ 2,649 (a) Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments. Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of June 30, 2020 and 2019, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $ 1.4 billion and $ 1.2 billion, respectively. Unrealized Losses on Debt Investments Debt investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2020 U.S. government and agency securities $ 2,323 $ ( 1 ) $ 0 $ 0 $ 2,323 $ ( 1 ) Foreign government bonds 500 ( 3 ) 0 0 500 ( 3 ) Mortgage- and asset-backed securities 1,014 ( 6 ) 0 0 1,014 ( 6 ) Corporate notes and bonds 649 ( 17 ) 0 0 649 ( 17 ) Municipal securities 66 ( 4 ) 0 0 66 ( 4 ) Total $ 4,552 $ ( 31 ) $ 0 $ 0 $ 4,552 $ ( 31 ) 70 PART II Item 8 Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2019 U.S. government and agency securities $ 1,491 $ ( 1 ) $ 39,158 $ ( 103 ) $ 40,649 $ ( 104 ) Foreign government bonds 25 0 77 ( 8 ) 102 ( 8 ) Mortgage- and asset-backed securities 664 ( 1 ) 378 ( 2 ) 1,042 ( 3 ) Corporate notes and bonds 498 ( 3 ) 376 ( 4 ) 874 ( 7 ) Total $ 2,678 $ ( 5 ) $ 39,989 $ ( 117 ) $ 42,667 $ ( 122 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Cost Basis Estimated Fair Value June 30, 2020 Due in one year or less $ 36,169 $ 36,276 Due after one year through five years 51,465 54,700 Due after five years through 10 years 32,299 35,674 Due after 10 years 2,967 3,148 Total $ 122,900 $ 129,798 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, interest rates, equity prices, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Foreign currency risks related to certain non-U.S. dollar-denominated investments are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. Foreign currency risks related to certain Euro-denominated debt are hedged using foreign exchange forward contracts that are designated as cash flow hedging instruments. In the past, option and forward contracts were used to hedge a portion of forecasted international revenue and were designated as cash flow hedging instruments. Principal currencies hedged included the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. 71 PART II Item 8 Interest Rate Interest rate risks related to certain fixed-rate debt are hedged using interest rate swaps that are designated as fair value hedging instruments to effectively convert the fixed interest rates to floating interest rates. Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Equity Securities held in our equity investments portfolio are subject to market price risk. At times, we may hold options, futures, and swap contracts. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $ 1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2020, our long-term unsecured debt rating was AAA , and cash investments were in excess of $ 1.0 billion. As a result, no collateral was required to be posted. The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents: (In millions) June 30, 2020 June 30, 2019 Designated as Hedging Instruments Foreign exchange contracts purchased $ 635 $ 0 Foreign exchange contracts sold 6,754 6,034 Interest rate contracts purchased 1,295 0 Not Designated as Hedging Instruments Foreign exchange contracts purchased 11,896 14,889 Foreign exchange contracts sold 15,595 15,614 Other contracts purchased 1,844 2,007 Other contracts sold 757 456 72 PART II Item 8 Fair Values of Derivative Instruments The following table presents our derivative instruments: Derivative Derivative Derivative Derivative (In millions) Assets Liabilities Assets Liabilities June 30, 2020 June 30, 2019 Designated as Hedging Instruments Foreign exchange contracts $ 44 $ ( 54 ) $ 0 $ ( 93 ) Interest rate contracts 93 0 0 0 Not Designated as Hedging Instruments Foreign exchange contracts 245 ( 334 ) 204 ( 172 ) Other contracts 18 ( 11 ) 46 ( 7 ) Gross amounts of derivatives 400 ( 399 ) 250 ( 272 ) Gross amounts of derivatives offset in the balance sheet ( 154 ) 158 ( 113 ) 114 Cash collateral received 0 ( 154 ) 0 ( 78 ) Net amounts of derivatives $ 246 $ ( 395 ) $ 137 $ ( 236 ) Reported as Short-term investments $ 35 $ 0 $ ( 13 ) $ 0 Other current assets 199 0 146 0 Other long-term assets 12 0 4 0 Other current liabilities 0 ( 334 ) 0 ( 221 ) Other long-term liabilities 0 ( 61 ) 0 ( 15 ) Total $ 246 $ ( 395 ) $ 137 $ ( 236 ) Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $ 399 million and $ 399 million, respectively, as of June 30, 2020, and $ 247 million and $ 272 million, respectively, as of June 30, 2019. The following table presents the fair value of our derivatives instruments on a gross basis: (In millions) Level 1 Level 2 Level 3 Total June 30, 2020 Derivative assets $ 1 $ 398 $ 1 $ 400 Derivative liabilities 0 ( 399 ) 0 ( 399 ) June 30, 2019 Derivative assets 0 247 3 250 Derivative liabilities 0 ( 272 ) 0 ( 272 ) 73 PART II Item 8 Gains (losses) on derivative instruments recognized in our consolidated income statements were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Revenue Other Income (Expense), Net Revenue Other Income (Expense), Net Revenue Other Income (Expense), Net Designated as Fair Value Hedging Instruments Foreign exchange contracts Derivatives $ 0 $ 1 $ 0 $ ( 130 ) $ 0 $ ( 78 ) Hedged items 0 3 0 130 0 78 Excluded from effectiveness assessment 0 139 0 168 0 103 Interest rate contracts Derivatives 0 93 0 0 0 0 Hedged items 0 ( 93 ) 0 0 0 0 Equity contracts Derivatives 0 0 0 0 0 ( 324 ) Hedged items 0 0 0 0 0 324 Excluded from effectiveness assessment 0 0 0 0 0 80 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Amount reclassified from accumulated other comprehensive income 0 0 341 0 185 0 Excluded from effectiveness assessment 0 0 ( 64 ) 0 ( 255 ) 0 Not Designated as Hedging Instruments Foreign exchange contracts 0 ( 123 ) 0 ( 97 ) 0 ( 33 ) Other contracts 0 50 0 38 0 ( 104 ) Gains (losses), net of tax, on derivative instruments recognized in our consolidated comprehensive income statements were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Included in effectiveness assessment $ ( 38 ) $ 159 $ 219 NOTE 6 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2020 2019 Raw materials $ 700 $ 399 Work in process 83 53 Finished goods 1,112 1,611 Total $ 1,895 $ 2,063 74 PART II Item 8 NOTE 7 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2020 2019 Land $ 1,823 $ 1,540 Buildings and improvements 33,995 26,288 Leasehold improvements 5,487 5,316 Computer equipment and software 41,261 33,823 Furniture and equipment 4,782 4,840 Total, at cost 87,348 71,807 Accumulated depreciation ( 43,197 ) ( 35,330 ) Total, net $ 44,151 $ 36,477 During fiscal years 2020, 2019, and 2018, depreciation expense was $ 10.7 billion, $ 9.7 billion, and $ 7.7 billion, respectively. We have committed $ 5.0 billion for the construction of new buildings, building improvements, and leasehold improvements as of June 30, 2020. During fiscal year 2020, we recorded an impairment charge of $ 186 million to Property and Equipment, primarily to leasehold improvements, due to the closing of our Microsoft Store physical locations. NOTE 8 — BUSINESS COMBINATIONS GitHub, Inc. On October 25, 2018 , we acquired GitHub, Inc. (“GitHub”), a software development platform, in a $ 7.5 billion stock transaction (inclusive of total cash payments of $ 1.3 billion in respect of vested GitHub equity awards and an indemnity escrow). The acquisition is expected to empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences. The financial results of GitHub have been included in our consolidated financial statements since the date of the acquisition. GitHub is reported as part of our Intelligent Cloud segment. The allocation of the purchase price to goodwill was completed as of June 30, 2019. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash, cash equivalents, and short-term investments $ 234 Goodwill 5,497 Intangible assets 1,267 Other assets 143 Other liabilities ( 217 ) Total $ 6,924 The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth and is not expected to be deductible for tax purposes. We assigned the goodwill to our Intelligent Cloud segment. 75 PART II Item 8 Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Customer-related $ 648 8 years Technology-based 447 5 years Marketing-related 170 10 years Contract-based 2 2 years Total $ 1,267 7 years Transactions recognized separately from the purchase price allocation were approximately $ 600 million, primarily related to equity awards recognized as expense over the related service period. Other During fiscal year 2020, we completed 15 acquisitions for $ 2.4 billion, substantially all of which were paid in cash. These entities have been included in our consolidated results of operations since their respective acquisition dates. The effects of these business combinations, individually and in aggregate, were not material to our consolidated results of operations. NOTE 9 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2018 Acquisitions Other June 30, 2019 Acquisitions Other June 30, 2020 Productivity and Business Processes $ 23,823 $ 514 $ ( 60 ) $ 24,277 $ 7 $ ( 94 ) $ 24,190 Intelligent Cloud 5,703 5,605 (a) 43 (a) 11,351 1,351 ( 5 ) 12,697 More Personal Computing 6,157 289 ( 48 ) 6,398 96 ( 30 ) 6,464 Total $ 35,683 $ 6,408 $ ( 65 ) $ 42,026 $ 1,454 $ ( 129 ) $ 43,351 (a) Includes goodwill of $ 5.5 billion related to GitHub. See Note 8 – Business Combinations for further information . The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2020, May 1, 2019, or May 1, 2018 tests. As of June 30, 2020 and 2019, accumulated goodwill impairment was $ 11.3 billion. 76 PART II Item 8 NOTE 10 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2020 2019 Technology-based $ 8,160 $ ( 6,381 ) $ 1,779 $ 7,691 $ ( 5,771 ) $ 1,920 Customer-related 4,967 ( 2,320 ) 2,647 4,709 ( 1,785 ) 2,924 Marketing-related 4,158 ( 1,588 ) 2,570 4,165 ( 1,327 ) 2,838 Contract-based 474 ( 432 ) 42 574 ( 506 ) 68 Total $ 17,759 $ ( 10,721 ) $ 7,038 $ 17,139 (a) $ ( 9,389 ) $ 7,750 (a) Includes intangible assets of $ 1.3 billion related to GitHub. See Note 8 – Business Combinations for further information . No material impairments of intangible assets were identified during fiscal years 2020, 2019, or 2018. We estimate that we have no significant residual value related to our intangible assets. The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2020 2019 Technology-based $ 531 6 years $ 814 5 years Customer-related 303 5 years 710 8 years Marketing-related 2 2 years 177 10 years Contract-based 0 0 years 7 3 years Total $ 836 5 years $ 1,708 7 years Intangible assets amortization expense was $ 1.6 billion, $ 1.9 billion, and $ 2.2 billion for fiscal years 2020, 2019, and 2018, respectively. The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2020: (In millions) Year Ending June 30, 2021 $ 1,483 2022 1,399 2023 1,219 2024 851 2025 447 Thereafter 1,639 Total $ 7,038 77 PART II Item 8 NOTE 11 — DEBT The components of debt were as follows: (In millions, issuance by calendar year) Maturities (calendar year) Stated Interest Rate Effective Interest Rate June 30, 2020 June 30, 2019 2009 issuance of $ 3.8 billion (a) 2039 5.20 % 5.24 % $ 559 $ 750 2010 issuance of $ 4.8 billion (a) 2020 – 2040 3.00 % – 4.50 % 3.14 % – 4.57 % 1,571 2,000 2011 issuance of $ 2.3 billion (a) 2021 – 2041 4.00 % – 5.30 % 4.08 % – 5.36 % 1,270 1,500 2012 issuance of $ 2.3 billion 2022 – 2042 2.13 % – 3.50 % 2.24 % – 3.57 % 1,650 1,650 2013 issuance of $ 5.2 billion (a) 2023 – 2043 2.38 % – 4.88 % 2.47 % – 4.92 % 2,919 3,500 2013 issuance of € 4.1 billion 2021 – 2033 2.13 % – 3.13 % 2.23 % – 3.22 % 4,549 4,613 2014 issuance 0 18 2015 issuance of $ 23.8 billion (a) 2020 – 2055 2.00 % – 4.75 % 2.09 % – 4.78 % 15,549 22,000 2016 issuance of $ 19.8 billion (a) 2021 – 2056 1.55 % – 3.95 % 1.64 % – 4.03 % 16,955 19,750 2017 issuance of $ 17.0 billion (a) 2022 – 2057 2.40 % – 4.50 % 2.52 % – 4.53 % 12,385 17,000 2020 issuance of $ 10.0 billion (a) 2050 – 2060 2.53 % – 2.68 % 2.53 % – 2.68 % 10,000 0 Total face value 67,407 72,781 Unamortized discount and issuance costs ( 554 ) ( 603 ) Hedge fair value adjustments ( b ) 93 0 Premium on debt exchange (a) ( 3,619 ) 0 Total debt 63,327 72,178 Current portion of long-term debt ( 3,749 ) ( 5,516 ) Long-term debt $ 59,578 $ 66,662 (a) In June 2020, we exchanged a portion of our existing debt at premium for cash and new debt with longer maturities. The premium will be amortized over the term of the new debt. (b) Refer to Note 5 – Derivatives for further information on the interest rate swaps related to fixed-rate debt. As of June 30, 2020 and 2019, the estimated fair value of long-term debt, including the current portion, was $ 77.1 billion and $ 78.9 billion, respectively. The estimated fair values are based on Level 2 inputs. Debt in the table above is comprised of senior unsecured obligations and ranks equally with our other outstanding obligations. Interest is paid semi-annually, except for the Euro-denominated debt, which is paid annually. The following table outlines maturities of our long-term debt, including the current portion, as of June 30, 2020: (In millions) Year Ending June 30, 2021 $ 3,750 2022 7,966 2023 2,750 2024 5,250 2025 2,250 Thereafter 45,441 Total $ 67,407 78 PART II Item 8 NOTE 12 — INCOME TAXES Tax Cuts and Jobs Act On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business. We recorded a provisional net charge of $ 13.7 billion related to the enactment of the TCJA in fiscal year 2018, and adjusted the provisional net charge by recording additional tax expense of $ 157 million in fiscal year 2019 pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 118. In fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland. The transfers of intangible properties resulted in a $ 2.6 billion net income tax benefit recorded in the fourth quarter of fiscal year 2019, as the value of future tax deductions exceeded the current tax liability from foreign jurisdictions and U.S. global intangible low-taxed income (“GILTI”) tax. Provision for Income Taxes The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Current Taxes U.S. federal $ 3,537 $ 4,718 $ 19,764 U.S. state and local 763 662 934 Foreign 4,444 5,531 4,348 Current taxes $ 8,744 $ 10,911 $ 25,046 Deferred Taxes U.S. federal $ 58 $ ( 5,647 ) $ ( 4,292 ) U.S. state and local ( 6 ) ( 1,010 ) ( 458 ) Foreign ( 41 ) 194 ( 393 ) Deferred taxes $ 11 $ ( 6,463 ) $ ( 5,143 ) Provision for income taxes $ 8,755 $ 4,448 $ 19,903 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2020 2019 2018 U.S. $ 24,116 $ 15,799 $ 11,527 Foreign 28,920 27,889 24,947 Income before income taxes $ 53,036 $ 43,688 $ 36,474 79 PART II Item 8 Effective Tax Rate The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2020 2019 2018 Federal statutory rate 21.0 % 21.0 % 28.1 % Effect of: Foreign earnings taxed at lower rates ( 3.7 )% ( 4.1 )% ( 7.8 )% Impact of the enactment of the TCJA 0 % 0.4 % 37.7 % Impact of intangible property transfers 0 % ( 5.9 )% 0 % Foreign-derived intangible income deduction ( 1.1 )% ( 1.4 )% 0 % State income taxes, net of federal benefit 1.3 % 0.7 % 1.3 % Research and development credit ( 1.1 )% ( 1.1 )% ( 1.3 )% Excess tax benefits relating to stock-based compensation ( 2.2 )% ( 2.2 )% ( 2.5 )% Interest, net 1.0 % 1.0 % 1.2 % Other reconciling items, net 1.3 % 1.8 % ( 2.1 )% Effective rate 16.5 % 10.2 % 54.6 % The decrease from the federal statutory rate in fiscal year 2020 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, and tax benefits relating to stock-based compensation. The decrease from the federal statutory rate in fiscal year 2019 is primarily due to a $ 2.6 billion net income tax benefit related to intangible property transfers, and earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. The increase from the federal statutory rate in fiscal year 2018 is primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018, offset in part by earnings taxed at lower rates in foreign jurisdictions. In fiscal year 2020, our foreign regional operating centers in Ireland and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 86 % of our foreign income before tax. In fiscal years 2019 and 2018, our foreign regional operating centers in Ireland, Singapore, and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 82 % and 87 % of our foreign income before tax, respectively. Other reconciling items, net consists primarily of tax credits and GILTI tax. In fiscal years 2020, 2019, and 2018, there were no individually significant other reconciling items. The increase in our effective tax rate for fiscal year 2020 compared to fiscal year 2019 was primarily due to a $ 2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. The decrease in our effective tax rate for fiscal year 2019 compared to fiscal year 2018 was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018, and a $2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. 80 PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2020 2019 Deferred Income Tax Assets Stock-based compensation expense $ 461 $ 406 Accruals, reserves, and other expenses 2,721 2,287 Loss and credit carryforwards 865 3,518 Depreciation and amortization 6,361 7,046 Leasing liabilities 3,025 1,594 Unearned revenue 1,553 475 Other 354 367 Deferred income tax assets 15,340 15,693 Less valuation allowance ( 755 ) ( 3,214 ) Deferred income tax assets, net of valuation allowance $ 14,585 $ 12,479 Deferred Income Tax Liabilities Book/tax basis differences in investments and debt $ ( 2,642 ) $ ( 738 ) Unearned revenue 0 ( 30 ) Leasing assets ( 2,817 ) ( 1,510 ) Deferred GILTI tax liabilities ( 2,581 ) ( 2,607 ) Other ( 344 ) ( 291 ) Deferred income tax liabilities $ ( 8,384 ) $ ( 5,176 ) Net deferred income tax assets $ 6,201 $ 7,303 Reported As Other long-term assets $ 6,405 $ 7,536 Long-term deferred income tax liabilities ( 204 ) ( 233 ) Net deferred income tax assets $ 6,201 $ 7,303 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. As of June 30, 2020, we had federal, state, and foreign net operating loss carryforwards of $ 547 million, $ 975 million, and $ 2.0 billion, respectively. The federal and state net operating loss carryforwards will expire in various years from fiscal 2021 through 2040 , if not utilized. The majority of our foreign net operating loss carryforwards do not expire. Certain acquired net operating loss carryforwards are subject to an annual limitation, but are expected to be realized with the exception of those which have a valuation allowance. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and other net deferred tax assets that may not be realized. In fiscal year 2020, we removed $ 2.0 billion of foreign net operating losses and corresponding valuation allowances as a result of the liquidation of a foreign subsidiary. There was no impact to our consolidated financial statements. Income taxes paid, net of refunds, were $ 12.5 billion, $ 8.4 billion, and $ 5.5 billion in fiscal years 2020, 2019, and 2018, respectively. Uncertain Tax Positions Gross unrecognized tax benefits related to uncertain tax positions as of June 30, 2020, 2019, and 2018, were $ 13.8 billion, $ 13.1 billion, and $ 12.0 billion, respectively, which were primarily included in long-term income taxes in our consolidated balance sheets. If recognized, the resulting tax benefit would affect our effective tax rates for fiscal years 2020, 2019, and 2018 by $ 12.1 billion, $ 12.0 billion, and $ 11.3 billion, respectively. 81 PART II Item 8 As of June 30, 2020, 2019, and 2018, we had accrued interest expense related to uncertain tax positions of $ 4.0 billion, $ 3.4 billion, and $ 3.0 billion, respectively, net of income tax benefits. The provision for income taxes for fiscal years 2020, 2019, and 2018 included interest expense related to uncertain tax positions of $ 579 million, $ 515 million, and $ 688 million, respectively, net of income tax benefits. The aggregate changes in the gross unrecognized tax benefits related to uncertain tax positions were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Beginning unrecognized tax benefits $ 13,146 $ 11,961 $ 11,737 Decreases related to settlements ( 31 ) ( 316 ) ( 193 ) Increases for tax positions related to the current year 647 2,106 1,445 Increases for tax positions related to prior years 366 508 151 Decreases for tax positions related to prior years ( 331 ) ( 1,113 ) ( 1,176 ) Decreases due to lapsed statutes of limitations ( 5 ) 0 ( 3 ) Ending unrecognized tax benefits $ 13,792 $ 13,146 $ 11,961 We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under audit for tax years 2004 to 2013 . In April 2020, the IRS commenced the audit for tax years 2014 to 2017 . As of June 30, 2020, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2019 , some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NOTE 13 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2020 2019 Productivity and Business Processes $ 18,643 $ 16,831 Intelligent Cloud 16,620 16,988 More Personal Computing 3,917 3,387 Total $ 39,180 $ 37,206 Changes in unearned revenue were as follows: (In millions) Year Ended June 30, 2020 Balance, beginning of period $ 37,206 Deferral of revenue 78,922 Recognition of unearned revenue ( 76,948 ) Balance, end of period $ 39,180 82 PART II Item 8 Revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods, was $ 111 billion as of June 30, 2020, of which $ 107 billion is related to the commercial portion of revenue. We expect to recognize approximately 50 % of this revenue over the next 12 months and the remainder thereafter. NOTE 14 — LEASES We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. Our leases have remaining lease terms of 1 year to 20 years, some of which include options to extend the leases for up to 5 years , and some of which include options to terminate the leases within 1 year. The components of lease expense were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Operating lease cost $ 2,043 $ 1,707 $ 1,585 Finance lease cost: Amortization of right-of-use assets $ 611 $ 370 $ 243 Interest on lease liabilities 336 247 175 Total finance lease cost $ 947 $ 617 $ 418 Supplemental cash flow information related to leases was as follows: (In millions) Year Ended June 30, 2020 2019 2018 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 1,829 $ 1,670 $ 1,522 Operating cash flows from finance leases 336 247 175 Financing cash flows from finance leases 409 221 144 Right-of-use assets obtained in exchange for lease obligations: Operating leases 3,677 2,303 1,571 Finance leases 3,467 2,532 1,933 83 PART II Item 8 Supplemental balance sheet information related to leases was as follows: (In millions, except lease term and discount rate) June 30, 2020 2019 Operating Leases Operating lease right-of-use assets $ 8,753 $ 7,379 Other current liabilities $ 1,616 $ 1,515 Operating lease liabilities 7,671 6,188 Total operating lease liabilities $ 9,287 $ 7,703 Finance Leases Property and equipment, at cost $ 10,371 $ 7,041 Accumulated depreciation ( 1,385 ) ( 774 ) Property and equipment, net $ 8,986 $ 6,267 Other current liabilities $ 540 $ 317 Other long-term liabilities 8,956 6,257 Total finance lease liabilities $ 9,496 $ 6,574 Weighted Average Remaining Lease Term Operating leases 8 years 7 years Finance leases 13 years 13 years Weighted Average Discount Rate Operating leases 2.7 % 3.0 % Finance leases 3.9 % 4.6 % Maturities of lease liabilities were as follows: (In millions) Year Ending June 30, Operating Leases Finance Leases 2021 $ 1,807 $ 880 2022 1,652 894 2023 1,474 903 2024 1,262 916 2025 1,000 1,236 Thereafter 3,122 7,194 Total lease payments 10,317 12,023 Less imputed interest ( 1,030 ) ( 2,527 ) Total $ 9,287 $ 9,496 As of June 30, 2020, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $ 3.4 billion and $ 3.5 billion, respectively. These operating and finance leases will commence between fiscal year 2021 and fiscal year 2023 with lease terms of 1 year to 16 years . During fiscal year 2020, we recorded an impairment charge of $ 161 million to operating lease right-of-use assets due to the closing of our Microsoft Store physical locations. 84 PART II Item 8 NOTE 15 — CONTINGENCIES Patent and Intellectual Property Claims There were 64 patent infringement cases pending against Microsoft as of June 30, 2020, none of which are material individually or in aggregate. Antitrust, Unfair Competition, and Overcharge Class Actions Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010. The trial of the British Columbia action commenced in May 2016. Following a mediation, the parties agreed to a global settlement of all three Canadian actions, and submitted the proposed settlement agreement to the courts in all three jurisdictions for approval. The final settlement has been approved by the courts in British Columbia, Ontario, and Quebec, and the claims administration process will commence once each court approves the form of notice to the class . Other Antitrust Litigation and Claims China State Administration for Industry and Commerce Investigatio n In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. The SAMR has presented its preliminary views as to certain possible violations of China's Anti-Monopoly Law, and discussions are expected to continue. Product-Related Litigation U.S. Cell Phone Litigation Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 40 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. In August 2018, the trial court issued an order striking portions of the plaintiffs’ expert reports. A hearing is expected to occur in the second quarter of fiscal year 2021 . 85 PART II Item 8 Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact in our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2020, we accrued aggregate legal liabilities of $ 306 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $ 500 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact in our consolidated financial statements for the period in which the effects become reasonably estimable. NOTE 16 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Balance, beginning of year 7,643 7,677 7,708 Issued 54 116 68 Repurchased ( 126 ) ( 150 ) ( 99 ) Balance, end of year 7,571 7,643 7,677 Share Repurchases On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in December 2016 and was completed in February 2020. On September 18, 2019, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in February 2020, following completion of the program approved on September 20, 2016, has no expiration date, and may be terminated at any time. As of June 30, 2020, $ 31.7 billion remained of this $ 40.0 billion share repurchase program. 86 PART II Item 8 We repurchased the following shares of common stock under the share repurchase programs: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2020 2019 2018 First Quarter 29 $ 4,000 24 $ 2,600 22 $ 1,600 Second Quarter 32 4,600 57 6,100 22 1,800 Third Quarter 37 6,000 36 3,899 34 3,100 Fourth Quarter 28 5,088 33 4,200 21 2,100 Total 126 $ 19,688 150 $ 16,799 99 $ 8,600 Shares repurchased during the fourth quarter of fiscal year 2020 were under the share repurchase program approved on September 18, 2019. Shares repurchased during the third quarter of fiscal year 2020 were under the share repurchase programs approved on both September 20, 2016 and September 18, 2019. All other shares repurchased were under the share repurchase program approved on September 20, 2016. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards of $ 3.3 billion, $ 2.7 billion, and $ 2.1 billion for fiscal years 2020, 2019, and 2018, respectively. All share repurchases were made using cash resources. Dividends Our Board of Directors declared the following dividends: Declaration Date Record Date Payment Date Dividend Per Share Amount Fiscal Year 2020 (In millions) September 18, 2019 November 21, 2019 December 12, 2019 $ 0.51 $ 3,886 December 4, 2019 February 20, 2020 March 12, 2020 0.51 3,876 March 9, 2020 May 21, 2020 June 11, 2020 0.51 3,865 June 17, 2020 August 20, 2020 September 10, 2020 0.51 3,861 Total $ 2.04 $ 15,488 Fiscal Year 2019 September 18, 2018 November 15, 2018 December 13, 2018 $ 0.46 $ 3,544 November 28, 2018 February 21, 2019 March 14, 2019 0.46 3,526 March 11, 2019 May 16, 2019 June 13, 2019 0.46 3,521 June 12, 2019 August 15, 2019 September 12, 2019 0.46 3,510 Total $ 1.84 $ 14,101 The dividend declared on June 17, 2020 was included in other current liabilities as of June 30, 2020. 87 PART II Item 8 NOTE 17 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table summarizes the changes in accumulated other comprehensive income (loss) by component : (In millions) Year Ended June 30, 2020 2019 2018 Derivatives Balance, beginning of period $ 0 $ 173 $ 134 Unrealized gains (losses), net of tax of $( 10 ) , $ 2 , and $ 11 ( 38 ) 160 218 Reclassification adjustments for gains included in revenue 0 ( 341 ) ( 185 ) Tax expense included in provision for income taxes 0 8 6 Amounts reclassified from accumulated other comprehensive income (loss) 0 ( 333 ) ( 179 ) Net change related to derivatives, net of tax of $( 10 ) , $( 6 ), and $ 5 ( 38 ) ( 173 ) 39 Balance, end of period $ ( 38 ) $ 0 $ 173 Investments Balance, beginning of period $ 1,488 $ ( 850 ) $ 1,825 Unrealized gains (losses), net of tax of $ 1,057 , $ 616 , and $( 427 ) 3,987 2,331 ( 1,146 ) Reclassification adjustments for (gains) losses included in other income (expense), net 4 93 ( 2,309 ) Tax expense (benefit) included in provision for income taxes ( 1 ) ( 19 ) 738 Amounts reclassified from accumulated other comprehensive income (loss) 3 74 ( 1,571 ) Net change related to investments, net of tax of $ 1,058 , $ 635 , and $( 1,165 ) 3,990 2,405 ( 2,717 ) Cumulative effect of accounting changes 0 ( 67 ) 42 Balance, end of period $ 5,478 $ 1,488 $ ( 850 ) Translation Adjustments and Other Balance, beginning of period $ ( 1,828 ) $ ( 1,510 ) $ ( 1,332 ) Translation adjustments and other, net of tax effects of $ 1 , $( 1 ), and $ 0 ( 426 ) ( 318 ) ( 178 ) Balance, end of period $ ( 2,254 ) $ ( 1,828 ) $ ( 1,510 ) Accumulated other comprehensive income (loss), end of period $ 3,186 $ ( 340 ) $ ( 2,187 ) NOTE 18 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. As of June 30, 2020, an aggregate of 283 million shares were authorized for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2020 2019 2018 Stock-based compensation expense $ 5,289 $ 4,652 $ 3,940 Income tax benefits related to stock-based compensation 938 816 823 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a service period of four years or five years . 88 PART II Item 8 Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a service period of four years . PSUs generally vest over a performance period of three years . The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for All Stock Plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year ended June 30, 2020 2019 2018 Dividends per share (quarterly amounts) $ 0.46 – 0.51 $ 0.42 – 0.46 $ 0.39 – 0.42 Interest rates 0.1 % – 2.2 % 1.8 % – 3.1 % 1.7 % – 2.9 % During fiscal year 2020, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 147 $ 78.49 Granted (a) 53 140.49 Vested ( 65 ) 75.35 Forfeited ( 9 ) 90.30 Nonvested balance, end of year 126 $ 105.23 (a) Includes 2 million, 2 million, and 3 million of PSUs granted at target and performance adjustments above target levels for fiscal years 2020, 2019, and 2018, respectively. As of June 30, 2020, there was approximately $ 10.2 billion of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of three years . The weighted average grant-date fair value of stock awards granted was $ 140.49 , $ 107.02 , and $ 75.88 for fiscal years 2020, 2019, and 2018, respectively. The fair value of stock awards vested was $ 10.1 billion, $ 8.7 billion, and $ 6.6 billion, for fiscal years 2020, 2019, and 2018, respectively. Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90 % of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15 % of their gross compensation during an offering period. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2020 2019 2018 Shares purchased 9 11 13 Average price per share $ 142.22 $ 104.85 $ 76.40 As of June 30, 2020, 96 million shares of our common stock were reserved for future issuance through the ESPP. 89 PART II Item 8 Savings Plan We have savings plans in the U.S. that qualify under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Eligible U.S. employees may contribute a portion of their salary into the savings plans, subject to certain limitations. We contribute fifty cents for each dollar a participant contributes into the plans, with a maximum employer contribution of 50 % of the IRS contribution limit for the calendar year. Employer-funded retirement benefits for all plans were $ 1.0 billion, $ 877 million, and $ 807 million in fiscal years 2020, 2019, and 2018, respectively, and were expensed as contributed. NOTE 19 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial, including Office 365 subscriptions, the Office portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises, comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business, and related Client Access Licenses (“CALs”). • Office Consumer, including Microsoft 365 Consumer (formerly Office 365 Consumer) subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Learning Solutions, Marketing Solutions, Sales Solutions, and Premium Subscriptions. • Dynamics business solutions, including Dynamics 365, a set of cloud-based applications across ERP and CRM, Dynamics ERP on-premises, and Dynamics CRM on-premises. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related CALs; and GitHub. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things; and MSN advertising. • Devices, including Surface and PC accessories. 90 PART II Item 8 • Gaming, including Xbox hardware and Xbox content and services, comprising Xbox Live ( transactions, subscriptions, cloud services, and advertising ), video games, and third-party video game royalties. • Search. Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments. Segment revenue and operating income were as follows during the periods presented: (In millions) Year Ended June 30, 2020 2019 2018 Revenue Productivity and Business Processes $ 46,398 $ 41,160 $ 35,865 Intelligent Cloud 48,366 38,985 32,219 More Personal Computing 48,251 45,698 42,276 Total $ 143,015 $ 125,843 $ 110,360 Operating Income Productivity and Business Processes $ 18,724 $ 16,219 $ 12,924 Intelligent Cloud 18,324 13,920 11,524 More Personal Computing 15,911 12,820 10,610 Total $ 52,959 $ 42,959 $ 35,058 No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for fiscal years 2020, 2019, or 2018. Revenue, classified by the major geographic areas in which our customers were located, was as follows: (In millions) Year Ended June 30, 2020 2019 2018 United States (a) $ 73,160 $ 64,199 $ 55,926 Other countries 69,855 61,644 54,434 Total $ 143,015 $ 125,843 $ 110,360 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. 91 PART II Item 8 Revenue from external customers, classified by significant product and service offerings, was as follows: (In millions) Year Ended June 30, 2020 2019 2018 Server products and cloud services $ 41,379 $ 32,622 $ 26,129 Office products and cloud services 35,316 31,769 28,316 Windows 22,294 20,395 19,518 Gaming 11,575 11,386 10,353 LinkedIn 8,077 6,754 5,259 Search advertising 7,740 7,628 7,012 Devices 6,457 6,095 5,134 Enterprise Services 6,409 6,124 5,846 Other 3,768 3,070 2,793 Total $ 143,015 $ 125,843 $ 110,360 Our commercial cloud revenue, which includes Office 365 Commercial, Azure, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $ 51.7 billion, $ 38.1 billion and $ 26.6 billion in fiscal years 2020, 2019, and 2018, respectively. These amounts are primarily included in Office products and cloud services, Server products and cloud services, and LinkedIn in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2020 2019 2018 United States $ 60,789 $ 55,252 $ 44,501 Ireland 12,734 12,958 12,843 Other countries 29,770 25,422 22,538 Total $ 103,293 $ 93,632 $ 79,882 92 PART II Item 8 NOTE 20 — QUARTERLY INFORMATION (UNAUDITED) (In millions, except per share amounts) Quarter Ended September 30 December 31 March 31 June 30 Total Fiscal Year 2020 Revenue $ 33,055 $ 36,906 $ 35,021 $ 38,033 $ 143,015 Gross margin 22,649 24,548 24,046 25,694 96,937 Operating income 12,686 13,891 12,975 13,407 52,959 Net income 10,678 11,649 10,752 11,202 44,281 Basic earnings per share 1.40 1.53 1.41 1.48 5.82 Diluted earnings per share 1.38 1.51 1.40 1.46 5.76 Fiscal Year 2019 Revenue 29,084 32,471 30,571 33,717 125,843 Gross margin 19,179 20,048 20,401 23,305 82,933 Operating income 9,955 10,258 10,341 12,405 42,959 Net income (a) 8,824 8,420 8,809 13,187 39,240 Basic earnings per share 1.15 1.09 1.15 1.72 5.11 Diluted earnings per share (b) 1.14 1.08 1.14 1.71 5.06 (a) Reflects the $ 157 million net charge related to the enactment of the TCJA for the second quarter and the $ 2.6 billion net income tax benefit related to the intangible property transfers for the fourth quarter, which together increased net income by $ 2.4 billion for fiscal year 2019. See Note 12 – Income Taxes for further information. (b) Reflects the net charge related to the enactment of the TCJA and the net income tax benefit related to the intangible property transfers, which decreased (increased) diluted EPS $ 0.02 for the second quarter, $( 0.34 ) for the fourth quarter, and $( 0.31 ) for fiscal year 2019 . 93 PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2020 and 2019, the related consolidated statements of income, comprehensive income, cash flows, and stockholders' equity, for each of the three years in the period ended June 30, 2020, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2020 and 2019, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2020, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of June 30, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 30, 2020, expressed an unqualified opinion on the Company's internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 94 PART II Item 8 Revenue Recognition – Refer to Note 1 to the financial statements Critical Audit Matter Description The Company recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company offers customers the ability to acquire multiple licenses of software products and services, including cloud-based services, in its customer agreements through its volume licensing programs. Significant judgment is exercised by the Company in determining revenue recognition for these customer agreements, and includes the following: • Determination of whether products and services are considered distinct performance obligations that should be accounted for separately versus together, such as software licenses and related services that are sold with cloud-based services. • The pattern of delivery (i.e., timing of when revenue is recognized) for each distinct performance obligation. • Identification and treatment of contract terms that may impact the timing and amount of revenue recognized (e.g., variable consideration, optional purchases, and free services). • Determination of stand-alone selling prices for each distinct performance obligation and for products and services that are not sold separately. Given these factors and due to the volume of transactions, the related audit effort in evaluating management's judgments in determining revenue recognition for these customer agreements was extensive and required a high degree of auditor judgment. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures related to the Company's revenue recognition for these customer agreements included the following: • We tested the effectiveness of controls related to the identification of distinct performance obligations, the determination of the timing of revenue recognition, and the estimation of variable consideration. • We evaluated management's significant accounting policies related to these customer agreements for reasonableness. • We selected a sample of customer agreements and performed the following procedures: – Obtained and read contract source documents for each selection, including master agreements, and other documents that were part of the agreement. – Tested management's identification and treatment of contract terms. – Assessed the terms in the customer agreement and evaluated the appropriateness of management's application of their accounting policies, along with their use of estimates, in the determination of revenue recognition conclusions. • We evaluated the reasonableness of management's estimate of stand-alone selling prices for products and services that are not sold separately. • We tested the mathematical accuracy of management's calculations of revenue and the associated timing of revenue recognized in the financial statements. 95 PART II Item 8 Income Taxes – Uncertain Tax Positions – Refer to Note 12 to the financial statements Critical Audit Matter Description The Company's long-term income taxes liability includes uncertain tax positions related to transfer pricing issues that remain unresolved with the Internal Revenue Service ("IRS"). The Company remains under IRS audit, or subject to IRS audit, for tax years subsequent to 2003. While the Company has settled a portion of the IRS audits, resolution of the remaining matters could have a material impact on the Company's financial statements. Conclusions on recognizing and measuring uncertain tax positions involve significant estimates and management judgment and include complex considerations of the Internal Revenue Code, related regulations, tax case laws, and prior-year audit settlements. Given the complexity and the subjective nature of the transfer pricing issues that remain unresolved with the IRS, evaluating management's estimates relating to their determination of uncertain tax positions required extensive audit effort and a high degree of auditor judgment, including involvement of our tax specialists. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures to evaluate management's estimates of uncertain tax positions related to unresolved transfer pricing issues included the following: • We evaluated the appropriateness and consistency of management's methods and assumptions used in the identification, recognition, measurement, and disclosure of uncertain tax positions, which included testing the effectiveness of the related internal controls. • We read and evaluated management's documentation, including relevant accounting policies and information obtained by management from outside tax specialists, that detailed the basis of the uncertain tax positions. • We tested the reasonableness of management's judgments regarding the future resolution of the uncertain tax positions, including an evaluation of the technical merits of the uncertain tax positions. • For those uncertain tax positions that had not been effectively settled, we evaluated whether management had appropriately considered new information that could significantly change the recognition, measurement or disclosure of the uncertain tax positions. • We evaluated the reasonableness of management's estimates by considering how tax law, including statutes, regulations and case law, impacted management's judgments. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 30, 2020 We have served as the Company's auditor since 1983. 96 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our consolidated financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our consolidated financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our consolidated financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of June 30, 2020. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2020 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2020; their report is included in Item 9A. 97 PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2020, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2020, based on the criteria established in Internal Control — Integrated Framework (2013) issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements and the related notes (collectively referred to as the "financial statements") as of and for the year ended June 30, 2020, of the Company and our report dated July 30, 2020, expressed an unqualified opinion on those financial statements. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 30, 2020 98 PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held December 2, 2020 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and other finance organization employees. The finance code of ethics is publicly available on our website at https://aka.ms/FinanceCodeProfessionalConduct. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive officer compensation,” “Compensation Committee interlocks and insider participation,” and “Compensation Committee report” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock ownership information,” “Principal shareholders” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 99 PART IV Item 15 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 55 Comprehensive Income Statements 56 Balance Sheets 57 Cash Flows Statements 58 Stockholders’ Equity Statements 59 Notes to Financial Statements 60 Report of Independent Registered Public Accounting Firm 94 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/14/17 4.1 Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 10/29/15 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/10 100 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 101 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/3/15 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 8/5/16 102 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/17 4.16 Thirteenth Supplemental Indenture for 2.525% Notes due 2050 and 2.675% Notes due 2060, dated June 1, 2020, between Microsoft Corporation and U.S. Bank National Association, as trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee. 8-K 4.1 6/1/20 4.17 Description of Securities 10-K 6/30/19 4.16 8/1/19 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.1 10/20/16 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-K 6/30/18 10.5 8/3/18 10.6* Microsoft Corporation 2017 Stock Plan DEF14A Annex C 10/16/17 10.7* Form of Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.26 4/26/18 10.8* Form of Performance Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.27 4/26/18 10.12 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.12 10/20/16 10.13 Form of Indemnification Agreement and Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-K 6/30/19 10.13 8/1/19 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-Q 12/31/17 10.14 1/31/18 10.15* Microsoft Corporation Executive Incentive Plan 8-K 10.1 9/19/18 103 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.19* Microsoft Corporation Executive Incentive Plan 10-Q 9/30/16 10.17 10/20/16 10.20* Form of Executive Incentive Plan (Executive Officer SAs) Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.18 10/20/16 10.21* Form of Executive Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.25 10/20/16 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/16 10.22 10/20/16 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 10.25 Assumption of Beneficiaries’ Representative Obligation Under Amended and Restated Officers’ Indemnification Trust X 10.26 Assumption of Beneficiaries’ Representative Obligation Under Amended and Restated Directors’ Indemnification Trust X 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS Inline XBRL Instance Document —the instance document does not appear in the Interactive Data File as its XBRL tags are embedded within the Inline XBRL document X 101.SCH Inline XBRL Taxonomy Extension Schema X 104 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase X 101.DEF Inline XBRL Taxonomy Extension Definition Linkbase X 101.LAB Inline XBRL Taxonomy Extension Label Linkbase X 101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase X 104 Cover page formatted as Inline XBRL and contained in Exhibit 101 X * Indicates a management contract or compensatory plan or arrangement. ** Furnished, not filed. 105 PART IV Item 16 ITEM 1 6 . FORM 10-K SUMMARY None. 106 SIGNAT URES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 30, 2020. M ICROSOFT C ORPORATION / S /    F RANK H. B ROD Frank H. Brod Corporate Vice President, Finance and Administration; Chief Accounting Officer (Principal Accounting Officer) 107 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on July 3 0 , 20 20 . Signature Title /s/    J OHN W. T HOMPSON John W. Thompson Chairman /s/    S ATYA N ADELLA Satya Nadella Director and Chief Executive Officer /s/    R EID H OFFMAN Reid Hoffman Director /s/    H UGH F. J OHNSTON Hugh F. Johnston Director /s/ T ERI L. L IST -S TOLL Teri L. List-Stoll Director /s/ S ANDRA E. P ETERSON Sandra E. Peterson Director /s/    P ENNY S. P RITZKER Penny S. Pritzker Director /s/ C HARLES W. S CHARF Charles W. Scharf Director /s/    A RNE M. S ORENSON Arne M. Sorenson Director /s/ J OHN W. S TANTON John W. Stanton Director /s/    E MMA N. W ALMSLEY Emma N. Walmsley Director /s/ P ADMASREE W ARRIOR Padmasree Warrior Director /s/    A MY E. H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/    F RANK H. B ROD Frank H. 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to Commission File Number 001-37845 MICROSOFT CORPORATION Washington 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY , REDMOND , Washington 98052-6399 ( 425 ) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol Name of exchange on which registered Common stock, $ 0.00000625 par value per share MSFT Nasdaq 2.125% Notes due 2021 MSFT Nasdaq 3.125% Notes due 2028 MSFT Nasdaq 2.625% Notes due 2033 MSFT Nasdaq Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large Accelerated Filer ☒ Accelerated Filer ☐ Non-accelerated Filer ☐ Smaller Reporting Company ☐ Emerging Growth Company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes ☐ No ☒ As of December 31, 2020, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $ 1.7 trillion based on the closing sale price as reported on the NASDAQ National Market System. As of July 26, 2021, there were 7,514,891,248 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on November 30, 2021 are incorporated by reference into Part III . MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2021 INDEX Page PART I Item 1. Business 3 Information about our Executive Officers 20 Item 1A. Risk Factors 22 Item 1B. Unresolved Staff Comments 36 Item 2. Properties 36 Item 3. Legal Proceedings 36 Item 4. Mine Safety Disclosures 36 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 37 Item 6. [Reserved] 38 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 39 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 56 Item 8. Financial Statements and Supplementary Data 57 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 99 Item 9A. Controls and Procedures 99 Report of Management on Internal Control over Financial Reporting 99 Report of Independent Registered Public Accounting Firm 100 Item 9B. Other Information 101 PART III Item 10. Directors, Executive Officers and Corporate Governance 101 Item 11. Executive Compensation 101 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 101 Item 13. Certain Relationships and Related Transactions, and Director Independence 101 Item 14. Principal Accounting Fees and Services 101 PART IV Item 15. Exhibits, Financial Statement Schedules 102 Item 16. Form 10-K Summary 108 Signatures 109 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Embracing Our Future Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We bring technology and products together into experiences and solutions that unlock value for our customers. Our ecosystem of customers and partners has stepped up to help people and organizations in every country use technology to be resilient and transform during the most trying of circumstances. Amid rapid change we’ve witnessed technology empower telehealth, remote manufacturing, and new ways of working from home and serving customers. These capabilities have relied on the public cloud, which is built on the investments we have made over time. We are living in the new era of the intelligent cloud and intelligent edge, which is being sharpened by rapid advances in distributed computing, ambient intelligence, and multidevice experiences. This means the places we go and the things we interact with will increasingly become digitized, creating new opportunities and new breakthroughs. In the next phase of innovation, computing is more powerful and ubiquitous from the cloud to the edge. Artificial intelligence (“AI”) capabilities are rapidly advancing, fueled by data and knowledge of the world. Physical and virtual worlds are coming together with the Internet of Things (“IoT”) and mixed reality to create richer experiences that understand the context surrounding people, the things they use, the places they go, and their activities and relationships. A person’s experience with technology spans a multitude of devices and has become increasingly more natural and multi-sensory with voice, ink, and gaze interactions. What We Offer Founded in 1975, we develop and support software, services, devices, and solutions that deliver new value for customers and help people and businesses realize their full potential. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. Our products include operating systems, cross-device productivity applications, server applications, business solution applications, desktop and server management tools, software development tools, and video games. We also design and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. 3 PART I Item 1 The Ambitions That Drive Us To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud and intelligent edge platform. • Create more personal computing. Reinvent Productivity and Business Processes At Microsoft, we’re providing technology and resources to help our customers navigate a remote environment. We’re seeing our family of products play key roles in the ways the world is continuing to work, learn, and connect. Our growth depends on securely delivering continuous innovation and advancing our leading productivity and collaboration tools and services, including Office, Dynamics, and LinkedIn. Microsoft 365 brings together Office 365, Windows, and Enterprise Mobility + Security to help organizations empower their employees with AI-backed tools that unlock creativity, increase teamwork, and fuel innovation, all the while enabling compliance coverage and data protection. Microsoft Teams is enabling rapid digital transformation by giving people a single tool to chat, call, meet, and collaborate. Microsoft Viva is an employee experience platform that brings together communications, knowledge, learning, resources, and insights powered by Microsoft 365. Microsoft Relationship Sales solution brings together LinkedIn Sales Navigator and Dynamics to transform business to business sales through social selling. Dynamics 365 for Talent with LinkedIn Recruiter and Learning gives human resource professionals a complete solution to compete for talent. Microsoft Power Platform empowers employees to build custom applications, automate workflow, and analyze data no matter their technical expertise. These scenarios represent a move to unlock creativity and discover new habits, while simplifying security and management. Organizations of all sizes have digitized business-critical functions, redefining what they can expect from their business applications. This creates an opportunity to reach new customers and increase usage and engagement with existing customers. Build the Intelligent Cloud and Intelligent Edge Platform In the new remote world, companies have accelerated their own digital transformation to empower their employees, optimize their operations, engage customers, and in some cases, change the very core of their products and services. Partnering with organizations on their digital transformation during this period is one of our largest opportunities and we are uniquely positioned to become the strategic digital transformation platform and partner of choice; their success is our success. Our strategy requires continued investment in datacenters and other hybrid and edge infrastructure to support our services. Azure is a trusted cloud with comprehensive compliance coverage and AI-based security built in. Our cloud business benefits from three economies of scale: datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. The Microsoft Cloud is the most comprehensive and trusted cloud, providing the best integration across the technology stack while offering openness, improving time to value, reducing costs, and increasing agility. Being a global-scale cloud, Azure uniquely offers hybrid consistency, developer productivity, AI capabilities, and trusted security and compliance. We see more emerging use cases and needs for compute and security at the edge and are accelerating our innovation across the spectrum of intelligent edge devices, from IoT sensors to gateway devices and edge hardware to build, manage, and secure edge workloads. With Azure Stack, organizations can extend Azure into their own datacenters to create a consistent stack across the public cloud and the intelligent edge. Our hybrid infrastructure consistency spans security, compliance, identity, and management, helping to support the real-world needs and evolving regulatory requirements of commercial customers and enterprises. Azure Arc simplifies governance and management by delivering a consistent multi-cloud and on-premises management platform. Security, compliance, identity, and management underlie our entire tech stack. We offer integrated, end-to-end capabilities to protect people and organizations. In April 2021, we entered into a definitive agreement to acquire Nuance Communications, Inc., a cloud and AI software provider with healthcare and enterprise AI experience. The acquisition will build on our industry-specific cloud offerings. 4 PART I Item 1 We are accelerating our development of mixed reality solutions with new Azure services and devices. Microsoft Mesh enables presence and shared experiences from anywhere through mixed reality applications. The opportunity to merge the physical and digital worlds, when combined with the power of Azure cloud services, unlocks the potential for entirely new workloads and experiences which we believe will shape the next era of computing. The ability to convert data into AI drives our competitive advantage. Azure SQL Database makes it possible for customers to take SQL Server from their on-premises datacenter to a fully managed instance in the cloud to utilize built-in AI. Azure Synapse Analytics, a limitless analytics service, brings together data integration, enterprise data warehousing, and big data analytics for immediate business intelligence and machine learning needs. We are accelerating adoption of AI innovations from research to products. Our innovation helps every developer be an AI developer, with approachable new tools from Azure Machine Learning Studio for creating simple machine learning models, to the powerful Azure Machine Learning Workbench for the most advanced AI modeling and data science. From GitHub to Visual Studio, we provide a developer tool chain for everyone, no matter the technical experience, across all platforms, whether Azure, Windows, or any other cloud or client platform. Create More Personal Computing We strive to make computing more personal by putting people at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. Microsoft 365 is empowering people and organizations to be productive and secure as they adapt to more fluid ways of working and learning. The PC has been mission-critical across work, school, and life to sustain productivity in a remote everything world. Windows 10 serves the enterprise as the most secure and productive operating system. It empowers people with AI-first interfaces ranging from voice-activated commands through Cortana, inking, immersive 3D content storytelling, and mixed reality experiences. Our ambition for Windows 10 monetization opportunities includes gaming, services, subscriptions, and search advertising. In June 2021, Microsoft announced the next generation of Windows – Windows 11. Windows 11 builds on the strengths of productivity, versatility, and security on Windows 10 today and adds in new experiences that include powerful task switching tools like new snap layouts, snap groups, and desktops; new ways to stay connected through chat; the information you want at your fingertips; and more. Windows also plays a critical role in fueling our cloud business and Microsoft 365 strategy, and it powers the growing range of devices on the “intelligent edge.” Microsoft Edge is our fast and secure browser that helps protect your data, with built-in shopping tools designed to save you time and money. Organizational tools such as Collections, Vertical Tabs, and Immersive Reader help you make the most of your time while browsing, streaming, searching, sharing, and more. We are committed to designing and marketing first-party devices to help drive innovation, create new device categories, and stimulate demand in the Windows ecosystem. The Surface family includes Surface Book 3, Surface Laptop Go, Surface Go 2, Surface Pro 7, Surface Laptop 4, Surface Pro X, Surface Studio 2, and Surface Duo. To expand usage and deepen engagement, we continue to invest in content, community, and cloud services as we pursue the expansive opportunity in the gaming industry. We have broadened our approach to how we think about gaming end-to-end, from the way games are created and distributed to how they are played, including cloud gaming so players can stream across PC, console, and mobile. We have a strong position with our large and growing highly engaged community of gamers, including the March 2021 acquisition of ZeniMax Media Inc., the parent company of Bethesda Softworks LLC, one of the largest, privately held game developers and publishers in the world. Xbox Game Pass is a community with access to a curated library of over 100 first- and third-party console and PC titles. Xbox Cloud Gaming is Microsoft’s game streaming technology that is complementary to our console hardware and gives fans the ultimate choice to play the games they want, with the people they want, on the devices they want. 5 PART I Item 1 Our Future Opportunity In a time of great disruption and uncertainty, customers are looking to us to accelerate their own digital transformations as software and cloud computing play a huge role across every industry and around the world. We continue to develop complete, intelligent solutions for our customers that empower people to stay productive and collaborate, while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long-term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modern, modular business applications to improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Applying AI to drive insights and act on our customer’s behalf by understanding and interpreting their needs using natural methods of communication. • Using Windows to fuel our cloud business, grow our share of the PC market, and drive increased engagement with our services like Microsoft 365 Consumer, Teams, Edge, Bing, Xbox Game Pass , and more. • Tackling security from all angles with our integrated, end-to-end solutions spanning security, compliance, identity, and management, across all clouds and platforms. • Inventing new gaming experiences that bring people together around their shared love for games on any devices and pushing the boundaries of innovation with console and PC gaming by creating the next wave of entertainment. Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. We have the opportunity to redefine what customers and partners can expect and are working to deliver new solutions that reflect the best of Microsoft. COVID-19 In March 2020, the World Health Organization declared the outbreak of COVID-19 to be a pandemic. The COVID-19 pandemic continues to have widespread and unpredictable impacts on global society, economies, financial markets, and business practices, and continues to impact our business operations, including our employees, customers, partners, and communities. Refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations (Part II, Item 7 of this Form 10-K) for further discussion regarding the impact of COVID-19 on our fiscal year 2021 financial results. The extent to which the COVID-19 pandemic impacts our business going forward will depend on numerous evolving factors we cannot reliably predict. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Corporate Social Responsibility Commitment to Sustainability We work to ensure that technology is inclusive, trusted, and increases sustainability. We are accelerating progress toward a more sustainable future by reducing our environmental footprint, advancing research, helping our customers build sustainable solutions, and advocating for policies that benefit the environment. In January 2020, we announced a bold commitment and detailed plan to be carbon negative by 2030, and to remove from the environment by 2050 all the carbon we have emitted since our founding in 1975. This included a commitment to invest $1 billion over four years in new technologies and innovative climate solutions. We built on this pledge by adding commitments to be water positive by 2030, zero waste by 2030, and to protect ecosystems by developing a Planetary Computer. We also help our suppliers and customers around the world use Microsoft technology to reduce their own carbon footprint. In January 2021, we announced that in fiscal year 2020 we reduced Microsoft’s carbon emissions by 586,683 metric tons. We purchased the removal of 1.3 million metric tons of carbon from 26 projects around the world. Furthermore, we shared a commitment to transparency by subjecting the data in our annual sustainability report to third-party review and to accountability by including progress on sustainability goals as a factor in determining executive pay. 6 PART I Item 1 The investments we make in sustainability carry through to our products, services, and devices. We design our devices, from Surface to Xbox, to minimize their impact on the environment . Our cloud and AI services and datacenters help businesses cut energy consumption, reduce physical footprints, and design sustainable products. We also pledged a $50 million investment in AI for Earth to accelerate innovation by putting AI in the hands of those working to directly address sustainability challenges. We are committed to playing our part to help accelerate the world’s transition to a more economically and environmentally sustainable future for us all . Addressing Racial Injustice and Inequity Our future opportunity depends on reaching and empowering all communities, and we are committed to taking action to help address racial injustice and inequity. With significant input from employees and leaders who are members of the Black and African American community, our senior leadership team and board of directors announced in June 2020 that we had developed a set of actions to help improve the lived experience at Microsoft and drive change in the communities in which we live and work. These efforts include increasing our representation and strengthening our culture of inclusion by doubling the number of Black and African American people managers, senior individual contributors, and senior leaders in the United States by 2025; evolving our ecosystem with our supply chain, banking partners, and partner ecosystem; and strengthening our communities by using data, technology, and partnerships to help address racial injustice and inequities of the Black and African American communities in the U.S. and improve the safety and wellbeing of our employees and their communities. Over the last year, we have collaborated with partners and worked within neighborhoods and communities to launch and scale a number of projects and programs including: expanding our existing justice reform work with a five-year, $50 million sustained effort, expanding access to affordable broadband and devices for Black and African American communities and key institutions that support them in major urban centers, expanding access to skills and education to support Black and African American students and adults to succeed in the digital economy, and increasing technology support for nonprofits that provide critical services to Black and African American communities. We have more than doubled our percentage share of transaction volume with Black- and African American-owned financial institutions and increased our deposits with Black- and African American-owned minority depository institutions, enabling increased funds into local communities. Additionally, we have seen growth in our Black- and African American-owned supplier base and in Black- and African American-owned technology partners in the Microsoft Partner Network, and we launched the Black Channel Partner Alliance community to support partners onboarding to the Microsoft Cloud and to unlock partner benefits for co-selling with Microsoft. We acknowledge we have more work ahead of us to address racial injustice and inequity, and are applying many of the programs above to help other underrepresented communities. Investing in Digital Skills With a continued focus on digital transformation, Microsoft is helping to ensure that no one is left behind, particularly as economies recover from the COVID-19 pandemic. We announced in June 2020 that we are expanding access to the digital skills that have become increasingly vital to many of the world’s jobs, and especially to individuals hardest hit by recent job losses. Our skills initiative brings together learning resources, certification opportunities, and job-seeker tools from LinkedIn, GitHub, and Microsoft Learn, and is built on data insights drawn from LinkedIn’s Economic Graph. We also invested $20 million in key non-profit partnerships through Microsoft Philanthropies to help people from underserved communities that are often excluded by the digital economy. Over 42 million people across every continent have accessed free training through our skills initiative. The effort surpassed its initial goals and has been expanded with a new emphasis on connecting learners with jobs that help put their new training to use and connecting employers with skilled job seekers they might not find in traditional networks. 7 PART I Item 1 HUMAN CAPITAL RESOURCES Overview Microsoft aims to recruit, develop, and retain diverse, world-changing talent. To foster their and our success, we seek to create an environment where people can do their best work – a place where they can proudly be their authentic selves, guided by our values, and where they know their needs can be met. We strive to maximize the potential of our human capital resources by creating a respectful, rewarding, and inclusive work environment that enables our global employees to create products and services that further our mission to empower every person and every organization on the planet to achieve more. As of June 30, 2021, we employed approximately 181,000 people on a full-time basis, 103,000 in the U.S. and 78,000 internationally. Of the total employed people, 67,000 were in operations, including manufacturing, distribution, product support, and consulting services; 60,000 were in product research and development; 40,000 were in sales and marketing; and 14,000 were in general and administration. Certain of our employees are subject to collective bargaining agreements. Our Culture Microsoft’s culture is grounded in the growth mindset. This means everyone is on a continuous journey to learn and grow. We believe potential can be nurtured and is not pre-determined, and we should always be learning and curious - trying new things without fear of failure. We identified four attributes that allow growth mindset to flourish: • Obsessing over what matters to our customers. • Becoming more diverse and inclusive in everything we do. • Operating as one company, One Microsoft, instead of multiple siloed businesses. • Making a difference in the lives of each other, our customers, and the world around us. Our employee listening systems enable us to gather feedback directly from our workforce to inform our programs and employee needs globally. 88% of employees globally participated in our fiscal year 2021 MS Poll engagement survey, which covers a variety of topics such as inclusion, pay and benefits, and learning and development. Throughout the fiscal year, we also collect nearly 75,000 Daily Pulse employee survey responses. During fiscal year 2021, our Daily Pulse surveys gave us invaluable insights into ways we could support employees through the COVID-19 pandemic and addressing racial injustice. In addition to poll and pulse surveys, we gain insights through onboarding and exit surveys, internal Yammer channels, employee Q&A sessions, and AskHR Service support. Diversity and Inclusion At Microsoft we have an inherently inclusive mission: to empower every person and every organization on the planet to achieve more. We think of diversity and inclusion as core to our business model, informing our actions to impact economies and people around the world. There are billions of people who want to achieve more, but have a different set of circumstances, abilities, and backgrounds that often limit access to opportunity and achievement. The better we represent that diversity inside Microsoft, the more effectively we can innovate for those we seek to empower. We strive to include others by holding ourselves accountable for diversity, driving global systemic change in our workplace and workforce, and creating an inclusive work environment. Through this commitment we can allow everyone the chance to be their authentic selves and do their best work every day. We support multiple highly active Employee Resource Groups for women, families, racial and ethnic minorities, military, people with disabilities, or who identify as LGBTQI+, where employees can go for support, networking, and community-building. As described in our 2020 Proxy Statement , annual performance and compensation reviews of our senior leadership team include an evaluation of their contributions to employee culture and diversity. To ensure accountability over time, we publicly disclose our progress on a multitude of workforce metrics including: • Detailed breakdowns of gender, racial, and ethnic minority representation in our employee population, with data by job types, levels, and segments of our business. • Our EEO-1 report (equal employment opportunity). • Disability representation. 8 PART I Item 1 Total Rewards We develop dynamic, sustainable, and strategic programs with the goal of providing a highly differentiated portfolio to attract, reward, and retain top talent and enable our employees to do their best work. These programs reinforce our culture and values such as collaboration and growth mindset. Managers evaluate and recommend rewards based on, for example, how well we leverage the work of others and contribute to the success of our colleagues. We monitor pay equity and career progress across multiple dimensions. As part of our effort to promote a One Microsoft and inclusive culture, we expanded stock eligibility to all Microsoft employees as part of our annual rewards process. This includes all non-exempt and exempt employees and equivalents across the globe including business support professionals and datacenter and retail employees. Pay Equity In our 2020 Diversity and Inclusion Report, we reported that all racial and ethnic minority employees in the U.S. combined earn $1.006 for every $1.000 earned by their white counterparts, that women in the U.S. earn $1.001 for every $1.000 earned by their counterparts in the U.S. who are men, and women in the U.S. plus our ten other largest employee geographies (Australia, Canada, China, France, Germany, India, Ireland, Israel, Japan, and United Kingdom) combined earn $1.000 for every $1.000 by men in these countries. Our intended result is a global performance and development approach that fosters our culture, and competitive compensation that ensures equitable pay by role while supporting pay for performance. Wellness and Safety Microsoft is committed to supporting our employees’ well-being and safety while they are at work and in their personal lives. We took a wide variety of measures to protect the health and well-being of our employees, suppliers, and customers during the COVID-19 pandemic. We made substantial modifications to employee travel policies and implemented office closures so non-essential employees could work remotely. We continued to pay hourly service providers such as cleaning and reception staff who may have otherwise been furloughed. We implemented a global Paid Pandemic School and Childcare Closure Leave to support working parents, added wellbeing days for those who needed to take time off for mental health and wellness, implemented on-demand COVID-19 testing and vaccinations on our Redmond, Washington campus, and extended full medical plan coverage for coronavirus testing, treatment, and telehealth services. We also expanded existing programs such as our Microsoft CARES Employee Assistance Program and family backup care. In addition to the extraordinary steps and programs relating to COVID-19, our comprehensive benefits package includes many physical, emotional, and financial wellness programs including counseling through the Microsoft CARES Employee Assistance Program, flexible fitness benefits, savings and investment tools, adoption assistance, and back-up care for children and elders. Finally, our Occupational Health and Safety program helps ensure employees can stay safe while they are working. Learning and Development Our growth mindset culture begins with valuing learning over knowing – seeking out new ideas, driving innovation, embracing challenges, learning from failure, and improving over time. To support this culture, we offer a wide range of learning and development opportunities. We believe learning can be more than formal instruction, and our learning philosophy focuses on providing the right learning, at the right time, in the right way. Opportunities include: • Personalized, integrated, and relevant views of all learning opportunities on our internal learning portal, our external learning portal MS Learn, and LinkedIn Learning that is available to all employees worldwide. • In-the-classroom learning, learning “pods,” our early-in-career Aspire program, and manager excellence communities. • On-the-job “stretch” and advancement opportunities. • Managers holding conversations about employees’ career and development plans, coaching on career opportunities, and programs like mentoring and sponsorship. • Customized manager learning to build people manager capabilities and similar learning solutions to build leadership skills for all employees including differentiated leadership development programs. 9 PART I Item 1 • New employee orientation covering a range of topics including company values, culture, and Standards of Business Conduct , as well as ongoing onboarding program . Our employees embrace the growth mindset and take advantage of the formal learning opportunities as well as thousands of informal and on-the-job learning opportunities. In terms of formal on-line learning solutions, in fiscal year 2021 our employees completed over 5 million courses, averaging over 18 hours per employee. Given our focus on understanding core company beliefs and compliance topics, all employees complete required learning programs like Standards of Business Conduct, Privacy, Unconscious Bias, and preventing harassment courses. Our corporate learning portal has over 100,000 average monthly active users. All of our approximately 23,000 people managers must complete between 25-30 hours of required manager capability and excellence training and are assigned ongoing required training each year. In addition, all employees complete skills training based on the profession they are in each year. New Ways of Working The global pandemic has accelerated our capabilities and culture with respect to flexible work. Microsoft has introduced a Hybrid Workplace Flexibility Guide to better support managers and employees as they adapt to new ways of working that shift paradigms, embrace flexibility, promote inclusion, and drive innovation. Our ongoing survey data shows employees value the flexibility related to work location, work site, and work hours, and while many indicate they intend to return to a worksite once conditions permit, they also intend to adjust hours or spend some portions of workweeks working remotely. We are focused on building capabilities to support a variety of workstyles where individuals, teams, and our business can be successful. OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business. • Office Consumer, including Microsoft 365 Consumer subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, Sales Solutions, and Learning Solutions. • Dynamics business solutions, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM, Customer Insights, Power Apps, and Power Automate; and on-premises ERP and CRM applications. 10 PART I Item 1 Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users in new markets such as frontline workers, small and medium businesses, and growth markets, as well as add value to our core product and service offerings to span productivity categories such as communication, collaboration, analytics, security, and compliance. Office Commercial revenue is mainly affected by a combination of continued installed base growth and average revenue per user expansion, as well as the continued shift from Office licensed on-premises to Office 365. Office Consumer Office Consumer is designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift from Office licensed on-premises to Microsoft 365 Consumer subscriptions. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. LinkedIn LinkedIn connects the world’s professionals to make them more productive and successful and transforms the way companies hire, market, sell, and learn. Our vision is to create economic opportunity for every member of the global workforce through the ongoing development of the world’s first Economic Graph, a digital representation of the global economy. In addition to LinkedIn’s free services, LinkedIn offers monetized solutions: Talent Solutions, Marketing Solutions, Premium Subscriptions, Sales Solutions, and Learning Solutions. Talent Solutions provide insights for workforce planning and tools to hire, nurture, and develop talent. Marketing Solutions help companies reach, engage, and convert their audiences at scale. Premium Subscriptions enables professionals to manage their professional identity, grow their network, and connect with talent through additional services like premium search. Sales Solutions help companies strengthen customer relationships, empower teams with digital selling tools, and acquire new opportunities. Finally, Learning Solutions, including Glint, help businesses close critical skills gaps in times where companies are having to do more with existing talent. LinkedIn has over 750 million members and has offices around the globe. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions , Learning Solutions, Sales Solutions, and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. Dynamics Dynamics provides cloud-based and on-premises business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and other application development platforms for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is driven by the number of users licensed and applications consumed, expansion of average revenue per user, and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications, including Power Apps and Power Automate. 11 PART I Item 1 Competition Competitors to Office include software and global application vendors, such as Apple, Cisco Systems, Facebook, Google, IBM, Okta, Proofpoint, Slack, Symantec, Zoom, and numerous web-based and mobile application competitors as well as local application developers. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides a hosted messaging and productivity suite. Slack provides teamwork and collaboration software. Zoom offers videoconferencing and cloud phone solutions. Skype for Business and Skype also compete with a variety of instant messaging, voice, and video communication providers, ranging from start-ups to established enterprises. Okta, Proofpoint, and Symantec provide security solutions across email security, information protection, identity, and governance. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products and services. We compete by providing powerful, flexible, secure, integrated industry-specific, and easy-to-use productivity and collaboration tools and services that create comprehensive solutions and work well with technologies our customers already have both on-premises or in the cloud. LinkedIn faces competition from online professional networks, recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers, and Sales Solutions competes with online and offline outlets for companies with lead generation and customer intelligence and insights. Dynamics competes with cloud-based and on-premises business solution providers such as Oracle, Salesforce.com, and SAP. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and GitHub. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. Server Products and Cloud Services Azure is a comprehensive set of cloud services that offer developers, IT professionals, and enterprises freedom to build, deploy, and manage applications on any platform or device. Customers can use Azure through our global network of datacenters for computing, networking, storage, mobile and web application services, AI, IoT, cognitive services, and machine learning. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Azure revenue is mainly affected by infrastructure-as-a-service and platform-as-a-service consumption-based services, and per user-based services such as Enterprise Mobility + Security. Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. GitHub provides a collaboration platform and code hosting service for developers. Server products revenue is mainly affected by purchases through volume licensing programs, licenses sold to original equipment manufacturers (“OEM”), and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Enterprise Services Enterprise Services, including Premier Support Services and Microsoft Consulting Services, assist customers in developing, deploying, and managing Microsoft server and desktop solutions and provide training and certification to developers and IT professionals on various Microsoft products. 12 PART I Item 1 Competition Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, VMware, and open source offerings. Our Enterprise Mobility + Security offerings also compete with products from a range of competitors including identity vendors, security solution vendors, and numerous other security point solution vendors. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. We believe our cloud’s global scale, coupled with our broad portfolio of identity and security solutions, allows us to effectively solve complex cybersecurity challenges for our customers and differentiates us from the competition. Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Our Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows IoT; and MSN advertising. • Devices, including Surface and PC accessories. • Gaming, including Xbox hardware and Xbox content and services, comprising digital transactions, Xbox Game Pass and other subscriptions, video games, third-party video game royalties, cloud services, and advertising. • Search advertising. 13 PART I Item 1 Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and growth markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Constraints in the supply chain of device components. • Piracy. Windows Commercial revenue, which includes volume licensing of the Windows operating system and Windows cloud services such as Microsoft Defender Advanced Threat Protection, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance (“SA”), as well as advanced security offerings. Windows Commercial revenue often reflects the number of information workers in a licensed enterprise and is relatively independent of the number of PCs sold in a given year. Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. MSN advertising includes both native and display ads. Devices We design and sell devices, including Surface and PC accessories. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. Growth in Devices is dependent on total PC shipments, the ability to attract new customers, our product roadmap, and expanding into new categories. Gaming Our gaming platform is designed to provide a variety of entertainment through a unique combination of content, community, and cloud. Our exclusive game content is created through Xbox Game Studios, a collection of first-party studios creating iconic and differentiated gaming experiences. We continue to invest in new gaming studios and content to expand our IP roadmap and leverage new content creators. These unique gaming experiences are the cornerstone of Xbox Game Pass, a subscription service and gaming community with access to a curated library of over 100 first- and third-party console and PC titles. The gamer remains at the heart of the Xbox ecosystem. We continue to open new opportunities for gamers to engage both on- and off-console with both the launch of Xbox Cloud Gaming, our game streaming service, and continued investment in gaming hardware. Xbox Cloud Gaming utilizes Microsoft’s Azure cloud technology to allow direct and on-demand streaming of games to PCs, consoles, and mobile devices, enabling gamers to take their favorites games with them and play on the device most convenient to them. 14 PART I Item 1 Xbox enables people to connect and share online gaming experiences that are accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox revenue is mainly affected by subscriptions and sales of first- and third-party content, as well as advertising. Growth of our Gaming business is determined by the overall active user base through Xbox enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences through first-party content creators. Search Advertising Our Search business, including Bing and Microsoft Advertising, is designed to deliver relevant online advertising to a global audience. We have several partnerships with other companies, including Verizon Media Group, through which we provide and monetize search queries. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. Devices face competition from various computer, tablet, and hardware manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. Xbox and our cloud gaming services face competition from various online gaming ecosystems and game streaming services, including those operated by Amazon, Apple, Facebook, Google, and Tencent. We also compete with other providers of entertainment services such as video streaming platforms. Our gaming platform competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. We believe our gaming platform is effectively positioned against, and uniquely differentiated from, competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own first-party game franchises as well as other digital content offerings. Our search business competes with Google and a wide array of websites, social platforms like Facebook, and portals that provide content and online offerings to end users. OPERATIONS We have operations centers that support operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Europe, Australia, and Asia, as well as in the Middle East and Africa. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our devices are primarily manufactured by third-party contract manufacturers. For the majority of our products, we have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. However, some of our products contain certain components for which there are very few qualified suppliers. For these components, we have limited near-term flexibility to use other manufacturers if a current vendor becomes unavailable or is unable to meet our requirements. Extended disruptions at these suppliers could lead to a similar disruption in our ability to manufacture devices on time to meet consumer demand. 15 PART I Item 1 RESEARCH AND DEVELOPMENT Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Cloud and AI , focuses on making IT professionals, developers, and their systems more productive and efficient through development of cloud infrastructure, server, database, CRM, ERP, management and development tools, AI cognitive services, and other business process applications and services for enterprises. • Experiences and Devices , focuses on instilling a unifying product ethos across our end-user experiences and devices, including Office, Windows, Enterprise Mobility + Security, and Surface. • AI and Research , focuses on our AI innovations and other forward-looking research and development efforts spanning infrastructure, services, applications, and search. • LinkedIn , focuses on our services that transform the way customers hire, market, sell, and learn. • Gaming , focuses on developing hardware, content, and services across a large range of platforms to help grow our user base through game experiences and social interaction. Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software and hardware design. Before releasing new software platforms, and as we make significant modifications to existing platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 65,000 U.S. and international patents issued and over 21,000 pending worldwide. While we employ much of our internally-developed intellectual property exclusively in our products and services, we also engage in outbound licensing of specific patented technologies that are incorporated into licensees’ products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We may also purchase or license technology that we incorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, supporting societal and/or environmental efforts, or attracting and enabling our external development community. Our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, services, and business methods, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the Company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, devices, and operating systems. While our main product research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. 16 PART I Item 1 In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest corporate research organizations and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science and a broad range of other disciplines, providing us a unique perspective on future trends and contributing to our innovation. We generally fund research at the corporate level to ensure that we are looking beyond immediate product considerations to opportunities further in the future. We also fund research and development activities at the operating segment level. Much of our segment level research and development is coordinated with other segments and leveraged across the Company. We plan to continue to make significant investments in a broad range of research and development efforts. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales force performs a variety of functions, including working directly with commercial enterprises and public-sector organizations worldwide to identify and meet their technology and digital transformation requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. OEMs We distribute our products and services through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Dell, Hewlett-Packard, Lenovo, and with many regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors” or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. We also sell commercial and consumer products and services directly to customers, such as cloud services, search, and gaming, through our digital marketplaces and online stores. In fiscal year 2021, we closed our Microsoft Store physical locations and opened our Microsoft Experience Centers. Microsoft Experience Centers are designed to facilitate deeper engagement with our partners and customers across industries. Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. 17 PART I Item 1 We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers, and provide product training and sales support. Our Dynamics business solutions are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and SA. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. SA conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, training, and other licensing benefits to help customers deploy and use software efficiently. SA is included with certain volume licensing agreements and is an optional purchase with others. Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. SA is included. Microsoft Product and Services Agreement Microsoft Product and Services Agreements are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. SA is optional for customers that purchase perpetual licenses. Open Open agreements are a simple, cost-effective way to acquire the latest Microsoft technology. Open agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a one- to three-year period. Under the Open agreements, organizations purchase perpetual licenses and SA is optional. Under Open Value agreements, organizations can elect to purchase perpetual licenses or subscribe to licenses and SA is included. 18 PART I Item 1 Select Plus Select Plus agreements are designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and SA is optional. Microsoft Online Subscription Agreement Microsoft Online Subscription Agreements are designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web. The agreement allows customers to acquire monthly or annual subscriptions for cloud-based services. Partner Programs The Microsoft Cloud Solution Provider program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, managed services provider, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows hosting service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. The Independent Software Vendor Royalty program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, Internet service providers, application developers, and OEMs. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 19 PART I Item 1 INFORMATION ABOUT OUR EXECUTIV E OFFICERS Our executive officers as of July 29, 2021 were as follows: Name Age Position with the Company Satya Nadella 53 Chairman of the Board and Chief Executive Officer Judson Althoff 48 Executive Vice President and Chief Commercial Officer Christopher C. Capossela 51 Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer Kathleen T. Hogan 55 Executive Vice President, Human Resources Amy E. Hood 49 Executive Vice President, Chief Financial Officer Bradford L. Smith 62 President and Chief Legal Officer Christopher D. Young 49 Executive Vice President, Business Development, Strategy, and Ventures Mr. Nadella was appointed Chairman of the Board in June 2021 and Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Althoff was appointed Executive Vice President and Chief Commercial Officer in July 2021. He served as Executive Vice President, Worldwide Commercial Business from July 2017 until that time. Prior to that, Mr. Althoff served as the President of Microsoft North America. Mr. Althoff joined Microsoft in March 2013 as President of Microsoft North America. Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 28 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hogan also serves on the Board of Directors of Alaska Air Group, Inc. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Hood also serves on the Board of Directors of 3M Corporation. Mr. Smith was appointed President and Chief Legal Officer in September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. Mr. Young joined Microsoft in November 2020 as Executive Vice President, Business Development, Strategy, and Ventures. Prior to Microsoft, he served as the Chief Executive Officer of McAfee, LLC from 2017 to 2020, and served as a Senior Vice President and General Manager of Intel Security Group from 2014 until 2017, when he led the initiative to spin out McAfee into a standalone company. Mr. Young also serves on the Board of Directors of American Express Company. 20 PART I Item 1 AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”) at www.sec.gov. • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts to have information pushed in real time. We publish a variety of reports and resources related to our Corporate Social Responsibility programs and progress on our Reports hub website, www.microsoft.com/corporate-responsibility/reports-hub, including reports on sustainability, responsible sourcing, accessibility, digital trust, and public policy engagement. The information found on these websites is not part of, or incorporated by reference into, this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 21 PART I Item 1A ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. STRATEGIC AND COMPETITIVE RISKS We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platform-based ecosystems An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, wearables, and other endpoint devices. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on PCs. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users may incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. Competitors’ rules governing their content and applications marketplaces may restrict our ability to distribute products and services through them in accordance with our technical and business model objectives. 22 PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us by modifying and then distributing open source software at little or no cost to end users, and earning revenue on advertising or integrated products and services. These firms do not bear the full costs of research and development for the open source software. Some open source software mimics the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We embrace cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge worldview is connected with the growth of the Internet of Things (“IoT”). Our success in the IoT will depend on the level of adoption of our offerings such as Azure, Azure Stack, Azure IoT Edge, and Azure Sphere. We may not establish market share sufficient to achieve scale necessary to achieve our business objectives. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other IoT endpoints. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data as well as help them meet their own compliance needs. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. 23 PART I Item 1A RISKS RELATING TO THE EVOLUTION OF OUR BUSINESS We make significant investments in products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Microsoft 365, Office, Bing, SQL Server, Windows Server, Azure, Office 365, Xbox, LinkedIn, and other products and services. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. We may not get engagement in certain features, like Edge and Bing, that drive post-sale monetization opportunities. Our data handling practices across our products and services will continue to be under scrutiny and perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or product experiences, which could negatively impact product and feature adoption, product design, and product quality. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. For example, in October 2018 we completed our acquisition of GitHub, Inc. (“GitHub”) for $7.5 billion, in March 2021 we completed our acquisition of ZeniMax Media Inc. for $8.1 billion, and in April 2021 we announced a definitive agreement to acquire Nuance Communications, Inc. for $19.7 billion. These acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that we have difficulty integrating and retaining new employees, business systems, and technology, that they distract management from our other businesses, or that announced transactions may not be completed. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones. It may take longer than expected to realize the full benefits from these transactions and arrangements such as increased revenue or enhanced efficiencies, or the benefits may ultimately be smaller than we expected. These events could adversely affect our consolidated financial statements. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record, a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. 24 PART I Item 1A CYBERSECURITY, DATA PRIVACY, AND PLATFORM ABUSE RISKS Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position. Security of our information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Nation state and state sponsored actors can deploy significant resources to plan and carry out exploits. Inadequate account security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems or reveal confidential information. Malicious actors may employ the IT supply chain to introduce malware through software updates or compromised supplier accounts or hardware. Cyberthreats are constantly evolving and becoming increasingly sophisticated and complex, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network, or data security could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, require us to allocate more resources to improve technologies or remediate the impacts of attacks, or otherwise adversely affect our business. The cyberattacks uncovered in late 2020 known as “Solorigate” or “Nobelium” are an example of a supply chain attack where malware was introduced to a software provider’s customers, including us, through software updates. The attackers were later able to create false credentials that appeared legitimate to certain customers’ systems. We may be targets of further attacks similar to Solorigate/Nobelium as both a supplier and consumer of IT. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge. 25 PART I Item 1A Security of our products, services, devices, and customers’ data The security of our products and services is important in our customers’ decisions to purchase or use our products or services across cloud and on-premises environments. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. In addition, adversaries can attack our customers’ on-premises or cloud environments, sometimes exploiting previously unknown (“zero day”) vulnerabilities, such as occurred in early calendar year 2021 with several of our Exchange Server on-premises products. Vulnerabilities in these or any product can persist even after we have issued security patches if customers have not installed the most recent updates, or if the attackers exploited the vulnerabilities before patching to install additional malware to further compromise customers’ systems. Adversaries will continue to attack customers using our cloud services as customers embrace digital transformation. Adversaries that acquire user account information can use that information to compromise our users’ accounts, including where accounts share the same attributes as passwords. Inadequate account security practices may also result in unauthorized access, and user activity may result in ransomware or other malicious software impacting a customer’s use of our products or services. We are increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks. Our customers operate complex IT systems with third-party hardware and software from multiple vendors that may include systems acquired over many years. They expect our products and services to support all these systems and products, including those that no longer incorporate the strongest current security advances or standards. As a result, we may not be able to discontinue support in our services for a product, service, standard, or feature solely because a more secure alternative is available. Failure to utilize the most current security advances and standards can increase our customers’ vulnerability to attack. Further, customers of widely varied size and technical sophistication use our technology, and consequently may have limited capabilities and resources to help them adopt and implement state of the art cybersecurity practices and technologies. In addition, we must account for this wide variation of technical sophistication when defining default settings for our products and services, including security default settings, as these settings may limit or otherwise impact other aspects of IT operations and some customers may have limited capability to review and reset these defaults. The Solorigate/Nobelium or similar cyberattacks may adversely impact our customers even if our production services are not directly compromised. We are committed to notifying our customers whose systems have been impacted as we become aware and have available information and actions for customers to help protect themselves. We are also committed to providing guidance and support on detection, tracking, and remediation. We may not be able to detect the existence or extent of these attacks for all of our customers or have information on how to detect or track an attack, especially where an attack involves on-premises software such as Exchange Server where we may have no or limited visibility into our customers’ computing environments. Development and deployment of defensive measures To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide security tools such as firewalls, anti-virus software, and advanced security and information about the need to deploy security measures and the impact of doing so. Customers in certain industries such as financial services, health care, and government may have enhanced or specialized requirements to which we must engineer our product and services. 26 PART I Item 1A The cost of measures to protect products and customer-facing services could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers, and third parties granted access to their systems, may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches, or may otherwise fail to adopt adequate security practices. Any of these could adversely affect our reputation and revenue. Actual or perceived vulnerabilities may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers. Our products operate in conjunction with and are dependent on products and components across a broad ecosystem of third parties. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position. Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number and scale of our cloud-based offerings, we store and process increasingly large amounts of personally identifiable information of our customers and users. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and third parties on data security, and other practices we follow may not prevent the improper disclosure or misuse of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services. We may not be able to protect information in our products and services from use by others . LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services. Abuse of our platforms may harm our reputation or user engagement. Advertising, professional, and social platform abuses For platform products and services that provide content or host ads that come from or can be influenced by third parties, including GitHub, LinkedIn, Microsoft Advertising, MSN, and Xbox, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate. This activity may come from users impersonating other people or organizations, use of our products or services to spread terrorist or violent extremist content or to disseminate information that may be viewed as misleading or intended to manipulate the opinions of our users, or the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing or responding to these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and consolidated financial statements. 27 PART I Item 1A Digital safety and service misuse Our hosted consumer services as well as our enterprise services may be used by third parties to disseminate harmful or illegal content in violation of our terms or applicable law. We may not proactively discover such content due to scale and the limitations of existing technologies, and when discovered by users, such content may negatively affect our reputation, our brands, and user engagement. Regulations and other initiatives to make platforms responsible for preventing or eliminating harmful content online are gaining momentum and we expect this to continue. We may be subject to enhanced regulatory oversight, civil or criminal liability, or reputational damage if we fail to comply with content moderation regulations, adversely affecting our business and consolidated financial statements. The development of the IoT presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT, a network of distributed and interconnected devices employing sensors, data, and computing capabilities including AI. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins. Issues in the use of AI in our offerings may result in reputational harm or liability . We are building AI into many of our offerings and we expect this element of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many disruptive innovations, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms may be flawed. Datasets may be insufficient or contain biased information. Inappropriate or controversial data practices by Microsoft or others could impair the acceptance of AI solutions. These deficiencies could undermine the decisions, predictions, or analysis AI applications produce, subjecting us to competitive harm, legal liability, and brand or reputational harm. Some AI scenarios present ethical issues. If we enable or offer AI solutions that are controversial because of their impact on human rights, privacy, employment, or other social issues, we may experience brand or reputational harm. OPERATIONAL RISKS We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Azure, Microsoft Account services, Microsoft 365, Microsoft Teams, Dynamics 365, OneDrive, SharePoint Online, Skype, Xbox, and Outlook.com. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex, and requires development of principles for datacenter builds in geographies with higher safety risks. It requires that we maintain an Internet connectivity infrastructure and storage and compute capacity that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data, insufficient Internet connectivity, or inadequate storage and compute capacity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may adversely impact our consolidated financial statements. We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. 28 PART I Item 1A Our software products and services also may experience quality or reliability problems. The highly sophisticated software we develop may contain bugs and other defects that interfere with their intended operation. Our customers increasingly rely on us for critical business functions and multiple workloads. Many of our products and services are interdependent with one another. Each of these circumstances potentially magnifies the impact of quality or reliability issues. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. We acquire some device and datacenter components from sole suppliers. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If a component from a sole-source supplier is delayed or becomes unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes that restrict supply sources, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. These same risks would apply to any other hardware and software products we may offer. LEGAL, REGULATORY, AND LITIGATION RISKS Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scrutinize us under U.S. and foreign competition laws. Governments are actively enforcing competition laws and regulations, and this includes scrutiny in potentially large markets such as the European Union (“EU”), the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments we offered to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices for our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. Government regulatory actions and court decisions such as these may result in fines or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. 29 PART I Item 1A • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows post-sale monetization opportunities may be limited. Our global operations subject us to potential consequences under anti-corruption, trade, and other laws and regulations. The Foreign Corrupt Practices Act (“FCPA”) and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents, and the accounting provisions of the FCPA require us to maintain accurate books and records and adequate internal controls. From time to time, we receive inquiries from authorities in the U.S. and elsewhere which may be based on reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Periodically, we receive such reports directly and investigate them. On July 22, 2019, our Hungarian subsidiary entered into a non-prosecution agreement (“NPA”) with the U.S. Department of Justice (“DOJ”) and we agreed to the terms of a cease and desist order with the Securities and Exchange Commission. These agreements required us to pay $25.3 million in monetary penalties, disgorgement, and interest pertaining to activities at Microsoft’s subsidiary in Hungary. The NPA, which has a three-year term, also contains certain ongoing compliance requirements, including the obligations to disclose to the DOJ issues that may implicate the FCPA and to cooperate in any inquiries. Most countries in which we operate also have competition laws that prohibit competitors from colluding or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our U.S. and international compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Increasing trade laws, policies, sanctions, and other regulatory requirements also affect our operations in and outside the U.S. relating to trade and investment. Economic sanctions in the U.S., the EU, and other countries prohibit most business with restricted entities or countries such as Crimea, Cuba, Iran, North Korea, and Syria. U.S. export controls restrict Microsoft from offering many of its products and services to, or making investments in, certain entities in specified countries. U.S. import controls restrict us from integrating certain information and communication technologies into our supply chain and allow for government review of transactions involving information and communications technology from countries determined to be foreign adversaries. Non-compliance could result in reputational harm, operational delays, monetary fines, loss of export privileges, or criminal sanctions. Other regulatory areas that may apply to our products and online services offerings include requirements related to user privacy, telecommunications, data storage and protection, advertising, and online content. For example, some regulators are taking the position that our offerings such as Microsoft Teams and Skype are covered by existing laws regulating telecommunications services, and some new laws, including EU Member State laws under the European Electronic Communications Code, are defining more of our services as regulated telecommunications services. This trend may continue and will result in these offerings being subjected to additional data protection, security, and law enforcement surveillance obligations. Regulators may assert that our collection, use, and management of customer and other data is inconsistent with their laws and regulations. Legislative or regulatory action relating to cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Legislative and regulatory action is emerging in the areas of AI and content moderation, which could increase costs or restrict opportunity. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, customers, and other stakeholders to make technology more accessible. If our products do not meet customer expectations or global accessibility requirements, we could lose sales opportunities or face regulatory or legal actions. 30 PART I Item 1A Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us, or reputational damage . The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, in July 2020 the Court of Justice of the EU invalidated a framework called Privacy Shield for companies to transfer data from EU member states to the United States. This ruling has led to uncertainty about the legal requirements for data transfers from the EU under other l egal mechanisms. Potential new rules and restrictions on the flow of data across borders could increase the cost and complexity of delivering our products and services in some markets. In May 2018, the EU General Data Protection Regulation (“GDPR”), became effective. The law, which applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of compliance obligations regarding the handling of personal data. Engineering efforts to build and maintain capabilities to facilitate compliance with the law have entailed substantial expense and the diversion of engineering resources from other projects and may continue to do so. We might experience reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under the GDPR or other data regulations, or if our implementation to comply with the GDPR make s our offerings less attractive. The GDPR imposes significant new obligations and compliance with these obligations depends in part on how particular regulators interpret and apply them. If we fail to comply with the GDPR, or if regulators assert we have failed to comply with the GDPR, it may lead to regulatory enforcement actions, which can result in monetary penalties of up to 4% of worldwide revenue, private lawsuits, reputational damage , and loss of customers . Countries around the world, and states in the U.S . such as California , Colorado, and Virginia , ha ve adopted, or are considering adopting or expanding , laws and regulations imposing obligations regarding the handling of personal data. The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Ongoing legal analyses, reviews, and inquiries by regulators of Microsoft practices, or relevant practices of other organizations, may result in burdensome or inconsistent requirements, including data sovereignty and localization requirements, affecting the location, movement, collection, and use of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in some jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity, as well as negative publicity and diversion of management time and effort. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact in our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. Our business with government customers may present additional uncertainties. We derive substantial revenue from government contracts. Government contracts generally can present risks and challenges not present in private commercial agreements. For instance, we may be subject to government audits and investigations relating to these contracts, we could be suspended or debarred as a governmental contractor, we could incur civil and criminal fines and penalties, and under certain circumstances contracts may be rescinded. Some agreements may allow a government to terminate without cause and provide for higher liability limits for certain losses. Some contracts may be subject to periodic funding approval, reductions, or delays which could adversely impact public-sector demand for our products and services. These events could negatively impact our results of operations, financial condition, and reputation. 31 PART I Item 1A We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cuts and Jobs Act (“TCJA”) and possible future legislative changes may require the collection of information not regularly produced within the Company, the use of estimates in our consolidated financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to the TCJA or possible future legislative changes , and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our consolidated financial statements. We regularly are under audit by tax authorities in different jurisdictions. Although we believe that our provision for income taxes and our tax estimates are reasonable, tax authorities may disagree with certain positions we have taken. In addition, economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. We are currently under Internal Revenue Service audit for prior tax years, with the primary unresolved issues relating to transfer pricing. The final resolution of those audits, and other audits or litigation, may differ from the amounts recorded in our consolidated financial statements and may materially affect our consolidated financial statements in the period or periods in which that determination is made. We earn a significant amount of our operating income outside the U.S. A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the Company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our consolidated financial statements. INTELLECTUAL PROPERTY RISKS We may not be able to protect our source code from copying if there is an unauthorized disclosure. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described elsewhere in these risk factors. Legal changes, our evolving business model, piracy, and other factors may decrease the value of our intellectual property. Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly countries in which the legal system provides less protection for intellectual property rights. Our revenue in these markets may grow more slowly than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing or cross-licensing our patents to others in return for a royalty and/or increased freedom to operate. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties or may contest the scope and extent of their obligations. The royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, price changes in products using licensed patents, greater value from cross-licensing, or the difficulty of discovering infringements. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations and may negatively impact revenue. 32 PART I Item 1A Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. GENERAL RISKS If our reputation or our brands are damaged, our business and operating results may be harmed . Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, or our environmental impact and sustainability, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things: • The introduction of new features, products, services, or terms of service that customers, users, or partners do not like. • Public scrutiny of our decisions regarding user privacy, data practices, or content. • Data security breaches, compliance failures, or actions of partners or individual employees. The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees. Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, pandemic, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced a decline in fair value, requiring impairment charges that could adversely affect our consolidated financial statements. 33 PART I Item 1A Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, pandemic, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems, or the infrastructure or systems they rely on, such as power grids, could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans and magnifies the potential impact of prolonged service outages in our consolidated financial statements. Abrupt political change, terrorist activity, and armed conflict pose a risk of general economic disruption in affected countries, which may increase our operating costs. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory systems and requirements and market interventions that could impact our operating strategies, access to national, regional, and global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues. The occurrence of regional epidemics or a global pandemic may adversely affect our operations, financial condition, and results of operations. The COVID-19 pandemic continues to have widespread, rapidly evolving, and unpredictable impacts on global society, economies, financial markets, and business practices. Federal and state governments have implemented measures to contain the virus, including social distancing, travel restrictions, and vaccination programs. Even as efforts to contain the pandemic have made progress and some restrictions have relaxed, new variants of the virus are causing additional outbreaks. The COVID-19 pandemic has impacted and may continue to impact our business operations, including our employees, customers, partners, and communities, and there is substantial uncertainty in the nature and degree of its continued effects over time. The extent to which the COVID-19 pandemic impacts our business going forward will depend on numerous evolving factors we cannot reliably predict, including the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity including the possibility of recession or financial market instability. These factors may adversely impact consumer, business, and government spending on technology as well as customers' ability to pay for our products and services on an ongoing basis. This uncertainty also affects management’s accounting estimates and assumptions, which could result in greater variability in a variety of areas that depend on these estimates and assumptions, including investments, receivables, and forward-looking guidance. Measures to contain the virus that impact us, our partners, distributors, and suppliers may further intensify these impacts and other risks described in these Risk Factors. Any of these may adversely impact our ability to: • Maintain our operations infrastructure, including the reliability and adequate capacity of cloud services. • Satisfy our contractual and regulatory compliance obligations as we adapt to changing usage patterns, such as through datacenter load balancing. • Ensure a high-quality and consistent supply chain and manufacturing operations for our hardware devices and datacenter operations. • Effectively manage our international operations through changes in trade practices and policies. • Hire and deploy people where we most need them. • Sustain the effectiveness and productivity of our operations including our sales, marketing, engineering, and distribution functions. We may incur increased costs to effectively manage these aspects of our business. If we are unsuccessful it may adversely impact our revenues, cash flows, market share growth, and reputation. 34 PART I Item 1A The long-term effects of climate change on the global economy and the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in climate where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Our global business exposes us to operational and economic risks. Our customers are located throughout the world and a significant part of our revenue comes from international sales. The global nature of our business creates operational, economic, and geopolitical risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist and protectionist trends and concerns about human rights and political expression in specific countries may significantly alter the trade and commercial environments. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, and non-local sourcing restrictions, export controls, investment restrictions, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our results of operations. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees representing diverse backgrounds, experiences, and skill sets. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation, as well as a diverse and inclusive work environment that enables all our employees to thrive, are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. 35 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our fiscal year 2021 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 520 acres of land we own at our corporate headquarters, and approximately 5 million square feet of space we lease. In addition, we own and lease space domestically that includes office and datacenter space. We also own and lease facilities internationally for datacenters, research and development, and other operations. The largest owned properties include space in the following locations: China, India, Ireland, the Netherlands, Singapore, and South Korea. The largest leased properties include space in the following locations: Australia, Canada, China, France, Germany, India, Israel, Japan, Netherlands, and the United Kingdom. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described under Research and Development (Part I, Item 1 of this Form 10-K). The table below shows a summary of the square footage of our office, datacenter, and other facilities owned and leased domestically and internationally as of June 30, 2021: (Square feet in millions) Location Owned Leased Total U.S. 22 17 39 International 9 19 28 Total 31 36 67 ITEM 3. LEGAL PROCEEDINGS While not material to the Company, the Company was required to make annual reports of the general activities of the Company’s Antitrust Compliance Office as required by the Final Order and Judgment in Barovic v. Ballmer et al, United States District Court for the Western District of Washington (“Final Order”). For more information see http://aka.ms/MSLegalNotice2015 . The Final Order expired in April of 2021. During fiscal year 2021, the Antitrust Compliance Office (a) monitored the Company’s compliance with the European Commission Decision of March 24, 2004, (“2004 Decision”) and with the Company’s Public Undertaking to the European Commission dated December 16, 2009 (“2009 Undertaking”); (b) monitored, in the manner required by the Final Order, employee, customer, competitor, regulator, or other third-party complaints regarding compliance with the 2004 Decision, the 2009 Undertaking, or other EU or U.S. laws or regulations governing tying, bundling, and exclusive dealing contracts; and, (c) monitored, in the manner required by the Final Order, the training of the Company’s employees regarding the Company’s antitrust compliance polices. In addition, prior to expiration of the Final Order, the Antitrust Compliance Officer reported to the Regulatory and Public Policy Committee of the Board at each of its regularly scheduled meetings. Refer to Note 15 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 36 PART II Item 5 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 26, 2021, there were 89,291 registered holders of record of our common stock. SHARE REPURCHASES AND DIVIDENDS Following are our monthly share repurchases for the fourth quarter of fiscal year 2021: Period Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet be Purchased Under the Plans or Programs (In millions) April 1, 2021 – April 30, 2021 7,493,732 $ 255.23 7,493,732 $ 13,030 May 1, 2021 – May 31, 2021 8,823,524 247.36 8,823,524 10,847 June 1, 2021 – June 30, 2021 8,155,857 258.07 8,155,857 8,742 24,473,113 24,473,113 All share repurchases were made using cash resources. Our share repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. Our Board of Directors declared the following dividends during the fourth quarter of fiscal year 2021: Declaration Date Record Date Payment Date Dividend Per Share Amount (In millions) June 16, 2021 August 19, 2021 September 9, 2021 $ 0.56 $ 4,211 We returned $10.4 billion to shareholders in the form of share repurchases and dividends in the fourth quarter of fiscal year 2021. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding share repurchases and dividends. 37 PART II Item 6 ITEM 6. [RESERVED] 38 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). This section generally discusses the results of our operations for the year ended June 30, 2021 compared to the year ended June 30, 2020. For a discussion of the year ended June 30, 2020 compared to the year ended June 30, 2019, please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended June 30, 2020. OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by offering a wide range of cloud-based and other services to people and businesses; licensing and supporting an array of software products; designing, manufacturing, and selling devices; and delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes. As the world continues to respond to COVID-19, we are working to do our part by ensuring the safety of our employees, striving to protect the health and well-being of the communities in which we operate, and providing technology and resources to our customers to help them do their best work while remote. Highlights from fiscal year 2021 compared with fiscal year 2020 included: • Commercial cloud revenue increased 34% to $69.1 billion. • Office Commercial products and cloud services revenue increased 13% driven by Office 365 Commercial growth of 22%. • Office Consumer products and cloud services revenue increased 10% and Microsoft 365 Consumer subscribers increased to 51.9 million. • LinkedIn revenue increased 27%. • Dynamics products and cloud services revenue increased 25% driven by Dynamics 365 growth of 43%. • Server products and cloud services revenue increased 27% driven by Azure growth of 50%. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue increased slightly. • Windows Commercial products and cloud services revenue increased 14%. • Xbox content and services revenue increased 23%. • Search advertising revenue, excluding traffic acquisition costs, increased 13%. • Surface revenue increased 5%. On March 9, 2021, we completed our acquisition of ZeniMax Media Inc. (“ZeniMax”), the parent company of Bethesda Softworks LLC, for a total purchase price of $8.1 billion, consisting primarily of cash. The purchase price included $768 million of cash and cash equivalents acquired. The financial results of ZeniMax have been included in our consolidated financial statements since the date of the acquisition. ZeniMax is reported as part of our More Personal Computing segment. Refer to Note 8 – Business Combinations of the Notes to Financial Statements ( Part II, Item 8 of this Form 10-K ) for further discussion. 39 PART II Item 7 Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our devices are primarily manufactured by third-party contract manufacturers, some of which contain certain components for which there are very few qualified suppliers. For these components, we have limited near-term flexibility to use other manufacturers if a current vendor becomes unavailable or is unable to meet our requirements. Extended disruptions at these suppliers could lead to a similar disruption in our ability to manufacture devices on time to meet consumer demand. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Weakening of the U.S. dollar relative to certain foreign currencies increased reported revenue and did not have a material impact on reported expenses from our international operations in fiscal year 2021. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. COVID-19 In fiscal year 2021, the COVID-19 pandemic continued to impact our business operations and financial results. Cloud usage and demand benefited as customers accelerate their digital transformation priorities. Our consumer businesses also benefited from the remote environment, with continued demand for PCs and productivity tools, as well as strong engagement across our Gaming platform. We saw improvement in customer advertising spend and savings in operating expenses related to COVID-19, but experienced weakness in transactional licensing. The COVID-19 pandemic may continue to impact our business operations and financial operating results, and there is uncertainty in the nature and degree of its continued effects over time. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Seasonality Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period. 40 PART II Item 7 Change in Accounting Estimate In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years. This change in accounting estimate was effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2020, the effect of this change in estimate for fiscal year 2021 was an increase in operating income of $2.7 billion and net income of $2.3 billion, or $0.30 per both basic and diluted share. Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted in the United States of America (“GAAP”), along with certain corporate-level and other activity, are included in Corporate and Other. Additional information on our reportable segments is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Metrics We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Financial metrics are calculated based on GAAP results and growth comparisons relate to the corresponding period of last fiscal year. Commercial Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance. Commercial remaining performance obligation Commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods Commercial cloud revenue Revenue from our commercial cloud business, which includes Azure, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties Commercial cloud gross margin percentage Gross margin percentage for our commercial cloud business 41 PART II Item 7 Productivity and Business Processes and Intelligent Cloud Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends. Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and cloud services (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud services, including Microsoft 365 Consumer subscriptions and Office licensed on-premises Office 365 Commercial seat growth The number of Office 365 Commercial seats at end of period where seats are paid users covered by an Office 365 Commercial subscription Microsoft 365 Consumer subscribers The number of Microsoft 365 Consumer (formerly Office 365 Consumer) subscribers at end of period Dynamics products and cloud services revenue growth Revenue from Dynamics products and cloud services, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM, Customer Insights, Power Apps, and Power Automate; and on-premises ERP and CRM applications LinkedIn revenue growth Revenue from LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, Sales Solutions, and Learning Solutions Server products and cloud services revenue growth Revenue from Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and GitHub More Personal Computing Metrics related to our More Personal Computing segment assess the performance of key lines of business within this segment. These metrics provide strategic product insights which allow us to assess the performance across our commercial and consumer businesses. As we have diversity of target audiences and sales motions within the Windows business, we monitor metrics that are reflective of those varying motions. Windows OEM Pro revenue growth Revenue from sales of Windows Pro licenses sold through the OEM channel, which primarily addresses demand in the commercial market Windows OEM non-Pro revenue growth Revenue from sales of Windows non-Pro licenses sold through the OEM channel, which primarily addresses demand in the consumer market 42 PART II Item 7 Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and cloud services, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings Surface revenue Revenue from Surface devices and accessories Xbox content and services revenue growth Revenue from Xbox content and services, comprising digital transactions, Xbox Game Pass and other subscriptions, video games, third-party video game royalties, cloud services, and advertising Search advertising revenue, excluding TAC, growth Revenue from search advertising excluding traffic acquisition costs (“TAC”) paid to Bing Ads network publishers SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2021 2020 Percentage Change Revenue $ 168,088 $ 143,015 18% Gross margin 115,856 96,937 20% Operating income 69,916 52,959 32% Net income 61,271 44,281 38% Diluted earnings per share 8.05 5.76 40% Adjusted net income (non-GAAP) 60,651 44,281 37% Adjusted diluted earnings per share (non-GAAP) 7.97 5.76 38% Adjusted net income and adjusted diluted earnings per share (“EPS”) are non-GAAP financial measures which exclude tax benefits related to an India Supreme Court decision on withholding taxes in fiscal year 2021 . Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results. See Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Revenue increased $25.1 billion or 18% driven by growth across each of our segments. Intelligent Cloud revenue increased driven by Azure. Productivity and Business Processes revenue increased driven by Office 365 Commercial and LinkedIn. More Personal Computing revenue increased driven by Gaming. Cost of revenue increased $6.2 billion or 13% driven by growth in commercial cloud and Gaming, offset in part by a reduction in depreciation expense due to the change in estimated useful lives of our server and network equipment. Gross margin increased $18.9 billion or 20% driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased with the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage decreased slightly driven by gross margin percentage reduction in More Personal Computing. Commercial cloud gross margin percentage increased 4 points to 71% driven by gross margin percentage improvement in Azure and the change in estimated useful lives of our server and network equipment, offset in part by sales mix shift to Azure. Operating expenses increased $2.0 billion or 4% driven by investments in cloud engineering and commercial sales, offset in part by savings related to COVID-19 across each of our segments, prior year charges associated with the closing of our Microsoft Store physical locations, and a reduction in bad debt expense. Key changes in operating expenses were: • Research and development expenses increased $1.4 billion or 8% driven by investments in cloud engineering. • Sales and marketing expenses increased $519 million or 3% driven by investments in commercial sales, offset in part by a reduction in bad debt expense. Sales and marketing included an unfavorable foreign currency impact of 2%. • General and administrative expenses were relatively unchanged, driven by prior year charges associated with the closing of our Microsoft Store physical locations, offset in part by an increase in certain employee-related expenses and business taxes. 43 PART II Item 7 Operating income increased $17.0 billion or 32% driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment. Current year net income and diluted EPS were positively impacted by the tax benefit related to the India Supreme Court decision on withholding taxes, which resulted in an increase to net income and diluted EPS of $620 million and $0.08, respectively. Revenue, gross margin, and operating income included a favorable foreign currency impact of 3%, 3%, and 4%, respectively. SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2021 2020 Percentage Change Revenue Productivity and Business Processes $ 53,915 $ 46,398 16% Intelligent Cloud 60,080 48,366 24% More Personal Computing 54,093 48,251 12% Total $ 168,088 $ 143,015 18% Operating Income Productivity and Business Processes $ 24,351 $ 18,724 30% Intelligent Cloud 26,126 18,324 43% More Personal Computing 19,439 15,911 22% Total $ 69,916 $ 52,959 32% Reportable Segments Productivity and Business Processes Revenue increased $7.5 billion or 16%. • Office Commercial products and cloud services revenue increased $4.0 billion or 13%. Office 365 Commercial revenue grew 22% driven by seat growth of 17% and higher revenue per user. Office Commercial products revenue declined 23% driven by continued customer shift to cloud offerings and transactional weakness. • Office Consumer products and cloud services revenue increased $474 million or 10% driven by Microsoft 365 Consumer subscription revenue, on a strong prior year comparable that benefited from transactional strength in Japan. Microsoft 365 Consumer subscribers increased 22% to 51.9 million. • LinkedIn revenue increased $2.2 billion or 27% driven by advertising demand in our Marketing Solutions business. • Dynamics products and cloud services revenue increased 25% driven by Dynamics 365 growth of 43%. Operating income increased $5.6 billion or 30%. • Gross margin increased $6.5 billion or 18% driven by growth in Office 365 Commercial and LinkedIn, and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased with the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage decreased slightly driven by a sales mix shift to cloud offerings, on a low prior year comparable impacted by increased usage. • Operating expenses increased $839 million or 5% driven by investments in commercial sales, cloud engineering, and LinkedIn. Revenue, gross margin, and operating income included a favorable foreign currency impact of 2%, 3%, and 4%, respectively. 44 PART II Item 7 Intelligent Cloud Revenue increased $11.7 billion or 24%. • Server products and cloud services revenue increased $11.2 billion or 27% driven by Azure. Azure revenue grew 50% due to growth in our consumption-based services. Server products revenue increased 6% driven by hybrid and premium solutions, on a strong prior year comparable that benefited from demand related to SQL Server 2008 and Windows Server 2008 end of support. • Enterprise Services revenue increased $534 million or 8% driven by growth in Premier Support Services. Operating income increased $7.8 billion or 43%. • Gross margin increased $9.7 billion or 29% driven by growth in Azure and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased with the change in estimated useful lives of our server and network equipment. Excluding this impact, gross margin percentage was relatively unchanged driven by gross margin percentage improvement in Azure, offset in part by sales mix shift to Azure. • Operating expenses increased $1.9 billion or 12% driven by investments in Azure. Revenue, gross margin, and operating income included a favorable foreign currency impact of 2%, 3%, and 4%, respectively. More Personal Computing Revenue increased $5.8 billion or 12%. • Windows revenue increased $933 million or 4% driven by growth in Windows Commercial. Windows Commercial products and cloud services revenue increased 14% driven by demand for Microsoft 365. Windows OEM revenue increased slightly driven by consumer PC demand, on a strong prior year OEM Pro comparable that benefited from Windows 7 end of support. Windows OEM Pro revenue decreased 9% and Windows OEM non-Pro revenue grew 21%. • Gaming revenue increased $3.8 billion or 33% driven by growth in Xbox content and services and Xbox hardware. Xbox content and services revenue increased $2.3 billion or 23% driven by growth in third-party titles, Xbox Game Pass subscriptions, and first-party titles. Xbox hardware revenue increased 92% driven by higher price of consoles sold due to the Xbox Series X|S launches. • Search advertising revenue increased $788 million or 10%. Search advertising revenue excluding traffic acquisition costs increased 13% driven by higher revenue per search and search volume. • Surface revenue increased $302 million or 5%. Operating income increased $3.5 billion or 22%. • Gross margin increased $2.8 billion or 10% driven by growth in Windows, Gaming, and Search advertising. Gross margin percentage decreased driven by sales mix shift to Gaming hardware. • Operating expenses decreased $752 million or 6% driven by prior year charges associated with the closing of our Microsoft Store physical locations and reductions in retail store expenses and marketing, offset in part by investments in Gaming. Gross margin and operating income included a favorable foreign currency impact of 2% and 3%, respectively. 45 PART II Item 7 OPERATING EXPENSES Research and Development (In millions, except percentages) 2021 2020 Percentage Change Research and development $ 20,716 $ 19,269 8% As a percent of revenue 12% 13% (1)ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Research and development expenses increased $1.4 billion or 8% driven by investments in cloud engineering. Sales and Marketing (In millions, except percentages) 2021 2020 Percentage Change Sales and marketing $ 20,117 $ 19,598 3% As a percent of revenue 12% 14% (2)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased $519 million or 3% driven by investments in commercial sales, offset in part by a reduction in bad debt expense. Sales and marketing included an unfavorable foreign currency impact of 2%. General and Administrative (In millions, except percentages) 2021 2020 Percentage Change General and administrative $ 5,107 $ 5,111 0% As a percent of revenue 3% 4% (1)ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, severance expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. General and administrative expenses were relatively unchanged, driven by prior year charges associated with the closing of our Microsoft Store physical locations, offset in part by an increase in certain employee-related expenses and business taxes. 46 PART II Item 7 OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2021 2020 Interest and dividends income $ 2,131 $ 2,680 Interest expense (2,346 ) (2,591 ) Net recognized gains on investments 1,232 32 Net gains on derivatives 17 187 Net gains (losses) on foreign currency remeasurements 54 (191 ) Other, net 98 (40 ) Total $ 1,186 $ 77 We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net. Interest and dividends income decreased due to lower yields on fixed-income securities. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized gains on investments increased due to higher gains on equity securities. Net gains on derivatives decreased due to lower gains on foreign currency contracts. INCOME TAXES Effective Tax Rate Our effective tax rate for fiscal years 2021 and 2020 was 14% and 17%, respectively. The decrease in our effective tax rate was primarily due to tax benefits from a decision by the India Supreme Court on withholding taxes in the case of Engineering Analysis Centre of Excellence Private Limited vs The Commissioner of Income Tax, an agreement between the U.S. and India tax authorities related to transfer pricing, final Tax Cuts and Jobs Act (“TCJA”) regulations, and an increase in tax benefits relating to stock-based compensation. We have historically paid India withholding taxes on software sales through distributor withholding and tax audit assessments in India. In March 2021, the India Supreme Court ruled favorably for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject to India withholding taxes. Although we were not a party to the appeals, our software sales in India were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of $620 million in the third quarter of fiscal year 2021 to reflect the results of the India Supreme Court decision impacting fiscal year 1996 through fiscal year 2016. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, tax benefits relating to stock-based compensation, and tax benefits from the India Supreme Court decision on withholding taxes. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2021, our U.S. income before income taxes was $35.0 billion and our foreign income before income taxes was $36.1 billion. In fiscal year 2020, our U.S. income before income taxes was $24.1 billion and our foreign income before income taxes was $28.9 billion. Uncertain Tax Positions We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017. 47 PART II Item 7 As of June 30, 202 1 , the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2020, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Adjusted net income and adjusted diluted EPS are non-GAAP financial measures which exclude the tax benefits related to the India Supreme Court decision on withholding taxes in fiscal year 2021. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results: (In millions, except percentages and per share amounts) 2021 2020 Percentage Change Net income $ 61,271 $ 44,281 38% Net income tax benefit related to India Supreme Court decision on withholding taxes (620 ) 0 * Adjusted net income (non-GAAP) $ 60,651 $ 44,281 37% Diluted earnings per share $ 8.05 $ 5.76 40% Net income tax benefit related to India Supreme Court decision on withholding taxes (0.08 ) 0 * Adjusted diluted earnings per share (non-GAAP) $ 7.97 $ 5.76 38% * Not meaningful. 48 PART II Item 7 FINANCIAL CONDITION Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $130.3 billion and $136.5 billion as of June 30, 2021 and 2020. Equity investments were $6.0 billion and $3.0 billion as of June 30, 2021 and 2020, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Cash from operations increased $16.1 billion to $76.7 billion for fiscal year 2021, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees. Cash used in financing increased $2.5 billion to $48.5 billion for fiscal year 2021, mainly due to a $4.4 billion increase in common stock repurchases and a $1.4 billion increase in dividends paid, offset in part by a $1.8 billion decrease in repayments of debt and a $1.7 billion decrease in cash premium paid on debt exchange. Cash used in investing increased $15.4 billion to $27.6 billion for fiscal year 2021, mainly due to a $6.4 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, a $5.2 billion increase in additions to property and equipment, and a $4.1 billion decrease in cash from net investment purchases, sales, and maturities. Debt We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. In March 2021 and June 2020, we exchanged a portion of our existing debt at a premium for cash and new debt with longer maturities to take advantage of favorable financing rates in the debt markets, reflecting our credit rating and the low interest rate environment. Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 49 PART II Item 7 Unearned Revenue Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. The following table outlines the expected future recognition of unearned revenue as of June 30, 2021: (In millions) Three Months Ending September 30, 2021 $ 15,922 December 31, 2021 12,646 March 31, 2022 8,786 June 30, 2022 4,171 Thereafter 2,616 Total $ 44,141 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. Share Repurchases During fiscal years 2021 and 2020, we repurchased 101 million shares and 126 million shares of our common stock for $23.0 billion and $19.7 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Off-Balance Sheet Arrangements We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented. 50 PART II Item 7 Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2021: (In millions) 2022 2023-2024 2025-2026 Thereafter Total Long-term debt: (a) Principal payments $ 8,075 $ 8,000 $ 5,250 $ 42,585 $ 63,910 Interest payments 1,628 2,847 2,438 17,320 24,233 Construction commitments (b) 8,927 529 0 0 9,456 Operating leases, including imputed interest (c) 2,801 4,956 3,469 6,747 17,973 Finance leases, including imputed interest (c) 1,341 3,256 3,774 14,096 22,467 Transition tax (d) 1,427 4,105 8,030 0 13,562 Purchase commitments (e) 29,129 1,708 446 270 31,553 Other long-term liabilities (f) 0 365 68 263 696 Total $ 53,328 $ 25,766 $ 23,475 $ 81,281 $ 183,850 (a) Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Refer to Note 7 – Property and Equipment of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (c) Refer to Note 14 – Leases of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (d) Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (e) Amounts represent purchase commitments, including open purchase orders and take-or-pay contracts that are not presented as construction commitments above. (f) We have excluded long-term tax contingencies, other tax liabilities, and deferred income taxes of $14.6 billion from the amounts presented as the timing of these obligations is uncertain. We have also excluded unearned revenue and non-cash items. Other Planned Uses of Capital On April 11, 2021, we entered into a definitive agreement to acquire Nuance Communications, Inc. (“Nuance”) for $56.00 per share in an all-cash transaction valued at $19.7 billion, inclusive of Nuance’s net debt. The acquisition has been approved by Nuance’s shareholders, and we expect it to close by the end of calendar year 2021, subject to the satisfaction of certain regulatory approvals and other customary closing conditions. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. Liquidity As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of $4.7 billion, which included $1.5 billion for fiscal year 2021. The remaining transition tax of $13.6 billion is payable over the next five years with a final payment in fiscal year 2026. We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future. 51 PART II Item 7 RECENT ACCOUNTING GUIDANCE Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. APPLICATION OF CRITICAL ACCOUNTING POLICIES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies, as well as uncertainty in the current economic environment due to COVID-19. Critical accounting policies for us include revenue recognition, impairment of investment securities, goodwill, research and development costs, contingencies, income taxes, and inventories. Revenue Recognition Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Impairment of Investment Securities We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. 52 PART II Item 7 Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. 53 PART II Item 7 The TCJA significantly changes existing U.S. tax law and includes numerous provisions that affect our business. Refer to Note 12 – Income Taxes of the Notes to Financial Statements (Part I I , Item 8 of this Form 10-K) for further discussion. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. 54 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Alice L. Jolla Corporate Vice President and Chief Accounting Officer 55 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITAT IVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions, including hedges. Principal currency exposures include the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. Equity Securities held in our equity investments portfolio are subject to price risk. SENSITIVITY ANALYSIS The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices: (In millions) Risk Categories Hypothetical Change June 30, 2021 Impact Foreign currency–Revenue 10% decrease in foreign exchange rates $ (6,756 ) Earnings Foreign currency–Investments 10% decrease in foreign exchange rates (136 ) Fair Value Interest rate 100 basis point increase in U.S. treasury interest rates (3,511 ) Fair Value Credit 100 basis point increase in credit spreads (309 ) Fair Value Equity 10% decrease in equity market prices (602 ) Earnings 56 PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2021 2020 2019 Revenue: Product $ 71,074 $ 68,041 $ 66,069 Service and other 97,014 74,974 59,774 Total revenue 168,088 143,015 125,843 Cost of revenue: Product 18,219 16,017 16,273 Service and other 34,013 30,061 26,637 Total cost of revenue 52,232 46,078 42,910 Gross margin 115,856 96,937 82,933 Research and development 20,716 19,269 16,876 Sales and marketing 20,117 19,598 18,213 General and administrative 5,107 5,111 4,885 Operating income 69,916 52,959 42,959 Other income, net 1,186 77 729 Income before income taxes 71,102 53,036 43,688 Provision for income taxes 9,831 8,755 4,448 Net income $ 61,271 $ 44,281 $ 39,240 Earnings per share: Basic $ 8.12 $ 5.82 $ 5.11 Diluted $ 8.05 $ 5.76 $ 5.06 Weighted average shares outstanding: Basic 7,547 7,610 7,673 Diluted 7,608 7,683 7,753 Refer to accompanying notes. 57 PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2021 2020 2019 Net income $ 61,271 $ 44,281 $ 39,240 Other comprehensive income (loss), net of tax: Net change related to derivatives 19 ( 38 ) ( 173 ) Net change related to investments ( 2,266 ) 3,990 2,405 Translation adjustments and other 873 ( 426 ) ( 318 ) Other comprehensive income (loss) ( 1,374 ) 3,526 1,914 Comprehensive income $ 59,897 $ 47,807 $ 41,154 Refer to accompanying notes. 58 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2021 2020 Assets Current assets: Cash and cash equivalents $ 14,224 $ 13,576 Short-term investments 116,110 122,951 Total cash, cash equivalents, and short-term investments 130,334 136,527 Accounts receivable, net of allowance for doubtful accounts of $ 751 and $ 788 38,043 32,011 Inventories 2,636 1,895 Other current assets 13,393 11,482 Total current assets 184,406 181,915 Property and equipment, net of accumulated depreciation of $ 51,351 and $ 43,197 59,715 44,151 Operating lease right-of-use assets 11,088 8,753 Equity investments 5,984 2,965 Goodwill 49,711 43,351 Intangible assets, net 7,800 7,038 Other long-term assets 15,075 13,138 Total assets $ 333,779 $ 301,311 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 15,163 $ 12,530 Current portion of long-term debt 8,072 3,749 Accrued compensation 10,057 7,874 Short-term income taxes 2,174 2,130 Short-term unearned revenue 41,525 36,000 Other current liabilities 11,666 10,027 Total current liabilities 88,657 72,310 Long-term debt 50,074 59,578 Long-term income taxes 27,190 29,432 Long-term unearned revenue 2,616 3,180 Deferred income taxes 198 204 Operating lease liabilities 9,629 7,671 Other long-term liabilities 13,427 10,632 Total liabilities 191,791 183,007 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000 ; outstanding 7,519 and 7,571 83,111 80,552 Retained earnings 57,055 34,566 Accumulated other comprehensive income 1,822 3,186 Total stockholders’ equity 141,988 118,304 Total liabilities and stockholders’ equity $ 333,779 $ 301,311 Refer to accompanying notes. 59 PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2021 2020 2019 Operations Net income $ 61,271 $ 44,281 $ 39,240 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other 11,686 12,796 11,682 Stock-based compensation expense 6,118 5,289 4,652 Net recognized gains on investments and derivatives ( 1,249 ) ( 219 ) ( 792 ) Deferred income taxes ( 150 ) 11 ( 6,463 ) Changes in operating assets and liabilities: Accounts receivable ( 6,481 ) ( 2,577 ) ( 2,812 ) Inventories ( 737 ) 168 597 Other current assets ( 932 ) ( 2,330 ) ( 1,718 ) Other long-term assets ( 3,459 ) ( 1,037 ) ( 1,834 ) Accounts payable 2,798 3,018 232 Unearned revenue 4,633 2,212 4,462 Income taxes ( 2,309 ) ( 3,631 ) 2,929 Other current liabilities 4,149 1,346 1,419 Other long-term liabilities 1,402 1,348 591 Net cash from operations 76,740 60,675 52,185 Financing Cash premium on debt exchange ( 1,754 ) ( 3,417 ) 0 Repayments of debt ( 3,750 ) ( 5,518 ) ( 4,000 ) Common stock issued 1,693 1,343 1,142 Common stock repurchased ( 27,385 ) ( 22,968 ) ( 19,543 ) Common stock cash dividends paid ( 16,521 ) ( 15,137 ) ( 13,811 ) Other, net ( 769 ) ( 334 ) ( 675 ) Net cash used in financing ( 48,486 ) ( 46,031 ) ( 36,887 ) Investing Additions to property and equipment ( 20,622 ) ( 15,441 ) ( 13,925 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets ( 8,909 ) ( 2,521 ) ( 2,388 ) Purchases of investments ( 62,924 ) ( 77,190 ) ( 57,697 ) Maturities of investments 51,792 66,449 20,043 Sales of investments 14,008 17,721 38,194 Other, net ( 922 ) ( 1,241 ) 0 Net cash used in investing ( 27,577 ) ( 12,223 ) ( 15,773 ) Effect of foreign exchange rates on cash and cash equivalents ( 29 ) ( 201 ) ( 115 ) Net change in cash and cash equivalents 648 2,220 ( 590 ) Cash and cash equivalents, beginning of period 13,576 11,356 11,946 Cash and cash equivalents, end of period $ 14,224 $ 13,576 $ 11,356 Refer to accompanying notes. 60 PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2021 2020 2019 Common stock and paid-in capital Balance, beginning of period $ 80,552 $ 78,520 $ 71,223 Common stock issued 1,963 1,343 6,829 Common stock repurchased ( 5,539 ) ( 4,599 ) ( 4,195 ) Stock-based compensation expense 6,118 5,289 4,652 Other, net 17 ( 1 ) 11 Balance, end of period 83,111 80,552 78,520 Retained earnings Balance, beginning of period 34,566 24,150 13,682 Net income 61,271 44,281 39,240 Common stock cash dividends ( 16,871 ) ( 15,483 ) ( 14,103 ) Common stock repurchased ( 21,879 ) ( 18,382 ) ( 15,346 ) Cumulative effect of accounting changes ( 32 ) 0 677 Balance, end of period 57,055 34,566 24,150 Accumulated other comprehensive income (loss) Balance, beginning of period 3,186 ( 340 ) ( 2,187 ) Other comprehensive income (loss) ( 1,374 ) 3,526 1,914 Cumulative effect of accounting changes 10 0 ( 67 ) Balance, end of period 1,822 3,186 ( 340 ) Total stockholders’ equity $ 141,988 $ 118,304 $ 102,330 Cash dividends declared per common share $ 2.24 $ 2.04 $ 1.84 Refer to accompanying notes. 61 PART II Item 8 NOTES TO FINANCI AL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have recast certain prior period amounts to conform to the current period presentation. The recast of these prior period amounts had no impact on our consolidated balance sheets, consolidated income statements, or consolidated cash flows statements. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of uncertain tax positions that have been recognized in our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions due to risks and uncertainties, including uncertainty in the current economic environment due to COVID-19. In July 2020, we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years . This change in accounting estimate was effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2020, the effect of this change in estimate for fiscal year 2021 was an increase in operating income of $ 2.7 billion and net income of $ 2.3 billion, or $ 0.30 per both basic and diluted share. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income. Revenue Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems, cross-device productivity applications, server applications, business solution applications, desktop and server management tools, software development tools, video games, and hardware such as PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Office 365, Azure, Dynamics 365, and Xbox; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. 62 PART II Item 8 Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental authorities. Nature of Products and Services Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. In cases where we allocate revenue to software updates, primarily because the updates are provided at no additional charge, revenue is recognized as the updates are provided, which is generally ratably over the estimated life of the related device or license. Certain volume licensing programs, including Enterprise Agreements, include on-premises licenses combined with Software Assurance (“SA”). SA conveys rights to new software and upgrades released over the contract period and provides support, tools, and training to help customers deploy and use products more efficiently. On-premises licenses are considered distinct performance obligations when sold with SA. Revenue allocated to SA is generally recognized ratably over the contract period as customers simultaneously consume and receive benefits, given that SA comprises distinct performance obligations that are satisfied over time. Cloud services, which allow customers to use hosted software over the contract period without taking possession of the software, are provided on either a subscription or consumption basis. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract period. Revenue related to cloud services provided on a consumption basis, such as the amount of storage used in a period, is recognized based on the customer utilization of such resources. When cloud services require a significant level of integration and interdependency with software and the individual components are not considered distinct, all revenue is recognized over the period in which the cloud services are provided. Revenue from search advertising is recognized when the advertisement appears in the search results or when the action necessary to earn the revenue has been completed. Revenue from consulting services is recognized as services are provided. Our hardware is generally highly dependent on, and interrelated with, the underlying operating system and cannot function without the operating system. In these cases, the hardware and software license are accounted for as a single performance obligation and revenue is recognized at the point in time when ownership is transferred to resellers or directly to end customers through retail stores and online marketplaces. Refer to Note 19 – Segment Information and Geographic Data for further information, including revenue by significant product and service offering. Significant Judgments Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 63 PART II Item 8 Judgment is required to determine the SSP for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Contract Balances and Other Receivables Timing of revenue recognition may differ from the timing of invoicing to customers. We record a receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For multi-year agreements, we generally invoice customers annually at the beginning of each annual coverage period. We record a receivable related to revenue recognized for multi-year on-premises licenses as we have an unconditional right to invoice and receive payment in the future related to those licenses. Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include SA and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for consulting services to be performed in the future, LinkedIn subscriptions, Office 365 subscriptions, Xbox subscriptions, Windows 10 post-delivery support, Dynamics business solutions, and other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 13 – Unearned Revenue for further information, including unearned revenue by segment and changes in unearned revenue during the period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with revenue recognized upfront. As of June 30, 2021 and 2020, other receivables due from suppliers were $ 965 million and $ 442 million, respectively, and are included in accounts receivable, net in our consolidated balance sheets. As of June 30, 2021 and 2020, long-term accounts receivable, net of allowance for doubtful accounts, was $ 3.4 billion and $ 2.7 billion, respectively, and is included in other long-term assets in our consolidated balance sheets. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. 64 PART II Item 8 Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2021 2020 2019 Balance, beginning of period $ 816 $ 434 $ 397 Charged to costs and other 234 560 153 Write-offs ( 252 ) ( 178 ) ( 116 ) Balance, end of period $ 798 $ 816 $ 434 Allowance for doubtful accounts included in our consolidated balance sheets: (In millions) June 30, 2021 2020 2019 Accounts receivable, net of allowance for doubtful accounts $ 751 $ 788 $ 411 Other long-term assets 47 28 23 Total $ 798 $ 816 $ 434 We record financing receivables when we offer certain of our customers the option to acquire our software products and services offerings through a financing program in a limited number of countries. As of June 30, 2021 and 2020, our financing receivables, net were $ 4.4 billion and $ 5.2 billion, respectively, for short-term and long-term financing receivables, which are included in other current assets and other long-term assets in our consolidated balance sheets. We record an allowance to cover expected losses based on troubled accounts, historical experience, and other currently available evidence. Assets Recognized from Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets in our consolidated balance sheets. We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less. These costs include our internal sales force compensation program and certain partner sales incentive programs as we have determined annual compensation is commensurate with annual sales activities. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by original equipment manufacturers (“OEM”), to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain online products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. 65 PART II Item 8 Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 1.5 billion, $ 1.6 billion, and $ 1.6 billion in fiscal years 2021, 2020, and 2019, respectively. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term in our consolidated balance sheets. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. 66 PART II Item 8 Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding credit losses and impairments, are recorded in other comprehensive income . Fair value is calculated based on publicly available market information or other estimates determined by management. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. To determine credit losses, we employ a systematic methodology that considers available quantitative and qualitative evidence. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery , then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a periodic basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net. Derivatives Derivative instruments are recognized as either assets or liabilities and measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments designated as cash flow hedges, gains and losses are initially reported as a component of other comprehensive income and subsequently recognized in earnings with the corresponding hedged item. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in earnings. For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 investments include commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts. 67 PART II Item 8 • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets and liabilities include investments in corporate notes and bonds , municipal securities , and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure equity investments without readily determinable fair values on a nonrecurring basis. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. Our other current financial assets and current financial liabilities have fair values that approximate their carrying values. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years ; computer equipment, two to four years ; buildings and improvements, five to 15 years ; leasehold improvements, three to 20 years ; and furniture and equipment, one to 10 years . Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets, other current liabilities, and operating lease liabilities in our consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in our consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we generally use our incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. We have lease agreements with lease and non-lease components, which are generally accounted for separately. For certain equipment leases, such as vehicles, we account for the lease and non-lease components as a single lease component. Additionally, for certain equipment leases, we apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. 68 PART II Item 8 Intangible Assets Our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 20 years . We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Recently Adopted Accounting Guidance Financial Instruments – Credit Losses In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We adopted the standard effective July 1, 2020. We use a forward-looking expected credit loss model for accounts receivable, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities are recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. We applied a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date to align our credit loss methodology with the new standard. The adoption of the standard did not have a material impact on our consolidated financial statements. Recent Accounting Guidance Not Yet Adopted Accounting for Income Taxes In December 2019, the FASB issued a new standard to simplify the accounting for income taxes. The guidance eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period, and the recognition of deferred tax liabilities for outside basis differences related to changes in ownership of equity method investments and foreign subsidiaries. The guidance also simplifies aspects of accounting for franchise taxes and enacted changes in tax laws or rates, and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. The standard will be effective for us beginning July 1, 2021. We have completed our assessment and concluded that adoption of the new standard will not have a material impact on our consolidated financial statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2021 2020 2019 Net income available for common shareholders (A) $ 61,271 $ 44,281 $ 39,240 Weighted average outstanding shares of common stock (B) 7,547 7,610 7,673 Dilutive effect of stock-based awards 61 73 80 Common stock and common stock equivalents (C) 7,608 7,683 7,753 Earnings Per Share Basic (A/B) $ 8.12 $ 5.82 $ 5.11 Diluted (A/C) $ 8.05 $ 5.76 $ 5.06 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. 69 PART II Item 8 NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Interest and dividends income $ 2,131 $ 2,680 $ 2,762 Interest expense ( 2,346 ) ( 2,591 ) ( 2,686 ) Net recognized gains on investments 1,232 32 648 Net gains on derivatives 17 187 144 Net gains (losses) on foreign currency remeasurements 54 ( 191 ) ( 82 ) Other, net 98 ( 40 ) ( 57 ) Total $ 1,186 $ 77 $ 729 Net Recognized Gains (Losses) on Investments Net recognized gains (losses) on debt investments were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Realized gains from sales of available-for-sale securities $ 105 $ 50 $ 12 Realized losses from sales of available-for-sale securities ( 40 ) ( 37 ) ( 93 ) Impairments and allowance for credit losses ( 2 ) ( 17 ) ( 16 ) Total $ 63 $ ( 4 ) $ ( 97 ) Net recognized gains (losses) on equity investments were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Net realized gains on investments sold $ 123 $ 83 $ 276 Net unrealized gains on investments still held 1,057 69 479 Impairments of investments ( 11 ) ( 116 ) ( 10 ) Total $ 1,169 $ 36 $ 745 70 PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments were as follows: (In millions) Fair Value Level Adjusted Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2021 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 4,316 $ 0 $ 0 $ 4,316 $ 1,331 $ 2,985 $ 0 Certificates of deposit Level 2 3,615 0 0 3,615 2,920 695 0 U.S. government securities Level 1 90,664 3,832 ( 111 ) 94,385 1,500 92,885 0 U.S. agency securities Level 2 807 2 0 809 0 809 0 Foreign government bonds Level 2 6,213 9 ( 2 ) 6,220 225 5,995 0 Mortgage- and asset-backed securities Level 2 3,442 22 ( 6 ) 3,458 0 3,458 0 Corporate notes and bonds Level 2 8,443 249 ( 9 ) 8,683 0 8,683 0 Corporate notes and bonds Level 3 63 0 0 63 0 63 0 Municipal securities Level 2 308 63 0 371 0 371 0 Municipal securities Level 3 95 0 ( 7 ) 88 0 88 0 Total debt investments $ 117,966 $ 4,177 $ ( 135 ) $ 122,008 $ 5,976 $ 116,032 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 1,582 $ 976 $ 0 $ 606 Equity investments Other 5,378 0 0 5,378 Total equity investments $ 6,960 $ 976 $ 0 $ 5,984 Cash $ 7,272 $ 7,272 $ 0 $ 0 Derivatives, net (a) 78 0 78 0 Total $ 136,318 $ 14,224 $ 116,110 $ 5,984 71 PART II Item 8 (In millions) Fair Value Level Adjusted Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2020 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 4,687 $ 1 $ 0 $ 4,688 $ 1,618 $ 3,070 $ 0 Certificates of deposit Level 2 2,898 0 0 2,898 1,646 1,252 0 U.S. government securities Level 1 92,067 6,495 ( 1 ) 98,561 3,168 95,393 0 U.S. agency securities Level 2 2,439 2 0 2,441 449 1,992 0 Foreign government bonds Level 2 6,982 6 ( 3 ) 6,985 1 6,984 0 Mortgage- and asset-backed securities Level 2 4,865 41 ( 6 ) 4,900 0 4,900 0 Corporate notes and bonds Level 2 8,500 327 ( 17 ) 8,810 0 8,810 0 Corporate notes and bonds Level 3 58 0 0 58 0 58 0 Municipal securities Level 2 313 57 ( 4 ) 366 0 366 0 Municipal securities Level 3 91 0 0 91 0 91 0 Total debt investments $ 122,900 $ 6,929 $ ( 31 ) $ 129,798 $ 6,882 $ 122,916 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 1,198 $ 784 $ 0 $ 414 Equity investments Other 2,551 0 0 2,551 Total equity investments $ 3,749 $ 784 $ 0 $ 2,965 Cash $ 5,910 $ 5,910 $ 0 $ 0 Derivatives, net (a) 35 0 35 0 Total $ 139,492 $ 13,576 $ 122,951 $ 2,965 (a) Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments. Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of June 30, 2021 and 2020, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $ 3.3 billion and $ 1.4 billion, respectively. Unrealized Losses on Debt Investments Debt investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2021 U.S. government and agency securities $ 5,294 $ ( 111 ) $ 0 $ 0 $ 5,294 $ ( 111 ) Foreign government bonds 3,148 ( 1 ) 5 ( 1 ) 3,153 ( 2 ) Mortgage- and asset-backed securities 1,211 ( 5 ) 87 ( 1 ) 1,298 ( 6 ) Corporate notes and bonds 1,678 ( 8 ) 34 ( 1 ) 1,712 ( 9 ) Municipal securities 58 ( 7 ) 1 0 59 ( 7 ) Total $ 11,389 $ ( 132 ) $ 127 $ ( 3 ) $ 11,516 $ ( 135 ) 72 PART II Item 8 Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2020 U.S. government and agency securities $ 2,323 $ ( 1 ) $ 0 $ 0 $ 2,323 $ ( 1 ) Foreign government bonds 500 ( 3 ) 0 0 500 ( 3 ) Mortgage- and asset-backed securities 1,014 ( 6 ) 0 0 1,014 ( 6 ) Corporate notes and bonds 649 ( 17 ) 0 0 649 ( 17 ) Municipal securities 66 ( 4 ) 0 0 66 ( 4 ) Total $ 4,552 $ ( 31 ) $ 0 $ 0 $ 4,552 $ ( 31 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Adjusted Cost Basis Estimated Fair Value June 30, 2021 Due in one year or less $ 22,612 $ 22,676 Due after one year through five years 67,541 70,315 Due after five years through 10 years 25,212 26,327 Due after 10 years 2,601 2,690 Total $ 117,966 $ 122,008 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, interest rates, equity prices, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Foreign currency risks related to certain non-U.S. dollar-denominated investments are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. Foreign currency risks related to certain Euro-denominated debt are hedged using foreign exchange forward contracts that are designated as cash flow hedging instruments. In the past, option and forward contracts were used to hedge a portion of forecasted international revenue and were designated as cash flow hedging instruments. Principal currencies hedged included the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. Interest Rate Interest rate risks related to certain fixed-rate debt are hedged using interest rate swaps that are designated as fair value hedging instruments to effectively convert the fixed interest rates to floating interest rates. 73 PART II Item 8 Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts . These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Equity Securities held in our equity investments portfolio are subject to market price risk. At times, we may hold options, futures, and swap contracts. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $ 1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2021, our long-term unsecured debt rating was AAA , and cash investments were in excess of $ 1.0 billion. As a result, no collateral was required to be posted. The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents: (In millions) June 30, 2021 June 30, 2020 Designated as Hedging Instruments Foreign exchange contracts purchased $ 635 $ 635 Foreign exchange contracts sold 6,081 6,754 Interest rate contracts purchased 1,247 1,295 Not Designated as Hedging Instruments Foreign exchange contracts purchased 14,223 11,896 Foreign exchange contracts sold 23,391 15,595 Other contracts purchased 2,456 1,844 Other contracts sold 763 757 74 PART II Item 8 Fair Values of Derivative Instruments The following table presents our derivative instruments: Derivative Derivative Derivative Derivative (In millions) Assets Liabilities Assets Liabilities June 30, 2021 June 30, 2020 Designated as Hedging Instruments Foreign exchange contracts $ 76 $ ( 8 ) $ 44 $ ( 54 ) Interest rate contracts 40 0 93 0 Not Designated as Hedging Instruments Foreign exchange contracts 227 ( 291 ) 245 ( 334 ) Other contracts 56 ( 36 ) 18 ( 11 ) Gross amounts of derivatives 399 ( 335 ) 400 ( 399 ) Gross amounts of derivatives offset in the balance sheet ( 141 ) 142 ( 154 ) 158 Cash collateral received 0 ( 42 ) 0 ( 154 ) Net amounts of derivatives $ 258 $ ( 235 ) $ 246 $ ( 395 ) Reported as Short-term investments $ 78 $ 0 $ 35 $ 0 Other current assets 137 0 199 0 Other long-term assets 43 0 12 0 Other current liabilities 0 ( 182 ) 0 ( 334 ) Other long-term liabilities 0 ( 53 ) 0 ( 61 ) Total $ 258 $ ( 235 ) $ 246 $ ( 395 ) Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $ 395 million and $ 335 million, respectively, as of June 30, 2021, and $ 399 million and $ 399 million, respectively, as of June 30, 2020. The following table presents the fair value of our derivatives instruments on a gross basis: (In millions) Level 1 Level 2 Level 3 Total June 30, 2021 Derivative assets $ 0 $ 396 $ 3 $ 399 Derivative liabilities 0 ( 335 ) 0 ( 335 ) June 30, 2020 Derivative assets 1 398 1 400 Derivative liabilities 0 ( 399 ) 0 ( 399 ) 75 PART II Item 8 Gains (losses) on derivative instruments recognized in our consolidated income statements were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Revenue Other Income (Expense), Net Revenue Other Income (Expense), Net Revenue Other Income (Expense), Net Designated as Fair Value Hedging Instruments Foreign exchange contracts Derivatives $ 0 $ 193 $ 0 $ 1 $ 0 $ ( 130 ) Hedged items 0 ( 188 ) 0 3 0 130 Excluded from effectiveness assessment 0 30 0 139 0 168 Interest rate contracts Derivatives 0 ( 37 ) 0 93 0 0 Hedged items 0 53 0 ( 93 ) 0 0 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Amount reclassified from accumulated other comprehensive income 0 17 0 0 341 0 Excluded from effectiveness assessment 0 0 0 0 ( 64 ) 0 Not Designated as Hedging Instruments Foreign exchange contracts 0 27 0 ( 123 ) 0 ( 97 ) Other contracts 0 9 0 50 0 38 Gains (losses), net of tax, on derivative instruments recognized in our consolidated comprehensive income statements were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Included in effectiveness assessment $ 34 $ ( 38 ) $ 159 NOTE 6 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2021 2020 Raw materials $ 1,190 $ 700 Work in process 79 83 Finished goods 1,367 1,112 Total $ 2,636 $ 1,895 76 PART II Item 8 NOTE 7 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2021 2020 Land $ 3,660 $ 1,823 Buildings and improvements 43,928 33,995 Leasehold improvements 6,884 5,487 Computer equipment and software 51,250 41,261 Furniture and equipment 5,344 4,782 Total, at cost 111,066 87,348 Accumulated depreciation ( 51,351 ) ( 43,197 ) Total, net $ 59,715 $ 44,151 During fiscal years 2021, 2020, and 2019, depreciation expense was $ 9.3 billion, $ 10.7 billion, and $ 9.7 billion, respectively. Depreciation expense declined in fiscal year 2021 due to the change in estimated useful lives of our server and network equipment. We have committed $ 9.5 billion for the construction of new buildings, building improvements, and leasehold improvements as of June 30, 2021. During fiscal year 2020, we recorded an impairment charge of $ 186 million to Property and Equipment, primarily to leasehold improvements, due to the closing of our Microsoft Store physical locations. NOTE 8 — BUSINESS COMBINATIONS ZeniMax Media Inc. On March 9, 2021 , we completed our acquisition of ZeniMax Media Inc. (“ZeniMax”), the parent company of Bethesda Softworks LLC (“Bethesda”), for a total purchase price of $ 8.1 billion, consisting primarily of cash. The purchase price included $ 768 million of cash and cash equivalents acquired. Bethesda is one of the largest, privately held game developers and publishers in the world, and brings a broad portfolio of games, technology, and talent to Xbox. The financial results of ZeniMax have been included in our consolidated financial statements since the date of the acquisition. ZeniMax is reported as part of our More Personal Computing segment. The purchase price allocation as of the date of acquisition was based on a preliminary valuation and is subject to revision as more detailed analyses are completed and additional information about the fair value of assets acquired and liabilities assumed becomes available. The major classes of assets and liabilities to which we have preliminarily allocated the purchase price were as follows: (In millions) Cash and cash equivalents $ 768 Goodwill 5,469 Intangible assets 1,968 Other assets 139 Other liabilities ( 223 ) Total $ 8,121 Goodwill was assigned to our More Personal Computing segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of ZeniMax. None of the goodwill is expected to be deductible for income tax purposes. 77 PART II Item 8 Following are details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Technology-based $ 1,341 4 years Marketing-related 627 11 years Total $ 1,968 6 years GitHub, Inc. On October 25, 2018 , we acquired GitHub, Inc. (“GitHub”), a software development platform, in a $ 7.5 billion stock transaction (inclusive of total cash payments of $ 1.3 billion in respect of vested GitHub equity awards and an indemnity escrow). The acquisition is expected to empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences. The financial results of GitHub have been included in our consolidated financial statements since the date of the acquisition. GitHub is reported as part of our Intelligent Cloud segment. The allocation of the purchase price to goodwill was completed as of June 30, 2019. The major classes of assets and liabilities to which we allocated the purchase price were as follows: (In millions) Cash, cash equivalents, and short-term investments $ 234 Goodwill 5,497 Intangible assets 1,267 Other assets 143 Other liabilities ( 217 ) Total $ 6,924 The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth and is not expected to be deductible for tax purposes. We assigned the goodwill to our Intelligent Cloud segment. Following are the details of the purchase price allocated to the intangible assets acquired: (In millions) Amount Weighted Average Life Customer-related $ 648 8 years Technology-based 447 5 years Marketing-related 170 10 years Contract-based 2 2 years Total $ 1,267 7 years Transactions recognized separately from the purchase price allocation were approximately $ 600 million, primarily related to equity awards recognized as expense over the related service period. Nuance Communications, Inc. On April 11, 2021 , we entered into a definitive agreement to acquire Nuance Communications, Inc. (“Nuance”) for $ 56.00 per share in an all-cash transaction valued at $ 19.7 billion, inclusive of Nuance’s net debt. Nuance is a cloud and artificial intelligence (“AI”) software provider with healthcare and enterprise AI experience, and the acquisition will build on our industry-specific cloud offerings. The acquisition has been approved by Nuance’s shareholders, and we expect it to close by the end of calendar year 2021, subject to the satisfaction of certain regulatory approvals and other customary closing conditions. 78 PART II Item 8 NOTE 9 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2019 Acquisitions Other June 30, 2020 Acquisitions Other June 30, 2021 Productivity and Business Processes $ 24,277 $ 7 $ ( 94 ) $ 24,190 $ 0 $ 127 $ 24,317 Intelligent Cloud 11,351 1,351 ( 5 ) 12,697 505 54 13,256 More Personal Computing 6,398 96 ( 30 ) 6,464 5,556 (a) 118 (a ) 12,138 Total $ 42,026 $ 1,454 $ ( 129 ) $ 43,351 $ 6,061 $ 299 $ 49,711 (a) Includes goodwill of $ 5.5 billion related to ZeniMax. See Note 8 – Business Combinations for further information . The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2021, May 1, 2020, or May 1, 2019 tests. As of June 30, 2021 and 2020, accumulated goodwill impairment was $ 11.3 billion. NOTE 10 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2021 2020 Technology-based $ 9,779 $ ( 7,007 ) $ 2,772 $ 8,160 $ ( 6,381 ) $ 1,779 Customer-related 4,958 ( 2,859 ) 2,099 4,967 ( 2,320 ) 2,647 Marketing-related 4,792 ( 1,878 ) 2,914 4,158 ( 1,588 ) 2,570 Contract-based 446 ( 431 ) 15 474 ( 432 ) 42 Total $ 19,975 (a) $ ( 12,175 ) $ 7,800 $ 17,759 $ ( 10,721 ) $ 7,038 (a) Includes intangible assets of $ 2.0 billion related to ZeniMax. See Note 8 – Business Combinations for further information . No material impairments of intangible assets were identified during fiscal years 2021, 2020, or 2019. We estimate that we have no significant residual value related to our intangible assets. 79 PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2021 2020 Technology-based $ 1,628 4 years $ 531 6 years Customer-related 96 4 years 303 5 years Marketing-related 625 6 years 2 2 years Contract-based 10 3 years 0 0 years Total $ 2,359 5 years $ 836 5 years Intangible assets amortization expense was $ 1.6 billion, $ 1.6 billion, and $ 1.9 billion for fiscal years 2021, 2020, and 2019, respectively. The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2021: (In millions) Year Ending June 30, 2022 $ 1,683 2023 1,722 2024 1,415 2025 755 2026 498 Thereafter 1,727 Total $ 7,800 80 PART II Item 8 NOTE 11 — DEBT The components of debt were as follows: (In millions, issuance by calendar year) Maturities (calendar year) Stated Interest Rate Effective Interest Rate June 30, 2021 June 30, 2020 2009 issuance of $ 3.8 billion (a) 2039 5.20 % 5.24 % $ 520 $ 559 2010 issuance of $ 4.8 billion (a) 2040 4.50 % 4.57 % 486 1,571 2011 issuance of $ 2.3 billion (a) 2041 5.30 % 5.36 % 718 1,270 2012 issuance of $ 2.3 billion (a) 2022 – 2042 2.13 % – 3.50 % 2.24 % – 3.57 % 1,204 1,650 2013 issuance of $ 5.2 billion (a) 2023 – 2043 2.38 % – 4.88 % 2.47 % – 4.92 % 2,814 2,919 2013 issuance of € 4.1 billion 2021 – 2033 2.13 % – 3.13 % 2.23 % – 3.22 % 4,803 4,549 2015 issuance of $ 23.8 billion (a) 2022 – 2055 2.38 % – 4.75 % 2.47 % – 4.78 % 12,305 15,549 2016 issuance of $ 19.8 billion (a) 2021 – 2056 1.55 % – 3.95 % 1.64 % – 4.03 % 12,180 16,955 2017 issuance of $ 17.0 billion (a) 2022 – 2057 2.40 % – 4.50 % 2.52 % – 4.53 % 10,695 12,385 2020 issuance of $ 10.0 billion (a) 2050 – 2060 2.53 % – 2.68 % 2.53 % – 2.68 % 10,000 10,000 2021 issuance of $ 8.2 billion (a) 2052 – 2062 2.92 % – 3.04 % 2.92 % – 3.04 % 8,185 0 Total face value 63,910 67,407 Unamortized discount and issuance costs ( 511 ) ( 554 ) Hedge fair value adjustments ( b ) 40 93 Premium on debt exchange (a) ( 5,293 ) ( 3,619 ) Total debt 58,146 63,327 Current portion of long-term debt ( 8,072 ) ( 3,749 ) Long-term debt $ 50,074 $ 59,578 (a) In March 2021 and June 2020, we exchanged a portion of our existing debt at a premium for cash and new debt with longer maturities. The premiums are amortized over the terms of the new debt. (b) Refer to Note 5 – Derivatives for further information on the interest rate swaps related to fixed-rate debt. As of June 30, 2021 and 2020, the estimated fair value of long-term debt, including the current portion, was $ 70.0 billion and $ 77.1 billion, respectively. The estimated fair values are based on Level 2 inputs. Debt in the table above is comprised of senior unsecured obligations and ranks equally with our other outstanding obligations. Interest is paid semi-annually, except for the Euro-denominated debt, which is paid annually. Cash paid for interest on our debt for fiscal years 2021, 2020, and 2019 was $ 2.0 billion, $ 2.4 billion, and $ 2.4 billion, respectively . The following table outlines maturities of our long-term debt, including the current portion, as of June 30, 2021: (In millions) Year Ending June 30, 2022 $ 8,075 2023 2,750 2024 5,250 2025 2,250 2026 3,000 Thereafter 42,585 Total $ 63,910 81 PART II Item 8 NOTE 12 — INCOME TAXES Tax Cuts and Jobs Act On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business. We recorded a provisional net charge of $ 13.7 billion related to the enactment of the TCJA in fiscal year 2018 and adjusted the provisional net charge by recording additional tax expense of $ 157 million in fiscal year 2019 pursuant to Securities and Exchange Commission Staff Accounting Bulletin No. 118. In fiscal year 2019, in response to the TCJA and recently issued regulations, we transferred certain intangible properties held by our foreign subsidiaries to the U.S. and Ireland. The transfers of intangible properties resulted in a $ 2.6 billion net income tax benefit recorded in the fourth quarter of fiscal year 2019, as the value of future tax deductions exceeded the current tax liability from foreign jurisdictions and U.S. global intangible low-taxed income (“GILTI”) tax. Provision for Income Taxes The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Current Taxes U.S. federal $ 3,285 $ 3,537 $ 4,718 U.S. state and local 1,229 763 662 Foreign 5,467 4,444 5,531 Current taxes $ 9,981 $ 8,744 $ 10,911 Deferred Taxes U.S. federal $ 25 $ 58 $ ( 5,647 ) U.S. state and local ( 204 ) ( 6 ) ( 1,010 ) Foreign 29 ( 41 ) 194 Deferred taxes $ ( 150 ) $ 11 $ ( 6,463 ) Provision for income taxes $ 9,831 $ 8,755 $ 4,448 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2021 2020 2019 U.S. $ 34,972 $ 24,116 $ 15,799 Foreign 36,130 28,920 27,889 Income before income taxes $ 71,102 $ 53,036 $ 43,688 82 PART II Item 8 Effective Tax Rate The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2021 2020 2019 Federal statutory rate 21.0 % 21.0 % 21.0 % Effect of: Foreign earnings taxed at lower rates ( 2.7 )% ( 3.7 )% ( 4.1 )% Impact of the enactment of the TCJA 0 % 0 % 0.4 % Impact of intangible property transfers 0 % 0 % ( 5.9 )% Foreign-derived intangible income deduction ( 1.3 )% ( 1.1 )% ( 1.4 )% State income taxes, net of federal benefit 1.4 % 1.3 % 0.7 % Research and development credit ( 0.9 )% ( 1.1 )% ( 1.1 )% Excess tax benefits relating to stock-based compensation ( 2.4 )% ( 2.2 )% ( 2.2 )% Interest, net 0.5 % 1.0 % 1.0 % Other reconciling items, net ( 1.8 )% 1.3 % 1.8 % Effective rate 13.8 % 16.5 % 10.2 % We have historically paid India withholding taxes on software sales through distributor withholding and tax audit assessments in India. In March 2021, the India Supreme Court ruled favorably in the case of Engineering Analysis Centre of Excellence Private Limited vs The Commissioner of Income Tax for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject to India withholding taxes. Although we were not a party to the appeals, our software sales in India were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of $ 620 million in the third quarter of fiscal year 2021 to reflect the results of the India Supreme Court decision impacting fiscal year 1996 through fiscal year 2016 . The decrease from the federal statutory rate in fiscal year 2021 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, tax benefits relating to stock-based compensation, and tax benefits from the India Supreme Court decision on withholding taxes. The decrease from the federal statutory rate in fiscal year 2020 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, and tax benefits relating to stock-based compensation. The decrease from the federal statutory rate in fiscal year 2019 is primarily due to a $ 2.6 billion net income tax benefit related to intangible property transfers, and earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico. In fiscal year 2021 and 2020, our foreign regional operating centers in Ireland and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 82 % and 86 % of our foreign income before tax. In fiscal years 2019, our foreign regional operating centers in Ireland, Singapore, and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 82 % of our foreign income before tax, respectively. Other reconciling items, net consists primarily of tax credits and GILTI tax, and in fiscal year 2021, includes tax benefits from the India Supreme Court decision on withholding taxes. In fiscal years 2021, 2020, and 2019, there were no individually significant other reconciling items. 83 PART II Item 8 The decrease in our effective tax rate for fiscal year 2021 compared to fiscal year 2020 was primarily due to tax benefits from the India Supreme Court decision on withholding taxes, an agreement between the U.S. and India tax authorities related to transfer pricing , final TCJA regulations, and an increase in tax benefits relating to stock-based compensation. The increase in our effective tax rate for fiscal year 2020 compared to fiscal year 2019 was primarily due to a $ 2.6 billion net income tax benefit in the fourth quarter of fiscal year 2019 related to intangible property transfers. The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2021 2020 Deferred Income Tax Assets Stock-based compensation expense $ 502 $ 461 Accruals, reserves, and other expenses 2,960 2,721 Loss and credit carryforwards 1,090 865 Amortization 6,346 6,737 Leasing liabilities 4,060 3,025 Unearned revenue 2,659 1,553 Other 543 354 Deferred income tax assets 18,160 15,716 Less valuation allowance ( 769 ) ( 755 ) Deferred income tax assets, net of valuation allowance $ 17,391 $ 14,961 Deferred Income Tax Liabilities Book/tax basis differences in investments and debt $ ( 2,605 ) $ ( 2,642 ) Leasing assets ( 3,834 ) ( 2,817 ) Depreciation ( 1,010 ) ( 376 ) Deferred GILTI tax liabilities ( 2,815 ) ( 2,581 ) Other ( 144 ) ( 344 ) Deferred income tax liabilities $ ( 10,408 ) $ ( 8,760 ) Net deferred income tax assets $ 6,983 $ 6,201 Reported As Other long-term assets $ 7,181 $ 6,405 Long-term deferred income tax liabilities ( 198 ) ( 204 ) Net deferred income tax assets $ 6,983 $ 6,201 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. As of June 30, 2021, we had federal, state, and foreign net operating loss carryforwards of $ 304 million, $ 1.3 billion, and $ 2.0 billion, respectively. The federal and state net operating loss carryforwards will expire in various years from fiscal 2022 through 2041 , if not utilized. The majority of our foreign net operating loss carryforwards do not expire. Certain acquired net operating loss carryforwards are subject to an annual limitation but are expected to be realized with the exception of those which have a valuation allowance. The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards and other net deferred tax assets that may not be realized. In fiscal year 2020, we removed $ 2.0 billion of foreign net operating losses and corresponding valuation allowances as a result of the liquidation of a foreign subsidiary. There was no impact to our consolidated financial statements. Income taxes paid, net of refunds, were $ 13.4 billion, $ 12.5 billion, and $ 8.4 billion in fiscal years 2021, 2020, and 2019, respectively. 84 PART II Item 8 Uncertain Tax Positions Gross unrecognized tax benefits related to uncertain tax positions as of June 30, 2021, 2020, and 2019, were $ 14.6 billion, $ 13.8 billion, and $ 13.1 billion, respectively, which were primarily included in long-term income taxes in our consolidated balance sheets. If recognized, the resulting tax benefit would affect our effective tax rates for fiscal years 2021, 2020, and 2019 by $ 12.5 billion, $ 12.1 billion, and $ 12.0 billion, respectively. As of June 30, 2021, 2020, and 2019, we had accrued interest expense related to uncertain tax positions of $ 4.3 billion, $ 4.0 billion, and $ 3.4 billion, respectively, net of income tax benefits. The provision for income taxes for fiscal years 2021, 2020, and 2019 included interest expense related to uncertain tax positions of $ 274 million, $ 579 million, and $ 515 million, respectively, net of income tax benefits. The aggregate changes in the gross unrecognized tax benefits related to uncertain tax positions were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Beginning unrecognized tax benefits $ 13,792 $ 13,146 $ 11,961 Decreases related to settlements ( 195 ) ( 31 ) ( 316 ) Increases for tax positions related to the current year 790 647 2,106 Increases for tax positions related to prior years 461 366 508 Decreases for tax positions related to prior years ( 297 ) ( 331 ) ( 1,113 ) Decreases due to lapsed statutes of limitations ( 1 ) ( 5 ) 0 Ending unrecognized tax benefits $ 14,550 $ 13,792 $ 13,146 We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $ 1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017 . As of June 30, 2021, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2020 , some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NOTE 13 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2021 2020 Productivity and Business Processes $ 22,120 $ 18,643 Intelligent Cloud 17,710 16,620 More Personal Computing 4,311 3,917 Total $ 44,141 $ 39,180 85 PART II Item 8 Changes in unearned revenue were as follows: (In millions) Year Ended June 30, 2021 Balance, beginning of period $ 39,180 Deferral of revenue 94,565 Recognition of unearned revenue ( 89,604 ) Balance, end of period $ 44,141 Revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods, was $ 146 billion as of June 30, 2021, of which $ 141 billion is related to the commercial portion of revenue. We expect to recognize approximately 50 % of this revenue over the next 12 months and the remainder thereafter. NOTE 14 — LEASES We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. Our leases have remaining lease terms of 1 year to 15 years, some of which include options to extend the leases for up to 5 years , and some of which include options to terminate the leases within 1 year. The components of lease expense were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Operating lease cost $ 2,127 $ 2,043 $ 1,707 Finance lease cost: Amortization of right-of-use assets $ 921 $ 611 $ 370 Interest on lease liabilities 386 336 247 Total finance lease cost $ 1,307 $ 947 $ 617 Supplemental cash flow information related to leases was as follows: (In millions) Year Ended June 30, 2021 2020 2019 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 2,052 $ 1,829 $ 1,670 Operating cash flows from finance leases 386 336 247 Financing cash flows from finance leases 648 409 221 Right-of-use assets obtained in exchange for lease obligations: Operating leases 4,380 3,677 2,303 Finance leases 3,290 3,467 2,532 86 PART II Item 8 Supplemental balance sheet information related to leases was as follows: (In millions, except lease term and discount rate) June 30, 2021 2020 Operating Leases Operating lease right-of-use assets $ 11,088 $ 8,753 Other current liabilities $ 1,962 $ 1,616 Operating lease liabilities 9,629 7,671 Total operating lease liabilities $ 11,591 $ 9,287 Finance Leases Property and equipment, at cost $ 14,107 $ 10,371 Accumulated depreciation ( 2,306 ) ( 1,385 ) Property and equipment, net $ 11,801 $ 8,986 Other current liabilities $ 791 $ 540 Other long-term liabilities 11,750 8,956 Total finance lease liabilities $ 12,541 $ 9,496 Weighted Average Remaining Lease Term Operating leases 8 years 8 years Finance leases 12 years 13 years Weighted Average Discount Rate Operating leases 2.2 % 2.7 % Finance leases 3.4 % 3.9 % The following table outlines maturities of our lease liabilities as of June 30, 2021: (In millions) Year Ending June 30, Operating Leases Finance Leases 2022 $ 2,125 $ 1,179 2023 1,954 1,198 2024 1,751 1,211 2025 1,463 1,537 2026 1,133 1,220 Thereafter 4,111 8,856 Total lease payments 12,537 15,201 Less imputed interest ( 946 ) ( 2,660 ) Total $ 11,591 $ 12,541 As of June 30, 2021, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $ 5.4 billion and $ 7.3 billion, respectively. These operating and finance leases will commence between fiscal year 2022 and fiscal year 2026 with lease terms of 1 year to 15 years . During fiscal year 2020, we recorded an impairment charge of $ 161 million to operating lease right-of-use assets due to the closing of our Microsoft Store physical locations. 87 PART II Item 8 NOTE 15 — CONTINGENCIES Patent and Intellectual Property Claims There were 63 patent infringement cases pending against Microsoft as of June 30, 2021, none of which are material individually or in aggregate. Antitrust, Unfair Competition, and Overcharge Class Actions Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010. The trial of the British Columbia action commenced in May 2016. Following a mediation, the parties agreed to a global settlement of all three Canadian actions and submitted the proposed settlement agreement to the courts in all three jurisdictions for approval. The final settlement and form of notice have been approved by the courts in British Columbia, Ontario, and Quebec. The ten-month claims period commenced on November 23, 2020 and will close on September 23, 2021. Other Antitrust Litigation and Claims China State Administration for Market Regulation Investigatio n In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. In 2019, the SAMR presented preliminary views as to certain possible violations of China’s Anti-Monopoly Law. Product-Related Litigation U.S. Cell Phone Litigation Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 46 lawsuits, including 45 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. In August 2018, the trial court issued an order striking portions of the plaintiffs’ expert reports. A hearing on general causation is scheduled for January and February of 2022 . 88 PART II Item 8 Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact in our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2021, we accrued aggregate legal liabilities of $ 339 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $ 500 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact in our consolidated financial statements for the period in which the effects become reasonably estimable. NOTE 16 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Balance, beginning of year 7,571 7,643 7,677 Issued 49 54 116 Repurchased ( 101 ) ( 126 ) ( 150 ) Balance, end of year 7,519 7,571 7,643 Share Repurchases On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in December 2016 and was completed in February 2020. On September 18, 2019, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in February 2020, following completion of the program approved on September 20, 2016, has no expiration date, and may be terminated at any time. As of June 30, 2021, $ 8.7 billion remained of this $ 40.0 billion share repurchase program. 89 PART II Item 8 We repurchased the following shares of common stock under the share repurchase programs: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2021 2020 2019 First Quarter 25 $ 5,270 29 $ 4,000 24 $ 2,600 Second Quarter 27 5,750 32 4,600 57 6,100 Third Quarter 25 5,750 37 6,000 36 3,899 Fourth Quarter 24 6,200 28 5,088 33 4,200 Total 101 $ 22,970 126 $ 19,688 150 $ 16,799 Shares repurchased during fiscal year 2021 and the fourth quarter of fiscal year 2020 were under the share repurchase program approved on September 18, 2019. Shares repurchased during the third quarter of fiscal year 2020 were under the share repurchase programs approved on both September 20, 2016 and September 18, 2019. All other shares repurchased were under the share repurchase program approved on September 20, 2016. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards of $ 4.4 billion, $ 3.3 billion, and $ 2.7 billion for fiscal years 2021, 2020, and 2019, respectively. All share repurchases were made using cash resources. Dividends Our Board of Directors declared the following dividends: Declaration Date Record Date Payment Date Dividend Per Share Amount Fiscal Year 2021 (In millions) September 15, 2020 November 19, 2020 December 10, 2020 $ 0.56 $ 4,230 December 2, 2020 February 18, 2021 March 11, 2021 0.56 4,221 March 16, 2021 May 20, 2021 June 10, 2021 0.56 4,214 June 16, 2021 August 19, 2021 September 9, 2021 0.56 4,211 Total $ 2.24 $ 16,876 Fiscal Year 2020 September 18, 2019 November 21, 2019 December 12, 2019 $ 0.51 $ 3,886 December 4, 2019 February 20, 2020 March 12, 2020 0.51 3,876 March 9, 2020 May 21, 2020 June 11, 2020 0.51 3,865 June 17, 2020 August 20, 2020 September 10, 2020 0.51 3,856 Total $ 2.04 $ 15,483 The dividend declared on June 16, 2021 was included in other current liabilities as of June 30, 2021. 90 PART II Item 8 NOTE 17 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table summarizes the changes in accumulated other comprehensive income (loss) by component : (In millions) Year Ended June 30, 2021 2020 2019 Derivatives Balance, beginning of period $ ( 38 ) $ 0 $ 173 Unrealized gains (losses), net of tax of $ 9 , $( 10 ), and $ 2 34 ( 38 ) 160 Reclassification adjustments for gains included in earnings ( 17 ) 0 ( 341 ) Tax expense included in provision for income taxes 2 0 8 Amounts reclassified from accumulated other comprehensive income (loss) ( 15 ) 0 ( 333 ) Net change related to derivatives, net of tax of $ 7 , $( 10 ), and $( 6 ) 19 ( 38 ) ( 173 ) Balance, end of period $ ( 19 ) $ ( 38 ) $ 0 Investments Balance, beginning of period $ 5,478 $ 1,488 $ ( 850 ) Unrealized gains (losses), net of tax of $( 589 ) , $ 1,057 , and $ 616 ( 2,216 ) 3,987 2,331 Reclassification adjustments for (gains) losses included in other income (expense), net ( 63 ) 4 93 Tax expense (benefit) included in provision for income taxes 13 ( 1 ) ( 19 ) Amounts reclassified from accumulated other comprehensive income (loss) ( 50 ) 3 74 Net change related to investments, net of tax of $( 602 ) , $ 1,058 , and $ 635 ( 2,266 ) 3,990 2,405 Cumulative effect of accounting changes 10 0 ( 67 ) Balance, end of period $ 3,222 $ 5,478 $ 1,488 Translation Adjustments and Other Balance, beginning of period $ ( 2,254 ) $ ( 1,828 ) $ ( 1,510 ) Translation adjustments and other, net of tax effects of $( 9 ) , $ 1 , and $( 1 ) 873 ( 426 ) ( 318 ) Balance, end of period $ ( 1,381 ) $ ( 2,254 ) $ ( 1,828 ) Accumulated other comprehensive income (loss), end of period $ 1,822 $ 3,186 $ ( 340 ) NOTE 18 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. As of June 30, 2021, an aggregate of 251 million shares were authorized for future grant under our stock plans. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2021 2020 2019 Stock-based compensation expense $ 6,118 $ 5,289 $ 4,652 Income tax benefits related to stock-based compensation 1,065 938 816 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a service period of four years or five years . 91 PART II Item 8 Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a service period of four years . PSUs generally vest over a performance period of three years . The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for All Stock Plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year ended June 30, 2021 2020 2019 Dividends per share (quarterly amounts) $ 0.51 – 0.56 $ 0.46 – 0.51 $ 0.42 – 0.46 Interest rates 0.01 % – 1.5 % 0.1 % – 2.2 % 1.8 % – 3.1 % During fiscal year 2021, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 126 $ 105.23 Granted (a) 40 221.13 Vested ( 58 ) 99.41 Forfeited ( 8 ) 129.92 Nonvested balance, end of year 100 $ 152.51 (a) Includes 2 million of PSUs granted at target and performance adjustments above target levels for fiscal years 2021, 2020, and 2019. As of June 30, 2021, there was approximately $ 12.0 billion of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of three years . The weighted average grant-date fair value of stock awards granted was $ 221.13 , $ 140.49 , and $ 107.02 for fiscal years 2021, 2020, and 2019, respectively. The fair value of stock awards vested was $ 13.4 billion, $ 10.1 billion, and $ 8.7 billion, for fiscal years 2021, 2020, and 2019, respectively. Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90 % of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15 % of their gross compensation during an offering period. Under the terms of the ESPP that were approved in 2012, the plan will terminate on December 31, 2022. We intend to request shareholder approval for a successor ESPP with a January 1, 2022 effective date and ten-year expiration of December 31, 2031 at our 2021 Annual Shareholders Meeting. No additional shares will be requested at this meeting. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2021 2020 2019 Shares purchased 8 9 11 Average price per share $ 207.88 $ 142.22 $ 104.85 As of June 30, 2021, 88 million shares of our common stock were reserved for future issuance through the ESPP. 92 PART II Item 8 Savings Plan We have savings plans in the U.S. that qualify under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Eligible U.S. employees may contribute a portion of their salary into the savings plans, subject to certain limitations. We contribute fifty cents for each dollar a participant contributes into the plans, with a maximum employer contribution of 50 % of the IRS contribution limit for the calendar year. Employer-funded retirement benefits for all plans were $ 1.2 billion, $ 1.0 billion, and $ 877 million in fiscal years 2021, 2020, and 2019, respectively, and were expensed as contributed. NOTE 19 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Skype for Business. • Office Consumer, including Microsoft 365 Consumer subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive. • LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, Sales Solutions, and Learning Solutions. • Dynamics business solutions, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM, Customer Insights, Power Apps, and Power Automate; and on-premises ERP and CRM applications. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and GitHub. • Enterprise Services, including Premier Support Services and Microsoft Consulting Services. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things; and MSN advertising. • Devices, including Surface and PC accessories. 93 PART II Item 8 • Gaming, including Xbox hardware and Xbox content and services, comprising digital transactions, Xbox Game Pass and other subscriptions, video games, third-party video game royalties , cloud services, and advertising . • Search advertising. Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include legal, including settlements and fines, information technology, human resources, finance, excise taxes, field selling, shared facilities services, and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments. Segment revenue and operating income were as follows during the periods presented: (In millions) Year Ended June 30, 2021 2020 2019 Revenue Productivity and Business Processes $ 53,915 $ 46,398 $ 41,160 Intelligent Cloud 60,080 48,366 38,985 More Personal Computing 54,093 48,251 45,698 Total $ 168,088 $ 143,015 $ 125,843 Operating Income Productivity and Business Processes $ 24,351 $ 18,724 $ 16,219 Intelligent Cloud 26,126 18,324 13,920 More Personal Computing 19,439 15,911 12,820 Total $ 69,916 $ 52,959 $ 42,959 No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for fiscal years 2021, 2020, or 2019. Revenue, classified by the major geographic areas in which our customers were located, was as follows: (In millions) Year Ended June 30, 2021 2020 2019 United States (a) $ 83,953 $ 73,160 $ 64,199 Other countries 84,135 69,855 61,644 Total $ 168,088 $ 143,015 $ 125,843 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. 94 PART II Item 8 Revenue from external customers, classified by significant product and service offerings, was as follows: (In millions) Year Ended June 30, 2021 2020 2019 Server products and cloud services $ 52,589 $ 41,379 $ 32,622 Office products and cloud services 39,872 35,316 31,769 Windows 23,227 22,294 20,395 Gaming 15,370 11,575 11,386 LinkedIn 10,289 8,077 6,754 Search advertising 8,528 7,740 7,628 Enterprise Services 6,943 6,409 6,124 Devices 6,791 6,457 6,095 Other 4,479 3,768 3,070 Total $ 168,088 $ 143,015 $ 125,843 Our commercial cloud revenue, which includes Azure, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $ 69.1 billion, $ 51.7 billion and $ 38.1 billion in fiscal years 2021, 2020, and 2019, respectively. These amounts are primarily included in Server products and cloud services, Office products and cloud services, and LinkedIn in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2021 2020 2019 United States $ 76,153 $ 60,789 $ 55,252 Ireland 13,303 12,734 12,958 Other countries 38,858 29,770 25,422 Total $ 128,314 $ 103,293 $ 93,632 95 PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2021 and 2020, the related consolidated statements of income, comprehensive income, cash flows, and stockholders' equity, for each of the three years in the period ended June 30, 2021, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2021 and 2020, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2021, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of June 30, 2021, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 29, 2021, expressed an unqualified opinion on the Company's internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 96 PART II Item 8 Revenue Recognition – Refer to Note 1 to the financial statements Critical Audit Matter Description The Company recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company offers customers the ability to acquire multiple licenses of software products and services, including cloud-based services, in its customer agreements through its volume licensing programs. Significant judgment is exercised by the Company in determining revenue recognition for these customer agreements, and includes the following: • Determination of whether products and services are considered distinct performance obligations that should be accounted for separately versus together, such as software licenses and related services that are sold with cloud-based services. • The pattern of delivery (i.e., timing of when revenue is recognized) for each distinct performance obligation. • Identification and treatment of contract terms that may impact the timing and amount of revenue recognized (e.g., variable consideration, optional purchases, and free services). • Determination of stand-alone selling prices for each distinct performance obligation and for products and services that are not sold separately. Given these factors and due to the volume of transactions, the related audit effort in evaluating management's judgments in determining revenue recognition for these customer agreements was extensive and required a high degree of auditor judgment. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures related to the Company's revenue recognition for these customer agreements included the following: • We tested the effectiveness of controls related to the identification of distinct performance obligations, the determination of the timing of revenue recognition, and the estimation of variable consideration. • We evaluated management's significant accounting policies related to these customer agreements for reasonableness. • We selected a sample of customer agreements and performed the following procedures: - Obtained and read contract source documents for each selection, including master agreements, and other documents that were part of the agreement. - Tested management's identification and treatment of contract terms. - Assessed the terms in the customer agreement and evaluated the appropriateness of management's application of their accounting policies, along with their use of estimates, in the determination of revenue recognition conclusions. • We evaluated the reasonableness of management's estimate of stand-alone selling prices for products and services that are not sold separately. • We tested the mathematical accuracy of management's calculations of revenue and the associated timing of revenue recognized in the financial statements. 97 PART II Item 8 Income Taxes – Uncertain Tax Positions – Refer to Note 12 to the financial statements Critical Audit Matter Description The Company's long-term income taxes liability includes uncertain tax positions related to transfer pricing issues that remain unresolved with the Internal Revenue Service ("IRS"). The Company remains under IRS audit, or subject to IRS audit, for tax years subsequent to 2003. While the Company has settled a portion of the IRS audits, resolution of the remaining matters could have a material impact on the Company's financial statements. Conclusions on recognizing and measuring uncertain tax positions involve significant estimates and management judgment and include complex considerations of the Internal Revenue Code, related regulations, tax case laws, and prior-year audit settlements. Given the complexity and the subjective nature of the transfer pricing issues that remain unresolved with the IRS, evaluating management's estimates relating to their determination of uncertain tax positions required extensive audit effort and a high degree of auditor judgment, including involvement of our tax specialists. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures to evaluate management's estimates of uncertain tax positions related to unresolved transfer pricing issues included the following: • We evaluated the appropriateness and consistency of management's methods and assumptions used in the identification, recognition, measurement, and disclosure of uncertain tax positions, which included testing the effectiveness of the related internal controls. • We read and evaluated management's documentation, including relevant accounting policies and information obtained by management from outside tax specialists, that detailed the basis of the uncertain tax positions. • We tested the reasonableness of management's judgments regarding the future resolution of the uncertain tax positions, including an evaluation of the technical merits of the uncertain tax positions. • For those uncertain tax positions that had not been effectively settled, we evaluated whether management had appropriately considered new information that could significantly change the recognition, measurement or disclosure of the uncertain tax positions. • We evaluated the reasonableness of management's estimates by considering how tax law, including statutes, regulations and case law, impacted management's judgments. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 29, 2021 We have served as the Company's auditor since 1983. 98 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our consolidated financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our consolidated financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our consolidated financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of June 30, 2021. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2021; their report is included in Item 9A. 99 PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2021, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2021, based on the criteria established in Internal Control — Integrated Framework (2013) issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements and the related notes (collectively referred to as the "financial statements") as of and for the year ended June 30, 2021, of the Company and our report dated July 29, 2021, expressed an unqualified opinion on those financial statements. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 29, 2021 100 PART II, III Item 9B, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our director nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held November 30, 2021 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board committees” in the Proxy Statement. That information is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and other finance organization employees. The finance code of ethics is publicly available on our website at https://aka.ms/FinanceCodeProfessionalConduct. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director compensation,” “Named executive officer compensation,” “Compensation Committee report,” and, if required, “Compensation Committee interlocks and insider participation,” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock ownership information,” “Principal shareholders” and “Equity compensation plan information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director independence” and “Certain relationships and related transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Information concerning principal accountant fees and services appears in the Proxy Statement under the headings “Fees billed by Deloitte & Touche” and “Policy on Audit Committee pre-approval of audit and permissible non-audit services of independent auditor” and is incorporated herein by reference. 101 PART IV Item 15 PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 57 Comprehensive Income Statements 58 Balance Sheets 59 Cash Flows Statements 60 Stockholders’ Equity Statements 61 Notes to Financial Statements 62 Report of Independent Registered Public Accounting Firm 96 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/14/17 4.1 Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 10/29/15 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/10 102 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 103 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 11/3/15 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 8/5/16 104 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/17 4.16 Thirteenth Supplemental Indenture for 2.525% Notes due 2050 and 2.675% Notes due 2060, dated as of June 1, 2020, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 6/1/20 4.17 Fourteenth Supplemental Indenture for 2.921% Notes due 2052 and 3.041% Notes due 2062, dated as of March 17, 2021, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 3/17/21 4.18 Description of Securities 10-K 6/30/19 4.16 8/1/19 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.1 10/20/16 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-K 6/30/18 10.5 8/3/18 10.6* Microsoft Corporation 2017 Stock Plan DEF14A Annex C 10/16/17 10.7* Form of Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.26 4/26/18 10.8* Form of Performance Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.27 4/26/18 10.12 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.12 10/20/16 105 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.13 Form of Indemnification Agreement and Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-K 6/30/19 10.13 8/1/19 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-Q 12/31/17 10.14 1/31/18 10.15* Microsoft Corporation Executive Incentive Plan 8-K 10.1 9/19/18 10.19* Microsoft Corporation Executive Incentive Plan 10-Q 9/30/16 10.17 10/20/16 10.20* Form of Executive Incentive Plan (Executive Officer SAs) Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.18 10/20/16 10.21* Form of Executive Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.25 10/20/16 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/16 10.22 10/20/16 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 10.25 Assumption of Beneficiaries’ Representative Obligations Under Amended and Restated Officers’ Indemnification Trust Agreement 10-K 6/30/2020 10.25 7/30/2020 10.26 Assumption of Beneficiaries’ Representative Obligations Under Amended and Restated Directors’ Indemnification Trust Agreement 10-K 6/30/2020 10.26 7/30/2020 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certifications of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certifications of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certifications of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 106 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 32.2** Certifications of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS Inline XBRL Instance Document —the instance document does not appear in the Interactive Data File as its XBRL tags are embedded within the Inline XBRL document X 101.SCH Inline XBRL Taxonomy Extension Schema X 101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase X 101.DEF Inline XBRL Taxonomy Extension Definition Linkbase X 101.LAB Inline XBRL Taxonomy Extension Label Linkbase X 101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase X 104 Cover page formatted as Inline XBRL and contained in Exhibit 101 X * Indicates a management contract or compensatory plan or arrangement. ** Furnished, not filed. 107 PART IV Item 16 ITEM 1 6 . FORM 10-K SUMMARY None. 108 SIGNAT URES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 29, 2021. M ICROSOFT C ORPORATION /s/ A LICE L. J OLLA Alice L. Jolla Corporate Vice President and Chief Accounting Officer (Principal Accounting Officer) 109 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on July 29 , 2021 . Signature Title /s/ S ATYA N ADELLA Satya Nadella Chairman and Chief Executive Officer (Principal Executive Officer) /s/ R EID H OFFMAN Reid Hoffman Director /s/ H UGH F. J OHNSTON Hugh F. Johnston Director /s/ T ERI L. L IST Teri L. List Director /s/ S ANDRA E. P ETERSON Sandra E. Peterson Director /s/ P ENNY S. P RITZKER Penny S. Pritzker Director /s/ C HARLES W. S CHARF Charles W. Scharf Director /s/ J OHN W. S TANTON John W. Stanton Director /s/ J OHN W. T HOMPSON Lead Independent Director John W. Thompson /s/ E MMA N. W ALMSLEY Emma N. Walmsley Director /s/ P ADMASREE W ARRIOR Padmasree Warrior Director /s/ A MY E. H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/ A LICE L. J OLLA Alice L. 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2021-06-30 0000789019 country:US 2020-06-30 0000789019 country:IE 2022-06-30 0000789019 country:IE 2021-06-30 0000789019 country:IE 2020-06-30 0000789019 msft:OtherCountriesMember 2022-06-30 0000789019 msft:OtherCountriesMember 2021-06-30 0000789019 msft:OtherCountriesMember 2020-06-30 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Fiscal Year Ended June 30, 2022 OR ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Transition Period From                  to Commission File Number 001-37845 MICROSOFT CORPORATION Washington 91-1144442 (STATE OF INCORPORATION) (I.R.S. ID) ONE MICROSOFT WAY , REDMOND , Washington 98052-6399 ( 425 ) 882-8080 www.microsoft.com/investor Securities registered pursuant to Section 12(b) of the Act: Title of each class Trading Symbol Name of exchange on which registered Common stock, $ 0.00000625 par value per share MSFT Nasdaq 3.125% Notes due 2028 MSFT Nasdaq 2.625% Notes due 2033 MSFT Nasdaq Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ☒ No ☐ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes ☐ No ☒ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large Accelerated Filer ☒ Accelerated Filer ☐ Non-accelerated Filer ☐ Smaller Reporting Company ☐ Emerging Growth Company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report. ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes ☐ No ☒ As of December 31, 2021, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $ 2.5 trillion based on the closing sale price as reported on the NASDAQ National Market System. As of July 25, 2022, there were 7,457,891,872 shares of common stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the definitive Proxy Statement to be delivered to shareholders in connection with the Annual Meeting of Shareholders to be held on December 13 , 2022 are incorporated by reference into Part III. MICROSOFT CORPORATION FORM 10-K For the Fiscal Year Ended June 30, 2022 INDEX Page PART I Item 1. Business 3 Information about our Executive Officers 21 Item 1A. Risk Factors 23 Item 1B. Unresolved Staff Comments 37 Item 2. Properties 37 Item 3. Legal Proceedings 37 Item 4. Mine Safety Disclosures 37 PART II Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities 38 Item 6. [Reserved] 39 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 40 Item 7A. Quantitative and Qualitative Disclosures about Market Risk 56 Item 8. Financial Statements and Supplementary Data 57 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 99 Item 9A. Controls and Procedures 99 Report of Management on Internal Control over Financial Reporting 99 Report of Independent Registered Public Accounting Firm 100 Item 9B. Other Information 101 Item 9C. Disclosure Regarding Foreign Jurisdictions that Prevent Inspections 101 PART III Item 10. Directors, Executive Officers and Corporate Governance 101 Item 11. Executive Compensation 101 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 101 Item 13. Certain Relationships and Related Transactions, and Director Independence 101 Item 14. Principal Accountant Fees and Services 101 PART IV Item 15. Exhibit and Financial Statement Schedules 102 Item 16. Form 10-K Summary 108 Signatures 109 2 PART I Item 1 Note About Forward-Looking Statements This report includes estimates, projections, statements relating to our business plans, objectives, and expected operating results that are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements may appear throughout this report, including the following sections: “Business” (Part I, Item 1 of this Form 10-K), “Risk Factors” (Part I, Item 1A of this Form 10-K), and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (Part II, Item 7 of this Form 10-K). These forward-looking statements generally are identified by the words “believe,” “project,” “expect,” “anticipate,” “estimate,” “intend,” “strategy,” “future,” “opportunity,” “plan,” “may,” “should,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially. We describe risks and uncertainties that could cause actual results and events to differ materially in “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and “Quantitative and Qualitative Disclosures about Market Risk” (Part II, Item 7A of this Form 10-K). Readers are cautioned not to place undue reliance on forward-looking statements, which speak only as of the date they are made. We undertake no obligation to update or revise publicly any forward-looking statements, whether because of new information, future events, or otherwise. PART I ITEM 1. BUSINESS GENERAL Embracing Our Future Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. We are creating the tools and platforms that deliver better, faster, and more effective solutions to support new startups, improve educational and health outcomes, and empower human ingenuity. Microsoft is innovating and expanding our entire portfolio to help people and organizations overcome today’s challenges and emerge stronger. We bring technology and products together into experiences and solutions that unlock value for our customers. In a dynamic environment, digital technology is the key input that powers the world’s economic output. Our ecosystem of customers and partners have learned that while hybrid work is complex, embracing flexibility, different work styles, and a culture of trust can help navigate the challenges the world faces today. Organizations of all sizes have digitized business-critical functions, redefining what they can expect from their business applications. Customers are looking to unlock value while simplifying security and management. From infrastructure and data, to business applications and collaboration, we provide unique, differentiated value to customers. We are building a distributed computing fabric – across cloud and the edge – to help every organization build, run, and manage mission-critical workloads anywhere. In the next phase of innovation, artificial intelligence (“AI”) capabilities are rapidly advancing, fueled by data and knowledge of the world. We are enabling metaverse experiences at all layers of our stack, so customers can more effectively model, automate, simulate, and predict changes within their industrial environments, feel a greater sense of presence in the new world of hybrid work, and create custom immersive worlds to enable new opportunities for connection and experimentation. What We Offer Founded in 1975, we develop and support software, services, devices, and solutions that deliver new value for customers and help people and businesses realize their full potential. We offer an array of services, including cloud-based solutions that provide customers with software, services, platforms, and content, and we provide solution support and consulting services. We also deliver relevant online advertising to a global audience. 3 PART I Item 1 Our products include operating systems , cross-device productivity and collaboration applications , server applications , business solution applications , desktop and server management tools , software development tools , and video games. We also design and sell devices, including PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. The Ambitions That Drive Us To achieve our vision, our research and development efforts focus on three interconnected ambitions: • Reinvent productivity and business processes. • Build the intelligent cloud and intelligent edge platform. • Create more personal computing. Reinvent Productivity and Business Processes At Microsoft, we provide technology and resources to help our customers create a secure hybrid work environment. Our family of products plays a key role in the ways the world works, learns, and connects. Our growth depends on securely delivering continuous innovation and advancing our leading productivity and collaboration tools and services, including Office 365, Dynamics 365, and LinkedIn. Microsoft 365 brings together Office 365, Windows, and Enterprise Mobility + Security to help organizations empower their employees with AI-backed tools that unlock creativity, increase collaboration, and fuel innovation, all the while enabling compliance coverage and data protection. Microsoft Teams is a comprehensive platform for work, with meetings, calls, chat, collaboration, and business process automation. Microsoft Viva is an employee experience platform that brings together communications, knowledge, learning, resources, and insights powered by Microsoft 365. Together with the Microsoft Cloud, Dynamics 365, Microsoft Teams, and Azure Synapse bring a new era of collaborative applications that transform every business function and process. Microsoft Power Platform is helping domain experts drive productivity gains with low-code/no-code tools, robotic process automation, virtual agents, and business intelligence. In a dynamic labor market, LinkedIn is helping professionals use the platform to connect, learn, grow, and get hired. Build the Intelligent Cloud and Intelligent Edge Platform As digital transformation accelerates, organizations in every sector across the globe can address challenges that will have a fundamental impact on their success. For enterprises, digital technology empowers employees, optimizes operations, engages customers, and in some cases, changes the very core of products and services. Microsoft has a proven track record of delivering high value to our customers across many diverse and durable growth markets. We continue to invest in high performance and sustainable computing to meet the growing demand for fast access to Microsoft services provided by our network of cloud computing infrastructure and datacenters. Azure is a trusted cloud with comprehensive compliance coverage and AI-based security built in. Our cloud business benefits from three economies of scale: datacenters that deploy computational resources at significantly lower cost per unit than smaller ones; datacenters that coordinate and aggregate diverse customer, geographic, and application demand patterns, improving the utilization of computing, storage, and network resources; and multi-tenancy locations that lower application maintenance labor costs. The Microsoft Cloud is the most comprehensive and trusted cloud, providing the best integration across the technology stack while offering openness, improving time to value, reducing costs, and increasing agility. Being a global-scale cloud, Azure uniquely offers hybrid consistency, developer productivity, AI capabilities, and trusted security and compliance. We see more emerging use cases and needs for compute and security at the edge and are accelerating our innovation across the spectrum of intelligent edge devices, from Internet of Things (“IoT”) sensors to gateway devices and edge hardware to build, manage, and secure edge workloads. With Azure Stack, organizations can extend Azure into their own datacenters to create a consistent stack across the public cloud and the intelligent edge. 4 PART I Item 1 Our hybrid infrastructure consistency spans security, compliance, identity, and management, helping to support the real-world needs and evolving regulatory requirements of commercial customers and enterprises. Our industry clouds bring together capabilities across the entire Microsoft Cloud, along with industry-specific customizations, to improve time to value, increase agility, and lower costs. Azure Arc simplifies governance and management by delivering a consistent multi-cloud and on-premises management platform. Security, compliance, identity, and management underlie our entire tech stack. We offer integrated, end-to-end capabilities to protect people and organizations. In March 2022, we completed our acquisition of Nuance Communications, Inc. (“Nuance”). Together, Microsoft and Nuance will enable organizations across industries to accelerate their business goals with security-focused, cloud-based solutions infused with powerful, vertically optimized AI. We are accelerating our development of mixed reality solutions with new Azure services and devices. Microsoft Mesh enables presence and shared experiences from anywhere through mixed reality applications. The opportunity to merge the physical and digital worlds, when combined with the power of Azure cloud services, unlocks new workloads and experiences to create common understanding and drive more informed decisions. The ability to convert data into AI drives our competitive advantage. Azure SQL Database makes it possible for customers to take SQL Server from their on-premises datacenter to a fully managed instance in the cloud to utilize built-in AI. Azure Synapse brings together data integration, enterprise data warehousing, and big data analytics in a comprehensive solution. We are accelerating adoption of AI innovations from research to products. Our innovation helps every developer be an AI developer, with approachable new tools from Azure Machine Learning Studio for creating simple machine learning models, to the powerful Azure Machine Learning Workbench for the most advanced AI modeling and data science. From GitHub to Visual Studio, we provide a developer tool chain for everyone, no matter the technical experience, across all platforms, whether Azure, Windows, or any other cloud or client platform. Additionally, we are extending our infrastructure beyond the planet, bringing cloud computing to space. Azure Orbital is a fully managed ground station as a service for fast downlinking of data. Create More Personal Computing We strive to make computing more personal by putting people at the core of the experience, enabling them to interact with technology in more intuitive, engaging, and dynamic ways. Microsoft 365 is empowering people and organizations to be productive and secure as they adapt to more fluid ways of working, learning, and playing. Windows also plays a critical role in fueling our cloud business with Windows 365, a desktop operating system that’s also a cloud service. From another internet-connected device, including Android or macOS devices, you can run Windows 365, just like a virtual machine. With Windows 11, we have simplified the design and experience to empower productivity and inspire creativity. Windows 11 offers innovations focused on enhancing productivity and is designed to support hybrid work. It adds new experiences that include powerful task switching tools like new snap layouts, snap groups, and desktops; new ways to stay connected through Microsoft Teams chat; the information you want at your fingertips; and more. Windows 11 security and privacy features include operating system security, application security, and user and identity security. Tools like search, news, and maps have given us immediate access to the world’s information. Today, through our Search, News, Mapping, and Browse services, Microsoft delivers unique trust, privacy, and safety features. Microsoft Edge is our fast and secure browser that helps protect your data, with built-in shopping tools designed to save you time and money. Organizational tools such as Collections, Vertical Tabs, and Immersive Reader help make the most of your time while browsing, streaming, searching, and sharing. We are committed to designing and marketing first-party devices to help drive innovation, create new device categories, and stimulate demand in the Windows ecosystem. The Surface family includes Surface Laptop Studio, Surface Laptop 4, Surface Laptop Go 2, Surface Laptop Pro 8, Surface Pro X, Surface Go 3, Surface Studio 2, and Surface Duo 2. 5 PART I Item 1 With three billion people actively playing games today, and a new generation steeped in interactive entertainment, Microsoft continues to invest in content, community, and cloud services . We have broadened our approach to how we think about gaming end-to-end, from the way games are created and distributed to how they are played , including cloud gaming so players can stream across PC, console, and mobile. We have a strong position with our large and growing highly engaged community of gamers , including the acquisition of ZeniMax Media Inc., the parent company of Bethesda Softworks LLC . In January 2022, we announced plans to acquire Activision Blizzard , Inc., a leader in game development and an interactive entertainment content publisher . Xbox Game Pass is a community with access to a curated library of over 100 first- and third-party console and PC titles . Xbox Cloud Gaming is Microsoft’s game streaming technology that is complementary to our console hardware and gives fans the ultimate choice to play the games they want, with the people they want, on the devices they want. Our Future Opportunity The case for digital transformation has never been more urgent. Customers are looking to us to help improve productivity and the affordability of their products and services. We continue to develop complete, intelligent solutions for our customers that empower people to stay productive and collaborate, while safeguarding businesses and simplifying IT management. Our goal is to lead the industry in several distinct areas of technology over the long term, which we expect will translate to sustained growth. We are investing significant resources in: • Transforming the workplace to deliver new modern, modular business applications, drive deeper insights, and improve how people communicate, collaborate, learn, work, play, and interact with one another. • Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals. • Applying AI to drive insights and act on our customer’s behalf by understanding and interpreting their needs using natural methods of communication. • Tackling security from all angles with our integrated, end-to-end solutions spanning security, compliance, identity, and management, across all clouds and platforms. • Inventing new gaming experiences that bring people together around their shared love for games on any devices and pushing the boundaries of innovation with console and PC gaming by creating the next wave of entertainment. • Using Windows to fuel our cloud business, grow our share of the PC market, and drive increased engagement with our services like Microsoft 365 Consumer, Teams, Edge, Bing, Xbox Game Pass, and more. Our future growth depends on our ability to transcend current product category definitions, business models, and sales motions. We have the opportunity to redefine what customers and partners can expect and are working to deliver new solutions that reflect the best of Microsoft. Corporate Social Responsibility Commitment to Sustainability We work to ensure that technology is inclusive, trusted, and increases sustainability. We are accelerating progress toward a more sustainable future by reducing our environmental footprint, advancing research, helping our customers build sustainable solutions, and advocating for policies that benefit the environment. In January 2020, we announced a bold commitment and detailed plan to be carbon negative by 2030, and to remove from the environment by 2050 all the carbon we have emitted since our founding in 1975. This included a commitment to invest $1 billion over four years in new technologies and innovative climate solutions. We built on this pledge by adding commitments to be water positive by 2030, zero waste by 2030, and to protect ecosystems by developing a Planetary Computer. We also help our suppliers and customers around the world use Microsoft technology to reduce their own carbon footprint. Fiscal year 2021 was a year of both successes and challenges. While we continued to make progress on several of our goals, with an overall reduction in our combined Scope 1 and Scope 2 emissions, our Scope 3 emissions increased, due in substantial part to significant global datacenter expansions and growth in Xbox sales and usage as a result of the COVID-19 pandemic. Despite these Scope 3 increases, we will continue to build the foundations and do the work to deliver on our commitments, and help our customers and partners achieve theirs. We have learned the impact of our work will not all be felt immediately, and our experience highlights how progress won’t always be linear. 6 PART I Item 1 While fiscal year 2021 presented us with some new learnings, we also made some great progress. A few examples that illuminate the diversity of our work include: • We purchased the removal of 1.4 million metrics tons of carbon. • Four of our datacenters received new or renewed Zero Waste certifications. • We granted $100 million to Breakthrough Energy Catalyst to accelerate the development of climate solutions the world needs to reach net-zero across four key areas: direct air capture, green hydrogen, long duration energy storage, and sustainable aviation fuel. • We joined the First Movers Coalition as an early leader and expert partner in the carbon dioxide removal sector, with a commitment of $200 million toward carbon removal by 2030. Sustainability is an existential priority for our society and businesses today. This led us to create our Microsoft Cloud for Sustainability, an entirely new business process category to help organizations monitor their carbon footprint across their operations. We also joined with leading organizations to launch the Carbon Call – an initiative to mobilize collective action to solve carbon emissions and removal accounting challenges for a net zero future. The investments we make in sustainability carry through to our products, services, and devices. We design our devices, from Surface to Xbox, to minimize their impact on the environment. Our cloud and AI services and datacenters help businesses cut energy consumption, reduce physical footprints, and design sustainable products. Addressing Racial Injustice and Inequity We are committed to addressing racial injustice and inequity in the United States for Black and African American communities and helping improve lived experiences at Microsoft, in employees’ communities, and beyond. Our Racial Equity Initiative focuses on three multi-year pillars, each containing actions and progress we expect to make or exceed by 2025. • Strengthening our communities: using data, technology, and partnerships to help improve the lives of Black and African American people in the United States, including our employees and their communities. • Evolving our ecosystem: using our balance sheet and relationships with suppliers and partners to foster societal change and create new opportunities. • Increasing representation and strengthening inclusion: build on our momentum, adding a $150 million investment to strengthen inclusion and double the number of Black, African American, Hispanic, and Latinx leaders in the United States by 2025. Over the last year, we collaborated with partners and worked within neighborhoods and communities to launch and scale a number of projects and programs, including: working with 70 organizations in 145 communities on the Justice Reform Initiative, expanding access to affordable broadband and devices for Black and African American communities and key institutions that support them in major urban centers, expanding access to skills and education to support Black and African American students and adults to succeed in the digital economy, and increasing technology support for nonprofits that provide critical services to Black and African American communities. We have made meaningful progress on representation and inclusion at Microsoft. We are 90 percent of the way to our 2025 commitment to double the number of Black and African American people managers, senior individual contributors, and senior leaders in the U.S., and 50 percent of the way for Hispanic and Latinx people managers, senior individual contributors, and senior leaders in the U.S. We exceeded our goal on increasing the percentage of transaction volumes with Black- and African American-owned financial institutions and increased our deposits with Black- and African American-owned minority depository institutions, enabling increased funds into local communities. Additionally, we enriched our supplier pipeline, reaching more than 90 percent of our goal to spend $500 million with double the number of Black and African American-owned suppliers. We also increased the number of identified partners in the Black Partner Growth Initiative and continue to invest in the partner community through the Black Channel Partner Alliance by supporting events focused on business growth, accelerators, and mentorship. Progress does not undo the egregious injustices of the past or diminish those who continue to live with inequity. We are committed to leveraging our resources to help accelerate diversity and inclusion across our ecosystem and to hold ourselves accountable to accelerate change – for Microsoft, and beyond. 7 PART I Item 1 Investing in Digital Skills The COVID-19 pandemic led to record unemployment, disrupting livelihoods of people around the world. After helping over 30 million people in 249 countries and territories with our global skills initiative, we introduced a new initiative to support a more skills-based labor market, with greater flexibility and accessible learning paths to develop the right skills needed for the most in-demand jobs. Our skills initiative brings together learning resources, certification opportunities, and job-seeker tools from LinkedIn, GitHub, and Microsoft Learn, and is built on data insights drawn from LinkedIn’s Economic Graph. We previously invested $20 million in key non-profit partnerships through Microsoft Philanthropies to help people from underserved communities that are often excluded by the digital economy. We also launched a national campaign with U.S. community colleges to help skill and recruit into the cybersecurity workforce 250,000 people by 2025, representing half of the country’s workforce shortage. To that end, we are making curriculum available free of charge to all of the nation’s public community colleges, providing training for new and existing faculty at 150 community colleges, and providing scholarships and supplemental resources to 25,000 students. HUMAN CAPITAL RESOURCES Overview Microsoft aims to recruit, develop, and retain world-changing talent from a diversity of backgrounds. To foster their and our success, we seek to create an environment where people can thrive, where they can do their best work, where they can proudly be their authentic selves, guided by our values, and where they know their needs can be met. We strive to maximize the potential of our human capital resources by creating a respectful, rewarding, and inclusive work environment that enables our global employees to create products and services that further our mission to empower every person and every organization on the planet to achieve more. As of June 30, 2022, we employed approximately 221,000 people on a full-time basis, 122,000 in the U.S. and 99,000 internationally. Of the total employed people, 85,000 were in operations, including manufacturing, distribution, product support, and consulting services; 73,000 were in product research and development; 47,000 were in sales and marketing; and 16,000 were in general and administration. Certain employees are subject to collective bargaining agreements. Our Culture Microsoft’s culture is grounded in the growth mindset. This means everyone is on a continuous journey to learn and grow. We believe potential can be nurtured and is not pre-determined, and we should always be learning and curious – trying new things without fear of failure. We identified four attributes that allow growth mindset to flourish: • Obsessing over what matters to our customers. • Becoming more diverse and inclusive in everything we do. • Operating as one company, One Microsoft, instead of multiple siloed businesses. • Making a difference in the lives of each other, our customers, and the world around us. Our employee listening systems enable us to gather feedback directly from our workforce to inform our programs and employee needs globally. Seventy percent of employees globally participated in our fiscal year 2022 Employee Signals survey, which covers a variety of topics such as thriving, inclusion, team culture, wellbeing, and learning and development. Throughout the fiscal year, we collect over 75,000 Daily Pulse employee survey responses. During fiscal year 2022, our Daily Pulse surveys gave us invaluable insights into ways we could support employees through the COVID-19 pandemic, addressing racial injustice, the war in Ukraine, and their general wellbeing. In addition to Employee Signals and Daily Pulse surveys, we gain insights through onboarding, internal mobility, leadership, performance and development, exit surveys, internal Yammer channels, employee Q&A sessions, and AskHR Service support. 8 PART I Item 1 Diversity and Inclusion At Microsoft we have an inherently inclusive mission: to empower every person and every organization on the planet to achieve more. We think of diversity and inclusion as core to our business model, informing our actions to impact economies and people around the world. There are billions of people who want to achieve more, but have a different set of circumstances, abilities, and backgrounds that often limit access to opportunity and achievement. The better we represent that diversity inside Microsoft, the more effectively we can innovate for those we seek to empower. We strive to include others by holding ourselves accountable for diversity, driving global systemic change in our workplace and workforce, and creating an inclusive work environment. Through this commitment we can allow everyone the chance to be their authentic selves and do their best work every day. We support multiple highly active Employee Resource Groups for women, families, racial and ethnic minorities, military, people with disabilities, and employees who identify as LGBTQIA+, where employees can go for support, networking, and community-building. As described in our 2021 Proxy Statement , annual performance and compensation reviews of our senior leadership team include an evaluation of their contributions to employee culture and diversity. To ensure accountability over time, we publicly disclose our progress on a multitude of workforce metrics including: • Detailed breakdowns of gender, racial, and ethnic minority representation in our employee population, with data by job types, levels, and segments of our business. • Our EEO-1 report (equal employment opportunity). • Disability representation. • Pay equity (see details below). Total Rewards We develop dynamic, sustainable, market-driven, and strategic programs with the goal of providing a highly differentiated portfolio to attract, reward, and retain top talent and enable our employees to thrive. These programs reinforce our culture and values such as collaboration and growth mindset. Managers evaluate and recommend rewards based on, for example, how well we leverage the work of others and contribute to the success of our colleagues. We monitor pay equity and career progress across multiple dimensions. As part of our effort to promote a One Microsoft and inclusive culture, in fiscal year 2021 we expanded stock eligibility to all Microsoft employees as part of our annual rewards process. This includes all non-exempt and exempt employees and equivalents across the globe including business support professionals and datacenter and retail employees. In response to the Great Reshuffle, in fiscal year 2022 we announced a sizable investment in annual merit and annual stock award opportunity for all employees below senior executive levels. We also invested in base salary adjustments for our datacenter and retail hourly employees and hourly equivalents outside the U.S. These investments have supported retention and help to ensure that Microsoft remains an employer of choice. Pay Equity In our 2021 Diversity and Inclusion Report, we reported that all racial and ethnic minority employees in the U.S. combined earn $1.006 for every $1.000 earned by their white counterparts, that women in the U.S. earn $1.002 for every $1.000 earned by their counterparts in the U.S. who are men, and women in the U.S. plus our twelve other largest employee geographies representing 86.6% of our global population (Australia, Canada, China, France, Germany, India, Ireland, Israel, Japan, Romania, Singapore, and the United Kingdom) combined earn $1.001 for every $1.000 by men in these countries. Our intended result is a global performance and development approach that fosters our culture, and competitive compensation that ensures equitable pay by role while supporting pay for performance. Wellness and Safety Microsoft is committed to supporting our employees’ well-being and safety while they are at work and in their personal lives. We took a wide variety of measures to protect the health and well-being of our employees, suppliers, and customers during the COVID-19 pandemic and are now supporting employees in shifting to return to office and/or hybrid arrangements. We developed hybrid guidelines for managers and employees to support the transition and continue to identify ways we can support hybrid work scenarios through our employee listening systems. 9 PART I Item 1 We have invested significantly in holistic wellbeing, and offer a differentiated benefits package which includes many physical, emotional, and financial wellness programs including counseling through the Microsoft CARES Employee Assistance Program, mental wellbeing support, flexible fitness benefits, savings and investment tools, adoption assistance, and back-up care for children and elders. Finally, our Occupational Health and Safety program helps ensure employees can stay safe while they are working. We continue to strive to support our Ukrainian employees and their dependents during the Ukraine crisis with emergency relocation assistance, emergency leave, and other benefits. Learning and Development Our growth mindset culture begins with valuing learning over knowing – seeking out new ideas, driving innovation, embracing challenges, learning from failure, and improving over time. To support this culture, we offer a wide range of learning and development opportunities. We believe learning can be more than formal instruction, and our learning philosophy focuses on providing the right learning, at the right time, in the right way. Opportunities include: • Personalized, integrated, and relevant views of all learning opportunities on both our internal learning portal Learning (Viva Learning + LinkedIn Learning) and our external learning portal MS Learn are available to all employees worldwide. • In-the-classroom learning, learning cohorts, our early-in-career Aspire program, and manager excellence communities. • Required learning for all employees and managers on topics such as compliance, regulation, company culture, leadership, and management. This includes the annual Standards of Business Conduct training. • On-the-job “stretch” and advancement opportunities. • Managers holding conversations about employees’ career and development plans, coaching on career opportunities, and programs like mentoring and sponsorship. • Customized manager learning to build people manager capabilities and similar learning solutions to build leadership skills for all employees including differentiated leadership development programs. • New employee orientation covering a range of topics including company values, and culture, as well as ongoing onboarding programs. • New tools to assist managers and employees in learning how to operate, be productive, and connect in the new flexible hybrid world of work. These include quick guides for teams to use, such as Creating Team Agreements, Reconnecting as a Team, and Running Effective Hybrid Meetings. Our employees embrace the growth mindset and take advantage of the formal learning opportunities as well as thousands of informal and on-the-job learning opportunities. In terms of formal on-line learning solutions, in fiscal year 2022 our employees completed over 4.7 million courses, averaging over 14 hours per employee. Given our focus on understanding core company beliefs and compliance topics, all employees complete required learning programs like Standards of Business Conduct, Privacy, Unconscious Bias, and preventing harassment courses. Our corporate learning portal has over 100,000 average monthly active users. We have over 27,000 people managers, all of whom must complete between 20-33 hours of required manager capability and excellence training and are assigned ongoing required training each year. In addition, all employees complete skills training based on the profession they are in each year. New Ways of Working The COVID-19 pandemic accelerated our capabilities and culture with respect to flexible work. We introduced a Hybrid Workplace Flexibility Guide to better support managers and employees as they adapt to new ways of working that shift paradigms, embrace flexibility, promote inclusion, and drive innovation. Our ongoing survey data shows employees value the flexibility related to work location, work site, and work hours, and while many have begun returning to worksites as conditions have permitted, they also continue to adjust hours and/or spend some of workweeks working at home, another site, or remotely. We are focused on building capabilities to support a variety of workstyles where individuals, teams, and our business can deliver success. 10 PART I Item 1 OPERATING SEGMENTS We operate our business and report our financial performance using three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our segments provide management with a comprehensive financial view of our key businesses. The segments enable the alignment of strategies and objectives across the development, sales, marketing, and services organizations, and they provide a framework for timely and rational allocation of resources within businesses. Additional information on our operating segments and geographic and product information is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Microsoft Viva. • Office Consumer, including Microsoft 365 Consumer subscriptions, Office licensed on-premises, and other Office services. • LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions. • Dynamics business solutions, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM, Customer Insights, Power Apps, and Power Automate; and on-premises ERP and CRM applications. Office Commercial Office Commercial is designed to increase personal, team, and organizational productivity through a range of products and services. Growth depends on our ability to reach new users in new markets such as frontline workers, small and medium businesses, and growth markets, as well as add value to our core product and service offerings to span productivity categories such as communication, collaboration, analytics, security, and compliance. Office Commercial revenue is mainly affected by a combination of continued installed base growth and average revenue per user expansion, as well as the continued shift from Office licensed on-premises to Office 365. Office Consumer Office Consumer is designed to increase personal productivity through a range of products and services. Growth depends on our ability to reach new users, add value to our core product set, and continue to expand our product and service offerings into new markets. Office Consumer revenue is mainly affected by the percentage of customers that buy Office with their new devices and the continued shift from Office licensed on-premises to Microsoft 365 Consumer subscriptions. Office Consumer Services revenue is mainly affected by the demand for communication and storage through Skype, Outlook.com, and OneDrive, which is largely driven by subscriptions, advertising, and the sale of minutes. 11 PART I Item 1 LinkedIn LinkedIn connects the world’s professionals to make them more productive and successful and transforms the way companies hire, market, sell, and learn. Our vision is to create economic opportunity for every member of the global workforce through the ongoing development of the world’s first Economic Graph, a digital representation of the global economy. In addition to LinkedIn’s free services, LinkedIn offers monetized solutions: Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions. Talent Solutions provide insights for workforce planning and tools to hire, nurture, and develop talent. Talent Solutions also includes Learning Solutions, which help businesses close critical skills gaps in times where companies are having to do more with existing talent. Marketing Solutions help companies reach, engage, and convert their audiences at scale. Premium Subscriptions enables professionals to manage their professional identity, grow their network, and connect with talent through additional services like premium search. Sales Solutions help companies strengthen customer relationships, empower teams with digital selling tools, and acquire new opportunities. LinkedIn has over 850 million members and has offices around the globe. Growth will depend on our ability to increase the number of LinkedIn members and our ability to continue offering services that provide value for our members and increase their engagement. LinkedIn revenue is mainly affected by demand from enterprises and professional organizations for subscriptions to Talent Solutions, Sales Solutions, and Premium Subscriptions offerings, as well as member engagement and the quality of the sponsored content delivered to those members to drive Marketing Solutions. Dynamics Dynamics provides cloud-based and on-premises business solutions for financial management, enterprise resource planning (“ERP”), customer relationship management (“CRM”), supply chain management, and other application development platforms for small and medium businesses, large organizations, and divisions of global enterprises. Dynamics revenue is driven by the number of users licensed and applications consumed, expansion of average revenue per user, and the continued shift to Dynamics 365, a unified set of cloud-based intelligent business applications, including Power Apps and Power Automate. Competition Competitors to Office include software and global application vendors, such as Apple, Cisco Systems, Meta, Google, IBM, Okta, Proofpoint, Slack, Symantec, Zoom, and numerous web-based and mobile application competitors as well as local application developers. Apple distributes versions of its pre-installed application software, such as email and calendar products, through its PCs, tablets, and phones. Cisco Systems is using its position in enterprise communications equipment to grow its unified communications business. Google provides a hosted messaging and productivity suite. Slack provides teamwork and collaboration software. Zoom offers videoconferencing and cloud phone solutions. Okta, Proofpoint, and Symantec provide security solutions across email security, information protection, identity, and governance. Web-based offerings competing with individual applications have also positioned themselves as alternatives to our products and services. We compete by providing powerful, flexible, secure, integrated industry-specific, and easy-to-use productivity and collaboration tools and services that create comprehensive solutions and work well with technologies our customers already have both on-premises or in the cloud. LinkedIn faces competition from online professional networks, recruiting companies, talent management companies, and larger companies that are focusing on talent management and human resource services; job boards; traditional recruiting firms; and companies that provide learning and development products and services. Marketing Solutions competes with online and offline outlets that generate revenue from advertisers and marketers, and Sales Solutions competes with online and offline outlets for companies with lead generation and customer intelligence and insights. Dynamics competes with cloud-based and on-premises business solution providers such as Oracle, Salesforce, and SAP. 12 PART I Item 1 Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure and other cloud services; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and Nuance and GitHub. • Enterprise Services, including Enterprise Support Services, Microsoft Consulting Services, and Nuance professional services. Server Products and Cloud Services Azure is a comprehensive set of cloud services that offer developers, IT professionals, and enterprises freedom to build, deploy, and manage applications on any platform or device. Customers can use Azure through our global network of datacenters for computing, networking, storage, mobile and web application services, AI, IoT, cognitive services, and machine learning. Azure enables customers to devote more resources to development and use of applications that benefit their organizations, rather than managing on-premises hardware and software. Azure revenue is mainly affected by infrastructure-as-a-service and platform-as-a-service consumption-based services, and per user-based services such as Enterprise Mobility + Security. Our server products are designed to make IT professionals, developers, and their systems more productive and efficient. Server software is integrated server infrastructure and middleware designed to support software applications built on the Windows Server operating system. This includes the server platform, database, business intelligence, storage, management and operations, virtualization, service-oriented architecture platform, security, and identity software. We also license standalone and software development lifecycle tools for software architects, developers, testers, and project managers. GitHub provides a collaboration platform and code hosting service for developers. Server products revenue is mainly affected by purchases through volume licensing programs, licenses sold to original equipment manufacturers (“OEM”), and retail packaged products. CALs provide access rights to certain server products, including SQL Server and Windows Server, and revenue is reported along with the associated server product. Nuance and GitHub include both cloud and on-premises offerings. Nuance provides healthcare and enterprise AI solutions. GitHub provides a collaboration platform and code hosting service for developers. Enterprise Services Enterprise Services, including Enterprise Support Services, Microsoft Consulting Services, and Nuance Professional Services, assist customers in developing, deploying, and managing Microsoft server solutions, Microsoft desktop solutions, and Nuance conversational AI and ambient intelligent solutions, along with providing training and certification to developers and IT professionals on various Microsoft products. Competition Azure faces diverse competition from companies such as Amazon, Google, IBM, Oracle, VMware, and open source offerings. Our Enterprise Mobility + Security offerings also compete with products from a range of competitors including identity vendors, security solution vendors, and numerous other security point solution vendors. Azure’s competitive advantage includes enabling a hybrid cloud, allowing deployment of existing datacenters with our public cloud into a single, cohesive infrastructure, and the ability to run at a scale that meets the needs of businesses of all sizes and complexities. We believe our cloud’s global scale, coupled with our broad portfolio of identity and security solutions, allows us to effectively solve complex cybersecurity challenges for our customers and differentiates us from the competition. Our server products face competition from a wide variety of server operating systems and applications offered by companies with a range of market approaches. Vertically integrated computer manufacturers such as Hewlett-Packard, IBM, and Oracle offer their own versions of the Unix operating system preinstalled on server hardware. Nearly all computer manufacturers offer server hardware for the Linux operating system and many contribute to Linux operating system development. The competitive position of Linux has also benefited from the large number of compatible applications now produced by many commercial and non-commercial software developers. A number of companies, such as Red Hat, supply versions of Linux. 13 PART I Item 1 We compete to provide enterprise-wide computing solutions and point solutions with numerous commercial software vendors that offer solutions and middleware technology platforms, software applications for connectivity (both Internet and intranet), security, hosting, database, and e-business servers. IBM and Oracle lead a group of companies focused on the Java Platform Enterprise Edition that competes with our enterprise-wide computing solutions. Commercial competitors for our server applications for PC-based distributed client-server environments include CA Technologies, IBM, and Oracle. Our web application platform software competes with open source software such as Apache, Linux, MySQL, and PHP. In middleware, we compete against Java vendors. Our database, business intelligence, and data warehousing solutions offerings compete with products from IBM, Oracle, SAP, Snowflake, and other companies. Our system management solutions compete with server management and server virtualization platform providers, such as BMC, CA Technologies, Hewlett-Packard, IBM, and VMware. Our products for software developers compete against offerings from Adobe, IBM, Oracle, and other companies, and also against open-source projects, including Eclipse (sponsored by CA Technologies, IBM, Oracle, and SAP), PHP, and Ruby on Rails. We believe our server products provide customers with advantages in performance, total costs of ownership, and productivity by delivering superior applications, development tools, compatibility with a broad base of hardware and software applications, security, and manageability. Our Enterprise Services business competes with a wide range of companies that provide strategy and business planning, application development, and infrastructure services, including multinational consulting firms and small niche businesses focused on specific technologies. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing (“Windows OEM”) and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; and Windows Internet of Things. • Devices, including Surface and PC accessories. • Gaming, including Xbox hardware and Xbox content and services, comprising first- and third-party content (including games and in-game content), Xbox Game Pass and other subscriptions, Xbox Cloud Gaming, third-party disc royalties, advertising, and other cloud services. • Search and news advertising. Windows The Windows operating system is designed to deliver a more personal computing experience for users by enabling consistency of experience, applications, and information across their devices. Windows OEM revenue is impacted significantly by the number of Windows operating system licenses purchased by OEMs, which they pre-install on the devices they sell. In addition to computing device market volume, Windows OEM revenue is impacted by: • The mix of computing devices based on form factor and screen size. • Differences in device market demand between developed markets and growth markets. • Attachment of Windows to devices shipped. • Customer mix between consumer, small and medium businesses, and large enterprises. • Changes in inventory levels in the OEM channel. • Pricing changes and promotions, pricing variation that occurs when the mix of devices manufactured shifts from local and regional system builders to large multinational OEMs, and different pricing of Windows versions licensed. • Constraints in the supply chain of device components. • Piracy. 14 PART I Item 1 Windows Commercial revenue, which includes volume licensing of the Windows operating system and Windows cloud services such as Microsoft Defender for Endpoint, is affected mainly by the demand from commercial customers for volume licensing and Software Assurance (“SA”), as well as advanced security offerings. Windows Commercial revenue often reflects the number of information workers in a licensed enterprise and is relatively independent of the number of PCs sold in a given year. Patent licensing includes our programs to license patents we own for use across a broad array of technology areas, including mobile devices and cloud offerings. Windows IoT extends the power of Windows and the cloud to intelligent systems by delivering specialized operating systems, tools, and services for use in embedded devices. Devices We design and sell devices, including Surface and PC accessories. Our devices are designed to enable people and organizations to connect to the people and content that matter most using Windows and integrated Microsoft products and services. Surface is designed to help organizations, students, and consumers be more productive. Growth in Devices is dependent on total PC shipments, the ability to attract new customers, our product roadmap, and expanding into new categories. Gaming Our gaming platform is designed to provide a variety of entertainment through a unique combination of content, community, and cloud. Our exclusive game content is created through Xbox Game Studios, a collection of first-party studios creating iconic and differentiated gaming experiences. We continue to invest in new gaming studios and content to expand our IP roadmap and leverage new content creators. These unique gaming experiences are the cornerstone of Xbox Game Pass, a subscription service and gaming community with access to a curated library of over 100 first- and third-party console and PC titles. The gamer remains at the heart of the Xbox ecosystem. We continue to open new opportunities for gamers to engage both on- and off-console with both the launch of Xbox Cloud Gaming, our game streaming service, and continued investment in gaming hardware. Xbox Cloud Gaming utilizes Microsoft’s Azure cloud technology to allow direct and on-demand streaming of games to PCs, consoles, and mobile devices, enabling gamers to take their favorite games with them and play on the device most convenient to them. Xbox enables people to connect and share online gaming experiences that are accessible on Xbox consoles, Windows-enabled devices, and other devices. Xbox is designed to benefit users by providing access to a network of certified applications and services and to benefit our developer and partner ecosystems by providing access to a large customer base. Xbox revenue is mainly affected by subscriptions and sales of first- and third-party content, as well as advertising. Growth of our Gaming business is determined by the overall active user base through Xbox enabled content, availability of games, providing exclusive game content that gamers seek, the computational power and reliability of the devices used to access our content and services, and the ability to create new experiences through first-party content creators. Search and News Advertising Our Search and news advertising business is designed to deliver relevant search, native, and display advertising to a global audience. We have several partnerships with other companies, including Yahoo, through which we provide and monetize search queries. Growth depends on our ability to attract new users, understand intent, and match intent with relevant content and advertiser offerings. On June 6, 2022, we acquired Xandr, Inc., a technology platform with tools to accelerate the delivery of our digital advertising solutions. Competition Windows faces competition from various software products and from alternative platforms and devices, mainly from Apple and Google. We believe Windows competes effectively by giving customers choice, value, flexibility, security, an easy-to-use interface, and compatibility with a broad range of hardware and software applications, including those that enable productivity. 15 PART I Item 1 Devices face competition from various computer, tablet, and hardware manufacturers who offer a unique combination of high-quality industrial design and innovative technologies across various price points. These manufacturers, many of which are also current or potential partners and customers, include Apple and our Windows OEMs. Xbox and our cloud gaming services face competition from various online gaming ecosystems and game streaming services, including those operated by Amazon, Apple, Meta, Google, and Tencent. We also compete with other providers of entertainment services such as video streaming platforms. Our gaming platform competes with console platforms from Nintendo and Sony, both of which have a large, established base of customers. We believe our gaming platform is effectively positioned against, and uniquely differentiated from, competitive products and services based on significant innovation in hardware architecture, user interface, developer tools, online gaming and entertainment services, and continued strong exclusive content from our own first-party game franchises as well as other digital content offerings. Our Search and news advertising business competes with Google and a wide array of websites, social platforms like Meta, and portals that provide content and online offerings to end users. OPERATIONS We have operations centers that support operations in their regions, including customer contract and order processing, credit and collections, information processing, and vendor management and logistics. The regional center in Ireland supports the European, Middle Eastern, and African region; the center in Singapore supports the Japan, India, Greater China, and Asia-Pacific region; and the centers in Fargo, North Dakota, Fort Lauderdale, Florida, Puerto Rico, Redmond, Washington, and Reno, Nevada support Latin America and North America. In addition to the operations centers, we also operate datacenters throughout the Americas, Europe, Australia, and Asia, as well as in the Middle East and Africa. To serve the needs of customers around the world and to improve the quality and usability of products in international markets, we localize many of our products to reflect local languages and conventions. Localizing a product may require modifying the user interface, altering dialog boxes, and translating text. Our devices are primarily manufactured by third-party contract manufacturers. For the majority of our products, we have the ability to use other manufacturers if a current vendor becomes unavailable or unable to meet our requirements. However, some of our products contain certain components for which there are very few qualified suppliers. For these components, we have limited near-term flexibility to use other manufacturers if a current vendor becomes unavailable or is unable to meet our requirements. Extended disruptions at these suppliers and/or manufacturers could lead to a similar disruption in our ability to manufacture devices on time to meet consumer demand. RESEARCH AND DEVELOPMENT Product and Service Development, and Intellectual Property We develop most of our products and services internally through the following engineering groups. • Cloud and AI , focuses on making IT professionals, developers, and their systems more productive and efficient through development of cloud infrastructure, server, database, CRM, ERP, software development tools and services (including GitHub), AI cognitive services, and other business process applications and services for enterprises. • Experiences and Devices , focuses on instilling a unifying product ethos across our end-user experiences and devices, including Office, Windows, Teams, con sumer web experiences (including search and news advertising), and the Surface line of devices. • Security, Compliance, Identity, and Management , focuses on cloud platform and application security, identity and network access, enterprise mobility, information protection, and managed services. • Technology and Research , focuses on our AI innovations and other forward-looking research and development efforts spanning infrastructure, services, and applications. • LinkedIn , focuses on our services that transform the way customers hire, market, sell, and learn. • Gaming , focuses on developing hardware, content, and services across a large range of platforms to help grow our user base through game experiences and social interaction. 16 PART I Item 1 Internal development allows us to maintain competitive advantages that come from product differentiation and closer technical control over our products and services. It also gives us the freedom to decide which modifications and enhancements are most important and when they should be implemented. We strive to obtain information as early as possible about changing usage patterns and hardware advances that may affect software and hardware design. Before releasing new software platforms, and as we make significant modifications to existing platforms, we provide application vendors with a range of resources and guidelines for development, training, and testing. Generally, we also create product documentation internally. We protect our intellectual property investments in a variety of ways. We work actively in the U.S. and internationally to ensure the enforcement of copyright, trademark, trade secret, and other protections that apply to our software and hardware products, services, business plans, and branding. We are a leader among technology companies in pursuing patents and currently have a portfolio of over 69,000 U.S. and international patents issued and over 19,000 pending worldwide. While we employ much of our internally-developed intellectual property exclusively in our products and services, we also engage in outbound licensing of specific patented technologies that are incorporated into licensees’ products. From time to time, we enter into broader cross-license agreements with other technology companies covering entire groups of patents. We may also purchase or license technology that we incorporate into our products and services. At times, we make select intellectual property broadly available at no or low cost to achieve a strategic objective, such as promoting industry standards, advancing interoperability, supporting societal and/or environmental efforts, or attracting and enabling our external development community. Our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, services, and business methods, we believe, based upon past experience and industry practice, such licenses generally can be obtained on commercially reasonable terms. We believe our continuing research and product development are not materially dependent on any single license or other agreement with a third party relating to the development of our products. Investing in the Future Our success is based on our ability to create new and compelling products, services, and experiences for our users, to initiate and embrace disruptive technology trends, to enter new geographic and product markets, and to drive broad adoption of our products and services. We invest in a range of emerging technology trends and breakthroughs that we believe offer significant opportunities to deliver value to our customers and growth for the Company. Based on our assessment of key technology trends, we maintain our long-term commitment to research and development across a wide spectrum of technologies, tools, and platforms spanning digital work and life experiences, cloud computing, AI, devices, and operating systems. While our main product research and development facilities are located in Redmond, Washington, we also operate research and development facilities in other parts of the U.S. and around the world. This global approach helps us remain competitive in local markets and enables us to continue to attract top talent from across the world. We plan to continue to make significant investments in a broad range of product research and development activities, and as appropriate we will coordinate our research and development across operating segments and leverage the results across the Company. In addition to our main research and development operations, we also operate Microsoft Research. Microsoft Research is one of the world’s largest corporate research organizations and works in close collaboration with top universities around the world to advance the state-of-the-art in computer science and a broad range of other disciplines, providing us a unique perspective on future trends and contributing to our innovation. DISTRIBUTION, SALES, AND MARKETING We market and distribute our products and services through the following channels: OEMs, direct, and distributors and resellers. Our sales force performs a variety of functions, including working directly with commercial enterprises and public-sector organizations worldwide to identify and meet their technology and digital transformation requirements; managing OEM relationships; and supporting system integrators, independent software vendors, and other partners who engage directly with our customers to perform sales, consulting, and fulfillment functions for our products and services. 17 PART I Item 1 OEMs We distribute our products and services through OEMs that pre-install our software on new devices and servers they sell. The largest component of the OEM business is the Windows operating system pre-installed on devices. OEMs also sell devices pre-installed with other Microsoft products and services, including applications such as Office and the capability to subscribe to Office 365. There are two broad categories of OEMs. The largest category of OEMs are direct OEMs as our relationship with them is managed through a direct agreement between Microsoft and the OEM. We have distribution agreements covering one or more of our products with virtually all the multinational OEMs, including Dell, Hewlett-Packard, Lenovo, and with many regional and local OEMs. The second broad category of OEMs are system builders consisting of lower-volume PC manufacturers, which source Microsoft software for pre-installation and local redistribution primarily through the Microsoft distributor channel rather than through a direct agreement or relationship with Microsoft. Direct Many organizations that license our products and services transact directly with us through Enterprise Agreements and Enterprise Services contracts, with sales support from system integrators, independent software vendors, web agencies, and partners that advise organizations on licensing our products and services (“Enterprise Agreement Software Advisors” or “ESA”). Microsoft offers direct sales programs targeted to reach small, medium, and corporate customers, in addition to those offered through the reseller channel. A large network of partner advisors support many of these sales. We also sell commercial and consumer products and services directly to customers, such as cloud services, search, and gaming, through our digital marketplaces and online stores. In fiscal year 2021, we closed our Microsoft Store physical locations and opened our Microsoft Experience Centers. Microsoft Experience Centers are designed to facilitate deeper engagement with our partners and customers across industries. Distributors and Resellers Organizations also license our products and services indirectly, primarily through licensing solution partners (“LSP”), distributors, value-added resellers (“VAR”), and retailers. Although each type of reselling partner may reach organizations of all sizes, LSPs are primarily engaged with large organizations, distributors resell primarily to VARs, and VARs typically reach small and medium organizations. ESAs are also typically authorized as LSPs and operate as resellers for our other volume licensing programs. Microsoft Cloud Solution Provider is our main partner program for reselling cloud services. We distribute our retail packaged products primarily through independent non-exclusive distributors, authorized replicators, resellers, and retail outlets. Individual consumers obtain these products primarily through retail outlets. We distribute our devices through third-party retailers. We have a network of field sales representatives and field support personnel that solicit orders from distributors and resellers and provide product training and sales support. Our Dynamics business solutions are also licensed to enterprises through a global network of channel partners providing vertical solutions and specialized services. LICENSING OPTIONS We offer options for organizations that want to purchase our cloud services, on-premises software, and SA. We license software to organizations under volume licensing agreements to allow the customer to acquire multiple licenses of products and services instead of having to acquire separate licenses through retail channels. We use different programs designed to provide flexibility for organizations of various sizes. While these programs may differ in various parts of the world, generally they include those discussed below. SA conveys rights to new software and upgrades for perpetual licenses released over the contract period. It also provides support, tools, training, and other licensing benefits to help customers deploy and use software efficiently. SA is included with certain volume licensing agreements and is an optional purchase with others. 18 PART I Item 1 Volume Licensing Programs Enterprise Agreement Enterprise Agreements offer large organizations a manageable volume licensing program that gives them the flexibility to buy cloud services and software licenses under one agreement. Enterprise Agreements are designed for medium or large organizations that want to license cloud services and on-premises software organization-wide over a three-year period. Organizations can elect to purchase perpetual licenses or subscribe to licenses. SA is included. Microsoft Customer Agreement A Microsoft Customer Agreement is a simplified purchase agreement presented, accepted, and stored through a digital experience. A Microsoft Customer Agreement is a non-expiring agreement that is designed to support all customers over time, whether purchasing through a partner or directly from Microsoft. Microsoft Online Subscription Agreement A Microsoft Online Subscription Agreement is designed for small and medium organizations that want to subscribe to, activate, provision, and maintain cloud services seamlessly and directly via the web. The agreement allows customers to acquire monthly or annual subscriptions for cloud-based services. Microsoft Products and Services Agreement Microsoft Products and Services Agreements are designed for medium and large organizations that want to license cloud services and on-premises software as needed, with no organization-wide commitment, under a single, non-expiring agreement. Organizations purchase perpetual licenses or subscribe to licenses. SA is optional for customers that purchase perpetual licenses. Open Value Open Value agreements are a simple, cost-effective way to acquire the latest Microsoft technology. These agreements are designed for small and medium organizations that want to license cloud services and on-premises software over a three-year period. Under Open Value agreements, organizations can elect to purchase perpetual licenses or subscribe to licenses and SA is included. Select Plus A Select Plus agreement is designed for government and academic organizations to acquire on-premises licenses at any affiliate or department level, while realizing advantages as one organization. Organizations purchase perpetual licenses and SA is optional. Partner Programs The Microsoft Cloud Solution Provider program offers customers an easy way to license the cloud services they need in combination with the value-added services offered by their systems integrator, managed services provider, or cloud reseller partner. Partners in this program can easily package their own products and services to directly provision, manage, and support their customer subscriptions. The Microsoft Services Provider License Agreement allows hosting service providers and independent software vendors who want to license eligible Microsoft software products to provide software services and hosted applications to their end customers. Partners license software over a three-year period and are billed monthly based on consumption. The Independent Software Vendor Royalty program enables partners to integrate Microsoft products into other applications and then license the unified business solution to their end users. 19 PART I Item 1 CUSTOMERS Our customers include individual consumers, small and medium organizations, large global enterprises, public-sector institutions, Internet service providers, application developers, and OEMs. Our practice is to ship our products promptly upon receipt of purchase orders from customers; consequently, backlog is not significant. 20 PART I Item 1 INFORMATION ABOUT OUR EXECUTIV E OFFICERS Our executive officers as of July 28, 2022 were as follows: Name Age Position with the Company Satya Nadella 54 Chairman of the Board and Chief Executive Officer Judson Althoff 49 Executive Vice President and Chief Commercial Officer Christopher C. Capossela 52 Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer Kathleen T. Hogan 56 Executive Vice President, Human Resources Amy E. Hood 50 Executive Vice President, Chief Financial Officer Bradford L. Smith 63 President and Vice Chair Christopher D. Young 50 Executive Vice President, Business Development, Strategy, and Ventures Mr. Nadella was appointed Chairman of the Board in June 2021 and Chief Executive Officer in February 2014. He served as Executive Vice President, Cloud and Enterprise from July 2013 until that time. From 2011 to 2013, Mr. Nadella served as President, Server and Tools. From 2009 to 2011, he was Senior Vice President, Online Services Division. From 2008 to 2009, he was Senior Vice President, Search, Portal, and Advertising. Since joining Microsoft in 1992, Mr. Nadella’s roles also included Vice President of the Business Division. Mr. Nadella also serves on the Board of Directors of Starbucks Corporation. Mr. Althoff was appointed Executive Vice President and Chief Commercial Officer in July 2021. He served as Executive Vice President, Worldwide Commercial Business from July 2017 until that time. Prior to that, Mr. Althoff served as the President of Microsoft North America. Mr. Althoff joined Microsoft in March 2013 as President of Microsoft North America. Mr. Capossela was appointed Executive Vice President, Marketing and Consumer Business, and Chief Marketing Officer in July 2016. He had served as Executive Vice President, Chief Marketing Officer since March 2014. Previously, he served as the worldwide leader of the Consumer Channels Group, responsible for sales and marketing activities with OEMs, operators, and retail partners. In his more than 25 years at Microsoft, Mr. Capossela has held a variety of marketing leadership roles in the Microsoft Office Division. He was responsible for marketing productivity solutions including Microsoft Office, Office 365, SharePoint, Exchange, Skype for Business, Project, and Visio. Ms. Hogan was appointed Executive Vice President, Human Resources in November 2014. Prior to that Ms. Hogan was Corporate Vice President of Microsoft Services. She also served as Corporate Vice President of Customer Service and Support. Ms. Hogan joined Microsoft in 2003. Ms. Hogan also serves on the Board of Directors of Alaska Air Group, Inc. Ms. Hood was appointed Executive Vice President and Chief Financial Officer in July 2013, subsequent to her appointment as Chief Financial Officer in May 2013. From 2010 to 2013, Ms. Hood was Chief Financial Officer of the Microsoft Business Division. From 2006 through 2009, Ms. Hood was General Manager, Microsoft Business Division Strategy. Since joining Microsoft in 2002, Ms. Hood has also held finance-related positions in the Server and Tools Business and the corporate finance organization. Ms. Hood also serves on the Board of Directors of 3M Corporation. Mr. Smith was appointed President and Vice Chair in September 2021. Prior to that, he served as President and Chief Legal Officer since September 2015. He served as Executive Vice President, General Counsel, and Secretary from 2011 to 2015, and served as Senior Vice President, General Counsel, and Secretary from 2001 to 2011. Mr. Smith was also named Chief Compliance Officer in 2002. Since joining Microsoft in 1993, he was Deputy General Counsel for Worldwide Sales and previously was responsible for managing the European Law and Corporate Affairs Group, based in Paris. Mr. Smith also serves on the Board of Directors of Netflix, Inc. Mr. Young has served as Executive Vice President, Business Development, Strategy, and Ventures since joining Microsoft in November 2020. Prior to Microsoft, he served as the Chief Executive Officer of McAfee, LLC from 2017 to 2020, and served as a Senior Vice President and General Manager of Intel Security Group from 2014 until 2017, when he led the initiative to spin out McAfee into a standalone company. Mr. Young also serves on the Board of Directors of American Express Company. 21 PART I Item 1 AVAILABLE INFORMATION Our Internet address is www.microsoft.com. At our Investor Relations website, www.microsoft.com/investor, we make available free of charge a variety of information for investors. Our goal is to maintain the Investor Relations website as a portal through which investors can easily find or navigate to pertinent information about us, including: • Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any amendments to those reports, as soon as reasonably practicable after we electronically file that material with or furnish it to the Securities and Exchange Commission (“SEC”) at www.sec.gov. • Information on our business strategies, financial results, and metrics for investors. • Announcements of investor conferences, speeches, and events at which our executives talk about our product, service, and competitive strategies. Archives of these events are also available. • Press releases on quarterly earnings, product and service announcements, legal developments, and international news. • Corporate governance information including our articles of incorporation, bylaws, governance guidelines, committee charters, codes of conduct and ethics, global corporate social responsibility initiatives, and other governance-related policies. • Other news and announcements that we may post from time to time that investors might find useful or interesting. • Opportunities to sign up for email alerts to have information pushed in real time. We publish a variety of reports and resources related to our Corporate Social Responsibility programs and progress on our Reports Hub website, www.microsoft.com/corporate-responsibility/reports-hub, including reports on sustainability, responsible sourcing, accessibility, digital trust, and public policy engagement. The information found on these websites is not part of, or incorporated by reference into, this or any other report we file with, or furnish to, the SEC. In addition to these channels, we use social media to communicate to the public. It is possible that the information we post on social media could be deemed to be material to investors. We encourage investors, the media, and others interested in Microsoft to review the information we post on the social media channels listed on our Investor Relations website. 22 PART I Item 1A ITEM 1A. RISK FACTORS Our operations and financial results are subject to various risks and uncertainties, including those described below, that could adversely affect our business, financial condition, results of operations, cash flows, and the trading price of our common stock. STRATEGIC AND COMPETITIVE RISKS We face intense competition across all markets for our products and services, which may lead to lower revenue or operating margins. Competition in the technology sector Our competitors range in size from diversified global companies with significant research and development resources to small, specialized firms whose narrower product lines may let them be more effective in deploying technical, marketing, and financial resources. Barriers to entry in many of our businesses are low and many of the areas in which we compete evolve rapidly with changing and disruptive technologies, shifting user needs, and frequent introductions of new products and services. Our ability to remain competitive depends on our success in making innovative products, devices, and services that appeal to businesses and consumers. Competition among platform-based ecosystems An important element of our business model has been to create platform-based ecosystems on which many participants can build diverse solutions. A well-established ecosystem creates beneficial network effects among users, application developers, and the platform provider that can accelerate growth. Establishing significant scale in the marketplace is necessary to achieve and maintain attractive margins. We face significant competition from firms that provide competing platforms. • A competing vertically-integrated model, in which a single firm controls the software and hardware elements of a product and related services, has succeeded with some consumer products such as personal computers, tablets, phones, gaming consoles, wearables, and other endpoint devices. Competitors pursuing this model also earn revenue from services integrated with the hardware and software platform, including applications and content sold through their integrated marketplaces. They may also be able to claim security and performance benefits from their vertically integrated offer. We also offer some vertically-integrated hardware and software products and services. To the extent we shift a portion of our business to a vertically integrated model we increase our cost of revenue and reduce our operating margins. • We derive substantial revenue from licenses of Windows operating systems on PCs. We face significant competition from competing platforms developed for new devices and form factors such as smartphones and tablet computers. These devices compete on multiple bases including price and the perceived utility of the device and its platform. Users are increasingly turning to these devices to perform functions that in the past were performed by personal computers. Even if many users view these devices as complementary to a personal computer, the prevalence of these devices may make it more difficult to attract application developers to our PC operating system platforms. Competing with operating systems licensed at low or no cost may decrease our PC operating system margins. Popular products or services offered on competing platforms could increase their competitive strength. In addition, some of our devices compete with products made by our original equipment manufacturer (“OEM”) partners, which may affect their commitment to our platform. • Competing platforms have content and application marketplaces with scale and significant installed bases. The variety and utility of content and applications available on a platform are important to device purchasing decisions. Users may incur costs to move data and buy new content and applications when switching platforms. To compete, we must successfully enlist developers to write applications for our platform and ensure that these applications have high quality, security, customer appeal, and value. Efforts to compete with competitors’ content and application marketplaces may increase our cost of revenue and lower our operating margins. Competitors’ rules governing their content and applications marketplaces may restrict our ability to distribute products and services through them in accordance with our technical and business model objectives. 23 PART I Item 1A Business model competition Companies compete with us based on a growing variety of business models. • Even as we transition more of our business to infrastructure-, platform-, and software-as-a-service business model, the license-based proprietary software model generates a substantial portion of our software revenue. We bear the costs of converting original ideas into software products through investments in research and development, offsetting these costs with the revenue received from licensing our products. Many of our competitors also develop and sell software to businesses and consumers under this model. • Other competitors develop and offer free applications, online services and content, and make money by selling third-party advertising. Advertising revenue funds development of products and services these competitors provide to users at no or little cost, competing directly with our revenue-generating products. • Some companies compete with us by modifying and then distributing open source software at little or no cost to end users, and earning revenue on advertising or integrated products and services. These firms do not bear the full costs of research and development for the open source software. Some open source software mimics the features and functionality of our products. The competitive pressures described above may cause decreased sales volumes, price reductions, and/or increased operating costs, such as for research and development, marketing, and sales incentives. This may lead to lower revenue, gross margins, and operating income. Our increasing focus on cloud-based services presents execution and competitive risks. A growing part of our business involves cloud-based services available across the spectrum of computing devices. Our strategic vision is to compete and grow by building best-in-class platforms and productivity services for an intelligent cloud and an intelligent edge infused with artificial intelligence (“AI”). At the same time, our competitors are rapidly developing and deploying cloud-based services for consumers and business customers. Pricing and delivery models are evolving. Devices and form factors influence how users access services in the cloud and sometimes the user’s choice of which cloud-based services to use. We are devoting significant resources to develop and deploy our cloud-based strategies. The Windows ecosystem must continue to evolve with this changing environment. We embrace cultural and organizational changes to drive accountability and eliminate obstacles to innovation. Our intelligent cloud and intelligent edge worldview is connected with the growth of the Internet of Things (“IoT”). Our success in the IoT will depend on the level of adoption of our offerings such as Azure, Azure Stack, Azure IoT Edge, and Azure Sphere. We may not establish market share sufficient to achieve scale necessary to meet our business objectives. Besides software development costs, we are incurring costs to build and maintain infrastructure to support cloud computing services. These costs will reduce the operating margins we have previously achieved. Whether we succeed in cloud-based services depends on our execution in several areas, including: • Continuing to bring to market compelling cloud-based experiences that generate increasing traffic and market share. • Maintaining the utility, compatibility, and performance of our cloud-based services on the growing array of computing devices, including PCs, smartphones, tablets, gaming consoles, and other devices, as well as sensors and other IoT endpoints. • Continuing to enhance the attractiveness of our cloud platforms to third-party developers. • Ensuring our cloud-based services meet the reliability expectations of our customers and maintain the security of their data as well as help them meet their own compliance needs. • Making our suite of cloud-based services platform-agnostic, available on a wide range of devices and ecosystems, including those of our competitors. It is uncertain whether our strategies will attract the users or generate the revenue required to succeed. If we are not effective in executing organizational and technical changes to increase efficiency and accelerate innovation, or if we fail to generate sufficient usage of our new products and services, we may not grow revenue in line with the infrastructure and development investments described above. This may negatively impact gross margins and operating income. 24 PART I Item 1A RISKS RELATING TO THE EVOLUTION OF OUR BUSINESS We make significant investments in products and services that may not achieve expected returns. We will continue to make significant investments in research, development, and marketing for existing products, services, and technologies, including the Windows operating system, Microsoft 365, Office, Bing, SQL Server, Windows Server, Azure, Office 365, Xbox, LinkedIn, and other products and services. We also invest in the development and acquisition of a variety of hardware for productivity, communication, and entertainment including PCs, tablets, gaming devices, and HoloLens. Investments in new technology are speculative. Commercial success depends on many factors, including innovativeness, developer support, and effective distribution and marketing. If customers do not perceive our latest offerings as providing significant new functionality or other value, they may reduce their purchases of new software and hardware products or upgrades, unfavorably affecting revenue. We may not achieve significant revenue from new product, service, and distribution channel investments for several years, if at all. New products and services may not be profitable, and even if they are profitable, operating margins for some new products and businesses will not be as high as the margins we have experienced historically. We may not get engagement in certain features, like Edge and Bing, that drive post-sale monetization opportunities. Our data handling practices across our products and services will continue to be under scrutiny and perceptions of mismanagement, driven by regulatory activity or negative public reaction to our practices or product experiences, could negatively impact product and feature adoption, product design, and product quality. Developing new technologies is complex. It can require long development and testing periods. Significant delays in new releases or significant problems in creating new products or services could adversely affect our revenue. Acquisitions, joint ventures, and strategic alliances may have an adverse effect on our business. We expect to continue making acquisitions and entering into joint ventures and strategic alliances as part of our long-term business strategy. For example, in March 2021 we completed our acquisition of ZeniMax Media Inc. for $8.1 billion, and in March 2022 we completed our acquisition of Nuance Communications, Inc. for $18.8 billion. In January 2022 we announced a definitive agreement to acquire Activision Blizzard , Inc. for $68.7 billion. These acquisitions and other transactions and arrangements involve significant challenges and risks, including that they do not advance our business strategy, that we get an unsatisfactory return on our investment, that they raise new compliance-related obligations and challenges, that we have difficulty integrating and retaining new employees, business systems, and technology, that they distract management from our other businesses, or that announced transactions may not be completed. If an arrangement fails to adequately anticipate changing circumstances and interests of a party, it may result in early termination or renegotiation of the arrangement. The success of these transactions and arrangements will depend in part on our ability to leverage them to enhance our existing products and services or develop compelling new ones, as well as acquired companies’ ability to meet our policies and processes in areas such as data governance, privacy, and cybersecurity. It may take longer than expected to realize the full benefits from these transactions and arrangements such as increased revenue or enhanced efficiencies, or the benefits may ultimately be smaller than we expected. These events could adversely affect our consolidated financial statements. If our goodwill or amortizable intangible assets become impaired, we may be required to record a significant charge to earnings. We acquire other companies and intangible assets and may not realize all the economic benefit from those acquisitions, which could cause an impairment of goodwill or intangibles. We review our amortizable intangible assets for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. We test goodwill for impairment at least annually. Factors that may be a change in circumstances, indicating that the carrying value of our goodwill or amortizable intangible assets may not be recoverable, include a decline in our stock price and market capitalization, reduced future cash flow estimates, and slower growth rates in industry segments in which we participate. We have in the past recorded, and may in the future be required to record, a significant charge in our consolidated financial statements during the period in which any impairment of our goodwill or amortizable intangible assets is determined, negatively affecting our results of operations. 25 PART I Item 1A CYBERSECURITY, DATA PRIVACY, AND PLATFORM ABUSE RISKS Cyberattacks and security vulnerabilities could lead to reduced revenue, increased costs, liability claims, or harm to our reputation or competitive position. Security of our information technology Threats to IT security can take a variety of forms. Individual and groups of hackers and sophisticated organizations, including state-sponsored organizations or nation-states, continuously undertake attacks that pose threats to our customers and our IT. These actors may use a wide variety of methods, which may include developing and deploying malicious software or exploiting vulnerabilities in hardware, software, or other infrastructure in order to attack our products and services or gain access to our networks and datacenters, using social engineering techniques to induce our employees, users, partners, or customers to disclose passwords or other sensitive information or take other actions to gain access to our data or our users’ or customers’ data, or acting in a coordinated manner to launch distributed denial of service or other coordinated attacks. Nation-state and state-sponsored actors can deploy significant resources to plan and carry out exploits. Nation-state attacks against us or our customers may intensify during periods of intense diplomatic or armed conflict, such as the ongoing conflict in Ukraine. Inadequate account security practices may also result in unauthorized access to confidential data. For example, system administrators may fail to timely remove employee account access when no longer appropriate. Employees or third parties may intentionally compromise our or our users’ security or systems or reveal confidential information. Malicious actors may employ the IT supply chain to introduce malware through software updates or compromised supplier accounts or hardware. Cyberthreats are constantly evolving and becoming increasingly sophisticated and complex, increasing the difficulty of detecting and successfully defending against them. We may have no current capability to detect certain vulnerabilities, which may allow them to persist in the environment over long periods of time. Cyberthreats can have cascading impacts that unfold with increasing speed across our internal networks and systems and those of our partners and customers. Breaches of our facilities, network, or data security could disrupt the security of our systems and business applications, impair our ability to provide services to our customers and protect the privacy of their data, result in product development delays, compromise confidential or technical business information harming our reputation or competitive position, result in theft or misuse of our intellectual property or other assets, subject us to ransomware attacks, require us to allocate more resources to improve technologies or remediate the impacts of attacks, or otherwise adversely affect our business. The cyberattacks uncovered in late 2020 known as “Solorigate” or “Nobelium” are an example of a supply chain attack where malware was introduced to a software provider’s customers, including us, through software updates. The attackers were later able to create false credentials that appeared legitimate to certain customers’ systems. We may be targets of further attacks similar to Solorigate/Nobelium as both a supplier and consumer of IT. In addition, our internal IT environment continues to evolve. Often, we are early adopters of new devices and technologies. We embrace new ways of sharing data and communicating internally and with partners and customers using methods such as social networking and other consumer-oriented technologies. Our business policies and internal security controls may not keep pace with these changes as new threats emerge, or emerging cybersecurity regulations in jurisdictions worldwide. 26 PART I Item 1A Security of our products, services, devices, and customers’ data The security of our products and services is important in our customers’ decisions to purchase or use our products or services across cloud and on-premises environments. Security threats are a significant challenge to companies like us whose business is providing technology products and services to others. Threats to our own IT infrastructure can also affect our customers. Customers using our cloud-based services rely on the security of our infrastructure, including hardware and other elements provided by third parties, to ensure the reliability of our services and the protection of their data. Adversaries tend to focus their efforts on the most popular operating systems, programs, and services, including many of ours, and we expect that to continue. In addition, adversaries can attack our customers’ on-premises or cloud environments, sometimes exploiting previously unknown (“zero day”) vulnerabilities, such as occurred in early calendar year 2021 with several of our Exchange Server on-premises products. Vulnerabilities in these or any product can persist even after we have issued security patches if customers have not installed the most recent updates, or if the attackers exploited the vulnerabilities before patching to install additional malware to further compromise customers’ systems. Adversaries will continue to attack customers using our cloud services as customers embrace digital transformation. Adversaries that acquire user account information can use that information to compromise our users’ accounts, including where accounts share the same attributes such as passwords. Inadequate account security practices may also result in unauthorized access, and user activity may result in ransomware or other malicious software impacting a customer’s use of our products or services. We are increasingly incorporating open source software into our products. There may be vulnerabilities in open source software that may make our products susceptible to cyberattacks. Our customers operate complex IT systems with third-party hardware and software from multiple vendors that may include systems acquired over many years. They expect our products and services to support all these systems and products, including those that no longer incorporate the strongest current security advances or standards. As a result, we may not be able to discontinue support in our services for a product, service, standard, or feature solely because a more secure alternative is available. Failure to utilize the most current security advances and standards can increase our customers’ vulnerability to attack. Further, customers of widely varied size and technical sophistication use our technology, and consequently may have limited capabilities and resources to help them adopt and implement state of the art cybersecurity practices and technologies. In addition, we must account for this wide variation of technical sophistication when defining default settings for our products and services, including security default settings, as these settings may limit or otherwise impact other aspects of IT operations and some customers may have limited capability to review and reset these defaults. Cyberattacks such as Solorigate/Nobelium may adversely impact our customers even if our production services are not directly compromised. We are committed to notifying our customers whose systems have been impacted as we become aware and have available information and actions for customers to help protect themselves. We are also committed to providing guidance and support on detection, tracking, and remediation. We may not be able to detect the existence or extent of these attacks for all of our customers or have information on how to detect or track an attack, especially where an attack involves on-premises software such as Exchange Server where we may have no or limited visibility into our customers’ computing environments. Development and deployment of defensive measures To defend against security threats to our internal IT systems, our cloud-based services, and our customers’ systems, we must continuously engineer more secure products and services, enhance security and reliability features, improve the deployment of software updates to address security vulnerabilities in our own products as well as those provided by others, develop mitigation technologies that help to secure customers from attacks even when software updates are not deployed, maintain the digital security infrastructure that protects the integrity of our network, products, and services, and provide security tools such as firewalls, anti-virus software, and advanced security and information about the need to deploy security measures and the impact of doing so. Customers in certain industries such as financial services, health care, and government may have enhanced or specialized requirements to which we must engineer our products and services. 27 PART I Item 1A The cost of measures to protect products and customer-facing services could reduce our operating margins. If we fail to do these things well, actual or perceived security vulnerabilities in our products and services, data corruption issues, or reduced performance could harm our reputation and lead customers to reduce or delay future purchases of products or subscriptions to services, or to use competing products or services. Customers may also spend more on protecting their existing computer systems from attack, which could delay adoption of additional products or services. Customers, and third parties granted access to their systems, may fail to update their systems, continue to run software or operating systems we no longer support, or may fail timely to install or enable security patches, or may otherwise fail to adopt adequate security practices. Any of these could adversely affect our reputation and revenue. Actual or perceived vulnerabilities may lead to claims against us. Our license agreements typically contain provisions that eliminate or limit our exposure to liability, but there is no assurance these provisions will withstand legal challenges. At times, to achieve commercial objectives, we may enter into agreements with larger liability exposure to customers. Our products operate in conjunction with and are dependent on products and components across a broad ecosystem of third parties. If there is a security vulnerability in one of these components, and if there is a security exploit targeting it, we could face increased costs, liability claims, reduced revenue, or harm to our reputation or competitive position. Disclosure and misuse of personal data could result in liability and harm our reputation. As we continue to grow the number, breadth, and scale of our cloud-based offerings, we store and process increasingly large amounts of personal data of our customers and users. The continued occurrence of high-profile data breaches provides evidence of an external environment increasingly hostile to information security. Despite our efforts to improve the security controls across our business groups and geographies, it is possible our security controls over personal data, our training of employees and third parties on data security, and other practices we follow may not prevent the improper disclosure or misuse of customer or user data we or our vendors store and manage. In addition, third parties who have limited access to our customer or user data may use this data in unauthorized ways. Improper disclosure or misuse could harm our reputation, lead to legal exposure to customers or users, or subject us to liability under laws that protect personal data, resulting in increased costs or loss of revenue. Our software products and services also enable our customers and users to store and process personal data on-premises or, increasingly, in a cloud-based environment we host. Government authorities can sometimes require us to produce customer or user data in response to valid legal orders. In the U.S. and elsewhere, we advocate for transparency concerning these requests and appropriate limitations on government authority to compel disclosure. Despite our efforts to protect customer and user data, perceptions that the collection, use, and retention of personal information is not satisfactorily protected could inhibit sales of our products or services and could limit adoption of our cloud-based solutions by consumers, businesses, and government entities. Additional security measures we may take to address customer or user concerns, or constraints on our flexibility to determine where and how to operate datacenters in response to customer or user expectations or governmental rules or actions, may cause higher operating expenses or hinder growth of our products and services. We may not be able to protect information in our products and services from use by others . LinkedIn and other Microsoft products and services contain valuable information and content protected by contractual restrictions or technical measures. In certain cases, we have made commitments to our members and users to limit access to or use of this information. Changes in the law or interpretations of the law may weaken our ability to prevent third parties from scraping or gathering information or content through use of bots or other measures and using it for their own benefit, thus diminishing the value of our products and services. Abuse of our platforms may harm our reputation or user engagement. Advertising, professional, marketplace, and gaming platform abuses For platform products and services that provide content or host ads that come from or can be influenced by third parties, including GitHub, LinkedIn, Microsoft Advertising, Microsoft News, Microsoft Store, Bing, and Xbox, our reputation or user engagement may be negatively affected by activity that is hostile or inappropriate. This activity may come from users impersonating other people or organizations, dissemination of information that may be viewed as misleading or intended to manipulate the opinions of our users, or the use of our products or services that violates our terms of service or otherwise for objectionable or illegal ends. Preventing or responding to these actions may require us to make substantial investments in people and technology and these investments may not be successful, adversely affecting our business and consolidated financial statements. 28 PART I Item 1A Other digital safety abuses Our hosted consumer services as well as our enterprise services may be used to disseminate harmful or illegal content in violation of our terms or applicable law. We may not proactively discover such content due to scale, the limitations of existing technologies, and conflicting legal frameworks. When discovered by users, such content may negatively affect our reputation, our brands, and user engagement. Regulations and other initiatives to make platforms responsible for preventing or eliminating harmful content online have been enacted, and we expect this to continue. We may be subject to enhanced regulatory oversight, civil or criminal liability, or reputational damage if we fail to comply with content moderation regulations, adversely affecting our business and consolidated financial statements. The development of the IoT presents security, privacy, and execution risks. To support the growth of the intelligent cloud and the intelligent edge, we are developing products, services, and technologies to power the IoT, a network of distributed and interconnected devices employing sensors, data, and computing capabilities including AI. The IoT’s great potential also carries substantial risks. IoT products and services may contain defects in design, manufacture, or operation that make them insecure or ineffective for their intended purposes. An IoT solution has multiple layers of hardware, sensors, processors, software, and firmware, several of which we may not develop or control. Each layer, including the weakest layer, can impact the security of the whole system. Many IoT devices have limited interfaces and ability to be updated or patched. IoT solutions may collect large amounts of data, and our handling of IoT data may not satisfy customers or regulatory requirements. IoT scenarios may increasingly affect personal health and safety. If IoT solutions that include our technologies do not work as intended, violate the law, or harm individuals or businesses, we may be subject to legal claims or enforcement actions. These risks, if realized, may increase our costs, damage our reputation or brands, or negatively impact our revenues or margins. Issues in the development and use of AI may result in reputational harm or liability . We are building AI into many of our offerings, including our productivity services, and we are also making first- and third-party AI available for our customers to use in solutions that they build. We expect these elements of our business to grow. We envision a future in which AI operating in our devices, applications, and the cloud helps our customers be more productive in their work and personal lives. As with many innovations, AI presents risks and challenges that could affect its adoption, and therefore our business. AI algorithms may be flawed. Datasets may be insufficient or contain biased information. Ineffective or inadequate AI development or deployment practices by Microsoft or others could result in incidents that impair the acceptance of AI solutions or cause harm to individuals or society. These deficiencies and other failures of AI systems could subject us to competitive harm, regulatory action, legal liability, including under new proposed legislation regulating AI in jurisdictions such as the European Union (“EU”), and brand or reputational harm. Some AI scenarios present ethical issues. If we enable or offer AI solutions that are controversial because of their impact on human rights, privacy, employment, or other social, economic, or political issues, we may experience brand or reputational harm. OPERATIONAL RISKS We may have excessive outages, data losses, and disruptions of our online services if we fail to maintain an adequate operations infrastructure. Our increasing user traffic, growth in services, and the complexity of our products and services demand more computing power. We spend substantial amounts to build, purchase, or lease datacenters and equipment and to upgrade our technology and network infrastructure to handle more traffic on our websites and in our datacenters. Our datacenters depend on predictable energy and networking supplies, the cost or availability of which could be adversely affected by a variety of factors, including the transition to a clean energy economy and geopolitical disruptions. These demands continue to increase as we introduce new products and services and support the growth of existing services such as Bing, Azure, Microsoft Account services, Microsoft 365, Microsoft Teams, Dynamics 365, OneDrive, SharePoint Online, Skype, Xbox, and Outlook.com. We are rapidly growing our business of providing a platform and back-end hosting for services provided by third parties to their end users. Maintaining, securing, and expanding this infrastructure is expensive and complex, and requires development of principles for datacenter builds in geographies with higher safety risks. It requires that we maintain an Internet connectivity infrastructure and storage and compute capacity that is robust and reliable within competitive and regulatory constraints that continue to evolve. Inefficiencies or operational failures, including temporary or permanent loss of customer data, insufficient Internet connectivity, or inadequate storage and compute capacity, could diminish the quality of our products, services, and user experience resulting in contractual liability, claims by customers and other third parties, regulatory actions, damage to our reputation, and loss of current and potential users, subscribers, and advertisers, each of which may adversely impact our consolidated financial statements. 29 PART I Item 1A We may experience quality or supply problems. Our hardware products such as Xbox consoles, Surface devices, and other devices we design and market are highly complex and can have defects in design, manufacture, or associated software. We could incur significant expenses, lost revenue, and reputational harm as a result of recalls, safety alerts, or product liability claims if we fail to prevent, detect, or address such issues through design, testing, or warranty repairs. Our software products and services also may experience quality or reliability problems. The highly sophisticated software we develop may contain bugs and other defects that interfere with their intended operation. Our customers increasingly rely on us for critical business functions and multiple workloads. Many of our products and services are interdependent with one another. Each of these circumstances potentially magnifies the impact of quality or reliability issues. Any defects we do not detect and fix in pre-release testing could cause reduced sales and revenue, damage to our reputation, repair or remediation costs, delays in the release of new products or versions, or legal liability. Although our license agreements typically contain provisions that eliminate or limit our exposure to liability, there is no assurance these provisions will withstand legal challenge. There are limited suppliers for certain device and datacenter components. Our competitors use some of the same suppliers and their demand for hardware components can affect the capacity available to us. If components are delayed or become unavailable, whether because of supplier capacity constraint, industry shortages, legal or regulatory changes that restrict supply sources, or other reasons, we may not obtain timely replacement supplies, resulting in reduced sales or inadequate datacenter capacity. Component shortages, excess or obsolete inventory, or price reductions resulting in inventory adjustments may increase our cost of revenue. Xbox consoles, Surface devices, datacenter servers, and other hardware are assembled in Asia and other geographies that may be subject to disruptions in the supply chain, resulting in shortages that would affect our revenue and operating margins. LEGAL, REGULATORY, AND LITIGATION RISKS Government litigation and regulatory activity relating to competition rules may limit how we design and market our products. As a leading global software and device maker, government agencies closely scrutinize us under U.S. and foreign competition laws. Governments are actively enforcing competition laws and regulations, and this includes scrutiny in potentially large markets such as the EU, the U.S., and China. Some jurisdictions also allow competitors or consumers to assert claims of anti-competitive conduct. U.S. federal and state antitrust authorities have previously brought enforcement actions and continue to scrutinize our business. The European Commission (“the Commission”) closely scrutinizes the design of high-volume Microsoft products and the terms on which we make certain technologies used in these products, such as file formats, programming interfaces, and protocols, available to other companies. Flagship product releases such as Windows can receive significant scrutiny under competition laws. For example, in 2004, the Commission ordered us to create new versions of our Windows operating system that do not include certain multimedia technologies and to provide our competitors with specifications for how to implement certain proprietary Windows communications protocols in their own products. In 2009, the Commission accepted a set of commitments we offered to address the Commission’s concerns relating to competition in web browsing software, including an undertaking to address Commission concerns relating to interoperability. The web browsing commitments expired in 2014. The remaining obligations may limit our ability to innovate in Windows or other products in the future, diminish the developer appeal of the Windows platform, and increase our product development costs. The availability of licenses related to protocols and file formats may enable competitors to develop software products that better mimic the functionality of our products, which could hamper sales of our products. Our portfolio of first-party devices continues to grow; at the same time our OEM partners offer a large variety of devices for our platforms. As a result, increasingly we both cooperate and compete with our OEM partners, creating a risk that we fail to do so in compliance with competition rules. Regulatory scrutiny in this area may increase. Certain foreign governments, particularly in China and other countries in Asia, have advanced arguments under their competition laws that exert downward pressure on royalties for our intellectual property. 30 PART I Item 1A Government regulatory actions and court decisions such as these may result in fines or hinder our ability to provide the benefits of our software to consumers and businesses, reducing the attractiveness of our products and the revenue that come s from them. New competition law actions could be initiated, potentially using previous actions as precedent. The outcome of such actions, or steps taken to avoid them, could adversely affect us in a variety of ways, including: • We may have to choose between withdrawing products from certain geographies to avoid fines or designing and developing alternative versions of those products to comply with government rulings, which may entail a delay in a product release and removing functionality that customers want or on which developers rely. • We may be required to make available licenses to our proprietary technologies on terms that do not reflect their fair market value or do not protect our associated intellectual property. • We are subject to a variety of ongoing commitments because of court or administrative orders, consent decrees, or other voluntary actions we have taken. If we fail to comply with these commitments, we may incur litigation costs and be subject to substantial fines or other remedial actions. • Our ability to realize anticipated Windows post-sale monetization opportunities may be limited. • Regulatory scrutiny may inhibit our ability to consummate acquisitions or impose conditions that reduce the ultimate value of such transactions. Our global operations subject us to potential consequences under anti-corruption, trade, and other laws and regulations. The Foreign Corrupt Practices Act (“FCPA”) and other anti-corruption laws and regulations (“Anti-Corruption Laws”) prohibit corrupt payments by our employees, vendors, or agents, and the accounting provisions of the FCPA require us to maintain accurate books and records and adequate internal controls. From time to time, we receive inquiries from authorities in the U.S. and elsewhere which may be based on reports from employees and others about our business activities outside the U.S. and our compliance with Anti-Corruption Laws. Periodically, we receive such reports directly and investigate them, and also cooperate with investigations by U.S. and foreign law enforcement authorities. An example of increasing international regulatory complexity is the EU Whistleblower Directive, initiated in 2021, which may present compliance challenges to the extent it is implemented in different forms by EU member states. Most countries in which we operate also have competition laws that prohibit competitors from colluding or otherwise attempting to reduce competition between themselves. While we devote substantial resources to our U.S. and international compliance programs and have implemented policies, training, and internal controls designed to reduce the risk of corrupt payments and collusive activity, our employees, vendors, or agents may violate our policies. Our failure to comply with Anti-Corruption Laws or competition laws could result in significant fines and penalties, criminal sanctions against us, our officers, or our employees, prohibitions on the conduct of our business, and damage to our reputation. Increasing trade laws, policies, sanctions, and other regulatory requirements also affect our operations in and outside the U.S. relating to trade and investment. Economic sanctions in the U.S., the EU, and other countries prohibit most business with restricted entities or countries such as Crimea, Cuba, Iran, North Korea, and Syria. U.S. export controls restrict Microsoft from offering many of its products and services to, or making investments in, certain entities in specified countries. U.S. import controls restrict us from integrating certain information and communication technologies into our supply chain and allow for government review of transactions involving information and communications technology from countries determined to be foreign adversaries. Periods of intense diplomatic or armed conflict, such as the ongoing conflict in Ukraine, may result in (1) new and rapidly evolving sanctions and trade restrictions, which may impair trade with sanctioned individuals and countries, and (2) negative impacts to regional trade ecosystems among our customers, partners, and us. Non-compliance with sanctions as well as general ecosystem disruptions could result in reputational harm, operational delays, monetary fines, loss of revenues, increased costs, loss of export privileges, or criminal sanctions. 31 PART I Item 1A Other regulatory areas that may apply to our products and online services offerings include requirements related to user privacy, telecommunications, data storage and protection, advertising, and online content. For example, some regulators are taking the position that our offerings such as Microsoft Teams and Skype are covered by existing laws regulating telecommunications services, and some new laws , including EU Member State laws under the European Electronic Communications Code, are defining more of our services as regulated telecommunications services. This trend may continue and will result in these offerings being subjected to additional data protection, security, and law enforcement surveillance obligations. Regulators may assert that our collection, use, and management of customer data and other information is inconsistent with their laws and regulations , including laws that apply to the tracking of users via technology such as cookies . Legislative or regulatory action relating to cybersecurity requirements may increase the costs to develop, implement, or secure our products and services. Legislative and regulatory action is emerging in the area s of AI and content moderation, which could increase costs or restrict opportunity. Applying these laws and regulations to our business is often unclear, subject to change over time, and sometimes may conflict from jurisdiction to jurisdiction. Additionally, these laws and governments’ approach to their enforcement, and our products and services, are continuing to evolve. Compliance with these types of regulation may involve significant costs or require changes in products or business practices that result in reduced revenue. Noncompliance could result in the imposition of penalties or orders we stop the alleged noncompliant activity. We strive to empower all people and organizations to achieve more, and accessibility of our products is an important aspect of this goal. There is increasing pressure from advocacy groups, regulators, competitors, customers, and other stakeholders to make technology more accessible. If our products do not meet customer expectations or global accessibility requirements, we could lose sales opportunities or face regulatory or legal actions. Laws and regulations relating to the handling of personal data may impede the adoption of our services or result in increased costs, legal claims, fines against us, or reputational damage. The growth of our Internet- and cloud-based services internationally relies increasingly on the movement of data across national boundaries. Legal requirements relating to the collection, storage, handling, and transfer of personal data continue to evolve. For example, in July 2020 the Court of Justice of the EU invalidated a framework called Privacy Shield for companies to transfer data from EU member states to the United States. This ruling continues to generate uncertainty about the legal requirements for data transfers from the EU under other legal mechanisms and has resulted in some EU data protection authorities blocking the use of U.S.-based services that involve the transfer of data to the U.S. The U.S. and the EU in March 2022 agreed in principle on a replacement framework for the Privacy Shield, called the Trans-Atlantic Data Privacy Framework. A failure of the U.S. and EU to finalize the Trans-Atlantic Data Privacy Framework could compound that uncertainty and result in additional blockages of data transfers. Potential new rules and restrictions on the flow of data across borders could increase the cost and complexity of delivering our products and services in some markets. For example, the EU General Data Protection Regulation (“GDPR”) applies to all of our activities conducted from an establishment in the EU or related to products and services offered in the EU, imposes a range of compliance obligations regarding the handling of personal data. More recently, the EU has been developing new requirements related to the use of data, including in the Digital Markets Act, the Digital Services Act, and the Data Act, that will add additional rules and restriction on the use of data in our products and services. Engineering efforts to build and maintain capabilities to facilitate compliance with these laws involve substantial expense and the diversion of engineering resources from other projects. We might experience reduced demand for our offerings if we are unable to engineer products that meet our legal duties or help our customers meet their obligations under the GDPR and other data regulations, or if our implementation to comply with the GDPR makes our offerings less attractive. Compliance with these obligations depends in part on how particular regulators interpret and apply them. If we fail to comply, or if regulators assert we have failed to comply (including in response to complaints made by customers), it may lead to regulatory enforcement actions, which can result in monetary penalties (of up to 4% of worldwide revenue in the case of GDPR), private lawsuits, reputational damage, blockage of international data transfers, and loss of customers. The highest fines assessed under GDPR have recently been increasing, especially against large technology companies. Jurisdictions around the world, such as China, India, and states in the U.S. have adopted, or are considering adopting or expanding, laws and regulations imposing obligations regarding the handling or transfer of personal data. 32 PART I Item 1A The Company’s investment in gaining insights from data is becoming central to the value of the services we deliver to customers, to our operational efficiency and key opportunities in monetization, customer perceptions of quality, and operational efficiency. Our ability to use data in this way may be constrained by regulatory developments that impede realizing the expected return from this investment. Ongoing legal analyses, reviews, and inquiries by regulators of Microsoft practices, or relevant practices of other organizations, may result in burdensome or inconsistent requirements, including data sovereignty and localization requirements, affecting the location, movement, collection, and use of our customer and internal employee data as well as the management of that data. Compliance with applicable laws and regulations regarding personal data may require changes in services, business practices, or internal systems that result in increased costs, lower revenue, reduced efficiency, or greater difficulty in competing with foreign-based firms. Compliance with data regulations might limit our ability to innovate or offer certain features and functionality in some jurisdictions where we operate. Failure to comply with existing or new rules may result in significant penalties or orders to stop the alleged noncompliant activity, as well as negative publicity and diversion of management time and effort. We have claims and lawsuits against us that may result in adverse outcomes. We are subject to a variety of claims and lawsuits. These claims may arise from a wide variety of business practices and initiatives, including major new product releases such as Windows, significant business transactions, warranty or product claims, and employment practices. Adverse outcomes in some or all of these claims may result in significant monetary damages or injunctive relief that could adversely affect our ability to conduct our business. The litigation and other claims are subject to inherent uncertainties and management’s view of these matters may change in the future. A material adverse impact in our consolidated financial statements could occur for the period in which the effect of an unfavorable outcome becomes probable and reasonably estimable. Our business with government customers may present additional uncertainties. We derive substantial revenue from government contracts. Government contracts generally can present risks and challenges not present in private commercial agreements. For instance, we may be subject to government audits and investigations relating to these contracts, we could be suspended or debarred as a governmental contractor, we could incur civil and criminal fines and penalties, and under certain circumstances contracts may be rescinded. Some agreements may allow a government to terminate without cause and provide for higher liability limits for certain losses. Some contracts may be subject to periodic funding approval, reductions, or delays which could adversely impact public-sector demand for our products and services. These events could negatively impact our results of operations, financial condition, and reputation. We may have additional tax liabilities. We are subject to income taxes in the U.S. and many foreign jurisdictions. Significant judgment is required in determining our worldwide provision for income taxes. In the course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. For example, compliance with the 2017 United States Tax Cuts and Jobs Act (“TCJA”) and possible future legislative changes may require the collection of information not regularly produced within the Company, the use of estimates in our consolidated financial statements, and the exercise of significant judgment in accounting for its provisions. As regulations and guidance evolve with respect to the TCJA or possible future legislative changes, and as we gather more information and perform more analysis, our results may differ from previous estimates and may materially affect our consolidated financial statements. We regularly are under audit by tax authorities in different jurisdictions. Although we believe that our provision for income taxes and our tax estimates are reasonable, tax authorities may disagree with certain positions we have taken. In addition, economic and political pressures to increase tax revenue in various jurisdictions may make resolving tax disputes favorably more difficult. We are currently under Internal Revenue Service audit for prior tax years, with the primary unresolved issues relating to transfer pricing. The final resolution of those audits, and other audits or litigation, may differ from the amounts recorded in our consolidated financial statements and may materially affect our consolidated financial statements in the period or periods in which that determination is made. We earn a significant amount of our operating income outside the U.S. A change in the mix of earnings and losses in countries with differing statutory tax rates, changes in our business or structure, or the expiration of or disputes about certain tax agreements in a particular country may result in higher effective tax rates for the Company. In addition, changes in U.S. federal and state or international tax laws applicable to corporate multinationals, other fundamental law changes currently being considered by many countries, including in the U.S., and changes in taxing jurisdictions’ administrative interpretations, decisions, policies, and positions may materially adversely impact our consolidated financial statements. 33 PART I Item 1A INTELLECTUAL PROPERTY RISKS We may not be able to protect our source code from copying if there is an unauthorized disclosure. Source code, the detailed program commands for our operating systems and other software programs, is critical to our business. Although we license portions of our application and operating system source code to several licensees, we take significant measures to protect the secrecy of large portions of our source code. If our source code leaks, we might lose future trade secret protection for that code. It may then become easier for third parties to compete with our products by copying functionality, which could adversely affect our revenue and operating margins. Unauthorized disclosure of source code also could increase the security risks described elsewhere in these risk factors. Legal changes, our evolving business model, piracy, and other factors may decrease the value of our intellectual property. Protecting our intellectual property rights and combating unlicensed copying and use of our software and other intellectual property on a global basis is difficult. While piracy adversely affects U.S. revenue, the impact on revenue from outside the U.S. is more significant, particularly countries in which the legal system provides less protection for intellectual property rights. Our revenue in these markets may grow more slowly than the underlying device market. Similarly, the absence of harmonized patent laws makes it more difficult to ensure consistent respect for patent rights. Throughout the world, we educate users about the benefits of licensing genuine products and obtaining indemnification benefits for intellectual property risks, and we educate lawmakers about the advantages of a business climate where intellectual property rights are protected. Reductions in the legal protection for software intellectual property rights could adversely affect revenue. We expend significant resources to patent the intellectual property we create with the expectation that we will generate revenues by incorporating that intellectual property in our products or services or, in some instances, by licensing or cross-licensing our patents to others in return for a royalty and/or increased freedom to operate. Changes in the law may continue to weaken our ability to prevent the use of patented technology or collect revenue for licensing our patents. These include legislative changes and regulatory actions that make it more difficult to obtain injunctions, and the increasing use of legal process to challenge issued patents. Similarly, licensees of our patents may fail to satisfy their obligations to pay us royalties or may contest the scope and extent of their obligations. The royalties we can obtain to monetize our intellectual property may decline because of the evolution of technology, price changes in products using licensed patents, greater value from cross-licensing, or the difficulty of discovering infringements. Finally, our increasing engagement with open source software will also cause us to license our intellectual property rights broadly in certain situations and may negatively impact revenue. Third parties may claim we infringe their intellectual property rights. From time to time, others claim we infringe their intellectual property rights. The number of these claims may grow because of constant technological change in the markets in which we compete, the extensive patent coverage of existing technologies, the rapid rate of issuance of new patents, and our offering of first-party devices, such as Surface. To resolve these claims, we may enter into royalty and licensing agreements on terms that are less favorable than currently available, stop selling or redesign affected products or services, or pay damages to satisfy indemnification commitments with our customers. These outcomes may cause operating margins to decline. Besides money damages, in some jurisdictions plaintiffs can seek injunctive relief that may limit or prevent importing, marketing, and selling our products or services that have infringing technologies. In some countries, such as Germany, an injunction can be issued before the parties have fully litigated the validity of the underlying patents. We have paid significant amounts to settle claims related to the use of technology and intellectual property rights and to procure intellectual property rights as part of our strategy to manage this risk, and may continue to do so. GENERAL RISKS If our reputation or our brands are damaged, our business and operating results may be harmed . Our reputation and brands are globally recognized and are important to our business. Our reputation and brands affect our ability to attract and retain consumer, business, and public-sector customers. There are numerous ways our reputation or brands could be damaged. These include product safety or quality issues, our environmental impact and sustainability, supply chain practices, or human rights record. We may experience backlash from customers, government entities, advocacy groups, employees, and other stakeholders that disagree with our product offering decisions or public policy positions. Damage to our reputation or our brands may occur from, among other things: • The introduction of new features, products, services, or terms of service that customers, users, or partners do not like. 34 PART I Item 1A • Public scrutiny of our decisions regarding user privacy, data practices, or content. • Data security breaches, compliance failures, or actions of partners or individual employees. The proliferation of social media may increase the likelihood, speed, and magnitude of negative brand events. If our brands or reputation are damaged, it could negatively impact our revenues or margins, or ability to attract the most highly qualified employees. Adverse economic or market conditions may harm our business. Worsening economic conditions, including inflation, recession, pandemic, or other changes in economic conditions, may cause lower IT spending and adversely affect our revenue. If demand for PCs, servers, and other computing devices declines, or consumer or business spending for those products declines, our revenue will be adversely affected. Our product distribution system relies on an extensive partner and retail network. OEMs building devices that run our software have also been a significant means of distribution. The impact of economic conditions on our partners, such as the bankruptcy of a major distributor, OEM, or retailer, could cause sales channel disruption. Challenging economic conditions also may impair the ability of our customers to pay for products and services they have purchased. As a result, allowances for doubtful accounts and write-offs of accounts receivable may increase. We maintain an investment portfolio of various holdings, types, and maturities. These investments are subject to general credit, liquidity, market, and interest rate risks, which may be exacerbated by market downturns or events that affect global financial markets. A significant part of our investment portfolio comprises U.S. government securities. If global financial markets decline for long periods, or if there is a downgrade of the U.S. government credit rating due to an actual or threatened default on government debt, our investment portfolio may be adversely affected and we could determine that more of our investments have experienced a decline in fair value, requiring impairment charges that could adversely affect our consolidated financial statements. Catastrophic events or geopolitical conditions may disrupt our business. A disruption or failure of our systems or operations because of a major earthquake, weather event, cyberattack, terrorist attack, pandemic, or other catastrophic event could cause delays in completing sales, providing services, or performing other critical functions. Our corporate headquarters, a significant portion of our research and development activities, and certain other essential business operations are in the Seattle, Washington area, and we have other business operations in the Silicon Valley area of California, both of which are seismically active regions. A catastrophic event that results in the destruction or disruption of any of our critical business or IT systems, or the infrastructure or systems they rely on, such as power grids, could harm our ability to conduct normal business operations. Providing our customers with more services and solutions in the cloud puts a premium on the resilience of our systems and strength of our business continuity management plans and magnifies the potential impact of prolonged service outages in our consolidated financial statements. Abrupt political change, terrorist activity, and armed conflict, such as the ongoing conflict in Ukraine, pose a risk of general economic disruption in affected countries, which may increase our operating costs and negatively impact our ability to sell to and collect from customers in affected markets. These conditions also may add uncertainty to the timing and budget for technology investment decisions by our customers and may cause supply chain disruptions for hardware manufacturers. Geopolitical change may result in changing regulatory systems and requirements and market interventions that could impact our operating strategies, access to national, regional, and global markets, hiring, and profitability. Geopolitical instability may lead to sanctions and impact our ability to do business in some markets or with some public-sector customers. Any of these changes may negatively impact our revenues. The occurrence of regional epidemics or a global pandemic such as COVID-19 may adversely affect our operations, financial condition, and results of operations. The COVID-19 pandemic has had widespread, rapidly evolving, and unpredictable impacts on global society, economies, financial markets, and business practices. The extent to which global pandemics impact our business going forward will depend on factors such as the duration and scope of the pandemic; governmental, business, and individuals' actions in response to the pandemic; and the impact on economic activity including the possibility of recession or financial market instability. 35 PART I Item 1A Measures to contain a global pandemic may intensify other risks described in these Risk Factors. Any of these measures may adversely impact our ability to: • Maintain our operations infrastructure, including the reliability and adequate capacity of cloud services. • Satisfy our contractual and regulatory compliance obligations as we adapt to changing usage patterns, such as through datacenter load balancing. • Ensure a high-quality and consistent supply chain and manufacturing operations for our hardware devices and datacenter operations. • Effectively manage our international operations through changes in trade practices and policies. • Hire and deploy people where we most need them. • Sustain the effectiveness and productivity of our operations including our sales, marketing, engineering, and distribution functions. We may incur increased costs to effectively manage these aspects of our business. If we are unsuccessful it may adversely impact our revenues, cash flows, market share growth, and reputation. The long-term effects of climate change on the global economy and the IT industry in particular are unclear. Environmental regulations or changes in the supply, demand or available sources of energy or other resources may affect the availability or cost of goods and services, including natural resources, necessary to run our business. Changes in climate where we operate may increase the costs of powering and cooling computer hardware we use to develop software and provide cloud-based services. Our global business exposes us to operational and economic risks. Our customers are located throughout the world and a significant part of our revenue comes from international sales. The global nature of our business creates operational, economic, and geopolitical risks. Our results of operations may be affected by global, regional, and local economic developments, monetary policy, inflation, and recession, as well as political and military disputes. In addition, our international growth strategy includes certain markets, the developing nature of which presents several risks, including deterioration of social, political, labor, or economic conditions in a country or region, and difficulties in staffing and managing foreign operations. Emerging nationalist and protectionist trends and concerns about human rights and political expression in specific countries may significantly alter the trade and commercial environments. Changes to trade policy or agreements as a result of populism, protectionism, or economic nationalism may result in higher tariffs, local sourcing initiatives, and non-local sourcing restrictions, export controls, investment restrictions, or other developments that make it more difficult to sell our products in foreign countries. Disruptions of these kinds in developed or emerging markets could negatively impact demand for our products and services or increase operating costs. Although we hedge a portion of our international currency exposure, significant fluctuations in foreign exchange rates between the U.S. dollar and foreign currencies may adversely affect our results of operations. Our business depends on our ability to attract and retain talented employees. Our business is based on successfully attracting and retaining talented employees representing diverse backgrounds, experiences, and skill sets. The market for highly skilled workers and leaders in our industry is extremely competitive. Maintaining our brand and reputation, as well as a diverse and inclusive work environment that enables all our employees to thrive, are important to our ability to recruit and retain employees. We are also limited in our ability to recruit internationally by restrictive domestic immigration laws. Changes to U.S. immigration policies that restrain the flow of technical and professional talent may inhibit our ability to adequately staff our research and development efforts. If we are less successful in our recruiting efforts, or if we cannot retain highly skilled workers and key leaders, our ability to develop and deliver successful products and services may be adversely affected. Effective succession planning is also important to our long-term success. Failure to ensure effective transfer of knowledge and smooth transitions involving key employees could hinder our strategic planning and execution. How employment-related laws are interpreted and applied to our workforce practices may result in increased operating costs and less flexibility in how we meet our workforce needs. Our global workforce is primarily non-unionized, but we have several unions and works councils outside of the United States. In the U.S., there has been a general increase in workers exercising their right to form or join a union. While Microsoft has not received such petitions in the U.S., the unionization of significant employee populations could result in higher costs and other operational changes necessary to respond to changing conditions and to establish new relationships with worker representatives. 36 PART I Item 1B, 2, 3, 4 ITEM 1B. UNRESOLVED STAFF COMMENTS We have received no written comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our fiscal year 2022 that remain unresolved. ITEM 2. PROPERTIES Our corporate headquarters are located in Redmond, Washington. We have approximately 15 million square feet of space located in King County, Washington that is used for engineering, sales, marketing, and operations, among other general and administrative purposes. These facilities include approximately 10 million square feet of owned space situated on approximately 520 acres of land we own at our corporate headquarters, and approximately 5 million square feet of space we lease. In addition, we own and lease space domestically that includes office and datacenter space. We also own and lease facilities internationally for datacenters, research and development, and other operations. The largest owned properties include space in the following locations: China, India, Ireland, the Netherlands, and Singapore. The largest leased properties include space in the following locations: Australia, Canada, China, France, Germany, India, Ireland, Israel, Japan, the Netherlands, and the United Kingdom. In addition to the above locations, we have various product development facilities, both domestically and internationally, as described under Research and Development (Part I, Item 1 of this Form 10-K). The table below shows a summary of the square footage of our office, datacenter, and other facilities owned and leased domestically and internationally as of June 30, 2022: (Square feet in millions) Location Owned Leased Total U.S. 25 19 44 International 8 21 29 Total 33 40 73 ITEM 3. LEGAL PROCEEDINGS Refer to Note 15 – Contingencies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for information regarding legal proceedings in which we are involved. ITEM 4. MINE SAFETY DISCLOSURES Not applicable. 37 PART II Item 5 PART II ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY SECURITIES MARKET AND STOCKHOLDERS Our common stock is traded on the NASDAQ Stock Market under the symbol MSFT. On July 25, 2022, there were 86,465 registered holders of record of our common stock. SHARE REPURCHASES AND DIVIDENDS Following are our monthly share repurchases for the fourth quarter of fiscal year 2022: Period Total Number of Shares Purchased Average Price Paid Per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares That May Yet Be Purchased Under the Plans or Programs (In millions) April 1, 2022 – April 30, 2022 9,124,963 $ 289.34 9,124,963 $ 45,869 May 1, 2022 – May 31, 2022 9,809,727 265.95 9,809,727 43,260 June 1, 2022 – June 30, 2022 9,832,841 259.42 9,832,841 40,709 28,767,531 28,767,531 All share repurchases were made using cash resources. Our share repurchases may occur through open market purchases or pursuant to a Rule 10b5-1 trading plan. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. Our Board of Directors declared the following dividends during the fourth quarter of fiscal year 2022: Declaration Date Record Date Payment Date Dividend Per Share Amount (In millions) June 14, 2022 August 18, 2022 September 8, 2022 $ 0.62 $ 4,627 We returned $12.4 billion to shareholders in the form of share repurchases and dividends in the fourth quarter of fiscal year 2022. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion regarding share repurchases and dividends. 38 PART II Item 6 ITEM 6. [RESERVED] 39 PART II Item 7 ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help the reader understand the results of operations and financial condition of Microsoft Corporation. MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying Notes to Financial Statements (Part II, Item 8 of this Form 10-K). This section generally discusses the results of our operations for the year ended June 30, 2022 compared to the year ended June 30, 2021. For a discussion of the year ended June 30, 2021 compared to the year ended June 30, 2020, please refer to Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the year ended June 30, 2021. OVERVIEW Microsoft is a technology company whose mission is to empower every person and every organization on the planet to achieve more. We strive to create local opportunity, growth, and impact in every country around the world. Our platforms and tools help drive small business productivity, large business competitiveness, and public-sector efficiency. They also support new startups, improve educational and health outcomes, and empower human ingenuity. We generate revenue by offering a wide range of cloud-based and other services to people and businesses; licensing and supporting an array of software products; designing, manufacturing, and selling devices; and delivering relevant online advertising to a global audience. Our most significant expenses are related to compensating employees; designing, manufacturing, marketing, and selling our products and services; datacenter costs in support of our cloud-based services; and income taxes. Highlights from fiscal year 2022 compared with fiscal year 2021 included: • Microsoft Cloud (formerly commercial cloud) revenue increased 32% to $91.2 billion. • Office Commercial products and cloud services revenue increased 13% driven by Office 365 Commercial growth of 18%. • Office Consumer products and cloud services revenue increased 11% and Microsoft 365 Consumer subscribers grew to 59.7 million. • LinkedIn revenue increased 34%. • Dynamics products and cloud services revenue increased 25% driven by Dynamics 365 growth of 39%. • Server products and cloud services revenue increased 28% driven by Azure and other cloud services growth of 45%. • Windows original equipment manufacturer licensing (“Windows OEM”) revenue increased 11%. • Windows Commercial products and cloud services revenue increased 11%. • Xbox content and services revenue increased 3%. • Search and news advertising revenue excluding traffic acquisition costs increased 27%. • Surface revenue increased 3%. On March 4, 2022, we completed our acquisition of Nuance Communications, Inc. (“Nuance”) for a total purchase price of $18.8 billion, consisting primarily of cash. Nuance is a cloud and artificial intelligence (“AI”) software provider with healthcare and enterprise AI experience, and the acquisition will build on our industry-specific cloud offerings. The financial results of Nuance have been included in our consolidated financial statements since the date of the acquisition. Nuance is reported as part of our Intelligent Cloud segment. Refer to Note 8 – Business Combinations of the Notes to Financial Statements ( Part II, Item 8 of this Form 10-K ) for further discussion. Industry Trends Our industry is dynamic and highly competitive, with frequent changes in both technologies and business models. Each industry shift is an opportunity to conceive new products, new technologies, or new ideas that can further transform the industry and our business. At Microsoft, we push the boundaries of what is possible through a broad range of research and development activities that seek to identify and address the changing demands of customers and users, industry trends, and competitive forces. 40 PART II Item 7 Economic Conditions, Challenges, and Risks The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user’s choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one’s career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our devices are primarily manufactured by third-party contract manufacturers, some of which contain certain components for which there are very few qualified suppliers. For these components, we have limited near-term flexibility to use other manufacturers if a current vendor becomes unavailable or is unable to meet our requirements. Extended disruptions at these suppliers and/or manufacturers could lead to a similar disruption in our ability to manufacture devices on time to meet consumer demand. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than the U.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Fluctuations in the U.S. dollar relative to certain foreign currencies did not have a material impact on reported revenue or expenses from our international operations in fiscal year 2022. Refer to Risk Factors (Part I, Item 1A of this Form 10-K) for a discussion of these factors and other risks. Seasonality Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period. Reportable Segments We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. Additional information on our reportable segments is contained in Note 19 – Segment Information and Geographic Data of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Metrics We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). Financial metrics are calculated based on financial results prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”), and growth comparisons relate to the corresponding period of last fiscal year. In the first quarter of fiscal year 2022, we made updates to the presentation and method of calculation for certain metrics, most notably changes to incorporate all current and anticipated revenue streams within our Office Consumer and Server products and cloud services metrics and changes to align with how we manage our Windows OEM and Search and news advertising businesses. None of these changes had a material impact on previously reported amounts in our MD&A. 41 PART II Item 7 In the third quarter of fiscal year 2022, we completed our acquisition of Nuance. Nuance is included in all commercial metrics and our Server products and cloud services revenue growth metric. Azure and other cloud services revenue includes Nuance cloud services, and Server products revenue includes Nuance on-premises offerings. Commercial Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance. Commercial remaining performance obligation Commercial portion of revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods Microsoft Cloud revenue Revenue from Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties Microsoft Cloud gross margin percentage Gross margin percentage for our Microsoft Cloud business Productivity and Business Processes and Intelligent Cloud Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends. Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and cloud services (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Microsoft Viva Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud services, including Microsoft 365 Consumer subscriptions, Office licensed on-premises, and other Office services Office 365 Commercial seat growth The number of Office 365 Commercial seats at end of period where seats are paid users covered by an Office 365 Commercial subscription Microsoft 365 Consumer subscribers The number of Microsoft 365 Consumer subscribers at end of period Dynamics products and cloud services revenue growth Revenue from Dynamics products and cloud services, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM, Customer Insights, Power Apps, and Power Automate; and on-premises ERP and CRM applications LinkedIn revenue growth Revenue from LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions Server products and cloud services revenue growth Revenue from Server products and cloud services, including Azure and other cloud services; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and Nuance and GitHub 42 PART II Item 7 More Personal Computing Metrics related to our More Personal Computing segment assess the performance of key lines of business within this segment. These metrics provide strategic product insights which allow us to assess the performance across our commercial and consumer businesses. As we have diversity of target audiences and sales motions within the Windows business, we monitor metrics that are reflective of those varying motions. Windows OEM revenue growth Revenue from sales of Windows Pro and non-Pro licenses sold through the OEM channel Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and cloud services, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings Surface revenue growth Revenue from Surface devices and accessories Xbox content and services revenue growth Revenue from Xbox content and services, comprising first- and third-party content (including games and in-game content), Xbox Game Pass and other subscriptions, Xbox Cloud Gaming, third-party disc royalties, advertising, and other cloud services Search and news advertising revenue, excluding TAC, growth Revenue from search and news advertising excluding traffic acquisition costs (“TAC”) paid to Bing Ads network publishers and news partners SUMMARY RESULTS OF OPERATIONS (In millions, except percentages and per share amounts) 2022 2021 Percentage Change Revenue $ 198,270 $ 168,088 18% Gross margin 135,620 115,856 17% Operating income 83,383 69,916 19% Net income 72,738 61,271 19% Diluted earnings per share 9.65 8.05 20% Adjusted net income (non-GAAP) 69,447 60,651 15% Adjusted diluted earnings per share (non-GAAP) 9.21 7.97 16% Adjusted net income and adjusted diluted earnings per share (“EPS”) are non-GAAP financial measures which exclude the net income tax benefit related to transfer of intangible properties in the first quarter of fiscal year 2022 and the net income tax benefit related to an India Supreme Court decision on withholding taxes in the third quarter of fiscal year 2021 . Refer to the Non-GAAP Financial Measures section below for a reconciliation of our financial results reported in accordance with GAAP to non-GAAP financial results. See Note 12 – Income Taxes of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Fiscal Year 2022 Compared with Fiscal Year 2021 Revenue increased $30.2 billion or 18% driven by growth across each of our segments. Intelligent Cloud revenue increased driven by Azure and other cloud services. Productivity and Business Processes revenue increased driven by Office 365 Commercial and LinkedIn. More Personal Computing revenue increased driven by Search and news advertising and Windows. Cost of revenue increased $10.4 billion or 20% driven by growth in Microsoft Cloud. Gross margin increased $19.8 billion or 17% driven by growth across each of our segments. • Gross margin percentage decreased slightly. Excluding the impact of the fiscal year 2021 change in accounting estimate for the useful lives of our server and network equipment, gross margin percentage increased 1 point driven by improvement in Productivity and Business Processes. • Microsoft Cloud gross margin percentage decreased slightly to 70%. Excluding the impact of the change in accounting estimate, Microsoft Cloud gross margin percentage increased 3 points driven by improvement across our cloud services, offset in part by sales mix shift to Azure and other cloud services. 43 PART II Item 7 Operating expenses increased $ 6 .3 billion or 14 % driven by investments in cloud engineering , LinkedIn, Gaming, and commercial sales . Key changes in operating expenses were: • Research and development expenses increased $3.8 billion or 18% driven by investments in cloud engineering, Gaming, and LinkedIn. • Sales and marketing expenses increased $1.7 billion or 8% driven by investments in commercial sales and LinkedIn. Sales and marketing included a favorable foreign currency impact of 2%. • General and administrative expenses increased $793 million or 16% driven by investments in corporate functions. Operating income increased $13.5 billion or 19% driven by growth across each of our segments. Current year net income and diluted EPS were positively impacted by the net tax benefit related to the transfer of intangible properties, which resulted in an increase to net income and diluted EPS of $3.3 billion and $0.44, respectively. Prior year net income and diluted EPS were positively impacted by the net tax benefit related to the India Supreme Court decision on withholding taxes, which resulted in an increase to net income and diluted EPS of $620 million and $0.08, respectively. Gross margin and operating income both included an unfavorable foreign currency impact of 2%. SEGMENT RESULTS OF OPERATIONS (In millions, except percentages) 2022 2021 Percentage Change Revenue Productivity and Business Processes $ 63,364 $ 53,915 18% Intelligent Cloud 75,251 60,080 25% More Personal Computing 59,655 54,093 10% Total $ 198,270 $ 168,088 18% Operating Income Productivity and Business Processes $ 29,687 $ 24,351 22% Intelligent Cloud 32,721 26,126 25% More Personal Computing 20,975 19,439 8% Total $ 83,383 $ 69,916 19% Reportable Segments Fiscal Year 2022 Compared with Fiscal Year 2021 Productivity and Business Processes Revenue increased $9.4 billion or 18%. • Office Commercial products and cloud services revenue increased $4.4 billion or 13%. Office 365 Commercial revenue grew 18% driven by seat growth of 14%, with continued momentum in small and medium business and frontline worker offerings, as well as growth in revenue per user. Office Commercial products revenue declined 22% driven by continued customer shift to cloud offerings. • Office Consumer products and cloud services revenue increased $641 million or 11% driven by Microsoft 365 Consumer subscription revenue. Microsoft 365 Consumer subscribers grew 15% to 59.7 million. • LinkedIn revenue increased $3.5 billion or 34% driven by a strong job market in our Talent Solutions business and advertising demand in our Marketing Solutions business. • Dynamics products and cloud services revenue increased 25% driven by Dynamics 365 growth of 39%. 44 PART II Item 7 Operating income increased $5.3 billion or 22%. • Gross margin increased $7.3 billion or 17% driven by growth in Office 365 Commercial and LinkedIn. Gross margin percentage was relatively unchanged. Excluding the impact of the change in accounting estimate, gross margin percentage increased 2 points driven by improvement across all cloud services. • Operating expenses increased $2.0 billion or 11% driven by investments in LinkedIn and cloud engineering. Gross margin and operating income both included an unfavorable foreign currency impact of 2%. Intelligent Cloud Revenue increased $15.2 billion or 25%. • Server products and cloud services revenue increased $14.7 billion or 28% driven by Azure and other cloud services. Azure and other cloud services revenue grew 45% driven by growth in our consumption-based services. Server products revenue increased 5% driven by hybrid solutions, including Windows Server and SQL Server running in multi-cloud environments. • Enterprise Services revenue increased $464 million or 7% driven by growth in Enterprise Support Services. Operating income increased $6.6 billion or 25%. • Gross margin increased $9.4 billion or 22% driven by growth in Azure and other cloud services. Gross margin percentage decreased. Excluding the impact of the change in accounting estimate, gross margin percentage was relatively unchanged driven by improvement in Azure and other cloud services, offset in part by sales mix shift to Azure and other cloud services. • Operating expenses increased $2.8 billion or 16% driven by investments in Azure and other cloud services. Revenue and operating income included an unfavorable foreign currency impact of 2% and 3%, respectively. More Personal Computing Revenue increased $5.6 billion or 10%. • Windows revenue increased $2.3 billion or 10% driven by growth in Windows OEM and Windows Commercial. Windows OEM revenue increased 11% driven by continued strength in the commercial PC market, which has higher revenue per license. Windows Commercial products and cloud services revenue increased 11% driven by demand for Microsoft 365. • Search and news advertising revenue increased $2.3 billion or 25%. Search and news advertising revenue excluding traffic acquisition costs increased 27% driven by higher revenue per search and search volume. • Gaming revenue increased $860 million or 6% on a strong prior year comparable that benefited from Xbox Series X|S launches and stay-at-home scenarios, driven by growth in Xbox hardware and Xbox content and services. Xbox hardware revenue increased 16% due to continued demand for Xbox Series X|S. Xbox content and services revenue increased 3% driven by growth in Xbox Game Pass subscriptions and first-party content, offset in part by a decline in third-party content. • Surface revenue increased $226 million or 3%. Operating income increased $1.5 billion or 8%. • Gross margin increased $3.1 billion or 10% driven by growth in Windows and Search and news advertising. Gross margin percentage was relatively unchanged. • Operating expenses increased $1.5 billion or 14% driven by investments in Gaming, Search and news advertising, and Windows marketing. 45 PART II Item 7 OPERATING EXPENSES Research and Development (In millions, except percentages) 2022 2021 Percentage Change Research and development $ 24,512 $ 20,716 18% As a percent of revenue 12% 12% 0ppt Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Research and development expenses increased $3.8 billion or 18% driven by investments in cloud engineering, Gaming, and LinkedIn. Sales and Marketing (In millions, except percentages) 2022 2021 Percentage Change Sales and marketing $ 21,825 $ 20,117 8% As a percent of revenue 11% 12% (1)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Sales and marketing expenses increased $1.7 billion or 8% driven by investments in commercial sales and LinkedIn. Sales and marketing included a favorable foreign currency impact of 2%. General and Administrative (In millions, except percentages) 2022 2021 Percentage Change General and administrative $ 5,900 $ 5,107 16% As a percent of revenue 3% 3% 0ppt General and administrative expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with finance, legal, facilities, certain human resources and other administrative personnel, certain taxes, and legal and other administrative fees. General and administrative expenses increased $793 million or 16% driven by investments in corporate functions. 46 PART II Item 7 OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2022 2021 Interest and dividends income $ 2,094 $ 2,131 Interest expense (2,063 ) (2,346 ) Net recognized gains on investments 461 1,232 Net gains (losses) on derivatives (52 ) 17 Net gains (losses) on foreign currency remeasurements (75 ) 54 Other, net (32 ) 98 Total $ 333 $ 1,186 We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net. Interest and dividends income decreased due to lower portfolio balances. Interest expense decreased due to a decrease in outstanding long-term debt due to debt maturities. Net recognized gains on investments decreased primarily due to lower gains on equity securities. INCOME TAXES Effective Tax Rate Our effective tax rate for fiscal years 2022 and 2021 was 13% and 14%, respectively. The decrease in our effective tax rate was primarily due to a $3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties, offset in part by changes in the mix of our income before income taxes between the U.S. and foreign countries, as well as tax benefits in the prior year from the India Supreme Court decision on withholding taxes in the case of Engineering Analysis Centre of Excellent Private Limited vs The Commissioner of Income Tax, an agreement between the U.S. and India tax authorities related to transfer pricing, and final Tax Cuts and Jobs Act (“TCJA”) regulations. In the first quarter of fiscal year 2022, we transferred certain intangible properties from our Puerto Rico subsidiary to the U.S. The transfer of intangible properties resulted in a $3.3 billion net income tax benefit in the first quarter of fiscal year 2022, as the value of future U.S. tax deductions exceeds the current tax liability from the U.S. global intangible low-taxed income tax. We have historically paid India withholding taxes on software sales through distributor withholding and tax audit assessments in India. In March 2021, the India Supreme Court ruled favorably for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject to India withholding taxes. Although we were not a party to the appeals, our software sales in India were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of $620 million in the third quarter of fiscal year 2021 to reflect the results of the India Supreme Court decision impacting fiscal year 1996 through fiscal year 2016. Our effective tax rate was lower than the U.S. federal statutory rate, primarily due to the net income tax benefit related to the transfer of intangible properties, earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center in Ireland, and tax benefits relating to stock-based compensation. The mix of income before income taxes between the U.S. and foreign countries impacted our effective tax rate as a result of the geographic distribution of, and customer demand for, our products and services. In fiscal year 2022, our U.S. income before income taxes was $47.8 billion and our foreign income before income taxes was $35.9 billion. In fiscal year 2021, our U.S. income before income taxes was $35.0 billion and our foreign income before income taxes was $36.1 billion. 47 PART II Item 7 Uncertain Tax Positions We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017. As of June 30, 2022, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2021, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NON-GAAP FINANCIAL MEASURES Adjusted net income and adjusted diluted EPS are non-GAAP financial measures which exclude the net tax benefit related to the transfer of intangible properties in the first quarter of fiscal year 2022 and the net income tax benefit related to an India Supreme Court decision on withholding taxes in the third quarter of fiscal year 2021. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP. The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results: (In millions, except percentages and per share amounts) 2022 2021 Percentage Change Net income $ 72,738 $ 61,271 19% Net income tax benefit related to transfer of intangible properties (3,291 ) 0 * Net income tax benefit related to India Supreme Court decision on withholding taxes 0 (620 ) * Adjusted net income (non-GAAP) $ 69,447 $ 60,651 15% Diluted earnings per share $ 9.65 $ 8.05 20% Net income tax benefit related to transfer of intangible properties (0.44 ) 0 * Net income tax benefit related to India Supreme Court decision on withholding taxes 0 (0.08 ) * Adjusted diluted earnings per share (non-GAAP) $ 9.21 $ 7.97 16% * Not meaningful. 48 PART II Item 7 LIQUIDITY AND CAPITAL RESOURCES We expect existing cash, cash equivalents, short-term investments, cash flows from operations, and access to capital markets to continue to be sufficient to fund our operating activities and cash commitments for investing and financing activities, such as dividends, share repurchases, debt maturities, material capital expenditures, and the transition tax related to the TCJA, for at least the next 12 months and thereafter for the foreseeable future. Cash, Cash Equivalents, and Investments Cash, cash equivalents, and short-term investments totaled $104.8 billion and $130.3 billion as of June 30, 2022 and 2021, respectively. Equity investments were $6.9 billion and $6.0 billion as of June 30, 2022 and 2021, respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantly U.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. Valuation In general, and where applicable, we use quoted prices in active markets for identical assets or liabilities to determine the fair value of our financial instruments. This pricing methodology applies to our Level 1 investments, such as U.S. government securities, common and preferred stock, and mutual funds. If quoted prices in active markets for identical assets or liabilities are not available to determine fair value, then we use quoted prices for similar assets and liabilities or inputs other than the quoted prices that are observable either directly or indirectly. This pricing methodology applies to our Level 2 investments, such as commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Level 3 investments are valued using internally-developed models with unobservable inputs. Assets and liabilities measured at fair value on a recurring basis using unobservable inputs are an immaterial portion of our portfolio. A majority of our investments are priced by pricing vendors and are generally Level 1 or Level 2 investments as these vendors either provide a quoted market price in an active market or use observable inputs for their pricing without applying significant adjustments. Broker pricing is used mainly when a quoted price is not available, the investment is not priced by our pricing vendors, or when a broker price is more reflective of fair values in the market in which the investment trades. Our broker-priced investments are generally classified as Level 2 investments because the broker prices these investments based on similar assets without applying significant adjustments. In addition, all our broker-priced investments have a sufficient level of trading volume to demonstrate that the fair values used are appropriate for these investments. Our fair value processes include controls that are designed to ensure appropriate fair values are recorded. These controls include model validation, review of key model inputs, analysis of period-over-period fluctuations, and independent recalculation of prices where appropriate. Cash Flows Cash from operations increased $12.3 billion to $89.0 billion for fiscal year 2022, mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees. Cash used in financing increased $10.4 billion to $58.9 billion for fiscal year 2022, mainly due to a $5.3 billion increase in common stock repurchases and a $5.3 billion increase in repayments of debt. Cash used in investing increased $2.7 billion to $30.3 billion for fiscal year 2022, mainly due to a $13.1 billion increase in cash used for acquisitions of companies, net of cash acquired, and purchases of intangible and other assets, and a $3.3 billion increase in additions to property and equipment, offset in part by a $15.6 billion increase in cash from net investment purchases, sales, and maturities. 49 PART II Item 7 Debt Proceeds We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. In March 2021 and June 2020, we exchanged a portion of our existing debt at a premium for cash and new debt with longer maturities to take advantage of favorable financing rates in the debt markets, reflecting our credit rating and the low interest rate environment. Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Unearned Revenue Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include Software Assurance (“SA”) and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. The following table outlines the expected future recognition of unearned revenue as of June 30, 2022: (In millions) Three Months Ending September 30, 2022 $ 17,691 December 31, 2022 13,923 March 31, 2023 9,491 June 30, 2023 4,433 Thereafter 2,870 Total $ 48,408 If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable. 50 PART II Item 7 Material Cash Requirements and Other Obligations Contractual Obligations The following table summarizes the payments due by fiscal year for our outstanding contractual obligations as of June 30, 2022: (In millions) 2023 Thereafter Total Long-term debt: (a) Principal payments $ 2,750 $ 52,761 $ 55,511 Interest payments 1,468 21,139 22,607 Construction commitments (b) 7,942 576 8,518 Operating and finance leases, including imputed interest (c) 4,609 44,045 48,654 Purchase commitments ( d ) 42,669 2,985 45,654 Total $ 59,438 $ 121,506 $ 180,944 ( a) Refer to Note 11 – Debt of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (b) Refer to Note 7 – Property and Equipment of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). (c) Refer to Note 14 – Leases of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K). ( d ) Purchase commitments primarily relate to datacenters and include open purchase orders and take-or-pay contracts that are not presented as construction commitments above. Income Taxes As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8% due in each of the first five years, 15% in year six, 20% in year seven, and 25% in year eight. We have paid transition tax of $6.2 billion, which included $1.5 billion for fiscal year 2022. The remaining transition tax of $12.0 billion is payable over the next four years, with $1.3 billion payable within 12 months. Provisions enacted in the TCJA related to the capitalization for tax purposes of research and experimental expenditures became effective on July 1, 2022. These provisions require us to capitalize research and experimental expenditures and amortize them on the U.S. tax return over five or fifteen years, depending on where research is conducted. The final foreign tax credit regulations, also effective on July 1, 2022, introduced significant changes to foreign tax credit calculations in the U.S. tax return. While these provisions are not expected to have a material impact on our fiscal year 2023 effective tax rate on a net basis, our cash paid for taxes would increase unless these provisions are postponed or modified through legislative processes. Share Repurchases During fiscal years 2022 and 2021, we repurchased 95 million shares and 101 million shares of our common stock for $28.0 billion and $23.0 billion, respectively, through our share repurchase programs. All repurchases were made using cash resources. As of June 30, 2022, $40.7 billion remained of our $60 billion share repurchase program. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. Dividends During fiscal year 2022, our Board of Directors declared quarterly dividends of $0.62 per share. We intend to continue returning capital to shareholders in the form of dividends, subject to declaration by our Board of Directors. Refer to Note 16 – Stockholders’ Equity of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. 51 PART II Item 7 Other Planned Uses of Capital On January 18, 2022 , we entered into a definitive agreement to acquire Activision Blizzard , Inc. (“Activision Blizzard” ) for $ 95 .00 per share in an all-cash transaction valued at $ 68 .7 billion, inclusive of Activision Blizzard’s net cash. The acquisition has been approved by Activision Blizzard’s shareholders, and we expect it to close in fiscal year 2023, subject to the satisfaction of certain regulatory approvals and other customary closing conditions. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. RECENT ACCOUNTING GUIDANCE Refer to Note 1 – Accounting Policies of the Notes to Financial Statements (Part II, Item 8 of this Form 10-K) for further discussion. CRITICAL ACCOUNTING ESTIMATES Our consolidated financial statements and accompanying notes are prepared in accordance with GAAP. Preparing consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Critical accounting estimates are those estimates that involve a significant level of estimation uncertainty and could have a material impact on our financial condition or results of operations. We have critical accounting estimates in the areas of revenue recognition, impairment of investment securities, goodwill, research and development costs, legal and other contingencies, income taxes, and inventories. Revenue Recognition Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. Judgment is required to determine the stand-alone selling price (“SSP") for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. 52 PART II Item 7 Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Impairment of Investment Securities We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net. Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach. Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit. Research and Development Costs Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products. 53 PART II Item 7 Legal and Other Contingencies The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. An estimated loss from a loss contingency such as a legal proceeding or claim is accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. In determining whether a loss should be accrued we evaluate, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact our consolidated financial statements. Income Taxes The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year, and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. We recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. Accounting literature also provides guidance on derecognition of income tax assets and liabilities, classification of deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our consolidated financial statements. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. These reviews include analysis of demand forecasts, product life cycle status, product development plans, current sales levels, pricing strategy, and component cost trends. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. CHANGE IN ACCOUNTING ESTIMATE In July 2022, we completed an assessment of the useful lives of our server and network equipment. Due to investments in software that increased efficiencies in how we operate our server and network equipment, as well as advances in technology, we determined we should increase the estimated useful lives of both server and network equipment from four years to six years. This change in accounting estimate will be effective beginning fiscal year 2023. Based on the carrying amount of server and network equipment included in property and equipment, net as of June 30, 2022, it is estimated this change will increase our fiscal year 2023 operating income by $3.7 billion. We had previously increased the estimated useful lives of both server and network equipment in July 2020. 54 PART II Item 7 STATEMENT OF MANAGEMENT’S RESPONSIBILITY FOR FINANCIAL STATEMENTS Management is responsible for the preparation of the consolidated financial statements and related information that are presented in this report. The consolidated financial statements, which include amounts based on management’s estimates and judgments, have been prepared in conformity with accounting principles generally accepted in the United States of America. The Company designs and maintains accounting and internal control systems to provide reasonable assurance at reasonable cost that assets are safeguarded against loss from unauthorized use or disposition, and that the financial records are reliable for preparing consolidated financial statements and maintaining accountability for assets. These systems are augmented by written policies, an organizational structure providing division of responsibilities, careful selection and training of qualified personnel, and a program of internal audits. The Company engaged Deloitte & Touche LLP, an independent registered public accounting firm, to audit and render an opinion on the consolidated financial statements and internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). The Board of Directors, through its Audit Committee, consisting solely of independent directors of the Company, meets periodically with management, internal auditors, and our independent registered public accounting firm to ensure that each is meeting its responsibilities and to discuss matters concerning internal controls and financial reporting. Deloitte & Touche LLP and the internal auditors each have full and free access to the Audit Committee. Satya Nadella Chief Executive Officer Amy E. Hood Executive Vice President and Chief Financial Officer Alice L. Jolla Corporate Vice President and Chief Accounting Officer 55 PART II Item 7A ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK RISKS We are exposed to economic risk from foreign exchange rates, interest rates, credit risk, and equity prices. We use derivatives instruments to manage these risks, however, they may still impact our consolidated financial statements. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency positions, including hedges. Principal currency exposures include the Euro, Japanese yen, British pound, Canadian dollar, and Australian dollar. Interest Rate Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of the fixed-income portfolio to achieve economic returns that correlate to certain global fixed-income indices. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. Equity Securities held in our equity investments portfolio are subject to price risk. SENSITIVITY ANALYSIS The following table sets forth the potential loss in future earnings or fair values, including associated derivatives, resulting from hypothetical changes in relevant market rates or prices: (In millions) Risk Categories Hypothetical Change June 30, 2022 Impact Foreign currency – Revenue 10% decrease in foreign exchange rates $ (6,822 ) Earnings Foreign currency – Investments 10% decrease in foreign exchange rates (94 ) Fair Value Interest rate 100 basis point increase in U.S. treasury interest rates (2,536 ) Fair Value Credit 100 basis point increase in credit spreads (350 ) Fair Value Equity 10% decrease in equity market prices (637 ) Earnings 56 PART II Item 8 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA INCOME STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2022 2021 2020 Revenue: Product $ 72,732 $ 71,074 $ 68,041 Service and other 125,538 97,014 74,974 Total revenue 198,270 168,088 143,015 Cost of revenue: Product 19,064 18,219 16,017 Service and other 43,586 34,013 30,061 Total cost of revenue 62,650 52,232 46,078 Gross margin 135,620 115,856 96,937 Research and development 24,512 20,716 19,269 Sales and marketing 21,825 20,117 19,598 General and administrative 5,900 5,107 5,111 Operating income 83,383 69,916 52,959 Other income, net 333 1,186 77 Income before income taxes 83,716 71,102 53,036 Provision for income taxes 10,978 9,831 8,755 Net income $ 72,738 $ 61,271 $ 44,281 Earnings per share: Basic $ 9.70 $ 8.12 $ 5.82 Diluted $ 9.65 $ 8.05 $ 5.76 Weighted average shares outstanding: Basic 7,496 7,547 7,610 Diluted 7,540 7,608 7,683 Refer to accompanying notes. 57 PART II Item 8 COMPREHENSIVE INCOME STATEMENTS (In millions) Year Ended June 30, 2022 2021 2020 Net income $ 72,738 $ 61,271 $ 44,281 Other comprehensive income (loss), net of tax: Net change related to derivatives 6 19 ( 38 ) Net change related to investments ( 5,360 ) ( 2,266 ) 3,990 Translation adjustments and other ( 1,146 ) 873 ( 426 ) Other comprehensive income (loss) ( 6,500 ) ( 1,374 ) 3,526 Comprehensive income $ 66,238 $ 59,897 $ 47,807 Refer to accompanying notes. 58 PART II Item 8 BALANCE SHEETS (In millions) June 30, 2022 2021 Assets Current assets: Cash and cash equivalents $ 13,931 $ 14,224 Short-term investments 90,826 116,110 Total cash, cash equivalents, and short-term investments 104,757 130,334 Accounts receivable, net of allowance for doubtful accounts of $ 633 and $ 751 44,261 38,043 Inventories 3,742 2,636 Other current assets 16,924 13,393 Total current assets 169,684 184,406 Property and equipment, net of accumulated depreciation of $ 59,660 and $ 51,351 74,398 59,715 Operating lease right-of-use assets 13,148 11,088 Equity investments 6,891 5,984 Goodwill 67,524 49,711 Intangible assets, net 11,298 7,800 Other long-term assets 21,897 15,075 Total assets $ 364,840 $ 333,779 Liabilities and stockholders’ equity Current liabilities: Accounts payable $ 19,000 $ 15,163 Current portion of long-term debt 2,749 8,072 Accrued compensation 10,661 10,057 Short-term income taxes 4,067 2,174 Short-term unearned revenue 45,538 41,525 Other current liabilities 13,067 11,666 Total current liabilities 95,082 88,657 Long-term debt 47,032 50,074 Long-term income taxes 26,069 27,190 Long-term unearned revenue 2,870 2,616 Deferred income taxes 230 198 Operating lease liabilities 11,489 9,629 Other long-term liabilities 15,526 13,427 Total liabilities 198,298 191,791 Commitments and contingencies Stockholders’ equity: Common stock and paid-in capital – shares authorized 24,000 ; outstanding 7,464 and 7,519 86,939 83,111 Retained earnings 84,281 57,055 Accumulated other comprehensive income (loss) ( 4,678 ) 1,822 Total stockholders’ equity 166,542 141,988 Total liabilities and stockholders’ equity $ 364,840 $ 333,779 Refer to accompanying notes. 59 PART II Item 8 CASH FLOWS STATEMENTS (In millions) Year Ended June 30, 2022 2021 2020 Operations Net income $ 72,738 $ 61,271 $ 44,281 Adjustments to reconcile net income to net cash from operations: Depreciation, amortization, and other 14,460 11,686 12,796 Stock-based compensation expense 7,502 6,118 5,289 Net recognized gains on investments and derivatives ( 409 ) ( 1,249 ) ( 219 ) Deferred income taxes ( 5,702 ) ( 150 ) 11 Changes in operating assets and liabilities: Accounts receivable ( 6,834 ) ( 6,481 ) ( 2,577 ) Inventories ( 1,123 ) ( 737 ) 168 Other current assets ( 709 ) ( 932 ) ( 2,330 ) Other long-term assets ( 2,805 ) ( 3,459 ) ( 1,037 ) Accounts payable 2,943 2,798 3,018 Unearned revenue 5,109 4,633 2,212 Income taxes 696 ( 2,309 ) ( 3,631 ) Other current liabilities 2,344 4,149 1,346 Other long-term liabilities 825 1,402 1,348 Net cash from operations 89,035 76,740 60,675 Financing Cash premium on debt exchange 0 ( 1,754 ) ( 3,417 ) Repayments of debt ( 9,023 ) ( 3,750 ) ( 5,518 ) Common stock issued 1,841 1,693 1,343 Common stock repurchased ( 32,696 ) ( 27,385 ) ( 22,968 ) Common stock cash dividends paid ( 18,135 ) ( 16,521 ) ( 15,137 ) Other, net ( 863 ) ( 769 ) ( 334 ) Net cash used in financing ( 58,876 ) ( 48,486 ) ( 46,031 ) Investing Additions to property and equipment ( 23,886 ) ( 20,622 ) ( 15,441 ) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets ( 22,038 ) ( 8,909 ) ( 2,521 ) Purchases of investments ( 26,456 ) ( 62,924 ) ( 77,190 ) Maturities of investments 16,451 51,792 66,449 Sales of investments 28,443 14,008 17,721 Other, net ( 2,825 ) ( 922 ) ( 1,241 ) Net cash used in investing ( 30,311 ) ( 27,577 ) ( 12,223 ) Effect of foreign exchange rates on cash and cash equivalents ( 141 ) ( 29 ) ( 201 ) Net change in cash and cash equivalents ( 293 ) 648 2,220 Cash and cash equivalents, beginning of period 14,224 13,576 11,356 Cash and cash equivalents, end of period $ 13,931 $ 14,224 $ 13,576 Refer to accompanying notes. 60 PART II Item 8 STOCKHOLDERS’ EQUITY STATEMENTS (In millions, except per share amounts) Year Ended June 30, 2022 2021 2020 Common stock and paid-in capital Balance, beginning of period $ 83,111 $ 80,552 $ 78,520 Common stock issued 1,841 1,963 1,343 Common stock repurchased ( 5,688 ) ( 5,539 ) ( 4,599 ) Stock-based compensation expense 7,502 6,118 5,289 Other, net 173 17 ( 1 ) Balance, end of period 86,939 83,111 80,552 Retained earnings Balance, beginning of period 57,055 34,566 24,150 Net income 72,738 61,271 44,281 Common stock cash dividends ( 18,552 ) ( 16,871 ) ( 15,483 ) Common stock repurchased ( 26,960 ) ( 21,879 ) ( 18,382 ) Cumulative effect of accounting changes 0 ( 32 ) 0 Balance, end of period 84,281 57,055 34,566 Accumulated other comprehensive income (loss) Balance, beginning of period 1,822 3,186 ( 340 ) Other comprehensive income (loss) ( 6,500 ) ( 1,374 ) 3,526 Cumulative effect of accounting changes 0 10 0 Balance, end of period ( 4,678 ) 1,822 3,186 Total stockholders’ equity $ 166,542 $ 141,988 $ 118,304 Cash dividends declared per common share $ 2.48 $ 2.24 $ 2.04 Refer to accompanying notes. 61 PART II Item 8 NOTES TO FINANCIAL STATEMENTS NOTE 1 — ACCOUNTING POLICIES Accounting Principles Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We have recast certain prior period amounts to conform to the current period presentation. The recast of these prior period amounts had no impact on our consolidated balance sheets, consolidated income statements, or consolidated cash flows statements. Principles of Consolidation The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated. Estimates and Assumptions Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price (“SSP”) of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of uncertain tax positions that have been recognized in our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions due to risks and uncertainties. In July 2022, we completed an assessment of the useful lives of our server and network equipment. Due to investments in software that increased efficiencies in how we operate our server and network equipment, as well as advances in technology, we determined we should increase the estimated useful lives of both server and network equipment from four years to six years . This change in accounting estimate will be effective beginning fiscal year 2023. We had previously increased the estimated useful lives of both server and network equipment in July 2020. Foreign Currencies Assets and liabilities recorded in foreign currencies are translated at the exchange rate on the balance sheet date. Revenue and expenses are translated at average rates of exchange prevailing during the year. Translation adjustments resulting from this process are recorded to other comprehensive income. Revenue Product Revenue and Service and Other Revenue Product revenue includes sales from operating systems, cross-device productivity applications, server applications, business solution applications, desktop and server management tools, software development tools, video games, and hardware such as PCs, tablets, gaming and entertainment consoles, other intelligent devices, and related accessories. Service and other revenue includes sales from cloud-based solutions that provide customers with software, services, platforms, and content such as Office 365, Azure, Dynamics 365, and Xbox; solution support; and consulting services. Service and other revenue also includes sales from online advertising and LinkedIn. 62 PART II Item 8 Revenue Recognition Revenue is recognized upon transfer of control of promised products or services to customers in an amount that reflects the consideration we expect to receive in exchange for those products or services. We enter into contracts that can include various combinations of products and services, which are generally capable of being distinct and accounted for as separate performance obligations. Revenue is recognized net of allowances for returns and any taxes collected from customers, which are subsequently remitted to governmental authorities. Nature of Products and Services Licenses for on-premises software provide the customer with a right to use the software as it exists when made available to the customer. Customers may purchase perpetual licenses or subscribe to licenses, which provide customers with the same functionality and differ mainly in the duration over which the customer benefits from the software. Revenue from distinct on-premises licenses is recognized upfront at the point in time when the software is made available to the customer. In cases where we allocate revenue to software updates, primarily because the updates are provided at no additional charge, revenue is recognized as the updates are provided, which is generally ratably over the estimated life of the related device or license. Certain volume licensing programs, including Enterprise Agreements, include on-premises licenses combined with Software Assurance (“SA”). SA conveys rights to new software and upgrades released over the contract period and provides support, tools, and training to help customers deploy and use products more efficiently. On-premises licenses are considered distinct performance obligations when sold with SA. Revenue allocated to SA is generally recognized ratably over the contract period as customers simultaneously consume and receive benefits, given that SA comprises distinct performance obligations that are satisfied over time. Cloud services, which allow customers to use hosted software over the contract period without taking possession of the software, are provided on either a subscription or consumption basis. Revenue related to cloud services provided on a subscription basis is recognized ratably over the contract period. Revenue related to cloud services provided on a consumption basis, such as the amount of storage used in a period, is recognized based on the customer utilization of such resources. When cloud services require a significant level of integration and interdependency with software and the individual components are not considered distinct, all revenue is recognized over the period in which the cloud services are provided. Revenue from search advertising is recognized when the advertisement appears in the search results or when the action necessary to earn the revenue has been completed. Revenue from consulting services is recognized as services are provided. Our hardware is generally highly dependent on, and interrelated with, the underlying operating system and cannot function without the operating system. In these cases, the hardware and software license are accounted for as a single performance obligation and revenue is recognized at the point in time when ownership is transferred to resellers or directly to end customers through retail stores and online marketplaces. Refer to Note 19 – Segment Information and Geographic Data for further information, including revenue by significant product and service offering. Significant Judgments Our contracts with customers often include promises to transfer multiple products and services to a customer. Determining whether products and services are considered distinct performance obligations that should be accounted for separately versus together may require significant judgment. When a cloud-based service includes both on-premises software licenses and cloud services, judgment is required to determine whether the software license is considered distinct and accounted for separately, or not distinct and accounted for together with the cloud service and recognized over time. Certain cloud services, primarily Office 365, depend on a significant level of integration, interdependency, and interrelation between the desktop applications and cloud services, and are accounted for together as one performance obligation. Revenue from Office 365 is recognized ratably over the period in which the cloud services are provided. 63 PART II Item 8 Judgment is required to determine the SSP for each distinct performance obligation. We use a single amount to estimate SSP for items that are not sold separately, including on-premises licenses sold with SA or software updates provided at no additional charge. We use a range of amounts to estimate SSP when we sell each of the products and services separately and need to determine whether there is a discount to be allocated based on the relative SSP of the various products and services. In instances where SSP is not directly observable, such as when we do not sell the product or service separately, we determine the SSP using information that may include market conditions and other observable inputs. We typically have more than one SSP for individual products and services due to the stratification of those products and services by customers and circumstances. In these instances, we may use information such as the size of the customer and geographic region in determining the SSP. Due to the various benefits from and the nature of our SA program, judgment is required to assess the pattern of delivery, including the exercise pattern of certain benefits across our portfolio of customers. Our products are generally sold with a right of return, we may provide other credits or incentives, and in certain instances we estimate customer usage of our products and services, which are accounted for as variable consideration when determining the amount of revenue to recognize. Returns and credits are estimated at contract inception and updated at the end of each reporting period if additional information becomes available. Changes to our estimated variable consideration were not material for the periods presented. Contract Balances and Other Receivables Timing of revenue recognition may differ from the timing of invoicing to customers. We record a receivable when revenue is recognized prior to invoicing, or unearned revenue when revenue is recognized subsequent to invoicing. For multi-year agreements, we generally invoice customers annually at the beginning of each annual coverage period. We record a receivable related to revenue recognized for multi-year on-premises licenses as we have an unconditional right to invoice and receive payment in the future related to those licenses. Unearned revenue comprises mainly unearned revenue related to volume licensing programs, which may include SA and cloud services. Unearned revenue is generally invoiced annually at the beginning of each contract period for multi-year agreements and recognized ratably over the coverage period. Unearned revenue also includes payments for consulting services to be performed in the future, LinkedIn subscriptions, Office 365 subscriptions, Xbox subscriptions, Windows post-delivery support, Dynamics business solutions, and other offerings for which we have been paid in advance and earn the revenue when we transfer control of the product or service. Refer to Note 13 – Unearned Revenue for further information, including unearned revenue by segment and changes in unearned revenue during the period. Payment terms and conditions vary by contract type, although terms generally include a requirement of payment within 30 to 60 days. In instances where the timing of revenue recognition differs from the timing of invoicing, we have determined our contracts generally do not include a significant financing component. The primary purpose of our invoicing terms is to provide customers with simplified and predictable ways of purchasing our products and services, not to receive financing from our customers or to provide customers with financing. Examples include invoicing at the beginning of a subscription term with revenue recognized ratably over the contract period, and multi-year on-premises licenses that are invoiced annually with revenue recognized upfront. As of June 30, 2022 and 2021, other receivables due from suppliers were $ 1.0 billion and $ 965 million, respectively, and are included in accounts receivable, net in our consolidated balance sheets. As of June 30, 2022 and 2021, long-term accounts receivable, net of allowance for doubtful accounts, was $ 3.8 billion and $ 3.4 billion, respectively, and is included in other long-term assets in our consolidated balance sheets. The allowance for doubtful accounts reflects our best estimate of probable losses inherent in the accounts receivable balance. We determine the allowance based on known troubled accounts, historical experience, and other currently available evidence. 64 PART II Item 8 Activity in the allowance for doubtful accounts was as follows: (In millions) Year Ended June 30, 2022 2021 2020 Balance, beginning of period $ 798 $ 816 $ 434 Charged to costs and other 157 234 560 Write-offs ( 245 ) ( 252 ) ( 178 ) Balance, end of period $ 710 $ 798 $ 816 Allowance for doubtful accounts included in our consolidated balance sheets: (In millions) June 30, 2022 2021 2020 Accounts receivable, net of allowance for doubtful accounts $ 633 $ 751 $ 788 Other long-term assets 77 47 28 Total $ 710 $ 798 $ 816 We record financing receivables when we offer certain of our customers the option to acquire our software products and services offerings through a financing program in a limited number of countries. As of June 30, 2022 and 2021, our financing receivables, net were $ 4.1 billion and $ 4.4 billion, respectively, for short-term and long-term financing receivables, which are included in other current assets and other long-term assets in our consolidated balance sheets. We record an allowance to cover expected losses based on troubled accounts, historical experience, and other currently available evidence. Assets Recognized from Costs to Obtain a Contract with a Customer We recognize an asset for the incremental costs of obtaining a contract with a customer if we expect the benefit of those costs to be longer than one year. We have determined that certain sales incentive programs meet the requirements to be capitalized. Total capitalized costs to obtain a contract were immaterial during the periods presented and are included in other current and long-term assets in our consolidated balance sheets. We apply a practical expedient to expense costs as incurred for costs to obtain a contract with a customer when the amortization period would have been one year or less. These costs include our internal sales force compensation program and certain partner sales incentive programs as we have determined annual compensation is commensurate with annual sales activities. Cost of Revenue Cost of revenue includes: manufacturing and distribution costs for products sold and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by original equipment manufacturers (“OEM”), to drive traffic to our websites, and to acquire online advertising space; costs incurred to support and maintain online products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized software development costs. Capitalized software development costs are amortized over the estimated lives of the products. Product Warranty We provide for the estimated costs of fulfilling our obligations under hardware and software warranties at the time the related revenue is recognized. For hardware warranties, we estimate the costs based on historical and projected product failure rates, historical and projected repair costs, and knowledge of specific product failures (if any). The specific hardware warranty terms and conditions vary depending upon the product sold and the country in which we do business, but generally include parts and labor over a period generally ranging from 90 days to three years. For software warranties, we estimate the costs to provide bug fixes, such as security patches, over the estimated life of the software. We regularly reevaluate our estimates to assess the adequacy of the recorded warranty liabilities and adjust the amounts as necessary. 65 PART II Item 8 Research and Development Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content. Such costs related to software development are included in research and development expense until the point that technological feasibility is reached, which for our software products, is generally shortly before the products are released to production. Once technological feasibility is reached, such costs are capitalized and amortized to cost of revenue over the estimated lives of the products. Sales and Marketing Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs. Advertising costs are expensed as incurred. Advertising expense was $ 1.5 billion, $ 1.5 billion, and $ 1.6 billion in fiscal years 2022, 2021, and 2020, respectively. Stock-Based Compensation Compensation cost for stock awards, which include restricted stock units (“RSUs”) and performance stock units (“PSUs”), is measured at the fair value on the grant date and recognized as expense, net of estimated forfeitures, over the related service or performance period. The fair value of stock awards is based on the quoted price of our common stock on the grant date less the present value of expected dividends not received during the vesting period. We measure the fair value of PSUs using a Monte Carlo valuation model. Compensation cost for RSUs is recognized using the straight-line method and for PSUs is recognized using the accelerated method. Compensation expense for the employee stock purchase plan (“ESPP”) is measured as the discount the employee is entitled to upon purchase and is recognized in the period of purchase. Income Taxes Income tax expense includes U.S. and international income taxes, and interest and penalties on uncertain tax positions. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes. Deferred tax assets are reported net of a valuation allowance when it is more likely than not that a tax benefit will not be realized. All deferred income taxes are classified as long-term in our consolidated balance sheets. Financial Instruments Investments We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations. 66 PART II Item 8 Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding credit losses and impairments, are recorded in other comprehensive income . Fair value is calculated based on publicly available market information or other estimates determined by management. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. To determine credit losses, we employ a systematic methodology that considers available quantitative and qualitative evidence. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery , then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a periodic basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net. Derivatives Derivative instruments are recognized as either assets or liabilities and measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For derivative instruments designated as fair value hedges, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments designated as cash flow hedges, gains and losses are initially reported as a component of other comprehensive income and subsequently recognized in other income (expense), net with the corresponding hedged item. Gains and losses representing hedge components excluded from the assessment of effectiveness are recognized in other income (expense), net. For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net. Fair Value Measurements We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are: • Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges. • Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 investments include commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Our Level 2 derivative assets and liabilities include certain over-the-counter forward, option, and swap contracts. 67 PART II Item 8 • Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets and liabilities include investments in corporate notes and bonds , municipal securities , and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities. We measure equity investments without readily determinable fair values on a nonrecurring basis. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections. Our other current financial assets and current financial liabilities have fair values that approximate their carrying values. Inventories Inventories are stated at average cost, subject to the lower of cost or net realizable value. Cost includes materials, labor, and manufacturing overhead related to the purchase and production of inventories. Net realizable value is the estimated selling price less estimated costs of completion, disposal, and transportation. We regularly review inventory quantities on hand, future purchase commitments with our suppliers, and the estimated utility of our inventory. If our review indicates a reduction in utility below carrying value, we reduce our inventory to a new cost basis through a charge to cost of revenue. Property and Equipment Property and equipment is stated at cost less accumulated depreciation, and depreciated using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. The estimated useful lives of our property and equipment are generally as follows: computer software developed or acquired for internal use, three to seven years ; computer equipment, two to four years ; buildings and improvements, five to 15 years ; leasehold improvements, three to 20 years ; and furniture and equipment, one to 10 years . Land is not depreciated. Leases We determine if an arrangement is a lease at inception. Operating leases are included in operating lease right-of-use (“ROU”) assets, other current liabilities, and operating lease liabilities in our consolidated balance sheets. Finance leases are included in property and equipment, other current liabilities, and other long-term liabilities in our consolidated balance sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. As most of our leases do not provide an implicit rate, we generally use our incremental borrowing rate based on the estimated rate of interest for collateralized borrowing over a similar term of the lease payments at commencement date. The operating lease ROU asset also includes any lease payments made and excludes lease incentives. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for lease payments is recognized on a straight-line basis over the lease term. We have lease agreements with lease and non-lease components, which are generally accounted for separately. For certain equipment leases, such as vehicles, we account for the lease and non-lease components as a single lease component. Additionally, for certain equipment leases, we apply a portfolio approach to effectively account for the operating lease ROU assets and liabilities. Goodwill Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. 68 PART II Item 8 Intangible Assets Our intangible assets are subject to amortization and are amortized using the straight-line method over their estimated period of benefit, ranging from one to 20 years . We evaluate the recoverability of intangible assets periodically by taking into account events or circumstances that may warrant revised estimates of useful lives or that indicate the asset may be impaired. Recent Accounting Guidance Accounting for Income Taxes In December 2019, the Financial Accounting Standards Board issued a new standard to simplify the accounting for income taxes. The guidance eliminates certain exceptions related to the approach for intraperiod tax allocation, the methodology for calculating income taxes in an interim period, and the recognition of deferred tax liabilities for outside basis differences related to changes in ownership of equity method investments and foreign subsidiaries. The guidance also simplifies aspects of accounting for franchise taxes and enacted changes in tax laws or rates and clarifies the accounting for transactions that result in a step-up in the tax basis of goodwill. We adopted the standard effective July 1, 2021. Adoption of the standard did not have a material impact on our consolidated financial statements. NOTE 2 — EARNINGS PER SHARE Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards. The components of basic and diluted EPS were as follows: (In millions, except earnings per share) Year Ended June 30, 2022 2021 2020 Net income available for common shareholders (A) $ 72,738 $ 61,271 $ 44,281 Weighted average outstanding shares of common stock (B) 7,496 7,547 7,610 Dilutive effect of stock-based awards 44 61 73 Common stock and common stock equivalents (C) 7,540 7,608 7,683 Earnings Per Share Basic (A/B) $ 9.70 $ 8.12 $ 5.82 Diluted (A/C) $ 9.65 $ 8.05 $ 5.76 Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. NOTE 3 — OTHER INCOME (EXPENSE), NET The components of other income (expense), net were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Interest and dividends income $ 2,094 $ 2,131 $ 2,680 Interest expense ( 2,063 ) ( 2,346 ) ( 2,591 ) Net recognized gains on investments 461 1,232 32 Net gains (losses) on derivatives ( 52 ) 17 187 Net gains (losses) on foreign currency remeasurements ( 75 ) 54 ( 191 ) Other, net ( 32 ) 98 ( 40 ) Total $ 333 $ 1,186 $ 77 69 PART II Item 8 Net Recognized Gains (Losses) on Investments Net recognized gains (losses) on debt investments were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Realized gains from sales of available-for-sale securities $ 162 $ 105 $ 50 Realized losses from sales of available-for-sale securities ( 138 ) ( 40 ) ( 37 ) Impairments and allowance for credit losses ( 81 ) ( 2 ) ( 17 ) Total $ ( 57 ) $ 63 $ ( 4 ) Net recognized gains (losses) on equity investments were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Net realized gains on investments sold $ 29 $ 123 $ 83 Net unrealized gains on investments still held 509 1,057 69 Impairments of investments ( 20 ) ( 11 ) ( 116 ) Total $ 518 $ 1,169 $ 36 70 PART II Item 8 NOTE 4 — INVESTMENTS Investment Components The components of investments were as follows: (In millions) Fair Value Level Adjusted Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2022 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 2,500 $ 0 $ 0 $ 2,500 $ 2,498 $ 2 $ 0 Certificates of deposit Level 2 2,071 0 0 2,071 2,032 39 0 U.S. government securities Level 1 79,696 29 ( 2,178 ) 77,547 9 77,538 0 U.S. agency securities Level 2 419 0 ( 9 ) 410 0 410 0 Foreign government bonds Level 2 506 0 ( 24 ) 482 0 482 0 Mortgage- and asset-backed securities Level 2 727 1 ( 30 ) 698 0 698 0 Corporate notes and bonds Level 2 11,661 4 ( 554 ) 11,111 0 11,111 0 Corporate notes and bonds Level 3 67 0 0 67 0 67 0 Municipal securities Level 2 368 19 ( 13 ) 374 0 374 0 Municipal securities Level 3 103 0 ( 6 ) 97 0 97 0 Total debt investments $ 98,118 $ 53 $ ( 2,814 ) $ 95,357 $ 4,539 $ 90,818 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 1,590 $ 1,134 $ 0 $ 456 Equity investments Other 6,435 0 0 6,435 Total equity investments $ 8,025 $ 1,134 $ 0 $ 6,891 Cash $ 8,258 $ 8,258 $ 0 $ 0 Derivatives, net (a) 8 0 8 0 Total $ 111,648 $ 13,931 $ 90,826 $ 6,891 71 PART II Item 8 (In millions) Fair Value Level Adjusted Cost Basis Unrealized Gains Unrealized Losses Recorded Basis Cash and Cash Equivalents Short-term Investments Equity Investments June 30, 2021 Changes in Fair Value Recorded in Other Comprehensive Income Commercial paper Level 2 $ 4,316 $ 0 $ 0 $ 4,316 $ 1,331 $ 2,985 $ 0 Certificates of deposit Level 2 3,615 0 0 3,615 2,920 695 0 U.S. government securities Level 1 90,664 3,832 ( 111 ) 94,385 1,500 92,885 0 U.S. agency securities Level 2 807 2 0 809 0 809 0 Foreign government bonds Level 2 6,213 9 ( 2 ) 6,220 225 5,995 0 Mortgage- and asset-backed securities Level 2 3,442 22 ( 6 ) 3,458 0 3,458 0 Corporate notes and bonds Level 2 8,443 249 ( 9 ) 8,683 0 8,683 0 Corporate notes and bonds Level 3 63 0 0 63 0 63 0 Municipal securities Level 2 308 63 0 371 0 371 0 Municipal securities Level 3 95 0 ( 7 ) 88 0 88 0 Total debt investments $ 117,966 $ 4,177 $ ( 135 ) $ 122,008 $ 5,976 $ 116,032 $ 0 Changes in Fair Value Recorded in Net Income Equity investments Level 1 $ 1,582 $ 976 $ 0 $ 606 Equity investments Other 5,378 0 0 5,378 Total equity investments $ 6,960 $ 976 $ 0 $ 5,984 Cash $ 7,272 $ 7,272 $ 0 $ 0 Derivatives, net (a) 78 0 78 0 Total $ 136,318 $ 14,224 $ 116,110 $ 5,984 (a) Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments. Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of June 30, 2022 and 2021, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $ 3.8 billion and $ 3.3 billion, respectively. Unrealized Losses on Debt Investments Debt investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows: Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2022 U.S. government and agency securities $ 59,092 $ ( 1,835 ) $ 2,210 $ ( 352 ) $ 61,302 $ ( 2,187 ) Foreign government bonds 418 ( 18 ) 27 ( 6 ) 445 ( 24 ) Mortgage- and asset-backed securities 510 ( 26 ) 41 ( 4 ) 551 ( 30 ) Corporate notes and bonds 9,443 ( 477 ) 786 ( 77 ) 10,229 ( 554 ) Municipal securities 178 ( 12 ) 74 ( 7 ) 252 ( 19 ) Total $ 69,641 $ ( 2,368 ) $ 3,138 $ ( 446 ) $ 72,779 $ ( 2,814 ) 72 PART II Item 8 Less than 12 Months 12 Months or Greater Total Unrealized Losses (In millions) Fair Value Unrealized Losses Fair Value Unrealized Losses Total Fair Value June 30, 2021 U.S. government and agency securities $ 5,294 $ ( 111 ) $ 0 $ 0 $ 5,294 $ ( 111 ) Foreign government bonds 3,148 ( 1 ) 5 ( 1 ) 3,153 ( 2 ) Mortgage- and asset-backed securities 1,211 ( 5 ) 87 ( 1 ) 1,298 ( 6 ) Corporate notes and bonds 1,678 ( 8 ) 34 ( 1 ) 1,712 ( 9 ) Municipal securities 58 ( 7 ) 1 0 59 ( 7 ) Total $ 11,389 $ ( 132 ) $ 127 $ ( 3 ) $ 11,516 $ ( 135 ) Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent impairments based on our evaluation of available evidence. Debt Investment Maturities (In millions) Adjusted Cost Basis Estimated Fair Value June 30, 2022 Due in one year or less $ 26,480 $ 26,470 Due after one year through five years 52,006 50,748 Due after five years through 10 years 18,274 16,880 Due after 10 years 1,358 1,259 Total $ 98,118 $ 95,357 NOTE 5 — DERIVATIVES We use derivative instruments to manage risks related to foreign currencies, interest rates, equity prices, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. Foreign Currencies Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Foreign currency risks related to certain non-U.S. dollar-denominated investments are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments. Foreign currency risks related to certain Euro-denominated debt are hedged using foreign exchange forward contracts that are designated as cash flow hedging instruments. Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures. Interest Rate Interest rate risks related to certain fixed-rate debt are hedged using interest rate swaps that are designated as fair value hedging instruments to effectively convert the fixed interest rates to floating interest rates. 73 PART II Item 8 Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts . These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Equity Securities held in our equity investments portfolio are subject to market price risk. At times, we may hold options, futures, and swap contracts. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. These contracts are not designated as hedging instruments and are included in “Other contracts” in the tables below. Credit-Risk-Related Contingent Features Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $ 1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of June 30, 2022, our long-term unsecured debt rating was AAA , and cash investments were in excess of $ 1.0 billion. As a result, no collateral was required to be posted. The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents: (In millions) June 30, 2022 June 30, 2021 Designated as Hedging Instruments Foreign exchange contracts purchased $ 635 $ 635 Foreign exchange contracts sold 0 6,081 Interest rate contracts purchased 1,139 1,247 Not Designated as Hedging Instruments Foreign exchange contracts purchased 10,322 14,223 Foreign exchange contracts sold 21,606 23,391 Other contracts purchased 2,773 2,456 Other contracts sold 544 763 74 PART II Item 8 Fair Values of Derivative Instruments The following table presents our derivative instruments: Derivative Derivative Derivative Derivative (In millions) Assets Liabilities Assets Liabilities June 30, 2022 June 30, 2021 Designated as Hedging Instruments Foreign exchange contracts $ 0 $ ( 77 ) $ 76 $ ( 8 ) Interest rate contracts 3 0 40 0 Not Designated as Hedging Instruments Foreign exchange contracts 333 ( 362 ) 227 ( 291 ) Other contracts 20 ( 112 ) 56 ( 36 ) Gross amounts of derivatives 356 ( 551 ) 399 ( 335 ) Gross amounts of derivatives offset in the balance sheet ( 130 ) 133 ( 141 ) 142 Cash collateral received 0 ( 75 ) 0 ( 42 ) Net amounts of derivatives $ 226 $ ( 493 ) $ 258 $ ( 235 ) Reported as Short-term investments $ 8 $ 0 $ 78 $ 0 Other current assets 218 0 137 0 Other long-term assets 0 0 43 0 Other current liabilities 0 ( 298 ) 0 ( 182 ) Other long-term liabilities 0 ( 195 ) 0 ( 53 ) Total $ 226 $ ( 493 ) $ 258 $ ( 235 ) Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $ 343 million and $ 550 million, respectively, as of June 30, 2022, and $ 395 million and $ 335 million, respectively, as of June 30, 2021. The following table presents the fair value of our derivatives instruments on a gross basis: (In millions) Level 1 Level 2 Level 3 Total June 30, 2022 Derivative assets $ 1 $ 349 $ 6 $ 356 Derivative liabilities 0 ( 551 ) 0 ( 551 ) June 30, 2021 Derivative assets 0 396 3 399 Derivative liabilities 0 ( 335 ) 0 ( 335 ) 75 PART II Item 8 Gains (losses) on derivative instruments recognized in other income (expense), net were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Designated as Fair Value Hedging Instruments Foreign exchange contracts Derivatives $ 49 $ 193 $ 1 Hedged items ( 50 ) ( 188 ) 3 Excluded from effectiveness assessment 4 30 139 Interest rate contracts Derivatives ( 92 ) ( 37 ) 93 Hedged items 108 53 ( 93 ) Designated as Cash Flow Hedging Instruments Foreign exchange contracts Amount reclassified from accumulated other comprehensive income ( 79 ) 17 0 Not Designated as Hedging Instruments Foreign exchange contracts 383 27 ( 123 ) Other contracts ( 72 ) 9 50 Gains (losses), net of tax, on derivative instruments recognized in our consolidated comprehensive income statements were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Designated as Cash Flow Hedging Instruments Foreign exchange contracts Included in effectiveness assessment $ ( 57 ) $ 34 $ ( 38 ) NOTE 6 — INVENTORIES The components of inventories were as follows: (In millions) June 30, 2022 2021 Raw materials $ 1,144 $ 1,190 Work in process 82 79 Finished goods 2,516 1,367 Total $ 3,742 $ 2,636 76 PART II Item 8 NOTE 7 — PROPERTY AND EQUIPMENT The components of property and equipment were as follows: (In millions) June 30, 2022 2021 Land $ 4,734 $ 3,660 Buildings and improvements 55,014 43,928 Leasehold improvements 7,819 6,884 Computer equipment and software 60,631 51,250 Furniture and equipment 5,860 5,344 Total, at cost 134,058 111,066 Accumulated depreciation ( 59,660 ) ( 51,351 ) Total, net $ 74,398 $ 59,715 During fiscal years 2022, 2021, and 2020, depreciation expense was $ 12.6 billion, $ 9.3 billion, and $ 10.7 billion, respectively. We have committed $ 8.5 billion, primarily related to datacenters, for the construction of new buildings, building improvements, and leasehold improvements as of June 30, 2022. NOTE 8 — BUSINESS COMBINATIONS Nuance Communications, Inc. On March 4, 2022 , we completed our acquisition of Nuance Communications, Inc. (“Nuance”) for a total purchase price of $ 18.8 billion, consisting primarily of cash. Nuance is a cloud and artificial intelligence (“AI”) software provider with healthcare and enterprise AI experience, and the acquisition will build on our industry-specific cloud offerings. The financial results of Nuance have been included in our consolidated financial statements since the date of the acquisition. Nuance is reported as part of our Intelligent Cloud segment. The purchase price allocation as of the date of acquisition was based on a preliminary valuation and is subject to revision as more detailed analyses are completed and additional information about the fair value of assets acquired and liabilities assumed becomes available. The major classes of assets and liabilities to which we have preliminarily allocated the purchase price were as follows: (In millions) Goodwill (a) $ 16,308 Intangible assets 4,365 Other assets 59 Other liabilities (b) ( 1,971 ) Total $ 18,761 (a) Goodwill was assigned to our Intelligent Cloud segment and was primarily attributed to increased synergies that are expected to be achieved from the integration of Nuance. None of the goodwill is expected to be deductible for income tax purposes. (b) Includes $ 986 million of convertible senior notes issued by Nuance in 2015 and 2017, of which $ 985 million was redeemed prior to June 30, 2022. The remaining $ 1 million of notes are redeemable through their respective maturity dates and are included in other current liabilities on our consolidated balance sheets as of June 30, 2022. 77 PART II Item 8 Following are the details of the purchase price allocated to the intangible assets acquired: (In millions, except average life) Amount Weighted Average Life Customer-related $ 2,610 9 years Technology-based 1,540 5 years Marketing-related 215 4 years Total $ 4,365 7 years ZeniMax Media Inc. On March 9, 2021 , we completed our acquisition of ZeniMax Media Inc. (“ZeniMax”), the parent company of Bethesda Softworks LLC (“Bethesda”), for a total purchase price of $ 8.1 billion, consisting primarily of cash. The purchase price included $ 766 million of cash and cash equivalents acquired. Bethesda is one of the largest, privately held game developers and publishers in the world, and brings a broad portfolio of games, technology, and talent to Xbox. The financial results of ZeniMax have been included in our consolidated financial statements since the date of the acquisition. ZeniMax is reported as part of our More Personal Computing segment. The allocation of the purchase price to goodwill was completed as of December 31, 2021. The major classes of assets and liabilities to which we have allocated the purchase price were as follows: (In millions) Cash and cash equivalents $ 766 Goodwill 5,510 Intangible assets 1,968 Other assets 121 Other liabilities ( 244 ) Total $ 8,121 Goodwill was assigned to our More Personal Computing segment. The goodwill was primarily attributed to increased synergies that are expected to be achieved from the integration of ZeniMax. None of the goodwill is expected to be deductible for income tax purposes. Following are details of the purchase price allocated to the intangible assets acquired: (In millions, except average life) Amount Weighted Average Life Technology-based $ 1,341 4 years Marketing-related 627 11 years Total $ 1,968 6 years Activision Blizzard, Inc. On January 18, 2022 , we entered into a definitive agreement to acquire Activision Blizzard , Inc. (“Activision Blizzard ”) for $ 95.00 per share in an all-cash transaction valued at $ 68.7 billion, inclusive of Activision Blizzard’s net cash. Activision Blizzard is a leader in game development and an interactive entertainment content publisher. The acquisition will accelerate the growth in our gaming business across mobile, PC, console, and cloud and will provide building blocks for the metaverse. The acquisition has been approved by Activision Blizzard’s shareholders, and we expect it to close in fiscal year 202 3 , subject to the satisfaction of certain regulatory approvals and other customary closing conditions. 78 PART II Item 8 NOTE 9 — GOODWILL Changes in the carrying amount of goodwill were as follows: (In millions) June 30, 2020 Acquisitions Other June 30, 2021 Acquisitions Other June 30, 2022 Productivity and Business Processes $ 24,190 $ 0 $ 127 $ 24,317 $ 599 $ ( 105 ) $ 24,811 Intelligent Cloud 12,697 505 54 13,256 16,879 (b) 47 (b) 30,182 More Personal Computing 6,464 5,556 (a) 118 (a) 12,138 648 ( 255 ) 12,531 Total $ 43,351 $ 6,061 $ 299 $ 49,711 $ 18,126 $ ( 313 ) $ 67,524 (a) Includes goodwill of $ 5.5 billion related to ZeniMax. See Note 8 – Business Combinations for further information . (b) Includes goodwill of $ 16.3 billion related to Nuance. See Note 8 – Business Combinations for further information. The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined. Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable. Goodwill Impairment We test goodwill for impairment annually on May 1 at the reporting unit level, primarily using a discounted cash flow methodology with a peer-based, risk-adjusted weighted average cost of capital. We believe use of a discounted cash flow approach is the most reliable indicator of the fair values of the businesses. No instances of impairment were identified in our May 1, 2022, May 1, 2021, or May 1, 2020 tests. As of June 30, 2022 and 2021, accumulated goodwill impairment was $ 11.3 billion. NOTE 10 — INTANGIBLE ASSETS The components of intangible assets, all of which are finite-lived, were as follows: (In millions) Gross Carrying Amount Accumulated Amortization Net Carrying Amount Gross Carrying Amount Accumulated Amortization Net Carrying Amount June 30, 2022 2021 Technology-based $ 11,277 $ ( 6,958 ) $ 4,319 $ 9,779 $ ( 7,007 ) $ 2,772 Customer-related 7,342 ( 3,171 ) 4,171 4,958 ( 2,859 ) 2,099 Marketing-related 4,942 ( 2,143 ) 2,799 4,792 ( 1,878 ) 2,914 Contract-based 16 ( 7 ) 9 446 ( 431 ) 15 Total $ 23,577 (a) $ ( 12,279 ) $ 11,298 $ 19,975 (b) $ ( 12,175 ) $ 7,800 (a) Includes intangible assets of $ 4.4 billion related to Nuance. See Note 8 – Business Combinations for further information. (b) Includes intangible assets of $ 2.0 billion related to ZeniMax. See Note 8 – Business Combinations for further information . No material impairments of intangible assets were identified during fiscal years 2022, 2021, or 2020. We estimate that we have no significant residual value related to our intangible assets. 79 PART II Item 8 The components of intangible assets acquired during the periods presented were as follows: (In millions) Amount Weighted Average Life Amount Weighted Average Life Year Ended June 30, 2022 2021 Technology-based $ 2,611 4 years $ 1,628 4 years Customer-related 2,837 9 years 96 4 years Marketing-related 233 4 years 625 6 years Contract-based 0 0 years 10 3 years Total $ 5,681 7 years $ 2,359 5 years Intangible assets amortization expense was $ 2.0 billion, $ 1.6 billion, and $ 1.6 billion for fiscal years 2022, 2021, and 2020, respectively. The following table outlines the estimated future amortization expense related to intangible assets held as of June 30, 2022: (In millions) Year Ending June 30, 2023 $ 2,654 2024 2,385 2025 1,631 2026 1,227 2027 809 Thereafter 2,592 Total $ 11,298 80 PART II Item 8 NOTE 11 — DEBT The components of debt were as follows: (In millions, issuance by calendar year) Maturities (calendar year) Stated Interest Rate Effective Interest Rate June 30, 2022 June 30, 2021 2009 issuance of $ 3.8 billion (a) 2039 5.20 % 5.24 % $ 520 $ 520 2010 issuance of $ 4.8 billion (a) 2040 4.50 % 4.57 % 486 486 2011 issuance of $ 2.3 billion (a) 2041 5.30 % 5.36 % 718 718 2012 issuance of $ 2.3 billion (a) 2022 – 2042 2.13 % – 3.50 % 2.24 % – 3.57 % 1,204 1,204 2013 issuance of $ 5.2 billion (a) 2023 – 2043 2.38 % – 4.88 % 2.47 % – 4.92 % 2,814 2,814 2013 issuance of € 4.1 billion 2028 – 2033 2.63 % – 3.13 % 2.69 % – 3.22 % 2,404 4,803 2015 issuance of $ 23.8 billion (a) 2022 – 2055 2.65 % – 4.75 % 2.72 % – 4.78 % 10,805 12,305 2016 issuance of $ 19.8 billion (a) 2023 – 2056 2.00 % – 3.95 % 2.10 % – 4.03 % 9,430 12,180 2017 issuance of $ 17.0 billion (a) 2024 – 2057 2.88 % – 4.50 % 3.04 % – 4.53 % 8,945 10,695 2020 issuance of $ 10.0 billion (a) 2050 – 2060 2.53 % – 2.68 % 2.53 % – 2.68 % 10,000 10,000 2021 issuance of $ 8.2 billion (a) 2052 – 2062 2.92 % – 3.04 % 2.92 % – 3.04 % 8,185 8,185 Total face value 55,511 63,910 Unamortized discount and issuance costs ( 471 ) ( 511 ) Hedge fair value adjustments ( b ) ( 68 ) 40 Premium on debt exchange (a) ( 5,191 ) ( 5,293 ) Total debt 49,781 58,146 Current portion of long-term debt ( 2,749 ) ( 8,072 ) Long-term debt $ 47,032 $ 50,074 (a) In March 2021 and June 2020, we exchanged a portion of our existing debt at a premium for cash and new debt with longer maturities. The premiums are amortized over the terms of the new debt. (b) Refer to Note 5 – Derivatives for further information on the interest rate swaps related to fixed-rate debt. As of June 30, 2022 and 2021, the estimated fair value of long-term debt, including the current portion, was $ 50.9 billion and $ 70.0 billion, respectively. The estimated fair values are based on Level 2 inputs. Debt in the table above is comprised of senior unsecured obligations and ranks equally with our other outstanding obligations. Interest is paid semi-annually, except for the Euro-denominated debt, which is paid annually. Cash paid for interest on our debt for fiscal years 2022, 2021, and 2020 was $ 1.9 billion, $ 2.0 billion, and $ 2.4 billion, respectively . The following table outlines maturities of our long-term debt, including the current portion, as of June 30, 2022: (In millions) Year Ending June 30, 2023 $ 2,750 2024 5,250 2025 2,250 2026 3,000 2027 8,000 Thereafter 34,261 Total $ 55,511 81 PART II Item 8 NOTE 12 — INCOME TAXES Provision for Income Taxes The components of the provision for income taxes were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Current Taxes U.S. federal $ 8,329 $ 3,285 $ 3,537 U.S. state and local 1,679 1,229 763 Foreign 6,672 5,467 4,444 Current taxes $ 16,680 $ 9,981 $ 8,744 Deferred Taxes U.S. federal $ ( 4,815 ) $ 25 $ 58 U.S. state and local ( 1,062 ) ( 204 ) ( 6 ) Foreign 175 29 ( 41 ) Deferred taxes $ ( 5,702 ) $ ( 150 ) $ 11 Provision for income taxes $ 10,978 $ 9,831 $ 8,755 U.S. and foreign components of income before income taxes were as follows: (In millions) Year Ended June 30, 2022 2021 2020 U.S. $ 47,837 $ 34,972 $ 24,116 Foreign 35,879 36,130 28,920 Income before income taxes $ 83,716 $ 71,102 $ 53,036 Effective Tax Rate The items accounting for the difference between income taxes computed at the U.S. federal statutory rate and our effective rate were as follows: Year Ended June 30, 2022 2021 2020 Federal statutory rate 21.0 % 21.0 % 21.0 % Effect of: Foreign earnings taxed at lower rates ( 1.3 ) % ( 2.7 ) % ( 3.7 ) % Impact of intangible property transfers ( 3.9 ) % 0 % 0 % Foreign-derived intangible income deduction ( 1.1 ) % ( 1.3 ) % ( 1.1 ) % State income taxes, net of federal benefit 1.4 % 1.4 % 1.3 % Research and development credit ( 0.9 ) % ( 0.9 ) % ( 1.1 ) % Excess tax benefits relating to stock-based compensation ( 1.9 ) % ( 2.4 ) % ( 2.2 ) % Interest, net 0.5 % 0.5 % 1.0 % Other reconciling items, net ( 0.7 ) % ( 1.8 ) % 1.3 % Effective rate 13.1 % 13.8 % 16.5 % In the first quarter of fiscal year 2022, we transferred certain intangible properties from our Puerto Rico subsidiary to the U.S. The transfer of intangible properties resulted in a $ 3.3 billion net income tax benefit in the first quarter of fiscal year 2022, as the value of future U.S. tax deductions exceeds the current tax liability from the U.S. global intangible low-taxed income (“GILTI”) tax. 82 PART II Item 8 We have historically paid India withholding taxes on software sales through distributor withholding and tax audit assessments in India. In March 2021, the India Supreme Court ruled favorably in the case of Engineering Analysis Centre of Excellence Private Limited vs The Commissioner of Income Tax for companies in 86 separate appeals, some dating back to 2012, holding that software sales are not subject to India withholding taxes. Although we were not a party to the appeals, our software sales in India were determined to be not subject to withholding taxes. Therefore, we recorded a net income tax benefit of $ 620 million in the third quarter of fiscal year 2021 to reflect the results of the India Supreme Court decision impacting fiscal year 1996 through fiscal year 2016 . The decrease from the federal statutory rate in fiscal year 2022 is primarily due to the net income tax benefit related to the transfer of intangible properties, earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations center in Ireland, and tax benefits relating to stock-based compensation. The decrease from the federal statutory rate in fiscal year 2021 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, tax benefits relating to stock-based compensation, and tax benefits from the India Supreme Court decision on withholding taxes. The decrease from the federal statutory rate in fiscal year 2020 is primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland and Puerto Rico, and tax benefits relating to stock-based compensation. In fiscal years 2022, 2021, and 2020, our foreign regional operating centers in Ireland and Puerto Rico, which are taxed at rates lower than the U.S. rate, generated 71 %, 82 %, and 86 % of our foreign income before tax. Other reconciling items, net consists primarily of tax credits and GILTI tax, and in fiscal year 2021, includes tax benefits from the India Supreme Court decision on withholding taxes. In fiscal years 2022, 2021, and 2020, there were no individually significant other reconciling items. The decrease in our effective tax rate for fiscal year 2022 compared to fiscal year 2021 was primarily due to a $ 3.3 billion net income tax benefit in the first quarter of fiscal year 2022 related to the transfer of intangible properties, offset in part by changes in the mix of our income before income taxes between the U.S. and foreign countries, as well as tax benefits in the prior year from the India Supreme Court decision on withholding taxes, an agreement between the U.S. and India tax authorities related to transfer pricing, and final Tax Cuts and Jobs Act (“TCJA”) regulations. The decrease in our effective tax rate for fiscal year 2021 compared to fiscal year 2020 was primarily due to tax benefits from the India Supreme Court decision on withholding taxes, an agreement between the U.S. and India tax authorities related to transfer pricing, final TCJA regulations, and an increase in tax benefits relating to stock-based compensation. 83 PART II Item 8 The components of the deferred income tax assets and liabilities were as follows: (In millions) June 30, 2022 2021 Deferred Income Tax Assets Stock-based compensation expense $ 601 $ 502 Accruals, reserves, and other expenses 2,874 2,960 Loss and credit carryforwards 1,546 1,090 Amortization 10,656 6,346 Leasing liabilities 4,557 4,060 Unearned revenue 2,876 2,659 Other 461 319 Deferred income tax assets 23,571 17,936 Less valuation allowance ( 1,012 ) ( 769 ) Deferred income tax assets, net of valuation allowance $ 22,559 $ 17,167 Deferred Income Tax Liabilities Book/tax basis differences in investments and debt $ ( 174 ) $ ( 2,381 ) Leasing assets ( 4,291 ) ( 3,834 ) Depreciation ( 1,602 ) ( 1,010 ) Deferred tax on foreign earnings ( 3,104 ) ( 2,815 ) Other ( 103 ) ( 144 ) Deferred income tax liabilities $ ( 9,274 ) $ ( 10,184 ) Net deferred income tax assets $ 13,285 $ 6,983 Reported As Other long-term assets $ 13,515 $ 7,181 Long-term deferred income tax liabilities ( 230 ) ( 198 ) Net deferred income tax assets $ 13,285 $ 6,983 Deferred income tax balances reflect the effects of temporary differences between the carrying amounts of assets and liabilities and their tax bases and are stated at enacted tax rates expected to be in effect when the taxes are paid or recovered. As of June 30, 2022, we had federal, state, and foreign net operating loss carryforwards of $ 318 million, $ 1.3 billion, and $ 2.1 billion, respectively. The federal and state net operating loss carryforwards will expire in various years from fiscal 2023 through 2042 , if not utilized. The majority of our foreign net operating loss carryforwards do not expire. Certain acquired net operating loss carryforwards are subject to an annual limitation but are expected to be realized with the exception of those which have a valuation allowance. As of June 30, 2022, we had $ 1.3 billion federal capital loss carryforwards for U.S. tax purposes from our acquisition of Nuance. The federal capital loss carryforwards are subject to an annual limitation and will expire in various years from fiscal 2023 through 2025 . The valuation allowance disclosed in the table above relates to the foreign net operating loss carryforwards, federal capital loss carryforwards, and other net deferred tax assets that may not be realized. Income taxes paid, net of refunds, were $ 16.0 billion, $ 13.4 billion, and $ 12.5 billion in fiscal years 2022, 2021, and 2020, respectively. Uncertain Tax Positions Gross unrecognized tax benefits related to uncertain tax positions as of June 30, 2022, 2021, and 2020, were $ 15.6 billion, $ 14.6 billion, and $ 13.8 billion, respectively, which were primarily included in long-term income taxes in our consolidated balance sheets. If recognized, the resulting tax benefit would affect our effective tax rates for fiscal years 2022, 2021, and 2020 by $ 13.3 billion, $ 12.5 billion, and $ 12.1 billion, respectively. 84 PART II Item 8 As of June 30, 2022, 2021, and 2020, we had accrued interest expense related to uncertain tax positions of $ 4.3 billion, $ 4.3 billion, and $ 4.0 billion, respectively, net of income tax benefits. The provision for income taxes for fiscal years 2022, 2021, and 2020 included interest expense related to uncertain tax positions of $ 36 million, $ 274 million, and $ 579 million, respectively, net of income tax benefits. The aggregate changes in the gross unrecognized tax benefits related to uncertain tax positions were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Beginning unrecognized tax benefits $ 14,550 $ 13,792 $ 13,146 Decreases related to settlements ( 317 ) ( 195 ) ( 31 ) Increases for tax positions related to the current year 1,145 790 647 Increases for tax positions related to prior years 461 461 366 Decreases for tax positions related to prior years ( 246 ) ( 297 ) ( 331 ) Decreases due to lapsed statutes of limitations 0 ( 1 ) ( 5 ) Ending unrecognized tax benefits $ 15,593 $ 14,550 $ 13,792 We settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of the IRS audits for tax years 2004 to 2013 and made a payment of $ 1.7 billion, including tax and interest. We remain under audit for tax years 2004 to 2017 . As of June 30, 2022, the primary unresolved issues for the IRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside the U.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2021 , some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. NOTE 13 — UNEARNED REVENUE Unearned revenue by segment was as follows: (In millions) June 30, 2022 2021 Productivity and Business Processes $ 24,558 $ 22,120 Intelligent Cloud 19,371 17,710 More Personal Computing 4,479 4,311 Total $ 48,408 $ 44,141 Changes in unearned revenue were as follows: (In millions) Year Ended June 30, 2022 Balance, beginning of period $ 44,141 Deferral of revenue 110,455 Recognition of unearned revenue ( 106,188 ) Balance, end of period $ 48,408 85 PART II Item 8 Revenue allocated to remaining performance obligations, which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods, was $ 193 billion as of June 30, 2022, of which $ 189 billion is related to the commercial portion of revenue. We expect to recognize approximately 45 % of this revenue over the next 12 months and the remainder thereafter. NOTE 14 — LEASES We have operating and finance leases for datacenters, corporate offices, research and development facilities, Microsoft Experience Centers, and certain equipment. Our leases have remaining lease terms of 1 year to 19 years, some of which include options to extend the leases for up to 5 years , and some of which include options to terminate the leases within 1 year. The components of lease expense were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Operating lease cost $ 2,461 $ 2,127 $ 2,043 Finance lease cost: Amortization of right-of-use assets $ 980 $ 921 $ 611 Interest on lease liabilities 429 386 336 Total finance lease cost $ 1,409 $ 1,307 $ 947 Supplemental cash flow information related to leases was as follows: (In millions) Year Ended June 30, 2022 2021 2020 Cash paid for amounts included in the measurement of lease liabilities: Operating cash flows from operating leases $ 2,368 $ 2,052 $ 1,829 Operating cash flows from finance leases 429 386 336 Financing cash flows from finance leases 896 648 409 Right-of-use assets obtained in exchange for lease obligations: Operating leases 5,268 4,380 3,677 Finance leases 4,234 3,290 3,467 86 PART II Item 8 Supplemental balance sheet information related to leases was as follows: (In millions, except lease term and discount rate) June 30, 2022 2021 Operating Leases Operating lease right-of-use assets $ 13,148 $ 11,088 Other current liabilities $ 2,228 $ 1,962 Operating lease liabilities 11,489 9,629 Total operating lease liabilities $ 13,717 $ 11,591 Finance Leases Property and equipment, at cost $ 17,388 $ 14,107 Accumulated depreciation ( 3,285 ) ( 2,306 ) Property and equipment, net $ 14,103 $ 11,801 Other current liabilities $ 1,060 $ 791 Other long-term liabilities 13,842 11,750 Total finance lease liabilities $ 14,902 $ 12,541 Weighted Average Remaining Lease Term Operating leases 8 years 8 years Finance leases 12 years 12 years Weighted Average Discount Rate Operating leases 2.1 % 2.2 % Finance leases 3.1 % 3.4 % The following table outlines maturities of our lease liabilities as of June 30, 2022: (In millions) Year Ending June 30, Operating Leases Finance Leases 2023 $ 2,456 $ 1,477 2024 2,278 1,487 2025 1,985 1,801 2026 1,625 1,483 2027 1,328 1,489 Thereafter 5,332 9,931 Total lease payments 15,004 17,668 Less imputed interest ( 1,287 ) ( 2,766 ) Total $ 13,717 $ 14,902 As of June 30, 2022, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $ 7.2 billion and $ 8.8 billion, respectively. These operating and finance leases will commence between fiscal year 2023 and fiscal year 2028 with lease terms of 1 year to 18 years . 87 PART II Item 8 NOTE 15 — CONTINGENCIES Antitrust Litigation and Claims China State Administration for Market Regulation Investigatio n In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. In 2019, the SAMR presented preliminary views as to certain possible violations of China’s Anti-Monopoly Law. Product-Related Litigation U.S. Cell Phone Litigation Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 46 lawsuits, including 45 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines. In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. In August 2018, the trial court issued an order striking portions of the plaintiffs’ expert reports. A hearing on general causation is scheduled for September of 2022 . Other Contingencies We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact in our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future. As of June 30, 2022, we accrued aggregate legal liabilities of $ 364 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $ 600 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact in our consolidated financial statements for the period in which the effects become reasonably estimable. 88 PART II Item 8 NOTE 16 — STOCKHOLDERS’ EQUITY Shares Outstanding Shares of common stock outstanding were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Balance, beginning of year 7,519 7,571 7,643 Issued 40 49 54 Repurchased ( 95 ) ( 101 ) ( 126 ) Balance, end of year 7,464 7,519 7,571 Share Repurchases On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in December 2016 and was completed in February 2020. On September 18, 2019, our Board of Directors approved a share repurchase program authorizing up to $ 40.0 billion in share repurchases. This share repurchase program commenced in February 2020 and was completed in November 2021. On September 14, 2021, our Board of Directors approved a share repurchase program authorizing up to $ 60.0 billion in share repurchases. This share repurchase program commenced in November 2021, following completion of the program approved on September 18, 2019, has no expiration date, and may be terminated at any time. As of June 30, 2022, $ 40.7 billion remained of this $ 60.0 billion share repurchase program. We repurchased the following shares of common stock under the share repurchase programs: (In millions) Shares Amount Shares Amount Shares Amount Year Ended June 30, 2022 2021 2020 First Quarter 21 $ 6,200 25 $ 5,270 29 $ 4,000 Second Quarter 20 6,233 27 5,750 32 4,600 Third Quarter 26 7,800 25 5,750 37 6,000 Fourth Quarter 28 7,800 24 6,200 28 5,088 Total 95 $ 28,033 101 $ 22,970 126 $ 19,688 All repurchases were made using cash resources. Shares repurchased during the fourth and third quarters of fiscal year 2022 were under the share repurchase program approved on September 14, 2021. Shares repurchased during the second quarter of fiscal year 2022 were under the share repurchase programs approved on both September 14, 2021 and September 18, 2019. Shares repurchased during the first quarter of fiscal year 2022, fiscal year 2021, and the fourth quarter of fiscal year 2020 were under the share repurchase program approved on September 18, 2019. Shares repurchased during the third quarter of fiscal year 2020 were under the share repurchase programs approved on both September 20, 2016 and September 18, 2019. All other shares repurchased were under the share repurchase program approved on September 20, 2016. The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards of $ 4.7 billion, $ 4.4 billion, and $ 3.3 billion for fiscal years 2022, 2021, and 2020, respectively. 89 PART II Item 8 Dividends Our Board of Directors declared the following dividends: Declaration Date Record Date Payment Date Dividend Per Share Amount Fiscal Year 2022 (In millions) September 14, 2021 November 18, 2021 December 9, 2021 $ 0.62 $ 4,652 December 7, 2021 February 17, 2022 March 10, 2022 0.62 4,645 March 14, 2022 May 19, 2022 June 9, 2022 0.62 4,632 June 14, 2022 August 18, 2022 September 8, 2022 0.62 4,627 Total $ 2.48 $ 18,556 Fiscal Year 2021 September 15, 2020 November 19, 2020 December 10, 2020 $ 0.56 $ 4,230 December 2, 2020 February 18, 2021 March 11, 2021 0.56 4,221 March 16, 2021 May 20, 2021 June 10, 2021 0.56 4,214 June 16, 2021 August 19, 2021 September 9, 2021 0.56 4,206 Total $ 2.24 $ 16,871 The dividend declared on June 14, 2022 was included in other current liabilities as of June 30, 2022. 90 PART II Item 8 NOTE 17 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The following table summarizes the changes in accumulated other comprehensive income (loss) by component : (In millions) Year Ended June 30, 2022 2021 2020 Derivatives Balance, beginning of period $ ( 19 ) $ ( 38 ) $ 0 Unrealized gains (losses), net of tax of $( 15 ) , $ 9 , and $( 10 ) ( 57 ) 34 ( 38 ) Reclassification adjustments for (gains) losses included in other income (expense), net 79 ( 17 ) 0 Tax expense (benefit) included in provision for income taxes ( 16 ) 2 0 Amounts reclassified from accumulated other comprehensive income (loss) 63 ( 15 ) 0 Net change related to derivatives, net of tax of $ 1 , $ 7 , and $( 10 ) 6 19 ( 38 ) Balance, end of period $ ( 13 ) $ ( 19 ) $ ( 38 ) Investments Balance, beginning of period $ 3,222 $ 5,478 $ 1,488 Unrealized gains (losses), net of tax of $( 1,440 ) , $( 589 ), and $ 1,057 ( 5,405 ) ( 2,216 ) 3,987 Reclassification adjustments for (gains) losses included in other income (expense), net 57 ( 63 ) 4 Tax expense (benefit) included in provision for income taxes ( 12 ) 13 ( 1 ) Amounts reclassified from accumulated other comprehensive income (loss) 45 ( 50 ) 3 Net change related to investments, net of tax of $( 1,428 ) , $( 602 ), and $ 1,058 ( 5,360 ) ( 2,266 ) 3,990 Cumulative effect of accounting changes 0 10 0 Balance, end of period $ ( 2,138 ) $ 3,222 $ 5,478 Translation Adjustments and Other Balance, beginning of period $ ( 1,381 ) $ ( 2,254 ) $ ( 1,828 ) Translation adjustments and other, net of tax of $ 0 , $( 9 ), and $ 1 ( 1,146 ) 873 ( 426 ) Balance, end of period $ ( 2,527 ) $ ( 1,381 ) $ ( 2,254 ) Accumulated other comprehensive income (loss), end of period $ ( 4,678 ) $ 1,822 $ 3,186 NOTE 18 — EMPLOYEE STOCK AND SAVINGS PLANS We grant stock-based compensation to employees and directors. Awards that expire or are canceled without delivery of shares generally become available for issuance under the plans. We issue new shares of Microsoft common stock to satisfy vesting of awards granted under our stock plans. We also have an ESPP for all eligible employees. Stock-based compensation expense and related income tax benefits were as follows: (In millions) Year Ended June 30, 2022 2021 2020 Stock-based compensation expense $ 7,502 $ 6,118 $ 5,289 Income tax benefits related to stock-based compensation 1,293 1,065 938 Stock Plans Stock awards entitle the holder to receive shares of Microsoft common stock as the award vests. Stock awards generally vest over a service period of four years or five years . 91 PART II Item 8 Executive Incentive Plan Under the Executive Incentive Plan, the Compensation Committee approves stock awards to executive officers and certain senior executives. RSUs generally vest ratably over a service period of four years . PSUs generally vest over a performance period of three years . The number of shares the PSU holder receives is based on the extent to which the corresponding performance goals have been achieved. Activity for All Stock Plans The fair value of stock awards was estimated on the date of grant using the following assumptions: Year ended June 30, 2022 2021 2020 Dividends per share (quarterly amounts) $ 0.56 – 0.62 $ 0.51 – 0.56 $ 0.46 – 0.51 Interest rates 0.03 % – 3.6 % 0.01 % – 1.5 % 0.1 % – 2.2 % During fiscal year 2022, the following activity occurred under our stock plans: Shares Weighted Average Grant-Date Fair Value (In millions) Stock Awards Nonvested balance, beginning of year 100 $ 152.51 Granted (a) 50 291.22 Vested ( 47 ) 143.10 Forfeited ( 10 ) 189.88 Nonvested balance, end of year 93 $ 227.59 (a) Includes 1 million, 2 million, and 2 million of PSUs granted at target and performance adjustments above target levels for fiscal years 2022, 2021, and 2020, respectively. As of June 30, 2022, there was approximately $ 16.7 billion of total unrecognized compensation costs related to stock awards. These costs are expected to be recognized over a weighted average period of three years . The weighted average grant-date fair value of stock awards granted was $ 291.22 , $ 221.13 , and $ 140.49 for fiscal years 2022, 2021, and 2020, respectively. The fair value of stock awards vested was $ 14.1 billion, $ 13.4 billion, and $ 10.1 billion, for fiscal years 2022, 2021, and 2020, respectively. As of June 30, 2022, an aggregate of 211 million shares were authorized for future grant under our stock plans. Employee Stock Purchase Plan We have an ESPP for all eligible employees. Shares of our common stock may be purchased by employees at three-month intervals at 90 % of the fair market value on the last trading day of each three-month period. Employees may purchase shares having a value not exceeding 15 % of their gross compensation during an offering period. Under the terms of the ESPP that were approved in 2012, the plan was set to terminate on December 31, 2022. At our 2021 Annual Shareholders Meeting, our shareholders approved a successor ESPP with a January 1, 2022 effective date and ten-year expiration of December 31, 2031. No additional shares were requested at this meeting. Employees purchased the following shares during the periods presented: (Shares in millions) Year Ended June 30, 2022 2021 2020 Shares purchased 7 8 9 Average price per share $ 259.55 $ 207.88 $ 142.22 As of June 30, 2022, 81 million shares of our common stock were reserved for future issuance through the ESPP. 92 PART II Item 8 Savings Plans We have savings plans in the U.S. that qualify under Section 401(k) of the Internal Revenue Code, and a number of savings plans in international locations. Eligible U.S. employees may contribute a portion of their salary into the savings plans, subject to certain limitations. We match a portion of each dollar a participant contributes into the plans. Employer-funded retirement benefits for all plans were $ 1.4 billion, $ 1.2 billion, and $ 1.0 billion in fiscal years 2022, 2021, and 2020, respectively, and were expensed as contributed. NOTE 19 — SEGMENT INFORMATION AND GEOGRAPHIC DATA In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. Our reportable segments are described below. Productivity and Business Processes Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises: • Office Commercial (Office 365 subscriptions, the Office 365 portion of Microsoft 365 Commercial subscriptions, and Office licensed on-premises), comprising Office, Exchange, SharePoint, Microsoft Teams, Office 365 Security and Compliance, and Microsoft Viva. • Office Consumer, including Microsoft 365 Consumer subscriptions, Office licensed on-premises, and other Office services. • LinkedIn, including Talent Solutions, Marketing Solutions, Premium Subscriptions, and Sales Solutions. • Dynamics business solutions, including Dynamics 365, comprising a set of intelligent, cloud-based applications across ERP, CRM, Customer Insights, Power Apps, and Power Automate; and on-premises ERP and CRM applications. Intelligent Cloud Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business and developers. This segment primarily comprises: • Server products and cloud services, including Azure and other cloud services; SQL Server, Windows Server, Visual Studio, System Center, and related Client Access Licenses (“CALs”); and Nuance and GitHub. • Enterprise Services, including Enterprise Support Services, Microsoft Consulting Services, and Nuance professional services. More Personal Computing Our More Personal Computing segment consists of products and services that put customers at the center of the experience with our technology. This segment primarily comprises: • Windows, including Windows OEM licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; and Windows Internet of Things. • Devices, including Surface and PC accessories. • Gaming, including Xbox hardware and Xbox content and services, comprising first- and third-party content (including games and in-game content), Xbox Game Pass and other subscriptions, Xbox Cloud Gaming, third-party disc royalties, advertising, and other cloud services. • Search and news advertising. 93 PART II Item 8 Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin. In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include legal, including settlements and fines, information technology, human resources, finance, excise taxes, field selling, shared facilities services, and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Segment revenue and operating income were as follows during the periods presented: (In millions) Year Ended June 30, 2022 2021 2020 Revenue Productivity and Business Processes $ 63,364 $ 53,915 $ 46,398 Intelligent Cloud 75,251 60,080 48,366 More Personal Computing 59,655 54,093 48,251 Total $ 198,270 $ 168,088 $ 143,015 Operating Income Productivity and Business Processes $ 29,687 $ 24,351 $ 18,724 Intelligent Cloud 32,721 26,126 18,324 More Personal Computing 20,975 19,439 15,911 Total $ 83,383 $ 69,916 $ 52,959 No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for fiscal years 2022, 2021, or 2020. Revenue, classified by the major geographic areas in which our customers were located, was as follows: (In millions) Year Ended June 30, 2022 2021 2020 United States (a) $ 100,218 $ 83,953 $ 73,160 Other countries 98,052 84,135 69,855 Total $ 198,270 $ 168,088 $ 143,015 (a) Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue. 94 PART II Item 8 Revenue, classified by significant product and service offerings, was as follows: (In millions) Year Ended June 30, 2022 2021 2020 Server products and cloud services $ 67,321 $ 52,589 $ 41,379 Office products and cloud services 44,862 39,872 35,316 Windows 24,761 22,488 21,510 Gaming 16,230 15,370 11,575 LinkedIn 13,816 10,289 8,077 Search and news advertising 11,591 9,267 8,524 Enterprise Services 7,407 6,943 6,409 Devices 6,991 6,791 6,457 Other 5,291 4,479 3,768 Total $ 198,270 $ 168,088 $ 143,015 We have recast certain previously reported amounts in the table above to conform to the way we internally manage and monitor our business. Our Microsoft Cloud (formerly commercial cloud) revenue, which includes Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $ 91.2 billion, $ 69.1 billion and $ 51.7 billion in fiscal years 2022, 2021, and 2020, respectively. These amounts are primarily included in Server products and cloud services, Office products and cloud services, and LinkedIn in the table above. Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss. Long-lived assets, excluding financial instruments and tax assets, classified by the location of the controlling statutory company and with countries over 10% of the total shown separately, were as follows: (In millions) June 30, 2022 2021 2020 United States $ 106,430 $ 76,153 $ 60,789 Ireland 15,505 13,303 12,734 Other countries 44,433 38,858 29,770 Total $ 166,368 $ 128,314 $ 103,293 95 PART II Item 8 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2022 and 2021, the related consolidated statements of income, comprehensive income, cash flows, and stockholders' equity, for each of the three years in the period ended June 30, 2022, and the related notes (collectively referred to as the "financial statements"). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2022 and 2021, and the results of its operations and its cash flows for each of the three years in the period ended June 30, 2022, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the Company's internal control over financial reporting as of June 30, 2022, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated July 28, 2022, expressed an unqualified opinion on the Company's internal control over financial reporting. Basis for Opinion These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion. Critical Audit Matters The critical audit matters communicated below are matters arising from the current-period audit of the financial statements that were communicated or required to be communicated to the audit committee and that (1) relate to accounts or disclosures that are material to the financial statements and (2) involved our especially challenging, subjective, or complex judgments. The communication of critical audit matters does not alter in any way our opinion on the financial statements, taken as a whole, and we are not, by communicating the critical audit matters below, providing separate opinions on the critical audit matters or on the accounts or disclosures to which they relate. 96 PART II Item 8 Revenue Recognition – Refer to Note 1 to the financial statements Critical Audit Matter Description The Company recognizes revenue upon transfer of control of promised products or services to customers in an amount that reflects the consideration the Company expects to receive in exchange for those products or services. The Company offers customers the ability to acquire multiple licenses of software products and services, including cloud-based services, in its customer agreements through its volume licensing programs. Significant judgment is exercised by the Company in determining revenue recognition for these customer agreements, and includes the following: • Determination of whether products and services are considered distinct performance obligations that should be accounted for separately versus together, such as software licenses and related services that are sold with cloud-based services. • The pattern of delivery (i.e., timing of when revenue is recognized) for each distinct performance obligation. • Identification and treatment of contract terms that may impact the timing and amount of revenue recognized (e.g., variable consideration, optional purchases, and free services). • Determination of stand-alone selling prices for each distinct performance obligation and for products and services that are not sold separately. Given these factors and due to the volume of transactions, the related audit effort in evaluating management's judgments in determining revenue recognition for these customer agreements was extensive and required a high degree of auditor judgment. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures related to the Company's revenue recognition for these customer agreements included the following: • We tested the effectiveness of controls related to the identification of distinct performance obligations, the determination of the timing of revenue recognition, and the estimation of variable consideration. • We evaluated management's significant accounting policies related to these customer agreements for reasonableness. • We selected a sample of customer agreements and performed the following procedures: - Obtained and read contract source documents for each selection, including master agreements, and other documents that were part of the agreement. - Tested management's identification and treatment of contract terms. - Assessed the terms in the customer agreement and evaluated the appropriateness of management's application of their accounting policies, along with their use of estimates, in the determination of revenue recognition conclusions. • We evaluated the reasonableness of management's estimate of stand-alone selling prices for products and services that are not sold separately. • We tested the mathematical accuracy of management's calculations of revenue and the associated timing of revenue recognized in the financial statements. 97 PART II Item 8 Income Taxes – Uncertain Tax Positions – Refer to Note 12 to the financial statements Critical Audit Matter Description The Company's long-term income taxes liability includes uncertain tax positions related to transfer pricing issues that remain unresolved with the Internal Revenue Service ("IRS"). The Company remains under IRS audit, or subject to IRS audit, for tax years subsequent to 2003. While the Company has settled a portion of the IRS audits, resolution of the remaining matters could have a material impact on the Company's financial statements. Conclusions on recognizing and measuring uncertain tax positions involve significant estimates and management judgment and include complex considerations of the Internal Revenue Code, related regulations, tax case laws, and prior-year audit settlements. Given the complexity and the subjective nature of the transfer pricing issues that remain unresolved with the IRS, evaluating management's estimates relating to their determination of uncertain tax positions required extensive audit effort and a high degree of auditor judgment, including involvement of our tax specialists. How the Critical Audit Matter Was Addressed in the Audit Our principal audit procedures to evaluate management's estimates of uncertain tax positions related to unresolved transfer pricing issues included the following: • We evaluated the appropriateness and consistency of management's methods and assumptions used in the identification, recognition, measurement, and disclosure of uncertain tax positions, which included testing the effectiveness of the related internal controls. • We read and evaluated management's documentation, including relevant accounting policies and information obtained by management from outside tax specialists, that detailed the basis of the uncertain tax positions. • We tested the reasonableness of management's judgments regarding the future resolution of the uncertain tax positions, including an evaluation of the technical merits of the uncertain tax positions. • For those uncertain tax positions that had not been effectively settled, we evaluated whether management had appropriately considered new information that could significantly change the recognition, measurement or disclosure of the uncertain tax positions. • We evaluated the reasonableness of management's estimates by considering how tax law, including statutes, regulations and case law, impacted management's judgments. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 28, 2022 We have served as the Company's auditor since 1983. 98 PART II Item 9, 9A ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. ITEM 9A. CONTROLS AND PROCEDURES Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures as required by Exchange Act Rule 13a-15(b) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective. REPORT OF MANAGEMENT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of our financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect our transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of our consolidated financial statements; providing reasonable assurance that receipts and expenditures of company assets are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use, or disposition of company assets that could have a material effect on our consolidated financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of our consolidated financial statements would be prevented or detected. Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that the Company’s internal control over financial reporting was effective as of June 30, 2022. There were no changes in our internal control over financial reporting during the quarter ended June 30, 2022 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Deloitte & Touche LLP has audited our internal control over financial reporting as of June 30, 2022; their report is included in Item 9A. 99 PART II Item 9A REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Stockholders and the Board of Directors of Microsoft Corporation Opinion on Internal Control over Financial Reporting We have audited the internal control over financial reporting of Microsoft Corporation and subsidiaries (the "Company") as of June 30, 2022, based on criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of June 30, 2022, based on criteria established in Internal Control — Integrated Framework (2013) issued by COSO. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (PCAOB), the consolidated financial statements as of and for the year ended June 30, 2022, of the Company and our report dated July 28, 2022, expressed an unqualified opinion on those financial statements. Basis for Opinion The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Report of Management on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. Definition and Limitations of Internal Control over Financial Reporting A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. /s/ D ELOITTE & T OUCHE LLP Seattle, Washington July 28, 2022 100 PART II, III Item 9B, 9C, 10, 11, 12, 13, 14 ITEM 9B. OTHER INFORMATION Not applicable. ITEM 9C. DISCLOSURE REGARDING FOREIGN JURISDICTIONS THAT PREVENT INSPECTIONS Not applicable. PART III ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE A list of our executive officers and biographical information appears in Part I, Item 1 of this Form 10-K. Information about our directors may be found under the caption “Our Director Nominees” in our Proxy Statement for the Annual Meeting of Shareholders to be held December 13, 2022 (the “Proxy Statement”). Information about our Audit Committee may be found under the caption “Board Committees” in the Proxy Statement. That information is incorporated herein by reference. We have adopted the Microsoft Finance Code of Professional Conduct (the “finance code of ethics”), a code of ethics that applies to our Chief Executive Officer, Chief Financial Officer, Chief Accounting Officer, and other finance organization employees. The finance code of ethics is publicly available on our website at https://aka.ms/FinanceCodeProfessionalConduct. If we make any substantive amendments to the finance code of ethics or grant any waiver, including any implicit waiver, from a provision of the code to our Chief Executive Officer, Chief Financial Officer, or Chief Accounting Officer, we will disclose the nature of the amendment or waiver on that website or in a report on Form 8-K. ITEM 11. EXECUTIVE COMPENSATION The information in the Proxy Statement set forth under the captions “Director Compensation,” “Named Executive Officer Compensation,” “Compensation Committee Report,” and, if required, “Compensation Committee Interlocks and Insider Participation,” is incorporated herein by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information in the Proxy Statement set forth under the captions “Stock Ownership Information,” “Principal Shareholders” and “Equity Compensation Plan Information” is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE The information set forth in the Proxy Statement under the captions “Director Independence Guidelines” and “Certain Relationships and Related Transactions” is incorporated herein by reference. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information concerning fees and services provided by our principal accountant, Deloitte & Touche LLP (PCAOB ID No. 34 ), appears in the Proxy Statement under the headings “Fees Billed by Deloitte & Touche” and “Policy on Audit Committee Pre-Approval of Audit and Permissible Non-Audit Services of Independent Auditor” and is incorporated herein by reference. 101 PART IV Item 15 PART IV ITEM 15. EXHIBIT AND FINANCIAL STATEMENT SCHEDULES (a) Financial Statements and Schedules The financial statements are set forth under Part II, Item 8 of this Form 10-K, as indexed below. Financial statement schedules have been omitted since they either are not required, not applicable, or the information is otherwise included. Index to Financial Statements Page Income Statements 57 Comprehensive Income Statements 58 Balance Sheets 59 Cash Flows Statements 60 Stockholders’ Equity Statements 61 Notes to Financial Statements 62 Report of Independent Registered Public Accounting Firm 96 (b) Exhibit Listing Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 3.1 Amended and Restated Articles of Incorporation of Microsoft Corporation 8-K 3.1 12/1/16 3.2 Bylaws of Microsoft Corporation 8-K 3.2 6/14/17 4.1 Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee (“Base Indenture”) S-3ASR 4.1 10/29/15 4.2 Form of First Supplemental Indenture for 2.95% Notes due 2014, 4.20% Notes due 2019, and 5.20% Notes due 2039, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Base Indenture 8-K 4.2 5/15/09 4.5 Form of Second Supplemental Indenture for 0.875% Notes due 2013, 1.625% Notes due 2015, 3.00% Notes due 2020, and 4.50% Notes due 2040, dated as of September 27, 2010, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 9/27/10 102 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.6 Third Supplemental Indenture for 2.500% Notes due 2016, 4.000% Notes due 2021, and 5.300% Notes due 2041, dated as of February 8, 2011, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 2/8/11 4.7 Fourth Supplemental Indenture for 0.875% Notes due 2017, 2.125% Notes due 2022, and 3.500% Notes due 2042, dated as of November 7, 2012, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 11/7/12 4.8 Fifth Supplemental Indenture for 2.625% Notes due 2033, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 5/1/13 4.9 Sixth Supplemental Indenture for 1.000% Notes due 2018, 2.375% Notes due 2023, and 3.750% Notes due 2043, dated as of May 2, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 5/1/13 4.10 Seventh Supplemental Indenture for 2.125% Notes due 2021 and 3.125% Notes due 2028, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.1 12/6/13 103 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.11 Eighth Supplemental Indenture for 1.625% Notes due 2018, 3.625% Notes due 2023, and 4.875% Notes due 2043, dated as of December 6, 2013, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee 8-K 4.2 12/6/13 4.12 Ninth Supplemental Indenture for 1.850% Notes due 2020, 2.375% Notes due 2022, 2.700% Notes due 2025, 3.500% Notes due 2035, 3.750% Notes due 2045, and 4.000% Notes due 2055, dated as of February 12, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/12/15 4.13 Tenth Supplemental Indenture for 1.300% Notes due 2018, 2.000% Notes due 2020, 2.650% Notes due 2022, 3.125% Notes due 2025, 4.200% Notes due 2035, 4.450% Notes due 2045, and 4.750% Notes due 2055, dated as of November 3, 2015, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 11/3/15 4.14 Eleventh Supplemental Indenture for 1.100% Notes due 2019, 1.550% Notes due 2021, 2.000% Notes due 2023, 2.400% Notes due 2026, 3.450% Notes due 2036, 3.700% Notes due 2046, and 3.950% Notes due 2056, dated as of August 8, 2016, between Microsoft Corporation and U.S. Bank, National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 8/5/16 104 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 4.15 Twelfth Supplemental Indenture for 1.850% Notes due 2020, 2.400% Notes due 2022, 2.875% Notes due 2024, 3.300% Notes due 2027, 4.100% Notes due 2037, 4.250% Notes due 2047, and 4.500% Notes due 2057, dated as of February 6, 2017, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 2/3/17 4.16 Thirteenth Supplemental Indenture for 2.525% Notes due 2050 and 2.675% Notes due 2060, dated as of June 1, 2020, between Microsoft Corporation and U.S. Bank National Association, as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 6/1/20 4.17 Fourteenth Supplemental Indenture for 2.921% Notes due 2052 and 3.041% Notes due 2062, dated as of March 17, 2021, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as Trustee, to the Indenture, dated as of May 18, 2009, between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 8-K 4.1 3/17/21 4.18 Description of Securities 10-K 6/30/19 4.16 8/1/19 10.1* Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.1 10/20/16 10.4* Microsoft Corporation Employee Stock Purchase Plan 10-K 6/30/12 10.4 7/26/12 10.5* Microsoft Corporation Deferred Compensation Plan 10-K 6/30/18 10.5 8/3/18 10.6* Microsoft Corporation 2017 Stock Plan DEF14A Annex C 10/16/17 10.7* Form of Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.26 4/26/18 10.8* Form of Performance Stock Award Agreement Under the Microsoft Corporation 2017 Stock Plan 10-Q 3/31/2018 10.27 4/26/18 10.9 Amended and Restated Officers’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-Q 9/30/16 10.12 10/20/16 105 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 10.10 Assumption of Beneficiaries’ Representative Obligations Under Amended and Restated Officers’ Indemnification Trust Agreement 10-K 6/30/2020 10.25 7/30/2020 10.11 Form of Indemnification Agreement and Amended and Restated Directors’ Indemnification Trust Agreement between Microsoft Corporation and The Bank of New York Mellon Trust Company, N.A., as trustee 10-K 6/30/19 10.13 8/1/19 10.12 Assumption of Beneficiaries’ Representative Obligations Under Amended and Restated Directors’ Indemnification Trust Agreement 10-K 6/30/2020 10.26 7/30/2020 10.14* Microsoft Corporation Deferred Compensation Plan for Non-Employee Directors 10-Q 12/31/17 10.14 1/31/18 10.15* Microsoft Corporation Executive Incentive Plan 8-K 10.1 9/19/18 10.19* Microsoft Corporation Executive Incentive Plan 10-Q 9/30/16 10.17 10/20/16 10.20* Form of Executive Incentive Plan (Executive Officer SAs) Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.18 10/20/16 10.21* Form of Executive Incentive Plan Performance Stock Award Agreement under the Microsoft Corporation 2001 Stock Plan 10-Q 9/30/16 10.25 10/20/16 10.22* Senior Executive Severance Benefit Plan 10-Q 9/30/16 10.22 10/20/16 10.23* Offer Letter, dated February 3, 2014, between Microsoft Corporation and Satya Nadella 8-K 10.1 2/4/14 10.24* Long-Term Performance Stock Award Agreement between Microsoft Corporation and Satya Nadella 10-Q 12/31/14 10.24 1/26/15 21 Subsidiaries of Registrant X 23.1 Consent of Independent Registered Public Accounting Firm X 31.1 Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 31.2 Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 X 32.1** Certification of Chief Executive Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 106 PART IV Item 15 Incorporated by Reference Exhibit Number Exhibit Description Filed Herewith Form Period Ending Exhibit Filing Date 32.2** Certification of Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 X 101.INS Inline XBRL Instance Document —the instance document does not appear in the Interactive Data File as its XBRL tags are embedded within the Inline XBRL document X 101.SCH Inline XBRL Taxonomy Extension Schema X 101.CAL Inline XBRL Taxonomy Extension Calculation Linkbase X 101.DEF Inline XBRL Taxonomy Extension Definition Linkbase X 101.LAB Inline XBRL Taxonomy Extension Label Linkbase X 101.PRE Inline XBRL Taxonomy Extension Presentation Linkbase X 104 Cover page formatted as Inline XBRL and contained in Exhibit 101 X * Indicates a management contract or compensatory plan or arrangement. ** Furnished, not filed. 107 PART IV Item 16 ITEM 16. FORM 10-K SUMMARY None. 108 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, in the City of Redmond, State of Washington, on July 28, 2022. M ICROSOFT C ORPORATION /s/ A LICE L. J OLLA Alice L. Jolla Corporate Vice President and Chief Accounting Officer (Principal Accounting Officer) 109 Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Registrant and in the capacities indicated on July 28, 2022. Signature Title /s/ S ATYA N ADELLA Satya Nadella Chairman and Chief Executive Officer (Principal Executive Officer) /s/ R EID H OFFMAN Reid Hoffman Director /s/ H UGH F. J OHNSTON Hugh F. Johnston Director /s/ T ERI L. L IST Teri L. List Director /s/ S ANDRA E. P ETERSON Sandra E. Peterson Director /s/ P ENNY S. P RITZKER Penny S. Pritzker Director /s/ C ARLOS A. R ODRIGUEZ Director Carlos A. Rodriguez /s/ C HARLES W. S CHARF Charles W. Scharf Director /s/ J OHN W. S TANTON John W. Stanton Director /s/ J OHN W. T HOMPSON Lead Independent Director John W. Thompson /s/ E MMA N. W ALMSLEY Emma N. Walmsley Director /s/ P ADMASREE W ARRIOR Padmasree Warrior Director /s/ A MY E. H OOD Amy E. Hood Executive Vice President and Chief Financial Officer (Principal Financial Officer) /s/ A LICE L. J OLLA Alice L. Jolla Corporate Vice President and Chief Accounting Officer (Principal Accounting Officer) 110 \ No newline at end of file diff --git a/src/data/output-json/full-submission.json b/src/data/output-json/full-submission.json new file mode 100644 index 0000000..1a2cee0 --- /dev/null +++ b/src/data/output-json/full-submission.json @@ -0,0 +1,22 @@ +{ + "id": "gen-CDcLf9HXVr4h67A5g32lIbcGCvGQ", + "model": "mistralai/mistral-7b-instruct:free", + "object": "chat.completion", + "created": 1714695661, + "choices": [ + { + "index": 0, + "message": { + "role": "assistant", + "content": " Can you provide me with more context on what you are asking? Are you asking me to provide a detailed financial analysis of Apple's financial statements? If so, I can provide you with the financial ratios and analysis of Apple's financial statements for the past several years. However, please provide me with specific years you are interested in." + }, + "finish_reason": "stop" + } + ], + "usage": { + "prompt_tokens": 21330, + "completion_tokens": 70, + "total_tokens": 21400, + "total_cost": 0 + } +} \ No newline at end of file